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97452_1993.txt

97452_1993

1993

97452

ITEM 1. BUSINESS. GENERAL Texas Gas Transmission Corporation (the Company) is a wholly owned subsidiary of Transco Gas Company, which is wholly owned by Transco Energy Company (Transco). As used herein, the term Transco refers to Transco Energy Company together with its wholly owned subsidiary companies unless the context otherwise requires. The Company is a major interstate natural gas pipeline company primarily engaged in the transportation of natural gas. The Company owns and operates an extensive pipeline system originating in major gas supply areas in the Louisiana Gulf Coast area and in East Texas and running generally north and east through Louisiana, Arkansas, Mississippi, Tennessee, Kentucky, Indiana and into Ohio, with smaller diameter lines extending into Illinois. The Company's system currently consists of approximately 6,050 miles of transmission lines. In conjunction with its pipeline facilities, the Company owns and operates ten underground storage reservoirs having a total capacity of 176.7 Bcf* and a working capacity of 86.5 Bcf. The Company's direct market area encompasses eight states in the South and Midwest, and includes the Memphis, Tennessee; Louisville, Kentucky; Cincinnati and Dayton, Ohio; and Indianapolis, Indiana metropolitan areas. The Company also has indirect market access to Northeast markets through interconnections with Columbia Gas Transmission Corporation (Columbia), CNG Transmission Corporation (CNG) and Texas Eastern Transmission Corporation (Texas Eastern). A large portion of the gas delivered by the Company to its market area is used for space heating, resulting in substantially higher daily requirements during winter months than summer months. TRANSPORTATION AND SALES Traditionally, interstate pipelines, including the Company, served primarily as merchants of natural gas, purchasing gas under long-term contracts with numerous producers in the production area and reselling gas to local utilities in the market area under long-term sales agreements. Such merchant service was known as bundled service. Regulatory policies under the Natural Gas Act of 1938 (NGA), relating to both pipeline rates and conditions of service, stressed security of gas supplies and service, and the recovery by pipelines of their prudently incurred costs of providing that service. However, commencing in 1984, the Federal Energy Regulatory Commission (FERC) issued a series of orders which have resulted in a major restructuring of the natural gas pipeline industry and its business practices. With FERC Order 380, issued in 1984, the FERC freed pipeline customers from their contractual obligations to purchase certain minimum levels of gas from their pipeline suppliers. With implementation of "open access" transportation rules contained in FERC Orders 436 and 500, the FERC afforded pipeline customers the opportunity to purchase gas from third parties with pipelines transporting this supply to the customers' markets. These FERC rules, coupled with a nationwide excess of deliverable natural gas, have resulted in increased competition for markets and decreases in natural gas prices. Faced with these changing conditions and declining sales, the Company altered the manner in which it had traditionally conducted its business. In September 1984, the Company began transporting gas for industrial end-users served by its direct-served local distribution customers. As excess natural gas became available and prices declined, transportation of customer-owned gas increased. In September 1988, the - --------------- * As used in this report, the term "Mcf" means thousand cubic feet, the term "MMcf" means million cubic feet, the term "Bcf" means billion cubic feet and the term "Tcf" means trillion cubic feet. Unless otherwise stated in this report, gas volumes are stated at a pressure base of 14.73 pounds per square inch and at 60 degrees Fahrenheit. Company accepted a certificate and became a permanent open access pipeline system under FERC Orders 436 and 500. On April 8, 1992, the FERC issued Order 636 which brought about fundamental changes in the way natural gas pipelines conduct their businesses. The FERC's stated purpose of FERC Order 636 was to improve the competitive structure of the natural gas pipeline industry by, among other things, unbundling a pipeline's merchant role from its transportation services; ensuring "equality" of transportation services; ensuring that shippers and customers have equal access to all sources of gas; providing "no-notice" firm transportation services that are equal in quality to bundled sales service; and changing rate design methodology from Modified Fixed Variable (MFV) to Straight Fixed Variable (SFV), unless the pipeline and its customers agree to a different form. FERC Order 636 also set forth methods for recovery by pipelines of costs associated with compliance under FERC Order 636 (transition costs), including unrecovered gas costs, gas supply realignment (GSR) costs, the cost of stranded pipeline investment and the costs of new facilities required. On August 3, 1992, the FERC issued Order 636-A which modified the original order to include one-part volumetric rates for small customers; the option of unbundled gas sales to small customers at a cost-based rate for a one-year period after the effective date of restructuring; a capacity release program; recovery of certain transition costs through interruptible transportation (IT) rates; and its use of either SFV methodology or other ratemaking techniques to design rates which result in equitable treatment of customers with varying load factors. On November 27, 1992, the FERC issued Order 636-B which reaffirmed several significant requirements of FERC Order 636-A. FERC Order 636-B marked the end of the restructuring rulemaking. The FERC has stated that it will not accept further rehearing petitions. FERC Orders 636, 636-A and 636-B are presently subject to court appeals. FERC Order 636 was implemented on the Company's system on November 1, 1993. As a result of FERC Order 636, the Company's gas sales have been fundamentally restructured. Prior to implementation of FERC Order 636, the Company had maximum peak-day sales delivery obligations in excess of 1.7 Bcf per day under individually certificated bundled sales contracts with more than 90 customers. Effective November 1, 1993, all of these bundled sales services ceased and were abandoned pursuant to FERC Order 636. Also as a result of FERC Order 636, the Company entered into a limited number of new unbundled sales contracts under the blanket certificate issued to it pursuant to that order. In compliance with another FERC decision, FERC Order 497, the sales under this unbundled merchant function are separately administered by Transco Gas Marketing Company (TGMC), an affiliate of the Company. TGMC has been appointed the Company's exclusive agent for the purpose of administering all existing and future sales and purchases for the Company after implementation of FERC Order 636, except for the auction transactions discussed below. Through its agent, TGMC, the Company currently sells gas to fewer than ten customers with a total deliverability obligation of substantially less than 0.2 Bcf per day. The only remaining sales administered by the Company are volumes purchased from a limited number of non-market-responsive gas purchase contracts which are auctioned each month to the highest bidder. The Company may file to recover the price differential, between the cost to buy the gas under these gas purchase contracts and the price realized from the resale of the gas at the auction, as a GSR cost pursuant to FERC Order 636. The following table sets forth the Company's total system deliveries, which exclude unbundled sales, and the mix of sales and transportation volumes for the periods shown: The Company's facilities are divided into five rate zones. Receipts and deliveries are made in four zones to serve sales and long-haul transportation markets. Receipts and deliveries in the remaining zone are made to serve sales and short-haul transportation markets in southern Louisiana. The decline in gas sales in 1993 primarily was attributable to the Company's implementation of FERC Order 636. The increase in transportation volumes resulted primarily from the Company's implementation of additional firm service for Transcontinental Gas Pipe Line Corporation (TGPL), an affiliate of the Company, implementation of FERC Order 636 and colder weather during the winter months of 1993 than the winter months of 1992. The revenues associated with short-haul transportation volumes are not material to the Company. The following table sets forth the names of the Company's five largest customers, along with the related sales and long-haul transportation volumes for the periods shown (expressed in Bcf). GAS SUPPLY During 1993, as part of the Company's restructuring under FERC Order 636, the Company has engaged in negotiations with suppliers which have resulted in the successful termination of approximately 90% of the deliverability under its non-market-responsive gas purchase contracts. Pursuant to FERC Order 636, the Company is entitled to file for recovery of up to 100% of its prudently incurred costs of terminating these contracts as GSR costs. The Company's remaining gas purchase commitments at the end of 1993 consist of both market-responsive and non-market-responsive contracts. Pursuant to FERC Order 636, gas purchased from the Company's non-market-responsive contracts is being resold at a monthly auction. The Company continues to pay to the supplier the actual contract price and is entitled to file for full recovery of the difference between said contract price and the amount received for sales at auction as GSR costs under FERC Order 636. The Company's market-responsive contracts are being separately managed by its marketing affiliate, TGMC. As a result of the foregoing, it is no longer material to the Company's business to have proved gas reserves committed to the Company. REGULATION INTERSTATE GAS PIPELINE OPERATIONS The Company is subject to regulation by the FERC as a "natural gas company" under the NGA. The NGA grants to the FERC authority over the construction and operation of pipeline and related facilities utilized in the transportation and sale of natural gas in interstate commerce, including the extension, enlargement and abandonment of such facilities. The FERC requires the filing of appropriate applications by natural gas companies showing that the extension, enlargement or abandonment of any facilities, as the case may be, is or will be required by a certificate of public convenience and necessity. The Company holds certificates of public convenience and necessity issued by the FERC authorizing it to construct and operate all pipelines, facilities and properties now in operation for which certificates are required, except for certain facilities that are not material or with respect to which the FERC has issued temporary certificates. The NGA also grants to the FERC authority to regulate rates, charges and terms of service for natural gas transported in interstate commerce or sold by a natural gas company in interstate commerce for resale, and to regulate curtailments of sales to customers. The FERC has authorized the Company to charge natural gas sales rates that are market-based. As necessary, the Company files with the FERC changes in its transportation and storage rates and charges designed to allow it to recover fully its costs of providing service to its interstate system customers, including a reasonable rate of return. Regulation of gas curtailment priorities and the importation of gas are, under the Department of Energy Reorganization Act of 1977, vested in the Secretary of Energy. The Company is 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 its interstate gas transmission facilities. REGULATORY MATTERS Pursuant to FERC Order 500, certain other pipelines, from which the Company made gas purchases (upstream pipelines), had received approval from the FERC to bill customers for their producer settlement costs. The Company had, in turn, received FERC approval to flow these costs through to its customers under the FERC Order 500 purchase deficiency-based direct bill methodology. Following the issuance of FERC Order 528, which replaced the purchase deficiency-based recovery methodology, the Company, in 1991, made a series of filings which reallocated these costs among customers pursuant to the provisions of FERC Order 528. Pursuant to these filings, the Company proposed to ultimately flow through to its customers approximately $64.3 million of costs billed from upstream pipelines. The FERC has issued orders accepting these filings subject to the ultimate outcome of the underlying filings of the upstream pipelines and future settlement by the Company. Although the total billings to the Company are unresolved and the Company may be required to refund certain amounts previously collected, the Company believes that it will be entitled to ultimately collect all amounts that are billed by the upstream pipelines. On September 2, 1993, the Company filed to recover 75% of $3.4 million of its producer settlement costs under FERC Order 528 which have resulted from reimbursements to producers for certain royalty payments. A FERC order, accepting the filing subject to refund and certain conditions, was issued on October 1, 1993, allowing for recovery of $0.9 million through direct bill and $1.7 million through a volumetric surcharge, both to be collected over a 12-month period which began October 3, 1993. FERC ORDER 94-A In 1983, the FERC issued FERC Order 94-A, which permitted producers to collect certain production-related gas costs from pipelines on a retroactive basis. The FERC subsequently issued orders allowing pipelines, including the Company, to bill their customers for such production-related costs through fixed monthly charges based on a customer's historical purchases. In February 1990, the D.C. Circuit Court overturned the FERC's authorization for pipelines to bill production-related costs to customers based on gas purchased in prior periods and remanded the matter to the FERC to determine an appropriate recovery mechanism. On April 28, 1992, the Company filed a settlement with the FERC providing for a reallocation of the FERC Order 94-A payments previously collected from customers. The settlement provided for net refunds of $8.1 million to certain customers and direct bill recovery of $2.7 million from other customers. The remaining $5.4 million would be recovered through the PGA mechanism. On February 11, 1993, the FERC issued an order approving the settlement. Certain parties filed for rehearing of the settlement. On January 12, 1994, the FERC issued its "Order Granting Rehearing" which found that the FERC had committed a legal error in allowing the previously mentioned direct bill of FERC Order 94-A costs. The effect of this order as issued would be to require the Company to make refunds to certain customers of $13.5 million, recover $2.7 million through direct billing of other customers, recover $5.4 million as part of the direct billing of its unrecovered purchase gas costs and absorb the remaining $5.4 million. The Company believes it is entitled to full recovery of these FERC-ordered costs. The Company has filed for rehearing of this order and has received an extension staying the effectiveness of this order until 30 days after the FERC rules on rehearing. The Company believes that its reserve for regulatory and rate matters is adequate to provide for any costs which the Company may ultimately be required to absorb. FERC ORDER 636 The Company has restructured its business to implement the provisions of FERC Order 636. On October 1, 1993, the FERC issued its "Order on Compliance Filing and Granting, In Part, and Denying, In Part, Rehearing and Clarification," which essentially approved the major aspects of the Company's FERC Order 636 compliance plan. The Company filed revised tariff sheets and other changes pursuant to the October 1, 1993 order on October 18, 1993, which permitted implementation of FERC Order 636 restructured services on November 1, 1993. On December 16, 1993, the FERC issued another order which required minor tariff modifications. The Company submitted a filing in compliance with this order on January 7, 1994. This filing was accepted by an order issued on February 10, 1994. The Company's analysis of FERC Order 636 indicates that the Company's transition costs are not currently expected to exceed $90 million, primarily related to GSR contract termination costs, GSR pricing differential costs incurred pursuant to the auction transactions, as discussed below, and unrecovered purchased gas costs. As of December 31, 1993, the Company had recorded $38 million of GSR costs. FERC Order 636 provides that pipelines should be allowed the opportunity to recover all prudently incurred transition costs. Therefore, the Company expects that any transition costs incurred should be recovered from its customers, subject only to the costs and other risks associated with the difference between the time such costs are incurred and the time when those costs may be recovered from customers. On January 28, 1994, the Company submitted its first filing to recover $11.5 million of GSR costs pursuant to the transition cost recovery provisions of FERC Order 636 and the Company's FERC-approved Gas Tariff. This amount represents 90% of the total GSR costs paid through November 30, 1993, which are expected to be recovered over a 12-month period by application of a demand surcharge to its firm transportation rates. The remaining 10% is expected to be recovered from interruptible transportation service. The Company plans to make quarterly filings to allow recovery of its GSR costs as such costs are paid. As part of its implementation of FERC Order 636, the Company has been allowed to retain its storage gas, in part to meet operational balancing needs on its system, and in part to meet the requirements of the Company's "no-notice" transportation service, which allows customers to temporarily draw from the Company's storage gas to be repaid in-kind during the following summer season. Although no assurances can be given, the Company does not believe the implementation of FERC Order 636 will have a material adverse effect on its financial position or results of operations. For further discussion of regulatory matters, see Note C of Notes to Financial Statements contained in Item 8 hereof. ENVIRONMENTAL MATTERS The Company is subject to extensive federal, state and local environmental laws and regulations which affect the Company's operations related to the construction and operation of its pipeline facilities. Appropriate governmental authorities may enforce these laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties, assessment and remediation requirements and injunctions as to future compliance. The Company's use and disposal of hazardous materials are subject to the requirements of the federal Toxic Substances Control Act (TSCA), the federal Resource Conservation and Recovery Act (RCRA) and comparable state statutes. The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), also known as "Superfund," imposes liability, without regard to fault or the legality of the original act, for release of a "hazardous substance" into the environment. Because these laws and regulations change from time to time, practices which have been acceptable to the industry and to the regulators have to be changed and assessment and monitoring have to be undertaken to determine whether those practices have damaged the environment and whether remediation is required. Since 1989, the Company has had studies underway to test its facilities for the presence of toxic and hazardous substances to determine to what extent, if any, remediation may be necessary. On the basis of the findings to date, the Company estimates that environmental assessment and remediation costs that will be incurred over the next five years under TSCA, RCRA, CERCLA and comparable state statutes will total approximately $7 million to $11 million. As of December 31, 1993, the Company had a reserve of approximately $7 million for these estimated costs. This estimate depends upon a number of assumptions concerning the scope of remediation that will be required at certain locations and the cost of remedial measures to be undertaken. The Company is continuing to conduct environmental assessments and is implementing a variety of remedial measures that may result in increases or decreases in the total estimated costs. The Company has used lubricating oils containing polychlorinated biphenyls (PCBs) and, although the use of such oils was discontinued in the 1970s, has discovered residual PCB contamination in equipment and soils at certain gas compressor station sites. The Company continues to work closely with the Environmental Protection Agency (EPA) and state regulatory authorities regarding PCB issues and has programs to assess and remediate such conditions where they exist, the costs of which are a significant portion of the $7 million to $11 million range discussed above. Proposed civil penalties have been assessed by the EPA against another major natural gas pipeline company for the alleged improper use and disposal of PCBs. Although similar penalties have not been asserted against the Company to date, no assurance can be given that the EPA may not seek such penalties in the future. The Company has either been named as a potentially responsible party (PRP) or received an information request regarding its potential involvement at four federal "Superfund" waste disposal sites and one state waste disposal site. Based on present volumetric estimates, the Company believes its estimated aggregate exposure for remediation of these sites is approximately $500,000. Liability under CERCLA (and applicable state law) can be joint and several with other PRPs. Although volumetric allocation is a factor in assessing liability, it is not necessarily determinative; thus the ultimate liability could be substantially greater than the amount estimated above. The anticipated remediation costs associated with these sites have been included in the $7 million to $11 million range discussed above. Although no assurances can be given, the Company does not believe that its PRP status will have a material adverse effect on its financial position or results of operations. The Company is currently recovering in its rates amounts approximately equal to its annual expenditures for these environmental matters. The Company considers these expenditures prudent operating and maintenance expenses incurred in the ordinary course of business and anticipates that these costs will continue to be recoverable through its rates. The Company is also subject to the Federal Clean Air Act and to the Federal Clean Air Act Amendments of 1990 (1990 Amendments), which added significantly to the existing requirements established by the Federal Clean Air Act. The 1990 Amendments required that the EPA issue new regulations, mainly related to mobile sources, air toxics, ozone non-attainment areas and acid rain. In addition, pursuant to the 1990 Amendments, the EPA has issued regulations under which states must implement new air pollution controls to achieve attainment of national ambient air quality standards in areas where they are not currently achieved. The Company has compressor stations in ozone non-attainment areas that could require additional air pollution reduction expenditures, depending on the requirements imposed. Additions to facilities for compliance with currently known Federal Clean Air Act standards and the 1990 Amendments are expected to cost in the range of $2 million to $3 million over the next five years and will be recorded as assets as the facilities are added. The Company considers costs associated with compliance with environmental laws to be prudent costs incurred in the ordinary course of business and, therefore, recoverable through its rates. RATES GENERAL The Company's rates are established primarily through the FERC ratemaking process. Key determinants in the ratemaking process are (i) volume throughput assumptions, (ii) costs of providing service and (iii) allowed rate of return. The allowed rate of return is determined by the FERC in each rate case. Rate design and the allocation of costs between the demand and commodity rates also impact profitability. RATE ISSUES In April 1990, the Company filed a general rate case (Docket No. RP90-104), which became effective in November 1990, subject to refund. A settlement agreement was filed on July 22, 1991, and approved by the FERC's "Order Granting Reconsideration," on October 21, 1992. Refunds, including interest, of $36.3 million were made to customers on January 19, 1993. On April 29, 1993, the Company filed a general rate case (Docket No. RP93-106) which, pursuant to the FERC's Suspension Order issued May 28, 1993, became effective on November 1, 1993, subject to refund. The new rate case was filed to satisfy the three-year filing requirements of the FERC's regulations, to recover increased operating costs, to provide a return on increased capital investment in pipeline facilities, to implement the SFV rate design methodology and to facilitate resolution of various rate-related issues in the Company's FERC Order 636 restructuring proceeding. The Company is currently engaged in settlement proceedings regarding this case. The Company has established a reserve, which it believes to be adequate, to reflect the difference between the rates currently being charged and the rates expected to ultimately be effective upon settlement of the case. During 1993, the Company made several filings under the provisions of its approved tariff and FERC Orders 483 and 483-A to reflect changes in its purchased gas costs. The Company also made filings to reflect changes in costs of transportation by others, pursuant to the Transport Cost Adjustment (TCA) tracker provisions of the approved tariff. Pursuant to that tariff, on December 30, 1993, the Company refunded $14.9 million of overcollected transportation costs. The Annual PGA filing for gas costs incurred through August 1992 (Docket No. TA93-1-18) was accepted by FERC Letter Order dated January 29, 1993, with no purchasing practice issues being raised. On November 1, 1993, the Company implemented the provisions of FERC Order 636 (see discussion on FERC Order 636). Pursuant to FERC Order 636, the Company terminated its PGA clause on that date. On January 31, 1994, the Company filed a limited Section 4(e) filing pursuant to its approved FERC Gas Tariff to direct bill the balance of its unrecovered purchase gas costs at October 31, 1993, to its former sales customers. This filing is necessary to recover $3.0 million of deferred gas costs applicable to the period September 1992 through October 1993. The Company has no outstanding deferred gas cost issues pending in any other proceeding. COMPETITION The Company and its primary market area competitors (ANR Pipeline Company, Panhandle Eastern Pipe Line Company, Trunkline Gas Company, Texas Eastern, Columbia, Tennessee Gas Pipeline Company and Midwestern Gas Transmission Company) implemented FERC Order 636 on their respective systems during the period May 1993 to November 1993. The Company and its major competitors all employ SFV rate design for firm transportation as mandated by FERC Order 636. Future utilization of the Company's pipeline capacity will depend on competition from other pipelines and alternative fuels, the general level of natural gas demand and weather conditions. Although some of the Company's major competitors implemented FERC Order 636 and SFV rates prior to the Company's implementation, the impact on the Company's throughput was minimal. The Company believes that under FERC Order 636, with SFV rates, its rate structure will remain competitive and surcharges for recovery of its total transition costs will not make its rates noncompetitive in its market as competitor pipelines are believed to have transition costs also to be recovered in their rates. The end-use markets of several of the Company's customers have the ability to switch to alternative fuels. To date, however, losses from fuel switching have not been significant. PIPELINE PROJECTS The Company is involved in expanding its markets through the following projects: LIBERTY PIPELINE COMPANY In 1992, Liberty Pipeline Company (Liberty Pipeline), a partnership of interstate pipelines and local distribution companies, filed for FERC approval to construct and operate a natural gas pipeline to provide up to 500 MMcf per day in firm transportation service to the greater New York City area. The partnership is comprised of subsidiaries of Transco, two other interstate pipelines and subsidiaries of three of Transco's customers in New York, collectively known as The New York Facilities Group. The pipeline is expected to cost approximately $162 million and is proposed to be in service by the 1995-1996 winter heating season, subject to timely FERC approval. Liberty Operating Company, a subsidiary of Transco, will construct and operate the pipeline for the partnership. The Company has filed two separate applications with the FERC requesting authority to expand its pipeline facilities to provide upstream transportation service in connection with the Liberty Pipeline project. One application requests authority to construct facilities at an estimated cost of $59.4 million to provide an incremental 100 MMcf per day of firm service for The New York Facilities Group and KIAC Partners, a cogeneration affiliate of The Brooklyn Union Gas Company. The Company plans, subject to FERC approval, to construct $16 million of facilities to implement 30.3 MMcf per day of this incremental firm service for the 1995-1996 winter heating season with the remaining $43.4 million of facilities being constructed during 1996 to provide the remaining 69.7 MMcf per day of incremental service for the 1996-1997 winter heating season. This volume of gas will ultimately be transported by TGPL for redelivery to Liberty Pipeline. The second application requests authority to expand the Company's facilities to provide an incremental 35 MMcf per day of firm service for The Power Authority of the State of New York at an estimated cost of $20.9 million. The Company plans, subject to FERC approval, to construct the $20.9 million of facilities during 1995 in order to implement the incremental firm transportation service for The Power Authority of New York in time for the 1995-1996 winter heating season. WEST TENNESSEE PIPELINE EXPANSION In January 1994, the Company received approval from the FERC to expand its Jackson-Ripley pipeline system located in northwest Tennessee to provide 4.6 MMcf per day of additional firm deliveries to three West Tennessee customers and to construct additional pipeline looping providing system security on that part of the Company's system. Construction is anticipated to commence during the first quarter of 1994. Total cost for this system expansion is expected to be $3.2 million, which the Company anticipates it will incur during the first half of 1994. EMPLOYEE RELATIONS The Company had 1,155 employees as of December 31, 1993. Certain of those employees were covered by a collective bargaining agreement. A favorable relationship existed between management and labor during the period. The International Chemical Workers Local 187 represents 199 of the Company's 494 field operating employees. The current collective bargaining agreement between the Company and Local 187 expires on April 30, 1995. The Company has a non-contributory pension plan and various other plans which provide regular active employees with group life, hospital and medical benefits as well as disability benefits and savings benefits. Officers and directors who are full-time employees may participate in these plans. ITEM 2. ITEM 2. PROPERTIES. See "Item 1. Business." ITEM 3. ITEM 3. LEGAL PROCEEDINGS. For a discussion of the Company's current legal proceedings, see Note D of Notes to Financial Statements contained in Item 8 hereof. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) and (b) As of December 31, 1993, all of the outstanding shares of the Company's common stock are owned by Transco Gas Company, a wholly owned subsidiary of Transco. The Company's common stock is not publicly traded and there exists no market for such common stock. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL ANALYSIS OF OPERATIONS 1993 COMPARED TO 1992 As discussed in Note C of Notes to Financial Statements contained in Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Texas Gas Transmission Corporation: We have audited the accompanying balance sheets of Texas Gas Transmission Corporation (a Delaware corporation and an indirect wholly owned subsidiary of Transco Energy Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings and paid-in capital and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Texas Gas Transmission Corporation as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in the index to 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. 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. Houston, Texas February 18, 1994 MANAGEMENT RESPONSIBILITY FOR FINANCIAL STATEMENTS The financial statements have been prepared by the management of Texas Gas Transmission Corporation (the Company) in conformity with generally accepted accounting principles. Management is responsible for the fairness and reliability of the financial statements and other financial data included in this report. In the preparation of the financial statements, it is necessary to make informed estimates and judgments of the effects of certain events and transactions based on currently available information. The Company maintains accounting and other controls that management believes provide reasonable assurance that financial records are reliable, assets are safeguarded and that transactions are properly recorded in accordance with management's authorizations. However, limitations exist in any system of internal control based upon the recognition that the cost of the system should not exceed benefits derived. The Company's independent auditors, Arthur Andersen & Co., are engaged to audit the financial statements and to express an opinion thereon. Their audit is conducted in accordance with generally accepted auditing standards to enable them to report that the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of the Company in conformity with generally accepted accounting principles. The Audit Committee of the Board of Directors of Transco Energy Company (Transco), composed of three directors who are not employees of Transco, meets regularly with the independent auditors and management. The independent auditors have full and free access to the Audit Committee and meet with them, with and without management being present, to discuss the results of their audits and the quality of financial reporting. TEXAS GAS TRANSMISSION CORPORATION BALANCE SHEETS (THOUSANDS OF DOLLARS) ASSETS The accompanying notes are an integral part of these financial statements. TEXAS GAS TRANSMISSION CORPORATION STATEMENTS OF INCOME (THOUSANDS OF DOLLARS) The accompanying notes are an integral part of these financial statements. TEXAS GAS TRANSMISSION CORPORATION STATEMENTS OF RETAINED EARNINGS AND PAID-IN CAPITAL (THOUSANDS OF DOLLARS) The accompanying notes are an integral part of these financial statements. TEXAS GAS TRANSMISSION CORPORATION STATEMENTS OF CASH FLOWS (THOUSANDS OF DOLLARS) The accompanying notes are an integral part of these financial statements. TEXAS GAS TRANSMISSION CORPORATION NOTES TO FINANCIAL STATEMENTS A. CORPORATE STRUCTURE AND CONTROL AND BASIS OF PRESENTATION Corporate Structure and Control Texas Gas Transmission Corporation (the Company) is a wholly owned subsidiary of Transco Gas Company (TGC), which is a wholly owned subsidiary of Transco Energy Company (Transco). As used herein, the term Transco refers to Transco Energy Company and its wholly owned subsidiary companies; the term TGMC refers to Transco Gas Marketing Company, a wholly owned subsidiary of Transco, and its wholly owned subsidiary companies; and the term TGPL refers to Transcontinental Gas Pipe Line Corporation, a wholly owned subsidiary of TGC, unless the context otherwise requires. The Company's sole subsidiary, Texam Offshore Gas Transmission, Inc. (Texam), was sold on July 20, 1992 (see Note H). The financial information presented for periods prior to the date of sale represents the Company's consolidated financial position and results of operations. Basis of Presentation The acquisition of the Company was accounted for using the purchase method of accounting. Accordingly, the acquisition debt and the purchase price were "pushed down" and recorded in the Company's financial statements. Retained earnings, deferred taxes and accumulated depreciation and amortization were eliminated at the date of acquisition. Included in property, plant and equipment as of the date of Transco's acquisition of the Company in 1989 is an aggregate of $226 million related to amounts in excess of the original cost of the regulated facilities. This amount is amortized over the estimated life of the assets acquired at approximately $9 million per year. Current Federal Energy Regulatory Commission (FERC) policy does not permit the Company to recover through its rates amounts in excess of original cost. Related Parties As a subsidiary of Transco, the Company engages in transactions with Transco and other Transco subsidiaries characteristic of group operations. For consolidated cash management purposes, the Company makes interest-bearing advances to Transco. These advances are represented by demand notes payable to the Company. Those amounts that the Company anticipates Transco will repay in the next twelve months are classified as current assets, while the remainder are classified as noncurrent. As general corporate policy, the interest rate on intercompany demand notes is 1 1/2% below the prime rate of Citibank, N.A. Net interest income on advances to or from associated companies was $9.4 million, $9.6 million and $11.5 million for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, respectively. See Note F for a discussion of Transco's credit facilities and indentures as they relate to the Company. Transco has a policy of charging subsidiary companies for management services provided by the parent company and other affiliated companies. During the years ended December 31, 1993, December 31, 1992 and December 31, 1991, the Company was charged $6.7 million, $4.2 million and $4.4 million, respectively, for Transco management services. Management considers the cost of these services reasonable. Effective November 1, 1993, the Company contracted with TGMC to become the Company's agent for the purpose of administering all existing and future gas sales and market-responsive purchase obligations, except for its auction gas transactions. Sales and purchases under this agreement do not impact the Company's results of operations. For the two months ended December 31, 1993, the Company paid TGMC agency fees of $0.7 million for these services. Included in the Company's gas sales revenues for the year ended December 31, 1993 is $4.2 million applicable to gas sales to the Company's affiliate, TGMC. There were no intercompany gas sales for the years ended December 31, 1992 and December 31, 1991. Included in the Company's gas transportation revenues for the years 1993, 1992 and 1991 are amounts applicable to transportation for affiliates as follows (expressed in thousands): Included in the Company's cost of gas sold for the years ended December 31, 1993 and December 31, 1992, is $11.1 million and $4.2 million, respectively, applicable to gas purchases from the Company's affiliate, TGMC. There were no intercompany gas purchases for the year ended December 31, 1991. B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Revenue Recognition The Company recognizes revenues for the sale and transportation of natural gas in the period of sale and in the period service is provided, respectively. Pursuant to FERC regulations, a portion of the revenues being collected may be subject to possible refunds upon final orders in pending rate cases. The Company has established reserves, where required, for such cases (see Note C for a summary of pending rate cases before the FERC). Costs Recoverable from/Refundable to Customers The Company has various mechanisms whereby rates or surcharges are established and revenues are collected and recognized based on estimated costs. Costs incurred over or under approved levels are deferred and recovered or refunded through future rate or surcharge adjustments (see Note C for a discussion of the Company's rate matters). Depreciation and Amortization The Company's depreciation rates are principally mandated by the FERC. Depreciation rates used for regulated gas plant facilities at year end 1993, 1992 and 1991 are as follows: Tax Policy Transco and its wholly owned subsidiaries file a consolidated federal income tax return. It is Transco's policy to charge or credit each subsidiary with an amount equivalent to its federal income tax expense or benefit computed as if each subsidiary had a separate return, but including benefits from each subsidiary's losses and tax credits that may be utilized only on a consolidated basis. Accounting for Income Taxes The Company uses the liability method of accounting for deferred taxes which requires, among other things, adjustments to the existing deferred tax balances for changes in tax rates, whereby such balances will more closely approximate the actual taxes to be paid. Liabilities to customers of $7.9 million and $15.2 million at December 31, 1993 and December 31, 1992, respectively, resulting from net tax rate reductions related to regulated operations and to be refunded to customers over the average remaining life of natural gas transmission plant, have been shown in the accompanying balance sheets as income taxes refundable to customers, the current portion of which is included in other current liabilities. In the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes," which superseded SFAS 96, "Accounting for Income Taxes." Due to the Company's prior adoption of SFAS 96 in 1987, the adoption of SFAS 109 did not have a material effect on its financial position or results of operations. Capitalized Interest The allowance for funds used during construction represents the cost of funds applicable to regulated natural gas transmission plant under construction as permitted by FERC regulatory practices. The allowance for borrowed funds used during construction and capitalized interest for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, was $0.2 million, $0.6 million and $0.7 million, respectively. The allowance for equity funds for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, was $0.5 million, $1.2 million and $1.3 million, respectively. Gas in Storage As part of its implementation of FERC Order 636, the Company has been allowed to retain its storage gas, in part to meet operational balancing needs on its system, and in part to meet the requirements of the Company's "no-notice" transportation service, which allows customers to temporarily draw from the Company's storage gas to be repaid in-kind during the following summer season. As a result, the Company's gas stored underground has been reclassified from current assets to other noncurrent assets. Gas Imbalances In the course of providing transportation services to customers, the Company may receive different quantities of gas from shippers than the quantities delivered on behalf of those shippers. These transactions result in imbalances which are repaid or recovered in cash or through the receipt or delivery of gas in the future. Customer imbalances to be repaid or recovered in-kind are recorded as transportation and exchange gas receivable or payable on the accompanying balance sheet. Settlement of imbalances requires agreement between the pipelines and shippers as to allocations of volumes to specific transportation contracts and timing of delivery of gas based on operational conditions. The Company's tariff includes a provision whereby imbalances generated after November 1, 1993 are settled on a monthly basis. The Company anticipates filing for a mechanism whereby imbalances pre-dating November 1, 1993 will be recovered or repaid in cash or through the future receipt or delivery of gas upon agreements for allocation and as permitted by operating conditions. Cash Flows from Operating Activities The Company uses the indirect method to report cash flows from operating activities, which requires adjustments to net income to reconcile to net cash flows from operating activities. The Company includes short-term highly-liquid investments that have a maturity of three months or less in cash equivalents. Postemployment Benefits The Financial Accounting Standards Board has issued SFAS 112, "Employers' Accounting for Post employment Benefits," which requires the Company, effective January 1994, to accrue the estimated cost of providing postemployment benefits to former or inactive employees after employment but before retirement if the obligation is attributable to employees' services previously rendered, employees' rights to those benefits accumulate or vest, payment of the benefits is probable and the amount of the benefits can be reasonably estimated. The Company does not expect adoption of SFAS 112 to have a material effect on its financial position or results of operations. Reclassifications Certain reclassifications have been made in the 1992 and 1991 financial statements to conform to the 1993 presentation. C. REGULATORY AND RATE MATTERS FERC Order 636 In 1992, the FERC issued Order 636 which brought about fundamental changes in the way natural gas pipelines conduct their businesses. The FERC's stated purpose of Order 636 was to improve the competitive structure of the natural gas pipeline industry by, among other things, unbundling a pipeline's merchant role from its transportation services; ensuring "equality" of transportation services; ensuring that shippers and customers have equal access to all sources of gas; providing "no-notice" firm transportation service that is equal in quality to bundled sales service; and changing rate design methodology from Modified Fixed Variable (MFV) to Straight Fixed Variable (SFV), unless the pipeline company and its customers agree to a different form. FERC Order 636 also set forth methods for recovery by pipelines of costs associated with compliance under FERC Order 636 (transition costs), including unrecovered gas costs, GSR costs, the cost of stranded pipeline investment and costs of new facilities required. The Company has restructured its business to implement the provisions of FERC Order 636. On October 1, 1993, the FERC issued its "Order on Compliance Filing and Granting, In Part, and Denying, In Part, Rehearing and Clarification," which essentially approved the major aspects of the Company's FERC Order 636 compliance plan. The Company filed revised tariff sheets and other changes pursuant to the October 1, 1993 order on October 18, 1993, which permitted implementation of FERC Order 636 restructured services on November 1, 1993. On December 16, 1993, the FERC issued another order which required minor tariff modifications. The Company submitted a filing in compliance with this order on January 7, 1994. This filing was accepted by an order issued on February 10, 1994. The Company's analysis of FERC Order 636 indicates that the Company's transition costs are not currently expected to exceed $90 million, primarily related to GSR contract termination costs, GSR pricing differential costs incurred pursuant to the auction process and unrecovered purchased gas costs. As of December 31, 1993, the Company had paid or committed to pay $38 million of GSR costs, as discussed below in "Long-term Gas Purchase Contracts." FERC Order 636 provides that pipelines should be allowed the opportunity to recover all prudently incurred transition costs. Therefore, the Company expects that any transition costs incurred should be recovered from its customers, subject only to the costs and other risks associated with the difference between the time such costs are incurred and the time when those costs may be recovered from customers. As part of its implementation of FERC Order 636, the Company has been allowed to retain its storage gas, in part to meet operational balancing needs on its system, and in part to meet the requirements of the Company's "no-notice" transportation service, which allows customers to temporarily draw from the Company's storage gas to be repaid in-kind during the following summer season. Although no assurances can be given, the Company does not believe the implementation of FERC Order 636 will have a material adverse effect on its financial position or results of operations. General Rate Issues In April 1990, the Company filed a general rate case (Docket No. RP90-104), which became effective in November 1990, subject to refund. A settlement agreement was filed on July 22, 1991, and approved by the FERC's "Order Granting Reconsideration," on October 21, 1992. The refunds, including interest, of $36.3 million were distributed to customers on January 19, 1993. On April 29, 1993, the Company filed a general rate case (Docket No. RP93-106) which, pursuant to the FERC's Suspension Order issued May 28, 1993, became effective on November 1, 1993, subject to refund. The new rate case was filed to satisfy the three-year filing requirement of the FERC's regulations, to recover increased operating costs, to provide a return on increased capital investment in pipeline facilities, to implement the SFV rate design methodology and to facilitate resolution of various rate-related issues in the Company's FERC Order 636 restructuring proceeding. The Company is currently engaged in settlement proceedings regarding this case. The Company has established a reserve, which it believes to be adequate, to reflect the difference between the rates currently being collected and the rates expected to ultimately be effective upon settlement of the rate case. During 1993, the Company made several filings under the provisions of its approved tariff and FERC Orders 483 and 483-A to reflect changes in its purchased gas costs. The Company also made a filing to reflect changes in costs of transportation by others, pursuant to the Transport Cost Adjustment (TCA) tracker provisions of the approved tariff. Pursuant to that tariff, on December 30, 1993, the Company refunded $14.9 million of overcollected transportation costs. The Annual PGA filing for gas costs incurred through August 1991 (Docket No. TA92-2-18) was accepted by FERC Letter Orders dated January 31, 1992 and May 22, 1992, with no purchasing practice issues being raised. The Annual PGA filing for gas costs incurred through August 1992 (Docket No. TA93-1-18) was accepted by FERC Letter Order dated January 29, 1993, with no purchasing practice issues being raised. On November 1, 1993, the Company implemented the provisions of FERC Order 636 (see discussion on FERC Order 636). Pursuant to FERC Order 636, the Company terminated its PGA clause on that date. On January 31, 1994, the Company filed a limited Section 4(e) filing, pursuant to its FERC-approved FERC Gas Tariff, to direct bill the balance of its unrecovered purchase gas costs at October 31, 1993 to its former sales customers. This filing is necessary to recover $3.0 million of deferred gas costs applicable to the period September 1992 through October 1993. The Company has no outstanding deferred gas cost issues pending in any other proceeding. FERC Orders 500 and 528 Pursuant to FERC Order 500, certain other pipelines, from which the Company made gas purchases (upstream pipelines), had received approval from the FERC to bill customers for their producer settlement costs. The Company had, in turn, received FERC approval to flow these costs through to its customers under the FERC Order 500 purchase deficiency-based direct bill methodology. Following the issuance of FERC Order 528, which replaced the purchase deficiency-based recovery methodology, the Company, in 1991, made a series of filings which reallocated these costs among customers. Pursuant to these filings, the Company proposed to ultimately flow through to its customers approximately $64.3 million of costs billed from upstream pipelines. The FERC has issued orders accepting these filings subject to the ultimate outcome of the underlying filings of the upstream pipelines and future settlement by the Company. Although the total billings to the Company are unresolved and the Company may be required to refund certain amounts previously collected, the Company believes that it will be entitled to ultimately collect all amounts that are billed by the upstream pipelines. On September 2, 1993, the Company filed to recover 75% of $3.4 million of its producer settlement costs under FERC Order 528 which have resulted from reimbursements to producers for certain royalty payments. A FERC order, accepting the filing subject to refund and certain conditions, was issued on October 1, 1993, allowing for recovery of $0.9 million through direct bill and $1.7 million through a volumetric surcharge, both to be collected over a 12-month period which began October 3, 1993. FERC Order 94-A In 1983, the FERC issued FERC Order 94-A, which permitted producers to collect certain production-related gas costs from pipelines on a retroactive basis. The FERC subsequently issued orders allowing pipelines, including the Company, to direct bill their customers for such production-related costs through fixed monthly charges based on a customer's historical purchases. In February 1990, the D. C. Circuit Court overturned the FERC's authorization for pipelines to bill production-related costs to customers based on gas purchased in prior periods and remanded the matter to the FERC to determine an appropriate recovery mechanism. On April 28, 1992, the Company filed a settlement with the FERC providing for a reallocation of the FERC Order 94-A payments previously collected from customers. The settlement provided for net refunds of $8.1 million to certain customers and direct bill recovery of $2.7 million from other customers. The remaining $5.4 million would be recovered through the PGA mechanism. On February 11, 1993, the FERC issued an order approving the settlement. Certain parties filed for rehearing of the settlement. On January 12, 1994, the FERC issued its "Order Granting Rehearing" which found that the FERC had committed a legal error in allowing the previously mentioned direct bill of FERC Order 94-A costs. The effect of this order as issued would be to require the Company to make refunds to certain customers of $13.5 million, recover $2.7 million through direct billing of other customers, recover $5.4 million as part of the direct billing of its unrecovered purchase gas costs and absorb the remaining $5.4 million. The Company believes it is entitled to full recovery of these FERC-ordered costs. The Company has filed for rehearing of this order and has received an extension staying the effectiveness of this order until 30 days after the FERC rules on rehearing. The Company believes that its reserve for regulatory and rate matters is adequate to provide for any costs which the Company may ultimately be required to absorb. Reserve for Regulatory and Rate Matters The Company has established reserves for its outstanding regulatory and rate matters which it believes are adequate to provide for any costs incurred or refunds to be made in regard to the resolution of its regulatory and rate issues, including general rate matters and the royalty claims discussed in Note D. Although no assurances can be given, the Company believes that the resolution of these matters will not have a material adverse effect on its financial position or results of operations. Long-term Gas Purchase Contracts During 1993, as part of the Company's restructuring under FERC Order 636, the Company engaged in negotiations which have resulted in the successful termination of approximately 90% of the Company's deliverability under its non-market responsive gas purchase contracts. Gas purchased under its remaining non-market responsive contracts is being resold at a monthly auction pursuant to FERC Order 636. The Company continues to pay to the supplier the actual contract price and is entitled to file for full recovery of the difference between said contract price and the amount received for sales at auction as GSR costs under FERC Order 636. Through December 31, 1993, the Company had paid or committed to pay a total of $38.2 million for GSR costs, primarily as a result of the contract terminations. As of December 31, 1993, the Company had paid $13.4 million of such costs; the remaining $24.8 million is recorded as a current liability in the accompanying balance sheet. Pursuant to FERC Order 636, the Company may file to recover 100% of these costs as GSR costs. On January 28, 1994, the Company submitted its first filing to recover $11.5 million of GSR costs pursuant to the transition costs recovery provisions of FERC Order 636 and the Company's approved FERC Gas Tariff. This amount represents 90% of the total GSR costs paid through November 30, 1993, which are expected to be recovered over a 12-month period by application of a surcharge to its firm transportation demand rates. The remaining 10% is expected to be recovered from interruptible transportation service. The Company plans to make quarterly filings to allow recovery of its GSR costs as such costs are paid. The Company's market-responsive gas purchase contracts are being separately managed by its marketing affiliate, TGMC. Environmental Matters The Company is subject to extensive federal, state and local environmental laws and regulations which affect the Company's operations related to the construction and operation of its pipeline facilities. Appropriate governmental authorities may enforce these laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties, assessment and remediation requirements and injunctions as to future compliance. The Company's use and disposal of hazardous materials are subject to the requirements of the federal Toxic Substances Control Act (TSCA), the federal Resource Conservation and Recovery Act (RCRA) and comparable state statutes. The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), also known as "Superfund," imposes liability, without regard to fault or the legality of the original act, for release of a "hazardous substance" into the environment. Because these laws and regulations change from time to time, practices which have been acceptable to the industry and to the regulators have to be changed and assessment and monitoring have to be undertaken to determine whether those practices have damaged the environment and whether remediation is required. Since 1989, the Company has had studies underway to test its facilities for the presence of toxic and hazardous substances to determine to what extent, if any, remediation may be necessary. On the basis of the findings to date, the Company estimates that environmental assessment and remediation costs that will be incurred over the next five years under TSCA, RCRA, CERCLA and comparable state statutes will total approximately $7 million to $11 million. As of December 31, 1993, the Company had a reserve of approximately $7 million for these estimated costs. This estimate depends upon a number of assumptions concerning the scope of remediation that will be required at certain locations and the cost of remedial measures to be undertaken. The Company is continuing to conduct environmental assessments and is implementing a variety of remedial measures that may result in increases or decreases in the total estimated costs. The Company is currently recovering in its rates amounts approximately equal to its annual expenditures for these environmental matters. The Company considers these expenditures prudent operating and maintenance expenses incurred in the ordinary course of business and anticipates that these costs will continue to be recoverable through its rates. The Company has used lubricating oils containing polychlorinated biphenyls (PCBs) and, although the use of such oils was discontinued in the 1970's, has discovered residual PCB contamination in equipment and soils at certain gas compressor station sites. The Company continues to work closely with the Environmental Protection Agency (EPA) and state regulatory authorities regarding PCB issues and has programs to assess and remediate such conditions where they exist, the costs of which are a significant portion of the $7 million to $11 million range discussed above. Proposed civil penalties have been assessed by the EPA against another major natural gas pipeline company for the alleged improper use and disposal of PCBs. Although similar penalties have not been asserted against the Company to date, no assurance can be given that the EPA may not seek such penalties in the future. The Company has either been named as a potentially responsible party (PRP) or received an information request regarding its potential involvement at four federal "Superfund" waste disposal sites and one state waste disposal site. Based on present volumetric estimates, the Company believes its estimated aggregate exposure for remediation of these sites is approximately $500,000. Liability under CERCLA (and applicable state law) can be joint and several with other PRPs. Although volumetric allocation is a factor in assessing liability, it is not necessarily determinative; thus the ultimate liability could be substantially greater than the amount estimated above. The anticipated remediation costs associated with these sites have been included in the $7 million to $11 million range discussed above. Although no assurances can be given, the Company does not believe that its PRP status will have a material adverse effect on its operations. The Company is also subject to the Federal Clean Air Act and to the Federal Clean Air Act Amendments of 1990 (1990 Amendments), which added significantly to the existing requirements established by the Federal Clean Air Act. The 1990 Amendments required that the EPA issue new regulations, mainly related to mobile sources, air toxics, ozone non-attainment areas and acid rain. In addition, pursuant to the 1990 Amendments, the EPA has issued regulations under which states must implement new air pollution controls to achieve attainment of national ambient air quality standards in areas where they are not currently achieved. The Company has compressor stations in ozone non-attainment areas that could require additional air pollution reduction expenditures, depending on the requirements imposed. Additions to facilities for compliance with currently known Federal Clean Air Act standards and the 1990 Amendments are expected to cost in the range of $2 million to $3 million over the next five years and will be recorded as assets as the facilities are added. D. ROYALTY CLAIMS AND LEGAL PROCEEDINGS In connection with the Company's renegotiations of supply contracts with producers to resolve take-or-pay and other contract claims, the Company has entered into certain settlements which may require the indemnification by the Company of certain claims for royalties which a producer may be required to pay as a result of such settlements. On October 15, 1992, the United States Court of Appeals for the Fifth Circuit and the Louisiana Supreme Court, with respect to the same litigation in applying Louisiana law, determined that royalties are due on take-or-pay payments under the royalty clauses of the specific mineral leases reviewed by the Courts. Furthermore, the State Mineral Board of Louisiana has passed a resolution directing the State's lessees to pay to the State royalties on gas contract settlement payments. As a result of these and related developments, the Company has been made aware of demands on producers for additional royalties and may receive other demands which could result in claims against the Company pursuant to the indemnification provisions in its settlements. Indemnification for royalties will depend on, among other things, the specific lease provisions between the producer and the lessor and the terms of the settlement between the producer and the Company. The Company may file to recover 75% of any such amounts it may be required to pay pursuant to indemnifications for royalties. As discussed in Note C (see discussion on FERC Orders 500 and 528), on September 2, 1993, the Company made a filing pursuant to FERC Order 528 to recover 75% of approximately $3.4 million in additional take-or-pay settlement payments made by the Company as a result of certain obligations to indemnify a producer against additional royalty obligations arising out of the producer's prior take-or-pay settlement with the Company. Some additional indemnity payments may also be required with respect to such royalties. In addition, two lawsuits have been filed against the Company in Louisiana, seeking reimbursement of certain royalties allegedly incurred by the producers on amounts previously paid the producers by the Company to settle past take-or-pay disputes and to reform the gas purchase contract pursuant to an "excess royalty" clause in a gas purchase contract. The amount in dispute is estimated to be less than $10 million. The Company disputes the application of the "excess royalty" clause to the particular royalties in question; however, to the extent any obligation to reimburse the producers exists, it is subject to the Company's ability to include such payments in its rates or cost of service. Although no assurances can be given, the Company believes it has provided reserves which are adequate for the final resolution of its royalty claims and litigation and that the final resolution of these matters will not have a material adverse effect on its financial position or results of operations. E. INCOME TAXES Following is a summary of the provision for income taxes for 1993, 1992 and 1991 (expressed in thousands): On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 was signed into law. Among its provisions was an overall increase in corporate federal income tax rates from 34% to 35%, effective January 1, 1993. The Company recorded in the third quarter of 1993 an adjustment to its existing deferred tax balances and current tax accruals subsequent to January 1, 1993 to reflect the effects of the increase in corporate federal income tax rates. The adjustment, which included a reduction to income taxes refundable to customers, did not have a material adverse effect on the Company's financial position or results of operations. There are no material differences between the Company's effective tax rate and the statutory federal income tax rate for all periods presented. Deferred income taxes result from temporary differences between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable or deductible amounts in future years, or temporary differences resulting from events that have been recognized in the financial statements that will result in taxable or deductible amounts in future years. The tax effect of each type of temporary difference and carryforward reflected in deferred income tax benefits and liabilities as of December 31, 1993 and 1992 are as follows (expressed in thousands): F. FINANCING Long-term debt At December 31, 1993 and 1992, long-term debt issues were outstanding as follows (expressed in thousands): On July 8, 1992, the Company sold $100 million of 9 5/8% Notes due July 15, 1997. Proceeds from the sale of the Notes were used to retire the Company's 9.25% Debentures that matured July 15, 1992. The Company's debentures and notes have restrictive covenants which provide that neither the Company nor any subsidiary may create, assume or suffer to exist any lien upon any principal property, as defined, to secure any indebtedness unless the debentures and notes shall be equally and ratably secured. Transco has in place a $450 million working capital line with a group of fifteen banks. The Company is guarantor of up to $180 million of this working capital line. At December 31, 1993, Transco had no outstanding borrowings under this facility. Transco also has in place a $50 million reimbursement facility dated as of December 31, 1993 between Transco and a group of five banks. This facility provides Transco the opportunity to obtain standby letters of credit under certain circumstances from the banks. The Company is guarantor of up to $20 million of the obligations that arise under this facility. At December 31, 1993, Transco had no amounts outstanding under this facility. These credit facilities prohibit the Company from, among other things, incurring or guaranteeing any additional indebtedness (except for indebtedness incurred to refinance existing indebtedness), issuing preferred stock or advancing cash to affiliates other than Transco. Further, these credit facilities and Transco's indentures contain restrictive covenants which could limit Transco's ability to make additional borrowings and, therefore, under certain circumstances, its ability to repay advances or make capital contributions to the Company. Sale of Receivables In September 1993, the Company entered into a new program to sell monthly trade receivables, which replaced the Company's previous program. The new trade receivables program, which expires in September 1995, provides for the sale of up to $40 million of trade receivables without recourse. As of December 31, 1993 and December 31, 1992, $33.6 million and $43.3 million, respectively, of trade receivables were held by the investor. Significant Group Concentrations of Credit Risk As of December 31, 1993, the Company had trade receivables of $16.4 million. These trade receivables are primarily due from local distribution companies and other pipeline companies predominantly located in the Midwestern United States. The Company's credit risk exposure in the event of nonperformance by the other parties is limited to the face value of the receivables. No collateral is required on these receivables. G. EMPLOYEE BENEFIT PLANS Retirement Plan Substantially all of the Company's employees are covered under a retirement plan (Retirement Plan) offered by the Company. The benefits under the Retirement Plan are determined by a formula based upon years of service and the employee's highest average base compensation during any five consecutive years within the last ten years of employment. The Retirement Plan provides for vesting of employees' benefits after five years of credited service. The Company's general funding policy is to contribute amounts deductible for federal income tax purposes. Due to its overfunded status, the Company has not been required to fund the Retirement Plan since 1986. The Retirement Plan's assets, which are managed by external investment organizations, include cash and cash equivalents, corporate and government debt instruments, preferred and common stocks, commingled funds, international equity funds and venture capital limited partnership interests. The Retirement Plan was amended effective November 15, 1991, to provide a Voluntary Window Retirement Program with special retirement benefits for those eligible members who elected to retire during the Window Period. The net cost of the program to the Retirement Plan was approximately $5.1 million. The following table sets forth the funded status of the Retirement Plan at September 30, 1993 and September 30, 1992, and the amount of prepaid pension costs as of December 31, 1993 and 1992 (expressed in thousands): Prepaid pension costs related to the Retirement Plan have been classified as other assets in the accompanying balance sheets. The following table sets forth the components of net pension cost for the Retirement Plan, which is included in the accompanying financial statements, for the years ended December 31, 1993, 1992 and 1991 (expressed in thousands): The projected unit credit method is used to determine the actuarial present value of the accumulated benefit obligation and the projected benefit obligation. The following table summarizes the various interest rate assumptions used to determine the projected benefit obligation for the years 1993, 1992 and 1991: Pension costs are determined using the assumptions as of the beginning of the Retirement Plan year. The funded status is determined using the assumptions as of the end of the Retirement Plan year. Postretirement Benefits Other than Pensions The Company's Employee Welfare Benefit Plan provides medical and life insurance benefits to Company employees who retire under the Company's Retirement Plan with at least five years of service. The Employee Welfare Benefit Plan is contributory for medical benefits and for life insurance benefits in excess of specified limits. In the first quarter of 1993, the Company adopted SFAS 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," which requires the Company to accrue, during the years that employees render the necessary service, the estimated cost of providing postretirement benefits other than pensions to those employees. At the January 1, 1993 date of adoption of SFAS 106, the Company's postretirement benefits obligation (transition obligation) was $68 million which is being amortized over the remaining life of active participants. The medical benefits are currently funded for all retired Company employees at a specified amount per quarter through a trust established under the provisions of section 501(c)(9) of the Internal Revenue Code. The following table sets forth the Employee Welfare Benefit Plan's funded status at December 31, 1993, reconciled with the accrued postretirement benefits cost included in the accompanying balance sheet at December 31, 1993 (in thousands): The following table sets forth the components of the net periodic postretirement benefit cost, net of deferred costs, which is included in the accompanying financial statements for the year ended December 31, 1993 (in thousands): The annual expense is subject to change in future periods as a result of, among other things, the passage of time, changes in participants, changes in Employee Welfare Benefit Plan benefits and changes in assumptions upon which the estimates are made. For measurement purposes as of December 31, 1993, the initial annual rate of increase in the per capita cost of covered health care benefits was assumed to be 12%. The rate was assumed to decrease gradually to 6% for the year 2005 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 rate by one percentage point in each year would increase the accumulated postretirement benefit obligation for health care benefits as of January 1, 1994 by 16% and the aggregate of the service and interest cost components of the net periodic postretirement health care benefit cost for 1994 by 19%. To determine the accumulated postretirement benefit obligation, the Employee Welfare Benefit Plan used a discount rate of 7.25% and a salary growth assumption of 5.0% per annum. Employee Welfare Benefit Plan assets are managed by external investment organizations and include cash and cash equivalents, commingled funds, preferred and common stocks and government and corporate debt instruments. The expected long-term rate of return on Employee Welfare Benefit Plan assets was 7% after taxes. Realized returns on Employee Welfare Benefit Plan assets are subject to federal income taxes at a sliding scale that increases up to a 39.6% tax rate. In November 1993, the Company placed into effect a general rate case that provides for the increase in postretirement benefits costs pursuant to SFAS 106 to be collected in rates. Prior to November 1, 1993 the Company deferred the difference between its postretirement benefits expense accrued in 1993 under SFAS 106 and the amount it collected in rates and recorded a regulatory asset of approximately $5 million as of November 1, 1993. Pursuant to its rate case filing, the Company proposes to recover the regulatory asset in rates over a 36-month period beginning November 1, 1993. The Company believes that all costs of providing postretirement benefits to its employees are necessary and prudent operating expenses and that such costs will continue to be recoverable in rates. Adoption of SFAS 106 did not have a material adverse effect on the Company's financial position or results of operations. H. SALE OF SUBSIDIARY On June 8, 1992, Transco and certain of its subsidiaries (including the Company) entered into a definitive agreement to sell their interests in certain gas gathering and related facilities for $65 million in cash, subject to certain adjustments. The sale, which was closed on July 20, 1992, included the stock of the Company's subsidiary, Texam. Of the total sales price, $12.5 million was allocated to the sale of Texam. The Company recognized a $6.9 million gain ($4.4 million after-tax) in connection with this sale. I. FAIR VALUE OF FINANCIAL INSTRUMENTS Cash and Short-Term Financial Assets and Liabilities For short-term instruments, the carrying amount is a reasonable estimate of fair value due to the short maturity of those instruments, except for the Company's current maturities of long-term debt which is publicly traded. Therefore, the fair value of these maturities is estimated based on quoted market prices, less accrued interest, at December 31, 1993. Long-Term Notes Receivable The carrying amount for the long-term notes receivable, which are shown as advances to affiliates on the balance sheet, is a reasonable estimate of fair value. As discussed in Note A, the notes earn a variable rate of interest which is adjusted regularly to reflect current market conditions. Long-Term Debt All of the Company's debt is publicly traded; therefore, fair value is estimated based on quoted market prices, less accrued interest, at December 31, 1993 and 1992. The carrying amount and estimated fair values of the Company's financial instruments as of December 31, 1993 and 1992 are as follows (in thousands): J. SUPPLEMENTARY PROFIT AND LOSS INFORMATION Major Customers Listed below are sales and transportation revenues received from the Company's major customers in 1993, 1992 and 1991, portions of which are included in the refund reserve discussed in Note C (expressed in thousands): Expenditures for Maintenance and Repairs Expenditures for maintenance and repairs for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, were $16.8 million, $14.1 million and $14.6 million, respectively. K. QUARTERLY INFORMATION (UNAUDITED) The following summarizes selected quarterly financial data for 1993 and 1992 (expressed in thousands): - --------------- (1) Includes $6,948 gain on sale of subsidiary. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1.* Financial Statements Included in Item 8, Part II of this Report Report of Independent Public Accountants on Financial Statements and Schedules Report of Management Responsibility for Financial Statements Balance Sheets at December 31, 1993 and December 31, 1992 Statements of Income for the years ended December 31, 1993, December 31, 1992 and December 31, 1991. Statements of Retained Earnings and Paid-In Capital for the years ended December 31, 1993, December 31, 1992 and December 31, 1991. Statements of Cash Flows for the years ended December 31, 1993, December 31, 1992 and December 31, 1991. Notes to Financial Statements (a) 2.* Financial Statement Schedules Included in Item 14, Part IV of this Report Financial Statement Schedules for the years ended December 31, 1993, December 31, 1992 and December 31, 1991. Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. (a) 3. Exhibits (b) Reports on Form 8-K None. - --------------- * Filed herewith TEXAS GAS TRANSMISSION CORPORATION SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (THOUSANDS OF DOLLARS) - --------------- (1) Included in Transfers and Other Changes for Other Natural Gas Plant, for the year ended December 31, 1991, is $33.8 million related to transfers of gas stored underground-noncurrent. TEXAS GAS TRANSMISSION CORPORATION SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (THOUSANDS OF DOLLARS) - --------------- (1) Does not include amortization of intangible assets which are not classified as property, plant and equipment. 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. TEXAS GAS TRANSMISSION CORPORATION BY /s/ E. J. RALPH E. J. Ralph, Vice President and Controller DATE 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 on the date indicated.

702163_1993.txt

702163_1993

1993

702163

Item 1 - Business As used in this Annual Report, unless the context indicates otherwise, the terms "Citizens" or "Company" refer to Citizens First Bancorp, Inc. and its subsidiary, the term "Bank" refers to Citizens First National Bank of New Jersey and its subsidiaries, the term "Investment" refers to Citizens First Investment Corp. and its subsidiary, the term "Financial" refers to C. F. Financial Corp., the term "Leasing" refers to C F Leasing Corp., and the term "Property" refers to C. F. Property, Inc. Citizens' and the Bank's principal executive offices are located at 208 Harristown Road, Glen Rock, New Jersey 07452-3306; telephone number (201) 445-3400. Citizens First Bancorp, Inc. is a bank holding company incorporated in New Jersey and registered under the Bank Holding Company Act of 1956, as amended. It commenced business in 1982 when it acquired all the outstanding capital stock of the Bank. The Bank accounts for substantially all of the consolidated assets, revenues and operating results of Citizens. The only subsidiary of Citizens is the Bank, a full service commercial bank offering a complete range of individual, commercial and trust services through 50 banking offices located in the northern New Jersey counties of Bergen, Hudson, Morris and Passaic, and in Ocean County in southern New Jersey. On the basis of total deposits at June 30, 1993, Citizens ranked 182nd of the top 300 commercial banks in the United States and eleventh in size among commercial banking organizations in New Jersey. As of December 31, 1993, Citizens and the Bank employed 878 full-time equivalent employees. On March 21, 1994, Citizens announced the execution of a definitive merger agreement among National Westminster Bank Plc ("NatWest"), NatWest Holdings Inc., a subsidiary of NatWest, and Citizens. For information relating to the merger, see "Item 8 - Financial Statements and Supplementary Data" on page 13 hereof under the heading "Subsequent Event." The Bank The Bank is a national banking association which was organized in 1920 and is a full service commercial bank providing a broad spectrum of personal, commercial and trust services, including secured and unsecured personal and business loans, real estate financing and letters of credit to consumers and local businesses. In addition, the Bank makes available to its customers checking, savings, time and retirement accounts, certificates of deposit and repurchase agreements. In response to the growing preference of customers seeking alternatives to traditional deposit products, the Bank introduced annuity and mutual fund sales programs. The trust department manages discretionary assets with a market value of $497,635,000 at year-end 1993. Financial, a wholly-owned subsidiary of Investment since 1985, was established in 1983 for the purpose of holding certain investment securities. Prior to 1985, Financial was a wholly-owned subsidiary of the Bank. Investment, a wholly-owned subsidiary of the Bank, was established in 1985 for the purpose of owning Financial. Leasing, a wholly-owned subsidiary of the Bank, was established in 1986 for the purpose of originating and servicing equipment leases. Property, a wholly-owned subsidiary of the Bank, was established in 1990 for the purpose of holding certain real estate acquired through foreclosure. Market Area Citizens' offices are located in 5 New Jersey counties with the largest representation in Bergen County. The Bank's customer base is comprised of a variety of commercial and retail clients including a high concentration of middle and above average household incomes. The average household income of the Bank's northern New Jersey market area is 18% higher than the state average.* In Citizens' Bergen, Passaic and Morris County market areas, the average household income is 27%, 14% and 39% respectively higher than the state average.* Thirty-one branch offices are concentrated in Citizens' northern Bergen County market area including such communities as Ridgewood, Hillsdale and Bergenfield. The Bank's market area also includes communities within Morris, Passaic, Ocean and Hudson counties. In Bergen County, the Bank holds approximately 7.73% of the countywide deposits.** Citizens' deposit base of $2.3 billion is supported by 50 branch facilities. Substantially all branch offices provide a full range of consumer and commercial banking services. The Bank has implemented a "relationship banking" approach to serving customers, providing attractive packages of high quality services, developing new business, and proactively serving community needs. The "relationship banking" strategy was reinforced during the year with the introduction of SMARTBanking -TM-, a value-oriented package of consumer services, and annuity and mutual fund sales programs. The Bank believes that customer relationships will be strengthened and fee income increased by expanding the product line with these financial services. * The household income data is from the 1991 Sheshunoff New Jersey Branch Deposit Book. ** The market share information is from the 1994 Sheshunoff New Jersey Branch Deposit Book. Supervision and Regulation Citizens is a holding company registered under the Bank Holding Company Act of 1956, as amended ("Act"). Under the Act, bank holding companies may engage directly, or indirectly through subsidiaries, in activities which the Board of Governors of the Federal Reserve System ("FRS") determines to be so closely related to banking, managing or controlling banks as to be a proper incident thereto. There is generally no restriction under the Act on the geographical area in which these non-banking activities may be conducted. Engaging in activities which the FRS has not determined to be incidental to banking requires specific FRS approval. Under FRS regulations, Citizens and its subsidiary are prohibited from engaging in certain tie-in arrangements in connection with extensions of credit, leases, the sale of property, or the franchising of services. The Act prohibits a bank holding company from acquiring more than five percent of the voting shares or substantially all of the assets of any bank without the prior approval of the FRS, which is prohibited from approving an application by a bank holding company to acquire voting shares of any commercial bank in another state unless such acquisition is specifically authorized by the laws of the other state. New Jersey law permits mergers with banking organizations in other states, subject to reciprocal legislation. As a national bank, the Bank is subject to regulation and supervision by federal bank regulatory agencies. Federal law imposes certain restrictions on the Bank in extending credit to Citizens, and with certain exceptions, to other affiliates of Citizens, in investing in the stock or securities of Citizens, and in taking such stock or securities as collateral for loans to any borrower. The Bank is also subject to other statutes and regulations concerning required reserves, investments, loans, interest payable on deposits, establishment of branches and other aspects of its operation. In December 1992, as a result of the Bank's improved capital position and other factors, the Office of the Comptroller of the Currency ("OCC") terminated a Cease and Desist order issued in 1990 and entered into a Memorandum of Understanding ("MOU") with the Board of Directors setting forth areas that the Bank will continue to address to further the rebuilding process, including reducing the levels of nonperforming assets. The MOU requires the Bank to maintain a Tier 1 capital ratio of 6.5% of adjusted total assets, a Tier 1 capital ratio of 7.5% of risk-weighted assets, and total capital of 10.0% of risk-weighted assets. At December 31, 1993, the Bank was in full compliance with all regulatory capital requirements. As a result of the improved financial condition of the Bank, on March 15, 1994, the MOU was terminated. In December 1990, the Board of Directors of Citizens entered into a written agreement with the Federal Reserve Bank of New York ("FRB") concerning the operations of Citizens, the purpose of which is to restore and maintain the financial health of Citizens. Included among the matters covered by the agreement with the FRB are restrictions on the payment of dividends, bonuses, benefits and expenditures of an extraordinary nature by Citizens without notice to, or the prior approval of, the FRB. In March 1993, Citizens executed an amendment to its written agreement with the FRB permitting Citizens to declare and pay regular quarterly dividends on the preferred stock without being required to obtain prior written approval. In addition, in the fourth quarter of 1993, the FRB approved Citizens' request to declare and pay a Common Stock dividend of $.0425 per share, payable on February 1, 1994, to shareholders of record on January 14, 1994. As a result of the improved financial condition of Citizens, on March 15, 1994, the written agreement was terminated. Governmental Monetary Policies The earnings of Citizens and the Bank are affected by domestic and foreign economic conditions, particularly by the monetary and fiscal policies of the United States government and its agencies. The monetary policies of the Federal Reserve Board have had, and will continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to mitigate recessionary and inflationary pressures by regulating the national money supply. The techniques used by the Federal Reserve Board include setting the reserve requirements of member banks and establishing the discount rate on member bank borrowings. The Federal Reserve Board also conducts open market transactions in United States government securities. From time to time various proposals are made in the United States Congress and the New Jersey legislature and before various regulatory authorities which would alter the powers of, and restrictions on, different types of banking organizations and which would restructure part or all of the existing regulatory framework for financial institutions. It is impossible to predict whether any of the proposals will be adopted and the impact, if any, of such adoption on the business of Citizens and the Bank. Statistical Information and Analysis This section presents certain statistical data concerning Citizens on a consolidated basis. Average data throughout this section was calculated on a daily basis and is representative of the consolidated operations of Citizens. I. Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential Citizens responds to this segment by incorporating by reference the material under the caption "Average Rates and Yields on a Taxable-Equivalent Basis" on pages 36 and 37 of Citizens' 1993 Annual Report to Shareholders, and the material under the captions "Net Interest Income" and "Rate/Volume Analysis of Net Interest Income" on pages 25 and 26 of Citizens' 1993 Annual Report to Shareholders. II. Securities Portfolio A. Book Value of Securities Portfolio Citizens responds to this segment by incorporating by reference the material under the caption "Securities Portfolio" on page 29 of Citizens' 1993 Annual Report to Shareholders. B. The following table presents the maturity distributions and weighted average interest yields on a taxable-equivalent basis of securities of Citizens at December 31, 1993: III. Loan Portfolio A. Types of Loans Citizens responds to this segment by incorporating by reference the material under the caption "Loans," "Commercial and Industrial Loans," "Real Estate Loans" and "Consumer Loans" on pages 29 and 30 of Citizens' 1993 Annual Report to Shareholders. B. Maturities and Sensitivity of Loans to Changes in Interest Rates The following table presents information on the scheduled maturity and interest sensitivity of total loans by category at the date indicated: C. Risk Elements Citizens responds to this segment by incorporating by reference the material under the caption "Asset Quality" on pages 31 through 32 of Citizens' 1993 Annual Report to Shareholders. IV. Summary of Loan Loss Experience A. The following table sets forth an analysis of changes in the allowance for loan losses at the dates indicated: The allowance for loan losses is a valuation reserve established through charges to income. Loan losses are charged against the allowance when management believes that the collectibility of all or a portion of the principal is unlikely. This evaluation is based upon identification of loss elements and known facts which are reasonably determined and quantified. If, as a result of loans charged off or an increase in the level of portfolio risk characteristics, the allowance is below the level considered by management to be sufficient to absorb future losses on outstanding loans and commitments, the provision for loan losses is increased to the level considered necessary to provide an adequate allowance. In the opinion of management, the allowance for loan losses at December 31, 1993 was adequate to absorb possible future losses on existing loans and commitments. On a monthly basis management reviews the adequacy of the allowance. That process includes a review of all delinquent, nonaccrual and other loans identified as needing additional review and analysis. The evaluation of loans in these categories involves an element of subjectivity, but the process takes into consideration the risk of loss presented by the loans and potential sources of repayment, including collateral security. The evaluation is based upon a credit rating system that conforms to regulatory classification definitions that are extensively tested by management and the internal loan review department. Consideration is also given to historical data, trends in overall delinquencies, concentration of loans by industry and current economic conditions that may result in increased delinquencies, as well as other relevant factors. At December 31, 1993, the allowance for loan losses was $63,788,000, a decrease of 15.9% over the $75,838,000 reported for 1992. The decrease was primarily attributable to a charge to the allowance of approximately $15,000,000 related to a bulk sale of loans and foreclosed real estate during 1993. The provision for loan losses was $17,000,000 and $23,000,000 in 1993 and 1992, respectively. The allowance for loan losses to total loans was 3.6%, 4.5% and 4.4% at December 31, 1993, 1992 and 1991, respectively. The allowance for loan losses to nonperforming loans was 99.4% at December 31, 1993 compared to 74.1% and 61.2% at December 31, 1992 and 1991, respectively. B. The following table presents an allocation by loan category of the allowance for loan losses at the dates indicated: Allocation of the Allowance for Loan Losses by Category The allocation of the allowance for loan losses by loan category is an estimate which involves the exercise of judgment and requires consideration of the loan loss experience of prior years. It also requires assumptions concerning economic conditions in Citizens' market areas, the value and adequacy of collateral and the growth and composition of the loan portfolio. Since these factors are subject to change, the allocation of the allowance for loan losses should not be interpreted as an indication that charge-offs in 1994 will occur in these amounts or proportions, or that the allocation indicates future trends. The following table presents the percentage of loans in each loan category to total loans at the dates indicated: Percentage of Total Loans by Category V. Deposits A. Citizens responds to this segment by incorporating by reference the material under the caption "Average Rates and Yields on a Taxable-Equivalent Basis" on pages 36 and 37 of Citizens' 1993 Annual Report to Shareholders. D. The following table sets forth, by time remaining until maturity, time deposits in amounts of $100,000 or more at December 31 in each of the past three years: VI. Return on Equity and Assets Citizens responds to this item by incorporating by reference the material under the caption "Financial Ratios" on page 35 of Citizens' 1993 Annual Report to Shareholders. VII. Short-Term Borrowings Citizens responds to this item by incorporating by reference the material under Footnote 10 to the Consolidated Financial Statements, "Short-Term Borrowings," found on page 17 of Citizens' 1993 Annual Report to Shareholders. Item 2 Item 2 - Properties The headquarters of Citizens, Investment, Leasing and Property is located at 208 Harristown Road, Glen Rock, New Jersey. The property is leased by the Bank, which also maintains its administrative headquarters and a full service banking office at that location. The main office of the Bank is located at 54 East Ridgewood Avenue, Ridgewood, New Jersey and is owned by the Bank. A full service banking office is maintained at that location. Financial is located at 1100 North Market Street, Wilmington, Delaware; the property is leased. Citizens has a total of 50 banking offices, all in New Jersey, of which 28 are owned with the remainder leased. The owned properties are free and clear of all mortgages. The leased properties required $2,280,000 in rental payments in 1993. In the opinion of management, all properties are well maintained and suitable to their respective present needs and operations. Item 3 Item 3 - Legal Proceedings In 1990, two class action lawsuits against Citizens and certain of its present and former directors and officers were filed in the United States District Court for the District of New Jersey. These actions have been consolidated since they involve common questions of law and fact. The plaintiffs allege that purchasers of Citizens' stock during a certain period were victims of knowing or reckless misrepresentations by the defendants concerning the financial condition of Citizens. The court has certified October 4, 1989 through August 31, 1990 as the class period. Specifically, the plaintiffs claim that the defendants knowingly or recklessly stated that Citizens' allowance for loan losses at December 31, 1989 was adequate; overstated Citizens' profit for 1989; and artificially inflated the value of Citizens' stock. The plaintiffs claim similar misrepresentations by the defendants with respect to the March 31, 1990 interim financial statements of Citizens. Plaintiffs claim that the misrepresentations of the defendants violate Section 10(b) of the Securities Exchange Act, Rule 10(b) of the Rules and Regulations promulgated thereunder, Section 20 of the Exchange Act, and constitute common law fraud and negligent omissions. The plaintiffs demand unspecified compensatory damages, punitive damages and costs of the suits. Citizens believes that the allegations of wrongdoing by it and its directors and officers are without merit and is vigorously defending the action. However, in consideration of the uncertainties of litigation, preliminary analyses of potential liability prepared by experts and the coverage of certain defendants under a Directors and Officers liability insurance policy, management has determined it prudent to accrue $875,000 for this matter during the year ended December 31, 1993. Based upon these and other factors and advice received from Citizens' legal counsel, management believes that the outcome of the litigation will not result in an additional liability which would be material to Citizens' consolidated results of operations or financial position. Citizens is also subject to other claims and litigation that arise primarily in the ordinary course of business. Based on information presently available and advice received from legal counsel representing Citizens, it is the opinion of management that the disposition or ultimate determination of such other claims and litigation will not have a material adverse effect on the consolidated financial position of Citizens. 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 year covered by this report, either through the solicitation of proxies or otherwise. PART II Item 5 Item 5 - Market for Citizens' Common Equity and Related Stockholder Matters The number of common shareholders of record on December 31, 1993 was 4,311. For information relating to restrictions on the ability of the Bank to pay dividends to Citizens, see Footnote 19 to the Consolidated Financial Statements, "Dividend Limitation," found on page 21 of Citizens' 1993 Annual Report to Shareholders, which is incorporated by reference herein, and the last two paragraphs on page 5 hereof under the heading "Supervision and Regulation." For information relating to stock price ranges and dividends per share, see the tables included under the caption "Common Stock and Dividend Information" found on page 33 of Citizens' 1993 Annual Report to Shareholders, which is incorporated by reference herein. Item 6 Item 6 - Selected Financial Data Citizens responds to this item by incorporating by reference the material under the caption "Comparison of Selected Data" on pages 34 and 35 of Citizens' 1993 Annual Report to Shareholders. Item 7 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations Citizens responds to this item by incorporating by reference the material under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 24 through 33 of Citizens' 1993 Annual Report to Shareholders. Item 8 Item 8 - Financial Statements and Supplementary Data Citizens responds to this item by incorporating by reference the material on pages 9 through 37 of Citizens' 1993 Annual Report to Shareholders. Subsequent Event (unaudited) On March 21, 1994, Citizens announced the execution of a definitive merger agreement among National Westminster Bank Plc ("NatWest"), NatWest Holdings Inc., a subsidiary of NatWest, and Citizens. Under the terms of the merger, Citizens will be merged into National Westminster Bank NJ, a subsidiary of National Westminster Bancorp, Inc., which is itself a subsidiary of NatWest Holdings Inc. Shareholders of Citizens, at their option, will have the right to have their shares converted into $9.75 per share in cash or .22034 American Depository Receipts ("ADRs") of NatWest per share. Each ADR represents six ordinary shares of NatWest. After taking into account shareholder elections, no more than 60% nor less than 50% of Citizens shares will be converted into ADRs and the remaining Citizens shares will be converted into cash. The transaction is designed to be tax-free to Citizens shareholders electing to receive ADRs. The agreement is subject to approvals by the Federal Reserve Board, other regulatory authorities and the shareholders of Citizens. It is intended that the transaction will be completed as soon as possible after approvals are obtained and is expected to occur in the Fall of 1994. For further information regarding this transaction, please see Form 8-K filed by Citizens. 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 Citizens Directors of Citizens Citizens responds to this segment by incorporating by reference the material under the caption "Election of Directors," found in Citizens' definitive proxy statement concerning its 1994 Annual Shareholders' Meeting to be filed with the Securities and Exchange Commission pursuant to Regulation 14A. Executive Officers of Citizens These officers are appointed annually by the Board of Directors of Citizens, the Bank, Investment, Financial, and Leasing, as the case may be. There are no family relationships among the officers listed. Item 11 Item 11 - Executive Compensation Citizens responds to this item by incorporating by reference the material under the captions "Meetings and Fees of Board of Directors," "Executive Compensation" and "Compensation Committee Report" found in Citizens' definitive proxy statement concerning the 1994 Annual Shareholders' Meeting to be filed with the Securities and Exchange Commission pursuant to Regulation 14A. Item 12 Item 12 - Security Ownership of Certain Beneficial Owners and Management Citizens responds to this item by incorporating by reference the material under the caption "Information Concerning Nominees for Directors of the Company" found in Citizens' definitive proxy statement concerning the 1994 Annual Shareholders' Meeting to be filed with the Securities and Exchange Commission pursuant to Regulation 14A. Item 13 Item 13 - Certain Relationships and Related Transactions Citizens responds to this item by incorporating by reference the material under the caption "Certain Transactions" found in Citizens' definitive proxy statement concerning the 1994 Annual Shareholders' Meeting to be filed with the Securities and Exchange Commission pursuant to Regulation 14A. PART IV Item 14 Item 14 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page (a) Financial Statements and Schedules - Index (1) Financial Statements * Citizens First Bancorp, Inc. and Subsidiary - Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Income for each of the three years in the period ended December 31, 1993 Consolidated Statements of Changes in Shareholders' Equity for each of the three years in the period ended December 31, 1993 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 Independent Auditors' Report Notes to Consolidated Financial Statements (2) Financial Statement Schedules All schedules have been omitted as inapplicable, or not required, or because the information required is included in the financial statements or the notes thereto. *Incorporated by reference to pages 9 through 23 of Citizens' 1993 Annual Report to Shareholders. (3) Exhibits included herein: 3(a) Amendment to Certificate of Incorporation of Citizens First Bancorp, Inc., increasing the number of common shares authorized from 50,000,000 to 56,393,972, incorporated by reference to Exhibit 3(a) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 3(b) Amendment to Certificate of Incorporation of Citizens First Bancorp, Inc., adding articles EIGHTH and NINTH regarding indemnification of officers and directors, incorporated by reference to Exhibit 3(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 3(c) Certificate of Incorporation of Citizens First Bancorp, Inc., as amended to date, incorporated by reference to Exhibit 3(c) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 3(d) Bylaws of Citizens First Bancorp, Inc., as amended to date, incorporated by reference to Exhibit 3(d) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(a) Citizens First National Bank of New Jersey's Annual Incentive Plan dated January 31, 1983, incorporated by reference to Exhibit 10(a) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(b) Citizens First Bancorp, Inc.'s Incentive Stock Option Plan (1983), incorporated by reference to Exhibit 10(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(c) Form of Citizens First Bancorp, Inc.'s Individual Incentive Stock Option Agreement, incorporated by reference to Exhibit 10(c) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(d) Change in Control Agreement, dated as of September 19, 1989, between Citizens First Bancorp, Inc. and Richard G. Kelley, incorporated by reference to Exhibit 10(g) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(e) Change in Control Agreement, dated as of September 19, 1989, between Citizens First Bancorp, Inc. and Rodney T. Verblaauw, incorporated by reference to Exhibit 10(h) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(f) Employment Agreement dated as of September 19, 1989, among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Richard G. Kelley, incorporated by reference to Exhibit 10(i) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(g) Employment Agreement dated as of September 19, 1989, among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Rodney T. Verblaauw, incorporated by reference to Exhibit 10(j) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(h) Citizens First Bancorp, Inc. Director Retirement Plan, incorporated by reference to Exhibit 10(k) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(i) Citizens First Bancorp, Inc. Restated Director Retirement Plan, incorporated by reference to Exhibit 10(i) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(j) Citizens First Bancorp, Inc.'s 1985 Incentive Stock Plan, incorporated by reference to Exhibit 10(j) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(k) Stock Option Agreement dated July 16, 1985 between Richard G. Kelley and Citizens First Bancorp, Inc., incorporated by reference to Exhibit 10(l) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(l) Stock Option Agreement dated July 16, 1985 between Rodney T. Verblaauw and Citizens First Bancorp, Inc., incorporated by reference to Exhibit 10(m) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(m) Amendment No. 2 to the Amended and Restated Retirement Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(n) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(n) Amended and Restated Retirement Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(o) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(o) Amendment No. 3 to the Amended and Restated Retirement Plan of Citizens First National Bank of New Jersey. 10(p) Amended and Restated Employee Stock Ownership Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(r) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(q) Amendment No. 1 to the Amended and Restated Employee Stock Ownership Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(s) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(r) Amendment No. 2 to the Amended and Restated Employee Stock Ownership Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(t) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(s) Amendment No. 3 to the Amended and Restated Employee Stock Ownership Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(u) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(t) Benefit Equalization Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(q) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(u) Amendment No. 1 to the Benefit Equalization Plan of Citizens First National Bank of New Jersey. 10(v) Employment Agreement dated February 26, 1992 among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Allan D. Nichols. 10(w) Amendment to the Employment Agreement among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Allan D. Nichols. 10(x) Stock Option Agreement dated February 26, 1992 between Allan D. Nichols and Citizens First Bancorp, Inc. 10(y)* Employment Agreement among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Rodney T. Verblaauw as of January 5, 1994. 10(z)* Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and Allan D. Nichols and Rodney T. Verblaauw. 10(aa)*Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and Frank A. DeLisi, J. Michael Feeks, Eugene V. Malinowski and Jeffrey B. Morris. 10(bb)*Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and John C. Anello, Ronald H. Barnett, Steven A. Cole, Gregg N. Gerken, Charles E. O'Neal, George J. Theiller and James R. Van Horn. 11* Computation of Per Share Income. 13* 1993 Annual Report to Shareholders. 21 For 1993 Citizens First National Bank of New Jersey constituted the only significant subsidiary. Separate financial statements are omitted for the Bank since omission criteria under Rule 3A-02(e)(1) of Regulation S-X are satisfied. 23* Independent Auditors' Consent. Copies of the foregoing Exhibits will be furnished upon request and payment of Citizens' reasonable expenses in furnishing the Exhibits. (b)Reports on Form 8-K On October 14, 1993, Citizens filed a report on Form 8-K, as referenced in the September 30, 1993 Form 10-Q. On December 21, 1993, Citizens filed a report on Form 8-K indicating that the Board of Directors of Citizens First Bancorp, Inc. announced that it had declared the first dividend on the Company's Common Stock in three and one-half years. The dividend, in the amount of $.0425 per share, was payable on February 1, 1994 to shareholders of record at the close of business on January 14, 1994. The Board also declared the regular quarterly dividend of $.625 per share on the Company's Preferred Stock, Series A $2.50 Cumulative Convertible, payable on February 1, 1994 to shareholders of record at the close of business on January 14, 1994. "The reinstatement of Common Stock dividends represents an important milestone in our rebuilding program," said Allan D. Nichols, Chairman and Chief Executive Officer. Less than two years ago the viability of the Company and the Bank were in question. Today we have the highest level of capital in our history and strong core earnings." Nichols noted that the successful recapitalization of Citizens through an oversubscribed rights offering of new stock, the restructuring of the management team, significant improvement in earnings and a marked reduction in the level of the Bank's nonperforming assets were all important factors leading to the reinstatement of Common Stock dividend payments. "While the rebuilding of Citizens is not yet complete, we have come a long way in a relatively short time," Nichols said. "The Board of Directors has been grateful for the support of our shareholders through this process and is pleased to acknowledge this support through the restoration of the Common Stock dividend." No other reports on Form 8-K were required to be filed by Citizens during the last quarter of the period covered by this report. 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. 33-2287 (filed December 19, 1985) and 33-2302 (filed December 20, 1985): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CITIZENS FIRST BANCORP, INC. By:ALLAN D. NICHOLS Allan D. Nichols, Chairman of the Board and Chief Executive Officer (Principal Executive Officer) Glen Rock, New Jersey Dated: 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 dates indicated. Each person hereby appoints Eugene V. Malinowski and James R. Van Horn and each of them as his attorney-in-fact to execute and file such amendments to this report on Form 8 as such attorney-in-fact, or either of them, may deem appropriate. Signature Title Date ALLAN D. NICHOLS Chairman of the Board and March 21, 1994 (Allan D. Nichols) Chief Executive Officer RODNEY T. VERBLAAUW President and Chief Adminis- March 21, 1994 (Rodney T. Verblaauw) trative Officer, Director DANIEL AMSTER Director March 21, 1994 (Daniel Amster) DOUGLAS H. DITTRICK Director March 21, 1994 (Douglas H. Dittrick) DANIEL M. DWYER Director March 21, 1994 (Daniel M. Dwyer) ROBERT D. HUNTER Director March 21, 1994 (Robert D. Hunter) SAMUEL M. LYON, JR. Director March 21, 1994 (Samuel M. Lyon, Jr.) HARRY RANDALL, JR. Director March 21, 1994 (Harry Randall, Jr.) Signature Title Date ALFRED S. TEO Director March 21, 1994 (Alfred S. Teo) WALTER W. WEBER, JR. Director March 21, 1994 (Walter W. Weber, Jr.) EUGENE V. MALINOWSKI, CPA Treasurer (Principal March 21, 1994 (Eugene V. Malinowski, CPA) Financial Officer and Principal Accounting Officer) EXHIBIT INDEX EXHIBIT NO. (3) Exhibits included herein: 10(y)* Employment Agreement among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Rodney T. Verblaauw as of January 5, 1994. 10(z)* Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and Allan D. Nichols and Rodney T. Verblaauw. 10(aa)*Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and Frank A. DeLisi, J. Michael Feeks, Eugene V. Malinowski and Jeffrey B. Morris. 10(bb)*Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and John C. Anello, Ronald H. Barnett, Steven A. Cole, Gregg N. Gerken, Charles E. O'Neal, George J. Theiller and James R. Van Horn. 11* Computation of Per Share Income 13* 1993 Annual Report to Shareholders 23* Independent Auditors' Consent Copies of the foregoing Exhibits will be furnished upon request and payment of Citizens' reasonable expenses in furnishing the Exhibits.

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ITEM 1. BUSINESS: THE COMPANY AND ITS SUBSIDIARIES. The Company, incorporated in Texas in 1976, is a holding company operating principally in two business segments, the electric utility business and the cable television business. The Company conducts its operations primarily through three subsidiaries: HL&P, its principal operating subsidiary, KBLCOM and HI Energy. See "Regulation of the Company" for a description of the Company's status under the 1935 Act. HL&P is engaged in the generation, transmission, distribution and sale of electric energy and serves over 1.4 million customers in an approximately 5,000 square-mile area of the Texas Gulf Coast, including Houston. As of December 31, 1993, the total assets and common stock equity of HL&P represented 88% of the Company's consolidated assets and 113% of the Company's consolidated common stock equity, respectively. For the year ended December 31, 1993, the operations of HL&P accounted for 108% of the Company's consolidated net income. See "Business of HL&P." The cable television operations of the Company are conducted through KBLCOM and its subsidiaries. This segment includes five cable television systems located in four states and a 50% interest in Paragon, a partnership which owns systems located in seven states. As of December 31, 1993, KBLCOM's systems served approximately 605,000 basic cable customers subscribing to approximately 488,000 premium programming units. According to information provided by Paragon's managing partner, Paragon served approximately 932,000 basic cable customers subscribing to approximately 542,000 premium programming units. See "Business of KBLCOM." HI Energy was recently organized by the Company to participate in domestic and foreign power generation projects and to invest in the privatization of foreign electric utilities. HI Energy is actively engaged in the evaluation of several such projects, but has not yet committed significant financial or other resources to any single project. See "Businesses of Other Subsidiaries - HI Energy." As of December 31, 1993, the Company and its subsidiaries had 11,350 full-time employees. HL&P had 9,578 full-time employees, and KBLCOM and its subsidiaries had 1,581 full-time employees (excluding employees of joint ventures and partnerships in which the Company holds less than a majority interest). For certain financial information with respect to each of the Company's two principal business segments, see Note 16 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. BUSINESS OF HL&P. HL&P, incorporated in Texas in 1906, is engaged in the generation, transmission, distribution and sale of electric energy. Sales are made to residential, commercial and industrial customers in an approximately 5,000 square-mile area of the Texas Gulf Coast, including Houston. CERTAIN FACTORS AFFECTING THE ELECTRIC UTILITY BUSINESS As an electric utility, HL&P has been affected, to varying degrees, by a number of factors that have affected the electric utility industry in general. These factors include, among others, difficulty in obtaining rate increases sufficient to provide an adequate return on invested capital, high costs and delays associated with environmental and nuclear regulations, changes in regulatory climate, prudence audits, competition from other energy suppliers and difficulty in obtaining regulatory approval for construction of new generating plants. HL&P is unable to predict the future effect of these or other factors upon its operations and financial condition. HL&P's results of operations are significantly affected by decisions of the Utility Commission primarily in connection with rate increase applications filed prior to 1991 by HL&P. Although Utility Commission action on those applications has been completed, a number of the orders of the Utility Commission are currently subject to judicial review. Rate issues relating to a possible proceeding to review HL&P's rate levels and to review costs associated with the outage of the South Texas Project are also pending before the Utility Commission. For a discussion of these matters, see Notes 9, 10, 11 and 12 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. HL&P is project manager and one of four co-owners of the South Texas Project, which consists of two 1,250 MW nuclear generating units. HL&P owns a 30.8% interest in the South Texas Project. Both generating units at the South Texas Project were out of service from February 1993 to February 1994 when Unit No. 1 was authorized by the NRC to return to service. In June 1993, the NRC placed the South Texas Project on its "watch list" of plants with "weaknesses that warrant increased NRC attention." Such action followed the NRC's issuance of a report issued by its Diagnostic Evaluation Team which identified a number of areas requiring improvement. For a description of litigation and regulatory proceedings relating to the South Texas Project including, among other things, the NRC's diagnostic evaluation of the South Texas Project, the operating status of the South Texas Project and Austin's lawsuit filed on February 22, 1994, see "Regulatory Matters" below, Item 3 of this Report, "Results of Operations - HL&P - United States Nuclear Regulatory Commission (NRC) Diagnostic Evaluation of the South Texas Project" in Item 7 of this Report and Notes 9(b), 9(c), 9(f), 10 and 11 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. In 1992, Congress enacted the Energy Act which, among other changes, exempts from the 1935 Act EWGs, a class of electric power producers engaged in sales of electric energy exclusively at wholesale. For information with respect to the Energy Act, see "Competition" and "Regulatory Matters" below and Note 8(a) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. In 1995, the Texas legislature is expected to consider various proposals regarding the organization and responsibilities of the Utility Commission. For information regarding the Sunset Act review process and Utility Commission rulemaking activities regarding IRP, see "Regulatory Matters - Rates and Services" below. SERVICE AREA While employment, personal income and industrial activity in the Houston area steadily increased from 1987 to 1990, the effects of the national recession have since slowed growth in HL&P's service area. While the local economy continues to slowly expand and diversify in numerous areas, such as medical, professional and engineering services, it is still dependent, to a large degree, on oil, gas, refined products, petrochemicals and related businesses. HL&P operates under a certificate of convenience and necessity granted by the Utility Commission which covers HL&P's present service area and facilities. In addition, HL&P holds franchises to provide electric service within the incorporated municipalities in its service territory. None of such franchises expires before 2007. MAXIMUM HOURLY FIRM DEMAND AND CAPABILITY The following table sets forth, for the years indicated, information with respect to HL&P's net capability, maximum hourly firm demand and the resulting reserve margin: - ------------------- (1) Reflects firm capacity purchased. (2) Does not include interruptible load at time of peak. At December 31, 1993, HL&P owned and operated generating facilities with installed net generating capability of 13,679 MW. HL&P experienced a maximum hourly firm demand in 1993, a year of unusually warm summer weather, of 11,397 MW, a 5.7% increase over the maximum hourly firm demand in 1992, a year of unusually mild summer weather. Including interruptible demand, the maximum hourly firm demand actually served in 1993 was 12,472 MW compared to 11,638 MW in 1992. For planning purposes, HL&P currently expects maximum hourly firm demand for electricity to grow at a compound annual rate of about 1.6% over the next ten years. Assuming average weather conditions, reserve margins are projected to decrease from an estimated 25% in 1994 to an estimated 21% in 1997 as a result of growth in maximum hourly firm demand and the expiration of certain firm cogeneration contracts. Assuming average weather conditions, HL&P projects that reserve margins in 1998 will decrease to 18%. For long-term planning purposes, HL&P expects to maintain a reserve margin in the range of 17%-20% in excess of its estimate of maximum hourly firm demand load requirements. See "Capital Program" and "Competition" below. HL&P experiences significant seasonal variation in its sales of electricity. Sales during the summer months are typically higher than sales during other months of the year due, in large part, to the reliance on air conditioning in HL&P's service territory. See Note 20 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report for a presentation of certain quarterly unaudited financial information for 1992 and 1993. CAPITAL PROGRAM HL&P has a continuous program to maintain its existing facilities and to expand its physical plant as needed to meet customer requirements. Such program and the estimated construction costs set forth below are subject to periodic review and revision because of changes in load forecasts, the need to retire older plants, changing regulatory and environmental standards and other factors. HL&P's capital program is currently estimated to cost approximately $1.28 billion during the three-year period 1994-1996 with approximately $478 million, $381 million and $418 million to be spent in 1994, 1995 and 1996, respectively, excluding AFUDC. In 1993, total capital expenditures and nuclear fuel were approximately $329 million. HL&P's capital program for 1994-1996 consists of the following principal estimated expenditures: HL&P's near-term construction program includes the installation of two gas turbines with attendant heat recovery steam generators at the DuPont chemical plant located in the Houston area. The project, which is estimated to cost $117 million, is expected to be available for peak demand in 1995 and is designed to add approximately 160 MW of electrical capacity to HL&P's system while providing needed process steam to the DuPont chemical plant. For further information regarding the DuPont project, see "Liquidity and Capital Resources - - HL&P - Capital Program" in Item 7 of this Report. The remaining construction expenditures relating to generating facilities expected in 1994-1996 are primarily associated with improvements to existing generating stations. HL&P does not forecast additional capacity needs until 1999-2001. HL&P currently believes that future capacity needs will likely be met through the construction of combined cycle gas turbines at existing HL&P plant sites, the development of additional steam sale projects or through other means, such as purchased power or additional DSM activities. The scheduled in-service dates for the Malakoff units have been indefinitely postponed. For information with respect to expenditures on Malakoff, see Note 12 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Expenditures for environmental protection facilities for the five years ended December 31, 1993 aggregated $34.5 million (excluding AFUDC), including expenditures of $12.8 million and $7.6 million in 1993 and 1992, respectively. Environmental protection expenditures for 1994-1996 are estimated to be $71 million (excluding AFUDC), primarily for nitrogen oxide emissions controls and monitoring equipment. See "Regulatory Matters - Environmental Quality" below. Actual construction expenditures and scheduled in-service dates may vary from estimates as a result of numerous factors including, but not limited to, changes in the rate of inflation, changes in equipment delivery schedules, construction delays and deferrals, the availability and relative cost of fuel, the availability and cost of purchased power, environmental protection requirements, regulatory requirements related to the South Texas Project, the availability of adequate and timely rate relief and other regulatory approvals, ability to secure external financing, legislative changes, and changes in anticipated customer demand and business conditions. In connection with its construction program planning, HL&P employs value-based planning techniques that take into account energy conservation and load management programs along with traditional utility supply options and renewable energy resources to select the plan utilizing the most appropriate and cost-effective alternatives. In 1993, HL&P spent approximately $9.5 million, excluding AFUDC, for uranium concentrate and nuclear fuel processing services for its share of the fuel for the South Texas Project. See "Fuel - Nuclear Fuel Supply" below. Total gross additions to the plant of HL&P during the five years ended December 31, 1993 amounted to approximately $2.9 billion and, during the same period, retirements amounted to approximately $351 million. Gross additions during the five-year period amounted to approximately 25% of total utility plant at December 31, 1993. COMPETITION HL&P and the electric utility industry in general are experiencing increased competition as a result of legislative and regulatory changes, technological advances, the cost and availability of natural gas, consumer demands, environmental needs and other factors. A number of cogeneration facilities have been built in HL&P's service area as a result of the high concentration of process industries located in the Gulf Coast region and the availability of attractively priced fuels. Cogeneration is the simultaneous generation of two forms of energy, usually steam and electricity. The Public Utility Regulatory Policy Act of 1978 generally requires utilities to purchase all electricity offered to them by qualifying cogeneration facilities at or below avoided costs. In Texas, however, cogenerators generally are not permitted to make sales of electricity to parties other than electric utilities or the thermal purchaser. HL&P has experienced the loss of a number of industrial customers and continues to be faced with further customer losses as a result of cogeneration. As of December 31, 1993, HL&P purchased energy from fourteen cogeneration facilities, representing over 3,400 MW of total generating capability. As of December 31, 1993, HL&P had contracts totaling 720 MW of firm cogeneration capacity and associated energy which expire as follows: 1994 - 325 MW; 1998 - 125 MW and 2005 - 270 MW. In addition, a ten-year contract for 50 MW of firm capacity and associated energy becomes effective in 1994. Electric utilities in Texas are required to provide transmission wheeling service for power sales by cogenerators to other electric utilities at a compensatory rate. During 1993, approximately 1,400 MW of cogenerated power was transmitted or "wheeled" by HL&P to other utilities in Texas. Given the uncertainties associated with efforts to obtain additional commitments for firm power on reasonable terms, HL&P is continuing to pursue plans to meet its needs for increased generation in 1999-2001, which plans include new construction. See "Capital Program" above. In October 1992, the Energy Act became law. The Energy Act contains provisions which affect the regulatory structure of the electric utility industry. First, the legislation amends the 1935 Act, exempting a class of power producers known as EWGs. Companies that are already exempt from registration under the 1935 Act, as well as companies not otherwise engaged in the electric utility business, will be permitted to own EWGs without being subject, as a result of such ownership, to the registration requirements and the geographic, ownership and other restrictions imposed by the 1935 Act on non-exempt holding companies and their subsidiaries. Companies registered under the 1935 Act are also permitted to own EWGs. Although the Energy Act instructs state regulatory commissions to consider standards applicable to wholesale power purchases by electric utilities, including purchases from EWGs, EWG generation sources, to the extent any may be located in Texas, currently would be treated as regulated public utilities under PURA. In addition, the Energy Act permits exempt and registered holding companies to acquire and maintain an interest in "foreign utility companies" that meet certain requirements for an exemption from the 1935 Act. Second, the Energy Act significantly expands the authority of the FERC to order owners of transmission lines, such as HL&P, to carry power at the request of any electric utility, federal power marketing agency or any person generating electric energy for sale or for resale over such transmission lines. The Energy Act requires transmission for third parties to wholesale customers, provided the reliability of service to the utility's local customer base is protected and the local customer base does not subsidize the third-party service. The Energy Act prohibits the FERC from ordering the transmission of electric energy directly to an ultimate consumer (i.e. retail wheeling); however, it does not affect any authority of any state or local government under state law concerning transmission of electric energy directly to an ultimate consumer. The Energy Act is expected to have significant implications for the utility industry by moving utilities toward a more competitive environment. Competition may be increased in connection with the generation of electricity. Pressure for access to utility retail customers is also expected to increase. The Company will actively oppose any access to its retail customers by third-party generators. In addition, the amendments to the 1935 Act will remove barriers to the Company, allowing it to develop independent electric generating plants in the United States for sales to wholesale customers as well as to contract for utility projects internationally, without becoming subject to registration under the 1935 Act as an electric utility holding company. HL&P continues to address the issue of increased competition, among other things, by focusing on the energy needs of its customers and by controlling and, where possible, reducing the cost to serve its customers. HL&P undertook a major operating performance improvement program in 1992 to improve the effectiveness and efficiency of its operations and continues to seek ways to improve its operations and lower costs. HL&P is attempting to control its fuel costs, which compose a substantial portion of its operating cost, by (1) purchasing gas at generally low prices and utilizing gas storage facilities to mitigate significant variations in gas demand, (2) purchasing spot coal at prices below existing contract terms and (3) contracting for additional purchased power when available on attractive terms. For information on HL&P's operating performance improvement programs, see "Results of Operations - HL&P - STEP Program" in Item 7 of this Report and Note 18 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Additionally, HL&P continues to encourage industrial expansion in its service area by offering an economic development tariff and economically attractive interruptible rates for those customers capable of taking such service. FUEL Approximately 42% of HL&P's energy requirements during 1993 were met with natural gas, 40% with coal and lignite and 1% with nuclear fuel. The remaining 17% was purchased power, principally cogenerated power. However, both nuclear-fueled units of the South Texas Project were out of service during most of 1993. During 1992, the most recent year not affected by the outage of the South Texas Project, HL&P's energy requirements were obtained from the following sources: natural gas (34%); coal and lignite (39%); nuclear fuel (9%) and purchased power (18%). Based upon various assumptions relating to the cost and availability of fuels, plant operation schedules, actual in-service dates of HL&P's planned generating facilities, load growth, load management and environmental protection requirements, HL&P currently expects its future energy mix to be in the following proportions for the indicated periods: There can be no assurance that the various assumptions upon which the estimates set forth in the table above are based will prove to be correct, and HL&P's actual energy mix in future years may vary from the percentages shown in the table. For information on the outage of the South Texas Project, see Note 9(f) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which is incorporated herein by reference. NATURAL GAS SUPPLY. During 1993, HL&P purchased approximately 63% of its natural gas requirements pursuant to long-term contracts with various suppliers. No individual supplier provided more than approximately 24% of HL&P's natural gas requirements during 1993. Substantially all of HL&P's natural gas supply contracts contain pricing provisions based on fluctuating market prices. HL&P's natural gas supply contracts have expiration dates ranging from 1994 to 2002. HL&P believes that it will be able to renew such contracts as they expire or enter into similar contractual arrangements with other natural gas suppliers. HL&P expects to purchase its remaining natural gas requirements on the spot market. HL&P has a long-term contract for gas storage and gas transportation arrangements with gas pipelines connected to certain of its generating facilities. The contract for gas storage provides working storage capacity of up to 3,500 BBtu of natural gas. HL&P's average daily gas consumption during 1993 was 749 BBtu per day with peak consumption of 1,427 BBtu per day. Although natural gas has been relatively plentiful in recent years, supplies available to HL&P and other consumers are vulnerable to disruption due to weather conditions, transportation disruptions, 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. As a result of this vulnerability, supplies of natural gas may become unavailable from time to time, or prices may increase rapidly in response to temporary supply disruptions or other factors. Such events could require HL&P to withdraw gas from its gas storage facility or 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. Since most of the purchased power capacity available to HL&P is also gas-fired, gas supply disruptions may also affect these suppliers. Currently, HL&P anticipates that its alternate fuel capability, combined with its solid-fueled generating resources and available gas storage capability is adequate to meet fuel needs during any temporary gas supply interruptions. However, there is no assurance that adequate levels of gas supply will be available over the long term. HL&P's average cost of natural gas was $2.15 per MMBtu in 1993 (excluding storage costs). HL&P's average cost of natural gas in 1992 and 1991 was $1.85 and $1.54 per MMBtu, respectively. COAL AND LIGNITE SUPPLY. Substantially all of the coal for HL&P's four coal-fired units at W. A. Parish is purchased under two long- term contracts from mines in the Powder River Basin area of Wyoming. Additional coal is obtained on the spot market. The coal is transported under terms of a long-term rail transportation contract to the W. A. Parish coal handling facilities in HL&P's fleet of approximately 2,300 railcars. A substantial portion of the coal requirements for the projected operating lives of the four coal-fired units at W. A. Parish is expected to be met under such contracts. The lignite for the Limestone units is obtained from a mine adjacent to the plant. HL&P owns the mining equipment, facilities and a portion of the lignite leases at the mine, which is operated by a contract miner under the terms of a long-term agreement. The lignite reserves currently under lease and contract are expected to provide a substantial portion of the fuel requirement for the projected operating lives of the Limestone units. Prior to October 1993, coal and lignite purchasing, transportation and handling services were provided to HL&P by a subsidiary of the Company, Utility Fuels, which has since been merged into HL&P. See "Businesses of Other Subsidiaries - Utility Fuels." NUCLEAR FUEL SUPPLY. The supply of fuel for nuclear generating facilities involves the acquisition of uranium concentrates, conversion to uranium hexafluoride, enrichment of the uranium hexafluoride and fabrication of nuclear fuel assemblies. Contracts have been entered into with various suppliers to provide the South Texas Project with converted uranium hexafluoride to permit operation through 1996, enrichment services through 2014 (except as noted below) and fuel fabrication services for the initial cores and 16 additional years of operation. Contracts for enrichment services from October 2000 through September 2002 have been terminated by HL&P, as Project Manager for the South Texas Project, under a ten-year termination notice provision, because HL&P believes that other, lower-cost options will be available. In addition to the above, flexible contracts for the supply of uranium concentrates and uranium hexafluoride have been entered into that will provide approximately 50% of the uranium needed for South Texas Project operation from 1997 through 2000. Contracts for the balance of the uranium requirements will soon be under negotiation; however, HL&P does not presently anticipate difficulty in obtaining contracts for those requirements. By contract, the DOE will ultimately take possession of all spent fuel generated by the South Texas Project. HL&P has been advised that the DOE plans to place the spent fuel in a permanent underground storage facility in an as-yet undetermined location. The DOE contract currently requires payment of a spent fuel disposal fee on nuclear plant generated electricity of one mill (one-tenth of a cent) per net KWH sold. This fee is subject to adjustment to ensure full cost recovery by the DOE. The South Texas Project is designed to have sufficient on-site storage facilities to accommodate over 40 years of the spent fuel discharges for each unit. For information relating to a fee assessment upon domestic utilities having purchased enrichment services from the DOE, see Note 8(a) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. OIL SUPPLY. Fuel oil is maintained in inventory by HL&P to provide for fuel needs in emergency situations in the event sufficient supplies of natural gas are not available. In addition, certain of HL&P's generating plants have the ability to use fuel oil if oil becomes a more economical fuel than incremental gas supplies. HL&P has storage facilities for over six million barrels of oil located at those generating plants capable of burning oil. HL&P's oil inventory is adjusted periodically to accommodate changes in the availability of primary fuel supplies. RECOVERY OF FUEL COSTS. For information relating to the cost of fuel over the last three years, see "Operating Statistics of HL&P" below and "Results of Operations - HL&P - Fuel and Purchased Power Expense" in Item 7 of this Report. Utility Commission rules provide for the recovery of certain fuel and purchased power costs through an energy component of electric rates (fixed fuel factor). The fixed fuel factor is established during either a utility's general rate proceeding or an interim fuel proceeding and is to be generally effective for a minimum of six months, unless a substantial change in a utility's cost of fuel occurs. In that event, a utility may be authorized to revise the fixed fuel factor in its rates appropriately. In any event, a fuel reconciliation is required every three years. In October 1991, the Utility Commission approved HL&P's fixed fuel factor as contemplated in the settlement agreement reached in February 1991 by HL&P and most other parties to Docket No. 9850. See Note 10(c) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. In November 1993, the Utility Commission authorized HL&P to implement a higher fuel factor under Docket No. 12370. The Company can request a revision to its fuel factor in April and October each year. Reconciliation of fuel costs after March 1990 is required in 1994, and under Utility Commission rules, HL&P has anticipated that a filing would be required in May 1994. However, the Utility Commission staff has requested that such filing be delayed to the fourth quarter of 1994. If that request is granted by the Utility Commission, HL&P anticipates that fuel costs through some time in 1994 will be submitted for reconciliation at that time. No hearing would be anticipated in that reconciliation proceeding before 1995, and the schedule for reconciliation of those costs could be affected by the institution of a rate proceeding by the Utility Commission and/or a prudence inquiry concerning the outage at the South Texas Project. For a discussion of that outage and the possibility that a rate proceeding may be instituted, see Notes 9(f), 10(f) and 10(g), respectively, to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. REGULATORY MATTERS ENERGY ACT. In October 1992, the Energy Act became law. For a description of the Energy Act, see "Competition" above and Note 8(a) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. RATES AND SERVICES. Pursuant to the PURA, the Utility Commission has original jurisdiction over electric rates and services in unincorporated areas of the State of Texas and in the incorporated municipalities that have relinquished original jurisdiction. Original jurisdiction over electric rates and services in the remaining incorporated municipalities served by HL&P is exercised by such municipalities, including Houston, but the Utility Commission has appellate jurisdiction over electric rates and services within those incorporated municipalities. In 1993, the Texas Legislature considered changes to PURA as part of a required review under the Sunset Act. None of the proposed changes to the Utility Commission or Texas utility regulation were enacted. However, the legislature passed legislation continuing the current PURA until September 1, 1995. The legislature also established a joint interim committee to study certain regulatory issues prior to the next legislative session which begins in January 1995. These issues include, among other items, tax issues relating to public utilities, the organization and authority of the Utility Commission and IRP. Recommendations from this study period will be considered during the next legislative session. UTILITY COMMISSION PROCEEDINGS. For information concerning the Utility Commission's orders with respect to HL&P's applications for general rate increases with the Utility Commission (Docket No. 8425 for the 1988 rate case and Docket No. 9850 for the 1990 rate case) and the municipalities within HL&P's service area and the appeals of such orders, see Notes 10(b) and 10(c) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. HL&P's 1986 general rate case (Docket Nos. 6765 and 6766) and 1984 rate case (Docket No. 5779) have been affirmed and are no longer subject to appellate review. For a discussion of the possibility that a rate proceeding may be instituted, see Notes 10(f) and 10(g) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. PRUDENCE REVIEW OF CONSTRUCTION OF THE SOUTH TEXAS PROJECT. For information concerning the Utility Commission's orders with respect to a prudence review of the planning, management and construction of the South Texas Project (Docket No. 6668) and the appeals of such orders, see Note 10(d) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which note is incorporated herein by reference. DEFERRED ACCOUNTING DOCKETS. For information concerning the Utility Commission's orders allowing deferred accounting treatment for certain costs associated with the South Texas Project (Docket Nos. 8230, 9010 and 8425), the appeals of such orders and related proceedings, see Notes 10(b), 10(e) and 11 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. ENVIRONMENTAL QUALITY. General. HL&P is subject to regulation with respect to air and water quality, solid waste management and other environmental matters by various federal, state and local authorities. Environmental regulations continue to be affected by legislation, administrative actions and judicial review and interpretation. As a result, the precise effect of potential regulations upon existing and proposed facilities and operations cannot presently be determined. However, developments in these and other areas of regulation have required HL&P to make substantial expenditures to modify, supplement or replace equipment and facilities and may, in the future, delay or impede construction and operation of new facilities or require expenditures to modify existing facilities. For information regarding environmental expenditures, see "Capital Program" above. Air. The TNRCC has jurisdiction and enforcement power to determine the permissible level of air contaminants emitted in the State of Texas. The standards established by the Texas Clean Air Act and the rules of the TNRCC are subject to modification by standards promulgated by the EPA. Compliance with such standards has resulted, and is expected to continue to result, in substantial expenditures by HL&P. In addition, expanded permit and fee systems and enforcement penalties may discourage industrial growth within HL&P's service area. In November 1990, significant amendments to the Clean Air Act became law. The law is designed to control emissions of air pollutants which contribute to acid rain, to reduce urban air pollution and to reduce emissions of toxic air pollutants. Parts of the Clean Air Act are directed at reducing emissions of sulfur dioxide from electric utility generating units. This reduction program includes an "allowance" system which sets forth formulas and criteria to establish a cap on sulfur dioxide emissions from utility generating units. HL&P has been allocated allowances sufficient to permit continued operation of its existing facilities and some expansion of its solid-fuel generating facilities without substantial additional expense relating to modification of its facilities. HL&P has already made substantial investments in pollution control facilities, and all of its generating facilities currently comply in all material respects with sulfur dioxide emission standards established by the Clean Air Act. As a result of this previous investment, HL&P does not anticipate that significant expenditures for sulfur dioxide removal equipment will be required. Provisions of the Clean Air Act dealing with urban air pollution require establishing new emission limitations for nitrogen oxides from existing sources. Although initial limitations were finalized in 1993, further reductions may be required in the future. The cost of modifications necessary to reduce nitrogen oxide emissions from existing sources has been estimated at $29 million in 1994 and $10.5 million in 1995. The Clean Air Act also calls for additional stack gas continuous emissions monitoring equipment to be installed on various HL&P generating facilities. Capital expenditures of $12 million in 1994 and $2 million in 1995 are anticipated for installation of this new monitoring equipment. See "Capital Program" above. The Clean Air Act established a new permitting program to be administered in Texas by the TNRCC. The precise requirements of the program cannot be determined until the permit program is approved by the EPA. However, based on regulations promulgated by the TNRCC, HL&P anticipates that additional expenditures may be required for administering the permitting process. The legislation could also substantially increase the cost of constructing new generating units. Water. The TNRCC has jurisdiction over water discharges in the State of Texas and is empowered to set water quality standards and issue permits regulating water quality. The TNRCC jurisdiction is currently shared with the EPA, which also issues water discharge permits and reviews the Texas water quality standards program. HL&P has obtained permits from both the TNRCC and the EPA for all facilities currently in operation which require such permits. Applications for renewal of permits for existing facilities have been submitted as required. The reissued permits reflect changes in federal and state regulations which may increase the cost of maintaining compliance. Although compliance with the new regulations has resulted and will continue to result in additional costs to HL&P, the costs are not expected to have a material impact on HL&P's financial condition or results of operations. For a description of certain Administrative Orders issued by the EPA to HL&P under the Clean Water Act and for a description of certain other environmental litigation, see Item 3 of this Report. SOLID AND HAZARDOUS WASTE. HL&P is also subject to regulation by the TNRCC and the EPA with respect to the handling and disposal of solid waste generated on-site. Although legislation that would expand the scope of the RCRA was not adopted in 1993, the TNRCC has promulgated new rules regulating the classification of industrial solid waste. These regulations will result in increased analytical and disposal costs to HL&P. Although the precise amount of these costs is unknown at this time, HL&P does not believe, based on its current analysis, that such costs will be material. The EPA has promulgated a number of regulations to protect human health and the environment from hazardous waste. Compliance with the regulations promulgated to date has not materially affected the operation of HL&P's facilities, but such compliance has increased operating costs. The EPA has identified HL&P as a "potentially responsible party" for the costs of remediation of a CERCLA site located adjacent to one of HL&P's transmission lines in Harris County. For information regarding this site, see "Liquidity and Capital Resources - HL&P - Environmental Expenditures" in Item 7 of this Report. FEDERAL REGULATION OF NUCLEAR POWER. Under the Atomic Energy Act of 1954 and the Energy Reorganization Act of 1974, operation of nuclear plants is extensively regulated by the NRC, which has broad power to impose licensing and safety requirements. In the event of non-compliance, the NRC has the authority to impose fines or shut down nuclear plants, or both, depending upon its assessment of the severity of the situation, until compliance is achieved. For information concerning a diagnostic evaluation that was completed by the NRC at the South Texas Project, the placement of the South Texas Project on the NRC's watch list and related matters, see "Results of Operations - HL&P - - United States Nuclear Regulatory Commission (NRC) Diagnostic Evaluation of the South Texas Project" in Item 7 of this Report and Note 9(f) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which note is incorporated herein by reference. LOW-LEVEL RADIOACTIVE WASTE. The federal Low-Level Radioactive Waste Policy Act assigns responsibility for low-level waste disposal to the states. Texas created the Texas Low-Level Radioactive Waste Disposal Authority to build and operate a low-level waste disposal facility. HL&P was assessed approximately $5.9 million in 1993 by the State of Texas for the development work on this facility and estimates that the assessment for 1994 and 1995 will be $2.2 million and $4.2 million, respectively. Texas currently has access to the low-level waste disposal facility at Barnwell, South Carolina through June 1994. Extended access beyond June will depend upon action by the governor and state legislature of South Carolina. HL&P has constructed a temporary low-level radioactive waste storage facility at the South Texas Project. The facility was completed in late 1992 and will be utilized for interim storage of low-level radioactive waste after access to the Barnwell facility is suspended and prior to the opening of the Texas Low-Level Radioactive Waste Site. NUCLEAR INSURANCE AND NUCLEAR DECOMMISSIONING For information concerning nuclear insurance and nuclear decommissioning, see Notes 9(d) and 9(e) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. LABOR MATTERS As of December 31, 1993, HL&P had 9,578 full-time employees of whom 3,715 were hourly-paid employees represented by the International Brotherhood of Electrical Workers under a collective bargaining agreement which expires on May 25, 1995. For a discussion of HL&P's STEP program and related employee matters, see "Results of Operations - HL&P - STEP Program" in Item 7 of this Report and Note 18 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. OPERATING STATISTICS OF HL&P (1) Both generating units of the South Texas Project were out of service from February 1993 to February 1994 when Unit No. 1 was authorized by the NRC to return to service. See "Results of Operations-HL&P-Fuel and Purchased Power Expense" in Item 7 of this Report. BUSINESS OF KBLCOM. GENERAL The cable television operations of the Company are conducted through KBLCOM and its subsidiaries. KBL Cable, a subsidiary of KBLCOM, owns and operates five cable television systems located in four states. Another subsidiary of KBLCOM owns a 50% interest in Paragon, a Colorado partnership, which in turn owns twenty systems located in seven states. KBLCOM's 50% interest in Paragon is recorded in the financial statements using the equity method of accounting. The remaining 50% interest in Paragon is owned by subsidiaries of ATC, which is a subsidiary of Time Warner Inc. ATC serves as the general manager for all but one of the Paragon systems. The partnership agreement provides that, at any time after December 31, 1993, either partner may elect to divide the assets of the partnership under certain predefined procedures set forth in the agreement. To date, neither party has initiated such procedures. As of December 31, 1993, KBL Cable served approximately 605,000 basic cable customers who subscribed to approximately 488,000 premium programming units. As of the same date, Paragon served approximately 932,000 basic cable customers who subscribed to approximately 542,000 premium programming units. The Company has engaged an investment banking firm to assist in finding a strategic partner or investor for KBLCOM in the telecommunications industry. Unless otherwise indicated or the context otherwise requires, all references in this section to "KBLCOM" mean KBLCOM and its subsidiaries. All references to KBL Cable mean KBL Cable and its subsidiaries, and all references to Paragon mean the Paragon partnership. All information pertaining to Paragon has been provided to KBLCOM by Paragon's managing partner, ATC, unless stated otherwise. For a discussion regarding recent developments in regulations affecting the cable television industry, see "Regulation - Rate Regulation" and "Regulation - Recent Developments in Rate Regulation" below. CABLE TELEVISION SERVICES The cable television business of KBLCOM consists primarily of selling to subscribers, for a monthly fee, television programming that is distributed through a network of coaxial and fiber optic cables. KBLCOM offers its subscribers both basic services and, for an extra monthly charge, premium services. Each of the KBLCOM systems carries the programming of all three major television networks, programming from independent and public television stations and certain other local and distant (out-of-market) broadcast television stations. KBLCOM also offers to its subscribers locally produced or originated video programming, advertiser-supported cable programming (such as ESPN and CNN), premium programming (such as HBO and Showtime) and a variety of other types of programming services such as sports, family and children, news, weather and home shopping programming. As is typical in the industry, KBLCOM subscribers may terminate their cable television service on notice. KBLCOM's business is generally not considered to be seasonal. All of KBL Cable's systems are "addressable," allowing individual subscribers, among other things, to electronically select pay-per-view programs. Approximately 48% of KBL Cable's customers presently have converters permitting addressability. This allows KBL Cable to offer pay-per-view services for various movies, sports events, concerts and other entertainment programming. OVERVIEW OF SYSTEMS AND DEVELOPMENT The KBL Cable systems are located in the areas of greater San Antonio and Laredo, Texas; Minneapolis, Minnesota; Portland, Oregon and Orange County, California. All of these systems other than the Laredo system, which is the smallest system, were built between 1979 and 1986 and have channel capacities ranging from 46 channels (San Antonio and California) to 132 channels (Minneapolis). The Laredo system was originally wired for cable in the 1960s and upgraded in 1979. It has a 42-channel capacity. Although all of these systems are considered fully built, annual capital expenditures will be required to accommodate growth within the service areas and to replace and upgrade existing equipment. Capital expenditures, which were approximately $54 million in 1993, are expected to be approximately $276 million over the 1994-1996 period. KBL Cable has projected an increase in its capital expenditures over the next three years in order to stay competitive in the increasingly complex cable environment. KBL Cable anticipates increased investments in rebuilds, fiber plant and addressable converter boxes. For additional information with respect to capital expenditures, see "Liquidity and Capital Resources - KBLCOM" in Item 7 of this Report and Note 8(b) to the Company's Consolidated Financial Statements in Item 8 of this Report. Paragon owns cable television systems that serve a number of cities, towns or other areas in Texas (including El Paso), Arizona, Florida (including the Tampa Bay area), New Hampshire, New York (including a portion of Manhattan), Maine and southern California (areas in Los Angeles County). Paragon made capital expenditures of approximately $54 million in 1993 and expects to make capital expenditures of approximately $200.8 million during the 1994-1996 period. For information regarding KBLCOM's financial results and liquidity and the financing of KBLCOM, see "Results of Operations - KBLCOM" in Item 7 of this Report and Note 4 to the Company's Consolidated Financial Statements in Item 8 of this Report. The following table summarizes certain information relating to the cable television systems owned by KBL Cable and Paragon: 1) A KBLCOM subsidiary has a 50% interest in Paragon. Information has been furnished by ATC, the general manager of Paragon. 2) A home is "passed by cable" if it can be connected to cable service without extension of the distribution system. 3) Basic subscribers means the sum of (i) the number of homes receiving cable services, (ii) all units in multiple dwellings which receive one bill and (iii) each commercial establishment (hotels, hospitals, etc.) less (iv) complimentary accounts. 4) Premium (or pay) units consist of the number of subscriptions to premium programming services counting, as separate subscriptions, each service received by a subscriber. Over the three-year period ended December 31, 1993, growth in the number of subscribers in the KBLCOM systems was achieved through marketing efforts aimed at existing homes passed by cable, population growth in the franchise areas and increased access to potential subscribers through the construction of additional distribution facilities within existing franchise areas. KBLCOM believes these same factors will contribute to continued growth. In addition, KBLCOM may, from time to time, acquire additional cable television systems. In 1993, KBL Cable acquired a small cable television system (comprising approximately 1,150 basic subscribers) which adjoined one of the existing systems. KBLCOM is also actively marketing premium programming services and intends to introduce new services as they become commercially feasible. On February 17, 1994, KBLCOM entered into an agreement to acquire three cable companies serving approximately 47,000 customers in the Minneapolis area. KBLCOM will acquire the stock of the companies in exchange for the issuance of common stock of the Company. The amount of common stock of the Company to be issued, currently estimated to be approximately $24 million, is dependent on the amount of liabilities assumed, currently estimated to be approximately $63 million. Approximately 40,000 of the cable customers served by the properties to be acquired are in the Minneapolis metropolitan area. The remaining 7,000 customers are located in small communities south and west of the metropolitan area. Closing of the transaction is subject to the satisfaction of certain conditions. SOURCES OF REVENUES AND RATES TO SUBSCRIBERS For the year ended December 31, 1993, the average monthly revenue per subscriber for KBL Cable was approximately $34.43. Approximately 67% of KBL Cable's revenue was derived from monthly fees paid by subscribers for basic cable services, and 16% was derived from premium programming services. Rates to subscribers vary from system to system and in accordance with the type of service selected. As of December 31, 1993, the average monthly basic revenue per subscriber for the KBL Cable systems generally ranged from $18.36 to $23.00. As of December 31, 1993, approximately 39% of KBL Cable's customers subscribed to one or more premium channels. KBL Cable's premium units increased during 1993 and 1992; however, the premium revenue has declined during this period due to the reduction of rates. The rates have been reduced for a variety of reasons including the effect of recessionary economic conditions, value perception and competition from other forms of entertainment such as pay-per-view and home video rental. KBL Cable implemented a number of strategies designed to strengthen this service category including new packaging of premium units and multiplexing, which is the delivery of multiple channels of a premium service (with programs beginning at different times) with no change in price to the subscriber. The fourth quarter of 1993 showed results from these efforts as the premium revenues increased over the corresponding period in the prior year. The remainder of KBL Cable's revenues for the year ended December 31, 1993 was derived from advertising, pay-per-view services, installation fees and other ancillary services. KBL Cable's management believes, within its present markets, the sale of commercial advertising to local, regional and national advertisers, pay-per-view services and other ancillary services offer the potential for increased revenues. Advertising revenues for the year ended December 31, 1993 increased $1.4 million or 10% over the previous year while pay-per-view and the other ancillary revenues increased by $2.0 million or 8%. For the year ended December 31, 1993, the average monthly revenue per subscriber for the Paragon systems was approximately $30.99. Approximately 68% of Paragon's revenues was derived from monthly fees for basic services, and 19% was derived from premium services. As of December 31, 1993, the average monthly basic revenue per subscriber for the Paragon systems ranged from $18.13 to $24.10. As of December 31, 1993, approximately 31% of Paragon's customers subscribed to one or more premium channels. FRANCHISES KBLCOM's cable television systems generally operate pursuant to non-exclusive franchises or permits awarded by local governmental authorities, and accordingly, other applicants may obtain franchises or permits in franchise areas served by KBLCOM. See "Regulation" below. As of December 31, 1993, KBL Cable held 56 franchises with unexpired terms ranging from under one year to approximately 18 years. A single franchise agreement with San Antonio, which expires in 2003, covered approximately 32% of KBL Cable's subscribers as of December 31, 1993. The expiration periods and approximate percentages of subscribers for KBL Cable's franchises are as follows: As of December 31, 1993, Paragon held 147 franchises with unexpired terms ranging from 1994 to 2010. The single largest franchise, which covers a portion of Manhattan, included more than 20% of Paragon's subscribers as of December 31, 1993. This franchise expires in 2003. The provisions of state and local franchises are subject to Federal regulation under the Cable Act. See "Regulation" below. Cable television franchises generally can be terminated prior to their stated expiration date under certain circumstances such as a material breach of the franchise by the cable operator. Franchises typically contain a number of provisions dealing with, among other things, minimum technical specifications for the systems; operational requirements; total channel capacity; local governmental, community and educational access; franchise fees (which range up to 5% of cable system revenues) and procedures for renewal of the franchise. Sometimes conditions of franchise renewal require improved facilities, increased channel capacity or enhanced services. One franchise, with approximately 58,000 subscribers as of December 31, 1993, held by a subsidiary of KBL Cable, provides that the city granting the franchise may, at any time, require the KBL Cable subsidiary to sell, at fair market value, its franchise and operations in the city to another cable television operator with a franchise for another portion of the city. KBLCOM's franchises are also subject to renewal and generally are not transferable without the prior approval of the franchising authority. In addition, some franchises provide for the purchase of the franchise under certain circumstances, such as a failure to renew the franchise. To date, KBLCOM's franchises have generally been renewed or extended upon their stated expirations, but there can be no assurance of renewal of franchises in the future. PROGRAMMING CONTRACTS A substantial portion of KBLCOM's programming is obtained under contracts with terms that typically extend for more than one year. KBLCOM generally pays program suppliers a monthly fee per subscriber. Certain of these contracts have price escalation provisions. COMPETITION Cable television systems experience competition from a variety of sources, including broadcast television signals, multipoint microwave distribution systems, direct broadcast satellite systems (satellite signals directly to a subscriber's satellite dish) and satellite master antenna systems (a satellite dish which receives signals and distributes them within a multiple dwelling unit). The effectiveness of such competition depends, in part, upon the quality of the signals and the variety of the programming offered over such competitive technologies and the cost thereof as compared with cable television systems. These competitive technologies are not generally subject to the same form of local regulation that affects cable television. Cable television systems also compete, to varying degrees, with other communications and entertainment media such as motion picture theaters and video cassette rental stores, and such competition may increase with the development and growth of new technologies. It is expected that, in April 1994, two national direct broadcast satellite (DBS) systems will commence operation. These national DBS providers will compete in all KBLCOM franchise areas and it is expected that they will constitute significant new competition to such KBLCOM systems. As a result of the programming access requirements contained in the 1992 Cable Act, these two national DBS providers will have access to virtually all cable television programming services. Additionally, within the next two years, there may be significant development in the provision of "Video Dialtone" programming over telephone company facilities. This new source of competition will result from telephone companies leasing video capacity to independent programmers in KBLCOM service areas. Finally, both federal legislation and FCC proceedings are currently underway which may allow telephone companies to own and distribute their own programming over their own facilities in direct competition with cable systems. Specifically, US West has indicated, in an FCC filing, that it intends to upgrade facilities in at least one KBLCOM service area in order to provide either Video Dialtone service or to own and distribute its own video programming services. KBLCOM is addressing increased competition by focusing on (i) improving customer service; (ii) carrying a greater variety of local and national programming, some of which will be available in its markets only through KBLCOM and (iii) furthering the development of the interactive use of its cable systems. Since KBLCOM's systems operate under non-exclusive franchises, other companies may obtain permission to build cable television systems in areas where KBLCOM presently operates. A 1986 United States Supreme Court decision has raised questions regarding the constitutionality of the cable television franchising process. The decision requires lower courts to decide whether, in areas where more than one cable operator can be physically accommodated by local utilities, franchising authorities may refuse to grant more than one franchise to serve that area. No prediction can be made at this time as to whether additional franchises will be granted to any competitors, or if granted and a cable television system is constructed, what the impact on KBLCOM and the Company might be. KBLCOM competes with a variety of other media in the sale of advertising time on its cable television systems. REGULATION Cable television is subject to regulation at the federal, local and, in some cases, state level. In October 1992, the 1992 Cable Act became law. The 1992 Cable Act expands the scope of cable industry regulation beyond that imposed by the Cable Act. The following are new and significant areas of regulation imposed by the 1992 Cable Act as interpreted by the FCC. RATE REGULATION. Under the 1992 Cable Act, virtually all of the Company's cable systems are subject to rate regulation. The 1992 Cable Act mandates that the FCC establish rate standards and procedures governing regulation of basic cable service rates. Franchising authorities may certify to the FCC that they will follow the FCC standards and procedures in regulating basic rates, and once such certification is made, the franchising authorities will assume such rate regulation authority over basic rates. The 1992 Cable Act also requires that the FCC, upon complaint from a franchising authority or a cable subscriber, review the reasonableness of rates for additional tiers of cable service. Only rates for premium pay channels, single-event, pay-per-view services and a la carte (pay-per-channel) services are excluded entirely from rate regulation. Pursuant to the congressional directive in the 1992 Cable Act, the FCC issued rules implementing, among other things, the provisions of the 1992 Act establishing rate standards and procedures governing regulation of cable television services. Prior to the release of its rate regulation rules, the FCC entered an order, effective April 5, 1993, freezing rates for all cable television services, other than premium and pay-per-view services, for 120 days (Rate Freeze Order). Under the Rate Freeze Order, the rate frozen is the average monthly subscriber rate for non-premium cable services for the most recent billing cycle ending prior to April 5, 1993. The Rate Freeze Order was subsequently extended by the FCC through May 15, 1994. On May 3, 1993, the FCC issued its rate regulation rules (Rate Rule), which became effective on September 1, 1993. The Rate Rule relies primarily on a "benchmark" approach. Current rates charged by cable operators are to be evaluated initially against "competitive benchmark" rate formulas established by the FCC based upon a nationwide cable rate survey previously conducted by the FCC. At that time, the FCC estimated that, on average, the cable industry's existing rates exceed its "benchmark" levels by approximately 10%, and that up to 75% of all cable television systems have rates which exceed applicable benchmarks. Under the Rate Rule, if a cable system's rates exceed the applicable benchmark, the cable operator can be required to reduce its rates to the higher of (i) a level 10% below the level that existed as of September 30, 1992 or (ii) the applicable benchmark. For additional information regarding rate reductions, see the discussion regarding the FCC's announcement of further changes in the Rate Rule in "Recent Developments in Rate Regulation" below. The benchmarks published in the Rate Rule vary depending on the size of cable systems, the total number of channels subject to regulation and the total number of channels which contain satellite-delivered programming. Using the benchmark tables published in the Rate Rule, the cable operator calculates a permitted monthly "per channel/per subscriber" charge. In making this calculation, the operator must include all revenues it derives from the lease of equipment to customers, such as converters, remote control devices and additional outlets, and installation services, such as installation fees, disconnect fees, reconnect fees and tier change fees, during the operator's last fiscal year. The benchmark tables apply to both basic cable services and the tier services, known in the 1992 Act as "cable programming services". Once calculated, the same monthly per channel/per subscriber rate applies to all regulated channels. In addition, once calculated and approved by the applicable regulating authority, this benchmark rate functions as a price cap. In the future, rates for regulated channels must remain at or below this benchmark rate, adjusted for inflation measured on the gross national product-price index (GNP-PI) published by the United States government. Certain limited "external" costs beyond the cable operator's control, such as franchise fees or program license fee increases which exceed the level of GNP-PI inflation, can be charged directly through to cable consumers. Under the Rate Rule, a cable operator which believes that the benchmark approach produces a rate which does not adequately cover its actual costs can choose to defend its current rates in a cost-of-service hearing before the applicable regulating authority. Election of this cost-of-service mode of rate regulation preempts the application of the benchmark approach and may result in rates for regulated channels below the indicated benchmark levels. On July 15, 1993, the FCC adopted a notice of proposed rulemaking requesting comment on the substance of, and the procedure for the cost-of-service mode of rate regulation. For additional information regarding the cost-of-service mode of rate regulation, see the discussion regarding the FCC's announcement of interim cost-of-service standards (Interim COS Standards) in "Recent Developments in Rate Regulation" below. The Rate Rule implements the requirement in the 1992 Act that local franchising authorities have the opportunity to regulate rates for basic cable service, defined as that level of service containing all local broadcast channels, all public, educational and governmental access channels and all equipment used to receive that level of service. In order for a local franchising authority to exercise regulatory authority under the Rate Rule, the local franchising authority must seek certification from the FCC. A local franchising authority must, among other things, represent in its application to the FCC that it will follow all provisions of the Rate Rule. Certification will be granted no earlier than 30 days after the date the local franchising authority's application is filed with the FCC. The 1992 Cable Act and the Rate Rule vest regulatory authority regarding regulation of cable programming services with the FCC. The FCC's regulatory authority must be triggered, if at all, by the filing of a complaint concerning a cable operator's rate for cable programming service tier(s). Both local franchising authorities and subscribers may file such rate complaints. The Rate Rule defines a new rate standard for commercial leased channels on a cable system. Under this standard, the FCC will allow the cable operator to charge a rate equal to the highest equivalent value which the operator could otherwise secure by distributing commercial programming of its own choice on that channel. The FCC order establishing the September 1, 1993 effective date for the Rate Rule preempted all local, state and federal advance notice requirements, thus permitting KBLCOM to restructure its rates and service offerings up until September 1, 1993 without prior notice to subscribers. Local franchise authorities with jurisdiction over KBLCOM's franchises covering significant numbers of cable television subscribers have given KBLCOM notice that they have obtained, or are seeking, certification from the FCC to regulate basic service level rates. RECENT DEVELOPMENTS IN RATE REGULATION. On February 22, 1994, the FCC announced further changes in the Rate Rule in several Executive Summaries. The Commission stated that it has determined that the differential between average cable system rates and rates charged by cable systems in markets with effective competition is 17%, rather than 10% as stated in the Rate Rule. Therefore, the FCC will issue revised benchmark formulas which will produce lower benchmarks, effective on May 15, 1994 (Revised Benchmarks). At that time, cable operators will be required to reduce their rates for regulated services by 17% below the level in effect in September 1992, or to the new benchmark, whichever is higher. The FCC stated that the Revised Benchmarks will require approximately 90% of all cable operators to reduce their regulated rates by about an additional 7% from their current rate levels. In announcing the Revised Benchmarks, the FCC stated that they would apply prospectively. Therefore, the existing Rate Rule governs regulated rates from September 1, 1993 until May 15, 1994, while the Revised Benchmarks will govern regulated rates effective May 15, 1994. The FCC also announced new criteria for determining whether a la carte carriage of previously regulated channels was valid under the 1992 Cable Act. Among other criteria, the FCC stated it will look to: (1) whether a la carte carriage avoids a rate reduction that would otherwise have been required under the FCC's rules; (2) whether an entire tier of regulated services has been converted to a la carte carriage; (3) whether the services involved have been traditionally offered a la carte; (4) whether there is a significant equipment charge to order a la carte services rather than a discounted package of such services; (5) whether the individual subscriber is able to select the channels which comprise the a la carte package and (6) how significantly the package of a la carte services is discounted from the per channel charges for those services. A la carte packages which are found to evade rate regulation rather than enhance subscriber choice will be treated as regulated tiers, and operators engaging in such practices may be subject to sanctions. The FCC also announced, in an Executive Summary, its Interim COS Standards. Under the Interim COS Standards which the FCC characterized as based upon principles similar to those which govern rate regulation of telephone companies, cable operators facing "unusually" high costs, may recover through their regulated rates, their normal operating expenses and a "reasonable" return on investment. The FCC provided, in the Executive Summary, that the presumptive permissible rate of return on investment under the Interim COS Standard is 11.25%. The FCC presumptively excluded acquisition costs above book value from the rate base because such "excess acquisition costs" represent the value of the monopoly rents the acquirer expected to earn during the period when an acquired cable system was effectively an unregulated monopoly. The FCC further stated that it will, under certain unspecified circumstances, allow cable operators to rebut this presumption excluding "excess acquisition costs." Under the Interim COS Standards, cable operators which opt for the cost-of-service approach may make such filings only once every two years. The FCC also announced a streamlined cost-of-service procedure under which cable systems regulated under the Revised Benchmarks will be allowed to recover a share of system upgrade costs, offset for savings in operating expenses due to efficiencies gained by the upgrade. While KBLCOM believes that the Revised Benchmarks will impose some further reduction in rates and new obligations which are burdensome and will increase KBLCOM's costs of doing business, it is impossible to assess the detailed impact of the Revised Benchmarks on KBLCOM until the FCC completes and issues the actual text of its rules on the Revised Benchmarks and the Interim COS Standards. MUST CARRY/RETRANSMISSION CONSENT. The 1992 Cable Act specified certain rights for mandatory carriage on cable systems for local broadcast stations, known as must-carry rights. As an alternative, local broadcast stations were authorized to elect retransmission consent rights. Under the must carry option, a cable operator can be compelled to allocate up to one-third of its channel capacity for carriage of local commercial broadcast television stations. In addition, a cable operator can also be required to allocate up to three additional channels to local non-commercial broadcast television stations. Such non-commercial broadcasters do not have the retransmission consent option under the 1992 Cable Act. Under the retransmission consent option, a local commercial broadcasters can require a cable operator to make payments as a condition to granting its consent for the carriage of the broadcast station's signal on the cable system. Established "super stations" are exempted from this provision. On March 29, 1993, the FCC issued its rules clarifying and implementing the must carry/retransmission consent portions of the 1992 Cable Act (Must Carry Rule). By June 17, 1993, the deadline specified by the Must Carry Rule, approximately 40% of the local broadcasters in KBL Cable's markets elected retransmission consent. According to the terms of the 1992 Cable Act and the Must Carry Rule, if the local commercial broadcast stations that had elected retransmission consent rights had not granted such consent by October 6, 1993, KBL Cable was required to remove them from carriage on the relevant cable system. To date, all local broadcast stations having elected retransmission consent rights have granted to KBL Cable their consent to carriage at no material cost to KBL Cable. Paragon has also reached retransmission consent agreements with all of the local broadcast affiliates in its service areas. A challenge to the Must Carry portion of the 1992 Cable Act is presently pending in the Supreme Court of the United States, Turner Broadcasting System, Inc., et al. v. Federal Communications Commission, et al., No. 93-44. Appellants argue that the Must Carry provisions violate their rights under the First Amendment of the United States Constitution. The Supreme Court has heard oral argument, and a decision is expected by the end of June 1994. BUY-THROUGH PROHIBITION. The 1992 Cable Act prohibits cable systems which have addressable technology and addressable converters in place from requiring cable subscribers to purchase service tiers above basic as a condition to purchasing premium channels, such as HBO or Showtime. If cable systems do not have such addressable technology or addressable converters in place, they are given up to ten years to comply with this provision. PROGRAMMING ACQUISITION. The 1992 Cable Act directs the FCC to promulgate regulations regarding the sale and acquisition of cable programming between cable operators and programming services in which the cable operator has an attributable interest. The legislation and the subsequent FCC regulations will preclude most exclusive programming contracts, will limit volume discounts that can be offered to affiliated cable operators and will generally prohibit cable programmers from providing terms and conditions to affiliated cable operators that are more favorable than those provided to unaffiliated operators. Furthermore, the 1992 Cable Act requires that such cable programmers make their programming services available to competing video technologies, such as multi-channel, microwave distribution systems and direct broadcast satellite systems on terms and conditions that do not discriminate against such competing technologies. PROGRAMMING CARRIAGE AGREEMENTS. The 1992 Cable Act requires the FCC to adopt regulations that will prohibit cable operators from (1) requiring ownership of a financial interest in a program service as a condition to carriage of such service, (2) coercing exclusive rights in a programming service or (3) favoring affiliated programmers so as to restrain unreasonably the ability of unaffiliated programmers to compete. OWNERSHIP RESTRICTIONS. The 1992 Cable Act requires the FCC to (1) prescribe rules and regulations establishing reasonable limits on the number of cable subscribers a person is authorized to reach through cable systems owned by such person, or in which such person has an attributable interest; (2) prescribe rules and regulations establishing reasonable limits on the number of channels on a cable system that can be occupied by a video programmer in which a cable operator has an attributable interest and (3) consider the necessity and appropriateness of imposing limitations on the degree to which multi-channel video programming distributors may engage in the creation or production of video programming. Additionally, cable operators are prohibited from selling a cable system within three years of acquisition or construction of such cable system. CUSTOMER SERVICE/TECHNICAL STANDARDS. The 1992 Cable Act requires the FCC to promulgate regulations establishing minimum standards for customer service and technical system performance. Franchising authorities are allowed to enforce stricter customer service requirements than the standards so promulgated by the FCC. The majority of the provisions of the Cable Act remain in place. The Cable Act continues to: (a) restrict the ownership of cable systems by prohibiting cross-ownership by a telephone company within its operating area and cross-ownership by local television broadcast station owners; (b) require cable television systems with 36 or more "activated" channels to reserve a percentage of such channels for commercial use by unaffiliated third parties; (c) permit franchise authorities to require the cable operator to provide channel capacity, equipment and facilities for public, educational and governmental access; (d) limit the amount of fees required to be paid by the cable operator to franchise authorities to a maximum of 5% of annual gross revenues; (e) grant cable operators access to public rights of way and utility easements; (f) establish a federal privacy policy regulating the use of subscriber lists and subscriber information; (g) establish civil and criminal liability for unauthorized reception or interception of programming offered over a cable television system or satellite delivered service; (h) authorize the FCC to preempt state regulation of rates, terms and conditions for pole attachments unless the state has issued effective rules; (i) require the sale or lease to subscribers of devices enabling them to block programming considered offensive and (j) contain provisions governing cable operators' compliance with equal employment opportunity requirements. The 1992 Cable Act, together with the Cable Act, creates a comprehensive regulatory framework for cable television. Violation by a cable operator of the statutory provisions or the rules and regulations of the FCC can subject the operator to substantial monetary penalties and other significant sanctions. While many of the specific obligations imposed on cable television systems under the 1992 Cable Act are complex, burdensome and will increase KBLCOM's costs of doing business, it is impossible to assess the detailed impact of the 1992 Cable Act, other than the Rate Rule and the Must Carry Rule on KBLCOM. Telephone companies continue in their efforts to repeal legislative prohibitions against their ownership of cable television systems. At this time, RBOCs are still prohibited by the Cable Act from owning or operating a cable television system within their service areas. However, in a decision rendered in The Chesapeake and Potomac Telephone Company of Virginia, et al. v. United States, et al., No. 92-1751-A, on August 24, 1993, the U. S. District Court for the Eastern District of Virginia ruled that the portion of the Cable Act prohibiting subsidiaries of Bell Atlantic from owning a cable television system within their service areas violated the First Amendment to the United States Constitution. The court, in subsequent rulings, refused to extend its ruling to other RBOCs and refused to stay its decision pending appeal. As a consequence, the Bell Atlantic subsidiaries can engage in the cable television business, including owning cable television systems, despite the Cable Act's language. A final affirmation of the court's decision could result in additional direct competition for KBLCOM. No prediction can be made at this time concerning the impact, if any, of this decision on KBLCOM and the Company. Any changes to the ownership prohibitions could result in additional direct competition for KBLCOM. FINANCIAL IMPACT ON KBLCOM. KBLCOM's responses to the Rate Rule included, among other things, restructuring of certain program offerings, a reduction in rates for services regulated according to the Rate Rule and an increase in rates for programming services previously offered in the basic service or cable programming service tier which are not subject to rate regulation and for which fees will be charged on a per-channel basis. KBLCOM estimates that revenues in 1993 from its owned and operated cable systems were reduced by approximately $6.8 million. A large portion of this decrease in revenues is derived from a reduction in revenue from additional outlets. There can be no assurance at this time, however, that the reaction of customers to these changes will continue, and variations in such matters could change the financial impact on KBLCOM. For information regarding the impact of the Cable Act regulations on KBLCOM's financial condition and results of operation, see "KBLCOM - Financial Impact on KBLCOM" in Item 7 of this Report. EMPLOYEES Excluding employees of Paragon, KBLCOM had 1,581 full-time employees as of December 31, 1993, none of whom are represented by a union. As of December 31, 1993, Paragon had 1,820 full-time employees of whom 583 were represented by unions. BUSINESSES OF OTHER SUBSIDIARIES. HI ENERGY HI Energy was recently organized by the Company to participate in domestic and foreign power generation projects and to invest in the privatization of foreign electric utilities. HI Energy is actively engaged in the evaluation of several such projects, but has not yet committed significant financial or other resources to any single project. HOUSTON ARGENTINA Houston Argentina, a subsidiary of the Company located in Buenos Aires, Argentina, acquired a 32.5% interest in Compania de Inversiones en Electricidad S.A. (COINELEC), an Argentine holding company which acquired, in December 1992, a 51% interest in Empresa Distribuidora La Plata S.A. (EDELAP), an electric utility company operating in La Plata, Argentina and surrounding areas. Houston Argentina's share of the purchase price was $37.4 million in cash. Subsequent to the acquisition, the generating assets of EDELAP were transferred to Central Dique S.A., an Argentine corporation, 51% of the stock of which is owned by COINELEC. Houston Argentina provides technical and managerial service to EDELAP and Central Dique S.A. UTILITY FUELS On October 8, 1993, Utility Fuels, the Company's coal supply subsidiary, was merged into HL&P. The Company's consolidated financial statements have been reclassified, and HL&P's financial statements have been restated to reflect the merger. See Note 1(b) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Prior to the merger, Utility Fuels provided coal and lignite purchasing, transportation and handling services to HL&P. For information with respect to HL&P's sources of coal and lignite, see "Business of HL&P - Fuel - Coal and Lignite Supply." REGULATION OF THE COMPANY. FEDERAL 1935 ACT. The Company is a holding company as defined in the 1935 Act. It is exempt from regulation under the 1935 Act except with respect to the acquisition of certain voting securities of other domestic public utility companies and holding companies. The Company's exemption is based upon the intrastate character of the operations of its public utility subsidiary, HL&P, and the filing with the SEC of an annual exemption statement pursuant to Section 3(a)(1) of the 1935 Act and Rule 2 thereunder. The SEC is authorized by the 1935 Act and by its own rules to deny or terminate such an exemption upon a determination that it is detrimental to the public interest or to the interest of investors or consumers. Based on past SEC policy, there may be limits on the extent to which the Company and its non-utility subsidiaries may engage in non-utility activity without affecting the Company's exempt status. The Company has no present intention, however, of becoming a registered holding company subject to regulation by the SEC under the 1935 Act. The Energy Act, which amended the 1935 Act, provides that, subject to certain conditions, foreign utility companies are exempt from the provisions of the 1935 Act and will not be deemed to be "public utility companies" under the 1935 Act. For information with respect to the Energy Act, see "Business of HL&P - Competition" and "Business of HL&P - Regulatory Matters" and Note 8(a) to the Company's and HL&P's Financial Statements in Item 8 of this Report. STATE The Company is not subject to regulation by the Utility Commission under PURA or by the incorporated municipalities served by HL&P. Those regulatory bodies do, however, have authority to review accounts, records and contracts relating to transactions by HL&P with the Company and its other subsidiaries. The exemption for foreign utility affiliates of the Company from regulation under the 1935 Act as "public utility companies" is dependent upon certification by the Utility Commission to the SEC to the effect that it has the authority to protect HL&P's ratepayers from any adverse consequences of the Company's investment in foreign utilities and that it intends to exercise its authority. The Utility Commission provided to the SEC such certification at the time of the Company's acquisition of an indirect interest in an Argentine utility company. The certification is subject, however, to being revised or withdrawn by the Utility Commission as to any future acquisition. EXECUTIVE OFFICERS OF THE COMPANY (1) AS OF MARCH 1, 1994 - ----------------- (1) All of the officers have been elected to serve until the annual meeting of the Board of Directors scheduled to occur on May 4, 1994 and until their successors qualify. (2) At December 31, 1993. EXECUTIVE OFFICERS OF HL&P (1)(2) AS OF MARCH 1, 1994 - ----------------- (1) All of the officers have been elected to serve until the annual meeting of the Board of Directors scheduled to occur on May 4, 1994 and until their successors qualify. (2) For the purposes of the requirements of this Report, the HL&P officers listed may also be deemed to be executive officers of the Company. (3) At December 31, 1993. ITEM 2. ITEM 2. PROPERTIES. The Company considers its property and the property of its subsidiaries to be well maintained, in good operating condition and suitable for their intended purposes. HL&P All of HL&P's electric generating stations and all of the other operating property of HL&P are located in the State of Texas. ELECTRIC GENERATING STATIONS. As of December 31, 1993, HL&P owned eleven electric generating stations (61 generating units) with a combined turbine nameplate rating of 13,425,868 KW, including a 30.8% interest in one station (two units) with a combined turbine nameplate rating of 2,623,676 KW. SUBSTATIONS. As of December 31, 1993, HL&P owned 204 major substations (with capacities of at least 10.0 Mva) having a total installed rated transformer capacity of 55,257 Mva (exclusive of spare transformers), including a 30.8% interest in one major substation with an installed rated transformer capacity of 3,080 Mva. ELECTRIC LINES-OVERHEAD. As of December 31, 1993, HL&P operated 24,084 pole miles of overhead distribution lines and 3,569 circuit miles of overhead transmission lines including 534 circuit miles operated at 69,000 volts, 2,005 circuit miles operated at 138,000 volts and 1,030 circuit miles operated at 345,000 volts. ELECTRIC LINES-UNDERGROUND. As of December 31, 1993, HL&P operated 7,840 circuit miles of underground distribution lines and 12.6 circuit miles of underground transmission lines including 8.1 circuit miles operated at 138,000 volts and 4.5 circuit miles operated at 69,000 volts. GENERAL PROPERTIES. HL&P owns various properties including division offices, service centers, telecommunications equipment and other facilities used for general purposes. TITLE. The electric generating plants and other important units of property of HL&P are situated on lands owned in fee by HL&P. Transmission lines and distribution systems have been constructed in part on or across privately owned land pursuant to easements or on streets and highways and across waterways pursuant to authority granted by municipal and county permits, and by permits issued by state and federal governmental authorities. Under the laws of the State of Texas, HL&P has the right of eminent domain pursuant to which it may secure or perfect rights-of-way over private property, if necessary. The major properties of HL&P are subject to liens securing its long-term debt, and title to some of its properties are subject to minor encumbrances and defects, none of which impairs the use of such properties in the operation of its business. KBLCOM The principal tangible assets (other than real estate) relating to KBLCOM's cable television operations consist of operating plant and equipment for each of its cable television systems. These include signal receiving apparatus, "headend" facilities, coaxial and fiber optic cable or wire and related electronic equipment over which programming and data are distributed, and decoding converters attached to subscribers' television receivers. The signal receiving apparatus typically includes a tower, antennae, ancillary electronic equipment and earth stations for reception of video, audio and data signals transmitted by satellite. Headend facilities, which consist of associated electronic equipment necessary for the reception, amplification, switching and modulation of signals, are located near the signal receiving apparatus and control the programming and data signals distributed on the cable system. For certain information with respect to property owned directly or indirectly by KBLCOM, see "Business of KBLCOM" in Item 1 of this Report. OTHER SUBSIDIARIES For certain information with respect to property owned directly or indirectly by the other subsidiaries of the Company, see "Businesses of Other Subsidiaries" in Item 1 of this Report. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. For a description of certain legal and regulatory proceedings affecting the Company and its subsidiaries, see Notes 9 through 12 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report, which notes are incorporated herein by reference. In August 1993, HL&P entered into a Consent Agreement with the EPA that resolved three Administrative Orders issued by the EPA in 1991 and 1992 regarding alleged violations of certain provisions of the Clean Water Act at Limestone during the period 1989 through 1992. Pursuant to the Consent Agreement, HL&P, while neither admitting nor denying the allegations contained in the complaint, agreed to pay the EPA $87,500. On August 29, 1991, the EPA issued an Administrative Order related to alleged noncompliance at W. A. Parish. HL&P has taken action to address the issues cited by the EPA and believes them to be substantially resolved at this time. From time to time, HL&P sells equipment and material it no longer requires for its business. In the past, some purchasers may have improperly handled the material, principally through improper disposal of oils containing PCBs used in older transformers. Claims have been asserted against HL&P for clean-up of environmental contamination as well as for personal injury and property damages resulting from the purchasers' alleged improper activities. Although HL&P has disputed its responsibility for the actions of such purchasers, HL&P has, in some cases, participated in or contributed to the remediation of those sites. Such undertakings in the past have not required material expenditures by HL&P. In 1990, HL&P, together with other companies, participated in the clean-up of one such site. Three suits have been brought against HL&P and a number of other parties for personal injury and property damages in connection with that site and its cleanup. In two of the cases, Dumes, et al. vs. Houston Lighting & Power Company, et al., pending in the United States District Court for the Southern District of Texas, Corpus Christi Division, and Trevino, et al. vs. Houston Lighting & Power Company, et al., pending before the 117th District Court of Nueces County, Texas, landowners near the site are seeking damages primarily for lead contamination to their property. A third lawsuit, Holland vs. Central Power and Light Company, et al., involving an allegation of exposure to PCBs disposed of at the site, was dismissed pursuant to a settlement agreement entered into by the parties in July 1993. The terms of the settlement were not material. In all these cases, HL&P has disputed its responsibility for the actions of the disposal site operator and whether injuries or damages occurred. In addition, Gulf States has filed suit in the United States District Court for the Southern District of Texas, Houston Division, against HL&P and two other utilities concerning another site in Houston, Texas, which allegedly has been contaminated by PCBs and which Gulf States has undertaken to remediate pursuant to an EPA order. Gulf States seeks contribution from HL&P and the other utilities for Gulf States' remediation costs. HL&P does not currently believe that it has any responsibility for that site, and HL&P has not been determined by the EPA to be a responsible party for that site. Discovery is underway in all these pending cases and, although their ultimate outcomes cannot be predicted at this time, HL&P and the Company believe, based on information currently available, that none of these cases will result in a material adverse effect on the Company's or HL&P's financial condition or results of operations. For information with respect to the EPA's identification of HL&P as a "potentially responsible party" for remediation of a CERCLA site adjacent to one of HL&P's transmission lines in Harris County, see "Liquidity and Capital Resources - HL&P - Environmental Expenditures" in Item 7 of this Report, which information is incorporated herein by reference. HL&P and the other owners of the South Texas Project have filed suit against Westinghouse in the District Court for Matagorda County, Texas (Cause No. 90-S-0684-C), alleging breach of warranty and misrepresentation in connection with the steam generators supplied by Westinghouse for the South Texas Project. In recent years, other utilities have encountered stress corrosion cracking in steam generator tubes in Westinghouse units similar to those supplied for the South Texas Project. Failure of such tubes can result in a reduction of plant efficiency, and, in some cases, utilities have replaced their steam generators. During an inspection concluded in the fall of 1993, evidence was found of stress corrosion cracking consistent with that encountered with Westinghouse steam generators at other facilities, and a small number of tubes were found to require plugging. To date, stress corrosion cracking has not had a significant impact on operation of either unit; however, the owners of the South Texas Project have approved remedial operating plans and have undertaken expenditures to minimize and delay further corrosion. The litigation, which is in discovery, seeks appropriate damages and other relief from Westinghouse and is currently scheduled for trial in the fall of 1994. No prediction can be made as to the ultimate outcome of that litigation. 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 Company's Common Stock, which at February 1, 1994 was held of record by approximately 70,730 shareholders, is listed on the New York, Chicago (formerly Midwest) and London Stock Exchanges (symbol: HOU). The following table sets forth the high and low sales prices of the Common Stock on the composite tape during the periods indicated, as reported by The Wall Street Journal, and the dividends declared for such periods. Third quarter 1993 includes two quarterly dividends of $.75 per share due to a change in the timing of the Company's Board of Directors' declaration of dividends. Dividend payout was $3.00 per share for 1993. The dividend declared during the fourth quarter of 1993 is payable in March 1994. On December 31, 1993, the consolidated book value of the Company's common stock was $25.06 per share, and the closing market price was $47.63 per share. There are no contractual limitations on the payment of dividends on the common stock of the Company or on the common stock of the Company's subsidiaries other than KBL Cable. Restrictions on distributions and other financial covenants in KBL Cable credit agreements and other debt instruments affecting KBL Cable will effectively prevent the payment of common stock dividends by these subsidiaries for the foreseeable future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA OF THE COMPANY The following table sets forth selected financial data with respect to the Company's consolidated financial condition and consolidated results of operations and should be read in conjunction with the Consolidated Financial Statements and the related notes included elsewhere herein. (1) Reflects reclassification for the years 1989-1992 due to the merger of Utility Fuels into HL&P. (2) The 1990 cumulative effect reflects the effects for years prior to 1990 of the adoption of SFAS No. 109, "Accounting for Income Taxes." The 1992 cumulative effect relates to the change in accounting for revenues. See also Note 19 to the Company's Consolidated and HL&P's Financial Statements. (3) Year ended December 31, 1993 includes five quarterly dividends of $.75 per share due to a change in the timing of the Company's Board of Directors declaration of dividends. Dividend payout was $3.00 per share for 1993. (4) Amounts differ from previously reported amounts for 1991 and 1992 because of the reclassification of interest income on ESOP note. (5) Includes Cumulative Preferred Stock subject to mandatory redemption. ITEM 6. SELECTED FINANCIAL DATA OF HL&P The following table sets forth selected financial data with respect to HL&P's financial condition and results of operations and should be read in conjunction with the Financial Statements and the related notes included elsewhere herein. (1) The 1992 cumulative effect relates to the change in accounting for revenues. See also Note 19 to HL&P's Financial Statements. (2) Includes Cumulative Preferred Stock subject to mandatory redemption. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS COMPANY. Selected financial data for Houston Industries Incorporated (Company) is set forth below: Consolidated earnings per share were $3.20 for 1993 as compared to $3.36 per share in 1992 and $3.24 per share in 1991. The Company's 1992 earnings were increased by non-recurring items at Houston Lighting & Power Company (HL&P), the Company's electric utility subsidiary, as discussed below. Without these items, the Company's earnings for the year ended 1992 would have been $397.5 million or $3.07 per share. HL&P contributed $3.46 to the 1993 consolidated earnings per share on income of $449.8 million after preferred dividends. KBLCOM Incorporated (KBLCOM), the Company's cable television subsidiary, posted a loss of $13.0 million or $.10 per share. The Company and its other subsidiaries posted a combined loss of $.l6 per share. Omnibus Budget Reconciliation Act of 1993 (OBRA). As a result of the 1% general corporate income tax rate increase imposed by OBRA, the Company's 1993 results were negatively impacted by $14.3 million. For additional information regarding the effect of OBRA on the Company, see Note 14 to the Company's Consolidated and HL&P's Financial Statements in Item 8 Item 8 of this Report. THE COMPANY. Sources of Capital Resources and Liquidity. The Company has consolidated its financing activities in order to provide a coordinated, cost-effective method of meeting short and long-term capital requirements. As part of the consolidated financing program, the Company has established a "money fund" through which its subsidiaries can borrow or invest on a short-term basis. The funding requirements of individual subsidiaries are aggregated and borrowing or investing is conducted by the Company based on the net cash position. Net funding requirements are met with borrowings under the Company's commercial paper program except that HL&P's borrowing requirements are generally met with HL&P's commercial paper program. As of December 31, 1993, the Company had a bank credit facility of $500 million (exclusive of bank credit facilities of subsidiaries), which was used to support its commercial paper program. At December 31, 1993, the Company had approximately $420 million of commercial paper outstanding. Rates paid by the Company on its short-term borrowings are generally lower than the prime rate. Subsequent to December 31, 1993, the Company's bank line of credit was increased to $600 millon. The Company has registered with the Securities and Exchange Commission (SEC) $250 million principal amount of debt securities which remain unissued. Proceeds from any sales of these debt securities are expected to be used for general corporate purposes including investments in and loans to subsidiaries. The Company also has registered with the SEC five million shares of its common stock. Proceeds from the sale of these securities will be used for general corporate purposes, including, but not limited to, the redemption, repayment or retirement of outstanding indebtedness of the Company or the advance or contribution of funds to one or more of the Company's subsidiaries to be used for their general corporate purposes, including, without limitation, the redemption, repayment or retirement of indebtedness or preferred stock. Employee Stock Ownership Plan (ESOP). In October 1990, the Company amended its existing savings plan to add an ESOP component to the plan. The ESOP component of the plan allows the Company to satisfy a portion of its obligations to make matching contributions under the plan. The ESOP trustee purchased shares of the Company's common stock in open market transactions with funds provided by loans from the Company and completed the purchase of stock under the ESOP in December 1991 after purchasing 9,381,092 shares at a cost of $350 million. As the ESOP loans are repaid by the ESOP trustee over a period of up to 20 years, the common stock purchased for the plan will be allocated to the participants' accounts. The loans will be repaid with dividends on the common stock in, and Company contributions to, the plan. The loans to the plan were funded initially by the Company from short-term borrowings which have been refinanced with long-term debt. At December 31, 1993, the balance of the ESOP loans was approximately $332 million. For a further discussion, see Note 7(b) to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Houston Argentina. Houston Argentina S. A. (Houston Argentina), a subsidiary of the Company, owns a 32.5% interest in Compania de Inversiones en Electricidad S. A. (COINELEC), an Argentine holding company which acquired, in December 1992, a 51% interest in Empresa Distribuidora La Plata S. A. (EDELAP), an electric utility company operating in La Plata, Argentina and surrounding regions. Houston Argentina's share of the purchase price was approximately $37.4 million, of which $1.6 million was paid in December 1992 with the remainder paid in March 1993. Subsequent to the acquisition, the generating assets of EDELAP were transferred to Central Dique S. A., an Argentine corporation, 51% of the stock of which is owned by COINELEC. HL&P. HL&P's cash requirements stem primarily from operating expenses, capital expenditures, payment of common stock dividends, payment of preferred stock dividends, and interest and principal payments on debt. HL&P's net cash provided by operating activities for 1993 totaled approximately $1.1 billion. Net cash used in HL&P's investing activities for 1993 totaled $345.9 million. HL&P's financing activities for 1993 resulted in a net cash outflow of $782.4 million. Included in these activities were the payment of dividends, the payment and extinguishment of long-term debt and redemption of preferred stock, partially offset by the issuance of long-term debt. For information with respect to these matters, see Notes 3 and 4 to the Company's Consolidated and HL&P's Financial Statements in Item 8 of this Report. Capital Program. HL&P's construction and nuclear fuel expenditures (excluding AFUDC) for 1993 totaled $329 million, which was below the authorized budgeted level of $345 million. Estimated expenditures for 1994, 1995 and 1996 are $478 million, $381 million and $418 million, respectively. Maturities of long-term debt and preferred stock with mandatory redemption provisions and capital leases for this same period include $45 million in 1994, $50 million in 1995 and $200 million in 1996. HL&P's construction program for the next three years is expected to relate to costs for production, transmission, distribution, and general plant. HL&P began construction of the E.I. du Pont de Nemours Company (DuPont) project in 1993 in order to provide generating capacity in 1995. The DuPont project is based on a contractual agreement between HL&P and DuPont, whereby HL&P will construct, own, and operate two 80 megawatt gas turbine units located at DuPont's LaPorte, Texas facility. The project will supply DuPont with process steam while all electrical energy will be used in the HL&P system. HL&P's capital program is subject to periodic review and portions may be revised from time to time due to changes in load forecasts, changing regulatory and environmental standards and other factors. Financing Activities. In January 1993, HL&P repaid at maturity $136 million aggregate principal amount of its 9 3/8% first mortgage bonds. In March 1993, HL&P issued $250 million principal amount of 7 3/4% first mortgage bonds due 2023 and $150 million principal amount of 6.10% collateralized medium-term notes due 2000. In April 1993, HL&P issued $150 million principal amount of 6.50% collateralized medium-term notes due 2003. Proceeds of the offerings were used to provide funds for the purchases and redemptions of HL&P's first mortgage bonds (including those series described below) and for general corporate purposes, including the repayment of short-term indebtedness of HL&P. In April 1993, HL&P purchased the following first mortgage bonds pursuant to tender offers for any and all bonds of such series: In April 1993, HL&P called for redemption the remaining $18,220,500 of its 8 3/4% first mortgage bonds due 2005 at 100.61% of their principal amount, the remaining $50,473,500 of its 8 3/8% first mortgage bonds due 2006 at 100.38% of their principal amount, the remaining $52,565,000 of its 8 3/8% first mortgage bonds due 2007 at 100.64% of their principal amount, the remaining $54,045,000 of its 8 1/8% first mortgage bonds due 2004 at 101.13% of their principal amount, the outstanding $50,000,000 of its 7 1/2% first mortgage bonds due 2001 at 100.85% of their principal amount and the outstanding $30,000,000 of its 7 1/2% first mortgage bonds due 1999 at 100.68% of their principal amount. Approximately $263 million deposited in the Replacement Fund in March 1993 was applied to the May 1993 redemption of these bonds. In June 1993, HL&P redeemed 400,000 shares of its $8.50 cumulative preferred stock at $100 per share pursuant to sinking fund provisions. In July 1993, HL&P issued $200 million principal amount of 7 1/2% first mortgage bonds due 2023. Proceeds were used to provide funds for the redemption of HL&P's first mortgage bonds referenced in the following paragraph and the repayment of approximately $80 million aggregate principal amount of intercompany debt owed to the Company, which was assumed by HL&P upon the merger of Utility Fuels, Inc. into HL&P. In October 1993, HL&P redeemed, at 106.57% of their principal amount, $390,519,000 aggregate principal amount of its 9% first mortgage bonds due 2017. In December 1993, the Brazos River Authority (BRA) and the Gulf Coast Waste Disposal Authority (GCWDA) issued on behalf of HL&P $100,165,000 aggregate principal amount of revenue refunding bonds collateralized by HL&P's first mortgage bonds. The BRA issuance of $83,565,000 principal amount has an interest rate of 5.6% and matures in 2017. The GCWDA issuance of $16,600,000 principal amount has an interest rate of 4.9% and matures in 2003. Proceeds were used in 1994 to redeem, at 102% of their aggregate principal amount, $83,565,000 principal amount of pollution control revenue bonds previously issued on behalf of HL&P by the BRA and, at 100% of their aggregate principal amount, $16,600,000 principal amount of pollution control revenue bonds previously issued on behalf of HL&P by the GCWDA. Sources of Capital Resources and Liquidity. HL&P expects to finance its capital program for the period 1994-1996 with funds generated internally from operations. HL&P has registered with the SEC $230 million aggregate liquidation value of preferred stock and $580 million aggregate principal amount of debt securities that may be issued as first mortgage bonds and/or as debt securities collateralized by first mortgage bonds. Proceeds from the sales of these securities are expected to be used for general corporate purposes including the purchase, redemption (to the extent permitted by the terms of the outstanding securities), repayment or retirement of outstanding indebtedness or preferred stock of HL&P. HL&P's interim financing requirements are met through the issuance of short-term debt, primarily commercial paper. At December 31, 1993, HL&P had outstanding commercial paper of approximately $171 million, which was supported by a bank credit facility of $250 million. Subsequent to December 31, 1993, HL&P's line of credit was increased to $400 millon. HL&P's capitalization at December 31, 1993 was 43% long-term debt, 7% preferred stock and 50% common equity. Environmental Expenditures. In November 1990, the Clean Air Act was extensively amended by Congress. HL&P has already made an investment in pollution control facilities, and all of its generating facilities currently comply in all material respects with sulfur dioxide emission standards established by the statute. Provisions of the Clean Air Act dealing with urban air pollution required establishing new emission limitations for nitrogen oxides from existing sources. The cost of modifications necessary to reduce nitrogen oxide emissions from existing sources has been estimated at $29 million in 1994 and $10.5 million in 1995. In addition, continuous emission monitoring regulations are anticipated to require expenditures of $12 million in 1994 and $2 million in 1995. Capital expenditures are expected to total $71 million for the years 1994 through 1996. The United States Environmental Protection Agency (EPA) has identified HL&P as a "potentially responsible party" for the costs of remediation of a Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) site located adjacent to one of HL&P's transmission lines in Harris County. Although HL&P did not contribute waste to or operate the site, the party primarily responsible for contributing waste to the site and possibly other potentially responsible parties have alleged that waste disposal pits dug by the site operator encroach onto HL&P's property and therefore HL&P is responsible as a site owner. Although HL&P admits that it owns an adjacent strip of land onto which substances from the site appear to have migrated, it denies that it ever owned the strip of land containing the pits. In June 1993, a Galveston County District Court entered a final judgment to the effect that HL&P did not own the disputed strip of land. In October 1992, the EPA issued an Administrative Order to HL&P and several other companies purporting to require those parties to implement the management of migration remediation at the site. A related Administrative Order had been issued in June 1990. Neither the EPA nor any other responsible party has presented HL&P with a claim for a share of costs for the management of the migration remediation design or operation. However, in the event HL&P were ultimately held to be a responsible party for the remediation of this site and if other responsible parties do not complete the management of migration remediation, CERCLA provides for substantial remedies that could be pursued by the United States, including substantial fines, punitive damages and treble damages for costs incurred by the United States in completing such remediation. The aggregate potential clean-up costs for the entire site have been estimated to be approximately $80 million. Although no prediction can be made at this time as to the ultimate outcome of this matter, in light of all the circumstances, the Company and HL&P do not believe that any costs that HL&P incurs in this matter will have a material adverse effect on the Company's or HL&P's financial condition or results of operations. KBLCOM. KBLCOM's cash requirements stem primarily from operating expenses, capital expenditures, and interest and principal payments on debt. KBLCOM's net cash provided by operating activities was $13.9 million in 1993. Net cash used in KBLCOM's investing activities for 1993 totaled $61.9 million, primarily due to property additions which approximated $54.5 million. These amounts were financed principally through internally generated funds and intercompany advances. A substantial portion of KBLCOM's 1994-1996 capital requirements is expected to be met through internally generated funds. It is expected that any shortfall will be met through intercompany borrowings. KBLCOM's financing activities for 1993 resulted in a net cash inflow of $47.9 million. Included in these activities were the reduction of third party debt, proceeds from additional paid-in capital and an increase in borrowings from the Company. Financing Activities. In the first quarter of 1993, KBL Cable repaid $6.4 million principal amount of its senior notes and senior subordinated notes. In the second and third quarters of 1993, KBL Cable repaid borrowings under its senior bank credit facility in the amounts of $15 million and $56 million, respectively. These repayments were partially offset by $20 million in additional borrowing under the senior bank credit facility during the first quarter of 1993. In the first quarter of 1993, KBLCOM prepaid $167.3 million of senior bank debt funded with proceeds from the Company's additional equity investment. The Company obtained the funds for such investment from the sale of commercial paper. This KBLCOM debt was included in current portion of long-term debt and preferred stock at December 31, 1992 on the Company's Consolidated Balance Sheets. Sources of Capital Resources and Liquidity. In the first quarter of 1993, KBLCOM reduced its outstanding indebtedness by approximately $153.7 million. This was accomplished through an equity investment of approximately $167.3 million from the Company (funded with proceeds from the sale of commercial paper by the Company) and offset by net additional borrowing of $13.6 million. In the second quarter of 1993, the Company made capital contributions to KBLCOM aggregating approximately $114.3 million. The capital contributions included KBL Cable senior notes aggregating approximately $29 million and KBL Cable senior subordinated notes aggregating approximately $36 million that had been previously acquired by the Company. The Company contributed such notes to KBLCOM which, in turn, contributed such notes to KBL Cable, a subsidiary of KBLCOM which retired and canceled the notes. The balance of the capital contributions resulted from the conversion to equity of intercompany debt payable by KBLCOM to the Company. The capital contributions will have no impact on the consolidated earnings of the Company. Additional borrowing under KBL Cable's bank facility is subject to certain covenants which relate primarily to the maintenance of certain financial ratios, principally debt to cash flow and interest coverages. KBL Cable presently is in compliance with such covenants. Cash requirements for 1994 are expected to be met through intercompany borrowing and contributions, internally generated funds, and borrowing under existing credit lines of KBLCOM's subsidiaries. At December 31, 1993, KBL Cable had $108.5 million available for borrowing under its bank facility. The line of credit has scheduled reductions in March of each year until it is eliminated in March 1999. Recent Developments. The Company has engaged an investment banking firm to assist in finding a strategic partner or investor for KBLCOM in the telecommunications industry. On February 17, 1994, KBLCOM entered into an agreement to acquire three cable companies serving approximately 47,000 customers in the Minneapolis area. KBLCOM will acquire the stock of the companies in exchange for the issuance of common stock of the Company. The amount of common stock of the Company to be issued, currently estimated to be approximately $24 million, is dependent on the amount of liabilities assumed, currently estimated to be approximately $63 million. Approximately 40,000 of the cable customers served by the properties to be acquired are in the Minneapolis metropolitan area. The remaining 7,000 customers are located in small communities south and west of the metropolitan area. Closing of the transaction is subject to the satisfaction of certain conditions. HOUSTON INDUSTRIES FINANCE. During 1992, Houston Industries Finance, Inc. (Houston Industries Finance) purchased accounts receivable of HL&P and of certain KBLCOM subsidiaries. In January 1993, Houston Industries Finance sold the receivables back to the respective subsidiaries. HL&P is now selling its accounts receivable and most of its accrued unbilled revenues to a third party. As of January 12, 1993, Houston Industries Finance ceased operations and its $300 million bank revolving credit facility and related commercial paper program were terminated. The subsidiary was merged into the Company effective June 8, 1993. NEW ACCOUNTING PRONOUNCEMENTS In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This accounting standard, effective for fiscal years beginning after December 15, 1993 requires companies to recognize the liability for benefits provided to former or inactive employees, their beneficiaries and covered dependents after employment but before retirement. Those benefits include, but are not limited to, salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits (including worker's compensation), job training and counseling, and continuation of benefits such as health care and life insurance. The Company will adopt SFAS No. 112 in 1994. The transition obligation of approximately $20 million will be expensed upon adoption and reported similar to the cumulative effect of a change in accounting principle. The Company estimates that benefit costs for 1994 (exclusive of the transition obligation) will be approximately $1 million over the expected pay-as-you-go amount. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED INCOME (THOUSANDS OF DOLLARS) (continued on next page) HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED INCOME (THOUSANDS OF DOLLARS) (CONTINUED) See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED RETAINED EARNINGS (THOUSANDS OF DOLLARS) See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (THOUSANDS OF DOLLARS) ASSETS See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (THOUSANDS OF DOLLARS) CAPITALIZATION AND LIABILITIES See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (continued on next page) HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (CONTINUED) (continued on next page) HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (CONTINUED) See Notes to Consolidated Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED CASH FLOWS INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (THOUSANDS OF DOLLARS) (continued on next page) HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED CASH FLOWS INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (THOUSANDS OF DOLLARS) See Notes to Consolidated Financial Statements. HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF INCOME (THOUSANDS OF DOLLARS) See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF RETAINED EARNINGS (THOUSANDS OF DOLLARS) See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY BALANCE SHEETS (THOUSANDS OF DOLLARS) ASSETS See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY BALANCE SHEETS (THOUSANDS OF DOLLARS) CAPITALIZATION AND LIABILITIES See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (continued on next page) HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF CAPITALIZATION (THOUSANDS OF DOLLARS) (CONTINUED) See Notes to Financial Statements. HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF CASH FLOWS Increase (Decrease) in Cash and Cash Equivalents (Thousands of Dollars) (continued on next page) HOUSTON LIGHTING & POWER COMPANY STATEMENTS OF CASH FLOWS Increase (Decrease) in Cash and Cash Equivalents (Thousands of Dollars) (Continued) See Notes to Financial Statements. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) SYSTEM OF ACCOUNTS. The accounting records of Houston Lighting & Power Company (HL&P), the principal subsidiary of Houston Industries Incorporated (Company), are maintained in accordance with the Federal Energy Regulatory Commission's Uniform System of Accounts as adopted by the Public Utility Commission of Texas (Utility Commission). (B) PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Effective October 8, 1993, the Company merged Utility Fuels Inc. (Utility Fuels), the Company's coal supply subsidiary, into HL&P. Accounting for the merger did not affect consolidated earnings. All significant intercompany transactions and balances are eliminated in consolidation except sales of accounts receivable to Houston Industries Finance, Inc. (Houston Industries Finance), a former subsidiary of the Company, which were not eliminated because of the distinction for regulatory purposes between utility and non-utility operations. As of January 12, 1993, Houston Industries Finance sold the receivables back to the respective subsidiaries and ceased operations. HL&P is now selling its accounts receivable and most of its accrued unbilled revenues to a third party. Investments in affiliates in which the Company has a 20% to 50% interest, which include the investment in Paragon Communications (Paragon), are recorded using the equity method of accounting. See Note 17. (C) ELECTRIC PLANT. Additions to electric plant, betterments to existing property and replacements of units of property are capitalized at cost. Cost includes the original cost of contracted services, direct labor and material, indirect charges for engineering supervision and similar overhead items and an Allowance for Funds Used During Construction (AFUDC). Customer advances for construction reduce additions to electric plant. HL&P computes depreciation using the straight-line method. The depreciation provision as a percentage of the depreciable cost of plant was 3.1% for 1993, and 3.2% for 1992 and 1991. (D) CABLE TELEVISION PROPERTY. KBLCOM Incorporated (KBLCOM), the Company's cable television subsidiary, records additions to property at cost which include amounts for material, labor, overhead and interest. Depreciation is computed using the straight-line method. Depreciation as a percentage of the depreciable cost of property was 11.3% for 1993, 12.1% for 1992, and 11.7% for 1991. Expenditures for maintenance and repairs are expensed as incurred. (E) CABLE TELEVISION FRANCHISES AND INTANGIBLE ASSETS. KBLCOM has recorded the acquisition cost in excess of the fair market value of the tangible assets and liabilities of RCA Cablesystems Holding Co. (Cablesystems) in cable television franchises and intangible assets acquired in 1989. Such amount is being amortized over periods ranging from 8 to 40 years on a straight-line basis. KBLCOM periodically reviews the carrying value of cable television franchises and intangible assets in relation to current and expected operating results of the business in order to assess whether there has been a permanent impairment of such amounts. (F) ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION. HL&P accrues AFUDC on construction projects and nuclear fuel payments, except for amounts included in the rate base pursuant to regulatory authorization. The accrual rates were 7.25% in 1993 and 8.75% in 1992 and 1991. (G) REVENUES. Effective January 1, 1992, HL&P changed its method of recording electricity sales from cycle billing to a full accrual method, whereby unbilled electricity sales are estimated and recorded each month in order to better match revenues with expenses. Prior to January 1, 1992, electric revenues were recognized as bills were rendered (see Note 19). The Utility Commission provides for the recovery of certain fuel and purchased power costs through an energy component of base electric rates. Cable television revenues are recognized as the services are provided to subscribers, and advertising revenues are recorded when earned. (H) INCOME TAXES. The Company follows a policy of comprehensive interperiod income tax allocation. Investment tax credits are deferred and amortized over the estimated lives of the related property. In 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," with restatement to January 1, 1990 (see Note 14). Under current tax laws, the Company may realize tax savings by deducting for tax purposes dividends on the Company's common stock that are used to pay debt service on the Employee Stock Ownership Plan (ESOP) loans (see Note 7). (I) EARNINGS PER COMMON SHARE. Earnings per common share for the Company is computed by dividing net income by the weighted average number of shares outstanding during the respective period. (J) STATEMENTS OF CONSOLIDATED CASH FLOWS. For purposes of reporting cash flows, cash equivalents are considered to be short-term, highly liquid investments readily convertible to cash. (2) COMMON STOCK In May 1993, the Company's shareholders approved an increase in the Company's authorized common stock from 200,000,000 shares to 400,000,000 shares. In 1993, the Company paid four regular quarterly dividends aggregating $3.00 per share on its common stock pursuant to dividend declarations made in 1993. In December 1993, the Company declared its regular quarterly dividend of $.75 per share to be paid in March 1994. All dividends declared in 1993 have been included in 1993 common stock dividends on the Company's Statements of Consolidated Retained Earnings and, with respect to the dividends declared in December 1993, in dividends accrued at December 31, 1993 on the Company's Consolidated Balance Sheets. In May 1989, the Company adopted, with shareholder approval, a long-term incentive compensation plan (1989 LICP Plan), which provided for the issuance of certain stock incentives (including performance-based restricted shares and stock options). A maximum of 500,000 shares of common stock may be issued under the 1989 LICP Plan, of which 300,090 shares were available for issuance as of December 31, 1993. In 1993, 73,282 shares of performance-based restricted shares were issued to plan participants. In January 1992, non-statutory stock options for 67,984 shares of the Company's stock were granted to key employees of the Company and its subsidiaries at an option price of $43.50 per share, of which 679 shares were exercised during 1993. Options for 21,430 shares from the January 1992 grant were exercisable on December 31, 1993. In January 1993, non- statutory stock options for 65,776 shares of the Company's stock were granted at an option price of $46.25 per share. Beginning one year after the grant date, the options become exercisable in one-third increments each year. The options expire ten years from the grant date. At December 31, 1993, 7,132 shares had been canceled under provisions of the plan. In May 1993, the Company adopted, with shareholder approval, a new long-term incentive compensation plan (1994 LICP Plan), providing for the issuance of certain stock incentives (including performance-based restricted shares and stock options) of the general nature provided by the 1989 LICP Plan. A maximum of 2,000,000 shares of common stock may be issued under the 1994 LICP Plan. No stock incentives were awarded under the 1994 LICP Plan during the year ended December 31, 1993. However, in January of 1994, the Company granted to certain of its key employees non-statutory stock options under the 1994 LICP Plan for 65,726 shares of common stock at an option price of $46.50 per share. Beginning one year after the grant date, the options will become exercisable in one-third increments each year. The options expire ten years from the grant date. In July 1990, the Company adopted a shareholder rights plan and declared a dividend of one right for each outstanding share of the Company's common stock. The rights, which under certain circumstances entitle their holders to purchase one one-hundredth of a share of Series A Preference Stock for an exercise price of $85, will expire on July 11, 2000. The rights will become exercisable only if a person or entity acquires 20% or more of the Company's outstanding common stock or if a person or entity commences a tender offer or exchange offer for 20% or more of the outstanding common stock. At any time after the occurrence of such events, the Company may exchange unexercised rights at an exchange ratio of one share of common stock, or equity securities of the Company of equivalent value, per right. The rights are redeemable by the Company for $.01 per right at any time prior to the date the rights become exercisable. When the rights become exercisable, each right will entitle the holder to receive, in lieu of the right to purchase Series A Preference Stock, upon the exercise of such right, a number of shares of the Company's common stock (or under certain circumstances cash, property, other equity securities or debt of the Company) having a current market price (as defined in the plan) equal to twice the exercise price of the right, except pursuant to an offer for all outstanding shares of common stock which a majority of the independent directors of the Company determines to be a price which is in the best interests of the Company and its shareholders (Permitted Offer). In the event that the Company is a party to a merger or other business combination (other than a merger that follows a Permitted Offer), rights holders will be entitled to receive, upon the exercise of a right, a number of shares of common stock of the acquiring company having a current market price (as defined in the plan) equal to twice the exercise price of the right. In October 1990, the Company amended its savings plan to add an ESOP component. The ESOP component of the plan allows the Company to satisfy a portion of its obligation to make matching contributions under the plan. For additional information with respect to the ESOP component of the plan, see Note 7(b). (3) PREFERRED STOCK OF HL&P HL&P's cumulative preferred stock may be redeemed at the following per share prices, plus any unpaid accrued dividends to the date of redemption: (a) Rates for Variable Term Preferred stock as of December 31, 1993 were as follows: (b) HL&P is required to redeem 200,000 shares of this series annually. This series is redeemable at the option of HL&P at $100 per share beginning June 1, 1994. (c) HL&P is required to redeem 257,000 shares annually beginning April 1, 1995. This series is redeemable at the option of HL&P at $100 per share beginning April 1, 1997. Annual mandatory redemptions of HL&P's preferred stock are $20 million in 1994, $45.7 million for 1995 and 1996, and $25.7 million for 1997 and 1998. (4) LONG-TERM DEBT HL&P. Sinking or improvement fund requirements of HL&P's first mortgage bonds outstanding will be approximately $37 million for each of the years 1994 through 1998. Of such requirements, approximately $34 million for each of the years 1994 through 1998 may be satisfied by certification of property additions at 100% of the requirements, and the remainder through certification of such property additions at 166 2/3% of the requirements. Sinking or improvement fund requirements for 1993 and prior years have been satisfied by certification of property additions. HL&P has agreed to expend an amount each year for replacements and improvements in respect of its depreciable mortgaged utility property equal to $1,450,000 plus 2 1/2% of net additions to such mortgaged property made after March 31, 1948 and before July 1 of the preceding year. Such requirement may be met with cash, first mortgage bonds, gross property additions or expenditures for repairs or replacements, or by taking credit for property additions at 100% of the requirements. At the option of HL&P, but only with respect to first mortgage bonds of a series subject to special redemption, deposited cash may be used to redeem first mortgage bonds of such series at the applicable special redemption price. The replacement fund requirement to be satisfied in 1994 is approximately $271 million. The amount of HL&P's first mortgage bonds is unlimited as to issuance, but limited by property, earnings, and other provisions of the Mortgage and Deed of Trust dated as of November 1, 1944, between HL&P and South Texas Commercial National Bank of Houston (Texas Commerce Bank National Association, as Successor Trustee) and the supplemental indentures thereto. Substantially all properties of HL&P are subject to liens securing HL&P's long-term debt under the mortgage. HL&P's annual maturities of long-term debt and minimum capital lease payments are approximately $25 million in 1994, $4 million in 1995, $155 million in 1996, $229 million in 1997, and $40 million in 1998. KBLCOM and Subsidiaries. As of December 31, 1993, all borrowings under KBLCOM's letter of credit and term loan facility had been repaid and such facility was utilized only in the form of letters of credit aggregating $89.3 million. In January 1994, KBLCOM terminated this facility. KBL Cable, Inc. (KBL Cable), a subsidiary of KBLCOM, is a party to a $510.3 million revolving credit and letter of credit facility agreement with annual mandatory commitment reductions (which may require principal payments). At December 31, 1993, KBL Cable had $108.5 million available on such lines of credit. The available line of credit has scheduled reductions in March of each year until it is eliminated in March 1999. Loans have generally borne interest at an interest rate of LIBOR plus an "applicable margin." The margin was .625% at December 31, 1993. The bank credit agreement also contains certain restrictions, including restrictions on dividends, sales of assets and limitations on total indebtedness. The amount of indebtedness outstanding at December 31, 1993 and 1992 was $364 million and $415 million, respectively. KBL Cable has interest rate swap agreements with four banks which, as of December 31, 1993 and 1992, effectively fixed the rates on the $200 million of debt under the KBL Cable senior bank credit facility at approximately 9% plus the applicable margin. As of December 31, 1993 and 1992, the effective interest rates on such debt were approximately 9.625% and 9.875%, respectively. Interest rate swaps aggregating $75 million terminated in October 1992. The remaining interest rate swaps terminate in 1994 and 1996. The differential to be paid or received under the interest rate swap agreements is accrued and is recognized over the life of the agreement. KBL Cable is exposed to risk of nonperformance by the other parties to the interest rate swap agreements. However, KBL Cable does not anticipate nonperformance by the parties. Commitment fees are required on the unused capacity of the KBL Cable bank credit facility. As of December 31, 1993, KBL Cable had outstanding $67.1 million of 10.95% senior notes and $83.9 million of 11.30% senior subordinated notes. Both series mature in 1999 with annual principal payments which began in 1992. The agreement under which the notes were issued contains restrictions and covenants similar to those contained in the KBL Cable senior bank facility. During the second quarter of 1993, the Company contributed to KBLCOM KBL Cable senior notes aggregating approximately $29 million and KBL Cable senior subordinated notes aggregating approximately $36 million previously held by the Company. KBLCOM subsequently contributed such notes to KBL Cable, which retired and canceled the notes. Annual Maturities of Company Long-Term Debt. Consolidated annual maturities of long-term debt and minimum capital lease payments for the Company are approximately $35 million in 1994, $20 million in 1995, $431 million in 1996, $359 million in 1997 and $181 million in 1998. (5) SHORT-TERM FINANCING The interim financing requirements of the Company's operating subsidiaries are met through short-term bank loans, the issuance of commercial paper and short-term advances from the Company. The Company and its subsidiaries had bank credit facilities aggregating $750 million at December 31, 1993 and $1.05 billion at December 31, 1992, under which borrowings are classified as short-term indebtedness. Such bank facilities limit total short-term borrowings and provide for interest at rates generally less than the prime rate. Outstanding commercial paper was $591 million at December 31, 1993 and $564 million at December 31, 1992. Commitment fees are required on the bank facilities. For a description of bank credit facilities of KBLCOM and KBL Cable, borrowings under which are classified as long-term debt or current maturities of long-term debt, see Note 4. In January 1994, the Company's bank credit facility was increased from $500 million to $600 million and HL&P's bank credit facility was increased from $250 million to $400 million. The increased facilities aggregate $1 billion. Borrowings under these facilities continue to be available at rates generally less than the prime rate. (6) ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount and estimated fair value of the Company's financial instruments at December 31, 1993 and 1992 are as follows: The fair values of cash and short-term investments, short-term and other notes payable and bank debt are equivalent to the carrying amounts. The fair values of the ESOP loan, the Company's debentures, HL&P's cumulative preferred stock subject to mandatory redemption, HL&P's first mortgage bonds, pollution control revenue bonds issued on behalf of HL&P and KBL Cable senior and senior subordinated notes are estimated using rates currently available for securities with similar terms and remaining maturities. The fair value of interest rate swaps is the estimated amount that the swap counterparties would receive or pay to terminate the swap agreements, taking into account current interest rates and the current creditworthiness of the swap counterparties. (7) RETIREMENT PLANS (A) PENSION. The Company has noncontributory retirement plans covering substantially all employees. The plans provide retirement benefits based on years of service and compensation. The Company's funding policy is to contribute amounts annually in accordance with applicable regulations in order to achieve adequate funding of projected benefit obligations. The assets of the plans consist principally of common stocks and high quality, interest-bearing obligations. Net pension cost for the Company includes the following components: The funded status of the Company's retirement plans was as follows: The projected benefit obligation was determined using an assumed discount rate of 7.25% in 1993 and 8.5% in 1992. A long-term rate of compensation increase ranging from 3.9% to 6% was assumed for 1993 and ranging from 6.9% to 9.0% was assumed in 1992. The assumed long- term rate of return on plan assets was 9.5% in 1993 and 1992. The transitional asset at January 1, 1986, is being recognized over approximately 17 years, and the prior service cost is being recognized over approximately 15 years. (B) SAVINGS PLANS. In 1993, the Company (which includes HL&P) and KBLCOM had employee savings plans that qualified as cash or deferred arrangements under Section 401(k) of the Internal Revenue Code of 1986, as amended (IRC). Under the plans, participating employees could contribute a portion of their compensation, pre-tax or after-tax, up to a maximum of 16% of compensation limited by an annual deferral limit ($8,994 for calendar year 1993) prescribed by IRC Section 402(g) and the IRC Section 415 annual additions limits. The Company matched 70% (KBLCOM matched 50%) of the first 6% of each employee's compensation contributed, subject to a vesting schedule which entitled the employee to a percentage of the matching contributions depending on years of service. Substantially all of the Company's and KBLCOM's match was invested in the Company's common stock. Effective January 1, 1994, KBLCOM's plan was merged with the Company's plan and KBLCOM's matching contribution was increased to 70% of the first 6% of each employee's contributions. Under the ESOP component of the Company's savings plan, the ESOP trustee purchased shares of the Company's common stock in open-market transactions with funds provided by loans from the Company and completed the purchase of stock under the ESOP in December 1991, after purchasing 9,381,092 shares at a cost of $350 million. At December 31, 1993, the balance of the ESOP loans was approximately $332 million. The loans from the Company to the ESOP are shown on the Company's Consolidated Balance Sheets as a reduction in common stock equity. Principal and interest on the loans will be paid with dividends on the common stock in, and Company contributions to, the ESOP. Repayment of the loan is scheduled to occur over a 20-year period with the first mandatory repayment in 1997. The loans to the ESOP were funded initially by the Company from short-term borrowings which have been refinanced with long-term debt. Interest expense related to the ESOP debt service was $32.5 million in 1993, $32.6 million in 1992, and $17.9 million in 1991. ESOP benefit expense was $17.3 million, $20.0 million, and $21.3 million in 1993, 1992 and 1991, respectively. The Company match for the savings plan is satisfied with the allocation to employee accounts of released shares of stock and with cash contributions. Shares are released from the encumbrance of the loans upon the payment of debt service using dividends on unallocated shares in the ESOP, interest earnings and cash contributions by the Company. A summary of dividends on unallocated ESOP shares and ESOP cash contributions for the three years ended December 31, 1993 is as follows: (C) POSTRETIREMENT BENEFITS. The Company and HL&P adopted SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions" effective January 1, 1993. SFAS No. 106 requires companies to recognize the liability for postretirement benefit plans other than pensions, primarily health care. The Company and HL&P previously expensed the cost of these benefits as claims were incurred. SFAS No. 106 allows recognition of the transition obligation (liability for prior years' service) in the year of adoption or to be amortized over the plan participants' future service period. The Company and HL&P have elected to amortize the estimated transition obligation of approximately $213 million (including $211 million for HL&P) over 22 years. In March 1993, the Utility Commission adopted a rule governing the ratemaking treatment of postretirement benefits other than pensions. This rule provides for recovery in ratemaking proceedings (which, in HL&P's case, has not occurred) of the cost of postretirement benefits calculated in accordance with SFAS No. 106 including amortization of the transition obligation. For 1992, the Company and HL&P continued to fund postretirement benefit costs other than pensions on a "pay-as-you-go" basis. The Company made postretirement benefit payments in 1992 of $8.6 million. The Company's postretirement benefit costs were $38 million for 1993, an increase of $27 million over the 1993 "pay-as-you-go" amount. The net postretirement benefit cost for the Company in 1993 includes the following components, in thousands of dollars: The funded status of postretirement benefit costs for the Company at December 31, 1993 was as follows, in thousands of dollars: The assumed health care cost trend rates used in measuring the accumulated postretirement benefit obligation in 1993 are as follows: The assumed health care rates gradually decline to 5.4% for both medical categories and 3.7% for dental by the year 2001. The accumulated postretirement benefit obligation was determined using an assumed discount rate of 7.25% for 1993. If the health care cost trend rate assumptions were increased by 1%, the accumulated postretirement benefit obligation as of December 31, 1993 would be increased by approximately 8%. The annual effect of the 1% increase on the total of the service and interest costs would be an increase of approximately 10%. (8) COMMITMENTS AND CONTINGENCIES (a) HL&P. HL&P has various commitments for capital expenditures, fuel, purchased power, cooling water and operating leases. Commitments in connection with HL&P's capital program are generally revocable by HL&P subject to reimbursement to manufacturers for expenditures incurred or other cancellation penalties. HL&P's other commitments have various quantity requirements and durations. However, if these requirements could not be met, various alternatives are available to mitigate the cost associated with the contracts' commitments. HL&P's capital program (exclusive of AFUDC) is presently estimated to cost $478 million in 1994, $381 million in 1995 and $418 million in 1996. These amounts do not include expenditures on projects for which HL&P expects to be reimbursed by customers or other parties. HL&P has entered into several long-term coal, lignite and natural gas contracts which have various quantity requirements and durations. Minimum obligations for coal and transportation agreements are approximately $167 million in 1994, and $165 million in 1995 and 1996. In addition, the minimum obligations under the lignite mining and lease agreements will be approximately $14 million annually during the 1994-1996 period. HL&P has entered into several gas purchase agreements containing contract terms in excess of one year which provide for specified purchase and delivery obligations. Minimum obligations for natural gas purchase and natural gas storage contracts are approximately $57.4 million in 1994, $58.9 million in 1995 and $60.5 million in 1996. Collectively, the gas supply contracts included in these figures could amount to 11% of HL&P's annual natural gas requirements. The Utility Commission's rules provide for recovery of the coal, lignite and natural gas costs described above through the energy component of HL&P's electric rates. Nuclear fuel costs are also included in the energy component of HL&P's electric rates based on the cost of nuclear fuel consumed in the reactor. HL&P has commitments to purchase firm capacity from cogenerators of approximately $145 million in 1994, $32 million in 1995 and $22 million in 1996. The Utility Commission's rules allow recovery of these costs through HL&P's base rates for electric service and additionally authorize HL&P to charge or credit customers for any variation in actual purchased power cost from the cost utilized to determine its base rates. In the event that the Utility Commission, at some future date, does not allow recovery through rates of any amount of purchased power payments, the three principal firm capacity contracts contain provisions allowing HL&P to suspend or reduce payments and seek repayment for amounts disallowed. In November 1990, the Clean Air Act was extensively amended by Congress. HL&P has already made an investment in pollution control facilities, and all of its generating facilities currently comply in all material respects with sulfur dioxide emission standards established by the legislation. Provisions of the Clean Air Act dealing with urban air pollution required establishing new emission limitations for nitrogen oxides from existing sources. The cost of modifications necessary to reduce nitrogen oxide emissions from existing sources has been estimated at $29 million in 1994 and $10.5 million in 1995. In addition, continuous emission monitoring regulations are anticipated to require expenditures of $12 million in 1994 and $2 million in 1995. Capital expenditures are expected to total $71 million for the years 1994 through 1996. The Energy Policy Act of 1992, which became law in October 1992, includes a provision that assesses a fee upon domestic utilities having purchased enrichment services from the Department of Energy before October 22, 1992. This fee is to cover a portion of the cost to decontaminate and decommission the enrichment facilities. It is currently estimated that the assessment to the South Texas Project Electric Generating Station (South Texas Project) will be approximately $4 million in 1994 and approximately $2 million each year thereafter (subject to escalation for inflation), of which HL&P's share is 30.8%. This assessment will continue until the earlier of 15 years or when $2.25 billion (adjusted for inflation) has been collected from domestic utilities. Based on HL&P's actual payment of $579,810 in 1993, it recorded an estimated liability of $8.7 million. HL&P's service area is heavily dependent on oil, gas, refined products, petrochemicals and related business. Significant adverse events affecting these industries would negatively impact the revenues of the Company and HL&P. (b) KBLCOM COMMITMENTS AND OBLIGATIONS UNDER CABLE FRANCHISE AGREEMENTS. KBLCOM's capital additions are estimated to be $77 million in 1994, $110 million in 1995 and $89 million in 1996. KBLCOM and its subsidiaries presently have certain cable franchises containing provisions for construction of cable plant and service to customers within the franchise area. In connection with certain obligations under existing franchise agreements, KBLCOM and its subsidiaries obtain surety bonds and letters of credit guaranteeing performance to municipalities and public utilities. Payment is required only in the event of non-performance. KBLCOM and its subsidiaries have fulfilled all of their obligations such that no payments have been required. (c) IMPACT OF THE 1992 CABLE ACT ON KBLCOM. In May 1993, the Federal Communications Commission (FCC) issued its rate regulation rules (Rate Rule) which became effective on September 1, 1993. As a result of the Rate Rule, KBLCOM estimates that revenues in 1993 were reduced by approximately $6.8 million. In February 1994, the FCC announced further changes in the Rate Rule and announced its interim cost-of- service standards (Interim COS Standards). The FCC will issue revised benchmark formulas which will produce lower benchmarks, effective May 15, 1994 (Revised Benchmarks). It is impossible to assess the detailed impact of the revised Rate Rule and Interim COS Standards on KBLCOM until the FCC completes and issues the actual text of its rules on the Revised Benchmarks and the Interim COS Standards. (9) JOINTLY-OWNED NUCLEAR PLANT (a) HL&P INVESTMENT. HL&P is project manager and one of four co-owners in the South Texas Project, which consists of two 1,250 megawatt nuclear generating units. Unit Nos. 1 and 2 of the South Texas Project achieved commercial operation in August 1988 and June 1989, respectively. Each co-owner funds its own share of capital and operating costs associated with the plant, with HL&P's interest in the project being 30.8%. HL&P's share of the operation and maintenance expenses is included in electric operation and maintenance expenses on the Company's Statements of Consolidated Income and in the corresponding operating expense amounts on HL&P's Statements of Income. As of December 31, 1993, HL&P's investments (net of accumulated depreciation and amortization) in the South Texas Project and in nuclear fuel, including AFUDC, were $2.1 billion and $119 million, respectively. (b) CITY OF AUSTIN LITIGATION. In 1983, the City of Austin (Austin), one of the four co-owners of the South Texas Project, filed a lawsuit against the Company and HL&P alleging that it was fraudulently induced to participate in the South Texas Project and that HL&P failed to perform properly its duties as project manager. After a jury trial in 1989, judgment was entered in favor of HL&P, and that judgment was affirmed on appeal. In May 1993, following the expiration of Austin's rights to appeal to the United States Supreme Court, the judgment in favor of the Company and HL&P became final. On February 22, 1994, Austin filed a new suit against HL&P. In that suit, filed in the 164th District Court for Harris County, Texas, Austin alleges that the outages at the South Texas Project since February 1993 are due to HL&P's failure to perform obligations it owed to Austin under the Participation Agreement among the four co-owners of the South Texas Project (Participation Agreement). Austin asserts that such failures have caused Austin damages of at least $125 million, which are continuing, due to the incurrence of increased operating and maintenance costs, the cost of replacement power and lost profits on wholesale transactions that did not occur. Austin states that it will file a "more detailed" petition at a later date. For a discussion of the 1993 outage, see Note 9(f). As it did in the litigation filed against HL&P in 1983, Austin asserts that HL&P breached obligations HL&P owed under the Participation Agreement to Austin, and Austin seeks a declaration that HL&P had as duty to exercise reasonable care in the operation and maintenance of the South Texas Project. In that earlier litigation, however, the courts concluded that the Participation Agreement did not impose on HL&P a duty to exercise reasonable skill and care as Project Manager. Austin also asserts in its new suit that certain terms of a settlement reached in 1992 among HL&P and Central and South West Corporation (CSW) and its subsidiary, Central Power and Light Company (CPL), are invalid and void. The Participation Agreement permits arbitration of certain disputes among the owners, and the challenged settlement terms provide that in any future arbitration, HL&P and CPL would each appoint an arbitrator acceptable to the other. Austin asserts that, as a result of this agreement, the arbitration provisions of the Participation Agreement are void and Austin should not be required to participate in or be bound by arbitration proceedings; alternatively, Austin asserts that HL&P's rights with respect to CPL's appointment of an arbitrator should be shared with all the owners or canceled, and Austin seeks injunctive relief against arbitration of its dispute with HL&P. For a further discussion of the settlement among HL&P, CSW and CPL, see Note 9(c) below. HL&P and the Company do not believe there is merit to Austin's claims, and they intend to defend vigorously against them. However, there can be no assurance as to the ultimate outcome of this matter. (c) ARBITRATION WITH CO-OWNERS. During the course of the litigation filed by Austin in 1983, the City of San Antonio (San Antonio) and CPL, the other two co-owners in the South Texas Project, asserted claims for unspecified damages against HL&P as project manager of the South Texas Project, alleging HL&P breached its duties and obligations. San Antonio and CPL requested arbitration of their claims under the Participation Agreement. This matter was severed from the Austin litigation and is pending before the 101st District Court in Dallas County, Texas. The 101st District Court ruled that the demand for arbitration is valid and enforceable under the Participation Agreement, and that ruling has been upheld by appellate courts. Arbitrators were appointed by HL&P and each of the other co-owners in connection with the District Court's ruling. The Participation Agreement provides that the four appointed arbitrators will select a fifth arbitrator, but that action has not yet occurred. In 1992, the Company and HL&P entered into a settlement with CPL and CSW with respect to various matters including the arbitration and related legal proceedings. Pursuant to the settlement, CPL withdrew its demand for arbitration under the Participation Agreement, and the Company, HL&P, CSW and CPL dismissed litigation associated with the dispute. The settlement also resolved other disputes between the parties concerning various transmission agreements and related billing disputes. In addition, the parties also agreed to support, and to seek consent of the other owners of the South Texas Project to, certain amendments to the Participation Agreement, including changes in the management structure of the South Texas Project through which HL&P would be replaced as project manager by an independent entity. Although settlement with CPL does not directly affect San Antonio's pending demand for arbitration, HL&P and CPL have reached certain other understandings which contemplate that: (i) CPL's arbitrator previously appointed for that proceeding would be replaced by CPL; (ii) arbitrators approved by CPL and HL&P for any future arbitrations will be mutually acceptable to HL&P and CPL; and (iii) HL&P and CPL will resolve any future disputes between them concerning the South Texas Project without resorting to the arbitration provision of the Participation Agreement. The settlement with CPL did not have a material adverse effect on the Company's or HL&P's financial position and results of operations. In February 1994, San Antonio indicated a desire to move forward with its demand for arbitration and suggested that San Antonio considers all allegations of mismanagement against HL&P to be appropriate subjects for arbitration in that proceeding, not just allegations related to the planning and construction of the South Texas Project. It is unclear what additional allegations San Antonio may make, but it is possible that San Antonio will assert that HL&P has liability for all or some portion of the additional costs incurred by San Antonio due to the 1993 outage of the South Texas Project. For a discussion of that outage see Note 9(f). HL&P and the Company continue to regard San Antonio's claims to be without merit. From time to time, HL&P and other parties to these proceedings have held discussions with a view toward settling their differences on these matters. While HL&P and the Company cannot give definite assurance regarding the ultimate resolution of the San Antonio litigation and arbitration, they presently do not believe such resolutions will have a material adverse impact on HL&P's or the Company's financial position and results of operations. (d) NUCLEAR INSURANCE. HL&P and the other owners of the South Texas Project maintain nuclear property and nuclear liability insurance coverages as required by law and periodically review available limits and coverage for additional protection. The owners of the South Texas Project currently maintain $500 million in primary property damage insurance from American Nuclear Insurers (ANI). Effective November 15, 1993, the maximum amounts of excess property insurance available through the insurance industry increased from $2.125 billion to $2.2 billion. This $2.2 billion of excess property insurance coverage includes $800 million of excess insurance from ANI and $1.4 billion of excess property insurance coverage through participation in the Nuclear Electric Insurance Limited (NEIL) II program. The owners of the South Texas Project have approved the purchase of the additional available excess property insurance coverage. Additionally, effective January 1, 1994, ANI will be increasing their excess property insurance limits to $850 million, and the owners of the South Texas Project have also approved the purchase of the additional limits at the March 1, 1994 renewal for ANI excess property insurance. Under NEIL II, HL&P and the other owners of the South Texas Project are subject to a maximum assessment, in the aggregate, of approximately $15.9 million in any one policy year. The application of the proceeds of such property insurance is subject to the priorities established by the United States Nuclear Regulatory Commission (NRC) regulations relating to the safety of licensed reactors and decontamination operations. Pursuant to the Price Anderson Act, the maximum liability to the public for owners of nuclear power plants, such as the South Texas Project, was increased from $7.9 billion to $9.3 billion effective February 18, 1994. Owners are required under the Act to insure their liability for nuclear incidents and protective evacuations by maintaining the maximum amount of financial protection available from private sources and by maintaining secondary financial protection through an industry retrospective rating plan. Effective August 20, 1993, the assessment of deferred premiums provided by the plan for each nuclear incident has increased from $63 million to up to $75.5 million per reactor subject to indexing for inflation, a possible 5% surcharge (but no more than $10 million per reactor per incident in any one year) and a 3% state premium tax. HL&P and the other owners of the South Texas Project currently maintain the required nuclear liability insurance and participate in the industry retrospective rating plan. There can be no assurance that all potential losses or liabilities will be insurable, or that the amount of insurance will be sufficient to cover them. Any substantial losses not covered by insurance would have a material effect on HL&P's and the Company's financial condition. (e) NUCLEAR DECOMMISSIONING. HL&P and the other co-owners of the South Texas Project are required by the NRC to meet minimum decommissioning funding requirements to pay the costs of decommissioning the South Texas Project. Pursuant to the terms of the order of the Utility Commission in Docket No. 9850, HL&P is currently funding decommissioning costs for the South Texas Project with an independent trustee at an annual amount of $6 million. As of December 31, 1993, the trustee held approximately $18.7 million for decommissioning, for which the asset and liability are reflected on the Company's Consolidated and HL&P's Balance Sheets in deferred debits and deferred credits, respectively. HL&P's funding level is estimated to provide approximately $146 million in 1989 dollars, an amount which currently exceeds the NRC minimum. However, the South Texas Project co-owners have engaged an outside consultant to review the estimated decommissioning costs of the South Texas Project which review should be completed by the end of 1994. While changes to present funding levels, if any, cannot be estimated at this time, a substantial increase in funding may be necessary. No assurance can be given that the amounts held in trust will be adequate to cover the decommissioning costs. (f) NRC INSPECTIONS AND OPERATIONS. Both generating units at the South Texas Project were out of service from February 1993 to February 1994, when Unit No. 1 was authorized by the NRC to return to service. Currently, Unit No. 1 is out of service for repairs to a small steam generator leak encountered following the unit's shutdown to repair a feedwater control valve. Those repairs are scheduled for completion by mid-March 1994, and no formal NRC approval is required to resume operation of Unit No. 1. Unit No. 2 is currently scheduled to resume operation after completion of regulatory reviews, in the spring of 1994. HL&P removed the units from service in February 1993 when a problem was encountered with certain pumps. At that time HL&P concluded that the units should not resume operation until HL&P had determined the root cause of the failure and had briefed the NRC and corrective action had been taken. The NRC formalized that commitment in a Confirmatory Action Letter, which confirmed that HL&P would not resume operations until it had briefed the NRC on its findings and actions. Subsequently, that Confirmatory Action Letter was supplemented by the NRC to require HL&P, prior to resuming operations, to address additional matters which were identified during the course of analyzing the issues associated with the original pump failure and during various subsequent NRC inspections and reviews. In June 1993, the NRC announced that the South Texas Project had been placed on the NRC's "watch list" of plants with "weaknesses that warrant increased NRC attention." Plants in this category are authorized to operate but are subject to close monitoring by the NRC. The NRC reviews the status of plants on this list semi-annually, but HL&P does not anticipate that the South Texas Project would be removed from that list until there has been a period of operation for both units, and the NRC concludes that the concerns which led the NRC to place the South Texas Project on that list have been satisfactorily addressed. The NRC's decision to place the South Texas Project on its "watch list" followed the June 1993 issuance of a report by its Diagnostic Evaluation Team (DET) which conducted a review of the South Texas Project in the spring of 1993 and identified a number of areas requiring improvement at the South Texas Project. Conducted infrequently, NRC diagnostic evaluations do not evaluate compliance with NRC regulations but are broad-based evaluations of overall plant operations and are intended to review the strengths and weaknesses of the licensee's performance and to identify the root cause of performance problems. The DET report found, among other things, weaknesses in maintenance and testing, deficiencies in training and in the material condition of some equipment, strained staffing levels in operations and several weaknesses in engineering support. The report cited the need to reduce backlogs of engineering and maintenance work and to simplify work processes which, the DET found, placed excessive burdens on operating and other plant personnel. The report also identified the need to strengthen management communications, oversight and teamwork as well as the capability to identify and correct the root causes of problems. The DET also expressed concern with regard to the adequacy of resources committed to resolving issues at the South Texas Project but noted that many issues had already been identified and were being addressed by HL&P. In response to the DET report, HL&P presented its plan to address the issues raised in that report and began its action program to address those concerns. While those programs were being implemented, HL&P also initiated additional activities and modifications that were not previously scheduled during 1993 but which are designed to eliminate the need for some future outages and to enhance operations at the South Texas Project. The NRC conducted additional inspections and reviews of HL&P's plans and agreed in February 1994 that HL&P's progress in addressing the NRC's concerns had satisfied the issues raised in the Confirmatory Action Letter with respect to Unit No. 1. The NRC concurred in HL&P's determination that Unit No. 1 could resume operation. Work is now underway to address the NRC's concerns with respect to Unit No. 2, which HL&P anticipates will not require as extensive an effort as was required by the NRC for Unit No. 1. However, difficulties encountered in completing actions required on Unit No. 2 and any additional issues which may be raised in the conduct of those activities or in the operation of Unit No. 1 could adversely affect the anticipated schedule for resuming operation of Unit No. 2. During the outage, HL&P has not had, and does not anticipate having, difficulty in meeting its energy needs. During the outage, both fuel and non-fuel expenditures have been higher for HL&P than levels originally projected for the year. HL&P's non-fuel expenditures for the South Texas Project during 1993 were approximately $115 million greater than originally budgeted levels (of which HL&P's share was $35 million) for work undertaken in connection with the DET and for other initiatives taken during the year. It is expected that, subsequent to 1993, operation and maintenance costs will continue to be higher than previous levels in order to support additional initiatives developed in 1993. Fuel costs also were necessarily higher due to the use of higher cost alternative fuels. However, these increased expenditures are expected to be offset to some extent by savings from future outages that can now be avoided as a result of activities accelerated into 1993 and from overall improvement in operations resulting from implementing the programs developed during the outage. For a discussion of regulatory treatment related to the outage, see Notes 10(f) and 10(g). During 1993, the NRC imposed a total of $500,000 in civil penalties (of which HL&P's share was $154,000) in connection with violations of NRC requirements. In March 1993, a Houston newspaper reported that the NRC had referred to the Department of Justice allegations that the employment of three former employees and an employee of a contractor to HL&P had been terminated or disrupted in retaliation for their having made safety-related complaints to the NRC. Such retaliation, if proved, would be contrary to requirements of the Atomic Energy Act and regulations promulgated by the NRC. The NRC has confirmed to HL&P that these matters have been referred to the Department of Justice for consideration of further action and has notified HL&P that the NRC is considering enforcement action against HL&P and one or more HL&P employees in connection with one of those cases. HL&P has been advised by counsel that most referrals by the NRC to the Department of Justice do not result in prosecutions. The Company and HL&P strongly believe that the facts underlying these events would not support action by the Department of Justice against HL&P or any of its personnel; accordingly, HL&P intends to defend vigorously against such charges. HL&P also intends to defend vigorously against civil proceedings filed in the state court in Matagorda County, Texas, by the complaining employees and against administrative proceedings before the Department of Labor and the NRC, which, independently of the Department of Justice, could impose administrative sanctions if they find violations of the Atomic Energy Act or the NRC regulations. These administrative sanctions may include civil penalties in the case of the NRC and, in the case of the Department of Labor, ordering reinstatement and back pay and/or imposing civil penalties. Although the Company and HL&P do not believe these allegations have merit or will have a material adverse effect on the Company or HL&P, neither the Company nor HL&P can predict at this time their outcome. (10) UTILITY COMMISSION PROCEEDINGS Pursuant to a series of applications filed by HL&P in recent years, the Utility Commission has granted HL&P rate increases to reflect in electric rates HL&P's substantial investment in new plant construction, including the South Texas Project. Although Utility Commission action on those applications has been completed, judicial review of a number of the Utility Commission orders is pending. In Texas, Utility Commission orders may be appealed to a District Court in Travis County, and from that Court's decision an appeal may be taken to the Court of Appeals for the 3rd District at Austin (Austin Court of Appeals). Discretionary review by the Supreme Court of Texas may be sought from decisions of the Austin Court of Appeals. The pending appeals from the Utility Commission orders are in various stages. In the event the courts ultimately reverse actions of the Utility Commission in any of these proceedings, such matters would be remanded to the Utility Commission for action in light of the courts' orders. Because of the number of variables which can affect the ultimate resolution of such matters on remand, the Company and HL&P generally are not in a position at this time to predict the outcome of the matters on appeal or the ultimate effect that adverse action by the courts could have on the Company and HL&P. On remand, the Utility Commission's action could range from granting rate relief substantially equal to the rates previously approved, to a reduction in the revenues to which HL&P was entitled during the time the applicable rates were in effect, which could require a refund to customers of amounts collected pursuant to such rates. Judicial review has been concluded or currently is pending on the final orders of the Utility Commission described below. (a) DOCKET NOS. 6765, 6766 AND 5779. In February 1993, the Austin Court of Appeals granted a motion by the Office of Public Utility Counsel (OPC) to voluntarily dismiss its appeal of the Utility Commission's order in HL&P's 1984 rate case (Docket No. 5779). In December 1993, the Supreme Court of Texas granted a similar motion by OPC to dismiss its appeal of the Utility Commission's order in HL&P's 1986 rate case (Docket Nos. 6765 and 6766). As a result, appellate review of the Utility Commission's orders in those dockets has been concluded, and the orders have been affirmed. (b) DOCKET NO. 8425. In October 1992, a District Court in Travis County, Texas affirmed the Utility Commission's order in HL&P's 1988 rate case (Docket No. 8425). An appeal to the Austin Court of Appeals is pending. In its final order in that docket, the Utility Commission granted HL&P a $227 million increase in base revenues, allowed a 12.92% return on common equity, authorized a qualified phase-in plan for Unit No. 1 of the South Texas Project (including approximately 72% of HL&P's investment in Unit No. 1 of the South Texas Project in rate base) and authorized HL&P to use deferred accounting for Unit No. 2 of the South Texas Project. Rates substantially corresponding to the increase granted were implemented by HL&P in June 1989 and remained in effect until May 1991. In the appeal of the Utility Commission's order, certain parties have challenged the Utility Commission's decision regarding deferred accounting, treatment of federal income tax expense and certain other matters. A recent decision of the Austin Court of Appeals, in an appeal involving another utility (and to which HL&P was not a party), adopted some of the arguments being advanced by parties challenging the Utility Commission's order in Docket No. 8425. In that case, Public Utility Commission of Texas vs. GTE-SW, the Austin Court of Appeals ruled that when a utility pays federal income taxes as part of a consolidated group, the utility's ratepayers are entitled to a fair share of the tax savings actually realized, which can include savings resulting from unregulated activities. The Texas Supreme Court has agreed to hear an appeal of that decision, but on points not involving the federal income tax issues, though tax issues could be decided in such opinion. In its final order in Docket No. 8425, the Utility Commission did not reduce HL&P's tax expense by any of the tax savings resulting from the Company's filing of a consolidated tax return. Although the GTE decision was not legally dispositive of the tax issues presented in the appeal of Docket No. 8425, it is possible that the Austin Court of Appeals could utilize the reasoning in GTE in addressing similar issues in the appeal of Docket No. 8425. However, in February 1993 the Austin Court of Appeals, considering an appeal involving another telephone utility, upheld Utility Commission findings that the tax expense for the utility included the utility's fair share of the tax savings resulting from a consolidated tax return, even though the utility's fair share of the tax savings was determined to be zero. HL&P believes that the Utility Commission findings in Docket No. 8425 and in Docket No. 9850 (see Note 10(c)) should be upheld on the same principle (i.e., that the Utility Commission determined that the fair share of tax savings to be allocated to ratepayers is determined to be zero). However, no assurance can be made as to the ultimate outcome of this matter. The Utility Commission's order in Docket No. 8425 may be affected also by the ultimate resolution of appeals concerning the Utility Commission's treatment of deferred accounting. For a discussion of appeals of the Utility Commission's orders on deferred accounting, see Notes 10(e) and 11. (c) DOCKET NO. 9850. In August 1992, a district court in Travis County affirmed the Utility Commission's final order in HL&P's 1991 rate case (Docket No. 9850). That decision was appealed by certain parties to the Austin Court of Appeals, raising issues concerning the Utility Commission's approval of a non-unanimous settlement in that docket, the Utility Commission's calculation of federal income tax expense and the allowance of deferred accounting reflected in the settlement. In August 1993, the Austin Court of Appeals affirmed on procedural grounds the ruling by the Travis County District Court, and applications for writ of error were filed with the Supreme Court of Texas by one of the other parties to the proceeding. The Supreme Court has not yet ruled on these applications. In Docket No. 9850, the Utility Commission approved a settlement agreement reached with most parties. That settlement agreement provided for a $313 million increase in HL&P's base rates, termination of deferrals granted with respect to Unit No. 2 of the South Texas Project and of the qualified phase-in plan deferrals granted with respect to Unit No. 1 of the South Texas Project, and recovery of deferred plant costs. The settlement authorized a 12.55% return on common equity for HL&P, and HL&P agreed not to request additional increases in base rates that would be implemented prior to May 1, 1993. Rates contemplated by that settlement agreement were implemented in May 1991 and remain in effect. The Utility Commission's order in Docket No. 9850 found that HL&P would have been entitled to more rate relief than the $313 million agreed to in the settlement, but certain recent actions of the Austin Court of Appeals could, if ultimately upheld and applied to the appeal of Docket No. 9850, require a remand of that settlement to the Utility Commission. HL&P believes that the amount which the Utility Commission found HL&P was entitled to would exceed any disallowance that would have been required under the Austin Court of Appeals' ruling regarding deferred accounting (see Notes 10(e) and 11) or any adverse effect on the calculation of tax expense if the court's ruling in the GTE decision were applied to that settlement (see Note 10(b) above). However, the amount of rate relief to which the Utility Commission found HL&P to be entitled in excess of the $313 million agreed to in the settlement may not be sufficient if the reasoning in both the GTE decision and the ruling on deferred accounting were to be applied to the settlement agreement in Docket No. 9850. Although HL&P believes that it should be entitled to demonstrate entitlement to rate relief equal to that agreed to in the stipulation in Docket No. 9850, HL&P cannot rule out the possibility that a remand and reopening of that settlement would be required if decisions unfavorable to HL&P are rendered on both the deferred accounting treatment and the calculation of tax expense for ratemaking purposes. (d) DOCKET NO. 6668. In June 1990, the Utility Commission issued the final order in Docket No. 6668, the Utility Commission's inquiry into the prudence of the planning, management and construction of the South Texas Project. The Utility Commission's findings and order in Docket No. 6668 were incorporated in Docket No. 8425, HL&P's 1988 general rate case. Pursuant to the findings in Docket No. 6668, the Utility Commission found imprudent $375.5 million out of HL&P's $2.8 billion investment in the two units of the South Texas Project. The Utility Commission's findings did not reflect $207 million in benefits received in a settlement of litigation with the former architect-engineer of the South Texas Project or the effects of federal income taxes, investment tax credits or certain deferrals. In addition, accounting standards require that the equity portion of AFUDC accrued for regulatory purposes under deferred accounting orders be utilized to determine the cost disallowance for financial reporting purposes. After taking all of these items into account, HL&P recorded an after-tax charge of $15 million in 1990 and continued to reduce such loss with the equity portion of deferrals in 1991 related to Unit No. 2 of the South Texas Project. The findings in Docket No. 6668 represent the Utility Commission's final determination regarding the prudence of expenditures associated with the planning and construction of the South Texas Project. Unless the order is modified or reversed on appeal, HL&P will be precluded from recovering in rate proceedings the amount found imprudent by the Utility Commission. Appeals by HL&P and other parties of the Utility Commission's order in Docket No. 6668 were dismissed by a District Court in Travis County in May 1991. However, in December 1992 the Austin Court of Appeals reversed the District Court's dismissals on procedural grounds. HL&P and other parties have filed applications for writ of error with the Supreme Court of Texas concerning the order by the Austin Court of Appeals, but unless the order is modified on further review, HL&P anticipates that the appeals of the parties will be reinstated and that the merits of the issues raised in those appeals of Docket No. 6668 will be considered by the District Court, with the possibility of subsequent judicial review once the District Court has acted on those appeals. In addition, separate appeals are pending from Utility Commission orders in Dockets Nos. 8425 and 9850, in which the findings of the order in Docket No. 6668 are reflected in rates. See Notes 10(b) and 10(c). (e) DOCKET NOS. 8230 AND 9010. Deferred accounting treatment for Unit No. 1 of the South Texas Project was authorized by the Utility Commission in Docket No. 8230 and was extended in Docket No. 9010. Similar deferred accounting treatment with respect to Unit No. 2 of the South Texas Project was authorized in Docket No. 8425. For a discussion of the deferred accounting treatment granted, see Note 11. In September 1992, the Austin Court of Appeals, in considering the appeal of the Utility Commission's final order in Docket Nos. 8230 and 9010, upheld the Utility Commission's action in granting deferred accounting treatment for operation and maintenance expenses, but rejected such treatment for the carrying costs associated with the investment in Unit No. 1 of the South Texas Project. That ruling followed the Austin Court of Appeals decision rendered in August 1992, on a motion for rehearing, involving another utility which had been granted similar deferred accounting treatment for another nuclear plant. In its August decision, the court ruled that Texas law did not permit the Utility Commission to allow the utility to place the carrying costs associated with the investment in the utility's rate base, though the court observed that the Utility Commission could allow amortization of such costs. The Supreme Court of Texas has granted applications for writ of error with respect to the Austin Court of Appeals decision regarding Docket Nos. 8230 and 9010. The Supreme Court of Texas has also granted applications for writ of error on three other decisions by the Austin Court of Appeals regarding deferred accounting treatment granted to other utilities by the Utility Commission. The Supreme Court heard oral arguments on these appeals on September 13, 1993. The court has not yet ruled. (f) DOCKET NO. 12065. HL&P is not currently seeking authority to change its base rates for electric service, but the Utility Commission has authority to initiate a rate proceeding pursuant to Section 42 of the Public Utility Regulatory Policy Act (PURA) to determine whether existing rates are unjust or unreasonable. In 1993, the Utility Commission referred to an administrative law judge (ALJ) the complaint of a former employee of HL&P seeking to initiate such a proceeding. On February 23, 1994, the ALJ concluded that a Section 42 proceeding should be conducted and that HL&P should file full information, testimony and schedules justifying its rates. The ALJ acknowledged that the decision was a close one, and is subject to review by the Utility Commission. However, he concluded that information concerning HL&P's financial results as of December 1992 indicated that HL&P's adjusted revenues could be approximately $62 million (or 2.33% of its adjusted base revenues) more than might be authorized in a current rate proceeding. The ALJ's conclusion was based on various accounting considerations, including use of a different treatment of federal income tax expense than the method utilized in HL&P's last rate case. The ALJ also found that there could be a link between the 1993 outage at the South Texas Project, the NRC's actions with respect to the South Texas Project and possible mismanagement by HL&P, which in turn could result in a reduction of HL&P's authorized rate of return as a penalty for imprudent management. HL&P and the Company believe that the examiner's analysis is incorrect, that the South Texas Project has not been imprudently managed, and that ordering a Section 42 proceeding at this time is unwarranted and unnecessarily expensive and burdensome. HL&P has appealed the ALJ's decision to the Utility Commission. If HL&P ultimately is required to respond to a Section 42 inquiry, it will assert that it remains entitled to rates at least at the levels currently authorized. However, there can be no assurance as to the outcome of a Section 42 proceeding if it is ultimately authorized, and HL&P's rates could be reduced following a hearing. HL&P believes that any reduction in base rates as a result of a Section 42 inquiry would take effect prospectively. HL&P is also a defendant in a lawsuit filed in a Fort Bend County, Texas, district court by the same former HL&P employee who originally initiated the Utility Commission complaint concerning HL&P's rates. In that suit, Pace and Scott v. HL&P, the former employee contends that HL&P is currently charging illegal rates since the rates authorized by the Utility Commission do not allocate to ratepayers tax benefits accruing to the Company and to HL&P by virtue of the fact that HL&P's federal income taxes are paid as part of a consolidated group. HL&P is seeking dismissal of that suit because in Texas exclusive jurisdiction to set electric utility rates is vested in municipalities and in the Utility Commission, and the courts have no jurisdiction to set such rates or to set aside authorized rates except through judicial appeals of Utility Commission orders in the manner prescribed in applicable law. Although substantial damages have been claimed by the plaintiffs in that litigation, HL&P and the Company consider this litigation to be wholly without merit, and do not presently believe that it will have a material adverse effect on the Company's or HL&P's results of operations, though no assurances can be given as to its ultimate outcome at this time. (g) FUEL RECONCILIATION. HL&P recovers fuel costs incurred in electric generation through a fixed fuel factor that is set by the Utility Commission. The difference between fuel revenues billed pursuant to such factor and fuel expense incurred is recorded as an addition to or a reduction of revenues, with a corresponding entry to under- or over-recovered fuel, as appropriate. Amounts collected pursuant to the fixed fuel factor must be reconciled periodically by the Utility Commission against actual, reasonable costs as determined by the Utility Commission. Any fuel costs which the Utility Commission determines are unreasonable in a fuel reconciliation proceeding would not be recoverable from customers, and a charge against earnings would result. Under Utility Commission rules, HL&P is required to file an application to reconcile those costs in 1994. Such a filing would also be required in conjunction with any rate proceeding that may be filed, such as the Section 42 proceeding described in Note 10(f). Unless filed earlier in conjunction with a rate proceeding, HL&P currently anticipates filing its fuel reconciliation application in the fourth quarter of 1994 in accordance with a schedule proposed by the Utility Commission staff. If that schedule is approved by the Utility Commission, HL&P anticipates that fuel costs through some time in 1994 will be submitted for reconciliation. No hearing would be anticipated in that reconciliation proceeding before 1995. The schedule for a fuel reconciliation proceeding could be affected by the institution of a prudence inquiry concerning the outage at the South Texas Project. The Utility Commission staff has indicated a desire to conduct an inquiry into the prudence of HL&P's management prior to and during the outage, but it is currently unknown what action the Utility Commission will take on that request or what the nature and scope of any such proceeding would be. Such an inquiry could also be conducted in connection with a rate proceeding under Section 42 of PURA if one is instituted by the Utility Commission. Through the end of 1993, HL&P had recovered through the fuel factor approximately $115 million (including interest) less than the amounts expended for fuel, a significant portion of which under recovery occurred in 1993 during the outage at the South Texas Project. In any review of costs incurred during the period of the 1993 outage at the South Texas Project, it is anticipated that other parties will contend that a portion of fuel costs incurred should be attributed to imprudence on the part of HL&P and thus should be disallowed as unreasonable, with recovery from rate payers denied. Those amounts could be substantial. HL&P intends to defend vigorously against any allegation that its actions have been imprudent or that any portion of its costs incurred should be judged to be unreasonable, but no prediction can be made as to the ultimate outcome of such a proceeding. (11) DEFERRED PLANT COSTS Deferred plant costs were authorized for the South Texas Project by the Utility Commission in two contexts. In the first context, or "deferred accounting," the Utility Commission orders permitted HL&P, for regulatory purposes, to continue to accrue carrying costs in the form of AFUDC (at a 10% rate) on its investment in the two units of the South Texas Project until costs of such units were reflected in rates (which was July 1990 for approximately 72% of Unit No. 1, and May 1991 for the remainder of Unit No. 1 and 100% of Unit No. 2) and to defer and capitalize depreciation, operation and maintenance, insurance and tax expenses associated with such units during the deferral period. Accounting standards do not permit the accrual of the equity portion of AFUDC for financial reporting purposes under these circumstances. However, in accordance with accounting standards, such amounts were utilized to determine the amount of plant cost disallowance for financial reporting purposes. The deferred expenses and the debt portion of the carrying costs associated with the South Texas Project are included on the Company's Statements of Consolidated Income in deferred expenses and deferred carrying costs, respectively. Beginning with the June 1990 order in Docket No. 8425, deferrals were permitted in a second context, a "qualified phase-in plan" for Unit No. 1 of the South Texas Project. Accounting standards require allowable costs deferred for future recovery under a qualified phase-in plan to be capitalized as a deferred charge if certain criteria are met. The qualified phase-in plan as approved by the Utility Commission meets these criteria. During the period June 1990 through May 15, 1991, HL&P deferred depreciation and property taxes related to the 28% of its investment in Unit No. 1 of the South Texas Project not reflected in the Docket No. 8425 rates and recorded a deferred return on that investment as part of the qualified phase-in plan. Deferred return represents the financing costs (equity and debt) associated with the qualified phase-in plan. The deferred expenses and deferred return related to the qualified phase-in plan are included on the Company's Statements of Consolidated Income and HL&P's Statements of Income in deferred expenses and deferred return under phase-in plan, respectively. Under the phase-in plan, these accumulated deferrals will be recoverable within ten years of the June 1990 order. On May 16, 1991, HL&P implemented under bond, in Docket No. 9850, a $313 million base rate increase consistent with the terms of the settlement. Accordingly, HL&P ceased all cost deferrals related to the South Texas Project and began the recovery of such amounts. These deferrals are being amortized on a straight-line basis as allowed by the final order in Docket No. 9850. The amortization of these deferrals totaled $25.8 million for both 1993 and 1992 and $16.1 million in 1991, and is included on the Company's Statements of Consolidated Income and HL&P's Statements of Income in depreciation and amortization expense. See also Notes 10(b), 10(c) and 10(e). The following table shows the original balance of the deferrals and the unamortized balance at December 31, 1993. __________ (a) Amortized over the estimated depreciable life of the South Texas Project. (b) Amortized over nine years beginning in May 1991. As of December 31, 1993, HL&P has recorded deferred income taxes of $200.9 million with respect to deferred accounting and $14.5 million with respect to the deferrals associated with the qualified phase-in plan. (12) MALAKOFF ELECTRIC GENERATING STATION The scheduled in-service dates for the Malakoff Electric Generating Station (Malakoff) units were postponed during the 1980's as expectations of continued strong load growth were tempered. These units have been indefinitely deferred due to the availability of other cost effective resource options. In 1987, all developmental work was stopped and AFUDC accruals ceased. Due to the indefinite postponement of the in-service date for Malakoff, the engineering design work is no longer considered viable. The costs associated with this engineering design work are currently included in rate base and are earning a return per the Utility Commission's final order in Docket No. 8425. Pursuant to HL&P's determination that such costs will have no future value, $84.1 million was reclassified from plant held for future use to recoverable project costs as of December 31, 1992. An additional $7.0 million was reclassified to recoverable project costs in 1993. Amortization of these amounts began in 1993. Amortization amounts will correspond to the amounts being earned as a result of the inclusion of such costs in rate base. The Utility Commission's action in allowing treatment of those costs as plant held for future use has been challenged in the pending appeal of the Utility Commission's final order in Docket No. 8425. Also, recovery of such Malakoff costs may be addressed if rate proceedings are initiated such as that proposed under Section 42 of PURA. See Notes 10(b) and 10(f) for a discussion of these respective proceedings. In June 1990, HL&P purchased from its then fuel supply affiliate, Utility Fuels, all of Utility Fuels' interest in the lignite reserves and lignite handling facilities for Malakoff. The purchase price was $138.2 million, which represented the net book value of Utility Fuels' investment in such reserves and facilities. As part of the June 1990 rate order (Docket No. 8425), the Utility Commission ordered that issues related to the prudence of the amounts invested in the lignite reserves be considered in HL&P's next general rate case which was filed in November 1990 (Docket No. 9850). However, under the October 1991 Utility Commission order in Docket No. 9850, this determination was postponed to a subsequent docket. HL&P's remaining investment in Malakoff through December 31, 1993 of $167 million, consisting primarily of lignite reserves and land, is included on the Company's Consolidated and HL&P's Balance Sheets in plant held for future use. For the 1994-1996 period, HL&P anticipates $14 million of expenditures relating to lignite reserves, primarily to keep lignite leases and other related agreements in effect. (13) RECOVERABLE PROJECT COSTS The Utility Commission has allowed recovery of certain costs over a period of time by amortizing those costs for rate making purposes. However, recoverable project costs have not been included in rate base and, as a result, no return on investment is being earned during the recovery period. Malakoff is the only remaining project with an unrecovered amount of $118 million at December 31, 1993, with remaining recovery periods of 72 months ($78 million) and 78 months ($40 million). (14) INCOME TAXES The Company records income taxes under SFAS No. 109, which among other things, (i) requires the liability method be used in computing deferred taxes on all temporary differences between book and tax bases of assets other than goodwill; (ii) requires that deferred tax liabilities and assets be adjusted for an enacted change in tax laws or rates; and (iii) prohibits net-of-tax accounting and reporting. SFAS No. 109 requires that regulated enterprises recognize such adjustments as regulatory assets or liabilities if it is probable that such amounts will be recovered from or returned to customers in future rates. KBLCOM has significant temporary differences related to its 1986 and 1989 acquisitions of cable television systems, the tax effect of which were recognized when SFAS No. 109 was adopted. During 1993, federal tax legislation was enacted that changes the income tax consequences for the Company and HL&P. The principal provision of the new law which affects the Company and HL&P is the change in the corporate income tax rate from 34% to 35%. A net regulatory asset and the related deferred federal income tax liability of $71.3 million was recorded by HL&P in 1993. The effect of the new law, which decreased the Company's net income by $14.3 million was recognized as a component of income tax expense in 1993. The effect on the Company's deferred taxes for the change in the new law was $10.9 million in 1993. The Company's current and deferred components of income tax expense are as follows: The Company's effective income tax rates are lower than statutory corporate rates for each year as follows: Following are the Company's tax effects of temporary differences resulting in deferred tax assets and liabilities: At December 31, 1993, pursuant to the acquisition of Cablesystems, KBLCOM has unutilized Separate Return Limitation Year (SRLY) net operating loss tax benefits of approximately $23.1 million and unutilized SRLY investment tax credits of approximately $15.5 million which expire in the years 1995 through 2003, and 1994 through 2003, respectively. In addition, KBLCOM has unutilized restricted state loss tax benefits of $17.2 million, which expire in the years 1994 through 2008, and unutilized minimum tax credits of $1.8 million. The Company does not anticipate full utilization of these losses and tax credits and, therefore, has established a valuation allowance. Utilization of preacquisition carryforwards in the future would not affect income of the Company and KBLCOM but would be applied to reduce the carrying value of cable television franchises and intangible assets. (15) SUPPLEMENTARY EXPENSE INFORMATION Taxes, other than income taxes, were charged to expense as follows: (16) BUSINESS SEGMENT INFORMATION The Company operates principally in two business segments: electric utility and cable television. Financial information by business segment is summarized as follows: (a) Amounts do not include amounts attributable to Paragon, which is accounted for under the equity method. (b) 1992 amounts include the effect of a charge of $86.4 million which relates to HL&P's restructuring of operations as a result of the implementation of the Success Through Excellence in Performance (STEP) program (see Note 18). (17) INVESTMENTS (a) Cable Television Partnership. A KBLCOM subsidiary owns a 50% interest in Paragon, a Colorado partnership that owns cable television systems. The remaining interest in the partnership is owned by American Television and Communications Corporation (ATC), a subsidiary of Time Warner Inc. The partnership agreement provides that at any time after December 31, 1993 either partner may elect to divide the assets of the partnership under certain pre-defined procedures set forth in the agreement. Paragon is party to a $275 million revolving credit and letter of credit facility agreement with a group of banks. Paragon also has outstanding $100 million principal amount of 9.56% senior notes due 1995. In each case, borrowings are non-recourse to the Company and to ATC. (b) Foreign Electric Utility. Houston Argentina owns a 32.5% interest in Compania de Inversiones en Electricidad S. A. (COINELEC), an Argentine holding company which acquired, in December 1992, a 51% interest in Empresa Distribuidora La Plata S. A. (EDELAP), an electric utility company operating in La Plata, Argentina and surrounding regions. Houston Argentina's share of the purchase price was approximately $37.4 million, of which $1.6 million was paid in December 1992 with the remainder paid in March 1993. Subsequent to the acquisition, the generating assets of EDELAP were transferred to Central Dique S. A., an Argentine Corporation, 51% of the stock of which is owned by COINELEC. (18) RESTRUCTURING HL&P recorded a one-time, pre-tax charge of $86.4 million in the first quarter of 1992 to reflect the implementation of the STEP program, a restructuring of its operations. This charge includes $42 million related to the acceptance of an early retirement plan by 468 employees of HL&P, $31 million for severance benefits related to the elimination of an additional 1,100 positions and $13 million in other costs associated with the restructuring. (19) CHANGE IN ACCOUNTING METHOD FOR REVENUES During the fourth quarter of 1992, HL&P adopted a change in accounting method for revenue from a cycle billing to a full accrual method, effective January 1, 1992. Unbilled revenues represent the estimated amount customers will be charged for service received, but not yet billed, as of the end of each month. The accrual of unbilled revenues results in a better matching of revenues and expenses. This change impacts the pattern of revenue recognition, which had the effect of increasing revenues and earnings in the second and third quarters (periods of higher usage) and decreasing revenues and earnings in the first and fourth quarters (periods of lower usage). The cumulative effect of this accounting change, less income taxes of $48.5 million, amounted to $94.2 million, and was included in 1992 income. If this change in accounting method were applied retroactively, the effect on consolidated net income in 1991 would not have been material. (20) UNAUDITED QUARTERLY INFORMATION The following unaudited quarterly financial information includes, in the opinion of management, all adjustments (which comprise only normal recurring accruals) necessary for a fair presentation. Quarterly results are not necessarily indicative of a full year's operations because of seasonality and other factors, including rate increases and variations in operating expense patterns. (a) Quarterly earnings per common share are based on the weighted average number of shares outstanding during the quarter, and the sum of the quarters may not equal annual earnings per common share. (b) Adjustment required to reclassify quarterly amounts for the merger of Utility Fuels into HL&P. (see Note 1(b)). (c) Adjustment required to reclassify quarterly amounts for certain advertising expenses at KBLCOM. (d) Amounts include the effect of a pre-tax charge of $86.4 million which relates to HL&P's restructuring of operations as a result of the implementation of the STEP program and pre-tax income of $142.7 million associated with the adoption of a change in accounting principle reflecting a change in the timing of recognition of revenue from electricity sales. (see Notes 18 and 19, respectively). (e) Loss from continuing operations per share for the first quarter of 1992 was $.33. (21) RECLASSIFICATION Certain amounts from the previous years have been reclassified to conform to the 1993 presentation of financial statements. Such reclassifications do not affect earnings. (22) SUBSEQUENT EVENT On February 17 1994, KBLCOM entered into an agreement to acquire three cable companies serving approximately 47,000 customers in the Minneapolis area. KBLCOM will acquire the stock of the companies in exchange for the issuance of common stock of the Company. The amount of common stock of the Company to be issued, currently estimated to be approximately $24 million, is dependent on the amount of liabilities assumed, currently estimated to be approximately $63 million. Approximately 40,000 of the cable customers served by the properties to be acquired are in the Minneapolis metropolitan area. The remaining 7,000 customers are located in small communities south and west of the metropolitan area. Closing of the transaction is subject to the satisfaction of certain conditions. HOUSTON LIGHTING & POWER COMPANY NOTES TO FINANCIAL STATEMENTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 Except as modified below, the Notes to Consolidated Financial Statements of the Company are incorporated herein by reference insofar as they relate to HL&P: (1) Summary of Significant Accounting Policies, (3) Preferred Stock of HL&P, (4) Long-Term Debt, (5) Short-Term Financing, (7) Retirement Plans, (8) Commitments and Contingencies, (9) Jointly-Owned Nuclear Plant, (10) Utility Commission Proceedings, (11) Deferred Plant Costs, (12) Malakoff Electric Generating Station, (13) Recoverable Project Costs, (14) Income Taxes, (15) Supplementary Expense Information, (18) Restructuring, (19) Change in Accounting Method for Revenues, and (21) Reclassification. (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (b) MERGER OF UTILITY FUELS INTO HL&P. The merger has been accounted for in a manner similar to a pooling of interests. HL&P's financial statements have been restated to reflect the combined operations for the current and previous periods, with the appropriate eliminating entries. The merger increased HL&P's previously reported earnings by $28.3 million and $24.4 million in 1992 and 1991, respectively. (i) EARNINGS PER COMMON SHARE. All issued and outstanding Class A voting common stock of HL&P is held by the Company and all issued and outstanding Class B non-voting common stock of HL&P is held by Houston Industries (Delaware) Incorporated (Houston Industries Delaware), a wholly owned subsidiary of the Company. Accordingly, earnings per share is not computed. (j) STATEMENT OF CASH FLOWS. At December 31, 1993, HL&P did not have any investments with affiliated companies (considered to be cash equivalents). At December 31, 1992 and 1991, HL&P had affiliate investments of $2.1 million and $9.7 million, respectively. (2) COMMON STOCK All issued and outstanding Class A voting common stock of HL&P is held by the Company and all issued and outstanding Class B non-voting common stock of HL&P is held by Houston Industries Delaware. (5) SHORT-TERM FINANCING The interim financing requirements of HL&P are primarily met through the issuance of commercial paper. HL&P had a bank credit facility of $250 million at December 31, 1993 and 1992, which limits total short-term borrowings and provides for interest at rates generally less than the prime rate. Outstanding commercial paper was approximately $171 million at December 31, 1993 and $139 million at December 31, 1992. Commitment fees are required on HL&P's bank credit facility. (6) ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount and estimated fair value of HL&P's financial instruments at December 31, 1993 and 1992 are as follows: The fair values of cash and short-term investments, short-term and other notes payable, and notes payable to affiliated company are equivalent to the carrying amounts. The fair values of cumulative preferred stock subject to mandatory redemption, first mortgage bonds and pollution control revenue bonds issued on behalf of HL&P are estimated using rates currently available for securities with similar terms and remaining maturities. (7) RETIREMENT PLANS (a) PENSION. The Company maintains a noncontributory retirement plan covering substantially all employees of HL&P. Net pension cost for HL&P includes the following components: The funded status of HL&P's retirement plan was as follows: The projected benefit obligation was determined using an assumed discount rate of 7.25% in 1993 and 8.5% in 1992. A long-term rate of compensation increase ranging from 3.9% to 6% was assumed for 1993 and ranging from 6.9% to 9.0% was assumed in 1992. The assumed long- term rate of return on plan assets was 9.5% in 1993 and 1992. The transitional asset at January 1, 1986, is being recognized over approximately 17 years, and the prior service cost is being recognized over approximately 15 years. (c) POSTRETIREMENT BENEFITS. HL&P adopted SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions" effective January 1, 1993. For 1992, HL&P continued to fund postretirement benefit costs on a "pay-as-you-go" basis and made payments of $8.6 million. HL&P's 1993 postretirement benefit costs under SFAS No. 106 were $37 million, an increase of approximately $27 million over the 1993 "pay-as-you-go" amount. The net postretirement benefit cost for HL&P in 1993 includes the following components, in thousands of dollars: The funded status of postretirement benefit costs for HL&P at December 31, 1993 was as follows, in thousands of dollars: The assumed health care cost trend rates used in measuring the accumulated postretirement benefit obligation in 1993 are as follows: The assumed health care rates gradually decline to 5.4% for both medical categories and 3.7% for dental by the year 2001. The accumulated postretirement benefit obligation was determined using an assumed discount rate of 7.25% for 1993. If the health care cost trend rate assumptions were increased by 1%, the accumulated postretirement benefit obligation as of December 31, 1993 would be increased by approximately 8%. The annual effect of the 1% increase on the total of the service and interest costs would be an increase of approximately 10%. (14) INCOME TAXES HL&P records income taxes under SFAS No. 109. During 1993, federal tax legislation was enacted that changes the income tax consequences for HL&P. The principal provision of the new law which affects HL&P is the change in the corporate income tax rate from 34% to 35%. A net regulatory asset and the related deferred federal income tax liability of $71.3 million was recorded by HL&P in 1993. The effect of the new law, which decreased HL&P's net income by $8.0 million was recognized as a component of income tax expense in 1993. The effect on HL&P's deferred taxes for the change in the new law was $4.5 million in 1993. HL&P's current and deferred components of income tax expense are as follows: HL&P's effective income tax rates are lower than statutory corporate rates for each year as follows: Following are HL&P's tax effects of temporary differences resulting in deferred tax assets and liabilities: (20) UNAUDITED QUARTERLY INFORMATION The following unaudited quarterly financial information includes, in the opinion of management, all adjustments (which comprise only normal recurring accruals) necessary for a fair presentation. Quarterly results are not necessarily indicative of a full year's operations because of seasonality and other factors, including rate increases and variations in operating expense patterns. (a) Adjustment required to restate quarterly amounts for the merging of Utility Fuels into HL&P. (See Note 1(b)) (b) Amounts include the effect of a pre-tax charge of $86.4 million which relates to HL&P's restructuring of operations as a result of the implementation of the STEP program and pre-tax income of $142.7 million associated with the adoption of a change in accounting principle reflecting a change in the timing of recognition of revenue from electricity sales. (see Notes 18 and 19, respectively). (23) PRINCIPAL AFFILIATE TRANSACTIONS (a) Included in Operating Expenses (b) Included in Other Income (Expense) During 1992 and 1991, Houston Industries Finance purchased accounts receivable of HL&P. In January 1993, Houston Industries Finance sold the receivables back to the respective subsidiaries and ceased operations. HL&P is now selling its accounts receivable and most of its accrued unbilled revenues to an unaffiliated third party. INDEPENDENT AUDITORS' REPORT HOUSTON INDUSTRIES INCORPORATED We have audited the accompanying consolidated balance sheets and the consolidated statements of capitalization of Houston Industries Incorporated and its subsidiaries as of December 31, 1993 and 1992 and the related statements of consolidated income, consolidated retained earnings and consolidated cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the Company's financial statement schedules listed in Item 14(a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company 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. 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 19 to the consolidated financial statements, the Company changed its method of accounting for revenues in 1992. DELOITTE & TOUCHE Houston, Texas February 23, 1994 INDEPENDENT AUDITORS' REPORT HOUSTON LIGHTING & POWER COMPANY We have audited the accompanying balance sheets and the statements of capitalization of Houston Lighting & Power Company (HL&P) 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. Our audits also included the financial statement schedules of HL&P listed in Item 14(a)(2). These financial statements and financial statement schedules are the responsibility of HL&P's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of HL&P 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 Note 1 to the financial statements, Utility Fuels, Inc., HL&P's coal supply affiliate, was merged into HL&P in 1993. The merger has been accounted for in a manner similar to a pooling of interests with restatement of all years presented. As discussed in Note 19 to the financial statements, HL&P changed its method of accounting for revenues in 1992. DELOITTE & TOUCHE Houston, Texas February 23, 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 COMPANY AND HL&P. (a) The Company The information called for by Item 10, to the extent not set forth under Item 1 "Business - Executive Officers of the Company", is or will be set forth in the definitive proxy statement relating to the Company's 1994 annual meeting of shareholders pursuant to the Commission's Regulation 14A. Such definitive proxy statement relates to a meeting of shareholders involving the election of directors and the portions thereof called for by Item 10 is incorporated herein by reference pursuant to Instruction G to Form 10-K. (b) HL&P The information set forth under Item 1. "Business - Executive Officers of HL&P" is incorporated herein by reference. Each member of the board of directors of HL&P is also a member of the board of directors of the Company. Each member of the board of directors of HL&P is elected annually for a one-year term. The HL&P annual shareholder's meeting, at which the Company elects members to the HL&P board of directors, is expected to occur on May 4, 1994. Information is set forth below with respect to the business experience for the last five years of each person who currently serves as a member of the board of directors of HL&P, certain other directorships held by each such person and certain other information. Unless otherwise indicated, each person has had the same principal occupation for at least five years. MILTON CARROLL, age 43, has been a director since 1992. He is Chairman, President and Chief Executive Officer of Instrument Products Inc., an oil field supply manufacturing company, in Houston, Texas. Mr. Carroll currently serves as an advisor to Lazard Freres & Co., an investment banking firm, and is a director of Panhandle Eastern Corporation and the Federal Reserve Bank of Dallas. JOHN T. CATER, age 58, has been a director since 1983. Mr. Cater is Chairman, Chief Executive Officer and a director of River Oaks Trust Company in Houston, Texas. He also serves as President and director of Compass Bank-Houston. Until his retirement in July 1990, Mr. Cater served as President, Chief Operating Officer and a director of MCorp, a Texas bank holding company. He currently serves as a director of MCorp.(1) ROBERT J. CRUIKSHANK, age 63, has been a director since 1993. Mr. Cruikshank is primarily engaged in managing his personal investments in Houston, Texas. Prior to his retirement in 1993, Mr. Cruikshank was a Senior Partner in the accounting firm of Deloitte & Touche. Mr. Cruikshank is also Vice-Chairman of the Board of Regents of the University of Texas System. He also serves as a director of MAXXAM Inc., Compass Bank and Texas Biotechnology Corporation. LINNET F. DEILY, age 48, has been a director since 1993. Ms. Deily is Chairman, Chief Executive Officer and President of First Interstate Bank of Texas, N.A. She has served as Chairman since 1992, Chief Executive Officer since 1991 and President since 1988. (2) JOSEPH M. HENDRIE, PH.D., age 68, has been a director since 1985. Dr. Hendrie is a Consulting Engineer in Bellport, New York, having previously served as Chairman and Commissioner of the U.S. Nuclear Regulatory Commission and as President of the American Nuclear Society. He is also a director of Entergy Operations, Inc. of Jackson, Mississippi. HOWARD W. HORNE, age 67, has been a director since 1978. Mr. Horne is Vice Chairman of Cushman & Wakefield of Texas, Inc., a subsidiary of a national real estate brokerage firm. Until 1990, Mr. Horne was Chairman of the Board of The Horne Company, a realty firm. (3) DON D. JORDAN, age 61, has been a director of the Company since 1977 and of HL&P since 1974. Mr. Jordan is Chairman and Chief Executive Officer of the Company and Chairman and Chief Executive Officer of HL&P. Mr. Jordan also serves as a director of Texas Commerce Bancshares, Inc. and BJ Services Company, Inc. THOMAS B. MCDADE, age 70, has been a director since 1980. Mr. McDade is primarily engaged in managing his personal investments in Houston, Texas. Mr. McDade also serves as a director and trustee of eleven registered investment companies for which Transamerica Fund Management Company serves as investment advisor. (4) ALEXANDER F. SCHILT, PH.D., age 53, has been a director since 1992. He is Chancellor of the University of Houston System. Prior to 1990, Dr. Schilt was President of Eastern Washington University in Cheney and Spokane, Washington. KENNETH L. SCHNITZER, SR., age 64, has been a director since 1983. Mr. Schnitzer is Chairman of the Board of Schnitzer Enterprises, Inc., a Houston commercial real estate development company, having previously served as a director of American Building Maintenance Industries Incorporated and Weingarten Realty, Inc. (5) DON D. SYKORA, age 63, has been a director since 1982. Mr. Sykora is President and Chief Operating Officer of the Company. He also serves as a director of Powell Industries, Inc., Pool Energy Services Company, Inc. and TransTexas Gas Corporation. JACK T. TROTTER, age 67, has been a director since 1985. Mr. Trotter is primarily engaged in managing his personal investments in Houston, Texas. He also serves as a director of First Interstate Bank of Texas, N.A., Howell Corporation, Weingarten Realty Investors, Zapata Corporation and Continental Airlines, Inc. BERTRAM WOLFE, PH.D., age 66, has been a director since 1993. Prior to his retirement in 1992, Dr. Wolfe was Vice President and General Manager of General Electric Company's nuclear energy business in San Jose, California. - ----------------- (1) In March 1989, the FDIC declared 20 of MCorp's 25 banks to be insolvent and transferred their assets and deposits to another bank. In 1989, MCorp filed for protection under the Federal Bankruptcy Code. (2) First Interstate and certain of its affiliates participate in various credit facilities with HL&P, the Company and certain of HL&P's affiliates and other entities in which the Company has an ownership interest. Under these agreements, First Interstate and certain of its affiliates have maximum aggregate loans and commitments to lend approximately $81.24 million. (3) Under a consulting arrangement originally with Mr. Horne which was subsequently amended to be an agreement with Cushman & Wakefield of which Mr. Horne is Vice Chairman, Cushman & Wakefield represented the Company in negotiations concerning the purchase of an office building in 1993, for which that firm was paid $358,000 by the Company and $78,000 by the seller of the building. (4) Mr. McDade is expected to retire at the date of the Company's 1994 annual meeting of shareholders. (5) HL&P and certain of its affiliates currently lease office space in buildings owned or controlled by affiliates of Mr. Schnitzer. HL&P and certain of its affiliates paid a total of approximately $5.4 million to affiliates of Mr. Schnitzer during 1993, and it is expected that approximately $5.6 million will be paid in 1994. HL&P believes such payments are comparable to those that would have been made to other non-affiliated firms for comparable facilities and services. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. (a) The Company The information called for by Item 11 is or will be set forth in the definitive proxy statement relating to the Company's 1994 annual meeting of shareholders pursuant to the Commission's Regulation 14A. Such definitive proxy statement relates to a meeting of shareholders involving the election of directors and the portions thereof called for by Item 11 (excluding any information required by paragraphs (i), (k) and (l) of Item 402 of Regulation S-K) are incorporated herein by reference pursuant to Instruction G to Form 10-K. (b) HL&P SUMMARY COMPENSATION TABLE. The following table shows, for the years ended December 31, 1991, 1992 and 1993, the annual, long-term and certain other compensation of the chief executive officer and the other four most highly compensated executive officers of HL&P including Mr. Hall who retired effective January 1, 1994 (Named Officers). The format and information presented are as prescribed in revised rules of the Securities and Exchange Commission (SEC) and in accordance with transitional provisions of the rules, information in the "All Other Compensation" column is not presented for 1991. SUMMARY COMPENSATION TABLE - ----------------- (1) The amounts shown include salary earned and received by the Named Officers as well as salary earned but deferred. Also included are board of director and committee fees paid in 1991 prior to the time such fees were eliminated for employee directors. (2) The amount of bonus earned for 1993 has not been determined because it was not calculable as of the date of this Report. In accordance with the SEC's revised rules on executive compensation, these amounts will be included for such year in HL&P's Annual Report on Form 10-K for the year ended December 31, 1994. (3) The amounts shown represent (i) cash paid in 1991 and 1992 under the Company's executive incentive compensation plan for long-term awards based on the performance periods of 1987-1990 and 1988-1991 respectively and (ii) the dollar value of shares of the Company's common stock paid out in 1993 under the Company's long-term incentive compensation plans based on the achievement of certain performance objectives for the 1990-1992 performance cycle, plus dividend equivalent accruals during the performance period. (4) The amounts shown include (i) Company contributions to the Company's savings plan and accruals under its savings restoration plan for 1992 and 1993 on behalf of the Named Officers, as follows: Mr. Jordan 1992 - $41,348 and 1993 - $57,152; Mr. Kelly 1992 - $26,141 and 1993 - $19,569; Mr. Letbetter 1992 - $20,225 and 1993 - $16,672; Mr. Hall 1992 - $14,005 and 1993 - $16,933; and Mr. Greenwade 1992 - $16,898 and 1993 - $14,128 and (ii) the portion of accrued interest on amounts of compensation deferred under the Company's deferred compensation plan and executive incentive compensation plan that exceeds 120% of the applicable federal long-term rate provided under Section 1274(d) of the Internal Revenue Code, as follows: Mr. Jordan 1992 - $501,856 and 1993 - $590,339; Mr. Kelly 1992 - $39,125 and 1993 - $38,649; Mr. Letbetter 1992 - $24,588 and 1993 - $25,890; Mr. Hall 1992 - $1,664 and 1993 - $1,128; and Mr. Greenwade 1992 - $21,286 and 1993 - $22,658. With respect to the accrued interest on deferred amounts referenced in (ii) of this footnote, the Company owns and is the beneficiary under life insurance policies, and it is currently anticipated that the benefits associated with these policies will be sufficient to cover such accumulated interest. (5) The information related to Mr. Jordan includes his compensation as Chairman and Chief Executive Officer of the Company. STOCK OPTION GRANTS. The following table contains information concerning the grant of stock options under the Company's long-term incentive compensation plan to the Named Officers during 1993. OPTION GRANTS IN 1993 - ----------------- (1) The nonstatutory options for shares of the Company's common stock included in the table were granted on January 4, 1993, have a ten-year term and generally become exercisable in one-third increments commencing one year after date of grant, so long as employment with the Company or its subsidiaries continues. If a change in control (as defined in the plan) of the Company occurs before the options become exercisable, the options will become immediately exercisable. (2) Based on the Black-Scholes option pricing model adjusted for the payment of dividends. The calculations were made based on the following assumptions: volatility equal to historical volatility of the Company's common stock in the six-month period prior to grant date; risk-free interest rate equal to the ten-year average monthly U.S. Treasury rate for January 1993; option strike price equal to current stock price on the date of grant ($46.25); current dividend rate of $3 per share per year; and option term equal to the full ten-year period until the stated expiration date. No reduction has been made in the valuations on account of non-transferability of the options or vesting or forfeiture provisions. Valuations would change if different assumptions were made. Option values are dependent on general market conditions and the performance of the Company's common stock. There can be no assurance that the values in this table will be realized. (3) Under the terms of the Company's long-term incentive compensation plans, Mr. Hall's retirement effective January 1, 1994 resulted in his receiving options for only 770 shares of the originally granted number of shares, and resulted in the forfeiture, for no value, of his options for 1,539 shares. Options expire one year after date of retirement; therefore, Mr. Hall's options expire January 1, 1995. STOCK OPTION VALUES. The following table sets forth information for each of the Named Officers with respect to the unexercised options to purchase the Company's common stock granted under the Company's long-term incentive compensation plans and held as of December 31, 1993, including the aggregate amount by which the market value of the option shares exceeds the exercise price of the option shares at December 31, 1993. No options were exercised by the Named Officers during 1993. 1993 YEAR-END OPTION VALUES - ----------------- (1) Based on the average of the high and low sales prices of the the Company's common stock on the composite tape, as reported by The Wall Street Journal for December 31, 1993. LONG-TERM INCENTIVE COMPENSATION PLANS The following table sets forth information concerning awards made during the year ended December 31, 1993 under the Company's long-term incentive compensation plans. The table represents potential payouts of awards for performance shares (target and opportunity shares) of Common Stock based on the achievement of certain performance goals over a performance cycle of three years. The performance goals are weighted differently depending on the parent or subsidiary company by which the Named Officer is employed. The consolidated performance goal applicable to each of the Named Officers is achieving a superior total return to shareholders in relation to a panel of other companies. With respect to Messrs. Letbetter, Hall and Greenwade, subsidiary performance goals consist of (1) increasing HL&P's competitive rate advantage by maintaining current base electric rates and (2) achieving a superior cash flow performance in relation to a panel of other companies. With respect to Messrs. Jordan and Kelly, subsidiary performance goals include all of the above as well as goals from the Company's other major subsidiary. Each of these goals has attainment levels ranging from 50% to 150% of the target amounts. Target amounts for awards will be earned if goals are achieved at the 100% level; threshold amounts if goals are achieved at the 50% level and maximum amounts if goals are achieved at the 150% level. If a change in control (as defined in the plan) of the Company occurs before the end of a performance cycle, the payouts of awards for performance shares will occur without regard to achievement of the performance goals. LONG-TERM INCENTIVE COMPENSATION PLANS - AWARDS IN 1993 - ----------------- (1) The table does not reflect dividend equivalent accruals during the performance period. (2) Under the terms of the Company's long-term incentive compensation plans, Mr. Hall's retirement effective January 1, 1994 resulted in his receiving a payout in January, 1994 of 799 shares, a pro-rated amount based on the number of days elapsed in the performance cycle. RETIREMENT PLANS, RELATED BENEFITS AND OTHER AGREEMENTS. The following table shows the estimated annual benefit payable under the Company's retirement plan, benefit restoration plan and, in certain cases, supplemental agreements, to officers in various compensation classifications upon retirement at age 65 after the indicated periods of service, determined on a single-life annuity basis. The amounts in the table are not subject to any deduction for Social Security payments or other offsetting amounts. PENSION PLAN TABLE NOTE: The qualified pension plan limits compensation in accordance with IRC 401(a)(17) and also limits benefits in accordance with IRC 415. Pension benefits based on compensation above the qualified plan limit or in excess of the limit on annual benefits are provided through the benefit restoration plan. For the purpose of the pension table above, final average annual compensation means the average of covered compensation for the 36 consecutive months out of the 120 consecutive months immediately preceding retirement in which the participant's covered compensation was the highest. Covered compensation only includes the amounts shown in the "Salary" and "Bonus" columns of the Summary Compensation Table. At December 31, 1993 the credited years of service and current covered compensation for the following persons are: Mr. Jordan, 35 years $1,360,768; Mr. Kelly, 19 years, 10 of which result from a supplemental agreement $465,939; Mr. Letbetter, 20 years $396,952 and Mr. Greenwade, 28 years $336,380. Mr. Hall , who retired effective January 1, 1994, does not participate in the Company's retirement plan, but under supplemental agreements, he receives a pension of $50,000 per year. Because bonus amounts for 1993 are not yet available, the foregoing covered compensation amounts are based in part on 1992 data. The Company maintains an executive benefits plan that provides certain salary continuation, disability and death benefits to key officers of the Company and certain of its subsidiaries. The Named Officers participate in this plan pursuant to individual agreements. The agreements generally provide for (1) a salary continuation benefit of 100% of the officer's current salary for twelve months after death during active employment and then 50% of salary for nine years or until the deceased officer would have attained age 65, if later, and (2) if the officer retires after attainment of age 65, an annual post-retirement death benefit of 50% of the officer's preretirement annual salary payable for six years. Effective in 1994, the Company authorized an executive life insurance plan providing for split-dollar life insurance to be maintained on the lives of certain officers and all members of the Board of Directors. Pursuant to the plan, the Personnel Committee has authorized the Company to obtain coverage for the Named Officers, except for Mr. Hall who has retired. The amounts of their coverages are not finalized, pending completion of arrangements with the insurance carrier and certain elections by participants, but are expected to range from approximately two times current salary to six times current salary, assuming single life coverage is elected. The death benefit for the Company's nonemployee directors is six times the annual retainer (assuming single life coverage is elected). The plan also provides that the Company may make payments to the covered individuals designed to compensate for tax consequences with respect to imputed income that they must recognize for federal income tax purposes based on the term portion of the annual premiums. If a covered executive retires at age 65 or at an earlier age under circumstances approved for this purpose by the Board of Directors, rights under the plan vest so that coverage is continued based on the same death benefit in effect at the time of retirement. Upon death, the Company will receive the balance of the insurance proceeds payable in excess of the specified death benefit which should in all cases be at least sufficient to cover the Company's cumulative outlays to pay premiums and the after-tax cost to the Company of the tax gross-up payments. COMPENSATION OF DIRECTORS. Each nonemployee director receives an annual retainer fee of $20,000, in his or her capacity as a director of the Company, and a fee of $1,000 for each board meeting attended and a fee of $700 for each committee meeting attended. Directors may defer all or a part of their annual retainer fees (minimum deferral $2,000) and meeting fees under the Company's deferred compensation plan. Nonemployee directors participate in a director benefits plan pursuant to which a director who serves at least one full year will receive an annual benefit in cash equal to the annual retainer payable in the year the director terminates service. Benefits under this plan will be payable to the director, commencing the January following the later of the director's termination of service or attainment of age 65, for a period equal to the number of full years of service of the director. Nonemployee directors also participate in the Company's executive life insurance plan effective January 1994, described above under "Retirement Plans, Related Benefits and Other Agreements," under which the Company purchases split dollar life insurance so as to provide each nonemployee director a death benefit equal to six times his or her annual retainer (assuming single life coverage is elected) with coverage continuing after termination of service as a director. This plan also permits the Company to provide for a tax gross-up payment to make the directors whole with respect to imputed income recognized with respect to the term portion of the annual insurance premiums. For a description of a consulting arrangement with Mr. Horne and a fee paid to a company of which he is Vice Chairman, see Note 3 to Item 10(b). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) The Company The information called for by Item 12 is or will be set forth in the definitive proxy statement relating to the Company's 1994 annual meeting of shareholders pursuant to the Commission's Regulation 14A. Such definitive proxy statement relates to a meeting of shareholders involving the election of directors and the portions thereof called for by Item 12 is incorporated herein by reference pursuant to Instruction G to Form 10-K. (b) HL&P As of the date of this Report, the Company owned 1,000 shares of HL&P's Class A common stock, without par value, and Houston Industries (Delaware) Incorporated owned 100 shares of HL&P's Class B common stock, constituting all of the issued and outstanding shares of Class B common stock of HL&P. The following table shows the beneficial ownership reported as of the date of this Report unless otherwise noted of shares of the Company's common stock, including shares as to which a right to acquire ownership exists (for example, through the exercise of stock options) within the meaning of Rule 13d-3(d)(1) under the Securities Exchange Act of 1934, of each current director, the chief executive officer and the four other most highly compensated executive officers of HL&P and, as a group, of such persons and other executive officers of HL&P. No person or member of the group listed owns any equity securities of HL&P or any other subsidiary of the Company. Unless otherwise indicated, each person or member of the group listed has sole voting and investment power with respect to the shares of Common Stock listed. No ownership shown in the table represents 1% or more of the outstanding shares of the Company's common stock. - ----------------- (1) Mr. Cater disclaims beneficial ownership of these shares, which are owned by his adult children. (2) Voting power and investment power with respect to the shares listed for Ms. Deily and Dr. Hendrie are shared with the respective spouse of each. (3) Mr. Hall's ownership is reported as of December 31, 1993; he retired effective January 1, 1994. (4) Includes shares held under the Company's dividend reinvestment plan as of December 31, 1993. (5) Voting power and investment power with respect to 576 of the shares listed are shared with Mr. Jordan's spouse. (6) Includes shares held under the savings plan of the Company or KBLCOM Incorporated as of December 31, 1993 (which plans merged January 1, 1994), as to which the participant has sole voting power (subject to such power being exercised by the plan's trustees in the same proportion as directed shares in the savings plans are voted in the event the participant does not exercise voting power). (7) The ownership shown in the table includes shares which may be acquired within 60 days on exercise of outstanding stock options granted under the Company's long-term incentive compensation plans by each of the persons and group, as follows: Mr. Jordan - 13,115 shares; Mr. Sykora - 6,994 shares; Mr. Kelly - 2,652 shares; Mr. Letbetter - 2,150 shares; Mr. Hall - 2,333 shares; Mr. Greenwade - 1,921 shares and the group - 31,976 shares. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. (a) The Company The information called for by Item 13 is or will be set forth in the definitive proxy statement relating to the Company's 1994 annual meeting of shareholders pursuant to the Commission's Regulation 14A. Such definitive proxy statement relates to a meeting of shareholders involving the election of directors and the portions thereof called for by Item 13 is incorporated herein by reference pursuant to Instruction G to Form 10-K. (b) HL&P The information set forth in Notes 2, 3 and 5 to Item 10(b) above is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. The following schedules 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: I, II, III, IV, VII, X, XI, XII and XIII. (a)(3) EXHIBITS. See Index of Exhibits on page 135, which also includes the management contracts or compensatory plans or arrangements required to be filed as exhibits to this Form 10-K by Item 601(10)(iii) of Regulation S-K. (b) REPORTS ON FORM 8-K. None HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Notes: (A) Substantially all electric utility additions are originally charged to Construction Work in Progress and transferred to electric utility plant accounts upon completion. Additions at cost give effect to such transfers. (B) Additions at cost include noncash charges for AFUDC for HL&P and capitalized interest for other subsidiaries. (C) Depreciation is computed using the straight-line method. The depreciation provisions as a percentage of the depreciable cost of plant were 3.4%, for 1993, 1992 and 1991. (D) Other changes to Plant Held for Future Use in 1993 and 1992 represent the deduction of $7.0 million and $84.1 million, respectively, of recoverable costs related to Malakoff. (E) 1992 and 1991 have been adjusted to reflect reclassifications due to the merger of Utility Fuels into HL&P. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED PROVISION FOR DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) __________________________ Notes: (1) 1992 and 1991 have been adjusted to reflect reclassifications due to the merger of Utility Fuels into HL&P. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES SCHEDULE VIII - RESERVES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Notes: (A) Deductions from reserves represent losses or expenses for which the respective reserves were created. In the case of the uncollectible accounts reserve, such deductions are net of recoveries of amounts previously written off. (B) During 1992 and 1991, Houston Industries Finance purchased accounts receivable of HL&P and of certain KBLCOM subsidiaries. In January 1993, Houston Industries Finance sold the receivables back to the respective subsidiaries and ceased operations. HL&P is now selling its accounts receivable and most of its accrued unbilled revenues to a third party. HOUSTON INDUSTRIES INCORPORATED AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Note: The weighted average interest rate during the period is calculated by dividing interest by the weighted average proceeds from the borrowings. HOUSTON LIGHTING & POWER COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Notes: (A) 1992 and 1991 have been restated for the merger of Utility Fuels into HL&P. (B) Other Changes in Plant Held for Future Use in 1993 and 1992 represent the deduction of recoverable costs of $7.0 million and $84.1 million, respectively, of recoverable costs related to Malakoff. (C) Substantially all additions are originally charged to Construction Work In Progress and transferred to electric utility plant accounts upon completion. Additions at cost give effect to such transfers. (D) Additions at cost include non-cash charges for an allowance for funds used during construction. (E) HL&P computes depreciation using the straight-line method. The depreciation provisions as a percentage of the average depreciable cost of plant was 3.1% for 1993, 3.2% for 1992 and 1991. HOUSTON LIGHTING & POWER COMPANY SCHEDULE VI - ACCUMULATED PROVISION FOR DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________________ Notes: (1) 1992 and 1991 have been restated for the merger of Utility Fuels into HL&P. HOUSTON LIGHTING & POWER COMPANY SCHEDULE VIII - RESERVES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Notes: (A) Deductions from reserves represent losses or expenses for which the respective reserves were created. (B) HL&P has no reserves for uncollectible accounts due to sales of accounts receivable. HOUSTON LIGHTING & POWER COMPANY SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) _______________ Note: (A) The Balance at End of Period excludes $19 million in notes payable to the Company as of December 31, 1992. (B) The weighted average interest rate is calculated by dividing interest by the weighted average proceeds from the borrowings. 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 HOUSTON AND STATE OF TEXAS, ON THE 10TH DAY OF MARCH, 1994. HOUSTON INDUSTRIES INCORPORATED (Registrant) By DON D. JORDAN (Don D. Jordan, 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 DATE INDICATED. 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 HOUSTON AND STATE OF TEXAS, ON THE 10TH DAY OF MARCH, 1994. THE SIGNATURE OF HOUSTON LIGHTING & POWER COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. HOUSTON LIGHTING & POWER COMPANY (Registrant) By DON D. JORDAN (Don D. Jordan, 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 DATE INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO HOUSTON LIGHTING & POWER COMPANY AND ANY SUBSIDIARIES THEREOF. HOUSTON INDUSTRIES INCORPORATED HOUSTON LIGHTING & POWER COMPANY EXHIBITS TO THE ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 INDEX OF EXHIBITS Exhibits not incorporated by reference to a prior filing are designated by a cross (+); all exhibits not so designated are incorporated herein by reference to a prior filing as indicated. Exhibits designated by an asterisk (*) are management contracts or compensatory plans or arrangements required to be filed as exhibits to this Form 10-K by Item 601(10)(iii) of Regulation S-K. (a) Houston Industries Incorporated Pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K, the Company has not filed as exhibits to this Form 10-K certain long-term debt instruments, 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. The Company hereby agrees to furnish a copy of any such instrument to the SEC upon request. (b) Houston Lighting & Power Company +4(a)(8) Sixty-First through Sixty-Third Supplemental Indentures to HL&P Mortgage and Deed of Trust There have not been filed as exhibits to this Form 10-K certain long-term debt instruments, including indentures, under which the total amount of securities do not exceed 10% of the total assets of HL&P. HL&P hereby agrees to furnish a copy of any such instrument to the SEC upon request.

750577_1993.txt

750577_1993

1993

750577

ITEM 1 - BUSINESS BACKGROUND AND CURRENT OPERATIONS BACKGROUND GENERAL: Hancock Holding Company (the "Company") was organized in 1984 as a bank holding company registered under the Bank Holding Company Act of 1956, as amended. The Company, headquartered in Gulfport, Mississippi, operates 54 banking offices and 80 automated teller machines ("ATM's") (34 of which are free-standing) in the states of Mississippi and Louisiana through two wholly-owned bank subsidiaries, Hancock Bank, Gulfport, Mississippi ("Hancock Bank MS") and Hancock Bank of Louisiana, Baton Rouge, Louisiana ("Hancock Bank LA"). Hancock Bank MS and Hancock Bank LA hereinafter are referred to collectively as the "Banks." The Banks are community oriented and focus primarily on offering commercial, consumer and mortgage loans and deposit services to individuals and small to middle market businesses in their respective market areas. The Company's operating strategy is to provide its customers with the financial sophistication and breadth of products of a regional bank, while successfully retaining the local appeal and level of service of a community bank. At December 31, 1993, the Company had total assets of $1.8 billion and employed on a full-time basis 776 persons in Mississippi and 327 persons in Louisiana. Hancock Bank MS was originally chartered as Hancock County Bank in 1899 and since its organization the strategy of Hancock Bank MS has been to achieve a dominant market share on the Mississippi Gulf Coast. Prior to a series of acquisitions begun in 1985, growth was primarily internal and was accomplished by concentrating branch expansions in areas of population growth where no dominant financial institution previously served the market area. Economic expansion on the Mississippi Gulf Coast has resulted primarily from growth of military and government-related facilities, tourism, port facility activities, industrial complexes and the gaming industry. Hancock Bank MS currently has the largest market share in each of the four counties in which it operates, Harrison, Hancock, Jackson and Pearl River. With assets of $1.3 billion, Hancock Bank MS currently ranks as the fifth largest bank in Mississippi. Beginning with the 1985 acquisition of the Pascagoula-Moss Point Bank ("PMP") in Pascagoula, Mississippi, the Company has acquired approximately $611.9 million in assets and approximately $556.2 million in deposit liabilities through selected acquisitions or purchase and assumption transactions. RECENT ACQUISITION ACTIVITY: The majority of the Company's acquisition activity occurred in 1990 and 1991, beginning with the June 1990, merger of Metropolitan National Bank ("MNB") Biloxi, Mississippi into Hancock Bank MS. At the time of its acquisition, MNB had total assets of approximately $98.8 million and total deposit liabilities of approximately $95.1 million. Also in June 1990, pursuant to a purchase and assumption agreement, Hancock Bank MS acquired the Poplarville, Mississippi branch of Unifirst Bank for Savings from the Resolution Trust Corporation ("RTC"). The acquisition increased Hancock Bank MS total assets by approximately $7.8 million and its total deposit liabilities by approximately $7.4 million. In August 1990, the Company formed Hancock Bank LA for the purpose of assuming the deposit liabilities and acquiring the consumer loan portfolio, corporate credit card portfolio and non-adversely classified securities portfolio of American Bank and Trust ("AmBank") Baton Rouge, Louisiana, from the Federal Deposit Insurance Corporation ("FDIC"). As a result of this transaction, Hancock Bank LA acquired 15 banking offices in the greater Baton Rouge area, approximately $337.5 million in assets and approximately $300.9 million in deposit liabilities. During 1993, Hancock Bank LA's deposits increased approximately 3.4% to $468.2 million. It is currently one of the five largest banks in East Baton Rouge Parish. Economic expansion in East Baton Rouge Parish has resulted primarily from growth in state government and related service industries, educational and medical complexes, petrochemical industries, port facility activities and transportation and related industries. In August 1991, Hancock Bank MS acquired certain assets and deposit liabilities of Peoples Federal Savings Association, Bay St. Louis, Mississippi, from the RTC. As a result of this transaction, the Bank acquired assets of approximately $39.0 million and deposit liabilities of approximately $38.5 million. In connection with the MNB and AmBank acquisitions, the Company borrowed $18,750,000 from Whitney National Bank, New Orleans, Louisiana ("Whitney") to partially fund these acquisitions. On November 28, 1991, the Company sold 1,552,500 shares of its common stock at $17 per share, following a two-for-one stock split in the form of a 100% stock dividend on October 15, 1991 and an increase in the number of authorized shares to 20,000,000. The net proceeds of this sale, after underwriting discount and expenses, of approximately $24,700,000, were used to pay the interest, retire $18,500,000 of principal debt on the Whitney loans and increase Hancock Bank LA's capital by $5,000,000. PROPOSED ACQUISITION: In November 1993, the Company agreed to merge Hancock Bank of Louisiana, a wholly owned subsidiary of the Company with First State Bank and Trust Company of East Baton Rouge Parish, Baker, Louisiana. The merger will be consummated by the exchange of all outstanding common stock of First State Bank in return for approximately 520,000 shares of common stock of the Company. Completion of the merger is contingent upon approval by First State Bank shareholders, the Louisiana Commissioner of Financial Institutions, the Federal Deposit Insurance Corporation and the Federal Reserve. It is intended that the merger will be accounted for using the pooling of interests method. First State Bank had total assets of $82,000,000 and stockholders equity of $11,500,000 as of December 31, 1993 and net earnings of $1,250,000 for the year then ended. CURRENT OPERATIONS LOAN PRODUCTION AND CREDIT REVIEW: The Banks' primary lending focus is to provide commercial, consumer and real estate loans to consumers and to small and middle market businesses in their respective market areas. The Banks have no concentrations of loans to particular borrowers or loans to any foreign entities. Each loan officer has Board approved loan limits on the principal amount of secured and unsecured loans he or she can approve for a single borrower without prior approval of a loan committee. All loans, however, must meet the credit underwriting and loan policies of the Banks. For Hancock Bank MS, all loans over an individual loan officer's Board approved lending authority and below $150,000 must be approved by his or her region's loan committee or by another loan officer with greater lending authority. If a borrower's total indebtedness exceeds $150,000, any loan must be reviewed and approved by both the regional loan committee and the Bank's senior loan committee. Each loan file is reviewed by the Bank's loan review department to ensure proper documentation. For Hancock Bank LA, all loans over an individual loan officer's Board approved lending authority must be approved by the Bank's senior loan committee or by another loan officer with greater lending authority. Aggregate lending relationships above the loan officers' authority of up to $500,000 must be approved by the Company's loan committee. Each loan file is reviewed by the Bank's loan review department to ensure proper documentation. LOAN REVIEW AND ASSET QUALITY: Each Bank's portfolio of credit relationships aggregating $250,000 or more is continually reviewed by the respective Bank to identify any deficiencies and to take corrective actions as necessary. Credit relationships aggregating less than $250,000 are reviewed on a periodic basis. As a result of such reviews, each Bank places on its Watchlist loans that are deemed to require close or frequent review. All loans classified by a regulator are also placed on the Watchlist. All Watchlist and past due loans are reviewed at least monthly by the Banks' senior lending officers and monthly by the Banks' Board of Directors. In addition, all loans to a particular borrower are reviewed, regardless of classification, each time such borrower requests a renewal or extension of any loan or requests an additional loan. All lines of credit are reviewed annually prior to renewal. The Banks currently have mechanisms in place which allow for at least an annual review of the financial statements and the financial condition of all borrowers, except borrowers with secured installment and residential mortgage loans. As a matter of policy, the Banks place loans on nonaccrual status whenever debt service becomes impaired or collection becomes questionable. The Banks follow the standard FDIC loan classification system which is designed to serve the dual purpose of providing management with (1) a general view of the quality of the overall loan portfolio (each branch's loans and each commercial loan officer's lending portfolio) and (2) information on specific loans which may need individual attention. The Banks hold nonperforming assets, consisting of real property, vehicles and other items held for resale, which were acquired generally through the process of foreclosure. At December 31, 1993, the book value of nonperforming assets held for resale was approximately $700 thousand. SECURITIES PORTFOLIO: The Banks maintain portfolios of securities consisting primarily of U.S. Treasury securities, U.S. Government agency issues and tax-exempt obligations of states and political subdivisions. The portfolios are designed to enhance liquidity while providing acceptable rates of return. Therefore, the Banks invest only in high grade investment quality securities with acceptable yields and generally with maturities of less than 7 years. Investments are limited by the Banks' policies to securities having a rating of no less than "Baa" by Moody's Investors' Service, Inc., except that non-rated but creditworthy general obligations of Mississippi or Louisiana governmental agencies or political subdivisions are permissible. DEPOSITS: The Banks have a number of programs designed to attract depository accounts which are offered to consumers and to small and middle market businesses at interest rates generally consistent with market conditions. Additionally, the Banks offer 80 ATMs, 46 ATMs at their 54 banking offices and 34 free-standing ATMs at other locations. As members of regional and international ATM networks such as "GulfNet", "PLUS" and "CIRRUS", the Banks offer customers access to their depository accounts from regional, national and international ATM facilities. Deposit flows are controlled by the Banks primarily through pricing of such deposits and to a certain extent through promotional activities. Management believes that the rates it offers, which are posted weekly on deposit accounts, are generally competitive with or, in some cases, slightly below other financial institutions in the Banks' respective market areas. TRUST SERVICES: The Banks', through their respective Trust Departments, offer a full range of trust services on a fee basis. The Banks act as executor, administrator, or guardian in administering estates. Also provided are investment custodial services for individual, businesses and charitable and religious organizations. In their trust capacities, the Banks provide investment management services on an agency basis and act as trustee for pension plans, profit sharing plans, corporate and municipal bond issues, living trusts, life insurance trusts and various other types of trusts created by or for individuals, businesses and charitable and religious organizations. As of December 31, 1993, the Trust Departments of the Banks had approximately $2.3 billion of assets under management, of which $1.7 billion were corporate accounts and $600 million were personal, employee benefit, estate and other trust accounts. OPERATING EFFICIENCY STRATEGY: The primary focus of the Company's operating strategy is to increase operating income and to reduce operating expense. Management has taken steps beginning in January of 1988 to improve operating efficiencies and as a result, employees at Hancock Bank MS have been reduced from 0.78 per $1.0 million in assets in February 1988 to 0.61 as of December 31, 1993. Since its acquisition in August 1990, Hancock Bank LA's employees have been reduced from 0.97 per $1.0 million of assets to 0.62 as of December 31, 1993. Management annually establishes an employee to asset goal for each Bank. The Banks also have set an internal long range goal of at least covering total salary and benefit costs by fee income. The ratio of fee income to total salary and benefit costs is $0.49 per $1.00 of total salary and benefit costs at Hancock Bank MS. Hancock Bank LA has a higher level of fee income and through December 31, 1993 has achieved a ratio of $0.69 to $1.00 of salary and benefit costs. OTHER ACTIVITIES: Hancock Bank MS has six subsidiaries through which it engages in the following activities: providing consumer financing services; mortgage lending; owning, managing and maintaining certain real property; providing general insurance agency services; holding investment securities; and marketing credit life insurance. The income of these subsidiaries generally accounts for less than 10% of the Company's total income annually. Hancock Bank MS also owns approximately 3,700 acres of timberland in Hancock County, Mississippi, most of which was acquired through foreclosure in the 1930's. Less than 1% of the Company's annual income is generated from timber sales and oil and gas leases on this acreage. COMPETITION: The deregulation of the financial services industry, the elimination of many previous distinctions between commercial banks and other types of financial institutions and the enactment in Mississippi, Louisiana and other states of legislation permitting state-wide branching or multi-bank holding companies as well as regional interstate banking has created a highly competitive environment for commercial banking in the Company's market area. The principal competitive factors in the markets for deposits and loans are interest rates paid and charged. The Company also competes through the efficiency, quality, range of services and products it provides, convenience of office and ATM locations and office hours. In attracting deposits and in its lending activities, the Company competes generally with other commercial banks, savings associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, mutual funds, insurance companies and other financial institutions, many of which have greater resources than those available to the Company. SUPERVISION AND REGULATION BANK HOLDING COMPANY REGULATION GENERAL: As a bank holding company, the Company is subject to extensive regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve") pursuant to the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). The Company also is required to file certain reports with, and otherwise comply with the rules and regulations of, the Securities and Exchange Commission (the "Commission") under federal securities laws. FEDERAL REGULATION: The Bank Holding Company Act generally prohibits the Company from engaging in activities other than banking or managing or controlling banks or other permissible subsidiaries or from acquiring or obtaining direct or indirect control of any company engaged in activities other than those activities determined by the Federal Reserve to be so closely related to banking or managing or controlling banks as to be proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. For example, making, acquiring or servicing loans, leasing personal property, providing certain investment or financial advice, performing certain data processing services, acting as agent or broker in selling credit life insurance and certain other types of insurance in connection with credit transactions and certain insurance underwriting activities have all been determined by regulations of the Federal Reserve to be permissible activities. The Bank Holding Company Act does not place territorial limitations on permissible bank-related activities of bank holding companies. However, despite prior approval, the Federal Reserve has the power to order a holding company or its subsidiaries to terminate any activity, or terminate its ownership or control of any subsidiary, when it has reasonable cause to believe that continuation of such activity or ownership of such subsidiary or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that holding company. The Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve: (1) before it may acquire direct or indirect ownership or control of any voting shares of any bank if, after such acquisition, such bank holding company will directly or indirectly own or control more than 5% of the voting shares of such bank, (2) before it or any of its subsidiaries other than a bank may acquire all or substantially all of the assets of a bank, or (3) before it may merge or consolidate with any other bank holding company. In reviewing a proposed acquisition, the Federal Reserve considers financial, managerial and competitive aspects, and must take into consideration the future prospects of the companies and banks concerned and the convenience and needs of the community to be served. As part of its review, the Federal Reserve reviews the indebtedness to be incurred by a bank holding company in connection with the proposed acquisition to ensure that the bank holding company can service such indebtedness in a manner that does not adversely affect the capital requirements of the holding company or its subsidiaries. The Bank Holding Company Act further requires that consummation of approved acquisitions or mergers be delayed for a period of not less than 30 days following the date of such approval. During such 30-day period, complaining parties may obtain a review of the Federal Reserve's order granting its approval by filing a petition in the appropriate United States Court of Appeals petitioning that the order be set aside. The Federal Reserve has adopted capital adequacy guidelines for use in its examination and regulation of bank holding companies. The regulatory capital of a bank holding company under applicable federal capital adequacy guidelines is particularly important in the Federal Reserve's evaluation of a bank holding company and any applications by the bank holding company to the Federal Reserve. If regulatory capital falls below minimum guideline levels, a bank holding company or bank may be denied approval to acquire or establish additional banks or non-bank businesses or to open additional facilities. In addition, a financial institution's failure to meet minimum regulatory capital standards can lead to other penalties, including termination of deposit insurance or appointment of a conservator or receiver for the financial institution. There are two measures of regulatory capital presently applicable to bank holding companies, (1) risk- based capital and (2) leverage capital ratios. The Federal Reserve rates bank holding companies by a component and composite 1-5 rating system ("BOPEC"). The leverage ratios adopted by the Federal Reserve requires all but the most highly rated bank holding companies to maintain Tier 1 Capital at 4% to 5% of total assets. Certain bank holding companies having a composite 1 BOPEC rating and not experiencing or anticipating significant growth may satisfy the Federal Reserve guidelines by maintaining Tier 1 Capital of at least 3% of total assets. Tier 1 Capital for bank holding companies includes: stockholder's equity; minority interest in equity accounts of consolidated subsidiaries; and qualifying perpetual preferred stock. In addition, Tier 1 Capital excludes goodwill and other disallowed intangibles. The Company's leverage ratio at December 31, 1993, was 7.62%. The risk-based capital guidelines are designed to make regulatory capital requirements more sensitive to differences in risk profile among banks and bank holding companies, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Under the risk-based capital guidelines, assets are assigned to one of four risk categories; these are 0%, 20% 50% and 100%. As an example, U.S. Treasury securities are assigned to the 0% risk category while most categories of loans are assigned to the 100% risk category. The risk weight of off-balance sheet items such as standby letters of credit is determined by a two-step process. First, the amount of the off-balance sheet item is multiplied by a credit conversion factor of either 0%, 20%, 50% or 100%. Then, the result is assigned to one of the four risk categories. At December 31, 1993, the Company's off-balance sheet items aggregated $189.9 million; however, after the credit conversion these items represented $5.6 million of balance sheet equivalents. The primary component of risk-based capital is defined as Tier 1 Capital, which is essentially equal to common stockholders' equity, plus a certain portion of perpetual preferred stock. Tier 2 Capital, which consists primarily of the excess of any perpetual preferred stock, mandatory convertible securities, subordinated debt and general reserves for loan losses, is a secondary component of risk-based capital. The risk-weighted asset base is equal to the sum of the aggregate dollar values of assets and off-balance sheet items in each risk category, multiplied by the weight assigned to that category. Under these guidelines bank holding companies are required to maintain a ratio of Tier 1 Capital to risk-weighted assets of at least 4% and a ratio of Total Capital (Tier 1 and Tier 2) to risk-weighted assets of at least 8%. At December 31, 1993, the Company's Tier 1 and Total Capital ratios were 14.49% and 15.42%, respectively. Proposed regulations will increase capital requirements when as yet undetermined levels of interest rate risk are exceeded. Because the Company's liabilities generally reprice within periods of one year, interest rate risk occurs when assets funded by such liabilities reprice at longer intervals. It is not anticipated that such regulations will have a significant impact on the Company's capital requirements. The Company, as a bank holding company within the meaning of the Bank Holding Company Act, is required to obtain the prior approval of the Federal Reserve before it may acquire substantially all the assets of any bank, or ownership or control of any voting shares of any bank, if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. In no case, however, may the Federal Reserve approve the acquisition by the Company of the voting shares, or substantially all the assets, of any bank located outside Mississippi unless such acquisition is specifically authorized by the laws of the state in which the bank to be acquired is located. The banking laws of Mississippi presently permit out-of-state banking organizations to acquire Mississippi banking organizations, provided the out-of-state banking organization's home state grants similar privileges to banking organizations in Mississippi. This reciprocity privilege is restricted to banking organizations in specified geographic regions which encompass the states of Alabama, Arkansas, Florida, Georgia, Kentucky, Louisiana, Mississippi, Missouri, North Carolina, South Carolina, Tennessee, Texas, Virginia and West Virginia. In addition, Mississippi banking organizations are permitted to acquire certain out-of-state financial institutions. A bank holding company is additionally prohibited from itself engaging in, or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in, non-banking activities. As a bank holding company, the Company is required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the proceeding 12 months, is equal to 10% or more of the Company's consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal constitutes an unsafe or unsound practice, would violate any law, regulation, Federal Reserve order or directive or any condition imposed by, or written agreement with, the Federal Reserve. In November 1985, the Federal Reserve adopted its Policy Statement on Cash Dividends Not Fully Covered by Earnings (the "Policy Statement"). The Policy Statement sets forth various guidelines that the Federal Reserve believes that a bank holding company should follow in establishing its dividend policy. In general, the Federal Reserve stated that bank holding companies should not pay dividends except out of current earnings and unless the prospective rate of earnings retention by the holding company appears consistent with its capital needs, asset quality and overall financial condition. The activities of the Company are also restricted by the provisions of the Glass-Steagall Act of 1933 (the "Act"). The Act prohibits the Company from owning subsidiaries engaged principally in the issue, floatation, underwriting, public sale or distribution of securities. The interpretation, scope and application of the provisions of the Act currently are being reviewed by regulators and legislators. The outcome of the current examination and appraisal of the provisions in the Act and effect of such outcome on the ability of bank holding companies to engage in securities-related activities cannot be predicted. The Company is a legal entity separate and distinct from the Banks. There are various restrictions which limit the ability of the Banks to finance, pay dividends or otherwise supply funds to the Company or other affiliates. In addition, subsidiary banks of holding companies are subject to certain restrictions imposed by the Federal Reserve Act on any extension of credit to the bank holding company or any of its subsidiaries, on investments in the stock or other securities thereof and on the taking of such stock or securities as collateral for loans to any borrower. Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with extensions of credit, or leases or sales of property or furnishing of services. BANK REGULATION: The operations of the Banks are subject to state and federal statutes applicable to state banks and the regulations of the Federal Reserve and of the FDIC. Such statutes and regulations relate to, among other things, required reserves, investments, loans, mergers and consolidations, issuance of securities, payment of dividends, establishment of branches and other aspects of the Banks' operations. Hancock Bank MS is subject to regulation and periodic examinations by the FDIC and the State of Mississippi Department of Banking and Consumer Finance. Hancock Bank LA is subject to regulation and periodic examinations by the FDIC and the Office of Financial Institutions, State of Louisiana. These regulatory authorities examine such areas as reserves, loan and investment quality, management policies, procedures and practices and other aspects of operations. These examinations are designed for the protection of the Banks' depositors, rather than their stockholders. In addition to these regular examinations, the Company and the Banks must furnish periodic reports to their respective regulatory authorities containing a full and accurate statement of their affairs. The Banks are members of the FDIC, and their deposits are insured as provided by law by the Bank Insurance Fund ("BIF"). As of July 1, 1991, the annual BIF premium was 0.23% of the Banks' deposits. BIF premiums for the year ended December 31, 1993, were $3.45 million, 10% higher than the BIF premiums for the same period in 1992. This increase can be attributed to growth in deposits. On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDIC Improvement Act") was enacted. The Federal Deposit Insurance Act as amended by Section 302 of the FDIC Improvement Act calls for risk-related deposit insurance assessment rates. The risk classification of an institution will determine its deposit insurance premium. Assignment to one of three capital groups, coupled with assignment to one of three supervisory sub groups determines which of the nine risk classifications is appropriate for an institution. The Banks have received a risk classification of 1A for assessment purposes for the first six months of 1994 which translates to a 0.23% rate. In general, the FDIC Improvement Act subjects banks and bank holding companies to significantly increased regulation and supervision. The FDIC Improvement Act increased the borrowing authority of the FDIC in order to bolster the Bank Insurance Fund, and the future borrowings are to be repaid by increased assessments on FDIC member banks. Other significant provisions of the FDIC Improvement Act require a new regulatory emphasis linking supervision to bank capital levels and require the federal banking regulators to take prompt regulatory action with respect to depository institutions that fall below specified capital levels and to draft non-capital regulatory measures to assure bank safety, including underwriting standards and minimum earnings levels. The FDIC Improvement Act contains a "prompt regulatory action" section which is intended to resolve problem institutions at the least possible long-term cost to the deposit insurance funds. Pursuant to this section, which applies to both banks and savings associations, the federal banking agencies are required to prescribe both a leverage limit and a risk-based capital requirement indicating levels at which institutions will be deemed to be "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." In the case of a depository institution which is "critically undercapitalized" (a term defined to include institutions which still have a positive net worth), the federal banking regulators are generally required to appoint a conservator or receiver. The FDIC Improvement Act further requires regulators to perform annual on-site bank examinations, places limits on real estate lending and tightens audit requirements. The new legislation will eliminate after 1994 the "too big to fail" doctrine, which protects uninsured deposits of large banks, and restricts the ability of undercapitalized banks to obtain extended loans from the Federal Reserve Board discount window. As previously discussed, deposit insurance premiums for the Bank Insurance Fund have changed from flat premiums to fees that will require banks engaging in risk practices or with low capital to pay higher deposit insurance premiums than conservatively managed banks. The FDIC Improvement Act also imposes new disclosure requirements relating to fees charged and interest paid on checking and deposit accounts. Most of the significant changes brought about by the FDIC Improvement Act required new regulations. In addition to regulating capital, the FDIC has broad authority to prevent the development or continuance of unsafe or unsound banking practices. Pursuant to this authority, the FDIC has adopted regulations which, among other things, restrict preferential loans and loan amounts by banks to "affiliates" and "insiders" of banks, require banks to keep information on loans to major stockholders and executive officers and bar certain director and officer interlocks between financial institutions. The FDIC also is authorized to approve mergers, consolidations and assumption of deposit liability transactions between insured banks and between insured banks and uninsured banks or institutions to prevent capital or surplus diminution in such transactions where the resulting, continuing or assumed bank is an insured nonmember state bank, like the Banks. Although the Banks are not members of the Federal Reserve System, they are subject to Federal Reserve regulations that require the Banks to maintain reserves against transaction accounts (primarily checking accounts), money market deposit accounts and nonpersonal time deposits. Because reserves generally must be maintained in cash or in noninterest-bearing accounts, the effect of the reserve requirements is to increase the cost of funds for the Banks. Subject to an exemption from reserve requirements on a limited amount of an institution's transaction accounts, the Federal Reserve regulations currently require that reserves be maintained against net transaction accounts in the amount of 3% of the aggregate of such accounts up to $41.4 million, or, if the aggregate of such accounts exceeds $41.4 million, $1.233 million plus 12% of the total in excess of $41.4 million. The foregoing is a brief summary of certain statutes, rules and regulations affecting the Company and the Banks and is not intended to be an exhaustive discussion of all the statutes and regulations having an impact on the operations of such entities. EFFECT OF GOVERNMENTAL POLICIES: In general, the difference between the interest rate paid by a bank on its deposits and its other borrowings, and the interest rate received by a bank on loans extended to its customers and securities held in its portfolios, will comprise a major portion of the bank's earnings. However, due to recent deregulation of the industry, the banking business is becoming increasingly dependent on the generation of fees and service charges. The earnings and growth of a bank will be affected not only by general economic conditions, both domestic and foreign, but also by the monetary and fiscal policy of the United States Government and its agencies, particularly the Federal Reserve. The Federal Reserve can and does implement national monetary policy, such as seeking to curb inflation and combat recession by its open-market operations in United States Government securities, adjustments in the amount of reserves that banks and other financial institutions are required to maintain and adjustments to the discount rates applicable to borrowings by banks which are members of the Federal Reserve System and target rates for federal funds transactions. The actions of the Federal Reserve in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and timing of any future changes in monetary policies and their potential impact on the Company cannot be predicted. STATISTICAL INFORMATION The following tables and other material present certain statistical information regarding the Company. This information is not audited and should be read in conjunction with the Company's consolidated financial statements and the accompanying notes. DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDER'S EQUITY AND INTEREST RATES AND DIFFERENTIALS Net interest income, the difference between interest income and interest expense, is the most significant component of the Banks earnings. For internal analytical purposes, management adjusts net interest income to a "taxable equivalent" basis using a 34% in 1992 and 35% in 1993 federal tax rate on tax exempt items (primarily interest on municipal securities). Another significant statistic in the analysis of net interest income is the effective interest differential, which is the difference between the average rate of interest earned on earning assets and the effective rate paid for all funds, non-interest bearing as well as interest bearing. Since a portion of the Bank's deposits do not bear interest, such as demand deposits, the rate paid for all funds is lower than the rate on interest bearing liabilities alone. The rate differential for the years 1992 and 1993 was 5.12% and 4.85%, respectively. Recognizing the importance of interest differential to total earnings, management places great emphasis on managing interest rate spreads. Although interest differential is affected by national, regional, and area economic conditions, including the level of credit demand and interest rates, there are significant opportunities to influence interest differential through appropriate loan and investment policies. These policies are designed to maximize interest differential while maintaining sufficient liquidity and availability of funds for purposes of meeting existing commitments and for investment in loans and other investment opportunities that may arise. The following table shows interest income on earning assets and related average yields earned as well as interest expense on interest bearing liabilities and related average rates paid for the periods indicated: Comparative Average Balances - Yields and Costs - ---------- (1) Includes tax equivalent adjustments to interest earned of $3.3 million, $2.6 million and $1.8 million in 1991, 1992 and 1993 respectively, using an effective tax rate of 34% in 1991 and 1992 and 35% in 1993. (2) Interest earned includes fees on loans of $3.2 million in 1991 and 1992 and $3.1 million in 1993. (3) Includes nonaccrual loans. See "Nonperforming Assets." The following table sets forth, for the periods indicated, a summary of the changes in interest income on earning assets and interest expense on interest bearing liabilities relating to rate and volume variances. Nonaccrual loans are included in average amounts of loans and do not bear interest for purposes of the presentation. Analysis of Changes in Net Interest Income - ---------- (1) Yields on tax-exempt investments have been adjusted to a tax equivalent basis utilizing a 34% effective tax rate in 1991 and 1992 and 35% in 1993. RATE SENSITIVITY In order to control interest rate risk, management regularly monitors the volume of interest sensitive assets relative to interest sensitive liabilities over specific time intervals. The Company's interest rate management policy is to attempt to maintain a stable net interest margin in periods of interest rate fluctuations. Interest sensitive assets and liabilities are those that are subject to maturity or repricing within a given time period. The interest sensitivity gap is the difference between total interest sensitive assets and liabilities in a given time period. At December 31, 1993, the Company's cumulative interest sensitivity gap in the one year interval was (20.48%) as compared to a cumulative interest sensitivity gap in the one year interval of (29.81%) at December 31, 1992. The percentage reflects a higher level of interest sensitive liabilities than assets repricing within one year. Generally, where rate sensitive liabilities exceed rate sensitive assets, the net interest margin is expected to be positively impacted during periods of decreasing interest rates and negatively impacted during periods of increasing rates. The following tables set forth the Company's interest rate sensitivity gap at December 31, 1993 and December 31, 1992: Analysis of Interest Sensitivity at December 31, 1993 Analysis of Interest Sensitivity at December 31, 1992 The Company had income tax expense of $9.7 million and $6.7 million for the years ended December 31, 1993 and 1992, respectively. This represents effective tax rates of 30.42% and 25.71% for December 31, 1993 and 1992, respectively; a greater portion of the Company's income in 1993 has been generated from taxable sources coupled with a 1% corporate tax rate increasee contributed to the rise in the effective tax rate. PERFORMANCE AND EQUITY RATIOS The following table sets forth, for the periods indicated, the percentage of net income to average assets and average stockholders' equity, the percentage of common stock dividends to net income and the percentage of average stockholders' equity to average assets. SECURITIES PORTFOLIO The Company's general policy is to purchase securities to be held to maturity, with a maturity schedule that provides the Company with ample liquidity. Investment securities are carried at net amortized cost and securities held for sale are carried at the lower of net amortized cost or market value. The December 31, 1993 book value of the consolidated portfolio was $729.2 million and the market value was $743.6 million. The following table sets forth, for the period indicated, the composition and book value (purchase price less amortization of premiums plus discount accretion) of the portfolio of securities held for sale by the Company at December 31, 1993: Book Value of Securities Held for Sale The following tables set forth, for the period indicated, the maturity distributions and yields of the portfolio of securities held for sale by the Company. Securities Held for Sale Maturity Distributions and Yields at December 31, 1993 The following table sets forth, for the periods indicated, the composition and book value (purchase price less amortization of premiums plus discount accretion) of the investment securities portfolio held by the Company: Book Value of Investment Securities The following tables set forth, for the periods indicated, the maturity distributions and yields of the investment securities portfolio of the Company. Investment Securities Maturity Distributions and Yields at December 31, 1993 Investment Securities Maturity Distributions and Yields at December 31, 1992 - ---------- (1) Yields on tax-exempt investments have been adjusted to a tax equivalent basis utilizing a 34% effective tax rate in 1992 and 35% in 1993. LOAN PORTFOLIO The following tables set forth, for the periods indicated, the composition of the loan portfolio of the Company: 1990 consumer loan balances reflect an increase of 99.8% as a result of the acquisitions of MNB (approximately $7.8 million) and AmBank (approximately $127.0 million). Prior to July 1991, a correspondent bank of Hancock Bank MS issued credit cards under the Bank's name to customers of Hancock Bank MS and retained the outstanding receivables. In July 1991, Hancock Bank MS purchased, at par, from its correspondent bank, certain credit cards with outstanding balances of approximately $7.8 million and simultaneously transferred, at par, the cards and balances to Hancock Bank LA. The resulting combined consumer and corporate credit card portfolio aggregated approximately $11.5 million with approximately 17,700 cards outstanding. At December 31, 1993, the portfolio balance had increased to approximately $26.6 million with approximately 45,000 cards outstanding. The following table sets forth, for the periods indicated, the approximate maturity by type of the loan portfolio of the Company: The sensitivity to interest rate changes of that portion of the Company's loan portfolio that matures after one year is shown below: Loan Sensitivity to Changes in Interest Rates NONPERFORMING ASSETS The following table sets forth nonperforming assets by type for the periods indicated, consisting of nonaccrual loans, restructured loans, real estate owned and loans past due 90 days or more and still accruing: The following table sets forth, for the periods indicated, the amount of interest that would have been recorded on nonaccrual loans had the loans not been classified as "nonaccrual" as well as the interest which would have been recorded under the original terms of restructured loans: Interest actually received on nonaccrual and restructured loans was insignificant. LOAN LOSS, CHARGE-OFF AND RECOVERY EXPENSES The following table sets forth, for the periods indicated, average net loans outstanding, reserve for loan losses, amounts charged-off and recoveries of loans previously charged-off. The following table sets forth, for the periods indicated, certain ratios related to the Company's charge-offs, reserve for loan losses and outstanding loans: An allocation of the loan loss reserve by major loan category is set forth in the following table. The allocation is not necessarily indicative of the category of future losses and the full reserve at December 31, 1993 is available to absorb losses occurring in any category of loans. DEPOSITS AND OTHER DEBT INSTRUMENTS The following table sets forth the distribution of the average deposit accounts for the periods indicated and the weighted average interest rates on each category of deposits: The Banks traditionally price their deposits to position themselves in the middle of the local market. The Banks' policy is not to accept brokered deposits. Maturities of CD's of $100,000 and Over SHORT-TERM BORROWINGS The following table sets forth certain information concerning the Company's short-term borrowings, which consist of federal funds purchased and securities sold under agreements to repurchase. Hancock Bank LA acts as a correspondent bank for 70 Louisiana financial institutions. Many of those banks maintain federal funds relationships which accounts for most of the volume of federal funds bought and sold. LIQUIDITY Liquidity represents an institution's ability to provide funds to satisfy demands from depositors, borrowers and other commitments by either converting assets into cash or accessing new or existing sources of incremental funds. The principal sources of funds which provide liquidity are customer deposits, payments of interest and principal on loans, maturities in and sales of investment securities, earnings and borrowings. At December 31, 1993, cash and due from banks, investment securities, federal funds sold and repurchase agreements were 56.0% of total deposits, as compared to 58.3% at December 31, 1992. The Company depends upon the dividends paid to it from the Banks as a principal source of funds for its debt service requirements. As of December 31, 1993, there was approximately $50 million available to be dividended up to the Company from the Banks. CAPITAL RESOURCES Risk-based and leverage capital ratios for the Company and the Banks for the periods indicated are shown in the following table: Risk-based capital requirements are intended to make regulatory capital more sensitive to risk elements of the Company. Currently, the Company is required to maintain a minimum risk-based capital ratio of 8.0%, with not less than 4.0% in Tier 1 capital. In addition, the Company must maintain a minimum Tier 1 leverage ratio (Tier 1 capital to total assets) of at least 4.0% based upon the regulators latest composite rating of the institution. RECENT CHANGES IN FINANCIAL ACCOUNTING STANDARDS During 1992, the Company adopted Statement of Financial Accounting Standards No. 106, Employer's Accounting for Postretirement Benefits Other Than Pensions. This Statement requires accrual of postretirement benefits (such as health care benefits) during the years an employee provides services. The costs of these benefits were previously expenses on a pay-as-you-go basis. The adoption of this Statement decreased net earnings by $250,000 ($0.04 per share) in 1992. Effective January 1, 1993, the Company changed its method of accounting for income taxes for the deferred method to the liability method as required by Statement of Financial Accounting Standard No. 109. Prior years have not been restated. The cumulative effect of this accounting change did not have a significant effect on the Company's financial statements and was recorded in income tax expense in the year ended December 31, 1993. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, Employers' Accounting for Post Employment Benefits which requires the accrual of certain post employment benefits other than pension and health care. The Company does not anticipate that the adoption of this Statement in 1994 will have a significant effect on its financial condition or results of operations. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of Certain Loans, which requires the present value of expected future cash flows of impaired loans be discounted at the loan's effective interest rate. The Company does not anticipate that the adoption of this Statement in 1995 will have a significant effect on its financial condition or results of operations. The Financial Accounting Standards Board has issued Statement of Financial Standards No. 115 Accounting for Certain Investments in Debt and Equity Securities which is effective in 1994. This Statement requires the investment portfolio to be classified into one of three reporting categories, held-to-maturity, available-for-sale, or trading. The Company has not yet completed its review of Statement No. 115 relative to its securities portfolio but does not believe that the adoption of the Statement will have a material effect on its financial statements. IMPACT OF INFLATION: Unlike most industrial companies, the assets and liabilities of financial institutions such as the Banks are primarily monetary in nature. Therefore, interest rates have a more significant effect on the Banks' performance than the effect of general levels of inflation on the price of goods and services. While interest rates earned and paid by the Banks are affected to a degree by the rate of inflation, and noninterest income and expenses can be affected by increasing rates of inflation, the Company believes that the effects of inflation are generally manageable through asset/liability management. ITEM 2 ITEM 2 - PROPERTIES The Company's main offices are located at One Hancock Plaza, Gulfport, Mississippi. The building has fourteen stories, of which seven are utilized by the Company. The remaining seven stories are presently leased to outside parties. The building is leased from the City of Gulfport in connection with a urban development revenue bond issue with a present balance of $3,820,000. The lease payments by Hancock Bank MS, which are equivalent in amount to the payments of principal and interest on the bonds, are used by the City to make payments on the bonds. Hancock Bank MS, however, effectively has ownership of the building since title will revert when all outstanding bonds have been paid. For this reason, the Company carries the building as an asset and the bonds as a long term payable on its balance sheet. The bonds mature at various dates through 1997. The following banking offices in Mississippi and Louisiana are held in fee (number of locations shown in parenthesis): The following banking offices in Mississippi and Louisiana are leased under agreements with unexpired terms of from one to twelve years including renewal options (number of locations shown in parenthesis): In addition to the above, Hancock Bank MS owns land and other properties acquired through foreclosures of loans. The major item is approximately 3,700 acres of timber land in Hancock County, Mississippi, which Hancock Bank MS acquired by foreclosure in the 1930's. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS Not applicable. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5 ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDERS MATTERS The information under the caption "Market Information" on page 6 of the Company's 1993 Annual Report to Stockholders (filed with the Registrant's definitive proxy materials on January 25, 1994 and incorporated herein by reference). ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA The information under the caption "Consolidated Summary of Selected Financial Information" on Page 7 of the Company's 1993 Annual Report to Stockholders (filed with the Registrant's definitive proxy materials on January 25, 1994 and 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 32 and 33 of the Company's 1993 Annual Report to Stockholders (filed with the Registrant's definitive proxy materials on January 25, 1994 and incorporated herein by reference). ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Company and subsidiaries, and the independent auditors' report, appearing on Pages 18 through 30 of the Company's 1993 Annual Report to Stockholders (filed with the Registrant's definitive proxy materials on January 25, 1994 and incorporated herein by reference): Consolidated Balance Sheets on Page 18 Consolidated Statements of Earnings on Page 19 Consolidated Statements of Stockholders' Equity on Page 20 Consolidated Statements of Cash Flows on Page 21 Notes to Consolidated Financial Statements on Pages 22 through 30 Independent Auditors' Report on Page 31 ITEM 9 ITEM 9 - DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT For information responsive to this Item, see "Election of Directors" (Pages 2-6) and "Management Compensation" (Pages 10-15) in the Proxy Statement for the Annual Meeting of Stockholders held February 24, 1994 which was filed by the Registrant in definitive form with the Commission on January 25, 1994 and is incorporated herein by reference. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION For information responsive to this item see "Management Compensation" (Pages 10-15) in the Proxy Statement for the Annual Meeting of Stockholders held February 24, 1994 which was filed by the Registrant in definitive form with the Commission on January 25, 1994 and is incorporated herein by reference. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT For information responsive to this item see "Principal Stockholders" (Page 7) and "Election of Directors" (Pages 2-6) in the Proxy Statement for the Annual Meeting of Stockholders held February 24, 1994 which was filed by the Registrant in definitive form with the Commission on January 25, 1994 and is incorporated herein by reference. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information responsive to this item see "Certain Transactions and Relationships" (Page 16) in the Proxy Statement for the Annual Meeting of Stockholders held February 24, 1994 which was filed by the Registrant in definitive form with the Commission on January 25, 1994 and is incorporated herein by reference. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K HANCOCK HOLDING COMPANY AND CONSOLIDATED SUBSIDIARIES (A) 1. AND 2. CONSOLIDATED FINANCIAL STATEMENTS: The following have been incorporated herein from the Company's 1993 Annual Report to Stockholders (filed with the Registrant's definitive proxy materials on January 25, 1994 and incorporated herein by reference): - Independent Auditors' Report - Consolidated Balance Sheets as of December 31, 1993 and 1992. - Consolidated Statements of Earnings for the three years ended December 31, 1993 - Consolidated Statements of Stockholders' Equity for the three years ended December 31, 1993 - Consolidated Statements of Cash Flows for the three years ended December 31, 1993 - Notes to Consolidated Financial Statements for the three years ended December 31, 1993 All other financial statements and schedules are omitted as the required information is inapplicable or the required information is presented in the consolidated financial statements or related notes. (a) 3. Exhibits: (2.1) Agreement and Plan of Merger dated May 30, 1985 among Hancock Holding Company, Hancock Bank and Pascagoula-Moss Point Bank (filed as Exhibit 2 to the Registrant's Form 8-K dated June 6, 1985 and incorporated herein by reference). (2.2) Amendment dated July 9, 1985 to Agreement and Plan of Merger dated May 30, 1985 among Hancock Holding Company, Hancock Bank and Pascagoula-Moss Point Bank (filed as Exhibit 19 to Registrant's Form 10-Q for the quarter ended June 30, 1985 and incorporated herein by reference). (2.3) Stock Purchase Agreement dated February 12, 1990 among Hancock Holding Company, Metropolitan Corporation and Metropolitan National Bank (filed as Exhibit 2.3 to Registrant's Form 10-K for the year ended December 31, 1989 and incorporated herein by reference). (2.4) Modified Purchase and Assumption Agreement dated August 2, 1990, among Hancock Bank of Louisiana and the Federal Deposit Insurance Corporation, receiver of American Bank and Trust Company of Baton Rouge, Louisiana (filed as Exhibit 2.1 to the Registrant's Form 10-Q for the quarter ended June 30, 1990 and incorporated herein by reference). (2.5) Agreement and Plan of Reorganization dated November 30, 1993 among Hancock Holding Company, Hancock Bank of Louisiana and First State Bank and Trust Company of East Baton Rouge Parish, Baker, Louisiana (filed as Exhibit 2.5 to the Registrant's Form 10-K dated December 31, 1993). (3.1) Amended and Restated Articles of Incorporation dated November 8, 1990 (filed as Exhibit 3.1 to the Registrant's Form 10-K for the year ended December 31, 1990 and incorporated herein by reference). (3.2) Amended and Restated Bylaws dated November 8, 1990 (filed as Exhibit 3.2 to the Registrant's Form 10-K for the year ended December 31, 1990 and incorporated herein by reference). (3.3) Articles of Amendment to the Articles of Incorporation of Hancock Holding Company, dated October 16, 1991 (filed as Exhibit 4.1 to the Registrant's Form 10-Q for the quarter ended September 30, 1991). (3.4) Articles of Correction, filed with Mississippi Secretary of State on November 15, 1991 (filed as Exhibit 4.2 to the Registrant's Form 10-Q for the quarter ended September 30, 1991). (3.5) Articles of Amendment to the Articles of Incorporation of Hancock Holding Company, adopted February 13, 1992 (filed as Exhibit 3.5 to the Registrant's Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). (3.6) Articles of Correction, filed with Mississippi Secretary of State on March 2, 1992 (filed as Exhibit 3.6 to the Registrant's Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). (4.1) Specimen stock certificate (reflecting change in par value from $10.00 to $3.33, effective March 6, 1989) (filed as Exhibit 4.1 to the Registrant's Form 10-Q for the quarter ended March 31, 1989 and incorporated herein by reference). (4.2) By executing this Form 10-K, the Registrant hereby agrees to deliver to the Commission upon request copies of instruments defining the rights of holders of long-term debt of the Registrant or its consolidated subsidiaries or its unconsolidated subsidiaries for which financial statements are required to be filed, where the total amount of such securities authorized thereunder does not exceed 10 percent of the total assets of the Registrant and its subsidiaries on a consolidated basis. (10.1) Description of Hancock Bank Executive Supplemental Reimbursement Plan, as amended (provided on page 14 of the Registrant's definitive proxy statement for its annual shareholders' meeting on February 24, 1994 filed by the Registrant on January 25, 1994 and incorporated herein by reference). (10.2) Description of Hancock Bank Automobile Plan (provided on page 14 of the Registrant's definitive proxy statement for its annual shareholders' meeting on February 24, 1994 filed by the Registrant on January 25, 1994 and incorporated herein by reference). (10.3) Description of Deferred Compensation Arrangement for Directors (provided on pages 10-15 of the Registrant's definitive proxy statement for its annual shareholders' meeting on February 25, 1994 filed by the Registrant on January 25, 1994 and incorporated herein by reference). (10.4) Site Lease Agreement between Hancock Bank and City of Gulfport, Mississippi dated as of March 1, 1989 (filed as Exhibit 10.4 to the Registrant's Form 10-K for the year ended December 31, 1989 and incorporated herein by reference). (10.5) Project Lease Agreement between Hancock Bank and City of Gulfport, Mississippi dated as of March 1, 1989 (filed as Exhibit 10.5 to the Registrant's Form 10-K for the year ended December 31, 1989 and incorporated herein by reference). (10.6) Deed of Trust dated as of March 1, 1989 from Hancock Bank to Deposit Guaranty National Bank as trustee (filed as Exhibit 10.6 to the Registrant's Form 10-K for the year ended December 31, 1989 and incorporated herein by reference). (10.7) Trust Indenture between City of Gulfport, Mississippi and Deposit Guaranty National Bank dated as of March 1, 1989 (filed as Exhibit 10.7 to the Registrant's Form 10-K for the year ended December 31, 1989 and incorporated herein by reference). (10.8) Guaranty Agreement dated as of March 1, 1989 from Hancock Bank to Deposit Guaranty National Bank as trustee (filedas Exhibit 10.8 to the Registrant's Form 10-K for the year ended December 31, 1989 and incorporated herein by reference). (10.9) Bond Purchase Agreement dated as of February 23, 1989 among Hancock Bank, J. C. Bradford & Co. and City of Gulfport, Mississippi (filed as Exhibit 10.9 to the Registrant's Form 10-K for the year ended December 31, 1989 and incorporated herein by reference). (13) Annual Report to Stockholders for year ending December 31, 1993 (furnished for the information of the Commission only and not deemed "filed" except for those portions which are specifically incorporated herein by reference). (21) Proxy Statement for the Registrant's Annual Meeting of Shareholders on February 24, 1994 (deemed "filed" for the purposes of this Form 10-K only for those portions which are specifically incorporated herein by reference). (22) Subsidiaries of the Registrant. Jurisdiction Holder of Name Of Incorporation Outstanding Stock (1) - ---- ---------------- --------------------- Hancock Bank Mississippi Hancock Holding Company Hancock Bank of Louisiana Louisiana Hancock Holding Company Hancock Bank Securities Mississippi Hancock Bank Corporation Hancock Insurance Agency Mississippi Hancock Bank Town Properties, Inc. Mississippi Hancock Bank The Gulfport Building, Inc. Mississippi Hancock Bank of Mississippi Harrison Financial Services, Mississippi Hancock Bank Inc. Hancock Mortgage Corporation Mississippi Hancock Bank Harrison Life Insurance Mississippi 79% owned by Hancock Company Bank (1) All are 100% owned except as indicated. (23) Consent of Independent Accountants. 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. HANCOCK HOLDING COMPANY DATE February 1, 1994 /s/ LEO W. SEAL, JR. ___________________________________ By Leo W. Seal, Jr., President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ LEO W. SEAL, JR. President and Director February 1, 1994 ______________________________ (Principal Executive, Leo W. Seal, Jr. Financial, and Accounting Officer) /s/ JOSEPH F. BOARDMAN, JR. Director, February 1, 1994 ______________________________ Chairman of the Board Joseph F. Boardman, Jr. /s/ THOMAS W. MILNER, JR. Director February 1, 1994 ______________________________ Thomas W. Milner, Jr. /s/ GEORGE A. SCHLOEGEL Director, February 1, 1994 ______________________________ Vice-Chairman of the Board George A. Schloegel /s/ DR. HOMER C. MOODY, JR. Director February 1, 1994 ______________________________ Dr. Homer C. Moody, Jr. /s/ A. F. DANTZLER Director February 1, 1994 ______________________________ A. F. Dantzler /s/ CHARLES H. JOHNSON Director February 1, 1994 ______________________________ Charles H. Johnson /s/ L. A. KOENENN, JR. Director February 1, 1994 ______________________________ L. A. Koenenn, Jr. /s/ VICTOR MAVAR Director February 1, 1994 ______________________________ Victor Mavar

893958_1993.txt

893958_1993

1993

893958

ITEM 1. BUSINESS Each Capital Auto Receivables Asset Trust, (each a "Trust") was formed pursuant to a Trust Agreement, between Capital Auto Receivables, Inc. (the "Seller") and Bankers Trust (Delaware), as Owner Trustee of the related Trust. The Trusts have issued Asset-Backed Notes (the "Notes"). The Notes are issued and secured pursuant to Indentures, between the related Trust and The First National Bank of Chicago as Indenture Trustee. Each Trust has also issued Asset-Backed Certificates. CAPITAL AUTO RECEIVABLES ASSET TRUSTS ------------------------------------- CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 ___________________________ PART II ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Each of the Trusts was formed pursuant to a trust agreement between Capital Auto Receivables, Inc. (the "Seller") and Bankers Trust (Delaware), as Owner Trustee, and issued the following asset-backed notes and certificates. Each Trust acquired retail finance receivables from the Seller in the aggregate amount as shown below in exchange for asset-backed notes and asset-backed certificates representing undivided interests in each of the Trusts. Each Trust's property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, security interests in the vehicles financed thereby and certain other property. Retail Finance Date of Sale Receivables and Servicing Aggregate Asset-Backed Asset-Backed Trust Agreement Amount Notes Certificates - ---------- ----------------- --------- ---------------- ------------ (Millions) (Millions) (Millions) Capital December 17, 1992 $1,607.1 Class A-1 $ 657.7 $ 56.2 Auto Class A-2 $ 641.6 Receivables Class A-3 $ 251.6 Asset Trust 1992-1 Capital February 11, 1993 $2,912.9 Class A-1 $ 322.0 $ 101.9 Auto Class A-2 $ 225.0 Receivables Class A-3 $ 125.0 Asset Trust Class A-4 $ 478.0 1993-1 Class A-5 $1,147.0 Class A-6 $ 318.0 Class A-7 $ 196.0 Capital June 2, 1993 $2,009.3 Class A-1 $ 750.0 $ 58.6 Auto Class A-2 $ 100.0 Receivables Class A-3 $ 641.0 Asset Trust Class A-4 $ 403.0 1993-2 Capital October 21, 1993 $2,504.9 Class A-1 $ 430.0 $ 81.4 Auto Class A-2 $ 59.0 Receivables Class A-3 $ 63.0 Asset Trust Class A-4 $ 210.0 1993-3 Class A-5 $ 484.3 Class A-6 $1,177.2 (Private Placement) General Motors Acceptance Corporation (GMAC), the originator of the retail receivables, continues to service the receivables for the aforementioned Trusts and receives compensation and fees for such services. Investors receive periodic payments of principal and interest for each class of notes and certificates as the receivables are liquidated. ____________________ II-1 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CROSS REFERENCE SHEET Caption Page - ------------------------------------------------- ------ Capital Auto Receivables Asset Trust 1992-1, Independent Auditors' Report, Financial Statements II-3 and Selected Quarterly Data for the Year Ended December 31, 1993. Capital Auto Receivables Asset Trust 1993-1, Independent Auditors' Report, Financial Statements II-9 and Selected Quarterly Data for the period from February 11, 1993 to December 31, 1993. Capital Auto Receivables Asset Trust 1993-2, Independent Auditors' Report, Financial Statements II-15 and Selected Quarterly Data for the period from June 2, 1993 to December 31, 1993. Capital Auto Receivables Asset Trust 1993-3, Independent Auditors' Report, Financial Statements II-21 and Selected Quarterly Data for the period from October 21, 1993 to December 31, 1993. _____________________ II-2 INDEPENDENT AUDITORS' REPORT March 22, 1994 The Capital Auto Receivables Asset Trust 1992-1, its Noteholders and Certificateholders, Capital Auto Receivables, Inc., Bankers Trust (Delaware), Owner Trustee, and The First National Bank of Chicago, Indenture Trustee: We have audited the accompanying Statement of Assets, Liabilities and Equity of the Capital Auto Receivables Asset Trust 1992-1 as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. 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, liabilities and equity of the Capital Auto Receivables Asset Trust 1992-1 at December 31, 1993 and 1992 and its distributable income and distributions for the year 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-3 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 STATEMENT OF ASSETS, LIABILITIES AND EQUITY (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 759.3 1,607.1 ------- ------- TOTAL ASSETS ........................... 759.3 1,607.1 ======= ======= LIABILITIES AND EQUITY (Notes 2 and 3) Asset-backed Notes ..................... 709.7 1,550.9 ------- ------- Asset-backed Certificates (Equity) ..... 49.6 56.2 ------- ------- TOTAL LIABILITIES AND EQUITY............ 759.3 1,607.1 ======= ======= Reference should be made to the Notes to Financial Statements. II-4 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 (in millions of dollars) ------- $ Distributable Income Allocable to Principal ...................... 847.8 Allocable to Interest ...................... 53.3 ------- Distributable Income .......................... 901.1 ======= Income Distributed ............................ 901.1 ======= Reference should be made to the Notes to Financial Statements. II-5 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of Capital Auto Receivables Asset Trust 1992-1 (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 noteholders and certificateholders are recognized when paid rather than when the respective obligation is incurred. Certain expenses of the Trust are paid by Capital Auto Receivables, Inc. (the "Seller"). NOTE 2. SALE OF NOTES AND CERTIFICATES On December 17, 1992, Capital Auto Receivables Asset Trust 1992-1 acquired retail finance receivables aggregating approximately $1,607.1 million from the Seller in exchange for three classes of Asset-Backed Notes representing indebtedness of the Trust of $657.7 million Class A-1, $641.6 million Class A-2 and $251.6 million Class A-3, and $56.2 million of Asset-Backed Certificates representing equity interests 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 or received thereunder, security interests in the vehicles financed thereby and certain other property. The Servicer has the option to repurchase the remaining receivables and certain other property as of the last day of any month on or after which the principal balance declines to 10% or less of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Payments of interest and principal (including prepayments) on the Notes are made on the fifteenth day of March, June, September and December or, if any such day is not a Business Day, on the next succeeding Business Day, commencing March 15, 1993 (each, a "Payment Date"). Principal of the Notes will be payable on each Payment Date in an amount equal to the sum of the Noteholders' Principal Distributable Amounts for each of the three Monthly Periods preceding such Payment Date, to the extent of funds available therefor. Payments of principal on the Notes are made (i) on the Class A-1 Notes until they are paid in full, (ii) then on the Class A-2 Notes until they are paid in full and (iii) then on the Class A-3 Notes until they are paid in full. The principal balance of the Class A-1 Notes was paid in full on September 15, 1993, the then-unpaid principal balance of the Class A-2 Notes will be payable on September 15, 1995 and the then-unpaid principal balance of the Class A-3 Notes will be payable on December 15, 1997. The final scheduled Distribution Date for the Certificates will be December 15, 1997. On each Distribution Date on and after the date on which the Class A-1 Notes have been paid in full, Certificateholders will receive, in respect of the certificate balance, an amount equal to the Certficateholders' Principal Distributable Amount for the Monthly Period preceding such Distribution Date, to the extent of funds available therefor. II-6 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 3. PRINCIPAL AND INTEREST PAYMENTS (concluded) Interest on the outstanding principal amount of the Notes accrues from December 15, 1992 or, in the case of the Class A-2 Notes, December 17, 1992, or from the most recent Payment Date on which interest has been paid to but excluding the following Payment Date. During 1993, the Class A-1 Notes received interest at the rate of 3.73% per annum (calculated on the basis of a 360-day year of twelve 30-day months). The Class A-2 Notes receive a floating rate of interest which is reset for each Payment Date to be a rate equal to the lesser of (i) LIBOR plus 0.25% and (ii) 10% (calculated on the basis of actual days elapsed and a 360-day year). The Class A-2 Notes received or will receive interest at the following rates per annum for the following periods: 3.8750% for the period from January 1, 1993 through March 14, 1993 3.5000% for the period from March 15, 1993 through June 14, 1993 3.6250% for the period from June 15, 1993 through September 14, 1993 3.4375% for the period from September 15, 1993 through December 14, 1993 3.6250% for the period from December 15, 1993 through March 14, 1994 4.1250% for the period from March 15, 1994 through June 14, 1994 The Class A-3 Notes will bear interest at the rate of 5.75% per annum (calculated on the basis of a 360-day year of twelve 30-day months). On each Distribution Date, the Owner Trustee will distribute pro rata to Certificateholders accrued interest at the pass through rate of 6.20% per annum on the outstanding Certificate Balance. 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 Noteholder and Certificateholder, by the acceptance of a Note or Certificate, agrees to treat the Notes as indebtedness and the Certificates as equity interests in the Trust for federal, state and local income and franchise tax purposes. __________________________ II-7 CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 225.4 16.7 242.1 Second quarter ..................... 226.9 14.3 241.2 Third quarter ...................... 210.0 12.3 222.3 Fourth quarter ..................... 185.5 10.0 195.5 --------- -------- ----- Total ......................... 847.8 53.3 901.1 ========= ======== ===== II-8 INDEPENDENT AUDITORS' REPORT March 22, 1994 The Capital Auto Receivables Asset Trust 1993-1, its Noteholders and Certificateholders, Capital Auto Receivables, Inc., Bankers Trust (Delaware), Owner Trustee, and The First National Bank of Chicago, Indenture Trustee: We have audited the accompanying Statement of Assets, Liabilities and Equity of the Capital Auto Receivables Asset Trust 1993-1 as of December 31, 1993, and the related Statement of Distributable Income for the period February 11, 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, liabilities and equity of the Capital Auto Receivables Asset Trust 1993-1 at December 31, 1993 and its distributable income and distributions for the period February 11, 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-9 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 STATEMENT OF ASSETS, LIABILITIES AND EQUITY (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) ................... 1,660.8 ------- TOTAL ASSETS ........................... 1,660.8 ======= LIABILITIES AND EQUITY (Notes 2 and 3) Asset-backed Notes ..................... 1,565.8 ------- Asset-backed Certificates (Equity) ..... 95.0 ------- TOTAL LIABILITIES AND EQUITY............ 1,660.8 ======= Reference should be made to the Notes to Financial Statements. II-10 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 STATEMENT OF DISTRIBUTABLE INCOME For the period February 11, 1993 (inception) through December 31, 1993 (in millions of dollars) ------- $ Distributable Income Allocable to Principal ...................... 1,252.1 Allocable to Interest ...................... 72.5 ------- Distributable Income .......................... 1,324.6 ======= Income Distributed ............................ 1,324.6 ======= Reference should be made to the Notes to Financial Statements. II-11 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of Capital Auto Receivables Asset Trust 1993-1 (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 noteholders and certificateholders are recognized when paid rather than when the respective obligation is incurred. Certain expenses of the Trust are paid by Capital Auto Receivables, Inc. (the "Seller"). NOTE 2. SALE OF NOTES AND CERTIFICATES On February 11, 1993, Capital Auto Receivables Asset Trust 1993-1 acquired retail finance receivables aggregating approximately $2,912.9 million from the Seller in exchange for seven classes of Asset-Backed Notes representing indebtedness of the Trust of $322.0 million Class A-1; $225.0 million Class A-2; $125.0 million Class A-3; $478.0 million Class A-4; $1,147.0 million Class A-5; $318.0 million Class A-6; $196.0 million Class A-7 and $101.9 million of Asset-Backed Certificates representing equity interests 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 or received thereunder, security interests in the vehicles financed thereby, the interest rate cap and certain other property. The Servicer has the option to repurchase the remaining receivables and certain other property as of the last day of any month on or after which the principal balance declines to 10% or less of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Payments of interest and principal (including prepayments) on the Notes are made on the fifteenth day of February, May, August and November or, if any such day is not a Business Day, on the next succeeding Business Day, commencing May 17, 1993 (each, a "Payment Date"). Principal of the Notes will be payable on each Payment Date in an amount equal to the sum of the Noteholders' Principal Distributable Amounts for each of the three Monthly Periods preceding such Payment Date, to the extent of funds available therefor. Payments of principal on the Notes are payable by class in the priorities set forth in the Indenture (previously filed by Form 8-K). The principal balance of the Class A-1 Notes was paid in full on May 17, 1993; the principal balance of the Class A-2 Notes was paid in full on August 16, 1993; the principal balance of the Class A-3 Notes was paid in full on November 15, 1993; the principal balance of the Class A-4 Notes was paid in full on November 15, 1993; the then-unpaid principal balance of the Class A-5 Notes will be payable on November 15, 1995; and the then-unpaid principal balance of the Class A-6 Notes and the Class A-7 Notes will be payable on February 17, 1998. Payment of principal to the Certificateholders in respect of the Certificate Balance was initiated in 1993, subsequent to the full payment of the Class A-1, Class A-2, Class A-3, and Class A-4 Notes. On each Distribution Date, the Certificateholders receive an amount equal to the Certificateholders' Principal Distributable Amount for the Monthly Period preceding such Distribution Date, to the extent of funds available therefor. The final scheduled Distribution Date for the Certificates is February 17, 1998. II-12 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 3. PRINCIPAL AND INTEREST PAYMENTS (concluded) Interest on the outstanding principal amount of the Notes accrues from February 11, 1993 or, from the most recent Payment Date on which interest has been paid to but excluding the following Payment Date. The Class A-1 Notes received interest at the rate of 3.1875% per annum. The Class A-2 Notes received interest at the rate of 3.3125% per annum. The Class A-3 Notes received interest at the rate of 3.4375% per annum. The Class A-4 Notes received a floating rate of interest which was reset for each Payment Date to be equal to LIBOR, as follows: 3.3125% for the period from February 11, 1993 through May 16, 1993 3.1875% for the period from May 17, 1993 through August 15, 1993 3.2500% for the period from August 16, 1993 through November 14, 1993 The Class A-5 Notes receive a floating rate of interest which is reset for each Payment Date to be equal to LIBOR plus 0.15% (calculated on the basis of actual days elapsed and a 360-day year). The Class A-5 Notes received or will receive interest at the following rates per annum for the following periods: 3.4625% for the period from February 11, 1993 through May 16, 1993 3.3750% for the period from May 17, 1993 through August 15, 1993 3.4500% for the period from August 16, 1993 through November 14, 1993 3.6500% for the period from November 15, 1993 through February 14, 1994 3.7125% for the period from February 15, 1994 through May 15, 1994 The Class A-6 Notes bear interest at the rate of 4.90% per annum. The Class A-7 Notes bear interest at the rate of 5.35% per annum. On each Distribution Date, the Owner Trustee distributes pro rata to Certificateholders accrued interest at the pass-through rate of 5.85% per annum on the outstanding Certificate Balance. NOTE 4. FINANCIAL INSTRUMENT WITH OFF-BALANCE SHEET RISK The Trust is the holder of an interest rate cap agreement for the purpose of managing its floating interest rate exposure. An interest rate cap agreement provides the holder protection against interest rate movements above an established rate. The notional amount of this interest rate cap at December 31, 1993 was $956.1 million. NOTE 5. 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 Noteholder and Certificateholder, by the acceptance of a Note or Certificate, agrees to treat the Notes as indebtedness and the Certificates as equity interests in the Trust for federal, state and local income and franchise tax purpose II-13 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ------- $ $ $ First quarter ..................... 0.0 1.0 1.0 Second quarter ..................... 523.8 28.8 552.6 Third quarter ...................... 391.3 22.9 414.2 Fourth quarter ..................... 337.0 19.8 356.8 --------- -------- ------- Total ......................... 1,252.1 72.5 1,324.6 ========= ======== ======= II-14 INDEPENDENT AUDITORS' REPORT March 22, 1994 The Capital Auto Receivables Asset Trust 1993-2, its Noteholders and Certificateholders, Capital Auto Receivables, Inc., Bankers Trust (Delaware), Owner Trustee, and The First National Bank of Chicago, Indenture Trustee: We have audited the accompanying Statement of Assets, Liabilities and Equity of the Capital Auto Receivables Asset Trust 1993-2 as of December 31, 1993, and the related Statement of Distributable Income for the period June 2, 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, liabilities and equity of the Capital Auto Receivables Asset Trust 1993-2 at December 31, 1993, and its distributable income and distributions for the period June 2, 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-15 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 STATEMENT OF ASSETS, LIABILITIES AND EQUITY (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (net of $58.5 million of discount)(Note 2) 1,423.2 ------- TOTAL ASSETS ........................................ 1,423.2 ======= LIABILITIES AND EQUITY (Notes 2 and 3) Asset-backed Notes .................................. 1,364.6 ------- Asset-backed Certificates (Equity) .................. 58.6 ------- TOTAL LIABILITIES AND EQUITY......................... 1,423.2 ======= Reference should be made to the Notes to Financial Statements. II-16 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 STATEMENT OF DISTRIBUTABLE INCOME For the period June 2, 1993 (inception) through December 31, 1993 (in millions of dollars) ------- $ Distributable Income Allocable to Principal ...................... 529.4 Allocable to Interest ...................... 37.4 ------- Distributable Income .......................... 566.8 ======= Income Distributed ............................ 566.8 ======= Reference should be made to the Notes to Financial Statements. II-17 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of Capital Auto Receivables Asset Trust 1993-2 (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 noteholders and certificateholders are recognized when paid rather than when the respective obligation is incurred. Certain expenses of the Trust are paid by Capital Auto Receivables, Inc. (the "Seller"). NOTE 2. SALE OF NOTES AND CERTIFICATES On June 2, 1993, Capital Auto Receivables Asset Trust 1993-2 acquired retail finance receivables aggregating approximately $2,009.3 million at a discount of $56.7 million from the Seller in exchange for four classes of Asset-Backed Notes representing indebtedness of the Trust of $750.0 million Class A-1, $100.0 million Class A-2, $641.0 million Class A-3, $403.0 million Class A-4, and $58.6 million of Asset-Backed Certificates representing equity interests 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 or received thereunder, security interests in the vehicles financed thereby and certain other property. Substantially all of the Receivables comprising the Trust property were acquired by GMAC under special incentive rate financing programs. The Servicer has the option to repurchase the remaining receivables and certain other property as of the last day of any month on or after which the principal balance declines to 10% or less of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Payments of interest and principal (including prepayments) on the Notes are made on the fifteenth day of each month or, if any such day is not a Business Day, on the next succeeding Business Day, commencing June 15, 1993 (each, a "Distribution Date"). Principal of the Notes is payable on each Distribution Date in an amount equal to the sum of the Noteholders' Principal Distributable Amounts for the related Monthly Period to the extent of funds available therefor. Payments of principal on the Notes are payable by class in the priorities set forth in the Indenture (previously filed by Form 8-K). The unpaid principal balance of the Class A-1 Notes will be payable on June 15, 1994; the then-unpaid principal balance of the Class A-2 Notes will be payable on August 15, 1994; the then-unpaid principal balance of the Class A-3 Notes will be payable on November 15, 1995; and the then-unpaid principal balance of the Class A-4 Notes will be payable on May 15, 1997. II-18 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 3. PRINCIPAL AND INTEREST PAYMENTS (concluded) On each Distribution Date on and after the date on which the Class A-1 and Class A-2 Notes have been paid in full, Certificateholders will receive, in respect of the certificate balance, an amount equal to the Certificateholders' Principal Distributable Amount for the Monthly Period preceding such Distribution Date, to the extent of funds available therefor. The final scheduled Distribution Date for the Certificates is May 15, 1997. Interest on the outstanding principal amount of the Notes accrues from June 2, 1993 or, from the most recent Distribution Date on which interest has been paid to but excluding the following Distribution Date. The Class A-1 Notes bear interest at the rate of 3.35% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-2 Notes bear interest at the rate of 3.71% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-3 Notes bear interest at the rate of 4.20% per annum (calculated on the basis of a 360-day year of twelve 30-day months). The Class A-4 Notes bear interest at the rate of 4.70% per annum (calculated on the basis of a 360-day year of twelve 30-day months). On each Distribution Date, the Owner Trustee distributes pro rata to Certificateholders accrued interest at the pass-through rate of 4.70% per annum on the outstanding Certificate Balance. NOTE 4. FEDERAL INCOME TAX The Trust is classified as a partnership, and therefore is not taxable as a corporation for federal income tax purposes. Each Noteholder and Certificateholder, by the acceptance of a Note or Certificate, has agreed to treat the Notes as indebtedness and the Certificates as equity interests in the Trust for federal, state and local income and franchise tax purposes. __________________________ II-19 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 77.5 2.9 80.4 Third quarter ...................... 227.0 18.3 245.3 Fourth quarter ..................... 224.9 16.2 241.1 --------- -------- ----- Total ......................... 529.4 37.4 566.8 ========= ======== ===== II-20 INDEPENDENT AUDITORS' REPORT March 22, 1994 The Capital Auto Receivables Asset Trust 1993-3, its Noteholders and Certificateholders, Capital Auto Receivables, Inc., Bankers Trust (Delaware), Owner Trustee, and The First National Bank of Chicago, Indenture Trustee: We have audited the accompanying Statement of Assets, Liabilities and Equity of the Capital Auto Receivables Asset Trust 1993-3 as of December 31, 1993, and the related Statement of Distributable Income for the period October 21, 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, liabilities and equity of the Capital Auto Receivables Asset Trust 1993-3 at December 31, 1993 and its distributable income and distributions for the period October 21, 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-21 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 STATEMENT OF ASSETS, LIABILITIES AND EQUITY (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) ................... 2,438.7 ------- TOTAL ASSETS ........................... 2,438.7 ======= LIABILITIES AND EQUITY (Notes 2 and 3) Asset-backed Notes ..................... 2,357.3 ------- Asset-backed Certificates (Equity) ..... 81.4 ------- TOTAL LIABILITIES AND EQUITY............ 2,438.7 ======= Reference should be made to the Notes to Financial Statements. II-22 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 STATEMENT OF DISTRIBUTABLE INCOME For the period October 21, 1993 (inception) through December 31, 1993 (in millions of dollars) ------- $ Distributable Income Allocable to Principal ...................... 66.2 Allocable to Interest ...................... 5.4 ------- Distributable Income .......................... 71.6 ======= Income Distributed ............................ 71.6 ======= Reference should be made to the Notes to Financial Statements. II-23 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of Capital Auto Receivables Asset Trust 1993-3 (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 noteholders and certificateholders are recognized when paid rather than when the respective obligation is incurred. Certain expenses of the Trust are paid by Capital Auto Receivables, Inc. (the "Seller"). NOTE 2. SALE OF NOTES AND CERTIFICATES On October 21, 1993, Capital Auto Receivables Asset Trust 1993-3 acquired retail finance receivables aggregating approximately $2,504.9 million from the Seller in exchange for six classes of Asset-Backed Notes representing indebtedness of the Trust of $430.0 million Class A-1; $59.0 million Class A-2; $63.0 million Class A-3; $210.0 million Class A-4; $484.3 million Class A-5; $1,177.2 million Class A-6; and $81.4 million of Asset-Backed Certificates representing equity interests in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, monies due or received thereunder, security interests in the vehicles financed thereby and certain other property. The Servicer has the option to repurchase the remaining receivables and certain other property as of the last day of any month on or after which the principal balance declines to 10% or less of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Payments of interest on the Class A-1 Notes and the Class A-5 Notes will be made on the fifteenth day of each month or, if any such day is not a Business Day, on the next succeeding Business Day, commencing on November 15, 1993 (each a "Distribution Date"). Payments of interest on the Class A- 2 Notes, the Class A-3 Notes, the Class A-4 Notes, and the Class A-6 Notes are made on the fifteenth day of January, April, July and October or, if any such day is not a Business Day, on the next succeeding Business Day, commencing January 18, 1994 (each, a "Payment Date"). Principal of the Notes will be payable by class in the priorities and in the amounts as set forth in the Indenture (previously filed by Form 8-K), equal to the sum of the Aggregate Noteholders' Principal Distributable Amounts to the extent of funds available therefor. II-24 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 3. PRINCIPAL AND INTEREST PAYMENTS (concluded) The unpaid principal balance of the Class A-1 Notes will be payable on November 15, 1994; the principal balance of the Class A-2 Notes was paid in full on January 18, 1994; the then-unpaid principal balance of the Class A- 3 Notes will be payable on April 15, 1994; the then-unpaid principal balance of the Class A-4 Notes will be payable on October 17, 1994; the then-unpaid principal balance of the Class A-5 Notes will be payable on October 16, 1995; and the then-unpaid principal balance of the Class A-6 Notes will be payable on October 15, 1998. On each Distribution Date on and after the date on which the Class A-2 Notes, the Class A-3 Notes and the Class A-4 Notes have been paid (or provided for) in full, Certificateholders will receive, in respect of the certificate balance, an amount equal to the Certificateholders' Principal Distributable Amount for the Monthly Period preceding such Distribution Date, to the extent of funds available therefor. The final scheduled Distribution Date for the Certificates will be October 15, 1998. Interest on the outstanding principal amount of the Notes accrues from October 21, 1993 or, from the most recent Distribution Date or Payment Date, as applicable, on which interest has been paid to but excluding the following Payment Date. The Class A-1 Notes bear interest at the rate of 3.30% per annum (calculated on the basis of actual days elapsed and a 360- day year). The Class A-2 Notes received interest at the rate of 3.25% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-3 Notes bear interest at the rate of 3.25% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-4 Notes bear interest at the rate of 3.30% per annum (calculated on the basis of actual days elapsed and a 360-day year). The Class A-5 Notes bear interest at the rate of 3.65% per annum (calculated on the basis of a 360-day year of twelve 30-day months). The Class A-6 Notes bear interest at the rate of 4.60% per annum (calculated on the basis of a 360-day year of twelve 30-day months). On each Distribution Date, the Owner Trustee distributes pro rata to Certificateholders accrued interest at the pass- through rate of 4.60% per annum on the outstanding Certificate Balance. 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 Noteholder and Certificateholder, by the acceptance of a Note or Certificate, agrees to treat the Notes as indebtedness and the Certificates as equity interests in the Trust for federal, state and local income and franchise tax purposes. __________________________ II-25 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 66.2 5.4 71.6 ========= ======== ===== II-26 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8K (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). -- Capital Auto Receivables Asset Trust 1992-1, Financial Statements for the Year Ended December 31, 1993. -- Capital Auto Receivables Asset Trust 1993-1 Financial Statements for the period February 11, 1993 through December 31, 1993. -- Capital Auto Receivables Asset Trust 1993-2 Financial Statements for the period June 2, 1993 through December 31, -- Capital Auto Receivables Asset Trust 1993-3 Financial Statements for the period from October 21, 1993 through December 31, 1993. (b) REPORTS ON FORM 8-K. A current report on Form 8-K dated November 12, 1993 reporting matters under Item 7, Financial Statements and Exhibits, was filed 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 Trustees have duly caused this report to be signed on their behalf by the undersigned thereunto duly authorized. CAPITAL AUTO RECEIVABLES ASSET TRUST 1992-1 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-1 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-2 CAPITAL AUTO RECEIVABLES ASSET TRUST 1993-3 by: Bankers Trust (Delaware) -------------------------------------- (Owner Trustee, not in its individual capacity but solely as Owner Trustee on behalf of the Issuer.) s\ Louis Bodi --------------------------------- (Louis Bodi, Assistant Treasurer) Date: March 30, 1994 -------------- IV-2

48174_1993.txt

48174_1993

1993

48174

ITEM 1. Business HOME BENEFICIAL CORPORATION Home Beneficial Corporation ("the Corporation") was incorporated in Virginia on March 5, 1970, for the purpose of becoming a holding company for Home Beneficial Life Insurance Company ("the Life Company"), which originated in 1899. On December 31, 1970, pursuant to a Plan of Reorganization proposed by the Board of Directors and approved by the stockholders of the Life Company, the Corporation acquired all of the issued and outstanding capital stock of the Life Company by merger of the Life Company into a wholly-owned subsidiary of the Corporation, the name of which was immediately changed to Home Beneficial Life Insurance Company. At the present time, the Life Company, which is engaged in the life and accident and health insurance business, is the major subsidiary of the Corporation. There was no material change in the nature of business done by the Corporation during 1993. BUSINESS OF THE LIFE COMPANY General The Life Company sells group life insurance and substantially all of the forms of ordinary insurance, including universal life, whole life, term, and annuities, together with accidental death and disability riders. Prior to December 1, 1979, the Life Company also sold weekly premium industrial life insurance, and this line was replaced by a new ordinary line which provides the policyowners more flexibility in selecting the mode of payment which best suits their life style. Prior to 1960, the Life Company, as primary insurer, had group life insurance in force only for the group insurance issued on the lives of its own employees. Since January 1, 1960, the Life Company has written or reinsured regular group insurance which, as of December 31, 1993, represented approximately 99% of the $5.5 billion group life insurance then in force. Group life insurance in force is subject to wide fluctuation due to varying increases and decreases in the number of employees and coverage per employee under the various group reinsurance programs in which the Life Company participates. Life Insurance Underwriting Underwriting policy for ordinary applications requires medical exami- nations above certain prescribed maximum amounts which are graduated according to the age of the applicant; the maximum non-medical limit for ages 0 to 30 is $100,000, with lesser amounts at higher ages. Medical examinations are generally required for all applicants over age 56. The Life Company accepts certain substandard risks for which it charges a higher premium. Accident and Health Insurance The Life Company currently writes individual accident policies with accidental death and dismemberment benefits. The accident policies accounted for approximately 32% of total accident and health premiums for 1993. The individual accident coverage presently offered by the Life Company provides for lump-sum benefits for accidents occurring before age 70. The Life Company offers no major medical coverage other than to its own employees. A significant proportion of the Life Company's group accident and health insurance is attributable to medical expense benefit coverage provided for its own employees and their dependents under the Life Company's Protection and Retirement Plan. In recent years, the Life Company has increased the cost to its employees for the dependents' medical expense benefit coverage provided by the Plan. Assets and Investment Policy The investment of the Life Company's funds and assets is determined by an Investment Committee. Generally, investments made must meet requirements established by the applicable investment statutes of the Commonwealth of Virginia governing the nature and quality of investments which may be made by life insurance companies. The following table shows investments of the Life Company at December 31, 1993. Fixed maturities (bonds, notes and redeemable preferred stocks), mortgage loans on real estate, and short-term investments are stated at cost adjusted where appropriate for amortization of premium or discount; equity securities (nonredeemable preferred and common stocks) are stated at market and policy loans are stated at unpaid balances. Asset Value Amount Percent (000's) of Total The Life Company's mortgage portfolio consists of approximately 2600 conventional first mortgages on a wide range of residential, commercial and industrial properties located primarily in those mid-Atlantic states in which the Life Company conducts its insurance business. At December 31, 1993, the aggregate carrying value of mortgage loans was $316,371,747, broken down by category as follows: Residential $171,972,307 Commercial 144,399,440 Commercial loans include loans on apartments, shopping centers, office buildings and warehouses. Generally, commercial loans range from $250,000 to $3,500,000 in principal amount. The Life Company also makes some mortgage loans to churches. Every property is inspected by a staff under-writer prior to the issuance of a loan commitment. On commercial loans of more than $250,000, the property is inspected every two years after the loan is closed as long as the balance exceeds $250,000. As of December 31, 1993, approximately 1% of the Life Company's mortgages, constituting less than 1% of the aggregate mortgage portfolio book value, consisted of government insured or guaranteed mortgages. The Life Company's mortgage lending business is heavily concentrated in the states of Virginia and North Carolina. At December 31, 1993, approximately 73% of the Life Company's mortgages, constituting approxi- mately 73% of the total book value of the Life Company's mortgage port- folio, were on residential or commercial properties located in the State of Virginia. Additionally, at the same date approximately 17% of the Life Company's mortgages, constituting approximately 15% of the total book value of the Life Company's mortgage portfolio, were on properties in North Carolina. The relatively high percentage of mortgage loans made in these two states reflects the geographical concentration of the Life Company's insurance business activities in the same two states. Although the Life Company's mortgage loan portfolio is heavily concentrated in Virginia and North Carolina, the economies of those states have become increasingly diversified since World War II, and the Life Company does not believe its mortgage loan portfolio reflects undue risk from the large percentage of its loans originated in those two states. Although the economic downturn during 1990 and 1991 was characterized by troubled real estate loans in the portfolios of many financial institutions operating in the Life Company's market, the Life Company's mortgage loan portfolio has not reflected the widely-publicized experience of other financial institutions. The Life Company presently holds two real estate parcels acquired through foreclosure with a carrying value in the financial statements of $665,000. No mortgage loans were in foreclosure proceedings at December 31, 1993. Except as indicated below, there were no mortgage loans otherwise not performing in accordance with the contractual terms; there were no mortgage loans whose terms had been restructured; nor, is the Life Company aware of any potential problem loans. At December 31, 1993, the aging schedule for delinquent mortgage loans in terms of past due days was as follows: Past due days 30-60 60-90 Over 90 Total 130-60 days past due includes a substantial amount of loan payments that have been received by the Life Company's brokers after their December, 1993 cut-off reporting date to the Life Company. These amounts will be included in their next remittance report. The Life Company believes the quality of its loan portfolio is attributable to its relatively stringent underwriting standards which have been in force for many years. At the present time, and for a number of years, the Life Company's lending policies have restricted mortgage loans to a maximum loan to value ratio of 75%, based on the lower of cost or appraisal, except for purchase money mortgages and insured or guaranteed mortgages. The Life Company's policy is to place mortgage loans on non-accrual status where any mortgage payment is 90 days or more past due. During the period 1986-1993, the Life Company experienced only five foreclosures on real estate loans, one in each of the years 1986, 1989 and 1990, two in 1992 and none in 1993. The total of the unpaid principal balances of loans in these five foreclosures was $986,477. The Life Company disposed of three properties acquired in foreclosure proceedings prior to 1993 without loss. The respective market value of properties acquired in 1992 exceeds foreclosed balances, and the Life Company anticipates that they will be disposed of timely without loss. The Corporation does not provide a provision for loan losses in its financial statements. Based upon the de minimis loss experience of the mortgage loan portfolio over many years and the continuing satisfactory performance of its portfolio, the Corporation's management does not feel that a provision is required. In 1993 the Life Company had net investment income from interest and dividends of $85.5 million constituting 42% of total Life Company revenues excluding realized investment gains. The Life Company's return on invested assets after investment expenses, but before federal taxes, was 7.77% for 1993 compared to 8.47% for 1992, both figures having been based on net investment income and investment balances determined in accordance with generally accepted accounting principles. See Investment Operations, Note 2 of Notes to Consolidated Financial Statements, which is incorporated herein by reference from pages 12, 13, and 14 of the 1993 Annual Report to Stockholders, and Schedule I included in Part IV elsewhere herein, for additional information concerning the Corporation's consolidated investment portfolio. Reserves The Life Company, as a legal reserve company, is required by the various laws of the states in which it is licensed to transact business to carry as liabilities aggregate policy reserves which are considered adequate to meet its obligations on insurance policies in force. Such required reserves are considered statutory reserves because the methods and assumptions used in their calculation are explicitly prescribed by the laws of the various states. The liabilities shown herein for all policies issued in 1948 and subsequently are based on guidelines prescribed by the American Institute of Certified Public Accountants and have been calculated in accordance with generally accepted accounting principles. Such liabilities are calculated by the use of assumptions as to mortality rates, interest rates, withdrawal rates and expense rates in effect at the time the gross premiums were calculated. Liabilities on paid-up policies include a liability for future maintenance expenses which the Life Company expects to incur. See Revenues, Benefits, Claims and Expenses, Note 1 of the Notes to Consolidated Financial Statements, which is incorporated herein by reference from page 11 of the 1993 Annual Report to Stockholders for additional information relating to the Life Company's reserves. Reinsurance The Life Company, as do many other companies engaged in selling insurance, reinsures with other companies portions of the individual life insurance policies it has underwritten. The primary purpose of reinsurance is to enable an insurance company to write a policy in an amount larger than the risk it is willing to assume for itself. A contingent liability exists on insurance ceded to the reinsurer since the Life Company would be liable in the event that the reinsurer is unable to meet obligations assumed by it under the reinsurance agreement. The maximum amount of ordinary insurance presently retained by the Life Company without reinsurance is $150,000 plus an additional $75,000 coverage for accidental death. This maximum is scaled down according to the age and physical classification of the insured. The total amount of life insurance in force at December 31, 1993 reinsured by the Life Company with other companies aggregated $100 million representing 1% of the Life Company's life insurance in force on that date. The Life Company acts as a reinsurer on an automatic basis to the extent of its participation in several group life insurance programs. Group life reinsurance does not have a material impact on the Life Company's profitability. The Life Company also assumes reinsurance on a facultative basis on a yearly renewable ordinary term plan from two other life companies. As of December 31, 1993, life insurance assumed represented approxi- mately 55% of life insurance in force and 17% of life premium income. Territory Served and Regulation The Life Company writes insurance in six states and the District of Columbia. The following table sets forth the geographic distribution of premiums received (direct business only) during 1993 as well as the year in which the Life Company began writing insurance in each state: (1) Gross cash premiums received, before premiums on reinsurance ceded or assumed. The Life Company, in common with other insurance companies, is subject to regulation and supervision in each of the states in which it does business. Although the extent of such regulation varies from state to state, in general, the insurance laws of the respective states delegate broad administrative powers to supervisory agencies. These powers relate to the granting and revocation of licenses to transact business, the licensing of agents, the approval of the forms of policies used, reserve requirements, and the type and concentration of investments permitted. In addition, the supervisory agencies have power over the form and content of required financial statements and reports, including requirements regarding accounting practices to be employed in the presentation of such statements and reports. Certain of the required accounting practices vary from generally accepted accounting principles. See Notes 1 and 7 of the Notes to Consolidated Financial Statements, which Notes are incorporated herein by reference from pages 11, 12 and 17 of the 1993 Annual Report to Stockholders. The Life Company is also required under these laws to file detailed annual reports with the supervisory agencies in each of the states in which it does business. Its business and accounts are also subject to examination by such agencies. Under the laws of Virginia and procedures established by the National Association of Insurance Commissioners, the Life Company is examined periodically by one or more of the state supervisory agencies and is required to have an annual independent audit performed by a qualified certified public accountant. Under Virginia law, the Life Company must be examined at least every five years. The most recently completed examination, covering the years 1989 through 1991, was conducted by insurance department representatives from the state of Virginia. Such regulation is primarily for the benefit of the policyholders of the Life Company rather than the stockholders. Several jurisdictions in which the Life Company does business includ- ing its domiciliary state of Virginia, have enacted legislation providing for specific regulation of the relationship between licensed insurers and their holding companies and among affiliated members of a holding company group. These statutes vary in substance from state to state, but generally speaking, vest administrative control in the insurance regulatory authority. Among the provisions found in these statutes are provisions for the filing of registration statements by insurers which are members of a holding company group, provisions that the holding company will be subject to reporting requirements and to visitation by the insurance regulatory authorities, standards as to transactions between insurers and their holding companies or between members of a holding company group, and control over the payment of extraordinary dividends. See Stockholders' Equity and Restrictions, Note 7 of the Notes to Consolidated Financial Statements, which is incorporated herein by reference from page 17 of the 1993 Annual Report to Stockholders for additional information concerning transactions between the Life Company and its affiliates. Competition The life insurance business is intensely competitive and the Life Company competes with many other companies, both stock and mutual, in the states in which it is licensed. The American Council of Life Insurance in its "1993 Fact Book", estimates that of the 2,065 life companies doing business in the United States at the beginning of 1993, approximately 1,948 were stock companies. According to figures reported in the July 1993 issue of Best's Review, Life/Health Edition, calculated on a statutory accounting basis, the Life Company ranks in the top 10% of all stock companies in the United States based on total admitted assets as of December 31, 1992. Dependence Upon Single or a Few Customers No material portion of the business of the Life Company is dependent upon a single customer or a very few customers. The group life insurance sold by the Life Company consists largely of reinsurance participations described under "Business of the Life Company -- Reinsurance" above. Agency Force and Employees The Life Company offers its insurance through its own agency force and at December 31, 1993, the agency force consisted of approximately 1,150 full-time personnel assigned to some 47 districts and 13 smaller offices located in principal cities and towns. In addition to its agency force, at the end of 1993 there were some 270 supervisory, administrative, clerical and other personnel employed in the home office. The Life Company's employees are not represented by labor unions and the Life Company considers its relations with its agents and other personnel to be good. Industry Segment and Other Information The Corporation's only industry segment is the business of the Life Company, and its operations have contributed over 98% of the total consolidated revenues and income before income taxes for each of the past three years. Foreign Business Neither the Corporation nor any of its subsidiaries engage in material operations outside of the United States, or derives material business from customers outside the United States. ITEM 2. ITEM 2. Properties The principal office of the Corporation is located at 3901 West Broad Street, Richmond, Virginia 23230, which also serves as the home office premises of the Life Company. The home office building, which contains approximately 110,000 square feet of office space, was originally completed in 1950 with a 30,000 square foot addition completed in 1990. The building is used solely for company purposes. The Life Company presently leases space for 60 district and detached offices in Delaware, Maryland, the District of Columbia, West Virginia, Virginia, Tennessee and North Carolina. The termination dates on these leases range from 1994 to 2003; all of the longer term leases being for district office purposes. The maximum annual rent paid under any lease is $25,550. The annualized rent under all leases in effect on December 31, 1993 was approximately $795,000. ITEM 3. ITEM 3. Legal Proceedings As of the date of this report, neither the Corporation nor any of its subsidiaries was a party to any material pending legal proceedings. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of the Corporation's security holders during the fourth quarter of its fiscal year ended December 31, 1993. PART II ITEM 5. ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters Incorporated herein by reference from the 1993 Annual Report to Stockholders, page 21. ITEM 6. ITEM 6. Selected Consolidated Financial Data Incorporated herein by reference from the 1993 Annual Report to Stockholders, page 22. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Incorporated herein by reference from the 1993 Annual Report to Stockholders, pages 4, 5, 19 and 20. ITEM 8. ITEM 8. Financial Statements and Supplementary Data Consolidated financial statements of the Corporation at December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 and the auditor's report thereon and the Corporation's unaudited quarterly financial data for the two year period ended December 31, 1993 are incorporated herein by reference from the 1993 Annual Report to Stock-holders, pages 6 through 18 and 21. ITEM 9. ITEM 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosures None. PART III ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant (a) and (b) The following table gives the name and age of each of the directors (all of whom, except C. M. Glenn, Jr., L. W. Richardson, and Dianne N. Collins are executive officers of the Corporation and the Life Company) and their positions and offices with the Corporation and the Life Company and the dates first elected to those positions with the Corporation. Position and Offices with the Corporation and the Life Company and Date Elected to Name Age Corporation Officer Position Dianne N. Collins 48 Director of the Life Company and the Corporation and Community Volunteer H. D. Garnett 51 Vice President (since 1979), Controller (since 1974) and a director of the Corporation and the Life Company C. M. Glenn, Jr. 77 Retired Vice President-Treasurer and a director of the Corporation and the Life Company W. G. Hancock 43 Counsel (since 1984) and a director of the Corporation and the Life Company G. T. Richardson 41 Vice President (since 1983) and a director of the Corporation and the Life Company L. W. Richardson 74 Retired Vice President and a director of the Corporation and the Life Company J. M. Wiltshire, Jr. 68 Vice President (since 1972), Counsel (since 1982), Secretary (since 1994) and a director of the Corporation and the Life Company R. W. Wiltshire 72 Chairman of the Board (since 1983) and a director of the Corporation and the Life Company R. W. Wiltshire, Jr. 48 President (since 1988), Chief Executive Officer (since 1992) and a director of the Corporation and the Life Company W. B. Wiltshire 45 Vice President (since 1983) and a director of the Corporation and the Life Company Mrs. Collins was first elected to the Board of Directors of the Corporation on February 15, 1994, Messrs. Garnett, Hancock, G. T. Richardson, and W. B. Wiltshire were first elected to the Board in 1983, and Messrs. R. W. Wiltshire, Jr. and J. M. Wiltshire, Jr. were first elected to the Board in 1976 and 1971, respectively, all to fill then existing vacancies on the Board. The remaining persons named in the foregoing table have served as directors of the Corporation since its organization in 1970. All of the above persons serve one year terms as both executive officers and directors, or in the case of Messrs. Glenn and Richardson and Mrs. Collins, as directors only, which expire April 5, 1994. There are no executive officers of the Corporation who are not directors. (c) Not applicable. (d) C. M. Glenn, Jr. is the uncle of W. G. Hancock. L. W. Richardson is the father of G. T. Richardson and the first cousin of R. W. Wiltshire. R. W. Wiltshire is the father of R. W. Wiltshire, Jr. and W. B. Wiltshire and the first cousin of J. M. Wiltshire, Jr. (e)(1) Except as set forth below, each of the persons named in (a) and (b) above has been principally employed by the Corporation and the Life Company in the present or a comparable position for more than the past five years. Dianne N. Collins has been a Trustee of the 1984 Voting Trust described in Item 12 below since January 4, 1994 and a volunteer in the Richmond, Virginia community for more than the past five years. C. M. Glenn, Jr. and L. W. Richardson retired at the end of 1986 and 1987, respectively, each having served in the office shown for more than five years immediately prior to his retirement. W. G. Hancock has been a partner of the law firm of Mays & Valentine, Richmond, Virginia since 1981 specializing in real estate and mortgage lending, insurance company regulation and general business matters. He was designated as Counsel to the Corporation and the Life Company effective June 13, 1984. J. M. Wiltshire, Jr. was elected to the additional office of Secretary of the Corporation and Life Company effective January 18, 1994. R. W. Wiltshire, Jr. was elected President of the Life Company and Corporation in 1988. Effective April 7, 1992, he was elected Chief Executive Officer of the Life Company and the Corporation to succeed R. W. Wiltshire who had served in that office for more than five years immediately prior thereto. Prior to his election as Chief Executive Officer, R. W. Wiltshire, Jr. was responsible for the general management of the operations of the Corporation and the Life Company. R. W. Wiltshire retired as an employee and salaried officer of the Corporation and the Life Company effective September 6, 1993. (e)(2) Not applicable. (f) Not applicable. (g) Not applicable. (h) The Corporation's directors and executive officers are required to file reports with the Securities and Exchange Commission (the "Commission") concerning their initial ownership of shares of the Corporation's Class A and Class B Common Stock and any subsequent changes in that ownership, and the Corporation traditionally has assisted its directors and executive officers in the filing of these reports. In making these reports, the Corporation has relied on written representation of its directors and executive officers and copies of the reports that they have filed with the Commission. The Corporation believes that these filing requirements were satisfied in 1993 with the following exception. Three family trusts of which W. G. Hancock is one of the trustees inadvertently filed their initial reports of ownership eight days late. These family trust holdings, however, were included in individual reports which were timely filed by Mr. Hancock in his individual capacity. ITEM 11. ITEM 11. Executive Compensation (a) and (b) Summary Compensation Table The following Summary Compensation Table sets forth certain information concerning cash compensation paid to or contributed for the benefit of the six individuals named below for services rendered to the Corporation and its subsidiaries as executive officers during each of the three years in the period ended December 31, 1993. SUMMARY COMPENSATION TABLE 5% Class A Stockholders (Other Than Directors and Trustees) (1) Beneficial ownership has been determined in accordance with Rule 13d- 3 under the Securities Exchange Act of 1934. (2) Where an asterisk is shown, the percentage is less than 1%. (3) 5,401,024 shares of Class A Common Stock constituting 63.7% of the 8,476,576 shares outstanding are held by R. W. Wiltshire, L. W. Richardson, R. W. Wiltshire, Jr., G. T. Richardson and Dianne N. Collins, as Trustees under the 1984 Voting Trust. (4) All of the voting trust certificates for Class A shares and the Class B shares are held of record by Dixie Company and may be acquired by Mrs. Collins pursuant to her power to revoke an inter vivos trust. Such voting trust certificates are also included in the table for Dixie Company. (5) Some portion or all of the Class A shares shown for each of the indicated directors or stockholders are subject to the 1984 Voting Trust, and their beneficial ownership as to those shares is evidenced by voting trust certificates that have been issued to them thereunder. The number of Class A shares deposited in the 1984 Voting Trust by each of them is as follows: Dianne N. Collins - 13,536; C. M. Glenn, Jr. - 150,164; G. T. Richardson - 22,510; L. W. Richardson - 250,708; R. W. Wiltshire - 539,016; R. W. Wiltshire, Jr. - 1,876; W. B. Wiltshire - 1,728; Dixie Company - 2,423,800; Estate of Mary Morton Parsons - 1,174,427; and George L. Richardson - 404,600. (6) All of the Class B shares shown for Mr. Garnett are owned jointly with his wife. (7) Includes 165,520 shares of Class A (of which 90,000 shares are evidenced by voting trust certificates of the 1984 Voting Trust) and 23,280 shares of Class B Common Stock held in trust by Crestar Bank as trustee for the benefit of Mr. Glenn during his lifetime, with remainder to his issue. (8) Includes 80,822 shares of Class A and, in the case of Mr. Glenn, 3,644 shares of Class B Common Stock, held by Mr. Glenn and his sister, Doris G. Hancock and another sister, as trustees under the will of Hazel C. Glenn for the benefit of his daughter. (9) Includes an aggregate of 6,216 shares of Class A (of which 2,696 shares are evidenced by voting trust certificates of the 1984 Voting Trust) and 14,094 shares of Class B Common Stock held by directors as trustees or custodians for the benefit of children (that are not described in other footnotes to this table), or by their wives, and with respect to which beneficial ownership is or will be disclaimed by individual directors in ownership reports filed with the Securities and Exchange Commission. (10) The ownership shown for Mr. Hancock excludes 188,800 shares of Class A Common Stock held in trust by Crestar Bank for the benefit of his mother, Doris G. Hancock, with remainder to Mrs. Hancock's issue, in which Mr. Hancock has a vested one-third beneficial interest subject to partial divestment upon any further children of Mrs. Hancock. (11) Includes 2,400 shares of Class A Common Stock held by Mr. Hancock and his brother and sister as trustees under inter vivos trusts created by their mother for the benefit of her six grandchildren, three of whom are children of Mr. Hancock. (12) Includes 25,538 shares of Class A Common Stock evidenced by voting trust certificates of the 1984 Voting Trust and 36,912 shares of Class B Common Stock held by Mr. Richardson, as trustee with sole voting and shared investment power, for the benefit of a member of his immediate family. (13) 55,500 shares of Class A Common Stock, voting trust certificates for 94,976 shares of Class A Common Stock subject to the 1984 Voting Trust and 86,964 shares of Class B Common Stock are held by the Estate of Essie Lee Wiltshire for the life of R. W. Wiltshire with a vested remainder interest in the children of R. W. Wiltshire. R. W. Wiltshire is the sole executor of the Estate of Essie Lee Wiltshire. During the life of R. W. Wiltshire the income from the foregoing shares is paid to the children of R. W. Wiltshire. In addition, R. W. Wiltshire has a life estate in voting trust certificates evidencing 403,264 shares of Class A Common Stock subject to the 1984 Voting Trust and 47,260 shares of Class B Common Stock, with remainder to the children of R. W. Wiltshire. R. W. Wiltshire, Jr. and W. B. Wiltshire have vested one-fourth beneficial interests in all the foregoing shares, subject to partial divestment upon any further children of R. W. Wiltshire. The ownership shown includes such shares for R. W. Wiltshire and excludes all such shares for R. W. Wiltshire, Jr. and W. B. Wiltshire. Both R. W. Wiltshire, Jr. and W. B. Wiltshire also have the same vested one-fourth remainder interests subject to partial divestment in another 140,836 shares of Class B Common Stock in which various children and grandchildren of R. W. Wiltshire residing in other households have an interest for his life. The ownership shown for R. W. Wiltshire, R. W. Wiltshire, Jr. and W. B. Wiltshire does not reflect any of such shares, except in the case of R. W. Wiltshire, Jr. for 26,445 shares held by him as custodian for his minor children and another 8,764 shares held for his own benefit and in the case of W. B. Wiltshire for 17,630 shares held by him as custodian for his minor children and another 8,764 shares held for his own benefit. (14) Dixie Company is the nominee of Jefferson National Bank which holds 137,536 Class A shares and voting trust certificates for another 2,423,800 Class A shares in a number of fiduciary accounts that it administers (including voting trust certificates for 13,536 Class A shares previously reported in the table for Mrs. Collins). (15) Includes 188,800 shares of Class A Common Stock held in trust by Crestar Bank as trustee for the benefit of Mrs. Hancock during her lifetime with remainder to her issue. Also includes 18,205 Class A shares held by Mrs. Hancock's husband. (16) Clinton Webb and NationsBank of Virginia, N.A. are the co-executors of the Estate of Mary Morton Parsons. As of March 11, 1994, executive officers and directors of the Corporation as a group beneficially owned 1,418,499 shares or 16.7% of the Class A (including beneficial ownership evidenced by voting trust certificates of, but exclusive of shares held by the Trustees under, the 1984 Voting Trust) and 441,337 shares or 4.7% of the Class B Common Stock of the Corporation, respectively. (c) The Corporation has no knowledge of any contractual arrangement which may at a subsequent date result in a change of control of the Corporation, except that the 1984 Voting Trust is scheduled to expire on May 11, 1997. Upon its expiration, the shares of Class A Common Stock of the Corporation now held by the Trustees under the 1984 Voting Trust will be held by per-sons presently holding voting trust certificates representing those shares. ITEM 13. Certain Relationships and Related Transactions (a) On May 10, 1993, the Corporation repurchased 365,838 shares of its Class B Common Stock from the Estate of Mary Morton Parsons at a price of $9,008,761 or $24.625 per share. At the time of the repurchase, the Estate of Mary Morton Parsons was the beneficial owner of more than 5% of the Corporation's outstanding Class A Common Stock. In the case of the above purchase, the price paid by the Corporation was below the then applicable bid price for the Corporation's Class B Common Stock in the over-the-counter market. Prior to the purchase, the Board of Directors determined that reacquisition of the shares was in the best interest of the Corporation and its stockholders when compared with alternative investments available to the Corporation. Immediately upon their reacquisition, all of the shares became authorized but unissued shares under Virginia law. (b) W. G. Hancock is a partner in the law firm of Mays & Valentine which provided legal services as general counsel to the Corporation and its subsidiaries and affiliates during 1993, and is expected to serve in the same capacity in 1994. The amount of legal fees paid to that firm by the Corporation and its subsidiaries and affiliates for 1993 did not exceed 5% of the firm's gross revenues for its last full fiscal year. (c) Not applicable. (d) Not applicable. Part IV 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 financial statement schedules listed in the accompanying Index to Financial Statements and Financial Statement Schedules on page 27 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 HOME BENEFICIAL CORPORATION and Financial Statement Schedules (Item 14(a)) Annual Form Report to 10-K Stockholders Consolidated Financial Statements: Report of Ernst & Young, Independent Auditors 18 Consolidated Balance Sheet at December 31, 1993 and 1992 6-7 Consolidated Statement of Income for each of the three years in the period ended December 31, 1993 8 Consolidated Statement of Retained Earnings for each of the three years in the period ended December 31, 1993 9 Consolidated Statement of Cash Flows for each of the three years in the period ended December 31, 1993 10 Notes to Consolidated Financial Statements 11-17 Supplementary information-- Quarterly financial information (unaudited) 21 Financial Statement Schedules: I - Summary of investments - other than investments in related parties at December 31, 1993 (Consolidated) 29 III - Condensed Financial Information of Registrant (Parent Company): Balance Sheet at December 31, 1993 and 1992 30 Statement of Income for each of the three years in the period ended December 31, 1993 31 Statement of Cash Flows for each of the three years in the period ended December 31, 1993 32 VI - Reinsurance for each of the three years in the period ended December 31, 1993 (Consolidated) 33 All other schedules are 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 financial statements and notes thereto. The consolidated financial statements and supplementary information listed in the above index, which are included in the Annual Report to Stockholders for Home Beneficial Corporation for the year ended December 31, 1993, are incorporated herein by reference. CONSENT OF ERNST & YOUNG, INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report(Form 10-K) of Home Beneficial Corporation of our report dated February 10, 1994, included in the 1993 Annual Report to Stockholders of Home Beneficial Corporation. Our audits also included the financial statement schedules of Home Beneficial Corporation listed in Item 14(a). These schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Richmond, Virginia February 10, 1994 Schedule I HOME BENEFICIAL CORPORATION (CONSOLIDATED) SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES At December 31, 1993 Schedule III HOME BENEFICIAL CORPORATION (PARENT COMPANY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEET December 31, 1993 and 1992 (*) See Notes 6 and 7 to Consolidated Financial Statements Schedule III HOME BENEFICIAL CORPORATION (PARENT COMPANY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF INCOME Years Ended December 31, 1993, 1992 and 1991 Schedule III HOME BENEFICIAL CORPORATION (PARENT COMPANY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 Increase (Decrease) in Cash and Cash Equivalents (*) (*) Short-term investments, which consist of investments with maturities of 30 days or less, are considered cash equivalents. Schedule VI HOME BENEFICIAL CORPORATION (CONSOLIDATED) REINSURANCE Years Ended December 31, 1993, 1992 and 1991 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934 the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. HOME BENEFICIAL CORPORATION Registrant By: /s/ H. D. Garnett H.D. Garnett, Vice President and Controller, March 22, 1994 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 the Registrant and in the capacities and on the dates indicated: /s/ R. W. Wiltshire R.W. Wiltshire, Chairman of the Board & Director, March 22, 1994 /s/ C. M. Glenn, Jr. C.M. Glenn, Jr., Retired Vice President, Treasurer & Director, March 22, 1994 /s/ L. W. Richardson L.W. Richardson, Retired Vice President & Director, March 22, 1994 /s/ R. W. Wiltshire, Jr. R.W. Wiltshire, Jr., President, Chief Executive Officer & Director, March 22, /s/ J. M. Wiltshire, Jr. J.M. Wiltshire, Jr., Vice President, Counsel, Secretary & Director, March 22, /s/ W. B. Wiltshire W.B. Wiltshire, Vice President & Director, March 22, 1994 /s/ H. D. Garnett H.D. Garnett, Vice President, Controller & Director, March 22, 1994 /s/ G. T. Richardson G.T. Richardson, Vice President & Director, March 22, 1994 /s/ W. G. Hancock W.G. Hancock, Counsel & Director, March 22, 1994 /s/ Dianne N. Collins Dianne N. Collins, Director, March 22, 1994 HOME BENEFICIAL CORPORATION Index to Exhibits (Items 14(c)) ITEM 13. Certain Relationships and Related Transactions (a) On May 10, 1993, the Corporation repurchased 365,838 shares of its Class B Common Stock from the Estate of Mary Morton Parsons at a price of $9,008,761 or $24.625 per share. At the time of the repurchase, the Estate of Mary Morton Parsons was the beneficial owner of more than 5% of the Corporation's outstanding Class A Common Stock. In the case of the above purchase, the price paid by the Corporation was below the then applicable bid price for the Corporation's Class B Common Stock in the over-the-counter market. Prior to the purchase, the Board of Directors determined that reacquisition of the shares was in the best interest of the Corporation and its stockholders when compared with alternative investments available to the Corporation. Immediately upon their reacquisition, all of the shares became authorized but unissued shares under Virginia law. (b) W. G. Hancock is a partner in the law firm of Mays & Valentine which provided legal services as general counsel to the Corporation and its subsidiaries and affiliates during 1993, and is expected to serve in the same capacity in 1994. The amount of legal fees paid to that firm by the Corporation and its subsidiaries and affiliates for 1993 did not exceed 5% of the firm's gross revenues for its last full fiscal year. (c) Not applicable. (d) Not applicable. 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 financial statement schedules listed in the accompanying Index to Financial Statements and Financial Statement Schedules on page 27 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 HOME BENEFICIAL CORPORATION and Financial Statement Schedules (Item 14(a)) Annual Form Report to 10-K Stockholders Consolidated Financial Statements: Report of Ernst & Young, Independent Auditors 18 Consolidated Balance Sheet at December 31, 1993 and 1992 6-7 Consolidated Statement of Income for each of the three years in the period ended December 31, 1993 8 Consolidated Statement of Retained Earnings for each of the three years in the period ended December 31, 1993 9 Consolidated Statement of Cash Flows for each of the three years in the period ended December 31, 1993 10 Notes to Consolidated Financial Statements 11-17 Supplementary information-- Quarterly financial information (unaudited) 21 Financial Statement Schedules: I - Summary of investments - other than investments in related parties at December 31, 1993 (Consolidated) 29 III - Condensed Financial Information of Registrant (Parent Company): Balance Sheet at December 31, 1993 and 1992 30 Statement of Income for each of the three years in the period ended December 31, 1993 31 Statement of Cash Flows for each of the three years in the period ended December 31, 1993 32 VI - Reinsurance for each of the three years in the period ended December 31, 1993 (Consolidated) 33 All other schedules are 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 financial statements and notes thereto. The consolidated financial statements and supplementary information listed in the above index, which are included in the Annual Report to Stockholders for Home Beneficial Corporation for the year ended December 31, 1993, are incorporated herein by reference. CONSENT OF ERNST & YOUNG, INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report(Form 10-K) of Home Beneficial Corporation of our report dated February 10, 1994, included in the 1993 Annual Report to Stockholders of Home Beneficial Corporation. Our audits also included the financial statement schedules of Home Beneficial Corporation listed in Item 14(a). These schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Richmond, Virginia February 10, 1994 Schedule I HOME BENEFICIAL CORPORATION (CONSOLIDATED) SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES At December 31, 1993 Schedule III HOME BENEFICIAL CORPORATION (PARENT COMPANY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEET December 31, 1993 and 1992 (*) See Notes 6 and 7 to Consolidated Financial Statements Schedule III HOME BENEFICIAL CORPORATION (PARENT COMPANY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF INCOME Years Ended December 31, 1993, 1992 and 1991 Schedule III HOME BENEFICIAL CORPORATION (PARENT COMPANY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 Increase (Decrease) in Cash and Cash Equivalents (*) (*) Short-term investments, which consist of investments with maturities of 30 days or less, are considered cash equivalents. Schedule VI HOME BENEFICIAL CORPORATION (CONSOLIDATED) REINSURANCE Years Ended December 31, 1993, 1992 and 1991 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934 the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. HOME BENEFICIAL CORPORATION Registrant By: /s/ H. D. Garnett H.D. Garnett, Vice President and Controller, March 22, 1994 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 the Registrant and in the capacities and on the dates indicated: /s/ R. W. Wiltshire R.W. Wiltshire, Chairman of the Board & Director, March 22, 1994 /s/ C. M. Glenn, Jr. C.M. Glenn, Jr., Retired Vice President, Treasurer & Director, March 22, 1994 /s/ L. W. Richardson L.W. Richardson, Retired Vice President & Director, March 22, 1994 /s/ R. W. Wiltshire, Jr. R.W. Wiltshire, Jr., President, Chief Executive Officer & Director, March 22, /s/ J. M. Wiltshire, Jr. J.M. Wiltshire, Jr., Vice President, Counsel, Secretary & Director, March 22, /s/ W. B. Wiltshire W.B. Wiltshire, Vice President & Director, March 22, 1994 /s/ H. D. Garnett H.D. Garnett, Vice President, Controller & Director, March 22, 1994 /s/ G. T. Richardson G.T. Richardson, Vice President & Director, March 22, 1994 /s/ W. G. Hancock W.G. Hancock, Counsel & Director, March 22, 1994 /s/ Dianne N. Collins Dianne N. Collins, Director, March 22, 1994 HOME BENEFICIAL CORPORATION Index to Exhibits (Items 14(c))

56583_1993.txt

56583_1993

1993

56583

Item 1. Business. (a) General. Kollmorgen Corporation, incorporated in the State of New York in 1916, has operations in two industry segments: the motion technologies group and electro-optical instruments. The term the "Company" as used herein refers to Kollmorgen Corporation and its subsidiaries. (b) Financial Information about Industry Segments. The following table includes certain financial information relating to each of the Company's industry segments in each of its last three fiscal years: The operating profit and loss in the above table is defined as total revenue less operating expense and represents operating segment income before general corporate expense and income taxes. Identifiable assets by segment are those assets used exclusively in the operation of that industry segment. Corporate expenses, which include interest (net of investment income) and general and administrative expenses, are not allocated to respective segments. Corporate assets consist principally of cash and investments, as well as net assets held for disposition. The loss from operations in 1992 includes a restructuring charge of $10.0 million taken primarily to consolidate several motor operations. The charge is allocated as follows: Motion Technologies Group $ 8,000 Corporate $ 2,000 The loss from operations in 1991 includes restructuring and other charges of $26.3 million consisting primarily of employee severance costs, additional costs estimated to complete several large long-term military development contracts, and the write-off of certain inventories and non- performing long-term receivables, as follows: Motion Technologies Group $ 5,800 Electro-Optical Instruments $11,100 Corporate $ 9,400 (c) Narrative Description of Business Motion Technologies Group. The Company believes that it is one of the major worldwide manufacturers of specialty direct current ("d.c.") permanent magnet motors with associated electronic servo amplifiers and servo feedback components. These products are manufactured in the United States by the Company's Inland Motor and Industrial Drives/PMI Divisions. In addition, the Company's foreign subsidiary, Kollmorgen Artus in France, serves the European markets. The Inland Motor Division designs and manufactures specialty d.c. torque motors, servo motors, tachometer generators, electromechanical actuators and associated high technology drive electronics used worldwide in aerospace, defense, process control, medical, machine tool, and computer peripheral applications. The Industrial Drives/PMI Division manufactures a line of specialty drive motors and related electronic amplifiers which are used in a variety of industrial applications including industrial automation, process control, machine tools, underwater equipment, and robotics. This Division also designs, manufactures and distributes a line of low inertia, high speed of response, d.c. motors and associated electronics plus feedback devices under the U.S. registered trademark "PMI" used primarily in industrial automation and medical applications. In addition, Industrial Drives/PMI sells a line of stepper motors used for office and factory automation, instrumentation and medical applications. Kollmorgen Artus manufactures and sells d.c. servo and torque motors, electromechanical actuators and drive electronics, synchros, and resolvers, which are sold primarily into the European avionics and aerospace market. This subsidiary also manufactures and sells a line of fault detection instruments for the electric utility industry as well as calibration equipment for air traffic control navigation aids. In the specialty motor and drive business, competitive advantage is gained by the ability of the Company to design new or adapt existing motors and drive systems to meet relatively stringent packaging and performance requirements of customers, most of whom are original equipment manufacturers purchasing the motors and drives for inclusion in their end product. While meeting these stringent technical specifications, the motors and drives must also be price competitive. The number and identity of the competitors in this segment varies depending upon the particular industry and product application. In recent years, a number of large European and Japanese manufacturers, either directly or through joint ventures with American companies, have been able to compete successfully in the United States machine tool and industrial automation marketplaces, including the market for industrial motors of the type that the Company's Industrial Drives/PMI Division manufactures. In other markets, there are relatively few competitors for each marketplace or application, and generally they are specialized domestic or foreign motor manufacturers. In the United States, the industrial/commercial products manufactured in this segment are marketed and sold by the Company's Industrial and Commercial Products Group, and the defense and aerospace products are marketed by the Aerospace and Defense Products Group. Depending upon the particular motor product or control system in question, the products of the Company's motion technologies group are marketed and sold directly through qualified technical personnel employed by the Company, or through manufacturer's representatives or distributors, or by a combination of the foregoing. The backlog of the motion technologies group at the end of 1993 was $52.2 million of which approximately 80% is expected to be shipped in 1994. Electro-Optical Instruments. The Company's electro-optical business is conducted principally by one domestic division and two subsidiaries: the Electro-Optical Division, Kollmorgen Instruments Corporation, and Proto-Power Corporation. The products of this industry segment serve two broad customer groups: military and industrial/commercial. The Company serves the military market primarily through the Electro-Optical Division located in Northampton, Massachusetts. This Division has been the primary designer and major supplier of submarine periscopes and related spare parts to the United States Navy since 1916. The only other supplier of submarine periscopes to the United States Navy is Sperry Marine, Inc. In addition, the Electro-Optical Division markets and sells submarine periscopes to navies throughout the world. In January 1993, the Company received a contract for $24.7 million from the U.S. Navy to produce 16 optronic sights for the DDG-51 Arleigh-Burke class of guided-missile destroyers. In July 1993, the Company was also awarded a $10 million contract from the U.S. Navy for 19 submarine periscopes systems. Both contract awards have delivery schedules through 1996. This Division also has been an important supplier of other electro-optical instruments for various weapon systems, including sights for the U.S. Army's Abrams tank. These instruments often possess highly advanced servo-driven optical systems and may use lasers, infrared detectors, or low-light level television imaging systems for night vision. This Division also manufactures and sells diamond-machined optical components and air bearing assemblies. The Company serves the industrial/commercial marketplace for electro- optical instruments through a wholly-owned subsidiary, Kollmorgen Instruments Corporation, which operates through its Macbeth and Photo Research Divisions. The Macbeth Division, located in New Windsor, New York, designs, manufactures and sells worldwide specialized instruments and materials used for the measurement of color and light. This Division also manufactures and sells a line of spectrophotometers which measure color and are used in the textile, paint, paper, plastics and many other industries where the measurement of color is important. It is also a manufacturer of densitometers, which are instruments that are used to control photographic and printing processes by measuring the opacity or density of materials, such as films, inks, and dyes. In addition, this Division manufactures specialized lighting devices for the inspection and comparision of transparencies and prints in the photographic and printing industries. The Macbeth Division also manufactures standard lighting sources used in evaluating color and produces a line of color standards sold under the U.S. registered trademark "Munsell". The on-line version of the spectrophotometers manufactured by this Division permits the measurement of spectral characteristics on a production line in a broad range of industrial processes without interrupting production flow. Kollmorgen Instruments GmbH, a German subsidiary of Kollmorgen Instruments Corporation, designs and manufactures a product line of transportable spectrophotometers. The Photo Research Division located in Chatsworth, California, manufactures and sells specialized photometers and spectroradiometers, instruments which make very precise color and brightness measurements of displays (such as CRTs and lighted panels) and are used in both industrial and military applications. This Division also manufactures and sells on-line inspection and alignment systems for CRT displays used in the computer and medical industries. The Company believes that its businesses which manufacture industrial/ commercial electro-optical instruments are highly regarded in their respective markets. This position has been built upon high quality products which provide uniform results and meet specialized needs and standards, upon proprietary software, and upon superior after-sales service. The Company's competition in this field consists of a number of domestic and foreign privately held companies and divisions or subsidiaries of publicly held corporations. Depending upon the product and customers in question, the Company's industrial products are sold through dealers and independent sales representatives, distributors or systems houses and directly through the divisions' own sales forces. In Europe, these products are distributed through Kollmorgen Instruments GmbH, Kollmorgen (U.K.) Limited, the Company's wholly-owned English subsidiary, and through independent representatives and dealers. Proto-Power Corporation, a wholly-owned subsidiary of the Company, is an applications engineering company that primarily provides services for the modification and upgrade of nuclear and fossil energy plants of domestic electric utility companies. Within this segment, military products represented 47% of sales in 1993, 45% of sales in 1992, and 47% of sales in 1991. Generally speaking, the Company's military business is characterized by long-term contracts which call for the delivery of products over more than one year and progress payments during the manufacture of the product. Competition is generally limited to divisions of large multinational companies which specialize in military contracting. To date, the Company has been able to compete effectively against these larger companies because of the Company's experience and expertise in the specialized areas which it serves. The backlog of the electro-optical instruments segment at the end of 1993 was $58.3 million of which approximately 50% is expected to be shipped in 1994. Customer Base. Except to the extent that sales to the U.S. government under numerous prime and sub-contracts may be considered as sales to a single customer, the Company's business is not characterized by dependence upon one customer or a few customers, the loss of any of which would have a materially adverse effect on its total business. Typical of all engineered or custom-made component businesses, the Company's motion technologies group is characterized by a customer base founded upon a number of large key accounts, the importance of any one of which can vary from year to year. During 1993, no customer accounted for 10% or more of the Company's consolidated revenues. Government Sales. In 1993, sales to the U.S. Government or for U.S. Government end-use represented approximately 21% of revenues, of which 14% were generated from the electro-optical instruments segment and 7% was from the motion technologies group. Patents. The Company has either applied for or been granted a number of domestic and foreign patents pertaining to the motion technologies group and electro- optical instruments segments. The Company believes that these patents are and will be important to the Company's continued leadership position in these business segments and, when necessary, has and will continue to enforce its legal rights against alleged infringements of its patent estate. Raw Materials. The raw materials essential to the Company's business are generally available in the open market, and neither segment of the Company's business experienced any significant shortages in such materials during the past three years. The Company believes that it has adequate sources of raw materials available for use and does not anticipate any significant shortages. In the past, the Company has occasionally encountered rapid increases of the prices of certain isolated materials used in parts of its business, but such increases have not materially affected its ability to procure such materials or to pass on the consequent cost increases to its customers. However, in some circumstances, there is generally a slight lag between the time these higher costs are incurred and the time they can be reflected in price increases to customers. During 1993, the Company did not encounter such rapid price increases in raw materials. Research and Development. During 1993, the Company spent $9.3 million or approximately 5.0% of its consolidated sales on research activities related to the development of new products. This compares to $10.6 million or 5.5% in 1992 and $10.3 million or 5.2% in 1991. Substantially all of this amount was sponsored by the Company. Environmental Regulations. The Company's operations are subject to a variety of federal environmental laws and regulations. The most significant of these laws are the Clean Air Act, the Clean Water Act and the Resource Conservation and Recovery Act, all of which are administered by the United States Environmental Protection Agency. These statutes and the regulations impose certain controls on atmospheric emissions, discharges into sewers and domestic waters, and the handling and disposal of hazardous wastes. In addition, certain state and local jurisdictions have adopted environmental laws and regulations that are more stringent than federal regulations. Compliance with these federal and state laws and regulations has resulted in expenditures by the Company to improve or replace pollution control equipment. The Company's estimated capital expenditures for environmental control facilities are not expected to be material. Employees. As of December 31, 1993, the Company employed approximately 1,660 employees. The Company is a party to two collective bargaining agreements. In August 1993, the Company's Electro-Optical Division entered into a three- year agreement with the International Association of Machinists and Aerospace Workers currently covering 38 employees. On March 4, 1994, the Macbeth Division of Kollmorgen Instruments Corporation entered into a three-year contract with the International Brotherhood of Electrical Workers currently covering 24 employees at that Division. The Company believes that it enjoys good relations with its employees, including those covered by collective bargaining agreements. Financial Information About Foreign and Domestic Operations and Export Sales. Financial information on the Company's foreign and domestic operations and export sales is contained in the response to Item 14(a) of this Report. Item 2. Item 2. Properties. The Company's corporate office is located in Waltham, Massachusetts. The table which follows sets forth a current summary of the locations of the Company's principal operating plants and facilities, and other pertinent facts concerning them. The Company's facilities are substantially utilized, well maintained and suitable for its products and services. In addition, the Company maintains approximately 150,000 sq.ft. of unutilized space due to prior business segment dispositions and consolidations of facilities. The building in Nashua, New Hampshire, is an asset remaining from the Company's disposition of a business segment in 1989. This facility is currently being leased and is approximately 80% occupied. Item 3. Item 3. Legal Proceedings. The Company has various legal proceedings arising from the ordinary conduct of its business; however, they are not expected to have a material adverse effect on the consolidated financial position of the Company. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. Executive Officers of the Company. The following is a list of the Company's executive officers, their ages and their positions as of February 25, 1994: Present Business Experience During Name Age Office Past Five Years Gideon Argov 37 President President and Chief Executive and Officer since November 1991; Chief Director since May 1991. From Executive March 1988 to May 1991, Officer President and Chief Executive Officer and Director of High Voltage Engineering Company. Prior to that date, for five years a manager and senior consultant with Bain & Company. Robert J. Cobuzzi 52 Senior Senior Vice President (since Vice February 1993), Treasurer and President, Chief Financial Officer since Treasurer July 1991. From April 1989 to and July 1991, Vice President and Chief Treasurer of High Voltage Financial Engineering Company. Prior to Officer April 1989, Vice President and Chief Financial Officer of Ausimont N.V. James A. Eder 48 Vice Vice President since January President, 1990; General Counsel since Secretary December 1991, and Secretary and since 1983. Previously he had General been Assistant Corporate Counsel Counsel from 1977 to 1982. Robert W. Woodbury, Jr. 37 Vice Vice President since May 1993; President, Controller and Chief Accounting Controller Officer of the Company since and Chief February 1992. From May 1990 to Accounting February 1992, he was the Chief Officer Financial Officer of Kidde- Fenwal, a Division of Williams Holdings, PLC. Prior to that, from 1988 to 1990 he was the Controller of Unitrode Corporation. All officers are elected annually for one-year terms at the organizational meeting of the Board of Directors held immediately following the annual meeting of shareholders. PART II Item 5. Item 5. Market for the Company's Common Equity and Related Shareholder Matters. The Company's Common Stock is traded on the New York Stock Exchange. There were approximately 2,300 registered holders of the Company's Common Stock on February 25, 1994. The following table sets forth the high and low sales price for shares of the Company's Common Stock within the last two fiscal years and the dividends paid during each quarterly period. Item 6. Item 6. Selected Financial Data. The following table sets forth selected consolidated financial data for the Company for each of the five fiscal years 1989 through 1993. All dollar amounts are in thousands except per share data. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Results of Operations For the year ended December 31, 1993, the Company had sales of $185.5 million and net income of $4.8 million or $.25 per share. These results compare with 1992 sales of $194.9 million and a net loss of $8.7 million or a loss of $1.14 per share, and 1991 sales of $200.5 million and a net loss of $35.9 million or a loss of $3.97 per share. Earnings (loss) per share are calculated after payment of preferred dividends. The Company's 1993 sales decrease of 5% from the prior period is attributable to both business segments. The decrease in sales of 3% in the motion technologies group was primarily caused by a decline in spending in the military/aerospace portion of the business and changes in foreign exchange rates. Increased sales of 4% in the commercial portion of the segment offset some of the 1993 revenue decline. In the Company's electro- optical instruments segment sales were down 7% from the prior year primarily as a result of a decline in sales in the Company's commercial light and color instrumentation businesses as the markets for these products were impacted by the worldwide recession. Operating results for 1992 included a $10 million charge primarily for the consolidation of the Company's French motor facilities and the consolidation of several redundant functions in the domestic motion technologies businesses. Operating results for 1991 included a restructuring charge of $16.7 million primarily for employee severance costs and to write- off non-performing assets. In addition, $9.6 million was charged to operations in 1991 for estimates to complete long-term military contracts. By the end of 1993 the Company had completed most of its restructuring activities which began in 1991 and the actual requirements were consistent with the original reserve amounts. As a result, the Company's work force was reduced by approximately 850 people and a substantial portion of the facilities consolidation was complete by the end of 1993. The Company had a reserve balance of approximately $6.4 million at December 31, 1993, principally for the completion of its facilities consolidation. Research and development expense was $9.3 million in 1993 or 5.0% of sales as compared to $10.6 million in 1992 (5.5% of sales) and $10.3 million in 1991 (5.2% of sales). The reduction between 1993 and 1992 is primarily a result of decreased spending at the Company's French motor business due to the consolidation of its facilities. In 1993, interest expense, net, decreased to $4.1 million compared to $5.2 million in 1992 and $6.0 million in 1991. The decrease in both periods is due to lower average outstanding borrowings in the Company's French facilities, higher interest income from cash investments due to larger cash balances, and a lower outstanding balance on long-term debt. The use of funds is more fully discussed under "Liquidity and Capital Resources." The Company recognized tax benefits on income of $.8 million, $.8 million and $1.6 million in 1993, 1992 and 1991, respectively. In 1993, the recognition of the income tax benefit resulted from resolutions of certain prior year tax assessments. The Company also recognized the income tax benefits of applicable net operating losses and tax credits in 1992 and 1991 as a reduction in the provision for income taxes. The benefit of unutilized net operating losses and tax credits will be carried over to future periods to reduce income taxes otherwise payable. Liquidity and Capital Resources The Company's consolidated cash, restricted cash and short-term investments decreased by $4.8 million during 1993. Operations provided $10.9 million, while $9.7 million was used for capital expenditures and investing activities other than short-term investments. Financing activities used $6.9 million. The most significant changes in working capital included a decrease of recoverable amounts on long-term contracts of $6.2 million as several contracts were completed during the course of the year. Inventories were reduced by $1.2 million and accounts and notes receivable reduced by $2.1 million as result of increased efforts towards reducing working capital requirements. Accounts payable and accrued liabilities decreased by $8.5 million primarily as a result of expenses related to the Company's restructurings which were paid during the year consisting primarily of severance payouts. The Company's investing activities included expenditures of $5.5 million for property, plant and equipment. In addition, the Company purchased an unutilized leased facility for $4.3 million in cash as consideration for the termination of a 20-year lease having 13 years remaining. In addition, the Company assumed a $2.0 million mortgage for the property and the net realizable value of the property of $3.0 million is included in assets held for sale. The estimated loss in value of the property was recorded in the 1992 restructuring. The Company's financing activities used $6.9 million of cash during the year of which dividends, both common and preferred, accounted for $3.0 million while repayments under existing credit lines and long-term debt accounted for $3.9 million. Under the terms of the current bank agreement, the Company maintains a cash balance equal to approximately 50% of the outstanding standby letters of credit. The cash is held in custody by the issuing bank in an interest- bearing account and is restricted to withdrawal or use. Accordingly, the Company has classified these funds as restricted cash of $6.7 million. At December 31, 1993, the Company was contingently liable for $9.4 million for outstanding standby letters of credit issued principally to secure advance payments received from customers on long-term military contracts. In accordance with the terms of the Company's two convertible subordinated debentures, the Company is required to pay $3.8 million in sinking fund payments during 1994 and additional amounts in future years. Capital spending in 1994 is expected to be at similar levels to 1993. The Company believes that with the cash generated from operations and with its current borrowing capacity it will be able to finance 1994 capital expenditures and contribute the mandatory sinking fund payments. In January 1993, the Company adopted Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Company elected to amortize the transition obligation over 20 years. The financial statements include an expense of $.8 million in 1993. In February 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). The adoption of FAS 109 did not have a material effect on results of operations or financial position. The Company will adopt Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Post-Employment Benefits" ("FAS 112") in 1994. FAS 112 requires that benefits to be paid to former or inactive employees after employment but prior to retirement must be accrued if certain criteria are not met. The adoption of FAS 112 is not expected to have a material financial impact on the Company. Motion Technologies Group Revenues in the motion technologies group decreased to $112.8 million, down 3% from $116.6 million in 1992 and down 7% from $120.6 million in 1991. The effect of foreign exchange rates accounted for 2% of the decrease in sales in 1993. Reduced sales in the military/aerospace portion of the business were offset by an increase in volume in the domestic commercial motors businesses. The operating income was $9.2 million for 1993, compared to a loss in 1992 of $2.5 million which included an $8 million restructuring charge. The increase in operating income is a result of improved gross margins in the commercial and industrial businesses, reduced administrative and research and development expenses as a result of the consolidation of various domestic and French facilities. These spending reductions were slightly offset by increased spending in sales and marketing expenses in our commercial motors businesses as the Company expanded its sales organization by opening regional sales offices during the year in order to increase its direct sales efforts under the reorganized structure. Operating income was $.1 million in 1991 which included a restructuring charge of $5.8 million. New orders for this segment were up 3% in 1993 over 1992 as orders for commercial and industrial motors increased. New orders for military and aerospace products were essentially unchanged compared to 1992 results. Backlog at the end of 1993 was $52.2 million compared to $49.9 million in 1992. Capital expenditures in 1993 and 1992 for this segment was $3.3 million and $3.1 million, respectively, most of which was for replacement of existing equipment and investments in new equipment to improve efficiency and quality of products. Electro-Optical Instruments Revenues in the electro-optical instruments segment decreased to $72.8 million, down 7% from $78.3 million in 1992, and down 9% from $79.9 million in 1991. The decrease in 1993 was principally due to reduced sales in the commercial light and color instrumentation businesses. The decrease in 1992 over 1991 was due primarily to reduced sales in the Company's Electro-Optical Division as receipts of long-term orders were delayed, but were partially offset by increased revenues at our Proto-Power subsidiary. Operating income in this segment was $3.1 million, compared to a $4.1 million in 1992 and a $13.4 million loss in 1991, including an $11.1 million restructuring charge. The decrease in operating profit in 1993 is due to lower margins on reduced sales in the commercial color and light measurement products businesses and lower gross margins on military contracts at the Electro-Optical Division. Reductions in operating expenses of $1 million between 1993 and 1992 helped offset the decline in margins. The backlog for the electro-optical instruments segment was $58.3 million at the end of 1993 up 21% from $48.1 million at the end of the previous year. The backlog increase is due to long-term orders at the Electro-Optical Division for periscopes and optronic sights received during the year. During 1993 the electro-optical instruments segment spent $2.1 million on capital equipment primarily for replacement and maintenance of existing equipment. The Company's leased facility in Chatsworth, California, which manufactures high-end light measurement products, was damaged during the earthquake on January 17, 1994. The damage caused portions of the operations to be temporarily interrupted. Due to this disruption the Company anticipates a lower sales volume at this facility during the first quarter of 1994. The Company maintains an adequate amount of property and business interruption insurance to cover all assessed damages and, therefore, does not anticipate the impact on earnings in the first quarter of 1994 to be material. General corporate expenses included interest expense (net of investment income), and general and administrative expenses. In addition, the general corporate amounts include restructuring and other non-recurring costs of $2 million in 1992, $9.4 million in 1991. General corporate assets consist principally of cash and investments, as well as net assets held for disposition. Item 8. Item 8. Financial Statements and Supplementary Data. The information required by this Item 8 is included in Item 14(a) of this Report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. As previously reported by the Company on a Form 8-K dated September 11, 1992, upon the recommendation of the Audit Committee, the Board of Directors in September 1992 appointed Coopers & Lybrand, One International Place, Boston, Massachusetts, as independent accountants to examine the Corporation's financial statements for the fiscal year ended December 31, 1992 and thereafter. Coopers & Lybrand was appointed the Corporation's independent accountants by the Board of Directors after the Board had terminated the engagement of the accounting firm of KPMG Peat Marwick. During the fiscal year ending December 31, 1991, and the interim period preceding the termination of the engagement of KPMG Peat Marwick, the Corporation had no disagreements with such accountants on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure or any reportable events which disagreements, if not resolved to the satisfaction of KPMG Peat Marwick, would have caused it to make reference to the subject matter of such disagreements in connection with its reports. Furthermore, the KPMG Peat Marwick report on the Corporation's financial statements for the year ended December 31, 1991, presented in Item 14(a) of this report, contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. PART III Item 10. Item 10. Directors and Executive Officers of the Company. The information required by this Item 10 of Form 10-K relating to directors who are nominees, and to directors continuing in office after the Company's Annual Meeting of Shareholders to be held on May 11, 1994, is contained in the definitive proxy statement to be filed with the Securities and Exchange Commission (the "Commission") on or before April 5, 1994, under the headings "Nominees", and "Continuing Directors", and such information is incorporated herein by reference in response to this item. The information required by this Item 10 of Form 10-K with respect to executive officers is set forth in Part I of this Form 10-K under the heading "Executive Officers of the Company". Item 11. Item 11. Executive Compensation. The information required by this Item 11 of Form 10-K is contained in the Company's definitive proxy statement to be filed with the Commission on or before April 5, 1994, under the heading "Executive Compensation" and such information is incorporated herein by reference in response to this item. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required by this Item 12 of Form 10-K is contained in the definitive proxy statement to be filed with the Commission on or before April 5, 1994, under the headings "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" and such information is incorporated herein by reference in response to this item. Item 13. Item 13. Certain Relationships and Related Transactions. The information required by this Item 13 of Form 10-K is contained in the Company's definitive proxy statement to be filed with the Commission on or before April 5, 1994, under the heading "Certain Relationships and Related Transactions" and such information is incorporated herein by reference in response to this item. PART IV Item 14. Item 14. Exhibits, Financial Statements, Schedules, and Reports on Form 8-K. (a) The following documents are filed as part of this report: (1) Financial Statements. See Index to Financial Statements on page 18. (2) Financial Statements Schedules. See Index to Financial Statements Schedules on page 42. (3) Exhibits. See Exhibit Index on page 46. (b) Reports on Form 8-K. There were no reports on Form 8-K filed by the Company. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, Kollmorgen Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. KOLLMORGEN CORPORATION /s/ Robert J. Cobuzzi Robert J. Cobuzzi Its: Senior Vice President, Treasurer and Chief Financial Officer March 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 Company and in the capacities and on the dates indicated: /s/ Gideon Argov Gideon Argov March 3, 1994 President and Chief Executive Officer/Director /s/ Robert J. Cobuzzi Robert J. Cobuzzi March 3, 1994 Senior Vice President, Treasurer and Chief Financial Officer /s/ Robert W. Woodbury, Jr. Robert W. Woodbury, Jr. March 3, 1994 Vice President, Controller and Chief Accounting Officer /s/ James A. Eder James A. Eder March 3, 1994 Vice President and Secretary and Attorney-in-Fact For: Allan M. Doyle, Jr., Director Robert N. Parker, Director James H. Kasschau, Director Eric M. Ruttenberg, Director J. Douglas Maxwell, Jr., Director George P. Stephan, Director The following consolidated financial statements of the Company and its subsidiaries are included in response to Item 8. Page(s) in Form 10-K ----------- Report of Independent Accountants - Coopers & Lybrand 19 Independent Auditors' Report - KPMG Peat Marwick 20 Consolidated Balance Sheets as of December 31, 1993 and 1992. 21-22 Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991. 23 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991. 24 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. 25-26 Notes to Consolidated Financial Statements. 27-41 Index to Financial Statements Schedules 42 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders Kollmorgen Corporation: We have audited the accompanying consolidated balance sheets of Kollmorgen Corporation as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. The consolidated financial statements of Kollmorgen Corporation for the year ended December 31, 1991, were audited by other independent accountants whose report dated February 19, 1992, expressed an unqualified opinion on those statements. 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 Kollmorgen Corporation as of December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles. /s/ Coopers & Lybrand COOPERS & LYBRAND Boston, Massachusetts January 31, 1994 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders Kollmorgen Corporation: We have audited the accompanying consolidated statements of operations, shareholders' equity, and cash flows of Kollmorgen Corporation and subsidiaries for the year ended December 31, 1991. In connection with our audit of the consolidated financial statements, we also have audited the 1991 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 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 results of operations and cash flows of Kollmorgen Corporation and subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. Also in our opinion, the related 1991 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 Short Hills, New Jersey February 19, 1992 KOLLMORGEN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (Dollars in thousands, except per share amounts) _________________________________________________________________ Note 1. Summary of significant accounting policies A summary of the significant accounting policies followed by Kollmorgen Corporation is presented below. Certain reclassifications have been made to the prior years' financial statements to conform to 1993 classifications. For purposes of the Notes to Consolidated Financial Statements, the term the "Company" refers to Kollmorgen Corporation and its subsidiaries. Principles of Consolidation The consolidated financial statements include the accounts of the Company and all of its majority-owned subsidiaries. In 1993, the Company's wholly-owned subsidiary, Kollmorgen Artus, prospectively changed its financial reporting year from a fiscal year ending on October 31 to December 31. The consolidated statements of income are presented for the year ended December 31, 1993, excluding the results of operations for November and December, 1992, which were immaterial. Cash and Cash Equivalents Cash equivalents are stated at cost which approximates fair value. The Company considers all highly liquid investments purchased within an original maturity of three months or less to be cash equivalents. Recoverables Recoverable amounts on long-term contracts represent revenues recognized on a percentage-of-completion basis less progress billings. Inventories Inventories are stated at the lower of cost or market, principally using the first-in, first-out method. Progress payments received on contracts other than major long-term contracts are deducted from inventories. Property, Plant and Equipment and Accumulated Depreciation Property, plant and equipment are carried at cost and include expenditures for major improvements which substantially increase their useful life. Repairs and maintenance are expensed as incurred. When assets are retired or otherwise disposed of, the assets and related allowances for depreciation and amortization are eliminated from the accounts and any resulting gain or loss is recognized. For financial reporting purposes, depreciation is provided generally on a straight-line basis over the estimated useful lives of the buildings (10 to 50 years) and the machinery and equipment (3 to 12 years). Leasehold improvements are depreciated over the remaining period of the existing leases. For income tax purposes, depreciation is computed by using various accelerated methods and, in some cases, different useful lives than those used for financial reporting. Notes to Consolidated Financial Statements - continued Goodwill and Intangibles Goodwill consists of amounts by which the cost of acquisitions exceeded the values assigned to net tangible assets. Intangible assets consist principally of patents. All of the intangible assets are being amortized on a straight-line basis over periods of up to 40 years. Cumulative Translation Adjustments Assets and liabilities of foreign subsidiaries are translated at year-end exchange rates. The effects of these translation adjustments are reported in a separate component of shareholders' equity. The effect of exchange rates on cash flows is not material. Sales Sales, other than revenues from major long-term contracts, are recorded as products are shipped. Major programs that are performed under long-term contracts are accounted for using the percentage-of-completion method. Revenues recognized under this method were $24.5 million, $29.3 million, and $29.1 million in 1993, 1992, and 1991, respectively. In most cases the contracts also provide for progress billings over the life of the program. Earnings (Loss) Per Common Share Earnings (loss) per common share is based on net income less the dividends and interest accretion on redeemable preferred stock divided by the average number of common shares outstanding. Fully diluted net income assumes full conversion of all convertible securities into common stock which include the convertible subordinated debentures and redeemable preferred stock. The fully diluted calculation does not result in dilution of net income per common share and, accordingly, is not presented. Income Taxes Effective January 1, 1993 the Company adopted Statement of Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). The adoption of FAS 109 had no material effect on results of operations or financial position. Postretirement Benefits Other Than Pensions Effective January 1, 1993, the Company adopted Statement of Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"). Under FAS 106, the Company is required to accrue the expected benefit obligation for postretirement benefits during the employees' active service periods. The Company previously expensed the cost of these benefits, which are principally health care, as claims were incurred. The Company has elected the delayed recognition method in which the cost for employees hired prior to January 1, 1992, is being amortized over 20 years. The Company paid approximately $.8 million in 1993 for post- retirement benefits to current retirees. Note 2. Restricted cash The restricted cash balance of $6.7 million in 1993 serves as collateral for an irrevocable standby and documentary letter of credit facility at the Company's lead bank. Notes to Consolidated Financial Statements - continued Pursuant to the terms of this agreement, the cash is held in custody by the issuing bank and is restricted as to withdrawal or use, and is currently being invested in short-term money market instruments for the benefit of the Company. Note 3. Inventories Inventories at December 31 consist of the following: 1993 1992 --------- --------- Raw materials $ 11,530 $ 11,431 Work in process 7,847 9,634 Finished goods 2,641 3,268 --------- --------- $ 22,018 $ 24,333 ========= ========= Note 4. Property, Plant and Equipment Property, plant and equipment at December 31 consists of the following: 1993 1992 --------- --------- Land $ 1,459 $ 1,474 Leasehold improvements 669 988 Buildings 34,650 34,877 Machinery and equipment 70,369 70,470 --------- --------- 107,147 107,809 Less accumulated depreciation and amortization 76,686 76,051 --------- --------- $ 30,461 $ 31,758 ========= ========= Note 5. Accrued Liabilities Accrued liabilities at December 31 consist of the following: 1993 1992 --------- --------- Restructuring and related costs $ 6,390 $ 19,938 Salaries, wages, commissions 5,100 4,728 Pension/supplemental retirements 3,912 2,736 Insurance 3,169 1,898 Other accrued liabilities 13,990 13,746 --------- --------- $ 32,561 $ 43,046 ========= ========= Notes to Consolidated Financial Statements - continued Note 6. Lines of credit and notes payable At December 31 the Company had approximately $2.9 million or approximately 17 million French francs of unused lines of credit. Notes payable consist of the following at December 31: 1993 1992 -------- -------- Foreign $ 3,545 $ 5,450 Domestic 1,987 - -------- -------- $ 5,532 $ 5,450 ======== ======== In July 1993, the Company amended its existing agreement with its lead bank which provides for a one-year $18 million domestic standby letter of credit facility and extended the terms of the existing 21 million French franc revolving credit facility (approximately $4 million). Under the terms of the agreement, the Company maintains a cash collateral balance equal to approximately 50% of the outstanding letters of credit in an interest-bearing account. At December 31, 1993, the Company had $9.4 million of standby letters of credit outstanding at this bank. The agreement also requires the Company to maintain, among other things, certain financial ratios, the most restrictive of which is net worth, and contains other affirmative and negative covenants. The Company was in compliance with all covenants at December 31, 1993. Note 7. Long-term debt Long-term debt consists of the following: 1993 1992 -------- -------- 8 3/4% Convertible subordinated debentures due 2009 $ 39,840 $ 39,840 10 1/2% Convertible subordinated debentures due 1997 8,000 10,000 Term loans, 10.5% due through 1997 152 686 Capital lease obligations - 149 Other - 45 -------- -------- 47,992 50,720 Less current maturities 3,872 2,452 -------- -------- $ 44,120 $ 48,268 ======== ======== The 8 3/4% Convertible Subordinated Debentures are convertible at any time prior to maturity, unless previously redeemed, into 1,159,825 shares of common stock of the Company at a conversion price of $34.35 per share, subject to adjustment in certain events. The Company is required to make annual sinking fund payments sufficient to retire $1.75 million principal amount of debentures commencing in 1994 through 2008. The debentures are currently redeemable at the option of the Company at certain premiums through April, 1994, and at face value thereafter, with accrued interest to the redemption date. The 10-1/2% Convertible Subordinated Debentures issued in a private placement, are convertible into 320,000 shares of the Company's common stock at a price of $25 per share at any time prior to maturity, unless previously redeemed. The debentures are subject to mandatory sinking fund payments which commenced on August 1, 1993, and each year thereafter including August 1, 1997, in the amount of $2 million of principal reduction together with interest accrued and unpaid thereon to the date fixed for redemption. The Company incurred $5.1 million, $5.8 million, and $6.0 million of interest expenses on debt in 1993, 1992, and 1991, respectively. Long-term debt at December 31, 1993, matures as follows: Date Maturities ---- ---------- 1994 $ 3,872 1995 3,764 1996 3,764 1997 3,752 1998 1,750 Thereafter 31,090 -------- $47,992 ======== Note 8. Preferred Stock The Company's Restated Certificate of Incorporation provides that the Corporation is authorized to issue 500,000 shares of preferred stock, $1.00 par value, in series. Currently, there are 23,187.5 shares of preferred stock issued and outstanding. In March, 1990, the Company sold 23,187.5 shares of a new issue of Series D convertible preferred stock (the "Series D Stock") for $1,000 per share, or an aggregate of approximately $23.2 million, to a group of investors led by Tinicum Enterprises, Inc. ("Tinicum Group"). The stock has a cumulative dividend rate of 9.5 percent per year and is convertible into an aggregate of 1,717,591 shares of Kollmorgen common stock, subject to antidilution provisions. Under the agreement between the Company and the Tinicum Group, two representatives of the Tinicum Group were elected to the Company's Board of Directors. The Series D Stock is entitled to vote together with the Company's common stock based on the number of shares of the Company's common stock into which the Series D Stock is convertible. While the Series D Stock is outstanding, the Company has agreed, among other things, not to issue any capital stock of the Company other than the Company's common stock and securities issuable under the Company's Shareholder Rights Plan without first obtaining the consent of a majority of the outstanding Series D Stock. The Company is required to redeem all Notes to Consolidated Financial Statements - continued outstanding Series D Stock on April 1, 2000, at $1,000 per share, in each case plus accrued and unpaid dividends. The Series D Stock purchase agreement also includes certain financial covenants applicable to the Company, and certain restrictions applicable to the purchasers on the disposition, acquisition or the taking of other specified actions with respect to the voting securities of the Company. The balance of the preferred stock is shown net of the unamortized preferred stock discount. The unamortized amount in 1993 and 1992 is $781 and $906, respectively. Note 9. Common Stock, Additional Paid-in Capital and Treasury Stock Pursuant to the By-Laws of the Corporation, directors who are not employees of the Corporation receive an annual retainer of $12,000. Under the terms of the 1992 Stock Ownership Plan for Non-Employee Directors, each non-employee director receives at least 50% of his annual retainer in shares of common stock. The number of shares of common stock is based on the fair market value of such shares at the end of each quarterly period. Also, each non-employee director automatically receives an option to purchase an additional 2,000 shares of common stock every other year. At the implementaion of the Plan, 150,000 shares were reserved for issuance. The Company maintains a Shareholder Rights Plan which provides one Preferred Stock Purchase Right (Right) for each outstanding share of Common Stock of the Company. Each Right entitles the registered holder, subject to the terms of a Rights Agreement, to purchase one one-thousandth of a share (Unit) of Series B Preferred Stock, par value $1.00 per share (Preferred Stock), at a purchase price of $50 per Unit. The units of preferred stock are non-redeemable, voting, and are entitled to certain preferential dividend rights. The exercise price and the number of units issuable are subject to adjustment to prevent dilution. The Rights are not exercisable until the earlier to occur of (i) 10 days following a public announcement (the date of such announcement being the "Stock Acquisition Date") that a person or group has acquired beneficial ownership of 20% or more of the then outstanding shares of capital stock of the Company entitled to vote ("Acquiring Party") or (ii) a date determined by the Board of Directors following the commencement of a tender or exchange offer which would result in a party beneficially owning 30% or more of the shares of voting stock of the Company. The Board of Directors of the Company may redeem the Rights at any time on or prior to the tenth day following the Stock Acquisition Date at a price of $0.01 per Right. Unless earlier redeemed, the Rights will expire on December 20, 1998. Common stock reserved for issuance at December 31, 1993 and 1992, were as follows: conversion of debentures and redeemable preferred stock -- 3,197,416 and 3,277,416, respectively; and stock options and other awards -- 1,236,111 and 1,394,628, respectively. Notes to Consolidated Financial Statements - continued As a result of the Company's losses in previous years, there was not a sufficient amount of retained earnings from which to pay dividends and, accordingly, dividends paid on common and preferred stock were charged to "Additional Paid-in Capital." Note 10. Employee stock option and purchase plans The Company maintains two stock option plans under which grants have been made to officers and key employees. Options are generally first exercisable after one year but before ten years from date of grant. A summary of changes during 1993, 1992, and 1991 in shares of common stock authorized for grant to officers and key employees under the stock option plans are as follows: Number of Shares 1993 1992 1991 -------- -------- -------- Shares under option at January 1 892,337 1,044,189 551,239 Options granted 185,000 115,000 537,000 Options canceled (204,517) (266,852) (44,050) ---------- ---------- ---------- Shares under option at December 31 872,820 892,337 1,044,189 ========== ========== ========== Options exercisable at December 31 300,220 347,887 418,854 Price per share of options granted $ 6.00 to $ 4.50 to $ 5.38 to $ 7.75 $ 8.50 $ 8.38 Option prices at December 31, 1993, ranged from $4.50 to $20.00 per share. Options available for grant at December 31, 1993, 1992 and 1991 were 213,291, 352,291 and 815,102, respectively. Note 11. Taxes on income The components of income (loss) before income taxes were as follows: 1993 1992 1991 -------- -------- -------- Domestic $ 5,819 $ (3,526) $(34,554) Foreign (1,915) (5,971) (2,984) -------- -------- -------- Total $ 3,904 $ (9,497) $(37,538) ======== ======== ======== FAS 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 Notes to Consolidated Financial Statements - continued financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The provision (benefit) for income taxes consists of the following (in thousands): 1993 1992 1991 -------- -------- -------- Current provision (benefit): U.S. federal $ (703) $ 20 $ (1,444) Foreign - (196) (191) State - 50 35 -------- -------- -------- (703) (126) (1,600) -------- -------- -------- Deferred provision (benefit): U.S. federal - 20 - Foreign (145) (746) - State - 80 - -------- -------- -------- (145) (646) - -------- -------- -------- Total $ (848) $ (772) $ (1,600) ======== ======== ======== Deferred tax provisions (benefits) result from differences in the years in which certain elements of income or expense are included in financial statements and income tax returns. Deferred taxes related to the following temporary differences: 1993 1992 1991 -------- -------- -------- Unrecognized future tax benefits $ 7,304 $ 1,891 $ 3,745 Gross margins on long-term contracts 245 309 (1,163) Depreciation expense 864 (350) (411) Provision for costs not currently deductible (8,079) (1,457) (2,089) Cash basis accounting - - (250) Installment sale (364) (793) 8 Other items (115) (246) 160 -------- -------- -------- $ (145) $ (646) $ - ======== ======== ======== The U.S. effective income tax rate from operations is different from the U.S. federal statutory rate for the following reasons: Notes to Consolidated Financial Statements - continued 1993 1992 1991 -------- -------- -------- Income tax provision (benefit) if computed at U.S. federal rates $ 1,378 $ (3,229) $(12,776) Benefit of net operating loss carryforwards (1,534) - - Unutilized net operating losses and tax credits - 2,249 7,837 Carryback of net operating losses at less than statutory rates - - 2,695 State income taxes net of federal benefit - 86 23 Foreign tax rate variances - 9 822 Recognition of deferred tax asset due to carryback (703) - - Other 11 113 (201) -------- -------- -------- $ (848) $ (772) $ (1,600) ======== ======== ======== The deferred tax assets and liabilities are comprised of the following: 12/31/93 12/31/92 ---------- ---------- Restructuring reserve $ 483 $ 1,011 Bad debt reserve 300 454 Other 2,430 3,549 Employee benefit reserves 2,376 2,095 Allowance for doubtful accounts 1,090 1,680 Reserve for net realizable value of real estate 2,564 2,581 Other 1,093 1,371 Net operating losses and credits 17,024 13,920 Property, plant and equipment (2,526) (2,526) Other (195) - --------- --------- 24,639 24,135 --------- --------- Valuation allowance (24,639) (24,135) --------- --------- Net deferred tax asset $ - $ - ========= ========= For Federal income tax purposes,the Company has domestic regular tax net operating loss carryforwards of approximately $20 million and alternative minimum tax net operating loss carryforwards of $17.0 million as of December 31, 1993, which may be used to offset future taxable income. The Notes to consolidated Financial Statements - continued Company also has foreign net operating losses of approximately $5.0 million. These net operating losses expire beginning in 2002. Additionally, the Company has available $5.7 million of investment tax credit carryforwards which will expire beginning in 2002. Note 12. Restructuring costs and asset disposition In 1992 the Company recorded a $10 million restructuring charge principally for the consolidation of facilities in France and the elimination of redundant functions in the Company's motion technologies group. In 1991, the Company implemented a restructuring resulting in a charge of $16.7 million to, among other things, reduce the Company's domestic and foreign work force. In addition, the Company charged $9.6 million in 1991 to operations primarily to provide for unanticipated costs in completing several large, fixed-price military contracts. In November 1992 the Company sold certain assets of its proprietary MICRO-FLIR(R) thermal imaging products business to the Electronic Systems Group of Westinghouse Electric Corporation located in Baltimore, Maryland. Note 13. Leases The Company leases certain of its facilities and equipment under various operating lease arrangements. Such arrangements generally include fair market value renewal and/or purchase options. Rent expense for operating leases amounted to $3.0 million in 1993 (excluding $.9 million which was provided for in the prior restructuring provisions), $5.2 million in 1992, and $4.9 million in 1991. Future minimum rental payments required under non-cancellable operating leases having a lease term in excess of one year, together with the present value of the net minimum lease payments at December 31, 1993, are as follows: 1994 $ 2,606 1995 2,292 1996 1,794 1997 1,194 1998 1,029 Thereafter 7,871 -------- Total minimum lease payments $ 16,786 ======== Note 14. Contingencies The Company has various lawsuits, claims, commitments and contingent liabilities arising from the ordinary conduct of its business; however, they are not expected to have a material adverse effect on its consolidated financial position. Notes to Consolidated Financial Statements - continued In doing business with the U.S. Government, the Company is subject to routine audits and, in certain circumstances, to inquiry, review, or investigation by the U.S. Government Agencies relating to the Company's compliance with Government Procurement policies and practices. The Company's policy has been and continues to be to conduct its activities in compliance with all applicable rules and regulations. Management believes that any such potential audits or investigations, individually and in the aggregate, will not have any material adverse effect upon the financial condition of the Company. The Company is engaged primarily in the manufacture and sale of highly diversified lines of commercial, industrial, and military products into both domestic and international markets. The Company generally does not require collateral from its customers on the basis of ongoing reviews and evaluations of their credit and financial condition. Note 15. Retirement plans The Company maintains three non-conributory qualified defined benefit pension plans covering substantially all domestic employees. Plans covering most employees provide pension benefits based generally on the employee's years of service and final five-year or career average compensation. Due to full funding, the Plans currently have no required contribution by the Company. The net periodic pension cost for the years 1993, 1992 and 1991, including amounts related to discontinued operations, included the following components: 1993 1992 1991 -------- -------- -------- Service cost $ 2,146 $ 2,235 $ 2,609 Interest cost 3,058 3,289 3,030 Actual return on plan assets (6,376) (4,280) (10,389) Net amortization and deferral (65) (2,419) 4,748 -------- -------- -------- Net periodic pension cost (credit) $ (1,237) $ (1,175) $ (2) ======== ======== ======== The assumptions used in determining the end of year benefit obligations included a discount rate of 7.25% and 7.75% in 1993 and 1992, respectively, an expected investment return of 10% and compensation increases of 5%. During 1993 and 1992, the Company had pension curtailments resulting from the larger than expected reductions in the number of employees who would otherwise be eligible to participate in a defined benefit pension plan. Accordingly, the net amortization and deferral component of the credit includes a curtailment gain of $1.3 million for 1993 and $1.0 million for 1992. The Plan assets consist principally of cash, common stocks, and bonds. Notes to Consolidated Financial Statements - continued The Plans' funded status together with the amounts recognized in the Company's Balance Sheet at December 31 are as follows: 1993 1992 -------- -------- Actuarial present value of benefit obligations: Vested $ 29,991 $ 28,770 ======== ======== Accumulated 30,885 29,726 ======== ======== Projected 44,333 40,925 Plan assets at fair value 49,625 47,610 -------- -------- Plan assets in excess of projected benefit obligation 5,292 6,685 Unrecognized net (gain) loss 1,661 (839) Unrecognized net asset at January 1 (6,421) (6,993) Unrecognized prior service cost 2,081 2,523 -------- -------- Prepaid pension cost $ 2,613 $ 1,376 ======== ======== The Salaried Employees' Retirement Plan provides that in the event of a termination of that Plan following a change in control of the Company, any assets of the Plan remaining after provision is made for all benefits thereunder will be employed to supplement such benefits. The Company also maintains a Supplemental Retirement Income Plan ("SERP") for key employees. Eligibility is restricted to individuals designated by the Personnel and Compensation Committee of the Board who, in its sole discretion, have made outstanding long-term contributions to the Company. The SERP is designed to provide each designated participant with an increased level of retirement income commencing the month following his 65th birthday. Under the SERP, a supplemental amount is paid to each participant so that, together with any amounts payable under the Company's qualified retirement plans, any long-term disability insurance payments and any social security benefits, the participant receives a monthly benefit equal to 60% of his salary at the date of inclusion in the plan. Amounts payable under the SERP are subject to adjustment for inflation. The Company has accrued an actuarially determined liability of $2.8 million at December 31, 1993 ($2.3 million at December 31, 1992), in anticipation of the payment of such benefits in the future to seven former employees who were designated as eligible by the Personnel and Compensation Committee for participation in the SERP program. No one of these former employees is receiving benefits currently. The Company incurred a pension expense of $.3 million and $.2 million in 1993 and 1992, respectively, in additional funding for the SERP. Notes to Consolidated Financial Statements - continued Note 16. Postretirement medical insurance benefits The Company maintains a postretirement medical benefits plan covering substantially all domestic employees hired prior to January 1, 1992. The plan is contributory, retiree contributions are based on the difference between total cost and the employer contribution and are adjusted annually. The Company's contribution towards retiree medical benefits for employees retiring after January 1, 1992, are capped at 1991 levels. FAS 106 was implemented on a delayed recognition basis, resulting in amortization of the transition obligation amount over 20 years. The Company currently funds the plan as claims are paid. Net periodic postretirement benefit cost for 1993 included the following components: Service cost $ 125 Interest cost 412 Actual return on plan assets - Amortization of obligation at transition 278 ------- Net periodic postretirement benefit cost $ 815 ======= For measurement purposes, a 12% annual rate of increase in the per capital cost of covered medical benefits was assumed for 1993; the rate was assumed to decrease gradually to 6% for 1999 and remain at that level thereafter. Increasing the assumed health care cost trend rates by 1% in each year would increase the accumulated postretirement benefit obligation as of January 1, 1993, by $246 thousand and the aggregate of the service cost and interest cost components of net periodic postretirement benefit cost by $20 thousand. The plan's funded status together with the amounts recognized in the Company's Balance Sheet at December 31, 1993, are as follows: Accumulated postretirement benefit obligation: Retirees $ 4,166 Fully eligible plan participants 368 Other active plan participants 1,953 ------- Total 6,487 Plan assets at fair value - ------- Accumulated postretirement benefit obligation in excess of plan assets (6,487) Unrecognized net (gain) loss 805 Unrecognized prior service cost - Unrecognized transition obligation 5,282 ------- Accrued postretirement benefit cost $ (400) ======= Notes to Consolidated Financial Statements - continued The Company's postretirement benefit plans are unfunded. As of January 1, 1993, the accumulated postretirement benefit obligation was $5.6 million and the value of the plan assets was $0. The weighted average discount rate used in determining the accumulated postretirement benefit obligation are 7.25% and 7.75% as of December 31, 1993 and 1992, respectively. Note 17. Foreign Operations and Geographic Segments, and Export Sales The impact of the Company's foreign operations upon the consolidated financial statements are summarized as follows (in thousands): Foreign 1993 Consolidated Eliminations Domestic Operations - ---- ------------ ------------ --------- ---------- Net sales $185,538 $ (4,113) $150,260 $ 39,391 ======== ======== ======== ======== Net income (loss) from continuing operations $ 4,752 $ 325 $ 6,938 $ (2,511) ======== ======== ======== ======== Identifiable assets $ 95,943 $ (72) $ 66,814 $ 29,201 Corporate assets 38,065 - 38,065 - -------- -------- -------- -------- Total assets $134,008 $ (72) $104,879 29,201 ======== ======== ======== Liabilities 21,635 -------- Equity in foreign subsidiaries $ 7,566 ======== Foreign 1992 Consolidated Eliminations Domestic Operations - ---- ------------ ------------ --------- ---------- Net sales $194,859 $ (3,693) $150,914 $ 47,638 ======== ======== ======== ======== Net income (loss) from continuing operations $ (8,725) $ 316 $ (4,064) $ (4,977) ======== ======== ======== ======== Identifiable assets $110,691 $ (683) $ 77,372 $ 34,002 Corporate assets 38,877 - 38,877 - -------- -------- -------- -------- Total assets $149,568 $ (683) $116,249 34,002 ======== ======== ======== Liabilities 26,725 -------- Equity in foreign subsidiaries $ 7,277 ======== Notes to Consolidated Financial Statements - continued Foreign 1991 Consolidated Eliminations Domestic Operations - ---- ------------ ------------ --------- ---------- Net sales $200,457 $ (2,968) $153,946 $ 49,479 ======== ======== ======== ======== Net income (loss) from continuing operations $(35,938) $ - $(33,082) $ (2,856) ======== ======== ======== ======== Identifiable assets $137,675 $ (7,901) $104,599 $ 40,977 Corporate assets 16,768 (3,495) 15,474 4,789 -------- -------- -------- -------- Total assets $154,443 $(11,396) $120,073 45,766 ======== ======== ======== Liabilities 32,097 -------- Equity in foreign subsidiaries $ 13,669 ======== The Company's principal foreign operations include a d.c. motor manufacturing facility in France, together with sales subsidiaries in England and Germany. The sales eliminations are transfers at prevailing wholesale selling prices, principally from the domestic electro-optical instruments segment to a sales subsidiary in England. In addition to foreign operations, export sales amounted to $27.6 in 1993, $54.0 million in 1992, and $34.9 million in 1991. Sales to the U.S. Government or for U.S. Government end-use amounted to $39.4 in 1993, $38.9 million in 1992, and $40.9 million in 1991. Note 18. Other Financial Statement Data The following sections should be considered integral parts of the Notes to Consolidated Financial Statements: Page Lines of Credit (see Liquidity and Capital Resources) 12 Segments of Business Information 2 INDEX TO FINANCIAL STATEMENTS SCHEDULES Page in Schedule Form 10-K IX Short Term Borrowings at December 31, 1993, 1992 and 1991. 43 X Supplementary Income Statement Information - Years Ended December 31, 1993, 1992 and 1991. 44 Report of Independent Accountants on Financial Statement Schedules - Coopers & Lybrand 45 Schedules and Statements other than those enumerated above have been omitted because they are not required or are not applicable, or because the required information is set forth in the financial statements and notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES The Board of Directors and Shareholders Kollmorgen Corporation: Our report on the consolidated financial statements of Kollmorgen Corporation is included on page 19 of this Form 10-K. In connection with our audit of such financial statements, we have also audited the related financial statement schedules for 1993 and 1992 listed in the index on page 42 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ Coopers & Lybrand COOPERS & LYBRAND Boston, Massachusetts January 31, 1994 EXHIBIT INDEX Page in this Exhibit No. Description of Exhibit Form 10-K 3(a) Restated Certificate of Incorporation, as N/A amended, incorporated by reference to Exhibit 3(a) of the Form SE filed on April 2, 1990. 3(b) By-Laws, as amended. 50 4(a) Debenture Purchase Agreement dated as of N/A July 30, 1982, with respect to 10-1/2% Convertible Subordinated Debentures Due 1997 incorporated by reference to Exhibit 4 to the Quarterly Report on Form 10-Q of the Company for the quarter ended June 30, 1982. 4(b) Indenture dated as of May 1, 1984, with respect N/A to 8-3/4% Convertible Subordinated Debentures Due 2009 incorporated by reference to Exhibit 4 to Registration Statement on Form S-3 (2-90655) 4(c) Rights Agreement dated as of December 20, 1988, N/A as amended and restated as of March 27, 1990, between the Company and the First National Bank of Boston, as Rights Agent, incorporated by reference to Exhibit 4(d) of the Form SE filed on April 2, 1990. 4(d) Stock purchase agreement dated March 27, 1990, N/A with Annex II, Registration Rights, with respect to the issue of Series D Convertible Preferred Stock, par value $1.00, of the Company, incorporated by reference to Exhibit 4(e) of the Form SE filed on April 2, 1990. 10(a) Letter of Credit Facility Agreement dated N/A July 24, 1992, among Kollmorgen Corporation, The First National Bank of Boston, Certain Other Financial Institutions Listed on Schedule 1, and The First National Bank of Boston, as Agent, incorporated by reference to Ex-10 of the Form SE to Form 10-Q filed on August 11, 1992. 10(b) Fourth Amendment to Exhibit 10(a), incorporated N/A by reference to Ex-10 of the Form SE to Form 10-Q filed on November 10, 1993. Page in this Exhibit No. Description of Exhibit Form 10-K 10(c) Kollmorgen Stock Option Plan, as amended, N/A incorporated by reference to Exhibit A of the Company's Proxy Statement dated March 24, 1987, for the Annual Meeting of Shareholders held on April 22, 1987. 10(d) Kollmorgen 1991 Long Term Incentive Plan, N/A incorporated by reference to Exhibit A of the Company's Proxy Statement dated April 29, 1991, for the Annual Meeting of Shareholders held on May 23, 1991. 10(e) Form of 1983 Incentive Stock Option Agreement N/A for James A. Eder. Said agreement is incorporated by reference to Exhibit 10(e) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1987. 10(f) Form of 1988 Non-Qualified Stock Option N/A Agreement for James A. Eder. Said agreement is incorporated by reference to Exhibit 10(g) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1988. 10(g) Form of 1990 Non-Qualified Stock Option N/A Agreement for James A. Eder. Said agreement is incorporated by reference to Exhibit 10(h) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1991. 10(h) Form of 1991, 1992, and 1993 Non-Qualified Stock N/A Option Agreement under the Long-Term Incentive Plan and/or Kollmorgen Stock Option Plan for Gideon Argov, Robert J. Cobuzzi, James A. Eder and Robert W. Woodbury, Jr. Each agreement is identical except for the number of shares and the date of grant. Said agreement is incorporated by reference to Exhibit 10(j) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1991. 10(i) Kollmorgen 1992 Stock Ownership Plan for N/A Non-Employee Directors incorporated by reference to Exhibit A of the Company's Proxy Statement dated April 6, 1992, for the Annual Meeting of Shareholders held on May 13, 1992. 10(j) Form of 1992 Non-Qualified Stock Option N/A Agreement between each non-employee director and the Company pursuant to the Kollmorgen 1992 Stock Ownership Plan for Non-Employee Directors. Page in this Exhibit No. Description of Exhibit Form 10-K 10(k) Bonus Plan for Corporate Officers and other N/A key corporate employees. 10(l) Employment Agreement dated May 10, 1991, as N/A amended, for James A. Eder. Said Agreement is incorporated by reference to Exhibit 10(c) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1991. 10(m) Letter employment agreement dated May 21, N/A 1991, for Gideon Argov. Said Agreement is incorporated by reference to Exhibit 10(c) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1991. 10(n) Letter employment agreement dated July 1, N/A 1991, for Robert J. Cobuzzi. Said Agreement is incorporated by reference to Exhibit 10(c) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1991. 10(o) Form of severance agreement for each of the N/A following persons: Allan M. Doyle, Jr. and George P. Stephan. Said agreement is incorporated by reference to Exhibit 10(i) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1989. 10(p) Form of Indemnification Agreement for each of the N/A Company's executive officers, directors and director emeritus. Each agreement is identical to this exhibit except for the name and title of each individual. Said agreement is incorporated by reference to Exhibit 10(f) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1987. 10(q) Description of Post-Retirement Arrangement for N/A Non-Employee Directors. Said agreement is incorporated by reference to Exhibit 10(i) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1988. 10(r) Participation Agreement between Allan M. Doyle, Jr. N/A and the Corporation with respect to Mr. Doyle's service as a director of Millitech Corporation. 10(s) Supplemental Retirement Income Plan for key N/A executives. Said plan is incorporated by reference to Exhibit 10(n) to the Annual Report on Form 10-K of the Company for the year ended December 31, 1990. Page in this Exhibit No. Description of Exhibit Form 10-K 11 Calculations of Earnings Per Share. 62 16 Copy of the letter dated September 15, 1992, N/A from KPMG Peat Marwick. Said letter is incorporated by reference to Exhibit 16 of Form 8-K dated September 11, 1992. 21 Subsidiaries of the Company. 63 23(a) Consent of Independent Accountants - 64 Coopers & Lybrand 23(b) Independent Auditors' Consent - 65 KPMG Peat Marwick 24 Powers of Attorney 66

743368_1993.txt

743368_1993

1993

743368

ITEM 1. BUSINESS GENERAL Bowater Incorporated (together with its consolidated subsidiaries, the "Company") is engaged in the manufacture, sale and distribution of newsprint, directory paper, uncoated groundwood specialties, coated publication and educational workbook paper, market pulp, continuous stock computer forms and lumber. The Company operates facilities in both the United States and Canada, manages and controls approximately 4.0 million acres of timberlands to support these facilities and markets and distributes its various products both domestically and in the export market. On December 31, 1991, the Company acquired 80 percent of the stock of Great Northern Paper, Inc. ("GNP") from Great Northern Nekoosa Corporation ("GNN"), a subsidiary of Georgia-Pacific Corporation. In July 1992, the Company acquired the remaining 20 percent of GNP under the terms of its purchase agreement with GNN. The Company was incorporated in Delaware in 1964. The Company's principal executive offices are currently located at 55 East Camperdown Way, Greenville, South Carolina 29602, and its telephone number at that address is (803) 271-7733. Information regarding segment, geographic area, and net export sales is incorporated herein by reference to pages 8 and 27 of the Company's 1993 Annual Report (the "Annual Report"). Information regarding the pulp and paper industry is incorporated herein by reference to pages 2 through 5 of the Annual Report. Information regarding the Company's liquidity and capital resources is incorporated herein by reference to pages 12 through 14 of the Annual Report. NEWSPRINT, DIRECTORY PAPERS AND UNCOATED GROUNDWOOD SPECIALTIES The Company is the largest manufacturer of newsprint in the United States and, with its Nova Scotia mill, is the third largest manufacturer in North America. Its annual capacity is approximately 8 percent of the North American total. The Company presently manufactures newsprint at five separate locations: Calhoun, Tennessee; Catawba, South Carolina; Millinocket and East Millinocket, Maine; and Liverpool, Nova Scotia. Both the Company's Southern Division and Calhoun Newsprint Company ("CNC") (of which stock with approximately 51 percent voting power is held by the Company and stock with approximately 49 percent voting power is held by Advance Publications, Inc.) are located at Calhoun, Tennessee. The Company's Carolina Division is located at Catawba, South Carolina, and Bowater Mersey Paper Company ("Mersey") (which is owned 51 percent by the Company and 49 percent by The Washington Post Company) is located at Liverpool, Nova Scotia. GNP is comprised of two mills located at Millinocket and East Millinocket, Maine, the Pinkham Lumber Company in Ashland, Maine, and approximately 2.1 million acres of timberlands in Maine. The Calhoun facility, which produces newsprint for Southern Division and CNC, is located on the Hiwassee River in Tennessee and is the largest newsprint mill in North America. At this facility, Southern Division operates four paper machines, which produced 594,550 tons of newsprint and groundwood specialty papers in 1993. Also located at this facility is CNC's No. 5 paper machine, which produced 241,627 tons of newsprint in 1993. The continuing modernization of Southern Division's facilities has contributed substantially to improved product quality and is helping the mill to maintain its position as one of the most productive in the industry. Although Southern Division manages and operates the entire Calhoun facility, CNC owns 68.4 percent of the thermomechanical pulp ("TMP") mill and 100 percent of the recycled fiber plant located at the Calhoun facility. Southern Division owns the remaining 31.6 percent of the TMP mill and 100 percent of the other facilities at this location. These other facilities include kraft and stone groundwood pulp mills, a power plant, water treatment facilities, and other support equipment necessary to produce the finished product. The newsprint machine at the Company's Carolina Division, which produced 240,623 tons in 1993, is one of the largest and most productive newsprint machines in the industry. In 1988, the Company installed a twin-wire former and other ancillary equipment that have enhanced this machine's capacity and permitted it to produce a higher quality product. The Mersey mill is located on an ice-free port providing economical access to ports along the eastern seaboard of the United States and throughout the world. Its two paper machines, built in 1929, were completely rebuilt between 1983 and 1985 and produced 263,306 tons of newsprint in 1993. The mill also operates pulping and other support facilities required to produce the finished product. A new TMP mill was started up in late 1989 and now supplies 100 percent of the pulp to the two newsprint machines. This change has resulted in significant improvements in product quality. The East Millinocket mill is located on the West Branch of the Penobscot River in northern Maine. Its two paper machines (Nos. 5 and 6) were built in 1954 and completely rebuilt in 1986. These two machines produced a total of 276,824 tons of newsprint, directory paper and other groundwood specialties in 1993. The mill also operates a groundwood pulp mill and other support facilities required to produce the finished products. Sulfite pulp is pumped through a pipeline from the Millinocket mill for use at the East Millinocket mill. The Millinocket Mill is located eight miles from the East Millinocket mill, and in 1993 produced 154,207 tons of newsprint, directory papers and uncoated groundwood specialties. These paper grades are used in magazines, catalogs, directories, newspaper advertising inserts and business forms and are sold primarily to customers east of the Mississippi River. During the third quarter of 1993, the Company announced the phased closure of certain older, higher cost operations located at the Millinocket mill. The phaseout will involve the shutdown of the mill's woodyard, groundwood pulping facilities and a small paper machine that produces uncoated groundwood specialties. Approximately 200 positions will be eliminated throughout the mill's operations over a 12 month period as a result of this closure. The Company believes that these changes will significantly improve the mill's cost competitiveness. The production of all five newsprint mills is sold directly by the Company through regional sales offices located in major metropolitan areas of the eastern half of the United States. Advance Publications, Inc. purchases the equivalent of CNC's entire annual output, and The Washington Post purchases approximately 80,000 tons annually. Combined, these two customers in 1993 accounted for approximately 8.7 percent of the Company's consolidated net sales and 21.4 percent of the Company's newsprint sales. The geographical location of the Company's newsprint mills permits distribution of their products by rail, truck, ship or barge. COATED PAPER The Company is the fifth largest producer in the United States and the sixth largest North American producer of coated paper. Coated paper produced by the Company is light weight coated paper ("LWC") and is used in special interest magazines, mail order catalogs, advertising pieces and coupons. The Company manufactures a variety of coated grades on two paper machines (Nos. 1 and 2) at its Catawba, South Carolina, mill site and on three paper machines (Nos. 7, 8, and 10) at its Millinocket, Maine, mill site. The Company's No. 2 machine at Catawba began production in July 1986 and reached its design capacity during 1987. Both machines at Catawba include off-machine coaters. At Millinocket, the Nos. 7 and 8 machines produce a base stock which is coated on an off-machine blade coater while the No. 10 machine has an on-machine roll coater. In 1993, the two coated machines at Catawba produced 333,490 tons of LWC and the three coated machines at Millinocket produced 121,425 tons of LWC. Coated paper is sold by the Company to printers, publishers, mail order houses and paper merchants. It is distributed by truck and rail from the Catawba and Millinocket mill sites, which are strategically located to supply the southeastern and northeastern United States, respectively, as well as jointly serving the midwestern market. MARKET PULP In addition to furnishing its pulp requirements, the Company in 1993 supplied 256,599 tons of bleached kraft market pulp to manufacturers of fine paper, tissues and other paper products from its market pulp facility at Catawba, South Carolina. In 1990, the Company replaced its kraft mill at Calhoun, Tennessee. The new 900 tons per day capacity mill replaced a smaller 34-year old kraft pulp mill. This new mill utilizes the most up-to-date technology and has provided increased capacity, improved pulp quality, reduced energy consumption, and an improved environmental impact. During 1993, in addition to supplying the chemical pulp portion of the newsprint furnish, the new kraft mill produced an additional 42,438 tons of fully bleached market pulp for sale to customers. In 1994, the Southern Division will replace its present recovery boilers, which are 27 and 39 years old, with a new recovery boiler currently under construction. A recovery boiler is an essential part of the kraft pulping process. The new recovery boiler will enable the Company to realize significant cost reductions and meet currently proposed environmental regulations. Most of the Company's market pulp is fully bleached, but small amounts of semi-bleached kraft grades are also produced. In recent years, 70 percent to 80 percent of the Company's pulp sales have been to the export market, which is sold through agents. United States sales are made directly by the Company. COMMUNICATION PAPERS The Company's subsidiary, Bowater Communication Papers Inc. ("BCPI"), manufactures continuous stock computer forms at eight plants in the United States. BCPI markets this product and other business communication papers through its two divisions, Bowater Computer Forms ("BCF") and Star Forms, which use a network of 30 distribution centers to service customers in major metropolitan areas throughout the United States. BCF specializes in direct sales to numerous large-volume end-users, such as banks and governmental entities, while Star Forms concentrates on sales to smaller businesses and individuals through sales to numerous business forms distributors, paper merchants, office product dealers, computer stores and other outlets. LUMBER, STUMPAGE AND OTHER PRODUCTS In connection with its primary business of manufacturing and distributing various paper products and market pulp, the Company is engaged in several business areas related to its primary business. The Company currently owns or manages under lease approximately 4.0 million acres of timberlands throughout eight states and Nova Scotia. Approximately 2.1 million acres of these timberlands were acquired in the GNP acquisition and are located in the State of Maine. The Company also maintains two nurseries from which it supplies seedlings to replace trees harvested from its timberlands, generally planting three trees for each one that is cut. The Company operates three sawmills that produce construction grade lumber. The sawmill at Albertville, Alabama, produced 96.5 million board feet of lumber in 1993. This lumber is sold in the southern and midwestern United States. Mersey operates a small sawmill in Oak Hill, Nova Scotia, the products of which are sold to customers in eastern Canada and the United Kingdom. The Oak Hill sawmill produced 23.7 million board feet of lumber in 1993. The Pinkham Lumber Company sawmill in Ashland, Maine, produced 72.5 million board feet of lumber in 1993, with the majority of this product sold to customers in New England. RECYCLING CAPABILITY The Company has focused its efforts in recent years on meeting the demand for recycled content paper products, which provides an environmental benefit in reducing solid waste landfill deposits and creates a marketing imperative for publishers and other customers trying to meet recycled content standards. The Company broke ground for its first recycling plant in 1990 at Calhoun, Tennessee. The mill has been successful since its startup in 1991. Taking a mixture of 70 percent used newspapers and 30 percent used magazines, the plant utilizes advanced mechanical and chemical processes to produce high quality pulp. When up to 20 percent of this mixture is combined with virgin fiber, the resulting product is comparable in quality to paper produced with 100 percent virgin fiber pulp. Substantial tonnages of recycled content paper have been made available to newsprint customers, while increasing quantities of computer forms papers that contain 20 percent post-consumer or comparable recycled fiber have been shipped to the Company's communication papers group for conversion to computer forms. The first major project at GNP since the acquisition has been the construction of a similar recycling plant to provide recycled fiber for newsprint, directory papers and other groundwood papers at that location. When this second facility reaches full production, expected in the fourth quarter of 1994, the Company will have a combined capacity to supply over 250,000 tons per year of recycled fiber pulp to its paper mills. COMPETITION Newsprint and bleached softwood market pulp, two of the Company's principal products, are consumed in virtually every country of the world and produced in nearly all countries with adequate indigenous fiber sources. No proprietary process is employed in either their manufacture or use. Newsprint and market pulp from a variety of manufacturers may be used with relatively few process changes to produce customer products. The Company faces intense competition in these two products from a number of other producers in the United States and from pulp and paper companies of Canada, Scandinavia and other forested countries. In addition to price, quality, service, and the ability to produce paper with recycled content are important competitive determinants. Competition in the directory and groundwood specialty markets is intense. The Company uses price, quality and service to compete with other producers. The coated paper market is also highly competitive. Price, quality and service are important competitive determinants, but a degree of proprietary knowledge is required in both the manufacture and use of this product which requires close supplier-customer relationships. As with other globally manufactured and sold commodities, the Company's competitive position is significantly affected by the volatility of currency exchange rates. Since several of the Company's primary competitors are located in Canada, Sweden and Finland, the relative rates of exchange between those countries' currencies and the United States dollar can have a substantial effect on the Company's ability to compete. Recently, the Company's competitive position has been adversely affected by the relative strength of the United States dollar against these currencies. In addition, the degree to which the Company competes with foreign producers depends in part on the level of demand abroad. Shipping costs generally cause producers to prefer to sell in local markets when the demand is sufficient in those markets. Trends in electronic data transmission and storage could adversely affect traditional print media, including products of the Company's customers; however, neither the timing nor the extent of those trends can be predicted with certainty. Industry reports indicate that the Company's newspaper publishing customers in North America have experienced some loss of market share to other forms of media and advertising, such as direct mailings and newspaper inserts (both of which are end uses for selected Company products) and cable television. These customers are also facing a decline in newspaper readership, circulation and advertising lineage. The Company does not believe that this is the case in most overseas markets. Part of the Company's competitive strategy is to be a low cost producer of its products while maintaining strict quality standards and being responsive on environmental issues. The Company believes that its large woodland base, relative to its paper production, provides it with a competitive advantage in controlling costs and that its two recycling facilities have further enhanced its competitive position. The Company believes that the cost advantage of these recycling facilities, as compared to the more traditional methods of paper production, should continue until the price for wastepaper significantly rises. The Company's competitive advantage in the communication papers market has been to differentiate itself from others by developing new products, including forms with recycled content, and by gaining the benefits of additional vertical integration, using the capabilities of its paper mills. Paper is the primary cost of this business, and the Company is moving toward providing more of BCPI's paper needs internally to the extent consistent with customer product requirements. The Company believes that, notwithstanding the increase in use of business machines using higher grades of paper, customers that generate high volumes of internal documents will continue to demand groundwood based continuous stock computer forms. RAW MATERIALS The manufacture of pulp and paper requires significant amounts of wood and energy. Approximately 2.9 million cords of wood were consumed by the Company during 1993 for pulp and paper production. The Company harvests wood fiber from Company-owned properties equal to approximately 50% of its total wood fiber requirements with the balance of virgin wood requirements purchased, primarily under contract, from local wood producers, private landowners and sawmills (in the form of chips) at market prices. Wastepaper (in the form of old newspapers and magazines) is purchased from suppliers in the regions of the Company's two recycling plants. These suppliers collect, sort and bale the material before selling it to the Company, primarily under long-term contracts. Steam and electrical power are the primary forms of energy used in pulp and paper production. Process steam is produced in boilers at the various mill sites from a variety of fuel sources. In recent years, the Company has reduced its dependence upon oil and natural gas by increasing its ability to burn wood wastes and coal. Internally generated electrical power at the Calhoun and Catawba facilities is used to supplement purchased electrical power. The GNP operation is totally self-sufficient electrically with six hydroelectric facilities located on the West Branch of the Penobscot River (containing 31 hydroelectric generators) and seven steam turbine generators located in the mill power plants. The Company operates its Maine hydroelectric facilities pursuant to long-term licenses granted by the Federal Energy Regulatory Commission ("FERC") or its predecessor, the Federal Power Commission. The existing licenses for certain dams expired on December 31, 1993. The Company is currently engaged in the multi-year relicensing process to obtain new 30-year licenses. The relicensing proceedings have not yet concluded; however, annual extensions are expected to be granted while FERC proceeds with preparation of an environmental impact statement now scheduled to be issued in the third quarter of 1994. In connection with the relicensing process, various groups have intervened and raised objections that are now being considered by FERC. Although there can be no assurances, the Company believes that, notwithstanding these objections, new licenses will be issued and that such licenses will contain terms and conditions that will allow the Company to maintain most of the benefits that are provided under the existing licenses. In the interim period, the Company will continue to operate under the existing licenses or such annual licenses as FERC issues prior to the conclusion of the pending relicensing proceedings. EMPLOYEES The Company employs approximately 6,600 people, of whom approximately 4,300 are represented by bargaining units. The labor agreement at the Company's Catawba mill, covering all of the plant's hourly employees, was recently extended for four years beginning April 19, 1993. A 1991 labor contract at the Calhoun mill with most of the plant's hourly employees lasts until July, 1996. The labor contract covering all unionized employees at the Mersey mill has been renewed as of April 30, 1993, and expires on April 30, 1998. Contracts covering the large majority of unionized employees of GNP expire in August 1995. All plant facilities are situated in areas where an adequate labor pool exists and relations with employees are considered good. TRADEMARKS AND NAME The Company currently possesses the exclusive worldwide right to use the trademarked Company logo and, in the western hemisphere, the exclusive right to use the trade name "Bowater". The Company considers these rights to be valuable and necessary to the conduct of the Company's business. ENVIRONMENTAL MATTERS For a detailed explanation of the Company's environmental issues, see "Environmental Matters" on page 14 of the Annual Report, incorporated herein by reference. The Company believes that its U.S. and Canadian operations are in substantial compliance with all applicable federal and state environmental regulations, and that all currently required control equipment is in operation. While it is impossible to predict future environmental regulations that may be established, the Company believes that it will not be at a competitive disadvantage with regard to meeting future U.S. or Canadian standards, and that related expenditures and costs will not materially affect the Company's financial position or results of operations. The Company has taken positive action on the municipal solid waste issue by constructing two recycle facilities at its Tennessee and Maine mills. See "Recycling Capability" on page 3. ITEM 2. ITEM 2. PROPERTIES Reference is made to the information set forth in Item 1, "Business", pages 6 to 8 and the back cover page of the Annual Report for the location and general character of principal plants and other materially important properties of the Company. The Company owns all of its properties with the exception of certain timberlands, office premises, manufacturing facilities and transportation equipment which are leased by the Company under long-term leases. See "Timberland Leases and Operating Leases" on page 26 of the Annual Report, incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In January 1994, the Company settled for an aggregate sum of approximately $10.5 million all pending lawsuits naming the Company and other parties as defendants in the State Circuit Courts of Hamilton County, Knox County and McMinn County, Tennessee, and in the United States District Court for the Eastern District of Tennessee, that claimed compensatory and punitive damages for wrongful death, personal injury and/or property damage arising out of a series of vehicular accidents that occurred on December 11, 1990, in fog on Highway I-75, which passes in the general area of the Company's Calhoun, Tennessee, mill property. The plaintiffs in these actions had sought to make the Company liable on the theory that the mill's operations created the fog or contributed to its density. The Company's excess insurers reserved rights with respect to coverage of the plaintiffs' claims on various grounds including their assertion that coverage is not available for pollution claims, for consequences expected or intended by the Company or for any punitive damages. On November 22, 1993, the Company filed a complaint in the United States District Court for the Eastern District of Tennessee against its first excess insurer, National Union Fire Insurance Company, which seeks a declaratory judgment in favor of the Company on the issues in dispute with that insurer. The settlements will be funded by the Company's insurance carriers, subject, in the case of approximately $9.5 million funded by the Company's first excess insurer, to subsequent determination of ultimate coverage responsibility in the pending insurance coverage lawsuit. Although no assurance can be provided, the Company believes that it should prevail on the insurance coverage issue. The Company is also involved in various litigation relating to contracts, commercial disputes, tax, environmental, workers' compensation and other matters. The Company's management is of the opinion that the ultimate disposition of these matters will not have a material adverse effect on the Company's operations or its financial condition taken as a whole. 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 fiscal 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The Company's executive officers, who are elected by the Board of Directors to serve one-year terms, are listed below. There are no family relationships among officers, or any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. Anthony P. Gammie became Chairman of the Board in January 1985, and has been Chief Executive Officer of the Company since January 1983. He was the President from January 1983 to July 1, 1992. He was President of the Pulp and Paper Group from August 1981 to December 1982, and Executive Vice President from 1979 to 1982. He was a director of Bowater plc until July 1984, and prior to being transferred to the United States at the end of 1978, he was the Chairman and Managing Director of Bowater United Kingdom Limited. He has been a director of the Company since 1979. He is also a director of Alumax Inc. and The Bank of New York. Richard D. McDonough became Vice Chairman on July 1, 1992. He served as Chief Financial Officer of the Company from March 1979 to June 1993 and as Senior Vice President -- Finance from March 1979 to June 1992. He was formerly a Vice President of the Singer Company, where he was employed from 1963 to 1979. He has been a director of the Company since 1979.* Mr. McDonough also serves as a director of Geo International, Inc. John C. Davis became Senior Vice President -- Pulp and Paper Sales in February 1994. Previously he was Vice President -- Pulp and Paper Sales since July 1992 and Vice President -- Marketing of the Pulp and Paper Group and President of Bowater Sales Division since 1983. Robert C. Lancaster became Senior Vice President and Chief Financial Officer on July 1, 1993. He was Senior Vice President -- Finance from July 1, 1992 to July 1, 1993. Prior to that he was Vice President -- Controller from July 1984 to 1992. Previously he was Assistant Controller of ACF Industries Incorporated from 1980 to 1984, and was a Senior Manager with Price Waterhouse, where he was employed from 1968 to 1980. David E. McIntyre became Senior Vice President -- Pulp and Paper Manufacturing in February 1994. Previously he was Vice President -- Pulp and Paper Manufacturing since July 1992, Vice President -- Pulp and Paper Manufacturing Services of the Company's Pulp and Paper Group from 1988 to 1992, and Vice President-Manufacturing Services of the Pulp and Paper Group from 1986 to 1988. Robert J. Pascal became Senior Vice President in February 1994. Previously he was Vice President since December 1986 and President of the Communication Papers Group since December 1990, prior to which he was General Manager of that Group. He was Group Vice President of Pitney Bowes, Inc. from 1981 to 1986. Donald J. D'Antuono was appointed Vice President -- Corporate Development in September 1991. Previously he had been Vice President -- Investor Relations since April 1984. He was Controller from 1977 to 1978, Treasurer of Mersey from 1978 to 1979 and Vice President-Controller of the Company from 1979 to 1984. John P. Fucigna became Vice President -- Finance on July 1, 1992. Prior to that he had been Vice President -- Treasurer since February 1982, and was Treasurer from 1975 to January 1982. Robert D. Leahy was appointed Vice President -- Corporate Relations in March 1993. Previously he served as Director of Media Communications at International Paper Company, (a paper products company), from November 1989 to March 1993 where he was responsible for media, government, and investor relations, as well as employee communications and advertising. Earlier he held various senior level communications/public affairs positions in both corporate and agency settings from 1980 through 1989, most recently as Vice President of Corporate Communications for Endal Corporation, a metal products company, from 1987 to 1989. David G. Maffucci has been Vice President -- Treasurer since July 1, 1993. He served as Treasurer from July 1, 1992 to July 1, 1993. Prior to that he was Director of Financial Planning and Accounting Operations since 1987 and served as Assistant Controller since 1984. Ecton R. Manning has been Vice President since March 1988 and General Counsel since September 1988. Previously he was Vice President, General Counsel and Secretary of U.S. Plywood Corporation from 1985 to 1987, and was Vice President and General Counsel of Continental Forest Industries, Inc., where he was employed from 1973 to 1984. Robert A. Moran has been Vice President -- Pulp and Paper Manufacturing Services since July 1, 1992. Prior to that he was Vice President -- Manufacturing Services for the Pulp and Paper Group since 1991, Director of Planning and Development for the Pulp and Paper Group from August 1988 to November 1991 and also served as Assistant General Manager of the Company's Catawba, South Carolina, mill from April 1988 to August 1988. Michael F. Nocito has been Vice President -- Controller since July 1, 1993. He served as Controller of the Company's Southern Division from October 1, 1992 to July 1, 1993. Prior to this he served as Assistant Controller of the Southern Division since 1988. Mr. Nocito joined the Company in 1978. Aubrey S. Rogers has been Vice President -- Information Services since July 1, 1992. Prior to that he was Vice President -- Information Services of the Pulp and Paper Group since 1990 and Assistant Controller-Director of Planning and Information Services since 1989. He also served in various financial positions of the Company for more than twenty years. Wendy C. Shiba has been Secretary since July 28, 1993, and Assistant General Counsel since June 1993. From January 1992 to June 1993, she was Corporate Chair of the City of Philadelphia Law Department where she supervised the work of forty-five attorneys, paralegals and secretaries and was Associate Professor of Law from 1990 to 1993 and Assistant Professor of Law from 1985 to 1990 at Temple University School of Law where she taught subjects relating to corporate law and served as a consultant in legal writing and corporate law. Earlier she practiced corporate law in the private sector. Phillip A. Temple has been Vice President -- Human Resources and Administration since March 1993. Prior to that time he served as a consultant for two years in the areas of human resources, compensation and benefits. Previously he was Vice President -- Human Resources for the Sara Lee Corporation, a diversified consumer products company, from 1983 to 1991. * Except for the period March 1981 through December 1982. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The Company's Common Stock is listed on the New York Stock Exchange (stock symbol BOW), U.S. regional exchanges, the London Stock Exchange and the Swiss Stock Exchanges. Price information with respect to the Company's Common Stock on page 28 of the Annual Report is incorporated herein by reference. (b) As of March 10, 1994, there were approximately 7,150 holders of record of the Company's Common Stock. (c) The Company paid consecutive quarterly dividends of $.18 per common share for the period October 1, 1984, to January 1, 1987. In 1987, the Board of Directors announced two quarterly dividend increases. On January 8, 1987 the quarterly dividend was increased to $.20 per common share effective with the dividend payable on April 1, 1987. On November 18, 1987, the quarterly dividend was again increased to $.23 per common share effective with the dividend payable on January 1, 1988. On November 16, 1988, the quarterly dividend was increased to $.28 per common share effective with the dividend payable on January 1, 1989. On November 15, 1989, the quarterly dividend was increased to $.30 per common share effective with the dividend payable January 1, 1990. On February 26, 1993, the quarterly dividend was decreased to $.15 per common share effective with the dividend payable April 1, 1993. The dividend of $.15 per share was also paid on July 1 and October 1 of 1993. Future declarations of dividends on the Company's Common Stock are discretionary with the Board of Directors, and the declaration of any such dividends will depend upon, among other things, the Company's earnings, capital requirements and financial condition. Dividends on the Common Stock may not be paid if there are any unpaid or undeclared accrued dividends on the Company's outstanding preferred stock, which currently consists of the Company's LIBOR Preferred Stock, Series A, the 7% PRIDES, Series B Convertible Preferred Stock, and 8.40% Series C Cumulative Preferred Stock, and may include, upon the occurrence of certain events, the Company's Junior Participating Preferred Stock, Series A. At December 31, 1993, there were no arrearages on dividends accrued on the Company's LIBOR Preferred Stock, Series A. In addition, the Company's ability to pay dividends on any of its preferred stock and on its Common Stock will depend on its maintaining adequate net worth and compliance with the required ratio of total debt to total capital as defined in and required by the Company's current credit agreement (the "Credit Agreement"). The Credit Agreement requires the Company to maintain a minimum net worth (generally defined therein as common shareholders' equity plus any outstanding preferred stock) of $750 million. In addition, the Credit Agreement imposes a maximum 60 percent ratio of total debt to total capital (defined therein as total debt plus net worth). At December 31, 1993, the net worth of the Company and the ratio of total debt to total capital were $806.9 million and 58 percent, respectively. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Incorporated herein by reference to "Financial and Operating Record" appearing on pages 30 and 31 of the Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Incorporated herein by reference to "Business and Financial Review" appearing on pages 9 to 14 of the Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated herein by reference are the Consolidated Financial Statements, including related notes, and the Independent Auditors' Report appearing on pages 15 through 29 of the 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 THE REGISTRANT Information regarding the Company's directors is incorporated herein by reference to the material under the heading "Election of Directors -- Information on Nominees and Directors" in the Company's Proxy Statement with respect to the Annual Meeting of Shareholders scheduled to be held May 25, 1994, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 (the "Proxy Statement"). Information regarding the Company's executive officers is provided under the caption "Executive Officers of the Registrant" on pages 6 and 7 of this Form 10-K. Information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference to the material under the heading "Certain Information Concerning Stock Ownership" in the Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference to the material under the headings "Election of Directors -- Information on Nominees and Directors -- Director Compensation", "Executive Compensation", "Human Resources and Compensation Committee Report on Executive Compensation" and "Total Shareholder Return" in the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning (1) any person or group known to the Company to be the beneficial owner of more than five percent of the Company's voting stock, and (2) ownership of the Company's equity securities by management, is incorporated herein by reference to the material under the heading "Certain Information Concerning Stock Ownership" in the Proxy Statement. The Company knows of no arrangements that may result at a subsequent date in a change of control of the Company. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference to the material under the heading "Executive Compensation" in the Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following are filed as a part of this Report on Form 10-K: (1) The following are included at the indicated page in the Annual Report and are incorporated by reference herein: (2) The following financial statement schedules for each of the years in the three year period ended December 31, 1993 are submitted herewith: All other schedules are omitted because they are not applicable, not required, or because the required information is included in the financial statements or notes thereto. (3) (a) Exhibits (numbered in accordance with Item 601 of Regulation S-K): * Filed herewith (dagger) This is a management contract or compensatory plan or arrangement. (b) None. (c) The response to this portion of Item 14 is submitted as a separate section of this report. (d) 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 Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BOWATER INCORPORATED By: /s/ A. P. Gammie A. P. GAMMIE 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 and in the capacities indicated, on March 29, 1994. INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Bowater Incorporated: Under the date of February 11, 1994, we reported on the consolidated balance sheets of Bowater Incorporated and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, capital accounts, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index [Item 14(a)(2)]. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Greenville, South Carolina February 11, 1994 BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE II AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) (1) Net of completed construction transferred to other property accounts. (2) Assets of GNP, acquired December 31, 1991. BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) (1) Component replacements charged to accumulated depreciation. BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) (1) Consists primarily of accounts deemed to be uncollectible. BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE IX SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS EXCEPT PERCENTAGES) (1) Represents borrowings under available facilities. (2) Represents maximum amount outstanding at any month end during each year. (3) Average amount of short-term borrowings is determined by using the average of month end outstanding balances. (4) Weighted average interest rate computed by dividing short-term interest expense by average short-term borrowings. BOWATER INCORPORATED AND SUBSIDIARIES SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992, 1991 (IN THOUSANDS) NOTE: Depreciation and amortization of intangible assets, royalties and advertising costs are not presented since each such item does not exceed one percent of consolidated net sales as shown on the accompanying Consolidated Statement of Operations. EXHIBIT INDEX Exhibit Number Description

96919_1993.txt

96919_1993

1993

96919

ITEM 1. BUSINESS General TPI Enterprises, Inc. (the "Company") is a New Jersey Corporation, incorporated in 1970. Its principal executive offices are located at 777 South Flagler Drive, Phillips Point, East Tower, Suite 909, West Palm Beach, Florida 33401, telephone (407) 835-8888. CONTINUING OPERATIONS General The Company, through TPI Restaurants, Inc. ("Restaurants") is one of the largest restaurant franchisees in the United States. As of March 1, 1994, Restaurants owns and operates 258 restaurants including 191 Shoney's and 67 Captain D's in eleven states, primarily in the southern United States. TPI Restaurants is the largest Shoney's and Captain D's franchisee, operating more than four times as many Shoney's as the next largest Shoney's franchisee and more than three times as many Captain D's as the next largest Captain D's franchisee. The Company operates its Shoney's and Captain D's restaurants under license agreements with Shoney's, Inc., an unaffiliated public company. Approximately 84% and 16% of the Company's revenues from continuing operations in 1993 were from its Shoney's and Captain D's restaurants, respectively. "Shoney's" and "Captain D's" are registered trademarks of Shoney's, Inc. References to the Company include the operations of Restaurants. Shoney's Concept and Strategy. Shoney's are full-service, family-style restaurants which are generally open 18 hours per day, seven days per week, serving breakfast, lunch and dinner. Shoney's varied menu includes hamburgers, chicken, steaks, seafood and sandwiches as well as salad bars and breakfast bars. Shoney's offer a high quality dining experience at attractive prices; the average check per customer at the Company's Shoney's restaurants (based on entrees served at a sampling of restaurants) was approximately $5.46 for the year ending December 26, 1993. Shoney's has sought to differentiate themselves from similarly priced restaurants by providing a superior dining experience, excellent service and warm hospitality. Customers are greeted upon their arrival by a dining room manager who escorts them to their tables, where they are served by friendly waiters and waitresses. Shoney's restaurants are attractively styled using a contemporary mix of light woods, interior plants and earth tones. The Company places major emphasis on the quality, preparation and service of its food, the maintenance and repair of its premises and the appearance and conduct of its employees. Franchise agreements between Shoney's franchisees and Shoney's, Inc. require that all Shoney's restaurants conform to an express standard of appearance and menu content. Menu. Shoney's varied menu is designed to appeal to a broad spectrum of customers. Shoney's restaurants offer health-oriented soup and salad bars, which allow customers to prepare fresh salads using over 30 different items, and to choose from home-made soups. Shoney's popular breakfast bars, containing 40 different items, feature a variety of fresh fruits and traditional breakfast selections, including eggs, bacon, sausage, grits, home-fried potatoes, gravy, biscuits, muffins and specially prepared preserves. The breakfast bars have helped secure Shoney's position as a leader in the breakfast segment of the market, enabling Shoney's restaurants to have significant sales during all three daily meal periods. Pie shops are also now included in most of the Company's recently constructed Shoney's and are being added to most stores that are remodeled. The Company's menu strategy for its Shoney's restaurants is to provide distinctive, quality meals that represent good value and appeal to the varied dining preferences of its targeted customers. Shoney's strives to be sensitive to emerging food trends in order to exploit their sales potential. The restaurants feature separate menus for the three meal periods, and offer a wide variety of selections. Each restaurant offers a feature dessert which changes monthly and home-made soups which change weekly. Shoney's provides a complete dining experience, emphasizing value, speed of service, hospitality and menu diversity to a broad spectrum of value-conscious customers. In addition to its core menu, the Company has implemented a promotional program at its Shoney's restaurants offering a special feature entree at various times throughout the year. Successful promotional items may be later placed on the Shoney's regular daily menu. The Company also offers a senior citizen's discount and a children's menu at its Shoney's restaurants. The Company (in conjunction with its franchisor) continually modifies its Shoney's restaurant concept and menu in order to adapt to new market trends and to maintain its appeal to its traditional broad spectrum of customers. Management believes that, as a result of its diverse menu, its Shoney's restaurants are less dependent on the commercial success of any particular product than certain of its competitors. History. Shoney's restaurants have been in operation in the southern United States since 1952 and enjoy a high level of name recognition in that region. Shoney's restaurants (including those operated by Shoney's, Inc. and other franchisees) are now located in 37 states extending as far west as California. As of March 1, 1994, there were 917 Shoney's in operation, 568 of which are franchised. The Company currently operates 191 Shoney's which is approximately 34% of all franchised Shoney's restaurants and more than four times as many as the next largest Shoney's, Inc. franchisee. The Company's first Shoney's restaurant was opened in 1963. During 1993, the Company opened 18 newly constructed Shoney's restaurants and acquired six existing Shoney's restaurants. The Company closed nine underperforming Shoney's and relocated one restaurant in 1993 to a higher traffic location. Through March 1, 1994, the Company has opened four additional newly constructed restaurants and closed nine additional underperforming restaurants. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of the restructuring charge recorded in 1993 and the Company's plans to close additional underperforming restaurants during 1994. The Company has the exclusive right to develop Shoney's restaurants in more than 80% of the geographic territory of Texas, including the San Antonio, Corpus Christi, Austin, Amarillo, El Paso and Fort Worth metropolitan areas, most of Dallas County and portions of Houston. The Company also has exclusive rights to build Shoney's restaurants in the Orlando, Florida area and portions of Broward and Palm Beach Counties in south Florida. In addition, the Company has agreed to develop a territory in eastern Michigan jointly with Shoney's, Inc. See "Reserved Area and License Agreements" for additional discussions of the Company's reserved areas. Captain D's Concept and Strategy. Captain D's are fast-service restaurants, specializing in seafood meals, and are generally open 12 hours per day, seven days per week. Captain D's restaurants project a nautical theme, with a distinctive wood or stucco exterior and an inviting interior decor featuring light wood tones, interior plants and brass accessories. The Captain D's concept also provides a take-out service including drive-through window service representing approximately one-half of its 1993 sales at Captain D's. The average check per customer at the Company's Captain D's (based on entrees served at a sampling of restaurants), including take-out, was approximately $4.62 during the year ended December 26, 1993. The Company's operating strategy with respect to its Captain D's restaurants is to seek to increase same store sales averages through the continued introduction and promotion of distinctive, high quality menu items, and through increased emphasis on customer service, food quality and cost management. Menu. The Captain D's menu is designed to capitalize on the trend of increased per capita consumption of seafood by serving fried fish fillets, broiled fish, shrimp, clams, stuffed crab in a natural shell and salads. To extend the appeal of its menu to all family members, Captain D's also serves hamburgers, chicken fillets, french fries, hush puppies and country style vegetables. Captain D's also offers broiled entrees to benefit from the increased health consciousness of its customers. The Company, in conjunction with Shoney's, Inc., continually develops and tests new items for the Captain D's menu and seeks to improve existing products. The Company's Captain D's have reduced their dependence on cod fish, the price of which has risen in recent years, by increasing sales of other high quality fish. History. Captain D's restaurants have been in operation in the southeastern United States since 1969. As of March 1, 1994, there were 639 Captain D's in operation, 309 of which are franchised. TPI Restaurants operates approximately 22% of the franchised Captain D's restaurants. The Company opened its first Captain D's restaurant in 1975 and presently operates 67 Captain D's in Alabama, Arkansas, Georgia, Mississippi, North Carolina, South Carolina and Tennessee. During 1993, the Company opened two newly constructed Captain D's restaurants and closed four underperforming restaurants. Through March 1, 1994, the Company has opened one additional newly constructed restaurant and closed one additional underperforming restaurants. Other Restaurants During 1993, the Company closed all of its remaining Hungry Fisherman and Danver's restaurants. The Company recorded the estimated losses related to the disposition of these properties during 1992 and anticipates no future financial impact from these restaurants. Employees As of December 26, 1993, The Company had approximately 11,100 employees, including approximately 9,160 restaurant employees, 1,570 store management personnel (including field supervision and management-in-training), and 370 headquarters personnel (including commissary personnel). Employment in Shoney's restaurants is seasonal and is highest in the second and third quarters. None of the Company's employees are covered by a collective bargaining agreement. Competition and Markets The restaurant business is highly competitive. Key competitive factors in the industry are the quality, variety and value of the food products offered, quality and speed of service, advertising, name identification, restaurant location and attractiveness of facilities. There are a large number of national and regional chain operators, fast food restaurants and other family restaurants that compete directly and indirectly with the Company. Some of these entities have significantly greater financial resources and higher sales volume than does the Company. The restaurant business is often affected by changes in consumer tastes and discretionary spending priorities, national, regional or local economic conditions, demographic trends, consumer confidence in the economy, weather conditions, traffic patterns, employee availability, and the type, number and location of competing restaurants. Any change in these factors could adversely affect the Company. In addition, factors such as inflation and increased food, labor and other employee compensation costs could also adversely affect the Company. Financial Controls The Company maintains centralized accounting controls for all of its restaurants through the use of computerized management information systems. Weekly reports of individual restaurant sales, labor costs, food costs and other expenses and daily reports of sales, all with comparisons to prior periods, give the Company's management current operating results by restaurant as well as on a company-wide basis. The Company does not have significant receivables or inventory and receives trade credit based upon negotiated terms in purchasing food and supplies. Because funds available from cash sales are not needed immediately to pay for food and supplies or to finance receivables or inventory, they may be used for non-current capital expenditures. Therefore, the Company, like many other companies in the restaurant industry, normally operates with a working capital deficit. Acquisition and Distribution of Food and Supplies To achieve consistent food quality and control costs, the Company centrally purchases all major food and supply items used in its restaurants. These items, which account for approximately 98.4% of all food and supplies used, are delivered to the Company's commissary centers in Memphis, Tennessee and Charlotte, North Carolina, from which they are redistributed at least twice weekly to its restaurants. The Memphis distribution center contains 80,000 square feet of storage area, and the Charlotte distribution center contains 70,000 square feet of storage area. Since 1990, the range of products provided from the commissary has been significantly expanded from that provided in prior years. This strategy has led to reduced costs and consistent food quality and freshness and should continue to do so as the commissary operations are expanded to serve additional restaurants. The commissary centers are able to control costs by purchasing food and supply items in bulk quantities in anticipation of future needs and price increases. The Company uses its trucks to backhaul approximately 80% of the food items carried by the commissary, resulting in significant cost savings. In addition, the Company has begun backhauling for third parties in 1994. The Company's ability to maintain consistent quality throughout its chain of restaurants depends in part upon the ability to acquire food products and related items from reliable sources. In situations when supplies may be expected to become unavailable or prices are expected to rise significantly, the Company may enter into purchase contracts or purchase quantities for future use. The Company currently has no material long-term contracts for any of the items used in its restaurants and adequate alternative sources are believed to be available. However, certain items are purchased under agreements with vendors, negotiated from time to time, based on the Company's expected annual usage. Such agreements generally include an annual pricing schedule. Reserved Area and License Agreements Shoney's. The Company operates its Shoney's restaurants under a series of reserved area agreements, pursuant to which Shoney's, Inc. has granted the Company the exclusive right to develop Shoney's restaurants within specified geographic areas, and license agreements entered into between the Company and Shoney's, Inc. The existing license agreements for Shoney's generally providefor 20-year terms with 20-year renewal options subject to the satisfaction of certain conditions. The current expiration dates of the Shoney's license agreements, including renewals, range from 2016 to 2033. In 1993, the average royalty fee paid by the Company for its Shoney's restaurants was 1.9% of gross sales compared to 3.5% which new franchisees are currently being required to pay. Shoney's restaurants built by the Company pursuant to its reserved area agreements will be subject to varying royalty rates of up to 3.0% of sales. The license agreements impose specifications as to the preparation of the products as well as general procedures, such as advertising, maintenance of records, protection of trademarks and provisions for inspection by the franchisor. The license agreements also require the prior approval of Shoney's, Inc. (not to be unreasonably withheld) in order for the Company to close any of its Shoney's restaurants. Termination of the license agreements may be effected for breach of conditions of the agreements, including sale of adulterated products or failure to meet proper standards of quality and sanitation. The Company has never been subjected to any involuntary termination of its license agreements. Several of the Company's reserved area agreements include expansion schedules requiring the Company to develop a minimum number of stores over a defined period of time. The reserved area agreement for 28 counties in Texas, which covers Fort Worth and much of Dallas County, requires the development of 14 Shoney's restaurants over a nine year period ending in 1996. To date, the Company has opened five restaurants in the reserved area. The Company's development agreements for expansion of the Shoney's concept in certain parts of Broward and Palm Beach Counties in south Florida, northwest Harris County, Texas, and Maricopa County, Arizona, require the development of seven restaurants in the Florida area by 2003, six restaurants in the Harris County area by 1998, and three stores in the Arizona area by 1997. There were no restaurants opened in these three areas during 1993, but one store has opened in each of the Harris County, Texas area and the Florida area since December 26, 1993. In addition, the Company has agreed to develop a territory in eastern Michigan jointly with Shoney's, Inc. The agreement requires 13 stores to be opened at a rate equal to Shoney's Inc. in the area, which is expected to approximate two to three stores per year. The Company opened one store in this area during 1993 and one store during January, 1994. If above schedules are not satisfied, Shoney's, Inc. has the right to terminate the Company's exclusive rights in these areas. The reserved area agreements permit the Company to open as many Shoney's restaurants as it deems desirable within such reserved territories in compliance with the terms of the reserved area agreement, in addition to those required to be open in accordance with the development schedule. The Company is a party to other exclusive territory agreements in the areas of its Shoney's operations, including agreements covering over 170 additional counties in Texas; all of Arkansas; over 75 counties in North Carolina; over 30 counties in Mississippi; over 20 counties in Tennessee; and several additional counties in Georgia, South Carolina, Florida and Alabama. With respect to the reserved areas described in the preceding sentence, the Company has no required development schedule and is entitled to open as many Shoney's restaurants in such reserved areas as it deems desirable in compliance with the terms of the reserved area agreements. Shoney's, Inc. may terminate any reserved area agreement upon the default by Restaurants under the terms of any license agreement for operation of a Shoney's restaurant within such reserved area. In addition, the reserved area agreement covering the 28 counties in Texas provides that Shoney's, Inc. may terminate such reserved area agreement upon the expiration of more than 10% of the Company's license agreements for Shoney's restaurants within such reserved area (without replacing those restaurants within two years following such expiration). The Company has never had a reserved area agreement involuntarily terminated by Shoney's, Inc. Captain D's. The Company's Captain D's restaurants are operated under individual license agreements with Shoney's, Inc. The Company has the right to develop Captain D's in 124 counties in seven southeastern states (Alabama, Arkansas, Georgia, Mississippi, North Carolina, South Carolina and Tennessee). The Company must open an aggregate of 32 new Captain D's, by July 11, 2011, at a rate of two restaurants per year. The reserved area agreement permits the Company to open as many Captain D's restaurants as it deems desirable within its reserved territories in addition to those required to be opened in accordance with the development schedule. The reserved area agreement provides that Shoney's, Inc. may terminate the reserved area agreement (i) upon the default by Restaurants under the terms of any license agreement for operation of a Captain D's restaurant or (ii) after July 11, 2011, upon the expiration of more than 10% of Restaurants' license agreements for Captain D's (without replacing those restaurants within two years following such expiration). The Company's existing license agreements for Captain D's generally provide for 20-year terms with two 20-year renewal options subject to the satisfaction of certain conditions. The current expiration dates of the license agreements, including renewals, assuming compliance with the expansion schedule in the Captain D's reserved area agreement, range from 2035 to 2052. In 1993, the average royalty paid to Shoney's, Inc. by the Company's Captain D's was 1.5% of sales. Advertising and Promotion The license agreements for the Company's Shoney's and Captain D's restaurants require that the Company pay fees equal to 0.35% and 0.65% of sales, respectively, in addition to its franchise fees, which are put into production funds and used by the franchisor to produce radio and television commercials and printed advertising materials. Shoney's, Inc. uses such commercials in its nationwide advertising and marketing program. The Company is also required to spend for local marketing on its own behalf and through a cooperative in which other franchisees and Shoney's, Inc. participate. The aggregate amount spent by the Company in 1993 for such advertising, inclusive of the fee paid to the franchisor described above to the production funds, was approximately 3.3% of sales. As part of such local marketing, the Company purchases television and radio spots to air commercials produced by the franchisor. The Company also advertises Shoney's and Captain D's restaurants extensively on billboards. Through such advertising, management believes that Shoney's and Captain D's have a high level of name recognition and positive customer perceptions on key attributes of food quality, service and atmosphere. As part of its marketing program, the Company offers several weekly promotions, including free nights for children, special senior citizens' discounts and "all-you-care-to-eat" seafood buffets at Shoney's restaurants. In addition, the Company distributes coupons through local newspapers and direct mail as part of its advertising campaign. Regulation The Company is subject to the Fair Labor Standards Act and various state laws governing such matters as minimum wages, overtime and other working conditions. Significant numbers of the Company's food service personnel are paid at rates related to the federal and state minimum wage, and accordingly, increases in the minimum wage increase the Company's labor costs. TPI Transportation, Inc., a wholly-owned subsidiary of Restaurants, obtained a license from the Interstate Commerce Commission to conduct interstate trucking and is subject to applicable federal regulations relating to interstate trucking. Each Company restaurant is subject to licensing and regulation by state and local health, sanitation, safety, fire and other departments. Difficulties or failures in obtaining or renewing any required licensing or approval could affect the Company's restaurants. The Company is also subject to various federal, state and local laws regulating the discharge of materials into the environment. The cost of developing restaurants has increased as a result of the Company's compliance with such laws. Such costs relate primarily to the necessity of obtaining more land, landscaping and below surface storm drainage and the cost of more expensive equipment necessary to decrease the amount of effluent emitted into the air and ground. The Company believes it is in material compliance with the regulations to which it is subject. Other Activities Insurex Agency, Inc., a wholly-owned subsidiary of Restaurants, was organized as a Tennessee corporation in 1975 for the purpose of acting as agent for property and casualty, workers' compensation, life and health and other insurance policies for Restaurants, other corporations and the general public. Approximately 98% of the insurance premiums written by Insurex are for insured entities not affiliated with Restaurants. Insurex Benefits Administrators, Inc., ("IBA") a wholly-owned subsidiary of Restaurants, was organized as a Tennessee corporation in 1989 for the purpose of operating as a third party administrator of medical and dental claims for Restaurants and other corporations. Approximately 98% of IBA's revenues are from other corporations. Maxcell Telecom Plus, Inc.'s ("Maxcell"), a wholly-owned subsidiary of the Company, original business plan was to create a cellular telephone network that would operate throughout the southeastern United States. In 1986, Maxcell disposed of substantially all of its remaining interests in the cellular business. Since 1986, Maxcell has had no operations and its only significant asset is cash. Beginning in late 1988, and extending to 1989, Maxcell invested approximately $150,000 to participate in lotteries held by the Federal Communication Commission ("FCC") for rights to develop cellular systems for approximately 300 markets. Maxcell continues to have outstanding applications for markets which may be re-lotteried by the FCC. Maxcell does not intend to apply for any new permits from the FCC or to conduct any non-restaurant business other than in connection with the permits for which applications are pending. There can be no assurance that such markets will be re-lotteried or that Maxcell would win any such lottery. See Item 1 "Legal Proceedings". Discontinued Operations On February 24, 1989, the Company, through its wholly-owned subsidiary, TPI Entertainment, Inc. ("Entertainment"), acquired leasehold interests and other assets related to the operation of 55 movie theaters from American Multi-Cinema, Inc. ("AMC"), a wholly-owned subsidiary of AMC Entertainment Inc. ("AMCE"), subject to a management agreement and certain other agreements, which subsidiary at that time held 6,275,144 shares of the Company's common stock. On March 4, 1991, Entertainment entered into the General Partnership Agreement of Exhibition Enterprises Partnership (the "Partnership Agreement") with Cinema Enterprises, Inc. ("CENI"), a Missouri corporation and a wholly-owned subsidiary of AMC, forming Exhibition Enterprises Partnership, a New York general partnership (the "Partnership"). Pursuant to the Partnership Agreement, effective April 19, 1991, (a) Entertainment contributed to the Partnership its interest in the assets (subject to certain exclusions) relating to the 57 movie theaters Entertainment then owned and other leasehold interests, subject to obligations under notes, loans and capital leases, (b) the Partnership assumed certain liabilities of Entertainment and (c) CENI contributed to the Partnership 3,800,000 shares (the "Shares") of common stock, par value $.01 per share of the Company. Thereafter, the Partnership distributed the shares and cash to Entertainment. The Company agreed to pledge all of the issued and outstanding stock of Entertainment and its interest in the Partnership as security fora bank loan and agreed to guarantee the obligations of the Partnership pursuant to the loan documents. On May 28, 1993, the Company completed the sale of its 50% interest in the Partnership to AMC for $17,500,000. ITEM 2. ITEM 2. PROPERTIES General The Company's executive offices are located at 777 South Flagler Drive, West Palm Beach, Florida where it occupies approximately 4,800 square feet of space under a lease expiring in 1999 and providing for an annual base rent of approximately $119,000. The lease requires the Company to pay certain operating expenses and contains escalation clauses relating to real estate taxes and the like. Such payments currently aggregate approximately $50,000. Restaurants' corporate headquarters is located in Memphis, Tennessee in a leased building consisting of approximately 48,000 square feet. The lease agreement, which expires December 1995, provides for an annual rent of $84,000 and requires the Company to pay certain expenses of approximately $95,000 annually. Restaurants operates its commissary centers in leased facilities in Memphis, Tennessee and Charlotte, North Carolina consisting of 80,000 and 70,000 square feet of storage area in each location, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of the Company's plans to consolidate its West Palm Beach, Florida office with its Memphis, Tennessee office in a new facility in West Palm Beach, Florida. Restaurants The majority of the Company's Shoney's restaurants are free standing buildings of approximately 5,000 square feet and 170 seats. The average cost of building and equipment per restaurant opened in 1993 was approximately $945,000. Land costs averaged approximately $511,000 for each new restaurant during 1993. Each Captain D's is a free standing building of approximately 2,200 square feet and 70 seats. Building and equipment costs currently total approximately $465,000 for each restaurant. Land costs averaged approximately $146,000 for each new restaurant in 1993. A majority of the operating restaurant properties used by Restaurants are leased from others under noncancelable agreements. The following table sets forth certain information regarding Restaurants' restaurant properties as of March 1, 1994: Most of the restaurant leases provide for 10 to 25 year initial terms, with renewal options by Restaurants for additional periods ranging from 5 to 15 years. The leases generally have rents which are the greater of a fixed minimum amount or a percentage of gross sales ranging from 1.0% to 6.5%. The following table summarizes the expiration dates of the original or current terms of all of Restaurants' leases and the number of related leases currently having renewal options. The Company's experience has been that where leases do not contain renewal options and Restaurants desires to continue operating at the same location, negotiating a new lease at competitive terms has been possible. However, prior to negotiating a new lease (or exercising a renewal option ), the Company carefully reviews the site location to determine if it continues to be optimal. The Company has from time to time found alternative locations in the same area to be more desirable. The amount of rent varies considerably from lease to lease. Restaurants' philosophy is to own its restaurant sites in each situation where possible and to utilize lease financing, as necessary, to supplement other financing sources. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Maxcell Telecom Plus, Inc., et al., v. McCaw Cellular Communications, Inc., et al. On November 1, 1993, the Company and its wholly-owned subsidiary, Maxcell Telecom Plus, Inc., filed a complaint in the Circuit Court of the Fifteenth Judicial Circuit in and for Palm Beach County, Florida. The complaint against McCaw Cellular Communications, Inc. ("McCaw"), Charisma Communications Corp. ("Charisma") and various related parties, relates to McCaw's failure to disclose the existence of a side agreement between McCaw and Charisma to share in the net profits from the resale of certain cellular properties which were sold by the Company to McCaw. The Company seeks recision of the sales contract and damages based upon the defendants alleged fraudulent misrepresentation, breach of fiduciary duty, conspiracies and tortious interference with contracts. The Company's attorney's are unable at this time to state the likelihood of a favorable outcome. EEOC Settlement On January 15, 1993, Restaurants settled a class action lawsuit with the U. S. Equal Employment Opportunity Commission, which primarily related to events occurring prior to Restaurants' acquisition by the Company. Under the Settlement, Restaurants did not admit any violation of law, but will pay approximately $880,000, which was substantially provided for in 1990, during the first quarter of 1994 to satisfy the back pay and damages portion of the lawsuit as well as interest accrued from the date the lawsuit was filed. Restaurants also has undertaken certain affirmative action measures to promote the hiring of minorities and report to the EEOC on a semi-annual basis the results of these measures through 1995. Other Proceedings The Company and its subsidiaries are defendants in various lawsuits arising in the ordinary course of business. It is the opinion of the management of the Company that the outcome of such litigation will not have a material adverse 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 of the registrant during the fourth quarter of the fiscal year ended December 26, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G(3) of Form 10-K, the following list is included as an unnumbered Item in Part I of this Report in lieu of being included in its entirety in the Proxy Statement. The following sets forth certain information regarding the Company's executive officers: Stephen R. Cohen has served as Chairman of the Board of Directors of TPI Enterprises since 1976 and of TPI Restaurants since 1988. He served as President of TPI Enterprises from September 1976 through January 1980. He served as Chief Executive Officer of TPI Enterprises from 1965 to March 1993 and Chief Executive Officer of TPI Restaurants from 1988 to March 1993. J. Gary Sharp was an employee of Shoney's, Inc. from 1969 through 1986 holding positions ranging from store manager to group Vice President of all of Shoney's, Inc.'s operations. He left Shoney's, Inc. in 1986 to own and operate franchises in Orlando, Florida and was President of Sharp Concepts, Inc. from 1985 through September 1989. Mr. Sharp has served as President, Chief Operating Officer and a Director of TPI Restaurants since 1989. Mr. Sharp was elected a Director of TPI Enterprises in April 1992. He was named Chief Executive Officer of TPI Enterprises in March 1993. Frederick W. Burford joined TPI Restaurants in November 1991, after 14 years in top management positions at The Promus Companies (formerly Holiday Corporation). Mr. Burford was a Corporate Vice President and served in capacities as both Treasurer and Controller at the Promus Companies. Mr. Burford was elected Vice President, Chief Financial Officer, Treasurer and a Director of TPI Restaurants in November 1991. He was named Executive Vice President, Chief Financial Officer, Treasurer and a Director of TPI Enterprises, Inc. in March 1993. Robert A. Kennedy joined TPI Enterprises in February 1977 as a Vice President and was elected Executive Vice President in February 1985 and Secretary in September 1988. Mr. Kennedy was a Director of TPI Enterprises between August 1984 and March 1993. Mr. Kennedy was elected Vice Chairman of the Board and Assistant Secretary of TPI Restaurants in 1989, Secretary in 1991 and a Director in 1988. Haney A. Long, Jr., joined TPI Restaurants in November, 1989 as Vice President of Procurement and Distribution. Prior to joining the Company, Mr. Long served as Senior Vice President of Procurement at Rich SeaPak Corporation between 1979 and 1989. He also served as Executive Director of Commissary Operations for Shoney's, Inc., between 1975 and 1977. He was elected Director of TPI Restaurants in June 1993. Patricia M. Watts joined TPI Restaurants in April 1992. She was elected Assistant Treasurer of TPI Restaurants in August 1992. Prior to joining TPI Restaurants, Ms. Watts served in a variety of planning and analysis positions at The Promus Companies, Inc. She was elected Assistant Secretary of TPI Enterprises in June 1993. Patricia Hildebrand joined TPI Enterprises in 1976 as assistant to Stephen R. Cohen. She was elected Vice President of Administration of TPI Enterprises in August 1989. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The Company's common shares are traded in the National Market System of the over-the-counter market (NASDAQ symbol: TPIE). As of March 15, 1994, there were 1,947 shareholders of record of the Company's common shares. The following table sets forth, for the periods indicated, the high and low sales prices, as reported by the National Quotation Bureau, Incorporated. Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The Company has never paid any dividends on its common shares. The Company currently intends to retain all earnings, if any, to support the development and growth of the Company's restaurant business. Accordingly, the Company does not anticipate that any cash dividends will be declared on its common shares for the foreseeable future. The indentures covering the 8 1/4% Convertible Subordinated Debentures and the 5% Convertible Senior Subordinated Debentures prohibit the payment of cash dividends while the debentures remain outstanding. The Company's credit facility also limits the payment of dividends by the Company. See "Management's Discussion and Analysis of Financial Condition and Results of Operations". ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Company recognized a $5,273,000 gain, net of tax, in 1993 following the sale of its remaining interest in Exhibition Enterprises Partnership (the "Partnership"). During 1992, the Company recorded an extraordinary loss, net of tax, of $11,949,000 in connection with an early extinguishment of debt. (See Note 6 to the Consolidated Financial Statements.) During 1990, the Company recognized an after-tax gain of approximately $11,600,000 from the sale of a cellular telephone construction permit by its wholly-owned subsidiary Maxcell Telecom Plus, Inc. Discontinued operations include the results of TPI Entertainment, Inc. ("Entertainment") since February 24, 1989. Discontinued operations also include the gains or losses resulting from the disposal of the discontinued operations of Entertainment, as well as the Company's telecommunication business discontinued in 1986. The balance sheet data at December 31, 1992 and 1991 reflect Entertainment's investment in the Partnership. See Note 3 to the Consolidated Financial Statements for a discussion of the various disposals of discontinued operations, including the settlement of the disputes concerning the stock sale to Siemens Information Systems, Inc. in November 1991 and the sale of Entertainment's interest in its movie theater operations. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations 1993 Compared to 1992 Revenues Revenues for 1993 increased to $289.4 million, 4.3% over the $277.4 million earned last year. New restaurants accounted for $30.4 million of 1993 revenues, while comparable store sales declined $7.2 million, or 3.3%, in the Shoney's concept and remained flat in the Captain D's concept. The first twelve weeks of new restaurants operations are excluded from the comparable store sales computation. Revenues from closed stores, primarily Hungry Fisherman and Danver's restaurants, which are excluded from 1993 sales, totalled $11.2 million in 1992. The Company's comparable store sales have declined 4.4% in the Shoney's concept through March 13, 1994, although overall Shoney's sales have increased 3.5%. Costs and Expenses Cost of sales includes food, supplies and uniforms, restaurant labor and benefits, restaurant depreciation and amortization, and other restaurant operating expenses. A summary of cost of sales as a percentage of revenues for 1993 and 1992 is shown below. The Company's food costs suffered from significant price increases in several high volume commodities during 1993, including pork, eggs and shrimp. These increases were partially offset by a decrease in white fish prices, which contributed to a decrease in food costs as a percentage of revenues in the Company's Captain D's restaurants. Most restaurant operating expenses, including restaurant labor, restaurant depreciation and amortization, repairs and maintenance, utilities and advertising, are relatively fixed, and accordingly, a decrease in same store sales results in an unfavorable margin impact. Management recently completed an extensive review of the Company's exposure resulting from its self insurance program for workers' compensation and general liability. The review, which was based on improved data available to the Company relating to the trend in claims development, indicated that the Company's reserves for retained losses were near the lower end of the expected range of possible losses. Management determined it would be appropriate to increase the Company's reserves to better reflect the likely outcome of its liability within the possible range of losses. Accordingly, as of the end of the fourth quarter of 1993, workers' compensation insurance reserves were increased by charging $4.5 million to restaurant labor and benefits and $0.7 million to general and administrative expenses. Also, a charge of $1.8 million was made to other restaurant operating expenses and $0.6 million to the gain on sale of discontinued operations (theater operations) to increase the general liability insurance reserves. General and administrative expenses declined as a percentage of revenues from 10.2% in 1992 to 9.9% in 1993. The Company continued to experience savings during 1993 from the restructuring and relocation of TPI Enterprises, Inc.'s headquarters in the latter half of 1992. In addition to the workers' compensation reserve adjustment described above, the Company recorded charges of $1.2 million following the termination and settlement of its retirement plan in December 1993 and $0.9 million resulting from the reduction in the discount rate used to compute the Company's deferred compensation obligations. General and administrative expenses for 1992 include a $1.1 million charge to pension expense resulting from the early retirement of a senior executive officer. Restructuring Charges The Company adopted a restructuring plan as of the end of the fourth quarter of 1993 which includes (i) closing or relocating 31 of its restaurants by the end of 1994, (ii) not exercising options to renew leases with respect to an additional 19 of its restaurants upon expiration of the current lease terms and (iii) restructuring divisional management and consolidating the Company's two corporate offices. After an in-depth evaluation of the Company's Shoney's and Captain D's restaurants, management has identified 31 restaurants, which have not performed well and appear to have a limited potential for improvement in the future, to be closed or relocated. Included in these restaurants are five Shoney's and four Captain D's closed in December 1993. With respect to the restaurants closed or to be closed, the Company recorded $19.8 million of restructuring charges consisting primarily of the write-off of assets and the accrual of lease and other expenses, net of projected sales proceeds and sublease income. With respect to the 19 restaurants projected to be closed no later than the expiration of their current lease terms, the Company determined that the recoverability of the assets has been permanently impaired, and accordingly, recorded a charge of $4.5 million primarily for the write-down of assets. The Company is continuing its efforts to restructure and downsize corporate overhead by consolidating its Memphis, Tennessee corporate office with its headquarters office in West Palm Beach, Florida. The Company recorded approximately $1.8 million for the cost of moving the Memphis office and $1.3 million for the write-off of assets and accrual of remaining lease obligations at the Company's present facilities. In addition, the Company accrued $1.2 million for severance costs and other costs relating to the restructuring of divisional and corporate overhead. Further, the Company wrote down vacant properties to net realizable value and revised its estimated loss with respect to units closed prior to 1993 by increasing its restructuring charge and related reserve by $6.5 million. The Company's restructuring charges of $3.6 million in 1992 consisted of a $4.0 million provision for closed units relating primarily to the closings of the remaining Hungry Fisherman restaurants, and a $0.4 million reduction in previously accrued reserves relating to the 1991 charge of $2.8 million for restructuring the Company's operations and moving its headquarters. Other Income and Expenses Interest income decreased $3.0 million, primarily due to interest earned in 1992 on income tax refunds. During the third quarter of 1992, the Company refinanced Restaurants' 14 1/4% Senior Subordinated Notes. Primarily as a result of this debt restructuring, and the investment by the Airlie Group, L.P., and other related parties (the "Airlie Group"), in March 1993, interest expense decreased $3.8 million in 1993 compared to 1992. Discontinued Operations The Company realized a $5.3 million gain, net of $2.7 million of income tax expense, on the sale of its investment in Exhibition Enterprises Partnership in 1993. Extraordinary Item and Cumulative Effect of Accounting Changes The Company recorded a charge to income of $11.9 million during 1992 in connection with the refinancing of Restaurants' 14 1/4% Senior Subordinated Notes. The Company also recorded charges of $2.8 million during 1992 relating to the implementation of Financial Accounting Standard No. 112, "Employers' Accounting for Postemployment Benefits" and Financial Accounting Standard No. 109, "Accounting for Income Taxes". 1992 Compared to 1991 Revenues Revenues increased in 1992 by $16.3 million, or 6.2%, to $277.4 million from $261.1 million in 1991. New restaurants contributed additional sales of $15.7 million and comparable store sales increased $5.2 million, or 2.5%, in the Shoney's concept. These increases were partially offset by decreases totalling $2.4 million in revenues from closed restaurants. The Hungry Fisherman concept recorded $7.7 million in revenue during the eleven periods in 1992 prior to the Company's decision to close the restaurants compared to $10.0 million in 1991. Costs and Expenses Cost of sales includes food, supplies and uniforms, restaurant labor and benefits, restaurant depreciation and amortization, and other restaurant operating expenses. A summary of cost of sales as a percentage of revenues for 1992 and 1991 is shown below. The Company's food cost decreased as a percentage of revenue due to the decline in the market price of certain food items purchased by the Company, including beef, pork, poultry and coffee. Improvements in commissary operations as well as reduced waste at the stores, resulting in part from advancements in product packaging, contributed to this decrease. Labor costs at the restaurants decreased slightly at the restaurants due to management's efforts to ensure minimal under-and over-staffing and reduce employee overtime. Restaurant depreciation and amortization was negatively impacted by new construction and the Company's ongoing remodeling program. The additional number of units operating also resulted in increased facilities costs included in other operating expenses. General and administrative expenses decreased $2.1 million, or 1.4% as a percentage of revenues, in 1992. Increased employee contributions and improved claims experience resulted in a decrease of $1.3 million in healthcare costs allocated to general and administrative expenses. In addition, savings in other insurance costs and improved absorption of general and administrative costs by the Company's commissary operations were partially offset by increases in incentive compensation, advertising and professional fees. The Company also recorded pension expense of $1.1 million in 1992 in connection with the retirement of a senior executive officer. Finally, the Company realized savings of approximately $0.6 million in the latter half of the year from the restructuring of its operations and relocation of its headquarters. Other costs and expenses decreased $2.6 million, or 1.0% as a percentage of revenues, due to losses recorded in 1991 relating to the disposition of certain fixed assets, including certain parts of its computer system and software and certain restaurant fixed assets. Restructuring Charges During 1992, the Company recorded net restructuring charges of $3.6 million, consisting of a $4.0 million provision for closed units relating primarily to the closing of the remaining seven Hungry Fisherman restaurants, and a $0.4 million reduction in previously accrued reserves relating to the 1991 charge of $2.8 million for restructuring the Company's operations and moving its headquarters. The credit resulted from the sublease of the Company's facilities at its former location, which was not anticipated in the original reserve estimate. Restructuring charges in 1991 also include a provision for closed units of $1.6 million. Other Income and Expenses Interest income for 1992 increased by $0.5 million, primarily resulting from interest on income tax refunds received in 1992 following the resolution of certain prior year income tax examinations. Interest expense decreased $3.9 million due to the Company's repurchase of $15.9 million principal amount of Restaurants' 14 1/4% Senior Subordinated Notes during March and April of 1992 and the refinancing of an additional $82.7 million as of July 29, 1992. Liquidity and Capital Resources Working capital declined from $2.7 million in 1992 to a deficiency of $10.8 million in 1993 due primarily to the utilization of cash on hand at the end of 1992 for 1993 capital expenditures in the Company's restaurant operations and the increase in current liabilities resulting primarily from an increase in insurance reserves. Net cash provided by operating activities increased from $17.6 million in 1992 to $19.6 in 1993 primarily due to the impact of a net increase in revenues. Approximately 92% of the Company's restaurant sales are for cash and the remainder are for credit card receivables which are generally collected within 3 days. Because the Company's payables, including amounts for inventory and other operating expenses, are paid over a longer period of time, it is not unusual for the Company, like many others in the restaurant industry, to operate with a working capital deficit. During 1993, the Company invested $54.5 million in capital expenditures, including $27.4 million for the acquisition of sites and construction of 20 new Shoney's restaurants and 2 new Captain D's, $8.9 million for the acquisition of six operating Shoney's restaurants, $7.5 million for the remodeling of 16 Shoney's and 29 Captain D's, $3.9 million for maintenance type capital expenditures and $1.6 million for sites to be constructed in 1994. The remaining $5.2 million relates primarily to the purchase of additional trailers and commissary equipment and the acquisition of a new computer and related components. The acquisitions of the six operating Shoney's restaurants include three in northern Palm Beach County, Florida, two in the Phoenix, Arizona area and one in Houston, Texas. In connection with these acquisitions from other Shoney's franchisees, the Company acquired the exclusive rights to construct and operate Shoney's restaurants in the surrounding areas and has agreed to develop these areas in accordance with specific market development agreements with its franchisor. The Company has various other reserved areas with minimum development requirements . Requirements for 1994 include the construction of one Shoney's in the West Palm Beach area and the same number of Shoney's in the Michigan reserved area as constructed by Shoney's, Inc., which is expected to be two restaurants. The Company has opened four Shoney's restaurants in 1994 as of March 1, including two units required to meet the 1993 development schedule, and plans to construct an additional four new and three replacement Shoney's restaurants in 1994. The total cost of the eleven units constructed or to be constructed in 1994 is expected to be $15.5 million. Aggregate commitments beyond 1993 require 38 restaurants to be constructed in the Company's reserved areas in Phoenix, West Palm Beach, Michigan, Houston, and certain other counties in Texas prior to April 6, 2003. The Company believes that there is substantial potential to expand its Shoney's restaurants within the Company's existing markets as well as within the other areas in which the Company has been granted exclusive rights by Shoney's, Inc. The Company has the right to develop Captain D's restaurants in 124 counties in seven Southeastern states (Alabama, Arkansas, Georgia, Mississippi, North Carolina, South Carolina and Tennessee). To avoid termination of the reserved area agreement, the Company is required to open 32 additional Captain D's by July 11, 2011. The Company plans to open three Captain D's in 1994, including one which opened in January, at an approximate total cost of $2.2 million. In addition to the construction of new Shoney's and Captain D's, the Company anticipates investing $9.4 million on remodels and incurring maintenance and other capital expenditures of $4.0 million in 1994. The acquisition of the three Florida restaurants in 1993 for $5.1 million included the assumption of long term debt and capitalized lease obligations of $2.0 million in addition to the issuance of 94,300 shares of common stock valued at $895,000 at the date of the acquisition. The remainder of the 1993 capital expenditures were financed using cash flows from operations, proceeds from the investment in the Company by the Airlie Group and borrowings on the Credit Facility with a syndicate of banks (the "Credit Facility"). The Company's Credit Facility was renegotiated in March 1993 in connection with the Airlie investment (described below). The Credit Facility, which previously consisted of a term loan and a revolving loan was restructured and currently consists of a $50.0 million revolving credit facility, which bears interest at either a defined base rate or a rate based on the London Interbank Offered Rate. The amount available for borrowing under the Credit Facility is reduced by any outstanding letters of credit. The Company pays a fee of 2% on outstanding letters of credit and a commitment fee of .5% on the average daily unused Credit Facility. Borrowings under the Credit Facility are secured by all shares of the capital stock of Restaurants, whenever issued, intercompany debt of Restaurants owed to the Company and ground lease mortgages with respect to certain premises in which the land is currently leased but the building located thereon is owned by Restaurants. In addition, the banks have the right to obtain, as security, assignments of other leases and/or mortgages on real property currently owned or subsequently acquired. However, the Company has rights to finance certain of these properties and obtain a release of the collateral under certain conditions. The Credit Facility limits the amount of additional indebtedness which the Company and its subsidiaries may incur and the aggregate annual amount to be spent on capital expenditures. In addition, the Credit Facility limits, among other things, the ability of the Company and its subsidiaries to pay dividends, create liens, sell assets, engage in mergers or acquisitions and make investments in subsidiaries. Restaurants may not transfer amounts to the Company except for the payment of a management fee not to exceed $2.5 million in each fiscal year and a dividend in an amount sufficient to pay interest on the Company's 5% Convertible Senior Subordinated Debentures and 8 1/4% Convertible Subordinated Debentures, in each case provided that no defaults under the Credit Facility exist either immediately before or after the transfer. Restaurants must also maintain certain financial ratios. At December 26, 1993, $19.0 million was outstanding on the Credit Facility and letters of credit in the amount of $11.0 million were outstanding, resulting in a remaining balance available to borrow of $20.0 million. The Credit Facility currently matures on June 3, 1996, unless extended by the banks. On March 19, 1993, the Airlie Group made an investment in the Company of $30.0 million. The investment included $15.0 million of 5% Convertible Senior Subordinated Debentures, due 2003, convertible into common stock at $11 per share (the "Senior Debentures"), the issuance of 1,500,000 shares of the Company's common stock at $10 per share and the issuance of warrants to purchase an additional 1,000,000 shares of common stock at $11 per share. The Senior Debenture holders may also require the Company to repurchase the Senior Debentures, in whole or in part, in certain circumstances involving a change in control of the Company. Restaurants has guaranteed the repayment of the Senior Debentures on a subordinated basis. In addition, the Company has outstanding $51.7 million of 8 1/4% Convertible Subordinated Debentures (the "Debentures"). The Debentures are convertible at the option of the holder into common shares of the Company at any time prior to maturity, unless previously redeemed or repurchased, at a conversion price of $6.50 per share, subject to adjustment in certain events. The Debentures mature on July 15, 2002 and are redeemable, in whole or in part, at the option of the Company at any time on or after July 15, 1995, initially at 105.775% of their principal amount and declining to 100% of their principal amount on July 15, 2002, together with accrued and unpaid interest. The Debenture holders may also require the Company to repurchase the Debentures, in whole or in part, in certain circumstances involving a change in control of the Company as defined in the indenture covering the Debentures (the "Indenture"). However, a change in control, as defined in the Indenture, will create an event of default under the Credit Facility and, as a result, any repurchase would, absent a waiver, be blocked by the subordination provisions of the Indenture until the Credit Facility (and any other senior indebtedness of the Company and senior indebtedness of Restaurants with respect to which there is a payment default) has been repaid in full. The Debentures are unconditionally guaranteed (the "Guarantee") on a subordinated basis by Restaurants. The Debentures and the Guarantee are subordinated to all existing and future senior indebtedness, as defined in the Indenture, of the Company. The Indenture does not prohibit or limit the ability of the Company or any of its subsidiaries to incur additional indebtedness, including that which will rank senior to the Debentures. Management believes sufficient funds will be available from cash on hand, cash flow from operations and borrowings under the Credit Facility to meet its debt service requirements, as well as its capital expenditure and working capital requirements in the forseeable future. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of TPI ENTERPRISES, INC.: We have audited the accompanying consolidated balance sheets of TPI Enterprises, Inc., and its subsidiaries as of December 26, 1993 and December 31, 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three fiscal years in the period ended December 26, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of TPI Enterprises, Inc. and its subsidiaries as of December 26, 1993 and December 31, 1992, and the results of their operations and their cash flows for each of the three fiscal years in the period ended December 26, 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, in 1992 the Company changed its method of accounting for income taxes and postemployment benefits to conform with Statement of Financial Accounting Standards Nos. 109 and 112. The Company reflected the cumulative effect of these changes in 1992. /s/ DELOITTE & TOUCHE March 18, 1994 Memphis, Tennessee TPI ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements. TPI ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS See notes to consolidated financial statements. TPI ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS TPI ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) TPI ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1--SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of TPI Enterprises, Inc. (the "Company") and its wholly-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. During 1993, the Company changed its fiscal year from December 31 to a 52-53 week period, ending on the last Sunday in December in order to be consistent with the year end of its wholly-owned subsidiary, TPI Restaurants, Inc., ("Restaurants"). Quarterly reports to shareholders are issued as of the end of the 16th, 28th, and 40th weeks of each fiscal year. Cash and Cash Equivalents The Company considers cash on hand, deposits in banks, certificates of deposit and short-term marketable securities with maturities of 90 days or less when purchased, as cash and cash equivalents. Restaurants utilizes a cash management system under which cash overdrafts exist in the book balances of its primary disbursing accounts. These overdrafts represent the uncleared checks in the disbursing accounts. The cash amounts presented in the consolidated financial statements represent balances on deposit at other locations prior to their transfer to the primary disbursing accounts. Uncleared checks of $7,393,000 and $7,445,000 are included in accounts payable at December 26, 1993 and December 31, 1992, respectively. Inventories Inventories, consisting of food items, beverages and supplies, are stated at the lower of weighted average cost (which approximates first-in, first-out) or market. Pre-opening Costs Direct costs incidental to the opening of new restaurants are capitalized and amortized over the restaurants' first year of operations. Depreciation and Amortization Depreciation and amortization of property and equipment is provided on the straight-line method over the estimated useful lives of the assets or, in the case of leasehold improvements and certain property under capital leases, over the lesser of the useful life or the lease term. Goodwill related to the acquisition of Restaurants is amortized on a straight-line basis over a thirty-six year period. The costs of franchise license agreements which govern the individual Shoney's and Captain D's restaurants and reserved area agreements are amortized on a straight-line basis over the lives of the related franchise license agreements, up to 40 years. Postemployment Benefits The Company recognizes the cost of postemployment benefits on an accrual basis in accordance with Financial Accounting Standard No. 112, "Employers Accounting for Postemployment Benefits." The adoption of this statement during the year ended December 31, 1992 resulted in an increase of $102,000 in 1992 income from continuing operations. The cumulative effect on years prior to January 1, 1992 of $716,000, or $.04 per share, is included in 1992 net income. Income Taxes Effective January 1, 1992, the Company adopted Financial Accounting Standard No. 109, "Accounting for Income Taxes", which requires an asset and liability approach to financial accounting TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 1--SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) and reporting for income taxes. Deferred income tax assets and liabilities are computed annually for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. Prior to 1992, income taxes were accounted for under Accounting Principles Board Opinion No. 11. The effect of adopting Statement 109 on 1992 net income (loss) was a decrease of $697,000, or $.04 per share. This effect consists of an increase of $898,000, or $.05 per share, relating to continuing operations, an increase of $500,000, or $.03 per share, relating to the extraordinary item and $27,000 relating to the cumulative effect of adopting Statement 112. The cumulative effect of the change on years prior to January 1, 1992 of $2,122,000, or $.12 per share, decreased 1992 net income. Income (Loss) Per Share Primary earnings per share amounts are computed by dividing net income (loss) by the weighted average number of common and common equivalent shares outstanding during the period. Reported primary per share amounts include common equivalents relating to dilutive stock options of 514,000, 165,000 and 38,000 shares in 1993, 1992 and 1991, respectively. Fully diluted earnings per share amounts are similarly computed, but also include the effect, when dilutive, of the Company's 8 1/4% Convertible Subordinated Debentures issued in July and August of 1992 and 5% Convertible Senior Subordinated Debentures issued March 1993, after the elimination of the related interest requirements, net of income taxes. The Company's convertible debentures are excluded from the fiscal 1993 computation due to their antidilutive effect during that period. The inclusion of the Company's dilutive outstanding options in the calculation, determined based on market values at the end of each period, as applicable, is either antidilutive or does not result in a material dilution of earnings per share for 1993, 1992 and 1991. Reclassification Certain amounts for 1992 and 1991 have been reclassified to conform to the 1993 presentation. NOTE 2--RESTRUCTURING CHARGES The Company adopted a restructuring plan as of the end of the fourth quarter of 1993 which includes (i) closing or relocating 31 of its restaurants by the end of 1994, (ii) not exercising options to renew leases with respect to an additional 19 of its restaurants upon expiration of the current lease terms and (iii) restructuring divisional management and consolidating the Company's two corporate offices. After an in-depth evaluation of the Company's Shoney's and Captain D's restaurants, management has identified 31 restaurants, which have not performed well and appear to have a limited potential for improvement in the future, to be closed or relocated. Included in these restaurants are five Shoney's and four Captain D's closed in December 1993. With respect to the restaurants closed or to be closed, the Company recorded $19,800,000 of restructuring charges consisting primarily of the write-off of assets and the accrual of lease and other expenses, net of projected sales proceeds and sublease income. With respect to the 19 restaurants projected to be closed no later than the expiration of their current lease terms, the Company determined that the recoverability of the assets has been permanently impaired, and accordingly, recorded a charge of $4,500,000 primarily for the write-down of assets. The TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 2--RESTRUCTURING CHARGES--(CONTINUED) Company is continuing its efforts to restructure and downsize corporate overhead by consolidating its Memphis, Tennessee corporate office with its headquarters' office in West Palm Beach, Florida. The Company recorded approximately $1,800,000 for the cost of moving the Memphis office and $1,300,000 for the write-off of assets and accrual of remaining lease obligations at the Company's present facilities. In addition, the Company accrued $1,200,000 for severance costs and other costs relating to the restructuring of divisional and corporate overhead. Further, the Company wrote down vacant properties to net realizable value and revised its estimated loss with respect to units closed prior to 1993 by increasing its restructuring charge and related reserve by $6,500,000. Restructuring charges during 1992 included a $4,000,000 provision for closed units and a $400,000 credit relating to a 1991 restructuring charge. The $4,000,000 provision resulted from management's decision, during the fourth quarter of 1992, to close all seven remaining Hungry Fisherman restaurants. The restructuring credit of $400,000 in 1992 resulted from the sublease of the Company's facilities, previously reserved for in a 1991 charge of $2,800,000 to relocate the Company's headquarters following the discontinuation of the Company's theater operations. The provision for closed units charged to operating income of $1,600,000 in 1991 was due to an additional reserve established to provide for estimated remaining costs of properties designated in 1989 to be closed. Such additional reserves were determined to be necessary based on the subsequent decline in the real estate market. NOTE 3--DISCONTINUED OPERATIONS TPI Entertainment, Inc. Prior to April 1991, TPI Entertainment, Inc. ("Entertainment"), a wholly-owned subsidiary of the Company, owned and operated 57 movie theaters. On March 4, 1991, Entertainment entered into a partnership, Exhibition Enterprises Partnership, (the "Partnership"), with Cinema Enterprises, Inc., a wholly-owned subsidiary of American Multi-Cinema, Inc. ("AMC"), contributing all its theater operations in exchange for a 50% interest in the Partnership and 3,800,000 shares of the Company's stock valued at $24,225,000. As a result of this transaction, Entertainment recognized a gain of $7,922,000, net of taxes of $4,438,000, during 1991. At the end of 1991, the Company resolved to offer for sale its 50% interest in the Partnership. Accordingly, all theater operations are classified as discontinued operations in the financial statements and the Company's investment in the Partnership is designated as "held for sale" on the December 31, 1992 consolidated balance sheet. The Company's proportionate share of the Partnership loss was not recorded in 1993 or 1992, as the Company anticipated proceeds from the sale of its interest in the Partnership would exceed its carrying value. On May 28, 1993, the Company completed the sale of its 50% interest in the Partnership to AMC for $17,500,000. As a result of this transaction, the Company recognized a gain of $5,273,000, net of income taxes of $2,717,000 for the year ended December 26, 1993. The estimated fair value of the Company's investment in the Partnership at December 31, 1992 was $17,500,000, the sales price agreed to on March 19, 1993. TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3--DISCONTINUED OPERATIONS--(CONTINUED) The following condensed balanced sheets reflect the financial position of the Partnership as of May 28, 1993, the date of the completion of the sale of the Company's interest in the Partnership, and December 31, 1992, the last day of the Partnership's 1992 fiscal year. Results of theater operations are as follows: The Company received an administrative fee of 1/4% of theater revenue from the theater operations which was included in the results of discontinued operations through December 31, 1991. The fee paid to the Company for 1993 and 1992 was deducted from the carrying value of the Partnership. Such fees were $230,000, $370,000, and $320,000 for 1993, 1992 and 1991, respectively. Stock Sale to Siemens In November 1991, the Company settled its litigation with Siemens Information Systems, Inc. relating to the Company's 1987 sale of its 65% interest in Tel Plus Communications, Inc., and all of the outstanding common stock of Telecom Plus Supply Corp. and Telecom Plus Rental Systems, Inc., then wholly-owned subsidiaries of the Company. In connection with the settlement, the Company received a $43,000,000 cash payment and recognized a gain on disposal of discontinued operations of $17,525,000, including a tax benefit of $11,075,000. TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 4--PROPERTY AND EQUIPMENT Property and equipment consists of the following: Property and equipment with a net book value of approximately $22,681,000 and $22,525,000 were pledged as collateral for the Company's debt facilities as of December 26, 1993 and December 31, 1992, respectively. Depreciation and amortization are calculated using the straight-line method and are based on the estimated useful lives of the assets as follows: buildings, 30 years; equipment and furnishings, 3-15 years; and leasehold improvements, primarily representing buildings constructed on leased property, the lesser of the term of the lease or 30 years. Depreciation and amortization of property and equipment, exclusive of depreciation and amortization included in discontinued operations, totalled approximately $14,104,000, $12,880,000 and $11,873,000 during 1993, 1992 and 1991, respectively. In 1993, 1992 and 1991, approximately $1,716,000, $1,843,000 and $1,657,000, respectively, related to capitalized leases. Property and equipment includes capitalized interest on construction of $374,000 and $172,000 at December 26, 1993 and December 31, 1992, respectively. TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5--OTHER INTANGIBLE ASSETS Other intangible assets consists of the following: NOTE 6--LONG-TERM DEBT Long-term debt consists of the following: Scheduled annual principal maturities of long-term debt, excluding obligations under capital leases, for the five years subsequent to December 26, 1993, are as follows: $312,000 in 1994; $2,184,000 in 1995; $19,171,000 in 1996; $164,000 in 1997 and $177,000 in 1998. Interest expense from continuing operations for 1993, 1992 and 1991 includes interest on obligations under capital leases of $2,334,000, $2,610,000 and $2,261,000, respectively. Debentures On March 19, 1993, the Airlie Group, L.P., and certain related parties (the "Airlie Group") made an investment in the Company of $30,000,000 including $15,000,000 of 5% Convertible Senior Subordinated Debentures (the "Senior Debentures"), due 2003, the issuance of 1,500,000 shares of the Company's common stock at $10 per share and the issuance of warrants to purchase an additional 1,000,000 shares of common stock at $11 per share. The Senior Debentures are senior to the 8 1/4% Convertible Subordinated Debentures (the "Debentures"). The Senior Debentures are convertible at the option of the holder into common shares of the Company at any time prior to maturity at $11 per TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 6--LONG-TERM DEBT--(CONTINUED) share, subject to adjustment in certain events. The Senior Debentures mature on April 15, 2003 and are redeemable, in whole or in part, at the option of the Company at any time on or after April 15, 1996, initially at 103.5% of their principal amount and declining to 100% of their principal amount on April 15, 2003. The Debenture holders may require the Company to repurchase the Senior Debentures, in whole or in part, in certain circumstances involving a change in control of the Company as defined in the Debenture Purchase Agreement (the "Agreement"). However, a change in control, as defined in the Agreement, will create an event of default under the Credit Facility (described below) and, as a result, any repurchase would, absent a waiver, be blocked by the subordination provisions of the Agreement until the Credit Facility (and any other senior indebtedness of the Company and senior indebtedness of Restaurants with respect to which there is a payment default) has been repaid in full. The Senior Debentures are unconditionally guaranteed on a subordinated basis by Restaurants. They are subordinated to all existing and future senior indebtedness of the Company and Restaurants, excluding the Debentures. The 8 1/4% Convertible Subordinated Debentures (the "Debentures"), which provided proceeds to the Company of $47,948,000, net of $3,802,000 in deferred debt costs, are convertible at the option of the holder into common shares of the Company at any time prior to maturity at a conversion price of $6.50 per share subject to adjustment in certain events. The Debentures mature on July 15, 2002, and are redeemable at the option of the Company at any time on or after July 15, 1995, at a premium which declines as the Debentures approach maturity. The Debenture holders may also require the Company to repurchase the Debentures, in whole or in part, in certain circumstances involving a change in control of the Company as defined in the indenture covering the Debentures (the "Indenture"). However, a change in control, as defined in the Indenture, will create an event of default under the Credit Facility and, as a result, any repurchase would, absent a waiver, be blocked by the subordination provisions of the Indenture until the Credit Facility (and any other senior indebtedness of the Company and senior indebtedness of Restaurants with respect to which there is a payment default) has been repaid in full. The Debentures are unconditionally guaranteed on a subordinated basis by Restaurants. They are subordinated to all existing and future senior indebtedness of the Company and Restaurants. During 1992, the Company recorded a charge of $11,949,000 following the repurchase of $98,526,000 principal amount of the 14 1/4% Senior Subordinated Notes of Restaurants (the "Notes"). The costs of the repurchased Notes in excess of their principal amounts, together with the related deferred finance costs and expenses related to the repurchase, were charged to income as an extraordinary item, net of income tax of $6,170,000. The remaining $1,474,000 principal amount of the Notes was repurchased on November 15, 1993. Premiums on the purchases and the write-off of deferred debt costs resulted in a charge of $109,000 to other income and expense. Credit Facilities Credit facilities, which previously consisted of a $30,000,000 Term Loan Facility and a $25,000,000 Revolving Credit Facility (the "Original Credit Facilities"), were amended and restated on June 3, 1993 to a $50,000,000 revolving credit facility (the "Credit Facility") with a syndicate of banks (the "Banks"). The Credit Facility matures on June 3, 1996, unless extended by the Banks. The Credit Facility was amended, effective December 26, 1993, to amend certain covenants affected by restructuring and certain other charges totalling $40,704,000 recorded by the Company for the fourth quarter of 1993. TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 6--LONG-TERM DEBT (CONTINUED) Borrowings under the Credit Facility, at the Company's option, bear interest at either a defined base rate or a rate based on the London Interbank Offered Rate. At December 26, 1993 the weighted average interest rate on the amount outstanding was 5.72%. The Company paid certain fees and expenses to the Banks in connection with the original commitment letter, which along with other costs associated with the Original Credit Facilities, totalled approximately $2,000,000 and also agreed to indemnify the Banks against certain liabilities. The Company also pays a fee based on the Eurodollar rate, 2.0% at December 26, 1993, in connection with letters of credit issued and a commitment fee equal to 0.50% per annum on the average daily unused amount of the Credit Facility. Borrowings under the Credit Facility are secured by all shares of the capital stock of Restaurants, whenever issued, intercompany debt of Restaurants owed to the Company and ground lease mortgages with respect to certain premises in which the land is currently leased but the building located thereon is owned by Restaurants. In addition, the Banks have the right to obtain, as security, assignments of other leases and/or mortgages on real property currently owned or subsequently acquired. However, the Company has rights to finance certain of these properties and obtain a release of the collateral under certain conditions. The Credit Facility limits the amount of additional indebtedness which the Company and its subsidiaries may incur and the aggregate annual amount to be spent on capital expenditures. In addition, the Credit Facility limits, among other things, the ability of the Company and its subsidiaries to pay dividends, create liens, sell assets, engage in mergers or acquisitions and make investments in subsidiaries. Restaurants may not transfer amounts to the Company except for the payment of a management fee not to exceed $2,500,000 in each fiscal year and a dividend in an amount sufficient to pay interest on the Senior Debentures and the Debentures, in each case provided that no defaults under the Credit Facility exist either immediately before or after the transfer. Restaurants must also maintain certain financial ratios. At December 26, 1993, $19,000,000 was drawn on the facility and letters of credit in the amount of $10,951,000 were outstanding, resulting in a remaining available balance of $20,049,000. Notes Payable Notes payable as of December 26, 1993 consist of obligations secured by buildings, land, equipment, and cash value life insurance policies with a net book value of $7,595,000. Fair Value of Financial Instruments The estimated fair value of the Company's Debentures, based on the quoted market price, is $86,900,000 and $74,520,000 for December 26, 1993 and December 31, 1992, respectively. The estimated fair value of the Company's Senior Debentures at December 26, 1993 is $12,716,000, based on the estimated borrowing rates available to the Company. The Credit Facility reprices frequently at market rates; therefore, the carrying amount of this facility is a reasonable estimate of its fair value at December 26, 1993 and December 31, 1992. The estimated fair value of the Company's notes payable approximates the principal amount of such notes outstanding at December 26, 1993 and December 31, 1992, which is based upon the estimated borrowing rates available to the Company. The fair value estimates presented herein are based on pertinent information available to management as of December 26, 1993 and December 31, 1992. 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 that date, and current estimates of fair value may differ significantly from the amounts presented herein. TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7--ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES The Company is primarily self insured for general liability and workers' compensation risks supplemented by stop loss type insurance policies. The self insurance liabilities, related to continuing operations, included in accrued insurance at December 26, 1993 and December 31, 1992 were approximately $12,300,000 and $5,200,000, respectively. Management recently completed an extensive review of the Company's exposure resulting from its self insurance program for workers' compensation and general liability. The review, which was based on improved data available to the Company relating to the trend in claims development, indicated that the Company's reserves for retained losses were near the lower end of the expected range of possible losses. Management determined it would be appropriate to increase the Company's reserves to better reflect the likely outcome of its liability within the possible range of losses. Accordingly, as of the end of the fourth quarter of 1993, workers' compensation insurance reserves were increased by charging $4,500,000 to restaurant labor and benefits and $700,000 to general and administrative expenses. Also a charge of $1,800,000 was made to other restaurant operating expenses and $600,000 to the gain on sale of discontinued operations (theater operations) to increase the general liability insurance reserves. NOTE 8--INCOME TAXES The provision (benefit) for income taxes on continuing operations is as follows: TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 8--INCOME TAXES--(CONTINUED) The provision (benefit) for income taxes on continuing operations is different from the amount that would be computed by multiplying the income (loss) from continuing operations before provision (benefit) for income taxes by the statutory U.S. federal income tax rates for the following reasons: The tax effects of principal temporary differences in 1993 are shown in the following table: Other current assets include income tax refund receivables of $3,171,000 and $2,724,000 in 1993 and 1992, respectively. The Company increased its deferred tax asset and liability in 1993 as a result of legislation enacted during 1993, increasing the corporate tax rate from 34% to 35% commencing in 1993. The valuation TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 8--INCOME TAXES--(CONTINUED) allowance at December 26, 1993 of $9,502,000, resulted from a change in circumstances during 1993 surrounding the likelihood of the realization of the deferred tax assets in future years. The tax effects of principal temporary differences in 1992 are shown in the following table: The Company has tax carryforwards at December 26, 1993 expiring as follows: The use of these carryforwards is limited to future taxable income. Alternative minimum tax credits total $2,192,000 and may be carried forward indefinitely. TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 8--INCOME TAXES--(CONTINUED) The deferred income tax benefit credited to operations in 1991 arises from the following: The overall (benefit) provision for income taxes, during 1993, 1992 and 1991 is as follows: TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 9--LEASE COMMITMENTS The Company leases certain of its restaurant locations under long-term lease arrangements. Lease terms generally range from 10 to 25 years and normally contain renewal options ranging from 5 to 15 years, but do not contain purchase options. The Company is generally obligated for the cost of property taxes and insurance. Some of these leases contain contingent rental clauses based on a percentage of revenue. The building portions of such leases are capitalized and the land portions are accounted for as operating leases. Contingent rentals on capital leases in continuing operations were $526,000, $581,000 and $683,000 during 1993, 1992 and 1991, respectively. Rent expense under operating leases included in continuing operations is as follows: A summary of future minimum lease payments under capital leases, non-cancelable operating leases, and leases reserved for in the provision for restructuring recorded as of the fourth quarter of 1993 with remaining terms in excess of one year at December 26, 1993 follows: Future minimum lease payments on operating leases in continuing operations have been reduced for sublease rental income of approximately $107,000 to be received in the future under non-cancelable subleases. NOTE 10--COMMITMENTS AND CONTINGENCIES Several of the Company's reserved area agreements include expansion schedules requiring it to develop a minimum number of Shoney's restaurants in the reserved areas over a defined period of time. Pursuant to these agreements, the Company is required to open a minimum of 26 Shoney's restaurants through April 6, 2003. In addition, the Company has agreed to develop a territory in eastern Michigan jointly with Shoney's, Inc. Under this agreement, the Company is committed to develop 13 Shoney's restaurants at the same rate as Shoney's, Inc., which is expected to be approximately two to three stores TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--COMMITMENTS AND CONTINGENCIES--(CONTINUED) per year. In 1991, the Company entered into an agreement with Shoney's, Inc., to develop 38 new Captain D's restaurants over 20 years, at the approximate rate of two per year. The Company has constructed six restaurants with respect to this agreement. NOTE 11--LITIGATION Maxcell Telecom Plus, Inc., et al., v. McCaw Cellular Communications, Inc., et al. On November 1, 1993, the Company and its wholly-owned subsidiary, Maxcell Telecom Plus, Inc., filed a complaint in the Circuit Court of the Fifteenth Judicial Circuit in and for Palm Beach County, Florida. The complaint against McCaw Cellular Communications, Inc. ("McCaw"), Charisma Communications Corp. ("Charisma") and various related parties, relates to McCaw's failure to disclose the existence of a side agreement between McCaw and Charisma to share in the net profits from the resale of certain cellular properties which were sold by the Company to McCaw. The Company seeks recision of the sales contract and damages based upon the defendant's alleged fraudulent misrepresentation, breach of fiduciary duty, conspiracies and tortious interference with contracts. The Company's attorneys are unable at this time to state the likelihood of a favorable outcome. EEOC Settlement On January 15, 1993, Restaurants settled a class action lawsuit with the U.S. Equal Employment Opportunity Commission, which primarily related to events occurring prior to Restaurants' acquisition by the Company. Under the settlement, Restaurants did not admit any violation of law, but will pay approximately $880,000 during the first quarter of 1994 to satisfy the back pay and damages portion of the lawsuit as well as interest accrued from the date the lawsuit was filed. Restaurants also has undertaken certain affirmative action measures to promote the hiring of minorities and report to the EEOC on a semi-annual basis the results of these measures through 1995. Other The Company and its subsidiaries are defendants in various lawsuits arising in the ordinary course of business. It is the opinion of the management of the Company that the outcome of such litigation will not have a material adverse effect on the consolidated financial statements. NOTE 12--SHAREHOLDERS' EQUITY Stock Option Plans Officers and other key employees have been granted options to purchase common shares under nonqualified stock option plans adopted in 1982, 1983, 1984 and 1992. In addition, 150,000 shares of the Company's common stock are reserved under the 1992 stock option plan for non-employee directors. At December 26, 1993, an aggregate of 3,136,760 common shares were reserved under these plans. The number of shares available for future grants was 992,500 at December 26, 1993. Options are generally granted at the market price on the date of grant and generally become exercisable in increments of zero to sixty months and expire ten years from the date of grant. At December 26, 1993, options were TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--SHAREHOLDERS' EQUITY--(CONTINUED) exercisable to purchase 1,110,240 shares at prices ranging from $5.00 to $10.88. The Company's stock option transactions are summarized as follows: The Company has warrants outstanding at December 26, 1993 to purchase 1,000,000 shares of the Company's common stock at $11 per share. 1989 Employee Stock Purchase Plan On August 16, 1989, the Company adopted the 1989 Employee Stock Purchase Plan (the "Employee Plan") pursuant to which up to 500,000 common shares of the Company may be purchased at 85% of the fair market value of common shares on the first or last business day of each of thirteen purchase periods. The Employee Plan, which was approved by shareholders, is open to all active adult employees of the Company and Restaurants who have been employed for at least six months, customarily work more than 20 hours per week and more than five months per year, and are not directors or 5% shareholders of the Company or any subsidiary, as defined in the Employee Plan. Beginning October 1, 1989, employees could designate up to 10% of their compensation for the purchase of common shares. During 1993, 1992 and 1991, 73,419, 83,394 and 89,223 shares, respectively, were issued under the Employee Plan at prices ranging from $6.91 to $9.14 per Common Share in 1993, $4.78 to $6.59 per common share in 1992 and $3.51 to $5.63 per common share in 1991. Aggregate purchases were approximately $582,000, $444,000 and $387,000 in 1993, 1992 and 1991, respectively. NOTE 13--EMPLOYMENT AGREEMENTS, DEFERRED COMPENSATION AND RETIREMENT PLAN Employment Agreements The Company has agreements with four officers which expire at various dates through January 13, 1999. The aggregate minimum commitment for future salaries under these agreements is approximately $5,364,000. Additionally, three key employees of Restaurants are covered by agreements with two expiring on January 1, 1996 and one containing a self-renewing term of three years. The aggregate minimum commitment for future salaries under Restaurants' agreements is $1,133,000. In addition to TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 13--EMPLOYMENT AGREEMENTS, DEFERRED COMPENSATION AND RETIREMENT PLAN--(CONTINUED) salaries, the Company will pay minimum annual bonuses in connection with the above agreements of $305,000. The Company also is required to pay incentive bonuses equal to an aggregate of 8.2% of the annual increase in operating income over the prior year and $48,000 for each percentage point increase, or portion thereof, in the Company's same store sales. Additional bonuses are at the discretion of the Board of Directors. All of the above agreements provide severance benefits in the event of a change of control or an involuntary termination of the officer or key employee. The maximum contingent liability related to these severance benefits at December 26, 1993 was $4,618,000. Deferred Compensation Agreements Deferred compensation of $2,382,000 and $1,543,000 included in other liabilities at December 26, 1993 and December 31, 1992, respectively, relates to agreements with two former officers of Restaurants. In response to the recent decline in interest rates, the Company has adjusted the discount rate used to compute their deferred compensation obligation, resulting in a charge to operations of $913,000 during the fourth quarter of 1993. Retirement Plan In December 1993, the Board of Directors authorized the termination of the Company's non-qualified retirement plan for certain senior executives. Prior to December 31, 1992, the plan had four participants selected by the Board of Directors to participate in the plan. Three participants became eligible during 1992 to begin receiving retirement benefits under the early retirement provisions of the plan. In February 1993, one of these participants informed the Company of his intentions to retire prior to the end of 1993. The Company paid a lump sum benefit payment to this officer of $1,850,000 during March 1993. Operations was charged $1,148,000 for the year ended December 31, 1992 in connection with this curtailment. Upon termination of the plan, the Company made total lump sum benefit payments of $4,225,000 to the three remaining participants in the plan. These payments were determined through negotiations with the participants and were less than the aggregate actuarial present value of the retirement benefits otherwise payable under the plan. This termination resulted in a charge to operations of $1,220,000 during the year ended December 26, 1993. Net periodic pension cost for the fiscal years ended December 26, 1993, December 31, 1992 and December 31, 1991 consists of the following: TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--RELATED PARTY TRANSACTIONS Restaurants On July 21, 1993, the Company, through a wholly-owned subsidiary, acquired the stock of a company which operated three Shoney's restaurants, including one owned and two leased locations. Included in the acquisition were the exclusive rights to operate Shoney's restaurants in the surrounding northern Palm Beach County, Florida area. The purchase price of $3,860,000 included the issuance of 94,300 shares of the Company's common stock at $9.49 per share, the weighted average price for the prior twenty days. In conjunction with this transaction, the Company purchased the land and building at one of the leased restaurant locations for $1,240,000. The President and Chief Executive Officer of the Company was a 20% shareholder of the acquired company and had a 50% interest in the land and building the Company purchased. The Company engaged the services of an independent appraisal company to review the fairness of the transaction. On January 19, 1993, Restaurants purchased an airplane from a corporation owned by the President and Chief Executive Officer of the Company for $650,000. Prior to this purchase, Restaurants leased the airplane for approximately $87,000 per year during 1992 and 1991. In addition, Resturants paid chartering fees and expenses to the corporation of approximately $42,000 and $44,000 during 1992 and 1991, respectively. The cost of the charter arrangements and the lease arrangement were comparable to similar arrangements available from unrelated third parties. Exhibition Enterprises Partnership On May 28, 1993, the Company completed the sale of its 50% interest in the Partnership to American Multi-Cinema, Inc. ("AMC"), the parent company of Entertainment's partner in the Partnership and the original owner of 56 of the 57 theaters owned by the Partnership, for $17,500,000. In addition, AMC retired the bank loan owed by the Partnership, which was guaranteed by Entertainment. Prior to the formation of the Partnership on March 4, 1991, Entertainment was subject to a management agreement with AMC whereby AMC managed the theater operations for a fee based on a percentage of theater revenues. Effective April 19, 1991, the Partnership assumed Entertainment's obligations under the management agreement. For the 15 weeks ended April 18, 1991, Entertainment incurred AMC management fees of $1,921,000. For the year ended December 31, 1992, and the period April 19, 1991 through December 31, 1991, the Partnership incurred AMC management fees of $8,876,000 and $4,476,000, respectively. For the approximate five month period prior to the completion of the sale of Entertainment's 50% interest in the Partnership on May 28, 1993 to AMC, the Partnership incurred AMC management fees of $3,428,000. During the period ended May 28, 1993, the year ended December 31, 1992 and the period April 19, 1991 through December 31, 1991, the Partnership incurred interest expense on notes payable to AMC of $2,061,000, $5,084,000 and $3,559,000, respectively. For the fifteen weeks ended April 18, 1991, Entertainment incurred interest expense related to the notes of $1,482,000. Additionally, during the period ended May 28, 1993, the year ended December 31, 1992 and the period April 19, 1991 through December 31, 1991, the Partnership recorded charges of $133,000, $370,000 and $224,000, respectively, for an administrative fee payable to the Company. Chairman of the Board Pursuant to an agreement entered into on March 4, 1991, a limited partnership formed by the Company's Chairman purchased from AMC, on April 25, 1991, 1,000,000 of the Company's common shares at a price of $5.50 per share. In connection with the stock purchase, AMC granted such limited TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--RELATED PARTY TRANSACTIONS--(CONTINUED) partnership a ten-year option to purchase the approximately 1,475,000 common shares of the Company that AMC continues to own at an initial exercise price of $6.00 per share, escalating to $9.50 over the term of the options. NOTE 15--SUPPLEMENTARY INCOME STATEMENT INFORMATION RELATING TO CONTINUING OPERATIONS NOTE 16--QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial information for 1993 and 1992 reflects the results of operations of Restaurants as continuing operations and the Company's interest in theater operations as discontinued operations (Note 3). Restaurants' fiscal year is comprised of fifty-two or fifty-three weeks divided into four quarters of sixteen, twelve, twelve, twelve or thirteen weeks, respectively. Both 1993 and 1992 were fifty-two weeks. During 1993, the Company changed its fiscal year from a calendar year end to Restaurants fiscal year. During the fourth quarter of 1993 and 1992, the Company recorded restructuring charges of $35,082,000 and $3,586,000, respectively (Note 2). Other unusual charges during the fourth quarter of 1993 include $7,000,000 for additions to insurance reserves (Note 7), $1,220,000 for termination of the Company's retirement plan (Note 13), and $913,000 for adjustments to the Company's deferred compensation obligation (Note 13). The second and third quarters of 1993 include gains on the disposal of discontinued operations of $6,115,000, and $85,000, respectively. The fourth quarter of 1993 includes a loss on the disposal of discontinued operations of $927,000. A charge of $1,148,000 was recorded during the fourth quarter of 1992 relating to the early retirement of a Company executive (Note 13). The Company recorded losses, net of tax, on the early extinguishment of debt of $1,282,000, $282,000, and $10,385,000 in the first, second, and third quarters of 1992, respectively (Note 6). Also during the first quarter of 1992, the Company recorded charges of TPI ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 16--QUARTERLY FINANCIAL INFORMATION (UNAUDITED)--(CONTINUED) $2,838,000 resulting from the cumulative effect of adopting Financial Accounting Standards Nos. 109 and 112 (Note 1). Gross profit equals revenues less food, supplies and uniforms, restaurant labor and benefits, restaurant depreciation and amortization and other restaurant operating expenses. Net income (loss) per share is computed separately for each period and, therefore, the sum of such quarterly per share amounts may differ from the total for the year. The effect of convertible debentures and stock options on the fully-diluted earnings per share computation for the first, third, and fourth quarters of 1993 and the four quarters of 1992 were either antidilutive or did not result in a material dilution of earnings per share and, therefore, primary and fully-diluted earnings per share are equivalent. 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 during 1993. PART III ITEMS 10, 11, 12, AND 13. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT; AND CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by these Items is omitted because the Company will file a definitive proxy statement pursuant to Regulation 14A, which information is herein incorporated by reference as if set out in full. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements The following financial statements of the Company have been filed under Item 8 hereto: 2. Financial Statement Schedules The following financial statement schedules for the three years ended December 26, 1993 are filed herewith at the page indicated: ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8- K--CONTINUED The following financial statements and schedules of the Company's wholly-owned subsidiary, TPI Restaurants, Inc. are filed herewith at the page indicated: All other schedules have been omitted because they are inapplicable or the information required is shown in the consolidated financial statements or the notes thereto. 3. Exhibits A list of exhibits required to be filed as part of this report on Form 10-K is set forth in the "Exhibit Index," which immediately precedes such exhibits, and is incorporated herein by reference. (b). Reports on Form 8-K. There were no reports on Form 8-K filed by the Company during the last quarter of the period covered by this report. (c). Exhibits All exhibits required by item 601 are listed on the accompanying "Exhibit Index" described in (a) 3 above. (d). Financial Statements of Subsidiary The financial statements of the Company's wholly-owned subsidiary, TPI Restaurants, Inc. are filed under (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. TPI ENTERPRISES, INC. ............................... Registrant Date: March 25, 1994 By: /s/ STEPHEN R. COHEN ............................ Stephen R. Cohen Chairman of the Board of Directors Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. SCHEDULE III TPI ENTERPRISES, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET See notes to condensed financial statements. S-1 SCHEDULE III TPI ENTERPRISES, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF OPERATIONS See notes to condensed financial statements. S-2 SCHEDULE III TPI ENTERPRISES, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF CASH FLOWS See notes to condensed financial statements. S-3 SCHEDULE III TPI ENTERPRISES, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF SHAREHOLDERS' EQUITY FISCAL YEARS ENDED DECEMBER 26, 1993, 1992, 1991 (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) See notes to condensed financial statements. S-4 SCHEDULE III TPI ENTERPRISES, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTE 1--ACCOUNTING POLICIES The investments in the Company's subsidiaries are carried at the Company's equity in the subsidiary which represents amounts invested less the Company's equity in the earnings and losses to date. Significant intercompany balances and activities have not been eliminated in this unconsolidated financial information. Certain information and footnote disclosures normally included in financial statements prepared in conformity with generally accepted accounting principals have been condensed or omitted. Accordingly, these financial statements should be read in conjunction with the Company's consolidated financial statements. NOTE 2--CASH DIVIDEND PAID BY SUBSIDIARY Subsequent to the sale of its interest in the Partnership, the Company's wholly-owned subsidiary, TPI Entertainment, Inc., paid a dividend of $5,254,000 to the Company. On September 30, 1992, the Company's wholly-owned subsidiary, Maxcell Telecom Plus, Inc., paid a dividend of $9,000,000 to the Company. S-5 SCHEDULE V TPI ENTERPRISES, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN THOUSANDS) - --------------- (1) Includes additions related to discontinued operations of $418,000 in 1991. (2) Includes equipment and furnishings of $44,917,000, leasehold improvements of $27,717,000 and assets under capital leases of approximately $12,425,000, which were transferred to Exhibition Enterprises Partnership by TPI Entertainment, Inc. as of April 19, 1991. S-6 SCHEDULE VI TPI ENTERPRISES, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION (DOLLARS IN THOUSANDS) - --------------- (1) Includes depreciation and amortization expense related to discontinued operations of $2,649,000 in 1991. (2) Represents accumulated depreciation and amortization related to the assets of Entertainment which were transferred to the Partnership as of April 19, 1991. S-7 SCHEDULE VIII TPI ENTERPRISES, INC. AND SUBSIDIARIES RESERVES (DOLLARS IN THOUSANDS) S-8 SCHEDULE IX TPI ENTERPRISES, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS (DOLLARS IN THOUSANDS) - --------------- (1) Average amount outstanding during the period is computed by dividing the total of daily outstanding balances by the number of days in the year. (2) Weighted average interest rate during the period is computed by dividing the actual short-term interest expense by the average short-term debt outstanding. S-9 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholder of TPI Restaurants, Inc.: We have audited the accompanying consolidated balance sheets of TPI Restaurants, Inc., (a wholly-owned subsidiary of TPI Enterprises, Inc.) and its subsidiaries as of December 26, 1993 and December 27, 1992, and the related consolidated statements of operations, stockholder's equity and cash flows for each of the three fiscal years in the period ended December 26, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14 (a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of TPI Restaurants, Inc. and its subsidiaries as of December 26, 1993 and December 27, 1992, and the results of their operations and their cash flows for each of the three fiscal years in the period ended December 26, 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, in 1992 the Company changed its method of accounting for income taxes and postemployment benefits to conform with Statements of Financial Accounting Standards No. 109 and 112. The Company has reflected the cumulative effect of these changes in 1992. /s/ DELOITTE & TOUCHE March 18, 1994 Memphis, Tennessee W-1 TPI RESTAURANTS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements. W-2 TPI RESTAURANTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS See notes to consolidated financial statements W-3 TPI RESTAURANTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS W-4 TPI RESTAURANTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) See notes to consolidated financial statements. W-5 TPI RESTAURANTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY (DOLLARS IN THOUSANDS) See notes to consolidated financial statements W-6 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1--SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of TPI Restaurants, Inc. and its wholly-owned subsidiaries (the "Company"). All significant intercompany accounts and transactions are eliminated in consolidation. The Company maintains its books on a 52-53 week fiscal year ending on the last Sunday in December. Cash and Cash Equivalents The Company considers cash on hand, deposits in banks, certificates of deposit and short-term marketable securities with maturities of 90 days or less when purchased, as cash and cash equivalents. The Company utilizes a cash management system under which cash overdrafts exist in the book balances of its primary disbursing accounts. These overdrafts represent the uncleared checks in the disbursing accounts. The cash amounts presented in the consolidated financial statements represent balances on deposit at other locations prior to their transfer to the primary disbursing accounts. Uncleared checks of $7,393,000 and $7,445,000 are included in accounts payable at December 26, 1993 and December 27, 1992, respectively. Inventories Inventories, consisting of food items, beverages and supplies, are stated at the lower of weighted average cost (which approximates first-in, first-out) or market. Preopening Costs Direct costs incidental to the opening of new restaurants are capitalized and amortized over the restaurants' first year of operation. Depreciation and Amortization Depreciation and amortization of property and equipment is provided on the straight-line method over the estimated useful lives of the assets or, in the case of leasehold improvements and certain property under capital leases, over the lesser of the useful life or the lease term. Goodwill related to the acquisition of the Company by TPI Enterprises, Inc. is amortized on a straight-line basis over a thirty-six year period. The costs of franchise license agreements which govern the individual Shoney's and Captain D's restaurants and reserved area agreements are amortized on a straight-line basis over the lives of the related franchise license agreements, up to 40 years. Postemployment Benefits The Company recognizes the cost of postemployment benefits on an accrual basis in accordance with Financial Accounting Standard 112, "Employers' Accounting for Postemployment Benefits." The adoption of this statement during the year ended December 27, 1992 resulted in an increase of $79,000 in 1992 income before extraordinary item and cumulative effect of account charges. The cumulative effect on years prior to December 30, 1991 of $968,000 is included in 1992 net income. Income Taxes The Company's income taxes are computed in accordance with a tax sharing and payment agreement with its parent company. W-7 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 1--SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) Effective December 30, 1991, the Company adopted Financial Accounting Standard No. 109, "Accounting for Income Taxes", which requires an asset and liability approach to financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed annually for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. Prior to 1992, income taxes were accounted for under Accounting Principles Board Opinion No. 11. The effect of adopting Statement 109 was an increase of $646,000, relating to income before extraordinary item and cumulative effect of accounting changes, an increase of $849,000 relating to the extraordinary item and the cumulative effect of adopting Statement 112. The cumulative effect of the change on years prior to December 30, 1991 of $1,495,000 is a decrease in 1992 net income. The adoption of Statement 109 had no effect on 1992 net income. Working Capital Deficiency The Company had a working capital deficiency of $24,753,000 and $13,425,000 at December 26, 1993 and December 27, 1992, respectively. The Company does not have significant receivables or inventory and receives trade credit based upon negotiated terms in purchasing food and supplies. Because funds available from cash sales are not needed immediately to pay for food and supplies or to finance receivables or inventory, they may be used for non-current capital expenditures. Reclassification Certain amounts for 1992 and 1991 have been reclassified to conform to the 1993 presentation. NOTE 2--RESTRUCTURING CHARGES The Company approved a restructuring plan as of the end of the fourth quarter of 1993 which includes (i) closing or relocating 31 of its restaurants by the end of 1994, (ii) not exercising options to renew leases with respect to an additional 19 of its restaurants upon expiration of the current lease terms and (iii) restructuring divisional management and consolidating the Company's corporate office with its parent company's office. After an in-depth evaluation of the Company's Shoney's and Captain D's restaurants, management has identified 31 restaurants, which have not performed well and appear to have a limited potential for improvement in the future, to be closed or relocated. Included in these restaurants are five Shoney's and four Captain D's closed in December 1993. With respect to the restaurants closed or to be closed, the Company recorded $19,800,000 of restructuring charges consisting primarily of the write-off of assets and the accrual of lease and other expenses, net of projected sales proceeds and sublease income. With respect to the 19 restaurants projected to be closed no later than the expiration of their current lease terms, the Company determined that the recoverability of assets has been permanently impaired, and accordingly, recorded a charge of $4,500,000 primarily for the write-down of assets. The Company is continuing its efforts to restructure and downsize corporate overhead by consolidating its Memphis, Tennessee corporate office with its parent company's office in West Palm Beach, Florida. The Company recorded approximately $1,800,000 for the cost of moving the Memphis office and $800,000 for the write-off of assets and accrual of remaining lease obligations at the Company's present facilities. In addition, the Company accrued $1,200,000 for W-8 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 2--RESTRUCTURING CHARGES--(CONTINUED) severance costs and other costs relating to the restructuring of divisional and corporate overhead. Further, the Company wrote down vacant properties to net realizable value and revised its estimated loss with respect to units closed prior to 1993 by increasing its restructuring charge and related reserve by $6,500,000. Restructuring charges during 1992 included a $4,000,000 provision for closed units resulting rom management's decision, during the fourth quarter of 1992, to close all seven remaining Hungry Fisherman restaurants. The provision for closed units charged to operating income of $1,600,000 in 1991 was due to an additional reserve established to provide for estimated remaining costs of properties designated in 1989 to be closed. Such additional reserves were determined to be necessary based on the subsequent decline in the real estate market. NOTE 3--PROPERTY AND EQUIPMENT Property and equipment consists of the following: Property and equipment with a net book value of approximately $22,681,000 and $22,525,000 were pledged as collateral for the Company's debt facilities as of December 26, 1993 and December 27, 1992, respectively. Depreciation and amortization are calculated using the straight-line method and are based on the estimated useful lives of the assets as follows: buildings, 30 years; equipment and furnishings, 3-15 years; and leasehold improvements, primarily representing buildings constructed on leased property, the lesser of the term of the lease or 30 years. Depreciation and amortization of property and equipment totalled approximately $14,048,000, $12,833,000 and $11,730,000 during 1993, 1992 and 1991 respectively. In 1993, 1992 and 1991, approximately $1,649,000, $1,844,000 and $1,657,000, respectively, related to capitalized leases. Property and equipment includes capitalized interest on construction of $374,000 and $172,000 at December 26, 1993 and December 27, 1992, respectively. W-9 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 4--OTHER INTANGIBLE ASSETS Other intangible assets consists of the following: NOTE 5--LONG-TERM DEBT Long-term debt consists of the following: Scheduled annual principal maturities of long-term debt, excluding capital leases, for the five years subsequent to December 26, 1993, are as follows: $312,000 in 1994; $2,184,000 in 1995; $19,171,000 in 1996; $164,000 in 1997 and $177,000 in 1998. Interest expense for 1993, 1992, and 1991 includes interest on obligations under capital leases of $2,334,000, $2,610,000 and $2,261,000 respectively. Debentures On March 19, 1993, the Airlie Group, L.P. and certain related parties (the "Airlie Group") made an investment in TPI Enterprises, Inc. ("Enterprises") of $30,000,000 including $15,000,000 of 5% Convertible Senior Subordinated Debentures (the "Senior Debentures"), due 2003, the issuance of 1,500,000 shares of Enterprises' common stock at $10 per share and the issuance of warrants to purchase an additional 1,000,000 shares of common stock at $11 per share. The Senior Debentures are senior to the 8 1/4% Convertible Subordinated Debentures (described below). The Senior Debentures are convertible at the option of the holder into common shares of Enterprises at any time prior to maturity at $11 per share, subject to adjustment in certain events. The Senior Debentures mature on W-10 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5--LONG-TERM DEBT--(CONTINUED) April 15, 2003 and are redeemable, in whole or in part, at the option of Enterprises at any time on or after April 15, 1996, initially at 103.5% of their principal amount and declining to 100% of their principal amount on April 15, 2003. The Senior Debenture holders may require Enterprises to repurchase the Senior Debentures, in whole or in part, in certain circumstances involving a change in control of Enterprises as defined in the Debenture Purchase Agreement (the "Agreement"). However, a change in control, as defined in the Agreement, will create an event of default under the Credit Facility (described below) and, as a result, any repurchase would, absent a waiver, be blocked by the subordination provision of the Agreement until the Credit Facility (and any other senior indebtedness of Enterprises and senior indebtedness of the Company with respect to which there is a payment default) have been repaid in full. The Senior Debentures are unconditionally guaranteed on a subordinated basis by the Company. They are subordinated to all existing and future senior indebtedness of Enterprises and the Company. The 8 1/4% Convertible Subordinated Debentures (the "Debentures"), which provided proceeds to Enterprises of $47,948,000, net of $3,802,000 in deferred debt costs, are convertible at the option of the holder into common shares of Enterprises at any time prior to maturity at a conversion price of $6.50 per share subject to adjustment in certain events. The Debentures mature on July 15, 2002, and are redeemable at the option of Enterprises at any time on or after July 15, 1995, at a premium which declines as the Debentures approach maturity. The Debenture holders may also require Enterprises to repurchase the Debentures, in whole or in part, in certain circumstances involving a change in control of Enterprises as defined in the indenture covering the Debentures (the "Indenture"). However, a change in control, as defined in the Indenture, will create an event of default under the Credit Facility and, as a result, any repurchase would, absent a waiver, be blocked by the subordination provisions of the Indenture until the Credit Facility (and any other senior indebtedness of Enterprises and senior indebtedness of the Company with respect to which there is a payment default) have been repaid in full. During 1992, the Company recorded a charge of $16,069,000 following the repurchase of $82,676,000 principal amount of it's 14 1/4% Senior Subordinated Notes (the "Notes"). The Company had previously purchased $15,850,000 aggregate principal amount of the Notes in the open market. The costs of all repurchased Notes in excess of their principal amounts, together with the related deferred finance costs and expenses related to the repurchase, were charged to income as extraordinary items, net of income tax of $2,050,000. The remaining $1,474,000 principal amount was repurchased on November 15, 1993. Premiums on the purchases and the write-off of deferred debt costs resulted in a charge of $109,000 to other income and expense. Credit Facilities The Credit Facilities, which previously consisted of a $30,000,000 Term Loan Facility and a $25,000,000 Revolving Credit Facility, were amended and restated on June 3, 1993 to a $50,000,000 revolving credit facility (the "Credit Facility") with a syndicate of banks (the "Banks"). The Credit Facility matures on June 3, 1996, unless extended by the Banks. The Credit Facility was amended, effective December 26, 1993, to amend certain covenants affected by restructuring and certain other charges totalling $40,704,000 recorded by the Company for the fourth quarter of 1993. Borrowings under the Credit Facility, at the Company's option, bear interest at either a defined base rate or a rate based on the London Interbank Offered Rate. At December 26, 1993 the weighted average interest rate on the amount outstanding was 5.72%. The Company paid certain fees and expenses to the Banks in connection with the original commitment letter, which along with other costs W-11 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5--LONG-TERM DEBT--(CONTINUED) associated with the Original Credit Facilities, totalled approximately $2,000,000 and also agreed to indemnify the Banks against certain liabilities. The Company also pays a fee based on the Eurodollar rate, 2.00% at December 26, 1993, in connection with letters of credit issued and a commitment fee equal to 0.50% per annum on the average daily unused amount of the Credit Facility. Borrowings under the Credit Facility are secured by all shares of the capital stock of the Company, whenever issued, intercompany debt of the Company owed to Enterprises and ground lease mortgages with respect to certain premises in which the land is currently leased but the building located thereon is owned by the Company. In addition, the Banks have the right to obtain, as security, assignments of other leases and/or mortgages on real property currently owned or subsequently acquired. However, the Company has rights to finance certain of these properties and obtain a release of the collateral under certain conditions. The Credit Facility limits the amount of additional indebtedness which Enterprises, the Company and its subsidiaries may incur and the aggregate annual amount to be spent on capital expenditures. In addition, the Credit Facility limits, among other things, the ability of Enterprises, the Company and its subsidiaries to pay dividends, create liens, sell assets, engage in mergers or acquisitions and make investments in subsidiaries. The Company may not transfer amounts to Enterprises except for the payment of a management fee not to exceed $2,500,000 in each fiscal year and a dividend in an amount sufficient to pay interest on the Senior Debentures and the Debentures, in each case provided that no defaults under the Credit Facility exist either immediately before or after the transfer. The Company must also maintain certain financial ratios and defined levels of net worth. At December 26, 1993, $19,000,000 was drawn on the facility and letters of credit in the amount of $10,951,000 were outstanding, resulting in a remaining available balance of $20,049,000. Notes Payable Notes payable as of December 26, 1993 consists of obligations secured by buildings, land, equipment, and cash value life insurance policies with a net book value of $7,595,000. Fair Value of Financial Instruments The estimated fair value of the Company's Debentures, based on the quoted market price, is $86,900,000 and $74,520,000 at December 26, 1993 and December 27, 1992, respectively. The estimated fair value of the Company's Senior Debentures at December 26, 1993 is $12,716,000, based on the estimated borrowing rates available to the Company. The Credit Facility reprices frequently at market rates; therefore, the carrying amount of the Credit Facility is a reasonable estimate of its fair value at December 26, 1993 and December 27, 1992. The estimated fair value of the Company's notes payable approximates the principal amount of such notes outstanding at December 26, 1993 and December 27, 1992, which is based upon the estimated borrowing rates available to the Company. The fair value estimates presented herein are based on pertinent information available to management as of December 26, 1993 and December 27, 1992. 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 that date, and current estimates of fair value may differ significantly from the amounts presented herein. W-12 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 6--ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES The Company is primarily self insured for general liability and workers' compensation risks supplemented by stop loss type insurance policies. The self-insurance liabilities included in accrued insurance at December 26, 1993 and December 27, 1992 were approximately $9,451,000 and $5,200,000, respectively. Management recently completed an extensive review of the Company's exposure resulting from its self insurance program for workers' compensation and general liability. The review, which was based on improved data available to the Company relating to the trend in claims development, indicated that the Company's reserves for retained losses were near the lower end of the expected range of possible losses. Management determined it would be appropriate to increase the Company's reserves to better reflect the likely outcome of its liability within the possible range of losses. Accordingly, as of the end of the fourth quarter of 1993, workers' compensation insurance reserves were increased by charging $2,900,000 to restaurant labor and benefits and $1,800,000 to other operating expenses, respectively. NOTE 7--INCOME TAXES The provision (benefit) for income taxes on income before extraordinary item and cumulative effect of accounting changes is as follows: W-13 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7--INCOME TAXES--(CONTINUED) The provision (benefit) for income taxes is different from the amount that would be computed by multiplying the income (loss) before provision (benefit) for income taxes by the statutory U.S. federal income tax rates for the following reasons: The tax effects of principal temporary differences in 1993 are shown in the following table: W-14 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7--INCOME TAXES--(CONTINUED) The tax effects of principal temporary differences in 1992 are shown in the following table: The Company increased its deferred tax asset and liability in 1993 as a result of legislation enacted during 1993 increasing the corporate tax rate from 34% to 35% commencing in 1993. The net change in the valuation for deferred tax assets was an increase of $12,357,000. The Company's share of Enterprises' consolidated tax carryforwards at December 26, 1993 expire as follows: The use of these carryforwards is limited to future taxable income. Alternative minimum tax credits total $873,000 and may be carried forward indefinitely. W-15 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7--INCOME TAXES--(CONTINUED) Deferred income taxes benefit credited to operations in 1991 arise from the following: The overall (benefit) provision for income taxes, during 1992 is as follows: Other current assets include income tax refund receivables of $1,029,000 in 1992. The Company entered into a tax sharing and payment agreement with Enterprises (the "Agreement"), effective as of April 17, 1988, and applicable to the consolidated federal income tax returns filed by Enterprises for its taxable year beginning January 1, 1988. This Agreement provides that the Company, acting for itself and its subsidiaries, shall be allocated and shall reimburse Enterprises for their share of the consolidated federal income tax liability of the Enterprises consolidated group, and such share shall be determined by comparing the separate taxable incomes (as defined for consolidated federal income tax reporting purposes) of the Company and its subsidiaries to the sum of the separate taxable incomes of members of the Enterprises consolidated group. Enterprises will have the right to assess the Company on a quarterly basis for its share of the estimated consolidated federal income tax liability. Through December 26, 1993, deferred income taxes have not been provided with respect to timing differences which gave rise to approximately $1,300,000 of net operating losses, for tax purposes. The losses were utilized by Enterprises in the computation of its consolidated federal income tax liability in accordance with the Agreement. However, Enterprises has agreed to credit the Company with tax benefits related to such net operating losses to offset future federal income taxes otherwise payable by the Company under the Agreement. W-16 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 8--LEASE COMMITMENTS The Company leases certain of its restaurant locations under long-term lease arrangements. Lease terms generally range from 10 to 25 years and normally contain renewal options ranging from 5 to 15 years, but do not contain purchase options. The Company is generally obligated for the cost of property taxes and insurance. Some of these leases contain contingent rental clauses based on a percentage of revenue. The building portions of such leases are capitalized and the land portions are accounted for as operating leases. Contingent rentals on capital leases were $526,000, $581,000 and $683,000 during 1993, 1992 and 1991, respectively. Rent expense under operating leases included in continuing operations is as follows: A summary of future minimum lease payments under capital leases, non-cancelable operating leases, and leases reserved for in the provision for closed units recorded in the fourth quarter of 1993 with remaining terms in excess of one year at December 26, 1993 follows: Future minimum lease payments on operating leases have been reduced for sublease rental income of approximately $107,000 to be received in the future under non-cancelable subleases. NOTE 9--COMMITMENTS AND CONTINGENCIES Several of the Company's reserved area agreements include expansion schedules requiring the Company to develop a minimum number of Shoney's restaurants in the reserved areas over a defined period of time. Pursuant to these agreements, the Company is required to open a minimum of 26 Shoney's restaurants through April 6, 2003. In addition, the Company has agreed to develop a territory in eastern Michigan jointly with Shoney's, Inc. Under this agreement, the Company is committed to develop 13 Shoney's restaurants at the same rate as Shoney's, Inc., which is expected to be approximately two to three stores per year. In 1991, the Company entered into an agreement with Shoney's, W-17 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 9--COMMITMENTS AND CONTINGENCIES--(CONTINUED) Inc. to develop 38 new Captain D's restaurant over 20 years, at the approximate rate of two per year. The Company has constructed six restaurants with respect to this agreement. NOTE 10--LITIGATION EEOC Settlement On January 15, 1993, the Company settled a class action lawsuit with the U.S. Equal Employment Opportunity Commission. Under the settlement, the Company did not admit any violation of law, but will pay approximately $880,000 during the first quarter of 1994 to satisfy the back pay and damages portion of the lawsuit as well as interest accrued from the date the lawsuit was filed. The Company also has undertaken certain affirmative action measures to promote the hiring of minorities and report to the EEOC on a semi-annual basis the results of these measures through 1995. Other The Company and its subsidiaries are defendants in various lawsuits arising in the ordinary course of business. It is the opinion of the management of the Company that the outcome of such litigation will not have a material adverse effect on the consolidated financial statements. NOTE 11--STOCKHOLDER'S EQUITY The authorized capital stock of the Company consists of 10,000 shares of Series A Preferred Stock, par value $.01, which are issued and outstanding and 1,000 shares, par value $.01, of common stock which are issued and outstanding. Dividends are payable on the Series A Preferred Stock at the annual rate of $400 per share. The dividends begin to accrue and are cumulative from the date of issue and are payable when and if declared by the Board of Directors. As of December 26, 1993, there had been no dividends declared and the aggregate cumulative dividends were approximately $20,953,000. Cumulative dividends in arrears also have a liquidation preference and must be satisfied upon the redemption of the preferred stock by the Company. The payment of dividends on the Company's stock is limited as described in Note 5. NOTE 12--TRANSACTIONS WITH RELATED PARTIES On October 5, 1988, the Company and Enterprises entered into a management services agreement, pursuant to which Enterprises agreed to provide certain management services to the Company on an ongoing basis. These services include financial and tax advice and assistance, auditing and accounting advice and services, advice relating to personnel, including benefit plans, and assistance with the administration and operation of the Company in general. The management services agreement originally provided that the Company pay an annual fee of $1,000,000 to Enterprises as compensation for rendering management services. As of August 1, 1992, this fee was increased to $2,500,000. Enterprises will also be reimbursed for its out-of-pocket expenses incurred in connection with rendering the management services. The management services agreement is effective until December 31, 1998, at which time it may be renewed for succeeding one-year terms by mutual agreement of the parties. During the years ended December 26, 1993, December 27, 1992 and December 29, 1991, the Company accrued and expensed $2,487,000, $1,693,000 and $1,126,000, respectively, pursuant to this agreement. W-18 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--TRANSACTIONS WITH RELATED PARTIES--(CONTINUED) As part of the refinancing completed in August 1992, Enterprises purchased $15,850,000 aggregate principal amount of the Company's Notes. The Company paid approximately $798,000 of interest relating to these Notes to Enterprises during the year ended December 27, 1992. On July 21, 1993, Enterprises acquired, for a purchase price of $3,860,000, the stock of a company which operated three Shoney's restaurants, including one owned and two leased locations. Included in the acquisition were the exclusive rights to operate Shoney's restaurants in the surrounding northern Palm Beach County, Florida area. Enterprises subsequently contributed all assets and related liabilities acquired in the transaction to the Company. In conjunction with this transaction, the Company purchased the land and building at one of the leased restaurant locations for $1,240,000. The President and Chief Executive Officer of the Company was a 20% shareholder of the acquired company and had a 50% interest in the land and building the Company purchased. The Company engaged the service of an independent appraisal company to review the fairness of the transaction. On January 19, 1993, the Company purchased an airplane from a corporation owned by the President and Chief Executive Officer of the Company for $650,000. Prior to this purchase, the Company leased the airplane for approximately $87,000 per year during 1992 and 1991. In addition, the Company paid chartering fees and expenses to the corporation of approximately $42,000 and $44,000 during 1992 and 1991, respectively. The cost of the charter arrangements and the lease arrangement were comparable to similar arrangements available from unrelated third parties. NOTE 13--SUPPLEMENTARY INCOME STATEMENT INFORMATION NOTE 14--QUARTERLY FINANCIAL INFORMATION (UNAUDITED) During the fourth quarter of 1993, the Company recorded restructuring charges of $34,571,000 relating primarily to a provision for closed units (Note 2). The Company's fiscal year is comprised of fifty-two or fifty-three weeks divided into four quarters of sixteen, twelve, twelve and twelve or thirteen weeks, respectively. The Company recorded restructuring charges of $4,051,000 in the fourth quarter of W-19 TPI RESTAURANTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--QUARTERLY FINANCIAL INFORMATION (UNAUDITED)--(CONTINUED) 1992 (Note 2) and recorded an extraordinary loss, net of tax, on the early extinguishment of debt of $16,069,000 in the third quarter of 1992 (Note 5). Gross profit equals revenues less food, supplies and uniforms, restaurant labor and benefits, restaurant depreciation and amortization and other restaurant operating expense. W-20 SCHEDULE V TPI RESTAURANTS, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN THOUSANDS) WS-1 SCHEDULE VI TPI RESTAURANTS, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION (DOLLARS IN THOUSANDS) WS-2 SCHEDULE VIII TPI RESTAURANTS, INC. AND SUBSIDIARIES RESERVES (DOLLARS IN THOUSANDS) WS-3 SCHEDULE IX TPI RESTAURANTS, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS (DOLLARS IN THOUSANDS) - --------------- (1) Average amount outstanding during the period is computed by dividing the total of daily outstanding balances by the number of days in the year. (2) Weighted average interest rate during the period is computed by dividing the actual short-term interest expense by the average short-term debt outstanding. WS-4 EXHIBITS (Footnotes on following page) (Footnotes for preceding page) - ---------------

783996_1993.txt

783996_1993

1993

783996

Item 1. Business General Mendik Real Estate Limited Partnership (the "Partnership" or "Registrant") is a New York limited partnership which was formed in October 1985 pursuant to an agreement of limited partnership (as amended, the "Partnership Agreement") for the purpose of acquiring, maintaining and operating income-producing commercial office buildings in the Greater New York Metropolitan Area. NY Real Estate Services 1 Inc., a Delaware corporation ("NYRES1") (formerly known as Hutton Real Estate Services XV, Inc.), and Mendik Corporation, a New York corporation ("Mendik Corporation"), are the general partners (together, the "General Partners") of the Registrant. (See Item 10.) Commencing May 7, 1986, the Partnership began offering up to a maximum of 1,000,000 units of limited partnership interest (the "Units") at $500 per Unit with a minimum required purchase of 10 Units or $5,000 (four Units for an Individual Retirement Account or Keogh Plan). Investors who purchased the Units ("Investor Limited Partners") are not required to make any further capital contributions to the Partnership. Upon completion of the offering on September 18, 1987 the Partnership had accepted subscriptions for 395,169 Units for gross aggregate cash proceeds to the Partnership of $197,584,500. Net proceeds to the Partnership after deducting selling commissions, organization expenses, and other expenses of the offering were approximately $172,766,598. These proceeds were used to: (i) repay the principal amount of and interest on interim financing obtained by the Partnership to fund the acquisition of a property located at 1351 Washington Boulevard, Stamford, Connecticut (the "Stamford Property"); (ii) acquire the leasehold interests in a property located on Mamaroneck Avenue in Harrison, New York (the "Saxon Woods Corporate Center") and in a property located at 330 West 34th Street, New York, New York (the "34th Street Property") and; (iii) acquire an approximate 60% interest in Two Park Company, the joint venture which owns a property located at Two Park Avenue, New York, New York (the "Park Avenue Property"). The Stamford Property, Saxon Woods Corporate Center, 34th Street Property and Park Avenue Property are each referred to as a "Property" and collectively referred to as the "Properties." See Item 2 Item 2. Properties Saxon Woods Corporate Center Valuation. The Partnership's investment in the leasehold interest in the Saxon Woods Corporate Center at acquisition was $20,664,379, excluding acquisition expenses of $536,454. The Property's appraised value as of January 21, 1986 was $22,000,000. The appraised value of the leasehold interest as of December 31, 1993 was $15,000,000, as compared to appraised values of $14,000,000 at December 31, 1992 and $12,000,000 at December 31, 1991. Location. Saxon Woods Corporate Center is located on Mamaroneck Avenue in Harrison, New York, approximately 18 miles north of New York City in Westchester County. The office park is located near the Mamaroneck Avenue exit of Hutchinson River Parkway, approximately one mile north of Interstate 95, which is the major artery connecting New York City to Westchester County and Connecticut. Westchester County Airport is located approximately three miles north of the site. Site and Improvements. Saxon Woods Corporate Center consists of two five-story office buildings. The building at 550 Mamaroneck Avenue consists of approximately 112,000 net rentable square feet and the building at 600 Mamaroneck Avenue contains approximately 125,000 net rentable square feet, based on current standards of measurement. The buildings are situated on a 15.28 acre site, which provides ground-level parking for more than 800 cars. Ground Lease. The parcel of land underlying each building is leased from an unaffiliated ground lessor pursuant to a ground lease which terminates in September 2027 and provides the Partnership with the option to renew for two 25-year periods and one 39-year period. Each ground lease provides for an annual net rental of $170,000, with an increase of $20,000 every five years commencing in January 1996. Renovations. During the period from 1986 through 1993, the Partnership expended approximately $8.9 million on capitalized renovations, including tenant improvement construction, funded from cash flow, Partnership reserves, and borrowings. Financing. Through January 1994, the Partnership had borrowed approximately $4.7 million and made commitments to borrow an additional $362,000 under the $6.5 million non-recourse line of credit secured by the Partnership's leasehold interest in the Saxon Woods Corporate Center (the "Saxon Woods Line of Credit"). Reference is made to Note 6 to the Financial Statements, which is incorporated herein by reference thereto, for additional information regarding the Saxon Woods Line of Credit. Leasing. The Property's occupancy rates as of February 28, 1994, 1993 and 1992 were 75%, 67% and 42%, respectively. The vacancy rate in Westchester County, where the Saxon Woods Corporate Center is located, was 20.9% as of December 31, 1993, as compared to a vacancy rate of 15.1% at December 31, 1992. The Property's combined occupancy rate was lower than in the surrounding area primarily as a result of IBM's having vacated its more than 100,000 square feet of space in the Property (which constituted approximately 43% of the space in the Property) upon expiration of its lease in November 1988 in order to consolidate into other existing locations in Westchester County. This departure coincided with a severe and prolonged downturn in the Westchester County commercial real estate market. Although the Property's occupancy rate had risen since the departure of IBM, the Partnership experienced the loss of General Accident Insurance Company of America which vacated its 28,000 square feet in the Property (which constituted approximately 12% of the space in the Property) to relocate to the company's newly-constructed headquarters building upon expiration of its lease in July 1991. During 1993, utilizing funds available under the Saxon Woods Line of Credit, the Partnership entered into leasing transactions covering approximately 30,000 square feet at the Property including lease extensions and expansions by existing tenants. This activity is in addition to the leases for approximately 65,000 square feet that were signed during 1992. During 1994, the General Partners will continue to market the Property's available space to commercial office tenants and fund the costs of any additional leases utilizing proceeds from the Saxon Woods Line of Credit. Stamford Property Valuation. The Stamford Property was acquired by the Partnership for $31,250,000, excluding acquisition expenses of $313,125. The Property's appraised value as of October 17, 1985 was $34,000,000. The appraised value of the Property as of December 31, 1993 was $9,150,000, compared to appraised values of $10,600,000 as of December 31, 1992 and $14,100,000 as of December 31, 1991. Location. The Stamford Property is located at 1351 Washington Boulevard in the northwestern section of downtown Stamford, Connecticut approximately one mile north of the Stamford railroad station and Interstate 95, which is the major east/west freeway in the city, and 3.5 miles south of the Merritt Parkway, which bisects the city. In addition to fronting on Washington Boulevard, the Stamford Property is bounded by North Street, Franklin Street and Stanley Court. Stamford is located on the Long Island Sound in southwestern Connecticut, approximately 34 miles northeast of New York City. Site and Improvements. The office building and adjacent parking garage are located on a 1.73 acre parcel of land. The ten-story office building contains approximately 220,000 net rentable square feet, based on current standards of measurement. The above-ground parking garage provides over 550 parking spaces. Renovations. During the period from 1985 through 1993, the Partnership expended approximately $10 million on capitalized renovations, including tenant improvement construction, funded from cash flow, Partnership reserves, and borrowings. Financing. Reference is made to Note 6 to the Financial Statements, which is incorporated herein by reference thereto, for information regarding the terms of the $12.5 million non-recourse first mortgage loan to which the Stamford Property is subject (the "Stamford Loan"). The Partnership failed to make full payment of debt service due on February 10, 1994 and March 10, 1994 with respect to the Stamford Loan. Consequently, the Partnership is in default under the terms of the Stamford Loan and the property's lender, New York Life Insurance Company ("New York Life"), may elect to exercise its remedies under the loan agreement including accelerating the maturity date of the principal balance of the loan and electing to foreclose on its mortgage. The General Partners are now seeking a short-term agreement from New York Life, pursuant to which New York Life would forbear from exercising its remedies under the mortgage and Mendik Realty Company, Inc. ("Mendik Realty") would continue to defer its management fees and leasing commissions with respect to the Property. The Partnership would then attempt to sell the Property during the forbearance period. However, in light of the fact that the appraised value of the Property at December 31, 1993 was less than the mortgage, and New York Life is unlikely to accept a pay off of its mortgage at a discount, it is unlikely that such a sale would result in any cash proceeds being available for distribution. If the Partnership were unable to sell the Property and pay off the Stamford Loan within the forbearance period, the Partnership would transfer the deed in lieu of a foreclosure in order to provide an orderly and efficient transfer of title to the Property to New York Life. See Item 7. Leasing. The Property's occupancy rates as of February 28, 1994, 1993 and 1992, were 57%, 60% and 60%, respectively. Fairfield County, where the Stamford Property is located, has suffered from one of the highest metropolitan area vacancy rates in the country over the past six years as the vacancy rate increased from 17% in 1986 to 24.2% as of December 31, 1992. As of December 31, 1993, the vacancy rate in Fairfield County had declined slightly to 21%. Major tenants at the Stamford Property include D&B Computing Services, Inc. ("D&B") which leases 43,100 square feet (20% of the total leasable area in the Property) under a lease that expired on December 31, 1993. Effective January 1, 1994, the Partnership signed a ten-year lease extension with D&B whereby D&B will remain a tenant in the property through December 31, 2003. However, the rental rate D&B is paying under the terms of the extension represents a substantial reduction in the rate paid previously, reflecting current market conditions in Stamford. The property's other major tenant is Automatic Data Processing, Inc. ("ADP") which leases 34,700 square feet (16% of the total leasable area in the Property) under a lease expiring June 30, 1994. ADP has subleased approximately two-thirds of its space in the Property. The Partnership has entered into negotiations with ADP regarding a possible extension of the lease covering its portion of the space. The Partnership has also begun discussions with certain of ADP's subtenants in connection with new leases to extend the subtenants' tenancy beyond the expiration of ADP's lease. Based on current market conditions, it is likely that any lease extensions or renewals will be at lower rates than the Partnership currently receives, further adversely affecting the revenue generated by the Property. Currently, a lease for one of ADP's subtenants that occupies 8,200 square feet is close to being completed. The General Partners leasing strategy at the Property has been to market the Property's available space to potential tenants on an "as is" basis which would not require the Partnership to make additional investments for tenant improvement construction and would enable the Partnership to conserve its limited working capital reserves. The strategy was adopted recognizing that beginning in 1994, when the original modification was to expire, the Partnership would not have sufficient resources to meet its debt service payments and did not want to jeopardize any additional investment in the Property. Leases signed on an "as is" basis are likely to be at annual rental rates substantially below existing market rates. In addition, leasing space on an "as is" basis may have put and may continue to put the Partnership at a disadvantage compared to other landlords that provide allowances for tenant improvements. The occupancy rate at the Property, which is lower than that in the surrounding area, may have been and may continue to be adversely affected by the extremely competitive nature of the Stamford real estate market and the availability of space in newer buildings in the area as compared to the Partnership's older but renovated Property. 34th Street Property Valuation. The Partnership's investment in the leasehold interest in the 34th Street Property at acquisition was $34,883,132, excluding acquisition expenses of $728,268. The Property's appraised value as of November 1, 1986 was $39,000,000. The appraised value of the leasehold interest as of December 31, 1993 was $9,800,000 compared to appraised values of $12,500,000 at December 31, 1992 and $23,000,000 as of December 31, 1991. Location. The 34th Street Property is located at 330 West 34th Street, New York, New York, which is between Eighth and Ninth Avenues in Manhattan's Penn Plaza district, five blocks west of the Empire State Building, one-half block west of Pennsylvania Station and three blocks east of the Jacob Javits Convention Center. The Penn Plaza district is located in midtown Manhattan and comprises the seven-block area that surrounds Pennsylvania Station, New York City's largest transportation hub. Pennsylvania Station serves as the western terminus for the Long Island Railroad, the Manhattan terminal for the Amtrak rail system and the eastern terminus for the New Jersey Transit rail system. In addition, several major arteries of the New York City subway system have stops in and around Pennsylvania Station, providing access to passengers from the New York City boroughs of Brooklyn, Queens and the Bronx. Madison Square Garden, New York City's largest spectator arena, is located above Pennsylvania Station. Site and Improvements. The 34th Street Property consists of an 18-story structure and a two-story attached annex containing in the aggregate approximately 627,000 net rentable square feet, based on current standards of measurement. The 46,413 square foot site also includes an above-ground parking area containing 39 spaces that is currently leased to an independent garage operator. Ground Lease. Per the terms of the ground lease agreement, the annual ground lease payment to the unaffiliated ground lessor for the parcel of land underlying the 34th Street Property increased from $1.25 million to $2.25 million effective January 1, 1992. Reference is made to Note 5 to the Financial Statements, which is incorporated herein by reference thereto, for additional information on the ground lease. Renovations. During the period from 1987 through 1993, the Partnership expended approximately $9.6 million on capitalized renovations, including tenant improvement construction, funded from cash flow, Partnership reserves, and borrowings. Financing. On August 12, 1993, the Partnership entered into a modification of the 34th Street Line of Credit which will allow the Partnership to pay off the 34th Street Line of Credit at a substantial discount by payment of the sum of $6.5 million at any time through June 30, 1994. Should the Partnership be unable to pay off the 34th Street Line of Credit, the forbearance agreement provides that the Partnership will assign its leasehold interest to the Property to the lender, at the lender's election, in lieu of a foreclosure. Reference is made to Item 7 and Note 6 to the Financial Statements, which is incorporated herein by reference thereto, for additional information regarding the 34th Street Line of Credit. In order further to supplement the Property's cash flow, beginning in January 1992, Mendik Realty agreed to defer its management fees of approximately $170,000 a year that would otherwise have been payable with respect to the 34th Street Property, although it had no obligation to do so. Pursuant to the forbearance agreement, these fees will continue to be deferred. The Partnership's obligation to pay the management fees deferred by Mendik Realty, will be on a non-recourse basis to the Partnership and will bear interest at a rate per annum equal to the prime rate of Morgan Guaranty Trust Company of New York less 1.25%. Principal and interest will be payable on December 31, 2025, or such earlier date on which the term of the Partnership terminates, subject to a mandatory prepayment from the net proceeds from the sale of any of the Properties, after repayment of all debt secured by the Property sold. In addition, Mendik Realty agreed to defer its leasing commission with respect to the long-term lease with the City of New York as discussed below and any further leasing commissions associated with additional leasing activity at the Property. See Item 7. Leasing. On February 17, 1993, the Partnership signed a long-term lease with the City of New York effective August 1, 1992 for approximately 300,000 square feet or approximately 48% of the Property's leasable area. The term of the lease is for eight years and six months expiring on February 28, 2001. The City has the right to terminate the lease without penalty provided the City gives the Partnership one year's notice of its intent to terminate the lease. The City will also be required to pay the Partnership for certain improvement costs as defined in the lease. The City will make annual base rental payments of approximately $5.4 million and will pay its proportionate share of increases in real estate taxes and operating expenses. Approximately $1.25 million has been spent by the Partnership for tenant improvement costs required under the terms of the lease. The funds utilized for such purpose had been held as security by the unaffiliated ground lessor. The General Partners have been marketing the Property's remaining available space to light-industrial type tenants on an "as is" basis. Rental rates for light-industrial type tenants are substantially less than the rental rates received from commercial office tenants. Effective January 1, 1993, the Partnership signed a ten-year lease with Tiger Button Company, Inc. for approximately 25,000 square feet in the Property. In addition, effective July 1, 1993, the Partnership signed a nine and one-half year lease with G. Dinan & Co., Inc. for approximately 26,000 square feet. The General Partners believe that renting space on an "as is" basis to light-industrial type tenants may be an effective means to generate additional cash flow from the Property without requiring a significant current investment in tenant improvements. The Property's occupancy rates as of February 28, 1994, 1993 and 1992, were 61%, 57% and 50%, respectively. The Midtown West District, where the 34th Street Property is located has seen the vacancy rate for primary office space increase from 9.6% at December 31, 1987 to 16.2% at December 31, 1993. It should be noted that the Property's occupancy rate is not comparable with office buildings in the Midtown West District due to the Partnership's strategy of marketing space to light-industrial type tenants rather than commercial office tenants. However, the Property's occupancy rate continues to be below the average occupancy rate for office space in the area in which it is located primarily because of past uncertainty surrounding the City's tenancy, the character of the City's tenancy, the nature of the services the City provides, and the Partnership's strategy of conserving its limited resources. Park Avenue Property Valuation. Two Park Company, the joint venture in which the Partnership has an approximate 60% interest, acquired the Park Avenue Property for $151,500,000. The Property's appraised value as of September 1, 1987 was $165,000,000. The appraised value of the Property as of December 31, 1993 was $115,000,000, compared to appraised values of $125,000,000 as of December 31, 1992 and $135,000,000 as of December 31, 1991. The Partnership's investment in its interest in Two Park Company at acquisition was $95,965,732, including $35,820,000 which represents the Partnership's share of first mortgage debt to which the Property was subject when the Partnership acquired its interest and excluding $1,722,532 of acquisition expenses. The appraised value of the Partnership's interest in the Property as of December 31, 1993 was $68,655,000, compared to appraised values of $74,625,000 as of December 31, 1992, $80,595,000 as of December 31, 1991 and $98,505,000 as of September 1, 1987. Location. The Park Avenue Property is located at Two Park Avenue, New York, New York, on an approximately one-acre site that occupies the entire western frontage of Park Avenue between East 32nd and East 33rd Streets in midtown Manhattan. The Park Avenue Property is located four blocks east of Pennsylvania Station and nine blocks south of Grand Central Station, New York City's largest transportation hubs. Grand Central Station serves as the Manhattan terminal for the Metro North rail system. In addition to a subway stop located below the building, several major arteries for the New York City subway system have stops in and around Grand Central Station and Pennsylvania Station, providing access to passengers from the New York City boroughs of Brooklyn, Queens and the Bronx. Site and Improvements. The improvements to the Park Avenue Property consist of a 28-story office building that contains approximately 956,000 net rentable square feet, based on current standards of measurement. The building includes two lower levels consisting of a subway concourse, a small tenant garage containing approximately 43 spaces, rentable storage areas and mechanical facilities. Renovations. During the period from 1987 through 1993, a total of approximately $39.7 million was capitalized by Two Park Company on renovations. Financing. Reference is made to Note 6 to the Financial Statements, which is incorporated herein by reference thereto, for information regarding the non-recourse first mortgage, non-recourse second mortgage and non-recourse third mortgage secured by the Park Avenue Property which aggregate $75 million. Leasing. The Property's occupancy rates as of February 28, 1994, 1993 and 1992, were 89%, 90% and 92%, respectively. The vacancy rate for primary office space in the Grand Central District of Midtown Manhattan, where the Park Avenue Property is located, has increased from 10.2% at December 31, 1987 to 18.4% at December 31, 1992. At December 31, 1993, the vacancy rate in the Grand Central District had declined slightly to 17.6%. During 1994, the General Partners will continue to market the Property's available space to commercial office tenants. Major tenants at the Park Avenue Property are Times Mirror Magazines, Inc. and its affiliate Newsday, Inc. which, in the aggregate, lease 259,043 square feet (approximately 27% of the total leasable area in the Property) under two leases expiring on June 30, 2004 and National Benefit Life Insurance Company which leases 99,800 square feet (approximately 10% of the total leasable area in the Property) under a lease expiring on May 30, 1998. The base rental income under the leases with Times Mirror Magazines, Inc. and Newsday, Inc., and National Benefit Life Insurance Company represented approximately 18% and 8%, respectively, of the Partnership's consolidated rental income in 1993. Item 3. Item 3. Legal Proceedings Neither the Partnership nor any of the Properties is currently subject to any material legal proceedings. Item 4. Item 4. Submission of Matters to a Vote of Security Holders During the fourth quarter of 1993, no matter was submitted to a vote of security holders through the solicitation of proxies or otherwise. PART II Item 5. Item 5. Market for the Partnership's Limited Partnership Units and Related Security Holder Matters As of December 31, 1993, there were 19,815 holders of Units. No public trading market has developed for the Units, and it is not anticipated that such a market will develop in the future. The transfer of Units is subject to significant restrictions, including the requirement that an Investor Limited Partner may transfer his Units only with the consent of the General Partners, which consent may be withheld in the sole and absolute discretion of the General Partners. During the first quarter of 1989, a decision was made by the General Partners to establish reserves in the amount of what would otherwise be Net Cash From Operations to help meet anticipated Partnership requirements. For the years ended December 31, 1993 and 1992, no distributions were paid to the Partners, and the Partnership does not contemplate making any distributions during 1994. See Item 7 of this Report. Item 6. Item 6. Selected Financial Data The following financial data of the Partnership has been selected by the General Partners and derived from financial statements which have been audited by KPMG Peat Marwick, independent public accountants whose report thereon is included elsewhere herein. The information set forth below should be read in conjunction with the Partnership's financial statements and notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations," also included elsewhere herein. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources The commercial real estate market in the Greater New York Metropolitan Area remains weak. As vacancy rates have risen, increased competition among landlords has led to lower rents and increasingly generous tenant concession packages in the form of tenant improvements and free-rent periods. The significant cost of tenant improvements required to be funded under both new and renewal leases has sharply increased the demand for capital by landlords, including the Partnership. Expenditures for tenant improvements have contributed to the Partnership's reduced liquidity. In order to conserve the Partnership's limited resources, the General Partners have pursued a strategy intended to position each of the Partnership's four properties, to the extent possible, to meet its operating and other expenses as they come due using only the operating income generated by that Property, and, if necessary, proceeds from borrowings secured by such Property. During 1993, the Partnership funded operating costs, the cost of tenant improvements, leasing commissions, and building capital improvements from five sources: (i) positive cash flow generated by the approximately 60% joint venture interest in the Park Avenue Property and the Partnership's leasehold interest in the Saxon Woods Corporate Center, (ii) Partnership reserves, (iii) funds provided by certain unsecured loans and the deferral of property management fees by certain affiliates of the General Partners, (iv) additional borrowings from the $6.5 million Saxon Woods Line of Credit and (v) a portion of the $1.25 million security deposit maintained by the unaffiliated ground lessor for the 34th Street Property. It is expected that the availability of funds from certain of these sources will be reduced in the future. Park Avenue Property - Although the Partnership has continued to lease space at the Property, with the continuing softness in the real estate market, new and renewal leases generally have been signed at rental rates significantly less than the rental rates received on certain expiring leases. The Property's cash flow, however, is expected to remain stable for the foreseeable future because rental rate increases negotiated in leases signed in earlier years have offset the lower market rental rates reflected in the leases recently signed by the Partnership. At December 31, 1993, the unrestricted cash balance at the Property was approximately $5 million over and above a reserve for real estate taxes. The Park Avenue Property currently generates, and is expected to generate in the future, sufficient revenue to cover operating expenses and debt service obligations. The indebtedness secured by the Park Avenue Property currently matures in 1998 (or 1996 at the option of the lender). The Partnership expects, as the maturity of the loan approaches, to commence negotiations to extend the existing loan or to seek refinancing. However, as a result of the current lack of liquidity in the financial marketplace, no assurances can be made that the Partnership will be able to extend with the existing lender or refinance with a new lender, on terms acceptable to the Partnership or at all. Saxon Woods Corporate Center - The Partnership expects that cash flow from the Saxon Woods Corporate Center will cover operating expenses and debt service obligations in 1994. Although the Saxon Woods Line of Credit is in the amount of up to $6.5 million, as a result of Section 13(d) (xviii) of the Partnership Agreement which prohibits the Partnership from incurring indebtedness secured by a Property in excess of 40% of the then-appraised value of such Property (or 40% of the value of such Property as determined by the lender as of the date of financing or refinancing, if such value is lower) (the "Borrowing Limitation"), the Partnership is permitted to borrow only $6 million based on the most recent appraisal of the Saxon Woods Corporate Center which as of December 31, 1993 was $15 million. The loan agreement provides that all available cash flow from the Property will be used for expenses incurred at the Property prior to borrowing any additional funds under the Saxon Woods Line of Credit. The General Partners expect that additional leasing activity, the costs of which partially will be funded by borrowing amounts remaining available under the Saxon Woods Line of Credit, may result in an increase in the appraised value of the Property thereby enabling the Partnership to borrow the additional amounts available under the Saxon Woods Line of Credit up to the full amount of $6.5 million. There can be no assurance that future appraisals will reflect an increase in the Property's value which would enable the Partnership to borrow additional funds. As of December 31, 1993, the Partnership had borrowed $4,542,677 under the Saxon Woods Line of Credit. In January 1994 the Partnership borrowed an additional $138,000 and had made commitments to borrow an additional $362,000 which would increase the total borrowings on the Saxon Woods Line of Credit to $5,042,677. The indebtedness secured by the Saxon Woods Corporate Center currently matures in 1996. The Partnership expects, as the maturity of the loan approaches, to commence negotiations to extend the existing loan or to seek refinancing. However, as a result of the current lack of liquidity in the financial marketplace, no assurances can be made that the Partnership will be able to extend with the existing lender or refinance with a new lender, on terms acceptable to the Partnership or at all. 34th Street Property - On February 17, 1993, the Partnership signed a long-term lease with the City of New York effective August 1, 1992 for approximately 300,000 square feet in the 34th Street Property. The City has the right to terminate the lease without penalty provided the City gives the Partnership one year's notice of its intent to terminate the lease. The City will also be required to pay the Partnership for certain improvement costs as defined in the lease. The terms of the lease call for the City to make annual base rental payments of approximately $5.4 million and pay its proportionate share of increases in real estate taxes and operating expenses. Per the terms of the lease, approximately $1.25 million is being spent by the Partnership for tenant improvements required under the terms of the lease. In order to fund the tenant improvements required by the City lease, the Partnership negotiated an agreement with the unaffiliated ground lessor pursuant to which the ground lessor agreed to make available the $1.25 million that was being held as security under the ground lease. As of December 31, 1993, virtually all of these funds had been spent. The ground lessor also agreed to waive the lease requirement that the Partnership deposit an additional $1 million as security with the ground lessor in connection with the increase in the annual ground rent in 1992 to $2.25 million. During 1992, the cash flow from the 34th Street Property did not cover its debt service obligations after payment of operating expenses, and it was not expected to meet its debt service obligations in 1993. As a result, in order to conserve the Partnership's limited working capital reserves and induce The First National Bank of Chicago ("FNBC"), the Property's lender, to modify the mortgage's terms, the Partnership suspended its interest payments to FNBC beginning in September 1992. On August 12, 1993, the Partnership entered into a forbearance agreement which modified the terms of the 34th Street Line of Credit. Pursuant to the forbearance agreement FNBC agreed to forbear through June 30, 1994 from exercising its remedies under the loan agreement as a result of the Partnership's failure to pay interest. The forbearance agreement will also allow the Partnership to pay off the 34th Street Line of Credit for $6.5 million at any time through June 30, 1994, a substantial discount to the 34th Street Line of Credit's current outstanding balance and below the Property's December 31, 1993 appraised value of $9.8 million. As of December 31, 1993, there was $15 million of principal and approximately $1.3 million of accrued interest outstanding on the 34th Street Line of Credit. Also through June 30, 1994, the Partnership will be permitted to make interest payments to FNBC only to the extent of available cash flow from the 34th Street Property. Since the forbearance agreement went into effect, the Partnership has not made any interest payments to FNBC. The General Partners are seeking to obtain either debt or equity financing even if such financing would entail the Partnership's transferring all or a portion of its interest in the Property to the party providing the financing. In the event the Partnership obtains from a third party an offer to provide financing of less than the $6.5 million required by FNBC, the Partnership would explore with FNBC a pay off at a further discount. Should the Partnership be unable to pay off the 34th Street Line of Credit by June 30, 1994, the forbearance agreement provides that the Partnership will assign its interest in the Property and in the ground lease to the Property to FNBC, at FNBC's election, in lieu of foreclosure. The forbearance agreement with FNBC provides the Partnership with an opportunity to pay off the 34th Street Line of Credit at a substantial discount while at the same time establishing a cost-effective means to ensure an orderly and efficient transfer of the Property to FNBC in the event the 34th Street Line of Credit cannot be paid off. The Partnership has no assurances that it will be able to obtain the financing necessary to pay off the 34th Street Line of Credit and any such pay off will depend on numerous factors including general market conditions. Chief among these is the fact that many traditional sources of real estate financing such as banks, insurance companies and pension funds have dramatically curtailed their investment in commercial office properties. Consequently, only a limited number of investors is likely to be available, further hampering the Partnership's ability to secure a refinancing. Should the Partnership be unable to complete a refinancing, it will likely result in the loss of the Partnership's investment in the Property. In order to improve the 34th Street Property's cash flow, beginning in January 1992, Mendik Realty voluntarily agreed to defer its management fees of approximately $170,000 a year that would otherwise have been payable with respect to the 34th Street Property. In addition, Mendik Realty agreed to defer its leasing commission with respect to the signing of the long-term lease with the City of New York and any further leasing commissions associated with additional leasing activity at the Property. Both of these provisions will remain in effect pursuant to the terms of the forbearance agreement with FNBC. The forbearance agreement requires the Partnership to deposit all receipts from the Property into a lockbox at FNBC. FNBC will approve all releases from the lockbox to fund Property costs. As of December 31, 1993, approximately $1 million was in the lockbox account maintained at FNBC which was utilized to fund real estate taxes due in January 1994. Stamford Property - As described in Note 6 to the Financial Statements, the Partnership previously restructured the loan secured by the Stamford Property in 1991. As part of the terms of the restructured loan, Mendik Corporation and an affiliate of NYRES1 loaned $50,000 and $110,000, respectively, to the Partnership in each of 1991, 1992 and 1993. The loans were required to be deposited in an escrow account and may be used only to pay costs and expenses related to the Stamford Property. Mendik Realty also agreed to defer its management fees of approximately $70,000 a year in connection with the Stamford Property in each of calendar years 1991, 1992 and 1993. The restructuring was intended to enable the Stamford Property to generate sufficient cash flow to meet its operating expenses and debt service obligations through 1993 without utilizing the Partnership's working capital reserves in the hope that the Stamford real estate market would recover and that, as leases at the Property expired, the Partnership would be able to enter into new or renewal leases at rental rates in excess of the rates being paid by existing tenants under current leases. However, the Stamford real estate market has continued to deteriorate resulting in a further erosion of market lease rates. While the cash flow from the Stamford Property, together with the loans by Mendik Corporation and an affiliate of NYRES1 and the management fee deferrals by Mendik Realty, were sufficient to cover the Property's operating expenses and debt service obligations in 1993, due to a decline in the Property's revenue following the extension of D&B's lease, the Partnership failed to make full payment of debt service due on February 10, 1994 and March 10, 1994 with respect to the Stamford Loan. In order to preserve its limited working capital reserves, the Partnership currently does not intend to fund any operating shortfalls out of reserves. As a result of the Partnership's failure to make these interest payments, the Partnership is in default under the terms of the Stamford Loan and the property's lender, New York Life Insurance Company ("New York Life"), may elect to exercise its remedies under the loan agreement including accelerating the maturity date of the principal balance of the loan and electing to foreclose on its mortgage. The General Partners are now seeking a short-term agreement from New York Life, pursuant to which New York Life would forbear from exercising its remedies under the Stamford Loan and Mendik Realty would continue to defer its management fees and leasing commissions with respect to the Property. The Partnership would then attempt to sell the Property during the forbearance period. However, in light of the fact that the appraised value of the Property at December 31, 1993 was less than the mortgage, and New York Life is unlikely to accept a pay off of its mortgage at a discount, it is unlikely that such a sale would result in any cash proceeds being available for distribution. If the Partnership were unable to sell the Property and pay off the Stamford Loan within the forbearance period, the Partnership would transfer the deed in lieu of a foreclosure in order to provide an orderly and efficient transfer of title to the Property to New York Life. During the latter part of 1992, the General Partners concluded that the Partnership may be unable to hold the 34th Street Property and the Stamford Property on a long-term basis. As a result, the Partnership determined to account for each Property as held for disposition. Accordingly, as of December 31, 1993, these Properties are being carried at the lower of their depreciated cost or estimated market value resulting in the Partnership's recording an unrealized loss of approximately $43.2 million in 1992 and an additional $4.2 million loss in 1993. Cash Reserves - The Partnership's consolidated cash reserves decreased by $82,686 to $10,346,684 at December 31, 1993 from $10,429,370 at December 31, 1992. During 1993, approximately $2.8 million was expended for property improvements at the Park Avenue and 34th Street Properties, and Saxon Woods Corporate Center. These expenditures were offset by approximately $1.4 million in additional borrowings under the Saxon Woods Line of Credit and approximately $1.4 million of cash flow from operations which includes the release of the previously-restricted security deposit held by the 34th Street Property's unaffiliated ground lessor. In addition to the cash reserves, at December 31, 1993, the Partnership had $2,390,734 in restricted cash under various agreements including the FNBC lockbox required under the forbearance agreement. As a result of the additional borrowings under the Saxon Woods Line of Credit, mortgage notes payable increased from $105,654,502 at December 31, 1992 to $107,042,677 at December 31, 1993 on a consolidated basis. Results of Operations 1993 vs. 1992 During the year ended December 31, 1993, the Partnership realized operating income before non-cash expenses, on a consolidated basis, of approximately $1,541,000 as compared to operating income of approximately $2,454,000 for the corresponding period in 1992. As a result of the Partnership's decision to carry the 34th Street Property and Stamford Property at the lower of their depreciated cost or estimated market value, the Partnership recorded an unrealized loss on properties held for disposition of $4,240,608 and $43,166,559 for the years ended December 31, 1993 and 1992, respectively. Including the unrealized losses, the Partnership sustained a net loss after depreciation and amortization of $11,406,548 for the year ended December 31, 1993 as compared to $52,415,692, for 1992. If the Partnership had not recorded the unrealized losses in 1993 and 1992, the Partnership would have recorded losses of $7,165,940 and $9,249,133 for the years ended December 31, 1993 and 1992, respectively. Consolidated rental income for the year ended December 31, 1993 was $34,333,599 as compared with $34,094,669 for the corresponding period in 1992. Consolidated rental income remained stable from 1992 to 1993 as the income from the new leases signed in the Saxon Woods Corporate Center offset a decline in rental income from the Two Park Avenue Property that resulted from leases being renewed at the lower market rental rates. Consolidated interest income for 1993 was $282,740 as compared to $342,409 for the corresponding period in 1992. The decline is due to lower interest rates earned on the Partnership's cash balance and the Partnership's maintaining a lower average cash balance during 1993. Consolidated property operating expenses for 1993 increased slightly from 1992. Depreciation and amortization decreased in 1993 primarily due to the reduction in the carrying value of the 34th Street Property and Stamford Property effective December 31, 1992. Interest expense increased slightly during 1993 from the corresponding period in 1992 due to the increase in the principal balance outstanding under the Saxon Woods Line of Credit. 1992 vs. 1991 During 1992, the Partnership realized operating income before non-cash expenses, on a consolidated basis, of approximately $2,454,000 as compared to approximately $3,472,000 in 1991. As a result of the Partnership's decision to carry the 34th Street Property and Stamford Property at the lower of their cost or market value, the Partnership recorded an unrealized loss on properties held for disposition of $43,166,559. Including the unrealized loss, the Partnership sustained a net loss after depreciation and amortization of $52,415,692 for the year ended December 31, 1992. If the Partnership had not recorded the unrealized loss, the Partnership would have recorded a net loss after depreciation and amortization of $9,249,133 for the year ended December 31, 1992 as compared to a net loss of $8,062,874 for the year ended December 31, 1991. Consolidated rental income for the year ended December 31, 1992 decreased by approximately 5% or $1,612,082 from the year ended December 31, 1991 primarily as a result of a decline in occupancy at the Park Avenue Property. Consolidated interest income for the year ended December 31, 1992 decreased by $268,988 from the year ended December 31, 1991 due to lower interest rates earned on the Partnership's cash balance and the Partnership's maintaining a lower average cash balance during 1992. Consolidated property operating expenses for the year ended December 31, 1992 were virtually unchanged from the year ended December 31, 1991. It should be noted that although the annual ground lease rent for the 34th Street Property increased by $1 million, pursuant to the terms of the Property's ground lease, such increase was more than offset by reductions in property maintenance expenses at the four Properties. Interest expense during 1992 was also virtually unchanged from 1991 due to a decrease in the interest rate on the 34th Street Line of Credit which was offset by an increase in the principal balance outstanding under the Saxon Woods Line of Credit. Consolidated general and administrative expenses decreased by $260,962 from 1991 to 1992 primarily due to reduced legal fees. Item 8. Item 8. Financial Statements and Supplementary Data See Index of the Consolidated Financial Statements and Financial Statement Schedules at Item 14, filed as part 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 Partnership has no officers or directors. Mendik Corporation and NYRES1, as General Partners, jointly manage and control the affairs of the Partnership and have general responsibility and authority in all matters affecting its business. Mendik Corporation Mendik Corporation was incorporated under the laws of the State of New York on November 13, 1985. All of the capital stock of Mendik Corporation is owned by Bernard H. Mendik. Pursuant to Section 22(b) of the Partnership Agreement, Mr. Mendik has contributed to the capital of Mendik Corporation $2.5 million in the form of a demand promissory note, which represents the only substantial asset of Mendik Corporation. Mr. Mendik has a net worth in excess of such amount. Mendik Corporation maintains its principal office at 330 Madison Avenue, New York, New York 10017. The executive officers and sole director of Mendik Corporation (none of whom has a family relationship with another) are: Name Age Office Bernard H. Mendik 64 Chairman and Director David R. Greenbaum 42 President Christopher G. Bonk 39 Senior Vice President and Treasurer Michael M. Downey 52 Senior Vice President David L. Sims 47 Senior Vice President Kevin R. Wang 36 Senior Vice President John J. Silberstein 33 Senior Vice President and Secretary All officers and directors of Mendik Corporation, except for John J. Silberstein, have been officers or directors of the corporation since its incorporation in November 1985. All officers of Mendik Corporation hold the same position in Mendik Realty. Bernard H. Mendik has been an owner/manager and developer of office and commercial properties since 1957. Mr. Mendik was named Chairman of Mendik Realty in 1990. Prior to his appointment as Chairman, Mr. Mendik had served as President of Mendik Realty since 1978. David R. Greenbaum was appointed President of Mendik Realty in 1990. Prior to his appointment as President, Mr. Greenbaum had served as Executive Vice President of Mendik Realty since 1982. Christopher G. Bonk has been with Mendik Realty since 1981, most recently as Senior Vice President and Treasurer. Michael M. Downey has been with Mendik Realty since 1978, most recently as Senior Vice President of Operations. David L. Sims has been with Mendik Realty since 1984, most recently as Senior Vice President of Leasing. Kevin R. Wang has been with Mendik Realty since 1985, most recently as Senior Vice President of Leasing. John J. Silberstein has been with Mendik Realty since 1989, most recently as Senior Vice President and Secretary. Prior thereto, Mr. Silberstein had been associated with the law firm of Skadden, Arps, Slate, Meagher & Flom since 1986. NYRES1 NYRES1 is a Delaware Corporation formed on September 9, 1985, and is an indirect wholly-owned subsidiary of Lehman Brothers, Inc. ("Lehman"). On July 31, 1993, Shearson Lehman Brothers, Inc. ("Shearson") sold certain of its domestic retail brokerage and asset management businesses to Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Subsequent to the sale, Shearson changed its name to Lehman Brothers Inc. The transaction did not affect the ownership of the Partnership or the General Partners. However, the assets acquired by Smith Barney included the name "Hutton." Consequently, effective October 22, 1993, Hutton Real Estate Services XV, Inc. changed its name to NY Real Estate Services 1 Inc. to delete any references to "Hutton." Pursuant to Section 22(b) of the Partnership Agreement, an affiliate of Lehman has contributed to the capital of NYRES1 $2.5 million in the form of a demand promissory note, which represents the only substantial asset of NYRES1. Such affiliate has a net worth in excess of such amount. Certain officers and directors of NYRES1 are now serving (or in the past have served) as officers or directors of entities which act as general partners of a number of real estate limited partnerships which have sought protection under the provisions of the Federal Bankruptcy Code. The partnerships which have filed bankruptcy petitions own real estate which has been adversely affected by the economic conditions in the markets in which the real estate is located and, consequently, the partnerships sought the protection of the bankruptcy laws to protect the partnerships' assets from loss through foreclosure. The executive officers and sole director of NYRES1 (none of whom has a family relationship with another) are: Name Age Office Kenneth L. Zakin 46 Director and President Mark Sawicki 31 Vice President and Chief Financial Officer Kenneth L. Zakin has been an officer of NYRES1 since 1989. Mark Sawicki has been an officer of NYRES1 since October 1990. Kenneth L. Zakin is a Senior Vice President of Lehman and has held such title since November 1988. He is currently a senior manager in Lehman's Capital Preservation and Restructuring ("CPR") Group and was formerly group head of the Commercial Property Division of Shearson Lehman Brothers' Direct Investment Management Group responsible for the management and restructuring of limited partnerships owning commercial properties throughout the United States. From January 1985 through November 1988, Mr. Zakin was a Vice President of Shearson Lehman Brothers Inc. Mr. Zakin is a member of the Bar of the State of New York and previously practiced as an attorney in New York City from 1973 to 1984 specializing in the financing, acquisition, disposition, syndication and restructuring of real estate transactions. Mr. Zakin is currently an associate member of the Urban Land Institute, a member of the New York District Council Advisory Services Committee, and is a Director of Lexington Corporate Properties, Inc. He received a Juris Doctor degree from St. John's University School of Law in 1973 and a B.A. degree from Syracuse University in 1969. Mark Sawicki is a Vice President of Lehman and has been a member of the CPR Group since August 1988. Mr. Sawicki has been involved in the management, restructuring, and administration of real estate limited partnerships and has assisted in the budgeting, auditing, and portfolio review of the CPR Group. Prior to joining Lehman, Mr. Sawicki was a Senior Credit Analyst with Republic National Bank of New York where he was responsible for the credit review of Middle Market and Fortune 500 companies. Mr. Sawicki also worked in London with the accounting firm of Arthur Young as an auditor and as a junior consultant on a project for the National Health Service. Mr. Sawicki received his Bachelor's degree in 1985 from New York University, College of Business and Public Administration, with a concentration in Finance. He also completed the Diploma Program in Real Estate Investment Analysis at the Real Estate Institute of N.Y.U. in December 1991. Item 11. Item 11. Executive Compensation Neither of the General Partners nor any of their officers or directors received any compensation from the Partnership. See Item 13 below of this Report with respect to certain transactions of the General Partners and their affiliates with the Partnership. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 30, 1994, no person was known by the Partnership to be the beneficial owner of more than five percent of the Units. Set forth below is a chart indicating, as of March 30, 1994, the name and the amount and nature of beneficial ownership of Units held by the General Partners and officers and directors thereof. Only those General Partners and officers and directors thereof which beneficially own any Units are listed. No General Partner or any officer or director thereof, or the officers and directors of the General Partners as a group, beneficially owns in excess of 1% of the total number of Units outstanding. Beneficial Ownership of Units Name of Beneficial Owner Number of Units Owned Bernard H. Mendik 1,276 (1) David R. Greenbaum 485 (2) Kevin R. Wang 20 (3) Christopher G. Bonk 49 Michael M. Downey 33 David L. Sims 16 ----- The General Partners and all officers and directors thereof as a group (10 persons) 1,879 (1)(2)(3) ===== _________________________ (1) Includes 1,027 Units owned by Mr. Mendik, 200 Units held in trust for Mr. Mendik's children and 49 Units owned by Mendik Realty. Does not include 40 Units owned by Mr. Mendik's wife, as to which he disclaims beneficial ownership. (2) Includes 285 Units owned by Mr. Greenbaum and 200 Units owned by Mr. Greenbaum's wife. (3) Does not include four Units owned by Mr. Wang's wife, as to which he disclaims beneficial ownership. Item 13. Item 13. Certain Business Relationships and Related Transactions As a result of the suspension of cash distributions, neither NYRES1 nor Mendik Corporation received Net Cash from Operations with respect to the year ended December 31, 1993. $57,032.50 of the Partnership's net loss for the 1993 fiscal year was allocated to each of NYRES1 and Mendik Corporation. For a description of the shares of Net Cash From Operations and Sale or Refinancing Proceeds (as defined in the Partnership Agreement) and the allocation of items of income and loss to which the General Partners, the special limited partner, and the Investor Limited Partners are respectively entitled, see Note 4 of Notes to Consolidated Financial Statements. Pursuant to Section 12 of the Partnership Agreement, Mendik Realty has agreed to limit its payment of leasing commissions at any Property in any year to not more than 3% of the gross operating revenues of that Property in such year less leasing commissions paid to other brokers in connection with that Property in such year. Any excess will be deferred but is payable only if and to the extent such limit is not exceeded in the year paid. As of December 31, 1993, there was a contingent liability of approximately $316,337 to Mendik Realty as a result of leasing commissions earned in prior periods from the 34th Street Property and Park Avenue Property. There is no such contingent liability with respect to any of the other Properties. During 1993, the Partnership paid $454,373 to Mendik Realty, on a consolidated basis, in connection with leasing commissions earned in prior periods from the Park Avenue Property. TBC, a former affiliate of NYRES1, provides partnership accounting services and investor relations services to the Partnership. In May 1993, TBC was sold to Mellon Bank Corporation and is no longer an affiliate of NYRES1. During 1993, TBC earned from the Partnership $65,254 for such services and received reimbursement for out-of-pocket expenses of $981. B&B Park Avenue L.P., a limited partnership of which Mendik Corporation is a general partner, owns the remaining 40% interest in Two Park Company, the joint venture that owns the Park Avenue Property. Mendik Realty, an affiliate of Mendik Corporation, receives fees for the management of the Partnership's Properties and is reimbursed for the cost of on-site building management staff. During 1993, Mendik Realty earned management fees of $700,725 from the Partnership and were reimbursed $527,019 for the cost of on-site building management salaries. During 1993, the General Partners or their affiliates made certain loans to the Partnership and Mendik Realty deferred certain management fees payable to it by the Partnership in connection with the Stamford Property and the 34th Street Property. During 1994, Mendik Realty will continue to defer fees and leasing commissions in connection with the Stamford Property and 34th Street Property. See the information under the captions "Stamford Property" and "34th Street Property" in Item 2 of this Report. See Note 8 of Notes to the Consolidated Financial Statements. Building Management Service Corporation ("BMSC"), an affiliate of Mendik Corporation, performs cleaning and related services for the properties at cost. As of January 1, 1993, Guard Management Service Corporation ("GMSC"), an affiliate of Mendik Corporation, began providing security services at the Park Avenue Property and Saxon Woods Corporate Center, which services will be provided by GMSC at cost. During 1993, GMSC and BMSC earned from the Partnership $4,581,196 for such services. See Note 8 of Notes to Consolidated Financial Statements for additional information concerning amounts paid or accrued to the General Partners and their affiliates during the years ended December 31, 1993, 1992 and 1991 and all balances unpaid at December 31, 1993. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) (1),(2) See page 20. (3) See Index to Exhibits contained herein. (b) Reports on Form 8-K. No reports on Form 8-K were filed in the fourth quarter of fiscal year 1993. (c) See Index to Exhibits contained herein. (d) See page 20. INDEX TO EXHIBITS Exhibit No. 3 (a) Amended and Restated Certificate and Agreement of Limited Partnership of the Partnership (included as Exhibit A to the Prospectus of Registrant dated April 7, 1986 included as Exhibit 28(b) to the 1986 Annual Report on Form 10-K of the Partnership and incorporated herein by reference thereto). (b) Amendments to Amended and Restated Certificate and Agreement of Limited Partnership of the Partnership (included as Exhibit A to the Prospectus Amendment of Registrant dated April 29, 1987 included as Exhibit 29(c) to the 1989 Annual Report on Form 10-K of the Partnership and incorporated herein by reference thereto). 10 (a) Form of Property Management Agreement between the Partnership and Mendik Realty Company, Inc. (included as Exhibit 10(a) to Amendment No. 2 to the Registration Statement (Registration No. 33-01779) (the "Registration Statement") and incorporated herein by reference thereto). (b) James Felt Realty Services appraisal of the Stamford Property (included as Exhibit 10(b) to the Registration Statement and incorporated herein by reference thereto). (c) Contract of Sale, dated June 25, 1985, between 1351 Washington Blvd. Limited Partnership, Bernard H. Mendik and Hutton Real Estate Services XV, Inc. and related assignments (included as Exhibit 10(f) to Amendment No. 1 to the Registration Statement and incorporated herein by reference thereto). (d) Cushman & Wakefield, Inc. appraisal of Saxon Woods Corporate Center (included as Exhibit 10(g) to Amendment No. 2 to the Registration Statement and incorporated herein by reference thereto). (e) Copies of Ground Leases relating to Saxon Woods Corporate Center (included as Exhibit 10(h) to Amendment No. 2 to the Registration Statement and incorporated herein by reference thereto). (f) Memorandum of Contract, dated December 24, 1985, between The Prudential Insurance Company of America and 550/600 Mamaroneck Company relating to the acquisition of Saxon Woods Corporate Center (included as Exhibit 10(i) to Amendment No. 2 to the Registration Statement and incorporated by reference thereto). (g) The Weitzman Group, Inc. appraisal of the 330 West 34th Street property (included as Exhibit 10(j) to Post-Effective Amendment No. 2 to the Registration Statement and incorporated herein by reference thereto). (h) Copy of Ground Lease relating to the 34th Street property (included as Exhibit 10(k) to Post-Effective Amendment No. 1 to the Registration Statement and incorporated herein by reference thereto). (i) Agreement of Assignment of Contract of Sale, dated September 25, 1986, between 330 West 34th Street Associates and M/H 34th Street Associates (included as Exhibit 10(l) to Post-Effective Amendment No. 1 to the Registration Statement and incorporated herein by reference thereto). (j) Agreement, dated December 5, 1986, between Park Fee Associates, The Mendik Company, Chase Investors Management Corporation New York and M/H Two Park Associates relating to the acquisition of the Park Avenue Property (included as Exhibit 10(m) to Post-Effective Amendment No. 1 to the Registration Statement and incorporated by reference thereto). (k) James Felt Realty Services appraisal of the Park Avenue Property (included as Exhibit 10(n) to Post-Effective Amendment No. 7 to the Registration Statement and incorporated herein by reference thereto). Exhibit No. (l) Exhibits (l) through (aa) to the Partnership's Form 10-K for the fiscal year ended December 31, 1990 are incorporated herein by reference thereto. (m) Loan Agreement of $6,500,000 to Mendik Real Estate Limited Partnership from Friesch-Groningsche Hypotheekbank Realty Credit Corporation dated September 25, 1991 secured by the Saxon Woods Corporate Center (included as Exhibit 10(m) to the Partnership's Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference thereto). (n) Appraisal of the 34th Street Property as of January 1992 by Cushman & Wakefield, Inc. (included as Exhibit 10(n) to the Partnership's Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference thereto). (o) Letter Opinion of Value of the Park Avenue Property as of January 1992 by Cushman & Wakefield, Inc. (included as Exhibit 10(o) to the Partnership's Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference thereto). (p) Letter Opinion of Value of the Stamford Property as of January 1992 by Cushman & Wakefield, Inc. (included as Exhibit 10(p) to the Partnership's Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference thereto). (q) Letter Opinion of Value of the Saxon Woods Corporate Center as of January 1992 by Cushman & Wakefield, Inc. (included as Exhibit 10(q) to the Partnership's Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference thereto). (r) Modification effective January 1, 1991 of the $12,500,000 first mortgage loan secured by the Stamford Property between New York Life Insurance Company and the Partnership (included as Exhibit 10(r) to the Partnership's Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference thereto). (s) Reimbursement Agreement dated as of January 1, 1991 among the Partnership, Mendik Realty, Mendik Corporation and SLH Lending Corp. related to the deferral of management fees and loans made to the Partnership with respect to the Stamford Property (included as Exhibit 10(s) to the Partnership's Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference thereto). (t) Agreement dated as of January 1, 1992 among the Partnership, Mendik Realty, Mendik Corporation and SLH Lending Corp. (included as Exhibit 10(a) to the Partnership's Form 10-Q for the quarter ended June 30, 1992 and incorporated herein by reference thereto). (u) Appraisal of the 34th Street Property as of January 1993 by Cushman & Wakefield, Inc. (included as Exhibit 10(u) to the Partnership's Form 10-K for the fiscal year ended December 31, 1992 and incorporated herein by reference thereto). (v) Letter Opinion of Value of the Park Avenue Property as of January 1993 by Cushman & Wakefield, Inc. (included as Exhibit 10(v) to the Partnership's Form 10-K for the fiscal year ended December 31, 1992 and incorporated herein by reference thereto). (w) Letter Opinion of Value of the Stamford Property as of January 1993 by Cushman & Wakefield, Inc. (included as Exhibit 10(w) to the Partnership's Form 10-K for the fiscal year ended December 31, 1992 and incorporated herein by reference thereto). (x) Letter Opinion of Value of the Saxon Woods Corporate Center as of January 1993 by Cushman & Wakefield, Inc. (included as Exhibit 10 (x) to the Partnership's Form 10-K for the fiscal year ended December 31, 1992 and incorporated herein by reference thereto). Form 10-K - Item 14 (a) (1) and (2) MENDIK REAL ESTATE LIMITED PARTNERSHIP INDEX OF THE CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Mendik Real Estate Limited Partnership and Consolidated Venture are included in Item 8: Independent Auditors' Report Consolidated Balance Sheets December 31, 1993 and 1992 Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Partners' Capital (Deficit) for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Schedule XI - Real Estate and accumulated depreciation All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted since (1) the information required is disclosed in the financial statements and the notes thereto; (2) the schedules are not required under the related instructions; or (3) the schedules are inapplicable. 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. MENDIK REAL ESTATE LIMITED PARTNERSHIP BY: Mendik Corporation General Partner Date: March 30, 1994 BY: s/David R. Greenbaum/ Name: David R. Greenbaum Title: President BY: NY Real Estate Services 1 Inc. General Partner Date: March 30, 1994 BY: s/Kenneth L. Zakin/ Name: Kenneth L. Zakin Title: Director 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 the Registrant in the capabilities and on the dates indicated. NY REAL ESTATE SERVICES 1 INC. A General Partner Date: March 30, 1994 BY: s/Kenneth L. Zakin/ Name: Kenneth L. Zakin Title: Director and President Date: March 30, 1994 BY: s/Mark Sawicki/ Name: Mark Sawicki Title: 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 in the capabilities and on the dates indicated. MENDIK CORPORATION A General Partner Date: March 30, 1994 BY: s/Bernard H. Mendik/ Name: Bernard H. Mendik Title: Chairman and Director Date: March 30, 1994 BY: s/David R. Greenbaum/ Name: David R. Greenbaum Title: President Date: March 30, 1994 BY: s/Christopher G. Bonk/ Name: Christopher G. Bonk Title: Senior Vice President and Treasurer Independent Auditors' Report The Partners Mendik Real Estate Limited Partnership We have audited the consolidated financial statements of Mendik Real Estate Limited Partnership and Consolidated Venture (a New York Limited Partnership) as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall 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 Mendik Real Estate Limited Partnership and Consolidated Venture 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 schedule, when considered in relation to the consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Boston, Massachusetts February 15, 1994 Notes to Consolidated Financial Statements December 31, 1993, 1992 and 1991 1. Organization Mendik Real Estate Limited Partnership (the "Partnership") was organized as a limited partnership under the laws of the State of New York pursuant to a Certificate and Agreement of Limited Partnership dated and filed October 30, 1985 (the "Partnership Agreement") and subsequently amended and restated on February 25, 1986. The Partnership was formed for the purpose of acquiring, maintaining and operating income producing commercial office buildings in the Greater New York Metropolitan Area. The general partners of the Partnership are Mendik Corporation and NYRES1 (See below). The Partnership will continue until December 31, 2025, unless sooner terminated in accordance with the terms of the Partnership Agreement. The Partnership offered Class A units to taxable investors and Class B units to tax exempt investors. On July 31, 1993, Shearson Lehman Brothers Inc. sold certain of its domestic retail brokerage and asset management businesses to Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Subsequent to the sale, Shearson Lehman Brothers Inc. changed its name to Lehman Brothers Inc. The transaction did not affect the ownership of the general partners. However, the assets acquired by Smith Barney included the name "Hutton." Consequently, effective October 22, 1993, Hutton Real Estate Services XV, Inc., a general partner, changed its name to NY Real Estate Services 1 Inc. ("NYRES1") to delete any reference to "Hutton." 2. Liquidity The commercial real estate market in the Greater New York Metropolitan Area remains weak. As vacancy rates continue to rise, increased competition among landlords has led to lower rents and increasingly generous tenant concession packages in the form of tenant improvements and free-rent periods. The significant cost of tenant improvements required to be funded under both new and renewal leases has sharply increased the demand for capital by landlords, including the Partnership. Expenditures for tenant improvements have contributed to the Partnership's reduced liquidity. In order to conserve the Partnership's limited resources, the General Partners have pursued a strategy intended to position each of the Partnership's four properties, to the extent possible, to meet its operating and other expenses as they come due using only the operating income generated by that property, and if necessary, proceeds from borrowings secured by such property. During 1993, the Partnership funded operating costs, the cost of tenant improvements, leasing commissions and building capital improvements from five sources: (i) positive cash flow generated by the approximately 60% joint venture interest in the Park Avenue Property and the Partnership's leasehold interest in the Saxon Woods Corporate Center, (ii) Partnership reserves, (iii) funds provided by certain unsecured loans and the deferral of property management fees by certain affiliates of the General Partners, (iv) additional borrowings from the $6.5 million Saxon Woods Line of Credit and (v) a portion of the $1.25 million security deposit maintained by the unaffiliated ground lessor for the 330 West 34th Street Property. It is expected that the availability of funds from some of these sources will be reduced in the future. Park Avenue Property - Although the Partnership has continued to lease space at the Property, with the continuing softness in the real estate market, new and renewal leases generally have been signed at rental rates significantly less than the rental rates received on certain expiring leases. The Property's cash flow, however, is expected to remain stable for the foreseeable future because rental rate increases negotiated in leases signed in earlier years have offset the lower market rental rates reflected in the leases recently signed by the Partnership. At December 31, 1993, the unrestricted cash balance at the Property was approximately $5 million over and above a reserve for real estate taxes. The Park Avenue Property currently generates, and is expected to generate in the future, sufficient revenue to cover operating expenses and debt service obligations. The indebtedness secured by the Park Avenue Property currently matures in 1998 (or 1996 at the option of the lender). The Partnership expects, as the maturity of the loan approaches, to commence negotiations to extend the existing loan or to seek refinancing. However, as a result of the current lack of liquidity in the financial marketplace, no assurances can be made that the Partnership will be able to extend with the existing lender or refinance with a new lender, on terms acceptable to the Partnership or at all. The property was 89% and 90% occupied at December 31, 1993 and 1992, respectively. Saxon Woods Corporate Center - The Partnership expects that cash flow from the Saxon Woods Corporate Center will cover operating expenses and debt service obligations in 1994. Although the Saxon Woods Line of Credit is in the amount of up to $6.5 million, as a result of Section 13(d) (xviii) of the Partnership Agreement which prohibits the Partnership from incurring indebtedness secured by a Property in excess of 40% of the then-appraised value of such Property (or 40% of the value of such Property as determined by the lender as of the date of financing or refinancing, if such value is lower) (the "Borrowing Limitation"), the Partnership is permitted to borrow only $6 million based upon the most recent appraisal of the Saxon Woods Corporate Center which as of December 31, 1993 was $15 million. The loan agreement provides that all available cash flow from the Saxon Woods Corporate Center will be used for expenses incurred at the Saxon Woods Corporate Center prior to borrowing additional funds under the Saxon Woods Line of Credit. The General Partners expect that additional leasing activity, the costs of which will be partially funded by borrowing amounts remaining available under the Saxon Woods Line of Credit, may result in an increase in the appraised value of the Property thereby enabling the Partnership to borrow the additional amounts available under the Saxon Woods Line of Credit up to the full amount of $6.5 million. There can be no assurance that future appraisals will reflect an increase in the Property's value which would enable the Partnership to borrow additional funds. As of December 31, 1993, the Partnership had borrowed $4,542,677 under the Saxon Woods Line of Credit. In January 1994 the Partnership borrowed an additional $138,000 and had made commitments to borrow an additional $362,000 which would increase the total borrowings on the Saxon Woods Line of Credit to $5,042,677. The indebtedness secured by the Saxon Woods Corporate Center currently matures in 1996. The Partnership expects, as the maturity of the loan approaches, to commence negotiations to extend the existing loan or to seek refinancing. However, as a result of the current lack of liquidity in the financial marketplace, no assurances can be made that the Partnership will be able to extend with the existing lender or refinance with a new lender, on terms acceptable to the Partnership or at all. The property was 72% and 67% occupied at December 31, 1993 and 1992, respectively. 34th Street Property - On February 17, 1993, the Partnership signed a long-term lease with the City of New York effective August 1, 1992 for approximately 300,000 square feet in the 34th Street Property. The terms of the lease call for the City to make annual base rental payments of approximately $5.4 million and pay its proportionate share of increases in real estate taxes and operating expenses. Approximately $1.25 million is being spent by the Partnership for tenant improvements under the terms of the lease. As of December 31, 1993 virtually all of these funds have been spent. In order to fund the tenant improvements required by the City lease, the Partnership negotiated an agreement with the unaffiliated ground lessor pursuant to which the ground lessor agreed to make available the $1.25 million that was being held as security under the ground lease. The ground lessor also agreed to waive the lease requirement that the Partnership deposit an additional $1 million as security with the ground lessor in connection with the increase in the annual ground rent in 1992 to $2.25 million. In order to improve the 34th Street Property's cash flow, beginning in January 1992, Mendik Realty Company, Inc. ("Mendik Realty"), an affiliate of Mendik Corporation, voluntarily agreed to defer its management fees of approximately $170,000 a year that would otherwise have been payable with respect to the 34th Street Property. The Partnership's obligation to pay the management fees deferred by Mendik Realty, will be on a non-recourse basis to the Partnership and will bear interest at a rate per annum equal to the prime rate of Morgan Guaranty Trust Company of New York less 1.25%. Principal and interest will be payable on December 31, 2025, or such earlier date on which the term of the Partnership terminates, subject to a mandatory prepayment from the net proceeds from the sale of any of the Properties, after repayment of all debt secured by the Property sold. In addition, Mendik Realty agreed to defer its leasing commission in the amount of $153,182 with respect to the signing of the long-term lease with the City of New York and any further leasing commissions associated with additional leasing activity at the Property. Both of these provisions will remain in effect pursuant to the terms of the forbearance agreement with The First National Bank of Chicago ("FNBC") (see below). Additionally, the forbearance agreement gives FNBC control of the property's cash flow by requiring the Partnership to maintain a lockbox at FNBC. FNBC will approve all releases of funds from the lockbox. As of December 31, 1993, approximately $1 million was on deposit in the lockbox account maintained by FNBC. During 1992, the cash flow from the 34th Street Property did not cover its debt service obligations after payment of operating expenses, and it was not expected to meet its debt service obligations in 1993. As a result, in order to conserve the Partnership's limited working capital reserves and induce FNBC, the Property's lender, to modify the mortgage's terms, the Partnership suspended its interest payments to FNBC beginning in September 1992. On August 12, 1993, the Partnership entered into a forbearance agreement which modified the terms of the 34th Street Line of Credit. Pursuant to the forbearance agreement, FNBC agreed to forbear through June 30, 1994 from exercising its remedies under the loan agreement as a result of the Partnership's failure to pay interest. The forbearance agreement will also allow the Partnership to pay off the 34th Street Line of Credit for $6.5 million, a substantial discount to the current outstanding balance, at any time through June 30, 1994. As of December 31, 1993, there was $15 million of principal and approximately $1.3 million of accrued interest outstanding on the 34th Street Line of Credit. Also through June 30, 1994, the Partnership will be permitted to make interest payments to FNBC only to the extent of available cash flow from the 34th Street Property. Since the forbearance agreement went into effect, the Partnership has not made any interest payments to FNBC. The General Partners are seeking to obtain either debt or equity financing even if such financing would entail the Partnership's transferring all or a portion of its interest in the Property to the party providing the financing. In the event the Partnership obtains from a third party an offer to provide financing of less than the $6.5 million required by FNBC, the Partnership would explore with FNBC a pay off at a further discount. As of December 31, 1993, the 34th Street Property's appraised value was $9.8 million. Should the Partnership be unable to pay off the 34th Street Line of Credit by June 30, 1994, the forbearance agreement provides that the Partnership will assign its interest in the property and in the ground lease to the Property to FNBC, at FNBC's election, in lieu of foreclosure. The forbearance agreement with FNBC provides the Partnership with an opportunity to pay off the 34th Street Line of Credit at a substantial discount while at the same time establishing a cost-effective means to ensure an orderly and efficient transfer of the Property to FNBC in the event the 34th Street Line of Credit cannot be paid off. The Partnership has no assurances that it will be able to obtain the financing necessary to pay off the 34th Street Line of Credit and any such pay off will depend on numerous factors including general market conditions. Chief among these is the fact that many traditional sources of real estate financing such as banks, insurance companies and pension funds have dramatically curtailed their investment in commercial office properties. Consequently, only a limited number of investors is likely to be available, further hampering the Partnership's ability to secure a refinancing. Should the Partnership be unable to complete a refinancing, it might result in the loss of the Partnership's investment in the Property. The property was 64% and 50% occupied at December 31, 1993 and 1992, respectively. Stamford Property - The Partnership previously restructured the loan secured by the Stamford Property in 1991. As part of the terms of the restructured loan, Mendik Corporation and an affiliate of NYRES1 loaned in each of 1991, 1992 and 1993 $50,000 and $110,000, respectively, to the Partnership. The loans were required to be deposited in an escrow account and may be used only to pay costs and expenses related to the Stamford Property. Mendik Realty also agreed to defer its management fees of approximately $70,000 a year in connection with the Stamford Property in each of calendar years 1991, 1992 and 1993. The restructuring was intended to enable the Stamford Property to generate sufficient cash flow to meet its operating expenses and debt service obligations through 1993 without utilizing the Partnership's working capital reserves in the hope that the Stamford real estate market would recover and that, as leases at the Property expired, the Partnership would be able to enter into new or renewal leases at rental rates in excess of the rates being paid by existing tenants under current leases. However, the Stamford real estate market has continued to deteriorate resulting in a further erosion of market lease rates. While the cash flow from the Stamford Property, together with the loans by Mendik Corporation and an affiliate of NYRES1 and the management fee deferrals by Mendik Realty, were sufficient to cover the Property's operating expenses and debt service obligations in 1993, due to a decline in the Property's revenue following the extension of D&B Computing Services, Inc.'s ("D&B") lease, the Partnership failed to make full payment of debt service due on February 10, 1994 and March 10, 1994 with respect to the Stamford Loan. In order to preserve its limited working capital reserves, the Partnership currently does not intend to fund any operating shortfalls out of reserves. As a result of the Partnership's failure to make these interest payments, the Partnership is in default under the terms of the Stamford Loan and the Property's lender, New York Life Insurance Company ("New York Life"), may elect to exercise its remedies under the loan agreement including accelerating the maturity date of the principal balance of the loan and electing to foreclose on its mortgage. The General Partners are now seeking a short-term agreement from New York Life, pursuant to which New York Life would forbear from exercising its remedies under the Stamford Loan and Mendik Net Loss Per Limited Partnership Unit. Net loss per limited partnership unit is based upon the limited partnership units outstanding during the year and the loss allocated to the limited partners in accordance with the terms of the Partnership Agreement. 4. The Partnership Agreement The Partnership Agreement provides that the net cash from operations, as defined, for each fiscal year will be distributed on a quarterly basis, 99% to the limited partners and 1% to the general partners (as defined) until each limited partner has received an amount equal to an 8% annual preferred return. The net cash from operations will then be distributed, 99% to the special limited partner, Bernard H. Mendik, and 1% to Mendik Corporation until the special limited partner has received his special preferred return (as defined). Thereafter, net cash from operations will be distributed 85% to the limited partners, 14% to the special limited partner and 1% to the general partners. Net proceeds from sales or refinancing will be distributed first to the limited partners until each limited partner has received an 8% cumulative annual return (as defined) and then an additional amount equal to his adjusted capital contribution (as defined). Second, the net proceeds from sale or refinancing will be distributed 99% to the special limited partner and 1% to the Mendik Corporation until the special limited partner has received any shortfall on his special cumulative return (as defined). Third, the net proceeds will be distributed to the general partners until the general partners have received their deferred incentive shares (as defined). Thereafter, net proceeds will be distributed 75% to the limited partners, 20.33% to the special limited partner and 4.67% to the general partners. Taxable income and all depreciation for any fiscal year shall be allocated in substantially the same manner as net cash from operations except that depreciation allocated to the limited partners will be allocated solely to the Class A units (for taxable investors). Tax losses for any fiscal year will generally be allocated to the limited partners and special limited partner to the extent of their positive capital accounts and then 99% to the limited partners and 1% to the general partners. 5. Real Estate Investments The major tenants described below represented 49% of the Partnership's rental income in 1993. See Note 2 for leasing activity. The Stamford Property. In 1985, the Partnership acquired the Stamford Property, a ten-story office building containing approximately 220,000 net rentable square feet (based on current standards of measurement) and an attached parking garage located on 1351 Washington Blvd. in Stamford, Connecticut. The purchase price of the property was $31,250,000. The property was appraised at $9,150,000 at December 31, 1993 as compared to $10,600,000 at December 31, 1992. Major tenants at the Stamford Property are Electronic Information Systems which leases 25,846 square feet (12% of the total leasable area in the property) under a lease expiring March 31, 1998, D&B which leases 43,100 square feet (20% of the total leasable area in the property) under a lease expiring December 31, 1993, Automatic Data Processing, Inc. ("ADP") which leases 34,700 square feet (16% of the total leasable area in the property) under a lease expiring June 30, 1994 and Wyatt Company, Inc. which leases, but does not occupy, 17,000 square feet (8% of the total leasable area in the property) under a lease expiring August 31, 1995. ADP has subleased approximately 69% of its space. The Saxon Woods Corporate Center. In 1986, the Partnership acquired Saxon Woods Corporate Center, two office buildings located in Harrison, New York containing an aggregate of approximately 237,000 net rentable square feet (based on current standards of measurement), from an affiliate of the Partnership. The property was purchased by the affiliate for the purpose of facilitating the acquisition by the Partnership. The purchase price of $21,282,805 was paid from the proceeds of the Partnership's offering and consisted of the purchase price to the affiliate plus the acquisition and closing costs and costs associated with carrying the property. The buildings are situated on a 15.28 acre site which is subject to two ground leases, each of which terminates in September 2027 and provides the lessee with the option to renew for two 25-year periods and one 39-year period. Each ground lease provides for an annual net rental of $170,000 with an increase of $20,000 every five years, commencing January 1996. The property was appraised at $15,000,000 at December 31, 1993 as compared to $14,000,000 at December 31, 1992. Major tenants at the Saxon Woods Corporate Center are Commodity Quotations which leases 24,540 square feet (10% of the total leasable area) under leases expiring October 31, 2001 and October 31, 1998. Commodity Quotations has the option to cancel the lease expiring October 31, 2001 at the end of the seventh year, October 23, 1998. Icon Capital Corp. leases 29,040 square feet (12% of the total leasable area) under a lease expiring November 30, 2004. Commodity Quotations and Icon Capital Corp represented approximately 13% and 16%, respectively, of the property's rental income in 1993. The 34th Street Property. In 1987, the Partnership acquired the 34th Street Property, an eighteen-story office building containing approximately 627,000 net rentable square feet (based on current standards of measurement) from an affiliate of the Partnership. The building was purchased by the affiliate for the purpose of facilitating the acquisition by the Partnership. The purchase price of $35,611,400 consisted of the purchase price to the affiliate plus the acquisition and closing costs and costs associated with carrying the property. The building is situated on a 46,413 square foot site. The parcel of land underlying the 34th Street Property is leased from an unaffiliated third party pursuant to a ground lease with an initial term ending on December 31, 1999 that provided for annual lease payments of $1.25 million through December 31, 1991 and requires annual lease payments of $2.25 million for the remaining eight years. The ground lease may be renewed at the option of the Partnership for successive terms of 21, 30, 30, 30 and 39 years at annual rentals, determined at the commencement of each renewal term, equal to 7% of the then-market value of the land considered as if vacant, unimproved and unencumbered, valued at the highest and best use under then-applicable zoning and other land use regulations as office, hotel or residential property, but in no event less than the higher of (i) $2.75 million or (ii) the base rent for any consecutive 12-month period during the then-preceding renewal term. The property was appraised at $9,800,000 at December 31, 1993. The appraised value at December 31, 1992 was $12,500,000. The major tenant at the 34th Street property is the City which leases 300,000 square feet (48% of the total leasable area in the property) under a lease expiring February 28, 2001. The City has the option to terminate its lease without penalty effective anytime from March 31, 1993 to February 28, 2001 provided that the City gives the Partnership one year's notice of its intent to terminate the lease. The City will also be required to pay the Partnership for certain improvement costs as defined in accordance with the terms of the lease agreement. The City represented approximately 92% of the property's total revenue in 1993. The Park Avenue Property. In 1987, the Partnership indirectly acquired from an affiliate an approximate 60% interest in a joint venture, Two Park Company, formed in 1986 for the purpose of acquiring and operating a parcel of land located at Two Park Avenue, New York, New York, together with the 28-story office building and related improvements located thereon containing approximately 956,000 net rentable square feet (based on current standards of measurement). The affiliate acquired such interest to facilitate the acquisition by the Partnership. Two Park Company acquired the Park Avenue Property in 1986 from an unaffiliated seller for approximately $151.5 million, $60 million of which was financed by a first mortgage loan. The Partnership acquired its interest by contributing $61,868,264 in cash, and assuming its share of the $60 million loan secured by a first mortgage on the property. The remaining approximate 40% interest in Two Park Company is owned by B & B Park Avenue L.P., an affiliate of Mendik Corporation. At December 31, 1993, the property was appraised at $115,000,000 ($125,000,000 at December 31, 1992), and the appraised value of the property net of the minority interest was $68,655,000 ($74,625,000 at December 31, 1992). Major tenants at Two Park Avenue are Times Mirror Magazines, Inc. and its affiliate Newsday, Inc. which lease 262,774 square feet (28% of total leasable area in the property) under two leases expiring June 30, 2004 and National Benefit Life Insurance Company which leases 99,800 square feet (11% of total leasable area in the property) under a lease expiring May 30, 1998. Times Mirror Magazines, Inc. and its affiliate Newsday, Inc. and National Benefit Life Insurance Company represented 32% and 14%, respectively, of the property's total rental income in 1993. 6. Mortgage and Notes Payable The Partnership is currently only able to incur additional indebtedness secured by the Saxon Woods Property (See Note 2). The Stamford Property The $12,500,000 non-recourse first mortgage loan is for a term of ten years and accrues interest at the rate of 10% per annum through December 10, 1993 and 10.3% thereafter (See below) (the "Stamford Loan"). While the $12,500,000 principal amount outstanding currently exceeds the Borrowing Limitation, it did not exceed the Borrowing Limitation when the loan was incurred. The loan was modified effective January 1, 1991. Prior to modification interest only was payable in monthly installments of $104,167 through July 10, 1991. Thereafter, constant monthly installments in the amount of $113,625 were to be applied first to the payment of interest, then the balance to the reduction of principal through the maturity date, July 10, 1996, at which time the balance of principal and any accrued interest was to be due and payable. Under the terms of the loan modification one-half of the monthly interest payments due under the loan from January 10, 1991 to December 10, 1991 are deferred until July 10, 1996, the loan's maturity date, and bear interest at the rate of 10% per annum (collectively, the "Deferred Interest"). During the period from December 10, 1991 to December 10, 1993, monthly payments of interest only were due at the rate of 10% per annum on the principal balance of the note. In addition, principal amortization payments previously required to be paid commencing August 10, 1991 have been deferred until the maturity of the loan. Commencing December 10, 1993 through the maturity date of the loan, interest is payable on the principal balance of the loan and the Deferred Interest at the rate of 10.3% per annum. If the Partnership prepays the Deferred Interest in full, interest under the loan will be reduced to 10% per annum. Deferred interest payable at December 31, 1993 is $798,777. The loan modification requires that in each of calendar years 1991, 1992 and 1993, (i) Mendik Corporation will lend the Partnership $50,000, (ii) an affiliate of NYRES1 will lend the Partnership $110,000, and (iii) Mendik Realty Company, Inc. will defer management fees of approximately $70,000 a year payable to it in connection with services performed at the Stamford Property. The loans by Mendik Corporation and the affiliate of NYRES1 are required to be deposited in an escrow account and may be used only to pay building improvement costs, lease-up costs and operating expenses related to the Stamford Property. Accordingly, as of December 31, 1993, $281,071 is being held as restricted cash with respect to these loans and fees. The loans and management fee deferral by Mendik Corporation, Mendik Realty and the affiliate of NYRES1 are on a non-recourse basis and bear interest at the prime rate less 1.25%. Principal and interest is payable on December 31, 2025, or upon termination of the Partnership if earlier, subject to a mandatory prepayment from the net proceeds from the sale of any of the properties, after repayment of all debt secured by the property sold. The Partnership failed to make full payment of debt service due on February 10, 1994 and March 10, 1994 with respect to the Stamford Loan due to a decline in the property's revenue following the extension of D&B's lease. As a result, the Partnership is in default under the terms of the Stamford Loan. The General Partners are currently attempting to negotiate a further modification of the property's loan, however, no agreement has been reached to date. It appears unlikely that such efforts will be successful. Should the Partnership be unable to secure a loan modification, the lender may elect to exercise its remedies under the loan agreement including accelerating the maturity date of the principal balance of the loan. Should title to the property ultimately be transferred to the lender, it would result in the loss of the Partnership's investment in the property. The Saxon Woods Corporate Center. In September 1991, the Partnership established a non-recourse line of credit of $6,500,000 (the "Saxon Woods line of credit") secured by the Partnership's leasehold interest in the property located at 550/600 Mamaroneck Avenue, Harrison, New York (the "Saxon Woods Property"). The Saxon Woods line of credit has a term of five (5) years, is secured by a first leasehold mortgage on the Saxon Woods Property and generally bears interest at the rate of 2.5% per annum in excess of the London Interbank Offered Rate ("LIBOR"). The interest rate was 5.875% at December 31, 1993. In addition, the Partnership is required to pay 1/2% per annum on the undrawn balance of the Saxon Woods line of credit. As additional security for the repayment of the Saxon Woods line of credit, the Partnership deposited $500,000 with the lender, which deposit was used by the Partnership to pay operating expenses in connection with the Saxon Woods Property prior to borrowing any sums under the Saxon Woods line of credit for operating expenses. The Saxon Woods line of credit provides the partnership with a source of funds to pay for those improvements necessary to lease additional space at the property. In order to reduce the need for additional borrowings under the Saxon Woods line of credit, the Partnership has agreed to use all available cash flow from the Saxon Woods Property (which cash flow has been pledged to the lender) for all expenses incurred at the Saxon Woods Property prior to borrowing any additional funds under the Saxon Woods line of credit. Based on the current appraised value of the Saxon Woods Property, only $6,000,000 of the Saxon Woods line of credit is available to the Partnership due to the Borrowing Limitation. The General Partners believe that the Saxon Woods line of credit will provide the Partnership with a source of funds which should be sufficient to pay for those improvements necessary to lease additional space at the property and anticipated operating shortfalls. As of December 31, 1993, the Partnership had borrowed $4,542,677 under the Saxon Woods line of credit. In January 1994, the Partnership borrowed an additional $138,000 and have made commitments to borrow an additional $362,000. The General Partners expect that additional leasing activity, the costs of which will be covered by borrowings from the Saxon Woods Line of Credit, may result in a further increase in the appraised value of the property thereby enabling the Partnership to borrow the additional amounts available under the Saxon Woods Line of Credit up to the full amount of $6,500,000. The Partnership has the option to request an updated appraisal at any time; however, there can be no assurance that subsequent appraised values for the Property will continue to increase. The Park Avenue Property. The $60,000,000 first mortgage is for a term of twelve years and accrues interest at the rate of 9.75% per annum. Interest only is payable in monthly installments until the maturity date (December 19, 1998) at which time the full amount of principal and any accrued interest shall be due and payable. On June 15, 1989, Two Park Company placed a second mortgage on the Park Avenue Property in the amount of $10,000,000. Interest only is payable in monthly installments at a rate of 10.791% through June 15, 1992 and thereafter at the rate of 10.625% through December 19, 1998 at which time the full amount of principal and any accrued interest shall be due and payable. On December 26, 1990, Two Park Company placed a third mortgage on the Park Avenue Property in the amount of $5,000,000. Interest only is payable in monthly installments at a rate of 11.5% through its maturity date of December 19, 1998 at which time the full amount of principal and any accrued interest shall be due and payable. The lender has the right to accelerate the maturity date of the first, second and third mortgage loans (collectively the "Park Avenue Loans") to a date not earlier than December 19, 1996 upon at least 180 days prior notice. The loans are being treated as one loan and at any time upon request of Two Park Company, the lender will combine and consolidate all of the loans to make a non-recourse first mortgage loan in the principal amount of $75,000,000. While the $75,000,000 principal outstanding currently exceeds the Borrowing Limitation, it did not exceed the Borrowing Limitation when the loans were incurred. The 34th Street Property. On December 12, 1989, the Partnership entered into a loan agreement with First National Bank of Chicago (the "Bank"). The loan provides for a $30,000,000 credit facility in the form of a first mortgage secured by the Partnership's leasehold interest on the 34th Street Property (the "34th Street line of credit"). The lender agreed to advance amounts under the credit facility up to 40% of the lesser of the appraised value of the 34th Street Property or the value thereof as determined by the lender. The credit facility matures on May 31, 1997 and provided the Partnership with the flexibility to draw funds at 110 basis points over Libor, or 110 basis points over the Bank's C.D. rate or at the Bank's prime rate. If the net operating income (as defined) for the property is less than 115% of the projected debt service for the property for any six month period, the lender may increase the interest rate to 125 basis points over Libor or 125 basis points over the Bank's C.D. rate. As of December 31, 1993, the Partnership had $15,000,000 outstanding under the credit facility at Libor plus 1.25% per annum. The rate was fixed at 6.4375% for the period from March 20, 1992 to March 18, 1993. The interest rate for the period March 19, 1993 through December 31, 1993 was 6% (see below). Of the $30,000,000 maximum principal amount of the credit facility, up to $20,000,000 was permitted to be used by the Partnership for building improvements, tenant improvement allowances and leasing commissions relating to the 34th Street Property, as well as closing costs, interest reserves and mortgage recording tax reserves with respect to the credit facility. The remaining $10,000,000, substantially all of which had been advanced by March 1991, was unrestricted and was allowed to be used by the Partnership for any purpose. As of December 31, 1992, $15,000,000 had been advanced under the 34th Street line of credit. As a result of the default on the loan (See Note 2) and the decline in the appraised value of the 34th Street Property, the Partnership is currently prevented from borrowing any additional funds. While the $15,000,000 principal amount outstanding currently exceeds the Borrowing Limitation and the appraised value, it did not exceed the Borrowing Limitation when the loan was incurred. The Partnership suspended its interest payments to the lender beginning with the September 1992 payment. On August 12, 1993, the Partnership entered into a forbearance agreement which modified the terms of the 34th Street Line of Credit with The First National Bank of Chicago ("FNBC"), under which $15 million of principal and approximately $1.3 million of accrued interest is outstanding at December 31, 1993. Pursuant to the forbearance agreement, FNBC agreed to forbear through June 30, 1994 from exercising its remedies under the loan agreement as a result of the Partnership's failure to pay interest. Subject to the terms of the forbearance agreement, the Partnership will have the ability to pay off the 34th Street Line of Credit for $6.5 million, a substantial discount to the current outstanding balance, at any time through June 30, 1994. Also through June 30, 1994, the Partnership will be permitted to make interest payments, based upon the Corporate Base Rate or the prime rate beginning March 19, 1993, to FNBC only to the extent of available cash flow from the 34th Street Property. No interest payments have been made by the Partnership since entering into the forbearance agreement. If the Partnership is not successful in obtaining the financing necessary to pay off the 34th Street Line of Credit by June 30, 1994, the Partnership has agreed to assign its interest in the property and in the ground lease to the Property to FNBC, at FNBC's election, in lieu of foreclosure. This agreement provides the Partnership with an opportunity to pay off the 34th Street Line of Credit at a substantial discount while at the same time establishing a cost-effective means to ensure an orderly and efficient transfer of the Property to FNBC in the event the 34th Street Line of Credit cannot be paid off. The Partnership has no assurances that it will be able to obtain the financing necessary to pay off the 34th Street Line of Credit and any such pay off will depend on numerous factors including general market conditions. Should the Partnership be unable to complete a refinancing, it might result in the loss of the Partnership's investment in the Property. The deferral of management fees and leasing commissions by Mendik Realty will remain in effect pursuant to the terms of the forbearance agreement. Additionally, the forbearance agreement gives FNBC control of the property's cash flow by requiring the Partnership to maintain a lockbox at FNBC. FNBC will approve all releases of funds from the lockbox. As of December 31, 1993, approximately $1 million was on deposit in the lockbox account maintained by FNBC. 7. Rental Income Under Operating Leases 8. Transactions With General Partners and Affiliates 10. Supplementary Information

783425_1993.txt

783425_1993

1993

783425

ITEM 1. BUSINESS (A) GENERAL DEVELOPMENT OF BUSINESS ALC Communications Corporation was incorporated in Delaware on August 26, 1985 ("ALC" or the "Registrant"). ALC commenced business on December 19, 1985, the date of the affiliation of two long distance telephone companies, Allnet Communication Services, Inc. ("Allnet") and Lexitel Corporation ("Lexitel"). Allnet, a wholly owned subsidiary of ALC, now has the former businesses and operations of both Allnet and Lexitel. ALC conducts no business other than its position as a holding company for its subsidiary, Allnet. Unless the context otherwise requires, the term "Company" includes ALC, its wholly owned subsidiary, Allnet, and all of the wholly owned subsidiaries of Allnet. The principal executive offices of ALC are located at 30300 Telegraph Road, Bingham Farms, Michigan 48025 (810/647-4060). In the summer of 1990 the Company had begun an overall refinancing (the "Refinancing") of substantially all of its funded debt and in 1992 concluded the second phase of the Refinancing by substantially deferring or reducing the debt service obligations of the Company. In August 1992, the Company's then majority shareholder, Communications Transmission, Inc. ("CTI") conveyed the ALC Common Stock (the "Common Stock" or "ALC Stock"), Class B Preferred Stock (the "Class B Preferred") and Class C Preferred Stock (the "Class C Preferred") it owned to NationsBank of Texas, N.A., The First National Bank of Chicago, National Westminster Bank USA, CoreStates Bank, N.A. and First Union National Bank of North Carolina (the "Banks") pro-rata in exchange for the release of certain portions of CTI's obligations to each of the Banks. The Banks, in the aggregate, acquired all of the outstanding Class B Preferred and Class C Preferred, as well as 14,324,000 shares of Common Stock. In October 1992, the Company completed a stock offering (the "1992 Equity Offering") for 9,863,600 shares of Common Stock, a portion of which resulted from the exchange of the Class A Preferred Stock (the "Class A Preferred") held by individual stockholders and the remainder of which was due to Common Stock held by other entities, including the Banks. The Banks sold, in the aggregate, 3,000,000 shares of Common Stock in the 1992 Equity Offering. In January 1993, the Company filed a registration statement (the "shelf registration") under the Securities Act of 1933, as amended (the "Securities Act") to permit the sale, from time to time, of up to 19,500,909 shares of Common Stock held by certain stockholders, including the Banks, or issuable upon exercise of certain outstanding warrants or conversion of outstanding Class B Preferred and Class C Preferred. Pursuant to the shelf registration, in March 1993, the Company completed a stock offering (the "March 1993 Equity Offering") whereby the Banks and the Prudential Insurance Company of America ("Prudential") sold an aggregate of 10,350,000 shares of Common Stock to the public. As part of the March 1993 Equity Offering, the Banks converted all outstanding shares of Class B Preferred and Class C Preferred to Common Stock. The Class B Preferred and Class C Preferred were retired effective March 25, 1993. The Banks subsequently reduced their ownership interest in the Company to a minimal position through subsequent sales and the transfer of other shares to Prudential by four of the five Banks. In February 1994 the one remaining Bank, First Union National Bank of North Carolina, sold shares in a series of brokerage transactions, then transferred the remaining balance of shares to or as directed by Prudential. In May 1993, the Company completed an offering of $85.0 million principal amount 9% Senior Subordinated Notes ("1993 Notes") and in June 1993 redeemed all of the 11-7/8% Subordinated Notes then outstanding, which were issued as part of the note exchange offer which occurred during the 1992 phase of the Refinancing. As of June 30, 1993, the Company executed an agreement for a $40.0 million line of credit (the "Revolving Credit Facility"), replacing the Company's prior revolving credit facility. Effective December 31, 1993, the Company redeemed the issued and outstanding Class A Preferred Stock (the "Class A Preferred"). Following such redemption, the Class A Preferred was retired effective January 4, 1994. For more detailed information regarding stock ownership in the Company, reference is hereby made to "Item 13. Certain Relationships and Related Transactions." In July 1993, the Company acquired the specialized 800 customer base of Call Home America, Inc. Call Home America, Inc. had approximately 50,000 customers, including parents of college students and frequent travelers, who continue to receive services under the Call Home America(R) name. These customers, who were then generating annualized revenue of approximately $20 million, are also able to utilize a wide range of other telecommunications services from the Company. (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Company operates in one industry segment. All significant revenues relate to sales of telecommunication services to the general public. (C) NARRATIVE DESCRIPTION OF BUSINESS ALC is the holding company for Allnet and conducts no other business. Allnet provides long distance telecommunications services primarily to commercial and, to a lesser extent, residential subscribers in the majority of the United States and completes subscriber calls to all directly dialable locations worldwide. Allnet is one of the few nationwide carriers of long distance services and in 1993 carried in excess of 800 million calls over its network. The Company operates its own switches, develops and implements its own products, monitors and deploys its transmission facilities and prepares and designs its own billing and reporting systems. The Company focuses on a highly profitable segment of the long distance industry with high operating margins, specifically, commercial accounts, whose calling volume consists primarily of calls made during regular business hours which command peak-hour pricing. Commercial subscribers tend to make most of their calls on weekdays during normal business hours, while the Company's residential subscribers tend to make most of their calls in the evening and on weekends, when business usage is lowest. Neither commercial nor residential subscribers' access to the Company's service is limited as to the time of day or day of week. SEASONALITY The Company experiences certain limited seasonality in the use of its services due to periods where commercial subscribers experience higher levels of time-off by their employees, such as during national holidays and vacation periods. Fewer business days during a calendar month will also impact usage. The Company will experience decreased commercial usage resulting from these factors. Seasonality in usage from residential subscribers tends to vary with the return of students to college and national holidays. The Company will experience increased residential usage resulting from these factors. PRODUCTS AND SERVICES The Company provides a variety of long distance telephone products and services to commercial and residential subscribers nationwide. The bulk of the Company's revenue is derived from outbound and inbound long distance services which are all under the "Allnet(R)" trademark. Many of the Company's products, however, differ from those of certain of its competitors due to the level of value-added services the Company offers, the flexibility of product pricing to maintain competitiveness and its broader geographic reach. The variety of products offered are categorized by the Company based upon certain primary characteristics: pricing, value-added services, reporting and 800 Services. Pricing. All of the Company's customers are identified by their telephone number, dedicated trunk or validated access code, and have a rating which is used to determine the price per minute that they pay on their outbound or inbound long distance calls. Rates typically vary by the volume of usage, the distance of the calls, the time of day that calls are made, the region that originates the call, and whether or not the product is being provided on a promotional basis. The outbound commercial product line is broken into three major types of services. Regional: Rates vary by area code or region and subscribers pay a flat rate for all long distance calls within these area codes or regions. Rates are determined by competitive positioning and vary according to the regions which the Company currently services. These products are priced at the area code level, and rates offered on these products are the primary method used to compete with small and more regionalized carriers. Nationwide: Rates are by mileage bands set at a distance around the call initiating point. Long Haul: Rates are designed for users who tend to make substantial bicoastal and international calls. These products offer distance-insensitive domestic pricing and two time-of-day period rates, along with aggressive international pricing options. The Company's outbound residential product line is made up of Allnet "Dial 1" Service which also has two special discount options to service employees of commercial accounts ("EBP") and members of associations ("ABP"). Different rates are applied to inbound telephone services than to outbound telephone services. The inbound product line is provided for commercial accounts which use 800 telephone numbers to receive and pay for calls from customers and potential prospects and for residential accounts wishing similar type services. Value-added Services. When customers subscribe to value-added services on the Company's network, their calls are charged a fee based on the services provided. Customers access value-added services through Allnet Access(R), which is an interactive voice response system that allows subscribers to interact with the phone system by pressing numbers on the telephone. Allnet Access(R) is a customized platform or menu from which customers select the desired services to which they have subscribed. For example, a customer who would like to deliver a prerecorded message would dial an Allnet Access(R) 800 number or through a new streamlined dialing method known as "00 Platform" from an Allnet presubscribed Touch Tone(R) telephone and select "call delivery" from the voice menu. If the customer had subscribed to other services, these services would be offered on the menu as well. Once the customer makes a selection, the call is routed and charged accordingly. The Company's value-added services are aimed primarily at the business subscriber, although the Company also offers products for residential customers. Value-added services include: Allnet Call Delivery(R), a message delivery service which enables a customer to send a prerecorded message to a number; VoiceQuote, an interactive stock quotation service; Allnet InfoReach(R), numerous audio/text programs such as news and weather; a voice mail service; Option USA(R), a service to provide calls to the U.S. from selected international locations on Allnet Access(R); and three different teleconferencing services. During 1992 the Company launched a full spectrum of facsimile services including Allnet Broadcast FAX(R), which allows the customer to send or fax documents to multiple locations at the same time; fax on demand, which allows the customer to make a fax document available to people who call an 800 number; fax mail, which allows a customer to receive facsimile messages in a fax mailbox and pick them up at a later date; PC software, which allows the customer to manage his facsimile lists and documents from a PC; and special international pricing to accommodate short duration facsimile traffic. During 1993 the Company began to focus on mobile products and services, offering MobileLine, the resale of cellular service provided by the regional Bell Operating Companies ("BOCs"), along with consolidated billing. In addition, the Company currently plans to introduce PageLine, a nationwide paging resale and consolidated billing product, in the second quarter of 1994. Reporting. The Company offers its customers a variety of billing options and media (two sizes of paper invoices [8-1/2X11 or 4X7 inches], diskette, and magnetic tape) aimed primarily at business customers. When a new commercial account is opened, the customer is offered the opportunity to custom design the format of its reports. For example, the Company can include company accounting codes or internal auditing codes for each call made with each billing statement. If a customer would like to change a particular reference code for a telephone line, the code can be changed automatically. The Company's primary product in this area is Allnet ESP(R) or Executive Summary Profile. A typical Allnet ESP(R) statement breaks out calls in a number of ways: by initiating caller number, by terminating number, by ranking, by department, by frequently dialed number/area/country or by time of day. Allnet customers pay a fixed monthly fee for these custom-tailored billing services. In late 1992, Allnet ESP(R) II was launched which gives customers graphic reports of traffic patterns on a nationwide basis by state, within state by area of dominant influence ("ADI") and within ADI by zip code. The Company believes this will be useful to certain customers for direct response and customer service applications. In mid-1992, the Company also launched its proprietary personal computer reporting service Allnet Invoice Manager(sm) ("AIM") which allows customers to design their own reports, prepare separate itemized bills, do mark-up reporting and generate numerous other customized reports. 800 Services. The Company greatly expanded its 800 product offerings, capitalizing on opportunities resulting from FCC mandated portability in May 1993 (which allows customers to select a different long distance carrier without changing their 800 number). These new offerings include area code blocking and routing; time of day routing; Home Connection 800(sm) , fractional 800 service which allows residential customers to acquire 800 service utilizing a 4 digit security Personal Identification Number ("PIN"); Multi-Point(sm) 800 services, which allow the customer to use accounting codes on an 800 number or route a single 800 number to numerous locations simultaneously; Follow-Me 800, which allows a customer to change his routing from a Touch Tone(R) telephone; and TargetLine(sm) 800, which routes calls to the closest location and provides custom prompts based upon a customer specific database. To supplement the Company's internal growth in this market, the Company also will evaluate strategic external growth opportunities. For example, in July 1993, the Company acquired the specialized 800 customer base of Call Home America, Inc. These customers, who were then generating annualized revenue of approximately $20 million, are also able to utilize a wide range of other telecommunications services from the Company. TRANSMISSION The Company endeavors to have sufficient switching capacity, local access circuits and long distance circuits at and between its network switching centers to permit subscribers to obtain access to the switching centers and its long distance circuits on a basis which exceeds industry standards regarding clarity, busy signals or delays. The network utilizes fiber optic and digital microwave transmission circuits to complete long distance calls. With the exception of a digital microwave system located in California for which Allnet holds the Federal Communications Commission ("FCC") licenses, such facilities are leased on a fixed price basis under both short and long term contracts. The California microwave facilities are on leased real estate and are subject to zoning and other land use restrictions. In recent years abundant availability and declining prices have dictated a strategy of generally obtaining new capacity for terms between six months and one year. While the Company has several long term contracts, these contracts have either annual "mark-to-market" clauses or, in one case, a "most favored nation" clause. These provisions function to keep the price the Company pays at or near current market rates. An important aspect of the Company's operation is planning the mix of the types of circuits and transmission capacity to be leased or used for each network switching center so that calls are completed on a basis which is cost effective for the Company without compromising prompt service and high quality to subscribers. Over 99% of the Company's domestic traffic is carried on owned or leased facilities ("on-net"). In establishing a network switching center, the Company can select equipment with varying capacities in order to meet the anticipated needs of the service origination region(s) served by the center. The equipment used by the Company is, for the most part, designed to permit expansion to its capacity by the addition of standard components. If the maximum capacity of the equipment in any center is reached, the Company replaces it with higher capacity switching equipment and attempts to move the replaced unit to a network switching center in a different service origination region. The Company is dependent upon the local telephone company for installing local access circuits and providing related service when establishing a network switching center. As of December 31, 1993, the Company had 16 network switching centers which originate traffic in all Local Access Transport Areas ("LATAs") in the United States. International service is provided through participation in the International Carrier Group ("ICG") with three other major long distance companies. The ICG in turn contracts with other long distance companies and foreign entities to provide high quality international service at competitive rates. MARKETING Approximately 60% of the Company's employees are engaged in sales, marketing or customer services. The Company markets its services and products through personal contacts with an emphasis on customer service, network quality, value-added services, reporting, rating and promotional discounts. Allnet currently operates a sales network with 48 offices in the United States. The Company employs 866 sales, marketing and customer service individuals. Field sales representatives focus on making initial sales to commercial users. They solicit business through face-to-face meetings with small- to medium-sized businesses. Each field sales representative earns a commission dependent on the customer's usage and value-added services. The Company's sales strategy is to make frequent personal contact with existing and potential customers. The prices and promotions offered for the Company's services are designed to be competitive with other long distance carriers. Prices will vary as to interstate or intrastate calls as well as with the distance, duration and time-of-day of a call. In addition, the Company may offer promotional discounts based upon duration of commitment to purchase services, incremental increases in service or "free" trial use of the many value-added and reporting services. Volume discounts are also offered based upon amount of monthly usage in the day, evening and night periods or based solely on total volume of usage. The Company has three groups which provide ongoing customer service designed to maximize customer satisfaction and increase usage. First, customer service personnel located in Southfield, Michigan are available telephonically free of charge 24 hours a day, seven days a week. Second, a customer service center in Columbus, Ohio processes calls from customers with significant usage levels who have been enrolled in the Company's "Select Service" programs. Third, communications specialists located at the sales offices provide personal service to large commercial accounts. The Company services more than 295,000 customers. Of these customers, approximately 137,000 are commercial accounts, with the remainder being residential accounts. During the past two years, the Company has become more geographically diversified, adding new markets as necessary. The Company is currently focusing on an agent program to increase customer acquisition in specific target markets. COMPETITION AND GOVERNMENT REGULATION Competition is based upon pricing, customer service, network quality and value-added services. The Company views the long distance industry as a three tiered industry which is dominated on a volume basis by the nation's three largest long distance providers: American Telephone and Telegraph Company ("AT&T"), MCI Telecommunications Corporation ("MCI") and Sprint Communications, Inc. ("Sprint"). AT&T, MCI and Sprint, which generate an aggregate of approximately 88% of the nation's long distance revenue of $65 billion, comprise the first tier. Allnet is positioned in the second tier with four other companies with annual revenues of $250 million to $1.5 billion each. The third tier consists of more than 300 companies with annual revenues of less than $250 million each, the majority below $50 million each. Allnet targets small- and medium-sized commercial customers ($100 to $50,000 in monthly long distance volume) with the same focus and attention to customer service that AT&T, MCI and Sprint offer to large commercial customers. Allnet is one of the few long distance companies with the ability to offer high quality value-added services to small- and medium-sized commercial customers on a nationwide basis. A number of the Company's competitors are primarily regional in nature, limited by the size of their transmission systems or dependent on third parties for their billing services and product offerings. Generally, the current trend is toward lessened regulation for both the Company and its competitors. Regulatory trends have had, and may have in the future, both positive and negative effects upon Allnet. For example, more markets are opening up to Allnet, as state regulators allow Allnet to compete in markets from which it was previously barred. On the other hand, the largest competitor, AT&T, has gained increased pricing flexibility over the years, allowing it to price its services more aggressively. As a nondominant Interexchange Carrier ("IXC"), the Company is not required to maintain a certificate of public convenience and necessity with the FCC other than with respect to international calls, although the FCC retains general regulatory jurisdiction over the sale of interstate long distance services by IXCs, including the requirement that calls be charged on a nondiscriminatory, just and reasonable basis. Although the FCC had previously ruled that nondominant carriers, such as Allnet, do not need to file tariffs for their interstate service offerings, a recent Court of Appeals decision has vacated that FCC ruling. The impact of the Court of Appeals decision on Allnet was minimal and primarily administrative in nature. Allnet has already taken any necessary steps to comply with that decision, including filing an interstate tariff with the FCC. The FCC has since adopted reduced requirements regarding the filing of tariffs for non-dominant carriers, including Allnet. The Company believes that it has operated and continues to operate in compliance with all applicable tariffing and related requirements of the Communications Act of 1934, as amended. In the FCC decision implementing certain provisions of the Telephone Operator Consumer Services Improvement Act ("TOCSIA"), Allnet was designated subject to the payment of charges by "private payphone owners." Allnet presently is challenging that designation with the FCC and in the courts, as it does not believe that it is engaged in the sort of activity intended to be regulated under TOCSIA. In addition, by virtue of its ownership of interstate microwave facilities located in California (as described in "Transmission"), Allnet is subject to the FCC's common carrier radio service regulations. In 1984, pursuant to the AT&T Divestiture Decree, AT&T divested its 22 Bell Operating Companies ("BOCs"). In 1987, as part of the triennial review of the AT&T Divestiture Decree, the U.S. District Court for the District of Columbia denied the BOCs' petition to enter, among other things, the long distance ("inter-LATA") telecommunications market. The District Court's ruling was appealed to the United States Court of Appeals for the District of Columbia which, in 1990, affirmed the District Court's decision to retain the inter-LATA prohibition for the BOCs. Currently pending before Congress is legislation that would allow the BOCs into the inter-LATA business in competition with long distance carriers, such as Allnet. The recently introduced "Brooks-Dingell Bill" (in the House of Representatives, H.R. 3626) and the "Hollings Bill" (in the Senate, S. 1822) set forth various time frames and certain entry requirements for the BOCs to enter certain markets, including the long distance market, from which the BOCs are currently barred under the AT&T Divestiture Decree. As initially proposed, the Brooks-Dingell Bill would allow entry into various segments of the long distance business when various combinations of conditions and timing requirements have been satisfied. Some entry requirements may be successfully applied almost immediately upon the passage of the bill, while others may not be applied until 18 months or 60 months have passed. In contrast, as initially proposed, the Hollings Bill would require that long distance only be offered by a BOC through a separate subsidiary, but only after the FCC, after consultation with the Attorney General, finds that the BOCs have met certain entry requirements. Under the Hollings Bill, there is one set of entry tests for "out-of-market" services, and another for "in-market" services. To allow a BOC to provide long distance service outside of its market area through a separate subsidiary, the FCC must find there is no substantial possibility that the BOC could use its market power to impede competition in the long distance market that the BOC seeks to enter. To allow a BOC to provide long distance service in its local market (i.e., where it provides telephone exchange or exchange access services), the FCC must make additional findings that the BOC has opened up its local network to competitors, and that it faces actual and demonstrable competition based on objective standards of competitive penetration set forth in the Hollings Bill. It cannot be determined at this time whether these or other bills will be adopted or the timing of such adoption or, if adopted, whether the final legislation will be similar to either of these proposed bills. To the extent final legislation, if any, results in the BOCs being permitted to provide inter-LATA long distance telecommunications services and to compete in the long distance market, existing IXCs, including the Company, would likely face substantial additional competition from local BOC monopolies. As part of the AT&T Divestiture Decree, the divested BOCs were required to charge AT&T and all other carriers (including Allnet) equal per minute rates for "local transport" service (the transmission of switched long distance traffic between the BOCs' central offices and the IXCs' points of presence). BOC and other local exchange company ("LEC") tariffs for local transport service have been based upon these "equal per unit" rules since 1984, pursuant to the AT&T Divestiture Decree and the FCC's waiver of certain local transport pricing rules. Although the portion of the AT&T Divestiture Decree containing this rule ceased to be effective by its terms on September 1, 1991, the FCC had extended its effect until it concluded the rulemaking proceeding in which it considered whether to retain or modify the "equal per unit" local transport pricing structure. On September 17, 1992, the FCC voted to maintain the existing "equal per unit" pricing rules until late 1993. A two year interim would then begin. Based on the interim plan rates that have now taken effect as of January 1, 1994, Allnet does not anticipate a material impact during 1994 and 1995. To moderate IXC costs, the FCC has ordered that non-recurring charges for reconfiguring a carrier's access lines should be waived until May 1994, to accommodate the change in access pricing structure. The FCC has left open the access rate structure issue for the post 1995 period. The FCC issued a Further Notice of Proposed Rulemaking for consideration of a permanent rate structure to take effect beginning no earlier than late 1995. The FCC has also recently voted to allow expanding competition for monopoly local access through expanded local switched access interconnection. This could ultimately provide Allnet with alternatives to purchasing its local access from the monopoly local exchange carriers. The FCC has issued orders stating that carriers, such as Allnet, were entitled to refunds for overcharges paid to a number of local exchange carriers during the 1985-1986 and 1987-1988 periods. These awards have, in most cases, been paid to Allnet. Although these awards are in the aggregate significant, they are not a material portion of the Company's total access costs. Some local exchange carriers have appealed the orders and some of the awards which were paid are conditioned on the outcome of the appeals. In addition Allnet has pending claims for overcharges during the 1989-1990 period. Two of the four claims have been settled. At this time, Allnet is not aware of any pending rulings on the remaining claims. The intrastate long distance telecommunications operations of the Company are also subject to various state laws and regulations, including certification requirements. Generally, the Company must obtain and maintain certificates of public convenience and necessity as well as tariffs from regulatory authorities in most states in which it offers intrastate long distance services, and in most of these jurisdictions, must also file and obtain prior regulatory approval of tariffs for its intrastate offerings. At the present time, the Company can provide originating services to customers in all 50 states and the District of Columbia. Those services may terminate in any state in the United States, and may also terminate to countries abroad. Only 31 states have public utility commissions that actively assert regulatory oversight over the services currently offered by the Company. Like the FCC, many of these regulating jurisdictions are relaxing the regulatory restrictions currently imposed on telecommunication carriers for intrastate service. While some of these states restrict the offering of intra-LATA services by the Company and other IXCs, the general trend is toward opening up these markets to the Company and other IXCs. Those states that do permit the offering of intra-LATA services by IXCs generally require that end users desiring to access these services dial special access codes which place the Company and other IXCs at a disadvantage as compared to LEC intra-LATA toll service which generally requires no access code. PATENTS In December 1992, MCI filed a lawsuit in the United States District Court for the District of Columbia against AT&T. The complaint seeks, among other things, a declaration that certain AT&T patents relating to basic long distance services, toll free "800" service, and other telephone services are invalid or unenforceable against MCI (and other similarly situated telecommunications providers). AT&T counterclaimed against MCI for patent infringement. Contemporaneously with the filing of its declaratory judgment action, MCI requested the court in the AT&T Divestiture Decree case to rule that AT&T should be barred from asserting its pre-divestiture patents to impede competition in the interexchange telecommunications market. Both of the foregoing actions are currently pending. AT&T has generally indicated that it believes that long distance telecommunications companies may be infringing on certain AT&T patents and has offered to license such patents. AT&T has numerous patents, some of which may pertain to the provision of services similar to those currently provided or to be provided by the Company or to equipment similar to that used or to be used by the Company. If it were ultimately determined that the Company has infringed on any AT&T patents and the Company is required to license such patents and pay damages for infringement, such costs could have an adverse effect on the Company. EMPLOYEES As of December 31, 1993, the Company employed 1,488 employees in the United States, none of whom were subject to any collective bargaining agreements. ITEM 2. ITEM 2. PROPERTIES On December 31, 1993, the Company had under lease approximately 113,000 square feet of office space in Bingham Farms, Michigan for executive and administrative functions and approximately 43,000 square feet in Southfield, Michigan for customer service, collections, and data processing. The Company also leases approximately 290,000 square feet in the aggregate for sales and administrative offices, network switching centers and unmanned microwave sites in 90 other locations in the continental United States. Most of the leased premises are for an initial term of five-to-ten years with, in many cases, options to renew. All properties presently being used for operations of the Company are suitable, well maintained and equipped for the purposes for which they are used. ITEM 3. ITEM 3. LEGAL PROCEEDINGS None. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. Executive Officers Of The Registrant The following table sets forth as of February 14, 1994 the executive officers of ALC as designated by the Company or otherwise required by law to be so designated. Executives are elected annually and serve at the pleasure of the Board. John M. Zrno has held his positions since August 1988. From December 1981 until joining the Company, Mr. Zrno held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was President and Chief Executive Officer. Between 1972 and 1981, Mr. Zrno first served as an officer of MCI Telecommunications Corporation, a long distance provider, then as an officer of American Satellite Corporation, a satellite common carrier, and finally as an officer of F/S Communications Corporation, an independent telephone interconnect company. Marvin C. Moses has held his officer positions since October 1988, and director since September 1989. From February 1982 through September 1988, Mr. Moses held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was Chief Financial Officer and Senior Vice President. From 1980 through February 1982, Mr. Moses worked with Atlantic Research Corporation, where he was involved in obtaining project financing for an alternative energy product. From 1975 to 1980, Mr. Moses was Vice President - Finance and Chief Financial Officer of GTE Telenet, a data communications company now part of Sprint. William H. Oberlin has held the position of Chief Operating Officer since July 1990, the position of Executive Vice President since October 1988 and director since July 1993. From November 1983 through September 1988, Mr. Oberlin held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was Senior Vice President - Sales and Marketing. During 1983, Mr. Oberlin was founder and principal shareholder of Electronic Express, Inc., a facsimile-based priority mail and delivery system. From April 1982 through March 1983, Mr. Oberlin was Chief Executive Officer of DHL Business Systems, Inc., a worldwide manufacturer and distributor of word processing terminals. From 1974 through April 1982, Mr. Oberlin was employed by Sprint. From September 1979 through April 1982, Mr. Oberlin was President of Southern Pacific/Distributed Message Systems, Inc., distributors of facsimile machines and electronic mail services. Gregory M. Jones has held the position of Senior Vice President since December 1990 and had formerly served as Vice President - Marketing since January 1989. Mr. Jones was previously director of Sure Check and Retail Services, Inc., a wholly owned subsidiary of Comp-U-Check, Inc. From July 1979 to June 1987 Mr. Jones held various positions with MCI Telecommunications Corporation including director of marketing for MCI Midwest in Chicago, senior manager of telemarketing, and senior manager of customer service. Connie R. Gale has held the position of Vice President since January 1991 and has held the positions of General Counsel and Secretary since October 1988, commencing her employment with the Company December 1986 as Associate General Counsel and Assistant Secretary. Ms. Gale previously served as corporate counsel for Chrysler Corporation from July 1973 to February 1980 and for American Natural Resources, Inc. from February 1980 to March 1981. Ms. Gale was Associate General Counsel at Federal-Mogul Corporation from April 1981 to November 1986. _____________________________ References to "Sprint" include its former designations: Southern Pacific Communications Co., GTE Sprint and U.S. Sprint. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Common Stock, $.01 par value, has been traded on the AMEX since September 4, 1991 and is listed under the symbol ALC. The table below sets forth the ranges of high and low closing sales prices of the Common Stock as reported on the AMEX composite tape for calendar years 1992 and 1993. As of February 21, 1994, there were 2,079 holders of record of the Common Stock. The high and low sales price per share of the Common Stock for the period from January 1, 1994 to February 21, 1994, as reported by AMEX, were $33.63 and $28.13, respectively. Since its inception, ALC has not declared or paid any dividends on its Common Stock. While any Preferred Stock was outstanding, dividends could not be paid on Common Stock if any dividends were due on, or ALC had any past-due obligation to redeem, Preferred Stock. The Company is allowed to pay dividends by the terms of its Revolving Credit Facility as long as (a) the sum of such dividend distribution does not exceed at any one time an amount equal to 30 percent of cumulative Net Adjusted Income (calculated after January 1, 1993) and (b) no default in payment of any Obligations or Event of Default exists at the time such distribution is made, or would be created by any such distribution (capitalized terms not otherwise defined herein are defined in the Revolving Credit Facility). ALC paid $1.5 million in cash dividends to the Class A Preferred holders in 1988. On July 22, 1993 and on October 21, 1993, the Board of Directors of ALC declared current quarterly dividends of $0.32 per share on each of the 355,956 issued and outstanding shares of Class A Preferred. On December 10, 1993, the ALC Board of Directors announced the redemption of the 355,956 issued and outstanding shares of Class A Preferred on December 31, 1993 to stockholders of record at the close of business December 13, 1993. The redemption price was $20.00 per share plus all accrued dividends (including the dividend which was declared on October 21, 1993) in the total amount of $10,361,879. Following the redemption, the Class A Preferred was retired as of January 4, 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth for the indicated fiscal years and periods ended, selected historical financial information for the Company. Such information is derived from financial statements presented in Part IV, Item 14. of this Annual Report on Form 10-K and should be read in conjunction with such financial statements and related notes thereto. ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY Selected Financial Data - ------------- (1) 1989 and 1990 have been restated to reflect the 1:5 reverse stock split. (2) 1989 through 1992 include Class A Preferred Stock. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW By 1993, ALC had completed a multi-year series of refinancing transactions which provided for the simplification and improvement of the debt and capital structure of the Company. ALC was successfully transformed from a Company that in 1990 was owned by a controlling interest stockholder, Communications Transmission, Inc. ("CTI"), and had an equity structure that included three issues of preferred stock. In addition, at December 31, 1990 the Company had a debt structure which required principal and interest payments of as much as $79 million in 1992, a level which could not be met from operating cash flow and therefore required significant refinancing actions. Accordingly, during 1992, the Company completed the Refinancing which included the rescheduling of substantially all debt, resulting in significantly reduced or deferred debt service obligations. In 1992, the Company's major debt instrument represented by the Company's Original Debentures, Replacement Debentures, PIK Debentures and accrued interest was replaced by 11 7/8% Subordinated Notes of Allnet ("1992 Notes"). As part of the restructuring of the Debentures, 3,400,000 ALC Common Stock warrants were issued representing 10.2% of the fully-diluted equity of ALC. These debentures were replaced in May 1993 with 9% Senior Subordinated Notes ("1993 Notes") which do not mature until May 2003. Additional debt including the $20.0 million Restructured Promissory Note and the approximately $8.0 million balance on the 1990 Note Agreements was paid in full. As a result, at December 31, 1993 ALC has a single debt instrument outstanding, $85.0 million of 9% Senior Subordinated Notes. During 1992, the Refinancing also included the restructuring and simplification of the equity of ALC. In August 1992, the equity interest of CTI represented by 14,324,000 shares of ALC Common Stock, and the ALC Class B and Class C Convertible Preferred Stock ("Preferred Stock") was transferred to a group of five banks ("Banks"). Subsequently such Preferred Stock was converted into 3,796,000 shares of ALC Common Stock. A series of stock offerings in 1992 and 1993 was used to facilitate the sale of substantially all of the shares held by the Banks. As part of the stock offering in October 1992, the Company also completed an Exchange Agreement which provided for the exchange of 2,144,044 Class A Preferred Shares for 6,399,227 shares of ALC Common Stock at an effective 40% discount. During 1992 and continuing throughout 1993, the Company achieved both the successful completion of the Refinancing and a significant financial turnaround which included twelve consecutive quarters of income through the quarter ended December 31, 1993. Net income grew from a level of $3.3 million for the first quarter of 1992 to $12.4 million for the fourth quarter of 1993. Net income for the year ended 1993 increased approximately 90% over the previous year (excluding the effect of the extraordinary item and cumulative effect of the accounting change in 1993). The results of operations for 1992 and 1993 reflect increases in both billable minutes and revenue and a significant reduction in operating expenses as a percent of revenue. RESULTS OF OPERATIONS The Company reported net income of $45.7 million for the year ended December 31, 1993. This includes the impact of both the $13.5 million cumulative effect of a change in method of accounting for income taxes and the $7.5 million net loss related to early retirement of debt. Excluding these items, income for the year ended December 31, 1993 totalled $39.7 million on revenue of $436.4 million. This compares to net income of $20.8 million on revenue of $376.1 million and $5.3 million on revenue of $346.9 million for the years ended December 31, 1992 and 1991, respectively. Operating income increased from $23.9 million for the year ended December 31, 1991 to $40.7 million in 1992 to $68.9 million in 1993. This improvement is primarily the result of increased revenue from increased billable minutes and improved gross margin. REVENUE Revenue increased 16.1% to $436.4 million from 1992 to 1993 resulting from an 18.9% increase in billable minutes offset somewhat by a decrease in the revenue per minute. Revenue per minute decreased from 1992 to 1993 resulting from certain changes in the sales mix which were more than offset by additional efficiencies in network costs. Billable minutes have continued to increase since the third quarter of 1990 when compared to the same quarter in the prior year. Most importantly, billable minutes reached their highest level in 1993. The increase in billable minutes results from traffic generated by new customers and increased minutes per customer. Beginning in May 1993, the Company benefited from new traffic growth generated from the availability of 800 portability. Beginning in July 1993, the Company had additional revenue from the acquisition of the customer base of Call Home America, Inc. ("CHA") which represented 2.5% of the increase in revenue for the year ended December 31, 1993 compared to 1992. In addition, resellers contributed an additional $20.0 million to revenue during 1993. Revenue increased from $346.9 million in 1991 to $376.1 million in 1992. The 8.4% increase in revenue represents a 9.6% increase in billable minutes offset by a modest decrease in the revenue per minute. Revenue per minute decreased slightly from 1991 to 1992 resulting from lower unit prices which were more than offset by the impact of reduced cost of communication services as a percent of revenue. The revenue generated from customers' first full month of service in 1993 was 30.7% higher than in 1992 and 7.5% higher in 1992 than in 1991. The increased revenue from new sales along with revenue from existing customers is outpacing revenue lost from customer attrition. Attrition improved from 2.0% in 1991 to 1.8% in 1992. Attrition increased in 1993 to 2.4%, reflecting the change to the portability of 800 numbers from carrier to carrier. The provision for uncollectible revenue, which is deducted from gross revenue to arrive at reported revenue, was 1.9% for the year ended December 31, 1993, 3.0% for the year ended December 31, 1992, and 3.4% for the year ended December 31, 1991. During the last three years, procedures were implemented to improve the collection process and provide earlier detection of credit risks. Procedures include an expanded system for initial credit review and screening, monitoring of early usage levels on new accounts, modification of dunning and collection methods and timing, and improved collection processes on past due accounts. COST OF COMMUNICATION SERVICES The cost of communication services increased from $212.7 million and $216.9 million to $234.8 million for the years 1991, 1992, and 1993, respectively. The increase in cost of communication services is due to the 18.9% and 9.6% increase in billable minutes in 1993 and 1992. These increases were offset by unit cost reductions for transmission capacity experienced in 1992 and further efficiencies gained during 1993. The cost of communication services decreased, however, as a percent of revenue from 61.3% for 1991 to 53.8% in 1993, the lowest rate in the Company's history. Switched access costs per hour as a percent of revenue declined 3.5% reflecting lower tariffed rates. A combination of the use of high volume, fixed price leased facilities to transmit traffic and reduced international costs through contractual agreements have contributed to this percentage decline. In addition, the Company has continued to reconfigure its network to optimize utilization. The Company's use of high volume, fixed price transmission capacity is significantly more cost effective than the use of measured services. By utilizing fixed price leased facilities to transmit traffic, the Company has successfully decreased its network costs without the capital expenditures associated with construction of its own fiber optic or digital microwave network. Over 99% of traffic traverses low cost "on-net" digital facilities. OTHER EXPENSES Sales, general and administrative expense was $98.0 million, $107.3 million and $119.8 million for the years 1991, 1992 and 1993, respectively. Sales, general and administrative expense for 1993 increased $12.5 million or 11.7% compared to 1992. The increase reflects increased commissions, taxes other than income, and other expenses related to sales. Sales, general and administrative expense, however, declined as a percent of revenue which reflects management's continuing focus on cost containment. Procedures implemented to improve efficiencies and contain expenses included improved budgeting techniques, continued review of actual expenses against budgeted levels, incentive programs tied directly to achievement of budget objectives, and detailed review of general expense programs. Sales, general and administrative expense for 1992 increased $9.3 million or 9.5% compared to 1991. Sales expense increased 19.6% from 1991 which resulted from increased advertising and marketing expenses as well as increased commissions reflecting higher first full month revenue as well as enhancements to the commission plan to encourage customer retention. General and administrative expenses continued to decrease as a percent of net revenue. The increase in depreciation and amortization from $11.2 million in 1992 to $12.8 million in 1993 is primarily the result of depreciation on newly capitalized fixed assets and intangible assets reflecting the increase in capital expenditures in 1992 and 1993 and the purchase of CHA. The decrease from 1991 to 1992 reflected the termination of depreciation on analog multiplex and switch equipment, for which the Company provided a reserve, and the termination of depreciation as assets reach the end of their useful lives. These reductions in depreciation were partially offset by depreciation on assets capitalized during the period. INTEREST EXPENSE Interest expense has dramatically decreased from $18.1 million in 1991 and $17.2 million in 1992 to $10.5 million in 1993. This resulted from reduced interest related to the replacement of the 11 7/8% Subordinated Notes, which had an effective interest rate of 13.6%, with the 9% Senior Subordinated Notes. In connection with the Refinancing, the Restructured Promissory Note and the 1990 Note Agreement were paid in full in 1993 and 1992, respectively. Interest expense also declined due to lower average balances on the Revolving Credit Facility, as well as lower interest rate charged under the new Revolving Credit Facility. INCOME TAXES Effective January 1, 1993, the required implementation date, the Company adopted the Financial Accounting Standards Board Statement 109 "Accounting for Income Taxes" ("Statement 109"). Application of the new rules resulted in the recording of a net deferred tax asset and additional income of $13.5 million as of January 1, 1993, related primarily to the future tax benefits which are expected to be realized upon utilization of a portion of the Company's tax net operating loss carryforwards ("NOLs"). Statement 109 requires that the tax benefit of NOLs be recorded as an asset to the extent that management assesses that the realization of such NOLs is "more likely than not". Management believes that realization of the benefit of the NOLs beyond a three-year period is difficult to predict and therefore has recorded a valuation allowance which has the effect of limiting the recognition of future NOL benefits to those expected to be realized within the three year period. The Company has not applied Statement 109 retroactively and thus did not restate prior year financial statements to reflect adoption of the new rules. Prior to January 1, 1993, the Company accounted for income taxes in accordance with Accounting Principles Board Opinion No. 11. The tax provisions for the years ended December 31, 1992 and 1991 included an amount that would have been payable except for the availability of NOLs. The tax benefits of the loss carryforwards utilized were reported as an extraordinary item for the years ended 1992 and 1991. With the adoption of Statement 109, the income tax expense for 1993 includes the benefit of utilizing net operating losses. In 1992 and 1993 the Company was subject to regular tax and due to a Code Section 382 "ownership change", the utilization of net operating losses was limited. In 1991, the Company was subject to alternative minimum tax and the operating losses were utilized to offset 90% of the taxable income. SECTION 382 LIMITATION Section 382 (in conjunction with Sections 383 and 384) of the Code provides rules governing the utilization of certain tax attributes, including a corporation's NOLs, "built-in-losses," capital loss carryforwards, unused investment tax credits ("ITCs") and other unused credits, following significant changes in ownership of a corporation's stock. Generally, Section 382 provides that if an ownership change occurs, the taxable income of a corporation available for offset by these tax attributes will be subject to an annual limitation ("382 Limitation"). The transfer of ALC Common Stock, Class B Preferred and Class C Preferred by CTI to the Banks in August 1992 resulted in an ownership change with a 382 Limitation of approximately $10 million per annum. As a result of this annual limitation, along with the 15 year carryforward limitation, the maximum cumulative NOLs and ITCs which can be utilized for federal income tax purposes in 1994 and future years are limited to approximately $120 million, assuming no future ownership change or built-in gain recognition. The Company is also subject to numerous state and local income tax laws which limit the utilization of NOLs after an ownership change. Future events beyond the control of the Company could reduce or eliminate the Company's ability to utilize the tax benefit of its NOLs and ITCs. Any future ownership change under Section 382 would require a new computation of the 382 Limitation based on the value of the Company and the long term tax-exempt rate in effect at that time. Furthermore, the tax benefit of NOLs would be reduced to zero if the Company fails to satisfy the continuity of business enterprise requirement for the two-year period following an ownership change. Under the continuity of business requirement, the Company must either continue its historic business or use a significant portion of its pre-ownership change assets in a business. SEASONALITY The Company's long distance revenue is subject to certain limited seasonal variations. Because most of the Company's revenue is generated by commercial customers, the Company traditionally experiences decreases in long distance usage and revenue in those periods with holidays. In past years the Company's long distance traffic has declined slightly during fourth quarters from previous quarters due to the holiday periods. However, in 1993 and 1992 the impact of this trend was more than offset by strong year over year traffic growth, which was up 26.0% and 12.3% from the fourth quarter of 1992 and 1991, respectively. LIQUIDITY AND CAPITAL RESOURCES For the years ended December 31, 1993, 1992 and 1991, the Company generated positive cash flow from operations of $59.4 million, $30.4 million and $27.3 million, respectively, reflecting the strong trend of profitability. The positive cash flow reflects fourteen consecutive quarters of increased revenue and operating profits as of December 31, 1993 versus prior year comparable quarters. The positive cash flow from operations resulted in working capital of $1.4 million at December 31, 1993 compared to negative $31.7 million at December 31, 1992. The increase in working capital is largely attributable to: (a) the pay down of the Revolving Credit Facility which was classified at December 31, 1992 as a short term liability, (b) the increase in accounts receivable due to the increase in revenue, and (c) the reduced balance in the current portion of notes payable due to the payoff of the Restructured Promissory Notes and payments made on capital leases. In addition to the positive cash flow from operations, the Company's short term liquidity position is further strengthened by the unused availability under the Revolving Credit Facility. As of June 30, 1993 the Company executed an agreement for a $40.0 million line of credit, replacing the previous Facility. The new Revolving Credit Facility expires June 30, 1995. Under this Revolving Credit Facility, the Company is able to minimize interest expense by structuring the borrowings under three alternatives. Each alternative has a varying interest rate calculation associated with it. The effective rate under the Facility during 1993 approximated 5.8%. The agreement includes financial covenants which allow the Company to further reduce interest expense on outstanding borrowings beginning in July 1994. A .375% per annum charge is made on the unused portion of the line. Advances under the Revolving Credit Facility are made based on the level of receivables. As of December 31, 1993, the Company had availability of $39.8 million under the line and no balance outstanding. Further evidence of the Company's stronger liquidity position was the Company's ability to finance the cash needs of $19.6 million for the CHA customer base acquisition and $10.4 million for the redemption including accrued dividends of Class A Preferred Stock from cash flow from operations. Because the Company has chosen to lease rather than own its transmission facilities, the Company's requirements for capital expenditures are modest. Capital expenditures totalled $16.2 million in 1993. Capital expenditures during the year ended December 31, 1993 included projects for enhanced efficiency and technical advancement in the network, information systems and customer service. The future investment requirements for capital expenditures relate directly to traffic growth which necessitates the purchase of switching and related equipment. In addition, a major component of the capital budget relates to technological advancements as the Company continually updates its network capabilities to offer enhanced products and services. The level of capital expenditures for 1994 is expected to be $20 - $25 million. In March 1993, an equity offering was completed in which an aggregate of 10,350,000 shares of ALC Common Stock were sold by certain stockholders of ALC at $14.25 per share. ALC did not receive any of the proceeds from the sale of these shares, although it did receive $1.9 million upon exercise of 963,684 warrants. In May 1993, the Company completed an offering of $85.0 million of 9% Senior Subordinated Notes. Interest on the 1993 Notes is payable semiannually commencing November 15, 1993. The 1993 Notes will mature on May 15, 2003 but are redeemable at the option of the Company on or after May 15, 1998. Management used the $84.3 million of proceeds of this offering to repay the outstanding 1992 Notes aggregating $72.4 million, and to reduce the amount outstanding under the Revolving Credit Facility. The 1993 Notes provide additional benefits on both short and long term liquidity by reducing interest expense as well as deferring redemption requirements. In September 1993, an equity offering was completed in which an aggregate of 7,763,391 shares of ALC Common Stock were sold by certain shareholders at $25.50 per share. This offering included the exercise of 3,240,025 warrants. In October 1993, an additional 177,100 warrants were exercised, and the shares subsequently sold to the public. ALC did not receive any proceeds from the sale of any of these shares but did receive $6.9 million from the exercise of warrants. In December 1993, the Company redeemed the remaining 355,956 shares of Class A Preferred for $10.4 million including $3.2 million of accrued dividends. Management believes that the Company's cash flow from operations will provide adequate sources of liquidity to meet the Company's anticipated short and long-term liquidity needs. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data required by this Item 8. are set forth in Part IV, Item 14. of this Annual Report on Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT As of the date of this Annual Report on Form 10-K, the Board of Directors of ALC consists of seven positions, all elected by the holders of Common Stock. Six of the seven positions are presently filled. The following list identifies (i) the persons who are Directors of the Company; and (ii) each Director's principal occupation for the past five years. RICHARD D. IRWIN has held the position of Chairman of the Board of Directors since August 1988. He is the President of Grumman Hill Associates, Inc. ("Grumman Hill"), a merchant banking firm, having held that position since its formation in 1985. Prior to the formation of Grumman Hill, Mr. Irwin was a Managing Director of Dillon, Read & Co. Inc. from 1983 through 1985. Mr. Irwin is also a member of the Board of Directors of Caire, Inc. and Pharm Chem Laboratories, Inc. JOHN M. ZRNO has held the positions of President, Chief Executive Officer and Director since August 1988. From December 1981 until joining Allnet, Mr. Zrno held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was President and Chief Executive Officer. Between 1972 and 1981, Mr. Zrno first served as an officer of MCI, then as an officer of American Satellite Corporation, a satellite common carrier, and finally as an officer of F/S Communications Corporation, an independent telephone interconnect company. MARVIN C. MOSES has held the positions of Executive Vice President, Chief Financial Officer and Assistant Secretary since October 1988. Mr. Moses was elected as a Director in September 1989. From February 1982 through September 1988, Mr. Moses held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was Chief Financial Officer and Senior Vice President. From 1980 through February 1982, Mr. Moses worked with Atlantic Research Corporation, where he was involved in obtaining project financing for an alternative energy product. From 1975 to 1980, Mr. Moses was Vice President - Finance and Chief Financial Officer of GTE Telenet, a data communications company now part of Sprint. WILLIAM H. OBERLIN has held the position of Director since July 22, 1993, and has held the position of Chief Operating Officer since July 1990 and the position of Executive Vice President since October 1988. From November 1983 through September 1988, Mr. Oberlin held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was Senior Vice President - Sales and Marketing. During 1983, Mr. Oberlin was founder and principal stockholder of Electronic Express, Inc., a facsimile-based priority mail and delivery system. From April 1982 through March 1983, Mr. Oberlin was Chief Executive Officer of DHL Business Systems, Inc., a worldwide manufacturer and distributor of word processing terminals. From 1974 through April 1982, Mr. Oberlin was employed by Sprint. From September 1979 through April 1982, Mr. Oberlin was President of Southern Pacific/Distributed Message Systems, Inc., distributors of facsimile machines and electronic mail services. RICHARD J. UHL has held the position of Director since September 3, 1991. Mr. Uhl is the President and a member of the Board of Directors of Chicago Holdings, Inc. ("CHI"), having held those positions since 1985. CHI is a privately owned company which manages several lease portfolios owned by it and its subsidiaries. Since November 1990 he has also been the Chief Executive Officer and a member of the Board of Directors of Hurrah Stores, Inc. ("Hurrah"), a subsidiary of CHI. Mr. Uhl has also been President of Steiner Financial Corporation, another subsidiary of CHI, since December 1987. Mr. Uhl currently serves on the Boards of Directors of Dealers Alliance Credit Corp. (as Chairman of the Board, since October 1993) and of First Merchants Acceptance Corporation, since March 1991, which are both privately-owned companies in which CHI has a significant equity investment. Prior to 1991, Mr. Uhl served in a number of executive capacities as well as on the Boards of Directors of certain finance organizations as well as a distributor of personal computer equipment, and a manufacturer of automotive products. MICHAEL E. FAHERTY has held the position of Director since June 23, 1992. Mr. Faherty primarily works (since 1977) as a business consultant and in the contract executive business, in connection with which Mr. Faherty formerly served in a number of executive positions, including Chairman of the Board and President, with Shared Financial Systems, Inc. from January 1992 through January 1994. As part of his duties as a contract executive, he has worked for Digital Sound Corporation, Systeme Corporation, Advanced Business Communications, Inc., BancTec, Inc. and Intec Corporation. Mr. Faherty is also a member of the Board of Directors of BancTec, Inc., Biomagnetic Technologies, Inc. and Davox Corporation. The Board of Directors held eight regularly scheduled and special meetings in the aggregate during the fiscal year from January 1, 1993 through December 31, 1993. Several important functions of the Board of Directors of ALC have been performed by committees comprised of members of the Board of Directors. The Amended and Restated Bylaws of ALC (the "Bylaws") prescribe the functions and the standards for membership on the Audit Committee. Subject to those standards, the Board of Directors acting as a body appoints the members of the Audit Committee at the meeting of the Board of Directors coincident with the annual meeting of stockholders. However, the Board of Directors has the power at any time to change the authority or responsibility delegated to the committee or the members serving on the committee. Under the Bylaws, the Audit Committee performs the following functions: (i) recommends to the Board of Directors annually a firm of independent public accountants to act as auditors of the Company; (ii) reviews with the auditors the scope of the annual audit; (iii) reviews accounting and reporting principles, policies and practices; (iv) reviews with the auditors the results of their audit and the adequacy of accounting, financial and operating controls; and (v) performs such other duties as are delegated to it by the Board of Directors. The members of the Audit Committee during the 1993 fiscal year were Richard D. Irwin, Richard J. Uhl and Michael E. Faherty. During 1993, the Audit Committee met four times. The Board, pursuant to the Bylaws, also established a Compensation Committee. The Compensation Committee has the authority to: (i) establish the compensation (including salaries and bonuses) of the officers; (ii) establish incentive compensation plans for the officers; (iii) administer the stock option plans and grants of options under those plans; and (iv) perform such other duties as are from time to time delegated to the Compensation Committee by the Board of Directors. The members of the Compensation Committee during fiscal 1993 were Richard D. Irwin, Richard J. Uhl and Michael E. Faherty. During 1993, the Compensation Committee met five times. The Board of Directors does not have a standing committee responsible for nominating individuals to become directors. Section 16(a) of the Securities Exchange Act requires the Company's officers and directors, and persons who own more than ten percent of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership on Forms 3, 4 and 5 with the Securities and Exchange Commission and the American Stock Exchange. In addition, officers, directors and greater than ten percent shareholders are required to furnish the Company with copies of all Forms 3, 4 and 5 they file. Based solely on the Company's review of the copies of such forms it has received and written representations from certain reporting persons that they were not required to file Forms 5 for specified fiscal years, the Company believes that all of its officers, directors, and greater than ten percent shareholders complied with all filing requirements applicable to them with respect to transactions during fiscal 1993 except that the Company has been informed as follows: Saulene M. Richer, a former director elected by holders of the Company's Class A Preferred Stock (redeemed in 1993) and also a ten percent shareholder of Class A Preferred, failed to timely file one required report relating to one transaction in ALC Stock. A series of five related transactions, although reported on a timely basis by NationsBank of Texas, N.A., was not reported on a timely basis by NationsBank Corporation (the parent corporation of NationsBank of Texas, N.A.) due to its late filing of a required report (which transactions were otherwise properly disclosed in the Company's reports filed under the Exchange Act). The Trustees of General Electric Pension Trust ("General Electric") failed to timely file three required reports relating to seventeen transactions in ALC Stock. General Electric subsequently filed three late Forms 4 regarding such transactions. Reference is made to the Item captioned "Executive Officers of the Registrant" in Part I of this Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION DIRECTOR COMPENSATION For 1992 and 1993, and to be continued for 1994, Richard J. Uhl and Michael E. Faherty received or will receive remuneration of up to $20,000 per year for their services as Board members. Of that fee, $8,000 is dependent upon per meeting attendance at the four regularly scheduled Board meetings. Richard D. Irwin waived his right to fees throughout his term of service on the Board. On September 3, 1991, ALC granted Richard J. Uhl an option to purchase 40,000 shares of Common Stock at $4.25 per share, the market price at date of grant. Mr. Uhl is entitled to exercise the option in full; it expires on the earlier of 60 days subsequent to Mr. Uhl's death, resignation or removal as a director and September 3, 1998. On June 23, 1992, ALC granted Michael E. Faherty an option to purchase 40,000 shares of Common Stock at $4.63 per share, the market price at date of grant. Mr. Faherty is entitled to exercise the option in full; it expires on the earlier of 60 days subsequent to Mr. Faherty's death, resignation or removal as a director and June 23, 1998. It is anticipated that the Common Stock issuable upon the exercise of the options held by Messrs. Uhl and Faherty will be registered under the Securities Act. In addition, Grumman Hill, of which Richard D. Irwin is President, entered into an Advisory Agreement with Stock Option dated September 7, 1988 (the "Advisory Agreement") with the Company. Pursuant to the terms of the Advisory Agreement, Grumman Hill performs certain advisory services with respect to the management, operation and business development activities of the Company. In exchange for such services, Grumman Hill was initially granted a stock option to purchase at a price of $11.25 per share 153,163 shares of Common Stock and receives an annual fee of $100,000. In conjunction with the 1990 phase of the Refinancing, the option was regranted at an exercise price of $3.50 per share. The option was subsequently assigned to Grumman Hill Investments, L.P. ("Grumman Hill, L.P.") (of which Mr. Irwin is the General Partner). Grumman Hill, L.P. is entitled to exercise the option in full. It is anticipated that the Common Stock issuable upon the exercise of the option will be registered under the Securities Act. The option will expire on September 7, 1998. EXECUTIVE COMPENSATION Summary Compensation Table The following table summarizes the total compensation paid to the Chief Executive Officer and the four most highly compensated executive officers at the end of calendar year 1993 for each of the past three fiscal years during which the named executive acted as an executive officer. - ------------------------- (1) Total perquisites for each officer were less than either $50,000 or 10% of total salary and bonus. (2) Options granted in 1992 include options granted in 1990 and amended in 1992 (the exercise price was not changed). (3) Consists of Company contributions to defined contribution plan during 1993 and 1992 in the amounts of $600 and $500, respectively, for each officer. (4) Represents gross up for income taxes relating to a perquisite. STOCK OPTION GRANTS DURING LAST FISCAL YEAR The following table sets forth information about stock option awards granted to the Chief Executive Officer and the four most highly compensated executive officers during 1993. - ------------------------- * These amounts represent assumed rates of appreciation which may not necessarily be achieved. The actual gains, if any, are dependent on the market value of the Company's Common Stock at a future date as well as the option holder's continued employment throughout the vesting period. Appreciation reported is net of exercise price. (1) All options were granted at market value on date of grant. The 1990 Stock Option Plan allows the exercise price and tax withholding obligations to be paid by delivery of already owned shares or with shares purchased pursuant to the exercise, subject to certain conditions. Vesting may be accelerated in the event of certain situations resulting in a change of ownership of the Company. The Compensation Committee, as administrator of the Company's stock option plans, has discretion to modify the terms of outstanding options, subject to certain limitations set forth in the plans. (2) One third of each grant will vest one third November 22, 1994, November 22, 1995 and November 22, 1996. The second third shall vest one third November 22, 1995, November 22, 1996 and November 22, 1997. The final third shall vest one third November 22, 1996, November 22, 1997 and November 22, 1998. (3) Unless earlier terminated due to such events as termination of employment or death. Note: No matter what theoretical value is placed on a stock option on the date of grant, its ultimate value will be dependent on the market value of the Company's Common Stock at a future date. AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES - ------------------------- (1) Values are calculated by determining the difference between the fair market value of the Common Stock at December 31, 1993 and the exercise price of the options. EMPLOYMENT CONTRACTS AND TERMINATION OR CHANGE IN CONTROL ARRANGEMENTS In late 1988, ALC entered into employment agreements with John M. Zrno, Marvin C. Moses and William H. Oberlin. These arrangements had initial four year terms and were amended in 1991 to extend for an additional two years. In January 1994, ALC and Allnet jointly entered into amended and restated employment agreements with John M. Zrno, Marvin C. Moses and William H. Oberlin. These agreements provide for a base salary of $319,041, $245,417 and $245,417, respectively, for Messrs. Zrno, Moses and Oberlin for service provided in 1993 through 1994, beginning and ending with the month of each officer's respective anniversary of hire. Each of these agreements has an initial three year term and contains a provision that, in the event the officer's employment is terminated for any reason except death, disability, voluntary resignation or cause, such officer will continue to receive his current salary from twelve to twenty-four months. Should the officer be terminated without cause, the stock options granted in the agreement would fully vest and remain exercisable for the succeeding twelve months. According to the employment agreements with Messrs. Zrno, Moses and Oberlin, each officer may receive incentive compensation as determined by the Board of Directors, based on the Board's determination of the officer's individual achievements. Officers below the level of Executive Vice President entered into severance agreements wherein the Company agreed to provide salary continuation and certain employee benefits for a period of twelve months (formerly, from six-to-twelve months) should an officer be terminated from employment prior to December 31, 1995. These agreements, originally effective February 1990, were renewed in February 1991, August 1992, July 1993 and January 1994. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The members of the Compensation Committee during fiscal 1993 were Richard D. Irwin, Richard J. Uhl and Michael E. Faherty. Richard D. Irwin, Chairman of the Board of Directors since August 1988 and a member of the Compensation Committee, is a former officer of the Company because, prior to March 1991, the position of Chairman of the Board was an officer position under the Company's Bylaws. Grumman Hill, of which Richard D. Irwin is President, entered into the Advisory Agreement with the Company in 1988. Pursuant to the terms of the Advisory Agreement, Grumman Hill performs certain advisory services with respect to the management, operation and business development activities of the Company. In exchange for such services, Grumman Hill was initially granted a stock option to purchase 153,163 shares of Common Stock at a price of $11.25 per share and receives an annual fee of $100,000. In conjunction with the 1990 phase of the Refinancing, the option was regranted at an exercise price of $3.50 per share. The option was subsequently assigned to Grumman Hill, L.P. (of which Mr. Irwin is the General Partner). Grumman Hill, L.P. is entitled to exercise the option in full. It is anticipated that the Common Stock issuable upon the exercise of the option will be registered under the Securities Act. The option will expire on September 7, 1998. Prior to the Note Exchange Offer (as defined in "Certain Relationships and Related Transactions - Banks Stock Ownership in the Company"), Grumman Hill, L.P., the Grumman Hill Associates Pension Plan, Mr. Irwin and Mr. Irwin's Individual Retirement Account held approximately $2.5 million, $75,000, $339,000 and $188,000, respectively, in principal amount of 11 7/8% Senior Subordinated Debentures of ALC due December 31, 1995 (the "Replacement Debentures") (exclusive of PIK Debentures issued or issuable in respect of certain interest payments on the Replacement Debentures). As a consequence of the Note Exchange Offer, prior to January 28, 1993 Mr. Irwin and Grumman Hill, L.P. and affiliates owned $4.1 million in principal amount of 1992 Notes and owned 194,393 1992 Warrants (capitalized terms as defined in "Certain Relationships and Related Transactions - Banks Stock Ownership in the Company"). Mr. Irwin subsequently purchased 40,000 shares of Common Stock in the 1992 Equity Offering, which, together with other options and warrants, give these entities the right to purchase in the aggregate up to 815,646 shares of Common Stock. Grumman Hill, L.P. subsequently sold $3.3 million in principal amount of 1992 Notes. In June 1993, the 1992 Notes, including the remaining $800,000 in principal amount held by Mr. Irwin and affiliates, were paid in full. As of January 1994, Mr. Irwin, Mr. Faherty (as general partner of a family-owned partnership), Mr. Uhl, Mr. Zrno and Mr. Moses own $533,000, $600,000, $200,000, $100,000 and $100,000, respectively, in principal amount of 1993 Notes which they acquired either in the 1993 Note Offering or in open-market transactions. PRINCIPAL STOCKHOLDERS The following table sets forth information regarding beneficial ownership of the stock of ALC as of February 21, 1994 by each person known by ALC to be the beneficial owner of more than 5.0% of any class of stock, each director of ALC and all executive officers and directors of ALC as a group. The figures presented are based upon information available to ALC. - ------------------------- * Percentage calculation based on 33,101,601 shares of Common Stock, issued and outstanding on February 21, 1994, plus shares of Common Stock which may be acquired pursuant to warrants and options exercisable within sixty days by such individual or group listed. ** Less than one percent. (1) Based on information set forth in a Schedule 13G, dated February 14, 1994, filed with the Securities and Exchange Commission. (2) Includes all shares held by Fidelity Management & Research Company (acting as investment adviser) and by Fidelity Management Trust Company (acting as investment manager), which are wholly-owned subsidiaries of FMR Corp. These shares are deemed to be beneficially owned by Edward Johnson 3d; Mr. Johnson is the Chairman of the Board and a member of a controlling group with respect to FMR Corp. (3) Based on information set forth in a Schedule 13G, dated February 2, 1994, filed with the Securities and Exchange Commission. (4) Includes 1,494,845 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding warrants. (5) Includes 153,163 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding stock options held by Grumman Hill, L.P. and 622,483 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding warrants held individually and by Grumman Hill and Grumman Hill, L.P. These Grumman Hill and Grumman Hill, L.P. shares are deemed to be beneficially owned by Mr. Irwin, as President and Director of Grumman Hill and as General Partner of Grumman Hill, L.P. (6) Includes 485,992 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding warrants and 153,163 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding stock options. (7) These shares of ALC Stock may be acquired pursuant to the exercise of outstanding warrants. (8) Includes 395,108 shares of ALC Stock which Mr. Zrno has the right to acquire pursuant to the exercise of outstanding stock options, and 800 shares of ALC Stock which Mr. Zrno's wife and mother-in-law own jointly (Mr. Zrno disclaims beneficial interest as to these shares). (9) Includes 386,060 shares of ALC Stock which Mr. Moses has the right to acquire pursuant to the exercise of outstanding stock options, 3,000 shares of ALC Stock which Mr. Moses owns as custodian for his children under UGMA and 1,000 shares of ALC Stock which Mr. Moses' daughter owns (Mr. Moses disclaims beneficial interest as to the latter 1,000 shares). (10) Includes 40,000 shares of ALC Stock which Mr. Uhl has the right to acquire pursuant to the exercise of outstanding stock options. (11) Shares of ALC Stock which Mr. Faherty has the right to acquire pursuant to the exercise of outstanding stock options. (12) Includes 420,666 shares of ALC Stock which Mr. Oberlin has the right to acquire pursuant to the exercise of outstanding stock options. (13) Includes 61,542 shares of ALC Stock which Ms. Gale has the right to acquire pursuant to the exercise of outstanding stock options. (14) Includes 1,663,483 shares of ALC Stock which executive officers and directors of ALC have the right to acquire pursuant to the exercise of outstanding stock options and 622,483 shares of ALC Stock which Mr. Irwin has the right to acquire or is deemed to have the right to acquire pursuant to the exercise of outstanding stock warrants held individually and by Grumman Hill and Grumman Hill, L.P. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS BANKS STOCK OWNERSHIP IN THE COMPANY In August 1992, the Company's then majority stockholder, CTI conveyed the Common Stock, Class B Preferred and Class C Preferred it owned to the Banks pro-rata in exchange for the release of certain portions of CTI's obligations to each of the Banks. The Banks, in the aggregate, acquired all of the Class B Preferred and Class C Preferred, as well as 14,324,000 shares of Common Stock. Pursuant to a Registration Rights Agreement dated June 4, 1990, the Banks, Prudential, General Electric and Grumman Hill and Grumman Hill, L.P. (and their transferees of securities covered by such agreement) (the "Registration Rights Agreement") each had the right to require ALC to register the 1990 Warrants issued in connection with the 1990 phase of the Refinancing (the "1990 Warrants"), shares of Common Stock issuable upon exercise of such 1990 Warrants, shares of Common Stock issuable upon conversion of the Class B Preferred and Class C Preferred, and the shares of Common Stock previously held by the Banks, in each case held by such party, to permit a public sale of such shares under the Securities Act and applicable state securities laws. The parties could demand, in the aggregate, six such registrations, and may join in an unlimited number of ALC initiated registrations. Pursuant to the Registration Rights Agreement and an Assignment of Rights Agreement dated August 6, 1992 among the Banks and ALC (the "Assignment of Rights"), ALC registered and otherwise accommodated the 1992 Equity Offering and the 1993 Equity Offering through a "shelf registration." Also in the Assignment of Rights, ALC gave the Banks the right to participate on a preemptive basis in certain future private issuances of Common Stock by ALC. In October 1992, the Company completed the 1992 Equity Offering for 9,863,600 shares of Common Stock, a portion of which resulted from the exchange of the Class A Preferred held by individual stockholders and the remainder of which was due to Common Stock held by other entities, including the Banks. The Banks sold, in the aggregate, 3,000,000 shares of Common Stock in the 1992 Equity Offering. In the 1993 Equity Offering (which term includes all secondary public offerings pursuant to the shelf registration in 1993), the Banks sold 8,386,216 shares of Common Stock, of which 3,796,000 were received upon conversion of all outstanding shares of Class B Preferred and Class C Preferred. After the 1993 Equity Offering, the Banks held an aggregate of 4,321,784 shares of Common Stock, representing 15.0% of the then total voting power of ALC capital stock (10.9% assuming the exercise of certain warrants and options). Also pursuant to the shelf registration, in September 1993, the Company completed a stock offering whereby General Electric, Prudential and a major lessor sold an aggregate of 7,763,391 shares of Common Stock to the public. As a result of the 1993 Equity Offering and subsequent transfers pursuant to an escrow agreement, Prudential no longer holds a significant number of shares of Common Stock. Prudential agreed with a group of equipment lessors of Communications Transmission Group, Inc. ("CTGI") to allow them to share in up to half of the shares of ALC capital stock acquired by Prudential pursuant to a Residual Option or received from the Banks, in each case under certain circumstances. Further, in August 1992 the Banks agreed under certain circumstances to transfer to Prudential 10% of the shares subject to the Residual Option upon disposition of any shares of ALC capital stock owned by them. In addition, each Bank agreed that after each Bank had received its pro rata portion of an amount calculated by the formula used to determine the aggregate exercise price for the Residual Option, plus interest thereon at 10% per annum from August 6, 1992 to the date of determination, each Bank would pay Prudential any additional proceeds received by it from the disposition of any shares of the ALC capital stock owned by it as a result of the August 1992 transactions and to deliver to Prudential any remaining shares of such ALC capital stock. In accordance with an agreement entered into in August 1992, the Banks paid Prudential 10% of their net proceeds from the 1992 Equity Offering, and transferred 1,412,000 shares of Common Stock to Prudential as a consequence of the 1993 Equity Offering. Subsequently, by March 1994, all of the Banks disposed of a sufficient number of shares to result in such Banks receiving their respective pro rata portions of the amount of debt of CTI released by the Banks on August 18, 1992 (plus interest), and such Banks tranferred all of their remaining shares of Common Stock to or as directed by Prudential. In October 1993, Electra Communications Holding Corporation ("ECHC") acquired rights from certain of CTGI's equipment lessors, including the right to share in 30.77% of the shares of ALC Stock subsequently acquired by Prudential from the Banks. ECHC further agreed to pledge any such shares it might receive to Sanwa as pledge agent for Nissho Iwai American Corporation ("NIAC"), one of CTGI's other equipment lessors. Prudential retained 282,035 shares of the 407,388 shares of ALC Stock it received from the Banks in March 1994 and transferred the remaining 125,353 shares to ECHC, subject to ECHC's pledge to NIAC. Pursuant to a certain escrow agreement (the "Escrow Agreement") among Prudential, Nissho Iwai American Corporation, as administrative lessor for certain of CTGI's equipment lessors, and Sanwa Bank & Trust Company of New York ("Sanwa"), as Escrow Agent, on August 27, 1993, Prudential deposited 1,555,683 shares of Common Stock (the "Escrow Shares") with the Escrow Agent. Under the terms of the Escrow Agreement, subject to contractual restrictions to which Prudential was subject contained in one or more underwriting agreements relating to ALC Stock, the Escrow Agent had the power to sell the Escrow Shares under certain circumstances. These Escrow Shares were subsequently sold in the 1993 Equity Offering and the Escrow Agreement terminated in October 1993. In August 1992, ALC had agreed with the Banks that it would not issue in excess of 8,000,000 shares of Common Stock prior to the earlier of (a) August 6, 1994 or (b) the date on which the Banks collectively held less than 8,000,000 shares of Common Stock or Common Stock equivalents. As a result of the 1993 Equity Offering, this restriction on ALC terminated. In addition, ALC agreed with Prudential that it would not issue in excess of 8,000,000 shares of Common Stock prior to the earlier of (a) March 31, 1994, or (b) the expiration of the Residual Option. As a result of the 1993 Equity Offering, this restriction on ALC also terminated. Also in August 1992, the Banks entered into a Stock Option Agreement (the "Stock Option") and a Residual Stock Option Agreement (the "Residual Option" and, together with the Stock Option, the "Options") with Prudential. By exercise of the Options, Prudential had the ability to acquire all of the shares of Class B Preferred, Class C Preferred and Common Stock owned by the Banks. The Stock Option covered 1,000,000 shares of Common Stock owned by the Banks. As part of the 1993 Equity Offering, Prudential exercised the Stock Option and sold the 1,000,000 shares of Common Stock acquired thereby. The Residual Option covered all of the shares of Class B Preferred and Class C Preferred, and all shares of Common Stock (other than the shares covered by the Stock Option), owned by the Banks. The exercise price for the Residual Option was an amount calculated by a formula that equaled the amount of the debt of CTI released by the Banks on August 18, 1992 as adjusted according to a formula. Upon the sale by the Banks of shares of Common Stock in the 1993 Equity Offering, the Residual Option terminated. TRANSACTIONS WITH GENERAL ELECTRIC AND PRUDENTIAL General Electric and Prudential participated in the cash financing as part of the 1990 phase of the Refinancing. As a result, General Electric held a note issued in 1990 (the "1990 Note") in the original principal amount of $3.5 million and was issued 1990 Warrants to purchase up to 2,305,105 shares of the Common Stock. In addition, prior to a note exchange offer (the "Note Exchange Offer") pursuant to which ALC and Allnet exchanged 11 7/8% debentures previously issued by ALC (the "Debentures") for note-warrant units (the "Units") consisting of 11 7/8% Subordinated Notes of Allnet due June 30, 1999 (the "1992 Notes") and warrants to purchase shares of Common Stock (the "1992 Warrants"), General Electric held $23.8 million in principal amount of the outstanding Original Debentures and Replacement Debentures (exclusive of PIK Debentures issued or issuable in respect of certain interest payments due on certain Debentures), which constituted 43% of the total outstanding amount of those Debentures. As a consequence of the Note Exchange Offer, General Electric owns 1,494,845 1992 Warrants. Also as a consequence of the Note Exchange Offer, General Electric owned $31.8 million in principal amount of 1992 Notes (which the Company has been informed were subsequently sold by General Electric). General Electric purchased 500,000 shares of Common Stock in the 1992 Equity Offering; the Company has been informed 400,000 shares were subsequently sold in the open market. General Electric is also deemed to be the beneficial owner of 120,000 shares of Common Stock which are held of record by its investment manager. General Electric sold the 2,305,105 shares of Common Stock issued pursuant to its 1990 Warrants in the 1993 Equity Offering and in subsequent brokerage transactions. Pursuant to the 1990 Note Agreement between ALC and General Electric, as amended in August 1992, General Electric also had the right to nominate one person for election to the Board of Directors of ALC. There was no such nominee proposed by General Electric for election at the most recent Annual Meeting of Shareholders and, following its participation in the 1993 Equity Offering, General Electric no longer has equity ownership sufficient to maintain this right. The General Electric 1990 Note was amended and replaced in August 1992. Such amended and restated 1990 Note in the principal amount of $3,908,700 was paid in full as of December 1992. Prudential was the holder of a 1990 Note in the original principal amount of $3.0 million which was paid in full as of August 1992. Prudential retained the right to purchase up to 1,975,804 shares of Common Stock pursuant to warrants for same. These warrants were exercised and the related shares were sold in the 1993 Equity Offering. FINANCIAL SERVICES Richard D. Irwin has been a director of CTGI since June 1986 and is President of Grumman Hill. See also "Compensation Committee Interlocks and Insider Participation." TRANSACTIONS WITH MANAGEMENT AND OTHERS As of January 1994, Mr. Irwin, Mr. Faherty (as general partner of a family-owned partnership), Mr. Uhl, Mr. Zrno and Mr. Moses own $533,000, $600,000, $200,000, $100,000 and $100,000, respectively, in principal amount of 1993 Notes which they acquired either in the 1993 Note Offering or in open-market transactions. 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 1. Financial Statements. The following consolidated financial statements of ALC and its subsidiary required by Part II, Item 8. are included in Part IV of this Report: 3. Exhibits required by Item 601 of Regulation S-K EXHIBIT INDEX [refer to definitions at end of Index] * Except as otherwise indicated, all references to "Forms" are to those of ALC. _______________ ** Management contract or compensation plan or arrangement required to be identified by Item 14(a)(3) of this report _______________ ** Management contract or compensation plan or arrangement required to be identified by Item 14(a)(3) of this report The Registrant hereby agrees to furnish the Commission a copy of each of the Indentures or other instruments defining the rights of security 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. (b) Reports on Form 8-K A report on Form 8-K was filed by the Company on December 29, 1993 to describe the redemption of the Class A Preferred Stock on December 31, 1993 and to summarize the contents of the letter of resignation dated December 28, 1993 of Saulene M. Richer, the former Director elected by holders of the Class A Preferred. (c) Refer to Item 14(a)(3) above for Exhibits required by Item 601 of Regulation S-K. (d) Schedules other than those set forth in response to Item 14(a)(2) above for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the duly authorized, undersigned individual on the 29th day of March, 1994. ALC Communications Corporation Registrant By: /s/ John M. Zrno John M. Zrno, Director, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons in their respective capacities on behalf of the registrant as of the 29th day of March, 1994. Signature Title --------- ----- /s/ John M. Zrno President, Chief Executive - ---------------------------- Officer, Director John M. Zrno /s/ Richard D. Irwin Chairman of the Board, - ---------------------------- Director Richard D. Irwin /s/ Marvin C. Moses Executive Vice President and - ---------------------------- Chief Financial Officer, Marvin C. Moses Director (Principal Financial Officer) /s/ Marilyn M. Lesnau Vice President, Controller - --------------------------- Marilyn M. Lesnau (Principal Accounting Officer) /s/ William H. Oberlin Executive Vice President and - --------------------------- Chief Operating Officer, William H. Oberlin Director /s/ Richard J. Uhl Director - --------------------------- Richard J. Uhl /s/ Michael E. Faherty Director - --------------------------- Michael E. Faherty REPORT OF INDEPENDENT AUDITORS BOARD OF DIRECTORS AND STOCKHOLDERS ALC COMMUNICATIONS CORPORATION We have audited the accompanying consolidated balance sheets of ALC Communications Corporation and subsidiary as of December 31,1993 and 1992, and the related consolidated statements of operations, cash flows, and preferred stock and stockholders' equity 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 ALC Communications Corporation and subsidiary 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. /s/ ERNST & YOUNG Ernst & Young Detroit, Michigan January 25, 1994 ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS LIABILITIES, CLASS A PREFERRED STOCK AND STOCKHOLDERS' EQUITY See notes to consolidated financial statements ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS See notes to consolidated financial statements ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENT OF CLASS A PREFERRED STOCK AND STOCKHOLDERS' EQUITY ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENT OF CLASS A PREFERRED STOCK AND STOCKHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 (In Thousands) See notes to consolidated financial statements ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 Note A -- Summary of Significant Accounting Policies Description of Business Allnet Communication Services, Inc. ("Allnet"), the operating subsidiary of ALC Communications Corporation ("ALC" or the "Company"), provides long distance telecommunications services primarily to commercial and, to a lesser extent, residential subscribers in a majority of the United States and completes subscriber calls to all directly dialable locations worldwide. The Company transmits long distance telephone calls through its network facilities over transmission lines which are leased from other long haul transmission providers. All of the transmission facilities utilized by the Company are digital. Basis of Consolidation The consolidated financial statements include the accounts of ALC and its wholly-owned subsidiary, Allnet Communication Services, Inc. Intercompany transactions have been eliminated. Fixed Assets Fixed assets are stated at cost. Depreciation is provided on the straight-line method over the estimated useful lives or lease terms of the assets. Maintenance and repairs are charged to operations as incurred. Intangible Assets The cost in excess of net assets acquired of $61.0 million, resulting from the acquisition of Lexitel is being amortized on a straight line basis over 40 years. In July 1993, the Company acquired the customer base of Call Home America, Inc. ("CHA") (Note C). The purchase price has been allocated between the value of the customer base acquired and the covenant not to compete which are being amortized over seven years and 42 months, respectively. Additionally, the Company is amortizing over five years the costs incurred under a marketing agreement with CHA. Amortization expense related to the acquisition and marketing agreement totaled $1.2 million in 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Amortization expense, including amortization of cost in excess of net assets acquired and cost associated with the issuance of debentures and the Revolving Credit Facility as well as amortization associated with CHA, totaled $3.1 million, $1.8 million and $1.8 million for the years ended December 31, 1993, 1992 and 1991, respectively. Revenue Recognition Customers are billed as of monthly cycle dates. Revenue is recognized as service is provided and unbilled usage is accrued. Accrued Facility Costs In the normal course of business, the Company estimates its accrual for facility costs. Subsequently, the accrual is adjusted based on invoices received from local exchange carriers. Income Taxes The Company adopted Statement of Financial Standards No. 109 "Accounting for Income Taxes" as of January 1, 1993, the required implementation date (Note F). Prior to January 1, 1993, income taxes were accounted for in accordance with Accounting Principles Board Opinion No. 11 ("APB 11"). Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. NOTE B -- Refinancing Events During 1992, the Company completed a comprehensive refinancing plan ("Refinancing") which included the rescheduling of substantially all debt and resulted in significantly reduced or deferred debt service obligations. The Refinancing resulted in a simplified equity structure and a revised redemption and maturity schedule. The Company anticipates it will be able to meet these obligations from expected cash flow from operations. Highlights of the Refinancing include the following: * A Note Exchange Offer was completed in August 1992 whereby the Company's Original Debentures, Replacement Debentures, PIK Debentures, and accrued interest on the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) nonconsenting Debentures totalling $73.3 million were replaced by 11 7/8% Subordinated Notes of Allnet ("1992 Notes"). As part of the Note Exchange Offer, 3,400,000 Common Stock warrants ("1992 Warrants") were issued representing 10.2% of the fully diluted equity of ALC at an exercise price of $5.00 per share of Common Stock. * In August 1992, the Restructured Promissory Note was restated and extended to June 30, 1995 and a $5.0 million principal prepayment was made. The note was subsequently paid in full in May 1993. * In August 1992, 14,324,000 shares of ALC Common Stock and the ALC Class B and Class C Preferred Stock ("Preferred Stock") held by Communications Transmission Inc. ("CTI") were transferred to a group of five banks ("Banks"). Subsequently, the Preferred Stock was converted into 3,796,000 shares of Common Stock. * In October 1992 an equity offering for 9,863,600 shares of ALC Common Stock at $5.50 per share was completed. A portion of the 1992 equity offering relating to 3,464,373 shares was to facilitate the sale of shares for existing major holders. * The remaining 6,399,227 shares of the equity offering were issued in conjunction with an Exchange Agreement with the major holders of the Class A Preferred Stock ("Class A Preferred"). The major holders of the Class A Preferred agreed to exchange the 2,144,044 shares of Class A Preferred with an aggregate redemption value of $58.7 million, including all accrued and unpaid dividends, for shares of ALC Common Stock at an effective 40% discount. * The 1990 Note Agreements with a principal balance of approximately $8.0 million were paid in full by December 1992. Financing activities in 1993 included: * In March 1993, an equity offering was completed in which an aggregate of 10,350,000 shares of ALC Common Stock were sold at $14.25 per share. ALC did not receive the proceeds from the sale of these shares by existing major holders, although it did receive $1.9 million upon exercise of 963,784 warrants. * In May 1993, the Company completed an offering of $85.0 million 9% Senior Subordinated Notes ("1993 Notes"). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The net proceeds of $84.3 million were used to repay the outstanding 11 7/8% Senior Subordinated Notes of Allnet aggregating $72.4 million and to reduce the amount outstanding under the short term Revolving Credit Facility. The early retirement of the 1992 Notes resulted in an extraordinary loss of $7.5 million, net of the related tax effect of $4.0 million. * As of June 30, 1993, the Company executed an agreement for a $40.0 million long term line of credit, replacing the previous Revolving Credit Facility. * In September 1993, an equity offering was completed in which an aggregate of 7,763,391 shares of ALC Common Stock were sold at $25.50 per share. This offering included the exercise of 3,240,025 warrants. ALC did not receive any proceeds from the sale of these shares by existing major holders, but did receive $6.9 million from the exercise of warrants. * As of December 31, 1993, the Company redeemed the remaining 355,956 shares of Class A Preferred for a total of $10.4 million including $3.2 million of accrued dividends. Note C - Purchase of Customer Base During July 1993, the Company acquired the specialized 800 customer base of Call Home America, Inc. for $15.5 million plus a future payment to be made based on certain average monthly revenue generated by the customers in April, May and June 1994. The Company is also acquiring additional customers from CHA under a marketing agreement from August 1993 through 1994. Under this agreement, an additional $4.1 million has been allocated to the purchase price for customers acquired during 1993. The following unaudited proforma summary presents the Company's revenue and income as if the transaction occurred at the beginning of the periods presented. The proforma financial data is not necessarily indicative of the results that actually would have occurred had the transactions taken place on the dates presented and do not project the Company's results of operations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE D - Long Term Debt and Other Financing Long-term debt, including amounts due within one year, consists of: Revolving Credit Facility The Company has a $40.0 million Revolving Credit Facility which expires on June 30, 1995. Under this Facility, the Company is able to minimize interest expense by structuring borrowings under three alternatives. Each alternative has a varying interest rate calculation associated with it. The effective rate under the Facility during 1993 approximated 5.8%. The agreement includes financial covenants which allow the Company to further reduce interest expense on outstanding borrowings beginning in July 1994. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) A .375% per annum charge is made on the unused portion of the line. Availability under the Facility is based on the level of eligible accounts receivable. As of December 31, 1993, the Company had $39.8 million of availability under the line. Borrowings under the facility (none at December 31, 1993) are collateralized by accounts receivable. 9% Senior Subordinated Notes In May 1993, the Company issued the 1993 Notes with a face value of $85.0 million. Interest on the 1993 Notes is payable semi-annually commencing November 15, 1993. The Notes will mature on May 15, 2003, but are redeemable at the option of the Company, in whole or in part, on or after May 15, 1998. In the event of an ownership change, the holders have the right to require the Company to purchase all or part of the 1993 Notes. The 1993 Notes contain restrictive covenants which could limit additional indebtedness and restrict the payment of dividends. Other Long-Term Debt Other long-term debt represents deferred liabilities relating to certain operating leases. Future Maturities The future maturities of long-term debt at December 31, 1993 are as follows: NOTE E - Redeemable Preferred Stock As of December 31, 1991, the Company had 2,500,000 shares of Class A Preferred outstanding with a redemption value of $48.9 million plus accrued dividends. In October 1992, pursuant to the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Exchange Agreement with the major holders of the Class A Preferred the Company exchanged 2,144,044 shares of Class A Preferred for 6,399,227 shares of ALC Common Stock at an effective 40% discount. In September 1992, ALC paid approximately $1.3 million to certain major holders of the Class A Preferred in connection with a concession agreement entered into in June 1990. In July 1993, a dividend of $0.32 per share was declared which was subsequently paid September 30, 1993. In December 1993, the Company redeemed the remaining 355,956 shares of Class A Preferred for $10.4 million including $3.2 million of accrued dividends. NOTE F - Taxes on Income Effective as of January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement 109"). 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 the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when those differences are expected to reverse. As permitted by Statement 109, the Company has elected not to restate the financial statements of any prior years. The cumulative effect of the change resulted in recording net deferred tax assets and increasing net income in 1993 by $13.5 million. Income tax expense and the extraordinary item as shown in the Consolidated Statement of Operations are composed of the following: Due to the change of ownership which occurred in August 1992 and the resulting limitation on the utilization of net operating loss carryforwards ("NOLs"), the Company is subject to the regular tax, resulting in federal taxes currently payable of $6.7 million NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) for 1993 and $1.6 million for 1992. In 1991, the Company was subject to alternative minimum tax which was imposed at a 20% rate on the Company's alternative minimum taxable income. NOLs were used to offset 90% of the taxable income resulting in federal taxes currently payable of $100,000 for 1991. The provisions for state and local income taxes reflect the effect of filing separate company state and local income tax returns for members of the consolidated group. This amount is reduced, where appropriate, by the availability to utilize state and local portions of operating loss carryforwards. State and local income taxes currently payable were $1.2 million, $1.1 million, and $200,000 in 1993, 1992, and 1991, respectively. The $5.5 million tax benefit realized from the exercise of stock options in 1993 was added to capital in excess of par value and is not reflected in operations. A reconciliation between the statutory federal and the effective income tax rates follows: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the Company's deferred taxes as of December 31, 1993 are as follows (in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company has tax net operating loss, alternative tax net operating loss and investment tax credit ("ITC") carryforwards which can be utilized annually to offset future taxable income. Because of the "ownership changes" which occurred in 1989 and 1992 under provisions of Internal Revenue Code Section 382, the utilization of carryforwards is presently limited to approximately $10 million per year through 2005. This annual limitation, coupled with the 15 year carryforward limitation, results in a maximum cumulative NOL and ITC carryforward which may be utilized of approximately $120 million as of December 31, 1993. Because it is difficult to predict the realization of the NOL benefit beyond a period of three years, the Company has established a valuation allowance of $34.9 million as of December 31, 1993. NOTE G - Earnings Per Share and Stockholders' Equity Earnings per share Earnings per share are computed using weighted average shares outstanding, adjusted for the one for five reverse stock split in 1991, and common stock equivalents. To arrive at income available for common stockholders, the Company's net income is adjusted by amounts relating to the accretion of discount and dividends accrued on Class A Preferred, and in 1992 and 1991, the accretion of a contract payment to certain major holders of the Class A Preferred. Anti-dilutive securities for 1992 were warrants and options and for 1991 also included Class B and Class C Preferred Stock. Earnings per share for the third and fourth quarters of 1992 and for all of 1993 include the impact of the exercise of outstanding stock options and warrants utilizing the Treasury Stock Method. Common Stock Warrants As of December 31, 1993, warrants for the purchase of 428,090 shares of Common Stock at $2.00 per share, 3,177,856 shares at $5.00 per share and 660,000 shares at $63.75 per share were outstanding. The warrants expire in June 2005, June 1997 and December 1995, respectively. The $2.00 and $5.00 warrants were issued in connection with the Company's refinancings and the difference between the exercise price and the fair value of the warrants at NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) the time of issuance was recorded as a discount on the related notes and an increase to Paid-in-capital - warrants. Employee Stock Options The Company has two Employee Stock Option Plans. The maximum number of shares for which options may be granted under both plans is 6,000,000 (adjusted for certain events such as a recapitalization). The plans provide for the granting of stock options and stock appreciation rights to key employees. Shares under option are summarized below: NOTE H - Leases NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Future minimum rental payments under non-cancelable operating leases with initial or remaining terms of one or more years are $36.4 million, $24.8 million, $20.2 million, $14.7 million, $11.6 million and $15.0 million for 1994, 1995, 1996, 1997, 1998 and 1999 and thereafter, respectively. The Company's lease arrangements frequently include renewal options and/or bargain purchase or fair market value purchase options, and for leases relating to office space, rent increases based on the Consumer Price Index or similar indices. Non-cancelable operating leases relate primarily to intercity transmission facilities, building and office space, and office equipment. Rental expense was $49.9 million, $52.3 million, and $56.9 million for the years ended December 31, 1993, 1992 and 1991, respectively. Fixed assets include amounts financed by capital leases of $600,000 net of $400,000 of accumulated depreciation, and $11.4 million, net of $9.4 million of accumulated depreciation as of December 31, 1993 and 1992, respectively. NOTE I - Transactions with Related Parties The Company leases transmission capacity, multiplexing and various other technical equipment on both capital and operating leases from an affiliate of CTI, a major shareholder through August 1992. Amounts paid under the leases were $17.7 million and $19.7 million for the years ended December 31, 1992 and 1991, respectively. In June 1992, the Company paid $2.0 million to CTI for the purchase of certain assets including an $800,000 note from a major holder of Class A Preferred which was paid in full upon closing of the 1992 equity offering. Consideration for the transaction also included $1.2 million of prepaid transmission capacity to be utilized over a 37 month period. During August 1992, CTI conveyed 14,324,000 shares of ALC Common Stock, 1,000,000 shares of Class B Preferred Stock and 1,000,000 shares of Class C Preferred Stock to the Banks in exchange for the release of certain obligations of CTI. This exchange effected a transfer of controlling interest in the Company from CTI to the Banks. Pursuant to this transfer, The Prudential Insurance Company of America ("Prudential") became a related party through beneficial ownership of options on the stock held by the Banks. During 1992, Prudential held $3.4 million of 1990 Notes which were paid in full in August 1992. As of December 31, 1992, Prudential owned 1990 Warrants to purchase NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1,975,804 shares of ALC Common Stock. During the March 1993 equity offering Prudential sold 1,963,784 shares of which 963,784 represented the exercise of a portion of their warrants. Prudential exercised their remaining 1,012,020 warrants during the September 1993 equity offering and as a result of these sales, no longer has a substantial equity position in ALC. The transfer of stock during August 1992 from CTI to the Banks gave NationsBank of Texas, N.A. and The First National Bank of Chicago related party status through their ownership of Common, Class B Preferred Stock and Class C Preferred Stock. The March 1993 equity offering facilitated the sale by the Banks of 8,386,216 shares of which 3,796,000 were received upon the conversion of all the Class B and Class C Preferred Stock. The Banks further reduced their ownership interest in the Company to a minimal position through subsequent sales and the transfer of other shares to Prudential. The Banks held the Restructured Promissory Note which was paid in full in May 1993. As of December 31, 1993, Grumman Hill Associates, Inc. and Grumman Hill Investments L.P., of which Richard D. Irwin (the Chairman of the Board of Directors of the Company) is the General Partner, held an aggregate of 622,486 warrants to purchase shares of Common Stock. Additionally, Grumman Hill Investments, L.P. holds options to purchase 153,163 shares of Common Stock. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE J - Selected Quarterly Financial Data (Unaudited) ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY SCHEDULE V Property and Equipment ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY SCHEDULE VI Accumulated Depreciation on Property and Equipment ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY SCHEDULE VIII Valuation and Qualifying Accounts and Reserves - ----------------------- (1) Amounts accounted for as a reduction of revenue. (2) In connection with the Company's adoption of Statement of Financial Standards No. 109, "Accounting for Income Taxes", a valuation allowance for deferred tax assets of $37,000,000 was recorded January 1, 1993. (See Note F to the Consolidated Financial Statements). (3) Uncollectible accounts written off, net of recoveries. ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY SCHEDULE IX Short-term Borrowings (1) Based on month end amounts outstanding during the period (2) Based on total interest expense for the period and average amount outstanding during the period (3) Line of Credit was classified as short-term through May 1993, upon refinancing the line in June 1993, the balance was transfered to long-term.

71428_1993.txt

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ITEM 1. BUSINESS GENERAL Bell Atlantic - New Jersey, Inc. (formerly New Jersey Bell Telephone Company) (the "Company") is incorporated under the laws of the State of New Jersey and has its principal offices at 540 Broad Street, Newark, New Jersey 07101 (telephone number 201-649-9900). The Company is a wholly owned subsidiary of Bell Atlantic Corporation ("Bell Atlantic"), which is one of the seven regional holding companies ("RHCs") formed in connection with the court-approved divestiture (the "Divestiture"), effective January 1, 1984, of those assets of the American Telephone and Telegraph Company ("AT&T") related to exchange telecommunications, exchange access functions, printed directories and cellular mobile communications. The Company presently serves a territory consisting of three Local Access and Transport Areas ("LATAs"). These LATAs are generally centered on a city or based on some other identifiable common geography and, with certain limited exceptions, each LATA marks the boundary within which the Company may provide telephone service. The Company provides two basic types of telecommunications services. First, the Company transports telecommunications traffic between subscribers located within the same LATA ("intraLATA service"), including both local and toll services. Local service includes the provision of local exchange ("dial tone"), local private line and public telephone services (including dial tone service for pay telephones owned by the Company and other pay telephone providers). Among other local services provided are Centrex (telephone company central office-based switched telephone service enabling the subscriber to make both intercom and outside calls) and a variety of special and custom calling services. Toll service includes message toll service (calling service beyond the local calling area) within LATA boundaries, and intraLATA Wide Area Toll Service (WATS)/800 services (volume discount offerings for customers with highly concentrated demand). The Company also earns toll revenue from the provision of telecommunications service between LATAs ("interLATA service") in the corridors between the cities (and certain surrounding counties) of (i) New York, New York and Newark, New Jersey, and (ii) Philadelphia, Pennsylvania and Camden, New Jersey. Second, the Company provides exchange access service, which links a subscriber's telephone or other equipment to the transmission facilities of interexchange carriers which, in turn, provide interLATA telecommunications service to their customers. See "Competiton - IntraLATA Toll Competition". The communications industry is currently undergoing fundamental changes driven by the accelerated pace of technological innovation, the convergence of the telecommunications, cable television, information services and entertainment businesses, and a regulatory environment in which many traditional regulatory barriers are being lowered and competition permitted or encouraged. Although no definitive predictions can be made of the market opportunities these changes will present or whether Bell Atlantic and its subsidiaries, including the Company, will be able successfully to take advantage of these opportunities, Bell Atlantic is positioning itself to be a leading communications, information services and entertainment company. OPERATIONS During 1993, Bell Atlantic reorganized certain functions formerly performed by each of the seven Bell System operating companies ("BOCs") transferred to it pursuant to the Divestiture, including the Company (collectively, the "Network Services Companies"), into nine lines of business ("LOBs") organized across the Network Services Companies around specific market segments. The Network Services Companies, however, remain responsible within their respective service areas for the provision of telephone services, for financial performance and for regulatory matters. The nine LOBs are: BELL ATLANTIC - NEW JERSEY, INC. The Consumer Services LOB markets communications services to residential ----------------- customers within the service territories of the Network Services Companies, including the service territory of the Company, and plans in the future to market information services and entertainment programming. The Carrier Services LOB markets (i) switched and special access to the ---------------- Company's local exchange network, and (ii) billing and collection services, including recording, rating, bill processing and bill rendering. The principal customers of this LOB are interexchange carriers; AT&T is the largest single customer. Other customers include business customers and government agencies with their own special access network connections, wireless customers and other local exchange carriers ("LECs") which resell network connections to their own customers. The Small Business Services LOB markets communications and information ----------------------- services to small businesses (customers having up to 20 access lines or 100 Centrex lines). The Large Business Services LOB markets communications and information ----------------------- services to large businesses (customers having more than 20 access lines or more than 100 Centrex lines). These services include voice switching/processing services (e.g., dedicated private lines, custom Centrex, call management and voice messaging), end-user networking (e.g., credit and debit card transactions, and personal computer-based conferencing, including data and video), internetworking (establishing links between the geographically disparate networks of two or more companies or within the same company), network integration (integrating multiple geographically disparate networks into one system), network optimization (disaster avoidance, 911, intelligent vehicle highway systems), video services (distance learning, telemedicine, surveillance, videoconferencing) and integrated multi-media applications services. The Directory Services LOB manages the provision of (i) advertising and ------------------ marketing services to advertisers, and (ii) listing information (e.g., White Pages and Yellow Pages). These services are currently provided primarily through print media, but the Company expects that use of electronic formats will increase in the future. In addition, the Directory Services LOB manages the provision of photocomposition, database management and other related products and services to publishers. The Public and Operator Services LOB markets pay telephone and operator ---------------------------- services in the service territories of the Network Services Companies to meet consumer needs for accessing public networks, locating and identifying network subscribers, providing calling assistance and arranging billing alternatives (e.g., calling card, collect and third party calls). The Federal Systems LOB markets communications and information technology and --------------- services to departments, agencies and offices of the executive, judicial and legislative branches of the federal government. The Information Services LOB has been established to provide programming -------------------- services, including on-demand entertainment, transactions and interactive multimedia applications within the Territory and in selected other markets. See "FCC Regulation and Interstate Rates - Telephone Company Provision of Video Dial Tone and Video Programming". The Network LOB manages the technologies, services and systems platforms ------- required by the other eight LOBs and the Network Services Companies, including the Company, to meet the needs of their respective customers, including, without limitation, switching, feature development and on-premises installation and maintenance services. The Company has been making and expects to continue to make significant capital expenditures on its networks to meet the demand for communications services and to further improve such services. Capital expenditures of the Company were approximately $609 million in 1991, $596 million in 1992 and $590 million in 1993. The total investment of the Company in plant, property and equipment decreased from approximately $8.39 billion at December 31, 1991 to BELL ATLANTIC - NEW JERSEY, INC. approximately $8.08 billion at December 31, 1992, and increased to approximately $8.38 billion at December 31, 1993, in each case after giving effect to retirements, but before deducting accumulated depreciation at such date. The Company is projecting construction expenditures for 1994 of approximately $630 million. However, subject to regulatory approvals, the Network Services Companies, including the Company, plan to allocate capital resources to the deployment of broadband network platforms (technologies ultimately capable of providing a switched facility for access to and transport of high-speed data services, video-on-demand, and image and interactive multimedia applications). Most of the funds for these expenditures are expected to be generated internally. Some additional external financing may be necessary or desirable. LINE OF BUSINESS RESTRICTIONS The consent decree entitled "Modification of Final Judgment" ("MFJ") approved by the United States District Court for the District of Columbia (the "D.C. District Court") which, together with the Plan of Reorganization ("Plan") approved by the D.C. District Court, set forth the terms of Divestiture also established certain restrictions on the post-Divestiture activities of the RHCs, including Bell Atlantic. The MFJ's principal restrictions on post-Divestiture RHC activities included prohibitions on (i) providing interexchange telecommunications, (ii) providing information services, (iii) engaging in the manufacture of telecommunications equipment and customer premises equipment ("CPE"), and (iv) entering into any non-telecommunications businesses, in each case without the approval of the D.C. District Court. Since Divestiture, the D.C. District Court has retained jurisdiction over the construction, modification, implementation and enforcement of the MFJ. In September 1987, the D.C. District Court rendered a decision which eliminated the need for the RHCs to obtain its approval prior to entering into non-telecommunications businesses. However, the D.C. District Court refused to eliminate the restrictions relating to equipment manufacturing or providing interexchange services. With respect to information services, the Court issued a ruling in March 1988 which permitted the RHCs to engage in a number of information transport functions as well as voice storage and retrieval services, including voice messaging, electronic mail and certain information gateway services. However, the RHCs were generally prohibited from providing the content of the data they transmitted. As the result of an appeal of the D.C. District Court's September 1987 and March 1988 decisions by the RHCs and other parties, the United States Court of Appeals for the District of Columbia Circuit ordered the D.C. District Court to reconsider the RHCs' request to provide information content and determine whether removal of the restrictions thereon would be in the public interest. In July 1991, the D.C. District Court removed the remaining restrictions on RHC participation in information services, but imposed a stay pending appeal of that decision. In October 1991, the United States Court of Appeals for the District of Columbia Circuit vacated the stay, thereby permitting the RHCs to provide information services, and in May 1993 affirmed the D.C. District Court's July 1991 decision. The United States Supreme Court denied certiorari in November 1993. Several bills have been introduced in the current session of Congress pursuant to which the line of business restrictions established by the MFJ could be eliminated or modified. No definitive prediction can be made as to whether or when any such legislation will be enacted, the provisions thereof or their impact on the business or financial condition of the Company. FCC REGULATION AND INTERSTATE RATES The Company is subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to interstate services and certain related matters. The FCC prescribes a uniform system of accounts for telephone companies, interstate depreciation rates and the principles and standard procedures used to separate plant investment, expenses, taxes and reserves BELL ATLANTIC - NEW JERSEY, INC. between those applicable to interstate services under the jurisdiction of the FCC and those applicable to intrastate services under the jurisdiction of the respective state regulatory authorities ("separations procedures"). The FCC also prescribes procedures for allocating costs and revenues between regulated and unregulated activities. Interstate Access Charges The Company provides intraLATA service and, with certain limited exceptions, does not participate in the provision of interLATA service except through offerings of exchange access service. The FCC has prescribed structures for exchange access tariffs to specify the charges ("Access Charges") for use and availability of the Company's facilities for the origination and termination of interstate interLATA service. Access Charges are intended to recover the related costs of the Company which have been allocated to the interstate jurisdiction ("Interstate Costs") under the FCC's separations procedures. In general, the tariff structures prescribed by the FCC provide that Interstate Costs of the Company which do not vary based on usage ("non-traffic sensitive costs") are recovered from subscribers through flat monthly charges ("Subscriber Line Charges"), and from interexchange carriers through usage- sensitive Carrier Common Line ("CCL") charges. See "FCC Regulation and Interstate Rates - FCC Access Charge Pooling Arrangements". Traffic-sensitive Interstate Costs are recovered from carriers through variable access charges based on several factors, primarily usage. In May 1984, the FCC authorized the implementation of Access Charge tariffs for "switched access service" (access to the local exchange network) and of Subscriber Line Charges for multiple line business customers (up to $6.00 per month per line). In 1985, the FCC authorized Subscriber Line Charges for residential and single-line business customers at the rate of $1.00 per month per line, which increased in installments to $3.50 effective April 1, 1989. As a result of the phasing in of Subscriber Line Charges, a substantial portion of non-traffic sensitive Interstate Costs is now recovered directly from subscribers, thereby reducing the per-minute CCL charges to interexchange carriers. This significant reduction in CCL charges has tended to reduce the incentive for interexchange carriers and their high-volume customers to bypass the Company's switched network via special access lines or alternative communications systems. However, competition for this access business has increased in recent years. See "Competition - Alternative Access and Local Services". FCC Access Charge Pooling Arrangements The FCC previously required that all LECs, including the Company, pool revenues from CCL and Subscriber Line Charges that cover the non-traffic sensitive costs of the local exchange network, that is, the Interstate Costs associated with the lines from subscribers' premises to telephone company central offices. To administer such pooling arrangements, the FCC mandated the formation of the National Exchange Carrier Association, Inc. Some LECs received more revenue from the pool than they billed their interexchange carrier customers using the nationwide average CCL rate. Other companies, including the Company, received substantially less from the pool than the amount billed to their interexchange carrier customers. By an order adopted in 1987, the FCC changed its mandatory pooling requirements. These changes, which became effective April 1, 1989, permitted all of the Network Services Companies as a group to withdraw from the pool and to charge CCL rates which more closely reflect their non-traffic sensitive costs. The Network Services Companies, including the Company, are still obligated to make contributions of CCL revenues to companies who choose to continue to pool non-traffic sensitive costs so that the pooling companies can charge a CCL rate no greater than the nationwide average CCL rate. In addition to this continuing obligation, the Network Services Companies, including the Company, have a transitional support obligation to high cost companies who left the pool in 1989 and 1990. This transitional support obligation phases out over five years. BELL ATLANTIC - NEW JERSEY, INC. These long-term and transitional support requirements will be recovered in the Network Services Companies' (including the Company's) CCL rates. Depreciation Depreciation rates provide for the recovery of the Company's investment in telephone plant and equipment, and are revised periodically to reflect more current estimates of remaining service lives and future net salvage values. In October 1993, the FCC issued an order simplifying the depreciation filing process by reducing the information required for certain categories of plant and equipment whose remaining service life, salvage estimates and depreciatation rates fall within an approved range. Petitions for reconsideration of that order were filed in December 1993. In November 1993, the FCC issued a further order inviting comments on proposed ranges for an initial group of categories of plant and equipment. Price Caps In September 1990, the FCC adopted "price cap" regulation to replace the traditional rate of return regulation of LECs. LEC price cap regulation became effective on January 1, 1991. The price cap system places a cap on overall prices for interstate services and requires that the cap decrease annually, in inflation-adjusted terms, by a fixed percentage which is intended to reflect expected increases in productivity. The price cap level can also be adjusted to reflect "exogenous" changes, such as changes in FCC separations procedures or accounting rules. LECs subject to price caps have somewhat increased flexibility to change the prices of existing services within certain groupings of interstate services, known as "baskets". Under price cap regulation, the FCC set an authorized rate of return of 11.25% for the years 1991 and beyond. To the extent that a company is able to earn a higher rate of return through improved efficiency, the FCC's price cap rules permit them to retain the full amount of this higher return up to 100 basis points above the authorized rate of return (currently, up to a 12.25% rate of return). If a company's rate of return is between 100 and 500 basis points above the authorized rate of return (that is, currently, between 12.25% and 16.25%), the company must share 50% of the earnings above the 100-basis-point level with customers by reducing rates prospectively. All earnings above the 500-basis-point level must be returned to customers in the form of prospective rate decreases. If, on the other hand, a company's rate of return is more than 100 basis points below the authorized rate of return (that is, currently, below 10.25%), the company is permitted to increase rates prospectively to make up the deficiency. Under FCC-approved tariffs, the Network Services Companies are charging uniform rates for interstate access services (with the exception of Subscriber Line Charges) throughout their service areas and are regarded as a single unit by the FCC for rate of return measurement. On February 16, 1994, the FCC initiated a rulemaking proceeding to determine the effectiveness of LEC price cap rules and decide what changes, if any, should be made to those rules. This rulemaking is expected to be concluded by the end of 1994. In January 1993, the FCC denied the Company exogenous treatment of the increased expense for postretirement benefits required under Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which the Company adopted effective January 1, 1991. The Company has appealed this decision. The appeal is likely to be decided during the second half of 1994. BELL ATLANTIC - NEW JERSEY, INC. Computer Inquiry III In August 1985, the FCC initiated Computer Inquiry III to re-examine its regulations requiring that "enhanced services" (e.g., voice messaging services, electronic mail, videotext gateway, protocol conversion) be offered only through a structurally separated subsidiary. In 1986, the FCC eliminated this requirement, permitting the Company to offer enhanced services, subject to compliance with a series of nonstructural safeguards designed to promote an effectively competitive market. These safeguards include detailed cost accounting, protection of customer information and certain reporting requirements. In June 1990, the United States Court of Appeals for the Ninth Circuit vacated and remanded the Computer Inquiry III decisions to the FCC, finding that the FCC had not fully justified those decisions. In December 1991, the FCC adopted an order which reinstated relief from the separate subsidiary requirement upon a company's compliance with the FCC's Computer III Open Network Architecture ("ONA") requirements and strengthened some of the nonstructural safeguards. In the interim, the Network Services Companies, including the Company, had filed interstate tariffs implementing the ONA requirements. Those tariffs became effective in February 1992, subject to further investigation. That investigation was completed on December 15, 1993, when an order was released making minor changes to the Network Services Companies' ONA rates. In March 1992, the Company certified to the FCC that it had complied with all initial ONA obligations and therefore should be granted structural relief for enhanced services. The FCC granted the Company structural relief in June 1992. Other parties have appealed this decision, which remains in effect pending the outcome of the appeal. A decision on the appeal is likely by the end of 1994. The FCC's December 1991 order has been appealed to the United States Court of Appeals for the Ninth Circuit by several parties. Pending decision on those appeals, the FCC's decision remains in effect. If a court again reverses the FCC, the Company's right to offer enhanced services could be impaired. FCC Cost Allocation and Affiliate Transaction Rules In 1987, the FCC adopted rules governing (i) the allocation of costs between the regulated and unregulated activities of a communications common carrier and (ii) transactions between the regulated and unregulated affiliates of a communications common carrier. The cost allocation rules apply to certain unregulated activities: activities that have never been regulated as communications common carrier offerings and activities that have been preemptively deregulated by the FCC. The costs of these activities are removed prior to the separations procedures process and are allocated to unregulated activities in the aggregate, not to specific services for pricing purposes. Other activities must be accounted for as regulated activities, and their costs are subject to separations procedures. These activities include (i) those which have been deregulated by the FCC without preempting state regulation, (ii) those which have been deregulated by a state but not the FCC and (iii) "incidental activities," which cannot, in the aggregate, generate more than 1% of a company's revenues. Since the Network Services Companies, including the Company, engage in these types of activities, the Network Services Companies, including the Company, pursuant to the FCC's cost allocation rules, filed a cost allocation manual, which has been approved by the FCC. The affiliate transaction rules govern the pricing of assets transferred to and services provided by affiliates. These rules generally require that assets be transferred between affiliates at "market price", if such price can be established through a tariff or a prevailing price actually charged to third parties. In the absence of a tariff or prevailing price, "market price" cannot be established, in which case (i) asset transfers from a regulated to an unregulated affiliate must be valued at the higher of cost or fair market value, and (ii) asset transfers from an unregulated to a regulated affiliate must be valued at the lower of cost or fair market value. The affiliate transaction rules require that a service provided by one affiliate to another affiliate, BELL ATLANTIC - NEW JERSEY, INC. which service is also provided to unaffiliated entities, must be valued at tariff rates or market prices. If the affiliate does not also provide the service to unaffiliated entities the price must be determined in accordance with the FCC's cost allocation principles. In October 1993, the FCC proposed new affiliate transaction rules which would essentially eliminate the different rules for the provision of services and apply the asset transfer rules to all affiliate transactions. The Network Services Companies, including the Company, have filed comments opposing the proposed rules. The FCC has not attempted to make its cost allocation or affiliate transaction rules preemptive. State regulatory authorities are free to use different cost allocation methods and affiliate transaction rules for intrastate ratemaking and to require carriers to keep separate allocation records. Telephone Company Provision of Video Dial Tone and Video Programming In 1987, the FCC initiated an inquiry into whether developments in the cable and telephone industries warranted changes in the rules prohibiting telephone companies such as the Company from providing video programming in their respective service territories directly or indirectly through an affiliate. In November 1991, the FCC released a Further Notice of Proposed Rulemaking in these proceedings. In August 1992, the FCC issued an order permitting telephone companies such as the Company to provide "video dial tone" service. Video dial tone permits telephone companies to provide video transport to multiple programmers on a non-discriminatory common carrier basis. The FCC has also ruled that neither telephone companies that provide video dial tone service, nor video programmers that use these services, are required to obtain local cable franchises. Other parties have appealed these orders, which remain in effect pending the outcome of the appeal. In late 1992, the Company entered into agreements pursuant to which, pending regulatory approval, it would provide video dial tone transport services to two video programmers in New Jersey. As contemplated by its contract with Sammons Communications, Incorporated ("Sammons"), the Company will deploy fiber optic technology that will enable Sammons and other video information providers to deliver video programming in three Morris County, New Jersey communities over a video dial tone platform. The Company's contract with Future Vision of America Corporation ("Future Vision") contemplates that the Company will deploy fiber optic technology in the Dover Township, New Jersey telephone network to establish a video dial tone platform that will allow Future Vision and other video information providers to deliver competitive video programming services in that community. Applications for approval to deploy these video dial tone systems are pending at the FCC. In December 1992, two Bell Atlantic Companies, Bell Atlantic - Virginia, Inc. and Bell Atlantic Video Services Company, filed a lawsuit against the federal government in the United States District Court for the Eastern District of Virginia seeking to overturn the prohibition in the Cable Communications Policy Act of 1984 against LECs providing video programming in their respective service areas. In a decision rendered in August 1993 and clarified in October 1993, the court struck down this prohibition as a violation of the First Amendment's freedom of speech protections and enjoined its enforcement against Bell Atlantic, the Network Services Companies, including the Company, and Bell Atlantic Video Services Company. This decision has been appealed to the United States Court of Appeals for the Fourth Circuit. In early 1993, the FCC granted Bell Atlantic authority to test a new technology known as Asynchronous Digital Subscriber Line ("ADSL") for use in delivering video entertainment and information over existing copper telephone lines. Beginning in March 1993, Bell Atlantic began a one-year technical trial of ADSL serving up to 400 Bell Atlantic employees in northern Virginia. In the Fall of 1993, Bell Atlantic petitioned the FCC for authorization to expand and convert this technical trial upon its completion into a six month market trial serving up to 2000 customers. Bell Atlantic also requested authority to offer a commercial video dial tone service to customers served by 25 central offices in parts of northern Virginia and southern Maryland BELL ATLANTIC - NEW JERSEY, INC. upon completion of the six month market trial. These applications are pending at the FCC. Interconnection and Collocation In October 1992, the FCC issued an order allowing third parties to collocate their equipment in telephone company offices to provide special access (private line) services to the public. The FCC's stated purpose was to encourage greater competition in the provision of interstate special access services. The order permits collocating parties to pay LECs an interconnection charge that is lower than the existing tariffed rates for similar non-collocated services; it allows LECs limited additional pricing flexibility for their own special access services when collocated interconnection is operational. In February 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for special access services. This tariff is currently effective. Bell Atlantic and certain other parties have appealed the FCC's special access collocation order. Bell Atlantic expects the appeal to be decided in 1994. On September 2, 1993, the FCC extended collocation to switched access services. The terms and conditions for switched access collocation are similar to those for special access collocation. On November 18, 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for switched access services. This tariff became effective on February 16, 1994. Bell Atlantic and certain other parties have appealed the FCC's switched access collocation order. Appeals of this order have been stayed pending a decision on the appeals of the special access collocation order. Increased competition through collocation will adversely affect the revenues of the Company, although some of the lost revenues could be offset by increased demand of the Company's own special access services as a result of the slightly increased pricing flexibility that the FCC has permitted. The Company does not expect the net revenue impact of special access collocation to be material. Revenue losses from switched access collocation, however, may be larger than from special access collocation. Intelligent Networks In December 1991, the FCC issued a Notice of Inquiry into the plans of the BOCs, including the Company, to deploy new "modular" network architectures, such as Advanced Intelligent Network ("AIN") technology. The Notice of Inquiry asks what, if any, regulatory action the FCC should take to assure that such architectures are deployed in a manner that is "open, responsive, and procompetitive". On August 31, 1993, the FCC issued a Notice of Proposed Rulemaking proposing a schedule for AIN deployment. The proposals in that Notice of Proposed Rulemaking generally follow those that Bell Atlantic proposed in its response to the Notice of Inquiry. The Company cannot estimate when the FCC will conclude this proceeding. The results of this proposed rulemaking could include a requirement that the Company offer individual components of its services, such as switching and transport, to competitors who will provide the remainder of such services through their own facilities. Such increased competition could divert revenues from the Company. However, deployment of AIN technology may also enable the Company to respond more quickly and efficiently to customer requests for new services. This could result in increased revenues from new services that could at least partially offset losses resulting from increased competition. STATE REGULATION AND INTRASTATE RATES The communications services of the Company are subject to regulation by the New Jersey Board of Regulatory Commissioners (formerly the Board of Public Utilities) (the "BRC") with respect to intrastate rates and services and other matters. BELL ATLANTIC - NEW JERSEY, INC. In June 1987, the BRC issued an order approving a Rate Stability Plan ("RSP") that modified the way the BRC monitors the Company's intrastate earnings. Rather than continue to monitor overall company financial performance, the RSP authorized financial performance surveillance only of less competitive services. The RSP also capped intrastate tariffed rates for its six year duration (July 1, 1987 through June 30, 1993), subject, however, to certain exceptions which would permit the Company to seek increases in tariffed rates during the RSP's fourth through sixth years. The RSP separated the Company's intrastate services into two categories: Group I (more competitive) services such as directory advertising, Centrex, pay telephone services, billing and collection services, high capacity channel and special access services, public data networks, central office local area networks, pay-per-view ordering service, high capacity digital hand-off service, Bellboy/(R)/ paging service, 911 enhanced terminal equipment and Home Intercom; and Group II (less competitive) services such as local exchange service, local usage, message toll service, 800 data base complementary service, and Repeat Call and Return Call. Only the Group II services were subject to financial performance monitoring by the BRC for the purpose of determining whether or not the Company was earning the target rate of return for those services. In January 1989, the BRC issued an order which established a target rate of return on equity of 12.9% for the purpose of monitoring the financial performance of the Group II category of services. Under the RSP, the Company was allowed to charge competitive rates for Group I services, without restriction and without financial performance monitoring. The New Jersey Telecommunications Act of 1992 (the "NJ Telecommunications Act") became effective in January 1992. The NJ Telecommunications Act authorized the BRC to adopt alternative regulatory frameworks that provide incentives to telecommunications companies for aggressive deployment of new technologies. It also deregulated services which the BRC has found to be competitive. Pursuant to that legislation, the Company filed its Plan for Alternative Form of Regulation in March 1992, and a revised plan in May 1992. This revised plan was unanimously approved by the BRC in December 1992, with certain modifications the written order reflecting that approval was issued on May 6, 1993. The Company filed a plan conforming to the BRC's order (the "NJ PAR"), which became effective on May 20, 1993. Several parties have filed judicial appeals of the BRC's order. The briefing schedule for this appeal extends through the middle of August 1994. The NJ PAR, which supersedes the RSP, divides the Company's services into Rate-Regulated Services (formerly Group II services) and Competitive Services (formerly Group I and services which have never been regulated by the BRC). Under this Plan, the Company's Rate-Regulated Services are grouped in two categories: - "Protected Services": Basic residence and business service, Touch-Tone, access services, message toll services and the ordering, installation and restoration of these services. Rates for Protected Services, other than basic residence service, may be increased beginning January 1996 in an amount limited to the prior year's increase in the Gross National Product-Price Index ("GNP- PI") less a 2% productivity offset, as long as the return on equity for Rate- Regulated Services does not exceed 11.7%. Basic residence service rates are frozen through December 1999. - "Other Services": Custom calling, Custom Local Area Signaling Services ("CLASS" services which utilize Signaling System 7), operator services and 911 enhanced service. Rates for Other Services may be increased beginning January 1996 in an amount limited to the prior year's increase in the GNP-PI less a 2% productivity offset, as long as the return on equity for Rate-Regulated Services does not exceed 12.7%. All earnings above a return on equity of 13.7% for Rate-Regulated Services will be shared equally with customers. There is no point at which the earnings are capped. Competitive Services are deregulated under the NJ Telecommunications Act. Other services such as premises wire maintenance, Answer Call and electronic BELL ATLANTIC - NEW JERSEY, INC. messaging, which have never been regulated by the BRC, continue to be deregulated under the NJ Telecommunications Act. NEW PRODUCTS AND SERVICES The following were among the new products and services introduced by the Company in 1993: IntelliLinQ PRI (Integrated Service Digital Network - Primary Rate Interface --------------- (ISDN-PRI) is an optional arrangement for local exchange access, directed at medium and large business customers with PBX service, which enables customers to increase the efficacy of their current trunking and to transmit 64Kbps circuit- switch data over the public network. 64 Clear Channel Capability is a new option of Feature Group D Access Service --------------------------- which increases a channel's traffic capacity and provides customers with the ability to establish interLATA calls to and from end-users who are served by ISDN-equipped switches and access lines. Three-Way Calling Usage Service is an interim limited product offering ------------------------------- providing the ability to add another party to an established call and conduct a three-way conference or after establishing the conference call allowing the initiating party to hang up without disconnecting the remaining two parties; Centrex Extend permits multi-location Centrex intercom service for a closed -------------- end user group of a single Centrex customer. The Company also introduced Flexible Automatic Number Identification Service, ------------------------------------------------ Call Restriction, Expanded Calling Area Service and Connect Request Service. - ---------------- ----------------------------- ----------------------- COMPETITION Regulatory proceedings, as well as new technology, are continuing to expand the types of available communications services and equipment and the number of competitors offering such services. An increasing amount of this competition is from large companies which have substantial capital, technological and marketing resources, many of which do not face the same regulatory constraints as the Company. Alternative Access and Local Services A substantial portion of the Company's revenues from business and government customers is derived from a relatively small number of large, multiple-line subscribers. The Company faces competition from alternative communications systems, constructed by large end users, interexchange carriers, and alternative access vendors which are capable of originating and/or terminating calls without the use of the local telephone company's plant. Teleport Communications Group Inc. ("Teleport") provides competitive access service in the New York metropolitan area, including northern New Jersey. The ability of such alternative access providers to compete with the Company has been enhanced by the FCC's orders requiring the Company to offer collocated interconnection for special and switched access services. Other potential sources of competition are cable television systems, shared tenant services and other non-carrier systems which are capable of bypassing the Company's local plant, either partially or completely, through substitution of special access for switched access or through concentration of telecommunications traffic on fewer of the Company's lines. Well-financed competitors may soon seek authority to offer competing local exchange services, such as dial tone and local usage, in some of the most lucrative of the Company's local telephone service areas. BELL ATLANTIC - NEW JERSEY, INC. Teleport and MFS Communications Company, Inc. ("MFS") both offer local exchange service in metropolitan New York and may seek to extend that service into northern New Jersey. The two largest long-distance carriers are also positioning themselves to begin to offer services that will compete with the Company's local exchange services. In November 1992, AT&T announced its intention to acquire a controlling interest in McCaw Cellular Communications Inc. ("McCaw"), the largest cellular company in the United States, and to integrate McCaw's wireless local service network with AT&T's long distance network. In December 1993, MCI Communications Corporation ("MCI") announced its intention to invest $2 billion to begin building competing local exchange and access networks in twenty major markets in the United States, some of which are likely to be in the Company's service territory. In March 1994, MCI also announced its intention to acquire a substantial interest in Nextel Communications Inc. (formerly Fleet Call Inc.), and to integrate Nextel's wireless local service network with MCI's long distance network in at least 10 major markets, one or more of which might be in the Company's service territory. The entry of these and other local exchange service competitors will almost certainly reduce the local exchange service revenues of the Company, at least in the market segments and geographical areas in which the competitors operate. Depending on such competitors' success in marketing their services, and the conditions of interconnection established by the regulatory commissions, these reductions could be significant. These revenue reductions may be offset to some extent by revenues from interconnection charges to be paid to the Company by these competitors. The Company seeks to meet such competition by establishing and/or maintaining competitive cost-based prices for local exchange services (to the extent the FCC and state regulatory authorities permit the Company's prices to move toward costs), by keeping service quality high and by effectively implementing advances in technology. See "FCC Regulation and Interstate Rates -Interstate Access Charges" and "- FCC Access Charge Pooling Arrangements". Personal Communications Services Radio-based personal communications services ("PCS") also constitute potential sources of competition to the Company. PCS consists of wireless portable telephone services which would allow customers to make and receive telephone calls from any location using small handsets, and which could also be used for data transmission. The FCC has authorized trials of such services, using a variety of technologies, by numerous companies. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing PCS. Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States; five of the spectrum blocks would be auctioned by "basic trading area" and the remaining two would be auctioned by larger "major trading area" (as such trading areas are defined by Rand McNally). LECs and companies with LEC subsidiaries, such as Bell Atlantic, are eligible to bid for PCS licenses, except that cellular carriers, such as Bell Atlantic, are limited to obtaining only 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994 or in early 1995. In December 1993, the FCC awarded Pioneer's preference PCS licenses to, among other entities, Omnipoint Communications, Inc. ("Omnipoint"), whose license authorizes it to provide service in the New York metropolitan area, which includes the northern New Jersey areas served by the Company. If implemented, PCS and other similar services would compete with services currently offered by the Company, and could result in losses of revenues. BELL ATLANTIC - NEW JERSEY, INC. Centrex The Company offers Centrex service, which is a telephone company central office-based communications system for business, government and other institutional customers consisting of a variety of integrated software-based features located in a centralized switch or switches and extended to the customer's premises primarily via local distribution facilities. In the provision of Centrex, the Company is subject to significant competition from the providers of CPE systems, such as private branch exchanges ("PBXs"), which perform similar functions with less use of the Company's switching facilities. Users of Centrex systems generally require more subscriber lines than users of PBX systems of similar capacity. The FCC increased the maximum Subscriber Line Charge on embedded Centrex lines to $6.00 per month per line effective April 1, 1989. Increases in Subscriber Line Charges result in Centrex users incurring higher charges than users of comparable PBX systems. The BRC has permitted flexible pricing of certain Centrex services, which helps offset the effects of higher Subscriber Line Charges. IntraLATA Toll Competition The ability of interexchange carriers to engage in the provision of intrastate intraLATA toll service in competition with the Company is subject to state regulation. Such competition has not been permitted in New Jersey, but the BRC has initiated a proceeding in response to petitions filed by interexchange carriers to consider whether and on what terms to permit intraLATA competition. The Company does not oppose competition in principle, but has urged the BRC to implement certain required fundamental regulatory changes necessary for competition to be fair and effective. Parties participating in the proceeding include, among others, AT&T, MCI, Sprint Communications Company, L.P.and MFS, all of which are urging the BRC to revise its current policy and permit competition. A comment phase of the proceeding was completed in October, 1993. Evidentiary hearings will be held over the next several months and a BRC decision is expected in mid-1994. Directories The Company continue to face significant competition from other providers of directories as well as competition from other advertising media. In particular, the former sales representative of several of the Network Services Companies, including the Company, publishes directories in competition with those published by the Company in its service territory. Public Telephone Services The Company faces increasing competition in the provision of pay telephone services from other pay telephone service providers. In addition, the growth of wireless communications negatively impacts usage of public telephones. Operator Services Alternative operator services providers have entered into competition with the Company's operator services product line. CERTAIN CONTRACTS AND RELATIONSHIPS Certain planning, marketing, procurement, financial, legal, accounting, technical support and other management services are provided on behalf of the Company on a centralized basis by Bell Atlantic's wholly owned subsidiary, Bell Atlantic Network Services, Inc. ("NSI"). Bell Atlantic Network Funding Corporation provides short-term financing and cash management services to the Company. The seven RHCs each own (directly or through subsidiaries) a one-seventh interest in Bell Communications Research, Inc. ("Bellcore"). Pursuant to the Plan, Bellcore furnishes the RHCs and their BOC subsidiaries with technical BELL ATLANTIC - NEW JERSEY, INC. assistance such as network planning, engineering and software development, as well as various other consulting services that can be provided more effectively on a centralized basis. Bellcore is the central point of contact for coordinating the efforts of the RHCs in meeting the national security and emergency preparedness requirements of the federal government. It also helps to mobilize the combined resources of the RHCs in times of natural disasters. EMPLOYEE RELATIONS As of December 31, 1993, the Company employed approximately 15,000 persons, including employees of the centralized staff at NSI. This represents approximately a 1% decrease from the number of employees at December 31, 1992. The Company's workforce is augmented by members of the centralized staff of NSI, who perform services for the Company on a contract basis. Approximately 85% of the employees of the Company are represented by unions. Of those so represented, approximately 39% are represented by the Communications Workers of America, and approximately 61% are represented by the International Brotherhood of Electrical Workers, which are both affiliated with the American Federation of Labor - Congress of Industrial Organizations. Under the terms of the three-year contracts ratified in October 1992 by unions representing associate employees of the Network Services Companies, including the Company, and NSI, represented associates received a base wage increase of 3.74% in August 1993. Under the same contracts, associates received a Corporate Profit Sharing payment of $495 per person in 1994 based upon Bell Atlantic's 1993 financial performance. BELL ATLANTIC - NEW JERSEY, INC. ITEM 2. ITEM 2. PROPERTIES The principal properties of the Company do not lend themselves to simple description by character and location. At December 31, 1993, the Company's investment in plant, property and equipment consisted of the following: "Connecting lines" consists primarily of aerial cable, underground cable, poles, conduit and wiring. "Central office equipment" consists of switching equipment, transmission equipment and related facilities. "Land and buildings" consists of land owned in fee and improvements thereto, principally central office buildings. "Telephone instruments and related equipment" consists primarily of public telephone terminal equipment and other terminal equipment. "Other" property consists primarily of furniture, office equipment, vehicles and other work equipment, capital leases, leasehold improvements and plant under construction. The Company's central offices are served by various types of switching equipment. At December 31, 1993 and 1992, the number of local exchanges and the percent of subscriber lines served by each type of equipment were as follows: BELL ATLANTIC - NEW JERSEY, INC. ITEM 3. ITEM 3. LEGAL PROCEEDINGS PRE-DIVESTITURE CONTINGENT LIABILITIES AND LITIGATION The Plan provides for the recognition and payment by AT&T and the former BOCs (including the Company) of liabilities that are attributable to pre- Divestiture events but do not become certain until after Divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). Except to the extent that affected parties otherwise agree, contingent liabilities that are attributable to pre-Divestiture events are shared by AT&T and the BOCs in accordance with formulas prescribed by the Plan, whether or not an entity was a party to the proceeding and regardless of whether an entity was dismissed from the proceeding by virtue of settlement or otherwise. Each company's allocable share of liability under these formulas depends on several factors, including the type of contingent liability involved and each company's relative net investment as of the effective date of Divestiture. Under the formula generally applicable to most of the categories of these contingent liabilities, the Company's aggregate allocable share of liability is approximately 2.8%. AT&T and various of its subsidiaries and the BOCs (including, in some cases, the Company) have been and are parties to various types of litigation relating to pre-Divestiture events, including actions and proceedings involving environmental claims and allegations of violations of equal employment laws. Damages, if any, ultimately awarded in the remaining actions relating to pre- Divestiture events could have a financial impact on the Company whether or not the Company is a defendant since such damages will be treated as contingent liabilities and allocated in accordance with the allocation rules established by the Plan. While complete assurance cannot be given as to the outcome of any contingent liabilities or litigation, in the opinion of the Company's management, any monetary liability or financial impact to which the Company would be subject after final adjudication of all of the remaining potential or actual pre- Divestiture claims would not be material in amount to the financial position of the Company. BELL ATLANTIC - NEW JERSEY, INC. PART I ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (Omitted pursuant to General Instruction J(2).) PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (Inapplicable.) ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (Omitted pursuant to General Instruction J(2).) BELL ATLANTIC - NEW JERSEY, INC. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Abbreviated pursuant to General Instruction J(2).) This discussion should be read in conjunction with the Financial Statements and Notes to the Financial Statements included in the index set forth on page. RESULTS OF OPERATIONS Net income for 1993 increased $6.0 million or 1.4% from the same period last year. Results for 1993 reflect an after-tax charge of $30.0 million for the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112) and an extraordinary charge, net of tax, of $6.9 million for the early extinguishment of debt. Results for 1992 included a $16.7 million extraordinary charge, net of tax, for the early extinguishment of debt. OPERATING REVENUES Operating revenues increased $69.6 million or 2.2% in 1993. The increase in total operating revenues was comprised of the following: Local service revenues are earned from the provision of local exchange, local private line, and public telephone services. Local service revenues increased $43.6 million or 4.0% in 1993. The increase resulted primarily from growth in network access lines and higher demand for value-added central office services such as Custom Calling and Caller ID. The growth in access lines in service was approximately 139,000 lines or a 2.8% increase in 1993. Network access revenues are received from interexchange carriers (IXCs) for their use of the Company's local exchange facilities in providing long-distance services to IXCs' customers and from end-user subscribers. Switched access revenues are derived from usage-based charges paid by IXCs for access to the Company's network. Special access revenues arise from access charges paid by customers who have private lines, and end-user access revenues are earned from local exchange carrier customers who pay for access to the network. Network access revenues increased $24.5 million or 3.0% in 1993, primarily due to lower support payments to the National Exchange Carrier Association (NECA) interstate common line pool and a 3.9% growth in access minutes of use. Also contributing to this increase were higher end-user revenues principally due to growth in network access lines. These increases were partially offset by the effect of interstate rate reductions filed by the Company with the Federal Communications Commission (FCC), which became effective on July 2, 1993 and July 1, 1992, and by related estimated price cap sharing liabilities. Toll service revenues are earned from interexchange usage services such as Message Toll Services (MTS), Unidirectional Services (Wide Area Telecommunications Services (WATS) and 800 services), Corridor Services between northern New Jersey and New York City and southern New Jersey and southeastern Pennsylvania, and private line services. Toll service revenues increased $15.6 million or 2.2% in 1993. Total message volumes were 4.5% higher than the prior year. Toll service revenues increased principally due to increased demand for MTS, Corridor, WATS, and private line services. BELL ATLANTIC - NEW JERSEY, INC. Directory advertising, billing services and other revenues include amounts earned from directory advertising, billing and collection services provided to IXCs, premises services such as inside wire installation and maintenance, intraLATA toll compensation, rent of Company facilities by affiliates and non- affiliates, and certain nonregulated enhanced network services. Directory advertising, billing services and other revenues in 1993 increased $9.4 million or 1.7%. This increase was primarily due to higher intraLATA toll compensation; an increase in revenues from Answer Call, a nonregulated enhanced network service; and higher business volumes for premises services. Also contributing to this increase was higher directory advertising revenue due to volume growth. Partially offsetting these increases were lower billing and collection revenues in 1993, primarily as a result of the effect of favorable claim adjustments recorded in 1992 and reductions in services provided under long-term contracts with certain IXCs, and lower rent revenue. The provision for uncollectibles, expressed as a percentage of total revenue, was 1.7% in 1993 and 1.1% in 1992. The increase in the provision reflects unfavorable collection experience principally related to directory revenues. OPERATING EXPENSES Operating expenses increased $23.1 million or 1.0% in 1993. The increase in total operating expenses was comprised of the following: Employee costs consist of salaries, wages and other employee compensation, employee benefits and payroll taxes paid directly by the Company. Similar costs incurred by employees of Bell Atlantic Network Services, Inc. (NSI), who provide centralized services on a contract basis, are allocated to the Company and are included in other operating expenses. Employee costs decreased $10.6 million or 1.4% in 1993. The decrease in employee costs is principally due to savings resulting from workforce reduction programs implemented in 1992, partially offset by higher costs from salary and wage increases and overtime. The Company continues to evaluate ways to streamline and restructure its operations and reduce its workforce requirements in an effort to improve its cost structure. Depreciation and amortization expense increased $60.8 million or 11.3% in 1993 due primarily to approximately $58 million of additional expense resulting from represcribed intrastate depreciation rates in 1993. Also contributing to the increase was growth in the level of depreciable plant in 1993. These increases were partially offset by the completion of the FCC-ordered Reserve Deficiency Amortization in June 1992. Pursuant to the Plan for Alternative Regulation (PAR), approved by the Board of Regulatory Commissioners (BRC), the Company plans to annually adjust intrastate depreciation rates in connection with the Company's technology deployment program and BRC-approved depreciation methods and techniques. Taxes other than income increased $6.7 million or 3.8% in 1993, primarily due to an increase in property taxes and higher gross receipts tax resulting from an increase in operating revenues. BELL ATLANTIC - NEW JERSEY, INC. Other operating expenses consist primarily of contracted services including centralized service expenses allocated from NSI, rent, network software costs, and other general and administrative expenses. Other operating expenses decreased $33.8 million or 3.7% in 1993. The decrease was principally due to decreases in contracted services and the effect of the reversal of accruals in 1993 for certain liabilities. Also contributing to these decreases were lower rent expense and a reduction in network software costs. OPERATING INCOME TAXES The provision for income taxes increased $33.8 million or 18.3% in 1993. The Company's effective income tax rate was 30.7% in 1993, compared to 28.7% in 1992. The increase in the 1993 effective tax rate is principally the result of federal tax legislation enacted in 1993, which increased the federal corporate tax rate from 34% to 35%, a decrease in the amortization of investment tax credits, and the effect of recording in 1992 an adjustment to deferred taxes associated with the retirement of certain plant investment. A reconciliation of the statutory federal income tax rate to the effective rate for each period is provided in Note 5 of Notes to Financial Statements. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). In connection with the adoption of Statement No. 109, the Company recorded a charge to income of $.8 million in the first quarter of 1993. (see Note 5 of Notes to Financial Statements). OTHER INCOME AND EXPENSE Other income, net of expense, increased $8.1 million in 1993, primarily as a result of the reversal in 1993 of an accrual related to a tax issue. Partially offsetting this increase was the effect of interest income recognized in 1992 in connection with the settlement of various federal income tax matters related to prior periods. INTEREST EXPENSE Interest expense decreased $5.4 million or 4.6% in 1993, principally due to the effects of long-term debt refinancings in 1993 and 1992. EXTRAORDINARY ITEM The Company called $200.0 million in 1993 of long-term debentures which were refinanced at more favorable interest rates. As a result of these early retirements, the Company incurred after-tax charges of $6.9 million in 1993. These debt refinancings will reduce interest costs on the refinanced debt by approximately $3 million annually. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE In connection with the adoption of Statement No. 112, effective January 1, 1993, the Company recorded a one-time, cumulative effect after-tax charge of $30.0 million in 1993 (see Note 4 of Notes to Financial Statements). The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of expense in 1993 and is not expected to have a significant effect in future periods. COMPETITION AND REGULATORY ENVIRONMENT The telecommunications industry is currently undergoing fundamental changes which may have a significant impact on future financial performance of all telecommunications companies. These changes are driven by a number of factors, including the accelerated pace of technology change, customer requirements, a changing industry structure characterized by strategic alliances and the convergence of telecommunications and cable television, and a changing regulatory BELL ATLANTIC - NEW JERSEY, INC. environment in which traditional regulatory barriers are being lowered and competition encouraged. The convergence of cable television, computer technology, and telecommunications can be expected to dramatically increase competition in the future. The Company is already subject to competition from numerous sources, including competitive access providers for network access services, competing cellular telephone companies and others. During 1993, a number of business alliances were announced that have the potential to significantly increase competition both within the industry and within the areas currently served by Bell Atlantic. Over the past several years, Bell Atlantic has taken a number of actions in anticipation of the increasingly competitive environment. Cost reductions have been achieved, giving greater pricing flexibility for services exposed to competition. A new lines of business organization structure was adopted. Subject to regulatory approval, the Company plans to allocate capital resources to the deployment of broadband network platforms. On the regulatory front, the BRC has approved a plan for alternative regulation, which will be in effect through 1999, pending appeals. The Company conducts ongoing evaluations of its accounting practices, many of which have been prescribed by regulators. These evaluations include the assessment of whether costs that have been deferred as a result of actions of regulators and the cost of the Company's telephone plant will be recoverable in the future. In the event recoverability of costs becomes unlikely due to decisions by the Company to accelerate deployment of new technology, in response to specific regulatory actions or increasing levels of competition, the Company may no longer apply the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). The discontinued application of Statement No. 71 would require the Company to write off its regulatory assets and liabilities and may require the Company to adjust the carrying amount of its telephone plant should it determine that such amount is not recoverable. The Company believes that it continues to meet the criteria for continued financial reporting under Statement No. 71. A determination in the future that such criteria are no longer met may result in a significant one-time, non-cash, extraordinary charge, if the Company determines that a substantial portion of the carrying value of its telephone plant may not be recoverable. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing personal communications services (PCS). Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States. The geographical units by which the licenses would be allocated will be "basic trading areas" or larger "major trading areas." Five of the spectrum blocks are to be auctioned on a basic trading area basis, and the remaining two are to be auctioned by major trading area. Local exchange carriers such as the Company are eligible to bid for PCS licenses, except that cellular carriers are limited to obtaining 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994. In August 1993, the United States District Court for the Eastern District of Virginia ruled unconstitutional the 1984 Cable Act's limitation on in-territory provision of programming by local exchange carriers such as the Company. The Cable Act currently prohibits local exchange carriers from owning more than 5% of any company that provides cable programming in their local service area. In a case originally brought by two Bell Atlantic subsidiaries, the court ruled that this prohibition violates the First Amendment's freedom of speech protections, and enjoined enforcement of the prohibition against Bell Atlantic and its telephone subsidiaries. The ruling has been appealed. BELL ATLANTIC - NEW JERSEY, INC. STATE REGULATORY ENVIRONMENT The communications services of the Company are subject to regulation by the New Jersey Board of Regulatory Commissioners (formerly the Board of Public Utilities) (the BRC) with respect to intrastate rates and services and other matters. In June 1987, the BRC issued an order approving a Rate Stability Plan ("RSP") that modified the way the BRC monitors the Company's intrastate earnings. Rather than continue to monitor overall company financial performance, the RSP authorized financial performance surveillance only of less competitive services. The RSP also capped intrastate tariffed rates for its six year duration (July 1, 1987 through June 30, 1993), subject, however, to certain exceptions which would permit the Company to seek increases in tariffed rates during the RSP's fourth through sixth years. The RSP separated the Company's intrastate services into two categories: Group I (more competitive) services such as directory advertising, Centrex, pay telephone services, billing and collection services, high capacity channel and special access services, public data networks, central office local area networks, pay-per-view ordering service, high capacity digital hand-off service, Bellboy/(R)/ paging service, 911 enhanced terminal equipment and Home Intercom; and Group II (less competitive) services such as local exchange service, local usage, message toll service, 800 data base complementary service, and Repeat Call and Return Call. Only the Group II services were subject to financial performance monitoring by the BRC for the purpose of determining whether or not the Company was earning the target rate of return for those services. In January 1989, the BRC issued an order which established a target rate of return on equity of 12.9% for the purpose of monitoring the financial performance of the Group II category of services. Under the RSP, the Company was allowed to charge competitive rates for Group I services, without restriction and without financial performance monitoring. The New Jersey Telecommunications Act of 1992 (the "NJ Telecommunications Act") became effective in January 1992. The NJ Telecommunications Act authorized the BRC to adopt alternative regulatory frameworks that provide incentives to telecommunications companies for aggressive deployment of new technologies. It also deregulated services which the BRC has found to be competitive. Pursuant to that legislation, the Company filed its Plan for Alternative Form of Regulation in March 1992, and a revised plan in May 1992. This revised plan was unanimously approved by the BRC in December 1992, with certain modifications the written order reflecting that approval was issued on May 6, 1993. The Company filed a plan conforming to the BRC's order (the "NJ PAR"), which became effective on May 20, 1993. Several parties have filed judicial appeals of the BRC's order. The briefing schedule for this appeal extends through the middle of August 1994. The NJ PAR, which supersedes the RSP, divides the Company's services into Rate-Regulated Services (formerly Group II services) and Competitive Services (formerly Group I and services which have never been regulated by the BRC). Under this Plan, the Company's Rate-Regulated Services are grouped in two categories: - "Protected Services": Basic residence and business service, Touch-Tone, access services, message toll services and the ordering, installation and restoration of these services. Rates for Protected Services, other than basic residence service, may be increased beginning January 1996 in an amount limited to the prior year's increase in the Gross National Product-Price Index (GNP- PI) less a 2% productivity offset, as long as the return on equity for Rate- Regulated Services does not exceed 11.7%. Basic residence service rates are frozen through December 1999. - "Other Services": Custom calling, Custom Local Area Signaling Services ("CLASS" services which utilize Signaling System 7), operator services and 911 enhanced service. Rates for Other Services may be increased beginning January 1996 in an amount limited to the prior year's increase in the GNP-PI less a 2% BELL ATLANTIC - NEW JERSEY, INC. productivity offset, as long as the return on equity for Rate-Regulated Services does not exceed 12.7%. All earnings above a return on equity of 13.7% for Rate-Regulated Services will be shared equally with customers. There is no point at which the earnings are capped. Competitive Services are deregulated under the NJ Telecommunications Act. Other services such as premises wire maintenance, Answer Call and electronic messaging, which have never been regulated by the BRC, continue to be deregulated under the NJ Telecommunications Act. The BRC has initiated a proceeding to consider whether to continue its existing policy that prohibits intraLATA toll service competition. The Company does not oppose competition in principle, but has urged the BRC to implement certain required fundamental regulatory changes necessary for competition to be fair and effective. Parties participating in the proceeding include, among others, AT&T, MCI Communications Corporation, Sprint Communications Company, L.P. and MFS Communications Company, Inc., all of which are urging the BRC to revise its current policy and permit competition. A comment phase of the proceeding was completed in October, 1993. Evidentiary hearings will be held over the next several months and a BRC decision is expected in mid-1994. OTHER MATTERS The Company has been designated as a potentially responsible party by the U.S. Environmental Protection Agency in connection with one Superfund site. Designation as a potentially responsible party subjects the named company to potential liability for costs relating to cleanup of the affected sites. Management believes that the aggregate amount of any potential liability would not have a material effect on the Company's financial condition or results of operations. FINANCIAL CONDITION Management believes that the Company has adequate internal and external resources available to meet ongoing operating requirements including network expansion and modernization, and payment of dividends. Management expects that presently foreseeable capital requirements will be financed primarily through internally generated funds, although additional long-term debt may be needed to fund development activities and to maintain the Company's capital structure within management's guidelines. During 1993, as in prior years, the Company's primary source of funds continued to be cash generated from operations. Revenue growth, cost containment measures and savings on interest costs contributed to cash provided from operations of $1,105.6 million for the year ended December 31, 1993. The primary use of capital resources continued to be capital expenditures. The Company invested $590.0 million in 1993 in the network. This level of investment is expected to continue in 1994. The Company plans to allocate capital resources to the deployment of broadband network platforms, subject to regulatory approval. The Company's debt ratio was 39.6% as of December 31, 1993 compared to 39.6% at December 31, 1992. On March 11, 1993, the Company sold $100.0 million of Thirty Year 7 1/4% Debentures through a public offering. The debentures are not redeemable prior to March 1, 2003. The net proceeds from this issuance were ultimately used on April 7, 1993 to redeem $100.0 million of Forty Year 8 3/4% Debentures. This refinancing will reduce annual interest costs on the refinanced debt by approximately $2 million. On December 22, 1993, the Company sold $100.0 million of Thirty-one Year 6.8% Debentures through a public offering. The debentures are not redeemable prior to December 15, 2008. The net proceeds from this issuance were used on January 7, 1994 to redeem $100.0 million of Forty Year 8 1/4% Debentures. This BELL ATLANTIC - NEW JERSEY, INC. refinancing will reduce annual interest costs on the refinanced debt by approximately $1 million. On February 14, 1994, the Company sold $250.0 million of Ten Year 5 7/8% Debentures through a public offering. The debentures are not redeemable prior to maturity. The net proceeds from this issuance were used on March 2, 1994 to redeem $150.0 million of Forty Year 7 3/4% Debentures and $100.0 million of Forty Year 8% Debentures. These refinancings will reduce annual interest costs on the refinanced debt by approximately $5 million. As of December 31, 1993, the Company had $300.0 million outstanding under an a shelf registration statement filed with the Securities and Exchange Commission. After the $250.0 million debt issuance on February 14, 1994, the total debt securities outstanding under the shelf registration statement is $50.0 million. BELL ATLANTIC - NEW JERSEY, INC. PART II ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is set forth on pages through . ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (Omitted pursuant to General Instruction J(2).) ITEM 11. ITEM 11. EXECUTIVE COMPENSATION (Omitted pursuant to General Instruction J(2).) ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (Omitted pursuant to General Instruction J(2).) ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Omitted pursuant to General Instruction J(2).) PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: (1) Financial Statements See Index to Financial Statements and Financial Statement Schedules appearing on Page. (2) Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules appearing on Page. (3) Exhibits Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. BELL ATLANTIC - NEW JERSEY, INC. Exhibit Number (Referenced to Item 601 of Regulation S-K) --------------------------------------------------------- 3a Restated Certificate of Incorporation of the registrant, dated September 28, 1989 and filed November 28, 1989. (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-3488. 3a(i) Certificate of Amendment to the Certificate of Incorporation of the registrant, dated January 7, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended March 31, 1988. (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1988, File No. 1-3488.) 3b(i) By-Law resolution, dated June 25, 1992, amending Article VI, Section 6:1, of the Company's By-Laws (re: the indemnification by the Company of reasonable costs and expenses incurred for actions brought against Directors, Trustees and Officers of the Company). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 3b(ii) By-Law resolution, dated November 19, 1992, amending Article III, Section 3:1, of the Company's By-Laws (re: the establishment of a Dividend Committee). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 3b(iii) By-Law resolution, dated January 28, 1993, amending Article V, Section 5:7, of the Company's By-Laws (re: the elimination of the title "Vice President - External Affairs and Chief Financial Officer" and the substitution therein of the title "Chief Financial Officer"). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606). 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606). 23 Consent of Coopers & Lybrand. 24 Powers of attorney. (b) Reports on Form 8-K: A Current Report on Form 8-K, dated December 8, 1993, was filed reporting on Item 7 (Financial Statements and Exhibits) in connection with the sale of debt securities. BELL ATLANTIC - NEW JERSEY, 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. Bell Atlantic - New Jersey, Inc. By /s/ Michael J. Losch ------------------------------------ Michael J. Losch Controller and Treasurer and Chief Financial Officer 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 DATE INDICATED. Principal Executive Officer: ____ Alfred C. Koeppe President and Chief ) Executive Officer ) ) Principal Accounting and Financial Officer: ) ) Michael J. Losch Controller and Treasurer ) and Chief Financial ) Officer ) ) ) ) By /s/ Michael J. Losch ) --------------------------- ) Michael J. Losch ) (individually and as ) attorney-in-fact) ) March 29, 1994 ) Directors: ) ) Brendan T. Byrne ) Robert E. Campbell ) Bruce S. Gordon ) Jon F. Hanson ) Alfred C. Koeppe ) James M. Seabrook ) Anthony P. Terracciano ) Leslie A. Vial ____) (constituting a majority of the registrant's Board of Directors) BELL ATLANTIC - NEW JERSEY, INC. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Financial statement schedules other than those listed above have been omitted either because the required information is contained in the financial statements and the notes thereto, or because such schedules are not required or applicable. BELL ATLANTIC - NEW JERSEY, INC. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowner of Bell Atlantic - New Jersey, Inc. We have audited the financial statements and financial statement schedules of Bell Atlantic - New Jersey, Inc. as listed in the index on page of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Bell Atlantic - New Jersey, Inc. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes 1, 4 and 5 to the financial statements, the Company changed its method of accounting for income taxes and postemployment benefits in 1993 and postretirement benefits other than pensions in 1991. /s/ Coopers & Lybrand 2400 Eleven Penn Center Philadelphia, Pennsylvania February 7, 1994, except as to the information presented in paragraph 6 of Note 2, for which the date is March 2, 1994 BELL ATLANTIC - NEW JERSEY, INC. STATEMENTS OF INCOME AND REINVESTED EARNINGS FOR THE YEARS ENDED DECEMBER 31 (DOLLARS IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - NEW JERSEY, INC. BALANCE SHEETS (DOLLARS IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - NEW JERSEY, INC. BALANCE SHEETS (DOLLARS IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - NEW JERSEY, INC. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31 (DOLLARS IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - NEW JERSEY, INC. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Bell Atlantic - New Jersey, Inc. (formerly New Jersey Bell Telephone Company) (the Company), a wholly owned subsidiary of Bell Atlantic Corporation (Bell Atlantic), maintains its accounts in accordance with the Uniform System of Accounts (USOA) prescribed by the Federal Communications Commission (FCC) and makes certain adjustments necessary to present the accompanying financial statements in accordance with generally accepted accounting principles applicable to regulated entities. Such principles differ in certain respects from those used by unregulated entities, but are required to appropriately reflect the financial and economic impacts of regulation and the ratemaking process. Significant differences resulting from the application of these principles are disclosed elsewhere in these Notes to Financial Statements where appropriate. REVENUE RECOGNITION Revenues are recognized as earned on the accrual basis, which is generally when services are rendered based on the usage of the Company's local exchange network and facilities. CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of 90 days or less when purchased to be cash equivalents. Cash equivalents are stated at cost, which approximates market value. MATERIAL AND SUPPLIES New and reusable materials are carried in inventory, principally at average original cost, except that specific costs are used in the case of large individual items. Nonreusable material is carried at estimated salvage value. PREPAID DIRECTORY Costs of directory production and advertising sales are deferred until the directory is published. Such costs are amortized to expense and the related advertising revenues are recognized over the average life of the directory, which is generally 12 months. PLANT AND DEPRECIATION The Company's provision for depreciation is based principally on the remaining life method of depreciation and straight-line composite rates. The provision for depreciation is based on the following estimated remaining service lives: buildings, 25 to 35 years; central office equipment, 2 to 11 years; telephone instruments and related equipment, 4 to 7 years; poles, 21 to 25 years; cable and wiring, 10 to 18 years; conduit, 44 to 45 years; office equipment and furniture, 4 to 14 years; and vehicles and other work equipment, 3 to 7 years. This method provides for the recovery of the remaining net investment in telephone plant, less anticipated net salvage value, over the remaining service lives authorized by regulatory commissions. Depreciation expense also includes amortization of certain classes of telephone plant (and certain identified depreciation reserve deficiencies) over periods authorized by regulatory commissions. When depreciable plant is replaced or retired, the amounts at which such plant has been carried in plant, property and equipment are removed from the respective accounts and charged to accumulated depreciation, and any gains or losses on disposition are amortized over the remaining service lives of the remaining net investment in telephone plant. BELL ATLANTIC - NEW JERSEY, INC. MAINTENANCE AND REPAIRS The cost of maintenance and repairs of plant, including the cost of replacing minor items not constituting substantial betterments, is charged to operating expenses. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION Regulatory commissions allow the Company to record an allowance for funds used during construction, which includes both interest and equity return components, as a cost of plant and as an item of other income. Such income is not recovered in cash currently, but will be recoverable over the service life of the plant through higher depreciation expense recognized for regulatory purposes. EMPLOYEE BENEFITS Pension Plans Substantially all employees of the Company are covered under noncontributory multi-employer defined benefit pension plans sponsored by Bell Atlantic and its subsidiaries, including the Company. The Company uses the projected unit credit actuarial cost method for determining pension cost for financial reporting purposes. Amounts contributed to the Company's pension plans are actuarially determined principally under the aggregate cost actuarial method, and are subject to applicable federal income tax regulations. Postretirement Benefits Other Than Pensions Substantially all employees of the Company are covered under postretirement health and life insurance benefit plans. Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. A portion of the postretirement accrued benefit obligation is contributed to 501(c)(9) trusts and 401h accounts under applicable federal income tax regulations. The amounts contributed to these trusts and accounts are actuarially determined, principally under the aggregate cost actuarial method. Postemployment Benefits The Company provides employees with postemployment benefits such as disability benefits, workers' compensation, and severance pay. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. Prior to 1993, the cost of these benefits was primarily charged to expense as the benefits were paid. INCOME TAXES Bell Atlantic and its domestic subsidiaries, including the Company, file a consolidated federal income tax return. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109), which requires the determination of deferred taxes using the liability method. BELL ATLANTIC - NEW JERSEY, INC. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. The consolidated amount of current and deferred tax expense is allocated by applying the provisions of Statement No. 109 to each subsidiary as if it were a separate taxpayer. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes" (APB No. 11). Under APB No. 11, deferred taxes were generally provided to reflect the effect of timing differences on the recognition of revenue and expense determined for financial and income tax reporting purposes. The Tax Reform Act of 1986 repealed the investment tax credit (ITC) as of January 1, 1986, subject to certain transitional rules. ITCs were deferred and are being amortized as a reduction to income tax expense over the estimated service lives of the related assets. RECLASSIFICATIONS Certain reclassifications of prior years' data have been made to conform to 1993 classifications. 2. DEBT LONG-TERM Long-term debt consists principally of debentures issued by the Company. Interest rates and maturities of the amounts outstanding at December 31 are as follows: BELL ATLANTIC - NEW JERSEY, INC. Long-term debt outstanding at December 31, 1993 includes $640.0 million that is callable by the Company. The call prices range from 104.1% to 100% of face value, depending upon the remaining term to maturity of the issue. In addition, long-term debt includes $150.0 million that will become redeemable only on November 15, 1999 at the option of the holders. The redemption prices will be 100% of face value plus accrued interest. On March 11, 1993, the Company sold $100.0 million of Thirty Year 7 1/4% Debentures, due March 1, 2023, through a public offering. The debentures are not redeemable by the Company prior to March 1, 2003. The net proceeds of this debt issuance were ultimately used to redeem $100.0 million of Forty Year 8 3/4% Debentures due in 2018, which were redeemed by the Company on April 7, 1993 at a call price equal to 104.59% of the principal amount, plus accrued interest from December 1, 1992. As a result of the early extinguishment of this debt, which was called on March 8, 1993, the Company recorded a charge of $5.7 million, before an income tax benefit of $1.9 million, in the first quarter of 1993. On December 22, 1993, the Company sold $100.0 million of Thirty-one Year 6.8% Debentures, due December 15, 2024, through a public offering. The debentures are not redeemable by the Company prior to December 15, 2008. The net proceeds from this issuance were used to redeem $100.0 million of Forty Year 8 1/4% Debentures with an original maturity date of 2016, which were redeemed by the Company on January 7, 1994 at a call price equal to 103.7% of the principal amount, plus accrued interest from August 15, 1993. As a result of the early extinguishment of this debt, which was called on December 8, 1993, the Company recorded a charge of $4.8 million, before an income tax benefit of $1.7 million, in the fourth quarter of 1993. In 1992, the Company recorded extraordinary charges associated with the early extinguishment of debentures called by the Company of $25.3 million, before an income tax benefit of $8.6 million. On February 14, 1994, the Company sold $250.0 million of Ten Year 5 7/8% Debentures, due February 1, 2004, through a public offering. The debentures are not redeemable by the Company prior to maturity. The net proceeds from this issuance were used on March 2, 1994, to redeem $150.0 million of Forty Year 7 3/4% Debentures due in 2013, and $100.0 million of Forty Year 8% Debentures due in 2016. The Company redeemed the $150.0 million 7 3/4% debentures at a call price equal to 102.8% of the principal amount, plus accrued interest from March 1, 1994, and the $100 million 8% debentures at a call price equal to 104.1% of the principal amount, plus accrued interest from September 15, 1993. As a result of the early extinguishment of these debentures, which were called on January 31, 1994, the Company recorded a charge of $10.3 million, before an income tax benefit of $3.6 million, in the first quarter of 1994. At December 31, 1993, the Company had $300.0 million outstanding under a shelf registration statement filed with the Securities and Exchange Commission. After the $250.0 million debt issuance in February 1994, the total debt securities outstanding under the shelf registration is $50.0 million. The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues. At December 31, 1993 and 1992, the fair value of the Company's long-term debt, excluding the amount maturing within one year, unamortized discount and premium and capital lease obligations, is estimated at $1,345 million and $1,271 million, respectively. BELL ATLANTIC - NEW JERSEY, INC. MATURING WITHIN ONE YEAR Debt maturing within one year consists of the following at December 31: * Amounts represent average daily face amount of the note. ** Weighted average interest rates are computed by dividing the average daily face amount of the note into the aggregate related interest expense. At December 31, 1993, the Company had an unused line of credit balance of $472.1 million with an affiliate, Bell Atlantic Network Funding Corporation (BANFC) (Note 7). The fair value of debt maturing within one year, excluding capital lease obligations, is estimated based on quoted market prices for the same or similar issues. At December 31, 1993, the fair value of debt maturing within one year, excluding capital lease obligations, is estimated at $104 million. At December 31, 1992, the carrying amount of debt maturing within one year, excluding capital lease obligations, approximates fair value. 3. LEASES The Company has entered into both capital and operating leases for facilities and equipment used in operations. Plant, property and equipment included capital leases of $85.4 million and $87.7 million and related accumulated amortization of $47.1 million and $36.9 million at December 31, 1993 and 1992, respectively. The Company incurred no initial capital lease obligations in 1993, as compared to $.3 million in 1992 and $20.3 million in 1991. Total rent expense amounted to $53.6 million in 1993, $55.1 million in 1992, and $50.7 million in 1991. Of these amounts, the Company incurred rent expense of $6.8 million, $3.6 million, and $2.9 million in 1993, 1992, and 1991, respectively, from affiliated companies. BELL ATLANTIC - NEW JERSEY, INC. At December 31, 1993, the aggregate minimum rental commitments under noncancelable leases for the periods shown are as follows: 4. EMPLOYEE BENEFITS PENSION PLANS Substantially all of the Company's management and associate employees are covered under multi-employer noncontributory defined benefit pension plans sponsored by Bell Atlantic and its subsidiaries, including the Company. The pension benefit formula is based on a flat dollar amount per year of service according to job classification under the associate plan and a stated percentage of adjusted career average earnings under the plans for management employees. The Company's objective in funding the plans is to accumulate funds at a relatively stable level over participants' working lives so that benefits are fully funded at retirement. Plan assets consist principally of investments in domestic and foreign corporate equity securities, U.S. and foreign Government and corporate debt securities, and real estate. Aggregate pension cost for the plans is as follows: The decrease in pension cost in 1993 is due to the net effect of the elimination of one-time charges associated with special termination benefits that were recognized in the preceding years, favorable investment experience and changes in plan demographics due to retirement and severance programs. In 1992, the Company recognized $14.6 million of special termination benefit costs related to the early retirement of associate employees. The special termination benefit costs and the net effect of changes in plan provisions, certain actuarial assumptions, and the amortization of actuarial gains and losses related to demographic and investment experience increased pension cost in 1992. A change in the expected long-term rate of return on plan assets resulted in a reduction of $16.6 million in pension cost (which reduced operating expenses by $14.4 million after capitalization of amounts related to the construction program) and substantially offset the 1992 cost increase. BELL ATLANTIC - NEW JERSEY, INC. Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" (Statement No. 87) requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic pension costs and a reconciliation of the funded status of the plans with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not allow for the determination of this information on an individual participating company basis. Significant actuarial assumptions are as follows: The Company has in the past entered into collective bargaining agreements with unions representing certain employees and expects to do so in the future. Pension benefits have been included in these agreements and improvements in benefits have been made from time to time. Additionally, the Company has amended the benefit formula under pension plans maintained for its management employees. Expectations with respect to future amendments to the Company's pension plans have been reflected in determining the Company's pension cost under Statement No. 87. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (Statement No. 106). Statement No. 106 requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. In conjunction with the adoption of Statement No. 106, the Company elected for financial reporting purposes, to recognize immediately the accumulated postretirement benefit obligation for current and future retirees, net of the fair value of plan assets and recognized accrued postretirement benefit cost (transition obligation), in the amount of $469.1 million, net of a deferred income tax benefit of $241.7 million. For purposes of measuring the interstate rate of return achieved by the Company, the FCC permits recognition of postretirement benefit costs, including amortization of the transition obligation, in accordance with the prescribed accrual method included in Statement No. 106. In January 1993, the FCC denied adjustments to the interstate price cap formula which would have permitted tariff increases to reflect the incremental postretirement benefit cost resulting from the adoption of Statement No. 106. For the purposes of measuring intrastate rate of return, the Company recognizes the accrued postretirement benefit cost, including amortization of the transition obligation, in accordance with the prescribed method in Statement No. 106. This method is subject to authoritative approval by the Board of Regulatory Commissioners. Pursuant to Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71), a regulatory asset associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery given the Company's assessment of its long-term competitive environment. BELL ATLANTIC - NEW JERSEY, INC. Substantially all of the Company's management and associate employees are covered under multi-employer postretirement health and life insurance benefit plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The determination of benefit cost for postretirement health benefit plans is based on comprehensive hospital, medical, surgical and dental benefit plan provisions. The postretirement life insurance benefit formula used in the determination of postretirement benefit cost is primarily based on annual basic pay at retirement. The Company funds the postretirement health and life insurance benefits of current and future retirees. Plan assets consist principally of investments in domestic and foreign corporate equity securities, and U.S. Government and corporate debt securities. The aggregate postretirement benefit cost for the year ended December 31, 1993, 1992, and 1991, was $64.1 million, $59.7 million, and $57.8 million, respectively. As a result of the 1992 collective bargaining agreements, Bell Atlantic amended the postretirement medical benefit plan for associate employees and certain associate retirees of the Company. The increases in the postretirement benefit cost between 1993 and 1991 were primarily due to the change in benefit levels and claims experience. Also contributing to these increases were changes in actuarial assumptions and demographic experience. Statement No. 106 requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic postretirement benefit costs, and a reconciliation of the funded status of the plan with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not provide for the determination of this information on an individual participating company basis. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 8.25% for 1993 and 1992 and 7.5% for 1991. The medical cost trend rate in 1993 was approximately 13.0%, grading down to an ultimate rate in 2003 of approximately 5.0%. The dental cost trend rate in 1993 and thereafter is approximately 4.0%. Postretirement benefits other than pensions have been included in collective bargaining agreements and have been modified from time to time. The Company has periodically modified benefits under the plans maintained for its management employees. Expectations with respect to future amendments to the Company's postretirement plans have been reflected in determining the Company's postretirement benefit costs under Statement No. 106. POSTEMPLOYMENT BENEFITS Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112). Statement No. 112 requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. This change principally affects the Company's accounting for disability and workers' compensation benefits, which previously were charged to expense as the benefits were paid. The cumulative effect at January 1, 1993 of adopting Statement No. 112 reduced net income by $30.0 million, net of a deferred income tax benefit of $15.4 million. The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of operating expense in 1993. BELL ATLANTIC - NEW JERSEY, INC. 5. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). Statement No. 109 requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11. Statement No. 109 has been adopted on a prospective basis and amounts presented for prior years have not been restated. As of January 1, 1993, the Company recorded a charge to income of $.8 million, representing the cumulative effect of adopting Statement No. 109, which has been reflected in Federal Operating Income Taxes in the Statement of Income and Reinvested Earnings. Upon adoption of Statement No. 109, the effects of required adjustments to deferred tax balances were primarily deferred on the balance sheet as regulatory assets and liabilities in accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). At January 1, 1993, the Company recorded income tax-related regulatory assets totaling $130.6 million in Other Assets. These regulatory assets represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize temporary differences for which deferred income taxes had not been provided. In addition, income tax-related regulatory liabilities totaling $228.6 million were recorded in Deferred Credits and Other Liabilities - Other. These regulatory liabilities represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) a reduced deferred tax liability resulting from decreases in federal income tax rates subsequent to the dates the deferred taxes were recorded and (ii) a deferred tax benefit required to recognize the effects of the temporary differences attributable to the Company's policy of accounting for investment tax credits using the deferred method. These deferred taxes and regulatory assets and liabilities have been increased for the tax effect of future revenue requirements. These regulatory assets and liabilities are amortized at the time the related deferred taxes are recognized in the ratemaking process. Prior to the adoption of Statement No. 109, the Company had income tax timing differences for which deferred taxes had not been provided pursuant to the ratemaking process of $197.8 million and $177.5 million at December 31, 1992 and 1991, respectively. These timing differences principally related to the allowance for funds used during construction and certain taxes and payroll- related construction costs capitalized for financial statement purposes, but deducted currently for income tax purposes, net of applicable depreciation. The Omnibus Budget Reconciliation Act of 1993, which was enacted in August 1993, increased the federal corporate income tax rate from 34% to 35%, effective January 1, 1993. In the third quarter of 1993, the Company recorded a net charge to the tax provision of $.1 million, which included a $6.7 million charge for the nine month effect of the 1% rate increase, largely offset by a one-time net benefit of $6.6 million related to adjustments to deferred tax assets associated with the postretirement benefit obligation. Pursuant to Statement No. 71, the effect of the income tax rate increase on the deferred tax balances was primarily deferred through the establishment of regulatory assets of $5.9 million and the reduction of regulatory liabilities of $21.7 million. The Company did not recognize regulatory assets and liabilities related to the postretirement benefit obligation or the associated deferred income tax asset. BELL ATLANTIC - NEW JERSEY, INC. The components of income tax expense are as follows: Income tax expense (benefit) which relates to non-operating income and expense and is included in Miscellaneous-net was $(2.5) million, $1.1 million, and $1.6 million in 1993, 1992, and 1991, respectively. For the years ended December 31, 1992 and 1991, deferred income tax expense resulted from timing differences in the recognition of revenue and expense for financial and income tax accounting purposes. The sources of these timing differences and the tax effects of each were as follows: The provision for income taxes varies from the amount computed by applying the statutory federal income tax rate to income before provision for income taxes. The difference is attributable to the following factors: At December 31, 1993, the significant components of deferred tax assets and liabilities were as follows: BELL ATLANTIC - NEW JERSEY, INC. Total deferred tax assets include approximately $257 million related to postretirement benefit costs recognized in accordance with Statement No. 106. This deferred tax asset will gradually be realized over the estimated lives of current retirees and employees. 6. SUPPLEMENTAL CASH FLOW AND ADDITIONAL FINANCIAL INFORMATION For the years ended December 31, 1993, 1992, and 1991, revenues generated from services provided to AT&T, principally network access, billing and collection, and sharing of network facilities, were $423.8 million, $470.1 million, and $474.5 million, respectively. At December 31, 1993 and 1992, Accounts receivable, net, included $66.1 million and $54.8 million, respectively, from AT&T. Financial instruments that potentially subject the Company to concentrations of credit risk consist of trade receivables with AT&T, as noted above. Credit risk with respect to other trade receivables is limited due to the large number of customers included in the Company's customer base. At December 31, 1993 and 1992, $22.0 million and $90.6 million, respectively, of negative cash balances were classified as Accounts payable. 7. TRANSACTIONS WITH AFFILIATES The Company has contractual arrangements with an affiliated company, Bell Atlantic Network Services, Inc. (NSI), for the provision of various centralized corporate, administrative, planning, financial and other services. These arrangements serve to fulfill the common needs of Bell Atlantic's telephone subsidiaries on a centralized basis. In connection with these services, the Company recognized $498.7 million, $512.0 million, and $479.0 million in operating expenses for the years ended December 31, 1993, 1992, and 1991, respectively. Included in these expenses were $39.9 million in 1993, $55.0 million in 1992, and $45.2 million in 1991 billed to NSI and allocated to the Company by Bell Communications Research, Inc., another affiliated company owned jointly by the seven regional holding companies. In 1991, these charges included $12.7 million associated with NSI's adoption of Statement No. 106. In addition, in 1991, the Company recognized $128.0 million representing the Company's proportionate share of NSI's accrued transition obligation under Statement No. 106. In connection with the adoption of Statement No. 112 in 1993, the cumulative effect included $2.5 million, net of a deferred income tax benefit of $1.3 million, representing the Company's proportionate share of NSI's accrued cost of postemployment benefits at January 1, 1993. BELL ATLANTIC - NEW JERSEY, INC. The Company has a contractual agreement with an affiliated company, BANFC, for the provision of short-term financing and cash management services. BANFC issues commercial paper and secures bank loans to fund the working capital requirements of the telephone subsidiaries and NSI and invests funds in temporary investments on their behalf. In connection with this arrangement, the Company recognized interest expense of $3.1 million, $3.0 million, and $8.4 million in 1993, 1992, and 1991, respectively, and $.1 million in interest income in 1993. In 1993, the Company received $54.3 million in revenue from affiliates, principally related to rent received for the use of Company facilities and equipment, and paid $12.8 million in other operating expenses to affiliated companies. These amounts were $46.0 million and $3.6 million, respectively, in 1992 and $37.9 million and $2.9 million, respectively, in 1991. On February 1, 1994, the Company declared and paid a dividend in the amount of $91.7 million to Bell Atlantic. 8. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Net income for the first quarter of 1993 has been restated to include a charge of $30.0 million, net of a deferred income tax benefit of $15.4 million, related to the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Note 4). BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS) The notes on page are an integral part of this schedule. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) The notes on page are an integral part of this schedule. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN MILLIONS) The notes on page are an integral part of this schedule. BELL ATLANTIC - NEW JERSEY, INC. NOTES TO SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT - ---------------- (a) These additions include (1) the original cost (estimated if not specifically determinable) of reused material, which is concurrently credited to material and supplies, and (2) allowance for funds used during construction. Transfers between Plant in Service, Plant Under Construction and Other are also included in Additions at Cost. (b) Items of plant, property and equipment are deducted from the property accounts when retired or sold at the amounts at which they are included therein, estimated if not specifically determinable. (c) The Company's provision for depreciation is principally based on the remaining life method and straight-line composite rates prescribed by regulatory authorities. The remaining life method provides for the full recovery of the remaining net investment in plant, property and equipment. In 1993 and 1991, the Company implemented changes in depreciation rates approved by regulatory authorities. These changes reflect reductions in estimated service lives of the Company's plant, property and equipment in service. The rulings will allow a more rapid recovery of the Company's investment in plant, property and equipment through closer alignment with current estimates of its remaining economic useful life. For the years 1993, 1992, and 1991, depreciation expressed as a percentage of average depreciable plant was 7.5%, 6.5%, and 6.3%, respectively. (d) See Note 1 of Notes to Financial Statements for the Company's depreciation policies. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE VI - ACCUMULATED DEPRECIATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN MILLIONS) - --------------------------- (a) Includes any gains or losses on disposition of plant, property and equipment. These gains and losses are amortized to depreciation expense over the remaining service lives of remaining net investment in plant, property and equipment. Consists primarily of salvage and cost of removal amounts related to the retirement of plant assets. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN MILLIONS) - --------------------------- (a) (i) Amounts previously written off which were credited directly to this account when recovered; and (ii) accruals charged to accounts payable for anticipated uncollectible charges on purchases of accounts receivable from others which were billed by the Company. (b) Amounts written off as uncollectible. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN MILLIONS) Advertising costs for 1993 are not presented, as such amounts are less than 1 percent of total operating revenues. Amounts reported for 1992 and 1991 for maintenance and repairs have been revised to include certain additional costs. EXHIBITS FILED WITH ANNUAL REPORT FORM 10-K UNDER THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 Bell Atlantic - New Jersey, Inc. COMMISSION FILE NUMBER 1-3488 Form 10-K for 1993 File No. 1-3488 Page 1 of 1 EXHIBIT INDEX Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. Exhibit Number (Referenced to Item 601 of Regulation S-K) --------------------------------------------------------- 3a Restated Certificate of Incorporation of the registrant, dated September 28, 1989 and filed November 28, 1989. (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-3488.) 3a(i) Certificate of Amendment to the Certificate of Incorporation of the registrant, dated January 7, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended March 31, 1988. (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1988, File No. 1-3488.) 3b(i) By-Law resolution, dated June 25, 1992, amending Article VI, Section 6:1, of the Company's By-Laws (re: the indemnification by the Company of reasonable costs and expenses incurred for actions brought against Directors, Trustees and Officers of the Company). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 3b(ii) By-Law resolution, dated November 19, 1992, amending Article III, Section 3:1, of the Company's By-Laws (re: the establishment of a Dividend Committee). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 3b(iii) By-Law resolution, dated January 28, 1993, amending Article V, Section 5:7, of the Company's By-Laws (re: the elimination of the title "Vice President - External Affairs and Chief Financial Officer" and the substitution therein of the title "Chief Financial Officer"). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 23 Consent of Coopers & Lybrand. 24 Powers of attorney.

716634_1993.txt

716634_1993

1993

716634

ITEM 1. BUSINESS CITADEL HOLDING CORPORATION GENERAL Citadel Holding Corporation ("Citadel"), incorporated in Delaware in 1983, is a financial services holding company engaged primarily in the savings bank business through its wholly owned subsidiary, Fidelity Federal Bank, a Federal Savings Bank ("Fidelity" or the "Bank"). Citadel is also engaged in the securities brokerage business through its wholly owned subsidiary, Gateway Investment Services, Inc. ("Gateway"). Citadel currently has no significant business or operations other than serving as the holding company for Fidelity and Gateway. Citadel is actively pursuing a significant internal restructuring plan described below in "Recent Developments." Unless otherwise indicated, references to the "Company" include Citadel, Fidelity, and all subsidiaries of Fidelity and Citadel. The principal executive offices of Citadel and Fidelity are located at 600 North Brand Boulevard, Glendale, California 91203, telephone number (818) 956-7100. Fidelity operates through 42 branches, all of which are located in Southern California, principally in Los Angeles and Orange counties. At December 31, 1993, Fidelity's mortgage loan portfolio (including loans held for sale) aggregated approximately $3.8 billion, of which approximately 71% was secured by residential properties containing 2 or more apartment units, 21% was secured by single family residences and 8% was secured by commercial property. At that same date, 96% of Fidelity's loans consisted of adjustable rate mortgages. Fidelity funds its portfolio lending operations principally with deposits. At December 31, 1993, Fidelity had deposits of approximately $2.8 billion, exclusive of $593 million in certificates of deposit of $100,000 or more. Other borrowings on that date included $326.4 million in Federal Home Loan Bank ("FHLB") Advances, $100.0 million in mortgage-backed borrowings, $304.0 million in commercial paper backed by a letter of credit issued by the FHLB of San Francisco and $60.0 million in subordinated debt that qualifies as supplementary Tier 2 regulatory capital. Fidelity's deposit accounts are insured by the Federal Deposit Insurance Corporation (the "FDIC") through the Savings Association Insurance Fund (the "SAIF"). Citadel and Fidelity are subject to the examination, supervision and reporting requirements of the Office of Thrift Supervision (the "OTS"), their primary federal banking regulator. Fidelity is also subject to examination and supervision by the FDIC. See "Regulation and Supervision." Gateway became a National Association of Securities Dealers, Inc. ("NASD") registered broker/dealer in October 1993. Through Gateway, the Company currently provides customers of the Bank with investment products including a number of mutual funds, annuities and unit investment trusts. Fidelity is implementing a new business strategy that integrates traditional banking functions (mortgage originations and deposit services) with the sale of investment services and products by Gateway. See "Retail Financial Services Group." The Southern California economy and real estate markets further declined during 1993, adversely affecting the Bank's loan and real estate portfolios. The Company reported a net loss of $67.2 million for the year ended December 31, 1993, as compared to net earnings of $2.0 million and $2.7 million for the years ended December 31, 1992 and 1991, respectively. Pre-tax loss for the Company increased by $99.8 million from a loss of $3.8 million in 1992 to a loss of $103.6 million in 1993. Operating expenses increased $27.4 million in 1993 to $105.3 million from $77.9 million in 1992. The increase in 1993 expenses was attributable in part to increased staffing levels required to manage rising problem assets, strengthen internal asset review, handle increased financial services offered at the retail branch network and expand originations and sales of residential mortgages in the mortgage banking network. The increase in expenses is also attributable to certain nonrecurring charges incurred in connection with the Company's valuation of its intangible assets and further development of the internal reorganization and restructuring plan discussed below, including the write-off of $8.8 million of goodwill and $5.2 million in core deposit intangibles, and an increase of $5.9 million in professional fees, of which approximately $3.3 million was attributable to analysis and development of the Company's restructuring plan and to the related asset valuation process. At December 31, 1993, the Bank had nonperforming assets ("NPAs") totaling $235.6 million and a general valuation allowance ("GVA") totaling $80.0 million. NPAs include nonaccruing loans, in-substance foreclosed real estate ("ISF") and real estate acquired in settlement of loans by foreclosure or otherwise, but do not include troubled debt restructurings ("TDRs") unless the TDRs would otherwise fall into nonaccruing loans or ISF. At year-end 1993, the Bank's GVA equaled 2.03% of total loans and real estate owned (including ISF, "REO") and 32.8% of NPAs. The following table sets forth selected financial and other data for the Company at or for the periods indicated: - -------- (1) Net of treasury shares, where applicable. (2) 1993 data includes 3,297,812 shares issued in March 1993 in connection with a stock rights offering which produced net proceeds to the Company of $31.4 million. (3) The efficiency ratio is computed by dividing total operating expense by net interest income and noninterest income, excluding nonrecurring items, provisions for estimated loan and real estate losses, direct costs of real estate operations and gains/losses on the sale of securities. (4) NPAs include nonaccruing loans, foreclosed real estate and ISF (net of REO GVA), but do not include TDRs, unless they fall into one of the foregoing categories. (5) NPAs in this ratio are calculated prior to the reduction for REO GVA. (6) Loans and REO in the ratio are calculated prior to the reduction for loan and REO GVA, but are net of specific reserves. (7) All retail branch offices are located in Southern California. For additional information, see Item 6. "Selected Financial Data," Item 7. "MD&A" and Item 8. "Financial Statements and Supplementary Data." RECENT DEVELOPMENTS Internal Reorganization and Restructuring In mid-1992, the Company commenced a series of steps to internally reorganize in order to strengthen the Bank's internal operations and meet the needs of its customer base. First, a new Chief Executive Officer and certain additional senior management personnel were hired to strengthen key areas of future potential growth, such as mortgage banking, residential loan originations, credit administration and retail financial services. The Company broadened the product line of loans originated by the Bank and increased its emphasis on mortgage banking, in particular developing its loan pipeline hedging capability. It also reorganized the retail branch system to integrate the provision of traditional banking services with the provision through Gateway of a broader range of nontraditional financial services and uninsured investment products. Additionally, Fidelity upgraded its systems management capabilities by converting to new computer systems in its retail banking and loan administration operations and by adding state-of-the-art software capability to the asset/liability management function. Fidelity also enhanced its real estate management operations by adding experienced real estate professionals to that department. In October 1992, the Company hired outside financial advisors to identify and assess strategic alternatives for the Company to pursue with a view to maximizing value for stockholders. In mid-1993, as an outgrowth of the reorganization effort, management evaluated the strategic alternatives available to it and subsequently determined that the proposed restructuring plan described below had the greatest potential to maximize stockholder value in the foreseeable future. The Company is actively pursuing a restructuring plan that would include both the transfer to a newly-formed Citadel subsidiary or division of certain problem assets of the Bank and a sale of the Bank and Gateway (the "Restructuring"; discussions of the sale of the Bank in the context of the Restructuring include the sale of Gateway). The Company is currently seeking another financial institution (a "strategic buyer") or a new core set of equity investors for the Bank. Any such sale of the Bank will be subject to the approval of Citadel's Board of Directors (the "Board") and stockholders as well as the OTS. Following the proposed sale of the Bank, Citadel would become a real estate company and focus on the servicing and enhancement of its loan and real estate portfolio. The Restructuring calls for the Bank's disposition of substantially all of its problem assets, together with a small amount of its performing assets, so as to improve the attractiveness of the Bank to potential acquisition or investment candidates. Most of the Bank's problem assets would be transferred to the new Citadel real estate subsidiary or division using securitized debt financing. These assets would consist of commercial and large multifamily loans and real estate owned properties with a current net book value of approximately $401 million. The impact of the January 1994 Northridge Earthquake on the assets to be transferred is not expected to alter significantly the value of such assets. The Restructuring also calls for the Bank's disposition of a smaller group of problem assets, consisting primarily of smaller multifamily loans with a current net book value of approximately $81 million, in a bulk sale to a third-party purchaser or Citadel. While the Board will fully explore the market values of this Restructuring before making any final decisions, the Board views this approach as having the greatest potential to maximize stockholder value in the foreseeable future. In formulating the proposed Restructuring, the Company believes that the value of Fidelity to a purchaser or investor would be heavily, and perhaps excessively, discounted due to its problem assets. Thus, it was determined that the Bank's attractiveness to an acquisition or investment candidate would be enhanced if the Bank disposed of these problem assets. However, management also believes that these assets, if managed outside the environment of a federally regulated institution, may present the potential for Citadel stockholders to realize future values that would not be reflected in the bulk sale price of those assets to a third party today. Accordingly, the Restructuring was designed to retain in a Citadel subsidiary or division approximately $401 million of primarily problem assets after a sale of the Bank. Management believes that an asset disposition is critical to a successful major recapitalization program for Fidelity. Citadel has commenced efforts to raise the financing necessary to consummate its problem asset purchase from Fidelity. Because of the significant conditions to and uncertainty in accomplishing a successful Restructuring, the Company expects that the losses associated with the Restructuring would only be incurred upon the sale of the Bank, at which time the effects of the losses on capital should be offset by either a new infusion of capital from investors, who would purchase ownership of the Bank, or a merger with another financial institution. The following discussion focuses on certain financial consequences of the Restructuring and is not indicative of the loss content of the Bank's assets in the absence of the Restructuring or other bulk asset dispositions. To consummate the bulk transfers of assets to a Citadel subsidiary or division and obtain debt financing in the capital markets for the larger transfer, Fidelity would be required to write down these assets to their bulk sale values. These losses would be offset in part by the reduction in the Bank's GVA (reflecting the healthier remaining asset pool) and possible tax benefits. If the restructuring were to be consummated in mid-1994, management's latest estimate is that the Bank's core capital, after giving effect to the writedowns on the asset transfers, tax benefits associated therewith, use of relevant reserves and extraordinary charges relating to the Restructuring, but before giving effect to any new capital infusion into the Bank by the acquiror or new investors, would be approximately $102 million. This estimate will be subject to ongoing adjustment in view of changing variables such as future earnings or losses, changes in the composition and size of the problem assets and other factors. The Bank does not intend to implement the above-described bulk problem asset dispositions, or to incur the consequent losses, in the absence of an acquisition of the Bank by another financial institution or financial investors who are able to infuse additional core capital into the Bank. Any such acquisition will also require the approval of Citadel's Board and stockholders, as well as the OTS, which will condition its approval in part on the adequacy of the capital of the Bank after the Restructuring. No assurances can be given that the proposed Restructuring can be successfully implemented. On March 4, 1994, The Chase Manhattan Bank, N.A. ("Chase"), one of four lenders under Fidelity's $60 million subordinated loan agreement of 1990 (the "Subordinated Loan Agreement"), sued Fidelity, Citadel and Citadel's Chairman of the Board, alleging, among other things, that the transfer of assets pursuant to the Restructuring would constitute a breach of the Subordinated Loan Agreement, and seeking to enjoin the Restructuring and to recover damages in unspecified amounts. In addition, the lawsuit alleges that past responses of Citadel and Fidelity to requests by Chase for information regarding the Restructuring violate certain provisions of the Subordinated Loan Agreement and that such alleged violations, with the passage of time, have become current defaults under the Subordinated Loan Agreement. While the other three lenders under the Subordinated Loan Agreement hold $25 million of the subordinated notes (the "Notes"), none of them has joined Chase in this lawsuit. The Company is evaluating the lawsuit and, based on its current assessment, the Company does not believe that the allegations have merit. See Item 7. "MD&A--Capital Resources and Liquidity" for additional considerations relating to the Subordinated Loan Agreement. OTS Examinations In January 1994, Citadel and the Bank received reports of the various regular examinations conducted by the OTS in 1993. As a result of the findings of the OTS in its safety and soundness examination of the Bank, Fidelity will be subject to higher examination assessments and is subject to additional regulatory restrictions including, but not limited to, (a) a prohibition, absent prior OTS approval, on increases in total assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities during the quarter; (b) a requirement that the Bank submit to the OTS for prior review and approval the names of proposed new directors and executive officers and proposed employment contracts with any director or senior officer; (c) a requirement that the Bank submit to the OTS for prior review and approval any third-party contract outside the normal course of business; and (d) the OTS would have the ability, in its discretion, to require 30 days' prior notice of all transactions between Fidelity and its affiliates (including Citadel and Gateway). The OTS also expressed concern in a number of specific areas principally relating to asset quality, asset review administration and the resulting negative impact on capital levels and earnings, as well as management effectiveness in certain areas. Management believes that the proposed Restructuring, if accomplished, would be responsive to most of the OTS' concerns. Capital and Liquidity Despite the negative impact of losses and provisions to GVA on the Bank's earnings and thus its capital, at December 31, 1993 and to date, the Bank was and is classified as "adequately capitalized" for purposes of the prompt corrective action regulations promulgated by the OTS. An institution is "adequately capitalized" if its ratio of core capital to adjusted total assets ("core capital ratio") is at least 4.0%, its ratio of core capital to risk- weighted assets is at least 4.0% and its ratio of total capital to risk- weighted assets is at least 8.0%. At December 31, 1993, Fidelity's ratios were 4.15%, 6.27% and 9.32%, respectively. See "Regulation and Supervision--FDICIA Prompt Corrective Action Requirements" and Item 7. "MD&A--Capital Resources and Liquidity." However, Citadel supplemented the Bank's capital in 1993 with two capital infusions totaling $28.0 million, without which the Bank would have had to significantly reduce its assets or at December 31, 1993 the Bank would not have met the 4% core capital requirement of the "adequately capitalized" category, and thus the Bank would have been classified as "undercapitalized" for purposes of the OTS' prompt corrective action regulations. See "Regulation and Supervision--FDICIA Prompt Corrective Action Requirements". Citadel, with only $2.3 million in liquid assets at December 31, 1993, and ongoing expenses in connection with the contemplated Restructuring, is not in a position to make further capital contributions to the Bank, nor does Citadel have ready access to additional funds under current circumstances. See Item 7. "MD&A--Capital Resources and Liquidity." Management anticipates that the Bank will incur losses in the first and second quarters of 1994. The losses will, in the absence of a new capital infusion or a reduction in the Bank's total assets, reduce the Bank's core capital ratio to less than 4%. In an effort to maintain the Bank's core capital ratio above 4% at March 31, 1994 by downsizing its balance sheet, the Bank has entered into an agreement to sell approximately $160 million of single family and multifamily (2 to 4 units) performing loans in the first quarter of 1994. Additionally, in order to maintain the Bank's capital above the regulatory minimums necessary to continue to be designated "adequately capitalized" while the Restructuring is pursued, management continues to explore possibilities for increasing the Bank's capital, either through the issuance of new equity or the sale of assets. Management may also consider further downsizings in the Bank's balance sheet through additional loan sales, although such dispositions of income- producing assets would reduce the Bank's future income. Downsizing options will be limited due to the relative illiquidity of the commercial and multifamily loan portfolio. Because of Fidelity's current capital levels, dividends and distributions from Fidelity will not be available to Citadel for the foreseeable future. Thus, Citadel's current cash balances, together with future dividends from Gateway, are the only sources of cash to Citadel. Gateway's ability to pay dividends to Citadel may be restricted by certain regulatory net capital rules. See "Regulation and Supervision--Gateway." Management believes that Citadel's cash resources will only be sufficient to meet Citadel expenditures through mid-1994. If the Restructuring is not completed at such time, Citadel will be required to raise additional cash to fund its expenditures, and no assurances can be given that Citadel will be able to raise any such funds. The defaults alleged by Chase under the Subordinated Loan Agreement and possible resulting cross defaults under other debt instruments could also adversely affect the liquidity of the Company. See Item 7. "MD&A--Capital Resources and Liquidity." Impact of Not Accomplishing the Restructuring If the Restructuring is not accomplished, the Bank will be required to take other actions to maintain its capital ratios, including the further downsizing of the Bank and the raising of additional equity. If such actions are not successful, the Bank would likely become "undercapitalized" for purposes of the prompt corrective action regulations of the OTS. The consequences of becoming undercapitalized would include, but would not be limited to, (a) the obligation of Fidelity to file a capital restoration plan that is accompanied by an acceptable Citadel guarantee; (b) restrictions on asset growth, branch acquisitions and new activities; (c) a prohibition on dividends and capital distributions by Fidelity (subject to certain limited exceptions); and (d) increased monitoring by the OTS. An acceptable capital restoration plan guarantee would require Citadel to demonstrate appropriate assurances of its ability to perform on the guarantee. Given Citadel's current capital resources and liquidity position, no assurance can be given that such a Citadel guarantee would be found acceptable by the OTS. Failure to provide an acceptable capital restoration plan could result in additional OTS sanctions typically reserved for "significantly undercapitalized" institutions. These discretionary sanctions include, but are not limited to, (a) OTS authority to require the recapitalization, merger or sale of the Bank; (b) divestiture of subsidiaries of the Bank or a holding company divestiture of the Bank; (c) more stringent asset growth restrictions than applicable to "undercapitalized" institutions; and(d) management changes, including election of new directors, and dismissal of directors or senior officers who have held office for more than 180 days, among other things. If the Restructuring is not successful and if the Bank has no viable problem asset disposition alternative, the Bank anticipates that it may be required to increase its GVA to higher levels that cannot currently be determined. Further, should the Restructuring not be accomplished and the Bank's financial condition continue to deteriorate, the future viability of the Bank and Citadel may be significantly threatened unless the Company is able to raise substantial additional capital. Northridge Earthquake The Northridge Earthquake of January 17, 1994, and subsequent aftershocks will adversely affect the Bank's loan and real estate portfolios. The Bank's portfolio includes loans and REO with a net book value of approximately $937 million secured by or comprised of 1,414 multifamily (5 units or more), 15 commercial, and 2,313 single family and multifamily (2 to 4 units) collateral properties in the primary earthquake areas. After the earthquake, the Bank's appraisers surveyed all the multifamily (5 units or more) and commercial properties located in these areas which secured the Bank's loans or constitute REO of the Bank. The Bank also made selected inspections at more remote locations where damage has been reported. In total, approximately 1,450 properties have been inspected. Of such inspected properties, 231 properties, representing loans and REO with a net book value of $140 million, have been identified as having sustained more than "cosmetic" damage. Of such 231 properties, 204 properties related to the Bank's loans and REO with a net book value of $124 million were identified as having "possible serious damage" and an additional 27 properties with a net book value of $16 million were identified as "actually or potentially condemned". The Bank commissioned structural and building engineers or building inspectors to estimate the cost of repairs to properties in these two categories. The cost of repairs has been preliminarily estimated to be $5.7 million and $11.1 million, respectively. Of this total $16.8 million, approximately $6.0 million of seismic damage exceeds the net book value of the related loans and REO. Accordingly, the Bank currently would not expect its losses due to the earthquake to exceed $10.8 million with respect to its commercial and multifamily loans and REO. The Bank expects the actual losses payable by the Bank to be lower because many repair costs may be borne by the borrowers, who in addition to their own funds, may have access to government assistance and/or earthquake insurance proceeds. As part of its normal internal asset review process, the Bank will adjust its reserves as its losses become quantifiable. In addition to the multifamily and commercial assets referenced above, the Bank has identified 2,313 single family and multifamily (2 to 4 units) assets in the affected areas. 173 borrowers with unpaid principal balances totaling $29.4 million called in to report damages through February 8, 1994. The Bank has commenced inspection of these properties and continues to assess damages and potential earnings and loss impact with respect to these properties. The earthquake will also have some adverse affect on loan originations and the sale of financial services in the retail branch network in the near term. RETAIL FINANCIAL SERVICES GROUP Fidelity operates 42 branches in Los Angeles, Orange, San Bernardino, Riverside and Ventura counties. In 1993, Fidelity reorganized internally to provide at each of its branch locations, either directly or through Gateway, a broad array of mortgage products, financial services and investment products to current and potential customers. Fidelity's deposits are highly concentrated in Los Angeles and Orange counties. Each of Fidelity's branches generally has between $40 million and $100 million in deposits. Seventeen of the branches are in the $40 million to $59 million range. Total deposits at Fidelity have decreased since December 1991. Management believes that depositors have reacted to current low interest rates by placing short-term fixed income investments into mutual funds and other uninsured product alternatives. Management believes that, given the highly competitive nature of the Bank's historical business and the regulatory constraints it faces in competing with unregulated companies, the Bank must expand from its historical business focus and adopt a broader product line business strategy. Specifically, management believes that the Bank's existing customers provide a ready market for the sale of nontraditional financial services and investment products. This belief prompted the implementation of a new business strategy for the retail financial services group that integrated its traditional functions (mortgage origination, deposit services, checking, savings, etc.) with the sale of investment services and products by Gateway. Management's objective is to build a "relationship bank" that works with clients to determine their financial needs and offers a broad array of more customized products and services. Through this new strategy of targeting retail and mortgage customers and offering a variety of new investment products and services, Fidelity and Gateway hope to attract more of the Bank customers' deposits, investment accounts and mortgage business. Management believes that this new strategy has been successful, as evidenced by the increase of 22% in total checking accounts at December 31, 1993 over the level a year earlier. As a result of this strategy, fee income should become a growing portion, and net interest income a declining portion, of the Company's total income. Gateway currently sells a combination of investment products including mutual funds, annuities and unit investment trusts. Gateway offers mutual funds of a number of well-known sponsors. The fixed and variable annuities that are offered are issued by insurance companies all of which maintain a rating of A+ or better by A.M. Best. These product offerings are continually under review and change from time to time depending on market demand, management's judgment and product availability. During 1993, Fidelity reorganized the personnel structure of its branches to further its strategy of integrating investment services with its traditional deposit activities. Most branches are now individual profit centers reporting to a branch business manager who has responsibility for determining the sales focus and resource allocation within the branch area. On average, branch staffing consists of eight individuals who are divided into administrative personnel and sales personnel, with a branch operations manager and a financial sales manager reporting to the business manager. The sales group merges the responsibilities of the broker/dealer specialists and the traditional deposit products personnel into the role of a "relationship banker", responsible for selling all deposit and nondeposit product offerings. Relationship bankers will eventually be located at each branch. In connection with its strategy of integrating investment services with its traditional deposit activities, Fidelity conducts its activities in compliance with the February 1994 interagency guidance of the federal bank and thrift regulators on retail sales of uninsured, nondeposit investment products by federally insured financial institutions. In order to minimize customer confusion, Fidelity endeavors to ensure that customers are fully informed that such investment products are not insured, are not deposits of or guaranteed by the Bank and involve investment risk, including the potential loss of principal. Also during 1993, Fidelity and Gateway retrained sales personnel as "relationship bankers." The training program lasted four to eight weeks and covered professional topics from accounting to sales management. The focus of this program was to educate the managers about product offerings, identification of customer needs and profitable operation of a business unit. Appropriate personnel are licensed to sell securities and insurance products. This retail strategy is being reinforced through revised incentive and performance measurements based in part on customer satisfaction levels. Such measurements were implemented during 1993. To support this new marketing effort, Fidelity is upgrading its computer and reporting systems for tracking customer profiles and investment activities, for monitoring demographic data for marketing purposes, and for updating new financial products being offered. Fidelity is also employing customer surveys, focus groups and private interviews to determine actual and potential customer needs and desires and thereby to tailor its financial services and investment products. Management also intends to offer a wider range of loan types than the Bank currently originates. While continuing to offer adjustable rate mortgages and to maintain an expertise in originating and servicing multifamily mortgages, the Bank plans to increase its mortgage banking capabilities and to originate mortgages that, while not appropriate for inclusion in the Bank's portfolio in significant quantities, are attractive to borrowers and to the secondary market. MORTGAGE BANKING GROUP OPERATIONS The Bank conducts its residential real estate lending activities through its Mortgage Banking Group. Operating as a Fidelity division, the Mortgage Banking Group is responsible for originating single family and multifamily residential real estate loans for retention in the Company's loan portfolio or sale to secondary market investors and conduits. After receiving completed loan applications, the Bank reviews applicant credit history, obtains verification of employment and other pertinent financial information, confirms property value through appraisal and completes a transaction evaluation and loan underwriting. Approved loans are then submitted to the Bank's loan funding staff. Payment processing, collection and related loan functions are performed by the Bank's servicing employees. The extent of Fidelity's direct responsibility for applicant information collection and verification may depend on whether business is sourced entirely through its own employees (retail origination) or third parties (as in wholesale or correspondent business). The Mortgage Banking Group has adopted an operating strategy more similiar to that of a mortgage bank than a thrift or savings and loan institution. In the second quarter of 1993, the Bank adopted a requirement that substantially all loan originations meet secondary market standards, to enable the Bank to sell or securitize more loans and thereby enhance its financial liquidity and operating flexibility. The Bank also enhanced its single family loan program features and gave borrowers more competitive interest rate lock-in options for its fixed-rate loan product offerings. The associated increase in the Company's interest rate risk was addressed through modifications of its secondary market capabilities and operations. From 1986 to mid-1992, the Bank had emphasized the origination and retention of loans secured by multifamily property (2 or more units). From mid-1992 to present, emphasis has been redirected toward originating single family residential loans. At December 31, 1993, 71% of Fidelity's loan portfolio was secured by residential properties containing two or more apartment units, 21% by single family residential properties and 8% by other properties. OTS capital regulations established generally lower risk-based capital requirements for loans secured by single family and multifamily properties with 36 or fewer units, than for commercial and consumer loans. See "Regulation and Supervision--FIRREA Capital Requirements." In the first quarter of 1993, the Bank completed a reorganization of its real estate lending operations. The loan origination function was separated into two divisions: a Residential Production Division, focused on increasing the volume of single family mortgages and two to four unit loan products; and a Major Loan Production Division, responsible for the Bank's five or more unit residential lending. The Bank also consolidated all "retail" mortgage application processing and underwriting in one business unit located in its administration center. All single family loan production personnel were relocated from regional lending offices and assigned to key branch locations, furthering the integration of mortgage products into the Bank's retail financial services delivery system. These actions resulted in the closure of two of the Bank's four existing regional lending offices as well as the refocus of the remaining regional offices solely on five unit or over loan originations. The Bank also started a new business effort designed to increase single family and two to four unit origination from third party loan brokers. A number of staff additions were made in 1993 to implement this operational plan. Fidelity's overall goal is to reposition itself in the residential lending business as a secondary market, mortgage banking-oriented loan originator. In retail loan origination, the Bank's employees have direct control over verification of necessary applicant income, deposit and credit information as well as other important elements of the application process. This is in contrast to third party mortgage origination or wholesale business, where approved loan brokers assemble key application material and verifications and submit these completed information packages to the Bank for underwriting, approval and funding. Wholesale mortgage origination offers the opportunity for increased loan funding volume at lower fixed operational expense than would be possible through retail mortgage origination. However, since a greater portion of the application processing and information verification is performed by the third-party loan brokers, wholesale business poses greater credit risk than retail loan originations. The Bank has addressed this potential credit quality issue through qualification standards for approval of new loan broker accounts as well as underwriting practices and quality control procedures. In addition to the structural reorganization of its multifamily loan origination function discussed above, the Bank took severe measures in 1993 to reposition its multifamily lending business orientation and to revise its multifamily lending criteria. From January to April 1993, the Bank sharply curtailed new multifamily loan generation by limiting new transactions to purchase money funding or the refinancing of existing loans and reassigning key major loan production staff to internal multifamily loan due diligence and property inspection teams. Significantly reduced multifamily business origination and lower funding levels resulted from these actions. Over the January to April interval, the Company reevaluated its multifamily loan approval guidelines and operational practices, resulting in new underwriting procedures and more conservative qualifying standards. When multifamily business origination was resumed in May, the Major Loan Production Division instituted a new multifamily property scoring system that establishes a numerical score and corresponding letter grade for each multifamily loan request. The score and grade then determine qualifying loan-to-value ratios and debt service coverage requirements, with higher-graded properties eligible for more favorable underwriting guidelines. Transaction review procedures were also modified so that multifamily transactions now require, at a minimum, two loan officer signatures for final loan approval. The Bank believes these operational enhancements and evaluation measures provide adequate business credit quality and are appropriate due to current adverse multifamily property operating economics and market values in the geographic areas where the Bank's loan portfolio is concentrated. While the Bank is aware that certain of its underwriting guidelines and standards may be more conservative than other local market competitors, and thus may decrease new business volume, the Bank believes that the multifamily origination effort remains competitive and increases the Bank's ability to securitize the multifamily loan product. Until the third quarter of 1993, almost all loans funded were generated through employee loan personnel and outside loan agents. Outside loan agents are independent real estate brokers who are compensated on a commission basis upon funding of their loans. Beginning in the third quarter of 1993, however, Fidelity's single family origination volume increasingly came from third party loan brokers, reflecting the Bank's conscious decision to develop and expand this residential mortgage origination channel as discussed above. In July 1993, the Bank opened and staffed two loan origination offices devoted exclusively to processing single family and two to four unit residential loan applications from third party loan brokers or "wholesale" mortgage business. A third wholesale office became fully operational in October. The Bank plans to open additional wholesale operations in 1994, including one or more offices in Northern California. Fidelity made significant enhancements in its internal computer systems and reporting capabilities in 1993. In October, the Bank converted its loan servicing operation to a new computer system which is expected to result in systems expense reduction in 1994. The Bank also installed a new automated loan application processing and tracking computer system which will further its mortgage banking and secondary marketing capabilities. Multifamily Residential Loans The Company offers adjustable rate mortgage ("ARM") loans secured by apartment buildings with 2 or more units with a maximum amortized loan term of 30 years, with some loans having balloon payments due in 15 years. A majority of Fidelity's ARM loans adjust with the FHLB Eleventh District Cost of Funds Index ("COFI"), with a monthly interest rate adjustment commencing after an initial introduction period of up to six months. Since the borrower's monthly payment amount adjusts only annually, if COFI increases, these loans can negatively amortize if the monthly payment is not sufficient to pay in full the additional interest accruing on the loan. Although multifamily loans in the Company's loan portfolio contain a due-on-sale clause, by their terms they are generally transferable to a purchaser of the property if the purchaser meets the Company's credit standards. Multifamily real estate lending entails certain risks different from those posed by single family residential lending. Multifamily and commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. In addition, the payment experience on loans secured by multifamily and commercial real estate is typically dependent on the successful operation of the related real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy in general than are loans secured by single family properties. Multifamily ARM loans may have greater vulnerability to default than fixed rate loans during times of increasing interest rates due to the potential for increase in the amount of a borrower's payment obligations, while the borrower's income from the property may not increase. See "ARM Loans." The Company is concerned about the elevated delinquency rates and loan restructuring requests being experienced in certain parts of its multifamily portfolio. Among other things, with respect to its multifamily loan portfolio, the Company is also concerned about: (a) increasing vacancy rates which diminish the ability of the property to service the underlying loan; (b) decreasing apartment rental rates; (c) the potentially greater willingness of investors to abandon such properties or seek bankruptcy protection, particularly where such properties are experiencing negative cash flow and the loans are not cross-collateralized by other performing properties; (d) the substantial decreases in the market value of multifamily properties experienced in recent periods (resulting, in many cases, in appraised or resale values less than the outstanding loan balances) and the general illiquidity of such properties at the current time in Southern California; (e) the comparative illiquidity of multifamily residential mortgages, given the limited secondary market for such mortgages; and (f) potential losses resulting from the January 1994 Northridge Earthquake. On March 18, 1994, the OTS published a final regulation effective on that date that permits a loan secured by multifamily residential property, regardless of the number of units, to be risk-weighted at 50% for purposes of the risk-based capital standards if the loan meets specified criteria relating to term of the loan, timely payments of interest and principal, loan-to-value ratio and ratio of net operating income to debt service requirements. Under the prior rule, loans secured by multifamily residential properties with more than 36 units were required to be risk-weighted at 100%. As of December 31, 1993, Fidelity held $406.3 million in loans secured by multifamily residential properties with 37 or more units and therefore risk- weighted at 100%, some of which qualify for 50% risk-weighting under the criteria of the new regulation. Thus, Fidelity's risk-based capital ratio could increase. However, the additional criteria of the new rule could cause some of Fidelity's existing loans secured by 5 to 36 unit residential properties to increase in risk-weighting from 50% to 100%. See "Regulation and Supervision-- FIRREA Capital Requirements." The ultimate impact on Fidelity of the new regulation has not been determined. Single Family Residential Loans The Bank offers single family residential mortgage loans with fixed interest rates having maximum amortization loan terms of up to 30 years. Some single family loan programs have maturities of only 15 years or balloon payments due in 5 or 7 years. Due to the interest rate risk presented by the holding of fixed rate loans combined with variable cost sources of funding, the Bank sells substantially all originations of fixed rate residential 1 to 4 unit loans to secondary market investors. While this reduces the interest rate exposure from a portfolio investor standpoint, there remains the risk associated with adverse movements in interest rates from the date of loan application to approval, investor settlement and final delivery. In the second quarter of 1993, Fidelity modified and augmented internal policies to provide for greater management control of loan pipeline interest rate risk exposure. During the same quarter, the Bank also entered into a consulting arrangement with a nationally recognized organization for daily pipeline valuation services, hedging strategies and trading execution. This agreement provided Fidelity with state- of-the-art computer-based valuation methodology for application tracking and securities commitments necessary for mortgage pipeline hedging management until these capabilities were developed internally. In October 1993, the Bank reduced the consulting arrangement to an advisory service, with hedging management being performed internally. The Bank will assess on a regular basis the continuation of this pipeline tracking and valuation advisory service arrangement over in-house alternatives. Management anticipates that secondary market practices and pipeline interest rate risk management techniques will continue to be enhanced in 1994 to provide higher quality data transmission and more efficient product pricing and delivery to secondary market investors. The Bank also offers ARM loans secured by owner and non-owner occupied single family residences with a maximum amortized loan term of 30 years. ARM loans adjust with the one-year U.S. Treasury index or COFI with a monthly interest rate adjustment commencing after an initial introduction period of up to six months. Since the borrower's payment amount adjusts annually for the loans indexed to COFI, if COFI increases these loans can negatively amortize if the monthly payment is not sufficient to pay in full the additional interest accruing on the loan. Although single family ARM loans in the Bank's loan portfolio contain a due-on-sale clause, by their terms they are transferable to a purchaser of the property if the purchaser meets the Bank's credit standards. See "ARM Loans" for further discussion of the Bank's asset/liability strategy. Home Equity Loans The Bank offers home equity credit lines. The maximum term of the credit lines offered is 15 years. All of the credit lines provide for variable interest rates based on a prime rate. These loans are generally underwritten using a maximum loan-to-value ratio of between 70% and 75%. The total of undrawn credit lines plus outstanding balances at December 31, 1993, 1992 and 1991 was $108 million, $129 million and $138 million, respectively. The decline in undrawn credit lines plus outstanding balances was due to a slowdown in new credit facility growth over the 1992 to 1993 period. New home equity credit lines originated during 1993, 1992 and 1991 totaled approximately $13.6 million, $26.9 million and $42.5 million, respectively. In 1993, new home equity credit line originations declined 49% from 1992 levels as a function, the Bank believes, of borrowers accessing equity in their homes through refinancings of their mortgage loans, as well as lower homeowner equity, as single family housing appraisals fell from higher values of prior years. In addition, in May 1993, management implemented a new $300 home equity application fee which also contributed to the home equity volume reduction from 1992 levels. Portfolio statistics All presentations of the Company's total loan portfolio include loans receivable and loans held for sale unless stated otherwise. The following table sets forth the composition of the Company's total loans receivable by type of security at the dates indicated: The following table sets forth the composition of the Company's loans held for sale, which are included in the table above, by type of security at the dates indicated: The following table presents the Company's gross mortgage loans by type and location as of December 31, 1993: - -------- (1) Includes home equity loans of $55,060 and $1,286 on single family and multifamily (2 to 4 units) properties, respectively. Therefore, including the home equity loans, loans on single family and multifamily (2 to 4 units) properties total $792,054 and $505,219, respectively. The following table sets forth the types of loans by repricing attribute, held by the Company at the dates indicated: The following table sets forth by contractual maturity and interest rate, the Company's fixed rate and adjustable rate real estate loan portfolio at December 31, 1993. The table does not consider the prepayment experience of the loan portfolio when scheduling the maturities of loans. See Item 7. "MD&A--Interest Rate Risk Management." The following table details the activity in the Company's loan portfolio for the periods indicated: - ------- (1) Includes loans originated to finance sales of REO of $51.6 million, $11.2 million and $1.6 million, for the years ended December 31, 1993, 1992 and 1991, respectively. In 1990 and 1989 loans originated to finance sales of REO were insignificant. (2) Net of repurchases. Declines in total real estate loans originated in 1993 and 1992 were due primarily to the curtailment of multifamily origination during the reorganization of the Mortgage Banking Group and the imposition of more stringent multifamily loan underwriting criteria. Declines in loan originations in 1991 were due primarily to the Company's decision to reduce assets to strengthen its capital ratios. Sale of Loans Over the past several years, the Company has sold most of its current production of fixed rate single family residential loans in the secondary mortgage market and has retained its ARM production. Loan sales totaled approximately $138.4 million, $204.4 million and $282.7 million for the years ended December 31, 1993, 1992 and 1991, respectively. In addition, sales of mortgage-backed securities totaled $522.1 million, $0 and $273.1 million, respectively, in the three years. Fidelity is an approved originator and servicer for the Federal National Mortgage Association (the "FNMA"), the Federal Home Loan Mortgage Corporation (the "FHLMC"), the Federal Housing Administration (the "FHA") and the Veterans Administration (the "VA"). As Fidelity's single family lending volumes increase, sales of loans in the secondary mortgage market will increase. In the beginning of 1993, Fidelity concentrated on selling all fixed rate loans it originated into the secondary market to maximize liquidity and reduce interest rate risk. During 1993, the Company approved a policy of more active management of its loans and investment portfolio with a view toward disposition of securities with unfavorable risk/return profiles and to allow more asset/liability management and asset size flexibility to facilitate further downsizing of the Bank. To this end, the Company designated $321 million of certain adjustable rate mortgage loans meeting specific criteria as held for sale as of December 31, 1993. In connection with loan sales, Fidelity is required to make representations and warranties with respect to the loans and their underwriting criteria. These representations and warranties create a contingent liability to repurchase the loans to the extent they are subsequently found to be untrue. ARM Loans To assist in reducing the sensitivity of its earnings to interest rate fluctuations, Fidelity has emphasized the origination of ARMs for its portfolio. ARMs help to improve the matching of interest rate repricing between Fidelity's asset and liability portfolios. ARMs reduce the interest rate risk inherent in a portfolio of long-term mortgages by repricing each individual asset at regular intervals over the life of the asset. The initial period before the first adjustment varies between one month and five years. ARM loans represented 52% of all loans funded in 1993 and 96% of the total loan portfolio at December 31, 1993. Fidelity's ARMs generally bear an interest rate which periodically adjusts at a stated margin (the "contractual spread") above COFI, which is the index which most closely matches Fidelity's liability base. The risk of different asset and liability repricing can be reduced by diversifying the ARM portfolio. Other ARMs originated are generally indexed to U.S. Treasury indices, which more closely match the repricing speed of deposits, but are more volatile than a COFI index. ARMs may have greater vulnerability to default than fixed rate loans during times of increasing interest rates due to the potential for substantial increase in the amount of a borrower's payments or, to the extent payments do not increase, erosion of a borrower's equity in the underlying property. Risks of default are reduced by caps on both the maximum interest that can be charged and the amount by which a borrower's payments can be periodically increased. However, during periods of significant interest rate increases, interest rate caps can adversely affect interest rate margins and payment caps can increase borrower exposure to negative amortization, unless the loan contains a prohibition on negative amortization. When the borrower's payment is not sufficient to cover the computed interest amount, negative amortization occurs and the difference then increases the principal balance of the loan. Fidelity uses a combination of interest rate caps and payment caps to reduce risk of default, and to date, negative amortization has not adversely affected Fidelity's default ratios. At December 31, 1993, the total negative amortization included in the loan portfolio was $0.7 million compared to $3.7 million at December 31, 1992. During periods of declining interest rates, ARMs with high interest rate caps relative to market are vulnerable to prepayment as borrowers refinance into ARMs with lower caps or into fixed rate loans. Fidelity has also attempted to minimize the risk of default associated with all ARMs by using the COFI (a relatively stable index) for adjustment, thereby limiting interest rate volatility over short periods, and utilizing loan-to-value ratios generally not in excess of 80% unless private mortgage insurance is obtained. During periods of declining interest rates, ARMs with negative amortization potential will experience accelerated amortization, thereby offsetting, in whole or in part, previously incurred negative amortization, if any, or reducing the principal balance ahead of the original schedule. Most of Fidelity's ARMs provide for a lifetime interest rate cap (currently ranging from 1.875% to 6.250% above the initial rate). A limited number of Fidelity's ARMs also provide for an annual interest rate cap. In addition, for competitive reasons, ARMs are often offered at an initial reduced interest rate (the "introductory rate") for a period of time (one, three, or six months). Fidelity's ARMs are underwritten for credit purposes based on the pro forma payment which would be required at the fully-indexed rate or at the time of the first interest rate adjustment, depending on the type of property. Fidelity currently offers primarily three types of ARMs. One type has a lifetime interest rate cap and payment cap on the amount by which monthly payments can increase from one annual or semiannual payment adjustment to the next; another type provides for a lifetime interest rate cap but includes payment adjustments concurrent with interest rate adjustments without a cap on the payment increase; and the last type provides for an initial five-year fixed rate of interest after which it reverts to the type of ARM first described above. CREDIT ADMINISTRATION Appraisal and Underwriting Standards All properties taken as collateral are appraised utilizing either an outside appraiser or a Fidelity staff appraiser. Fidelity requires that loans secured by real estate be approved at various levels of management, depending upon the size of the loan. Until 1991, Fidelity had a low delinquency rate on all of its single family and multifamily loans as well as its commercial properties located in California. However, with worsening economic conditions and declines in the real estate values in Southern California, delinquency rates have been steadily increasing. Fidelity has reassessed its underwriting practices and, in light of current conditions, has taken steps to increase qualifying ratios including debt service coverage minimums and loan-to-value maximums. During the underwriting process for single family loans, Fidelity obtains information regarding the applicant's income, financial condition, employment and credit history to determine the applicant's ability to service the debt obligations. Fidelity underwrites loans pursuant to internal underwriting criteria as well as to the requirements of the secondary market for such loans or special investor needs. Increasing third party generation of single family loans will require Fidelity to maintain strict underwriting and quality control standards. Fidelity's underwriting standards for multifamily and commercial real estate lending require the underwriter to review an applicant's experience in owning and operating such type of income-producing property to determine if the applicant is qualified to manage such property. At the time of origination, Fidelity reviews the borrower's financial resources, credit history and income- producing capacity, verifies employment, reviews an appraisal of the security property, analyzes the anticipated occupancy, operating expenses and cash flow of income-producing properties, and performs other underwriting procedures. In accordance with its underwriting guidelines Fidelity generally requires a minimum debt coverage ratio (net operating income divided by debt service payment) of from 112% to 130%, depending on the rated quality of the property, whether the loan involves the arms-length market sale of the property or is a refinancing and if it is a refinancing whether there is "cash out" or "no cash out." The debt service coverage ratio is calculated on actual occupancy figures typically utilizing a 10% vacancy factor and using a payment which is the greater of a fully indexed rate, start rate or (typically higher) qualifying rate. The Bank also limits its loans to a maximum of 50% to 75% of the appraised value of the property, again depending on the rated quality of the property and other circumstances outlined above with respect to debt service coverage. Loan Portfolio Risk Elements Fidelity's loan portfolio risk elements and credit loss experience may be more clearly understood when the following sections are read in conjunction with Item 7. "MD&A--Asset Quality." Fidelity originates loans with the expectation that borrowers will honor their repayment obligations. In an attempt to reduce credit risk, Fidelity maintained the underwriting criteria described above. As is the case with other lenders, however, some of Fidelity's borrowers have or will become unable or unwilling to pay interest or principal when due. The reasons for such defaults include, without limitation, (a) adverse conditions in the regional or national economy; (b) unemployment; (c) an oversupply of apartments for lease; (d) an increase in vacancies; (e) a decline in real estate values; (f) declines in rents; and (g) loss of equity. If the borrower is unable to meet his obligation but is willing to make an additional financial commitment to the property securing the loan, Fidelity may restructure the loan to more closely match the reduced cash flow and value of the collateral. In other circumstances, Fidelity commences proceedings to foreclose upon the property securing the loan. Such proceedings may be delayed by litigation or bankruptcy initiated by the borrower. Fidelity's risk of loss relates both to the frequency of such defaults and to the severity of loss, namely, the excess, if any, of the outstanding principal balance of the loan plus accrued interest over the amount realized upon ultimate disposition of the collateral. In rare instances, Fidelity may be able to recover all or some of the loss it incurs from other assets of the borrower. Fidelity also is exposed to loss if the value of the collateral declines between the time of foreclosure and the time of resale. Fidelity is also exposed to loss to the extent that it is required to invest significant funds to foreclose on and sell its collateral, which may include rehabilitating dilapidated or distressed collateral. Loan Monitoring Fidelity has established a monitoring system for its loan portfolio to attempt to identify potential problem loans. Loans that are currently performing but have met certain criteria requiring further scrutiny are placed on a "watch list". These criteria include, but are not limited to, a large outstanding balance, collateral performing in an inadequate manner, origination for the purpose of facilitating the sale of real estate owned by Fidelity, and other high risk characteristics identified through the internal asset review process that warrant further analysis. Fidelity's relationship management group actively gathers updated operating information on large multifamily loans. The following table details Fidelity's net loans which are 30 to 89 days delinquent at the dates indicated: The following table presents net delinquent loans at December 31, 1993, including those detailed above (30 to 89 days delinquent) as well as those 90 days or more delinquent: Nonaccrual Loans The Bank generally places a loan on nonaccrual status whenever the payment of interest is 90 or more days delinquent, or earlier if a loan exhibits materially deficient characteristics. At December 31, 1993, $13.6 million of loans were less than 90 days delinquent but had been placed on nonaccrual status. Loans on nonaccrual status are resolved by the borrower bringing the loan current, by the Company and the borrower agreeing to modify the terms of the loan or by foreclosure upon the collateral securing the loan. See "Restructured Loans" and "Foreclosure Policies." The following table presents Fidelity's net nonaccrual loans by type of collateral at the dates indicated: - -------- (1) Includes loans over 90 days contractually delinquent and other nonaccrual loans. It is the Company's policy to reserve all earned but unpaid interest on loans placed on nonaccrual status. The reduction in income related to nonaccrual loans upon which interest was not paid was $8.7 million, $13.6 million, and $7.6 million in 1993, 1992 and 1991, respectively. The following table presents net nonaccrual loans by property type and location at December 31, 1993: Restructured Loans The Bank has modified the terms of a number of its loans. In some cases, the modifications have taken the form of "early recasts" in which the amortizing payments are revised (or recalculated) earlier than scheduled to reflect current lower interest rates. In other cases, the Bank has agreed to accept interest only payments for a limited time at current interest rates. In still other cases, the Bank has reduced the loan balance in exchange for a paydown of the loan or otherwise modified loans at terms that are less favorable to the Bank than the current market. These loans have interest rates that may be less than current market rates or may contain other concessions. Modified loans are categorized as TDRs by the Bank when the modification contains concessions to the borrower that the Bank would not otherwise consider except for the borrower's poor financial condition. The following table presents TDRs by property type at December 31, 1993 and 1992: Of the total $87.3 million of TDRs at December 31, 1992, during 1993, the terms of the modification expired on $39.8 million which are performing in accordance with their original terms (of which $19.6 million are classified as Substandard, $6.2 million are categorized as Special Mention and $14.0 million are Pass assets), $20.4 million became nonperforming loans, $9.8 million defaulted and were foreclosed, $3.5 million became ISF, $0.5 million was paid, and $13.3 million continued to be categorized as TDRs at December 31, 1993. The following table presents TDRs at December 31, 1993, by property type and location: The following table presents the loan balances of the TDRs at the dates indicated by the type of modification: - -------- (1) $1.0 million in actual principal forgiveness in 1993 on $3.3 million of outstanding loans. During 1993, interest income of $8.3 million was recorded on TDRs, $0.1 million less than would have been recorded had the loans performed according to their original terms. In 1992, the amounts were $10.0 million and $0.3 million, respectively. During 1991, $0.7 million of interest income was recorded on TDRs, which consisted of one loan of $6.9 million at year-end 1991. The modification of this loan did not result in any reduction of interest income in 1991. The Bank did not have any TDRs at December 31, 1990 or 1989. Please refer to Item 7. "MD&A--Asset Quality" for further information on nonperforming assets during 1993 and 1992. Internal Asset Classifications The OTS has promulgated a regulation and issued other regulatory guidance requiring savings institutions to utilize an internal asset classification system as a means of reporting problem and potential problem assets for regulatory supervision purposes. The Bank has incorporated the OTS' internal asset classifications as a part of its credit monitoring system. The Bank currently designates its assets as Pass, Special Mention, Substandard, Doubtful, or Loss. A brief description of these categories follows: A Pass asset is considered of sufficient quality to preclude designation as Special Mention or an adverse classification. Pass assets generally are protected by the current net worth and paying capacity of the obligor or by the value of the asset or underlying collateral. An asset designated as Special Mention does not currently expose an institution to a sufficient degree of risk to warrant an adverse classification. However, it does possess credit deficiencies or potential weaknesses deserving management's close attention. If uncorrected, such weaknesses or deficiencies may expose an institution to an increased risk of loss in the future. An asset classified as Substandard is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness or weaknesses. They are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Assets classified as Doubtful have all the weaknesses inherent in those classified as Substandard. In addition, these weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable or improbable. The Bank views the Doubtful classification as a temporary category. The Bank will generally classify assets as Doubtful when inadequate data is available or when such uncertainty exists as to preclude a Substandard classification. Therefore, the Bank will normally tend to have a minimal amount of assets classified in this category. Assets classified as Loss are considered uncollectible and of such little value that their continuance as assets without establishment of a specific reserve is not warranted. A Loss classification does not mean that an asset has absolutely no recovery or salvage value; rather it means that it is not practical or desirable to defer establishing a specific allowance for a basically worthless asset even though partial recovery may be effected in the future. The Bank will generally classify as Loss the portion of assets identified as exceeding the asset's fair market value and a specific reserve is established for such excess. A "classified asset" is one that has been designated a Substandard, Doubtful or Loss. Classified assets do not include Special Mention or Pass assets. All of the foregoing standards require the application of considerable subjective judgments by the Bank. The following table summarizes Fidelity's net classified assets at the dates indicated: - -------- (1) For presentation purposes, NPAs include REO net of REO GVA. The following tables present the quarterly data for 1993 and 1992 of Fidelity's net classified assets: Loans meeting certain criteria are accounted for as ISFs. These substantially foreclosed assets are recorded at the lower of the loan's book value or at the estimated fair value of the collateral at the date the loan was determined to be in-substance foreclosed. These assets are reported as "real estate owned" as if they were formally foreclosed real estate. The estimated fair value is based on the net amount that the Bank could reasonably expect to receive for the asset in a current sale between a willing buyer and a willing seller, that is, other than in a forced or liquidation sale. Inherent in the estimated fair value of these properties are assumptions about the length of time the Bank may have to hold the property before disposition. The holding costs through the expected date of sale and estimated disposition costs are considered in the valuations. CREDIT LOSS EXPERIENCE Credit losses are inherent in the business of originating and retaining real estate loans. As previously discussed, the Bank, in an effort to identify and mitigate the risk of credit losses in a timely manner, performs periodic reviews of any asset that has been identified as having potential excess credit risk. The Bank maintains specific departments with responsibility for resolving problem loans and selling real estate acquired through foreclosure to facilitate this process. Valuation allowances for estimated potential future losses are established on a specific and general basis for loans and real estate owned. Specific reserves for individual assets are determined by the excess of the recorded investment over the fair market value of the collateral or property when it is probable that the asset has been impaired. General valuation allowances are provided for losses inherent in the loan and real estate portfolios which have yet to be specifically identified. The GVA is based upon a number of factors, including historical loss experience, composition of the loan and real estate portfolios, loan delinquency experience patterns, loan classifications, prevailing and forecasted economic conditions and management's judgment. A more detailed discussion of the Bank's policies for determining valuation allowances is presented in Item 7. "MD&A--Asset Quality" and in Note 6 to the consolidated financial statements. See also "Real Estate Acquired in Settlement of Loans." The following table sets forth Fidelity's GVA and specific reserves by loan or real estate portfolio as of December 31, 1993: The following summarizes Fidelity's GVA to total loans and real estate owned and GVA to NPAs for the period indicated: - -------- (1) Loans and REO in this ratio are calculated prior to the reduction for loan and REO GVA, but are net of specific reserves. (2) NPAs in this ratio are calculated prior to the reduction for REO GVA. The following summarizes the activity in Fidelity's allowance for estimated loan losses for the periods indicated: The following table presents loan and REO charge-offs by property type and year of loan origination for the year ended December 31, 1993: The following table presents loan and REO charge-offs by property type and year of loan origination for the year ended December 31, 1992: The following table presents Fidelity's real estate loan portfolio (including loans held for sale) as of December 31, 1993 by year of origination and type of security: During the years 1990, 1989 and 1988, Fidelity originated loans at peak levels totaling $1,211.3 million, $897.6 million and $1,467.1 million, respectively. During 1993, the Bank reserved and/or charged off amounts corresponding to these peak origination years totaling $36.5 million, $10.4 million and $11.3 million, respectively. These losses were due primarily to the decline of the California economy and real estate market. Multifamily (5 or more units) and commercial loans accounted for a substantial percentage of such losses, and as a result, the Bank has reduced recent loan origination activities in these areas. However, continued downward pressure on the economy and real estate market could lead to additional losses in these portfolios. The high level of provisions for loss and charge-offs during 1993, 1992 and 1991 is primarily due to a depressed market for real estate in Southern California. If recent economic trends do not abate, it is likely that additional charge-offs and reserves will be required and if future declines in the Southern California economy and real estate market are substantial, it is likely that the future corresponding charge-offs and reserves will also be significant. FORECLOSURE POLICIES The Bank typically initiates foreclosure proceedings between 30 and 90 days after a borrower defaults on a loan. The proceedings take at least four months before the collateral for the loan can be sold at "foreclosure" auction, and this period can be extended under certain circumstances, such as, if the borrower files bankruptcy or if the Bank enters into negotiations with the borrower to restructure the loan. In California, foreclosure proceedings almost always take the form of a nonjudicial foreclosure, upon the completion of which the lender is left without recourse against the borrower for any deficiency or shortfall from the difference between the value of the collateral and the amount of the loan, and in most cases the Bank ends up with title to the property. In some cases, while the foreclosure proceedings are under way, the borrower requests forbearance from collection efforts, more time to cure the default, or a restructuring of the loan. The Bank agrees to such a request if it determines that the loan, as modified, is likely to result in a greater ultimate recovery than taking title to the property. Among the factors the Bank considers in granting the borrower a concession is the extent to which the borrower pays down the loan, furnishes more collateral or makes a further investment in the property by way of repairs or refurbishment, and demonstrates an awareness and ability to manage the property according to a reasonable operating plan. REAL ESTATE ACQUIRED IN SETTLEMENT OF LOANS Real estate acquired in settlement of loans results when property collateralizing a loan is foreclosed upon or otherwise acquired in satisfaction of the loan and the Bank takes title to the property. This property owned by the Bank is included in REO. The Bank experiences foreclosures as part of the normal process of conducting its primary business activity, real estate lending. Certain loans are also included in REO when they exhibit characteristics more closely associated with the risk of real estate ownership than with loans. These loans are designated in-substance foreclosures if they meet the following criteria: (a) the borrower currently has little or no equity at fair market value in the underlying collateral; (b) the only source of repayment is the property securing the loan; and (c) the borrower has abandoned the property or will not be able to rebuild equity in the foreseeable future. Collateral that has been categorized as ISF is reported in the same manner as property that is owned by the Bank. ISFs and property owned by the Bank differ in one key respect: the Bank can only sell or dispose of property it owns. As with any loan, it must complete foreclosure of an ISF before it can sell the underlying collateral. As a result of the adoption of SFAS No. 114, beginning January 1, 1994, loans that meet the criteria for ISF designation will no longer be reported as REO, although they will continue to be valued based on the fair value of the collateral and will generally continue to be included in NPAs. The following table presents Fidelity's net REO, including ISF, by property type at the dates indicated: - -------- (1) Foreclosed real estate is shown net of first trust deed loans to others, where applicable. The following table presents the Bank's real estate acquired in settlement of loans (ISF is excluded) by location and property type at December 31, 1993: The following table presents the Bank's ISF by location and property type at December 31, 1993: In the current market, the Bank rarely sells REO for a price equal to or greater than the loan balance, and the losses suffered are impacted by the market factors discussed elsewhere in this report. REO is recorded at acquisition at the lower of the recorded investment in the subject loan or the fair market value of the assets received. The fair market value of the assets received is based upon a current appraisal adjusted for estimated carrying, rehabilitation and selling costs. Income-producing properties acquired by the Bank through foreclosure are managed by third party contract managers, under the supervision of Bank personnel. During 1993 and 1992, the Bank's policy has been generally to proceed promptly to market the properties acquired through foreclosure, and the Bank often makes financing terms available to buyers of such properties. Generally, the Bank experiences higher losses on sale of REO properties for all cash, as opposed to financing the sale, although when it finances the sale, the Bank incurs the risk that the loan may not be repaid in full. During 1993, the Bank sold 210 REO properties for net sales proceeds of $83.5 million, with a gross book and net book value totaling $138.5 million and $89.8 million, respectively. This compares to 43 properties sold in 1992 for net sales proceeds of $25.6 million, with a gross book and net book value of $34.9 million and $27.6 million, respectively. The Bank made 107 loans in connection with the sale of REO for the year ended December 31, 1993 for a total of $51.6 million. Of these, $10.9 million contained terms favorable to the borrower that were not available for the purchase of non-REO property. The comparable data for 1992 were 15 loans for $11.2 million, of which $10.7 million were made with favorable terms. The following table shows real estate sold by property type during the years indicated: Direct costs of foreclosed real estate operations totaled $18.8 million, $3.6 million and $1.1 million for the years ended December 31, 1993, 1992 and 1991 respectively. The large increase in 1993 over 1992 is due primarily to an increase in the number of properties foreclosed in 1993 over 1992. During 1993, the Bank foreclosed on 282 properties with a gross book value of $204.7 million compared to 139 properties with a gross book value of $112.9 million, during 1992. The average number of REOs held during 1993 was 205 compared to 117 during 1992. Property tax expense on foreclosed property for the year ended 1993 was $5.1 million (at the time of foreclosure, a typical property was delinquent for three property tax payments). Due to the deterioration in the real estate market in Southern California, property tax assessments are generally higher than the appraised value of REO properties at the time of foreclosure. The Bank's policy is to appeal all property tax valuations on REO property at the time of acquisition. INVESTMENT ACTIVITIES As a matter of prudent business practice, Fidelity maintains assets that are easily liquidated or otherwise saleable to meet unexpected funding requirements. Fidelity also is required by federal regulations to maintain a minimum level of liquid assets which may be invested in certain government and other specified securities. See "Regulation and Supervision--Required Liquidity." Investment decisions are made within guidelines approved by Fidelity's Board of Directors. Such investments are managed in an effort to produce a yield consistent with maintaining safety of principal and compliance with applicable regulations. The Company's securities portfolio consisted of the following at the dates indicated: The following table summarizes the maturity and weighted average yield of the Company's investment securities at December 31, 1993: Interest income from the investment portfolio contributed 6.5%, 3.9% and 4.3% of the Company's total revenue not including the impact of real estate loss provisions and direct costs of real estate operations, for the years ended December 31, 1993, 1992 and 1991, respectively. SOURCES OF FUNDS The Company derives funds from deposits, FHLB Advances, securities sold under agreements to repurchase, and other short-term and long-term borrowings. In addition, funds are generated from loan payments and payoffs as well as from the sale of loans and investments. Deposits The largest source of funds for the Company is deposits. Customer deposits are insured by the FDIC up to $100,000 per account. The Company has several types of deposit accounts designed to attract both short-term and long-term deposits. The following table sets forth the weighted average interest rates paid by the Company and the amounts of deposits held by the Company at the dates indicated: The following table provides additional deposit information by remaining maturity at December 31, 1993: Certificates of deposits of $100,000 or more accounted for $592.7 million and represented 17.6% of all deposits at December 31, 1993; $549.5 million or 15.9% of all deposits at December 31, 1992 and $628.5 million or 16.2% of all deposits at December 31, 1991. Fidelity intends to continue to use such certificates of deposit as a source of funds to manage its liquidity. However, a significant increase is not currently expected. The following table summarizes certificates of deposit of $100,000 or more by remaining maturity and weighted average rate at December 31, 1993: The distribution of certificate accounts by date of maturity is an important indicator of the relative stability of a major source of lendable funds. Longer term certificate accounts generally provide greater stability as a source of lendable funds, but currently entail greater interest costs than passbook accounts. The following table summarizes certificate accounts by maturity, as a percentage of total deposits and weighted average rate at December 31, 1993: The Bank also utilizes brokered deposits as a short-term means of funding. These deposits are obtained or placed by or through a deposit broker and are subject to certain regulatory limitations. Should the Bank become undercapitalized, it would be prohibited from accepting, renewing or rolling over deposits obtained through a deposit broker. See "Regulation and Supervision--FDICIA Prompt Corrective Action Requirements." The following table summarizes the Bank's outstanding balance of brokered deposits at the dates indicated: Borrowings The Company utilizes borrowings from the FHLB System ("FHLB Advances") as a source of funds for operations. The FHLB System functions as a source of credit to savings institutions which are members of a Federal Home Loan Bank. See "Regulation and Supervision--Federal Home Loan Bank System." Fidelity may apply for advances from the FHLB secured by the capital stock of the FHLB owned by Fidelity and certain of Fidelity's mortgages and other assets (principally obligations issued or guaranteed by the United States Government or agencies thereof). Advances can be requested for any business purpose in which Fidelity is authorized to engage, except that advances with a term greater than 5 years can be granted only for the purpose of providing funds for residential housing finance. In granting advances, the FHLB considers a member's creditworthiness and other relevant factors. FHLB Advances to Fidelity totaled $326.4 million, $581.4 million, and $325.0 million at December 31, 1993, 1992 and 1991, respectively. The decreased use of FHLB Advances in 1993 as a source of funds results primarily from the use of commercial paper, which is less costly, as an alternate source of funds. Fidelity's available FHLB line of credit is based primarily on a portion of Fidelity's residential loan portfolio pledged for such purpose, up to a maximum 25% of total assets. At December 31, 1993, Fidelity's remaining available line of credit was $297.7 million, after deducting outstanding advances and a $304.0 million backup letter of credit for outstanding commercial paper, as described below. The Company also utilizes the capital markets to obtain funds for its lending operations. This source has been used for long-term borrowings in the past and can be utilized in the future. Details on borrowings on the Company's books for all or part of 1993 are as follows: . Mortgage-backed medium-term notes, Series A, with a fixed interest rate of 8 7/8%. These notes had a balance of $100 million, matured and were paid off on May 15, 1993. . Commercial mortgage-backed bonds, with a fixed interest rate of 9 3/4%. These bonds had a balance of $62 million, matured and were paid off on September 15, 1993. . 8 1/2% Mortgage-backed medium-term notes, Series A, due April 15, 1997 (the "1997 MTNs"). At December 31, 1993, the 1997 MTNs had a balance of $100 million. The 1997 MTNs are secured by mortgage loans and U.S. Treasury notes with a combined principal balance of $255.7 million at December 31, 1993. During 1992, the Bank started issuing commercial paper, backed by a $400 million letter of credit from the FHLB of San Francisco to ensure a high quality investment grade rating. The letter of credit commitment varies with the level of commercial paper outstanding, and the FHLB line of credit for advances described above increases or decreases accordingly. Commercial paper outstanding totaled $304 million and $65 million at December 31, 1993 and 1992, respectively. All commercial paper outstanding at December 31, 1993 matures within 120 days with an average interest rate of 3.38%. From time to time, Fidelity enters into reverse repurchase agreements by which it sells securities with an agreement to repurchase the same securities at a specific future date (overnight to 30 days). Fidelity deals only with dealers perceived by management to be financially strong and who are recognized as primary dealers in U.S. Treasury securities by the Federal Reserve Board. Reverse repurchase agreements outstanding totaled $3.8 million at December 31, 1993. In May 1990, Fidelity issued the Notes which were approved by the OTS as additional regulatory risk-based capital. The Notes were issued to institutional investors in the amount of $60 million, with interest payable semiannually at 11.68% per annum and are repayable in five equal annual installments commencing May 15, 1996. See "Recent Developments--Internal Reorganization and Restructuring," Item 3. "Legal Proceedings and Item 7. "MD&A--Capital Resources and Liquidity" for a description of certain litigation relating to the Notes and certain circumstances that may result in the Notes and outstanding FHLB Advances being declared due and payable and/or the unavailability of funds under the Bank's commercial paper program and the FHLB credit line. The following table sets forth certain information as to the Company's FHLB Advances, other borrowings and subordinated notes at the dates indicated: For more information on the Company's borrowings see Notes 9 and 10 to the consolidated financial statements. Loan Repayments and Loan Sales Another important source of funds for the Company is the repayment of loans it has made and sales of loans. Receipts from loan repayments (scheduled and unscheduled) and sales of loans, net of repurchases, were approximately $690 million, $878 million, and $926 million for the years ended December 31, 1993, 1992 and 1991, respectively. See "Mortgage Banking Group Operations." INTEREST RATE RISK MANAGEMENT Net interest income is the difference between interest earned on the Company's loans and investment securities and interest paid on its deposits and borrowings. Net interest income is affected by the interest rate spread, which is the difference between the rates earned on its interest-earning assets and rates paid on its interest-bearing liabilities, as well as the relative amounts of its interest-earning assets and interest-bearing liabilities. When interest- earning assets exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Company's average interest rate margin for the years ended December 31, 1993, 1992 and 1991 was 2.28%, 2.67% and 2.54%, respectively. Excluding the writedown of core deposit intangibles of $5.2 million, the average interest rate margin for the year ended December 31, 1993 would have been 2.39%. See Item 7. "MD&A" and Note 7 to the consolidated financial statements. The objective of interest rate risk management is to manage interest rate risk in a prudent manner to maximize the net income of the Bank. Banks and savings institutions are subject to interest rate risk when assets and liabilities mature or reprice at different times (duration risk), against different indices (basis risk) or for different terms (yield curve risk). The decision to control or accept interest rate risk can only be made with an understanding of the probability of various scenarios occurring. Having liabilities that reprice more quickly than assets is beneficial when interest rates fall, but may be detrimental when interest rates rise. Since 1985, the Company has shifted its portfolio toward adjustable rate mortgage loans that reprice more closely with its interest-bearing liabilities. ARM loans comprised 96% of the total loan portfolio at December 31, 1993, 1992 and 1991. The percentage of monthly adjustable ARMs to total loans was 74.7% at December 31, 1993 compared to 74.4% and 71.6% at December 31, 1992 and 1991, respectively. Interest sensitive assets provide the Company with a degree of long-term protection from rising interest rates. At December 31, 1993, approximately 96% of Fidelity's total loan portfolio consisted of loans which mature or reprice within one year, compared with approximately 95% at December 31, 1992 and approximately 97% at December 31, 1991. Fidelity has in recent periods benefited from the fact that decreases in the interest rates accruing on Fidelity's ARMs lagged the decreases in interest rates accruing on its deposits, primarily due to the lagging effects of the COFI, the index to which most of Fidelity's ARMs reprice. Fidelity benefited in 1992 and 1991 from the fact that decreases in its asset yield lagged decreases in its liability cost. During 1993, short and intermediate term rates to which most of Fidelity's liabilities reprice, remained essentially constant. As COFI continued to decline, the Company's interest rate spread narrowed. If market rates fall, the Company's spread will initially improve. If market rates increase, the Company's spread will deteriorate initially until a catch up in lag in the COFI index. See "ARM Loans." The Company took steps in 1993 to reduce the impact of its declining spread. These steps include the decision not to replace expired interest rate cap agreements, and the decision to enter into interest rate swap contracts. The Company continues to monitor and control its interest rate risk exposure within approved guidelines and in such a way as to avoid the need to hold extra capital because of interest rate risk. See Item 7. "MD&A--Interest Rate Risk Management" for a table of projected maturities and repricing details of major financial asset and liability categories of the Company as of December 31, 1993, for further information regarding the Company's off-balance sheet hedging activities and a discussion of interest rate risk capital requirements. The following table presents, for the periods indicated, the Company's total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities and the resultant costs, expressed both in dollars and rates. The table also sets forth the net interest income and the net earnings balance for the periods indicated. Average balances are computed using an average of the daily balances during the year. Certain reclassifications have been made to prior periods to conform to the 1993 presentation. - ------- (1) Nonaccrual loans are included in the average balance column, however, only collected interest on such loans is included in the interest column. (2) The "net earning balance" equals the difference between the average balance of interest-earning assets and the average balance of interest-bearing liabilities. (3) The net yield on interest-earning assets during the period equals (a) the difference between the interest income on interest-earning assets and interest expense on interest-bearing liabilities, divided by (b) average interest-earning assets for the period. (4) Excluding the writedown of core deposit intangibles of $5.2 million, the interest rate spread and the net yield on interest-earning assets for the year ended December 31, 1993, would have been 2.39% and 2.44%, respectively. The following table presents the dollar amount of changes in interest income and expense for each major component of interest-earning assets and interest- bearing liabilities and the amount of change attributable to changes in average balances and average rates for the periods indicated. The net change attributable to changes in both volume and rate, which cannot be segregated, has been allocated proportionately to the change due to volume and the change due to rate. Interest-bearing asset and liability balances in the calculations are computed using the average of the daily balances during the periods. Certain reclassifications have been made to prior periods to conform to the 1993 presentation. COMPETITION The Company believes that the traditional role of thrift institutions, such as Fidelity, as the nation's primary housing lenders has diminished, and that thrift institutions are subject to increasing competition from commercial banks, mortgage bankers and others for both depositor funds and lending opportunities. In addition, with assets of approximately $4.4 billion, the Company faces competition from a number of substantially larger institutions. The ability of thrift institutions, such as Fidelity, to compete by diversifying into lending activities other than real estate lending (and residential real estate lending in particular) and by offering investments other than deposit-like investments is limited by law and by these institutions' relative lack of experience in such other activities. However, the Company believes these nontraditional activities and the related fee income is vital for future success. See "Retail Financial Services Group." The Company faces intense competition in attracting savings deposits and in making real estate loans as many of the nation's largest depository and other financial institutions are headquartered or have a significant number of branches in the areas where Fidelity conducts its business. Competition for depositors' funds comes principally from other savings institutions, commercial banks, money market mutual funds, credit unions, other thrift institutions, corporate and government debt securities, insurance companies, pension funds and money market mutual funds offered through investment banking firms. The principal basis of competition for deposits is the interest rate paid, the perceived credit risk and the quality and types of services offered. In addition to offering competitive rates and terms, the Company attracts deposits through advertising, readily accessible office locations and the quality of its customer service. EMPLOYEES At January 31, 1994, the Company had 1,007 active employees (this includes both full-time and part-time employees with full-time equivalents of 940), none of whom were represented by a collective bargaining group. Management believes that it maintains good relations with its employees. Employees are provided with retirement, 401(k) and other benefits, including life, medical, dental, vision insurance and short and long-term disability insurance. However, the Company is exploring various alternatives to the existing plans to reduce the total cost, which may include reducing future benefits accruing to employees. Employees severely affected by the January 1994 Northridge Earthquake were provided with access to additional time off, salary advances, favorable short- term loans and alternate living arrangements. The total cost of these programs is not expected to be material. TAXATION The Company files a consolidated federal income tax return on a calendar year basis. For federal income tax purposes, the maximum rate of tax applicable to savings institutions is currently 35% for taxable income over $10 million. Savings institutions are generally subject to federal taxation in the same manner as other types of corporations. However, under applicable provisions of the Internal Revenue Code, savings institutions that meet certain definitional and other tests ("qualifying institutions") can, unlike most other corporations, use the reserve (versus specific charge-off) method to compute their deduction for bad debt losses. Under the reserve method, qualifying associations are generally allowed to use either of two alternative computations. Under the "percentage of taxable income method" computation, qualifying institutions can claim a bad debt deduction computed as a percentage of taxable income before such deduction. Alternatively, a qualifying association may elect to utilize its own bad debt loss experience to compute its annual addition to its bad debt reserves (the "experience method"). Prior to the enactment of the Tax Reform Act of 1986 ("1986 Act"), many qualifying institutions, including the Bank, used the percentage of taxable income method which generally resulted in a lower effective federal income tax rate than that applicable to other types of corporations. However, the 1986 Act reduced the maximum percent that could be deducted under the percentage of taxable income method from 40% to 8% for tax years beginning after December 31, 1986; thus many qualifying institutions, including the Bank, began to use the experience method beginning in 1987. The amount by which a qualifying institution's total bad debt reserves exceed the amount computed under the experience method ("excess tax bad debt reserves") may be subject to recapture tax as noted below. On December 31, 1993, the bad debt reserves of the Bank for federal income tax purposes included $14.0 million representing excess tax bad debt reserves. If, in the future, amounts appropriated to these excess tax bad debt reserves are used for the payment of dividends or other distributions by the Bank (including distributions in dissolution, liquidation or redemption of stock), an amount equal to the distribution plus the tax attributable thereto, but not exceeding the aggregate amount of excess tax bad debt reserves, will generally be included in the Bank's taxable income and be subject to tax. In addition, if in the future the Bank fails to meet the definitional or other tests of a qualifying association, the entire tax bad debt reserves of $52.5 million will have to be recaptured and included in taxable income. It is not contemplated that the accumulated reserves will be used in a manner that will create such liabilities. The Company's tax returns have been audited by the Internal Revenue Service through December 31, 1987 and by the California Franchise Tax Board through December 31, 1985. The tax returns filed for 1986, 1987 and 1988 are currently under audit by the California Franchise Tax Board. The tax returns for years ended 1988 and 1989 are currently in the appeals process with the Internal Revenue Service. In addition, the Internal Revenue Service is currently auditing the tax returns filed for 1990 and 1991. For additional information regarding the federal income and California franchise taxes payable by the Company, see Note 12 to the consolidated financial statements. For California franchise tax purposes, savings institutions are taxed as "financial corporations" at a higher rate than that applicable to nonfinancial corporations because of exemptions from certain state and local taxes. The California franchise tax rate applicable to financial corporations is approximately 11%. REGULATION AND SUPERVISION General Citadel is a savings and loan holding company subject to regulation by the OTS. Fidelity is a federally-chartered savings bank, a member of the Federal Home Loan Bank of San Francisco, and is subject to regulation by the OTS and the FDIC. Fidelity's deposits are insured by the FDIC through the Savings Association Insurance Fund ("SAIF"). As described in more detail below, statutes and regulations applicable to Citadel govern such matters as changes of control of Citadel and transactions between Fidelity and Citadel. Statutes and regulations applicable to Fidelity govern such matters as the amount of capital Fidelity must hold; dividends, mergers and changes of control; establishment and closing of branch offices; and the investments and activities in which Fidelity can engage. Citadel and Fidelity are subject to the examination, supervision and reporting requirements of the OTS, their primary federal regulator, including a requirement for Fidelity of at least one full scope, on-site examination every year. The Director of the OTS is authorized to impose assessments on Fidelity to fund OTS operations, including the cost of examinations. Fidelity is also subject to examination and supervision by the FDIC, and the FDIC has "back-up" authority to take enforcement action against Fidelity if the OTS fails to take such action after a recommendation by the FDIC. The FDIC may impose assessments on Fidelity to cover the cost of FDIC examinations. In addition, Fidelity is subject to regulation by the Board of Governors of the Federal Reserve System ("FRB") with respect to certain aspects of its business. FIRREA Capital Requirements The OTS's capital regulations, as required by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), include three separate minimum capital requirements for the savings institution industry--a "tangible capital requirement," a "leverage limit" and a "risk-based capital requirement." These capital standards must be no less stringent than the capital standards applicable to national banks. The OTS also has the authority, after giving the affected institution notice and an opportunity to respond, to establish individual minimum capital requirements ("IMCR") for a savings institution which are higher than the industry minimum requirements, upon a determination that an IMCR is necessary or appropriate in light of the institution's particular circumstances, such as if the institution is expected to have losses resulting in capital inadequacy, has a high degree of exposure to credit risk, or has a high amount of nonperforming loans. The OTS has proposed a regulation that would add to the list of circumstances in which an IMCR may be appropriate for a savings association the following: a high degree of exposure to concentration of credit risk or risks arising from nontraditional activities, or failure to adequately monitor and control the risks presented by concentration of credit and nontraditional activities. The industry minimum capital requirements are as follows: Tangible capital of at least 1.5% of adjusted total assets. Tangible capital is composed of (1) an institution's common stock, perpetual noncumulative preferred stock, and related earnings, and (2) the amount, if any, of equity investment by others in the institution's subsidiaries, after deducting (a) intangible assets other than purchased mortgage servicing rights, and (b) the institution's investments in and extensions of credit to subsidiaries engaged as principal in activities not permissible for national banks, net of any reserves established against such investments, subject to a phase-out ending July 1, 1996 rather than a deduction for the amount of investments made or committed to be made prior to April 12, 1989. In general, adjusted total assets equal the institution's consolidated total assets, minus any assets that are deducted in calculating capital. Core capital of at least 3% of adjusted total assets (the "leverage limit"). Core capital consists of tangible capital plus (1) goodwill resulting from pre- April 12, 1989 acquisitions of troubled savings institutions, subject to a phase-out ending December 31, 1994; and (2) certain marketable intangible assets, such as core deposit premium (the premium paid for acquisition of deposits from other institutions). Deferred tax assets whose realization depends on the institution's future taxable income (exclusive of income attributable to reversing taxable temporary differences and carry forwards) or on the institution's tax-planning strategies must be deducted from core capital to the extent that such assets exceed the lesser of (1) 10% of core capital, or (2) the amount of such assets that can be realized within one year, unless such assets were reportable as of December 31, 1992, in which case no deduction is required. The OTS has recently adopted a regulation effective March 4, 1994 with respect to the inclusion of intangible assets in regulatory capital. Under this regulation, purchased mortgage servicing rights will generally be includible in tangible and core capital, and purchase credit card relationships will generally be includible in core capital, as long as they do not exceed 50% of core capital in the aggregate, with a separate sublimit of 25% for purchased credit card relationships. All other intangible assets, including, core deposit premium, will generally have to be deducted. Core deposit intangible in existence on March 4, 1994, however, may continue to be included in core capital to the extent permitted by the OTS, as long as the premium is valued in accordance with GAAP, supported by credible assumptions, and its amortization is adjusted at least annually. At December 31, 1993, Fidelity included $2.1 million of core deposit premium in core capital. Fidelity anticipates that such $2.1 million in core deposit premium will continue to be includible in core capital after March 4, 1994. Total capital of at least 8% of risk-weighted assets (the "risk-based capital requirement"). Total capital includes both core capital and "supplementary" capital items deemed less permanent than core capital, such as subordinated debt and general loan loss allowances (subject to certain limits), but equity investments (with the exception of investments in subsidiaries and investments permissible for national banks) and portions of certain high-risk land loans and nonresidential construction loans must be deducted from total capital, subject to a phase-out rather than a deduction until July 1, 1994. At least half of total capital must consist of core capital. Risk-weighted assets are determined by multiplying each category of an institution's assets, including off balance sheet asset equivalents, by an assigned risk weight based on the credit risk associated with those assets, and adding the resulting sums. The four risk weight categories range from zero percent for cash and government securities to 100% for assets (including past- due loans and real estate owned) that do not qualify for preferential risk- weighting. Effective September 30, 1994, institutions that are deemed to have above- normal exposure to interest-rate risk, based on their assets and liabilities as of the end of the third quarter prior to the measuring date, will be required to deduct from their total capital an amount equal to 50% of the excess risk. If this requirement had been in effect at December 31, 1993, based on its assets and liabilities as of March 31, 1993, Fidelity would not have been deemed to have above-normal exposure to interest-rate risk. On March 18, 1994, the OTS published a final regulation effective on that date that permits a loan secured by multifamily residential property, regardless of the number of units, to be risk-weighted at 50% for purposes of the risk-based capital standards if the loan meets specified criteria relating to the term of the loan, timely payments of interest and principal, loan-to- value ratio and ratio of net operating income to debt service requirements. Under the prior regulation, only loans secured by multifamily residential properties consisting of 5 to 36 units were eligible for risk-weighting at 50%, and then only if such loans had a loan-to-value ratio at origination of not more than 80% and the collateral property had an average annual occupancy rate of at least 80% for a year or more. Based upon the results of Fidelity's annual survey, management believes that at December 31, 1993, at which time the prior rule was still in effect, approximately 85% of Fidelity's portfolio of loans secured by multifamily residences with 5 to 36 units qualified for 50% risk-weighting. Any loans that qualified for risk-weighting under the prior regulation as of March 18, 1994 will be "grandfathered" and will continue to be risk-weighted at 50% as long as they continue to meet the criteria of the prior regulation. Thus occupancy rates, which recently have been decreasing generally, will continue to affect the risk-weighting of such grandfathered multifamily loans unless such loans qualify for 50% risk-weighting under the criteria of the new rule, which criteria do not include an occupancy requirement. Under the prior rule, loans secured by multifamily residential properties with more than 36 units were required to be risk-weighted at 100% even if they met the loan-to-value and occupancy criteria applicable to loans secured by 5 to 36 unit properties. As of December 31, 1993, Fidelity held $406.3 million in loans secured by multifamily residential properties with 37 or more units, some of which qualify under the criteria of the new regulation for 50% risk- weighting. Therefore, Fidelity's risk-based capital ratio could increase. However, some of Fidelity's existing loans secured by 5 to 36 unit residential properties could increase in risk-weighting from 50% to 100% if they fail to qualify for grandfathering and if they do not meet the additional criteria of the new rule, which would have a negative effect on Fidelity's risk-based capital ratio. The ultimate impact on Fidelity of the new regulation has not been determined. Fidelity exceeded all three of the industry minimum capital requirements at December 31, 1993, with a tangible capital ratio of 4.10%, a core capital ratio of 4.15%, and a risk-based capital ratio of 9.32%. A discussion of Fidelity's compliance with the industry minimum requirements appears in Item 7. "MD&A-- Capital Resources and Liquidity." Savings institutions that do not meet the industry minimum capital requirements are subject to a number of sanctions similar to but less restrictive than the sanctions under the FDICIA Prompt Corrective Action system described below, and to a requirement that the OTS be notified of any changes in Fidelity's directors or senior executive officers. FDICIA Prompt Corrective Action Requirements The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") required the OTS to implement a system requiring regulatory sanctions against institutions that are not adequately capitalized, with the sanctions growing more severe the lower the institution's capital. The OTS was required to and has established specific capital ratios for five separate capital categories: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Under the OTS regulations implementing FDICIA, an institution is treated as well capitalized if its ratio of total capital to risk-weighted assets is at least 10.0%, its ratio of core capital to risk-weighted assets is at least 6.0%, its ratio of core capital to adjusted total assets is at least 5.0%, and it is not subject to any order or directive by the OTS to meet a specific capital level. An institution will be adequately capitalized if its ratio of total capital to risk-weighted assets is at least 8.0%, its ratio of core capital to risk-weighted assets is at least 4.0%, and its ratio of core capital to adjusted total assets (leverage ratio) is at least 4.0% (3.0% if the institution receives the highest rating on the MACRO financial institutions rating system). The OTS has stated that it intends to lower the leverage ratio requirement to 3.0% for all savings institutions after September 30, 1994, when the interest rate risk component of its capital regulations goes into effect. The OTS' reduction of the leverage ratio requirement may depend on obtaining agreement of the other federal banking agencies to such a reduction, and no assurances can be given that the reduction will occur. An institution whose capital does not meet the amounts required in order to be adequately capitalized will be treated as undercapitalized. If an undercapitalized institution's capital ratios are less than 6.0%, 3.0%, or 3.0% respectively, it will be treated as significantly undercapitalized. Finally, an institution will be treated as critically undercapitalized if its ratio of "tangible equity" (core capital plus cumulative preferred stock minus intangible assets other than supervisory goodwill and purchased mortgage servicing rights) to adjusted total assets is equal to or less than 2.0%. At December 31, 1993 and to date, the Bank was and is classified as adequately capitalized. However, Citadel supplemented the Bank's capital in 1993 with two capital infusions totaling $28 million, without which the Bank would have had to significantly reduce its assets or the Bank's core capital ratio at December 31, 1993 would have fallen below 4% and the Bank would have been classified as undercapitalized. Management anticipates that the Bank will incur losses in the first and second quarters of 1994. These losses will, in the absence of a new capital infusion or a further reduction in the Bank's total assets, reduce the Bank's core capital ratio to less than 4% at June 30, 1994 and thereby render it undercapitalized. See "Recent Developments--Capital and Liquidity." Fidelity's capital category under the prompt corrective action system may not be an accurate representation of Fidelity's overall financial condition or prospects. A discussion of Fidelity's compliance with the industry minimum capital requirements and the standards of the prompt corrective action capital categories appears in Item 7. "MD&A--Capital Resources and Liquidity." An institution's capital category is based on its capital levels as of the most recent of the following dates: (1) the date the institution's most recent quarterly Thrift Financial Report ("TFR") was required to be filed with the OTS; (2) the date the institution received from the OTS its most recent final report of examination; or (3) the date the institution received written notice from the OTS of the institution's capital category. If subsequent to the most recent TFR or report of examination a material event has occurred that would cause the institution to be placed in a lower capital category, the institution must provide written notice to the OTS within 15 days, and the OTS shall determine whether to change the association's capital category. Mandatory Sanctions Tied to Prompt Corrective Action Capital Categories Capital Restoration Plan. An institution that is undercapitalized must submit a capital restoration plan to the OTS within 45 days after becoming undercapitalized. The capital restoration plan must specify the steps the institution will take to become adequately capitalized, the levels of capital the institution will attain while the plan is in effect, the types and levels of activities the institution will conduct, and such other information as the OTS may require. The OTS must act on the capital restoration plan expeditiously, and generally not later than 60 days after the plan is submitted. The OTS may approve a capital restoration plan only if the OTS determines that the plan is likely to succeed in restoring the institution's capital and will not appreciably increase the risks to which the institution is exposed. In addition, the OTS may approve a capital restoration plan only if the institution's performance under the plan is guaranteed by every company that controls the institution, up to the lesser of (a) 5% of the institution's total assets at the time the institution became undercapitalized, or (b) the amount necessary to bring the institution into compliance with all capital standards as of the time the institution fails to comply with its capital restoration plan. Such guarantee must remain in effect until the institution has been adequately capitalized for four consecutive quarters, and the controlling company or companies must provide the OTS with appropriate assurances of their ability to perform the guarantee. If the controlling company guarantee is not acceptable, the OTS may treat the "undercapitalized" institution as "significantly undercapitalized." There are additional restrictions which are applicable to "significantly undercapitalized" institutions which are described below. Limits on Expansion. An institution that is undercapitalized, even if its capital restoration plan has been approved, may not acquire an interest in any company, open a new branch office, or engage in a new line of business unless the OTS determines that such action would further the implementation of the institution's capital plan or the FDIC approves the action. An undercapitalized institution also may not increase its average total assets during any quarter except in accordance with an approved capital restoration plan. Capital Distributions. With one exception, an undercapitalized savings institution generally may not pay any dividends or make other capital distributions. Under the exception, the OTS may permit, after consultation with the FDIC, repurchases or redemptions of the institution's shares that are made in connection with the issuance of additional shares to improve the institution's financial condition. Undercapitalized institutions also may not pay management fees to any company or individual that controls the institution. Similarly, an adequately capitalized institution may not make a capital distribution or pay a management fee to a controlling person if such payment would cause the institution to become undercapitalized. Brokered Deposits and Benefit Plan Deposits. An undercapitalized savings institution cannot accept, renew, or rollover deposits obtained through a deposit broker, and may not solicit deposits by offering interest rates that are more than 75 basis points higher than market rates. Savings institutions that are adequately capitalized but not well capitalized must obtain a waiver from the FDIC in order to accept, renew, or rollover brokered deposits, and even if a waiver is granted may not solicit deposits, through a broker or otherwise, by offering interest rates that exceed market rates by more than 75 basis points. Institutions that are ineligible to accept brokered deposits can only offer FDIC insurance coverage for employee benefit plan deposits up to $100,000 per plan, rather than $100,000 per plan participant, unless, at the time such deposits are accepted, the institution meets all applicable capital standards and certifies to the benefit plan depositor that its deposits are eligible for coverage on a per-participant basis. Restrictions on Significantly and Critically Undercapitalized Institutions. In addition to the above mandatory restrictions which apply to all undercapitalized savings institutions, institutions that are significantly undercapitalized may not without the OTS's prior approval (a) pay a bonus to any senior executive officer, or (b) increase any senior executive officer's compensation over the average rate of compensation (excluding bonuses, options and profit-sharing) during the 12 months preceding the month in which the institution became undercapitalized. The same restriction applies to undercapitalized institutions that fail to submit or implement an acceptable capital restoration plan. If a savings institution is critically undercapitalized, the institution is also prohibited from making payments of principal or interest on subordinated debt beginning sixty days after the institution becomes critically undercapitalized, unless the FDIC permits such payments or the subordinated debt was outstanding on July 15, 1991 and has not subsequently been extended or renegotiated. In addition, the institution cannot without prior FDIC approval enter into any material transaction outside the ordinary course of business. Critically undercapitalized savings institutions must be placed in receivership or conservatorship within 90 days of becoming critically undercapitalized unless the OTS, with the concurrence of the FDIC, determines that some other action would better resolve the problems of the institution at the least possible long-term loss to the insurance fund, and documents the reasons for its determination. A determination by the OTS not to place a critically undercapitalized institution in conservatorship or receivership must be reviewed every 90 days. If the institution remains critically undercapitalized on average during the calendar quarter beginning 270 days after it became critically undercapitalized, the findings which the OTS must make regarding the viability of the institution in order to avoid the appointment of a conservator or receiver become more stringent. Discretionary Sanctions Tied to Prompt Corrective Action Capital Categories Operating Restrictions. With respect to an undercapitalized institution, the OTS will, if it deems such actions necessary to resolve the institution's problems at the least possible loss to the insurance fund, have the explicit authority to: (a) order the institution to recapitalize by selling shares of capital stock or other securities; (b) order the institution to agree to be acquired by another depository institution holding company or combine with another depository institution; (c) restrict transactions with affiliates; (d) restrict the interest rates paid by the institution on new deposits to the prevailing rates of interest in the region where the institution is located; (e) require reduction of the institution's assets; (f) restrict any activities that the OTS determines pose excessive risk to the institution; (g) order a new election of directors; (h) order the institution to dismiss any director or senior executive officer who held office for more than 180 days before the institution became undercapitalized, subject to the director's or officer's right to obtain administrative review of the dismissal; (i) order the institution to employ qualified senior executive officers subject to the OTS's approval; (j) prohibit the acceptance of deposits from correspondent depository institutions; (k) require the institution to divest any subsidiary or the institution's holding company to divest the institution or any other subsidiary; or (l) take any other action that the OTS determines will better resolve the institution's problems at the least possible loss to the deposit insurance fund. If an institution is significantly undercapitalized, or if it is undercapitalized and its capital restoration plan is not approved or implemented within the required time periods, the OTS must take one or more of the above actions, and must take the actions described in clauses (a) or (b), (c) and (d) above unless it finds that such actions would not resolve the institution's problems at the least possible loss to the deposit insurance fund. The OTS also may prohibit the institution from making payments on any outstanding subordinated debt or entering into material transactions outside the ordinary course of business without the OTS's prior approval. The OTS' determination to order one or more of the above discretionary actions will be evidenced by a written directive to the institution, and the OTS will generally issue a directive only after giving the institution prior notice and an opportunity to respond. The period for response shall be at least 14 days unless the OTS determines that a shorter period is appropriate based on the circumstances. The OTS, however, may issue a directive without providing any prior notice if the OTS determines that such action is necessary to resolve the institution's problems at the least possible loss to the deposit insurance fund. In such a case, the directive will be effective immediately, but the institution may appeal the directive to the OTS within 14 days. Receivership or Conservatorship. In addition to the mandatory appointment of a conservator or receiver for critically undercapitalized institutions, described above, the OTS or FDIC may appoint a receiver or conservator for an institution if the institution is undercapitalized and (a) has no reasonable prospect of becoming adequately capitalized, (b) fails to submit a capital restoration plan within the required time period, or (c) materially fails to implement its capital restoration plan. FDICIA provides that directors of an FDIC-insured depository institution will have no liability to the institution's stockholders or creditors if they consent in good faith to the appointment of a conservator or receiver or to an FDIC-assisted sale of the institution. Down-grading to Lower Capital Category. The OTS can apply to an institution in a particular capital category the sanctions that apply to the next lower capital category, if the OTS determines, after providing the institution notice and opportunity for a hearing, that (a) the institution is in an unsafe or unsound condition, or (b) the institution received, in its most recent report of examination, a less-than-satisfactory rating for asset quality, management, earnings or liquidity, and the deficiency has not been corrected. The OTS cannot, however, use this authority to require an adequately capitalized institution to file a capital restoration plan, or to subject a significantly undercapitalized institution to the sanctions applicable to critically undercapitalized institutions. Expanded Regulatory Authority Under FDICIA In addition to the prompt corrective action provisions discussed above based on an institution's regulatory capital ratios, FDICIA contains several measures intended to promote early identification of management problems at depository institutions and to ensure that regulators intervene promptly to require corrective action by institutions with inadequate operational and managerial standards. Safety and Soundness Standards. FDICIA requires the OTS to prescribe minimum acceptable operational and managerial standards, and standards for asset quality, earnings, and valuation of publicly traded shares, for savings institutions and their holding companies. Such standards were to be effective no later than December 1, 1993, but have not yet been finalized. The operational standards must cover internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth, and employee compensation. The asset quality and earnings standards must specify a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, and minimum ratio of market value to book value for publicly traded shares. Any institution or holding company that fails to meet the standards must submit a plan for corrective action within 30 days. If a savings institution fails to submit or implement an acceptable plan, the OTS must order it to correct the safety and soundness deficiency, and may restrict its rate of asset growth, prohibit asset growth entirely, require the institution to increase its ratio of tangible equity to assets, restrict the interest rate paid on deposits to the prevailing rates of interest on deposits of comparable amounts and maturities, or require the institution to take any other action that the OTS determines will better carry out the purpose of prompt corrective action. Imposition of these sanctions is within the discretion of the OTS in most cases but is mandatory if the savings institution commenced operations or experienced a change in control during the 24 months preceding the institution's failure to meet the safety and soundness standards, or underwent extraordinary growth during the preceding 18 months. The OTS and the other federal banking agencies have jointly published a proposed regulation prescribing the required safety and soundness standards. Among other things, the proposed regulation would set out asset quality standards which specify that the ratio of a depository institution's classified assets to the sum of(a) its total capital and (b) any allowances for loan losses not included in total capital should not exceed 100%. Minimum earnings standards would require that institutions be able to demonstrate pro forma compliance with capital requirements if net earnings or losses over the preceding four quarters continue over the next four quarters. If the proposed safety and soundness standards had been in effect at December 31, 1993, Fidelity would not have been in compliance with the minimum earnings standard or the maximum ratio of classified assets to capital standard and would have been required to submit a plan for corrective action. Under the proposed regulation, the safety and soundness standards would apply primarily at the savings institution level, and savings and loan holding companies such as Citadel would only be required (a) to ensure that their transactions with a subsidiary savings institution are not detrimental to the institution, (b) to avoid creating a serious risk that the holding company's liabilities would be imposed on the institution, (c) not to take any action that would impede the institution's compliance with the safety and soundness standards, and (d) if the subsidiary institution is required to submit a plan for corrective action, to take any corporate actions necessary to enable the subsidiary to take the actions required by the plan. Expanded Requirements Relating to Internal Controls. Each depository institution with assets above a specified threshold (which the FDIC has set at $500 million and which therefore includes Fidelity) must prepare an annual report, signed by the chief executive officer and chief financial officer, on the effectiveness of the institution's internal control structures and procedures for financial reporting, and on the institution's compliance with laws and regulations relating to safety and soundness. The institution's independent public accountant must attest to, and report separately on, management's assertions in the annual report. The report and the attestation, along with financial statements and such other disclosure requirements as the FDIC and the OTS may prescribe, must be submitted to the FDIC and OTS and will be available to the public. Every institution with assets above the $500 million threshold must also have an audit committee of its Board of Directors made up entirely of directors who are independent of the management of the institution. Fidelity is in compliance with this requirement. Audit committees of "large" institutions (defined by the FDIC as an institution with more than $3 billion in assets, which includes Fidelity) must include members with banking or financial management expertise, may not include members who are large customers of the institution, and must have access to independent counsel. Activities Restrictions Not Related to Capital Compliance Qualified Thrift Lender Test. The qualified thrift lender ("QTL") test requires that, in at least nine out of every twelve months, at least 65% of a savings bank's "portfolio assets" must be invested in a limited list of qualified thrift investments, primarily investments related to housing loans. If Fidelity fails to satisfy the QTL test and does not requalify as a QTL within one year, Citadel must register and be regulated as a bank holding company, and Fidelity must either convert to a commercial bank charter or become subject to restrictions on branching, business activities and dividends as if it were a national bank. Portfolio assets consist of tangible assets minus (a) assets used to satisfy liquidity requirements, and(b) property used by the institution to conduct its business. Assets that may be counted as qualified thrift investments without limit include residential mortgage and construction loans; home improvement and repair loans; mortgage-backed securities; home equity loans; Federal Savings and Loan Insurance Corporation ("FSLIC"), FDIC, Resolution Funding Corporation and Resolution Trust Corporation obligations; and FHLB stock. Assets includable subject to an aggregate maximum of 20% of portfolio assets include Federal National Mortgage Association and Federal Home Loan Mortgage Corporation stock; investments in residential housing-oriented subsidiaries; consumer and education loans up to a maximum of 10% of portfolio assets; 200% of loans for development of low-income housing; 200% of certain community development loans; loans to construct, purchase or maintain churches, schools, nursing homes and hospitals; and 50% of any residential mortgage loans originated by the institution and sold during the month for which the QTL calculation is made, if such loans were sold within 90 days of origination. At December 31, 1993, 89.8% of Fidelity's portfolio assets constituted qualified thrift investments. Investments and Loans. In general, federal savings institutions such as Fidelity may not invest directly in equity securities, noninvestment grade debt securities, or real estate, other than real estate used for the institution's offices and related facilities. Indirect equity investment in real estate through a subsidiary is permissible, but subject to limitations based on the amount of the institution's assets, and the institution's investment in such a subsidiary must be deducted from regulatory capital in full or (for certain subsidiaries owned by the institution prior to April 12, 1989) phased out of capital by no later than July 1, 1996. Loans by a savings institution to a single borrower are generally limited to 15% of the institution's "unimpaired capital and unimpaired surplus," which is similar but not identical to total capital. At December 31, 1993, the largest Fidelity borrower had a total outstanding balance of $31.5 million or 10.1% of unimpaired capital and unimpaired surplus. Aggregate loans secured by nonresidential real property are generally limited to 400% of the institution's total capital. Commercial loans may not exceed 10% of Fidelity's total assets, and consumer loans may not exceed 35% of Fidelity's total assets. At December 31, 1993, Fidelity was in compliance with the above investment limits. Activities of Subsidiaries. A savings institution seeking to establish a new subsidiary, acquire control of an existing company or conduct a new activity through an existing subsidiary must provide 30 days prior notice to the FDIC and OTS. A subsidiary of Fidelity may be able to engage in activities that are not permissible for Fidelity directly, if the OTS determines that such activities are reasonably related to Fidelity's business, but Fidelity may be required to deduct its investment in such a subsidiary from capital. The OTS has the power to require a savings institution to divest any subsidiary or terminate any activity conducted by a subsidiary that the OTS determines to be a serious threat to the financial safety, soundness or stability of such savings institution or to be otherwise inconsistent with sound banking practices. Real Estate Lending Standards. The OTS and the other federal banking agencies have adopted regulations, effective March 19, 1993, which require institutions to adopt and at least annually review written real estate lending policies. The lending policies must include diversification standards, underwriting standards (including loan-to-value limits), loan administration procedures, and procedures for monitoring compliance with the policies. The policies must reflect consideration of guidelines adopted by the banking agencies. Among the guidelines adopted by the agencies are maximum loan-to-value ratios for land loans (65%); development loans (75%); construction loans (80%-85%); loans on owner-occupied 1 to 4 family property, including home equity loans (no limit, but loans at or above 90% require private mortgage insurance); and loans on other improved property (85%). The guidelines permit institutions to make loans in excess of the supervisory loan-to-value limits if such loans are supported by other credit factors, but the aggregate of such nonconforming loans should not exceed the institution's risk-based capital, and the aggregate of nonconforming loans secured by real estate other than 1 to 4 family property should not exceed 30% of risk-based capital. Fidelity believes that its current lending policies and practices are consistent with the guidelines. Additional Regulatory Restrictions. As a result of its findings in a recent examination of Fidelity, the OTS has taken action that will result in Fidelity's being subjected to higher examination assessments and subjects Fidelity to additional regulatory restrictions including, but not limited to (a) a requirement that Fidelity submit to the OTS for prior approval any changes in its board of directors or senior executive officers and any proposed employment contracts with a director or senior officer; (b) a prohibition, absent prior OTS approval, on increases in Fidelity's total assets during any quarter in excess of an amount equal to the net interest credited on deposit liabilities during the quarter; (c) a requirement that Fidelity submit to the OTS for prior review and approval any third party contracts outside the normal course of business; and (d) the OTS would have the ability, in its discretion, to require 30 days' prior notice of all transactions between Fidelity and its affiliates (including Citadel and Gateway). See "Recent Developments--OTS Examinations." Deposit Insurance General. Fidelity's deposits are insured by the FDIC to a maximum of $100,000 for each insured depositor. Under FIRREA, the FDIC administers two separate deposit insurance funds: the Bank Insurance Fund (the "BIF") which insures the deposits of institutions that were insured by the FDIC prior to FIRREA, and the SAIF which maintains a fund to insure the deposits of institutions, such as Fidelity, that were insured by the FSLIC prior to FIRREA. Insurance Premium Assessments. The Federal Deposit Insurance Corporation Improvement Act of 1991 directed the FDIC to establish by January 1, 1994, a risk-based system for setting deposit insurance assessments. The FDIC has implemented such a system, under which an institution's insurance assessments will vary depending on the level of capital the institution holds and the degree to which it is the subject of supervisory concern to the FDIC. Under the FDIC's system, the assessment rate for both BIF deposits and SAIF deposits varies from 0.23% of covered deposits for well-capitalized institutions that are deemed to have no more than a few minor weaknesses, to 0.31% of covered deposits for less than adequately capitalized institutions that pose substantial supervisory concern. The FDIC in the future may determine to change the assessment rates, or the parity of BIF and SAIF rates, based on the condition of the BIF and the SAIF. Under current law, the SAIF has three major obligations: beginning in 1995, to fund losses associated with the failure of institutions with SAIF-insured deposits; to increase its reserves to 1.25% of insured deposits over a reasonable period of time; and to make interest payments on debt incurred to provide funds to the former Federal Savings and Loan Insurance Corporation ("FICO debt"). The reserves of the SAIF are currently lower than the reserves of the BIF, and the BIF does not have an obligation to pay interest on FICO debt. Recent legislation authorizes the United States Treasury to provide up to $8 billion to the SAIF, but use of such funds would require additional Congressional action, and the funds could be used only to cover SAIF losses and only under limited circumstances. Therefore, in the future premiums assessed on deposits insured by the SAIF may be higher than premiums on deposits insured by the BIF. Such a premium structure could provide institutions whose deposits are exclusively or primarily BIF-insured (such as almost all commercial banks) certain competitive advantages over institutions whose deposits are SAIF- insured (such as Fidelity) in the pricing of loans and deposits and in lower operating costs. Such a competitive disadvantage could have an adverse effect on Fidelity's results of operations. Termination of Deposit Insurance. The FDIC may initiate a proceeding to terminate an institution's deposit insurance if, among other things, the institution is in an unsafe or unsound condition to continue operations. It is the policy of the FDIC to deem an insured institution to be in an unsafe or unsound condition if its ratio of Tier 1 capital to total assets is less than 2%. Tier 1 capital is similar to core capital but includes certain investments in and extensions of credit to subsidiaries engaged in activities not permitted for national banks. Conversion of Deposit Insurance. Generally, savings institutions may not convert from SAIF membership to BIF membership until SAIF has increased its reserves to 1.25% of insured deposits. However, a savings institution may convert to a bank charter, if the resulting bank remains a SAIF member, and may merge with a BIF member institution as long as deposits attributable to the savings institution remain subject to assessment by the SAIF. Institutions that convert from SAIF to BIF membership, either under an exception during the moratorium or after expiration of the moratorium, must pay exit fees to SAIF and entrance fees to BIF. Savings and Loan Holding Company Regulation Affiliate and Insider Transactions. The ability of Citadel and its non- depository subsidiaries to deal with Fidelity is limited by the affiliate transaction rules, including Sections 23A and 23B of the Federal Reserve Act which also govern BIF-insured banks. With very limited exceptions, these rules require that all transactions between Fidelity and an affiliate must be on arms' length terms. The term "affiliate" covers any company that controls or is under common control with Fidelity, but does not include individuals and generally does not include Fidelity's subsidiaries. Under Section 23A and section 11 of the Home Owners' Loan Act, specific restrictions apply to transactions in which Fidelity provides funding to its affiliates: Fidelity may not purchase the securities of an affiliate, make a loan to any affiliate that is engaged in activities not permissible for a bank holding company, or acquire from an affiliate any asset that has been classified, a nonaccrual loan, a restructured loan, or a loan that is more than 30 days past due. As to affiliates engaged in bank holding company- permissible activities, the aggregate of (a) loans, guarantees, and letters of credit provided by the savings bank for the benefit of any one affiliate, and (b) purchases of assets by the savings bank from the affiliate, may not exceed 10% of the savings bank's capital stock and surplus (20% for the aggregate of permissible transactions with all affiliates). All loans to affiliates must be secured by collateral equal to at least 100% of the amount of the loan (130% if the collateral consists of equity securities, leases or real property). In addition, OTS regulations on affiliate transactions require, among other things, that savings institutions retain records of their affiliate transactions that reflect such transactions in reasonable detail. If a savings institution has been the subject of a change of control application or notice within the preceding two-year period, does not meet its minimum capital requirements, has entered into a supervisory agreement, is subject to a formal enforcement proceeding, or is determined by the OTS to be the subject of supervisory concern, the institution may be required to provide the OTS with 30 days' prior notice of any affiliate transaction. Loans by Fidelity to its directors, executive officers, and 10% stockholders of Fidelity, Citadel, or Citadel's subsidiaries (collectively, "insiders"), or to a corporation or partnership that is at least 10% owned by an insider (a "related interest") are subject to limits separate from the affiliate transaction rules. However, a company (such as Citadel) that controls a savings institution is excluded from the coverage of the insider lending rules even if it owns 10% or more of the stock of the institution, and is subject only to the affiliate transaction rules. All loans to insiders and their related interests must be underwritten and made on non-preferential terms; loans in excess of $500,000 must be approved in advance by Fidelity's Board of Directors; and Fidelity's total of such loans may not exceed 100% of Fidelity's capital. Loans by Fidelity to its executive officers are subject to additional limits which are even more stringent. Fidelity has adopted a policy which requires prior approval of its Board of Directors for any loans to insiders or their related interests. Payment of Dividends and Other Capital Distributions. The payment of dividends, stock repurchases, and other capital distributions by Fidelity to Citadel is subject to regulation by the OTS. Currently, 30 days prior notice to the OTS of any capital distribution is required. The OTS has promulgated a regulation that measures a savings institution's ability to make a capital distribution according to the institution's capital position. The rule establishes "safe-harbor" amounts of capital distributions that institutions can make after providing notice to the OTS, but without needing prior approval. Institutions can distribute amounts in excess of the safe harbor only with the prior approval of the OTS. For institutions ("Tier 1 institutions") that meet their fully phased-in capital requirements (the requirements that will apply when the phase-out of supervisory goodwill and investments in certain subsidiaries from capital is complete), the safe harbor amount is the greater of (a) 75% of net income for the prior four quarters, or (b) the sum of (1) the current year's net income and (2) the amount that would reduce the excess of the institution's total capital to risk-weighted assets ratio over 8% to one-half of such excess at the beginning of the year in which the dividend is paid. For institutions that meet their current minimum capital requirements but do not meet their fully phased-in requirements ("Tier 2 institutions"), the safe harbor distribution is 75% of net income for the prior four quarters. As a function of the prompt corrective action provisions discussed above and the OTS regulation regarding capital distributions, savings institutions that do not meet their current minimum capital requirements ("Tier 3 institutions") may not make any capital distributions, with the exception of repurchases or redemptions of the institution's shares permitted by the OTS, after consultation with the FDIC, that are made in connection with the issuance of additional shares and that will improve the institution's financial condition. The OTS retains the authority to prohibit any capital distribution otherwise authorized under the regulation if the OTS determines that the distribution would constitute an unsafe or unsound practice. The OTS also may reclassify a Tier 1 institution as a Tier 2 or Tier 3 institution by notifying the institution that it is in need of more than normal supervision. While Fidelity was a Tier 1 institution at December 31, 1993, the OTS has taken action that could cause Fidelity to be reclassified as a Tier 2 or Tier 3 institution. Further, while Fidelity is currently classified as adequately capitalized for purposes of the prompt corrective action system, an adequately capitalized institution may not make a capital distribution if such payment would cause the institution to become undercapitalized. Because of Fidelity's current capital levels, dividends and distributions from Fidelity will not be available to Citadel for the foreseeable future. On December 31, 1993, the bad debt reserves of the Bank for federal income tax purposes included $14.0 million representing excess tax bad debt reserves. If, in the future, amounts appropriated to these excess tax bad debt reserves are used for the payment of dividends or other distributions by the Bank (including distributions in dissolution, liquidation or redemption of stock), an amount equal to the distribution plus the tax attributable thereto, but not exceeding the aggregate amount of excess tax bad debt reserves, will generally be included in the Bank's taxable income and be subject to tax. In addition, if in the future the Bank fails to meet the definitional or other tests of a qualifying association, the entire tax bad debt reserves of $52.5 million will have to be recaptured and included in taxable income. It is not contemplated that the accumulated reserves will be used in a manner that will create such liabilities. Enforcement. Whenever the OTS has reasonable cause to believe that the continuation by a savings and loan holding company of any activity or of ownership or control of any non FDIC-insured subsidiary constitutes a serious risk to the financial safety, soundness, or stability of a savings and loan holding company's subsidiary savings institution and is inconsistent with the sound operation of the savings institution, the OTS may order the holding company, after notice and opportunity for a hearing, to terminate such activities or to divest such noninsured subsidiary. FIRREA also empowers the OTS, in such a situation, to issue a directive without any notice or opportunity for a hearing, which directive may (a) limit the payment of dividends by the savings institution, (b) limit transactions between the savings institution and its holding company or its affiliates, and (c) limit any activity of the association that creates a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings institution. In addition, FIRREA includes savings and loan holding companies within the category of person designated as "institution-affiliated parties." An institution-affiliated party may be subject to significant penalties and/or loss of voting rights in the event such party took any action for or toward causing, bringing about, participating in, counseling, or aiding and abetting a violation of law or unsafe or unsound practice by a savings institution. Limits on Change of Control. Subject to certain limited exceptions, control of Fidelity or Citadel may only be obtained with the approval (or in the case of an acquisition of control by an individual, the nondisapproval) of the OTS, after a public comment and application review process. Under OTS regulations defining "control," a rebuttable presumption of control arises if an acquiring party acquires more than 10% of any class of voting stock of Fidelity or Citadel (or more than 25% of any class of stock, whether voting or non-voting) and is subject to any "control factors" as defined in the regulation. Control is conclusively deemed to exist if an acquirer holds more than 25% of any class of voting stock of Fidelity or Citadel, or has the power to control in any manner the election of a majority of directors. Any company acquiring control of Fidelity or Citadel becomes a savings and loan holding company, must register and file periodic reports with the OTS, and is subject to OTS examination. With limited exceptions, a savings and loan holding company may not directly or indirectly acquire more than 5% of the voting stock of another savings and loan holding company or savings institution without prior OTS approval. Notification of New Officers and Directors. A savings and loan holding company that has undergone a change in control in the preceding two years, is subject to a supervisory agreement with the OTS, or is deemed to be in "troubled condition" by the OTS, must give the OTS 30 days' notice of any change to its Board of Directors or its senior executive officers. The OTS must disapprove such change if the competence, experience or integrity of the affected individual indicates that it would not be in the best interests of the public to permit the appointment. The OTS has taken action as a result of which Fidelity is deemed to be in "troubled condition" for this purpose. Classification of Assets Savings institutions are required to classify their assets on a regular basis, to establish appropriate allowances for losses and report the results of such classification quarterly to the OTS. A savings institution is also required to set aside adequate valuation allowances to the extent that an affiliate possesses assets posing a risk to the institution, and to establish liabilities for off-balance sheet items, such as letters of credit, when loss becomes probable and estimable. The OTS has the authority to review the institution's classification of its assets and to determine whether and to what extent (a) additional assets must be classified, and (b) the institution's valuation allowances must be increased. See Item 7. "MD&A--Asset Quality." Troubled assets are classified into one of three categories as follows: SUBSTANDARD ASSETS. Prudent general valuation allowances are required to be established for such assets. DOUBTFUL ASSETS. Prudent GVAs are required to be established for such assets. LOSS ASSETS. 100% of the amount classified as loss must be charged off, or a specific allowance of 100% of the amount classified as loss must be established. GVAs for loan and lease losses are included within regulatory capital for certain purposes and up to certain limits, while specific allowances and other general allowances are not included at all. The OTS and the other federal banking agencies have adopted a statement of policy regarding the appropriate levels of GVA for loan and lease losses that institutions should maintain. Under the policy statement, examiners will generally accept management's evaluation of adequacy of GVAs for loans and lease losses if the institution has maintained effective systems and controls for identifying and addressing asset quality problems, analyzed in a reasonable manner all significant factors that affect the collectability of the portfolio, and established an acceptable process for evaluating the adequacy of GVAs. However, the policy statement also provides that OTS examiners will review management's analysis more closely if GVAs for loan and lease losses do not equal at least the sum of (a) 15% of assets classified as substandard, (b) 50% of assets classified as doubtful, and (c) for the portfolio of unclassified loans and leases, an estimate of credit losses over the upcoming twelve months based on the institution's average rate of net charge-offs over the previous two or three years on similar loans, adjusted for current trends and conditions. The GVA policy statement has had no material impact on Fidelity's results of operations or financial condition. Community Reinvestment Act The Community Reinvestment Act ("CRA") requires each savings institution, as well as other lenders, to identify the communities served by the institution's offices and to identify the types of credit the institution is prepared to extend within such communities. The CRA also requires the OTS to assess the performance of the institution in meeting the credit needs of its community and to take such assessment into consideration in reviewing applications for mergers, acquisitions, and other transactions. An unsatisfactory CRA rating may be the basis for denying such an application. In connection with its assessment of CRA performance, the OTS assigns a rating of "outstanding," "satisfactory," "needs to improve," or "substantial noncompliance." Based on an examination conducted during 1993, Fidelity was rated satisfactory. The OTS and the other federal banking agencies have jointly proposed amendments to their CRA regulations that would replace the current assessment system, which is based on the adequacy of the processes an institution has established to comply with the CRA, with a new system based on the institution's performance in making loans and investments and maintaining branches in low- and moderate-income areas. Federal Home Loan Bank System The Federal Home Loan Banks provide a credit facility for member institutions. As a member of the FHLB of San Francisco, Fidelity is required to own capital stock in the FHLB of San Francisco in an amount at least equal to the greater of 1% of the aggregate principal amount of its unpaid home loans, home purchase contracts and similar obligations at the end of each calendar year, assuming for such purposes that at least 30% of its assets were home mortgage loans, or 5% of its advances from the FHLB of San Francisco. At December 31, 1993, Fidelity was in compliance with this requirement with an investment in the stock of the FHLB of San Francisco of $52.0 million. Long- term FHLB advances may be obtained only for the purpose of providing funds for residential housing finance and all FHLB advances must be secured by specific types of collateral. Required Liquidity OTS regulations require savings institutions to maintain, for each calendar month, an average daily balance of liquid assets (including cash, certain time deposits, bankers' acceptances, specified United States government, state and federal agency obligations, and balances maintained in satisfaction of the FRB reserve requirements described below) equal to at least 5% of the average daily balance of its net withdrawable accounts plus short-term borrowings during the preceding calendar month. The OTS may change this liquidity requirement from time to time to an amount within a range of 4% to 10% of such accounts and borrowings depending upon economic conditions and the deposit flows of member institutions, and may exclude from the definition of liquid assets any item other than cash and the balances maintained in satisfaction of FRB reserve requirements. Fidelity's average regulatory liquidity ratio for the month of December 1993 was 8.79%, and accordingly Fidelity was in compliance with the liquidity requirement. Monetary penalties may be imposed for failure to meet liquidity ratio requirements. OTS regulations also require each member institution to maintain, for each calendar month, an average daily balance of short-term liquid assets (generally those having maturities of 12 months or less) equal to at least 1% of the average daily balance of its net withdrawable accounts plus short-term borrowings during the preceding calendar month. The average short-term liquidity ratio of Fidelity for the month of December 1993 was 5.70%. Federal Reserve System The FRB requires savings institutions to maintain noninterest-earning reserves against certain of their transaction accounts (primarily deposit accounts that may be accessed by writing unlimited checks) and non-personal time deposits. For the calculation period including December 31, 1993, Fidelity was required to maintain $28.6 million in noninterest-earning reserves and was in compliance with this requirement. The balances maintained to meet the reserve requirements imposed by the FRB may be used to satisfy Fidelity's liquidity requirements discussed above. As a creditor and a financial institution, Fidelity is subject to certain regulations promulgated by the FRB, including, without limitation, Regulation B (Equal Credit Opportunity Act), Regulation D (Reserves), Regulation E (Electronic Funds Transfers Act), Regulation F (limits on exposure to any one correspondent depository institution), Regulation Z (Truth in Lending Act), Regulation CC (Expedited Funds Availability Act), and Regulation DD (Truth in Savings Act). As creditors of loans secured by real property and as owners of real property, financial institutions, including Fidelity, may be subject to potential liability under various statute and regulations applicable to property owners, generally including statutes and regulations relating to the environmental condition of the property. Gateway Gateway became an NASD-registered broker/dealer in October 1993 and offers securities products, such as mutual funds and variable annuities, to customers of the Bank. All securities transactions are executed and cleared by another broker/dealer. Gateway does not maintain security accounts for customers or perform custodial functions relating to customer securities. The securities business is subject to regulation by the Securities and Exchange Commission ("SEC"), the NASD and other federal and state agencies. Regulatory violations can result in the revocation of broker/dealer licenses, the imposition of censures or fines and the suspension or expulsion from the securities business of a firm, its officers or employees. With the enactment of the Insider Trading and Securities Fraud Enforcement Act of 1988, the SEC and the securities exchanges have intensified their regulation of broker/dealers, emphasizing in particular the need for supervision and control by broker/dealers of their own employees. As a broker/dealer registered with the NASD, Gateway is subject to the SEC's uniform net capital rules, designed to measure the general financial condition and liquidity of a broker/dealer. These rules require Gateway to maintain minimum net capital of $100,000 as of January 1, 1994 and do not permit Gateway's aggregate indebtedness to exceed eight times its net capital during its first twelve months of operations. At December 31, 1993, Gateway's net capital and required net capital were $579,929 and $52,000, respectively, and its ratio of aggregate indebtedness to net capital was .72 to 1. Under certain circumstances, these rules limit the ability of Citadel to make withdrawals of capital from Gateway. In addition, Gateway is required to file monthly reports with the NASD and quarterly and annual reports with the NASD and SEC containing detailed financial information with respect to its broker/dealer operations. ITEM 2. ITEM 2. PROPERTIES The executive offices of Citadel and Fidelity are located at 600 N. Brand Boulevard, Glendale, California 91203. This facility contains approximately 90,000 square feet of office space including a branch banking facility of approximately 12,000 square feet. Fidelity also owns an approximately 130,000 square feet facility located at 4565 Colorado Boulevard, Los Angeles, California 90039, which houses most of the administrative operations of Citadel and Fidelity. Present local zoning entitlements will allow for the construction of an additional approximately 300,000 square feet of office space plus parking on this 7.75-acre parcel. The potential for increasing the amount of office space at this Los Angeles site would satisfy Fidelity's anticipated facilities requirements for future years. The aggregate net book value of all owned administrative facilities was approximately $26.0 million as of December 31, 1993. On December 31, 1993, Fidelity owned 16 of its branch and/or loan office facilities having an aggregate net book value of approximately $9.4 million, and leased the remaining 26 of its branch and/or loan office facilities under leases with terms (including optional extension periods) expiring from 1994 through 2050. The aggregate annual rent under those leases as of December 31, 1993 was approximately$2.6 million and the aggregate net book value of Fidelity's leasehold improvements associated with those leased premises was approximately $1.9 million. At December 31, 1993, Fidelity owned furniture, fixtures and equipment, related to both owned and leased facilities, having a net book value of approximately$11.7 million. As a result of the January 1994 Northridge Earthquake, physical damage was sustained at some of the Bank administrative and branch office facilities located in the Los Angeles area, however, only one Bank-owned building in the San Fernando Valley region of Los Angeles sustained major damage. It is estimated that necessary repairs to all affected facilities, net of anticipated insurance reimbursement, shall not exceed $0.5 million. All owned office facilities are located in Southern California. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company has lawsuits pending against it in the ordinary course of business. As of December 31, 1993, the Company's management and its counsel believe that none of the pending lawsuits or claims taken separately or together will have a materially adverse impact on the financial condition or business of the Company. On March 4, 1994, Chase, one of four lenders under Fidelity's $60 million Subordinated Loan Agreement, sued Fidelity, Citadel and Citadel's Chairman of the Board alleging, among other things, that the transfer of assets pursuant to the Restructuring would constitute a breach of the Subordinated Loan Agreement, and seeking to enjoin the Restructuring and to recover damages in unspecified amounts. In addition, the lawsuit alleges that past responses of Citadel and Fidelity to requests by Chase for information regarding the Restructuring violate certain provisions of the Subordinated Loan Agreement and that such alleged violations, with the passage of time, have become current defaults under the Subordinated Loan Agreement. While the other three lenders under the Subordinated Loan Agreement hold $25 million of the subordinated debt, none of them has joined Chase in this lawsuit. The Company is evaluating the lawsuit and, based on its current assessment, the Company does not believe that the allegations have merit. See Item 7. "MD&A"--Capital Resources and Liquidity" for additional considerations relating to the Subordinated Loan Agreement. 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 year ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION The Company's common stock is listed and quoted on the American Stock Exchange ("AMEX"). The following table sets forth the high and low closing bid prices of the common stock of the Company as reported by AMEX for each of the following quarters: - -------- (1) The closing price of the Company's common stock on March 15, 1994 was $4.25 per share. (2) The closing price of the Company's common stock on March 29, 1993 was $22.13 per share. This price reflects the sale of 3,297,812 newly issued shares of common stock on March 29, 1993 for $10 per share. HOLDERS OF RECORD The number of holders of record of the Company's common stock at February 28, 1994 was 259. DIVIDENDS While Citadel has never declared a dividend and has no current plan to declare a dividend, it is Citadel's policy to review this matter on an ongoing basis. Regulatory restrictions applicable to Fidelity and certain provisions of the Company's Subordinated Loan Agreement currently limit the ability of the Company to declare or pay dividends. These limitations include: (a) a statutory prohibition on Fidelity making capital distributions that would cause it to become undercapitalized for purposes of the prompt corrective action system and other potentially applicable restrictions under OTS regulations; (b) limitations in the Subordinated Loan Agreement as to the aggregate amount declared and paid as a proportion of the Company's consolidated net earnings and (c) the absence of any default by the Company in its obligations as specified in the Subordinated Loan Agreement. See Item 1. "Business--Regulation and Supervision--Savings and Loan Holding Company Regulation--Payment of Dividends and Other Capital Distributions." See also Item 3. "Legal Proceedings" and Item 7. "MD&A--Capital Resources and Liquidity" for additional information regarding the Subordinated Loan Agreement. At December 31, 1993, Fidelity had accumulated earnings and profits for federal income tax purposes. Any dividend paid by Fidelity in excess of current or accumulated earnings and profits for federal income tax purposes would be treated as made out of the tax bad debt reserve and will increase income for federal income tax purposes. Currently Fidelity's accumulated earnings and profits for federal income tax purposes is of such an amount that it would be highly unlikely that any dividend, if such dividend were payable by Fidelity, would be treated as made out of the tax bad debt reserve. See Item 1. "Business--Taxation." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FIVE-YEAR SELECTED FINANCIAL DATA The tables below set forth certain historical financial data regarding the Company. This information is derived in part from, and should be read in conjunction with, the consolidated financial statements of the Company. None of the data in the tables have been adjusted for effects of the Citadel rights offering in March 1993. - ------- (1) Net of treasury shares, where applicable. (2) 1993 data includes 3,297,812 shares issued in March 1993 in connection with a stock rights offering, which produced net proceeds to the Company of $31.4 million. (3) Excluding the writedown of core deposit intangibles of $5.2 million, interest rate margins at and for the year ended December 31, 1993, would have been 2.32% and 2.39%, respectively. (4) All retail branch offices are located in Southern California. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS NET EARNINGS Citadel Holding Corporation ("Citadel") reported a net loss of $67.2 million, or $11.56 per share (average outstanding shares of 5,809,570) in 1993 compared to net earnings of $2.0 million, or $0.62 per share (average outstanding shares of 3,297,812) in 1992 and $2.7 million, or $0.81 per share (average outstanding shares of 3,297,812) in 1991. Unless otherwise indicated, references to the "Company" include Citadel, Fidelity Federal Bank, a Federal Savings Bank ("Fidelity" or the "Bank") and all subsidiaries of Fidelity and Citadel. The following table summarizes these results: - -------- (1) 1993 data includes 3,297,812 shares issued in March 1993 in connection with a stock rights offering. The components of the changes in earnings/loss before income taxes are shown below: The $99.8 million change in earnings/loss before income taxes between 1992 and 1993 is primarily due to (a) decreased net interest income of $29.6 million, (b) increased operating expense of $27.4 million, (c) a $26.3 million increase in the provision for loan and real estate losses, (d) a $14.2 million increase in direct costs related to real estate operations, and (e) decreased fee income and other income of $3.6 million. This was partially offset by a $1.3 million increase in gains on sales of securities. The $27.4 million increase in expenses from 1992 to 1993 was attributable in part to increased staffing levels required to manage rising problem assets, strengthen internal asset review, handle increased financial services offered at the retail branch network and expand originations and sales of residential mortgages in the mortgage banking network. The increase is also attributable to certain nonrecurring charges incurred in connection with the Company's valuation of its intangible assets and further development of the internal reorganization and restructuring plan discussed below, including the write-off $8.8 million of goodwill and $5.2 million in core deposit intangibles, and an increase of $5.6 million in professional fees, of which approximately $3.3 million was attributable to analysis and development of the Company's restructuring plan and related asset valuation process. In 1993, Fidelity reassessed the valuation of its intangible assets. Based upon the results of a branch profitability analysis and an analysis of the recoverability of its core deposit intangible assets, Fidelity wrote down the carrying value of its core deposit intangible assets in the amount of $5.2 million (which writedown is included in interest expense). In addition, an analysis was performed of the recoverability of the goodwill related to the acquisition of Mariners Savings and Loan ("Mariners") in 1978. These analyses indicated that the net expected future earnings from the branches or assets acquired did not support the carrying value of the goodwill. As a result, Fidelity wrote down the remaining $8.8 million balance of goodwill related to the Mariners acquisition (which writedown is included in operating expense). The $22.1 million change in earnings/loss before income taxes between 1991 and 1992 was mainly due to (a) an $11.3 million decrease in net interest income, (b) an increase in the provision for loan and real estate operations of $10.6 million, (c) a $9.0 million decrease in gains on sales of securities, and (d) a $2.4 million increase in direct costs related to real estate operations. These were partially offset by increased fee income and other income of $9.7 million and decreased operating expenses of $1.5 million. The following table summarizes certain regulatory capital and asset quality information for Fidelity as of the dates indicated: - -------- (1) 1993 capital includes capital contributions from Citadel of $28.0 million. See "Capital Requirements." See "Asset Quality" for more information. NET INTEREST INCOME Net interest income is the difference between interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities. Stated differently, the level of net interest income is the sum of (a) the interest rate margin (the difference between the yield earned on the interest-earning assets and the rate paid on the interest-bearing liabilities) multiplied by the amount of interest-earning assets; plus (b) the excess balance of interest-earning assets over interest-bearing liabilities multiplied by the rate paid on interest-bearing liabilities. Therefore, the higher the yield on interest-earning assets relative to the rate paid on interest-bearing liabilities, the higher the net interest income. Conversely, the lower the yield on interest-earning assets relative to the rate paid on interest-bearing liabilities, the lower the net interest income. Similarly, the smaller the level of interest-earning assets relative to the level of interest-bearing liabilities, the smaller the net interest income. As a result, net interest income between two periods will decline if the interest rate margin declines, the excess of interest-earning assets over interest-bearing liabilities declines, interest-earning accounts decline and the rate paid on interest-bearing liabilities increases. The converse also holds true. In a period of increased loan defaults, interest-earning assets tend to decline faster than interest-bearing liabilities, which in turn tends to depress net interest income. As a result, a higher interest rate margin would be needed to maintain a constant level of net interest income. In a period of declining interest rates, prepayments on mortgages tend to increase and as a result, the level of interest earning-assets will decline if the volume of new loan originations held in the portfolio does not increase to offset the increased level of prepayments. The decline in net interest income is partially offset by the decline in the rate paid on interest-bearing liabilities. The change in net interest income is a result of: (a) the change in interest-earning assets multiplied by the current interest rate margin, plus (b) the change in the interest rate margin multiplied by prior interest- earning assets, plus (c) the change in the rate paid on interest-bearing liabilities multiplied by the current excess balance of interest-earning assets over interest-bearing liabilities, plus (d) the change in the excess balance of interest-earning assets over interest-bearing liabilities multiplied by the prior rate paid on interest-bearing liabilities. In addition, net interest income is affected by the level of nonperforming loans. The Bank generally places loans on nonaccrual status whenever the payment of interest is 90 or more days delinquent or when the Bank believes they exhibit materially deficient characteristics. The reduction in income related to these nonaccruing loans was approximately $8.7 million in 1993 compared to $13.6 million in 1992 and $7.6 million in 1991. As previously discussed, net interest income was also reduced by a $5.2 million writedown of core deposit intangibles ("CDI") in 1993. The remaining net unamortized balance of core deposit intangibles at December 31, 1993 was $2.1 million which is being amortized over the average remaining life of the deposits acquired, generally 1 to 3 years. Net interest income for 1993 of $101.2 million decreased by $29.6 million or 22.6% from $130.8 million for 1992. This decrease resulted from the combined impacts of (a) a 6.7% decrease in average interest-earning assets, reducing net interest income by $14.7 million, and (b) a 48 basis point decrease in the effective yield on interest-earning assets, decreasing net interest income by $14.9 million, caused in part by the impact of the CDI write-off discussed above. Net interest income for 1992 of $130.8 million decreased by $11.3 million or 8.0% from $142.1 million for 1991. This $11.3 million decrease resulted from the offsetting impacts of (a) a 12.0% decrease in average interest-earning assets, reducing net interest income by $12.8 million, and (b) a 13 basis point increase in the effective yield on interest-earning assets, increasing net interest income by $1.5 million. The following table displays the components of the Company's interest rate margin at the end of, and for each period, as well as the effective yield for each period: - -------- (1) Excluding the writedown of core deposit intangibles of $5.2 million, the interest rate margins at and for the year ended December 31, 1993 and the effective yield on interest-earning assets for the year ended December 31, 1993, would have been 2.32%, 2.39% and 2.44%, respectively. The reduction in the interest rate margin in 1993 from 1992 can be attributed to the lagging relationship between the repricing of assets and liabilities as market interest rates stabilize. The average rate paid on interest-bearing liabilities adjusts to market rates faster than the average rate earned on interest-earning assets. This difference in the speed of adjustment to changes in market interest rates is primarily due to the nature of the Federal Home Loan Bank ("FHLB") of San Francisco Eleventh District Cost of Funds Index (the "COFI") to which most of the Bank's loans are tied, the contractual repricing terms of the loans held in the portfolio, the advance notification requirements to borrowers for any rate change, the time lag in the availability of the actual index, as well as the amount of the lifetime interest rate caps. As a result of these factors, changes in the yield on COFI-based loans lag changes in market interest rates. The interest rate margin of the Company increases in a period of steady decline in interest rates, since the yield on interest-bearing assets drops more slowly than the rates paid on interest-bearing liabilities. Conversely, as market interest rates stabilize and then increase, the interest rate margin of the Company will shrink, other conditions being equal. This factor, together with the timing of asset repricing and the increase in nonperforming assets, resulted in a reduction of 132 basis points in the yield on loans in 1993 from 1992 average levels, while the decrease in market interest rates resulted in a reduction in the cost of funds of only 90 basis points for the comparable period. The Federal Reserve Board ("FRB") increased the federal funds rate by 0.25% in February 1994 and another 0.25% in March 1994, which may be indicative of future reductions to the Company's interest rate margin. The increase in the Company's interest margin for 1992 compared to 1991 was primarily caused by the continued downward trend in market interest rates during 1992 which resulted in a decrease in the cost of funds of 199 basis points. The effect of the reduced cost of funds on the interest margin was partially offset by a decrease of 179 basis points in the yield on loans from 1991 due to declines in the COFI. Since 1990, the Company has continued its strategy to more closely match the repricing periods of its interest-bearing liability and interest-earning asset portfolios by concentrating on the origination and retention of ARM loans. In 1993, 1992 and 1991, the Bank retained substantially all of the ARM loans it originated. The percentage of monthly adjustable ARMs outstanding to the total ARM portfolio was 78%, 77% and 74% at December 31, 1993, 1992 and 1991, respectively, while the percentage of semiannual adjustable ARMs was 19% at December 31, 1993 compared to 21% in 1992 and 24% in 1991. This trend of increasing the monthly adjustable ARM portfolio in relation to the decreasing semiannual adjustable ARM portfolio will reduce, but not eliminate, the risk created by the mismatch of the assets' repricing index and the liabilities' repricing indices. However, certain ARMs meeting specific criteria have been identified as held for sale and transferred to the held for sale portfolio as part of the asset/liability strategy and the possible need to increase regulatory capital in the future. See "Interest Rate Risk Management" for further discussion. NONINTEREST INCOME Noninterest income has three major components: (a) gains and losses on the sale of loans and fee income associated with other on-going operations, such as fees earned on the sale of securities and annuities, loan origination fees and service charges on deposit accounts, (b) income/expenses associated with owned real estate, which includes both the provision for real estate losses as well as income/expenses experienced by the Bank related to the operations of its owned real estate properties (e.g., maintenance expenses, capital expenditures and payment of current and delinquent property taxes), and (c) gains and losses on the sale of investment securities and mortgage-backed securities. The last two items can fluctuate widely, and could therefore mask the underlying fee generating performance of the Company on an ongoing basis. Noninterest income declined from a loss of $5.5 million in 1992 to a loss of $34.4 million in 1993. The following table details the noninterest income/expense: Noninterest income from ongoing operations decreased by $3.6 million, to $13.2 million during 1993 from $16.8 million during 1992 partly due to the Company's retooling and refocusing efforts during 1993 (see "Operating Expense"). An increase in fee income from investment products of $0.9 million to $4.3 million was offset by decreases in loan and other fees, gains on sales of loans and fee income from deposits. Foreclosure activities increased markedly from December 31, 1992 to December 31, 1993, resulting in an increase in real estate owned ("REO") both in terms of numbers of properties and total dollars. REO consists of real estate acquired in settlement of loans and in-substance foreclosures ("ISFs"). The following table summarizes certain components of Fidelity's real estate operations: The Bank has a policy of providing general valuation allowances for both estimated loan and real estate losses, in addition to valuation allowances on specific loans and REO, in response to the continuing deterioration of the quality of the Bank's loan and REO portfolio. Provisions for real estate losses increased by $12.4 million in the year ended December 31, 1993 as compared to the same period in 1992, and provisions for loan losses increased by $13.9 million over the same period. See "Asset Quality" for further detail. Noninterest income decreased by $11.7 million in 1992 compared to 1991. This decrease was due to the combined effects of (a) an increase in net expense from real estate operations of $11.6 million, inclusive of provisions for estimated real estate losses, (b) a decrease in gains on sales of mortgage- backed securities of $9.0 million as there were no such sales in 1992, and (c) a decrease in other expense of $7.0 million due to the accrual for contingent liabilities of $6.0 million in 1991 with a $1.0 million reduction in such accrual in 1992. OPERATING EXPENSE Operating expense increased to $105.3 million in 1993 from $77.9 million in 1992 and $79.4 million in 1991. The following table details the operating expenses for 1993 and 1992: - -------- (1) The efficiency ratio is computed by dividing total operating expense by net interest income and noninterest income, excluding nonrecurring items, provisions for estimated loan and real estate losses, direct costs of real estate operations and gains/losses on the sale of securities. (2) The operating expense ratio is computed by dividing total operating expense by average total assets. A substantial portion of the increase from 1992 to 1993, as detailed below, was due to the re-engineering of certain functions of the Bank, including the related training and personnel costs. The associated improved operating results are expected to be realized in later years. The increases in personnel and benefits are mainly due to increased staffing levels during 1993 (with average full-time equivalent employees ("FTEs") of 882) over 1992 (with average FTEs of 828). The increased staffing levels are due to (a) increased staffing required to manage the rising problem asset portfolio and to strengthen the internal asset review function, (b) increased staffing levels in the retail branch network to support the 1993 strategies of customer orientation and retail financial services focus, and (c) increased staffing levels in the mortgage banking network to expand the origination and sale of residential mortgages. These increases were partially offset by the reduction of data processing personnel in connection with the outsourcing of substantially all of the information systems functions in May 1993. The Bank has aggressively increased the staff of its real estate asset management department by 27 FTEs during 1993, which handles foreclosures, loan restructurings and REO sales. The Bank continues to increase the staff of its internal asset review department, which continuously monitors asset quality and adequacy of loss reserves. The staffing level in the retail network increased due to improved ability to fill open positions and an increased emphasis on providing investment products to customers. The staffing level in the mortgage banking network also increased due to the increased emphasis on meeting a broader range of customer real estate borrowing requirements. The general rise in office-related expenses is due to the higher staffing levels. In addition to staffing increases, the Bank incurred higher personnel and benefits costs related to (a) training costs associated with the data systems conversions and reorganization of the retail financial services group, (b) the adoption in 1993 of a new accounting pronouncement related to retiree health and life insurance benefits (as discussed below), (c) increased costs of employee insurance benefit and retirement plans, and (d) increased travel costs associated with data systems conversion training and the exploration of strategic alternatives and restructuring of the Company. Effective January 1, 1993, the Bank adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" for its unfunded postretirement health care and life insurance program. This statement requires the cost of postretirement benefits to be accrued during the service lives of employees. The Bank's previous practice was to expense these costs on a cash basis. The net periodic postretirement benefit cost for 1993 totaled $0.6 million. However, in an effort to reduce operating expense, the Bank is exploring various alternatives to all the existing benefit plans, which may include reducing future benefits accruing to employees. The Bank's Federal Deposit Insurance Corporation ("FDIC") insurance premium is based upon three factors: (a) the volume of deposits, (b) the rate at which the FDIC assesses the deposits, and (c) any other adjustments or credits the FDIC may allow. The increase in the FDIC insurance expense in 1993, from the level of expense in 1992, was primarily due to an increase in the rate the FDIC assessed to deposits in 1993, which was partially offset by a credit received from the FDIC for the final distribution of the secondary reserve and from the reduced level of deposits. Professional services increased in 1993 over 1992 primarily due to financial advisory fees associated with (a) costs of approximately $3.3 million incurred in reviewing the Company's strategic objectives and developing a restructuring plan and in the related asset valuation process and (b) higher outside data services costs of approximately $2.9 million relative to the outsourcing of the primary information systems functions in May 1993, which costs were partially offset by some savings in compensation expense of approximately $1.0 million. As previously discussed, amortization of intangibles included an $8.8 million writedown of goodwill in 1993. Operating expense decreased by $1.5 million in 1992 from the level in 1991. This decrease was caused principally due to (a) $0.3 million decrease in FDIC insurance expense due to average deposit shrinkage during the assessment period, (b) a $0.7 million decrease in professional services due to reduction in consulting expense, (c) a $0.4 million decrease in other operating expense due to reductions in marketing expense and level of amortization of intangible assets, and (d) a $0.6 million increase in capitalized costs due to an increase in the number of loan originations (although the total dollar amount of loan originations decreased in 1992 over 1991). These decreases were partially offset by a $0.9 million increase in personnel and benefits primarily due to increases in personnel, severance and pension costs. The increase in operating expenses combined with the decrease in the total average asset size of the Company (from $5.5 billion at December 31, 1991 to $4.9 billion at December 31, 1992 and to $4.6 billion at December 31, 1993), resulted in an increase in the operating expense ratio from 1.43% in 1991 to 1.61% in 1992 and 2.30% in 1993. The operating expense ratio would have been 2.04% for 1993 without the nonrecurring expenses directly related to the Company's restructuring and the $8.8 million writedown of goodwill. Due to the sensitivity of the operating expense ratio to changes in the size of the balance sheet, management also looks at trends in the efficiency ratio to assess the changing relationship between operating expenses and income generated. EFFICIENCY RATIO The efficiency ratio measures the amount of cost expended by the Company to generate a given level of revenues in the normal course of business. It is computed by dividing total operating expense by net interest income and noninterest income, excluding nonrecurring items, provisions for estimated loan and real estate losses, costs of real estate operations on specific properties and gains/losses on the sale of securities. This computation reflects a change from the method of computation used in previous periods in that the impact of real estate operations on specific properties is now excluded from the computation. The lower the efficiency ratio, the lower the amount of resources being expended by the Company to generate a given level of revenues. As a result, an increase in the efficiency ratio indicates that the Company is expending more resources to generate revenues and the Company is thus becoming less efficient in the use of its resources. A decrease in the efficiency ratio indicates the opposite (i.e. an improvement). Changes in the efficiency ratio are due to three factors: (a) changes in net interest income, (b) changes in noninterest income, and (c) changes in operating expenses. A decline in net interest income and/or noninterest income and/or a rise in operating expenses will have an unfavorable impact on the ratio (i.e. will increase the ratio) and the converse holds true. The Company's efficiency ratio worsened by 24.39 percentage points between the year ended December 31, 1992 and 1993 due to unfavorable variances in all three components. Asset quality problems adversely affected two of the components of the efficiency ratio; reduced net interest income via an increase in nonperforming loans and mounting foreclosure activities, which resulted in a decrease in interest-bearing assets and lower asset yield; and higher operating expenses associated with the increased staffing level described above. Additionally, the increased staffing levels in the retail financial services network and mortgage banking network adversely impacted the efficiency ratio. These increases should result in increased expense in the short-term, but increased income in the long-term. In spite of lower operating expenses in 1992 compared to 1991 levels, the Company's efficiency ratio worsened by approximately 1.98 percentage points from 51.18% in 1991 to 53.16% in 1992, as a result of lower interest income due to increases in nonperforming assets and a smaller balance sheet, partially offset by increased noninterest income. An analysis of the change in the efficiency ratios during 1993 and 1992 is shown below: Continued deterioration in the asset quality of the Bank, and/or stable or higher short-term interest rates in the future (if they occur) would have an adverse effect on net interest income and noninterest income, which would in turn lead to an increase (or worsening) in the efficiency ratio, assuming expenses remain constant. CAPITAL RESOURCES AND LIQUIDITY Regulatory Capital Requirements The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") and implementing capital regulations require Fidelity to maintain: (1) Tangible Capital of at least 1.5% of Adjusted Total Assets (as defined in the regulations); (2) Core Capital of at least 3% of Adjusted Total Assets (as defined in the regulations); and (3) Total Risk-based Capital equal to 8.0% of Total Risk-weighted Assets (as defined in the regulations). See Item 1. "Business--Regulation and Supervision--FIRREA Capital Requirements." The following table summarizes the regulatory capital requirements for Fidelity at December 31, 1993, but does not reflect the required future phasing out of certain assets, including investments in, and loans to, subsidiaries which may presently be engaged in activities not permitted for national banks and, for risk-based capital, real estate held for investment (the impact of which the Bank believes to be immaterial). As indicated in the table, Fidelity's capital levels exceed all three of the currently applicable minimum capital requirements. Fidelity's capital as shown below includes $28.0 million of capital contributions from Citadel during 1993. Fidelity's capital levels also exceeded all of the then applicable minimum capital requirements at December 31, 1992 and 1991. - -------- (1) The term "adjusted assets" refers to the term "adjusted total assets" as defined in 12 C.F.R. section 567.1(a) for purposes of tangible and core capital requirements, and for purposes of risk-based capital requirements, refers to the term "risk-weighted assets" as defined in 12 C.F.R. section 567.1(bb). At December 31, 1993, Fidelity met the fully phased-in capital requirements for all three measurements based upon regulations currently in effect. However, because of the regulatory advantages available to benefit well-capitalized institutions, the Bank continues to have as its objective to increase its core capital to at least 5%. At December 31, 1993, based on then current asset levels, Fidelity would have been required to increase its core capital by approximately $37.3 million to reach the 5% core capital level. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires the OTS and the federal bank regulatory agencies to revise their risk- based capital standards to ensure that those standards take adequate account of interest rate risk, concentration of credit risk, and risks of nontraditional activities. The OTS added an interest rate risk capital component to its risk- based capital requirement. This component is effective September 30, 1994, based on the December 31, 1993 balance sheet. This capital component will require institutions deemed to have above normal risk to hold additional capital equal to 50% of the excess risk. As of December 31, 1993, the Bank's internal risk measurement system showed a risk level less than half of the OTS limit. The most recently available OTS report (September 30, 1993) shows an even lower risk. Therefore, if the requirement had been in effect on December 31, 1993, using the year-end balance sheet, there would have been no interest rate risk component required to be added to Fidelity's risk-based capital requirement. In addition, FDICIA required the OTS to implement a system requiring regulatory sanctions against institutions that are not adequately capitalized, with the sanctions growing more severe, the lower the institution's capital. Under FDICIA, the OTS issued regulations establishing specific capital ratios for five separate capital categories. The five categories of ratios are: The following table summarizes the capital ratios of the adequately capitalized category and Fidelity's regulatory capital at December 31, 1993 as compared to such ratios. As indicated in the table, Fidelity's capital levels exceeded the three minimum capital ratios of the adequately capitalized category. - -------- (1) The term "adjusted assets" refers to the term "adjusted total assets" as defined in 12 C.F.R. section 567.1(a) for purposes of core capital requirements, and for purposes of risk-based capital requirements, refers to the term "risk-weighted assets" as defined in 12 C.F.R. section 567.1(bb). Although the Bank was deemed adequately capitalized at December 31, 1993, at such date, absent the $28 million in capital contributed to the Bank by Citadel during the year, the Bank would have had to significantly reduce its assets or the Bank would not have met the 4% core capital to adjusted total assets requirement of the adequately capitalized category and thus would have been classified as undercapitalized for purposes of the OTS' prompt corrective action regulations. Citadel, with only $2.3 million in liquid assets at December 31, 1993 and ongoing expenses in connection with the contemplated Restructuring of the Company defined below, is not in a position to make further capital contributions to the Bank, nor does Citadel have ready access to additional funds under current circumstances. Management anticipates that the Bank will incur losses in the first and second quarters of 1994 that will, in the absence of a new capital infusion or a reduction in the Bank's total assets, reduce the Bank's core capital ratio to less than 4%. In an effort to maintain the Bank's core capital ratio above 4% at March 31, 1994 by downsizing its balance sheet, the Bank has entered into an agreement to sell approximately $160 million of single family and multifamily (2 to 4 units) performing loans in the first quarter of 1994. Additionally, in order to maintain the Bank's capital above the regulatory minimums necessary to continue to be designated "adequately capitalized" while the Restructuring is pursued, management continues to explore possibilities for increasing the Bank's capital, either through the issuance of new equity or the sale of assets. Management may also consider further downsizings in the Bank's balance sheet through additional loan sales, although such dispositions of income-producing assets would reduce the Bank's future income. If the Restructuring of the Company discussed below is not accomplished, the Bank will be required to take other actions to maintain its capital ratios, including further downsizing the Bank and raising of additional equity. If such actions are not successful, the Bank would likely become "undercapitalized" for purposes of the prompt corrective action regulations of the OTS. The consequences of becoming undercapitalized would include, but would not be limited to, (a) the obligation of Fidelity to file a capital restoration plan that is accompanied by an acceptable Citadel guarantee; (b) restrictions on asset growth, branch acquisitions and new activities; (c) a prohibition on dividends and capital distributions by Fidelity (subject to certain exceptions); and (d) increased monitoring by the OTS. An acceptable capital restoration plan guarantee would require Citadel to demonstrate appropriate assurances of its ability to perform on the guarantee. Given Citadel's current capital resources and liquidity position, no assurance can be given that such a Citadel guarantee would be found acceptable by the OTS. Failure to provide an acceptable capital restoration plan could result in additional OTS sanctions typically reserved for "significantly undercapitalized" institutions. These discretionary sanctions include, but are not limited to, (a) OTS authority to require the recapitalization, merger or sale of the Bank; (b) divestiture of subsidiaries of the Bank or a holding company divestiture of the Bank; (c) more stringent asset growth restrictions than applicable to "undercapitalized" institutions; and (d) management changes, including election of new directors, and dismissal of directors or senior officers who have held office for more than 180 days, among other things. Economic trends in Southern California continue to adversely affect both the delinquencies being experienced by thrifts such as Fidelity and the ability of such institutions to recoup principal and accrued interest by realization upon underlying collateral. No assurances can be given that such trends will not continue in future periods creating increasing downward pressure on the capital and earnings of thrift institutions. The OTS has the ability to fix specific capital-required levels for Fidelity higher than those set forth above. Fidelity is under continuing regulatory pressure to raise capital ratios. The Company is actively pursuing a restructuring plan that would include both the transfer to a newly-formed Citadel subsidiary or division of certain problem assets of the Bank and a sale of the Bank and Gateway (the "Restructuring"; discussions of the sale of the Bank in the context of the Restructuring include the sale of Gateway). The Company is currently seeking a strategic buyer or a new core set of equity investors for the Bank. Any such sale of the Bank will be subject to the approval of Citadel's Board of Directors (the "Board") and stockholders, as well as the OTS. Following the proposed sale of the Bank, Citadel would become a real estate company and focus on the servicing and enhancement of its loan and real estate portfolio. The Restructuring calls for the Bank's disposition of substantially all of its problem assets, together with a small amount of performing assets, so as to improve the attractiveness of the Bank to potential acquisition or investment candidates. Most of the Bank's problem assets would be transferred to the new Citadel real estate subsidiary or division using securitized debt financing. These assets would consist of commercial and large multifamily loans and real estate owned properties with a current net book value of approximately $401 million. The impact of the January 1994 Northridge Earthquake on the assets to be transferred is not expected to alter significantly the value of such assets. The Restructuring plan also calls for the Bank's disposition of a smaller group of problem assets, consisting primarily of smaller multifamily loans with a current net book value of approximately $81 million, in a bulk sale to a third- party purchaser or Citadel. While the Board will fully explore the market values of this Restructuring before making any final decisions, the Board views this approach as having the greatest potential to maximize stockholder values in the foreseeable future. In formulating the proposed Restructuring, the Company believes that the value of Fidelity to a purchaser or investor would be heavily, and perhaps excessively, discounted due to its problem assets. Thus, it was determined that the Bank's attractiveness to an acquisition or investment candidate would be enhanced if the Bank disposed of these problem assets. However, management also believes that these assets, if managed outside the environment of a federally regulated institution, present the potential for Citadel stockholders to realize future value that would not be reflected in the bulk sale price of those assets to a third party today. Accordingly, the Restructuring was designed to retain in a Citadel subsidiary or division approximately $401 million of primarily problem assets after a sale of the Bank. Management believes that an asset disposition is critical to a successful major recapitalization program for Fidelity. Citadel has commenced efforts to raise the financing necessary to consummate its problem asset purchase from Fidelity. Because of the significant conditions to and uncertainty in accomplishing a successful Restructuring, the Company expects that the losses associated with the Restructuring would only be incurred upon the sale of the Bank, at which time the effects of the losses on capital should be offset by either a new infusion of capital from investors, who would purchase ownership of the Bank, or a merger with another financial institution. The following discussion focuses on certain financial consequences of the Restructuring and is not indicative of the loss content of the Bank's assets in the absence of the restructuring or other bulk asset dispositions. To consummate the bulk transfers of assets to a Citadel subsidiary or division and obtain debt financing in the capital markets for the larger transfer, Fidelity would be required to write down these assets to their bulk sale values. These losses would be offset in part by the reduction in the Bank's GVA (reflecting the healthier remaining asset pool) and possible tax benefits. If the Restructuring were to be consummated in mid-1994, management's latest estimate is that the Bank's core capital, after giving effect to the writedowns on the asset transfers, tax benefits associated therewith, use of relevant reserves and extraordinary charges relating to the Restructuring, but before giving effect to any new capital infusion into the Bank by the acquiror or new investors, would be approximately $102 million. This estimate will be subject to ongoing adjustment in view of changing variables such as future earnings or losses, changes in the composition and size of the problem assets and other factors. The Bank does not intend to implement the above-described bulk problem asset dispositions, or to incur the consequent losses, in the absence of an acquisition of the Bank by another financial institution or financial investors who are able to infuse additional core capital into the Bank. Any such acquisition will also require the approval of Citadel's Board and stockholders, as well as the OTS, which will condition its approval in part on the adequacy of the capital of the Bank after the Restructuring. No assurances can be given that the proposed Restructuring can be successfully implemented. Sources of Funds and Liquidity The Bank's primary sources of operating funds are deposits, borrowings, loan payments and prepayments, loan sales and earnings. Deposit activity is an important factor in Fidelity's cash flow position. At December 31, 1993, Fidelity had deposits of $3.4 billion, down from $3.5 billion at December 31, 1992 and $3.9 billion at December 31, 1991. This reduction has been, in part, the natural result of the Company's determination to reduce total assets and, in part, the result of the need on the part of its depositors to withdraw funds to meet current living expenses and/or increase yields through other investments. As a part of its strategy of preserving and enhancing the value of its customer franchise, Fidelity has increasingly focused its efforts on attracting and retaining a greater number of profitable, low-cost transaction accounts, such as checking, passbook and money market accounts. In the year ended December 31, 1993, Fidelity increased the number of checking accounts to 94,100 from 77,400 at year-end 1992 and 65,400 at year-end 1991. Similarly, the number of passbook accounts increased from 19,700 at year-end 1991 to 24,300 at year-end 1992 and 28,100 at year-end 1993. The number of money market savings accounts declined from 21,600 at year-end 1991 to 18,800 at year-end 1992 and 15,200 at year-end 1993, primarily due to decreasing interest rates during those periods. The Bank has also restructured its branch network with an emphasis on providing retail financial services to its customers. In order to capture the funds moving out of traditional bank products into higher yield investments, sales of investment products have been integrated into the retail network, and new positions and compensation systems have been developed and implemented. In 1993, the Company, through Gateway, sold investment and annuities products to customers of the Bank totaling $96.4 million, compared with total sales of $79.9 million in 1992 and $57.8 million in 1991. During 1993, the total balance of certificates of deposit increased by $22.3 million to $2.6 billion, while the total balance of retail transaction accounts (checking, passbook and money market savings) and other lower-cost accounts decreased by $111.6 million to $729.6 million. These reductions in total balance have been influenced by lower rates of interest offered on retail accounts, causing depositors to seek increased yields through other investments. On December 31, 1993, certificates of deposit over $100,000 represented approximately 18% of total deposits compared to 16% at December 31, 1992 and 16% at December 31, 1991. Broker-originated deposits totaling $92.2 million, $12.9 million and $0 were included in certificates of deposit at the comparable periods. FHLB Advances are another major source of funds. At December 31, 1993, 1992 and 1991, the outstanding balances were $326.4 million, $581.4 million and $325.0 million, respectively. The decreased use of FHLB Advances in 1993 as a source of funds results primarily from the use of commercial paper, which is less costly, as an alternative source of funds. In an ongoing effort to diversify its funding source, the Bank started issuing commercial paper during the third quarter of 1992. The commercial paper is backed by a letter of credit from the FHLB to ensure a high quality investment grade rating. Fidelity's obligation to reimburse the FHLB for any amounts paid under the letter of credit is secured by a pledge of mortgage loans by Fidelity to the FHLB. At December 31, 1993, $239.0 million of net funds were provided by the issuance of commercial paper, compared to $65.0 million at December 31, 1992. The Bank also enters into reverse repurchase agreements ("repos") whereby the Bank sells securities under agreements to repurchase the securities at a specific price and date. The Bank deals only with dealers judged by management to be financially strong or who are recognized as primary dealers in U.S. Treasury securities by the FRB. In 1993, $3.8 million of net funds were provided by repo activity. Loan principal payments including prepayments, were a major source of funds in 1993, providing$290.0 million, compared to $469.0 million in 1992, and $408.0 million in 1991. It is anticipated that loan payments and prepayments will continue to be a major source of funds in the future. Another source of operating funds is the proceeds from the sale of loans which totaled $138.4 million in 1993, compared to $204.4 million in 1992 and $282.7 million in 1991. Sales of loans are dependent upon various factors, including interest rate movements, investor demand for loan products, deposit flows, the availability and attractiveness of other sources of funds, loan demand by borrowers, desired asset size and evolving capital and liquidity requirements. In 1993, the Bank designated $321 million of adjustable rate mortgage loans as held for sale to enhance asset/liability management and liquidity. Due to the volatility and unpredictability of these factors, the volume of Fidelity's sales of loans has fluctuated significantly and therefore, an accurate estimate of future sales cannot be made at this time. The sale of investment and mortgage-backed securities ("MBS") also provides operating funds to the Bank. During 1993, the Bank changed its investment strategy and as a result moved its entire portfolio of its investment and mortgage-backed securities securities from the investment portfolio to the held for sale portfolio. Sales of investment securities totaled $351.8 million for the year ended December 31, 1993, compared to no such sales in 1992 and $1.5 million in 1991. Sales of MBS totaled $522.1 million in 1993 compared to no such sales during 1992 and to $273.0 million in sales during 1991. Sales of loans and securities from the held for investment portfolio would be caused by unusual events. The level of future sales, if any, is difficult to predict. During 1993, the Bank approved a policy of more active management of its investment portfolio with a view toward disposition of securities and loans with unfavorable risk/return profiles. This policy may result in loans being reclassified from held for investment to held for sale. Any subsequent sale of such loans would not generally be expected to result in any material gain or loss. The higher level of sales of loans and mortgage-backed securities in 1993 was from the Bank's held for sale portfolio and the result of efforts to reduce its asset size for capital planning purposes. At December 31, 1993 and 1992, the Bank had $367.7 million and $26.5 million, respectively, of loans in its held for sale portfolio. Fidelity's sources of cash are utilized in funding loans and investments, for payment of its debt obligations and in maintaining a liquidity ratio in compliance with regulatory requirements. Fidelity's total loans funded (excluding Fidelity's refinances) in the year ended December 31, 1993 were $383 million versus $386 million in the corresponding 1992 period. The Bank had commitments outstanding to originate $37.9 million in loans at market interest rates at December 31, 1993 compared to $37.5 million at December 31, 1992. In addition, the Bank had a total of $155.8 million at December 31, 1993 and $138.1 million at December 31, 1992 of unfunded loans in its pipeline. The overall decline in the loan pipeline resulted from: (a) a decision by the Bank to limit multifamily loan originations in accordance with the Bank's more rigorous view of multifamily loans as, in fact, business loans which require considerably more scrutiny and continuous monitoring, (b) the restructuring associated with the development and implementation of the Bank's strategy in building a mortage banking division geared toward single family residential loan originations, (c) the development of independent originators for multifamily originations, and (d) a reduction in market demand for products Fidelity desired for its portfolio. Fidelity also had $52.1 million in the unused balance of home equity credit lines at December 31, 1993, compared to $66.2 million at December 31, 1992 and $66.3 million at December 31, 1991. The decline in unused balances of home equity credit lines was due to a slowdown in new credit facility growth over the 1992 to 1993 period. New home equity credit lines totaled approximately $13.6 million, $26.9 million and $42.5 million for the years 1993, 1992 and 1991, respectively. The 49% decline in 1993 new home equity lines reflected significant levels of first trust deed refinancings as well as lower homeowner equity as single family housing appraisals fell from higher values of prior years. In May 1993, management implemented a new $300 home equity application fee which also contributed to a home equity volume reduction over the third and fourth quarters of 1992. The OTS regulations require the maintenance of an average regulatory liquidity ratio of at least 5% of deposits and short-term borrowings. Fidelity's monthly average regulatory liquidity ratio was 8.8% and 5.3% for December 1993 and 1992, respectively. Fidelity's year-end liquidity ratios were 6.1% in 1993 and 5.7% in 1992. Both Fidelity's short-term and long-term cash flow forecasts indicate an adequate liquidity margin to meet foreseeable operational demands. Fidelity maintains other sources of liquidity to draw upon if unforeseen circumstances should occur such as changes in regulatory liquidity, capital requirements, sudden deposit outflows or pending tax legislation. At December 31, 1993, these sources of liquidity included: (a) presently available line of credit from the FHLB of $201.7 million (assuming all of the $400 million capacity of commercial paper is used); (b) unused commercial paper facility of $96 million; (c) unpledged securities in the amount of $106.1 million available to be placed in reverse repurchase agreements or sold; and (d) unpledged loans of $1.4 billion, of which some portion would be available to collateralize additional FHLB or private borrowings or which may be securitized. In 1993, Fidelity received two capital contributions totaling $28.0 million from Citadel. See "Citadel" below for further discussion. Citadel has limited cash assets and no material potential cash-producing operations or assets other than its investment in Fidelity and in Gateway Investment Services, Inc., its securities brokerage subsidiary ("Gateway"). In March 1993, Citadel issued 3,297,812 shares of common stock through a rights offering to stockholders and received net proceeds of approximately $31.4 million. Of this amount, Citadel contributed $18.0 million in March 1993 and $10.0 million in December 1993 to the capital of Fidelity and retained the balance for liquidity and working capital purposes. Gateway paid a dividend of $1.0 million to Citadel in December 1993. Citadel had $2.3 million in cash and cash equivalents at December 31, 1993. Because of Fidelity's current capital levels, dividends and distributions from Fidelity will not be available to Citadel for the foreseeable future. Thus, Citadel's current cash balances, together with future dividends from Gateway, are the only sources of cash to Citadel. Gateway's ability to pay dividends may be restricted by certain regulatory net capital rules. See Item 1. "Business--Regulation and Supervision--Gateway." Management believes that Citadel's cash resources will only be sufficient to meet Citadel expenditures through mid-1994. If the Restructuring is not completed at such time, Citadel will be required to raise additional cash to fund its expenditures, and no assurances can be given that Citadel will be able to raise any such funds. The Bank entered into a Subordinated Loan Agreement dated as of May 15, 1990 (the "Subordinated Loan Agreement") pursuant to which $60 million in subordinated notes (the "Notes") are outstanding, which Notes are guaranteed by Citadel. The Subordinated Loan Agreement, among other covenants, contains a provision requiring Fidelity to maintain a consolidated tangible net worth at least equal to the greater of (a) $170 million plus 50% of consolidated net earnings since January 1, 1990, or (b) 3.25% of consolidated assets. As stated above, management anticipates that additional losses are likely to be incurred during 1994 and that, as a result, consolidated tangible net worth may be reduced to less than $170 million during the first quarter of 1994. However, management's projections for 1994 indicate that the Bank's consolidated tangible net worth will remain above the net worth requirement under the foregoing clause (a) through the first quarter of the year, assuming the formula in clause (a) permits a reduction of the $170 million test if a consolidated net loss has been sustained since January 1, 1990. Under this interpretation, the amount of consolidated tangible net worth necessary to meet the requirement of clause (a) would be $153.9 million at December 31, 1993 and would be further reduced by 50% of all losses during 1994. The amount of consolidated tangible net worth necessary to meet the requirement of clause (b) was less than $153.9 million at December 31, 1993. As of December 31, 1993, the Bank's consolidated tangible net worth amounted to $180.2 million. Management's projections for the balance of 1994 indicate that the Bank's consolidated tangible net worth will remain above the net worth requirement under the test of either clause (a) (assuming it is interpreted as described above) or clause (b) only if the Restructuring is accomplished or other capital-raising efforts are successful. The holders of the Notes could take the position that the amount under clause (a) may not be reduced by losses to less than $170 million. Under that position, Fidelity would be in violation of the covenant as soon as consolidated tangible net worth were reduced to less than $170 million. Management believes that such position is not correct; however, there can be no assurance that such position would not prevail if the issue were ever tested in court. If the above covenant were violated, the holders of 66 2/3% in aggregate principal amount of the Notes would be entitled to declare the entire amount of the Notes immediately due and payable. However, if such acceleration would result in the Bank's failure to meet applicable regulatory capital requirements, the holders would be prohibited from accelerating the Notes without the prior approval of the OTS. If the Bank failed to make such payment, Citadel would be required to make such payment under its guarantee of the Notes. Management anticipates that Citadel's funds would be insufficient to make such payment, unless additional funds were raised. The holders of the Notes have power of approval over certain matters, including certain asset sales, and may require a repurchase of the Notes upon a "Significant Event." Management believes that neither the approval of the holders nor a Significant Event repurchase offer would be required for consummation of the proposed Restructuring if an acquiror of the Bank has outstanding, immediately prior to the closing of the Restructuring, unsecured debt with a credit rating of BBB or better by Standard & Poor's Corporation or Baa2 or better by Moody's Investors Service, Inc. and various financial tests are satisfied after giving effect to the Restructuring. However, should the Restructuring be found to trigger the Significant Event repurchase requirement, Fidelity could be required to pay the principal balance of the Notes of $60 million plus accrued interest and a premium of approximately $12.8 million (calculated as of December 31, 1993). Also, if the consent of the holders should be required under any of the covenants of the Subordinated Loan Agreement but not be obtained, an event of default would occur under the Subordinated Loan Agreement (subject to grace or cure periods in the case of certain covenants) if the Restructuring is completed. On March 4, 1994, Chase Manhattan Bank, N.A. ("Chase"), one of four lenders under the Subordinated Loan Agreement, sued Fidelity, Citadel and Citadel's Chairman of the Board, alleging, among other things, that the transfer of assets pursuant to the Restructuring would constitute a breach of the Subordinated Loan Agreement, including the tangible net worth and various other financial tests contained therein, and seeking to enjoin the Restructuring and to recover damages in unspecified amounts. In addition, the lawsuit alleges that past responses of Citadel and Fidelity to requests by Chase for information regarding the Restructuring violate certain provisions of the Subordinated Loan Agreement and that such alleged violations, with the passage of time, have become current defaults under the Subordinated Loan Agreement. While the other three lenders under the Subordinated Loan Agreement hold $25 million of the Notes, none of them has joined Chase in this lawsuit. The Company is evaluating the lawsuit and, based on its current assessment, the Company does not believe that the allegations have merit. Any violation of the tangible net worth covenant or the occurrence of any other event of default under the Subordinated Loan Agreement would also result in a cross default under Fidelity's debt agreements with the FHLB (whether or not the Notes are accelerated) and entitle the FHLB to declare all amounts outstanding to become immediately due and payable. Also, the FHLB may elect not to make further Advances to the Bank and may prevent the Bank from issuing further commercial paper under its existing facility. ASSET QUALITY The Bank continues to be principally involved in the Southern California single family and multifamily (2 units or more) residential lending businesses. At December 31, 1993, 20.8% of Fidelity's total loan portfolio (including loans held for sale) consisted of California single family residences while another 71.2% consisted of California multifamily dwellings. At December 31, 1992, 21.1% of Fidelity's loan portfolio consisted of California single family residences and 70.2% consisted of California multifamily dwellings. Current Southern California economic conditions have adversely impacted the credit risk profile of the Bank's loan portfolio. The Company's performance continues to be adversely affected by increased foreclosure activities of the Bank reflecting the continued weakness of the Southern California economy and a depressed real estate market. Nonperforming assets increased slightly to $235.6 million at December 31, 1993 from $234.4 million at December 31, 1992. Classified assets increased from $353.7 million in 1992 to $372.5 million at December 31, 1993. Troubled debt restructuring declined by $58.6 million in 1993 to $28.7 million as of December 31, 1993 compared to $87.3 million at December 31, 1992. Asset quality details of Fidelity are as follows: There was a marked shift in the composition of NPAs in 1993. Foreclosed real estate increased from 32.0% of NPAs at December 31, 1992 to 48.3% at December 31, 1993 while nonaccruing loans and in-substance foreclosures declined from 68.0% to 51.7% in the same time period. This shift may be an indicator that the problem assets are working their way through the system toward eventual resolution. However, as stated previously, the Southern California economy remains weak and no assurance can be made that problem assets will not increase in the future. Loans are categorized as ISF based upon meeting all of the following three criteria: (a) the borrower currently has little or no equity at fair market value in the underlying collateral, (b) the only source of repayment is the property securing the loan, and (c) the borrower has abandoned the property or will not be able to rebuild equity in the foreseeable future. The Bank generally places a loan on nonaccrual status whenever the payment of interest is 90 or more days delinquent, or earlier if a loan exhibits materially deficient characteristics. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan." This statement prescribes the recognition criteria for loan impairment and the measurement methods for certain impaired loans and loans whose terms are modified in TDRs. SFAS No. 114 defines a loan as impaired when it is probable that a creditor will be unable to collect all principal and interest amounts due according to the contracted terms of the loan agreement. This statement also clarified the existing accounting for ISFs by stating that a collateral dependent real estate loan would be reported as REO only if the lender had taken possession of the collateral. Additionally, in June 1993, the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Reserve Board and Office of Thrift Supervision issued a joint statement providing interagency guidance on the reporting of ISFs. This joint statement clarified that losses must be recognized on real estate loans that meet the existing ISF criteria based on fair value of the collateral, but such loans need not be reported as REO unless possession of the underlying collateral has been obtained. The Company intends to adopt SFAS No. 114 as of January 1, 1994. As the Bank already measures impairment based on the fair value of the collateral, the estimated impact of such application will consist of a reclassification of ISFs on the statement of financial condition from REO to loans. This reclassification will also result in an increase in nonaccrual loans. As NPAs consist of nonaccrual loans plus REO, this shift from ISF to nonaccrual loans will not affect the level of NPAs. At December 31, 1993 and 1992, the amount of ISFs totaled $28.4 million, and $47.3 million, respectively. This shift would not have had a material impact on the results of operations had this standard been in effect at December 31, 1993. The Bank has modified the terms of certain loans that resulted in those loans being defined as TDRs according to SFAS No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings". TDRs represent loans that are current as to payment of principal and interest, but have had their terms renegotiated to a more favorable position for the borrower due to an inability to meet the original terms of the note. Troubled debt restructurings decreased by $58.6 million during 1993 as a number of borrowers were either able to return to the original payment terms at the expiration of the modification period or the loans migrated to nonperforming loans or REO. The average loan balance of loans being modified has also declined, further reducing TDRs. Classified assets consist of NPAs and all other assets classified for internal and regulatory purposes, including other assets that are currently performing, but exhibit deficiencies that indicate the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected ("performing loans with increased risk"). Classified assets are assigned to one of the following three categories in the order of increasing credit risk: (a) Substandard - an asset with well-defined weaknesses characterized by a distinct possibility that some loss will be sustained if the weaknesses are not corrected, (b) Doubtful - an asset which has all the weaknesses of a Substandard asset 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, and (c) Loss - an asset, or portion thereof, considered uncollectible and of such little value that a loss classification is warranted; the amount identified as loss can be charged off or a specific reserve established for the amount considered uncollectible. As of December 31, 1993, classified assets were $372.5 million (8.49% of total assets), increasing from $353.7 million (7.53% of total assets) at December 31, 1992 and $228.4 million (4.46% of total assets) as of December 31, 1991. The increase in classified assets in 1993 consisted primarily of a sharp increase in performing loans with increased risk. The increase in classified assets in 1992 primarily consisted of the increase in NPAs of $109.7 million and the increase of performing loans with increased risk of $19.3 million (primarily attributed to 25 multifamily residential loans in Southern California and two commercial and industrial complexes in Southern California). In addition to classifying assets, the Bank also designates certain assets as Special Mention which are considered criticized assets but not classified as they do not currently expose the Bank to a sufficient degree of risk to warrant an adverse classification. However, they do possess credit deficiencies or potential weaknesses deserving management's close attention. If uncorrected, such weaknesses or deficiencies may expose an institution to an increased risk of loss in the future. Criticized assets consist of loans on 1 to 4 unit properties which are 60 to 89 days delinquent and on other multifamily properties (5 units and over) which are 30 to 89 days delinquent, assets in bankruptcy less than 60 days delinquent, and all other assets otherwise criticized for internal or regulatory purposes. Total criticized assets increased by $53.4 million during 1993 due to an increase in delinquent loans and loans having delinquent property taxes and as the result of increased internal review. Total loan delinquencies decreased by $3.8 million during 1993. This decrease was due primarily to the migration of loans delinquent 90 days and over to REO. The following table illustrates the trend of delinquencies of the respective loan portfolios: NET LOAN DELINQUENCIES TO NET REAL ESTATE LOAN PORTFOLIO California has been hit particularly hard by the current recession and Southern California has experienced the brunt of the economic downturn in the state. While the rest of the nation is experiencing a modest economic recovery, the Southern California economy remains sluggish with higher unemployment than elsewhere in the country and real estate values that continue to deteriorate. There can be no assurances that these economic conditions will improve in the near future. Consequently, rents and real estate values may continue to decline which may affect future delinquency and foreclosure levels and may adversely impact the Bank's asset quality, earnings performance and capital. The Bank recorded additions to its allowances for estimated loan losses and real estate losses totaling $95.3 million during 1993 compared to $69.0 million in 1992. The total allowances for such losses consist of the sum of the GVA for both loans and real estate and all specific loss reserves for assets classified as "Loss." These provisions have been made in response to continuing deterioration of the Bank's loan portfolio. In the opinion of the Bank, this deterioration is caused by the decline in apartment occupancy levels and of rents available to apartment owners in Southern California; downward revisions in projections as to inflation and rental income growth; the increased returns currently being required by purchasers of multifamily income-producing properties; announced cutbacks in public sector spending; the general illiquidity in the Southern California market for multifamily income-producing properties; and the continuing high level of unemployment in and migration of skilled and white collar labor from Southern California. The Bank's combined GVA for loan and real estate losses at December 31, 1993 was $80.0 million or 2.03% of total loans and real estate up from $75.6 million or 1.82% at December 31, 1992 and $52.4 million or 1.13% at December 31, 1991. The following table summarizes Fidelity's reserves, writedowns and certain coverage ratios at the dates indicated: - -------- (1) Writedowns include cumulative charge-offs taken on outstanding loans and REO as of the date indicated. (2) Loans, REO and NPAs in these ratios are calculated prior to the reduction for loan and REO GVA, but are net of specific reserves. During current market conditions, the Bank rarely sells REO for a price equal to or greater than the loan balance, and the losses suffered are impacted by the market factors discussed elsewhere in this report. REO is recorded at acquisition at the lower of the recorded investment in the subject loan or the fair market value of the assets received. The fair market value of the assets received is based upon a current appraisal adjusted for estimated carrying, rehabilitation and selling costs. The Bank's policy has been generally to proceed promptly to market the properties acquired through foreclosure, and the Bank often makes financing terms available to buyers of such properties. Generally, the Bank experiences higher losses on sales of REO properties for all cash, as opposed to financing the sale. However, by financing the sale, the Bank incurs the risk that the loan may not be repaid. During 1993, the Bank sold 210 REO properties for net sales proceeds of $83.5 million, with a gross book and net book value totaling $138.5 million and $89.8 million, respectively. This compares to 43 properties sold in 1992 for net sales proceeds of $25.6 million, with a gross book and net book value of $34.9 million and $27.6 million, respectively. The loss on sale of REO (i.e., the shortfall between the net proceeds and net book value) is charged to the REO GVA upon sale. The Company is pursuing its Restructuring plan, including the possible transfer of a significant portion of certain Fidelity assets (including substantially all of its problem assets). As a result of such plan the Bank is not currently marketing the assets expected to be transferred in the Restructuring transaction, and thus a slowdown from the rate at which REO properties were disposed in 1993 can be expected in the first half of 1994. During 1993, 1992 and 1991, the Bank charged off a total of $79.4 million, $41.2 million and $25.6 million, respectively, on loans and on real estate owned. The following table indicates the charge-offs and recoveries by property type for the respective years: The following table presents loan and REO charge-offs by property type and year of loan origination for the year ended December 31, 1993: The following table presents loan and REO charge-offs by property type and year of loan origination for the year ended December 31, 1992: The following table presents Fidelity's real estate loan portfolio (including loans held for sale) as of December 31, 1993 by year of origination and type of security: During the years 1990, 1989 and 1988, Fidelity originated loans at peak levels totaling $1,211.3 million, $897.6 million and $1,467.1 million, respectively. During 1993, the Bank reserved and/or charged off amounts corresponding to these peak origination years totaling $36.5 million, $10.4 million and $11.3 million, respectively. These losses were due primarily to the decline of the California economy and real estate market. Multifamily (5 or more units) and commercial loans accounted for a substantial percentage of such losses, and as a result, the Bank has reduced recent loan origination activities in these areas. However, continued downward pressure on the economy and real estate market could lead to additional losses in these portfolios. The ongoing uncertainty in the Southern California economy, the weak real estate market and the level of the Bank's nonperforming assets continue to be significant concerns to the Company. The Bank increased the staff of the Real Estate Asset Management ("REAM") Group in 1993 from 13 to 40 in order to handle the increased number of foreclosed properties and the increased volume of loan workout requests. In 1993, the REAM Group sold 210 properties, generating net sales proceeds of $83.5 million and restructured109 loans with an aggregate gross book value of $89.1 million. These increased loan workout activities are expected to continue in 1994, due primarily to the January 1994 Northridge Earthquake, property tax delinquencies and the continued soft real estate market. The REAM Group will shift its focus to bulk sales transactions in 1994 and concentrate its efforts on the "hands on" management of its real estate assets. All of these factors may require additional loss provisions, as the Bank performs its quarterly reviews of the adequacy of its allowance for estimated losses on loans and real estate, based upon the then current economic environment. If economic conditions in Southern California do not improve and delinquent loans continue at current levels, it is likely that Fidelity will need to establish further reserves in 1994. If the trend continues, no assurances can be given that potentially significant additional reserves will not be needed in future periods. As of December 31, 1993, Fidelity's 15 largest borrowers accounted for $226.7 million of gross loans. A number of these borrowing relationships also include Fidelity's largest loans. Details of these relationships follow: - -------- (1) Includes 9 loans totaling $8.0 million that were considered as ISF as of December 31, 1993. (2) Amounts are shown net of participations. Fidelity's 10 largest loans aggregated $114.8 million at December 31, 1993, of which $21.1 million was classified as Substandard and $37.9 million was listed as Special Mention. As of December 31, 1993, 3 of Fidelity's 5 largest borrowers and 4 of Fidelity's 15 largest borrowers had loans either considered nonperforming or performing with increased risk. At December 31, 1993, Fidelity had approximately $31.5 million total loans outstanding (including 9 loans designated as ISF) to its largest borrower on 46 loans secured by multifamily apartment dwellings located in the San Gabriel Valley and eastern Los Angeles areas. Of the total loans, $24.1 million were classified as Substandard, including the 9 loans considered ISF. Fidelity began discussions with the borrower regarding modifications in mid-1993. In January 1994, Fidelity completed the restructure of $3.3 million of loans and is continuing the modification process with the remaining loans. During 1992, Fidelity's second largest borrower was in default on eight of that borrower's nine loans. Six of the eight defaulted loans were restructured in 1992 allowing the borrower to make interest only payments through the end of 1992. The remaining two loans in default were modified in February 1993 to include interest only payments through June 1993. These two loans were classified as Substandard and identified as TDRs. As of December 31, 1993, seven of the loans totaling $24.6 million were 29 days delinquent and one totaling $2.1 million was 59 days delinquent. At December 31, 1993, 5 loans totaling $17.2 million were classified as Substandard. Fidelity has entered into a forebearance agreement with the borrower whereby Fidelity agreed not to instigate foreclosure proceedings against the borrower's eight properties securing the loans until February 28, 1994, in exchange for $150,000. Fidelity is currently pursuing a workout arrangement with the borrower. However, the January 1994 Northridge Earthquake has further complicated the situation, as several of the borrower's properties are located in the most severely damaged areas. In January 1994, an additional 3 loans totaling $9.5 million were moved to the Substandard classified loans, for a total of 8 loans and $26.7 million. It is the Bank's practice to review the adequacy of its GVA on loans and real estate owned on a quarterly basis. The Bank uses two methodologies in determining the adequacy of its GVA. These are delinquency migration and classification methods. The delinquency migration method attempts to capture the potential future losses as of a particular date associated with a given portfolio of loans, based on the Bank's own historical experience over a given period of time, in a 4-step process: first, estimate the percentage of a given portfolio of performing loans which will become newly delinquent; second, evaluate the probability that new delinquent loans will become REO; third, calculate the historical loss ratio on REO and other problem loans; and fourth, derive the resulting potential losses for the portfolio of performing loans by multiplying the corresponding potential amount of REO with the reserve factor. The likelihood that new delinquent loans will become REO is estimated historically by tracing the percentage of the balances of a given set of new delinquent loans that have migrated toward an increasingly worse credit status: i.e., the percentage of the balances of 30 to 59 days delinquent loans that have become 60 to 89 days delinquent; then the percentage of the balances of these loans that have become at least 90 days delinquent; and the percentage of the balances of these loans which have become REO. To ensure that the historically derived percentages are calculated on a consistent basis, only those loans that have become newly delinquent are traced through the different stages of delinquencies all the way to REO. The total projected loss associated with a given portfolio of performing and nonperforming loans and REO is calculated by summing the losses corresponding to each credit status category at a given point in time. The result is sensitive to a number of factors, including the historical period over which the estimates are derived; the growth pattern of the portfolio, the composition of the portfolio and the stability of the underwriting criteria over the period covered. The Bank has derived migration statistics over past periods and updates them quarterly to take into account the most recent trends. The Bank has applied the results of such methodology with respect to the December 31, 1993 financial statements and the Bank updates its analysis quarterly. The Bank has observed an increasing delinquency trend as a percentage of the net real estate loan portfolio and during 1993, as property values deteriorated, the resulting historical loss ratios increased. Continuation of these trends may increase the historical loss ratios in 1994. The second methodology for determining the adequacy of GVA is the classification method. During 1993, the Bank utilized this approach to analyze classifications including Pass, Special Mention, Substandard, Doubtful and Loss. A reserve factor is applied to each aggregate classification level by asset collateral type in an effort to estimate the loss content in the portfolio. The Company's actual loss experience with Pass and Special Mention assets is 0.0% while the actual loss experience on Substandard assets is 23.5%. Again, the Company has observed an increase of classified loans at all levels which will inevitably lead to increased estimates of loss exposure under this method. See Item 1. "Business--Regulation and Supervision--Classification of Assets." Each quarter, the Bank calculates a range of loss using both methodologies. Once a range is established, the Company applies judgment and a knowledge of particular credits, trends in the market, and other factors to estimate the GVA amount. As of December 31, 1993, the Bank's GVA was approximately $80.0 million. Once a GVA is estimated, the Bank applies three separate stress tests to the portfolio to analyze the ability of the Bank to maintain adequate capital levels under different economic scenarios. This process is considered appropriate given the weak economy and the unstable market in which the Bank operates. The scenarios range from mild change (continuation of current rates of loss migration and expected percentage loss estimates) to severe change (the worst experience in the 1980s in Texas and Arizona). The Bank's peak loan balance was reached in late 1990 and early 1991. The stress tests assume the losses in the peak portfolio will be experienced for the most part over a five- year cycle and that three years of this cycle has lapsed. The peak portfolio performance is stressed with a variety of projected levels of NPA, REO, and loss on sale of REO. Projected losses are first absorbed by current levels of GVA, then by forecasted Company earnings over the remaining three years of the assumed cycle. Tangible capital ratios are then calculated for each of the economic scenarios. At December 31, 1993, these studies showed the Company could maintain capital in excess of the 1.5% minimum required level of tangible capital under the capital regulations and the 2.0% level of tangible equity to total assets required to avoid being "critically undercapitalized," as defined by the OTS regulations implementing the FDICIA prompt corrective action requirements. See "Capital Resources and Liquidity" and Item 1. "Business-- Regulation and Supervision--FDICIA Prompt Corrective Action Requirements." The foregoing exercise is only a test, based on assumptions that can change at any time. There can be no assurance that the Bank would be allowed to operate independently if its tangible capital began to approach the minimum required levels. If the OTS disagrees with management's assessment of the adequacy of such reserves, it can effectively require Fidelity to increase its reserves to levels satisfactory to the OTS. The Bank increased its GVA for losses on loans and real estate to approximately $80.0 million at year-end 1993 from its third quarter 1993 level of approximately $71.0 million in part to address OTS concerns regarding the Bank's asset quality. If the Restructuring is not successful and the Bank has no viable problem asset disposition alternative, the Bank anticipates that it may be required to increase its GVA to higher levels that cannot currently be determined. Approximately 71.1% of Fidelity's loan portfolio consisted of loans secured by multifamily properties at December 31, 1993. Although, in the view of the Bank, this portfolio is less sensitive to the effects of the recession than those of institutions which have emphasized commercial and/or construction lending, it is likely to be more sensitive than the portfolios of institutions which have placed greater emphasis on single family residential lending. IMPACT OF INFLATION The Company's assets and liabilities are primarily monetary in nature and are affected most directly by changes in interest rates rather than other elements of the Consumer Price Index. As a result, increases in the prices of goods and services do not have a significant impact on the Company's results of operations. INTEREST RATE RISK MANAGEMENT Prevailing economic conditions, particularly changes in market interest rates, as well as governmental policies and regulations concerning, among other things, monetary and fiscal affairs, significantly affect interest rates and a savings institution's net interest income. Fidelity actively manages its assets and liabilities in an effort to mitigate its exposure to interest rate risk, but it cannot eliminate this exposure entirely without unduly affecting its profitability. As is the case with many thrift institutions, Fidelity's deposits historically have matured or repriced more rapidly than its loans and other investments, and consequently, increases in market interest rates have tended to reduce Fidelity's net interest income, while decreases in market interest rates have tended to increase its net interest income. Fidelity's interest rate risk ("IRR") management plan is aimed at maximizing net interest income while controlling interest rate risk exposure in terms of market value of portfolio equity, consistent with the objectives and limits set by the Board of Directors and applicable regulations. Financial institutions, by their funds intermediation function, gather deposits which have a different duration than the loans that they originate, i.e., interest rate risk exposure is an inherent characteristic of the banking business. The IRR management plan is designed to maintain interest rate exposure within target limits. Elimination of interest rate risk is usually not cost effective; while excess exposure could result in additional capital requirements. There are two ways by which Fidelity maintains its exposure profile within satisfactory limits: first, by explicitly changing the composition of its balance sheet; second, by the use of financial instruments, often in the form of off-balance sheet derivative products. The extent to which Fidelity elects to use either or both of these methods will depend on the observed preferences of its customers, time horizon of its objectives (short-term versus long-term objectives), conditions in the financial markets (especially volatility of interest rates and steepness of the yield curves), its operating characteristics and the associated cost/benefit tradeoffs. In accordance with the Company's IRR management plan, the Company continues to monitor its interest rate risk position and to maintain its sensitivity to rate changes within desired limits. The balance sheet strategies consist of reducing basis risk by adding market index loans to the asset portfolio and decreasing liability sensitivity by encouraging growth of its transactions account base. The Bank provides products to meet its customers' needs. The Bank uses derivative products and changes its asset mix to maintain its desired risk profile in response to changing customers' preference. The Company continues to naturally reduce its IRR exposure by originating ARM loans for its portfolio. Since 1985, the Company has consistently moved toward building a portfolio consisting predominantly of interest rate sensitive loans. ARM loans comprised 96% of the portfolio of total loans at December 31, 1993, 1992 and 1991. The percentage of monthly adjustable ARMs to total loans was 75% at December 31, 1993, 74% at December 31, 1992, and 72% at December 31, 1991. Interest sensitive assets provide the Company with long-term protection from rising interest rates. The Bank is also emphasizing the growth of its transaction account base to reduce its overall cost of funds. The ratio of retail transaction accounts, money market savings and passbook accounts to total deposits decreased to 21.6% at December 31, 1993 from 24.3% at December 31, 1992 and increased from 19.4% at December 31, 1991. At December 31, 1993, the Company had synthetic hedges with a total notional principal amount of $250 million. These were composed of interest rate swap contracts with an average receive rate of 4.84% and a current pay rate of 3.43%. These contracts support the Bank's total risk management by lengthening certain short-term assets and shortening certain long-term liabilities. In 1993, the Bank had also sold options to enter into swap contracts with a notional principal amount of $200 million. These options give the buyers the right to cancel the swap agreements at a specified future date and if not cancelled, provide the Bank with additional synthetic hedges. During the life of the agreement, the Bank receives a fixed interest rate and pays a floating interest rate tied to LIBOR. At December 31, 1993, the average fixed receive rate was 5.00% and the average pay rate was 3.34%. The swap options were held as trading positions during the option period and were carried at market value with gains and losses recorded. In January 1994, the options to cancel were not exercised and the average fixed receive rate adjusted to 4.70%. The swaps have remaining maturities of less than four years. In 1990, the Company purchased interest rate caps to protect against rising rates. In 1993, the final $400 million of interest rate caps matured and were not renewed. During 1992 and the first 6 months of 1993, the average maturity of the Company's liabilities lengthened, due primarily to customer preference for longer term CDs. To maintain its target risk position, the Company entered interest rate swap contracts to synthetically shorten the maturity of these liabilities. The Company's maturity and repricing mismatch ("Gap") between interest rate sensitive assets and liabilities due within one year was a negative 3.38% and a positive 6.12% of total assets at December 31, 1993 and 1992, respectively. A positive gap indicates an excess of maturing or repricing assets over such liabilities while a negative gap indicates an excess of maturing or repricing liabilities over such assets. However, Gap is not a particularly helpful measure of IRR exposure, because of four major deficiencies: (a) Gap assumes that both assets and liabilities react immediately to market rate changes although loans usually reprice to an index that is approximately two months old and therefore cannot immediately react to current rates; (b) Gap assumes that all instruments react fully to market rates, whereas loans tied to COFI or other lagging indices can take many months to fully adjust to market rate changes; (c) Gap assumes that there will be no change in repricing behavior caused by a change in interest rates and, in reality, prepayment speed, amortization schedules and early withdrawal are all impacted by changes in rate; and (d) finally, Gap does not consider periodic rate caps and floors. Consequently, the Company does not use Gap as an IRR measurement and management tool. Instead, it uses a scenario-based approach which measures bankwide risk and a probabilistic approach for specific products. The Bank regularly analyzes scenarios that contemplate low, expected and high inflation. The Bank also complies with OTS requirements for interest rate shock scenarios (immediate permanent change in interest rates of various levels). For product and option valuation, the Bank employs a Monte Carlo simulation model (one that assumes random variation in interest rates) to measure and evaluate risk and return trade-offs. The Company's IRR management plan is reviewed on a continuing basis. As previously discussed, the Bank's interest rate risk is less than half of the OTS limit. See "Capital Resources and Liquidity." Even at this lower risk level, due to the lag effect that COFI has on Fidelity's loan portfolio the decline in short-term rates from 1990 to early 1993 contributed significantly to the Company's net interest margin. Recent stable rates have eroded this margin, and an increase in rates could produce an initial reduction in net interest income. Management intends to continue to manage its IRR exposure through introducing products tied to indices that reprice without a timing lag and by using hedging techniques. The following table of projected maturities and repricings details major financial asset and liability categories of the Company as of December 31, 1993. Projected maturities are based on contractual maturities as adjusted for estimates of prepayments and normal historical amortization. (Prepayment estimates are based on recent portfolio experience of approximately 15% Constant Prepayment Rate ("CPR") on all residential 1 to 4 unit loans and 10% on all other loans.) While the estimated prepayment rates utilized are based on the best information available to the Company, there can be no assurance that the projected rates used in developing this table will coincide with the actual results. MATURITY AND RATE SENSITIVITY ANALYSIS - ------- (1) Maturities shown are based on the contractual maturity of the instrument. (2) Includes investments in FHLB and FRB stock and cash equivalents. (3) ARMs and variable rate FHLB Advances are in the "within 0-3 months" categories as they are subject to interest rate adjustments. (4) These liabilities are subject to daily adjustments and are therefore included in the "within one year" category. (5) Fidelity had synthetic hedges with a total notional principal amount of $450 million at December 31, 1993. These off-balance sheet instruments support the Bank's total risk management by enhancing yield and altering its exposure to interest rate risk. OTHER FACTORS AFFECTING EARNINGS Growing Emphasis on Fee Income Generation Management believes that, given the highly competitive nature of the Bank's historical business and the regulatory constraints it faces in competing with unregulated companies, the Bank must expand from its historical business focus and adopt a broader product line business strategy. Specifically, management believes that the Bank's existing customers provide a ready market for the sale of nontraditional financial services and investment products. This belief prompted the implementation of a new business strategy for the retail financial services group that integrated its traditional functions (mortgage origination, deposit services, checking, savings, etc.) with the sale of investment services and products by Gateway. Management's objective is to build a "relationship bank" that works with clients to determine their financial needs and offers a broad array of more customized products and services. Through this new strategy of targeting retail and mortgage customers and offering a variety of new investment products and services, Fidelity and Gateway hope to attract more of the Bank customers' deposits, investment accounts and mortgage business. Management believes that this new strategy has been successful, as evidenced by the increase of 22% in total checking accounts at December 31, 1993 over the level a year earlier. As a result of this strategy, fee income should become a growing portion, and net interest income a declining portion, of the Company's total income. Management also intends to offer a wider range of loan types than the Bank currently originates. While continuing to offer adjustable rate mortgages and to maintain an expertise in originating and servicing multifamily mortgages, the Bank plans to increase its mortgage banking capabilities and to originate mortgages that, while not appropriate for inclusion in the Bank's portfolio in significant quantities, are attractive to borrowers and to the secondary market. Northridge Earthquake The Northridge Earthquake of January 17, 1994, and subsequent aftershocks will adversely affect the Bank's loan and real estate portfolios. The Bank's portfolio includes loans and REO with a net book value of approximately $937 million secured by or comprised of 1,414 multifamily (5 units or more), 15 commercial, and 2,313 single family and multifamily (2 to 4 units) collateral properties in the primary earthquake areas. After the earthquake, the Bank's appraisers surveyed all the multifamily (5 units or more) and commercial properties located in these areas which secured the Bank's loans or constitute REO of the Bank. The Bank also made selected inspections at more remote locations where damage has been reported. In total, approximately 1,450 properties have been inspected. Of such inspected properties, 231 properties, representing loans and REO with a net book value of $140 million, have been identified as having sustained more than "cosmetic" damage. Of such 231 properties, 204 properties related to the Bank's loans and REO with a net book value of $124 million were identified as having "possible serious damage" and an additional 27 properties with a net book value of $16 million were identified as "actually or potentially condemned". The Bank commissioned structural and building engineers or building inspectors to estimate the cost of repairs to properties in these two categories. The cost of repairs has been preliminarily estimated to be $5.7 million and $11.1 million, respectively. Of this total $16.8 million, approximately $6.0 million of seismic damage exceeds the net book value of the related loans and REO. Accordingly, the Bank currently would not expect its losses due to the earthquake to exceed $10.8 million with respect to its commercial and multifamily loans and REO. The Bank expects the actual losses payable by the Bank to be lower because many repair costs may be borne by the borrowers, who in addition to their own funds, may have access to government assistance and/or earthquake insurance proceeds. As part of its normal internal asset review process, the Bank will adjust its reserves as its losses become quantifiable. In addition to the multifamily and commercial assets referenced above, the Bank has identified 2,313 single family and multifamily (2 to 4 units) assets in the affected areas. 173 borrowers with unpaid principal balances totaling $29.4 million called in to report damages through February 8, 1994. The Bank has commenced inspection of these properties and continues to assess damages and potential earnings and loss impact with respect to these properties. The earthquake will also have some adverse affect on loan originations and the sale of financial services in the retail branch network in the near term. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders Citadel Holding Corporation Glendale, California We have audited the accompanying consolidated statements of financial condition of Citadel Holding Corporation and subsidiaries (the "Company") 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. 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 principle 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 Citadel Holding 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. As discussed in Note 17 to the consolidated financial statements, on March 4, 1994, one of four lenders to Fidelity Federal Bank, F.S.B. (the "Bank") under its $60 million Subordinated Loan Agreement of 1990 filed a lawsuit against the Bank and Citadel Holding Corporation ("Citadel") alleging a breach of the loan agreement and other allegations, and is seeking to enjoin a restructuring plan (described in footnote 14) and to recover damages in unspecified amounts. The impact of this lawsuit on the capital position of the Bank, cross default provisions under the Bank's other debt agreements and the guarantee by Citadel is uncertain. Accordingly, no adjustments that may result from the ultimate resolution of this uncertainty have been made in the accompanying financial statements. As discussed in Notes 14 and 16 to the financial statements, the Bank, the primary subsidiary of Citadel, is subject to numerous regulatory requirements, including, among others: (i) minimum capital to be considered "adequately capitalized" under the Prompt Corrective Action provisions of the Federal Deposit Insurance Corporation Improvement Act ("FDICIA") as implemented by the Office of Thrift Supervision ("OTS"), and (ii) minimum capital requirements of the OTS. Although the Bank met these capital requirements at December 31, 1993, the Bank's ability to meet the prescribed capital requirements in the future is uncertain. Failure on the part of the Bank to meet these capital requirements may subject the Bank to significant regulatory sanctions. Management's immediate plans to address these capital requirements are described in Note 14. The financial statement impact, if any, that might result from the failure of the Bank to comply with the capital requirements prescribed by the OTS cannot presently be determined. Accordingly, no adjustments that may result from the ultimate resolution of the uncertainty have been made in the accompanying financial statements. Deloitte & Touche February 4, 1994, except for Note 17, as to which the date is March 4, 1994 Los Angeles, California CITADEL HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See notes to consolidated financial statements. CITADEL HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See notes to consolidated financial statements. CITADEL HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. CITADEL HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) CITADEL HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS--(CONTINUED) (DOLLARS IN THOUSANDS) See notes to consolidated financial statements. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1993 NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Citadel Holding Corporation ("Citadel") and subsidiaries. Citadel is the holding company of Fidelity Federal Bank, a Federal Savings Bank ("Fidelity" or the "Bank") and Gateway Investment Services, Inc. ("Gateway"). Unless otherwise indicated, references to the "Company" include Citadel, Fidelity, Gateway, and all subsidiaries of Fidelity and Citadel. All significant intercompany transactions and balances have been eliminated. Certain reclassifications have been made to prior years' consolidated financial statements to conform to the 1993 presentation. Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and federal funds sold. Generally, federal funds are sold for one-day periods. Fidelity is required by the Federal Reserve System to maintain noninterest-earning cash reserves against certain of its transaction accounts. At December 31, 1993, the required reserves totaled $28.6 million including vault cash. Investment Securities and Mortgage-backed Securities U.S. Government and agency obligations, commercial paper, mortgage-backed securities and other corporate debt securities identified as held for investment are recorded at cost, with any discount or premium recognized over the life of the related security by using a methodology which approximates the interest method. The Bank's portfolio of mortgage-backed securities consists of pools of mortgage loans exchanged for mortgage-backed securities and those purchased. Securities held for investment are those securities which the Company has the intent and ability to hold until maturity, and are carried on an amortized cost basis. Securities to be held for indefinite periods of time, including securities that management intends to use as part of its asset/liability strategy, or that may be sold in response to changes in interest rates, changes in prepayment risk, the need to increase regulatory capital or other similar factors, are classified as held for sale and are carried at the lower of cost or market value. Any gains or losses incurred on sales of securities are calculated based upon the specific identification method. Any investment securities held for trading are carried at market value. Loans Interest on loans is credited to income as earned and is accrued only if deemed collectible. Accrued interest is fully reserved on loans over 90 days contractually delinquent and on other loans which have developed inherent problems prior to being 90 days delinquent. Discounts and premiums on loans are included with loans receivable and are credited or charged to operations over the estimated life of the related loans using the interest method. The Bank charges fees for originating loans. Loan origination fees, net of direct costs of originating the loan are recognized as an adjustment of the loan yield over the life of the loan by the interest method, which results in a constant rate of return. When a loan is sold, net loan, origination fees and direct costs are recognized in operations. Other loan fees and charges representing service costs for the prepayment of loans, for delinquent payments or for miscellaneous loan services are recognized when collected. Loan commitment fees received are deferred to the extent they exceed direct underwriting costs. The Bank has designated certain of its loans receivable as being held for sale. In determining the level of loans held for sale, the Bank considers whether loans (a) would be sold as part of its asset/liability strategy, or (b) may be sold in response to changes in interest rates, changes in prepayment risk, the need to increase regulatory capital or other similar factors. Such loans are classified as held for sale and are carried at the lower of cost or market value. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) The Bank's current policy is to designate substantially all originations of fixed rate residential 1 to 4 unit loans as being held for sale as part of the asset/liability strategy. In further compliance with the Bank's policy, $321 million of adjustable FHLB Eleventh District Cost of Funds Index ("COFI") loans were transferred from held for investment to held for sale in December 1993 as part of the Bank's asset/liability strategy and the possible need to increase regulatory capital in the future. Loans held for sale are valued at the lower of aggregate cost or market value as determined by outstanding commitments from investors or, in the absence of such commitments, the current investor yield requirements calculated on an aggregate loan basis. The market value calculation includes consideration of commitments and related fees. Adjustments to the lower of cost or market are charged to current operations and are included in net gains/losses on loan sales in the statement of operations. Fidelity has sold loans which have generated gains on sale, a stream of loan servicing revenue and cash for lending or liquidity. Sales of loans are dependent upon various factors, including interest rate movements, investor demand for loan products, deposit flows, the availability and attractiveness of other sources of funds, loan demand by borrowers and liquidity and capital requirements. Due to the volatility and unpredictability of these factors, the volume of Fidelity's sales of loans has fluctuated. All loans sold during 1993 and 1992 were from the held for sale portfolio. Fidelity has the intent and ability to hold all of its loans, other than those designated as held for sale, until maturity. Owned Real Estate Real estate held for sale acquired in settlement of loans generally results when property collateralizing a loan is foreclosed upon or otherwise acquired by the Bank in satisfaction of the loan. Real estate acquired through foreclosure is recorded at the lower of fair value or the recorded investment in the loan satisfied at the date of foreclosure. Fair value is based on the amount that the Company could reasonably expect to receive for the asset in a current sale between a willing buyer and a willing seller, that is, other than in a forced or liquidation sale. Inherent in the computation of estimated fair value are assumptions about the length of time the Company may have to hold the property before disposition. The holding costs through the expected date of sale and estimated disposition costs are included in the valuations. Real estate held for investment or development is carried at the lower of cost or fair value. Adjustments to the carrying value of the assets are made through valuation allowances and charge-offs, through a charge to operations. Net cash receipts on real estate owned or on those loans designated as in-substance foreclosures and net cash payments are recorded in real estate operations on specific properties. Loans meeting certain criteria are accounted for as "in-substance foreclosures." These substantially foreclosed assets are recorded at the lower of the loan's carrying amount or at the estimated fair value of the collateral at the date the loan was determined to be in-substance foreclosed. These assets are reported as "real estate owned" in addition to formally foreclosed real estate. Statement of Position ("SOP") 92-3, "Accounting for Foreclosed Assets," was issued by the Accounting Standards Division of the American Institute of Certified Public Accountants in April 1992 and became effective for the Company's December 31, 1992 financial statements. SOP 92-3 presumes that foreclosed assets are held for sale and not for the production of income. It requires the Company to carry foreclosed assets held for sale, after foreclosure, at the lower of (a) fair value minus estimated costs to sell or (b) cost. The impact of implementing SOP 92-3 was immaterial to the Company's financial position, due to the Company's policy of carrying foreclosed assets at fair value, net of disposition costs. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) Allowances for Estimated Losses on Loans and Real Estate The Company has established valuation allowances for estimated losses on specific loans and real estate ("specific reserves") and for the inherent risk in the loan and real estate portfolios which has yet to be specifically identified ("general valuation allowances" or "GVA"). The internal asset review department reviews the quality and recoverability of the Company's assets on a quarterly basis in order to establish adequate specific reserves and general valuation allowances. The Bank utilizes the delinquency migration and the classification methods in determining the adequacy of its GVA. The delinquency migration method attempts to capture the potential future losses as of a particular date associated with a given portfolio of loans, based on the Bank's own historical migration experience over a given period of time. Under the classification method, a reserve factor is applied to each aggregate classification level by asset collateral type in an effort to estimate the loss content in the portfolio. The Bank calculates a range of loss by applying both methodologies and then applies judgment and knowledge of particular credits, economic trends, industry experience and other relevant factors to estimate the GVA amount. Additions to the allowances, in the form of provisions, are reflected in current operations. Charge-offs to the allowances are made when the loss is determined to be significant and permanent. Depreciation and Amortization Depreciation and amortization are 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 useful lives of the improvements, whichever is shorter. Earnings per Share Earnings per share are based on weighted average common shares outstanding, net of treasury stock in 1992 and 1991, of 5,809,570 in 1993 and 3,297,812 in 1992 and 1991. Intangible Assets In 1993, the Company reassessed the valuation of its intangible assets which resulted in a writedown of $14.0 million. See Note 7 for further information. Until 1993, the excess of cost over the fair value of net assets acquired (goodwill) in connection with the acquisition of Mariners Savings and Loan in 1978, was included in intangible assets in the statements of financial condition and was being amortized to operations over forty years. The cost of core deposits purchased from various financial institutions is amortized over the average life of the deposits acquired, generally five to ten years. Income Taxes The Company files a consolidated federal income tax return with its subsidiaries and a combined California franchise tax return. Beginning in 1991, income taxes have been determined pursuant to Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Prior to 1991, income taxes were determined pursuant to SFAS No. 96. The impact of adopting SFAS No. 109 was not material in relation to SFAS No. 96. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) Financial Instruments In the normal course of business, the Company enters into off-balance sheet instruments to enhance yields and to alter its exposure to interest rate risk. These financial instruments include interest rate swaps and swap option agreements and puts and calls. The differences to be paid or received on swaps are included in interest expense as payments are made or received. The swap options are held as trading positions during the option period and are carried at market value and gains and losses are reflected in operations. SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information about financial instruments, whether or not recognized in the statement of financial condition, for which it is practicable to estimate that value. Financial instruments are defined as cash, evidence of an ownership in an entity, or a contract that conveys or imposes on an entity the contractual right or obligation to either receive or deliver cash or another financial instrument. Much of the information used to determine fair value is highly subjective. When applicable, readily available market information has been utilized. However, for a significant portion of the Bank's financial instruments, active markets do not exist. Therefore, considerable judgment was required in estimating fair value for certain items. The subjective factors include, among other things, the estimated timing and amount of cash flows, risk characteristics, credit quality and interest rates, all of which are subject to change. Since the fair value is estimated as of December 31, 1993, the amounts that will actually be realized or paid at settlement or maturity of the instruments could be significantly different. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The following methods and assumptions were used in estimating fair value disclosures for financial instruments which are contained in the notes to the consolidated financial statements that describe each financial instrument. Cash and cash equivalents: The book value amounts reported in the statement of financial condition for cash and cash equivalents approximate the fair value of such assets, because of the short maturity of such investments. Investment securities and mortgage-backed securities: Estimated fair values for investment and mortgage-backed securities are based on quoted market prices, where available. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments. Loans: The estimated fair values of real estate loans held for sale are based on quoted market prices. The estimated fair values of loans receivable are based on quoted market prices, when available, or an option adjusted cash flow valuation ("OACFV"). The OACFV includes forward interest rate simulations and the credit quality of performing and nonperforming loans. Such valuations may not be indicative of the value derived upon a sale of all or part of the portfolio. The book value of accrued interest approximates its fair value. Investment in FHLB stock: The book value reported in the statement of financial condition for the investment in FHLB stock approximates fair value as the stock may be sold back to the Federal Home Loan Bank at face value to the extent that it exceeds the amount of FHLB stock which Fidelity is required to hold. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) Deposits: The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand. The fair value of fixed rate certificates of deposits is estimated by using an OACFV analysis. Borrowings (including FHLB Advances, other borrowings and subordinated notes): The estimated fair value is based on an OACFV model. Off-balance sheet instruments: The estimated fair value for the Bank's off- balance sheet instruments are based on quoted market prices, when available, or an OACFV analysis. Recent Accounting Pronouncements In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." This statement prescribes the recognition criteria for loan impairment and the measurement methods for certain impaired loans and loans whose terms are modified in troubled debt restructurings ("TDRs"). SFAS No. 114 states that a loan is impaired when it is probable that a creditor will be unable to collect all principal and interest amounts due according to the contracted terms of the loan agreement. A creditor is required to measure impairment by discounting expected future cash flows at the loan's effective interest rate, or by reference to an observable market price, or by determining the fair value of the collateral for a collateral dependent asset. The statement also clarified the existing accounting for in-substance foreclosures ("ISFs") by stating that a collateral dependent real estate loan would be reported as real estate owned ("REO") only if the lender had taken possession of the collateral. The statement is effective for financial statements issued for fiscal years beginning after December 15, 1994. Earlier application is encouraged. Additionally, in June 1993, the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Reserve Board and Office of Thrift Supervision issued a Joint Statement providing interagency guidance on the reporting of ISFs. This Joint Statement lent support to SFAS No. 114, further clarifying that losses must be recognized on real estate loans that meet the existing ISF criteria based on fair value of the collateral, but such loans need not be reported as REO unless possession of the underlying collateral has been obtained. Management will implement SFAS No. 114 beginning in 1994. The Company already measures impairment based on the fair value of the collateral, therefore, the estimated impact of application will consist of a reclassification of ISFs on the statement of financial condition from REO to loans. At December 31, 1993, the amount of ISFs totaled $28.4 million. In May 1993, the FASB also issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows: (a) debt securities for which the enterprise has the positive intent and ability to hold to maturity are classified as held to maturity securities and reported at amortized cost; (b) debt and equity securities that are bought and held principally for the purpose of selling in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; and (c) debt and equity securities not classified as either held to maturity securities or trading securities are classified as available for sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of tax effect, in a separate component of stockholders' CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) equity. SFAS No. 115 does not apply to unsecuritized loans. However, after mortgage loans are converted to mortgage-backed securities, they are subject to its provisions. SFAS No. 115 is effective for fiscal years beginning after December 15, 1993. It is to be initially applied as of the beginning of a company's fiscal year and cannot be applied retroactively to prior years' financial statements. However, a company may elect to initially apply this statement as of the end of 1993. The Company has not elected to apply this statement in 1993. However, the impact of the adoption of SFAS No. 115 as of December 31, 1993, would not have had a material effect on stockholders' equity. NOTE 2--CASH EQUIVALENTS AND INVESTMENT SECURITIES Federal funds sold are included in cash and cash equivalents. The Company had $60.0 million of federal funds sold at December 31,1993 and no outstanding federal funds sold at December 31, 1992. Investment securities held for trading Investment securities held for trading during 1993 consisted of U.S.Treasury securities purchased with the intent to be subsequently sold to provide net securities gains. Proceeds from sales of investment securities held for trading during 1993 were $248.3 million. Gross gains of $332,000 and gross losses of $345,000 were realized from those sales and are reported in the statement of operations as a component of gains/losses on sales of investment securities. There were no investment securities held for trading activities during 1992 and 1991 and the Company had no outstanding investment securities held for trading at year-end 1993 or 1992. Investment securities held for sale The following table summarizes the investment securities held for sale at December 31, 1993: Other investments represent U.S. Treasury securities, carried at the lower of cost or market value, which have been pledged and placed in trust to provide a credit enhancement to a FNMA securitization of loans in September 1992 of $114.3 million. The Company had no outstanding investment securities held for sale at December 31, 1992 or 1991. During the year ended December 31, 1993, the Company had gross gains of $110,000 and gross losses of $23,000 on the sale of investment securities held for sale. The Company also recorded a loss of $2.1 million at December 31, 1993 to adjust the book value of investment securities held for sale to the lower of cost or market. During the years ended December 31, 1992 and 1991, the Company had no gross gains or losses on the sale of investment securities held for sale. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 2--CASH EQUIVALENTS AND INVESTMENT SECURITIES--(CONTINUED) The following maturity table shows the book value and market value of investment securities held for sale at December 31, 1993: Investment securities held for investment Proceeds from sales of securities held for investment during 1993, 1992 and 1991 were $26.9 million, $0 and $1.5 million, respectively. The following gross gains and gross losses were realized from those sales and are reported in the statements of operations for the indicated periods, as a component of gains/losses on sales of investment securities, net: During 1993, the Company changed its investment strategy and as a result, moved its entire portfolio of investment securities from the investment portfolio to the held for sale portfolio. The Company had no outstanding investment securities held for investment at December 31, 1993. The following table summarizes the investment securities held for investment at December 31, 1992: Other investments represents U.S. Treasury securities which have been pledged and placed in trust to provide a credit enhancement to a FNMA securitization of loans in September 1992 of $114.3 million. At December 31, 1993 and 1992, the Company had accrued interest receivable of $0.7 million and $0.8 million, respectively, on investment securities held for sale and investment, which is included in interest receivable in the accompanying statements of financial condition. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 3--MORTGAGE-BACKED SECURITIES Mortgage-backed securities held for trading The Company had no outstanding mortgage-backed securities held for trading at December 31, 1993 and 1992. Proceeds from sales of mortgage-backed securities held for trading during 1993 totaled $51.3 million. Gross gains of $54,000 were realized from those sales and are reported in the statement of operations as a component of gains/losses on sales of mortgage-backed securities, net. There were no comparable activities for mortgage-backed securities held for trading during 1992 and 1991. Mortgage-backed securities held for sale Summarized below are mortgage-backed securities held for sale at December 31, 1993: The Company had no outstanding mortgage-backed securities held for sale at December 31, 1992. During the year ended December 31, 1993, the Company had gross gains of $4.9 million and gross losses of $5.1 million on the sale of mortgage-backed securities held for sale compared to no gross gains or losses for the years ended December 31, 1992 and 1991. Mortgage-backed securities held for investment During 1993, the Company changed its investment strategy and as a result, moved its entire portfolio of mortgage-backed securities from the investment portfolio to the held for sale portfolio. The Company had no outstanding mortgage-backed securities held for investment at December 31, 1993. During the year ended December 31, 1993, the Company had gross gains of $1.5 million and gross losses of $1,000 on the sale of mortgage-backed securities held for investment compared to no gross gains or losses for the year ended December 31, 1992 and gross gains of $9.3 million and gross losses of $.3 million for the year ended December 31, 1991. Summarized below are mortgage-backed securities held for investment at December 31, 1992: CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 3--MORTGAGE-BACKED SECURITIES--(CONTINUED) At December 31, 1993 and 1992, the Company had accrued interest receivable on mortgage-backed securities held for sale and investment of $0.5 million and $1.5 million, respectively, which is included in interest receivable in the accompanying statements of financial condition. NOTE 4--LOANS RECEIVABLE AND LOANS HELD FOR SALE Total loans include loans receivable and loans held for sale and are summarized as follows: Fidelity's portfolio of mortgage loans serviced for others amounted to $888.4 million at December 31, 1993 and $982.7 million at December 31, 1992. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 4--LOANS RECEIVABLE AND LOANS HELD FOR SALE--(CONTINUED) Fidelity's loan portfolio includes multifamily, commercial and industrial loans of $2.9 billion which depend on operating income to provide debt service coverage. Therefore, these loans generally have a greater risk of default than single family residential loans and, accordingly, earn a higher rate of interest to compensate in part for the risk. Approximately 99% of these loans are secured by property within the state of California. The continued weakening in the California real estate market does not make the market compare as favorably to other sections of the country as it has in the past. The Company has modified a number of its loans. In some cases, the modifications have taken the form of "early recasts" in which the amortizing payments are revised (or recalculated) earlier than scheduled to reflect current lower interest rates. In other cases, the Company has agreed to accept interest only payments for a limited time at current interest rates. In still other cases, the Company has modified loans at terms that are less favorable to the Company than the current market. These loans have interest rates that may be less than current market rates or may contain other concessions. Due to the fact that these modifications resulted from formal requests from borrowers claiming economic distress and due to increased risk of borrower inability to perform according to contractual terms, these modified loans have been categorized by the Company as "TDRs". At December 31, 1993 and 1992, outstanding TDRs totaled $28.7 million and $87.3 million, respectively. For the year ended December 31, 1993, interest income of $8.3 million was recorded on TDRs, $0.1 million less than would have been recorded had the loans performed according to their original terms. During 1992, $10.0 million of interest income was recorded on TDRs, $0.3 million less than would have been recorded had the loans performed according to their original terms. It is the Company's policy to reserve all earned but unpaid interest on loans over 90 days contractually delinquent and other loans the Company believes exhibit materially deficient characteristics. The total of these loans was $93.5 million, $112.0 million, and $69.0 million at December 31, 1993, 1992 and 1991, respectively. The reduction in income related to these loans upon which interest was not paid was $8.7 million,$13.6 million and $7.6 million for the corresponding periods. The estimated fair value of loans receivable (not including loans held for sale) as of December 31, 1993, was $3.4 billion, which includes $93.5 million of nonperforming loans (See Note 1 discussion of SFAS No. 107). At December 31, 1993, loans held for sale consisted of $321 million of adjustable rate loans and $47 million of fixed rate loans on 1 to 4 unit properties. The estimated fair value of loans held for sale as of December 31, 1993, was $368.8 million (see Note 1 discussion of SFAS No. 107). NOTE 5--OWNED REAL ESTATE Owned real estate consists of the following: CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 5--OWNED REAL ESTATE--(CONTINUED) The following summarizes the results of real estate operations: NOTE 6--ALLOWANCE FOR ESTIMATED LOAN AND REAL ESTATE LOSSES The following summarizes the activity in the Company's allowance for estimated loan and real estate losses: Current Southern California economic conditions have adversely affected the credit risk profile and performance of the Company's loan portfolio. In light of the concentration of the Company's loan portfolio in loans secured by Southern California multifamily residential properties, there is particular concern about the potential for further declines in the Southern California economy, increasing vacancy rates, declining rents, declining debt coverage ratios, declining market values for multifamily residential properties, and the possibility that investors may abandon properties or seek bankruptcy protection with respect to properties experiencing negative cash flow, particularly where such properties are not cross-collateralized by other performing assets. Fidelity's percentage of nonperforming assets to total assets increased to 5.37% at December 31, 1993 from 4.99% at December 1992 and 2.43% at December 31, 1991. NOTE 7--INTANGIBLE ASSETS In 1993, Fidelity reassessed the valuation of its intangible assets. Based upon the results of a branch profitability analysis and an analysis of the recoverability of its core deposit intangible assets, Fidelity wrote CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 7--INTANGIBLE ASSETS--(CONTINUED) down the carrying value of its core deposit intangible assets in an amount of $5.2 million (which writedown is included in interest expense). The net unamortized balance of core deposit intangibles was $2.1 million at December 31, 1993 and is being amortized over the remaining average life of the deposits acquired, generally one to three years. In addition, an analysis was performed of the recoverability of the goodwill related to the acquisition of Mariners Savings and Loan ("Mariners") in 1978. This analysis indicated that the expected future net earnings from the branches or assets acquired did not support the carrying value of the goodwill. As a result, Fidelity wrote down the remaining $8.8 million balance of goodwill related to the Mariners acquisition (which writedown is included in operating expense). The amortization and writedown of core deposit intangibles, resulting from purchases of deposits, and goodwill acquired in the acquisitions of other financial institutions for each of the three years in the period ended December 31, 1993, are summarized as follows: CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 8--DEPOSITS Deposits consist of the following: Fidelity had noninterest-bearing checking accounts of $52.9 million and $31.6 million at December 31, 1993 and 1992, respectively. At December 31, 1993, certificate accounts were scheduled to mature as follows: At December 31, 1993, loans totaling $98.3 million were pledged as collateral for $5.9 million of public funds on deposit with the Bank and potential future deposits. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 8--DEPOSITS--(CONTINUED) Certificates of deposits of $100,000 or more accounted for $593 million and represented 18% of all deposits at December 31, 1993, $550 million or 16% of all deposits at December 31, 1992 and $629 million or 16% of all deposits at December 31, 1991. The Bank also utilizes brokered deposits as a short-term means of funding. These deposits are obtained or placed by or through a deposit broker and are subject to certain regulatory limitations. The following table summarizes the Bank's outstanding balance of brokered deposits at the dates indicated: The carrying amounts and the estimated fair values of deposits consisted of the following at December 31, 1993 (see Note 1 discussion of SFAS No. 107): SFAS No. 107 defines the fair value of demand deposits as the stated amount of passbook, checking and certain money market accounts. Although SFAS No. 107 specifically prohibits including a deposit-based intangible element as part of the fair value disclosure for deposit liabilities, it does allow supplemental disclosure, which is unaudited. The core deposit intangible is the excess of the fair value of demand deposits over recorded amounts and represents the benefit of retaining these deposits for an expected period of time. Fair value is based on a discounted cash flow analysis using the Bank's alternative funding costs for similar maturities and assumed retention rates for each type of deposit. The core deposit intangible is estimated to be $63.0 million at December 31, 1993, and is not included in the above fair values or recorded as an asset in the statement of financial condition. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 9--FEDERAL HOME LOAN BANK ADVANCES FHLB Advances are summarized as follows: - -------- (1) Includes pledged loans available for use under the letter of credit securing commercial paper (available unused balance was $96 million at December 31, 1993). See Note 10. The maturities and weighted average interest rates on FHLB Advances are summarized as follows: The estimated fair value of FHLB Advances at December 31, 1993, was $328 million (see Note 1 discussion of SFAS No. 107). CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 10--OTHER BORROWINGS AND SUBORDINATED NOTES Other borrowings consist of the following: The mortgage-backed bonds and notes are summarized as follows: CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 10--OTHER BORROWINGS AND SUBORDINATED NOTES--(CONTINUED) Borrowings other than the mortgage-backed bonds and notes are summarized as follows: The Bank entered into a Subordinated Loan Agreement dated as of May 15, 1990 (the "Subordinated Loan Agreement") pursuant to which $60 million in subordinated notes (the "Notes") are outstanding, which Notes are guaranteed by Citadel. The Notes were approved by the OTS as additional regulatory capital. The Notes were issued to institutional investors in the amount of $60.0 million, interest payable semiannually at 11.68% per annum, and are repayable in five equal annual installments commencing May 15, 1996. The Subordinated Loan Agreement, among other covenants, contains a provision requiring Fidelity to maintain a consolidated tangible net worth at least equal to the greater of (a) $170 million plus 50% of consolidated net earnings since January 1, 1990, or (b) 3.25% of consolidated assets. Management anticipates that additional losses are likely to be incurred during 1994 and that, as a result, consolidated tangible net worth may be reduced to less than $170 million sometime during the first quarter of 1994. However, management's projections for 1994 indicate that the Bank's consolidated tangible net worth will remain above the net worth requirement under the foregoing clause (a) through the end of the year, assuming the formula in clause (a) permits a reduction of the $170 million test if a consolidated net loss has been sustained since January 1, 1990. Under this interpretation, the required consolidated tangible net worth under clause (a) would be $153.9 million at December 31, 1993 and would be further reduced by 50% of all losses during 1994. As of December 31, 1993, the Bank's consolidated tangible net worth amounted to $180.2 million. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 10--OTHER BORROWINGS AND SUBORDINATED NOTES--(CONTINUED) On the other hand, the holders of the Notes could take the position that the amount under clause (a) may not be reduced by losses to less than $170 million. Under that position, Fidelity would be in violation of the covenant as soon as consolidated tangible net worth were reduced to less than $170 million. Management believes that such position is not correct; however, there can be no assurance that such position would not prevail if the issue were ever tested in court. If the above covenant were violated, the holders of 66 2/3% in aggregate principal amount of the Notes would be entitled to declare the entire amount of the Notes immediately due and payable. However, if such acceleration would result in the Bank's failure to meet applicable regulatory capital requirements, the holders would be prohibited from accelerating the Notes without the prior approval of the OTS. If the Bank failed to make such payment, Citadel would be required to make such payment under its guarantee of the Notes. Management anticipates that Citadel's funds would be insufficient to make such payment, unless additional funds were raised. The holders of the Notes have power of approval over certain matters, including certain asset sales, and may require a repurchase of the Notes upon a "Significant Event." Management believes that neither the approval of the holders nor a Significant Event repurchase offer would be required for consummation of the proposed Restructuring (See Note 14.) if an acquiror of the Bank has outstanding, immediately prior to the closing of the Restructuring, unsecured debt with a credit rating of BBB or better by Standard & Poor's Corporation or Baa2 or better by Moody's Investors Service, Inc. and various financial tests are satisfied after giving effect to the Restructuring. However, should the Restructuring be found to trigger the Significant Event repurchase requirement, Fidelity could be required to pay the principal balance of the Notes of $60 million plus accrued interest and a premium of approximately $12.8 million (calculated as of December 31, 1993). Also, if the consent of the holders should be required under any of the covenants of the Subordinated Loan Agreement but not be obtained, an event of default would occur under the Subordinated Loan Agreement (subject to grace or cure periods in the case of certain covenants) if the Restructuring is completed. On March 4, 1994, The Chase Manhattan Bank, N.A. ("Chase"), one of four lenders under the Subordinated Loan Agreement, sued Fidelity, Citadel and Citadel's Chairman of the Board, alleging, among other things, that the transfer of assets pursuant to the Restructuring would constitute a breach of the Subordinated Loan Agreement, including the tangible net worth and other various financial tests contained therein, and seeking to enjoin the Restructuring and to recover damages in unspecified amounts. In addition, the lawsuit alleges that past responses of Citadel and Fidelity to requests by Chase for information regarding the Restructuring violate certain provisions of the Subordinated Loan Agreement and that such alleged violations, with the passage of time, have become current defaults under the Subordinated Loan Agreement. While the other three lenders under the Subordinated Loan Agreement hold $25 million of the Notes, none of them has joined Chase in this lawsuit. The Company is evaluating the lawsuit and, based on its current assessment, the Company does not believe that the allegations have merit. Any violation of the tangible net worth covenant or the occurrence of any other event of default under the Subordinated Loan Agreement would also result in a cross default under Fidelity's debt agreements with the FHLB (whether or not the Notes are accelerated) and entitle the FHLB to declare all amounts outstanding to become immediately due and payable. Also, the FHLB may elect not to make further Advances to the Bank and may prevent the Bank from issuing further commercial paper under its existing facility. During 1992 and 1991, the Company paid $0.4 million and $0.7 million, respectively, in interest to Craig Corporation (an 8.9% stockholder of the Company and thus a related party) on a $15 million borrowing from that entity. The loan was paid off in June 1992. The weighted average interest rate on other borrowings and subordinated notes was 5.54% and 8.39% at December 31, 1993 and 1992, respectively. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 10--OTHER BORROWINGS AND SUBORDINATED NOTES--(CONTINUED) The carrying and estimated fair values of other borrowings and subordinated notes consisted of the following at December 31, 1993 (see Note 1 discussion of SFAS No. 107): NOTE 11--EMPLOYEE BENEFIT PLANS Postretirement Benefits The Company provides certain health and life insurance postretirement benefits for all eligible retired employees. Eligibility for the plan is met when the participant reaches age 55 and has 10 years of continuous service. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" for its unfunded postretirement health care and life insurance program. This statement requires the cost of postretirement benefits to be accrued during the service lives of employees. The Company's previous practice was to expense these costs on a cash basis. As of December 31, 1992, the Company's accumulated postretirement benefit obligation ("APBO") was approximately $3.1 million. Upon adoption of the statement, the Company could make the election to immediately recognize the liability or to amortize the amount to expense over 20 years. The Company has elected to amortize this transition obligation over 20 years. Net periodic postretirement benefit costs for 1993 included the following components: CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 11--EMPLOYEE BENEFIT PLANS--(CONTINUED) The following table sets forth the postretirement benefit liability at December 31, 1993: Accumulated postretirement benefit obligation: The APBO as of December 31, 1993, was determined using a 7.25% weighted average discount rate. The health care cost trend rates were assumed to be 9.5% at December 31, 1993, gradually declining to 5.25% after ten years and remaining at that level thereafter. The health care cost trend rate assumption has a significant effect on the amount reported. For example, a 1% increase in the health care trend rate in each year, would increase the accumulated postretirement benefit obligation by $0.6 million (or 17.2%) at December 31, 1993 and the net periodic cost by $0.1 million (or 14.6%) for the year. Retirement Income Plan The Company has a retirement income plan covering substantially all employees. The defined benefit plan provides for payment of retirement benefits commencing normally at age 65 in a monthly annuity, however, the option of a single cash payment is available. An employee becomes vested upon five years of service. Benefits payable under the plan are generally determined on the basis of the employee's length of service and average earnings. Annual contributions to the plans are sufficient to satisfy legal funding requirements. 401(k) Plan The Company has a 401(k) defined contribution plan available to all employees who have been with the Company for one year and have reached the age of 21. Employees may generally contribute up to 15% of their salary each year, and the Company matches 50% up to the first 6% contributed by the employee. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 12--INCOME TAXES Income tax expense/benefit was comprised of the following: Income tax liability/receivable was comprised of the following: CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 12--INCOME TAXES--(CONTINUED) The components of the net deferred tax liability/asset are as follows: No valuation allowance under SFAS No. 109 was required for federal purposes. Federal deferred tax assets would be fully realized as an offset against reversing temporary differences which create net future tax liabilities, and/or through loss carrybacks. Therefore, even if no future income was expected, federal deferred tax assets would still be fully realized. However, a valuation allowance under SFAS No. 109 was required for state purposes, as certain state deferred tax assets would not be realized as an offset against reversing temporary differences which create net future state tax liabilities. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 12--INCOME TAXES--(CONTINUED) A reconciliation from the statutory income tax expense/benefit to the consolidated effective income tax expense/benefit follows: The Company's tax returns have been audited by the Internal Revenue Service through December 31, 1987 and by the California Franchise Tax Board through December 31, 1985. The tax returns filed for 1986, 1987 and 1988 are currently under audit by the California Franchise Tax Board. The tax returns filed for 1988 and 1989 are currently in the appeals process with the Internal Revenue Service. In addition, the Internal Revenue Service is currently auditing the tax returns filed for 1990 and 1991. Although the Company's management believes its federal income tax returns properly reflect the Company's tax liability, the Internal Revenue Service might assess additional taxes related to, among other things, certain disputed industry issues affecting the industry as a whole. If additional taxes are assessed, the Company intends to utilize all statutorily allowable remedies to achieve a favorable outcome for years under examination. Savings institutions are allowed a bad debt deduction for federal income tax purposes based on either 8% of taxable income or the savings institution's actual loss experience. Fidelity's bad debt deductions for the years presented were based on actual loss experience. Under the provisions of SFAS No. 109 (paragraphs 31 and 32), a deferred tax liability has not been provided for tax bad debt and loan loss reserves which arose in tax years prior to December 31, 1987. The Company had $52.5 million of such reserves at December 31, 1993, for which $18.4 million of taxes have not been provided. If these reserves are used for any purpose other than to absorb bad debt losses, federal taxes would have to be provided at the then current income tax rate. It is not contemplated that the accumulated reserves will be used in a manner that will create such liabilities. NOTE 13--COMMITMENTS AND CONTINGENCIES The Company and certain of its subsidiaries had a number of lawsuits and claims pending at December 31, 1993. The Company's management and its counsel believe that none of the lawsuits or claims pending will have a materially adverse impact on the financial condition or business of the Company. See Note 17--Subsequent Events. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 13--COMMITMENTS AND CONTINGENCIES--(CONTINUED) Fidelity enters into agreements to extend credit to customers on an ongoing basis. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Most commitments are expected to be drawn upon, and therefore the total commitment amounts generally represent future cash requirements. At December 31, 1993, the Bank had commitments to fund loans of $37.9 million at market interest rates on the dates such commitments are to be funded. At December 31, 1993, the Bank was a party to interest rate swap agreements in which the Bank receives a fixed interest rate and pays a floating interest rate on a total notional principal amount of $250 million. These agreements have remaining maturities of less than four years and an estimated fair value of $2.0 million (See Note 1 discussion of SFAS No. 107). As of December 31, 1993, the Bank had sold several interest rate swap option agreements with a total notional amount of $200 million. The agreements give the right to the buyer to cancel the swap agreement at a specified future date. The Bank receives a fixed interest rate and pays a floating interest rate tied to LIBOR over the life of the agreement for the option and swap. At December 31, 1993, the average fixed receive rate was 5.00% and the average pay rate was 3.34%. The swap options are held as trading positions during the option period and are carried at market value and gains and losses are recorded in operations. The estimated fair value of these positions at December 31, 1993 was a loss of approximately $1.7 million. In January 1994, the options to cancel were not exercised and the average fixed receive rate adjusted to 4.70%. The swaps have remaining maturities of less than four years. As of December 31, 1993, the Bank had several open put and call positions for mortgage loans expiring in January 1994. These positions were minor and no losses were incurred. As of December 31, 1993, the Bank had certain loans with a gross principal balance of $127.3 million, of which $106.3 million had been sold in the form of mortgage pass-through certificates, over various periods of time, to four investor financial institutions leaving a balance of $21.0 million retained by the Bank. These mortgage pass-through certificates provide a credit enhancement to the investor financial institutions in the form of the Bank's subordination of its retained percentage interest to that of the investor financial institutions. In this regard, the aggregate of $106.3 million held by the investor financial institutions are deemed Senior Mortgage Pass-Through Certificates and the $21.0 million held by the Bank are subordinated to the Senior Mortgage Pass-Through Certificates in the event of borrower default. Full recovery of the $21.0 million is subject to this contingent liability due to its subordination. In 1993, the Bank repurchased one of the Senior Mortgage Pass-Through Certificates with a face value of $38.3 million, from one of the investor institutions. It is included in the mortgage-backed securities held for sale portfolio at December 31, 1993. The other Senior Mortgage Pass-Through Certificates totaling $68.0 million are owned by other investor institutions. During 1992, the Bank effected the securitization by FNMA of $114.3 million of multifamily mortgages wherein $114.3 million in whole loans were swapped for Triple A rated mortgage-backed securities through FNMA's Alternative Credit Enhancement Structure ("ACES") program. These mortgage-backed securities were sold in December 1993 and the current outstanding balance as of December 31, 1993 of $102.0 million is serviced by the Bank. As part of a credit enhancement to absorb losses relating to the ACES transaction, the Bank has pledged and placed in a trust account, as of December 31, 1993, $13.3 million, comprised of (a) $2.7 million in cash and (b) $10.6 million in book value U.S. Treasury securities. The Bank shall absorb losses, if any, which may CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 13--COMMITMENTS AND CONTINGENCIES--(CONTINUED) be incurred on the securitized multifamily loans and FNMA is responsible for losses, if any, in excess of the $13.3 million. The securities have been included in other investments held for sale and in response to this classification, an adjustment has been recorded for lower of cost or market in addition to any credit losses. Total reserves equal $8.4 million as of December 31, 1993. The Company conducts portions of its operations from leased facilities. All of the Company's leases are operating leases. At December 31, 1993, aggregate minimum rental commitments on operating leases with noncancelable terms in excess of one year were as follows: Operating expense includes rent expense of $3.0 million in 1993, $2.8 million in 1992, and $2.7 million in 1991. NOTE 14--STOCKHOLDERS' EQUITY Fidelity's Regulatory Capital The Federal Deposit Insurance Corporation Improvement Act ("FDICIA") required the OTS to implement a system requiring regulatory sanctions action against institutions that are not adequately capitalized, with the sanctions growing more severe, the lower the institution's capital. Under FDICIA, the OTS issued regulations establishing specific capital ratios for five separate capital categories. The five categories of ratios are: CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 14--STOCKHOLDERS' EQUITY--(CONTINUED) The following table summarizes the capital ratios of the adequately capitalized category and Fidelity's regulatory capital at December 31, 1993 as compared to such ratios. As indicated in the table, Fidelity's capital levels exceeded the three minimum capital ratios of the adequately capitalized category. - -------- (1) The term "adjusted assets" refers to the term "adjusted total assets" as defined in 12 C.F.R. section 567.1(a) for purposes of core capital requirements, and for purposes of risk-based capital requirements, refers to the term "risk-weighted assets" as defined in 12 C.F.R. section 567.1(bb). Although the Bank was deemed adequately capitalized at December 31, 1993, at such date, absent the $28 million in capital contributed to the Bank by Citadel during the year (see "Other Equity Transactions" below), the Bank would not have met the 4% core capital to adjusted total assets requirement of the adequately capitalized category and thus would have been classified as undercapitalized for purposes of the OTS' prompt corrective action regulations. The OTS' capital regulations, as required by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), include three separate minimum capital requirements for the savings institution industry--a "tangible capital requirement," a "leverage limit" and a "risk-based capital requirement." These capital standards must be no less stringent than the capital standards applicable to national banks. The OTS also has the authority, after giving the affected institution notice and an opportunity to respond, to establish individual minimum capital requirements ("IMCR") for a savings institution which are higher than the industry minimum requirements, upon a determination that an IMCR is necessary or appropriate in light of the institution's particular circumstances, such as if the institution is expected to have losses resulting in capital inadequacy, has a high degree of exposure to credit risk, or has a high amount of nonperforming loans. The OTS has proposed a regulation that would add to the list of circumstances in which an IMCR may be appropriate for a savings association the following: a high degree of exposure to concentration of credit risk or risks arising from nontraditional activities, or failure to adequately monitor and control the risks presented by concentration of credit and nontraditional activities. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 14--STOCKHOLDERS' EQUITY--(CONTINUED) The following table summarizes the regulatory capital requirements for Fidelity under FIRREA at December 31, 1993, but does not reflect the required future phasing out of certain assets, including investments in, and loans to, subsidiaries which may presently be engaged in activities not permitted for national banks and, for risk-based capital, real estate held for investment (the impact of which the Bank believes to be immaterial), nor does the table reflect the impact of certain proposed regulations. As indicated in the table, Fidelity's capital levels exceed all three of the currently applicable minimum capital requirements. - -------- (1) Fidelity's total stockholder's equity, calculated in accordance with generally accepted accounting principles, was 4.16% of its total assets at December 31, 1993. (2) At periodic intervals, both the OTS and the FDIC routinely examine the bank as part of their legally prescribed oversight of the industry. Based on their examinations, the regulators can direct that the Bank's financial statements be adjusted in accordance with their findings. (3) The term "adjusted assets" refers to the term "adjusted total assets" as defined in 12 C.F.R. section 567.1(a) for purposes of tangible and core capital requirements, and for purposes of risk-based capital requirements, refers to the term "risk-weighted assets" as defined in 12 C.F.R. section 567.1(bb). The Company is actively pursuing a restructuring plan that would include both the transfer to a newly-formed Citadel subsidiary or division of certain problem assets of the Bank and a sale of the Bank and Gateway (the "Restructuring"; discussions of the sale of the Bank in the context of the Restructuring include the sale of Gateway). The Company is currently seeking a strategic buyer or a new core set of equity investors for the Bank. Any such sale of the Bank will be subject to the approval of Citadel's Board of Directors (the "Board") and stockholders as well as the OTS. Following the proposed sale of the Bank, Citadel would become a real estate company and focus on the servicing and enhancement of its loan and real estate portfolio. The Restructuring calls for the Bank's disposition of substantially all of its problem assets, together with a small amount of its performing assets, so as to improve the attractiveness of the Bank to potential acquisition or investment candidates. Most the Bank's problem assets would be transferred to the new Citadel real estate subsidiary or division using securitized debt financing. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 14--STOCKHOLDERS' EQUITY--(CONTINUED) The Bank does not intend to implement the above-described bulk problem asset dispositions in the absence of an acquisition of the Bank by another financial institution or financial investors who are able to infuse additional core capital into the Bank. Any such acquisition will also require the approval of Citadel's Board and stockholders, as well as the OTS, which will condition its approval in part on the adequacy of the capital of the Bank after the Restructuring. OTS Examinations In January 1994, Citadel and the Bank received reports of the various regular examinations conducted by the OTS in 1993. As a result of the findings of the OTS in its safety and soundness examination of the Bank, Fidelity will be subject to higher examination assessments and is subject to additional regulatory restrictions including, but not limited to, (a) a prohibition, absent prior OTS approval, on increases in total assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities during the quarter; (b) a requirement that the Bank submit to the OTS for prior review and approval the names of proposed new directors and executive officers and proposed employment contracts with any director or senior officer; (c) a requirement that the Bank submit to the OTS for prior review and approval any third-party contract outside the normal course of business; and (d) the OTS would have the ability, in its discretion, to require 30 days' prior notice of all transactions between Fidelity and its affiliates (including Citadel and Gateway). The OTS also expressed concern in a number of specific areas principally relating to asset quality and the resulting negative impact on capital levels and earnings, as well as management effectiveness in certain areas. Management believes that the proposed Restructuring of the Company discussed above, if accomplished, will be responsive to most of the OTS' concerns. Other Equity Transactions In March 1993, the Company completed a rights offering in which approximately $31.4 million of capital, net of expenses, was raised. Of that amount, $18.0 million was contributed to the capital of Fidelity in the first quarter of 1993 and an additional $10.0 million was contributed in the fourth quarter of 1993. Also, in the fourth quarter of 1993, Gateway paid a $1.0 million dividend to Citadel. In the third quarter of 1992, the Company retired its treasury stock of 179,700 shares. The carrying value of the stock of $6.1 million reduced the common stock and paid-in capital accounts as reflected in the statement of financial condition. The retirement of treasury stock did not affect the Bank's regulatory capital. The Bank paid a cash dividend of $1.0 million in the third quarter of 1992 to Citadel and during the fourth quarter of 1992, Fidelity paid a dividend in kind to Citadel consisting of its equity ownership of its securities brokerage subsidiary, Gateway. These dividends reduced Fidelity's capital by $2.1 million and had an immaterial effect on the Bank's tangible, core and risk- based capital. Stock Option Plans Citadel has two qualified stock option plans under which options to purchase shares of Citadel's common stock may be granted. Under the Key Employee Stock Option Program (the "1982 Stock Option Plan"), all options available for grant have been granted. Under the 1987 Stock Option and Stock Appreciation Rights Plan (the "1987 Stock Option Plan"), options to purchase up to 175,000 shares may be granted through April 22, 1997 and at December 31, 1993, there were 140,450 shares still available to grant. Options granted under both plans may not have an exercise price less than the fair market value of the common stock on the date of the grant, are exercisable in whole or in part, and expire no later than the tenth anniversary of the date of grant. CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 14--STOCKHOLDERS' EQUITY--(CONTINUED) A summary of the 1982 Stock Option Plan and the 1987 Stock Option Plan activity follows: At December 31, 1993, all of the options outstanding under the 1987 Stock Option Plan were fully exercisable. NOTE 15--QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 15--QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)--(CONTINUED) - -------- (1) The 1991 third quarter earnings originally reported had been reduced by $11,593,000 due to the temporary Staff Accounting Bulletin ("SAB") No. 91 limitation of tax benefits on loan loss reserves. The restated third quarter amounts reflect earnings which were increased by $11,593,000 in tax benefits which were allowable under SFAS No. 109 and SFAS No. 96. No other amounts were required to be restated. See Notes 1 and 12 to the consolidated financial statements. The effect of the change on the third quarter of 1991 is as follows: CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 16--PARENT COMPANY CONDENSED FINANCIAL INFORMATION This information should be read in conjunction with the other notes to the consolidated financial statements. CITADEL HOLDING CORPORATION STATEMENTS OF FINANCIAL CONDITION CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 16--PARENT COMPANY CONDENSED FINANCIAL INFORMATION--(CONTINUED) CITADEL HOLDING CORPORATION STATEMENTS OF OPERATIONS CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 16--PARENT COMPANY CONDENSED FINANCIAL INFORMATION--(CONTINUED) CITADEL HOLDING CORPORATION STATEMENTS OF CASH FLOWS CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 16--PARENT COMPANY CONDENSED FINANCIAL INFORMATION--(CONTINUED) Citadel's Liquidity Citadel has limited cash assets and no material cash producing operations or assets other than its investment in Fidelity and in Gateway. Because of Fidelity's current capital levels, dividends and distributions from Fidelity will not be available to Citadel for the foreseeable future. Thus, Citadel's current cash balances, together with potential future dividends from Gateway, are the only sources of cash to Citadel. Management believes that these cash resources will only be sufficient to meet Citadel expenditures through mid-1994. Unless the Restructuring (see Note 14) is consummated at that time, Citadel will be required to obtain additional cash to fund its expenditures, and no assurances can be given that Citadel will be able to obtain such funds. NOTE 17--SUBSEQUENT EVENTS Northridge Earthquake In January 1994, the greater Los Angeles area was seriously affected by a major earthquake and attendant aftershocks, centered in the San Fernando Valley. Because the Bank's main operations are located near the most seriously affected areas, and a substantial number of its customers are located in the most seriously affected areas, management has initiated, but not completed, efforts to evaluate the effect of the earthquake on the Bank's operations and customers. The Bank's portfolio includes loans and REO with a net book value of approximately $937 million secured by or comprised of 1,414 multifamily (5 units or more), 15 commercial, and 2,313 single family and multifamily (2 to 4 units) collateral properties in the primary earthquake areas. After the earthquake, the Bank's appraisers surveyed all of Fidelity's multifamily and commercial properties located in these areas and identified 231 properties, representing loans and REO with a net book value of $140 million, with more than "cosmetic" damage. Of such 231 properties, 204 properties related to the Bank's loans and REO with a net book value of $124 million were identified as having "possible serious damage" and an additional 27 properties with a net book value of $16 million were identified as "actually or potentially condemned". The Bank commissioned structural and building engineers or building inspectors to estimate the cost of repairs to properties in these two categories. The cost of repairs has been preliminarily estimated to be $5.7 million and $11.1 million, respectively. Of this total $16.8 million, approximately $6.0 million of seismic damage exceeds the principal balance on the collateral properties' respective loans. Accordingly, the Bank currently would not expect its losses due to the earthquake to exceed $10.8 million with respect to its commercial and multifamily properties. The Bank expects the actual losses payable by the Bank to be lower because many repair costs may be borne by the borrowers, who in addition to their own funds, may have access to government assistance and/or earthquake insurance proceeds. As part of its normal internal asset review process, the Bank will adjust its reserves as its losses become quantifiable. In addition to the multifamily and commercial assets referenced above, the Bank has identified 2,313 single family and multifamily (2 to 4 units) assets in the affected areas. 173 borrowers with unpaid principal balances totaling $29.4 million called in to report damages through February 8, 1994. The Bank has commenced inspection of these properties and continues to assess damages and potential earnings and loss impact with respect to these properties. The earthquake will also have some adverse affect on loan originations and the sale of financial services in the retail branch network in the near term. In addition, physical damage was sustained at some of CITADEL HOLDING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE YEARS ENDED DECEMBER 31, 1993 NOTE 17--SUBSEQUENT EVENTS--(CONTINUED) the Bank administrative and branch office facilities located in the Los Angeles area, however, only one Bank-owned building in the San Fernando Valley region of Los Angeles sustained major damage. It is estimated that necessary repairs to all affected facilities, net of anticipated insurance reimbursement, shall not exceed $0.5 million. Other potential financial impacts of the earthquake include additional personnel costs, property inspection costs, and others. Based upon the information gathered to date, the total estimated cost to the Company for these items is not expected to be material. Pending Litigation On March 4, 1994, The Chase Manhattan Bank, N.A. ("Chase"), one of four lenders under Fidelity's $60 million subordinated loan agreement of 1990 (the "Subordinated Loan Agreement"), sued Fidelity, Citadel and Citadel's Chairman of the Board, alleging, among other things, that the transfer of assets pursuant to the Restructuring would constitute a breach of the Subordinated Loan Agreement, and seeking to enjoin the Restructuring and to recover damages in unspecified amounts. In addition, the lawsuit alleges that past responses of Citadel and Fidelity to requests by Chase for information regarding the Restructuring violate certain provisions of the Subordinated Loan Agreement and that such alleged violations, with the passage of time, have become current defaults under the Subordinated Loan Agreement. While the other three lenders under the Subordinated Loan Agreement hold $25 million of the subordinated notes (the "Notes"), none of them has joined Chase in this lawsuit. The Company is evaluating the lawsuit and, based on its current assessment, the Company does not believe that the allegations have merit. The impact of this lawsuit on the capital position of the Bank, cross default provisions under the Bank's other debt agreements and the guarantee by Citadel is uncertain. See Notes 10 and 14. ITEM 9. ITEM 9. CHANGE 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 this reference is the information set forth in the sections entitled "ELECTION OF DIRECTORS" and "MANAGEMENT" contained in the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders (the "1994 Proxy Statement"). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by this reference is the information set forth in the section entitled "EXECUTIVE COMPENSATION" contained in the 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by this reference is the information set forth in the sections entitled "ELECTION OF DIRECTORS" and '"PRINCIPAL HOLDERS OF CITADEL COMMON STOCK" contained in the 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by this reference is the information set forth in the section entitled "RELATED PARTY TRANSACTIONS" contained in the 1994 Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A)(1) FINANCIAL STATEMENTS (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. (B) REPORTS ON FORM 8-K The Company filed a Report on Form 8-K on January 11, 1994 reporting on Item 5. "Other Events." II-1 (C) EXHIBITS 3.1 Certificate of Amendment of Restated Certificate of Incorporation of the Company (filed as Exhibit 3.1(a) to the Company's Form 10-K for the year ended December 31, 1988, and incorporated herein by reference). 3.2 Restated By-laws of the Company (filed as Exhibit 3.2 to the Company's Form 10-K for the year ended December 31, 1988, and incorporated herein by reference). 4.1 Indenture dated as of March 1, 1985, between Fidelity and First Interstate Bank of California, as trustee (filed as Exhibit 4 to the Company's Form 10-K for the year ended December 31, 1984, and incorporated herein by reference). 4.2 The Company agrees to provide the Securities and Exchange Commission, upon request, copies of instruments defining the rights of holders of long-term debt of the Company and all of its subsidiaries for which consolidated or unconsolidated financial statements are required to be filed with the Commission. 10.1 Fidelity Federal Savings and Loan Association Key Employee Stock Option Program (filed as Exhibit A to the Company's Registration Statement on Form S-8 (No. 2-96207) filed on March 4, 1985, and incorporated herein by reference). 10.2 Loan Agreement between Fidelity and Royal Shore Associates Limited Partnership, dated February 17, 1984 (filed as Exhibit 10.10 to the Company's Form 10-K for the year ended December 31, 1984, and incorporated herein by reference). 10.3 Agreement, dated August 2, 1984, between Fidelity and Marine Midland Bank, N.A. (filed as Exhibit 10.13 to the Company's Form 10-K for the year ended December 31, 1984, and incorporated herein by reference). 10.4 Indemnity Agreement, dated August 13, 1987, between the Company and the Directors and Officers of the Company (filed as Exhibit 10.15 to the Company's Form 10-K for the year ended December 31, 1987, and incorporated herein by reference). 10.5 Indemnity Agreement dated August 26, 1987 between Fidelity and the Directors and Officers of Fidelity (filed as Exhibit 10.16 to the Company's Form 10-K for the year ended December 31, 1987, and incorporated herein by reference). 10.6 Citadel Holding Corporation 1987 Stock Option and Stock Appreciation Rights Plan (filed as Exhibit A to the Company's definitive Proxy Statement dated May 29, 1987, and incorporated herein by reference). 10.7 Form of Incentive Stock Option Agreement (filed as Exhibit 10.18 to the Company's Form 10-K for the year ended December 31, 1987, and incorporated herein by reference). 10.8 Form of Indemnity agreement approved June 27, 1990, between Citadel and directors and certain officers of Citadel terminating and replacing that certain Indemnity Agreement dated August 22, 1987 (filed as Exhibit 10.15 to the Company's Form 10-K for the year ended December 31, 1987, and incorporated herein by reference). 10.9 Form of Indemnity Agreement approved June 27, 1990, between Fidelity and directors and certain officers of Fidelity terminating and replacing that certain Indemnity Agreement dated August 22, 1987 (filed as Exhibit 10.16 to the Company's Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. 10.10 Loan agreement dated as of May 15, 1990, between Fidelity, the Company and certain lenders as defined in said Loan Agreement regarding the issuance by Fidelity of $60 million of Fidelity's 11.68% subordinated notes (filed as Exhibit 10.24 to the Company's Form 10-K for the year ended December 31, 1990, and incorporated herein by reference). II-2 10.11 Letter agreement dated May 1, 1991 summarizing the terms and conditions of employment between Philip R. Sherringham and Fidelity (filed as Exhibit 10.18 to the Company's Form 10-K for the year ended December 31, 1991, and incorporated herein by reference). 10.12 Letter agreement dated as of June 29, 1992 with Walter H. Morris, Jr. with respect to employment (filed as Exhibit 10.12 to the Company's Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). 10.13 Consulting Agreement with Scott A. Braly dated as of August 3, 1992, and amendments thereto dated as of August 26, 1992 and November 30, 1992 (filed as Exhibit 10.13 to the Company's Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). 10.14 Form of Severance Agreement and related Guaranty Agreement to be entered into with Kirk S. Sellman, Walter H. Morris, Jr., Godfrey B. Evans, and other company executives (filed as Exhibit 10.14 to the Company's Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). 10.15 Executive Employment Agreement dated as of June 2, 1992 between Richard M. Greenwood and Fidelity and Amendment No. 1 thereto dated March 24, 1993 (filed as Exhibit 10.15 to the Company's Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). 10.16 Letter agreement of employment and guaranty dated as of June 2, 1992 between Richard M. Greenwood and Citadel Holding Corporation and Amendment No. 1 thereto dated January 24, 1993 (filed as Exhibit 10.16 to the Company's Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). 10.17 Dealer agreement, Letter of Credit Reimbursement Agreement and Depository Agreement dated as of July 31, 1992 relating to the commercial paper of Fidelity (filed as Exhibit 10.17 to the Company's Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). 10.18 Data Processing Agreement by and between Systematics Financial Services, Inc. and Fidelity dated May 1, 1993, with exhibits and First Amendment thereto (filed herewith). 10.19 Letter agreement dated January 4, 1994 summarizing the terms and conditions of employment between James E. Stutz and Fidelity (filed herewith). 10.20 Letter agreement dated December 14, 1993 summarizing the terms and conditions of employment between Steve Wesson and Citadel (filed herewith). 22 Subsidiaries of the Company (filed herewith). 27 Financial Data Schedule (filed herewith). II-3 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. Citadel Holding Corporation By /s/ James J. Cotter ___________________________________ James J. Cotter Chairman of the Board 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 REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. II-4

202356_1993.txt

202356_1993

1993

202356

Item 1. DESCRIPTION OF BUSINESS (a) General Development of Business. Kysor Industrial Corporation ("Kysor", the "Company" or the "Registrant") is a Michigan corporation. It is the successor to a Delaware corporation of the same name organized in 1970 and also previously a Michigan corporation of the same name originally organized in 1925. In April 1988, Kysor purchased an 80 percent interest in Kysor/Warren Refrigeration GmbH of Limburg, West Germany. In January 1989 the remaining 20 percent interest was acquired. Kysor/Warren Refrigeration GmbH designs, manufactures and markets refrigerated display cases for the European market. In July 1990, Kysor acquired a portion of the truck and off-highway heater and air-conditioning business from Valeo Climate Control Ltd., located in South Wales, United Kingdom. In February 1994, Kysor acquired Kalt Manufacturing Co., Inc., located in Portland, Oregon and Goodyear, Arizona. Kalt manufactures walk-in coolers and panels for the supermarket convenience store and food service industry. The Aluminum Fabricated Products operations, located in Perry, Florida and Greeneville, Tennessee, were divested during 1990 in three separate transactions. (b) Segment Information. Kysor Industrial Corporation's operations include two segments: commercial products and transportation products. Operations in the commercial products segment design, manufacture and market refrigerated display cases, energy control systems, refrigerated building systems, and heating and air-conditioning systems. Operations in the transportation products segment design, manufacture and market engine performance systems, engine protection systems, and components and accessories for heavy-duty trucks, other commercial vehicles and marine equipment. The information in the following schedule excludes intercompany transactions which are deemed to be immaterial. KYSOR INDUSTRIAL CORPORATION AND SUBSIDIARIES Financial Information by Segment Years Ended December 31, (amounts in thousands) ________________________________ NET SALES 1993 1992 1991 ________ ________ ________ Commercial products United States $166,347 $171,437 $135,433 Europe 19,398 16,234 18,287 _________ _________ _________ Total commercial products 185,745 187,671 153,720 _________ _________ _________ Transportation products United States 80,518 65,075 57,578 Europe 6,344 9,428 12,345 _________ _________ _________ Total transportation products 86,862 74,503 69,923 _________ _________ _________ NET SALES $272,607 $262,174 $223,643 _________ _________ _________ _________ _________ _________ OPERATING PROFIT (LOSS)* Commercial products United States $ 21,784 $ 22,651 $ 12,866 Europe (1,871) (1,599) (1,478) _________ _________ _________ Total commercial products 19,913 21,052 11,388 _________ _________ _________ Transportation products United States 11,859 8,210 5,017 Europe (412) (346) (1,991) _________ _________ _________ Total transportation products 11,447 7,864 3,026 _________ _________ _________ TOTAL OPERATING PROFIT 31,360 28,916 14,414 Corporate administrative expense (net) (11,190) (8,794) (6,732) Provision for litigation - (1,500) (4,000) Interest expense (2,162) (2,595) (3,748) _________ _________ _________ INCOME (LOSS) BEFORE INCOME TAXES AND BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE $ 18,008 $ 16,027 $ (66) _________ _________ _________ _________ _________ _________ * Operating profit includes net sales less operating expenses. Excluded from the computation of operating profit are interest and other non- operating revenues, general corporate expenses and interest expense. KYSOR INDUSTRIAL CORPORATION AND SUBSIDIARIES Financial Information by Segment Years Ended December 31, (amounts in thousands) ________________________________ 1993 1992 1991 ________ ________ ________ ASSETS Commercial products United States $ 63,667 $ 65,718 $ 63,789 Europe 9,847 9,937 10,950 _________ _________ _________ Total commercial products 73,514 75,655 74,739 _________ _________ _________ Transportation products United States 29,542 26,921 29,383 Europe 2,938 4,356 5,880 _________ _________ _________ Total transportation products 32,480 31,277 35,263 ________ ________ ________ Subtotal 105,994 106,932 110,002 Cash and other corporate assets 50,461 28,918 23,008 ________ ________ ________ TOTAL ASSETS $156,455 $135,850 $133,010 ________ ________ ________ ________ ________ ________ DEPRECIATION AND AMORTIZATION Commercial products $ 3,734 $ 3,784 $ 3,718 Transportation products 3,677 3,617 3,699 Corporate 243 249 296 ________ ________ ________ TOTAL DEPRECIATION AND AMORTIZATION $ 7,654 $ 7,650 $ 7,713 ________ ________ ________ ________ ________ ________ CAPITAL EXPENDITURES Commercial products $ 3,829 $ 2,398 $ 2,864 Transportation products 4,758 1,379 2,005 Corporate 66 142 87 ________ ________ ________ TOTAL CAPITAL EXPENDITURES $ 8,653 $ 3,919 $ 4,956 ________ ________ ________ ________ ________ ________ (c) Narrative Description of Business. At December 31, 1993, Kysor had approximately 1,904 employees. Information as of December 31, 1993 concerning Kysor's two industry segments is presented below. Certain financial information related to the individual industry segments is incorporated in response to Item 1.(b) above. There were no material expenditures for compliance with federal, state or local provisions regulating the discharge of materials into the environment except with respect to ongoing proceedings relating to soil and groundwater contamination at the Cadillac Industrial Park in Cadillac, Michigan which is explained further under Note 11, Contingent Liabilities, to the Consolidated Financial Statements included under Part II, Item 8. Commercial Products The principal products of the commercial products group include supermarket refrigerated display cases, condensing units, insulated panels for refrigerated building systems and walk-in coolers, commercial vehicle heating, ventilating and air-conditioning (HVAC) units and truck trailer supports. The principal markets for Kysor's commercial products group include supermarkets, convenience stores and original equipment manufacturers for such vehicles as heavy-duty trucks, buses, vans, agriculture and military off-highway equipment and truck trailers. Refrigerated display equipment, refrigerated building systems, and sundry food store equipment are sold directly to supermarkets and convenience stores, as well as through independent commercial refrigeration distributors. Vehicle HVAC units and truck trailer support product sales are made directly to original equipment manufacturers and through a nationwide network of distributors. The basic raw materials used by Kysor in this group are galvanized sheet and other types of steel, aluminum, glass, copper tubing, foam insulation, refrigerants, brass, copper, plastics and a variety of purchased electronic components. All raw materials used in this segment are readily available in adequate quantities from a number of sources. Kysor holds or is licensed under a number of patents and trademarks relating to its commercial products. While none of these patents or trademarks are considered individually to be material, collectively these patents and trademarks are important to the business of the commercial products group. There are no significant seasonal factors. Backlogs at year-end 1993 and 1992 were approximately $48.0 million and no material portion of this business is subject to renegotiation or termination by the government. There are no working capital requirements peculiar to this industry segment. The commercial products industry is highly competitive. Kysor competes with numerous companies in this group, some of which are larger and have greater financial resources than Kysor. Kysor believes that it competes primarily on the basis of quality, service, product performance, and price for most of its products, and warrants the majority of its products in accordance with general industry practices. The commercial products group generated $29.0 million, $48.4 million and $34.7 million of sales and revenues from Food Lion Stores in the years ended December 31, 1993, 1992 and 1991 respectively. Transportation Products The principal products of this group include engine performance systems consisting of radiator shutters, fan clutches and plastic fans; engine protection systems consisting of various engine monitoring devices, truck fuel tanks, and marine instruments. The principal markets for Kysor's transportation products group are original equipment manufacturers of such vehicles as medium- and heavy-duty trucks, buses, off-highway equipment and the marine industry. The majority of the group's sales are made directly to manufacturers. Additionally, Kysor utilizes a network of independent distributors to provide aftermarket and replacement parts service to end users. The basic raw materials used by Kysor in this group are steel, brass, copper, aluminum, plastics and a variety of purchased electronic components which are widely available in adequate quantities from a number of sources. Kysor holds or is licensed under a number of patents and trademarks relating to its transportation products. While none of these patents or trademarks are considered individually to be of material value, collectively these patents and trademarks are important to the business of the transportation products group. There are no significant seasonal factors. Backlogs at year-end 1993 were approximately $16.0 million compared to $13.0 million in 1992 and no material portion of this business is subject to renegotiation or termination by the government. There are no working capital requirements peculiar to this industry segment. The Transportation Products Group generated $26.5 million of sales and revenue from Ford Motor Company in the year ended December 31, 1993. The transportation products industry is highly competitive. Kysor competes with numerous companies in this group, some of which are larger and have greater financial resources than Kysor. Kysor believes that it competes primarily on the basis of quality, service, product performance, and price for most of its products, and warrants the majority of its products in accordance with general industry practices. (d) Financial Information About Foreign and Domestic Operations and Export Sales This information is included in Item 1(b) above under the heading "Financial Information by Segment". The "Financial Information by Segment" does not include separately reported export sales as they are not significant. Item 2. Item 2. PROPERTIES Kysor and its subsidiaries owned or leased the following offices and manufacturing facilities as of December 31, 1993: COMMERCIAL PRODUCTS GROUP LOCATION DESCRIPTION INTEREST GEORGIA: Conyers Plant & office; 480,000 Owned in fee simple sq. ft. on 50-acre site Columbus Plant & office; 295,826 Owned in fee simple sq. ft. on 22.7-acre site TEXAS: Fort Worth Plant & office; 100,162 Owned in fee simple sq. ft. on 11-acre site ILLINOIS: Byron Plant, warehouse & office; 176,716 sq. ft. on Owned in fee simple 31-acre site W.GERMANY: Limburg Plant & office; 52,096 Owned in fee simple sq. ft. on 6.9-acre site TRANSPORTATION PRODUCTS GROUP INDIANA: Scottsburg Plant & office; 42,048 Owned in fee simple sq. ft. on 10.7-acre site MICHIGAN: Cadillac Plant, warehouse & office; Owned in fee simple 131,426 sq. ft. on 12.4-acre site Spring Lake Plant & office; 80,000 Owned in fee simple sq. ft. on 8.l-acre site Rothbury Plant, warehouse & office; Owned in fee simple 18,543 sq. ft. on 3.4-acre site Walker Plant & office; 49,188 Owned in fee simple sq. ft. on 3-acre site White Pigeon Plant & office; 42,000 Owned in fee simple sq. ft. on 5-acre site N.CAROLINA: Charlotte Plant & office; 91,150 Owned in fee simple sq. ft. on 3.5-acre site SOUTH WALES: Hengoed Plant & office; Leased 50,000 sq. ft. CORPORATE MICHIGAN: Cadillac Executive office; Owned in fee simple 23,000 sq. ft. on 102-acre site OKLAHOMA: Duncan Vacant plant, wrhse. Owned in fee simple & office; 93,000 sq. ft. on 22.1-acre site It is believed that Kysor's facilities are generally adequate for its operations and such properties are maintained in a good state of repair. Item 3. Item 3. LEGAL PROCEEDINGS. As previously reported, the Company is involved in the following legal proceedings: The Company is involved in an environmental proceeding with respect to a site in Cadillac, Michigan. The description of such proceeding is set forth in Part II, Item 8 of this report, Note 11 to the Consolidated Financial Statements. On July 3, 1991, the Michigan Attorney General and the Department of Natural Resources filed a lawsuit against the Company and various other parties in the United States Federal District Court for the Western District of Michigan. The description of such proceeding is set forth under Part II, Item 8 of this report, Note 11 to the Consolidated Financial Statements. On December 31, 1991, General Electric ("GE") filed a third-party claim against the Company in the United States District Court for the Western District of Michigan. The dispute arose out of claims made by Midwest Aluminum Manufacturing Company ("Midwest") against GE. The description of such proceeding is set forth in Part I, Item 3 of the Company's 1991 Annual Report on Form 10-K filed with the Commission on March 25, 1992. In February 1993, an agreement-in- principle was reached settling the underlying dispute between Midwest and GE, which settlement was finanlized in early 1994. As part of the settlement, the Company has been released by Midwest from all past and future environmental claims with respect to the Midwest site, and by GE with respect to all claims for indemnity or contribution arising out of Midwest's underlying claims against GE. The settlement is without prejudice to GE's remaining claims against the Company, pursuant to which GE seeks to recover response costs associated with certain environmental cleanup at GE's property, formerly owned by Kysor, and its defense costs incurred in connection with the Midwest suit. On December 4, 1992, Kysor was named as a defendant, together with over 30 other parties, in an action commenced by the Township of Oshtemo, City of Kalamazoo, Kalamazoo County and The Upjohn Company with respect to alleged contamination at the West KL Avenue Landfill site located in Kalamazoo, Michigan. On November 16, 1993 Kysor Industrial Corporation entered into a settlement agreement requiring the payment of $20,000 which dismisses Kysor from all claims. On March 30, 1993, the Company received a notification from the Michigan Department of Natural Resources that it has been named as a potentially responsible party ("PRP") with respect to a site commonly referred to as the SCA Independent Landfill Superfund Site, located in Muskegon County, Michigan. The notice alleges that the Company, together with numerous other parties, was an owner, generator or transporter of waste materials deposited at the site. The PRP notice request the Company and the other named PRPs to conduct a Remedial Investigation/Feasibility Study to determine the extent of contamination at the site, and seeks recovery of investigative costs expended by the MDNR to date. No significant discovery has taken place with respect to this matter. Other contingent liabilities include various legal actions, proceedings and claims which are pending or which may be instituted or asserted in the future against the Company. Litigation is subject to many uncertainties, the outcome of individual matters is not predictable with assurance and it is reasonably possible that some of these other legal actions, proceedings and claims could be decided unfavorable to the Company. Although the liability with regard to these matters at December 31, 1993 cannot be ascertained, it is the opinion of management, after conferring with counsel, that any liability resulting from these other matters should not materially affect the consolidated financial position of the Company and its subsidiaries at December 31, 1993. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II Item 5. Item 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. As of December 31, 1993, Kysor Industrial Corporation had a total of 5,467,840 shares of Common Stock issued and outstanding and 1,396 shareholders of record. A large number of shares are held by brokerage firms and banks for the benefit of other shareholders in all 50 states of the United States and several foreign countries. In addition, the Corporation had 810,163 shares of Series A. Convertible Voting Preferred Stock outstanding, all of which are owned by the Kysor Industrial Corporation Employee Stock Ownership Plan. The annual dividends declared amounted to $.44 and $.40 during 1993 and 1992, respectively. The quarterly rate was $.10 per share for all of 1992 and the first quarter 1993, $.11 for the second and third quarter, 1993, and $.12 for the fourth quarter. A quarterly summary of Kysor Industrial Corporation's Common Stock trading range is as follows: 1993 1992 High Low High Low First Quarter 21.75 16.125 8.875 6.875 Second Quarter 20.875 15.875 11.25 8.625 Third Quarter 18.00 14.50 13.00 10.125 Fourth Quarter 17.875 15.625 19.125 12.00 ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Comparison of 1993 and 1992 Kysor Industrial Corporation's 1993 total sales and revenues were $273.9 million, up 3.8 percent from 1992. Net income, before the accounting change for postretirement benefits, was $10.1 million compared to $9.1 million reported in 1992. Primary earnings per share before the accounting change was $1.62 in 1993, compared to $1.52 per share in 1992. Primary earnings per share after the accounting change was $.27 per share in 1993. Included in 1993 results is a provision for environmental matters amounting to $.14 per share, which are described in greater detail under Note 11, while 1992 results include a provision for litigation equaling $.18 per share. The increase in 1993 profitability resulted primarily from the increases in the Transportation Products Group where they benefited from the best Class-8 heavy-duty truck market since 1979 and the increased market penetration of Kysor's injection molded polymer engine fans. On December 21, 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard #106 ("SFAS #106"), effective for 1993. SFAS #106 requires employers to accrue the cost of postretirement benefits other than pensions during the working careers of active employees instead of expensing the benefits when paid as allowed under prior rules. Actuarial valuation of the Company's transition obligation is $7.5 million (net of tax). In addition to the transition obligation, the Company is now required to accrue recurring annual postretirement benefits higher than the "pay as you go" expense. This additional accrual was $564,000 for 1993. The Company elected to record the transition obligation as a charge against income during the first quarter, 1993. In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard #112 ("SFAS #112") which requires employers, effective for fiscal years beginning after December 15, 1993, to recognize the liability for postemployment benefits provided to former or inactive employees. The Company has reviewed the requirements of SFAS #112 and determined that the impact on the Company was not material. The Financial Accounting Standards Board also has adopted SFAS #109, Accounting for Income Taxes effective for years beginning after December 15, 1992 which replaces SFAS #96. There was no material impact on the Company when this standard was adopted in 1993. Sales backlogs at the end of 1993 were up 4.6 percent from record levels at year-end 1992. The continued improvement in 1993 results allowed Kysor to reduce its long-term debt and improve its debt ratio from 40.8 percent to 38.1 percent at the end of the year, after giving consideration to the decrease in equity resulting from the accrual for postretirement benefits. The Company is presently involved in certain environmental proceedings with respect to soil and groundwater contamination in Cadillac, Michigan, as described below under the heading "Liquidity and Capital Resources" and in Note 11, Contingent Liabilities. In addition, the Company is involved in various other legal proceedings including certain proceedings involving allegedly contaminated sites with respect to which the Company has been named a potentially responsible party under the Federal Superfund law or comparable state laws. Although discovery in certain of these proceedings has not been completed, subject to the contingencies discussed in Note 11, the information presently available to management does not cause management to believe that the ultimate aggregate cost to the Company of such proceedings will result in a material adverse effect on its future financial condition or results of operation. Comparative summaries and review of operations for the two business groups follows: TRANSPORTATION PRODUCTS AMOUNTS IN THOUSANDS 1993 1992 1991 Net Sales $ 86,862 $ 74,503 $69,923 Operating Profit 11,447 7,864 3,026 Sales in the Transportation Products Group increased 16.6 percent and operating profit increased 45.6 percent compared to 1992. The increase in sales and the significant increase in operating profit are the result of improved market conditions in the heavy-duty truck market and the positive impact of cost containment measures initiated over the past years. Backlogs at year-end 1993 were 22.9 percent above year-end 1992 levels and set the stage for another outstanding year in 1994. During 1993, the Company's Kysair injection molded fan continued to gain market share, both domestically and internationally. As a result of that success, Kysor approved capital expenditures for 1994 which will establish manufacturing capabilities in the United Kingdom and management is currently studying a similar expansion into Korea. COMMERCIAL PRODUCTS AMOUNTS IN THOUSANDS 1993 1992 1991 Net Sales $185,745 $187,671 $153,710 Operating Profit 19,913 21,052 11,388 Commercial Products Group sales and operating profits decreased slightly as a result of the trimming of expansion plans by a major customer in the Kysor/Warren division during 1993. Kysor/Needham, the group's walk-in cooler manufacturer, increased sales 13.8 percent and made significant inroads in Mexico where sales increased substantially year-over-year. Additionally, in February 1994, Kysor purchased another cooler and panel manufacturer, Kalt Manufacturing Co., Inc., with manufacturing facilities in Portland, Oregon and Phoenix, Arizona. Backlogs at year-end 1993 and 1992 for the Commercial Products Group were approximately $48.0 million. Comparison of 1992 and 1991 Kysor Industrial Corporation's 1992 total sales and revenues were $264 million, up 17.3 percent from 1991. Net income was $9 million compared to a loss of $726,000 in 1991. Primary earnings per share were $1.52 in 1992 compared to a loss of $.35 per share in 1991. 1991's loss was the result of establishing a $4.0 million provision for a judgment in a commercial lawsuit equaling $.49 per share. Although the Company was in the process of appealing the verdict in the lawsuit, the parties, on December 15, 1992, reached an acceptable settlement agreement. The settlement was adequately reserved in 1991 and had no adverse effect on income in 1992. The increase in 1992 sales and revenue and its positive impact on profits resulted from improvement in all six domestic divisions, particularly the commercial refrigeration division where Kysor's major customers continued to expand aggressively throughout the year. Included in 1992 results is a $1.5 million provision for litigation which relates primarily to certain environmental proceedings against the Company which is described in greater detail under Note 11, Contingent Liabilities of the 1993 Annual Report to Shareholders. International Operations Kysor Industrial Corporation has two foreign manufacturing subsidiaries - Kysor/Warren Refrigeration GmbH, which is part of the Commercial Products Group, and Kysor/Europe, part of the Transportation Products Group. Kysor/Warren Refrigeration GmbH, with manufacturing operations in Limburg, Germany, experienced a 19.5 percent increase in sales compared to 1992. The increase in sales was primarily the result of low margin sales to Eastern Europe which contributed to additional losses during 1993. A new German general manager has been hired during 1994 and stringent cost-containment programs have been implemented to stem losses in the future. Kysor/Europe, serving the European commercial vehicle truck market, with manufacturing operations located in Hengoed, South Wales, experienced a 29 percent decrease in sales in 1993 compared to 1992. The decrease is primarily attributable to the significant recession in the European markets. Notwithstanding the significant decrease in sales, improved internal controls and cost-containment programs allowed Kysor/Europe to minimize its operating losses at $412,000 in 1993 compared to $346,000 in 1992. Liquidity and Capital Resources The Company's debt to invested capital ratio decreased from 40.8 percent at December 31, 1992, to 38.1 percent at December 31, 1993. Working capital at December 31, 1993 was $45.1 million, an increase of $3.5 million from the same period last year. Cash flow generated from operating activities in 1993 was $27.6 million, an increase of $8.7 million over the cash flow generated during 1992. At December 31, 1993, the Company has current maturities of long-term debt amounting to $5.7 million. All temporary borrowings are executed under a $20 million, long-term, revolving credit facility of which none was utilized at December 31, 1993. Corporate philosophy is that long-term debt, properly utilized, can contribute to the sustained long-term growth of the Company. In furtherance of this philosophy, the Company will use long-term debt to the point financial flexibility is preserved and undue financial risk is not incurred. The Company's long-term objective is to maintain debt at less than 40 percent of total capitalization. Capital expenditures during 1993 were financed through internally generated funds. The Company's capital expenditures for the year were $8.7 million relating primarily to the replacement and improvement of manufacturing equipment. Depreciation and amortization were $7.7 million for 1993. Capital expenditures are expected to increase during 1994, while depreciation and amortization should remain at approximately the same levels. The ultimate amount of the environmental cleanup costs associated with the Cadillac, Michigan site described in Note 11 to the financial statements, the amount of costs allocated to the Company and the other contingencies discussed in such note, could impact earnings and liquidity in a material way, could result in the violation of one or more loan covenants and could result in the limitation or discontinuance of the payment of future dividends. However, the Company believes, subject to the referenced contingencies, that anticipated cash flow from operations, available borrowings on the resolving line of credit, and other potential sources of borrowing will be adequate to meet its short- and long-term liquidity and capital resource needs. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT ACCOUNTANTS Kysor Industrial Corporation Cadillac, Michigan We have audited the accompanying consolidated balance sheet of Kysor Industrial Corporation and Subsidiaries as of December 31, 1993 and 1992 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. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform 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 Kysor Industrial 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. As discussed in Note 8 to the consolidated financial statements, effective January 1, 1993, the Corporation changed its method of accounting for postretirement benefits other than pensions. Detroit, Michigan February 14, 1994 KYSOR INDUSTRIAL CORPORATION Consolidated Balance Sheet (Dollars in thousands, except per share data) December 31, December 31, ASSETS 1993 1992 ____________ ____________ CURRENT ASSETS Cash and equivalents $ 21,339 $ 6,913 Accounts receivable less $1,546 and $1,496 allowance for doubtful accounts 35,968 32,070 Inventories 28,409 34,435 Prepaid expenses 1,228 1,402 Deferred income taxes 6,266 5,695 __________ __________ TOTAL CURRENT ASSETS 93,210 80,515 __________ __________ PROPERTY, PLANT AND EQUIPMENT Land 2,616 2,628 Buildings 30,155 29,336 Machinery and equipment 61,970 55,180 __________ __________ 94,741 87,144 Less accumulated depreciation 51,918 45,246 __________ __________ TOTAL PROPERTY, PLANT AND EQUIPMENT 42,823 41,898 __________ __________ OTHER ASSETS Goodwill, patents and other intangibles 2,806 3,046 Cash value of officers' life insurance 9,547 8,589 Deferred income taxes 4,031 - Miscellaneous receivables and other assets 4,038 1,802 __________ __________ TOTAL OTHER ASSETS 20,422 13,437 __________ __________ TOTAL ASSETS $ 156,455 $ 135,850 __________ __________ __________ __________ The accompanying notes are an integral part of the financial statements. KYSOR INDUSTRIAL CORPORATION Consolidated Balance Sheet (Dollars in thousands, except per share data) (continued) December 31, December 31, LIABILITIES 1993 1992 ____________ ____________ CURRENT LIABILITIES Current maturities of long-term debt $ 5,670 $ 1,595 Accounts payable 14,353 14,388 Accrued income taxes payable 2,426 1,719 Accrued expenses and contingent liabilities 25,699 21,204 __________ __________ TOTAL CURRENT LIABILITIES 48,148 38,906 Long-term debt, less current maturities, plus guarantee of ESOP indebtedness 33,673 36,521 Deferred income taxes - 1,108 Accumulated postretirement benefit obligation 12,628 - Other long-term liabilities 7,313 6,410 __________ __________ TOTAL LIABILITIES AND DEFERRED CREDITS 101,762 82,945 __________ __________ PREFERRED SHAREHOLDERS' EQUITY Employee Stock Ownership Plan Preferred Stock, shares authorized 5,000,000; outstanding 810,163 and 814,612 stated value of $24.375 19,748 19,856 Unearned deferred compensation under employee stock ownership plan (16,175) (17,039) __________ __________ TOTAL PREFERRED SHAREHOLDERS' EQUITY 3,573 2,817 __________ __________ COMMON SHAREHOLDERS' EQUITY Common stock, $1 par value, shares authorized 30,000,000, outstanding 5,467,840 and 5,332,201 5,468 5,332 Additional paid-in capital 3,386 1,631 Retained earnings 43,997 44,908 Translation adjustment 286 627 Notes receivable-common stock 99,116 and 104,188 shares (1,319) (1,364) Unearned deferred compensation under employee stock ownership plan (698) (1,046) __________ __________ TOTAL COMMON SHAREHOLDERS' EQUITY 51,120 50,088 __________ __________ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 156,455 $ 135,850 __________ __________ __________ __________ KYSOR INDUSTRIAL CORPORATION AND SUBSIDIARIES Consolidated Statement of Shareholders' Equity (Dollars in thousands, except per share data) Unearned Total Deferred Preferred Preferred Compensation Shareholders' Stock ESOP Equity BALANCE, DECEMBER 31, 1990 $19,982 ($18,780) $1,202 Employee Stock Ownership Plan, deferred compensation earned 0 877 877 Purchase of common stock, returned to an unissued status (85,180 shares) 0 0 0 Preferred stock distributions (1,933 shares for 5,345 shares of common) (47) 0 (47) Exercise of employee stock options, 8,005 shares issued 0 0 0 Collections of notes receivable 0 0 0 Forfeitures of notes receivable 0 0 0 Translation adjustment on investments in foreign subsidiaries 0 0 0 Net income (loss) 0 0 0 Preferred stock dividends (net of income tax benefit of $542) 0 0 0 share 0 0 0 BALANCE, DECEMBER 31, 1991 19,935 (17,903) 2,032 Employee Stock Ownership Plan, deferred compensation earned 0 864 864 Preferred stock distributions (3,223 shares for 8,040 shares of common) (79) 0 (79) Exercise of employee stock options, 172,975 shares issued 0 0 0 Collections of notes receivable 0 0 0 Translation adjustment on investments in foreign subsidiaries 0 0 0 Net income 0 0 0 Preferred stock dividends (net of income tax benefit of $541) 0 0 0 Common dividends declared, $ .40 per share 0 0 0 BALANCE, DECEMBER 31, 1992 19,856 (17,039) 2,817 Employee Stock Ownership Plan, deferred compensation earned 0 864 864 Preferred stock distributions (4,449 shares for 6,528 shares of common) (108) 0 (108) Exercise of employee stock options, 129,111 shares issued 0 0 0 Collections of notes receivable 0 0 0 Translation adjustment on investments in foreign subsidiaries 0 0 0 Net income 0 0 0 Preferred stock dividends (net of income tax benefit of $601) 0 0 0 share 0 0 0 BALANCE, DECEMBER 31, 1993 $19,748 ($16,175) $3,573 KYSOR INDUSTRIAL CORPORATION AND SUBSIDIARIES Consolidated Statement of Shareholders' Equity (Dollars in thousands, except per share data) Paid-In Retained Common Stock Capital Earnings BALANCE, DECEMBER 31, 1990 $5,264 $0 $44,948 0 0 0 Employee Stock Ownership Plan, deferred compensation earned 0 0 0 Purchase of common stock, returned to an unissued status (85,180 shares) (85) 0 (915) Preferred stock distributions (1,933 shares for 5,345 shares of common) 5 0 41 Exercise of employee stock options, 8,005 shares issued 8 0 36 Collections of notes receivable 0 0 0 Forfeitures of notes receivable (41) 0 (548) Translation adjustment on investments in foreign subsidiaries 0 0 0 Net income (loss) 0 0 (726) Preferred stock dividends (net of income tax benefit of $542) 0 0 (1,053) share 0 0 (2,869) BALANCE, DECEMBER 31, 1991 5,151 0 38,914 Employee Stock Ownership Plan, deferred compensation earned 0 0 0 Preferred stock distributions (3,223 shares for 8,040 shares of common) 8 70 0 Exercise of employee stock options, 172,975 shares issued 173 1,561 0 Collections of notes receivable 0 0 0 Translation adjustment on investments in foreign subsidiaries 0 0 0 Net income 0 0 9,127 Preferred stock dividends (net of income tax benefit of $541) 0 0 (1,050) Common dividends declared, $ .40 per share 0 0 (2,083) BALANCE, DECEMBER 31, 1992 5,332 1,631 44,908 Employee Stock Ownership Plan, deferred compensation earned 0 0 0 Preferred stock distributions (4,449 shares for 6,528 shares of common) 7 101 0 Exercise of employee stock options, 129,111 shares issued 129 1,654 0 Collections of notes receivable 0 0 0 Translation adjustment on investments in foreign subsidiaries 0 0 0 Net income 0 0 2,470 Preferred stock dividends (net of income tax benefit of $601) 0 0 (983) share 0 0 (2,398) BALANCE, DECEMBER 31, 1993 $5,468 $3,386 $43,997 KYSOR INDUSTRIAL CORPORATION AND SUBSIDIARIES Consolidated Statement of Shareholders' Equity (Dollars in thousands, except per share data) Unearned Notes Deferred Translation Receivable- Compensation Adjustment Common Stock ESOP BALANCE, DECEMBER 31, 1990 $1,632 ($2,042) ($1,744) Employee Stock Ownership Plan, deferred compensation earned 0 0 349 Purchase of common stock, returned to an unissued status (85,180 shares) 0 0 0 Preferred stock distributions (1,933 shares for 5,345 shares of common) 0 0 0 Exercise of employee stock options, 8,005 shares issued 0 0 0 Collections of notes receivable 0 38 0 Forfeitures of notes receivable 0 589 0 Translation adjustment on investments in foreign subsidiaries (347) 0 0 Net income (loss) 0 0 0 Preferred stock dividends (net of income tax benefit of $542) 0 0 0 share 0 0 0 BALANCE, DECEMBER 31, 1991 1,285 (1,415) (1,395) Employee Stock Ownership Plan, deferred compensation earned 0 0 349 Preferred stock distributions (3,223 shares for 8,040 shares of common) 0 0 0 Exercise of employee stock options, 172,975 shares issued 0 0 0 Collections of notes receivable 0 51 0 Translation adjustment on investments in foreign subsidiaries (658) 0 0 Net income 0 0 0 Preferred stock dividends (net of income tax benefit of $541) 0 0 0 Common dividends declared, $ .40 per share 0 0 0 BALANCE, DECEMBER 31, 1992 627 (1,364) (1,046) Employee Stock Ownership Plan, deferred compensation earned 0 0 348 Preferred stock distributions (4,449 shares for 6,528 shares of common) 0 0 0 Exercise of employee stock options, 129,111 shares issued 0 0 0 Collections of notes receivable 0 45 0 Translation adjustment on investments in foreign subsidiaries (341) 0 0 Net income 0 0 0 Preferred stock dividends (net of income tax benefit of $601) 0 0 0 share 0 0 0 BALANCE, DECEMBER 31, 1993 $286 ($1,319) ($698) KYSOR INDUSTRIAL CORPORATION AND SUBSIDIARIES Consolidated Statement of Shareholders' Equity Dollars in thousands, except per share data) Total Common Total Stockholders' Shareholders' Equity Equity BALANCE, DECEMBER 31, 1990 $48,058 $49,260 Employee Stock Ownership Plan, deferred compensation earned 349 1,226 Purchase of common stock, returned to an unissued status (85,180 shares) (1,000) (1,000) Preferred stock distributions (1,933 shares for 5,345 shares of common) 46 (1) Exercise of employee stock options, 8,005 shares issued 44 44 Collections of notes receivable 38 38 Forfeitures of notes receivable 0 0 Translation adjustment on investments in foreign subsidiaries (347) (347) Net income (loss) (726) (726) Preferred stock dividends (net of income tax benefit of $542) (1,053) (1,053) share (2,869) (2,869) BALANCE, DECEMBER 31, 1991 42,540 44,572 Employee Stock Ownership Plan, deferred compensation earned 349 1,213 Preferred stock distributions (3,223 shares for 8,040 shares of common) 78 (1) Exercise of employee stock options, 172,975 shares issued 1,734 1,734 Collections of notes receivable 51 51 Translation adjustment on investments in foreign subsidiaries (658) (658) Net income 9,127 9,127 Preferred stock dividends (net of income tax benefit of $541) (1,050) (1,050) Common dividends declared, $ .40 per share (2,083) (2,083) BALANCE, DECEMBER 31, 1992 50,088 52,905 Employee Stock Ownership Plan, deferred compensation earned 348 1,212 Preferred stock distributions (4,449 shares for 6,528 shares of common) 108 0 Exercise of employee stock options, 129,111 shares issued 1,783 1,783 Collections of notes receivable 45 45 Translation adjustment on investments in foreign subsidiaries (341) (341) Net income 2,470 2,470 Preferred stock dividends (net of income tax benefit of $601) (983) (983) share (2,398) (2,398) BALANCE, DECEMBER 31, 1993 $51,120 $54,693 The accompanying notes are an integral part of the financial statements. NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Kysor Industrial Corporation and all of its subsidiaries ("Kysor" or "Company"). Foreign Currency Translation Translation adjustments have been accumulated as a separate component of Shareholders' Equity. Cash and Equivalents Kysor considers all highly-liquid debt instruments purchased with a maturity of less than one year to be cash equivalents. Inventories Inventories are generally stated at the lower of FIFO (first in, first out) cost or market. Kysor has one subsidiary on LIFO (last in, first out), the inventory value of which was $828,000 and $735,000 lower than it would have been under FIFO at December 31, 1993 and 1992, respectively. Property, Plant and Equipment and Depreciation Property, plant and equipment are stated at cost. Depreciation is computed by the straight-line method based on the estimated useful lives of the assets. Buildings are depreciated over lives ranging from 10 to 40 years. Machinery, equipment, and office furniture are depreciated over lives ranging from 3 to 25 years. When properties are retired, the cost of such properties, net of accumulated depreciation and any salvage proceeds, is reflected in income. Goodwill Goodwill, resulting from the excess of cost over the net assets of purchased companies, is amortized on a straight-line basis over periods not exceeding 20 years. Income Taxes In 1993, the Company adopted Statement of Financial Accounting Standards # 109, "Accounting for Income Taxes," which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse (see Note 10). Prior to 1993, 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. Financial Instruments The Company has cash, cash equivalents, and long-term debt which are considered financial instruments. The market values of these financial instruments, as determined through information obtained from banking sources and management estimates, approximate their carrying values. Pension and Retirement Plans Annual provisions for pension and retirement plan costs recognize amortization of prior service costs over the expected service period of active employees. Accrued pension costs are funded annually to the extent deductible for federal income tax purposes. In 1993, the Company adopted Financial Accounting Standards # 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" which requires the accrual of postretirement benefits such as health care and life insurance during the working careers of active employees instead of expensing the benefits when paid as allowed under prior rules (see Note 8). Product Warranty Costs Anticipated costs related to product warranty are expensed in the period of sale. Environmental Costs Environmental expenditures that relate to current or future revenues are expensed or capitalized as appropriate. Expenditures that relate to an existing condition caused by past operations, and do not contribute to current or future revenues, are expensed. Liabilities are recorded when environmental assessments and/or cleanups are probable and the costs can be reasonably estimated. Generally, the timing of these accruals coincides with Kysor's commitment to a formal plan of action. NOTE 2. BALANCE SHEET INFORMATION (amounts in thousands) The following information is provided as of December 31: Inventories 1993 1992 Finished products $ 5,338 $ 7,442 Work-in-process 8,973 9,689 Raw materials 14,098 17,304 $28,409 $34,435 Nonoperating Properties Nonoperating properties included in property, plant and equipment are as follows: 1993 1992 Land $ 118 $ 134 Buildings 654 654 772 788 Less accumulated depreciation 100 100 $ 672 $ 688 Nonoperating properties held for resale are stated at cost less accumulated depreciation, which amounts are not in excess of net realizable value. Goodwill, Patents and Other Intangible Assets 1993 1992 Goodwill 4,868 4,968 Less accumulated amortization 2,062 1,922 $ 2,806 $ 3,046 Accrued Expenses and Contingent Liabilities 1993 1992 Compensation $ 5,744 $ 3,689 Workers' compensation insurance 5,078 4,483 Warranty 4,120 4,010 Litigation 2,900 2,900 Other 7,857 6,122 $25,699 $21,204 NOTE 3. FINANCING (amounts in thousands) Long-term debt consists of the following: Years Ended December 31, 1993 1992 Long-Term Debt Term note, $750 quarterly principal payments, beginning 1994, plus interest at 9.9% $ 15,000 $15,000 Loan agreement for Kysor Industrial Corporation Employee Stock Ownership Plan, $1,250 semiannual principal payments beginning 1996, plus interest at 8.36% 20,000 20,000 Other, $2,321 principal payments due in, 1994, plus interest at rates ranging from 5.0% to 8.0% 3,646 2,070 Loan Guarantee Loan guarantee for Kysor Industrial Corporation Employee Stock Ownership Plan, $174 semiannual principal payments, plus interest at 7.0% 697 1,046 39,343 38,116 Less current maturities 5,670 1,595 $33,673 $36,521 At December 31, 1993, the Company maintained revolving credit agreements with two banks which provide for borrowings up to $20 million. At December 31, 1993, there were no outstanding borrowings under this facility. Interest rates are fixed at the date of borrowing based on current LIBOR or CD rates plus a spread of .75 - 1.0 percent. An annual commitment fee of .375 percent is paid on the unused balance. In January 1994, the Company entered into a modification of the revolving credit terms which reduced the spread on LIBOR borrowing to .50 percent and reduced the annual commitment fee to .25 percent. The Company has an interest rate swap under which the variable rate of interest on the $15 million term note is converted to a fixed rate. During the years ended December 31, 1993 and 1992, there was no short-term debt. Aggregate maturities of obligations under long-term debt, during the next five years ended December 31, are as follows: (amounts in thousands) 1994 1995 1996 1997 1998 Maturities of Long-Term Debt $5,670 $3,349 $4,250 $5,500 $5,500 Under various loan arrangements, Kysor is subject to certain restrictions relating, among other things, to the creation of indebtedness, the maintenance of minimum consolidated working capital, the payment of dividends, and the purchase of common stock. Interest paid was $2,073,000, $3,039,000, and $3,348,000 for the years ended December 31, 1993, 1992, and 1991, respectively. NOTE 4. STOCK OPTION PLANS As of December 31, 1993, Kysor administered its 1980 Nonqualified Stock Option Plan; 1983 Incentive Stock Option Plan; 1984 Stock Option Plan; 1987 Stock Option and Restricted Stock Plan, and 1993 Long-Term Incentive Plan which was approved by Shareholders on April 30, 1993. Options may be granted to officers, directors, and key employees to purchase common shares of the Company's stock at a price equal to the mean market value of such stock at the date of the grant. All options granted prior to January 1, 1990 are exercisable at the date of grant, except for a nonqualified stock option for 100,000 shares granted to the Chairman of the Board on January 30, 1987 which vested at the rate of 20 percent per year through January 30, 1991. All options granted after January 1, 1990 vest at the rate of 20 percent at time of grant and 20 percent each year thereafter, except for the final 20 percent which vests only upon exercise and retention for one year of the entire vested 80 percent. Changes in options outstanding for the years ended December 31, 1992 and 1993 are as follows: Number of Number of Shares Optioned Reserved Shares Option Price Range Total Balance December 31, 1991 574,391 1,587,256 $ 3.875 - $19.125 19,913,818 Granted [377,000] 377,000 7.8125- 16.1875 3,164,500 Terminated 114,950 [114,950] 7.25 - 18.6875 [1,337,576] Exercised - [207,156] 3.875 - 14.375 [1,753,905] Balance December 31, 1992 312,341 1,642,150 7.25 - 19.125 19,986,837 Granted [288,500] 288,500 16.3125- 18.9375 5,384,719 Terminated 59,700 [59,700] 7.25 - 19.125 [668,300] Exercised - [138,650] 7.25 - 18.6875 [1,488,494] 1993 Long-Term Incentive Plan 1,000,000 - - - - Balance December 31, 19931,083,541 1,732,300 $ 7.25 -$19.125 $23,214,762 At December 31, 1993, 1,179,470 of the shares granted were exercisable. The fair market value of options exercised in 1993 ranged from $15.50 to $20.4375 per share for a total market value of $2,591,225. The fair market value of options exercised in 1992 ranged from $9.0625 to $18.8125 for a total market value of $3,411,376. In 1989, optionees executed 4.5 percent nonrecourse installment purchase agreements of $2,090,793 with respect to 157,128 shares previously granted under the nonqualified plans. During 1991, three optionee participants relinquished their stock option loans in the amount of $589,383 and forfeited the attendant 41,150 common shares. Under the terms of the installment purchase agreements, the shares are pledged as collateral and the extension of credit is subject to Federal Reserve Bank Regulation G. Required annual payments are calculated using a 15-year amortization with a balloon payment due within the original life of the option being exercised. The participants have limited rights of principal deferral in cases of hardship. The Board of Directors, in January 1992, passed a resolution to permit participants to defer the 1992 principal payments to the end of the loan. Dividends paid, in respect to the shares, are received by the Company and first applied to accrued interest and then to principal. NOTE 5. COMMON STOCK REPURCHASED In October 1991, Kysor purchased 85,108 shares of its Common Stock for $11.75 per share in accordance with an agreement, granted in conjunction with restricted stock issued for the 1986 acquisition of Medallion Instruments, Inc. NOTE 6. PREFERRED STOCK On February 24, 1989, Kysor sold 820,513 shares of newly issued 8 percent cumulative Series A Convertible Voting Preferred Stock, $24.375 stated value per share (the "Convertible Stock"), to the Kysor Industrial Corporation Employee Stock Ownership Plan (the "ESOP"). The Convertible Stock may be voluntarily converted at the option of the holder, unless previously redeemed, into shares of Kysor Industrial Corporation Common Stock (the "Common Stock") on a one-for-one basis, subject to certain antidilution adjustments, and will convert automatically into Common Stock (in certain instances subject to a conversion floor equal to liquidation value of $24.375 per share plus accrued and unpaid dividends) if transferred to a holder other than the ESOP or another Kysor Industrial Corporation employee benefit plan. The Convertible Stock is subject to redemption by the Company. Each share of Convertible Stock entitles its holder to one vote on all matters submitted for a vote of shareholders, again subject to possible antidilution adjustments. The Convertible Stock ranks senior to the Common Stock and is at least on a parity with any other series of Preferred Stock that may be subsequently issued. Preferred Stock issued and outstanding was 810,163 and 814,612 shares at December 31, 1993 and 1992, respectively. Preferred shares allocated to ESOP participants were 35,463 for each of the years ended December 31, 1993 and 1992. NOTE 7. EARNINGS PER COMMON SHARE Primary earnings per common share have been computed using the weighted average shares of Common Stock and dilutive Common Stock equivalents outstanding during the year. The Convertible Stock has been determined not to be a Common Stock equivalent. Fully diluted earnings per common share are calculated assuming the conversion of the Convertible Stock to Common Stock as well as other dilutive assumptions. NOTE 8. PENSION AND RETIREMENT PLANS Kysor has several noncontributory defined benefit pension plans and defined contribution plans covering substantially all of its domestic employees. The defined benefit plans provide benefits based on the participants' years of service and compensation or stated amounts for each year's service. The Company's funding policy is to make annual contributions as required by contract or applicable regulations. The pension cost components were: (amounts in thousands) Years Ended December 31, 1993 1992 1991 Defined Benefit Plans: Service cost benefits earned during period $1,905 $1,497 $1,595 Interest cost on projected benefit obligation 3,388 3,024 2,858 Actual investment return on plan assets [6,001] [3,434] [6,937] Net amortization and deferral 2,967 670 4,347 Net periodic pension cost $2,259 $1,757 $1,863 Assumptions used in the accounting were: Years Ended December 31, 1993 1992 1991 Discount rates 8.0% 8.0% 8.0% Rates of increase in compensation levels 5.4% 5.3% 6.0% Expected long-term rate of return on assets 8.0% 8.0% 8.0% The following table sets forth the funded status and amounts recognized in the Company's statement of financial position for defined benefit plans: (amounts in thousands) Years Ended December 31, 1993 1992 Plans in Which Plans in Which Assets Accum. Assets Accum. Exceed Benefits Exceed Benefits Accum. Exceed Accum. Exceed Benefits Assets Benefits Assets Actuarial present value of benefit obligations: Vested benefit obligation $[30,503] $[3,239] $[28,375] $[3,336] Accumulated benefit obligation $[32,955] $[5,804] $[30,475] $[4,919] Projected benefit obligation $[38,434] $[7,432] $[35,490] $[5,551] Plan assets at fair market value 49,267 - 42,376 - Projected benefit obligation (in excess of) or less than plan assets 10,833 [7,432] 6,886 [5,551] Unrecognized net (gain) or loss [6,782] 1,678 [4,703] 677 Prior service cost not yet recognized in net periodic pension cost 778 82 966 98 Unrecognized net (asset) obligation at January 1, [1,980] 779 [2,229] 890 Pension asset (liability) recognized in the statement of financial position $ 2,849 $[4,893] $ 920 $[3,886] At both December 31, 1993 and 1992, 100 percent of plan assets was invested in publicly traded stocks, bonds, and money market investments. In 1985, Kysor adopted a nonqualified, unfunded supplemental executive retirement plan for senior management. Kysor has purchased life insurance policies on the lives of participants and is the sole owner and beneficiary of such policies. The amount of coverage is designed to provide sufficient revenues to cover all costs of the plan if the assumptions made as to mortality experience, policy earnings, and other factors are realized. The Company is charging earnings with the present value of the future cost of the plan over the remaining working life of the participants. In addition, life insurance premiums, in excess of the increase in cash value of the policies, are expensed as a period cost. In September 1985, Kysor established an Employee Stock Ownership Plan ("ESOP") and trust for its domestic salaried employees. The ESOP authorized the trust to borrow $3,487,000 from a bank in September 1985. The proceeds were used to purchase 357,668 shares of common stock at $9.75 per share, that being the mean market price on the New York Stock Exchange on August 22, 1985, the day preceding the date the transaction was agreed upon. The Company has guaranteed the loan and is obligated to contribute sufficient cash to the ESOP to enable it to repay the loan principal ($349,000 annually) plus interest. In February 1989, Kysor expanded the ESOP with the sale to the ESOP of $20 million of newly issued Series A Convertible Voting Preferred Stock from the Company (see Note 6). The ESOP purchase of Preferred Stock was financed by a loan from the Company which issued a $20 million, 15-year ESOP note to raise the necessary funds. In 1993, 1992, and 1991, dividends on Preferred Stock of $1,584,000, $1,591,000, and $1,595,000 plus interest expense of $88,000, $81,000, and $77,000, respectively, were used to service the debt obligation related to the ESOP. The Company amortized $864,000 in 1993 and 1992, and $877,000 in 1991, of unearned deferred compensation relating to the shares allocated for the year as a percentage of the total shares to be allocated. Postretirement Health and Life Insurance Benefits Kysor provides certain defined health care and life insurance benefits for retired employees. All salaried and certain hourly employees may become eligible for these benefits if they reach retirement age while working for the Company. Effective January 1, 1993, the Company adopted Statement of Accounting Standards #106, "Employers accounting for Postretirement Benefits other than Pensions" ("'SFAS #106"). SFAS #106 requires the accrual method of accounting for postretirement health care and life insurance benefits based on actuarially determined cost 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. At January 1, 1993, the Company recognized the full amount of its estimated accumulated postretirement benefit obligation which 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 for this transition obligation was $12,063,000 ($7,628,000 net of income tax benefit) or $1.35 per share. This amount has been reflected in the consolidated statement of income as the cumulative effect of an accounting change. The incremental cost in 1993 of accounting for postretirement health care and life insurance benefits under the new accounting method amounted to $564,000, less a deferred tax benefit of $212,000, or $.06 per share. In prior years, the Company expensed claims for postretirement benefits on a pay as you go method. The total pretax amount recognized for retiree health and life insurance benefits in 1993 was $1,352,000. The amounts included in expense for 1992 was $862,000. For the year ended December 31, 1993, the components of periodic expense for these postretirement benefits were as follows: (amounts in thousands) Service cost - benefits earned during the year $ 413 Interest cost on accumulated postretirement benefit obligation 939 Net periodic benefit costs $1,352 At December 31, 1993, the actuarial and recorded liabilities for these postretirement benefits, none of which have been funded, were as follows: (amounts in thousands) Accumulated postretirement benefit obligation (APBO): Retirees $10,191 Fully eligible active plan participants 1,146 Other active participants 1,429 Total APBO 12,766 Fair market value of plan assets - Accumulated postretirement benefit obligation in excess of plan assets 12,766 Unrecognized net (loss) [138] Accrued postretirement benefit liability at December 31, 1993 $12,628 The accumulated postretirement benefit obligation was determined using the unit credit method and an assumed discount rate of 8 percent. The assumed gross claim health care trend rate used for under age 65 claims was 10 percent in 1993, graded uniformly down to 5.5 percent in 2005 and level thereafter. For ages 65 and over claims, the assumed trend rate was 8 percent in 1993, graded uniformly down to 5.5 percent in 2005 and level thereafter. A 1 percent increase each year in the health care cost trend rate used would have resulted in a $129,000 increase in the aggregate service and interest components of expense for the year ended December 31, 1993, and a $1,279,000 increase in the accumulated postretirement benefit obligation at December 31, 1993. The Company has a continuing deferred compensation arrangement with Raymond A. Weigel former chairman which provides for annual payments of $350,000. NOTE 9. LEASE COMMITMENTS Kysor leases some real estate and equipment. In most cases, management expects that in the normal course of business these leases will be renewed and replaced by other leases. Kysor has future minimum rental payments required through 1998 under operating leases that have initial or remaining noncancelable lease terms in excess of one year in the following amounts: (amounts in thousands) Years Ended December 31, 1994 1995 1996 1997 1998 Future minimum rental payments $966 $513 $368 $342 $475 In addition to fixed rentals, certain of these leases requires Kysor to pay maintenance, property taxes, and insurance. Rental expense charged to operations is as follows: (amounts in thousands) Years Ended December 31, 1993 1992 1991 Minimum rentals $1,829 $1,909 $1,811 Contingent rentals 53 30 31 $1,882 $1,939 $1,842 NOTE 10. INCOME TAXES The Company adopted Statement of Financial Accounting Standards #109, "Accounting for Income Taxes" ("SFAS #109"), as of January 1, 1993. The cumulative effect of this change in accounting principle was immaterial. Prior years' financial statements have not been restated to apply the provisions of SFAS #109. The adoption of SFAS #109 changes the Company's method of accounting for income taxes from the deferred method using Accounting Principles Board Opinion #11 ("APB #11") to an asset and liability approach. The provision (credit) for income tax consists of the following: (amounts in thousands) Year Ended December 31, 1993 1992 1991 Currently payable Federal $7,733 $7,318 $2,025 State and local 1,022 800 283 Foreign 55 28 - Total currently payable 8,810 8,146 2,308 Deferred Federal [790] [1,076] [1,268] State and local [110] [170] [154] Foreign - - [226] Total deferred [900] [1,246] [1,648] Total Provision $7,910 $6,900 $ 660 Deferred income taxes, on a SFAS #109 basis, reflect the estimated future tax effect of temporary differences between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations. The components of deferred income tax assets and liabilities as of December 31, 1993 are as follows: (amounts in thousands) Deferred tax Deferred tax assets liabilities Post-retirement health care $4,644 $ - Employee benefit plans 3,147 1,053 Workers' compensation/product liability 2,377 - Warranty 1,100 - Litigation expense 1,072 - Service contract 896 - Slow-moving inventory 704 - Bad debts 482 - Environmental costs 481 - Vacation pay 453 - Depreciation - 3,693 LIFO reserve at acquisition - 535 Other 297 75 $15,653 $ 5,356 Deferred income taxes for 1992 and 1991 were derived using guidelines in APB #11. Under APB #11 deferred income taxes result from timing differences in the recognition of revenues and expenses between financial statements and tax returns. The sources of these differences and the related effect of each on the Company's provision for income taxes were as follows: (amounts in thousands) Year Ended December 31, 1992 1991 Slow-moving inventory $ [496] $148 Workers' compensation/product liability [433] 336 Depreciation [395] [58] Warranty [360] [61] Bad debts [156] 22 Service contract [99] [129] Reserves for self-insurance [72] 521 Foreign earnings - [226] Environmental costs 90 183 Employee benefit plans 127 [622] Interest 145 [145] Alternative minimum tax 150 [150] Litigation 407 [1,477] Other [154] 10 $[1,246] $[1,648] Major differences between the income taxes computed using the United States statutory tax rate and the actual income tax expense were as follows: (amounts in thousands) Years Ended December 31, 1993 1992 1991 Federal income taxes at statutory rate $ 6,303 $ 5,449 $[22] Nondeductible losses related to foreign subsidiaries and other foreign expenses 1,071 981 728 Goodwill 84 82 82 State and local income taxes (net of Federal benefit) 593 472 85 Life insurance [165] [169] [161] Other 24 85 [52] Provision for income taxes $ 7,910 $ 6,900 $660 Income taxes paid were $7,427,000, $6,245,000, and $1,788,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Income tax refunds were $71,000 in 1993, $283,000 in 1992, and $657,000 in 1991. Domestic operations contributed a profit of $15,305,000, $18,261,000, and $3,513,000 to income before income taxes and before cumulative effect of accounting change for 1993, 1992, and 1991, respectively. Foreign operations sustained a loss of $2,704,000, $2,234,000, and $3,579,000 for the same periods. Income tax benefits of $473,000 and $560,000 have been credited to shareholders' equity for the years ended December 31, 1993 and 1992, respectively, for deemed compensation deductions attributable to stock options. Income tax benefits of $601,000, $541,000, and $542,000 for preferred stock dividends related to the Company's ESOP have been credited to shareholders' equity in 1993, 1992, and 1991, respectively. NOTE 11. CONTINGENT LIABILITIES As previously reported, the Company has been involved in ongoing proceedings relating to soil and groundwater contamination at the Cadillac Industrial Park in Cadillac, Michigan. Since the Company's initial involvement in the referenced proceedings, extensive testing has been performed to determine the extent of contamination at the site. Based upon certain of those tests, in 1989 the United States Environmental Protection Agency ("U.S. EPA") issued a Record of Decision which selected certain cleanup methods for the site and estimated the present value of the costs for selected cleanups. In particular, the EPA estimated the cost for the Company's soil cleanup at $925,000, and estimated the costs for the areawide groundwater cleanup at $15,124,000. Pursuant to a unilateral administrative order that was issued by the U.S. EPA in 1990 to the Company and other potentially responsible parties ("PRPs"), the Company is continuing to perform design work for remedial action for the area groundwater contamination and for the soil contamination at the Company site. The Company is the only PRP that is complying with the order. The order was issued pursuant to Section 106 of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, which authorizes the U.S. EPA to seek treble damages and civil penalties of up to $25,000 per day for violation of an administrative order. The scope of the present order is limited to design work, and does not at this time require the Company or the other PRPs to undertake the construction or implementation of any remedial action. The Company's design work plan has been approved by the U.S. EPA and, as required by the design work plan, the Company has submitted an Additional Studies Report to the U.S. EPA, which was also approved. As further required by the design work plan, the Company submitted to the U.S. EPA preliminary design documents, which EPA has reviewed up through 95% of the design. The current schedule calls for completion of design work in 1994. The costs presently estimated for completion of the remaining design work, including the incremental work described in the following paragraph, is $90,000. The costs to date for design work have been approximately $1,300,000. Approximately $255,000 of the total estimated design costs relate to the soil cleanup at the Company site, and the Company has previously accrued these estimated cleanup costs. U.S. EPA recently requested that the Company include two additional areas of groundwater contamination within the area to be addressed by the remediation system which is the subject of the ongoing design work. These additional areas are immediately adjacent to the original area of groundwater contamination covered by the remedial design. Without admitting liability for the contamination, the Company has agreed to include these additional areas in the remedial design. The incremental design and remediation costs are estimated at $40,000 and $310,000, respectively. As a potential solution to the referenced groundwater contamination, the Company has become a limited partner in Beaver Michigan Associates, a Michigan limited partnership formed to construct a $58 million wood-fired cogeneration plant in Cadillac, Michigan. It is intended that the project would facilitate treatment of the groundwater contamination at the Cadillac Industrial Park. In that regard, the City of Cadillac, also a limited partner in the venture, has established a Local Development Finance Authority ("LDFA") which intends to use tax- generated revenues from the project to service bonds to be issued to pay the capital cost to build the groundwater cleanup facility. It is anticipated that assessments for operating and maintenance costs of the cleanup facility would be shared primarily by the PRPs, including Kysor, as well as other beneficiaries within the Cadillac Industrial Park. In January 1992, Beaver Michigan Associates obtained financing to construct the facility from General Electric Capital Corporation. In 1993, the cogeneration facility construction was completed and the plant began commercial operation. The LDFA is currently pursuing the permanent placement of bonds totally $7.4 million to fund the capital costs to build the cleanup facility. With respect to the groundwater cleanup discussed above, there are a number of evolving factors that will affect the extent of the Company's liability for these costs. First, the U.S. EPA's cost estimate may be overstated. While detailed estimates cannot be made until completion of the ongoing design work, the initial modeling work performed by the Company's consultants indicates that the U.S. EPA's cost estimate is too high. In addition, the Company is continuing to pursue mixed funding (i.e., partial government funding) from the U.S. EPA and participation of others PRPs, and the extent of funding from these sources is not yet known. The regional office of the U.S. EPA has agreed that mixed funding should be provided for a portion of the remedial design and remedial action, although the actual amount of such funding, if any, is subject to further negotiation with the regional office of the U.S. EPA and final approval by the U.S. EPA headquarters. As described above, the LDFA is presently pursuing the permanent placement of bonds, the proceeds of which would pay the initial capital costs for the cleanup facility and certain future capital costs for continued operation of the facility. The bond debt would be serviced by tax increment revenues collected by the LDFA from the cogeneration facility. Possible insurance coverage for this matter remains unresolved. On July 3, 1991, the Michigan Attorney General and Department of Natural Resources commenced a lawsuit in Federal District Court, Western District Michigan against the Company and various other parties seeking to recover expenses allegedly incurred by the State in investigating the nature and extent of contamination at the Cadillac site, incidental expenses associated therewith, fines, penalties, interest, attorneys' fees and damages for injury to the natural resources of the State. Discovery has commenced in this action although it is not yet complete. The suit also seeks a declaratay judgement holding Kysor and others jointly and severally liable for clean-up at the site. The Attorney General asserts that the Department of Natural Resources has expended approximately $3.0 million to date on tests and related studies at the site and provide city water to contaminated areas, for which the Attorney General claims Kysor and others are jointly responsible. The Attorney General also asserts that the State is entitled to statutory interest, which it claims is approximately $1.6 million as of Fall 1992, and noted that under the Michigan Water Resource Commission Act the court in its discretion may impose penalties of up to $10,000 a day ($25,000 a day from May 1990) dating back to the early 1980's. The Attorney General finally asserts that the Company may be responsible for injury to the State's natural resources as well as attorneys fees. The Company continues to dispute the State's allegations and intends to vigorously defend against the damages sought. Though discovery is not yet complete, the Company believes that many of the costs claimed by the State were duplicative or related to areas of contamination for which the Company is not responsible. The Company also disputes the claimed interest calculation and believes that it is unlikely that material penalties would be imposed due to the continuing efforts of the Company to investigate and remediate the contamination at the site which date back to as early as 1980. If ongoing settlement negotiations are unsuccessful, the Company intends to vigorously defend against the claims to the extent they relate to the testing of contamination not caused by the Company or costs which were duplicative and unnecessary. The Company is investigating the possibility of insurance coverage of the matter and has made cross-claims and third-party claims for contribution against other parties located at this site, including parties involved in the referenced proceeding as a co-defendant. While it is clear that the Company is responsible for the soil contamination at its site and the Company shares a portion of the responsibility for the groundwater contamination described above, it is presently impossible to provide a precise estimate of the Company's actual liability. Kysor has accrued its best estimate of the liability for soil cleanup costs. As noted above, the U.S. EPA cost figures on the groundwater cleanup are estimates that may be overstated, and the Company continues to aggressively promote the referenced cogeneration project as a means of facilitating a cleanup at the site. The Company is also pursuing insurance coverage as well as mixed funding from the EPA for this matter, but there has been no determination as to the availability or extent of such coverage or funding. Specifically, with respect to the referenced costs for design and the capital costs of the cleanup work, the Company is not only pursuing insurance coverage and mixed funding, but also intends to seek reimbursement and funding from a bond offering planned by the Cadillac LDFA in connection with the cogeneration project, as described above. The availability of this latter source of reimbursement would depend, among other things, upon the sale of the referenced bonds. Other contingent liabilities include various legal actions, proceedings and claims which are pending or which may be instituted or asserted in the future against the Company. Litigation is subject to many uncertainties, the outcome of individual matters is not predictable with assurance and it is reasonably possible that some of these other legal actions, proceedings and claims could be decided unfavorable to the Company. Although the liability with regard to these matters at December 31, 1993 cannot be ascertained, it is the opinion of management, after conferring with counsel, that any liability resulting from these other matters should not materially affect the consolidated financial position of the Company and its subsidiaries at December 31, 1993. NOTE 12. SEGMENT INFORMATION Kysor Industrial Corporation's operations include two segments: commercial products and transportation products. Operations in the commercial products segment design, manufacture and market refrigerated display cases, energy control systems, refrigerated building systems, and heating and air-conditioning systems. Operations in the transportation products segment design, manufacture and market engine performance systems, engine protection systems, and components and accessories for heavy-duty trucks, other commercial vehicles and marine equipment. The commercial products segment generated $29.0 million, $48.4 million and $34.7 million of sales and revenues from one customer in the years ended December 31, 1993, 1992 and 1991, respectively. The transportation products segment generated $27.3 million of sales and revenues from one customer in the year ended December 31, 1993. 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 under the caption "Directors and Executive Officers" in the Company's definitive Proxy Statement for its April 29, 1994 Annual Meeting of Shareholders is here incorporated by reference. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers and directors, and persons who own more than 10 percent of the Company's Common Stock, to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the New York Stock Exchange. Officers, directors and greater than 10 percent shareholders are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. Based solely on its review of the copies of such forms received by it, or written representations from certain reporting persons that no Forms 5 were required for those persons, the Company believes that all filing requirements applicable to its officers, directors, and greater than 10 percent beneficial owners, with respect to fiscal year 1992, were satisfied. Item 11. Item 11. EXECUTIVE COMPENSATION. The information under the caption "Executive Compensation" in the Company's definitive Proxy Statement for its April 29, 1994 Annual Meeting of Shareholders is here incorporated by reference. In lieu of filing Annual Reports on Form 11-K on behalf of the Kysor Industrial Corporation Employee Stock Ownership Plan, pursuant to Rule 15d-21 promulgated under the Securities Exchange Act of 1934, as amended, the report of Coopers & Lybrand, Certified Public Accountants, and Examination of Financial Statements and Supplemental Schedule of Reportable Transactions with respect to the Plan is included in the exhibits to this Form 10-K Annual Report. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information under the caption "Voting Securities" in the Company's definitive Proxy Statement for its April 29, 1994 Annual Meeting of Shareholders is here incorporated by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information under the caption "Management Transactions", "Indebtedness of Management", and "Compensation Committee Interlocks and Insider Participation", in the Company's definitive Proxy Statement for its April 29, 1994 Annual Meeting of Shareholders is here incorporated by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. The following financial statement schedules are filed as a part of this report: II. Amounts Receivable From Related Parties, Underwriters, Promoters and Employees Other Than Related Parties - pages 45, 46 & 47. V. Property, Plant and Equipment - pages 48, 49 & 50. VI. Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment - pages 51, 52 & 53. VIII. Valuation and Qualifying Accounts and Reserves - page 54. X. Supplementary Income Statement Information from Continuing Operations - page 55. Schedules other than those listed above are omitted because they are not required, not applicable, or the information is disclosed elsewhere in the financial statements. Individual financial statements of the Company are omitted because the Company is primarily an operating Company and the subsidiaries included in the consolidated financial statements are wholly owned subsidiaries and are not indebted to any person other than the Parent or the consolidated subsidiaries in amounts exceeding five percent (5%) of the total assets as shown by the Consolidated Balance Sheet at December 31, 1993. 2. The following exhibits are filed as part of this report: NUMBER EXHIBIT LOCATION 3(a) Restated Articles of Incorporation (8) (b) Restated Bylaws (1) (c) Certificate of Designations, Rights and Preferences - Series A Convertible Voting Preferred Stock (11) 4(a) Rights Agreement dated as of April 28, 1986 between Kysor Industrial Corporation and NBD, N.A. (5) (b) Amendment dated as of May, 1988 to Rights Agreement dated as of April 28, 1986 between Kysor Industrial Corporation and NBD Bank, N.A. (8) (c) Revolving Credit Agreements between Kysor Industrial Corporation and NBD Bank, N.A., and Old Kent Bank and Trust Company (12) (d) Amendment dated January 1994 to the Revolving Credit Agreements between NBD Bank, N.A., and Old Kent Bank and Trust Company (1) (e) Term Note Agreement with NBD Bank, N.A. dated as of October4, 1988 (8) (f) Note Agreement between Kysor Industrial Corporation and Massachusetts Mutual Life Insurance Company dated February 24, 1989 (8) (g) Loan Agreement between Kysor Industrial Corporation Employee Stock Ownership Plan and NBD Bank, N.A. and Related Guaranty and Note Purchase Agreement (3) (h) The Company has outstanding several classes of long-term debt instruments. None of these classes of debt is registered under the Securities Act of 1933. None of these classes of debt outstanding at the date of this report exceeds 10% of the Company's total consolidated assets except for the previously disclosed item included as exhibit 4(d) and 4(f). The Company agrees to furnish copies of the agreements defining the rights of holders of such long-term indebtedness to the Securities and Exchange Commission upon request The following management contracts of compensatory plans or arrangements are included in the exhibits filed as part of this report: 10(a) Stock Option and Stock Appreciation Rights Plan of 1980 (2) (b) Kysor Industrial Corporation amended 1983 Incentive Stock Option Plan (6) (c) Kysor Industrial Corporation amended 1984 Stock Option Plan (6) (d) Kysor Industrial Corporation 1987 Stock Option Plan (4) (e) Kysor Industrial Corporation 1993 Long-Term Incentive Plan (14) (f) Form of Termination Agreements with corporate officers David W. Crooks, Thomas P. Forrestal, Jr., Timothy J. Campbell, Timothy D. Peterson, Peter W. Gravelle, Richard G. De Boer, Ellen E. Hovey, Mary C. Janik, Robert L. Joseph, Terry M. Murphy (3) (g) Employment Contract with corporate officer George R. Kempton (4) (h) Service Contract with Raymond A. Weigel (3) (i) Form of Supplemental Executive Retirement Plan with George R. Kempton, Peter W. Gravelle, Timothy J. Campbell, Thomas P. Forrestal, Jr., David W. Crooks, Timothy D. Peterson, Logan F. Wernz, Wilbert J. Venema, John B. Stevenson, William G. Cobb (3) (j) Amendment dated as of August 15, 1989 to Supplemental Executive Retirement Plan dated July 10, 1985 (9) (k) Amendment dated as of January 31, 1990 to Supplemental Executive Retirement Plan dated July 10, 1985 (9) (l) Kysor Industrial Corporation S.E.R.P. Irrevocable Trust (9) (m) Form of Indemnity Agreement with directors and corporate officers; William E. Callahan, Timothy J. Campbell, Thomas P. Forrestal, Jr., Paul K. Gaston, Grant C. Gentry, Peter W. Gravelle, George R. Kempton, Philip LeBoutillier, Jr., Robert W. Navarre, Frederick W. Schwier, John D. Selby, Raymond A. Weigel, David W. Crooks, Terry M. Murphy, Timothy D. Peterson, Richard G. De Boer, Ellen E. Hovey, Mary C. Janik, Robert L. Joseph (6) (n) Kysor Industrial Corporation Pension Plan for Directors dated January 1, 1985, amended January, 1989 (9) (o) Amendment dated as of July 28, 1989 to Kysor Industrial Corporation Pension Plan for Directors dated January 1, 1985 (8) (p) Directors Pension Plan Trust (9) (q) Kysor Industrial Corporation Corporate Management Variable Compensation Program (12) (r) Form of Nonrecourse Promissory Note and Pledge Agreement - Stock Option Loan Program; George R. Kempton, Philip LeBoutillier,Jr., Paul K. Gaston (12) The Following are Other Material Contracts Included in the Exhibits Filed as Part of this Report: (s) AFP Divestiture Agreements (10) (t) Beaver Michigan Associates Limited Partnership Agreement (12) (u) Development Agreement between Beaver Michigan Associates Limited Partnership, The City of Cadillac and the Local Development Finance Authority of the City of Cadillac (12) (v) Kysor Industrial Corporation Employee Stock Ownership Plan Amended and Restated effective January 1, 1989 (1) (w) Employee Stock Ownership Trust between Kysor Industrial Corporation and Old Kent Bank and Trust Co. dated January 1, 1989 (1) (x) Note Agreement between Employee Stock Ownership Plan and Kysor Industrial Corporation (7) 11 Computation of Consolidated Earnings Per Share (1) 22 Significant Subsidiaries (1) 24 Consent of Independent Accountants (1) 25 Power of Attorney (1) 28 Report of Coopers & Lybrand, Certified Public Accountants, on Examination of Financial Statements and Supplemental Schedule of Reportable Transactions for the Kysor Industrial Corporation Employee Stock Ownership Plan (1) Notes (1) Filed as a new exhibit to this report. (2) This exhibit was previously filed as an exhibit to the Registrant's Form 10-K Annual Report for its fiscal year ended December 31, 1981, and is here incorporated by reference. (3) This exhibit was previously filed as an exhibit to the Registrant's Form 10-K Annual Report for its fiscal year ended December 31, 1985, and is here incorporated by reference. (4) This exhibit was previously filed as an exhibit to the Registrant's Form 10-K Annual Report for its fiscal year ended December 31, 1986, and is here incorporated by reference. (5) This exhibit was previously filed as an exhibit to the Registrant's Form 8-K Current Report dated May 1, 1986, and is here incorporated by reference. (6) This exhibit was previously filed as an exhibit to the Registrant's Form 10-K Annual Report for its fiscal year ended December 31, 1987, and is here incorporated by reference. (7) This exhibit was filed as an exhibit to the Registrant's Form 8-K Current Report dated March 1, 1989, and is here incorporated by reference. (8) This exhibit was previously filed as an exhibit to the Registrant's Form 10-K Annual Report for its fiscal year ended December 31, 1988, and is here incorporated by reference. (9) This exhibit was previously filed as an exhibit to the Registrant's Form 10-K Annual Report for its fiscal year ended December 31, 1989, and is here incorporated by reference. (10) This exhibit was previously filed as an exhibit to the Registrant's Form 10-K Annual Report for its fiscal year ended December 31, 1990, and is here incorporated by reference. (11) This exhibit was filed as an exhibit to the Registrant's Form 8-K Current Report dated February 28, 1989, and is here incorporated by reference. (12) This exhibit was previously filed as an exhibit to the Registrant's Form 10-K Annual Report for its fiscal year ended December 31, 1991, and is here incorporated by reference. (13) This exhibit was previously filed as an exhibit to the Registrant's Form 10-K Annual Report for its fiscal year ended December 31, 1992, and is here incorporated by reference. (14) This exhibit was previously filed as an exhibit to the Registrant's Proxy Statement for its fiscal year ended December 31, 1992 and is here incorporated by reference. The Company will furnish a copy of any exhibit listed above to any shareholder of the Company without charge upon written request to Investor Relations, Kysor Industrial Corporation, One Madison Avenue, Cadillac, Michigan 49601-9785. 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. KYSOR INDUSTRIAL CORPORATION By /s/ Terry M. Murphy Terry M. Murphy Vice President, Chief Financial 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. /s/ Raymond A. Weigel * /s/ George R. Kempton * Raymond A. Weigel, Chairman George R. Kempton,Chairman of Emeritus, Director the Board, Chief Executive Officer, Director (Principal Executive Officer) Date: March 9, 1994 Date: March 9, 1994 /s/ Peter W. Gravelle * /s/ Robert L. Joseph * Peter W. Gravelle, Executive Robert L. Joseph, Comptroller Vice President and Chief (Principal Accounting Officer) Operating Officer Date: March 9, 1994 Date: March 9, 1994 /s/ William E. Callahan * /s/ Thomas P. Forrestal, Jr. * William E. Callahan, Director Thomas P. Forrestal, Jr., Group Vice President, Director Date: March 9, 1994 Date: March 9, 1994 /s/ Paul K. Gaston * /s/ Grant C. Gentry * Paul K. Gaston, Director Grant C. Gentry, Director Date: March 9, 1994 Date: March 9, 1994 /s/ Philip LeBoutillier, Jr. * /s/ Timothy J. Campbell * Philip LeBoutillier, Jr., Timothy J.Campbell, Group Director Vice President, Director Date: March 9, 1994 Date: March 9, 1994 /s/ Frederick W. Schwier * /s/ John D. Selby * Frederick W. Schwier, Director John D. Selby, Director Date: March 9, 1994 Date: March 9, 1994 /s/ Robert W. Navarre* Robert W. Navarre, Director Date: March 9, 1994 *By /s/ Terry M. Murphy Terry M. Murphy Attorney-in-fact REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES Kysor Industrial Corporation Cadillac, Michigan Our report on the consolidated financial statements of Kysor Industrial Corporation and Subsidiaries is included in Item 8 of this Form 10-K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14(a)1 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. Detroit, Michigan February 14, 1994

751652_1993.txt

751652_1993

1993

751652

ITEM 3. LEGAL PROCEEDINGS There are various legal proceedings pending against the Company and its affiliates. While it is not feasible to predict or determine the outcome of these proceedings, the Company's management believes that the outcome will not have a material adverse effect on the Company's financial position. Litigation involving certain environmental matters is described below. Questar, Entrada, and Mountain Fuel have each been named a "potentially responsible party" for contaminants on property owned by Entrada in Salt Lake City, Utah. The property, known as the Wasatch Chemical property, was the location of chemical operations conducted by Entrada's Wasatch Chemical division, which ceased operation in 1978. A portion of the property is included on the national priorities list, commonly known as the "Superfund" list. In September of 1992, a consent order governing clean-up activities was formally entered by the federal district court judge presiding over the underlying litigation involving the property. The underlying lawsuits seek declaratory relief that the named potentially responsible parties, including the Questar affiliates and unrelated parties, are liable for the expense of the investigation and clean-up. The consent order was agreed to by Questar, Entrada, and other affiliates as well as the Utah Department of Health and the Environmental Protection Agency. Entrada has settled with the named unrelated parties and has assumed the liability of such parties. Entrada has obtained approval for a specific design using in situ vitrification procedure to clean up the Wasatch Chemical property and expects this process to begin before year-end. The clean-up procedure may take as long as three years. Entrada has recorded all costs spent on the matter and has accounted for all settlement proceeds, accruals, and insurance claims. It has received cash settlements, which together with accruals and insurance receivables, should be sufficient for future clean-up costs. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company did not submit any matters to a vote of stockholders during the last quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information concerning the market for the common equity of the Company and the dividends paid on such stock is located in Note O in the Notes to Consolidated Financial Statements. As of March 21, 1994, Questar had 11,614 shareholders of record and estimates that it had an additional 10,000 -- 12,000 beneficial holders. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Note - Selected financial data for 1989-1992 has been reclassified for the reporting of discontinued operations. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SUMMARY Questar Corporation's income from continuing operations was $84,464,000, or $2.10 per share, in 1993, compared with $73,771,000, or $1.85 per share, in 1992 and $66,752,000, or $1.70 per share, in 1991. Exploration and production operations had 1993 income of $36,325,000, compared with $27,762,000 in 1992 and $20,965,000 in 1991. Natural gas production and prices increased in 1993 but were partially offset by lower oil production and prices. Natural gas transmission operation's 1993 income was $23,275,000 compared with $22,463,000 in 1992 and $22,057,000 in 1991. Questar Pipeline began operating in accordance with Federal Energy Regulatory Commission (FERC) Order No. 636 in September 1993. The demand component of rates is now structured to recover 94% of the cost of service. Natural gas distribution operations earned $25,069,000 in 1993 compared with $23,395,000 in 1992 and $25,074,000 in 1991. The 1993 weather was 5% colder than normal and 16% colder than 1992. In October 1993, Questar announced that it had reached a binding agreement to sell Questar Telecom to Nextel Communications, Inc. (Nextel). The sale is expected to be completed in the first half of 1994. Questar spent $168,388,000 for capital expenditures in 1993 and estimates 1994 capital expenditures to be $300,000,000. Cash provided from operating activities financed the majority of the 1993 expenditures. Long-term debt represented 38% of consolidated capitalization at December 31, 1993. RESULTS OF OPERATIONS EXPLORATION AND PRODUCTION - Celsius Energy, Universal Resources and Wexpro conduct exploration and production (E&P) operations. Following are operating income and statistics for these operations: Noncost-of-service natural gas production increased 32% in 1993 following a 73% 1992 increase. The E&P group increased natural gas reserves over the last several years through a successful natural gas exploration, development and acquisition program. The E&P group changed its production strategy in the last half of 1992 by increasing natural gas production to near full capacity. Higher prices and lower full cost amortization rates allowed the E&P group to produce at this level. The natural gas sales price increased 12% in 1993 after a 2% decline in 1992. The E&P group sold the majority of its 1993 and 1992 production based on spot-market or short-term contracts. The national market price of natural gas increased in 1993 because excess delivery capacity decreased. Although Rocky Mountain region natural gas is sold at a lower price than the national average, the differential decreased in 1993. Current low oil prices may limit increases in natural gas prices because many industrial energy users have the ability to switch from natural gas to fuel oil. Oil and natural gas liquid production decreased 5% in 1993 and increased 2% in 1992. Declining production in mature fields was partially offset by oil reserve increases. The E&P group has focused most of its exploration and development efforts towards natural gas reserves in the last few years, which has lessened the significance of oil and natural gas liquid production to the Company. Oil and natural gas liquid prices decreased 11% in 1993 and 14% in 1992 as a result of worldwide production increases. The price at the end of 1993 was lower than the average for the year, and therefore, 1994 prices may be lower than 1993. Declining oil prices reduced the oil income sharing paid by Wexpro to Mountain Fuel as required by the Wexpro settlement agreement. See Note L in the Notes to the Consolidated Financial Statements for a description of this agreement. Natural gas marketing volumes decreased 10% in 1993 and 23% in 1992. The E&P group changed its marketing strategy from a high volume program to targeting premium markets and marketing of E&P group production (marketing volumes do not include E&P group production). The margin from gas marketing was $3,864,000 in 1993 compared with $1,292,000 in 1992 and $6,833,000 in 1991. The E&P group uses natural gas futures and options to reduce the risk associated with the marketing activity. Wexpro's revenue from cost-of-service gas operations increased 14% in 1993 and 28% in 1992 as a result of additional investment in gas-development wells and recovery of higher costs associated with increased production. Wexpro's net investment in cost-of-service gas operations was $92,561,000, $81,261,000, and $71,936,000 at December 31, 1993, 1992 and 1991, respectively. Wexpro has increased its investment primarily through participation in infill-drilling programs in the Church Buttes, Bruff, and Birch Creek fields in southwestern Wyoming. In the first quarter of 1994, the E&P group announced two acquisitions of oil and gas reserves, processing plants, gathering systems and leasehold acreage for a cost of $117,100,000. The E&P group obtained oil and gas reserves of approximately 115 Bcf equivalent located in the Midcontinent and San Juan Basin regions. These acquisitions increase the noncost-of-service oil and gas reserves by approximately 45%. NATURAL GAS TRANSMISSION - Questar Pipeline conducts natural gas transmission, storage, and gathering operations. Following are operating income and statistics for these operations: Effective September 1, 1993, Questar Pipeline began operating in accordance with FERC Order No. 636, which restructured the operations of natural gas transmission companies. The order unbundled the sales-for-resale service from the transportation, gathering and storage services. Questar Pipeline eliminated its merchant function. That activity was assumed by Mountain Fuel along with the gas-purchase contracts. Order No. 636 requires a greater percentage of the cost of service to be collected through demand charges. The percentage of costs included in the demand component of rates increased from 66% prior to implementation to about 94% after implementation. Substantially all of Questar Pipeline's transportation capacity has been reserved by firm-transportation customers. The customers can release that capacity to third parties when it is not required for their own needs. Mountain Fuel has reserved transportation capacity from Questar Pipeline of approximately 800,000 decatherms per day, or approximately 85% of the total transportation capacity. As a result of these changes in the rate structure, Questar Pipeline's transportation throughput volumes do not have a significant impact on short-term operating results. Firm-transportation customers continue to pay the same demand charges regardless of actual volumes transported. After $1.5 million in revenues are received from interruptible transportation customers, 90% of the remaining revenues from the transportation of gas for interruptible customers is credited back to firm customers. Questar Pipeline is allowed to retain all interruptible-transportation revenues from projects that have not been included in the transportation rate case. Total transmission system throughput decreased 2% in 1993 and 1% in 1992. Throughput for Mountain Fuel (including sales for resale and transportation) increased 23% in 1993 and decreased 11% in 1992. The 1993 increase was primarily due to colder weather in Mountain Fuel's service area. Expiring contracts resulted in deceased throughput for other customers. Reported gathering volumes increased 25% in 1993 and more than doubled in 1992. The 1993 increase was due to higher gas production in the Company's operating areas, including production from affiliates. The 1992 increase was mostly due to a change in rate structure that unbundled gathering from sales for resale. Questar Pipeline began billing separately for gas gathering service provided on sales-for-resale volumes in November 1991. Storage revenues increased 88% in 1993 and 19% in 1992. Customers have subscribed to all available working natural gas storage at Questar Pipeline's Clay Basin storage field. A portion of the 1993 increase was due to unbundling of storage services for Mountain Fuel that were included with the sales for resale prior to the implementation of Order No. 636. Order No. 636 allows pipelines to receive rate coverage for all prudently incurred transition costs associated with the restructuring. Questar Pipeline incurred capital costs of approximately $9 million in conjunction with Order No. 636 implementation. Most of these costs were for electronic metering and a bulletin board system and are expected to be included in the next general rate case. NATURAL GAS DISTRIBUTION - Mountain Fuel conducts natural gas distribution operations. Following are operating income and statistics for these operations: Natural gas volumes sold to residential and commercial customers increased 16% in 1993 following a 10% decrease in 1992. Temperatures were 5% colder than normal in 1993 and 10% warmer than normal in 1992. The number of customers increased 3.4% in 1993 and 3.2% in 1992 because of expanding population and construction in Mountain Fuel's service area. Natural gas deliveries to industrial customers increased 5% in 1993 and 7% in 1992, due to increased usage by metals, mining and petroleum customers. These customers are using more natural gas because of expanded operations and environmental concerns. The Company's industrial customers have not switched to residual fuel oil with the decline in oil prices because gas prices have been competitive and sufficient fuel oil is not readily available. Mountain Fuel assumed the responsibility for purchasing its own gas supplies on September 1, 1993, when Questar Pipeline began operating in accordance with FERC Order No. 636. Questar Pipeline transferred its gas purchase contracts to Mountain Fuel. The majority of these contracts are priced using a current natural gas market value. Mountain Fuel also acquired an inventory of working gas to meet customer requirements. Mountain Fuel has reserved transportation capacity on Questar Pipeline's system of approximately 800,000 decatherms per day and pays an annual demand charge of $49.2 million for this reservation. Mountain Fuel releases excess capacity to its industrial transportation or other customers and receives a credit from Questar Pipeline for the majority of Questar Pipeline's interruptible-transportation revenues. Mountain Fuel reached a settlement of its Wyoming general rate case in July 1993, with the new rates effective August 1, 1993. The settlement approved an annualized increase in rates of $721,000, including recovery of costs attributable to FERC Order No. 636 and higher federal income tax rates. In April 1993, Mountain Fuel filed a general rate case with the Public Service Commission of Utah (PSCU). The original rate increase request was revised to $10.3 million based on September 30, 1993 results and included a 12.1% rate of return on equity. Hearings on the case were held in November 1993 and a rate order was received in January 1994. The PSCU rate order granted Mountain Fuel a $1.6 million decrease in general rates and a $2.1 million increase in costs allowed through the purchased-gas adjustment account for a net increase in rates of $500,000. The PSCU allowed a return on equity of 11%, required Mountain Fuel to reduce rates over a five-year period for unbilled revenues, and disallowed rate coverage for certain incentive compensation and advertising costs. Mountain Fuel requested a rehearing of the PSCU order for the allowed return on equity and the treatment of unbilled revenues, and the PSCU granted a rehearing on these issues. OTHER OPERATIONS - Following is a summary of the results from Questar's other operations: Questar owns a one-third interest in FuelMaker Corp., a Canadian company that is developing a natural gas vehicle refueling appliance for commercial or home use. Losses continued in 1993 as FuelMaker completed the design and began production of a new model. FuelMaker plans to begin full-scale production of the new model in 1994. Corporate and other operations generated positive income in 1993 and 1992 due to lower interest and operating expenses compared with a loss in 1991. The Company's subsidiary, Entrada Industries, Inc., has been named as a potentially responsible party in an environmental clean-up action involving a site in Salt Lake City. The site was the location of chemical operations conducted by Entrada's Wasatch Chemical Division, which ceased operation in 1978. Entrada has proposed a remediation that has received approval from the Environmental Protection Agency and the Utah Department of Health. The Company has reached settlements with the other major potentially responsible parties and has established an accrual for the remedial work costs. Management believes that current accruals of $7,239,000 will be sufficient for estimated future clean-up costs, which are expected to be incurred over the next several years. The Company has recorded a receivable from an insurance company of $3,500,000 for expected payments related to the Wasatch Chemical clean-up. Additional amounts may be collected from the insurance company if clean-up costs are higher than anticipated. DISCONTINUED OPERATIONS - In October 1993, the Company announced that it had reached a binding agreement to sell Questar Telecom to Nextel. The Company will receive 3,886,000 shares of Nextel common stock in exchange for all of the common stock of Questar Telecom. The operating results for Questar Telecom have been reported as discontinued operations since Questar Telecom represented all of Questar's investment in the specialized mobile radio business. The sale of Questar Telecom is expected to be completed in the first half of 1994, at which time Questar expects to recognize a gain on the transaction based on the Nextel stock price. Questar's net investment in Questar Telecom is anticipated to be approximately $40 million at the time of the sale, including the acquisition of approximately $11 million of additional channels as required by the sale agreement. Nextel common stock was $37 1/4 per share at December 31, 1993. Net losses from Questar Telecom subsequent to the sale agreement have been deferred until the sale is recorded. Questar has agreed to continue operating the Questar Telecom business and provide any working capital requirements until the sale is completed. CONSOLIDATED OPERATING RESULTS - Consolidated revenues increased 12% in 1993 due to higher natural gas production from the E&P group and greater volumes sold by Mountain Fuel to residential and commercial customers. Consolidated revenues decreased 5% in 1992 because of lower gas marketing volumes and reduced sales to residential and commercial customers. Natural gas purchases increased 12% in 1993 after decreasing 19% in 1992 because of greater volumes sold by Mountain Fuel. Operating and maintenance expenses increased 10% in 1993 and 1% in 1992. Major reasons for the 1993 increase were: more customers and expanded service territory for Mountain Fuel, recording of postretirement medical and life insurance benefits on an accrual basis, increased natural gas production and restructuring of Questar Pipeline operations in accordance with FERC Order No. 636. Depreciation and amortization expense increased 18% in 1993 and 13% in 1992 due to capital expenditure programs in all lines of business and higher natural gas production. The full cost amortization rate was $.80 per Mcfe in 1993 compared with $.79 in 1992 and $.99 in 1991. The Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 106 on Employer's Accounting for Postretirement Benefits Other than Pensions effective January 1, 1993. This statement requires the Company to expense the costs of postretirement benefits, principally health-care benefits, over the service life of employees using an accrual method. The Company is amortizing the transition obligation over a 20-year period. Total cost of postretirement benefits other than pensions under SFAS No. 106 was $5,918,000 in 1993 compared with the costs based on cash payments to retirees plus the prefunding of some benefits totaling $1,553,000 in 1992 and $1,740,000 in 1991. Mountain Fuel and Questar Pipeline account for approximately 57% and 18% of the postretirement benefit costs, respectively. The impact of SFAS No. 106 on Questar's future net income will be mitigated by recovery of these costs from customers. Both the PSCU and the Public Service Commission of Wyoming (PSCW) allowed Mountain Fuel to recover future SFAS No. 106 costs in the 1993 rate cases if the amounts are funded in an external trust. The FERC issued an order granting rate recovery methodology for SFAS No. 106 costs to the extent that pipeline companies contribute the amounts to an external trust. Questar Pipeline expects to receive coverage of future SFAS No. 106 costs in its next general rate case and recovery of costs in excess of the amounts currently included in rates for the period from 1993 to the rate case filing if the rate case is filed prior to January 1, 1996. Debt expense decreased 5% in 1993 because of lower rates and the refinancing of higher cost debt in 1993 and 1992. The effective income tax rate was 28.4% in 1993, 32.0% in 1992, and 36.8% in 1991. The 1993 and 1992 rates were lower because of tight-sands gas production credits of $11,026,000 in 1993 and $5,722,000 in 1992. The higher production credits in 1993 were partially offset by an increase in the federal income tax rate to 35% effective January 1, 1993. Mountain Fuel and Questar Pipeline recorded the change in deferred income taxes resulting from the increase in the federal tax rate as an increase to income taxes recoverable from customers since the regulatory commissions have adopted procedures to include underprovided deferred taxes in rates on a systematic basis. The Financial Accounting Standards Board (FASB) has issued SFAS No. 112, Accounting for Postemployment Benefits. This statement requires the Company to recognize the liability for postemployment benefits when employees become eligible for such benefits. Postemployment benefits are paid to former employees after employment has been terminated, but before retirement benefits are paid. The Company's principal liability under SFAS No. 112 is a long-term disability program. The Company is required to adopt SFAS No. 112 in the first quarter of 1994 and recognize a cumulative effect of a change in accounting method amounting to approximately $3,300,000. Some of this amount may be recovered from Mountain Fuel's and Questar Pipeline's customers through subsequent rate changes. The effect on ongoing net income is not expected to be significant. The FASB has issued SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, to be effective beginning in 1994. This statement requires companies to adjust the value of the majority of investments to fair value. The statement would not have a significant impact on current operations, but will require Questar to carry the investment in Nextel stock to be received from the sale of Questar Telecom at fair value. LIQUIDITY AND CAPITAL RESOURCES The Company has met the majority of its cash needs for capital expenditures and dividend payments with cash from operations for the last three years. Net cash from operating activities was $194,982,000 in 1993, $160,179,000 in 1992, and $156,029,000 in 1991. Higher income from continuing operations, and increased depreciation and amortization contributed to the higher 1993 amount. Reduced gas storage inventory and increased accounts payable and accrued expenses also provided a source of cash in 1993. Following is a summary of capital expenditures for 1993, and a forecast of projected 1994 expenditures, which is subject to board of director approval. The exploration and production operations participated in 206 wells in 1993, of which 143 were completed as gas wells, 11 were oil wells, 25 were dry holes and 27 were in progress at year end. The 1993 drilling program had an overall success rate of 86% and included the completion of tight-sands gas credit wells that were spudded in 1992. In the first quarter of 1994, the E&P group announced two acquisitions of oil and gas reserves, processing plants, gathering systems and leasehold acreage for a cost of $117,100,000. The E&P group obtained oil and gas reserves of approximately 115 Bcf equivalent located in the Midcontinent and San Juan Basin regions. The first acquisition was for properties from Petroleum, Inc. and was completed in January 1994 at a cost of $22,600,000. This purchase was financed with short-term debt. In the second acquisition, the E&P group acquired the properties of Amax Oil & Gas's northern division at a cost of $94,500,000 through an alliance with Union Pacific Resources Corporation. This transaction is expected to be closed in the first half of 1994 and will be financed with short-term debt and an expansion of the production-based long-term credit facility. Questar Pipeline is expanding the capacity of its Clay Basin underground gas storage facility. After expansion, the storage field will have a total capacity of 110 Bcf, including 46 Bcf of working gas storage. Capital expenditures include the purchase of cushion gas. The first phase of the expansion project is expected to be completed in mid-1994. Questar Pipeline is a one-third partner in the TransColorado pipeline project. The Company estimates the total cost of this project at $184 million, with Questar Pipeline's equity investment approximately $18 million. Construction of the pipeline has been delayed pending receipt of final regulatory approvals and completion of contracts with shippers. Mountain Fuel's number of customers increased 18,075 during 1993 and 16,284 in 1992 due to population growth and building construction activity in its service area. The 1994 capital expenditures anticipate a similar level of customer growth. Questar estimates that it will invest an additional $11 million in Questar Telecom for the purchase of FCC licenses and working capital requirements prior to the completion of the sale of Questar Telecom to Nextel. The Company funded its 1993 capital expenditures primarily with cash provided from operations. The Company expects to finance the 1994 capital expenditure program with: cash provided from operations, an expansion of the E&P production-based credit facility, the issuance of an additional $17 million in medium-term notes by Mountain Fuel, and increased borrowing under short-term line-of-credit arrangements. In addition, the Company may issue common stock, or sell or monetize a portion of its investment in Nextel common stock to fund capital expenditures. The Company has short-term line-of-credit arrangements with several banks under which it may borrow up to $150,700,000. These lines are generally below the prime interest rate and are renewable annually. At December 31, 1993, outstanding short-term bank loans were $12,300,000 and commercial paper borrowings were $66,000,000. Commercial paper borrowings are backed by the short-term line-of-credit arrangements. Two national debt-rating agencies have rated Questar's commercial paper P-1 and A-1. The exploration and production operations have a long-term revolving-credit arrangement with a bank to borrow up to $50,000,000. Borrowings under this arrangement were $44,000,000 at December 31, 1993. During 1993, Mountain Fuel issued $91,000,000 of 15-year and 30-year medium-term notes at interest rates of 7.19% to 8.28%. Proceeds from these notes and $16,000,000 remaining from the 1992 issuances were used to redeem Mountain Fuel's $100,000,000 9 3/8% debentures and pay the associated refinancing costs. At December 31, 1993, Mountain Fuel had a registration statement filed with the Securities and Exchange Commission to issue an additional $17,000,000 of medium-term notes. The Company typically has negative net working capital at the end of the year because of short-term borrowings. These borrowings are seasonal and generally peak at the end of December because of cold-weather gas purchases. Questar has a consolidated capital structure of 38% long-term debt, 1% preferred stock and 61% common shareholders' equity. Two national debt-rating agencies have rated Mountain Fuel's and Questar Pipeline's long-term debt A1 and A+. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and financial statement schedules required by this Item are submitted in a separate section of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Company has not changed its independent auditors or had any disagreements with them concerning accounting matters and financial statement disclosures within the last 24 months. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information requested in this item concerning Questar's directors is presented in the Company's definitive Proxy Statement dated April 4, 1994, under the section entitled "Election of Directors" and is incorporated herein by reference. A copy of the definitive Proxy Statement will be filed with the Securities and Exchange Commission on or about April 4, 1994. The following individuals served as executive officers of the Company during 1993: Primary Positions Held with Name the Company and Affiliates R. D. Cash 51 Chairman of the Board of Directors (May 1985); President and Chief Executive Officer, Director (May 1984); Chairman of the Boards of Directors, all affiliates. D. N. Rose 49 President and Chief Executive Officer, Mountain Fuel (October 1984); Director (May 1984); Director, Mountain Fuel (May 1984); Senior Vice President, Questar (May 1985). Clyde M. Heiner 55 Senior Vice President, Questar (May 1988);President and Chief Executive Officer, Questar Service Corporation (February 1993); President and Chief Executive Officer, Questar Development (May 1984); Director, Entrada (May 1984), Questar Development (May 1984), and Questar Service (February 1993). A. J. Marushack 58 President and Chief Executive Officer, Questar Pipeline (June 1984); Senior Vice President, Questar (May 1985); Director, Questar Pipeline (May 1984) and Wexpro (May 1985). Gary L. Nordloh 46 President and Chief Executive Officer, Wexpro, Celsius, and Universal Resources (March 1991); Senior Vice President, Questar (March 1991); Executive Vice President and Chief Operating Officer, Wexpro, Celsius, and Universal Resources (June 1989 to March 1991); Director, Celsius and Wexpro (June 1989); Director, Universal Resources (May 1989); Senior Vice President, Celsius and Wexpro (May 1988 to June 1989). W. F. Edwards 48 Senior Vice President and Chief Fi- nancial Officer, Questar (February 1989); Vice President and Chief Financial Officer, affiliates (at various dates beginning in May 1984); Vice President and Chief Financial Officer, Questar (May 1984 to February 1989); Director, Questar Pipeline (May 1985). R. G. Groussman 58 Vice President and General Counsel (October 1984); Director, Wexpro (November 1976) and Celsius (May 1988). N. R. Potter 51 President and Chief Executive Officer, Questar Telecom (February 1989); President and Chief Executive Officer, Questar Service (January 1985 to February 1993); Vice President, Information Services and Telecommunications (February 1989 to February 1993). (Mr. Potter does not currently function as an executive officer.) Connie C. Holbrook 47 Vice President and Corporate Secretary (October 1984); Corporate Secretary, Mountain Fuel and other affiliates (at various dates beginning in March 1982); Director, Celsius (May 1985), Wexpro (May 1988), and Universal Resources (June 1987). There is no "family relationship" between any of the listed officers or between any of them and the Company's directors. The executive officers serve at the pleasure of the Board of Directors. There is no arrangement or understanding under which the officers were selected. Information concerning compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, is presented in the Company's definitive Proxy Statement dated April 4, 1994, under the section entitled "Section 16(a) Compliance" and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information requested in this item is presented in Questar's definitive Proxy Statement dated April 4, 1994, under the sections entitled "Executive Compensation" and "Election of Directors" and is incorporated herein by reference. The sections of the Proxy Statement labelled "Committee Report on Executive Compensation" and "Cumulative Total Shareholder Return" are expressly not incorporated into this document. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information requested in this item for certain beneficial owners is presented in Questar's definitive Proxy Statement dated April 4, 1994, under the section entitled "Security Ownership, Principal Holders" and is incorporated herein by reference. Similar information concerning the securities ownership of directors and executive officers is presented in the definitive Proxy Statement dated April 4, 1994, under the section entitled "Security Ownership, Directors and Executive Officers" and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information requested in this item for related transactions involving the Company's directors and executive officers is presented in the definitive Proxy Statement dated April 4, 1994, under the section entitled "Election of Directors." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) Financial Statements and Financial Statement Schedules. The financial statements and schedules identified in the List of Financial Statements and Financial Statement Schedules are filed as part of this report. The following consolidated financial statement schedules of the Company 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 IX - Short-term borrowing. Schedule X - Supplemental income statement information. (a)(3) Exhibits. The following is a list of exhibits required to be filed as a part of this report in Item 14(c). Exhibit No. Exhibit 2.* Plan and Agreement of Merger dated as of December 16, 1986, by and among the Company, Questar Systems Corporation, and Universal Resources Corporation. (Exhibit No. (2) to Current Report on Form 8-K dated December 16, 1986.) 3.1.* Restated Articles of Incorporation effective May 28, 1991. (Exhibit No. 3.2. to Form 10-Q Report for Quarter ended June 30, 1991.) 3.2.* Bylaws (as amended effective August 11, 1992). (Exhibit No. 3. to Form 10-Q Report for Quarter ended June 30, 1992.) 4.1.* Rights Agreement, dated as of March 14, 1986, between the Company and Morgan Guaranty Trust Company of New York pertaining to the Company's Shareholder Rights Plan. (Exhibit No. 4. to Current Report on Form 8-K dated March 14, 1986.) 4.2.* First Amendment to the Rights Agreement, dated as of May 15, 1989, between the Company and Morgan Shareholder Service Trust Company pertaining to the Company's Shareholder Rights Plan. (Exhibit No. 28(a) to Current Report on Form 8-K dated May 15, 1989.) 10.1.* Stipulation and Agreement, dated October 14, 1981, executed by Mountain Fuel; Wexpro; the Utah Department of Business Regulations, Division of Public Utilities; the Utah Committee of Consumer Services; and the staff of the Public Service Commission of Wyoming. (Exhibit No. 10(a) to Mountain Fuel Supply Company's Form 10-K Annual Report for 1981.) 10.2.* 1 Questar Corporation Annual Management Incentive Plan, as amended effective February 11, 1992. (Exhibit No. 10.2. to Form 10-K Annual Report for 1991.) 10.3.* 1 Questar Corporation Executive Incentive Retirement Plan, as amended effective November 1, 1993. (Exhibit No. 10.3. to Form 10-Q Report for Quarter ended September 30, 1993.) 10.4.* 1 Questar Corporation Stock Option Plan, as amended effective February 13, 1990. (Exhibit No. 10.4. to Form 10-K Annual Report for 1989.) 10.5.* 1 Questar Corporation Long Term Stock Incentive Plan effective March 1, 1991. (Exhibit No. 10.5. to Form 10-K Annual Report for 1990.) 10.6.* 1 Questar Corporation Executive Severance Compensation Plan, as amended effective January 1, 1990. (Exhibit No. 10.5. to Form 10-K Annual Report for 1989.) 10.7.* 1 Questar Corporation Deferred Compensation Plan for Directors, as amended April 30, 1991. (Exhibit No. 10.7. to Form 10-K Annual Report for 1991.) 10.8.* 1 Questar Corporation Supplemental Executive Retire- ment Plan, as amended and restated effective November 1, 1993. (Exhibit No. 10.8. to Form 10-Q Report for Quarter ended September 30, 1993.) 10.9.* 1 Questar Corporation Equalization Benefit Plan, as amended and restated effective November 1, 1993. (Exhibit No. 10.9. to Form 10-Q Report for Quarter ended September 30, 1993.) 10.10.* 1 Questar Corporation Stock Option Plan for Directors, as amended effective February 9, 1993. (Exhibit No. 10.10. to Form 10-K Annual Report for 1992.) 10.11.* 1 Form of Individual Indemnification Agreement dated February 9, 1993 between Questar Corporation and Directors. (Exhibit No. 10.11. to Form 10-K Annual Report for 1992.) 10.12.* 1 Questar Corporation Deferred Share Plan, as amended and restated November 1, 1993. (Exhibit No. 10.12. to Form 10-Q Report for Quarter ended September 30, 1993.) 10.13.* 1 Questar Corporation Deferred Compensation Plan as adopted effective November 1, 1993. (Exhibit No. 10.13. to Form 10-Q Report for Quarter ended September 30, 1993.) 11. Statement concerning computation of earnings per share. 22. Subsidiary Information. 24. Consent of Independent Auditors. 25. Power of Attorney. 28.1.* Press Release dated October 18, 1993, announcing the agreement with Nextel Communications, Inc. (Exhibit No. 28.1. to Form 10-Q Report for Quarter ended September 30, 1993.) 28.2. Form 11-K Annual Report for the Questar Corporation Employee Stock Purchase Plan. 28.3. Undertakings for Registration Statements on Form S- 3 (No. 33-48168) and on Form S-8 (Nos. 33-4436, 33- 15148, 33-15149, 33-40800, 33-40801, and 33-48169). * Exhibits so marked have been filed with the Securities and Exchange Commission as part of the indicated filing and are incorporated herein by reference. 1 Exhibit so marked is management contract or compensation plan or arrangement (b) The Company did not file a Current Report on Form 8-K during the last quarter of 1993. ANNUAL REPORT ON FORM 10-K ITEM 8, ITEM 14 (a) (1) and (2), (c) and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 QUESTAR CORPORATION SALT LAKE CITY, UTAH FORM 10-K -- ITEM 14 (a) (1) and (2) QUESTAR CORPORATION AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Questar Corporation and subsidiaries are included in Item 8: Consolidated statements of income -- Years ended December 31, 1993, 1992 and Consolidated balance sheets -- December 31, 1993 and 1992 Consolidated statements of common 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 The following consolidated financial statement schedules of Questar Corporation 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 IX -- Short-term borrowings Schedule X -- Supplementary income statement information All other schedules, for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission, are not required under the related instructions or are inapplicable, and therefore have been omitted. Report of Independent Auditors Shareholders and Board of Directors Questar Corporation We have audited the accompanying consolidated balance sheets of Questar Corporation and subsidiaries as of December 31, 1993 and 1992, 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 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 Questar Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As noted in Note K to the financial statements, in 1993 Questar Corporation changed its method of accounting for postretirement benefits other than pensions. ERNST & YOUNG Salt Lake City, Utah February 11, 1994, except for Note M as to which the date is March 1, 1994 QUESTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME See notes to consolidated financial statements. QUESTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS See notes to consolidated financial statements. QUESTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS' EQUITY See notes to consolidated financial statements. QUESTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements. QUESTAR CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note A - Summary of Accounting Policies Principles of Consolidation: The consolidated financial statements contain the accounts of Questar Corporation and subsidiaries (Questar or the Company). Questar is engaged in three principal lines of business. Oil and gas exploration and production operations are conducted by Celsius Energy Company (Celsius Energy), Universal Resources Corporation (Universal Resources) and Wexpro Company (Wexpro). Natural gas transmission operations are conducted by Questar Pipeline Company (Questar Pipeline). Natural gas distribution operations are conducted by Mountain Fuel Supply Company (Mountain Fuel). Questar discontinued the consolidation of its specialized mobile radio telecommunication operations in October 1993 with the announced sale of Questar Telecom Inc. (Questar Telecom) discussed in Note B. All significant intercompany accounts and transactions have been eliminated in consolidation. Regulation: Mountain Fuel is regulated by the Public Service Commission of Utah (PSCU) and the Public Service Commission of Wyoming (PSCW). Questar Pipeline is regulated by the Federal Energy Regulatory Commission (FERC). These regulatory agencies establish rates for the storage, transportation and sale of natural gas. The regulatory agencies also regulate, among other things, the extension and enlargement or abandonment of jurisdictional natural gas facilities. Regulation is intended to permit the recovery, through rates, of the cost of service, including a rate of return on investment. See Note J on rate matters. The financial statements of rate regulated businesses are presented in accordance with regulatory requirements. Methods of allocating costs to time periods, in order to match revenues and expenses, may differ from those of nonregulated businesses because of cost-allocation methods used in establishing rates. Purchased-Gas Adjustments: The Company accounts for purchased-gas costs in accordance with procedures authorized by the PSCU and PSCW whereby purchased-gas costs that are different from those provided for in the present rates are accumulated and recovered or credited through future rate changes. Credit Risk: The Company's primary market area is the Rocky Mountain region of the United States. The Company's exposure to credit risk may be impacted by the concentration of customers in this region due to changes in economic or other conditions. The Company's customers include individuals and numerous industries that may be impacted differently by changing conditions. The Company believes that it has adequately reserved for expected credit-related losses. Property, Plant and Equipment: Property, plant and equipment are stated at cost. Celsius Energy and Universal Resources account for exploration and development activities using the full-cost accounting method. Under the full-cost method, all costs associated with acquisition, exploration and development of oil and gas reserves are capitalized. If net capitalized costs exceed the present value of estimated future net revenues from proved oil and gas reserves plus the fair market value of unproved properties, the excess is expensed. Wexpro uses the successful-efforts accounting method to account for its production and development activities under the terms of the Wexpro settlement agreement. See Note L. The provision for depreciation and amortization is based upon rates that will amortize costs of assets over their estimated useful lives. The costs of natural gas distribution and natural gas transmission property, plant and equipment, excluding gas wells, are amortized using the straight-line method. The costs of oil and gas wells, production plants and leaseholds are amortized using the unit-of-production method. Average depreciation and amortization rates used in 1993 were as follows: Exploration and production, per Mcf equivalent Full-cost amortization rate $0.80 Wexpro amortization rate 0.48 Natural gas transmission 3.6% Natural gas distribution Distribution plant 3.9% Gas wells, per Mcf $0.18 Other operations 12.4% Investment in Unconsolidated Affiliates: The Company uses the equity method to account for affiliates in which it does not own a controlling interest. Principal affiliates include: Overthrust Pipeline Company, FuelMaker Corporation, TransColorado Gas Transmission Company and Canyon Creek Compression Company. The Company's investment in these affiliates equals the underlying equity in net assets. Futures Contracts and Options: The Company periodically enters into futures contracts or option agreements to hedge its exposure to price fluctuations on marketing of natural gas. Recognized gains and losses on hedge transactions are reported as a component of the related transaction. Income Taxes: On December 31, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109 by recording a cumulative effect of the change in accounting related to prior years. The deferred tax balance represents the temporary differences between book and taxable income multiplied by the effective tax rates. These temporary differences relate primarily to depreciation, intangible drilling costs, unbilled revenues, leasehold costs, purchased-gas adjustments and net operating loss carryforwards. Mountain Fuel and Questar Pipeline use the deferral method to account for investment tax credits as required by regulatory commissions. The Company allocates income taxes to subsidiaries on a seperate return basis except that subsidiaries are paid for all tax benefits utilized in the consolidated tax return. See Note H. Reacquisition of Debt: Gains and losses on the reacquisition of debt by Mountain Fuel and Questar Pipeline are deferred and amortized as debt expense over the remaining life of the issue or the life of the replacement debt in order to match regulatory treatment. Allowance for Funds Used During Construction: The Company's regulated subsidiaries capitalize the cost of capital during the construction period of plant and equipment. This amounted to $1,725,000 in 1993, $1,153,000 in 1992, and $1,040,000 in 1991. Earnings Per Common Share: Earnings per common share are computed by dividing net income less preferred stock dividends by the weighted average number of common shares outstanding during the year. Common stock equivalents in the form of stock options do not have a material dilutive effect on the earnings-per-share calculations and are excluded from the computation. Reclassifications: Certain reclassifications were made to the 1992 and 1991 financial statements to conform with the 1993 presentation. Note B - Discontinued Operations In October 1993, the Company announced that it had reached a binding agreement to sell its Questar Telecom to Nextel Communications, Inc. (Nextel). The Company will receive 3,886,000 shares of Nextel common stock in exchange for all of the common stock of Questar Telecom. The operating results for Questar Telecom have been reported as discontinued operations since Questar Telecom represented all of Questar's investment in the specialized mobile radio business. The sale of Questar Telecom is expected to be completed in the first half of 1994, at which time, Questar expects to recognize a gain on the transaction based on the Nextel stock price. Questar's net investment in Questar Telecom is anticipated to be approximately $40 million at the time of the sale, including the acquisition of additional channels as required by the sale agreement. Nextel common stock traded in a range of $17 7/8 to $54 7/8 during 1993 and was $37 1/4 per share at December 31, 1993. Net losses from Questar Telecom subsequent to the sale agreement have been deferred until the sale is recorded. Questar Telecom's operating results prior to the sale agreement were as follows: Questar's investment in discontinued operations at September 30, 1993, including liabilities to be assumed by the purchaser, was as follows: Note C - Cash and Short-Term Investments Short-term investments at December 31, 1993, and 1992, valued at cost (approximates market), amounted to $11,917,000 and $14,958,000, respectively. Short-term investments consisted principally of Euro-time deposits and repurchase agreements with maturities of three months or less. Note D - Debt The Company has short-term line-of-credit arrangements with several banks under which it may borrow up to $150,700,000. These lines have interest rates generally below the prime interest rate and are renewable annually. At December 31, 1993, outstanding short-term bank loans were $12,300,000 at an average interest rate of 3.5% and commercial paper borrowings were $66,000,000 at an average interest rate of 3.5%. Commercial paper borrowings are backed by the short-term line-of-credit arrangements. The details of long-term debt at December 31, were as follows: Maturities of long-term debt for the five years following December 31, 1993, are as follows (no amounts are due in 1994): The exploration and production operations have a production-based long-term credit facility with a bank to borrow up to $50,000,000. During 1993, Mountain Fuel issued $91,000,000 of 15-year and 30-year medium-term notes at interest rates of 7.19% to 8.28%. Proceeds from these notes and $16,000,000 remaining from the 1992 issuances were used to redeem Mountain Fuel's $100,000,000 9 3/8% debentures and pay the associated refinancing costs. At December 31, 1993, Mountain Fuel had a registration statement filed with the Securities and Exchange Commission to issue an additional $17,000,000 of medium-term notes. Cash paid for interest was $33,414,000 in 1993, $36,115,000 in 1992, and $37,374,000 in 1991. Note E - Redeemable Cumulative Preferred Stock Mountain Fuel has authorized 4,000,000 shares of nonvoting redeemable cumulative preferred stock with no par value. The two current outstanding issues of stock have a stated and redemption value of $100 per share. Redemption requirements for the five years following December 31, 1993, are as follows: Note F - Estimated Fair Values of Financial Instruments The carrying amounts and estimated fair values of the Company's financial instruments were as follows: The Company used the following methods and assumptions in estimating fair values: (1) Cash and short-term investments - the carrying amount approximates fair value; (2) Short-term loans - the carrying amount approximates fair value; (3) Long-term debt - the carrying amounts of variable rate debt approximates fair value, the fair value of marketable debt is based on quoted market prices, and the fair value of other debt is based on the discounted present value of cash flows using the Company's current borrowing rates; (4) Redeemable cumulative preferred stock - the fair value is based on the discounted present value of cash flows using current preferred stock rates. Note G - Common Stock Employee Investment Plan: An Employee Investment Plan (ESOP) allows the majority of employees to purchase Company stock or other investments with payroll deductions. The Company makes contributions to the ESOP of approximately 75% of the employee's purchases. In June 1989, the Company sold 1,992,884 shares of its common stock (LESOP shares) to the trustee of the ESOP. The ESOP trustee financed the purchase of stock by borrowing $35,000,000 from the Company. The note receivable from the ESOP was recorded as a reduction of common shareholders' equity. At the same time, the Company borrowed $35,000,000 from a group of insurance companies. Interest expense on these notes to the insurance companies totaled $2,918,000 in 1993, 1992 and 1991. The ESOP is repaying the loan to the Company over ten years using Company contributions and dividends on the LESOP shares. The Company's expense and contribution to the ESOP was $2,368,000 in 1993, $2,477,000 in 1992 and $2,884,000 in 1991. Dividends paid by the Company to the ESOP on the LESOP shares totaled $2,112,000 in 1993, $2,033,000 in 1992 and $1,989,000 in 1991. The Company received an income tax benefit for dividends paid on ESOP shares and dividends paid directly to ESOP participants of $911,000 in 1993, $858,000 in 1992 and $835,000 in 1991. Income tax benefits of $351,000 in 1993 and $278,000 in 1992 were recorded as a reduction of income tax expense as required by SFAS No. 109. The remaining tax benefits were recorded as an increase to retained earnings. The American Institute of Certified Public Accountants issued a Statement of Position in 1993 on accounting for ESOPs, which changes the recognition of expense on company contributions. The new rules will not impact expense on the current LESOP shares. Dividend Reinvestment and Stock Purchase Plan: A Dividend Reinvestment and Stock Purchase Plan (Reinvestment Plan) allows shareholders to reinvest dividends or invest additional funds in common stock. The Reinvestment Plan purchased common stock from the Company amounting to 148,708 shares in 1993, 241,322 shares in 1992 and 498,483 shares in 1991. At December 31, 1993, 1,059,865 shares were reserved for future issuance. Stock Plans: The Company has a Long-term Stock Incentive Plan for officers and key employees and a Stock Option Plan for nonemployee directors (Stock Plans). The Long-term Stock Incentive Plan was approved by shareholders in 1991 and replaces a previous stock option plan for officers and key employees. The number of shares available for options or other stock awards under the Long-term Stock Incentive Plan is increased each year by 1% of the outstanding shares of common stock on the first day of the calendar year. No awards may be granted under the Long-term Stock Incentive Plan after May 2001. The Stock Option Plan for nonemployee directors was amended in 1991 and the term extended to May 1996. Transactions involving option shares in the Stock Plans are summarized as follows: Shareholder Rights: In 1986, Questar issued one common share purchase right for each outstanding share of stock. The rights expire in March 1996. The rights become exercisable if a person acquires 20% or more of the Company's common stock or announces an offer for 20% or more of the common stock. Each right initially represents the right to buy one share of the Company's common stock for $50. Once any person acquires 20% or more of the Company's common stock, the rights are automatically modified. Each right not owned by the 20% owner becomes exercisable for the number of shares of Questar's stock that have a market value equal to two times the exercise price of the right. This same result occurs if a 20% owner acquires the Company through a reverse merger when Questar and its stock survive. If the Company is involved in a merger or other business combination at any time after the rights become exercisable, rights holders will be entitled to buy shares of common stock in the acquiring company having a market value equal to twice the exercise price of each right. The rights may be redeemed by the Company at a price of $.025 per right until 15 days after a person acquires 20% ownership of the common stock. Note H - Income Taxes Effective January 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by SFAS No. 109, Accounting for Income Taxes. The Company did not restate prior years' financial statements. The cumulative effect of adopting SFAS No. 109 as of January 1, 1992, increased net income by $9,303,000, or $.23 per share. The application of the rules did not have a significant impact on the 1992 income before cumulative effect. Regulated operations recorded cumulative increases in deferred taxes as income taxes recoverable from customers. Mountain Fuel and Questar Pipeline have adopted procedures with their regulatory commissions to include under-provided deferred taxes in customer rates on a systematic basis. The amounts of income taxes recoverable from customers was higher in 1993 due to an increase in the federal income tax rate. As of January 1, 1992, Universal Resources recorded a cumulative decrease in deferred taxes of $8,626,000 as a reduction of property, plant and equipment. This cumulative effect was a result of net operating loss carryforwards acquired by Questar in the 1987 purchase of Universal Resources. At December 31, 1993, the Company had net operating loss carryforwards of $44,778,000 which expire from 1995 through 2001. These carryforwards can be used to offset Universal Resources' future taxable income. The tax benefit of these carryforwards is $15,672,000. For financial reporting purposes, the Company has recorded a valuation allowance of $6,414,000 to offset a portion of the deferred tax asset relating to these carryforwards. Future changes in this valuation allowance will be recorded as an adjustment to property, plant and equipment. The components of income taxes were as follows: The difference between income tax expense and the tax computed by applying the statutory federal income tax rate to income before income taxes is explained as follows: Significant components of the Company's deferred tax liabilities and assets were as follows: Cash paid for income taxes was $25,588,000 in 1993, $25,028,000 in 1992 and $33,523,000 in 1991. Note I - Litigation, Environmental Matters and Commitments The Company's subsidiary, Entrada Industries, Inc., has been named as a potentially responsible party in an environmental clean-up action involving a site in Salt Lake City. The site was the location of chemical operations conducted by Entrada's Wasatch Chemical Division, which ceased operation in 1978. Entrada has proposed a remediation that has received approval from the Environmental Protection Agency and the Utah Department of Health. Settlements have been reached with the other major potentially responsible parties and an accrual has been established for the remedial work costs. Management believes that current accruals of $7,239,000 will be sufficient for estimated future clean-up costs, which are expected to be incurred over the next several years. The Company has recorded a receivable from an insurance company of $3,500,000 for expected payments related to the Wasatch Chemical clean-up. Additional amounts may be collected from the insurance company if clean-up costs are higher than anticipated. The Company and its subsidiaries have received notice that they may be partially liable in several additional environmental clean-up actions on sites that involve numerous other parties. Management believes that the Company's responsibility for remediation will be minor and that any potential liability will not be significant to the results of operations or its financial position. There are various other legal proceedings against Questar and its subsidiaries. While it is not currently possible to predict or determine the outcome of these proceedings, it is the opinion of management that the outcome will not have a material adverse effect on the Company's results of operations, financial position or liquidity. Many of Mountain Fuel's gas-purchase contracts include take-or-pay provisions that obligate it, on an annual basis, to take delivery of at least a specified percentage of volumes producible from wells or pay for such volumes. The contracts allow for the subsequent delivery of the gas within a specified period. Other gas-purchase contracts include provisions that obligate Mountain Fuel to schedule a specific volume for delivery on a daily or monthly basis. All gas-purchase contracts were transferred from Questar Pipeline to Mountain Fuel in 1993. Purchases of natural gas under gas-purchase contracts totalled $85,909,000 in 1993, $104,032,000 in 1992 and $123,319,000 in 1991. Following is a summary of projected purchase commitments under gas-purchase contracts with terms of one year or more. Prices under these contracts are based on the current market price. These commitments will change as a result of future negotiations with sellers. Note J - Rate Matters On September 1, 1993, Questar Pipeline began operating in compliance with FERC Order No. 636. The order unbundled the sale-for-resale service from the transportation, gathering and storage services provided by natural gas pipelines. Questar Pipeline eliminated its merchant function. That activity was assumed by Mountain Fuel along with the gas-purchase contracts. In its order approving Questar Pipeline's Order No. 636 implementation plan, the FERC accepted Questar Pipeline's plan for the assignment of gas-purchase contracts to Mountain Fuel. Order No. 636 requires a greater percentage of the cost of service to be collected through demand charges. The percentage of costs included in the demand component of rates increased from 66% prior to implementation to about 94% after implementation. The majority of Questar Pipeline's transportation capacity has been reserved by firm transportation customers, which, under Order No. 636, can release that capacity to third parties when it is not required for their own needs. After $1.5 million of revenues are received from interruptible transportation customers, 90% of the remaining revenues from the transportation of gas for interruptible customers is credited back to firm customers. Questar Pipeline is allowed to retain all interruptible transportation revenues on projects that have not been included in the transportation rate case. Mountain Fuel filed a general rate case for its Utah operations in April 1993. The revised amount of deficiency requested in the case was $10.3 million, including a 12.1% return on equity. In January 1994, the PSCU issued a rate order granting Mountain Fuel a $1.6 million decrease in general rates and a $2.1 million increase in costs allowed through the purchase-gas adjustment account for a net increase in rates of $500,000. The PSCU allowed a return on equity of 11%, required Mountain Fuel to reduce rates over a five-year period for unbilled revenues, and disallowed rate coverage for certain incentive compensation and advertising costs. Mountain Fuel requested a rehearing of the PSCU order for the allowed return on equity and the treatment of unbilled revenues and the PSCU granted a rehearing on these issues. In 1993, Mountain Fuel began accruing gas distribution revenues for gas delivered to residential and commercial customers but not billed at the end of the year. The impact of these accruals on the income statement has been deferred in accordance with a rate order received from the PSCU. This rate order reduces customer rates by $2,011,000 per year over the five-year period from 1994 through 1998. Mountain Fuel will recognize the unbilled revenues and the associated gas costs over this same five-year period to offset the reduction in rates. In July 1993, the PSCW issued an order in Mountain Fuel's general rate case for Wyoming operations. The order approved a stipulation that had been negotiated by the Company and the PSCW's staff which allowed for an increase in general rates of $721,000 including recovery of costs attributable to FERC Order No. 636 and higher federal income tax rates. Note K - Employee Benefits The Company and its subsidiaries have a defined-benefit pension plan covering the majority of its employees. Benefits are generally based on years of service and the employee's 36-month period of highest earnings during the ten years preceding retirement. The Company's policy is to make contributions to the plan at least sufficient to meet the minimum funding requirements of of the Internal Revenue Code. Plan assets consist principally of equity securities and corporate and U.S. government debt obligations. A summary of pension cost is as follows: Assumptions used to calculate cost at January 1, were as follows: The status of the plan at December 31, was as follows: The Company used a discount rate of 7% and a rate of increase in compensation of 5.35% to measure the actuarial present value of benefits at December 31, 1993. The Company pays a portion of the health-care costs and all the life insurance costs for retired employees. Effective January 1, 1992, this program was changed for employees retiring after January 1, 1993, to link the health-care benefit to years of service and to limit the Company's monthly health-care contribution per individual to 170% of the 1992 contribution. The Company's policy is to fund amounts allowable for tax deduction under the Internal Revenue Code. Plan assets consist of equity securities, corporate and U.S. government debt obligation, and insurance company general accounts. The Company adopted the provisions of SFAS No. 106 on Employer's Accounting for Postretirement Benefits Other than Pensions effective January 1, 1993. This statement requires the Company to expense the costs of postretirement benefits, principally health-care benefits, over the service life of employees using an accrual method. The Company is amortizing the transition obligation over a 20-year period. Total cost of postretirement benefits other than pensions under SFAS No. 106 was $5,918,000 in 1993 compared with the costs based on cash payments to retirees plus the prefunding of some benefits totaling $1,553,000 in 1992 and $1,740,000 in 1991. Components of the postretirement benefit cost for 1993 were as follows: The status of the postretirement benefit programs at December 31, 1993 was as follows: Significant assumptions used to measure postretirement benefits at December 31, 1993 were as follows: A 1% increase in the health-care inflation rate would increase the service cost by $4,000, the interest cost by $232,000 and the accumulated benefit obligation by $2,898,000. Mountain Fuel and Questar Pipeline account for approximately 57% and 18% of the postretirement benefit costs, respectively. The impact of SFAS No. 106 on Questar's future net income will be mitigated by recovery of these costs from customers. Both the PSCU and the PSCW allowed Mountain Fuel to recover future SFAS No. 106 costs in the 1993 rate cases if the amounts are funded in an external trust. The FERC issued an order granting rate recovery methodology for SFAS No. 106 costs to the extent that pipeline companies contribute the amounts to an external trust. Questar Pipeline expects to receive coverage of future SFAS No. 106 costs in its next general rate case and recovery of costs in excess of the amounts currently included in rates for the period from 1993 to the rate case filing if the rate case is filed prior to January 1, 1996. The Financial Accounting Standards Board (FASB) has issued SFAS No. 112, Accounting for Postemployment Benefits. This statement requires the Company to recognize the liability for postemployment benefits when employees become eligible for such benefits. Postemployment benefits are paid to former employees after employment has been terminated but before retirement benefits are paid. The Company's principal liability under SFAS No. 112 is a long-term disability program. The Company is required to adopt SFAS No. 112 in the first quarter of 1994 and recognize a cumulative effect of a change in accounting method amounting to approximately $3,300,000. Some of this amount may be recovered from Mountain Fuel's and Questar Pipeline's customers through subsequent rate changes. The effect on ongoing net income is not expected to be significant. Note L - Wexpro Settlement Agreement Wexpro's operations are subject to the terms of the Wexpro settlement agreement. The agreement was effective August 1, 1981, and sets forth the rights of Mountain Fuel's utility operations to share in the results of Wexpro's operations. The agreement was approved by the PSCU and PSCW in 1981 and affirmed by the Supreme Court of Utah in 1983. Major provisions of the settlement agreement are as follows: a. Wexpro continues to hold and operate all oil-producing properties previously transferred from Mountain Fuel's nonutility accounts. The oil production from these properties is sold at market prices, with the revenues used to recover operating expenses and to give Wexpro a return on its investment. The rate of return is adjusted annually and is currently 14.6%. Any net income remaining after recovery of expenses and Wexpro's return on investment is divided between Wexpro and Mountain Fuel, with Wexpro retaining 46%. b. Wexpro conducts developmental oil drilling on productive oil properties and bears any costs of dry holes. Oil discovered from these properties is sold at market prices, with the revenues used to recover operating expenses and to give Wexpro a return on its investment in successful wells. The rate of return is adjusted annually and is currently 19.6%. Any net income remaining after recovery of expenses and Wexpro's return on investment is divided between Wexpro and Mountain Fuel, with Wexpro retaining 46%. c. Amounts received by Mountain Fuel from the sharing of Wexpro's oil income are used to reduce natural gas costs to utility customers. d. Wexpro conducts developmental gas drilling on productive gas properties and bears any costs of dry holes. Natural gas produced from successful drilling is owned by Mountain Fuel. Wexpro is reimbursed for the costs of producing the gas plus a return on its investment in successful wells. The return allowed Wexpro is currently 22.6%. e. Wexpro operates natural gas properties owned by Mountain Fuel. Wexpro is reimbursed for its costs of operating these properties, including a rate of return on any investment it makes. This rate of return is currently 14.6%. Note M - Subsequent Events In the first quarter of 1994, the E&P group announced two acquisitions of oil and gas reserves, processing plants, gathering systems and leasehold acreage for a cost of $117,100,000. The E&P group obtained oil and gas reserves of approximately 115 Bcf equivalent located in the Midcontinent and San Juan Basin regions. The first acquisition was for properties from Petroleum, Inc. and was completed in January 1994 at a cost of $22,600,000. This purchase was financed with short-term debt. In the second acquisition, the E&P group acquired the properties of Amax Oil & Gas's northern division at a cost of $94,500,000 through an alliance with Union Pacific Resources Corporation. This transaction is expected to be closed in the first half of 1994 and will be financed with short-term debt and an expansion of the production-based long-term credit facility. Note N - Oil and Gas Producing Activities (Unaudited) The following information discusses the Company's oil and gas producing activities. Separate disclosures are presented for cost-of-service and noncost-of-service activities. Cost-of-service properties are those for which the operations and return on investment are governed by state regulatory agencies or the Wexpro settlement agreement (see Note L). Production from gas properties owned or operated by Wexpro is delivered to Mountain Fuel at cost of service. Noncost-of-service properties are properties from which production is sold at market prices. These properties include all Celsius Energy and Universal Resources properties and Wexpro oil properties. Production from Wexpro oil properties is sold at market prices and the income is shared with Mountain Fuel after a specified return on investment is earned. Information on the results of operations and standardized measure of future net cash flows has not been included for cost-of-service activities because operating results and the value of the related properties is dependent upon returns established by state regulatory agencies based on historical costs or the terms of the Wexpro settlement agreement (see Note L). NONCOST-OF-SERVICE ACTIVITIES Capitalized Costs: The aggregate amounts of costs capitalized for noncost-of-service oil and gas-producing activities and the related amounts of accumulated depreciation and amortization follow: Full-Cost Amortization: Unproved properties held by Celsius Energy and Universal Resources are currently excluded from amortization until evaluation. A summary of costs excluded from amortization at December 31, 1993, and the year in which these costs were incurred is as follows: Costs Incurred: The following costs were incurred in noncost-of-service oil and gas-producing activities. Results of Operations: Following are the results of operations of noncost-of-service oil and gas-producing activities before corporate overhead and interest expenses. Standardized Measure of Future Net Cash Flows Relating to Proved Reserves for Noncost-of-Service Activities: Future net cash flows were calculated using December 31, 1993, prices and known contract price changes. Year-end production, development costs and income tax rates were used to compute the future net cash flows. All cash flows were discounted at 10% to reflect the time value of cash flows, without regard to the risk of specific properties. The assumptions used to derive the standardized measure of future net cash flows are those required by the FASB and do not necessarily reflect the Company's expectations. The usefulness of the standardized measure of future net cash flows is impaired because of the reliance on reserve estimates and production schedules that are inherently imprecise, and because the costs of oil-income sharing under the Wexpro settlement agreement were not included. The principal sources of change in the standardized measure of discounted future net cash flows were: COST-OF-SERVICE ACTIVITIES Capitalized Costs: Capitalized costs for cost-of-service oil and gas-producing activities net of the related accumulated depreciation and amortization were as follows: Costs Incurred: Costs incurred by Wexpro for cost-of-service gas-producing activities were $21,829,000 in 1993, $18,348,000 in 1992 and $19,771,000 in 1991. Estimated Quantities of Proved Oil and Gas Reserves for Cost-of-Service Properties: The following estimates were made by the Company's reservoir engineers. No estimates are available for cost-of-service proved undeveloped reserves that may exist. Note O - Quarterly Financial and Stock Price Data (Unaudited) Following is a summary of quarterly financial and stock price data. The quarterly results have been reclassified for the discontinued operations. Note P - Operations by Line of Business Following is a summary of operations by line of business: SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT QUESTAR CORPORATION AND SUBSIDIARIES Note A - Other changes consist of the following: 1993 - Transfer of a portion of Questar Pipeline's current gas stored underground to cushion gas stored underground of $3,874,000; 1992 - Reduction of Universal Resource's property, plant and equipment for the adoption of SFAS No. 109 of $8,626,000; and 1991 - Reduction of Universal Resource's property, plant and equipment for the effect of preacquisition net operating loss carryforwards of $1,868,000. SCHEDULE VI- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT QUESTAR CORPORATION AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS QUESTAR CORPORATION AND SUBSIDIARIES Note A - Notes payable to banks represent borrowings under line-of-credit arrangements that have no termination date but are subject to negotiation. Commercial paper matures 30 to 90 days from the date of issue with no provision for the extension of maturity. Note B - The average amount outstanding during the period was computed by averaging the daily principal balances. Note C - The weighted average interest rate during the period was computed by dividing the actual interest expense by the average short-term debt outstanding during the period. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION QUESTAR CORPORATION AND SUBSIDIARIES Advertising costs, which are less than 1% of total revenues, are not presented separately. Royalty costs for exploration and production operations have not been disclosed since production revenues are reported net of royalties. The Company does not have any depreciation and amortization of intangible assets. 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 24th day of March, 1994. QUESTAR CORPORATION (Registrant) By /s/ R. D. Cash R. D. Cash 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 date indicated. /s/ R. D. Cash Chairman, President and Chief R. D. Cash Executive Officer (Principal Executive Officer) /s/ W. F. Edwards Senior Vice President and Chief W. F. Edwards Financial Officer (Principal Financial and Accounting Officer) *Robert H. Bischoff Director *R. D. Cash Director *U. Edwin Garrison Director *James A. Harmon Director *W. W. Hawkins Director *W. N. Jones Director *Robert E. Kadlec Director *Dixie L. Leavitt Director *Neal A. Maxwell Director *Gary G. Michael Director *Mary Mead Director *D. N. Rose Director *Harris H. Simmons Director March 24, 1994 *By /s/ R. D. Cash Date R. D. Cash, Attorney in Fact EXHIBIT INDEX Sequential Page Exhibit Number Number Exhibit 2.* Plan and Agreement of Merger dated as of December 16, 1986, by and among the Company, Questar Systems Corporation, and Universal Resources Corporation. (Exhibit No. (2) to Current Report on Form 8-K dated December 16, 1986.) 3.1.* Restated Articles of Incorporation effective May 28, 1991. (Exhibit No. 3.2. to Form 10-Q Report for Quarter ended June 30, 1991.) 3.2.* Bylaws (as amended effective August 11, 1992). (Exhibit No. 3. to Form 10-Q Report for Quarter ended June 30, 1992.) 4.1.* Rights Agreement, dated as of March 14, 1986, between the Company and Morgan Guaranty Trust Company of New York pertaining to the Company's Shareholder Rights Plan. (Exhibit No. 4. to Current Report on Form 8-K dated March 14, 1986.) 4.2.* First Amendment to the Rights Agreement, dated as of May 15, 1989, between the Company and Morgan Shareholder Service Trust Company pertaining to the Company's Shareholder Rights Plan. (Exhibit No. 28(a) to Current Report on Form 8-K dated May 15, 1989.) 10.1.* Stipulation and Agreement, dated October 14, 1981, executed by Mountain Fuel; Wexpro; the Utah Department of Business Regulations, Division of Public Utilities; the Utah Committee of Consumer Services; and the staff of the Public Service Commission of Wyoming. (Exhibit No. 10(a) to Mountain Fuel Supply Company's Form 10-K Annual Report for 1981.) 10.2.* 1 Questar Corporation Annual Management Incentive Plan, as amended effective February 11, 1992. (Exhibit No. 10.2. to Form 10-K Annual Report for 1991.) 10.3.* 1 Questar Corporation Executive Incentive Retirement Plan, as amended effective November 1, 1993. (Exhibit No. 10.3. to Form 10-Q Report for Quarter ended September 30, 1993.) 10.4.* 1 Questar Corporation Stock Option Plan, as amended effective February 13, 1990. (Exhibit No. 10.4. to Form 10-K Annual Report for 1989.) 10.5.* 1 Questar Corporation Long Term Stock Incentive Plan effective March 1, 1991. (Exhibit No. 10.5. to Form 10-K Annual Report for 1990.) 10.6.* 1 Questar Corporation Executive Severance Compensation Plan, as amended effective January 1, 1990. (Exhibit No. 10.5. to Form 10-K Annual Report for 1989.) 10.7.* 1 Questar Corporation Deferred Compensation Plan for Directors, as amended April 30, 1991. (Exhibit No. 10.7. to Form 10-K Annual Report for 1991.) 10.8.* 1 Questar Corporation Supplemental Executive Retirement Plan, as amended and restated effective November 1, 1993. (Exhibit No. 10.8. to Form 10-Q Report for Quarter ended September 30, 1993.) 10.9.* 1 Questar Corporation Equalization Benefit Plan, as amended and restated effective November 1, 1993. (Exhibit No. 10.9. to Form 10-Q Report for Quarter ended September 30, 1993.) 10.10.*1 Questar Corporation Stock Option Plan for Directors, as amended effective February 9, 1993. (Exhibit No. 10.10. to Form 10-K Annual Report for 1992.) 10.11.*1 Form of Individual Indemnification Agreement dated February 9, 1993 between Questar Corporation and Directors. (Exhibit No. 10.11. to Form 10-K Annual Report for 1992.) 10.12.*1 Questar Corporation Deferred Share Plan, as amended and restated November 1, 1993. (Exhibit No. 10.12. to Form 10-Q Report for Quarter ended September 30, 1993.) 10.13.*1 Questar Corporation Deferred Compensation Plan as adopted effective November 1, 1993. (Exhibit No. 10.13. to Form 10-Q Report for Quarter ended September 30, 1993.) 11. Statement concerning computation of earnings per share. 22. Subsidiary Information. 24. Consent of Independent Auditors. 25. Power of Attorney. 28.1.* Press Release dated October 18, 1993, announcing the agreement with Nextel Communications, Inc. (Exhibit No. 28.1. to Form 10-Q Report for Quarter ended September 30, 1993.) 28.2. Form 11-K Annual Report for the Questar Corporation Employee Stock Purchase Plan. 28.3. Undertakings for Registration Statements on Form S-3 (No. 33-48168) and on Form S-8 (Nos. 33-4436, 33- 15148, 33-15149, 33-40800, 33-40801, and 33-48169). *Exhibits so marked have been filed with the Securities and Exchange Commission as part of the indicated filing and are incorporated herein by reference. 1 Exhibit so marked is management contract or compensation plan or arrangement (b) The Company did not file a Current Report on Form 8-K during the last quarter of 1993.

706116_1993.txt

706116_1993

1993

706116

Item 1 - Business Vermont Financial Services Corp. (VFSC), a Delaware corporation organized in 1990, is a registered bank holding company under the Bank Holding Company Act of 1956, as amended, and its main office is located in Brattleboro, Vermont. Assets of VFSC were $934 million at December 31, 1993. VFSC owns 100 percent of the stock of Vermont National Bank (VNB). VFSC has no other active subsidiaries and engages in no activities other than holding the stock of VNB. VNB, a national banking association, is the successor to the original Bank of Brattleborough, which was chartered in 1821. VNB is the second largest bank in the State of Vermont with total deposits of $773 million and total assets of $931 million at December 31, 1993. VNB conducts business through 32 offices located in seven of Vermont's 14 counties, including the cities of Brattleboro, Burlington, Rutland and Montpelier. The offices of VNB are in good physical condition with modern equipment and facilities adequate to meeting the banking needs of customers in the communities served. VNB offers a wide range of personal and commercial banking services, including the acceptance of demand, savings, and time deposits; making secured and unsecured loans; issuing letters of credit; and offering fee based services. In addition, VNB offers a wide range of trust and trust related services, including services as executor, trustee, administrator, custodian and guardian. VNB lending services include making real estate, commercial, industrial, agricultural and consumer loans. VNB also offers data processing services consisting primarily of payroll and automated clearing house for several outside clients. VNB provides financial and investment counseling to municipalities and school districts within its service area and also provides central depository, lending payroll and other banking services for such customers. VNB also provides safe deposit facilities, Master Card and Visa credit card services. Over ninety percent of VNB's loans are made to individuals and business which are located in or have properties in Vermont. VNB owns and operates 27 automated teller machines (ATMs) at its branch locations and 4 ATMs in other locations. In addition, VNB is a member of the Plus, Yankee 24, NYCE, and VISA networks and has access to the Honor, Cirrus, Discover, American Express and Master Card networks. According to the State Department of Banking, Insurance and Securities, as of September 30, 1993, 5 state-chartered savings banks, 11 state-chartered commercial banks and 9 national banks are located and do business in the State of Vermont, the area in which VNB conducts its business. As of such date, VNB had 12.3%, 12.7% and 12.5% of the total assets, loans and deposits, respectively, of these 25 banking institutions. VNB competes on the local and the regional levels with other commercial banks and financial institutions for all types of deposits, loans and trust accounts. Competitors include metropolitan banks and financial institutions based in southern New England and New York City, many of which have greater financial resources. In the retail market for financial services, competitors include other banks, credit unions, finance companies, thrift institutions and, increasingly, brokerage firms, insurance companies, and mortgage loan companies. In the personal and commercial trust business, competitors include mutual funds, insurance companies and investment advisory firms. VFSC and its subsidiary, on December 31, 1993, employed approximately 600 persons. VFSC enjoys good relations with its employees. A variety of employee benefits are available to officers and employees, including health, group life and disability income replacement insurance, a funded, non-contributory pension plan and an incentive savings and profit sharing plan. Impact of Inflation. The Consolidated Financial Statements and related consolidated financial data presented herein have been prepared in accordance with generally accepted accounting principles which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. The primary impact of inflation on the operation of the Company is reflected in increased operating costs. Unlike industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation. Interest rates generally move in the same direction and with the same magnitude as the expected rate of inflation. Management believes that continuation of its efforts to manage the rates, liquidity and interest sensitivity of the Company's assets and liabilities is necessary to generate an acceptable return. Supervision and Regulation. VFSC and VNB are subject to extensive regulation under federal and state banking laws and regulations. The following discussion of certain of the material elements of the regulatory framework applicable to banks and bank holding companies is not intended to be complete and is qualified in its entirety by the text of the relevant state and federal statutes and regulations. A change in the applicable laws or regulations may have a material effect on the business of VFSC and/or VNB. Regulation of VFSC General. As a bank holding company, VFSC is 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 "BHC Act"). Under the BHC Act, bank holding companies generally may not acquire 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. In addition, bank holding companies are generally prohibited under the BHC Act from engaging in non-banking activities, subject to certain exceptions. VFSC's activities are limited generally to the business of banking and activities determined by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto. The Federal Reserve Board has authority to issue cease and desist orders and assess civil money penalties against bank holding companies and their non-bank subsidiaries, officers, directors and other institution-affiliated parties and to remove officers, directors and other institution-affiliated parties to terminate or prevent unsafe or unsound banking practices or violations of laws or regulations. Interstate Acquisitions. Under the BHC Act, a bank holding may acquire a bank in another state only if the law of the state in which the bank to be acquired is located specifically authorizes such acquisition of an in-state bank by an out-of-state bank holding company. State legislation enacted in recent years has substantially lessened prior legislative restrictions on geographic expansion by bank holding companies from and into Vermont. For example, under nationwide interstate banking legislation which became effective in 1990, bank holding companies whose subsidiaries' banking operations are principally conducted in any state outside Vermont are now authorized to acquire Vermont banking organizations, provided that such companies' home states afford Vermont banking organizations reciprocal rights to acquire banks in such states. Dividends. The Federal Reserve Board has authority to prohibit bank holding companies from paying dividends if such payment would be an unsafe or unsound practice. The Federal Reserve Board has indicated generally that it may be an unsound practice for bank holding companies to pay dividends unless the bank holding company's net income over the preceding year is sufficient to fund the dividends and the expected rate of earnings retention is consistent with the organization's capital needs, asset quality, and overall financial condition. The payment of dividends by VFSC is also subject to the requirement that VFSC provide notification to the Federal Reserve Board at least 15 days prior to any proposed dividend action. This 15-day prior notice requirement imposed by the Federal Reserve Bank will continue until rescinded by the Federal Reserve Bank. VFSC's ability to pay dividends is dependent upon the flow of dividend income to it from VNB , which may be affected or limited by regulatory restrictions imposed by federal or state bank regulatory agencies. See "-Regulation of VNB-Dividends." VFSC has a policy to pay out over time 30% - - - 35% of net income to shareholders in the form of cash dividends. Earnings for prior years as well as prospective earnings are analyzed to determine compliance with this policy. Dividend payout rates for any one year may vary from this long term payout policy based on these analyses and projections of future earnings and future capital needs. For the three-year period ended December 31, 1993, an aggregate of $0.47 per share of dividends were declared. Earnings per share for the same period were $2.55. Certain Transactions by Bank Holding Companies with Their Affiliates. There are various legal restrictions on the extent to which bank holding companies and their non-bank subsidiaries can borrow, obtain credit from or otherwise engage in "covered transactions" with their insured depository institution subsidiaries. Such borrowings and other covered transactions by an insured depository institution subsidiary (and its subsidiaries) with its non-depository institution affiliates are limited to the following amounts: (a) in the case of any one such affiliate, the aggregate amount of covered transactions of the insured depository institutions and its subsidiaries cannot exceed 10% of the capital stock and surplus of the insured depository institution; (b) in the case of all affiliates, the aggregate amount of stock and surplus of the insured depository institution. "Covered transactions" are defined by statute for these purposes to include a loan or extension of credit to an affiliate, a purchase of or investment in securities issued by an affiliate, a purchase of assets from an affiliate unless exempted by the Federal Reserve Board, the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any person or company, or the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. Covered transactions are also subject to certain collateral security requirements. Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection with any extension of credit, lease or sale of property of any kind, or furnishing of any service. Holding Company Support of Subsidiary Banks. Under Federal Reserve Board policy, VFSC is expected to act as a source of financial strength to VNB and to commit resources to support VNB. This support of VNB may be required at times when, absent such Federal Reserve Board policy, VFSC might not otherwise 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 certain other indebtedness of such subsidiary banks. 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 capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. Under the Federal Deposit Insurance Act, as amended ("FDI ACT"), an FDIC-insured depository institution, such as VNB 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 depository institution in "danger of default". For these purposes, the term "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 without Federal regulatory assistance. Regulation of VNB General. As a national bank, VNB is subject to supervision of and regulation by the Office of the Comptroller of the Currency (the "OCC"). Examinations and Supervision. The OCC regularly examines the operations of VNB, including but not limited to its capital adequacy, reserves, loans, investments, earnings, liquidity, compliance with laws and regulations, record of performance under the Community Reinvestment Act and management practices. In addition, VNB is required to furnish quarterly and annual reports of income and condition to the FDIC and periodic reports to the OCC. The enforcement authority of the FDIC includes the power to impose civil money penalties, terminate insurance coverage, remove officers and directors and issue cease-and-desist orders to prevent unsafe or unsound practices or violations of laws or regulations governing its business. In addition, under recent federal banking legislation, the FDIC has authority to impose additional restrictions and requirements with respect to banks that do not satisfy applicable regulatory capital requirements. See "Recent Banking Legislation-Prompt Corrective Action" below. Dividends. The principal source of VFSC's revenue is dividends from VNB. At December 31, 1993, VNB had available approximately $8.8 million for payment of dividends to VFSC under regulatory guidelines. The FDIC has authority to prevent VNB from paying dividends if such payment would constitute an unsafe or unsound banking practice or reduce its capital below safe and sound levels. In addition, recently enacted federal legislation prohibits FDIC-insured depository institutions from paying dividends or making capital distributions that would cause the institution to fail to meet minimum capital requirements. See "Recent Banking Legislation-Prompt Corrective Action" below. Affiliate Transactions. VNB is subject to restrictions imposed by federal law on extensions of credit to, purchases from, and certain other transactions with, affiliates, and on investments in stock or other securities issued by affiliates. Such restrictions prevent VNB from making loans to affiliates unless the loans are secured by collateral in specified amounts and have terms at least as favorable to the bank as the terms of comparable transactions between the bank and non-affiliates. Further, federal laws significantly restrict extensions of credit by VNB to its directors, executive officers and principal stockholders and related interests of such persons. Deposit Insurance. VNB's deposits are insured by the Bank Insurance Fund ("BIF") of the FDIC to the legal maximum of $100,000 for each insured depositor. The Federal Deposit Insurance Act provides that the FDIC shall set deposit insurance assessment rates on a semi-annual basis at a level sufficient to increase the ratio of BIF reserves to BIF-insured deposits to at least 1.25% over a 15-year period commencing in 1991. The FDIC has recently established a framework of risk-based insurance assessments to accomplish this increase. See "Recent Banking Legislation-Risk-Based Deposit Insurance Assessments" below. The BIF insurance assessments may be increased further in the future if necessary to restore and maintain BIF reserves. Federal Reserve Board Policies. The monetary policies and regulations of the Federal Reserve Board have had a significant effect on the operating results of banks in the past and are expected to continue to do so in the future. Federal Reserve Board Policies affect the levels of bank earnings on loans and investments and the levels of interest paid on bank deposits through the Federal Reserve System's open-market operations in United States government securities, regulation of the discount rate on bank borrowings from Federal Reserve Banks and regulation of non-earning reserve requirements applicable to bank deposit account balances. Consumer Protection Regulation; Bank Secrecy Act. Other aspects of the lending and deposit business of VNB that are subject to regulation by the FDIC, the Commissioner and the OCC include disclosure requirements with respect to interest, payment and other terms of consumer and residential mortgage loans and disclosure of interest and fees and other terms of and the availability of funds for withdrawal from consumer deposit accounts. In addition, VNB is subject to federal and state laws and regulations prohibiting certain forms of discrimination in credit transactions, and imposing certain record keeping, reporting and disclosure requirements with respect to residential mortgage loan applications. In addition, VNB is subject to federal laws establishing certain record keeping, customer identification, and reporting requirements with respect to certain large cash transactions, sales of travelers checks or other monetary instruments and the international transportation of cash or monetary instruments. Capital Requirements General. The FDIC has established guidelines with respect to the maintenance of appropriate levels of capital by FDIC-insured banks. The Federal Reserve Board has established substantially identical guidelines with respect to the maintenance of appropriate levels of capital, on a consolidated basis, by bank holding companies. If a banking organization's capital levels fall below the minimum requirements established by such guidelines, a bank or bank holding company will be expected to develop and implement a plan acceptable to the FDIC or the Federal Reserve Board, respectively, to achieve adequate levels of capital within a reasonable period, and may be denied approval to acquire or establish additional banks or non-bank businesses, merge with other institutions or open branch facilities until such capital levels are achieved. Recently enacted Federal legislation requires federal bank regulators to take "prompt corrective action" with respect to insured depository institutions that fail to satisfy minimum capital requirements and imposes significant restrictions on such institutions. See "Recent Banking Legislation-Prompt Corrective Action" below. Leverage Capital Ratio. The regulations of the FDIC require FDIC-insured banks to maintain a minimum "leverage Capital Ratio" or "Tier 1 Capital" (as defined in the Risk-Based Capital Guidelines discussed in the following paragraphs) to Total Assets of 3.0%. The regulations of the FDIC state that only banks with the highest federal bank regulatory examination rating will be permitted to maintain an additional margin of capital, equal to at least 1% to 2% of Total Assets, above the minimum ratio. Any bank experiencing or anticipating significant growth is expected to maintain capital well above the minimum levels. The Federal Reserve Board's guidelines impose substantially similar leverage capital requirements on bank holding companies on a consolidated basis. Risk-Based Capital Requirements. The regulations of the FDIC also require FDIC-insured banks to maintain minimum capital levels measured as a percentage of such banks' risk-adjusted assets. A bank's capital for this purpose may include two components - "Core" (Tier 1) Capital and "Supplementary" (Tier 2) Capital. Core Capital consists primarily of common stockholders' equity, which generally includes common stock, related surplus and retained earnings, certain non-cumulative perpetual preferred stock and primarily goodwill. Supplementary Capital elements include, subject to certain limitations, a portion of the allowance for losses on loans and leases, perpetual preferred stock that does not qualify for inclusion in Tier 1 capital, long-term preferred stock with an original maturity of at least 20 years for issuance and related surplus, certain forms of perpetual debt and mandatory convertible securities, and certain forms of subordinated debt and intermediate-term preferred stock. The risk-based capital rules of the FDIC and the Federal Reserve Board assign a bank's balance sheet assets and the credit equivalent amounts of the bank's off-balance sheet obligations to one of four risk categories, weighted at 0%, 20%, 50% or 100%, respectively. Applying these risk-weights to each category of the bank's balance sheet assets and to the credit equivalent amounts of the bank's off-balance sheet obligations and summing the totals results in the amount of the bank's total Risk-Adjusted Assets for purposes of the risk-based capital requirements. Risk-Adjusted Assets can either exceed or be less than reported balance sheet assets, depending on the risk profile of the banking organization. Risk-Adjusted Assets for institutions such as VNB will generally be less than reported balance sheet assets because its retail banking activities include proportionally more residential mortgage loans with a lower risk weighting and relatively smaller off-balance sheet obligations. Effective as of December 31, 1992, the risk-based capital regulations require all banks to maintain a minimum ratio of Total Capital to Risk-Adjusted Assets of 8.0%, of which at least one-half (4.0%) must be Core (Tier 1) Capital. For the purpose of calculating these ratios: (i) a banking organization's Supplementary Capital eligible for inclusion in Total Capital is limited to no more than 100% of Core Capital; and (ii) the aggregate amount of certain types of Supplementary Capital eligible for inclusion in Total Capital is further limited. The regulations limit the portion of the allowance for loan losses eligible for inclusion in Total Capital to 1.25% of Risk-Adjusted Assets. The Federal Reserve Board has established substantially identical risk-based capital requirements to be applied to bank holding companies on a consolidated basis. At December 31, 1993, VFSC's consolidated Total and Tier 1 Risk-Based Capital Ratios were 11.40% and 10.14%, respectively. These ratios exceeded applicable regulatory requirements. Recent Banking Legislation General. On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted. The FDICIA extensively revised the regulatory and funding provision of the FDI Act and made revisions to several federal banking statutes. Certain of these changes are summarized below. Prompt Corrective Action. Among other things, FDICIA requires the federal banking regulators to take "prompt corrective action" with respect to, and imposes significant restrictions on, any bank that fails to satisfy its applicable minimum capital requirements. FDICIA establishes five capital categories consisting of "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." Under applicable regulations, a bank that has a Total Risk-Based Capital Ratio of 10.0% or greater, a Tier Risk-Based Capital Ratio of 6.0% or greater and a leverage Capital Ratio of 5.0% or greater, and is not subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure is deemed to be "well capitalized." A bank that has a Total Risk-Based Capital Ratio of 8.0% or greater, a Tier 1 Risk-Based Capital Ratio of 4.0% or greater and a Leverage Capital Ratio of 4.0% or greater and does not meet the definition of a well capitalized bank is considered to be "adequately capitalized." A bank that has a Total Risk-Based Capital Ratio of less than 8.0% or has a Tier 1 Risk-Based Capital Ratio that is less than 4.0% (or a Leverage Capital Ratio of less than 4.0%) is considered "undercapitalized." A bank that has a Total Risk-Based Capital Ratio of less than 6.0%, or a Tier 1 Risk-Based Capital Ratio that is less than 3.0% or a Leverage Capital Ratio that is less than 3.0% is considered to be "significantly undercapitalized", and a bank that has a ratio of tangible equity to total assets equal to or less than 2% is deemed to be "critically undercapitalized." A bank may be deemed to be in a capital category lower than is indicated by its actual capital position if it is determined to be in an unsafe or unsound condition or receives an unsatisfactory examination rating. At December 31, 1993, VNB's ratio of tangible equity to assets as calculated under the prompt correction action rule was 6.88%. FDICIA generally prohibits a bank from making capital distributions (including payment of dividends) or paying management fees to controlling stockholders or their affiliates, if, after such payment, the bank would be undercapitalized. Under FDICIA and the applicable implementing regulations, an undercapitalized bank will be (i) subject to increased monitoring by the FDIC; (ii) required to submit to the FDIC an acceptable capital restoration plan within 45 days, (iii) subject to strict asset growth limitations; and (iv) required to obtain prior regulatory approval for certain acquisitions, transactions not in the ordinary course of business, and entry into new lines of business. In addition to the foregoing, the FDIC may issue a "prompt corrective action directive" to any undercapitalized institution. Such a directive may require sale or recapitalization of the bank, impose additional restrictions on transactions between the bank and its affiliates, limit interest rates paid by the bank on deposits, limit asset growth and other activities, require divestiture of the subsidiaries, require replacement of directors and officers, and restrict capital distributions by the bank's parent holding company. In addition to the foregoing, a significantly undercapitalized institution may not award bonuses or increases in compensation to its senior executive officers until it has submitted an acceptable capital restoration plan and received approval from the FDIC. Not later than 90 days after an institution becomes critically undercapitalized, the appropriate federal banking agency for the institution must appoint a receiver or, with the concurrence of the FDIC, a conservator, unless the agency, with the concurrence of the FDIC, determines that the purposes of the prompt corrective action provisions would be better served by another course of action. FDICIA requires that any alternative determination be "documented" and reassessed on a periodic basis. Notwithstanding the foregoing, a receiver must be appointed after 270 days unless the appropriate federal banking agency and the FDIC certify that the institution is viable and not expected to fail. Risk-Based Deposit Insurance Assessments. Effective January 1, 1993, a transitional risk-based structure was implemented by the FDIC pursuant to the FDICIA and the average assessment rate paid by Savings Association Insurance Fund-insured and BIF-insured institutions was increased. Under the rule implementing the transitional system, the FDIC assigns an institution to one of three capital categories consisting of (1) well capitalized, (2) adequately capitalized, or (3) undercapitalized, and one of three supervisory categories. An institution's assessment rate depends on the capital category and supervisory category to which it is assigned. Under the transitional system, there are nine assessment risk classifications (i.e., combinations of capital categories and supervisory subgroups within each capital group) to which differing assessment rates are applied. Assessment rates will range from 0.23% of deposits for an institution in the highest category (i.e., well-capitalized and healthy from a supervisory standpoint) to 0.31% of deposits for an institution in the lowest category (i.e., undercapitalized and substantial supervisory concern). The risk classification to which an institution is assigned by the FDIC is confidential and may not be disclosed. On June 17, 1993, the FDIC adopted a final rule establishing a new risk-based system that will be implemented beginning with the semi-annual assessment period commencing on January 1, 1994, as required under FDICIA. Except for limited changes, the structure of the new risk-based system will be substantially the same as the structure of the transitional system it will replace. Under the FDIC rule implementing the new risk-based system, an institution's deposit insurance assessment rate will be determined by assigning the institution to a capital category and a supervisory subgroup to determine which one of the nine risk classification categories is applicable, in substantially the same manner as for the transitional system discussed above. The FDIC is authorized to raise the assessment rates in certain circumstances. If the FDIC determines to increase the assessment rates for all institutions, institutions in all risk categories could be affected. The FDIC has exercised this authority several times in the past and may raise BIF insurance premiums again in the future. If such action is taken by the FDIC, it could have an adverse effect on the earnings of VFSC, the extent of which is not currently quantifiable. Brokered Deposits and Pass-Through Deposit Insurance Limitations. Under FDICIA, a bank cannot accept brokered deposits unless it either (i) is "Well Capitalized" or (ii) is "Adequately Capitalized" and has received a written waiver from the FDIC. For this purpose, "Well Capitalized" and "Adequately Capitalized" are defined the same as under the Prompt Corrective Action regulations. See "-Prompt Corrective Action" above. Banks that are not in the "Well Capitalized" category are prohibited from offering rates of interest on deposits that are more than 75 basis points above prevailing deposits. Pass-through insurance coverage is not available for deposits of certain employee benefits plans in banks that do not satisfy the requirements for acceptance of brokered deposits, except that pass-through insurance coverage will be provided for employee benefit plan deposits in institutions which at the time of acceptance of the deposit meet all applicable regulatory requirements and send written notice to their depositors that their funds are eligible for pass-through deposit insurance. Real Estate Lending Standards. FDICIA requires the federal bank regulatory agencies to adopt uniform real estate lending standards. The FDIC recently adopted implementing regulations which establish supervisory limitations on Loan-to-Value ("LTV") ratios in real estate loans by FDIC-insured banks. The regulations require FDIC-insured banks to establish LTV ratio limitations within or below the prescribed uniform range of supervisory limits. Standards for Safety and Soundness. FDICIA requires the federal bank regulatory agencies describe, by regulation, standards for all insured depository institutions and depository institution holding companies relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit 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 that could lead to material financial loss. In addition, the federal bank regulatory agencies are required by FDICIA to prescribe 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. Consumer Protection Provisions. FDICIA also includes provisions requiring advance notice to regulators and customers for any proposed branch closing and authorizing (subject to future appropriation of the necessary funds) reduced insurance assessments for institutions offering "lifeline" banking accounts or engaged in lending in distressed communities. FDICIA also includes provisions requiring depository institutions to make additional and uniform disclosures to depositors with respect to the rates of interest, fees and other terms applicable to consumer deposit accounts. The United States Congress has periodically considered and adopted legislation which has resulted in and could result in further regulation or deregulation of both banks and other financial institutions. Such legislation could place VNB in more direct competition with other financial institutions, including mutual funds, securities brokerage firms and investment banking firms. No assurance can be given as to whether any additional legislation will be enacted or as to the effect of such legislation on the business of VNB. Item 2 Item 2 - Properties The principal offices of the Company and the Bank are located at 100 Main Street in Brattleboro, Vermont. The Bank operates 31 other locations in the Counties of Chittenden, Washington, Rutland, Bennington, Franklin, Windsor, Orange and Windham. Eight offices are located in Windham County - The Main Office and two branches in Brattleboro, and offices in Bellows Falls, Jamaica, Newfane, West Dover and Wilmington. An office is operated in Bennington County in the Town of Bennington, and five offices operate in Chittenden County in the City of Burlington, two in South Burlington, Essex Junction Winooski. The Bank has six offices in Windsor County in the Towns of Chester, Ludlow, Springfield, White River Junction, Windsor and Woodstock. Four facilities are located in Rutland County, three in Rutland and one in Fair Haven. Six offices are located in Washington County, one each located on State Street and Main Street in Montpelier, the Berlin Shopping Mall, the Vermont Shopping Center in Berlin, Northfield and Barre. One office is operated in Franklin County in the town of St. Albans and one office is located in Orange County in the town of Williamstown. Of these offices, seventeen are owned by the Bank, twelve are leased directly from independent parties as lessors, and two buildings are owned by the Bank, but are situated on leased land. The Bank also owns and occupies a building in Brattleboro which it uses for its operational functions. The Company and Bank do not own any other real estate, except real estate that may be held temporarily following a foreclosure in connection with loan business. See Notes 5 and 8 to the Consolidated Financial Statements for information as to amounts at which bank premises are carried, and as to commitments for lease obligations. Item 3 Item 3 - Legal Proceedings VFSC is a party to litigation arising in the ordinary course of its business. Management, after reviewing these claims with legal counsel, is of the opinion that these matters, when resolved, will not have a material effect on VFSC's consolidated financial condition or results of operation, including quarterly earnings. Item 4 Item 4 - Submission of Matters to a Vote of Security Holders No matter was submitted during the fourth quarter to a vote of security holders. PART II Item 5 Item 5 - Market for Registrant's Common Equity and Related Stockholder Matters As of February 28, 1994, VFSC Common Stock consisted of 20,000,000 authorized shares, $1.00 par value per share, of which 3,417,829 were issued and outstanding (exclusive of treasury shares). VFSC Common Stock is traded on NASDAQ-NMS. The transfer agent and registrar for VFSC Common Stock is VNB. Presented below is the range of market prices paid on Common Stock of Vermont Financial Services Corp. for each quarter in 1993 and 1992. Dividends Year Quarter High Low Declared 1993 4th $19-1/4 $16-3/4 $.08 3rd 19-1/2 17 .08 2nd 23 16-1/2 .08 1st 21 14-1/2 - 1992 4th $16-3/8 $13-1/2 .08 3rd 16-1/4 13 - 2nd 17-7/8 14-1/2 - 1st 19-1/2 9 - Per the Bank's stockholder reports, the approximate number of stockholders as of January 24, 1994 was 2,200. Item 6 Item 6 - Selected Financial Data The following table sets forth selected data regarding the Company's operating results and financial position. This data should be read in conjunction with Management's Discussion and Analysis and the Consolidated Financial Statements and Notes thereto. The results of operations, per share data and the total cash dividends, allowance for loan losses and nonperforming assets ratios as of and for the five years ended December 31, 1993 are derived from the financial statements of the Company which have been audited by Coopers & Lybrand, independent certified public accountants. The financial condition and operations of the Company essentially reflect the operations of Vermont National Bank. (1)Net interest income stated on a fully taxable equivalent basis divided by average earning assets. (2)Equal to stockholders' equity less intangilbes divided by total assets less intangibles. (3)Equal to stockholders' equity less intagnibles plus the allowable portion of the allowance for loan losses divided by total risk weighted assets. (4)Nonperforming assets include nonaccrual loans, restructured loans and other real estate owned. Item 7 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations For the years ended December 31, 1993, 1992 and 1991. Overview Net income for 1993 was $4.8 million, up from the $3.8 million and $184,000 earned in 1992 and 1991, respectively. Return on average assets was 0.52% in 1993, 0.42% in 1992 and 0.02% in 1991. Return on average stockholders' equity was 7.35% in 1993, 6.20% in 1992 and 0.32% in 1991. On a primary and fully diluted per share basis, net income was $1.40, $1.10 and $0.05 in 1993, 1992 and 1991, respectively. Results of Operations Net Interest Income The following table presents the major categories of earning assets and interest-bearing liabilities with their corresponding average balances, related interest income or expense and resulting yields and rates on a fully taxable equivalent basis for the years indicated. (1) Includes a fully taxable equivalent adjustment based on a 34% federal income tax rate. (2) Nonaccrual loans are included in the average amounts outstanding. (3) The difference between the rate earned on total earning assets and the rate paid on total interest-bearing liabilities. Net interest income increased $3.1 million or 8.1% to $41.6 million in 1993 from $38.5 million in 1992. This compared to a $2.2 million or 6.1% increase in 1992 from 1991. On a fully taxable equivalent basis, net interest income increased $3.3 million or 8.6% from 1992 to 1993 and $1.9 million or 5.2% from 1991 to 1992. The increase in 1993 was primarily caused by the following: First, total earning assets increased $16.1 million while total interest-bearing liabilities only rose $5.3 million as nonperforming asset levels decreased. Second, the rate paid on interest-bearing liabilities decreased 1.10% while the rate earned on earning assets only decreased 0.74%. During 1990 and 1991 banks in New England generally paid premium rates for deposits. These premiums narrowed in 1992 and 1993. In addition, the Company's growth in savings and transactional deposits and the ability to attract low cost securities sold under agreements to repurchase allowed it to reduce its reliance on higher cost certificates of deposit and other time deposits of $100,000 or more and under $100,000. Average earning assets increased slowly over the last two years with 2.0% and 1.4% growth rates in 1993 and 1992, respectively. The 1993 growth came from loans, primarily in the municipal area. Average interest-bearing liabilities increased $5.3 million, or 0.7% in 1993 following a $10.9 million, or 1.5% growth in 1992. Over the two-year period, average core interest-bearing deposits (savings and transactional deposits and certificates of deposit and other time deposits under $100,000) increased by $56.8 million. Non-core interest-bearing liabilities were reduced by $40.6 million over the same period. In spite of rate fluctuations, the Company's net interest margin had been between 5.01% and 5.09% from 1987 to 1989. Continued weakness in the New England and Vermont economies in 1990 and 1991 resulted in higher levels of nonaccrual loans and nonearning assets for 1990 and 1991. This resulted in a loss of interest income and a reversal of previously accrued interest on loans placed on nonaccrual status. This, combined with the premium rates paid for deposits in New England in 1991 and 1990, resulted in net interest margins of 4.63% and 4.50% for 1991 and 1990, respectively. During 1992, the reduction of the New England premium rates and higher loan fees in the mortgage area (see discussion of mortgage activity following) led to an improved margin of 4.79%. Continued strong loan fees, a reduction in the level of nonperforming assets and an improved net interest spread as discussed above resulted in a margin of 5.10% in 1993. Management expects some deterioration in this rate in 1994 as competition leads to a lower interest spread. The following table provides an analysis of the variances in net interest income, on a fully taxable equivalent basis, attributable to changes in volume and rate. Volume variances are calculated by multiplying the preceding year's rate by the current year's change in the average balance. Rate variances are calculated by multiplying the current year's change in rate by the prior year's average balance. (1) The effect of changes due to both volume and rate have been allocated to the change in volume and change in rate categories in proportion to the relationship of the absolute dollar amounts of the change in each category. (2) Includes nonaccrual loans. Provision for Loan Losses The provision for loan losses charged to operating expense is based upon management's judgment of the amount necessary to maintain the allowance for loan losses at a level adequate to absorb possible losses. The factors evaluated include, but are not limited to: the size, composition, growth and quality of the loan portfolio, specific and potential problem loans, current economic conditions and their effect on a borrower's performance in relation to contract terms, historical loss experience by loan type and loan collectibility. The provision for loan losses in 1993 was $4.9 million compared to $7.5 million in 1992 and $14.4 million in 1991. Net loans charged off were $8.2 million, $7.0 million and $10.3 million for the respective years. The $6.9 million reduction in the provision for 1992 was principally due to 1) the lower level of charge-offs (See "Allowance for Loan Losses" section following), 2) a small reduction in the level of nonperforming assets (See "Nonperforming Assets and Risk Elements" section following) and 3) management's view that the Vermont economy began a slow recovery near the end of 1992. The provision was reduced an additional $2.6 million in 1993 as nonperforming asset levels improved significantly, and the Vermont economy continued to improve. Other Operating Income and Other Operating Expense In 1993, other operating income increased $2.5 million, or 18%, from the $13.9 million earned in 1992. Net of the $1.1 million increase in securities gains, other operating income was up $1.4 million, or 11%, compared to 1992. In 1992, other operating income increased $595,000, or 4.5% over 1991. The two major items representing the increase were service charges on deposit accounts and securities gains. Respectively, they contributed $446,000 and $374,000 to the increase. Noninterest income is expected to continue to grow at a similar pace in 1994. Total other operating expense increased $6.8 million, or 17%, in 1993 and $4.2 million, or 12% in 1992. Net OREO and collection expenses and losses represented $4.1 million, or 61%, and $1.6 million, or 38% of the increases in 1993 and 1992, respectively. As a result of the reduction of nonperforming assets achieved in 1993, management expects a significant reduction of this expense in 1994. Pension and other employee benefits increased $1.1 million in 1993 due to 1) a $497,000 increase in early retirement and termination costs, 2) a $114,000 profit sharing allocation as a result of the Company 25% match of employees' contributions to the Company's 401k plan, 3) a $152,000 increase in medical insurance payments, 4) a $146,000 increase in the cost of the Company's supplemental executive officers' retirement plan due to decreasing the discount rate used to calculate benefits from 9% to 7-1/2% and 5) a $98,000 increase in pension expense. The discount rate that will be used to calculate pension and other employee benefits for 1994 will be 7% versus 7-1/2% in 1993. Although a decrease in the discount rate will increase the costs of the associated benefits, management expects that it will not be significant. Salary expense was $16.3 million in 1993, $15.8 million in 1992 and $14.6 million in 1991, increases of 3% and 8%, respectively. Applicable Income Taxes During 1993 and 1992 the Company recorded income tax expense of $1.7 million and $1.3 million respectively, versus a benefit of $0.6 million in 1991. The change was almost entirely due to the level of pre-tax earnings. See footnotes 1 and 9 to the financial statements. Financial Condition Loans Over the past two years the loan portfolio has increased $25.3 million, or 3.8%. Of the $23.0 million increase in commercial loans over the two year period, $21.5 million has resulted from a higher level of municipal loans. Residential loans and consumer loans are up $14.2 million and $9.2 million, respectively over the period while construction and commercial loans secured by real estate are down $21.1 million. Loans, net of unearned income, totaled $689.3 million at December 31, 1993 and represented 73.8% of total assets compared to 75.4% and 74.3% in 1992 and 1991, respectively. In structuring the composition of its loan portfolio, the Company considers the following factors: profitability, liquidity, risk, rate sensitivity and service in its market area. The Bank makes commercial business loans to small and medium sized companies in Vermont and is the leading commercial lender in the State. Construction and commercial loans secured by real estate include loans secured by residential and commercial properties, office and industrial buildings, condominium development and land development properties. The Company limits both of these types of lending activities and the properties securing these loans to its primary market area in Vermont and adjacent communities in neighboring states. Over 60% of the commercial real estate portfolio represents loans on owner occupied properties. Real estate values in Vermont have been depressed as a result of the recent recession in New England and the Nation, but have experienced some recent improvement. Management's goal is to keep the construction loan portion of the loan portfolio below 5% of total loans. As of December 31, 1993 this sector represented 3.3% of the portfolio. Residential real estate loans increased 2.9% to $222.9 million in 1993 and 3.7% to $216.5 million in 1992. The lack of growth in this portfolio reflects the Company's strategy to originate fixed-rate mortgage loans for sale in the secondary market, while retaining servicing on such loans. Also included in this category are home equity loans which totaled $37.1 million, $38.5 million and $39.6 million on December 31, 1993, 1992 and 1991, respectively. In 1993, the Bank originated $231.3 million of residential mortgage loans and sold $189.7 million of loans in the secondary market, compared to $235.6 million originated and $192.1 million sold in 1993 and $144.4 million originated and $117.0 million sold in 1991. The high levels of the last two years in part reflect lower interest rates which led to a significant number of mortgage refinancings. This trend is expected to subside in 1994 due to anticipated interest rate increases. At year end 1993, the mortgage servicing portfolio totaled $438.9 million compared to $416.9 million at year end 1992 and $369.1 million at year end 1991 and currently generates income of approximately $2.0 million per year. Of the residential real estate portfolio, 72.8% were adjustable rate loans and 27.2% were fixed rate loans. Residential real estate loans represented 32.3%, 32.1% and 31.9% of gross loans at year end 1993, 1992 and 1991, respectively. Consumer loans represented 13.4%, 12.7% and 12.7% of gross loans at year end 1993, 1992 and 1991, respectively. It is the Company's strategy to increase the size of the consumer portfolio at a faster rate than either the commercial or real estate portfolios during 1994. Credit card loans and related plans were $36.9 and $28.2 million of total consumer loans at December 31, 1993 and 1992, respectively. The following table summarizes the compositions of the Company's loan portfolio at the dates indicated. (1) Includes loans to Vermont municipalities and industrial revenue bonds of $30,339, $13,680, $8,857, $11,767 and $14,517 for years 1993 through 1989, respectively. The following table details the loan maturity and interest rate sensitivity of loans, exclusive of loans secured by 1-4 family residential property and consumer loans, at December 31, 1993. Nonperforming Assets and Risk Elements It is the Company's policy to manage the loan portfolio so as to recognize and respond to problem loans at an early stage and thereby minimize losses. All new loan originations, loan renewals, loans categorized as past due and classified loans are reviewed on a weekly basis by the administrative officers in charge of the commercial, mortgage and consumer loan portfolios. In turn, the status of these loans is reported in detail to senior management and the Loan Committee of the Board of Directors on a monthly basis. From these reviews, determinations are made on a case-by-case basis as to the collectibility of principal and interest. Nonreceipt of contractually due principal or interest payments on loans 30 days after the due date results in their being reported as past due with increased monitoring and collecting efforts to restore such loans to current status. Mortgage loans are classified as nonaccrual and placed on a cash basis for purposes of income recognition when they become 180 days past due or when foreclosure action is started. Commercial loans are placed on nonaccrual status and placed on a cash basis when they become 90 days past due as to principal or interest, unless they are adequately collateralized or are expected to result in collection within the next 60 days. While no specific period of delinquency triggers nonaccrual status for consumer loans, unsecured installment loans 90 days or more past due and secured installment loans 180 days or more past due are generally recommended for charge-off. A loan remains in nonaccrual status until the factors which indicate doubtful collectibility no longer exist and six consecutive months of contractual payments are received or until the loan is determined to be uncollectible and is charged off against the allowance for loan losses. Credit card loans are required to be charged off after 180 days without a payment. Commercial loans 180 days or more past due must be recommended for charge-off unless management determines the collateral is sufficient. When a mortgage loan in default is transferred to OREO, its carrying value is the lesser of the loan amount or the fair value of the property collateralizing the loan, less the estimated cost to sell the property. A loan is classified as a restructured loan when the interest rate is materially reduced or when the term is extended beyond the original maturity date because of the inability of the borrower to service the interest payments at the contractual rate. All of the $1.5 million of accruing restructured loans as of December 31, 1993 were in full compliance with restructured terms and conditions. An additional $4.3 million of loans have been restructured and are in full compliance with restructured terms and conditions. However, as there remains some doubt as to the ultimate collectibility of all principal and interest on these loans, they are classified as nonaccrual as of December 31, 1993 in the table below. The average yield on these loans is 5.1% with $2.7 million of the balance at a rate of interest below the current market. The following table provides information with respect to the Company's past due loans and the components of nonperforming assets at the dates indicated. In December 1993, $5.5 million of insubstance foreclosures (ISF) were transferred from OREO to loans and are included with nonaccrual loans in the above table. Prior years' ISF loans have been reclassified accordingly. Interest income of $1,765,000 and $2,161,000 would have been recorded in 1993 and 1992, respectively, if nonaccrual and restructured loans had been on a current basis in accordance with their original terms. No interest income was recorded on nonaccrual loans during 1993 or 1992. All payments, totaling $818,000 and $668,000, respectively were applied as principal reductions. At December 31, 1993, all nonaccrual loans were collateralized. In addition, it is the Company's policy to obtain personal guarantees of the principals whenever it is possible. As of December 31, 1993, 36% of the total nonaccrual loans are current as to contractual terms. Loans to three borrowers, totaling $4.9 million represented 24% of nonaccrual loans. Management expects to see improvement in 1994 over the 1993 charged-off loan total with a further decrease in the level of nonperforming assets. Management is not aware of any current recommendations by regulatory authorities or suggestions with respect to loans classified as loss, doubtful, substandard or special mention which, if they were implemented, would have a material effect on the Company. Allowance for Loan Losses The allowance for loan losses is available to absorb future losses which are anticipated in the current loan portfolio. The adequacy of the allowance for loan losses, which is formally reviewed on a monthly basis by management, is evaluated according to the factors outlined in "Provision for Loan Losses". To maintain the allowance at an adequate level, current earnings are charged with an amount necessary to restore the allowance to the desired level. A loan loss is charged against the allowance when management believes the collectibility of principal and interest with respect to such loan is unlikely. The allowance for loan losses equalled $14.6 million, or 2.11% of the total loan portfolio at December 31, 1993, compared with 2.65% at year end 1992 and 2.66% at year end 1991. On December 31, 1993 the allowance for loan losses represented 58% of total nonperforming assets and 65% of nonperforming loans, compared to 45% and 57%, respectively, at year end 1992. The following table provides an analysis of the allowance for loan losses and an analysis of loans charged off and recoveries by type of loan and for the years indicated. Net loans charged off in 1993 totaled $8,234,000 or 1.20% of average loans. This compares with $7,017,000 or 1.05% in 1992 and $10,316,000 or 1.55% in 1991. In 1993 and 1992, no loan charged off exceeded 10% of the net loans charged off during the year. In 1991 loans charged off for one customer totaled $1,125,000. No other charge-offs exceeded 10% of the year's total. The increase in charge-offs for 1993 is consistent with the decrease in nonperforming assets noted above. Management entered into certain stipulated agreements and took deeds in lieu of foreclosure in order to speed up the foreclosure process. While this strategy reduced the ultimate cost of these problem assets, it did increase the charge-offs for 1993. While all segments of the Company's loan portfolio are subject to continuous quality evaluation, there is no precise method for predicting loan losses. An evaluation of the collectibility of a loan requires the exercise of management's judgment. Since the determination of the adequacy of the allowance is necessarily judgmental and involves consideration of various factors and assumptions, management is of the opinion that an allocation of the reserve is not necessarily indicative of the specific amount of future charge-offs or the specific loan categories in which these charge-offs may ultimately occur. The following table summarizes the allocation of the allowance for loan losses at December 31, 1993, 1992, 1991, 1990 and 1989. Notwithstanding these allocations, the entire allowance for loan losses is available to absorb charge-offs in any category of loans. Also during the last four years, management provided an unallocated allowance for expected charge-offs not specifically identified in the loan portfolio. Investment Portfolio The investment portfolio is utilized primarily for liquidity and secondarily for investment income. As a result, the portfolio is primarily comprised of short-term U. S. Treasury instruments and high grade municipal obligations, mortgage-backed securities and corporate bonds with short maturities. These various segments of the investment portfolio and their related income are reported monthly to the Company's Board of Directors. The following table summarizes the composition of the Company's investment portfolio at the dates indicated. The investment portfolio increased 25.0% to $161.2 million at year end. During 1992 the portfolio decreased 11.9% to $129.0 million at year end. The total portfolio as a percent of total assets was 17.3% at year end 1993 compared to 14.2% and 16.4% at year end 1992 and 1991, respectively. On December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (See Note 1 to the Consolidated Financial Statements). Securities are carried at fair market value at December 31, 1993 in the above tables. The other two year's values reflect the amortized cost of the securities at the respective dates. During 1993 the Company and national economy saw record low interest rates and record high repayments in the mortgage-backed securities portfolio. These mortgage-backed securities include newly issued and seasoned securities of government housing agencies and those portions of agency-backed collateralized mortgage obligations with relatively short and stable average lives. During 1993 management reinvested the proceeds of sales and prepayments in this portfolio. Additional funds were primarily invested in U. S. Treasury and other U. S. government agency securities. The average maturity of the investment portfolio remains at approximately 3-1/2 years. The Company invests a portion of its capital in marketable equity securities which comprised 3.0%, 3.7% and 3.0% of total investments at December 31, 1993, 1992 and 1991, respectively. The following table sets forth the maturities of the Company's investment securities at December 31, 1993 and the weighted average yields of such securities. Weighted average yields on tax exempt obligations have been computed on a fully taxable equivalent basis assuming a federal tax rate of 34%. The yields are calculated by dividing annual interest, net of amortization of premiums and accretion of discounts, by the book value of the securities at December 31, 1993. (1) Does not include equity securities of $4,849 at December 31, 1993. Deposits Average total deposits for 1993 of $755.2 million represented a $10.2 million, or 1.3%, decrease from 1992's average, which had decreased $5.0 million, or 0.6%, over 1991's average balances. The reduction for both years was due to management's decision to replace high cost certificates of deposit and other time deposits of $100,000 or more (large CDs) with less expensive deposits, securities sold under agreements to repurchase and other borrowings. The average balance of these large CDs was $29.3 million in 1993, $71.3 million in 1992 and $118.7 million in 1991. In 1993 this reduction was offset by a $31.8 million total increase in the average balance of all other deposit categories, considered core deposits by management. Large CDs represented 3.9% of average total deposits in 1993 versus 9.3% in 1992 and 15.4% in 1991. The majority of these deposits were obtained from local Vermont customers. Management expects to limit future asset growth primarily to the growth of core deposits as opposed to the more volatile large CDs and other borrowed funds. The following table summarizes the daily average amount of deposits for the years indicated, and rates paid on such deposits on the last day of the respective year. The following table shows the maturity schedule of certificates of deposit and other time deposits of $100,000 or more at December 31, 1993. Capital Resources The Company engages in an ongoing assessment of its capital needs in order to maintain an adequate level of capital to support business growth and ensure depositor protection. The Company's two sources of capital are internally generated funds and the capital markets. Primary reliance is on internally generated capital. Stockholders' equity as a percent of assets was 7.30%, 6.96% and 6.65% as of December 31, 1993, 1992 and 1991, respectively. Management's goal is to maintain a 7% equity to asset ratio so that the Company has sufficient capital to take advantage of expansion or capital opportunities that might arise. Average equity to average assets equalled 7.13% in 1993, 6.81% in 1992 and 6.63% in 1991. As a result of the Federal Deposit Insurance Corporation (FDIC) Improvement Act of 1991 (FDICIA), bank regulators have established uniform capitalization standards as per the following table. The ratios for the Company and the Bank as of December 31, 1993 and 1992 are shown for comparative purposes placing it in the "well capitalized" category at each respective date. FDIC insurance rates after 1992 vary depending on a bank's capital ratio and regulatory rating. Well-capitalized institutions will be assessed less than those that are adequately capitalized, which are in turn lower than the other categories. Liquidity and Interest Rate Sensitivity Liquidity measures the ability of the Company to meet its maturing obligations and existing commitments, to withstand fluctuation in deposit levels, to fund its operations and to provide for customers' credit needs. Liquidity is monitored by the Company on an ongoing basis. Ready asset liquidity is provided by cash and due from banks, sales of excess funds, loan repayments and an investment portfolio with short maturities and ready marketability. In addition, the Company has a strong core deposit base which supports a significant portion of its earning assets. Secondary liquidity is provided by the potential sale of loans and other assets, large certificates of deposit, short or long-term debt borrowings, federal funds purchased, repurchase agreements and borrowing from the Federal Reserve Bank. During 1990, the Bank became a member of the Federal Home Loan Bank (FHLB) and has a borrowing capability of approximately $132 million with the FHLB. During 1993, total loans and securities increased by $6 million and $32 million, respectively. These increases were primarily funded through a $44 million increase in core deposits (deposits other than certificates of deposit and other time deposits of $100,000 or more.) Effective asset/liability management includes maintaining adequate liquidity and minimizing the impact of future interest rate changes on net interest income. The Company attempts to manage its interest rate sensitivity position through the composition of its loan and investment portfolios and by adjusting the average maturity of and establishing rates on earning assets in line with its expectations for future interest rates. The Company endeavors to maintain a cumulative gap ratio in all periods under one year of approximately one to one. The following table summarizes the Company's interest rate sensitivity over various periods at December 31, 1993. (1) Does not include non-accrual loans of $20,761 at December 31, 1993. (2) Does not include equity securities of $4,849 at December 31, 1993. (3) Repricing dates for mortgage-backed securities are based upon estimated actual principal prepayments obtained from third party sources. Amounts differ from maturity distribution in Note 2 to the financial statements, which reports the original average life date for mortgage-backed securities. (4) Estimated based upon historical experience over the last five years. Money-market deposit accounts with an interest rate tied to an external index are included in the 0-30 day category. Recent Developments During 1994, the Company plans to open a new branch in Barre, Vermont and convert its computer software. The cost of these capital expenditures will be approximately $2 million. No other additions to premises or equipment are expected to exceed $500,000. All additions will be funded through the operations of the Company. The Company's financial statements will be affected by rules and regulations which have been announced but are not yet effective. The Financial Accounting Standards Board (FASB) has issued Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan". This Statement shall be effective for financial statements issued for fiscal years beginning after December 15, 1994. This Statement is not expected to have a material impact on the financial statements of the Company. The FASB has also issued SFAS No. 112 "Employers' Accounting for Postemployment Benefits", which is effective for the Company's 1994 financial statements. This statement's impact on the Company is expected to be immaterial. A recent District of Columbia federal court of appeals ruling, Chemical Manufacturers Association vs. Environmental Protection Agency No. 92-1314, potentially increased banks' liabilities for hazardous waste cleanup costs. It is the Bank's policy to require Phase I site assessments from a qualified engineering firm for all real estate loans in excess of $500,000 and any property of concern for loans below $500,000. Management is not aware of any hazardous waste actions against the Company or its borrowers. In the third quarter of 1993 the Company announced a definitive merger agreement with West Mass Bankshares, Inc. ("West Mass") of Greenfield, Mass. The Company has agreed to acquire West Mass in a stock-for-stock merger which will result in West Mass' banking subsidiary, United Savings Bank, becoming a wholly owned subsidiary of VFSC. West Mass has total assets of approximately $220 million as of December 31, 1993 and operates 6 banking offices in or near Greenfield, Mass. The Company anticipates closing the transaction in the second quarter of 1994 subject to receiving shareholder and regulatory approval. A special shareholders' meeting to consider the proposed merger has been called for April 26, 1994. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. Vermont Financial Services Corp. Consolidated Statements of Cash Flow Non-monetary Transactions: Transfer of loans to OREO for the years ended December 31, 1993, 1992 and 1991 totaled $3,093,745, $11,063,725 and $8,126,000, respectively. See notes to consolidated financial statements. Notes To Consolidated Financial Statements 1. Basis of Financial Statements and Significant Accounting Policies The accounting and reporting policies of Vermont Financial Services Corp. (the "Company") and its subsidiary are in conformity with generally accepted accounting principles and general practices within the banking industry. The following is a description of the more significant policies. The Company, organized in April 1982, became a registered bank holding company, acquired controlling interest in Vermont National Bank (the "Bank") on March 1, 1983, upon exchange of all of the outstanding shares of common stock of the Bank for shares of the Company. All intercompany transactions have been eliminated in the consolidated financial statements. Cash equivalents include amounts due from banks, interest bearing deposits with other banks and Federal Funds sold and securities purchased under agreements to resell with original maturities of three months or less. For these items the carrying amount approximates fair value. Effective December 31, 1993 the Company adopted, on a prospective basis, Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115") and revised its securities accounting policy. Securities that may be sold as part of the Company's asset/liability or liquidity management or in response to or in anticipation of changes in interest rates and resulting prepayment risk, or for other similar factors, are classified as available for sale and carried at fair market value which is based on quoted market prices or dealer quotes. Unrealized holding gains and losses on such securities are reported net of related taxes as a separate component of shareholders' equity. Realized gains and losses on the sales of all securities are reported in earnings and computed using the specific identification cost basis. The adoption of SFAS 115 has not been applied retroactively to prior years' financial statements. Prior to December 31, 1993 all securities were classified as available for sale and were carried at the lower of aggregate cost or market value. Unrealized losses on marketable equity securities were reported as a separate component of shareholders' equity unless the loss was deemed to be other than temporary in which case a charge to earnings was made. The reserve for loan losses is maintained at a level which, in management's judgment, is adequate to absorb future loan losses through charges to operating expenses. Principal factors considered by management include the historical loan loss experience, the value and adequacy of collateral, the level of nonperforming (nonaccrual) loans, the growth and composition of the loan portfolio and examination of individual loans by senior management. OREO is carried at the lower of cost or fair value less the estimated cost to sell the property. Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed principally on the straight-line method over the estimated useful life of the related assets. Leasehold improvements are amortized over the lease periods or the useful life of the improvement, whichever is shorter. When assets are sold or retired, the related cost and accumulated depreciation and amortization are removed from the respective accounts and any gain or loss is credited or charged to income. In the fourth quarter of 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Prior years' financial statements have not been restated to apply to the provisions of SFAS No. 109. Prior to that time, 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. Securities and other property held by the Trust Department in a fiduciary or agency capacity are not included in the accompanying balance sheet, since such items are not assets of the Bank. Trust Department income is recorded on the cash basis which is not materially different from income that would be reported on the accrual basis. Loan origination and commitment fees and certain direct loan origination costs are deferred and amortized as an adjustment of the related loan's yield over the contractual life of the related loans by the level yield method. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". SFAS 106 changed the Company's policy of accounting for postretirement benefits on a pay-as-you-go (cash) basis by requiring accrual of the expected cost of providing these benefits. Certain 1992 and 1991 amounts have been reclassified to conform with the current year presentation. Dollars in the following footnotes are in thousands except for per share amounts. 2. Securities Additional information with respect to the contractual maturities of securities available for sale at December 31, 1993 and 1992 follows: Proceeds from sales of securities available for sale during 1993, 1992 and 1991 were $50,542, $48,652 and $21,554, respectively. Gross gains of $1,998, $871 and $642 were realized on those sales in 1993, 1992 and 1991, respectively. Gross losses of $0, $1 and $31 were realized in the respective periods. Securities with a book value of $97,012 as of December 31, 1993 and $74,923 as of December 31, 1992 were pledged to qualify for fiduciary powers, to collateralize deposits of public bodies, for borrowed money and for other purposes as required or permitted by law. 3. Loans Loans classified by type are summarized as follows: At December 31, 1993 the amount of loans outstanding to directors, executive officers, principal holders of equity securities or to any of their associates total $6,019. The following table summarizes the related party loan activity for 1993: Balance at beginning of year $2,087 Additions 5,724 Repayments (1,792) Balance at end of year $6,019 ===== At December 31, 1993 and 1992 total loans, net of the allowance for loan losses, had a carrying value of $674,697 and $665,590, respectively. The fair value of these loans was $689,670 and $668,322, respectively. For certain homogeneous categories of loans, such as some residential mortgages, credit card receivables and other consumer 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 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. At December 31, 1993 and 1992 the Company's serviced mortgage portfolio totaled $438,911 and $416,885, respectively. Excess service fees associated with this portfolio had carrying values of $3,799 and $3,253, respectively, and fair values of $7,999 and $8,338, respectively. Fair value was based on quoted market prices for similar portfolios. Mortgage Banking Activities During 1993, the Bank originated $187,440 of mortgage loans for sale in the secondary market and sold $189,662. As of December 31, 1993, $19,907 of mortgage loans were held for sale and were carried at the lesser of the loan balance or market value. All loans are sold without recourse, except for certain technical underwriting exceptions, and none have been presented for recourse. Loan servicing is retained by the Bank and excess servicing is capitalized monthly and adjusted quarterly based on actual payments received on the sold loans. Gains, net of losses, from sales of mortgage loans are included in interest and fees on loans and was $2,738 for 1993, $2,945 for 1992 and $2,430 for 1991. Loan servicing income is included in other service charges, commissions and fees and was $1,986, $1,655 and $1,326 for 1993, 1992 and 1991, respectively. The following schedule represents excess servicing right activity for the past two years: Amortization represents quarterly valuation adjustments which are based on pool balances and prepayment assumptions on a pool by pool basis as reported by the Bloomberg Financial Market System. 4. Allowance for Loan Losses Transactions in the allowance for loan losses are summarized as follows: An allowance of $402 was acquired during 1991 as a result of the assumption of certain loans from the FDIC as a result of their liquidation of Valley Bank of White River Junction, Vermont. Transactions in the OREO valuation reserve are summarized as follows: Proceeds from sales of OREO were $13,641 in 1993 and $8,524 in 1992. Loans associated with these sales were $3,585 and $2,806, respectively. No loan exceeded 90% of the sale price and no unguaranteed commercial, commercial real estate or condominium loan exceeded 80% of the sale price. 5. Premises and Equipment Premises and equipment stated at cost, consist of the following: 6. Deposits Time certificates of deposit outstanding in denominations of $100 or more aggregated to $19,839 and $40,293 at December 31, 1993 and 1992, respectively. Other time deposits outstanding in denominations of $100 or more aggregated to $5,169 and $3,561 at December 31, 1993 and 1992, respectively. Total interest on these deposits amounted to $1,214, $3,870 and $8,714 for the years ended 31, 1993, 1992 and 1991, respectively. The Company paid $9,856, $16,501 and $26,297 in interest on certificates of deposit and other time deposits during 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992 total deposits had a fair value of $775,472 and $752,343, respectively. 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 deposit is estimated using the rates currently offered for deposits of similar remaining maturities. 7. Other Borrowings The following table shows the distribution of the Company's borrowings and the weighted average interest rate thereon at the end of each of the last three years. The table also shows the maximum amount of borrowings and the average amount of borrowings as well as weighted average interest rates for the last three years. Federal funds purchased and securities and loans sold under agreements to repurchase generally mature within 1 to 30 days from the transaction date. At December 31, 1993 the Bank owned $3,138 of stock in the Federal Home Loan Bank (FHLB) which provided borrowing capacity up to $131,860 from the FHLB at maturities, rates and terms determined by the FHLB. For all of the above borrowings, the carrying amount is a reasonable estimate of fair value. Included in the above tables is a long-term borrowing from the FHLB totaling $560 which is at a rate of 5.00% and matures August 1, 2011. 8. Commitments and Contingencies Leases -- The following is a schedule by years of future minimum rental payments required under operating leases for premises and data processing equipment that have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1993. Certain operating leases contain various options to renew. Year Ending December 31: 1994 $ 586 1995 376 1996 302 1997 286 1998 279 Later Years 2,375 Total Minimum Payments Required $ 4,204 ===== Operating expenses include approximately $1,144, $1,449, and $1,293 in 1993, 1992 and 1991, respectively, for rentals of premises and equipment used for banking purposes. Financial Instruments With Off-Balance Sheet Risk -- The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial 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 counterparty to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Total commitments to extend credit at December 31, 1993 were as follows: Home equity lines $42,961 Credit card lines 64,379 Commercial real estate 15,064 Other unused commitments 74,468 The Bank evaluates each customer's credit-worthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Bank upon extension of credit is based on management's credit evaluation of the counterparty. Collateral held varies but may include certificates of deposit, accounts receivable, inventory, property, plant and equipment, residential real estate and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The collateral varies but may include certificates of deposit, accounts receivable, inventory, property, plant and equipment and residential real estate for those commitments for which collateral is deemed necessary. As of December 31, 1993, the Bank had outstanding commitments for the following: financial standby letters of credit - $5,100, performance standby letters of credit - $2,744 and commercial and similar letters of credit - $6,649. The carrying amount of those financial instruments noted above represents accruals or deferred income (fees) arising from those unrecognized financial instruments. Such amounts are minimal and approximate fair value. As of December 31, 1993 the Company had entered into an interest rate floor arrangement on a notional value of $10,000. This financial instrument had a carrying value of $60 and a fair value of $272 as of December 31, 1993. Non-Interest Bearing Deposits and Cash -- The Bank is required by the Federal Reserve Bank to maintain a portion of deposits as a cash reserve. The Bank must maintain cash balances on hand or at the Federal Reserve Bank equal to its reserve requirement. At December 31, 1993 the Bank's reserve requirement of $6,778 was met with cash on hand and deposits at the Federal Reserve Bank. Subsequent to December 31, 1993, the Company filed with the Securities and Exchange Commission a registration statement under the Securities Act of 1933 relating to a proposed acquisition of West Mass Bankshares, Inc. The Company anticipates closing the transaction near the beginning of the second quarter of 1994 subject to receiving shareholder and regulatory approval. For complete details, see the registration statement. The Bank is also involved in litigation arising in the normal course of business. The Bank does not anticipate that any of these matters will result in the payment by the Bank of damages, that in the aggregate, would be material in relation to the consolidated results of operations or financial position of the Bank. 9. Income Taxes As discussed in Note 1, the Company adopted the provisions of SFAS No. 109 as of the fourth quarter of 1992. The change had no material effect on reported net income for 1992 or for any of the first three quarters of 1992. The provisions for income tax expense (benefit) included in the statements of income are as follows: The approximate tax effect of principal temporary differences giving rise to deferred taxes are summarized as follows: The Company made income tax payments of $975, $1,791 and $435 during 1993, 1992 and 1991, respectively. The components of the net deferred tax asset as of December 31 are as follows: No valuation allowance is required as there is sufficient taxable income in the carry back period and through future operating results to be able to fully realize the deferred tax asset. The provision for income taxes is less than the amount computed by applying the applicable federal income tax rate to income before taxes. The reasons therefore are as follows: 10. Employee Benefit Plans The Company has a trusteed non-contributory defined benefit pension plan covering substantially all of its employees. The benefits are based on years of service and the employee's final compensation. The Company's funding policy is to contribute annually an amount that can be deducted for federal income tax purposes using a different actuarial cost method and different assumptions from those used for financial reporting. Pension expense for 1993, 1992 and 1991 was $497, $399 and $316, respectively. The following table sets forth the plan's funded status and amounts recognized in the Company's statements of financial position as of December 31, 1993 and 1992: The weighted average discount rate which is the estimated rate as which the obligation for pension benefits could effectively be settled and rate of increase in salary levels were 7.5 and 5.5 percent, respectively. The expected long-term rate of return on assets was 8.5 percent. The respective rates expected to be used for 1994 are 7.0%, 5.0%, and 8.5%. The Company also has a Profit-Sharing Plan covering substantially all employees. A portion of the annual contribution by the Company is at the discretion of the Board of Directors and none was made for 1993, 1992 and 1991. The Plan also includes a 25% Company match of employee contributions to a 401k portion of the Plan. This Plan feature was added in 1993 and the associated expense for 1993 was $114. The Company also has an Employee Stock Purchase Plan covering substantially all employees. The Plan allows the purchase of Common Stock at a ten percent discount from the then current fair market value, without payment of any brokerage commission or service charge. The Company sponsors unfunded defined benefit postretirement medical and life insurance plans which cover all of its full time employees. All employees who retire from the Company at age 65 or over with at least ten years of service are eligible. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The accumulated postretirement benefit obligation (APBO) at the date of adoption was $228 of which the Company accrued $11. The remaining net unrecorded liability of $217 will be recognized over 20 years. During 1993, the Company recognized $44 of expense related to postretirement benefits consisting of service cost, interest cost and transition amortization of $16, $17, and $11, respectively. As of December 31, 1993, the APBO was $250 of which $81 relates to current retirees. The accrued liability as of December 31, 1993 was $20. A discount rate of 7% and a long-term medical inflation rate of 8% was used in calculating the APBO. A 1% increase in the medical inflation rate assumption would increase the APBO and expense provision by less than 2% as of December 31, 1993. 11. Stockholders' Equity Since the Company had no common stock equivalents outstanding from 1991 to 1993, both primary and fully diluted earnings per share are based on the average number of shares outstanding. The number of shares used in the computation was 3,411,211, 3,399,343, and 3,388,072 for 1993, 1992 and 1991, respectively. The per share amounts of cash dividends paid on an equivalent share basis were $0.24 for 1993, $0.08 for 1992 and $0.15 for 1991. At December 31, 1993 the Bank had available $8,775 for payment of dividends to the Company, under regulatory guidelines. At December 31, 1993, there were 59,085 and 89,916 shares of Common Stock reserved for issuance pursuant to the Company's Dividend Reinvestment and Stock Purchase Plan and pursuant to the Company's Employee Stock Purchase Plan, respectively. Options Agreements - On April 20, 1987, stockholders approved a non-qualified stock option plan for 105,000 shares of the Company's common stock and on April 17, 1990 stockholders approved a non-qualified stock option plan for 80,000 shares of the Company's common stock. In October, 1993 the 65,100 and 40,000 options that were then outstanding expired unexercised for these respective plans. On October 13, 1993 new options to purchase 36,000 and 12,000 shares, respectively, were granted under these plans at an option price of $19.00 per share and are exercisable for a five year period. None have been exercised to date. 12. Parent Company Financial Information Condensed financial information for Vermont Financial Services Corp. (parent company only) is as follows: 13. Supplemental Financial Data Selected Quarterly Data (unaudited) The following is a summary of selected consolidated quarterly data of the Company for the periods presented: Statement of Management Responsibility The management of Vermont Financial Services Corp. is responsible for the accuracy and content of the financial statements and other financial information in this annual report. The financial statements have been prepared in conformity with generally accepted accounting principals applied on a consistent basis in all material respects, and data include amounts based upon management's judgement where appropriate. The accounting systems which record, summarize and report financial data are supported by a system of internal controls which is augmented by written policies, internal audits and staff training programs. The Audit Committee of the Board of Directors, which is made up solely of outside directors who are not employees of the Company, reviews the activities of the internal audit function and meets regularly with representatives of Coopers & Lybrand, the Company's independent auditors. Coopers & Lybrand has been appointed by the Board of Directors to conduct an independent audit and to express an opinion as to the fairness of the presentation of the consolidated financial statements of Vermont Financial Services Corp. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Vermont Financial Services Corp. We have audited the accompanying consolidated balance sheets of Vermont Financial Services Corp. and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' equity and cash flow 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 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 Vermont Financial Services Corp. and subsidiary as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flow 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, 2 and 10 to the consolidated financial statements, the Company changed its method of accounting for certain investments in debt and equity securities and accounting for postretirement benefits other than pensions in 1993. As discussed in Notes 1 and 9 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992. Springfield, Massachusetts COOPERS & LYBRAND January 21, 1994 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 Registrant Executive Officers The following table shows the name of each executive officer of the Company, his age, the offices with the Company held by him, and the year he was first elected to a comparable office with the Bank. There are no family relationships among the executive officers. Directors The following table sets forth the name and address of each director of the Company, his or her age and principal occupation and the year in which he or she first became a Director of the Company or its predecessors. The business address of each of the nominees is the Company's address except as otherwise noted. No family relationship exists between any director. Year First Name, Age and Principal Became Occupation or Employment (1) Director Anthony F. Abatiell (54)................... 1982 Attorney, Partner, Abatiell & Wysolmerski Law Offices, Rutland Zane V. Akins (53).......................... 1987 President, Akins & Associates; President & Director, Anitech International, Inc., Brattleboro (Business Consulting) Charles A. Cairns (52)...................... 1986 President, Champlain Oil Co., Inc. and Coco Mart, Inc., South Burlington Robert C. Cody (69)......................... 1974 President, Cody Chevrolet, Inc. Chairman, Cody Management Associates (Real Estate Ownership and Management), Montpelier Beverly G. Davidson (62).................... 1980 Secretary, Treasurer of RCAS, Inc., (Vermont State Fair); Treasurer, N.M.&B. Ltd. (NutriSystem Weight Control), Rutland James E. Griffin (66)....................... 1972 President, J.R. Resources, Inc. (Business Consultants), Rutland John D. Hashagen, Jr. (52).................. 1987 President and Chief Executive Officer of Vermont Financial Services Corp., Brattleboro; President & Chief Executive Officer, Vermont National Bank, Brattleboro Daniel C. Lyons (62)........................ 1974 Lyons Pontiac-Cadillac GMC Trucks; Toyota, Inc., Berlin Kimball E. Mann (59)........................ 1969 President, J.E. Mann, Inc. (Women's Department Store), Brattleboro Stephan A. Morse (47)....................... 1986 President and CEO, The Windham Foundation, Inc., Grafton Donald E. O'Brien (68)...................... 1978 Attorney, Burlington Roger M. Pike (53).......................... 1980 Vice President, Kinney, Pike, Bell & Conner, Inc. (Insurance), Rutland Mark W. Richards (48)....................... 1988 President, Richards, Gates, Hoffman & Clay (Insurance) Brattleboro (1) During the past five years, the principal occupation and employment of each director has been as set forth above, except as follows: John D. Hashagen, Jr. previously served as Executive Vice President and Senior Vice President of Vermont Financial Services Corp.; Zane W. Akins was Chief Executive Officer, Holstein-Friesian Association of America; Executive Vice President Holstein-Friesian Services, Inc. (Cattle Registration) until December 31, 1990. Item 11 Item 11 - Executive Compensation The following tables contain three-year summary of the total compensation paid to the CEO and the other three executive offices whose salary and bonus exceeded $100,000 during 1993. I. SUMMARY COMPENSATION TABLE (1) In December, 1993 the discount rate used to compute the liability under the officers' deferred compensation plan (See "Deferred Compensation Agreements" following) was reduced from 9% to 7-1/2%. The associated expenses attributable to Messrs.. Hashagen, Madden, Soucy and Fenn due to this change were $19,597, $10,799, $12,211 and $13,998, respectively. (2) Represents the 25% Company match of the respective employees' 401k contribution. II. OPTION/SAR GRANTS TABLE III. OPTION EXERCISES AND YEAR-END VALUE TABLE Aggregated Option Exercises in Last Fiscal Year, and FY-End Option Value Deferred Compensation Agreements The Bank has entered in Executive Deferred Compensation Agreement with certain officers, including Mr. Hashagen and the other executive officers in the group referred to in the above table. The agreements provide for monthly payments for a ten-year period from retirement after age 60 but before age 65, and for a fifteen-year period from retirement after age 65, subject to certain conditions. The conditions include the requirements that the officer refrain from competitive activities, be available for certain advisory and consulting services subsequent to retirement and continue in the employment of the Bank until retirement. The agreements also provide for payments upon disability prior to retirement and payments to beneficiaries of the officers under certain circumstances. Mr. Hashagen's agreement provides for payments in the amount of $1,944.44 per month, and the agreements of the other three officers noted above provide for payments of $1,388.89 per month. The bank has purchased life insurance policies on the lives of these officers which, in effect, will provide the funds to make payments to reimburse the Bank for payments made under the agreements. Management Continuity Agreements The Company and the bank have entered into agreements with its six executive officers, Messrs. Hashagen, Madden, Soucy, Fenn, Dunham and George which provide for the payment of certain severance benefits if such officer's employment with the Company or the Bank is terminated within thirty-six months after a change of control of the company or the Bank. The agreements provide for severance payments to Mr. Hashagen equal to 250% of his base salary upon termination after a change of control and for payments to each of the other executive officers equal to 200% of his base salary upon termination after a change of control as defined in the agreements. The management continuity agreements do not provide for severance benefits in instances where termination is due to death, disability or retirement. Further, no benefits are payable in instances of termination for cause, or after a change of control if the officer voluntarily terminates his employment with both the Company and the Bank, unless such termination is for a "good reason" as defined in the agreements. Severance benefits payable in the event of a qualifying termination after a change of control are to be paid in equal consecutive biweekly installments. If severance payments due in the event of termination after a change of control were payable to each of the executive officers on the date of this filing, the aggregate amount of such severance payments would be $1,540,000. These severance payments are subject to up to a 50% reduction if the officer works for or participates in the management, operation or control of a commercial or savings bank, or bank holding company, which does business in Vermont, unless such officer's activities are substantially outside Vermont. Additionally, the officer will be entitled to continuation of life, disability, accident and health insurance benefits and a cash adjustment to compensate the executive for the market value of any stock options under the Company's Officers' or Directors' Non-Qualified Stock Option Plans in excess of their exercise price. The agreements contain each officer's undertaking to remain in the employ of the Company and the Bank if a potential change of control occurs until the earlier of six months, retirement (at normal age), disability or the occurrence of a change of control. Similar agreements have been executed by certain employees of the Bank and the Company which provide for severance payments ranging from 100% to 150% of the employee's base salary upon termination after a change in control. Profit-Sharing Plan Each employee, including executive officers, becomes eligible to participate in the Bank's Profit-Sharing Plan on January 1 of the Plan year in which he or she completes one full year of continuous service of 1,000 hours or more. Upon completion of three years of continuous service, a participant become 30% vested, increasing to 40% after four years, 60% after five years, 80% after six years, and fully vested after seven years. Vested participants may elect to receive, in cash, up to 50% of their annual allocation of the Bank's contribution to the Profit-Sharing Plan. Vested amounts not so received in cash are distributed to participants upon their retirement or earlier termination of employment. During 1993, the Bank did not make a contribution to the Profit-Sharing Plan. Retirement Plan The Vermont National Bank Retirement Plan covers substantially all eligible employees of the Bank, including officers, and provides for payment,of retirement benefits generally based upon an employee's years of credited service with the Bank and his or her salary level, reduced by a portion of the Social Security benefits to which it is estimated the employee will be entitled. The following table represents estimated annual benefits upon retirement at age 65 to employees at specified salary levels (based upon the average annual rate of salary during the highest five years within the final ten years of employment) at stated years of service with the Bank. The amounts show are after deduction of estimates for Social Security reductions based on the Social security law as of January 1, 1994. * Under current regulations of the Internal Revenue Code, the maximum annual benefit payable from a defined benefit plan during 1994 is $118,800 payable as a life annuity for retirements at age 65. In addition, the maximum annual compensation may not exceed $150,000. The amounts shown above in excess of $118,800 and those using compensation in excess of $150,000 are show for exhibit purposes only. The description of the Retirement Plan in this filing is intended solely to provide shareholders of the Company with general information concerning the plan as it relates to management remuneration. Under no circumstances should the description be construed as indicative of the rights of any particular employee, or as conferring any right upon any employee , which rights will in all cases be determined by the appropriate legal documents governing the plan. Compensation of Directors Each director who is not an officer of the Company or the Bank receives an annual retainer of $4,800 and, in addition, a $400 fee for each regular monthly Board of Directors' meeting attended, and a $300 fee for each meeting of a committee of the Board he or she attends. Item 12 Item 12 - Security Ownership of Certain Beneficial Owners and Management The following table sets forth information as of December 31, 1993 as to persons who are beneficial owners of more than 5% of the outstanding shares of VFSC Common Stock. (1) Includes sole voting power for 216,200 shares, shared voting power for 23,400 shares and sole dispositive power for 239,600 shares. (2) Includes sole voting power for 236,100 shares and sole dispositive power for 267,300 shares. (3) Includes sole voting power for 30,185 shares, shared voting power for 243,817 shares, sole dispositive power for 157,632 shares and shared dispositive power for 116,370 shares. The following table sets forth information as of February 28, 1994, with respect to the shares of VFSC Common Stock beneficially owned by each director of VFSC, by the chief executive officer of VFSC, and certain other executive officers of VFSC, and by all directors and executive officers as a group. __________ (1) Includes 813 shares held jointly with a family member in which Mr. Abatiell shares voting and investment power. Also includes 60,192 shares held in a custodial capacity in VNB's trust department in which Mr. Abatiell has sole voting and investment powers. Does not include options to acquire 1,000 additional shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (2) Does not include options acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (3) Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (4) Includes 10,149 shares held jointly with a family member in which Mr. Cody shares voting and investment powers. Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (5) Ms. Davidson shares voting and investment powers on 2,365 shares. Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (6) Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (7) Includes 224 shares held by a family member in which Mr. Hashagen has no voting or investment powers and as to which mr. Hashagen disclaims beneficial ownership. Also includes 200 shares held in the name of Green Mountain Investment Club in which Mr. Hashagen shares voting and investment powers and 7,154 shares held in the VNB Profit Sharing Plan. Does not include options to acquire 5,000 shares, exercisable within sixty (60) days, pursuant to the Officers' Non-qualified Stock Option Plan. (8) Includes 2,512 shares held jointly with a family member in which Mr. Lyons shares voting and investment powers. Also includes 7,206 shares held by a family member in which Mr. Lyons has no voting or investment powers and as to which Mr. Lyons disclaims beneficial ownership. Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (9) Includes 9,379 shares held jointly with a family member in which Mr. Mann shares voting and investment powers. Also includes 814 shares held by a family member in which Mr. Mann has no voting or investment powers and as to which Mr. Mann disclaims beneficial ownership. Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (10) Includes 2,507 shares held jointly with a family member. Also includes 505 shares held by a family member in which Mr. Morse has no voting or investment powers and as to which mr. Morse disclaims beneficial ownership. Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (11) Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (12) Includes 777 shares held jointly with family members and 1,125 shares held by Kinney, Pike, Bell & Conner, Inc. in which Mr. Pike shares voting and investment powers also includes 997 shares held by a family member in which mr. Pike has no voting power and as to which Mr. Pike disclaims beneficial ownership. Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (13) Includes 24,142 shares held jointly with family members in which mr. Richards shares voting and investment powers. Does not include options to acquire 1,000 shares, exercisable within sixty (60) days, pursuant to the Directors' Non-Qualified Stock Option Plan. (14) Includes 4,468 shares held in the VNB Profit Sharing Plan. Does not include options to acquire 4,000 shares, exercisable within sixty (60) days, pursuant to the Officers' Non-Qualified Stock Option Plan. (15) Includes 2,097 shares held in the VNB Profit Sharing Plan. (16) Includes 3,732 shares held in the VNB Profit Sharing Plan. Does not include options to acquire 4,000 shares, exercisable within sixty (60) days, pursuant to the Officers' Non-Qualified Stock Option Plan. (17) Does not include options to acquire 48,000 shares, or 1.40% of the outstanding shares, exercisable within sixty (60) days, pursuant to the Directors' and Officers' Non-Qualified Stock Option Plans. Item 13 Item 13 - Certain Relationships and Related Transactions Some directors and officers of the Bank and the Company and their associates were customers of and had transactions with the Bank and the Company in the ordinary course of business during 1993. Additional transactions may be expected to take place in the ordinary course of business in the future. Some of the Company's directors are directors, officers, trustees, or principal security holders of corporations or other organizations which were customers of or had transactions with the Bank in the ordinary course of business during 1993. All outstanding loans and commitments included in such transactions were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other person and did not involve more than the normal risk of collectibility nor present other unfavorable features. In addition to banking and financial transactions, the Bank and the Company have had other transactions with, or used products or services of, various organizations of which directors of the Company are directors or officers. The amounts involved have in no case been material in relation to the business of the Bank or the Company, and it is believed that they have not been material in relation to the business of such other organizations or to the individuals concerned. It is expected that the Bank and the Company will continue to have similar transactions with, and use products or services or, such organizations in the future. Two directors of the Company are attorneys who have been retained in the past to represent the Bank or the Company in appropriate circumstances. During 1993, no director was retained by the Bank as legal counsel. PART IV Item 14 Item 14 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Financial Statements and Exhibits (1) The following financial statements (including report thereon and notes thereto) are filed as part of this Report. Report of Independent Certified Public Accountants 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 Flow - For the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements (2) Schedules - None (3) Exhibits: 3.1 Certificate of Incorporation of Registrant. Incorporated by reference to Exhibit 3.1 to Registrant's Current Report on Form 8-K dated April 23, 1990. 3.2 By-Laws of Registrant. Incorporated by reference to Exhibit 3.2 to Registrant's Current Report on Form 8-K dated April 23, 1990. 10.1 Management continuity agreements dated February 9, 1990 between the Registrant's predecessor and four executive officers: (a) John D. Hashagen, Jr. (b) Richard O. Madden (c) W. Bruce Fenn (d) Robert G. Soucy Incorporated by reference to Exhibit 3.2 to Registrant's Form 10-K for the fiscal year ended December 31, 1990. Management continuity agreement with Louis J. Dunham dated March 17, 1994. Filed herewith. Management continuity agreement with William G. George dated January 11, 1994. Filed herewith. 10.2 Agreement of Merger dated February 28, 1990 between the Company and Vermont Financial Services Corp., a Delaware corporation. Incorporated by reference to Exhibit A of Registrant's Proxy Statement for its 1990 Annual Meeting of Shareholders, Exhibit 28 to Registrant's Form 10-K for the fiscal year ended December 31, 1989. 22. Subsidiaries of Registrant. Filed herewith. 24. Consent of Coopers & Lybrand. Filed herewith. (b) Reports on Form 8-K. During the Registrant's fiscal quarter ended December 31, 1993, the Registrant filed no 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. VERMONT FINANCIAL SERVICES CORP. Date: March 9, 1994 By /s/ John D. Hashagen, Jr. John D. Hashagen, Jr., President and Chief Executive Officer By /s/ Richard O. Madden Richard O. Madden, 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 in the capacities and on the dates indicated. Index to Exhibits Exhibit 10.1 Management Continuity Agreements Exhibit 22 Subsidiaries of Registrant Exhibit 24 Consent of Independent Certified Public Accountants Exhibit 10.1 Vermont National Bank 100 Main Street Brattleboro, Vermont 05301 January 11, 1994 Mr. William H. George Nine Woodbine Road Shelburne, Vermont 05482 Dear Mr. George: Vermont National Bank (the "Bank") considers it essential to the best interests of the Bank and its corporate parent, Vermont Financial Services Corp. ("VFSC") and their stockholders to foster the continuous employment of key management personnel. In this connection, the Boards of Directors of VFSC and the Bank (the "Boards") recognize that, as is the case with many publicly held businesses, the possibility of a change of control may exist and that such possibility, and the uncertainty and questions which it may raise among management, may result in the departure or distraction of management personnel to the detriment of the business and its stockholders. The Boards have determined that appropriate steps should be taken to reinforce and encourage the continued attention and dedication of members of the management of the Bank, including yourself, to their assigned duties without distraction in the face of potentially disturbing circumstances arising from the possibility of a change of control, although no such change is now contemplated. In order to induce you to remain in the employ of the Bank and in consideration of your agreement set forth in Subsection 2(ii) hereof, the Bank agrees that you shall receive the severance benefits set forth in this letter agreement (the "Agreement") in the event your employment is terminated subsequent to a "change in control" (as defined in Section 2 hereof) under the circumstances described below. When used herein, the term "Employer" shall mean the Bank. 1. Term of Agreement. This Agreement shall commence on the date hereof and shall continue in effect through January 31, 1997; provided, however, that commencing on January 31, 1995 and each January 31 thereafter, the term of this Agreement shall automatically be extended for one additional year unless, at least two years and thirty (30) days prior to the then scheduled termination of this Agreement, the Bank shall have given notice that it does not wish to extend this Agreement; provided, further, if a change in control (as defined in Subsection 2(i) hereof) shall have occurred during the original or extended term of this Agreement, this Agreement shall continue in effect for a period of thirty-six (36) months beyond the month in which such change in control occurred. 2. Change in Control. (1) No benefits shall be payable hereunder unless there shall have been a change in control of either VFSC or the Bank, as set forth below. For purposes of this Agreement, a "change in control" shall be deemed to have occurred if: (A) any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")), other than the Bank holding securities in a fiduciary capacity or a trustee or other fiduciary holding securities under an employee benefit plan of the Bank, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of VFSC or the Bank representing 25% or more of the combined voting power of the then outstanding securities of VFSC or the Bank, as the case may be; or (B) during any period of two consecutive years (not including any period prior to the execution of this Agreement), individuals who at the beginning of such period constitute the Board of either VFSC or the Bank and any new director (other than a director designated by a person who has entered into an agreement with VFSC or the Bank to effect a transaction described in clause (A) or (C) of this Subsection) whose election by such Board or nomination for election by the stockholders of VFSC or the Bank, as the case may be, was approved by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors at the beginning of such period or whose election or nomination for election was previously so approved, cease for any reason to constitute a majority of such Board; or (C) the stockholders of VFSC or the Bank approve a merger or consolidation of VFSC or the Bank, as the case may be, with any other corporation, other than a merger or consolidation which would result in the voting securities of VFSC or the Bank, as the case may be, outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least 70% of the combined voting power of the voting securities of the surviving entity outstanding immediately after such merger or consolidation, or the stockholders of VFSC or the Bank, as the case may be, approve an agreement for the sale or disposition of all or substantially all the assets of VFSC or the Bank, as the case may be. The merger of VFSC with another corporation effected for the purpose of reincorporating in another jurisdiction shall not constitute a change of control hereunder, neither shall the merger of VFSC with the Bank. (ii) For purposes of this Agreement, a "potential change in control" shall be deemed to have occurred if: (A) VFSC or the Bank enters into an agreement, the consummation of which would result in the occurrence of a change in control of VFSC or the Bank; (B) any person (including VFSC or the Bank) publicly announces an intention to take or to consider taking actions which if consummated would constitute a change in control of VFSC or the Bank; (C) any person, other than the Bank holding securities in a fiduciary capacity or a trustee or other fiduciary holding securities under an employee benefit plan of VFSC or the Bank, who is or becomes the beneficial owner, directly or indirectly, of securities of VFSC or the Bank representing 5% or more of the combined voting power of the then outstanding securities of VFSC or the Bank, as the case may be, increases its beneficial ownership of such securities by 5% or more over the percentage so owned by such person on the date hereof; or (D) the Board of VFSC or the Bank adopts a resolution to the effect that, for purposes of this Agreement, a potential change in control has occurred. You agree that, subject to the terms and conditions of this Agreement, in the event of a potential change in control, you will remain in the employ of the Employer until the earliest of (i) a date which is six (6) months from the occurrence of such potential change in control, (ii) the termination by you of your employment by reason of Disability or Retirement (at your normal retirement age), as defined in Subsection 3(i), or (iii) the occurrence of a change in control of VFSC or the Bank. 3. Termination Following Change in Control. If any of the events described in Subsection 2(i) hereof constituting a change in control shall have occurred, you shall be entitled to the benefits provided in Subsection 4(iii) hereof upon the subsequent termination of your employment with the Bank during the term of this Agreement unless such termination is (A) because of your death, Disability or Retirement, (B) for Cause, or (C) by you other than for Good Reason. (i) Disability; Retirement. Your employment may be terminated for "Disability" in accordance with the Employer's disability policy as in effect from time to time; provided that no discharge for Disability shall occur unless as a result of your incapacity due to physical or mental illness you shall have been absent from the full-time performance of your duties with the Employer for six (6) consecutive months, and within thirty (30) days after written notice of termination is given you shall not have returned to the full-time performance of your duties. Termination by the Employer or you of your employment based on "Retirement" shall mean termination in accordance with the Employer's retirement policy generally applicable to its salaried employees or in accordance with any retirement arrangement established with your consent with respect to you. (ii) Cause. Termination by the Employer of your employment for "Cause" shall mean termination upon (A) the willful and continued failure by you to substantially perform your duties with the Employer (other than (i) any such failure resulting from your incapacity due to physical or mental illness, or (ii) any such actual or anticipated failure after the issuance of a Notice of Termination by you for Good Reason, as defined in Subsections 3(iv) and 3(iii), respectively) after (a) a written demand for substantial performance is delivered to you by the Board of the Employer, which demand specifically identified the manner in which the Board believes that you have not substantially performed your duties, and (b) you have been afforded a reasonable opportunity to dispute any assertions of nonperformance, or (B) the willful engaging by you in conduct which is demonstrably and materially injurious to the Employer, monetarily or otherwise. For purposes of this Subsection, no act, or failure to act, on your part shall be deemed "willful" unless done, or omitted to be done, by you not in good faith and without reasonable belief that your action or omission was in the best interest of the Employer. Notwithstanding the foregoing, you shall not be deemed to have been terminated for Cause unless and until there shall have been delivered to you a copy of a resolution duly adopted by the affirmative vote of not less than three-quarters (3/4) of the Board called and held for such purpose (after reasonable notice to you and an opportunity for you, together with your counsel, to be heard before such Board), finding that in the good faith opinion of such Board you were guilty of conduct set forth above in clauses (A) or (B) of the first sentence of this Subsection and specifying the particulars thereof in detail. (iii) Good Reason. After a change in control defined in Subsection 2(i) hereof, you shall be entitled to the benefits provided in Subsection 4(iii) hereof, if you terminate your employment with the Employer for Good Reason. For purposes of this Agreement, "Good Reason" shall mean, without your express written consent, the occurrence after a change in control of VFSC or the Bank of any of the following circumstances unless, in the case of paragraphs (A), (E), (F), (G) or (H), such circumstances are fully corrected prior to the Date of Termination specified in the Notice of Termination, as defined in Subsections 3(v) and 3(iv), respectively, given in respect thereof: (A) the assignment to you of any duties inconsistent with your status as a senior executive officer of the Employer or a substantial adverse alteration in the nature or status of your responsibilities from those in effect immediately prior to the change in control; (B) a reduction in your annual base salary as in effect on the date hereof or as the same may be increased from time to time, except for across-the-board salary reductions similarly affecting all senior executives of VFSC and the Bank and all senior executives of any person in control of VFSC or the Bank; (C) the Employer's requiring you to be based anywhere other than VFSC's or the Bank's principal executive offices wherever located in Vermont from time to time, except for (i) transfers in connection with a demonstrable promotion and (ii) required travel substantially consistent with your present business travel obligations or in connection with a demonstrable promotion; (D) the failure by the Employer without your consent to pay to you any portion of your current compensation, except pursuant to an across-the-board compensation deferral similarly affecting all senior executives of VFSC and the Bank and all senior executives of any person in control of VFSC or the Bank, or to pay to you any portion of an installment of deferred compensation under any deferred compensation program, within seven (7) days of the date such compensation is due; (E) (i) the failure by the Employer to continue in effect any compensation plan in which you participate immediately prior to the change in control which is material to your total compensation, including but not limited to VFSC's Officers Nonqualified Stock Option Plan, Employee Stock Purchase Plan, Profit Sharing Plan and Retirement Plan, or any substitute plans adopted prior to the change in control, unless an equitable arrangement (embodied in an ongoing substitute or alternative plan or plans) has been made with respect to such plans in connection with the he change in control, or (ii) the failure by the Employer to continue your participation therein (or in such substitute or alternative plan or plans) on a basis not materially less favorable, both in terms of the amount of benefits provided and the level of your participation relative to other participants, as existed at the time of the change in control; (F) the failure by the Employer to continue to provide you with benefits substantially similar to those enjoyed by you under any pension, life insurance, medical, health and accident, or disability plans in which you were participating at the time of the change in control, the taking of any action which would directly or indirectly materially reduce any of such benefits or deprive you of any material fringe benefit enjoyed by you at the time of the change in control, or the failure to provide you with the number of paid vacation days to which you are entitled on the basis of years of service in accordance with normal vacation policy in effect at the time of the change in control; (G) the failure of the Employer to obtain a satisfactory agreement from any successor to assume and agree to perform this Agreement, as contemplated in Section 5 hereof; or (H) any purported termination of your employment which is not effected pursuant to a Notice of Termination satisfying the requirements of Subsection (iv) below (and, if applicable, the requirements of Subsection (ii) above); for purposes of this Agreement, no such purported termination shall be effective. Your right to terminate your employment pursuant to this Subsection shall not be affected by your incapacity due to physical or mental illness. Your continued employment shall not constitute consent to, or a waiver of rights with respect to, any circumstances constituting Good Reason hereunder. (iv) Notice of Termination. Any purported termination of your employment by the Employer or by you shall be communicated by written Notice of Termination to the other parties hereto in accordance with Section 6 hereof. For purposes of this Agreement, a "Notice of Termination" shall mean a notice which shall indicate the specific termination provision in this Agreement relied upon and shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of your employment under the provision so indicated. (v) Date of Termination, Etc. "Date of Termination shall mean (A) if your employment is terminated for Disability, thirty (30) days after Notice of Termination is given (provided that you shall not have returned to the full-time performance of your duties during such thirty (30 day period), and (B) if your employment is terminated pursuant to Subsection (ii) or (iii) above or for any other reason (other than Disability), the date specified in the Notice of Termination (which, in the case of a termination pursuant to Subsection (ii) above shall not be less than thirty (30) days, and in the case of a termination pursuant to Subsection (iii) above shall not be less than fifteen (15) nor more than sixty (60) days, respectively, from the date such Notice of Termination is given); provided that if within fifteen (15) days after any Notice of Termination is given, or, if later, prior to the Date of Termination (as determined without regard to this proviso), the party receiving such Notice of Termination notifies the other party that a dispute exists concerning the termination, the Date of Termination shall be the date on which the dispute is finally determined, either by mutual written agreement of the parties, by a binding arbitration award, or by a final judgment, order or decree of a court of competent jurisdiction (which is not appealable or with respect to which the time for appeal therefrom has expired and no appeal has been perfected); provided further that the Date of Termination shall be extended by a notice of dispute only if such notice is given in good faith and the party giving such notice pursues the resolution of such dispute with reasonable diligence. In the event of the pendency of any such dispute, the Employer will suspend your salary payments but will continue you as a participant in all benefit and insurance plans in which you were participating when the notice giving rise to the dispute was given, until the dispute is finally resolved in accordance with this Subsection. Amounts paid under this Subsection are in addition to all other amounts due under this Agreement and shall not be offset against or reduce any other amounts due under this Agreement. 4. Compensation Upon Termination or During Disability. Following a change in control, as defined by Subsection 2(i), upon termination of your employment or during a period of disability you shall be entitled to the following benefits: (i) During any period that you fail to perform your full-time duties with the Employer as a result of incapacity due to physical or mental illness, you shall continue to receive your base salary at the rate in effect at the commencement of any such period, together with all compensation payable to you under the Profit Sharing Plan or other similar plans in effect during such period, until this Agreement is terminated pursuant to Section 3(i) hereof. Thereafter, or in the event your employment shall be terminated by the Employer or by you for Retirement, or by reason of your death, your benefits shall be determined under the Employer's retirement, insurance and other compensation programs. (ii) If your employment shall be terminated by the Employer for Cause or by you other than for Good Reason, Disability, Death or Retirement, the Employer shall pay you your full base salary through the Date of Termination at the rate in effect at the time Notice of Termination is given, plus all other amounts to which you are entitled under any compensation plan at the time such payments are due, and VFSC and the Bank shall have no further obligations to you under this Agreement. (iii) If your employment shall be terminated (a) by the Bank other than for Cause, Retirement or Disability or (b) by you for Good Reason, then you shall be entitled to the benefits provided below: (A) The Employer shall pay you your full base salary (net of all required withholdings, if any) through the Date of Termination at the rate in effect at the time Notice of Termination is given, plus all other amounts to which you are entitled under any compensation plan of the Employer, at the time such payments are due, except as otherwise provided below. (B) In lieu of any further salary payments to you for periods subsequent to the Date of Termination, the Employer shall pay you as severance an aggregate amount equal to 200% of your annual base salary in effect immediately prior to the occurrence of the circumstance giving rise to the Notice of Termination given in respect thereof, such amount to be paid out in equal, consecutive biweekly installments commencing two weeks after the Date of Termination, except as provided in paragraph (F) below. (C) In lieu of shares of common stock of VFSC ("VFSC Shares") issuable upon exercise of outstanding options ("Options"), if any, granted to you under VFSC's Officers Nonqualified Stock Option Plan (which Options shall be cancelled upon the making of the payment referred to below), you shall receive an amount in cash equal to the produce of (i) the excess of the higher of the mean of the bid and the asked price of VFSC Shares as reported on the National Association of Securities Dealers Automated Quotation system ("NASDAQ") on or nearest the Date of Termination or the highest per share price for VFSC Shares actually paid in connection with any change in control, over the per share exercise price of each Option held by you (whether or not then fully exercisable), times (ii) the number of VFSC Shares covered by each such option. (D) The payment provided for in paragraph (C) above shall be made not later than the fifth day following the Date of Termination, provided, however, that if the amounts of such payments cannot be finally determined on or before such day, you shall be paid on such day an estimate, as determined in good faith, of the minimum amount of such payments, the remainder of such payments (together with interest at the rate provided in Section 1274(b) (2) (B) of the Internal Revenue Code) as soon as the amount thereof can be determined but in no event later than the thirtieth day after the Date of Termination. In the event that the amount of the estimated payments exceeds the amount subsequently determined to have been due, such excess shall constitute a loan to you, payable on the fifth day after demand (together with interest at the rate hereinabove provided). (E) The Employer also shall pay to you 50% of all legal fees and expenses incurred by you as a result of such termination (including all such fees and expenses, if any, incurred in contesting or disputing any such termination or in seeking to obtain or enforce any right or benefit provided by this Agreement or in connection with any tax audit or proceeding to the extent attributable to any payment or benefit provided hereunder). Such payments shall be made at the later of the time specified in paragraph (D) above, or within five (5) days after your request for payment accompanied with such evidence of fees and expenses incurred as the Employer reasonably may require. (F) The severance payments provided for in paragraph (B) above shall be reduced, as provided hereinbelow, in the event that, during the period in which you otherwise would be entitled to receive installments of such payments, you directly or indirectly serve as an officer, employee, director, agent, partner or consultant of, or otherwise participate in the management, operation or control of, any commercial or savings banking institution, or any entity which controls any such institution, which does business in the State of Vermont. The provisions of this paragraph (F) shall not apply in any instance (i) in which the services or activities performed by you which would otherwise result in a reduction of severance benefits are performed substantially outside of the State of Vermont, or (ii) in which your sole connection with such commercial or savings banking institution, or entity which controls such institution, consists of your ownership of less than five percent (5%) of the outstanding voting securities thereof. If an event described in the first sentence of this paragraph (F) occurs prior to your receipt of one-half of the severance payments provided for in paragraph (B) above, such severance payments shall cease upon the payment of one-half thereof. If such event occurs after your receipt of one-half of such severance payments, you shall be entitled to no further severance payments; provided, however, that there shall be no reduction in severance benefits if within thirty (30) days of your notification from the Employer that an event has occurred which would result in a reduction of severance payments as hereinabove provided (or the Employer's cessation of such payments without prior notification), you either sever the relationship which gives rise to such reduction of severance payments or demonstrate to the reasonable satisfaction of the Board of the Employer that no reduction of severance payments is warranted. (G) The Employer also shall reimburse you for the reasonable fee of a professional out-placement service selected by you within 90 days after termination of your employment. (iv) If your employment shall be terminated (A) by the Employer other than for Cause, Retirement or Disability or (B) by you for Good Reason, then the Employer shall arrange to provide you with life, disability, accident, health and dental insurance benefits substantially similar to those which you are receiving immediately prior to the Notice of Termination, such benefits to continue for so long as you are entitled to receive severance payments pursuant to Subsection 4(iii) (B) above; provided, however, that each such aforesaid category of benefits shall cease to be provided by the Employer upon your becoming eligible to receive benefits substantially similar to such category of benefits from another employer. (v) You shall not be required to mitigate the amount of any payment provided for in this Section 4 by seeking other employment or otherwise, nor shall the amount of any payment or benefit provided for in this Section 4 be reduced by any compensation earned by you as the result of employment by another Employer, by retirement benefits, by offset against any amount claimed to be owed by you to VFSC or the Bank, or otherwise, except as specifically provided in this Section 4. (vi) In addition to all other amounts payable to you under this Section 4, you shall be entitled to receive all benefits payable to you under the Employer's Pension Plan, Profit Sharing Plan and any other plan or agreement relating to retirement benefits. 5. Successors Binding Agreement. (i) The Bank will require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of its business and/or assets to assume expressly and agree to perform this Agreement in the same manner and to the same extent as if no such succession had taken place. Failure of the Bank to obtain such assumption and agreement prior to the effectiveness of any such succession shall be a breach of this Agreement and shall entitle you to compensation in the same amount and on the same terms as you would be entitled to hereunder if you terminate your employment for Good Reason following a change in control, except that for purposes of implementing the foregoing, the date on which any such succession becomes effective shall be deemed the Date of Termination. As used in this Agreement, "Bank" shall mean the Bank as hereinbefore defined and any successor to the business and/or assets of the Bank as aforesaid which successor assumes and agrees to perform this Agreement by operation of law, or otherwise. (ii) This Agreement shall inure to the benefit of and be enforceable by your personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If you should die while any amount would still be payable to you hereunder if you had continued to live, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to your devisee, legatee or other designee or, if there is no such designee, to your estate. 6. Notice. For the purpose of this Agreement, notices and all other communications provided for in the agreement shall be in writing and shall be deemed to have been duly given when delivered or mailed by United States registered mail, return receipt requested, postage prepaid, addressed to the respective addresses set forth on the first page of this Agreement, or to such other address as either party may have furnished to the other in writing in accordance herewith, except that notice of change of address shall be effective only upon receipt. 7. Miscellaneous. No provision of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing and signed by you and such officer or officers as may be specifically designated by the Boards. No waiver by a party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by another party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. No agreements or representations, oral or otherwise, express or implied, with respect of the subject matter hereof have been made by any party which are not expressly set forth in this Agreement. The validity, interpretation, construction and performance of this Agreement shall be governed by the laws of the State of Vermont. All references to sections of the Exchange Act or the Code shall be deemed also to refer to any successor provisions to such sections. Any payments provided for hereunder shall be paid net of any applicable withholding required under federal, state or local law. The obligations of the Bank under Section 4 shall survive the expiration of the term of this Agreement. 8. Validity. The invalidity or unenforceability or any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, which shall remain in full force and effect. 9. Counterparts. This Agreement may be executed in several counterparts, each of which shall be deemed to be an original but all of which together will constitute one and the same instrument. 10. Arbitration. Any dispute or controversy arising under or in connection with this Agreement shall be settled exclusively by arbitration in the city or town of VFSC's principal place of business as hereinbelow provided. If a dispute or controversy hereunder arises and, within thirty (30) days of each party's written notice thereof, such dispute or controversy has not been resolved by mutual accord, then such dispute or controversy shall be conclusively determined by three arbitrators, one arbitrator being selected by you, one arbitrator being selected by the Employer and the third being selected by the two arbitrators so selected. In the event of their inability to agree on the selection of a third arbitrator, the third arbitrator shall be designated in accordance with the rules of the American Arbitrator Association then in effect. In the event that within ten (10) business days after the above-referenced 30-day period expires without resolution of any dispute or controversy by mutual accord any party shall not have selected its arbitrator and given written notice thereof to the other party, such arbitrator shall be selected in accordance with the rules of the American Arbitration Association as then in effect. All determinations made by the arbitrators selected pursuant to the provision of this Section shall be by majority vote and shall be final. Notice of any such determination shall be forthwith given to each party. Upon the conclusion of the arbitration, the arbitrators shall allocate the costs of arbitration as follows: the Employer shall pay all the fees and expenses of such arbitration, except that you shall pay the portion of your legal fees specified in Subsection 4(iii) (E) above and the fees and expenses of the arbitrator selected by you. Judgment may be entered on the arbitrators' award in any court having jurisdiction; provided, however, that you shall be entitled to seek specific performance of your right to be paid until the Date of Termination during the pendency of any dispute or controversy arising under or in connection with this Agreement. If this letter sets forth our agreement on the subject matter hereof, kindly sign and return the enclosed copy of this letter which will then constitute our agreement on this subject. Vermont National Bank 100 Main Street Brattleboro, Vermont 05301 March 17, 1994 Mr. Louis J. Dunham RR 2, Box 469 Brattleboro, VT 05301 Dear Mr. Dunham: Vermont National Bank (the "Bank") considers it essential to the best interests of the Bank and its corporate parent, Vermont Financial Services Corp. ("VFSC") and their stockholders to foster the continuous employment of key management personnel. In this connection, the Boards of Directors of VFSC and the Bank (the "Boards") recognize that, as is the case with many publicly held businesses, the possibility of a change of control may exist and that such possibility, and the uncertainty and questions which it may raise among management, may result in the departure or distraction of management personnel to the detriment of the business and its stockholders. The Boards have determined that appropriate steps should be taken to reinforce and encourage the continued attention and dedication of members of the management of the Bank, including yourself, to their assigned duties without distraction in the face of potentially disturbing circumstances arising from the possibility of a change of control, although no such change is now contemplated. In order to induce you to remain in the employ of the Bank and in consideration of your agreement set forth in Subsection 2(ii) hereof, the Bank agrees that you shall receive the severance benefits set forth in this letter agreement (the "Agreement") in the event your employment is terminated subsequent to a "change in control" (as defined in Section 2 hereof) under the circumstances described below. When used herein, the term "Employer" shall mean the Bank. 1. Term of Agreement. This Agreement shall commence on the date hereof and shall continue in effect through January 31, 1997; provided, however, that commencing on January 31, 1995 and each January 31 thereafter, the term of this Agreement shall automatically be extended for one additional year unless, at least two years and thirty (30) days prior to the then scheduled termination of this Agreement, the Bank shall have given notice that it does not wish to extend this Agreement; provided, further, if a change in control (as defined in Subsection 2(i) hereof) shall have occurred during the original or extended term of this Agreement, this Agreement shall continue in effect for a period of thirty-six (36) months beyond the month in which such change in control occurred. 2. Change in Control. (1) No benefits shall be payable hereunder unless there shall have been a change in control of either VFSC or the Bank, as set forth below. For purposes of this Agreement, a "change in control" shall be deemed to have occurred if: (A) any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")), other than the Bank holding securities in a fiduciary capacity or a trustee or other fiduciary holding securities under an employee benefit plan of the Bank, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of VFSC or the Bank representing 25% or more of the combined voting power of the then outstanding securities of VFSC or the Bank, as the case may be; or (B) during any period of two consecutive years (not including any period prior to the execution of this Agreement), individuals who at the beginning of such period constitute the Board of either VFSC or the Bank and any new director (other than a director designated by a person who has entered into an agreement with VFSC or the Bank to effect a transaction described in clause (A) or (C) of this Subsection) whose election by such Board or nomination for election by the stockholders of VFSC or the Bank, as the case may be, was approved by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors at the beginning of such period or whose election or nomination for election was previously so approved, cease for any reason to constitute a majority of such Board; or (C) the stockholders of VFSC or the Bank approve a merger or consolidation of VFSC or the Bank, as the case may be, with any other corporation, other than a merger or consolidation which would result in the voting securities of VFSC or the Bank, as the case may be, outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least 70% of the combined voting power of the voting securities of the surviving entity outstanding immediately after such merger or consolidation, or the stockholders of VFSC or the Bank, as the case may be, approve an agreement for the sale or disposition of all or substantially all the assets of VFSC or the Bank, as the case may be. The merger of VFSC with another corporation effected for the purpose of reincorporating in another jurisdiction shall not constitute a change of control hereunder, neither shall the merger of VFSC with the Bank. (ii) For purposes of this Agreement, a "potential change in control" shall be deemed to have occurred if: (A) VFSC or the Bank enters into an agreement, the consummation of which would result in the occurrence of a change in control of VFSC or the Bank; (B) any person (including VFSC or the Bank) publicly announces an intention to take or to consider taking actions which if consummated would constitute a change in control of VFSC or the Bank; (C) any person, other than the Bank holding securities in a fiduciary capacity or a trustee or other fiduciary holding securities under an employee benefit plan of VFSC or the Bank, who is or becomes the beneficial owner, directly or indirectly, of securities of VFSC or the Bank representing 5% or more of the combined voting power of the then outstanding securities of VFSC or the Bank, as the case may be, increases its beneficial ownership of such securities by 5% or more over the percentage so owned by such person on the date hereof; or (D) the Board of VFSC or the Bank adopts a resolution to the effect that, for purposes of this Agreement, a potential change in control has occurred. You agree that, subject to the terms and conditions of this Agreement, in the event of a potential change in control, you will remain in the employ of the Employer until the earliest of (i) a date which is six (6) months from the occurrence of such potential change in control, (ii) the termination by you of your employment by reason of Disability or Retirement (at your normal retirement age), as defined in Subsection 3(i), or (iii) the occurrence of a change in control of VFSC or the Bank. 3. Termination Following Change in Control. If any of the events described in Subsection 2(i) hereof constituting a change in control shall have occurred, you shall be entitled to the benefits provided in Subsection 4(iii) hereof upon the subsequent termination of your employment with the Bank during the term of this Agreement unless such termination is (A) because of your death, Disability or Retirement, (B) for Cause, or (C) by you other than for Good Reason. (i) Disability; Retirement. Your employment may be terminated for "Disability" in accordance with the Employer's disability policy as in effect from time to time; provided that no discharge for Disability shall occur unless as a result of your incapacity due to physical or mental illness you shall have been absent from the full-time performance of your duties with the Employer for six (6) consecutive months, and within thirty (30) days after written notice of termination is given you shall not have returned to the full-time performance of your duties. Termination by the Employer or you of your employment based on "Retirement" shall mean termination in accordance with the Employer's retirement policy generally applicable to its salaried employees or in accordance with any retirement arrangement established with your consent with respect to you. (ii) Cause. Termination by the Employer of your employment for "Cause" shall mean termination upon (A) the willful and continued failure by you to substantially perform your duties with the Employer (other than (i) any such failure resulting from your incapacity due to physical or mental illness, or (ii) any such actual or anticipated failure after the issuance of a Notice of Termination by you for Good Reason, as defined in Subsections 3(iv) and 3(iii), respectively) after (a) a written demand for substantial performance is delivered to you by the Board of the Employer, which demand specifically identified the manner in which the Board believes that you have not substantially performed your duties, and (b) you have been afforded a reasonable opportunity to dispute any assertions of nonperformance, or (B) the willful engaging by you in conduct which is demonstrably and materially injurious to the Employer, monetarily or otherwise. For purposes of this Subsection, no act, or failure to act, on your part shall be deemed "willful" unless done, or omitted to be done, by you not in good faith and without reasonable belief that your action or omission was in the best interest of the Employer. Notwithstanding the foregoing, you shall not be deemed to have been terminated for Cause unless and until there shall have been delivered to you a copy of a resolution duly adopted by the affirmative vote of not less than three-quarters (3/4) of the Board called and held for such purpose (after reasonable notice to you and an opportunity for you, together with your counsel, to be heard before such Board), finding that in the good faith opinion of such Board you were guilty of conduct set forth above in clauses (A) or (B) of the first sentence of this Subsection and specifying the particulars thereof in detail. (iii) Good Reason. After a change in control defined in Subsection 2(i) hereof, you shall be entitled to the benefits provided in Subsection 4(iii) hereof, if you terminate your employment with the Employer for Good Reason. For purposes of this Agreement, "Good Reason" shall mean, without your express written consent, the occurrence after a change in control of VFSC or the Bank of any of the following circumstances unless, in the case of paragraphs (A), (E), (F), (G) or (H), such circumstances are fully corrected prior to the Date of Termination specified in the Notice of Termination, as defined in Subsections 3(v) and 3(iv), respectively, given in respect thereof: (A) the assignment to you of any duties inconsistent with your status as a senior executive officer of the Employer or a substantial adverse alteration in the nature or status of your responsibilities from those in effect immediately prior to the change in control; (B) a reduction in your annual base salary as in effect on the date hereof or as the same may be increased from time to time, except for across-the-board salary reductions similarly affecting all senior executives of VFSC and the Bank and all senior executives of any person in control of VFSC or the Bank; (C) the Employer's requiring you to be based anywhere other than VFSC's or the Bank's principal executive offices wherever located in Vermont from time to time, except for (i) transfers in connection with a demonstrable promotion and (ii) required travel substantially consistent with your present business travel obligations or in connection with a demonstrable promotion; (D) the failure by the Employer without your consent to pay to you any portion of your current compensation, except pursuant to an across-the-board compensation deferral similarly affecting all senior executives of VFSC and the Bank and all senior executives of any person in control of VFSC or the Bank, or to pay to you any portion of an installment of deferred compensation under any deferred compensation program, within seven (7) days of the date such compensation is due; (E) (i) the failure by the Employer to continue in effect any compensation plan in which you participate immediately prior to the change in control which is material to your total compensation, including but not limited to VFSC's Officers Nonqualified Stock Option Plan, Employee Stock Purchase Plan, Profit Sharing Plan and Retirement Plan, or any substitute plans adopted prior to the change in control, unless an equitable arrangement (embodied in an ongoing substitute or alternative plan or plans) has been made with respect to such plans in connection with the he change in control, or (ii) the failure by the Employer to continue your participation therein (or in such substitute or alternative plan or plans) on a basis not materially less favorable, both in terms of the amount of benefits provided and the level of your participation relative to other participants, as existed at the time of the change in control; (F) the failure by the Employer to continue to provide you with benefits substantially similar to those enjoyed by you under any pension, life insurance, medical, health and accident, or disability plans in which you were participating at the time of the change in control, the taking of any action which would directly or indirectly materially reduce any of such benefits or deprive you of any material fringe benefit enjoyed by you at the time of the change in control, or the failure to provide you with the number of paid vacation days to which you are entitled on the basis of years of service in accordance with normal vacation policy in effect at the time of the change in control; (G) the failure of the Employer to obtain a satisfactory agreement from any successor to assume and agree to perform this Agreement, as contemplated in Section 5 hereof; or (H) any purported termination of your employment which is not effected pursuant to a Notice of Termination satisfying the requirements of Subsection (iv) below (and, if applicable, the requirements of Subsection (ii) above); for purposes of this Agreement, no such purported termination shall be effective. Your right to terminate your employment pursuant to this Subsection shall not be affected by your incapacity due to physical or mental illness. Your continued employment shall not constitute consent to, or a waiver of rights with respect to, any circumstances constituting Good Reason hereunder. (iv) Notice of Termination. Any purported termination of your employment by the Employer or by you shall be communicated by written Notice of Termination to the other parties hereto in accordance with Section 6 hereof. For purposes of this Agreement, a "Notice of Termination" shall mean a notice which shall indicate the specific termination provision in this Agreement relied upon and shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of your employment under the provision so indicated. (v) Date of Termination, Etc. "Date of Termination shall mean (A) if your employment is terminated for Disability, thirty (30) days after Notice of Termination is given (provided that you shall not have returned to the full-time performance of your duties during such thirty (30 day period), and (B) if your employment is terminated pursuant to Subsection (ii) or (iii) above or for any other reason (other than Disability), the date specified in the Notice of Termination (which, in the case of a termination pursuant to Subsection (ii) above shall not be less than thirty (30) days, and in the case of a termination pursuant to Subsection (iii) above shall not be less than fifteen (15) nor more than sixty (60) days, respectively, from the date such Notice of Termination is given); provided that if within fifteen (15) days after any Notice of Termination is given, or, if later, prior to the Date of Termination (as determined without regard to this proviso), the party receiving such Notice of Termination notifies the other party that a dispute exists concerning the termination, the Date of Termination shall be the date on which the dispute is finally determined, either by mutual written agreement of the parties, by a binding arbitration award, or by a final judgment, order or decree of a court of competent jurisdiction (which is not appealable or with respect to which the time for appeal therefrom has expired and no appeal has been perfected); provided further that the Date of Termination shall be extended by a notice of dispute only if such notice is given in good faith and the party giving such notice pursues the resolution of such dispute with reasonable diligence. In the event of the pendency of any such dispute, the Employer will suspend your salary payments but will continue you as a participant in all benefit and insurance plans in which you were participating when the notice giving rise to the dispute was given, until the dispute is finally resolved in accordance with this Subsection. Amounts paid under this Subsection are in addition to all other amounts due under this Agreement and shall not be offset against or reduce any other amounts due under this Agreement. 4. Compensation Upon Termination or During Disability. Following a change in control, as defined by Subsection 2(i), upon termination of your employment or during a period of disability you shall be entitled to the following benefits: (i) During any period that you fail to perform your full-time duties with the Employer as a result of incapacity due to physical or mental illness, you shall continue to receive your base salary at the rate in effect at the commencement of any such period, together with all compensation payable to you under the Profit Sharing Plan or other similar plans in effect during such period, until this Agreement is terminated pursuant to Section 3(i) hereof. Thereafter, or in the event your employment shall be terminated by the Employer or by you for Retirement, or by reason of your death, your benefits shall be determined under the Employer's retirement, insurance and other compensation programs. (ii) If your employment shall be terminated by the Employer for Cause or by you other than for Good Reason, Disability, Death or Retirement, the Employer shall pay you your full base salary through the Date of Termination at the rate in effect at the time Notice of Termination is given, plus all other amounts to which you are entitled under any compensation plan at the time such payments are due, and VFSC and the Bank shall have no further obligations to you under this Agreement. (iii) If your employment shall be terminated (a) by the Bank other than for Cause, Retirement or Disability or (b) by you for Good Reason, then you shall be entitled to the benefits provided below: (A) The Employer shall pay you your full base salary (net of all required withholdings, if any) through the Date of Termination at the rate in effect at the time Notice of Termination is given, plus all other amounts to which you are entitled under any compensation plan of the Employer, at the time such payments are due, except as otherwise provided below. (B) In lieu of any further salary payments to you for periods subsequent to the Date of Termination, the Employer shall pay you as severance an aggregate amount equal to 200% of your annual base salary in effect immediately prior to the occurrence of the circumstance giving rise to the Notice of Termination given in respect thereof, such amount to be paid out in equal, consecutive biweekly installments commencing two weeks after the Date of Termination, except as provided in paragraph (F) below. (C) In lieu of shares of common stock of VFSC ("VFSC Shares") issuable upon exercise of outstanding options ("Options"), if any, granted to you under VFSC's Officers Nonqualified Stock Option Plan (which Options shall be cancelled upon the making of the payment referred to below), you shall receive an amount in cash equal to the produce of (i) the excess of the higher of the mean of the bid and the asked price of VFSC Shares as reported on the National Association of Securities Dealers Automated Quotation system ("NASDAQ") on or nearest the Date of Termination or the highest per share price for VFSC Shares actually paid in connection with any change in control, over the per share exercise price of each Option held by you (whether or not then fully exercisable), times (ii) the number of VFSC Shares covered by each such option. (D) The payment provided for in paragraph (C) above shall be made not later than the fifth day following the Date of Termination, provided, however, that if the amounts of such payments cannot be finally determined on or before such day, you shall be paid on such day an estimate, as determined in good faith, of the minimum amount of such payments, the remainder of such payments (together with interest at the rate provided in Section 1274(b) (2) (B) of the Internal Revenue Code) as soon as the amount thereof can be determined but in no event later than the thirtieth day after the Date of Termination. In the event that the amount of the estimated payments exceeds the amount subsequently determined to have been due, such excess shall constitute a loan to you, payable on the fifth day after demand (together with interest at the rate hereinabove provided). (E) The Employer also shall pay to you 50% of all legal fees and expenses incurred by you as a result of such termination (including all such fees and expenses, if any, incurred in contesting or disputing any such termination or in seeking to obtain or enforce any right or benefit provided by this Agreement or in connection with any tax audit or proceeding to the extent attributable to any payment or benefit provided hereunder). Such payments shall be made at the later of the time specified in paragraph (D) above, or within five (5) days after your request for payment accompanied with such evidence of fees and expenses incurred as the Employer reasonably may require. (F) The severance payments provided for in paragraph (B) above shall be reduced, as provided hereinbelow, in the event that, during the period in which you otherwise would be entitled to receive installments of such payments, you directly or indirectly serve as an officer, employee, director, agent, partner or consultant of, or otherwise participate in the management, operation or control of, any commercial or savings banking institution, or any entity which controls any such institution, which does business in the State of Vermont. The provisions of this paragraph (F) shall not apply in any instance (i) in which the services or activities performed by you which would otherwise result in a reduction of severance benefits are performed substantially outside of the State of Vermont, or (ii) in which your sole connection with such commercial or savings banking institution, or entity which controls such institution, consists of your ownership of less than five percent (5%) of the outstanding voting securities thereof. If an event described in the first sentence of this paragraph (F) occurs prior to your receipt of one-half of the severance payments provided for in paragraph (B) above, such severance payments shall cease upon the payment of one-half thereof. If such event occurs after your receipt of one-half of such severance payments, you shall be entitled to no further severance payments; provided, however, that there shall be no reduction in severance benefits if within thirty (30) days of your notification from the Employer that an event has occurred which would result in a reduction of severance payments as hereinabove provided (or the Employer's cessation of such payments without prior notification), you either sever the relationship which gives rise to such reduction of severance payments or demonstrate to the reasonable satisfaction of the Board of the Employer that no reduction of severance payments is warranted. (G) The Employer also shall reimburse you for the reasonable fee of a professional out-placement service selected by you within 90 days after termination of your employment. (iv) If your employment shall be terminated (A) by the Employer other than for Cause, Retirement or Disability or (B) by you for Good Reason, then the Employer shall arrange to provide you with life, disability, accident, health and dental insurance benefits substantially similar to those which you are receiving immediately prior to the Notice of Termination, such benefits to continue for so long as you are entitled to receive severance payments pursuant to Subsection 4(iii) (B) above; provided, however, that each such aforesaid category of benefits shall cease to be provided by the Employer upon your becoming eligible to receive benefits substantially similar to such category of benefits from another employer. (v) You shall not be required to mitigate the amount of any payment provided for in this Section 4 by seeking other employment or otherwise, nor shall the amount of any payment or benefit provided for in this Section 4 be reduced by any compensation earned by you as the result of employment by another Employer, by retirement benefits, by offset against any amount claimed to be owed by you to VFSC or the Bank, or otherwise, except as specifically provided in this Section 4. (vi) In addition to all other amounts payable to you under this Section 4, you shall be entitled to receive all benefits payable to you under the Employer's Pension Plan, Profit Sharing Plan and any other plan or agreement relating to retirement benefits. 5. Successors Binding Agreement. (i) The Bank will require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of its business and/or assets to assume expressly and agree to perform this Agreement in the same manner and to the same extent as if no such succession had taken place. Failure of the Bank to obtain such assumption and agreement prior to the effectiveness of any such succession shall be a breach of this Agreement and shall entitle you to compensation in the same amount and on the same terms as you would be entitled to hereunder if you terminate your employment for Good Reason following a change in control, except that for purposes of implementing the foregoing, the date on which any such succession becomes effective shall be deemed the Date of Termination. As used in this Agreement, "Bank" shall mean the Bank as hereinbefore defined and any successor to the business and/or assets of the Bank as aforesaid which successor assumes and agrees to perform this Agreement by operation of law, or otherwise. (ii) This Agreement shall inure to the benefit of and be enforceable by your personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If you should die while any amount would still be payable to you hereunder if you had continued to live, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to your devisee, legatee or other designee or, if there is no such designee, to your estate. 6. Notice. For the purpose of this Agreement, notices and all other communications provided for in the agreement shall be in writing and shall be deemed to have been duly given when delivered or mailed by United States registered mail, return receipt requested, postage prepaid, addressed to the respective addresses set forth on the first page of this Agreement, or to such other address as either party may have furnished to the other in writing in accordance herewith, except that notice of change of address shall be effective only upon receipt. 7. Miscellaneous. No provision of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing and signed by you and such officer or officers as may be specifically designated by the Boards. No waiver by a party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by another party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. No agreements or representations, oral or otherwise, express or implied, with respect of the subject matter hereof have been made by any party which are not expressly set forth in this Agreement. The validity, interpretation, construction and performance of this Agreement shall be governed by the laws of the State of Vermont. All references to sections of the Exchange Act or the Code shall be deemed also to refer to any successor provisions to such sections. Any payments provided for hereunder shall be paid net of any applicable withholding required under federal, state or local law. The obligations of the Bank under Section 4 shall survive the expiration of the term of this Agreement. 8. Validity. The invalidity or unenforceability or any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, which shall remain in full force and effect. 9. Counterparts. This Agreement may be executed in several counterparts, each of which shall be deemed to be an original but all of which together will constitute one and the same instrument. 10. Arbitration. Any dispute or controversy arising under or in connection with this Agreement shall be settled exclusively by arbitration in the city or town of VFSC's principal place of business as hereinbelow provided. If a dispute or controversy hereunder arises and, within thirty (30) days of each party's written notice thereof, such dispute or controversy has not been resolved by mutual accord, then such dispute or controversy shall be conclusively determined by three arbitrators, one arbitrator being selected by you, one arbitrator being selected by the Employer and the third being selected by the two arbitrators so selected. In the event of their inability to agree on the selection of a third arbitrator, the third arbitrator shall be designated in accordance with the rules of the American Arbitrator Association then in effect. In the event that within ten (10) business days after the above-referenced 30-day period expires without resolution of any dispute or controversy by mutual accord any party shall not have selected its arbitrator and given written notice thereof to the other party, such arbitrator shall be selected in accordance with the rules of the American Arbitration Association as then in effect. All determinations made by the arbitrators selected pursuant to the provision of this Section shall be by majority vote and shall be final. Notice of any such determination shall be forthwith given to each party. Upon the conclusion of the arbitration, the arbitrators shall allocate the costs of arbitration as follows: the Employer shall pay all the fees and expenses of such arbitration, except that you shall pay the portion of your legal fees specified in Subsection 4(iii) (E) above and the fees and expenses of the arbitrator selected by you. Judgment may be entered on the arbitrators' award in any court having jurisdiction; provided, however, that you shall be entitled to seek specific performance of your right to be paid until the Date of Termination during the pendency of any dispute or controversy arising under or in connection with this Agreement. If this letter sets forth our agreement on the subject matter hereof, kindly sign and return the enclosed copy of this letter which will then constitute our agreement on this subject. Exhibit 22 Subsidiaries of Registrant: 1. Vermont National Bank, a national banking association, with a principal place of business at 100 Main Street, Brattleboro, VT 05301. 2. Vermont Financial Services Corp., a Delaware corporation, with a principal place of business at 100 Main Street, Brattleboro, VT 05301 (incorporated in 1990). Exhibit 24 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Vermont Financial Services Corp. on Form S-8 (File No. 2-83361), Form S-3 (File No. 2-80833) and Form S-4 (File No. 33-72554) of our report dated January 21, 1994 on our audit of the consolidated financial statements of Vermont Financial Services Corp. and subsidiary as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which report is included in this Annual Report on From 10-K. COOPERS & LYBRAND Springfield, Massachusetts March 28, 1994

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35214

ITEM 1 Business - --------------- Ferro Corporation ("Ferro"), which was incorporated under the laws of Ohio in 1919, is a worldwide producer of specialty materials by organic and inorganic chemistry for industry. It operates (either directly or through wholly owned subsidiaries or partially owned affiliates) in 22 countries worldwide. Ferro produces a variety of specialty coatings, specialty colors, specialty chemicals, specialty ceramics, specialty plastics and related products and services. Ferro's most important product is frit produced for use in porcelain enamels and ceramic glazes. Most of the products produced by Ferro are classified as specialty materials, rather than commodities, because they are formulated or designed to perform a specific and important function in the manufacturing processes of Ferro customers or in their end products. These specialty materials are not sold in the high volume normally associated with commodity businesses. - 2 - Ferro specialty materials require a high degree of technical service on an individual customer basis. The value of these specialty materials stems not just from their raw materials composition, but from the result and performance they achieve in actual use. A further description of Ferro's business, its principal products, their markets and applications is contained under all headings on pages 4 through 13 of Ferro's 1993 Annual Report to Shareholders which is attached hereto as Exhibit 13 (the "Annual Report"). The information contained under the aforementioned headings on pages 4 through 13 of the Annual Report (excluding those pages on which only pictures appear and the pictures and text describing such pictures on pages 7, 9, 11, and 13) is incorporated herein by reference. Information concerning Ferro's business during 1993, 1992, and 1991 and certain transactions consummated during those years is included under the heading "Management's Discussion and Analysis" on pages 15 through 20 of the Annual Report and in Note 6 to Ferro's Consolidated Financial Statements, which are included in the Annual Report. Note 6 appears at page 29 of the Annual Report. Such information is incorporated herein by reference. Additional information about Ferro's industry segments, including financial information relating thereto, is set forth in Note 11 to Ferro's Consolidated Financial Statements, which appears on pages 33 through 35 of the Annual Report and is incorporated herein by reference. Raw Materials ------------- For the most part the raw materials essential to Ferro's operations both in the United States and overseas are obtainable from multiple sources worldwide. Ferro did not encounter significant raw material shortages in 1993 and does not anticipate such shortages in 1994. Patents and Licenses -------------------- Ferro owns a substantial number of patents relating to its various products and their uses. While these patents are of importance to Ferro, it does not consider that the invalidity or expiration of any single patent or group of patents would have a material adverse effect on its business. Ferro patents expire at various dates through the year 2010. Ferro does not hold any licenses, franchises or concessions which it considers to be material. Customers --------- Ferro does not consider that a material part of its business is dependent on any single customer or group of customers. Backlog of Orders ----------------- In general there is no significant lead time between order and delivery in any of Ferro's business segments. As a result, Ferro does not consider that the dollar amount of - 3 - backlog of orders believed to be firm as of any particular date is material for an understanding of its business. Ferro does not regard any material part of its business to be seasonal. Competition ----------- With respect to most of its products, Ferro competes with a substantial number of companies, none of which is dominant. An exception is frit, as to which Ferro believes that it is the largest worldwide supplier. The details of foreign competition necessarily vary with respect to each foreign market. Because of the specialty nature of Ferro's products, product performance characteristics and customer service are the most important components of the competition which Ferro encounters in the sale of nearly all of its products. However, in some of the markets served by Ferro, strong price competition is encountered from time to time. Research and Development ------------------------ A substantial number of Ferro's employees are involved in technical activities concerned with products required by the ever-changing markets of its customers. Laboratories are located at each of Ferro's major subsidiaries around the globe, where technical efforts are applied to the customer and market needs of that geographical area. In the United States, laboratories are maintained in each of its divisions. Backing up these divisional customer services laboratories is Corporate research activity involving approximately 52 scientists and support personnel in the Cleveland area. Expenditures for research and development activities relating to the development or significant improvement of new and/or existing products, services and techniques were approximately $19,334,000, $15,440,000, and $17,643,000 in 1993, 1992 and 1991, respectively. Expenditures for individual customer requested research and development were not material. Environmental Matters --------------------- Ferro's manufacturing facilities, like those of industry generally, are subject to numerous laws and regulations designed to protect the environment, particularly in regard to plant wastes and emissions. In general, Ferro believes that it is in substantial compliance with the environmental regulations to which its operations are subject and that, to the extent Ferro may not be in compliance with such regulations, such non-compliance has not had a material adverse effect on Ferro. Moreover, while Ferro has not generally experienced substantial difficulty in complying with environmental requirements, compliance has required a continuous management effort and significant expenditures. Ferro and its international subsidiaries authorized approximately $8,970,000, $9,622,000 and $3,287,000 in capital expenditures for environmental control during 1993, 1992 - 4 - and 1991, respectively. Three major projects accounted for the high level of environmental control capital expenditures in 1992. They were: Three major projects accounted for the high level of environmental control capital expenditures in 1993. They were: During 1993, the Company became involved in two separate environmental claims regarding Keil Chemical, a production facility owned and operated by Ferro in Hammond, Indiana. The Company has been named as one of several defendants, including three local municipalities, one local government agency (a sewer district) and four other area industrial concerns in a suit filed by the United States Environmental Protection Agency alleging violation of the Clean Water Act and the River and Harbors Act. The suit was filed in the Federal District Court for the Northern District of Indiana on August 2, 1993. The suit alleges violation of pre-treatment requirements for removal of pollutants prior to discharge of wastewater into the Grand Calumet and Little Calumet Rivers. Relief sought includes orders to comply with environmental regulations, civil penalties of up to $25,000 per day for each violation, and contribution to the cost of removing contaminated sediments from the west branch of the Grand Calumet River. The Company believes it is in substantial compliance with applicable law and intends to vigorously defend this litigation. However, the Company will also explore settlement - 5 - possibilities, and if it is more economical to settle than to defend, the Company will pursue that course of action. In a separate matter, in late July 1993, the United States Environmental Protection Agency, the Indiana Department of Environmental Management and the Hammond Department of Environmental Management alleged violation of air emission regulations by the Keil Chemical facility. The allegations relate to materials used in the manufacture of flame retardants. The notices from the governmental authorities threaten the possibility of proceedings to suspend operations in the manufacture of flame retardants and threaten civil penalties of up to $25,000 per day of violation. The Company has voluntarily commenced a capital program, estimated to cost $3.0 million, to reduce air emissions related to its flame retardant process at Keil Chemical and in consultation with the agencies, has taken interim measures to reduce air emissions pending completion of the capital program. The Company has been working with the appropriate environmental agencies and is exploring whether the agencies' claims can be settled on reasonable terms. If reasonable settlement cannot be reached, the Company intends to vigorously defend against the agencies' claims. Employees --------- At December 31, 1993, Ferro employed approximately 6,627 full-time employees, including 4,325 employees in its foreign subsidiaries and affiliates and 2,302 in the United States. Set forth below is a table of union contracts showing name of union, expiration date of union agreement, number of employees covered by the union agreement, and percentage of United States work force covered by the union agreement. - 6 - As indicated by the foregoing table, only 2.6% of Ferro's domestic work force is affected by union agreements which expire in 1994. - 7 - Foreign Operations ------------------ Financial information about Ferro's domestic and foreign operations is set forth under the heading "Geographic Operating Data" on page 35 of the Annual Report and is incorporated herein by reference. Ferro's products are produced and distributed in foreign as well as domestic markets. Ferro commenced its international operations in 1927. Wholly-owned subsidiaries operate manufacturing facilities in Argentina, Australia, Brazil, Canada, England, France, Germany, Holland, Italy, Mexico, New Zealand, Spain and Taiwan. Partially-owned affiliates manufacture in Ecuador, Indonesia, Italy, Japan, Portugal, Taiwan, Thailand, Turkey and Venezuela. Foreign operations (excluding Canada) accounted for 50% of the consolidated net sales and 57% of Ferro's consolidated operating income for the fiscal year 1993; comparable amounts for the fiscal year 1992 were 55% and 74% and for fiscal year 1991 were 55% and 159%. The split of operating income between foreign and domestic operations in 1991 was skewed heavily against domestic results due to the one time restructuring charge. Except for the sales of Ferro Enamel Espanola S.A. (Spain), Ferro France, S.a R.L. (France), Ferro Chemicals S.A. (France), Ferro (Holland) B.V., Ferro Mexicana S.A. de C.V. (Mexico), Ferro (Great Britain) Ltd., Ferro Industrial Products Limited (Taiwan), Ferro Toyo Co., Ltd. (Taiwan) and Metal Portuguesa S.A. (Portugal), the sales of each of Ferro's subsidiaries are principally for delivery in the country in which the subsidiary is located. Ferro's European Community subsidiaries continue to reduce and eliminate, to the extent practical, duplication of product lines with the intended result being that only one subsidiary will be the primary provider of each line of Ferro specialty products to the entire European Community market. Ferro receives technical service fees and/or royalties from many of its foreign subsidiaries. Under historical practice, as a matter of general corporate policy, the foreign subsidiaries were normally expected to remit a portion of their annual earnings to the parent by way of dividends. Under current practice, earnings of the Company's European subsidiaries are being reinvested in European operations. Several of the countries where Ferro has subsidiaries control the transfer of currency out of the country, but in recent years Ferro has been able to receive such remittances without material hindrance from foreign government restrictions. To the extent earnings of foreign subsidiaries are not remitted to Ferro, such earnings are intended to be indefinitely invested in those subsidiaries. - 8 - ITEM 2 ITEM 2 Properties - ------------------- Ferro's research and development center is located in leased space in Cleveland, Ohio. The corporate headquarters office is located at 1000 Lakeside Avenue, Cleveland, Ohio, and such property is owned by the Company. The business segments in which Ferro's plants are used and the locations of the principal manufacturing plants it owns in the United States are as follows: Coatings, Colors and Ceramics -- Cleveland, Ohio, Lake Park, Florida, Nashville, Tennessee, Pittsburgh, Pennsylvania, Toccoa, Georgia, Orrville, Ohio, Penn Yan, New York, East Liverpool, Ohio, Crooksville, Ohio, and East Rochester, New York; Plastics -- Plymouth, Indiana, Evansville, Indiana, Stryker, Ohio, Edison, New Jersey and South Plainfield, New Jersey; Chemicals - -- Bedford, Ohio, Hammond, Indiana and Baton Rouge, Louisiana. In addition, Ferro leases manufacturing facilities in Santa Barbara, California (Coatings); Schaumburg, Illinois (Plastics) and Lake Park, Florida (Coatings). Outside the United States, Ferro or its subsidiaries own manufacturing plants in Argentina, Australia, Brazil, Canada, France, Germany, Indonesia, Italy, Japan, Mexico, the Netherlands, Portugal, Spain, Taiwan, Thailand and the United Kingdom. Ferro or its subsidiaries lease manufacturing plants in Italy, the Netherlands and New Zealand. In many instances, the manufacturing facilities outside of the United States are used in multiple business segments of Ferro. Ferro believes that all of the foregoing facilities are generally well maintained and adequate for their present use. During the past year, several of Ferro's plants have been operating near capacity. ITEM 3 ITEM 3 Legal Proceedings - -------------------------- The information set forth in Note 7 to Ferro's Consolidated Financial Statements on page 29 of the Annual Report is incorporated herein by reference. Information regarding certain legal proceedings with respect to environmental matters is contained under Part I of this Annual Report on Form 10-K. The law firm of Squire, Sanders & Dempsey, of which Paul B. Campbell is a partner, provided legal services to Ferro in 1993 and Ferro plans to continue the use of such firm in 1994. Mr. Campbell is the Secretary and a Director of Ferro. ITEM 4 ITEM 4 Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ No matters were submitted to a vote of Ferro's security holders during the fourth quarter of the fiscal year covered by this report. - 9 - Executive Officers of the Registrant ------------------------------------ There is set forth below the name, age, positions and offices held by each of Ferro's executive officers as of March 15, 1994 as well as their business experience during the past five years. Years indicate the year the individual was named to the indicated position. There is no family relationship between any of Ferro's executive officers. Albert C. Bersticker - 59 President and Chief Executive Officer, 1991 President and Chief Operating Officer, 1988 Werner F. Bush - 54 Executive Vice President and Chief Operating Officer, 1993 Senior Vice President, Coatings, Colors and Ceramics, 1991 Group Vice President, Coatings, Colors and Electronic Materials, 1988 David G. Campopiano - 45 Vice President, Corporate Development, 1989 Senior Vice President, Prescott, Ball & Turben, Inc., 1987 Frank A. Carragher - 62 Senior Vice President, Chemicals and Polymers, 1991 Group Vice President, Chemicals, 1979 R. Jay Finch - 52 Vice President, Specialty Plastics, 1991 Vice President and General Manager, Plastics & Rubber Division, Mobay Corporation, 1984 James F. Fisher - 56 Senior Vice President, Coatings, Colors and Ceramics, 1993 Group Vice President, International, 1991 Vice President, International, 1988 D. Thomas George - 46 Treasurer, 1991 Director, Treasury Operations, 1989 Area Controller, Latin America and Far East, 1988 Marino Lopez-Vega - 52 Vice President, Frit, 1992 Managing Director of Ferro Spain, 1984 - 10 - Hector R. Ortino - 51 Executive Vice President and Chief Financial-Administrative Officer, 1993 Senior Vice President and Chief Financial Officer, 1991 Vice President, Finance and Chief Financial Officer, 1987 Richard C. Oudersluys - 55 Vice President, Pigments and Glass/Ceramics Colorants, 1992 General Manager, Color Division, 1987 Robert E. Price - 55 Vice President, International, 1993 Managing Director, Asia-Pacific, 1989 President, Ferro Far East Ltd., 1987 Thomas O. Purcell, Jr. - 50 Vice President, Research and Development, 1991 Associate Director Research, Plastics, 1990 Manager, Technology Assessment Operation, General Electric Plastics, 1988 Gary H. Ritondaro - 47 Vice President, Finance, 1993 Vice President, Controller, 1991 Controller, 1986 PART II ------- ITEM 5 ITEM 5 Market for Registrant's Common Equity and Related Stockholder Matters - ---------------------------------------------------------- Information regarding the recent price and dividend history of Ferro's Common Stock, the principal market for its Common Stock and the number of holders thereof is set forth under the heading "Quarterly Data" on page 38 of the Annual Report. Said information is incorporated herein by reference. Information concerning dividend restrictions is contained in Note 3 to Ferro's Consolidated Financial Statements on pages 26 and 27 of the Annual Report and said information is incorporated herein by reference. ITEM 6 ITEM 6 Selected Financial Data - -------------------------------- The summary of selected financial data for each of the last five years set forth under the heading "Selected Financial Data" on pages 36 and 37 of the Annual Report is incorporated herein by reference. - 11 - ITEM 7 ITEM 7 Management's Discussion and Analysis of Financial Conditions and Results of Operation - ---------------------------------------------------------- The information contained under the heading "Management's Discussion and Analysis" on pages 15 through 20 of the Annual Report is incorporated herein by reference. ITEM 8 ITEM 8 Financial Statements and Supplementary Data - ---------------------------------------------------- The Consolidated Financial Statements of Ferro and its subsidiaries contained on pages 21 through 35, inclusive, of the Annual Report, including the Notes to Consolidated Financial Statements, are incorporated herein by reference. ITEM 9 ITEM 9 Changes in and Disagreements With Accountants on Accounting and Financial Disclosure - ------------------------------------------------------------------------ There are no such changes or disagreements. PART III -------- ITEM 10 ITEM 10 Directors and Executive Officers of the Registrant - ----------------------------------------------------------- The information regarding directors of Ferro contained under the headings "Election of Directors" and "Certain Matters Pertaining to the Board of Directors" on pages 1 through 9, inclusive, of Ferro's Proxy Statement dated March 14, 1994 is incorporated herein by reference. Information regarding executive officers of Ferro is contained under Part I of this Annual Report on Form 10-K. ITEM 11 ITEM 11 Executive Compensation - ------------------------------- The information required by this Item 11 is set forth under the heading "Information Concerning Executive Officers" on pages 15 through 20, inclusive, of Ferro's Proxy Statement dated March 14, 1994 and is incorporated herein by reference. ITEM 12 ITEM 12 Security Ownership of Certain Beneficial Owners and Management - ----------------------------------------------------------------------- The information required by this Item 12 is set forth under the headings "Election of Directors" and "Security Ownership of Directors, Officers and Certain Beneficial Owners" on pages 1 through 8 of Ferro's Proxy Statement dated March 14, 1994 and is incorporated herein by reference. - 12 - ITEM 13 ITEM 13 Certain Relationships and Related Transactions - ------------------------------------------------------- There are no relationships or transactions that are required to be reported. PART IV ------- ITEM 14 ITEM 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K - ------------------------------------------------------------ 1. Documents filed as part of this Annual Report on Form 10-K (a) The following Consolidated Financial Statements of Ferro Corporation and its subsidiaries, contained on pages 21 through 35, inclusive, of the Annual Report are incorporated herein by reference: Consolidated Statements of Income for the Years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements (b) Financial Statement Schedules V, VI, VIII, IX and X, together with the independent Auditor's Report thereon, are contained on pages through of this Annual Report on Form 10-K. (c) Exhibits (3) Articles of Incorporation and by-laws (a) Eleventh Amended Articles of Incorporation. (Reference is made to Exhibit 3 to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended September 30, 1989, which Exhibit is incorporated herein by reference.) - 13 - (b) Amended Code of Regulations. (Reference is made to Exhibit (3)(b) to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended June 30, 1987, which Exhibit is incorporated herein by reference.) (4) Instruments defining rights of security holders, including indentures (a) Revolving Credit Agreement by and between Ferro and four commercial banks dated August 22, 1990. (Reference is made to Exhibit 10 to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended September 30, 1990, which Exhibit is incorporated herein by reference.) (b) Amendment Number 1 dated May 31, 1991, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is made to Exhibit 4(b)(1) to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended June 30, 1991, which Exhibit is incorporated herein by reference.) (c) Amendment Number 2 dated July 30, 1991, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is made to Exhibit 4(b)(2) to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended June 30, 1991, which Exhibit is incorporated herein by reference.) (d) Amendment Number 3 dated December 31, 1991, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is hereby made to Exhibit 4 to Ferro Corporation's Form 10-K for the year ended December 31, 1991, which Exhibit is incorporated herein by reference.) (e) Amendment Number 4 dated July 21, 1992, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is hereby made to Exhibit 4 to Ferro Corporation's Form 10-Q for the three months ended June 30, 1992, which Exhibit is incorporated herein by reference.) (f) Amendment Number 5 dated April 20, 1993, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is hereby made to Exhibit 4(b)(4) to Ferro Corporation's Form 10-Q for the three months ended June 30, 1993, which Exhibit is incorporated herein by reference.) - 14 - (g) The rights of the holders of Ferro's 11-3/4% Debentures due October 15, 2000 are described in the form of Indenture filed as Exhibit 4(b) to Amendment No. 1 to the Registration Statement on Form S- 3 filed with the Commission on October 8, 1985 (Registration No. 33-529). Said Exhibit is incorporated herein by reference. (h) Rights Agreement between Ferro Corporation and National City Bank, Cleveland, Ohio, as Rights Agent, dated as of March 21, 1986. (Reference is made to Exhibit 1.2 to the Registration Statement on Form 8-A dated March 26, 1986, which Exhibit is incorporated herein by reference.) (i) Amendment No. 1 to Rights Agreement between Ferro Corporation and National City Bank, Cleveland, Ohio, as Rights Agent, dated as of March 31, 1989. (Reference is made to Exhibit 1 to Form 8-K filed with the Commission on March 31, 1989, which Exhibit is incorporated herein by reference.) (j) The rights of the holders of Ferro's Debt Securities to be issued pursuant to an Indenture between Ferro and Society National Bank, as Trustee, are described in the form of Indenture dated May 1, 1993 filed as Exhibit 4(j) to Ferro Corporation's Form 10-Q for the three months ended June 30, 1993. Said Exhibit is incorporated herein by reference. (10) Material Contracts (a) Key elements of Ferro's Incentive Compensation Plan are set forth under the heading "Report of the Compensation and Organization Committee" on pages 11 through 13 of the Proxy Statement dated March 14, 1994. Said description is incorporated herein by reference. (b) Key elements of Ferro's Performance Share Plan are set forth under the heading "Performance Share Plan Awards" on pages 15, note 1, 17 and 18 of Ferro Corporation's Proxy Statement dated March 15, 1993. Said description is incorporated herein by reference. (c) Ferro Corporation Savings and Stock Ownership Plan. (Reference is made to Exhibit 4.3 to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended March 31, 1989, which Exhibit is incorporated herein by reference.) - 15 - (d) Ferro's 1985 Employee Stock Option Plan for Key Personnel (Amended and Restated). (Reference is hereby made to Exhibit A to Ferro Corporation's Proxy Statement dated March 11, 1991, which Exhibit is hereby incorporated by reference.) (e) Form of Indemnification Agreement (adopted January 25, 1991 for use from and after that date). (Reference is hereby made to Exhibit 10 to Ferro Corporation's Form 10-K for the year ended December 31, 1990, which Exhibit is incorporated herein by reference.) (f) Form of Executive Employment Agreement (adopted October 1, 1991 for use from and after that date). (Reference hereby is made to Exhibit 10 to Ferro Corporation's Form 10-K for the year ended December 31, 1991, which Exhibit is incorporated herein by reference.) (g) Schedule I listing the officers with whom Ferro has entered into currently effective executive employment agreements. A copy of such Schedule I is attached hereto as Exhibit 10. (h) Agreement between Ferro Corporation and Frank A. Carragher dated October 18, 1993 is attached hereto as Exhibit 10.1. (11) Statement Regarding Computation of Earnings Per Share. (12) Ratio of Earnings to Fixed Charges. (13) Annual Report to Shareholders for the year ended December 31, 1993. (21) List of Subsidiaries. (23) Consent of KPMG Peat Marwick to the incorporation by reference of their audit report on the Consolidated Financial Statements contained in the Annual Report into Ferro's Registration Statements on Form S-8 Registration Nos. 2-61407, 33-28520 and 33-45582 and Ferro's Registration Statement on Form S-3 Registration No. 33-51284. 2. No reports on Form 8-K were filed for the three months ended December 31, 1993. - 16 - SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. FERRO CORPORATION By /s/Albert C. Bersticker ----------------------------------- Albert C. Bersticker, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in their indicated capacities and as of this 28th day of March, 1994. - 17 - - 18 - FERRO CORPORATION AND SUBSIDIARIES Supporting Schedules to Consolidated Financial Statements and Schedules Submitted in Response to Part IV -- Form 10-K December 31, 1993, 1992 and 1991 KPMG PEAT MARWICK CERTIFIED PUBLIC ACCOUNTANTS 1500 National City Center 1800 East Ninth Street Cleveland, OH 44114-3495 INDEPENDENT AUDITORS' REPORT ---------------------------- The Shareholders and Board of Directors Ferro Corporation: Under date of January 27, 1994, we reported on the consolidated balance sheets of Ferro Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the years in the three- year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules listed in the accompanying table of contents. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG PEAT MARWICK Cleveland, Ohio January 27, 1994 FERRO CORPORATION AND SUBSIDIARIES ----------------- Financial Statements -------------------- Audited Consolidated Balance Sheets - December 31, 1992 and 1991 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, 1992, and 1991 Schedules --------- Plant and Equipment - Years ended December 31, 1993, 1992, and 1991 Schedule V Accumulated Depreciation of Plant and Equipment - Years ended December 31, 1993, 1992, and 1991 Schedule VI Valuation and Qualifying Accounts and Reserves - Years ended December 31, 1993, 1992, and 1991 Schedule VIII Short-Term Borrowings - Years ended December 31, 1993, 1992, and 1991 Schedule IX Supplementary Income Statement Information - Years ended December 31, 1993, 1992, and 1991 Schedule X All other schedules have been omitted because the material is not applicable or is not required as permitted by the rules and regulations of the Securities and Exchange Commission, or the required information is included in notes to consolidated financial statements. Financial statements of foreign affiliates in which Company ownership exceeds 20 percent, accounted for on the equity method, are not included herein since, in the aggregate, these companies do not constitute a significant subsidiary. Financial statements are incorporated herein by reference to the Company's annual report to its shareholders, the required number of copies of which were furnished to the Commission pursuant to Rule 14A-3. Schedule V ---------- Schedule VI ----------- Schedule VIII ------------- Schedule IX ----------- Schedule X ---------- EXHIBIT INDEX -------------

106135_1993.txt

106135_1993

1993

106135

Item 1. Business GENERAL DEVELOPMENT OF BUSINESS Western Investment Real Estate Trust is a real estate investment trust ("REIT") and qualifies as such under Sections 856 and 960 of the Internal Revenue Code. The Trust was organized under the laws of the State of California in 1962 and commenced real estate operations in 1964. In order that the Trust may continue to qualify as a real estate investment trust: (i) more than 75% of the Trust's total assets must be invested in real estate, cash, cash items or government securities, (ii) at least 75% of the Trust's gross income must be derived from real estate assets, (iii) the Trust can hold no property primarily for sale to customers in the ordinary course of business, (iv) beneficial ownership of the Trust must be held by more than 100 persons during at least 335 days of each taxable year, and (v) the Trust must distribute annually to its shareholders an amount equal to or exceeding 95% of its real estate investment trust taxable income. Under the terms of its Declaration of Trust, the Trust is permitted to invest its funds in ownership of real estate, mortgages, deeds of trust and certain financial instruments as permitted by law. Substantially all of the Trust's funds have been invested in the ownership of real estate. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Trust is not engaged in different segments of a business nor is the Trust engaged in more than one line of business. NARRATIVE DESCRIPTION OF BUSINESS The Trust, which at December 31, 1993 employed 43 people, is a self-administered and fully integrated equity REIT, which invests in a diversified portfolio of income-producing properties located principally in Northern and Central California and Nevada. At December 31, 1993, the Trust had investments in 58 income-producing properties. These properties contain, in the aggregate, approximately 4.4 million rentable square feet of improvements and approximately 19.8 million square feet of land. At year end, the occupancy rate of the Trust's properties was 90%. Of the amounts invested by the Trust at December 31, 1993, 88% is in shopping centers and retail properties with the balance in commercial and industrial properties. The Trust has not invested in residential income properties. The following table indicates the composition of the Trust's real estate investments as of December 31, 1993 by type based on amounts invested by the Trust. Portfolio Summary DECEMBER 31, 1993 Portfolio Distribution by Type of Real Estate Investment Major Revenue Producers 1993 OPERATING REVENUES In spite of a sluggish California economy, the Trust's occupancy rate at year- end was stable at 90% in 1993 and 1992. The Trust believes that it was unable to increase occupancy above this rate during this period due to the economy coupled with overbuilding in certain areas in which Trust properties are located. The smaller retail and service tenants at the Trust's community shopping centers, which tend to be more dependent on discretionary spending, have been more negatively impacted by the economy than the Trust's anchor tenants. The anchor tenants consist primarily of supermarkets and/or super drugstores. In the Trust's experience, these businesses tend to be impacted less by economic downturns than other types of retailers. The Trust is positioned to benefit from a general economic improvement which should result in increased occupancy. As occupancy increases, the Trust's rental income should increase and expenses should decrease, as more tenants assume responsibility for common area and other expenses presently absorbed by the Trust. Increased tenants' sales at its community shopping centers should also increase rental income by generating greater percentage rents under some leases. During the past several years, volume discount retailers, such as Wal-Mart and Costco, have entered certain areas of California and Nevada where Trust community shopping center properties are located. The Trust expects that these discounters may positively or negatively affect certain of the Trust's shopping center tenants. The Trust believes that its tenants could benefit if these discounters attract additional customers to nearby Trust properties and thereby generate increased sales for Trust tenants. Conversely, the Trust's tenants could be negatively affected if discounters draw customers away from the Trust's properties. The Trust believes that to date the trend has had no measurable impact on the Trust's results of operations. The Trust's principal shopping center and retail tenants include substantial, well-recognized businesses such as Kmart, Lucky Stores, Marshall's, J.C. Penney, Raley's, Ross Stores, Save Mart and Thrifty. The Trust's commercial tenants include Coast Federal Bank and Fireman's Fund. No single property investment accounted for more than 5% of operating revenues in 1993. However, at December 31, 1993, Raley's, a supermarket and super drug retailer, was a tenant in nineteen of the Trust's investments. Raley's, a privately owned company, currently operates 85 stores in Northern California and Nevada. The Raley's organization has released information indicating that its sales exceeded $1.58 billion in its most recently reported fiscal year ended June 26, 1993. The Trust receives sales and other information on a monthly, quarterly or annual basis from its retail tenants, including Raley's, whose leases provide for such reports. The Trust uses this information to monitor the payment of percentage rents. Virtually all of the Trust's existing leases include at least one of the following provisions for payment of additional rent: (1) scheduled and/or market rate increases, (2) percentage participation in tenants'gross sales, (3) or CPI based escalation clauses. The Trust endeavors to structure leases on a triple net basis with the lessees being responsible for most operating expenses, such as real estate taxes, certain types of insurance, utilities, normal repairs and maintenance. To the extent such provisions cannot be negotiated and in regard to vacant space, the Trust pays such expenses from current operating income. Most of the Trust's leases require the tenant to carry liability insurance coverage on their leased premises. The Trust monitors tenant compliance with insurance coverage requirements. While the Trust believes its properties are adequately insured, the Trust does not carry earthquake or flood coverage. Most of the Trust's properties are located in areas of California and Nevada where earthquakes have been known to occur. The Trust will consider future investments in existing or proposed shopping centers, industrial and commercial buildings and office buildings, as well as other kinds of income-producing properties which meet the Trust's return on investment, appreciation and risk criteria. The Trust may enter into development agreements and development mortgage loans in order to obtain future equity interests in properties. As of December 31, 1993, no such loans were outstanding. Although there may be attendant risks in such investments, the Trust seeks to minimize these risks by evaluating the financial substance and experience of developers and by obtaining construction, pre-leasing or other guarantees from the developer or other parties to the transaction. If a developer of a project under construction defaults or fails to complete the project, the Trust may incur substantial additional expense to complete construction. The Trust's investment focus has been in the Northern and Central areas of California and Nevada, generally outside of major cities in areas which are experiencing population growth. All but one of the Trust's properties are in this geographic area. The Trust's geographic focus and its experience in real estate investments in Northern California and Nevada allow for efficient asset management. The Trust has made and will consider making investments in other geographic locations if such investments have attractive returns, appreciation potential and can be effectively managed. The Trust competes for quality properties with other investors and engages in a continuing effort to identify desirable properties for acquisition. Management believes that the Trust can continue to compete effectively in the current real estate environment because of its experience in real estate investment, tenant selection and lease negotiation. The Trust plans to make additional investments in real properties, which will provide attractive yields to the Trust. The Trust has raised approximately $127.5 million during the five year period ending March 31, 1994 through the sale of additional shares and the issuance of senior notes, and will endeavor to raise additional capital, either debt or equity, to fund future purchases. The cost of debt or equity capital will be weighed against the anticipated yields of the investments which could be acquired with those funds. POTENTIAL ENVIRONMENTAL RISKS Investments in real property create a potential for environmental liability on the part of the owner of such real property. If hazardous substances are discovered on or emanating from any of the Trust's properties, the Trust and/or others may be held strictly liable for all costs and liabilities relating to the clean-up of such hazardous substances. The Trust, as far as it is aware, owns only four properties which presently contain underground storage tanks. The Trust has no knowledge of any leakage or contamination resulting from these tanks. There are, however, reported low levels of soil contamination from underground storage tanks removed from the Heritage Place Shopping center in Tulare, California prior to its acquisition by the Trust. In addition, there is a potential for contamination from reported off-site leaking petroleum underground storage tanks located on properties adjacent to certain Trust properties. In order to mitigate environmental risks, in 1989 the Trust adopted a policy of requesting at least a Phase I environmental study (a preliminary site assessment which does not include environmental sampling, monitoring or laboratory analysis) on each property it seeks to acquire. No independent environmental analysis has been implemented by the Trust with respect to any of the properties which the Trust acquired prior to 1989. Although the Trust has no knowledge that any material environmental contamination has occurred, no assurance can be given that hazardous substances are not located under any of the properties. The Trust carries no express insurance coverage for the type of environmental risk described above. The Trust assesses on an ongoing basis measures necessary to comply with environmental laws and regulations. The probable overall costs of these measures cannot be determined at this time due to uncertainty about the extent of environmental risks and the Trust's responsibility, the complexity of environmental laws and regulations and the selection of alternative compliance approaches. However, the Trust is not aware of any environmental conditions which will have a material impact on its financial position or results of operations. ASSET MANAGEMENT The Trust is a fully integrated REIT which directly provides full asset management services to all but three of its properties. Asset management includes property management, leasing, marketing, accounting and legal support. Internal management provides for regular interaction between the Trust and its tenants and close supervision of properties, while permitting the Trust to provide its tenants with a range of value added services. The Trust directly manages 55 of its 58 properties. In order to facilitate its present and future asset management activities the Trust has significantly expanded its asset management staff, improved its systems and controls, and opened two branch offices which are centrally located to the properties. The offices are located at the Trust's Country Gables shopping center in Granite Bay, California and at the Victorian Walk shopping center in Fresno, California. As part of its improved systems and controls, the Trust has implemented a state of the art computerized management information system which is capable of providing the Trust with real time access to all property accounting, lease administration and property related information. Internal management permits the Trust to provide value added services to its tenants. For example, the Trust's marketing staff works with the Trust's tenants on promotional and advertising activities to draw consumers to the shopping centers. These activities help the Trust attract and retain the national, regional, and local retail tenants which serve the Northern and Central California and Nevada markets. In addition, the Trust believes that over time the costs of internal property management and leasing should prove less expensive than employing independent property management and leasing firms due to lower commissions and fees and certain economies of scale. Three of the 58 properties are managed by independent property managers. G & W Management Co. continues to provide management services for the property leased to Fireman's Fund Insurance Company, in Petaluma, California, for fees equal to 3.5% of gross receipts. The Trust's property is a part of a larger office park which is managed in total by G & W Management Co. Commercial Real Estate Service (CRES) provides management services with respect to Serra Center, located in Colma, California, for fees equal to 4% of gross receipts attributable to the Trust's 30% interest in the center. CRES is an affiliate of the co-owner of the Serra Center and has been managing the property for approximately 20 years. The Trust and its co-owner have authorized the employment of Terranomics Management Services to manage Mid-Peninsula Plaza, in Redwood City, California for a fee equal to 6% of gross receipts. The cost of management services does not affect the Trust's priority return on this property. None of the above named property managers are affiliated with the Trust, its trustees, officers or any shareholder owning 5% or more of the Trust's shares. Repairs and maintenance of the Trust's properties not undertaken by tenants under the terms of the Trust's triple net leases are performed by independent contractors not affiliated with the Trust, its trustees or officers, or any shareholder owning 5% or more of the Trust's shares. Item 2: Item 2: Properties Item 3. Item 3. Legal Proceedings The Trust was named a defendant in two (2) lawsuits filed in the Second Judicial District Court for the State of Nevada, County of Washoe. One action was a class action (Gomer vs. Realm Development Corp. et al., No. CV90-6108) and the other was brought by 33 individuals (Bautista vs. Shaver Construction Co., Inc., No. CV92-01464). Plaintiffs in both lawsuits alleged that they suffered personal injury and/or property damage as the result of excessive dust generated from construction of the Caughlin Ranch development in Reno, Nevada. The Trust has reached a settlement in regard to these lawsuits involving a payment of $25,000 to the plaintiffs. On January 11, 1993, a complaint was filed by the United States against the Trust and other defendants with regard to an alleged disturbance of the wetlands at the Park Place shopping center in Vallejo, California (U.S. vs. Connolly Development Inc., et al., U.S. District Court, E.D. Cal No. S-93-044, WBS-GGH). The complaint sought implementation of a restoration plan, assessment of civil penalties, a permanent injunction prohibiting the discharge of fill materials into the wetlands, and the government's costs of suit and disbursements. This lawsuit has been settled by the execution of a consent decree under which the developer of the property is primarily liable for penalties and costs of restoration, and the action was dismissed against the Trust on February 11, 1994. However, the Trust has agreed to guarantee the performance of the restoration by, and to provide a loan to, the developer. In the event of a default by the developer, the Trust's exposure could be as much as $250,000. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Principal Market: The shares of beneficial interest, without par value, of the Trust are listed on the American Stock Exchange under the symbol "WIR". The following table sets forth the high and low sales prices of the shares as reported by the American Stock Exchange: Approximate number of equity security holders: Title of Class Number of Record Holders -------------- ------------------------ (as of December 31, 1993) Shares of Beneficial Interest, without par value 2,688 The Trust estimates that there were over 18,000 beneficial owners of shares, including owners whose shares were held in brokerage and trust accounts. Item 6. Item 6. Selected Financial Data Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations OPERATING REVENUES YEARS ENDED DECEMBER 31, 1993 AND 1992 Rental income increased 5% to $33,179,000 from $31,716,000. The increase consists of additional rental income of $851,000 from increased rental rates and collection of prior year rents and $612,000 of deferred rent receivable. Operating revenues increased 3% to $33,813,000 from $32,879,000 as a result of increased rental income of $1,463,000 (5%), partially offset by decreased interest income on mortgage loans of $506,000 (-2%) and decreased direct financing lease income of $23,000. YEARS ENDED DECEMBER 31, 1992 AND 1991 Rental income increased 2% to $31,716,000 from $31,220,000. The increase consists of $1,149,000 (5%) in rental income generated from properties acquired in 1991, $443,000 (2%) in rental income generated from the conversion of a loan on a property in 1991, and increased rental income of $405,000 (1%) due to increased rents and other income and collections from bankruptcy settlements of two previous tenants, offset by a decrease of $1,344,000 (-5%) in rental income due to the restructuring of master leases covering 17 of the Trust's shopping center properties and a decrease of $157,000 (-1%) due to the increase in the allowance for uncollectible accounts. Operating revenues increased 1% to $32,879,000 from $32,591,000 as a result of increased rental income of $496,000 (2%), partially offset by decreased interest income on participating convertible and other mortgage loans of $188,000 (-1%) and decreased direct financing lease income of $20,000. OPERATING EXPENSES YEARS ENDED DECEMBER 31, 1993 AND 1992 Operating expenses increased 17% to $3,936,000 from $3,357,000. The increase consists of $19,000 of increased repair, maintenance and other operating expenses and increased property management expense of $560,000 (17%) due primarily to the increase in allocated administrative expense and the development of internal asset management capabilities which include leasing, marketing and property management. YEARS ENDED DECEMBER 31, 1992 AND 1991 Operating expenses increased 85% to $3,357,000 from $1,810,000. The increase consists of $905,000 (50%) of increased repair, maintenance, and other operating expenses and increased property management expense of $642,000 (35%) due primarily to the restructuring of master leases covering 17 of the Trust's shopping center properties and the reclassification of certain administrative expenses to operating expenses in 1992. DEPRECIATION AND AMORTIZATION YEARS ENDED DECEMBER 31, 1993 AND 1992 Depreciation and amortization expense increased 5% to $9,078,000 from $8,610,000 due to additional depreciation from property improvements made in 1993 and a full year's depreciation from property improvements made in 1992. YEARS ENDED DECEMBER 31, 1992 AND 1991 Depreciation and amortization expense increased 9% to $8,610,000 from $7,880,000 due to additional depreciation from improvements on properties in 1992 and a full year's depreciation on properties purchased in 1991. DEBENTURE AND OTHER INTEREST EXPENSE YEARS ENDED DECEMBER 31, 1993 AND 1992 Debenture and other interest expense decreased $146,000 (-2%) primarily due to debenture redemptions during 1993. YEARS ENDED DECEMBER 31, 1992 AND 1991 Debenture and other interest expense increased $1,155,000 (17%) primarily due to decreased capitalization of interest costs for projects under development in 1992 and increased levels of bank borrowings in 1992 as compared to 1991 offset in part by debenture redemptions. ADMINISTRATIVE EXPENSES YEARS ENDED DECEMBER 31, 1993 AND 1992 The Trust's administrative expenses decreased 14% to $1,449,000 from $1,681,000. The decrease is principally due to substantially lower legal fees and to the allocation of certain administrative expenses to property management expenses. YEARS ENDED DECEMBER 31, 1992 AND 1991 The Trust's administrative expenses increased 11% to $1,681,000 from $1,510,000 primarily as the result of increased legal fees and other expenses, offset in part by a reallocation of certain administrative expenses to property management expenses. NET INCOME YEARS ENDED DECEMBER 31, 1993 AND 1992 Net income was $11,594,000 in 1993 compared to $11,323,000 in 1992, an increase of $271,000 (2%). The significant components of this change include increased rental income ($1,463,000), offset by decreased interest on mortgage loans (-$506,000), and increased property management expense (-$560,000). Additional significant components affecting net income are reduced legal fees ($218,000) and increased depreciation and amortization expense (-$468,000). Net income per share for the year ended December 31, 1993 increased to $0.70 on average outstanding shares of 16,548,198 from $.69 on average outstanding shares of 16,356,462 in 1992. YEARS ENDED DECEMBER 31, 1992 AND 1991 Net income was $11,323,000 in 1992 compared to $14,653,000 for the comparable period in 1991, a decrease of $3,330,000 (-23%). The significant components of this change include increased rental income ($496,000), offset by increased property operating expense (-$1,547,000), interest expense (-$1,155,000), depreciation expense (-$730,000), administrative expenses (-$171,000), and decreased mortgage interest and other income (-$223,000). Net income per share for the year ended December 31, 1992 decreased to $.69 from $.91 in 1991. LIQUIDITY AND CAPITAL RESOURCES The Trust has a $35,000,000 unsecured line of credit on which there was an outstanding balance of $33,244,000 as of December 31, 1993. On January 27, 1994, the Trust sold its Marin General Hospital property, located in Larkspur, California, for $12,412,000. The sales proceeds were used to reduce the outstanding balance on the line of credit. On February 24, 1994, the Trust issued $50,000,000 of 7 7/8% senior notes due February 15, 2004. Proceeds from the sale of senior notes were used to pay the remaining outstanding balance on the line of credit of $17,644,598. The remaining proceeds will be used to acquire properties as suitable opportunities arise and to expand and improve existing properties. The senior notes contain certain covenants which impose limitations on the incurrence of debt and other restrictions. Funds from operations (FFO), as defined by the National Association of Real Estate Investment Trusts, were $20,854,000 in 1993. Dividends paid in 1993 totaled $18,531,000, resulting in a payout ratio of 88.9% of FFO. The Trust believes that its current sources of funds will be sufficient to meet its existing capital commitments and operating requirements. The Trust's unsecured $35 million line of credit expires May 31, 1994 and it intends to renew or replace it. As noted above, the entire amount of the line of credit is currently available. Additionally, the Trust could borrow additional funds using its 55 properties which do not have mortgage debt. However, senior note borrowing limitations impose a cap on total borrowings of 55% of undepreciated real estate assets. IMPACT OF THE ECONOMY Occupancy rates of the Trust's investments remained stable at year-end at 90%. In spite of a sluggish California economy and some related tenant fall-out, the Trust has continued to lease space to sustain its occupancy levels. The Trust is positioned to benefit from a general economic improvement which should result in increased occupancy. As occupancy increases, the Trust's rental income should increase and expenses should decrease, as more tenants assume responsibility for operating expenses presently absorbed by the Trust. During the last several years, high-volume discount retailers, such as Wal-Mart and Costco, entered certain areas of California and Nevada where Trust community shopping center properties are located. The Trust expects that these discounters may positively or negatively affect certain of the Trust's shopping center tenants. The Trust believes that its tenants could benefit if these discounters attract additional customers to nearby Trust properties and thereby generate increased sales for Trust tenants. Conversely, the Trust's tenants could be negatively affected if discounters draw customers away from the Trust's tenants. The Trust believes that to date this trend has had no measurable impact on the Trust's results of operations. Given the current level of inflation, the Trust believes the effect of inflation on its results of operations is inconsequential. Future increases in inflation would likely increase Trust rental income by increasing tenant revenues upon which percentage rents are based, increasing rents subject to CPI-based escalation clauses and permitting an increase in base rents on new leases. DIVIDENDS On March 15, 1994, the Trust paid its 120th consecutive quarterly dividend since it commenced real estate operations in 1964. Dividends paid to shareholders totaled $18,531,000 in 1993. Since the 1993 distributions exceeded current and accumulated earnings and profits, 28.55% is non-taxable and constitutes a return of capital to shareholders. The Trust declares and pays quarterly dividends based on income and funds from operations and the Trust's anticipated ability to maintain or increase such dividends in future years. RECENT DEVELOPMENTS In February 1994, the Trust successfully completed a public offering of $50,000,000 in senior notes with a coupon rate of 7 7/8%. On January 27, 1994 the Trust sold its Marin General Hospital property in Larkspur, California, for $12,412,000 resulting in a gain on sale of $3,629,000. Additionally, the Trust has executed agreements for the sale of its interests in the Mid-Peninsula Plaza Shopping center and the Marshall's property in Redwood City, California. The aggregate book value of these three investments at December 31, 1993 was $16,972,000. Interest rates for the short-term investment of the proceeds from these property sales and the senior debt offering are substantially less than the previous yields on these properties and the cost of the senior notes. The Trust will benefit as new properties are acquired with yields substantially greater than yields on short-term investments. WESTERN INVESTMENT REAL ESTATE TRUST Financial Statements Form 10-K Item 8 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosures. None PART III Items 10, 11, 12 and 13 are incorporated by reference from the definitive proxy statement relating to the Annual Meeting of Shareholders to be held on May 12, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements - Included in Item 8 Page ---- Report of Independent Certified Public Accountants 21 Balance Sheets - December 31, 1993 and 1992 22 Financial Statements for the Years Ended December 31, 1993, 1992 and 1991: Statements of Income 23 Statements of Shareholders' Equity 24 Statements of Cash Flows 25 Notes to Financial Statements 26 to 33 2. Financial Statement Schedules 34 to 39 3. Exhibits Consent of Independent Certified Public Accountants 41 Incorporated by reference hereto is the Indenture Agreement which was filed as Exhibit 4.1 to Amendment No. 1 to Registration Statement No. 33-22893 filed on July 28, 1988 and the Declaration of Trust which was filed as Exhibit 3.1 to said registration statement. Consent of Independent Certified Public Accountants The Trustees Western Investment Real Estate Trust: We consent to incorporation by reference in the registration statement (No. 33-27016) on Form S-8 of Western Investment Real Estate Trust of our report dated February 7, 1994, except as to Note 14 which is as of February 24, 1994, relating to the balance sheets of Western Investment Real Estate Trust 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, and the related financial statement schedules as of December 31, 1993, which report appears in the December 31, 1993 annual report on Form 10-K of Western Investment Real Estate Trust. San Francisco, California KPMG PEAT MARWICK March 29, 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 there unto duly authorized. WESTERN INVESTMENT REAL ESTATE TRUST ------------------------------------ (Registrant) By: s/ Dennis D. Ryan ------------------------------ Dennis D. Ryan Vice President and Dated: March 29, 1994 Chief Financial Officer ------------------ Pursuant to the requirements of the Security 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/ O.A. Talmage Chairman of the March 29, 1994 _______________________________ Board, President, O. A. Talmage Chief Executive Officer and Trustee s/Dennis D. Ryan Vice President and March 29, 1994 _______________________________ Chief Financial Dennis D. Ryan Officer s/ William A. Talmage Trustee March 29, 1994 _______________________________ William A. Talmage s/ Chester R. MacPhee, Jr. Trustee March 29, 1994 _______________________________ Chester R. MacPhee, Jr. s/ Reginald B. Oliver Trustee March 29, 1994 _______________________________ Reginald B. Oliver s/ James L. Stell Trustee March 29, 1994 _______________________________ James L. Stell s/ John R. Beckett Trustee March 29, 1994 _______________________________ John R. Beckett

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ITEM 3. LEGAL PROCEEDINGS The Partnership is involved in a number of legal and administrative proceedings arising in the ordinary course of its oil and gas business. Although the ultimate outcome of these proceedings cannot be ascertained at this time, it is reasonably possible that some of the proceedings could be resolved unfavorably to the Partnership. Management of the Company believes that any liabilities which may arise would not be material in relation to the financial position of the Partnership at December 31, 1993. The Company intends to maintain liability and other insurance for the Partnership of the type customary in the oil and gas business with such coverage limits as the Company deems prudent. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF UNITHOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S LIMITED PARTNERSHIP UNITS AND RELATED SECURITY HOLDER MATTERS The depositary units of Sun Energy Partners, L.P. are traded on the New York Stock Exchange, Inc. The following table sets forth the high and low sales prices per unit, as reported on the New York Stock Exchange Composite Transactions quotations, for the periods indicated: The Partnership had approximately 3,074 holders of record of depositary units as of February 28, 1994. During 1993 and 1992, the quarterly cash distributions per unit paid to unitholders were as follows: The first quarterly cash distribution for 1994 in the amount of $.08 per unit was paid in March 1994. Future quarterly cash distributions to unitholders are expected to be paid on or about the 10th day of March, June, September and December in each year. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Cash Distribution Policy.") ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis of the Partnership's financial position and results of operations follows. This discussion should be read in conjunction with the Consolidated Financial Statements and Selected Financial Data included in this report. BUSINESS CLIMATE The Partnership's production is approximately 60 percent gas and 40 percent oil on an equivalent basis. The fundamentals in the U.S. gas market are better today than they have been since the mid 1980's. Excess deliverability is no longer a problem due to solid growth in demand and reduced supply, although oil prices have constrained the upward movement of gas prices. The Partnership's realized gas price in 1993 was $1.96 per mcf or 14 percent higher than the $1.72 per mcf realized in 1992. The fundamentals in worldwide oil markets continue to reflect an excess of supply over demand. OPEC members have not restrained their production in a weak global economy and prices have fallen to five-year lows. The Partnership's realized oil price in 1993 fell by $2.55 per barrel to $15.96 per barrel, or 14 percent less than the 1992 price. The crude price in the fourth quarter of 1993 was $5.59 per barrel lower than the fourth quarter of 1992. Prices in early 1994 have not shown any significant improvement from levels realized in late 1993. RESULTS OF OPERATIONS The Partnership's net income in 1993 was $44 million, or $.11 per unit, as compared to net income of $120 million, or $.29 per unit, in 1992 and net income of $114 million, or $.28 per unit in 1991. Lower net income in 1993 as compared to 1992 was caused by lower production volumes and a lower average oil price partially offset by a higher average price for gas and lower costs and expenses. Additionally, results for 1992 include $115 million in gains from the sale of assets while results for 1993 include $7 million in losses from asset disposals. Oil volumes were 13 percent lower and gas volumes were 11 percent lower in 1993 resulting from divestments of producing properties in 1992. The Partnership's hedging activities decreased the overall price it received by $.09 per mcf of gas in 1993 and by $.06 per barrel of oil and $.02 per mcf in 1992. Total costs and expenses decreased $185 million or 23 percent to $632 million in 1993 from $817 million in 1992. The Partnership is continuing to review its cost structure in an effort to further reduce costs at all levels. The improvement in net income for 1992 as compared to 1991 is reflective of a $148 million decrease in costs and expenses, substantially offset by a $142 million decrease in total revenues. The decrease in costs and expenses was driven by the cost cutting provisions of the restructuring which began in 1991, but were partially offset by a $62 million provision recognized in 1992 for the early relinquishment of non-producing properties. The decrease in total revenues was comprised of a $146 million, or 16 percent, decrease in oil and gas revenues, partially offset by a $4 million increase in other revenues. The decrease in oil and gas revenues is reflective of a 13 percent decline in volumes, due to asset sales and normal declines, and continued price volatility. The increase in other revenues is essentially comprised of a $40 million increase in gains on sales of assets, partially offset by a $27 million decrease in gas plant margins caused by the sale of substantially all of the Partnership's gas processing plants. Average net production of oil in 1993 was 55 thousand barrels daily, or 13 percent lower than the average net production in 1992 of 63 thousand barrels daily. The average price received for the Partnership's oil production in 1993 was $15.96 per barrel, representing a 14 percent decrease from the 1992 average price of $18.51. Average net production of oil in 1992 was 63 thousand barrels daily, or 16 percent lower than average net production in 1991 of 75 thousand barrels daily. The average price received for the Partnership's oil production in 1992 was $18.51 per barrel, representing a 11 percent decrease from the 1991 average price of $20.88. Average net production of gas in 1993 was 517 million cubic feet daily, or 11 percent lower than average net production for 1992 of 578 million cubic feet daily. The Partnership received an average price of $1.96 per thousand cubic feet for its gas production in 1993 compared to an average price of $1.72 per thousand cubic feet in 1992, representing a 14 percent increase. Average net production of gas in 1992 was 578 million cubic feet daily, or 10 percent lower than average net production of 644 for 1991. The average price received for the Partnership's gas production in 1992 was $1.72 per thousand cubic feet compared to $1.55 per thousand cubic feet in 1991, representing an 11 percent increase. LIQUIDITY AND CAPITAL RESOURCES In 1991, cash flow from operating activities decreased $102 million compared to 1990 primarily due to lower oil prices offset by favorable increases in working capital components. Investing activities provided $371 million more cash and cash equivalents in 1991 largely due to a $325 million increase in divestment proceeds and a $52 million reduction in capital expenditures. In 1991, financing activities used $725 million more cash and cash equivalents due to an increase in debt repayments of $547 million and a reduction in the sale of limited partnership units of $163 million. In 1992, cash flow from operating activities decreased $208 million compared to 1991 primarily due to lower sales volumes and oil prices, and reductions in current liabilities, offset in part by an increase in gas prices and reductions in costs and expenses. Cash flow provided from investing activities declined by $28 million, reflecting a $258 million decrease in proceeds from divestments, partially offset by a $206 million decrease in capital expenditures. Cash flow used for financing activities decreased by $445 million in 1992, principally reflective of declines of $361 million and $175 million in cash used for repayments of long-term debt and cash distributions paid to unitholders, offset in part by a $101 million decrease in cash flow provided from the sale of limited partnership units. In 1993, cash flow from operating activities increased $68 million from 1992 primarily due to favorable increases in cash from working capital components, a higher average price for gas and lower costs and expenses partially offset by lower production volumes and a lower average price for oil. Cash flow from investing activities used $148 million in 1993 compared to providing $252 million in 1992. Proceeds from divestments were $298 million lower in 1993 while capital expenditures increased by $99 million. Cash flow used for financing activities decreased by $305 million in 1993 primarily because of the repayment of $239 million in long-term debt in 1992 compared to repayment of $19 million in 1993. In the fourth quarter of 1993, the Company's Board of Directors elected to change its investment policy concerning ownership of the Partnership. Effective in 1994, the policy of distributing all cash to unitholders and then selling newly issued Partnership units to the Company to fund capital outlays was changed. The Partnership now funds its capital outlays from internally generated funds and makes distributions of only that cash remaining after such outlays. The Partnership's spending levels will be governed by its cash flow from operating activities which will continue to be affected by prevailing oil and gas prices, cost levels and production volumes. A shortfall in expected cash flow from operating activities may require adjustment of the business plans. Options include deferral of discretionary capital expenditures and the sale of Partnership units. The Partnership's long-term cash generation capability is ultimately tied to the value of its proved reserve base. RESERVE REPLACEMENT The ability to sustain cash flow is dependent, among other things, on the level of the Partnership's oil and gas reserves, oil and gas prices and cost containment. Replacement of proved reserves through extensions and discoveries, improved recovery, purchases and revisions to prior reserve estimates in 1993 was 74 percent of liquids production and 93 percent of gas production. Reserve replacement rates of liquids and gas were 17 and 68 percent in 1992 and 79 and 81 percent in 1991. ENVIRONMENTAL The Partnership's oil and gas operations are subject to stringent environmental regulations. The Company is dedicated to the preservation of the environment and has committed significant resources to comply with such regulations. Although the Partnership has been named as a potentially responsible party at sites related to past operations, the Company believes the Partnership is in general compliance with applicable governmental regulations and that the potential costs to it, in the aggregate, are not material to its financial condition. However, risks of substantial costs and liabilities are inherent in the oil and gas business. Should other developments occur, such as increasingly strict environmental laws, regulations and enforcement policies or claims for damages resulting from the Partnership's operations, they could result in additional costs and liabilities in the future. See Note 12 to the Consolidated Financial Statements. CASH DISTRIBUTION POLICY In the fourth quarter of 1993, the Company's Board of Directors elected to change the Company's investment policy concerning purchase of additional Partnership units. Effective in 1994, the Company will no longer routinely purchase newly issued Partnership units to fund capital outlays. As a result, the Partnership now funds its capital outlays from internally generated funds and make distributions of only that cash remaining after such outlays. The newly adopted policy will reduce the cash paid to unitholders, but will also end the ownership dilution caused by the issuance of additional units. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS, SUPPLEMENTARY FINANCIAL AND OPERATING INFORMATION AND FINANCIAL STATEMENT SCHEDULES SUN ENERGY PARTNERS, L.P. REPORT OF INDEPENDENT ACCOUNTANTS To the Partners of Sun Energy Partners, L.P. and the Board of Directors of Oryx Energy Company: We have audited the consolidated balance sheets of Sun Energy Partners, L.P. and its Subsidiaries 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. These financial statements are the responsibility of Oryx Energy 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 Sun Energy Partners, L.P. 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. COOPERS & LYBRAND Dallas, Texas February 19, 1994 SUN ENERGY PARTNERS, L.P CONSOLIDATED STATEMENTS OF INCOME (MILLIONS OF DOLLARS, EXCEPT PER UNIT AMOUNTS) (See Accompanying Notes) SUN ENERGY PARTNERS, L.P. CONSOLIDATED BALANCE SHEETS (MILLIONS OF DOLLARS) ASSETS (See Accompanying Notes) SUN ENERGY PARTNERS, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS (MILLIONS OF DOLLARS) (See Accompanying Notes) SUN ENERGY PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND CONTROL Sun Energy Partners, L.P. (Sun Energy Partners), a Delaware limited partnership, was formed on October 1, 1985 and prior to December 1, 1985 had no operations and nominal assets and equity. Effective as of December 1, 1985, Sun Energy Partners succeeded to all the domestic oil and gas operations of Oryx Energy Company and certain of its affiliates (collectively, the Company). These operations consist of the exploration and development of oil and natural gas reserves in the United States. Sun Energy Partners is controlled by the Company, which is the managing general partner. As of December 31, 1993, the Company had a partnership interest of 98 percent in Sun Energy Partners. The remaining two percent limited partnership interest is held by public unitholders in the form of depositary units. Eighty-five percent of the Company's Board of Directors must approve any additional issuance, sale or transfer of units which would reduce the Company's holdings in Sun Energy Partners below eighty-five percent. Sun Energy Partners operates through Sun Operating Limited Partnership, a Delaware limited partnership, and several other operating partnerships (collectively, the Operating Partnerships). In all of the partnerships which comprise the Operating Partnerships, Sun Energy Partners holds a 99 percent interest as the sole limited partner, while the Company holds a one percent interest as the managing general partner. Sun Energy Partners and the Operating Partnerships (collectively, the Partnership) have no officers or employees. The officers and employees of the Company perform all management functions. BASIS OF PRESENTATION The Partnership's consolidated financial statements have been prepared using the proportionate method of consolidation for Sun Energy Partners and its 99 percent interest in the Operating Partnerships. Such financial statements are prepared in accordance with generally accepted accounting principles which is different from the basis used for reporting taxable income or loss to unitholders. CASH AND SHORT-TERM INVESTMENTS The Partnership considers highly liquid investments with original maturities of less than three months to be cash equivalents. Cash equivalents are stated at cost which approximates market value. PROPERTIES, PLANTS AND EQUIPMENT The successful efforts method of accounting is followed for costs incurred in oil and gas operations. CAPITALIZATION POLICY. Acquisition costs are capitalized when incurred. Costs of unproved properties are transferred to proved properties when proved reserves are added. Exploration costs, including geological and geophysical costs and costs of carrying unproved properties, are charged against income as incurred. Exploratory drilling costs are capitalized initially; however, if it is determined that an exploratory well did not find proved reserves, such capitalized costs are charged to expense, as dry hole costs, at that time. Development costs are capitalized. Costs incurred to operate and maintain wells and equipment are expensed. LEASEHOLD IMPAIRMENT AND DEPRECIATION, DEPLETION AND AMORTIZATION. Periodic valuation provisions for impairment of capitalized costs of unproved properties are expensed. SUN ENERGY PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The acquisition costs of proved properties are depleted by the unit-of-production method based on proved reserves by field. Capitalized exploratory drilling costs which result in the addition of proved reserves and development costs are amortized by the unit-of-production method based on proved developed reserves by field. DISMANTLEMENT, RESTORATION AND ABANDONMENT COSTS. Estimated costs of future dismantlement, restoration and abandonment are accrued as a component of depreciation, depletion and amortization expense; actual costs are charged to the accrual. RETIREMENTS. Gains and losses on the disposals of fixed assets are generally reflected in income. For certain property groups, the cost less salvage value of property sold or abandoned is charged to accumulated depreciation, depletion and amortization except that gains and losses for these groups are taken into income for unusual retirements or retirements involving an entire property group. CAPITALIZED INTEREST The Partnership capitalizes interest costs incurred as a result of the acquisition and installation of significant assets. INCOME TAXES The Operating Partnerships and Sun Energy Partners are treated as partnerships for income tax purposes and, as a result, income or loss of the Partnership is includable in the tax returns of the individual unitholders. Accordingly, no recognition has been given to income taxes in the financial statements. At December 31, 1993, 1992 and 1991, the Partnership's financial reporting bases of assets and liabilities exceeded the tax bases of its assets and liabilities (net temporary differences) by $1,049 million, $1,077 million and $1,121 million. CASH FLOWS For purposes of reporting cash flows, cash and cash equivalents includes cash, highly liquid investments with remaining maturities of less than three months (see "Cash and Short-Term Investments", above) and advances to/from affiliate. Associated with the sale of the Midway-Sunset Field and related facilities in 1991, the purchaser assumed $53 million of Partnership debt. In accordance with Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows," non-cash transactions are not reflected within the accompanying Consolidated Statements of Cash Flows (see Note 3 to the Consolidated Financial Statements). Interest paid totaled $13 million, $45 million and $57 million in 1993, 1992 and 1991. SALES OF OIL AND GAS Sales of oil and gas are recorded on the entitlement method. Differences between actual production and entitlements result in amounts due when underproduction occurs and amounts owed when overproduction occurs. During 1993, sales of oil to the Partnership's top two purchasers totaled approximately 21 and 16 percent of oil revenue. During 1992, sales of oil to the Partnership's top purchasers totaled approximately 13, 11 and 10 percent. During 1993 and 1992, no individual customer accounted for more than 5 percent of the Partnership's gas sales. The Partnership believes that the loss of any major purchaser would not have a material adverse effect on its business. SUN ENERGY PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) FINANCIAL INSTRUMENTS The difference between the values calculated as prescribed by Statement of Financial Accounting Standards (SFAS) No. 107, "Disclosures about Fair Value of Financial Instruments," of the Partnership's financial instruments and their carrying value is not material. FUTURES TRADING ACTIVITY The Partnership, from time to time, enters into futures contracts to hedge the impact of price fluctuations on crude and natural gas production. Futures trading activity decreased oil and gas revenue by $17 million in 1993 and $7 million in 1992. At December 31, 1993, the Partnership had hedged about 30 percent of its gas production at an average floor of $2.04 per mmbtu and an average ceiling of $2.28 per mmbtu. ENVIRONMENTAL COSTS The Partnership establishes reserves for environmental liabilities as such liabilities are incurred (Note 12). CEILING TESTS For ceiling test purposes, the Partnership compares its undiscounted standardized measure of future net cash flows from estimated production of proved oil and gas reserves to its net properties, plants and equipment related to oil and gas operations. STATEMENT PRESENTATION Certain items in years prior to 1993 have been reclassified to conform to the 1993 presentation. 2) RELATED PARTY TRANSACTIONS ADVANCES TO/FROM AFFILIATE The Company has served as the Partnership's lender and borrower of funds and a clearing-house for the settlement of intercompany receivables and payables. Deposits earn interest at a rate equal to the rate paid by a major money market fund. Demand loans bear interest at a rate based on the prime rate. LONG-TERM DEBT DUE AFFILIATE The Partnership is indebted to the Company under a 9.75% note due 1994-2001. In 1992 and 1991 the Partnership prepaid $213 million and $575 million of such debt from proceeds of asset sales (see Note 8 to the Consolidated Financial Statements). DIRECT AND INDIRECT COSTS The Company is reimbursed by the Partnership for all direct costs incurred in performing management functions and indirect costs (including payroll and payroll related costs and the cost of postemployment benefits and management incentive plans) allocable to the Partnership. The full cost of direct and indirect costs incurred on behalf of the Partnership by the Company is allocated to the Partnership based on services rendered and extent of use. Such costs, which are charged principally to production cost, exploration cost and general and administrative expense, totaled $104 million, $127 million and $176 million for the years 1993, 1992 and 1991. The Company does not receive any carried interests, promotions, back-ins or other similar compensation as the general partner of the Partnership. INTEREST INCOME Interest income received from the Company, which is reflected in other income in the consolidated statements of income, was earned on advances to the Company and totaled $5 million, $9 million and $11 million during the years 1993, 1992 and 1991. SUN ENERGY PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2) RELATED PARTY TRANSACTIONS (CONTINUED) INTEREST COST Interest cost paid to the Company, which is included in interest and debt expense in the consolidated statements of income, was primarily incurred on long-term debt due the Company and totaled $12 million, $43 million and $55 million during the years 1993, 1992 and 1991 (see Note 8 to the Consolidated Financial Statements). 3) CHANGES IN BUSINESS Effective January 31, 1991, the Partnership sold its interest in the Midway-Sunset Field producing oil and gas assets and a steam cogeneration facility. Net proceeds of $529 million from the sale, including $53 million of debt assumed by the purchaser, were used to fund capital expenditures and prepay $575 million of debt. In 1991, the Company commenced a major restructuring program (Restructuring) to reduce the Company's and Partnership's cost structures. The program outlined a plan to sell substantially all of the Partnership's gas plant business (Note 4) and certain onshore producing oil and gas properties. Associated with the Restructuring, the Partnership recognized a $62 million provision for the early relinquishment of certain non-producing properties in 1992. At December 31, 1992, the asset disposal program was substantially complete although from time to time the Partnership will have divestments. In 1993, the Partnership completed asset disposals that generated $59 million in proceeds and generated a loss of $7 million. 4) OTHER REVENUES The components of other revenues were as follows: 5) PRODUCTION TAXES Production taxes consisted of the following: SUN ENERGY PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6) PROPERTIES, PLANTS AND EQUIPMENT At December 31, the Partnership's properties, plants and equipment and accumulated depreciation, depletion and amortization were as follows: 7) ACCRUED LIABILITIES At December 31, the Partnership's accrued liabilities were comprised of the following: 8) LONG-TERM DEBT At December 31, the Partnership's long-term debt consisted of the following: Under the Partnership's existing capitalized lease and other long-term debt obligations, the Partnership is obligated to make annual payments of $5 million, $2 million and $2 million in 1994, 1995 and 1996. Repayment obligations under the Partnership's long-term debt due affiliate are $9 million, $10 million, $11 million, $12 million and $13 million in 1994, 1995, 1996, 1997 and 1998. SUN ENERGY PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9) COMMITMENTS AND CONTINGENT LIABILITIES The Partnership has operating leases for property and equipment. Total rental expense for such leases for the years 1993, 1992 and 1991 was $28 million, $28 million and $38 million. Under contracts existing as of December 31, 1993, future minimum annual rentals applicable to noncancellable operating leases that have initial or remaining lease terms in excess of one year were as follows (in millions of dollars): Several legal and administrative proceedings are pending against the Partnership. Although the ultimate outcome of these proceedings cannot be ascertained at this time, and it is reasonably possible that some of them could be resolved unfavorably to the Partnership, management believes that any liabilities which may arise would not be material in relation to the financial position of the Partnership at December 31, 1993. 10) PARTNERS' CAPITAL 11) CASH DISTRIBUTIONS Beginning with the fourth quarter 1993, Distributable Cash will be reduced by the cash needed for capital outlays. This policy change will reduce the cash paid to unitholders but will eliminate the ongoing ownership dilution faced by unitholders due to Oryx Energy's purchase of newly issued partnership units to fund Sun Energy's capital outlays. Distributable Cash is defined as revenues (including interest income) less production cost; seismic, geological and geophysical costs (including related costs); payments of principal and interest on debt; general and administrative expenses including reimbursements of the Company as managing general partner; adjustments for capital SUN ENERGY PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11) CASH DISTRIBUTIONS (CONTINUED) expenditures (net of proceeds from divestments); and cash exploration costs. No deduction will be made for depreciation, depletion and amortization, for property acquisition and development expenditures. Sun Energy Partners' quarterly cash distributions per unit for the years 1993, 1992 and 1991 were as follows: 12) DEFERRED CREDITS AND OTHER LIABILITIES At December 31, the Partnership's deferred credits and other liabilities were comprised of the following: Environmental cleanup costs have been accrued in response to the identification of several sites that require cleanup based on environmental pollution, some of which have been designated as superfund sites by the Environmental Protection Agency (EPA). The Partnership has been designated as a Potentially Responsible Party (PRP) at a site in southern California where the EPA is requiring the PRP's to undertake remediation of the site in several phases. The Partnership is a member of the group that is responsible for carrying out the first phase of the work, which is expected to take 5 to 8 years. Completion of all phases is estimated to take up to 30 years. The maximum liability of the group, which is joint and several for each member of the group, is expected to range from approximately $450 million to $600 million, of which the Partnership's share is expected to be approximately $10 million (net of $3 million in recoveries from third parties). Cleanup costs are payable over the period that the work is completed. SUPPLEMENTARY FINANCIAL AND OPERATING INFORMATION (UNAUDITED) OIL AND GAS DATA CAPITALIZED COSTS COSTS INCURRED IN OIL AND GAS PRODUCING ACTIVITIES EXPLORATION COSTS ESTIMATED NET QUANTITIES OF PROVED OIL AND GAS RESERVES Proved reserves are the estimated quantities which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from reservoirs under existing economic and operating conditions. Proved developed reserves are the quantities expected to be recovered through existing wells with existing equipment and operating methods. These reserve estimates were principally prepared by Company engineers and are based on current technology and economic conditions. The Partnership considers such estimates to be reasonable; however, due to inherent uncertainties and the limited nature of reservoir data, estimates of underground reserves are imprecise and subject to change over time as additional information becomes available. There has been no major discovery or other favorable or adverse event that has caused a significant change in estimated proved reserves since December 31, 1993. The Partnership has no long-term supply agreements or contracts with governments or authorities in which it acts as producer nor does it have any interest in oil and gas operations accounted for by the equity method. All reserves are located onshore and offshore within the United States. STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS FROM ESTIMATED PRODUCTION OF PROVED OIL AND GAS RESERVES The standardized measure of discounted future net cash flows from estimated production of proved oil and gas reserves is presented in accordance with the provisions of Statement of Financial Accounting Standards No. 69, "Disclosures about Oil and Gas Producing Activities" (SFAS No. 69). In computing this data, assumptions other than those mandated by SFAS No. 69 could produce substantially different results. The Partnership cautions against viewing this information as a forecast of future economic conditions or revenues. The standardized measure has been prepared assuming year-end selling prices adjusted for future fixed and determinable contractual price changes, year-end development, production and direct general and administrative costs and a ten percent annual discount rate. No future income tax expense has been provided for the Partnership since it incurs no income tax liability. (See Summary of Significant Accounting Policies -- Income Taxes in the Notes to Consolidated Financial Statements.) SUMMARY OF CHANGES IN THE STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS FROM ESTIMATED PRODUCTION OF PROVED OIL AND GAS RESERVES QUARTERLY FINANCIAL INFORMATION QUARTERLY OPERATING INFORMATION SUN ENERGY PARTNERS, L.P. REPORT OF INDEPENDENT ACCOUNTANTS To the Partners of Sun Energy Partners, L.P. and the Board of Directors of Oryx Energy Company: Our report on the consolidated financial statements of Sun Energy Partners, L.P. and its Subsidiaries is included on page 13 of this Form 10-K Annual Report. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 12 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Dallas, Texas February 19, 1994 SUN ENERGY PARTNERS, L.P. 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 (MILLIONS OF DOLLARS) SUN ENERGY PARTNERS, L.P. SCHEDULE V -- PROPERTIES, PLANTS AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) SUN ENERGY PARTNERS, L.P. SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTIES, PLANTS AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) SUN ENERGY PARTNERS, L.P. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Partnership has no employees. The Company, as the managing general partner of the Partnership, has the responsibility for the Partnership's conduct of operations. Set forth below is information concerning the ten current directors of the Company and the 11 current executive officers of the Company. All executive officers of the Company are elected annually by the Board of Directors of the Company. The directors are divided into three classes with approximately one-third of the directors constituting the Board being elected each year to serve a three-year term. Class I directors (whose term expires in 1995) are Mr. Gill, Mr. Hollingsworth and Mr. Pistor. Class II directors (whose term expires in 1996) are Mr. Keiser, Mr. Seegers and Mr. White-Thomson. Class III directors (whose term expires in 1994) are Mr. Bradford, Ms. Dinkins, Dr. Grayson and Mr. Hauptfuhrer. Dr. Grayson will retire from the Board at the expiration of his term. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The directors, officers, and employees of the Company (the managing general partner) receive no direct compensation from the Partnership for their services to the Partnership. Such persons receive compensation from the Company, a substantial portion of which is generally reimbursed to the Company by the Partnership as costs allocable to it. (See Note 2 to the Consolidated Financial Statements.) The Partnership reimburses the Company for all direct costs and indirect costs associated with the Partnership's activities. For the year 1993, the Company received $104 million as reimbursement of costs allocable to the Partnership. Such amounts included salaries of employees and allocations of certain executive and administrative expenses. The aggregate amount reimbursed by the Partnership to the Company for salaries paid to the Chief Executive Officer of the Company and the four most highly compensated executive officers of the Company other than the Chief Executive Officer was approximately $1,310,000 for 1993. (See Note 2 to the Consolidated Financial Statements.) ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table provides certain information regarding beneficial ownership of the limited partnership units of Sun Energy Partners, L.P. as of December 31, 1993: UNITS OF SUN ENERGY PARTNERS, L.P. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In its capacity as managing general partner of the Partnership, the Company controls the Partnership and its operations, and has served as a lender and borrower of funds for the Partnership. Following is a table which summarizes lending activities between the Partnership and the Company during the year ended December 31, 1993: During 1993, the largest balance owed to the Partnership by the Company for variable rate advances was $20 million; the largest balance owed to the Company by the Partnership for variable rate advances was $69 million. The largest balance owed to the Company by the Partnership during 1992 under the 9.75% Note Payable was $99 million. Certain information required by this section is included in Notes to the Consolidated Financial Statements. See Notes 1, 2 and 8 and Schedules II, included elsewhere in this Form 10-K. 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: See Index to Financial Statements, Supplementary Financial and Operating Information and Financial Statement Schedules on page 12. 2. Financial Statement Schedules: See Index to Financial Statements, Supplementary Financial and Operating Information and Financial Statement Schedules on page 12. Other schedules are omitted because the information is shown elsewhere in this report, is not required or is not applicable. 3. Exhibits: (b) Reports on Form 8-K: The Partnership did not file any reports on Form 8-K during the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SUN ENERGY PARTNERS, L.P. By: ORYX ENERGY COMPANY (MANAGING GENERAL PARTNER) *By: _____/s/_EDWARD W. MONEYPENNY____ Edward W. Moneypenny SENIOR VICE PRESIDENT, FINANCE, AND CHIEF FINANCIAL OFFICER Date March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by or on behalf of the following persons on behalf of the Registrant and in the capacities with Oryx Energy Company, Managing General Partner, and on the date indicated: PRINCIPAL OFFICERS AND DIRECTORS OF ORYX ENERGY COMPANY MANAGING GENERAL PARTNER Jerry W. Box Senior Vice President, Exploration and Production William E. Bradford Director David F. Chavenson Treasurer Carol E. Dinkins Director Sherri T. Durst General Auditor Robert B. Gill Director C. Jackson Grayson, Jr. Director Robert P. Hauptfuhrer Chairman of the Board and Chief Executive Officer David S. Hollingsworth Director Robert L. Keiser President, Chief Operating Officer and Director Thomas W. Lynch Vice President and General Counsel Edward W. Moneypenny Senior Vice President, Finance, and Chief Financial Officer Charles H. Pistor, Jr. Director Paul R. Seegers Director William P. Stokes, Jr. Vice President, Corporate Development and Human Relations Barry L. Strong Comptroller Frank B. Sweeney Corporate Secretary Ian L. White-Thomson Director William F. Whitsitt Vice President, Marketing and Public Affairs EXECUTIVE OFFICES 13155 Noel Road Dallas, TX 75240-5067 Telephone (214) 715-4000 DEPOSITORY UNITS The depositary units are traded on the New York Stock Exchange, Inc. under the symbol SLP. MARKET PRICE RANGES: CASH DISTRIBUTIONS PAID PER UNIT: TRANSFER AGENT, DEPOSITARY AND REGISTRAR Chemical Bank Shareholder Relations Department P.O. Box 24935 New York, NY 10249 1-800-648-8393 FOR UNITHOLDER ASSISTANCE, PLEASE CONTACT: Unitholder Relations Sun Energy Partners, L.P. c/o Oryx Energy Company Managing General Partner P.O. Box 2880 Dallas, TX 75221-2880 1-800-846-ORYX

775368_1993.txt

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1993

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Item 1. Business. Alleghany Corporation ("Alleghany") was incorporated in 1984 under the laws of the State of Delaware. In December 1986, Alleghany succeeded to the business of its parent company, Alleghany Corporation, a Maryland corporation incorporated in 1929, upon the parent company's liquidation. Alleghany's principal executive offices are located at Park Avenue Plaza, New York, New York 10055 and its telephone number is (212) 752-1356. Alleghany is engaged, through its subsidiaries Chicago Title and Trust Company ("CT&T"), Chicago Title Insurance Company ("CTI"), Security Union Title Insurance Company ("Security Union") and Ticor Title Insurance Company ("Ticor Title") and their subsidiaries, in the sale and underwriting of title insurance and in certain other financial services businesses. Alleghany is also engaged, through its subsidiary Underwriters Reinsurance Company ("Underwriters"), in the property and casualty reinsurance business. In addition, Alleghany is engaged through its subsidiary Sacramento Savings Bank ("Sacramento Savings") in retail banking, and, through its subsidiaries World Minerals Inc. ("World Minerals"), Celite Corporation ("Celite") and Harborlite Corporation ("Harborlite") and their subsidiaries, in the industrial minerals business. Alleghany conducts a steel fastener importing and distribution business through its Heads and Threads division. Until December 31, 1991, Alleghany was also engaged, through its subsidiary The Shelby Insurance Company ("Shelby"), in the property and casualty insurance business. On that date, Shelby was sold to Associated Insurance Companies, Inc., an Indiana corporation, for a purchase price of $125 million in cash. On October 7, 1993, Alleghany acquired approximately 93 percent of the issued and outstanding capital stock of a new holding company which owns all of the issued and outstanding capital stock of Underwriters for a cash purchase price of approximately $201 million. Alleghany acquired its 93 percent interest in the new holding company from a holding company formerly owned by The Continental Corporation, Goldman, Sachs & Co. and certain affiliated investment partnerships, and members of Underwriters management. Prior to the acquisition by Alleghany, The Continental Corporation acquired the interests of the Goldman, Sachs entities for cash and the interests of the members of Underwriters management for cash and the remaining 7 percent of the issued and outstanding capital stock of the new holding company which owns Underwriters. Subsequent to the acquisition, Alleghany made capital contributions to the new holding company so as to increase Alleghany's equity interest to 94.6 percent of the issued and outstanding capital stock of the new holding company as of 1993 year-end. In 1993 Alleghany studied a number of potential acquisitions. Alleghany intends to continue to expand its operations through internal growth at its subsidiaries as well as through possible operating-company acquisitions. Reference is made to Items 7 and 8 of this Report for further information about the business of Alleghany in 1993. The consolidated financial statements of Alleghany, incorporated by reference in Item 8 of this Report, include the accounts of Alleghany and its subsidiaries for all periods presented. TITLE INSURANCE AND TRUST BUSINESS CT&T, headquartered in Chicago, is engaged in the sale and underwriting of title insurance and related services (including abstracting, searches, and escrow, closing and disbursement services) through CTI, Security Union, Ticor Title and other title insurance subsidiaries, collectively known as the CT&T Family of Title Insurers. Organized as an Illinois corporation in 1912, CT&T was acquired by Alleghany in June 1985. CTI, a Missouri corporation incorporated in 1961, succeeded to businesses conducted by predecessor corporations since 1847. Security Union (acquired in 1987) and Ticor Title (acquired in 1991) were incorporated in California in 1962 and 1965, respectively, but both were a part of business organizations that had succeeded to businesses conducted since around the turn of the century. CT&T is also a qualified Illinois trust company and conducts certain other financial services businesses through its Financial Services Group. On March 8, 1991, CT&T acquired Ticor Title Insurance Company of California (which was Ticor Title's immediate parent prior to its merger into CTI in September 1992), from Westwood Equities Corporation for a total cash purchase price of $55.6 million, subject to adjustment, and a promissory note in the principal amount of $15 million, subject to adjustment. The cash purchase price was required to be increased by up to $15 million based upon changes in consolidated net worth. The amount of this adjustment was determined to be zero by an arbitration decision rendered in February 1993. The principal amount of the promissory note issued by CT&T to Westwood Equities Corporation, which will mature on March 31, 1995, is subject to an increase to $20 million or a decrease to zero based on a re-evaluation of the title loss reserves of Ticor Title Insurance Company of California and its subsidiaries as of December 31, 1994. Alleghany believes that the principal amount of the promissory note will be zero and, accordingly, has excluded this note from the determination of the purchase price and from its consolidated financial statements. Since the acquisition of the Ticor Title organization by CT&T, CT&T has substantially integrated Ticor Title into its own operations. As part of that process, CT&T's title operations were reorganized into three geographic divisions: Northeastern, Central and Western. A primary objective of the integration was to create a system in which field and support personnel work effectively and efficiently together to provide the highest-quality product and best service in the industry. The goal of improved effectiveness and efficiency also triggered two other systematic, company-wide initiatives at CT&T. In 1992, Project Nimble Leader was implemented to assess and, where possible, streamline staff support activities. In 1993, CT&T initiated a customer-focused product quality project entitled Quest for Excellence. This project seeks to identify issues that are important to CT&T's customers in their business relationships with CT&T, and to provide training and support to CT&T's personnel to enable them to be more responsive to their customers' title insurance needs. CT&T plans an aggressive schedule of implementation in branch offices in 1994 and 1995. Streamlining activities at CT&T since the Ticor Title acquisition extended to its own corporate structure. Effective September 30, 1992, CT&T consolidated a number of the title insurance underwriters in its corporate family by merging three title insurers into CTI. The merged companies were Ticor Title Insurance Company of California, Chicago Title Insurance Company of Maryland and Chicago Title Insurance Company of Idaho. Immediately after the mergers, the ownership of Ticor Title, formerly a subsidiary of Ticor Title Insurance Company of California, was transferred from CTI to CT&T. Effective January 25, 1994, Richard P. Toft, who is a Senior Vice President of Alleghany, President and Chief Executive Officer of CT&T, and Chairman of CTI, assumed responsibility for Alleghany's liaison with Sacramento Savings, stepped down as Chief Executive Officer of CTI and assumed the vacant office of Chairman of CT&T. Richard L. Pollay, who was President and Chief Operating Officer of CTI, became Chief Executive Officer of CTI and Vice Chairman of CT&T. In mid-1993, CT&T acquired Heritage American Insurance Services, which is a San Francisco-based limited general line insurance broker. Heritage American was acquired to market mortgage layoff insurance, homeowners insurance and mortgage life insurance through CT&T internal systems in California. License applications have been submitted to expand Heritage American's business to several adjacent states. The CT&T Family of Title Insurers is the largest title insurance organization in the world. Each of the principal title insurance subsidiaries - -- CTI, Security Union and Ticor Title -- was assigned a claims-paying ability rating of "A-" by Standard & Poor's Corporation in 1992 and again in 1993, confirming the financial strength of the CT&T Family of Title Insurers. The CT&T Family of Title Insurers has approximately 200 full-service offices and 3,500 policy-issuing agents in 49 states, Puerto Rico, the Virgin Islands and Canada. CTI is headquartered in Chicago, and Security Union and Ticor Title are headquartered in Rosemead, California. The CT&T Family of Title Insurers insures a variety of interests in real property. For a one-time premium, purchasers of residential and commercial properties, mortgagees, lessees and others with an interest in real property purchase insurance policies to insure against loss suffered as a result of any encumbrances or other defects in title, as that title is defined in the policy. Prior to the issuance of a policy, a title insurer conducts a title search and examination of the property, a process by which it identifies risks and defines the risks to be assumed by the insurer under the policy. To conduct a title search and examination, an agent or employee of the CT&T Family of Title Insurers reviews various records providing a history of transfers of interests in the parcel of real estate with respect to which a policy of title insurance is to be issued. These records are maintained by local governmental entities, such as counties and municipalities. Title records, known as title plants, owned by the CT&T Family of Title Insurers are also used as a reference, allowing complete title searches without resorting to governmental records. The CT&T Family of Title Insurers' title plants consist of their own compilations of land title and deed information copied from public records dating back many years on properties in various geographical locations. These title plants are updated daily. While most other forms of insurance provide for the assumption of risk of loss arising out of unforeseen future events, title insurance serves to protect the policyholder from the risk of loss from events that predate the issuance of the policy. This distinction underlies the low claims loss experience of title insurers as compared with other insurance underwriters. Realized losses generally result from either judgment errors or mistakes made in the title search and examination process or the escrow process, or from other problems such as fraud or incapacity of persons transferring property rights. Operating expenses, on the other hand, are higher for title insurance companies than for other companies in the insurance industry. Most title insurers incur considerable costs relating to the personnel required to process forms, search titles, collect information on specific properties and prepare title insurance commitments and policies. Many title insurers also face ongoing costs associated with the establishment, operation and maintenance of title plants. CTI, Security Union and Ticor Title each have generally restricted the size of any one risk of loss that they will retain to $70 million, $30 million and $50 million, respectively. The title insurers in the CT&T Family of Title Insurers reinsure risks with each other and with other title insurance companies in excess of what they are willing to retain. In addition, the title insurers have purchased reinsurance coverage for individual losses in excess of $12.5 million, subject to certain exclusions. This coverage will pay 90 percent of such losses up to $50 million. However, reinsurance arrangements do not relieve a title insurance company that issues a policy from its legal liability to the holder of the policy and, thus, the risk of nonperformance by the assuming reinsurer is borne by the issuer of the policy. The CT&T Family of Title Insurers issues title insurance policies directly through its branch office operations as well as through policy-issuing independent agents. The CT&T Family of Title Insurers also sometimes issues policies of insurance in situations where the title search and examination process is performed by approved attorneys working as independent contractors. The primary sources of title insurance business are the major participants in local real estate markets: attorneys, builders, commercial banks, thrift institutions, mortgage banks and real estate brokers. Other significant sources of business are large commercial developers and real estate brokerage firms operating on a national scale. The title insurance business of the CT&T Family of Title Insurers is not dependent on one or a few customers. The title insurance industry is highly sensitive to the volume of real estate transactions and to interest rate levels. Industry revenues have tended to move cyclically with real estate sales and countercyclically to mortgage interest rates. The title industry was adversely affected by the recession and severely depressed real estate markets in 1990 and 1991. However, interest rates began to drop in 1992 and in 1993 reached new thirty-year lows. Driven by first-time buyers enticed into the market by the low interest rates, home sales increased 11.1 percent in 1992, and 3.4 percent in 1993. The 1993 home sales figures came within 5 percent of the all-time high recorded in 1978, producing record levels of title operations revenues and pre-tax earnings at CT&T. Low interest rates also resulted in a high volume of refinancing orders, including a record number of such orders in the last three quarters of 1993. In addition to an active residential market, CT&T title operations benefited from the beginnings of a recovery in the commercial sector in 1993. Though traditional commercial lenders remained on the sidelines, renewed interest in real estate-related investment vehicles, such as real estate investment trusts and real estate mortgage investment conduits, brought new sources of funds to the market and contributed to the first upturn in activity in the commercial sector since 1989. The business of the CT&T Family of Title Insurers is seasonal, as housing activity is seasonal. The strongest quarter is typically the third quarter because there are more home sales and commercial construction during the summer; the first quarter is typically the weakest quarter. Revenues generally are recognized by CT&T at the time of the closing of the real estate transaction with respect to which a title insurance policy is issued; accordingly, there is typically a lag of about two months between the time that a title insurance order is placed, at which time work commences, and the time that CT&T recognizes the revenues associated with the order. Approximately 70.5 percent of the revenues of the CT&T Family of Title Insurers in 1993 are estimated to have been generated by residential real estate activity, consisting of resales (43.1 percent), refinancings (16.2 percent) and new housing (11.2 percent). Commercial and industrial real estate activity is estimated to account for the remaining 29.5 percent of 1993 revenues, attributable to initial sales and resales (21.6 percent) and refinancings (7.9 percent). CT&T's National Business Group provides title insurance-related services on a nationwide basis. One component of the National Business Group is the network of National Business Units and National Title Services offices. As a one-stop source of title services for both single-site and multi-site commercial and industrial real estate ventures, CT&T's network had 21 offices at 1993 year-end, and is the title industry's largest. The other two components of CT&T's National Business Group are SAFETRANS, which services executive relocation firms, and the National Accounts Unit, which services national and regional residential lenders and low-liability commercial accounts. CT&T's Financial Services Group CT&T's Financial Services Group comprises four businesses, as follows: -- The institutional investment management group manages equity and fixed income institutional assets in excess of $3.0 billion, primarily for employee benefit plans, foundations and insurance companies. -- The employee benefits services group offers profit sharing plans, matching savings plans, money purchase pensions and consulting services, and has become one of the leading providers of 401(k) salary deferral plans to mid-sized companies in the upper Midwest. -- The personal trust and investment services group, with approximately $1.1 billion under management, provides investment management and trust and estate planning services primarily for accounts in the $250,000 to $15 million range. -- The real estate trust services group offers land trusts which permit real estate to be conveyed to a trustee while reserving to the beneficiaries the full management and control of the property. This group also facilitates tax-deferred exchanges of income-producing real property. In connection with its financial services activities, CT&T competes with national, regional and local providers of financial services. Such competition is chiefly on the basis of service and investment performance. As of December 31, 1993, CT&T held assets totalling $5 billion, of which $4 billion were actively managed. CT&T's financial services business is not seasonal, and is not dependent on one or a few customers. CT&T also owns Security Trust Company, a California corporation, which is a full-service trust company. In December 1993, CT&T received clearance from the Securities and Exchange Commission to establish a new management company, CT&T Funds, to offer four no-load, open-end mutual funds to the general public. The four funds are the CT&T Growth and Income Fund, a fund invested mainly in common stocks, the CT&T Intermediate Fixed Income Fund, a fund invested mainly in intermediate taxable bonds, CT&T Intermediate Municipal Bond Fund, a fund invested mainly in intermediate municipal bonds, and CT&T Money Market Fund, a fund invested mainly in short-term investments. Initially, the new funds will be marketed to individual investors to attract rollover funds from existing 401(k) and pension fund programs managed by CT&T. Competition The title insurance industry is competitive throughout the United States, with large firms such as CTI, Security Union and Ticor Title competing on a national basis, while smaller firms have significant market shares on a regional basis. During 1993, CTI, Security Union, Ticor Title, First American Title Insurance Company, Commonwealth Land Title Insurance Company and Lawyers Title Insurance Corporation, together accounted for approximately 70 percent of the revenues generated by title insurance companies. The CT&T Family of Title Insurers also competes with abstractors, attorneys issuing opinions and, in some areas, state land registration systems. Competition in the title insurance industry is primarily on the basis of service. In addition, the financial strength of the insurer has become an increasingly important factor in certain title insurance purchase decisions, particularly in multi-site transactions and -- with the growing market for real estate-related investment vehicles such as real estate investment trusts and real estate mortgage investment conduits -- in investment decisions. Regulation Title insurance companies are subject to regulation and supervision by state insurance regulators under the insurance statutes and regulations of states in which they are incorporated. CTI is incorporated in Missouri, Security Union is incorporated in California and has a title insurance subsidiary incorporated in Oregon, and Ticor Title is incorporated in California and has a title insurance subsidiary incorporated in New York. Each of these companies is also regulated in each jurisdiction in which it is authorized to write title insurance. Regulation and supervision vary from state to state, but generally cover such matters as the standards of solvency which must be met and maintained, the nature of limitations on investments, the amount of dividends which may be distributed to a parent corporation, requirements regarding reserves for unearned premiums and losses, the licensing of insurers and their agents, the approval of policy forms and premium rates, periodic examinations of title insurers and annual and other reports required to be filed on the financial condition of title insurance companies. The Financial Services Group, which acts as a fiduciary, is primarily regulated by the State of Illinois Commissioner of Banks and Trust Companies. Regulation covers such matters as the fiduciary's management capabilities, the soundness of its policies and procedures, the quality of the services it renders to the public and the effect of its trust activities on its financial soundness. Employees At December 31, 1993, CT&T and its subsidiaries had approximately 8,500 employees. BANKING BUSINESS In November 1989, a wholly owned subsidiary of Alleghany acquired Sacramento Savings and two ancillary companies for a cash purchase price of $150 million. Sacramento Savings is a California-licensed savings institution that has been offering retail banking services since 1874. With headquarters in Sacramento and 45 branch offices located in north central California, Sacramento Savings is engaged principally in the business of attracting deposits from the general public and using such deposits, together with borrowings and other funds, to originate residential and commercial real estate loans and consumer loans. In addition, through a subsidiary, Sacramento Savings offers its customers tax-deferred annuity plans and mutual funds. Sacramento Savings operates in fourteen counties in north central California. Its primary market area is the Sacramento Metropolitan Statistical Area, covering Sacramento, El Dorado, Placer and Yolo counties. Sacramento Savings is the leading thrift institution in that part of California, which has experienced strong economic and population growth in recent years and is expected to resume doing so as the northern California economy recovers. This expected growth suggests a continued increase in retail deposits in the primary market area of Sacramento Savings. As of December 31, 1993, Sacramento Savings had total assets of $3.0 billion, total deposits of $2.8 billion and shareholder's equity of $200 million. Sacramento Savings' deposits are insured by the Savings Association Insurance Fund of the Federal Deposit Insurance Corporation (the "FDIC"). Lending Activities Earning assets represent about 89 percent of Sacramento Savings' total assets. Real estate loans, the largest category, comprise about 67 percent of total assets. Nonmortgage loans represent less than 2 percent of total assets. Investment securities comprise the remainder, or about 21 percent, of total assets. Loan Portfolio Composition. The following table shows Sacramento Savings' loan portfolio in dollar amounts and percentages for the past three years (in thousands): The following table shows the fixed and adjustable-rate composition of Sacramento Savings' loan portfolio at December 31, 1993 (in thousands): Loan Classification Summary December 31, 1993 The following table shows, at December 31, 1993, dollar amounts of loans in Sacramento Savings' portfolio based on their contractual maturity dates (in thousands): Loan Maturity Summary December 31, 1993 (Table continues on next page) (continued) Of the $1.976 billion of loans due after December 31, 1994, $463.1 million, or 23.4 percent, have fixed rates of interest and $1.513 billion, or 76.6 percent, have adjustable rates of interest. The following table shows, at December 31, 1993, the dollar amounts and repricing periods of the adjustable rate loans with contractual maturity dates beyond December 31, 1994 (in thousands): One- to Four-Family Residential Real Estate Lending. Sacramento Savings presently offers a variety of residential real estate loans secured by one- to four-family living units for the purpose of purchase, refinance, or construction. Maximum loan-to-value ("LTV") ratios for these products generally range from 60 percent to 95 percent, and there is a maximum dollar limit of $750,000. These loans are secured by first deeds of trust. Traditional single family residential real estate loans historically were made only on a long-term, fixed-rate basis. The characteristics of these types of loans exposed the lender to a greater level of interest rate risk to the extent that its assets did not reprice as frequently as its liabilities. As a part of its asset and liability management strategy, Sacramento Savings has originated primarily adjustable rate mortgage ("ARM") loans for its portfolio in recent years. Sacramento Savings' ARM loans are indexed to the monthly average cost of funds of Eleventh District Savings Institutions ("11th COF"). Sacramento Savings offers numerous types of ARM loans: as of December 31, 1993, initial rates ranged from 3.875 percent to 5.375 percent, and margins over the index ranged from 2.375 percent to 2.50 percent. All types of ARM loans offered by Sacramento Savings provide for semi-annual adjustment caps of 1 percent and a lifetime ceiling of 11.95 percent. Loan origination fees generally approximate 1 percent of the loan amount plus $250. Sacramento Savings requires loans secured by non-owner occupied properties to have lower LTV ratios, lower maximum loan amounts ($400,000), higher initial interest rates and wider margins over the index. Unlike many competitors, Sacramento Savings does not offer ARM products permitting negative amortization. Negative amortization occurs when the monthly payment under the terms of the note is insufficient to pay accrued interest on the loan. The shortage is added to the principal balance of the loan. In periods of rising interest rates and/or moderating to declining collateral values, negative amortization loans can create an unsecured extension of credit. Sacramento Savings also offers a variety of fixed-rate loans secured by owner-occupied one- to four-family units for the purpose of purchase or refinance. While these loans are structured and underwritten to allow for immediate sale in the secondary market, Sacramento Savings performs an individual loan-by-loan review at the time of loan funding (after the loan commitment is extended to the borrower). As a result of such review, Sacramento Savings classifies its fixed-rate loans either as portfolio loans (held until maturity) or as loans held for sale, depending on characteristics such as contractual term, LTV ratio and borrower age. Loans held for sale are reported at the lower of aggregate historical cost or market value. At December 31, 1993 loans held for sale totalled $21.2 million. However, $16.6 million of such loans consisted of mortgages conforming to the requirements of the Federal Home Loan Mortgage Corporation ("FHLMC") or the Federal National Mortgage Association ("FNMA"), which were originated and sold by another area lender and temporarily owned by Sacramento Savings for the purpose of generating additional income. Fixed-rate loans held for sale are generally sold to either FHLMC or FNMA. Sacramento Savings continues to service such loans after their sale. At December 31, 1993, loans serviced for others totalled $192 million. Sacramento Savings retains fixed-rate loans which exceed the FHLMC or FNMA maximum dollar limits. These originations of one- to four-family unit loans amounted to $19.8 million in 1993. At December 31, 1993, the following rates and fees were effective for Sacramento Savings' fixed-rate one- to four-family unit loans, which conform to federal agency underwriting criteria: Loans secured by second deeds of trust amounted to less than $7.0 million at December 31, 1993. Income Property Real Estate and Construction Lending. Long-term loans to purchase or refinance income properties are offered at initial rates that, as of December 31, 1993, ranged from 5.35 percent (prime apartment properties) to 7.10 percent, adjustable semiannually with a margin over the 11th COF index of 2.375 percent to 3.50 percent. The maximum LTV ratio is 75 percent. Sacramento Savings also makes interim construction loans on these properties with a maximum term of 24 months. As of December 31, 1993, the initial rate on construction loans was the prime rate of a bank selected by Sacramento Savings plus 200 basis points, adjusted after 12 months. In addition, a substantial volume of interim construction loans is made on one- to four-family units, primarily single-family detached homes. Loan origination fees are higher on construction loans than on residential real estate loans as compensation for the greater risks and servicing costs inherent in this type of lending. In order to minimize the construction loan credit risk, Sacramento Savings utilizes conservative underwriting policies and employs construction loan inspectors who perform regular on-site inspections, approve disbursements and monitor compliance with the approved construction budget. Construction loans net of undisbursed loan funds totalled $88.0 million, or 2.91 percent of assets, at December 31, 1993. This represents a decline of approximately 33 percent from the prior year. The following tables show locations and types of properties securing Sacramento Savings' real estate loans at December 31, 1993, and the amount of such loans which are non-performing (i.e., which are more than 60 days delinquent, or with respect to which the collection of principal and/or interest is otherwise doubtful): Real Estate Loans (excluding Construction Loans) as of December 31, 1993 (Table continues on next page) (continued) Construction Loans as of December 31, 1993 (Table continues on next page) (continued) Construction Loans as of December 31, 1993 Lending Secured by Undeveloped Land. Until June 1992, Sacramento Savings made loans secured by undeveloped land, frequently to developers who planned to convert the land to building sites. Customarily such loans were offered at a floating rate of 3 percent over the Bank of America prime rate, with an origination fee of 3 percent. Since June 1992, Sacramento Savings has elected to limit new land loans to credit extensions which facilitate the sale and/or transfer of existing land loans held by Sacramento Savings, or the sale of Sacramento Savings real estate investments or foreclosed property. Loans secured by undeveloped land totalled $82.6 million at December 31, 1993, representing a decline of approximately 27 percent from the prior year. Consumer Lending. Nonmortgage loans represent less than 2 percent of total assets. Such loans include VISA/Mastercard loans, loans on savings accounts, education loans, mobile home loans, and automobile loans. Originations, Purchases, Sales and Servicing of Real Estate Loans. Sacramento Savings acquires loans primarily through originations. In 1993, new loans totalling $582.1 million were generated, all of which were originated by the internal lending staff of Sacramento Savings. Approximately 20.1 percent of 1993 originations were construction loans. In 1992, loan production totalled $829.5 million, with approximately $46.4 million acquired as a result of Sacramento Savings' purchase of Butte Savings and Loan in January 1992; approximately 23.5 percent of the originations were construction loans. In 1991, loan production totalled $555 million, with approximately 0.4 percent purchases of loans originated by other parties and 99.6 percent originations; approximately 46 percent of the originations were construction loans. Sacramento Savings expanded its loan portfolio purchase program in 1985 as a means to increase its portfolio and to offset excess liquidity. Since 1990, Sacramento Savings suspended its loan portfolio purchase program, with the exception of purchases of multi-family residential real estate loans in an aggregate principal amount of less than $5 million from institutions which were previously identified by Sacramento Savings as possible candidates for acquisition. Non-Residential Lending Limits. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), enacted on August 9, 1989, placed limitations on the total amount of non-residential real estate loans which a savings institution can maintain as portfolio assets. Generally, non-residential real estate loans are limited to 400 percent of capital. As a savings association subsidiary of a unitary savings and loan holding company, Sacramento Savings is also limited by the "qualified thrift lender" ("QTL") test in the amount of non-residential real estate loans it may have outstanding. Effective July 1, 1991, the QTL test required a savings association to invest at least 70 percent of its tangible assets in qualified thrift investments. This requirement was reduced to 65 percent pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which was enacted on December 19, 1991. Sacramento Savings is in compliance with all non-residential lending limitations. Its non-residential lending margin, the difference between the total amount of non-residential real estate loans maintained by Sacramento Savings and the lower of the QTL test limitation and the 400 percent of capital limitation, decreased 2 percent from $278 million at year-end 1992 to $272 million at year-end 1993. The available non-residential lending margin far exceeds the amount of non-residential real estate loans which Sacramento Savings desires to maintain. Loan Delinquencies, Troubled Debt Restructurings and Non-Performing Assets. The following table shows delinquent mortgage and other loans at December 31, 1993 in dollar amount and as a percentage of Sacramento Savings' total loan portfolio: Loans that are more than 60 days delinquent and loans with respect to which the collection of principal and/or interest otherwise becomes doubtful are placed on non-accrual status. Such non-accruing loans and assets which have been acquired by Sacramento Savings through foreclosure constitute Sacramento Savings' non-performing assets. In addition, Sacramento Savings restructures troubled debt from time to time, by forgiving a portion of interest or principal on outstanding loans or by making new loans to borrowers at rates of interest which are materially lower than market rates. The following table shows the amounts and categories of non-performing assets and troubled debt restructurings in Sacramento Savings' loan portfolio: Non-Performing Assets and Troubled Debt Restructurings Approximately $1.6 million of interest income on non-performing loans was included in net income for the year ended December 31, 1993. An additional $3.5 million of interest income would have been recorded on the non-accruing and past due loans in the foregoing table if such loans had been current. Allowance for Estimated Loan Losses. The following table shows an analysis of Sacramento Savings' allowance for estimated loan losses for the past three years: Allowance for Estimated Loan Losses Sacramento Savings periodically reviews its allowance for loan losses considering numerous factors, including, but not necessarily limited to, general economic conditions, loan portfolio composition, classified asset levels, prior loss experience, and independent appraisals. Specific loss allowances are established when Sacramento Savings determines that the value of the collateral is less than the amount of the unpaid principal of the related loan plus estimated costs of the acquisition and sale. The allowance for loan losses is maintained at an amount considered adequate to provide for potential losses. Allowance for Losses on Real Estate Owned. The following table shows an analysis of Sacramento Savings' allowance for losses on real estate owned (property obtained through foreclosure, deeds obtained in lieu of foreclosure and loans designated by Sacramento Savings as "in substance" foreclosed) for the past three years: Allowance for Losses on Real Estate Owned Investment Activities Investment Portfolio. Sacramento Savings' investment portfolio totalled $634.9 million, or approximately 21 percent of total assets, as of December 31, 1993. The size of the investment portfolio reflects liquidity needs, asset/liability management strategies and the extent to which deposit flows exceed Sacramento Savings' capacity to acquire loans with yield and credit characteristics that meet its portfolio requirements. The resulting excess liquidity is invested primarily in money market instruments, short-term U.S. Treasury and Agency securities and U.S. Agency-guaranteed short-term mortgage-backed derivative securities or adjustable rate U.S. Agency mortgage-backed securities. To facilitate asset/liability management, and because of the volatile nature of interest rates and new regulations affecting the leveraging of capital, Sacramento Savings has deemed it prudent to purchase only low risk-weighted short-term securities because the maturities on these investments are short and the yields tend to respond quickly to the level of interest rates in the money markets. The weighted average maturity of the current portfolio is 63 months, and its weighted average yield to maturity is 4.73 percent. However, contractual maturities of the U.S. Agency-guaranteed short-term mortgage-backed derivative securities and adjustable rate U.S. Agency mortgage-backed securities overstate the likely portfolio duration. Moreover, Sacramento Savings estimates that 50 percent of the portfolio reprices in one year and the weighted average portfolio repricing frequency equals 26.2 months. The following table shows the carrying and market values of investment securities for the past three years (in thousands): 1 Includes mortgage-backed securities issued by U.S. Government Agencies. The following table shows the contractual maturities and weighted average yields of investment securities at December 31, 1993 (in thousands)1: 1 This table does not reflect the impact of principal paydowns of any mortgage-backed security. 2 Includes mortgage-backed securities issued by U.S. Government Agencies. Real Estate Investment. Sacramento Savings began investing in real estate in the late 1960s as a diversification strategy. Since then, Sacramento Savings has concentrated its investments within the Sacramento Metropolitan Statistical Area, where economics, engineering, marketing, and political concerns are best understood by it; in fact, all of Sacramento Savings' real estate investments are located within a 25-mile radius of Sacramento. As of December 31, 1993, Sacramento Savings held real estate investments with an aggregate net book value of $37.6 million, representing 18.8 percent of its total capital (based on generally accepted accounting principles). Sacramento Savings is distinguished from many savings institutions that have pursued real estate activities by the strict policy constraints that have guided its activities. It has consistently limited the scope of its real estate activities so that such investments have never exceeded 5 percent of assets, and are currently 1.24 percent of assets. In most cases, Sacramento Savings acquired undeveloped land and developed it through the construction of infrastructure and the creation of a final parcel map. The property was then sold, predominantly to builders or users. Many of Sacramento Savings' investments are held in joint ventures with established local developers. As of December 31, 1993, $34.5 million, or 90 percent, of Sacramento Savings' real estate portfolio was held in joint venture arrangements (although Sacramento Savings is seeking to terminate a joint venture arrangement holding approximately $25.6 million of Sacramento Savings' real estate portfolio to comply with FDIC divestiture requirements as described below). FIRREA, however, imposes significant restrictions on investing activities of federal- and state-chartered savings associations. FIRREA generally prohibits state-chartered savings associations from directly acquiring or retaining any equity investment of a type or in an amount that is not permissible for a federal savings association. Such impermissible investments include equity investments in real estate, investments in equity securities and any other equity investment. Pursuant to a transition rule promulgated under FIRREA, the FDIC must require divestiture of these impermissible investments as quickly as can be prudently done, and in any event not later than July 1, 1994. In response to the required divestiture of equity investments, the Office of Thrift Supervision (the "OTS") promulgated capital regulations for savings associations requiring the phase-out of all impermissible equity investments from capital calculations by July 1, 1994. (Although the Housing and Community Development Act of 1992 ("HCDA") permitted an extension of the capital phase-out to July 1, 1996 for certain real estate investments held in subsidiaries or in-substance subsidiaries such as joint venture arrangements, the benefits to Sacramento Savings that would have resulted therefrom are offset by reductions in regulatory capital required by the FDIC, as described below). Sacramento Savings submitted a divestiture plan to the FDIC providing for complete divestiture of its real estate investments and related business by year-end 1993. In approving Sacramento Savings' plan, the FDIC stipulated that Sacramento Savings write off certain real estate investment ("REI") assets, regardless of the fair value of the assets to be divested, if the assets were not sold by the sale date set forth in Sacramento Savings divestiture plan. Sacramento Savings added $13.5 million to reserves in respect of REI assets in 1991. In response to the relaxation of FIRREA restrictions effected by HCDA, Sacramento Savings entered into negotiations with the FDIC in late 1992 for relief from the write-off requirements in its divestiture plan, and no comparable addition to reserves was made in that year. In early 1993, Sacramento Savings reached an understanding with the FDIC (in which the OTS acquiesced) pursuant to which the write-off requirements were rescinded. In lieu of the write-off requirements, Sacramento Savings makes a quarterly adjustment to its regulatory capital in an amount equal to such write-off requirements. In 1993, Sacramento Savings booked direct charges to its regulatory capital of $23.1 million in accordance with this understanding. It is expected that, if none of its REI assets are divested, Sacramento Savings will make additional charges of $15 million to its regulatory capital in the first half of 1994. By July 1, 1994, Sacramento Savings will have fully written off its REI assets for regulatory purposes. Notwithstanding such relief, until all of its REI assets are removed from the balance sheet, Sacramento Savings is following conservative accounting practices with respect to such assets. These practices include the expensing of all carrying costs and the deferral of income recognition until the entire portfolio is liquidated. Sources of Funds During the years 1983 to 1988, Sacramento Savings' assets doubled from $1.1 billion to more than $2.3 billion. As of December 31, 1993, Sacramento Savings' assets totalled $3.0 billion. The slowed rate of increase was due in part to recessionary pressures and Sacramento Savings' decision to limit asset growth to maintain a well-capitalized regulatory status. Sacramento Savings has pursued predominately traditional strategies with respect to both its funding sources and its investment mix. Its funding comes predominantly from retail deposits, and its investments are concentrated in real estate loans. Deposits. Deposits totalled about $2.8 billion and funded approximately 91 percent of Sacramento Savings' total assets as of December 31, 1993. Approximately 26 percent of total deposits were represented by passbook and transaction accounts, and 16 percent were in deferred compensation plan accounts. Another 4 percent of all deposits were time deposits of public entities, which have provided a readily available source of funds without disrupting Sacramento Savings' regular pricing structure. The remainder of total deposits was represented by retail certificates of deposit. Sacramento Savings has never accepted brokered deposits. Among all banking institutions in the 14-county region constituting Sacramento Savings' primary deposit market, Sacramento Savings has over 10 percent of all deposits, ranking third in deposits both in the 14 counties overall and in Sacramento County itself. Sacramento Savings ranks first in deposits among all savings institutions in Sacramento County, with a market share of more than 40 percent. Its market share of deposits held by all financial institutions in Sacramento County, including banks and thrifts, is about 12 percent. The following table shows the dollar amount of deposits, by interest rate range, in the various types of deposit programs offered by Sacramento Savings (in thousands): The following table shows the savings flows of Sacramento Savings (in thousands): The following table shows maturity information for Sacramento Savings' certificates of deposit as of December 31, 1993 (in thousands): * Certificates of deposit from governmental and other public entities. Deferred Compensation Deposits. State and local governmental employees may contribute up to 25 percent of their annual compensation (not exceeding $7,500) to approved deferred compensation plans, and these deferred compensation deposits are another funding source for Sacramento Savings. Such deposits are long-term in nature, and have fixed interest rates. At present, over 60 plans covering 64,000 participants are being administered by Sacramento Savings, with total deposits of over $447 million. However, $190 million of such amount earns a fixed rate of interest of 10 percent until 1994 year-end, substantially higher than current market rates. Return on Equity and Assets. In 1993, Sacramento Savings' return on average total assets was 0.57 percent and its return on equity was 8.52 percent. Its dividend payout ratio (dividends declared per share divided by net income per share) was 58.09 percent, and its equity to assets ratio (average equity divided by average total assets) was 6.71 percent. Borrowings. As a member of the FHLBank of San Francisco, Sacramento Savings is required to own capital stock in the FHLBank of San Francisco and is authorized to apply for advances from the FHLBank of San Francisco. The FHLBank of San Francisco may prescribe the permissible uses for such advances, as well as limitations on the interest rates and repayment provisions. FIRREA requires that all long-term FHLBank advances be for the purpose of financing residential housing, and that members meet established community lending standards in order to have continued access to long-term FHLBank advances. Sacramento Savings meets these standards and does not expect that these requirements will have a significant impact on its access to long-term advances. Sacramento Savings did not apply for any long-term FHLBank advances in 1993. Subsidiary and Affiliates Sacramento Savings has one subsidiary, a service corporation. SSB Financial Services, a California corporation, was organized in April 1987 to market to Sacramento Savings' customers tax-deferred annuity plans provided principally by various insurance companies and mutual funds. Two ancillary companies of Sacramento Savings which were also acquired by Alleghany are Superior California Insurance Agency ("Superior") and Central Valley Securities Company ("Central Valley"). Superior, a California corporation, handles "forced placed" casualty insurance for Sacramento Savings' mortgage loans, which provides casualty coverage on the security of those loans with respect to which the borrower has failed to do so. Central Valley, also a California corporation, acts as the assigned trustee for Sacramento Savings' deeds of trust. Competition Sacramento Savings' primary competitors for deposit funds are the major thrifts, commercial banks, brokerage and insurance firms in the region. Regulation Sacramento Savings is a California-licensed savings association, deposits of which are federally insured by the Savings Association Insurance Fund of the FDIC. Accordingly, Sacramento Savings is subject to broad state and federal regulation and oversight extending to all of its operations. As a California-licensed savings association, Sacramento Savings derives its authority from, and is governed by, the provisions of the California Savings Association Law and regulations of the Savings and Loan Commissioner of the State of California. Sacramento Savings is also subject to regulation by the OTS, pursuant to FIRREA. The OTS has extensive authority over the operations of savings institutions such as Sacramento Savings. Sacramento Savings is required to file periodic reports with the OTS and is subject to periodic examinations by the OTS. Furthermore, pursuant to FIRREA, the OTS was required to issue new capital standards for all savings associations, which included a tangible capital requirement (minimum ratio of tangible capital to adjusted total assets), a leverage, or core capital, ratio requirement (minimum ratio of core capital to adjusted total assets) and a risk-based capital requirement (minimum ratio of capital to total assets adjusted for the risk associated with individual assets). The various definitions of capital and adjusted total and risk-weighted assets are set forth in FIRREA and in rules and regulations of the OTS and the Comptroller of the Currency. FIRREA mandated that these new capital requirements be generally as stringent as comparable capital requirements established by the Comptroller of the Currency for national banks. Also pursuant to the new capital requirements and as further described above under the heading "Real Estate Investment," equity investments must be phased out from capital calculations over a five-year period. The new capital requirements became effective December 7, 1989, but were further modified by FDICIA. FDICIA established five new capital categories and, as implemented by federal banking regulatory agencies, established new "relevant capital measures" for those new capital categories. The new capital categories are: (i) "well capitalized," describing an institution which significantly exceeds the required minimum level for each relevant capital measure; (ii) "adequately capitalized," describing an institution which meets the required minimum level for each relevant capital measure; (iii) "undercapitalized," describing an institution which fails to meet the required minimum level for each relevant capital measure; (iv) "significantly undercapitalized," describing an institution which is significantly below the required minimum level for any relevant capital measure; and (v) "critically undercapitalized," describing an institution which fails to meet a ratio of "tangible equity" to total assets established by the appropriate federal banking agency, which ratio may not be less than 2 percent or greater than 65 percent of the required minimum level of capital under the leverage limit specified by the appropriate federal banking agency. The OTS will determine the capital category of each savings institution it regulates. The assignment of a capital category will have various consequences to the institution. For example, in addition to other requirements, an "under-capitalized" institution must file a capital restoration plan with the OTS. A "significantly undercapitalized" institution is subject to restrictions on transactions with affiliates, limitations on the interest rates paid on deposits, asset growth limitations and restrictions on the payment of any bonus to a senior executive officer of the institution without prior regulatory approval. Federal regulators may also order a "significantly undercapitalized" institution to hold a new election of directors, to terminate any director or senior executive officer employed more than 180 days prior to the time the institution became "significantly undercapitalized" or to hire qualified senior executive officers approved by the regulators. Under certain circumstances, the OTS may reclassify a "well capitalized" institution as "adequately capitalized," may require an "adequately capitalized" institution to comply with one or more requirements as if it were "undercapitalized," and may take action with respect to an "undercapitalized" institution as if it were "significantly undercapitalized." No institution may make any capital distribution or pay management fees if, as a result of such payments, such institution would become "undercapitalized." As directed by FDICIA, the OTS promulgated regulations defining the relevant capital measures for the new capital categories. Such measures consist of a "risk-based capital ratio" defined as the ratio of total capital to risk-weighted assets, a "Tier 1 risk-based capital ratio" defined as the ratio of Tier 1 capital, or core capital, to risk-weighted assets, and a "tangible capital ratio" defined as the ratio of total capital to adjusted total assets. At December 31, 1993, Sacramento Savings Bank met the requirements for inclusion in the highest, or "well capitalized" category, which is reserved for institutions that significantly exceed the required minimum level with respect to each of three specified capital measures. Sacramento Savings' capital ratios at December 31, 1993, compared with such capital measures for an "adequately capitalized" institution and a "well capitalized" institution, were as follows: Sacramento Savings' short-term liquidity ratio (the ratio of short-term liquid assets to withdrawable accounts) was 7.31 percent on December 31, 1993, far exceeding the federal requirement of 1 percent. As a savings and loan holding company, Alleghany is also subject to regulations of the California Savings and Loan Commissioner and the OTS. Pursuant to the California Savings Association Law and the Regulations For Savings and Loan Holding Companies promulgated by the OTS, Alleghany may be required to file periodic reports with, and is subject to examination by, the California Savings and Loan Commissioner and the OTS. As a condition to the approval of the acquisition of Sacramento Savings, in 1989 Alleghany entered into a voting and disposition rights/dividend agreement with the OTS. Pursuant to such agreement, if the core capital of Sacramento Savings were to fall below 1.5 percent of total assets, the OTS would be entitled to control and/or cause the disposition of Sacramento Savings. Alleghany's agreement with the OTS also sets forth limits relating to the amount of dividends that may be paid by Sacramento Savings. Such dividend limits have been superseded by stricter limits imposed by subsequent OTS regulations and FDICIA. Sacramento Savings believes that it is in compliance with such dividend regulations. At December 31, 1993, substantially all of Sacramento Savings' stockholder's equity was restricted as to dividend payment pursuant to OTS regulations and FDICIA. In addition, the board of Sacramento Savings has adopted a Capital Adequacy Policy Statement relating to the payment of dividends. Pursuant to such Statement, Sacramento Savings will be permitted to pay a quarterly dividend of 1.25 percent of its capital as measured by generally accepted accounting principles if its capital position after payment of such dividend exceeds the requirements for a "well capitalized" institution. Alleghany, as a unitary savings and loan holding company, and its subsidiaries other than Sacramento Savings, are generally not subject to restrictions on their business activities due to their affiliation with Sacramento Savings, so long as Sacramento Savings continues to be a "qualified thrift lender". Sacramento Savings anticipates that it will continue to exceed the QTL requirement and intends to take such action as may be appropriate to maintain compliance. Employees At December 31, 1993, Sacramento Savings, its ancillary companies and subsidiary had approximately 903 employees. Because of the extensive use of part-time service professionals, primarily in its retail operations, these were equivalent to 820 full-time employees. PROPERTY AND CASUALTY REINSURANCE BUSINESS Underwriters, headquartered in Woodland Hills, California, provides reinsurance to property and casualty insurers and reinsurers. Underwriters initially was organized in 1867 as a primary insurer in New York under the name "Buffalo German Insurance Company." By 1970, Underwriters had become principally a reinsurer, and in 1977 it changed its corporate domicile to New Hampshire. Although it writes many lines of business, Underwriters concentrates on coverages requiring specialized underwriting expertise, including certain excess and surplus lines programs, umbrella liability, and directors' and officers' liability. Underwriters is licensed or authorized to engage in business in 41 states, the District of Columbia and Canada, and has branch offices in Atlanta, Chicago, Houston, Woodland Hills and New York. Underwriters experienced substantial losses in the mid-1980's as a result of a strategy of increasing writings of treaty casualty business with pricing and terms which later proved to be inadequate. In early 1987, members of current management joined Underwriters and shortly thereafter began a program to restructure its reinsurance portfolio and operations. Among other steps, the restructuring undertaken by new management included (i) strengthening Underwriters' reserves for pre-1987 business and the purchase from The Continental Corporation of two reinsurance contracts providing coverage for pre-1987 business up to an aggregate limit of $200 million, (ii) tightening Underwriters' underwriting standards by initiating a program of pre-underwriting audits of prospective treaty business, (iii) expanding claims audits to improve monitoring of reported and unreported claims, (iv) employing actuaries to oversee Underwriters' underwriting activities and reserve practices and (v) adopting Underwriters' current business strategy. The restructuring contributed to an increase in the statutory surplus of Underwriters from $130.0 million at 1987 year-end to $185.0 million at September 30, 1993, after payment of more than $139.5 million in dividends over such period to its parent company. Underwriters was acquired by Alleghany in October 1993, and thereafter Alleghany, through a new holding company which owns Underwriters, contributed approximately $51 million to the capital of Underwriters, which increased Underwriters' statutory surplus to $247.7 million as of 1993 year-end. Underwriters' management currently owns about 5.4 percent of the capital stock of the new holding company which owns Underwriters. A.M. Best Company, Inc., an independent insurance industry rating organization ("Best's"), recently upgraded its rating of Underwriters to "A (Excellent)," from "A- (Excellent)." Best's publications indicate that the new rating is assigned to companies which Best's believes have achieved excellent overall performance and have a strong ability to meet their obligations over a long period of time. According to Best's, the new rating reflects Underwriters' strong capital base, reduced debt service obligations and operating performance. Alleghany's acquisition of Underwriters was accounted for as a purchase and, therefore, the accounts of Underwriters and its results of operations included in Alleghany's financial statements reflect purchase accounting adjustments and are not comparable to Underwriters' prior reported results. Furthermore, most of the information given about Underwriters herein relates to pre-acquisition periods. To capitalize on advantageous market conditions and on Underwriters' expertise in specialized coverages, Underwriters established Commercial Underwriters Insurance Company ("CUIC") at year-end 1992. CUIC, a California corporation, is a property and casualty insurance company that focuses on specialized insurance lines. In 1993, CUIC generated $19.4 million in gross written premiums. Underwriters or CUIC retained $8.8 million of such amount, constituting 5 percent of Underwriters' consolidated net written premiums in 1993. General Description of Reinsurance Reinsurance is an agreement between two insurance companies in which one company, the "reinsurer," agrees to indemnify the other company, the "reinsured" or "ceding company," for all or part of the insurance risks underwritten by the reinsured. Reinsurance provides reinsureds with three major benefits: it reduces net liability on individual risks, protects against catastrophic losses and helps to maintain acceptable surplus and reserve ratios. In general, property insurance protects the insured against financial loss arising out of loss of property or its use, caused by an insured peril. Casualty insurance protects the insured against financial loss arising out of its obligation to others for loss or damage to persons or property. Property and casualty reinsurance such as that provided by Underwriters protects the ceding company against loss to the extent of the reinsurance coverage provided. While both property and casualty reinsurance involve a high degree of volatility, property losses are generally reported within a relatively short time period after the event, while there tends to be a greater lag in the reporting and payment of casualty claims. Consequently, the ultimate losses associated with property risks are generally known in a shorter time than losses associated with casualty risks. The financial condition of property and casualty insurers and reinsurers can be adversely affected by volatile and unpredictable natural disasters, such as hurricanes, windstorms, earthquakes, floods, fires and periods of severely cold weather. Between 1989 and 1993, the worldwide reinsurance industry experienced unusual catastrophic losses, in terms of both frequency and severity, from a variety of natural disasters, including Hurricanes Hugo, Andrew and Iniki. This extended period of unusual catastrophic losses has caused many reinsurers to reduce significantly the amount of property catastrophe reinsurance they are prepared to write. The significant reduction in capacity has led to increased rates for such catastrophe coverage. Underwriters has increased its writings and retentions of this business because it believes that substantial increases in premium rates for property catastrophe coverage, combined, in certain instances, with higher deductibles retained by reinsureds, have significantly improved the risk/reward relationship on such coverage. Underwriters provides reinsurance on both a treaty and facultative basis. Treaty reinsurance is reinsurance based on a standing arrangement (a "treaty"), usually for a year or longer, between a reinsured and reinsurer for the cession and assumption of risks defined in the treaty. Under most treaties, the reinsured is obligated to offer and the reinsurer is obligated to accept a specified portion of all such risks originally underwritten by the reinsured. Facultative reinsurance is the reinsurance of individual risks. Rather than agreeing to reinsure all or a portion of a class of risk, the reinsurer separately rates and underwrites each individual risk and is free to accept or reject each risk offered by the reinsured. Facultative reinsurance is normally purchased by insurance companies for risks not covered or covered only in part by their reinsurance treaties. The demand for facultative reinsurance is normally inversely related to the supply of treaty reinsurance. Underwriters writes both of the two major forms of reinsurance, pro rata reinsurance and excess of loss reinsurance. The pro rata form is an agreement in which the reinsured and reinsurer share the premiums as well as the losses and expenses of a single risk, or an entire group of risks, based upon an established percentage. Under excess of loss reinsurance, the reinsurer agrees to reimburse the primary insurance company for all losses in excess of a predetermined amount (commonly referred to as the insurer's "retention"), generally up to a predetermined limit. Excess of loss reinsurance is often written in layers or levels, with one reinsurer taking the risk from the primary insurer's retention level up to an established level, above which another reinsurer assumes, or the primary insurer retains, the risk. Excess of loss reinsurance allows the reinsurer to control better the relationship of the premium charged to the exposures assumed. The reinsurer assuming the risk immediately above the primary insurer's retention level is said to write "working layer" or "low layer" excess of loss reinsurance. A loss that reaches just beyond the primary insurer's retention level would create a loss for the lower level reinsurers but not for the reinsurers on higher levels. Underwriting Operations Underwriters maintains a disciplined underwriting strategy with a focus on generating profitable business rather than on increasing market share. In response to the increased competition and lower premium rates which have characterized the industry in recent years, Underwriters has maintained a defensive underwriting posture by no longer writing those lines of business that it considers to be inadequate in terms of pricing or contract terms. Underwriters' underwriting discipline is enhanced by its focus on excess of loss casualty reinsurance with low level attachment points (i.e., dollar-levels at which risk is assumed). Such layers are characterized by greater loss frequency, lower loss severity and quicker loss settlement than layers with higher attachment points. Underwriters believes that these factors result in greater predictability of losses, which improves Underwriters' ability to analyze its exposure and price them appropriately. Another important element of Underwriters' underwriting strategy is to seek to respond quickly to market opportunities (such as increased demand or more favorable pricing) by adjusting the mix of business it writes. Recently, Underwriters has taken advantage of such market opportunities by increasing its writings of marine and aviation, property catastrophe, clash coverages (in which the primary insurer has insured more than one party in a single incident) and certain excess and surplus lines programs. Underwriters' business is not seasonal. Within the lines of business that Underwriters writes, including general liability, automobile liability, workers' compensation and commercial multiperil, Underwriters focuses on coverages requiring specialized underwriting expertise. These specialized coverages, which require a relatively high degree of underwriting and actuarial analysis, include certain excess and surplus lines programs, umbrella liability, and directors' and officers' liability. Underwriters believes that these risks offer greater potential for favorable results than more general risks. As part of its strategy, Underwriters seeks to serve as lead or co-lead underwriter on its treaties. As lead or co-lead underwriter, Underwriters believes that it is able to influence more effectively the pricing and terms of the treaties and achieve better underwriting results. During 1993, Underwriters was a lead or co-lead reinsurer on a majority of its treaty business. Treaty operations generated approximately $132.2 million or 72 percent of Underwriters' consolidated net written premiums in 1993. Casualty lines treaties represented approximately 64 percent of total treaty net written premiums with the remainder represented by property lines treaties. Approximately 64 percent of total treaty net written premiums represented treaty reinsurance written on an excess of loss basis and the balance represented treaty reinsurance written on a pro rata basis. In 1993, treaty net written premiums increased 23 percent from 1992 due to the increased writing of marine and aviation, property catastrophe, clash coverage and certain excess and surplus lines. Since July 1, 1987, Underwriters' treaty department has generally written up to $1.0 million per risk on a net basis and in certain circumstances has accepted more. The largest net risk assumed in 1993 was $2.5 million. Facultative operations generated approximately $41.5 million or 23 percent of Underwriters' consolidated net written premiums in 1993. Casualty risks represented 94 percent of total facultative net written premiums with property risks comprising the remainder. Approximately 80 percent of total facultative net written premiums represented facultative reinsurance written on an excess of loss basis and the balance represented facultative reinsurance written on a pro rata basis. Facultative net written premiums increased slightly in 1993 from $40.9 million in 1992. Since November 30, 1987, Underwriters has offered gross casualty facultative underwriting capacity of $2.5 million, with a net retention of $1.4 million. Underwriters has a $2.0 million gross property facultative underwriting capacity with a net retention of $500,000. Marketing Underwriters writes almost all of its treaty business and 80 percent of its facultative business through reinsurance brokers. The remainder of its facultative business is written directly with ceding companies. By working primarily through brokers, Underwriters does not need to maintain a large sales organization which, during periods of reduced premium volume, can comprise a significant and nonproductive part of overhead. In addition, Underwriters believes that submissions from the broker market, including certain targeted specialty coverages, are more numerous and diverse than would be available through a salaried sales organization, and Underwriters is able to exercise greater selectivity than would be possible in dealing directly with ceding companies. Reinsurance brokers regularly approach Underwriters and others for quotations on reinsurance being placed for the brokers' customers. In 1993, Underwriters paid brokers $8.2 million in commissions, which represents 4 percent of its gross written premiums of $225.9 million. Transactions arranged by BEP International Corporation accounted for 14 percent of Underwriters' gross written premiums in 1993. Transactions arranged by Underwriters' five leading brokers (including BEP International Corporation) accounted for 42 percent of gross written premiums in 1993. Loss of all or a substantial portion of the business provided by any of its five leading brokers could have a material adverse effect on the results of operations of Underwriters. A significant percentage of Underwriters' gross written premiums are generally obtained from a relatively small number of ceding companies. In 1993, approximately 41 percent of gross written premiums were obtained from Underwriters' ten largest ceding companies. Due to the nature of Underwriters' business, the identity of ceding companies accounting for relatively large percentages of gross written premiums tends to vary from year to year. While Underwriters has generally been successful in replacing accounts that have not been renewed, there can be no assurance that it will be able to do so in the future. Underwriters does not believe that the loss of the account of any one ceding company would have a material adverse effect on Underwriters' financial condition or results of operations. Outstanding Losses and Loss Adjustment Expenses In many cases, significant periods of time may elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the reinsurer and the insurer's payment of that loss and subsequent payments by the reinsurer. To recognize liabilities for unpaid losses, insurers and reinsurers establish "reserves," which are balance sheet liabilities representing estimates of future amounts needed to pay claims and related expenses with respect to insured events which have occurred, including events which have not been reported to the insurer. When a claim is reported by the ceding company, Underwriters' claims department establishes a "case" reserve for the estimated amount of Underwriters' ultimate payment. Such reserves are based upon the amount of reserves recommended by the ceding company and are supplemented by additional amounts as deemed necessary by Underwriters' claims department, after an evaluation of numerous factors including coverage, liability, severity of injury or damage, jurisdiction and ability of the ceding company to evaluate and handle the claim properly. In many cases Underwriters establishes case reserves even when the ceding company believes there is no liability of the reinsurer. In no instance is the case reserve established by Underwriters less than that suggested by the ceding company. These reserves are periodically adjusted by Underwriters' claims department based on its evaluation of subsequent reports from and audits of the ceding company. "Bulk" reserves or "incurred but not reported" reserves are established on an aggregate basis to provide for losses incurred but not yet reported to the insurer and to supplement the overall adequacy of reported case reserves and estimated expenses of settling such claims, including legal and other fees and general expenses of administering the claims adjustment process. Underwriters establishes bulk reserves by using generally accepted actuarial reserving techniques to estimate the ultimate net liability for losses and loss adjustment expenses ("LAE"). The process provides implicit recognition of the impact of inflation and other factors affecting claims reporting by taking into account changes in historic loss reporting patterns and perceived probable trends. Underwriters' actuarial department performs reviews of aggregate loss reserves at least twice each year. Between the semi-annual reviews, Underwriters uses an updating system which applies the loss ratios determined in the previous review to earned premiums to date, less incurred losses reported. Underwriters does not discount any of its reserves for reported or unreported claims in any line of its business for anticipated investment income. There are inherent uncertainties in estimating reserves primarily due to the long-term nature of most reinsurance business, the diversity of development patterns among different lines of business and types of reinsurance, and the necessary reliance on the ceding insurer for information regarding claims. Actual losses and LAE may deviate, perhaps substantially, from reserves on Underwriters' financial statements, which could have a material adverse effect on Underwriters' financial condition and results of operations. However, Underwriters believes that its reserves are being calculated in accordance with sound actuarial practices and, based upon current information, that Underwriters' reserves for losses and LAE at December 31, 1993 are adequate. Asbestos-related liability and environmental impairment have been recognized as industry-wide problems. In 1993, Underwriters paid $3.2 million in asbestos-related claims and $1.6 million in environmental impairment claims. Its net case and bulk reserves for asbestos-related liabilities totalled about $30.3 million, involving approximately 750 open claims, as of December 31, 1993. Additionally, ceding companies have reported 1,627 asbestos-related cases in which Underwriters may be subject to possible exposure. Underwriters did not write reinsurance during periods prior to 1970, when asbestos was most frequently used, and it has received very few property damage claims relating to asbestos. Underwriters' net case and bulk reserves for environmental impairment claims totalled about $22.3 million, involving approximately 412 open claims, as of December 31, 1993. Ceding companies have reported an additional 9,213 environmental impairment cases in which Underwriters may be subject to possible exposure. Underwriters' case reserves for individual asbestos-related and environmental impairment claims reflect amounts beyond those reserves recommended by its ceding companies. In addition to the case and bulk reserves for asbestos-related and environmental impairment claims reported on a statutory basis as of December 31, 1993, Underwriters carried an additional $35.8 million in reserves for such exposures. Taking into consideration these additional reserves, Underwriters believes that its total asbestos-related and environmental impairment reserves are adequate. The table below shows changes in historical net loss and LAE reserves for Underwriters for each year since 1983. Reported reserve development is derived primarily from information included in Underwriters' statutory financial statements. The first line of the upper portion of the table shows the net reserves at December 31 of each of the indicated years, representing the estimated amounts of net outstanding losses and LAE for claims arising during that year and in all prior years that are unpaid, including losses that have been incurred but not yet reported to Underwriters. The upper portion of the table shows the reestimated amount of the previously recorded net reserves for each year based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about claims for individual years. The lower portion of the table shows the cumulative net amounts paid as of December 31 of successive years with respect to the net reserve liability for each year. In evaluating the information in the table below, it should be noted that a reserve amount reported in any period includes the effect of any subsequent change in such reserve amount. For example, if a loss was first reserved in 1987 at $100,000 and was determined in 1990 to be $150,000, the $50,000 deficiency would be included in the Cumulative Redundancy (Deficiency) row shown below for each of the years 1987 through 1989. Conditions and trends that have affected the development of liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table. During the mid-1980s, the reinsurance industry, including Underwriters, experienced substantial underwriting losses. Such losses are reflected in the table, beginning with the comparatively high cumulative deficiencies in the years 1983-86. Changes in Historical Net Reserves for Losses and LAE (in millions) - ---------------- * Amounts for 1983-86 were determined in accordance with statutory accounting principles. The reconciliation between reserves determined in accordance with statutory accounting principles ("SAP") and reserves determined in accordance with generally accepted accounting principles ("GAAP") for the last three years is shown below (in thousands): Reconciliation of Reserves for Losses and LAE from SAP Basis to GAAP Basis (1) Amounts which relate to multiple-year retrospectively-rated contracts (i.e., contracts that provide for premium adjustments or changes in future coverage based on loss experience) are classified as ceded reserves on a statutory basis. A recent interpretation of GAAP, as promulgated by the FASB Emerging Issues Task Force, requires that such contracts be accounted for as deposits. (2) Amount represents additional reserves recorded by Underwriters for possible asbestos-related and environmental impairment claims exposure. (3) Amounts represent ceded outstanding losses and LAE reclassified to reinsurance receivables in accordance with Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." The reconciliation of reserves for the last three years on a GAAP basis is shown below (in thousands): Reconciliation of Reserves for Losses and LAE * Reserves as presented represent GAAP basis losses and LAE net of ceded losses and LAE. Retrocessional Arrangements A reinsurer often reinsures some of its business with other reinsurers ("retrocessionaires") pursuant to retrocession agreements, and pays to its retrocessionaires a portion of the premiums it receives. Reinsurance companies enter into retrocession agreements for reasons similar to those that cause primary insurers to purchase reinsurance. Underwriters' has long-term retrocessional agreements with a number of domestic and international reinsurance companies. Retrocessional contracts do not relieve Underwriters from its obligations to ceding companies and Underwriters remains liable to its ceding companies for the portion reinsured to the extent that any retrocessionaire does not meet the obligations assumed under the retrocessional agreements. Consequently, the most important factor in Underwriters' selection of retrocessionaires is financial stability. Underwriters utilizes several retrocessional arrangements to reduce its net liability on individual risks, protect against catastrophic losses and facilitate the maintenance of various financial ratios. Underwriters would be adversely affected to the extent of any defaulted amounts in the event any retrocessionaire is unable to meet its contractual obligations. Underwriters currently has reinsurance contracts in force which cede to retrocessionaires risks in excess of Underwriters' net risk retention, ceding up to $1.1 million per casualty facultative risk and up to $1.5 million per property facultative risk. Underwriters also has an aggregate reinsurance contract to cover losses, up to $30 million, incurred during the period July 1, 1993 through June 30, 1994 in excess of a 77 percent loss and LAE ratio. The contract covers essentially all lines of business written by Underwriters; however, property catastrophe losses are subject to a sublimit of $26 million. Also, Underwriters from time to time purchases retrocessional reinsurance in varying amounts for specific assumed treaties. As of December 31, 1993, Underwriters had reported reinsurance receivables of $353.9 million through retrocession agreements, including $200 million under two reinsurance contracts, with a subsidiary of Continental Insurance Group. The $200 million reinsurance receivable is secured by a combination of letters of credit and a trust fund dedicated solely to payments under the two reinsurance contracts. As of December 31, 1993, Underwriters had an allowance for estimated unrecoverable reinsurance of $1.8 million. Investment Operations Underwriters' investments must comply with the insurance laws of New Hampshire, the domiciliary state of Underwriters, California, the domiciliary state of CUIC, and the other states in which they are licensed. These laws prescribe the kind, quality and concentration of investments which may be made by insurance companies. In general, these laws permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, preferred and common stocks and real estate mortgages. Underwriters' current investment strategy is to maximize after-tax investment income through a high quality diversified investment portfolio, consisting primarily of taxable and tax-exempt fixed maturity securities, while maintaining an adequate level of liquidity. For the purpose of managing its investment portfolio, Underwriters has estimated that the average duration of its policy liabilities is approximately five years. The average duration of the investment portfolio has generally approximated five years. Underwriters may adjust the duration of its investment portfolio from time to time as necessary to maintain a reasonable relationship between the duration of its liabilities and its portfolio assets. The following table reflects investment results for Underwriters for the three months ended December 31, 1993 (in thousands except percentages): Investment Results (1) Average of amortized cost of fixed maturities plus cost of equity securities at beginning and end of period, excluding operating cash. (2) After investment expenses, excluding realized gains or losses from sale of investments. (3) Net pre-tax investment income less appropriate income taxes. (4) Annualized net pre-tax investment income for the period divided by average investments for the same period. (5) Annualized net after-tax investment income for the period divided by average investments for the same period. The following table summarizes the investments of Underwriters, excluding cash, as of December 31, 1993, with all investments carried at market value (in thousands except percentages): The following table indicates the composition of the long-term fixed maturity portfolio by Moody's rating as of December 31, 1993 (in thousands except percentages): The following table indicates the composition of the long-term fixed maturity portfolio by years until maturity as of December 31, 1993 (in thousands except percentages): Competition Competition in the property and casualty reinsurance industry has historically been cyclical in nature. Typically, a cycle begins with attractive premium rates for reinsurance, which cause increased writing by existing reinsurers and the entrance into the market of new reinsurers. Competition within the market continues to grow, resulting in a decline in premium rates. As the cycle continues, these decreased premium rates, in conjunction with a combination of fluctuations in interest rates, catastrophic events and general economic conditions, usually result in a period of underwriting losses. Such losses in turn cause reinsurers to slow or stop writing reinsurance or to withdraw from the market altogether, which results in decreased competition and a subsequent increase in premium rates. Underwriters believes this competitive cycle, which may affect particular market segments at different times, is a critical factor affecting reinsurance profitability over time. There are no assurances that historical trends in the property and casualty reinsurance industry will continue or that Underwriters will be able to accurately anticipate any such trends. The property and casualty reinsurance business is highly competitive. Underwriters competes primarily in the United States reinsurance market with numerous foreign and domestic reinsurers, many of which have greater financial resources than Underwriters. Competition in the types of reinsurance in which Underwriters is engaged is based on many factors, including the perceived overall financial strength of the reinsurer, premiums charged, contract terms and conditions, services offered, speed of claims payment, reputation and experience. Underwriters' competitors include independent reinsurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance departments of certain primary insurance companies and domestic, European and Asian underwriting syndicates. According to the Reinsurance Association of America, at December 31, 1993, there were 54 domestic professional reinsurers, and Underwriters was the nation's sixteenth-largest in terms of net premiums written. Regulation Underwriters and CUIC are subject to regulation and supervision by state insurance regulators under the insurance statutes and regulations of states in which they are incorporated (New Hampshire and California, respectively). In addition, each of these companies is regulated in each jurisdiction in which it conducts business. Among other things, insurance statutes and regulations typically limit the amount of dividends that can be paid without prior regulatory notification and approval, impose restrictions on the amounts and types of investments Underwriters and CUIC may each hold, prescribe solvency standards that must be met and maintained, require filing of annual or other reports with respect to financial condition and other matters and provide for periodic examinations of Underwriters and CUIC. The terms and conditions of reinsurance agreements generally are not subject to regulation by any governmental authority with respect to rates or policy terms. These agreements contrast with primary insurance policies and agreements, the rates and policy terms of which are generally closely regulated by state insurance departments. As a practical matter, however, the rates charged by primary insurers do have an effect on the rates that can be charged by reinsurers. As an insurance holding company, Alleghany is also subject to the insurance regulations of New Hampshire and California. Each state required prior regulatory approval of Alleghany's acquisition of Underwriters and CUIC, respectively. Alleghany and its other subsidiaries, however, are generally not subject to restrictions on their business activities due to their affiliation with Underwriters. Employees Underwriters employed 153 persons as of December 31, 1993. INDUSTRIAL MINERALS BUSINESS On July 31, 1991, a holding company subsidiary of Alleghany acquired all of Manville Corporation's worldwide industrial minerals business, now conducted principally through World Minerals, at a cost of about $144 million, including capitalized expenses. The present chief executive officer of World Minerals currently owns an equity interest of about 6.2 percent of World Minerals' immediate parent company. On September 16, 1991, certain assets of the Inorganic Specialties Division of Witco Corporation, including a diatomaceous earth mine and plant in Quincy, Washington, were acquired by World Minerals' subsidiary Celite. On November 16, 1992, New Harborlite Corporation ("Harborlite"), a newly formed subsidiary of World Minerals, acquired all of the outstanding capital stock of Harborlite Corporation ("Old Harborlite"), a privately owned perlite filter-aid company, for cash and non-voting preferred stock of Harborlite. All of World Minerals' pre-existing perlite operations were transferred to Harborlite, and Old Harborlite was merged into Harborlite, which was then renamed Harborlite Corporation. In 1993, Harborlite enhanced its position in the domestic perlite business through the acquisition of additional reserves near its perlite mine in Superior, Arizona and an additional perlite expansion plant in Fort Worth, Texas. Accordingly, World Minerals currently conducts its industrial minerals business through its subsidiaries Celite and Harborlite: Celite Celite is believed to be the world's largest producer of diatomite, which it markets under the Celite and Kenite brand names. Diatomite is a silica-based mineral consisting of the fossilized remains of microscopic freshwater or marine plants. Celite also produces calcium and magnesium silicate products. Diatomite's primary applications are in filtration and as a filler. Filtration accounts for the majority of the worldwide diatomite market and for over 50 percent of Celite's diatomite sales. Diatomite is used as a filter aid in the production of beer, food, juice, wine, water, sweeteners, fats and oils, pharmaceuticals, chemicals, lubricants and petroleum. Diatomite is used as a filler mainly in paints. Diatomite is also used as an anti-block agent in plastic film. Celite's calcium and magnesium silicate products, which have high surface area and adsorption and absorption capabilities, are used to convert liquid, semi-solid and sticky ingredients into dry, free-flowing powders. Celite's calcium and magnesium silicate products are used in the production of rubber, sweeteners, flavorings and pesticides. Harborlite Harborlite, which began operations on November 16, 1992, carries on the business of Old Harborlite and the perlite production businesses formerly conducted by Celite. These products are marketed under the Harborlite brand name. Harborlite is a world leader in the production and sale of perlite, a volcanic mineral. Perlite ore is mined at Harborlite's No Agua, New Mexico mine and is sold primarily to companies that will expand it in their own expansion plants and use it in the manufacture of roofing board, formed pipe insulation and acoustical ceiling tile. Perlite ore for filter-aid and filler applications is mined at Harborlite's Superior, Arizona mine and is expanded at one of Harborlite's five expansion plants located within the United States. Expanded perlite is also produced at Harborlite's expansion plants in Europe from perlite ore obtained from European and Middle Eastern suppliers. Most of Harborlite's expanded perlite is used as a filter aid in the brewing, food, wine, sweetener, pharmaceutical, chemical and lubricant industries, and as a filler and insulating medium in various construction applications. World Minerals directs its business from its world headquarters in Lompoc, California. Its Celite subsidiary also has its world headquarters in Lompoc, California and owns, directly or through wholly owned subsidiaries, diatomite mines and processing plants in Lompoc, California; Quincy, Washington; Murat, France; Alicante, Spain; and Guadalajara, Mexico. Celite also owns 48.6 percent of Kisilidjan, h.f., a joint venture with the Government of Iceland which mines and processes diatomite from Lake Myvatn in Iceland. Harborlite has its world headquarters in Vicksburg, Michigan and owns a perlite mine and mill in No Agua, New Mexico, a perlite-loading facility in Antonito, Colorado, a perlite mine and a mill in Superior, Arizona and perlite expansion facilities in Escondido, California; Green River, Wyoming; Fort Worth, Texas; Vicksburg, Michigan; Quincy, Florida; Wissembourg, France; and Hessle, England. Since World Minerals conducts certain of its operations in foreign countries, it is subject to the risk of currency fluctuation. In 1993, approximately 31 percent of World Minerals' revenues (equal to 2.4 percent of Alleghany's consolidated revenues) were generated by foreign operations, and an additional 15 percent of World Minerals' revenues were generated by export sales from the United States. Celite's largest diatomite mine and plant are located near Lompoc, California. All additional diatomite supplies are obtained by Celite from its mines in the state of Washington, France, Spain, Mexico and from the Lake Myvatn mine in Iceland (although environmental regulations and seismic activities may adversely affect future production at Lake Myvatn). Celite believes that its diatomite reserves are generally sufficient to last for at least 20 more years at the current rate of utilization. Harborlite obtains perlite ore from its No Agua and Superior mines, and believes that its perlite ore reserves are sufficient to last at least 20 more years at the current rate of utilization. The perlite used by Harborlite for expansion in Europe is obtained from third parties in Europe and the Middle East. Celite's silicate products are produced from purchased magnesium and calcium compounds and internally produced diatomite. World Minerals experienced no interruption in raw material availability in 1993, and barring unforeseen circumstances anticipates no such interruption in 1994. While there can be no assurance that adequate supplies of all raw materials will be available in the future, Celite and Harborlite believe that they have taken reasonable precautions for the continuous supply of their critical raw materials. Many of Celite's and Harborlite's operations use substantial amounts of energy, including electricity, fuel oil, natural gas, and propane. Celite and Harborlite have supply contracts for most of their energy requirements. Most of such contracts are for one year or less. Celite and Harborlite have not experienced any energy shortages and they believe that they have taken reasonable precautions to ensure that their energy needs will be met, barring any unusual or unpredictable developments. From the time World Minerals began operations in 1991, none of its customers accounted for 10 percent or more of World Minerals' annual sales. World Minerals presently owns, controls or holds licenses either directly or through its subsidiaries to approximately 22 United States and 40 foreign patents and patent applications. While World Minerals considers all of its patents and licenses to be valuable, World Minerals believes that none of its patents or licenses is by itself material to its business. World Minerals normally maintains approximately a one- to three-week supply of inventory on certain products due to production lead times. Although diatomite mining operations at Celite's principal mine in Lompoc, California must be suspended during periods of heavy rainfall, World Minerals believes that, because of the stockpiling of ore during dry periods, such suspension does not materially affect the supply of inventory. Barring unusual circumstances, World Minerals does not experience backlogs of orders. World Minerals' business is not seasonal. World Minerals acts as the sales agent for both Celite and Harborlite in the United States and procures orders from customers and distributors on their behalf. Celite distributes Harborlite's products in Europe to dealers, distributors and end users on Harborlite's behalf. World Minerals has research and development, environmental control and quality control laboratories at its Lompoc production facilities and quality control laboratories at each of its other production facilities. In 1993, World Minerals spent approximately $1.1 million on company-sponsored research and technical services (in addition to amounts spent on engineering and exploration) related to the development and improvement of its products and services. Competition Celite believes that it is the world's largest producer of diatomite. The remainder of the market is shared by Celite's four major competitors: Eagle-Picher (United States), Grefco (United States), CECA (France) and Showa (Japan), and a number of smaller competitors. Celite's silicates compete with a wide variety of other synthetic mineral products. Harborlite has two large competitors in the expanded perlite market, Grefco and CECA, and many smaller competitors. Competition is principally on the basis of service, product quality and performance, warranty terms, speed and reliability of delivery, availability of the product and price. Celite's and Harborlite's filter-aid products compete with other filter aids, such as cellulose, and other filtration technologies, such as crossflow and centrifugal separation. Regulation All of Celite's and Harborlite's domestic operations are subject to a variety of federal, state and local environmental laws and regulations. The most significant of these are the Comprehensive Environmental Response, Compensation and Liability Act of 1980, the Federal Clean Air Act, the Federal Clean Water Act, the Toxic Substances Control Act and the Resource Conservation and Recovery Act, and the regulations promulgated thereunder, all of which are administered by the United States Environmental Protection Agency ("EPA"). These laws and regulations establish potential liability for costs incurred in cleaning up waste sites and impose limitations on atmospheric emissions, discharges to domestic waters, and disposal of hazardous materials. Certain state and local jurisdictions have adopted regulations that may be more stringent than corresponding federal regulations. Moreover, federal and state laws governing disposal of wastes impact customers who must dispose of used filter-aid materials. Due to their environmental compliance programs, Celite and Harborlite believe that the impact of these environmental requirements on their respective operating results has been minimal; however, the exact nature of the environmental problems which Celite or Harborlite may encounter in the future cannot be predicted, primarily because of the increasing number and complexity and the changing character of the standards relating thereto. The operations of Celite and certain operations of Harborlite are also subject to regulation by the Mine Safety and Health Administration ("MSHA"). This agency establishes health and safety standards for employee work environments in the mining industry. MSHA's activity includes regulations relating to noise, respiratory protection and dust. Because of their ongoing programs of occupational health and safety surveillance, Celite and Harborlite believe that the impact of these regulations on their respective operating results is limited. Certain products of Celite and Harborlite are subject to the Hazard Communication Standard promulgated by the Occupational Safety and Health Administration ("OSHA"), which requires Celite and Harborlite, respectively, to disclose the hazards of their plants and products to employees and customers. Such requirements also mandate that customers who purchase diatomite or perlite for use as a filler in their products label such products to disclose hazards which may result from the inclusion of crystalline silica-based fillers, if any of such products contain in excess of 0.1% of crystalline silica by volume. Therefore, some manufacturers of paint may be considering the use of other fillers in place of Celite's products. However, Celite believes that the loss of these customers would not have a material adverse effect on its operating results. Several states have also enacted or adopted "right to know" laws or regulations, which seek to expand the federal Hazard Communication Standard to include providing notice of hazards to the general public, as well as to employees and customers. In 1987, the International Agency for Research on Cancer ("IARC") issued a report, which was supplemented in 1988, designating crystalline silica as "probably carcinogenic to humans," which is a tentative classification falling between "probably not carcinogenic to humans" and "sufficient evidence of human carcinogenicity." Crystalline silica is one of the earth's most abundant minerals, appearing in such forms as quartz, sandstone, gravel and sand. Celite's products contain varying amounts of crystalline silica ranging from less than 0.1 percent to 65 percent or more. Harborlite's No Agua-mined perlite generally contains less than 1 percent crystalline silica. Harborlite's Superior-mined perlite contains no detectable crystalline silica. Celite and Harborlite provide warning labels on their products containing in excess of 0.1 percent respirable crystalline silica, advising customers of the IARC designation and providing recommended safety precautions. The 1987 IARC designation has been the subject of controversy and continued study. Celite, through the industry-sponsored International Diatomite Producers Association ("IDPA"), has participated in funding several studies to examine in more detail the cancer risk to humans from crystalline silica. One such study, conducted by the University of Washington, is a cohort mortality study of approximately 2,570 workers in the diatomaceous-earth mining and processing industry. The cohort includes only workers who were employed for at least twelve months' cumulative service and were employed at some time between January 1942 and December 1986. Because employment records for the earlier periods of the study were often missing or incomplete, this cohort, at present, is comprised of workers from only a limited number of employers and work locations in the industry. A large number of the workers included in the cohort worked at Celite's Lompoc, California plant prior to the acquisition of its business by a holding company subsidiary of Alleghany. The final University of Washington report was issued in October 1992. The study found a modest increase in lung cancer deaths in the cohort compared with national rates (indicated by a standardized mortality ratio ("SMR") equal to 1.43). The standardized mortality ratio compares the number of cancer deaths in the cohort with 1, representing the number of cancer deaths in the population at large. The study also found an increase in non-malignant respiratory disease ("NMRD") (SMR equal to 2.59); this finding was expected because the NMRD category included silicosis resulting from exposures in past decades. With regard to the excesses over national rates of mortality as they relate to the present workforce, the authors of the study stated: The results for lung cancer and NMRD indicate that the excesses were most likely attributable to relatively intense exposures encountered during the 1930s and 1940s, before dust control measures were implemented on a wide-scale basis in the industry. At present it cannot be said with certainty that lung cancer and NMRD risks have been reduced to baseline levels experienced by the population at large. However, it is noteworthy that there has been no excess risk of lung cancer among Lompoc cohort workers hired since 1960, and there have been no deaths attributed to silicosis among cohort members since 1950. These trends are strongly suggestive of reduced hazards, probably related to improved environmental dust control and the increased use of respiratory protective devices by the workforce. After the publication of the Washington study, Celite conducted its own review of the portion of the cohort representing the Lompoc plant and found that more workers in this portion of the cohort may have been exposed to asbestos than originally thought. Since exposure to asbestos has been found to cause lung cancer and respiratory disease, this finding has raised some concern that the Washington study may overstate the adverse health effects of exposure to crystalline silica. IDPA has engaged an epidemiologist and an industrial hygienist to examine the cohort to determine whether asbestos exposure was fully accounted for in the Washington study's results. Certain other cohort mortality studies of workers occupationally exposed to crystalline silica, including a study of gold miners in North Dakota, have found no statistically significant increases in lung cancer compared with national populations. The issue remains subject to considerable debate. The various agreements covering the purchase of the business of Celite in 1991 provide for the indemnification of the holding company subsidiary of Alleghany which acquired Celite by the various selling Manville entities in respect of any environmental and health claims arising from the operations of the business of Celite prior to its acquisition by the holding company subsidiary. Employees As of December 31, 1993, World Minerals had 7 employees, all located in the United States, Celite had a total of about 970 employees worldwide, and Harborlite had a total of about 165 employees worldwide. Approximately 399 of Celite's employees and 34 of Harborlite's employees in the United States are covered by collective bargaining agreements. All of the collective bargaining agreements covering workers at Celite and Harborlite are in full force and effect and none are scheduled to expire in 1994. STEEL FASTENER BUSINESS The Heads and Threads division of Alleghany, headquartered in Northbrook, Illinois, is believed to be the nation's leading distributor of imported steel fasteners. Heads and Threads imports and sells commercial fasteners - nuts, bolts, screws and washers - for resale to fastener manufacturers and distributors through a network of sales offices and warehouses located in fourteen states. The strength of Heads and Threads lies in its five major warehouses and thirteen regional satellite warehouses, long years of association with suppliers and customers, and ability to control operating costs. Since Heads and Threads imports virtually all of its fasteners, it is necessary to forecast inventory requirements from six months to a year in advance to allow time for shipments to reach their destinations in the U.S. In addition, Heads and Threads' costs are subject to foreign currency fluctuations and increases in import duties, which may result from determinations by U.S. federal agencies that foreign countries are violating U.S. laws or intellectual property rights, or are following restrictive import policies. Rules that have been proposed to implement the Fastener Quality Assurance Act, which became law in late 1990, also may increase costs. Heads and Threads has about 169 employees. Item 2. Item 2. Properties. Alleghany's headquarters is located in leased office space of about 10,000 square feet at Park Avenue Plaza in New York City. CT&T and CTI lease about 278,000 square feet for their headquarters operations in the Chicago Title and Trust Center, a 50-story office complex at 171 North Clark Street in Chicago, Illinois. Ticor Title's and Security Union's headquarters are in company-owned premises of about 180,000 square feet in Rosemead, California. CT&T and its subsidiaries own or lease buildings or office space in approximately 425 locations throughout the United States, primarily for CTI, Security Union and Ticor Title branch office operations. Underwriters leases about 27,000 square feet of office space for its headquarters operations in Woodland Hills, California. All of its five branch office locations are also in leased spaces, ranging in size from about 3,200 square feet to 6,200 square feet. CUIC leases about 9,400 square feet of office space. Sacramento Savings owns its principal office in Sacramento, California, which has approximately 50,000 square feet of floor space. Sacramento Savings owns 30 of its 45 branch offices and leases the remainder. It also owns about 385 acres of improved and unimproved land in the Sacramento area, and is a party to joint ventures which own an additional 837 acres of such land. World Minerals' headquarters is located in leased premises of approximately 17,300 square feet in Lompoc, California, which it shares with Celite. Harborlite's headquarters is located at its Vicksburg, Michigan plant. A description of the major plants and properties owned and operated by Celite and Harborlite is set forth below. All of the following properties are owned, with the exception of Plant # 1 at Quincy, Washington, the headquarters offices at Lompoc, California, the Rueil, France office and the plant at Wissembourg, France, which are leased. World Minerals' largest mine is located on Celite-owned property immediately adjacent to the City of Lompoc, California, and is the site of one of the most unusual marine diatomite deposits in the world. The mine celebrated its 100th anniversary of production in 1993 and has been in continuous operation for more than 60 years. Reserves are believed to be sufficient for the operation of the plant for at least 20 more years at the current rate of utilization. The Lompoc production facility has a rated capacity in excess of 200,000 tons annually and currently supplies more than 25 different grades of products to the filtration and filler markets. The facility also houses World Minerals' research and development, and health, safety and environmental departments and Celite's quality control laboratories. Celite and Harborlite also lease warehouses, office space and other facilities in the United States and abroad. A joint venture between Celite and the Government of Iceland has mining rights to mine diatomaceous earth in sections of Lake Myvatn, Iceland. The operations of Alleghany's Heads and Threads division are conducted in 15 states at 18 locations, which serve as both sales offices and warehouses, two of which are owned and the rest of which are leased. Its headquarters in Northbrook, Illinois is owned by Alleghany. Alleghany also owns two truck terminal properties in Ohio which are being held for sale, and which have been leased from time to time on an interim basis. Item 3. Item 3. Legal Proceedings. A. On January 7, 1985, the Federal Trade Commission (the "FTC") filed a complaint alleging that six of the largest title insurance companies, including CTI, Security Union and Ticor Title, violated Section 5 of the Federal Trade Commission Act. The violation was asserted with respect to the participation of those companies in rating bureaus in thirteen states to the extent that the bureaus had proposed for state approval rates related to search and examination services and settlement services performed by those companies in connection with the issuance of title insurance policies. The FTC action sought injunctive relief. During adjudicative hearings, the Bureau of Competition of the FTC determined not to proceed with respect to five of the thirteen states. In an initial decision filed on December 22, 1986, an administrative law judge found that five of the companies (the sixth company having withdrawn due to a separate settlement) violated Section 5 in two states, Connecticut and Wisconsin, and recommended that the companies be ordered not to participate in rating bureaus in those states in the future. The administrative law judge found no violation of Section 5 in the remaining six states. Following cross appeals, on September 19, 1989 the FTC held that violations had occurred in four additional states: Arizona, Montana, New Jersey and Pennsylvania. On January 9, 1991, the United States Court of Appeals for the Third Circuit unanimously reversed the decision of the FTC and found in favor of the title insurance companies with respect to all states at issue, holding that the rating-bureau activity at issue was entitled to immunity from the antitrust laws under the state-action immunity doctrine. Under this doctrine, a state law or regulatory scheme can be the basis for antitrust immunity if the state (i) has articulated a clear and affirmative policy to allow the anticompetitive conduct and (ii) provides active supervision of anticompetitive conduct undertaken by private actors. On February 21, 1991, the FTC filed a petition for rehearing, which was denied on March 12, 1991. On October 7, 1991, upon petition of the FTC, the United States Supreme Court granted a writ of certiorari to review the decision of the Third Circuit Court of Appeals in favor of the title insurance companies. On June 12, 1992, the United States Supreme Court issued its decision in favor of the FTC, holding that rating-bureau activity in Montana and Wisconsin had not been sufficiently active to permit the title insurers to invoke the state-action immunity doctrine. The case was remanded to the Court of Appeals for further analysis by that court of the application of the state-action immunity doctrine in Arizona and Connecticut and for further consideration of general defenses, including the exemption provided by the McCarran Ferguson Act, which exempts the business of insurance from the antitrust laws. On July 15, 1993, a three-judge panel of the Court of Appeals issued a decision in favor of the FTC, with one judge dissenting. The Court held that the state-action immunity doctrine was not applicable in either Arizona or Connecticut due to a lack of active state supervision, and that other general defenses were unavailable, including the exemption provided by the McCarran-Ferguson Act. On August 29, 1993, the Third Circuit Court of Appeals dismissed the title insurers' petition for a rehearing en banc. The title insurers filed a petition for a writ of certiorari to the United States Supreme Court on November 29, 1993, and the FTC filed a brief in opposition on February 25, 1994. The title insurers' petition was denied on March 21, 1994. The FTC action was for injunctive relief only. Several federal and state actions involving the same issues as the FTC action were filed against the same title insurance companies, seeking damages and injunctive relief. One such action, a class action filed in state court in Wisconsin challenging rating-bureau activity in that state, was dismissed on June 9, 1993 by the Wisconsin Supreme Court, which held that the filed-rate defense applied, prohibiting plaintiffs from challenging in the courts rates that had been filed with and approved by a regulatory agency. On August 17, 1993, the Wisconsin Supreme Court denied plaintiffs' motion for reconsideration. On December 8, 1993, plaintiffs filed a petition for a writ of certiorari to the United States Supreme Court, seeking review of the Wisconsin Supreme Court decision; this petition was denied on February 22, 1994. The only other currently pending action involving the same issues as the FTC action is a federal case filed in the United States District Court for the District of Arizona challenging rating-bureau activity in Arizona and Wisconsin. That case was decided on motion in favor of the title insurers, but the decision was reversed by the Ninth Circuit Court of Appeals, which held that the defenses of res judicata and state-action immunity and the filed-rate defense did not apply. A petition by the title insurers for rehearing en banc was denied on March 17, 1993. On June 15, 1993, the title insurers filed a petition for a writ of certiorari to the United States Supreme Court, seeking review of the Ninth Circuit Court of Appeals decision. On October 1, 1993, the parties to the litigation entered into a memorandum of understanding which outlined the terms of a settlement of such litigation. The memorandum of understanding provided for a definitive written agreement and application for the necessary approval of the District Court. On that date, the parties also submitted a request to the United States Supreme Court that any action with respect to the title insurers' petition for a writ of certiorari be deferred to allow the District Court to consider the settlement reached by the parties. Despite such request, the United States Supreme Court granted the title insurers' petition on October 4, 1993. Thereafter, plaintiffs moved to defer briefing and argument and, on October 22, 1993, the title insurers filed a motion in opposition to plaintiffs' motion for such deferral. On November 1, 1993, the United States Supreme Court denied plaintiffs' motion, thus allowing Supreme Court review to proceed. Argument before the Supreme Court took place on March 1, 1994, and a decision is expected by the end of the current term of the Court in early summer 1994. On March 3, 1994, the Ninth Circuit Court of Appeals issued a limited mandate, in response to the parties' motion, to allow the District Court to consider the fairness of the settlement. The Stock Purchase Agreement between Alleghany and Lincoln National Corporation, among other parties, dated as of June 18, 1985 (the "CT&T Stock Purchase Agreement"), provides for the indemnification of Alleghany by Lincoln National Corporation in respect of a portion of any liability resulting from the foregoing FTC and private actions and in respect of certain other pending or potential claims against CT&T and its subsidiaries. B. Alleghany entered into a consent agreement with the FTC effective July 22, 1991, which settled certain antitrust objections raised by the FTC in respect of the acquisition of Ticor Title Insurance Company of California ("Ticor Title of California") by CT&T. The consent agreement provides for the divestiture by CT&T after its acquisition of Ticor Title of California of (i) one of the two title plants owned by subsidiaries of CT&T serving each of three Illinois counties, three Indiana counties, two Washington counties and one California county; and (ii) one of the two back plants owned by subsidiaries of CT&T serving each of six California counties and one county in each of Illinois, Indiana and Tennessee. A back plant is a title plant that is no longer being updated on a daily or regular basis. For a period of ten years from its effective date, the consent agreement prohibits Alleghany or any of its subsidiaries from acquiring an ownership interest or assets in certain named title insurance companies, or in any entity that has a direct or indirect ownership interest in a title plant or back plant that services the counties with respect to which divestiture of such a plant was ordered, without the prior approval of the FTC. For the same period, Alleghany or any of its subsidiaries is required to give prior notification to the FTC of any acquisitions of an ownership interest in a title plant or back plant serving the same county as a plant already owned by Alleghany or any of its subsidiaries. There is an exception to the prior approval or notice requirements which generally would apply to acquisitions solely for the purpose of investment of up to 3 percent of the shares of a publicly traded corporation. Also, acquisitions of shares of a publicly traded corporation are not subject to the prior approval or notice requirements solely by reason of the ownership by such corporation of less than 5 percent of the shares of the named title companies. The consent agreement required divestiture of the plants by July 23, 1992, and provides that the FTC may appoint a trustee and seek civil penalties and other relief if Alleghany failed to accomplish the divestitures by such date. As of July 21, 1992, Alleghany had received the FTC's approval for divestiture in four markets and had applications pending with respect to the remaining fourteen markets. On that date, Alleghany submitted a motion to the FTC to extend the time within which to complete the divestitures. On September 24, 1992, the FTC denied Alleghany's motion, advising that it had "not determined whether, or what, enforcement action would be warranted for [Alleghany's] failure to meet the July 23 deadline." As of the date hereof, applications with respect to all markets have been approved by the FTC, and all divestiture transactions have closed. On September 28, 1993, the staff of the Bureau of Competition of the FTC invited Alleghany to "address why [the Bureau] should not recommend that the [FTC] seek civil penalties, or what an appropriate penalty might be. . . ." On December 10, 1993, Alleghany submitted a response demonstrating its good faith in the fulfillment of its divestiture obligations to support its position that no penalties should be imposed. The staff of the Bureau of Competition subsequently informally advised Alleghany that it will not recommend that the FTC seek any penalties. C. Alleghany's subsidiaries and division are parties to pending litigation and claims in connection with the ordinary course of their businesses. Each such operating unit makes provision on its books, in accordance with generally accepted accounting principles, for estimated losses to be incurred in such litigation and claims, including legal costs. In the opinion of management, such provision is adequate under generally accepted accounting principles as of December 31, 1993. 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. Supplemental Item.Executive Officers of Registrant. The name, age, current position, date elected and five-year business history of each executive officer of Alleghany are as follows: PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The information required by this Item 5 is incorporated by reference from page 21 of Alleghany's Annual Report to Stockholders for the year 1993, dated March 15, 1994, filed as Exhibit 13 hereto. Item 6. Item 6. Selected Financial Data. The information required by this Item 6 is incorporated by reference from page 21 of Alleghany's Annual Report to Stockholders for the year 1993, dated March 15, 1994, filed as Exhibit 13 hereto. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information required by this Item 7 is incorporated by reference from pages 2 and 3, from pages 6 through 16, and from pages 22 and 23, of Alleghany's Annual Report to Stockholders for the year 1993, dated March 15, 1994, filed as Exhibit 13 hereto. Item 8. Item 8. Financial Statements and Supplementary Data. The information required by this Item 8 is incorporated by reference from pages 24 through 45 of Alleghany's Annual Report to Stockholders for the year 1993, dated March 15, 1994, filed as Exhibit 13 hereto. 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 Registrant. As permitted by General Instruction G(3), information concerning the executive officers of Alleghany is set forth as a supplemental item included in Part I of this Form 10-K Report under the caption "Executive Officers of Registrant." Information concerning the directors of Alleghany is incorporated by reference from pages 5 through 8 of Alleghany's Proxy Statement dated March 28, 1994, filed or to be filed in connection with its Annual Meeting of Stockholders to be held on April 22, 1994. Information concerning compliance with the reporting requirements under Section 16 of the Securities Exchange Act of 1934, as amended, is incorporated by reference from page 3 of Alleghany's Proxy Statement dated March 28, 1994, filed or to be filed in connection with its Annual Meeting of Stockholders to be held on April 22, 1994. Item 11. Item 11. Executive Compensation. The information required by this Item 11 is incorporated by reference from pages 11 through 24 of Alleghany's Proxy Statement dated March 28, 1994, filed or to be filed in connection with its Annual Meeting of Stockholders to be held on April 22, 1994. The information set forth beginning on page 25 through the first paragraph on page 33 of Alleghany's Proxy Statement dated March 28, 1994, filed or to be filed in connection with its Annual Meeting of Stockholders to be held on April 22, 1994, is not "filed" as a part hereof. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required by this Item 12 is incorporated by reference from pages 1 through 4, and from pages 9 and 10, of Alleghany's Proxy Statement dated March 28, 1994, filed or to be filed in connection with its Annual Meeting of Stockholders to be held on April 22, 1994. Item 13. Item 13. Certain Relationships and Related Transactions. The information required by this Item 13 is incorporated by reference from page 24 of Alleghany's Proxy Statement dated March 28, 1994, filed or to be filed in connection with its Annual Meeting of Stockholders to be held on April 22, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements. The consolidated financial statements of Alleghany and subsidiaries, together with the report thereon of KPMG Peat Marwick, independent certified public accountants, are incorporated by reference from the Annual Report to Stockholders for the year 1993, dated March 15, 1994, into Item 8 of this Report. 2. Financial Statement Schedules. The schedules relating to the consolidated financial statements of Alleghany and subsidiaries, together with the report thereon of KPMG Peat Marwick, independent certified public accountants, are detailed in a separate index herein. 3. Exhibits. The following are filed as exhibits to this Report: Exhibit Number Description 3.01 Restated Certificate of Incorporation of Alleghany, as amended by Amendment accepted and received for filing by the Secretary of State of the State of Delaware on June 23, 1988, filed as Exhibit 20 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988, is incorporated herein by reference. 3.02 By-Laws of Alleghany as amended July 1, 1992, filed as Exhibit 3.02 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, is incorporated herein by reference. 4.01 Indenture dated as of June 15, 1989 between Alleghany and Pittsburgh National Bank, as Trustee, relating to the 6-1/2% Subordinated Exchangeable Debentures due June 15, 2014 (the "Debentures"), including the form of Debenture, filed as Exhibit 4.1 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989, is incorporated herein by reference. 4.02 Escrow Agreement dated as of June 15, 1989 between Alleghany and Pittsburgh National Bank, as Escrow Agent, for the escrow of common shares of American Express Company for which the Debentures are exchangeable, filed as Exhibit 4.2 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989, is incorporated herein by reference. *10.01 Description of Alleghany Management Incentive Plan. *10.02(a) Agreement dated as of December 22, 1993 between Alleghany and David B. Cuming. Agreements dated as of December 22, 1993 between Alleghany and each of F.M. Kirby, John J. Burns, Jr., Richard P. Toft, Theodore E. Somerville, John E. Conway and Peter R. Sismondo are omitted pursuant to Instruction 2 of Item 601 of Regulation S-K. *10.02(b) Agreement dated as of December 15, 1993 between CT&T and Richard P. Toft. *10.03 Alleghany Corporation Deferred Compensation Plan as amended and restated as of December 15, 1992, filed as Exhibit 10.03 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. - ---------------------- * Compensatory plan or arrangement. *10.04(a) Alleghany 1983 Long-Term Incentive Plan as adopted on March 16, 1983, filed as Exhibit 10.24 to the Annual Report on Form 10-K of Alleghany Corporation, a Maryland corporation and the predecessor of Alleghany ("Old Alleghany"), for the year ended December 31, 1982, is incorporated herein by reference. *10.04(b) Description of amendments to the Alleghany 1983 Long-Term Incentive Plan as adopted on December 30, 1986, filed as Exhibit 10.05(b) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1986, is incorporated herein by reference. *10.05 Alleghany 1993 Long-Term Incentive Plan adopted and effective as of January 1, 1993, filed as Exhibit 10.05 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. *10.06 Alleghany Supplemental Death Benefit Plan dated as of May 15, 1985 and effective as of January 1, 1985, filed as Exhibit 10.08 to Old Alleghany's Annual Report on Form 10-K for the year ended December 31, 1985, is incorporated herein by reference. *10.07(a) Alleghany Retirement Plan effective as of January 1, 1989, as adopted on April 18, 1989, filed as Exhibit 10.2 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989, is incorporated herein by reference. 10.07(b) Trust Agreement dated as of January 1, 1989 between Alleghany and Bankers Trust Company, filed as Exhibit 10.5(b) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. - -------------------- * Compensatory plan or arrangement. *10.08 Alleghany Retirement COLA Plan dated and effective as of January 1, 1992, as adopted on March 17, 1992, filed as Exhibit 10.7 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. *10.09(a) Alleghany Directors' Stock Option Plan dated as of June 17, 1987 and effective as of April 22, 1988, filed as Exhibit 10.07 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1987, is incorporated herein by reference. *10.09(b) Amendment to Alleghany Directors' Stock Option Plan effective as of April 29, 1991, filed as Exhibit 10.3 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, is incorporated herein by reference. *10.09(c) Alleghany Amended and Restated Directors' Stock Option Plan effective as of April 20, 1993 (provided that options granted thereunder prior to the approval of Alleghany's stockholders are conditioned upon such approval), filed as Exhibit 10.1 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, is incorporated herein by reference. *10.10 Alleghany Non-Employee Directors' Retirement Plan effective July 1, 1990, filed as Exhibit 10.1 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990, is incorporated herein by reference. - -------------------- * Compensatory plan or arrangement. *10.11(a) Employment Agreement dated as of January 1, 1992, and Amendment to Employment Agreement dated as of January 1, 1993, among CT&T, Alleghany and Richard P. Toft, filed as Exhibit 10.12 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. *10.11(b) Second Amendment to Employment Agreement dated as of January 1, 1994, among CT&T, Alleghany and Richard P. Toft. *10.12 Split/Owner "Split Dollar" Life Insurance Plan Assignment dated March 19, 1986 by and between Richard P. Toft and CT&T, filed as Exhibit 10.10(c) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. *10.13 Description of CT&T Presidents' Plan, adopted and effective as of July 1, 1985 and as amended as of January 26, 1993, filed as Exhibit 10.14 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. *10.14 CT&T Performance Unit Incentive Plan, adopted and effective as of July 1, 1985, restated as the CT&T Performance Unit Incentive Plan of 1989, effective as of July 1, 1990, filed as Exhibit 10.12 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. *10.15 CT&T Executive Performance Unit Incentive Plan of 1992, adopted and effective as of January 1, 1992, as amended and restated effective January 1, 1993. - ------------------- * Compensatory plan or arrangement. *10.16 Description of CT&T Quality Business Management Incentive Program for the Presidents of CT&T and Chicago Title Insurance Company, effective as of January 1, 1989, as amended as of January 1, 1992. *10.17 CT&T Stock Purchase Plan for Key Employees effective as of April 6, 1989, as adopted on March 17, 1989, filed as Exhibit 10.13 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. *10.18 CT&T Executive Salary Continuation Plan effective as of January 1, 1979, as adopted on August 23, 1978, filed as Exhibit 10.15 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. *10.19(a) Description of compensatory arrangement between Alleghany Financial Inc. and Paul F. Woodberry filed as Exhibit 10.19(a) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. *10.19(b) Description of compensatory arrangement between Alleghany and Paul F. Woodberry. 10.20 Revolving Credit Loan Agreement dated as of July 9, 1991 among Alleghany, Chemical Bank and Manufacturers Hanover Trust Company, filed as Exhibit 10.1 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, is incorporated herein by reference. - -------------------- * Compensatory plan or arrangement. 10.21(a) Stock Purchase Agreement dated as of June 18, 1985 by and among Old Alleghany, Alleghany, Alleghany Capital Corporation and Lincoln National Corporation (the CT&T Stock Purchase Agreement"), filed as Exhibit (2)(i) to Old Alleghany's Current Report on Form 8-K dated July 11, 1985, is incorporated herein by reference. 10.21(b) List of Contents of Schedules to the CT&T Stock Purchase Agreement, filed as Exhibit (2)(ii) to Old Alleghany's Current Report on Form 8-K dated July 11, 1985, is incorporated herein by reference. 10.21(c) Amendment No. 1 dated December 20, 1985 to the CT&T Stock Purchase Agreement, filed as Exhibit 10.12(c) to Old Alleghany's Annual Report on Form 10-K for the year ended December 31, 1985, is incorporated herein by reference. 10.22 Distribution Agreement dated as of May 1, 1987 between Alleghany and MSL Industries, Inc., filed as Exhibit 10.21 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1987, is incorporated herein by reference. 10.23 Amendment to Distribution Agreement dated June 29, 1987, effective as of May 1, 1987, between Alleghany and MSL Industries, Inc., filed as Exhibit 10.22 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1987, is incorporated herein by reference. 10.24 Tax Sharing Agreement dated as of May 1, 1987 between Alleghany and MSL Industries, Inc., filed as Exhibit 10.24 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1987, is incorporated herein by reference. 10.25 Voting and Disposition Rights/Dividend Agreement dated November 1, 1989 by and between Alleghany, Alleghany Financial Inc. and the Office of Thrift Supervision in connection with the acquisition of Sacramento Savings, filed as Exhibit 10.25 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. 10.26(a) Loan Agreement dated as of April 30, 1990 between Alleghany Financial Inc. and The Chase Manhattan Bank (National Association), filed as Exhibit 10.1 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990, is incorporated herein by reference. 10.26(b) Amendment No. 1 to Loan Agreement dated as of May 1, 1993, between Alleghany Financial Inc. and The Chase Manhattan Bank (National Association), filed as Exhibit 10.2(a) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, is incorporated herein by reference. 10.26(c) Pledge Agreement dated as of April 30, 1990 between Alleghany Financial Inc. and The Chase Manhattan Bank (National Association), filed as Exhibit 10.2 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990, is incorporated herein by reference. 10.26(d) Amendment No. 1 to Pledge Agreement dated as of May 1, 1993 between Alleghany Financial Inc. and The Chase Manhattan Bank (National Association), filed as Exhibit 10.2(b) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, is incorporated herein by reference. 10.26(e) Collateral Account Agreement dated as of May 1, 1993 between Alleghany Financial Inc. and the Chase Manhattan Bank (National Association), filed as Exhibit 10.2(c) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 is incorporated herein by reference. 10.27(a) Installment Sales Agreement dated December 8, 1986 by and among Alleghany, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch & Co., Inc., filed as Exhibit 10.10 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1986, is incorporated herein by reference. 10.27(b) Intercreditor and Collateral Agency Agreement dated as of August 1, 1990 among Manufacturers Hanover Trust Company, Barclays Bank PLC and Alleghany Funding Corporation, filed as Exhibit 10.1 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, is incorporated herein by reference. 10.27(c) Interest Rate and Currency Exchange Agreement dated as of August 14, 1990 between Barclays Bank PLC and Alleghany Funding Corporation, and related Confirmation dated August 13, 1990 between Barclays Bank PLC and Alleghany Funding Corporation, filed as Exhibit 10.2 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, are incorporated herein by reference. 10.27(d) Indenture dated as of August 1, 1990 between Alleghany Funding Corporation and Manufacturers Hanover Trust Company, filed as Exhibit 10.3 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, is incorporated herein by reference. 10.28(a) Acquisition Agreement dated as of November 29, 1990 by and between CT&T and Westwood Equities Corporation (the "Ticor Acquisition Agreement"), filed as Exhibit (2)(i) to Alleghany's Current Report on Form 8-K dated December 21, 1990, is incorporated herein by reference. 10.28(b) List of Contents of Schedules to the Ticor Acquisition Agreement, filed as Exhibit 2(ii) to Alleghany's Current Report on Form 8-K dated December 21, 1990, is incorporated herein by reference. 10.28(c) Amendment to the Ticor Acquisition Agreement dated as of January 9, 1991 by and between CT&T and Westwood Equities Corporation, filed as Exhibit (2)(iii) to Alleghany's Current Report on Form 8-K dated March 21, 1991, is incorporated herein by reference. 10.28(d) Amended and Restated Credit Agreement dated as of December 30, 1993 among CT&T, certain commercial lending institutions and Continental Bank, N.A. as agent. 10.28(e) Letter Agreement dated May 2, 1991 between CT&T and Continental Bank, N.A. relating to an interest rate swap effective May 6, 1991, filed as Exhibit 10.2 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, is incorporated herein by reference. 10.29(a) Stock Purchase Agreement dated as of July 1, 1991 among Celite Holdings Corporation, Celite Corporation and Manville International, B.V. (the "Celite Stock Purchase Agreement"), filed as Exhibit 10.2(a) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, is incorporated herein by reference. 10.29(b) List of Contents of Exhibits and Schedules to the Celite Stock Purchase Agreement, filed as Exhibit 10.2(b) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, is incorporated herein by reference. 10.30(a) Joint Venture Stock Purchase Agreement dated as of July 1, 1991 among Celite Holdings Corporation, Celite Corporation and Manville Corporation (the "Celite Joint Venture Stock Purchase Agreement"), filed as Exhibit 10.3(a) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, is incorporated herein by reference. 10.30(b) List of Contents of Exhibits and Schedules to the Celite Joint Venture Stock Purchase Agreement, filed as Exhibit 10.3(b) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, is incorporated herein by reference. 10.31(a) Asset Purchase Agreement dated as of July 1, 1991 among Celite Holdings Corporation, Celite Corporation and Manville Sales Corporation (the "Celite Asset Purchase Agreement"), filed as Exhibit 10.4(a) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, is incorporated herein by reference. 10.31(b) List of Contents of Exhibits and Schedules to the Celite Asset Purchase Agreement, filed as Exhibit 10.4(b) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, is incorporated herein by reference. 10.31(c) Amendment No. 1 dated as of July 31, 1991 to the Celite Asset Purchase Agreement, filed as Exhibit 10.32(c) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.32(a) Acquisition Related Agreement dated as of July 1, 1991, by and between Celite Holdings Corporation, Celite Corporation and Manville Corporation (the "Celite Acquisition Related Agreement"), filed as Exhibit 10.5(a) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, is incorporated herein by reference. 10.32(b) List of Contents of Exhibits to the Celite Acquisition Related Agreement, filed as Exhibit 10.5(b) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, is incorporated herein by reference. 10.32(c) Amendment dated as of July 31, 1991 to Celite Acquisition Related Agreement, filed as Exhibit 10.33(c) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.33(a) Credit Agreement dated as of December 20, 1991 among Celite Holdings Corporation, Celite, Bank of America National Trust and Savings Association and Chemical Bank (the "Celite Credit Agreement"), filed as Exhibit 10.35(a) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.33(b) List of Contents of Exhibits and Annexes to the Celite Credit Agreement which are not being filed herewith, filed as Exhibit 10.35(b) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.33(c) Amendment No. 1 dated January 24, 1992 to the Celite Credit Agreement, filed as Exhibit 10.36 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.33(d) Letter Agreement dated January 23, 1992 between Celite and Bank of America National Trust and Savings Association relating to an interest rate swap effective January 16, 1992, filed as Exhibit 10.37 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.33(e) Letter Agreement dated January 13, 1992 between Celite and Chemical Bank relating to an interest rate swap effective January 13, 1992, filed as Exhibit 10.38 to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.34(a) Note Purchase Agreement dated September 24, 1991 among Armco Inc., Alleghany and certain of its subsidiaries (the "Note Purchase Agreement"), filed as Exhibit 10.39(a) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.34(b) Amendment dated as of March 17, 1992 to the Note Purchase Agreement, filed as Exhibit 10.39(b) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.34(c) Agreement dated as of September 24, 1991 among Armco Inc., Cyac Inc. and Alleghany (the "Voting Agreement"), filed as Exhibit 10.39(c) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.34(d) Amendment dated as of March 17, 1992 to the Voting Agreement, filed as Exhibit 10.39(d) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.34(e) Standstill Agreement dated as of September 24, 1991 between Armco Inc. and Alleghany (the "Standstill Agreement"), filed as Exhibit 10.39(e) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.34(f) Amendment dated as of March 17, 1992 to the Standstill Agreement, filed as Exhibit 10.39(f) to Alleghany's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.34(g) Amendment No. 2 dated as of April 24, 1992 to the Standstill Agreement, as amended as of March 17, 1992, filed as Exhibit 10.1 to Alleghany's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, is incorporated herein by reference. 10.35(a) Stock Purchase Agreement dated as of October 31, 1991 among Associated Insurance Companies, Inc., Alleghany and The Shelby Insurance Group, Inc. (the "Shelby Stock Purchase Agreement"), filed as Exhibit 10.1(a) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, is incorporated herein by reference. 10.35(b) List of Contents of Exhibits and Schedules to the Shelby Stock Purchase Agreement, filed as Exhibit 10.1(b) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, is incorporated herein by reference. 10.36(a) Stock Purchase Agreement dated as of July 28, 1993 (the "Underwriters Reinsurance Stock Purchase Agreement") among Alleghany, The Continental Corporation, Goldman, Sachs & Co. and certain funds which Goldman, Sachs & Co. either control or of which they are general partner, Underwriters Re Holdings Corp. and Underwriters Re Corporation, filed as Exhibit 10.3(a) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, is incorporated herein by reference. 10.36(b) List of Contents of Exhibits and Schedules to the Underwriters Reinsurance Stock Purchase Agreement, filed as Exhibit 10.3(b) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, is incorporated herein by reference. 10.36(c) Stock Purchase Related Agreement dated as of July 28, 1993 (the "Underwriters Re Stock Purchase Related Agreement") among certain persons named therein and Alleghany, filed as Exhibit 10.3(c) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, is incorporated herein by reference. 10.36(d) List of Exhibits and Schedules to the Underwriters Re Stock Purchase Related Agreement, filed as Exhibit 10.3(d) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, is incorporated herein by reference. 10.36(e) Supplement to Underwriters Re Stock Purchase Related Agreement dated as of August 12, 1993 among certain persons named therein and Alleghany, filed as Exhibit 10.1(a) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, is incorporated herein by reference. 10.36(f) Amendment to Underwriters Re Stock Purchase Related Agreement made as of October 7, 1993 among certain persons named therein and Alleghany, filed as Exhibit 10.1(b) to Alleghany's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, is incorporated herein by reference. 13 Pages 2 and 3, pages 6 through 16, and pages 21 through 45 of the Annual Report to Stockholders of Alleghany for the year 1993, dated March 15, 1994. 21 List of subsidiaries of Alleghany. 23 Consent of KPMG Peat Marwick, independent certified public accountants, to the incorporation by reference of their reports relating to the financial statements and related schedules of Alleghany and subsidiaries in the prospectus contained in the Registration Statement on Form S-8 of Alleghany (Registration No. 27598). 28 Information from reports furnished to state regulatory authorities by Underwriters Reinsurance Company and Commercial Underwriters Insurance Company. (b) Reports on Form 8-K. Alleghany filed a report on Form 8-K dated October 22, 1993, and an amendment thereto dated December 20, 1993, to report in Item 2 that, on October 7, 1993, Alleghany acquired approximately 93 percent of the issued and outstanding capital stock of a holding company which owns all of the issued and outstanding capital stock of Underwriters, and to furnish pursuant to Item 7 the required financial statements relating to such acquisition. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALLEGHANY CORPORATION ------------------------------ (Registrant) Date: March 28, 1994 By /s/ John J. Burns, Jr. -------------- --------------------------- John J. Burns, Jr. 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 28, 1994 By /s/ John J. Burns, Jr. -------------- --------------------------- John J. Burns, Jr. President and Director (principal executive officer) Date: March 28, 1994 By /s/ Dan R. Carmichael -------------- -------------------------- Dan R. Carmichael Director Date: March 28, 1994 By /s/ David B. Cuming -------------- --------------------------- David B. Cuming Senior Vice President (principal financial officer) Date: March 28, 1994 By /s/ Allan P. Kirby, Jr. -------------- --------------------------- Allan P. Kirby, Jr. Director Date: March 28, 1994 By /s/ F.M. Kirby -------------- --------------------------- F.M. Kirby Chairman of the Board and Director Date: March 28, 1994 By /s/ William K. Lavin -------------- --------------------------- William K. Lavin Director Date: March 28, 1994 By /s/ Peter R. Sismondo -------------- --------------------------- Peter R. Sismondo Vice President, Controller and Assistant Secretary (principal accounting officer) Date: March 28, 1994 By /s/ John E. Tobin -------------- --------------------------- John E. Tobin Director Date: March 28, 1994 By /s/ James F. Will -------------- --------------------------- James F. Will Director Date: March 28, 1994 By /s/ Paul F. Woodberry -------------- --------------------------- Paul F. Woodberry Director Date: March 28, 1994 By /s/ S. Arnold Zimmerman -------------- --------------------------- S. Arnold Zimmerman Director ALLEGHANY CORPORATION AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENT SCHEDULES I MARKETABLE SECURITIES III CONDENSED FINANCIAL INFORMATION OF REGISTRANT V SUPPLEMENTARY INSURANCE INFORMATION VI REINSURANCE XIV SUPPLEMENTAL PROPERTY AND CASUALTY INSURANCE INFORMATION INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES All other schedules are omitted since they are not required, are not applicable, or the required information is set forth in the financial statements or notes thereto. SCHEDULE I ALLEGHANY CORPORATION AND SUBSIDIARIES MARKETABLE SECURITIES DECEMBER 31, 1993 (in thousands) SCHEDULE III ALLEGHANY CORPORATION CONDENSED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (in thousands) See accompanying Notes to Condensed Financial Statements. SCHEDULE III ALLEGHANY CORPORATION CONDENSED STATEMENTS OF EARNINGS THREE YEARS ENDED DECEMBER 31, 1993 (in thousands) See accompanying Notes to Condensed Financial Statements. SCHEDULE III ALLEGHANY CORPORATION CONDENSED STATEMENTS OF CASH FLOWS THREE YEARS ENDED DECEMBER 31, 1993 (in thousands) SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES: In 1993, Alleghany made a noncash capital contribution of $16,315 to its consolidated subsidiaries by contributing a partnership interest with a cost basis of $2,525 and investment securities with a cost of $13,790. In 1991, Alleghany received a noncash dividend of $20,433 from its consolidated subsidiaries by receiving preferred stock with a cost of $17,000 and investment securities with a cost of $3,433. See accompanying Notes to Condensed Financial Statements. SCHEDULE III ALLEGHANY CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS (in thousands) 1. INVESTMENT IN CONSOLIDATED SUBSIDIARIES. Reference is made to Notes 2 and 3 of the Notes to Consolidated Financial Statements incorporated herein by reference for information regarding the acquisitions of Underwriters Re, Ticor Title and World Minerals and the sale of The Shelby Insurance Company. 2. LONG-TERM DEBT. Reference is made to Note 9 of the Notes to Consolidated Financial Statements incorporated herein by reference for information regarding the significant provisions of long-term debt of Alleghany. Included in long-term debt in the accompanying condensed balance sheets is $19,123 in 1993 and 1992 of intercompany notes payable due to Alleghany Funding. 3. INCOME TAXES. Reference is made to Note 10 of the Notes to Consolidated Financial Statements incorporated herein by reference regarding the Company's adoption of FASB Statement No. 109. 4. COMMITMENTS AND CONTINGENCIES. Reference is made to Note 14 of the Notes to Consolidated Financial Statements incorporated herein by reference. 5. STOCKHOLDERS' EQUITY. Reference is made to Note 11 of the Notes to Consolidated Financial Statements incorporated herein by reference with respect to stockholders' equity and surplus available for dividend payments to Alleghany from its subsidiaries. SCHEDULE V ALLEGHANY CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (in thousands) * Does not include Alleghany Corporation or Chicago Title and Trust Company's trust and escrow operations. ** On December 31, 1991, the Company sold The Shelby Insurance Company ("Shelby"). Accordingly, the operations of Shelby and its net assets have been designated as discontinued operations and amounts related to Shelby are not reflected in this schedule. *** On October 7, 1993, the Company acquired URC Holdings Corp., whose principal subsidiary is Underwriters Reinsurance Company. The acquisition for accounting purposes was effective as of October 1, 1993. Accordingly, results of operations are from October 1, 1993. SCHEDULE VI ALLEGHANY CORPORATION AND SUBSIDIARIES REINSURANCE THREE YEARS ENDED DECEMBER 31, 1993 (in thousands) * On December 31, 1991, the Company sold The Shelby Insurance Company ("Shelby"). Accordingly, the operations of Shelby and its net assets have been designated as discontinued operations and amounts related to Shelby are not reflected in this schedule. ** On October 7, 1993, the Company acquired URC Holdings Corp., whose principal subsidiary is Underwriters Reinsurance Company. The acquisition for accounting purposes was effective as of October 1, 1993. Accordingly, results of operations are from October 1, 1993. SCHEDULE XIV ALLEGHANY CORPORATION AND SUBSIDIARIES SUPPLEMENTAL PROPERTY AND CASUALTY INSURANCE INFORMATION (in thousands) * On October 7, 1993, the Company acquired URC Holdings Corp., whose principal subsidiary is Underwriters Reinsurance Company. The acquisition for accounting purposes was effective as of October 1, 1993. Accordingly, results of operations are from October 1, 1993. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders ALLEGHANY CORPORATION: Under date of February 23, 1994, we reported on the consolidated balance sheets of Alleghany Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, changes in 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 financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 1 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" and No. 109 "Accounting for Income Taxes" at December 31, 1993 and in 1992 respectively. /s/ KPMG Peat Marwick KPMG PEAT MARWICK New York, New York February 23, 1994 ALLEGHANY CORPORATION AND SUBSIDIARIES INDEX TO EXHIBITS Exhibit Number Description *10.01 Description of Alleghany Management Incentive Plan. *10.02(a) Agreement dated as of December 22, 1993 between Alleghany and David B. Cuming. Agreements dated as of December 22, 1993 between Alleghany and each of F.M. Kirby, John J. Burns, Jr., Richard P. Toft, Theodore E. Somerville, John E. Conway and Peter R. Sismondo are omitted pursuant to Instruction 2 of Item 601 of Regulation S-K. *10.02(b) Agreement dated as of December 15, 1993 between CT&T and Richard P. Toft. *10.11(b) Second Amendment to Employment Agreement dated as of January 1, 1994, among CT&T, Alleghany and Richard P. Toft. *10.15 CT&T Executive Performance Unit Incentive Plan of 1992, adopted and effective as of January 1, 1992, as amended and restated effective January 1, 1993. - --------------------- * Compensatory plan or arrangement. Exhibit Number Description *10.16 Description of CT&T Quality Business Management Incentive Program for the Presidents of CT&T and Chicago Title Insurance Company, effective as of January 1, 1989, as amended as of January 1, 1992. *10.19(b) Description of compensatory arrangement between Alleghany and Paul F. Woodberry. 10.28(d) Amended and Restated Credit Agreement dated as of December 30, 1993 among CT&T, certain commercial lending institutions and Continental Bank, N.A. as agent. 13 Pages 2 and 3, pages 6 through 16, and pages 21 through 45 of the Annual Report to Stockholders of Alleghany for the year 1993, dated March 15, 1994. 21 List of subsidiaries of Alleghany. 23 Consent of KPMG Peat Marwick, independent certified public accountants, to the incorporation by reference of their reports relating to the financial statements and related schedules of Alleghany and subsidiaries in the prospectus contained in the Registration Statement on Form S-8 of Alleghany (Registration No. 27598). 28 Information from reports furnished to state regulatory authorities by Underwriters Reinsurance Company and Commercial Underwriters Insurance Company. - ----------------------- * Compensatory plan or arrangement.

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1993

808450

Item 1. BUSINESS Navistar International Corporation is a holding company and its principal operating subsidiary is Navistar International Transportation Corp. referred to as "Transportation". As used hereafter, "Navistar" or "Company" refers to Navistar International Corporation and its subsidiaries and "Parent Company" refers to Navistar International Corporation alone. Navistar, through its wholly-owned subsidiary Transportation, operates in one principal business segment, the manufacture and marketing of medium and heavy diesel trucks, including school bus chassis, mid-range diesel engines and service parts in North America and in selected export markets. Transportation is the industry market share leader in the North American combined medium and heavy truck market, offering a full line of diesel- powered products in the common carrier, private carrier, government/service, leasing, construction, energy/petroleum and student transportation markets. Transportation also produces mid-range diesel engines for use in its medium trucks and for sale to original equipment manufacturers. Transportation markets its products through an extensive distribution network which includes 950 North American dealer and distribution outlets. Service and customer support are also supplied at these outlets. As a further extension of its business, Transportation provides financing and insurance for its dealers, distributors and retail customers through its wholly-owned subsidiary, Navistar Financial Corporation, referred to as "Navistar Financial". See "Important Supporting Operations". THE MEDIUM AND HEAVY TRUCK INDUSTRY Navistar competes in the North American market for medium and heavy trucks, including school bus chassis, which spans weight classes 5 and above (16,000 lbs. and over). This market is subject to considerable volatility as it moves in response to cycles in the overall business environment and is particularly sensitive to the industrial sector which generates a significant portion of the freight tonnage hauled. Government regulation has impacted and will continue to impact trucking operations and efficiency and the specifications of equipment. The following table shows retail deliveries in the combined United States and Canadian markets for the five years ended October 31, 1993, in thousands of units. YEARS ENDED OCTOBER 31, ----------------------- 1993 1992 1991 1990 1989 ----- ----- ----- ----- ----- Medium trucks and school bus chassis .. 122.5 118.3 120.1 149.8 162.8 Heavy trucks .............. 166.4 125.2 109.0 139.0 172.2 ----- ----- ----- ----- ----- Total ..................... 288.9 243.5 229.1 288.8 335.0 ===== ===== ===== ===== ===== Source: Based upon monthly data by the American Automobile Manufacturers Associations (AAMA) in the United States and Canada and other sources. The North American truck market is highly competitive. Major domestic competitors include PACCAR, Ford and General Motors, as well as foreign- controlled manufacturers, such as Freightliner, Mack and Volvo GM. In addition, manufacturers from Japan (Hino, Isuzu, Nissan, Mitsubishi) are attempting to increase their North American sales levels. The intensity of this competitiveness, which is expected to continue, results in price discounting and margin pressures throughout the industry. In addition to the influence of price, market position is driven by product quality, engineering, styling and utility and a comprehensive distribution system. TRANSPORTATION MARKET SHARE Transportation delivered 79,800 medium and heavy trucks in North America in fiscal 1993, compared to a total of 69,300 for fiscal 1992, an increase of 15.1% in overall units. Navistar's combined share of the medium and heavy truck market in 1993 was 27.6%. Transportation has been the leader in combined market share for medium and heavy trucks, including school bus chassis, in North America in each of its last 13 fiscal years. PRODUCTS AND SERVICES The following table illustrates the percentage of Transportation's sales by class of product by dollar amount: YEARS ENDED OCTOBER 31, -------------------------- PRODUCT CLASS 1993 1992 1991 - ------------- ---- ---- ---- Medium trucks and school bus chassis ........ 35% 40% 44% Heavy trucks .................... 40 34 31 Service parts ................... 14 16 16 Engines ......................... 11 10 9 --- --- --- Total ......................... 100% 100% 100% === === === Transportation offers a full line of medium and heavy trucks, with the objective of serving the customer better and more effectively by addressing requirements for increased performance and value. Transportation has made continuing improvements in its heavy truck image and performance and has responded to drivers' desires for increased amenities with the introduction of new sleeper compartments, interiors and aerodynamic chassis skirts for premium conventional models. New interiors were also introduced for cabover and severe service trucks. In addition, new mid-range DT 408 and DT 466 diesel engines were introduced into the medium model trucks which meet 1994 emission control standards without the need for catalytic converters. These engines will further enhance medium truck operating performance and life. In 1993, Transportation introduced new products including the 9200 model premium conventional tractor as well as other enhancements to its products to improve operating performance and durability. In addition, Transportation has launched special "NavTrucks" programs to meet the needs of customers in targeted regional vocations. Each NavTruck program tailors existing medium, heavy and severe service truck models to an individual regional vocation by packaging appropriate vehicle specifications and marketing programs. According to a recent survey conducted by J. D. Power and Associates on 1993 Medium-Duty Truck Customer Satisfaction, Navistar ranked number one in customer satisfaction in product and service for medium conventional trucks. For over two decades, Transportation has been the leading supplier of school bus chassis in the United States. Chassis have traditionally been sold to body companies, which complete the buses and deliver them to the ultimate customer. Transportation manufactures chassis for conventional and transit-style school buses, as well as chassis for use in small capacity buses designed to meet the needs of disabled students. In addition to its traditional chassis business, Transportation has invested in American Transportation Corporation (AmTran), a manufacturer of school bus bodies. Through its relationship with AmTran, Transportation participates in the trend toward the integrated design and manufacture of school buses, which offers the potential for improved production and marketing efficiencies and a reduction in the school bus order cycle. Transportation offers only diesel-powered trucks and buses because of their improved fuel economy, ease of serviceability and greater durability over gasoline-powered vehicles. Transportation's heavy trucks use diesel engines purchased from outside suppliers, while its medium trucks are powered by diesel engines manufactured by Transportation. In 1993, Transportation launched its all new world class series of in-line six cylinder diesel engines for bus, medium and heavy models. Transportation is the leading supplier of mid-range diesel engines in the 150-300 horsepower range according to data supplied by a private research firm, Power Systems Research of Minneapolis, Minnesota. Based upon information published by R.L. Polk & Company, diesel-powered medium truck shipments represented 81% of all medium truck shipments for fiscal year 1993 in North America. Transportation's North American truck manufacturing operations consist principally of the assembly of components manufactured by its suppliers, although Transportation produces its own medium range truck engines, sheet metal components (including cabs) and miscellaneous other parts. The following is a summary of Transportation's truck manufacturing capacity utilization for the five years ended October 31, 1993. YEARS ENDED OCTOBER 31, ------------------------------------------- 1993 1992 1991 1990 1989 ------- ------- ------- ------- ------- Production units .......... 88,274 73,901 70,502 80,737 90,897 Total production capacity ................ 106,032 106,088 106,762 114,402 119,325 Capacity utilization ...... 83.3% 69.7% 66.0% 70.6% 76.2% Total production capacity varies as a result of changes in the number of days of production during a year as well as changes in production constraints. ENGINE & FOUNDRY Transportation builds diesel engines for use in its medium trucks and for sale to original equipment manufacturers. Production in 1993 totalled 175,500 units, an increase of 18% from the 149,000 units produced in 1992. In 1993, Transportation produced the DTA 466 (195-270 horsepower), DTA 360 (170-190 horsepower) and 7.3 liter (155-190 horsepower) mid-range diesel engines. In September 1993, the DT 408 (175-230 horsepower) was introduced which replaced the DTA 360 while the DT 466 (195-275 horsepower) replaced the DTA 466. Transportation believes that its family of mid-range diesel engines, each designed to provide superior performance in customer applications, offers both the lowest cost of ownership and excellent durability to users. Based on U.S. registrations published by R.L. Polk & Company, the 7.3 liter diesel engine is the leading engine of its class. In addition to its strong contribution to the market position of Transportation's medium trucks, the 7.3 liter engine and the predecessor 6.9 liter engine have had significant external sales. Engine sales to original equipment manufacturers are primarily made to a major automotive company, which currently accounts for approximately 91% of sales, and to DINA Camiones, S.A. (DINA), a major truck manufacturer in Mexico. The automotive company uses the engine in all of its diesel- powered light trucks and vans having a gross vehicle weight between 8,500 pounds and 14,000 pounds. Shipments to original equipment manufacturers totalled a record 118,200 units in 1993, an increase of 21% from the 97,400 units shipped in 1992. In addition to the use of foundry castings in its products, Transportation sells castings to other original equipment manufacturers. Sales of rough grey iron engine blocks and cylinder heads to Consolidated Diesel Corporation (CDC) for its B and C engines were 24,700 tons in 1993 and represented 26% of total foundry capacity. 1993 was the fifth year of a five year agreement with CDC. The following is a summary of Transportation's engine capacity utilization for the five years ended October 31, 1993. YEARS ENDED OCTOBER 31, ------------------------------------------- 1993 1992 1991 1990 1989 ------- ------- ------- ------- ------- Engine production units ... 175,464 148,991 126,103 160,434 169,797 Total production capacity . 166,260 166,260 166,720 166,720 167,242 Capacity utilization ...... 105.5% 89.6% 75.6% 96.2% 101.5% Total production capacity varies as a result of changes in product mix. Transportation recently completed a major capital improvement program in its engine facilities to manufacture a new generation of mid-range diesel engines in both the in-line six cylinder and V-8 configurations to be used in trucks and school bus chassis manufactured by the Company and also sold to other original equipment manufacturers. This new generation of engines is designed to respond to customer demands for engines that have more power, improved fuel economy, longer life, and meet current emission requirements through 1997. The engines also will be offered in a wider horsepower range, which will give Transportation an opportunity to expand the number of applications for its engines and broaden its customer base. In September 1993, Transportation introduced three new in-line six cylinder engines that replaced its current DT family of engines in International medium trucks. These new engines, which offer displacements of 408, 466 and 530 cubic inches and encompass a horsepower range from 175 to 300, feature 20 percent longer life as a result of larger main and rod bearings, stronger crankshafts, gear driven accessories and, in 1994, electronically controlled fuel systems will be introduced. With their expanded horsepower range and larger displacement, Transportation will also be able to offer the new engines as a lighter-weight, more cost-effective product, which meet emission standards, to customers who currently buy heavier engines from other suppliers. The 7.3 Liter V-8 diesel engine product will also be replaced in February 1994, when Transportation begins production of an entirely new product, with electronically controlled fuel injection. This new diesel engine will offer significant customer advantages, with a 10 to 15 percent improvement in fuel economy, 30 to 40 percent enhancement in durability, and improved power and torque, when compared to Transportation's existing V-8 product. The new V-8 also will meet the 1994 emissions requirements cost-effectively and will allow such options as cruise control, electronically controlled power take-off and diagnostics capabilities. Transportation has entered into an agreement to supply the new 7.3 Liter engine to a major automotive company through the year 2000 for use in all of its diesel-powered light trucks and vans. Transportation is exploring the development of alternative fuel engines, including engines powered by compressed natural gas. Transportation has entered into an agreement with Detroit Diesel Corporation to develop a natural gas engine based upon one of Transportation's existing engines and Detroit Diesel's electronic alternative fuel technology. SERVICE PARTS The service parts business is a significant contributor to Transportation's sales and gross margin and to the maintenance of its medium and heavy truck customer base. In North America, Transportation operates seven regional parts distribution centers, which allows it to offer 24-hour availability and same day shipment of the parts most frequently requested by customers. Transportation is undertaking initiatives to increase parts sales outside of North America. As customers have explored ways to reduce their costs and improve efficiency, Transportation and its dealers have established programs to help them manage the parts and maintenance aspects of their businesses more efficiently. Transportation also offers a "Fleet Charge" program, which allows participating customers to purchase parts on credit at all of its dealer locations at consistent and competitive prices. In 1993, service parts sales increased as a result of higher net selling prices, export business expansion and growth in dealer and national accounts. MARKETING AND DISTRIBUTION North American Operations. Transportation's truck products are distributed in virtually all key markets in North America through the largest retail organization specializing in medium and heavy trucks. As part of its continuing program to adapt to changing market conditions, Transportation has been assisting dealers to expand their operations to better serve their customer base. Transportation's truck distribution and service network in North America was composed of 950, 952 and 919 dealers and retail outlets at October 31, 1993, 1992 and 1991, respectively. Included in these totals were 467, 460 and 415 secondary and associate locations at October 31, 1993, 1992 and 1991, respectively. Retail dealer activity is supported by 5 regional operations in the United States and a Canadian general office. Transportation has a national account sales group responsible for its 175 major national account customers. Transportation's 10 retail and 6 wholesale North American used truck centers provide sales and trade-in benefits to its dealers and retail customers. International Operations. International Operations exports trucks, components and service parts, both wholesale and retail, to more than 70 countries around the world and is active in procurement of United States Government business worldwide. Transportation exported 5,300 trucks in 1993 and 4,900 trucks in 1992 and cumulatively, from 1986 through 1992, was the leading North American exporter of Class 6-8 trucks from the United States and Canada, according to data provided by the AAMA. In Mexico, Transportation has an agreement with DINA to supply product technology, components and technical services for assembly of DINA trucks and buses. In 1993, Transportation exported almost 7,000 engines to DINA, bringing the total engines shipped to approximately 20,000 over the past three years. Transportation also has initiated sales of the in-line six cylinder family of mid-range diesel engines to Perkins Group, Ltd., of Peterborough, England, for worldwide distribution and to Detroit Diesel Corporation, the North American distributor of Perkins. NAVISTAR FINANCIAL CORPORATION Navistar Financial is engaged in the wholesale, retail and to a lesser extent lease financing of new and used trucks sold by Transportation and its dealers in the United States. Navistar Financial also finances wholesale accounts and selected retail accounts receivable of Transportation. To a minor extent, sales of new products (including trailers) of other manufacturers are also financed regardless of whether designed or customarily sold for use with Transportation's truck products. During fiscal 1993 and 1992, Navistar Financial provided wholesale financing for 90% and 89%, respectively, of the new truck units sold by Transportation to its dealers and distributors, and retail financing for approximately 15% and 14%, respectively, of the new truck units sold by Transportation and its dealers and distributors in the United States. Navistar Financial's wholly-owned insurance subsidiary, Harco National Insurance Company, provides commercial physical damage and liability insurance coverage to Transportation's dealers and retail customers and to the general public through an independent insurance agency system. IMPORTANT SUPPORTING OPERATIONS Third Party Sales Financing Agreements. In the United States, Transportation has an agreement with Associates Commercial Corporation (Associates) to provide wholesale financing to certain of its truck dealers and retail financing to their customers. During fiscal 1993 and 1992, Associates provided 10% and 11%, respectively, of the wholesale financing utilized by Transportation's dealers and distributors. Navistar International Corporation Canada has an agreement with a subsidiary of General Electric Canadian Holdings Limited to provide financing for Canadian dealers and customers. Foreign Insurance Subsidiaries. Harbour Assurance Company of Bermuda Limited offers a variety of programs to the Company, including general liability insurance, ocean cargo coverage for shipments to and from foreign distributors and reinsurance coverage for various Transportation policies. The company also writes minimal third party coverage and provides a variety of insurance programs to Transportation, its dealers, distributors and customers. CAPITAL EXPENDITURES AND RESEARCH AND DEVELOPMENT Transportation designs and manufactures its trucks and diesel engines to meet or exceed specific industry requirements. New models are introduced and improvements of current models are made, from time to time, in accordance with operating plans and market requirements and not on a predetermined cycle. During 1993, capital expenditures totalled $110 million. Major product program expenditures included continued investment in machinery and equipment at the Melrose Park, Illinois and Indianapolis, Indiana engine facilities to manufacture a new generation of mid-range diesel engines to be used in trucks and school bus chassis manufactured by the Company and also sold to other original equipment manufacturers. The Company began introducing these engines in the fall of 1993. Other expenditures were made for truck product improvements, modernization of facilities and compliance with environmental regulations. Capital expenditures totalled $55 million in 1992. Major product program expenditures included machinery and equipment to manufacture the new series of mid-range diesel engines at the Melrose Park, Illinois and Indianapolis, Indiana engine facilities. Other expenditures were made for truck product improvements, modernization of facilities and compliance with environmental regulations. In 1991, capital expenditures were $77 million. Product development is an ongoing process at Transportation. Research and development activities are directed toward the introduction of new products and improvement of existing products and processes used in their manufacture. Spending for company-sponsored activities totalled $95 million, $90 million and $87 million for 1993, 1992 and 1991, respectively. BACKLOG The backlog of unfilled truck orders (subject to cancellation or return in certain events) was as follows: AT OCTOBER 31 MILLIONS OF DOLLARS UNITS ------------- ------------------- ------- 1993 ........ $ 1,353 23,939 1992 ........ $ 1,124 20,456 1991 ........ $ 613 13,534 Although the backlog of unfilled orders is one of many indicators of market demand, many factors may affect point-in-time comparisons such as changes in production rates, available capacity, new product introductions and competitive pricing actions. EMPLOYEES The following table summarizes employment levels as of the end of fiscal years 1991 through 1993: TOTAL AT OCTOBER 31 EMPLOYMENT ------------- ---------- 1993 ........................... 13,612 1992 ........................... 13,945 1991 ........................... 13,472 LABOR RELATIONS At October 31, 1993, the United Automobile, Aerospace and Agricultural Implement Workers of America (UAW) represented approximately 7,144 of the Company's active employees in the U.S., and the Canadian Auto Workers (CAW) represented approximately 1,393 of the Company's active employees in Canada. Other unions represented approximately 1,342 of the Company's active employees in North America. The Company entered into collective bargaining agreements with the UAW and CAW in 1993 which expire on October 1, 1995 and October 24, 1996, respectively. These agreements permit greater productivity and efficiency, manufacturing flexibility and customer responsiveness, which will contribute to a reduction in costs and the Company's goal of improving profitability. PATENTS AND TRADEMARKS Transportation continuously obtains patents on its inventions and thus owns a significant patent portfolio. Additionally, many of the components which Transportation purchases for its products are protected by patents that are owned or controlled by the component manufacturer. Transportation has licenses under third party patents relating to its products and their manufacture, and Transportation grants licenses under its patents. The royalties paid or received under these licenses are not significant. No particular patent or group of patents is considered by Transportation to be essential to its business as a whole. Like all businesses which offer well-known products or services, Transportation's primary trademarks symbolize the Company's goodwill and provide instant identification of its products and services in the marketplace and thus, are an important part of its worldwide sales and marketing efforts. To support these efforts, Transportation maintains, or has pending, registrations of its primary trademarks in those countries in which it does business or expects to do business. RAW MATERIALS AND ENERGY SUPPLIES Transportation purchases raw materials, parts and components from numerous outside suppliers but relies upon some suppliers for a substantial number of components for its truck products. Transportation's purchasing strategies have been designed to improve access to the lowest cost, highest quality sources of raw materials, parts and components, and to reduce inventory carrying requirements. A portion of Transportation's requirements for raw materials and supplies is filled by single source suppliers. The impact of an interruption in supply will vary by commodity. Some parts are generic to the industry while others are of a proprietary design requiring unique tooling which would require time to recreate. However, the Company's exposure to a disruption in production as a result of an interruption of raw materials and supplies is no greater than the industry as a whole. In order to remedy any losses resulting from an interruption in supply, the Company maintains contingent business interruption insurance. Transportation does not currently foresee critical shortages of raw materials and supplies. IMPACT OF GOVERNMENT REGULATION Truck and engine manufacturers have faced continually increasing governmental regulation of their products especially in the environmental and safety areas. In particular, diesel engine manufacturers will be required to achieve lower emission levels in terms of unburned hydrocarbons, particulates and oxides of nitrogen. These regulations have and will impose significant research, design and tooling costs on diesel engine manufacturers. They may also result in the use of after-treatment equipment, such as particulate traps and catalytic converters, which will add to the cost of the vehicle emission control system. The Company's engines are subject to extensive regulatory requirements. Specific emissions standards for diesel engines are imposed by the U.S. Environmental Protection Agency (the U.S. EPA) and by other regulatory agencies such as the California Air Resources Board (CARB). The Company believes that its diesel engine products comply with all applicable emissions requirements currently in effect. The Company's ability to comply with emissions requirements which may be imposed in the future is an important element in maintaining and improving the Company's position in the diesel engine marketplace. Capital and operating expenditures will continue to be required to comply with these emissions requirements. The 1990 Clean Air Act amendments established the U.S. emissions standards for on-highway diesel engines produced through 2001. Insofar as light and medium heavy duty diesel engines are concerned, the CARB standards are similar to those adopted by the U.S. EPA. The Company's products meet the U.S. EPA and CARB standards for on-highway diesel engines produced through 1993. The Company expects that its engines will satisfy all U.S. EPA and CARB on-highway emissions control requirements applicable through 1997. In North America, both Canada and Mexico are expected to adopt U.S. emissions standards. Various diesel engine manufacturers, including the Company, have voluntarily signed a memorandum of understanding with the Canadian government, pursuant to which these manufacturers have agreed to sell only U.S. certified engines in Canada beginning in 1995. In June 1993, Mexico proposed a regulatory program that incorporates U.S. standards and test procedures. This program is expected to be in place in 1994. Truck manufacturers are subject to various noise standards imposed by federal, state and local regulations. The engine is one of a truck's primary noise sources, and the Company therefore works closely with original equipment manufacturers to develop strategies to reduce engine noise. The Company is also subject to the National Traffic and Motor Vehicle Safety Act (Safety Act) and Federal Motor Vehicle Safety Standards (Safety Standards) promulgated by the National Highway Traffic Safety Administration. The Company believes it is in compliance with the Safety Act and the Safety Standards. Expenditures to comply with various environmental regulations relating to the control of air, water and land pollution at production facilities and to control noise levels and emissions from Transportation's products have not been material. Investigations into the nature and extent of cleanup activities under the Superfund law are being conducted at two sites formerly owned by the Company. The eventual scope, timing and cost of such activities as well as the availability of defenses to any such claims, and possible claims against third parties and insurance companies are not known and cannot be reasonably estimated; however, substantial claims could be asserted against the Company. See "Management's Discussion and Analysis in the 1993 Annual Report to Shareowners-Environmental Matters." ITEM 2. ITEM 2. PROPERTIES Transportation has 7 manufacturing and assembly plants in the United States and 1 in Canada. All plants are owned by Transportation. The aggregate floor space of these 8 plants is approximately 8 million square feet. Transportation also owns or leases other significant properties in the United States and Canada, including a paint facility, a small component fabrication plant, vehicle and parts distribution centers, sales offices, engineering centers and its headquarters in Chicago. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ENVIRONMENTAL MATTERS Beginning in March 1984, Transportation received several enforcement notices from the U.S. EPA, all of which relate to Transportation's painting activities at its Springfield, Ohio assembly and body plants. The notices alleged that these painting activities violated the Federal Clean Air Act because the paint contained volatile organic compounds (VOC) in greater quantities than permitted under applicable Ohio regulations (the VOC Regulations). In an administrative action instituted under Section 120 of the Clean Air Act, begun in September 1984, U.S. EPA seeks to recover a noncompliance penalty, measured as the costs allegedly saved by Transportation by not complying with the VOC Regulations at the assembly plant. Transportation has calculated that it did not save any costs. The case went to a hearing before an administrative law judge who ruled in early 1987 that Transportation was liable for a noncompliance penalty in an amount to be determined in a subsequent hearing. All Transportation appeals of this ruling were denied. No hearing to determine the amount of the noncompliance penalty has yet been scheduled. In a court action instituted under Section 113(b) of the Clean Air Act, the United States filed civil complaints pertaining to the assembly plant (filed on April 30, 1985) and the body plant (filed on November 3, 1986) in the U.S. District Court in the Southern District of Ohio. These complaints ask the judge to impose fines of up to $25,000 per violation of the VOC Regulations per day since December 31, 1982, and also ask the judge to issue an injunction prohibiting Transportation from continuing the alleged violations. In March 1993, the judge granted the United States' motion for partial summary judgment, ruling that Transportation violated the VOC Regulations at the assembly plant during the period from December 31, 1982 to April 30, 1985. The judge has not yet made any determination as to fines for the violation. Transportation built a new paint facility adjacent to the assembly plant which replaced some of the painting activities formerly performed at the assembly plant and the body plant. New technology at the paint facility reduces or destroys VOCs emitted in the painting operations. These reductions enabled Transportation to apply for a bubble variance, an administrative exemption which permits Transportation to comply with the VOC Regulations by averaging VOC emissions from the assembly and body plants with VOC emissions from the paint facility. Ohio EPA issued the bubble variance to Transportation in February 1989. U.S. EPA approved the bubble variance in December 1990, effective January 1991. In November 1993, Transportation received a settlement offer from U.S. EPA to settle all allegations contained in both the administrative action and the court action in exchange for a payment of $2.7 million. Transportation is pursuing settlement discussions to resolve these cases. OTHER MATTERS In July 1992, the Company announced its decision to change its retiree health care benefit plans and concurrently filed a declaratory judgment class action lawsuit in the U.S. District Court for the Northern District of Illinois (Illinois Court) to confirm its right to change these benefits. A countersuit was filed against the Company by its unions in the U.S. District Court for the Southern District of Ohio (Ohio Court). On October 16, 1992, the Company withdrew its declaratory judgment action in the Illinois Court and began negotiations with the UAW to resolve issues affecting both retirees and employees. On December 17, 1992, the Company announced that a tentative agreement had been reached with the UAW on restructuring retiree health care and life insurance benefits (the Settlement Agreement). During the third quarter of 1993, all court, regulatory agency and shareowner approvals required to implement the Settlement Agreement concerning retiree health care benefit plans were obtained. The Settlement Agreement became effective and the restructured retiree health care and life insurance plan was implemented on July 1, 1993. In May 1993, a jury issued a verdict in favor of Vernon Klein Truck & Equipment, Inc. and against Transportation in the amount of $10.8 million in compensatory damages and $15 million in punitive damages. In order to appeal the verdict in the case, the Company was required to post a bond collateralized with $30 million in cash. This amount has been recorded as restricted cash on the Statement of Financial Condition. The amount of any potential liability is uncertain and Transportation believes that there are meritorious arguments for overturning or diminishing the verdict. The Company and its subsidiaries are subject to various other claims arising in the ordinary course of business, and are parties to various legal proceedings which constitute ordinary routine litigation incidental to the business of the Company and its subsidiaries. In the opinion of the Company's management, none of these proceedings or claims are material to the business or the financial condition of the Company. EXECUTIVE OFFICERS The following selected information for each of the Company's current executive officers was prepared as of November 5, 1993. OFFICERS AND POSITIONS WITH NAME AGE NAVISTAR AND OTHER INFORMATION ---- --- ------------------------------ James C. Cotting ... 60 Chairman and Chief Executive Officer since 1987 and a Director since 1983. Mr. Cotting also is Chairman and Chief Executive Officer of Transportation since 1990 and a Director since 1987. Prior to this, Mr. Cotting served as Vice Chairman and Chief Financial Officer, 1983-1987. John R. Horne ...... 55 President and Chief Operating Officer and a Director since 1990. Mr. Horne also is President and Chief Operating Officer of Transportation since 1990 and a Director since 1987. Prior to this, Mr. Horne served as Group Vice President and General Manager, Engine and Foundry, 1990 and Vice President and General Manager, Engine and Foundry, 1983-1990. Robert C. Lannert .. 53 Executive Vice President and Chief Financial Officer and a Director since 1990. Mr. Lannert also is Executive Vice President and Chief Financial Officer of Transportation since 1990 and a Director since 1987. Prior to this, Mr. Lannert served as Vice President and Treasurer, 1987-1990 and Vice President and Treasurer of Transportation, 1979-1990. Robert A. Boardman . 46 Senior Vice President and General Counsel since 1990. Mr. Boardman also is Senior Vice President and General Counsel of Transportation since 1990. Prior to this, Mr. Boardman served as Vice President of Manville Corporation, 1988-1990 and Corporate Secretary, 1983-1990. Thomas M. Hough ... 48 Vice President and Treasurer since 1992. Mr. Hough also is Vice President and Treasurer of Transportation since 1992. Prior to this, Mr. Hough served as Assistant Treasurer 1987-1992, and Assistant Treasurer of Transportation, 1987-1992. Mr. Hough also served as Assistant Controller, Accounting and Financial Systems, 1987 and Controller of Navistar Financial Corporation, 1982-1987. Robert I. Morrison . 55 Vice President and Controller since 1987. Mr. Morrison also is a Vice President and Controller of Transportation since 1985. Prior to this, Mr. Morrison served as Assistant Treasurer and Vice President, Finance and Planning, International Group, 1983-1985. Steven K. Covey ... 42 Corporate Secretary since 1990. Mr. Covey is Associate General Counsel of Transportation since November 1992. Prior to this, Mr. Covey served as General Attorney, Finance and Securities of Transportation, 1989-1992, Senior Counsel, Finance and Securities, 1986-1989 and Senior Attorney, Corporate Operations 1984-1986. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable PART II The information required by Items 5-8 is incorporated herein by reference from the 1993 Annual Report to Shareowners, filed as Exhibit 13 to this Form 10-K as follows: Annual Report Page -------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS .............. 62 ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ...................... 60 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION .......................... 3 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA .. 17 With the exception of the aforementioned information (Part II; Items 5- 8) and the information specified under Items 1 and 14 of this report, the 1993 Annual Report to Shareowners is not to be deemed filed as part of this report. ---------------------------------------------------------- ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEMS 10, 11, 12 AND 13 Information required by Part III (Items 10, 11, 12 and 13) of this Form is incorporated herein by reference from Navistar's definitive Proxy Statement for the March 16, 1994 Annual Meeting of Shareowners. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Information required by Part IV (Item 14) of this form is incorporated herein by reference from Navistar International Corporation's 1993 Annual Report to Shareowners, filed as Exhibit 13 to this Form 10-K as follows: Annual Report Page ------ Financial Statements - -------------------- Statement of Income (Loss) for the years ended October 31, 1993, 1992 and 1991 ...................... 17 Statement of Financial Condition as of October 31, 1993 and 1992 ............................ 19 Statement of Cash Flow for the years ended October 31, 1993, 1992 and 1991 ...................... 21 Statement of Non-Redeemable Preferred, Preference and Common Shareowners' Equity for the years ended October 31, 1993, 1992 and 1991 ................ 23 Notes to Financial Statements .......................... 25 Form 10-K Schedules Page - --------- ---- VII - Guarantees of Securities of Other Issuers ..... VIII - Valuation and Qualifying Accounts and Reserves. IX - Short-Term Borrowings ......................... X - Supplementary Income Statement Information .... All schedules other than those indicated above are omitted because of the absence of the conditions under which they are required or because information called for is shown in the financial statements and notes thereto in the 1993 Annual Report to Shareowners. Finance and Insurance Subsidiaries: The financial statements of Navistar Financial Corporation for the years ended October 31, 1993, 1992 and 1991 appearing on pages 5 through 7 in Annual Report on Form 10-K for Navistar Financial Corporation for the fiscal year ended October 31, 1993, Commission No. 1-4146-1, are incorporated herein by reference and filed as Exhibit 28 to this Form 10-K. Financial information regarding all Navistar subsidiaries engaged in finance and insurance operations, including Navistar Financial Corporation, appears as supplemental information to the Financial Statements in the Navistar 1993 Annual Report to Shareowners and is incorporated herein by reference. Exhibits, Including those Incorporated by Reference Form 10-K Page - --------------------------------------------------- -------------- (3) Articles of Incorporation and By-Laws ......... E-1 (4) Instruments Defining the Rights of Security Holders, including Indentures ... E-2 (10) Material Contracts ............................ E-4 (11) Computation of Net Income (Loss) Per Common Share ............................ E-5 (13) Navistar International Corporation 1993 Annual Report to Shareowners ........... N/A (22) Subsidiaries of the Registrant ................ E-6 (24) Independent Auditors' Consent ................. 20 (25) Power of Attorney ............................. 18 (28) Navistar Financial Corporation Annual Report on Form 10-K for the fiscal year ended October 31, 1993 ............................ N/A All exhibits other than those indicated above are omitted because of the absence of the conditions under which they are required or because the information called for is shown in the financial statements and notes thereto in the 1993 Annual Report to Shareowners. Reports on Form 8-K - ------------------- A report on Form 8-K dated December 9, 1992, was filed by the Company to describe developments in negotiations with the United Automobile, Aerospace and Agricultural Implement Workers of America. A report on Form 8-K dated December 9, 1992, was filed by the Company to disclose a change in credit rating. A report on Form 8-K dated December 14, 1992, was filed by the Company to disclose a change in credit rating. A report on Form 8-K dated December 18, 1992, was filed by the Company to announce a tentative agreement on restructuring retiree health care and life insurance benefits. A report on Form 8-K, dated May 14, 1993, was filed by the Company indicating Navistar Financial Corporation granted security interests in substantially all of its assets pursuant to an Amended and Restated Credit Agreement and amended and restated an existing revolving credit facility and a retail notes receivable purchase facility. A report on Form 8-K, dated May 28, 1993, was filed by the Company announcing court approval of a retiree health care and life insurance benefit settlement. A report on Form 8-K, dated July 1, 1993, was filed by the Company describing shareowner approval of the postretirement health care and life insurance benefit settlement as well as a one-for-ten reverse split of the Common stock and Class B Common stock. A report on Form 8-K, dated July 9, 1993, was filed by the Company announcing the merger of Navistar International Corporation with and into its wholly-owned subsidiary, Navistar Holding, Inc. SIGNATURE NAVISTAR INTERNATIONAL CORPORATION AND SUBSIDIARIES ---------------------------------- SIGNATURE Pursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NAVISTAR INTERNATIONAL CORPORATION - ---------------------------------- (Registrant) /s/ Robert I. Morrison - ------------------------------------- Robert I. Morrison January 27, 1994 Vice President and Controller (Principal Accounting Officer) PAGE 20 EXHIBIT 25 SIGNATURE NAVISTAR INTERNATIONAL CORPORATION AND SUBSIDIARIES --------------------------------- POWER OF ATTORNEY Each person whose signature appears below does hereby make, constitute and appoint James C. Cotting and Robert I. Morrison and each of them acting individually, true and lawful attorneys-in-fact and agents with power to act without the other and with full power of substitution, to execute, deliver and file, for and on such person's behalf, and in such person's name and capacity or capacities as stated below, any amendment, exhibit or supplement to the Form 10-K Report making such changes in the report as such attorney-in-fact deems appropriate. 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: Signature Title Date - ------------------------ -------------------------- ---------------- /s/ James C. Cotting - ------------------------ James C. Cotting Chairman of the Board, January 27, 1994 and Chief Executive Officer and Director (Principal Executive Officer) /s/ Robert I. Morrison - ------------------------- Robert I. Morrison Vice President and Controller January 27, 1994 (Principal Accounting Officer) /s/ Jack R. Anderson - ------------------------- Jack R. Anderson Director January 27, 1994 /s/ William F. Andrews - ------------------------- William F. Andrews Director January 27, 1994 /s/ Wallace W. Booth - ------------------------- Wallace W. Booth Director January 27, 1994 /s/ Andrew F. Brimmer - ------------------------- Andrew F. Brimmer Director January 27, 1994 /s/ Bill Casstevens - ------------------------- Bill Casstevens Director January 27, 1994 PAGE 21 EXHIBIT 25 (CONTINUED) SIGNATURE NAVISTAR INTERNATIONAL CORPORATION AND SUBSIDIARIES --------------------------------- SIGNATURES (Continued) /s/ Richard F. Celeste - ------------------------- Richard F. Celeste Director January 27, 1994 /s/ William Craig - ------------------------- William Craig Director January 27, 1994 /s/ Jerry E. Dempsey - ------------------------- Jerry E. Dempsey Director January 27, 1994 /s/ Mary Garst - ------------------------- Mary Garst Director January 27, 1994 /s/ Arthur G. Hansen - ------------------------- Arthur G. Hansen Director January 27, 1994 /s/ John R. Horne - ------------------------- John R. Horne Director January 27, 1994 /s/ Robert C. Lannert - ------------------------- Robert C. Lannert Director January 27, 1994 /s/ Donald D. Lennox - ------------------------- Donald D. Lennox Director January 27, 1994 /s/ Elmo R. Zumwalt, Jr. - ------------------------- Elmo R. Zumwalt, Jr. Director January 27, 1994 SIGNATURE NAVISTAR INTERNATIONAL CORPORATION AND SUBSIDIARIES ---------------------------------- INDEPENDENT AUDITORS' REPORT Navistar International Corporation: We have audited the Statement of Financial Condition of Navistar International Corporation and Consolidated Subsidiaries as of October 31, 1993 and 1992, and the related Statement of Income (Loss), of Cash Flow, and of Non-Redeemable Preferred, Preference and Common Shareowners' Equity for each of the three years in the period ended October 31, 1993, and have issued our report thereon dated December 15, 1993 (which includes an explanatory paragraph relating to the change in methods of accounting for postretirement benefits other than pensions and for income taxes as required by Statements of Financial Accounting Standards No. 106 and No. 109); such consolidated financial statements and report are included in your 1993 Annual Report to Shareowners and are incorporated herein by reference. Our audits also included the financial statement schedules of Navistar International Corporation and Consolidated Subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche December 15, 1993 Chicago, Illinois ---------------------------------- EXHIBIT 24 INDEPENDENT AUDITORS' CONSENT Navistar International Corporation: We consent to the incorporation by reference in this Post-Effective Amendment No. 1 to Registration No. 2-70979 on Form S-8 and in Post- Effective Amendment No. 6 to Registration No. 2-55544 on Form S-8 and in Post-Effective Amendment No. 1 to Registration No. 2-9604 on Form S-8 of our report dated December 15, 1993 (which includes an explanatory paragraph relating to the change in methods of accounting for postretirement benefits other than pensions and for income taxes as required by Statements of Financial Accounting Standards No. 106 and 109); appearing in the Annual Report on Form 10-K of Navistar International Corporation for the year ended October 31, 1993. Deloitte & Touche January 27, 1994 Chicago, Illinois ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Information required by Part IV (Item 14) of this form is incorporated herein by reference from Navistar International Corporation's 1993 Annual Report to Shareowners, filed as Exhibit 13 to this Form 10-K as follows: Annual Report Page ------ Financial Statements - -------------------- Statement of Income (Loss) for the years ended October 31, 1993, 1992 and 1991 ...................... 17 Statement of Financial Condition as of October 31, 1993 and 1992 ............................ 19 Statement of Cash Flow for the years ended October 31, 1993, 1992 and 1991 ...................... 21 Statement of Non-Redeemable Preferred, Preference and Common Shareowners' Equity for the years ended October 31, 1993, 1992 and 1991 ................ 23 Notes to Financial Statements .......................... 25 Form 10-K Schedules Page - --------- ---- VII - Guarantees of Securities of Other Issuers ..... VIII - Valuation and Qualifying Accounts and Reserves. IX - Short-Term Borrowings ......................... X - Supplementary Income Statement Information .... All schedules other than those indicated above are omitted because of the absence of the conditions under which they are required or because information called for is shown in the financial statements and notes thereto in the 1993 Annual Report to Shareowners. Finance and Insurance Subsidiaries: The financial statements of Navistar Financial Corporation for the years ended October 31, 1993, 1992 and 1991 appearing on pages 5 through 7 in Annual Report on Form 10-K for Navistar Financial Corporation for the fiscal year ended October 31, 1993, Commission No. 1-4146-1, are incorporated herein by reference and filed as Exhibit 28 to this Form 10-K. Financial information regarding all Navistar subsidiaries engaged in finance and insurance operations, including Navistar Financial Corporation, appears as supplemental information to the Financial Statements in the Navistar 1993 Annual Report to Shareowners and is incorporated herein by reference. Exhibits, Including those Incorporated by Reference Form 10-K Page - --------------------------------------------------- -------------- (3) Articles of Incorporation and By-Laws ......... E-1 (4) Instruments Defining the Rights of Security Holders, including Indentures ... E-2 (10) Material Contracts ............................ E-4 (11) Computation of Net Income (Loss) Per Common Share ............................ E-5 (13) Navistar International Corporation 1993 Annual Report to Shareowners ........... N/A (22) Subsidiaries of the Registrant ................ E-6 (24) Independent Auditors' Consent ................. 20 (25) Power of Attorney ............................. 18 (28) Navistar Financial Corporation Annual Report on Form 10-K for the fiscal year ended October 31, 1993 ............................ N/A All exhibits other than those indicated above are omitted because of the absence of the conditions under which they are required or because the information called for is shown in the financial statements and notes thereto in the 1993 Annual Report to Shareowners. Reports on Form 8-K - ------------------- A report on Form 8-K dated December 9, 1992, was filed by the Company to describe developments in negotiations with the United Automobile, Aerospace and Agricultural Implement Workers of America. A report on Form 8-K dated December 9, 1992, was filed by the Company to disclose a change in credit rating. A report on Form 8-K dated December 14, 1992, was filed by the Company to disclose a change in credit rating. A report on Form 8-K dated December 18, 1992, was filed by the Company to announce a tentative agreement on restructuring retiree health care and life insurance benefits. A report on Form 8-K, dated May 14, 1993, was filed by the Company indicating Navistar Financial Corporation granted security interests in substantially all of its assets pursuant to an Amended and Restated Credit Agreement and amended and restated an existing revolving credit facility and a retail notes receivable purchase facility. A report on Form 8-K, dated May 28, 1993, was filed by the Company announcing court approval of a retiree health care and life insurance benefit settlement. A report on Form 8-K, dated July 1, 1993, was filed by the Company describing shareowner approval of the postretirement health care and life insurance benefit settlement as well as a one-for-ten reverse split of the Common stock and Class B Common stock. A report on Form 8-K, dated July 9, 1993, was filed by the Company announcing the merger of Navistar International Corporation with and into its wholly-owned subsidiary, Navistar Holding, Inc. SIGNATURE NAVISTAR INTERNATIONAL CORPORATION AND SUBSIDIARIES ---------------------------------- SIGNATURE Pursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NAVISTAR INTERNATIONAL CORPORATION - ---------------------------------- (Registrant) /s/ Robert I. Morrison - ------------------------------------- Robert I. Morrison January 27, 1994 Vice President and Controller (Principal Accounting Officer) PAGE 20 EXHIBIT 25 SIGNATURE NAVISTAR INTERNATIONAL CORPORATION AND SUBSIDIARIES --------------------------------- POWER OF ATTORNEY Each person whose signature appears below does hereby make, constitute and appoint James C. Cotting and Robert I. Morrison and each of them acting individually, true and lawful attorneys-in-fact and agents with power to act without the other and with full power of substitution, to execute, deliver and file, for and on such person's behalf, and in such person's name and capacity or capacities as stated below, any amendment, exhibit or supplement to the Form 10-K Report making such changes in the report as such attorney-in-fact deems appropriate. 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: Signature Title Date - ------------------------ -------------------------- ---------------- /s/ James C. Cotting - ------------------------ James C. Cotting Chairman of the Board, January 27, 1994 and Chief Executive Officer and Director (Principal Executive Officer) /s/ Robert I. Morrison - ------------------------- Robert I. Morrison Vice President and Controller January 27, 1994 (Principal Accounting Officer) /s/ Jack R. Anderson - ------------------------- Jack R. Anderson Director January 27, 1994 /s/ William F. Andrews - ------------------------- William F. Andrews Director January 27, 1994 /s/ Wallace W. Booth - ------------------------- Wallace W. Booth Director January 27, 1994 /s/ Andrew F. Brimmer - ------------------------- Andrew F. Brimmer Director January 27, 1994 /s/ Bill Casstevens - ------------------------- Bill Casstevens Director January 27, 1994 PAGE 21 EXHIBIT 25 (CONTINUED) SIGNATURE NAVISTAR INTERNATIONAL CORPORATION AND SUBSIDIARIES --------------------------------- SIGNATURES (Continued) /s/ Richard F. Celeste - ------------------------- Richard F. Celeste Director January 27, 1994 /s/ William Craig - ------------------------- William Craig Director January 27, 1994 /s/ Jerry E. Dempsey - ------------------------- Jerry E. Dempsey Director January 27, 1994 /s/ Mary Garst - ------------------------- Mary Garst Director January 27, 1994 /s/ Arthur G. Hansen - ------------------------- Arthur G. Hansen Director January 27, 1994 /s/ John R. Horne - ------------------------- John R. Horne Director January 27, 1994 /s/ Robert C. Lannert - ------------------------- Robert C. Lannert Director January 27, 1994 /s/ Donald D. Lennox - ------------------------- Donald D. Lennox Director January 27, 1994 /s/ Elmo R. Zumwalt, Jr. - ------------------------- Elmo R. Zumwalt, Jr. Director January 27, 1994 SIGNATURE NAVISTAR INTERNATIONAL CORPORATION AND SUBSIDIARIES ---------------------------------- INDEPENDENT AUDITORS' REPORT Navistar International Corporation: We have audited the Statement of Financial Condition of Navistar International Corporation and Consolidated Subsidiaries as of October 31, 1993 and 1992, and the related Statement of Income (Loss), of Cash Flow, and of Non-Redeemable Preferred, Preference and Common Shareowners' Equity for each of the three years in the period ended October 31, 1993, and have issued our report thereon dated December 15, 1993 (which includes an explanatory paragraph relating to the change in methods of accounting for postretirement benefits other than pensions and for income taxes as required by Statements of Financial Accounting Standards No. 106 and No. 109); such consolidated financial statements and report are included in your 1993 Annual Report to Shareowners and are incorporated herein by reference. Our audits also included the financial statement schedules of Navistar International Corporation and Consolidated Subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche December 15, 1993 Chicago, Illinois ---------------------------------- EXHIBIT 24 INDEPENDENT AUDITORS' CONSENT Navistar International Corporation: We consent to the incorporation by reference in this Post-Effective Amendment No. 1 to Registration No. 2-70979 on Form S-8 and in Post- Effective Amendment No. 6 to Registration No. 2-55544 on Form S-8 and in Post-Effective Amendment No. 1 to Registration No. 2-9604 on Form S-8 of our report dated December 15, 1993 (which includes an explanatory paragraph relating to the change in methods of accounting for postretirement benefits other than pensions and for income taxes as required by Statements of Financial Accounting Standards No. 106 and 109); appearing in the Annual Report on Form 10-K of Navistar International Corporation for the year ended October 31, 1993. Deloitte & Touche January 27, 1994 Chicago, Illinois

904255_1993.txt

904255_1993

1993

904255

ITEM 1. BUSINESS. OVERVIEW AirTouch Communications, formerly PacTel Corporation (the "Company"), is one of the world's leading wireless telecommunications companies, with significant cellular interests in the United States, Germany, and Japan. The Company's worldwide cellular interests represented 75.3 million POPs and more than 1.2 million subscribers on a proportionate basis at December 31, 1993. In the United States, the Company has 34.9 million POPs and controls or shares control over cellular systems in ten of the thirty largest markets, including Los Angeles, San Francisco, San Diego, Detroit, and Atlanta. Internationally, the Company has 40.4 million POPs and holds significant ownership interests, with board representation and substantial operating influence, in national cellular systems operating in Germany, Portugal, and Sweden and in cellular systems under construction in three major metropolitan areas in Japan, including Tokyo and Osaka. The Company is also the fourth largest provider of paging services in the United States, based on industry surveys, with approximately 1.2 million units in service at December 31, 1993. The following table sets forth the Company's POPs and proportionate subscribers at December 31, 1993. PROPORTIONATE POPS SUBSCRIBERS(1) ---- ------------- (In thousands) Domestic Cellular: Southern California........................ 15,551 436 San Francisco Bay Area..................... 3,075 104 Sacramento Valley.......................... 1,817 67 Michigan/Ohio(2)........................... 8,866 267 Georgia and Kansas/Missouri................ 4,825 172 Other domestic interests................... 755 ------ ------ Domestic Total........................... 34,889 1,046 ------ ------ International Cellular: Germany(3)................................. 23,378 144 Portugal................................... 2,254 9 Japan(4)................................... 10,332 Sweden..................................... 4,437 7 ------ ------ International Total...................... 40,401 160 ------ ------ Worldwide Total.......................... 75,280 1,206 ====== ====== _______________ (1) Domestic proportionate subscriber data does not include subscribers to cellular systems over which the Company does not have or share operational control. For a list of such systems, see "Domestic Cellular." (2) POPs and proportionate subscribers for the Michigan/Ohio region reflect both the Company's 50% interest in a partnership with Cellular Communications, Inc. ("CCI") and the Company's ownership of approximately 12% of the equity in CCI at December 31, 1993. (3) Includes POPs and proportionate subscribers represented by a 2.25% interest which, under the terms of the cellular license, the Company is under a current obligation to sell to small and medium-sized German businesses. See "International Cellular-Germany." (4) Three regional cellular systems in Japan in which the Company has an ownership interest are under construction and are expected to commence operations by the end of 1994. On December 2, 1993, the Company sold 68,500,000 shares of common stock, par value $.01 per share (the "Common Stock") representing 13.9% of the total number of outstanding shares, in an initial public offering (the "Offering"). The net proceeds to the Company from the Offering were approximately $1.5 billion. The remaining 86.1% of the Company's outstanding Common Stock is owned by Pacific Telesis Group ("Telesis"). On March 10, 1994, the Telesis Board of Directors approved a distribution to Telesis shareowners of all of the Common Stock of the Company owned by Telesis (the "Spin-off"). The distribution, which will be tax-free, will be effective as of April 1, 1994 and will be made on a one-for-one basis to Telesis shareowners of record as of March 21, 1994. INVESTMENT CONSIDERATIONS The following factors, in addition to the other information contained elsewhere herein, should be considered carefully in evaluating the Company and its business. RELATIONSHIP BETWEEN THE COMPANY AND TELESIS In February 1993, the California Public Utilities Commission ("CPUC") instituted an investigation of the Spin-off for the purpose of assessing any effects it might have on the telephone customers of Pacific Bell, the California telephone subsidiary of Telesis. On November 2, 1993, the CPUC issued a decision authorizing Telesis to proceed with the Spin-off. On December 3, 1993, two parties filed applications for rehearing with the CPUC and the CPUC staff filed a petition to modify the decision, all of which were denied on March 9, 1994. Under California law, judicial review of the CPUC decision is available only by petition for writ of certiorari or review to the California Supreme Court, and any such petition must be filed by early April 1994. In the event the California Supreme Court were to review and reverse the CPUC's decision, no assurance can be given that the CPUC might not reach a new decision materially less favorable to the Company. In addition, a substantial period of time could elapse before final resolution of these issues should a review be granted. Based on the Company's evaluation of the legal and factual matters relating to the investigation and matters of public and regulatory policy, the Company believes that any request for judicial review would be without merit and that the California Supreme Court will deny any such request. Until the Spin-off is effected, Telesis will control the Company. The Company currently has a variety of contractual relationships with Telesis and its affiliates, including an agreement with respect to the allocation of corporate opportunities arising prior to the Spin-off. See "Transactions between the Company and Telesis." In order to minimize any potential confusion concerning the relationship of the Company to Telesis, the Company changed its name to "AirTouch Communications" in March 1994. In addition, the Company has agreed not to use the name "PacTel," including the names "PacTel Cellular" and "PacTel Paging," after the second anniversary of the Spin-off. Furthermore, the Company's right to use the PacTel name prior to that date is non-exclusive. As a result, after the Spin-off Telesis will be free to market wireless services under the "PacTel" name. The Company may initially encounter difficulty in marketing its wireless services under its new brand names, and has incurred, and expects to continue to incur, certain expenses in connection with the transition to such names. SHARES ELIGIBLE FOR FUTURE SALE; EFFECT OF THE SPIN-OFF ON THE PUBLIC MARKET The Spin-off will involve the distribution of 424,000,000 shares of Common Stock of the Company to the shareowners of Telesis. Substantially all of such shares would be eligible for immediate resale in the public market. The Company is unable to predict whether substantial amounts of Common Stock will be sold in the open market in anticipation of, or following, the Spin-off. Sales of substantial amounts of Common Stock in the public market, or the perception that such sales might occur, whether as a result of the Spin-off or otherwise, could adversely affect the market price of the Common Stock. Purchasers of the Company's Common Stock prior to the Spin-off are referred to the statement in the CPUC's decision that anyone who might seek to control the Company should be mindful that under Section 854 of the California Public Utilities Code, acquisition of control of a utility without CPUC authorization is void. COMPETITION The offering of cellular and paging services in each of the Company's markets is expected to become increasingly competitive. In Germany, for example, Mannesman Mobilfunk GmbH ("MMO") will face competition from a third cellular operator in 1994, and in Japan, the Company's systems will compete against three other cellular operators. In the United States, where the Company currently has one competitor in each cellular market, competition is expected to increase as a result of recent regulatory and legislative initiatives. The Federal Communications Commission ("FCC") has licensed specialized mobile radio ("SMR") system operators to construct digital mobile communications systems on existing SMR frequencies in many cities throughout the United States. When constructed, these systems are expected to be competitive with the Company's cellular service. One such operator began offering service in the Los Angeles metropolitan area in early 1994, and has announced plans to initiate service in the San Francisco Bay Area by mid-1994 and in several other metropolitan areas, including Dallas, by mid-1995. In addition, the FCC has recently allocated radiofrequency spectrum for seven personal communications services ("PCS") licenses in each market. Auctions for such licenses are expected to begin in late 1994. See "Domestic Cellular-Competition" and "Domestic Paging-Competition." Although the Company plans to pursue PCS licenses, whether through consortia or otherwise, the Company may not be successful in expanding the scale of its wireless services coverage. In such event, the Company may be adversely affected. The Company has been conducting tests with both code division multiple access ("CDMA") and time division multiple access ("TDMA") digital technology and intends to determine which technology to deploy in particular markets based upon customer service and efficiency considerations. Any commercial implementation by the Company of CDMA-based service in its markets may be delayed up to two years beyond the introduction of TDMA-based service by the Company's competitors in certain such markets. Thus, to the extent the Company deploys CDMA in certain markets, it may not be able to offer digital service for a period during which its competitors may have deployed TDMA. See "Domestic Cellular-Technology." The Company faces competition in its pursuit of new wireless telecommunications opportunities in international markets. In deciding which companies should engineer, build and manage their new telecommunications systems, most countries have adopted merit-based selection criteria to ensure the necessary expertise and financial strength. The Company believes that its technical and operating expertise have been critical in its success in attracting desirable joint venture partners and winning international wireless licenses. However, in prior application processes it is possible that foreign countries may have taken into account the fact that the Company was a wholly owned subsidiary of Telesis. Although the Company believes that its capitalization will be more than adequate to allay any concerns that licensing authorities or joint venture partners might have regarding the Company's financial strength, there can be no assurance that this will be the case. See "Future Funding Requirements." Recently, several countries have included an "auction" element among the criteria used to determine the award of wireless licenses. While auction procedures have not been adopted by any of the other countries in which the Company is competing or planning to compete for wireless licenses, such procedures may be adopted in the future. In the United States, the Omnibus Budget Reconciliation Act of 1993 authorized the FCC to auction future licenses for services utilizing radio frequency spectrum, including PCS. Where auction procedures apply, whether domestically or internationally, there can be no assurance that the Company will be willing or able to compete as successfully as certain of its competitors possessing greater financial resources. REGULATION The licensing, construction, operation, sale and acquisition of wireless systems, as well as the number of competitors permitted in each market, are regulated by the FCC and its counterparts in other countries. In addition, certain aspects of the Company's domestic wireless operations, including the setting of rates, may be subject to public utility regulation in the state in which service is provided. The cellular regulatory structure in California is the subject of a CPUC investigation, which is in rehearing. An order adopted by the CPUC in October 1992 would have imposed on cellular operators an accounting methodology to separate wholesale and retail costs, permitted resellers to operate a switch interconnected to the cellular carrier's facilities, and required the unbundling of certain wholesale rates to the resellers. These unbundled rates would have been calculated by applying a rate of return of 14.75% to the cost basis of assets utilized by such reseller switch. The issues raised in the rehearing were consolidated with a new investigation, which commenced in December 1993, into the regulation of all wireless services provided in California. The CPUC instituted the investigation to review the wireless market in light of the entrance of multiple new competitors in 1994 and 1995, including PCS and SMR. The order proposes a dominant/nondominant regulatory framework whereby cellular carriers would be classified as dominant carriers as controllers of facilities characterized by the CPUC as "bottleneck" facilities, and may be subject to cost-based rate regulation. The CPUC also intends to explore regulation that would require cellular carriers to offer the radio portion of cellular service on an unbundled basis from all other aspects of services they may offer. Nondominant carriers, including PCS and SMR, would be subject to minimal regulation involving registration, record inspection and consumer safeguards. The Company believes, and will urge in the proceeding, that regulation of cellular carriers in California should be reduced, not increased, in order to encourage competition and innovation. The CPUC also is investigating whether California cellular carriers have complied with the CPUC's rules regarding the filing of applications and permits to locate and construct cell sites. No assurance can be given that the outcome of either of these investigations, or regulatory changes that may be enacted by federal, state or foreign governmental authorities, will not have a material adverse effect on the Company's business. The Company, as an affiliate of Telesis' subsidiaries Pacific Bell and Nevada Bell, is also currently subject to the 1982 consent decree known as the Modification of Final Judgment ("MFJ"), which imposes lines-of-business restrictions on affiliates of the Bell operating companies. The Company will remain subject to the MFJ until the Spin-off. The Company believes, based on the terms of the MFJ and its underlying policies, that the MFJ will cease to apply to it thereafter, although there can be no assurance that will be the case because the MFJ does not expressly provide that former affiliates of Bell operating companies are not subject to the MFJ. For a further description of the restrictions imposed by the MFJ and the reasons for the Company's belief that the MFJ will not apply to it after the Spin-off, see "Regulation-MFJ." Finally, the FCC granted all cellular licenses in the United States with an initial 10-year term. The Company has filed an application for renewal of its Los Angeles cellular license, whose initial term expired in October 1993. The Company expects that its application will be granted, although an opposing party has filed an informal objection and a petition to deny the Company's application, alleging violations of FCC rules and the Communications Act of 1934. See "Regulation-Federal." The Company's licenses in San Diego, Detroit, Cleveland and Sacramento expire in October 1994 and all of its other significant domestic cellular licenses expire before the end of 1996. While the Company believes that each of these licenses will be renewed based upon FCC rules establishing a presumption in favor of licensees that have complied with their regulatory obligations during the initial license period, there can be no assurance that any license will be renewed. The licensing authorities in Germany and Portugal have not established any procedures for renewal of the cellular licenses held by MMO and Telecel Comunicacoes Pessoais, S.A. ("Telecel"). Such licenses expire in 2009 and 2006, respectively. See "Regulation." POTENTIAL DILUTION OF FUTURE OPERATING RESULTS The Company is currently pursuing opportunities to expand its wireless operations in international markets and intends to participate actively in the license application process for PCS in the United States. To the extent that the Company is successful in its pursuit of new wireless licenses, the Company will incur start-up expenses, which, at least in the short-term, will have a dilutive effect on the Company's future earnings. For example, primarily as a result of start-up losses from MMO, Telecel, and the Company's other international wireless ventures, the Company had international equity losses of $37.5 million (including a $20.7 million tax benefit recognized as a result of the adoption of SFAS 109), $38.5 million (including a $32.0 million tax benefit) and $21.4 million for 1993, 1992, and 1991, respectively. FUTURE FUNDING REQUIREMENTS The Company expects that proceeds from the Offering and cash flows from operations will provide the Company with adequate capital to satisfy its projected funding requirements through mid-1995. The Company, however, currently is pursuing or planning to pursue several wireless license awards and is continually considering acquisitions and other new opportunities for future growth both domestically and internationally. If the Company is more successful than anticipated in its pursuit of license opportunities, the Company may require substantial additional external funding prior to mid-1995 for any related acquisition costs, auction fees, construction costs or start-up losses. Furthermore, in October 1995, the Company has certain obligations to purchase additional equity in CCI. These obligations are expected to require the Company to raise substantial additional funding through bank borrowings or public or private sales of debt or equity securities. See "Domestic Cellular-Joint Ventures-New Par." The Company believes that it will be able to access the capital markets on terms and in amounts that will be adequate to accomplish its objectives, although there can be no assurance that that will be the case. The Company was essentially debt-free at year-end 1993 and that has been assigned a BBB+ implied senior debt rating by Standard & Poor's based in part upon that agency's analysis of the expected future financial performance of the Company. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources." CCI TRANSACTION Concurrent with the formation in 1991 of an equally owned joint venture with CCI ("New Par"), the Company purchased 5% of the equity in CCI, agreed to purchase additional equity in CCI and obtained the right to acquire all of CCI's remaining equity in stages over the next several years. The Company currently owns approximately 12% of the equity in CCI and has the right to purchase up to an additional 15.5% of CCI's equity in the open market, through privately negotiated transactions or otherwise, through October 1995. Pursuant to an agreement between the Company and CCI, in October 1995 the Company is obligated to purchase up to approximately $720 million of stock and stock options in CCI, depending on the number of shares tendered to CCI in a related redemption. The per share purchase price underlying such obligation is $60. The stock and options that the Company is obligated to purchase represented approximately 25% of CCI's equity on a fully diluted basis at December 31, 1993. The Company also has the right (but not the obligation) during an 18-month period commencing in August 1996 to purchase the remainder of CCI (but excluding any assets and related liabilities other than CCI's interest in New Par unless otherwise agreed by the partners) at a price that reflects appraised private market value of CCI (excluding such assets and related liabilities) at that time. In the event that the Company does not exercise such right, New Par effectively terminates and CCI may be obligated to sell its assets, including those relating to the joint venture, to a third party. If New Par assets (and related liabilities) are sold within a specified period (not to exceed two years) at less than the appraised price, the Company will be obligated to effect certain "make-whole" payments to CCI's stockholders based upon the amount of the shortfall. The Company's exercise of its rights to purchase additional equity in CCI will depend upon the Company's evaluation of the market for CCI's stock, CCI's business, prospects and financial condition, other investment opportunities available to the Company, prospects for the Company's business, general economic conditions, and other factors. No assurance can be given that the Company's investment in CCI will be favorable to the Company or that any sale of the joint venture assets, if required, will be consummated at a price that will eliminate the Company's make-whole obligation. See "Domestic Cellular-Joint Ventures-New Par." IMPLICATIONS OF LICENSEE OWNERSHIP STRUCTURE The Company holds most of its domestic cellular properties through partnership interests, a number of which are controlling interests. In addition, the Company's interests in international wireless licenses are held almost exclusively through foreign corporations in which the Company is a significant, but not controlling, shareholder. Many of these partnerships or corporations were formed in connection with the applications for new licenses. Others, like New Par and an equally owned joint venture with McCaw Cellular Communications, Inc. ("CMT Partners"), were formed as part of the Company's strategy to create regional networks. Under the governing documents for certain of these partnerships and corporations, decisions as to the timing and amount of cash distributions may require a greater percentage vote than that held by the Company. Although the Company has not been materially impeded by the nature of its wireless ownership interests from pursuing its corporate objectives, no assurance can be given that it will not experience difficulty in this regard in the future. The Company expects to enter into similar arrangements in the future as it participates in consortia to pursue wireless opportunities. FLUCTUATIONS IN THE VALUE OF WIRELESS LICENSES A substantial portion of the Company's assets consists of interests in entities holding cellular licenses, the value of which will depend significantly upon the success of the operations of such entities and the growth and future direction of the industry generally. Values of licenses also have been affected by fluctuations in the level of supply and demand for such licenses. Any transfer of control of an entity holding a domestic license is subject to prior FCC (and possibly state regulatory) approval. Analogous governmental approvals are required for transfers of interests in foreign licenses. Where licenses are held by partnerships or foreign corporations, transfers of interests also are often subject to contractual restrictions. See "Regulation" and "International Cellular." The Company believes that major license awards in the next several years will establish two or more cellular competitors in most of the world's developed countries and that international cellular opportunities thereafter will arise primarily through acquisitions or combinations with existing license holders or through awards by developing countries. Investment returns from acquisitions of interests in existing entities holding wireless licenses or from licenses acquired through auctions may be lower than those resulting from the Company's prior license awards because of the substantial purchase prices required to acquire such interests. In addition, licenses in developing countries may involve risks beyond those encountered in developed countries. EXCHANGE RATE FLUCTUATIONS Foreign currency exchange rates are increasingly material to the Company's results of operations. The Company evaluates the risk of significant exchange rate volatility and its ability to hedge as part of its decision whether to pursue an international opportunity. A significant weakening against the dollar of the currency of a country where the Company recognizes revenues or earnings may adversely affect the Company's results, while any weakening of the dollar against such currency could have an adverse effect if the Company is obligated to make significant foreign denominated capital investments in such country. The Company attempts to mitigate the effect of foreign currency fluctuations through the use of foreign currency contracts and local banking accounts. RADIOFREQUENCY EMISSIONS CONCERNS Media reports have suggested that certain radiofrequency ("RF") emissions from portable cellular telephones might be linked to cancer. The Company has collected and 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. Additional concerns have been expressed about the safety of emissions from cellular facilities which transmit calls to subscriber's telephone handsets. The Company's facilities are licensed by the FCC and comply with the exposure levels set by the FCC. The CPUC has also opened an investigation into the safety of cellular facilities licensed in California. The Company submitted extensive scientific data to the CPUC to support its conclusion that cellular emissions will cause no adverse health effects. A CPUC staff report issued in December 1993 concluded that the CPUC is unlikely to adopt stricter requirements than the FCC absent convincing evidence of risk. DOMESTIC CELLULAR The Company is one of the largest providers of cellular services in the United States, with interests in some of the most attractive cellular markets based upon total population and demographic characteristics. The Company's United States cellular interests represented 34.9 million POPs and more than 1 million proportionate subscribers at December 31, 1993. The Company has or shares operational control over cellular systems in Los Angeles, San Francisco, San Diego, Atlanta, Detroit, Cleveland, San Jose, Sacramento, Cincinnati, and Kansas City. These cities represent ten of the thirty largest cellular markets in the United States. The Company also has or shares operational control over cellular systems in 34 additional markets, including Columbus, Dayton and Toledo, Ohio, and owns minority interests in cellular systems serving 10 other markets, including Dallas/Fort Worth, Tucson, and Las Vegas. The FCC licenses only two cellular systems in each market. One license (the "Block B" license) was initially reserved for applicants affiliated with a company engaged in the wireline telephone business (the "wireline licensee") and the other license (the "Block A" license) was initially reserved for a non-wireline licensee. Through FCC license applications and grants, the Company acquired controlling interests in wireline licensees in San Diego, the greater Los Angeles area, including Oxnard and Ventura, and the greater Sacramento area, including Stockton and Reno. Following the FCC's initial license awards, the Company has aggressively pursued the acquisition of additional cellular interests throughout the United States. In evaluating its acquisition opportunities, the Company considers the attractiveness of the market for cellular services, the Company's ability to control or significantly influence the operations of the system and the opportunity to create a regional network through integration with the Company's existing systems or by acquiring licenses in adjacent markets. The following table sets forth as of December 31, 1993, (i) by region the markets in which the Company owns an interest in a cellular system, (ii) whether each such system is the wireline or non-wireline licensee, (iii) the total population of the market served by such system, (iv) the Company's percentage ownership in the operator of the system, and (v) the Company's POPs based on its percentage ownership. MARKETING The Company aggressively markets its cellular services through its own sales force and arrangements with independent agents, as well as newspaper and radio advertising, toll-free telephone numbers and affiliations with nationwide groups of cellular carriers under the brand names MobiLink and Cellular One. In certain markets, the Company's cellular service is sold through resellers who, pursuant to FCC requirements, are allowed to purchase blocks of cellular telephone numbers and access to cellular services at wholesale rates for resale to the public. Agents are independent contractors who solicit customers for the Company's cellular service, and typically include automobile dealers, specialized electronics stores and department stores. The Company generally pays its agents a commission for each subscriber who uses the Company's service for a specified period and makes residual payments to the agent based on the subscriber's ongoing service charges. Recently, the Company has been placing greater emphasis on residual payments in order to align more closely the payment of sales commissions with revenues. The Company is continually seeking new methods of marketing its cellular service. In 1991 and 1992, the Company introduced cellular telephone rental programs in the systems it contributed to New Par and in its Atlanta system. Under these rental programs, new subscribers rent cellular telephones for a nominal monthly fee and commit to a two-year subscription. The Company believes that this program, which eliminates the need to purchase a cellular telephone, has contributed significantly to subscriber growth and has reduced customer disconnects in these markets. The Company and fourteen other cellular companies have formed an alliance to market their Block B (wireline) cellular service in the United States and Canada under the brand name MobiLink. The group has set common standards for cellular service, set up cellular telephone service centers, established standard dialing codes for customer service, dialing instructions and technical assistance and offers a 24-hour customer service line. Members of the MobiLink group utilize new software that makes it much easier for subscribers to make and receive telephone calls when they are traveling within the area covered by the MobiLink network. This national network became operational in July 1993 and covers more than 80% of the population of the United States and Canada. Through licensing agreements, MobiLink expects to cover virtually all of North America. The Company's block a (non-wireline) cellular systems in the San Francisco Bay Area and in Michigan/Ohio are part of the North American Cellular Network, an alliance of non-wireline cellular operators that offers service under the Cellular One brand name in broad areas throughout the United States and Canada. The North American Cellular Network allows subscribers to travel from city to city within the coverage area and have their calls and custom calling features, such as call waiting, three-way calling and call-forwarding, follow them automatically without having to notify callers of their location or to rely on access codes. In June 1993, the Company and three other cellular operators entered into an arrangement to simplify and enhance calling services for their subscribers in the southeastern United States. The new service, SouthReach, connects the Company's Georgia regional network with nearby systems of other operators, enabling cellular customers in an area covering more than 85,000 square miles to make and receive intermarket calls as easily as calls in their home markets. Another feature of SouthReach allows subscribers to continue calls without interruption while traveling between systems served by the four operators. SERVICES In addition to providing high quality wireless telephone service, in most markets the Company makes available to subscribers custom calling services such as voice-mail, call-forwarding, call-waiting, three-way calling, no-answer and busy transfer. In some markets, the Company also provides news, weather, sports and financial news recordings. The Company charges its subscribers for service activation, monthly access, per-minute airtime and custom calling features. The Company pays the local telephone service company directly for interconnection of cellular telephone calls with the wireline telephone network. Subscribers are billed directly by their selected long distance carrier or the Company provides the billing services for a fee charged to the long distance carrier. The Company generally offers a variety of pricing options, most of which combine a fixed monthly access fee and per-minute charges. Service is generally arranged on a month-by-month basis with access fees paid in advance. The Company has developed a variety of rate plans to serve specific market segments. The Company has roaming agreements with other cellular carriers across the United States and Canada that permit the Company's subscribers to receive service while they are traveling in cellular markets other than those served by the Company. The Company maintains a customer service department in each of its cellular markets for billing and service inquiries. Using a toll free telephone number, customers are able to report any problems and obtain up-to-date information with respect to their accounts. In each of its markets, the Company has technicians on call on a 24-hour basis. Through the use of sophisticated monitoring equipment, these technicians are able to check the performance of the cellular network. The Company also has improved its business operations to deliver a higher level of customer service. The Company recently developed automated systems designed to sharply reduce the time it takes to activate service for a new customer. Paperless activation now allows the Company to perform a credit check and activate a cellular telephone in approximately ten minutes. Previously, this process consumed an hour or more. The Company is exploring the possibility of introducing remote phone programming capability in connection with its digital cellular service. NEW SERVICES WIRELESS DATA. The Company is developing additional revenue sources such as wireless data for delivery over its existing cellular networks. In 1992, the Company established a wireless data division which focuses on opportunities for using the Company's cellular network to transmit data. For example, the Company and three other cellular carriers were the primary developers of the United States' first nationwide cellular data service for United Parcel Service ("UPS"). This service allows UPS drivers, who record package tracking information on an electronic clipboard, to send the information over the networks of cellular carriers throughout the country, including the Company's networks, to UPS' private network and ultimately to UPS' mainframe computers. The Company and several other cellular operators have formed a consortium to test packet-switching technology, which the Company believes will create significant new opportunities in the wireless data market. Packet-switching technology is designed to allow data to be transmitted much more quickly and efficiently than the current circuit-switching technology. Packet-switching uses the intervals between voice traffic on cellular channels to send packets of data, instead of tying up dedicated cellular channels. The packets of information, which may be transmitted using several different channels, are reassembled and directed to the correct party at the receiving end. It is expected that the development of this technology will make it possible for cellular carriers to offer a broad range of cost-effective wireless data services, including fax and electronic mail transmissions and communications between laptop units and local area networks or other computer databases. In November 1993, the Company announced that it expects to begin offering data transmission services using packet-switching technology in most of its domestic markets by the end of 1994. PERSONAL COMMUNICATIONS SERVICES. The Company is actively exploring opportunities to provide PCS. While the marketing and technical elements of PCS are not yet well defined, the Company anticipates that PCS will involve a network of small, low-powered transceivers placed throughout a neighborhood, business complex, community or metropolitan area to provide customers with mobile voice and data communications. PCS subscribers could have dedicated personal telephone numbers and would communicate using small digital radio handsets that can be carried in a pocket or purse. PCS also could be used for data transmission utilizing computers, portable facsimile machines or other devices. Through an affiliate of Telesis, the Company currently is conducting trials under experimental licenses for PCS granted by the FCC. The Company believes that it is capable of offering PCS over its existing cellular networks and plans to do so where there is sufficient demand for such services. The Company is also planning to participate actively, through consortia or otherwise, in the auction process for PCS licenses. LONG DISTANCE SERVICES. The Company believes that following the Spin-off it will no longer be subject to the restrictions of the MFJ. Among other things, freedom from the MFJ would permit the Company to begin providing long distance telephone services across local access and transport area ("LATA") boundaries. As an affiliate of a Bell operating company, the Company currently is prohibited, absent a court waiver, from directly connecting calls across LATAs, even within its contiguous operating areas. See "Regulation-MFJ." Such calls must be directed to the subscriber's interexchange carrier, which separately charges the subscriber for long distance services. Unencumbered by the MFJ, the Company would be able to complete its subscribers' interexchange calls by a variety of methods, including through an exclusive arrangement with a single interexchange carrier or by establishing its own microwave network. Either of these methods would create a new source of revenue and allow its subscribers to avoid a separate long distance charge. TECHNOLOGY The Company is an industry leader in cellular technology. The Company's Los Angeles network was the first to introduce cell site sectorization and overlay/underlay techniques which simultaneously provide increased coverage in high traffic areas and umbrella coverage of difficult terrain. The Company was an early proponent of research into CDMA and worked with Qualcomm Incorporated ("Qualcomm") and others to develop this technology. In July 1993, the Cellular Telephone Industry Association adopted an interim standard based on Qualcomm's CDMA technology. In 1991, the Company became the first to deploy microcells, which make use of low power antennas located significantly farther from cell sites than permitted by earlier technology, thereby allowing coverage inside buildings, in canyons and tunnels and in other areas that are difficult or impossible to serve with conventional cellular technology. Microcell technology also includes a fast hand-off capability, which is valuable in downtown settings where a greater number of antennas at lower power settings allows the network to handle high traffic densities. The Company also has developed advanced network design and management tools. The Company's proprietary software predicts cell site coverage, which is critical in engineering new cellular networks and in making design improvements to existing systems. Other proprietary software developed by the Company detects and analyzes system problems, allowing the Company to react quickly, often before the problem noticeably affects service quality. The Company introduced digital cellular service in its network in the San Francisco Bay Area in October 1993 and plans to introduce digital service in its other regional networks by late 1995. Currently, in most markets the radio transmission between the cellular telephone and the cell site is an analog transmission, and both the cellular telephone and the transmitting equipment are designed to send and receive voice signals exclusively in this mode. The Company believes that digital technology will offer many advantages over analog technology, including substantially increased capacity, improved voice quality, greater call privacy, lower operating costs and the opportunity to provide improved data transmissions. Because existing analog cellular telephones will not be able to receive digital transmissions from the cell site, the Company expects that the transition by subscribers who prefer digital service will occur over a number of years. During such transition, cellular systems will maintain transmitting equipment to serve both formats and it is expected that manufacturers will make dual-mode cellular telephones capable of sending and receiving both analog and digital transmissions in order to meet subscriber needs for roaming. The Company has been conducting tests with both CDMA and TDMA and intends to determine which to deploy in particular markets based upon customer service and efficiency considerations. The Company has agreed to purchase CDMA infrastructure equipment for Los Angeles and certain other markets as well as CDMA-compatible cellular telephone handsets for sale in such markets following the installation of the system. The Company will continue to evaluate the choice of a digital standard in all of its markets. In certain markets, the Company may defer the installation of digital equipment until competitive conditions or capacity constraints warrant digital service. COMPETITION The cellular services industry in the United States is highly competitive. Cellular systems compete principally on the basis of network quality, customer service, price and coverage area. The Company's chief competition in each market is from the other cellular licensee. In certain markets, the Company also competes at the retail level with resellers. The Company believes that its technological expertise, emphasis on customer service, large coverage areas, and development of new products and services make it a strong competitor. Several recent FCC initiatives indicate that the Company is likely to face greater competition in the future. The FCC has permitted SMR system operators to construct digital mobile communications systems on existing SMR frequencies in many metropolitan areas throughout the United States. When constructed, these multi-site configuration systems will offer interconnected mobile telephone service and are expected to compete with the Company's cellular service. One such operator, NexTel Communications, Inc., initiated service in the Los Angeles metropolitan area in early 1994 and has announced plans to initiate service in the San Francisco Bay Area by mid-1994 and in several other metropolitan areas, including Dallas, by mid-1995. At this time, the Company is unable to predict the extent to which NexTel's service will successfully compete with cellular service. In March 1994, NexTel and MCI announced the formation of a strategic alliance to provide wireless services under the MCI brand name throughout the United States. As a result, the Company's domestic cellular systems may encounter such competition sooner then previously anticipated. Pursuant to the FCC's decision to allocate radio frequency spectrum for PCS, seven new licenses will be granted: two 30 MHz blocks, one 20 MHz block and four 10 MHz blocks. (By comparison, the two cellular carriers in each market currently have 25 MHz of spectrum each.) Each 30 MHz license will authorize the holder to provide service in one of 51 geographic market areas covering the United States referred to as Major Trading Areas ("MTAs"), and each of the other licenses will cover one of 492 Basic Trading Areas ("BTAs"), representing smaller areas within the MTAs. The rules adopted by the FCC permit a licensee to acquire up to 40 MHz in a single service area. Cellular licensees (defined as entities owning more than 20% of a cellular system) are not restricted from participating in PCS in areas outside of their cellular service areas, although they are only permitted to obtain a 10 MHz block in their cellular service areas. The Company expects that certain PCS services will be competitive with the Company's cellular service. AT&T's announcement in August 1993 that it will merge with McCaw may increase the level of competition that the Company faces in Los Angeles and Sacramento, where the Company's cellular operations compete with McCaw. The merger will permit McCaw to use the AT&T brand name in marketing its cellular services and give McCaw access to AT&T's sales, customer service and distribution channels, as well as to the research and development capabilities of AT&T Bell Laboratories. The Company and McCaw jointly operate cellular systems in San Francisco, San Jose, Dallas, Kansas City and certain other markets through CMT Partners. See "Joint Ventures CMT Partners." JOINT VENTURES NEW PAR. In August 1991, the Company and CCI formed New Par, to which CCI contributed its cellular systems, located primarily in Ohio, and the Company contributed its cellular systems in Michigan and Ohio. New Par is equally owned by CCI and the Company and is governed by a four-person committee, with two members appointed by each company. The Company and CCI have entered into an agreement (the "Merger Agreement") under which CCI will, in October 1995, offer to redeem up to 10.04 million shares of its redeemable stock at $60 per share and the Company is obligated to purchase from CCI shares or stock options representing in the aggregate approximately 2.4 million shares at a price of $60 per share, less the exercise price in the case of stock options (the "MRO"). The Company is obligated to purchase from CCI at $60 per share a number of newly issued shares of stock equal to the number of shares purchased by CCI in the MRO. Pursuant to the Merger Agreement, the Company acquired approximately 5% of CCI and obtained the right to acquire all of CCI's remaining equity in stages over the next several years. The Company currently owns approximately 12% of CCI and has the right to purchase up to an additional 15.5% of CCI's equity in the open market, through privately negotiated purchases or otherwise, through October 1995. Beginning in August 1996, the Company has the right, by causing CCI to redeem all of its redeemable stock not held by the Company (the "Redemption"), to acquire CCI, including its interests in New Par and such other CCI assets and related liabilities as the Company and CCI may agree upon, at a price per share that reflects the appraised private market value of New Par (and such other CCI assets and related liabilities as the Company and CCI agree shall be retained) determined in accordance with an appraisal process set forth in the Merger Agreement. The Company has the opportunity to evaluate up to three different appraisal values during the 18-month period beginning in August 1996, prior to determining whether to cause the Redemption. The Company will finance the Redemption by providing to CCI any necessary funds. In the event that the Company does not exercise its right to cause the Redemption, CCI is obligated to promptly commence a process to sell itself (and, if directed by the Company, the Company's interest in New Par). In the event that the Company does not direct CCI to sell the Company's interest in New Par, such partnership will dissolve and the assets will be returned to the contributing partner. CCI may, in the alternative, purchase the Company's interest in CCI or CCI and New Par, as the case may be, at a price based upon their appraised values determined in accordance with the Merger Agreement. If CCI or its interest in New Par is sold within certain specified time periods not to exceed two years for a price less than the appraised private market value, the Company is obligated to pay to each other CCI stockholder a specified percentage of such shortfall. In connection with the Merger Agreement, Telesis delivered a letter of responsibility in which it agreed, among other things, to continue to own a controlling interest in the Company. Telesis and CCI have agreed to the termination of such letter of responsibility at the time that Telesis no longer has a controlling interest in the Company in exchange for the provision by the Company of substitute credit assurance, consisting of a $600 million letter of credit and a pledge of up to 15% of CCI's shares on a fully diluted basis, for the Company's obligations in connection with the MRO and for the payment of any make-whole obligation, respectively. CMT PARTNERS. In September 1993, the Company and McCaw formed CMT Partners, an equally owned partnership that holds interests in cellular systems operating in San Francisco, San Jose, Dallas, Kansas City and certain adjacent suburban areas. CMT Partners is governed by a four-person committee consisting of two members from each company. The Company's contributions to the partnership included its 61.1% interest in Bay Area Cellular Telephone Company ("BACTC"), which operates in the San Francisco and San Jose markets, and its 34% interest in the non-wireline licensee operating in the Dallas/Fort Worth market, as well as certain assets and liabilities of its retail reseller operations in the San Francisco Bay Area. McCaw contributed its 32.9% interest in BACTC, as well as its interests in the nearby Vallejo, Santa Rosa and Salinas/Monterey systems. McCaw also contributed its interests in Kansas City, Missouri, Lawrence, Kansas and St. Joseph, Missouri. In addition, the Company purchased McCaw's interests in the Wichita and Topeka, Kansas cellular systems for $100 million. The partnership has a 99-year term. Upon dissolution of CMT Partners its assets will be sold unless either the Company or McCaw elects to have the assets distributed in kind. If that election is made, the Dallas/Fort Worth interest would be distributed to McCaw, the Kansas/Missouri interests would be distributed to the Company, and the interests in the other systems held by the partnership would be distributed pro rata to both partners. INTERNATIONAL CELLULAR The Company has been highly successful in obtaining significant interests in cellular licenses in some of the world's most attractive markets. The Company's cellular interests in Germany, Portugal and Japan reflect government preferences or requirements that local owners hold at least a majority interest in their telecommunications licenses. However, the Company has board representation and substantial operating influence in each of its cellular systems outside of the United States. The Company has the second largest ownership position in MMO and three of the Japanese companies, and currently has the third largest ownership position in Telecel. In addition, agreements among the shareholders of MMO and Telecel require the Company's consent on such matters as annual budgets and business plans, capital calls, the incurrence of certain recourse debt and certain other fundamental corporate actions. The Company has appointed the director of engineering of each of its cellular systems in Germany, Portugal and Japan. Each of these directors is responsible for network buildout and technical operations. GERMANY The Company currently holds a 29.15% interest and is the second largest shareholder of MMO, the joint venture that holds the second of three national digital cellular licenses in Germany. The Company's interest in MMO includes a 2.25% interest which, under the terms of MMO's license, the Company is under a current obligation to sell to small or medium-sized German businesses. MMO began commercial operations in June 1992 and had approximately 493,000 subscribers at December 31, 1993. The system presently covers approximately 94% of the population, including all of the major cities and highways. MMO's network, known as "D2," was the world's first commercial cellular system to be operated on the pan-European Global System for Mobile Communications ("GSM"). The Company played the lead role in the design and construction of the D2 network. In June 1991, the government extended MMO's license by four years to December 31, 2009 in exchange for MMO's agreement to extend the network to the former East Germany. The Company believes that Germany's dense population, high per capita income and attractive workforce profile make it a promising market for cellular services. Cellular use may have been constrained in Germany by the quality of the state-owned analog system, which operated without competition until MMO initiated operations in June 1992, and by relatively high analog cellular telephone and service prices. Cellular penetration in Germany is approximately 2.2%, as compared to approximately 5.5% in the United States. There can be no assurance, however, that cellular penetration in Germany will be comparable to that in the United States. The other principal shareholders of MMO and their ownership interests are Mannesmann AG ("Mannesmann"), a German industrial engineering company and steel manufacturer (55.02%, including 2.25% held in trust for sale to small and medium-sized German businesses), Deutsche Genossenschaftsbank, a German commercial bank (10.29%), and Cable & Wireless plc, a British telecommunications company (5.03%). At December 31, 1993, MMO's contributed capital was approximately DM 1.62 billion (US $931 million), of which the Company's contribution has been approximately DM 472 million (US $271 million). MMO does not expect to require further capital contributions from its shareholders and will fund its remaining capital needs through operating cash flows and bank loans. MMO has a DM 1.1 billion credit facility, of which DM 518 million (US $298 million) had been drawn down at December 31, 1993. OPERATIONS. The Company has had significant participation in the design and operation of the D2 network. In addition to appointing the director of engineering, the Company provided a large technical staff during the design and construction phase of operations. The Company also has contributed to the development and installation of MMO's customer service and billing system and has assisted with MMO's business planning and marketing, sales and distribution arrangements. The Company continues to influence MMO's operations through its right to appoint two of the eight members of the shareholder board, including the deputy chairman. The Company believes that D2's success in attracting customers reflects the significantly improved quality of the digital system, falling equipment prices, D2's customer-oriented service and aggressive marketing. For example, all D2 subscribers have 24-hour toll-free telephone access to customer service. Demand is expected to increase as hand-held cellular telephones, as well as roaming on the GSM standard within Europe, become more available. MMO utilizes three channels of distribution. Resellers have provided the most significant portion of D2's subscribers to date. While they receive a discount from the retail rate based on customer longevity, the Company believes that such resellers nonetheless are an efficient means of distribution. D2 also makes use of an increasing number of third-party agents and dealers. Agent commissions generally are paid per new subscriber and are based primarily on the volume of subscribers generated by the dealer. The remainder of D2's customers are acquired through direct sales. While D2's per-minute charges are relatively high by United States standards, they are comparable to those of the competing digital cellular system. Unlike in the United States, there is no additional charge for long distance service within Germany. In addition, because D2 is a national franchise, there is no roaming charge within Germany, although such a charge is imposed for international roaming. In further contrast to United States systems, the calling party in Germany pays for cellular calls. Accordingly, cellular users in Germany are generally less reluctant than their counterparts in the United States to make available their cellular telephone numbers. COMPANY RIGHTS AND OBLIGATIONS. Under MMO's joint venture agreement, the Company has significant participation in management. The Company's consent is required for such matters as increases in capital contributions, incurrence of certain recourse debt, material transactions with affiliates and any fundamental corporate transactions. In addition, the Company must consent to the adoption of annual budgets and business plans (which cover, among other matters, distributions to the partners, external financing and projected reserves). MMO's senior management group consists of six members, of which the Company has appointed the director of engineering and, jointly with Mannesmann, the director of marketing and the director of operations. In addition, the Company and Mannesmann each appoint one member to a technical committee, which is charged with resolving matters presented by the director of engineering and must do so unanimously. The joint venture agreement provides that any transfer of MMO shares is subject to the other partners' rights of first refusal. Under the terms of the license, any transfer of an ownership interest in MMO must be approved by the German telecommunications ministry. Mannesmann and the Company have committed in principle to maintaining a substantial share of ownership in MMO until certain debt is retired pursuant to agreements with MMO's banks. COMPETITION. Deutsche Bundespost Telekom ("DBPT"), the state-owned telephone and postal carrier, currently is MMO's sole competitor. It operates three mobile telephone networks. DBPT's "D1" network also operates on the GSM standard. D1 commenced operations in July 1992 and had a reported 480,000 subscribers at January 1, 1994. Although D1 benefits from DBPT's name recognition and a well-developed distribution channel integrated with the landline service, the Company believes that D2 competes favorably with the state-owned digital system based upon network quality and customer service. DBPT also operates "B-Netz," which is an older system with fewer than 20,000 subscribers. It is no longer marketed and is used primarily by government agencies. DBPT's third system, "C-Netz," is an analog cellular system covering all of Germany that began operations in 1985 and is reportedly near capacity, with approximately 800,000 subscribers reported at January 1, 1994. In February 1993, the German government awarded a third digital license to E-Plus Mobilfunk GmbH. The third digital system, known as "E1," will reportedly emphasize buildout initially in eastern Germany, where telephone density is much lower, and is expected to begin commercial operations in Berlin and Leipzig by the spring of 1994. The terms of the license require that over 90% of the population of Germany be covered by 1997. The pricing for this service has not been announced. The Company expects E1 to be a significant competitor in the German cellular market. Because E1 will use a different set of frequencies than those of the GSM cellular systems being constructed throughout Europe, E1 subscribers will in general not be able to make calls from or receive calls on such GSM systems without a "dual-mode" handset. The German government has stated that no additional licenses will be issued for cellular or cellular-like services through 1996. PORTUGAL The Company owns a 23% interest in Telecel, the cellular company that was awarded one of two national GSM licenses by the Portuguese government in October 1991. Telecel began commercial service in October 1992, covering all of Portugal's major cities and highways, and had approximately 40,000 subscribers at December 31, 1993. Telecel currently covers approximately 92% of the population and is required under the terms of its license to cover 99% by October 1996. The Company's equity interest in Telecel will increase by up to an additional 12% if Portugal changes its law to allow non-residents to own a greater than 25% interest in its telecommunications licenses. Under an agreement among the shareholders of Telecel, until January 1, 1997 the Company is required to fund Telecel's capital as if it held a 35% equity interest. To the extent that the Company's funding exceeds the amount it would be required to contribute as a 23% shareholder in Telecel, such funding is required to be in the form of five-year interest-free loans. If Portuguese law is amended to permit greater than 25% ownership by non-residents, the Company has the assignable obligation to convert its loans into an additional 12% equity interest (or such lesser percentage as is permitted under the new law). In the event that Portugal does not relax its non-resident ownership restrictions before October 1996, the Company has agreed to nominate a third party to purchase and convert the loans, subject to the approval of the shareholders of Telecel. As of December 31, 1993, Telecel's contributed capital was approximately ESC 18.3 billion (US $103.4 million), of which the Company's contribution was approximately ESC 6.4 billion (US $36.2 million). The Company expects that it will be required to contribute approximately an additional $18 million to Telecel through 1995, after which Telecel's capital needs will be met through operating cash flow and borrowings. At December 31, 1993, Telecel had approximately ESC 6 billion (US $33.9 million) in short-term commercial paper and other short-term borrowings outstanding. In addition to the Company, Telecel's shareholders include Espirito Santo e Irmaos, SA (34.33%), an affiliate of Espirito Santo-Sociedade de Investimentos, SA, a Lisbon-based international finance and investment company; Amorim, Investimentos e Participacoes SGPS, SA (34.33%), a diversified Portuguese company; Centrel, Gestao e Comparticipacoes, SA (6.34%), a Portuguese telecommunications manufacturer; and Eurofon of Portugal, Inc. (2%), a subsidiary of LCC Incorporated, a United States software and engineering company. OPERATIONS. The Company appoints Telecel's director of network engineering and operations and provides other seconded employees. The Company has played the lead role in the design and implementation of Telecel's network. The Company also is active in many other areas of Telecel's business, including marketing, strategic planning, management information systems, and customer service. The Company anticipates that it will continue to have significant involvement in Telecel's operations. Telecel has a distribution network of exclusive agents that account for a majority of customer activations. These agents, through their own outlets and those of subagents, represent several hundred points of sale in Portugal. Telecel also has a direct sales force which accounts for the balance of the activations. There are no resellers in Portugal. Telecel's pricing plan is slightly more expensive than that of its sole competitor, Telecomunicacoes Moveis Nacionais ("TMN"), which is operated by the three Portuguese state-owned wireline telephone companies. COMPANY RIGHTS AND OBLIGATIONS. Under the Telecel shareholders' agreement, the Company appoints the director of engineering, who occupies one of five positions on the board of directors, and three of the eleven members of Telecel's shareholder board. As a greater than 20% shareholder, the Company's consent is necessary for certain fundamental corporate actions such as issuances of stock or debt convertible into stock, as well as for the incurrence of recourse debt, material transactions with affiliates and the approval of business plans and budgets. Telecel's shareholders may not transfer their shares to non-shareholders without government approval for five years following the grant of the license. Any transfer, other than in connection with the conversion of the Company's loans to equity or a transfer to a parent or affiliate of the transferring partner, is subject to the other shareholders' rights of first refusal. COMPETITION. TMN was awarded the competing GSM license in Portugal, and commenced operations at approximately the same time as Telecel. TMN's digital service was reported to have approximately 31,000 subscribers at January 1, 1994. Management believes that Telecel competes favorably with TMN based upon coverage, network quality, service offerings, customer service, distribution network and price. Cellular service has been available in Portugal since September 1989 when TMN initiated analog cellular service. TMN's analog system, which utilizes technology similar to that of the German C-Netz system, was estimated to have approximately 31,000 subscribers at January 1, 1994. JAPAN The Company is the second largest shareholder in three companies licensed to build and operate digital cellular systems in the Tokyo, Kansai (Western) and Tokai (Central) regions of Japan. These three systems are expected to be operational by the end of 1994 and are expected to be able to offer service to approximately 74 million people, or 60% of the Japanese population, by 1997. In February 1994, the Company agreed to acquire a 4.5% interest in a fourth company, which plans to build a digital cellular system that will reach about 70% of the population of the Kyushu/Okinawa region when it begins offering service in 1996. There are approximately 15 million people in the region, which is the fourth most populous of Japan's 11 cellular regions. Tokyo Digital Phone Company ("TDP"), in which the Company owns a 15% interest, was granted a cellular license in April 1992 for the Tokyo metropolitan region, covering 39 million people. Service in metropolitan Tokyo is scheduled to begin by mid-1994. The Company also owns a 13% stake in Kansai Digital Phone Company ("KDP"), which is licensed to serve the cities of Osaka, Kyoto and Kobe, a region with a population of approximately 21 million people. Central Japan Digital Phone Company ("CDP"), in which the Company owns a 13% interest, holds a license for the Tokai region of over 14 million people. Nagoya is the principal city in this region, which is located between Tokyo and Kansai. KDP and CDP received their licenses in August and December, 1992, respectively. Both companies expect to begin service by December 1994. The three companies' contributed capital through December 31, 1993 was approximately Y26 billion (US $232.5 million), of which the Company's share was approximately Y3.6 billion (US $32.2 million). The Company does not expect to be required to make additional capital contributions to TDP, KDP and CDP. The principal shareholders of each of the three companies include Japan Telecom (a long distance carrier in Japan) as lead partner, a regional railway company, Cable & Wireless plc and Toyota Motor Corporation. The Company believes that favorable demographics make Japan an attractive cellular market. Currently, cellular penetration in Japan is approximately 1.6%, which is attributable to several factors, including the relatively high activation, access and usage charges that have characterized the current Nippon Telegraph and Telephone ("NTT") analog system, the only recent introduction of non-wireline competitors, and the traditional requirement of the Japanese Ministry of Post and Telecommunications ("MPT") that customers lease or rent (not purchase) cellular phones. The MPT has adopted regulations, effective April 1, 1994, permitting the purchase of cellular handsets. OPERATIONS. The Company has been integrally involved in the design of each of the systems through its appointment of the director of engineering for each company. The Company also has contributed in other areas, including assisting with preparation of business plans. The Company is working with senior management of each venture to ensure that the systems operate to the extent possible as one network with common marketing and pricing policies and equipment offerings. COMPANY RIGHTS AND OBLIGATIONS. The Company has the right to appoint one member to each board of directors. To date, the Company's appointee to the board of directors of each company has also functioned as the director of engineering. COMPETITION. Cellular competition is anticipated to be substantial in Japan, with up to four digital cellular operators in each of the markets served by TDP, KDP and CDP. Currently, there are two existing analog operators in each region: NTT, which provides nationwide service, and one other provider for each region. Each of the analog providers has been awarded additional spectrum to introduce digital service by the end of 1994. In addition to the licenses held by the Company's joint ventures, another digital license has been awarded in each of the Company's markets and the recipients have made in-service commitments similar to those made by the Company's systems. SWEDEN In October 1993, the Company acquired a 51% interest in NordicTel Holdings AB ("NordicTel"), one of three providers of GSM cellular services in Sweden, for $153 million. The Company also contributed $5.4 million to NordicTel's equity capital. The other principal shareholders of NordicTel are Vodafone Group Plc, with an 18.5% interest, and AB Volvo, Trellswitch Intressenter AB, and Spectra-Physics AB, the three of which hold in the aggregate a 28.5% interest. The Company also holds an option, exercisable between July 1 and September 30, 1994, to purchase from Vodafone an additional 6.75% of NordicTel's equity for approximately $20 million. The Company expects that it will be required to contribute an additional Skr 282 million (US $35.7 million) to NordicTel in 1994. NordicTel's capital requirements thereafter are expected to be met through operating cash flow. NordicTel is planning an initial public offering in 1994. NordicTel's cellular service, which is marketed under the name "Europolitan," began offering service in late 1992. The system presently covers approximately 80% of the population and all of the major cities. Under the terms of the authority granted by the Swedish government, NordicTel will be required to cover all of the major highways and all cities with a population greater than 10,000 by the end of 1995. Cellular penetration in Sweden, which has a population of 8.7 million and more than 800,000 cellular subscribers at December 31, 1993, is among the highest in the world. COMPANY RIGHTS AND OBLIGATIONS. Under the NordicTel shareholders agreement, the Company is entitled to appoint five of the nine members of NordicTel's board of directors. In addition, under such agreement, 80% shareholder approval is required for material corporate actions. The approval required for certain of such actions will decrease to 51% following NordicTel's initial public offering. COMPETITION. NordicTel competes with two other cellular operators in Sweden. Telia Mobitel AB, a wholly owned subsidiary of the state-owned telephone company, operates one GSM network and two analog networks. Comvik GSM AB operates the third GSM network. Nearly all of Sweden's cellular subscribers belong to one of Telia Mobitel's two analog networks, which had no GSM competition until late 1992, when all three GSM networks commenced operations. Subscriber growth on the three Swedish GSM networks has been hampered to date by limited GSM system coverage and a shortage of digital cellular telephone handsets, which is expected to ease significantly. DENMARK OPTION. Prior to the Company's acquisition, NordicTel held a 20% interest in Dansk Mobiltelefon I/S ("DMT"), one of two GSM cellular licensees in Denmark, through a wholly owned subsidiary, NordicTel Dk ("Dk"). Certain shareholders of DMT have taken the position that the indirect acquisition by the Company of a controlling interest in Dk would, under the terms of the DMT joint venture agreement, trigger a transfer at book value to them of Dk's interest in DMT. NordicTel and the Company oppose that position, and the issue is expected to be submitted to arbitration for a binding decision. In order not to trigger such a transfer, NordicTel sold Dk to the shareholders of NordicTel other than the Company (the "Dk Shareholders") immediately prior to the Company's acquisition of its 51% interest in NordicTel. NordicTel also undertook to be responsible to the government of Denmark, jointly with the Dk Shareholders, for fulfillment of DMT's obligations under the terms of its license. The DK Shareholders have in turn agreed to hold NordicTel harmless for any loss caused by such undertaking. NordicTel concurrently entered into an agreement with the Dk Shareholders under which it has the right to purchase a 100% interest in Dk in the event that the arbitration concludes, among other things, that the book-value transfer of Dk's interest in DMT would not be triggered. The Company concurrently entered into an agreement with the Dk Shareholders under which it has the right to purchase a 49% interest in Dk. The Company's right is exercisable only if NordicTel is unable to exercise its right to repurchase Dk in its entirety. Under such agreements, the Dk Shareholders also have the right to sell either a 100% interest in Dk to NordicTel (exercisable only if NordicTel's right to purchase is exercisable) or a 49% interest in Dk to the Company (exercisable only if the Company's right to purchase is exercisable). BELGIUM In July 1993, the Company was chosen by Belgium's state-owned telephone company, Belgacom, from among twenty applicants to provide technical, operating and marketing support for Belgacom's GSM network, which commenced operations on January 1, 1994. Operating under the name "Proximus," the network covers all of the major cities, including Brussels, Antwerp, Liege and Ghent. By the end of 1994, the system is expected to reach approximately 85% of the country and 95% of Belgium's 10 million people. The Company is negotiating with Belgacom to acquire a 25% interest in a new mobile communications joint venture, which will hold Belgacom's analog and GSM cellular telephone operations. The Company currently expects that the terms of its participation in such joint venture will be finalized by mid-1994. NEW OPPORTUNITIES The Company plans to actively pursue new opportunities to acquire interests in wireless systems throughout the world. Such opportunities are expected to arise through awards of new licenses and through the acquisition of interests in existing licenses. The Company believes that its proven technical, operating and marketing expertise make it a highly desired participant in consortia formed to pursue new international opportunities. The Company led the design and construction of MMO's and Telecel's nationwide digital cellular systems. The Company also is integrally involved in the design of all three of its digital cellular systems in Japan. The Company believes that the technical expertise it developed in the United States and Germany was a significant factor in the success of the license applications of its consortia in Portugal and Japan and in the Company's selection as technical adviser to Belgacom. The Company measures each international investment against such criteria as demographic factors, the degree of economic, political and regulatory stability, the quality of local partners and the degree to which the Company would control or meaningfully participate in management. Although the Company assesses each opportunity independently, its strategy is to leverage off each venture to evaluate and pursue other telecommunications opportunities in such markets. For example, the Company has won paging licenses in Spain and France and intends to pursue cellular opportunities in both countries. In addition, the Company is now pursuing opportunities to provide paging and long distance services in Germany, where MMO commenced operations in June 1992. The Company's primary focus in pursuing licenses is Europe and Asia because the Company believes that these regions currently provide the highest potential for value creation, although the Company also is considering opportunities in other parts of the world. The Company is currently competing or planning to compete for wireless licenses in South Korea, Italy, the Netherlands, Spain and France. SOUTH KOREA. Korea Mobile Telecom Corporation, a subsidiary of the government-owned telephone company, is currently the sole provider of cellular service in South Korea. In August 1992, the government's award of the second national cellular license to a consortium not involving the Company was rescinded following allegations of improper influence. In late February 1994, the second license was awarded to a partially formed consortium consisting of a subsidiary of POSCO (Pohang Iron and Steel), and the Kolon Group, which hold interests of 15% and 14%, respectively. Telesis had been a 20% shareholder of the POSCO joint venture. However, all prior agreements between POSCO and Kolon and their respective joint venture partners have been voided and the makeup of the remainder of the consortium is uncertain. According to the announcement of the award, foreign participants would be allowed a maximum interest in the consortium of 20.2%, with no single interest greater than 10%. The Company is actively pursuing a share in the consortium. ITALY. The state-owned telephone company, "SIP," operates three cellular networks in Italy: two analog cellular systems and one GSM system. The Company has an indirect interest of 10.2% in Omnitel, one of two consortia prequalified by the government to apply for the second license. Ing. C. Olivetti is the lead partner in Omnitel, with an interest of 35.7%; other significant partners include Bell Atlantic (11.6%), Cellular Communications International, Inc. (10.3%), Telia Mobitel AB (6.8%), Lehman Brothers (5.6%) and Mannesmann AG (4.5%). An award of the license is expected by mid-1994. THE NETHERLANDS. The Netherlands has one cellular operator, the state-owned PTT Telecom B.V., which operates two analog systems and is constructing a GSM system. The Netherlands Parliament is currently reviewing legislation that would provide for the awarding of a second GSM license, and a request for proposals is expected in mid-1994. The Company has signed a memorandum of understanding for pursuit of the second GSM license with a consortium including ABN AMRO Bank N.V., Cable & Wireless plc, Radio Holland Cellular Services B.V., De Nationale Investeringsbank N.V., PGEM Energy, a Dutch utility, and Heidemij Holding N.V. SPAIN. Telefonica, the partially state-owned telephone company, operates three cellular networks in Spain: two analog systems launched in 1982 and 1990 and a GSM system that commenced service in 1993. The Spanish government is expected to release a request for proposals in mid-1994, for an additional GSM cellular license to be awarded in late 1994 or early 1995. The Company intends to pursue this license actively. FRANCE. Cellular service is available in France over two analog and two digital systems, with state-owned France Telecom and Societe Francaise du Radiotelephone, a private concern, operating one of each. The French government is expected to announce the procedure for the award of a PCS license, with service expected to be launched in 1996. Although the Company has held discussions with several potential partners, it has not yet reached an agreement for the pursuit of the PCS license. TECHNOLOGY GSM. The Company's cellular systems in Germany and Portugal conform to the GSM digital cellular standard. Developed by a standards body within the European Telecommunications Standards Institute with substantial input from the Company's engineers, the GSM standard is a wide-band TDMA standard substantially different from United States TDMA technology and has been adopted by more than 50 countries worldwide, including all those in the European Union and others such as Australia, New Zealand, Singapore and Hong Kong. The GSM standard allows users to place and receive calls on any GSM cellular telephone while traveling in all countries utilizing the standard. A subscriber identification module ("SIM") card is necessary in order to receive GSM cellular service. Each subscriber receives a SIM card, which is about the size of a credit card, that contains a microchip identifying the subscriber. By inserting the card into any GSM telephone, customers can make calls from the telephone and have the calls billed directly to them. The card also allows the subscriber's home GSM system to locate the subscriber on any GSM network throughout the world. In addition to these conveniences, the SIM card can reduce fraud significantly, because each customer has a unique personal identification number that must be used in conjunction with the card. MMO was the first GSM system to offer commercial service. PERSONAL DIGITAL CELLULAR ("PDC") STANDARD. The technology utilized by TDP, KDP and CDP represents Japan's entry into second-generation cellular communications. The PDC standard uses narrow-band Japanese TDMA technology and allows enhanced roaming potential and expanded supplementary services potential. To provide service to subscribers away from their home regions, TDP, KDP and CDP are implementing automatic roaming throughout their combined coverage areas. Subscribers of any of the companies will be able to initiate and receive calls anywhere within the combined coverage area. Two separate digital system frequencies will be utilized throughout Japan: NTT's network and one competing operator will dominate the 800 MHz band while the main operators in the 1500 MHz band will be TDP, KDP and CDP and the other new market entrant. DOMESTIC PAGING The Company offers local, regional, statewide, and nationwide narrow-band data and messaging, or "paging," services in a total of 100 markets in 15 states, including many of the largest metropolitan areas in the United States, such as Atlanta, Dallas/Fort Worth, Detroit, Houston, Jacksonville, Kansas City, Las Vegas, Los Angeles, Louisville, Miami, Orlando, Phoenix, Portland, Sacramento, Salt Lake City, St. Louis, San Antonio, San Diego, the San Francisco Bay Area, Seattle and Tampa/St. Petersburg. At December 31, 1993, the Company had approximately 1.2 million paging units in service and, based upon industry surveys, was the fourth largest provider of paging services in the United States. The Company's growth strategy is to expand into new markets through start-ups or acquisitions, to increase its share in existing markets by providing superior customer service, to refine its mix of distribution channels, including further expansion of its retail sales and to provide new narrow-band PCS services. PAGING SERVICES. The Company currently offers four types of paging services: numeric display, alphanumeric, tone-only and tone and voice. Numeric display service alerts the subscriber and then displays a short message, usually a telephone number entered by the calling party via a touch-tone keypad. More than 90% of the Company's subscribers use numeric display units. The Company's paging revenues consist primarily of monthly charges for paging service and equipment rental. The Company also offers nationwide coverage on its own private carrier paging frequency through an inter-carrier agreement with other paging providers and as a reseller of a nationwide common carrier paging service. A nationwide system permits a subscriber to receive pages in most metropolitan areas of the United States, including markets not otherwise served by the Company. In addition, the Company offers voice retrieval service, which allows callers to leave voice messages instead of telephone numbers, and then alerts the subscriber that a message has been left. Subscribers then call in to retrieve the message, much as they would with a remotely accessible answering machine. The Company is actively exploring new opportunities to provide narrow-band PCS services, including acknowledgment paging and news services. In 1992, the Company began offering its Page Line News Service in San Diego, which provides continuously updated news, financial reports, weather and sports information. The Company now offers Page Line News Service in Los Angeles, Miami, Detroit, Dallas, Phoenix and Seattle. In 1993, the Company introduced KidTrack, a value-priced service specifically designed for families with young children. KidTrack was introduced in the Company's Arizona markets and is now available in San Diego and Las Vegas as well. MARKETING. The Company utilizes a decentralized marketing approach, tailored to each market, to promote and sell its paging services. In all of its markets, the Company relies on both direct and indirect sales channels. The Company conducts its direct marketing through its sales, service and customer service representatives, who are located in the Company's local offices in each market. The Company's indirect sales channels generally consist of resellers, who purchase paging services from the Company in bulk quantities at a wholesale monthly rate, and agents and retailers, who sell only pagers and refer purchasers to the Company for service at the Company's rates. The Company typically pays agents and retailers a commission for such referrals. The Company, which was one of the first to offer paging service through retail outlets, has greatly expanded its retail marketing efforts and now has sales arrangements with over 2,000 retail locations nationwide. Sales of pagers and service through retail outlets generally result in lower selling costs per unit sold. In addition, the Company has found that a substantial number of the units added through retail channels are sold to customers who are new to paging. COMPETITION. The Company's paging operations face intense competition from local or regional carriers as well as from carriers with a broad nationwide presence. Paging systems compete primarily on the basis of reliability, geographic coverage, customer service and price. The Company believes that its extensive experience in the paging business and emphasis on cost control and customer service make it an effective paging competitor. In June 1993, the FCC allocated spectrum and adopted rules (which were amended in February 1994) that authorize the operation of narrow-band PCS, which is expected to be competitive with the Company's paging services. Narrow-band PCS offerings over this spectrum could include advanced voice paging, two-way acknowledgment paging, data messaging, electronic mail and facsimile transmissions. The FCC plans to issue nationwide, regional, MTA and BTA licenses for narrow-band PCS and to license certain response channels to existing licensees. The method for selecting licensees is yet to be determined, and licenses may be auctioned. Existing cellular and paging providers will be eligible for such licenses under the FCC's rules. While the Company believes that it will be able to provide many PCS-type services over its existing paging networks, competition is expected to intensify when PCS offerings become available in the Company's paging markets. Technological advances in the telecommunications industry are expected to continue to create new services or products competitive with the paging services currently offered by the Company. INTERNATIONAL PAGING PORTUGAL. Through Telecel, the Company owns a 23% interest in Telechamada-Servico de Chamada de Pessoas, S.A. ("Telechamada"), Portugal's first nationwide private paging company. Telechamada began service in October 1992, on the same date that Telecel's nationwide cellular service became available, six months ahead of schedule. Telechamada received its license in April 1992 and offers numeric and alphanumeric paging services. At December 31, 1993, Telechamada had approximately 4,900 subscribers. Telechamada estimates that it currently covers 91% of the population. SPAIN. The Company holds a 17.5% indirect interest in Sistelcom-Telemensaje, S.A., which was awarded a nationwide paging license by the Spanish government in August 1992. By January 1993, the digital paging system was operational in 14 cities, including Madrid, Barcelona and Seville. Sistelcom-Telemensaje offers tone-only, numeric and alphanumeric paging services. At December 31, 1993, Sistelcom-Telemensaje had approximately 17,600 subscribers. The license requires that all provincial capitals and all cities with a population of greater than 150,000 be covered by September 1994. THAILAND. The Company provides nationwide paging service in Thailand through a 49% interest in PerCom Service Limited ("PerCom"), which has served all of Thailand's major population centers since February 1991, and through a wholly owned subsidiary that has provided service in Bangkok since 1987. These companies operate together under the name PacLinkTM and jointly served approximately 98,000 subscribers at December 31, 1993. PerCom is obligated under its license to pay between 25% and 40% of its annual paging revenues to the Communications Authority of Thailand ("CAT") during the fifteen-year term of the license, with guaranteed payments of approximately $57 million over such period, of which approximately $3.8 million had been paid as of December 1993. Under the Bangkok paging license, the Company is obligated to pay 33% of its annual paging revenues to CAT, with guaranteed payments of at least $12.4 million required during the remaining term of the license. FRANCE. In September 1993, the French government awarded one of three national digital paging licenses to Omnicom, a joint venture in which the Company has an 18.5% interest. The Company's principal partners in Omnicom are Bouygues S.A., Societe Generale, Preussen Elektra Telekom GmbH and DeNeufliz-Schlumberger-Mallet Finance. Omnicom will construct and operate a nationwide digital paging network based on ERMES, the European radio messaging standard, and expects to begin service in Paris by the end of 1994. The license requires that 20% of the population be covered by the end of 1994 and 60% by the end of 1999. OTHER SERVICES TELETRAC. The Company, through its subsidiary Location Technologies, Inc. ("LTI"), has a 51% interest in Teletrac, a partnership that offers vehicle location services. Teletrac currently has operations in Los Angeles, Detroit, Chicago, Dallas/Fort Worth, Houston and Miami, and has licenses to operate in more than 100 additional cities. The Los Angeles system, the first to commence commercial operations, began offering such services in January 1991. Teletrac is in the start-up phase of its operations and to date its services have not achieved a significant degree of commercial acceptance. Teletrac reported net losses before taxes of $41.6 million, $49.1 million and $36.8 million in 1993, 1992 and 1991, respectively. The Company does not expect Teletrac's operations to be profitable for several years. The Company intends to take actions to reduce Teletrac's operating losses and does not plan to expand Teletrac's operations significantly until its services achieve a higher level of commercial acceptance. In February 1994, the Company reduced Teletrac's workforce by 30%, to approximately 200 employees. The Company is exploring various opportunities to expand the market for Teletrac's services and is continuously evaluating and considering other commercial applications of its technology and radio spectrum. TECHNOLOGY. Teletrac locates vehicles through the precise calculation of the time a radio signal takes to travel from a vehicle equipped with a Teletrac vehicle location unit ("VLU") to Teletrac's land-based receiver stations. Teletrac's proprietary software automatically determines the vehicle's location based on the time the signal arrives at each station, the geographic relationship between the stations, and the speed at which the signal travels. This location is then displayed on a computer-generated map. This process takes only seconds and is generally accurate to within 100 feet, depending on building obstruction, vehicle direction and radio wave interference. PRODUCTS AND SERVICES. Teletrac offers two primary services: fleet tracking and stolen vehicle location. Fleet tracking allows subscribers to monitor the location of all of their vehicles equipped with VLUs, such as taxicabs, ambulances, municipal buses and intra-city delivery trucks. A subscriber may use the fleet tracking service to determine, for example, which vehicle is closest to a customer or whether a vehicle is deviating from its route. In addition, an alert button located in the vehicle allows a driver to signal an emergency. Teletrac had approximately 24,000 fleet tracking units in service at December 31, 1993. Teletrac's stolen vehicle location service is automatically triggered when a car alarm connected to a VLU is not deactivated within a short time after being triggered. The VLU will automatically broadcast a signal that will appear on Teletrac's monitors. Teletrac personnel will simultaneously attempt to contact the owner of the car and the police. Teletrac provides the police with information such as the model and license number of the car, as well as its location. The Company also is in the process of introducing an emergency roadside assistance program for subscribers of its stolen vehicle location service. Teletrac had approximately 6,700 stolen vehicle location units in service at December 31, 1993. MARKETING. Teletrac's fleet tracking service is marketed through a direct sales force located in the individual markets served, and, for national accounts, through a sales group located in Los Angeles. Teletrac sells the VLUs used for fleet tracking directly to the purchaser of the service at negotiated prices, and charges a monthly fee based on system usage. Teletrac's stolen vehicle location service is marketed by distributors of VLUs, such as automobile and electronics dealerships who purchase them directly from manufacturers. Teletrac is not involved in the sale of such units. Once a customer has purchased a unit, Teletrac receives an activation fee and a monthly service fee thereafter. COMPETITION. In fleet tracking, Teletrac's competitors include satellite services and traditional fleet management services, such as specialized mobile radio, which allows a driver to communicate with a dispatcher. In the stolen vehicle location market, a competitor that uses a substantially different technology began to offer service in several major cities prior to Teletrac, and competes directly with Teletrac in most of its markets. Another competitor using technology similar to Teletrac's offers services in certain of Teletrac's markets. JOINT VENTURE. The Company, through LTI, currently owns 51% of Teletrac. North American Teletrac ("NAT") (the other partner in Teletrac) owns, directly or indirectly, 49%. Prior to March 31, 1995, and if certain conditions have been fulfilled, LTI and NAT may each elect to cause a combination of NAT and LTI. In the combination, the shareholders of LTI and NAT would receive stock in the combined entity in an amount reflecting their indirect interest in Teletrac. The shareholders of NAT may also elect to have the combined entity register its shares in an initial public offering (the "LTI IPO"). The LTI IPO must generally occur prior to March 31, 1995. The Company and its affiliates have the right, but not the obligation, to provide capital to Teletrac or the combined entity using convertible notes, prior to the earlier of March 31, 1995 or the LTI IPO. If the Company's affiliates do not purchase such notes, funds may be sought from other sources (subject to certain restrictions). Teletrac also guaranteed a $49.5 million debt of NAT's subsidiary. Convertible securities may only be converted after the earlier of the LTI IPO or March 31, 1995. If converted within two years after that date, the conversion rate will generally be 50% of the price at which stock was sold in the LTI IPO (or, if the LTI IPO did not occur, an appraised price). The Company may not convert during that two-year period to the extent the conversion would result in the Company owning more than 70% of the company. After that time, the conversion rate will equal the LTI IPO price until another limitation, based on a 1:9 relative ownership ratio between the former NAT shareholders and the Company, is reached. Thereafter, the conversion rate will equal the fair market value of the shares. LONG DISTANCE. The Company presently holds a 10% interest in International Digital Communications ("IDC"). IDC provides long-distance telephone service between Japan and over 60 countries, including the United States, to business and residential customers. IDC also offers private leased circuit services within Japan. In 1991, IDC began offering service over a 5,200 mile undersea fiber optic cable, the first such cable to connect Japan directly with the U.S. mainland. CREDIT CARD VERIFICATION. In conjunction with Korea Information and Communications Company, a local service provider in South Korea, the Company sells point-of-sale terminals and provides technology and management support for a nationwide credit card verification system. More than 150,000 terminals have been installed, which are linked to a central data base in Seoul. In 1993, the network handled more than 69 million transactions, representing an increase of 35% over the previous year. AIR-TO-GROUND SERVICES. The Company also provides air-to-ground telephone services in Elmira, New York, New York City, Atlanta and Houston. The Company has entered into an agreement to purchase additional air-to-ground facilities in a number of other cities, including Denver, Phoenix, Portland, Oregon and Seattle. Air-to-ground telephone service allows subscribers to place calls over the public switched telephone network while in a private airplane. INVESTMENT IN QUALCOMM. The Company owns 400,000 shares of common stock of Qualcomm, a publicly held developer of digital mobile communications technology. The Company also holds warrants to purchase approximately 780,000 additional shares of Qualcomm common stock at an exercise price of $5.50 per share. EMPLOYEES At December 31, 1993, the Company had approximately 4,695 employees, none of whom is represented by a labor organization. Management considers its relations with employees to be good. REGULATION The Company is subject to extensive regulation by federal, state and foreign governments as a provider of cellular, paging and radiolocation services. The Spin-off has been the subject of an investigation by the CPUC, which resulted in a decision adopted on November 2, 1993. Until the Spin-off, the Company will be subject to the restrictions imposed by the MFJ. CPUC SPIN-OFF INVESTIGATION In February 1993, the CPUC instituted an investigation of the Spin-off for the purpose of assessing any effects it might have on the telephone customers of Pacific Bell. On November 2, 1993, the CPUC issued a decision in the investigation authorizing Telesis to proceed with the Spin-off. The decision prohibits the Company and subsidiaries of Telesis from agreeing not to compete after the Spin-off and from transferring utility assets, which may include pension funds, out of the California utilities. The decision further requires an independent auditor (selected by and under contract to the CPUC) to perform an audit and file a compliance report with the CPUC to ensure that Telesis and the Company have complied with the terms of the separation as described to the CPUC and that the transaction complies with the conditions imposed by the decision and the CPUC's affiliate transaction rules. The Company believes that the audit will not result in any material liability for the Company. All five Commissioners concurred in the result permitting Telesis to proceed with the Spin-off. Two Commissioners issued partial dissents contending that further proceedings should be held to determine the amount of customer compensation, of no more than $265 million, for pre-1974 cellular research, cellular licenses, and the Company's use of the PacTel name. On December 3, 1993, two parties filed applications for rehearing with the CPUC and the CPUC staff filed a petition to modify the decision, all of which were denied on March 9, 1994. Under California law, judicial review of the CPUC decision is available only by petition for writ of certiorari or review to the California Supreme Court, and any such petition must be filed by early April 1994. The decision whether to grant a petition for a writ of review of a CPUC decision is at the discretion of the California Supreme Court. There is no time limit within which the Court must act on any such petition. In the event the California Supreme Court were to grant review and thereafter reverse the CPUC's decision in a manner adverse to Telesis or the Company, the CPUC could hold further hearings and reach a new decision with respect to the basis for and amount of any potential compensation to Pacific Bell or its customers. Based on the Company's evaluation of the legal and factual matters relating to the investigation and matters of public and regulatory policy, the Company believes that any petition for a writ of review would be without merit and that the California Supreme Court will deny any such petition that might be filed. FEDERAL The construction, operation and transfer of cellular systems in the United States are regulated by the FCC pursuant to the Communications Act of 1934, as amended ("Communications Act"). The FCC has promulgated guidelines for construction and operation of cellular systems and licensing and technical standards for the provision of cellular telephone service. For licensing purposes, the United States is divided into separate markets, called Metropolitan Statistical Areas ("MSAs") and Rural Service Areas ("RSAs"). In each market, the frequencies allocated for cellular use are divided into two equal blocks designated as Block A or Block B. Block B licenses were initially reserved for entities affiliated with a wireline telephone company such as the Company, while Block A licenses were initially reserved for non-wireline entities. Under current FCC rules, a Block A or Block B license may be transferred after FCC approval, but no entity may own any interest in both systems in any one MSA or RSA. The FCC may prohibit or impose conditions on sales or transfers of licenses. Initial operating licenses are generally granted for terms of 10 years, renewable upon application to the FCC. Licenses may be revoked at any time and license renewal applications may be denied for cause. The Company has filed an application for renewal of its Los Angeles cellular license, the initial term of which expired in October 1993. The initial terms of the Company's licenses in San Diego, Detroit, Cleveland and Sacramento expire in October 1994 and the initial terms of all of its other significant domestic cellular licenses expire before the end of 1996. The FCC has issued a decision confirming that current licensees will be granted a relicensing presumption (renewal expectancy) if they have complied with their obligations under the Communications Act during the initial period. The FCC's order has been appealed, and oral argument before the United States Court of Appeals has been set for April 1994. Notwithstanding the status of the appeal, the Company believes that the licenses held by entities controlled by the Company will be renewed upon application for relicensing. Although no competing applications for the Los Angeles license were filed, the Company's operations in Los Angeles and its application for renewal are the subject of an informal objection and a petition to deny, both filed by the same party. The filings allege, among other things, that the Company constructed and operates cells in certain outlying areas of Los Angeles without authorization and filed incorrect or misleading coverage maps with the FCC in violation of its rules and the Communications Act. The Company does not believe that the informal objection and the petition to deny will adversely affect the renewal of its Los Angeles license. Under FCC rules, each cellular licensee was given the exclusive right to construct one of two cellular systems within the licensee's MSA or RSA during the initial five-year period of its authorization. At the end of such five-year period, other persons are permitted to apply to serve areas within the licensed market that are not served by the licensee. Current FCC rules provide that competing "unserved area" applications are to be resolved through a lottery. In 1988, several entities, including the party that filed the informal objection and petition to deny the Company's Los Angeles renewal application, applied to the FCC to obtain the rights to serve certain sparsely populated areas within the Los Angeles market that were unserved by the Company at the end of its initial five-year period. The Company has also applied for such rights. The Company does not expect any material adverse impact on its operations or financial performance in the event that others ultimately acquire rights to such unserved areas. The Company's radio common carrier activities in connection with its paging services also are subject to regulation by the FCC. The Company's paging activities are conducted on radio frequencies assigned by the FCC. The FCC allocates radio common carrier frequencies in specific geographic areas and grants licenses for use of an initial frequency only upon a satisfactory demonstration of an applicant's legal and technical qualifications. The FCC allocates frequencies to a number of competitors in each paging market, unlike the FCC's limitation to two cellular licenses in each cellular market. The Company's paging licenses are subject to periodic renewal by the FCC and, as with all such licenses, can be revoked at any time for cause. However, renewal applications are generally granted by the FCC upon a showing of compliance with FCC regulations and the provision of adequate service to the public. The Communications Act prohibits the holding of a common carrier license (such as the Company's cellular licenses) by a corporation of which any officer or director is an alien, or of which more than 20% of the capital stock is owned directly or beneficially by aliens. Where a corporation such as the Company controls another entity that holds an FCC license, such corporation may not have any aliens as officers, may not have more than 25% of its directors as aliens, and may not have more than 25% of its capital stock owned directly or beneficially by aliens, in each case if the FCC finds that the public interest would be served by such prohibitions. Failure to comply with these requirements may result in fines or a denial or revocation of the license. The FCC regulates the operation and construction of vehicle location systems. Certain of Teletrac's radio frequencies are subordinate to industrial, scientific and government uses. In a rulemaking before the FCC, Teletrac is seeking improved radio frequency interference protection from vehicle identification systems and other location systems utilizing the radio spectrum. However, others have opposed all or parts of Teletrac's request. One service provider is seeking to have the FCC shift Teletrac's frequencies, which would have a material adverse impact on Teletrac's operations. The Company is unable to predict the outcome of this rulemaking. Each of Teletrac's licenses has been issued by the FCC for a term of five years. During that period, the system must be constructed and 1,500 vehicle location units must be placed in service under each license. There are no assurances, even if these requirements are met, that the FCC will renew Teletrac's licenses. The Omnibus Budget Reconciliation Act of 1993 includes a provision preempting state regulation of rates or entry for any "commercial mobile service." The FCC has determined that the Company's cellular, paging and air-to-ground services are commercial mobile services, and that the Company's vehicle location services are private services. The FCC has also exercised its authority to forbear from rate and entry regulation, including tariffs, for cellular, paging and air-to-ground services. In states that regulate cellular services, such as California, authority to continue such regulation extends until August 10, 1994, prior to which time a state may petition the FCC for continued authority. The state must show either that "market conditions with respect to [commercial mobile] services fail to protect subscribers adequately from unjust and unreasonable rates or rates that are unjustly or unreasonably discriminatory" or that such conditions exist and commercial mobile service is a "replacement for land line telephone exchange service for a substantial portion of the telephone land line exchange service within such state." The FCC must take final action on a state petition within one year of receipt, and the state retains regulatory authority over cellular services during its petition's pendency. STATE AND LOCAL In many states, the Company must obtain approvals and certification from state regulators prior to the commencement of commercial service by a cellular system (or in certain states, prior to construction). In addition, certain state authorities, including the CPUC, regulate the acquisition of control of cellular systems and the prices of services or require the filing of prices, price changes and other terms and conditions of service. The siting and construction of cellular transmitter towers, antennas and equipment shelters are often subject to state or local zoning, land use and other local regulation, which may include zoning and building permit approvals or other state or local certification. In November 1988, the CPUC began an examination of the regulation of cellular radiotelephone utilities operating in California. In June 1990, the CPUC issued an interim order which granted cellular carriers greater pricing flexibility and a faster approval process for rate changes. The interim order deferred several issues to further proceedings in 1991, including a request by resellers to perform switching functions, and certain modifications to the system of accounts used by cellular companies. In October 1992, the CPUC issued its decision on these deferred issues. Among other things, the order adopted by the CPUC would have imposed on cellular utilities an accounting methodology to separate wholesale and retail costs, would have permitted resellers to operate a switch interconnected to the cellular carrier's facilities, and would have required the unbundling of certain wholesale rates to the resellers. These unbundled rates would have been calculated by applying a rate of return of 14.75% to the cost basis of utility assets utilized by such reseller switch. In addition, the order would have required the Company to divest its retail reseller operations in the San Francisco Bay Area. In October 1992, the Company filed an Application for Rehearing, which stayed the effect of the decision. In May 1993, the CPUC granted limited rehearing of the decision on the issues of the unbundling of carriers' wholesale rates and the imposition of a 14.75% benchmark rate of return. The CPUC noted that the hearing record was sufficient regarding the technical feasibility of a reseller switch and would seek comments only on the economic aspects of the concept. The CPUC also rescinded its order to modify the method for allocating costs between wholesale and retail operations. The CPUC did not alter its prohibition on resales of cellular service by a carrier's affiliate in the same market. As a result, the Company transferred its reseller operations in the San Francisco Bay Area directly to its San Francisco/San Jose cellular system at the time of the formation of CMT Partners. In December 1993, the CPUC consolidated the foregoing issues designated for rehearing into a new order instituting investigation (the "OII") into mobile telephone service and wireless communications. The OII will review the wireless market in light of the entrance of multiple new competitors in 1994 and 1995 such as PCS and SMR. The order proposes a dominant/nondominant regulatory framework whereby cellular carriers would be classified as dominant carriers and controllers of facilities characterized by the CPUC as "bottleneck" facilities, and may be subject to cost based rate regulation. The CPUC also intends to explore regulation that would require cellular carriers to offer the radio portion of cellular service on an unbundled basis from all other aspects of services they may offer. Nondominant carriers, including PCS and SMR, would be subject to minimal regulation involving registration, record inspection and consumer safeguards. The Company believes, and will urge in the proceeding, that regulation of cellular carriers in California should be reduced, not increased, in order to encourage competition and innovation. Cellular carriers, as well as other telecommunications service providers, have been named as respondents to the proceeding. The order solicits comments on the status of the mobile telecommunications market and the appropriate regulatory response. Opening and reply comments on the issues raised in the OII have been filed. The CPUC will hold a prehearing conference to determine if any issues will proceed to hearing. The Company is unable to estimate the effects of the OII, which could be material, because the impact on future operations will depend on the ultimate outcome of the OII or other subsequent proceedings. In November 1992, the CPUC staff issued an interim report outlining the partial findings of an investigation into compliance with General Order 159 ("G.O. 159"), which requires prior CPUC approval of cellular facility additions. In January 1993, the Company responded to the report indicating that it contains significant inaccuracies and goes beyond the scope of the CPUC's authority. In April 1993, the CPUC alleged that the Company failed to obtain five required permits and issued an order requesting that the Company show why a particular cellular facility should not be disapproved. Certain of the Company's markets may have taken steps that the CPUC might consider to be construction of cellular facilities prior to filing advice letters with the CPUC and/or might be considered by the CPUC to involve the failure to obtain necessary governmental permits for certain cellular facilities. The Company does not anticipate that sanctions, if any, that may be imposed by the CPUC for any failures to comply with G.O. 159 or to obtain other governmental permits will have a material adverse effect on the Company. In April 1993, Pacific Bell filed a petition with the CPUC seeking authority to place cellular and paging interconnection service under tariff. Currently, the price, terms and conditions of cellular and paging interconnection to landline telephone company facilities are governed by negotiated contracts. Concurrent with the petition, Pacific Bell filed an amended application in a collateral CPUC case setting forth the proposed tariff rates if the petition is granted. The Company's preliminary evaluation of the Pacific Bell tariff rates suggests that the elimination of negotiated contracts could increase the cost to the Company of cellular interconnection by as much as 15% in some markets. The Company opposes the elimination of contracts for interconnection service. The impact of the Pacific Bell request on future operations is uncertain and depends upon the outcome of proceedings before both the CPUC and FCC. Certain states also require radio common carriers providing paging services to be certified prior to commencing operations. Certain states in which the Company operates paging activities require the carrier to file notices of its prices or price changes for informational purposes or regulate the acquisition of control of paging systems. INTERNATIONAL REGULATION GERMANY. MMO holds a license to operate the D2 network to supply digital cellular mobile telephone services in the Federal Republic of Germany. The license was issued in accordance with, and is governed by, the applicable provisions of the German Law on Telecommunications Installations. Under such law the right to erect and operate telecommunications facilities is reserved to the government, represented by the Federal Ministry of Postal and Telecommunications Services. The law contains the authority for the Minister for Postal and Telecommunications Services to grant licenses for the exercise of the right to erect and operate telecommunications installations. The Minister also determines the terms and conditions of any license so granted and, to ensure compliance therewith, issues regulations for the supervision of telecommunications installations erected and/or operated by a licensee. To date, no such regulations have been issued. PORTUGAL. Cellular and paging services in Portugal are governed by laws establishing the public tender process for the granting of licenses to provide telecommunications services as well as the guidelines for installation, management and use of network equipment. The government agency with oversight over cellular and paging providers is the Institute das Comunicacoes de Portugal ("ICP"). The applicable Portuguese laws require that licensed operators commence providing service within eighteen months of the date of issuance of their licenses and restrict changes in share ownership for five years from such date without the permission of the ICP. JAPAN. Telecommunication companies ("TCs") engaged in cellular telecommunications businesses in Japan are regulated by (i) the Telecommunications Business Law ("TBL") with respect to the installation of telecommunication circuits, and (ii) the Electric Wave Law ("EWL") with respect to the establishment of electric wave stations. The Ministry of Posts and Telecommunications ("MPT") has the authority under these laws to grant licenses to TCs which will engage in these businesses. Under the TBL and EWL, material restrictions imposed upon foreign companies and foreign persons (collectively "Foreigners") include: (a) Foreigners may not be selected as the representative director or other representing position of TCs; (b) the number of Foreigners who may be elected as directors and senior officers (including statutory auditors) shall be limited to less than one-third of the total number of those directors and officers of a TC; and (c) the number of voting rights which may be held directly or indirectly by Foreigners shall be limited to less than one-third of the voting rights in a TC. A prior notice to, and clearance from, the Ministry of Finance and other relevant ministries are required under the Foreign Exchange Law ("FEL") before Foreigners may acquire shares in TCs. Such FEL requirement has been complied with by the Company with respect to the three cellular companies in Japan in which the Company has investments. SWEDEN. Under the Swedish Act on Telecommunications, a mobile telephone operator is required to have a license in order to provide services over a public telecommunication network, if the operator's business, measured by area of distribution, number of users and other factors, is substantial. The licensing authority is the National Telecommunications Board, which is also the supervisory authority. A license application is typically approved, and an applicant is disqualified only if there is a reason to believe that the licensing requirements cannot be met by the applicant. NordicTel has applied for a license and expects that its application will be approved. However, the terms and conditions of the license have not been finalized. A mobile telephone operator must also obtain permission under the Act on Radio Communications to hold and use radio transmitters. Such permission is granted by the National Telecommunications Board and an application for permission is typically approved. NordicTel's license application includes an application for permission in accordance with the Act on Radio Communications. MFJ Prior to the Spin-off, the Company will be subject to the restrictions imposed by the MFJ, as modified from time to time. In general, the MFJ provided for the divestiture by AT&T of the Bell Operating Companies ("BOCs") by means of a reorganization of the BOCs into seven regional holding companies ("RHCs"), including Telesis, and imposed restrictions on the business activities of the BOCs and their affiliates, successors and assigns. Among other things, the MFJ generally prohibits BOCs and their affiliates from providing voice and data services that cross LATAs. The MFJ also precludes BOCs and their affiliates from engaging in the design, development or manufacturing of telecommunications equipment or "customer premises equipment" such as cellular telephones or the provision of telecommunications equipment such as switches. The stated purpose of the MFJ was to prevent BOCs and their affiliated enterprises from using a BOC's asserted local exchange monopoly to discriminate against companies in other markets in which BOCs or their affiliates compete. Although the MFJ does not contain any provisions directly governing the termination of status as a BOC or BOC affiliate, the Company believes, based on the terms of the MFJ and its underlying policies, that it will not be bound by the MFJ after the planned Spin-off. This conclusion is consistent with the conclusion apparently reached in other transactions in which BOC affiliates or their assets have been sold. For example, BellSouth Corporation has sold or traded cellular properties to, among others, McCaw, United Telespectrum, Contel Cellular Inc., United States Cellular Corporation and ALLTEL Corporation, and NYNEX Corporation has sold its paging operations to Page America of New York, Inc. Neither the Federal District Court which administers the MFJ (the "Court") nor the United States Department of Justice ("DOJ") has, to the Company's knowledge, taken the position that the purchasers of these assets or affiliates are bound by the MFJ. By letter dated January 19, 1993, Telesis notified the DOJ of its planned Spin-off and advised the DOJ of its belief that the MFJ would not apply to the Company after the Spin-off. DOJ has not stated any intention to object to Telesis' position. There is no assurance, however, that DOJ or a third party might not object at some time in the future or that the Court would not interpret the MFJ contrary to Telesis' position. The Company will remain subject to the MFJ until the Spin-off by virtue of Telesis' ownership of Pacific Bell and Nevada Bell. The MFJ provides that the Court may waive certain of the restrictions on the BOCs and their affiliates. When a waiver is contested by the DOJ or AT&T, however, it will be granted only upon a showing that there is no substantial possibility that the BOC's market power could be used to impede competition in the markets it or its affiliate seeks to enter. If neither the DOJ nor any other party to the MFJ contests the waiver, then the Court should grant the requested waiver of these restrictions if it would serve the public interest. In the past, the Court has imposed conditions on waivers with respect to cellular and paging lines of business restricted by the MFJ. Telesis has been granted a number of waivers of the MFJ with regard to the cellular and paging services provided by the Company. For example, in November 1988, following the acquisition of certain cellular systems in the Detroit metropolitan area, Telesis was granted a waiver to allow it to operate the cellular system among the LATAs in Michigan and northwestern Ohio. In February 1993, Telesis was granted a waiver to allow New Par to provide interLATA cellular service in northern Ohio. While Telesis ultimately has been successful in obtaining each of the waivers it has requested on behalf of the Company, the waiver process is lengthy. ITEM 2. ITEM 2. PROPERTIES. For each market served by the Company's cellular operations, the Company maintains at least one sales or administrative office and many transmitter and antenna sites. Some of the facilities are leased, and some are owned. The Company also maintains both owned and leased sales and administrative facilities for its paging services. The Company believes that its facilities are suitable for its current business and that additional facilities will be available for its foreseeable needs. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is involved in legal proceedings that have arisen in the ordinary course of business. While complete assurance cannot be given as to the outcome of any litigation, the Company believes that with respect to such pending litigation, any financial impact or effect on the business of the Company would not be material. In addition, the Company may be subject to legal challenges and litigation from time to time in connection with matters under the jurisdiction of the FCC and state regulatory authorities with respect to its wireless businesses and with respect to requests for waivers from provisions of the MFJ. On November 24, 1993, a class action complaint was filed in Orange County Superior Court naming, among others, the Company, as general partner of Los Angeles SMSA Limited Partnership, and Los Angeles Cellular Telephone Company ("LACTC"). The complaint alleges that the Company and LACTC conspired to fix the prices of retail and wholesale cellular radio services in the Los Angeles market, and alleges damages for the class "in a sum in excess of $100,000,000." The Company filed a demurrer to the complaint on January 31, 1994 and at March 3, 1994, no discovery or other action had taken place. The Company intends to defend itself vigorously and does not expect that this proceeding will have a material adverse effect on its 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 quarter ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Common Stock has been listed on the New York and Pacific Stock Exchanges under the symbol PTW since the Company's initial public offering on December 2, 1993, and will be listed under the symbol "ATI" following the spin-off. The following table sets forth, for the periods indicated, the high and low sales prices of the Common Stock as reported in published financial sources. YEAR HIGH LOW ---- -------- -------- 1993: Fourth Quarter (December 3 $27 1/4 $24 3/4 to December 31) 1994: First Quarter (to March 4) $25 3/4 $21 As of March 4, 1994, there were 9,411 holders of record of the Company's Common Stock. Such number does not include persons whose shares are held of record by a broker or clearing agency, but does include such broker house or clearing agency as one recordholder. The Company currently intends to retain future earnings for the development of its business and does not anticipate paying cash dividends on its Common Stock in the foreseeable future. The Company's future dividend policy will be determined by its Board of Directors on the basis of various factors, including the Company's results of operation, financial condition, capital requirements and investment opportunities. In February 1994, Telesis as sole shareholder of record, approved the reincorporation of the Company in Delaware subject to the condition subsequent that the Board of Directors of the Company, after such further study as it deems necessary or appropriate, also shall have approved the reincorporation. If any such reincorporation in approved, the articles and bylaws of the new Delaware company are expected to be substantially the same as those of the Company immediately prior to any such reincorporation, except for such modifications, amendments or deletions as the Board of Directors determines are necessary to comply with Delaware law or which it deems necessary or appropriate and relate to provisions required under California but not Delaware law. The Board of Directors of the Company is expected to resolve by year-end 1994 whether to pursue such a reincoporation. Any such reincorporation would be subject to any necessary governmental approvals. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Set forth below are selected consolidated financial data with respect to the Company for each of the five fiscal years in the period ended December 31, 1993. The selected consolidated financial data at December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, have been derived from the consolidated financial statements included elsewhere herein and audited by Coopers & Lybrand as set forth in their report also included elsewhere herein. The selected consolidated financial data for the year ended December 31, 1990, has been derived from audited consolidated financial statements not included herein. The selected consolidated financial data as of December 31, 1990 and 1989, and for the year ended December 31, 1989, have been derived from unaudited consolidated financial statements not included herein. The selected consolidated financial data presented below should be read in conjunction with the consolidated financial statements and related notes thereto appearing elsewhere herein; note references below are to the notes to those consolidated financial statements. SUMMARY CONSOLIDATED STATEMENTS OF INCOME For the Year Ended December 31, ---------------------------------------------- 1993(1) 1992 1991(1) 1990 1989 -------- -------- -------- -------- -------- (Dollars in millions, except per share amounts) NET OPERATING REVENUES....... $988.0 $838.5 $753.2 $677.4 $536.4 TOTAL OPERATING EXPENSES..... 859.8 742.6 616.6 510.7 408.7 -------- -------- -------- -------- -------- OPERATING INCOME............. 128.2 95.9 136.6 166.7 127.7 Interest expense............. (22.1) (52.9) (37.6) (21.7) (17.2) Minority interests in net income of consolidated part- nerships and corporations.. (46.4) (45.5) (45.2) (38.1) (34.1) Equity in net income (loss) of unconsolidated partner- ships and corporations: Domestic................... 70.4 41.1 15.5 5.3 2.1 International.............. (37.5) (38.5) (21.4) (11.2) (2.8) Gain on sale of telecommuni- cations interests.......... 3.8 - 26.0 - - Other income (expense)....... 11.5 14.3 19.0 0.7 (1.1) -------- -------- -------- -------- -------- INCOME BEFORE INCOME TAXES, EXTRAORDINARY ITEM AND CUMULATIVE EFFECTS OF ACCOUNTING CHANGES......... 107.9 14.4 92.9 101.7 74.6 Income taxes................. 67.8 24.5 49.8 51.7 35.2 -------- -------- -------- -------- -------- INCOME (LOSS) BEFORE EXTRA- ORDINARY ITEM AND CUMULATIVE EFFECTS OF ACCOUNTING CHANGES ................... 40.1 (10.1) 43.1 50.0 39.4 Extraordinary item-loss from retirement of debt (net of income taxes of $5.1) (Note G) .................. - (7.6) - - - Cumulative effect of accounting change for postretirement costs in 1993 (net of income taxes of $3.5) (Notes A and J) and income taxes in 1992 (Notes A and H) ........... (5.6) 27.9 - - - -------- -------- -------- -------- -------- NET INCOME .................. $ 34.5 $ 10.2 $ 43.1 $ 50.0 $ 39.4 ======== ======== ======== ======== ======== Income per share before Extraordinary item and cumulative effects of accounting changes ........ $ 0.09 $(0.02) $ 0.10 $ 0.12 $ 0.09 ======== ======== ======== ======== ======== Weighted average shares outstanding (in millions).. 429.6 424.0 424.0 424.0 424.0 ======== ======== ======== ======== ======== SUMMARY CONSOLIDATED BALANCE SHEETS For the Year Ended December 31, ------------------------------------------------ 1993(1) 1992 1991(1) 1990 1989 -------- --------- --------- --------- --------- (Dollars in millions) Total assets .............. $4,076.7 $2,371.1 $1,900.1 $1,433.2 $1,173.0 Total long-term obligations .. $ 78.9 $ 257.3 $ 276.0 $ 225.1 $ 220.2 Total shareholders' equity. $3,337.3 $ 752.1 $ 635.2 $ 644.6 $ 613.8 Working capital (deficit).. $1,346.8 $ (698.4) $ (426.3) $ (147.4) $ (41.5) Capital expenditures, excluding acquisitions .. $ 225.9 $ 231.0 $ 230.2 $ 241.3 $ 263.7 (1) In 1991 and 1993, the Company contributed net cellular assets totaling $330.0 million to the New Par joint venture and net cellular assets totaling $206.0 million to the CMT Partners joint venture, respectively. See Note E "Joint Ventures and Acquisitions," under Cellular Communications, Inc. and McCaw Cellular Communications, Inc. The effect of these transactions was a reduction in the individual assets and liabilities and income statement accounts, and the reporting of income and expense associated with these assets in the line item entitled "Equity in net income (loss) of unconsolidated partnerships and corporations: Domestic." SELECTED REPORTS OF OPERATIONS The following table sets forth unaudited, supplemental financial data for the Company's total, domestic cellular, and domestic paging operations. The table reflects the proportionate consolidation of each cellular entity in which the Company has or shares operational control and excludes certain minority investments, principally the Company's investments in cellular systems serving Dallas/Fort Worth, Las Vegas and Tucson, for which the Company does not receive timely financial and operating data and which in total represented approximately five percent of its proportionate domestic cellular operating income in 1993. Domestic Paging is 100% owned. This table does not include any data for the Company's international cellular and paging operations, except for the Selected Total Proportionate Data. TOTAL PROPORTIONATE DATA (1,2) For the Year Ended December 31, -------------------------------- 1993 1992 1991 ---------- --------- ---------- (Dollars in millions) Total proportionate net operating revenues. $1,226.1 $ 873.2 $ 687.0 Total proportionate operating cash flow.... $ 351.5 $ 191.5 $ 223.9 Selected Proportionate Domestic Cellular Operating Results (1,2) For the Year Ended December 31, -------------------------------- 1993 1992 1991 ---------- --------- ---------- (Dollars in millions) Cellular service and other revenues ....... $ 892.0 $ 699.4 $ 564.6 Equipment sales ........................... $ 40.2 $ 24.8 $ 19.3 Cost of equipment sales ................... $ (42.2) $ (23.9) $ (18.4) Net operating revenues .................... $ 890.0 $ 700.3 $ 565.5 Total operating expenses .................. $ 675.1 $ 545.3 $ 412.3 Operating income .......................... $ 214.9 $ 155.0 $ 153.2 Operating cash flow ....................... $ 379.6 $ 279.1 $ 246.9 Capital expenditures, excluding acquisitions ............................ $ 198.4 $ 199.8 $ 159.6 CELLULAR OPERATING DATA For the Year Ended December 31, ---------------------------------- 1993 1992 1991 ---------- ---------- ---------- Domestic POPs(3)............................ 34,889,000 34,121,000 32,560,000 POPs in controlled markets(4)...... 33,595,000 32,264,000 30,806,000 Proportionate subscribers(5)....... 1,046,000 744,000 558,000 Penetration(6)..................... 3.1% 2.3% 1.8% Controlled markets(7).............. 51 42 41 Total markets(8)................... 61 55 54 International POPs(9)............................ 40,401,000 35,347,000 24,991,000 Proportionate subscribers(10)...... 159,600 35,200 0 Countries(11)...................... 4 3 2 SELECTED DOMESTIC PAGING OPERATING RESULTS For the Year Ended December 31, ---------------------------------- 1993 1992 1991 ---------- --------- --------- (Dollars in millions) Paging service and other revenues...... $145.7 $113.5 $ 92.6 Equipment sales........................ $ 35.2 $ 22.2 $ 9.7 Cost of equipment sales................ $(31.9) $(19.2) $ (7.4) Net operating revenues................. $149.0 $116.5 $ 94.9 Total operating expenses............... $129.3 $100.3 $ 79.6 Operating income....................... $ 19.7 $ 16.2 $ 15.3 Operating cash flow (2)................ $ 50.3 $ 42.5 $ 38.7 Capital expenditures, excluding acquisitions......................... $ 53.4 $ 42.9 $ 34.8 PAGING OPERATING DATA For the Year Ended December 31, ---------------------------------- 1993 1992 1991 ---------- --------- --------- Domestic Units in service (12)............... 1,167,000 821,000 601,000 Markets (13)........................ 100 81 60 International Proportionate units in service (14). 101,200 78,200 68,200 Countries (15)...................... 3 2 1 ------------------------ (1) Significant assets of the Company are not consolidated, and because of the substantial effect of the formation of certain joint ventures on the year-to-year comparability of the Company's consolidated financial results, the Company believes that proportionate operating data and results facilitate the understanding and assessment of its consolidated financial statements. Unlike consolidated accounting, proportionate accounting is not in accordance with generally accepted accounting principles for the cellular industry. Proportionate accounting reflects the relative weight of the Company's ownership interests in its domestic cellular systems. (2) Total proportionate operating revenues net of cellular and paging costs of equipment sales and total proportionate operating cash flow. Total proportionate operating cash flow equals proportionate operating income plus depreciation and amortization. Proportionate amounts are computed by multiplying the entities' total amount by the Company's interests in the entities. The total proportionate amount includes proportionate domestic cellular, 100% domestic paging, 100% Teletrac, 100% headquarter's costs and the Company's proportionate interests in MMO, Telecel and NordicTel. Proportionate domestic cellular operating results represent the Company's interests in the entities multiplied by the entities' operating data. (3) "POPs" for domestic cellular markets means the population of a Federal Communications Commission ("FCC") licensed cellular market based on Donnelly Marketing Information Service population estimates for counties comprising such market, multiplied by the Company's ownership interest in the cellular licensee operating in such market as of the date specified. (4) POPs in controlled markets include only POPs of Controlled Cellular Systems (i.e., those cellular systems that are included in Selected Proportionate Domestic Cellular Operating Results). (5) Aggregate number of subscribers to Controlled Cellular System multiplied by the Company's ownership interest in the operator of such systems. Excludes subscribers to cellular systems in which the Company has an ownership interest but does not have or share operational control. (6) Proportionate subscribers to the Company's Controlled Cellular System divided by the Company's POPs in such Controlled Cellular Systems. (7) Number of Metropolitan Statistical Areas ("MSAs") and Rural Service Areas ("RSAs") in which the Company has a Controlled Cellular System. (8) Number of MSAs and RSAs in which the Company owns an interest in a cellular system. (9) International POPs is based upon mid-1992 estimated population of the licensed cellular market, multiplied by the Company's ownership interest in the cellular licensee operating in such market as of the date specified and includes POPs for networks under construction. Includes POPs represented by a 2.25% interest in the Company's cellular system in Germany which, under the terms of the cellular license, the Company is under a current obligation to sell to small and medium-sized German businesses. (10) Total subscribers to all cellular systems outside the United States in which the Company owns an interest multiplied by the Company's ownership interest. Includes proportionate subscribers represented by a 2.25% interest in the Company's cellular system in Germany which, under the terms of the cellular license, the Company is under a current obligation to sell to small and medium-sized German businesses. (11) Number of countries outside the United States in which the Company owns an interest in a cellular system that is in operation or under construction. (12) The 1993 amount includes 22,000 units that were purchased through a fourth quarter acquisition. (13) Number of markets in which the Company provides paging services. (14) Total units in service of all paging systems outside the United States in which the Company owns an interest multiplied by the Company's ownership interest. (15) Number of countries outside the United States in which the Company owns an interest in a provider of paging services. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL The following discussion is intended to facilitate the understanding and assessment of significant changes and trends related to the results of operations and financial condition of AirTouch Communications ("the Company"). This discussion and analysis should be read in conjunction with the Company's consolidated financial statements and notes. CONSOLIDATION VS. EQUITY METHOD OF ACCOUNTING. For financial statement reporting purposes, the Company consolidates each wireless subsidiary and partnership in which it has a controlling interest. Therefore, in addition to the Company's wholly owned cellular systems in San Diego and Atlanta, the Company consolidates the entities that hold the licenses for cellular systems operating in Los Angeles and Sacramento. The Company also consolidated the partnership which operates a cellular system in the San Francisco and San Jose markets prior to the closing of the partnership with McCaw ("CMT Partners") in September 1993. In addition, the Company consolidates its domestic paging operations, all of which are wholly owned, PacTel Teletrac ("Teletrac"), a 51%-owned partnership offering vehicle location service in six markets in the United States, NordicTel Holdings AB ("NordicTel"), a 51%-owned cellular network in Sweden, its paging subsidiaries in Thailand, and the Korean subsidiary providing credit card verification system sale and support. Revenues, expenses, assets and liabilities of consolidated entities are reflected in the corresponding line items in the Company's consolidated financial statements. The Company's consolidated financial statements during the period from January 1, 1991 through March 31, 1992 also reflect the consolidation of International Teletrac Systems ("ITS"), a corporation owned by the minority partner in Teletrac. While the Company did not own an equity interest in ITS or its assets prior to March 31, 1992, the Company believes that consolidation of ITS is appropriate under applicable accounting guidelines as a result of the Company's guarantee of ITS' substantial indebtedness during such period. The Company had agreed to guarantee ITS' debt as part of the arrangement under which Teletrac acquired an option to purchase the assets of ITS. At March 31, 1992, the Company had guaranteed bank loans totaling $49.5 million, the proceeds of which had been used to fund ITS' capital expenditures and start-up operating losses. This note has since been retired. Teletrac exercised its option to acquire the assets of ITS effective March 31, 1992. The exercise of such option had been prohibited prior to the generic waiver of the MFJ's information services restrictions in July 1991. The equity method of accounting is generally used to account for the operating results of entities over which the Company has significant influence but in which it does not have a controlling interest. These entities primarily include the partnership with CCI ("New Par"), CMT Partners (commencing in September 1993), and certain international interests, including Mannesmann Mobilfunk GmbH ("MMO") and Telecel Comunicacoes Pessoais, S.A. ("Telecel"). With respect to the entities accounted for under the equity method, the Company recognizes its proportionate share of the net income (loss) of each such entity in the line item entitled "Equity in net income (loss) of unconsolidated partnerships and corporations." The revenues and expenses of such entities are not otherwise reflected in the Company's consolidated financial statements. Prior to the formation of New Par in August 1991, the operations of the Company's cellular systems in Michigan and northwestern Ohio were consolidated. The use of the equity method to account for New Par since its formation has reduced the growth of the Company's reported revenues and expenses. The formation of CMT Partners in September 1993 had a similar effect in the third and fourth quarters of 1993. PROPORTIONATE ACCOUNTING. Because significant assets of the Company are not consolidated and because of the substantial effect of formation of New Par and CMT Partners on the year-to-year comparability of the Company's consolidated financial results, the Company believes that proportionate operating data facilitates the understanding and assessment of its consolidated financial statements. Unlike consolidation accounting, proportionate accounting is not in accordance with generally accepted accounting principles ("GAAP") for the cellular industry. Proportionate accounting reflects the relative weight of the Company's ownership interests in its domestic cellular systems. For example, under GAAP, 100% of the operating revenues and expenses of the Los Angeles cellular system would be included in the respective line items in the Company's consolidated financial statements with 16% of the net income from the system included in the line item entitled "Minority interests in consolidated partnerships and corporations." By contrast, under proportionate accounting, only 84% of such system's revenues and expenses would be included. In addition, under proportionate accounting, the Company includes its share of revenues and expenses of equity investments in which it shares control. For example, 50% of the revenues and expenses of New Par, as well as an additional interest reflecting the Company's ownership of equity in CCI, would be included. A discussion of the Company's domestic cellular results of operations on a proportionate basis is set forth below under "Proportionate Results of Operations." RESULTS OF OPERATIONS NET OPERATING REVENUES. The following table sets forth the components of the Company's net operating revenues for each of the last three years. Year Ended December 31, ------------------------------- 1993 1992 1991 --------- --------- --------- (Dollars in millions) NET OPERATING REVENUES Wireless services and other revenues: Cellular service ...................... $787.0 $681.7 $625.4 Paging service ........................ 148.7 117.9 98.0 Vehicle location service .............. 4.0 2.4 0.7 Other revenues ........................ 47.6 32.8 25.4 --------- --------- --------- 987.3 834.8 749.5 --------- --------- --------- Net cellular and paging equipment sales: Revenues .............................. 70.4 45.4 31.6 Costs of equipment sold ............... (69.7) (41.7) (27.9) --------- --------- --------- 0.7 3.7 3.7 --------- --------- --------- Net operating revenues .................. $988.0 $838.5 $753.2 ========= ========= ========= CELLULAR SERVICE. Cellular service revenues primarily consist of air time, access fees, and in-bound roaming charges. Cellular service revenues increased by 15.4% from 1992 to 1993 and by 9.0% from 1991 to 1992. The increase in cellular service revenues in both 1993 and 1992 was primarily due to continued domestic subscriber growth. On a percentage basis, subscriber growth in Southern California lagged behind the Company's other markets in 1992 as a result of the severity of the economic recession in Southern California. However, the Company's Los Angeles cellular system experienced a dramatic increase in the number of subscribers from the fourth quarter of 1992 through 1993 in response to advertising and promotional campaigns which commenced in September 1992. The increase in cellular service revenues did not keep pace with subscriber growth because of declining average revenue per subscriber, caused by lower usage by new subscribers and rate reductions made in 1993 to meet competitive pressures. The Company expects that average revenue per subscriber will continue to decline as it adds new subscribers and responds to further competitive pressures. Reported revenues also were affected by the formation of both New Par in August 1991 and CMT Partners in September 1993. Since the formation of each partnership, the Company's share of the net income has been recorded in "Equity in net income (loss) of unconsolidated partnerships and corporations." The change from consolidation to the equity method of accounting for these partnerships decreased 1993, 1992, and 1991 cellular service revenues by $232.9 million, $138.8 million, and $51.3 million, respectively, from what would have been reported had the Company been able to include in its revenues a 50% share of New Par's and CMT Partners' revenues. This change similarly increased "Equity in net income (loss) of unconsolidated partnerships and corporations" by $64.3 million, $34.5 million, and $9.1 million, respectively. PAGING SERVICE. Paging service revenues primarily consist of paging service charges and rentals of paging units in the United States and, to a small extent, Thailand. Paging service revenues increased 26.1% in 1993 and 20.3% in 1992, as compared to the previous year. Such increases in paging service revenues primarily resulted from 42.1% and 36.6% increases in the number of domestic paging units in service in 1993 and 1992, respectively, as compared to the previous year. The increases in domestic paging units in service reflect increased penetration in existing markets primarily through successful retail and reseller pager sales programs, the establishment of new paging operations, and the purchase of Front Page, adding approximately 22,000 units. With the acquisition of Front Page, the Company entered the Salt Lake City paging market and further expanded its existing substantial customer base in Northern California, San Diego, Los Angeles, Phoenix, and Tucson. The effect of the growth in paging units in service on revenues was offset in part by the decrease in the average revenue per paging unit in service, due to the increase in customer owned and maintained units (i.e., a corresponding loss in lease and maintenance revenues) as pager prices declined, and reduced contract prices to match competition. The decline in average revenue per paging unit is expected to continue. VEHICLE LOCATION SERVICE. Vehicle location service revenues from Teletrac primarily consist of charges on corporate fleet tracking and stolen vehicle tracking services. Teletrac's vehicle location business is in the start-up phase and its services have not yet achieved a significant degree of commercial acceptance. Teletrac initiated operations in Los Angeles, Chicago, Detroit, and Dallas/Fort Worth in 1991 and in Miami and Houston in 1992. Teletrac's vehicle location service revenues were $4.0 million in 1993, $2.4 million in 1992, and $0.7 million in 1991. OTHER REVENUES. Other revenues consist of cellular equipment rental and installation charges, pager replacement program revenues, paging voice retrieval revenues, paging activation charges, vehicle location unit sales and revenues related to credit card verification terminal sales and maintenance. Other revenues increased 45.1% and 29.1% in 1993 and 1992, respectively. The increases in both years are due to higher vehicle location unit sales, paging activation and voice retrieval charges, and credit card verification sales and maintenance charges. NET PAGING AND CELLULAR EQUIPMENT SALES. Equipment sales consist of revenues from sales of cellular telephones and sales of paging units. Equipment sales are not a primary part of the Company's cellular and paging businesses and therefore the costs associated with these sales have been removed from the cost of revenues and netted with equipment sales in the revenue section of the income statement. All prior periods have been revised to conform to this presentation format. The increase in equipment sales in 1993 and 1992 is attributable to increases in sales of paging units and, to a lesser extent, sales of cellular telephones. The Company sells cellular telephones at or below cost and paging units approximately at cost. OPERATING EXPENSES. The following table sets forth the components of the Company's operating expenses for each of the last three years. Year Ended December 31, --------------------------------- 1993 1992 1991 ---------- --------- --------- (Dollars in millions) OPERATING EXPENSES Cost of revenues...................... $144.0 $132.7 $110.5 Selling and customer operations expenses............................ 291.3 262.9 201.5 General, administrative, and other expenses............................ 250.3 203.6 174.6 Depreciation and amortization......... 174.2 143.4 130.0 ---------- --------- --------- Total operating expenses.............. $859.8 $742.6 $616.6 ========== ========= ========= COST OF REVENUES. Cost of revenues primarily consists of charges for interconnections of the Company's cellular and paging operations with wireline telephone companies and other network-related expenses. As a percentage of net operating revenues, cost of revenues remained relatively constant at 14.6%, 15.8%, and 14.7% in 1993, 1992, and 1991, respectively. The 1993 improvement was due to reassessment of property taxes and lower interconnect charges. Cost of revenues increased 8.5% in 1993 and 20.1% in 1992 as compared to the previous year as a result of the interconnection and other charges generated by the Company's increased wireless services customer base. Reported cost of revenues were also affected by the formation of both New Par in August 1991 and CMT Partners in September 1993. This change decreased cost of revenues by $30.1 million and $19.3 million in 1993 and 1992, respectively. SELLING AND CUSTOMER OPERATIONS EXPENSES. Selling and customer operations expenses primarily consist of compensation to sales channels, salaries, wages, and related benefits for sales and customer service personnel, and billing, advertising, and promotional expenses. As a percentage of net operating revenues, these expenses were 29.4%, 31.4%, and 26.8% in 1993, 1992, and 1991, respectively. The decrease in 1993 was primarily attributable to increased revenues from the larger subscriber base and cost containment initiatives particularly in the Company's domestic billing operations. This was partially offset by an increase in agent commissions resulting from the increase in new cellular subscribers and the increase in marketing and promotional expenses which commenced in 1992. The 1992 increase similarly reflects commissions paid for new cellular subscribers, expenses associated with new marketing efforts, and other business development initiatives. In particular, in both years, there were significant increases in commission expenses in the fourth quarter as a result of a large increase in the number of cellular subscribers during the quarter, with the related increases in revenue from the new subscribers not being realized until after year-end. In addition, as penetration of the consumer market increases, the most recently added cellular subscribers typically generate less average revenue per subscriber than existing subscribers. The 1992 increase in marketing and promotional expenses was substantial, particularly in the Company's Los Angeles and Atlanta markets. The Company expects to continue to have various promotional programs and marketing efforts in the future. In addition, billing expenses increased substantially during 1992 due to hardware and software upgrades in the billing system employed by the Company in its Los Angeles, Atlanta, and Sacramento cellular markets and its retail reseller operation in the San Francisco Bay Area. These upgrades were made in part to support the Company's rapid cellular subscriber growth. The Company expects continued investment in the billing system will be required to support subscriber growth, as well as, new cellular products and services. These investments are not expected to result in higher per subscriber costs, which should be at or below 1993 levels. The Company continues to explore more efficient billing delivery options. GENERAL, ADMINISTRATIVE, AND OTHER EXPENSES. General, administrative, and other expenses primarily consist of salaries and wages and related benefits for general and administrative personnel, international license application costs, and other overhead expenses. As a percentage of net operating revenues, these expenses were 25.3%, 24.3%, and 23.2% in 1993, 1992, and 1991, respectively. The increase in 1993 was primarily due to organizational and other costs associated with the spin-off, including a $5.0 million after-tax spin-off related reserve and increased start-up expenses relating to the development of wireless data services. In addition, the Company experienced an increase in bad debt expense as a percentage of revenues in 1993 in most of its markets; the Los Angeles market was particularly affected as a result of the lingering recession in Southern California. In response, the Company has initiated different means to limit exposure (e.g., prepayment for service and credit limits for high risk customers) while promoting subscriber growth. Increased expenses were partially offset by cost containment initiatives. The increase in 1992 from the previous year was primarily due to greater costs associated with the Company's pursuit of international license awards and expenses associated with investments in new products and services, such as wireless data. Increased start-up expenses for Teletrac's vehicle location operations also contributed to the increase. The Company expects that its selling and customer operations expenses and general, administrative, and other expenses as a percentage of net operating revenues will increase as a result of the reduction from 61.1% to 47.0% in the Company's interest in the San Francisco/San Jose cellular system following the formation of CMT Partners on September 1, 1993. The Company also expects that it will experience additional expenses as it begins to perform, as a separate publicly traded company in connection with the planned spin-off, certain corporate functions previously provided to the Company by Pacific Telesis Group ("Telesis"). The Company estimates $15.0 million in incremental operating expenses in 1994 for these activities. This, combined with the costs of supporting the Company's anticipated growth, including entry into new business opportunities, is expected to cause general, administrative, and other expenses to continue increasing as a percentage of net operating revenues. DEPRECIATION AND AMORTIZATION. Depreciation and amortization primarily consist of depreciation expense on the Company's domestic cellular and paging networks, as well as amortization of intangibles such as FCC license costs and goodwill. The increase in depreciation and amortization expense for 1993 and 1992 mainly reflects increased capital investment in the Company's domestic cellular network. The planned deployment of digital technology in the Company's domestic cellular markets is expected to have minimal impact on depreciation expense since most of the analog equipment will be redeployed in other areas or used in parallel systems needed for compatibility with existing customer equipment. The Company has negotiated to purchase network assets currently in service in the Dallas/Fort Worth market. As a result, depreciation expense will be lower than if the assets had been purchased new. NON-OPERATING INCOME (EXPENSE). The following table sets forth the components of the Company's non-operating income (expense) for each of the last three years: Year Ended December 31, -------------------------------- 1993 1992 1991 --------- --------- --------- (Dollars in millions) Interest expense....................... $(22.1) $(52.9) $(37.6) Minority interests in net income of consolidated partnerships and corporations..................... $(46.4) $(45.5) $(45.2) Equity in net income (loss) of unconsolidated partnerships and corporations: Domestic........................... $ 70.4 $ 41.1 $ 15.5 International...................... (37.5) (38.5) (21.4) --------- --------- --------- $ 32.9 $ 2.6 $ (5.9) ========= ========= ========= Interest income........................ $ 12.0 $ 13.3 $ 13.8 ========= ========= ========= Gain on sale of telecommunications interests............................ $ 3.8 - $ 26.0 ========= ========= ========= Miscellaneous income (expense)......... $ (0.5) $ 1.0 $ 5.2 ========= ========= ========= INTEREST EXPENSE. The $30.8 million decrease in interest expense in 1993 compared to the 1992 period primarily resulted from lower borrowings from PacTel Capital Resources ("PTCR") due to $1,179.8 million in equity contributions from Telesis. Interest expense increased in 1992 over the prior year primarily due to increased borrowings from PTCR used to fund construction costs and start-up losses for international joint ventures, the Company's purchases of equity in CCI, and start-up losses for Teletrac. The Company's indebtedness to PTCR totaled $0.3 million and $958.4 million at December 31, 1993 and 1992, respectively. At December 31, 1993, the debt outstanding on the note assumed by the Company as part of the NordicTel acquisition was $50.1 million. See Note G to the Consolidated Financial Statements of AirTouch Communications and Subsidiaries. Interest expense incurred during each of the periods presented will not be indicative of future expense. During 1993, Telesis settled the Company's tax benefits receivable arising from the tax losses utilized in the Telesis consolidated tax returns which the Company used to eliminate some of its indebtedness to PTCR. The Company used the equity contributions received from Telesis during 1993 to substantially eliminate its remaining indebtedness to PTCR. The Company believes that the net proceeds from the Initial Public Offering ("IPO"), together with cash flow from operations, will be sufficient to satisfy the Company's estimated funding requirements through mid-1995. See "Liquidity and Capital Resources." MINORITY INTERESTS IN NET INCOME OF CONSOLIDATED PARTNERSHIPS AND CORPORATIONS. The minority partners' portions of net income in consolidated partnerships and corporations are reported as "Minority interests in net income of consolidated partnerships and corporations." The increases in 1993 and 1992 are primarily attributable to better operating results for these partnerships and corporations. These increases were partially offset by the effect of the change from consolidation to equity method of accounting as a result of the formation of New Par and CMT Partners. EQUITY IN NET INCOME (LOSS) OF UNCONSOLIDATED PARTNERSHIPS AND CORPORATIONS. DOMESTIC. Domestic equity earnings increased in 1993 and 1992 over the prior year period primarily as a result of the inclusion of New Par commencing August 1, 1991 and CMT Partners commencing September 1, 1993. For at least the near term, equity earnings attributable to CMT Partners are likely to be less than the Company's prior share of the net income of the cellular systems which the Company contributed to the partnership. INTERNATIONAL. The decrease in international equity losses in 1993 was primarily due to lower losses incurred by MMO, partially offset by higher losses for cellular operations in Portugal and systems under construction in Japan, and paging systems in Portugal and Spain. In 1992, international equity losses increased due to the commencement of recognition of equity losses from Telecel and the Company's cellular systems under construction in Japan, and due to higher operating losses from the start-up of MMO. The international equity losses in 1992 were partially offset by $32.0 million in tax benefits recognized as a result of the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). The adoption of SFAS 109 had a similar earnings impact in 1993, resulting in a $20.7 million reduction in equity losses, due to a reduction in the German corporate tax rate. The deferred tax benefits recognized by MMO were lower in 1993. See "Income Taxes." Fluctuations in currency exchange rates will affect the equity earnings and losses from the Company's international ventures. For example, a significant weakening against the dollar of the currency of a country in which the Company's venture is generating net income would adversely affect the Company's results, although conversely it could reduce the Company's start-up losses. INTEREST INCOME. The Company's interest income in each of the periods presented was primarily the result of the interest earned on amounts loaned to an affiliate and interest earned by the San Francisco/San Jose cellular system. In 1993, interest income also reflected earnings on IPO proceeds, and in 1991, interest on an Internal Revenue Service tax settlement relating to 1987. The affiliated loan was settled during the third quarter of 1993 and the interest earned by the San Francisco/San Jose cellular system is no longer reflected in this account subsequent to the September 1, 1993 formation of CMT Partners, which is accounted for under the equity method. The Company expects to continue to earn interest income on the investment of the net proceeds from the IPO prior to their application, and therefore, interest income is expected in the near term to be higher than in 1993. GAIN ON SALE OF TELECOMMUNICATIONS INTERESTS. The 1991 gain of $26.0 million resulted from the sale of the Company's cellular holdings in St. Louis and the sale of the Company's interest in a personal communication services ("PCS") licensee in the United Kingdom. The $3.8 million gain in 1993 resulted from the sale of small interests in three wireline cellular systems in the San Francisco Bay Area. FCC rules required the Company to sell its interests in two of the three systems because the Company acquired interests in competing non-wireline carriers as a result of the formation of CMT Partners. MISCELLANEOUS INCOME (EXPENSE). Miscellaneous income (expense) primarily consists of currency exchange gains or losses on financial instruments which have not been deferred and one-time items such as gains or losses on sales of property, plant, or equipment. Such income in 1991 included $12.0 million received in settlement of litigation. The $0.5 million loss in 1993 primarily represented currency exchange losses of $3.4 million, which were partially offset by a $3.0 million net settlement gain due to an early retirement election by the employees of a joint venture who participated in the Company's qualified defined benefit plan. (See Note I to the Consolidated Financial Statements of AirTouch Communications and Subsidiaries.) The Company attempts to mitigate the effects of foreign currency fluctuation through the use of hedges and local banking accounts. At December 31, 1993, the Company had hedged a majority of its international investments against the risk of currency fluctuations. Certain of these hedge instruments do not qualify, in whole or in part, as hedges for financial accounting purposes. Accordingly, the Company is required to recognize the currency exchange gain or loss on these hedge instruments in the current period results of operations. The Company is unable to determine the impact of future currency exchange gains and losses. INCOME TAXES. The Company's income tax expenses and effective tax rates for 1993, 1992, and 1991 were $67.8 million (62.8%), $24.5 million (170.1%), and $49.8 million (53.6%), respectively. The effective tax rates for all such periods were primarily affected by the international equity losses of unconsolidated partnerships and corporations and ITS' losses prior to March 31, 1992, for which no U.S. tax provisions were made. See Note H to the Consolidated Financial Statements of AirTouch Communications and Subsidiaries for a detailed reconciliation of the effective tax rates to statutory rates. Effective January 1, 1992, the Company adopted SFAS 109. The use of the new rules resulted in a $59.8 million tax benefit to 1992 reported earnings. On the 1992 Statement of Income, $32.0 million of this increase is reflected in equity earnings and $27.9 million as the cumulative effect of an accounting change, offset by $0.1 million as income tax expense. The adoption of SFAS 109 had a similar impact in 1993, resulting in a $20.7 million reduction in equity losses. Financial statements of prior years before the effective date were not restated as permitted by SFAS 109. No deferred tax assets were recorded on the Company's books. Instead, the deferred tax assets were recorded on the joint ventures' books based on the applicable foreign tax rates as an adjustment to convert to U.S. GAAP. The Company recorded its share of the operating losses which reflected these tax benefits. At December 31, 1993, the Company had deferred tax assets and liabilities of $33.4 million and $205.9 million, respectively. A valuation allowance of $4.8 million has been provided for deferred tax assets. The Company believes that it is more likely than not that the future benefits from the remaining deferred tax assets will be realized in full. Of the $20.7 million tax benefit related to international equity earnings in 1993, approximately 58% ($12.0 million) is attributable to the tax benefits recorded by MMO for its net operating losses ("NOLs"). SFAS 109 requires that the tax benefit of such operating losses be recorded as an asset to the extent that management assesses the utilization of such losses to be "more likely than not." Accordingly, these assets represent the future realization of tax benefits to be gained by deducting current MMO operating losses from future taxable income. Although MMO has not yet reached break-even, the Company and MMO believe it is more likely than not that MMO will generate sufficient taxable income in the future to utilize its accumulated NOLs. Through December 31, 1993, MMO had accumulated NOLs of approximately $384.6 million (adjusted for U.S. GAAP and translated at December 31, 1993 spot rate), of which the Company's share is approximately $109.5 million. The Company's belief that MMO will produce taxable income sufficient to utilize its NOLs is based on the following facts and assumptions. MMO's current operating losses result from it being in the initial phase of its operations. In this initial phase, MMO is incurring substantial selling and marketing costs while building its subscriber base. At December 31, 1993 MMO had approximately 493,000 subscribers. It added, on average, more than 30,000 subscribers each month in 1993. At this rate MMO would reach break-even by mid-1994, at which time it would have over 600,000 subscribers. This represents a market penetration rate for MMO of approximately 0.7% on an estimated total German cellular market penetration of 2.3% to 2.5%. Market penetration is the percentage of Germany's population of approximately 80.2 million that subscribes to cellular service. Based on such number of subscribers and assuming an average revenue per subscriber of $112 per month, MMO's total revenues by mid-1994 would be in excess of $300 million. At this growth rate, MMO's accumulated NOLs would be fully utilized by the end of 1996, at which time its subscriber base would be over 1,300,000. Based on such number of subscribers and assuming an average revenue per subscriber of $90 per month, MMO's total revenues in 1996 would be approximately $1.4 billion. If subscriber growth dropped as low as 5,000 per month after MMO's operations reach break-even in mid-1994, MMO's NOLs would still be fully utilized by 1996. Under German tax law, NOLs can be carried forward indefinitely. The Company also has available to it tax planning strategies that would allow it to realize a United States tax benefit from MMO's losses. These strategies primarily involve the sale of all or part of its investment in MMO. In such a sale, the excess of tax basis over book basis in this investment would create either a lower tax gain or a greater tax loss than book gain or loss (depending on the sales price), thereby recognizing the deferred tax asset. If the sale were to result in a capital loss due to an unexpectedly low sales price, the Company has available to it sale or leaseback transactions for various other properties that could generate capital gain sufficient to offset any possible capital loss. However, because applicable tax rates in the United States are lower than in Germany, the United States tax benefit at December 31, 1993 would be approximately $38.3 million, which is $10.3 million less than the German tax benefit reflected in the Company's financial statements, including the impact of foreign currency translation. In July 1993, the German Parliament passed the German Tax Act of 1994 which, among other things, decreases the corporate tax rate on distributed earnings effective January 1, 1994. Accordingly, as required by SFAS 109, the deferred tax benefits recognized by MMO were adjusted downward to reflect the lower tax rate. The Company's share of the adjustment reduced net income by approximately $3.1 million in 1993. While the Company believes that it is more likely than not that the recorded deferred tax benefits will be fully realized, there can be no assurance that this will happen as certain factors beyond control of the joint ventures and the Company, such as worsening local economic conditions and increasing competition, can affect future levels of taxable income. In August 1993, the United States government enacted the Omnibus Budget Reconciliation Act of 1993, which incorporates new business tax provisions. These include an increase in the corporate tax rate from 34% to 35% retroactive to January 1, 1993. The Company's adjustment for the change in tax rate reduced net income by $4.4 million in 1993. INCOME (LOSS) BEFORE EXTRAORDINARY ITEM AND CUMULATIVE EFFECTS OF ACCOUNTING CHANGES. The Company reported income (loss) before extraordinary item and cumulative effects of accounting changes of $40.1 million, $(10.1) million, and $43.1 million (which included a $26.0 million pre-tax gain on the sale of wireless interests) for 1993, 1992, and 1991, respectively. The increase in income in 1993 was primarily due to increased cellular and paging revenues, cost containment initiatives, and decrease in interest expense, partially offset by additional agent commissions resulting from the increase in new cellular subscribers, expenses related to the spin-off, and start-up losses from wireless data service. The 1992 loss was primarily the result of increasing start-up losses from the Company's international wireless ventures, interest expenses related to the Company's international investments, expenses associated with the Company's international license applications, and operating losses from Teletrac. The Company experiences fraud in all of its markets. Costs of this fraud, which are common throughout the industry, include variable interconnect costs of usage, costs related to preventive measures, and payments to other carriers for unbillable fraudulent roaming activity. The Company is unable to quantify the costs of fraud. The incidence of fraud is generally increasing, particularly in the Los Angeles market. The Company is implementing measures to identify and block fraudulent usage. Teletrac (including ITS) reported pre-tax losses of $41.6 million, $49.1 million, and $36.8 million during 1993, 1992, and 1991, respectively. The Company does not expect Teletrac's operations to be profitable for several years. The Company intends to take actions to reduce Teletrac's operating losses and does not intend to expand Teletrac's operations significantly until its services achieve a higher level of commercial acceptance. In February of 1994, the Company reduced Teletrac's staff by 30% to approximately 200 employees. The Company is continuously evaluating and considering other commercial applications of its technology and radio location spectrum. The Company is currently pursuing opportunities to expand its wireless operations in international markets and intends to participate actively in the license application process for PCS in the United States. The Company will continue its efforts to grow and develop its wireless data operations. To the extent that the Company is successful in its pursuit of new wireless licenses and its development of wireless data operations, the Company will incur start-up expenses which, at least in the short-term, will have a dilutive effect on the Company's future earnings. EXTRAORDINARY ITEM. The extraordinary item recorded by the Company in 1992 is the result of a $12.7 million early redemption expense related to the refinancing of $100 million of long-term debt. The debt was retired with short-term funding provided by PTCR. CUMULATIVE EFFECT OF ACCOUNTING CHANGE. The Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective January 1, 1993 and recognized $5.6 million (net of $3.5 million tax benefit) transition obligation. See "Effects of Recently Issued Accounting Standards." PROPORTIONATE RESULTS OF OPERATIONS The following table sets forth unaudited, supplemental financial and operating data for the Company's domestic cellular operations. The table reflects the proportionate consolidation of each cellular entity in which the Company has or shares operational control and excludes certain minority investments, principally the Company's investments in cellular systems serving Dallas/Fort Worth, Las Vegas and Tucson, for which the Company does not timely receive financial and operating data and which in total represented approximately 5% of its proportionate domestic cellular operating income in 1993. SELECTED PROPORTIONATE DOMESTIC CELLULAR OPERATING DATA (1) Year Ended December 31, ------------------------------- 1993 1992 1991 --------- ---------- ---------- (Dollars in millions) OPERATING RESULTS: Service and other revenues............. $ 892.0 $ 699.4 $ 564.6 Equipment sales........................ 40.2 24.8 19.3 Cost of equipment sales................ (42.2) (23.9) (18.4) --------- ---------- ---------- Net operating revenues............... 890.0 700.3 565.5 --------- ---------- ---------- Cost of revenues....................... 116.3 98.7 80.0 Selling, general and administrative expenses............................. 394.1 322.5 238.6 Depreciation and amortization.......... 164.7 124.1 93.7 --------- ---------- ---------- Total operating expenses............. 675.1 545.3 412.3 --------- ---------- ---------- Operating income....................... $ 214.9 $ 155.0 $ 153.2 ========= ========== ========== Operating cash flow (2)................ $ 379.6 $ 279.1 $ 246.9 ========= ========== ========== Capital expenditures, excluding acquisitions......................... $ 198.4 $ 199.8 $ 159.6 ========= ========== ========== Year Ended December 31, ----------------------------------- 1993 1992 1991 ----------- ----------- ----------- OPERATING DATA: POPs (3)......................... 34,889,000 34,121,000 32,560,000 POPs in controlled markets (4)... 33,595,000 32,264,000 30,806,000 Proportionate cellular subscribers (4)............... 1,046,000 744,000 558,000 Penetration (5).................. 3.1% 2.3% 1.8% -------------------- (1) Unaudited, supplemental operating results for the Company's domestic cellular operations. This presentation differs from the consolidation and equity methods used to prepare the Company's audited financial statements, which are in accordance with generally accepted accounting principles. (2) Operating income plus depreciation and amortization. Proportionate operating cash flow represents the Company's interest in the entities multiplied by the entities' operating cash flow. As such, proportionate operating cash flow does not represent cash available to the Company. (3) "POPs" for domestic cellular markets means the population of a Federal Communications Commission ("FCC") licensed cellular market based on Donnelly Marketing Information Service population estimates for counties comprising such market, multiplied by the Company's ownership interest in the cellular licensee operating in such market as of the date specified. (4) POPs in controlled markets and cellular subscriber data include only those cellular systems that are included in the operating results shown in the Selected Proportionate Domestic Cellular Operating Data table. (5) Proportionate cellular subscribers divided by the Company's POPs in Controlled Cellular Systems. Cellular service and other revenues increased on a proportionate basis 27.5% in 1993 over 1992 and 23.9% in 1992 over 1991, primarily as a result of a 40.6% and 33.3% year-to-year increase in cellular subscribers in 1993 and 1992, respectively. In 1993, fixed-term discount plans and various promotional programs reduced customer disconnects in all of the Company's cellular markets and accounted for the increase in subscriber growth. Increase in cellular service revenues did not keep pace with subscriber growth because of declining average revenue per subscriber, caused by lower usage by new subscribers and rate reductions made in 1993 to meet competitive pressures. The Company plans to mitigate the impacts of the lower average revenue per subscriber by offering new products and services. The Company expects that average revenues per subscriber will continue to decline as it adds new subscribers and responds to further competitive pressures. In 1992 New Par and the Company's Atlanta cellular system experienced significant growth in subscribers on a percentage basis. Each of these regional networks benefitted from a cellular telephone rental program that was already in place in CCI's Ohio properties at the time New Par was formed in August 1991. The rental program was expanded throughout New Par and a similar program was introduced by the Atlanta system in mid-1992, making these programs the primary driver for subscriber growth in 1992. Equipment sales consist of revenues from sales of cellular telephones. Equipment sales are not a primary part of the Company's cellular business and therefore the costs associated with these sales have been removed from the cost of revenues and netted with equipment sales in the revenue section of the income statement. All prior periods have been revised to conform to this presentation format. Total operating expenses on a proportionate basis as a percentage of net operating revenues were 75.9%, 77.9%, and 72.9% in 1993, 1992, and 1991, respectively. These percentages reflect increases in expenses associated with subscriber growth and increased investments in new products and services, offset by cost containment efforts in 1993. Total operating expenses include cost of revenues, selling, general, and administrative expenses, and depreciation and amortization. Cost of revenues remained constant as a percentage of net operating revenues between 1991 and 1992, and declined in 1993. The trend reflects technical efficiencies and realization of economies of scale, and in 1993, the reassessment of property taxes and lower interconnect charges. Selling, general, and administrative expenses increased as a percentage of net operating revenues in 1992 and decreased in 1993. The 1992 increase reflects higher advertising and promotional expenses, increased agent commissions paid for new subscribers, who on average generate less revenue per month than existing subscribers, increased billing expenses associated with the increased number of domestic cellular subscribers and other expenses associated with the Company's business development initiatives, and investments in new technologies such as wireless data. The 1993 decrease reflects the effects of cost containment initiatives. The increase in depreciation and amortization expense in each year during the three- year period ended December 31, 1993 reflects the Company's increasing capital investment in its cellular systems. BUSINESS ENVIRONMENT COMPETITION. The competitive and regulatory environment for wireless communications companies in the United States is in a rapid state of development. The Company's domestic cellular systems are expected to encounter increased competition as a result of new operators of digital mobile communications systems, including NexTel Communications, Inc. ("NexTel"), which initiated service in Los Angeles in early 1994 with plans to expand to San Francisco by mid-1994, and Dallas and other markets by mid-1995. NexTel has announced that it intends to position itself as the third major provider of mobile telephone services in its markets. In March 1994, Nextel and MCI announced the formation of a strategic alliance to provide wireless services under the MCI brand name throughout the United States. As a result, the Company's domestic cellular systems may encounter such competition sooner than previously anticipated. In addition, the FCC has recently allocated radio frequency spectrum for seven PCS licenses in each market. Auctions for narrowband PCS licenses are expected to begin by May 1994 while broadband PCS licenses are not expected to be auctioned until much later in the year. Although the marketing and technical elements of PCS are not yet well defined, the Company expects some PCS services to be competitive with the Company's cellular and paging operations. The Company is unable to estimate the impact of such potentially competitive services on the Company's operations. AT&T's announcement in August 1993 that it will merge with McCaw may increase the level of competition that the Company faces in Los Angeles and Sacramento, where the Company's cellular operations compete with McCaw. The merger will permit McCaw to use the AT&T brand name in marketing its cellular service and give McCaw access to AT&T's sales, customer service and distribution channels, as well as to the research and development capabilities of AT&T Bell Laboratories. The Company and McCaw jointly operate cellular systems in San Francisco, San Jose, Kansas City, Dallas, and certain other markets through CMT Partners. REGULATION. The Company's operations are highly regulated and its results of operations may be significantly affected by new regulatory developments. For example, a decision rendered on October 26, 1993 by the California Public Utilities Commission ("CPUC") as a result of an investigation into the cellular industry would have imposed on cellular operators an accounting methodology to separate wholesale and retail cost, permitted resellers to operate a switch interconnected to the cellular carrier's facilities, and required unbundling of certain wholesale rates to the resellers. These unbundled rates would have been calculated by applying a rate of return of 14.75% to the cost basis of assets utilized by such reseller switch. On May 19, 1993, the CPUC granted limited rehearing of the decision. The CPUC granted the Company's application for rehearing on the issue of the unbundling of carrier's wholesale rates and the imposition of a 14.75% benchmark rate of return. It noted that the hearing record was sufficient regarding the technical feasibility of a reseller switch and would seek comments only on the economic aspects of the concept. The CPUC also rescinded its order to modify the method for allocating cost between wholesale and retail operations. On December 17, 1993, the CPUC issued an Order Instituting Investigation ("OII")into the regulation of Mobile Telephone Service and Wireless Communications, consolidating the rehearing of the above issues into a new investigation. The OII initiates a review of the Commission's historic policies governing cellular telephone service and proposes to classify cellular carriers as dominant carriers and resellers and new providers of mobile services as non-dominant carriers. The Commission requests comments on alternative frameworks for regulating cellular carriers: (1) price caps at current rates (the existing framework); (2) rate-of-return or cost-based price caps which would result in mandatory price reductions; and (3) relaxed regulation. Comments and rebuttals have been filed. Because the outcome of the OII is uncertain, the Company cannot estimate the effects of this matter, which could be material, on the Company's financial condition and results of operations. No assurance can be given that regulatory changes that may be enacted by federal, state, or foreign governmental authorities will not have a material adverse effect on the Company's future business. Initial operating licenses are generally granted for terms of 10 years, renewal upon application to the FCC. Licenses may be revoked any time and license renewal applications may be denied for cause. The Company has filed an application for renewal of its Los Angeles cellular license, whose initial term expired in October 1993. The Company expects that its application will be granted, although an opposing party has filed an informal objection and a petition to deny the Company's application, alleging violations of FCC rules and Communications Act of 1934. The Company's licenses in San Diego, Detroit, Cleveland and Sacramento expire in October 1994 and all of its other significant domestic cellular licenses expire before the end of 1996. While the Company believes that each of these licenses will be renewed based upon FCC rules establishing a presumption in favor of licensees that have complied with their regulatory obligations during the initial period, there can be no assurance that any license will be renewed. The licensing authorities in Germany and Portugal have not established any procedures for renewal of the cellular licenses held by MMO and Telecel. Such licenses expire in 2009 and 2006, respectively. EFFECT OF RECESSION. The effects of the recession have been felt in the areas of bad debt, increased promotional expense and rate reductions to generate subscriber growth, and lower usage. As most of the country slowly recovers, the California economy is still lagging. If the recession continues, the Company will continue to focus on cost containment efforts, closely monitor bad debt, and promote its products in existing markets. INTERNATIONAL ENVIRONMENTAL CONDITIONS. The Company has been successful in obtaining significant interests in cellular licenses in Germany, Portugal, Japan, and Sweden. Its paging and other operations cover Spain, Portugal, Thailand, France, and Korea. The Company is not presently aware of any economic, political, or competitive conditions in such countries that would have a material adverse effect on the Company. CONTINGENCIES GARABEDIAN DBA WESTERN MOBILE TELEPHONE COMPANY V. LASMSA LIMITED PARTNERSHIP, ET AL. A class action complaint has been filed naming as defendants, among others, Los Angeles Cellular Telephone Company ("LACTC") and the Company, as general partner for Los Angeles SMSA Limited Partnership. The plaintiff alleges that LACTC and the Company conspired to fix the price of wholesale and retail cellular service in the Los Angeles market. The plaintiff alleges damages for the class "in a sum in excess of $100 million." On January 31, 1994, the Company filed a demurrer to the complaint. No discovery has been undertaken as of March 3, 1994. The Company intends to defend itself vigorously. The Company does not anticipate this proceeding will have a material adverse effect on the Company's financial position. Also, see Note N to the Consolidated Financial Statements of AirTouch Communications and Subsidiaries. LIQUIDITY AND CAPITAL RESOURCES The Company defines liquidity as its ability to generate resources to finance business expansion, construct capital assets, and pay its current obligations. The Company has met its financing needs from internally generated funds, equity infusions from Telesis, and external financing through issuance of common stock. The Company requires substantial capital to expand and operate its existing wireless systems, to construct new wireless systems and to acquire interests in existing wireless systems. In the past, the Company has met its funding requirements primarily through short-term borrowings from PTCR and equity contributions from Telesis. During 1993, Telesis provided equity contributions of $1,179.8 million which the Company used to significantly reduce its indebtedness to PTCR. The Company's indebtedness to PTCR totaled $958.4 million at December 31, 1992 and, as a result of debt repayments and the settlement of the Company's tax benefits receivable from Telesis, the Company reduced its indebtedness to PTCR to $0.3 million at December 31, 1993. Prior to the IPO, the Company continued to borrow from PTCR to the extent that its existing cash resources and cash flow from operations were not sufficient to meet the Company's funding requirements. On December 2, 1993, the Company sold to the public 68,500,000 shares of Common Stock, representing 13.9% of the total number of outstanding shares. The net proceeds to the Company from such sale were $1,489.2 million. The Company generated cash from operating activities of $439.7 million, $198.9 million, and $169.1 million during 1993, 1992, and 1991, respectively. The Company's domestic cellular and paging operations were primarily responsible for these cash flows. The increase in 1993 also included the settlement of the Company's tax benefits receivable from Telesis. (See "Interest Expense" and "Income Taxes.") The Company's cash used for investing activities was $1,441.4 million, $491.9 million, and $430.2 million in 1993, 1992, and 1991, respectively. The Company's cash used for investing activities increased in 1993 primarily due to the investment of the proceeds from the IPO, and investments in Wichita and Topeka Cellular and NordicTel. The increase in investments in 1992 reflects increased construction funding for MMO's and Telecel's cellular systems (both of which became operational in 1992) and the purchase of an additional 6.6% equity in CCI for approximately $92.0 million. The Company will be required to make substantial expenditures in connection with its efforts to expand its wireless business. The size of such expenditures is difficult to anticipate primarily because of uncertainty as to the Company's success in its pursuit of new wireless licenses and attractive acquisition opportunities. In the United States, the Company plans to pursue additional cellular and paging opportunities and intends to participate actively in the license application process for PCS. Internationally, the Company currently is negotiating to acquire an interest in a digital cellular system in Belgium, is competing or planning to compete for wireless licenses in South Korea, Italy, the Netherlands, Spain, and France and also is considering opportunities in other parts of the world. The Company also expects to make capital expenditures of approximately $700 million with respect to its existing domestic and international wireless systems, including the deployment of digital technology in its domestic cellular systems during 1994 and 1995. As of March 1, 1994, the Company was committed to spend up to $191 million for the acquisition of property, plant and equipment and expects that capital contributions to its existing international ventures will total approximately $135 million prior to the end of 1995. The Company used approximately $49.5 million of the net IPO proceeds to purchase notes in connection with which a subsidiary of the Company has issued a letter of responsibility. For a description of a note payable to an affiliate to which these notes relate, see Notes E and G to the Consolidated Financial Statements of AirTouch Communications and Subsidiaries. The Company has agreed to fund CCI's redemption of up to 10.04 million shares of CCI stock at $60 per share in October 1995 and to purchase from CCI shares or stock options representing in the aggregate approximately 2.4 million shares at a price of $60 per share, less the exercise price in the case of stock options (the "Mandatory Redemption Obligation" or "MRO"). The Company's funding obligation in connection with the MRO will not exceed $720 million. In addition, the Company may be obligated to make payments to CCI stockholders in the event that the Company does not elect, after three appraisals during the 18-month period beginning in August 1996, to purchase, at a price reflecting the appraised private market value of CCI's interest in New Par (and such other CCI assets and related liabilities as the Company and CCI agree shall be retained), all of the outstanding shares of CCI stock which it does not then hold. The Company has agreed to provide CCI with a $600 million letter of credit in support of the Company's obligations in the MRO. See Note E to the Consolidated Financial Statements of AirTouch Communications and Subsidiaries. The Company's cash received from financing activities was $1,631.3 million, $293.1 million, and $254.6 million for 1993, 1992, and 1991, respectively. The cash received from financing activities primarily reflects proceeds from the IPO, short-term borrowings from PTCR, and equity contributions from Telesis. The Company does not expect its operations to generate sufficient cash to meet its capital requirements for the next several years. However, the Company currently believes that the net proceeds from the IPO, together with cash flow from operations, will be sufficient to satisfy the Company's estimated funding requirements through mid-1995. After such proceeds are invested, the Company expects that it will need to raise additional funds through bank borrowings or public or private sales of debt or equity securities. Although there can be no assurance that such funding will be available, the Company believes that it will be able to access the capital markets on terms and in amounts adequate to meet its objectives. DIVIDEND POLICY The Company currently intends to retain future earnings for the development of its business and does not anticipate paying cash dividends on its Common Stock in the foreseeable future. The Company's future dividend policy will be determined by its Board of Directors on the basis of various factors, including the Company's results of operations, financial condition, capital requirements and investment opportunities. EFFECTS OF RECENTLY ISSUED ACCOUNTING STANDARDS POSTRETIREMENT BENEFITS OTHER THAN PENSIONS. In December 1990, the Financial Accounting Standards Board ("FASB") issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"). The Company currently offers postretirement benefits other than pensions which are primarily retiree health care and life insurance benefits. SFAS 106 requires the Company to change the method of accounting for these postretirement benefits from a cash basis to an accrual basis. The Company adopted SFAS 106 effective January 1, 1993 with immediate recognition of its $9.1 million transition obligation (before tax benefit of $3.5 million) as permitted by SFAS 106. This accounting change increased the Company's 1993 operating expenses by approximately $1.9 million. POSTEMPLOYMENT BENEFITS. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). The Company offers workers' compensation, short- and long-term disability, medical benefit continuation, and severance pay. These benefits are paid to former employees not yet retired. SFAS 112 requires that these postemployment benefits be accounted for on an accrual basis beginning in 1994. The Company adopted SFAS 112 on January 1, 1994. Based on the accrual requirements, the Company expects that future recognized expense under SFAS 112 will not differ materially from current expenses and therefore believes that the adoption of SFAS 112 will not have a material impact on the Company's results of operations or financial condition. INVESTMENTS IN DEBT AND EQUITY SECURITIES. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). The new standard will change the carrying basis for certain equity and debt securities. The Company adopted SFAS 115 on January 1, 1994, consistent with the required adoption period. The Company does not expect SFAS 115 to materially affect its financial position or results of operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Company's consolidated financial statements and supplemental data, as well as those of its significant subsidiaries, New Par and MMO, together with the reports of Coopers & Lybrand, Ernst & Young and KPMG Peat Marwick, independent accountants, are included elsewhere herein. Reference is made to the "Index to Financial Statements" immediately preceding page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. No disagreements with accountants on any accounting or financial disclosure occurred during the Company's two most recent fiscal years or any subsequent interim period. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Set forth below is certain information concerning the persons who serve as directors and executive officers of the Company. The executive officers serve at the pleasure of the Board of Directors and are subject to removal at any time. At the time of the Spin-off, Messrs. Ginn, Christensen, Gyani and Sarin, who are also officers of Telesis, will resign their positions at Telesis. Directors are elected by shareholders at each annual meeting or, in the case of a vacancy or increase in the number of directors, by the directors then in office, to serve until the next annual meeting of shareholders and until their successors are elected and qualified. NAME AGE POSITION AND OFFICES HELD ------------------------ ----- -------------------------------------- Sam Ginn ............... 56 Chairman of the Board and Chief Executive Officer C. Lee Cox ............. 52 President and Chief Operating Officer and Director Lydell L. Christensen .. 59 Executive Vice President and Chief Financial Officer Margaret G. Gill ....... 54 Senior Vice President, Legal and External Affairs and Secretary Arun Sarin ............. 39 Senior Vice President, Corporate Strategy/ Development and Human Resources F. Craig Farrill ....... 41 Vice President, Technology, Planning and Development Mohan S. Gyani ......... 42 Vice President, Finance and Treasurer George F. Schmitt ...... 50 Vice President, International Operations Susan G. Swenson ....... 45 Vice President Paul H. White .......... 49 General Counsel Charlie E. Jackson ..... 59 President and Chief Executive Officer, AirTouch Paging John R. Lister ......... 55 President and Co-Chief Executive Officer, PacTel Teletrac Jan K. Neels .......... 55 President and Chief Executive Officer, AirTouch International Carol A. Bartz ........ 45 Director Donald G. Fisher ...... 65 Director James R. Harvey ....... 59 Director Paul Hazen ............ 51 Director Arthur Rock ........... 67 Director Charles R. Schwab ..... 56 Director George P. Shultz ...... 72 Director Mr. Ginn has been Chairman of the Board, President and Chief Executive Officer of Telesis since 1988. He served as President and Chief Operating Officer of Telesis from 1987 through 1988 and as Vice Chairman of the Board from 1983 through 1987. Previously, Mr. Ginn served as a director and as President and Chief Operating Officer of the Company from 1984, when the Company was formed, to 1987. He has been Chairman of Pacific Bell since 1988 and was Vice Chairman from 1987 through 1988. Mr. Ginn has been a director of Telesis since 1983 and is also a director of Chevron Corporation, Safeway Inc. and Transamerica Corporation. Mr. Ginn will resign from the Board of Directors of Telesis at the time of the Spin-off. Mr. Cox has been President of the Company since 1987. Mr. Cox was a director of the Company from 1987 to April 1993 and became a director again in January 1994. Mr. Cox has been a director and a Group President of Telesis since 1988. Mr. Cox began his career with Pacific Bell in 1964 and, prior to joining the Company in 1987, held various senior management positions at Pacific Bell. Mr. Cox will resign from the Board of Directors of Telesis at the time of the Spin-off. Mr. Christensen was named Executive Vice President, Chief Financial Officer and Treasurer of Telesis in 1992. In March 1993, Mohan S. Gyani, who reports to Mr. Christensen, was named Treasurer of Telesis. From 1987 to 1992, Mr. Christensen was Vice President and Treasurer of Telesis. He was a director of the Company from 1992 to 1993. Mrs. Gill became Senior Vice President, Legal and External Affairs and Secretary of the Company in January 1994. She had been a partner in the law firm of Pillsbury Madison & Sutro since 1973 and was the head of the firm's Corporate and Securities Group. Mr. Sarin was named Senior Vice President, Corporate Strategy/Development and Human Resources of the Company in December 1993. Mr. Sarin became a joint officer of Telesis and the Company in March 1993 when he was named Vice President, Organization Design at Telesis and Vice President, Strategy at the Company. In 1992, he became Vice President and General Manager, Bay Operations for Pacific Bell. In 1990, he became Vice President, Chief Financial Officer and Controller of Pacific Bell. He joined Pacific Bell in 1989 and shortly thereafter was named Vice President, Corporate Strategy for Telesis. In 1987, Mr. Sarin was named Vice President and Chief Financial Officer of PacTel Personal Communications ("PerCom"), the former holding company for AirTouch Cellular and AirTouch Paging. Mr. Farrill has been Vice President, Technology, Planning and Development for the Company since 1990. From 1987 to 1990, Mr. Farrill was a Vice President of AirTouch Cellular responsible for the engineering, design and management of domestic cellular operations. Mr. Gyani became Vice President, Finance and Treasurer of the Company in November 1993. He has been a Vice President and the Treasurer of Telesis since March 1993. In 1992 he was named Vice President and Controller at Pacific Bell. Previously Mr. Gyani held various positions at Telesis and Pacific Bell. He began his career with Pacific Bell in 1978. Mr. Schmitt has been Vice President of the Company and a member of the Board of Management of MMO since 1990. From 1987 to 1990, Mr. Schmitt was Vice President for State Regulatory Affairs for Pacific Bell. Mr. Schmitt began his career with Pacific Bell in 1965 and became a Vice President in 1985. Ms. Swenson has been Vice President of the Company and President of Bay Area Cellular Telephone Company since March 1994. From April 1993 to March 1994, she was Vice President and General Manager of Pacific Bell's Bay Area Regional Marketing Group, and from 1990 to April 1993, she was President and Chief Operating Officer of AirTouch Cellular. Prior to joining AirTouch Cellular, Ms. Swenson was Pacific Bell's Vice President for Customer Services in Southern California. Mr. White has been General Counsel for the Company since 1987. Mr. White was Assistant General Counsel for Telesis from 1985 to 1987 and prior to that was an attorney for Pacific Bell. Mr. White began his career with Pacific Bell in 1977. Mr. Jackson has been President and Chief Executive Officer of AirTouch Paging since 1986. He was named to that position after Telesis acquired Communication Industries, Inc. Prior to the acquisition, Mr. Jackson was President and General Manager of Gencom Incorporated, a subsidiary of Communication Industries that provided paging, mobile telephone and cellular services. Mr. Lister has been President and Co-Chief Executive Officer of PacTel Teletrac since April 1992. He has also been a Vice President of the Company since 1992. In November 1990, Mr. Lister joined PacTel Teletrac as President and Chief Operating Officer. Since 1988, Mr. Lister had been a Vice President at AirTouch Cellular. Mr. Lister joined PerCom in 1987 as Vice President of Corporate Development. Mr. Neels has been President and Chief Executive Officer of AirTouch International since 1987. Mr. Neels joined AirTouch International in 1986 as a Vice President, overseeing the business operations and marketing activities of subsidiaries in Spain, Japan, Korea and Thailand. Ms. Bartz became a director of the Company in February 1994. She has been Chairman of the Board, President and Chief Executive Officer of Autodesk, Inc. since April 1992. From 1983 to April 1992, Ms. Bartz served in various positions with Sun Microsystems, Inc., most recently as Vice President of Worldwide Field Operations. Mr. Fisher became a director of the Company in January 1994, and is a member of the Compensation and Personnel and Nominating Committees. Mr. Fisher is the founder, Chairman of the Board and Chief Executive Officer of The Gap, Inc. He is a director of Ross Stores, Inc., The Charles Schwab Corporation, San Francisco Bay Area Council and the National Retail Federation. Mr. Harvey became a director of the Company in April 1993, and is Chairman of the Compensation and Personnel Committee and a member of the Executive and Nominating Committees. Mr. Harvey has been Chairman of the Board of Transamerica Corporation since 1983 and was Chief Executive Officer of Transamerica from 1981 through 1991. He is a director of Telesis, The Charles Schwab Corporation, McKesson Corporation, Sedgwick Group plc, The National Park Foundation and The Nature Conservancy. Mr. Harvey will resign from the Board of Directors of Telesis at the time of the Spin-off. Mr. Hazen became a director of the Company in April 1993, and is Chairman of the Audit Committee and a member of the Executive and Nominating Committees. Mr. Hazen has been President and Chief Operating Officer of Wells Fargo & Company and its principal subsidiary, Wells Fargo Bank, N.A., since 1984. He is a director of Telesis, Wells Fargo & Company and its subsidiary, Wells Fargo Bank, N.A., Phelps Dodge Corporation and Safeway Inc. Mr. Hazen will resign from the Board of Directors of Telesis at the time of the Spin-off. Mr. Rock became a director of the Company in January 1994, and is a member of the Audit and Nominating Committees. Mr. Rock has been a principal in Arthur Rock & Co., a venture capital firm, since 1969. He is a director of Intel Corporation, Argonaut Group, Inc. and Teledyne, Inc. Mr. Rock is married to Toni Rembe, who is a director of Telesis. Ms. Rembe beneficially owns 1,573 shares of Telesis stock and holds options to purchase an additional 3,000 shares of Telesis stock. Mr. Schwab became a director of the Company in January 1994, and is Chairman of the Nominating Committee and a member of the Compensation and Personnel Committee. Mr. Schwab is the founder, Chairman of the Board and Chief Executive Officer of The Charles Schwab Corporation and Chairman of Charles Schwab & Co. Inc. He is a director of The Gap, Inc. and Transamerica Corporation. Mr. Shultz became a director of the Company in January 1994, and is a member of the Compensation and Personnel, Executive, and Nominating Committees. Mr. Shultz has been a Professor at the Stanford University Graduate School of Business since 1974. He served as United States Secretary of State from 1982 to 1989. Mr. Shultz is a Distinguished Fellow at the Hoover Institution, a member of the Board of the Bechtel Group, Chairman of J.P. Morgan's International Council and Chairman of the Governor's California Economic Policy Advisory Council. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The following table discloses compensation earned by the Chief Executive Officer and the four other most highly paid executive officers (the "Named Executive Officers") for the three fiscal years ended December 31, 1993. Unless otherwise indicated, positions listed are with the Company. 1993 LONG-TERM STOCK INCENTIVE PLAN ADOPTION AND AMENDMENTS. The Company's 1993 Long-Term Stock Incentive Plan (the "Stock Plan") was initially adopted by the Company's Board of Directors on June 25, 1993, and approved by Telesis (as the Company's majority shareholder) upon the recommendation of the Compensation and Personnel Committee of the Telesis Board. Such committee consists entirely of directors of Telesis who are not officers or employees of Telesis, the Company or any subsidiary of either. The Stock Plan has been amended from time to time thereafter, and the Board of Directors may amend any aspect of the Stock Plan at any time in the future. Amendments are subject to the approval of the Company's shareholders only to the extent required by applicable laws or regulations. SHARES AVAILABLE FOR ISSUANCE. The Stock Plan provides for awards in the form of restricted shares, stock units, options or SARs, or any combination thereof. The total number of shares of Common Stock available for issuance under the Stock Plan is 24,000,000, subject to anti-dilution provisions. If any restricted shares, stock units, options or Spars granted under the Plan are forfeited, or if options or Spars terminate for any other reason prior to exercise, then the underlying shares of Common Stock again become available for awards. ADMINISTRATION. The Stock Plan is administered by the Compensation and Personnel Committee (the "C&P Committee") of the Company's Board of Directors. The C&P Committee consists entirely of directors of the Company who are not officers or employees of Telesis, the Company or any subsidiary of either. The C&P Committee selects the employees of the Company or any subsidiary who will receive awards, determines the size of the award (limited, in the case of options or SARs, to 500,000 shares of Common Stock in any calendar year for any employee) and establishes the vesting or other conditions. The Company's Board of Directors may also appoint an additional committee, which consists of directors who may be officers of the Company. This committee may administer the Stock Plan with respect to participants other than directors and officers. ELIGIBILITY. Employees, directors, consultants and advisors of the Company, its subsidiaries, or affiliates of which the Company owns at least 50% are eligible to participate in the Stock Plan, although incentive stock options may be granted only to employees of the Company or a subsidiary. The participation of nonemployee directors of the Company is limited to certain automatic grants of nonstatutory stock options, except to the extent the Company's Board of Directors implements provisions that would permit a nonemployee director to convert the annual retainer payments and meeting fees to stock options or stock units, as described below. PAYMENT. In general, no payment will be required upon receipt of an award. The Stock Plan, however, permits the grant of awards in consideration of a cash payment or a voluntary reduction in cash compensation. RESTRICTED STOCK. Restricted shares are shares of Common Stock that are subject to forfeiture in the event that the applicable vesting conditions are not satisfied, and they are nontransferable prior to vesting (except for certain transfers to a trustee). Restricted shares have the same voting and dividend rights as other shares of Common Stock. STOCK UNITS. A stock unit is an unfunded bookkeeping entry representing the equivalent of one share of Common Stock, and it is nontransferable prior to the holder's death. A holder of stock units has no voting rights or other privileges as a stockholder but may be entitled to receive dividend equivalents equal to the amount of any dividends paid on the same number of shares of Common Stock. Dividend equivalents may be converted into additional stock units or settled in the form of cash, Common Stock or a combination of both. Stock units, when vested, may be settled by distributing shares of Common Stock or by a cash payment corresponding to the fair market value of the appropriate number of shares of Common Stock, or a combination of both. The number of shares of Common Stock (or the corresponding amount of cash) distributed in settlement of stock units may be greater or smaller than the number of stock units, depending upon the attainment of performance objectives. Vested stock units will be settled at the time determined by the C&P Committee. If the time of settlement is deferred, interest or additional dividend equivalents may be credited on the deferred payment. The recipient of restricted shares or stock units may pay all projected withholding taxes relating to the award with Common Stock rather than cash. STOCK OPTIONS. Options may include nonstatutory stock options ("NSOs") as well as incentive stock options ("ISOs") intended to qualify for special tax treatment. The term of an ISO cannot exceed 10 years, and the exercise price of an ISO must be equal to or greater than the fair market value of the Common Stock on the date of grant. (On March 4, 1994, the closing sale price of the Company's Common Stock on the New York Stock Exchange was $23 3/8) The Stock Plan permits the grant of NSOs with an exercise price that varies according to a predetermined formula. The exercise price of an option may be paid in any lawful form permitted by the C&P Committee, including (without limitation) the surrender of shares of Common Stock or restricted shares already owned by the optionee. The Stock Plan also allows the optionee to pay the exercise price of an option by giving "exercise/sale" or "exercise/pledge" directions. If exercise/ sale directions are given, the option shares are issued directly to a securities broker selected by the Company who, in turn, sells shares in the open market. The broker remits to the Company the proceeds from the sale of these shares to the extent necessary to pay the exercise price and any withholding taxes, and the optionee receives the remaining option shares or cash. If exercise/pledge directions are given, the option shares are issued directly to a securities broker or other lender selected by the Company. The broker or other lender will hold the shares as security and will extend credit for up to 50 percent of their market value. The loan proceeds will be paid to the Company to the extent necessary to pay the exercise price and any withholding taxes. Any excess loan proceeds may be paid to the optionee. If the loan proceeds are insufficient to cover the exercise price and withholding taxes, the optionee will be required to pay the deficiency to the Company at the time of exercise. The C&P Committee may also permit optionees to satisfy their withholding tax obligation upon exercise of an NSO by surrendering a portion of their option shares to the Company. STOCK APPRECIATION RIGHTS ("SARs"). SARs permit the participant to elect to receive any appreciation in the value of the underlying stock from the Company, either in shares of Common Stock or in cash or a combination of the two, with the C&P Committee having the discretion to determine the form in which such payment will be made. The amount payable on exercise of an SAR is measured by the difference between the market value of the underlying stock at exercise and the exercise price. SARs may, but need not, be granted in conjunction with options. Upon exercise of an SAR granted in tandem with an option, the corresponding portion of the related option must be surrendered and cannot thereafter be exercised. Conversely, upon exercise of an option to which an SAR is attached, the SAR may no longer be exercised to the extent that the corresponding option has been exercised. All options and SARs are nontransferable prior to the optionee's death. VESTING CONDITIONS. As noted above, the C&P Committee determines the number of restricted shares, stock units, options or SARs to be included in the award as well as the vesting and other conditions. The vesting conditions may be based on the employee's service, his or her individual performance, the Company's performance or other criteria. Vesting may be accelerated in the event of the employee's death, disability or retirement, in the event of a change in control with respect to the Company, or upon other events. Moreover, the C&P Committee may determine that outstanding options and SARs will become fully vested if it has concluded that there is a reasonable possibility that a change in control will occur within six months thereafter. For purposes of the Stock Plan, the term "change in control" is defined as (1) the acquisition, directly or indirectly, of at least 20 percent of the outstanding securities of the Company by a person other than Telesis or an employee benefit plan of the Company, (2) a greater than one-third change in the composition of the Board of Directors of the Company over a period of 24 months or, if fewer than 24 months have elapsed since the Spin-off, over the period following the Spin-off (if such change was not approved by a majority of the existing directors), (3) certain mergers and consolidations involving the Company, (4) a liquidation of the Company or (5) a sale of all or substantially all of the Company's assets. The term "change in control" does not include a reincorporation of the Company in a different state, the Spin-off and certain other transactions. LIMITATIONS UNDER TAX LAWS. Awards under the Stock Plan may provide that if any payment (or transfer) by the Company to a recipient would be nondeductible by the Company for federal income tax purposes pursuant to section 280G of the Internal Revenue Code, then the aggregate present value of all such payments (or transfers) will be reduced to an amount which maximizes such value without causing any such payment (or transfer) to be nondeductible. MODIFICATIONS. The C&P Committee is authorized, within the provisions of the Stock Plan, to amend the terms of outstanding restricted shares or stock units, to modify or extend outstanding options or SARs or to exchange new options for outstanding options, including outstanding options with a higher exercise price than the new options. NONEMPLOYEE DIRECTORS. Members of the Company's Board of Directors who are not employees of the Company or its subsidiaries will receive an annual grant of 1,000 NSOs (subject to anti-dilution adjustments) under the Stock Plan. Starting in 1995, these grants are made at the conclusion of each regular annual meeting of the Company's shareholders to nonemployee directors who will continue to serve on the Board of Directors thereafter. Nonemployee directors who join the Company's Board of Directors on or after February 25, 1994, will receive a one-time grant of 10,000 NSOs (subject to anti-dilution adjustments). As a condition to these one-time grants, the nonemployee director must demonstrate that he or she beneficially owns shares of Common Stock with a value of $100,000 or more within 30 days after the grant. The exercise price of NSOs granted to nonemployee directors is equal to the market value of Common Stock on the date of grant. The NSOs will become exercisable one year after the grant or, if earlier, in the event of the director's death or total and permanent disability or in the event of a change in control of the Company. The NSOs expire (i) ten years after the date of grant, (ii) 36 months after the termination of the director's service due to disability or due to retirement after serving at least three years, (iii) 12 months after the director's death, and (iv) three months after the termination of the director's service for any other reason. Nonemployee directors and prospective nonemployee directors named in the prospectus for the Company's initial public offering received a one-time grant of 10,000 NSOs under the Stock Plan on November 19, 1993. The exercise price is equal to the initial public offering price ($23 per share). These NSOs will become exercisable on the latest of (i) the first anniversary of the initial public offering (December 2, 1994), (ii) the date when the optionee completes one year of service as a member of the Company's Board of Directors or (iii) the Spin-off. These NSOs also become exercisable in full in the event of the director's death or total and permanent disability or a "change in control" of the Company. The NSOs expire on the earliest of (i) November 18, 2003, (ii) 12 months after the nonemployee director's death, (iii) 36 months after the termination of the director's service due to retirement after serving at least three years or due to disability or (iv) three months after the termination of the director's service for any other reason. As a condition to these one-time grants, the nonemployee director or prospective nonemployee director was required to demonstrate that he beneficially owned shares of Common Stock with a value of $100,000 or more at any time within 30 days after the initial public offering. Finally, the Company's Board of Directors may implement provisions of the Stock Plan that permit a nonemployee director to elect to receive all or a portion of his or her annual retainer payments and meeting fees in the form of NSOs or stock units to be issued under the Stock Plan, provided the election is made at least six months before such fees are payable. TELESIS OPTIONS. It is expected that, in connection with the Spin-off, unexercised Telesis Options held by the directors, officers and other employees of the Company will be replaced by Company Options granted under the Stock Plan. See "-Stock Ownership" for a description of the method by which Telesis Options will be converted into Company Options. TELESIS AND COMPANY LTIP AWARDS. It is expected that, in connection with the Spin-off, the awards made to officers of the Company under the Long-Term Incentive Plans of Telesis and the Company for the three-year performance cycles ending December 31, 1994 and December 31, 1995 will be converted into awards relating to the Company's Common Stock. Awards for those portions of these performance cycles which are completed as of the Spin-off will be settled on the basis of the actual results achieved under the applicable performance measures up to the date of the Spin-off. Settlement will be made in the form of restricted shares of the Company's Common Stock granted under the Stock Plan. Restricted shares granted in lieu of awards for the performance cycle ending December 31, 1994 will vest not later than January 28, 1995, and restricted shares granted to replace awards for the performance cycle ending December 31, 1995 will vest not later than January 27, 1996. Awards for the uncompleted portions of these performance cycles, and the dividend equivalents that would have been paid with respect to such awards, will be replaced by options to purchase Common Stock granted under the Stock Plan. To determine the number of options to be granted, an appropriate option valuation model will be used. Options granted to replace awards for the performance cycle ending December 31, 1994 will become exercisable not later than January 28, 1995, and options granted in substitution for awards for the performance cycle ending December 31, 1995 will become exercisable not later than January 27, 1996. INITIAL RESTRICTED STOCK GRANT. The Company intends to grant restricted shares under the Stock Plan to all employees of the Company and its wholly owned subsidiaries at the time of the Spin-off, except those employees who have received stock options under the Pacific Telesis Group Stock Option and Stock Appreciation Rights Plan. The value of shares included in each employee's award will not exceed 10% of that employee's total compensation. It is expected that these shares will vest on the earlier of (a) the date 10 years after the Spin-off or (b) the 15th consecutive trading day on which the closing price of Common Stock is at least 200% of the initial public offering price ($23 per share). If an employee's service terminates before these shares vest, they will be forfeited, except that a stock award agreement may provide for accelerated vesting in the event of termination of service on account of death, total and permanent disability, or retirement. As an example, assuming a price for the Common Stock of the Company of $23 per share at the time of the Spin-off, the Company would grant approximately 400,000 shares of restricted stock. TAX CONSEQUENCES OF OPTIONS. Neither the optionee nor the Company will incur any federal tax consequences as a result of the grant of an option. The optionee will have no taxable income upon exercising an ISO (except that the alternative minimum tax may apply), and the Company will receive no deduction when an ISO is exercised. Upon exercising an NSO, the optionee generally must recognize ordinary income equal to the "spread" between the exercise price and the fair market value of Common Stock on the date of exercise; the Company ordinarily will be entitled to a deduction for the same amount. In the case of an employee, the option spread at the time an NSO is exercised is subject to income tax withholding, but the optionee generally may elect to satisfy the withholding tax obligation by having shares of Common Stock withheld from those purchased under the NSO. The tax treatment of a disposition of option shares acquired under the Stock Plan depends on how long the shares have been held and on whether such shares were acquired by exercising an ISO or by exercising an NSO. The Company will not be entitled to a deduction in connection with a disposition of option shares, except in the case of a disposition of shares acquired under an ISO before the applicable ISO holding periods have been satisfied. EMPLOYEE STOCK PURCHASE PLAN The principal terms of an Employee Stock Purchase Plan (the "ESPP") were approved by the Company's Board of Directors on July 22, 1993 and by Telesis (as the Company's majority shareholder) upon the recommendation of the Compensation and Personnel Committee of the Telesis Board. The ESPP is expected to be adopted prior to the Spin-off and to take effect upon the Spin-off. The ESPP is intended to meet the requirements of Internal Revenue Code section 423. The ESPP will provide eligible employees of the Company and designated subsidiaries the opportunity to purchase Common Stock at a discount. Specific purchase periods will be established during which participants will contribute toward the purchase of stock through regular payroll deductions. Participants may withdraw their contributions at any time before the close of the purchase period. A pool of 2,400,000 shares of Common Stock has been reserved for issuance under the ESPP, subject to anti-dilution adjustments. SHORT-TERM INCENTIVE PLAN The Company sponsors a Short-Term Incentive Plan applicable to executive officers and all employees (except certain salespersons) that represents the bonus component of their compensation. Under the plan, the Board of Directors determines a standard award amount for each employee position or level. The plan provides for annual payment of individual cash awards in amounts equal to a percentage of the standard award, based on the level of achievement of corporate performance objectives and on individual performance in the preceding year. Performance objectives are established by the Board and are generally financial, operating and strategic in nature. Amounts awarded for a fiscal year are normally paid in February of the following year. PENSION PLANS It is expected that the Company's qualified pension plan, in connection with the Spin-off, will assume the liability for any accrued benefits of the Company's executive officers under a qualified pension plan of Telesis. ("Qualified pension plans" are plans that are intended to qualify for preferential tax treatment under section 401(a) of the Internal Revenue Code of 1986.) Corresponding assets will be transferred from the Telesis qualified plan to the Company's qualified plan. The accrual of service credit under the Company's qualified pension plan was discontinued on December 31, 1986 for most employees as of that date, although increases in compensation are still reflected in the computation of pensions. Accordingly, service after the Spin-off will not be counted in calculating the benefits of the Company's executive officers under the Company's qualified pension plan, but salary increases after the Spin-off will be taken into account. The following table shows the total annual pension benefits (stated as a single-life annuity) that would be received by an executive officer of the Company retiring today at age 65 under the Telesis qualified and nonqualified pension plans. It assumes various specified levels of total years of service and average annual compensation (which includes base salary and the standard award under the Short-Term Incentive Plan) during the final five years of service. The benefits shown in the table generally are not subject to offsets for Social Security benefits or other payments. Average Annual Compensation During Final Years of Service Prior to Retirement Five Years of Service 15 20 25 30 35 --------------- ---------- ---------- --------- ---------- ---------- $ 450,000 $ 97,875 $130,500 $163,125 $195,750 $228,375 500,000 108,750 145,000 181,250 217,500 253,750 650,000 141,375 188,500 235,625 282,750 329,875 700,000 152,250 203,000 253,750 304,500 355,250 800,000 174,000 232,000 290,000 348,000 406,000 900,000 195,750 261,000 326,250 391,500 456,750 1,000,000 217,500 290,000 362,500 435,000 507,500 1,150,000 250,125 333,500 416,875 500,250 583,625 1,250,000 217,875 362,500 453,125 543,750 634,375 1,400,000 304,500 406,000 507,500 609,000 710,500 The 1993 compensation of Messrs. Ginn, Cox, Christensen, Schmitt and Neels covered by the pension plans was $1,230,000, $720,000, $425,000, $399,300, and $0, respectively. As of December 31, 1993, the years of service of Messrs. Ginn, Cox, Christensen, Schmitt and Neels that are credited under the pension plans were 33, 29, 6, 28 and 0, respectively. Because Mr. Christensen is covered under a Telesis nonqualified pension plan providing increased pension benefits to mid-career hires, his pension is effectively calculated as if he had 12 years of service. Under other provisions of the Telesis nonqualified pension plans, eligible officers who terminate after attaining age 55 and completing 10 years of service as an officer are entitled to a minimum pension of 45% of average annual compensation. This minimum pension is increased by an additional 1% per year, up to a maximum of 50%, at 15 or more years of service as an officer. As of December 31, 1993, the completed years of service of Messrs. Ginn, Cox, Christensen, Schmitt and Neels that are credited under the minimum pension provisions were 15, 9, 5, 7 and 5, respectively. EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT OR CHANGE-IN-CONTROL ARRANGEMENTS Telesis has entered into employment agreements with certain officers of Telesis or the Company, including each of the Named Executive Officers, which provide for specified payments in the event of an involuntary termination of employment. Such agreements do not have a fixed term and may be terminated by either party upon three years' notice (in the case of Messrs. Ginn, Cox and Christensen) or one year's notice (in the case of Messrs. Schmitt and Neels). Telesis has assigned, or will assign prior to the Spin-off, such agreements to the Company (except that Mr. Ginn's employment agreement by its terms may not be assigned). The amount of the payments depends on whether the involuntary termination occurs within three years after a "change in control." If an officer's employment is involuntarily terminated for any reason other than cause, death or disability, whether or not there has been a "change in control," Telesis or the Company, as applicable, will make a cash payment of three times base compensation for Messrs. Ginn, Cox and Christensen or of one times base compensation for Messrs. Schmitt and Neels, plus 100% of the standard award under the Short-Term Incentive Plan applicable for that calendar year. In such event, Telesis or the Company will also compensate the officer for the value of any forfeited units under the Long-Term Incentive Plan, based on the fair market value of Telesis common stock on the date of employment termination, and for the value of any stock options and SARs that terminate at the officer's termination of employment, based on the difference between the fair market value of Telesis common stock at the effective date of termination and the option price (in the case of SARs, the difference between such fair market value and the option price at which the stock option related to the SAR was granted). Upon an involuntary termination (including "constructive termination," which is defined as a material reduction in responsibilities, a material reduction in salary or benefits or a requirement to relocate) within three years after a "change in control," all officers will receive a severance payment, in addition to the payments described in the preceding paragraph, when applicable, equal to approximately 200% of the officer's award under the Long-Term Incentive Plan for one year. Messrs. Ginn, Cox and Christensen would also receive approximately 200% of their standard award under the Short-Term Incentive Plan for the year in which employment terminates. For these agreements, "change in control" is defined generally as a party's acquisition, directly or indirectly, of 20% or more of Telesis' securities, a greater than one-third change in the composition of the Telesis Board of Directors in 24 months that was not approved by the majority of the existing directors, or certain mergers, consolidations, sales or liquidations of substantially all of the assets of Telesis. Any payments under the employment agreements are subject to the limitation that if the auditors of Telesis determine that any portion of the payments to be made is nondeductible by Telesis because of section 280G of the Internal Revenue Code, payments will be reduced to the extent of the nondeductible amount. In connection with the Spin-off, it is expected that such agreements will be replaced by new agreements between the Company and its executive officers, the terms and conditions of which will be determined prior to the Spin-off by the Company's Board of Directors upon the recommendation of its C&P Committee. DIRECTOR COMPENSATION AND RELATED TRANSACTIONS Nonemployee directors of the Company receive an annual retainer of $20,000 and fees of $1,200 for each board meeting attended and $800 for each committee meeting attended. The chairmen of the Audit, Compensation and Personnel, and Finance Committees each receive an additional annual retainer of $5,000, and the chairs of other committees of the Board receive additional annual retainers of $4,000. In addition, nonemployee directors are entitled to reimbursement for out-of-pocket expenses in connection with attendance at Board and committee meetings. Nonemployee directors may elect to defer receipt of all or part of their fees and retainers. Amounts deferred in 1994 will earn interest at a rate of 7.33% in 1994. Each nonemployee director of the Company has been granted stock options under the Company's 1993 Long-Term Stock Incentive Plan. See "-1993 Long-Term Stock Incentive Plan - Nonemployee Directors." In addition, the Company has adopted an equity purchase program for nonemployee directors under which unsecured loans of up to $100,000 will be available to enable such directors to purchase shares of the Company's Common Stock. The term of any loan under the program will be five years, with an option to extend for an additional five years. Final maturity is ten years or 30 days following the borrower's resignation from the Board. The interest rate for such loans would be the greater of the mid-term, adjusted Applicable Federal Rate, as published by the Internal Revenue Service (currently 5.23%) or the Company's cost of funds, currently equivalent to the five-year Treasury rate plus 85 basis points (currently 6.75%), but in no event higher than permitted under California usury laws (10%). The interest rate will be established at the time the loan is made and will be reset if the loan is renewed for an additional five years. Interest will compound annually and be paid at the end of each five-year term. Messrs. Harvey and Hazen, who are also directors of Telesis, will resign as such upon the Spin-off. They have not received annual retainers from the Company during their terms as joint directors of Telesis and the Company, but they have received fees for attendance at Board and committee meetings in the amounts specified above. Directors who are also employees of the Company receive no remuneration for serving as directors or as members of committees of the Board. All of the Company's directors are also reimbursed for the costs of certain telecommunications services and equipment. Employee directors receive similar reimbursements for services and equipment as part of their compensation as officers. The Company also provides travel accident insurance covering nonemployee directors on Company business. The Company has entered into indemnity agreements with each of its directors that provide for indemnification against any judgements or costs assessed against them in the course of their service as directors. Such agreements do not permit indemnification for acts or omissions for which indemnification is not permitted under California law. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table sets forth, as of February 28, 1994, certain information concerning the ownership of the Company's Common Stock by each shareholder known to the Company to be the beneficial owner of more than 5% of the outstanding shares of Common Stock, each Named Executive Officer, each director and by all executive officers and directors as a group. Amount and Nature of Name of Beneficial Owner Beneficial Ownership Percent of Class ------------------------------- -------------------- ---------------- Pacific Telesis Group ......... 424,122,960 86.1% 130 Kearny Street San Francisco, CA 94108 Sam Ginn ...................... 10,100 * C. Lee Cox .................... 500 * Lydell L. Christensen ......... 5,000 * George F. Schmitt ............. 5,000 * Jan K. Neels .................. 500 * Carol A. Bartz ................ 0 * Donald G. Fisher .............. 4,000 * James R. Harvey ............... 5,000 * Paul Hazen .................... 4,348 * Arthur Rock ................... 150,100 * Charles R. Schwab ............. 4,000 * George P. Shultz .............. 10,000 * All directors and executive officers as a group (20 persons).................. 215,448 * _____________________ * Less than 1%. The following table sets forth, as of February 28, 1994, the number of shares of common stock of Telesis beneficially owned by each Named Executive Officer, each director, and all executive officers and directors of the Company as a group, as well as their options to purchase shares of common stock of Telesis exercisable as of February 28, 1994. The total number of shares of common stock of Telesis beneficially owned by the group is less than 1% of the class outstanding. Amount and Nature of Presently Beneficial Exercisable Name of Beneficial Owner Ownership Options Total ------------------------------ ------------ ------------- ---------- Sam Ginn ..................... 9,883(1)(2) 166,600 176,483 C. Lee Cox ................... 6,598 93,000 99,598 Lydell L. Christensen ........ 1,489 23,750 25,239 George F. Schmitt ............ 689 20,800 21,489 Jan K. Neels ................. 1,482 19,047 20,529 Carol A. Bartz ............... 0 0 0 Donald G. Fisher ............. 0 0 0 James R. Harvey .............. 2,467(1) 3,000 5,467 Paul Hazen ................... 1,750 3,000 4,750 Arthur Rock .................. Charles R. Schwab . . . . . . 0 0 0 George P. Shultz . . . . . . 0 0 0 All directors and executive .. 0 0 0 officers as a group (20 persons) . . . . . . . . 41,133 458,590 499,723 _____________________ (1) Includes the following shares of Telesis common stock in which the beneficial owner shares voting and investment power: Mr. Ginn, 1,860 shares; and Mr. Harvey, 2,467 shares. (2) Includes one share beneficially owned by a dependent child, for which beneficial ownership is disclaimed. At the time of the Spin-off, such officers and, directors will receive shares of Common Stock in proportion to the shares of the common stock of Telesis they own and that unexercised options to purchase common stock of Telesis ("Telesis Options") held by directors, officers and employees of the Company will be replaced by options to purchase Common Stock of the Company ("Company Options"). Company Options will be granted under the Company's 1993 Long-Term Stock Incentive Plan. To determine the number and exercise price of Company Options to be granted to replace the Telesis Options, an exchange ratio will be computed by dividing the market price of the Company's Common Stock before the Spin-off by the market price of Telesis common stock before the Spin-off. The number of shares subject to each Telesis Option will be divided by that ratio, and the original exercise price per share under such Telesis Option will be multiplied by that ratio. The aggregate spread between the option exercise price and the market value of the underlying stock will not change as a result of the substitution of a Company Option for a Telesis Option, and the terms of the option (other than the exercise price) will remain the same in all material respects. As an example, based upon an assumed average price for Telesis common stock of $55 per share for the last 10 consecutive trading days before the ex-dividend date and an assumed average price for the Common Stock of the Company of $23 per share for the same period, and assuming that all options held on December 31, 1993, remain outstanding, the following individuals and groups would hold the Company Options exercisable in the following amounts: Mr. Ginn, 398,391 shares; Mr. Cox, 222,391 shares; Mr. Christensen, 56,793 shares; Mr. Schmitt, 49,739 shares; Mr. Neels, 45,547 shares; Mr. Harvey, 7,174 shares; Mr. Hazen, 7,174 shares; and all directors and executive officers as a group, 1,096,628 shares. Additional options to purchase Common Stock may be granted to directors, officers and other key employees of the Company in the future under the Company's plan. See "-1993 Long-Term Stock Incentive Plan." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Company currently has a variety of contractual and other relationships with Telesis and its affiliates and has entered or will enter into other arrangements to facilitate the Spin-off. A description of these existing and contemplated arrangements follows. PAST TRANSACTIONS WITH TELESIS AND ITS AFFILIATES The Company and Telesis maintain a number of financial and administrative arrangements and regularly engage in transactions with each other and their affiliates. The CPUC and the FCC have established rules and regulations requiring that the Company and its affiliates be fully separated from Pacific Bell and Nevada Bell. In addition, transactions between the Company and such entities are governed by extensive rules, regulations and reporting requirements established by the CPUC. The following summarizes transactions between the Company and Telesis or subsidiaries of Telesis since January 1, 1990. In the past, the Company has met its funding requirements primarily through borrowings from PTCR and equity contributions from Telesis. During the years ended December 31, 1993, 1992 and 1991, the largest aggregate month-end amount of indebtedness outstanding to PTCR was $718.0 million, $958.4 million and $597.9 million, respectively. During the third quarter of 1993, Telesis substantially settled the Company's tax benefits receivable arising from tax losses utilized in Telesis' consolidated tax returns. This settlement was used to substantially eliminate the Company's indebtedness to PTCR at December 31, 1993. PTCR has charged the Company interest on such borrowings at rates which averaged 6.1%, 5.7% and 8.1% during the years ended December 31, 1993, 1992 and 1991, respectively. Telesis' equity contributions to the Company were primarily used to repay the Company's loans from PTCR. Equity contributions to the Company by Telesis were $1,179.8 million, $212.2 million and $71.4 million in the years ended December 31, 1993, 1992 and 1991, respectively. The Company also paid dividends to Telesis. Such dividends totaled $113.6 million, $108.3 million and $125.3 million in the years ended December 31, 1993, 1992 and 1991, respectively. In addition, Telesis has historically provided administrative services, and Pacific Bell and Nevada Bell have provided interconnection with their wireline telephone systems and other services, to the Company. In the years ended December 31, 1993, 1992 and 1991, amounts paid by the Company to Telesis for accounting, tax, legal and other such services were $15.2 million, $13.3 million and $11.9 million, respectively. Amounts paid by the Company to Pacific Bell and Nevada Bell for interconnection and other expenses during such periods were $28.5 million, $29.0 million and $29.3 million, respectively. The Company paid insurance premiums in 1993, 1992 and 1991 of $2.6 million, $1.9 million and $1.2 million, respectively, to PacTel Reinsurance, a reinsurance subsidiary of Telesis. In addition, the Company recognized expenses in such years of $1.8 million, $2.2 million and $1.2 million, respectively, in connection with work done for Telesis Technologies Laboratory, a research and development subsidiary of Telesis. Telesis has issued various forms of financial support on behalf of the Company. Some of these forms of financial support have been renegotiated and the remainder will be renegotiated prior to the planned Spin-off. No assurance can be given that similar terms can be obtained. FUTURE RELATIONSHIP WITH TELESIS AND ITS AFFILIATES In anticipation of the separation of the ownership of the Company from Telesis, the Company and Telesis have reviewed the contractual and other arrangements that are necessary and appropriate for the Company and Telesis to operate effectively after the Spin-off. PRE-SPIN-OFF FUNDING Telesis has advised the Company that it may offer to purchase shares of Common Stock from the Company prior to the Spin-off at market prices if the Company requires additional funding to effect currently unanticipated opportunities arising during such period. Any shares of Common Stock so purchased by Telesis would be included in the Spin-off. SEPARATION AGREEMENT Telesis and the Company have entered into an agreement relating to various aspects of their operations (the "Separation Agreement") that will govern the relationship between the Company and Telesis and its subsidiaries other than the Company (collectively, the "Telesis Companies") after the Offering. The following summary of certain aspects of the Separation Agreement is qualified in its entirety by reference to the Separation Agreement, a copy of which has been filed as an exhibit to the Registration Statement. CORPORATE OPPORTUNITIES. Under the Separation Agreement, Telesis and the Company have agreed to allocate corporate business opportunities between (i) the Telesis Companies on the one hand and (ii) the Company on the other hand. This agreement, by its terms, will terminate at the time of the Spin-off. The agreement provides that Telesis will have the right to determine, in its sole discretion, what future business opportunities the Telesis Companies will pursue, in addition to or to the exclusion of the Company, even if such determination excludes the Company from currently existing or future opportunities that could be considered logical, natural or beneficial extensions of the Company's business. Notwithstanding the foregoing, the agreement further provides that (i) the Company will have the right to pursue, to the exclusion of the Telesis Companies, all domestic and international business opportunities which, in whole or substantial part, are: (a) cellular (as defined in 47 C.F.R. 22.900 et seq.), (b) paging or (c) radiolocation opportunities; and (ii) in the unlikely event that to any extent the FCC in its final regulations does not permit separate applications for PCS licenses (as defined in FCC GEN Docket No. 90-314) by both the Telesis Companies and the Company, whether by denial of waivers or otherwise, the Company will have the right to such extent to pursue, to the exclusion of the Telesis Companies, all PCS opportunities outside California and Nevada, and the Telesis Companies will have the right to such extent to pursue, to the exclusion of the Company, all PCS opportunities inside California and Nevada. If the FCC does not permit such separate applications and if the territory intended to be served under a prospective PCS license includes portions of California or Nevada as well as territories outside California and Nevada, the Telesis Companies will have the right to pursue such opportunity to the exclusion of the Company. (Such right is subject to an obligation on the part of the Telesis Companies to use their reasonable best efforts to assign (at the expense of the Company) all such opportunities outside California and Nevada to the Company, and if the Board of Directors of Telesis determines that the Telesis Companies would for any reason be unable to accomplish this assignment, the Board of Directors of Telesis will decide, in its sole discretion, whether such opportunity should be pursued exclusively by the Telesis Companies or exclusively by the Company.) The agreement also provides that each party must use its best efforts to decide whether to pursue a business opportunity as soon as reasonably possible after first learning of the opportunity. If a party decides not to pursue a business opportunity that it has the right to pursue to the exclusion of the other party, it must promptly inform the other party of such decision. The other party would then be free to pursue such opportunity. The Company's Amended and Restated Articles of Incorporation provide that the Company may not bring any claim against the Telesis Companies or the Company, or any officer, director or other affiliate thereof, for breach of any duty, including, but not limited to, the duty of loyalty or fair dealing, on account of a diversion of a corporate business opportunity to the Telesis Companies unless such opportunity relates solely to a business that the Company has the right to elect to pursue, to the exclusion of the Telesis Companies, pursuant to the agreement described above. Notwithstanding the foregoing, no such claim may be made in any event if the Company's directors who are not employees of any of the Telesis Companies disclaim the opportunity by a unanimous vote. EMPLOYEE BENEFITS. Another component of the Separation Agreement provides for (1) the exchange of participation, service and compensation records of employees who transfer between Telesis and the Company; (2) the filing of annual reports and compliance with other legal requirements applicable to the parties' employee benefit plans; (3) the transfer of pension assets and liabilities from Telesis to the Company and vice versa for employees who transfer between the two; (4) the allocation of assets and liabilities under various nonqualified pension and deferred-compensation plans maintained by Telesis for the benefit of employees and non-employee directors; (5) the disposition of outstanding stock options, stock appreciation rights and long term incentive awards; (6) the allocation of assets and liabilities pertaining to post-retirement life insurance and health care benefits; (7) the allocation of liabilities for accrued vacation, paid leave and certain other benefits; and (8) mutual indemnification by Telesis and the Company for certain matters. TAX SHARING. The Separation Agreement also governs the manner in which Telesis and the Company will allocate their respective shares of federal and state income taxes and make payments between them and to taxing authorities in accordance with such tax allocations. The Company will continue to join in filing consolidated federal income tax returns with Telesis for all taxable years in which the parties are required or permitted to file a consolidated return. In each taxable year for which the parties file a consolidated return, Telesis will pay the tax to the taxing authority, and the Company will pay Telesis the Company's share of the consolidated tax liability based upon the Company's separate taxable income. If the Company would have reported a net operating loss for any such year, Telesis will pay to the Company an amount equal to Telesis' reduction in tax liability attributable to the Company's net operating loss. The party with more than 50% of the liability exposure or refund claim for an issue will, to the extent possible, control any audit, appeals and refund procedures for that issue. In addition, the Separation Agreement provides that tax liabilities from the Spin-off and certain related transactions will be allocated to the Company if such liabilities result from any event occurring in the 24-month period commencing on the date of the Spin-off and involving either the stock or assets of the Company. The Company has not taken, and does not anticipate taking, any actions that it believes would result in the allocation to the Company of any material liabilities pursuant to this provision. INTELLECTUAL PROPERTY. The Separation Agreement addresses Telesis' and the Company's respective rights and obligations after the Spin-off with respect to pre-Spin-off intellectual property, including proprietary information, copyrights and copyrightable works, patents and patentable inventions, and trademarks and trade names as well as the use of proprietary information by employees of Telesis and the Company, including employees transferred in connection with the Spin-off. Telesis will convey or license certain intellectual property to the Company effective as of the Spin-off. Among other things, the Company is required to terminate its use of the Telesis symbol mark and the names "Pacific Telesis International" and "PacTel," including the "PacTel Cellular" and "PacTel Paging" brand names. The Company will have a non-exclusive license to use the PacTel name until the second anniversary of the Spin-off. CONTINGENT LIABILITIES. The Separation Agreement allocates financial responsibility for liabilities which are not recorded on the books of the Company or the Telesis Companies prior to the Spin-off and which are attributable to (1) a pre-Spin-off event, (2) a condition that existed prior to the Spin-off, or (3) a post-Spin-off event attributable to the separation of the Company and the Telesis Companies. In general, financial responsibility for liabilities associated with the business of the Company is placed with the Company and liabilities associated with the business of the Telesis Companies is placed with Telesis. The agreement allocates responsibility for the defense of litigation and other proceedings. The Separation Agreement also contains mutual releases from certain liabilities arising from events occurring on or before the Spin-off, including transactions and activities involved in implementing the Spin-off. TELESIS TECHNOLOGIES LABORATORY. The Separation Agreement provides that, no later than the Spin-off, Telesis will transfer to the Company certain assets that have been engaged in the wireless communications research and development work of Telesis Technologies Laboratory ("TTL"), which will remain a subsidiary of Telesis after the Spin-off. The experimental PCS licenses currently held by TTL will remain with TTL. Telesis and the Company will agree on the manner in which any uncompleted work of TTL will be completed after the Spin-off. Existing agreements governing the ownership of, and other rights in, the intellectual property work product of TTL produced prior to the Spin-off will remain in effect and will also apply to any current TTL work jointly completed by Telesis and the Company after the Spin-off. Such existing agreements provide that TTL owns all such TTL intellectual property and that the Company has a royalty-free, nonexclusive, perpetual license to use it. OTHER MATTERS. The Separation Agreement also governs, among other things, (1) the provision by Telesis of certain administrative services, such as tax, accounting and legal services, prior to the Spin-off and, if mutually agreed, for up to 90 days thereafter and the compensation to be paid by the Company for such services, (2) the transfer of certain additional assets and liabilities from Telesis to the Company at net book value, (3) the termination of certain specified agreements between the Company and Telesis upon the Spin-off and (4) the separation of the Company from the existing Telesis property and casualty insurance program, the allocation of insurance-related liabilities of Telesis and the Company and other insurance issues. Mr. White's wife is a principal of Price Waterhouse, which provides auditing, consulting, and tax return preparation services to the Company and certain of its subsidiaries. During the year ended December 31, 1993, the Company and such subsidiaries paid that firm fees of approximately $0.3 million. Charles Schwab & Co. Inc., of which Mr. Schwab is Chairman, has subleased office space from Telesis since April 6, 1992 under a lease that expires on December 17, 1999. The minimum rent payable over the entire term of the lease is approximately $5.6 million. 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: AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES Report of Independent Accountants Consolidated Statements of Income Years ended December 31, 1993, 1992, and 1991 Consolidated Balance Sheets December 31, 1993 and 1992 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 MANNESMANN MOBILFUNK GMBH Independent Auditors' Report Balance Sheets - December 31, 1993 and 1992 Statements of Operations - Years ended December 31, 1993, 1992, and Statements of Capital Subscribers' Equity - Years ended December 31, 1993, 1992, and 1991 Statements of Cash Flows - Years ended December 31, 1993, 1992, and Notes to Financial Statements NEW PAR Report of Independent Auditors Consolidated Balance Sheets December 31, 1993 and 1992 Consolidated Statements of Income Years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 Consolidated Statements of Partners' Capital Years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 Consolidated Statements of Cash Flows Years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 Notes to Consolidated Financial Statements 2. Financial Statement Schedules: AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES Schedule I -- Marketable Securities Schedule II -- Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other Than Related Parties Schedule IV -- Indebtedness of and to Related Parties - Not Current 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 Schedules other than those listed above are omitted because they are either not required or not applicable, or the required information is presented in the Consolidated Financial Statements. 3. Exhibits: Exhibits identified in parentheses below, on file with the Commission, are incorporated by reference as exhibits hereto. Exhibit Number Description ------- ----------- 3.1 Amended and Restated Articles of Incorporation of the Company, as filed with the Secretary of State of the State of California on November 29, 1993 3.2 Certificate of Amendment of Articles of Incorporation of the Company, as filed with the Secretary of State of the State of California on March 10, 1994 3.3 Amended and Restated By-laws of the Company, as amended to February 25, 1994 4.1 Form of Common Stock certificate (Exhibit 4.1 to the Company's Registration Statement on Form S-1, File No. 33-68012) 4.2 Rights Agreement between the Company and The Bank of New York, Rights Agent, dated as of July 22, 1993 (Exhibit 4.2 to the Company's Registration Statement on Form S-1, File No. 33-68012) 10.1 Separation Agreement by and between the Company and Pacific Telesis Group, dated as of October 7, 1993 (Exhibit 10.1 to the Company's Registration Statement on Form S-1, File No. 33-68012) 10.2 Amendment No. 1 to Separation Agreement, dated November 2, 1993 10.3 Amended and Restated Plan of Merger and Joint Venture Organization by and among the Company, CCI, CCI Newco, Inc. and CCI Newco Sub, Inc. dated as of December 14, 1990 (Exhibit 1 to the Company's Statement on Schedule 13D filed on February 18, 1992) 10.4 Termination Agreement by and among Telesis, the Company, CCI and Cellular Communications of Ohio, Inc. dated December 11, 1992 (Exhibit 5 to Amendment No. 28 to the Company's Statement on Schedule 13D filed on December 12, 1992) 10.5 Joint Venture agreement between Mannesmann Kienzle GmbH, Pacific Telesis Netherlands B.V., Cable and Wireless plc, DG Bank Deutsch Genossenschaftsbank and Lyonnaise des Eaux SA dated June 30, 1989 (Exhibit 10.43 to the Company's Registration Statement on Form S-1, File No. 33-68012) 10.6 Form of Indemnity Agreement between the Company and each of its directors (Exhibit 10.2 to the Company's Registration Statement on Form S-1, File No. 33-68012) 10.7 PacTel Corporation 1993 Long-Term Stock Incentive Plan 10.8 PacTel Corporation Long-Term Incentive Plan (Exhibit 10.4 to the Company's Registration Statement on Form S-1, File No. 33-68012) 10.9 PacTel Corporation Short-Term Incentive Plan 10.10 PacTel Corporation Deferred Compensation Plan for Nonemployee Directors 10.11 PacTel Corporation Deferred Compensation Plan 10.12 PacTel Corporation Supplemental Executive Pension Plan 10.13 PacTel Corporation Executive Life Insurance Plan 10.14 PacTel Corporation Executive Long-Term Disability Plan 10.15 Representative Employment Agreement for Certain Senior Officers of Pacific Telesis Group (Exhibit 10pp to Form 10-K of Telesis for 1988, File No. 1-8609) 10.16 Pacific Telesis Group Senior Management Short Term Incentive Plan (Exhibit 10-aa to Pacific Telesis Group Shareowner Dividend Reinvestment and Stock Purchase Plan Registration Statement No. 2-87852) 10.17 Resolutions amending the Plan, effective August 28, 1987 (Exhibit 10aa to Form 10-K of Telesis for 1991, File No. 1-8609) 10.18 Pacific Telesis Group Senior Management Long Term Incentive Plan (Exhibit 10aa to Form 10-K of Telesis for 1985, File No. 1-8609) 10.19 Pacific Telesis Group Executive Life Insurance Plan (Exhibit 10cc to Form 10-K of Telesis for 1986, File No. 1-8609) 10.20 Pacific Telesis Group Senior Management Long Term Disability and Survivor Protection Plan (Exhibit 10dd to Form 10-K of Telesis for 1988, file No. 1-8609) 10.21 Resolutions amending the Plan effective May 2, 1992 and November 20, 1992 (Exhibit 10dd(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.22 Pacific Telesis Group Senior Management Transfer Program (Exhibit 10ee to Pacific Telesis Group Shareowner Dividend Reinvestment and Stock Purchase Plan Registration Statement No. 2-87852) 10.23 Pacific Telesis Group Senior Management Financial Counseling Program (Exhibit 10ff to Pacific Telesis Group Shareowner Dividend Reinvestment and Stock Purchase Plan Registration Statement No. 2-87852) 10.24 Pacific Telesis Group Deferred Compensation Plan for Nonemployee Directors (Exhibit 10gg to Form 10-K of Telesis for 1990, File No. 1-8609) 10.25 Resolutions amending the Plan effective December 21, 1990, November 20, 1992 and December 18, 1992 (Exhibit 10gg(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.26 Description of Pacific Telesis Group Directors' and Officers' Liability Insurance Program (Exhibit 10hh to Form 10-K of Telesis for 1992, File No. 1-8609) 10.27 Description of Pacific Telesis Group for Nonemployee Directors' Travel Accident Insurance (Exhibit 10ii to Form 10-K of Telesis for 1989, File No. 1-8609) 10.28 Resolutions amending the Plan, effective as of June 28, 1991 (Exhibit 10kk to Form 10-K of Telesis for 1991, File No. 1-8609) 10.29 Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10kk(ii) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.30 Pacific Telesis Group Mid-Career Hire Program (Exhibit 10mm to Form 10-K of Telesis for 1988, File No. 1-8609) 10.31 Pacific Telesis Group Mid-Career Pension Plan (Exhibit 10nn to Form 10-K of Telesis for 1986, File No. 1-8609) 10.32 Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10kk(ii) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.33 Pacific Telesis Group Executive Deferral Plan (Exhibit 1011 to Form 10-K of Telesis for 1989, File No. 1-8609) 10.34 Resolutions amending the Plan effective November 20, 1992 and December 23, 1992 (Exhibit 1011(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.35 Pacific Telesis Group Stock Option and Stock Appreciation Rights Plan (Plan Text, Sections 1-17, in Registration Statement No. 33-15391) 10.36 Resolutions amending the Plan effective November 17, 1989 and June 26, 1992 (Exhibit 10oo(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.37 Pacific Telesis Group Outside Directors' Retirement Plan (Exhibit 10ss to Form 10-K of Telesis for 1984, File No. 1-8609) 10.38 Resolution amending the Plan effective May 25, 1990 (Exhibit 10ss(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.39 Representative Indemnity Agreement between Pacific Telesis Group and certain of its officers and each of its directors (Exhibit 10tt to Form 10-K of Telesis for 1987, File No. 1-8609) 10.40 Trust Agreement between Pacific Telesis Group and Bank of America National Trust and Savings Association in connection with the Pacific Telesis Group Executive Deferral Plan (Exhibit 10uu to Form 10-K of Telesis for 1988, File No. 1-8609) 10.41 Amendment to Trust Agreement No. 1 effective December 11, 1992 (Exhibit 10uu(i) to Form 10-K of Telesis of 1992, File No. 1-8609) 10.42 Trust Agreement between Pacific Telesis Group and Bank of America National Trust and Savings Association in connection with the Pacific Telesis Group Deferred Compensation Plan for the Non- Employee Directors (Exhibit 10vv to Form 10-K of Telesis for 1988, File No. 1-8609) 10.43 Amendment to Trust Agreement No. 2 effective December 11, 1992 (Exhibit 10vv(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.44 Pacific Telesis Group Long Term Incentive Award Deferral Plan (Exhibit 10ww to Form 10-K of Telesis for 1989, File No. 1-8609) 10.45 Resolutions merging the Plan with the Executive Deferral Plan effective May 22, 1992 (Exhibit 10ww(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.46 Pacific Telesis Group Nonemployee Director Stock Option Plan (Exhibit A to Pacific Telesis Group's 1990 Proxy Statement filed February 26, 1990, File No. 1-8609) 10.47 Pacific Telesis Group Supplemental Executive Retirement Plan (Exhibit 10yy to Form 10-K of Telesis for 1990, File No. 1-8609) 10.48 Resolutions amending the Plan effective November 20, 1992 (Exhibit 10yy(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 21 Subsidiaries of the Company (Exhibit 21 to the Company's Registration Statement on Form S-1, File No. 33-68012) 23.1 Consent of Coopers & Lybrand 23.2 Consent of Ernst & Young 23.3 Consent of KPMG Deutsche Treuhand-Gesellschaft 24 Powers of Attorney 99 Modification of Final Judgment, United States District Court, District of Columbia, in "U.S. v. American Tel. & Tel. Co.," Civil Action No. 82-0192 (Exhibit 99 to the Company's Registration Statement on Form S-1, File No. 33-68012) (b) 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 and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AIRTOUCH COMMUNICATIONS By: /s/ Mohan S. Gyani Title: Vice President, Finance and Treasurer Date: 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 dates indicated. Signatures Title ---------- ----- Samuel L. Ginn * Chairman of the Board and Chief Executive Officer (Principal Executive Officer) Lydell L. Christensen * Executive Vice President and Chief Financial Officer and Treasurer (Principal Financial Officer) Mohan S. Gyani * Vice President - Finance and Treasurer (Chief Accounting Officer) C. Lee Cox * President and Chief Operating Officer and Director James R. Harvey * Director Paul Hazen * Director Donald G. Fisher * Director Arthur Rock * Director Charles R. Schwab * Director George P. Shultz * Director * By /s/ Mohan S. Gyani Mohan S. Gyani, Attorney-in-fact Date: March 22, 1994 PAGE ---- AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES Report of Management . . . . . . . . . . . . . . . . . . . . . . . Report of Independent Accountants . . . . . . . . . . . . . . . . . Consolidated Statements of Income for the years ended December 31, 1993, 1992, and 1991 . . . . . . . . . . . . . . . . Consolidated Balance Sheets as of December 31, 1993 and 1992 . . . Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992, and 1991 . . . . . . . . . . Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991 . . . . . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . . . . NEW PAR (PARTNERSHIP BETWEEN CCI AND THE COMPANY) Report of Independent Auditors . . . . . . . . . . . . . . . . . . Consolidated Balance Sheets as of December 31, 1993 and 1992 . . . Consolidated Statements of Income for the year ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 . . . . . . . . . Consolidated Statements of Partners' Capital for the years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 . . . . . . . . . Consolidated Statements of Cash Flows for the years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . . . . MANNESMANN MOBILFUNK GMBH Independent Auditors' Report . . . . . . . . . . . . . . . . . . . Balance Sheets as of December 31, 1993 and 1992 . . . . . . . . . . Statements of Operations for the years ended December 31, 1993, 1992, and 1991 . . . . . . . . . . . . . . . . Statements of Capital Subscribers' Equity for the years ended December 31, 1993, 1992, and 1991 . . . . . . . . . . . . . . . . Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991 . . . . . . . . . . . . . . . . Notes to Financial Statements . . . . . . . . . . . . . . . . . . . REPORT OF MANAGEMENT To the Shareholders of AirTouch Communications: FINANCIAL STATEMENTS AirTouch Communications' management prepared the accompanying financial statements and is responsible for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles applied on a consistent basis and are not misstated as a result of material fraud or error. The financial statements include amounts based on management's best estimates and judgments, where necessary. Management also prepared the other information in this annual financial review and is responsible for its accuracy and consistency with the financial statements. The Company's financial statements have been audited by Coopers & Lybrand, independent accountants, whose appointment has been ratified by the Board of Directors. Management has made available to Coopers & Lybrand all the Company's financial records and related data, as well as the minutes of meeting of the Board of Directors. Furthermore, management believes that all of the representations made to Coopers & Lybrand during its audit were valid and appropriate. INTERNAL CONTROL SYSTEM AirTouch Communications maintains a system of internal controls over financial reporting, one of the purposes of which is to provide reasonable assurance to the Company's management and Board of Directors regarding the preparation of reliable published financial statements. The Audit Committee of the Pacific Telesis Board of Directors is responsible for overseeing the Company's financial reporting process on behalf of the Board. During 1993, the Audit committee met regularly with management, internal audit and the independent accountants to review internal controls, accounting, auditing, and financial reporting matters. The system of internal controls contains self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified. Even an effective internal control system, no matter how well designed, has inherent limitations including the possibility of the circumvention or overriding of controls and therefore can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control system effectiveness may vary over time. The Company assessed its internal control system in its consolidated operations throughout the year ended December 31, 1993 in relation to criteria for effective internal control over financial reporting described in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). To assess the internal control systems in its unconsolidated partnerships and corporations, management relied on reports issued by various external public accountants who performed audits of those entities, where such reports were available. Based on these assessments, the Company believes that, as of December 31, 1993, its overall system of internal control over financial reporting met the COSO criteria. /s/ Sam L. Ginn /s/ Lydell L. Christensen Chairman and Chief Executive Officer Executive Vice President and March 3, 1994 Chief Financial Officer REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of AirTouch Communications: We have audited the accompanying consolidated balance sheets of AirTouch Communications (formerly PacTel Corporation) and Subsidiaries (the "Company") as of December 31, 1993 and 1992 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. 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 did not audit the 1993 and 1992 financial statements of Mannesmann Mobilfunk GmbH ("MMO"), an equity investee of the Company, which statements reflect total assets of $1,221,135,000 and $850,661,000 as of December 31, 1993 and 1992, respectively, and total net loss of $67,655,000 and $52,983,000 for the years ended December 1993 and 1992, respectively. Those statements were audited by other auditors whose reports have been furnished to us, and our opinion, insofar as it related to the amounts included for MMO, is based solely on the reports of the other auditors. We conducted our audits in accordance with generally accepted accounting 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 and the reports of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of AirTouch Communications 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. As discussed in Notes A and H to the consolidated financial statements, in 1992 the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." As discussed in Notes A and J, in 1993 the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." /s/ Coopers & Lybrand San Francisco, California March 3, 1994 (except for Notes B, L, and R, as to which the date is March 9, 1994) AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME For the Year Ended December 31, ------------------------------- 1993 1992 1991 -------- -------- --------- (Dollars in millions, except per share amounts) OPERATING REVENUES Wireless services and other revenues........ $987.3 $834.8 $749.5 Cellular and paging equipment sales......... 70.4 45.4 31.6 Cost of cellular and paging equipment sales. (69.7) (41.7) (27.9) -------- -------- -------- NET OPERATING REVENUES...................... 988.0 838.5 753.2 -------- -------- -------- OPERATING EXPENSES Cost of revenues............................ 144.0 132.7 110.5 Selling, general, administrative, and other expenses........................ 541.6 466.5 376.1 Depreciation and amortization............... 174.2 143.4 130.0 -------- -------- -------- TOTAL OPERATING EXPENSES.................... 859.8 742.6 616.6 -------- -------- -------- OPERATING INCOME............................ 128.2 95.9 136.6 Interest expense............................ (22.1) (52.9) (37.6) Minority interests in net income of consol- idated partnerships and corporations...... (46.4) (45.5) (45.2) Equity in net income (loss) of unconsol- idated partnerships and corporations: Domestic................................ 70.4 41.1 15.5 International........................... (37.5) (38.5) (21.4) Interest income............................. 12.0 13.3 13.8 Gain on sale of telecommunications interests 3.8 - 26.0 Miscellaneous income (expense).............. (0.5) 1.0 5.2 -------- -------- -------- INCOME BEFORE INCOME TAXES, EXTRAORDINARY ITEM AND CUMULATIVE EFFECTS OF ACCOUNTING CHANGES................................... 107.9 14.4 92.9 Income taxes................................ 67.8 24.5 49.8 -------- -------- -------- INCOME (LOSS) BEFORE EXTRAORDINARY ITEM AND CUMULATIVE EFFECTS OF ACCOUNTING CHANGES.. 40.1 (10.1) 43.1 Extraordinary item-loss from retirement of debt (net of income taxes of $5.1) (Note T).................................. - (7.6) - Cumulative effect of accounting change for income taxes (Notes A and H).......... - 27.9 - Cumulative effect of accounting change for other postretirement benefits (net of income taxes of $3.5) (Notes A and J)..... (5.6) - - -------- -------- -------- NET INCOME.................................. $ 34.5 $ 10.2 $ 43.1 ======== ======== ======== (Continued next page) AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Continued) For the Year Ended December 31, ------------------------------- 1993 1992 1991 -------- -------- -------- (Dollars in millions, except per share amounts) PER SHARE AMOUNTS: Income (loss) before extraordinary item and cumulative effect of the changes in accounting for other postretirement benefits in 1993 and income taxes in 1992....................................... $0.09 $(0.02) $0.10 Extraordinary item........................... - (0.02) - Cumulative effect of the changes in accounting for other postretirement benefits in 1993 and income taxes in 1992.. (0.01) 0.06 - -------- -------- -------- NET INCOME................................... $0.08 $0.02 $0.10 ======== ======== ======== Weighted average shares outstanding (in millions).............................. 429.6 424.0 424.0 ======== ======== ======== The accompanying Notes are an integral part of the Consolidated Financial Statements. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, -------------------- 1993 1992 --------- --------- (Dollars in millions) ASSETS Cash and cash equivalents............................ $ 646.7 $ 17.1 Accounts receivable-net of allowance for uncollectibles of $9.2 and $10.0, in 1993 and 1992, respectively ................................ 132.7 121.6 Short-term investments............................... 814.0 - Other receivables.................................... 15.1 24.9 Due from affiliates.................................. 7.0 246.9 Other current assets................................. 45.3 28.6 --------- --------- Total current assets................................. 1,660.8 439.1 --------- --------- Property, plant, and equipment....................... 1,175.5 1,098.8 Less: accumulated depreciation....................... 433.4 373.1 --------- --------- Property, plant, and equipment-net................... 742.1 725.7 Investments in unconsolidated partnerships and corporations...................... 1,154.5 935.4 Intangible assets-net................................ 413.2 225.0 Deferred charges and other noncurrent assets......... 106.1 45.9 --------- --------- TOTAL ASSETS......................................... $4,076.7 $2,371.1 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY Accounts payable..................................... $ 149.2 $ 141.8 Due to affiliates within one year.................... 40.7 906.7 Other current liabilities............................ 124.1 89.0 --------- --------- Total current liabilities............................ 314.0 1,137.5 Due to non-affiliates................................ 68.6 22.4 Due to affiliates.................................... - 134.5 Deferred income taxes................................ 197.6 180.4 Deferred credits..................................... 54.1 17.6 --------- --------- TOTAL LIABILITIES.................................... 634.3 1,492.4 --------- --------- Commitments and contingencies. Minority interests in consolidated partnerships and corporations...................... 105.1 126.6 --------- --------- (Continued on next page) AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Continued) December 31, -------------------- 1993 1992 --------- --------- (Dollars in millions, except per share amounts) Preferred stock ($.01 par value; 50,000,000 shares authorized; no shares issued or outstanding)....... - - Common stock ($.01 par value; 1,100,000,000 shares authorized; 492,622,960 shares issued and 492,500,000 shares outstanding at December 31, 1993; 424,122,960 shares issued and 424,000,000 shares outstanding at December 31, 1992)........... 4.9 4.2 Additional paid-in capital .......................... 3,719.5 1,051.2 Accumulated deficit.................................. (387.9) (308.8) Currency translation adjustment...................... 0.8 5.5 --------- --------- TOTAL SHAREHOLDERS' EQUITY........................... 3,337.3 752.1 --------- --------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........... $4,076.7 $2,371.1 ========= ========= The accompanying Notes are an integral part of the Consolidated Financial Statements. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY For the Year Ended December 31, ------------------------------- 1993 1992 1991 --------- --------- --------- PREFERRED STOCK (Dollars in millions) Balance at beginning of period............ - - - --------- --------- --------- Balance at end of period.................. - - - --------- --------- --------- COMMON STOCK Balance at beginning of period............ $ 4.2 $ 4.2 $ 4.2 Shares issued during the period .......... 0.7 - - --------- --------- --------- Balance at end of period ................. 4.9 4.2 4.2 --------- --------- --------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period ........... 1,051.2 839.0 767.6 Equity infusion by parent................. 1,179.8 212.2 71.4 Net proceeds from stock offering ......... 1,488.5 - - --------- --------- --------- Balance at end of period.................. 3,719.5 1,051.2 839.0 --------- --------- --------- ACCUMULATED DEFICIT Balance at beginning of period............ (308.8) (210.7) (128.5) Net income ............................... 34.5 10.2 43.1 Dividends paid to parent.................. (113.6) (108.3) (125.3) --------- --------- --------- Balance at end of period.................. (387.9) (308.8) (210.7) --------- --------- --------- CURRENCY TRANSLATION ADJUSTMENT Balance at beginning of period............ 5.5 2.7 1.3 Gains (losses)............................ (4.7) 2.8 1.4 --------- --------- --------- Balance at end of period.................... 0.8 5.5 2.7 --------- --------- --------- TOTAL SHAREHOLDERS' EQUITY.................. $3,337.3 $ 752.1 $ 635.2 ========= ========= ========= COMMON SHARES OUTSTANDING (in millions) Balance at beginning of period............ 424.0 424.0 424.0 Shares issued during the period........... 68.5 - - --------- --------- --------- Balance at end of period.................. 492.5 424.0 424.0 ========= ========= ========= The accompanying Notes are an integral part of the Consolidated Financial Statements. AIRTOUCH COMMMUNICATIONS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Year Ended December 31, -------------------------- 1993 1992 1991 -------- -------- -------- CASH FROM (USED FOR) OPERATING ACTIVITIES: (Dollars in millions) Net income................................. $ 34.5 $ 10.2 $ 43.1 Adjustments to reconcile net income for items currently not affecting operating cash flows: Depreciation and amortization.......... 174.2 143.4 130.0 Deferred income taxes.................. 15.5 36.0 33.5 Minority interests in net income of consolidated partnerships and corporations......................... 46.4 45.5 45.2 Equity in net (income) loss of unconsolidated partnerships and corporations......................... (32.9) (2.6) 5.9 Gain on sale of telecommunications interests............................ (3.8) - (26.0) Distributions received from equity investments.......................... 42.2 17.0 - Loss on sale of property, plant, and equipment............................ 7.2 3.9 4.1 Loss from retirement of debt........... - 12.7 - Cumulative effect of accounting change for income taxes..................... - (27.9) - Cumulative effect of accounting change for postretirement costs............. 9.1 - - Changes in assets and liabilities: Accounts receivable-net.............. (30.3) (21.8) (21.1) Other current assets and receivables. 131.8 (126.8) (10.8) Deferred charges and other noncurrent assets............................. 3.1 47.7 (49.4) Accounts payable and other current liabilities........................ 18.0 62.4 17.8 Deferred credits and other liabilities........................ 24.7 (0.8) (3.2) -------- -------- -------- CASH FROM OPERATING ACTIVITIES............. 439.7 198.9 169.1 -------- -------- -------- CASH FROM (USED FOR) INVESTING ACTIVITIES: Additions to property, plant, and equipment (226.3) (233.0) (234.8) Proceeds from sale of property, plant, and equipment............................ 9.5 7.6 20.3 Proceeds from sale of telecommunications interests................................ 4.3 8.1 37.4 Capital contributions to unconsolidated partnerships and corporations............ (123.8) (135.0) (93.8) (Continued on next page) AIRTOUCH COMMMUNICATIONS AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Year Ended December 31, ----------------------------- 1993 1992 1991 --------- --------- --------- Cost of acquiring telecommunications (Dollars in millions) interests: Cellular Communications, Inc............. (9.9) (92.2) (89.7) Wichita and Topeka Cellular.............. (100.0) - - NordicTel Holdings AB.................... (153.0) - - Other ................................... (0.2) (6.6) (36.5) Purchase of short-term investments......... (814.0) - - Other investing activities................. (28.0) (40.8) (33.1) --------- --------- --------- CASH USED FOR INVESTING ACTIVITIES......... (1,441.4) (491.9) (430.2) --------- --------- --------- CASH FROM (USED FOR) FINANCING ACTIVITIES: Retirement of notes and obligations payable.................................. (1.0) (100.7) (0.8) Retirement of long-term debt from affiliate (234.5) - - Distributions to minority interests in consolidated partnerships and corporations............................ (30.3) (41.5) (28.1) Contributions from minority interests in consolidated partnerships and corporations............................ 2.8 3.3 10.2 Dividends paid to parent................... (113.6) (108.3) (125.3) Increase (decrease) in short-term borrowings from affiliates.............. (773.1) 275.5 351.3 Proceeds from non-current affiliate borrowings.............................. - 85.0 40.0 Proceeds from issuing long-term debt....... 13.8 1.2 11.3 Proceeds from stock offering............... 1,489.2 - - Equity infusion by parent.................. 1,179.8 212.2 71.4 Issuance of loan to affiliate.............. (6.8) (30.0) (79.4) Loan repayments from affiliate............. 106.5 5.5 4.2 Other financing activities................. (1.5) (9.1) (0.2) --------- --------- --------- CASH FROM FINANCING ACTIVITIES............. 1,631.3 293.1 254.6 --------- --------- --------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS......................... 629.6 0.1 (6.5) BEGINNING CASH AND CASH EQUIVALENTS........ 17.1 17.0 23.5 --------- --------- --------- ENDING CASH AND CASH EQUIVALENTS........... $ 646.7 $ 17.1 $ 17.0 ========= ========= ========= The accompanying Notes are an integral part of the Consolidated Financial Statements. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION AirTouch Communications (the "Company"), formerly PacTel Corporation, and its subsidiaries provide wireless telecommunications services in the United States, Europe, and Asia. The Company is a holding company. Its principal subsidiaries are AirTouch Cellular, AirTouch Paging, AirTouch International, and PacTel Teletrac. These subsidiaries principally provide cellular, paging, and vehicle location services. The Company is an 86.1% owned subsidiary of Pacific Telesis Group ("Telesis"), a reporting company under the Securities and Exchange Act of 1934 that also owns Pacific Bell and Nevada Bell, its local telephone companies. In December 1992, Telesis announced that its Board of Directors had approved a plan to separate its wireless telecommunications operations from its other businesses (principally Pacific Bell and Nevada Bell) through a distribution to its shareowners of all of the Common Stock of the Company (the "spin-off") held by Telesis. For further discussion see Note B. The Consolidated Financial Statements include the accounts of the Company and its subsidiaries and partnerships in which the Company has controlling interests. All significant intercompany balances and transactions have been eliminated. Prior periods have been revised to agree with the 1993 presentation format. Equipment sales and cost of equipment are now both presented in the revenue section of the income statements. The Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles applicable in the United States. CASH AND CASH EQUIVALENTS All highly liquid monetary instruments with original maturities of ninety days or less from the date of purchase are considered to be cash equivalents. FINANCIAL INSTRUMENTS Short-term investments consist principally of highly liquid financial instruments with original maturities in excess of three months and are carried at cost, which approximates market. Market value gains and losses on financial instruments that are designated and effective as hedges of foreign currency commitments and net investments are deferred to the extent that the financial instrument is equal to or less than the underlying commitment or investment. The cash that is received from or used for the hedges is reflected as an investing activity in the statements of cash flows. FOREIGN CURRENCY TRANSLATION AND TRANSACTIONS Results of operations for foreign investments are translated using average exchange rates during the period, while assets and liabilities are translated using end-of-period rates. The resulting net exchange gains or losses are accumulated in a separate section of shareholders' equity titled "Currency translation adjustment." Gains and losses resulting from foreign currency transactions are generally included in operations. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) PROPERTY, PLANT, AND EQUIPMENT Assets of businesses purchased are recorded at their fair values at the date of acquisition. All other property, plant, and equipment are recorded at cost. Depreciation is computed using the straight-line method over the related assets' estimated useful lives ranging from three to forty years except land, which is not depreciated (see Note C). Gains and losses on disposals are included in income at amounts equal to the difference between net book value of the disposed assets and proceeds received upon disposal. Expenditures for replacements and betterments are capitalized, while expenditures for maintenance and repairs are charged against earnings as incurred. FCC LICENSES The Federal Communications Commission ("FCC") issues licenses that enable cellular carriers to provide service in specific Cellular Geographic Service Areas. A cellular license is issued conditionally for ten years. The FCC has stated that "a renewal expectancy would be awarded to a cellular licensee if, during the past ten-year term, it had substantially complied with applicable commission rules, policies, and the Communications Act; and not otherwise engaged in substantial relevant misconduct." Historically, the FCC has granted license renewals routinely. The Company believes it has complied and intends to continue to comply with these standards and is amortizing the related costs using the straight-line method over forty years. FCC licenses acquired by the Company through business combinations are stated at appraised values as of the date of acquisition and amortized using the straight-line method over forty years. The Company also has FCC licenses for its paging and vehicle location operations. Amortization is computed on a straight-line basis over periods ranging from twenty to forty years. LICENSE APPLICATION COSTS Costs associated with international license applications for telecommunications services are expensed as incurred. Once the license is granted, the Company capitalizes and amortizes these costs using the straight-line method over the term of the license. SUBSCRIBER LISTS Subscriber lists acquired through business combinations are stated at appraised values as of the date of acquisition. Amortization is computed using the straight-line method over estimated useful lives of up to thirty-six months. GOODWILL The excess of the purchase price paid over the fair value of net assets acquired in business combinations is recorded as goodwill and is amortized using the straight-line method over twenty to forty years. INVESTMENTS IN UNCONSOLIDATED PARTNERSHIPS AND CORPORATIONS The equity method is used to account for all domestic cellular markets and international consortia in which the Company has significant influence but is AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) not the controlling or managing general partner, even though the ownership percentage may be less than 20%. Limited partnership interests and joint ventures in which the Company does not have significant influence are accounted for using the cost method. EARNINGS PER SHARE Earnings per share are calculated by using weighted average common shares outstanding. INCOME TAXES Effective January 1, 1992, the Company adopted new accounting rules for accounting for income taxes (see Note H) which require the use of the liability method of accounting for deferred income taxes. As permitted under the new rules, prior years' financial statements have not been restated. Use of the new rules resulted in a $59.8 million tax benefit to 1992 earnings. Of this amount, $32.0 million is included in "Equity in net income (loss) of unconsolidated partnerships and corporations-international" and $27.9 million is reported within "Cumulative effect of accounting change for income taxes." These amounts were offset by $0.1 million included in "Income Taxes." Deferred income taxes are provided to 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 tax purposes, income tax loss carryforwards and income tax credits. The Company accounts for investment tax credits under the deferral method. The Company is included in the consolidated federal and combined state income tax returns of Telesis (see Note Q). OTHER POSTRETIREMENT BENEFITS In December 1990, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"). The Company currently offers postretirement benefits other than pensions ("postretirement benefits") which are primarily retiree health care and life insurance benefits. SFAS 106 requires the Company to change the method of accounting for these postretirement benefits from a cash basis to an accrual basis beginning in 1993 (see Note J). In the first quarter of 1993, the Company recorded a one-time pre-tax expense and liability of $9.1 million for the transition obligation. In addition, the Company recorded $2.0 million pre-tax expense for the periodic SFAS 106 charge for 1993. The income tax benefits related to these expenses totalled $4.4 million. OTHER POSTEMPLOYMENT BENEFITS In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). The Company offers workers' compensation, short- and long-term disability benefits, medical benefit continuation, and severance pay. These benefits are paid to former employees not yet retired. SFAS 112 requires accrual basis accounting for these postemployment benefits AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) to begin no later than January 1, 1994. The Company intends to adopt this standard by the required adoption date. The Company expects that future recorded expense under SFAS 112 (including any cumulative adjustment upon adoption) will not differ materially from expenses recorded using the current method and therefore believes the adoption of SFAS 112 will not have a material impact on the Company's results of operations and financial condition. INVESTMENTS IN DEBT AND EQUITY SECURITIES In May 1993, the FASB issued Statement of Financial Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). The new standard will change the carrying basis for certain equity and debt securities. The Company intends to adopt SFAS 115 in 1994, consistent with the required adoption period. The Company does not expect SFAS 115 to affect materially its financial position or results of operations. B. PLANNED SPIN-OFF In December 1992, Telesis announced that its Board of Directors had approved a plan to separate its wireless telecommunications operations from its other businesses (principally Pacific Bell and Nevada Bell, its local telephone companies) through a distribution to its shareowners of all of the common stock of the Company held by Telesis. In March 1993, the Company accrued an after tax reserve of $5.0 million related to incremental costs directly attributable to the spin-off. Of such amount, approximately $3.8 million represents estimated costs that will be incurred in connection with the Company's name change, including new signage for the Company's retail and other business locations showing the new name and logo. The remaining $1.2 million represents estimated moving and relocation expenses. All these costs are expected to be incurred only after the spin-off. The Company's operations will continue to function under its current structure. Accordingly, the Company does not expect to write down any assets as a result of the spin-off. In March 1994, Telesis announced that its Board of Directors had given final approval to the spin-off of the Company, which will occur April 1, 1994. On the spin-off date, Telesis will distribute to its shareowners all common shares of the Company it holds. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) C. Property, Plant, and Equipment Property, plant, and equipment consists of the following: December 31, Depreciable -------------------- Lives 1993 1992 ----------- --------- ---------- (Dollars in millions) Property, plant, and equipment: Land and buildings................... 5-40 years $ 128.2 $ 140.1 Cellular plant and equipment......... 5-15 years 647.3 587.1 Pagers, paging terminals, and other paging equipment......... 3-15 years 165.0 138.6 Office furniture and other equipment.................... 3-7 years 172.8 163.7 Construction in progress................ 62.2 69.3 --------- --------- 1,175.5 1,098.8 Less: accumulated depreciation.......... 433.4 373.1 --------- --------- $ 742.1 $ 725.7 ========= ========= Depreciation and amortization expense relating to property, plant, and equipment for the years ended December 31, 1993, 1992, and 1991 was $161.7 million, $132.4 million, and $114.0 million, respectively. Commitments for future acquisitions of property, plant, and equipment at December 31, 1993 are approximately $86.1 million and, depending upon final design specifications, could reach approximately $104.1 million. D. INVESTMENTS IN UNCONSOLIDATED PARTNERSHIPS AND CORPORATIONS Interests owned in cellular and other telecommunications systems of unconsolidated partnerships and corporations are as follows: December 31, -------------------- 1993 1992 --------- --------- (Dollars in millions) Investments at equity.............................. $1,127.2 $ 913.6 Investments at cost................................ 27.3 21.8 --------- --------- $1,154.5 $ 935.4 ========= ========= AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, -------------------- 1993 1992 --------- --------- At equity: (Dollars in millions) Centel Cellular Company of Nevada Limited Partnership (Las Vegas, Nevada)........... 28% 28% Metroplex Telephone Company (Dallas/Fort Worth, Texas)............................................ - 34% Tucson Cellular Telephone Company (Tucson, Arizona). 6% 6% New Par (Ohio/Michigan)............................. 50% 50% Telecel Comunicacoes Pessoais, S.A. (Portugal)...... 23% 23% Mannesmann Mobilfunk GmbH (Germany)................. 29% 28% Tokyo Digital Phone Co. (Japan)..................... 15% 15% Kansai Digital Phone Co. (Japan).................... 13% 13% Central Japan Digital Phone Co. (Japan)............. 13% 13% Telechamada-Servico de Chamada de Pessoas, S.A. (Portugal)................................... 23% 23% Sistelcom, S.A. (Spain)............................. 25% 25% Cellular Communications, Inc. (Ohio/Michigan)....... 12% 12% Nevada RSA2 Ltd. Partnership (Lander, Nevada)....... 50% 50% Muskegon Cellular Partnership (Muskegon, Michigan).. 41% 41% CMT Partners (California, Texas, Missouri, and Kansas)........................................... 50% - Omnicom, S.A. (France).............................. 19% - In May 1993, the Company purchased an additional 0.75% interest in Mannesmann Mobilfunk GmbH ("MMO"). Cellular Communications, Inc. ("CCI") represents the only equity method investment for which a quoted market price is available. At December 31, 1993, the market value of this investment was $235.8 million, compared to the Company's recorded net investment of $174.2 million. The Company has the right to purchase the remainder of CCI at a price reflecting private market value (see Note E). CMT Partners was formed in September 1993 and the Metroplex Telephone Company was one of the investments contributed by the Company in the formation of this partnership (see Note E). December 31, -------------------- 1993 1992 --------- --------- At cost: Fresno MSA Limited Partnership (Fresno, California)................................... 1% 1% GTE Mobilnet of California Limited Partnership (Salinas, Santa Cruz, and Santa Rosa, California)................................... - 3% GTE Mobilnet of Santa Barbara Limited Partnership (Santa Barbara, California)................... 10% 10% Cal-One Cellular Limited Partnership (Eureka, California)................................... 6% 6% IDC (Japan)..................................... 10% 10% Qualcomm (San Diego, California)................ 1% 1% AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Qualcomm represents the only cost method investment for which a quoted market price is available. At December 31, 1993, the market value of this investment was $10.6 million compared to the Company's recorded net investment of $2.0 million. Condensed combined financial information for unconsolidated partnerships and corporations accounted for under the equity method is summarized as follows: December 31, --------------------------------------- 1993 1992 ------------------- ------------------- Inter- Inter- Domestic national Domestic national --------- --------- --------- --------- (Dollars in millions) Current assets................ $ 350.4 $ 370.0 $ 289.1 $ 250.0 Noncurrent assets............. 1,513.7 1,631.5 1,102.8 923.4 Current liabilities........... (116.3) (373.0) (81.6) (228.9) Noncurrent liabilities........ (420.1) (630.8) (341.4) (30.2) Redeemable preferred stock.... - - (32.7) - --------- --------- --------- --------- Total partners' and shareholders'capital........ $1,327.7 $ 997.7 $ 936.2 $ 914.3 ========= ========= ========= ========= Total partners' and shareholders'capital........ $1,327.7 $ 997.7 $ 936.2 $ 914.3 Other partners' and shareholders' share of capital..................... 753.4 732.8 554.2 679.6 --------- --------- --------- --------- Company share of capital...... 574.3 264.9 382.0 234.7 Goodwill and other intangible items....................... 255.8 32.2 273.6 23.3 --------- --------- --------- --------- Equity investments in unconsolidated partnerships and corporations............ $ 830.1 $ 297.1 $ 655.6 $ 258.0 ========= ========= ========= ========= AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Year Ended December 31, -------------------------------------------------------- 1993 1992 1991 -------------------------------------------------------- Inter- Inter- Inter- Domestic national Domestic national Domestic national -------- -------- -------- -------- -------- -------- (Dollars in millions) Net operating revenues.......... $ 697.5 $ 527.7 $501.6 $ 75.9 $338.8 $ 2.2 Cost of revenues.... 223.0 194.7 154.6 97.8 125.2 32.0 -------- -------- -------- -------- -------- ------- Gross profit (loss). 474.5 333.0 347.0 (21.9) 213.6 (29.8) Selling, general, administrative, and other expenses, net............... 277.3 555.8 226.2 244.7 178.1 53.9 Interest expense (income).......... 10.8 10.7 11.8 (20.3) 11.7 (10.8) Income tax expense (benefit)......... 6.5 (93.3) 2.2 (114.0) - - -------- -------- -------- -------- -------- ------- Income (loss) before accounting change. 179.9 (140.2) 106.8 (132.3) 23.8 (72.9) Cumulative effect of accounting changes 8.5 - - 51.4 - - -------- -------- -------- -------- -------- ------- Net income (loss)... $188.4 $(140.2) $106.8 $(80.9) $ 23.8 $(72.9) ======== ======== ======== ======== ======== ======= Net income (loss)... $188.4 $(140.2) $106.8 $(80.9) $ 23.8 $(72.9) Other partners' and shareholders'share of net income (loss)............ 110.4 (103.5) 60.0 (56.6) 5.2 (51.8) -------- -------- -------- -------- -------- ------- Company share of net income (loss). 78.0 (36.7) 46.8 (24.3) 18.6 (21.1) Cumulative effect of accounting change for income taxes recorded by the Company........... - - - (13.7) - - Amortization of goodwill and other intangible items.. (7.6) (0.8) (5.7) (0.5) (3.1) (0.3) -------- -------- -------- -------- -------- ------- Equity in net income (loss) of unconsolidated partnerships and corporations...... $ 70.4 $(37.5) $ 41.1 $(38.5) $ 15.5 $(21.4) ======== ======== ======== ======== ======== ======= AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Goodwill and other intangible items are amortized primarily over forty years. Anticipated future international capital calls are $140.7 million at December 31, 1993. CCI adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," ("SFAS 109") effective January 1, 1993. The Company's portion of the increase to CCI's net income from adoption was approximately $1.0 million. E. JOINT VENTURES AND ACQUISITIONS CELLULAR COMMUNICATIONS, INC. On August 1, 1991, the Company and CCI combined their cellular telephone interests in Ohio and Michigan by forming an equally owned joint venture ("New Par"). The Company also purchased an initial ownership interest in CCI of approximately 5% for $39 per share, or approximately $90.0 million including related acquisition costs. During 1992 the Company increased its holding in CCI to approximately 12% through open-market purchases of stock. Both the Company's joint venture interest in New Par and its purchase of CCI shares are accounted for under the equity method. The investment in net assets contributed by the Company to the joint venture has been recorded at the same net book value reflected in the Company's consolidated accounts prior to closing (see Note S). The Company and CCI have entered into an agreement (the "Merger Agreement") under which CCI will, in October 1995, offer to redeem up to 10.04 million shares of its redeemable stock at $60 per share (the "Mandatory Redemption Obligation" or "MRO"). The Company is obligated to purchase from CCI at such price a number of newly issued shares of stock equal to the number of shares purchased by CCI in the MRO. At the same time, the Company is obligated to purchase from CCI shares or stock options representing in the aggregate approximately 2.4 million shares at a price of $60 per share, less the exercise price in the case of stock options. Pursuant to the Merger Agreement, the Company initially acquired approximately 5% of CCI and obtained the right to acquire all of CCI's remaining equity in stages over the next several years. Beginning in August 1996, the Company has the right, by causing CCI to redeem all of its redeemable stock not held by the Company (the "Redemption"), to acquire CCI, including its interests in New Par and such other CCI assets and related liabilities as the Company and CCI may agree upon, at a price per share that reflects the appraised private market value of New Par (and such other CCI assets and related liabilities as the Company and CCI agree shall be retained) determined in accordance with an appraisal process set forth in the Merger Agreement. The Company has the opportunity to evaluate up to three different appraisal values during the 18-month period beginning in August 1996, prior to determining whether to cause the Redemption. The Company will finance the Redemption by providing to CCI any necessary funds. In the event that the Company does not exercise its right to cause the Redemption, CCI is obligated to commence promptly a process to sell itself (and, if directed by the Company, the Company's interest in New Par). In the AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) event that the Company does not direct CCI to sell the Company's interest in New Par, such partnership dissolves and the assets are returned to the contributing partner. CCI may, in the alternative, purchase the Company's interest in CCI or CCI and New Par, as the case may be, at a price based upon their appraised values determined in accordance with the Merger Agreement. If CCI or its interest in New Par is sold within certain specified time periods not to exceed two years for a price less than the appraised private market value, the Company is obligated to pay to each other CCI stockholder a specified percentage of such shortfall. In connection with the CCI transaction, Telesis delivered a letter of responsibility in which it agreed, among other things, to continue to own a controlling interest in the Company. Telesis and CCI have agreed to the termination of such letter of responsibility at the time that Telesis no longer has a controlling interest in the Company in exchange for the provision by the Company of substitute credit assurance, consisting of a $600 million letter of credit and a pledge of up to 15% of CCI's shares on a fully diluted basis, for the Company's obligations in connection with the MRO and for the payment of any make-whole obligation, respectively (see Note R). MCCAW CELLULAR COMMUNICATIONS, INC. In September 1993, the Company and McCaw Cellular Communications, Inc. ("McCaw") contributed their respective cellular operations in San Francisco, San Jose, Dallas, Kansas City (Missouri/Kansas) and certain adjoining areas to a joint venture with equal ownership by each company. The new venture ("CMT Partners") manages two large cellular regional networks covering an estimated population of 9.2 million people. (The Company previously had operations covering an estimated population of 4.5 million people in the joint venture service area.) In a related transaction, the Company purchased McCaw's Wichita and Topeka systems for $100.0 million. PACTEL TELETRAC PacTel Teletrac ("Teletrac"), a start-up company offering vehicle location services in six markets in the United States, is 51% owned by the Company, and thus its operations are consolidated with the Company. Effective March 31, 1992, Teletrac exercised its option to acquire all of the assets of International Teletrac Systems ("ITS"). The acquisition price was $9.5 million to be paid over two years and the creation of a $69.7 million "preferred capital account," for the benefit of ITS, which Teletrac accounted for as long-term debt. This amount was netted with a $20.2 million receivable from ITS and was reflected as $49.5 million long-term debt in the Consolidated Balance Sheet at December 31, 1992 (see Note G). This $49.5 million debt has since been retired. Additionally, the Company's 49% partner in Teletrac provided ITS with a 24% ownership interest in Teletrac, and, as a part of the purchase agreement, Teletrac credited ITS' capital account $2.5 million. Prior to the March 31, 1992 acquisition of ITS' assets, Teletrac had no ownership interest in ITS. However, the Company had an obligation through Teletrac to ITS' lender, who had funded the substantial operating losses of ITS. Because of this obligation, Teletrac has consolidated ITS for all periods presented. Through December 31, 1993, the Company had advanced Teletrac a total of $170.5 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) million for ongoing operating expenses, of which $91.0 million was advanced in 1993. Teletrac pays interest quarterly at Wells Fargo's prime rate plus 2%. Advances issued prior to May 29, 1992 have a three-year term with an option to extend for up to an additional five years. Advances issued after May 29, 1992 have a six-year term. The Company can convert the advances into additional equity interests in Teletrac or Teletrac's corporate successor. The conversion rate may be based on an appraised price or a percentage of the price of stock issued in an initial public offering for Teletrac's corporate successor. Such initial public offering, which may be solely elected by the shareholders of the minority partner of Teletrac, must generally occur prior to March 31, 1995. NORDICTEL In October 1993, the Company acquired a 51% interest in NordicTel Holdings AB ("NordicTel"), one of three providers of global digital services in Sweden, for $153.0 million. The Company also contributed $5.4 million to NordicTel's equity capital. The Company also holds an option exercisable between July 1 and September 30, 1994, to purchase an additional 6.75% of NordicTel's equity for approximately $20.0 million. PRO FORMA RESULTS (UNAUDITED) The unaudited pro forma data for significant acquisitions occurring in 1993 include the results of the Company, Wichita, Topeka, NordicTel, and the Company's share of the results of CMT Partners. The results listed below reflect purchase method accounting adjustments assuming the acquisitions occurred at the beginning of each year presented. The unaudited pro forma results are not necessarily indicative of what actually would have occurred if the acquisitions had been in effect for the entire periods and are not necessarily indicative of the results of future operations. December 31, ------------------- 1993 1992 --------- --------- (Dollars in millions, except per share amounts) Net operating revenues.......................... $844.3 $645.6 Income (loss) before extraordinary item and cumulative effects of accounting changes.... $ 15.4 $(33.9) Net income (loss)............................... $ 9.8 $(13.6) Net income (loss) per share before extraordinary item and cumulative effects of accounting changes..................................... $ 0.04 $(0.08) AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) F. INTANGIBLE ASSETS Intangible assets consist of the following: December 31, ------------------- 1993 1992 --------- --------- (Dollars in millions) FCC licenses, at cost, less accumulated amortization of $36.9 and $26.8 for 1993 and 1992, respectively....................... $143.7 $ 163.8 Goodwill, at cost, less accumulated amortization of $8.4 and $8.0 for 1993 and 1992, respectively........................... 262.3 45.9 Other intangible assets, at cost, less accumulated amortization of $9.6 and $20.3 for 1993 and 1992, respectively.............. 7.2 15.3 --------- --------- $ 413.2 $ 225.0 ========= ========= In 1993 goodwill increased approximately $133.7 million as a result of purchasing NordicTel in October 1993, and approximately $85.7 million as a result of purchasing McCaw's cellular systems in Wichita and Topeka in September 1993 (see Note E for further discussion). Amortization expense relating to intangible assets for the years ended December 31, 1993, 1992, and 1991 was $12.5 million, $11.0 million, and $16.0 million, respectively. G. DEBT DUE TO AFFILIATES WITHIN ONE YEAR Amounts due to affiliates at December 31, 1993 consisted principally of accounts payable and accrued liabilities. Amounts due to affiliates within one year at December 31, 1992 of $906.7 million were primarily promissory notes bearing interest at variable rates which averaged 6.1% during 1993 and 5.7% during 1992. Included in this amount were accounts payable and accrued liabilities totalling $33.3 million at December 31, 1992. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NON-CURRENT BORROWINGS DUE TO AFFILIATES Non-current borrowings due to affiliates are as follows: December 31, ------------------- 1993 1992 --------- --------- (Dollars in millions) Variable rate note payable relating to the CCI transaction. Interest averaged 6.1% during 1993 and 5.7% during 1992 and was payable semi-annually. Principal was originally due in 1997. This note was redeemed in 1993.......................................... - $ 85.0 Variable rate note payable relating to the Teletrac transaction with interest payable quarterly at prime plus 3%. Principal originally due in 1995 and 1996. This note was redeemed in 1993 (see related discussion in Note E).................................... - 49.5 Variable rate note payable which matured September 25,1993. Interest averaged 6.1% during 1993 and 5.7% during 1992 and was payable semi-annually......................... - 100.0 --------- --------- - 234.5 Less portion due within one year................ - 100.0 --------- --------- - $ 134.5 ========= ========= AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NON-CURRENT BORROWINGS DUE TO NON-AFFILIATES Non-current borrowings due to non-affiliates are as follows: December 31, ------------------- 1993 1992 --------- --------- (Dollars in millions) Variable rate revolving credit facility expiring in 1998. The credit available under this agreement, approximately $51 million, supports a NordicTel purchase contract. Principal and interest are due in ten equal semi-annual installments beginning in June, 1994. Amounts repaid, except prepayments, are available for redrawing. The draw-down period for the additional advances commences on January 1, 1994 and ends on December 31, 1997*............. $50.1 - Notes (two) payable to a bank. The first note, which has two draw-downs, matures May 30, 1999, and had interest rates of 5.4% for the first draw-down and 7.2% for the second draw-down; semi-annual interest payments began November 30, 1993. The second note matures June 10, 2001, with an interest rate of 7.5%; semi-annual interest payments begin December 10, 1995. Balances are payable in full at maturity **............................. 24.1 $20.7 Various other notes and obligations............... 4.7 2.1 --------- -------- 78.9 22.8 Less portion due within one year.................. 10.3 0.4 --------- -------- $68.6 $22.4 ========= ======== ------------------------- * Terms of the note prevent NordicTel from making distributions/ repayments or interest payments on its common stock or on shareholders' contribution until at least 50% of the credit has been repaid. Such distributions / repayments or interest payments can be made only if the funds available for such payment exceed $24.0 million and only from funds in excess of that amount. In addition, all of the outstanding shares of NordicTel have been pledged as collateral until the credit has been repaid in full. The lender also holds as collateral a chattel mortgage on NordicTel's principal subsidiary. The total amount of chattel mortgages outstanding at December 31, 1993 was approximately $39.0 million. ** Under the terms of both notes, prepayment of the entire outstanding balance may be made after May 1994 at a premium of 0.25% of the amount payable. Terms of the notes require Telesis to retain 51% of the AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) ownership of AirTouch International, formerly Pacific Telesis International. The Company has been granted a temporary waiver of this restriction and continues to renegotiate this restriction. Maturities of non-current borrowings due to non-affiliates are as follows: December 31, 1993 ------------------- (Dollars in millions) Maturities: 1995............................................. $13.2 1996............................................. 10.0 1997............................................. 10.0 1998............................................. 10.0 1999............................................. 17.6 Thereafter....................................... 6.4 ------- 67.2 Long-term capital lease obligations................... 1.4 ------- $68.6 ======= LINES OF CREDIT The Company has various lines of credit with certain banks. For the most part, these arrangements do not require compensating balances or commitment fees and, accordingly, are subject to continued review by the lending institutions. At December 31, 1993 and 1992, the total unused lines of credit available were approximately $86.2 and $5.0 million, respectively. H. INCOME TAXES Effective January 1, 1992, the Company adopted the provisions of SFAS 109. This standard requires companies to record all deferred tax liabilities or assets for the deferred tax consequences of all temporary differences and requires ongoing adjustments for enacted changes in tax rates and laws. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The components of income tax expense for each year ended December 31, are as follows: 1993 1992 1991 -------- -------- -------- (Dollars in millions) Current: Federal..................................... $48.8 $ 1.5 $17.0 State and other taxes....................... 9.4 (4.4) 6.1 -------- -------- -------- Total current............................... 58.2 (2.9) 23.1 -------- -------- -------- Deferred: Federal..................................... 8.5 19.1 25.1 Change in federal enacted tax rate.......... 4.4 - - State and other taxes....................... (3.3) 8.4 2.7 -------- -------- -------- Total deferred.............................. 9.6 27.5 27.8 -------- -------- -------- Amortization of investment tax credits-net................................. - (0.1) (1.1) -------- -------- -------- Total income taxes............................ $67.8 $24.5 $49.8 ======== ======== ======== The Company recorded international tax expense on its consolidated foreign subsidiaries for 1993, 1992, and 1991 of $1.6 million, $1.3 million, and $2.2 million, respectively. The net change in the valuation allowance for deferred tax assets was an increase of $1.8 million relating to benefits arising from foreign net operating loss carryforwards of consolidated subsidiaries. At December 31, 1993, the Company had unused tax benefits of $4.8 million related to foreign net operating loss carryforwards. Of this amount, $0.7 million can be carried forward indefinitely and the balance expires at various dates through 2001. The loss before income tax expense on the Company's consolidated foreign subsidiaries was $5.2 million and $1.5 million in 1993 and 1992, respectively. Significant components of the Company's deferred tax assets and liabilities as of December 31, are as follows: AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 1993 1992 -------- -------- (Dollars in millions) Deferred tax liabilities: Depreciation and amortization............... $124.6 $111.9 Equity investments.......................... 59.0 54.9 Other....................................... 22.3 19.0 -------- -------- 205.9 185.8 -------- -------- Deferred tax assets: Postretirement benefits obligation.......... 4.4 - Foreign tax benefits in consolidated subsidiaries (1).......................... 4.8 3.0 Equity investments.......................... - 0.2 Accruals deductible for tax purposes when paid................................. 16.0 10.2 Other....................................... 8.2 4.5 -------- -------- 33.4 17.9 Valuation allowance (1)....................... (4.8) (3.0) -------- -------- Total deferred taxes recorded in consolidated balance sheets................. $177.3 $170.9 ======== ======== Current....................................... $(13.1) $ (3.5) Non-current................................... 190.4 174.4 -------- -------- Net deferred tax liabilities.................. $177.3 $170.9 ======== ======== (1) 1992 has been revised to agree with the 1993 presentation. At December 31, 1993, amounts due to affiliates include $20.6 million for the Company's tax liability to be included in the Telesis consolidated tax returns. At December 31, 1992, amounts receivable from affiliates include $101.9 million for the Company's tax losses utilized in the Telesis consolidated tax returns (see Note Q). AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The components of federal, state, and other deferred income taxes for the year ended December 31, 1991 are as follows (dollars in millions): Deferred tax-due to: Depreciation and amortization....................... $26.2 Interest capitalized................................ 1.5 FCC license adjustment.............................. - Partnership income-net.............................. 2.8 Reserves............................................ (0.9) State taxes......................................... (1.6) Other............................................... (0.2) --------- Total deferred taxes................................ $27.8 ========= The reasons for differences each year between the statutory federal income tax rate and the effective income tax rate are provided in the following reconciliations: 1993 1992 1991 -------- -------- -------- Statutory federal income tax rate............. 35.0% 34.0% 34.0% Increase (decrease) in taxes resulting from: Equity losses of unconsolidated partnerships and corporations............. 11.5 101.0 5.6 ITS losses prior to March 31, 1992.......... - 36.8 10.2 Nondeductible amortization.................... 3.0 4.6 2.6 Change in deferred taxes due to tax rate change................................. 4.1 - - Nondeductible amortization of investment tax credits..................................... - (0.6) (1.2) State income taxes-net of federal tax benefit................................. 3.7 (9.3) 4.7 Tax on international income................... 1.5 8.9 2.4 Settlement of litigation...................... - - (4.4) Other......................................... 4.0 (5.3) (0.3) -------- -------- -------- Effective income tax rate..................... 62.8% 170.1% 53.6% ======== ======== ======== In July 1993, the German Parliament passed the German Tax Act of 1994 which, among other provisions, decreases the corporate tax rate on distributed earnings effective January 1, 1994. As required by SFAS 109, deferred tax assets recognized by MMO through June 1993 were adjusted downward to reflect the lower tax rate. The Company's share of this adjustment reduced net income by $3.1 million in 1993. The Company's investment balance in MMO, an equity method investee, contains significant deferred tax asset amounts as shown in the attached MMO financial statements and notes thereto. At December 31, 1993, deferred tax liabilities relating to cumulative unrepatriated earnings on consolidated foreign subsidiaries totalling $7.3 million were excluded from recognition under SFAS 109, because such earnings are intended to be reinvested indefinitely. Federal income tax expense of $2.6 million would be due if this income were repatriated. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In August 1993, the United States government enacted the Omnibus Budget Reconciliation Act of 1993 which incorporates new business tax provisions. These include an increase in the corporate tax rate from 34% to 35% retroactive to January 1, 1993. The Company's adjustment for this change reduced net income by $4.4 million in 1993. I. EMPLOYEE RETIREMENT PLANS DEFINED BENEFIT PLAN The Company provides pension, death, and survivor benefits under a qualified defined benefit plan, the PacTel Corporation Employees Pension Plan, qualified under Section 401(a) of the Internal Revenue Code, which covers employees of the Company and certain subsidiaries. Benefits are based on a percentage of final five-year average pay and vary according to years of service. The accrual of service credit was discontinued on December 31, 1986 for most employees. Certain long-service employees were given the option of continuing to have their service credited under this pension plan in lieu of full participation in the Company's defined contribution plan. The Company is responsible for contributing enough to the pension plan to ensure that adequate funds are available to provide benefit payments upon the employee's retirement. These contributions are made to an irrevocable trust fund in amounts determined using the aggregate cost actuarial method, one of the actuarial methods specified by the Employee Retirement Income Security Act of 1974 ("ERISA"), subject to ERISA and IRS limitations. A joint venture of Telesis has been treated as a participating employer in the defined benefit pension plan. Approximately 130 joint venture employees who previously were employees of the Company were not included in the Company's pension obligation or plan assets. However, pursuant to recent IRS regulations, the Company determined that its pension obligation and plan assets should include amounts attributable to the joint venture employees. The Company has approved plan changes effective November 1, 1993, requiring pension assets and obligations for the joint venture employees to be included in the footnotes to the financial statements for the year ended December 31, 1993. These actions increased the reported plan assets by $3.7 million and the reported actuarial present value of projected benefit obligations by $2.1 million. In November and December of 1993, approximately 85% of the employees at the joint venture who participated in the qualified defined benefit plan elected early retirement or termination benefits from the plan under a program offered by the Company. The 1993 annual pension income in the table below excludes a one-time $3 million net gain recognized for this program, under Statement of Financial Accounting Standards No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Plans and for Termination Benefits." AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Annual pension income for each year consisted of the following components: 1993 1992 1991 -------- -------- -------- (Dollars in millions) Service cost-benefits earned during the year.... $(0.1) $(0.3) $(0.2) Interest cost on projected benefit obligations.. (2.6) (1.6) (1.1) Actual return on assets......................... 10.2 0.6 7.3 Net amortization and deferral of items subject to delayed recognition*....................... (4.8) 3.4 (3.0) -------- -------- -------- Pension income recognized....................... $ 2.7 $ 2.1 $ 3.0 ======== ======== ======== * Under Statement of Financial Accounting Standard No. 87, "Employers' Accounting for Pensions," ("SFAS 87"), differences between actual returns and losses on assets and assumed returns, which are based on an expected long-term rate of return, are deferred and included with other "unrecognized net gain" (see following table). During 1993, actual returns exceeded assumed returns by $5.8 million. During 1992, actual returns were less than assumed returns by $3.5 million. During 1991, actual returns exceeded assumed returns by $6.3 million. Recognition of these differences has been deferred. The amount of annual pension income recognized in 1993, 1992, and 1991 reflects a substantially diminished participant count since inception of the plan (which reduces both service and interest costs) and the effects of strong fund asset performance. The following table sets forth the status of the plan's assets and obligations and the amounts recognized in the Company's consolidated balance sheets: December 31, -------------------- 1993 1992 --------- --------- (Dollars in millions) Plan assets at estimated fair value.............. $68.3 $60.7 Actuarial present value of projected benefit obligations.................................... 31.1 28.5 --------- --------- Plan assets in excess of projected benefit obligations.................................... 37.2 32.2 Less items subject to delayed recognition: Unrecognized net gain *........................ 15.4 18.1 Unrecognized transition amount **.............. 5.3 6.6 Unrecognized prior service cost................ 1.1 (0.3) --------- --------- Prepaid pension cost recognized in the consolidated balance sheets.................... $15.4 $ 7.8 ========= ========= AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) ---------------------- * Gains or losses from actual returns on assets different from assumed returns, as well as from demographic experience different from assumed and the effects of changes in other assumptions, are recognized through amortization, over time, when the cumulative gains or losses exceed certain limits. ** The $10.2 million excess of the fair value of the plan's assets over projected benefit obligations as of the January 1, 1987 adoption of SFAS 87 is being recognized through amortization over approximately 17 years. Recognition has been accelerated due to the settlement of pension obligations through lump sum benefit payments. The assets of the plan are primarily composed of common stocks, United States government and corporate obligations, index funds, and real estate investments. The plan's projected benefit obligations for employee service to date reflect the Company's expectations of the effects of future salary progressions of 5.5% per year. As of December 31, 1993 and 1992, the actuarial present value of the plan's accumulated benefit obligations, which do not anticipate future salary increases, were $26.1 million and $22.0 million, respectively. Of these amounts, $23.2 million and $19.3 million, respectively, were vested. The assumptions used in computing the present values of benefit obligations include a discount rate of 7.5% for 1993 and 8.5% for 1992 and 1991. An 8.0% long-term rate of return on assets was assumed in calculating pension costs in 1993 and 1992. DEFINED CONTRIBUTION PLAN The Company sponsors a defined contribution plan, the PacTel Corporation Retirement Plan, formerly the Retirement Plan, which covers substantially all full-time employees. The Company's contributions to the AirTouch Communications Retirement Plan are based on a combination of percentage of pay and on matching a portion of employee contributions. The cost recognized for the plan was $12.9 million, $9.8 million, and $5.4 million for 1993, 1992, and 1991, respectively. J. OTHER POSTRETIREMENT BENEFITS The Company provides health care benefits for retired employees and their eligible dependents and provides life insurance benefits to retired employees. Employees become eligible for these benefits upon retirement with eligibility for a service pension under the defined benefit pension plan or attainment of "retirement status" under the defined contribution plan. Substantially all retirees and their dependents are covered under the Company's plans for medical, dental, and life insurance benefits. Approximately 50 retirees were eligible to receive benefits as of January 1, 1993. The Company retains the right, subject to applicable legal requirements, to amend or terminate these benefits. The Company currently pays a portion of the cost of these benefits, with retirees paying monthly contributions for medical and dental costs based on the individual's family status. Commencing in 1994, the Company has implemented managed care in order to reduce and contain medical costs. The terms of this cost sharing have been reflected in the financial statements. Through 1992, postretirement health care costs were expensed as claims were AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) incurred. Postretirement life insurance benefits were expensed as premiums were paid. The costs of these benefits recognized in 1992 and 1991 were $0.2 million and $0.3 million, respectively. On January 1, 1993, the Company implemented SFAS 106 on an immediate recognition basis. The standard requires that the cost of retiree benefits be recognized in the financial statements from an employee's date of hire until becoming eligible for these benefits. Previously, the Company expensed these retiree benefits as they were paid. Immediate recognition of the transition obligation resulted in a one-time, noncash expense of $9.1 million before a tax benefit of $3.5 million. In addition, the periodic expense recognized in 1993 amounted to $2.0 million before a tax benefit of $0.9 million. The $2.0 million is an increase of $1.9 million over the amount that would have been expensed during the period using the previous method of accounting. The projected unit credit actuarial method was used to determine the cost of these benefits. A discount rate of 7.5% was used to measure the accumulated postretirement benefit obligation ("APBO") at December 31, 1993. An 8.5% discount rate was assumed in calculating the 1993 net periodic postretirement benefit cost. At December 31, 1993, the other postretirement benefits plans were unfunded. The 1993 annual net periodic postretirement benefit cost consisted of the following components : --------- (Dollars in millions) Service cost.............................................. $1.2 Interest cost on accumulated postretirement benefit obligation.............................................. 0.8 --------- Postretirement benefit cost............................... $2.0 ========= The following table sets forth the funded status of the plans and the amounts recognized in the Company's consolidated balance sheets: December 31, 1993 --------------- (Dollars in millions) Retirees.............................................. $ 3.5 Eligible active employees............................. 1.0 Other active employees................................ 7.9 ------------- Total accumulated postretirement benefit obligation... 12.4 Less fair value of plan assets........................ - Less unrecognized net loss (1), subject to delayed recognition......................................... 1.1 ------------- Accrued postretirement benefit obligation in excess of plan assets...................................... $11.3 ============= AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (1) Gains or losses from actual returns on assets different than assumed returns, as well as from demographic experience different than assumed and the effects of changes in other assumptions, are recognized through amortization, over time, when the cumulative gains or losses exceed certain limits. A 14% annual increase in health care costs is assumed in 1994 for retirees in the medical network and for those outside the network. The rate of increase is assumed to decline to an ultimate 6% by the year 2002. Should the health care cost trend rate increase by 1% each year, the 1993 impact increases the APBO by $2.1 million and the aggregate of the service and interest cost components of the net period cost by $0.5 million. K. FINANCIAL INSTRUMENTS The Company uses various financial instruments that involve off-balance-sheet risk. These include foreign currency swap contracts. These contracts are used to reduce the impact of foreign currency fluctuations on international investments. The Company also engages in forward contracts. As of December 31, 1993 and 1992, the Company had outstanding foreign currency swap and forward contracts with face amounts totalling $291.2 million and $354.0 million, respectively, with maturities through November 2001. The off-balance-sheet risk in these contracts involves both the risk of a counterparty not performing under the terms of the contract and the risk associated with changes in market value. The counterparties to these contracts are major financial institutions. The Company monitors its positions, the credit ratings of counterparties and the level of contracts the Company enters with any one party. Therefore, the Company believes the likelihood of realizing material losses from counterparty nonperformance is remote. The settlements of these transactions are not expected to have any material adverse effect upon the Company's financial position or results of operations. The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of Statement of Financial Accounting Standard No. 107, "Disclosures about Fair Value of Financial Instruments." The Company uses available market information and appropriate valuation methods to determine fair value amounts. However, considerable judgment enters into estimates of fair value. Accordingly, the estimates presented may not be indicative of the amounts that the Company could realize in a current market exchange. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, ------------------------------------------ 1993 1992 ------------------------------------------ Estimated Estimated Carrying Fair Carrying Fair Amount Value Amount Value ---------- --------- ---------- ---------- (Dollars in millions) Assets: Cash and cash equivalents..... $646.7 $646.7 $ 17.1 $ 17.1 Short-term investments........ $814.0 $814.0 - - Notes receivable.............. - - $ 99.8 $ 99.8 Long-term investments: Practicable to estimate fair value................ $ 2.0 $ 10.6 $ 2.0 $ 4.9 Not practicable to estimate fair value................ $ 25.3 - $ 19.8 - Liabilities: Current obligations........... $ 12.7 $ 12.7 $878.5 $878.5 Deposit liabilities........... $ 22.4 $ 22.4 $ 23.1 $ 23.1 Long-term debt................ $ 67.2 $ 70.0 $155.7 $155.7 Off-balance-sheet financial instruments-net............... - $ 13.8 - $ 11.0 Cash and cash equivalents, short-term investments, notes receivable, and current obligations. Carrying amounts are a reasonable approximation of fair value. Long-term investments. It is not practicable to estimate the fair value of the Company's investment in several joint ventures since valuations are not available in the current market. Ownership interests in such joint ventures range from 1% to 10% in various cellular companies and a network cable under the Pacific Ocean. Certain of these ventures are in the start-up mode. At December 31, 1993, the Company's ownership interest in these ventures' assets and shareholders' equity was approximately $72.9 million and $3.9 million, respectively. In addition, the Company's ownership interest in 1993 revenues and net loss was $42.3 million and $5.0 million, respectively. Long-term debt. Interest rates that are currently available to the Company for issuance of debt with similar terms and remaining maturities are used to estimate fair value for debt issues that are not quoted on an exchange. Off-balance-sheet financial instruments. These amounts primarily represent foreign exchange hedge contracts. Fair value is based upon current value in the market for transactions with similar terms. As a result of the planned spin-off, these contracts will be renegotiated. No assurances can be given that similar terms can be obtained. Financial guarantees. The Company has letters of responsibility and letters of support for various credit facilities and financing activities of certain of its subsidiaries and affiliates (see Note N). Fair value is based on estimated fees to enter similar agreements. There is no carrying value since AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) fees were not paid originally. As a result of the planned spin-off, these letters of responsibility and letters of support will be renegotiated. No assurances can be given that similar terms can be obtained. Telesis has issued various forms of financial support on behalf of the Company. All of these forms of financial support will be renegotiated before the planned spin-off. No assurances can be given that similar terms can be obtained. L. REGULATORY MATTERS SPIN-OFF HEARINGS In February 1993, the CPUC instituted an investigation of the spin-off for the purpose of assessing any effects it might have on the telephone customers of Pacific Bell. The CPUC identified certain issues for evidentiary hearings, including whether Pacific Bell customers should be compensated as a result of the manner in which cellular research and development had been funded by Telesis' predecessor companies (AT&T and the former Bell System operating telephone companies) and cellular licenses had been granted by the FCC, and whether Pacific Bell customers should be compensated for any continued use of the PacTel name by the Company. On November 2, 1993, the CPUC issued a decision in the investigation authorizing Telesis to proceed with the spin-off. Among other things, the decision prohibits the Company and subsidiaries of Telesis from agreeing not to compete after the spin-off and from transferring utility assets, which may include pension funds, out of the California utilities. The CPUC expects Telesis to complete the spin-off in a manner which allows Pacific Bell to compete for PCS licenses. An independent auditor (selected by and under contract to the CPUC) will perform an audit and file a compliance report with the CPUC to ensure that Telesis and the Company have complied with the terms of the separation as described to the CPUC and that the transaction complies with the conditions imposed by the decision and the CPUC's affiliate transaction rules. The Company believes that the audit will not result in any material liability for the Company and that Telesis and the Company will satisfy all conditions in the CPUC decision. The CPUC decision was effective immediately. On December 3, 1993, two parties filed applications for rehearing with the CPUC and the CPUC staff filed a petition to modify the decision. On March 9, 1994, the CPUC denied these requests. Under California law, judicial review of the CPUC decision is available only by petition for writ of certiorari or review to the California Supreme Court. As the CPUC denied the applications for rehearing, only a party that has filed such an application with the CPUC may file such a petition, which must be filed by early April 1994. One of the parties that urged the establishment of a reserve for compensation has stated that it would seek review of the CPUC decision. The decision whether to grant a petition for a writ of review of a CPUC decision is at the discretion of the California Supreme Court. The Company believes the California Supreme Court would deny a review. CELLULAR REGULATION AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In October 1992, the CPUC issued an order that, among other things: required cellular utilities to adopt a specific accounting methodology to separate wholesale and retail costs; permitted resellers to operate a reseller switch interconnected to the cellular carrier's facilities; mandated the unbundling of certain wholesale rates requiring a cost basis plus a 14.75% rate of return; and directed the Company to divest its reseller operations in the San Francisco Bay Area. In May 1993, the CPUC granted a limited rehearing of its October 1992 order. The CPUC agreed to rehear the issues of unbundling wholesale rates and the imposition of a rate of return. Also, the CPUC rescinded the order's requirement that cellular utilities modify the accounting methodology for allocating wholesale and retail costs. The CPUC did not alter, however, the prohibition of a carrier's affiliate from reselling cellular services in the carrier's same markets. As a result, in September 1993, the Company contributed certain of the assets and liabilities of its retail reseller operations in the San Francisco Bay Area to CMT Partners (see Note E). In December 1993, the CPUC adopted an Order Instituting Investigation into the regulation of Mobile Telephone Service and Wireless Communications. The CPUC has consolidated the rehearing of the October 1992 decision with the new investigation. The new investigation initiates a review of the Commission's historic policies governing cellular telephone service and proposes to classify cellular carriers as dominant carriers and resellers and new providers of mobile service as non-dominant carriers. The Commission requests comments on alternative frameworks for regulating cellular carriers: (1) price caps at current rates (the existing framework); (2) rate-of-return or cost-based price caps which would result in mandatory price reductions; and (3) relaxed regulation. Because the outcome of the CPUC's new investigation is uncertain, the Company cannot estimate the future effects of this investigation. GENERAL ORDER 159 In November 1992, the CPUC staff issued an interim report outlining the partial findings of an investigation into compliance with General Order 159 ("G.O. 159"), which requires prior CPUC approval of cellular facility additions. In January 1993, the Company responded to the report indicating that it contains significant inaccuracies and goes beyond the scope of the CPUC's authority. In April 1993, the CPUC alleged that the Company failed to obtain five required permits and issued an order requesting that the Company show why a particular cellular facility should not be disapproved. Certain of the Company's markets may have taken steps that the CPUC might consider to be construction of cellular facilities prior to filing advice letters with the CPUC and/or might be considered by the CPUC to involve the failure to obtain necessary governmental permits for certain cellular facilities. The Company does not anticipate that sanctions, if any, that may be imposed by the CPUC for any failure to comply with G.O. 159 or to obtain other governmental permits will have a material adverse effect on the Company. FCC LICENSE RENEWAL The Company has filed an application for renewal of its Los Angeles cellular AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) license, whose initial term expired in October 1993. The Company expects that its application will be granted, although an opposing party has filed an informal objection and a petition to deny the Company's application, alleging violations of FCC rules and the Communications Act of 1934. The Company's licenses in San Diego, Detroit, Cleveland and Sacramento expire in October 1994 and all of its other significant domestic cellular licenses expire before the end of 1996. While the Company believes that each of these licenses will be renewed based upon FCC rules establishing a presumption in favor of licensees that have complied with their regulatory obligations during the initial license period, there can be no assurance that any license will be renewed. The licensing authorities in Germany and Portugal have not established any procedures for renewal of the cellular licenses held by MMO and Telecel. Such licenses expire in 2009 and 2006, respectively. M. CAPITAL STOCK CAPITAL RESTRUCTURING In 1993, the Company amended and restated its Articles of Incorporation to include, among other things, the conversion of its existing two classes of no par value common stock into 1,150,000,000 shares of $.01 par value capital stock. In connection with the conversion, the number of common shares outstanding increased from 100,000 to 424,000,000. The Consolidated Financial Statements of prior years have been restated to reflect the new capital structure. The newly authorized capital stock consists of 50,000,000 shares of preferred stock and 1,100,000,000 shares of common stock. On December 2, 1993, the Company completed a public offering of 68,500,000 shares of newly issued common stock for proceeds of $1,489.2 million, net of underwriting discounts and direct stock issuance costs. As a result of this offering, the number of common shares outstanding increased from 424,000,000 to 492,500,000. COMMON STOCK In addition to the 492,500,000 common shares outstanding, a subsidiary of the Company owns 122,960 shares of the Company's common stock. Because the accounting treatment for subsidiary-held shares is similar to that for treasury stock, the subsidiary-held shares are not considered outstanding. PREFERRED STOCK Of the 50,000,000 authorized shares of preferred stock, 6,000,000 shares have been designated as Series A Participating Preferred Stock. There are no outstanding shares of Series A Participating Preferred Stock. The remaining authorized preferred stock may be issued in one or more series, and the Board of Directors is authorized to designate the series and fix the relative rights, preferences, and limitations of the respective series without any further vote or action of the shareholders. SHAREHOLDER RIGHTS PLAN In July 1993, the Company's Board of Directors adopted a shareholder rights plan (the "Rights Plan"), which provides for the distribution of rights AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) ("Rights") to holders of outstanding shares of common stock. Except as set forth below, each Right, when exercisable, entitles the shareholder to purchase from the Company one one-hundredth of a share of Series A Participating Preferred Stock at a price of $80 per share, subject to adjustment. The Rights are not currently exercisable, but would become exercisable if certain events occurred related to a person or group ("Acquiring Party") acquiring or attempting to acquire 10% or more of the Company's common stock. In the event that the Rights become exercisable, each holder of a Right (other than an Acquiring Party) would be entitled to purchase, for the exercise price then in effect, shares of the Company's common stock having a market value at the time of such transaction of two times the exercise price for each Right. The Board of Directors, at its option, may at any time after a person becomes an Acquiring Party (but not after the acquisition by such person of 50% or more of the outstanding common stock) exchange on behalf of the Company all or part of the then outstanding and exercisable Rights for shares of common stock at an exchange ratio of one share of common stock for each Right. At any time prior to the earlier of the occurrence of either (i) a person becoming an Acquiring Party or (ii) the expiration of the Rights, the Company may redeem the Rights in whole, but not in part, at a price of $0.01 per Right. N. COMMITMENTS AND CONTINGENCIES CELLULAR PLUS INC. A complaint has been filed in San Diego against the Company's wholly owned subsidiary, AirTouch Cellular ("Cellular"), formerly PacTel Cellular, and another regional telephone company (Cellular's competitor in San Diego), alleging on behalf of agents and dealers that Cellular engaged in price fixing of wholesale and retail cellular service. The outcome of this action is uncertain. Accordingly, no accrual for a contingency has been made. The Company intends to defend itself vigorously in this action and does not expect that any unfavorable outcome will have a material impact on the Company's results of operations or financial condition. GARABEDIAN DBA WESTERN MOBILE TELEPHONE COMPANY V. LASMSA LIMITED PARTNERSHIP, ET AL. A class action complaint has been filed naming as defendants, among others, Los Angeles Cellular Telephone Company ("LACTC") and the Company, as general partner for Los Angeles SMSA Limited Partnership. The plaintiff alleges that LACTC and the Company conspired to fix the price of wholesale and retail cellular service in the Los Angeles market. The plaintiff alleges damages for the class "in a sum in excess of $100 million." On January 31, 1994, the Company filed a demurrer to the complaint. No discovery had been undertaken as of March 3, 1994. The Company intends to defend itself vigorously. The Company does not anticipate this proceeding will have a material adverse effect on the Company's financial position. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) OTHER The Company is party to various other legal proceedings in the ordinary course of business. Although the ultimate resolution of these proceedings cannot be ascertained, management does not believe they will have a materially adverse effect on the results of operations or financial position of the Company. The Company has no material long-term capital lease obligations or operating leases. Rental expense for the years ended December 31, 1993, 1992, and 1991 was $33.3 million, $31.9 million, and $26.6 million, respectively. The Company and Telesis have various letters of responsibility and letters of support for performance guarantees, refundable security deposits and credit facilities of certain subsidiaries and affiliates. These letters of responsibility and letters of support do not provide for recourse to either Telesis or to the Company. Separately, as of December 31, 1993, the Company guaranteed approximately $10.4 million owed by a third party. The Company believes that the likelihood of having to pay under the guarantee is remote. A subsidiary of the Company guarantees the liabilities of a third party, for which the subsidiary is indemnified by minority shareholders unaffiliated with the Company. The Company believes it is remote that it will be required to pay under this guarantee. Additionally, in August 1993, the Company provided a letter supporting the commercial paper program entered into by Telecel Comunicacoes Pessoais, S.A. in which the Company may be liable for its proportionate share of the loans issued under the program if certain loan covenants are not met. As of December 31, 1993, the potential liability is approximately $6.5 million. The Company believes that the likelihood of having to pay under the letter is remote. O. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS COMPENSATION TO EMPLOYEES Certain key employees of the Company are eligible for the grant of options to purchase shares of Telesis common stock and stock appreciation rights ("SARs") under the Pacific Telesis Group Stock Option and Stock Appreciation Rights Plan (the "Plan"). The Plan was adopted by Telesis on January 1, 1984. Following the spin-off, it is expected that outstanding awards under the Plan as of the record date for the spin-off will be replaced by Company awards (the "Replacement Awards"). For stock options and SARs, it is expected that the Replacement Awards will have the same aggregate exercise prices, cover the same aggregate fair market values of stock and continue the vesting schedules and other conditions for exercise of the Telesis options or SARs they replace. The formula to determine the total number of Replacement Awards to be issued to Company employees is dependent on the respective market values of the Telesis and Company common stock in the 10 trading days prior to the record date associated with the spin-off. As such, the Company cannot accurately determine the number of Replacement Awards that will be outstanding after the spin-off date. The formula is a fraction, with the pre-spin-off market value of Telesis common shares as the numerator and the pre-spin-off market value of the Company's common stock as the denominator, multiplied by the number of Telesis options held by Company employees. At December 31, 1993, Company AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) employees held approximately 1.3 million options on Telesis common stock. COMPENSATION TO INVESTMENT ADVISERS Telesis and the Company have agreed to the terms of compensation to be paid to Sterling Payot Company, an investment firm that advised Telesis and the Company. The terms require Telesis and the Company to each issue 350,000 SARs to Sterling Payot on the spin-off date. The exercise price for one-half of the Telesis and one-half of the Company SARs is $30 per share and $20 per share, respectively, and the exercise price for the remaining one-half is $36 per share and $24 per share, respectively. The agreement provides that once SARs with an aggregate value of $6 million have been exercised, any remaining SARs expire and may not be exercised. The stock appreciation rights are exercisable for three years from the date of issuance. P. INTERNATIONAL OPERATIONS The Company's subsidiary, AirTouch International ("International"), formerly Pacific Telesis International, provides paging services through two companies in Thailand. Company assets in that nation totalled $34.9 million at December 31, 1993, and 1993 revenues and net loss totalled $26.6 million and $2.6 million, respectively. International also has substantial investments in consortia that do business in other countries (see Note D). These consortia, for the most part, are start-up businesses that are either in the process of constructing networks or are just beginning operations. One consortium, Mannesmann Mobilfunk GmbH, operates the world's largest digital cellular network. At the end of 1993, the Company had a net investment in this German consortium of $234.2 million. The Company's share of consortium revenues and net loss for 1993 totalled $125.8 million and $20.6 million, respectively. In Japan, the Company owns an interest in three ventures that will provide cellular services to various metropolitan areas, including Tokyo and Osaka. At December 31, 1993, the Company's net investment in these consortia totalled $29.8 million. No revenues were recognized for 1993, and the Company's share of the year's net loss was $4.2 million. Another consortium, Telecel Comunicacoes Pessoais, S.A., operates a national digital cellular system in Portugal. The Company's net investment in this consortium at the end of 1993 totalled $26.9 million. The Company's share of 1993 revenues and net loss was $14.2 million and $6.3 million, respectively. In Sweden, the Company owns a 51% interest in NordicTel, one of three providers of global digital cellular services in Sweden. The Company's assets in NordicTel totalled $77.9 million at December 31, 1993, and 1993 revenues and net loss totalled $1.2 million and $4.2 million, respectively. While the Company has chosen not to do business in nations with highly inflationary economies, the Company continues to try to mitigate the effects of foreign currency fluctuations through the use of hedges and local banking accounts. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Q. RELATED PARTY TRANSACTIONS The Company and Telesis' affiliated companies have entered into several transactions and agreements related to their respective businesses. The following represents the material transactions between the Company and Telesis' affiliated companies. EQUITY CONTRIBUTIONS Telesis provided equity contributions of $1,179.8 million during 1993 prior to the IPO. Equity contributions from Telesis totalled $212.2 million and $71.4 million during 1992 and 1991, respectively. ADMINISTRATIVE SERVICES The Company obtains certain administrative services and other additional benefits from Telesis. Service costs that are specifically attributable to the Company are directly charged to the Company by Telesis. Other service costs and corporate charges are allocated proportionately among Telesis' subsidiaries, including the Company. The Company believes that the terms of the arrangements determining charges to it by Telesis are reasonable, although there can be no assurance that these terms are or will be as favorable to the Company as could be obtained from unaffiliated third parties. Telesis may be providing administrative services to the Company for up to 90 days after the spin-off. In the ordinary course of business, the Company participated in the following transactions with affiliated companies: For the Year Ended December 31, ------------------------------- 1993 1992 1991 ---------- ---------- --------- PROVIDED BY THE COMPANY: (Dollars in millions) Revenues from cellular services......... $ 2.7 $ 2.3 $1.8 Revenues from paging services........... $ 1.7 $ 1.4 $1.3 PROVIDED TO THE COMPANY: Expenses from telephone services........ $28.5 $29.0 $29.3 Expenses from administrative, research and development, and insurance services. $16.3 $17.4 $14.3 Expenses from lending services.......... $19.6 $46.6 $33.1 CONTEMPLATED AGREEMENTS AND ARRANGEMENTS In contemplation of the proposed spin-off, the Company and Telesis have entered into a separation agreement that provides for complete separation of all properties after the spin-off as well as transition agreements that disengage the affairs of the Company and Telesis in an orderly manner. INCOME TAX SHARING The separation agreement provides that the Company will continue to join in filing consolidated federal income tax returns with Telesis for all taxable periods in which the parties are required or permitted to file a consolidated AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) return. In each taxable period, the Company must pay Telesis an amount equal to the Company's share of the consolidated tax liability based on the Company's separate taxable income and an amount equal to the Company's contribution to Telesis' state tax liability. If the Company were to report a net operating loss for any such year, Telesis would pay an amount equal to its reduction in tax liability attributable to such loss. A similar method of allocation would be applied to state income taxes filed pursuant to a combined return. EMPLOYEE BENEFIT ALLOCATION The separation agreement provides for the transfer of a limited number of employees' and retirees' accounts between Telesis and the Company and for indemnification against certain claims. Telesis and the Company will exchange such payroll data, service records, tax-related information, and other employee information as may be necessary for the effective administration of their benefit plans and compliance with governmental reporting requirements after the spin-off. CONTINGENT LIABILITIES In general, the separation agreement will allocate nontax liabilities that become certain after the spin-off and were not recognized in the financial statements according to the origin of the claim and acts by, or benefits to, Telesis or the Company. DIVIDEND PAYMENTS The Company does not expect to pay cash dividends on its common stock in the foreseeable future. Management believes that the consolidated financial statements of the Company, presented herein, reasonably reflect the historical relationships with Telesis and its affiliates and reflect all of the Company's costs of doing business. Management believes that there would not have been any material difference from the amounts presented in the historical financial statements had the Company operated on a stand-alone basis. However, the historical financial statements are not necessarily indicative of future financial condition, results of operations, or cash flows. R. SUBSEQUENT EVENTS In January 1994, the Company's cellular services subsidiary signed a definitive agreement to purchase digital cellular network equipment for use in the greater Los Angeles area. The contract is initially valued at approximately $77 million but could reach $130 million by the year 2000 depending upon final system design specifications. In February 1994, the Company signed a commitment letter authorizing a major financial institution to proceed with arranging and syndicating a $600 million revolving credit facility. The proposed credit facility, which is subject to the negotiation and execution of a definitive bank loan agreement, would provide the Company with funding for general corporate purposes and with standby letters of credit to support its obligations to purchase additional shares in Cellular Communications, Inc. under the Mandatory Redemption AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Obligation as described in Note E. The new credit facility is anticipated to close on or before the spin-off and would replace an existing letter of responsibility issued by Telesis. In February 1994, the Company announced a new corporate name, AirTouch Communications. In March 1994, Telesis announced that its Board of Directors had given final approval to the spin-off of the Company which will occur on April 1, 1994. S. ADDITIONAL FINANCIAL INFORMATION December 31, --------------------- 1993 1992 ---------- ---------- (Dollars in millions) Accounts payable: Trade............................................. $110.8 $111.5 Other............................................. 38.4 30.3 ---------- ---------- Total............................................. $149.2 $141.8 ========== ========== Miscellaneous other current liabilities: Accrued taxes .................................... $ 28.2 $ 18.7 Advance billings and customer deposits............ $ 22.4 $ 23.1 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Year Ended December 31, ---------------------------- 1993 1992 1991 -------- -------- -------- (Dollars in millions) Miscellaneous income (expense): Foreign currency transaction gain (loss)..... $(3.4) $ 2.2 $ (1.4) Defined benefit plan settlement gain, net.... 3.0 - - Settlement of litigation..................... - - 12.0 Loss on sale of equipment.................... - - (3.3) Other........................................ (0.1) (1.2) (2.1) -------- -------- -------- Total........................................ $(0.5) $ 1.0 $ 5.2 ======== ======== ======== Wireless services and other revenues: Cellular service............................. $787.0 $681.7 $625.4 Paging service............................... 148.7 117.9 98.0 Vehicle location service..................... 4.0 2.4 0.7 Other revenues............................... 47.6 32.8 25.4 -------- -------- -------- Total........................................ $987.3 $834.8 $749.5 ======== ======== ======== Advertising.................................... $ 48.4 $ 37.1 $ 26.3 Property taxes................................. $ 16.7 $ 20.8 $ 18.5 Supplemental Cash Flow information: Cash payments for: Interest, net*........................... $ 26.4 $ 51.4 $ 37.7 Income taxes............................. $ 51.5 $ 16.3 $ 20.5 Noncash transactions: Contribution of assets to CMT Partners at book value.......................... $206.0 - - Assumption of liabilities in exchange for ITS' net assets.................... - $ 80.0 - Contribution of assets to CCI joint venture at book value.................. - - $330.0 ----------------- * Net of amounts capitalized of $3.7 million, $3.6 million, and $11.6 million for 1993, 1992, and 1991, respectively. AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) T. QUARTERLY FINANCIAL DATA (UNAUDITED) (Dollars in millions, except per share amounts) --------------------------------------- 1993 First Second Third Fourth -------------------------------------------------------------------------- Net operating revenues........... $239.1 $259.5 $254.7 $234.7 Operating income................. $ 28.2 $ 42.4 $ 47.9 $ 9.7 Income (loss) before cumulative effect of accounting change.... $ (2.3) $ 12.5 $ 15.3 $ 14.6 Net income (loss)................ $ (7.9) $ 12.5 $ 15.3 $ 14.6 Per share data: Income (loss) before cumulative effect of accounting change.. $(0.01) $ 0.03 $ 0.04 $ 0.03 Net income (loss).............. $(0.02) $ 0.03 $ 0.04 $ 0.03 - -------------------------------------------------------------------------- 1992 First Second Third Fourth - -------------------------------------------------------------------------- Net operating revenues........... $193.1 $203.1 $214.3 $228.0 Operating income................. $ 24.2 $ 21.6 $ 25.5 $ 24.6 Loss before extraordinary item and cumulative effect of accounting change.......... $ (6.5) $ (0.4) $ (0.1) $ (3.1) Net income (loss)................ $ 21.4 $ (8.0) $ (0.1) $ (3.1) Per share data: Loss before extraordinary item and cumulative effect of accounting change............ $(0.01) $ 0.00 $ 0.00 $(0.01) Net income (loss).............. $ 0.05 $(0.02) $ 0.00 $(0.01) ========================================================================== In 1993, the Company implemented SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." The implementation of SFAS No. 106 reduced net income by $5.6 million in the first quarter of 1993. Effective January 1, 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes." The adoption of SFAS No. 109 increased net income by $27.9 million in the first quarter of 1992. In 1992, the Company prepaid $100 million of long-term debt. The early redemption expense related to the prepayment reduced net income by $7.6 million in the second quarter of 1992. REPORT OF INDEPENDENT ACCOUNTANTS Our report on the consolidated financial statements of AirTouch Communications (formerly PacTel Corporation) and Subsidiaries is included on page of this Form 10-K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14(a) 2 of the Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ Coopers & Lybrand San Francisco, California March 3, 1994 New Par (A Partnership) Index of Consolidated Financial Statements Page ---- Report of Independent Auditors ............................... Consolidated Balance Sheets - December 31, 1993 and 1992 ..... Consolidated Statements of Income - Years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 ............ Consolidated Statement of Partners' Capital - Years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 ....... Consolidated Statements of Cash Flows - Years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 .......................................... Notes to Consolidated Financial Statements .................. Report of Independent Auditors The Partnership Committee New Par We have audited the accompanying balance sheets of New Par and the related consolidated statements of income, partners' capital and cash flows for the years ended December 31, 1993 and 1992 and for the period from August 1, 1991 (inception) to December 31, 1991. 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 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 New Par at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for the years ended December 31, 1993 and 1992 and for the period from August 1, 1991 (inception) to December 31, 1991 in conformity with generally accepted accounting principles. /s/ Ernst and Young Columbus, Ohio February 25, 1994 New Par (A Partnership) Consolidated Balance Sheets DECEMBER 31, ---------------------------- 1993 1992 ------------- ------------- ASSETS Current assets: Cash and cash equivalents $ 36,845,000 $ 6,279,000 Accounts receivable trade, less allowance for doubtful accounts of $4,382,000 (1993) and $4,431,000 (1992) 57,691,000 43,770,000 Due from affiliates 49,000 107,000 Telephone equipment inventory 8,149,000 8,225,000 Prepaid expenses and other current assets 1,866,000 1,785,000 ------------- ------------- Total current assets 104,600,000 60,166,000 Property, plant and equipment, net 304,548,000 269,734,000 License acquisition costs, net 367,063,000 349,692,000 Other assets, net of accumulated amortization of $10,583,000 (1993) and $8,496,000 (1992) 14,190,000 11,830,000 ------------- ------------- Total assets $790,401,000 $691,422,000 ============= ============= LIABILITIES AND PARTNERS' CAPITAL Current liabilities: Accounts payable $ 18,148,000 $ 7,577,000 Accrued expenses 14,123,000 17,554,000 Distribution payable to partners 22,982,000 22,318,000 Due to affiliates 1,813,000 1,257,000 Property and other taxes payable 10,955,000 11,541,000 Commissions payable 9,321,000 6,899,000 Deferred revenue 11,066,000 8,886,000 ------------- ------------- Total current liabilities 88,408,000 76,032,000 Commitments and contingent liabilities Partners' capital 701,993,000 615,390,000 ------------- ------------- Total liabilities and partners' capital $790,401,000 $691,422,000 ============= ============= See accompanying notes. New Par (A Partnership) Consolidated Statements of Income For the period from August 1, 1991 Year ended December 31, (inception) to ---------------------------- December 31, 1993 1992 1991 ------------ ------------ ------------- REVENUES Cellular service $390,181,000 $311,197,000 $109,961,000 Telephone equipment sales, rental and other 45,668,000 29,135,000 9,245,000 ------------ ------------ ------------- 435,849,000 340,332,000 119,206,000 COSTS AND EXPENSES Cost of telephone equipment sold 28,037,000 14,538,000 6,357,000 Operating expenses 85,575,000 69,818,000 23,952,000 Selling, general and administrative expenses 148,248,000 123,108,000 46,283,000 Restructuring charges 648,000 -- 2,697,000 Depreciation expense 39,796,000 30,437,000 10,615,000 Amortization expense 12,950,000 13,572,000 5,484,000 Depreciation of rental telephones 28,496,000 18,957,000 4,756,000 ------------ ------------ ------------- 343,750,000 270,430,000 100,144,000 ------------ ------------ ------------- Operating income 92,099,000 69,902,000 19,062,000 Other income (expense): Interest and other income 1,100,000 272,000 354,000 Interest expense (124,000) (140,000) (24,000) ------------ ------------ ------------- Income before provision for income taxes 93,075,000 70,034,000 19,392,000 Provision for income taxes (522,000) (771,000) (535,000) ------------ ------------ ------------- Net income $ 92,553,000 $ 69,263,000 $ 18,857,000 ============ ============ ============= See accompanying notes. New Par (A Partnership) Consolidated Statement of Partners' Capital PacTel CCI Group Group Total ------------ ------------ ------------- Initial capital contributions $330,187,000 $216,917,000 $547,104,000 Capital contributions 3,000,000 4,337,000 7,337,000 Distribution payable (6,750,000) (6,750,000) (13,500,000) Net income for the period from August 1, 1991 (inception) to December 31, 1991 9,428,500 9,428,500 18,857,000 ------------ ------------ ------------- Balance, December 31, 1991 335,865,500 223,932,500 559,798,000 Capital contributions 6,694,000 6,694,000 13,388,000 Distribution payable (13,529,500) (13,529,500) (27,059,000) Net income for the year ended December 31, 1992 34,631,500 34,631,500 69,263,000 ------------ ------------ ------------- Balance, December 31, 1992 363,661,500 251,728,500 615,390,000 Capital contributions -- 29,714,000 29,714,000 Distribution payable (17,832,000) (17,832,000) (35,664,000) Net income for the year ended December 31, 1993 46,276,500 46,276,500 92,553,000 ------------ ------------ ------------- Balance, December 31, 1993 $392,106,000 $309,887,000 $701,993,000 ============ ============ ============= See accompanying notes. New Par (A Partnership) Consolidated Statements of Cash Flows For the period from August 1, 1991 Year ended December 31, (inception) to ---------------------------- December 31, 1993 1992 1991 ------------ ------------ ------------- OPERATING ACTIVITIES Net income $ 92,553,000 $ 69,263,000 $ 18,857,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 81,242,000 62,966,000 20,855,000 Provision for losses on accounts receivable 16,877,000 6,603,000 2,973,000 Loss on sale of property, plant and equipment 3,534,000 1,526,000 24,000 Provision for rental telephone losses 4,426,000 1,214,000 592,000 Equity in earnings of unconsolidated partnership -- -- (31,000) Change in operating assets and liabilities: Accounts receivable (30,871,000) (15,987,000) (4,756,000) Due from affiliates 58,000 773,000 (767,000) Inventory 76,000 (2,567,000) (1,246,000) Prepaid expenses and other current assets (41,000) (56,000) 759,000 Other assets (4,278,000) (3,882,000) (2,499,000) Accounts payable 4,460,000 (3,782,000) (10,250,000) Accrued expenses (3,703,000) (3,219,000) 2,462,000 Due to affiliates 556,000 (4,044,000) 4,639,000 Taxes payable (645,000) 3,386,000 3,518,000 Commissions payable 2,422,000 1,537,000 2,584,000 Deferred revenues 2,180,000 2,707,000 113,000 ------------ ------------ ------------- Net cash provided by operating activities 168,846,000 116,438,000 37,827,000 ------------ ------------ ------------- INVESTING ACTIVITIES Purchase of property, plant and equipment (104,288,000) (114,300,000) (27,210,000) Proceeds from sale of property, plant and equipment 1,035,000 617,000 143,000 Purchase of cellular license interests (27,000) (4,463,000) (55,000) ------------ ------------ ------------- Net cash (used in) investing activities (103,280,000) (118,146,000) (27,122,000) ------------ ------------ ------------- (Continued on next page) New Par (A Partnership) Consolidated Statements of Cash Flows (continued) For the period from August 1, 1991 Year ended December 31, (inception) to ---------------------------- December 31, 1993 1992 1991 ------------ ------------ ------------- FINANCING ACTIVITIES Capital distributions (35,000,000) (18,241,000) -- Capital contributions -- 4,463,000 6,000,000 Cash contributed at inception -- -- 597,000 Due to affiliate -- -- 4,463,000 ------------ ------------ ------------- Net cash provided by (used in) financing activities (35,000,000) (13,778,000) 11,060,000 ------------ ------------ ------------- Increase (decrease) in cash and cash equivalents 30,566,000 (15,486,000) 21,765,000 Cash and cash equivalents at beginning of period 6,279,000 21,765,000 -- ------------ ------------ ------------- Cash and cash equivalents at end of period $ 36,845,000 $ 6,279,000 $21,765,000 ============ ============ ============= Supplemental Disclosures of Cash Flow Information: Cash paid during the period for interest $ 76,000 $ 79,000 $ 24,000 Income taxes paid $ 944,000 $ 675,000 $ 392,000 Supplemental Disclosures of Noncash Investing Activities: Cellular license interests contributed by Cellular Communications, Inc. $28,207,000 $ 4,462,000 $ 1,337,000 Purchases of property, plant and equipment included in current liabilities $10,800,000 $ 4,417,000 $ 7,739,000 Supplemental Disclosures of Noncash Financing Activities: Distribution payable to partners $22,982,000 $22,318,000 $13,500,000 See accompanying notes. New Par (A Partnership) Notes to Consolidated Financial Statements December 31, 1993 and 1992 1. ORGANIZATION New Par was formed on August 1, 1991 (inception) pursuant to the Amended and Restated Agreement and Plan of Merger and Joint Venture Organization dated as of December 14, 1990 between PacTel Corporation ("PacTel"), Cellular Communications, Inc. ("CCI"), CCI Newco, Inc. and CCI Newco Sub, Inc. (the "Merger Agreement"). New Par is a Delaware general partnership equally owned by PacTel and CCI through the following wholly-owned, indirect corporate subsidiaries: Percentage Ownership of General Partners New Par ---------------- ------------ The PacTel Group ---------------- PacTel Cellular Inc. of Michigan 27.74% PacTel Cellular Inc. of Ohio 18.18 PacTel Cellular of Saginaw, Inc. 2.64 PacTel Cellular Inc. of Lima 1.44 --------- 50.00 --------- The CCI Group ------------- Cellular Communications of Cleveland, Inc. 12.45 Cellular Communications of Cincinnati, Inc. 11.22 Cellular Communications of Columbus, Inc. 7.94 Cellular Communications of Dayton, Inc. 5.19 Cellular Communications of Akron, Inc. 4.14 Cellular Communications of Canton, Inc. 2.29 Cellular Communications of Hamilton, Inc. 1.98 Lorain/Elyria Cellular Telephone Company 1.86 E&J Mobile Radio Service, Inc. .97 Cellular Communications of Mansfield, Inc. .87 Midwest Mobilephone of Cincinnati, Inc. .81 Star-Cel, Inc. .21 Cellular One Sales and Service, Inc. .07 --------- 50.00 --------- 100.00% ========= New Par (A Partnership) Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION (continued) Each wholly-owned, indirect corporate subsidiary of PacTel and CCI initially contributed to New Par its interests in the General Partnerships (see below). The initial contributions were accounted for at the net book value of the assets and liabilities of the General Partnerships. Each of these partnerships, among other assets, holds a license or licenses from the Federal Communications Commission ("FCC") and state authorities to operate cellular telephone systems in Cellular Geographic Service Areas as listed below. New Par owns 100% of the partnership interests in each partnership, except as noted. General Partnership Service Area ----------------------------------------- ------------------ Detroit Cellular Telephone Company Detroit, MI Northern Ohio Cellular Telephone Company Cleveland, OH Lorain/Elyria, OH Mansfield, OH Ashtabula, OH Southern Ohio Telephone Company Cincinnati, OH Clinton, OH Columbus Cellular Telephone Company Columbus, OH Mercer, OH Dayton Cellular Telephone Company Dayton, OH Toledo Cellular Telephone Company Toledo, OH Lima, OH Grand Rapids Cellular Telephone Company Grand Rapids, MI Akron Cellular Telephone Company Akron, OH Flint Cellular Telephone Company Flint, MI Saginaw, MI Lansing Cellular Telephone Company Lansing, MI Canton Cellular Telephone Company Canton, OH Hamilton Cellular Telephone Company Hamilton/Middletown, OH Springfield Cellular Telephone Company Springfield, OH Muskegon Cellular Telephone Company (a) Muskegon, MI (a) New Par is a 38.91% general partner in the Muskegon partnership. PacTel Cellular, Inc. of Michigan is a 40.5% general partner. The remaining 20.59% interests are owned by unaffiliated entities. Each of the above General Partnerships owns 100% of the FCC license in the Service Area, except for Hamilton/Middletown and Springfield in which the applicable partnership owns 99.6% and 89.23% of the FCC license, respectively. New Par owns 100% of Cellular One Sales and Service Company, which operates New Par's sales and service center business. New Par (A Partnership) Notes to Consolidated Financial Statements (continued) 2. SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of New Par and its wholly-owned partnerships. Significant intercompany accounts and transactions have been eliminated in consolidation. Cash and Cash Equivalents Cash and cash equivalents include cash, deposits in interest-bearing accounts and short-term highly liquid investments purchased with a maturity of three months or less. Telephone Equipment Inventory Telephone equipment inventory, which consists of telephones and accessories, is stated at the lower of cost (first-in, first-out method) or market. Property, Plant and Equipment Property, plant and equipment is stated at cost. Depreciation is computed by the straight-line method over the estimated useful lives of the assets. Estimated useful lives are as follows: building - 25 years, operating plant and equipment - 7 to 25 years, rental telephones - 3 years and office furniture, computer and other equipment - 3 to 5 years. License Acquisition Costs Deferred cellular license costs include costs incurred to design cellular telephone systems for specific geographic areas, select and acquire sites to place equipment for such systems, demographic and traffic pattern studies, legal and organization costs, and costs incurred in connection with the preparation and filing of FCC license applications. These costs are amortized by the straight-line method from the commencement of operations over the life of the Partnership's initial license period (ten years). In connection with the purchase of license interests, the excess of purchase price paid over the fair market value of tangible assets acquired is amortized by the straight-line method over 40 years. Revenue Recognition Service revenue is recognized at the time the cellular service is rendered. Telephone equipment sales are recorded when the equipment is shipped to the customer. Telephone rental revenue is billed and recognized on a monthly basis. New Par (A Partnership) Notes to Consolidated Financial Statements (continued) Income Taxes No provision has been made for federal income taxes since such taxes, if any, are the responsibility of the individual partners. Provision has been made for state and local income taxes assessed on partnership income which is a liability of the Partnership. Allocation of Income Pursuant to the New Par Partnership Agreement, income is allocated to the General Partners in proportion to their respective percentage ownership of New Par. Fair Value of Financial Instruments New Par's financial instruments consist primarily of cash and cash equivalents, accounts receivable, due from affiliates, accounts payable, accrued expenses, distribution payable to partners, due to affiliates, property and other taxes payable, and commissions payable. The terms and short term nature of these assets and liabilities result in their carrying value approximating fair value. 3. LICENSE ACQUISITION COSTS License acquisition costs consist of: December 31, ---------------------------- 1993 1992 ------------- ------------ Deferred cellular license costs $ 3,418,000 $ 3,418,000 Excess of purchase price paid over the fair market value of tangible assets acquired 430,990,000 402,756,000 ------------- ------------ 434,408,000 406,174,000 Accumulated amortization 67,345,000 56,482,000 ------------- ------------ $367,063,000 $349,692,000 ============= ============ In August 1991, a subsidiary of CCI ("CCI RSA") acquired the Mercer, OH FCC license. This license was contributed to one of the General Partnerships in accordance with the New Par Partnership Agreement. The contribution was initially recorded at CCI RSA's cost through December 31, 1991 of $1,315,000. During 1993, CCI RSA incurred an additional $19,575,000 upon the receipt of a favorable determination with respect to certain FCC matters. The additional cost was recorded as a contribution in 1993. In 1992, New Par purchased the Clinton, OH FCC license from CCI RSA for $8,925,000 (CCI RSA's cost). New Par (A Partnership) Notes to Consolidated Financial Statements (continued) 3. LICENSE ACQUISITION COSTS (continued) In 1993, a subsidiary of CCI contributed the Ashtabula, OH FCC license and the related assets and liabilities to one of the General Partnerships in accordance with the New Par Partnership Agreement. The contribution was recorded at $10,139,000, of which $8,632,000 was for the FCC license and $1,507,000 was for other assets, net of liabilities. 4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of: December 31, ---------------------------- 1993 1992 ------------- ------------ Land $ 8,709,000 $ 6,591,000 Building 10,540,000 6,911,000 Operating plant and equipment 313,966,000 247,493,000 Rental telephones 97,930,000 80,271,000 Office furniture, computer and other equipment 69,587,000 56,181,000 Construction-in-progress 8,940,000 15,014,000 ------------- ------------ 509,672,000 412,461,000 Allowance for depreciation 202,876,000 142,026,000 Allowance for unreturned rental telephones 2,248,000 701,000 ------------- ------------ $304,548,000 $269,734,000 ============= ============ New Par (A Partnership) Notes to Consolidated Financial Statements (continued) 5. RELATED PARTY TRANSACTIONS Due from affiliates consists of the following: December 31, ---------------------------- 1993 1992 ------------- ------------ CCPR Services, Inc. $24,000 $107,000 Cellular Communications International, Inc. 17,000 - International CableTel Incorporated 8,000 - ------------- ------------ $49,000 $107,000 ============= ============ Due to affiliates consists of the following: December 31, ---------------------------- 1993 1992 ------------- ------------ PacTel and affiliates $ 937,000 $ 622,000 CCI and subsidiaries 510,000 471,000 OCOM Corporation 366,000 163,000 Cellular Communications International, Inc. - 1,000 ------------- ------------ $1,813,000 $1,257,000 ============= ============ New Par (A Partnership) Notes to Consolidated Financial Statements (continued) 5. RELATED PARTY TRANSACTIONS (continued) Pursuant to the New Par Partnership Agreement, the CCI Group is responsible for appointing and employing New Par's chief executive officer and half of the next level executives and the PacTel Group is responsible for appointing and employing the other half of the next level executives. In addition, the PacTel Group employed the individuals associated with its former partnerships until July 1, 1992. For the year ended December 31, 1993, New Par was charged $779,000 and $816,000 for payroll and benefits by PacTel affiliates and CCI, respectively, of which $176,000 and $1,419,000 are included in operating expenses and selling, general and administrative expenses, respectively. For the year ended December 31, 1992, New Par was charged $9,364,000 and $836,000 for payroll and benefits by PacTel affiliates and CCI, respectively, of which $2,154,000 and $8,046,000 are included in operating expenses and selling, general and administrative expenses, respectively. For the period from August 1, 1991 (inception) to December 31, 1991, New Par was charged $5,745,000 and $421,000 for payroll and benefits by PacTel affiliates and CCI, respectively, of which $1,147,000 and $5,019,000 are included in operating expenses and selling, general and administrative expenses, respectively. In connection with the Merger Agreement, CCI distributed its wholly-owned subsidiary OCOM Corporation ("OCOM") to its shareholders on July 31, 1991. OCOM owns the long distance and microwave operations formerly owned by the partnerships that CCI contributed to New Par. Most of CCI's officers and directors are officers and directors of OCOM. New Par provides billing and collection services to OCOM for the long distance telephone service OCOM sells to certain of New Par's subscribers. OCOM operates the microwave transmission service between the cell sites and switches contributed by CCI. For the years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991, OCOM charged New Par $4,043,000, $4,846,000 and $1,871,000, respectively, for microwave transmission services which is included in operating expenses. 6. LEASES Leases for office space, sales and service centers and cell sites extend through 2039. Total rent expense for the years ended December 31, 1993 and 1992 and the period from August 1, 1991 (inception) to December 31, 1991 under operating leases was $5,608,000, $4,359,000 and $1,852,000, respectively. Future minimum lease payments under noncancellable operating leases as of December 31, 1993 are as follows: Year ending December 31: 1994 $ 4,296,000 1995 3,863,000 1996 3,438,000 1997 2,456,000 1998 1,288,000 Thereafter 8,170,000 -------------- $23,511,000 ============== New Par (A Partnership) Notes to Consolidated Financial Statements (continued) 7. RESTRUCTURING CHARGES Restructuring charges include costs incurred and expected to be incurred for the consolidation of operations, relocation of operations, termination and/or relocation of employees and abandonment of certain equipment. Restructuring charges included in accrued expenses as of December 31, 1993 and 1992 are $795,000 and $934,000, respectively. 8. PENSION PLAN New Par has a defined contribution plan covering all employees who have completed six months of service and worked over 500 hours. New Par's matching and discretionary contributions are determined annually by New Par's Operating Committee. Participants can make salary deferral contributions of 1% to 16% of annual compensation not to exceed the maximum allowed by law. New Par's expense for the years ended December 31, 1993 and 1992 was $3,186,000 and $2,272,000, respectively. 9. COMMITMENTS AND CONTINGENT LIABILITIES As of December 31, 1993, New Par had purchase commitments of approximately $44,012,000 primarily for operating equipment, computer equipment and cellular telephones and accessories. In the ordinary course of business, there are various legal proceedings pending against New Par. Management believes the aggregate liabilities, if any, arising from such proceedings would not have a material adverse effect on New Par's consolidated financial position. 10. PACTEL AND CCI RELATIONSHIP A subsidiary of CCI, Cellular Communications of Ohio, Inc., (the parent of the CCI Group) has a loan agreement which places certain restrictions on New Par. These restrictions include the following: (i) New Par's aggregate lease payments may not exceed $8,000,000 for any twelve consecutive months, (ii) New Par's unsecured indebtedness, capital lease obligations and indebtedness for cellular network equipment or cellular telephones and accessories evidenced by a note or subject to a lien may not exceed $5,000,000, (iii) New Par's borrowings secured by real property may not exceed $10,000,000, (iv) New Par may not enter into an agreement that restricts partnership distributions and (v) the aggregate payment obligations outstanding at any time for (ii) and (iii) may not exceed $5,000,000 for any twelve consecutive months. New Par (A Partnership) Notes to Consolidated Financial Statements (continued) 10. PACTEL AND CCI RELATIONSHIP (continued) Pursuant to the Merger Agreement, at specified times from August 1996 through January 1998, PacTel has the right to buy the shares of CCI it does not own at an appraised value, subject to certain adjustments. If PacTel does not exercise this right, it will determine whether New Par should be dissolved or PacTel's interest in New Par and CCI should be sold as a whole. Upon such determination, CCI must promptly commence a process to sell CCI, although in lieu of any sales to a third party, CCI may purchase PacTel's CCI shares and, in certain circumstances, its interest in New Par at their appraised values. Any decision by CCI to buy out PacTel or any irrevocable election by CCI not to effect a sale pursuant to the above sale process would require the approval of CCI stockholders. In the event that either CCI or CCI's interest in New Par is sold to a third party for less than the appraised value of CCI's interest in New Par, PacTel may be required to pay a "make-whole" amount, subject to certain downward adjustments, to the other CCI stockholders. 11. PARTNERS' CAPITAL New Par is required to make cash distributions of a portion of estimated federal taxable income on a quarterly basis, subject to the amount of cash available including cash borrowable by New Par. Such distributions shall be made to the partners in proportion to their respective ownership percentages. As of December 31, 1993 and 1992, there was approximately $22,982,000 and $22,318,000, respectively, payable to the partners for the estimated federal taxable income distribution. During 1993 and 1992, New Par distributed $35,000,000 and $18,241,000, respectively, pursuant to this requirement. New Par must also distribute the amount, if any, that exceeds 120% of the amount required for estimated federal income tax distributions, plus cash reasonably contemplated as being necessary for the cash payment of New Par's operating expenses (net of receipts), debt service, contingencies, budgeted capital expenditures and working capital requirements within 45 days after each quarter. Such distributions are to be made to the partners in proportion to their respective ownership percentages. MANNESMANN MOBILFUNK GMBH Independent Auditors' Report .......................... Balance Sheets ........................................ Statements of Operations .............................. Statements of Capital Subscribers' Equity ............. Statements of Cash Flows .............................. Notes to Financial Statements ......................... INDEPENDENT AUDITORS' REPORT ---------------------------- The Board of Directors and Capital Subscribers Mannesmann Mobilfunk GmbH We have audited the accompanying balance sheets of Mannesmann Mobilfunk GmbH as of December 31, 1993 and 1992, and the related statements of operations, capital subscribers' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted German auditing standards which, in all material respects, are similar to auditing standards generally accepted in the United States. 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 Mannesmann Mobilfunk GmbH at December 31, 1993 and 1992, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States. As discussed in Notes 1 and 6 to the financial statements, the Company changed its method of accounting for income taxes in 1992 to adopt the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Dusseldorf, Germany, February 28, 1994 KPMG Deutsche Treuhand-Gesellschaft Aktiengesellschaft Wirtschaftsprufungsgesellschaft Scheffler Haas Wirtschaftsprufer Wirtschaftsprufer MANNESMANN MOBILFUNK GMBH BALANCE SHEETS DECEMBER 31, 1993 and 1992 (In thousands) ASSETS 1993 1993 1992 ---------------------------- ---------------- ------------- ------------- U.S. Dollars (1) Deutschmarks Deutschmarks Current assets: Cash and cash equivalents (Note 2) ............... $ 17,747 DM 30,848 DM 62,745 Accounts receivable, less allowance for doubtful accounts of DM 10,397 in 1993 and DM 2,561 in 1992 ................... 95,825 166,563 55,328 Due from affiliated companies (Note 3) ..... 8,962 15,577 29,147 Inventories of affiliated products, parts and related supplies (Note 4) ............... 11,103 19,300 8,929 Prepaid expenses ......... 6,211 10,796 5,175 Other current assets ..... 1,151 2,001 768 ------------ ------------ ----------- Total current assets 140,999 245,085 162,092 ------------ ------------ ----------- Property, plant, and equipment (Notes 3 and 5): Telecommunications equipment .............. 912,820 1,586,664 835,396 Equipment in course of construction ........... 65,363 113,614 99,989 Other equipment .......... 37,882 65,847 47,878 ------------ ------------ ----------- 1,016,065 1,766,125 983,263 Less accumulated depreciation ........... 153,051 266,034 87,363 ------------ ------------ ----------- Net property, plant, and equipment .... 863,014 1,500,091 895,900 Other assets, at cost, less accumulated amortization of DM 45,445 in 1993 and DM 25,096 in 1992 ........ 46,973 81,650 91,480 Deferred tax asset (Note 6) 79,121 137,528 109,616 Due from affiliated company (Notes 3 and 6) .......... 91,028 158,224 119,408 ------------ ------------ ----------- $1,221,135 DM2,122,578 DM1,378,496 ============ ============ =========== (Continued on next page) MANNESMANN MOBILFUNK GMBH BALANCE SHEETS (Continued) DECEMBER 31, 1993 and 1992 (In thousands) LIABILITIES AND CAPITAL SUBSCRIBERS' EQUITY 1993 1993 1992 ---------------------------- ---------------- ------------- ------------- U.S. Dollars (1) Deutschmarks Deutschmarks Current liabilities: Due to banks (Note 9) .... $ 44,671 DM 77,648 - Accounts payable and accrued expenses ....... 190,897 331,815 DM 277,954 Due to affiliated companies (Note 3) ..... 8,788 15,276 13,378 ------------ ------------ ----------- Total current liabilities ....... 244,356 424,739 291,332 ------------ ------------ ----------- Long-term debt (Note 9) .... 253,135 440,000 - Pension liabilities (Note 7) 3,599 6,256 4,982 Other non-current liabilities 2,503 4,350 2,350 ------------ ------------ ----------- Total non-current liabilities ....... 259,237 450,606 7,332 ------------ ------------ ----------- Commitments (Note 10) Capital subscribers' equity: Subscribed capital (Note 8) 233,000 405,000 405,000 Additional capital ....... 698,998 1,215,000 1,215,000 Unpaid capital ........... - - (285,000) ------------ ------------ ----------- 931,998 1,620,000 1,335,000 Accumulated deficit ...... (214,456) (372,767) (255,168) ------------ ------------ ----------- Total capital subscribers' equity ............ 717,542 1,247,233 1,079,832 ------------ ------------ ----------- $1,221,135 DM2,122,578 DM1,378,496 ============ ============ =========== See accompanying Notes to financial statements. MANNESMANN MOBILFUNK GMBH STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992, and 1991 (In thousands) 1993 1993 1992 1991 ------------ ------------ ------------ ------------ U.S. Dollars Deutschmarks Deutschmarks Deutschmarks (Note 1) (unaudited) Net revenues ........... $ 518,468 DM901,201 DM 137,486 - ---------- ---------- ----------- ---------- Operating costs and expenses: Cost of services and products, including DM 2,583, DM 2,134, and DM 1,270 with related parties in 1993, 1992, and 1991, respectively (Note 3) 272,740 474,077 173,598 DM 49,298 Selling, general, and administrative expenses, including DM 46,302, DM 29,612, and DM 22,800 with related parties in 1993, 1992, and 1991, respectively (Note 3) 231,926 403,134 200,639 74,776 Depreciation and amortization ....... 118,645 206,229 105,916 15,056 ---------- ---------- ----------- ---------- Operating loss (104,843) (182,239) (342,667) (139,130) ---------- ---------- ----------- ---------- (Continued on next page) MANNESMANN MOBILFUNK GMBH STATEMENTS OF OPERATIONS (Continued) YEARS ENDED DECEMBER 31, 1993, 1992, and 1991 (In thousands) 1993 1993 1992 1991 ------------ ------------ ------------ ------------ U.S. Dollars Deutschmarks Deutschmarks Deutschmarks (Note 1) (unaudited) Other income (expense): Interest income ...... 3,789 6,587 25,809 17,761 Interest expense (Note 5) ........... (5,735) (9,969) (150) (21) Other, net ........... 745 1,294 2,124 423 ---------- ---------- ----------- ---------- (1,201) (2,088) 27,783 18,163 ---------- ---------- ----------- ---------- Loss before income tax benefit and cumulative effect of change in accounting principle (106,044) (184,327) (314,884) (120,967) Income tax benefit (Note 6) ........... 38,389 66,728 148,941 - ---------- ---------- ----------- ---------- Loss before cumulative effect of change in accounting principle (67,655) (117,599) (165,943) (120,967) Cumulative effect at January 1, 1992 of change in accounting for income taxes (Note 6) ........... - - 80,083 - ---------- ---------- ----------- ---------- Net loss ........... $ (67,655) DM(117,599) DM (85,860) DM(120,967) ========== ========== =========== ========== See accompanying Notes to financial statements. MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992, and 1991 (All amounts in thousands of Deutschmarks) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Description of Business Mannesmann Mobilfunk GmbH was incorporated on September 11, 1989. At December 31, 1993, Mannesmann AG, held a controlling interest of 52.77%, and Pacific Telesis Netherlands B.V. held an interest of 26.90%. In addition, a 4.5% interest equally owned by Mannesmann AG and Pacific Telesis Netherlands B.V. was held in a trust, which under the terms of the Company's license, must be sold to small or medium sized German businesses. The Company's primary business is the construction, manufacture, and operation of a private mobile cellular network ("D2") within Germany. It is conducted under a licence agreement with the Federal Postal and Telecommunications Ministry expiring at the end of 2009. Commercial activities commenced in mid 1992 and by the end of 1993 the Company had nearly 500,000 customer subscribers. (b) Basis of Presentation In order to conform with accounting principles generally accepted in the United States, certain adjustments are reflected in the financial statements which are not recorded in the German books of account. These adjustments relate primarily to capitalization of own payroll and related costs associated with the design and construction of telecommunications equipment and accounting for income taxes. (c) Cash and Cash Equivalents The Company considers all highly liquid monetary instruments with original maturities of three months or less to be cash equivalents. (d) Inventories Inventories are stated at the lower of average cost or market. MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (e) Property, Plant, and Equipment Property, plant and equipment are stated at cost. Depreciation is calculated on both the straight-line and declining balance methods over the estimated useful lives of the assets as follows: Useful Classification lives Method ----------------------------- ------ ------------------------------ Telecommunications equipment: D2 infrastructure center 10 10% straight-line Switching locations 15 6.67% straight-line Base station equipment - poles 20 15% declining balance - components 20 5% straight-line Transmission and message switching technology 8 12.5% straight-line Other equipment: Data processing equipment 4 30% declining balance Office equipment 10 30% declining balance Measuring instruments 5 30% declining balance Vehicles 4 30% declining balance To the extent permissible under tax laws, systematic depreciation is computed according to the declining balance method at a rate of up to 30 percent. Wherever straight-line depreciation results in higher charges, this method is used. Certain equipment installed at third party locations for rental periods less than the above useful lives are depreciated over the corresponding terms of the agreements. (f) Other Assets Other assets are stated at cost. They consist mainly of computer software, patents, rights, concessions, and loan commitment fees which are being amortized over periods ranging from three to eight years on a straight-line basis. MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (g) Income Taxes Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," and has reported the cumulative effect of the change in the method of accounting for income taxes in the 1992 statement of operations. 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. (h) Pension Plans The Company has defined benefit plans limited to its management group and a small minority of its employees transferred with continuing pension rights from other Mannesmann AG group companies. The benefits are based on years of service and recent compensation. The accumulated benefit obligation is determined based on annual actuarial calculations and recorded as a liability in the balance sheet with a corresponding charge to income. The liability is not funded but represented by the Company's assets. (i) Financial Statement Translation The financial statements are expressed in Deutschmarks and, solely for the convenience of the reader, have been translated into United States dollars at the rate of DM 1.7382 to U.S. $1, the 3:00pm (Pacific time - U.S.A.) Reuters quotation on December 31, 1993. MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (2) CASH AND CASH EQUIVALENTS This caption includes cash equivalents representing time deposits and commercial paper for amounts maturing within periods of between one day and three months. The balances at December 31, 1993 and 1992 are as follows: 1993 1992 ------------- ------------ Time deposits ................ DM28,000 DM25,000 Commercial paper ............. - 30,000 ------------- ------------ DM28,000 DM55,000 ============= ============ The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of the investments. (3) RELATED PARTY TRANSACTIONS The Company has significant business transactions with its main capital subscribers, Mannesmann AG and Pacific Telesis Netherlands B.V. and their respective group companies. Such transactions are normally concluded within a range of terms similar to those made with non-related parties. The significant balances and transactions with these related parties are shown separately in the balance sheets and statements of operations. In addition, purchases of property, plant, and equipment and other assets from related parties during the periods stated are shown below: 1993 1992 1991 --------- --------- --------- (unaudited) Purchases included under property, plant, and equipment........... DM30,050 DM20,176 DM36,387 Purchases included under other assets ........................ - DM 2,996 DM22,253 MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (4) INVENTORIES This caption includes stocks of affiliated products, parts, and related supplies. The balances at December 31, 1993 and 1992 are as follows: 1993 1992 --------- --------- Mobile telephones .......................... DM10,942 DM5,603 Spare parts ................................ 2,527 1,908 Subscriber identification module cards ..... 5,794 1,240 Other trade goods .......................... 37 178 --------- --------- DM19,300 DM8,929 ========= ========== (5) INTEREST COST The Company commenced capitalization of interest cost during 1993 commensurate with the drawdown of its credit facility to finance continuing expansion of the infrastructure for its private mobile cellular network. Of the total interest cost amounting to DM12,949, DM2,980 has been included in the telecommunications equipment component of property, plant, and equipment. (6) INCOME TAXES As discussed in Note 1, the Company adopted Statement 109 as of January 1, 1992. The cumulative effect of this change in accounting for income taxes of DM80,083 was determined as of January 1, 1992 and has been reported separately in the Statement of Operations for the year ended December 31, 1992. As a result of applying Statement 109, the loss from continuing operations for the years ended December 31, 1993 and 1992 was decreased by DM66,728 and DM148,941, respectively, due to the recognition of the net benefits attributable mainly to the deferred tax effects of net operating loss carryforwards offset partially by other temporary differences. Under APB Opinion 11, which was applied to the year ended December 31, 1991 and all prior periods, the Company did not recognize the net tax benefit representing the excess of the tax effect of the tax loss carryforwards, representing deferred tax assets, over the timing differences representing deferred tax liabilities, because the criteria for such recognition were not considered to have been met at any time during that year and all prior periods. MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (6) INCOME TAXES (Continued) Accordingly, income taxes for the years ended December 31, 1993 and 1992, but not 1991 as explained above, consist solely of net deferred income tax benefits. There is no current income tax expense to date due to the net operating loss carryforwards incurred by the Company during its development phase. Such losses recorded in the German books of account can be carried forward indefinitely for German tax purposes. The net deferred income tax benefits were allocated as follows: 1993 1992 ----------- ---------- Loss from continuing operations ............. DM66,728 DM148,941 Cumulative effect of change in accounting for income taxes .............. 80,083 ----------- ---------- DM66,728 DM229,024 =========== ========== The various types of taxes contributing to the net deferred income tax benefits attributable to the loss from continuing operations for the years ended December 31, 1993 and 1992 are as follows: 1993 1992 ----------- ----------- German corporate tax ......................... DM45,250 DM113,359 German trade tax ............................. 18,688 35,582 German solidarity surcharge tax .............. 2,790 ----------- ----------- DM66,728 DM148,941 =========== =========== The above reflects a decrease in German corporate tax rates to 30% for 1993 from 36% for 1992, an increase in net German trade tax rates to 12.39% for 1993 from 11.3% for 1992, because the unchanged gross rate of 17.7% is applied to income net of corporate tax, and an increase due to the new German solidarity surcharge tax to be introduced in 1995 at a rate of 1.85%. These rates are based on the assumption that future profits will be distributable, otherwise higher rates would apply to retained profits. Since this accords with the future dividend policy agreed by the capital subscribers, the adoption of the above lower basis rates is considered appropriate. MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (6) INCOME TAXES (Continued) Therefore due to the above changes, the net deferred income tax benefits attributable to the loss from continuing operations differed from the amount computed by applying the combined German corporate and trade tax rate of 44.24% to the pretax loss for the year ended December 31, 1993 as a result of the following: ------------ Computed "expected" tax benefit ......................... DM 81,546 Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates from 47.3% to 44.24% ................................ (14,818) ------------ DM 66,728 ============ For the year ended December 31, 1992 there was no difference between the "expected" tax benefit at a combined rate of 47.3% and that actually recorded. The significant components of the deferred income tax benefits attributable to the loss from continuing operations for the years ended December 31, 1993 and 1992 are as follows: 1993 1992 ----------- ------------ Tax effect of the German fiscal basis operating loss for the year .......... DM(97,017) DM(159,586) Tax effect of the temporary differences attributable to items expensed for tax purposes but capitalized as property, plant, and equipment and partly depreciated for book purposes ........ 16,353 24,666 Tax effect of the temporary difference attributable to a loan commitment fee expensed for tax purposes but deferred as other assets and partly amortized for book purposes .......... (882) 4,521 Tax effect of the temporary difference attributable to a charge expensed for tax purposes prior to 1992, but expensed for book purposes in 1992 .............................. - (18,542) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates ................... 14,818 - ----------- ------------ Net tax benefit ......................... DM(66,728) DM(148,941) =========== ============ MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (6) INCOME TAXES (continued) The tax effects of temporary differences that give rise to significant portions of the deferred tax asset and deferred tax liabilities at December 31, 1993 and 1992 are presented below: 1993 1992 ----------- ----------- Deferred tax asset: Net operating loss carryforwards ....... DM237,247 DM199,689 Deferred tax liabilities: Property, plant, and equipment due to differences in capitalization and related depreciation ............. (96,191) (85,359) Loan commitment fee ..................... (3,528) (4,714) ----------- ----------- Net deferred tax asset .................. DM137,528 DM109,616 =========== =========== No valuation allowance for the deferred tax asset at December 31, 1993 and 1992 has been recognized. In assessing the realizability of the deferred tax asset, management considers whether it is more likely than not that some portion or all of the deferred tax asset will not be realized. The ultimate realization of the deferred tax asset is dependent on the generation of future taxable income. The Company's net operating losses to date have been incurred in the start-up phase of its operations. Based on the growth rate in the number of subscribers and projected market penetration, management believes it is more likely than not that the Company will realize the benefits of the net operating loss carryforwards, which are available to reduce future income taxes over an indefinite period. Due to its controlling interest of over 50%, Mannesmann AG has already realized the full benefit of the Company's operating loss carryforwards for German trade tax purposes in its consolidated tax return. Under an agreement common to all majority owned subsidiaries of Mannesmann AG within the German fiscal jurisdiction, the Company will not be liable to such taxes on future profits until all prior losses have been absorbed. This group arrangement is not applicable to corporation tax which is assessed on an individual legal entity basis without the benefit of group relief. Based on the gross rate of 17.7% for both years 1993 and 1992, the DM158,224 and DM119,408 under the caption due from affiliated company at December 31, 1993 and 1992 represent amounts that will be paid by Mannesmann AG on behalf of the Company in respect of German trade tax, as the Company generates future taxable income. MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (7) PENSION PLANS The Company has two defined benefit pension plans. The first covers all of its 73 member management group (1992 - 73 members, 1991 - 55 members). The second covers only 45 of its employee group (1992 - 45 employees, 1991 - 48 employees) representing those employees transferred with continuing pension rights from other Mannesmann AG group companies. The remaining employees totalling about 2,100 at the end of 1993 (about 1,500 and 800 at the end of 1992 and 1991, respectively) are not presently covered by such plans. It is intended that these employees will be covered by a defined contribution plan funded externally with an insurance company during 1994. All personnel are covered by a German state pension scheme under a defined contribution plan funded equally by the employer and the employee. The pension liabilities shown in the Balance Sheet result directly from independent actuarial calculations based on the situation at the end of each year in accordance with German tax and commercial rules. Due to the relatively insignificant amount of such pension liabilities given the small number of employees covered, together with the short periods of prior service, the Company considers that any potential adjustment or additional disclosures, that would be required had Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions," been applied, would not be material. As noted above, the pension liabilities shown in the Balance Sheet represent the actuarial present value of accumulated benefit obligations. Projected benefit obligations and increases in compensation levels are not considered. The pension liabilities under these plans are not funded but considered to be represented by the Company's assets. The pension costs charged to income for 1993, 1992, and 1991 are DM 1,076, DM 1,192, and DM 854, respectively. The discount rate assumed in the actuarial valuations for each of the years ended December 31, 1993, 1992, and 1991 is 6%. (8) SUBSCRIBED CAPITAL Subscribed capital is represented by whole sum subscription amounts, issued in the form of participation certificates, on a proportional basis to the various investing parties. The respective amounts of proportional subscriptions directly reflect the percentage of respective ownership and related voting and dividend rights. As discussed below in Note 9, the payment of dividends is restricted under the credit facility agreement. MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (9) LONG-TERM DEBT During 1993, the Company began to utilize its unsecured credit facility negotiated with a banking consortium for DM 1,100,000. The Company is entitled to draw against the arrangement until December 31, 1995 and is able to draw Domestic and Eurofacilities on roll-over or fixed interest basis and to choose up to a maximum of five currencies with fixed and variable interest rates. The arrangement provides for a flexible repayment schedule with final maturity between June 30, 1995 and December 30, 2001. During 1993, the Company borrowed DM 440,000 in three drawings on roll-over basis with interest rates between 6.81% and 7.41%. These rates are based on Libor plus a fixed margin. In accordance with the credit facility agreement, the Company is also entitled to borrow up to 10% of its capital subscribers' equity on a short-term basis. The payment of dividends will be dependent upon the attainment of certain minimum cash flow requirements. Maturities of non-current borrowings are as follows: 1994 ...................................... - 1995 ...................................... - 1996 ...................................... - 1997 ...................................... - 1998 ...................................... DM110,000 Thereafter ................................ 330,000 ---------- DM440,000 ========== The carrying amount of the long-term debt at December 31, 1993 is also considered to approximate fair value since market rates and conditions have not changed significantly between the time of initial utilization of the facility during 1993 and the end of the year. MANNESMANN MOBILFUNK GMBH NOTES TO FINANCIAL STATEMENTS (Continued) (10) COMMITMENTS The Company is obligated under various noncancelable operating leases, primarily of a long-term nature, for the main administrative building, base stations, and sales offices. The rental expense charged to income during 1993, 1992, and 1991 was DM 40,739, DM 25,254, and DM 14,491, respectively. Future minimum lease payments under noncancelable leases (with initial or remaining lease terms in excess of one year) are: Year ending December 31: 1994 ...................................... DM 24,633 1995 ...................................... 23,605 1996 ...................................... 21,924 1997 ...................................... 21,335 1998 ...................................... 9,468 1999 and beyond ........................... 48,622 ----------- Total minimum lease payments ............ DM149,587 =========== REPORT OF INDEPENDENT ACCOUNTANTS Our report on the consolidated financial statements of AirTouch Communications (formerly PacTel Corporation) and Subsidiaries is included on page of this Form 10-K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14(a) 2 of the Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ Coopers & Lybrand San Francisco, California March 3, 1994 X-1 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES (Dollars in millions) COL. A COL. B COL. C COL. D COL. E -------------------------- ----------- --------- --------- --------------- Amount at Which Each Portfolio Number of of Equity Shares of Market Security Issues Units - Value of and Each Other Principal Cost Each Issue Security Issue Amounts of of at Balance Carried in the Name of Issuer and Bonds and Each Sheet Balance Sheet Title of Each Issue Notes Issue Date (a) -------------------------- ----------- --------- --------- --------------- As of December 31, 1993: United States Government Treasury Bonds ....... $650.0 $661.3 $661.3 $672.0 Governmental Municipal Bonds ................ 49.9 58.5 58.5 60.0 Other Municipal Bonds .. 47.0 54.6 54.6 55.3 Miscellaneous Commercial Paper and Mutual Funds 26.7 26.7 26.7 26.7 ------- ------ ------ ------ Total .................. $773.6 $801.1 $801.1 $814.0 ======= ====== ====== ======= ------------------- (a) Includes accrued interest, except for Miscellaneous Commercial Paper and Mutual Funds. X-2 X-3 X-4 X-5 X-6 X-7 X-8 X-9 X-10 X-11 Sheet 3 of 4 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES SCHEDULE V-PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) COL. A COL. B COL. C COL. D COL. E COL. F -------------------- ----------- ---------- ---------- ---------- ---------- Transfer Other to Charges Balance Balance at In-Service Add/ at Beginning Additions & Retire- (Deduct) End of Classification of Period at Cost ments (a) Period --------------------- ---------- ---------- ---------- ---------- ---------- Year ended December 31, 1991: (b) Land .............. $ 11.2 $ 0.4 $ 2.6 $(0.4) $ 8.6 Buildings and leasehold improvements .... 82.9 40.3 17.6 - 105.6 Cellular plant and equipment ... 445.4 127.2 79.0 0.7 494.3 Pagers, paging terminals, and other paging equipment ....... 101.9 35.1 15.8 (0.6) 120.6 Office furniture and other equipment ....... 81.2 46.1 10.0 (0.4) 116.9 Construction in process ...... 69.2 109.1 128.6 - 49.7 ---------- ---------- ---------- ---------- ---------- Total $791.8 $358.2 $253.6 $(0.7) $895.7 ========== ========== ========== ========== ========== See footnotes on Sheet 4 of 4 X-12 Sheet 4 of 4 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES SCHEDULE V-PROPERTY, PLANT, AND EQUIPMENT ----------------- (a) Reductions in 1993 are primarily the result of contributing Property, Plant, and Equipment to CMT Partners, a jointly owned partnership with McCaw Cellular Communications, Inc. See Notes E and S to the Consolidated Financial Statements for further information. (b) In 1991 amounts originally recorded to "Office furniture and other equipment" were reclassified to other accounts within "Property, plant, and equipment." X-13 Sheet 1 of 4 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES SCHEDULE VI-ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) COL. A COL. B COL. C COL. D COL. E COL. F -------------------- ----------- ---------- ---------- ---------- ---------- Transfer Other to Charges Balance Balance at In-Service Add/ at Beginning Additions & Retire- (Deduct) End of Classification of Period at Cost ments (a) Period --------------------- ---------- ---------- ---------- ---------- ---------- Year ended December 31, 1993: Buildings and leasehold improvements ...... $ 34.9 $ 15.5 $ 0.8 $(13.9) $ 35.7 Cellular plant and equipment ......... 218.4 84.2 0.9 (50.8) 250.9 Pagers, paging terminals, and other paging equipment ......... 56.6 27.3 20.7 - 63.2 Office furniture and other equipment ......... 63.2 34.7 10.3 (4.0) 83.6 ---------- ---------- ---------- ---------- ---------- Total ............... $373.1 $161.7 $32.7 $(68.7) $433.4 ========== ========== ========== ========== ========== ---------------- See footnotes on Sheet 4 of 4 X-14 Sheet 2 of 4 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES SCHEDULE VI-ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) COL. A COL. B COL. C COL. D COL. E COL. F -------------------- ----------- ---------- ---------- ---------- ---------- Transfer Other to Charges Balance Balance at In-Service Add/ at Beginning Additions & Retire- (Deduct) End of Classification of Period at Cost ments (a) Period --------------------- ---------- ---------- ---------- ---------- ---------- Year ended December 31, 1992: Buildings and leasehold improvements ...... $ 23.9 $ 11.2 $ 0.2 - $ 34.9 Cellular plant and equipment ..... 145.4 74.2 1.2 - 218.4 Pagers, paging terminals, and other paging equipment ......... 48.4 23.0 14.8 - 56.6 Office furniture and other equipment ......... 41.9 24.0 2.9 $0.2 63.2 ---------- ---------- ---------- ---------- ---------- Total $259.6 $132.4 $19.1 $0.2 $373.1 ========== ========== ========== ========== ========== ----------------- See footnotes on Sheet 4 of 4 X-15 Sheet 3 of 4 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES SCHEDULE VI-ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) COL. A COL. B COL. C COL. D COL. E COL. F -------------------- ----------- ---------- ---------- ---------- ---------- Transfer Other to Charges Balance Balance at In-Service Add/ at Beginning Additions & Retire- (Deduct) End of Classification of Period at Cost ments (a) Period --------------------- ---------- ---------- ---------- ---------- ---------- Year ended December 31, 1991: (b) Buildings and leasehold improvements ...... $ 22.9 $ 8.4 $ 7.3 $(0.1) $ 23.9 Cellular plant and equipment ..... 104.0 67.6 27.3 1.1 145.4 Pagers, paging terminals, and other paging equipment ......... 40.9 19.4 11.9 - 48.4 Office furniture and other equipment ......... 29.0 18.6 4.5 (1.2) 41.9 ---------- ---------- ---------- ---------- ---------- Total $196.8 $114.0 $51.0 $(0.2) $259.6 ========== ========== ========== ========== ========== ---------------- See footnotes on Sheet 4 of 4 X-16 Sheet 4 of 4 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES SCHEDULE VI-ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT ----------------------- (a) Reductions in 1993 are primarily the result of contributing Property, Plant, and Equipment and related Accumulated Depreciation to CMT Partners, a jointly owned partnership with McCaw Cellular Communications, Inc. See Notes E and S to the Consolidated Financial Statements for further information. (b) In 1991 amounts originally recorded to "Office furniture and other equipment" were reclassified to other accounts within "Property, plant, and equipment." X-17 AIRTOUCH COMMUNICATIONS AND SUBSIDIARIES SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (Dollars in millions) COL. A COL. B COL. C COL. D COL. E ------------------------------- ---------- ---------- ---------- ---------- Balance Charged at to Costs Balance Beginning and Deductions at End Description of Period Expenses (a) of Period ------------------------------- ---------- ---------- ---------- ---------- Year ended December 31, 1993: Allowance for doubtful accounts ................. $10.0 $23.8 $ 24.6 $ 9.2 Deferred tax valuation allowance ................ $ 3.0 $ 1.8 - $ 4.8 Various loss reserves ...... $ 1.7 $ 5.7 $ 1.8 $ 5.6 Year ended December 31, 1992: Allowance for doubtful accounts ................ $ 9.7 $15.1 $ 14.8 $10.0 Deferred tax valuation allowance ............... - $ 3.0 - $ 3.0 Various loss reserves ..... $ 2.3 $ 1.2 $ 1.8 $ 1.7 Year ended December 31, 1991: Allowance for doubtful accounts ................ $ 7.8 $15.4 $13.5 $ 9.7 Various loss reserves...... $10.9 $ 1.7 $10.3 $ 2.3 -------------------- (a) Amounts in this column reflect items written off, net of recoveries. X-18 X-19 EXHIBIT INDEX ------------- Exhibits identified in parentheses below, on file with the Commission, are incorporated by reference as exhibits hereto. Exhibit Number Description ------- ----------- 3.1 Amended and Restated Articles of Incorporation of the Company, as filed with the Secretary of State of the State of California on November 29, 1993 3.2 Certificate of Amendment of Articles of Incorporation of the Company, as filed with the Secretary of State of the State of California on March 10, 1994 3.3 Amended and Restated By-laws of the Company, as amended to February 25, 1994 4.1 Form of Common Stock certificate (Exhibit 4.1 to the Company's Registration Statement on Form S-1, File No. 33-68012) 4.2 Rights Agreement between the Company and The Bank of New York, Rights Agent, dated as of July 22, 1993 (Exhibit 4.2 to the Company's Registration Statement on Form S-1, File No. 33-68012) 10.1 Separation Agreement by and between the Company and Pacific Telesis Group, dated as of October 7, 1993 (Exhibit 10.1 to the Company's Registration Statement on Form S-1, File No. 33-68012) 10.2 Amendment No. 1 to Separation Agreement, dated November 2, 1993 10.3 Amended and Restated Plan of Merger and Joint Venture Organization by and among the Company, CCI, CCI Newco, Inc. and CCI Newco Sub, Inc. dated as of December 14, 1990 (Exhibit 1 to the Company's Statement on Schedule 13D filed on February 18, 1992) 10.4 Termination Agreement by and among Telesis, the Company, CCI and Cellular Communications of Ohio, Inc. dated December 11, 1992 (Exhibit 5 to Amendment No. 28 to the Company's Statement on Schedule 13D filed on December 12, 1992) 10.5 Joint Venture agreement between Mannesmann Kienzle GmbH, Pacific Telesis Netherlands B.V., Cable and Wireless plc, DG Bank Deutsch Genossenschaftsbank and Lyonnaise des Eaux SA dated June 30, 1989 (Exhibit 10.43 to the Company's Registration Statement on Form S-1, File No. 33-68012) 10.6 Form of Indemnity Agreement between the Company and each of its directors (Exhibit 10.2 to the Company's Registration Statement on Form S-1, File No. 33-68012) 10.7 PacTel Corporation 1993 Long-Term Stock Incentive Plan 10.8 PacTel Corporation Long-Term Incentive Plan (Exhibit 10.4 to the Company's Registration Statement on Form S-1, File No. 33-68012) I-1 10.9 PacTel Corporation Short-Term Incentive Plan 10.10 PacTel Corporation Deferred Compensation Plan for Nonemployee Directors 10.11 PacTel Corporation Deferred Compensation Plan 10.12 PacTel Corporation Supplemental Executive Pension Plan 10.13 PacTel Corporation Executive Life Insurance Plan 10.14 PacTel Corporation Executive Long-Term Disability Plan 10.15 Representative Employment Agreement for Certain Senior Officers of Pacific Telesis Group (Exhibit 10pp to Form 10-K of Telesis for 1988, File No. 1-8609) 10.16 Pacific Telesis Group Senior Management Short Term Incentive Plan (Exhibit 10-aa to Pacific Telesis Group Shareowner Dividend Reinvestment and Stock Purchase Plan Registration Statement No. 2-87852) 10.17 Resolutions amending the Plan, effective August 28, 1987 (Exhibit 10aa to Form 10-K of Telesis for 1991, File No. 1-8609) 10.18 Pacific Telesis Group Senior Management Long Term Incentive Plan (Exhibit 10aa to Form 10-K of Telesis for 1985, File No. 1-8609) 10.19 Pacific Telesis Group Executive Life Insurance Plan (Exhibit 10cc to Form 10-K of Telesis for 1986, File No. 1-8609) 10.20 Pacific Telesis Group Senior Management Long Term Disability and Survivor Protection Plan (Exhibit 10dd to Form 10-K of Telesis for 1988, file No. 1-8609) 10.21 Resolutions amending the Plan effective May 2, 1992 and November 20, 1992 (Exhibit 10dd(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.22 Pacific Telesis Group Senior Management Transfer Program (Exhibit 10ee to Pacific Telesis Group Shareowner Dividend Reinvestment and Stock Purchase Plan Registration Statement No. 2-87852) 10.23 Pacific Telesis Group Senior Management Financial Counseling Program (Exhibit 10ff to Pacific Telesis Group Shareowner Dividend Reinvestment and Stock Purchase Plan Registration Statement No. 2-87852) 10.24 Pacific Telesis Group Deferred Compensation Plan for Nonemployee Directors (Exhibit 10gg to Form 10-K of Telesis for 1990, File No. 1-8609) 10.25 Resolutions amending the Plan effective December 21, 1990, November 20, 1992 and December 18, 1992 (Exhibit 10gg(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.26 Description of Pacific Telesis Group Directors' and Officers' Liability Insurance Program (Exhibit 10hh to Form 10-K of Telesis I-2 for 1992, File No. 1-8609) 10.27 Description of Pacific Telesis Group for Nonemployee Directors' Travel Accident Insurance (Exhibit 10ii to Form 10-K of Telesis for 1989, File No. 1-8609) 10.28 Resolutions amending the Plan, effective as of June 28, 1991 (Exhibit 10kk to Form 10-K of Telesis for 1991, File No. 1-8609) 10.29 Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10kk(ii) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.30 Pacific Telesis Group Mid-Career Hire Program (Exhibit 10mm to Form 10-K of Telesis for 1988, File No. 1-8609) 10.31 Pacific Telesis Group Mid-Career Pension Plan (Exhibit 10nn to Form 10-K of Telesis for 1986, File No. 1-8609) 10.32 Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10kk(ii) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.33 Pacific Telesis Group Executive Deferral Plan (Exhibit 1011 to Form 10-K of Telesis for 1989, File No. 1-8609) 10.34 Resolutions amending the Plan effective November 20, 1992 and December 23, 1992 (Exhibit 1011(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.35 Pacific Telesis Group Stock Option and Stock Appreciation Rights Plan (Plan Text, Sections 1-17, in Registration Statement No. 33-15391) 10.36 Resolutions amending the Plan effective November 17, 1989 and June 26, 1992 (Exhibit 10oo(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.37 Pacific Telesis Group Outside Directors' Retirement Plan (Exhibit 10ss to Form 10-K of Telesis for 1984, File No. 1-8609) 10.38 Resolution amending the Plan effective May 25, 1990 (Exhibit 10ss(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.39 Representative Indemnity Agreement between Pacific Telesis Group and certain of its officers and each of its directors (Exhibit 10tt to Form 10-K of Telesis for 1987, File No. 1-8609) 10.40 Trust Agreement between Pacific Telesis Group and Bank of America National Trust and Savings Association in connection with the Pacific Telesis Group Executive Deferral Plan (Exhibit 10uu to Form 10-K of Telesis for 1988, File No. 1-8609) 10.41 Amendment to Trust Agreement No. 1 effective December 11, 1992 (Exhibit 10uu(i) to Form 10-K of Telesis of 1992, File No. 1-8609) 10.42 Trust Agreement between Pacific Telesis Group and Bank of America National Trust and Savings Association in connection with the I-3 Pacific Telesis Group Deferred Compensation Plan for the Non- Employee Directors (Exhibit 10vv to Form 10-K of Telesis for 1988, File No. 1-8609) 10.43 Amendment to Trust Agreement No. 2 effective December 11, 1992 (Exhibit 10vv(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.44 Pacific Telesis Group Long Term Incentive Award Deferral Plan (Exhibit 10ww to Form 10-K of Telesis for 1989, File No. 1-8609) 10.45 Resolutions merging the Plan with the Executive Deferral Plan effective May 22, 1992 (Exhibit 10ww(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 10.46 Pacific Telesis Group Nonemployee Director Stock Option Plan (Exhibit A to Pacific Telesis Group's 1990 Proxy Statement filed February 26, 1990, File No. 1-8609) 10.47 Pacific Telesis Group Supplemental Executive Retirement Plan (Exhibit 10yy to Form 10-K of Telesis for 1990, File No. 1-8609) 10.48 Resolutions amending the Plan effective November 20, 1992 (Exhibit 10yy(i) to Form 10-K of Telesis for 1992, File No. 1-8609) 21 Subsidiaries of the Company (Exhibit 21 to the Company's Registration Statement on Form S-1, File No. 33-68012) 23.1 Consent of Coopers & Lybrand 23.2 Consent of Ernst & Young 23.3 Consent of KPMG Deutsche Treuhand-Gesellschaft 24 Powers of Attorney 99 Modification of Final Judgment, United States District Court, District of Columbia, in "U.S. v. American Tel. & Tel. Co.," Civil Action No. 82-0192 (Exhibit 99 to the Company's Registration Statement on Form S-1, File No. 33-68012) (b) Reports on Form 8-K: No reports on Form 8-K were filed during the last quarter of the period covered by this report. I-4

40877_1993.txt

40877_1993

1993

40877

Item 1. Business GTE Northwest Incorporated (the Company) (formerly General Telephone Company of the Northwest, Inc., formerly West Coast Telephone Company) was incorporated in Washington on March 31, 1964. The Company is a wholly-owned subsidiary of GTE Corporation (GTE). Together with its wholly-owned subsidiary, GTE West Coast Incorporated, the Company provides communications services in the states of California, Idaho, Montana, Oregon and Washington. On February 23, 1993, the Idaho properties of Contel of the West, Inc. were purchased by the Company. On February 26, 1993, Contel of the Northwest, Inc. merged into the Company. Both Contel of the West, Inc. and Contel of the Northwest, Inc. were wholly-owned subsidiaries of Contel Corporation (a wholly- owned subsidiary of GTE). The merger was accounted for in a manner consistent with a transfer of entities under common control which is similar to that of a "pooling of interests." On December 31, 1993, the Company sold its telephone plant in service, materials and supplies and customers (representing 17,000 access lines) in the state of Idaho to Citizens Utilities Company. The Company provides local telephone service within its franchise area 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 in Idaho and Montana. 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 for access to the facilities of the long distance carrier. 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 934,856 on January 1, 1989 to 1,271,916 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 ----- ------------ Washington 753,005 Oregon 397,799 Idaho 101,474 California 12,010 Montana 7,628 --------- Total 1,271,916 ========= 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 $ 331,369 $ 321,575 $ 303,880 % of Total Revenues 38% 36% 36% Network Access Services $ 370,980 $ 382,997 $ 379,382 % of Total Revenues 42% 43% 45% Long Distance Services $ 14,444 $ 17,789 $ 16,994 % of Total Revenues 2% 2% 2% Equipment Sales and Services $ 77,989 $ 78,279 $ 80,272 % of Total Revenues 9% 9% 9% Other $ 80,513 $ 86,147 $ 67,365 % of Total Revenues 9% 10% 8% At December 31, 1993, the Company had 4,509 employees. The Company has written agreements with the Communications Workers of America (CWA) and the International Brotherhood of Electrical Workers (IBEW) covering substantially all non-management employees. In 1993, agreements were reached on two contracts with the IBEW. During 1994, there are no contracts which will expire. 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 regulatory bodies of the states of California, Idaho, Montana, Oregon and Washington as to its intrastate business operations and 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 12 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 1991, 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 (82%), customer premises equipment (14%), company facilities (1%) and other (3%). From January 1, 1989 to December 31, 1993, the Company made gross property additions of $1.2 billion and property retirements of $0.5 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. Larry J. Sparrow 50 1992 Director and President, GTE California Incorporated and GTE Northwest Incorporated; Director and Chairman of the Board and Chief Executive Officer of GTE Hawaiian Telephone Company Incorporated, 1992; Vice President - Regulatory and Governmental Affairs, GTE Telephone Operations, 1989; Director, California Chamber of Commerce; Director, The Los Angeles Area Chamber of Commerce; Director, California Economic Development Corporation. 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. Sparrow, were elected December 10, 1993 following the resignations from the Board of Donald M. Anderson, J. Cleve Borth, Walter A. Dods, Jr., Elizabeth A. Edwards, Admiral Ronald J. Hays, William N. Lampson, Dr. John N. Lein, Donald A. Lockwood, Harry F. Magnuson, Charles T. Manatt, Esq. and James B. Thayer. b. Identification of Executive Officers Year Assumed Current Name Age Position Position with Company --------- --- -------- -------------------------------- Larry J. Sparrow(1) 50 1992 Area President - West Elizabeth A. Edwards 42 1991 Regional Vice President - General Manager-Northwest Anthony W. Armstrong 47 1984 Regional Vice President - External Affairs-Northwest Clark Michael Crawford (1) 47 1992 Area Vice President - General Manager Jorge Jackson (1)(2) 49 1993 Area Vice President - Public Affairs Timothy J. McCallion (1)(3) 40 1993 Area Vice President - Regulatory and Governmental Affairs Robert G. McCoy (1) 49 1992 Area Vice President - Sales Richard J. Nordman (1)(4) 44 1993 Area Vice President - Finance Kenneth K. Okel (1) 47 1991 Area Vice President - General Counsel and Secretary Ronald E. Pejsa (1)(5) 50 1993 Area Vice President - Human Resources Year Assumed Current Position with Name Age Position GTE Telephone Operations (6) ---- --- -------- --------------------------------- Kent B. Foster 50 1989 President Michael B. Esstman (7) 47 1993 Executive Vice President - Operations Thomas W. White 47 1989 Executive Vice President Guillermo Amore 55 1990 Senior Vice President - International Gerald K. Dinsmore (8) 44 1993 Senior Vice President - Finance and Planning Robert C. Calafell (9) 52 1993 Vice President - Video Services A. T. Jones 54 1992 Vice President - International Brad M. Krall (10) 52 1993 Vice President - Centralized Services Donald A. Hayes 56 1992 Vice President - Information Technology Richard L. Schaulin 51 1989 Vice President - Human Resources Clarence F. Bercher 50 1991 Vice President - Sales Mark S. Feighner 45 1991 Vice President - Product Management Geoff C. Gould 41 1989 Vice President - Regulatory and Governmental Affairs G. Bruce Redditt 43 1991 Vice President - Public Affairs Richard M. Cahill 55 1989 Vice President and General Counsel Leland W. Schmidt 60 1989 Vice President - Industry Affairs Paul E. Miner 49 1990 Vice President - Regional Operations Support Katherine J. Harless 43 1992 Vice President- Intermediary Markets William M. Edwards, III(11) 45 1993 Controller Each of these executive officers has been an employee of the Company or an affiliated company for the last five years. Except for duly elected officers and directors, no other employees had a significant role in decision making. All officers are appointed for a term of one year. - ---------- NOTES: (1) Individual is an executive officer for West Area which is comprised of GTE California Incorporated, GTE Hawaiian Telephone Company Incorporated and GTE Northwest Incorporated. (2) Jorge Jackson was appointed Area Vice President - Public Affairs effective November 12, 1993, replacing Jim J. Parrish who retired. (3) Timothy J. McCallion was appointed Area Vice President- Regulatory and Governmental Affairs effective November 21, 1993, replacing Keith M. Kramer who retired. (4) Richard J. Nordman was appointed Area Vice President - Finance effective November 7, 1993, replacing Paul R. Shuell. (5) Ronald E. Pejsa was appointed Area Vice President - Human Resources effective October 24, 1993, replacing James R. Poling who retired. (6) Position is with, and duties are performed at, the GTE Telephone Operations General Office Headquarters in Irving, Texas. (7) Michael B. Esstman was appointed Executive Vice President - Operations effective April 25, 1993 replacing Charles A. Crain who retired on April 1, 1993. (8) Gerald K. Dinsmore, previously South Area President, was appointed Senior Vice President - Finance and Planning effective November 21, 1993, replacing John L. Hume who retired. (9) Robert C. Calafell was appointed Vice President - Video Services effective March 28, 1993. (10) Brad M. Krall was appointed Vice President - Centralized Services effective November 7, 1993. (11) William M. Edwards, III was appointed Controller effective November 7, 1993 replacing John D. Utzinger. 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. Executive Agreements GTE has entered into agreements (the Agreements) with Messrs. Sparrow, Foster and White 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. Sparrow, Foster and White 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 1, 1994, the credited years of service under the plan for Mr. Sparrow, Ms. Edwards, Messrs. Armstrong, Foster and White are 26, 17, 20, 23 and 25, 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 Mr. Sparrow, Ms. Edwards, Messrs. Armstrong, Foster and White 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 17,920,000 100% GTE Northwest One Stamford Forum shares of Incorporated Stamford, Connecticut record (b) Security Ownership of Management as of December 31, 1993: Name of Director or Nominee --------------------------- Common Stock of Richard M. Cahill (1) 37,188 All less GTE Corporation Gerald K. Dinsmore (1) 18,503 than 1% Michael B. Esstman 54,051 Kent B. Foster 168,299 Larry J. Sparrow 33,749 Thomas W. White 83,071 ------- 394,861 ======= Executive Officers(1)(2) ------------------------ Larry J. Sparrow 33,749 Elizabeth A. Edwards 11,256 Anthony W. Armstrong 1,451 Kent B. Foster 168,299 Thomas W. White 33,749 ------- 248,504 ======= All directors and executive officers as a group(1)(2) 771,063 ======= - ---------- (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 Mr. Sparrow, Ms. Edwards, Messrs. Armstrong, Foster and White and all directors and executive officers as a group are 27,537; 6,033; 0; 115,583; 69,466 and 522,451, 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. 2.1 Plan of Merger of Contel of the Northwest, Inc. into GTE Northwest Incorporated dated November 18, 1992. 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 Northwest Incorporated: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in GTE Northwest 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. GTE NORTHWEST INCORPORATED AND SUBSIDIARY 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 $ 144,364 $ 136,018 $ 140,579 ========== ========== ========== Taxes, other than payroll and income taxes, are as follows: Real and personal property $ 28,742 $ 21,207 $ 26,461 State gross receipts 10,015 7,578 8,467 Other 6,926 4,728 6,728 Portion of above taxes charged to plant and other accounts (4,333) (4,301) (4,450) ---------- ---------- ---------- Total $ 41,350 $ 29,212 $ 37,206 ========== ========== ========== 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 NORTHWEST INCORPORATED (Registrant) Date March 21, 1994 By LARRY J. SPARROW -------------- --------------------------- LARRY J. SPARROW Area President - West 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 President and Director March 21, 1994 - ---------------- (Principal Executive Officer) LARRY J. SPARROW 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

83047_1993.txt

83047_1993

1993

83047

ITEM 1. BUSINESS. GENERAL Reliance Financial Services Corporation ("Reliance Financial", "Company" or "Registrant") owns all of the common stock of Reliance Insurance Company ("Reliance Insurance Company"). Reliance Insurance Company and its property and casualty insurance subsidiaries (such subsidiaries, together with Reliance Insurance Company, the "Reliance Property and Casualty Companies") and its title insurance subsidiaries (collectively, the "Reliance Insurance Group") underwrite a broad range of standard commercial and specialty commercial lines of property and casualty insurance, as well as title insurance. Reliance Insurance Company has conducted business since 1817, making it one of the oldest property and casualty insurance companies in the United States. The Reliance Property and Casualty Companies consist of four principal operations: Reliance National, Reliance Insurance, Reliance Reinsurance and Reliance Surety. Reliance National was established in 1987 to provide specialty commercial insurance products and services, and innovative coverages in standard commercial lines, to selected segments of the property and casualty market which do not lend themselves to traditional insurance products and services, and which are not extensively served by competitors. In 1993, Reliance National accounted for 49% of the net premiums written by the Reliance Property and Casualty Companies. Reliance Insurance offers standard commercial lines of property and casualty insurance and is focused on the diverse needs of mid-sized companies throughout the United States. Reliance Reinsurance primarily provides property and casualty treaty reinsurance for small to medium sized regional and specialty insurance companies located in the United States. Reliance Surety is a leading writer of surety bonds and fidelity bonds in the United States. The Reliance Property and Casualty Companies accounted for $1,571.5 million (64%) of the Reliance Insurance Group's 1993 net premiums earned. The Reliance Insurance Group's title insurance business consists of Commonwealth Land Title Insurance Company ("Commonwealth") and Transamerica Title Insurance Company ("Transamerica Title", together with Commonwealth and their respective subsidiaries, "Commonwealth/Transamerica Title"). Commonwealth/Transamerica Title comprised the third largest title insurance operation in the United States, in terms of 1992 total premiums and fees. Commonwealth/Transamerica Title accounted for $893.4 million (36%) of the Reliance Insurance Group's 1993 net premiums earned. Business segment information for the years ended December 31, 1993, 1992 and 1991 is set forth in Note 17 to the Company's consolidated financial statements, which are included in the Company's 1993 Annual Report and are incorporated herein by reference. All financial information in this Annual Report on Form 10-K is presented in accordance with generally accepted accounting principles ("GAAP") unless otherwise specified. The common stock of Reliance Insurance Company, which represents approximately 98% of the combined voting power of all Reliance Insurance Company stockholders, has been pledged by the Company to secure certain indebtedness. See Note 7 to the Company's consolidated financial statements. The Company is a wholly-owned subsidiary of Reliance Group Holdings, Inc. ("Reliance Group Holdings"). Approximately 49.5% of the common stock of Reliance Group Holdings, the only class of voting securities outstanding, is owned by Saul P. Steinberg, members of his family and affiliated trusts. In November 1993, Reliance Group, Incorporated, which owned all of the Common Stock of the Company and was a wholly-owned subsidiary of Reliance Group Holdings, was merged into Reliance Group Holdings. The reason for the merger was to simplify the corporate structure of Reliance Group Holdings by eliminating an intermediate holding company. OPERATING UNITS Property and Casualty Insurance. The Reliance Property and Casualty Companies consist of four principal operations: Reliance National, Reliance Insurance, Reliance Reinsurance and Reliance Surety. The following table sets forth the amount of net premiums written in each line of business by Reliance National, Reliance Insurance, Reliance Reinsurance and Reliance Surety for the years ended December 31, 1993, 1992 and 1991. The Company has been following a strategy of changing the business mix of the Reliance Property and Casualty Companies by emphasizing specialty commercial insurance products and services and focusing its standard commercial insurance business on programs, larger accounts, and loss sensitive and retrospectively rated policies. The following table sets forth underwriting results, on a GAAP basis, for the Reliance Property and Casualty Companies' standard commercial and specialty commercial lines for the years ended December 31, 1993, 1992, 1991, 1990 and 1989. - -------- (1) Includes net premiums written in personal lines of $45.4 million, $8.8 million, $7.7 million, $178.6 million and $408.0 million for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. The increase in net premiums written in personal lines for 1993 resulted from the expiration and non-renewal of a quota share treaty on June 30, 1993. The personal lines quota share treaty was not renewed in anticipation of transferring or running off the Company's personal lines business. (2) Catastrophe losses (net of reinsurance) for the Reliance Property and Casualty Companies for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 were $39.3 million, $61.1 million, $28.7 million, $22.8 million and $29.2 million, respectively. Gross catastrophe losses (before reinsurance) for the Reliance Property and Casualty Companies for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 were $88.5 million, $119.2 million, $29.7 million, $28.4 million and $46.3 million, respectively. For the years ended December 31, 1993, 1992, 1991, 1990 and 1989, the provision for the insured events of prior years was $40.2 million, $31.5 million, $271.7 million, $93.7 million and $78.1 million, respectively. The following table sets forth certain financial information of the Reliance Property and Casualty Companies based upon statutory accounting practices and common shareholder's equity of Reliance Insurance Company based upon GAAP, in thousands: - -------- * Includes Reliance Insurance Company's investment in title insurance operations of $176.9 million at December 31, 1993. The Reliance Property and Casualty Companies write insurance in every state of the United States, the District of Columbia and Puerto Rico and through offices located in the United Kingdom, the Netherlands and Canada, and have an affiliation with an insurer in Mexico. In 1993, California, New York, Pennsylvania and Texas accounted for approximately 19%, 12%, 7%, and 5%, respectively, of direct premiums written. No other state accounted for more than 5% of direct premiums written by the Reliance Property and Casualty Companies. The Reliance Property and Casualty Companies write insurance through independent agents and brokers. No single insurance agent or broker accounts for 10% or more of the direct premiums written by the Reliance Property and Casualty Companies. The Reliance Property and Casualty Companies ranked 31st among property and casualty insurance companies and groups in terms of net premiums written during 1992, according to Best's Insurance Management Reports. A. M. Best & Company, Inc. ("Best"), publisher of Best's Insurance Reports, Property-- Casualty, has assigned an A- (Excellent) rating to the Reliance Property and Casualty Companies. Best's ratings are based on an analysis of the financial condition and operations of an insurance company as they relate to the industry in general. An A- (Excellent) rating is assigned to those companies which have achieved excellent overall performance when compared to the norms of the property and casualty industry. Standard & Poor's ("S&P") rates the claims-paying ability of the Reliance Property and Casualty Companies A. S&P's ratings are based on quantitative and qualitative analysis including consideration of ownership and support factors, if applicable. An A rating is assigned to those companies which have good financial security, but capacity to meet policyholder obligations is somewhat susceptible to adverse economic and underwriting conditions. Best's ratings are not designed for the protection of investors and do not constitute recommendations to buy, sell or hold any security. Although the Best and S&P ratings of the Reliance Property and Casualty Companies are lower than those of many of the insurance companies with which the Reliance Property and Casualty Companies compete, management believes that the current ratings are adequate to enable the Reliance Property and Casualty Companies to compete successfully. Reliance National. Reliance National was established in 1987 to provide specialty commercial insurance products and services, and innovative coverages in standard commercial lines, to selected segments of the property and casualty market which do not lend themselves to traditional insurance products and services, and which are not extensively served by competitors. In 1993, Reliance National accounted for 49% of the net premiums written by the Reliance Property and Casualty Companies. Reliance National, which conducts business nationwide, is headquartered in New York City and has offices in eight states and in Canada, the United Kingdom and the Netherlands and has an affiliation with an insurer in Mexico. Reliance National distributes its products primarily through national insurance brokers. Reliance National maintains a strong centralized underwriting and actuarial staff and makes extensive use of third party administrators and technical consultants for certain claims and loss control services. Net premiums written by Reliance National were $872.2 million, $828.6 million and $785.8 million for the years ended December 31, 1993, 1992 and 1991, respectively. Reliance National is organized into eight divisions. Each division is comprised of individual departments, each focusing on a particular type of business, program or market segment. Each department makes use of underwriters, actuaries and other professionals to market, structure and price its products. Reliance National's eight divisions are: . Risk Management Services, Reliance National's largest division, targets Fortune 1,000 companies and multinationals with a broad array of coverages and services. Its use of risk financing techniques such as retrospectively rated policies, self-insured retentions, deductibles, captives and fronting arrangements all help clients to reduce costs and/or manage cash flow more efficiently. It also applies risk management principles to pollution exposures. In 1993, this division had net premiums written of $329.2 million. . Special Operations provides coverages for the construction and transportation industries and has started a new facility for ocean marine risks and a new facility for non-standard personal automobile coverage. In 1993, this division had net premiums written of $162.1 million. . Excess and Surplus Lines provides professional liability insurance to architects and engineers, lawyers, healthcare providers and other professions, and markets excess and umbrella coverages. It also develops and provides insurance products to certain markets requiring specialized underwriting. In 1993, this division had net premiums written of $147.2 million. . Financial Products provides directors and officers liability insurance and, for financial institutions, errors and omissions insurance. In 1993, this division had net premiums written of $67.0 million. . International writes predominantly large accounts and specialty business in the United Kingdom and Canada and provides management, insurance and reinsurance services to a Mexican insurer with which Reliance National has an affiliation. It also provides some risk management services for foreign subsidiaries of United States multinational corporations. In 1993, this division had net premiums written of $66.4 million. . Property, a recently constituted division, provides commercial property coverage focusing on excess and specialty commercial property. In 1993, the departments which were combined into this division had net premiums written of $36.5 million. . Financial Specialty Coverages provides finite risk insurance and other unusual coverages. In 1993, this division had net premiums written of $33.1 million. . Accident and Health provides high limit disability, group accident, blanket special risk and medical excess of loss programs. In 1993, this division had net premiums written of $30.7 million. In the fourth quarter of 1993, Reliance National realigned several of its departments, including those which had comprised its Specialty Lines and Programs division which provided liability and property insurance (including pollution, casualty and commercial property coverages), primarily for companies in hard to insure industries, and formed a new Property division. The 1993 net premiums written for all divisions include the premiums of the departments previously within the Specialty Lines and Programs division. Reliance National attempts to reduce its losses through the use of retrospectively rated pricing, claims-made policies and reinsurance. Approximately 21% of Reliance National's net premiums written during 1993 were written on a retrospectively rated or loss sensitive basis, whereby the insured effectively pays for a large portion or, in many cases, all of its losses. With retrospectively rated pricing, Reliance National provides insurance and loss control management services, while reducing its underwriting risk. Reliance National does, however, assume a credit risk and, therefore, accounts with retrospectively rated pricing undergo extensive credit analysis. Collateral in the form of bank letters of credit or cash collateral is generally provided by the insured to cover Reliance National's exposure. Nearly 66% of Reliance National's specialty commercial net premiums written during 1993 were written on a "claims-made" basis which provides coverage only for claims reported during the policy period or within an established reporting period as opposed to "occurrence" basis policies which provide coverage for events during the policy period without regard for when the claim is reported. Claims-made policies mitigate the "long tail" nature of the risks insured. To further limit exposures, approximately 91% of Reliance National's net premiums written during 1993 were for policies with net retentions equal to or lower than $1.5 million per risk. By reinsuring a large proportion of its business, Reliance National seeks to limit its exposure to losses on each line of business it writes. Its largest single exposure, net of reinsurance, at December 31, 1993, was $2.4 million per occurrence. Reliance Insurance. Reliance Insurance offers standard commercial lines property and casualty insurance products, focusing on the diverse needs of mid-sized companies nationwide. Reliance Insurance distributes its products primarily through approximately 2,400 independent agents, as well as through regional and national brokers. Reliance Insurance's customers are primarily closely held companies with 25 to 1,000 employees and annual sales of $5 million to $300 million. Reliance Insurance underwrites a variety of commercial insurance coverages including property, general liability, automobile and workers' compensation (written on both a guaranteed cost and a retrospectively rated basis). Reliance Insurance is headquartered in Philadelphia and operates in 50 states and the District of Columbia. Reliance Insurance provides its products and services through a decentralized network of profit centers. This organization allows it to place major responsibility and accountability for underwriting, sales, claims, and customer service close to the insured. Historically, Reliance Insurance underwrote personal lines insurance and commodity-type standard commercial lines of insurance for small accounts. Regulatory restrictions, intense competition and inadequate pricing in these lines caused Reliance Insurance to change its strategic direction in order to position itself for improved operating results. Reliance Insurance's strategy includes: . Increased emphasis on custom underwriting. Reliance Insurance's custom underwriting facility provides centralized underwriting of excess and surplus exposures (generally with lower net retentions than for other standard commercial lines written by Reliance Insurance) and provides property and liability insurance programs, targeting homogeneous groups of insureds with particular insurance needs, such as auto rental companies, day care centers, municipalities and trash haulers. These programs are administered by independent program agents, with Reliance Insurance retaining authority for all underwriting and pricing decisions. Program agents market the programs, gather the initial underwriting data and, if authorized by Reliance Insurance, issue the policies. All claims and other services are handled by Reliance Insurance. Net premiums written under the custom underwriting facility were $179.1 million in 1993. . Increased emphasis on its large accounts division. Reliance Insurance's large accounts division targets accounts with annual premiums in excess of $500,000, where it is able to offer more flexible coverages that can be quoted on a loss sensitive or experience rated basis. The large accounts division wrote $136.0 million of net premiums in 1993. . Withdrawal from personal lines. Reliance Insurance has substantially withdrawn from personal lines, where it has had unfavorable experience and it does not perceive a potential for long-term profitability. The Reliance Property and Casualty Companies derived 2.6% of their net premiums written from personal lines in 1993, compared with 22.7% in 1989. . Reductions in employees and offices. To reduce the number of its employees and offices, Reliance Insurance has merged its East and West Coast operations, implemented automated systems to process policies and related data, eliminated non-productive branch offices (resulting in a reduction in the number of branch offices from 48 in 1989 to 40 in 1993), and streamlined and downsized its home office support functions. These efforts have resulted in a reduction in head count from approximately 2,900 in 1989 to approximately 1,950 at December 31, 1993. . Reduction in guaranteed cost workers' compensation. Reliance Insurance has restructured its workers' compensation business to reduce its guaranteed cost writings in those states where Reliance Insurance believes there is limited opportunity for profit. These actions have resulted in Reliance Insurance's guaranteed cost net premiums written declining from $116.2 million in 1990 to $42.4 million in 1993. Policies written on a retrospectively priced basis increased from $36.0 million in 1990 to $103.3 million in 1993. Reliance Reinsurance. Reliance Reinsurance provides property reinsurance on a treaty basis and casualty reinsurance on both a treaty and facultative basis. All treaty business is marketed through reinsurance brokers who negotiate contracts of reinsurance on behalf of the primary insurer or ceding reinsurer, while facultative business is produced both directly and through reinsurance brokers. While Reliance Reinsurance's treaty clients include all types and sizes of insurers, Reliance Reinsurance typically targets treaty reinsurance for small to medium sized regional and specialty insurance companies, as well as captives, risk retention groups and other alternative markets, providing both pro rata and excess of loss coverage. Reliance Reinsurance believes that this market is subject to less competition and provides Reliance Reinsurance an opportunity to develop and market innovative programs where pricing is not the key competitive factor for success. Reliance Reinsurance typically avoids participating in large capacity reinsurance treaties where price is the predominant competitive factor. It generally writes reinsurance in the "lower layers," the first $1 million of primary coverage, where losses are more predictable and quantifiable. The assumed reinsurance business of the Reliance Property and Casualty Companies is conducted nationwide and is headquartered in Philadelphia. Reliance Surety. Reliance Surety is a leading writer of surety bonds and fidelity bonds in the United States. Reliance Surety concentrates on writing performance bonds for contractors of public works projects, commercial real estate and multi-family housing. It also writes financial institution and commercial fidelity bonds. Reliance Surety has established an operation targeting smaller contractors, an area traditionally less fully serviced by national surety companies and one providing potential growth for Reliance Surety. Reliance Surety is headquartered in Philadelphia and conducts business nationwide through 39 branch offices and approximately 3,200 independent agents and brokers. Surety bonds guarantee the payment or performance of one party (called the principal) to another party (called the obligee). This guarantee is typically evidenced by a written agreement by the surety (e.g., Reliance Insurance Company) to discharge the payment or performance obligations of the principal pursuant to the underlying contract between the obligee and the principal. An example of a surety bond is a performance bond posted by a contractor to guarantee the completion of his work on a construction project. Fidelity bonds insure against losses arising from employee dishonesty. Financial institution fidelity bonds insure against losses arising from employee dishonesty and other specifically named theft and fraud perils. Reliance Surety performs extensive credit analysis on its clients, and actively manages the claims function to minimize losses and maximize recoveries. Reliance Surety has enjoyed long relationships with the major contractors it has insured. Title Insurance. Through Commonwealth/Transamerica Title, the Company writes title insurance for commercial and residential real estate nationwide and provides escrow and settlement services in connection with real estate closings. The acquisition of Transamerica Title in 1990 allowed the Company to solidify its national presence and expand its National Title Service division, whereby the Company provides title services for large and multi-state commercial transactions, as well as high-volume residential title services for national lenders. Commercial business has grown to include transactions relating to the formation of real estate investment trusts (REITs), sales of troubled properties and sales of mortgage-backed securities. Commonwealth/Transamerica Title comprised the third largest title insurance operation in the United States, based on 1992 total premiums and fees. Commonwealth/Transamerica Title had premiums and fees (excluding Commonwealth Mortgage Assurance Corporation, its mortgage insurance subsidiary which was sold in the fourth quarter of 1992) of $893.4 million, $770.5 million and $613.7 million for the years 1993, 1992 and 1991, respectively. Commonwealth/Transamerica Title is organized into six regions with more than 250 branch offices covering all 50 states, as well as Puerto Rico and the Virgin Islands. In 1993, California, Texas, Florida, Pennsylvania, Washington, New York and Michigan accounted for approximately 16%, 11%, 8%, 7%, 6%, 6% and 5%, respectively, of revenues for premiums and services related to title insurance. No other state accounted for more than 5% of such revenues. Commonwealth/ Transamerica Title is committed to increasing its market share through a carefully developed plan of expanding its direct and agency operations, including selective acquisitions. Commonwealth has been consistently profitable through periods of both strong and weak economic conditions, including the recent commercial real estate downturn. The Company believes that the primary reasons for Commonwealth's consistent profitability are Commonwealth's continuous efforts to monitor and control losses and expenses, while growing the business on a selective basis. Successful efforts in loss mitigation include strict quality control procedures, as well as extensive educational programs for its agents and employees. A title insurance policy protects the insured party and certain successors in interest against losses resulting from title defects, liens and encumbrances existing as of the date of the policy and not specifically excepted from the policy's provisions. Generally, a title policy is obtained by the buyer, the mortgage lender or both at the time real property is transferred or refinanced. The policy is written for an indefinite term for a single premium which is due in full upon issuance of the policy. The face amount of the policy is usually either the purchase price of the property or the amount of the loan secured by the property. Title policies issued to lenders insure the priority position of the lender's lien. Many lenders require title insurance as a condition to making loans secured by real estate. Title insurers, unlike other types of insurers, seek to eliminate future losses through the title examination process and the closing process, and a substantial portion of the expenses of a title insurer relate to those functions. Consulting and Technical Services. RCG International, Inc. ("RCG"), a subsidiary of the Reliance Insurance Group, and its subsidiaries provide a broad range of consulting and technical services to industry, government and nonprofit organizations, principally in the United States and Europe, and also in Canada, Asia, South America, Africa and Australia. The services provided by RCG include consulting in two principal areas: information technology and energy/environmental services. RCG and its subsidiaries had revenues of $116.8 million and $109.1 million for 1993 and 1992, respectively. SALE OF NON-CORE OPERATIONS During 1992 and 1993, the Company realigned its operations in line with its strategy of emphasizing specialty commercial property and casualty insurance products and services and title insurance and focusing its standard commercial insurance business on programs, larger accounts and loss sensitive and retrospectively rated policies. In July 1993, the Company completed the sale of its life insurance subsidiary, United Pacific Life Insurance Company ("UPL"), for total consideration of $567 million. Pursuant to the terms of the sale, Reliance Insurance Company purchased $482 million of UPL's invested assets consisting principally of (a) publicly traded non-investment grade securities and (b) income-producing real estate. In the fourth quarter of 1992, the Company sold substantially all of the operating assets and insurance brokerage, employee benefits consulting and related services businesses of its insurance brokerage subsidiary, Frank B. Hall & Co. Inc. ("Hall") to Aon Corporation ("Aon") for total consideration of $457 million (consisting of $125 million in cash, $225 million of 8% cumulative perpetual preferred stock of Aon and $107 million of 6 1/4% cumulative convertible exchangeable preferred stock of Aon) plus the assumption by Aon of certain of Hall's operating liabilities. In connection with the sale of Hall, the Reliance Insurance Group agreed to place reinsurance through an Aon subsidiary, providing reinsurance brokerage commissions to Aon of $18 million per year until the year 2007. Concurrently with this sale, Hall was merged with a wholly-owned subsidiary of Reliance Group Holdings and each outstanding share of common stock of Hall, other than shares owned by the Company, was converted into .625 of a share of Reliance Group Holdings Common Stock. In the first quarter of 1994, Reliance Group Holdings agreed to increase such conversion ratio by .02 of a share of Reliance Group Holdings Common Stock. Also in the fourth quarter of 1992, the Company sold its mortgage insurance subsidiary, Commonwealth Mortgage Assurance Corporation ("CMAC"), through a public offering of 100% of the common stock of CMAC Investment Corporation ("CMAC Investment"), a newly-formed holding company for CMAC, for net proceeds of $118.5 million. In connection with this sale, the Company purchased 800,000 shares of $4.125 redeemable preferred stock of CMAC Investment for an aggregate purchase price of $40 million. In connection with the sales of UPL and Hall, customary representations, warranties and indemnities were made to the buyers. For a further description of the above transactions, see Notes 12 and 15 to the Consolidated Financial Statements. INSURANCE CEDED All of the Reliance Insurance Group's insurance operations purchase reinsurance to limit the Company's exposure to losses. Although the ceding of insurance does not discharge an insurer from its primary legal liability to a policyholder, the reinsuring company assumes a related liability and, accordingly, it is the practice of the industry, as permitted by statutory regulations, to treat properly reinsured exposures as if they were not exposures for which the primary insurer is liable. The Reliance Insurance Group enters into reinsurance arrangements that are both facultative (individual risks) and treaty (blocks of risk). Limits and retentions are based on a number of factors, including the previous loss history of the operating unit, policy limits and exposure data, industry studies as to potential severity, market terms, conditions and capacity, and may change over time. Reliance Insurance and Reliance National limit their exposure to individual risks by purchasing excess of loss and quota share reinsurance, with treaty structures and net retentions varying with the specific requirements of the line of business or program being reinsured. In many cases, Reliance Insurance and Reliance National purchase additional facultative reinsurance to further reduce their retentions below the treaty levels. During 1993, the highest net retention per occurrence for casualty risk was $2.7 million for Reliance Insurance and $2.4 million for Reliance National. In addition, both Reliance Insurance and Reliance National purchase "casualty clash" coverage to provide protection in the event of losses incurred by multiple coverages on one occurrence. During 1993, the highest net retention per occurrence for property risk was $3.2 million for Reliance Insurance and $2.3 million for Reliance National. In addition, as of December 31, 1993, Reliance Insurance and Reliance National together had reinsurance for property catastrophe losses in excess of $15 million. Between $15 million and $22 million, Reliance Insurance and Reliance National together retained up to $2.1 million of all losses attributable to a single catastrophe. Between $22 million and $107 million, Reliance Insurance and Reliance National together retained up to $10.5 million of all losses attributable to a single catastrophe. Thus, for all losses attributable to a single catastrophe of $107 million, Reliance Insurance and Reliance National together retained a maximum exposure of $27.6 million. Effective January 1, 1994, Reliance Insurance and Reliance National together retain up to $4.6 million of all losses attributable to a single catastrophe between $15 million and $107 million. Thus, for all losses attributable to a single catastrophe of $107 million, Reliance Insurance and Reliance National together retain a maximum exposure of $19.6 million. Any loss from a single catastrophe beyond $107 million is not reinsured and is retained by Reliance Insurance and Reliance National together. Renewal of catastrophe coverage during the term of the treaty is provided by a provision for one automatic reinstatement of the original coverage at a contractually determined premium. The Company believes that the limit of $107 million per occurrence is sufficient to cover its probable maximum loss in the event of a catastrophe. Additionally, Reliance National has catastrophe protection for losses in excess of a retention of $8 million, up to the $15 million attachment point of the property catastrophe cover. Catastrophe losses, including losses incurred by Reliance Reinsurance on insurance assumed, were $39.3 million in 1993 ($88.5 million before insurance ceded) compared to $61.1 million in 1992 ($119.2 million before insurance ceded), which included $45.6 million ($94.1 million before insurance ceded) arising from Hurricane Andrew. Catastrophe losses, including losses incurred by Reliance Reinsurance on insurance assumed, were $28.7 million ($29.7 million before insurance ceded) in 1991. A catastrophic event can cause losses in lines of insurance other than property. Both Reliance Insurance and Reliance National purchase workers' compensation reinsurance coverage up to $200 million to provide protection against losses under workers' compensation policies which might be caused by catastrophes. Any such losses over $200 million would be covered by the property catastrophe treaty to the extent of available capacity. Reliance Insurance and Reliance National have also purchased reinsurance to cover aggregate retained catastrophe losses in the event of multiple catastrophes in any one year. This reinsurance agreement provides coverage for up to 70% of aggregate catastrophe losses between $12.5 million and $39.0 million, after applying a deductible of $3.8 million per catastrophe. Reliance Surety retains 100% of surety bond limits up to $1 million. For surety bonds in excess of $1 million, up to $35 million, Reliance Surety obtains 50% quota share reinsurance. In addition, Reliance Surety has excess of loss protection, with a net retention of $3 million, for losses up to $25 million on any one principal insured. For fidelity business, Reliance Surety retains 100% of each loss up to $500,000. Reliance Surety has obtained reinsurance above that retention up to a maximum of $9,500,000 on each loss subject, however, to an annual aggregate deductible of $1,500,000. Reliance Reinsurance writes treaty property and casualty reinsurance and facultative casualty reinsurance with limits of $1.5 million per program. Facultative property reinsurance, which was discontinued in February 1994, was written with limits of $10 million per risk, of which the Company retained $500,000 after the purchase of reinsurance. Reliance Reinsurance purchases catastrophe protection for its property treaty and facultative insurance assumed of $5.2 million in excess of a $3 million per occurrence retention, with a contractual provision for a reinstatement. Reliance Reinsurance also writes a specific catastrophe book of business with an aggregate limit of $25 million for any one event, not subject to the above protection. In 1993, no losses were incurred under this specific catastrophe program. Commonwealth/Transamerica Title generally retains no more than $60 million on any one risk, although it often retains significantly less than this amount, with reinsurance placed with other title companies. Commonwealth/Transamerica Title also purchases reinsurance from Lloyd's of London which provides coverage for 80% of losses in excess of $20 million, up to $60 million, on any one risk. The largest net loss paid by Commonwealth or, since its acquisition, Transamerica Title on any one risk was approximately $3 million. Premiums ceded by the Reliance Insurance Group to reinsurers were $1.1 billion and $1.2 billion in 1993 and 1992, respectively. The Reliance Insurance Group is subject to credit risk with respect to its reinsurers, as the ceding of risk to reinsurers does not relieve the Reliance Insurance Group of its liability to insureds. At December 31, 1993, the Reliance Insurance Group had reinsurance recoverables of $2.6 billion, representing estimated amounts recoverable from reinsurers pertaining to paid claims, unpaid claims, claims incurred but not reported and unearned premiums. The Reliance Insurance Group holds substantial amounts of collateral, consisting of letters of credit and cash collateral, to secure recoverables from unauthorized reinsurers. In order to minimize losses from uncollectible reinsurance, the Reliance Insurance Group places its reinsurance with a number of different reinsurers, and utilizes a security committee to approve in advance the reinsurers which meet its standards of financial strength and are acceptable for use by Reliance Insurance Group. The Company had $8.2 million reserved for potentially unrecoverable reinsurance at December 31, 1993. The Company is not aware of any impairment of the creditworthiness of any of the Reliance Insurance Group's significant reinsurers. While the Company is aware of financial difficulties experienced by certain Lloyd's of London syndicates, the Company has not experienced deterioration of payments from the Lloyd's of London syndicates from which it has reinsurance. The Company has no reason to believe that the Lloyd's of London syndicates from which it has reinsurance will be unable to satisfy claims that may arise with respect to ceded losses. In 1993, the Reliance Property and Casualty Companies did not cede more than 5.4% of direct premiums to any one reinsurer and no one reinsurer accounted for more than 12.2% of total ceded premiums. The Reliance Insurance Group's ten largest reinsurers, based on 1993 ceded premiums, are as follows: - -------- (1) Assigned a Best's Rating of NA-4 (Rating Procedure Inapplicable) as the normal rating procedures for property/casualty companies do not apply to companies that retain less than 25% of gross writings. (2) An unrated captive reinsurer that is not affiliated with the Company. Obligations are fully collateralized. Reliance Insurance Company arranged with Centre Reinsurance International Company a five-year aggregate excess of loss Reinsurance Treaty effective January 1, 1994 through December 31, 1998 (the "Reinsurance Treaty"). The Reinsurance Treaty indemnifies Reliance Insurance Company for ultimate accident year losses (including loss adjustment expenses) in excess of retained accident year losses for each accident year. The retained accident year losses are determined in advance of each accident year and expressed as a planned loss ratio. The recoveries under the Reinsurance Treaty are subject to a limit of $200 million per accident year and an aggregate five-year limit of $700 million. The Reinsurance Treaty provides for an annual premium deposit of $25 million which is subject to adjustment based on loss experience and a maximum aggregate five-year premium of $400 million. Premiums in the amount of 57% of ceded losses will be paid to the reinsurer whenever losses are ceded. The Reinsurance Treaty is cancelable by Reliance Insurance Company on any December 31 during the five-year term upon thirty (30) days written notice. Reliance Insurance Company is able to commute the Reinsurance Treaty on December 31, 2003 or any December 31, thereafter subject to specific terms of the Reinsurance Treaty. The Reinsurance Treaty does not apply to the Company's title insurance subsidiaries. The Reliance Insurance Group maintains no "Funded Cover" reinsurance agreements. "Funded Cover" reinsurance agreements are multi-year retrospectively rated reinsurance agreements which do not meet relevant accounting standards for risk transfer and under which the reinsured must pay additional premiums in subsequent years if losses in the current year exceed levels specified in the reinsurance agreement. PROPERTY AND CASUALTY LOSS RESERVES As of March 15, 1994, the Reliance Insurance Group maintains a staff of 89 actuaries, of whom 15 are fellows of the Casualty Actuarial Society and one is a fellow of the Society of Actuaries. This staff regularly performs comprehensive analyses of reserves and reviews the pricing and reserving methodologies of the Reliance Insurance Group. Although the Company believes, in light of present facts and current legal interpretations, that the Reliance Insurance Group's overall property and casualty reserve levels are adequate to meet its obligations under existing policies, due to the inherent uncertainty and complexity of the reserving process, the ultimate liability may be more or less than such reserves. The following tables present information relating to the liability for unpaid claims and related expenses ("loss reserves") for the Reliance Property and Casualty Companies. The table below provides a reconciliation of beginning and ending liability balances (net of reinsurance recoverables) for the years ended December 31, 1993, 1992 and 1991. - -------- * Loss reserves exclude estimated reinsurance recoverables of $2.12 billion at December 31, 1993, $1.87 billion at December 31, 1992 and $1.31 billion at December 31, 1991 and exclude the loss reserves of title operations of $204.7 million at December 31, 1993 and $173.3 million at December 31, 1992 and the loss reserves of title and mortgage insurance operations of $177.4 million at December 31, 1991. The table below provides a reconciliation of beginning and ending liability balances (before reinsurance recoverables) for the year ended December 31, 1993. - -------- * Loss reserves at December 31, 1993 exclude the loss reserves of title operations of $204.7 million at December 31, 1993. Policy claims and related expenses include a provision for insured events of prior years of $40.2 million in 1993, compared to $31.5 million in 1992 and $271.7 million in 1991. The 1993 provision includes $21.1 million of adverse development from workers' compensation reinsurance pools and $35.2 million of adverse development related to prior-year asbestos-related and environmental pollution claims. This development was partially offset by favorable development in other lines of business, including specialty commercial general liability lines. The 1992 provision includes $55.6 million of adverse development from workers' compensation and automobile reinsurance pools. This development was partially offset by favorable development of $11.9 million from two general liability claims and favorable development of $10.7 million related to unallocated loss adjustment expenses. The 1991 provision includes $156.0 million to strengthen loss reserves principally in guaranteed cost workers' compensation business and loss adjustment expense reserves in other standard commercial lines. The 1991 provision also includes $57.3 million of adverse development from workers' compensation reinsurance pools and a $5.2 million provision in personal lines resulting from prior years' catastrophes. The table below summarizes the development of the estimated liability for loss reserves (net of reinsurance recoverables) as of December 31 of each of the prior ten years. The amounts shown on the top line of the table represent the estimated liability for loss reserves (net of reinsurance recoverables) for claims that are unpaid at the particular balance sheet date, including losses that had been incurred but not reported to the Reliance Property and Casualty Companies. The upper portion of the table indicates the loss reserves as they are reestimated in subsequent periods as a percentage of the originally recorded reserves. These estimates change as losses are paid and more accurate information becomes available about remaining loss reserves. A redundancy exists when the original loss reserve estimate is greater, and a deficiency exists when the original loss reserve estimate is less, than the reestimated loss reserve at December 31, 1993. A redundancy or deficiency indicates the cumulative percentage change, as of December 31, 1993, of originally recorded loss reserves. The lower portion of the table indicates the cumulative amounts paid as of successive periods as a percentage of the original loss reserve liability. In calculating the percentage of cumulative paid losses to the loss reserve liability in each year, unpaid losses of General Casualty at April 30, 1990 (the date of sale), relating to 1983 to 1989, were deducted from the original liability in each year. Each amount in the following table includes the effects of all changes in amounts for prior periods. The table does not present accident or policy year development data. For the years 1983 through 1992, the Company has experienced deficiencies in its estimated liability for loss reserves. Included in these deficiencies were provisions of $156.0 million in 1991 and $100.0 million in 1986 specifically made to strengthen prior-years' loss reserves. The Company's loss reserves during this period have been adversely affected by a number of factors beyond the Company's control as follows: (i) significant increases in claim settlements reflecting, among other things, inflation in medical costs; (ii) increases in the costs of settling claims, particularly legal expenses; (iii) more frequent resort to litigation in connection with claims; and (iv) a widening interpretation of what constitutes a covered claim. - ------- (1) The liability for unpaid claims and related expenses (loss reserves), before reinsurance recoverables, was $5.0 billion at December 31, 1993. The loss reserve, before reinsurance recoverables, for years 1992 and prior was redundant by $115.0 million at December 31, 1993. The difference between the property and casualty liability for loss reserves at December 31, 1993 and 1992 reported in the Company's consolidated financial statements (net of reinsurance recoverables) and the liability which would be reported in accordance with statutory accounting practices is as follows: The difference between the property and casualty liability for loss reserves at December 31, 1993 reported in the Company's consolidated financial statements (before reinsurance recoverables) and the liability which would be reported in accordance with statutory accounting practices (before reinsurance recoverables) is as follows: Property and casualty loss reserves are based on an evaluation of reported claims and statistical projections of claims incurred but not reported and loss adjustment expenses. Estimates of salvage and subrogation are deducted from the liability for unpaid claims. Also considered are other factors such as the promptness with which claims are reported, the history of the ultimate liability for such claims compared with initial and intermediate estimates, the type of insurance coverage involved, the experience of the property and casualty industry and other economic indicators when applicable. The establishment of loss reserves requires an estimate of the ultimate liability based primarily on past experience. The Reliance Property and Casualty Companies apply a variety of generally accepted actuarial techniques to determine the estimates of ultimate liability. The techniques recognize, among other factors, the Reliance Insurance Group's and the industry's experience with similar business, historical trends in reserving patterns and loss payments, pending level of unpaid claims, the cost of claim settlements, the Reliance Insurance Group's product mix, the economic environment in which property and casualty companies operate and the trend toward increasing claims and awards. Estimates are continually reviewed and adjustments of the probable ultimate liability based on subsequent developments and new data are included in operating results for the periods in which they are made. In general, reserves are initially established based upon the actuarial and underwriting data utilized to set pricing levels, and are reviewed as additional information, including claims experience, becomes available. The Reliance Property and Casualty Companies regularly analyze their reserves and review their pricing and reserving methodologies, using Reliance Insurance Group actuaries, so that future adjustments to prior year reserves can be minimized. From time to time, the Reliance Property and Casualty Companies consult with independent actuarial firms concerning reserving practices and levels. The Reliance Property and Casualty Companies are required by state insurance regulators to file, along with their statutory reports, a statement of actuarial reserve opinion setting forth an actuary's assessment of their reserve status and, in 1993, the Reliance Property and Casualty Companies used an independent actuarial firm to meet such requirements. However, given the complexity of this process, reserves will require continual updates. The process of estimating claims is a complex task and the ultimate liability may be more or less than such estimates indicate. Since 1989, the Reliance Property and Casualty Companies have increased their premium writings in specialty commercial lines of business. Estimation of loss reserves for many specialty commercial lines of business is more difficult than for certain standard commercial lines because claims may not become apparent for a number of years, and a relatively higher proportion of ultimate losses are considered incurred but not reported. As a result, variations in loss development are more likely in these lines of business. The Reliance Property and Casualty Companies attempt to reduce these variations in certain of its specialty commercial lines, primarily directors and officers liability, professional liability and general liability, by writing policies on a claims-made basis, which mitigates the long tail nature of the risks. The Reliance Property and Casualty Companies also seeks to limit the loss from a single event through the use of reinsurance. In calculating the liability for loss reserves, the Reliance Property and Casualty Companies discount workers' compensation pension claims which are expected to have regular, periodic payment patterns. These claims are discounted for mortality and for interest using statutory annual rates ranging from 3% to 6%. In addition, the reserves for claims assumed through the participation of the Reliance Property and Casualty Companies in workers' compensation reinsurance pools are discounted. In the fourth quarter of 1993, the Reliance Property and Casualty Companies commuted a treaty with a voluntary workers' compensation pool and is holding the same reserves for claims incurred but not reported and discount as was previously held by such pool before the treaty was commuted. The discounting of all claims (net of reinsurance recoverables) resulted in a $284.7 million, $289.5 million and $243.8 million decrease in the liability for loss reserves at December 31, 1993, 1992 and 1991, respectively. The discounts taken in 1993, 1992 and 1991 were $7.9 million, $54.1 million and $50.9 million, respectively. In 1993, these discounts were more than offset by discount amortization resulting in a decrease in pretax income of $4.8 million. In 1992 and 1991, these discounts were partially offset by discount amortization, resulting in an increase in pretax income of $45.7 million and $43.7 million, respectively. The liability for loss reserves includes provisions for inflation in several ways, depending on how the reserve is established. An explicit provision for inflation is used where estimates of ultimate loss are based on pricing. A provision for inflation is also included for certain discounted workers' compensation claims. In these cases, the provision for inflation is based on factors supplied by the respective workers' compensation rating bureaus which have jurisdiction for states which provide for cost-of-living increases in indemnity benefits. In other reserves, the analysis reflects the effect of inflationary trends as part of the overall effect on claim costs, as well as changes in marketing, underwriting, reporting and processing systems, claims settlement and coverages purchased. Included in the liability for loss reserves at December 31, 1993 are $152 million ($122 million net of reinsurance recoverables) of loss reserves pertaining to asbestos-related and environmental pollution claims. Included in these reserves are reserves for claims incurred but not reported and reserves for loss expenses, which include litigation expenses. The Company continues to receive claims asserting injuries from hazardous materials and alleged damages to cover various clean-up costs relating to policies written in prior years. Coverage and claim settlement issues, such as the determination that coverage exists and the definition of an occurrence, may cause the actual loss development to exhibit more variation than the remainder of the Company's book of business. The Company's net paid losses and related expenses for asbestos- related and environmental pollution claims have not been material in relation to the Company's total net paid losses and related expenses. Net paid losses and related expenses (primarily legal fees and expenses) relating to these claims were $23.0 million (including $8.6 million of related expenses), $17.3 million (including $7.7 million of related expenses) $20.3 million (including $11.5 million of related expenses), $5.6 million (including $3.6 million of related expenses) and $8.5 million (including $5.0 million of related expenses) for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. Total payments for all policy claims and related expenses were $1.0 billion, $961.1 million, $910.6 million, $1.0 billion and $1.1 billion for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. As of December 31, 1993, the Company had approximately 700 direct insureds for which one or more environmental or asbestos claims were open. As of December 31, 1993, the Company was involved in approximately 40 coverage disputes (where a motion for declaratory judgment had been filed, the resolution of which will require a judicial interpretation of an insurance policy) related to asbestos or environmental pollution claims. The Company is not aware of any pending litigation or pending claim which will result in significant contingent liabilities in these areas. The Company believes it has made reasonable provisions for these claims, although the ultimate liability may be more or less than such reserves. The Company believes that future losses associated with these claims will not have a material adverse effect on its financial position, although there is no assurance that such losses will not materially affect the Company's results of operations for any period. Although the Company believes, in light of present facts and current legal interpretations, that the overall loss reserves of the Reliance Property and Casualty Companies are adequate to meet their obligations under existing policies, due to the inherent uncertainty and complexity of the reserving process, the ultimate liability may be more or less than such reserves. PORTFOLIO INVESTMENTS Investment activities are an integral part of the business of the Reliance Insurance Group. The Reliance Insurance Group believes that the investment objectives of safety and liquidity, while seeking the best available return, can be achieved by active portfolio management and by the intensive monitoring of investments. Reference is made to "Reliance Financial Services Corporation and Subsidiaries Financial Review--Investment Portfolio" on page 31 of the Company's 1993 Annual Report, which section is incorporated herein by reference, and Note 2 to the Consolidated Financial Statements. The following table details the distribution of the Company's investments at December 31, 1993: - -------- (1) Does not include investment in Zenith National Insurance Corp. which is accounted for by the equity method and which, as of December 31, 1993, had a carrying value of $157.0 million. See "--Investee Company." (2) In the Company's Consolidated Financial Statements, mortgage loans are included in other accounts and notes receivable. The Company seeks to maintain a diversified and balanced fixed maturity portfolio representing a broad spectrum of industries and types of securities. The Company holds virtually no investments in commercial real estate mortgages. Purchases of fixed maturity securities are researched individually based on in-depth analysis and objective predetermined investment criteria and are managed to achieve a proper balance of safety, liquidity and investment yields. The Reliance Insurance Group primarily invests in investment grade securities (those rated "BBB" or better by S&P), and, to a lesser extent, non-investment grade and non-rated securities. Equity investments are made after in-depth analysis of individual companies' fundamentals by the Reliance Insurance Group's staff of investment professionals. They seek to identify equities that appear to be undervalued relative to the issuer's business fundamentals, such as earnings, cash flows, balance sheets and future prospects. Rather than maintaining a portfolio with large numbers of issuers weighted across a broad range of industry sectors, the Company invests in sufficiently few issuers to allow it to effectively monitor each investment. The Reliance Insurance Group has increased the liquidity of its equity portfolio by investing in issuers which have significant market capitalizations. At December 31, 1993, the Company's real estate holdings had a carrying value of $282.8 million, which includes 11 shopping centers with an aggregate carrying value of $130.3 million, office buildings and other commercial properties with an aggregate carrying value of $91.9 million, and undeveloped land with a carrying value of $60.6 million. At December 31, 1993, the Reliance Insurance Group's investment portfolio was $3.6 billion (at cost) with 87.4% in fixed maturities and short-term securities (including redeemable preferred stock) and 12.6% in equity securities, including convertible preferred stock. All publicly traded investment grade securities are priced using the Merrill Lynch Matrix Pricing model, which model is one of the standard methods of pricing such securities in the industry. All publicly traded non-investment grade securities, except as indicated below, are priced from broker-dealers who make markets in these and other similar securities. For fixed maturities not publicly traded, prices are estimated based on values obtained from independent third parties or quoted market prices of comparable instruments. Upon sale, such prices may not be realized when the size of a particular investment in an issue is significant in relation to the total size of such issue. Non-investment grade securities that are thinly traded are priced using internally developed calculations. Such securities represent less than 1% of the Reliance Insurance Group's fixed maturities portfolio. The following table presents the investment results of the Reliance Insurance Group's investment portfolio for each of the years ended December 31, 1993, 1992 and 1991: - -------- (1) The average is computed by dividing the total market value of investments at the beginning of the period plus the individual quarter-end balances by five for the years ended December 31, 1993, 1992 and 1991. (2) Consists principally of interest and dividend income, less investment expenses. (3) Does not include investment in Zenith National Insurance Corp. see "-- Investee Company." (4) The impact on the overall rate of return of a one percent increase or decrease in the December 31, 1993 fixed maturity portfolio market value would be approximately 0.78%. The carrying value and market value at December 31, 1993 of fixed maturities for which interest is payable on a deferred basis was $77.4 million. At December 31, 1993, the aggregate carrying value and market value of fixed maturities (other than short-term investments and cash) that either have been rated by S&P in the following categories or are non-rated were as follows: Substantially all of the non-investment grade fixed maturities are classified as "available for sale" and, accordingly, are carried at quoted market value. The contractual maturities of short-term and fixed maturity investments at December 31, 1993 are set forth below: As of March 15, 1994, the Reliance Insurance Group owned 3,568,634 shares of common stock of Symbol Technologies, Inc. ("Symbol"), representing 14.8% of the then outstanding common stock of Symbol. Symbol is the nation's largest manufacturer of bar code-based data capture systems. As of March 15, 1994, the market value of the Reliance Insurance Group's investment in Symbol was $72,264,839 (based upon the closing price on such date as reported by the NYSE). INVESTEE COMPANY As of March 15, 1994, the Reliance Insurance Group owned 6,574,445 shares of common stock of Zenith National Insurance Corp. ("Zenith"), representing 34.4% of the outstanding common stock of Zenith, a California-based insurance company with significant workers' compensation and standard commercial and personal lines business. As of March 15, 1994, the market value of the Reliance Insurance Group's investment in Zenith was $139,706,957 (based upon the closing price on such date as reported by the NYSE). The board of directors of Zenith includes certain executive officers of the Company. The Company's investment in Zenith is accounted for by the equity method. See Note 3 to the Consolidated Financial Statements. REGULATION The businesses of the Reliance Insurance Group, in common with those of other insurance companies, are subject to comprehensive, detailed regulation in the jurisdictions in which they do business. Such regulation is primarily for the protection of policyholders rather than for the benefit of investors. Although their scope varies from place to place, insurance laws in general grant broad powers to supervisory agencies or officials to examine companies and to enforce rules or exercise discretion touching almost every significant aspect of the conduct of the insurance business. These include the licensing of companies and agents to transact business, varying degrees of control over premium rates (particularly for property and casualty companies), the forms of policies offered to customers, financial statements, periodic reporting, permissible investments and adherence to financial standards relating to surplus, dividends and other criteria of solvency intended to assure the satisfaction of obligations to policyholders. Other legislation obliges the Reliance Property and Casualty Companies to offer policies or assume risks in various markets which they would not seek if they were acting solely in their own interest. While such regulation and legislation is sometimes burdensome, inasmuch as all insurance companies similarly situated are subject to such controls, the Company does not believe that the competitive position of the Reliance Insurance Group is adversely affected. State holding company acts also regulate changes of control in insurance holding companies and transactions and dividends between an insurance company and its parent or affiliates. Although the specific provisions vary, the holding company acts generally prohibit a person from acquiring a controlling interest in an insurer incorporated in the state promulgating the act or in any other controlling person of such insurer unless the insurance authority has approved the proposed acquisition in accordance with the applicable regulations. In many states, including Pennsylvania, where Reliance Insurance Company is domiciled, "control" is presumed to exist if 10% or more of the voting securities of the insurer are owned or controlled by a party, although the insurance authority may find that "control" in fact does or does not exist where a person owns or controls either a lesser or a greater amount of securities. The holding company acts also impose standards on certain transactions with related companies, which generally include, among other requirements, that all transactions be fair and reasonable and that certain types of transactions receive prior regulatory approval either in all instances or when certain regulatory thresholds have been exceeded. Other states, in addition to an insurance company's state of domicile, may regulate affiliated transactions and the acquisition of control of licensed insurers. The State of California, for example, presently treats certain insurance subsidiaries of the Company which are not domiciled in California as though they were domestic insurers for insurance holding company purposes and such subsidiaries are required to comply with the holding company provisions of the California Insurance Code, which provisions are more restrictive than the comparable laws of the states of domicile of such subsidiaries. The Insurance Law of Pennsylvania, where Reliance Insurance Company is domiciled, was amended in February 1994 (effective immediately) to establish a new test limiting the maximum amount of dividends which may be paid without prior approval by the Pennsylvania Insurance Department. Under such test, Reliance Insurance Company may pay dividends during the year equal to the greater of (a) 10% of the preceding year-end policyholders' surplus or (b) the preceding year's net income, but in no event to exceed the amount of "unassigned funds (surplus)", which is defined as "undistributed, accumulated surplus, including net income and unrealized gains, since the organization of the insurer." In addition, the Pennsylvania law specifies factors to be considered by the Pennsylvania Insurance Department to allow it to determine that statutory surplus after the payment of dividends is reasonable in relation to an insurance company's outstanding liabilities and adequate for its financial needs. Such factors include the size of the company, the extent to which its business is diversified among several lines of insurance, the number and size of risks insured, the nature and extent of the company's reinsurance, and the adequacy of the company's reserves. 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, such as the impact of dividends on surplus, which could affect an insurer's ratings, competitive position, the amount of premiums that can be written and the ability to pay future dividends. Furthermore, the Pennsylvania Insurance Department has broad discretion to limit the payment of dividends by insurance companies. Total common and preferred stock dividends paid by Reliance Insurance Company during 1993, 1992 and 1991 were, $133.7 million ($130.6 million for common stock), $143.7 million ($140.4 million for common stock) and $160.6 million ($156.9 million for common stock), respectively. During 1994, $126.8 million would be available for dividend payments by Reliance Insurance Company based upon the new dividend test under Pennsylvania Law. As a result of the refinancing completed on November 15, 1993, the Company believes such amount will be sufficient to meet its cash needs. There is no assurance that Reliance Insurance Company will meet the tests in effect from time to time under Pennsylvania law for the payment of dividends without prior Insurance Department approval or that any requested approval will be obtained. However, Reliance Insurance Company has been advised by the Pennsylvania Insurance Department that any required prior approval will be based upon a solvency standard and will not be unreasonably withheld. Any significant limitation of Reliance Insurance Company's dividends would adversely affect the Company's ability to service its debt and to pay dividends on its Common Stock. The NAIC has adopted a "risk-based capital" requirement for the property and casualty insurance industry which becomes effective in 1995 (based on 1994 financial results). "Risk-based capital" refers to the determination of the amount of statutory capital required for an insurer based on the risks assumed by the insurer (including, for example, investment risks, credit risks relating to reinsurance recoverables and underwriting risks) rather than just the amount of net premiums written by the insurer. A formula that applies prescribed factors to the various risk elements in an insurer's business would be used to determine the minimum statutory capital requirement for the insurer. An insurer having less statutory capital than the formula calculates would be subject to varying degrees of regulatory intervention, depending on the level of capital inadequacy. Although the regulations governing risk based capital are not effective until 1995 (based on 1994 financial results), the Company has calculated that its capital exceeds the risk based capital that would be required if the formula was currently in effect (based on 1993 financial results). However, because certain terms of the regulation have yet to be defined, management cannot predict the ultimate impact of risk-based capital requirements on the Company's capital requirements or its competitive position. Maintaining appropriate levels of statutory surplus is considered important by the Company's management, state insurance regulatory authorities, and the agencies that rate insurers' claims-paying abilities and financial strength. Failure to maintain certain levels of statutory capital and surplus could result in increased scrutiny or, in some cases, action taken by state regulatory authorities and/or downgrades in an insurers' ratings. The Company's principal property and casualty insurance subsidiary, Reliance Insurance Company, has operated outside of the NAIC financial ratio range concerning liabilities to liquid assets (the "NAIC liquidity test"). This ratio is intended only as a guideline for an insurance company to follow. The Company believes that it has sufficient marketable assets on hand to make timely payment of claims and other operating requirements. On November 8, 1988, voters in California approved Proposition 103, which requires a rollback of rates for property and casualty insurance policies issued or renewed after November 8, 1988 of 20% from November 1987 levels and freezes rates at such lower levels until November 1989. Proposition 103 also requires that subsequent rate changes be justified to, and approved by, an elected Insurance Commissioner, automobile insurance rates be determined primarily by the driver's safety record and mileage driven, and "good drivers" be given a 20% discount (in addition to the 20% rollback). In 1989, the California Department of Insurance notified United Pacific Insurance Company, one of the Company's California subsidiaries, which writes business in California, that under Proposition 103, profits generated by current rates exceeded the Department's rates for a fair and reasonable return by approximately $10.0 million. Since then, there have been several administrative hearings on rate rollback and several different regulations issued. None survived the administrative process until Emergency Regulations were approved in August and October 1991 and then readopted in February 1992. The regulations allowed the Commissioner of Insurance to order insurance companies to rollback 1988 rates and issue refunds to policyholders. In June 1992, the California Office of Administrative Law (the "OAL") disapproved the Department's Emergency Regulations. In July 1992 the OAL disapproved the Department's permanent regulations governing rate rollbacks, which were materially the same as the Department's Emergency Regulations. In February 1993, a Los Angeles Superior Court issued a decision in the consolidated case challenging the Department's Emergency Regulations and the application of these regulations. The court declared several sections of the regulations invalid and enjoined the enforcement of the regulations. In June 1993, the California Supreme Court agreed to hear the appeal from this decision. The regulations, if ultimately adopted and upheld, could result in the Company having to make a refund to policyholders possibly in excess of the amount specified in the Department's 1989 notice. In October 1991, the Commissioner announced orders to fourteen insurer groups directing specified refunds to policyholders. Insurers could comply or a departmental hearing would be scheduled. The Company was not included in the group of fourteen insurers. The amount and timing of any rate rollback or refunds by the Company remain uncertain. The Company's property and casualty insurance subsidiaries have not earned underwriting profits in California in the past five years. The Company believes that even after considering investment income, total returns in California have been less than what would be considered "fair". The Company will contest vigorously any unreasonable premium rollback determination by the California Insurance Department. Accordingly, the Company believes that it is probable that its premium revenues will not be subject to a refund which would have a material effect on the results of operations or financial condition of the Company. From time to time, other states have considered adopting legislation or regulations which could adversely affect the manner in which the Reliance Insurance Group sets rates for policies of insurance, particularly as they relate to personal lines. No assurance can be given as to what effect the adoption of any such legislation or regulation would have on the ability of the Company to raise its rates. However, since the Company has substantially withdrawn from personal lines, the Company believes that these initiatives will not have a material effect on its on-going business. COMPETITION All of the Company's businesses are highly competitive. The property and casualty insurance business is fragmented and no single company dominates any of the markets in which the Company operates. The Reliance Insurance Group competes with individual companies and with groups of affiliated companies with greater financial resources, larger sales forces and more widespread agency and broker relationships. Competition in the property and casualty insurance industry is based primarily on both price and service. In addition, because the Reliance Insurance Group sells its policies through independent agents and insurance brokers who are not obligated to choose the Reliance Insurance Group's policies over those of another insurer, the Reliance Insurance Group must compete for agents and brokers and for the business they control. Such competition is based upon price, product design, policyholder service, commissions and service to agents and brokers. Commonwealth/Transamerica Title compete with large national title insurance companies and with smaller, locally established businesses which may possess distinct competitive advantages. Competition in the title insurance business is based primarily on the quality and timeliness of service. In some market areas, abstracts and title opinions issued by attorneys are used as an alternative to title insurance and other services provided by title companies. In addition, certain jurisdictions have title registration systems which can lessen the demand for title insurance. ITEM 2. ITEM 2. PROPERTIES. The Company and its consolidated subsidiaries own and lease offices in various locations primarily in the United States. None of these properties is material to the Company's business. At December 31, 1993, the Company and its consolidated subsidiaries employed approximately 9,600 persons in approximately 440 offices. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company and its subsidiaries are involved in certain litigation arising in the course of their businesses, some of which involve claims of substantial amounts. Although the ultimate outcome of these matters cannot be ascertained at this time, and the results of legal proceedings cannot be predicted with certainty, the Company is contesting the allegations of the complaints in each pending action and believes, based on current knowledge and after consultation with counsel, that the resolution of these matters will not have a material adverse effect on the consolidated financial statements of the Company. In addition, Hall, the predecessor corporation of Prometheus Funding Corp., a subsidiary of the Company ("Prometheus"), entered into a settlement agreement, which is subject to court approval, with the Superintendent of Insurance of the State of New York (the "Superintendent"), arising out of the insolvency of Union Indemnity Insurance Company of New York, Inc. ("Union Indemnity"). The settlement agreement was submitted to the court for approval in October 1989 and objections were filed by various parties. In March 1994, the Superintendent informed Prometheus that he did not intend to pursue court approval of the settlement until the resolution of appellate proceedings in a pending litigation between the Superintendent and certain of Union Indemnity's reinsurers. Prometheus has advised the Superintendent that this position is in breach of the settlement agreement's requirement that the parties diligently make every effort to obtain court approval of the settlement, and Prometheus has reserved all of its rights with respect thereto. There is no assurance that such approval will be obtained. The settlement agreement will not become effective until final approval by the court. See Note 16 to the consolidated financial statements for additional information concerning such legal proceedings and contingencies affecting the Company and its subsidiaries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Item 4 is not required pursuant to the reduced disclosure requirements applicable to this Form 10-K. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. As of March 15, 1994, all 1,000 outstanding shares of Reliance Financial's common stock are held of record by Reliance Group Holdings and are not publicly traded. See the information in "Market and Dividend Information for Common Stock" on page 33 of the Reliance Financial 1993 Annual Report, which information is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Item 6 is not required pursuant to the reduced disclosure requirements applicable to this Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See the information in "Reliance Financial Services Corporation and Subsidiaries Financial Review" on pages 26 through 33 of the Reliance Financial 1993 Annual Report, which information is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See the information on pages 1 through 24 of the Reliance Financial 1993 Annual Report, which information is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III Items 10, 11, 12 and 13, which comprise Part III, are not required pursuant to the reduced disclosure requirements applicable to this Form 10-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (A) 1. FINANCIAL STATEMENTS. The consolidated financial statements of Reliance Financial Services Corporation and Subsidiaries, which appear on pages 1 through 24 of the Reliance Financial 1993 Annual Report, are incorporated herein by reference. 2. FINANCIAL STATEMENT SCHEDULES: All other schedules have been omitted because they are inapplicable, not required, or the information is included elsewhere in the financial statements or notes thereto. Pursuant to Rule 1-02(v) of Regulation S-X, Reliance Insurance Group's investment in Zenith National Insurance Corp. meets the definition of a "significant subsidiary." Zenith National Insurance Corp. files financial statements with the Securities and Exchange Commission which should be referred to for additional information. 3. EXHIBITS - -------- * Neither Reliance Financial nor its subsidiaries is a party to any instrument relating to long-term debt under which the securities authorized exceed 10% of the total consolidated assets of Reliance Financial and its subsidiaries. Copies of instruments relating to long-term debt of lesser amounts will be provided to the Securities and Exchange Commission upon request. - -------- ** Schedule P from the statutory reports of Zenith National Insurance Corp., 34.4% of the outstanding common stock of which is owned by the Reliance Insurance Group, is omitted herefrom as such Schedule P is filed directly with the Securities and Exchange Commission. (B) REPORTS ON FORM 8-K 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, ON THE 29TH DAY OF MARCH, 1994. Reliance Financial Services Corporation Saul P. Steinberg By: ___________________________________ SAUL P. STEINBERG 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 TITLE DATE Saul P. Steinberg Chairman of the Board, March 29, 1994 - ------------------------------------- Principal Executive SAUL P. STEINBERG Officer and Director George E. Bello Principal Accounting March 29, 1994 - ------------------------------------- Officer and Director GEORGE E. BELLO Lowell C. Freiberg Principal Financial March 29, 1994 - ------------------------------------- Officer and Director LOWELL C. FREIBERG George R. Baker Director March 29, 1994 - ------------------------------------- GEORGE R. BAKER Carter Burden Director March 29, 1994 - ------------------------------------- CARTER BURDEN Dennis A. Busti Director March 29, 1994 - ------------------------------------- DENNIS A. BUSTI Dean W. Case Director March 29, 1994 - ------------------------------------- DEAN W. CASE SIGNATURE TITLE DATE --------- ----- ---- Thomas P. Gerrity Director March 29, 1994 - ------------------------------------- THOMAS P. GERRITY Jewell J. McCabe Director March 29, 1994 - ------------------------------------- JEWELL J. MCCABE Irving Schneider Director March 29, 1994 - ------------------------------------- IRVING SCHNEIDER Bernard L. Schwartz Director March 29, 1994 - ------------------------------------- BERNARD L. SCHWARTZ Director - ------------------------------------- RICHARD E. SNYDER Thomas J. Stanton, Jr. Director March 29, 1994 - ------------------------------------- THOMAS J. STANTON, JR. Robert M. Steinberg Director March 29, 1994 - ------------------------------------- ROBERT M. STEINBERG James E. Yacobucci Director March 29, 1994 - ------------------------------------- JAMES E. YACOBUCCI INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholder Reliance Financial Services Corporation New York, New York We have audited the consolidated financial statements of Reliance Financial Services Corporation (a subsidiary of Reliance Group Holdings, 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 18, 1994, except for note 16, as to which the date is March 9, 1994 (which report includes an explanatory paragraph concerning the adoption of Statement of Financial Accounting Standards No. 106, 109, 113 and 115); such 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 Reliance Financial Services Corporation, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/Deloitte & Touche New York, New York February 18, 1994, except for note 16, as to which the date is March 9, 1994 A-1 SCHEDULE I ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1993 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- (1) In the consolidated financial statements, mortgage loans are included in other accounts and notes receivable. A-2 SCHEDULE II ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (a) Accrued interest receivable. (b) Demand note receivable bearing interest at the prime rate. A-3 SCHEDULE III ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION (PARENT COMPANY) STATEMENT OF OPERATIONS A-4 SCHEDULE III ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION (PARENT COMPANY) BALANCE SHEET A-5 SCHEDULE III ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION (PARENT COMPANY) STATEMENT OF CASH FLOWS SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES: In 1993, non-cash dividends of $99,936,000 were recorded as a reduction in notes receivable from parent company. A-6 SCHEDULE V ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (a) An allocation of net investment income to the individual underwriting segments is not appropriate since allocation would be arbitrary and, in management's judgment, misleading. A-7 SCHEDULE VI ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES REINSURANCE - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- A-8 SCHEDULE IX ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES SHORT-TERM BORROWINGS - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- (a) Average amount outstanding during the period was computed by dividing the total of the principal outstanding at the beginning of the period plus the individual month-end principal balances by 13. (b) Weighted average interest rate during the period was computed by dividing interest expense on short-term borrowings by the average short-term borrowings outstanding. A-9 SCHEDULE X ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND CASUALTY INSURANCE OPERATIONS (a)Liabilities (net of reinsurance recoverables) for unpaid claims and related expenses for short-duration contracts which are expected to have fixed, periodic payment patterns are discounted to present values using statutory annual rates ranging from 3% to 6%. A-10 EXHIBITS TO FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF FOR THE FISCAL YEAR ENDED DECEMBER COMMISSION FILE NUMBER 1-7080 31, 1993 RELIANCE FINANCIAL SERVICES CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) RELIANCE FINANCIAL SERVICES CORPORATION EXHIBIT INDEX EXHIBIT NUMBER - ------- 3.1 Reliance Financial's Certificate of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to Registration Statement No. 2-458933). 3.2 Amendment to Exhibit 3.1 (incorporated by reference to Exhibit 3.2 to Registration Statement No. 2-60201). 3.3 Amendment to Exhibit 3.1 (incorporated by reference to Exhibit 3.3 to Reliance Financial's Annual Report on Form 10-K for the year ended December 31, 1983). 3.4 Reliance Financial's By-Laws, as amended (incorporated by reference to Exhibit 3.4 to Reliance Financial's Annual Report on Form 10-K for the year ended December 31, 1990). *4. 10.1 Asset Purchase Agreement, dated July 24, 1992, between Frank B. Hall & Co. Inc. ("Hall") and Aon Corporation ("Aon") (incorporated by reference to Exhibit 2.1 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended June 30, 1992). 10.2 Agreement and Plan of Merger, dated as of July 24, 1992, among Reliance Group Holdings, Hall and Prometheus Liquidating Corp. (incorporated by reference to Exhibit 2.2 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended June 30, 1992). 10.3 Parent Undertaking Agreement, dated July 24, 1992, among Reliance Group Holdings, Inc., Reliance Insurance Company and Aon (incorporated by reference to Exhibit 28.1 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended June 30, 1992). 10.4 Employee Benefit Agreement, dated July 24, 1992, among Reliance Group Holdings and Aon (incorporated by reference to Exhibit 28.2 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended June 30, 1992). 10.5 Amendment, dated November 2, 1992, to Exhibit 10.1 (incorporated by reference to Exhibit 2.1 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended September 30, 1992). 10.6 Underwriting Agreement, dated October 30, 1992, among Shearson Lehman Brothers Inc., Salomon Brothers, Inc, Commonwealth Land Title Insurance Company ("Commonwealth"), Commonwealth Mortgage Assurance Company ("CMAC") and CMAC Investment Corporation ("CIC") (incorporated by reference to Exhibit 10.1 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended September 30, 1992). - -------- * Neither Reliance Financial nor its subsidiaries is a party to any instrument relating to long-term debt under which the securities authorized exceed 10% of the total consolidated assets of Reliance Financial and its subsidiaries. Copies of instruments relating to long-term debt of lesser amounts will be provided to the Securities and Exchange Commission upon request. EXHIBIT NUMBER - ------- 10.7 International Underwriting Agreement, dated October 30, 1992, among Lehman Brothers International Limited, Salomon Brothers International Limited, Commonwealth, CMAC and CIC (incorporated by reference to Exhibit 10.2 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended September 30, 1992). 10.8 Settlement Agreement and Release, dated June 2, 1989, between James P. Corcoran, Superintendent of Insurance of the State of New York, as Liquidator of Union Indemnity Insurance Company of New York, Inc. and Hall (now known as Prometheus Funding Corp.) (incorporated herein by reference to Exhibit 10.01 to Frank B. Hall & Co. Inc.'s report on Form 10-Q for the Quarter ended June 30, 1989). 10.9 Stock Purchase Agreement, dated April 3, 1993, by and among Reliance Group Holdings, Inc., Reliance Insurance Company and General Electric Capital Corporation (incorporated by reference to Exhibit 10.22 to Reliance Insurance Company's Annual Report on Form 10-K for the year ended December 31, 1992). 10.10 First Amendment, dated as of May 31, 1993, to Exhibit 10.9 (incorporated by reference to Exhibit 2.2 to Reliance Insurance Company's Current Report on Form 8-K dated (date of earliest event reported) July 14, 1993). 10.11 Amendment, dated July 14, 1993, to Exhibit 10.9 (incorporated by reference to Exhibit 2.3 to Reliance Insurance Company's Current Report on Form 8-K dated (date of earliest event reported) July 14, 1993). 13.1 Reliance Financial 1993 Annual Report. **28.1 Schedule P from the statutory reports of the Reliance Property and Casualty Companies (incorporated by reference to Exhibit 28.1 to Reliance Insurance Company's Annual Report on Form 10-K for the year ended December 31, 1993). - -------- ** Schedule P from the statutory reports of Zenith National Insurance Corp., 34.4% of the outstanding common stock of which is owned by the Reliance Insurance Group, is omitted herefrom as such Schedule P is filed directly with the Securities and Exchange Commission.

25757_1993.txt

25757_1993

1993

25757

Item 1. Business General The Registrant, Crompton & Knowles Corporation (sometimes hereinafter referred to as the "Corporation"), was incorporated in Massachusetts in 1900. The Corporation has engaged in the manufacture and sale of specialty chemicals since 1954 and, since 1961, in the manufacture and sale of specialty process equipment and controls. The Corporation expanded its specialty chemical business in 1988 with the acquisitions of Ingredient Technology Corporation, a leading supplier of ingredients for the food and pharmaceutical industries, and Townley Dyestuffs Auxiliaries Company, Ltd., one of the largest independent suppliers of dyes for Great Britain's textile and paper industries. The Corporation made two acquisitions in calendar year 1990, acquiring the business and certain assets and liabilities of Atlantic Industries, Inc., a domestic dye manufacturer, and APV Chemical Machinery, Inc., which manufactured the Sterling line of extruders, extrusion systems and industrial blow molding equipment for the plastics industry. In 1991, the Corporation acquired a wire and cable equipment business from Clipper Machines, Inc. In 1992, the Corporation acquired a pre-metallized dyes business and facility located in Oissel, France. Information as to the sales, operating profit, and identifiable assets attributable to each of the Corporation's business segments during each of its last three fiscal years is set forth in the Notes to Consolidated Financial Statements on page 24 of the Corporation's 1993 Annual Report to Stockholders, and such information is incorporated herein by reference. Products and Services The principal products and services offered by the Corporation are described below. SPECIALTY CHEMICALS Textile dyes manufactured and sold by the Corporation are used on both synthetic and natural fibers for knit and woven garments, home furnishings such as carpets, draperies, and upholstery, and automotive furnishings including carpeting, seat belts, and upholstery. Industrial dyes and chemicals are marketed to the paper, leather, and ink industries for use on stationery, tissue, towels, shoes, apparel, luggage, and other products and for transfer printing inks. The Corporation also markets organic chemical intermediates and a line of chemical auxiliaries for the textile industry, including leveling agents, dye fixatives, and scouring agents. Sales of this class of products accounted for 57%, 59%, and 57% of the total revenues of the Corporation in 1993, 1992, and 1991, respectively. The Corporation manufactures and sells reaction and compounded flavor ingredients for the food processing, bakery, beverage and pharmaceutical industries; colors certified by the Food & Drug Administration for sale to domestic producers of food and pharmaceuticals; inactive ingredients for the pharmaceutical industry; and fragrance formulations used in personal care and household products. The Corporation is also a leading supplier of specialty sweeteners, including edible molasses, molasses blends, malt extracts, and syrups for the bakery, confectionery and food processing industries and a supplier of seasonings and seasoning blends for the food processing industry. Sales of this class of products accounted for 16%, 17%, and 19% of the total revenues of the Corporation in 1993, 1992, and 1991, respectively. SPECIALTY PROCESS EQUIPMENT AND CONTROLS The Corporation, through its Davis-Standard Division, manufactures and sells plastics and rubber extrusion equipment, industrial blow molding equipment, electronic controls, and integrated extrusion systems and offers specialized service and modernization programs for in-place extrusion systems. Sales of this class of products accounted for 27%, 24%, and 24% of the total revenues of the Corporation in 1993, 1992, and 1991, respectively. Integrated extrusion systems, which include extruders in combination with controls and other accessory equipment, are used to process plastic resins and rubber into various products such as plastic sheet used in appliances, automobiles, home construction, sports equipment, and furniture; blown film used to package many consumer products; and extruded shapes used as house siding, furniture trim, and substitutes for wood molding. Integrated extrusion systems are also used to compound engineered plastics, to recycle and reclaim plastics, and to apply plastic or rubber insulation to high voltage power cable for electrical utilities and to wire for the communications, construction, automotive, and appliance industries. Industrial blow molding equipment produced by the Corporation is sold to manufacturers of non-disposable plastic parts such as tool cases and beverage coolers. The Corporation's HES unit produces electrical and electronic controls primarily for use with extrusion systems. The Davis- Standard Division is a major user of such controls. Sources of Raw Materials Chemicals, steel, castings, parts, machine components, edible molasses, spices, and other raw materials required in the manufacture of Crompton & Knowles' products are generally available from a number of sources, some of which are foreign. Significant sales of the dyes and auxiliary chemicals business consist of dyes manufactured from intermediates purchased from foreign sources. Patents and Licenses Crompton & Knowles owns patents, trade names, and trademarks and uses know-how, trade secrets, formulae, and manufacturing techniques which assist in maintaining the competitive position of certain of its products. Patents, formulae, and know-how are of particular importance in the manufacture of a number of the dyes and flavor ingredients sold in the Corporation's specialty chemicals business, and patents and know-how are also significant in the manufacture of certain wire insulating and plastics processing machinery product lines. The Corporation believes that no single patent, trademark, or other individual right is of such importance, however, that expiration or termination thereof would materially affect its business. The Corporation is also licensed to use certain patents and technology owned by foreign companies to manufacture products complementary to its own products, for which it pays royalties in amounts not considered material to the consolidated results of the enterprise. Products to which the Corporation has such rights include certain dyes and plastics machinery. Seasonal Business No material portion of any segment of the business of the Corporation is seasonal. Customers The Corporation does not consider any segment of its business dependent on a single customer or a few customers, the loss of any one or more of whom would have an adverse effect on the segment. No one customer's business accounts for more than ten percent of the Corporation's gross revenues nor more than ten percent of its earnings before taxes. Backlog Because machinery production schedules range from about 60 days to 10 months, backlog is important to Crompton & Knowles' specialty process equipment and controls business. Firm backlog of customers' orders at December 25, 1993, for this business, totalled approximately $38 million compared with $33.8 million at December 26, 1992. It is expected that most of the December 25, 1993, backlog will be shipped during 1994. Orders for specialty chemicals and equipment repair parts are filled primarily from inventory stocks and thus are excluded from backlog. Competitive Conditions Crompton & Knowles is among the largest suppliers of dyes in the United States and is a leading domestic producer of specialty dyes for nylon, polyester, acrylics, and cotton. The Corporation is less of a factor in other segments of the domestic dyes industry and in the European market. The Corporation is also a major United States and Canadian supplier of edible molasses, a major United States supplier of malt extracts, and a significant supplier of other sugar-based specialty products. As a supplier of flavors and seasonings, the Corporation has many competitors in the United States and abroad. Crompton & Knowles is a leading producer of extrusion machinery for the plastics industry and a leading domestic producer of industrial blow molding equipment and competes with domestic and foreign producers of such products. The Corporation is one of a number of producers of other types of plastics processing machinery. Product performance, service, and competitive prices are all important factors in competing in the specialty chemicals and specialty process equipment and controls product lines. No one competitor or small number of competitors is believed to be dominant in any of the Corporation's major markets. Research and Development Crompton & Knowles employs about 240 engineers, draftsmen, chemists, and technicians responsible for developing new and improved chemical products and process equipment systems for the industries served by the Corporation. Often, new products are developed in response to specific customer needs. The Corporation's process of developing and commercializing new products and product improvements is ongoing and involves many products, no one of which is large enough to significantly impact the Corporation's results of operations from year to year. Research and development expenditures totalled $11.2 million for the year 1993, $10.1 million for the year 1992 and $9.7 million for the year 1991. Environmental Matters The Corporation's manufacturing facilities are subject to various federal, state and local requirements with respect to the discharge of materials into the environment or otherwise relating to the protection of the environment. Although precise amounts are difficult to define, in 1993, the Corporation spent approximately $13.0 million to comply with those requirements, including approximately $4.1 million in capital expenditures. The Corporation has been designated, along with others, as a potentially responsible party under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, or comparable state statutes, at two waste disposal sites; and two inactive subsidiaries have been designated, along with others, as potentially responsible parties at a total of four other sites. While the cost of compliance with existing environmental requirements is expected to increase, based on the facts currently known to the Corporation, management expects that those costs, including the cost to the Corporation of remedial actions at the waste disposal sites where it has been named a potentially responsible party, will not have a material effect on the Corporation's liquidity and financial condition and that the cost to the Corporation of any remedial actions will not be material to the results of the Corporation's operations in any given year. Employees The Corporation had 2,352 employees on December 25, 1993. Financial Information Concerning Foreign Operations and Export Sales The information with respect to sales, operating profit, and identifiable assets attributable to each of the major geographic areas served by the Corporation and export sales, for each of the Corporation's last three fiscal years, set forth in the Notes to Consolidated Financial Statements on page 24 of the Corporation's 1993 Annual Report to Stockholders, is incorporated herein by reference. The Corporation considers that the risks relating to operations of its foreign subsidiaries are comparable to those of other U.S. companies which operate subsidiaries in developed countries. All of the Corporation's international operations are subject to fluctuations in the relative values of the currencies in the various countries in which its activities are conducted. Item 2. Item 2. Properties The following table sets forth information as to the principal operating properties of the Corporation and its subsidiaries: Ownership Business Segment Dates or Lease and Location Products Built Expiration Specialty Chemicals: Carrollton, TX Seasonings 1982 1994 office and plant Des Plaines, IL Flavors and 1968 Owned office and plant fragrances Elyria, OH Seasonings 1978 2001 office and plant Gibraltar, PA Textile and other 1964- office, laboratory dyes 1980 Owned and chemical plant Lowell, NC Textile dyes, chemical plant organic chemicals 1961 Owned Mahwah, NJ Flavors, 1984- 1999 office, laboratory fragrances, 1989 seasonings and color dispersions Newark, NJ Textile dyes, 1949- chemical plant organic chemicals 1985 Owned Nutley, NJ Textile and 1949- office, laboratory, other dyes 1977 Owned and chemical plant Oissel, France Textile and 1946- Owned office, laboratory other dyes 1992 and chemical plant Pennsauken, NJ Food and 1975 1994 office and plant pharmaceutical ingredients Reading, PA Textile dyes, 1910- chemical plant organic chemicals, 1979 Owned and food colors Tertre, Belgium Textile and office, laboratory, other dyes 1970 Owned and chemical plant Specialty Process Equipment and Controls: Edison, NJ Blow Molding and 1974- 1995 office and extrusion 1979 machine shop equipment Pawcatuck, CT Plastics and 1965- office and machine rubber extrusion 1985 Owned shop and electronic control equipment and systems Pawcatuck, CT Extrusion 1968 1996 office, machine systems shop and warehouse All plants are built of brick, tile, concrete, or sheet metal materials and are of one-floor construction except parts of the plants located in Reading and Gibraltar, Pennsylvania, Nutley, New Jersey, Oissel, France and Tertre, Belgium. All are considered to be in good operating condition, well maintained, and suitable for the Corporation's requirements. Item 3. Item 3. Legal Proceedings Kem Manufacturing Corporation ("Kem"), a wholly-owned subsidiary of the Corporation acquired in 1976, has been named, along with others, a potentially responsible party under the New Jersey Spill Compensation and Control Act by the New Jersey Department of Environmental Protection and Energy with respect to the Evor Phillips waste disposal site located in central New Jersey. It appears that Kem held title to the site between 1970 and 1974, prior to the acquisition of Kem by the Corporation, but that Kem did not own or operate any facility at the site. Based on the facts currently known to the Corporation, the Corporation does not believe that the cost to the Corporation of any remedial actions at the site will have a material effect on the Corporation's liquidity and financial condition or the results of the Corporation's operations in any given year. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The information concerning the range of market prices for the Corporation's Common Stock on the New York Stock Exchange and the amount of dividends paid thereon during the past two years, set forth in the Notes to Consolidated Financial Statements on page 23 of the Corporation's 1993 Annual Report to Stockholders, is incorporated herein by reference. The number of registered holders of Common Stock of the Corporation on December 25, 1993 was 3,973. Item 6. Item 6. Selected Financial Data The selected financial data for the Corporation for each of its last five fiscal years, set forth under the heading "Eleven Year Selected Financial Data" on pages 26 and 27 of the Corporation's 1993 Annual Report to Stockholders, 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 the Corporation's financial condition and results of operations, set forth under the heading "Management's Discussion and Analysis" on pages 10 through 13 of the Corporation's 1993 Annual Report to Stockholders, is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data The financial statements of the Corporation, notes thereto, and supplementary data, appearing on pages 14 through 25 of the Corporation's 1993 Annual Report to Stockholders, are 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 Information called for by this Item concerning directors of the Corporation is included in the definitive proxy statement for the Corporation's Annual Meeting of Stockholders to be held on April 12, 1994, which has been filed with the Commission pursuant to Regulation 14A, and such information is incorporated herein by reference. The executive officers of the Corporation are as follows: Vincent A. Calarco, age 51, has served as President and Chief Executive Officer of the Registrant since 1985 and Chairman of the Board since 1986. He is former Vice President for Strategy and Development, Uniroyal, Inc. (1984-1985), and former President of Uniroyal Chemical Company (1979-1984). Mr. Calarco has been a member of the Board of Directors of the Registrant since 1985. Mr. Calarco also serves as a director of Caremark International Inc. and J.M. Huber Corporation. Robert W. Ackley, age 52, has served as a Vice President of the Registrant since 1986 and as President of the Registrant's Davis-Standard Division since 1983. Peter Barna, age 50, has served as Treasurer of the Registrant since 1980 and as Principal Accounting Officer since 1986. John T. Ferguson, II, age 47, has served as Chief Legal Officer and Secretary of the Registrant since 1989. Nicholas Fern, Ph.D., age 50, has served as President of the Registrant's International Dyes and Chemicals Division since 1992, and as Managing Director of Crompton & Knowles Europe, S.A. (formerly Crompton & Knowles Tertre) since 1978. Edmund H. Fording, Jr., age 57, has served as Vice President of the Registrant since 1991 and as President of the Registrant's Dyes and Chemicals Division since 1989. He is the former General Manager of the Dyes Division of Hilton Davis Co. (1988-1989) and Director of the Organic Department of Mobay Corporation (1980-1988). Marvin H. Happel, age 54, has served as Vice President - Organization of the Registrant since 1986. He is the former Director of Human Resources of Uniroyal Chemical Company (1979-1986). Charles J. Marsden, age 53, has served as Vice President - Finance and Chief Financial Officer and as a member of the Board of Directors of the Registrant since 1985. Frank H. Schoonyoung, age 51, has served as President of the Corporation's Ingredient Technology Division since July 1992. He is the former Vice President and General Manager of Universal Flavors - U.S.A., Inc. (1990-1992) and Senior Vice President and Director, Flavor Division, Fritzsche Dodge & Olcott, a unit of BASF K&F Corporation (1965-1990). The term of office of each of the above-named executive officers is until the first meeting of the Board of Directors following the next annual meeting of stockholders and until the election and qualification of his successor. There is no family relationship between any of such officers, and there is no arrangement or understanding between any of them and any other person pursuant to which any such officer was selected as an officer. Item 11. Item 11. Executive Compensation Information called for by this Item is included in the definitive proxy statement for the Corporation's Annual Meeting of Stockholders to be held on April 12, 1994, which has been filed with the Commission pursuant to Regulation 14A, and such information is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information called for by this Item is included on page 5 of the definitive proxy statement for the Corporation's Annual Meeting of Stockholders to be held on April 12, 1994, and such information is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions Information called for by this Item is included in the definitive proxy statement for the Corporation's Annual Meeting of Stockholders to be held on April 12, 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) The following documents are filed as a part of this report: 1. The financial statements and financial statement schedules listed in the Index on page of Exhibit 27 hereof. 2. The Exhibits listed in paragraph (c), below. (b) There were no reports on Form 8-K filed during the last quarter of the period covered by this report. (c) The following Exhibits are either filed with this report on Form 10-K or incorporated herein by reference to the respective reports and registration statements of the Registrant identified in the parenthetical clause following the description of the Exhibit: Exhibit Description Sequential No. of Exhibit Page No. 3(i) Restated Articles of Organization of the Corp- oration filed with the Commonwealth of Massachusetts on October 27, 1988, as amended on April 10, 1990 and on April 14, 1992. (Exhibit 3(a) to Form 10-K for the fiscal year ended December 26, 1992.) -- 3(ii) By-laws of the Corporation as amended to date. (Exhibit 3(b) to Form 10-K for the fiscal year ended December 30, 1989.) -- 4(a)(1) Rights Agreement dated as of July 20, 1988, between the Registrant and The Chase Manhattan Bank, N.A., as Rights Agent. (Exhibit 1 to Form 8-K dated July 29, 1988.) -- 4(a)(2) Agreement dated as of March 28, 1991, amending Rights Agreement dated as of July 20, 1988, between the Registrant and The Chase Manhattan Bank, N.A., as Rights Agent. (Exhibit 4(i)(i) to Form 10-K for the fiscal year ended December 29, 1990.) -- 4(b) Credit Agreement dated as of September 28, 1992, among the Registrant, five banks, and Bankers Trust Company as Agent. (Exhibit 10.1 to Registration Statement No. 33-52642 on Form S-3.) (Other instruments defining the rights of holders of long-term debt of the Registrant are not being filed herewith pursuant to the provisions of Instruction 4(iii) to Item 601 of Regulation S-K. The Registrant agrees to furnish a copy of any such instrument to the Commission upon request.) **10(a) 1983 Stock Option Plan of Crompton & Knowles Corporation, as amended through April 14, 1987. (Exhibit 10(c) to Form 10-Q for the quarter ended March 28, 1987.) -- **10(b) 1977 Stock Option Plan of Crompton & Knowles Corporation, as amended. (Exhibit 28(b) to Registration Statement No. 2-83339 on Form S-8.) -- **10(c) Amendments to Crompton & Knowles Corporation Stock Option Plans adopted February 22, 1988. (Exhibit 10(d) to Form 10-K for the fiscal year ended December 26, 1987.) -- **10(d) Amended Annual Incentive Compensation Plan * for "A" Group of Senior Executives dated January 24, 1994. -- **10(e) Summary of Management Incentive Bonus Plan for selected key management personnel. (Exhibit 10(m) to Form 10-K for the fiscal year ended December 27, 1980.) -- **10(f) Supplemental Medical Reimbursement Plan. (Exhibit 10(n) to Form 10-K for the fiscal year ended December 27, 1980.) -- **10(g) Supplemental Dental Reimbursement Plan. (Exhibit 10(o) to Form 10-K for the fiscal year ended December 27, 1980.) -- **10(h) Employment Agreement dated February 22, 1988, between the Registrant and Vincent A. Calarco. (Exhibit 10(j) to the Form 10-K for the fiscal year ended December 26, 1987.) -- **10(i) Form of Employment Agreement entered into in 1988, 1989 and 1992 between the Registrant and seven of its executive officers. (Exhibit 10(k) to Form 10-K for the fiscal year ended December 26, 1987.) -- **10(j) Amended Supplemental Retirement Agreement dated * October 20, 1993 between the Registrant and Vincent A. Calarco. -- **10(k) Form of Amended Supplemental Retirement Agreement * dated October 20, 1993 between the Registrant and three of its executive officers. -- **10(l) Supplemental Retirement Agreement Trust * Agreement dated October 20, 1993 between the Registrant and Shawmut Bank, N.A. -- **10(m) Amended Benefit Equalization Plan dated * October 20, 1993. -- **10(n) Amended Benefit Equalization Plan Trust Agreement * dated October 20, 1993 by and between the Registrant and Shawmut Bank, N.A. -- **10(o) Amended 1988 Long Term Incentive Plan. -- * 10(p) Trust Agreement dated as of May 15, 1989, by and between the Registrant and Shawmut Worcester County Bank, N.A. and First Amendment thereto dated as of February 8, 1990. (Exhibit 10(w) to Form 10-K for the fiscal year ended December 30, 1989.) -- **10(q) Form of 1989 - 1991 Long Term Performance Award Agreement (as amended). (Exhibit 10(x) to Form 10-K for the fiscal year ended December 30, 1989.) -- **10(r) Form of 1992 - 1994 Long Term Performance Award Agreement. (Exhibit 10(y) to Form 10-K for the fiscal year ended December 28, 1991.) -- **10(s) Crompton & Knowles Corporation Restricted Stock Plan for Directors approved by the stockholders on April 9, 1991. (Exhibit 10(z) to Form 10-K for the fiscal year ended December 28, 1991.) -- 10(t) Share Purchase Agreement dated as of April 30, 1992 between Crompton & Knowles Europe, S.A., a subsidiary of the Registrant, and Imperial Chemical Industries PLC. (Exhibit 10(z) to Form 10-K for the fiscal year ended December 26, 1992.) -- **10(u) 1993 Stock Option Plan for Non-Employee Directors __ * *11 Statement re computation of per share earnings. -- *13 1993 Annual Report to Stockholders of Crompton & Knowles Corporation. (Not to be deemed to be filed with the Securities and Exchange Commission except for those portions thereof which are expressly incorporated by reference into this report on Form 10-K.) -- 21 Subsidiaries of the Registrant. (Exhibit 22 to Form 10-K for the fiscal year ended December 26, 1992.) -- *23 Consent of independent auditors. *24 Power of attorney from directors and executive officers of the Registrant authorizing signature of this report. (Original on file at principal executive offices of Registrant.) *27 Financial Statements and Financial Statement Schedules. *29 Annual Report on Form 11-K of Crompton & Knowles Corporation Employee Stock Ownership Plan for the fiscal year ended December 31, 1993. *Copies of these Exhibits are annexed to this report on Form 10-K provided to the Securities and Exchange Commission and the New York Stock Exchange. **This Exhibit is a compensatory plan, contract or arrangement in which one or more directors or executive officers of the Registrant participate. 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. CROMPTON & KNOWLES CORPORATION (Registrant) Date: March 25, 1994 By: /s/ Charles J. Marsden Charles J. Marsden, 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 date indicated. Name Title Vincent A. Calarco* Chairman of the Board, President, and Director (Principal Executive Officer) Charles J. Marsden* Vice President-Finance and Director (Principal Financial Officer) Peter Barna* Treasurer (Principal Accounting Officer) James A. Bitonti* Director Harry W. Buchanan* Director Robert A. Fox* Director Roger L. Headrick* Director Leo I. Higdon, Jr.* Director Michael W. Huber* Director Warren A. Law* Director C. A. Piccolo* Director Howard B. Wentz, Jr. * Director Date: March 25, 1994 *By: /s/ Charles J. Marsden Charles J. Marsden, as attorney-in-fact

73986_1993.txt

73986_1993

1993

73986

Item 1.BUSINESS - -------------------------------------------------------------------------------- GENERAL AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company which owns, directly or indirectly, all of the outstanding common stock of its operating electric utility subsidiaries. Substantially all of the operating revenues of AEP and its subsidiaries are derived from the furnishing of electric service. The service area of AEP's electric utility subsidiaries covers portions of the states of Indiana, Kentucky, Michigan, Ohio, Tennessee, Virginia and West Virginia. The generating and transmission facilities of AEP's subsidiaries are physically interconnected, and their operations are coordinated, as a single integrated electric utility system. Transmission networks are interconnected with extensive distribution facilities in the territories served. At December 31, 1993, the subsidiaries of AEP had a total of 20,007 employees. AEP, as such, has no employees. The principal operating subsidiaries of AEP are: APCo (organized in Virginia in 1926), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 838,000 customers in the southwestern portion of Virginia and southern West Virginia, and in supplying electric power at wholesale to other electric utility companies and municipalities in those states and in Tennessee. At December 31, 1993, APCo and its wholly owned subsidiaries had 4,587 employees. A generating subsidiary of APCo, Kanawha Valley Power Company, which owns and operates under Federal license three hydroelectric generating stations located on Government lands adjacent to Government- owned navigation dams on the Kanawha River in West Virginia, sells its net output to APCo. Among the principal industries served by APCo are coal mining, primary metals, chemicals, textiles, paper, stone, clay, glass and concrete products and furniture. In addition to its AEP System interconnection, APCo also is interconnected with the following unaffiliated utility companies: Carolina Power & Light Company, Duke Power Company and VEPCo. A comparatively small part of the properties and business of APCo is located in the northeastern end of the Tennessee Valley. APCo has several points of interconnection with TVA and has entered into agreements with TVA under which APCo and TVA interchange and transfer electric power over portions of their respective systems. CSPCo (organized in Ohio in 1937, the earliest direct predecessor company having been organized in 1883), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 578,000 customers in Ohio, and in supplying electric power at wholesale to other electric utilities and to municipally owned distribution systems within its service area. At December 31, 1993, CSPCo had 2,143 employees. CSPCo's service area is comprised of two areas in Ohio, which include portions of twenty-five counties. One area includes the City of Columbus and the other is a predominantly rural area in south central Ohio. Approximately 80% of CSPCo's retail revenues are derived from the Columbus area. Among the principal industries served are food processing, chemicals, primary metals, electronic machinery and paper products. In addition to its AEP System interconnection, CSPCo also is interconnected with the following unaffiliated utility companies: CG&E, DP&L and Ohio Edison Company. I&M (organized in Indiana in 1925), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 525,000 customers in northern and eastern Indiana and southwestern Michigan, and in supplying electric power at wholesale to other electric utility companies, rural electric cooperatives and municipalities. At December 31, 1993, I&M had 3,944 employees. Among the principal industries served are transportation equipment, primary metals, fabricated metal products, electrical and electronic machinery, rubber and miscellaneous plastic products and chemicals and allied products. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana. In addition to its AEP System interconnection, I&M also is interconnected with the following unaffiliated utility companies: Central Illinois Public Service Company, CG&E, Commonwealth Edison Company, Consumers Power Company, Illinois Power Company, Indianapolis Power & Light Company, Louisville Gas and Electric Company, Northern Indiana Public Service Company, PSI Energy Inc. and Richmond Power & Light Company. KEPCo (organized in Kentucky in 1919), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 161,000 customers in an area in eastern Kentucky, and in supplying electric power at wholesale to other utilities and municipalities in Kentucky. At December 31, 1993, KEPCo had 842 employees. In addition to its AEP System interconnection, KEPCo also is interconnected with the following unaffiliated utility companies: Kentucky Utilities Company and East Kentucky Power Cooperative Inc. KEPCo is also interconnected with TVA. Kingsport Power Company (organized in Virginia in 1917), which provides electric service to approximately 41,000 customers in Kingsport and eight neighboring communities in northeastern Tennessee. Kingsport Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from APCo. At December 31, 1993, Kingsport Power Company had 102 employees. OPCo (organized in Ohio in 1907 and reincorporated in 1924), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 657,000 customers in the northwestern, east central, eastern and southern sections of Ohio, and in supplying electric power at wholesale to other electric utility companies and municipalities. At December 31, 1993, OPCo and its wholly owned subsidiaries had 5,749 employees. Among the principal industries served by OPCo are primary metals, stone, clay, glass and concrete products, rubber and plastic products, petroleum refining, chemicals and metal and wire products. In addition to its AEP System interconnection, OPCo also is interconnected with the following unaffiliated utility companies: CG&E, The Cleveland Electric Illuminating Company, DP&L, Duquesne Light Company, Kentucky Utilities Company, Monongahela Power Company, Ohio Edison Company, The Toledo Edison Company and West Penn Power Company. Wheeling Power Company (organized in West Virginia in 1883 and reincorporated in 1911), which provides electric service to approximately 41,000 customers in northern West Virginia. Wheeling Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from OPCo. At December 31, 1993, Wheeling Power Company had 143 employees. Another principal electric utility subsidiary of AEP is AEGCo, which was organized in Ohio in 1982 as an electric generating company. AEGCo sells power at wholesale to I&M, KEPCo and VEPCo. AEGCo has no employees. See Item 2 Item 2.PROPERTIES - -------------------------------------------------------------------------------- At December 31, 1993, subsidiaries of AEP owned (or leased where indicated) generating plants with the net power capabilities (winter rating) shown in the following table: - -------- (a) Unit 1 of the Rockport Plant is owned one-half by AEGCo and one-half by I&M. Unit 2 of the Rockport Plant is leased one-half by AEGCo and one-half by I&M. The leases terminate in 2022 unless extended. (b) Unit 3 of the John E. Amos Plant is owned one-third by APCo and two-thirds by OPCo. (c) Represents CSPCo's ownership interest in generating units owned in common with CG&E and DP&L. (d) I&M plans to close the Breed Plant on March 31, 1994. (e) Leased from the City of Fort Wayne. Indiana. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana under a 35-year lease with a provision for an additional 15-year extension at the election of I&M. See Item 1 under Fuel Supply, for information concerning coal reserves owned or controlled by subsidiaries of AEP. The following table sets forth the total circuit miles of transmission and distribution lines of the AEP System, APCo, CSPCo, I&M, KEPCo and OPCo and that portion of the total representing 765,000-volt lines: - -------- (a)Includes jointly owned lines. (b)Includes lines of other AEP System companies not shown. TITLES The AEP System's electric generating stations are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the System has been constructed over lands of private owners pursuant to easements or along public highways and streets pursuant to appropriate statutory authority. The rights of the System in the realty on which its facilities are located are considered by it to be adequate for its use in the conduct of its business. Minor defects and irregularities customarily found in title to properties of like size and character may exist, but such defects and irregularities do not materially impair the use of the properties affected thereby. System companies generally have the right of eminent domain whereby they may, if necessary, acquire, perfect or secure titles to or easements on privately-held lands used or to be used in their utility operations. Substantially all the physical properties of APCo, CSPCo, I&M, KEPCo and OPCo are subject to the lien of the mortgage and deed of trust securing the first mortgage bonds of each such company. SYSTEM TRANSMISSION LINES AND FACILITY SITING Legislation in the states of Indiana, Kentucky, Michigan, Ohio, Virginia, and West Virginia requires prior approval of sites of generating facilities and/or routes of high-voltage transmission lines. Delays and additional costs in constructing facilities have been experienced as a result of proceedings conducted pursuant to such statutes, as well as in proceedings in which operating companies have sought to acquire rights-of-way through condemnation, and such proceedings may result in additional delays and costs in future years. PEAK DEMAND The AEP System is interconnected through 119 high-voltage transmission interconnections with 29 neighboring electric utility systems. The all-time and 1993 one-hour peak demands were 25,174,000 and 22,142,000 kilowatts, respectively, (including 6,459,000 and 4,043,000 kilowatts, respectively, of scheduled deliveries to unaffiliated systems which the System might, on appropriate notice, have elected not to schedule for delivery) and occurred on January 18, 1994 and July 26, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual obligations, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time and 1993 one-hour internal peak demands were 19,236,000 and 18,085,000 kilowatts, respectively, and occurred on January 19, 1994 and July 28, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual arrangements, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time one-hour integrated and internal net system peak demands and 1993 peak demands for AEP's generating subsidiaries are shown in the following tabulation: HYDROELECTRIC PLANTS Licenses for hydroelectric plants, issued under the Federal Power Act, reserve to the United States the right to take over the project at the expiration of the license term, to issue a new license to another entity, or to relicense the project to the existing licensee. In the event that a project is taken over by the United States or licensed to a new licensee, the Federal Power Act provides for payment to the existing licensee of its "net investment" plus severance damages. Licenses for six System hydroelectric plants expired in 1993 and applications for new licenses for these plants were filed in 1991. The existing licenses for these plants were extended on an annual basis and will be renewed automatically until new licenses are issued. No competing license applications were filed. One new license was issued in March 1994. COOK NUCLEAR PLANT Unit 1 of the Cook Plant, which was placed in commercial operation in 1975, has a nominal net electric rating of 1,020,000 kilowatts. Unit 1's availability factor was 100% during 1993 and 64.8% during 1992. Unit 2, of slightly different design, has a nominal net electrical rating of 1,090,000 kilowatts and was placed in commercial operation in 1978. Unit 2's availability factor was 96.6% during 1993 and 19.5% during 1992. The availability of Units 1 and 2 was affected in 1992 by outages to refuel and Unit 2 main turbine/generator vibrational problems. Units 1 and 2 are licensed by the NRC to operate at 100% of rated thermal power to October 25, 2014 and December 23, 2017, respectively. NUCLEAR INSURANCE The Price-Anderson Act limits public liability for a nuclear incident at any nuclear plant in the United States to $9.4 billion. I&M has insurance coverage for liability from a nuclear incident at its Cook Plant. Such coverage is provided through a combination of private liability insurance, with the maximum amount available of $200,000,000, and mandatory participation for the remainder of the $9.4 billion liability, in an industry retrospective deferred premium plan which would, in case of a nuclear incident, assess all licensees of nuclear plants in the U.S. Under the deferred premium plan, I&M could be assessed up to $158,600,000 payable in annual installments of $20,000,000 in the event of a nuclear incident at Cook or any other nuclear plant in the U.S. There is no limit on the number of incidents for which I&M could be assessed these sums. I&M also has property damage, decontamination and decommissioning insurance for loss resulting from damage to the Cook Plant facilities in the amount of $2.75 billion. Nuclear insurance pools provide $1.265 billion of coverage and Nuclear Electric Insurance Limited (NEIL) and Energy Insurance Bermuda (EIB) provide the remainder. If NEIL's and EIB's losses exceed their available resources, I&M would be subject to a total retrospective premium assessment of up to $15,327,023. NRC regulations require that, in the event of an accident, whenever the estimated costs of reactor stabilization and site decontamination exceed $100,000,000, the insurance proceeds must be used, first, to return the reactor to, and maintain it in, a safe and stable condition and, second, to decontaminate the reactor and reactor station site in accordance with a plan approved by the NRC. The insurers then would indemnify I&M for property damage up to $2.5 billion less any amounts used for stabilization and decontamination. The remaining $250,000,000, as provided by NEIL (reduced by any stabilization and decontamination expenditures over $2.5 billion), would cover decommissioning costs in excess of funds already collected for decommissioning. See Fuel Supply--Nuclear Waste. NEIL's extra-expense program provides insurance to cover extra costs resulting from a prolonged accidental outage of a nuclear unit. I&M's policy insures against such increased costs up to approximately $3,500,000 per week (starting 21 weeks after the outage) for one year, $2,350,000 per week for the second and third years, or 80% of those amounts per unit if both units are down for the same reason. If NEIL's losses exceed its available resources, I&M would be subject to a total retrospective premium assessment of up to $8,929,456. POTENTIAL UNINSURED LOSSES Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including liabilities relating to damage to the Cook Plant and costs of replacement power in the event of a nuclear incident at the Cook Plant. Future losses or liabilities which are not completely insured, unless allowed to be recovered through rates, could have a material adverse effect on results of operation and the financial condition of AEP, I&M and other AEP System companies. Item 3. Item 3.LEGAL PROCEEDINGS - -------------------------------------------------------------------------------- In February 1990 the Supreme Court of Indiana overturned an order of the IURC, affirmed by the Indiana Court of Appeals, which had awarded I&M the right to serve a General Motors Corporation light truck manufacturing facility located in Fort Wayne. In August 1990 the IURC issued an order transferring the right to serve the GM facility to an unaffiliated local distribution utility. In October 1990 the local distribution utility sued I&M in Indiana under a provision of Indiana law that allows the local distribution utility to seek damages equal to the gross revenues received by a utility that renders retail service in the designated service territory of another utility. On November 30, 1992, the DeKalb Circuit Court granted I&M's motion for summary judgment to dismiss the local distribution utility's complaint. The local distribution utility has begun an appeal to the Indiana Court of Appeals. I&M received revenues of approximately $29,000,000 from serving the GM facility. It is not clear whether the plaintiffs claim will be upheld on appeal because the service was rendered in accordance with an IURC order I&M believed in good faith to be valid. On April 4, 1991, then Secretary of Labor Lynn Martin announced that the U.S. Department of Labor ("DOL") had issued a total of 4,710 citations to operators of 847 coal mines who allegedly submitted respirable dust sampling cassettes that had been altered so as to remove a portion of the dust. The cassettes were submitted in compliance with DOL regulations which require systematic sampling of airborne dust in coal mines and submission of the entire cassettes (which include filters for collecting dust particulates) to the Mine Safety and Health Administration ("MSHA") for analysis. The amount of dust contained on the cassette's filter determines an operator's compliance with respirable dust standards under the law. OPCo's Meigs No. 2, Meigs No. 31, Martinka, and Windsor Coal mines received 16, 3, 15 and 2 citations, respectively. MSHA has assessed civil penalties totalling $56,900 for all these citations. OPCo's samples in question involve about 1 percent of the 2,500 air samples that OPCo submitted over a 20-month period from 1989 through 1991 to the DOL. OPCo is contesting the citations before the Federal Mine Safety and Health Review Commission. An administrative hearing was held before an administrative law judge with respect to all affected coal operators. On July 20, 1993, the administrative law judge rendered a decision in this case holding that the Secretary of Labor failed to establish that the presence of a "white center" on the dust sampling filter indicated intentional alteration. The administrative law judge has set for trial the case of an unaffiliated mine to determine if there was an intentional alteration of the dust sampling filter. All remaining cases, including the citations involving OPCo's mines, have been stayed. On September 21, 1993, CSPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Conesville Plant of the Toxic Substances Control Act and proposed a penalty of $41,000. On October 4, 1993, I&M was served with a complaint issued by Region V, Federal EPA which alleged violations by Breed Plant of the Clean Water Act and proposed a penalty of $70,000. On October 4, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by OPCo's General Service Center (Canton, Ohio) of the Toxic Substances Control Act and proposed a penalty of $24,000. Settlement discussions have been held in each of these cases and it is expected that these matters will be resolved shortly. On June 18, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Muskingum River Plant of the Toxic Substances Control Act and proposed a penalty of $87,000. In February 1994, OPCo paid a penalty of $12,185 and agreed to undertake supplemental environmental projects in 1994 valued at $61,547. On February 28, 1994, Ormet Corporation filed a complaint in the U.S. District Court, Northern District of West Virginia, against AEP, OPCo, the Service Corporation and two of its employees, Federal EPA and the Administrator of Federal EPA. Ormet is the operator of a major aluminum reduction plant in Ohio and is a customer of OPCo. See Certain Industrial Contracts. Pursuant to the Clean Air Act Amendments of 1990, OPCo received sulfur dioxide emission allowances for its Kammer Plant. See Environmental and Other Matters. Ormet's complaint seeks a declaration that it is the owner of approximately 89% of the Phase I and Phase II allowances issued for use by the Kammer Plant. OPCo believes that since it is the owner and operator of Kammer Plant and Ormet is a contract power customer, Ormet is not entitled to any of the allowances attributable to the Kammer Plant. See Item 1 for a discussion of certain environmental and rate matters. Meigs Mine--On July 11, 1993, water from an adjoining sealed and abandoned mine owned by Southern Ohio Coal Company ("SOCCo"), a mining subsidiary of OPCo, entered Meigs 31 mine, one of two mines currently being operated by SOCCo. Ohio EPA approved a plan to pump water from the mine to certain Ohio River tributaries under stringent conditions for biological and water quality monitoring and restoring the streams after pumping. On July 30, pumping commenced in accordance with the Ohio EPA approved plan. Since September 16, 1993, SOCCo has processed all water removed from the mine through its expanded treatment system and is in compliance with the effluent limitations in its water discharge permit. Pumping has removed most of the water that entered the mine on July 11 and the mine was returned to service in February 1994. On July 26, 1993, the Ohio Department of Natural Resources Division of Reclamation issued an administrative order directing SOCCo to cease pumping due to that agency's concern over possible environmental harm. On July 26, 1993, following SOCCo's appeal of the cessation order, the chairman of the Reclamation Board of Review issued a temporary stay pending a hearing by the full Reclamation Board. On January 14, 1994, the administrative proceeding was settled on the basis of agreements by the Division of Reclamation to dismiss the administrative order and by SOCCo to treat all water removed from the mine in accordance with its discharge permit and to pay certain expenses of the Division of Reclamation. On August 19, 1993, the U.S. District Court for the Southern District of Ohio granted SOCCo's motion for a preliminary injunction against the Federal Office of Surface Mining Reclamation and Enforcement ("OSM") and Federal EPA preventing them from exercising jurisdiction to issue orders to cease pumping. On August 30, 1993, the U.S. Court of Appeals for the Sixth Circuit denied OSM's motion for a stay of the District Court's preliminary injunction but granted Federal EPA's motion for a stay in part which allowed Federal EPA to investigate and make findings with respect to alleged violations of the Clean Water Act and thereafter to exercise its enforcement authority under the Clean Water Act if a violation was identified. On September 2, 1993, Federal EPA issued an administrative order requiring a partial cessation of pumping, the effect of which was delayed by Federal EPA until September 8, 1993. On September 8, 1993, the District Court granted SOCCo's motion requesting that enforcement of the Federal EPA order be stayed. On September 23, 1993, the Court of Appeals ruled that the District Court could not review the Federal EPA order in the absence of a civil enforcement action and lifted the stay. A further decision of the Court of Appeals with respect to the appeal of the preliminary injunction is pending. On January 3, 1994, the District Court held that the complaint filed by SOCCo should not be dismissed and concluded that sufficient legal and factual grounds existed for the court to consider SOCCo's claim that Federal EPA could not override Ohio EPA's authorization for SOCCo to bypass its water treatment system on an emergency basis during pumping activities. In a separate opinion, the District Court denied Federal EPA's request that the District Court defer consideration of SOCCo's motion involving a request for a Declaration of Rights with respect to the mine water releases into area streams. The West Virginia Division of Environmental Protection ("West Virginia DEP") has proposed fining SOCCo $1,800,000 for violations of West Virginia Water Quality Standards and permitting requirements alleged to have resulted from the release of mine water into the Ohio River. SOCCo is meeting with the West Virginia DEP in an attempt to resolve this matter. Although management is unable to predict what enforcement action Federal EPA or OSM may take, the resolution of the aforementioned litigation, environmental mitigation costs and mine restoration costs are not expected to have a material adverse impact on results of operations or financial condition. Item 4. Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - -------------------------------------------------------------------------------- AEP, APCO, I&M AND OPCO. None. AEGCO, CSPCO AND KEPCO. Omitted pursuant to Instruction J(2)(c). ---------------- EXECUTIVE OFFICERS OF THE REGISTRANTS AEP The following persons are, or may be deemed, executive officers of AEP. Their ages are given as of March 15, 1994. - -------- (a) All of the executive officers listed above have been employed by the Service Corporation or System companies in various capacities (AEP, as such, has no employees) during the past five years, except E. Linn Draper, Jr. who was Chairman of the Board, President and Chief Executive Officer of Gulf States Utilities Company from 1987 until 1992 when he joined AEP and the Service Corporation. All of the above officers are appointed annually for a one-year term by the board of directors of AEP, the board of directors of the Service Corporation, or both, as the case may be. APCO The names of the executive officers of APCo, the positions they hold with APCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appears below. The directors and executive officers of APCo are elected annually to serve a one-year term. - -------- (a)Positions are with APCo unless otherwise indicated. OPCO The names of the executive officers of OPCo, the positions they hold with OPCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of OPCo are elected annually to serve a one-year term. - -------- (a)Positions are with OPCo unless otherwise indicated. PART II --------------------------------------------------------------------- Item 5. Item 5.MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - -------------------------------------------------------------------------------- AEP. AEP Common Stock is traded principally on the New York Stock Exchange. The following table sets forth for the calendar periods indicated the high and low sales prices for the Common Stock as reported on the New York Stock Exchange Composite Tape and the amount of cash dividends paid per share of Common Stock. - -------- (1) See Note 5 of the Notes to the Consolidated Financial Statements of AEP for information regarding restrictions on payment of dividends. At December 31, 1993, AEP had approximately 194,000 shareholders of record. AEGCO, APCO, CSPCO, I&M, KEPCO AND OPCO. The information required by this item is not applicable as the common stock of all these companies is held solely by AEP. Item 6. Item 6.SELECTED FINANCIAL DATA - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). AEP. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). I&M. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). OPCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the AEGCo 1993 Annual Report (for the fiscal year ended December 31, 1993). AEP. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the CSPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). I&M. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the KEPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). OPCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 8. Item 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - -------------------------------------------------------------------------------- AEGCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. AEP. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. APCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. CSPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. I&M. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. KEPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. OPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. Item 9. Item 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - -------------------------------------------------------------------------------- AEGCO, AEP, APCO, CSPCO, I&M, KEPCO AND OPCO. None. PART III -------------------------------------------------------------------- Item 10. Item 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Nominees for Director and Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. APCO. The information required by this item is incorporated herein by reference to the material under Election of Directors of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. The names of the directors and executive officers of I&M, the positions they hold with I&M, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of I&M are elected annually to serve a one- year term. - -------- (a)Positions are with I&M unless otherwise indicated. (b)Dr. Draper is a director of Pacific Nuclear Systems, Inc. and Mr. Lhota is a director of Huntington Bancshares Incorporated. (c)Messrs. DeMaria, Dowd, Draper, Lhota and Maloney are directors of AEGCo, APCo, CSPCo, KEPCo and OPCo. Messrs. DeMaria, Dowd, Draper and Maloney are also directors of AEP. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under the heading Election of Directors of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. Item 11. Item 11.EXECUTIVE COMPENSATION - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Compensation of Directors, Executive Compensation and the performance graph of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. I&M Certain executive officers of I&M are employees of the Service Corporation. The salaries of these executive officers are paid by the Service Corporation and a portion of their salaries has been allocated and charged to I&M. The following table shows for 1993, 1992 and 1991 the compensation earned from all AEP System companies by (i) the chief executive officer and four other most highly compensated executive officers (as defined by regulations of the SEC) of I&M at December 31, 1993 and (ii) a chief executive officer and executive officer, both of whom retired in 1993. Summary Compensation Table - -------- (1) Reflects payments under the AEP Management Incentive Compensation Plan ("MICP") in which individuals in key management positions with AEP System companies participate. Amounts for 1993 are estimates but should not change significantly. For 1991 and 1993, these amounts included both cash paid and a portion deferred in the form of restricted stock units. These units are paid out in cash after three years based on the price of AEP Common Stock at that time. Dividend equivalents are paid during the three- year period. At December 31, 1993, Dr. Draper and Messrs. DeMaria, Maloney, Dowd and Lhota held 813, 746, 715, 593 and 639 units having a value of $30,177, $27,701, $26,526, $22,020 and $23,730, respectively, based upon a $37 1/8 per share closing price of AEP's Common Stock as reported on the New York Stock Exchange. For 1992, MICP payments were made entirely in cash. (2) Includes amounts contributed by AEP System companies under the American Electric Power System Employees Savings Plan on behalf of their employee participants. For 1993 this amount was $7,075 for Dr. Draper and Messrs. Katlic, Maloney, Dowd and Lhota and $6,000 for Mr. Disbrow and $7,006 for Mr. DeMaria. The AEP System Savings Plan is available to all employees of AEP System companies (except for employees covered by certain collective bargaining agreements) who have met minimum service requirements. Includes director's fees for AEP System companies. For 1993 these fees were: Dr. Draper, $11,105; Mr. Disbrow, $3,580; Mr. DeMaria, $10,805; Mr. Katlic, $2,300; Mr. Maloney, $10,925; Mr. Dowd, $8,685; and Mr. Lhota, $10,085. Includes payments of $93,173 and $36,077 for unused accrued vacation which Messrs. Disbrow and Katlic, respectively, received upon their retirement. (3) Dr. Draper was elected chairman of the board and chief executive officer of I&M and other AEP System companies and chairman of the board, president and chief executive officer of AEP and the Service Corporation, succeeding Mr. Disbrow, who retired, effective April 28, 1993. Retirement Benefits The American Electric Power System Retirement Plan provides pensions for all employees of AEP System companies (except for employees covered by certain collective bargaining agreements), including the executive officers of I&M. The Retirement Plan is a noncontributory defined benefit plan. The following table shows the approximate annual annuities under the Retirement Plan that would be payable to employees in certain higher salary classifications, assuming retirement at age 65 after various periods of service. The amounts shown in the table are the straight life annuities payable under the Plan without reduction for the joint and survivor annuity. Retirement benefits listed in the table are not subject to any deduction for Social Security or other offset amounts. The retirement annuity is reduced 3% per year in the case of retirement between ages 60 and 62 and further reduced 6% per year in the case of retirement between ages 55 and 60. If an employee retires after age 62, there is no reduction in the retirement annuity. PENSION PLAN TABLE Compensation upon which retirement benefits are based consists of the average of the 36 consecutive months of the employee's highest salary, as listed in the Summary Compensation Table, out of the employee's most recent 10 years of service. With respect to Messrs. Disbrow and Katlic, since they retired in 1993, the amounts of $600,000 and $316,944, respectively, are the actual salaries upon which their retirement benefits are based. Mr. Disbrow's retirement benefit was enhanced by computing his benefit based on his 1992 base salary. As of December 31, 1993, the number of full years of service credited under the Retirement Plan to each of the executive officers of I&M named in the Summary Compensation Table were as follows: Dr. Draper, 1 year; Mr. Disbrow, 39 years; Mr. DeMaria, 34 years; Mr. Katlic, 10 years; Mr. Maloney, 38 years; Mr. Dowd, 31 years; and Mr. Lhota, 29 years. Dr. Draper's employment agreement described below provides him with a supplemental retirement annuity that credits him with 24 years of service in addition to his years of service credited under the Retirement Plan less his actual pension entitlement under the Retirement Plan and any pension entitlements from prior employers. Mr. Katlic has a contract with the Service Corporation under which the Service Corporation agrees to provide him with a supplemental retirement annuity equal to the annual pension that Mr. Katlic would have received with service of 30 years under the AEP System Retirement Plan as then in effect, less his actual annual pension entitlement under the Retirement Plan. Mr. Katlic commenced receiving his supplemental annuity upon his retirement effective October 31, 1993. AEP has determined to pay supplemental retirement benefits to 23 AEP System employees (including Messrs. Disbrow, DeMaria, Maloney and Lhota) whose pensions may be adversely affected by amendments to the Retirement Plan made as a result of the Tax Reform Act of 1986. Such payments, if any, will be equal to any reduction occurring because of such amendments. Upon his retirement on April 28, 1993, Mr. Disbrow began receiving an annual supplemental benefit of $2,642. Assuming retirement of the remaining eligible employees in 1994, none would be eligible to receive supplemental benefits. AEP made available a voluntary deferred-compensation program in 1982 and 1986, which permitted certain executive employees of AEP System companies to defer receipt of a portion of their salaries. Under this program, an executive was able to defer up to 10% or 15% annually (depending on the terms of the program offered), over a four-year period, of his or her salary, and receive supplemental retirement or survivor benefit payments over a 15-year period. The amount of supplemental retirement payments received is dependent upon the amount deferred, age at the time the deferral election was made, and number of years until the executive retires. The following table sets forth, for the executive officers named in the Summary Compensation Table, the amounts of annual deferrals and, assuming retirement at age 65, annual supplemental retirement payments under the 1982 and 1986 programs. Employment Agreement Dr. Draper has a contract with AEP and the Service Corporation which provides for his employment for an initial term from no later than March 15, 1992 until March 15, 1997. Dr. Draper commenced his employment with AEP and the Service Corporation on March 1, 1992. AEP or the Service Corporation may terminate the contract at any time and, if this is done for reasons other than cause and other than as a result of Dr. Draper's death or permanent disability, the Service Corporation must pay Dr. Draper's then base salary through March 15, 1997, less any amounts received by Dr. Draper from other employment. -------------- Directors of I&M receive a fee of $100 for each meeting of the Board of Directors attended in addition to their salaries. -------------- The AEP System is an integrated electric utility system and, as a result, the member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity, transportation and handling of fuel, sales or rentals of property and interest or dividend payments on the securities held by the companies' respective parents. Item 12. Item 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. All 1,400,000 outstanding shares of Common Stock, no par value, of I&M are directly and beneficially held by AEP. Holders of the Cumulative Preferred Stock of I&M generally have no voting rights, except with respect to certain corporate actions and in the event of certain defaults in the payment of dividends on such shares. The table below shows the number of shares of AEP Common Stock that were beneficially owned, directly or indirectly, as of December 31, 1993, by each director and nominee of I&M and each of the executive officers of I&M named in the summary compensation table, and by all directors and executive officers of I&M as a group. It is based on information provided to I&M by such persons. No such person owns any shares of any series of the Cumulative Preferred Stock of I&M. Unless otherwise noted, each person has sole voting power and investment power over the number of shares of AEP Common Stock set forth opposite his name. Fractions of shares have been rounded to the nearest whole share. - -------- (a) The amounts include shares held by the trustee of the AEP Employees Savings Plan, over which directors, nominees and executive officers have voting power, but the investment/disposition power is subject to the terms of such Plan, as follows: Mr. Bailey, 550 shares; Mr. DeMaria, 2,081 shares; Mr. Disbrow, 4,027 shares; Mr. D'Onofrio, 2,889 shares; Mr. Katlic, 2,230 shares; Mr. Lhota, 5,245 shares; Mr. Maloney, 2,142 shares; Mr. Menge, 2,566 shares; Mr. Prater, 1,561 shares; Mr. Synowiec, 1,754 shares; Mr. Walters, 3,685 shares; and all directors and executive officers as a group, 33,806 shares. Messrs. Disbrow's, Dowd's and Maloney's holdings include 85 shares each; Messrs. Bailey's, DeMaria's, D'Onofrio's, Katlic's, Lhota's, Menge's, Prater's, Synowiec's, and Walter's holdings include 44, 83, 59, 60, 60, 62, 48, 53 and 45 shares, respectively; and the holdings of all directors and executive officers as a group include 738 shares, each held by the trustee of the AEP Employee Stock Ownership Plan, over which shares such persons have sole voting power, but the investment/disposition power is subject to the terms of such Plan. (b) Includes shares with respect to which such directors, nominees and executive officers share voting and investment power as follows: Mr. DeMaria, 3,624 shares; Mr. Disbrow, 283 shares; Mr. Draper, 115 shares; Mr. Lhota, 1,368 shares; Mr. Maloney, 2,000 shares; Mr. Menge, 24 shares; and all directors and executive officers as a group, 7,883 shares. Mr. DeMaria disclaims beneficial ownership of 807 shares. (c) 85,231 shares in the American Electric Power System Educational Trust Fund, over which Messrs. DeMaria, Lhota and Maloney share voting and investment power as trustees (they disclaim beneficial ownership of such shares), are not included in their individual totals, but are included in the group total. (d) Represents less than 1 percent of the total number of shares outstanding on December 31, 1993. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Item 13. Item 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------------------------------- AEP. The information required by this item is incorporated herein by reference to the material under Transactions With Management of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO, I&M AND OPCO. None. AEGCO, CSPCO, AND KEPCO. Omitted pursuant to Instruction J(2)(c). PART IV ------------------------------------------------------------------- Item 14. Item 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------------- (a) The following documents are filed as a part of this report: (b) No Reports on Form 8-K were filed during the quarter ended December 31, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. AEP Generating Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Henry Fayne *John R. Jones, III *Wm. J. Lhota *James J. Markowsky /s/ G. P. Maloney *By: ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. American Electric Power Company, Inc. By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Treasurer and March 23, 1994 - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Robert M. Duncan *Arthur G. Hansen *Lester A. Hudson, Jr. *Angus E. Peyton *Toy F. Reid *W. Ann Reynolds *Linda Gillespie Stuntz *Morris Tanenbaum *Ann Haymond Zwinger *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Appalachian Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Luke M. Feck *Wm. J. Lhota *James J. Markowsky *J. H. Vipperman *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Columbus Southern Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: Vice President, March 23, 1994 /s/ P. J. DeMaria Treasurer and - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Indiana Michigan Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *Mark A. Bailey *W. N. D'Onofrio *A. Joseph Dowd *Wm. J. Lhota *Richard C. Menge *R. E. Prater *D. B. Synowiec *W. E. Walters *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Kentucky Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *C. R. Boyle, III *A. Joseph Dowd *Wm. J. Lhota *Ronald A. Petti *By: /s/ G. P. Maloney --------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Ohio Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURES TITLE DATE ---------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) INDEX TO FINANCIAL STATEMENT SCHEDULES S-1 INDEPENDENT AUDITORS' REPORT American Electric Power Company, Inc. and Subsidiaries: We have audited the consolidated financial statements of American Electric Power Company, Inc. and its subsidiaries and the financial statements of certain of its subsidiaries, listed in Item 14 herein, as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our reports thereon dated February 22, 1994; such financial statements and reports are included in your respective 1993 Annual Report to Shareowners and are incorporated herein by reference. Our audits also included the financial statement schedules of American Electric Power Company, Inc. and its subsidiaries and of certain of its subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the respective Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the corresponding basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche Columbus, Ohio February 22, 1994 S-2 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $676,404,000 in 1993, $718,154,000 in 1992 and $733,909,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $278,435,000 in 1993, $297,460,000 in 1992 and $198,352,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 3 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-3 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-4 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Recoveries on accounts previously written off. (b)Uncollectible accounts written off. (c)Billings to others. (d)Payments and accrual adjustments. (e)Includes interest on trust funds. (f)Adjust royalty provision. S-5 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-6 AEP GENERATING COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $4,089,000 in 1993, $4,512,000 in 1992 and $3,796,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $1,038,000 in 1993, $1,830,000 in 1992 and $1,450,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-7 AEP GENERATING COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-8 AEP GENERATING COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-9 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $201,169,000 in 1993, $198,116,000 in 1992 and $196,937,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $47,254,000 in 1993, $42,926,000 in 1992 and $32,428,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-10 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-11 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments and transfers. S-12 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-13 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $97,455,000 in 1993, $80,279,000 in 1992 and $111,856,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $18,161,000 in 1993, $21,999,000 in 1992 and $19,773,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 2 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-14 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Reflects the write-off of accumulated depreciation related to a portion of the Zimmer Plant investment that was disallowed by the PUCO as discussed in Note 2 of the Notes to Consolidated Financial Statements. S-15 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-16 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-17 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $125,247,000 in 1993, $175,728,000 in 1992 and $149,187,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $61,586,000 in 1993, $25,301,000 in 1992 and $40,396,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-18 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-19 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments and accrual adjustments. (e) Includes interest on trust funds. (f) Adjust Royalty Provision. S-20 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-21 KENTUCKY POWER COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $37,808,000 in 1993, $35,203,000 in 1992 and $31,369,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $12,000,000 in 1993, $11,352,000 in 1992 and $8,092,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-22 KENTUCKY POWER COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-23 KENTUCKY POWER COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-24 KENTUCKY POWER COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-25 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $197,089,000 in 1993, $201,737,000 in 1992 and $228,500,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $128,775,000 in 1993, $191,662,000 in 1992 and $90,472,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions for other than mining assets were determined using the following composite rates for functional classes of property: The current provisions for mining assets were calculated by use of the following methods: S-26 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-27 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments. S-28 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-29 EXHIBIT INDEX Certain of the following exhibits, designated with an asterisk(*), are filed herewith. The exhibits not so designated have heretofore been filed with the Commission and, pursuant to 17 C.F.R. (S)201.24 and (S)240.12b-32, are incorporated herein by reference to the documents indicated in brackets following the descriptions of such exhibits. Exhibits, designated with a dagger (+), are management contracts or compensatory plans or arrangements required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. AEGCO E-1 AEGCO (continued) E-2 AEP++ (continued) E-3 AEP++ (continued) E-4 APCO++ (continued) E-5 APCO++ (continued) E-6 CSPCO++ (continued) E-7 I&M++ (continued) E-8 I&M++ (continued) E-9 KEPCO (continued) E-10 OPCO++ (continued) E-11 OPCO++ (continued) -------------- ++Certain instruments defining the rights of holders of long-term debt of the registrants included in the financial statements of registrants filed herewith have been omitted because the total amount of securities authorized thereunder does not exceed 10% of the total assets of registrants. The registrants hereby agree to furnish a copy of any such omitted instrument to the SEC upon request. E-12

5405_1993.txt

5405_1993

1993

5405

ITEM 1 - BUSINESS American Maize-Products Company is a Maine corporation organized in 1906 (together with its subsidiaries hereinafter referred to as "American Maize" or "the Company"). American Maize is engaged primarily in the manufacture and sale of products derived from corn wet milling, such as corn sweeteners and starches. It also manufactures and markets cigars and smokeless tobacco products. Prior to February 1993, the high fructose corn syrup component of the Company's corn wet milling business was conducted by American Fructose Corporation ("AFC"), which was organized by American Maize in 1983. In February 1993, the Company acquired all of the shares of AFC that it did not already own in exchange for 3,738,483 shares of the Company's Class A Common Stock and $30,817,495 in cash, and AFC merged with and into American Maize. On July 1, 1993 Patric J. McLaughlin became President and Chief Executive Officer of the Company following the retirement of William Ziegler, III who continues as Chairman of the Board. Mr. McLaughlin had been President and Chief Operating Officer. In October 1993, the Company's Board of Directors approved a $160,000,000 program to modernize and expand its corn wet milling plant located in Hammond, Indiana. As part of the program the grind capacity will be increased by approximately 30% and the corn syrup capacity by approximately 50%. The program is expected to be completed by mid-1996. Information required with respect to industry segments of American Maize, is hereby incorporated by reference to Note 13 of "NOTES TO CONSOLIDATED FINANCIAL STATEMENTS" in the Company's 1993 Annual Report to Shareholders, attached hereto as Exhibit 13. See "INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES" elsewhere in this report. CORN BUSINESS American Maize manufactures a number of corn-derived products by the wet milling process through its ingredients and sweetener divisions. The wet milling process involves grinding wet corn and then separating it into starch and other components; thereafter, the starch component is either dried for sale as common starch or processed further into other principal products. The Sweetener Division produces glucose corn syrups and high fructose corn syrup and the Ingredients Division makes unmodified and modified starches, corn syrup solids, maltodextrins, dextrins and cyclodextrins. Corn syrup is used in many foods and beverages for both sweetness and to provide a wide range of functionalities such as color, texture and freezability. High fructose corn syrup is primarily used by the soft drink industry as a sweetener. American Maize extracts starch from common, waxy, high amylose, and various new hybrid strains of corn. American Maize also produces modifications of these starches by chemical or physical processes to make products designed to serve the particular needs of a wide variety of food and industrial users. The Company continues to research new hybrid corn strains to develop new specialty starches which reduce or eliminate chemical usage in the modification process and for new product applications. Specialty starch products derived from waxy corn have characteristics differing from common corn starches, making them useful in many specialty applications. The Company's waxy corn based specialty starches are used as stabilizers, fillers, thickeners and extenders in such products as canned and frozen foods, pie fillings, puddings, salad dressings, baby foods, soups and snack foods. Corn syrup solids and maltodextrins are used in a variety of food applications, including dry food mixes, beverage mixes, microwaveable and convenience foods. American Maize is one of the leading dextrin suppliers in the industry. Its dextrins and industrial starches are sold to the paper, adhesives, textile and chemical industries for their sizing and adhesive properties. Significant quantities of American Maize's waxy corn starches are used as adhesives by the gummed tape industry. The Company completed the modernization of its dextrin manufacturing facility during 1993. American Maize is the largest producer of cyclodextrins in the world and the only producer in North America. Cyclodextrins are doughnut-shaped molecular structures, produced from starch, which have many food and non-food applications, including fragrance carrying, cholesterol removing, and drug delivery in the pharmaceutical industry. In 1993 American Maize completed a major expansion of its cyclodextrin facility at Hammond, Indiana. The principal by-products produced by American Maize are corn germ, corn gluten feed and corn gluten meal. Corn germ is sold for further processing into corn oil and its co-product, corn germ meal. Corn oil is used as a cooking oil and as an ingredient in salad dressings and margarine. Corn gluten feed and corn gluten meal are sold in commodities markets and directly to manufacturers of various animal feeds. Competition The corn wet milling business is highly competitive. Almost all of the Company's products compete with virtually identical or similar products and derivatives manufactured by other companies in the industry. In addition to American Maize, there are ten companies in the corn wet milling industry in the United States, most of which are larger and have greater resources than American Maize. In addition, many of American Maize's products are in competition with products made from raw materials other than corn. Corn syrup and high fructose corn syrup compete principally with cane and beet sugar. By-products compete with products of the corn dry milling industry and with soybean products. Fluctuation in the prices of these competing products may affect prices of and profits derived from the products of American Maize. The cost of producing corn products is largely dependent upon the market price of corn. As a result, American Maize's profit margins in its corn business are frequently subjected to commodity price pressures which the Company is unable to anticipate. The price of corn sweeteners (especially high fructose corn syrups) is indirectly impacted by government programs supporting sugar prices. If sugar price supports are not continued, American Maize's earnings may be adversely affected. Raw Materials Corn is the basic raw material of the corn wet milling industry, which generally processes approximately 10-15% of the annual domestic crop. The supply of domestic corn has been, and continues to be, adequate for American Maize's needs. The price of this agricultural commodity fluctuates widely as a result of a number of factors, including levels of agricultural production, market demand, livestock feeding demand, government agricultural programs and exports. Due to the competitive nature of the business and to fluctuating prices of competing products such as sugar, end-product prices may not necessarily relate to raw material costs; therefore, an increase in corn prices may adversely affect American Maize's earnings. American Maize purchases common corn in both the cash market and the corn futures market. Waxy and high amylose corn are purchased under contracts with individual farmers. General Sales of American Maize's corn products generally are highest during the spring, summer and fall, and decrease during the winter months. Sales to The Coca-Cola Company accounted for approximately 12% of American Maize's revenues in 1993 and is expected to account for greater than 10% in 1994. The Coca-Cola Company is publicly reported to control approximately 40% of the domestic soft drink industry, the principal user of 55% high fructose corn syrup. TOBACCO BUSINESS The Company manufactures and sells cigars through its wholly owned subsidiary, Swisher International, Inc. ("Swisher"). It manufactures and sells smokeless tobacco products through Swisher's wholly owned subsidiary, Helme Tobacco Company ("Helme"). Swisher is a leading producer of popular priced cigars in the United States under the "King Edward" and "Swisher Sweets" brand names. Swisher manufactures and sells mid-priced cigars under several brands including "Optimo", "El Trelles", "Santa Fe" and "Keep Moving". Swisher also sells higher priced cigars under the "Bering" brand name. Swisher markets little cigars nationally under the brand names "Swisher Sweets Little Cigars", "Swisher Sweets Lights Little Cigars", "Swisher Sweets Menthol Little Cigars" and "King Edward Little Cigars". In addition, Swisher imports and markets "Pleiades" and "Dannemann" cigars and other tobacco products including "MacBaren" pipe tobacco. Helme competes in the dry snuff, loose leaf chewing tobacco and moist snuff market segments of the smokeless tobacco industry. Since 1888, it has been a significant producer of dry snuff, the original smokeless tobacco product, which consists of finely powdered tobacco. Helme markets its dry snuffs, some of which are flavored, under a variety of brands including "Navy" and "Railroad Mills." Helme's brands represent approximately one-third of the total dry snuff market. Helme has also been in the loose leaf chewing tobacco business for many years and currently holds approximately a seven percent market share with its "Mail Pouch", "Chattanooga Chew" and "Lancaster" brands, among others. This product consists of shredded tobacco leaf which is sweetened, flavored and packaged in foil pouches. Helme has a small share of the moist snuff market with its "Silver Creek", "Gold River" and "Redwood" brands. It markets a low nicotine moist snuff under the "Cooper" brand name. In recent years, Helme began marketing to a "price-value" segment of the smokeless tobacco market with a "buy-one-get-one-free" pricing strategy for its moist snuff brands and with the sale of private label moist snuff and loose leaf chewing tobacco. Industry and Markets Unit sales in the domestic cigar industry have been in a general decline for a number of years. During this period, Swisher's large cigar sales have declined to a lesser degree than the industry trend. As a result, Swisher's percentage of this market has increased. Swisher's share of the little cigar market has grown each year since it entered this market in 1987. Swisher's share of the combined market for both large and little cigars is approximately 30%. Total industry unit sales of dry snuff and chewing tobacco have declined over the past three years while moist snuff unit sales have increased. The Company cannot predict whether these trends will continue. Swisher and Helme sell cigars and smokeless tobacco products through separate sales forces to direct buying accounts, consisting principally of tobacco distributors, grocery wholesalers and retail chains. Although each company's products are sold nationwide, the majority of Swisher's sales are concentrated in the Southeast, Southwest and Midwest, and the majority of Helme's sales are concentrated in the Southeast, Southwest and Mid-Atlantic states. A small percentage of cigar sales results from exports to the United Kingdom, other European Economic Community member countries and approximately 50 other foreign markets. Although exports represent a small percentage of sales, Swisher is the leading exporter of domestic cigars and is increasing its presence in foreign markets through licensing agreements in addition to its export activities. All of the tobacco markets in which Swisher and Helme compete are highly competitive. Sales of Swisher's and Helme's tobacco products are not dependent upon any one customer or group of customers and are not affected by seasonal selling factors in any significant degree. Raw Materials There are three tobacco components of cigars: filler, binder and wrapper. Swisher uses domestic and imported tobacco purchased through domestic sources for filler and manufactures its own binder. Swisher uses natural wrapper tobacco purchased from domestic dealers, who deal with growers and suppliers in Central America, or specially formulated structured wrapper tobacco which Swisher also manufactures. The various tobaccos used in the manufacture of Helme's smokeless tobacco products are purchased primarily in domestic markets either directly from growers or at auction from several growing areas. The supply of all the raw materials used in manufacturing Swisher's and Helme's tobacco products has been, and is expected to continue to be, adequate. However, due to consumer resistance, increases in raw material costs cannot always be passed along on a timely basis in the form of price increases for finished products. Neither Swisher nor Helme is substantially dependent upon any one supplier of raw materials and, to date, neither has experienced any significant shortage of raw materials. Trademarks and Trade Secrets Swisher and Helme market their tobacco products under numerous registered trademarks, including the brand names referred to above. These United States trademarks, which are significant to the Company's tobacco businesses, expire periodically and are renewable for additional ten year terms upon expiration. A number of these trademarks are registered in several foreign countries. Flavor formulas relating to all of the Company's tobacco products are principal assets of the Company and are maintained under strict secrecy. GENERAL The backlog of orders of American Maize and its subsidiaries estimated to be firm at December 31, 1992 and 1993 was $9,249,000 and $11,911,000, respectively. All of the backlog orders at December 31, 1993 are expected to be filled within the current fiscal year. American Maize is committed to sell some of its products under short-term (two to three months) and long-term (up to one year) contracts. Long-term commitments at December 31, 1992 and 1993, approximated $109,443,000 and $69,717,000 respectively. Long-term commitments were lower at December 31, 1993 than at December 31, 1992 due to the timing of contract negotiations. American Maize owns a number of patents, is licensed under others, and owns various registered trademarks, relating to products sold by it and processes used in its business. No one patent and no one registered trademark is considered material to the business as a whole. The day-to-day activities of American Maize are conducted through its operating divisions and subsidiaries. At December 31, 1993, the total number of persons employed by American Maize and its subsidiaries was 1,986, approximately 930 of whom are members of labor unions. Collective bargaining agreements covering approximately 90% of such employees are up for renegotiation in 1994. American Maize and certain of its subsidiaries maintain for their respective employees who are eligible, employee pension or retirement plans on a non-contributory basis, group life, temporary disability and medical insurance plans, some of which are contributory. American Maize considers its employee relations to be good. American Maize is engaged continuously in the development of new products and new applications and uses of existing products. During 1991, 1992 and 1993 the expenditures on research activities relating to the development of new products and improvements of existing products were approximately $3,373,000, $3,147,000 and $3,890,000 respectively. GOVERNMENT REGULATION General production, packaging, labeling and distribution of many of American Maize's products are subject to various laws and regulations, including regulation by the Federal Food and Drug Administration, the United States Department of Agriculture, the Federal Trade Commission, the Alcohol and Tobacco Tax Unit of the Treasury Department and by various comparable state agencies. Certain of these federal and state agencies have the power, among other things, to order the recall of products that do not meet applicable standards. In recent years, an increasing amount of legislation affecting the use and sale of tobacco products has been implemented or proposed. Federal legislation requires, among other things, that smokeless tobacco products and advertisements for such products bear one of a series of specified health warnings on a rotating basis and prohibits radio or television advertising of such products. In addition, federal, state and local regulations have been implemented or proposed that would prohibit smoking in certain areas or in certain buildings, require stronger health warnings on tobacco products, impose bans on advertising and promotion, significantly increase tobacco excise taxes, prohibit or impose restrictions on sampling of tobacco products, impose mandatory negative advertising campaigns and eliminate the tax deductions for tobacco advertising and promotional expenses. As part of its health care reform proposals submitted to Congress in 1993 the Clinton Administration has proposed significant increases in tobacco excise taxes. It is expected that these and other regulatory initiatives will continue in 1994. The Company is unable to assess the future effects these actions may have on the marketing and sale of its tobacco products. ENVIRONMENTAL MATTERS The application of federal and state regulations to protect the environment, particularly with respect to emissions into the air and wastewater discharges, may limit or prevent the operation of American Maize's businesses or may substantially increase the cost of operation and/or financing of its operations. American Maize presently spends various amounts, from time to time, for capital improvements to regulate discharges into the environment. In 1994 and 1995 the Company intends to spend approximately $20 million for wastewater treatment facilities at its Hammond, Indiana facility. See also "ITEM 3 - LEGAL PROCEEDINGS" below. ITEM 2 ITEM 2 - PROPERTIES American Maize leases its executive offices consisting of approximately 17,000 square feet of space in Stamford, Connecticut, and the offices of its Sweetener Division consisting of approximately 6,500 square feet of space in Chicago, Illinois. In 1993, the aggregate annual rental of all leased real and personal properties of American Maize and all of its subsidiaries was approximately $13,992,000 most of which represents railroad tank car leases. The Company's leases contain expiration dates ranging from 1994 to 2005. Corn Processing Facilities American Maize operates three manufacturing facilities in the corn wet milling business located in Hammond, Indiana; Decatur, Alabama; and Dimmitt, Texas. All three facilities are operated on a continuous basis except for normal maintenance. Capacity utilization of the three facilities in 1993 was approximately 90% reflecting seasonal demand variations and maintenance shutdowns. The Hammond facility, which is owned by the Company, is located on approximately 113 acres and has a grind capacity of approximately 85,000 bushels per day. For a discussion of expansion and modernization of the Hammond facility, see Item I - Business on page 1. The Decatur facility and most of its equipment are leased from the Industrial Development Board of the City of Decatur, Alabama under an Industrial Revenue Bond financing lease. The Decatur facility is located on a 33 acre site and has a grind capacity of approximately 55,000 bushels per day. The Dimmitt facility, is owned by the Company in part, and the remainder is leased from Dimmitt Agri Industries, Inc. with an option for the Company to purchase the leased premises and equipment at the end of the lease term for a nominal price. The Dimmitt facility is located on a 22 acre site and has a grind capacity of approximately 55,000 bushels per day. Additionally, there is a 410 acre parcel of undeveloped land approximately two miles from the facility which is used for disposition of processed wastewater. American Maize also owns or leases various storage and distribution facilities in various locations and leases its rail transportation equipment. Tobacco Facilities Swisher owns cigar manufacturing plants in Jacksonville, Florida (325,000 square feet) and in Waycross, Georgia (105,000 square feet). A portion of the Waycross facility is leased pursuant to an Industrial Revenue Bond financing lease. Swisher also owns virtually all of its cigar manufacturing equipment except for certain machinery which is leased on a year-to-year basis. In addition, Swisher owns a storage facility in Quincy, Florida (107,000 square feet) and a warehouse in Stoughton, Wisconsin (62,000 square feet) which are currently for sale. Helme owns, and has listed for sale, its manufacturing facility in Helmetta, New Jersey and leases another in Wheeling, West Virginia (389,000 square feet) pursuant to an Industrial Revenue Bond financing lease. During 1993 Helme completed the consolidation of the two manufacturing facilities into the Wheeling, West Virginia location and now manufactures dry snuff, moist snuff and chewing tobacco at that location. Helme also owns tobacco warehouses in Edgerton, Wisconsin; Lancaster, Pennsylvania; Brookneal, Virginia; and Hopkinsville, Kentucky. These facilities comprise an aggregate of approximately 543,000 square feet. In addition, Helme leases approximately 8,000 square feet of office space in Stamford, Connecticut, for its executive offices. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS Application of Helen Z. Steinkraus In March 1991, an agreement was entered into settling various lawsuits which concerned disputes between William Ziegler, III, Helen Z. Steinkraus, GIH Corp. and United States Trust Company of New York with respect to issues of corporate governance and management succession of the Company (the "Settlement Agreement"). Mr. Ziegler is a director and Chairman of the Board and former Chief Executive Officer of the Company. Mrs. Steinkraus, the sister of Mr. Ziegler, is the wife of William C. Steinkraus, a director of the Company. GIH Corp. is a Delaware corporation which owns a majority of the Class B Common Stock of the Company and is thereby able to elect 70% of the Board of Directors. GIH Corp., in turn, is wholly owned by a group of trusts for the benefit of Mr. Ziegler, Mrs. Steinkraus and their respective descendants and by Mr. Ziegler, Mrs. Steinkraus and members of their respective families. In December 1991, Mrs. Steinkraus commenced an action in the Surrogate's Court for New York County, New York to enforce the Settlement Agreement, alleging that the management succession and other provisions of the Settlement Agreement had been breached by Mr. Ziegler and by Donald E. McNicol, a former director of the Company and a party to the Settlement Agreement. Mr. Ziegler and Mr. McNicol have filed answers and counterclaims against Mrs. Steinkraus. The court has held hearings from time to time but has not reached a decision in the matter. During 1992 and 1993, the Company paid approximately $676,204 to reimburse the director/defendants for their legal expenses in this matter pursuant to the Company's By-laws and indemnification agreements. See discussion below under Eric M. Steinkraus v. William Ziegler, III, et al. for description of settlement discussions. Eric M. Steinkraus v. William Ziegler, III, et al. On February 20, 1992, a lawsuit was filed in Superior Court for the County of Cumberland, Maine naming as defendants five then directors of the Company (William Ziegler, III, Leslie C. Liabo, Charles B. Cook, Jr., Patric J. McLaughlin and Donald E. McNicol) and naming the Company as a nominal defendant. The complaint was filed by Eric M. Steinkraus (a son of William C. Steinkraus and Helen Z. Steinkraus). The plaintiff filed the action in the right of the Company, personally and on behalf of a class of the Company's stockholders. The complaint alleges two counts of breach of fiduciary duty and one count of common law fraud, and includes derivative and class action allegations. The charges are based on (a) allegations of deception and concealment regarding the "forcible retirement" of two directors of the Company and a proposal to sell the Company's Hammond, Indiana plant to American Fructose Corporation ("AFC"), a former subsidiary of the Company which was merged with and into the Company on February 26, 1993, (b) allegations of actions taken to prevent the election of a new president of the Company, (c) allegations of scheming and misrepresentation to cause the Company to pay fees on behalf of certain of the defendants and salaries to certain other defendants, and (d) an alleged failure to disclose what plaintiff characterizes as an unconditional offer by Archer-Daniels-Midland Company ("ADM") to purchase all of the Company's stock at a premium. The lawsuit follows settlement of various litigations brought against Mr. Ziegler and others in connection with corporate governance issues relating to the Company and alleges violations of the settlement agreement terminating those litigations, which alleged violations are the subject of the action entitled Application of Helen Z. Steinkraus described above. The lawsuit seeks damages in excess of $45,000,000 for the plaintiff class and damages in excess of $2,000,000 for the Company together with the return of various fees, salaries and benefits paid by the Company to the defendant directors and their affiliates as well as unspecified exemplary damages. On December 3, 1992 the Court dismissed the action insofar as it asserted claims in the right of the Company so that the Company is no longer a defendant. The Court also dismissed a portion of the complaint against the defendant directors and left standing the class-action claim alleging breach of fiduciary duty with respect to the alleged ADM offer. The plaintiff has filed a motion with the Court seeking permission to appeal the partial dismissal. During 1992 and 1993, the Company paid approximately $283,654 to reimburse the director/defendants for their legal expenses in this matter pursuant to the Company's By-laws and indemnification agreements. In April 1993, counsel for the parties have agreed in principle to settle this case and the lawsuit entitled Application of Helen Z. Steinkraus discussed above, subject to agreement by the parties and the Company to the terms of a definitive settlement agreement and court approvals. Under the terms of the proposed settlement, which would result in the dismissal of both cases, the parties would release each other and the Company from any claims related to the Company and would covenant not to sue each other or the Company for the next five years on any claims related to the Company. In addition, the shares of the Company held by GIH Corp., which control the election of a majority of the Company's Board of Directors, would be voted during the next five years in support of a Board having a majority of Directors who are neither employees of the Company nor members of the Steinkraus or Ziegler families. The agreement in principle also provides that the Company would pay $600,000 to reimburse plaintiffs for a portion of their legal fees. The Board of Directors of the Company approved the agreement in principle on April 28, 1993. Thus far the parties have been unable to agree on the terms of a definitive settlement agreement. Grain Processing Corporation v. American Maize-Products Company On May 12, 1981, Grain Processing Corporation ("GPC") brought a lawsuit against the Company in the United States District Court for the Northern District of Indiana alleging infringement of a patent owned by GPC relating to certain kinds of waxy starch maltodextrins. The trial court found infringement as to one small-volume product, which had been discontinued by the time of the decision. In an appeal by GPC, the Court of Appeals found that another product also had infringed, in some instances. The case was sent back to the trial court to determine how much of the accused product was infringing, to assess what damages should be paid to GPC, and to rule on GPC's claims for increased damages and attorney fees. The GPC patent expired in 1991 and has no present effect on the Company's activities. The Company has filed a motion, not yet decided, seeking a ruling that no damages should be paid for the past because the patent is invalid. GPC is contending that it should receive damages based on its lost profits on products not covered by the patent. The Company contends that if any damages are awarded, they should be based on a reasonable royalty, because GPC never sold the patented product. The law on that issue is in conflict at present. Because of the Company's undecided motion and the conflict in the law on damages, no reasonable estimate can be given at this time as to how much the Company may be required to pay when this litigation is ultimately resolved, or when that is likely to occur. Lloyd T. Whitaker v. Swisher International, Inc. On April 23, 1992, Lloyd T. Whitaker, the trustee in bankruptcy for Olympia Holding Corporation a/k/a P-I-E Nationwide, Inc. ("Olympia") commenced a lawsuit in United States Bankruptcy Court for the Middle District of Florida against Swisher seeking recovery of freight charges that allegedly should have been paid under tariffs filed with the Interstate Commerce Commission ("ICC"). Actual amounts paid were pursuant to a separate lower tariff filed with the ICC which the trustee claims is unlawful. The trustee seeks recovery of approximately $973,000 plus interest on behalf of Olympia for past shipments. In September, 1993, the court ruled in a similar case that the trustee does not have standing to challenge the lower tariff. Swisher believes that it has meritorious defenses to plaintiff's claims, and is contesting this litigation vigorously. U.S. v. The Sanitary District of Hammond, et al. On August 2, 1993, the United States, on behalf of the U.S. Environmental Protection Agency (EPA), filed a civil action against the Company, four other industrial companies and four municipalities for alleged violations of the Clean Water Act and the Rivers and Harbors Act. The issue in the suit involves discharges of industrial and municipal wastewater by the defendants into the sewage treatment facilities of the City of Hammond, Indiana and from there into the Grand Calumet River. The Government is seeking civil penalties in an unspecified amount for alleged violations of discharge permit limitations, injunctive relief to require compliance with permit terms, and, from the Company and the other industrial defendants and the City of Hammond, additional injunctive relief requiring the development and implementation of a plan to remediate allegedly contaminated sediments in the Grand Calumet River. The Company does not believe that its discharges have caused or contributed to any sedimentation problem in the Grand Calumet River, and it has already taken measures to ensure continued compliance with the terms of its discharge permits. The Company intends to contest the Government's allegations vigorously. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None EXECUTIVE OFFICERS OF THE COMPANY Name Age Office William Ziegler, III (1) 65 Chairman of the Board Patric J. McLaughlin (1) 48 President and Chief Executive Officer Cynthia Z. Brighton 34 Secretary Robert A. Britton 47 Vice President, Treasurer and Assistant Secretary Jane E. Downey 43 Vice President - Human Resources Thomas H. Fisher 47 Director of Taxes Edmond G. Herve, Jr. 44 Controller Charles A. Koons 50 Vice President - Corporate Development and Planning Edward P. Norris 53 Vice President and Chief Financial Officer Robert M. Stephan 51 Vice President, General Counsel and Assistant Secretary _____________________________ (1) Member of Board of Directors and its Executive Committee The Company's Executive Officers do not have a fixed term of office; they serve at the pleasure of the Board of Directors. Messrs. Britton, Herve, Fisher, Koons and Norris have served in their respective capacities with the Company for more than the past five years. Mr. Ziegler retired as Chief Executive Officer effective July 1, 1993 and remains Chairman of the Board of Directors; prior thereto he served as Chairman and Chief Executive Officer since 1976. Mr. McLaughlin was elected President and Chief Executive Officer of the Company effective July 1, 1993; prior thereto he served as President and Chief Operating Officer (1992-1993) and President of the Corn Processing Division (1984-1992). Mrs. Brighton was elected Secretary of the Company in April, 1992; prior thereto she served as Assistant Secretary since 1983, and Secretary of American Fructose Corporation, a former subsidiary of the Company, since 1986. Mrs. Brighton is the daughter of Mr. Ziegler. Ms. Downey was elected Vice President - Human Resources of the Company effective August 1, 1993; prior thereto she served as Vice President - Human Resources of the Corn Processing Division (1988-1993). Mr. Stephan was elected Vice President and General Counsel of the Company in April 1992, following a one-month period during which he served as Vice President and Associate General Counsel; prior thereto he served as Vice President, General Counsel and Secretary of Erbamont N.V. since 1983. PART II Item 5 Item 5 - MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) Market Information. Information required with respect to this Item 5 (a) is hereby incorporated by reference to information under "Stock Price and Dividend Review" on page 21 of the Company's 1993 Annual report to security holders, attached hereto as Exhibit "13". (b) Holders. Information required with respect to this Item 5 (b) is hereby incorporated by reference to information under "Stock Price and Dividend Review" on page 21 of the Company's 1993 Annual Report to security holders, attached hereto as Exhibit "13". (c) Dividends. During 1992 and 1993, the Company declared and paid a quarterly dividend of $.16 per share on its Class A Common Stock and Class B Common Stock. Other information required with respect to this Item 5 (c) is hereby incorporated by reference to the Company's 1993 Annual Report to security holders, attached hereto as Exhibit "13", as follows: (i) With respect to dividend history, see "Five-Year Summary of Selected Financial Data" on page 20. (ii) With respect to restrictions on the payment of dividends, see Note 4 of "Notes to Consolidated Financial Statements" on page 27. Item 6 Item 6 - SELECTED FINANCIAL DATA Information required with respect to this Item 6 is hereby incorporated by reference to information under "Five-Year Summary of Selected Financial Data" on page 20 of the Company's 1993 Annual Report to security holders, attached hereto as Exhibit "13". Item 7 Item 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information required with respect to this Item 7 is hereby incorporated by reference to material under "Financial Review" on page 15 of the Company's 1993 Annual Report to security holders, attached hereto as Exhibit "13". Item 8 Item 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information required with respect to this Item 8 is hereby incorporated by reference to the applicable sections in the Company's 1993 Annual Report to security holders, attached hereto as Exhibit "13". See Financial Statements Incorporated by Reference under "Index to Consolidated Financial Statements and Financial Statement Schedules" elsewhere in this report. Item 9 Item 9 - CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY Information required by this Item 10 with respect to the directors of Company is hereby incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation l4A promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, which proxy statement is anticipated to be filed within 120 days after the end of the Company's fiscal year ended December 31, 1993. With respect to information regarding executive officers of the Company, see pages 15-16 of this report. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION Information required by this Item 11 is hereby incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation l4A promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, which proxy statement is anticipated to be filed within 120 days after the end of the Company's fiscal year ended December 31, 1993. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this Item 12 is hereby incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation l4A promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, which proxy statement is anticipated to be filed within 120 days after the end of the Company's fiscal year ended December 31, 1993. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this Item 13 is hereby incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation l4A promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, which proxy statement is anticipated to be filed within 120 days after the end of the Company's fiscal year ended December 31, 1993. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) and (2) See "Consolidated Financial Statements and Schedules" elsewhere in this report. (a)(3) Exhibits Regulation S-K Exhibit No.: 2. -- The Amended and Restated Agreement and Plan of Merger, dated as of December 15, 1992, by and between the Company and AFC attached as Annex A to the Joint Proxy Statement/Prospectus forming a part of the Company's registration statement on Form S-4 (File No. 33-55946), is incorporated herein by reference. 3.(a) -- The Restated Articles of Incorporation of the Company, as amended through February 26, 1993, filed as Exhibit "3.(a)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244), is incorporated herein by reference. (b) -- By-Laws, as amended to February 24, 1993, filed as Exhibit "3.(b)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244), is incorporated herein by reference. 4.(a) -- A specimen copy of the certificates for the Company's Class A Common Stock, par value $.80 per share, filed as Exhibit "4.3" to the Company's registration statement on Form S-4 (File No. 33-55946), is incorporated herein by reference. (b) -- A specimen copy of the certificates for the Company's Class B Common Stock, par value $.80 per share, filed as Exhibit "4.(b)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244), is incorporated herein by reference. (c) -- Note Agreement dated as of March 3, 1993 among the Company and each Purchaser in the Private Placement of the Company's 7.875% Senior Notes due March 3, 2003, filed as Exhibit "4.(g)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244), is incorporated herein by reference. 10.(a)-- Supplemental Pension Program, filed as Exhibit "10.(f)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244), is incorporated herein by reference. (b) -- Unfunded Supplemental Pension Plan Trust Agreement relating to Item 10.(a) above, filed as Exhibit "10.(g)" to the Company's From 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244) is incorporated herein by reference. (c) -- Funded Supplemental Pension Plan Trust Agreement relating to Item 10.(a) above, filed as Exhibit "10.(h)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244), is incorporated herein by reference. (d) -- Deferred Compensation Plan, filed as Exhibit "10." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1981 (File No. 1-6244), is incorporated herein by reference. (e) -- Executive Life Insurance Program summary, filed as Exhibit "10.(j)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244), is incorporated herein by reference. (f) -- Pertinent provisions of Incentive Compensation Program, filed as Exhibit "11." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1981 (File No. 1-6244), is incorporated herein by reference. (g) -- American Maize-Products Company Directors Retirement Benefit Plan, filed as Exhibit "10.(l)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244), is incorporated herein by reference. (h) -- The 1976 Stock Option Plan, as amended November 24, l981, filed as Exhibit "12." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, l981 (File No. 1-6244), is incorporated herein by reference. (i) -- The 1985 Stock Option Plan, filed as Exhibit "5." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1985 (File No. 1-6244), is incorporated herein by reference. (j) -- The 1985 Stock Option Plan, as amended, filed as Exhibit "4.(f)" to the Company's registration statement on Form S-8 on July 7, 1988 (File No. 33-22943), is incorporated herein by reference. (k) -- Lease between Harbor Plaza Associates, Landlord, and the Company, Tenant, relating to the offices located at 41 Harbor Plaza Drive (presently known as 250 Harbor Drive), Stamford, Connecticut, filed as Exhibit "13." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, l981 (File No. 1-6244), is incorporated herein by reference. (l) -- Services Agreement dated February 1, 1973 between Dimmitt Agri Industries, Inc. and Amstar Corporation, filed as Exhibit "10.1(a)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244), is incorporated herein by reference. (m) -- Assignment of Services Agreement dated November 28, 1984 among Amstar Corporation, Dimmitt Operating Inc. and Dimmitt Agri Industries, Inc., filed as Exhibit "10.1(e)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244), is incorporated herein by reference. (n) -- Letter Amendments dated August 24, 1977, November 24, 1980 and November 18, 1982 in connection with Exhibit "10(m)" above, filed as Exhibits "10.1(b)," "10.1(c)" and "10.1(d)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244), are incorporated herein by reference. (o) -- Lease Agreement dated as of February 1, 1973 between Dimmitt Agri Industries, Inc. and Amstar Corporation, filed as Exhibit "10.2(a)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244), is incorporated herein by reference. (p) -- Assignment of Lease Agreement dated November 28, 1984 among Amstar Corporation, Dimmitt Operating Inc., Dimmitt Agri Industries, Inc. and Texas Bank for Cooperatives filed as Exhibit "10.2(b)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244), is incorporated herein by reference. (q) -- Credit Agreement dated as of July 1, 1991 among the Company, the signatory lenders thereto, and The Bank of New York, as agent, filed as Exhibit "10.(a)" to the Company's Form 10-Q Quarterly Report for the quarterly period ended September 30, 1991 (File No. 1-6244), is incorporated herein by reference. (r) -- Guaranty dated as of July 1, 1991 made by Jno. H. Swisher & Son, Inc., to The Bank of New York, as Agent, and the signatory lenders under the Credit Agreement referenced in Item 10.(q) above, filed as Exhibit "10.(b)" to the Company's Form 10-Q Quarterly Report for the quarterly period ended September 30, 1991 (File No. 1-6244), is incorporated herein by reference. (s) -- Guaranty dated as of July 1, 1991 made by Helme Tobacco Company to The Bank of New York, as agent, and the signatory lenders under the Credit Agreement referenced in Item 10.(q) above, filed as Exhibit "10.(c)" to the Company's Form 10-Q Quarterly Report for the quarterly period ended September 30, 1991 (File No. 1-6244), is incorporated herein by reference. (t) -- Agreement dated as of March 1, 1991 among William Ziegler, III, Helen Z. Steinkraus, GIH Corp., Donald E. McNicol and the trustees of certain trusts for the benefit of Mr. Ziegler and his issue and the trustees of certain trusts for the benefit of Mrs. Steinkraus and her issue, filed as Exhibit "10.(a)" to the Company's Form 8-K Current Report dated March 29, 1991 (File No. 1-6244), is incorporated herein by reference. (u) -- Amendment No. 1 dated as of March 14, 1991, to Item 10.(t) above, filed as Exhibit "10.(b)" to the Company's Form 8-K Current Report dated March 29, 1991 (File No. 1-6244), is incorporated herein by reference. (v) -- Stockholders Agreement dated as of March 1, 1991 among William Ziegler, III, Helen Z. Steinkraus, certain trusts for the benefit of Mr. Ziegler and his issue and certain trusts for the benefit of Mrs. Steinkraus and her issue, filed as Exhibit "10.(c)" to the Company's Form 8-K Current Report dated March 29, 1991 (File No. 1-6244), is incorporated herein by reference. (w) -- Amendment No. 1 dated as of July 1, 1992, to Item 10.(q) above, filed as Exhibit "10.(w)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244), is incorporated herein by reference. (x) -- Consent and Amendment No. 2 dated as of March 3, 1993, to Item 10.(q) above, filed as Exhibit "10.(x)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244), is incorporated herein by reference. (y) -- Amendment effective April 24, 1992 to the 1985 Stock Option Plan, as amended, filed as Exhibit "10.(bb)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244), is incorporated herein by reference. (z) -- Consent and Amendment No. 3 dated as of July 19, 1993, to Item 10.(q) above, is attached hereto as Exhibit "10.(z)". (aa) -- Consent No. 4 and Waiver to the Credit Agreement dated as of March 4, 1994, to Item 10.(q) above, is attached hereto as Exhibit "10.(aa)". (bb) -- The American Fructose Corporation 1986 Stock Option Plan, assumed by the Company pursuant to the merger of American Fructose Corporation with and into the Company on February 26, 1993, filed on July 14, 1986 on Form S-8 (File No. 33-7062), is incorporated herein by reference. (cc) -- Employment Agreement dated as of July 1, 1993 between the Company and Patric J. McLaughlin is attached hereto as Exhibit "10.(cc)". (dd) -- Promissory Note dated April 29, 1993 in the amount of $150,000 of Patric J. McLaughlin in favor of the Company is attached hereto as Exhibit "10.(dd)". 11.(a)-- Calculation of Primary Earnings Per Share for the fiscal years ended December 31, 1993, 1992 and 1991 inclusive is attached hereto as Exhibit "11.(a)". 11.(b)-- Calculation of Fully-Diluted Earnings Per Share for the fiscal years ended December 31, 1993, 1992 and 1991 inclusive is attached hereto as Exhibit "11.(b)". 13. -- 1993 Annual Report to security holders of the Company, is attached hereto as Exhibit "13". 21. -- Subsidiaries of the Company as of December 31, 1993 is attached hereto as Exhibit "21.". 23. -- Consent of Coopers & Lybrand, dated March 25, 1994, is attached hereto as Exhibit "23.". (b) Reports on Form 8-K No report on Form 8-K was filed during the last quarter of the fiscal year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AMERICAN MAIZE-PRODUCTS COMPANY (Company) March 18, 1994 By Edward P. Norris ________________________________________ Edward P. Norris, 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. March 18, 1994 By William Ziegler, III ________________________________________ William Ziegler, III, Chairman of the Board and Director March 18, 1994 By Patric J. McLaughlin ________________________________________ Patric J. McLaughlin, President and Chief Executive Officer and Director (Principal Executive Officer) March 18, 1994 By Leslie C. Liabo ________________________________________ Leslie C. Liabo, Director March 18, 1994 By Charles B. Cook, Jr. ________________________________________ Charles B. Cook, Jr., Director March 18, 1994 By Paul F. Engler ________________________________________ Paul F. Engler, Director March 18, 1994 By James E. Harwood ________________________________________ James E. Harwood, Director March 18, 1994 By John R. Kennedy ________________________________________ John R. Kennedy, Director March 18, 1994 By C. Alan MacDonald ________________________________________ C. Alan MacDonald, Director March 18, 1994 By H. Barclay Morley ________________________________________ H. Barclay Morley, Director March 18, 1994 By William L. Rudkin ________________________________________ William L. Rudkin, Director March 18, 1994 By Wendell M. Smith ________________________________________ Wendell M. Smith, Director March 18, 1994 By William C. Steinkraus ________________________________________ William C. Steinkraus, Director March 18, 1994 By Raymond S. Troubh ________________________________________ Raymond S. Troubh, Director March 18, 1994 By Edward P. Norris ________________________________________ Edward P. Norris, Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) SECURITITES AND EXCHANGE COMMISSION Washington, D.C. 20549 __________ FORM 10-K ANNUAL REPORT __________ CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES for the years ended December 31, 1993, 1992 and 1991 __________ AMERICAN MAIZE-PRODUCTS COMPANY __________ AMERICAN MAIZE-PRODUCTS COMPANY AND ITS SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Consolidated Financial Statements Incorporated by Reference The consolidated financial statements of American Maize-Products Company and its subsidiaries and the Report of Independent Accountants related thereto are incorporated herein by reference to the Company's 1993 Annual Report to shareholders (Exhibit 13), which Exhibit is not "filed" as a part of this Form 10-K except for the consolidated financial statements and notes thereto and Report of Independent Accountants on pages 21 through 36 thereof and certain other information incorporated elsewhere herein. Consolidated Financial Statements and Financial Statement Schedules: Page Report of Independent Accountants Financial Statement Schedules: II. Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other Than Related Parties V. Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 VI. Accumulated Depreciation of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 VIII. Valuation and Qualifying Accounts and Reserves 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 Financial Statement Schedules Omitted Financial Statement Schedules other than those listed above are omitted because they are not required or are not applicable or that the required information is presented in the consolidated financial statements or notes thereto. Columns omitted from financial statement schedules filed have been omitted because the information is not applicable. Any other information omitted from the financial statement schedules filed has been omitted due to immateriality. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders, American Maize-Products Company: Our report on the consolidated financial statements of American Maize-Products Company has been incorporated by reference in this Form 10-K from the 1993 Annual Report to security holders of American Maize-Products Company (Exhibit 13), and appears on page 21 therein. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the accompanying index on page of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND One Canterbury Green Stamford, Connecticut February 22, 1994. AMERICAN MAIZE-PRODUCTS COMPANY AND ITS SUBSIDIARIES 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 (In thousands) AMERICAN MAIZE-PRODUCTS COMPANY AND ITS SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT For the years ended December 31, 1993, 1992 and 1991 (In thousands) AMERICAN MAIZE-PRODUCTS COMPANY AND ITS SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION of PROPERTY, PLANT AND EQUIPMENT For the years ended December 31, 1993, 1992 and 1991 (In thousands) Col A. Col B. Col C. Col. D. Col. E. Col. F. Additions Balance at Charged to Other Balance at Beginning Costs and Changes Add End of Description of Period Expenses Retirements (Deduct) Period December 31, 1993: (A) Buildings and $ 25,691 $ 3,964 $ 2,481 $ (2,101)(B) $ 25,073 improvements Machinery and equipment 185,078 26,319 2,878 (52,999)(B) 155,520 $210,769 $30,283 $ 5,359 $ (55,100) $ 180,593 December 31, 1992:(A) Buildings and improvements $ 23,881 $ 2,646 $ 836 $ - $ 25,691 Machinery and equipment 171,934 22,796 9,652 - 185,078 $195,815 $25,442 $10,488 $ - $ 210,769 December 31, 1991:(A) Buildings and improvements $ 21,321 $ 2,569 $ 9 $ - $ 23,881 Machinery and equipment 152,010 22,601 2,677 - 171,934 $173,331 $25,170 $ 2,686 $ - $ 195,815 Note: (A) Buildings and improvements and machinery and equipment are depreciated over their useful lives, generally on the straight-line method. Assets recorded under capital leases are amortized over the lease term or, if title ultimately passes to the Company, over the estimated useful lives. Depreciation is based on the following useful lives: Buildings and improvements, 3 to 45 years; machinery and equipment, 3 to 20 years. (B) In connection with the merger of American Fructose Corporation with and into the Company, the accumulated depreciation relating to the assets held by the minority interest were eliminated. /TABLE AMERICAN MAIZE-PRODUCTS COMPANY AND ITS SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES For the years ended December 31, 1993, 1992 and 1991 (In thousands) Col A. Col B. Col C. Col. D. Col. E. Additions Balance at Charged to Beginning Costs and Balance at Description of Period Expenses Deductions End of Period For the year ended December 31, 1993: Allowance for doubtful accounts $2,109 $1,979 $ 479(A) $3,609 For the year ended December 31, 1992: Allowance for doubtful accounts $1,600 $ 895 $ 386(A) $2,109 For the year ended December 31, 1991: Allowance for doubtful accounts $3,237 $ 553 $2,190(B) $1,600 _________________________ Notes: (A) Doubtful accounts written off. (B) Doubtful accounts written off during the year including $2,000,000 related to certain accounts of a discontinued international sales and trading company business. /TABLE AMERICAN MAIZE-PRODUCTS COMPANY AND ITS SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION For the years ended December 31, 1993, 1992 and 1991 (In thousands) Col. A Col. B Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $24,515 $24,529 $24,553 Taxes, other than payroll and income taxes: Federal excise $10,099 $ 8,247 $ 8,131 Other 5,947 6,348 5,619 $16,046 $14,595 $13,750 INDEX TO EXHIBITS Sequential Regulation S-K Page Exhibit No: Exhibit Number 2. -- The Amended and Restated Agreement * and Plan of Merger, dated as of December 15, 1992, by and between the Company and AFC attached as Annex A to the Joint Proxy Statement/Prospectus forming a part of the Company's registration statement on Form S-4 (File No. 33-55946). 3.(a)-- The Restated Articles of Incorporation of * the Company, as amended through February 26, 1993, filed as Exhibit "3.(a)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244). (b)-- By-Laws, as amended to February 24, 1993, * filed as Exhibit "3.(b)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244). 4.(a)-- A specimen copy of the certificates for the * Company's Class A Common Stock, par value $.80 per share, filed as Exhibit "4.3" to the Company's registration statement on Form S-4 (File No. 33-55946). (b)-- A specimen copy of the certificates for the * Company's Class B Common Stock, par value $.80 per share, filed as Exhibit "4.(b)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244). (c)-- Note Agreement dated as of March 3, 1993 * among the Company and each Purchaser in the Private Placement of the Company's 7.875% Senior Notes due March 3, 2003, filed as Exhibit "4.(g)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244). 10.(a)-- Supplemental Pension Program, filed as * Exhibit "10.(f)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244). (b)-- Unfunded Supplemental Pension Plan Trust * Agreement relating to Item 10.(a) above, filed as Exhibit "10.(g)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244). (c)-- Funded Supplemental Pension Plan Trust * Agreement relating to Item 10.(a) above, filed as Exhibit "10.(h)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244). (d)-- Deferred Compensation Plan, filed as * Exhibit "10." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1981 (File No. 1-6244). (e)-- Executive Life Insurance Program summary, * filed as Exhibit "10.(j)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244). (f)-- Pertinent provisions of Incentive * Compensation Program, filed as Exhibit "11." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1981 (File No. 1-6244). (g)-- American Maize-Products Company Directors * Retirement Benefit Plan, filed as Exhibit "10.(l)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1991 (File No. 1-6244). (h)-- The 1976 Stock Option Plan, as amended * November 24, 1981, filed as Exhibit "12." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1981 (File No. 1-6244). (i)-- The 1985 Stock Option Plan, filed as * Exhibit "5." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1985 (File No. 1-6244). (j)-- The 1985 Stock Option Plan, as * amended, filed as Exhibit "4.(f)" to the Company's registration statement on Form S-8 on July 7, 1988 (File No. 33-22943). (k)-- Lease between Harbor Plaza Associates, * Landlord, and the Company, Tenant, relating to the offices located at 41 Harbor Plaza Drive (presently known as 250 Harbor Drive), Stamford, Connecticut, filed as Exhibit "13." to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1981 (File No. 1-6244). (l)-- Services Agreement dated February 1, 1973 * between Dimmitt Agri Industries, Inc. and Amstar Corporation, filed as Exhibit "10.1(a)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244). (m)-- Assignment of Services Agreement dated * November 28, 1984 among Amstar Corporation, Dimmitt Operating Inc. and Dimmitt Agri Industries, Inc., filed as Exhibit "10.1(e)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244). (n)-- Letter Amendments dated August 24, 1977, * November 24, 1980 and November 18, 1982 in connection with Exhibit "10(m)" above, filed as Exhibits "10.1(b)," "10.1(c)" and "10.1(d)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244). (o)-- Lease Agreement dated as of February 1, * 1973 between Dimmitt Agri Industries, Inc. and Amstar Corporation, filed as Exhibit "10.2(a)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244). (p)-- Assignment of Lease Agreement dated * November 28, 1984 among Amstar Corporation, Dimmitt Operating Inc., Dimmitt Agri Industries, Inc. and Texas Bank for Cooperatives filed as Exhibit "10.2(b)" to the Company's Form 8-K Current Report on December 13, 1984 (File No. 1-6244). (q)-- Credit Agreement dated as of July 1, 1991 * among the Company, the signatory lenders thereto, and The Bank of New York, as agent, filed as Exhibit "10.(a)" to the Company's Form 10-Q Quarterly Report for the quarterly period ended September 30, 1991 File No. 1-6244). (r)-- Guaranty dated as of July 1, 1991 made by * Jno. H. Swisher & Son, Inc., to The Bank of New York, as Agent, and the signatory lenders under the Credit Agreement referenced in Item 10.(q) above, filed as Exhibit "10.(b)" to the Company's Form 10-Q Quarterly Report for the quarterly period ended September 30, 1991 (File No. 1-6244). (s)-- Guaranty dated as of July 1, 1991 made by * Helme Tobacco Company to The Bank of New York, as agent, and the signatory lenders under the Credit Agreement referenced in Item 10.(q) above, filed as Exhibit "10.(c)" to the Company's Form 10-Q Quarterly Report for the quarterly period ended September 30, 1991 (File No. 1-6244). (t)-- Agreement dated as of March 1, 1991 * among William Ziegler, III, Helen Z. Steinkraus, GIH Corp., Donald E. McNicol and the trustees of certain trusts for the benefit of Mr. Ziegler and his issue and the trustees of certain trusts for the benefit of Mrs. Steinkraus and her issue, filed as Exhibit "10.(a)" to the Company's Form 8-K Current Report dated March 29, 1991 (File No. 1-6244). (u)-- Amendment No. 1 dated as of March 14, * 1991, to Item 10.(t) above, filed as Exhibit "10.(b)" to the Company's Form 8-K Current Report dated March 29, 1991 (File No. 1-6244). (v)-- Stockholders Agreement dated as of * March 1, 1991 among William Ziegler, III, Helen Z. Steinkraus, certain trusts for the benefit of Mr. Ziegler and his issue and certain trusts for the benefit of Mrs. Steinkraus and her issue, filed as Exhibit "10.(c)" to the Company's Form 8-K Current Report dated March 29, 1991 (File No. 1-6244). (w)-- Amendment No. 1 dated as of July 1, 1992, * to Item 10.(q) above, filed as Exhibit "10.(w)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244). (x)-- Consent and Amendment No. 2 dated as of March 3, 1993, to Item 10.(q) above, filed as Exhibit "10.(x)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244). (y)-- Amendment effective April 24, 1992 to the * 1985 Stock Option Plan, as amended, filed as Exhibit "10.(bb)" to the Company's Form 10-K Annual Report for the fiscal year ended December 31, 1992 (File No. 1-6244). (z)-- Consent and Amendment No. 3 dated as of July 19, 1993, to Item 10.(q) above, is attached hereto as Exhibit "10.(z)". (aa)-- Consent No. 4 and Waiver to the Credit Agreement dated as of March 4, 1994, to Item 10.(q) above, is attached hereto as Exhibit "10.(aa)". (bb))-- The American Fructose Corporation 1986 * Stock Option Plan, assumed by the Company pursuant to the merger of American Fructose Corporation with and into the Company on February 26, 1993, filed on July 14, 1986 on Form S-8 (File No. 33-7062). (cc)-- Employment Agreement dated as of July 1, 1993 between the Company and Patric J. McLaughlin is attached hereto as Exhibit "10.(cc)". (dd)-- Promissory Note dated April 29, 1993 in the amount of $150,000 of Patric J. McLaughlin in favor of the Company is attached hereto as Exhibit "10.(dd)". 11.(a)-- Calculation of Primary Earnings Per Share for the fiscal years ended December 31, 1993, 1992 and 1991 inclusive is attached hereto as Exhibit "11.(a)". 11.(b)-- Calculation of Fully-Diluted Earnings Per Share for the fiscal years ended December 31, 1993, 1992 and 1991 inclusive is attached hereto as Exhibit "11.(b)". 13. -- 1993 Annual Report to security holders of the Company is attached hereto as Exhibit "13". 21. -- Subsidiaries of the Company as of December 31, 1993 is attached hereto as Exhibit "21.". 23. -- Consent of Coopers & Lybrand, dated March 25, 1994, is attached hereto as Exhibit "23.". __________________ * Incorporated by Reference. The Company will make the foregoing exhibits available upon request upon payment of a charge of $.25 per page and postage. Requests should be addressed to the Secretary, American Maize- Products Company, P.O. Box 10128, 250 Harbor Drive, Stamford, CT 06904.

60251_1993.txt

60251_1993

1993

60251

ITEM 1. BUSINESS THE COMPANY: Long Island Lighting Company (the "Company") was incorporated in 1910 under the Transportation Corporations Law of the State of New York and supplies electric and gas service in Nassau and Suffolk Counties and to the Rockaway Peninsula in Queens County, all on Long Island, New York. The mailing address of the Company is 175 East Old Country Road, Hicksville, New York 11801 and its general telephone number is (516) 755-6650. TERRITORY: The Company's service territory covers an area of approximately 1,230 square miles. The population of the service area, according to the Company's 1993 estimate, is about 2.7 million persons, including approximately 98,000 persons who reside in Queens County within the City of New York. The 1993 population estimate reflects a .14% increase since the 1990 census. Approximately 80% of all workers residing in Nassau and Suffolk Counties are employed within the two counties. In 1993, total non-agricultural employment in Nassau and Suffolk Counties increased by approximately 5,200 employees, an employment increase of 0.5%. The area served is predominantly residential, but the Company receives approximately one-half of its electric revenues from commercial and industrial customers. Although electronics and aerospace are the largest manufacturing industries in the area, about 88% of total employment is non-manufacturing. Industrialization is gradually increasing in Suffolk County which, with three times the land area, has only one-third the population density of Nassau County. SEGMENTS OF BUSINESS: The percentages of total revenues and operating income before income taxes derived from electric and gas operations for each of the last three years are shown in the following table: - --------------- * Before income taxes. - --------------- For additional information respecting the Company's electric and gas financial results and operations, see "Management's Discussion and Analysis of Financial Condition and Results of Operations for the Year Ended December 31, 1993" and "Selected Financial Data" and Notes 2, 3, and 11 of Notes to Financial Statements for the Year Ended December 31, 1993. EMPLOYEES: The Company has approximately 6,300 full-time employees, of which approximately 2,500 belong to Local 1049 and approximately 1,500 belong to Local 1381 of the International Brotherhood of Electrical Workers ("A.F.L.-C.I.O."). On February 6, 1992, the Company and the unions agreed upon contracts which will expire on February 13, 1996. REGULATION AND ACCOUNTING CONTROLS: The Company is subject to regulation by the Public Service Commission of the State of New York (the "PSC") with respect to rates, issuance and sale of securities, adequacy and continuance of service, safety and siting of certain facilities, accounting, conservation of energy, management effectiveness and other matters. To ensure that its accounting controls and procedures are consistently maintained, the Company has created a program which is monitoring those controls and procedures. The Audit Committee of the Company's Board of Directors, as part of its responsibilities, periodically reviews this monitoring program. New York law requires that all utilities be periodically audited to identify those aspects of their operations, if any, which are in need of improvement. A comprehensive management audit report was issued by the PSC in March 1993. The audit report favorably recognized many of the initiatives the Company is taking, including its efforts to improve customer service and control costs while changing the basic culture and orientation of employees. The report also contains constructive recommendations for improving the effectiveness of the Company's overall management. During 1993, the PSC also completed an audit of the Company Customer Service Incentives Program and of the practices for provision and management of legal services. The Company is also subject, in certain of its activities, including accounting, to the jurisdiction of the United States Department of Energy ("DOE") and the Federal Energy Regulatory Commission ("FERC"). In addition to its accounting jurisdiction, FERC has jurisdiction over the rates the Company may charge for the sale of electric energy for resale in interstate commerce, including the rates the Company charges for electricity sold to municipal electric systems within the Company's territory, and for the transmission, through the Company's system, of electric energy to other utilities or to industrial customers. FERC also has some jurisdiction over a portion of the Company's gas supplies and substantial jurisdiction over transportation to the Company of its gas supplies. Operation of Nine Mile Point Nuclear Power Station, Unit 2 ("Nine Mile Point 2"), a nuclear facility in which the Company has an 18% interest, is subject to regulation by the Nuclear Regulatory Commission ("NRC"). ELECTRIC OPERATIONS: General The Company's system energy requirements are supplied from sources located both on and off Long Island. Company-owned generating facilities with an aggregate summer generating capability of approximately 4,251,000 kilowatts ("kW") include five steam electric generating stations and a number of internal combustion and diesel supplemental generating units, all located on Long Island, and the Company's 18% share of Nine Mile Point 2, a nuclear generating station located in upstate New York. Generating facilities owned by others, such as independent power producers and cogenerators located on Long Island and investor-owned and public electric systems located off Long Island, provide the balance of the Company's energy supplies. In the years between 1982 and 1991, the Company purchased between 13% to 25% of its power requirements from others. In 1992, purchased power increased to 38%. In 1993, the amount of power purchased from others amounted to 41%. In 1992 and 1993, cogenerators and independent power producers provided 9.4% of the Company's system requirements for each of those years. During 1995, after the 136 MW Holtsville facility owned by the New York Power Authority ("NYPA") is completed in early 1994 and the new 40 MW cogeneration facility at the Stony Brook campus of the State University of New York ("Stony Brook")is completed in early 1995, independent power producers and cogenerators will provide an estimated 13.7% of the Company's system energy requirements. For information about a 300 MW cogeneration facility that is the subject of litigation, see the discussion about Mayflower Energy Partners, L.P. ("Mayflower") under the heading "Energy Sources -- Independent Power Producers and Cogenerators." The Company does not expect any new major independent power producers to be built on Long Island in the foreseeable future for several reasons. Under federal law, the Company is required to buy energy from qualified producers at the Company's avoided costs. Current long-range avoided cost estimates for the Company have significantly reduced the economic advantage to entrepreneurs seeking to compete with the Company and with existing independent power producers. Also, with the Company's load being 45% residential, 52% commercial and industrial and 3% other sales, and with approximately 200 MW of net capacity from independent power producers and cogenerators already installed on Long Island, the market for additional large electric projects to provide power to the Company's remaining commercial and industrial customers is small. The following table indicates the 1993 summer capacity of the Company's major generating stations and internal combustion units as reported to the New York Power Pool ("NYPP") in December 1993: The maximum demand on the Company's system to date was 3,967,000 kW on July 9, 1993, representing 83% of its total available capacity of 4,799,000 kW on that day, which included 548,000 kW of firm capacity purchased from other sources. By agreement with the NYPP, the Company is required to maintain, on a monthly basis, an installed and contracted firm power reserve generating capacity equal to at least 18% of its actual peak load. The Company is currently meeting this NYPP requirement. System Requirements and Reliability The Company's current electric load forecasts indicate that, with continued implementation of its conservation and load management programs and with the availability of electricity provided by the Company's existing generating facilities, by its portion of nuclear energy generated at NMP2 and by power purchased from other electric systems and from certain non- Company-owned facilities, located within the Company's service territory, Long Island has adequate generating sources to meet its energy demands through the end of the century. System kWh energy requirements in 1993 were 2.6% higher than in 1992 and .5% higher than in 1988. The compound annual growth rate for the five-year period ended December 31, 1993 was .1%. As a result of the implementation of conservation programs and the availability to customers of energy supplies from cogeneration sources discussed below under the heading "Independent Power Producers and Cogenerators," the Company forecasts a 0.7% and 1.7% decrease, relative to the year 1993, in system energy requirements for the years 1994 and 1995, respectively. However, for the period 1993-2003, the Company forecasts an average annual growth rate in system energy requirements of .6%. The Company's system electric requirements for the last three years were provided as follows: Percentage of System Requirements - --------------- * Generated on the Company's own system. Oil consumption for the Company's system electric energy requirements in 1993 was 9.7 million barrels compared to 10.7 million barrels in 1992. Certain units may be fired with natural gas when it is available on an economic or as-required basis. Gas consumption for the Company's system electric energy requirements in 1993 was 36.3 million dekatherms compared to 34.5 million dekatherms in 1992. ** Generated at Nine Mile Point 2. *** Generated at (i) more economical nuclear, coal, oil and hydroelectric units owned by other electric systems and transmitted to the Company over its interconnections and (ii) cogenerators and independent power producers located within the Company's service territory. - --------------- Energy Sources Oil: Oil is the principal fuel burned in the Company's electric generating stations. In recent years, the Company has been able to reduce its oil requirements by burning natural gas, by using nuclear energy generated at Nine Mile Point 2 and by purchasing power from other systems, cogenerators and independent power producers. The availability and cost of oil used by the Company are affected by factors beyond its control such as the international oil market, environmental regulations, conservation measures and the availability of alternative fuels. However, any changes in oil costs are reflected in rates charged to the Company's customers. The Company's fuel oil is supplied principally by five suppliers, no one of which normally provides more than one-half of the total requirements. For information concerning federal and other regulatory environmental limitations on fuel oil burned by the Company, see "Environment -- Air." For additional information concerning the recovery of fuel oil costs, see Note 1 to Notes to Financial Statements for the Year Ended December 31, 1993. Gas: In addition to burning oil, several of the Company's generating stations have the capability of burning natural gas. These dual-fired units enable the Company to burn the most cost efficient fuel and to reduce its dependency on oil. Nuclear: The Company holds an 18% interest in Nine Mile Point 2, a 1,047 megawatt ("MW") nuclear generating unit near Oswego, New York. The cotenants of Nine Mile Point 2, in addition to the Company, are Niagara Mohawk Power Corporation ("Niagara Mohawk"), New York State Electric & Gas Corporation ("NYSEG"), Rochester Gas and Electric Corporation ("RG&E") and Central Hudson Gas & Electric Corporation. For additional information on Nine Mile Point 2 and nuclear plant insurance, see Notes 5 and 9, respectively, of Notes to Financial Statements for the Year Ended December 31, 1993. Independent Power Producers and Cogenerators: Independent power producers and cogenerators located within the Company's service territory provided approximately 200 MW of power to the Company, the equivalent of approximately 9.4% of the Company's energy requirements in 1993. Capacity from these sources is expected to reach 340 MW by the summer of 1994. The Company has also entered into contracts for approximately 50 MW of power from various projects under construction on an energy-only basis, including the Stony Brook project. The Company has also signed contracts for energy-only purchases totaling over 400 MW from several projects that are not expected to be built prior to the expiration date of these contracts, December 31, 1994. In addition, the Company was ordered by the PSC to enter into a contract, which it executed under protest, with Mayflower to purchase, on an energy-only basis, power for 15 years from a 300 MW facility scheduled to begin commercial operation in 1995. On December 30, 1993, the Appellate Division, Third Department, of the New York Supreme Court, affirmed the Supreme Court of the State of New York Special Term's decision that had annulled the PSC order requiring the Company to enter into the agreement with Mayflower (Long Island Lighting Company v. Public Service Commission of the State of New York and Mayflower Energy Partners, L.P.). In the Special Term decision, the court held that the PSC had violated the federal Public Utility Regulatory Policies Act ("PURPA") and the New York Public Service Law, and had acted arbitrarily when it ordered the Company to sign a power purchase contract with Mayflower incorporating the PSC's 1989 Long Run Avoided Cost estimates. The Third Judicial Department affirmed the Special Term's decision, finding that the PSC-determined rates were not just and reasonable as required under PURPA and the New York Public Service Law. Interconnections: Five interconnections allow for the transfer of electricity between the Company and members of the NYPP and the New England Power Pool. Energy from these sources is transmitted pursuant to transmission agreements with Niagara Mohawk, NYPA and Consolidated Edison Company of New York, Inc. ("Con Edison") and displaces energy which would otherwise be generated on the Company's system with higher cost fuel oil. The capacity of these interconnections is utilized for (i) the requirements of Con Edison, a co-owner with the Company of three of these interconnections, (ii) the requirements on Long Island of NYPA, the owner of one of these interconnections, (iii) the transmission of the Company's share of power from Nine Mile Point 2 and (iv) the Company's purchases from NYPA and other utilities. Conservation Services: The Company's 1993 Electric Conservation and Load Management Plan called for a cumulative 194 MW reduction in coincident peak demand by December 31, 1993 and a cumulative annualized energy savings of 578 gigawatthours ("GWh"). The Company has met these targets with an expenditure of $33.5 million. These reductions were achieved through several different program types including customer education/information rebate, audit and direct installation which targeted a number of energy efficient technologies. In the fourth quarter of 1993, the Company filed a Modified Demand Side Management ("DSM") Plan with the PSC to support the objectives of the Company's December 31, 1993 electric filing. For additional information, see the discussion under the heading, "1989 Settlement and Electric Rates--Electric Rates." Under this modified plan, which includes a substantially lower budget than the one approved for 1994, a greater emphasis will be placed on the educational aspect of the Company's conservation efforts in lieu of the conventional reliance on rebates. This will help to shift the responsibility for adopting and implementing energy efficient practices away from the utility and to the customer. In addition, to control DSM costs further, the Company will promote financing programs and look to foster cost sharing relationships with manufacturers of energy efficient appliances. 1989 Settlement and Electric Rates General: On February 28, 1989, the Company and the State of New York (by its Governor) entered into an agreement (the "1989 Settlement") settling certain issues relating to the Company and providing for, among other matters, the transfer of the Shoreham Nuclear Power Station ("Shoreham") to the Long Island Power Authority ("LIPA"), Shoreham's subsequent decommissioning and the return of the Company to financial health. For additional information respecting the 1989 Settlement, see the discussion under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations for the Year Ended December 31, 1993" and Note 2 of Notes to Financial Statements for the Year Ended December 31, 1993. The Rate Moderation Agreement: The Rate Moderation Agreement ("RMA"), a constituent document of the 1989 Settlement approved by the PSC, created an asset known as the Financial Resource Asset (the "FRA") and provides for its full recovery. The FRA has two components, the Base Financial Component (the "BFC") and the Rate Moderation Component (the "RMC"). The RMA, by its terms, specifies that the FRA was created to provide the Company with adequate financial indicia to restore the Company's debt securities to investment grade levels as determined by independent rating agencies. The BFC, as initially established, represented the present value of the future net-after-tax cash flows which the RMA provided the Company for its financial recovery. The BFC was granted rate base treatment under the terms of the RMA, similar to other plant investments, and is included in the Company's electric rates through an amortization over 40 years on a straight-line basis. At December 31, 1993, the BFC amounted to $3.6 billion. The RMC reflects the difference between the Company's revenue requirements under conventional ratemaking and the revenues resulting from the implementation of the rate moderation plan provided for in the RMA. This revenue difference, together with a carrying charge equal to the allowed rate of return on rate base, has been deferred. The RMC has provided the Company with a substantial amount of non-cash earnings since the effective date of the 1989 Settlement through December 31, 1992, because the revenues provided under the RMA were less than the revenues required under conventional ratemaking. The RMC balance was $652 million at December 31, 1992. During 1993, however, as revenues provided under the RMA began to exceed the revenues that would have been provided under conventional ratemaking, the RMC balance began to decline. Thus, at December 31, 1993, the RMC balance was $610 million. The Company has no reason to believe that the PSC will fail to continue to honor its commitments, contained in the RMA, respecting the recovery of the FRA and other 1989 Settlement-deferred charges. This belief is based, in part, upon the PSC's actions granting the Company six of the 11 electric rate increases contemplated by the RMA, discussed below, and, in part, upon the PSC's publicly confirmed commitment to the effectuation of the 1989 Settlement. Those actions have been consistent with provisions of the RMA regarding the establishment and recovery from ratepayers of the FRA and other 1989 Settlement-deferred charges provided by the RMA. For additional information respecting the RMA, the BFC and the RMC, see Notes 1, 2 and 3 of Notes to Financial Statements for the Year Ended December 31, 1993. Electric Rates: The RMA contemplated, among other objectives, a series of rate increases designed to restore the Company to financial health. Pursuant to the RMA, the Company received electric rate increases of 5.4% effective February 18, 1989 and 5.0% for each of the rate years that began on December 1, 1989 and December 1, 1990. In 1991, the PSC approved annual electric rate increases of 4.15%, 4.1% and 4.0% to be effective on December 1 of 1991, 1992 and 1993, respectively. On December 31, 1993, the Company filed a three-year electric rate plan with the PSC for the period beginning December 1, 1994, that minimizes future electric rate increases while retaining consistency with the RMA's objective of continuing the restoration of the Company's financial health. The filing proposes no base electric rate increases in years one and two of the plan and an overall increase of 4.3% in the third year. The Company's electric rate plan filing is subject to PSC approval. Although base electric rates would be frozen during the first two years of the plan, annual rate increases of 1% in the first year and 2% in the second year are expected to result in these years from the operation of the Company's fuel cost adjustment clause ("FCA"). The FCA captures, among other amounts, any increases in the cost of fuel above the level recovered in base rates and, under the rate mechanisms that have been in effect since 1991, a portion of (i) earned incentives and (ii) variances in actual versus forecasted electric revenues and certain cost components occurring in prior periods. The Company's proposed electric rate plan provides for lower annual electric rate increases than were originally anticipated under the 1989 Settlement. However, as a result of changes in certain assumptions upon which the RMA was based, their impact on the RMC and the Company's plans to reduce DSM, operations, maintenance and capital expenditures, the Company has determined that the overall objectives of the RMA can be met under the proposed multi-year plan described in the preceding paragraph. Because of lower inflation rates, interest costs, property taxes, fuel costs and return on common equity allowed by the PSC, the RMC, which originally had been anticipated to peak at $1.2 billion in 1994, has already peaked at $652 million in 1992. With the exception of an increase in 1995-1996, which is not now projected to cause the RMC to increase above its $652 million peak, the RMC is expected to decline until it is fully amortized. The actual length of the period over which the RMC is to be amortized will depend on the extent to which the assumptions underlying the rate plan materialize. While the proposed electric rate plan may extend the recovery period for the RMC by one but not more than three years, the Company's current projections indicate that the RMC will be recovered in a period of approximately 11 years that began on July 1, 1989. On November 2, 1993, the New York State Consumer Protection Board and the Long Island Power Authority ("CPB/LIPA") filed a Petition with the PSC asking the PSC to hold a proceeding on freezing or possibly reducing the Company's electric rates for the period December 1994 to November 1997. In written comments filed on January 12, 1994 in response to the CPB/LIPA Petition, LILCO urged the PSC to reject the Petition and consider the CPB/LIPA's issues in the proceeding that has been established regarding the Company's three-year rate application. Staff of the Department of Public Service filed a response urging the PSC to reject the Petition and consider these issues in the Company's current electric rate proceeding. The Attorney General for New York State also filed comments that urge the PSC to conduct a full investigation of the Company's rates in the course of the current proceeding concerning its proposed electric rate plan. For additional information respecting electric rate increases, see Note 3 of Notes to Financial Statements for the Year Ended December 31, 1993. GAS OPERATIONS: General In 1993, recognizing the growing importance of its gas operations and the dynamic changes then anticipated as a result of proceedings before FERC to deregulate the transportation of natural gas, the Company established its gas operations as a separate corporate business unit. During 1993, the Company's gas business unit focused on two areas: one, continuing its marketing efforts on Long Island and two, seeking opportunities in the newly de-regulated national natural gas market. Gas System Requirements At year-end 1993, the Company had a total of 445,830 firm gas customers, compared to 441,580 at year-end 1992, and 436,352 at year-end 1991. Of the 1993 year-end total, 269,994 were space heating customers. Total sales in 1993 were 59,182,674 dekatherms ("Dth"), compared to 56,292,131 Dth in 1992. The maximum daily firm demand experience on the Company's gas system in 1993 was 485,896 Dth on December 26, 1993; the prior maximum daily firm demand of 466,517 Dth was on February 1, 1993. Accompanied by unusually cold weather, seven new maximum daily firm demand records came in early 1994 -- the highest being 585,227 Dth on January 19, 1994. The forecasted maximum daily firm gas demand for the 1993-94 winter season (November 1 - March 31) was 577,900 Dth, representing 85% of the Company's maximum daily firm operating supply capability of 682,284 Dth for this period. This forecast was exceeded in January 1994. Based on the forecasted maximum daily firm gas demand, the Company should have a peak day surplus of 77,057 Dth of firm supply including peak shaving capability for the 1993-94 winter season. The Company recovers the costs of its gas supply from both its firm and interruptible customers through provisions in the Company's rate schedules. Continuing its recent efforts to expand the base of customers across which its fixed costs can be absorbed, the Company is emphasizing residential and commercial gas marketing. In particular, new market segments and new uses for natural gas are being sought. The technology for natural gas vehicles ("NGVs") is becoming commercially viable, and the Company is working internally and with customers to put NGVs on the road. For example, the Metropolitan Suburban Bus Authority ("MSBA"), a subsidiary corporation of the Metropolitan Transportation Authority principally serving Nassau County, has installed a natural gas compression station and is operating ten dedicated NGVs. MSBA anticipates purchasing more than 200 buses fueled by compressed natural gas over the next five years. Gas Transportation and Supply The proceedings before FERC, developing out of its Order No. 636, have resulted in a regulatory "unbundling" of the gas supply, transportation and storage services that for decades had been provided by the nation's natural gas pipelines. In the past, local distribution companies ("LDCs") have purchased their gas supplies at the citygate from those pipelines serving their territories. The citygate is generally the location where the interstate pipeline meets the local distribution company's system. The Company shares common citygate facilities, known as the New York Facilities, with Con Ed and the Brooklyn Union Gas Company. The Company's principal pipelines have been Transcontinental Gas Pipe Line Corporation ("Transcontinental"), Texas Eastern Transmission Corporation ("Texas Eastern"), CNG Transmission Corporation ("CNG"), Tennessee Gas Pipeline Company ("Tennessee") and, beginning in early 1992, the Iroquois Gas Transmission System ("Iroquois"). Through two wholly-owned subsidiaries, the Company is a general partner in Iroquois, with an equity share of 1%, and in the Liberty Pipeline Company ("Liberty"), with an equity share of 3-1/3%. With respect to Liberty, proceedings for authority to construct and operate are now pending before FERC. Under FERC Order No. 636, pipelines, for the most part, no longer act as sales agents to bundle the mix of services from the producers and other interstate pipelines. LDCs must now make arrangements for gas supplies and gas storage directly with producers, marketers and the owners of storage facilities. In addition, each LDC must now also make separate transportation arrangements with each pipeline in the path between the supplier and the LDC's citygate and not merely with the nearest pipeline connecting to the LDC's system. This fundamental change in the way LDCs conduct their activities has affected the reliability, pricing and diversification of their natural gas supplies. Gas Transportation: The Company's gas transportation capacity for meeting its 1993-94 winter season requirements is provided from a portfolio of year-round, winter seasonal and storage services summarized below: Year-Round Pipeline Firm Transportation: The Company has 303,692 Dth per day of year- round pipeline firm transportation capacity from four interstate pipeline companies: Transcontinental, Texas Eastern, Tennessee and Iroquois. For the winter 1993-1994 season, options on 60,000 Dth per day of capacity have been granted to off-system markets leaving a total of 243,692 Dth available to meet system peak-day requirements. Winter Seasonal Pipeline Firm Transportation: The Company has winter seasonal pipeline firm transportation capacity on Transcontinental amounting to 2,726 Dth per day. This incremental capacity is available through March 31, 1994. Storage: The Company also has long-term firm storage services to meet higher winter demand which provide a total operating supply of approximately 287,839 Dth per day with a total capacity of 22,692,363 Dth for the winter period. Of these totals, 277,589 Dth per day, or a total capacity of 21,455,363 Dth, is provided by a gas storage field at Leidy, Pennsylvania, and 10,250 Dth per day, or a total capacity of 1,237,000 Dth for the winter period is provided by a gas storage field in upstate New York operated by Honeoye Storage Corporation, in which the Company has a 23-1/3% equity interest. In addition, the Company has the right to request 812,500 Dth in the winter period from a cogeneration facility with the obligation to return quantities in kind during the following summer period. The Company also contracts for storage capacity in a facility in the Gulf Coast near sources of supply and pipeline transportation. Up to 50,687 Dth per day can be withdrawn with a total of 4,459,220 Dth of storage capacity in the Washington storage facility in Louisiana. While this facility provides the Company with greater security of supply and enhanced operational flexibility in meeting peak-day requirements, the Company has no related firm pipeline transportation agreement for these supplies. Therefore, to take gas from this storage, the Company must curtail the transportation of some of its firm contract supply. Gas Supply: The Company's gas supplies for the 1993-94 winter season are provided from a portfolio of year-round, winter seasonal, storage and peak shaving supplies summarized below. Year-Round Firm Supply: Of the 213,469 Dth of firm supplies, 83,575 Dth are Canadian and 129,894 Dth are domestic. The Company is a 2.7% equity owner of Boundary Gas, Inc., ("Boundary"), a corporation formed with 15 other gas utility companies to act as a purchasing agent for the importation of natural gas from Canada. The Company obtains 2,470 Dth per day of its long-term firm Canadian supply from this source. Gas supplies to use 90,223 Dth per day of the remaining year-round pipeline firm transportation capacity are purchased by the Company in both the seasonal and monthly spot markets. Winter Seasonal Firm Supply: The Company also contracts for firm seasonal supply of 90,223 Dth delivered during the five winter months each year from a number of winter seasonal suppliers. Peak Shaving: The Company has its own peak shaving supplies to meet its requirements on excessively cold winter days. This includes a liquefied natural gas plant with a storage capacity of approximately 620,000 Dth of gas and vaporization facilities which provide 103,300 Dth per day to the peak-day capability of the Company's system. In addition, the Company has propane facilities that produce 17,400 Dth per day of peak shaving with a storage capacity of approximately 100,000 Dth. Gas Rates In December 1993, the PSC approved a three-year gas rate settlement between the Company and the Staff of the PSC. The gas rate settlement provides that the Company receives, for each of the rate years beginning December 1, 1993, 1994 and 1995, annual gas rate increases of 4.7%, 3.8% and 2.8%, respectively. In the determination of the revenue requirements for the first year of the gas rate settlement, an allowed rate of return on equity of 10.1% was used. The gas rate decision also provides for earnings in excess of a 10.6% return on equity in any of the three rate years covered by the settlement, to be shared equally between the Company's firm gas customers and its shareowners. In November 1992, the PSC approved a gas rate increase of 7.1%, or $35.7 million annually, effective December 1, 1992, with an allowed return on common equity from gas operations of 11.0%. In November 1991, the Company received a gas rate increase of 4.1% effective December 1, 1991. Non-Regulated Activities The unbundling of gas transportation activities and the need for local distribution companies to negotiate directly with producers and other suppliers and with pipelines has provided the Company with new business opportunities. These new opportunities include providing gas to non- traditional markets including LDCs and end-users from Mississippi to Connecticut. In addition, the Company has formed a wholly-owned subsidiary, Northeast Gas Marketers, Inc. ("NGMI"), to broker natural gas in the unregulated market. The Company is presently awaiting PSC authorization to fund up to $20 million of NGMI's unregulated gas brokering activities. Recovery of Transition Costs Transition costs are the costs associated with unbundling the pipelines' merchant services in compliance with FERC Order No. 636. They include pipelines' unrecovered gas costs and the costs that pipelines incur as a result of reforming or terminating their gas supply contracts. In order to recover transition costs, pipelines must demonstrate to FERC (i) that such costs were attributable to FERC Order No. 636 and (ii) that they were prudently incurred. While the Company is challenging, on both eligibility and prudence grounds, its pipelines' efforts to recover their claimed transition costs, the Company presently estimates that it could be charged as much as $14 million in transition costs by several of its pipelines. The Company will seek permission from the PSC to recover these costs from its gas customers. ENVIRONMENT: General The Company is subject to federal, state and local laws and regulations dealing with air and water quality and other environmental matters. It is not possible to ascertain with certainty if or when the various required governmental approvals for which applications have been made will be issued, whether, except as noted below, additional facilities or modifications of existing or planned facilities will be required or, generally, what effect existing or future controls may have upon Company operations. Except as set forth herein below, no material proceedings have been commenced or, to the knowledge of the Company, are contemplated by any federal, state or local agency against the Company, nor is the Company a defendant in any material litigation with respect to any matter relating to the protection of the environment. In 1994 and 1995, the Company anticipates expenditures of $12.5 million and $4.1 million, respectively, for environmental projects including projects described below for emission monitoring requirements and nitrogen oxide ("NOx") reduction requirements. Air Federal, state and local regulations affecting new and existing electric generating plants govern, among other emissions, sulfur dioxide and NOx and, in the future, hazardous air pollutants. The laws governing the sulfur content, by weight, of the fuel oil being burned by the Company in compliance with the United States Environmental Protection Agency ("EPA")-approved Air Quality State Implementation Plan ("SIP") are administered by the New York State Department of Environmental Conservation ("DEC"). The Company does not expect to incur any costs to satisfy amendments to the Clean Air Act with respect to the reduction of sulfur dioxide emissions, since the Company already uses fuel with acceptable low levels of sulfur. The Company expects that it will have to expend $4.3 million in 1994 to meet continuous emission monitoring requirements and $3.5 million in 1994 and $2.0 million in 1995 to meet Phase I NOx reduction requirements. In addition, subject to requirements that are expected to appear in regulations that have not yet been issued, the Company estimates that it may be required to expend as much as $125 million by May 1999 to meet Phase II NOx reduction requirements and approximately $50 million by 2000 to meet requirements for the control of hazardous air pollutants from power plants. Water Under the federal Clean Water Act and the New York State Environmental Conservation Law, the Company is required to obtain a State Pollutant Discharge Elimination System permit to make any discharge into the waters of the United States or New York State. The DEC has the jurisdiction to issue those permits and their renewals and has issued permits for the Company's existing generating units. The permits allow the continued use of the existing circulating water systems which have been determined to be in compliance with State Water Quality Standards. The permits also allow for the continued use of the existing chemical treatment systems. Land The Company is the owner of six pieces of property on which the Company or certain of its predecessor companies produced manufactured gas. The Company has investigated two of these sites for possible environmental contamination caused by these prior operations and plans to submit the findings to the appropriate regulatory agencies in 1994. The Company's clean-up costs, if any, cannot be determined until the remediation alternatives have been reviewed by the regulatory agencies and negotiations with them have been completed. The Company will conduct similar investigations of the remaining four sites over the next several years. The Company cannot determine the costs of remediation for these four sites until the investigations have been completed and the results reviewed by the appropriate regulatory agencies. The costs for the remediation of these sites are not expected to have a material impact on the Company's financial condition. The Company and nine other potentially responsible parties ("PRPs") have entered into an Administrative Order by Consent ("Consent Order") with the EPA to complete a Remedial Investigation and Feasibility Study ("RI/FS") for a site in Philadelphia, Pennsylvania, operated by a company known as Metal Bank of America, to which the EPA alleges that the Company shipped scrap transformers, possibly containing polychlorinated biphenyls. The RI/FS, which will be completed in 1994, will assess the nature and extent of site contamination and will suggest cleanup alternatives. The amount of the Company's liability, if any, which may be joint and several if imposed, cannot be ascertained until the EPA has selected a remedy from among the cleanup alternatives. The Company has notified the appropriate insurers but no lawsuit has been commenced. The EPA has conducted a thorough, unannounced inspection of the Company's hazardous waste Treatment Storage and Disposal Facility ("TSDF"). The inspection focused on compliance with hazardous waste management regulations. The EPA subsequently issued a Complaint and Compliance Order which noted several deficiencies, primarily related to permit modifications and minor operational issues, and proposed a $29,000 civil penalty. The Company has protested the amount of the penalty. The EPA also issued a letter requesting additional information on the Company's TSDF operations to which the Company has responded. Nuclear Waste Niagara Mohawk, on behalf of the NMP2 cotenants, entered into a contract with the Department of Energy ("DOE") for the permanent storage of NMP2 spent nuclear fuel. Under that contract, the NMP2 cotenants are currently paying DOE a user-fee of one-mil per kilowatthour of net nuclear generation. The Company is collecting its portion of the user-fee from the Company's ratepayers. Under the federal Low Level Radioactive Waste Policy Amendment Act of 1985, New York was required, by January 1, 1993, to have arranged for the disposal of all low level, radioactive waste generated within the state or, in the alternative, contracted for the disposal of waste at an operating facility outside the state. Failure to do so would require New York to either (1) take title to and possession of, and assume all liability for, all waste generated in the state or (2) forfeit to the generators of waste in the state the rebate of a portion of the surcharges paid by such generators for the disposal of waste at operating facilities outside the state. New York has entered into a contract with the State of South Carolina for the disposal of all low level radioactive waste (except mixed wastes) through June 1994. The Company can provide no assurance as to what disposal arrangements, if any, New York will have in place after that date if New York fails to make other waste disposal arrangements. The Company may incur additional costs for temporary storage of NMP2-generated waste at the NMP2 site. The Company expects that its costs to dispose of low level radioactive waste, including any surcharges or penalties, in an amount yet undetermined, will be recovered in electric rates. Moreover, under the Amended and Restated Asset Transfer Agreement, discussed below, LIPA is responsible for the disposal of waste associated with the decommissioning of Shoreham, although such costs will be paid by the Company and recovered through electric rates. THE COMPANY'S SECURITIES: General The Company's securities are rated by Moody's Investors Service, Inc. ("Moody's"), Standard and Poor's Corporation ("S&P"), Fitch Investors Service, Inc. ("Fitch") and Duff and Phelps, Inc. ("D&P"). The Company's securities are rated as follows: * - Secured by Letters of Credit. NR - Not rated. - --------------- The G&R Mortgage The Company's General and Refunding Indenture dated June 1, 1975 (the "G&R Indenture" or "G&R Mortgage") is a lien upon substantially all of the Company's properties. The lien of the G&R Mortgage, which is currently subordinate to the lien of the Company's Indenture of Mortgage and Deed of Trust dated September 1, 1951 (the "Indenture of Mortgage" or "First Mortgage"), will become the Company's most senior mortgage in 1997, the year in which the last of the currently outstanding non- pledged First Mortgage Bonds matures. Outstanding at December 31, 1993 were approximately $1.7 billion of General and Refunding Bonds (the "G&R Bonds") and $125 million of First Mortgage Bonds, excluding $1.0 billion of First Mortgage Bonds (the "Pledged Bonds") which are pledged with the G&R Trustee as additional security for the G&R Bonds. Additional information concerning the Company's G&R Mortgage and the First Mortgage is discussed below and in Note 7 of Notes to Financial Statements for the Year Ended December 31, 1993. Under the G&R Mortgage, the Company may issue G&R Bonds on the basis of either matured or redeemed G&R Bonds and First Mortgage Bonds (other than Pledged Bonds) or on the basis of the Bondable Value of Property Additions ("BVPA"). Generally, when issuing G&R Bonds, the Company must satisfy a mortgage interest coverage requirement (the "G&R Mortgage Interest Coverage"). The G&R Mortgage Interest Coverage requires that the Net Earnings available for interest for any 12 consecutive calendar months within the 15 consecutive calendar months preceding the issuance of the G&R Bonds must be equal to at least two times the stated annual interest payable on outstanding G&R Bonds and Prior Lien Bonds (other than Pledged Bonds), including any new G&R Bonds. Under the G&R Mortgage Interest Coverage, the Company would currently be able to issue approximately $4.3 billion of additional G&R Bonds based upon: (i) earnings for the 12 months ended December 31, 1993 and (ii) an assumed interest rate of 9% for such additional G&R Bonds. A change of 1/8 of 1% in the assumed interest rate of such G&R Bonds would result in a change of approximately $58.6 million in the amount of such G&R Bonds that the Company could issue. Currently, the Company is able to issue G&R Bonds only on the basis of matured or redeemed G&R Bonds and First Mortgage Bonds (other than Pledged Bonds). The maximum amount of additional G&R Bonds which the Company is able to issue on this basis is approximately $683 million. The Company is currently unable to issue G&R Bonds on the basis of the BVPA because it is required to recognize, for purposes of the G&R Mortgage, a "deficit" in the BVPA of approximately $202 million as of December 31, 1993. As the Company continues to make capital improvements to its system (i.e., add Property Additions), this deficit will be reduced at an estimated rate of approximately $250 million each year. The existence of the deficit in the BVPA does not require that any outstanding G&R Bonds be retired or that the deficit be eliminated by deposits of cash or retired G&R Bonds or First Mortgage Bonds. The Company expects this deficit to be eliminated prior to 1995. G&R Bonds are, however, subject to retirement through the normal operation of the G&R Sinking and Maintenance Funds or through maturities. The Company believes that, based upon currently scheduled redemptions and maturities, it will have sufficient retired G&R Bonds and First Mortgage Bonds for the foreseeable future to satisfy the requirements of the G&R Sinking Fund or to withdraw with retired G&R Bonds and First Mortgage Bonds any cash that may be deposited to satisfy the Sinking Fund requirements. The Sinking Fund requires the Company to pay $24 million or to certify a like amount of retired G&R Bonds and First Mortgage Bonds on or before June 30, 1994. The Company is planning to satisfy this requirement in 1994 with retired G&R Bonds. In addition, subsequent to 1994, when the Company expects that Property Additions will again become available for the various purposes contemplated by the G&R Mortgage, the Company may elect to use such Property Additions either to issue G&R Bonds or to satisfy the G&R Sinking Fund requirements. The Maintenance Fund covenant under the G&R Mortgage requires that the aggregate amount of Property Additions added subsequent to December 31, 1974 must be, as of the end of each calendar year subsequent to 1974, at least equal to the cumulative Provision for Depreciation (as defined in the G&R Mortgage) from December 31, 1974. The G&R Mortgage requires cash (or retired G&R Bonds or retired First Mortgage Bonds) to be deposited to satisfy the Maintenance Fund requirements only when such cumulative Provision for Depreciation exceeds such aggregate amount of Property Additions. As of December 31, 1993, the amount of such cumulative Property Additions calculated pursuant to the G&R Mortgage was approximately $9.4 billion, including approximately $5.5 billion of Property Additions attributable to Shoreham. Also, as of December 31, 1993, the amount of the cumulative Provision for Depreciation, similarly calculated, was approximately $1.4 billion. The Company anticipates that the aggregate amount of Property Additions will continue to exceed the cumulative Provision for Depreciation. The First Mortgage Under the provisions of the G&R Mortgage, the Company may not issue any additional bonds under the Company's First Mortgage other than Pledged Bonds which are required, concurrently with the issuance of each new series of G&R Bonds, to be deposited with the G&R Trustee. The issuance of any such Pledged Bonds does not create additional indebtedness. The coverage requirements of the First Mortgage and the Company's ability to issue additional Pledged Bonds do not restrict the Company's ability to issue additional G&R Bonds. Of the approximately $1.2 billion of First Mortgage Bonds outstanding at December 31, 1993, $1.0 billion, or 89%, were Pledged Bonds. After satisfying the 1993 Depreciation Fund and Sinking Fund requirements discussed below, the Company expects that it will issue additional Pledged Bonds when it next issues additional G&R Bonds. The First Mortgage requires the Company to pay the First Mortgage Trustee by June 30 of each year cash equal to 1% of all previously issued First Mortgage Bonds (excluding bonds issued on the basis of retired bonds). Currently, the annual First Mortgage Sinking Fund requirement is approximately $18 million. The Company expects to satisfy this requirement prior to June 30, 1994, with retired First Mortgage Bonds. The annual Sinking Fund requirement is not expected to change, because of restrictions in the G&R Mortgage, until and unless the Company issues additional G&R Bonds. The Company expects to be able to satisfy the Sinking Fund requirement in each year through 1996, the last year in which this requirement must be met, with cash, available Property Additions or retired First Mortgage Bonds which become available through scheduled maturities. The Depreciation Fund covenant of the First Mortgage requires that the Company pay to the First Mortgage Trustee by June 30 of each year cash (which may be withdrawn up to the amount of Gross Bondable Additions and First Mortgage Bonds made the basis for such withdrawal) equal to the greater of (a) the amount actually charged on the Company's books as a utility operating revenue deduction for the preceding calendar year for depreciation, depletion, obsolescence, retirements and amortization of the Company's Utility Plant ("Book Depreciation") or (b) an amount equal to (i) 15% of gross operating revenues (less the cost of electricity and gas purchased for resale) from Utility Plant for such year less (ii) the amount actually expended for maintenance of Utility Plant during such year ("Revenue Depreciation"). Since the oil crisis of the 1970s, Revenue Depreciation in each year has been greater than Book Depreciation for such year. The Revenue Depreciation requirement for 1993 was approximately $216 million. Instead of paying cash to satisfy this Depreciation Fund requirement, the First Mortgage permits the Company to deliver First Mortgage Bonds or certify Property Additions. The Company expects to satisfy the 1993 requirement by June 30, 1994, using a combination of First Mortgage Bonds and Property Additions. The Company presently plans, assuming that its expenditures for capital improvements are approximately $250 million annually and notwithstanding that G&R Bonds may be issued which would require, in turn, the issuance of First Mortgage Bonds to be pledged, that it will have adequate Property Additions to satisfy the Depreciation Fund requirements in 1995 and 1996, the last year in which this requirement must be met. The Company also expects that retired First Mortgage Bonds, including Pledged Bonds, will be available to satisfy the Depreciation Fund requirement in 1995 and 1996, if such retired First Mortgage Bonds are not applied to other purposes. Unsecured Debt The Company's First Mortgage, its G&R Mortgage and its Restated Certificate of Incorporation do not contain any limitations upon the issuance of debt secured by liens which are subordinate to the above mortgages or upon the issuance of unsecured debt. The Company's Debenture Indenture, dated as of November 1, 1986, as supplemented, and the Debenture Indenture, dated as of November 1, 1992, as supplemented, (together, the "Debenture Indentures") each provide for the issuance of an unlimited amount of Debentures to be issued in amounts that may be authorized from time to time in one or more series. The Debentures are unsecured and rank pari passu with all other unsecured indebtedness of the Company subordinate to the obligations secured by the Company's two mortgages. Currently, there are approximately $2.9 billion of Debentures outstanding. As of December 31, 1993, the Company had outstanding approximately $817 million principal amount of promissory notes, securing $215 million of tax-exempt Pollution Control Revenue Bonds (the "PCRBs"), $2 million of tax-exempt Industrial Development Revenue Bonds and $600 million of tax-exempt Electric Facilities Revenue Bonds ("EFRBs"). Of these amounts, $17 million issued in 1982, $150 million issued in 1985 (the "1985 PCRBs") and $100 million issued in 1993 (the "1993 EFRBs") are subject to periodic tenders by the holders of the tax-exempt bonds. The 1985 PCRBs and 1993 EFRBs are supported by letters of credit pursuant to which the letter of credit banks have agreed to pay the principal, interest and premium, if applicable, on any tendered 1985 PCRBs or 1993 EFRBs, in the aggregate, up to approximately $163 million and $109 million, respectively, in the event of default. These letters of credit expire on March 16, 1996 and November 17, 1996, respectively. The obligations of the Company to reimburse the letter of credit banks supporting the 1985 PCRBs and the 1993 EFRBs are unsecured. Each of the PCRBs, the Industrial Development Revenue Bonds and the EFRBs have been issued by the New York State Energy Research and Development Authority ("NYSERDA"). See Note 7 of Notes to Financial Statements for the Year Ended December 31, 1993 for additional information respecting the Company's Notes securing tax-exempt bonds and the Company's other outstanding unsecured debt. Equity Securities The Company's Restated Certificate of Incorporation provides that the Company may not issue additional Preferred Stock unless the net earnings of the Company available for payment of interest on its debt after depreciation and all taxes for any 12 consecutive calendar months within the 15 calendar months preceding the month of issuance are at least 1.50 times the aggregate of the annual interest charges and dividend requirements on the debt and Preferred Stock to be outstanding immediately after the issuance of such Preferred Stock (the "Earnings Ratio"). Currently, the Company cannot satisfy the Earnings Ratio and therefore cannot issue Preferred Stock except, under certain circumstances, to redeem outstanding Preferred Stock. When the proceeds from the sale of the Preferred Stock to be issued are used to redeem outstanding Preferred Stock, the requirement to satisfy the Earnings Ratio is not applicable if the dividend requirement and the requirements for redemption in a voluntary liquidation of the Preferred Stock to be issued do not exceed the respective amounts for the Preferred Stock which is to be retired. Additional Preferred Stock may also be issued beyond amounts permitted under the Earnings Ratio with the approval of at least two-thirds of the votes entitled to be cast by the holders of the total number of shares of outstanding Preferred Stock. Default in the payment of dividends on any shares of Preferred Stock in an amount equivalent to or exceeding four full quarterly dividends for any series of Preferred Stock entitles all holders of shares of Preferred Stock, voting separately as a class and regardless of series, to elect a majority of the Board of Directors of the Company. The remaining Directors are elected by the holders of Common Stock. The right of holders of shares of Preferred Stock to elect a majority of the Board of Directors ceases when and if the Company ceases to be in default in the payment of its Preferred Stock dividends. At that time, the terms of office of the Directors of the Company elected by the holders of Preferred Stock terminates and the resulting vacancies are to be filled by the vote of the remaining Common Stock Directors. Issuance of Preference Stock, which is subordinate to the Company's Preferred Stock, but senior to its Common Stock, with respect to declaration and payment of dividends and the right to receive amounts payable on any dissolution, does not require satisfaction of a net earnings test or any other coverage requirement, unless established by the Board of Directors for one or more series of Preference Stock, prior to the issuance of such series. No Preference Stock has been issued by the Company nor does the Company currently plan to issue any Preference Stock. Before paying any dividends, the Company's Board of Directors considers, among other factors, the Company's financial condition, its ability to comply with provisions of the Company's Restated and Amended Certificate of Incorporation and the availability of retained earnings, future earnings and cash. SHOREHAM DECOMMISSIONING: As contemplated by the 1989 Settlement, the Company transferred Shoreham and the Company's possession-only license for Shoreham to LIPA on February 29, 1992, following a decision by the NRC that approved the transfer. The NRC decision requires that the Company maintain adequate capability to take over the possession-only license in the event LIPA ceases to exist or is otherwise found to be unqualified to hold the license. On June 11, 1992, the NRC issued an order authorizing the decommissioning of Shoreham by LIPA. The order requires that additional NRC approvals be obtained if certain conditions regarding fuel and solid radioactive waste are not met. The Company is required under an agreement with LIPA (the "Amended and Restated Asset Transfer Agreement") to reimburse LIPA for any of its costs associated with the decommissioning of Shoreham and recover these reimbursed amounts from its ratepayers. The Site Cooperation and Reimbursement Agreement (the "Site Agreement") entered into by the Company and LIPA describes the payment by the Company of LIPA's and NYPA's expenses attributable to the transfer, ownership, possession, maintenance and decommissioning of Shoreham, including certain taxes and payments in-lieu-of-taxes with respect to the Shoreham site, and governs, among other things, the conduct of the parties and of NYPA, and their access to facilities and properties at the Shoreham site. The NRC has granted the Company an exemption from decommissioning funding requirements which generally require utilities to maintain separate funds or obtain letters of credit dedicated to and sufficient to cover all expected decommissioning costs. Instead, the NRC has approved the dedication of a portion of the funds available to the Company under the 1989 Revolving Credit Agreement (the "1989 RCA") to support the Company's obligation to provide funding for the decommissioning of Shoreham. For additional information respecting the 1989 RCA, see Notes 2 and 7 of Notes to Financial Statements for the Year Ended December 31, 1993. The NRC also required that the Company establish an external fund of $10 million to cover emergency decommissioning costs. The RMA assumed that post settlement costs would total approximately $670 million, including $330 million for property taxes and payments-in-lieu-of-taxes ("PILOTS"). The remaining $340 million was estimated for decommissioning costs, fuel disposal costs and all other costs incurred at Shoreham after June 30, 1989. These post settlement costs are being capitalized and amortized over a 40-year period on a straight line remaining life basis. The RMA also contemplated that Shoreham would be transferred to LIPA on July 1, 1989. Certain of the assumptions in the RMA have changed. For example, the Company experienced delays in obtaining approval to transfer the plant, resulting in the payment of additional property taxes. In addition, PILOTS have been greater than had been assumed in the RMA. As a result, at December 31, 1993, Shoreham post settlement costs totalled approximately $777 million (net of accumulated amortization of $34 million). The $777 million includes $363 million of property taxes and PILOTS and $448 million of decommissioning costs, fuel disposal costs and all other costs incurred at Shoreham after June 30, 1989. The Company currently estimates that post settlement costs (other than property taxes and PILOTS) will total approximately $550 million. The precise amount of taxes and PILOTS that must be paid is the subject of the litigation described in Item 3, "Legal Proceedings -- Shoreham." Although the Company can give no assurance that the cost to decommission Shoreham will approximate its current estimate, the amount which is assumed in the LIPA decommissioning plan or the RMA, or that the decommissioning process will be completed within the period stated above, the PSC has determined that all costs associated with Shoreham which are prudently incurred by the Company subsequent to the effectiveness of the 1989 Settlement are decommissioning costs, and has confirmed that the RMA provides for the recovery of such expenses through electric rates. It is the Company's position that, should the decommissioning costs be greater and the duration of decommissioning be longer than the amount and the time, respectively, assumed in the RMA, the additional prudently incurred costs relating to decommissioning, including maintenance of Shoreham during such longer period, will be recovered from the Company's ratepayers through electric rates over the balance of a 40-year period ending 2029. Pursuant to the 1989 Settlement, the Company reflects the costs of the nuclear fuel related to Shoreham as a deferred charge under the heading "Regulatory Assets." The RMA contemplates that the Company will recover from its ratepayers the costs of its Shoreham nuclear fuel. The Company is required under the Amended and Restated Asset Transfer Agreement to reimburse LIPA for any of its costs associated with the storage and disposal of Shoreham's fuel and recover these reimbursed amounts from its ratepayers as well. For additional information respecting the 1989 Settlement, see Note 2 of Notes to Financial Statements for the Year Ended December 31, 1993. EXECUTIVE OFFICERS OF THE COMPANY: Current information regarding the Company's Executive Officers, all of whom serve at the will of the Board of Directors, follows: William J. Catacosinos: Dr. Catacosinos has served as Chairman of the Board of Directors and Chief Executive Officer of the Company since January 1984, and as a Director since December 1978. Dr. Catacosinos is currently serving as President on an interim basis and previously served in that capacity from March 1984 to January 1987. Dr. Catacosinos, 63, a resident of Mill Neck, Long Island, earned a bachelor of science degree, a masters degree in business administration and a doctoral degree in economics from New York University. He is the former chairman and chief executive officer of Applied Digital Data Systems, Inc., Hauppauge, New York, a manufacturer of computer and related products. Previously, Dr. Catacosinos served as chairman of the board and treasurer of Corometric Systems, Inc. of Wallingford, Connecticut and was Assistant Director at Brookhaven National Laboratory. Dr. Catacosinos currently chairs the Executive Committee of the Company's Board of Directors and he is a member of the board of Utilities Mutual Insurance Co. and Ketema, Inc., a diversified manufacturer of, among other things, electrical and aerospace equipment. In compliance with Section 305(b) of the Federal Power Act, Dr. Catacosinos has authorization from FERC to hold the position of an officer or director of a public utility and at the same time the position of an officer or director of a firm that supplies electrical equipment to such public utility. Theodore A. Babcock: Mr. Babcock was named Treasurer of the Company on February 4, 1994. As Treasurer, he will be responsible for Treasury Operations, Debt Management, Trust Asset Management, Risk Management and Remittance Processing. Mr. Babcock, 39, joined the Company in July 1992 as Assistant Treasurer. He previously spent five years in the AMBASE Corporation as an Assistant Vice President and was promoted in 1988 to Vice President and Treasurer. Prior to AMBASE, Mr. Babcock spent 11 years with the Associated Dry Goods Corporation where he was promoted to Assistant Treasurer and Director of Corporate Treasury Operations in 1984. Mr. Babcock received a bachelor of science degree in accounting from Manhattan College and a masters degree in finance from Iona College. William N. Dimoulas: Vice President of Information Systems and Technology since May 1990, Mr. Dimoulas, 50, joined the Company in 1988. He received a bachelor of science degree and a masters of business administration degree from Long Island University. Previously, Mr. Dimoulas was a vice president at Chemical Bank concentrating in Corporate Banking and Information Technology. James T. Flynn: Mr. Flynn was named Chief Operating Officer of the Company on March 1, 1994 and will continue in his position of Executive Vice President which he assumed in April 1992. Mr. Flynn joined the Company in October 1986 as Vice President of Fossil Production and later assumed the position of Group Vice President, Engineering and Operations. Before joining the Company, Mr. Flynn, 60, was general manager-Eastern Service Department for General Electric. His career began as a member of General Electric's Technical Marketing Program in 1957. He holds a bachelor of science degree in mechanical engineering from Bucknell University and is a Licensed Professional Engineer in the State of Pennsylvania. Robert J. Grey: Mr. Grey joined the Company in September 1992 as General Counsel. Before joining the Company, Mr. Grey, 43, was senior utility partner and managing partner of the Portland office with the northwest law firm of Preston, Thorgrimson, Shidler, Gates & Ellis. Previously, Mr. Grey was staff counsel for the New York State Public Service Commission and an attorney for the United States Environmental Protection Agency. Mr. Grey has a bachelors degree from Columbia University, a juris doctorate from Emory University and an LL.M in Taxation from George Washington University. Robert X. Kelleher: Vice President of Human Resources since July 1986, Mr. Kelleher, 57, joined the Company in 1959 and has held various managerial positions in the Finance, Accounting, Purchasing, Stores and Employee Relations organizations. He was Industrial Relations Manager from 1975 to 1979, Manager of the Employee Relations Department from 1979 to 1985 and Assistant Vice President of the Employee Relations Department from 1985 to 1986. Mr. Kelleher is a graduate of St. Francis College and the Human Resources Management and Executive Management Programs of Pennsylvania State University. Mr. Kelleher is a member of the American Compensation Association, Personnel Directors Council, Industrial Relations Research Institute, Edison Electric Institute's Labor Relations Committee and is on the advisory council of New York Institute of Technology's Center for Labor Relations. John D. Leonard, Jr.: Mr. Leonard joined the Company in 1984, initially serving as Vice President of Nuclear Operations. In July 1989, he assumed additional duties as Vice President of Corporate Services. Mr. Leonard, 61, was the vice president and assistant chief engineer for design and analysis at the New York Power Authority, from 1980 to 1984. Prior to this position, he served as a resident manager of the Fitzpatrick Nuclear Power Plant for approximately five years. Before accepting a position at the New York Power Authority, Mr. Leonard served as corporate supervisor of operational quality assurance of the Virginia Electric Power Company from 1974 to 1976. In 1974, Mr. Leonard retired with the rank of Commander from the United States Navy, having commanded two nuclear powered submarines in a career that spanned 20 years. He holds a bachelor of science degree from Duke University and a master of science degree from the Naval Post Graduate School. He is a registered professional engineer in the State of New York. Adam M. Madsen: Vice President of Corporate Planning since 1984, Mr. Madsen, 57, holds a bachelors degree in electrical engineering from Manhattan College and a master of science degree in nuclear engineering from Long Island University. He has been with the Company since 1961, serving in various engineering positions including Manager of Engineering from 1978 to 1984. Prior to that time, he held the position of Manager of the Planning Department. Since 1978, Mr. Madsen has been the Company's representative to the Planning Committee of the New York Power Pool. He is a member of the Northeast Power Coordinating Council's Joint Coordinating Committee and an alternate to the Council's Executive Committee. He also serves on the Board of Directors of the Empire State Electric Energy Research Company. Mr. Madsen is a registered professional engineer in the State of New York. Kathleen A. Marion: Corporate Secretary since April 1992, Ms. Marion served as Assistant Corporate Secretary from April 1990 to 1992. Ms. Marion also continues to serve as Assistant to the Chairman, a position she has held since April 1987. Ms. Marion, 39, has a bachelor of science degree in business and finance from the State University of New York at Old Westbury. Arthur C. Marquardt: Senior Vice President of Gas Business Unit since March 1992, Mr. Marquardt, 47, joined the Company in January 1991. He held the position of Vice President of Strategic Business Planning from January 1991 through March 1992. He is chairman of the New York Facilities executive committee and a director of the Huntington Chamber of Commerce and the Huntington Chamber Foundation. Mr. Marquardt has had extensive and varied business experience at Combustion Engineering Inc., General Electric Company, Quadrex Corporation, and at Pacific Nuclear Systems, Inc. where he was president and chief operating officer. He received a bachelor of science degree in mechanical engineering from Tufts University. Brian R. McCaffrey: Vice President of Administration since March 1987, Mr. McCaffrey, 48, joined the Company in 1973. Mr. McCaffrey holds a bachelor of science degree in aerospace engineering from the University of Notre Dame. He also received a master of science degree in aerospace engineering from Pennsylvania State University and a master of science degree in nuclear engineering from Polytechnic University. He is a licensed professional engineer in New York. Prior to this assignment as Vice President, Mr. McCaffrey served in many positions in the nuclear organizations of the Company and positions in engineering capacities associated with gas turbine and fossil power station projects. Mr. McCaffrey is a member of the executive board of the Suffolk County Council Boy Scouts of America. Joseph W. McDonnell: Vice President of External Affairs since July 1992, Dr. McDonnell, 42, joined the Company in 1984. Dr. McDonnell was Assistant to the Chairman from 1984 through 1988 when he was named Vice President of Communications. Prior to joining the Company, Dr. McDonnell was the director of strategic planning and business administration for Applied Digital Data Systems, Inc. and associate director of the University Hospital at the State University of New York at Stony Brook. He holds bachelor of arts and master of arts degrees in philosophy and a master of arts degree in theology from the State University of New York at Stony Brook and a Ph.D in communications from the University of Southern California. Anthony Nozzolillo: Mr. Nozzolillo was named Senior Vice President of Finance and Chief Financial Officer of the Company on February 4, 1994. His reporting responsibilities will include the offices of Controller, Treasurer, Tax & Benefits Planning, Investor Relations and Financial Planning. Prior to this appointment he had been the Company's Treasurer since July 1992. He has been with the Company since 1972 serving in various positions including Manager of Financial Planning and Manager of Systems Planning. Mr. Nozzolillo is a director of Utilities Mutual Insurance Company and Nuclear Mutual Ltd. Mr. Nozzolillo, 45, holds a bachelor of science degree in electrical engineering from the Polytechnic Institute of Brooklyn and a master of business administration degree from Long Island University C.W. Post Campus. William G. Schiffmacher: Vice President of Electric Operations since July 1990, Mr. Schiffmacher, 50, joined the Company in 1965 after receiving a bachelor of electrical engineering degree from Manhattan College. Mr. Schiffmacher also holds a master of science degree in management engineering from Long Island University. He has held a variety of positions in the Company, including Manager of Electric System Operation, Manager of Electrical Engineering and Vice President of Engineering and Construction. Robert B. Steger: Vice President of Fossil Production since February 1990, Mr. Steger, 57, joined the Company in 1963 and has since held progressive operating and engineering positions including Manager of Electric Production-Fossil from 1985 through 1989. He holds a bachelor of mechanical engineering degree from Pratt Institute and is a registered professional engineer in the State of New York. William E. Steiger, Jr.: Vice President of Engineering and Construction since July 1990, Mr. Steiger, 50, has been with the Company since 1968. During his career with the Company, Mr. Steiger has served, among other positions, as Lead Nuclear Engineer for Shoreham, Chief Operations Engineer for Shoreham, Plant Manager for Shoreham as well as Assistant Vice President of Nuclear Operations. He received a bachelor of science degree in marine engineering from the United States Merchant Marine Academy and a master of science degree in nuclear engineering from Long Island University. Thomas J. Vallely, III: Controller and Chief Accounting Officer of the Company since February 1991, Mr. Vallely, 47, holds a bachelor of science degree in accounting from St. John's University and a masters degree in corporate financial management from Pace University. He is the former controller and chief accounting officer of the New York City Transit Authority, an agency of the Metropolitan Transportation Authority. Walter F. Wilm, Jr.: Vice President of Corporate Reorganization since March 1992, Mr. Wilm, 57, joined the Company in 1962. During his career with the Company, Mr. Wilm has served, among other positions, as Assistant Manager of Gas Construction and Maintenance, Manager of Meter and Test, Vice President of Administration, Vice President of Customer Relations and Vice President of Gas Operations. Mr. Wilm holds a bachelor of science degree in electrical engineering from Indiana Institute of Technology and is a licensed professional engineer. Edward J. Youngling: Vice President of Customer Relations and Conservation since March 1993, Mr. Youngling, 49, holds a bachelor of science degree in mechanical engineering from Lehigh University. He joined the Company in 1968 as an Assistant Engineer in the Electric Production Department and has held various positions in the offices of fossil production, engineering and nuclear operations including service as Department Manager of Nuclear Engineering. In 1988, Mr. Youngling was named Vice President of Conservation and Load Management. In 1990, Mr. Youngling became Vice President of Customer Relations. The Office of Customer Relations and the Office of Conservation were merged in March 1993. CAPITAL REQUIREMENTS, LIQUIDITY AND CAPITAL PROVIDED: Information as to Capital Requirements, Liquidity and Capital Provided appears in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations for the Year Ended December 31, 1993." ITEM 2. ITEM 2. PROPERTIES The location and general character of the principal properties of the Company are described in Item 1, "Business" under the headings "Electric Operations" and "Gas Operations." ITEM 3. ITEM 3. LEGAL PROCEEDINGS Shoreham The Company's Shoreham-related litigation includes a lawsuit against certain contractors and suppliers regarding the construction of Shoreham, a breach of contract suit against Suffolk County and a tax certiorari proceeding seeking review of certain tax assessments of Shoreham. On December 13, 1993, the United States District Court for the Eastern District of New York issued an opinion in Long Island Lighting Company v. Stone & Webster Engineering Corp. granting a motion by Stone & Webster Engineering Corp. ("SWEC") to dismiss the Company's complaint in this action and dismissing SWEC's counter-claim. The Company's complaint had sought to recover damages against SWEC for breach of contract, negligence, professional malpractice and gross negligence in connection with SWEC's work as architect-engineer and construction manager for Shoreham. The parties entered into a settlement in which both parties agreed not to pursue an appeal. On February 11, 1988, the Company began a lawsuit in Suffolk County Supreme Court against Suffolk County, seeking the recovery of approximately $54 million in damages for Suffolk County's breach of a contract to prepare an offsite emergency response plan for Shoreham (Long Island Lighting Company v. County of Suffolk). In addition, the complaint alleges that, because of the delays that have resulted, the Company has been damaged in an additional amount of $706 million. On October 30, 1992, the court granted, in part, and denied, in part, Suffolk County's motion to amend its answer to assert additional defenses and counterclaims. Two proposed counterclaims were allowed seeking approximately $16 million in damages as well as $700 million in alleged punitive damages. The outcome of these counterclaims, if adverse, could have a material effect on the financial condition of the Company. The Company maintains that there is no basis for punitive damages and intends to vigorously prosecute its claims against Suffolk County and to defend against Suffolk County's counterclaims. Pursuant to the Long Island Power Authority Act ("LIPA Act"), LIPA is required to make PILOTS to the municipalities that impose real property taxes on Shoreham. Under the 1989 Settlement Agreement with New York State which resolved disputes over the Shoreham plant, the Company agreed to fund LIPA's PILOTS obligation. The timing and duration of PILOTS under the LIPA Act are the subject of the litigation entitled LIPA, et al. v. Shoreham-Wading River Central School District, et al. LIPA brought this action in Nassau County Supreme Court against, among others, Suffolk County, Town of Brookhaven and the Shoreham-Wading River Central School District. The Company was permitted to intervene in the lawsuit. On January 10, 1994, the Appellate Division, Second Department, affirmed a lower court's March 29, 1993 decision holding, in major part, that the Company is not obligated for any real property taxes that accrued after February 28, 1992, attributable to property that it conveyed to LIPA, that PILOTS commence on March 1, 1992, that PILOTS are subject to refunds and that the LIPA Act does not provide for the termination of PILOTS. The effects of this affirmance cannot yet be quantified. Furthermore, all of the parties have filed motions with the Second Department seeking leave to appeal to the New York Court of Appeals. Generally, these holdings are favorable to the Company. The proper amount of PILOTS is to be determined in pending litigation described in the next paragraph. The costs of Shoreham included real property taxes imposed by the Town of Brookhaven on Shoreham and capitalized by the Company during construction. The Company has sought judicial review in Suffolk County Supreme Court (Long Island Lighting Company v. The Assessor of the Town of Brookhaven, et al.) of the assessments upon which those taxes were based for the years 1976 through 1992 (excluding 1979). The Court has consolidated the review of the tax years at issue into two phases: 1976 through 1983, excluding 1979 (Phase 1); and 1984 through 1992 (Phase 2). On October 26, 1992, the court ruled that Shoreham had been overvalued for property tax purposes for Phase 1. Although the Court did not award a refund because of a need to make further factual findings, the Company estimates that it is entitled to a refund of approximately $34 million plus interest. In Phase 2, the Company is seeking to recover over $500 million, excluding interest, in property taxes paid on Shoreham during this period. A trial date of April 14, 1994 has been set by the Suffolk County Supreme Court. The amount of the Company's recovery, if any, in the 1984-1992 proceeding and the timing of all refunds cannot yet be determined. The Company has indicated to the PSC that all refunds, less litigation costs, will be used to reduce future electric costs. LIPA has been permitted to intervene for limited purposes in this pending litigation. Nine Mile Point 2 In 1988, the Company and the other cotenants of Nine Mile Point 2 commenced a lawsuit entitled Niagara Mohawk Power Corporation, et al. v. Stone & Webster Engineering Corp., ITT Fluid Products Corp. and ITT Fluid Technology Corporation in the United States District Court for the Northern District of New York, alleging damages arising from breach of contract, negligence, professional malpractice and gross negligence in connection with certain work performed at Nine Mile Point 2. SWEC furnished architect-engineering and construction management services, while ITT fabricated and erected piping for the Nine Mile Point 2 unit. The case against SWEC was settled in 1991. The case against the ITT defendants was not settled and went to trial before a jury in June 1992. The jury returned a verdict for the ITT defendants on all causes of action. The parties entered into a settlement in which the cotenants agreed not to pursue an appeal. ITT agreed to withdraw its claim for costs and to pay the cotenants $25,000. Environmental On February 18, 1994, a lawsuit was filed in the United States District Court for the Eastern District of New York by the Town of Oyster Bay (the "Town"), New York, against the Company and 19 other potentially responsible parties ("PRPs"). The Town is seeking indemnification for remediation and investigation costs that have been or will be incurred for a federal Superfund site in Syosset, New York, which served as a Town-owned and operated landfill between 1954 and 1975. In a Record of Decision issued on or about September 27, 1990, the EPA set forth a remedial design plan, the cost of which was estimated at $27 million and is reflected in the Town's lawsuit. In an Administrative Consent Decree entered into between the EPA and the Town on December 6, 1990, the Town agreed to undertake remediation at the site. The Company has agreed to participate in a joint PRP defense effort with several other defendants. Liability, if imposed, would be joint and several. While the outcome of this matter is not certain, based upon the Company's past experience in similar matters and the number and financial condition of the corporate defendants named in the litigation, the Company does not believe that this proceeding will have a material impact on its financial condition. Human Resources Pending before federal courts, the Federal Equal Employment Opportunity Commission and the New York State Division of Human Rights are charges by individuals alleging that the Company discriminated against them on various grounds. The Civil Rights Bureau of the New York Attorney General's office has subpoenaed the Company for the production of documents to aid in its investigation as to whether the Company has engaged in discriminatory employment practices based upon age. No charges have been filed by the Attorney General. The Company has estimated that any costs to the Company resulting from these matters will not have a material adverse effect on its financial condition. Other Matters On January 13, 1993, the New York State Department of Law ("DOL") informed the Company that the DOL's Antitrust Bureau opened an investigation into its Full Service Pilot Program and Contractor Advisory Council, two programs designed to increase the Company's residential natural gas sales. The DOL stated that the implementation of the Full Service Pilot Program and the practices of the Contractor Advisory Council may have anticompetitive effects in the gas-fired heating equipment installation and conversion business and that a preliminary investigation has raised questions of possible violations of the New York General Business Law and the Sherman Act. The Company expects that it can demonstrate that the programs identified by the DOL for investigation are very limited in scope and do not involve any violations. The outcome of the investigation by the DOL, if adverse, is not expected to have a material effect on the financial condition of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS At February 22, 1994, the Company had 95,084 registered holders of record of Common Stock. The Common Stock of the Company is traded on the New York Stock Exchange and the Pacific Stock Exchange. Certain of the Company's Preferred Stock series are traded on the New York Stock Exchange. Information respecting the high and low sales prices and the dividends paid on the Company's Common Stock during the past two years is set forth in the table below. ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion and analysis addresses matters of significance with regard to the Company and its financial condition, liquidity, capital requirements and results of operations for the last three years. OVERVIEW Nearly five years have passed since the effective date of the 1989 Settlement, discussed in Note 2 of Notes to Financial Statements, which resolved the controversy surrounding the Shoreham Nuclear Power Station (Shoreham). Over this period of time, the Company has focused on managing costs and improving operating efficiencies. This, coupled with six electric rate increases, lower than anticipated fuel and financing costs and significantly lower production expenses has helped to improve the Company's financial health. This also enabled the Company to file with the Public Service Commission of the State of New York (PSC) on December 31, 1993 an electric rate plan requesting that base rates be frozen for a two-year period beginning December 1, 1994. The Company's electric rate plan to freeze base rates is designed to moderate the rate increases that were originally contemplated in the 1989 Settlement. The two-year base rate freeze will help better position the Company to respond to the current environment in the utility industry and to assist in Long Island's economic recovery. Other significant events during 1993 included: o Approval, by the PSC, of the third annual electric rate increase of 4.0% effective December 1, 1993, under the three-year electric rate plan authorized in 1991. o For the first time since the 1989 Settlement became effective, revenues provided under the Rate Moderation Agreement exceeded revenues that would have been provided under conventional ratemaking, resulting in the decline of the Rate Moderation Component balance and an improvement in the Company's cash flow position. o An increase in the Company's common stock quarterly dividend from 43 1/2 cents per share to 44 1/2 cents per share, representing the fourth consecutive year of dividend increases. Earnings for common stock in 1993 were $2.15 per common share compared to $2.14 per common share in 1992. o The approval by the PSC of a three-year gas rate plan providing annual rate increases of 4.7%, 3.8% and 2.8%, for the rate years beginning December 1, 1993, 1994, and 1995, respectively. This follows an increase in gas rates of 7.1% that was effective December 1, 1992. o The addition of over 9,000 new gas space heating customers, resulting from the Company's gas expansion program. o The refinancing of a significant amount of the Company's higher-cost securities as a result of very favorable long-term interest rates. Refinancing of approximately $983 million of higher-cost securities significantly lowered the Company's cost of debt and preferred stock. These 1993 refinancings will result in more than $18 million in annual cash savings through lower interest expense and preferred stock dividends. Since the 1989 Settlement became effective, the Company's aggressive refinancing program has resulted in annual cash savings of approximately $88 million. LIQUIDITY AND CAPITAL RESOURCES CASH AND REVOLVING CREDIT At December 31, 1993, the Company's cash and cash equivalents amounted to approximately $249 million, compared to $309 million at December 31, 1992. In addition, the Company has approximately $276 million available through October 1, 1994, provided by its 1989 Revolving Credit Agreement (1989 RCA). At December 31, 1993, no amounts were outstanding under the 1989 RCA. For a further discussion of the 1989 RCA, see Note 7 of Notes to Financial Statements. CAPITAL REQUIREMENTS AND CAPITAL PROVIDED During 1993, the Company continued its aggressive refinancing of higher-cost debt and preferred stock, taking advantage of declining interest rates. In 1993, the Company redeemed $568 million of higher-cost securities through the issuance of approximately $382 million of debentures and $204 million of preferred stock. The Company also issued $420 million of debentures to redeem $415 million of maturing debt. In addition to these refinancings, the Company issued $200 million of debentures and $100 million of tax-exempt securities and used the proceeds to reimburse the Company's treasury for previously incurred capital expenditures. In November 1993, the Company satisfied the maturity of $175 million of debentures with cash on hand. For a further discussion on the Company's capital stock and long-term debt, see Notes 6 and 7 of Notes to Financial Statements. The Company expects that it will seek external financing of approximately $1.1 billion solely for the purpose of refunding maturing debt in the years 1994, 1995 and 1996 as follows: The Company is planning, subject to market conditions, to fund a portion of these mandatory redemptions with the issuance of common equity in order to improve its debt-to-equity ratio. Capital requirements and capital provided for 1993 and 1992 were as follows: For further information, see the Statement of Cash Flows. For 1994, total capital requirements (excluding common stock dividends) are estimated at $1.1 billion, of which mandatory redemptions are $600 million, construction requirements are $327 million, preferred stock sinking fund requirements are $5 million, preferred stock dividends are $53 million and Shoreham post settlement costs are $158 million. During 1994, the Company expects to access the capital markets only for funds required to satisfy maturing securities or to refund outstanding securities to reduce financing costs. It is anticipated that the internal funds generated from operations will be sufficient to satisfy all other capital requirements, including both common and preferred stock dividends. CAPITALIZATION The Company's capitalization, including current maturities of long-term debt and current redemption requirements of preferred stock, at December 31, 1993, was approximately $8.4 billion, as compared to $8.2 billion at December 31, 1992. This increase in capitalization of approximately $185 million principally reflects an increase in long-term debt and preferred stock associated with the Company's financing activities in 1993 and an increase in common shareowners' equity comprising 1993 net income of approximately $296 million reduced by common and preferred stock dividends of approximately $253 million. At December 31, 1993 and 1992, the components of the Company's capitalization ratios were as follows: The Company's debt-to-equity ratio reflects two substantial charges to common shareowners' equity made in 1988 and 1989. In 1988, the Company was required to write-down net assets of approximately $1.3 billion, net of tax effects, relating to its investments in Shoreham and Nine Mile Point Nuclear Power Station, Unit 2 (NMP2). In 1989, the Company incurred a loss for common stock of approximately $175 million, reflecting the effects of the 1989 Settlement and the Class Settlement, discussed in Notes 2 and 4 of Notes to Financial Statements. The Company is committed to improving its debt-to-equity ratio through growth in retained earnings, debt reduction through improved cash flows, and the issuance of common equity. RATE MATTERS ELECTRIC In conjunction with the 1989 Settlement, the PSC authorized the recognition of a regulatory asset known as the Financial Resource Asset (FRA). The FRA consists of two components, the Base Financial Component (BFC) and the Rate Moderation Component (RMC). The Rate Moderation Agreement (RMA), one of the constituent documents of the 1989 Settlement, provides for the full recovery of the FRA. The RMA, by its terms, specifies that the FRA was created to provide the Company adequate financial indicia for the period 1989 through 1999 and to restore the Company's debt securities to investment grade levels as determined by independent rating agencies. The BFC, as initially established, represents the present value of the future net-after-tax cash flows which the RMA provided the Company for its financial recovery. The BFC was granted rate base treatment under the terms of the RMA and is included in the Company's revenue requirements through an amortization included in rates over forty years on a straight-line basis that began July 1, 1989. The RMC reflects the difference between the Company's revenue requirements under conventional ratemaking and the revenues resulting from the implementation of the rate moderation plan provided for in the RMA. This revenue difference, together with a carrying charge equal to the allowed rate of return on rate base, has been deferred. The RMC has provided the Company with a substantial amount of non-cash earnings since the effective date of the 1989 Settlement through December 31, 1992, because the revenues provided under the RMA were less than the revenues required under conventional ratemaking. During 1993, however, as revenues provided under the RMA began to exceed the revenues that would have been provided under conventional ratemaking the RMC balance began to decline. Pursuant to the 1989 Settlement, the Company has received six electric rate increases consistent with the objectives of the RMA. In response to the Company's rate filing in December 1990, the PSC approved the Long Island Lighting Company Ratemaking and Performance Plan (LRPP) in November 1991, which provided for annual electric rate increases of 4.15%, 4.1% and 4.0% effective December 1, 1991, 1992 and 1993, respectively. Effective December 1, 1993, the Company began receiving the third of these three annual electric rate increases. The LRPP provides for an allowed return on common equity from electric operations of 11.6% for each of the three rate years. The LRPP was designed to be consistent with the RMA's long-term goals. One principal objective of the LRPP is to reassign risk so that the Company assumes the responsibility for risks within the control of management, whereas risks largely beyond the control of management would be assumed by the ratepayers. One of the major components of the LRPP provides for a revenue reconciliation mechanism that mitigates the impact on earnings of experiencing electric sales that are above or below the LRPP forecast by providing a fixed annual net margin level (defined as sales revenues, net of fuel and gross receipts taxes) that the Company will receive for each of the three rate years under the LRPP. Another component of the LRPP allows the Company to earn for each rate year up to 60 additional basis points, or forfeit up to 38 basis points, of the allowed return on common equity as a result of its performance within certain incentive and/or penalty programs. These programs consist of a customer service performance plan, a demand side management program, a time-of-use program, a partial pass through fuel cost incentive plan and effective December 1, 1993, an electric transmission and distribution reliability plan. For the rate years ended November 30, 1993 and 1992, the Company earned approximately $9.2 million and $4.3 million, net of tax effects, respectively, based upon its performance within these programs. The LRPP contains a mechanism whereby earnings in excess of the allowed rate of return on common equity (11.6%), excluding the impacts of the various incentive and/or penalty programs, are shared equally between ratepayers and shareowners. For the rate years ended November 30, 1993 and 1992, the Company earned approximately $8.9 million and $21.4 million, net of tax effects, respectively, in excess of its allowed rate of return on common equity which was shared equally between ratepayers and shareowners. In December 1993, the Company filed a three-year electric rate plan with the PSC for the period beginning December 1, 1994 that minimizes future electric rate increases while retaining consistency with the RMA's objective of continuing the restoration of the Company's financial health. The filing provides for zero percentage base rate increases in years one and two of the plan and a rate increase of 4.3% in the third year. Although base electric rates would be frozen during the first two years of the plan, annual rate increases of approximately 1% to 2% are expected to result in these years from the operation of the Company's fuel cost adjustment (FCA) clause. The FCA captures, among other amounts, any increases in the cost of fuel above the level recovered in base rates and, under a continuation of the rate mechanisms provided by the LRPP, any amounts to be recovered or refunded to ratepayers in excess of $15 million which result from the reconciliation of revenue, certain expenses and earned performance incentive components. The electric rate plan requests an allowed rate of return on equity of 11.0%. The Company's rate filing reflects four underlying objectives: (i) to limit the balance of the RMC during the three-year period to no more than its 1992 peak balance of $652 million; (ii) to recover the RMC within no more than thirteen years of its 1989 inception; (iii) to minimize the final three rate increases that will follow the two-year rate freeze period; and (iv) to continue the Company's gradual return to financial health. The Company's electric rate plan is subject to approval by the PSC. The Company's current electric rate plan provides for lower annual electric rate increases than originally anticipated under the 1989 Settlement. However, as a result of changes in certain assumptions upon which the RMA was based, their impact on the RMC, and the Company's plans to reduce demand side management (DSM), operations, maintenance and capital expenditures, the Company has determined that the overall objectives of the RMA can be met under the multi-year plan described above. As a result of lower than originally anticipated inflation rates, interest costs, property taxes, fuel costs and the return on common equity allowed by the PSC, the RMC, which originally had been anticipated to peak at $1.2 billion in 1994, has already peaked at $652 million in 1992. With the exception of an increase in the 1995-1996 period, which is not now projected to cause the RMC to increase above its $652 million peak, the RMC is expected to decline until it is fully amortized. Under this electric rate plan, the recovery of the RMC would be extended, if necessary, for an additional period of not more than three years beyond the approximate ten-year period envisioned in the RMA. The actual length of the RMC extension will depend on the extent to which the assumptions underlying the rate plan materialize. The Company's current projections indicate that the RMC will be recovered in eleven years. For a further discussion of the 1989 Settlement and Rate Matters, see Notes 2 and 3 of Notes to Financial Statements. GAS In December 1993, the PSC approved a three-year gas rate settlement between the Company and the staff of the PSC. The gas rate settlement provides that the Company receive, for the rate years beginning December 1, 1993, 1994 and 1995, annual gas rate increases of 4.7%, 3.8% and 2.8%, respectively. In the determination of the revenue requirements for the first year of the gas rate settlement an allowed rate of return on equity of 10.1% was used. The gas rate decision also provides for earnings in excess of a 10.6% return on equity in any of the three rate years covered by the settlement be shared equally between the Company's firm gas customers and its shareowners. The allowed rate of return for the rate year that began December 1, 1992 was 11.0 %. ELECTRIC COMPETITION NON-UTILITY GENERATORS (NUGs) The development of the NUG industry has been encouraged by federal and state legislation. There are two ways that NUGs may negatively impact the Company: first, NUGs may locate on a customer's site, providing part or all of that customer's electric energy requirements. The Company estimates that in 1993 sales lost to such on-site NUGs totalled 234 gigawatt-hours (Gwh) in sales or approximately $20 million in revenues, net of fuel. This represents only 1.0% of the Company's 1993 net revenues. Second, in accordance with the Public Utility Regulatory Policy Act of 1978 (PURPA), the Company is required to purchase all the power offered by NUGs that are Qualified Facilities (QF). QFs have the choice of pricing these sales at either (i) PSC published estimates of the Company's long run avoided costs (LRAC) or (ii) the Company's tariff rates. Additionally, until repeal in 1992, New York State law set a minimum price of six cents per kilowatt-hour (Kwh) for certain categories of QFs, considerably above the Company's avoided cost. The six-cent minimum now only applies to contracts entered into before June 1992. The Company believes that the repeal of the six-cent law, coupled with the PSC's updates which resulted in lower LRAC estimates, has significantly reduced the economic advantage to entrepreneurs seeking to compete with the Company. As of December 31, 1993, 39 QFs were on line and selling approximately 200 megawatts (MW) of power to the Company. The Company estimates that in 1993, the purchases federal and state law required it to make from QFs cost the Company $47 million more than it would have cost to generate this power itself. With the exception of approximately 40 MW of power to be produced at the Stony Brook campus of the State University of New York beginning in early 1995, the Company does not expect any new major NUGs to be built on Long Island in the foreseeable future. RETAIL COMPETITION For over a decade, the Company has voluntarily provided wheeling of New York Power Authority (NYPA) power for economic development. As a result, NYPA power has displaced approximately 400 Gwh of energy sales. The net revenue loss associated with this amount of sales is approximately $27 million or 1.3% of the Company's 1993 net revenues. The potential loss of additional load is limited by conditions in the Company's current transmission agreements with NYPA. Competition for customer loads also comes from other electric utilities (including those in Connecticut, New York, and New Jersey) which seek to entice commercial and industrial customers to relocate within their service territories by offering reduced rates and other incentives. In order to retain existing and attract new commercial and industrial customers, the Company offers an Economic Development Rate which provides rate abatement to new or existing customers that qualify under the program approved by the PSC. Neither federal nor New York State law mandates retail wheeling. The Staff of the PSC has recently recommended that the PSC examine the issues attending retail wheeling. CONSERVATION AND SUPPLY The Company's 1993 Electric Conservation and Load Management Plan called for a cumulative 194 MW reduction in coincident peak demand by December 31, 1993 and a cumulative annualized energy savings of 578 Gwh, at a cost of $33.5 million. The Company has met these targets. These reductions were achieved through several different programs including customer education/information, rebate, audit and direct installation which targeted a number of energy efficient technologies. In the fourth quarter of 1993, a modified DSM Plan was filed with the PSC to support the objectives of the Company's December 31, 1993 electric rate plan filing. Under this modified plan a greater emphasis will be placed on the educational aspect of the Company's conservation efforts in lieu of the conventional reliance on rebates. This will help to shift the responsibility for adopting and implementing energy efficient practices away from the utility and to the customer. The Company's current electric load forecasts indicate that, with continued implementation of its conservation and load management programs and with the availability of electricity provided by QFs located within the Company's service territory, the Company's existing generating facilities, its portion of nuclear energy generated at NMP2 and power purchased from other electric systems are adequate to meet the energy demands on Long Island beyond the end of the century. INVESTMENT RATING The Company's securities are rated by Moody's Investors Service, Inc. (Moody's), Standard and Poor's Corporation (S&P), Fitch Investors Service, Inc. (Fitch) and Duff and Phelps (D&P). During the period 1989 through 1992, the rating agencies significantly upgraded their ratings of the Company's securities. In 1993, both Moody's and Fitch reaffirmed their assigned ratings on the Company's securities. S&P however, lowered its ratings on the Company's First Mortgage Bonds and G&R Bonds one level to minimum investment grade and lowered its ratings on the Company's Debentures and Preferred Stock to one level below minimum investment grade. D&P lowered its ratings on the Company's debentures and preferred stock one level. S&P's actions reflect its concerns regarding the utility industry's challenges relating to intensified competitive pressures, sluggish demand expectations, slow earnings growth prospects, high common dividend payouts, environmental cost pressures and nuclear operating and decommissioning costs. CLEAN AIR ACT In late 1990, significant amendments to the federal Clean Air Act were adopted. As a result, the Company expects that it will have to expend $4.3 million in 1994 to meet continuous emission monitoring requirements and $3.5 million in 1994 and $2.0 million in 1995 to meet Phase I nitrogen oxide (NOx) reduction requirements. In addition, subject to regulations that have not yet been issued, the Company estimates that it may be required to expend as much as $125 million by May 1999 to meet Phase II NOx reduction requirements and approximately $50 million by 2000 to meet requirements for the control of hazardous air pollutants from power plants. The Company believes that all such costs would be recoverable in rates. RESULTS OF OPERATIONS EARNINGS Summary results of earnings for the years 1993, 1992 and 1991 were as follows: For all periods, net income, earnings for common stock and earnings per common share include a non-cash allowance for funds used during construction (AFC) and the effects of the RMC. Overall earnings remained stable in 1993 while the Company's improved cash flow continued, consistent with the 1989 Settlement. The earnings in the electric business were lower in 1993 when compared to 1992 due primarily to the expensing of previously deferred storm costs, lower interest rates associated with the short-term investments, and regulatory adjustments. The lower level of earnings in the electric business was offset by a significant increase in the gas business earnings. The Company saw continued expansion in the gas business in 1993. REVENUES Total revenues in 1993, including revenues from recovery of fuel costs, were $2.9 billion, representing an increase of $259 million or 9.9% over 1992 revenues. Total revenues for the Company's electric and gas operations for the years 1993, 1992 and 1991 were as follows: ELECTRIC REVENUES In 1993, electric revenues increased $157 million when compared to 1992. Revenues in 1992 had decreased $2 million compared with 1991. The changes in the level of revenues when compared to the prior year resulted from the following factors: RATE INCREASES The Company received electric rate increases of 4.0% effective December 1, 1993 and 4.1% effective December 1, 1992. These rate increases provided $75 million in additional revenues for 1993 when compared to 1992. A 4.15% rate increase effective December 1, 1991 provided $72 million in additional revenues for 1992 when compared to 1991. SALES VOLUMES The increase in revenue from sales volumes was primarily attributable to warmer weather experienced in the summer of 1993 when compared to the same period in 1992. The decrease in revenues from sales volumes for 1992 when compared to 1991 is also attributable to weather. The Company's current electric rate structure, discussed above under the heading "Rate Matters," provides for a revenue reconciliation mechanism which mitigates the impact on earnings of experiencing electric sales that are above or below the levels reflected in rates. As a result of lower than adjudicated electric sales, the Company recorded non-cash income, which is included in "Other Regulatory Amortizations" of $43.5 million, $78.5 million and $0.4 million in 1993, 1992 and 1991, respectively. For a further discussion on the recoverability of these amounts see the discussion under the heading "Rate Matters." Summary of electric kilowatt hour (Kwh) sales for the years 1993, 1992 and 1991 were as follows: The increase in residential and commercial/industrial sales in 1993 was largely due to the warmer weather experienced during the summer months. Residential sales, representing 45% of system sales, were up by 4.9% when compared with 1992, while commercial/industrial sales, which accounted for 52% of system sales, increased by 0.9%. Power pool sales fluctuate with relative costs and power pool system availabilities. The average number of electric customers served in 1993 and 1992 was approximately 1,013,000 and 1,009,000, respectively. The customer increase in 1993 is similar to the increase experienced in 1992 when compared to 1991. FUEL COST RECOVERIES Total electric fuel cost recoveries for 1993 were up $22 million compared with 1992, primarily as a result of higher sales volumes, partially offset by a decrease in the average cost of fuel. In 1992, fuel cost recoveries decreased by $13 million compared with 1991, principally due to lower sales volumes, partially offset by an increase in the average cost of fuel. GAS REVENUES In 1993, gas revenues increased by $102 million, or 23.8%, when compared to 1992. Revenues in 1992 increased by $76 million, or 21.7%, when compared to 1991. The changes in the level of revenues when compared to the prior year resulted from the following factors: RATE INCREASES The Company received a gas rate increase of 4.7%, effective December 31, 1993, but was permitted by the PSC to recognize additional revenues of $4.6 million in 1993, as if the rate increase had been effective on December 1, 1993. The Company had also received rate increases of 7.1%, effective December 1, 1992, and 4.1%, effective December 1, 1991. The effects of these rate increases was to increase revenues by $35 million in 1993 when compared with 1992, and by $17 million in 1992 when compared with 1991. SALES VOLUMES The increase in 1993 revenues due to sales volumes was primarily due to customer additions and conversions resulting from the Company's gas expansion program. The Company added over 9,000 new gas space heating customers to its system in 1993. In 1992, the Company added approximately 10,000 new gas space heating customers. Summary of gas decatherm (dth) sales for the years 1993, 1992 and 1991 were as follows: FUEL COST RECOVERIES Recoveries of gas fuel expenses in 1993 revenues increased by $33 million compared with 1992, primarily due to higher sales volumes. In 1992, fuel recovery revenues had increased by $9 million, primarily due to higher average gas prices. FUELS AND PURCHASED POWER Expenses for fuels and purchased power increased by $86 million in 1993 compared with 1992, and decreased by $27 million in 1992 compared with 1991. Summary of fuel and purchased power expenses for the years 1993, 1992 and 1991 were as follows: The Company has significantly reduced the amount of oil it would otherwise have used to generate electricity by burning gas, purchasing power and utilizing nuclear generation from NMP2. Summary of electric fuel and purchased power mix for the years 1993, 1992 and 1991 were as follows: OPERATIONS AND MAINTENANCE EXPENSES Total operations and maintenance expenses, excluding fuel and purchased power, for 1993, 1992 and 1991 were $522 million, $498 million and $523 million, respectively. The $24 million, or 4.8%, increase in 1993 when compared to 1992 was primarily due to the recognition of previously deferred storm costs, the recording of higher accruals for uncollectible accounts and higher transmission and distribution costs for both the electric and gas businesses. The $25 million, or 4.8%, decrease in 1992 compared to 1991 was primarily attributable to lower electric operations expenses. INTEREST EXPENSE Interest expense for 1993, 1992 and 1991 was $534 million, $513 million and $524 million, respectively. The increase in 1993 when compared to 1992 was attributable to higher debt levels and the conversion in June 1992 of $400 million of tax-exempt securities from a weekly variable interest rate to a higher 30-year fixed rate. Also contributing to the increase, was the issuance in November 1992 of 30-year fixed rate debentures, the proceeds of which were used to eliminate variable rate bank debt. The conversion of the tax-exempt securities and refinancing of bank debt was done in order to take advantage of historically low interest rates. Partially offsetting this increase in interest expense were the effects of the Company's aggressive refinancing of higher-cost debt in 1993. The decrease in 1992 when compared to 1991 is due to significantly lower interest rates on the Company's outstanding debt, primarily resulting from the Company's aggressive refinancing efforts in the latter part of 1991 and during 1992. RATE MODERATION COMPONENT In 1993, the Company recorded non-cash charges to income of approximately $49 million reflecting the amortization of the RMC offset by related carrying charges. In 1992 and 1991, the Company recorded non-cash credits to income of approximately $73 million and $269 million, respectively, representing the accretion of the RMC and related carrying charges. For a discussion of the RMC and RMA, see Notes 2 and 3 of Notes to Financial Statements. BASE FINANCIAL COMPONENT For each of the years 1993, 1992 and 1991, the Company recorded non-cash charges to income of approximately $101 million, reflecting the continuing amortization of the BFC, which is afforded rate base treatment under the RMA. For a further discussion of the BFC and 1989 Settlement, see Notes 1 and 2 of Notes to Financial Statements. ACCOUNTING PRONOUNCEMENTS Effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS No. 106 requires the Company to recognize the expected cost of providing postretirement benefits when employee services are rendered rather than on a pay-as-you-go method. The Company recorded an accumulated postretirement benefit obligation and corresponding regulatory asset of approximately $376 million which represents the transition obligation at January 1, 1993. As a result of adopting SFAS No. 106, the Company's annual postretirement benefit cost for 1993 increased by approximately $28 million above the amount that would have been recorded under the pay-as-you-go method. This additional non-cash postretirement benefit cost has been accounted for as a regulatory asset. The PSC has permitted recovery of these regulatory assets through rates. The adoption of SFAS No. 106 had no impact on net income for the year ended December 31, 1993. For a further discussion of SFAS No. 106, see Note 8 of Notes to Financial Statements. Effective January 1, 1993 the Company adopted SFAS No. 109, Accounting for Income Taxes. As permitted under SFAS No. 109, the Company has elected not to restate the financial statements of prior years. The adoption of SFAS No. 109 is in compliance with the PSC's Statement of Interim Policy on Accounting and Ratemaking issued in January 1993. This statement asserts that the adoption and ongoing implementation of SFAS No. 109 on an interim basis will be done in such a manner that all its provisions shall be complied with on a revenue neutral basis. As of January 1, 1993, the cumulative adjustment to the deferred tax liability and the corresponding regulatory asset is approximately $1.6 billion. The $800 million increase from the amount reported in interim financial statements results from the Company's further analysis of deferred taxes to recognize SFAS No. 109 requirements to present tax assets and liabilities gross. SFAS No. 109 requires, among other matters, recognition of the amount of current and deferred taxes payable or refundable at the date of the financial statements as a result of all events that have been recognized in the financial statements and adjustment of deferred income taxes for an enacted change in tax laws. For regulated enterprises, SFAS No. 109 prohibits net of tax accounting and reporting and requires recognition of a deferred tax liability for the tax benefits which are flowed through to its customers. A regulatory asset or liability will be recognized relating to such items if it is probable that the future increase or decrease in taxes payable thereon shall be recovered from or returned to customers through future rates. For a further discussion of SFAS No. 109, see Notes 1 and 10 of Notes to Financial Statements. SELECTED FINANCIAL DATA Additional information respecting revenues, expenses, electric and gas operating income and operations data and balance sheet information for the last five years is provided in Tables 1 through 9 of Item 6, Selected Financial Data. Information with regard to the Company's business segments for the last three years is provided in Note 11 of Notes to Financial Statements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENTS See Notes to Financial Statements. See Notes to Financial Statements. See Notes to Financial Statements. See Notes to Financial Statements. See Notes to Financial Statements. See Notes to Financial Statements. NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES REGULATION The Company's accounting policies conform to generally accepted accounting principles (GAAP) as they apply to a regulated enterprise. Its accounting records are maintained in accordance with the Uniform Systems of Accounts prescribed by the Public Service Commission of the State of New York (PSC) and the Federal Energy Regulatory Commission (FERC). UTILITY PLANT Additions to and replacements of utility plant are capitalized at original cost, which includes material, labor, overhead and an allowance for the cost of funds used during construction. The cost of renewals and betterments relating to units of property is added to utility plant. The cost of property replaced, retired or otherwise disposed of is deducted from utility plant and, generally, together with dismantling costs less any salvage, is charged to accumulated depreciation. The cost of repairs and minor renewals is charged to maintenance expense. Mass properties (such as poles, wire and meters) are accounted for on an average unit cost basis by year of installation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION The Uniform Systems of Accounts defines the allowance for funds used during construction (AFC) as the net cost of borrowed funds for construction purposes and a reasonable rate of return upon the utility's equity when so used. AFC is not an item of current cash income. AFC is computed monthly using a rate permitted by FERC on a portion of construction work in progress. The average annual AFC rate, without giving effect to compounding, was 9.73%, 9.98% and 10.74% for the years 1993, 1992 and 1991, respectively. DEPRECIATION The provisions for depreciation result from the application of straight-line rates to the original cost, by groups, of depreciable properties in service. The rates are determined by age-life studies performed annually on depreciable properties. Depreciation for electric properties was equivalent to approximately 3.0%, 3.2% and 3.3% of respective average depreciable plant costs for the years 1993, 1992 and 1991. Depreciation for gas properties was equivalent to approximately 2.0%, 2.6% and 2.9% of respective average depreciable plant costs for the years 1993, 1992 and 1991. FINANCIAL RESOURCE ASSET GAAP authorizes recognition of the existence of a regulatory asset when it is probable that a regulator will permit full recovery of a previously incurred cost. Pursuant to the 1989 Settlement and in accordance with GAAP, the Company recorded a regulatory asset known as the Financial Resource Asset (FRA). The FRA is designed to provide the Company with sufficient cash flows to assure its financial recovery. The FRA has two components, the Base Financial Component (BFC) and the Rate Moderation Component (RMC). The Rate Moderation Agreement (RMA), one of the constituent documents of the 1989 Settlement, provides for the full recovery of the FRA. For a further discussion of the 1989 Settlement and the FRA, see Note 2. CASH AND CASH EQUIVALENTS Cash equivalents are highly liquid investments with maturities of three months or less when purchased. The carrying amount approximates fair value because of the short maturity of these investments. FAIR VALUES OF FINANCIAL INSTRUMENTS The fair values for the Company's long-term debt and redeemable preferred stock are based on quoted market prices, where available. The fair values for all other long-term debt and redeemable preferred stock are estimated using a discounted cash flow analyses which is based upon the Company's current incremental borrowing rate for similar types of securities. CAPITALIZATION-PREMIUMS, DISCOUNTS AND EXPENSES Premiums or discounts and expenses related to the issuance of long-term debt are amortized over the life of each issue. Unamortized premiums or discounts and expenses related to issues of long-term debt that are refinanced are amortized and recovered through rates over the shorter life of either the redeemed or new issues. Capital stock expense and redemption costs related to certain issues of preferred stock that have been refinanced as well as the cost of issuance of the preferred stock issued are recorded as deferred charges. These amounts are being amortized and recovered through rates over the shorter life of the redeemed or new issues. REVENUES The Company accrues electric and gas revenues for services rendered to customers but not billed at month-end. FUEL COST ADJUSTMENTS The Company's electric and gas tariffs include fuel cost adjustment (FCA) clauses which provide for the disposition of the difference between actual fuel costs and the fuel costs allowed in the Company's base tariff rates (base fuel costs). The Company defers these differences to future periods in which they will be billed or credited to customers, except for base electric fuel costs in excess of actual electric fuel costs, which are currently credited to the RMC as incurred. FEDERAL INCOME TAXES Effective January 1, 1993, the Company adopted the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. As permitted under SFAS No. 109, the Company has elected not to restate the financial statements of prior years. The adoption of SFAS No. 109 is in compliance with the PSC's Statement of Interim Policy on Accounting and Ratemaking issued January 15, 1993. This statement asserts that the adoption and ongoing implementation of SFAS No. 109 on an interim basis will be done in such a manner that all its provisions shall be complied with on a revenue neutral basis. As of January 1, 1993, the cumulative adjustment to the deferred tax liability and the corresponding regulatory asset is approximately $1.6 billion. The $800 million increase from the amount reported in interim financial statements results from the Company's further analysis of deferred taxes to recognize SFAS No. 109 requirements to present tax assets and liabilities gross. SFAS No. 109 requires, among other matters, recognition of the amount of current and deferred taxes payable or refundable at the date of the financial statements as a result of all events that have been recognized in the financial statements and adjustment of deferred income taxes for an enacted change in tax laws. For regulated enterprises, SFAS No. 109 prohibits net of tax accounting and reporting and requires recognition of a deferred tax liability for the tax benefits which are flowed through to its customers. A regulatory asset or liability will be recognized relating to such items if it is probable that the future increase or decrease in taxes payable thereon shall be recovered from or returned to customers through future rates. The tax effects of other differences between income for financial statement purposes and for federal income tax purposes are accounted for as current adjustments in federal income tax provisions. Prior to the adoption of SFAS No. 109 the Company provided deferred federal income taxes with respect to certain items of income and expense that were reported in different years in the financial statements and the tax return. The Company defers the benefit of 60% of pre-1982 gas and pre-1983 electric and 100% of all other investment tax credits, with respect to regulated properties, when realized on its tax returns. Accumulated deferred investment tax credits are amortized ratably over the lives of the related properties. For ratemaking purposes, the Company provides deferred federal income taxes with respect to certain differences between net income before income taxes and taxable income in certain instances when approved by the PSC, as disclosed in Note 10. Also certain accumulated deferred federal income taxes are deducted from rate base and amortized or otherwise applied as a reduction (increase) in federal income tax expense in future years. RESERVES FOR CLAIMS AND DAMAGES Losses arising from claims against the Company, including worker's compensation claims, property damage, extraordinary storm costs and general liability claims, are partially self-insured. Extraordinary storm losses incurred by the Company are partially insured by certain commercial insurance carriers. These insurance carriers provide partial insurance coverage for individual storm losses between $5 million and $50 million. Storm losses which are outside of the above-mentioned range are self-insured by the Company. Reserves for these losses are based on, among other things, experience, risk of loss and the ratemaking practices of the PSC. RECLASSIFICATIONS To conform with an order of the FERC, dated March 31, 1993, the Company reclassified certain deferred items as regulatory assets and regulatory liabilities on its Balance Sheet. Regulatory assets and liabilities, as defined in this order, are assets and liabilities created through the ratemaking actions of regulatory agencies. Certain other prior year amounts have been reclassified in the financial statements to be consistent with the current year's presentation. NOTE 2. THE 1989 SETTLEMENT On February 28, 1989, the Company and the State of New York (by its Governor) entered into the 1989 Settlement resolving certain issues relating to the Company and providing, among other matters, for the transfer of the Shoreham Nuclear Power Station (Shoreham) and its subsequent decommissioning. On February 29, 1992, the Company transferred ownership of Shoreham to the Long Island Power Authority (LIPA), an agency of the State of New York. Pursuant to the 1989 Settlement, LIPA is responsible for the decommissioning of Shoreham and has estimated that the decommissioning, in which Company employees are participating, will be completed in 1994. Based on the latest available information, LIPA has projected that the cost of decommissioning Shoreham will total approximately $164 million. This estimate excludes the costs associated with the disposal of Shoreham's fuel which is estimated to be $122 million. At December 31, 1993, the Company has funded approximately $140 million and $30 million of these costs, respectively. LIPA anticipates that the Nuclear Regulatory Commission (NRC) will terminate its license for Shoreham by the end of 1994. Upon the effectiveness of the 1989 Settlement, in June of 1989, the Company simultaneously recorded on its Balance Sheet the retirement of its investment of approximately $4.2 billion principally in Shoreham and the establishment of the FRA, discussed in Note 1. The BFC, a component of the FRA, as initially established, represents the present value of the future net-after-tax cash flows which the RMA provided the Company for its financial recovery. The BFC was granted rate base treatment under the terms of the RMA and is included in the Company's revenue requirements through an amortization included in rates over forty years on a straight-line basis that began July 1, 1989. At December 31, 1993 and 1992, the unamortized balance of the BFC was approximately $3.6 billion and $3.7 billion, respectively. The RMC, a component of the FRA, reflects the difference between the Company's revenue requirements under conventional ratemaking and the revenues resulting from the implementation of the rate moderation plan provided for in the RMA. The RMC is currently adjusted, on a monthly basis, for the Company's share of certain Nine Mile Point Nuclear Power Station, Unit 2 (NMP2) operations and maintenance expenses, fuel credits resulting from the Company's electric fuel cost adjustment clause discussed in Note 1 and state gross receipts tax adjustments related to the FRA. The RMC has provided the Company with a substantial amount of non-cash earnings from the effective date of the 1989 Settlement through December 31, 1992. At December 31, 1993 and 1992, the RMC balance was $610 million and $652 million, respectively. Prior to December 31, 1992 the RMC had increased as the difference between revenues resulting from the implementation of the rate moderation plan provided for in the RMA and revenue requirements under conventional ratemaking, together with a carrying charge equal to the allowed rate of return on rate base, had been deferred. Subsequent to December 31, 1992, the RMC balance has been decreasing as revenues resulting from the implementation of the rate moderation plan are greater than revenue requirements under conventional ratemaking. For a further discussion of the impact on the amortization of the RMC under the Company's current electric rate structure and the Company's proposed electric rate plan for the three-year period beginning December 1, 1994, see Note 3. Under the 1989 Settlement, certain tax benefits attributable to the Shoreham abandonment are to be shared between ratepayers and shareowners. A regulatory liability of approximately $794 million was recorded in June 1989 to preserve an amount equivalent to the ratepayer tax benefits attributable to the Shoreham abandonment. This amount is being amortized over a ten-year period on a straight-line basis from the effective date of the 1989 Settlement. The Company has reclassified the regulatory liability component which was previously reported as a reduction of the corresponding deferred tax asset arising from the abandonment loss deduction. Shoreham post settlement costs (decommissioning, payments in lieu of property taxes and other costs as incurred) are being capitalized and amortized and recovered through rates over a forty-year period on a straight-line remaining life basis. Upon the effectiveness of the 1989 Settlement, Shoreham nuclear fuel was reclassified to deferred charges included in the Regulatory Asset section of the Balance Sheet and is being amortized and recovered through rates over a forty-year period on a straight-line remaining life basis. The 1989 Settlement credits on the Balance Sheet of approximately $155 million, net of amortization, reflect an adjustment of the book write- off to the negotiated 1989 Settlement amount. A portion of this amount is being amortized over a ten-year period. The remaining portion is not currently being recognized for ratemaking purposes under the 1989 Settlement. NOTE 3. RATE MATTERS ELECTRIC Pursuant to the 1989 Settlement, discussed in Note 2, the Company received electric rate increases contemplated by the RMA for each of the three rate years in the period ended November 30, 1991. The RMA contemplates that the Company will apply to the PSC for targeted annual rate increases of 4.5% to 5.0% in each year for an eight-year period beginning December 1, 1991. In response to the Company's December 1990 rate filing, the PSC approved the Long Island Lighting Company Ratemaking and Performance Plan (LRPP) in November 1991, which provides that the Company receive, for each of the three rate years in the period beginning December 1, 1991, annual electric rate increases of 4.15%, 4.1% and 4.0%, respectively, with an allowed return on common equity from electric operations of 11.6% for each of the three rate years. After giving effect to the reductions required by the Class Settlement discussed in Note 4, the Company's annual electric rate increases were approximately 4.15%, 3.9% and 3.9%, with an allowed return on common equity from electric operations of 10.92%, 10.72% and 10.58%, for the rate years beginning December 1, 1991, 1992 and 1993, respectively. The LRPP was designed to be consistent with the RMA's long-term goals. One principal objective of the LRPP is to reassign risk so that the Company assumes the responsibility for risks within the control of management, whereas risks largely beyond the control of management would be assumed by the ratepayers. The LRPP reflects an update of the long-range forecast of the Company's revenue requirements which was the basis of the RMA's initial three rate increases. The LRPP contains three major components--revenue reconciliation, expense attrition and reconciliation, and performance incentives. Revenue reconciliation is provided through a mechanism that reduces the impact of experiencing electric sales that are above or below the LRPP forecast by providing a fixed annual net margin level (defined as sales revenues, net of fuel and gross receipts taxes) that the Company will receive over the three rate years under the LRPP. The differences between the actual electric net revenues and the annual net margin level are deferred on a monthly basis during the rate year. The expense attrition and reconciliation component permits the Company to make adjustments for certain expenses recognizing that certain cost increases are unavoidable due to inflation and changes in the business. The LRPP includes the annual reconciliation of certain expenses for wage rates, property taxes, interest charges and demand side management (DSM) costs, the deferral and amortization of certain costs for enhanced reliability, production operations and maintenance expenses, and the application of an inflation index to other expenses for the rate years beginning December 1, 1992 and 1993. Under the performance incentive component of the LRPP, the Company is allowed to earn for each rate year up to 60 additional basis points, or forfeit up to 38 basis points, of the allowed return on common equity as a result of its performance within certain incentive and/or penalty programs. These programs consist of a customer service program, a time-of-use program, a partial pass through fuel cost incentive plan and, effective December 1, 1993, an electric transmission and distribution reliability plan. The incentives and/or penalties related to the customer service performance plan, the time-of-use program, the electric transmission and distribution reliability plan and the partial pass through fuel cost incentive plan are determined on a monthly basis during the rate year and deferred until final approval from the PSC. The incentives earned from the DSM program are collected in rates on a monthly basis through the FCA. Based upon the Company's performance within these programs, the Company earned a total of approximately 49 basis points or approximately $9.2 million, net of tax effects, and 23 basis points, or approximately $4.3 million, net of tax effects, for the rate years ended November 30, 1993 and 1992, respectively. The deferred balances resulting from the net margin, property taxes, interest expense, wage rates, performance incentives and associated carrying charges, excluding DSM incentives, are netted at the end of each rate year. The LRPP established a band whereby the first $15 million of the total net deferrals are used to increase or decrease the RMC balance. The LRPP provides for the disposition of the total net deferrals in excess of the $15 million band. Upon approval by the PSC, the total net deferrals in excess of $15 million are refunded or recovered from the ratepayers through the FCA over a twelve-month period in the following rate year. During 1993, the PSC authorized the Company recovery of $45.2 million of the total net deferrals for the rate year ended November 30, 1992. The first $15 million of the total net deferrals was recorded as an increase to the RMC, with the remaining $30.2 million being recovered from the ratepayers through the FCA through July 31, 1994. For the rate year ended November 30, 1993, the total net deferrals, to be recovered from the ratepayers, subject to PSC review, amounted to approximately $63 million of which $48 million will be recovered through the FCA, over a twelve-month period beginning December 1, 1994. The Company earned $8.9 million and $21.4 million, net of tax effects, for the rate years ended November 30, 1993 and 1992, respectively, in excess of its allowed rate of return on common equity of 11.6% which, in accordance with the LRPP, was shared equally between ratepayers (by a reduction to the RMC) and shareowners. Prior to December 1, 1991, the RMA provided that earned returns on common equity in excess of targeted allowed rates of return, were to be applied to reduce the RMC or mitigate rates, as determined by the PSC, at the end of each rate year. For the rate year ended November 30, 1991, the Company earned $10.1 million, net of tax effects, in excess of its allowed rate of return, which was applied as a reduction to the RMC. To assist in the recovery of the RMC balance under the rates provided by the LRPP, the Company, in accordance with the LRPP, has credited the RMC with several deferred ratepayer benefits. In December 1993 and 1992, the Company applied a total of approximately $10.1 million and $22.5 million of various deferred ratepayer benefits to the RMC including the ratepayers portion of the excess earnings for the rate years ended November 30, 1993 and 1992, respectively. In December 1993, the Company filed a three-year electric rate plan with the PSC for the period beginning December 1, 1994 that minimizes future electric rate increases while retaining consistency with the RMA's objective of continuing the restoration of the Company's financial health. The electric rate plan provides for zero percentage base rate increases before giving effect to the reductions required by the Class Settlement, discussed in Note 4, in years one and two of the plan and a base rate increase of 4.3% in the third year prior to giving effect to the reductions required by the Class Settlement. Although base electric rates would be frozen during the first two years of the plan, annual rate increases of approximately 1% to 2% are expected to result in these years from the operation of the Company's FCA. The FCA captures, among other amounts, any increases in the cost of fuel above the level recovered in base rates, and under the LRPP, any amounts to be recovered or refunded to ratepayers in excess of $15 million which result from the reconciliation of revenue, certain expenses and earned performance incentive components, discussed above. The electric rate plan requests an allowed rate of return on equity of 11.0%. The Company's two-year base rate freeze proposal reflects four underlying objectives: (i) to limit the balance of the RMC during the three-year period to no more than its 1992 peak balance of $652 million; (ii) to recover the RMC within no more than thirteen years of its 1989 inception; (iii) to minimize the final three rate increases that will follow the two-year rate freeze period; and (iv) to continue the Company's gradual return to financial health. The Company's electric rate plan is subject to approval by the PSC. The Company's current electric rate plan provides for lower annual electric rate increases than originally anticipated under the 1989 Settlement. However, as a result of changes in certain assumptions upon which the RMA was based, their impact on the RMC and the Company's plans to reduce DSM, operations and maintenance and capital expenditures, the Company has determined that the overall objectives of the RMA can be met under the multi-year plan described above. As a result of lower than originally anticipated inflation rates, interest costs, property taxes, fuel costs and return on common equity allowed by the PSC, the RMC, which originally had been anticipated to peak at $1.2 billion in 1994, has already peaked at $652 million in 1992. With the exception of an increase in 1995-1996, which is not now projected to cause the RMC to increase above its $652 million peak, the RMC is expected to decline until it is fully amortized. Under the electric rate plan, the recovery of the RMC would be extended, if necessary, for an additional period of not more than three years beyond the approximate ten-year period envisioned in the RMA. The actual length of the RMC extension will depend on the extent to which the assumptions underlying the rate plan materialize. The Company's current projections indicate that the RMC will be recovered in eleven years instead of ten years. GAS In December 1993, the PSC approved a three-year gas rate settlement between the Company and the Staff of the PSC. The gas rate settlement provides that the Company receive, for each of the rate years beginning December 1, 1993, 1994 and 1995, annual gas rate increases of 4.7%, 3.8% and 2.8%, respectively. In the determination of the revenue requirements for the first year of the gas rate settlement an allowed rate of return on equity of 10.1% was used. The gas rate decision also provides for earnings in excess of a 10.6% return on equity in any of the three rate years covered by the settlement be shared equally between the Company's firm gas customers and its shareowners. The allowed rate of return for the rate year that began December 1, 1992 was 11.0%. NOTE 4. THE CLASS SETTLEMENT The Class Settlement, which became effective on June 28, 1989, resolved a civil lawsuit against the Company brought under the federal Racketeer Influenced and Corrupt Organizations Act (RICO Act). The lawsuit which the Class Settlement resolved, had alleged that the Company made inadequate disclosures before the PSC concerning the construction and completion of nuclear generating facilities. The Class Settlement provides the Company's ratepayers with reductions, aggregating $390 million, that are to be reflected as adjustments to their monthly electric bills over a ten-year period which began on June 1, 1990. The reductions in each of the remaining twelve-month periods are as follows: Upon its effectiveness, the Company recorded its liability for the Class Settlement on a present value basis at $170 million and simultaneously recorded a charge to income (net of tax effects of $57 million) of approximately $113 million. Each month the Company records the changes in the present value of such liability that result from the passage of time and from monthly reductions. The Company expects the Class Settlement liability will be fully satisfied by May 31, 2000. As a result of the Class Settlement, the Company's electric rate increases on average will be approximately .2% to .3% per year lower than they would otherwise have been during the Class Settlement period. NOTE 5. NINE MILE POINT NUCLEAR POWER STATION, UNIT 2 The Company has an 18% undivided interest in NMP2 which is operated by Niagara Mohawk Power Corporation (NMPC) near Oswego, New York. Ownership of NMP2 is shared by five cotenants: the Company (18%), NMPC (41%), New York State Electric & Gas Corporation (18%), Rochester Gas and Electric Corporation (14%) and Central Hudson Gas & Electric Corporation (9%). At December 31, 1993, the Company's net utility plant investment in NMP2 was $759 million, net of accumulated depreciation of $119 million, which is included in the Company's rate base. Output of NMP2 is shared in the same proportions as the cotenants' respective ownership interests. The operating expenses of NMP2 are also allocated to the cotenants in the same proportions as their respective ownership interests. The Company's share of these expenses is included in the appropriate operating expenses on the Statement of Income. The Company is required to provide its respective share of financing for any capital additions to NMP2. Nuclear fuel costs associated with NMP2 are being amortized on the basis of the quantity of heat produced for the generation of electricity. NMPC has contracted with the United States Department of Energy for the disposal of nuclear fuel. The Company reimburses NMPC for its 18% share of the cost under the contract at a rate of $1.00 per megawatt hour of net generation less a factor to account for transmission line losses. Based upon a study performed by NMPC which reflects a change in the NRC minimum decommissioning funding requirement effective 1993, the Company's share of the decommissioning costs for NMP2 is estimated to be $80 million (in 1993 dollars) assuming that decommissioning will commence in 2027 (which will be $234 million in 2027 dollars). The Company's share of estimated decommissioning costs are being provided for in electric rates and are being charged to operations as depreciation expense. The amount of accumulated decommissioning costs collected from the Company's ratepayers through December 31, 1993 was $7.1 million. Amounts collected by the Company for the decommissioning of the contaminated portion of the NMP2 plant, which approximate 92% of total decommissioning costs, are held in an independent decommissioning trust fund. This fund complies with regulations issued by the NRC governing the funding of nuclear plant decommissioning costs. The Company's funding plan for its share of decommissioning costs will provide reasonable assurance that, at the time of termination of operation, adequate funds for the decommissioning of the Company's share of the contaminated portion of NMP2 plant will be available. NOTE 6. CAPITAL STOCK PREFERRED STOCK The Company has 7,000,000 authorized shares, cumulative preferred stock, par value $100 and 30,000,000 authorized shares, cumulative preferred stock, par value $25. Dividends on preferred stock are paid in preference to dividends on common stock or any other stock ranking junior to preferred stock. PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION The aggregate fair value of redeemable preferred stock with mandatory redemptions at December 31, 1993 and 1992 amounted to $658,795,000 and $581,984,000, respectively, compared to their carrying amounts of $653,950,000 and $566,100,000, respectively. At December 31, 1993, the Company had the option to redeem all outstanding preferred stock Series L, $100 par value, and Series R, $100 par value, at their optional redemption prices of $102.99 per share and $100.50 per share, respectively. No other preferred stock series subject to mandatory redemptions were redeemable at December 31, 1993. The Company is required to redeem the following series of preferred stock through the operation of various sinking fund provisions: (i) on each July 31, 10,500 shares of the Series L at a price of $100 per share; (ii) on each December 15, 37,500 shares of the Series R at a price of $100 per share; (iii) on each March 1, commencing March 1, 1999, 77,700 shares of the Series NN at a price of $25 per share; and (iv) on each October 15, commencing October 15, 1999, 112,000 shares of the Series UU at a price of $25 per share. In addition, the Company will have the noncumulative option to double the number of shares to be redeemed pursuant to the sinking fund in any year for the preferred stock series mentioned above. The aggregate par value of preferred stock required to be redeemed by use of sinking funds in each of the years 1994 through 1996 is $4.8 million and in 1997 and 1998 is $1.1 million. The Company is also required to redeem certain series of preferred stock which are not subject to sinking fund requirements. The scheduled mandatory redemption for these series are as follows: (i) Series CC on August 1, 2002; (ii) Series AA on June 1, 2000; (iii) Series GG on March 1, 1999; and (iv) Series QQ on May 1, 2001. During 1992, the Company issued $363 million Preferred Stock, 7.95% Series AA and $57 million Preferred Stock, 7.66% Series CC, the proceeds of which were used to redeem $320 million Preferred Stock, $2.65 Series Y and $55 million Preferred Stock, 9.80% Series S, respectively, at their optional redemption prices. PREFERRED STOCK NOT SUBJECT TO MANDATORY REDEMPTION The Company has the option to redeem certain series of its preferred stock. For the series subject to optional redemption at December 31, 1993, the call prices were as follows: PREFERENCE STOCK None of the authorized 7,500,000 shares of nonparticipating preference stock, par value $1 per share, which ranks junior to preferred stock, are outstanding. COMMON STOCK Of the 150,000,000 shares of authorized common stock at December 31, 1993, 1,789,842 shares were reserved for sale through the Company's Employee Stock Purchase Plan, 5,946,929 shares were committed to the Automatic Dividend Reinvestment Plan (ADRP) and 118,812 shares were reserved for conversion of the Series I Convertible Preferred Stock at a rate of $17.15 per share. In June 1992, the Company reinstated the ADRP which had been suspended since February 1984. Common and preferred stock dividend limitations in the mortgage securing the Company's First Mortgage Bonds are not material. There are no dividend limitations contained in the Company's other debt instruments. NOTE 7. LONG-TERM DEBT Each of the Company's outstanding mortgages is a lien on substantially all of the Company's properties. FIRST MORTGAGE All of the bonds issued under the First Mortgage, including those issued after June 1, 1975 and pledged with the Trustee of the G&R Mortgage (G&R Trustee) as additional security for General & Refunding Bonds (G&R Bonds), are secured by the lien of the First Mortgage. First Mortgage Bonds pledged with the G&R Trustee do not represent outstanding indebtedness of the Company. Amounts of such pledged bonds outstanding were $1.03 billion at December 31, 1993 and 1992. The annual First Mortgage depreciation fund and sinking fund requirements for 1993, due not later than June 30, 1994, are estimated at $216 million and $18 million, respectively. The Company expects to meet these requirements with property additions and retired First Mortgage Bonds. G&R MORTGAGE The lien of the G&R Mortgage is subordinate to the lien of the First Mortgage. The annual G&R Mortgage sinking fund requirement for 1993, due not later than June 30, 1994, is estimated at $24 million. The Company expects to satisfy this requirement with retired G&R Bonds. 1989 REVOLVING CREDIT AGREEMENT The Company has an estimated $276 million available to it through October 1, 1994, under its $300 million 1989 Revolving Credit Agreement (1989 RCA). This line of credit is secured by a first lien upon the Company's accounts receivable and fuel oil inventories. The Company is currently, with the approval of the NRC, dedicating $24 million of the 1989 RCA to cover estimated, not yet incurred, costs attributable to the decommissioning of Shoreham, discussed in Note 2. The amount of credit available to the Company under the 1989 RCA will increase as decommissioning costs are funded by the Company. At December 31, 1993, no amounts were outstanding under the 1989 RCA. The Company has the option, when amounts are outstanding, to commit to one of three interest rates including: (i) the Adjusted Certificate of Deposit Rate which is a rate based on the certificate of deposit rates of certain of the lending banks, (ii) the Base Rate which is generally a rate based on Citibank, N.A.'s prime rate and (iii) the Eurodollar Rate which is a rate based on the London Interbank Offering Rate (LIBOR). The Company has agreed to pay a fee of one quarter of one percent per annum on the unused portion. The termination date of the 1989 RCA may be extended for one-year periods upon the acceptance by the lending banks of the Company's request delivered to the lending banks prior to April 1 in each year. AUTHORITY FINANCING NOTES Authority Financing Notes are issued by the Company to the New York State Energy Research and Development Authority (NYSERDA) to secure certain tax-exempt Pollution Control Revenue Bonds (PCRBs), Electric Facilities Revenue Bonds (EFRBs) and Industrial Development Revenue Bonds issued by NYSERDA. Certain of these bonds are subject to periodic tender at which time their interest rates are subject to redetermination. The 1993 EFRBs and the 1985 PCRBs are supported by letters of credit pursuant to which the letter of credit banks have agreed to pay the principal, interest and premium if applicable, in the aggregate, up to approximately $272 million in the event of default. The obligation of the Company to reimburse the letter of credit banks is unsecured. These letters of credit expire November 17, 1996 for the 1993 EFRBs and on March 16, 1996 for the 1985 PCRBs, at which time the Company is required to obtain either an extension of the letters of credit or substitute credit backup. If neither can be obtained, the 1993 EFRBs and the 1985 PCRBs must be redeemed unless the Company purchases them in lieu of redemption and subsequently remarkets them. Tender requirements of Authority Financing Notes at December 31, 1993 are as follows: FAIR VALUES OF LONG-TERM DEBT The carrying amounts and fair values of the Company's long-term debt consisted of the following at December 31: MATURITY SCHEDULE Total long-term debt maturing in the next five years is $600 million (1994), $25 million (1995), $455 million (1996), $286 million (1997) and $1 million (1998). NOTE 8. RETIREMENT BENEFIT PLANS PENSION PLANS The Company maintains a primary defined benefit pension plan (Primary Plan) which covers substantially all employees, a supplemental plan (Supplemental Plan) which covers officers and certain key executives and a retirement plan which covers the Board of Directors (Directors' Plan). Primary Plan The Company's funding policy is to contribute annually to the Primary Plan a minimum amount consistent with the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) plus such additional amounts, if any, as the Company may determine to be appropriate from time to time. Effective January 1, 1992, the Plan was amended to update the benefit calculation, whereby for service before January 1, 1992, pension benefits are determined based on the greater of the accrued benefit as of December 31, 1991, or by applying a moving five-year average of Plan compensation, not to exceed the January 1, 1992 salary, to a certain percentage, determined by years of service at December 31, 1991. For service after January 1, 1992, pension benefits are equal to 2% of Plan compensation through age 49 and 2 1/2% thereafter. Employees are vested in the pension plan after five years of service with the Company. The Primary Plan's funded status reflects changes in assumptions used in accounting due to changes in market conditions. The 1993 projected benefit obligation increased by approximately $31 million due to changes in the discount rate used, partially offset by a lower rate of future compensation increases. The Primary Plan's funded status and amounts recognized on the Balance Sheet at December 31, 1993 and 1992 were as follows: Periodic pension cost for 1993, 1992 and 1991 for the Primary Plan included the following components: Assumptions used in accounting for the Primary Plan were: The Primary Plan assets at fair value primarily include cash, cash equivalents, group annuity contracts, bonds and listed equity securities. In 1993, the PSC issued an order which addressed the accounting and ratemaking treatment of pension costs in accordance with SFAS No. 87, Employers' Accounting For Pensions. Under the PSC order, the Company is required to recognize any deferred net gains or losses over a ten- year period rather than using the corridor approach method. The Company believes that by adopting this method of accounting for financial reporting purposes, a better matching of revenues and the Company's pension cost will result from the implementation of the PSC order. For the year ended December 31, 1993, this change in the annual pension cost calculation reduced pension expense by approximately $4.6 million. The Company deferred a like amount of revenues to reflect the difference between pension expense in rates and pension expense under the PSC's order. In addition, the PSC authorized the Company to defer the difference between the pension rate allowance and annual pension contributions deposited into the pension fund. The Company is required to accrue, to the benefit of the ratepayer, a carrying charge on any such deferred balance. Supplemental Plan The Supplemental Plan, the cost of which is borne by the Company's shareowners, provides supplemental death and retirement benefits for officers and other key executives without contribution from such employees. The Supplemental Plan is a non-qualified plan under the Internal Revenue Code. Death benefits are currently provided by insurance. The provision for retirement benefits, which is unfunded, totaled approximately $2,800,000, $685,000 and $675,000 which was recognized as an expense in 1993, 1992 and 1991, respectively. Directors' Plan The Directors' Plan, adopted in February 1990, provides benefits to directors who are not officers of the Company. Directors who have served in that capacity for more than five years qualify as participants under the plan. The Directors' Plan is a non-qualified plan under the Internal Revenue Code. The provision for retirement benefits, which is unfunded, totaled approximately $150,000, $133,000 and $101,000 which was recognized as expense in 1993, 1992 and 1991, respectively. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In addition to providing pension benefits, the Company provides certain medical and life insurance benefits for retired employees. Substantially all of the Company's employees may become eligible for these benefits if they reach retirement age after working for the Company for a minimum of five years. These and similar benefits for active employees are provided by the Company or by insurance companies whose premiums are based on the benefits paid during the year. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, which requires the Company to recognize the expected cost of providing postretirement benefits when employee services are rendered rather than on a pay-as-you-go method. Effective January 1, 1993, the Company recorded an accumulated postretirement benefit obligation and a corresponding regulatory asset of approximately $376 million. Additionally, as a result of adopting SFAS No. 106, the Company's annual postretirement benefit cost for 1993 increased by approximately $28 million above the amount that would have been recorded under the pay-as-you-go method. In 1993, the PSC issued a final order which required that the effects of implementing SFAS No. 106 be phased into rates. The order required the Company to defer as a regulatory asset the difference between postretirement benefit expense recorded for accounting purposes in accordance with SFAS No. 106 and the postretirement benefit expense reflected in rates. The ongoing annual postretirement benefit expense will be phased into and fully reflected in rates within a five-year period with the accumulated postretirement obligation being recovered in rates over a twenty-year period. Accumulated postretirement benefits obligation other than pensions at December 31 were as follows: Periodic postretirement benefit cost other than pensions for the years 1993 and 1992 were as follows: Assumptions used in accounting for postretirement benefits other than pensions were as follows: The assumed health care cost trend rates used in measuring the accumulated postretirement benefit obligation at December 31, 1993 and 1992 were 9.5% and 15.0%, respectively, gradually declining to 6.0% in 2001 and thereafter. A one-percentage point increase in the health care cost trend rate would increase the accumulated postretirement benefit obligation as of December 31, 1993 and 1992 by approximately $46 million and $58 million, respectively, and the sum of the service and interest costs in 1993 by $8 million. POSTEMPLOYMENT BENEFITS In November 1992, the FASB issued SFAS No. 112, Employers' Accounting for Postemployment Benefits, which establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement. The Company will be required to comply with the new rules beginning in 1994. The effect of adopting the new rules will not be material to the Company's financial position or results of operations. The Company believes it will be permitted to recover these costs through rates. NOTE 9. COMMITMENTS AND CONTINGENCIES COMMITMENTS The Company has entered into substantial commitments for fossil fuel, gas supply, purchased power and transmission facilities. The costs associated with these commitments are normally recovered from ratepayers through provisions in the Company's rate schedules. The Company expects that it will have to expend $4.3 million in 1994 to meet continuous emission monitoring requirements and $3.5 million in 1994 and $2.0 million in 1995 to meet Phase I nitrogen oxide (NOx) reduction requirements. In addition, subject to details that are expected to appear in regulations that have not yet been issued, the Company estimates that it may be required to expend as much as $125 million by May 1999 to meet Phase II NOx reduction requirements and approximately $50 million by 2000 to meet requirements for the control of hazardous air pollutants from power plants. The Company believes that such cost would be recoverable in rates. CONTINGENCIES Litigation On February 11, 1988, the Company began a lawsuit in Suffolk County Supreme Court against Suffolk County, seeking the recovery of approximately $54 million in damages for Suffolk County's breach of a contract to prepare an off site emergency response plan for Shoreham (Long Island Lighting Company v. County of Suffolk). In addition, the complaint alleges that, because of the delays that have resulted, the Company has been damaged in an additional amount of $706 million. On October 30, 1992, the court granted in part and denied in part Suffolk County's motion to amend its answer to assert additional defenses and counterclaims. Two proposed counterclaims were allowed seeking approximately $16 million in damages as well as $700 million in alleged punitive damages. The outcome of these counterclaims, if adverse, could have a material effect on the financial condition of the Company. The Company has argued that there is no basis for punitive damages and intends to vigorously prosecute its claim against Suffolk County and to defend against these counterclaims. Environmental The Company is subject to environmental laws and regulations of the United States Environmental Protection Agency (EPA) and other regulatory agencies. The Company is monitoring its activities and to date, has not identified any material environmental contingencies. The Company believes that costs related to such contingencies, if any, would be recoverable in rates. NUCLEAR PLANT INSURANCE The Company has property damage insurance and third-party bodily injury and property liability insurance for its 18% share in NMP2 and for Shoreham. The premiums for this coverage are not material. The policies for this coverage provide for retroactive premium assessments under certain circumstances. Maximum retroactive premium assessments could be as much as approximately $4.7 million. For property damage at each nuclear generating site, the NRC requires a minimum of $1.06 billion of coverage. The NRC has provided the Company with a partial exemption from these requirements for Shoreham. Under certain circumstances, the Company may be assessed additional amounts in the event of a nuclear incident. Under agreements established pursuant to the Price Anderson Act, the Company could be assessed up to approximately $79.3 million per nuclear incident in any one year at any nuclear unit, but not in excess of approximately $10 million in payments per year for each incident. The Price Anderson Act also limits liability for third-party bodily injury and third-party property damage arising out of a nuclear occurrence at each unit to $9.4 billion. NOTE 10. FEDERAL INCOME TAXES As of December 31, 1993, the significant components of the Company's deferred tax assets and liabilities calculated under the provisions of SFAS No. 109 were as follows: The Company's net operating loss (NOL) carryforward for federal income tax purposes is estimated to be approximately $2 billion at December 31, 1993. The NOL will expire in the years 2003 through 2007. The amount of investment tax credit (ITC) carryforward is approximately $219 million. The ITC credits expire by the year 2002. In accordance with the Tax Reform Act of 1986 (TRA 86), ITC allowable as credits to tax returns for years after 1987 must be reduced by 35%. The amount of the reduction will not be allowed as a credit for any other taxable year. For financial reporting purposes, a valuation allowance was not required to offset the deferred tax assets related to these carryforwards. On January 8, 1990 and October 10, 1992, the Company received Revenue Agents' Reports disallowing certain deductions claimed by the Company on its tax returns for the audit cycle years 1984-1987 and 1988-1989, respectively. The Revenue Agents' Reports reflects proposed adjustments to the Company's federal income tax returns for 1984 through 1989 which, if sustained, would give rise to tax deficiencies totaling approximately $220 million. The Revenue Agents have proposed ITC adjustments which, if sustained, would reduce the Company's carryforward by approximately $96 million. The Company is protesting some of the adjustments and seeks an administrative and, if necessary, a judicial review of the conclusions reached in the Revenue Agents' Reports. The Company cannot predict either the timing or the manner in which these matters will be resolved. If however, the ultimate disposition of any or all matters raised in the Revenue Agents' Reports are adverse to the Company, the Company expects that any deficiencies that may arise will be substantially offset by the net operating loss carrybacks associated with the 1989 Shoreham abandonment loss deduction of $1.8 billion and thus any impact would not have a material effect on the Company's financial condition or cash flows. The federal income tax amounts included in the Statement of Income differ from the amounts which result from applying the statutory federal income tax rate to net income before income taxes. The table below sets forth the reasons for such differences. NOTE 11. SEGMENTS OF BUSINESS The Company is a public utility engaged in the generation, distribution and sale of electric energy and the purchase, distribution and sale of natural gas to residential, commercial and industrial customers in Nassau and Suffolk Counties and the Rockaway Peninsula in Queens County, all on Long Island, New York. Identifiable assets by segment include net utility plant, regulatory assets, materials and supplies (excluding common), accrued unbilled revenues, gas in storage, fuel and deferred charges (excluding common). Assets utilized for overall Company operations consist of other property and investments, cash and cash equivalents, special deposits, accounts receivable, prepayments and other current assets, unamortized debt expense and other deferred charges. NOTE 12. QUARTERLY FINANCIAL INFORMATION (Unaudited) In the fourth quarter of 1993, the Company recorded income of approximately $6.5 million, net of tax effects, or $.06 per common share related to the settlement of certain litigation. In addition, during the fourth quarter of 1993, the Company recorded a charge to earnings of approximately $7.3 million, net of tax effects or $.07 per common share principally related to previously deferred storm costs and the reconciliation of certain ratemaking mechanisms recorded in connection with the conclusion of the Company's rate year. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS To the Shareowners and Board of Directors of Long Island Lighting Company We have audited the accompanying balance sheet of Long Island Lighting Company and the related statement of capitalization, 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. 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 all 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 Long Island Lighting Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 8 and 10 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and income taxes. /s/ ERNST & YOUNG Melville, New York February 4, 1994 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 COMPANY Information required by Item 10 as to the Company's Executive Officers is set forth in Item 1, "Business" under the heading "Executive Officers of the Company" above. Information required by Item 10 as to the Company's Directors may be found in the Company's proxy statement for its Annual Meeting to be held on April 12, 1994. Such proxy statement is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION Information required by Item 11 may be found in the Company's proxy statement for its Annual Meeting to be held on April 12, 1994. Such proxy statement is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by Item 12 may be found in the Company's proxy statement for its Annual Meeting to be held on April 12, 1994. Such proxy statement is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by Item 13 may be found in the Company's proxy statement for its Annual Meeting to be held on April 12, 1994. Such proxy statement is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) List of Financial Statements Balance Sheet at December 31, 1993 and 1992. Statement of Income for each of the three years in the period ended December 31, 1993. Statement of Capitalization at December 31, 1993 and 1992. Statement of Cash Flows for each of the three years in the period ended December 31, 1993. Statement of Retained Earnings for each of the three years in the period ended December 31, 1993. Notes to Financial Statements. (2) List of Financial Statement Schedules Property, Plant and Equipment (Schedule V) Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment (Schedule VI) Valuation and Qualifying Accounts (Schedule VIII) Supplementary Income Statement Information (Schedule X) (3) List of Exhibits *3(a) Restated Certificate of Incorporation of the Company dated November 11, 1993. (b) By-laws of the Company as amended on May 28, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 4(a) General and Refunding Indenture dated as of June 1, 1975 and 21 supplements thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as follows: G&R Indenture dated as of June 1, 1975. First Supplemental Indenture to G&R Indenture dated as of June 1, 1975. Second Supplemental Indenture to G&R Indenture dated as of September 1, 1975. Third Supplemental Indenture to G&R Indenture dated as of June 1, 1976. Fourth Supplemental Indenture to G&R Indenture dated as of December 1, 1976. Fifth Supplemental Indenture to G&R Indenture dated as of May 1, 1977. Sixth Supplemental Indenture to G&R Indenture dated as of April 1, 1978. - ------------------------ * Filed herewith. Seventh Supplemental Indenture to G&R Indenture dated as of March 1, 1979. Eighth Supplemental Indenture to G&R Indenture dated as of February 1, 1980. Ninth Supplemental Indenture to G&R Indenture dated as of March 1, 1981. Tenth Supplemental Indenture to G&R Indenture dated as of July 1, 1981. Eleventh Supplemental Indenture to G&R Indenture dated as of July 1, 1981. Twelfth Supplemental Indenture to G&R Indenture dated as of December 1, 1981. Thirteenth Supplemental Indenture to G&R Indenture dated as of December 1, 1981. Fourteenth Supplemental Indenture to G&R Indenture dated as of June 1, 1982. Fifteenth Supplemental Indenture to G&R Indenture dated as of October 1, 1982. Sixteenth Supplemental Indenture to G&R Indenture dated as of April 1, 1983. Seventeenth Supplemental Indenture to G&R Indenture dated as of May 1, 1983. Eighteenth Supplemental Indenture to G&R Indenture dated as of September 1, 1984. Nineteenth Supplemental Indenture to G&R Indenture dated as of October 1, 1984. Twentieth Supplemental Indenture to G&R Indenture dated as of June 1, 1985. Twenty-first Supplemental Indenture to G&R Indenture dated as of April 1, 1986. Twenty-second Supplemental Indenture to G&R Indenture dated as of February 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Twenty-third Supplemental Indenture to G&R Indenture dated as of May 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Twenty-fourth Supplemental Indenture to G&R Indenture dated as of July 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Twenty-fifth Supplemental Indenture to G&R Indenture dated as of May 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Twenty-sixth Supplemental Indenture to G&R Indenture dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 4(b) Indenture of Mortgage and Deed of Trust dated as of September 1, 1951 and 44 supplements thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as follows: Indenture of Mortgage dated as of September 1, 1951. First Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1951. Second Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1952. Third Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1953. Fourth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1954. Fifth Supplemental Indenture to the Indenture of Mortgage dated as of November 1, 1955. Sixth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1956. Seventh Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1958. Eighth Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1959. Ninth Supplemental Indenture to the Indenture of Mortgage dated as of August 1, 1961. Tenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1963. Eleventh Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1964. Twelfth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1965. Thirteenth Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1966. Fourteenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1967. Fifteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1969. Sixteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1970. Seventeenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1971. Eighteenth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1971. Nineteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1972. Twentieth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1973. Twenty-first Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1974. Twenty-second Supplemental Indenture to the Indenture of Mortgage dated as of November 1, 1974. Twenty-third Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1975. Twenty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1975. Twenty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1976. Twenty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1976. Twenty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1977. Twenty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1978. Twenty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1979. Thirtieth Supplemental Indenture to the Indenture of Mortgage dated as of February 1, 1980. Thirty-first Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1981. Thirty-second Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1981. Thirty-third Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1981. Thirty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1981. Thirty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1981. Thirty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1982. Thirty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1982. Thirty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1983. Thirty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1983. Fortieth Supplemental Indenture to the Indenture of Mortgage dated as of February 29, 1984. Forty-first Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1984. Forty-second Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1984. Forty-third Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1985. Forty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1986. Forty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of February 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Forty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Forty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Forty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Forty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *4(c) Debenture Indenture dated as of November 1, 1986 from the Company to The Connecticut Bank and Trust Company, National Association, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). First Supplemental Indenture dated as of November 1, 1986 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). Second Supplemental Indenture dated as of April 1, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Third Supplemental Indenture dated as of July 1, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Fourth Supplemental Indenture dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Fifth Supplemental Indenture dated as of November 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *Sixth Supplemental Indenture dated as of June 1, 1993. *Seventh Supplemental Indenture dated as of July 1, 1993. 4(d) Debenture Indenture dated as of November 1, 1992 from the Company to Chemical Bank, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). First Supplemental Indenture dated as of January 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). - ------------------------ * Filed herewith. Second Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Third Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Fourth Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(a) Sound Cable Project Facilities and Marketing Agreement dated as of August 26, 1987 between the Company and the Power Authority of the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). 10(b) Transmission Agreement by and between the Company and Consolidated Edison Company of New York, Inc. dated as of March 31, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(c) Contract for the sale of Firm Power and Energy by and between the Company and the State of New York dated as of April 26, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(d) Capacity Supply Agreement dated as of December 13, 1991 between the Company and the Power Authority of the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). *10(e) Nine Mile Point Nuclear Station Unit 2 Operating Agreement dated as of January 1, 1993 by and between the Company, New York State Electric & Gas Corporation, Rochester Gas and Electric Corporation and Central Hudson Gas and Electric Corporation. 10(f) Settlement Agreement on Issues Related to Nine Mile Two Nuclear Plant dated as of June 6, 1990 by and between the Company, the Staff of the Department of Public Service and others (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). - ------------------------ * Filed herewith. 10(g) Settlement Agreement -- LILCO Issues dated as of February 28, 1989 by and between the Company and the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). 10(h) Amended and Restated Asset Transfer Agreement by and between the Company and the Long Island Power Authority dated as of June 16, 1988 as amended and restated on April 14, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(i) Memorandum of Understanding concerning proposed agreements on power supply for Long Island dated as of June 16, 1988 by and between the Company and New York Power Authority as amended May 24, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(j) Rate Moderation Agreement submitted by the staff of the New York State Public Service Commission on March 16, 1989 and supported by the Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(k) Site Cooperation and Reimbursement Agreement dated as of January 24, 1990 by and between the Company and Long Island Power Authority (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(l) Stipulation of settlement of federal Racketeer Influenced and Corrupt Organizations Act ("RICO") Class Action and False Claims Action dated as of February 27, 1989 among the attorneys for the Company, the ratepayer class, the United States of America and the individual defendants named therein (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). 10(m) Revolving Credit Agreement dated as of June 27, 1989, between Long Island Lighting Company and the banks and co-agents listed therein, with the Exhibits thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) and as amended by the First Amendment dated as of October 13, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) and as amended by the Second Amendment dated as of March 5, 1992 and as modified by a Waiver dated November 5, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(n) Indenture of Trust dated as of December 1, 1989 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1989 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Participation Agreement dated as of December 1, 1989 by and between the New York State Energy Research and Development Authority and the Company relating to the 1989 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(o) Indenture of Trust dated as of May 1, 1990 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1990 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Participation Agreement dated as of May 1, 1990 by and between the New York State Energy Research and Development Authority and the Company relating to the 1990 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). 10(p) Indenture of Trust dated as of January 1, 1991 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1991 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Participation Agreement dated as of January 1, 1991 by and between the New York State Energy Research and Development Authority and the Company relating to the 1991 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). 10(q) Indenture of Trust dated as of February 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series A (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Participation Agreement dated as of February 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series A (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 10(r) Indenture of Trust dated as of February 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series B (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Participation Agreement dated as of February 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series B (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 10(s) Indenture of Trust dated as of August 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series C (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Participation Agreement dated as of August 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series C (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(t) Indenture of Trust dated as of August 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series D (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Participation Agreement dated as of August 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series D (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *10(u) Indenture of Trust dated as of November 1, 1993 by and between New York State Energy Research and Development Authority and Chemical Bank, as Trustee, relating to the 1993 Electric Facilities Revenue Bonds, Series A. Participation Agreement dated as of November 1, 1993 by and between the New York State Energy Research and Development Authority and the Company relating to the 1993 Electric Facilities Revenue Bonds, Series A. *10(v) Indenture of Trust dated as of November 1, 1993 by and between New York State Energy Research and Development Authority and Chemical Bank, as Trustee, relating to the 1993 Electric Facilities Revenue Bonds, Series B. Participation Agreement dated as of November 1, 1993 by and between the New York State Energy Research and Development Authority and the Company relating to the 1993 Electric Facilities Revenue Bonds, Series B. - ------------------------ * Filed herewith. *10(w) Supplemental Death and Retirement Benefits Plan as amended and restated effective January 1, 1993 and related Trust Agreement, which Trust Agreement was filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference. *10(x) Executive Agreements and Management Contracts *(1) Executive Employment Agreement dated as of January 30, 1984 by and between William J. Catacosinos and Long Island Lighting Company, as amended by amendments dated March 20, 1987 (filed as Exhibit 10(e) to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference), December 22, 1989 (filed as Exhibit 10(o) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) and December 2, 1991 (filed as Exhibit 10(u) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference); an Employment Agreement dated as of March 20, 1987 (filed as Exhibit 10(e) to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by amendments dated November 30, 1989 (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference), an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference), an amendment dated December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference), and as amended by an amendment dated December 31, 1993. *(2) Employment Agreement dated as of February 23, 1994 by and between Theodore A. Babcock and Long Island Lighting Company and related Trust Agreement, which Trust Agreement was filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference. (3) Employment Agreement dated as of May 14, 1990 by and between William N. Dimoulas and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). - ------------------------ * Filed herewith. (4) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between James T. Flynn and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (5) Employment Agreement dated as of September 11, 1992 by and between Robert J. Grey and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (6) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Robert X. Kelleher and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (7) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between John D. Leonard, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (8) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Adam M. Madsen and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (9) Employment Agreement dated as of May 30, 1990 by and between Kathleen A. Marion and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated December 2, 1991 as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (10) Employment Agreement dated as of January 21, 1991 by and between Arthur C. Marquardt and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (11) Employment Agreement dated as of April 16, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Brian R. McCaffrey and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 incorporated herein by reference) and as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (12) Employment Agreement dated as of March 18, 1988 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Joseph W. McDonnell and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (13) Employment Agreement dated as of July 29, 1992 by and between Anthony Nozzolillo and Long Island Lighting Company and related Trust Agreement and as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (14) Employment Agreement dated as of July 29, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between William G. Schiffmacher and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (15) Employment Agreement dated as of February 20, 1990 by and between Robert B. Steger and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (16) Employment Agreement dated as of March 9, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between William E. Steiger, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (17) Employment Agreement dated as of April 17, 1991 by and between Thomas J. Vallely, III and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (18) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Walter F. Wilm, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (19) Employment Agreement dated as of November 4, 1988 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Edward J. Youngling and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (20) Retirement Agreement dated as of January 7, 1987 by and between George J. Sideris and Long Island Lighting Company, as amended March 20, 1987, and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). *(21) Indemnification Agreement dated as of February 23, 1994 by and between Theodore A. Babcock and Long Island Lighting Company. (22) Indemnification Agreement dated as of January 31, 1992 by and between A. James Barnes and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). (23) Indemnification Agreement dated as of May 30, 1990 by and between George Bugliarello and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (24) Indemnification Agreement dated as of April 17, 1992 by and between Renso L. Caporali and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (25) Indemnification Agreement dated as of November 19, 1987 by and between William J. Catacosinos and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (26) Indemnification Agreement dated as of April 23, 1992 by and between Peter O. Crisp and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (27) Indemnification Agreement dated as of May 14, 1990 by and between William N. Dimoulas and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (28) Indemnification Agreement dated as of November 25, 1987 by and between James T. Flynn and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (29) Indemnification Agreement dated as of November 19, 1987 by and between Winfield E. Fromm and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). - ----------------------- * Filed herewith. *(30) Indemnification Agreement dated as of January 3, 1994 by and between Vicki L. Fuller and Long Island Lighting Company. (31) Indemnification Agreement dated as of September 11, 1992 by and between Robert J. Grey and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (32) Indemnification Agreement dated as of November 25, 1987 by and between Robert X. Kelleher and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (33) Indemnification Agreement dated as of November 25, 1987 by and between John D. Leonard, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (34) Indemnification Agreement dated as of November 25, 1987 by and between Adam M. Madsen and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (35) Indemnification Agreement dated as of May 30, 1990 by and between Kathleen A. Marion and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (36) Indemnification Agreement dated as of January 21, 1991 by and between Arthur C. Marquardt and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (37) Indemnification Agreement dated as of November 25, 1987 by and between Brian R. McCaffrey and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (38) Indemnification Agreement dated as of March 18, 1988 by and between Joseph W. McDonnell and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (39) Indemnification Agreement dated as of July 29, 1992 by and between Anthony Nozzolillo and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). - --------------------- * Filed herewith. *(40) Indemnification Agreement dated as of April 20, 1993 by and between Katherine D. Ortega and Long Island Lighting Company. (41) Indemnification Agreement dated as of November 19, 1987 by and between Basil A. Paterson and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (42) Indemnification Agreement dated as of November 25, 1987 by and between William Schiffmacher and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (43) Indemnification Agreement dated as of February 8, 1992 by and between Richard L. Schmalensee and Long Island Lighting Company (filed as an Exhibit to the Company Form 10- K for the Year Ended December 31, 1991 and incorporated herein by reference). (44) Indemnification Agreement dated as of November 30, 1987 by and between George J. Sideris and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (45) Indemnification Agreement dated as of February 20, 1990 by and between Robert B. Steger and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). (46) Indemnification Agreement dated as of March 1, 1989 by and between William E. Steiger, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (47) Indemnification Agreement dated as of November 19, 1987 by and between John H. Talmage and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (48) Indemnification Agreement dated as of April 17, 1991 by and between Thomas J. Vallely, III and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). (49) Indemnification Agreement dated as of November 19, 1987 by and between Phyllis A. Vineyard and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). - --------------------- * Filed herewith. (50) Indemnification Agreement dated as of November 25, 1987 by and between Walter F. Wilm, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (51) Indemnification Agreement dated as of November 4, 1988 by and between Edward J. Youngling and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (52) Long Island Lighting Company Officers' and Directors' Protective Trust dated as of April 18, 1988 by and between the Company and Clarence Goldberg, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (53) Long Island Lighting Company's Retirement Plan for Directors dated as of February 2, 1990 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). *(54) Agreement dated as of April 20, 1993 by and between the Company and Lionel M. Goldberg. *(55) Agreement dated as of April 20, 1993 by and between the Company and Eben W. Pyne. *23 Consent of Ernst & Young, Independent Auditors. *24(a) Powers of Attorney executed by the Directors and Officers of the Company. *24(b) Certificate as to Corporate Power of Attorney. *24(c) Certified copy of Resolution of Board of Directors authorizing signature pursuant to Power of Attorney. Financial Statements of subsidiary companies accounted for by the equity method have been omitted because such subsidiaries do not constitute significant subsidiaries. - ---------------------- * Filed herewith. (b) Reports on Form 8-K In its Report on Form 8-K dated October 8, 1993, the Company stated that: 1. On September 22, 1993, the United States Court of Appeals for the Second Circuit issued its opinion affirming the United States District Court for the Southern District of New York's jury award of $18.4 million, in favor of the Company, for a breach of warranty cause of action against Transamerica Delaval, Inc., now IMO Industries, Inc. and the District Court's dismissal of the Company's claims as to all categories of damages other than the amount attributable to the breach of warranty action. 2. If the Company concludes that the overall objectives of the RMA can be met, it may submit to the PSC, for the rate period commencing December 1, 1994, a multi-year electric rate plan providing for annual percentage increases that are significantly lower than the targeted levels contemplated by the RMA. 3. Subsequent to the issuance of the ALJ's Recommended Decision on the Company's gas rate application, the Company negotiated a multi-year rate settlement with Staff of the PSC which is subject to review by the ALJ and approval by the PSC. In its Report on Form 8-K dated December 3, 1993, the Company stated that: 1. On November 15, 1993, the PSC authorized the Company to increase its base electric rates by 4% effective December 1, 1993. This increase is the sixth in a series of 11 rate increases contemplated in the PSC-approved 1989 RMA. 2. The Company is in the process of preparing a three-year electric rate plan for the period beginning December 1, 1994 that provides for zero percentage base rate increases in years one and two of the plan and a base rate increase of approximately 4% in the third year, while retaining consistency with the RMA's objective of continuing the restoration of the Company's financial health. No other Reports on Form 8-K were filed in the fourth quarter of 1993. In its Report on Form 8-K dated January 21, 1994, the Company stated that: 1. The Company has announced the resignation of its President and Chief Operating Officer, Anthony F. Earley, Jr., effective March 1, 1994. 2. On December 31, 1993, the Company filed a three-year electric rate plan with the PSC for the period beginning December 1, 1994 that proposes no base electric rate increases in years one and two of the plan and an overall increase of 4.3% in the third year. 3. On January 12, 1994, the Company filed comments in response to the November 2, 1993 Petition filed by the CPB and LIPA with the PSC asking the PSC to hold a proceeding on freezing or possibly reducing the Company's electric rates for the period December 1994 to November 1997. 4. In December 1993, the PSC approved, with an effective date of December 31, 1993, the Company's negotiated three-year gas rate settlement with the Staff of the PSC which provided for a first year increase of $26.6 million and two subsequent increases of $23 million and $20 million to be effective on December 1, 1995 and 1996, respectively. 5. On December 30, 1993, the Appellate Division, Third Judicial Department, affirmed the Supreme Court of the State of New York Special Term's decision in LILCO v. PSC/Mayflower, which held that the PSC had violated PURPA and the New York Public Service Law and had acted arbitrarily when it ordered the Company to sign a power purchase contract with Mayflower Energy Partners, L.P. incorporating the PSC's 1989 Long Run Avoided Cost estimates. 6. On December 13, 1993, the United States District Court for the Eastern District of New York issued an opinion in LILCO v. Stone & Webster Engineering Corp. granting a motion by SWEC to dismiss the Company's complaint in this action which had sought to recover damages against SWEC for breach of contract, negligence, professional malpractice and gross negligence in connection with SWEC's work as architect-engineer and construction manager for Shoreham. 7. Pursuant to the LIPA Act, LIPA is required to make PILOTS to the municipalities that impose real property taxes on Shoreham. On January 10, 1994, the Appellate Division, Second Department, affirmed Nassau County Supreme Court's March 29, 1993 decision in LIPA, et al. v. Shoreham-Wading River Central School District, et al. holding, in major part, that the Company is not obligated for any real property taxes that accrued after February 28, 1992, attributable to property that it conveyed to LIPA, that PILOTS commence on March 1, 1992, that PILOTS are subject to refunds and that the LIPA Act does not provide for the termination of PILOTS. In its Report on Form 8-K dated February 7, 1994, the Company reported earnings of $2.15 per common share on revenues of $2,880,995,000 for the year ended December 31, 1993. LONG ISLAND LIGHTING COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1993 (Thousands of Dollars) (A) Adjustments between Plant Accounts. LONG ISLAND LIGHTING COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1992 (Thousands of Dollars) (A) Adjustments between Plant Accounts. LONG ISLAND LIGHTING COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1991 (Thousands of Dollars) (A) Adjustments between Plant Accounts. LONG ISLAND LIGHTING COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1993 (Thousands of Dollars) Note: (A) Includes transfers between reserves, costs of removal and salvage. LONG ISLAND LIGHTING COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1992 (Thousands of Dollars) Note: (A) Includes transfers between reserves, costs of removal and salvage. LONG ISLAND LIGHTING COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1991 (Thousands of Dollars) Note: (A) Includes transfers between reserves, costs of removal and salvage. LONG ISLAND LIGHTING COMPANY SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS (Thousands of Dollars) (1) Uncollectible accounts written off, net of recoveries. LONG ISLAND LIGHTING COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Advertising expenses for the years 1993 - 1991 were not presented as such amounts represent less than 1% of total revenues. 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. 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. LONG ISLAND LIGHTING COMPANY Date: March 15, 1994 By: ANTHONY NOZZOLILLO ------------------------ Anthony Nozzolillo Chief Financial Officer Original powers of attorney, authorizing Kathleen A. Marion, Anthony Nozzolillo and Robert J. Grey, and each of them, to sign this report and any amendments thereto, as attorney-in-fact for each of the Directors and Officers of the Company, and a certified copy of the resolution of the Board of Directors of the company authorizing said persons and each of them to sign this report and amendments thereto as attorney-in-fact for any Officers signing on behalf of the Company, have been, are being filed or will be filed with the Securities and Exchange Commission. Exhibit 23 Consent of Independent Auditors We consent to the incorporation by reference in the Post-Effective Amendment No. 3 to Registration Statement (No 33-16238) on Form S-8 relating to Long Island Lighting Company's Employee Stock Purchase Plan, Post-Effective Amendment No. 1 to Registration Statement (No. 2-87427) on Form S-3 relating to Long Island Lighting Company's Automatic Dividend Reinvestment Plan and in the related Prospectus, Registration Statement (No. 2-88578) on Form S-3 relating to the issuance of Common Stock and in the related Prospectus and Registration Statement (No. 33-45834) on Form S-3 relating to the issuance of General and Refunding Bonds and in the related Prospectus and Registration Statement (No. 33-60744) on Form S-3 relating to the issuance of General and Refunding Bonds, Debentures, Preferred Stock or Common Stock and in the related Prospectus, of our report dated February 4, 1994, with respect to the financial statements and schedules of Long Island Lighting Company included in this Annual Report on Form 10-K for the year ended December 31, 1993. ERNST & YOUNG Melville, New York March 11, 1994 EXHIBIT INDEX Exhibit No. Description - ------- ----------- *3(a) Restated Certificate of Incorporation of the Company dated November 11, 1993. (b) By-laws of the Company as amended on May 28, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 4(a) General and Refunding Indenture dated as of June 1, 1975 and 21 supplements thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as follows: G&R Indenture dated as of June 1, 1975. First Supplemental Indenture to G&R Indenture dated as of June 1, 1975. Second Supplemental Indenture to G&R Indenture dated as of September 1, 1975. Third Supplemental Indenture to G&R Indenture dated as of June 1, 1976. Fourth Supplemental Indenture to G&R Indenture dated as of December 1, 1976. Fifth Supplemental Indenture to G&R Indenture dated as of May 1, 1977. Sixth Supplemental Indenture to G&R Indenture dated as of April 1, 1978. - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- Seventh Supplemental Indenture to G&R Indenture dated as of March 1, 1979. Eighth Supplemental Indenture to G&R Indenture dated as of February 1, 1980. Ninth Supplemental Indenture to G&R Indenture dated as of March 1, 1981. Tenth Supplemental Indenture to G&R Indenture dated as of July 1, 1981. Eleventh Supplemental Indenture to G&R Indenture dated as of July 1, 1981. Twelfth Supplemental Indenture to G&R Indenture dated as of December 1, 1981. Thirteenth Supplemental Indenture to G&R Indenture dated as of December 1, 1981. Fourteenth Supplemental Indenture to G&R Indenture dated as of June 1, 1982. Fifteenth Supplemental Indenture to G&R Indenture dated as of October 1, 1982. Sixteenth Supplemental Indenture to G&R Indenture dated as of April 1, 1983. Seventeenth Supplemental Indenture to G&R Indenture dated as of May 1, 1983. Eighteenth Supplemental Indenture to G&R Indenture dated as of September 1, 1984. Nineteenth Supplemental Indenture to G&R Indenture dated as of October 1, 1984. Twentieth Supplemental Indenture to G&R Indenture dated as of June 1, 1985. Twenty-first Supplemental Indenture to G&R Indenture dated as of April 1, 1986. Twenty-second Supplemental Indenture to G&R Indenture dated as of February 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Exhibit No. Description - ------- ----------- Twenty-third Supplemental Indenture to G&R Indenture dated as of May 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Twenty-fourth Supplemental Indenture to G&R Indenture dated as of July 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Twenty-fifth Supplemental Indenture to G&R Indenture dated as of May 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Twenty-sixth Supplemental Indenture to G&R Indenture dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 4(b) Indenture of Mortgage and Deed of Trust dated as of September 1, 1951 and 44 supplements thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as follows: Indenture of Mortgage dated as of September 1, 1951. First Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1951. Second Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1952. Third Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1953. Fourth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1954. Fifth Supplemental Indenture to the Indenture of Mortgage dated as of November 1, 1955. Sixth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1956. Seventh Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1958. Exhibit No. Description - ------- ----------- Eighth Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1959. Ninth Supplemental Indenture to the Indenture of Mortgage dated as of August 1, 1961. Tenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1963. Eleventh Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1964. Twelfth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1965. Thirteenth Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1966. Fourteenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1967. Fifteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1969. Sixteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1970. Seventeenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1971. Eighteenth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1971. Nineteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1972. Twentieth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1973. Twenty-first Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1974. Twenty-second Supplemental Indenture to the Indenture of Mortgage dated as of November 1, 1974. Twenty-third Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1975. Exhibit No. Description - ------- ----------- Twenty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1975. Twenty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1976. Twenty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1976. Twenty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1977. Twenty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1978. Twenty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1979. Thirtieth Supplemental Indenture to the Indenture of Mortgage dated as of February 1, 1980. Thirty-first Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1981. Thirty-second Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1981. Thirty-third Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1981. Thirty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1981. Thirty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1981. Thirty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1982. Thirty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1982. Thirty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1983. Thirty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1983. Exhibit No. Description - ------- ----------- Fortieth Supplemental Indenture to the Indenture of Mortgage dated as of February 29, 1984. Forty-first Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1984. Forty-second Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1984. Forty-third Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1985. Forty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1986. Forty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of February 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Forty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Forty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Forty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Forty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Exhibit No. Description - ------- ----------- *4(c) Debenture Indenture dated as of November 1, 1986 from the Company to The Connecticut Bank and Trust Company, National Association, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). First Supplemental Indenture dated as of November 1, 1986 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). Second Supplemental Indenture dated as of April 1, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Third Supplemental Indenture dated as of July 1, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Fourth Supplemental Indenture dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Fifth Supplemental Indenture dated as of November 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *Sixth Supplemental Indenture dated as of June 1, 1993. *Seventh Supplemental Indenture dated as of July 1, 1993. 4(d) Debenture Indenture dated as of November 1, 1992 from the Company to Chemical Bank, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). First Supplemental Indenture dated as of January 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- Second Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Third Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Fourth Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(a) Sound Cable Project Facilities and Marketing Agreement dated as of August 26, 1987 between the Company and the Power Authority of the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). 10(b) Transmission Agreement by and between the Company and Consolidated Edison Company of New York, Inc. dated as of March 31, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(c) Contract for the sale of Firm Power and Energy by and between the Company and the State of New York dated as of April 26, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(d) Capacity Supply Agreement dated as of December 13, 1991 between the Company and the Power Authority of the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). *10(e) Nine Mile Point Nuclear Station Unit 2 Operating Agreement dated as of January 1, 1993 by and between the Company, New York State Electric & Gas Corporation, Rochester Gas and Electric Corporation and Central Hudson Gas and Electric Corporation. 10(f) Settlement Agreement on Issues Related to Nine Mile Two Nuclear Plant dated as of June 6, 1990 by and between the Company, the Staff of the Department of Public Service and others (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- 10(g) Settlement Agreement -- LILCO Issues dated as of February 28, 1989 by and between the Company and the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). 10(h) Amended and Restated Asset Transfer Agreement by and between the Company and the Long Island Power Authority dated as of June 16, 1988 as amended and restated on April 14, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(i) Memorandum of Understanding concerning proposed agreements on power supply for Long Island dated as of June 16, 1988 by and between the Company and New York Power Authority as amended May 24, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(j) Rate Moderation Agreement submitted by the staff of the New York State Public Service Commission on March 16, 1989 and supported by the Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(k) Site Cooperation and Reimbursement Agreement dated as of January 24, 1990 by and between the Company and Long Island Power Authority (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(l) Stipulation of settlement of federal Racketeer Influenced and Corrupt Organizations Act ("RICO") Class Action and False Claims Action dated as of February 27, 1989 among the attorneys for the Company, the ratepayer class, the United States of America and the individual defendants named therein (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). 10(m) Revolving Credit Agreement dated as of June 27, 1989, between Long Island Lighting Company and the banks and co-agents listed therein, with the Exhibits thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) and as amended by the First Amendment dated as of October 13, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) and as amended by the Second Amendment dated as of March 5, 1992 and as modified by a Waiver dated November 5, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(n) Indenture of Trust dated as of December 1, 1989 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1989 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Exhibit No. Description - ------- ----------- Participation Agreement dated as of December 1, 1989 by and between the New York State Energy Research and Development Authority and the Company relating to the 1989 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(o) Indenture of Trust dated as of May 1, 1990 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1990 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Participation Agreement dated as of May 1, 1990 by and between the New York State Energy Research and Development Authority and the Company relating to the 1990 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). 10(p) Indenture of Trust dated as of January 1, 1991 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1991 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Participation Agreement dated as of January 1, 1991 by and between the New York State Energy Research and Development Authority and the Company relating to the 1991 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). 10(q) Indenture of Trust dated as of February 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series A (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Participation Agreement dated as of February 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series A (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 10(r) Indenture of Trust dated as of February 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series B (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Exhibit No. Description - ------- ----------- Participation Agreement dated as of February 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series B (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 10(s) Indenture of Trust dated as of August 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series C (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Participation Agreement dated as of August 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series C (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(t) Indenture of Trust dated as of August 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series D (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Participation Agreement dated as of August 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series D (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *10(u) Indenture of Trust dated as of November 1, 1993 by and between New York State Energy Research and Development Authority and Chemical Bank, as Trustee, relating to the 1993 Electric Facilities Revenue Bonds, Series A. Participation Agreement dated as of November 1, 1993 by and between the New York State Energy Research and Development Authority and the Company relating to the 1993 Electric Facilities Revenue Bonds, Series A. *10(v) Indenture of Trust dated as of November 1, 1993 by and between New York State Energy Research and Development Authority and Chemical Bank, as Trustee, relating to the 1993 Electric Facilities Revenue Bonds, Series B. Participation Agreement dated as of November 1, 1993 by and between the New York State Energy Research and Development Authority and the Company relating to the 1993 Electric Facilities Revenue Bonds, Series B. - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- *10(w) Supplemental Death and Retirement Benefits Plan as amended and restated effective January 1, 1993 and related Trust Agreement, which Trust Agreement was filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference. *10(x) Executive Agreements and Management Contracts *(1) Executive Employment Agreement dated as of January 30, 1984 by and between William J. Catacosinos and Long Island Lighting Company, as amended by amendments dated March 20, 1987 (filed as Exhibit 10(e) to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference), December 22, 1989 (filed as Exhibit 10(o) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) and December 2, 1991 (filed as Exhibit 10(u) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference); an Employment Agreement dated as of March 20, 1987 (filed as Exhibit 10(e) to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by amendments dated November 30, 1989 (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference), an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference), an amendment dated December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference), and as amended by an amendment dated December 31, 1993. *(2) Employment Agreement dated as of February 23, 1994 by and between Theodore A. Babcock and Long Island Lighting Company and related Trust Agreement, which Trust Agreement was filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference. (3) Employment Agreement dated as of May 14, 1990 by and between William N. Dimoulas and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- (4) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between James T. Flynn and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (5) Employment Agreement dated as of September 11, 1992 by and between Robert J. Grey and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (6) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Robert X. Kelleher and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (7) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between John D. Leonard, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). Exhibit No. Description - ------- ----------- (8) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Adam M. Madsen and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (9) Employment Agreement dated as of May 30, 1990 by and between Kathleen A. Marion and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated December 2, 1991 as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (10) Employment Agreement dated as of January 21, 1991 by and between Arthur C. Marquardt and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (11) Employment Agreement dated as of April 16, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Brian R. McCaffrey and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 incorporated herein by reference) and as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). Exhibit No. Description - ------- ----------- (12) Employment Agreement dated as of March 18, 1988 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Joseph W. McDonnell and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (13) Employment Agreement dated as of July 29, 1992 by and between Anthony Nozzolillo and Long Island Lighting Company and related Trust Agreement and as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (14) Employment Agreement dated as of July 29, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between William G. Schiffmacher and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (15) Employment Agreement dated as of February 20, 1990 by and between Robert B. Steger and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). Exhibit No. Description - ------- ----------- (16) Employment Agreement dated as of March 9, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between William E. Steiger, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (17) Employment Agreement dated as of April 17, 1991 by and between Thomas J. Vallely, III and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (18) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Walter F. Wilm, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (19) Employment Agreement dated as of November 4, 1988 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Edward J. Youngling and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). Exhibit No. Description - ------- ----------- (20) Retirement Agreement dated as of January 7, 1987 by and between George J. Sideris and Long Island Lighting Company, as amended March 20, 1987, and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). *(21) Indemnification Agreement dated as of February 23, 1994 by and between Theodore A. Babcock and Long Island Lighting Company. (22) Indemnification Agreement dated as of January 31, 1992 by and between A. James Barnes and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). (23) Indemnification Agreement dated as of May 30, 1990 by and between George Bugliarello and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (24) Indemnification Agreement dated as of April 17, 1992 by and between Renso L. Caporali and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (25) Indemnification Agreement dated as of November 19, 1987 by and between William J. Catacosinos and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (26) Indemnification Agreement dated as of April 23, 1992 by and between Peter O. Crisp and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (27) Indemnification Agreement dated as of May 14, 1990 by and between William N. Dimoulas and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (28) Indemnification Agreement dated as of November 25, 1987 by and between James T. Flynn and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (29) Indemnification Agreement dated as of November 19, 1987 by and between Winfield E. Fromm and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). - ----------------------- * Filed herewith. Exhibit No. Description - ------- ----------- *(30) Indemnification Agreement dated as of January 3, 1994 by and between Vicki L. Fuller and Long Island Lighting Company. (31) Indemnification Agreement dated as of September 11, 1992 by and between Robert J. Grey and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (32) Indemnification Agreement dated as of November 25, 1987 by and between Robert X. Kelleher and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (33) Indemnification Agreement dated as of November 25, 1987 by and between John D. Leonard, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (34) Indemnification Agreement dated as of November 25, 1987 by and between Adam M. Madsen and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (35) Indemnification Agreement dated as of May 30, 1990 by and between Kathleen A. Marion and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (36) Indemnification Agreement dated as of January 21, 1991 by and between Arthur C. Marquardt and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (37) Indemnification Agreement dated as of November 25, 1987 by and between Brian R. McCaffrey and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (38) Indemnification Agreement dated as of March 18, 1988 by and between Joseph W. McDonnell and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (39) Indemnification Agreement dated as of July 29, 1992 by and between Anthony Nozzolillo and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). - --------------------- * Filed herewith. Exhibit No. Description - ------- ----------- *(40) Indemnification Agreement dated as of April 20, 1993 by and between Katherine D. Ortega and Long Island Lighting Company. (41) Indemnification Agreement dated as of November 19, 1987 by and between Basil A. Paterson and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (42) Indemnification Agreement dated as of November 25, 1987 by and between William Schiffmacher and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (43) Indemnification Agreement dated as of February 8, 1992 by and between Richard L. Schmalensee and Long Island Lighting Company (filed as an Exhibit to the Company Form 10- K for the Year Ended December 31, 1991 and incorporated herein by reference). (44) Indemnification Agreement dated as of November 30, 1987 by and between George J. Sideris and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (45) Indemnification Agreement dated as of February 20, 1990 by and between Robert B. Steger and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). (46) Indemnification Agreement dated as of March 1, 1989 by and between William E. Steiger, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (47) Indemnification Agreement dated as of November 19, 1987 by and between John H. Talmage and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (48) Indemnification Agreement dated as of April 17, 1991 by and between Thomas J. Vallely, III and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). (49) Indemnification Agreement dated as of November 19, 1987 by and between Phyllis A. Vineyard and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). - --------------------- * Filed herewith. Exhibit No. Description - ------- ----------- (50) Indemnification Agreement dated as of November 25, 1987 by and between Walter F. Wilm, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (51) Indemnification Agreement dated as of November 4, 1988 by and between Edward J. Youngling and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (52) Long Island Lighting Company Officers' and Directors' Protective Trust dated as of April 18, 1988 by and between the Company and Clarence Goldberg, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (53) Long Island Lighting Company's Retirement Plan for Directors dated as of February 2, 1990 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). *(54) Agreement dated as of April 20, 1993 by and between the Company and Lionel M. Goldberg. *(55) Agreement dated as of April 20, 1993 by and between the Company and Eben W. Pyne. *23 Consent of Ernst & Young, Independent Auditors. *24(a) Powers of Attorney executed by the Directors and Officers of the Company. *24(b) Certificate as to Corporate Power of Attorney. *24(c) Certified copy of Resolution of Board of Directors authorizing signature pursuant to Power of Attorney. Financial Statements of subsidiary companies accounted for by the equity method have been omitted because such subsidiaries do not constitute significant subsidiaries. - ---------------------- * Filed herewith. ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion and analysis addresses matters of significance with regard to the Company and its financial condition, liquidity, capital requirements and results of operations for the last three years. OVERVIEW Nearly five years have passed since the effective date of the 1989 Settlement, discussed in Note 2 of Notes to Financial Statements, which resolved the controversy surrounding the Shoreham Nuclear Power Station (Shoreham). Over this period of time, the Company has focused on managing costs and improving operating efficiencies. This, coupled with six electric rate increases, lower than anticipated fuel and financing costs and significantly lower production expenses has helped to improve the Company's financial health. This also enabled the Company to file with the Public Service Commission of the State of New York (PSC) on December 31, 1993 an electric rate plan requesting that base rates be frozen for a two-year period beginning December 1, 1994. The Company's electric rate plan to freeze base rates is designed to moderate the rate increases that were originally contemplated in the 1989 Settlement. The two-year base rate freeze will help better position the Company to respond to the current environment in the utility industry and to assist in Long Island's economic recovery. Other significant events during 1993 included: o Approval, by the PSC, of the third annual electric rate increase of 4.0% effective December 1, 1993, under the three-year electric rate plan authorized in 1991. o For the first time since the 1989 Settlement became effective, revenues provided under the Rate Moderation Agreement exceeded revenues that would have been provided under conventional ratemaking, resulting in the decline of the Rate Moderation Component balance and an improvement in the Company's cash flow position. o An increase in the Company's common stock quarterly dividend from 43 1/2 cents per share to 44 1/2 cents per share, representing the fourth consecutive year of dividend increases. Earnings for common stock in 1993 were $2.15 per common share compared to $2.14 per common share in 1992. o The approval by the PSC of a three-year gas rate plan providing annual rate increases of 4.7%, 3.8% and 2.8%, for the rate years beginning December 1, 1993, 1994, and 1995, respectively. This follows an increase in gas rates of 7.1% that was effective December 1, 1992. o The addition of over 9,000 new gas space heating customers, resulting from the Company's gas expansion program. o The refinancing of a significant amount of the Company's higher-cost securities as a result of very favorable long-term interest rates. Refinancing of approximately $983 million of higher-cost securities significantly lowered the Company's cost of debt and preferred stock. These 1993 refinancings will result in more than $18 million in annual cash savings through lower interest expense and preferred stock dividends. Since the 1989 Settlement became effective, the Company's aggressive refinancing program has resulted in annual cash savings of approximately $88 million. LIQUIDITY AND CAPITAL RESOURCES CASH AND REVOLVING CREDIT At December 31, 1993, the Company's cash and cash equivalents amounted to approximately $249 million, compared to $309 million at December 31, 1992. In addition, the Company has approximately $276 million available through October 1, 1994, provided by its 1989 Revolving Credit Agreement (1989 RCA). At December 31, 1993, no amounts were outstanding under the 1989 RCA. For a further discussion of the 1989 RCA, see Note 7 of Notes to Financial Statements. CAPITAL REQUIREMENTS AND CAPITAL PROVIDED During 1993, the Company continued its aggressive refinancing of higher-cost debt and preferred stock, taking advantage of declining interest rates. In 1993, the Company redeemed $568 million of higher-cost securities through the issuance of approximately $382 million of debentures and $204 million of preferred stock. The Company also issued $420 million of debentures to redeem $415 million of maturing debt. In addition to these refinancings, the Company issued $200 million of debentures and $100 million of tax-exempt securities and used the proceeds to reimburse the Company's treasury for previously incurred capital expenditures. In November 1993, the Company satisfied the maturity of $175 million of debentures with cash on hand. For a further discussion on the Company's capital stock and long-term debt, see Notes 6 and 7 of Notes to Financial Statements. The Company expects that it will seek external financing of approximately $1.1 billion solely for the purpose of refunding maturing debt in the years 1994, 1995 and 1996 as follows: The Company is planning, subject to market conditions, to fund a portion of these mandatory redemptions with the issuance of common equity in order to improve its debt-to-equity ratio. Capital requirements and capital provided for 1993 and 1992 were as follows: For further information, see the Statement of Cash Flows. For 1994, total capital requirements (excluding common stock dividends) are estimated at $1.1 billion, of which mandatory redemptions are $600 million, construction requirements are $327 million, preferred stock sinking fund requirements are $5 million, preferred stock dividends are $53 million and Shoreham post settlement costs are $158 million. During 1994, the Company expects to access the capital markets only for funds required to satisfy maturing securities or to refund outstanding securities to reduce financing costs. It is anticipated that the internal funds generated from operations will be sufficient to satisfy all other capital requirements, including both common and preferred stock dividends. CAPITALIZATION The Company's capitalization, including current maturities of long-term debt and current redemption requirements of preferred stock, at December 31, 1993, was approximately $8.4 billion, as compared to $8.2 billion at December 31, 1992. This increase in capitalization of approximately $185 million principally reflects an increase in long-term debt and preferred stock associated with the Company's financing activities in 1993 and an increase in common shareowners' equity comprising 1993 net income of approximately $296 million reduced by common and preferred stock dividends of approximately $253 million. At December 31, 1993 and 1992, the components of the Company's capitalization ratios were as follows: The Company's debt-to-equity ratio reflects two substantial charges to common shareowners' equity made in 1988 and 1989. In 1988, the Company was required to write-down net assets of approximately $1.3 billion, net of tax effects, relating to its investments in Shoreham and Nine Mile Point Nuclear Power Station, Unit 2 (NMP2). In 1989, the Company incurred a loss for common stock of approximately $175 million, reflecting the effects of the 1989 Settlement and the Class Settlement, discussed in Notes 2 and 4 of Notes to Financial Statements. The Company is committed to improving its debt-to-equity ratio through growth in retained earnings, debt reduction through improved cash flows, and the issuance of common equity. RATE MATTERS ELECTRIC In conjunction with the 1989 Settlement, the PSC authorized the recognition of a regulatory asset known as the Financial Resource Asset (FRA). The FRA consists of two components, the Base Financial Component (BFC) and the Rate Moderation Component (RMC). The Rate Moderation Agreement (RMA), one of the constituent documents of the 1989 Settlement, provides for the full recovery of the FRA. The RMA, by its terms, specifies that the FRA was created to provide the Company adequate financial indicia for the period 1989 through 1999 and to restore the Company's debt securities to investment grade levels as determined by independent rating agencies. The BFC, as initially established, represents the present value of the future net-after-tax cash flows which the RMA provided the Company for its financial recovery. The BFC was granted rate base treatment under the terms of the RMA and is included in the Company's revenue requirements through an amortization included in rates over forty years on a straight-line basis that began July 1, 1989. The RMC reflects the difference between the Company's revenue requirements under conventional ratemaking and the revenues resulting from the implementation of the rate moderation plan provided for in the RMA. This revenue difference, together with a carrying charge equal to the allowed rate of return on rate base, has been deferred. The RMC has provided the Company with a substantial amount of non-cash earnings since the effective date of the 1989 Settlement through December 31, 1992, because the revenues provided under the RMA were less than the revenues required under conventional ratemaking. During 1993, however, as revenues provided under the RMA began to exceed the revenues that would have been provided under conventional ratemaking the RMC balance began to decline. Pursuant to the 1989 Settlement, the Company has received six electric rate increases consistent with the objectives of the RMA. In response to the Company's rate filing in December 1990, the PSC approved the Long Island Lighting Company Ratemaking and Performance Plan (LRPP) in November 1991, which provided for annual electric rate increases of 4.15%, 4.1% and 4.0% effective December 1, 1991, 1992 and 1993, respectively. Effective December 1, 1993, the Company began receiving the third of these three annual electric rate increases. The LRPP provides for an allowed return on common equity from electric operations of 11.6% for each of the three rate years. The LRPP was designed to be consistent with the RMA's long-term goals. One principal objective of the LRPP is to reassign risk so that the Company assumes the responsibility for risks within the control of management, whereas risks largely beyond the control of management would be assumed by the ratepayers. One of the major components of the LRPP provides for a revenue reconciliation mechanism that mitigates the impact on earnings of experiencing electric sales that are above or below the LRPP forecast by providing a fixed annual net margin level (defined as sales revenues, net of fuel and gross receipts taxes) that the Company will receive for each of the three rate years under the LRPP. Another component of the LRPP allows the Company to earn for each rate year up to 60 additional basis points, or forfeit up to 38 basis points, of the allowed return on common equity as a result of its performance within certain incentive and/or penalty programs. These programs consist of a customer service performance plan, a demand side management program, a time-of-use program, a partial pass through fuel cost incentive plan and effective December 1, 1993, an electric transmission and distribution reliability plan. For the rate years ended November 30, 1993 and 1992, the Company earned approximately $9.2 million and $4.3 million, net of tax effects, respectively, based upon its performance within these programs. The LRPP contains a mechanism whereby earnings in excess of the allowed rate of return on common equity (11.6%), excluding the impacts of the various incentive and/or penalty programs, are shared equally between ratepayers and shareowners. For the rate years ended November 30, 1993 and 1992, the Company earned approximately $8.9 million and $21.4 million, net of tax effects, respectively, in excess of its allowed rate of return on common equity which was shared equally between ratepayers and shareowners. In December 1993, the Company filed a three-year electric rate plan with the PSC for the period beginning December 1, 1994 that minimizes future electric rate increases while retaining consistency with the RMA's objective of continuing the restoration of the Company's financial health. The filing provides for zero percentage base rate increases in years one and two of the plan and a rate increase of 4.3% in the third year. Although base electric rates would be frozen during the first two years of the plan, annual rate increases of approximately 1% to 2% are expected to result in these years from the operation of the Company's fuel cost adjustment (FCA) clause. The FCA captures, among other amounts, any increases in the cost of fuel above the level recovered in base rates and, under a continuation of the rate mechanisms provided by the LRPP, any amounts to be recovered or refunded to ratepayers in excess of $15 million which result from the reconciliation of revenue, certain expenses and earned performance incentive components. The electric rate plan requests an allowed rate of return on equity of 11.0%. The Company's rate filing reflects four underlying objectives: (i) to limit the balance of the RMC during the three-year period to no more than its 1992 peak balance of $652 million; (ii) to recover the RMC within no more than thirteen years of its 1989 inception; (iii) to minimize the final three rate increases that will follow the two-year rate freeze period; and (iv) to continue the Company's gradual return to financial health. The Company's electric rate plan is subject to approval by the PSC. The Company's current electric rate plan provides for lower annual electric rate increases than originally anticipated under the 1989 Settlement. However, as a result of changes in certain assumptions upon which the RMA was based, their impact on the RMC, and the Company's plans to reduce demand side management (DSM), operations, maintenance and capital expenditures, the Company has determined that the overall objectives of the RMA can be met under the multi-year plan described above. As a result of lower than originally anticipated inflation rates, interest costs, property taxes, fuel costs and the return on common equity allowed by the PSC, the RMC, which originally had been anticipated to peak at $1.2 billion in 1994, has already peaked at $652 million in 1992. With the exception of an increase in the 1995-1996 period, which is not now projected to cause the RMC to increase above its $652 million peak, the RMC is expected to decline until it is fully amortized. Under this electric rate plan, the recovery of the RMC would be extended, if necessary, for an additional period of not more than three years beyond the approximate ten-year period envisioned in the RMA. The actual length of the RMC extension will depend on the extent to which the assumptions underlying the rate plan materialize. The Company's current projections indicate that the RMC will be recovered in eleven years. For a further discussion of the 1989 Settlement and Rate Matters, see Notes 2 and 3 of Notes to Financial Statements. GAS In December 1993, the PSC approved a three-year gas rate settlement between the Company and the staff of the PSC. The gas rate settlement provides that the Company receive, for the rate years beginning December 1, 1993, 1994 and 1995, annual gas rate increases of 4.7%, 3.8% and 2.8%, respectively. In the determination of the revenue requirements for the first year of the gas rate settlement an allowed rate of return on equity of 10.1% was used. The gas rate decision also provides for earnings in excess of a 10.6% return on equity in any of the three rate years covered by the settlement be shared equally between the Company's firm gas customers and its shareowners. The allowed rate of return for the rate year that began December 1, 1992 was 11.0 %. ELECTRIC COMPETITION NON-UTILITY GENERATORS (NUGs) The development of the NUG industry has been encouraged by federal and state legislation. There are two ways that NUGs may negatively impact the Company: first, NUGs may locate on a customer's site, providing part or all of that customer's electric energy requirements. The Company estimates that in 1993 sales lost to such on-site NUGs totalled 234 gigawatt-hours (Gwh) in sales or approximately $20 million in revenues, net of fuel. This represents only 1.0% of the Company's 1993 net revenues. Second, in accordance with the Public Utility Regulatory Policy Act of 1978 (PURPA), the Company is required to purchase all the power offered by NUGs that are Qualified Facilities (QF). QFs have the choice of pricing these sales at either (i) PSC published estimates of the Company's long run avoided costs (LRAC) or (ii) the Company's tariff rates. Additionally, until repeal in 1992, New York State law set a minimum price of six cents per kilowatt-hour (Kwh) for certain categories of QFs, considerably above the Company's avoided cost. The six-cent minimum now only applies to contracts entered into before June 1992. The Company believes that the repeal of the six-cent law, coupled with the PSC's updates which resulted in lower LRAC estimates, has significantly reduced the economic advantage to entrepreneurs seeking to compete with the Company. As of December 31, 1993, 39 QFs were on line and selling approximately 200 megawatts (MW) of power to the Company. The Company estimates that in 1993, the purchases federal and state law required it to make from QFs cost the Company $47 million more than it would have cost to generate this power itself. With the exception of approximately 40 MW of power to be produced at the Stony Brook campus of the State University of New York beginning in early 1995, the Company does not expect any new major NUGs to be built on Long Island in the foreseeable future. RETAIL COMPETITION For over a decade, the Company has voluntarily provided wheeling of New York Power Authority (NYPA) power for economic development. As a result, NYPA power has displaced approximately 400 Gwh of energy sales. The net revenue loss associated with this amount of sales is approximately $27 million or 1.3% of the Company's 1993 net revenues. The potential loss of additional load is limited by conditions in the Company's current transmission agreements with NYPA. Competition for customer loads also comes from other electric utilities (including those in Connecticut, New York, and New Jersey) which seek to entice commercial and industrial customers to relocate within their service territories by offering reduced rates and other incentives. In order to retain existing and attract new commercial and industrial customers, the Company offers an Economic Development Rate which provides rate abatement to new or existing customers that qualify under the program approved by the PSC. Neither federal nor New York State law mandates retail wheeling. The Staff of the PSC has recently recommended that the PSC examine the issues attending retail wheeling. CONSERVATION AND SUPPLY The Company's 1993 Electric Conservation and Load Management Plan called for a cumulative 194 MW reduction in coincident peak demand by December 31, 1993 and a cumulative annualized energy savings of 578 Gwh, at a cost of $33.5 million. The Company has met these targets. These reductions were achieved through several different programs including customer education/information, rebate, audit and direct installation which targeted a number of energy efficient technologies. In the fourth quarter of 1993, a modified DSM Plan was filed with the PSC to support the objectives of the Company's December 31, 1993 electric rate plan filing. Under this modified plan a greater emphasis will be placed on the educational aspect of the Company's conservation efforts in lieu of the conventional reliance on rebates. This will help to shift the responsibility for adopting and implementing energy efficient practices away from the utility and to the customer. The Company's current electric load forecasts indicate that, with continued implementation of its conservation and load management programs and with the availability of electricity provided by QFs located within the Company's service territory, the Company's existing generating facilities, its portion of nuclear energy generated at NMP2 and power purchased from other electric systems are adequate to meet the energy demands on Long Island beyond the end of the century. INVESTMENT RATING The Company's securities are rated by Moody's Investors Service, Inc. (Moody's), Standard and Poor's Corporation (S&P), Fitch Investors Service, Inc. (Fitch) and Duff and Phelps (D&P). During the period 1989 through 1992, the rating agencies significantly upgraded their ratings of the Company's securities. In 1993, both Moody's and Fitch reaffirmed their assigned ratings on the Company's securities. S&P however, lowered its ratings on the Company's First Mortgage Bonds and G&R Bonds one level to minimum investment grade and lowered its ratings on the Company's Debentures and Preferred Stock to one level below minimum investment grade. D&P lowered its ratings on the Company's debentures and preferred stock one level. S&P's actions reflect its concerns regarding the utility industry's challenges relating to intensified competitive pressures, sluggish demand expectations, slow earnings growth prospects, high common dividend payouts, environmental cost pressures and nuclear operating and decommissioning costs. CLEAN AIR ACT In late 1990, significant amendments to the federal Clean Air Act were adopted. As a result, the Company expects that it will have to expend $4.3 million in 1994 to meet continuous emission monitoring requirements and $3.5 million in 1994 and $2.0 million in 1995 to meet Phase I nitrogen oxide (NOx) reduction requirements. In addition, subject to regulations that have not yet been issued, the Company estimates that it may be required to expend as much as $125 million by May 1999 to meet Phase II NOx reduction requirements and approximately $50 million by 2000 to meet requirements for the control of hazardous air pollutants from power plants. The Company believes that all such costs would be recoverable in rates. RESULTS OF OPERATIONS EARNINGS Summary results of earnings for the years 1993, 1992 and 1991 were as follows: For all periods, net income, earnings for common stock and earnings per common share include a non-cash allowance for funds used during construction (AFC) and the effects of the RMC. Overall earnings remained stable in 1993 while the Company's improved cash flow continued, consistent with the 1989 Settlement. The earnings in the electric business were lower in 1993 when compared to 1992 due primarily to the expensing of previously deferred storm costs, lower interest rates associated with the short-term investments, and regulatory adjustments. The lower level of earnings in the electric business was offset by a significant increase in the gas business earnings. The Company saw continued expansion in the gas business in 1993. REVENUES Total revenues in 1993, including revenues from recovery of fuel costs, were $2.9 billion, representing an increase of $259 million or 9.9% over 1992 revenues. Total revenues for the Company's electric and gas operations for the years 1993, 1992 and 1991 were as follows: ELECTRIC REVENUES In 1993, electric revenues increased $157 million when compared to 1992. Revenues in 1992 had decreased $2 million compared with 1991. The changes in the level of revenues when compared to the prior year resulted from the following factors: RATE INCREASES The Company received electric rate increases of 4.0% effective December 1, 1993 and 4.1% effective December 1, 1992. These rate increases provided $75 million in additional revenues for 1993 when compared to 1992. A 4.15% rate increase effective December 1, 1991 provided $72 million in additional revenues for 1992 when compared to 1991. SALES VOLUMES The increase in revenue from sales volumes was primarily attributable to warmer weather experienced in the summer of 1993 when compared to the same period in 1992. The decrease in revenues from sales volumes for 1992 when compared to 1991 is also attributable to weather. The Company's current electric rate structure, discussed above under the heading "Rate Matters," provides for a revenue reconciliation mechanism which mitigates the impact on earnings of experiencing electric sales that are above or below the levels reflected in rates. As a result of lower than adjudicated electric sales, the Company recorded non-cash income, which is included in "Other Regulatory Amortizations" of $43.5 million, $78.5 million and $0.4 million in 1993, 1992 and 1991, respectively. For a further discussion on the recoverability of these amounts see the discussion under the heading "Rate Matters." Summary of electric kilowatt hour (Kwh) sales for the years 1993, 1992 and 1991 were as follows: The increase in residential and commercial/industrial sales in 1993 was largely due to the warmer weather experienced during the summer months. Residential sales, representing 45% of system sales, were up by 4.9% when compared with 1992, while commercial/industrial sales, which accounted for 52% of system sales, increased by 0.9%. Power pool sales fluctuate with relative costs and power pool system availabilities. The average number of electric customers served in 1993 and 1992 was approximately 1,013,000 and 1,009,000, respectively. The customer increase in 1993 is similar to the increase experienced in 1992 when compared to 1991. FUEL COST RECOVERIES Total electric fuel cost recoveries for 1993 were up $22 million compared with 1992, primarily as a result of higher sales volumes, partially offset by a decrease in the average cost of fuel. In 1992, fuel cost recoveries decreased by $13 million compared with 1991, principally due to lower sales volumes, partially offset by an increase in the average cost of fuel. GAS REVENUES In 1993, gas revenues increased by $102 million, or 23.8%, when compared to 1992. Revenues in 1992 increased by $76 million, or 21.7%, when compared to 1991. The changes in the level of revenues when compared to the prior year resulted from the following factors: RATE INCREASES The Company received a gas rate increase of 4.7%, effective December 31, 1993, but was permitted by the PSC to recognize additional revenues of $4.6 million in 1993, as if the rate increase had been effective on December 1, 1993. The Company had also received rate increases of 7.1%, effective December 1, 1992, and 4.1%, effective December 1, 1991. The effects of these rate increases was to increase revenues by $35 million in 1993 when compared with 1992, and by $17 million in 1992 when compared with 1991. SALES VOLUMES The increase in 1993 revenues due to sales volumes was primarily due to customer additions and conversions resulting from the Company's gas expansion program. The Company added over 9,000 new gas space heating customers to its system in 1993. In 1992, the Company added approximately 10,000 new gas space heating customers. Summary of gas decatherm (dth) sales for the years 1993, 1992 and 1991 were as follows: FUEL COST RECOVERIES Recoveries of gas fuel expenses in 1993 revenues increased by $33 million compared with 1992, primarily due to higher sales volumes. In 1992, fuel recovery revenues had increased by $9 million, primarily due to higher average gas prices. FUELS AND PURCHASED POWER Expenses for fuels and purchased power increased by $86 million in 1993 compared with 1992, and decreased by $27 million in 1992 compared with 1991. Summary of fuel and purchased power expenses for the years 1993, 1992 and 1991 were as follows: The Company has significantly reduced the amount of oil it would otherwise have used to generate electricity by burning gas, purchasing power and utilizing nuclear generation from NMP2. Summary of electric fuel and purchased power mix for the years 1993, 1992 and 1991 were as follows: OPERATIONS AND MAINTENANCE EXPENSES Total operations and maintenance expenses, excluding fuel and purchased power, for 1993, 1992 and 1991 were $522 million, $498 million and $523 million, respectively. The $24 million, or 4.8%, increase in 1993 when compared to 1992 was primarily due to the recognition of previously deferred storm costs, the recording of higher accruals for uncollectible accounts and higher transmission and distribution costs for both the electric and gas businesses. The $25 million, or 4.8%, decrease in 1992 compared to 1991 was primarily attributable to lower electric operations expenses. INTEREST EXPENSE Interest expense for 1993, 1992 and 1991 was $534 million, $513 million and $524 million, respectively. The increase in 1993 when compared to 1992 was attributable to higher debt levels and the conversion in June 1992 of $400 million of tax-exempt securities from a weekly variable interest rate to a higher 30-year fixed rate. Also contributing to the increase, was the issuance in November 1992 of 30-year fixed rate debentures, the proceeds of which were used to eliminate variable rate bank debt. The conversion of the tax-exempt securities and refinancing of bank debt was done in order to take advantage of historically low interest rates. Partially offsetting this increase in interest expense were the effects of the Company's aggressive refinancing of higher-cost debt in 1993. The decrease in 1992 when compared to 1991 is due to significantly lower interest rates on the Company's outstanding debt, primarily resulting from the Company's aggressive refinancing efforts in the latter part of 1991 and during 1992. RATE MODERATION COMPONENT In 1993, the Company recorded non-cash charges to income of approximately $49 million reflecting the amortization of the RMC offset by related carrying charges. In 1992 and 1991, the Company recorded non-cash credits to income of approximately $73 million and $269 million, respectively, representing the accretion of the RMC and related carrying charges. For a discussion of the RMC and RMA, see Notes 2 and 3 of Notes to Financial Statements. BASE FINANCIAL COMPONENT For each of the years 1993, 1992 and 1991, the Company recorded non-cash charges to income of approximately $101 million, reflecting the continuing amortization of the BFC, which is afforded rate base treatment under the RMA. For a further discussion of the BFC and 1989 Settlement, see Notes 1 and 2 of Notes to Financial Statements. ACCOUNTING PRONOUNCEMENTS Effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS No. 106 requires the Company to recognize the expected cost of providing postretirement benefits when employee services are rendered rather than on a pay-as-you-go method. The Company recorded an accumulated postretirement benefit obligation and corresponding regulatory asset of approximately $376 million which represents the transition obligation at January 1, 1993. As a result of adopting SFAS No. 106, the Company's annual postretirement benefit cost for 1993 increased by approximately $28 million above the amount that would have been recorded under the pay-as-you-go method. This additional non-cash postretirement benefit cost has been accounted for as a regulatory asset. The PSC has permitted recovery of these regulatory assets through rates. The adoption of SFAS No. 106 had no impact on net income for the year ended December 31, 1993. For a further discussion of SFAS No. 106, see Note 8 of Notes to Financial Statements. Effective January 1, 1993 the Company adopted SFAS No. 109, Accounting for Income Taxes. As permitted under SFAS No. 109, the Company has elected not to restate the financial statements of prior years. The adoption of SFAS No. 109 is in compliance with the PSC's Statement of Interim Policy on Accounting and Ratemaking issued in January 1993. This statement asserts that the adoption and ongoing implementation of SFAS No. 109 on an interim basis will be done in such a manner that all its provisions shall be complied with on a revenue neutral basis. As of January 1, 1993, the cumulative adjustment to the deferred tax liability and the corresponding regulatory asset is approximately $1.6 billion. The $800 million increase from the amount reported in interim financial statements results from the Company's further analysis of deferred taxes to recognize SFAS No. 109 requirements to present tax assets and liabilities gross. SFAS No. 109 requires, among other matters, recognition of the amount of current and deferred taxes payable or refundable at the date of the financial statements as a result of all events that have been recognized in the financial statements and adjustment of deferred income taxes for an enacted change in tax laws. For regulated enterprises, SFAS No. 109 prohibits net of tax accounting and reporting and requires recognition of a deferred tax liability for the tax benefits which are flowed through to its customers. A regulatory asset or liability will be recognized relating to such items if it is probable that the future increase or decrease in taxes payable thereon shall be recovered from or returned to customers through future rates. For a further discussion of SFAS No. 109, see Notes 1 and 10 of Notes to Financial Statements. SELECTED FINANCIAL DATA Additional information respecting revenues, expenses, electric and gas operating income and operations data and balance sheet information for the last five years is provided in Tables 1 through 9 of Item 6, Selected Financial Data. Information with regard to the Company's business segments for the last three years is provided in Note 11 of Notes to Financial Statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENTS See Notes to Financial Statements. See Notes to Financial Statements. See Notes to Financial Statements. See Notes to Financial Statements. See Notes to Financial Statements. See Notes to Financial Statements. NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES REGULATION The Company's accounting policies conform to generally accepted accounting principles (GAAP) as they apply to a regulated enterprise. Its accounting records are maintained in accordance with the Uniform Systems of Accounts prescribed by the Public Service Commission of the State of New York (PSC) and the Federal Energy Regulatory Commission (FERC). UTILITY PLANT Additions to and replacements of utility plant are capitalized at original cost, which includes material, labor, overhead and an allowance for the cost of funds used during construction. The cost of renewals and betterments relating to units of property is added to utility plant. The cost of property replaced, retired or otherwise disposed of is deducted from utility plant and, generally, together with dismantling costs less any salvage, is charged to accumulated depreciation. The cost of repairs and minor renewals is charged to maintenance expense. Mass properties (such as poles, wire and meters) are accounted for on an average unit cost basis by year of installation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION The Uniform Systems of Accounts defines the allowance for funds used during construction (AFC) as the net cost of borrowed funds for construction purposes and a reasonable rate of return upon the utility's equity when so used. AFC is not an item of current cash income. AFC is computed monthly using a rate permitted by FERC on a portion of construction work in progress. The average annual AFC rate, without giving effect to compounding, was 9.73%, 9.98% and 10.74% for the years 1993, 1992 and 1991, respectively. DEPRECIATION The provisions for depreciation result from the application of straight-line rates to the original cost, by groups, of depreciable properties in service. The rates are determined by age-life studies performed annually on depreciable properties. Depreciation for electric properties was equivalent to approximately 3.0%, 3.2% and 3.3% of respective average depreciable plant costs for the years 1993, 1992 and 1991. Depreciation for gas properties was equivalent to approximately 2.0%, 2.6% and 2.9% of respective average depreciable plant costs for the years 1993, 1992 and 1991. FINANCIAL RESOURCE ASSET GAAP authorizes recognition of the existence of a regulatory asset when it is probable that a regulator will permit full recovery of a previously incurred cost. Pursuant to the 1989 Settlement and in accordance with GAAP, the Company recorded a regulatory asset known as the Financial Resource Asset (FRA). The FRA is designed to provide the Company with sufficient cash flows to assure its financial recovery. The FRA has two components, the Base Financial Component (BFC) and the Rate Moderation Component (RMC). The Rate Moderation Agreement (RMA), one of the constituent documents of the 1989 Settlement, provides for the full recovery of the FRA. For a further discussion of the 1989 Settlement and the FRA, see Note 2. CASH AND CASH EQUIVALENTS Cash equivalents are highly liquid investments with maturities of three months or less when purchased. The carrying amount approximates fair value because of the short maturity of these investments. FAIR VALUES OF FINANCIAL INSTRUMENTS The fair values for the Company's long-term debt and redeemable preferred stock are based on quoted market prices, where available. The fair values for all other long-term debt and redeemable preferred stock are estimated using a discounted cash flow analyses which is based upon the Company's current incremental borrowing rate for similar types of securities. CAPITALIZATION-PREMIUMS, DISCOUNTS AND EXPENSES Premiums or discounts and expenses related to the issuance of long-term debt are amortized over the life of each issue. Unamortized premiums or discounts and expenses related to issues of long-term debt that are refinanced are amortized and recovered through rates over the shorter life of either the redeemed or new issues. Capital stock expense and redemption costs related to certain issues of preferred stock that have been refinanced as well as the cost of issuance of the preferred stock issued are recorded as deferred charges. These amounts are being amortized and recovered through rates over the shorter life of the redeemed or new issues. REVENUES The Company accrues electric and gas revenues for services rendered to customers but not billed at month-end. FUEL COST ADJUSTMENTS The Company's electric and gas tariffs include fuel cost adjustment (FCA) clauses which provide for the disposition of the difference between actual fuel costs and the fuel costs allowed in the Company's base tariff rates (base fuel costs). The Company defers these differences to future periods in which they will be billed or credited to customers, except for base electric fuel costs in excess of actual electric fuel costs, which are currently credited to the RMC as incurred. FEDERAL INCOME TAXES Effective January 1, 1993, the Company adopted the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. As permitted under SFAS No. 109, the Company has elected not to restate the financial statements of prior years. The adoption of SFAS No. 109 is in compliance with the PSC's Statement of Interim Policy on Accounting and Ratemaking issued January 15, 1993. This statement asserts that the adoption and ongoing implementation of SFAS No. 109 on an interim basis will be done in such a manner that all its provisions shall be complied with on a revenue neutral basis. As of January 1, 1993, the cumulative adjustment to the deferred tax liability and the corresponding regulatory asset is approximately $1.6 billion. The $800 million increase from the amount reported in interim financial statements results from the Company's further analysis of deferred taxes to recognize SFAS No. 109 requirements to present tax assets and liabilities gross. SFAS No. 109 requires, among other matters, recognition of the amount of current and deferred taxes payable or refundable at the date of the financial statements as a result of all events that have been recognized in the financial statements and adjustment of deferred income taxes for an enacted change in tax laws. For regulated enterprises, SFAS No. 109 prohibits net of tax accounting and reporting and requires recognition of a deferred tax liability for the tax benefits which are flowed through to its customers. A regulatory asset or liability will be recognized relating to such items if it is probable that the future increase or decrease in taxes payable thereon shall be recovered from or returned to customers through future rates. The tax effects of other differences between income for financial statement purposes and for federal income tax purposes are accounted for as current adjustments in federal income tax provisions. Prior to the adoption of SFAS No. 109 the Company provided deferred federal income taxes with respect to certain items of income and expense that were reported in different years in the financial statements and the tax return. The Company defers the benefit of 60% of pre-1982 gas and pre-1983 electric and 100% of all other investment tax credits, with respect to regulated properties, when realized on its tax returns. Accumulated deferred investment tax credits are amortized ratably over the lives of the related properties. For ratemaking purposes, the Company provides deferred federal income taxes with respect to certain differences between net income before income taxes and taxable income in certain instances when approved by the PSC, as disclosed in Note 10. Also certain accumulated deferred federal income taxes are deducted from rate base and amortized or otherwise applied as a reduction (increase) in federal income tax expense in future years. RESERVES FOR CLAIMS AND DAMAGES Losses arising from claims against the Company, including worker's compensation claims, property damage, extraordinary storm costs and general liability claims, are partially self-insured. Extraordinary storm losses incurred by the Company are partially insured by certain commercial insurance carriers. These insurance carriers provide partial insurance coverage for individual storm losses between $5 million and $50 million. Storm losses which are outside of the above-mentioned range are self-insured by the Company. Reserves for these losses are based on, among other things, experience, risk of loss and the ratemaking practices of the PSC. RECLASSIFICATIONS To conform with an order of the FERC, dated March 31, 1993, the Company reclassified certain deferred items as regulatory assets and regulatory liabilities on its Balance Sheet. Regulatory assets and liabilities, as defined in this order, are assets and liabilities created through the ratemaking actions of regulatory agencies. Certain other prior year amounts have been reclassified in the financial statements to be consistent with the current year's presentation. NOTE 2. THE 1989 SETTLEMENT On February 28, 1989, the Company and the State of New York (by its Governor) entered into the 1989 Settlement resolving certain issues relating to the Company and providing, among other matters, for the transfer of the Shoreham Nuclear Power Station (Shoreham) and its subsequent decommissioning. On February 29, 1992, the Company transferred ownership of Shoreham to the Long Island Power Authority (LIPA), an agency of the State of New York. Pursuant to the 1989 Settlement, LIPA is responsible for the decommissioning of Shoreham and has estimated that the decommissioning, in which Company employees are participating, will be completed in 1994. Based on the latest available information, LIPA has projected that the cost of decommissioning Shoreham will total approximately $164 million. This estimate excludes the costs associated with the disposal of Shoreham's fuel which is estimated to be $122 million. At December 31, 1993, the Company has funded approximately $140 million and $30 million of these costs, respectively. LIPA anticipates that the Nuclear Regulatory Commission (NRC) will terminate its license for Shoreham by the end of 1994. Upon the effectiveness of the 1989 Settlement, in June of 1989, the Company simultaneously recorded on its Balance Sheet the retirement of its investment of approximately $4.2 billion principally in Shoreham and the establishment of the FRA, discussed in Note 1. The BFC, a component of the FRA, as initially established, represents the present value of the future net-after-tax cash flows which the RMA provided the Company for its financial recovery. The BFC was granted rate base treatment under the terms of the RMA and is included in the Company's revenue requirements through an amortization included in rates over forty years on a straight-line basis that began July 1, 1989. At December 31, 1993 and 1992, the unamortized balance of the BFC was approximately $3.6 billion and $3.7 billion, respectively. The RMC, a component of the FRA, reflects the difference between the Company's revenue requirements under conventional ratemaking and the revenues resulting from the implementation of the rate moderation plan provided for in the RMA. The RMC is currently adjusted, on a monthly basis, for the Company's share of certain Nine Mile Point Nuclear Power Station, Unit 2 (NMP2) operations and maintenance expenses, fuel credits resulting from the Company's electric fuel cost adjustment clause discussed in Note 1 and state gross receipts tax adjustments related to the FRA. The RMC has provided the Company with a substantial amount of non-cash earnings from the effective date of the 1989 Settlement through December 31, 1992. At December 31, 1993 and 1992, the RMC balance was $610 million and $652 million, respectively. Prior to December 31, 1992 the RMC had increased as the difference between revenues resulting from the implementation of the rate moderation plan provided for in the RMA and revenue requirements under conventional ratemaking, together with a carrying charge equal to the allowed rate of return on rate base, had been deferred. Subsequent to December 31, 1992, the RMC balance has been decreasing as revenues resulting from the implementation of the rate moderation plan are greater than revenue requirements under conventional ratemaking. For a further discussion of the impact on the amortization of the RMC under the Company's current electric rate structure and the Company's proposed electric rate plan for the three-year period beginning December 1, 1994, see Note 3. Under the 1989 Settlement, certain tax benefits attributable to the Shoreham abandonment are to be shared between ratepayers and shareowners. A regulatory liability of approximately $794 million was recorded in June 1989 to preserve an amount equivalent to the ratepayer tax benefits attributable to the Shoreham abandonment. This amount is being amortized over a ten-year period on a straight-line basis from the effective date of the 1989 Settlement. The Company has reclassified the regulatory liability component which was previously reported as a reduction of the corresponding deferred tax asset arising from the abandonment loss deduction. Shoreham post settlement costs (decommissioning, payments in lieu of property taxes and other costs as incurred) are being capitalized and amortized and recovered through rates over a forty-year period on a straight-line remaining life basis. Upon the effectiveness of the 1989 Settlement, Shoreham nuclear fuel was reclassified to deferred charges included in the Regulatory Asset section of the Balance Sheet and is being amortized and recovered through rates over a forty-year period on a straight-line remaining life basis. The 1989 Settlement credits on the Balance Sheet of approximately $155 million, net of amortization, reflect an adjustment of the book write- off to the negotiated 1989 Settlement amount. A portion of this amount is being amortized over a ten-year period. The remaining portion is not currently being recognized for ratemaking purposes under the 1989 Settlement. NOTE 3. RATE MATTERS ELECTRIC Pursuant to the 1989 Settlement, discussed in Note 2, the Company received electric rate increases contemplated by the RMA for each of the three rate years in the period ended November 30, 1991. The RMA contemplates that the Company will apply to the PSC for targeted annual rate increases of 4.5% to 5.0% in each year for an eight-year period beginning December 1, 1991. In response to the Company's December 1990 rate filing, the PSC approved the Long Island Lighting Company Ratemaking and Performance Plan (LRPP) in November 1991, which provides that the Company receive, for each of the three rate years in the period beginning December 1, 1991, annual electric rate increases of 4.15%, 4.1% and 4.0%, respectively, with an allowed return on common equity from electric operations of 11.6% for each of the three rate years. After giving effect to the reductions required by the Class Settlement discussed in Note 4, the Company's annual electric rate increases were approximately 4.15%, 3.9% and 3.9%, with an allowed return on common equity from electric operations of 10.92%, 10.72% and 10.58%, for the rate years beginning December 1, 1991, 1992 and 1993, respectively. The LRPP was designed to be consistent with the RMA's long-term goals. One principal objective of the LRPP is to reassign risk so that the Company assumes the responsibility for risks within the control of management, whereas risks largely beyond the control of management would be assumed by the ratepayers. The LRPP reflects an update of the long-range forecast of the Company's revenue requirements which was the basis of the RMA's initial three rate increases. The LRPP contains three major components--revenue reconciliation, expense attrition and reconciliation, and performance incentives. Revenue reconciliation is provided through a mechanism that reduces the impact of experiencing electric sales that are above or below the LRPP forecast by providing a fixed annual net margin level (defined as sales revenues, net of fuel and gross receipts taxes) that the Company will receive over the three rate years under the LRPP. The differences between the actual electric net revenues and the annual net margin level are deferred on a monthly basis during the rate year. The expense attrition and reconciliation component permits the Company to make adjustments for certain expenses recognizing that certain cost increases are unavoidable due to inflation and changes in the business. The LRPP includes the annual reconciliation of certain expenses for wage rates, property taxes, interest charges and demand side management (DSM) costs, the deferral and amortization of certain costs for enhanced reliability, production operations and maintenance expenses, and the application of an inflation index to other expenses for the rate years beginning December 1, 1992 and 1993. Under the performance incentive component of the LRPP, the Company is allowed to earn for each rate year up to 60 additional basis points, or forfeit up to 38 basis points, of the allowed return on common equity as a result of its performance within certain incentive and/or penalty programs. These programs consist of a customer service program, a time-of-use program, a partial pass through fuel cost incentive plan and, effective December 1, 1993, an electric transmission and distribution reliability plan. The incentives and/or penalties related to the customer service performance plan, the time-of-use program, the electric transmission and distribution reliability plan and the partial pass through fuel cost incentive plan are determined on a monthly basis during the rate year and deferred until final approval from the PSC. The incentives earned from the DSM program are collected in rates on a monthly basis through the FCA. Based upon the Company's performance within these programs, the Company earned a total of approximately 49 basis points or approximately $9.2 million, net of tax effects, and 23 basis points, or approximately $4.3 million, net of tax effects, for the rate years ended November 30, 1993 and 1992, respectively. The deferred balances resulting from the net margin, property taxes, interest expense, wage rates, performance incentives and associated carrying charges, excluding DSM incentives, are netted at the end of each rate year. The LRPP established a band whereby the first $15 million of the total net deferrals are used to increase or decrease the RMC balance. The LRPP provides for the disposition of the total net deferrals in excess of the $15 million band. Upon approval by the PSC, the total net deferrals in excess of $15 million are refunded or recovered from the ratepayers through the FCA over a twelve-month period in the following rate year. During 1993, the PSC authorized the Company recovery of $45.2 million of the total net deferrals for the rate year ended November 30, 1992. The first $15 million of the total net deferrals was recorded as an increase to the RMC, with the remaining $30.2 million being recovered from the ratepayers through the FCA through July 31, 1994. For the rate year ended November 30, 1993, the total net deferrals, to be recovered from the ratepayers, subject to PSC review, amounted to approximately $63 million of which $48 million will be recovered through the FCA, over a twelve-month period beginning December 1, 1994. The Company earned $8.9 million and $21.4 million, net of tax effects, for the rate years ended November 30, 1993 and 1992, respectively, in excess of its allowed rate of return on common equity of 11.6% which, in accordance with the LRPP, was shared equally between ratepayers (by a reduction to the RMC) and shareowners. Prior to December 1, 1991, the RMA provided that earned returns on common equity in excess of targeted allowed rates of return, were to be applied to reduce the RMC or mitigate rates, as determined by the PSC, at the end of each rate year. For the rate year ended November 30, 1991, the Company earned $10.1 million, net of tax effects, in excess of its allowed rate of return, which was applied as a reduction to the RMC. To assist in the recovery of the RMC balance under the rates provided by the LRPP, the Company, in accordance with the LRPP, has credited the RMC with several deferred ratepayer benefits. In December 1993 and 1992, the Company applied a total of approximately $10.1 million and $22.5 million of various deferred ratepayer benefits to the RMC including the ratepayers portion of the excess earnings for the rate years ended November 30, 1993 and 1992, respectively. In December 1993, the Company filed a three-year electric rate plan with the PSC for the period beginning December 1, 1994 that minimizes future electric rate increases while retaining consistency with the RMA's objective of continuing the restoration of the Company's financial health. The electric rate plan provides for zero percentage base rate increases before giving effect to the reductions required by the Class Settlement, discussed in Note 4, in years one and two of the plan and a base rate increase of 4.3% in the third year prior to giving effect to the reductions required by the Class Settlement. Although base electric rates would be frozen during the first two years of the plan, annual rate increases of approximately 1% to 2% are expected to result in these years from the operation of the Company's FCA. The FCA captures, among other amounts, any increases in the cost of fuel above the level recovered in base rates, and under the LRPP, any amounts to be recovered or refunded to ratepayers in excess of $15 million which result from the reconciliation of revenue, certain expenses and earned performance incentive components, discussed above. The electric rate plan requests an allowed rate of return on equity of 11.0%. The Company's two-year base rate freeze proposal reflects four underlying objectives: (i) to limit the balance of the RMC during the three-year period to no more than its 1992 peak balance of $652 million; (ii) to recover the RMC within no more than thirteen years of its 1989 inception; (iii) to minimize the final three rate increases that will follow the two-year rate freeze period; and (iv) to continue the Company's gradual return to financial health. The Company's electric rate plan is subject to approval by the PSC. The Company's current electric rate plan provides for lower annual electric rate increases than originally anticipated under the 1989 Settlement. However, as a result of changes in certain assumptions upon which the RMA was based, their impact on the RMC and the Company's plans to reduce DSM, operations and maintenance and capital expenditures, the Company has determined that the overall objectives of the RMA can be met under the multi-year plan described above. As a result of lower than originally anticipated inflation rates, interest costs, property taxes, fuel costs and return on common equity allowed by the PSC, the RMC, which originally had been anticipated to peak at $1.2 billion in 1994, has already peaked at $652 million in 1992. With the exception of an increase in 1995-1996, which is not now projected to cause the RMC to increase above its $652 million peak, the RMC is expected to decline until it is fully amortized. Under the electric rate plan, the recovery of the RMC would be extended, if necessary, for an additional period of not more than three years beyond the approximate ten-year period envisioned in the RMA. The actual length of the RMC extension will depend on the extent to which the assumptions underlying the rate plan materialize. The Company's current projections indicate that the RMC will be recovered in eleven years instead of ten years. GAS In December 1993, the PSC approved a three-year gas rate settlement between the Company and the Staff of the PSC. The gas rate settlement provides that the Company receive, for each of the rate years beginning December 1, 1993, 1994 and 1995, annual gas rate increases of 4.7%, 3.8% and 2.8%, respectively. In the determination of the revenue requirements for the first year of the gas rate settlement an allowed rate of return on equity of 10.1% was used. The gas rate decision also provides for earnings in excess of a 10.6% return on equity in any of the three rate years covered by the settlement be shared equally between the Company's firm gas customers and its shareowners. The allowed rate of return for the rate year that began December 1, 1992 was 11.0%. NOTE 4. THE CLASS SETTLEMENT The Class Settlement, which became effective on June 28, 1989, resolved a civil lawsuit against the Company brought under the federal Racketeer Influenced and Corrupt Organizations Act (RICO Act). The lawsuit which the Class Settlement resolved, had alleged that the Company made inadequate disclosures before the PSC concerning the construction and completion of nuclear generating facilities. The Class Settlement provides the Company's ratepayers with reductions, aggregating $390 million, that are to be reflected as adjustments to their monthly electric bills over a ten-year period which began on June 1, 1990. The reductions in each of the remaining twelve-month periods are as follows: Upon its effectiveness, the Company recorded its liability for the Class Settlement on a present value basis at $170 million and simultaneously recorded a charge to income (net of tax effects of $57 million) of approximately $113 million. Each month the Company records the changes in the present value of such liability that result from the passage of time and from monthly reductions. The Company expects the Class Settlement liability will be fully satisfied by May 31, 2000. As a result of the Class Settlement, the Company's electric rate increases on average will be approximately .2% to .3% per year lower than they would otherwise have been during the Class Settlement period. NOTE 5. NINE MILE POINT NUCLEAR POWER STATION, UNIT 2 The Company has an 18% undivided interest in NMP2 which is operated by Niagara Mohawk Power Corporation (NMPC) near Oswego, New York. Ownership of NMP2 is shared by five cotenants: the Company (18%), NMPC (41%), New York State Electric & Gas Corporation (18%), Rochester Gas and Electric Corporation (14%) and Central Hudson Gas & Electric Corporation (9%). At December 31, 1993, the Company's net utility plant investment in NMP2 was $759 million, net of accumulated depreciation of $119 million, which is included in the Company's rate base. Output of NMP2 is shared in the same proportions as the cotenants' respective ownership interests. The operating expenses of NMP2 are also allocated to the cotenants in the same proportions as their respective ownership interests. The Company's share of these expenses is included in the appropriate operating expenses on the Statement of Income. The Company is required to provide its respective share of financing for any capital additions to NMP2. Nuclear fuel costs associated with NMP2 are being amortized on the basis of the quantity of heat produced for the generation of electricity. NMPC has contracted with the United States Department of Energy for the disposal of nuclear fuel. The Company reimburses NMPC for its 18% share of the cost under the contract at a rate of $1.00 per megawatt hour of net generation less a factor to account for transmission line losses. Based upon a study performed by NMPC which reflects a change in the NRC minimum decommissioning funding requirement effective 1993, the Company's share of the decommissioning costs for NMP2 is estimated to be $80 million (in 1993 dollars) assuming that decommissioning will commence in 2027 (which will be $234 million in 2027 dollars). The Company's share of estimated decommissioning costs are being provided for in electric rates and are being charged to operations as depreciation expense. The amount of accumulated decommissioning costs collected from the Company's ratepayers through December 31, 1993 was $7.1 million. Amounts collected by the Company for the decommissioning of the contaminated portion of the NMP2 plant, which approximate 92% of total decommissioning costs, are held in an independent decommissioning trust fund. This fund complies with regulations issued by the NRC governing the funding of nuclear plant decommissioning costs. The Company's funding plan for its share of decommissioning costs will provide reasonable assurance that, at the time of termination of operation, adequate funds for the decommissioning of the Company's share of the contaminated portion of NMP2 plant will be available. NOTE 6. CAPITAL STOCK PREFERRED STOCK The Company has 7,000,000 authorized shares, cumulative preferred stock, par value $100 and 30,000,000 authorized shares, cumulative preferred stock, par value $25. Dividends on preferred stock are paid in preference to dividends on common stock or any other stock ranking junior to preferred stock. PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION The aggregate fair value of redeemable preferred stock with mandatory redemptions at December 31, 1993 and 1992 amounted to $658,795,000 and $581,984,000, respectively, compared to their carrying amounts of $653,950,000 and $566,100,000, respectively. At December 31, 1993, the Company had the option to redeem all outstanding preferred stock Series L, $100 par value, and Series R, $100 par value, at their optional redemption prices of $102.99 per share and $100.50 per share, respectively. No other preferred stock series subject to mandatory redemptions were redeemable at December 31, 1993. The Company is required to redeem the following series of preferred stock through the operation of various sinking fund provisions: (i) on each July 31, 10,500 shares of the Series L at a price of $100 per share; (ii) on each December 15, 37,500 shares of the Series R at a price of $100 per share; (iii) on each March 1, commencing March 1, 1999, 77,700 shares of the Series NN at a price of $25 per share; and (iv) on each October 15, commencing October 15, 1999, 112,000 shares of the Series UU at a price of $25 per share. In addition, the Company will have the noncumulative option to double the number of shares to be redeemed pursuant to the sinking fund in any year for the preferred stock series mentioned above. The aggregate par value of preferred stock required to be redeemed by use of sinking funds in each of the years 1994 through 1996 is $4.8 million and in 1997 and 1998 is $1.1 million. The Company is also required to redeem certain series of preferred stock which are not subject to sinking fund requirements. The scheduled mandatory redemption for these series are as follows: (i) Series CC on August 1, 2002; (ii) Series AA on June 1, 2000; (iii) Series GG on March 1, 1999; and (iv) Series QQ on May 1, 2001. During 1992, the Company issued $363 million Preferred Stock, 7.95% Series AA and $57 million Preferred Stock, 7.66% Series CC, the proceeds of which were used to redeem $320 million Preferred Stock, $2.65 Series Y and $55 million Preferred Stock, 9.80% Series S, respectively, at their optional redemption prices. PREFERRED STOCK NOT SUBJECT TO MANDATORY REDEMPTION The Company has the option to redeem certain series of its preferred stock. For the series subject to optional redemption at December 31, 1993, the call prices were as follows: PREFERENCE STOCK None of the authorized 7,500,000 shares of nonparticipating preference stock, par value $1 per share, which ranks junior to preferred stock, are outstanding. COMMON STOCK Of the 150,000,000 shares of authorized common stock at December 31, 1993, 1,789,842 shares were reserved for sale through the Company's Employee Stock Purchase Plan, 5,946,929 shares were committed to the Automatic Dividend Reinvestment Plan (ADRP) and 118,812 shares were reserved for conversion of the Series I Convertible Preferred Stock at a rate of $17.15 per share. In June 1992, the Company reinstated the ADRP which had been suspended since February 1984. Common and preferred stock dividend limitations in the mortgage securing the Company's First Mortgage Bonds are not material. There are no dividend limitations contained in the Company's other debt instruments. NOTE 7. LONG-TERM DEBT Each of the Company's outstanding mortgages is a lien on substantially all of the Company's properties. FIRST MORTGAGE All of the bonds issued under the First Mortgage, including those issued after June 1, 1975 and pledged with the Trustee of the G&R Mortgage (G&R Trustee) as additional security for General & Refunding Bonds (G&R Bonds), are secured by the lien of the First Mortgage. First Mortgage Bonds pledged with the G&R Trustee do not represent outstanding indebtedness of the Company. Amounts of such pledged bonds outstanding were $1.03 billion at December 31, 1993 and 1992. The annual First Mortgage depreciation fund and sinking fund requirements for 1993, due not later than June 30, 1994, are estimated at $216 million and $18 million, respectively. The Company expects to meet these requirements with property additions and retired First Mortgage Bonds. G&R MORTGAGE The lien of the G&R Mortgage is subordinate to the lien of the First Mortgage. The annual G&R Mortgage sinking fund requirement for 1993, due not later than June 30, 1994, is estimated at $24 million. The Company expects to satisfy this requirement with retired G&R Bonds. 1989 REVOLVING CREDIT AGREEMENT The Company has an estimated $276 million available to it through October 1, 1994, under its $300 million 1989 Revolving Credit Agreement (1989 RCA). This line of credit is secured by a first lien upon the Company's accounts receivable and fuel oil inventories. The Company is currently, with the approval of the NRC, dedicating $24 million of the 1989 RCA to cover estimated, not yet incurred, costs attributable to the decommissioning of Shoreham, discussed in Note 2. The amount of credit available to the Company under the 1989 RCA will increase as decommissioning costs are funded by the Company. At December 31, 1993, no amounts were outstanding under the 1989 RCA. The Company has the option, when amounts are outstanding, to commit to one of three interest rates including: (i) the Adjusted Certificate of Deposit Rate which is a rate based on the certificate of deposit rates of certain of the lending banks, (ii) the Base Rate which is generally a rate based on Citibank, N.A.'s prime rate and (iii) the Eurodollar Rate which is a rate based on the London Interbank Offering Rate (LIBOR). The Company has agreed to pay a fee of one quarter of one percent per annum on the unused portion. The termination date of the 1989 RCA may be extended for one-year periods upon the acceptance by the lending banks of the Company's request delivered to the lending banks prior to April 1 in each year. AUTHORITY FINANCING NOTES Authority Financing Notes are issued by the Company to the New York State Energy Research and Development Authority (NYSERDA) to secure certain tax-exempt Pollution Control Revenue Bonds (PCRBs), Electric Facilities Revenue Bonds (EFRBs) and Industrial Development Revenue Bonds issued by NYSERDA. Certain of these bonds are subject to periodic tender at which time their interest rates are subject to redetermination. The 1993 EFRBs and the 1985 PCRBs are supported by letters of credit pursuant to which the letter of credit banks have agreed to pay the principal, interest and premium if applicable, in the aggregate, up to approximately $272 million in the event of default. The obligation of the Company to reimburse the letter of credit banks is unsecured. These letters of credit expire November 17, 1996 for the 1993 EFRBs and on March 16, 1996 for the 1985 PCRBs, at which time the Company is required to obtain either an extension of the letters of credit or substitute credit backup. If neither can be obtained, the 1993 EFRBs and the 1985 PCRBs must be redeemed unless the Company purchases them in lieu of redemption and subsequently remarkets them. Tender requirements of Authority Financing Notes at December 31, 1993 are as follows: FAIR VALUES OF LONG-TERM DEBT The carrying amounts and fair values of the Company's long-term debt consisted of the following at December 31: MATURITY SCHEDULE Total long-term debt maturing in the next five years is $600 million (1994), $25 million (1995), $455 million (1996), $286 million (1997) and $1 million (1998). NOTE 8. RETIREMENT BENEFIT PLANS PENSION PLANS The Company maintains a primary defined benefit pension plan (Primary Plan) which covers substantially all employees, a supplemental plan (Supplemental Plan) which covers officers and certain key executives and a retirement plan which covers the Board of Directors (Directors' Plan). Primary Plan The Company's funding policy is to contribute annually to the Primary Plan a minimum amount consistent with the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) plus such additional amounts, if any, as the Company may determine to be appropriate from time to time. Effective January 1, 1992, the Plan was amended to update the benefit calculation, whereby for service before January 1, 1992, pension benefits are determined based on the greater of the accrued benefit as of December 31, 1991, or by applying a moving five-year average of Plan compensation, not to exceed the January 1, 1992 salary, to a certain percentage, determined by years of service at December 31, 1991. For service after January 1, 1992, pension benefits are equal to 2% of Plan compensation through age 49 and 2 1/2% thereafter. Employees are vested in the pension plan after five years of service with the Company. The Primary Plan's funded status reflects changes in assumptions used in accounting due to changes in market conditions. The 1993 projected benefit obligation increased by approximately $31 million due to changes in the discount rate used, partially offset by a lower rate of future compensation increases. The Primary Plan's funded status and amounts recognized on the Balance Sheet at December 31, 1993 and 1992 were as follows: Periodic pension cost for 1993, 1992 and 1991 for the Primary Plan included the following components: Assumptions used in accounting for the Primary Plan were: The Primary Plan assets at fair value primarily include cash, cash equivalents, group annuity contracts, bonds and listed equity securities. In 1993, the PSC issued an order which addressed the accounting and ratemaking treatment of pension costs in accordance with SFAS No. 87, Employers' Accounting For Pensions. Under the PSC order, the Company is required to recognize any deferred net gains or losses over a ten- year period rather than using the corridor approach method. The Company believes that by adopting this method of accounting for financial reporting purposes, a better matching of revenues and the Company's pension cost will result from the implementation of the PSC order. For the year ended December 31, 1993, this change in the annual pension cost calculation reduced pension expense by approximately $4.6 million. The Company deferred a like amount of revenues to reflect the difference between pension expense in rates and pension expense under the PSC's order. In addition, the PSC authorized the Company to defer the difference between the pension rate allowance and annual pension contributions deposited into the pension fund. The Company is required to accrue, to the benefit of the ratepayer, a carrying charge on any such deferred balance. Supplemental Plan The Supplemental Plan, the cost of which is borne by the Company's shareowners, provides supplemental death and retirement benefits for officers and other key executives without contribution from such employees. The Supplemental Plan is a non-qualified plan under the Internal Revenue Code. Death benefits are currently provided by insurance. The provision for retirement benefits, which is unfunded, totaled approximately $2,800,000, $685,000 and $675,000 which was recognized as an expense in 1993, 1992 and 1991, respectively. Directors' Plan The Directors' Plan, adopted in February 1990, provides benefits to directors who are not officers of the Company. Directors who have served in that capacity for more than five years qualify as participants under the plan. The Directors' Plan is a non-qualified plan under the Internal Revenue Code. The provision for retirement benefits, which is unfunded, totaled approximately $150,000, $133,000 and $101,000 which was recognized as expense in 1993, 1992 and 1991, respectively. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In addition to providing pension benefits, the Company provides certain medical and life insurance benefits for retired employees. Substantially all of the Company's employees may become eligible for these benefits if they reach retirement age after working for the Company for a minimum of five years. These and similar benefits for active employees are provided by the Company or by insurance companies whose premiums are based on the benefits paid during the year. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, which requires the Company to recognize the expected cost of providing postretirement benefits when employee services are rendered rather than on a pay-as-you-go method. Effective January 1, 1993, the Company recorded an accumulated postretirement benefit obligation and a corresponding regulatory asset of approximately $376 million. Additionally, as a result of adopting SFAS No. 106, the Company's annual postretirement benefit cost for 1993 increased by approximately $28 million above the amount that would have been recorded under the pay-as-you-go method. In 1993, the PSC issued a final order which required that the effects of implementing SFAS No. 106 be phased into rates. The order required the Company to defer as a regulatory asset the difference between postretirement benefit expense recorded for accounting purposes in accordance with SFAS No. 106 and the postretirement benefit expense reflected in rates. The ongoing annual postretirement benefit expense will be phased into and fully reflected in rates within a five-year period with the accumulated postretirement obligation being recovered in rates over a twenty-year period. Accumulated postretirement benefits obligation other than pensions at December 31 were as follows: Periodic postretirement benefit cost other than pensions for the years 1993 and 1992 were as follows: Assumptions used in accounting for postretirement benefits other than pensions were as follows: The assumed health care cost trend rates used in measuring the accumulated postretirement benefit obligation at December 31, 1993 and 1992 were 9.5% and 15.0%, respectively, gradually declining to 6.0% in 2001 and thereafter. A one-percentage point increase in the health care cost trend rate would increase the accumulated postretirement benefit obligation as of December 31, 1993 and 1992 by approximately $46 million and $58 million, respectively, and the sum of the service and interest costs in 1993 by $8 million. POSTEMPLOYMENT BENEFITS In November 1992, the FASB issued SFAS No. 112, Employers' Accounting for Postemployment Benefits, which establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement. The Company will be required to comply with the new rules beginning in 1994. The effect of adopting the new rules will not be material to the Company's financial position or results of operations. The Company believes it will be permitted to recover these costs through rates. NOTE 9. COMMITMENTS AND CONTINGENCIES COMMITMENTS The Company has entered into substantial commitments for fossil fuel, gas supply, purchased power and transmission facilities. The costs associated with these commitments are normally recovered from ratepayers through provisions in the Company's rate schedules. The Company expects that it will have to expend $4.3 million in 1994 to meet continuous emission monitoring requirements and $3.5 million in 1994 and $2.0 million in 1995 to meet Phase I nitrogen oxide (NOx) reduction requirements. In addition, subject to details that are expected to appear in regulations that have not yet been issued, the Company estimates that it may be required to expend as much as $125 million by May 1999 to meet Phase II NOx reduction requirements and approximately $50 million by 2000 to meet requirements for the control of hazardous air pollutants from power plants. The Company believes that such cost would be recoverable in rates. CONTINGENCIES Litigation On February 11, 1988, the Company began a lawsuit in Suffolk County Supreme Court against Suffolk County, seeking the recovery of approximately $54 million in damages for Suffolk County's breach of a contract to prepare an off site emergency response plan for Shoreham (Long Island Lighting Company v. County of Suffolk). In addition, the complaint alleges that, because of the delays that have resulted, the Company has been damaged in an additional amount of $706 million. On October 30, 1992, the court granted in part and denied in part Suffolk County's motion to amend its answer to assert additional defenses and counterclaims. Two proposed counterclaims were allowed seeking approximately $16 million in damages as well as $700 million in alleged punitive damages. The outcome of these counterclaims, if adverse, could have a material effect on the financial condition of the Company. The Company has argued that there is no basis for punitive damages and intends to vigorously prosecute its claim against Suffolk County and to defend against these counterclaims. Environmental The Company is subject to environmental laws and regulations of the United States Environmental Protection Agency (EPA) and other regulatory agencies. The Company is monitoring its activities and to date, has not identified any material environmental contingencies. The Company believes that costs related to such contingencies, if any, would be recoverable in rates. NUCLEAR PLANT INSURANCE The Company has property damage insurance and third-party bodily injury and property liability insurance for its 18% share in NMP2 and for Shoreham. The premiums for this coverage are not material. The policies for this coverage provide for retroactive premium assessments under certain circumstances. Maximum retroactive premium assessments could be as much as approximately $4.7 million. For property damage at each nuclear generating site, the NRC requires a minimum of $1.06 billion of coverage. The NRC has provided the Company with a partial exemption from these requirements for Shoreham. Under certain circumstances, the Company may be assessed additional amounts in the event of a nuclear incident. Under agreements established pursuant to the Price Anderson Act, the Company could be assessed up to approximately $79.3 million per nuclear incident in any one year at any nuclear unit, but not in excess of approximately $10 million in payments per year for each incident. The Price Anderson Act also limits liability for third-party bodily injury and third-party property damage arising out of a nuclear occurrence at each unit to $9.4 billion. NOTE 10. FEDERAL INCOME TAXES As of December 31, 1993, the significant components of the Company's deferred tax assets and liabilities calculated under the provisions of SFAS No. 109 were as follows: The Company's net operating loss (NOL) carryforward for federal income tax purposes is estimated to be approximately $2 billion at December 31, 1993. The NOL will expire in the years 2003 through 2007. The amount of investment tax credit (ITC) carryforward is approximately $219 million. The ITC credits expire by the year 2002. In accordance with the Tax Reform Act of 1986 (TRA 86), ITC allowable as credits to tax returns for years after 1987 must be reduced by 35%. The amount of the reduction will not be allowed as a credit for any other taxable year. For financial reporting purposes, a valuation allowance was not required to offset the deferred tax assets related to these carryforwards. On January 8, 1990 and October 10, 1992, the Company received Revenue Agents' Reports disallowing certain deductions claimed by the Company on its tax returns for the audit cycle years 1984-1987 and 1988-1989, respectively. The Revenue Agents' Reports reflects proposed adjustments to the Company's federal income tax returns for 1984 through 1989 which, if sustained, would give rise to tax deficiencies totaling approximately $220 million. The Revenue Agents have proposed ITC adjustments which, if sustained, would reduce the Company's carryforward by approximately $96 million. The Company is protesting some of the adjustments and seeks an administrative and, if necessary, a judicial review of the conclusions reached in the Revenue Agents' Reports. The Company cannot predict either the timing or the manner in which these matters will be resolved. If however, the ultimate disposition of any or all matters raised in the Revenue Agents' Reports are adverse to the Company, the Company expects that any deficiencies that may arise will be substantially offset by the net operating loss carrybacks associated with the 1989 Shoreham abandonment loss deduction of $1.8 billion and thus any impact would not have a material effect on the Company's financial condition or cash flows. The federal income tax amounts included in the Statement of Income differ from the amounts which result from applying the statutory federal income tax rate to net income before income taxes. The table below sets forth the reasons for such differences. NOTE 11. SEGMENTS OF BUSINESS The Company is a public utility engaged in the generation, distribution and sale of electric energy and the purchase, distribution and sale of natural gas to residential, commercial and industrial customers in Nassau and Suffolk Counties and the Rockaway Peninsula in Queens County, all on Long Island, New York. Identifiable assets by segment include net utility plant, regulatory assets, materials and supplies (excluding common), accrued unbilled revenues, gas in storage, fuel and deferred charges (excluding common). Assets utilized for overall Company operations consist of other property and investments, cash and cash equivalents, special deposits, accounts receivable, prepayments and other current assets, unamortized debt expense and other deferred charges. NOTE 12. QUARTERLY FINANCIAL INFORMATION (Unaudited) In the fourth quarter of 1993, the Company recorded income of approximately $6.5 million, net of tax effects, or $.06 per common share related to the settlement of certain litigation. In addition, during the fourth quarter of 1993, the Company recorded a charge to earnings of approximately $7.3 million, net of tax effects or $.07 per common share principally related to previously deferred storm costs and the reconciliation of certain ratemaking mechanisms recorded in connection with the conclusion of the Company's rate year. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS To the Shareowners and Board of Directors of Long Island Lighting Company We have audited the accompanying balance sheet of Long Island Lighting Company and the related statement of capitalization, 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. 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 all 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 Long Island Lighting Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 8 and 10 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and income taxes. /s/ ERNST & YOUNG Melville, New York February 4, 1994 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 Information required by Item 10 as to the Company's Executive Officers is set forth in Item 1, "Business" under the heading "Executive Officers of the Company" above. Information required by Item 10 as to the Company's Directors may be found in the Company's proxy statement for its Annual Meeting to be held on April 12, 1994. Such proxy statement is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information required by Item 11 may be found in the Company's proxy statement for its Annual Meeting to be held on April 12, 1994. Such proxy statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by Item 12 may be found in the Company's proxy statement for its Annual Meeting to be held on April 12, 1994. Such proxy statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by Item 13 may be found in the Company's proxy statement for its Annual Meeting to be held on April 12, 1994. Such 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) List of Financial Statements Balance Sheet at December 31, 1993 and 1992. Statement of Income for each of the three years in the period ended December 31, 1993. Statement of Capitalization at December 31, 1993 and 1992. Statement of Cash Flows for each of the three years in the period ended December 31, 1993. Statement of Retained Earnings for each of the three years in the period ended December 31, 1993. Notes to Financial Statements. (2) List of Financial Statement Schedules Property, Plant and Equipment (Schedule V) Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment (Schedule VI) Valuation and Qualifying Accounts (Schedule VIII) Supplementary Income Statement Information (Schedule X) (3) List of Exhibits *3(a) Restated Certificate of Incorporation of the Company dated November 11, 1993. (b) By-laws of the Company as amended on May 28, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 4(a) General and Refunding Indenture dated as of June 1, 1975 and 21 supplements thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as follows: G&R Indenture dated as of June 1, 1975. First Supplemental Indenture to G&R Indenture dated as of June 1, 1975. Second Supplemental Indenture to G&R Indenture dated as of September 1, 1975. Third Supplemental Indenture to G&R Indenture dated as of June 1, 1976. Fourth Supplemental Indenture to G&R Indenture dated as of December 1, 1976. Fifth Supplemental Indenture to G&R Indenture dated as of May 1, 1977. Sixth Supplemental Indenture to G&R Indenture dated as of April 1, 1978. - ------------------------ * Filed herewith. Seventh Supplemental Indenture to G&R Indenture dated as of March 1, 1979. Eighth Supplemental Indenture to G&R Indenture dated as of February 1, 1980. Ninth Supplemental Indenture to G&R Indenture dated as of March 1, 1981. Tenth Supplemental Indenture to G&R Indenture dated as of July 1, 1981. Eleventh Supplemental Indenture to G&R Indenture dated as of July 1, 1981. Twelfth Supplemental Indenture to G&R Indenture dated as of December 1, 1981. Thirteenth Supplemental Indenture to G&R Indenture dated as of December 1, 1981. Fourteenth Supplemental Indenture to G&R Indenture dated as of June 1, 1982. Fifteenth Supplemental Indenture to G&R Indenture dated as of October 1, 1982. Sixteenth Supplemental Indenture to G&R Indenture dated as of April 1, 1983. Seventeenth Supplemental Indenture to G&R Indenture dated as of May 1, 1983. Eighteenth Supplemental Indenture to G&R Indenture dated as of September 1, 1984. Nineteenth Supplemental Indenture to G&R Indenture dated as of October 1, 1984. Twentieth Supplemental Indenture to G&R Indenture dated as of June 1, 1985. Twenty-first Supplemental Indenture to G&R Indenture dated as of April 1, 1986. Twenty-second Supplemental Indenture to G&R Indenture dated as of February 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Twenty-third Supplemental Indenture to G&R Indenture dated as of May 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Twenty-fourth Supplemental Indenture to G&R Indenture dated as of July 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Twenty-fifth Supplemental Indenture to G&R Indenture dated as of May 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Twenty-sixth Supplemental Indenture to G&R Indenture dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 4(b) Indenture of Mortgage and Deed of Trust dated as of September 1, 1951 and 44 supplements thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as follows: Indenture of Mortgage dated as of September 1, 1951. First Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1951. Second Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1952. Third Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1953. Fourth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1954. Fifth Supplemental Indenture to the Indenture of Mortgage dated as of November 1, 1955. Sixth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1956. Seventh Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1958. Eighth Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1959. Ninth Supplemental Indenture to the Indenture of Mortgage dated as of August 1, 1961. Tenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1963. Eleventh Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1964. Twelfth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1965. Thirteenth Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1966. Fourteenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1967. Fifteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1969. Sixteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1970. Seventeenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1971. Eighteenth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1971. Nineteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1972. Twentieth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1973. Twenty-first Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1974. Twenty-second Supplemental Indenture to the Indenture of Mortgage dated as of November 1, 1974. Twenty-third Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1975. Twenty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1975. Twenty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1976. Twenty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1976. Twenty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1977. Twenty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1978. Twenty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1979. Thirtieth Supplemental Indenture to the Indenture of Mortgage dated as of February 1, 1980. Thirty-first Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1981. Thirty-second Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1981. Thirty-third Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1981. Thirty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1981. Thirty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1981. Thirty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1982. Thirty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1982. Thirty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1983. Thirty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1983. Fortieth Supplemental Indenture to the Indenture of Mortgage dated as of February 29, 1984. Forty-first Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1984. Forty-second Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1984. Forty-third Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1985. Forty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1986. Forty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of February 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Forty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Forty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Forty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Forty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *4(c) Debenture Indenture dated as of November 1, 1986 from the Company to The Connecticut Bank and Trust Company, National Association, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). First Supplemental Indenture dated as of November 1, 1986 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). Second Supplemental Indenture dated as of April 1, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Third Supplemental Indenture dated as of July 1, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Fourth Supplemental Indenture dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Fifth Supplemental Indenture dated as of November 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *Sixth Supplemental Indenture dated as of June 1, 1993. *Seventh Supplemental Indenture dated as of July 1, 1993. 4(d) Debenture Indenture dated as of November 1, 1992 from the Company to Chemical Bank, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). First Supplemental Indenture dated as of January 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). - ------------------------ * Filed herewith. Second Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Third Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Fourth Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(a) Sound Cable Project Facilities and Marketing Agreement dated as of August 26, 1987 between the Company and the Power Authority of the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). 10(b) Transmission Agreement by and between the Company and Consolidated Edison Company of New York, Inc. dated as of March 31, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(c) Contract for the sale of Firm Power and Energy by and between the Company and the State of New York dated as of April 26, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(d) Capacity Supply Agreement dated as of December 13, 1991 between the Company and the Power Authority of the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). *10(e) Nine Mile Point Nuclear Station Unit 2 Operating Agreement dated as of January 1, 1993 by and between the Company, New York State Electric & Gas Corporation, Rochester Gas and Electric Corporation and Central Hudson Gas and Electric Corporation. 10(f) Settlement Agreement on Issues Related to Nine Mile Two Nuclear Plant dated as of June 6, 1990 by and between the Company, the Staff of the Department of Public Service and others (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). - ------------------------ * Filed herewith. 10(g) Settlement Agreement -- LILCO Issues dated as of February 28, 1989 by and between the Company and the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). 10(h) Amended and Restated Asset Transfer Agreement by and between the Company and the Long Island Power Authority dated as of June 16, 1988 as amended and restated on April 14, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(i) Memorandum of Understanding concerning proposed agreements on power supply for Long Island dated as of June 16, 1988 by and between the Company and New York Power Authority as amended May 24, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(j) Rate Moderation Agreement submitted by the staff of the New York State Public Service Commission on March 16, 1989 and supported by the Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(k) Site Cooperation and Reimbursement Agreement dated as of January 24, 1990 by and between the Company and Long Island Power Authority (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(l) Stipulation of settlement of federal Racketeer Influenced and Corrupt Organizations Act ("RICO") Class Action and False Claims Action dated as of February 27, 1989 among the attorneys for the Company, the ratepayer class, the United States of America and the individual defendants named therein (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). 10(m) Revolving Credit Agreement dated as of June 27, 1989, between Long Island Lighting Company and the banks and co-agents listed therein, with the Exhibits thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) and as amended by the First Amendment dated as of October 13, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) and as amended by the Second Amendment dated as of March 5, 1992 and as modified by a Waiver dated November 5, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(n) Indenture of Trust dated as of December 1, 1989 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1989 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Participation Agreement dated as of December 1, 1989 by and between the New York State Energy Research and Development Authority and the Company relating to the 1989 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(o) Indenture of Trust dated as of May 1, 1990 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1990 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Participation Agreement dated as of May 1, 1990 by and between the New York State Energy Research and Development Authority and the Company relating to the 1990 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). 10(p) Indenture of Trust dated as of January 1, 1991 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1991 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Participation Agreement dated as of January 1, 1991 by and between the New York State Energy Research and Development Authority and the Company relating to the 1991 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). 10(q) Indenture of Trust dated as of February 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series A (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Participation Agreement dated as of February 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series A (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 10(r) Indenture of Trust dated as of February 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series B (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Participation Agreement dated as of February 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series B (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 10(s) Indenture of Trust dated as of August 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series C (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Participation Agreement dated as of August 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series C (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(t) Indenture of Trust dated as of August 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series D (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Participation Agreement dated as of August 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series D (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *10(u) Indenture of Trust dated as of November 1, 1993 by and between New York State Energy Research and Development Authority and Chemical Bank, as Trustee, relating to the 1993 Electric Facilities Revenue Bonds, Series A. Participation Agreement dated as of November 1, 1993 by and between the New York State Energy Research and Development Authority and the Company relating to the 1993 Electric Facilities Revenue Bonds, Series A. *10(v) Indenture of Trust dated as of November 1, 1993 by and between New York State Energy Research and Development Authority and Chemical Bank, as Trustee, relating to the 1993 Electric Facilities Revenue Bonds, Series B. Participation Agreement dated as of November 1, 1993 by and between the New York State Energy Research and Development Authority and the Company relating to the 1993 Electric Facilities Revenue Bonds, Series B. - ------------------------ * Filed herewith. *10(w) Supplemental Death and Retirement Benefits Plan as amended and restated effective January 1, 1993 and related Trust Agreement, which Trust Agreement was filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference. *10(x) Executive Agreements and Management Contracts *(1) Executive Employment Agreement dated as of January 30, 1984 by and between William J. Catacosinos and Long Island Lighting Company, as amended by amendments dated March 20, 1987 (filed as Exhibit 10(e) to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference), December 22, 1989 (filed as Exhibit 10(o) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) and December 2, 1991 (filed as Exhibit 10(u) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference); an Employment Agreement dated as of March 20, 1987 (filed as Exhibit 10(e) to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by amendments dated November 30, 1989 (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference), an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference), an amendment dated December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference), and as amended by an amendment dated December 31, 1993. *(2) Employment Agreement dated as of February 23, 1994 by and between Theodore A. Babcock and Long Island Lighting Company and related Trust Agreement, which Trust Agreement was filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference. (3) Employment Agreement dated as of May 14, 1990 by and between William N. Dimoulas and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). - ------------------------ * Filed herewith. (4) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between James T. Flynn and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (5) Employment Agreement dated as of September 11, 1992 by and between Robert J. Grey and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (6) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Robert X. Kelleher and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (7) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between John D. Leonard, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (8) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Adam M. Madsen and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (9) Employment Agreement dated as of May 30, 1990 by and between Kathleen A. Marion and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated December 2, 1991 as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (10) Employment Agreement dated as of January 21, 1991 by and between Arthur C. Marquardt and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (11) Employment Agreement dated as of April 16, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Brian R. McCaffrey and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 incorporated herein by reference) and as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (12) Employment Agreement dated as of March 18, 1988 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Joseph W. McDonnell and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (13) Employment Agreement dated as of July 29, 1992 by and between Anthony Nozzolillo and Long Island Lighting Company and related Trust Agreement and as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (14) Employment Agreement dated as of July 29, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between William G. Schiffmacher and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (15) Employment Agreement dated as of February 20, 1990 by and between Robert B. Steger and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (16) Employment Agreement dated as of March 9, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between William E. Steiger, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (17) Employment Agreement dated as of April 17, 1991 by and between Thomas J. Vallely, III and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (18) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Walter F. Wilm, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (19) Employment Agreement dated as of November 4, 1988 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Edward J. Youngling and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (20) Retirement Agreement dated as of January 7, 1987 by and between George J. Sideris and Long Island Lighting Company, as amended March 20, 1987, and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). *(21) Indemnification Agreement dated as of February 23, 1994 by and between Theodore A. Babcock and Long Island Lighting Company. (22) Indemnification Agreement dated as of January 31, 1992 by and between A. James Barnes and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). (23) Indemnification Agreement dated as of May 30, 1990 by and between George Bugliarello and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (24) Indemnification Agreement dated as of April 17, 1992 by and between Renso L. Caporali and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (25) Indemnification Agreement dated as of November 19, 1987 by and between William J. Catacosinos and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (26) Indemnification Agreement dated as of April 23, 1992 by and between Peter O. Crisp and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (27) Indemnification Agreement dated as of May 14, 1990 by and between William N. Dimoulas and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (28) Indemnification Agreement dated as of November 25, 1987 by and between James T. Flynn and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (29) Indemnification Agreement dated as of November 19, 1987 by and between Winfield E. Fromm and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). - ----------------------- * Filed herewith. *(30) Indemnification Agreement dated as of January 3, 1994 by and between Vicki L. Fuller and Long Island Lighting Company. (31) Indemnification Agreement dated as of September 11, 1992 by and between Robert J. Grey and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (32) Indemnification Agreement dated as of November 25, 1987 by and between Robert X. Kelleher and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (33) Indemnification Agreement dated as of November 25, 1987 by and between John D. Leonard, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (34) Indemnification Agreement dated as of November 25, 1987 by and between Adam M. Madsen and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (35) Indemnification Agreement dated as of May 30, 1990 by and between Kathleen A. Marion and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (36) Indemnification Agreement dated as of January 21, 1991 by and between Arthur C. Marquardt and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (37) Indemnification Agreement dated as of November 25, 1987 by and between Brian R. McCaffrey and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (38) Indemnification Agreement dated as of March 18, 1988 by and between Joseph W. McDonnell and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (39) Indemnification Agreement dated as of July 29, 1992 by and between Anthony Nozzolillo and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). - --------------------- * Filed herewith. *(40) Indemnification Agreement dated as of April 20, 1993 by and between Katherine D. Ortega and Long Island Lighting Company. (41) Indemnification Agreement dated as of November 19, 1987 by and between Basil A. Paterson and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (42) Indemnification Agreement dated as of November 25, 1987 by and between William Schiffmacher and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (43) Indemnification Agreement dated as of February 8, 1992 by and between Richard L. Schmalensee and Long Island Lighting Company (filed as an Exhibit to the Company Form 10- K for the Year Ended December 31, 1991 and incorporated herein by reference). (44) Indemnification Agreement dated as of November 30, 1987 by and between George J. Sideris and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (45) Indemnification Agreement dated as of February 20, 1990 by and between Robert B. Steger and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). (46) Indemnification Agreement dated as of March 1, 1989 by and between William E. Steiger, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (47) Indemnification Agreement dated as of November 19, 1987 by and between John H. Talmage and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (48) Indemnification Agreement dated as of April 17, 1991 by and between Thomas J. Vallely, III and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). (49) Indemnification Agreement dated as of November 19, 1987 by and between Phyllis A. Vineyard and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). - --------------------- * Filed herewith. (50) Indemnification Agreement dated as of November 25, 1987 by and between Walter F. Wilm, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (51) Indemnification Agreement dated as of November 4, 1988 by and between Edward J. Youngling and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (52) Long Island Lighting Company Officers' and Directors' Protective Trust dated as of April 18, 1988 by and between the Company and Clarence Goldberg, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (53) Long Island Lighting Company's Retirement Plan for Directors dated as of February 2, 1990 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). *(54) Agreement dated as of April 20, 1993 by and between the Company and Lionel M. Goldberg. *(55) Agreement dated as of April 20, 1993 by and between the Company and Eben W. Pyne. *23 Consent of Ernst & Young, Independent Auditors. *24(a) Powers of Attorney executed by the Directors and Officers of the Company. *24(b) Certificate as to Corporate Power of Attorney. *24(c) Certified copy of Resolution of Board of Directors authorizing signature pursuant to Power of Attorney. Financial Statements of subsidiary companies accounted for by the equity method have been omitted because such subsidiaries do not constitute significant subsidiaries. - ---------------------- * Filed herewith. (b) Reports on Form 8-K In its Report on Form 8-K dated October 8, 1993, the Company stated that: 1. On September 22, 1993, the United States Court of Appeals for the Second Circuit issued its opinion affirming the United States District Court for the Southern District of New York's jury award of $18.4 million, in favor of the Company, for a breach of warranty cause of action against Transamerica Delaval, Inc., now IMO Industries, Inc. and the District Court's dismissal of the Company's claims as to all categories of damages other than the amount attributable to the breach of warranty action. 2. If the Company concludes that the overall objectives of the RMA can be met, it may submit to the PSC, for the rate period commencing December 1, 1994, a multi-year electric rate plan providing for annual percentage increases that are significantly lower than the targeted levels contemplated by the RMA. 3. Subsequent to the issuance of the ALJ's Recommended Decision on the Company's gas rate application, the Company negotiated a multi-year rate settlement with Staff of the PSC which is subject to review by the ALJ and approval by the PSC. In its Report on Form 8-K dated December 3, 1993, the Company stated that: 1. On November 15, 1993, the PSC authorized the Company to increase its base electric rates by 4% effective December 1, 1993. This increase is the sixth in a series of 11 rate increases contemplated in the PSC-approved 1989 RMA. 2. The Company is in the process of preparing a three-year electric rate plan for the period beginning December 1, 1994 that provides for zero percentage base rate increases in years one and two of the plan and a base rate increase of approximately 4% in the third year, while retaining consistency with the RMA's objective of continuing the restoration of the Company's financial health. No other Reports on Form 8-K were filed in the fourth quarter of 1993. In its Report on Form 8-K dated January 21, 1994, the Company stated that: 1. The Company has announced the resignation of its President and Chief Operating Officer, Anthony F. Earley, Jr., effective March 1, 1994. 2. On December 31, 1993, the Company filed a three-year electric rate plan with the PSC for the period beginning December 1, 1994 that proposes no base electric rate increases in years one and two of the plan and an overall increase of 4.3% in the third year. 3. On January 12, 1994, the Company filed comments in response to the November 2, 1993 Petition filed by the CPB and LIPA with the PSC asking the PSC to hold a proceeding on freezing or possibly reducing the Company's electric rates for the period December 1994 to November 1997. 4. In December 1993, the PSC approved, with an effective date of December 31, 1993, the Company's negotiated three-year gas rate settlement with the Staff of the PSC which provided for a first year increase of $26.6 million and two subsequent increases of $23 million and $20 million to be effective on December 1, 1995 and 1996, respectively. 5. On December 30, 1993, the Appellate Division, Third Judicial Department, affirmed the Supreme Court of the State of New York Special Term's decision in LILCO v. PSC/Mayflower, which held that the PSC had violated PURPA and the New York Public Service Law and had acted arbitrarily when it ordered the Company to sign a power purchase contract with Mayflower Energy Partners, L.P. incorporating the PSC's 1989 Long Run Avoided Cost estimates. 6. On December 13, 1993, the United States District Court for the Eastern District of New York issued an opinion in LILCO v. Stone & Webster Engineering Corp. granting a motion by SWEC to dismiss the Company's complaint in this action which had sought to recover damages against SWEC for breach of contract, negligence, professional malpractice and gross negligence in connection with SWEC's work as architect-engineer and construction manager for Shoreham. 7. Pursuant to the LIPA Act, LIPA is required to make PILOTS to the municipalities that impose real property taxes on Shoreham. On January 10, 1994, the Appellate Division, Second Department, affirmed Nassau County Supreme Court's March 29, 1993 decision in LIPA, et al. v. Shoreham-Wading River Central School District, et al. holding, in major part, that the Company is not obligated for any real property taxes that accrued after February 28, 1992, attributable to property that it conveyed to LIPA, that PILOTS commence on March 1, 1992, that PILOTS are subject to refunds and that the LIPA Act does not provide for the termination of PILOTS. In its Report on Form 8-K dated February 7, 1994, the Company reported earnings of $2.15 per common share on revenues of $2,880,995,000 for the year ended December 31, 1993. LONG ISLAND LIGHTING COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1993 (Thousands of Dollars) (A) Adjustments between Plant Accounts. LONG ISLAND LIGHTING COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1992 (Thousands of Dollars) (A) Adjustments between Plant Accounts. LONG ISLAND LIGHTING COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1991 (Thousands of Dollars) (A) Adjustments between Plant Accounts. LONG ISLAND LIGHTING COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1993 (Thousands of Dollars) Note: (A) Includes transfers between reserves, costs of removal and salvage. LONG ISLAND LIGHTING COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1992 (Thousands of Dollars) Note: (A) Includes transfers between reserves, costs of removal and salvage. LONG ISLAND LIGHTING COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For The Year Ended December 31, 1991 (Thousands of Dollars) Note: (A) Includes transfers between reserves, costs of removal and salvage. LONG ISLAND LIGHTING COMPANY SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS (Thousands of Dollars) (1) Uncollectible accounts written off, net of recoveries. LONG ISLAND LIGHTING COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Advertising expenses for the years 1993 - 1991 were not presented as such amounts represent less than 1% of total revenues. 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. 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. LONG ISLAND LIGHTING COMPANY Date: March 15, 1994 By: ANTHONY NOZZOLILLO ------------------------ Anthony Nozzolillo Chief Financial Officer Original powers of attorney, authorizing Kathleen A. Marion, Anthony Nozzolillo and Robert J. Grey, and each of them, to sign this report and any amendments thereto, as attorney-in-fact for each of the Directors and Officers of the Company, and a certified copy of the resolution of the Board of Directors of the company authorizing said persons and each of them to sign this report and amendments thereto as attorney-in-fact for any Officers signing on behalf of the Company, have been, are being filed or will be filed with the Securities and Exchange Commission. Exhibit 23 Consent of Independent Auditors We consent to the incorporation by reference in the Post-Effective Amendment No. 3 to Registration Statement (No 33-16238) on Form S-8 relating to Long Island Lighting Company's Employee Stock Purchase Plan, Post-Effective Amendment No. 1 to Registration Statement (No. 2-87427) on Form S-3 relating to Long Island Lighting Company's Automatic Dividend Reinvestment Plan and in the related Prospectus, Registration Statement (No. 2-88578) on Form S-3 relating to the issuance of Common Stock and in the related Prospectus and Registration Statement (No. 33-45834) on Form S-3 relating to the issuance of General and Refunding Bonds and in the related Prospectus and Registration Statement (No. 33-60744) on Form S-3 relating to the issuance of General and Refunding Bonds, Debentures, Preferred Stock or Common Stock and in the related Prospectus, of our report dated February 4, 1994, with respect to the financial statements and schedules of Long Island Lighting Company included in this Annual Report on Form 10-K for the year ended December 31, 1993. ERNST & YOUNG Melville, New York March 11, 1994 EXHIBIT INDEX Exhibit No. Description - ------- ----------- *3(a) Restated Certificate of Incorporation of the Company dated November 11, 1993. (b) By-laws of the Company as amended on May 28, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 4(a) General and Refunding Indenture dated as of June 1, 1975 and 21 supplements thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as follows: G&R Indenture dated as of June 1, 1975. First Supplemental Indenture to G&R Indenture dated as of June 1, 1975. Second Supplemental Indenture to G&R Indenture dated as of September 1, 1975. Third Supplemental Indenture to G&R Indenture dated as of June 1, 1976. Fourth Supplemental Indenture to G&R Indenture dated as of December 1, 1976. Fifth Supplemental Indenture to G&R Indenture dated as of May 1, 1977. Sixth Supplemental Indenture to G&R Indenture dated as of April 1, 1978. - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- Seventh Supplemental Indenture to G&R Indenture dated as of March 1, 1979. Eighth Supplemental Indenture to G&R Indenture dated as of February 1, 1980. Ninth Supplemental Indenture to G&R Indenture dated as of March 1, 1981. Tenth Supplemental Indenture to G&R Indenture dated as of July 1, 1981. Eleventh Supplemental Indenture to G&R Indenture dated as of July 1, 1981. Twelfth Supplemental Indenture to G&R Indenture dated as of December 1, 1981. Thirteenth Supplemental Indenture to G&R Indenture dated as of December 1, 1981. Fourteenth Supplemental Indenture to G&R Indenture dated as of June 1, 1982. Fifteenth Supplemental Indenture to G&R Indenture dated as of October 1, 1982. Sixteenth Supplemental Indenture to G&R Indenture dated as of April 1, 1983. Seventeenth Supplemental Indenture to G&R Indenture dated as of May 1, 1983. Eighteenth Supplemental Indenture to G&R Indenture dated as of September 1, 1984. Nineteenth Supplemental Indenture to G&R Indenture dated as of October 1, 1984. Twentieth Supplemental Indenture to G&R Indenture dated as of June 1, 1985. Twenty-first Supplemental Indenture to G&R Indenture dated as of April 1, 1986. Twenty-second Supplemental Indenture to G&R Indenture dated as of February 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Exhibit No. Description - ------- ----------- Twenty-third Supplemental Indenture to G&R Indenture dated as of May 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Twenty-fourth Supplemental Indenture to G&R Indenture dated as of July 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Twenty-fifth Supplemental Indenture to G&R Indenture dated as of May 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Twenty-sixth Supplemental Indenture to G&R Indenture dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 4(b) Indenture of Mortgage and Deed of Trust dated as of September 1, 1951 and 44 supplements thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as follows: Indenture of Mortgage dated as of September 1, 1951. First Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1951. Second Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1952. Third Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1953. Fourth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1954. Fifth Supplemental Indenture to the Indenture of Mortgage dated as of November 1, 1955. Sixth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1956. Seventh Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1958. Exhibit No. Description - ------- ----------- Eighth Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1959. Ninth Supplemental Indenture to the Indenture of Mortgage dated as of August 1, 1961. Tenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1963. Eleventh Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1964. Twelfth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1965. Thirteenth Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1966. Fourteenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1967. Fifteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1969. Sixteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1970. Seventeenth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1971. Eighteenth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1971. Nineteenth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1972. Twentieth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1973. Twenty-first Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1974. Twenty-second Supplemental Indenture to the Indenture of Mortgage dated as of November 1, 1974. Twenty-third Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1975. Exhibit No. Description - ------- ----------- Twenty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1975. Twenty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1976. Twenty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1976. Twenty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1977. Twenty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1978. Twenty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1979. Thirtieth Supplemental Indenture to the Indenture of Mortgage dated as of February 1, 1980. Thirty-first Supplemental Indenture to the Indenture of Mortgage dated as of March 1, 1981. Thirty-second Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1981. Thirty-third Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1981. Thirty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1981. Thirty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of December 1, 1981. Thirty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1982. Thirty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1982. Thirty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1983. Thirty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1983. Exhibit No. Description - ------- ----------- Fortieth Supplemental Indenture to the Indenture of Mortgage dated as of February 29, 1984. Forty-first Supplemental Indenture to the Indenture of Mortgage dated as of September 1, 1984. Forty-second Supplemental Indenture to the Indenture of Mortgage dated as of October 1, 1984. Forty-third Supplemental Indenture to the Indenture of Mortgage dated as of June 1, 1985. Forty-fourth Supplemental Indenture to the Indenture of Mortgage dated as of April 1, 1986. Forty-fifth Supplemental Indenture to the Indenture of Mortgage dated as of February 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Forty-sixth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Forty-seventh Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1991 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Forty-eighth Supplemental Indenture to the Indenture of Mortgage dated as of May 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Forty-ninth Supplemental Indenture to the Indenture of Mortgage dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Exhibit No. Description - ------- ----------- *4(c) Debenture Indenture dated as of November 1, 1986 from the Company to The Connecticut Bank and Trust Company, National Association, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). First Supplemental Indenture dated as of November 1, 1986 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). Second Supplemental Indenture dated as of April 1, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Third Supplemental Indenture dated as of July 1, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Fourth Supplemental Indenture dated as of July 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Fifth Supplemental Indenture dated as of November 1, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *Sixth Supplemental Indenture dated as of June 1, 1993. *Seventh Supplemental Indenture dated as of July 1, 1993. 4(d) Debenture Indenture dated as of November 1, 1992 from the Company to Chemical Bank, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). First Supplemental Indenture dated as of January 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- Second Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Third Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Fourth Supplemental Indenture dated as of March 1, 1993 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(a) Sound Cable Project Facilities and Marketing Agreement dated as of August 26, 1987 between the Company and the Power Authority of the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). 10(b) Transmission Agreement by and between the Company and Consolidated Edison Company of New York, Inc. dated as of March 31, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(c) Contract for the sale of Firm Power and Energy by and between the Company and the State of New York dated as of April 26, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(d) Capacity Supply Agreement dated as of December 13, 1991 between the Company and the Power Authority of the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). *10(e) Nine Mile Point Nuclear Station Unit 2 Operating Agreement dated as of January 1, 1993 by and between the Company, New York State Electric & Gas Corporation, Rochester Gas and Electric Corporation and Central Hudson Gas and Electric Corporation. 10(f) Settlement Agreement on Issues Related to Nine Mile Two Nuclear Plant dated as of June 6, 1990 by and between the Company, the Staff of the Department of Public Service and others (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- 10(g) Settlement Agreement -- LILCO Issues dated as of February 28, 1989 by and between the Company and the State of New York (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). 10(h) Amended and Restated Asset Transfer Agreement by and between the Company and the Long Island Power Authority dated as of June 16, 1988 as amended and restated on April 14, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(i) Memorandum of Understanding concerning proposed agreements on power supply for Long Island dated as of June 16, 1988 by and between the Company and New York Power Authority as amended May 24, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(j) Rate Moderation Agreement submitted by the staff of the New York State Public Service Commission on March 16, 1989 and supported by the Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(k) Site Cooperation and Reimbursement Agreement dated as of January 24, 1990 by and between the Company and Long Island Power Authority (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(l) Stipulation of settlement of federal Racketeer Influenced and Corrupt Organizations Act ("RICO") Class Action and False Claims Action dated as of February 27, 1989 among the attorneys for the Company, the ratepayer class, the United States of America and the individual defendants named therein (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). 10(m) Revolving Credit Agreement dated as of June 27, 1989, between Long Island Lighting Company and the banks and co-agents listed therein, with the Exhibits thereto (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) and as amended by the First Amendment dated as of October 13, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) and as amended by the Second Amendment dated as of March 5, 1992 and as modified by a Waiver dated November 5, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(n) Indenture of Trust dated as of December 1, 1989 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1989 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). Exhibit No. Description - ------- ----------- Participation Agreement dated as of December 1, 1989 by and between the New York State Energy Research and Development Authority and the Company relating to the 1989 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). 10(o) Indenture of Trust dated as of May 1, 1990 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1990 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Participation Agreement dated as of May 1, 1990 by and between the New York State Energy Research and Development Authority and the Company relating to the 1990 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). 10(p) Indenture of Trust dated as of January 1, 1991 by and between New York State Energy Research and Development Authority and The Connecticut National Bank, as Trustee, relating to the 1991 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). Participation Agreement dated as of January 1, 1991 by and between the New York State Energy Research and Development Authority and the Company relating to the 1991 Electric Facilities Revenue Bonds (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). 10(q) Indenture of Trust dated as of February 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series A (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Participation Agreement dated as of February 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series A (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 10(r) Indenture of Trust dated as of February 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series B (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). Exhibit No. Description - ------- ----------- Participation Agreement dated as of February 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series B (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). 10(s) Indenture of Trust dated as of August 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series C (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Participation Agreement dated as of August 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series C (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). 10(t) Indenture of Trust dated as of August 1, 1992 by and between New York State Energy Research and Development Authority and IBJ Schroder Bank and Trust Company, as Trustee, relating to the 1992 Electric Facilities Revenue Bonds, Series D (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). Participation Agreement dated as of August 1, 1992 by and between the New York State Energy Research and Development Authority and the Company relating to the 1992 Electric Facilities Revenue Bonds, Series D (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). *10(u) Indenture of Trust dated as of November 1, 1993 by and between New York State Energy Research and Development Authority and Chemical Bank, as Trustee, relating to the 1993 Electric Facilities Revenue Bonds, Series A. Participation Agreement dated as of November 1, 1993 by and between the New York State Energy Research and Development Authority and the Company relating to the 1993 Electric Facilities Revenue Bonds, Series A. *10(v) Indenture of Trust dated as of November 1, 1993 by and between New York State Energy Research and Development Authority and Chemical Bank, as Trustee, relating to the 1993 Electric Facilities Revenue Bonds, Series B. Participation Agreement dated as of November 1, 1993 by and between the New York State Energy Research and Development Authority and the Company relating to the 1993 Electric Facilities Revenue Bonds, Series B. - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- *10(w) Supplemental Death and Retirement Benefits Plan as amended and restated effective January 1, 1993 and related Trust Agreement, which Trust Agreement was filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference. *10(x) Executive Agreements and Management Contracts *(1) Executive Employment Agreement dated as of January 30, 1984 by and between William J. Catacosinos and Long Island Lighting Company, as amended by amendments dated March 20, 1987 (filed as Exhibit 10(e) to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference), December 22, 1989 (filed as Exhibit 10(o) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) and December 2, 1991 (filed as Exhibit 10(u) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference); an Employment Agreement dated as of March 20, 1987 (filed as Exhibit 10(e) to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by amendments dated November 30, 1989 (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference), an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference), an amendment dated December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference), and as amended by an amendment dated December 31, 1993. *(2) Employment Agreement dated as of February 23, 1994 by and between Theodore A. Babcock and Long Island Lighting Company and related Trust Agreement, which Trust Agreement was filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference. (3) Employment Agreement dated as of May 14, 1990 by and between William N. Dimoulas and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). - ------------------------ * Filed herewith. Exhibit No. Description - ------- ----------- (4) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between James T. Flynn and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (5) Employment Agreement dated as of September 11, 1992 by and between Robert J. Grey and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (6) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Robert X. Kelleher and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (7) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between John D. Leonard, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). Exhibit No. Description - ------- ----------- (8) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Adam M. Madsen and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (9) Employment Agreement dated as of May 30, 1990 by and between Kathleen A. Marion and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated December 2, 1991 as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (10) Employment Agreement dated as of January 21, 1991 by and between Arthur C. Marquardt and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (11) Employment Agreement dated as of April 16, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Brian R. McCaffrey and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 incorporated herein by reference) and as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). Exhibit No. Description - ------- ----------- (12) Employment Agreement dated as of March 18, 1988 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Joseph W. McDonnell and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (13) Employment Agreement dated as of July 29, 1992 by and between Anthony Nozzolillo and Long Island Lighting Company and related Trust Agreement and as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (14) Employment Agreement dated as of July 29, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between William G. Schiffmacher and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (15) Employment Agreement dated as of February 20, 1990 by and between Robert B. Steger and Long Island Lighting Company and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). Exhibit No. Description - ------- ----------- (16) Employment Agreement dated as of March 9, 1989 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between William E. Steiger, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (17) Employment Agreement dated as of April 17, 1991 by and between Thomas J. Vallely, III and Long Island Lighting Company and related Trust Agreement as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (18) Employment Agreement dated as of March 20, 1987 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Walter F. Wilm, Jr. and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). (19) Employment Agreement dated as of November 4, 1988 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference) as amended by an amendment dated November 30, 1989 by and between Edward J. Youngling and Long Island Lighting Company and related Trust Agreement (filed as Exhibit 10(q) to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference) as amended by an amendment dated December 2, 1991 (filed as Exhibit 10(w) to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference) as amended by an amendment dated as of December 31, 1992 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference) and as amended by an amendment dated December 31, 1993 which amendment is identical to that filed with Exhibit 10(x)(1). Exhibit No. Description - ------- ----------- (20) Retirement Agreement dated as of January 7, 1987 by and between George J. Sideris and Long Island Lighting Company, as amended March 20, 1987, and related Trust Agreement (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1986 and incorporated herein by reference). *(21) Indemnification Agreement dated as of February 23, 1994 by and between Theodore A. Babcock and Long Island Lighting Company. (22) Indemnification Agreement dated as of January 31, 1992 by and between A. James Barnes and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). (23) Indemnification Agreement dated as of May 30, 1990 by and between George Bugliarello and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (24) Indemnification Agreement dated as of April 17, 1992 by and between Renso L. Caporali and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (25) Indemnification Agreement dated as of November 19, 1987 by and between William J. Catacosinos and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (26) Indemnification Agreement dated as of April 23, 1992 by and between Peter O. Crisp and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (27) Indemnification Agreement dated as of May 14, 1990 by and between William N. Dimoulas and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (28) Indemnification Agreement dated as of November 25, 1987 by and between James T. Flynn and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (29) Indemnification Agreement dated as of November 19, 1987 by and between Winfield E. Fromm and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). - ----------------------- * Filed herewith. Exhibit No. Description - ------- ----------- *(30) Indemnification Agreement dated as of January 3, 1994 by and between Vicki L. Fuller and Long Island Lighting Company. (31) Indemnification Agreement dated as of September 11, 1992 by and between Robert J. Grey and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). (32) Indemnification Agreement dated as of November 25, 1987 by and between Robert X. Kelleher and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (33) Indemnification Agreement dated as of November 25, 1987 by and between John D. Leonard, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (34) Indemnification Agreement dated as of November 25, 1987 by and between Adam M. Madsen and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (35) Indemnification Agreement dated as of May 30, 1990 by and between Kathleen A. Marion and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (36) Indemnification Agreement dated as of January 21, 1991 by and between Arthur C. Marquardt and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (37) Indemnification Agreement dated as of November 25, 1987 by and between Brian R. McCaffrey and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (38) Indemnification Agreement dated as of March 18, 1988 by and between Joseph W. McDonnell and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (39) Indemnification Agreement dated as of July 29, 1992 by and between Anthony Nozzolillo and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1992 and incorporated herein by reference). - --------------------- * Filed herewith. Exhibit No. Description - ------- ----------- *(40) Indemnification Agreement dated as of April 20, 1993 by and between Katherine D. Ortega and Long Island Lighting Company. (41) Indemnification Agreement dated as of November 19, 1987 by and between Basil A. Paterson and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (42) Indemnification Agreement dated as of November 25, 1987 by and between William Schiffmacher and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (43) Indemnification Agreement dated as of February 8, 1992 by and between Richard L. Schmalensee and Long Island Lighting Company (filed as an Exhibit to the Company Form 10- K for the Year Ended December 31, 1991 and incorporated herein by reference). (44) Indemnification Agreement dated as of November 30, 1987 by and between George J. Sideris and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (45) Indemnification Agreement dated as of February 20, 1990 by and between Robert B. Steger and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). (46) Indemnification Agreement dated as of March 1, 1989 by and between William E. Steiger, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1990 and incorporated herein by reference). (47) Indemnification Agreement dated as of November 19, 1987 by and between John H. Talmage and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (48) Indemnification Agreement dated as of April 17, 1991 by and between Thomas J. Vallely, III and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1991 and incorporated herein by reference). (49) Indemnification Agreement dated as of November 19, 1987 by and between Phyllis A. Vineyard and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). - --------------------- * Filed herewith. Exhibit No. Description - ------- ----------- (50) Indemnification Agreement dated as of November 25, 1987 by and between Walter F. Wilm, Jr. and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1987 and incorporated herein by reference). (51) Indemnification Agreement dated as of November 4, 1988 by and between Edward J. Youngling and Long Island Lighting Company (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (52) Long Island Lighting Company Officers' and Directors' Protective Trust dated as of April 18, 1988 by and between the Company and Clarence Goldberg, as Trustee (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1988 and incorporated herein by reference). (53) Long Island Lighting Company's Retirement Plan for Directors dated as of February 2, 1990 (filed as an Exhibit to the Company's Form 10-K for the Year Ended December 31, 1989 and incorporated herein by reference). *(54) Agreement dated as of April 20, 1993 by and between the Company and Lionel M. Goldberg. *(55) Agreement dated as of April 20, 1993 by and between the Company and Eben W. Pyne. *23 Consent of Ernst & Young, Independent Auditors. *24(a) Powers of Attorney executed by the Directors and Officers of the Company. *24(b) Certificate as to Corporate Power of Attorney. *24(c) Certified copy of Resolution of Board of Directors authorizing signature pursuant to Power of Attorney. Financial Statements of subsidiary companies accounted for by the equity method have been omitted because such subsidiaries do not constitute significant subsidiaries. - ---------------------- * Filed herewith.

53540_1993.txt

53540_1993

1993

53540

ITEM 1. Business Registrant is not engaged in any business operations and has not been so engaged since 1968. ITEM 2. ITEM 2. Properties Registrant does not have an interest in any properties. ITEM 3. ITEM 3. Legal Proceedings None. PART II. ITEM 5. ITEM 5. Market for the Registrant's Common Stock and Related Security Holder Matters Increase and Decrease in Outstanding Securities Indebtedness None. Changes in Securities and Changes in Securities for Registered Securities None. Defaults Upon Senior Securities None. Approximate Number of Equity Security Holders - 2 - Number of Record Holders Title of Class As of July 31, 1993 -------------- --------------------- Common Stock 785 Submission of Matters to a Vote of Security Holders Not applicable. ITEM 6. ITEM 6. Selected Financial Data Five Year Summary of Operations Year ended July 31, --------------------------------- The numerical note referred to above is included in the Notes to Financial Statements. Registrant has not conducted any business operations during its last five (5) fiscal years, except that during the above fiscal years it has incurred expenses necessary to keep its good standing in its state of residence. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Refer to notes and financial statements. ITEM 8. ITEM 8. Financial Statements and Supplementary Data The financial statements of Registrant are attached hereto as Exhibit 14(a). - 3 - PART III. ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant ITEM 11. ITEM 11. Management Remuneration and Transaction No officer or director of Registrant receives any remuneration. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management Leonard M. Ross owns 400,955 shares of the issued and outstanding stock of Registrant which constitutes approximately 89% of such stock. Registrant does not have any subsidiaries. Indemnification of Directors and Officers The by-laws of the Corporation provide that the Corporation shall indemnify each of its officers and directors, whether or not then in office, to the extent permitted by the California General Corporation Law against all reasonable expenses actually and necessarily incurred by such individuals in connection with the defense of any litigation to which he or she may have been made a party because he or she is or was a director or officer of the Corporation. Directors and officers have no right to reimbursement in relation to any matter in which such officer or director has been adjudged liable to the Corporation for gross negligence or comparable misconduct in the performance of his or her duties. PART IV - 4 - ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The Registrant's financial statements are attached hereto. (b) No materially important events occurred during the fiscal year of Registrant that would require filing of Form 8-K. (c) The Exhibits listed in the accompanying Exhibit Index on Page 12 are filed as part of this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duty authorized. (Registrant) JILCO INDUSTRIES, INC. By: /s/ MARTHA J. KRETZMER ------------------------ Martha J. Kretzmer President Date: August 7, 1997 - 5 - JILCO INDUSTRIES, INC. List of Financial Statements The following financial statements of Jilco Industries, Inc. are included in Item 8: Balance sheets -- Years ended July 31, 1993 and 1992. Statements of operations -- Years ended July 31, 1993, 1992, and 1991. Statements of cash flows -- Years ended July 31, 1993, 1992, and 1991. Notes to financial statements -- July 31, 1993. - 6 - JILCO INDUSTRIES, INC. BALANCE SHEETS AS OF JULY 31, (UNAUDITED) ASSETS The accompanying notes are an integral part of these financial statements. - 7 - JILCO INDUSTRIES, INC. STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT FOR THE YEARS ENDED JULY 31, (UNAUDITED) The accompanying notes are an integral part of these financial statements. - 8 - JILCO INDUSTRIES, INC. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED JULY 31, The accompanying notes are an integral part of these financial statements. - 9 - NOTE 1 - THE COMPANY The Company has been inactive since April 2, 1968 when it was discharged from bankruptcy under its previous name of Sportways, Inc. The expenses the Company has incurred represent those necessary to keep the Company in good standing in its state of residence. Fair Value of Financial Instruments The Company measures its financial assets and liabilities in accordance with generally accepted accounting principles. For certain of the Company's financial instruments, including cash, accounts payable, and accrued expenses, the carrying amounts approximate fair value due to their short maturities. The amounts shown as notes payable also approximate fair value because current interest rates offered to the Company for notes payable of similar maturities are substantially the same. Estimates In preparing financial statements in conformity with generally accepted accounting principles, management makes estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, as well as the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. NOTE 2 - LOSS PER SHARE All per share computations are based on 449,991 shares outstanding. There are no common stock equivalents. - 10 - NOTE 3 - NOTES PAYABLE TO SHAREHOLDER Notes payable to shareholder consist of the following: (A) Accrued interest at 9% per annum. Principal and accrued interest due on demand. (B) Accrued interest at 11% per annum. Principal and accrued interest due on demand. (C) Accrued interest at 10% per annum. Principal and accrued interest due on demand. - 11 - EXHIBIT INDEX - 12 -

18568_1993.txt

18568_1993

1993

18568

ITEM 1 - -BUSINESS Compass Bancshares, Inc. (the "Company") is a financial institutions holding company with its principal place of business in Birmingham, Alabama. The Company was organized in 1970 and commenced business in late 1971 upon the acquisition of Central Bank & Trust Co. and State National Bank. The Company subsequently acquired substantially all of the outstanding stock of additional banks located in Alabama, 11 of which were merged in late 1981 to create Central Bank of the South, Alabama's first statewide bank. In February, 1987, the Company acquired First National Bank of Crosby near Houston, Texas, and became the first out-of-state holding company to acquire a bank in Texas. Since that time the Company has acquired 19 banks in the Houston and Dallas areas. In November, 1993, the Company changed its name from Central Bancshares of the South, Inc. to Compass Bancshares, Inc. and Central Bank of the South, the Company's lead bank subsidiary, changed its name to Compass Bank ("Compass Bank"). In addition to Compass Bank, the Company also owns Compass Bank, N.A., a national bank headquartered in Pensacola, Florida, Compass Bank, a federal savings bank headquartered in Jacksonville, Florida ("Compass Bank-Florida"), Central Bank of the South, an Alabama banking corporation headquartered in Anniston, Alabama, and Compass Banks of Texas, Inc., a Delaware bank holding company ("Compass of Texas"), which owns Compass Bank-Houston in Houston, Texas, and Compass Bank-Dallas in Dallas, Texas. The bank subsidiaries of the Company and Compass of Texas are referred to collectively herein as the "Subsidiary Banks". Compass of Texas also owns River Oaks Trust Company with offices in Houston and Dallas, Texas. The principal role of the Company is to supervise and coordinate the activities of its subsidiaries and to provide them with capital and services of various kinds. The Company derives substantially all of its income from dividends from its subsidiaries. Such dividends are determined on an individual basis, generally in relation to each subsidiary's earnings and capital position. SUBSIDIARY BANKS Compass Bank conducts a general commercial banking and trust business at 89 locations, in 48 communities in Alabama. Compass Bank-Houston conducts a general commercial banking business from 13 locations in Houston, Texas and Compass Bank-Dallas conducts a general commercial banking business from 22 banking offices in Dallas and Collin Counties, Texas. River Oaks Trust Company offers a full range of trust services to customers in Texas through its offices in Houston and Dallas. Compass Bank, N.A. conducts a general commercial banking business with five branches in Pensacola and Gulf Breeze, Florida. Compass Bank-Florida conducts business from 16 locations in Jacksonville, Florida and 7 locations in Ft. Walton Beach, Florida. Central Bank of the South primarily provides cash management services to commercial customers of the Subsidiary Banks. The Subsidiary Banks perform banking services customary for full service banks of similar size and character for their customers in Alabama and north Florida and the two largest metropolitan markets in Texas. Such services include receiving demand and time deposit accounts, making personal and commercial loans and furnishing personal and commercial checking accounts. The Trust Division of Compass Bank and River Oaks Trust Company offer customers in Alabama, Texas, North Carolina, Georgia and Florida a variety of fiduciary services, including the administration and investment of funds of estates, trusts and employee benefit plans. Other trust services include custodial and portfolio management services, and acting as fiscal and paying agent and trustee under corporate and government trust indentures. Through Compass Bancshares Insurance, Inc., a wholly-owned subsidiary of Compass Bank, the Subsidiary Banks make available to their customers and others, as agent for a variety of insurance companies, term life insurance, fixed-rate annuities and other insurance products. The Subsidiary Banks provide correspondent banking services including loan participations, investment services, and audit services to approximately 1,025 financial institutions located throughout the Southeast and Southwest. Through the Correspondent and Investment Services Division of Compass Bank, the Subsidiary Banks distribute or make available a variety of investment services and products to institutional and individual investors including sales of municipal bonds, U.S. Government securities and asset/liability services. Through Compass Brokerage, Inc., a wholly-owned subsidiary of Compass Bank, the Subsidiary Banks also provide discount brokerage services and variable-rate annuities to individuals and businesses. Through Compass Bank's wholly-owned subsidiary, Compass Financial Corporation, the Subsidiary Banks provide lease financing services to individuals and businesses. Compass Mortgage Corporation, a subsidiary of Compass Bank, was organized in 1992 as a full-service mortgage corporation and currently originates residential mortgage loans in Alabama, Texas and Florida. NON-BANKING ACTIVITIES Through wholly-owned subsidiaries, the Company is engaged in providing credit-related insurance products to customers of the Subsidiary Banks and owning real estate for bank premises. Revenues from operation of these subsidiaries do not presently constitute a significant portion of the Company's total operating revenues. The Company may subsequently engage in other activities permissible for registered bank holding companies when suitable opportunities develop. Any proposal for such further activities is subject to approval by appropriate regulatory authorities. (See "Supervision and Regulation".) ACQUISITIONS The Company may seek to acquire other banks and banking offices when suitable opportunities develop. Discussions are held from time to time with institutions primarily in Texas, Florida and Alabama about their possible affiliation with the Company. It is impossible to predict accurately whether any discussions will lead to agreement. Any bid or proposal for the acquisition of additional banks is subject to approval by appropriate regulatory authorities. (See "Supervision and Regulation".) From 1991 to 1994, the Company acquired 15 financial institutions in Texas and Florida. Acquisitions have been made on a competitive bid basis from the Federal Deposit Insurance Corporation ("FDIC") and the Resolution Trust Corporation ("RTC") and as the result of negotiations with boards of directors and shareholders of the institutions. A list of the acquisitions completed from 1991 to 1994 with their asset size and closing dates follows (in thousands): PENDING ACQUISITIONS On November 19, 1993, the Company entered into a definitive agreement to acquire Security Bank, N.A. ("Security") of Houston, Texas for Company common stock having a market value of $11,250,000, subject to certain conditions. At December 31, 1993, Security had assets of $82 million and equity of $6 million. The transaction is expected to close in the second quarter of 1994 and will be accounted for under the pooling-of-interests method of accounting. On November 12, 1993, the Company entered into a definitive agreement to acquire three branches of Anchor Savings Bank located in Jacksonville, Florida. At December 31, 1993, these branches had total deposits of approximately $35 million. COMPETITION The Subsidiary Banks encounter intense competition in their businesses, generally from other banks located in Alabama, Texas, Florida and adjoining states and compete for interest bearing funds with other banks, mutual funds and with many issuers of commercial paper and other securities which are not banks. Competition also exists for the correspondent banking and securities sales business, which is particularly important to Compass Bank, from commercial and investment banks and brokerage firms. In the case of larger customers, competition exists with financial institutions in Texas and other major metropolitan areas in the United States, many of which are larger in terms of capital, resources and personnel. Increasingly, in the conduct of certain aspects of their businesses, the Subsidiary Banks compete with finance companies, savings and loan associations, credit unions, mutual funds, factors, insurance companies and similar financial institutions. There is significant competition among bank holding companies in most of the markets served by the Subsidiary Banks. At December 31, 1993, the five largest bank holding companies in Alabama (including the Company) accounted for approximately 68 percent of the state's total bank deposits. The Company believes that intense competition for banking business among bank holding companies in Alabama, Texas, and Florida will continue and that during 1994 the competition may further intensify if additional regional bank holding companies enter such states through the acquisition of local bank holding companies or savings and loan institutions and with continued consolidation of savings and loan institutions with and into bank holding companies. Competition among bank holding companies is also significant in Texas where the Company's Texas Subsidiary Banks are located in major metropolitan markets having populations of 3.9 million and 3.7 million people. The Texas Subsidiary Banks are small in terms of assets and deposits in comparison with the super-regional banks they compete with in Houston and Dallas. Likewise, in Jacksonville and Fort Walton Beach, Florida, Compass Bank-Florida encounters intense competition from other financial institutions that are substantially larger in terms of assets and deposits. EMPLOYEES At February 28, 1994, the Company and its subsidiaries had approximately 3,900 employees. The Company and its subsidiaries provide a variety of benefit programs including group life, health, accident, and other insurance, retirement and stock ownership plans. The Company also maintains training, educational and affirmative action programs designed to equip employees for positions of increasing responsibility in both management and operating positions. GOVERNMENT MONETARY POLICY The Company and the Subsidiary Banks are affected by the credit policies of monetary authorities, including the Board of Governors of the Federal Reserve System. An important function of the Federal Reserve System is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are: open market operations in U.S. Government securities, changes in the discount rate, reserve requirements on member bank deposits and funds availability regulations. These instruments are used in varying combinations to influence the overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans or paid on deposits. The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of financial institutions in the past and will continue to do so in the future. In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to the future impact that changes in interest rates, deposit levels or loan demand may have on the business and income of the Company and the Subsidiary Banks. SUPERVISION AND REGULATION THE COMPANY The Company and Compass of Texas are multi-bank holding companies within the meaning of the BHC Act and are registered as such with the Federal Reserve. As bank holding companies, the Company and Compass of Texas are required to file with the Federal Reserve an annual report and such additional information as the Federal Reserve may require pursuant to the Bank Holding Company Act ("BHC Act"). The Federal Reserve may also make examinations of the Company and each of its subsidiaries. Under the BHC Act, bank holding companies are prohibited, with certain exceptions, from acquiring direct or indirect ownership or control of more than five percent of the voting shares of any company engaging in activities other than banking or managing or controlling banks or furnishing services to or performing services for their banking subsidiaries. However, the BHC Act authorizes the Federal Reserve to permit bank holding companies to engage in, and to acquire or retain shares of companies that engage in, activities which the Federal Reserve determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The BHC Act requires a bank holding company to obtain the prior approval of the Federal Reserve before it may acquire substantially all of the assets of any bank or ownership or control of any voting shares of any bank if, after such acquisition, it would own or control, directly or indirectly, more than five percent of the voting shares of any such bank. The BHC Act prohibits the Federal Reserve from approving an application by a registered bank holding company to acquire shares of a bank located outside of the state in which the operations of the applicant's banking subsidiaries are principally conducted unless such acquisition is specifically authorized by the laws of the state in which the bank to be acquired is located or the acquisition involves a closed or failed bank, which also requires special regulatory approval. The States of Alabama, Florida, and Texas, where the Company currently operates banking subsidiaries, each have laws relating specifically to acquisitions of banks, bank holding companies, and other types of financial institutions in those states by financial institutions that are based in, and not based in, those states. In 1986, the State of Alabama enacted a regional reciprocal banking act. In general, the Alabama statute permits Alabama banks and bank holding companies to be acquired by regional bank holding companies and effectively permits Alabama banks and bank holding companies to acquire banks located in 14 other designated jurisdictions including Texas and Florida if such jurisdictions have adopted reciprocal statutes. Texas law currently permits out-of-state bank holding companies to acquire banks in Texas regardless of where the acquiror is based, subject to the satisfaction of various conditions such as agreements with respect to compliance with state law and evidence as to certain financial matters. Florida's regional reciprocal banking act, enacted in 1984, permits acquisitions of banks and bank holding companies in Florida by financial institutions based in 13 designated jurisdictions other than Florida including Alabama, but not Texas. As a result of acquisitions in Texas which had the effect of increasing its consolidated deposits outside of Florida's region, the Company does not meet the definition of a regional bank holding company under Florida law. Therefore, in order to complete certain acquisitions in Florida, the Company established a Florida subsidiary federal savings bank into which the Company merged the banks which it had agreed to acquire. Unless there is additional growth by the Company within Florida's region or a change in governing statutes at the state or federal level, the Company anticipates that any Florida banks or other financial institutions that are acquired by it in the future will be acquired as part of the Company's federal savings bank in Florida. Because the laws of the states designated in Alabama's and Florida's regional reciprocal banking statutes are not uniform, there is an absence of complete symmetry with respect to the permissibility of interstate expansion in Alabama, Florida, Texas and other states in which the Company may in the future seek to undertake acquisitions. Unless and until federal or state legislation is enacted which permits nationwide interstate acquisitions of banks, bank holding companies, and other types of financial institutions, the Company may encounter various restrictions and limitations with respect to acquisitions outside of the States of Alabama and Texas by virtue of state laws relating to interstate expansion. The Federal Reserve Act generally imposes certain limitations on extensions of credit and other transactions by and between banks which are members of the Federal Reserve System and other affiliates (which includes any holding company of which such bank is a subsidiary and any other non-bank subsidiary of such holding company). Banks which are not members of the Federal Reserve System are also subject to these limitations. Further, federal law prohibits a bank holding company and its subsidiaries from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property, or the furnishing of services. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") enacted major regulatory reforms, stronger capital standards for savings associations and stronger civil and criminal enforcement provisions. FIRREA allows the acquisition of healthy and failed savings associations by bank holding companies and imposes no interstate barriers on such bank holding company acquisitions. With certain qualifications, FIRREA also allows bank holding companies to merge acquired savings and loans into their existing commercial bank subsidiaries. FIRREA also provides that a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989, in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. In December, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted. This act recapitalized the Bank Insurance Fund ("BIF") and the Savings Association Insurance Fund ("SAIF"), of which the Subsidiary Banks are members, substantially revised statutory provisions, including capital standards, restricted certain powers of state banks, gave regulators the authority to limit officer and director compensation and required holding companies to guarantee the capital compliance of their banks in certain instances. Among other things, FDICIA requires the federal banking agencies to take "prompt corrective action" with respect to banks that do not meet minimum capital requirements. FDICIA established five capital tiers: "well capitalized", "adequately capitalized", "undercapitalized", "significantly undercapitalized" and "critically undercapitalized", as defined by regulations adopted by the Federal Reserve, the FDIC and the other federal depository institution regulatory agencies. A depository institution is well capitalized if it significantly exceeds the minimum level required by regulation for each relevant capital measure, adequately capitalized if it meets such measure, undercapitalized if it fails to meet any such measure, significantly undercapitalized if it is significantly below such measure and critically undercapitalized if it fails to meet any critical capital level set forth in the regulations. The critical capital level must be a level of tangible equity capital equal to not less than 2 percent of total tangible assets and not more than 65 percent of the minimum leverage ratio to be prescribed by regulation (except to the extent that 2 percent would be higher than such 65 percent level). An 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. If a depository institution fails to meet regulatory capital requirements, the regulatory agencies can require submission and funding of a capital restoration plan by the institution, place limits on its activities, require the raising of additional capital and, ultimately, require the appointment of a conservator or receiver for the institution. The obligation of a controlling bank holding company under FDICIA to fund a capital restoration plan is limited to the lesser of 5 percent of an undercapitalized subsidiary's assets or the amount required to meet regulatory capital requirements. If the controlling bank holding company fails to fulfill its obligations under FDICIA and files (or has filed against it) a petition under the Federal Bankruptcy Code, the FDIC's claim may be entitled to a priority in such bankruptcy proceeding over third party creditors of the bank holding company. An insured depository institution may not pay management fees to any person having control of the institution nor may an institution, except under certain circumstances and with prior regulatory approval, make any capital distribution (including the payment of dividends) if, after making such payment or distribution, the institution would be undercapitalized. FDICIA also restricts the acceptance of brokered deposits by insured depository institutions and contains a number of consumer banking provisions, including disclosure requirements and substantive contractual limitations with respect to deposit accounts. At December 31, 1993, the Subsidiary Banks were "well capitalized", and were not subject to any of the foregoing restrictions, including, without limitation, those relating to brokered deposits. The Subsidiary Banks do not rely upon brokered deposits as a primary source of deposit funding, although such deposits are sold through the Correspondent and Investment Services Division of Compass Bank. FDICIA contains numerous other provisions, including new reporting requirements, termination of the "too big to fail" doctrine except in special cases, limitations on the FDIC's payment of deposits at foreign branches and revised regulatory standards for, among other things, real estate lending and capital adequacy. In addition, FDICIA requires the FDIC to establish a system of risk-based assessments for federal deposit insurance, by which banks that pose a greater risk of loss to the FDIC (based on their capital levels and the FDIC's level of supervisory concern) will pay a higher insurance assessment. THE SUBSIDIARY BANKS In general, federal and state banking laws and regulations govern all areas of the operations of the Subsidiary Banks, including reserves, loans, mortgages, capital, issuances of securities, payment of dividends and establishment of branches. Federal and state banking regulatory agencies also have the general authority to limit the dividends paid by insured banks and bank holding companies if such payments may be deemed to constitute an unsafe and unsound practice. Federal and state banking agencies also have authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices. Compass Bank, organized under the laws of the State of Alabama, is a member of the Federal Reserve System. As such, it is supervised, regulated and regularly examined by the Alabama State Banking Department and the Federal Reserve. Compass Bank, N.A. is a national banking association and Compass Bank- Florida is a federal savings bank which are subject to supervision, regulation and examination by the Office of the Comptroller of the Currency ("OCC") and the Office of Thrift Supervision ("OTS"), respectively. Compass Bank-Houston and Compass Bank-Dallas, both of which are organized under the laws of the State of Texas, are state banks that are not members of the Federal Reserve System. The Texas banks are supervised, regulated and regularly examined by the Department of Banking of the State of Texas and the FDIC. The Subsidiary Banks, as participants in the BIF and the SAIF of the FDIC, are subject to the provisions of the Federal Deposit Insurance Act and to examination by and regulations of the FDIC. (See "Supervision and Regulation--Implications of Being a Savings and Loan Holding Company".) Compass Bank is governed by Alabama laws restricting the declaration and payment of dividends to 90 percent of annual net income until its surplus funds equal at least 20 percent of capital stock. Compass Bank has surplus in excess of this amount. Compass Bank-Houston and Compass Bank-Dallas, governed by the laws of the State of Texas, are, under certain circumstances, restricted in the declaration and payment of dividends to the extent that before declaring any dividends, each of these banks must transfer to its "certified surplus" accounts an amount not less than 10 percent of the net profits of such bank earned since the last dividend was declared, except that there is no requirement for a transfer to certified surplus of a sum which would increase the certified surplus to more than the capital stock of the respective bank. In addition, Compass Bank-Houston has entered into an agreement with the Commissioner of the Department of Banking of the State of Texas that it will not declare dividends in excess of 50 percent of its current earnings. The approval of the OCC is required if the total of all dividends declared by Compass Bank, N.A. in any calendar year exceeds the total of the net profits for that year, plus its retained net profits for the preceding two years, less any required transfers to surplus. As a member of the Federal Reserve System, Compass Bank is also subject to dividend limitations imposed by the Federal Reserve that are similar to those applicable to national banks. (See "Supervision and Regulation--Implications of Being a Savings and Loan Holding Company".) Federal law further provides that no insured depository institution may make any capital distribution, including a cash dividend, if, after making the distribution, the institution would not satisfy one or more of its minimum capital requirements. Moreover, the federal bank regulatory agencies also have the general authority to limit the dividends paid by insured banks if such payments may be deemed to constitute an unsafe and unsound practice. Insured banks are prohibited from paying dividends on its capital stock while in default in the payment of any assessment due to the FDIC except in those cases where the amount of the assessment is in dispute and the insured bank has deposited satisfactory security for the payment thereof. The Community Reinvestment Act of 1977 ("CRA") and the regulations of the OCC, the Federal Reserve and the FDIC implementing that act are intended to encourage regulated financial institutions to help meet the credit needs of their local community or communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of such financial institutions. The CRA and such regulations provide that the appropriate regulatory authority will assess the records of regulated financial institutions in satisfying their continuing and affirmative obligations to help meet the credit needs of their local communities as part of their regulatory examination of the institution. The results of such examinations are made public and are taken into account upon the filing of any application to establish a domestic branch or to merge or to acquire the assets or assume the liabilities of a bank. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction. The bank regulatory agencies have announced a proposal to revise the regulations implementing the CRA. The proposal contemplates extensive changes to the existing procedures for determining compliance with the CRA and the full effect of the proposed regulations cannot be determined at this time. IMPLICATIONS OF BEING A SAVINGS AND LOAN HOLDING COMPANY As a result of the Company's ownership of a federal savings bank headquartered in Florida, the Company is a savings and loan holding company under Section 10 of the Home Owners' Loan Act, as amended ("HOLA"). Accordingly, the Company has registered with the OTS and is subject to OTS regulations, supervision and reporting requirements. With certain exceptions, a savings and loan holding company must obtain the prior written approval of the OTS before acquiring control of an insured savings association or savings and loan holding company through the acquisition of stock or through a merger or some other business combination. HOLA prohibits the OTS from approving an acquisition by a savings and loan holding company which would result in the holding company controlling savings associations in more than one state unless (i) the holding company is authorized to do so by the FDIC as an emergency acquisition, (ii) the holding company controls a savings association which operated an office in the additional state or states on March 5, 1987, or (iii) the statutes of the state in which the savings association to be acquired is located specifically permit a savings association chartered by such state to be acquired by an out-of-state savings association or savings and loan holding company. As a subsidiary of a savings and loan holding company, Compass Bank-Florida is subject to certain restrictions in its dealings with the Company and with other companies affiliated with the Company. In addition, savings association subsidiaries of savings and loan holding companies are required to give the OTS thirty days' prior notice of any proposed payment of dividends to the savings and loan holding company. Compass Bank-Florida is subject to the capital adequacy guidelines of the OTS. In general, a federal savings bank is required to satisfy three capital requirements: (i) a leverage ratio, (ii) a Tier 1 (core) risk-based capital ratio, and (iii) a total qualifying capital ratio. To be adequately capitalized under the fully phased-in capital requirements for January 1, 1995, an institution must meet or exceed (i) a leverage ratio of 4 percent, or a leverage ratio of 3 percent if the institution received the top rating in its most recent examination, (ii) a Tier 1 (core) risk-based capital ratio of 4 percent, and (iii) a total qualifying capital ratio of 8 percent. In general, a savings and loan holding company that has a federal savings bank subsidiary that fails to meet the "qualified thrift lender" test is required to become a bank holding company. In addition, if a federal savings bank does not satisfy the "qualified thrift lender" test, then such federal savings bank must either convert to a bank or it (i) will be limited to establishing new branches as if it were a national bank located in the same state, (ii) will be barred from obtaining new Federal Home Loan Bank ("FHLB") advances, (iii) will be prohibited from making any new investment or engaging in any new activity unless the investment or activity is permitted for a national bank, and (iv) will be subject to the dividend restrictions applicable to national banks. Moreover, three years after it has failed to qualify as a "qualified thrift lender", a federal savings bank must (i) divest any investments and activities not permitted for a national bank and (ii) repay any of its outstanding Federal Home Loan Bank advances "as promptly as can prudently be done" consistent with its safe and sound operation and must divest any investment and cease any activity not permitted for a national bank. Should a federal savings bank subsidiary of the Company fail the "qualified thrift lender" test, that institution might be required to convert to a bank and the Company's ability to retain it would be subject to question in light of Florida law which does not now authorize the Company to acquire a bank in that state. To be a "qualified thrift lender" a federal savings bank must maintain "qualified thrift investments" of at least 65 percent of its "portfolio assets" as measured on a monthly average basis in nine out of the last twelve months. The assets that qualify as "qualified thrift investments" include assets generally related to the development of domestic residential (and other) real property. "Portfolio assets" is defined as a federal savings bank's total assets, minus (i) goodwill and other intangible assets, (ii) the value of property used by the savings associations to conduct its business, and (iii) subject to a maximum of 20 percent of total assets, liquid assets required to be maintained under Section 6 of HOLA. OTHER Other legislative and regulatory proposals regarding changes in banking, and the regulation of banks, thrifts and other financial institutions, are being considered by the executive branch of the Federal government, Congress and various state governments, including Alabama, Texas and Florida. Certain of these proposals, if adopted, could significantly change the regulation of banks and the financial services industry. It cannot be predicted accurately whether any of these proposals will be adopted or, if adopted, how these proposals will affect the Company or the Subsidiary Banks. The Correspondent and Investment Services Division of Compass Bank is treated as a municipal securities dealer and a government securities dealer for purposes of the federal securities laws, and, therefore, is subject to certain reporting requirements and/or regulatory controls by the Securities and Exchange Commission (the "Commission"), the United States Department of the Treasury and the Federal Reserve. Compass Brokerage, Inc. is a discount brokerage service registered with the Commission and the National Association of Securities Dealers, Inc. and is subject to certain reporting requirements and regulatory control by these agencies. Compass Bancshares Insurance, Inc. is a licensed insurance agent or broker for various insurance companies and is subject to reporting and licensing regulations of the Alabama Insurance Commission. References to applicable statutes under the heading "Supervision and Regulation" are brief summaries of portions thereof, do not purport to be complete and are qualified in their entirety by reference to such statutes. ITEM 1 - -STATISTICAL DISCLOSURE ITEM 2 ITEM 2 - -PROPERTIES The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The principal executive offices of the Company are located at 15 South 20th Street, Birmingham, Alabama, in a 317,000 square-foot office building. During 1990, the Company entered into an agreement with the University of Alabama at Birmingham Medical and Educational Foundation ("UAB") and Daniel Properties III Limited Partnership which, during 1991, resulted in UAB acquiring the Company's former headquarters building and the Company acquiring its current headquarters building. The Company occupied its current headquarters in August, 1993, while maintaining a full service bank facility at its former headquarters site. The Subsidiary Banks own or lease various other offices and facilities in Alabama, Florida and Texas, with remaining lease terms of 1 to 20 years, exclusive of renewal options. In addition, the Company owns a 300,000 square- foot administrative headquarters facility completed in early 1988 and the River Oaks Bank Building in Houston, Texas, a 14-story, 168,000 square-foot office building. The River Oaks Bank Building is 34 percent occupied by Compass Bank- Houston and River Oaks Trust Company. The remaining space is leased to multiple tenants. See "Summary of Significant Accounting Policies" and "Notes to Consolidated Financial Statements" for information with respect to the amounts at which bank premises, equipment and other real estate are carried and information relating to commitments under long-term leases. ITEM 3 ITEM 3 - -LEGAL PROCEEDINGS Neither the Company nor any of its subsidiaries is presently involved in any material legal proceedings other than ordinary routine litigation incidental to its business. ITEM 4 ITEM 4 - -SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On October 19, 1993, the shareholders of the Company approved the change in the name of the Company from Central Bancshares of the South, Inc. to Compass Bancshares, Inc. With respect to the vote, 26,252,104 shares of the Company's common stock were voted in favor of the name change, 150,958 shares were voted against the change, and 224,482 shares abstained. PART II ITEM 5 ITEM 5 - -MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The following table sets forth the high and low closing prices of the common stock of the Company in the national over-the-counter market and the dividends paid thereon during the periods indicated. The prices shown do not reflect retail mark-ups, mark-downs, or commissions. All share prices have been rounded to the nearest 1/8 of one dollar and all share prices and dividends per share prior to the third quarter of 1992 have been restated to take into account the 3-for-2 stock split with respect to the Company's common stock, which was effected by a stock dividend paid on July 2, 1992. As of February 28, 1994, there were 5,901 shareholders of record of common stock of which 5,010 were residents of either Alabama, Texas or Florida. ITEM 6 ITEM 6 - -SELECTED FINANCIAL DATA The following table sets forth selected financial data for the last five years. All per share information for periods prior to July, 1992, has been restated to reflect the 3-for-2 stock split with respect to the Company's common stock, which was effected by a stock dividend paid on July 2, 1992. ITEM 7 ITEM 7 - -MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The purpose of this discussion is to focus on significant changes in the financial condition and results of operations of the Company and its subsidiaries during the past three years. The discussion and analysis is intended to supplement and highlight information contained in the accompanying consolidated financial statements and the selected financial data presented elsewhere in this report. Prior year information has been restated to reflect 1993 and 1992 acquisitions accounted for using the pooling-of-interests accounting method and prior period per share data has been restated to reflect a 3-for-2 stock split effected through the issuance of a 50 percent stock dividend paid in July, 1992. Financial institutions acquired by the Company during the past three years and accounted for as purchases are reflected in the financial position and results of operations of the Company since the date of their acquisition. SUMMARY Net income for 1993 was $89 million, an 18 percent increase over the Company's previous high of $75 million in 1992. Net income for 1992 was 20 percent higher than 1991 net income of $63 million. The increases in net income per common share for 1993 and 1992 were 19 percent and 16 percent, respectively. Net income per common share increased 14 percent during 1991. Pretax income for 1993 was up $24 million or 21 percent over 1992; however, income tax expense increased $10 million or 26 percent over the same period due to an increase in the Company's income subject to taxation and an increase in the effective tax rate in 1993 from 34 percent to 35 percent. One significant factor in the growth of the Company has been the Company's acquisitions in Texas, specifically the Houston and Dallas areas, since late 1987. The Texas expansion continued throughout 1993 and is expected to continue in 1994. Management expects the asset size of the Texas operations to continue to increase from the December 31, 1993 level of $1.9 billion. In addition, the Company has been able to expand its operations in north Florida and will seek to continue to increase its presence in that market in 1994. For additional information, see "Acquisitions" and "Pending Acquisitions" in Part I of this report and the accompanying "Notes to the Consolidated Financial Statements," Note 10, Mergers and Acquisitions. EARNING ASSETS Average earning assets in 1993 increased five percent over 1992 due to increases in both average loans and trading account securities. The average earning asset mix continued to change during 1993 with loans at 74 percent, investment securities and investment securities available for sale at 22 percent and other earning assets at 4 percent of the total. In 1992, loans were 68 percent, investment securities and investment securities available for sale 29 percent and other earning assets 3 percent. The mix of earning assets during 1993 and 1992 contributed to the higher net interest income. The mix of earning assets is monitored on a continuous basis in order to react to favorable interest rate movements and to maximize return on earning assets. Average loans increased 14 percent in 1993 with much of the increase concentrated in residential mortgage loans, commercial loans and consumer installment loans. Total loans outstanding at year-end increased 11 percent over previous year-end levels. The growth in the portfolio resulted from the Company's ongoing efforts to increase the loan portfolio through the origination of loans. Real estate construction loans increased 7 percent, residential mortgage loans increased 30 percent, commercial mortgage loans increased 1 percent and consumer installment loans decreased 1 percent from year-end 1992 to year-end 1993. Commercial, financial and agricultural loans, which were 22 percent of total loans in 1993, increased 7 percent compared to the previous year. Residential real estate lending increased due to a rise in demand for such loans, particularly due to the Company's introduction of variable rate residential mortgage loans with low introductory rates in the fourth quarter of 1992. Residential mortgage loans as a percentage of total loans increased from 32 percent at year-end 1992 to 37 percent at year-end 1993. The 17 percent increase in the Company's loan portfolio from 1991 to 1992 occurred primarily in residential mortgage loans which increased 44 percent. The Company's loan portfolio continues to reflect the diversity of the markets served by the Subsidiary Banks. The condition of the economy in states in which the Subsidiary Banks lend money is further reflected in the loan portfolio mix. There has been a decline in the volume of commercial, financial and agricultural loans and real estate construction loans, as a percentage of total loans outstanding, for the past five years. This shift is reflective of the general state of the economy in the markets served, specifically, the softening of the demand for commercial real estate loans in those markets. With fewer attractive lending opportunities in the commercial lending arena, other lending opportunities were sought and brought about the increases in the other categories within the portfolio. Specifically, the Company experienced an eight percent increase in its indirect auto loan portfolio from 1992 to 1993. At December 31, 1993, the Company's indirect loan portfolio, consisting primarily of indirect automobile loans, represented 15 percent of total loans outstanding. The Company has not invested in loans that would be considered highly leveraged transactions ("HLT") as defined by the Federal Reserve Board and other regulatory agencies. The Company also had no significant foreign loans or loans to lesser developed countries as of December 31, 1993. The Loan Portfolio table shows the classifications of loans by major category at December 31, 1993, and for each of the preceding four years. The second table shows maturities of certain loan classifications at December 31, 1993, and an analysis of the rate structure for such loans due in over one year. LOAN PORTFOLIO SELECTED LOAN MATURITY AND INTEREST RATE SENSITIVITY On December 31, 1993, the Company adopted Financial Accounting Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities ("FAS115") which requires that a company's debt and equity securities be classified based on management's intent to hold the securities into one of three categories: (i) trading account securities, (ii) held-to-maturity securities, or (iii) securities available for sale. Securities held in a trading account are required to be reported at fair value, with unrealized gains and losses included in earnings. Securities designated to be held to maturity are reported at amortized cost. Securities classified as available for sale are required to be reported at fair value with unrealized gains and losses, net of taxes, excluded from earnings and shown separately as a component of shareholder's equity. Previously, the Company's accounting policies regarding trading account securities and held-to-maturity securities were the same as those prescribed by FAS115. During all periods up to the date of adoption, the Company reported securities available for sale at the lower- of-cost-or-market with any valuation adjustment reflected in earnings as required by generally accepted accounting principles at that time. FAS115 is effective for fiscal years beginning after December 15, 1993 with earlier adoption at December 31, 1993 permitted. The Company elected to adopt FAS115 prior to its effective date. At December 31, 1993, net unrealized gains in the Company's available-for-sale portfolio totaled $10.4 million. Under the requirements of FAS115, the tax-effected unrealized gain of $6.5 million has been reflected as additional shareholders' equity. The composition of the Company's total investment securities portfolio reflects the Company's investment strategy of maximizing portfolio yields commensurate with risk and liquidity considerations. The primary objectives of the Company's investment strategy are to maintain an appropriate level of liquidity and provide a tool to assist in controlling the Company's interest rate position while at the same time producing adequate levels of interest income. For securities classified as held-to-maturity, the Company has the ability, and it is management's intention, to hold such securities to maturity. Management of the maturity of the portfolio is necessary to provide liquidity and to control interest rate risk. Certain securities that may be sold prior to maturity are reflected as investment securities available for sale on the Company's balance sheet. During 1992, the Company transferred approximately $566 million of investment securities from its held-to-maturity portfolio to the available-for-sale classification. With the adoption of FAS115 on December 31, 1993, the Company transferred an additional $58 million of investment securities to its available-for-sale portfolio. The transfer primarily involved fixed-rate CMOs that could be required to be transferred to the available-for- sale portfolio by Federal regulators in the future if sufficiently reduced prepayment speeds are experienced on the underlying mortgages. During 1993 and 1992, gross sales of held-to-maturity securities were $40 million and $54 million, respectively, while maturities totaled $435 million and $695 million, respectively. Sales and maturities of securities available for sale totaled $57 million and $252 million, respectively, in 1993 while sales in 1992 were $5 million. Gains associated with the sales were immaterial, accounting for less than one percent of noninterest income. Gross unrealized gains in the Company's held-to-maturity portfolio amounted to $28 million at year-end 1993 and gross unrealized losses amounted to $1 million. In recent years, the trend of the Company has been to invest in taxable securities due to the lack of preferential treatment afforded tax-exempt securities under the tax laws. Because of their liquidity, credit quality and yield characteristics, the majority of the purchases of taxable securities have been in mortgage-backed obligations. Total average investment securities, including those available for sale, decreased 21 percent during 1993 after increasing 9 percent from 1991. Total investment securities, including those available for sale, at December 31, 1993, decreased 26 percent from year-end 1992. The following table contains the carrying amount of the investment securities portfolio at the end of each of the last three years. INVESTMENT SECURITIES AND INVESTMENT SECURITIES AVAILABLE FOR SALE The maturities and weighted average yields of the investment securities and investment securities available for sale at the end of 1993 are presented in the following table using primarily the average expected lives including the effects of prepayments. The amounts and yields disclosed for investment securities available for sale reflect the amortized cost rather than the net carrying value, i.e., market value, of these securities. While the average stated maturity of the mortgage-backed securities was 17.9 years, the weighted average expected life assumed in the table is 5.4 years. The weighted average expected life of investment securities at December 31, 1993, was 4.0 years with a weighted average yield of 8.74 percent. The weighted average expected life of investment securities available for sale was 5.5 years with a weighted average yield of 5.24 percent. Taxable equivalent adjustments, using a 35 percent tax rate, have been made in calculating yields on tax-exempt obligations. INVESTMENT SECURITIES AND INVESTMENT SECURITIES AVAILABLE FOR SALE MATURITY SCHEDULE Securities carried in the trading account, while interest bearing, are held primarily for sale. The volume of activity is directly related to general market conditions and reactions to the changing interest rate environment. The average balance in the trading account portfolio for 1993 increased by 74 percent following a 5 percent decrease in 1992. Average federal funds sold and securities purchased under agreements to resell increased 29 percent in 1993 from 1992 levels compared to a 40 percent decrease in 1992 from 1991. The average balance of interest bearing deposits in other banks decreased 13 percent during 1993 from 1992 levels after decreasing 42 percent from 1991 to 1992. There were no foreign time deposits as of December 31, 1993 or 1992. DEPOSITS AND SHORT-TERM BORROWINGS Changes in the Company's markets and the economy in general were also reflected in the liability mix during 1993. The portion of average interest bearing liabilities represented by interest bearing deposits, the primary source of funding for the Company, remained unchanged from 79 percent in 1992 and 1991. Year-end deposit balances increased four percent in 1993 and six percent in 1992. Falling interest rates during the three years ended December 31, 1993, had a greater impact on the composition of the deposit base than on the aggregate amount of deposits outstanding. As a result of falling rates, the Company was able to restructure the mix of deposits toward more consumer- oriented, lower-cost sources of funds. During 1993, the average balance of demand deposits and savings accounts increased by $292 million while the average balance of certificates of deposit and other time deposits declined by $41 million. The largest dollar increase in average interest bearing deposits was in demand deposits, rising $104 million or 20 percent from 1992. Average noninterest bearing demand deposits increased $112 million, or 11 percent, after increasing 21 percent during 1992 and 1991. The increase during 1993 was due primarily to internally generated growth with a portion of the increase due to the Company's Florida acquisitions while the increase in 1992 was due solely to internally generated growth. Savings deposits, interest bearing demand deposits, and noninterest bearing demand deposits accounted for 63 percent of total average deposits during 1993. For 1992, these lower cost deposits equaled 61 percent of all deposits. Total average time deposits, including certificates of deposit over $100,000, were approximately $2.0 billion in 1992 and 1993 with the large certificates of deposit representing 24 percent of the total during both periods. The maturities of certificates of deposit of $100,000 or more and other time deposits of $100,000 or more issued by the Company at December 31, 1993, are summarized in the following table: MATURITIES OF TIME DEPOSITS Borrowed funds consist of short-term borrowings, primarily in the form of federal funds purchased, securities sold under agreements to repurchase, other short-term borrowings, and FHLB and other borrowings. Average federal funds purchased declined 34 percent during 1993 and average securities sold under agreements to repurchase declined 11 percent. Average other short-term borrowings, which include parent company commercial paper and trading account short sales, increased 9 percent. The average balance of FHLB and other borrowings increased during 1993 due to additional borrowings of $75 million of subordinated debentures issued in the second quarter and $48 million in FHLB advances in the third quarter of the year. The Short-Term Borrowings table shows the distribution of the Company's short-term borrowed funds and the weighted average interest rates thereon at the end of each of the last three years. Also provided are the maximum outstanding amounts of borrowings, the average amounts of borrowings and the average interest rates at year-end for the last three years. SHORT-TERM BORROWINGS LIQUIDITY MANAGEMENT Liquidity is the ability of a bank to convert assets into cash or cash equivalents without significant loss and to raise additional funds by increasing liabilities. Liquidity management involves maintaining the Company's ability to meet the day-to-day cash flow requirements of the Subsidiary Banks' customers, whether they are depositors wishing to withdraw funds or borrowers requiring funds to meet their credit needs. Without proper liquidity management, the Subsidiary Banks would not be able to perform the primary function of a financial intermediary and would, therefore, not be able to meet the needs of the communities they serve. Asset and liability management functions not only to assure adequate liquidity in order for the Subsidiary Banks to meet the needs of their customers, but also to maintain an appropriate balance between interest- sensitive assets and interest-sensitive liabilities so that the Company can also meet the investment requirements of its shareholders. Daily monitoring of the sources and uses of funds is necessary to maintain an acceptable cash position that meets both requirements. In a banking environment, both assets and liabilities are considered sources of liquidity funding and both are, therefore, monitored on a daily basis. The asset portion of the balance sheet provides liquidity primarily through loan principal repayments, maturities of investment securities and, to a lesser extent, sales of investment securities available for sale and trading account securities. Installment loan payments are becoming an increasingly important source of liquidity for the Subsidiary Banks as this portfolio continues to grow. Real estate construction and commercial, financial and agricultural loans that mature in one year or less amounted to $955 million or 19 percent of the total loan portfolio at December 31, 1993. Investment securities and investment securities available for sale maturing in the same time frame totaled $221 million or 18 percent of the investment securities portfolio at year-end 1993. Other short-term investments such as federal funds sold, securities purchased under agreements to resell and maturing interest bearing deposits with other banks are additional sources of liquidity funding. The liability portion of the balance sheet provides liquidity through various customers' interest bearing and noninterest bearing deposit accounts. Federal funds purchased, securities sold under agreements to repurchase and other short-term borrowings are additional sources of liquidity and basically represent the Company's incremental borrowing capacity. These sources of liquidity are short-term in nature and are used as necessary to fund asset growth and meet short-term liquidity needs. As disclosed in the Company's Consolidated Statement of Cash Flows, net cash provided by operating activities decreased $142 million primarily due to the substantial increase in trading account securities of $133 million and the increase in mortgage loans held for sale of $16 million offset to some extent by the increase in net income. Net cash used in investing activities of $34 million consisted primarily of net loans originated of $389 million and held- to-maturity securities and available-for-sale securities purchased of $34 million and $285 million, respectively, funded in part by maturities and paydowns of investment securities held to maturity and investment securities available for sale of $435 million and $252 million, respectively. This overall decrease in the Company's investment securities portfolios was due to management's continued efforts to reinvest funds in higher-yielding loans rather than in investment securities. Net cash provided by financing activities provided the remainder of funding sources for 1993. The $10 million of net cash provided consisted primarily of a $61 million net increase in deposits, a net increase of $119 million in FHLB and other borrowings, and a $39 million increase in other short-term borrowings offset partially by a reduction of $155 million in federal funds purchased and securities sold under agreements to repurchase. The increase in FHLB and other borrowings in 1993 consisted of $75 million of subordinated debentures issued by the Company during the second quarter of the year along with additional FHLB advances of $48 million. Additional cash used in financing activities included the September, 1993 redemption of all of the Company's preferred stock for $26 million, the payment of common stock dividends of $28 million, and the payment of $2 million in preferred stock dividends. INTEREST RATE SENSITIVITY MANAGEMENT Interest rate sensitivity is a function of the repricing characteristics of the Company's portfolio of assets and liabilities. These repricing characteristics are the time frames within which the interest bearing assets and liabilities are subject to change in interest rates either at replacement, repricing or maturity during the life of the instruments. Interest rate sensitivity management focuses on the maturity structure of assets and liabilities and their repricing characteristics during periods of changes in market interest rates. Effective interest rate sensitivity management seeks to ensure that both assets and liabilities respond to changes in interest rates within an acceptable time frame, thereby minimizing the effect of interest rate movements on net interest income. Interest rate sensitivity is measured as the difference between the volumes of assets and liabilities in the Company's current portfolio that are subject to repricing at various time horizons: immediate, 1 to 3 months, 4 to 12 months, 1 to 5 years and over 5 years and non-rate sensitive. The differences are known as interest sensitivity gaps. The following table shows interest sensitivity gaps for these different intervals as of December 31, 1993 and 1992, including the effect of interest rate swaps, interest rate floors, futures and other hedging instruments. Mortgage loans and mortgage-backed securities are presented reflecting recent prepayment experience of the Company. INTEREST RATE SENSITIVITY ANALYSIS In the preceding interest rate sensitivity analysis tables, variable rate commercial loans totaling $670 million and $600 million at December 31, 1993, and 1992, respectively, have been reflected as repricing immediately even though these loans are protected from declines in the interest rate earned due to interest rate floors associated with such loans. As seen in the tables, for the first 365 days 65 percent of earning asset funding sources will reprice compared to 59 percent of all interest earning assets. Changes in the mix of earning assets or supporting liabilities can either increase or decrease the net interest margin without affecting interest rate sensitivity. In addition, the interest rate spread between an asset and its supporting liability can vary significantly while the timing of repricing for both the asset and the liability remains the same, thus impacting net interest income. This characteristic is referred to as basis risk and relates to the possibility that the repricing characteristics of short-term assets tied to the Company's prime lending rate are different from those of short-term funding sources such as certificates of deposit. Varying interest rate environments can create unexpected changes in prepayment levels of assets and repricing of liabilities which are not reflected in the interest sensitivity analysis report. These prepayments may have significant effects on the Company's net interest margin. Because of these factors an interest sensitivity gap report may not provide a complete assessment of the Company's exposure to changes in interest rates. Management utilizes computerized interest rate simulation analysis to determine the Company's interest rate sensitivity. The above table indicates that the Company is in a liability sensitive gap position at twelve months; however, due to the factors cited, current simulation results indicate only minimal sensitivity to parallel shifts in interest rates. Management also evaluates the condition of the economy, the pattern of market interest rates and other economic data to determine the appropriate mix and repricing characteristics of assets and liabilities required to produce an optimal net interest margin. In addition to the ongoing monitoring of interest-sensitive assets and liabilities, the Company enters into various interest rate contracts not held in the trading account ("interest rate protection contracts") to help manage the Company's interest sensitivity. Such contracts generally have a fixed notional principal amount and include (i) interest rate swaps where the Company typically receives or pays a fixed rate and a counterparty pays or receives a floating rate based on a specified index, (ii) interest rate caps and floors purchased or written where the Company receives or pays, respectively, interest if the specified index falls below the floor rate or rises above the cap rate, and (iii) interest rate futures where the Company agrees to deliver or receive securities or money market instruments at a designated future date and at a specified price or yield. The interest rate risk factor in these contracts is considered in the overall interest management strategy and the Company's interest risk management program. The income or expense associated with interest rate swaps, caps and floors and gains or losses in futures contracts classified as hedges are ultimately reflected as adjustments to interest income or expense. Changes in the estimated fair value of interest rate protection contracts are not reflected in the financial statements until realized. A discussion of interest rate risks, credit risks and concentrations in off- balance sheet financial instruments is included in Note 6 of the Notes to Consolidated Financial Statements. The following table details various information regarding interest rate protection contracts as of December 31, 1993: INTEREST RATE PROTECTION CONTRACTS - -------- + Basis swaps represent swaps in which the Company receives interest based on a variable interest rate index and pays interest based on a different variable rate index. * Weighted average rates received/paid are shown only for swaps, caps and floors for which net interest amounts were receivable or payable at December 31, 1993. For caps and floors, the rate shown represents the weighted average net interest differential between the index rate and the cap or floor rate. In addition to interest rate protection contracts used to help manage overall interest sensitivity, the Company also enters into interest rate contracts for the trading account. The primary purposes for using interest rate contracts in the trading account are to facilitate customer transactions and to help protect cash market positions in the trading account against interest rate movement. Changes in the estimated fair value of contracts in the trading account are recorded in other noninterest income as trading profits and commissions. Net interest amounts received or paid on interest rate contracts in the trading account are recorded as an adjustment of interest on trading account securities. The following table summarizes interest rate contracts held in the trading account at December 31, 1993: INTEREST RATE CONTRACTS--TRADING ACCOUNT - -------- * Weighted average rates received/paid are shown only for swaps, caps and floors for which net interest amounts were receivable or payable at December 31, 1993. For caps and floors, the rate shown represents the weighted average net interest differential between the index rate and the cap or floor rate. In addition to the interest rate contracts shown above, the Company also uses exchange-traded options and futures in the trading account. At December 31, 1993, the trading account contained exchange-traded options purchased and written, each having three month expiration dates, with notional principal balances of $1,254 million and $700 million, respectively, and estimated fair values of $288,000 and $(302,000), respectively. The notional principal amounts indicated are substantially larger than the related credit or interest rate risks. The net purchased position in exchange-traded options was taken at December 31, 1993, in order to help protect the market value of the trading account against rising short-term interest rates while maintaining limited risk to declining rates. At December 31, 1993, futures contracts having a notional principal of $161 million were also used to help reduce the interest sensitivity of the trading account. FAIR VALUE OF FINANCIAL INSTRUMENTS In December, 1991, the Financial Accounting Standards Board issued Financial Accounting Statement No. 107, Disclosures about Fair Value of Financial Instruments ("FAS107"). FAS107 requires the Company to disclose the fair value of substantially all financial instruments, both assets and liabilities, including those recognized and those not recognized in the Company's balance sheet. There has been no impact to the Company's financial statements as a result of the recognition, measurement or classification of financial instruments. See "Notes to Consolidated Financial Statements," Note 15, Fair Value of Financial Instruments for a discussion of the Company's accounting policies and methodologies. These disclosures should not be considered a surrogate of the liquidation value of the Company or its Subsidiary Banks, but rather represent a good-faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination, or issuance. It should also be noted that the Company has not valued any intangibles associated with the Company's core deposits as is allowed by the provisions of FAS107. CAPITAL RESOURCES Shareholders' equity at December 31, 1993, increased 8 percent from December 31, 1992, after increasing 13 percent in 1992. Net income after dividends accounted for 92 percent of the increase in shareholders' equity in 1993, excluding the reduction in total shareholders' equity due to the redemption of all of the Company's preferred stock, and for 90 percent of the increase in 1992. During 1991, the Company issued 261,000 shares of preferred stock in an acquisition and sold 1,350,000 shares of common stock to European investors in a private placement. These two transactions contributed $44 million to equity and accounted for 49 percent of the increase in shareholders' equity for 1991. During the third quarter of 1993, the Company redeemed all of the outstanding preferred stock. Dividends of $28 million were declared on the Company's common stock in 1993, which represented a 24 percent increase over 1992. The 1993 annual dividend rate per common share was $.76, a 14 percent increase over 1992. The dividend payout ratio for 1993 was 32 percent compared to 33 percent for 1992 and 34 percent for 1991. The Company intends to continue a dividend payout ratio that is competitive in the banking industry while maintaining an adequate level of retained earnings to support continued growth. During the fourth quarter of 1992, executive officers and other individuals exercised stock options for 665,000 shares of common stock. In connection with the exercise of options for 308,000 of the shares, the Company received as payment the proceeds of a loan made by the Company for approximately $3 million. These shares have been reflected as issued and outstanding in the Statements of Shareholders' Equity with an offsetting reduction of total shareholders' equity for the amount of the loan. Additionally, the Company realized tax benefits of $1.9 million from the exercise of nonqualified stock options during the fourth quarter of 1992 which are reflected as increases in surplus in the Statements of Shareholders' Equity. A strong capital position, which is vital to the continued profitability of the Company, also promotes depositor and investor confidence and provides a solid foundation for the future growth of the organization. The Company has satisfied its capital requirements principally through the retention of earnings. The Company's five-year compound growth rate in shareholders' equity of 12 percent was achieved primarily through reinvested earnings. Average shareholders' equity as a percentage of total average assets is one measure used to determine capital strength. The ratio of average shareholders' equity to average assets for 1993 was 7.57 percent compared to 7.09 percent in 1992 and 6.69 percent in 1991. In order to maintain this ratio at appropriate levels with continued growth in total average assets, a corresponding level of capital growth must be achieved. The table below summarizes these and other key ratios for the Company for each of the last three years. RETURN ON EQUITY AND ASSETS Two important indicators of capital adequacy in the banking industry are the leverage ratio and the tangible leverage ratio. The leverage ratio is defined as common shareholders' equity, minus goodwill and other intangibles disallowed by the Subsidiary Bank's regulators, divided by total quarterly average assets minus goodwill and other disallowed intangibles. The tangible leverage ratio is defined as common shareholders' equity, minus all intangibles, divided by total quarterly average assets minus all intangibles. Even though core deposit intangibles and goodwill increased from acquisitions during 1993, the leverage ratio remained well within regulatory guidelines: 7.31 percent at year-end 1993; 6.86 percent at year-end 1992; and 6.43 percent at year-end 1991. For the same periods, the tangible leverage ratio was 6.95 percent at year-end 1993; 6.55 percent at year-end 1992; and 6.01 percent at year-end 1991. The detail for the computation of these ratios is provided in the following table. Other disallowed intangibles represent intangible assets, other than goodwill, recorded after February 19, 1992, that are excluded from regulatory capital. Other intangibles recorded before that date continue to be included in regulatory capital under the "grandfather" provision of Federal Reserve regulations. The $6.5 million increase in shareholders' equity resulting from the Company's adoption of FAS115 on December 31, 1993, is not presently allowed to be included in the calculation of regulatory capital by the Federal regulators. LEVERAGE RATIO CALCULATIONS Risk-based capital guidelines were issued with graduated compliance beginning in 1990 with full compliance by year-end 1992. The guidelines take into consideration risk factors, as defined by regulators, associated with various categories of assets, both on and off the balance sheet. Under the guidelines, capital strength is measured in two tiers which are used in conjunction with risk-adjusted assets to determine the risk-based capital ratios. The Company's Tier I capital, which consists of common equity less goodwill and other disallowed intangibles, amounted to $528 million at December 31, 1993. Tier II capital components include supplemental capital components such as qualifying allowance for loan losses and qualifying subordinated debt. Tier I capital plus the Tier II capital components is referred to as Total Qualifying Capital and was $666 million at year-end 1993. The percentage ratios, as calculated under the guidelines, were 10.49 percent and 13.23 percent for Tier I and Total Qualifying Capital, respectively, at year-end 1993. The $75 million of subordinated debt issued by the Company in the second quarter of 1993 represented Tier II capital and favorably impacted the Company's Total Qualifying Capital. The regulatory capital ratios of the Company's Subsidiary Banks currently exceed the minimum ratios of 5 percent leverage capital, 6 percent Tier I capital, and 10 percent Total Qualifying Capital required in 1993 for "well capitalized" banks as defined by federal regulators. The Company continually monitors these ratios to assure that the Subsidiary Banks exceed the guidelines. RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income is the principal component of a financial institution's income stream and represents the difference or spread between interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds. Fluctuations in interest rates as well as volume and mix changes in earning assets and interest bearing liabilities can materially impact net interest income. The discussion of net interest income is presented on a taxable equivalent basis, unless otherwise noted, to facilitate performance comparisons among various taxable and tax-exempt assets. Net interest income for 1993 increased 3 percent over 1992 and 22 percent in 1992 over 1991. Increased volumes of earning assets and a historically high interest rate spread generated the 1992 increase while in 1993 net interest income grew at a slower rate due to a nine basis point decline in net yield on earning assets. The schedule on pages 28 and 29 provides the detail of changes in interest income, interest expense and net interest income due to changes in volumes and rates. Interest income decreased three percent in 1993 and one percent in 1992 after increasing eight percent in 1991. Interest income in 1993 declined from 1992 despite a 5 percent increase in the volume of average earning assets due to a 71 basis point decline in the average interest rate. A 14 percent increase in the volume of average loans accounted for the majority of the 4 percent rise in fully taxable equivalent interest income on loans since rates declined 84 basis points. Interest income on investment securities, including securities available for sale, decreased 27 percent from 1992 to 1993. This decrease resulted from an 83 basis point decrease in the yield on investment securities available for sale offset by increases in the yield on taxable and tax-exempt securities held-to-maturity of 20 and 30 basis points, respectively. Interest income on trading securities increased by 49 percent as a result of a 74 percent increase in the average balance offset by a 101 basis point decline in yield. Total interest expense declined by 13 percent in 1993 due to a 66 basis point decline in the rate paid on interest bearing liabilities, which more than offset a 3 percent increase in volume. Interest expense on interest bearing deposits decreased 14 percent as the result of a 76 basis point decrease in rate and a 3 percent increase in the average volume. The one percent increase in average borrowed funds, which includes interest bearing liabilities that are not classified as deposits, was more than offset by the lower rates paid, resulting in an eight percent decrease in interest expense for this category. The trend in net interest income is commonly evaluated in terms of average rates using the net yield and the interest rate spread. The net yield on earning assets is computed by dividing fully taxable equivalent net interest income by average total earning assets. This ratio represents the difference between the average yield returned on average earning assets and the average rate paid for all funds used to support those earning assets, including both interest bearing and noninterest bearing sources of funds. The net yield declined 9 basis points to 5.10 percent in 1993 following a 48 basis point rise in 1992. The historically high net yield in 1992 of 5.19 percent resulted from the substantial decline in the general level of interest rates over the past few years coupled with an increase in the size of the Company's loan portfolio which generally are higher yielding assets than investment securities. While this loan growth continued throughout 1993, the 84 basis point decline in yield on the loan portfolio was not enough to maintain the prior year level of net yield given only a 66 basis point decrease in the cost of interest bearing liabilities, down from a 175 basis point decline in the cost of interest bearing liabilities from 1991 to 1992. The loan growth achieved in 1993 and 1992 was due primarily to the continued growth in the Company's indirect lending portfolio and the favorable consumer response to the Company's residential mortgage products. During 1993, the net yield on interest earning assets was positively impacted by the Company's use of interest rate contracts, primarily interest rate swaps and interest rate floors, increasing the taxable equivalent net yield on interest earning assets by 24 basis points. The use of interest rate contracts impacted the yield and interest income on commercial loans where the net yield was increased by 126 basis points and interest income was increased by $12 million. At the same time, the impact of interest rate contracts on interest bearing liabilities was negligible, increasing interest expense by slightly more than $2 million and the net cost of funds by 3 basis points. It is the Company's intention to continue to use interest rate contracts to manage its exposure to the changing interest rate environment in the future, although there can be no assurance that the impact of interest rate contracts on the earnings of future periods will be positive. The net cost of funds, defined as interest expense divided by average earning assets, decreased 62 basis points in 1993, while the net yield on total earning assets declined 9 basis points. The rate paid on interest bearing liabilities fell 66 basis points below 1992 levels. In 1992, the yield on total earning assets rose 48 basis points while the rate paid on interest bearing liabilities declined 175 basis points and the net cost of funds decreased 157 basis points. The interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities. The interest rate spread eliminates the impact of noninterest bearing funds and gives a direct perspective on the effect of market interest rate movements. The positive impact experienced from 1989 to 1992 from changes in the overall asset and liability mix, combined with the favorable rate environment, did not continue in 1993. The net interest rate spread decreased 5 basis points to 4.46 percent from the 1992 spread of 4.51 percent as the cost of interest bearing liabilities fell at a slower pace than the yields earned on earning assets. The increase in 1992 was 66 basis points from the 3.85 percent in 1991. See the accompanying schedules entitled "Rate/Volume Variance Analysis" and "Consolidated Average Balances, Interest Income/Expense and Yields/Rates" for more information. The following table presents certain interest rates without modification for tax equivalency. The table on pages 26 and 27 contains these same percentages on a taxable equivalent basis. Tax-exempt earning assets continue to make up a smaller percentage of total earning assets. As a result, the difference between these interest rates with and without modification for tax equivalency continues to narrow. Interest income, as reported in the consolidated statements of income, on a nominal yield basis decreased in 1993 by $17 million while net interest income increased by $12 million. The seven basis point decrease in the net yield in 1993 was primarily a result of a decrease in the yields in the Company's interest earning assets, specifically its loan portfolio. The Company will continue to focus its attention in 1994 on increasing net interest income while at the same time maintaining the current levels in interest rate spreads and net yields. However, it cannot be assured that the negative trend in net yield experienced in 1993 will not continue due to interest rate fluctuations and other factors. CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES Taxable Equivalent Basis - -------- * Loans on nonaccrual status have been included in the computation of average balances. RATE/VOLUME VARIANCE ANALYSIS Taxable Equivalent Basis PROVISION FOR LOAN LOSSES, NET CHARGE-OFFS AND ALLOWANCE FOR LOAN LOSSES The provision for loan losses is the annual cost of providing an allowance or reserve for anticipated future losses on loans. The amount for each year is dependent upon many factors including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's assessment of loan portfolio quality, the value of collateral and general economic factors. The economic outlook for the states in which the Company does business is guardedly optimistic in the midst of a gradual improvement of the economy overall. Real estate values, affected by the recessionary pressures of prior years, have shown a general stabilization in the Subsidiary Banks' markets. On a regional basis, however, any additional economic slowdown in these markets could have an effect on most regional bank holding companies and could be reflected by little or no overall asset growth. Such an economic slowdown would probably also have a negative impact on real estate lending as well as the level of net charge-offs and delinquencies. Since another economic slowdown could have an adverse effect on property values and, for commercial development projects, cause an increase in vacancy rates, the possibility exists for further write-downs, charge-offs and the transfer of currently performing loans to a nonaccrual status in the real estate and commercial loan categories. The mix of loans in the construction and development portfolios are diversified in areas such as office buildings, retail stores and malls, apartment buildings, health care facilities and industrial warehouses. In addition, the Subsidiary Banks' specialized real estate lending areas review, approve and monitor large real estate credits on a continuing basis. Loan review procedures, including such techniques as loan grading and on-site reviews, are constantly utilized by the Company's loan review department in order to ensure that potential problem loans are identified early in order to lessen any potentially negative impact such problem loans may have on the Company's earnings. Automated loan reports are prepared and used in conjunction with the identification and monitoring of such loans on a monthly basis. Management's involvement continues throughout the process and includes participation in the work-out process and recovery activity. These formalized procedures are monitored internally by the loan review area whose work is supplemented by regulatory agencies that provide an additional level of review on an annual basis. Such review procedures are quantified in monthly and quarterly reports to senior management and are used in determining whether such loans represent potential loss to the Company. Special reports are prepared for consumer installment loans to identify trends unique to that portfolio. A determination of a potential loss will result in a charge to the provision for loan losses, thereby increasing the allowance for loan losses available for potential risk. Management monitors the entire loan portfolio, including loans acquired in business combinations, in an attempt to identify problem loans so that risks in the portfolio can be timely identified and an appropriate allowance maintained. The provision for loan losses was decreased 32 percent in 1993 compared to an increase of 39 percent in 1992 and 59 percent in 1991. The decreased provision for 1993 primarily reflects the substantial decrease in nonperforming assets from year-end 1992 to year-end 1993 as well as the significant decline in net charge-offs for the year. Net loan charge-offs decreased 58 percent in 1993 after decreasing 21 percent in 1992 and increasing 65 percent in 1991. The decrease in 1993 was due to decreased net charge-offs in all loan categories other than real estate-- construction. The decrease in net charge-offs in 1992 resulted from decreased net charge-offs in commercial, financial and agricultural loans and real estate construction loans offset somewhat by increased net charge-offs in the Company's credit card portfolio. The increase in net charge-offs in 1991 was attributable to losses on credit card receivables and commercial real estate mortgage and construction loans as well as commercial, financial and agricultural loans. During 1993, net charge-offs of commercial, financial and agricultural loans decreased by 73 percent while net charge-offs of commercial real estate mortgages declined 93 percent and net charge-offs of consumer installment loans decreased 48 percent. With regard to the Company's consumer installment loan portfolio, net charge-offs for credit card receivables decreased as a percentage of loans from 5.68 percent in 1992 to 3.04 percent in 1993. Similarly, net charge-offs as a percentage of loans in the Company's indirect consumer installment portfolio, consisting primarily of new and used automobile loans, decreased from 0.43 percent in 1992 to 0.14 percent in 1993. Net charge-offs on residential mortgage loans declined by 51 percent from 1992 levels and represented 5 percent of total net charge-offs up from 4 percent in 1992. The following table sets forth information with respect to the Company's loans and the allowance for loan losses for the five years ended December 31, 1993. SUMMARY OF LOAN LOSS EXPERIENCE Management considers changes in the size and character of the loan portfolio, changes in nonperforming and past due loans, historical loan loss experience, the existing risk of individual loans, concentrations of loans to specific borrowers or industries and existing and prospective economic conditions when determining the adequacy of the allowance for loan losses. In connection with business combinations, the Company has also provided additional reserves on the acquired loan portfolios based on the nature and characteristics of the acquired loans. The allowance increased 32 percent in 1993 and at year-end was 2.14 percent of outstanding loans compared to 1.80 percent at December 31, 1992 and 1.41 percent at December 31, 1991. The increase is due in part to additional reserves on the loan portfolios acquired in business combinations. As shown in the table below, management determined that at December 31, 1993, approximately 14 percent of the allowance for loan losses was related to commercial, financial and agricultural loans, 22 percent was related to real estate loans and 16 percent was related to consumer installment loans. A portion of the allowance, approximately 48 percent, remained unallocated to any specific category. The nominal allowance allocations have remained relatively stable from the 1992 level, with the decreases in percentage allocation resulting from the increase in the unallocated portion of the allowance. The increase in the unallocated portion of the allowance is due to the favorable loan performance that the Company has experienced in the past two years. While nonperforming assets and gross charge-offs have continued to decline, the Company's provision for loan losses has decreased proportionately. ALLOCATION OF ALLOWANCE FOR LOAN LOSSES NONPERFORMING ASSETS Nonperforming assets include loans classified as nonaccrual or renegotiated and foreclosed real estate. It is the general policy of the Subsidiary Banks to stop accruing interest income and place the recognition of interest on a cash basis when any commercial, industrial or real estate loan is past due as to principal or interest and the ultimate collection of either is in doubt. Accrual of interest income on consumer loans is suspended when any payment of principal or interest, or both, is more than 120 days delinquent. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is reversed against current income unless the collateral for the loan is sufficient to cover the accrued interest or a guarantor assures payment of interest. Nonperforming assets at December 31, 1993, were $40 million, a decrease of $26 million from year-end 1992. Nonperforming loans were $19 million, a decrease of $9 million from year-end 1992. The decrease in nonperforming loans was the result of management's efforts in resolving a limited number of large, unrelated, geographically-dispersed commercial real estate credits previously on nonaccrual status. Some of the amounts removed from nonperforming status were transferred to the other real estate owned category. During 1993, $8 million of loans were transferred to other real estate owned, offset by total sales of other real estate owned of $24 million and writedowns of $2 million. Of the $24 million in sales of other real estate, $16 million were cash sales while $8 million represented loans originated by the Subsidiary Banks to facilitate the sale of other real estate. During 1992, loans transferred to other real estate owned totaled $21 million, cash sales were $10 million, loans to facilitate the sale of other real estate owned were $8 million, and writedowns totaled $5 million. Much of the increase in nonperforming assets during 1991 was due to the Texas acquisitions, which added $16 million to nonperforming assets. Without these acquisitions, total nonperforming assets would have declined by 20 percent in 1991. These nonperforming assets were acquired at a discount and are carried at appropriate values at the Subsidiary Banks. Even though the Southeastern part of the country experienced a stabilization in the commercial real estate market during 1993, management closely monitored and will continue to monitor the Company's real estate and commercial loan portfolio during 1994. Particular attention will be focused on those credits targeted by the loan monitoring and review process. Management continues to emphasize the need to maintain a low level of nonperforming assets and to return current nonperforming assets to earning status. Renegotiated loans decreased $429,000 from year-end 1992 while foreclosed real estate decreased $17 million for the year. Loans past due 90 days or more decreased $551,000 compared to the 1992 year-end level. No loans of $500,000 or more were past due 90 days or more at year-end 1993. At December 31, 1993, nonperforming assets were 0.77 percent of loans outstanding plus foreclosed real estate held for sale compared to 1.41 percent at year-end 1992. Nonaccrual loans were 0.23 percent of loans outstanding at year-end 1993 compared to the previous year-end level of 0.45 percent. Renegotiated loans were 0.14 percent of loans outstanding at December 31, 1993, compared to 0.16 percent a year earlier. Other foreclosed or repossessed assets at year-end 1993 totaled $303,000. The following table summarizes the Company's nonperforming assets for each of the last five years. Also provided are tables which detail nonaccrual loans and loans with terms modified in troubled debt restructurings at December 31, 1993 and 1992. NONPERFORMING ASSETS Nonperforming loans acquired during 1991 through acquisitions amounted to $7 million. Other real estate acquired in these acquisitions amounted to $9 million. There may be additional loans within the Company's portfolio that may become classified as nonperforming as conditions dictate; however, management was not aware of any such loans that are material in amount at December 31, 1993. Details of nonaccrual loans at December 31, 1993 and 1992 appear below: Details of loans with terms modified in troubled debt restructurings at December 31, 1993 and 1992 appear below: NONINTEREST INCOME Noninterest income consists of revenues generated from a broad range of financial services and activities, including fee-based services and profits and commissions earned through securities and insurance sales and trading activities. In addition, gains or losses realized from the sale of investment portfolio securities are included in noninterest income. Total noninterest income for 1993 increased 7 percent compared to 1992 while noninterest income for 1992 showed an increase of 11 percent from 1991. NONINTEREST INCOME Fee income from service charges on deposit accounts increased 8 percent in 1993 following a 10 percent increase in 1992. Continued emphasis on low cost checking account services, appropriate pricing for transaction deposit accounts and fee collection practices for other deposit services contributed to the increased levels of income for both years. Increases during 1993 and 1992 were further influenced by the increase in both the number of accounts and balances outstanding in transaction deposit accounts. Trust fees or income from fee-based fiduciary activities increased 17 percent in 1993 compared to the 23 percent increase in 1992. The increase in 1993 is due primarily to growth in assets administered at the Trust Division of Compass Bank and the Company's River Oaks Trust Company subsidiary from $4.9 billion at the end of 1992 to $5.9 billion at December 31, 1993. Management fees on corporate employee benefit plans and personal trusts further contributed to the increase. Trading account profits and commissions on bond sales and trading activities decreased 16 percent during 1993 following an increase of 16 percent in 1992. During 1993, the Company's trading account consisted primarily of mortgage- backed securities, obligations of state and political subdivisions and U.S. Treasury securities. The future results of the trading account activity are dependent on factors such as movements in interest rates and changes in the securities markets and, as such, cannot be predicted with certainty. For a discussion of interest rate contracts held in the trading account, see page 21. Credit card service charge and fee income increased seven percent in 1993 after increasing less than one percent in 1992. Increases in merchants' discounts and in the annual credit card fees accounted for the increase. Recurring items of other noninterest income increased $4 million in 1993 and in 1992. The increase in 1993 resulted primarily from increases in commission income on annuity sales and mutual funds sales and increased mortgage banking income. Nonrecurring items of other noninterest income equaled $3 million in 1993 and $4 million for 1992. Nonrecurring items of noninterest income include net gains on sales of investment portfolio securities, net gains on the sale of fixed assets and other real estate owned, and gains on loan settlements. Nonrecurring items represented three percent of overall noninterest income in 1993 and four percent in 1992. The net gains on sales of investment securities in 1993 were $920,000 compared to $821,000 in 1992. The gain in 1992 is net of a $355,000 writedown on investment securities available for sale. Also included in nonrecurring noninterest income are the gains recognized on the sales of assets such as fixed assets and other real estate owned. These gains increased from $73,000 in 1992 to $1 million in 1993 due primarily to increased sales of other real estate owned. Gains on loan settlements at amounts in excess of the discounted carrying values relating to the Company's 1990 and 1991 acquisitions of certain failed banks in Texas accounted for 42 percent of the total nonrecurring income for 1993 compared to 77 percent in 1992. NONINTEREST EXPENSE Noninterest expense for 1993 increased 5 percent following an increase of 15 percent in 1992. Total salaries and other personnel expenses increased eight percent from 1992 with regular incentive bonuses rising over 1992 levels as performance goals for 1993 were achieved. Salaries alone increased 6 percent during 1993 and 17 percent in 1992 due to normal increases relating to additions to staff and merit increases, while the increase in 1992 also reflected the impact of staff additions resulting from the Company's 1991 acquisitions. During 1993, sales commissions decreased 14 percent after increasing 11 percent in 1992. Additionally, the Company's accrual for projected contributions to the employee stock ownership plan, which is driven by the Company's performance, contributed to the increase in employee benefits expense in both years. NONINTEREST EXPENSE Net occupancy expense increased by 9 percent in 1993 following a 12 percent increase in 1992. These increases in occupancy expense were due principally to bank acquisitions, opening of new branches, and normal renovation of existing properties. Equipment expense increased 12 percent in 1993 and 18 percent in 1992 due to equipment replacements and upgrades necessary to support increased business growth. Other noninterest expense, as reflected in the consolidated statements of income, decreased by less than one percent compared to a nine percent increase in 1992. Professional service expenses increased 7 percent in 1993 and 21 percent in 1992 while bank travel and entertainment expenses increased 2 percent in 1993 and 23 percent in 1992, primarily due to acquisition activity. The amount the Subsidiary Banks paid for Federal deposit insurance increased less than $1 million in 1993 after increasing more than $2 million in 1992. The amount of FDIC insurance premiums paid by the Subsidiary Banks is a function of both the Subsidiary Banks' deposit base and the rate at which insurance premiums are assessed by the FDIC, which is based in part on the capital adequacy of each bank. Because each of the Subsidiary Banks meets the regulatory definition of "well capitalized", this expense reflects the lowest possible assessment rate charged by the FDIC. INCOME TAXES The effective tax rate as a percentage of pretax income was 35 percent in 1993, 34 percent in 1992 and 32 percent in 1991. The effective tax rate in 1991 is lower than the statutory Federal rate of 34 percent primarily due to investments in loans and securities earning interest income that is exempt from Federal taxation. The effective tax rate increased in 1993 due to the Omnibus Budget Reconciliation Act of 1993 which increased the Company's statutory Federal tax rate from 34 percent to 35 percent retroactive to January 1, 1993. The effective tax rate increased in 1992 due to a larger percentage of taxable income resulting from fewer tax- exempt investment securities and an increase in non-deductible expenses related to acquisitions. In 1993 and 1992, the Company's effective tax rate was 100 percent of the statutory Federal tax rate compared to 94 percent in 1991. The Company's effective tax rate should continue to equal or exceed the statutory Federal tax rate in future years. Financial Accounting Statement No. 109, Accounting for Income Taxes ("FAS109"), was issued by the Financial Accounting Standards Board in February, 1992. The Company adopted FAS109 effective January 1, 1993, with no material impact on the financial statements. Prior years' financial statements have not been restated to apply the provisions of FAS109. OTHER ACCOUNTING ISSUES During the second quarter of 1993, the Financial Accounting Standards Board ("FASB") issued Financial Accounting Statement No. 114, Accounting by Creditors for Impairment of a Loan ("FAS114"). FAS114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, which is the contractual interest rate adjusted for any deferred loan fees or costs, premium, or discount existing at the inception or acquisition of the loan. FAS114 is effective for fiscal years beginning after December 15, 1994, with earlier adoption permitted. The Company does not anticipate adopting FAS114 prior to its effective date. Presently, the Company is unable to determine the impact that adoption of FAS114 will have on the consolidated financial statements of the Company, but management anticipates that the impact will not be material. PENDING ACQUISITIONS For information on pending acquisitions, see the accompanying "Notes to Consolidated Financial Statements," Note 10, Mergers and Acquisitions. IMPACT OF INFLATION AND CHANGING PRICES A bank's asset and liability structure is substantially different from that of an industrial company in that virtually all assets and liabilities of a bank are monetary in nature. Management believes the impact of inflation on financial results depends upon the Company's ability to react to changes in interest rates and, by such reaction, reduce the inflationary impact on performance. Interest rates do not necessarily move in the same direction, or at the same magnitude, as the prices of other goods and services. As discussed previously, management seeks to manage the relationship between interest- sensitive assets and liabilities in order to protect against wide interest rate fluctuations, including those resulting from inflation. Various information shown elsewhere in this Annual Report will assist in the understanding of how well the Company is positioned to react to changing interest rates and inflationary trends. In particular, the summary of net interest income, the maturity distributions, the compositions of the loan and securities portfolios, the data on the interest sensitivity of loans and deposits, and the information related to off-balance sheet hedging activities discussed in Note 6 of "Notes to Consolidated Financial Statements" should be considered. ITEM 8 ITEM 8 - -FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data required by Regulation S-X and by Item 302 of Regulation S-K are set forth in the pages listed below. COMPASS BANCSHARES, INC. AND SUBSIDIARIES FINANCIAL STATEMENTS INDEPENDENT AUDITORS' REPORT The Shareholders and Board of Directors Compass Bancshares, Inc. We have audited the accompanying consolidated balance sheets of Compass Bancshares, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, 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 Compass Bancshares, 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 1 to the consolidated financial statements, the Company changed its method of accounting for income taxes to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, in 1993. Also, as discussed in Note 1, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities at December 31, 1993. KPMG Peat Marwick January 14, 1994 Birmingham, Alabama COMPASS BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS See accompanying summary of significant accounting policies and notes to consolidated financial statements. COMPASS BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME See accompanying summary of significant accounting policies and notes to consolidated financial statements. COMPASS BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying summary of significant accounting policies and notes to consolidated financial statements. COMPASS BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying summary of significant accounting policies and notes to consolidated financial statements. COMPASS BANCSHARES, INC. AND SUBSIDIARIES SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES DECEMBER 31, 1993, 1992 AND 1991 The accounting principles followed by Compass Bancshares, Inc. (the "Company") and its subsidiaries and the methods of applying these principles conform with generally accepted accounting principles and with general practices within the banking industry. Certain principles which significantly affect the determination of financial position, results of operations and cash flows are summarized below. Certain items in prior years' financial statements have been reclassified to conform with the current financial statement presentations. BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Company and its subsidiaries, Compass Bank (and its wholly-owned subsidiaries), Central Bank of the South, Compass Bank, N.A., Compass Bank-Florida, Compass Banks of Texas, Inc. (and its wholly-owned subsidiaries) (collectively, the "Subsidiary Banks"), Compass Land Holding Corporation and Compass Underwriters, Inc. All significant inter-company accounts and transactions have been eliminated in consolidation. SECURITIES Securities are held in three portfolios: (i) trading account securities, (ii) held-to-maturity securities, and (iii) securities available for sale. Trading account securities are stated at market value. Investment securities held to maturity are stated at cost adjusted for amortization of premiums and accretion of discounts. With regard to investment securities held to maturity, management has the intent and ability to hold such securities until maturity. On December 31, 1993, the Company adopted Financial Accounting Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities ("FAS115") which requires that investment securities available for sale be reported at fair value with any unrealized gains or losses excluded from earnings and reflected as a separate component of stockholders' equity. The adoption of FAS115 did not affect the Company's methodology for determining the carrying value of its trading account securities or its investment securities held to maturity. During all periods prior to the date of adoption, the Company reported securities available for sale at the lower-of-cost-or-market with any valuation adjustment reflected in earnings as required by generally accepted accounting principles at that time. Additionally, FAS115 specifies accounting principles in regard to transfers among the three portfolios and the conditions that would permit such transfers. Investment securities available for sale are classified as such due to the fact that management may decide to sell certain securities prior to maturity for liquidity, tax planning or other valid business purposes. The adoption of FAS115 resulted in the addition of $6.5 million to stockholders' equity at December 31, 1993, representing the tax- effected net unrealized gain on the Company's available-for-sale portfolio at that date. With the adoption of FAS115, the Company transferred additional securities totaling $58 million, primarily fixed-rate CMOs, to the available- for-sale portfolio at December 31, 1993. Subsequent increases and decreases in the net unrealized gain/loss on the portfolio of securities available for sale will be reflected as adjustments to the carrying value of the portfolio and as adjustments to the component of shareholders' equity. Interest earned on investment securities held to maturity, investment securities available for sale, and trading account securities is included in interest income. Net gains and losses on the sale of investment securities held to maturity and investment securities available for sale, computed principally on the specific identification method, are shown separately in noninterest income in the consolidated statements of income. As part of the Company's overall interest rate risk management, the Company uses interest rate futures, swaps, caps and floors. Gains and losses on futures contracts are deferred and amortized over the lives of the hedged assets or liabilities as an adjustment to interest income or expense. Interest income or expense related to interest rate swaps, caps and floors is recorded over the life of the agreement as an adjustment to net interest income. Gains or losses on futures contracts used in the securities trading portfolio, as well as gains or losses on short-sale transactions, are recognized currently by the mark-to-market method of accounting and are recorded in the noninterest income section of the consolidated statements of income. Income received as an intermediary for customers under interest rate contracts is amortized over the life of the respective contract and recorded in noninterest income. LOANS All loans are stated at principal outstanding. Interest income on installment loans is recognized primarily on the level yield method. Interest income on other loans is credited to income based primarily on the principal outstanding at appropriate rates of interest. It is the general policy of the Company's Subsidiary Banks to stop accruing interest income and place the recognition of interest on a cash basis when any commercial, industrial or real estate loan is past due as to principal or interest and the ultimate collection of either is in doubt. Accrual of interest income on consumer installment loans is suspended when any payment of principal or interest, or both, is more than 120 days delinquent. When a loan is placed on a nonaccrual basis, any interest previously accrued but not collected is reversed against current income unless the collateral for the loan is sufficient to cover the accrued interest or a guarantor assures payment of interest. ALLOWANCE FOR LOAN LOSSES The amount of the provision for loan losses charged to income is determined on the basis of several factors including actual loss experience, current and expected economic conditions and periodic examinations and appraisals of the loan portfolio. Such provisions, less net loan charge-offs, comprise the allowance for loan losses which is deducted from loans and is available for future loan charge-offs. The Subsidiary Banks generally follow the policy of charging off loans determined to be uncollectible by management, the Company's loan examination division or Federal and state supervisory authorities. Subsequent recoveries are credited to the allowance. OTHER REAL ESTATE For real estate acquired through foreclosure and in-substance foreclosed assets, a new cost basis is established at fair value at the time of foreclosure. Subsequent to foreclosure, foreclosed assets are carried at the lower of fair value less estimated costs to sell or cost, with the difference recorded as a valuation allowance, on an individual asset basis. Subsequent decreases in fair value and increases in fair value, up to the value established at foreclosure, are recognized as charges or credits to expense. Other real estate, net of allowance for losses, is reported in other assets in the consolidated balance sheets. LOAN FEES The Company accounts for loan fees and origination costs in accordance with Financial Accounting Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Direct Costs of Leases ("FAS91"). The basic requirement of FAS91 calls for the Company to treat loan fees, net of direct costs, as an adjustment to the yield of the related loan over the term of the loan. PREMISES AND EQUIPMENT Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using primarily the straight-line method over the estimated useful lives of assets. AMORTIZATION OF INTANGIBLES Intangibles are included in other assets. The amortization periods for these assets are dependent upon the type of intangible. Goodwill is amortized over a period not greater than 20 years; core deposit and other identifiable intangibles are amortized over a period based on the life of the intangible which generally varies from 10 to 20 years. Goodwill is amortized using the straight-line method and other identifiable intangibles are amortized using accelerated methods as appropriate. TREASURY STOCK Stock repurchases are accounted for using the cost method. INCOME TAX EXPENSE For 1993, the Company and its subsidiaries provide for income tax using the asset and liability method of accounting for income tax in accordance with Financial Accounting Statement No. 109, Accounting for Income Taxes ("FAS109"). For 1992 and 1991, the Company and its subsidiaries provide for income tax using the deferred method of accounting for income taxes under APB Opinion 11. Under the asset and liability method prescribed by FAS109, 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 FAS109, 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. Pursuant to the deferred method under APB Opinion 11, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. Effective January 1, 1993, the Company adopted FAS109, with no material impact on the financial statements. Prior years' financial statements have not been restated to apply the provisions of FAS109. EMPLOYEE BENEFIT PLANS The Company and its subsidiaries have various employee benefit plans which cover substantially all employees. Pension expense is determined based on an actuarial valuation. The Company contributes amounts to the pension fund sufficient to satisfy funding requirements of the Employee Retirement Income Security Act. Contributions to the various other plans are determined by the Board of Directors. NET INCOME PER COMMON SHARE Primary net income per common share is calculated based on the weighted average shares of common stock and common stock equivalents outstanding during the year. Common stock equivalents included in the computations represent the dilutive effect of shares issuable under stock options granted by the Company. For purposes of this calculation, net income is adjusted for preferred stock dividends paid by the Company during the year. All prior period per share data has been restated to reflect a 3-for-2 stock split effected through the issuance of a 50 percent stock dividend paid in July, 1992. COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) CASH AND DUE FROM BANKS The Subsidiary Banks are required to maintain cash balances with the Federal Reserve. The average amounts of those balances for the years ended December 31, 1993 and 1992 were approximately $77,491,000 and $69,694,000, respectively. (2) CASH FLOWS The Company paid approximately $201,070,000, $234,464,000 and $293,843,000 in interest on deposits and other liabilities during 1993, 1992 and 1991, respectively. (3) INVESTMENT SECURITIES AND INVESTMENT SECURITIES AVAILABLE FOR SALE The adjusted cost and approximate market value of investment securities and investment securities available for sale at December 31, 1993 and 1992 were as follows: COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 Securities with principal amounts of approximately $793,165,000 and $962,690,000 at December 31, 1993 and 1992, respectively, were sold under agreements to repurchase or pledged to secure public deposits and for other purposes as required by law. Unrealized gains and unrealized losses on investment securities held to maturity for 1993 were $28,343,000 and $1,022,000, respectively. For investment securities available for sale, unrealized gains and unrealized losses at year-end 1993 were $10,531,000 and $110,000, respectively. The unrealized gains and unrealized losses on investment securities and investment securities available for sale related to the various categories as of December 31, 1993 and 1992 are detailed in the following table. COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 The maturity of the securities portfolio is presented in the tables below. No maturity breakdown is presented for mortgage-backed securities because of the unpredictability as to the timing and amount of principal repayments on these securities. Proceeds from sales of investment securities classified as held-to-maturity were $40,207,000 in 1993, $54,511,000 in 1992, and $176,191,000 in 1991. Gross gains realized on those sales were $193,000 in 1993, $1,176,000 in 1992, and $1,848,000 in 1991. Gross losses realized on sales totaled $1,207,000 in 1991. Proceeds from sales of available-for-sale investment securities were $57,347,000 in 1993 and $5,296,000 in 1992. Gross gains realized on those sales were $727,000 in 1993. There were no losses realized on sales in 1993 or in 1992. There were no transfers of securities from the available-for-sale portfolio to the trading securities portfolio. With the adoption of FAS115 on December 31, 1993, the Company transferred an additional $58 million of investment securities to its available-for-sale portfolio. The transfer primarily involved fixed-rate CMOs that could be required to be transferred to the available-for-sale portfolio by Federal regulators in the future if sufficiently reduced prepayment speeds are experienced on the underlying mortgages. (4) LOANS AND ALLOWANCES FOR LOAN LOSSES AND LOSSES ON OTHER REAL ESTATE At December 31, 1993 and 1992, the composition of the loan portfolio was as follows: COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 During 1993 and 1992, certain executive officers and directors of the Company and its principal subsidiary, Compass Bank, including their immediate families and companies with which they are associated, were loan customers of the Subsidiary Banks. Total loans outstanding to these persons at December 31, 1993 and 1992 amounted to $56,660,000 and $54,393,000, respectively. The change from December 31, 1992 to December 31, 1993, reflects payments amounting to $25,580,000 and advances of $27,847,000. Such loans are made in the ordinary course of business at normal credit terms, including interest rate and collateral requirements, and do not represent more than normal credit risk. The Company does not have a concentration of loans to any one industry. A summary of the transactions in the allowance for loan losses for the years ended December 31, 1993, 1992 and 1991 follows: Details of nonaccrual loans at December 31, 1993 and 1992 appear below: Details of loans with terms modified in troubled debt restructurings at December 31, 1993 and 1992 appear below: A summary of the transactions in the allowance for losses on other real estate for the years ended December 31, 1993 and 1992 follows: COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 Other real estate, net of the allowance for losses, totaled $20,653,000 at December 31, 1993, and $37,243,000 at December 31, 1992, and is reported in other assets in the consolidated balance sheets. (5) FHLB AND OTHER BORROWINGS At December 31, 1993, the Company had 7 percent subordinated debentures of $75,000,000 maturing in 2003 with interest paid semi-annually. At December 31, 1993, the net carrying amount of these debentures was $74,499,000. The Company had a mortgage amounting to $4,938,000 as of December 31, 1993 secured by the River Oaks Bank Building in Houston, Texas. The 8.875 percent mortgage has monthly principal and interest payments of approximately $50,000 and matures December 31, 2008. At December 31, 1993, the Company also had $246,000,000 in outstanding advances from the Federal Home Loan Bank of which $100,000,000 matures in 1995, $48,000,000 matures in 1996, and $98,000,000 matures in 1997. The interest rate on these advances resets quarterly based on the 3-month LIBOR rate and interest payments are due quarterly. These advances are secured by first mortgages of $378,000,000 carried on the books of Compass Bank. (6) OFF-BALANCE SHEET RISK AND COMMITMENTS The Company and its subsidiaries lease certain facilities and equipment for use in their businesses. The leases for facilities generally run for periods of 10 to 20 years with various renewal options, while leases for equipment generally have terms not in excess of 5 years. The majority of the leases for facilities contain rental escalation clauses with fixed rental increases or increases tied to changes in consumer indexes. Certain real property leases contain purchase options. Management expects that most leases will be renewed or replaced with new leases in the normal course of business. The following is a schedule by years of future minimum rentals required under operating leases that have initial or remaining noncancellable lease terms in excess of one year as of December 31, 1993, for leased facilities (in Thousands): COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 Minimum rentals for all operating leases charged to earnings totaled $7,087,000, $8,072,000 and $7,194,000 for years ended December 31, 1993, 1992 and 1991, respectively. The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit, forward and futures contracts, interest rate swap agreements, options written, and floors and caps written. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated financial statements. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in the particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments to extend credit and issuing standby and commercial letters of credit as it does for on-balance sheet instruments. For interest rate caps, floors and swap transactions, forward and futures contracts and options written, the contract or notional amounts do not represent ultimate exposure to credit loss. The Company controls the credit risk of its financial instruments through credit approvals, limits and monitoring procedures. The following table summarizes the contract or notional amount of various off-balance sheet instruments and commitments as of December 31: OFF-BALANCE SHEET INSTRUMENTS AND COMMITMENTS - -------- * The Company has credit risk on uncollateralized interest rate swaps and purchased floors for the amount required to replace such contracts in the event of counterparty default. At December 31, 1993, the Company estimates its credit risk in the event of total counterparty default to be $900,000 for interest rate swaps and $27.6 million for purchased floors and caps. Commitments to extend credit are agreements to lend to customers as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 Standby letters of credit are commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions and expire in decreasing amounts. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds various assets as collateral supporting those commitments for which collateral is deemed necessary. Forward and futures contracts are contracts for delayed delivery of securities or money market instruments in which the seller agrees to make delivery of a specified instrument at a designated future date at a specific price or yield. Risks arise from the possible inability of counterparties to meet the terms of their contracts and from movements in securities' values and interest rates. The Company enters into a variety of interest rate contracts, including interest rate caps and floors written, interest rate options written and interest rate swap agreements, in its trading activities and in managing its interest rate exposure. Interest rate caps and floors written by the Company enable customers to transfer, modify or reduce their interest rate risk. Interest rate options are contracts that allow the holder of the option to purchase or sell a financial instrument at a specified price and within a specified period of time from or to the seller, or writer, of the option. As a writer of options, the Company receives a premium at the outset and then bears the risk of the unfavorable change in the price of the financial instrument underlying the option. Interest rate swap transactions generally involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying principal amounts. Entering into interest rate swap agreements involves not only the risk of dealing with counterparties and their ability to meet the terms of the contracts but also the interest rate risk associated with unmatched positions. Notional principal amounts often are used to express the volume of these transactions, however, the amounts potentially subject to credit risk are much smaller. The Company also has recorded as liabilities certain short-sale transactions amounting to $25,656,000 at December 31, 1993, which could result in losses to the extent the ultimate obligation exceeds the amount of the recorded liability. The amount of the ultimate obligation under such transactions will be affected by movements in the financial markets, which are not determinable, and the point at which securities are purchased to cover the short sales. The short-sale transactions relate principally to U.S. Government and mortgage- backed securities for which there is an active, liquid market. The Company does not expect the amount of losses, if any, on such transactions to be material. (7) STOCK OPTION AND STOCK APPRECIATION RIGHT PLANS The Company has two long-term incentive stock option plans for key senior officers of the Company and its subsidiaries. The stock option plans provide for these key employees to purchase shares of the Company's $2.00 par value common stock at the fair market value at the date of the grant. Pursuant to the 1982 Long Term Incentive Plan and the 1989 Long Term Incentive Plan, 2,475,000 and 1,500,000 shares, respectively, of the Company's common stock have been reserved for issuance. The options granted under the plans may be exercised within 10 years from the date of grant. The incentive stock option agreements state that incentive options may be exercised in whole or in part until expiration date, but for options issued before 1987 no incentive stock option may be exercised if an incentive stock option is outstanding that was granted before the granting of such option. The plans also provide for the granting of stock appreciation rights to holders of nonqualified stock options. A stock appreciation right allows the holder to surrender an exercisable stock option in exchange for common stock (at fair market value on the date of exercise), cash, or in a combination thereof, in an amount equal to the excess of the COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 fair market value of covered shares over the option price of such shares. All outstanding options were exercisable at December 31, 1993. The following summary sets forth activity under the plan for the years ended December 31 (restated for the 3-for-2 stock split in 1992): At December 31, 1993, the shares under option included nonqualified options issued to certain executives to acquire 30,000 shares of common stock which provide for tandem stock appreciation rights that are exercisable only upon the occurrence of certain contingent events. Because of the restrictions upon exercise of the stock appreciation rights, no compensation expense has been recorded with respect to these options. The shares under option also included nonqualified options without stock appreciation rights issued to certain executives to acquire shares of common stock as follows: 105,350 shares at year-end 1993 and year-end 1992 and 120,651 shares at year-end 1991. (8) DIVIDENDS FROM SUBSIDIARIES Dividends paid by the Subsidiary Banks are the primary source of funds available to the Company for payment of dividends to its shareholders and other needs. Applicable Federal and state statutes and regulations impose restrictions on the amounts of dividends that may be declared by the Subsidiary Banks. In addition to the formal statutes and regulations, regulatory authorities also consider the adequacy of each bank's total capital in relation to its assets, deposits and other such items. Capital adequacy considerations could further limit the availability of dividends from the Subsidiary Banks. At December 31, 1993, approximately $97,455,000 of the Subsidiary Banks' net assets were available for payment of dividends without prior regulatory approval. (9) MERGERS AND ACQUISITIONS On June 18, 1992, the Company completed the acquisition of Interstate Bancshares, Inc. ("Interstate") of Houston, Texas. In the acquisition, the Company exchanged 211,992 shares of the Company's common stock for the outstanding common shares of Interstate plus $308,550 in cash for the outstanding preferred shares of Interstate. The acquisition was accounted for under the pooling-of-interests method. The assets and equity of Interstate at acquisition date were $66 million and $4 million, respectively. On October 28, 1992, the Company acquired City National Bancshares, Inc. ("City National") of Carrollton, Texas through the exchange of 397,448 shares of the Company's common stock for the outstanding stock of City National. The acquisition was accounted for as a pooling-of-interests. Upon acquisition, City National had assets and equity of $62 million and $7 million, respectively. On December 22, 1992, the Company completed the acquisition of FWNB Bancshares, Inc. ("First Western") of Plano, Texas. The Company issued 704,923 shares of its common stock for the outstanding shares of First COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 Western. The acquisition was accounted for as a pooling-of-interests. Upon acquisition, First Western had assets of $161 million and equity of $8 million. The Company completed the acquisition of Cornerstone Bancshares, Inc. ("Cornerstone") in Dallas, Texas on January 19, 1993, through the issuance of 1,279,066 shares of the Company's common stock. The transaction was accounted for under the pooling-of-interests method of accounting and accordingly all prior period information has been restated to reflect the financial position and results of operations of Cornerstone. Upon acquisition, Cornerstone had assets of $239 million and equity of $15 million. On October 14, 1993, the Company acquired First Federal Savings Bank of Northwest Florida ("First Federal"), of Ft. Walton Beach, Florida for $13.7 million in cash. The acquisition was accounted for under the purchase method of accounting. At the date of acquisition, First Federal had assets of $101 million and equity of $10 million. On October 21, 1993, the Company acquired Peoples Holding Company, Inc. ("Liberty") and its bank subsidiary, Liberty Bank of Ft. Walton Beach, Florida for $5.0 million in cash. At the date of acquisition, Liberty had assets of $43 million and equity of $4 million. The acquisition was accounted for as a purchase. On November 3, 1993, the Company completed the acquisition of Spring National Bank ("Spring National"), of Houston, Texas with the issuance of 326,940 shares of the Company's common stock. At the date of acquisition, Spring National had assets of $75 million and equity of $6 million. The transaction was accounted for under the pooling-of-interests method of accounting and accordingly all prior period information has been restated to reflect the financial position and results of operations of Spring National. On January 27, 1994, the Company completed the acquisition of 1st Performance National Bank ("1st Performance"), of Jacksonville, Florida in a cash transaction. The acquisition was accounted for as a purchase. At the date of acquisition, 1st Performance had assets of $278 million and equity of $25 million. Presented below is summary operating information for the Company showing the effect of the business combinations described above. Prior to their respective acquisition dates in 1993, the entities accounted for under the pooling-of-interests method had net interest income of $3.4 million and net income of $800,000. COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 On November 19, 1993, the Company entered into a definitive agreement to acquire Security Bank, N.A. ("Security") of Houston, Texas for Company common stock having a market value of $11,250,000, subject to certain conditions. At December 31, 1993, Security had assets of $77 million and equity of $6 million. The transaction is expected to close in the second quarter of 1994 and to be accounted for under the pooling-of-interests method of accounting. On November 12, 1993, the Company entered into a definitive agreement to acquire three branches of Anchor Savings Bank located in Jacksonville, Florida. At December 31, 1993, these branches had total deposits of approximately $35 million. (10) BENEFIT PLANS The Company sponsors a defined benefit pension plan pursuant to which participants are entitled to an annual benefit upon retirement equal to a percentage of the average base compensation (generally defined as direct cash compensation exclusive of bonuses and commissions) earned in the five consecutive years of benefit service which produces the highest average. The percentage amount of the benefit is determined by multiplying the number of years, up to 30, of a participant's service with the Company by 1.8 percent. Benefits are reduced by Social Security payments at the rate of 1.8 percent of primary Social Security benefits times years of service up to 30 years. All employees of the Company who are over the age of 21 and have worked 1,000 hours or more in their first 12 months of employment or 1,000 hours or more in any calendar year thereafter are eligible to participate. Since 1989, under most circumstances, employees are vested after five years of service. Prior to 1989, the vesting period was 10 years. Benefits are payable monthly commencing on the later of age 65 or the participant's date of retirement. Eligible participants may retire at reduced benefit levels after reaching age 55, if they have at least 10 years of service. The Company contributes amounts to the pension fund sufficient to satisfy funding requirements of the Employee Retirement Income Security Act. The following table sets forth the plan's funded status and amounts recognized in the Company's consolidated balance sheets at December 31: Net pension cost for 1993, 1992 and 1991 included the following components: COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 The weighted average discount rate was 7.50 percent for 1993 and 8.50 percent for 1992 and 1991. The rate of increase in future compensation levels was six percent for 1993, 1992 and 1991. Both rates are used in determining the actuarial present value of the projected benefit obligation. The assumed long- term rate of return on plan assets was 10 percent in 1993, 1992 and 1991. The Company maintains an employee stock ownership plan to which contributions are made in amounts determined by the Board of Directors of the Company. Such contributions are invested in stock of the Company and are ordinarily distributed to employees upon their retirement or other termination of employment. Contributions to the plan are allocated to the accounts of the participants based upon their compensation, with right to such accounts vested after five years of employment. The Company contributed $3,874,000 during 1993, $3,380,000 during 1992, and $2,766,000 during 1991. The Company has a qualified employee benefit plan under section 401(k) of the Internal Revenue Code. Employees can contribute up to 10 percent of their salaries to the plan on a pre-tax basis subject to regulatory limits and the Company at its discretion can match up to 100 percent of 6 percent of the participants' compensation. The Company's contributions are based on predetermined income levels. The administrative costs incurred by the plan are paid by the Company at no cost to the participants. The Company also has a monthly investment plan. Under the plan, employees may contribute monthly up to 10 percent of their salary and the Company contributes 30 cents for each one dollar of the employees' contributions toward the purchase of common stock of the Company. The stock is purchased in the open market and brokerage fees and other incidental expenses are absorbed by the Company. (11) OTHER NONINTEREST EXPENSE The major components of other noninterest expense are as follows: (12) INCOME TAX EXPENSE Income taxes for the year ended December 31, 1993, were allocated as follows (in Thousands): COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 For the years ended December 31, 1993, 1992 and 1991 income tax expense attributable to income from operations consists of: During 1993, the Company made income tax payments of approximately $60,480,000 and received cash income tax refunds amounting to approximately $207,000. For 1992 and 1991, income tax payments were approximately $45,282,000 and $31,828,000, respectively. Cash income tax refunds amounted to approximately $247,000 and $479,000 for 1992 and 1991, respectively. Applicable income tax expense on securities gains of $347,000, $249,000, and $213,000 for 1993, 1992 and 1991, respectively, are included in the provision for income taxes. Income tax expense attributable to income from operations differed from the amount computed by applying the Federal statutory income tax rate to pretax earnings for the following reasons: The Omnibus Budget Reconciliation Act of 1993 increased the Federal statutory rate from 34 percent to 35 percent. The Act was signed into law on August 10, 1993, and the rate increase was made retroactive to January 1, 1993. The net effect of the rate change did not have a material impact on the financial statements. COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 For the years ended December 31, 1992 and 1991, deferred income tax expense (benefit), results from income and expense amounts reported for financial statements in different years than for income tax purposes. The tax effects of those timing differences are presented below. 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): The Company believes that the deferred tax asset is recoverable. COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (13) PARENT COMPANY The condensed financial information for Compass Bancshares, Inc. (Parent Company Only) is presented as follows: Parent Company Only Balance Sheets COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (13) PARENT COMPANY, Continued Parent Company Statements of Income COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (13) PARENT COMPANY, Continued Parent Company Only Statements of Cash Flows COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (14) FAIR VALUE OF FINANCIAL INSTRUMENTS Financial Accounting Statement No. 107, Disclosures about Fair Value of Financial Instruments ("FAS107") requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company's financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company or its Subsidiary Banks, but rather represent a good-faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination or issuance. The Company has not undertaken any steps to value any intangibles, which is permitted by the provisions of FAS107. The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments: Cash and cash equivalents and interest bearing deposits with other banks: Fair value equals the carrying value of such assets. Investment securities and investment securities available for sale: Fair values for investment securities are based on quoted market prices. Trading account securities: Fair value and book value of the Company's trading account securities (including off-balance sheet instruments) 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 except in the case of certain options and swaps where pricing models are used. Federal funds sold and securities purchased under agreements to resell: Due to the short-term nature of these assets, the carrying values of these assets approximate their fair value. Loans: For variable rate loans, those repricing within six months or less, fair values are based on carrying values. The fair value of certain mortgage loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for any differences in loan characteristics, with servicing retained. The fair value of the Company's credit card portfolio is based on quoted market prices. The Company's indirect lending portfolio, consisting primarily of indirect new and used auto loans, was valued based on securitization transactions with servicing retained. Fixed rate commercial loans, other installment loans, and certain real estate mortgage loans were valued using discounted cash flows. The discount rate used to determine the present value of these loans was based on interest rates currently being charged by the Subsidiary Banks on comparable loans as to credit risk and term. Off-balance-sheet instruments: Fair value of the Company's off-balance- sheet instruments (futures, forwards, swaps, caps, floors and options written) are based on quoted market prices. The Company's loan commitments are negotiated at current market rates and are relatively short-term in nature and, as a matter of policy, the Company generally makes commitments for fixed rate loans for relatively short periods of time, therefore, the estimated value of the Company's loan commitments approximates carrying amount. The fair value of stand-by letters of credit is based on current rates offered by the Company for letters of credit of similar remaining duration and amount. Deposit liabilities: The fair values of demand deposits are, as required by FAS107, equal to the carrying value of such deposits. Demand deposits include non-interest bearing demand deposits, savings accounts, NOW accounts and money market demand accounts. The fair value of variable rate term deposits, those repricing within six months or less, equals the carrying value of these deposits. Discounted cash flows have been used to value fixed rate term deposits and variable rate term deposits having an interest rate floor that has been COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 reached. The discount rate used is based on interest rates currently being offered by the Subsidiary Banks on comparable deposits as to amount and term. Short-term borrowings: The carrying value of Federal funds purchased, securities sold under agreements to repurchase and other short-term borrowings approximates their carrying values. FHLB and other borrowings: The fair value of the Company's fixed rate borrowings are estimated using discounted cash flows, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The carrying amount of the Company's variable rate borrowings approximates their fair values. COMPASS BANCSHARES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (15) QUARTERLY RESULTS (UNAUDITED) A summary of the unaudited results of operations for each quarter of 1993 and 1992 follows: 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 is incorporated by reference from the sections entitled "Election of Directors" and "Executive Compensation and Other Information" in the Proxy Statement for the Annual Meeting of Shareholders to be held May 16, 1994, which is to be filed with the Securities and Exchange Commission. ITEM 11 ITEM 11 - -EXECUTIVE COMPENSATION Information required by this item is incorporated by reference from the section entitled "Executive Compensation and Other Information" in the Proxy Statement for the Annual Meeting of Shareholders to be held May 16, 1994, which is to be filed with the Securities and Exchange Commission; provided, however, that such incorporation by reference shall not be deemed to specifically incorporate by reference the information referred to in Item 402(a)(8) of Securities and Exchange Commission Regulation S-K. ITEM 12 ITEM 12 - -SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this item is incorporated by reference from the sections entitled "Holdings of Voting Securities" and "Election of Directors" in the Proxy Statement for the Annual Meeting of Shareholders to be held May 16, 1994, which is to be filed with the Securities and Exchange Commission. ITEM 13 ITEM 13 - -CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item is incorporated by reference from the section entitled "Certain Transactions" in the Proxy Statement for the Annual Meeting of Shareholders to be held May 16, 1994, which is 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) INDEX OF DOCUMENTS FILED AS PART OF THIS REPORT: Compass Bancshares, Inc. and Subsidiaries Financial Statements Certain financial statement schedules and exhibits have been omitted because they are not applicable. EXHIBIT 11--STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS COMPASS BANCSHARES, INC. COMPUTATION OF NET INCOME PER COMMON SHARE EXHIBIT 12--STATEMENT RE: COMPUTATION OF RATIOS COMPASS BANCSHARES, INC. COMPUTATION OF RATIO OF EARNINGS TO COMBINED FIXED CHARGES AND PREFERRED STOCK DIVIDENDS EXHIBIT 12--STATEMENT RE: COMPUTATION OF RATIOS (Continued) COMPASS BANCSHARES, INC. COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES EXHIBIT 21--SUBSIDIARIES OF THE REGISTRANT SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. Compass Bancshares, Inc. Date: February 21, 1994 By /s/ D. Paul Jones, Jr. ---------------------------------- D. PAUL JONES, JR. CHAIRMAN AND CHIEF EXECUTIVE OFFICER Date: February 21, 1994 By /s/ Garrett R. Hegel ---------------------------------- GARRETT R. HEGEL CHIEF FINANCIAL OFFICER Date: February 21, 1994 By /s/ Michael A. Bean ---------------------------------- MICHAEL A. BEAN CHIEF ACCOUNTING OFFICER POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, THAT EACH PERSON WHOSE SIGNATURE APPEARS BELOW CONSTITUTES AND APPOINTS D. PAUL JONES, JR., JERRY W. POWELL AND DANIEL B. GRAVES, AND EACH OF THEM, HIS TRUE AND LAWFUL ATTORNEY-IN-FACT AS AGENT WITH FULL POWER OF SUBSTITUTION AND RESUBSTITUTION FOR HIM AND IN HIS NAME, PLACE AND STEAD, IN ANY AND ALL CAPACITIES, TO SIGN ANY OR ALL AMENDMENTS TO THIS FORM 10-K AND TO FILE THE SAME, WITH ALL EXHIBITS THERETO, AND OTHER DOCUMENTS IN CONNECTION THEREWITH, WITH THE SECURITIES AND EXCHANGE COMMISSION, GRANTING UNTO SAID ATTORNEYS-IN-FACT AND AGENTS FULL POWER AND AUTHORITY TO DO AND PERFORM EACH AND EVERY ACT AND THING REQUISITE AND NECESSARY TO BE DONE IN AND ABOUT THE PREMISES, AS FULLY AND TO ALL INTENTS AND PURPOSES AS THEY MIGHT OR COULD DO IN PERSON, HEREBY RATIFYING AND CONFIRMING ALL THAT SAID ATTORNEYS-IN- FACT AND AGENTS, AND THEIR SUBSTITUTE OR SUBSTITUTES, MAY LAWFULLY 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. DIRECTORS DATE /s/ Harry B. Brock, Jr. February 21, 1994 - ------------------------------------- HARRY B. BROCK, JR. /s/ Stanley M. Brock February 21, 1994 - ------------------------------------- STANLEY M. BROCK /s/ Charles W. Daniel February 21, 1994 - ------------------------------------- CHARLES W. DANIEL DIRECTORS DATE /s/ W. Eugene Davenport February 21, 1994 - ------------------------------------- W. EUGENE DAVENPORT /s/ Garry Neil Drummond, Sr. February 21, 1994 - ------------------------------------- GARRY NEIL DRUMMOND, SR. February 21, 1994 - ------------------------------------- MARSHALL DURBIN, JR. /s/ Tranum Fitzpatrick February 21, 1994 - ------------------------------------- TRANUM FITZPATRICK /s/ Thomas E. Jernigan February 21, 1994 - ------------------------------------- THOMAS E. JERNIGAN /s/ D. Paul Jones, Jr. February 21, 1994 - ------------------------------------- D. PAUL JONES, JR. /s/ G. W. "Red" Leach, Jr. February 21, 1994 - ------------------------------------- G.W. "RED" LEACH, JR. /s/ Goodwin L. Myrick February 21, 1994 - ------------------------------------- GOODWIN L. MYRICK /s/ John S. Stein February 21, 1994 - ------------------------------------- JOHN S. STEIN

823393_1993.txt

823393_1993

1993

823393

ITEM 1. Business. Shawmut National Corporation ("Corporation") is a multibank holding company, registered under the Bank Holding Company Act of 1956, as amended ("BHCA"). It was organized under the laws of the State of Delaware in October, 1987 and became a bank holding company on February 29, 1988 through the consummation of a plan of reorganization between Hartford National Corporation ("HNC") and Shawmut Corporation ("SC") pursuant to which both HNC and SC became wholly owned subsidiaries of the Corporation (the "Reorganization"). The Corporation maintains dual headquarters in the States of Connecticut and Massachusetts. The principal business of the Corporation is to provide, through its bank subsidiaries, comprehensive corporate, commercial, correspondent and individual banking services, and personal and corporate trust services through its network of approximately 270 branches located throughout Connecticut, Massachusetts and Rhode Island. The Corporation's principal subsidiaries are Shawmut Bank Connecticut, National Association ("SBC"), Hartford, Connecticut and Shawmut Bank, National Association ("SBM"), Boston, Massachusetts. SBC is among the oldest banks in the United States, having opened for business on August 9, 1792 under a charter granted by the State of Connecticut to its first predecessor on May 29, 1792. In 1865 SBC converted into a national banking association, in 1969 it became a subsidiary of HNC, and in 1993 its present name was adopted. At December 31, 1993, SBC had assets of $14.5 billion and deposits of $8.4 billion. SBC had trust assets under management totaling $8.4 billion as of December 31, 1993. SBM, also among the oldest banks in the United States, was established in 1836, under a charter granted by the Commonwealth of Massachusetts to its first predecessor. In 1864 SBM converted to a national banking association, in 1964 it became a subsidiary of SC, and in 1986 its present name was adopted. At December 31, 1993, SBM had assets of $12.9 billion and deposits of $7.5 billion. SBM had trust assets under management totaling $4.2 billion as of December 31, 1993. Through Shawmut Mortgage Company ("SMC"), which became a subsidiary of SBC at close of business December 31, 1993, the Corporation provides other financial services. With its principal office in West Hartford, Connecticut, SMC originates, sells and services substantially all of the residential mortgages among the Corporation's subsidiaries. In addition to its principal office, SMC maintains a network of 10 production offices in Connecticut, Massachusetts, Rhode Island and New Hampshire. At December 31, 1993 it had assets of $508 million. At December 31, 1993, the Corporation had assets of $27.2 billion, deposits of $15.3 billion, loans of $15.4 billion and shareholders' equity of $1.8 billion. A more detailed discussion concerning the Corporation's financial condition is contained in Part II of this report. Supervision and Regulation General The Corporation is a bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") pursuant to the BHCA, and files with the Federal Reserve Board an annual report and such additional reports as the Federal Reserve Board may require. As a bank holding company, the Corporation'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 Corporation may not directly or indirectly acquire the ownership or control of more than 5 percent 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 Corporation's subsidiary banks are subject to supervision and examination by various regulatory authorities. The Office of the Comptroller of the Currency (the "OCC") is the primary bank supervisor of the Corporation's bank subsidiaries, SBC and SBM, both of which are national banks. The deposits of the Corporation's subsidiary banks are insured by, and therefore the subsidiary banks are subject to the regulations of, the Federal Deposit Insurance Corporation (the "FDIC"), and 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 Corporation's subsidiary banks. Regulatory limitations on the payment of dividends to the Corporation by its banking subsidiaries are discussed in Note 16 (Regulatory Matters) to the consolidated financial statements on page of this report. Holding Company Liability Federal Reserve Board policy requires bank holding companies to serve as a source of financial strength to their subsidiary banks by standing ready to use available resources to provide adequate capital funds to subsidiary banks during periods of financial stress or adversity. A bank holding company also could be liable under certain provisions of a new banking law for the capital deficiencies of an undercapitalized bank subsidiary. In the event of a bank holding company's bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required to cure immediately any deficit under any commitment by the debtor to any of the federal banking agencies to maintain the capital of an insured depository institution, and any claim for a subsequent breach of such obligation will generally have priority over most other unsecured claims. Transactions with Affiliates The Corporation's subsidiary banks are subject to restrictions under federal law which limit certain transactions by each of them with the Corporation and its nonbanking subsidiaries, including loans, other extensions of credit, investments or asset purchases. Such transactions by any subsidiary bank with any one affiliate are limited in amount to 10 percent of such subsidiary bank's capital and surplus and with all affiliates to 20 percent of such subsidiary bank's capital and surplus. Furthermore, such loans and extensions of credit, as well as certain other transactions, are required to be secured in accordance with specific statutory requirements. The purchase of low quality assets from affiliates is generally prohibited. Federal law also provides that certain transactions with affiliates, including loans and asset purchases, must be on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to the institution as those prevailing at the time for comparable transactions involving other non-qualified companies or, in the absence of comparable transactions, on terms and under circumstances, including credit standards, that in good faith would be offered to, or would apply to, nonaffiliated companies. Certain regulations require the maintenance of minimum risk-based capital ratios, which are calculated with reference to risk-weighted assets, which include on- and off-balance sheet exposures. The Federal Reserve Board and the OCC have established guidelines for both the Corporation and its national banks, which are generally similar. The Federal Reserve Board and the OCC have also adopted minimum leverage ratios for bank holding companies and national banks. For a further discussion concerning capital guidelines and minimum leverage ratios, see Note 16 (Regulatory Matters) to the consolidated financial statements on page of this report. FIRREA Recent federal legislation that affects the competitive environment for the Corporation and its subsidiaries includes the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") which, among other things, provides for the acquisition of thrift institutions by bank holding companies, increases deposit insurance assessments for insured banks, broadens the enforcement power of federal bank regulatory agencies, and provides that any FDIC-insured depository institution may be liable for any loss incurred by the FDIC, or any loss which the FDIC reasonably anticipates incurring, in connection with the default of any commonly controlled FDIC-insured depository institution or any assistance provided by the FDIC to any such institution in danger of default. Recent Statutory Changes The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") substantially revises the depository institution regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking regulators to take prompt supervisory and regulatory actions against undercapitalized depository institutions. FDICIA establishes five capital categories: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Under the regulations, a "well capitalized" institution has a minimum total capital to total risk-weighted assets ratio of at least 10 percent, a minimum Tier I capital to total risk-weighted assets ratio of at least 6 percent, a minimum leverage ratio of at least 5 percent and is not subject to any written order, agreement, or directive; an "adequately capitalized" institution has a total capital to total risk-weighted assets ratio of at least 8 percent, a Tier I capital to total risk-weighted assets ratio of at least 4 percent, and a leverage ratio of at least 4 percent (3 percent if given the highest regulatory rating and not experiencing significant growth), but does not qualify as "well capitalized." An "undercapitalized" institution fails to meet any one of the three minimum capital requirements. A "significantly undercapitalized" institution has a total capital to total risk-weighted assets ratio of less than 6 percent, a Tier 1 capital to total risk-weighted assets ratio of less than 3 percent or a Tier 1 leverage ratio of less than 3 percent. A "critically undercapitalized" institution has a Tier 1 leverage ratio of 2 percent or less. Under certain circumstances, a "well capitalized," "adequately capitalized" or "undercapitalized" institution may be required to comply with supervisory actions as if the institution were in the next lowest capital category. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Effective December 19, 1993, undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth and activity limitations and are required to submit "acceptable" capital restoration plans. Such a plan will not be accepted unless, among other things, the depository institution's holding company guarantees the capital plan, up to an amount equal to the lesser of five percent 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. 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 and may be placed into conservatorship or receivership. 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, more stringent requirements to reduce total assets, cessation of receipt of deposits from correspondent banks, further activity restricting prohibitions on dividends to the holding company and requirements that the holding company divest its bank subsidiary, in certain instances. Subject to certain exceptions, critically undercapitalized depository institutions must have a conservator or receiver appointed for them within a certain period after becoming critically undercapitalized. Brokered Deposits FDIC regulations adopted under FDICIA prohibit a bank from accepting brokered deposits (which term is defined to include any deposit obtained, directly or indirectly, from any person engaged in the business of placing deposits with, or selling interests in deposits of, an insured depository institution) unless (i) it is well capitalized, or (ii) it is adequately capitalized and receives a waiver from the FDIC. For purposes of this regulation, a bank is defined to be well capitalized if it maintains a leverage ratio of at least 5 percent, a risk-adjusted Tier 1 capital ratio of at least 6 percent and a risk-adjusted total capital ratio of at least 10 percent and is not otherwise in a "troubled condition" as specified by its appropriate federal regulatory agency. A bank that is adequately capitalized and that accepts brokered deposits under a waiver from the FDIC may not pay an interest rate on any deposit in excess of 75 basis points over certain prevailing market rates. There are no such restrictions on a bank that is well capitalized. For the capital ratios of the Corporation's bank subsidiaries, see "Capital Requirements and Dividends" on page and Note 16 (Regulatory Matters) on page of this report. The Corporation does not believe that the brokered deposits regulation will have a material effect on the funding or liquidity of any of the Corporation's subsidiary banks. Regulatory Restrictions on Dividends It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization's expected future needs. The policy further provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company's ability to serve as a source of strength to its subsidiary banks. Principal sources of revenues for the Corporation are dividends received from its banks and other subsidiaries and interest earned on short-term investments and advances to subsidiaries. Federal law imposes limitations on the payment of dividends by the subsidiaries of the Corporation that are national banks. Two different calculations are performed to measure the amount of dividends that may be paid: a recent earnings test and an undivided profits test. Under the recent earnings test, a dividend may not be paid if the total of all dividends declared by a national bank in any calendar year is in excess of the current year's net profits combined with the retained net profits of the two preceding years unless the bank obtains the approval of the OCC. Under the undivided profits test, a dividend may not be paid in excess of a bank's undivided profits then on hand, after deducting bad debts in excess of the reserve for loan losses. Under the recent earnings test, which is the more restrictive of the two tests, at January 1, 1994, SBC could pay up to $113.8 million in dividends to HNC, the bank's lower-tiered parent holding company. SBM, under the recent earnings test at January 1, 1994, could pay up to $210.7 million in dividends to SC, the bank's lower-tiered parent holding company. SBC and SBM had undivided profits of $262.9 million and $469.6 million, respectively, at December 31, 1993. In addition, the Federal regulatory agencies are authorized to prohibit a banking organization from engaging in an unsafe or unsound banking practice. Depending upon the circumstances, the agencies could take the position that paying a dividend would constitute an unsafe or unsound banking practice. FDIC Insurance Assessments The Corporation's subsidiary banks, the deposits of which are insured by the Bank Insurance Fund (the "BIF") of the FDIC, are subject to FDIC deposit insurance assessments. The FDIC has adopted a risk-based assessment system under which the assessment rate for an insured depository institution varies according to the level of risk involved in its activities. An institution's risk category is based partly upon whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. Each insured depository institution is assigned to one of the following "supervisory subgroups": "A", "B" or "C". Group "A" institutions are financially sound institutions with only a few minor weaknesses. Group "B" institutions are institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration. Group "C" institutions are institutions for which there is a substantial probability that the FDIC will suffer a loss in connection with the institution unless effective action is taken to correct the areas of weakness. Based on its capital and supervisory subgroups, each BIF member institution is assigned an annual FDIC assessment rate varying between 0.23 percent and 0.31 percent of deposits. It remains possible that assessments will be raised to higher levels in the future. The FDIC is also authorized to impose special additional assessments. Conservatorship and Receivership Powers of Federal Banking Agencies FDICIA significantly expanded the authority of the federal banking regulators to place depository institutions into conservatorship or receivership to include, among other things, appointment of the FDIC as conservator or receiver of an undercapitalized institution under certain circumstances. In the event a bank is placed into conservatorship or receivership, the FDIC is required, subject to certain exceptions, to choose the method for resolving the institution that is least costly to the bank insurance fund ("BIF") of the FDIC, such as liquidation. In any event, if any of the Corporation's subsidiary banks were placed into conservatorship or receivership, because of the cross-guarantee provisions of the Federal Deposit Insurance Act, as amended, the Corporation as the sole stockholder of the Corporation's subsidiary banks would likely lose its investment in its subsidiary banks. The FDIC may provide federal assistance to a "troubled institution" without placing the institution into conservatorship or receivership. In such case, pre-existing debtholders and shareholders may be required to make substantial concessions and, insofar as practical, the FDIC will succeed to their interests in proportion to the amount of federal assistance provided. Various other legislation, including proposals to overhaul the banking regulatory system and to limit the investments that a depository institution may make with insured funds are from time to time introduced in Congress. The Corporation cannot determine the ultimate effect that FDICIA and the implementing regulations to be adopted thereunder, or any other potential legislation, if enacted, would have upon its financial condition or results of operations. Competition The banking business in New England is highly competitive. All of the Corporation's subsidiary banks and related financial services subsidiaries compete actively with national and state banks, savings banks, savings and loan associations, credit unions, finance companies, money market funds, mortgage banks, insurance companies, investment banking firms, brokerage firms and other nonbank institutions that provide one or more of the services offered by the Corporation's subsidiaries. In addition to national and regional economic problems, the banking industry is in a period of consolidation and regulatory reform that will affect banks in all regions of the country. The Corporation does not believe that there will be any material effect on capital expenditures, results of operations, financial condition or the competitive position of itself or any of its subsidiaries with regard to compliance with federal, state or local requirements related to the general protection of the environment. Employees As of December 31, 1993, the Corporation and its subsidiaries employed 10,060 persons (full-time equivalent). Supplementary Information The following supplementary information, some of which is required under Guide 3 (Statistical Disclosure by Bank Holding Companies), is found in this report on the pages indicated below, and should be read in conjunction with the related financial statements and notes thereto. Selected Financial Data Rate-volume Analysis Credit Risk Management Loan Portfolio Nonaccruing Loans, Restructured Loans and Accruing Loans Past Due 90 Days or More Loan Loss Experience Provision and Reserve for Loan Losses Foreclosed Properties Maturity of Loans Maturity of Securities Securities Consolidated Short-term Borrowings Domestic Time Deposits of $100 Thousand or More Consolidated Average Balance Sheet, Net Interest Income and Interest Rates ITEM 2. ITEM 2. Properties. The principal offices of the Corporation are located at 777 Main Street, Hartford, Connecticut and One Federal Street, Boston, Massachusetts. Properties and land owned and used by the Corporation and its subsidiaries had a net book value at December 31, 1993 of $198.9 million. None of these properties is subject to any material encumbrance. The Corporation and its subsidiaries lease properties from other parties and, during 1993, paid rentals of $46.0 million on these properties, net of subleases of $1.5 million. See Note 5 (Premises and Equipment) to the consolidated financial statements, which appears in Part II, Item 8, and on page of this report. The premises occupied or leased by the Corporation and its subsidiaries are considered to be well located and suitably equipped to serve as banking facilities. Neither the location of any particular office nor the unexpired term of any lease is deemed material to the business of the Corporation. ITEM 3. ITEM 3. Legal Proceedings. The Corporation and certain of its officers and directors were named as defendants in certain purported class action and derivative lawsuits filed during 1990 and 1991. Among other things, the complaints in the actions alleged violations of federal securities laws and negligent misrepresentation based upon certain allegedly false and misleading public statements relating to the Corporation's financial position and omissions in the Corporation's public reports, as well as breach of fiduciary duty by the Corporation's board of directors and senior executives. The Corporation and the plaintiffs entered into a settlement that was approved by the Court on October 27, 1992 as fair, reasonable and adequate after notice to all shareholders and members of an agreed upon class in the actions (which was defined to include all purchasers of the Corporation's common stock between December 8, 1988 and January 24, 1991) and a hearing. All claims have been dismissed with prejudice. The settlement provides that the Corporation will distribute to the members of the class who file proofs of claims that are approved by the court warrants to purchase the Corporation's common stock. The warrants will have an exercise price equal to the average closing price of the Corporation's common stock for a fixed period prior to the distribution, shall be listed on a national securities exchange, shall be freely tradable upon issuance and shall be exercisable for a period of one year, beginning one year after the warrants are distributed to class members. As a part of the settlement, defendants agreed to pay the costs of identifying and providing notice to members of the class and all costs associated with issuance of the warrants and the shares of common stock underlying the warrants and certain fees and expenses of plaintiffs. On January 7, 1994, the Corporation entered into a warrant agreement that provides for the issuance of 1,329,115 shares of the Corporation's common stock. The warrants were issued January 18, 1994 with an exercise price of $22.11. The warrants are traded on the New York Stock Exchange. Defendants vigorously denied all allegations of wrongdoing in these actions, and agreed to settle these actions solely to avoid the time and expense of contesting this burdensome litigation. The settlement did not have a material effect on the Corporation's results of operations or financial condition. During 1993, Shawmut Mortgage Company, which was then the Corporation's nonbank, mortgage lending subsidiary, was the subject of an investigation by the U.S. Department of Justice ("DOJ") and the Federal Trade Commission ("FTC") concerning possible discriminatory mortgage lending practices. On December 13, 1993, without admitting any wrongdoing, Shawmut Mortgage Company entered into a consent decree with the DOJ and the FTC regarding past lending practices. Pursuant to the consent decree, Shawmut Mortgage Company established a $960,000 monetary fund to compensate minority loan applicants who were denied mortgages between January 1990 and October 1992 but whose applications would be approved under the Corporation's more recent flexible underwriting criteria. This settlement did not have a material effect on the Corporation's results of operations or financial condition. As of December 31, 1993, full ownership of SMC was transferred to the Corporation's bank subsidiary, SBC. In addition, the Attorney General in the Commonwealth of Massachusetts started an investigation of Shawmut Mortgage Company for racial bias in its lending practices. The Corporation, together with the Massachusetts Bankers Association (the "MBA") and other banks in the region, resolved the investigation by agreeing to submit certain application files to an independent underwriting panel for review. Any applicants that the panel determines were impermissibly denied a loan will be given a $15,000 damage award. SMC will submit approximately 25 files for review. The MBA agreed to encourage its members to take affirmative lending measures, virtually all of which are currently in place at the Corporation. Shawmut Bank Connecticut, N.A., one of the Corporation's subsidiaries, which served as indenture trustee for certain healthcare receivable backed bonds issued by certain special purpose subsidiaries (the "Towers subsidiaries") of Towers Financial Corporation ("Towers"), has been named in a lawsuit filed in federal court in Manhattan by purchasers of the bonds. The suit seeks damages in an undetermined amount equal to the difference between the current value of the bonds and their face amount of approximately $200 million, plus interest, as well as punitive damages. The Towers subsidiaries defaulted on the bonds and Towers and the subsidiaries later filed for bankruptcy protection. The complaint, which also names as a defendant the company that issued a double-A rating on the bonds, alleges that Towers engaged in a massive fraud against bondholders which, according to the complaint, should have been detected at an early stage by the bond rating agency and the indenture trustee. The Corporation believes that its actions were not the cause of any loss by the bondholders, and it is vigorously defending the action. The Corporation is also subject to various other pending and threatened lawsuits in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the ultimate liability, if any, arising out of the other pending and threatened lawsuits will have a material effect on the Corporation's results of operations or 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. EXECUTIVE OFFICERS OF THE REGISTRANT All executive officers of the Corporation are appointed annually and serve at the pleasure of the board of directors. The terms of any positions in a subsidiary company extend until the next annual meeting of that company. The names, positions, ages and backgrounds of the Corporation's executive officers as of February 28, 1994 are set forth below. JOEL B. ALVORD, 55, is chairman, chief executive officer and a director of the Corporation, and a director of SBC and SBM. Mr. Alvord began his 30-year SBC tenure in 1963. He became an officer of SBC in 1965, a vice president in 1967, and executive vice president in 1976. During this period, he served in a variety of management positions with SBC, and from early 1978 to 1986 he served as president of SBC. From 1986 to 1988, Mr. Alvord served as chief executive officer of SBC; from 1986 to October 1992, as chairman of SBC; and from 1988 to October 1992, as chairman of SBM. In early 1978 he was elected president of HNC, and in 1986 he assumed the additional positions of chairman and chief executive officer of HNC. In early 1988, as part of the Reorganization, Mr. Alvord was appointed president and chief executive officer of the Corporation. In August 1988, Mr. Alvord assumed his current position as chairman and chief executive officer. Mr. Alvord has served as a director of the Corporation since 1987, SBC since 1978 and SBM since 1988. GUNNAR S. OVERSTROM, JR., 51, is president, chief operating officer and a director of the Corporation, and chairman, chief executive officer and a director of SBC and SBM. Mr. Overstrom joined SBC in 1975 as vice president of financial planning. He was promoted to senior vice president in 1977, and executive vice president and chief financial officer in 1979. He became chief financial officer of HNC in 1979, and a director and executive vice president of HNC in 1982. From 1986 to October 1992, Mr. Overstrom served as president of SBC. In 1988 Mr. Overstrom became chief executive officer of SBC, and in October 1992, he was also appointed chairman of SBC and chairman and chief executive officer of SBM. As part of the Reorganization in early 1988, Mr. Overstrom was named a vice chairman and chief financial officer of the Corporation. In August 1988, he was appointed president and chief operating officer of the Corporation. Mr. Overstrom has served as a director of the Corporation since 1987, SBC since 1986 and SBM since 1989. DAVID L. EYLES, 54, is a vice chairman and chief credit policy officer of the Corporation, and a vice chairman and a director of SBC and SBM. Mr. Eyles joined the Corporation in February 1992, following three months of working with the Corporation as a consultant. Between 1988 and late 1991, he was vice chairman and chairman of the credit policy committee at Mellon Bank Corporation/Mellon Bank, N.A. He served in a variety of executive management positions during his 27-year tenure at Chemical Bank, the most recent being executive vice president, chief credit officer and chairman of the credit policy committee. EILEEN S. KRAUS, 55, is a vice chairman of the Corporation, president and a director of SBC, and a vice chairman and a director of SBM. Mrs. Kraus joined SBC in 1979 as vice president of human resources planning and development, and was appointed senior vice president in 1980. In 1986, Mrs. Kraus was appointed to the position of executive vice president of SBC, responsible for consumer banking. She became the senior manager for consumer banking and marketing for the Corporation in 1988. In June 1990, Mrs. Kraus became vice chairman of SBC, and in January 1991, she became vice chairman of SBM. From January 1991 to May 1993, she was responsible for personal trust. Mrs. Kraus was appointed president of SBC in October 1992, and a vice chairman of the Corporation in January 1993. Mrs. Kraus has served as a director of SBC since June 1990, and as a director of SBM since May 1992. ALLEN W. SANBORN, 51, is a vice chairman of the Corporation, president and a director of SBM, and a vice chairman and a director of SBC. Mr. Sanborn joined the Corporation in May 1992 as a vice chairman of the Corporation and a vice chairman and director of SBM and SBC. In October 1992, Mr. Sanborn was appointed president of SBM. Prior to joining the Corporation, Mr. Sanborn was vice chairman of commercial markets (1990 to 1992) and executive vice president of real estate industries (1987 to 1990) at Bank of America. BHARAT BHATT, 50, is an executive vice president and chief financial officer of the Corporation and executive vice president of SBC and SBM. Mr. Bhatt joined SBC in September 1992 as executive vice president of credit administration. In December 1992, he became chief financial officer of the Corporation and in March 1993, was appointed an executive vice president of the Corporation. Prior to joining the Corporation, Mr. Bhatt was senior vice president of credit policy and portfolio management at Mellon Bank, N.A. (1989 to 1992), and vice president and head of less developed countries swap group at Chemical Bank (1986 to 1989). ALAN R. BUFFINGTON, 48, is an executive vice president and head of the corporate services group of SBC and SBM. Mr. Buffington joined SBC and SBM in August 1993 from Cigna Corporation, where he was senior vice president and head of systems for the employee benefits group from 1990 to 1993. He joined Cigna when it acquired Equicor - Equitable HCA Corporation in 1990, where he was head of technology and administration from 1986 to 1990. NIELS JENSEN, 47, is an executive vice president and head of the financial institutions business line of SBC and SBM. Mr. Jensen joined SBC and SBM in October 1993. From 1992 to 1993 he was senior vice president of corporate financial services at Northern Trust Company. He served in a variety of management positions during his 22-year tenure at Northern Trust Company, which included overall management of the bank's corporate cash management and correspondent services, and head of commercial banking operations and systems development. MICHAEL J. ROTHMEIER, 44, is executive vice president and head of the investment services business line of SBC and SBM. Mr. Rothmeier joined SBC and SBM in August 1992. From 1991 to 1992, Mr. Rothmeier was a member of the office of the president of Fidelity Investments, Inc. and was responsible for the financial, human resources, strategic planning, business implementation, systems technology and administrative functions of retail telephone operations of Fidelity Investments Inc. During 1990 and 1991, he was president and chief executive officer of Fidelity Retail Distribution Company and Fidelity Brokerage Services, Inc., and president of Fidelity Retail Marketing Services from 1989 to 1990. All of the named executive officers have been employed by the Corporation or one of its subsidiaries during the past five years, except for Messrs. Eyles, Sanborn, Bhatt, Buffington, Jensen and Rothmeier. There are no arrangements or understandings pursuant to which any of the above named executive officers were selected to serve in their respective capacities and no family relationships exist among any of them. PART II ITEM 5. ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Corporation's common stock is listed and traded principally on the New York Stock Exchange under the symbol "SNC." Information concerning the range of high and low sales prices for the Corporation's common shares for each quarterly period within the past two fiscal years, as well as the dividends declared for 1993, is set forth below. No dividends were declared for 1992. Dividends Quarter ended High Low Declared March 31 $23.88 $17.88 $.10 June 30 25.13 19.50 .10 September 30 26.38 22.50 .10 December 31 25.13 19.38 .20 March 31 $15.88 $ 8.88 - June 30 19.25 12.13 - September 30 18.75 13.38 - December 31 19.50 14.50 - As of February 22, 1994, the closing price of the Corporation's common stock on the New York Stock Exchange was $21.63 per share. As of that date, there were approximately 29,476 record holders of the Corporation's common stock. For a discussion of dividend restrictions on the Corporation's common stock, see Note 10 (Shareholders' Equity) and Note 16 (Regulatory Matters) to the consolidated financial statements on pages and of this report. ITEM 6. ITEM 6. Selected Financial Data. The information required by this item appears on page , under the caption "SELECTED FINANCIAL DATA," and is incorporated herein by reference. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information required by this item appears on pages through, under the caption "Financial Review," and is incorporated herein by reference. ITEM 8. ITEM 8. Financial Statements and Supplementary Data. The information required by this item appears on pages through, and on page under the caption "QUARTERLY CONSOLIDATED FINANCIAL INFORMATION (UNAUDITED)," and is incorporated herein by reference. ITEM 9. ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant. The information required by this item, to the extent not included under the caption "Executive officers of the registrant" in Part I of this report, or below, will appear under the caption "Election of directors" in the Corporation's 1994 proxy statement, and is incorporated herein by reference. ITEM 11. ITEM 11. Executive Compensation. The information required by this item will appear under the captions "Executive compensation" and "Transactions with directors and executive officers" in the Corporation's 1994 proxy statement, and is incorporated herein by reference. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. The information required by this item will appear under the caption "Common stock ownership" in the Corporation's 1994 proxy statement, and is incorporated herein by reference. ITEM 13. ITEM 13. Certain Relationships and Related Transactions. The information required by this item will appear under the caption "Transactions with directors and executive officers" in the Corporation's 1994 proxy statement, and is incorporated herein by reference. Also see Note 4 (Loans and Reserve for Loan Losses) to the consolidated financial statements on page of this report. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are part of this report and appear on the pages indicated. (1) Financial Statements: Management's Report Report of Independent Accountants Consolidated Statement of Income Consolidated Balance Sheet Consolidated Statement of Changes in Shareholders' Equity Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements (2) Financial Statement Schedules: Schedules are omitted because the information is either not required, not applicable or is included in Part II, Items 6-8 of this report. (3) Exhibits: The exhibits listed on the Exhibits Index on page 20 of this report are filed herewith or are incorporated herein by reference. (b) Reports on Form 8-K - The Corporation filed three reports on Form 8-K during the quarter ended December 31, 1993. The report dated November 16, 1993 (Items 5 and 7) reported that on November 16, 1993 the Corporation issued a press release relating to its application with the Board of Governors of the Federal Reserve System regarding its proposed acquisition of New Dartmouth Bank. The report filed a copy of the November 16, 1993 press release. The report dated December 1, 1993 (Items 5 and 7), reported that: (1)On December 2, 1993, the Massachusetts Bankers Association ("MBA") announced an agreement in principle with the Attorney General of Massachusetts, to resolve legal issues arising out of Civil Investigative Demands that were served on numerous financial institutions in Massachusetts. The agreement in principle, dated December 1, 1993, provides that institutions from which mortgage loan application files were sought will turn those files over to a three member panel for review to determine whether the applications were unfairly denied and whether the loans should have been approved using 1990 secondary market mortgage lending standards. Any individual whose loan application is determined to have been unfairly denied is entitled to receive $15,000. The Attorney General sought a total of 25 files from Shawmut Mortgage Company. The MBA also agreed to use its best efforts to encourage its members to engage in certain affirmative lending activities, virtually all of which Shawmut Mortgage Company currently makes available to consumers. The settlement will not have a material effect on Shawmut Mortgage Company or on the Corporation; (2)On December 13, 1993, the Corporation issued a press release relating to Shawmut Mortgage Company's announcement that it had entered a consent decree in U.S. District Court with the U.S. Department of Justice and the Federal Trade Commission regarding past lending practices. The report filed a copy of the December 13, 1993 press release; and (3)On December 20, 1993, the Corporation and New Dartmouth Bank announced a revision to their previously announced merger agreement extending the deadline for completing the transaction to June 30, 1994. The report filed the December 20, 1993 press release. The report dated December 20, 1993 (Item 7), filed: (1)Consent of Independent Accountants of New Dartmouth Bank; (2)Consent of Independent Auditors of Peoples Bancorp of Worcester, Inc. and Subsidiaries; (3)Consent of Independent Auditors of Gateway Financial Corporation and Subsidiaries; (4)Unaudited Financial Information of New Dartmouth Bank as of September 30, 1993; (5)Financial Statements of New Dartmouth Bank as of June 30, 1993; (6)Unaudited Financial Information of Peoples Bancorp of Worcester, Inc. and Subsidiaries as of September 30, 1993; (7)Financial Statements of Peoples Bancorp of Worcester, Inc. and Subsidiaries as of December 31, 1992; (8)Unaudited Financial Information of Gateway Financial Corporation and Subsidiaries as of September 30, 1993; (9)Financial Statements of Gateway Financial Corporation and Subsidiaries as of December 31, 1992; and (10)Shawmut National Corporation and Subsidiaries/ New Dartmouth Bank; Peoples Bancorp of Worcester, Inc. and Subsidiaries and Gateway Financial Corporation and Subsidiaries Unaudited Pro Forma Condensed Financial Information. (c) The exhibits listed on the Exhibits Index on page 20 of this report are filed herewith or are incorporated herein by reference. 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 "Act"), the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 No. 33-20387 (filed March 1, 1988) and 33-17765-02 (filed September 27, 1988). Insofar as indemnification for liabilities arising under the Act 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 Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 1, 1994. SHAWMUT NATIONAL CORPORATION By (Joel B. Alvord) ----------------------------- Joel B. Alvord 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 indicated on March 1, 1994. (Joel B. Alvord) (Robert J. Matura) --------------------------------- ----------------------------- Joel B. Alvord Robert J. Matura Chairman, Chief Executive Director Officer and Director (Gunnar S. Overstrom, Jr.) --------------------------------- ----------------------------- Gunnar S. Overstrom, Jr. Lois D. Rice President, Chief Operating Director Officer and Director (Stillman B. Brown) --------------------------------- ----------------------------- Stillman B. Brown Maurice Segall Director Director (John T. Collins) (Paul R. Tregurtha) --------------------------------- ----------------------------- John T. Collins Paul R. Tregurtha Director Director (Ferdinand Colloredo-Mansfeld) (Wilson Wilde) ---------------------------------- ----------------------------- Ferdinand Colloredo-Mansfeld Wilson Wilde Director Director (Bernard M. Fox) (Bharat Bhatt) ---------------------------------- ---------------------------- Bernard M. Fox Bharat Bhatt Director Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) ---------------------------------- Herbert W. Jarvis Director EXHIBITS INDEX FILED AS PART OF THIS REPORT ON FORM 10-K Sequentially Numbered Designation Description Page 3.1 Restated certificate of incorporation (incorporated by reference to Exhibit 3.1 to Registration Statement No. 33-17765 filed on October 7, 1987) N/A 3.2 By-laws, as amended on September 23, 1993 (incorporated by reference to the Corporation's Form 10-Q for the quarter ended September 30, 1993) N/A 3.3 Designation of adjustable rate preferred stock (incorporated by reference to Exhibit 3.1 to Registration Statement No. 33-17765, filed on October 7, 1987) N/A 3.4 Certificate of designation of 9.30% cumulative preferred stock (without par value, $250 stated value) (incorporated by reference to the Corporation's current report on Form 8-K, dated October 27, 1992, File No. 1-10102) N/A 3.5 Certificate of correction of certificate of designation of 9.30% cumulative preferred stock dated November 13, 1992 (incorporated by reference to Exhibit No. 4 to the Corporation's Form 10-Q for the period ended September 30, 1992, File No. 1-10102) N/A 3.6 Amended certificate of designation of 9.30% cumulative preferred stock, dated November 30, 1992 (incorporated by reference to the Corporation's annual report for 1992 on Form 10-K) N/A 4.1 Restated certificate of incorporation, articles fourth and seventh (incorporated by reference to Exhibit 3.1 to Registration Statement No. 33-17765 filed on October 7, 1987) N/A 4.2 By-laws, as amended on September 23, 1993 (incorporated by reference to the Corporation's Form 10-Q for the quarter ended September 30, 1993) N/A Sequentially Numbered Designation Description Page 4.3 The indentures and other instruments defining the rights of holders of long-term debt of the Corporation and its consolidated subsidiaries are omitted pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K. The Corporation agrees to furnish copies of such indentures and other instruments to the Commission upon request N/A 4.4 Shareholder rights plan (incorporated by reference to Form 8-A Registration Statement dated March 7, 1989, File No. 1-10102) N/A 4.5 Designation of adjustable rate preferred stock (incorporated by reference to Exhibit 3.1 to Registration Statement No. 33-17765, filed on October 7, 1987) N/A 4.6 Certificate of designation of 9.30% cumulative preferred stock (without par value, $250 stated value) (incorporated by reference to the Corporation's current report on Form 8-K, dated October 27, 1992, File No. 1-10102) N/A 4.7 Certificate of correction of certificate of designation of 9.30% cumulative preferred stock dated November 13, 1992 (incorporated by reference to Exhibit No. 4 to the Corporation's Form 10-Q for the period ended September 30, 1992, File No. 1-10102) N/A 4.8 Amended certificate of designation of 9.30% cumulative preferred stock, dated November 30, 1992 (incorporated by reference to the Corporation's annual report for 1992 on Form 10-K) N/A 4.9 Form of depositary share representing a one-tenth interest in a share of 9.30% preferred stock (incorporated by reference to the Corporation's current report on Form 8-K, dated October 27, 1992) N/A 4.10 Form of 9.30% preferred stock (incorporated by reference to the Corporation's current report on Form 8-K, dated October 27, 1992) N/A Sequentially Numbered Designation Description Page 4.11 Deposit agreement, dated as of November 3, 1992, among the Corporation, Chemical Bank, as depositary, and the holders from time to time of the depositary receipts (incorporated by reference to the Corporation's current report on Form 8-K, dated October 27, 1992) N/A *10.1 Stock option and restricted stock award plan (incorporated by reference to Form S-8 Registration Statement No. 33-20387 filed on March 1, 1988), as amended March 28, 1989 and January 28, 1993 (incorporated by reference to the Corporation's annual report for 1992 on Form 10-K) N/A *10.2 Form of executive employment agreement dated February 23, 1988 (incorporated by reference to the Corporation's Form 10-Q for the quarter ended March 31, 1988), as amended effective June 27, 1989 (incorporated by reference to the Corporation's annual report for 1990 on Form 10-K), as amended effective January 22, 1993 (incorporated by reference to the Corporation's annual report for 1992 on Form 10-K) N/A *10.3 Form of executive severance agreement dated February 23, 1988 (incorporated by reference to the Corporation's Form 10-Q for the quarter ended March 31, 1988), as amended effective June 27, 1989 (incorporated by reference to the Corporation's annual report for 1990 on Form 10-K) N/A *10.4 Form of executive severance agreement dated July 15, 1987, as amended July 27, 1989 (incorporated by reference to the Corporation's annual report for 1990 on Form 10-K) N/A *10.5 Deferred compensation plan for directors of Shawmut National Corporation effective February 23, 1988 (incorporated by reference to the Corporation's annual report for 1990 on Form 10-K) N/A *10.6 Shawmut National Corporation 1989 nonemployee directors' restricted stock plan effective April 25, 1989 (incorporated by reference to the Corporation's 1989 Proxy Statement dated March 13, 1989 and filed with the Securities and Exchange Commission) N/A Sequentially Numbered Designation Description Page *10.7 Shawmut National Corporation executive supplemental retirement plan effective July 1, 1990 (incorporated by reference to the Corporation's annual report for 1990 on Form 10-K) N/A *10.8 Shawmut National Corporation performance unit plan, as amended June 27, 1989 (incorporated by reference to the Corporation's annual report for 1990 on Form 10-K) N/A *10.9 Shawmut National Corporation executive group life insurance plan, as adopted September 10, 1991, effective October 31, 1991 (incorporated by reference to the Corporation's Form 10-Q for the quarter ended September 30, 1991) N/A *10.10 Shawmut National Corporation split-dollar life insurance plan, as adopted September 10, 1991, effective October 31, 1991, as amended and restated as of November 24, 1992 (incorporated by reference to the Corporation's current report on Form 8-K dated February 28, 1994, File No. 1-10102) N/A *10.11 Form of executive employment agreement dated March 1, 1992 (incorporated by reference to the Corporation's annual report for 1992 on Form 10-K) N/A *10.12 Form of executive employment agreement dated May 11, 1992 (incorporated by reference to the Corporation's annual report for 1992 on Form 10-K) N/A 12 Statements re computation of ratios 106 21 Principal subsidiaries 107 23 Consent of independent accountants 108 99.1 Notice of annual meeting of shareholders, April 26, 1994, and proxy statement to be filed within 120 days of the Corporation's fiscal year end pursuant to General Instruction G(3) of Form 10-K N/A Sequentially Numbered Designation Description Page 99.2 Shawmut National Corporation press release dated February 10, 1994, announcing the signing of a definitive agreement to purchase ten branches of Northeast Savings, F.A. located in Eastern Massachusetts and in Rhode Island 109 _______________________________________________ *Denotes management contract or compensation plan or arrangement. SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES MANAGEMENT'S REPORT MANAGEMENT'S REPORT The financial statements of Shawmut National Corporation and its subsidiaries have been prepared by management in accordance with generally accepted accounting principles. The supplementary financial data included in this annual report were also prepared by management and are consistent with the data included in the financial statements. The Corporation maintains a system of internal accounting controls intended to provide reasonable assurance that transactions are executed in accordance with corporate authorization and are properly recorded and reported in the financial statements and that assets are safeguarded. The concept of reasonable assurance recognizes that the cost of a system of internal accounting controls should not exceed the benefits derived. Such costs and benefits are not usually quantifiable and, accordingly, depend upon estimates and judgment. The internal control environment includes a framework of processes used to identify and monitor risk. Such processes include a corporate loan review staff to monitor compliance with prescribed lending and risk identification policies, an internal audit function which reviews, evaluates, monitors and makes recommendations on administrative and accounting control and a compliance function which establishes and monitors corporate-wide compliance with internal and regulatory policies. The financial statements have been reviewed by the audit committee of the Board of Directors, composed solely of outside directors. The committee recommends to the board the engaging, subject to shareholder approval, of the Corporation's independent accountants and reviews with the independent accountants the scope and results of the audit of the financial statements. The committee also reviews the scope and results of the Corporation's internal audit activities, the results of reviews performed by the corporate loan review staff and the compliance function and other matters involving risk management. The financial statements have been audited by Price Waterhouse whose report follows. 26 SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Shawmut National Corporation In our opinion, the consolidated financial statements appearing on pages to of this report present fairly, in all material respects, the financial position of Shawmut National Corporation and its subsidiaries at December 31, 1993 and 1992, 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 Corporation's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 1 to the consolidated financial statements, in 1993 the Corporation changed its methods of accounting for investments in debt and equity securities, postretirement benefits other than pensions, postemployment benefits and income taxes. (PRICE WATERHOUSE) Hartford, Connecticut January 19, 1994 27 28 30 31 SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of Shawmut National Corporation and its subsidiaries (the Corporation) are in conformity with generally accepted accounting principles followed within the banking industry. Certain amounts for prior years have been reclassified to conform to current year presentation. The significant accounting policies followed by the Corporation are summarized below. PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of Shawmut National Corporation and its subsidiaries after elimination of material intercompany balances and transactions. TRADING ACCOUNT SECURITIES - Trading account securities include debt securities that are purchased and held principally for the purpose of selling them in the near term and are stated at fair value, as determined by quoted market prices. Gains and losses realized on the sale of trading account securities and adjustments to fair value are included in trading account profits. RESIDENTIAL MORTGAGES HELD FOR SALE - Residential mortgages held for sale are primarily one to four family real estate mortgage loans which are reported at the lower of cost or market, as determined by outstanding commitments from investors or current investor yield requirements, calculated on an aggregate basis. Forward mandatory, standby and put option contracts are entered into to limit market risk on residential mortgages held for sale. Gains and losses from sales of residential mortgages held for sale are recognized upon settlement with investors and recorded in noninterest income. These activities, together with underwriting and servicing of residential mortgage loans, comprise the Corporation's mortgage banking business. SECURITIES - The Corporation adopted, as of December 31, 1993, Statement of Financial Accounting Standards (FAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as held to maturity and reported at cost, adjusted for the amortization of premiums and accretion of discounts. Debt and equity securities which are not classified as held to maturity or as trading securities are classified as available for sale and reported at fair value, with unrealized gains and losses excluded from the results of operations and reported as a separate component of shareholders' equity, net of income taxes. See "Note 3 - Securities". Prior to adoption of this new accounting standard, debt securities that were to be held for indefinite periods of time, including securities that management intended to use as part of its asset/liability strategy or that may be sold in response to changes in interest rates, prepayment risk or other factors, were reported at the lower of aggregate cost or fair value. Changes in net unrealized losses were included in the Corporation's results of operations. Equity securities were stated at the lower of aggregate cost or fair value with net unrealized losses reported as a reduction of retained earnings. Fair values of securities are determined by prices obtained from independent market sources. Realized gains and losses on securities sold are computed on the identified cost basis on the trade date and are included in the results of operations. 32 FOREIGN EXCHANGE TRADING - Foreign exchange trading positions, including spot, forward and option contracts, are reported at market value. The resulting realized and unrealized gains and losses from foreign exchange trading are included in other noninterest income. INTEREST RATE INSTRUMENTS - Interest rate instruments, such as futures contracts and forward rate agreements, are used in conjunction with foreign exchange trading activities. These instruments are carried at market value with realized and unrealized gains and losses recognized currently in other noninterest income. Interest rate swap and cap agreements and futures contracts are used to manage the Corporation's interest rate risk. The periodic net settlements on interest rate swap and cap agreements are recorded as an adjustment to interest expense. Deferred gains or losses on futures contracts are amortized over the expected remaining life of the underlying asset or liability. The Corporation also utilizes combination options, which involve a group of options consisting of at least one put and one call entered into as a unit in relation to specific underlying securities classified as available for sale, in order to limit the market risk of the securities. The market value of the options are included with the valuation of securities available for sale. LOANS - Loans are stated at the principal amounts outstanding, net of unearned income. Interest on undiscounted loans is recognized primarily utilizing the simple interest method based upon the principal amount outstanding. Interest on discounted loans is recognized utilizing the effective yield method. The net amount of loan origination and commitment fees and direct costs incurred to underwrite and issue a loan are deferred and amortized as an adjustment of the related loan's yield over the contractual life of the loan in a manner which approximates the interest method. When a loan is past due 90 days or more or the ability of the borrower to repay principal or interest is in doubt, the Corporation discontinues the accrual of interest and reverses any unpaid accrued amounts. If there is doubt as to subsequent collectibility, cash interest payments are applied to reduce principal. A loan is not restored to accruing status until the borrower has brought the loan current and demonstrated the ability to make payments of principal and interest, and doubt as to the collectibility of the loan is not present. The Corporation may continue to accrue interest on loans past due 90 days or more which are well secured and in the process of collection. Restructured loans are loans with original terms which have been modified as a result of a change in the borrower's financial condition. Interest income on restructured loans is accrued at the modified rates. A commitment to extend credit is a binding agreement to make a loan to a customer in the future if certain conditions are met and is subject to the same risk, credit review and approval process as a loan. Many commitments expire without being used and, therefore, do not represent future funding requirements. 33 SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES RESERVE FOR LOAN LOSSES - The reserve for loan losses is maintained at a level determined by management to be adequate to provide for probable losses inherent in the loan portfolio, including commitments to extend credit. The reserve is maintained through the provision for loan losses, which is a charge to operations. When a loan, or a portion of a loan, is considered uncollectible, the loss is charged to the reserve. Recoveries of previously charged off loans are credited to the reserve. The potential for loss in the portfolio reflects the risks and uncertainties inherent in the extension of credit. The determination of the adequacy of the reserve is based upon management's assessment of risk elements in the portfolio, factors affecting loan quality and assumptions about the economic environment in which the Corporation operates. The process includes identification and analysis of loss potential in various portfolio segments utilizing a credit risk grading process and specific reviews and evaluations of significant individual problem credits. In addition, management reviews overall portfolio quality through an analysis of current levels and trends in charge-off, delinquency and nonaccruing loan data, and a review of forecasted economic conditions and the overall banking environment. These reviews are of necessity dependent upon estimates, appraisals and judgments, which may change quickly because of changing economic conditions, and the Corporation's perception as to how these factors may affect the financial condition of debtors. PREMISES AND EQUIPMENT - Premises, leasehold improvements and equipment are stated at cost less accumulated depreciation and amortization computed primarily on the straight-line method. Depreciation of buildings and equipment is based on the estimated useful lives of the assets. Amortization of leasehold improvements is based on the term of the related lease or the estimated useful lives of the improvements, whichever is shorter. Major renewals and betterments are capitalized and recurring repairs and maintenance are charged to operations. Gains or losses on dispositions of premises and equipment are included in income as realized. FORECLOSED PROPERTIES - Properties acquired through foreclosure or in settlement of loans and in-substance foreclosures are classified as foreclosed properties and are valued at the lower of the loan value or estimated fair value of the property acquired less estimated selling costs. An in-substance foreclosure occurs when a borrower has little or no equity in the collateral, repayment can only be expected to come from the operation or sale of the collateral and the borrower has effectively abandoned the collateral or has doubtful ability to rebuild equity in the collateral. At the time of foreclosure the excess, if any, of the loan value over the estimated fair value of the property acquired less estimated selling costs is charged to the reserve for loan losses. Additional decreases in the carrying values of foreclosed properties or changes in estimated selling costs, subsequent to the time of foreclosure, are recognized through a provision charged to operations. A valuation reserve is maintained for estimated selling costs and to record the excess of the carrying values over the fair market values of properties if changes in the carrying values are judged to be temporary. The fair value of foreclosed properties is determined based upon appraised value, which primarily utilizes the selling price of properties for similar purposes, or discounted cash flow analyses of the properties' operations. GOODWILL - The excess cost over the fair value of net assets acquired from acquisitions accounted for as purchases is included in other assets and amortized on a straight-line basis over periods of up to 25 years. 34 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PENSION AND OTHER EMPLOYEE BENEFIT PLANS - The Corporation maintains a noncontributory defined benefit pension plan, which covers substantially all full-time employees. Pension expense is based upon an actuarial computation of current and future benefits for employees. The pension plan is funded annually in an amount consistent with the funding requirements of federal law and regulations. The Corporation adopted FAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", effective January 1, 1993. The Corporation sponsors postretirement health care and life insurance benefit plans that provide health care and life insurance benefits for retired employees that have met certain age and service requirements. Postretirement health care and life insurance benefits expense is based upon an actuarial computation of current and future benefits for employees and retirees. See "Note 11 - Pension and Other Employee Benefit Plans". The Corporation also adopted FAS No. 112, "Employers' Accounting for Postemployment Benefits", during the fourth quarter of 1993, retroactive to January 1, 1993. The Corporation provides disability and workers' compensation related benefits to former or inactive employees after employment but before retirement and had also provided supplemental severance benefits to certain former employees. Postemployment benefits expense is determined based upon various criteria depending on the type of benefit. See "Note 11 - Pension and Other Employee Benefit Plans". INCOME TAXES - The Corporation adopted FAS No. 109, "Accounting for Income Taxes", prospectively, effective January 1, 1993. Income tax expense is based on estimated taxes payable or refundable on a tax return basis for the current year and the changes in the amount of deferred tax assets and liabilities during the year. Deferred tax assets and liabilities are established for temporary differences between the accounting basis and the tax basis of the Corporation's assets and liabilities at enacted tax rates expected to be in effect when the amounts related to such temporary differences are realized or settled. Prior to January 1, 1993, the Corporation recognized income taxes based on income reported in the financial statements. See "Note 13 - Income Taxes". PER COMMON SHARE CALCULATIONS - Income (loss) per common share is calculated by dividing net income (loss) less preferred stock dividends by the weighted average common shares outstanding for each period presented. CASH FLOWS STATEMENT - For the purpose of reporting cash flows, the Corporation has defined cash equivalents as those amounts included in the balance sheet caption "Cash and due from banks". FAIR VALUE OF FINANCIAL INSTRUMENTS - FAS No. 107, "Disclosures about Fair Value of Financial Instruments", requires the disclosure of the fair value of financial instruments. A financial instrument is defined as cash, evidence of an ownership interest in an entity, or a contract that conveys or imposes the contractual right or obligation to either receive or deliver cash or another financial instrument. Examples of financial instruments included in the Corporation's balance sheet are cash, federal funds sold or purchased, debt and equity securities, loans, demand, savings and other interest-bearing deposits, notes and debentures and foreign exchange contracts. Examples of financial instruments which are not included in the Corporation's balance sheet are commitments to extend credit, standby letters of credit, loans sold with recourse and interest rate swap, cap and option agreements. Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced sale or liquidation, and is best evidenced by a quoted market price if one exists. 35 SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES The statement requires the fair value of deposit liabilities with no stated maturity, such as demand deposits, NOW and money market accounts, to equal the carrying value of these financial instruments and does not allow for the recognition of the inherent value of core deposit relationships, when determining fair value. While the statement does not require disclosure of the fair value of nonfinancial instruments, such as the Corporation's premises and equipment, its banking and trust franchises and its core deposit relationships, the Corporation believes these nonfinancial instruments have significant fair value. The Corporation has estimated fair value based on quoted market prices where available. In cases where quoted market prices were not available, fair values were based on the quoted market price of a financial instrument with similar characteristics, the present value of expected future cash flows or other valuation techniques. Each of these alternative valuation techniques utilize assumptions which are highly subjective and judgmental in nature. Subjective factors include, among other things, estimates of cash flows, the timing of cash flows, risk and credit quality characteristics and interest rates. Accordingly, the results may not be precise and modifying the assumptions may significantly affect the values derived. In addition, fair values established utilizing alternative valuation techniques may or may not be substantiated by comparison with independent markets. Further, fair values may or may not be realized if a significant portion of the financial instruments were sold in a bulk transaction or a forced liquidation. Therefore, any aggregate unrealized gains or losses should not be interpreted as a forecast of future earnings or cash flows. Furthermore, the fair values disclosed should not be interpreted as the aggregate current value of the Corporation. The fair value of financial instruments is disclosed in the related notes to the consolidated financial statements except for time deposits, which is disclosed below. The methodology and assumptions utilized to estimate the fair value of the Corporation's financial instruments, not previously discussed in the policy statements above, are described below. Financial instruments with fair value approximate to carrying value - The carrying value of cash and due from banks, interest-bearing deposits in other banks, federal funds sold and securities purchased under agreements to resell, residential mortgages held for sale, demand deposits, savings, NOW and money market deposits, foreign time deposits, other borrowings and accrued interest income and expense approximates fair value due to the short-term nature of these financial instruments. Loans - The fair value of loans was estimated for groups of similar loans based on the type of loan, interest rate characteristics, credit risk and maturity. The fair value of performing fixed-rate commercial and commercial real estate loans was estimated by discounting expected future cash flows utilizing risk-free rates of return, adjusted for credit risk and servicing costs. The carrying value of performing variable-rate commercial and commercial real estate loans was estimated to approximate fair value due to the short-term and frequent repricing characteristics of these loans. Prepayments were not anticipated for either fixed-rate or variable-rate commercial and commercial real estate loans. The fair value of performing residential mortgage, home equity and installment loans was estimated utilizing quoted market values for securities backed by similar loans. The fair value of nonaccruing loans was estimated by discounting expected future cash flows utilizing risk-free rates of returns, adjusted for credit risk and servicing costs commensurate with a portfolio of nonaccruing loans. 36 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deposits - The fair value of time deposits with fixed maturities was estimated by discounting expected future cash flows utilizing interest rates currently being offered on deposits with similar characteristics and maturities. The fair value of these deposits was approximately $3.4 billion and $4.3 billion at December 31, 1993 and 1992, respectively. Notes and debentures - The fair value of notes and debentures was estimated based on quoted market prices. Off-balance sheet financial instruments - The fair value of interest rate swap agreements was based on the amount the Corporation would receive or pay to terminate the agreements as of the reporting date based on the terms of the agreements, the creditworthiness of the counterparties and interest rates. The fair value of commitments to extend credit and standby letters of credit was determined based on the discounted value of fees currently charged for similar agreements. The fair value of other off-balance sheet financial instruments, such as interest rate cap and option agreements, was based on quoted market prices. NOTE 2 - ACQUISITIONS The Corporation announced during 1993 the signing of definitive agreements to acquire three banking organizations: New Dartmouth Bank of Manchester, New Hampshire, with assets of $1.7 billion at year end, was announced on March 24, 1993; Peoples Bancorp of Worcester, Inc. of Worcester, Massachusetts, with assets of $891.1 million at year end, was announced on August 26, 1993; and Gateway Financial Corporation of Norwalk, Connecticut, with assets of $1.3 billion at year end, was announced on November 5, 1993. The transactions will be accounted for as poolings of interests and are subject to approvals by the shareholders of the respective banks and federal and state regulatory agencies. On November 15, 1993, the Federal Reserve Board issued an order not approving the Corporation's application to acquire New Dartmouth Bank. The Federal Reserve Board cited a then-pending investigation of possible discriminatory lending at Shawmut Mortgage Company, the Corporation's mortgage banking subsidiary, by the United States Department of Justice (DOJ) and the Federal Trade Commission (FTC). The Federal Reserve Board further stated that in order to obtain approval, the Corporation would need to submit evidence of compliance with fair lending laws and accurate reporting pursuant to the Home Mortgage Disclosure Act. As discussed further in "Note 15 - Litigation", Shawmut Mortgage Company entered into a consent decree with the DOJ and FTC regarding past lending practices and established a $960 thousand monetary fund to compensate minority loan applicants who were denied mortgages between January 1990 and October 1992 but whose applications would be approved under the Corporation's more recent flexible underwriting criteria. The Federal Reserve Board has granted the Corporation an extension of time until March 1, 1994 within which to resubmit a petition requesting reconsideration of the Federal Reserve Board's November 15, 1993 decision. The amended New Dartmouth Bank merger agreement, dated December 20, 1993, provides for the establishment of an escrow fund which would be paid to New Dartmouth Bank in the event that the transaction is not consummated by June 30, 1994 and New Dartmouth Bank is not in breach of certain provisions of the agreement. Required deposits to the escrow fund will equal $10 million by May 1, 1994. The Corporation anticipates that the New Dartmouth Bank acquisition and the other transactions will be completed during 1994. 37 SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES The net unrealized gain on securities classified as available for sale at December 31, 1993 of $9.7 million, which is net of income taxes of $5.2 million, is reported as a separate component of shareholders' equity. U.S. Treasury securities with an aggregate carrying amount of $786.0 million, included in the table above, were subject to combination options at December 31, 1993, which limited the risk of changes in the market value of these securities. U.S. Treasury securities with a carrying amount of $311.0 million were put to the counterparty on January 5, 1994 upon expiration of the option, resulting in no realized gain or loss. The combination options on the remainder of the securities expired on January 6, 1994, unexercised by either party. 38 Securities with a carrying amount of $6.3 billion were pledged to secure public deposits, borrowings and for other purposes required by law at December 31, 1993. Proceeds from sales of debt securities during 1993, 1992 and 1991 totaled approximately $4.4 billion, $4.5 billion and $2.6 billion, respectively, and resulted in gains of $11.2 million, $85.7 million and $86.8 million. The fair value of the Corporation's loan portfolio was approximately $15.4 billion and $14.7 billion at December 31, 1993 and 1992, respectively. Loans outstanding to directors, executive officers, principal holders of equity securities or to any of their associates totaled $22.2 million at December 31, 1993 and $17.6 million at December 31, 1992. A total of $48.2 million in loans were made or added, while a total of $43.6 million were repaid or deducted during 1993. Changes in the composition of the board of directors or the group comprising executive officers result in additions to or deductions from loans outstanding to directors, executive officers or principal holders of equity securities. 40 Interest income related to nonaccruing and restructured loans would have been approximately $42.8 million in 1993 and $72.1 million in 1992 had these loans been current and the terms of the loans had not been modified. Interest income recorded on these loans totaled approximately $9.6 million in 1993 and $25.1 million in 1992. Interest income received on these loans and applied as a reduction of principal totaled approximately $14.4 million and $31.3 million in 1993 and 1992, respectively. The yield on the portfolio of restructured loans was 7.00 percent in 1993 and 7.85 percent in 1992. The Financial Accounting Standards Board issued FAS No. 114, "Accounting By Creditors for Impaired Loans", in May 1993. The new accounting standard will require that impaired loans, which are defined as loans where it is probable that a creditor will not be able to collect both the contractual interest and principal payments, be measured at the present value of expected future cash flows discounted at the loan's effective rate when assessing the need for a loss accrual. The new accounting standard is effective for the Corporation's financial statements beginning January 1, 1995. The effect on the Corporation of adopting this new accounting standard is currently being evaluated. 41 Depreciation and amortization expense of $48.6 million in 1993, $51.5 million in 1992 and $48.1 million in 1991 is included in occupancy expense or equipment expense, depending upon the nature of the asset. The Corporation occupies certain other premises and rents equipment, primarily data processing equipment, under leases that are accounted for as operating leases. These leases have expiration dates through 2023. Operating lease rentals aggregated $47.6 million in 1993, $52.1 million in 1992 and $54.8 million in 1991. Such amounts are recorded net of sublease income totaling $1.5 million in 1993 and $1.2 million in 1992 and 1991. The minimum rental commitments of the Corporation at December 31, 1993 under the terms of operating leases in excess of one year were as follows: $35.3 million in 1994; $31.0 million in 1995; $25.0 million in 1996; $19.2 million in 1997; $14.2 million in 1998; and $39.8 million after 1998. NOTE 6 - FORECLOSED PROPERTIES Foreclosed properties of $48.0 million and $244.4 million are stated net of reserves of $6.6 million and $34.5 million at December 31, 1993 and 1992, respectively. Provisions charged to operations for changes in the carrying value of foreclosed properties amounted to $68.1 million, $134.2 million and $77.1 million in 1993, 1992 and 1991, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Net deferred income taxes of $135.4 million at December 31, 1992 represent amounts computed under the prior accounting standard for income taxes. Effective January 1, 1993, net deferred income taxes computed under the new accounting standard were $188.2 million. The scheduled maturities of Federal Home Loan Bank of Boston borrowings are as follows: $802.0 million due in 1994 with interest rates at 3.20 to 3.97 percent; and $159.2 million due in 1995 and thereafter with interest rates at 4.12 to 9.01 percent. The fair value of the Corporation's notes and debentures was approximately $827.4 million and $828.4 million at December 31, 1993 and 1992, respectively. Both the 8 7/8% and 8 1/8% notes are unsecured obligations with interest payable semiannually. The floating rate subordinated notes bear interest at a rate of 3/8 percent above LIBOR (London Inter Bank Offered Rate). Both the 8 5/8% and 7.20% subordinated notes may not be redeemed prior to maturity. Interest is payable semiannually. The 7.20% subordinated notes were issued during April 1993. The agreement for the 9.85% subordinated capital notes provides that, on the maturity date of June 1, 1999, the notes, at the Corporation's option, will either be exchanged for common stock, preferred stock or certain other primary capital securities of the Corporation having a market value equal to the principal amount of the notes, or will be repaid from the proceeds of other issuances of such securities. The Corporation may, however, at its option, revoke its obligation to redeem the notes with capital securities based upon the capital treatment of the notes by its primary regulator or consent by its primary regulator for such revocation. The holders of the capital notes are subordinate in rights to depositors and other creditors. The Corporation redeemed the outstanding balances of the following notes with balances aggregating $85.2 million during 1993: 11 3/4% notes due 1995; 8 5/8% sinking fund debentures due 1999; 8 1/2% sinking fund debentures due 1996 and 8 1/8% promissory notes due 1998 included in other notes above. The redemption of these notes did not have a material effect on the Corporation's results of operations or financial condition. During 1993, the 8 1/4% notes matured and were fully paid. 44 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Certain of the Corporation's note and debenture agreements include provisions that limit the ability of the Corporation to sell the capital stock of its subsidiary banks or dispose of significant portions of assets of these subsidiaries. The Corporation has agreed to guarantee payment of certain notes and debentures of Hartford National Corporation totaling $149.9 million and of Shawmut Corporation totaling $249.6 million at December 31, 1993. See "Note 18 - Summarized Financial Information of Certain Note and Debenture Issuers". The scheduled maturities of the Corporation's notes and debentures for each of the next five years are as follows: $.4 million in 1994; $.4 million in 1995; $150.2 million in 1996; $150.4 million in 1997; $.5 million in 1998; and $457.0 million after 1998. NOTE 10 - SHAREHOLDERS' EQUITY The payment of dividends is determined by the Board of Directors in light of the earnings, capital levels, cash requirements and the financial condition of the Corporation and its subsidiaries, applicable government regulations and policies and other factors deemed relevant by the Board of Directors, including the amount of dividends payable to the Corporation by its subsidiary banks. Various federal laws, regulations and policies limit the ability of the Corporation's subsidiary banks to pay dividends. See "Note 16 - Regulatory Matters". Shawmut National Corporation's Board of Directors is authorized to issue up to 10,000,000 shares of preferred stock without par value in series and to determine the designation, dividend rates, redemption provisions, liquidation preferences, sinking fund provisions and all other rights of each series. Shawmut National Corporation had outstanding at December 31, 1993 a series of 575,000 shares of 9.30% Cumulative Preferred Stock with a stated value of $250 per share represented by Depositary Shares and a series of 700,000 shares of Preferred Stock with Cumulative and Adjustable Dividends with a stated value of $50 per share. Both series of preferred stock rank senior to the Corporation's common stock as to dividends and liquidation preference. The Depositary Shares represent a one-tenth interest in a share of 9.30% Cumulative Preferred Stock and are not subject to any mandatory redemption or sinking fund provisions. The 9.30% Cumulative Preferred Stock will be redeemable on at least 30 but not more than 60 days notice, at the option of the Corporation, as a whole or in part, at any time on and after October 15, 1997 at a redemption price equal to $250 per share plus dividends accrued and accumulated but unpaid to the redemption date. 45 SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES The dividend rate on the Preferred Stock with Cumulative and Adjustable Dividends is established quarterly and is based on a rate that is 2.25 percent below the highest interest rate of selected short- and long-term U. S. Treasury securities prevailing at the time the rate is set. The dividend rate for any dividend period will in no event be less than 6.00 percent or greater than 12.00 percent per annum. This series of preferred stock is redeemable, at the Corporation's option, at $50.00 per share. Dividends of $23.25 and $4.65 per share were declared on the 9.30% Cumulative Preferred Stock during 1993 and 1992, respectively. Dividends of $3.00, $3.01 and $3.23 per share were declared during 1993, 1992 and 1991, respectively, on the Preferred Stock with Cumulative and Adjustable Dividends. Dividends declared per common share were $.50 during 1993. There were no dividends declared on common shares during 1992 or 1991. The Corporation's Board of Directors previously adopted a rights plan which provides for the distribution of one right for each outstanding share of common stock. Each right entitles common stockholders to buy one-one hundredth of a newly issued share of Series A Junior Participating Preferred Stock of the Corporation at an exercise price of $100 per share, subject to adjustment. The rights, which will expire March 10, 1999, can be redeemed by the Corporation under certain circumstances at one cent per right. The rights become exercisable if certain events relating to the acquisition or proposed acquisition of common shares of the Corporation occur. When exercisable, under certain circumstances, each right will enable its holder to purchase, at the right's then current exercise price, common shares of the Corporation (or, under certain circumstances, a combination of cash, property, common shares or other securities) having a value of twice the right's exercise price. In addition, if thereafter the Corporation is involved in a merger or other business combination transaction with another person in which its shares are changed or exchanged, or if the Corporation sells more than 50 percent of its assets, cash flow, or earning power to another person or persons, each right (with certain exceptions) that has not previously been exercised will entitle its holder to purchase, at the right's then current exercise price, common shares of such other person having a value of twice the right's exercise price. Common shares totaling 19,716,617 at December 31, 1993 were reserved for issuance under the Dividend Reinvestment and Stock Purchase Plan and the Corporation's Stock Option and Restricted Stock Award Plan. In addition, approximately 25,438,198 common shares have been reserved for issuance relating to the Corporation's pending acquisitions. See "Note 2 - Acquisitions". In connection with the settlement of certain litigation, on January 18, 1994 the Corporation issued warrants for the purchase of up to 1,329,115 shares of common stock. The warrants have an exercise price of $22.11 per share, are listed on the New York Stock Exchange, are freely tradable and are exercisable for a period of one year, commencing January 18, 1995. See "Note 15 - Litigation". 46 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 11 - PENSION AND OTHER EMPLOYEE BENEFIT PLANS Pension and Thrift Plans - The Corporation has a noncontributory, qualified defined benefit pension plan covering substantially all full-time employees meeting certain requirements as to age and length of service. For those vested, the plan provides a monthly benefit upon retirement based on compensation during the five consecutive highest paid years of employment and years of credited service. It is the Corporation's policy to fund annually an amount consistent with the funding requirements of federal law and regulations and not to exceed an amount which would be deductible for federal income tax purposes. 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 assets of the plan are primarily invested in listed stocks. The Corporation also has supplemental retirement plans that cover certain employees and pay benefits that supplement any benefits paid under the qualified plan. Benefits under the supplemental plans are generally based on compensation not includible in the calculation of benefits to be paid under the qualified plan. SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES The Corporation's net pension income was $.2 million in 1993 and $3.0 million in 1992 and 1991. The Corporation also sponsors defined contribution plans covering substantially all employees. Contributions under such plans totaled $6.5 million in 1993, $6.1 million in 1992 and $6.4 million in 1991. Postretirement Health Care and Life Insurance Benefits - The Corporation sponsors four postretirement benefit plans that provide health care and life insurance benefits for retired employees that have met certain age and service requirements. One plan provides medical benefits and the other three plans provide life insurance benefits. The postretirement medical plan and one of the life insurance plans are contributory with contributions adjusted annually to reflect certain cost-sharing provisions of the plans. The remaining two postretirement life insurance plans are noncontributory. It is the Corporation's policy to fund the postretirement benefit plans as claims are paid. Plan assets represent the cash surrender value of life insurance policies related to one of the plans described above. The Corporation adopted FAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", effective January 1, 1993. This new accounting standard requires the expected cost of these postretirement health care and life insurance benefits to be accrued and charged to operations during the years the employees render the service. The Corporation is amortizing the transition obligation of $94.8 million on a straight-line basis over 20 years. The postretirement benefit expense for 1993 was $14.7 million. Previously, the the Corporation's postretirement benefits were expensed as claims were paid and totaled approximately $5.0 million for 1992 and $4.5 million for 1991. 48 The assumptions for medical costs and Medicare benefits trend to 5.0 percent by the year 2001 and remain constant thereafter. Increasing the assumed health care cost trend rate by one percentage point would increase the accumulated postretirement benefit obligation at December 31, 1993 by $5.6 million and increase the aggregate of the service and interest cost components of net periodic postretirement benefits expense for 1993 by $.8 million. SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES Postemployment Benefits - The Corporation provides disability and workers' compensation related benefits to former or inactive employees after employment but before retirement and had also provided supplemental severance benefits to certain former employees. The Corporation adopted, in the fourth quarter of 1993 retroactive to January 1, 1993, FAS No. 112, "Employers' Accounting for Postemployment Benefits". The new accounting standard requires that the cost of these benefits be accrued and charged to operations if the obligation is attributable to services already rendered, rights to such benefits accumulate or vest, payment of the benefits is probable and the amount of the benefits can be reasonably estimated. Previously, the Corporation's postemployment benefits were expensed as payments were made. The Corporation recognized an after-tax charge of $6.6 million recorded as a cumulative effect of a change in method of accounting for 1993 relating to the adoption of this new accounting standard. Stock Option and Restricted Stock Award Plan - The Corporation has a Stock Option and Restricted Stock Award Plan (the Plan), which provides for the granting of incentive and nonqualified stock options to certain employees for the purchase of Shawmut National Corporation common stock at 100 percent of fair market value at the date of grant. Options granted under the Plan are exercisable after a minimum of one year but within ten years of the date of grant. Also, options granted may be accompanied by stock appreciation rights (SARs) or limited stock appreciation rights (LSRs), or both. SARs and LSRs entitle the holder to receive payment equal to the increase in the market value of the common stock from the date of grant to the date of exercise. LSRs may be exercised only during the 60-day period following a change of control. SARs and LSRs may be granted only in tandem with stock options and may be paid in cash or common stock at the election of the employee. The Plan also provides for the granting of restricted stock and performance share units to certain key executives. A performance share unit represents an interest in a restricted share of common stock and any dividends declared. Grants of performance share units are determined using certain guidelines based on salary and responsibility levels, as well as predetermined performance criteria. A total of 7,600,000 shares of common stock have been reserved for the Plan, including the performance share units. Charges for the Plan related to restricted stock awards totaled $1.0 million in 1993 and $.8 million in 1992. There were no charges associated with the Plan in 1991. A grant of 308,200 shares of performance share units occurred on October 28, 1993, for the performance periods beginning January 1, 1994 through December 31, 1995. Compensation expense will be recognized based on the fair value of the performance share units over this period. At December 31, 1993, SARs had previously been issued in tandem with 605,000 outstanding stock options. Common stock issued relating to restricted stock awards amounted to 48,000 shares in 1993 and 226,000 shares in 1992. There were no restricted stock awards in 1991. NOTE 13 - INCOME TAXES The Corporation adopted FAS No. 109, "Accounting for Income Taxes" (FAS 109), prospectively, effective January 1, 1993. The Corporation's deferred tax asset (deferred tax assets less deferred tax liabilities) at December 31, 1992 was $135.4 million. The Corporation's deferred tax asset represents future deductible temporary differences attributable primarily to provisions for loan losses in excess of the deductible amounts for tax purposes. The Corporation's deferred federal tax asset recorded upon adoption of FAS 109 (prior to valuation allowance) at January 1, 1993 was $268.2 million. The income tax benefits of these deductible temporary differences recognized under FAS 109 were subjected to an evaluation of whether it was more likely than not that the income tax benefits will be realized and, as a result, a valuation allowance of $80.0 million was established, resulting in a net deferred tax asset of $188.2 million at January 1, 1993. The level of the valuation allowance reflected management's best judgment regarding the amounts and timing of future taxable income and the estimated reversal pattern of these temporary differences. Deferred state tax assets, net of the valuation allowance, were nil. The cumulative effect of this accounting change was the recognition of a $52.8 million income tax benefit in the first quarter of 1993. At December 31, 1993, the Corporation's deferred federal tax asset was $202.3 million. Based upon management's best judgment regarding the amounts and timing of future taxable income and the estimated pattern of temporary differences, no valuation allowance was recorded at year end. 52 Income tax expense associated with securities gains and losses, computed by applying the federal statutory rate of 35 percent (34 percent in 1992 and 1991) to securities transactions, was $2.0 million, $29.2 million and $26.6 million for the years ended December 31, 1993, 1992 and 1991, respectively. NOTE 14 - CONCENTRATIONS OF CREDIT RISK AND FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Corporation provides deposit and loan products and other financial services to consumer and commercial customers located principally in New England. The Corporation's loan portfolio at December 31, 1993 consisted of commercial and industrial loans (41 percent), consumer loans (41 percent), real estate investor/developer loans (9 percent) and owner-occupied commercial real estate loans (9 percent). Securities, short-term investments and off-balance sheet interest rate instruments, such as futures contracts and interest rate swaps, option and cap agreements, are among the financial instruments used by the Corporation in its balance sheet management activities. Securities and short-term investment activities are conducted with a diverse group of domestic and foreign governments, corporations and depository and other financial institutions. The Corporation evaluates the counterparty's creditworthiness and the need for collateral on a case by case basis. The Corporation manages its loan portfolio to avoid concentration by industry or loan size to minimize its credit exposure. Commercial loans may be collateralized by the assets underlying the borrowers' business such as accounts receivable, equipment, inventory and real property. Consumer loans such as residential mortgage and installment loans are generally secured by the real or personal property financed. Commercial real estate loans are generally secured by the underlying real property and rental agreements. 54 Commitments to extend credit at December 31, 1993 included commercial and industrial lines of $6.5 billion, consumer equity credit lines of $1.1 billion and commercial real estate lines of $170.6 million. The fair value of these commitments at December 31, 1993 and 1992, representing the discounted value of potential fee income, was approximately $25.4 million and $13.0 million, respectively. Standby letters of credit are obligations to make payments under certain conditions to meet contingencies related to customers' contractual agreements and are subject to the same risk, credit review and approval process as a loan. Letters of credit are primarily used to enhance credit for public and private borrowing arrangements and to guarantee a customer's financial performance. The fair value of the Corporation's standby letters of credit, representing the discounted value of potential fee income, was approximately $6.4 million and $5.4 million at December 31, 1993 and 1992, respectively. Residential mortgage loans sold with recourse represent loans sold to U.S. Government agencies which allows the purchaser the option of requiring the Corporation to reacquire a loan in the event of default by the borrower. The option may extend for a period of five years or for the life of the loan. The Corporation has determined that the liability under the terms of the option agreements is not material. Residential mortgage loans are underwritten and sold by the Corporation's mortgage banking subsidiary. Foreign exchange contracts are entered into primarily for trading activities. The risk associated with foreign exchange contracts arises from the counterparties' failure to meet the terms of the contracts. An additional risk is that the value of a foreign currency might change in relation to the U.S. dollar. In the event of a default by a counterparty, the cost to the Corporation, if any, would be the replacement cost of the contract at the current market rate. Exposure to changes in market rate is substantially lessened since the Corporation limits its risk by entering into offsetting contracts. The Corporation's foreign exchange contracts are valued monthly at current market value and changes in market value are included in other noninterest income. The Corporation has accrued net unrealized losses of approximately $4.9 million and $48.0 million in the balance sheet at December 31, 1993 and 1992, respectively, and estimates the liability to settle the foreign exchange contracts would not exceed these amounts at these dates. 55 SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES Interest rate swap agreements are used by the Corporation to manage its interest rate risk. These agreements involve the exchange of fixed and variable rate interest payments based upon a notional principal amount and maturity date. Interest rate cap agreements are similar to interest rate swap agreements except that interest payments are only made or received if current interest rates rise above a predetermined rate. Included in both written and purchased interest rate cap agreements are approximately $2.4 billion in notional balances of agreements which consist of a simultaneous purchase and sale of a cap. This combination of agreements are also known as interest rate corridors. The risk associated with these agreements arises from the counterparties' failure to meet the terms of agreements. Limits are set on the exposure to any one counterparty. The Corporation estimated it would pay approximately $21.5 million and $30.0 million at December 31, 1993 and 1992, respectively, if it were to terminate the agreements at these dates. The fair value of interest rate cap agreements at December 31, 1993 was approximately $4.2 million, which represents the amount that the Corporation would recognize as a loss if the agreements were terminated at that date. Futures contracts are also used by the Corporation to manage interest rate exposure. These instruments are exchange-traded contracts for the future delivery of securities, other financial instruments or cash settlement at a specified price or yield. The fair value of the futures contracts at December 31, 1993 was approximately $.3 million, which represents the amount that the Corporation would receive if the contracts were terminated at that date. The Corporation utilizes option contracts to limit its exposure to market fluctuations on securities classified as available for sale. Options give the holder the right to purchase or sell securities at a specified price at a future date. The risk associated with options arises from the counterparties' failure to meet the terms of the agreements. The fair value of the Corporation's option contracts approximated the carrying amount, or the net unamortized premium, at December 31, 1993 and 1992. NOTE 15 - LITIGATION The Corporation, certain of its officers and directors were named as defendants in several complaints during 1990 and 1991, purportedly brought on behalf of purchasers of the Corporation's common stock between December 8, 1988 and January 24, 1991. Among other things, the complaint in the actions alleged violations of federal securities laws and negligent misrepresentation based upon certain allegedly false and misleading public statements relating to the Corporation's financial position and omissions in the Corporation's public reports. The Corporation and the plaintiffs entered into a settlement which was approved by the court on October 27, 1992. The settlement provides that, in full and complete settlement of all claims that have been or could have been brought in the class actions, the defendants will distribute to the members of the class including all persons who purchased the Corporation's common stock during the period December 8, 1988 to January 24, 1991, inclusive, warrants to purchase the Corporation's common stock. On January 18, 1994 the Corporation issued warrants for the purchase of up to 1,329,115 shares of common stock. The warrants have an exercise price of $22.11 per share, are listed on the New York Stock Exchange, are freely tradable and are exercisable for a period of one year, commencing January 18, 1995. 56 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Defendants denied all allegations of wrongdoing contained in the pleadings in these actions and agreed to settle these actions solely to avoid the time and expense of contesting this burdensome litigation. The settlement did not have a material effect on the Corporation's results of operations or financial condition. During 1993, Shawmut Mortgage Company, the Corporation's mortgage banking subsidiary, was the subject of an investigation of possible discriminatory lending by the United States Department of Justice (DOJ) and the Federal Trade Commission (FTC). On December 13, 1993, without admitting any wrongdoing, Shawmut Mortgage Company entered into a consent decree with the DOJ and FTC regarding past lending practices. Pursuant to the consent decree, Shawmut Mortgage Company established a $960 thousand monetary fund to compensate minority loan applicants who were denied mortgages between January 1990 and October 1992 but whose applications would be approved under the Corporation's more recent flexible underwriting criteria. This settlement did not have a material effect on the Corporation's results of operations or financial condition. The Corporation's Shawmut Bank Connecticut subsidiary, which served as indenture trustee for certain healthcare receivable backed bonds issued by certain special purpose subsidiaries of Towers Financial Corporation, and another defendant, have been named in a lawsuit in federal court in Manhattan by purchasers of the bonds. The suit seeks damages in an undetermined amount equal to the difference between the current value of the bonds and their face amount of approximately $200 million, plus interest, as well as punitive damages. The Corporation believes its actions were reasonable and appropriate and were not the cause of any loss by the bondholders, and is vigorously defending the action. The Corporation is subject to various other pending and threatened lawsuits in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the ultimate liability, if any, arising out of other pending and threatened lawsuits will have a material effect on the Corporation's results of operations or financial condition. 57 SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES NOTE 16 - REGULATORY MATTERS The Corporation is a bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the Board) under the Bank Holding Company Act of 1956. As a bank holding company, the Corporation'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. The Corporation's subsidiary banks, Shawmut Bank Connecticut, National Association (Shawmut Bank Connecticut) and Shawmut Bank, National Association (Shawmut Bank Massachusetts), are subject to supervision and examination by the Office of the Comptroller of the Currency (OCC). The deposits of the Corporation's subsidiary banks are insured by, and therefore the subsidiary banks are subject to the regulations of, the Federal Deposit Insurance Corporation (FDIC). The 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, 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 Corporation's subsidiary banks. In October 1993, the Federal Reserve Bank of Boston (FRB) and the OCC removed certain regulatory agreements under which the Corporation and its subsidiary banks had been operating. The regulatory agreements focused on the need to improve asset quality and credit administration policies, as well as prior approval for dividend payments. The Board and the OCC have adopted minimum risk-based capital and leverage guidelines for bank holding companies and national banks. The minimum Total capital ratio requirement is 8.00 percent, of which one-half must be Tier 1 capital. The minimum Leverage ratio requires Tier 1 capital of at least 3.00 percent of average quarterly assets less goodwill and other intangibles. This Leverage ratio is the minimum requirement for the most highly rated banking organizations and other banking organizations are expected to maintain an additional level of at least 100 to 200 basis points. The Board, OCC and FDIC implemented regulations, pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), effective on December 19, 1992, concerning prompt supervisory and regulatory actions to be taken against undercapitalized depository institutions. FDICIA establishes five capital categories: "well-capitalized"; "adequately capitalized"; "undercapitalized"; "significantly undercapitalized"; and "critically undercapitalized". Under these regulations, an institution will be deemed "well-capitalized" if it has a Risk-based Total capital ratio of 10.00 percent or greater, a Risk-based Tier 1 capital ratio of 6.00 percent or greater and a Leverage ratio of 5.00 percent or greater. In addition, the institution cannot be subject to an order, written agreement, capital directive or prompt correction action directive. The Tier 1 capital, Total capital and Leverage ratios for the Corporation at December 31, 1993 were 8.15 percent, 12.32 percent and 6.34 percent, respectively. The Tier 1 capital, Total capital and Leverage ratios for Shawmut Bank Connecticut were 10.09 percent, 11.37 percent and 7.79 percent, respectively, while these ratios for Shawmut Bank Massachusetts were 9.77 percent, 11.32 percent and 7.39 percent, respectively, at December 31, 1993. The Corporation and its subsidiary banks at December 31, 1993 met the definition for a "well-capitalized" institution. 58 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Corporation's subsidiary banks are required to maintain reserves against certain deposit liabilities in either cash or balances on deposit with the Federal Reserve System. The Corporation's subsidiary banks maintained combined average reserves of approximately $561 million in 1993 with the FRB. The Board issued proposed revisions to its capital adequacy guidelines in February 1993 which proposes to limit the amount of deferred tax assets recorded under FAS 109 that can be used to meet risk-based capital requirements. This proposal would limit deferred tax assets to those assets which may be realized from income taxes paid in prior carryback years, the reversal of future taxable temporary differences and the lesser of: (1) the amount of deferred tax assets expected to be realized within one year of the quarter-end date based on future taxable income (exclusive of tax carryforwards and reversals of existing temporary differences) for that year, or (2) ten percent of Tier 1 capital. The Corporation believes the deferred tax asset at December 31, 1993 would be allowable in computing regulatory risk-based capital because the deferred tax asset would not exceed the amount of income taxes previously paid in prior carryback years. The Corporation cannot determine whether, or in what form, this proposal may be enacted. Principal sources of revenues for the Corporation are dividends received directly and indirectly from its banks and other subsidiaries and interest earned on short-term investments and advances to subsidiaries. Federal law imposes limitations on the payment of dividends by the subsidiaries of the Corporation that are national banks. Two different calculations are performed to measure the amount of dividends that may be paid: a recent earnings test and an undivided profits test. Under the recent earnings test, a dividend may not be paid if the total of all dividends declared by a national bank in any calendar year is in excess of the current year's net profits combined with the retained net profits of the two preceding years, unless the bank obtains the approval of the OCC. Under the undivided profits test, a dividend may not be paid in excess of a bank's undivided profits then on hand, after deducting bad debts in excess of the reserve for loan losses. Under the recent earnings test at January 1, 1994, which is the more restrictive of the two tests, Shawmut Bank Connecticut could pay up to $113.8 million in dividends to its parent holding company without prior approval. Shawmut Bank Massachusetts, under the recent earnings test at January 1, 1994, could pay up to $210.7 million in dividends to its parent holding company without prior approval. Shawmut Bank Connecticut and Shawmut Bank Massachusetts had undivided profits of $262.9 million and $469.6 million, respectively, at December 31, 1993. The Corporation's subsidiary banks are also restricted under federal law with respect to the transfer of funds from the subsidiary banks to the Corporation and its nonbanking subsidiaries. Such transfers are limited to certain percentages of the subsidiary bank's capital and surplus. Loans and extensions of credit must be secured in specified amounts. The Corporation had no borrowings outstanding from either of its subsidiary banks at December 31, 1993. 59 61 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FINANCIAL GLOSSARY Basis Point A basis point is equal to one one-hundredth of one percent (25 basis points equal 0.25 percent and 100 basis points equal one percent). Book value per Common Share The amount of the Corporation's net worth represented by each share of outstanding common stock. It is obtained by dividing common shareholders' equity by the number of shares of common stock outstanding. Core Deposits The deposit base represented by ongoing account relationships maintained by consumer, commercial, corporate, and institutional customers with the Corporation's banks. Demand deposits, savings, money market, NOW and domestic time accounts comprise Core Deposits. Efficiency Ratio The efficiency ratio is a measure of relative overhead expense levels and is computed by dividing total noninterest expenses, excluding the foreclosed properties provision, by the sum of tax-equivalent net interest income plus noninterest income, excluding securities gains and losses. Federal Funds Immediately available funds on deposit at a Federal Reserve Bank. Banks with excess reserves lend such funds, generally on an overnight basis, to banks that are temporarily deficient in required reserves or that want to borrow federal funds to fund short-term assets. Interest-Earning Assets and Interest-Bearing Liabilities Interest is a price paid by a borrower to a lender for the use of money. The Corporation's interest-earning assets result from transactions in which it acts as a provider of funds. These include loans to customers, purchases of debt and equity securities and various transactions in the short-term money markets. Interest-bearing liabilities are those for which the Corporation acts as borrower and pays interest to depositors and other suppliers of funds. Interest Rate Sensitivity The exposure to financial gain or loss due to a change in the level of interest rates. In a given period, if more interest-earning assets than interest-bearing liabilities are subject to a change in interest rates because the assets are maturing or the contract calls for a rate change, the Corporation is asset sensitive (or positive) for that period. Rising interest rates during that time would enhance earnings, while declining interest rates would reduce earnings. The reverse earnings effect would occur if the Corporation were liability sensitive. F- 40 64 Interest Rate Spread The difference between two interest rates. The phrase is most often used to refer to the difference between the interest yield on average interest-earning assets and the interest cost of average interest-bearing liabilities. Leverage Ratio The ratio was established by federal bank regulators and is computed by dividing Tier 1 capital by average quarterly assets less goodwill and other intangibles. A minimum Leverage ratio of at least 3.00 percent must be maintained. This Leverage ratio is a minimum requirement for the most highly rated banking organizations and other banking organizations will be expected to maintain an additional cushion of at least 100 to 200 basis points. Net Available Demand Deposits The remaining portion of demand deposits available for investment in interest-earning assets after deducting uncollected checks and federally mandated reserves required to be kept against such deposits. Net Interest Income Net interest income is the difference between the interest earned on assets and the interest paid on liabilities. Interest income and expense are affected by changes in the volume and mix of average interest-earning assets and interest-bearing liabilities, as well as changes in the level of interest rates. Net Interest Margin Net interest margin represents the tax-equivalent yield on interest-earning assets. This is obtained by dividing net interest income for a given accounting period by the average level of interest-earning assets for the period. This relationship is usually expressed on a tax-equivalent basis. Nonaccruing Loans Loans on which the accrual of interest income has been discontinued because of the uncertainty that exists regarding the collection of interest or principal. This circumstance typically results from the borrower's financial difficulties. Interest received on such loans is recorded as a reduction of principal or interest income if there is no doubt as to the collectibility of the loan. Repurchase Agreement A transaction in which securities are sold under an agreement that the selling institution will repurchase the securities from the buyer at a specified future date and price. In effect, the original seller is borrowing money for the period, using the securities as collateral. Restructured Loans Loans with original terms which have been modified as a result of a change in the borrower's financial condition. Typically, interest rate concessions are made or repayment schedules are lengthened in these cases. 65 Return on Average Assets A ratio obtained by dividing net income by average assets. It is a measure of profitability in banking. Return on Average Common Equity A ratio obtained by dividing net income applicable to common shareholders' (after payment of preferred stock dividends) by average common shareholders' equity. This is a standard measure of the rate of return on the common shareholders' investment. Risk-weighted Assets Established by federal bank regulators, this is computed based on the sum of Risk-weighted balance sheet assets and off-balance sheet credit equivalent amounts calculated in accordance with federal guidelines. Tax-equivalent Basis An adjustment of income exempt from federal and state taxes or taxed at preferential rates, such as interest income on state and municipal bonds or dividends on equity securities, to an amount that would yield the same pre-tax income had the income been subject to taxation. The result is to equate the true earnings value of tax-exempt and taxable income. Tier 1 Capital Established by federal bank regulators, this is composed of common equity, retained earnings and perpetual preferred stock reduced by goodwill and certain nonqualifying intangible assets. Tier 1 Capital and Total Capital Ratios These measures of capital adequacy have been established by federal bank regulators, who require institutions to have a minimum ratio of Tier 1 capital to Risk-weighted assets of 4.00 percent and a minimum ratio of Total capital to Risk-weighted assets of 8.00 percent. The ratios are obtained by dividing Tier 1 capital or Total capital by Risk-weighted assets. Total Capital Established by federal bank regulators, this consists of Tier 1 capital plus a limited amount of allowable debt, certain other financial instruments and a limited amount of the reserve for loan losses. 66 SHAWMUT NATIONAL CORPORATION AND SUBSIDIARIES FINANCIAL REVIEW SUMMARY Shawmut National Corporation (the Corporation) reported net income of $290.7 million, or $2.93 per common share, for the year ended December 31, 1993, compared with $75.2 million, or $.81 per common share for 1992 and a net loss of $170.6 million, or $2.35 per common share, for 1991. Several items influenced 1993 net income: - restructuring charges of $36.3 million relating to branch closings and personnel reductions, foreclosed properties provisions of $20.0 million related to a bulk sale of foreclosed properties and a $14.1 million writedown in the value of excess servicing rights in various securitized loan portfolios, all recorded in the first quarter of 1993; - expenses of $3.5 million related to the settlement with the United States Department of Justice and the Federal Trade Commission as well as for the strengthening of fair lending compliance programs; - an increase in annual employee benefits expense of approximately $9.7 million as a result of adopting Statement of Financial Accounting Standards (FAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions"; - income tax benefits of $140.7 million attributable to the adoption of a new accounting standard for income taxes, FAS No. 109, "Accounting for Income Taxes"; and - an after-tax charge of $6.6 million relating to the adoption of FAS No. 112, "Employers' Accounting for Postemployment Benefits". Income before the cumulative effect of accounting changes for the year ended December 31, 1993 was $244.5 million, or $2.44 per common share, compared with income before extraordinary credit of $56.8 million, or $.60 per common share for 1992. This compares to a loss of $170.6 million, or $2.35 per common share, for the year ended December 31, 1991. The cumulative effect of accounting changes of $46.2 million in the first quarter of 1993 represents the Corporation's adoption of FAS No. 109 and FAS No. 112. The extraordinary credit of $18.4 million during 1992 represents the realization of net operating loss carryforwards. There were no extraordinary credits or accounting changes during 1991. Securities gains of $5.7 million, $85.9 million and $78.2 million for the years ended December 31, 1993, 1992 and 1991, respectively, are included in the results of operations. In addition, the results for 1992 included gains of $22.3 million from the sale of automobile and home equity loan pass-through certificates and the results for 1991 included gains of $71.5 million from the sale of the Corporation's credit card portfolio and merchant card business and $5.0 million from the repurchase of long-term debt obligations. Asset quality improved as nonaccruing loans plus foreclosed properties decreased $504.9 million, or 59 percent, during 1993 to $357.5 million at December 31, 1993 from $862.4 million at December 31, 1992. Contributing to the decline in these assets were bulk sales of nonaccruing real estate loans and foreclosed properties in the second quarter of 1993 with a carrying value of $225.1 million. The ratio of nonaccruing loans plus foreclosed properties to loans plus foreclosed properties improved to 2.32 percent at December 31, 1993 from 5.69 percent at December 31, 1992. 68 Nonaccruing loans were $309.5 million at December 31, 1993, a decrease of $308.5 million, or 50 percent, from $618.0 million at December 31, 1992. The ratio of nonaccruing loans to loans improved to 2.01 percent at December 31, 1993 from 4.15 percent at December 31, 1992, while the ratio of the reserve for loan losses to nonaccruing loans improved to 205 percent at December 31, 1993 from 140 percent at December 31, 1992. Foreclosed properties decreased $196.4 million, or 80 percent, to $48.0 million at December 31, 1993 from $244.4 million at December 31, 1992. The Corporation provided $68.1 million during 1993 to reduce the carrying value of foreclosed properties, compared with $134.2 million during 1992. The 1993 provision for foreclosed properties included a charge of $20.0 million related to a bulk sale of foreclosed properties. The 1992 provision for foreclosed properties also included three special charges totaling $23.6 million: $5.5 million related to the bulk sale of $18.6 million of foreclosed residential properties; $9.4 million related to an auction of foreclosed commercial properties aggregating approximately $34 million; and $8.7 million to reduce the carrying value of the remaining foreclosed properties for estimated selling costs. The reserve for loan losses was $633.0 million at December 31, 1993, compared with $863.0 million at December 31, 1992. The provision for loan losses was $29.2 million for 1993, compared with $189.5 million in 1992. Net charge-offs for 1993 were $259.2 million and included a charge-off of $108.6 million related to bulk sales of nonaccruing real estate loans. Excluding this charge-off, net charge-offs for 1993 would have been $150.6 million, equal to a rate of 1.02 percent of average loans outstanding, compared with $293.4 million in net charge-offs for 1992, which are also exclusive of bulk sale related charge-offs, and a rate of 2.14 percent of average loans outstanding. Capital continued to improve as shareholders equity increased $320.9 million to $1.8 billion, or 6.62 percent of assets, at December 31, 1993 from $1.5 billion, or 5.86 percent of assets, at December 31, 1992. The increase in shareholders' equity is primarily attributable to current year net income. The Corporation's Tier 1 capital and Total capital ratios were 8.15 percent and 12.32 percent, respectively, at December 31, 1993, compared with a Tier 1 capital ratio of 7.52 percent and a Total capital ratio of 11.87 percent at December 31, 1992. The improvement in the Total capital ratio also reflects the addition of $150 million in subordinated notes issued in April 1993. The Leverage ratio for the Corporation at December 31, 1993 was 6.34 percent, compared with 5.90 percent at December 31, 1992. The Corporation and its subsidiary banks' at December 31, 1993 met the definition for a well capitalized institution under banking regulations. The Corporation's common stock closed at $21.75 per share on December 31, 1993, representing 128 percent of the $17.02 book value per common share, compared with a common stock closing price of $18.38 per share and 130 percent of the $14.09 book value per common share a year ago. The Corporation announced during 1993 the signing of definitive agreements to acquire three banking organizations: New Dartmouth Bank of Manchester, New Hampshire, with assets of $1.7 billion at year end, was announced on March 24, 1993; Peoples Bancorp of Worcester, Inc. of Worcester, Massachusetts, with assets of $891.1 million at year end, was announced on August 26, 1993; and Gateway Financial Corporation of Norwalk, Connecticut, with assets of $1.3 billion at year end, was announced on November 5, 1993. The transactions will be accounted for as poolings of interests and are subject to approvals by the shareholders of the respective banks and federal and state regulatory agencies. The transactions are expected to be completed during 1994. 69 BANKING ACTIVITIES The Corporation's banking activities primarily include consumer banking, commercial banking and investment services. Consumer banking consists of banking services for consumers and small businesses and includes such products as installment and residential mortgage loans. Commercial banking consists of various banking services to middle-market and large corporate customers and includes such products as commercial and real estate loans. Commercial banking also includes loans to financial institutions such as insurance companies and correspondent banks, as well as municipal and governmental entities. Investment services activities include trust and advisory services to personal, corporate and institutional clients. Revenues from these banking activities consist primarily of interest income on loans and fees for services. Net interest income for commercial and consumer banking and other activities is discussed further in "Net Interest Income". Noninterest income related to commercial and consumer banking and trust and advisory services is discussed further in "Noninterest Income". The Corporation operates these various banking activities as profit centers and noninterest expenses associated with these activities are accumulated on a functional, rather than a product line basis. AVERAGE BALANCES AND RATES The following table presents the Corporation's average interest-earning assets and interest-bearing liabilities and tax-equivalent interest rates for the years 1991 through 1993. INTEREST-EARNING ASSETS The Corporation manages its interest-earning assets by utilizing available capital resources within certain leverage, credit, interest rate and liquidity risk constraints. Loans and securities comprise the majority of the Corporation's interest-earning assets. The remaining leverage capacity is utilized by short-term investments, residential mortgages held for sale and trading account securities. Interest-earning assets averaged $23.2 billion in 1993, an increase of $3.0 billion, or 15 percent, from $20.2 billion in 1992 and 1991. Loans comprised 64 percent of average interest-earning assets in 1993, compared with 68 percent and 70 percent in 1992 and 1991, respectively. Securities represented 33 percent of average interest-earning assets in 1993, compared with 28 percent and 25 percent in 1992 and 1991, respectively. The change in the composition of average interest-earning assets is attributable to an increase in the securities portfolio. Average loans increased $1.1 billion to $14.8 billion in 1993 from $13.7 billion in 1992. Loans averaged $14.2 billion in 1991. The increase in average loans during 1993 is primarily attributable to higher levels of corporate and money market loans, as well as growth in consumer lending. Real estate investor/developer and owner occupied real estate loans also continued to decline during 1993. Commercial and industrial loans increased $499 million during 1993 to $6.3 billion from $5.8 billion at year end 1992. Consumer lending, which includes residential mortgage, home equity and installment loans, increased $558 million to $6.3 billion at year end 1993 from $5.7 billion at year end 1992. Average commercial and industrial loans increased during 1992 compared with 1991, due to the $686 million growth in money market loans and loans to securities brokers. Average consumer loans decreased $159 million in 1992 due to the sale of $551.4 million in home equity and automobile loan pass- through certificates, which was partially offset by the $379.6 million growth in residential mortgages. Securities principally include mortgage backed securities issued by the U.S. Government and its agencies and U.S. Treasury securities. The Corporation's Asset and Liability Committee establishes credit quality criteria and limits for individual securities. Approximately 96 percent of the securities portfolio is AAA rated. The Corporation adopted, as of December 31, 1993, FAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (FAS 115). Under this new accounting standard, debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as held to maturity and reported at cost, adjusted for the amortization of premiums and accretion of discounts. Debt and equity securities which are not classified as held to maturity or as trading securities are classified as available for sale and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity, net of income taxes. Prior to the adoption of FAS 115, debt securities that were to be held for indefinite periods of time, including securities that management intended to use as part of its asset/liability strategy or that may be sold in response to changes in interest rates, prepayment risk or other factors, were reported at the lower of aggregate cost or market value. Changes in net unrealized losses were included in the results of operations. Securities averaged $7.7 billion for 1993, compared with $5.7 billion in 1992 and $5.1 billion in 1991. Securities classified as available for sale totaled $2.6 billion at December 31, 1993. Included in shareholders' equity at December 31, 1993 is $9.7 million of net unrealized gains (net of income taxes) relating to the of securities classified as available for sale. Debt securities classified as held to maturity totaled $6.4 billion at December 31, 1993, compared with $2.7 billion at December 31, 1992. The fair value of debt securities classified as held to maturity exceeded amortized cost by approximately $76.7 million at December 31, 1993, consisting of unrealized gains of approximately $88.8 million and unrealized losses of approximately $12.1 million. 71 Securities reported at the lower of aggregate cost or fair value totaled $3.4 billion at December 31, 1992. The fair value of debt securities reported at the lower of aggregate cost or fair value exceeded amortized cost by approximately $75.5 million at December 31, 1992, consisting of unrealized gains of approximately $86.9 million and unrealized losses of approximately $11.4 million. Unrealized depreciation on equity securities included in shareholders' equity at December 31, 1992 totaled $23.7 million. The Corporation sold approximately $4.4 billion of debt securities in 1993 that were reported at the lower of aggregate cost or fair value. The Corporation sold $4.5 billion and $2.6 billion in 1992 and 1991, respectively, of mortgage backed securities in response to the significant reduction in interest rates and the resulting increase in prepayment risk as interest rates declined over the period. U.S. Treasury securities classified as available for sale with an aggregate carrying amount of $786.0 million were subject to combination options at December 31, 1993, which limited the risk of changes in the market value of these securities. U.S. Treasury securities with a carrying amount of $311.0 million were put to the counterparty on January 5, 1994 upon expiration of the option, resulting in no realized gain or loss. The combination options on the remainder of the securities expired on January 6, 1994, unexercised by either party. Short-term investments (federal funds sold, securities purchased under agreements to resell and time deposits in other banks) averaged $301 million for the year ended December 31, 1993, compared with $478 million for 1992 and $624 million for 1991. Residential mortgages held for sale averaged $405 million in 1993, compared with $344 million in 1992 and $222 million in 1991. Trading account securities averaged $35 million in 1993, compared with $32 million in 1992 and $33 million in 1991. SOURCES OF FUNDS The Corporation's liability management objective is to maintain liquidity through a diversified and stable base of funds suppliers. Management accomplishes this objective by offering competitively priced and attractive products to customers and by exercising prudent and sound balance sheet management practices. The Corporation funds interest-earning assets with interest-bearing deposits, other borrowings, notes and debentures, noninterest-bearing demand deposits and shareholders' equity. Interest-bearing liabilities averaged $19.3 billion during 1993, compared with $17.0 billion during 1992 and $17.3 billion in 1991. Interest-bearing liabilities represented 83 percent of interest-earning assets in 1993, compared with 84 percent in 1992 and 86 percent in 1991. Average interest-bearing deposits totaled $11.3 billion, or 58 percent of total interest-bearing liabilities, during 1993, compared with $12.0 billion, or 71 percent of total interest-bearing liabilities, during 1992. Average interest-bearing deposits were $13.3 billion, or 77 percent of total interest-bearing liabilities, during 1991. The decrease in the relationship of average interest-bearing deposits to total interest-bearing liabilities during 1993 was primarily due to an increase in other borrowings which supported, in part, the growth in the securities portfolio. The decline in interest-bearing deposits is attributable to the relatively lower interest rates offered on time deposits and time certificates of deposit of $100 thousand or more when compared to alternative savings and investment products. Total savings, money market and NOW accounts averaged $7.4 billion in 1993, compared with $7.1 billion in 1992 and $7.0 billion in 1991. Domestic time deposits averaged $3.2 billion in 1993, or 23 percent less than the $4.1 billion in 1992. Similarly, average time certificates of deposit of $100 thousand or more decreased $213 million, or 31 percent, to $480 million in 1993 from $693 million in 1992. 72 Core deposits averaged $14.9 billion in 1993, $15.2 billion in 1992 and $15.8 billion in 1991. Large denomination certificates of deposit, brokered retail deposits and foreign time deposits are not included in core deposits. The ratio of average loans to average core deposits was 99 percent in 1993, compared with 90 percent in both 1992 and 1991. Other borrowings include federal funds purchased, securities sold under agreements to repurchase, Treasury tax and loan funds, private placement notes and Federal Home Loan Bank of Boston borrowings. Other borrowings averaged $7.2 billion during 1993, $4.3 billion during 1992 and $3.3 billion in 1991. Notes and debentures averaged $839 million in 1993, compared with $668 million in 1992 and $669 million in 1991. The Corporation completed an offering of $150 million 7.20% subordinated notes due 2003 in April 1993. The Corporation redeemed, during the second quarter of 1993, the outstanding balances of four senior notes totaling $85.2 million. The redemption of these notes did not have a material effect on the Corporation's results of operations or financial condition. In the third quarter of 1993, 8 1/4% notes in the amount of $114.7 million matured and were fully paid. Average demand deposits increased $254 million, or 6 percent, to $4.3 billion for 1993 from $4.0 billion for 1992. Demand deposits averaged $3.8 billion for 1991. Net available demand deposits (that portion of demand deposits available for investment) averaged $2.8 billion during 1993, compared with $2.5 billion for 1992 and $2.2 billion for 1991. NET INTEREST INCOME Net interest income is the difference between the interest earned on assets and the interest paid on liabilities. Interest income and expense are affected by changes in the volume and mix of average interest-earning assets and interest-bearing liabilities, as well as changes in interest rates. The Corporation's tax-equivalent net interest income for 1993 was $937.6 million, an increase of $97.0 million, or 12 percent, from $840.6 million in 1992. The increase in tax-equivalent net interest income reflects higher levels of interest-earning assets, primarily securities, as well as an improvement in funding costs. Average interest-earning assets increased $3.0 billion, to $23.2 billion in 1993 from $20.2 billion in 1992. The increase in average interest-earning assets for 1993 reflects growth in the securities portfolio of $2.0 billion and in the loan portfolio of $1.1 billion. The growth in the securities portfolio in 1993 resulted from the reinvestment of earnings into available investment alternatives given the lack of overall loan demand. As the demand for loans increases, the Corporation will utilize the maturities of the securities portfolio to fund the growth. The net interest margin for 1993 decreased 12 basis points from 4.16 percent in 1992 to 4.04 percent in 1993, reflecting a shift in the mix of average interest-earning assets from loans to securities. Should the spread between the Corporation's interest earning assets and funding sources return to lower historical levels in the future, the Corporation's net interest margin would be expected to contract. 75 The Corporation's tax-equivalent net interest income increased $80.6 million, or 11 percent, in 1992 compared with 1991 as a result of improvement in the net interest margin. The net interest margin for 1992 increased 39 basis points from 3.77 percent in 1991 to 4.16 percent in 1992. The improvement in the 1992 net interest margin was principally due to lower levels of nonaccruing loans and wider spreads between the yield on average interest-earning assets and the ratio paid on average interest-bearing liabilities, primarily attributable to lower deposit costs. Interest income from consumer banking, commercial banking and other activities (investment in securities for liquidity and funds management purposes) was approximately $457.3 million, $594.9 million and $523.0 million, respectively, during 1993. Interest expense allocated to these banking activities was approximately $162.8 million, $242.5 million and $232.3 million, respectively, resulting in net interest income of $294.5 million, $352.4 million and $290.7 million, respectively. Average interest-earning assets related to these activities during 1993 were approximately $5.9 billion, $8.9 billion and $8.4 billion, respectively. Interest income from these activities during 1992 was approximately $408.5 million, $655.6 million and $496.9 million, respectively. Interest expense was approximately $169.6 million, $318.6 million and $232.2 million, respectively, resulting in net interest income of $238.9 million, $337.0 million and $264.7 million, respectively. Average interest-earning assets related to these activities during 1992 were approximately $4.8 billion, $8.9 billion and $6.5 billion, respectively. Interest income from these activities during 1991 was approximately $453.2 million, $859.8 million and $523.6 million, respectively. Interest expense was approximately $236.7 million, $522.1 million and $317.8 million, respectively, resulting in net interest income of $216.5 million, $337.7 million and $205.8 million, respectively. Average interest-earning assets related to these activities during 1991 were approximately $4.4 billion, $9.8 billion and $6.0 billion, respectively. Interest expense was allocated to these activities based on the Corporation's interest expense on total interest-bearing liabilities for each of these years and may not be indicative of the interest expense that would be allocated to such activities had a different allocation methodology been used or if the activities were operated as separate segments of the Corporation. 76 Customer service fees decreased $.8 million to $171.7 million in 1993 from $172.5 million in 1992, which was a decrease of $2.8 million from $175.3 million in 1991. Commercial banking fees include revenues from customer transaction analysis, cash management services and letter of credit fees. Consumer banking fees include deposit service charges, mutual funds commissions, and automatic teller, safe deposit and customer check order fees. The decline in commercial banking fees from 1992 to 1993 resulted primarily from customer preference for maintaining higher demand deposit balances in lieu of direct fee payments. The increase in consumer banking fees for this same period was due to increased fees for deposit service charges and commissions on new mutual fund products. Trust and agency fees increased $1.7 million to $116.8 million in 1993 from $115.1 million in 1992, which in turn was an increase of $3.1 million from $112.0 million in 1991. The improvement during both 1993 and 1992 resulted from higher levels of assets under management as well as increases in fees for services. Loan servicing income totaled $10.9 million in 1993, $19.9 million in 1992 and $32.9 million in 1991. Included in loan servicing income were gains of $1.1 million in 1993, $5.0 million in 1992 and $12.8 million in 1991 from the sale of mortgage servicing rights. Excluding these gains, the decline in loan servicing income in 1993, compared with 1992, is attributable to increased prepayments in the mortgage servicing portfolio. Gains from residential mortgage sales totaled $23.5 million in 1993, $5.4 million in 1992 and $.8 million in 1991. The 1993 increase in gains on residential mortgage sales was due to declining interest rates during the year as these loans were sold into the secondary market. Foreign exchange trading income declined $6.4 million to $2.9 million in 1993 from $9.3 million in 1992, due to less favorable interest rate differentials between the United States and foreign countries during 1993. 77 Total noninterest income in 1992 included gains of $22.3 million from the sale of automobile and home equity loan pass-through certificates. Income for 1991 included gains of $71.5 million from the sale of the Corporation's credit card portfolio and merchant card business and $5.0 million from the repurchase of long-term debt obligations. Total noninterest expenses for both 1993 and 1992 were $1.0 billion, compared with $969.7 million in 1991. Included in total noninterest expenses for 1993 were special expenses of $36.3 million relating to restructuring charges for branch closings and personnel reductions, a $14.1 million writedown in the value of excess servicing rights in various securitized loan portfolios and $3.5 million related to the Corporation's settlement with the United States Department of Justice and the Federal Trade Commission as well as for the strengthening of fair lending compliance programs. Excluding the foreclosed properties provision and special expenses, total noninterest expenses totaled $905.7 million in 1993, $902.2 million in 1992 and $892.6 million in 1991. The change from 1992 to 1993 represented an increase of $3.5 million, or less than 1 percent, notwithstanding increases in compensation and benefits as a result of the Corporation's adoption of a new accounting standard for postretirement employment benefits, normal salary increases and increases in the Corporation's FDIC premiums and advertising expenses. Offsetting these increases were declines in expenses associated with the resolution of problem assets, ongoing cost saving initiatives and savings achieved under the restructuring program discussed below. The increase of $9.6 million, or 1 percent, during 1992 is attributable to the Corporation's efforts to reduce nonaccruing loans and foreclosed properties. 78 The restructuring program announced in the first quarter of 1993, which resulted in charges of $36.3 million, included personnel reductions in data processing and operations, corporate staff and services and credit administration and has resulted in reductions of approximately 435 full-time employees at year end 1993. The program also included a number of branch closings and consolidations. Accrued restructuring expenses at December 31, 1993 relating to this program were $6.9 million, representing primarily severance related costs. Management expects that these restructuring activities will be completed during 1994. Noninterest expenses, exclusive of the provision for foreclosed properties and special expenses, were $220.7 million in the fourth quarter of 1993, compared with $230.0 million in the first quarter of 1993 and continued reductions in noninterest expenses are expected as further progress in implementing the restructuring program and ongoing cost saving initiatives are achieved. The provision to reduce the carrying value of foreclosed properties was $68.1 million in 1993, $134.2 million in 1992 and $77.1 million in 1991. The 1993 provision for foreclosed properties includes a charge of $20.0 million related to a bulk sale of foreclosed properties in the second quarter. The 1992 provision for foreclosed properties included three special charges totaling $23.6 million: $5.5 million related to the bulk sale of $18.6 million of foreclosed residential properties; $9.4 million related to a pool of foreclosed commercial properties aggregating approximately $34 million subject to auction; and $8.7 million to reduce the carrying value of the remaining foreclosed properties for estimated selling costs. The foreclosed properties expenses were $27.6 million in 1993 and $32.9 million in both 1992 and 1991. The decrease in the provision and expense in 1993 reflects the decline in the level of foreclosed properties. Legal, accounting and other costs associated with collection efforts prior to foreclosure are included in "Other noninterest expenses". The Corporation adopted FAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", effective January 1, 1993. This new accounting standard requires the expected cost of these postretirement health care and life insurance benefits to be accrued and charged to operations during the years the employees render the service. The Corporation is amortizing the transition obligation of $94.8 million on a straight-line basis over 20 years. The postretirement benefit expense for 1993 was $14.7 million. Previously, the Corporation's postretirement benefits were expensed as claims were paid and totaled approximately $5.0 million for 1992 and $4.5 million for 1991. The Corporation also adopted FAS No. 112, "Employers' Accounting for Postemployment Benefits," in the fourth quarter of 1993, retroactive to January 1, 1993. The Corporation provides disability and workers' compensation related benefits to former or inactive employees after employment but before retirement and had also provided supplemental severance benefits to certain former employees. The new accounting standard requires that the cost of these benefits be accrued and charged to operations if the obligation is attributable to services already rendered, rights to such benefits accumulate or vest, payment of the benefits is probable and the amount of the benefits can be reasonably estimated. The effect of adopting this new accounting standard resulted in an after-tax charge of $6.6 million recorded as a cumulative effect of a change in method of accounting for 1993. Previously, these benefits were expensed as payments were made. 79 INCOME TAXES The Corporation adopted FAS No. 109, "Accounting for Income Taxes" (FAS 109), prospectively, effective January 1, 1993. The Corporation's deferred tax asset (deferred tax assets less deferred tax liabilities) at December 31, 1992 was $135.4 million. The Corporation's deferred tax asset represents future deductible temporary differences attributable primarily to provisions for loan losses in excess of the deductible amounts for tax purposes. The Corporation's deferred federal tax asset recorded upon adoption of FAS 109 (prior to valuation allowance) at January 1, 1993 was $268.2 million. The income tax benefits of these deductible temporary differences recognized under FAS 109 were subjected to an evaluation of whether it was more likely than not that the income tax benefits will be realized and, as a result, a valuation allowance of $80.0 million was established, resulting in a net deferred tax asset of $188.2 million at January 1, 1993. The level of valuation allowance reflected management's best judgment regarding the amounts and timing of future taxable income and the estimated reversal pattern of these temporary differences. Deferred state tax assets, net of the valuation allowance, were nil. The cumulative effect of this accounting change was the recognition of a $52.8 million income tax benefit in the first quarter of 1993. At December 31, 1993, the Corporation's deferred federal tax asset was $202.3 million. Based upon management's best judgment regarding the amounts and timing of future taxable income and the estimated pattern of temporary differences, no valuation allowance was recorded at year end. Taxable income necessary to be generated in future periods to realize the deferred tax asset would be approximately $578 million. The Corporation's total income tax expense for 1993, prior to income tax benefits, was $80.3 million, representing an effective income tax rate of 34 percent. Income tax expense for 1992 was $20.7 million, representing an effective income tax rate of 27 percent. The increase in the effective income tax rate for 1993 when compared to 1992 was due to a decline in the level of nontaxable income during 1993. The income tax benefits for 1993 included the reduction of the deferred tax asset valuation allowance of $80.0 million during 1993 and $7.9 million recognized in the third quarter of 1993 for the increase in the deferred tax asset due to new higher corporate income tax rates. In addition, the cumulative effect from the adoption of the new accounting standard for income taxes resulted in a $52.8 million income tax benefit. These income tax benefits totaled $140.7 million in 1993. The Board of Governors of the Federal Reserve System (the Board) issued proposed revisions to capital adequacy guidelines in February 1993 which would limit the amount of deferred tax assets that can be used to meet risk-based capital requirements. This recommendation limits deferred tax assets to those assets which may be realized from income taxes paid in prior carryback years, the reversal of future taxable temporary differences and the lesser of: (1) the amount of deferred tax assets expected to be realized within one year of the quarter-end date based on future taxable income (exclusive of tax carryforwards and reversals of existing temporary differences) for that year, or (2) ten percent of Tier 1 capital. The Corporation believes the deferred tax asset at December 31, 1993 would be allowable in computing regulatory risk-based capital because the deferred tax asset would not exceed the amount of income taxes previously paid in prior carryback years. The Corporation cannot determine whether, or in what form, this proposal may be enacted. 80 FAIR VALUE OF FINANCIAL INSTRUMENTS FAS No. 107, "Disclosures about Fair Value of Financial Instruments" (FAS 107), requires the disclosure of the fair value of financial instruments. A financial instrument is defined as cash, evidence of an ownership in an entity, or a contract that conveys or imposes the contractual right or obligation to either receive or deliver cash or another financial instrument. Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced sale or liquidation, and is best evidenced by a quoted market price if one exists. The statement requires the fair value of deposit liabilities with no stated maturity, such as demand deposit, NOW and money market accounts, to equal the carrying value of these financial instruments and, therefore, does not allow for the recognition of the inherent value of these core deposit relationships. In addition, the statement does not require disclosure of the fair value of nonfinancial instruments, such as the Corporation's premises and equipment, and its banking and trust franchises or the fair value of its core deposit relationships. The Corporation believes these nonfinancial instruments have significant fair value. As discussed in the notes to the consolidated financial statements, the Corporation has estimated the fair value of financial instruments in accordance with FAS 107. The most significant difference between the carrying value and the fair value of the Corporation's financial instruments is attributable to the loan portfolio. Utilizing the assumptions described in the notes to the consolidated financial statements, the Corporation estimated the fair value of loans exceeded the carrying value by approximately $611 million and $600 million at December 31, 1993 and 1992, respectively. The assumptions utilized for credit risk in estimating the fair value of the loan portfolio were based on estimated future credit losses as reflected in the Corporation's current pricing structure. However, the assumptions utilized in determining the adequacy of the reserve for loan losses, included in the Corporation's consolidated financial statements, is based upon management's assessment of risk elements in the loan portfolio, factors affecting loan quality and assumptions about the economic environment. The Corporation's reserve for loan losses was established over a period of economic recession and weakness in the real estate market. The Corporation's reserve for loan losses was $633.0 million at December 31, 1993, which represents 205 percent of nonaccruing loans at that date. The Corporation has estimated fair value based on quoted market prices where available. In cases where quoted market prices were not available, fair values were based on the quoted market price of a financial instrument with similar characteristics, the present value of expected future cash flows or other valuation techniques. Each of these alternative valuation techniques utilize assumptions which are highly subjective and judgmental in nature. Subjective factors include, among other things, estimates of cash flows, the timing of cash flows, risk and credit quality characteristics and interest rates. Accordingly, the results may not be precise and modifying the assumptions may significantly affect the values derived. In addition, fair values established utilizing alternative valuation techniques may or may not be substantiated by comparison with independent markets. Further, fair values may or may not be realized if a significant portion of the financial instruments were sold in a bulk transaction or forced liquidation. Therefore, any aggregate unrealized gains or losses should not be interpreted as a forecast of future earnings or cash flows. Furthermore, the fair values disclosed should not be interpreted as the aggregate current value of the Corporation. 81 INTEREST RATE SENSITIVITY The table below depicts the Corporation's interest rate sensitivity as of December 31, 1993. Allocations of assets and liabilities, including noninterest-bearing sources of funds, to specific periods are based upon management's assessment of contractual or anticipated repricing characteristics. Those gaps are then adjusted for the net effect of off- balance sheet financial instruments such as interest rate swap and option agreements and futures contracts. INTEREST RATE RISK Interest rate risk for the Corporation and its subsidiaries is managed by the Asset and Liability Committee of the Corporation. Interest rate risk measurement and management techniques incorporate the repricing and cash flow attributes of balance sheet and off-balance sheet instruments as they relate to parallel and non-parallel shifts in interest rates, as well as changes in the spread relationships between asset and liability interest rates. Interest rate risk is measured in terms of the effect on net interest income and changes in the market value of the Corporation's assets and liabilities under different interest rate scenarios through the use of modeling and other analytical techniques. 82 Interest rate risk is evaluated continuously and reviewed by the Asset and Liability Committee at least monthly. The Asset and Liability Committee evaluates the Corporation's overall risk profile and determines actions required to maintain and achieve a profile that is consistent with the Corporation's policies and strategic direction. Actions taken will include utilizing specific asset, liability and interest rate instruments to achieve directives by the Asset and Liability Committee. Integrated into interest rate risk management is the use of interest rate instruments such as interest rate swaps, options and futures contracts. The Corporation actively uses these instruments in programs designed to achieve the established directives. These products are not reflected in the Corporation's balance sheet. However, these products are included in the interest rate sensitivity table above for purposes of analyzing interest rate risk. At December 31, 1993, the Corporation had approximately $2.0 billion in notional balances of interest rate swap contracts outstanding, an increase of $1.3 billion from $.7 billion at December 31, 1992. Interest rate swap agreements involve the exchange of fixed and variable rate interest payments based upon a notional principal amount and maturity date. Interest rate swap agreements are utilized to synthetically alter the maturity and repricing characteristics of assets and liabilities. The periodic net settlement on interest rate swap agreements is recorded as an adjustment to interest expense and resulted in a decrease in net interest income of $20.4 million in 1993 and $23.3 million in 1992. The decrease in net interest income was the result of certain higher rate fixed-pay swaps recorded in prior years. The average final maturity of the fixed-pay and fixed-receive interest rate swap agreements at December 31, 1993 was approximately 2.0 years and 3.0 years, respectively. In addition to the interest rate swap contracts, the Corporation also utilizes interest rate cap agreements to manage interest rate risk. Interest rate cap agreements are similar to interest rate swap agreements except that interest payments are only made or received if current interest rates rise above a predetermined interest rate. At year end 1993, the Corporation had approximately $950 million in notional balances of purchased interest rate cap agreements outstanding. The Corporation also had approximately $2.4 billion in notional balances of interest rate cap agreements which consisted of a simultaneous purchase and sale of a cap, which consists of a cap that is sold for a higher rate than the one that is purchased. This combination of agreements are also known as interest rate corridors. Interest rate corridors are utilized to protect the Corporation from a contraction in the interest rate spread due to a moderate rise in interest rates. At December 31, 1993, the fair value of the interest rate cap agreements, inclusive of interest rate corridors, was approximately $4.2 million, which represents the amount that the Corporation would recognize as a loss if the agreements were terminated at that date. The average final maturity of the interest rate cap portfolio at December 31, 1993 was approximately 1.2 years. Futures contracts are also used by the Corporation to manage interest rate exposure. These instruments are exchange-traded contracts for the future delivery of securities, other financial instruments or cash settlement at a specified price or yield and are also utilized as a protection against rising interest rates. The notional balances of futures contracts at December 31, 1993 were approximately $2.5 billion. The fair value of the futures contracts at December 31, 1993 was approximately $.3 million, which represents the amount that the Corporation would receive if the contracts were terminated at that date. Maturities of the notional balances of futures contracts are as follows: $1.3 billion in 1994; $.8 billion in 1995; and $.4 billion in 1996. 83 The Corporation's reported twelve month cumulative gap was liability sensitive in the amount of $2.7 billion at December 31, 1993. A liability sensitive interest rate gap would reduce earnings during periods of rising interest rates, while declining rates would enhance earnings. However, incorporating the effects of the interest rate caps and corridors would reduce the effective interest sensitivity of the Corporation. Based on an analysis of a moderate 100 basis point increase in interest rates, the twelve month cumulative liability sensitive gap at December 31, 1993 would decrease to $1.9 billion and the impact on net interest income would be a decrease of $18.7 million, or approximately 2 percent of 1993 tax-equivalent net interest income. LIQUIDITY Liquidity is the ability to meet cash needs arising from fluctuations in loans, securities, deposits and other borrowings. The Corporation manages liquidity on three levels: at a consolidated level; at the subsidiary banks level; and at the parent companies level. The parent companies include Shawmut National Corporation and its two bank holding companies, Hartford National Corporation and Shawmut Corporation. In each case, the objectives reflect management's most current assessment of economic and financial factors that could affect funding activities. Management has adjusted its strategy in response to the rapid changes occurring within the banking environment, the changing economic conditions in New England, the significant reductions in interest rates and the volatile nature of funding sources. Uncollateralized purchased funds (UPFs) consist of federal funds purchased, large denomination certificates of deposit, Eurodollar deposits and private placement notes. When measuring liquidity, UPFs are offset by available short-term investments including federal funds sold, bid-based money market loans, reverse repurchase agreements and unused repurchase agreement collateral (U.S. Government and agency securities and highly liquid marketable securities). The Corporation manages liquidity at the consolidated level and at the subsidiary banks level by measuring the difference between the volume of UPFs and the level of short-term investments and unused repurchase agreement collateral. At December 31, 1993, UPFs were $2.3 billion. This was offset by $3.8 billion in short-term investments and unused repurchase agreement collateral. The Corporation manages the parent companies' liquidity by measuring the difference between the volume of short-term investments and short-term funding sources and the parent companies' ongoing obligations, including debt maturities and interest payments. The parent companies had consolidated short-term borrowings of approximately $175 million and notes and debentures of $749 million at December 31, 1993. The parent companies had consolidated cash and cash equivalents at December 31, 1993 of approximately $294 million and securities, consisting of preferred stock holdings, with a fair value of $214 million. There are no scheduled maturities on notes and debentures in 1994 and 1995. Scheduled maturities are $150 million in 1996. The parent companies' long-term ability to meet obligations will depend on the Corporation's ability to raise funds from outside sources or the ability of the subsidiary banks to pay dividends. See "Capital Requirements and Dividends". 84 Shareholders' equity at December 31, 1993 was $1.8 billion, an increase of $320.9 million, or 22 percent, from $1.5 billion at December 31, 1992. The ratio of shareholders' equity to assets was 6.62 percent at December 31, 1993, compared with 5.86 percent at December 31, 1992. The growth in shareholders' equity is primarily attributable to current year net income and common stock issued under the Corporation's Dividend Reinvestment and Stock Purchase Plan. The Corporation completed an offering of 17.25 million shares of common stock in April 1992, which resulted in net proceeds of $199.3 million. The Corporation also completed an offering of depositary shares representing an interest in the Corporation's 9.30% Cumulative Preferred Stock in November 1992. This offering resulted in net proceeds of $138.0 million to the Corporation. The Corporation's Dividend Reinvestment and Stock Purchase Plan allows registered shareholders to purchase up to $5,000 per calendar quarter of the Corporation's common stock at a 3 percent discount from the market price. Proceeds from this plan resulted in an increase in shareholders' equity of $58.0 million and $17.9 million during 1993 and 1992, respectively. The final risk-based capital guidelines for bank holding companies, such as the Corporation, became effective on December 31, 1992. The guidelines require that assets recorded on the balance sheet and the credit equivalent amounts of off-balance sheet items be risk-weighted. Additionally, capital is divided into two tiers. Tier 1 capital is composed of common equity, retained earnings and perpetual preferred stock reduced by goodwill and other intangibles. Tier 2 capital consists of a limited amount of allowable debt, other preferred stock, certain other instruments and a limited amount of reserve for loan losses. The Tier 1 capital ratio is Tier 1 capital divided by risk-weighted assets and the Total capital ratio is the sum of Tier 1 and Tier 2 capital divided by risk-weighted assets. The regulatory minimum Total capital ratio is 8.00 percent of which one-half (4.00 percent) must be Tier 1 capital. Additionally, a minimum Leverage ratio has been adopted for bank holding companies requiring banking organizations to maintain Tier 1 capital of at least 3.00 percent of average quarterly assets less goodwill and other intangibles. This Leverage ratio is the minimum requirement for the most highly rated banking organizations and other banking organizations are expected to maintain an additional level of at least 100 to 200 basis points. 85 The Federal Reserve Board, OCC and FDIC implemented regulations, pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), effective on December 19, 1992, concerning prompt supervisory and regulatory actions to be taken against undercapitalized depository institutions. FDICIA establishes five capital categories: "well-capitalized"; "adequately capitalized"; "undercapitalized"; "significantly undercapitalized"; and "critically undercapitalized". Under these regulations, an institution will be deemed "well-capitalized" if it has a Risk-based Total capital ratio of 10.00 percent or greater, a Risk-based Tier 1 capital ratio of 6.00 percent or greater and a Leverage ratio of 5.00 percent or greater. In addition, the institution cannot be subject to an order, written agreement, capital directive or prompt correction action directive. The Corporation and its subsidiary banks at December 31, 1993 met the definition for a "well-capitalized" institution. The Corporation's Tier 1 capital ratio of 8.15 percent, Total capital ratio of 12.32 percent and Leverage ratio of 6.34 percent at December 31, 1993, are above the minimum requirements. Tier 1 capital and Total capital ratios were 7.52 percent and 11.87 percent, respectively, at December 31, 1992. The Corporation's Leverage ratio at December 31, 1992 was 5.90 percent. The improvement in the Corporation's Risk-based capital and Leverage ratios is primarily attributable to the increase in shareholders' equity. The Corporation's subsidiary banks are subject to similar risk-based capital guidelines and minimum Leverage ratio requirements as the Corporation. The Tier 1 capital and Total capital ratios at both banks exceeded the regulatory minimum capital ratios of 4.00 percent for Tier 1 capital and 8.00 percent for Total capital at December 31, 1993. Shareholder's equity at Shawmut Bank Connecticut increased $250.7 million to $1.1 billion at December 31, 1993, from $880.9 million at December 31, 1992. The increase in shareholder's equity is attributable to additional capital contributions by the Corporation during 1993 and current year net income. The Tier 1 capital and Total capital ratios for Shawmut Bank Connecticut were 10.09 percent and 11.37 percent, respectively, at December 31, 1993, compared with 9.17 percent and 10.46 percent, respectively, at December 31, 1992. 86 Shareholders' equity at Shawmut Bank Massachusetts increased $133.2 million to $984.6 million at December 31, 1993 from $851.4 million at December 31, 1992. The increase is attributable to current year net income. The Tier 1 capital and Total capital ratios for Shawmut Bank Massachusetts were 9.77 percent and 11.32 percent, respectively, at December 31, 1993, compared with 9.16 percent and 10.82 percent, respectively, at December 31, 1992. Principal sources of the parent companies' revenues are dividends received from its bank and other subsidiaries and interest earned on short-term investments and advances to subsidiaries. Dividends of $81.9 million were declared and paid by Shawmut Bank Massachusetts to the Corporation in 1993. No dividends were paid by the subsidiary banks to the Corporation in 1992. Federal law imposes limitations on the payment of dividends by the subsidiaries of the Corporation that are national banks. Two different calculations are performed to measure the amount of dividends that may be paid: a "recent earnings" test and an "undivided profits" test. Under the recent earnings test, a dividend may not be paid if the total of all dividends declared by a national bank in any calendar year is in excess of the current year's net profits combined with the retained net profits of the two preceding years, unless the bank obtains the approval of the OCC. Pursuant to regulations (Regulations) adopted in December 1990 by the OCC, "net profits" is defined as the net income reported by a bank in its Reports of Condition and Income and "retained net profits" is "net profits" less any common or preferred dividends declared for that reporting period. Under the recent earnings test, to the extent that a national bank has a loss in any year, the national bank must subtract that loss (as well as any dividends paid) from earnings during the next two years in determining its capacity to pay dividends. Under the undivided profits test, a dividend may not be paid in excess of a bank's undivided profits then on hand, after deducting (i) losses and (ii) bad debts in excess of the allowance for loan and lease losses. Under the Regulations, "allowance for loan and lease losses" and "undivided profits" are defined as the amounts reported as such by a bank in its Reports of Condition and Income; and "bad debts" is defined to include matured obligations due a bank on which the interest is past due and unpaid for six months, unless the debts are well-secured and in the process of collection. Generally, a debt is considered "matured" when all or part of the principal is due and payable as a result of demand, arrival of the stated maturity date, or acceleration by contract or by operation of law. In addition, the Regulations specify that only the portion of a bank's surplus account that is earned surplus (surplus derived from earnings of prior periods in excess of the minimum amount of surplus required under federal law to be maintained by the bank) may be transferred to undivided profits for the purpose of paying dividends, provided the transfer is approved by the OCC. Under the recent earnings test, which is the more restrictive of the two tests, at January 1, 1994, Shawmut Bank Connecticut could pay up to $113.8 million in dividends to its parent holding company without prior approval. Shawmut Bank Massachusetts could pay up to $210.7 million in dividends to its parent holding company, under the recent earnings test at January 1, 1994 without prior approval. Shawmut Bank Connecticut and Shawmut Bank Massachusetts had undivided profits of $262.9 million and $469.6 million, respectively, at December 31, 1993. 87 It is the policy of both the OCC and the Federal Reserve Board that banks and bank holding companies, respectively, should pay dividends only out of current earnings. Finally, the Federal regulatory agencies are authorized to prohibit a banking organization from engaging in an unsafe or unsound banking practice. Depending upon the circumstances, the agencies could take the position that paying a dividend would constitute an unsafe or unsound banking practice. The Corporation's subsidiary banks are subject to restrictions under federal law which limit the transfer of funds to the Corporation 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 Corporation or any nonbanking subsidiary are limited in amount to 10 percent of such subsidiary bank's capital and surplus and, with respect to the Corporation and certain of its affiliates, to an aggregate of 20 percent of such subsidiary bank's capital and surplus. Furthermore, such loans and extensions of credit are required to be secured in specified amounts. In October 1993, the Federal Reserve Bank of Boston and OCC removed certain regulatory agreements under which the Corporation and its subsidiary banks had been operating. The regulatory agreements focused on the need to improve asset quality and credit administration policies, as well as prior approval for dividend payments. CREDIT RISK MANAGEMENT Credit risk entails both general risk, which is inherent in the process of lending, and risk specific to individual borrowers. The management of credit risk involves two fundamental disciplines, loan underwriting and loan administration. The Corporation manages credit risk through a strategy of portfolio diversification, which seeks to avoid concentrations of credit by loan type and industry, and to limit total exposure to individual and affiliated borrowers. The evaluation of specific risk is a basic function of underwriting and loan administration and concerns the analysis of the borrower's ability to service debt as well as the value of pledged collateral. The Corporation's lending and loan administration staffs are charged with monitoring the Corporation's loan portfolio and identifying changes in the economy or in a borrower's circumstances, which may affect the ability to repay debt or the value of pledged collateral. In order to assess and monitor the degree of risk in the Corporation's loan portfolio, several credit risk identification and monitoring processes are utilized. A credit risk assessment process is employed that assigns a risk grade to each loan based upon an assessment of the borrower's financial capacity to service the debt and the presence and value of collateral for the loan. Credit grading of the portfolio is achieved through loan officers' monitoring of individual loans supplemented by periodic reviews performed by the Credit Review Department. Further, a special division of loan administration monitors adversely graded loans, recommending and approving courses of action and ensuring the accuracy and timeliness of recognizing changes in risk. 88 LENDING ACTIVITIES The Corporation extends credit primarily to consumers, large corporate customers, and middle market companies within New England. Commercial and industrial loans, which represented 41 percent of the Corporation's $15.4 billion loan portfolio at year end, consisted primarily of loans to a mix of middle market customers, typically with revenues of less than $150 million and loans to large corporate customers. Owner-occupied commercial real estate loans, which represented 9 percent of loans at year end, included loans to commercial borrowers for the construction or purchase of business space, primarily for the borrower's own use, or loans to commercial borrowers for operating purposes in which the Corporation has taken business real estate as collateral. The operating cash flow of the enterprise, rather than the real estate, is the primary source of repayment. Real estate investor/developer loans, which represented 9 percent of loans outstanding at year end, included a diverse mix of construction projects and commercial mortgages. Consumer loans, which represented 41 percent of the loan portfolio at year end, included residential mortgages, home equity loans and lines of credit and installment loans. The Corporation's commercial and industrial loans totaled $6.3 billion at year end 1993. Manufacturing, finance, insurance and real estate and communications made up 26 percent, 21 percent and 19 percent, respectively, of the portfolio at year end. Commercial and industrial loans increased $499 million in 1993 from $5.8 billion at December 31, 1992, primarily as a result of higher levels of corporate and money market loans. Owner-occupied commercial real estate loans represented $1.4 billion and $1.6 billion, respectively, of the Corporation's loan portfolio at year end 1993 and 1992. Loans to real estate investor/developers of $1.4 billion decreased $359 million in 1993, a 21 percent decline from $1.7 billion at December 31, 1992. The decrease in loans to real estate investor/developers is primarily attributable to the economic decline in the real estate market and management's decision to curtail lending in this area and loans sold in a bulk sale during the second quarter of 1993. 89 The Corporation's consumer loan portfolio was $6.3 billion at December 31, 1993, an increase of $558 million from $5.7 billion at December 31, 1992. The residential mortgage loan portfolio grew by $150 million and was generated principally by the Corporation's mortgage banking subsidiary. Installment loans increased $220 million primarily due to growth in indirect automobile lending. Information on aging of nonaccruing loans is not available for 1989. When a loan is past due 90 days or more or the ability of a borrower to repay principal or interest is in doubt, the Corporation's policy is to discontinue the accrual of interest and reverse any unpaid accrued amounts. If there is doubt as to collectibility, cash interest payments are applied to reduce principal. A loan is not restored to accruing status until the borrower has brought the loan current and demonstrated the ability to make payments of principal and interest, and doubt as to the collectibility of the loan is not present. The Corporation may continue to accrue interest on loans past due 90 days or more which are well secured and in the process of collection. The classification of a loan as nonaccruing does not necessarily indicate that loan principal and interest will be uncollectible. Nonaccruing loans can be reduced as a result of payments, restructurings, return to accruing status, liquidation or sale of collateral and charge-offs. 90 Nonaccruing loans declined $308.5 million, or 50 percent, to $309.5 million at December 31, 1993, from $618.0 million at December 31, 1992. Contributing to the decline were bulk sales of approximately $177.0 million of nonaccruing real estate loans during the second quarter of 1993. The ratio of nonaccruing loans to loans improved to 2.01 percent at December 31, 1993 from 4.15 percent at December 31, 1992. The ratio of the reserve for loan losses to nonaccruing loans also improved increasing to 205 percent at December 31, 1993, from 140 percent at December 31, 1992. Approximately $72.0 million, or 23 percent, of nonaccruing loans were current at December 31, 1993, compared with $201.3 million, or 33 percent, at December 31, 1992. These loans have been classified as nonaccruing because of concerns regarding future collectibility. Real estate investor/developer loans represented 34 percent of this balance at December 31, 1993. The Corporation seeks to limit its exposure to individual and affiliated borrowers. The ten largest nonaccruing loan relationships totaled $35.9 million, or less than .5 percent, of loans outstanding at December 31, 1993. At December 31, 1992 the ten largest nonaccruing loan relationships totaled $78.0 million. Restructured loans, which are loans with original terms that have been modified as a result of a change in the borrower's financial condition, totaled $66.2 million at December 31, 1993, compared with $165.0 million at the end of 1992. Contributing to the decline were bulk sales of approximately $75.4 million of restructured loans during the second quarter of 1993. Restructured loans included real estate investor/developer loans and owner-occupied loans of $47.8 million and $3.9 million, respectively, at December 31, 1993. The yield from the portfolio of restructured loans was 7.00 percent in 1993, compared with 7.85 percent for the year ended December 31, 1992. Interest income related to nonaccruing and restructured loans would have been approximately $42.8 million in 1993 and $72.1 million in 1992 had these loans been current and the terms of the loans had not been modified. Interest income recorded on these loans totaled approximately $9.6 million in 1993 and $25.1 million in 1992. Interest income received on these loans and applied as a reduction of principal totaled approximately $14.4 million and $31.3 million in 1993 and 1992, respectively. Accruing loans past due 90 days or more, which are well secured and in the process of collection, were $33.5 million at December 31, 1993, compared with $42.6 million at December 31, 1992. These loans represented less than .5 percent of loans at December 31, 1993 and 1992, respectively. Consumer loans represented 40 percent and 50 percent of loans past due 90 days or more and still accruing interest at the end of 1993 and 1992, respectively. 91 Information on nonaccruing owner-occupied commercial real estate loans is not available for 1989. PROVISION AND RESERVE FOR LOAN LOSSES The reserve for loan losses is maintained at a level determined by management to be adequate to provide for probable losses inherent in the loan portfolio including commitments to extend credit. The reserve is maintained through the provision for loan losses, which is a charge to operations. The potential for loss in the portfolio reflects the risks and uncertainties inherent in the extension of credit. The determination of the adequacy of the reserve is based upon management's assessment of risk elements in the portfolio, factors affecting loan quality and assumptions about the economic environment in which the Corporation operates. The process includes identification and analysis of loss potential in various portfolio segments utilizing a credit risk grading process and specific reviews and evaluations of significant individual problem credits. In addition, management reviews overall portfolio quality through an analysis of current levels and trends in charge-off, delinquency and nonaccruing loan data, review of forecasted economic conditions and the overall banking environment. These reviews are of necessity dependent upon estimates, appraisals and judgments, which may change quickly because of changing economic conditions and the Corporation's perception as to how these factors may affect the financial condition of debtors. 93 The reserve for loan losses was $633.0 million at December 31, 1993, compared with $863.0 million at December 31, 1992. The ratio of the reserve for loan losses to nonaccruing loans increased to 205 percent at December 31, 1993, from 140 percent at the end of 1992. The reserve for loan losses to total loans was 4.11 percent at December 31, 1993, compared with 5.79 percent at December 31, 1992. The reserve for loan losses at December 31, 1993 and 1992 was equal to 2.44 times net charge-offs for 1993 and 2.64 times net charge-offs for 1992, respectively. The provision for loan losses was $29.2 million for the year ended December 31, 1993, compared with $189.5 million and $466.4 million for the years ended December 31, 1992 and 1991, respectively. Net charge-offs for 1993 were $259.2 million, equal to 1.75 percent of average loans. Net charge-offs for 1993 included a charge-off of $108.6 million related to a bulk sale of nonaccruing real estate loans. Excluding this charge-off, net charge-offs for 1993 would have been $150.6 million, equal to 1.02 percent of average loans. The comparable net charge-offs experienced in 1992 were $293.4 million, or 2.14 percent of average loans, after excluding a charge-off of $33.1 million related to the bulk sale of nonaccruing residential mortgage loans, and for 1991 net charge-offs were $407.7 million, or 2.87 percent of average loans. The decrease in net charge-offs reflects improving asset quality over the periods presented. Management anticipates that net charge-offs for 1994, as a percent of average loans outstanding, will not exceed 1993 levels, after excluding charge-offs associated with bulk sales and also anticipates further reduction in the reserve for loan losses if loan quality trends continue to improve. However, future levels of net charge-offs and the reserve for loan losses will be affected by changing economic conditions and loan quality. Continued economic weakness in New England may adversely affect the level of net charge-offs and the reserve for loan losses in future periods. Real estate investor/developer charge-offs were $149.2 million, or 48 percent of total charge-offs in 1993, compared with $118.3 million, or 32 percent, and $140.1 million, or 31 percent, in 1992 and 1991, respectively. Commercial and industrial loans accounted for $56.6 million, or 18 percent of total charge-offs in 1993, compared with $100.1 million, or 27 percent, in 1992 and $163.1 million, or 36 percent, in 1991. Owner-occupied commercial real estate charge-offs were $41.7 million in 1993, $43.8 million in 1992 and $40.7 million in 1991, representing 13, 12 and 9 percent of total charge-offs in each of the years, respectively. Charge-offs of consumer loans were $62.2 million, or 20 percent of total charge-offs in 1993, compared with $109.6 million, or 29 percent, in 1992 and $103.6 million, or 23 percent, in 1991. The Financial Accounting Standards Board issued FAS No. 114, "Accounting By Creditors for Impaired Loans", in May 1993. The new accounting standard will require that impaired loans, which are defined as loans where it is probable that a creditor will not be able to collect both the contractual interest and principal payments, be measured at the present value of expected future cash flows discounted at the loan's effective rate when assessing the need for a loss accrual. The new accounting standard is effective for the Corporation's financial statements beginning January 1, 1995. The effect on the Corporation of adopting this new accounting standard is currently being evaluated. 94 FORECLOSED PROPERTIES Properties acquired through foreclosure or in settlement of loans and in-substance foreclosures are classified as foreclosed properties. An in-substance foreclosure occurs when a borrower has little or no equity in the collateral, repayment can only be expected to come from the operations or sale of the collateral, and the borrower has effectively abandoned the collateral or has doubtful ability to rebuild equity in the collateral. A valuation reserve is maintained for estimated selling costs and to record the excess of the carrying values over the fair market values of properties if a change in the carrying values are judged to be temporary. Foreclosed properties decreased $196.4 million, or 80 percent, to $48.0 million at December 31, 1993 from $244.4 million at December 31, 1992. The decrease in foreclosed properties resulted primarily from ongoing disposition efforts and also reflects the bulk sale of real estate loans and foreclosed properties in the second quarter of 1993. The provision to reduce the carrying values of foreclosed properties was $68.1 million during 1993, compared with $134.2 million in 1992 and $77.1 million in 1991. The 1993 provision for foreclosed properties included a charge of $20.0 million relating to a bulk sale of foreclosed properties in the second quarter of 1993. The provision for 1992 included three special charges totaling $23.6 million: $5.5 million related to the bulk sale of $18.6 million of foreclosed residential properties; $9.4 million related to a pool of foreclosed commercial properties aggregating approximately $34 million subject to auction; and $8.7 million to reduce the carrying value of the remaining foreclosed properties for estimated selling costs. The decrease in the foreclosed properties provision in 1993 reflects the overall decline in the levels of foreclosed properties throughout 1993. Foreclosed properties expense totaled $27.6 million in 1993 and $32.9 million in 1992 and 1991. Foreclosed properties expense includes the cost of managing, upgrading and maintaining the properties as well as legal fees, property taxes and appraisal fees, net of rental income. Gains or losses realized upon the sale of properties are included in the foreclosed properties provision. The decline in foreclosed properties expense in 1993 is consistent with the lower level of foreclosed properties throughout 1993. The increased level of foreclosed properties expense in 1992 and 1991 reflected the effort to maintain and sell these foreclosed properties. 95 Nonaccruing loans plus foreclosed properties decreased $504.9 million, or 59 percent, during 1993 to $357.5 million at December 31, 1993 from $862.4 million at December 31, 1992. Contributing to the decline in these assets were ongoing disposition efforts and bulk sales of nonaccruing loans and foreclosed properties in the second quarter of 1993. The ratio of nonaccruing loans plus foreclosed properties to loans plus foreclosed properties declined to 2.32 percent at December 31, 1993 from 5.69 percent at December 31, 1992. PORTFOLIO STATISTICS The following tables set forth detailed portfolio statistics for commercial and industrial loans, owner-occupied commercial real estate loans, real estate investor/developer loans, consumer loans, and the Corporation's ten largest nonaccruing loan relationships. Nonaccruing commercial and industrial loans declined $80.2 million, or 52 percent, from $152.8 million at December 31, 1992 to $72.6 million at December 31, 1993 and represented 23 percent of total nonaccruing loans. Nonaccruing loans represented 1 percent and 3 percent of total loans in this sector at December 31, 1993 and 1992, respectively. Nonaccruing owner-occupied commercial real estate loans declined $65.0 million, or 46 percent, from $140.6 million at December 31, 1992 to $75.6 million at December 31, 1993 and represented 24 percent of total nonaccruing loans. Nonaccruing loans represented 5 percent and 9 percent of total loans in this sector at December 31, 1993 and 1992, respectively. Nonaccruing real estate investor/developer loans decreased $128.0 million, or 55 percent, from $233.1 million at December 31, 1992 to $105.1 million at December 31, 1993 and represented 34 percent of total nonaccruing loans. Nonaccruing loans represented 8 percent and 13 percent of total loans in this sector at December 31, 1993 and 1992, respectively. 97 Nonaccruing consumer loans decreased $35.3 million, or 39 percent, from $91.5 million at December 31, 1992 to $56.2 million at December 31, 1993 and represented 19 percent of total nonaccruing loans. Nonaccruing loans represented 1 percent and 2 percent of total loans in this sector at December 31, 1993 and 1992, respectively. ACQUISITIONS The Corporation announced during 1993 the signing of definitive agreements to acquire three banking organizations: New Dartmouth Bank of Manchester, New Hampshire, with assets of $1.7 billion at year end, was announced on March 24, 1993; Peoples Bancorp of Worcester, Inc. of Worcester, Massachusetts, with assets of $891.1 million at year end, was announced on August 26, 1993; and Gateway Financial Corporation of Norwalk, Connecticut, with assets of $1.3 billion at year end, was announced on November 5, 1993. The transactions will be accounted for as poolings of interests and are subject to approvals by the shareholders of the respective banks and federal and state regulatory agencies. The transactions are expected to be completed during 1994. On November 15, 1993, the Federal Reserve Board issued an order not approving the Corporation's application to acquire New Dartmouth Bank. The Federal Reserve Board cited a then-pending investigation of possible discriminatory lending at Shawmut Mortgage Company, the Corporation's mortgage banking subsidiary, by the United States Department of Justice (DOJ) and the Federal Trade Commission (FTC). The Federal Reserve Board further stated that in order to obtain approval, the Corporation would need to submit evidence of compliance with fair lending laws and accurate reporting pursuant to the Home Mortgage Disclosure Act. 98 On December 13, 1993, without admitting any wrongdoing, Shawmut Mortgage Company entered into a consent decree with the DOJ and FTC regarding past lending practices. Pursuant to the consent decree, Shawmut Mortgage Company established a $960 thousand monetary fund to compensate minority loan applicants who were denied mortgages between January 1990 and October 1992 but whose applications would be approved under the Corporation's more recent flexible underwriting criteria. This settlement did not have a material effect on the Corporation's results of operations or financial condition. The Federal Reserve Board has granted the Corporation an extension of time until March 1, 1994 within which to resubmit a petition requesting reconsideration of the Federal Reserve Board's November 15, 1993 decision. The amended New Dartmouth Bank merger agreement, dated December 20, 1993, provides for the establishment of an escrow fund which would be paid to New Dartmouth Bank in the event that the transaction is not consummated by June 30, 1994 and New Dartmouth Bank is not in breach of certain provisions of the agreement. Required deposits to the escrow fund will equal $10 million by May 1, 1994. The Corporation anticipates that the New Dartmouth Bank acquisition and the other transactions will be completed during 1994. The Corporation anticipates that it will continue to pursue selected acquisitions of financial institutions in the future. FOURTH QUARTER RESULTS The Corporation reported net income of $133.6 million, or $1.36 per common share, for the fourth quarter of 1993, versus net income of $10.3 million, or 8 cents per common share, in the previous year's fourth quarter. Income before extraordinary credit for the fourth quarter of 1992 was $7.1 million, or 4 cents per common share. The extraordinary credit of $3.2 million for the 1992 fourth quarter was attributable to the realization of a net operating loss carryforward. The results for the fourth quarter of 1993 include income tax benefits of $70.2 million due to the reduction of the deferred tax asset valuation allowance recorded in the first quarter of 1993. Also included were $3.5 million of expenses related to the Corporation's settlement with the United States Department of Justice and the Federal Trade Commission as well as for the strengthening of fair lending compliance programs. The results for the fourth quarter of 1992 included securities gains of $6.3 million. Net interest income during the fourth quarter of 1993 rose to $242.6 million, up 2 percent, from $236.7 million in the third quarter of 1993 and an increase of 7 percent from $225.8 million in the fourth quarter of 1992. The tax-equivalent net interest margin for the fourth quarter of 1993 was 4.00 percent, compared with 4.05 percent in the third quarter of 1993 and 4.32 percent in the fourth quarter of 1992. The provision for loan losses was $5.0 million during the fourth quarter, unchanged from the three-month period ending September 30, 1993, compared with $28.7 million for the fourth quarter of 1992. Noninterest income for the fourth quarter of 1993 was $89.6 million, versus $88.0 million in the third quarter of 1993 and $93.1 million in the fourth quarter of 1992. Noninterest expenses (exclusive of foreclosed properties provisions and expenses related to the Corporation's settlement with the United States Department of Justice and the Federal Trade Commission as well as for the strengthening of fair lending compliance programs) during the fourth quarter of 1993 were $220.7 million. Comparable noninterest expenses were $225.4 million and $235.8 million for the third quarter of 1993 and the fourth quarter of 1992, respectively. The decline in noninterest expense levels over these periods is the result of actions under the restructuring program announced in the first quarter of 1993 as well as from declining problem asset resolution expenses. The provision to reduce the carrying value of foreclosed properties was $4.9 million during the fourth quarter of 1993, compared with $8.6 million during the third quarter of 1993 and $43.8 million for the comparable period a year ago. The fourth quarter provision in 1992 included three special charges totaling $20.9 million: $2.8 million related to the bulk sale of $8.9 million of foreclosed residential properties; $9.4 million related to a pool of foreclosed commercial properties aggregating approximately $34 million subject to auction; and $8.7 million to reduce the carrying value of the remaining foreclosed properties for estimated selling costs. 99 [This Page Intentionally Left Blank] 103

16906_1993.txt

16906_1993

1993

16906

Item 1. Business General Canal Electric Company (the Company) is a wholesale electric generating company organized in 1902 under the laws of the Commonwealth of Massachu- setts. The Company assumed its present corporate name in 1966 after the sale to an affiliated company of its electric distribution and transmission properties together with the right to do business in the territories served. The Company is a wholly-owned subsidiary of Commonwealth Energy System ("System"), which together with its subsidiaries is collectively referred to as "the system." The Company's generating station is located in Sandwich, Massachusetts at the eastern end of the Cape Cod Canal. The station consists of two oil- fired steam electric generating units: Canal Unit 1, with a rated capacity of 569 MW, wholly-owned by the Company; and Canal Unit 2, with a rated capacity of 580 MW, jointly-owned by the Company and Montaup Electric Company (Montaup) (an unaffiliated company). Canal Unit 2 is operated by the Company under an agreement with Montaup which provides for the equal sharing of output, fixed charges and operating expenses. Canal Units 1 and 2 commenced operation in 1968 and in 1976, respectively. The Company also has a 3.52% interest in the Seabrook 1 nuclear power plant located in Seabrook, New Hampshire, to provide for a portion of the capacity and energy needs of Cambridge Electric Light Company (Cambridge) and Commonwealth Electric Company (Commonwealth Electric), each of which are retail distribution companies and wholly-owned subsidiaries of the System. The plant has a rated capacity of 1,150 MW. For additional information pertaining to the Company's relationship with the system's retail distribution companies, together with more extensive disclosures on the Company's participation in the Seabrook plant and with other sources of power procurement, refer to the "Power Contracts" and "Power Supply Commitments and Support Agreements" sections of this Item 1 and Note 5 of Notes to Financial Statements filed under Item 8 of this report. New England Power Pool The Company, together with other electric utility companies in the New England area, is a member of the New England Power Pool (NEPOOL), which was formed in 1971 to provide for the joint planning and operation of electric systems throughout New England. NEPOOL operates a centralized dispatching facility to ensure reliability of service and to dispatch the most economically available generating units of the member companies to fulfill the region's energy requirements. This concept is accomplished by use of computers to monitor and forecast load requirements and provide for economic dispatching of generation. In the past, this has required that Canal Unit 1 operate whenever possible since it is one of the most efficient oil-fired units in the country. Canal Unit 2 CANAL ELECTRIC COMPANY is designed for cycling operation which provides for economic changes in unit load permitting reduced generation during nights and weekends when demand is lowest. It has performed as one of New England's most efficient units in this type of service. The Company and the System's other electric subsidiaries are also members of the Northeast Power Coordinating Council (NPCC), an advisory organization which includes the major power systems in New England and New York plus the provinces of Ontario and New Brunswick in Canada. NPCC establishes criteria and standards for reliability and serves as a vehicle for coordination in the planning and operation of these systems in enhancing reliability. Regulation The Company is a "public utility" within the meaning of Part II of the Federal Power Act and is subject to regulations thereunder by the FERC as to rates, accounting and other matters. The Company is subject to regulation by the DPU as to the issuance of securities. Fuel Supply (a) Oil Effective July 1, 1993, the Company executed a twenty-two month contract with Coastal Oil New England, Inc. (Coastal) for the purchase of residual fuel oil. The contract provides for delivery of a set percentage of the Company's fuel requirement, the balance (a maximum of 20%) to be met by spot purchases or by Coastal at the discretion of the Company. Energy Supply and Credit Corporation (ESCO Massachusetts, Inc.) operates the Company's oil terminal and manages the purchase, receipt and payment of oil under assignment of the Company's supply contracts to ESCO Massachusetts, Inc. Oil in the terminal's shore tanks is held in inventory by ESCO Massachusetts, Inc. and delivered upon demand to the Company's day tanks. Fuel oil storage facilities at the Canal site have a capacity of 1,199,000 barrels, representing approximately 60 days of normal operation of the two units. During 1993, ESCO maintained an average daily inventory of 583,000 barrels of fuel oil which represents 30 days of normal operation of the two units. This supply is maintained by tanker deliveries approximately every ten to fifteen days. For a discussion on the cost of fuel oil, refer to "Management's Discussion and Analysis of Results of Operations" filed under Item 7 of this report. (b) Nuclear Fuel The nuclear fuel contract and inventory information for Seabrook 1 has been furnished to the Company by North Atlantic Energy Services Corporation (NAESCO), the plant manager responsible for operation of the unit. CANAL ELECTRIC COMPANY The supply of fuel for nuclear generating plants generally involves the acquisition of uranium concentrates, its conversion to uranium hexafluoride, enrichment, fabrication of the nuclear fuel assemblies and, after its use in the reactor, its storage as spent fuel until final disposal by the federal government. Seabrook's requirement for each of these fuel components are 100% covered through 1999 by existing contracts. There are no spent fuel reprocessing or disposal facilities currently operating in the United States. Instead, commercial nuclear electric gener- ating units operating in the United States are required to retain high level wastes and spent fuel on-site. As required by the Nuclear Waste Policy Act of 1982 (the Act), as amended, the joint-owners entered into a contract with the Department of Energy for the transportation and disposal of spent fuel and high level radioactive waste at a national nuclear waste repository. Owners or generators of spent nuclear fuel or its associated wastes are required to bear all of the costs for such transportation and disposal through payment of a fee of approximately 1 mill/KWH based on net electric generation to the Nuclear Waste Fund. Under the Act, a temporary storage facility for nuclear waste was anticipated to be in operation by 1998; a reassessment of the project's schedule requires extending the completion date of the permanent facility until at least 2010. Seabrook 1 is currently licensed for enough on-site storage to accommodate all spent fuel expected to be accumulated through the year 2010. Power Contracts The Company is a party to substantially identical life-of-the-unit power contracts with Boston Edison Company, Montaup Electric Company and New England Power Company (unaffiliated utilities), under which each is severally obligated to purchase one-quarter of the capacity and energy of Canal Unit 1. Commonwealth Electric and Cambridge are jointly obligated to purchase the remaining one-quarter of the unit's capacity and energy. Similar contracts are in effect between the Company and Commonwealth Electric and Cambridge under which those companies are jointly obligated to purchase the Company's entire share of the capacity and energy of Canal Unit 2. The price of power is based on a two-part rate consisting of a demand charge and an energy charge. The demand charge covers all expenses except fuel costs and includes recovery of the original investment. It also provides for any adjustments to that investment over the economic lives of the units. The energy charge is based on the cost of fuel and is billed to each purchaser in proportion to its purchase of power. Purchasers are billed monthly. The power contracts are on file with the FERC. The Company's participation in various power arrangements is accomplished through the use of a Capacity Acquisition and Disposition Agreement (Agreement), a vehicle whereby bulk electric power is procured by the Company at the request of and for resale to its affiliates Commonwealth Electric and Cambridge. The Agreement allows the Company to act as agent for Commonwealth Electric and/or Cambridge in the procurement of additional capacity, or, to sell a portion of each company's entitlement in Unit 2. Exchange agreements are in place with several utilities whereby, in certain circumstances, it is possible to exchange capacity so that the mix of power improves the pricing for dispatch for both the seller and purchaser. Commonwealth Electric and Cambridge thus secure cost savings for their respective customers by planning for bulk power supply on a single system CANAL ELECTRIC COMPANY basis. This Agreement, which has been accepted for filing as a rate schedule by the FERC, enables the Company to recover costs incurred in connection with any unit covered by such Agreement whether or not the unit becomes operational. Power contracts are in place, whereby the Company bills Commonwealth Electric and Cambridge for certain costs associated with units subject to this Agreement. Commonwealth Electric and Cambridge, in turn, bill those charges to retail customers through rates subject to DPU regulation. In accordance with applicable provisions of the Agreement, when a source of power satisfactory to Commonwealth Electric and/or Cambridge has been identified, a document, hereafter referred to as a Capacity Acquisition or Disposition Commitment (Commitment), referencing such source of power and binding the parties thereto to the terms of the Agreement is created. Currently, Commitments are in effect for Seabrook 1, Phase I and Phase II of the Hydro-Quebec Project, varying amounts of power acquired from Northeast Utilities (NU), a 50 MW exchange with Central Vermont Public Service and a 20 MW exchange with New England Power Company through October 1993, increased to 50 MW through April 1997. Power Supply Commitments and Support Agreements In response to solicitations by NU and other utilities, the Company, on behalf of Commonwealth Electric and Cambridge, agreed to purchase entitlements through short-term contracts in various selected generating units. The contracts with NU cover the purchase of varying amounts of power through October 1994. These and other bulk electric power purchases are necessary in order to fulfill the system's NEPOOL obligation and for the Company to acquire and deliver electric generating capacity to meet Commonwealth Electric and Cambridge requirements. For additional information, refer to "Transactions with Affiliates" in Note 1 of Notes to Financial Statements and to "Management's Discussion and Analysis of Results of Operations" filed under Items 8 and 7, respectively, of this report. The Company is party to support agreements for Phase I and Phase II of the Hydro-Quebec Project and is thereby obligated to pay its share of operating and capital costs for Phase II over a 25 year period ending in 2015. Future minimum lease payments for Phase II have an estimated present value of $14.2 million at December 31, 1993. In addition, the Company has an equity interest in Phase II which amounted to $3.9 million in 1993 and $4.2 million in 1992. Construction and Financing Information concerning the Company's financing and construction programs is contained in Note 5 of Notes to Financial Statements filed under Item 8 of this report. Environmental Matters The Company is subject to laws and regulations administered by federal, state and local authorities relating to the quality of the environment. These laws and regulations affect, among other things, the siting and operation of generating facilities, and will continue to impact future operations, capital costs and construction schedules. CANAL ELECTRIC COMPANY The federal Clean Air Act, as amended, and certain state laws and regulations impose restrictions on air emissions. Some of these restrictions will become effective in 1995, and others by the year 2000. These laws and regulations have a particular impact on the cost of electric generating operations. As part of its emission reduction program, the Company has been burning more lower-sulphur content fuel oil at this plant. In addition, in October 1993, the Company reached an agreement with Montaup Electric Company (50% owner of Unit 2) and Algonquin Gas Transmission Company to build a natural gas pipeline that will serve Unit 2, subject to regulatory approvals. Unit 2 will be modified to burn gas in addition to oil. The project will improve air quality on Cape Cod, enable the plant to exceed the stringent 1995 air quality standards established by the Massachusetts Department of Environmental Protection and will also strengthen the Company's bargaining position as it seeks to secure the lowest-cost fuel for its customers. Plant conversion and pipeline construction are expected to be completed in 1996. Following the issuance of an environmental consent order in May 1993, the plant was subject to an intensive 26 week review by the Massachusetts Department of Environmental Protection. The on-site inspection of the plant ended in December 1993, with the plant meeting all state requirements. The plant will remain under state supervision and will be subject to unannounced emissions checks in order to ensure that the highest standards of air quality are maintained. Employees The Company has 124 regular employees, 88 (71%) are represented by the Utility Workers' Union of America, A.F.L.-C.I.O. The existing collective bargaining agreement expires on May 31, 1997. Employee relations have generally been satisfactory. Item 2. Item 2. Properties The Company operates a generating station located at the eastern end of the Cape Cod Canal in Sandwich, Massachusetts. The station consists of two oil-fired steam electric generating units: Canal Unit 1 with a rated capacity of 569 MW, wholly-owned by the Company; and Canal Unit 2, with a rated capacity of 580 MW, jointly-owned by the Company and Montaup Electric Company, a wholly-owned subsidiary of Eastern Utilities Associates. In addition, the Company has a 3.52% joint-ownership interest (40.5 MW of capacity) in Seabrook 1. Refer to Note 3 of Notes to Financial Statements filed under Item 8 of this report for encumbrances relative to the Company's property. Item 3. Item 3. Legal Proceedings The Company is subject to legal claims and matters arising from its normal course of business, including its ownership interest in the Seabrook plant. CANAL ELECTRIC COMPANY PART II. Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters (a) Principal Market Not applicable. The Company is a wholly-owned subsidiary of Commonwealth Energy System. (b) Number of Shareholders at December 31, 1993 One (c) Frequency and Amount of Dividends Declared in 1993 and 1992 1993 1992 Per Share Per Share Declaration Date Amount Declaration Date Amount January 28, 1993 $ 4.35 February 24, 1992 $ 3.15 April 26, 1993 2.65 April 27, 1992 2.85 July 26, 1993 2.62 July 20, 1992 2.50 October 18, 1993 2.50 October 19, 1992 3.00 December 29, 1993 8.54 $11.50 $20.66 Reference is made to Note 6 of Notes to Financial Statements filed under Item 8 of this report for restrictions against the payment of cash dividends. (d) Future dividends may vary depending upon the Company's earnings and capital requirements as well as financial and other conditions existing at that time. CANAL ELECTRIC COMPANY Item 7. Item 7. Management's Discussion and Analysis of Results of Operations The following is a discussion of certain significant factors which have affected operating revenues, expenses and net income during the periods included in the accompanying statements of income and is presented to facilitate an understanding of the results of operations. This discussion should be read in conjunction with the Notes to Financial Statements filed under Item 8 Item 8. Financial Statements and Supplementary Data The Company's financial statements required by this item are filed herewith on pages 14 through 32 of this report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None CANAL ELECTRIC COMPANY Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Canal Electric Company: We have audited the accompanying balance sheets of CANAL ELECTRIC COMPANY, (a Massachusetts corporation and wholly-owned subsidiary of Commonwealth Energy System) 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 and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Canal Electric Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 7 to the financial statements, effective January 1, 1993, the Company changed its method of accounting for costs associated with postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to 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 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. Arthur Andersen & Co. Boston, Massachusetts, February 17, 1994. CANAL ELECTRIC COMPANY INDEX TO FINANCIAL STATEMENTS AND SCHEDULES PART II. FINANCIAL STATEMENTS Balance Sheets at December 31, 1993 and 1992 Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Statements of Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and Notes to Financial Statements PART IV. SCHEDULES III Investments In, Equity Earnings of, and Dividends Received From Related Parties for the Years Ended December 31, 1993, 1992 and 1991 V Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 VI Accumulated Depreciation of Property, Plant and Equipment and Amortization of Nuclear Fuel for the Years Ended December 31, 1993, 1992 and 1991 IX Short-Term Borrowings for the Years Ended December 31, 1993, 1992 and SCHEDULES OMITTED All other schedules are not submitted because they are not applicable or required or because the required information is included in the financial statements or notes thereto. CANAL ELECTRIC COMPANY BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS 1993 1992 (Dollars in Thousands) PROPERTY, PLANT AND EQUIPMENT, at original cost $404 768 $402 595 Less - Accumulated depreciation and amortization 137 720 124 062 267 048 278 533 Add - Construction work in progress 2 501 1 625 Nuclear fuel in process 1 641 155 271 190 280 313 LEASED PROPERTY, net (Note 8) 14 150 14 868 INVESTMENTS Equity in corporate joint venture 3 861 4 170 CURRENT ASSETS Cash 12 446 Accounts receivable - Affiliated companies 12 215 11 754 Other 9 549 9 497 Unbilled revenues 659 883 Inventories, at average cost Electric production fuel oil 663 2 496 Materials and supplies 1 471 1 460 Prepaid taxes - Income 720 - Property 891 872 Other 1 472 1 086 27 652 28 494 DEFERRED CHARGES (Notes 1, 5 and 7) Seabrook 1 9 002 9 931 Seabrook 2 6 937 8 792 Other 11 509 11 454 27 448 30 177 $344 301 $358 022 CANAL ELECTRIC COMPANY BALANCE SHEETS DECEMBER 31, 1993 AND 1992 CAPITALIZATION AND LIABILITIES 1993 1992 (Dollars in Thousands) CAPITALIZATION Common Equity - Common stock, $25 par value - Authorized - 2,328,200 shares Outstanding - 1,523,200 shares, wholly-owned by Commonwealth Energy System (Parent) $ 38 080 $ 38 080 Amounts paid in excess of par value 8 321 8 321 Retained earnings (Note 6) 48 151 64 498 94 552 110 899 Long-term debt, including premiums, less current sinking fund requirements (Note 3) 88 446 98 478 182 998 209 377 CAPITAL LEASE OBLIGATIONS (Note 8) 13 575 14 270 CURRENT LIABILITIES Interim Financing - (Note 3) Notes payable to banks 28 000 19 350 Advances from affiliates 8 310 3 720 36 310 23 070 Other Current Liabilities - Current sinking fund requirements 1 110 1 108 Accounts payable - Affiliated companies 1 829 2 015 Other 15 244 16 149 Accrued taxes - Local property and other 923 934 Income 460 730 Capital lease obligations (Note 8) 575 598 Accrued interest and other 3 547 2 268 23 688 23 802 59 998 46 872 DEFERRED CREDITS Accumulated deferred income taxes 70 854 70 487 Unamortized investment tax credits 13 360 14 075 Other 3 516 2 941 87 730 87 503 COMMITMENTS AND CONTINGENCIES (Note 5) $344 301 $358 022 The accompanying notes are an integral part of these financial statements. CANAL ELECTRIC COMPANY STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) ELECTRIC OPERATING REVENUES (Note 1) Sales to affiliated companies $133 060 $144 214 $160 454 Sales to non-affiliated companies 70 000 77 451 83 374 203 060 221 665 243 828 OPERATING EXPENSES Fuel used in production 82 624 95 948 99 474 Electricity purchased for resale (Note 1) 27 977 28 847 31 343 Other operation 23 694 27 019 37 606 Maintenance 14 561 12 797 16 393 Depreciation 13 361 15 019 14 895 Amortization 3 423 3 423 (1 230) Taxes - Income (Note 2) 8 893 11 749 11 617 Local property 2 720 3 392 2 748 Payroll and other 790 686 697 178 043 198 880 213 543 OPERATING INCOME 25 017 22 785 30 285 OTHER INCOME Allowance for equity funds used during construction - 1 827 - Other, net 300 3 952 1 302 300 5 779 1 302 INCOME BEFORE INTEREST CHARGES 25 317 28 564 31 587 INTEREST CHARGES Long-term debt 9 267 9 403 9 416 Other interest charges 989 1 791 3 361 Allowance for borrowed funds used during construction (61) (1 977) (168) 10 195 9 217 12 609 NET INCOME $ 15 122 $ 19 347 $ 18 978 The accompanying notes are an integral part of these financial statements. CANAL ELECTRIC COMPANY STATEMENTS OF RETAINED EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) Balance at beginning of year $64 498 $62 668 $60 445 Add (Deduct) Net income 15 122 19 347 18 978 Cash dividends on common stock (31 469) (17 517) (16 755) Balance at end of year $48 151 $64 498 $62 668 The accompanying notes are an integral part of these financial statements. CANAL ELECTRIC COMPANY STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) OPERATING ACTIVITIES Net income $ 15 122 $ 19 347 $ 18 978 Effects of non-cash items - Depreciation and amortization 20 333 22 138 17 488 Deferred income taxes 1 445 3 950 3 866 Investment tax credits (715) (744) (729) Allowance for equity funds used during construction - (1 827) - Earnings from corporate joint venture (573) (620) (1 195) Dividends from corporate joint venture 882 822 277 Change in working capital, exclusive of cash and interim financing - Accounts receivable (513) 1 304 3 087 Unbilled revenues 224 (193) 176 Accrued income taxes, net (990) 1 313 (2 710) Local property and other taxes, net (30) (526) 326 Accounts payable and other 1 603 (2 491) (1 103) All other operating items, net (2 326) (2 988) 1 405 Net cash from operating activities 34 462 39 485 39 866 INVESTING ACTIVITIES Additions to property, plant and equipment (exclusive of AFUDC) - (6 574) (5 474) (4 889) Allowance for borrowed funds used during construction (61) (1 977) (168) Net cash used for investing activities (6 635) (7 451) (5 057) FINANCING ACTIVITIES Proceeds from (payment of) short-term borrowings 8 650 (13 850) (16 800) Proceeds from (payment of) affiliate borrowings 4 590 215 (1 085) Payment of dividends (31 469) (17 517) (16 755) Long-term debt issue refunded (9 300) - - Retirement of long-term debt through sinking funds (732) (436) (327) Net cash used for financing activities (28 261) (31 588) (34 967) Net increase (decrease) in cash (434) 446 (158) Cash at beginning of period 446 - 158 Cash at end of period $ 12 $ 446 $ - The accompanying notes are an integral part of these financial statements. CANAL ELECTRIC COMPANY NOTES TO FINANCIAL STATEMENTS (1) Significant Accounting Policies (a) General and Regulatory Canal Electric Company (the Company) is a wholly-owned subsidiary of Commonwealth Energy System. The parent company is referred to in this report as the "System" and together with its subsidiaries is referred to as "the system." The Company is regulated as to rates, accounting and other matters by various authorities including the Federal Energy Regulatory Commission (FERC) and the Massachusetts Department of Public Utilities (DPU). The System is an exempt holding company under the provisions of the Public Utility Holding Company Act of 1935 and, in addition to its investment in the Company, has interests in other utility companies and several non-regulated companies. The Company has established various regulatory assets in cases where the DPU and/or the FERC have permitted, or are expected to permit, recovery of specific costs over time. At December 31, 1993, principal regulatory assets included in deferred charges were $15.5 million for abandonment and nonconstruction costs related to the Seabrook project and $7.3 million related to deferred income taxes. (b) Reclassifications Certain prior year amounts are reclassified from time to time to conform with the presentation used in the current year's financial statements. (c) Transactions with Affiliates Transactions between the Company and other system companies include purchases and sales of electricity, including the Company's acquisition and resale of capacity entitlements and related energy generated by certain units of other New England utilities. The Company functions as the principal supplier of electric generation capacity for and on behalf of affiliates Cambridge Electric Light Company (Cambridge) and Commonwealth Electric Company (Commonwealth Electric) including abandonment and nonconstruction costs related to the Seabrook project. In addition, payments for management, accounting, data processing and other services are made to affiliate COM/Energy Services Company. Transactions with other system companies are subject to review by the FERC and the DPU. The Company's operating revenues included the following intercompany amounts for the periods indicated: Period Ended Electricity Sales Seabrook Units December 31, (Canal Units) Purchased Power and Other (Dollars in Thousands) 1993 $53 174 $31 777 $48 109 1992 60 440 32 592 51 182 1991 65 756 36 337 58 361 CANAL ELECTRIC COMPANY (d) Other Major Customers The Company is a wholesale electric generating company which sells power under life-of-the-unit contracts, approved by FERC to Boston Edison Company, Montaup Electric Company and New England Power Company, (unaffiliated utilities). Each utility is obligated to purchase one-quarter of the capacity and energy of Canal Unit 1. (e) Equity Method of Accounting The Company uses the equity method of accounting for its 3.8% invest- ment in the New England/Hydro-Quebec Phase II transmission facilities due, in part, to its ability to exercise significant influence over operating and financial policies of the entity. Under this method, it records as income the proportionate share of the net earnings of this project with a corre- sponding increase in the carrying value of the investment. The investment amount is reduced as cash dividends are received. For further information on this investment, refer to Schedule III in Part IV of this report. (f) Depreciation and Nuclear Fuel Amortization Depreciation is provided using the straight-line method at rates intended to amortize the original cost and the estimated cost of removal less salvage of properties over their estimated economic lives. The Company's composite depreciation rate, based on average depreciable property in service, was 3.47% in 1993 and 3.92% in 1992 and 1991. The depreciable life of Unit 1 was extended from 1996 to 2002 and resulted in a decrease in depreciation expense of approximately $1.7 million in 1993. The cost of nuclear fuel is amortized to fuel expense based on the quantity of energy produced. Nuclear fuel expense also includes a provision for the costs associated with the ultimate disposal of the spent nuclear fuel. (g) Maintenance Expenditures for repairs of property and replacement and renewal of items determined to be less than units of property are charged to maintenance expense. Additions, replacements and renewals of property considered to be units of property, are charged to the appropriate plant accounts. Upon retirement, accumulated depreciation is charged with the original cost of property units and the cost of removal net of salvage. (h) Allowance for Funds Used During Construction Under applicable rate-making practices, the Company is permitted to include an allowance for funds used during construction (AFUDC) as an element of its depreciable property costs. This allowance is based on the amount of construction work in progress that is not included in the rate base on which the Company earns a return. An amount equal to the AFUDC capitalized in the current period is reflected in the accompanying Statements of Income. While AFUDC does not provide funds currently, these amounts are recoverable in revenues over the service life of the constructed property. CANAL ELECTRIC COMPANY The Company develops rates based upon its current cost of capital and used a compound rate of 3.75% in 1993, 4.75% in 1992 and 6.5% in 1991. (2) Income Taxes For financial reporting purposes, the Company provides federal and state income taxes on a separate return basis. However, for federal income tax purposes, the Company's taxable income and deductions are included in the consolidated income tax return of the System and it makes tax payments or receives refunds on the basis of its tax attributes in the tax return in accordance with applicable regulations. The following is a summary of the provisions for income taxes for the years ended December 31, 1993, 1992 and 1991: 1993 1992 1991 (Dollars in Thousands) Federal: Current $ 7 192 $ 7 636 $ 7 454 Deferred 1 476 3 506 2 890 Investment tax credits (715) (744) (729) 7 953 10 398 9 615 State: Current 1 181 1 147 1 366 Deferred (31) 1 048 976 1 150 2 195 2 342 9 103 12 593 11 957 Amortization of regulatory liability relating to deferred income taxes - (604) - Total $ 9 103 $11 989 $11 957 Federal and state income taxes charged to: Operating expense $ 8 893 $11 749 $11 617 Other income 210 240 340 $ 9 103 $11 989 $11 957 Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). 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 tax basis of assets and liabilities using enacted tax rates in effect in the year in which the differences are expected to reverse. CANAL ELECTRIC COMPANY Accumulated deferred income taxes consisted of the following in 1993 and 1992: 1993 1992 (Dollars in Thousands) Liabilities Property-related $78 571 $75 948 Seabrook nonconstruction 6 017 8 175 All other 1 497 1 477 86 085 85 600 Assets Investment tax credit 8 623 8 733 Regulatory liability 5 189 4 903 All other 2 047 1 957 15 859 15 593 Accumulated deferred income taxes, net $70 226 $70 007 The net year-end deferred income tax liability above is net of a current deferred tax asset of $628,000 in 1993 and $480,000 in 1992 which was included in prepaid income taxes in the accompanying Balance Sheets. The following table, detailing the significant timing differences for 1991 which resulted in deferred income taxes, is required to be disclosed pursuant to accounting standards for income taxes in effect prior to adoption of SFAS No. 109: (Dollars in Thousands) Seabrook nonconstruction costs $ 1 179 Recovery of Seabrook 2 (826) Accelerated depreciation for tax purposes 4 308 Capitalized interest during construction (698) Seabrook 2 accretion 340 Other (437) Deferred income tax provision $ 3 866 The total income tax provision set forth on the previous page represents 38% in 1993 and 1992, and 39% in 1991 of income before such taxes. The following table reconciles the statutory federal income tax rate CANAL ELECTRIC COMPANY to these percentages: 1993 1992 1991 Federal statutory rate 35% 34% 34% Increase (Decrease) from statutory rate: State tax net of federal tax benefit 3 5 5 Amortization of investment tax credits (3) (2) (2) Allowance for equity funds used during construction - (2) - Tax versus book depreciation 5 4 3 Other (2) (1) (1) Effective federal tax rate 38% 38% 39% As a result of the Revenue Reconciliation Act of 1993, the Company's federal income tax rate increased to 35% effective January 1, 1993. (3) Long-Term Debt and Interim Financing (a) Long-Term Debt Long-term debt outstanding, exclusive of current sinking fund requirements and related premiums, collateralized by substantially all of the Company's property, is as follows: Original Balance December 31, Issue 1993 1992 (Dollars in Thousands) First Mortgage Bonds - Series A, 7%, due 1996 $19 000 $ 4 560 $ 5 320 Series B, 8.85%, due 2006 35 000 34 650 34 650 Series D, 11 1/8%, due 2007 9 300 - 9 300 Series E, 7 3/8%, due 2020 10 000 10 000 10 000 Series F, 9 7/8%, due 2020 40 000 40 000 40 000 $89 210 $99 270 The Series A First Mortgage Bonds require an annual sinking fund payment of $760,000 with an option to retire an additional $95,000 per quarter. The Series B First and General Mortgage Bonds require an annual sinking fund payment of $350,000. The requirement may be met by payment, repurchase of bonds or certification of an amount of property additions equal to 60% of bondable property (as that term is defined in the indenture). The Company expects to certify additional bondable property in lieu of making sinking fund payments on these bonds. The Series E and Series F First and General Mortgage Bonds were issued in conjunction with The Industrial Development Authority of the State of New Hampshire issuing Solid Waste Disposal Bonds and Pollution Control Bonds, CANAL ELECTRIC COMPANY respectively. The bonds were issued pursuant to a Loan and Trust Agreement dated December 1, 1990 among the Authority, the Company and the First National Bank of Boston, the Trustee. (b) Notes Payable to Banks The Company and other system companies maintain both committed and uncommitted lines of credit for the financing of their construction programs, on a short-term basis, and for other corporate purposes. As of December 31, 1993, system companies had $115 million of committed lines of credit that will expire at varying intervals in 1994. These lines are normally renewed upon expiration and require annual fees of up to .1875% of the individual line. At December 31, 1993, the uncommitted lines of credit totaled $70 million. Interest rates on the outstanding borrowings generally are at an adjusted money market rate. The Company's notes payable to banks totaled $28,000,000 and $19,350,000 at December 31, 1993 and 1992, respectively. (c) Advances from Affiliates At December 31, 1993 the Company had no notes payable to the System. The Company had short-term notes payable to the System totaling $2,840,000 at December 31, 1992. These notes are written for a term of eleven months and twenty-nine days. Interest is at the prime rate (6% at December 31, 1992) and is adjusted for changes in the rate during the term of the notes. The Company is a member of the COM/Energy Money Pool (the Pool), an arrangement among the subsidiaries of the System, whereby short-term cash surpluses are used to help meet the short-term borrowing needs of the utility subsidiaries. In general, lenders to the Pool receive a higher rate of return than they otherwise would on such investments, while borrowers pay a lower interest rate than that available from banks. At December 31, 1993 and 1992, the Company had borrowings from the Pool totaling $8,310,000 and $880,000, respectively. (d) Disclosures About Fair Value of Financial Instruments As required by Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," the fair value of certain financial instruments included in the accompanying Balance Sheets as of December 31, 1993 and 1992 are as follows: 1993 1992 (Dollars in Thousands) Carrying Fair Carrying Fair Value Value Value Value Long-Term Debt $89 556 $104 325 $99 586 $109 586 The carrying amount of cash, notes payable to banks and advances from affiliates approximates the fair value because of the short maturity of these financial instruments. CANAL ELECTRIC COMPANY The estimated fair value of long-term debt is based upon quoted market prices of the same or similar issues or on the current rates offered for debt with the same remaining maturity. The fair values shown above do not purport to represent the amounts at which those obligations would be settled. (4) Supplemental Disclosures of Cash Flow Information The Company's supplemental information concerning cash flow activities is as follows: 1993 1992 1991 (Dollars in Thousands) Interest paid (net of capitalized amounts) $ 9 704 $ 8 464 $12 529 Income taxes paid 9 467 8 123 11 072 (5) Commitments and Contingencies (a) Construction The Company is engaged in a continuous construction program presently estimated at $64.8 million for the five-year period 1994 through 1998. Of that amount, $13.2 million is estimated for 1994. The Company's program is subject to periodic review and revision. (b) Seabrook Nuclear Power Plant The system's 3.52% interest in the Seabrook nuclear power plant is owned by the Company to provide for a portion of the capacity and energy needs of Cambridge and Commonwealth Electric. The Company is recovering 100% of its Seabrook 1 investment through a power contract with Cambridge and Commonwealth Electric pursuant to FERC approval. Pertinent information with respect to the Company's joint-ownership interest in Seabrook 1 and information relating to operating expenses which are included in the accompanying financial statements are as follows: 1993 1992 (Dollars in Thousands) Utility plant-in-service $233 140 $233 651 Nuclear fuel 18 514 17 083 Accumulated depreciation and amortization (34 771) (25 382) Construction work in progress 881 623 $217 764 $225 975 CANAL ELECTRIC COMPANY 1993 1992 1991 (Dollars in Thousands) Operating expenses: Fuel $ 3 853 $ 3 952 $ 4 337 Other operation 4 580 5 705 9 239 Maintenance 893 1 508 1 601 Depreciation 6 522 6 426 7 214 Amortization 1 319 1 320 (3 333) $17 167 $18 911 $19 058 Plant capacity (MW) 1,150 In-service date 1990 Canal's share: Operating license Percent interest 3.52% expiration date 2026 Entitlement (MW) 40.5 The Company and the other joint-owners have established a Seabrook Nuclear Decommissioning Financing Fund to cover post-operational decommissioning costs. For the years 1993, 1992 and 1991, the Company paid $259,000, $235,000 and $181,000, respectively, as its share of the cost of this fund. The estimated cost to decommission the plant is $366 million. The Company's share, less its share of the market value of the decommissioning trust, would amount to approximately $11.6 million. (c)Power Contracts In response to solicitations made to NEPOOL member companies by Northeast Utilities (NU) and other utilities, the Company, on behalf of Commonwealth Electric and Cambridge, agreed to purchase entitlements through short-term contracts. These power contracts have been entered into with NU to purchase varying amounts of power through October 1994. These and other bulk electric power purchases are necessary in order to fulfill the system's NEPOOL obligation and for the Company to acquire and deliver electric generating capacity to meet Commonwealth Electric and Cambridge requirements. (d)Environmental Matters The Company is subject to laws and regulations administered by federal, state and local authorities relating to the quality of the environment. These laws and regulations affect, among other things, the siting and operation of electric generating and transmission facilities and can require the installation of expensive air and water pollution control equipment. These regulations have had an impact upon the Company's operations in the past and will continue to have an impact upon future operations, capital costs and construction schedules of major facilities. (6) Dividend Restriction At December 31, 1993, approximately $43,415,000 of retained earnings was restricted against the payment of cash dividends by terms of the Indenture of Trust securing long-term debt. CANAL ELECTRIC COMPANY (7) Employee Benefit Plans (a) Pension The Company has a noncontributory pension plan covering substantially all regular employees who have attained the age of 21 and have completed a year of service. Pension benefits are based on an employee's years of service and compensation. The Company makes monthly contributions to the plan consistent with the funding requirements of the Employee Retirement Income Security Act of 1974. Components of pension expense were as follows: 1993 1992 1991 (Dollars in Thousands) Service cost $ 384 $ 319 $ 343 Interest cost 960 799 676 Return on plan assets (1 741) (1 138) (2 119) Net amortization and deferral 913 386 1 508 Total pension expense 516 366 408 Transfers from affiliates, net 145 181 172 Less: Amounts capitalized and other 160 150 147 Net pension expense $ 501 $ 397 $ 433 The following economic assumptions were used to measure year-end obliga- tions and the estimated pension expense for the subsequent year: 1993 1992 1991 Discount rate 7.25% 8.50% 8.50% Assumed rate of return 8.50 8.50 8.50 Rate of increase in future compensation 4.50 5.50 5.50 Pension expense reflects the use of the projected unit credit method which is also the actuarial cost method used in determining future funding of the plan. The funded status of the Company's pension plan (using a measurement date of December 31) is as follows: 1993 1992 (Dollars in Thousands) Accumulated benefit obligation: Vested $ (9 333) $(6 525) Nonvested (1 614) (914) $(10 947) $(7 439) Projected benefit obligation $(13 668) $(9 898) Plan assets at fair market value 12 906 11 257 Projected benefit obligation less (greater) than plan assets (762) 1 359 Unamortized transition obligation 138 156 Unrecognized prior service cost 532 370 Unrecognized gain (248) (2 174) Accrued pension cost $ (340) $ (289) CANAL ELECTRIC COMPANY Plan assets consist primarily of fixed income and equity securities. Fluctuations in the fair market value of plan assets will affect pension expense in future years. The increase in the accumulated benefit obligation and the projected benefit obligation from December 31, 1992 to December 31, 1993 was primarily due to a reduction of the discount rate in light of current interest rates. (b) Other Postretirement Benefits Through December 31, 1992, the Company provided postretirement health care and life insurance benefits to all eligible retired employees. Employees became eligible for these benefits if their age plus years of service at retirement equaled 75 or more provided, however, that such service was performed for the Company or another subsidiary of the System. As of January 1, 1993, the Company eliminated postretirement health care benefits for those non-bargaining employees who were less than 40 years of age or had less than 12 years of service at that date. Under certain circumstances, eligible employees are now required to make contributions for postretirement benefits. Certain bargaining employees are also participating under these new eligibility requirements. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No.106). This new standard requires the accrual of the expected cost of such benefits during the employees' years of service and the recognition of an actuarially determined postretirement benefit obligation earned by existing retirees. The assumptions and calculations involved in determining the accrual and the accumulated postretirement benefit obligation (APBO) closely parallel pension accounting requirements. The cumulative effect of implementation of SFAS No. 106 as of January 1, 1993 was approximately $5 million which is being amortized over twenty years. Prior to 1993, the cost of postretirement benefits was recognized as the benefits were paid. The cost of retiree medical care and life insurance benefits under the traditional pay-as-you-go method totaled $131,000 in 1992 and $112,000 in 1991. In 1993, the Company began making contributions to various voluntary employee beneficiary association (VEBA) trusts that were established pursuant to section 501(c)9 of the Internal Revenue Code (the Code). The Company also made contributions to a sub-account of its pension plan pursuant to section 401(h) of the Code to satisfy a portion of its postretirement benefit obligation. The Company contributed approximately $684,000 to these trusts during 1993. The net periodic postretirement benefit cost for the year ended CANAL ELECTRIC COMPANY December 31, 1993 included the following components: (Dollars in Thousands) Service cost $ 169 Interest cost 428 Return on plan assets (35) Amortization of transition obligation over 20 years 249 Net amortization and deferral 1 Total postretirement benefit cost 812 Less: Amounts capitalized and other 536 Net postretirement benefit cost $ 276 The funded status of the Company's postretirement benefit plan using a measurement date of December 31, 1993 is as follows: (Dollars in Thousands) Accumulated postretirement benefit obligation: Retirees $ (2 596) Active participants (2 735) (5 331) Plan assets at fair market value 636 Projected postretirement benefit obligation greater than plan assets (4 695) Unamortized transition obligation 4 722 Unrecognized gain (27) $ - In determining its estimated APBO and the funded status of the plan, the Company assumed a discount rate of 7.25%, an expected long-term rate of return on plan assets of 8.5%, and a medical care cost trend rate of 9%, which gradually decreases to 5% in the year 2007 and remains at that level thereafter. The estimate also reflects a trend rate of 14.9% for reimbursement of Medicare Part B premiums which decreases to 5% by 2007 and a dental care trend rate of 5% in all years. A one percent change in the medical trend rate would have a $100,000 impact on the Company's annual expense (interest component-$60,000; service cost-$40,000) and would change the accumulated benefit obligation by approximately $755,000. Plan assets consist primarily of fixed income and equity securities. Fluctuations in the fair market value of plan assets will affect postretirement benefit expense in future years. (c) Savings Plan The Company has an Employees Savings Plan that provides for Company contributions equal to contributions by eligible employees up to four percent of each employee's compensation rate. Effective January 1, 1993, the rate was increased to five percent for those employees no longer eligible for postretirement benefits other than pensions. The Company's contribution was $234,000 in 1993, $197,000 in 1992 and $185,000 in 1991. CANAL ELECTRIC COMPANY (8) Lease Obligations The Company leases equipment and office space under arrangements that are classified as operating leases. These lease agreements are for terms of one year or longer. Leases currently in effect contain no provisions which prohibit the Company from entering into future lease agreements or obligations. The Company has entered into support agreements with other participating New England utilities for 3.8% of the Hydro-Quebec Phase II transmission facilities and makes monthly support payments to cover depreciation and interest costs. Future minimum lease payments, by period and in the aggregate, of capital leases and non-cancelable operating leases consisted of the following at December 31, 1993: Operating Leases Capital Leases (Dollars in Thousands) 1994 $ 438 $ 2 100 1995 372 2 036 1996 359 1 975 1997 359 1 912 1998 359 1 851 Beyond 1998 1 076 23 970 Total future minimum lease payments $2 963 33 844 Less:Estimated interest element included therein 19 694 Estimated present value of future minimum lease payments $14 150 Total rent expense for all operating leases, except those with terms of a month or less, amounted to $438,000 in 1993 and $452,000 in 1992 and 1991. There were no contingent rentals and no sublease rentals for the years 1993, 1992 and 1991. CANAL ELECTRIC COMPANY PART IV. Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Index to Financial Statements Financial statements and notes thereto of the Company together with the Report of Independent Public Accountants, are filed under Item 8 of this report and listed on the Index to Financial Statements and Schedules (page 15). (a) 2. Index to Financial Statement Schedules Filed herewith at page(s) indicated are financial statement schedules of the Company: Schedule III - Investments in, Equity Earnings of, and Dividends Received from Related Parties - Years Ended December 31, 1993, 1992 and 1991 (page 42). Schedule V - Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (pages 43-45). Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (page 46). Schedule IX - Short-Term Borrowings - Years Ended December 31, 1993, 1992 and 1991 (page 47). (a) 3. Exhibits: Notes to Exhibits - a. Unless otherwise designated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Securities and Exchange Commission file numbers indicated in parentheses. b. If applicable, as designated by an asterisk, certain documents previously filed by the Company have been disposed of by the Commission pursuant to its Records Control Schedule and are hereby being refiled by the Company. c. The following is a glossary of Commonwealth Energy System and subsidiary companies' acronyms that are used throughout the following Exhibit Index: CES.................... Commonwealth Energy System CE..................... Commonwealth Electric Company CEL.................... Cambridge Electric Light Company CEC.................... Canal Electric Company NBGEL.................. New Bedford Gas and Edison Light Company CANAL ELECTRIC COMPANY Exhibit Index Exhibit 3. Articles of incorporation and by-laws. 3.1. Articles of incorporation of CEC (Exhibit 1 to CEC's 1990 Form 10- K, File No. 2-30057). 3.2. By-laws of CEC, as amended (Exhibit 2 to the CEC 1990 Form 10-K, File No. 2-30057). Exhibit 4. Instruments defining the rights of security holders, including indentures 4.2.1 Indenture of Trust and First Mortgage between CEC and State Street Bank and Trust Company, Trustee, dated October 1, 1968 (Exhibit 4(b) to the CEC Form S-1, File No. 2-30057). 4.2.2 First and General Mortgage Indenture between CEC and Citibank, N.A., Trustee, dated September 1, 1976 (Exhibit 4(b)(2) to the CEC Form S-1, File No. 2-56915). 4.2.3 First Supplemental dated October 1, 1968 with State Street Bank and Trust Company, Trustee, dated September 1, 1976 (Exhibit 4(b)(3) to the CEC Form S-1, File No. 2-56915). 4.2.4 Second Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1983 (Exhibit 1 to the CEC 1983 Form 10-K, File No. 2-30057). 4.2.5 Third Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1990 (Exhibit 3 to the CEC 1990 Form 10-K, File No. 2-30057). 4.2.6 Fourth Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1990 (Exhibit 4 to the CEC 1990 Form 10-K, File No. 2-30057). Exhibit 10. Material Contracts 10.1 Power contracts. 10.1.1 Power contracts between CEC and NBGEL and CEL dated December 1, 1965 (Exhibit 13(a)(1-4) to the CEC Form S-1, File No. 2-30057). 10.1.2.1 Agreement between CEC and Montaup Electric Company (MEC) for use of common facilities by Canal Units I and II and for allocation of related costs, executed October 14, 1975 (Exhibit 1 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.2.2 Agreement between CEC and MEC for joint-ownership of Canal Unit II, executed October 14, 1975 (Exhibit 2 to the CEC 1985 Form 10-K, File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.2.3 Agreement between CEC and MEC for lease relating to Canal Unit II, executed October 14, 1975 (Exhibit 3 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.3 Contract between CEC, NBGEL and CEL, affiliated companies, for the sale of specified amounts of electricity from Canal Unit 2 dated January 12, 1976 (Exhibit 7 to the CES Form 10-K for 1985, File No. 1-7316). 10.1.4 Power contract, as amended to February 28, 1990, superceding the Power Contract dated September 1, 1986 and amendment dated June 1, 1988, between CEC (seller) and CE and CEL (purchasers) for seller's entire share of the Net Unit Capability of Seabrook 1 and related energy (Exhibit 1 to the CEC Form 10-Q (March 1990), File No. 2- 30057). 10.1.5 Purchase and Sale Agreement together with an implementing Addendum dated December 31, 1981 between CEC and CE for the purchase and sale of the CE 3.52% joint-ownership interest in the Seabrook units, dated January 2, 1981 (Exhibit 1 to the Company's Form 8-K (January 13, 1982), File No. 2-30057). 10.1.6 Agreement for Joint-Ownership, Construction and Operation of the New Hampshire Nuclear Units (Seabrook) dated May 1, 1973 and filed by NBGEL as Exhibit 13(N) on Form S-1 dated October 1973, File No. 2-49013, and as amended below: 10.1.6.1 First through Fifth Amendments to 10.1.6 dated May 24, 1974, June 21, 1974, September 25, 1974, October 25, 1974, and January 31, 1975, respectively (Exhibit 13(m) to the NBGEL Form S-1 (November 7, 1975), File No. 2-54995). 10.1.6.2 Sixth through Eleventh Amendments to 10.1.6 dated April 18, 1979, April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979 and December 15, 1979, respectively (Exhibit 1 to the CEC 1989 Form 10- K, File No. 2-30057). 10.1.6.3 Twelfth and Thirteenth Amendments to 10.1.6 dated May 16, 1980 and December 31, 1980, respectively ((Exhibit 1 and 2 to the CE Form 10-Q (June 1982), File No. 2-7749). 10.1.6.4 Fourteenth Amendment to 10.1.6 dated June 1, 1982 (Exhibit 3 to the CE Form 10-Q (June 1982), File No. 2-7749). 10.1.6.5 Fifteenth and Sixteenth Amendments to 10.1.6 dated April 27, 1984 and June 15, 1984, respectively (Exhibit 1 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.6.6 Seventeenth Amendment to 10.1.6 dated March 8, 1985 (Exhibit 1 to the CEC Form 10-Q (March 1985), File No. 2-30057). 10.1.6.7 Eighteenth Amendment to 10.1.6 dated March 14, 1986 (Exhibit 1 to the CEC Form 10-Q (March 1986), File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.6.8 Nineteenth Amendment to 10.1.6 dated May 1, 1986 (Exhibit 1 to the CEC Form 10-Q (June 1986), File No. 2-30057). 10.1.6.9 Twentieth Amendment to 10.1.6 dated September 19, 1986 (Exhibit 1 to the CEC Form 10-K for 1986, File No. 2-30057). 10.1.6.10 Twenty-First Amendment to 10.1.6 dated November 12, 1987 (Exhibit 1 to the CEC Form 10-K for 1987, File No. 2-30057). 10.1.6.11 Twenty-Second Amendment and Settlement Agreement to 10.1.6 dated January 13, 1989 (Exhibit 4 to the CEC 1988 Form 10-K, File No. 2- 30057). 10.1.7 Resolutions proposed by Merrill Lynch Capital Markets and adopted by the Joint-Owners of the Seabrook Nuclear Project regarding Project financing, dated May 14, 1984 (Exhibit 1 to the CEC Form 10-Q (March 1984), File No. 2-30057). 10.1.8 Interim Agreement to Preserve and Protect the Assets of and Investment in the New Hampshire Nuclear Units by and between CEC, PSNH and other Participants dated April 27, 1984 (Exhibit 2 to the CEC Form 10-Q (June 1984), File No.2-30057). 10.1.9 Agreement for Seabrook Project Disbursing Agent establishing Yankee Atomic Electric Company as the disbursing agent under the Joint- Ownership Agreement, dated May 23, 1984 (Exhibit 4 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.9.1 First Amendment to 10.1.9 dated March 8, 1985 (Exhibit 2 to the CEC Form 10-Q (March 1985),File No.2-30057). 10.1.9.2 Second through Fifth Amendments to 10.1.9 dated May 20, 1985, June 18, 1985, January 2, 1986 and November 12, 1987, respectively, (Exhibit 4 to the CEC 1987 Form 10-K, File No. 2-30057). 10.1.10 Capacity Acquisition Agreement between CEC, CEL and CE dated September 25, 1980 (Exhibit 1 to the CEC 1991 Form 10-K, File No. 2-30057). 10.1.10.1 Supplement to 10.1.10 consisting of three Capacity Acquisition Commitments each dated May 7, 1987, concerning Phases I and II of the Hydro-Quebec Project and electricity acquired from Connecticut Light and Power Company (CL&P) (Exhibit 1 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.10.2 Supplements to 10.1.10 consisting of two Capacity Acquisition Commitments each dated October 31, 1988, concerning electricity acquired from Western Massachusetts Electric Company and/or CL&P for periods ranging from November 1, 1988 to October 31, 1994 (Exhibit 2 to the CEC Form 10-Q (September 1989), File No. 2- 30057). CANAL ELECTRIC COMPANY 10.1.10.3 Amendment to 10.1.10 as amended, and restated, June 1, 1993, henceforth referred to as the Capacity Acquisition and Disposition Agreement, whereby CEC, as agent, in addition to acquiring power may also sell bulk electric power which CEL and/or CE owns or otherwise has the right to sell (Exhibit 1 to the CEC Form 10-Q (September 1993), File No. 2-30057). 10.1.10.4 Capacity Disposition Commitment dated June 25, 1993 by and between CEC (Unit 2) and CE for the sale of a portion of CE's entitlement in Unit 2 to Green Mountain Power Corporation (Exhibit 1 to the CEC Form 10-Q (September 1993), File No. 2-30057). 10.1.11 Termination Supplement between CEC, CE and CEL for Seabrook Unit 2, dated December 8, 1986 (Exhibit 3 to the CEC Form 10-K for 1986, File No. 2-30057). 10.1.12 Agreement, dated September 1, 1985, With Respect To Amendment of Agreement With Respect To Use Of Quebec Interconnection, dated December 1, 1981, among certain NEPOOL utilities to include Phase II facilities in the definition of "Project" (Exhibit 1 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.12.1 Amendatory Agreement No.3 with Respect to Use of Quebec Interconnection dated December 1, 1981, as amended to June 1, 1990, among certain NEPOOL utilities (Exhibit 1 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.13 Preliminary Quebec Interconnection Support Agreement - Phase II among certain New England electric utilities dated June 1, 1984 (Exhibit 6 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.13.1 First through Third Amendments to 10.1.13 as amended March 1, 1985, January 1, 1986 and March 1, 1987, respectively (Exhibit 1 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.13.2 Fifth through Seventh Amendments to 10.1.13 as amended October 15, 1987, December 15, 1987 and March 1, 1988, respectively (Exhibit 1 to the CEC Form 10-Q (June 1988), File No. 2-30057). 10.1.13.3 Fourth and Eighth Amendments to 10.1.13 as amended July 1, 1987 and August 1, 1988, respectively (Exhibit 3 to the CEC Form 10-Q (September 1988), File No. 2-30057). 10.1.13.4 Ninth and Tenth Amendments to 10.1.13 as amended November 1, 1988 and January 15, 1989, respectively (Exhibit 2 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.13.5 Eleventh Amendment to 10.1.13 as amended November 1, 1989 (Exhibit 4 to the CEC 1989 Form 10-K, File No. 2-30057). 10.1.13.6 Twelfth Amendment to 10.1.13 as amended April 1, 1990 (Exhibit 1 to the CEC Form 10-Q (June 1990) File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.14 Agreement to Preliminary Quebec Interconnection Support Agreement - Phase II among Public Service Company of New Hampshire (PSNH), New England Power Co. (NEP) , Boston Edison Co. (BECO), and CEC whereby PSNH assigns a portion of its interests under the original Agreement to the other three parties, dated October 1, 1987 (Exhibit 2 to the CEC 1987 Form 10-K, File No. 2-30057). 10.1.15 Phase II Equity Funding Agreement for New England Hydro Transmission Electric Company, Inc. (New England Hydro) (Massachusetts), dated June 1, 1985, between New England Hydro and certain NEPOOL utilities (Exhibit 2 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.16 Phase II Equity Funding Agreement for New England Hydro Transmission Corporation (New Hampshire Hydro), dated June 1, 1985, between New Hampshire Hydro and certain NEPOOL utilities (Exhibit 3 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.16.1 Amendment No. 1 to 10.1.16 as amended May 1, 1986 (Exhibit 6 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.16.2 Amendment No. 2 to 10.1.16 as amended September 1, 1987 (Exhibit 3 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.17 Phase II Massachusetts Transmission Facilities Support Agreement, dated June 1, 1985, refiled as a single agreement incorporating Amendments 1 through 7 dated May 1, 1986 through January 1, 1989, respectively, between New England Hydro and certain NEPOOL utilities (Exhibit 2 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.18 Phase II New Hampshire Transmission Facilities Support Agreement, dated June 1, 1985, refiled as a single agreement incorporating Amendments 1 through 8 dated May 1, 1986 through January 1, 1989, respectively, between New Hampshire Hydro and certain NEPOOL utilities (Exhibit 3 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.19 Phase II New England Power AC Facilities Support Agreement dated June 1, 1985, between New England Power and certain NEPOOL utilities (Exhibit 6 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.19.1 Amendments Nos. 1 and 2 to 10.1.19 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.19.2 Amendments Nos. 3 and 4 to 10.1.19 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (September 1987), File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.20 Phase II BECO AC Facilities Support Agreement, dated June 1, 1985, between BECO and certain NEPOOL utilities (Exhibit 7 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.20.1 Amendments Nos. 1 and 2 to 10.1.20 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 2 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.20.2 Amendments Nos. 3 and 4 to 10.1.20 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 4 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.21 Agreement Authorizing Execution of Phase II Firm Energy Contract, dated September 1, 1985, among certain NEPOOL utilities in regard to participation in the purchase of power from Hydro Quebec (Exhibit 8 to the CEC Form 10-Q (September 1985), File No. 2- 30057). 10.1.22 Agreement to Share Certain Costs Associated with the Tewksbury- Seabrook Transmission Line, by and among certain NEPOOL utilities, amending participants, dated May 8, 1986 (Exhibit 2 to the CEC 1986 Form 10-K, File No. 2-30057). 10.1.23 Power Contract between CEC (seller) and CE and CEL (purchasers) dated August 14, 1989 whereby purchasers agree to purchase the capacity and energy from seller's "Slice-of-System" entitlement from CL&P from November 1, 1989 to October 31, 1994 (Exhibit 1 to the CEC Form 10-Q (September 1989), File No. 2-30057). 10.1.23.1 Power Sale Agreement dated November 1, 1988, by and between CEC (buyer) and CL&P (seller) whereby buyer will purchase generating capacity totaling 250 MW from various seller's units ("Slice of System") for the term of November 1, 1989 to October 31, 1994 (Exhibit 3 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.24 Purchase Agreement dated March 1, 1991, by and between CEC (seller) and Central Vermont Public Service Corporation (CVPS) whereby CVPS will purchase 50 MW of capacity from CEC Unit 2 for the term of March 1, 1991 to October 31, 1995 (Exhibit 1 to the CEC Form 10-Q (June 1991), File No. 2-30057). 10.1.25 Power Sale Agreement dated March 1, 1991, by and between CEC (purchaser) and CVPS (seller) whereby buyer will purchase 50 MW of capacity from seller's units (25 MW from Vermont Yankee and 25 MW from Merrimack 2) for the term of March 1, 1991 to October 31, 1995 (Exhibit 2 to the CEC Form 10-Q (June 1991), File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.26 Power Exchange Contract, dated March 24, 1993, between New England Power Company (NEP) and CEC for an exchange of unit capacity in which NEP will purchase 20 MW of CEC's Unit 2 capacity in exchange for CEC's purchase of 20 MW of NEP's Bear Swamp Units 1 and 2 (10 MW per unit) commencing May 31, 1993 through April 28, 1997 and NEP will purchase 50 MW of CEC's Unit 2 capacity in exchange for CEC's purchase of 50 MW of NEP's Bear Swamp Units 1 and 2 (25 MW per unit) commencing November 1, 1993 through April 28, 1997 (Exhibit 1 to the CEC Form 10-Q (March 1993), File No. 2-30057). 10.2 Other agreements. 10.2.1 Employees Savings Plan of Commonwealth Energy System and Subsidiary Companies as amended and restated as of January 1, 1993 (Exhibit 2 to the CES Form 10-Q (September 1993), File No. 1-7316). 10.2.2 Pension Plan for Employees of Commonwealth Energy System and Subsidiary Companies as amended and restated January 1, 1993 (Exhibit 1 to the CES Form 10-Q (September 1993), File No.1-7316). 10.2.3 New England Power Pool Agreement (NEPOOL) dated September 1, 1971 as amended through August 1, 1977, between NEGEA Service Corp. as agent for CEL, CEC, NBGEL, and various other electric utilities operating in New England, together with amendments dated August 15, 1978 and January 31, 1979 and February 1, 1980 (Exhibit 5(c)(13) to the CES Form S-16 (April 1980), File No. 2-64731). 10.2.3.1 Thirteenth Amendment to 10.2.3 as amended September 1, 1981 (Exhibit 5 to the CES Form 10-K for 1981, File No. 1-7316). 10.2.3.2 Fourteenth through Twentieth Amendments to 10.2.3 as amended December 1, 1981, June 1, 1982, June 15, 1983, October 1, 1983, August 1, 1985, August 15, 1985 and September 1, 1985, respectively (Exhibit 4 to the CES Form 10-Q (September 1985), File No. 1-7316). 10.2.3.3 Twenty-first Amendment to the New England Power Pool Agreement dated September 1, 1971, as amended January 1, 1986 (Exhibit 1 to the CES Form 10-Q (March 1986), File No. 1-7316). 10.2.3.4 Twenty-second Amendment to 10.2.3 as amended to September 1, 1986 (Exhibit 1 to the CES Form 10-Q (September 1986), File No. 1-7316). 10.2.3.5 Twenty-third Amendment to 10.2.3 as amended to April 30, 1987 (Exhibit 1 to the CES Form 10-Q (June 1987), File No. 1-7316). 10.2.3.6 Twenty-fourth Amendment to 10.2.3 as amended to March 1, 1988 (Exhibit 1 to the CES Form 10-K for 1987, File No. 1-7316). 10.2.3.7 Twenty-fifth Amendment to 10.2.3 as amended to May 1, 1988 (Exhibit 1 to the CES Form 10-Q (March 1988), File No. 1-7316). 10.2.3.8 Twenty-sixth Amendment to 10.2.3 as amended to March 15, 1989 (Exhibit 1 to the CES Form 10-Q (March 1989), File No. 1-7316). CANAL ELECTRIC COMPANY 10.2.3.9 Twenty-seventh Amendment to 10.2.3 as amended to October 1, 1990 (Exhibit 3 to the CES 1990 Form 10-K, File No. 1-7316). 10.2.4 Fuel Supply, Facilities Lease and Operating Contract by and between on the one side, ESCO (Massachusetts), Inc. and Energy Supply & Credit Corporation on the other side and CEC dated February 1, 1985 (Exhibit 1 to the CEC Form 10-K for 1984, File No. 2-30057). 10.2.4.1 Amendments Nos. 1 and 2 to 10.2.4 as amended July 1, 1986 and November 15, 1989, respectively (Exhibit 3 to the CEC 1989 Form 10-K, File No. 2-30057). 10.2.5 Oil Supply Contract by and between CEC (buyer) and Carey Energy Fuels Corporation (seller) for a portion of CEC's requirements of No. 6 residual fuel oil, dated July 1, 1991 (Exhibit 3 to the CEC Form 10-Q (June 1991), File No. 2-30057). 10.2.6 Assignment Agreement between CEC and ESCO (Massachusetts), Inc. (ESCO-Mass) and Energy Supply and Credit Corporation whereby CEC assigns to ESCO-Mass rights and obligations under the Supply Contract with Carey Energy Fuels Corporation, dated July 1, 1991 (Exhibit 4 to the CEC Form 10-Q (June 1991), File No. 2-30057). 10.2.7 Assignment and Sublease Agreement and CEC's Consent of Assignment thereto whereby ESCO-Mass assigns its rights and obligations under Part II of the Resupply Agreement dated February 1, 1985 to ESCO Terminals Inc., dated June 4, 1985 (Exhibit 4 to the CEC Form 10-Q (June 1985), File No. 2-30057). (b) Reports on Form 8-K No reports on Form 8-K were filed during the three months ended December 31, 1993. SCHEDULE IX CANAL ELECTRIC COMPANY SHORT-TERM BORROWINGS (a) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) Maximum Weighted Month-End Average Weighted Category of Average Amount Amount Average Aggregate Balance Interest Outstanding Outstanding Interest Short-Term at End Rate at End During During the Rate During Borrowings of Period of Period the Period Period(b) the Period(c) December 31, 1993 Notes Payable to Banks $28 000 3.2% $28 000 $14 142 3.4% Notes Payable to System $ - - $ 2 840 $ 543 6.0% COM/Energy Money Pool $ 8 310 3.2% $ 8 310 $ 3 224 3.2% December 31, 1992 Notes Payable to Banks $19 350 4.3% $33 300 $26 083 4.0% Notes Payable to System $ 2 840 6.0% $ 6 185 $ 3 341 6.3% COM/Energy Money Pool $ 880 3.4% $ 2 490 $ 1 356 3.7% December 31, 1991 Notes Payable to Banks $33 200 5.4% $42 875 $35 523 6.3% Notes Payable to System $ 2 570 6.5% $ 2 700 $ 1 458 7.6% COM/Energy Money Pool $ 935 4.6% $ 3 240 $ 2 143 5.8% (a) Refer to Note 3 of Notes to Financial Statements filed under Item 8 of this report for the general terms of each category of short-term borrowings. (b) The average amount outstanding during the period is determined by averaging the level of month-end principal balances outstanding for the prior thirteen-month period ending December 31. (c) The weighted average interest rate during the period is determined by averaging the interest rates in effect on all loans transacted for the twelve-month period ended December 31. CANAL ELECTRIC COMPANY FORM 10-K 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. CANAL ELECTRIC COMPANY (Registrant) By: WILLIAM G. POIST William G. Poist, 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. Principal Executive Officers: WILLIAM G. POIST March 30, 1994 William G. Poist, Chairman of the Board and Chief Executive Officer R. D. WRIGHT March 28, 1994 Russell D. Wright, President and Chief Operating Officer Principal Financial Officer: JAMES D. RAPPOLI March 30, 1994 James D. Rappoli Financial Vice President and Treasurer Principal Accounting Officer: JOHN A. WHALEN March 28, 1994 John A. Whalen, Comptroller A majority of the Board of Directors: WILLIAM G. POIST March 30, 1994 William G. Poist, Director R. D. WRIGHT March 28, 1994 Russell D. Wright, Director JAMES D. RAPPOLI March 30, 1994 James D. Rappoli, Director

770618_1993.txt

770618_1993

1993

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ITEM 1. BUSINESS. (a) General Developments of Business Trump's Castle Funding, Inc. ("Funding") was incorporated under the laws of the State of New Jersey in May 1985 and is wholly-owned by Trump's Castle Associates, a New Jersey general partnership (the "Partnership"). Funding was formed to serve as a financing corporation to raise funds for the benefit of the Partnership. Since Funding has no business operations, its ability to service its indebtedness is completely dependent upon funds it receives from the Partnership. Accordingly, the discussion herein concentrates upon the Partnership and its operations. The Partnership is owner and operator of Trump's Castle Casino Resort ("Trump's Castle"), a luxury casino hotel located in the Marina area of Atlantic City, New Jersey. The partners in the Partnership are TC/GP, Inc. ("TC/GP"), which has a 37.5% interest in the Partnership, Donald J. Trump ("Trump"), who has a 61.5% interest in the Partnership, and Trump's Castle Hotel & Casino, Inc. ("TCHI"), which has a 1% interest in the Partnership. Trump, by virtue of his ownership of TC/GP and TCHI, is the beneficial owner of 100% of the common equity interest in the Partnership, subject to the right of the plaintiffs in certain litigation to be issued warrants for the common stock of TCHI (the "Litigation Warrants") representing the right to acquire an indirect beneficial interest in 0.5% of the common equity interest in the Partnership. See "LEGAL PROCEEDINGS" below. In December 1993, the Partnership, Funding and certain affiliated entities completed a recapitalization of their debt and equity capitalization (the "Recapitalization"). The purpose of the Recapitalization was (i) to improve the debt capitalization of the Partnership and, initially, to decrease its cash charges, (ii) to provide the holders of the Units, each Unit comprised of $1,000 principal amount of Funding's 9.5% Mortgage Bonds due 1998 (the "Bonds") and one share of TC/GP common stock, who participate in the Exchange Offer (as defined below) with a cash payment of $6.19 and securities having a combined principal amount of $905 for each Unit and (iii) to provide Trump with beneficial ownership of 100% of the common equity interests in the Partnership (subject to the Litigation Warrants). The Recapitalization was also designed to take advantage of certain provisions of the Units which were designed to provide Trump with incentives to cause the Units to be repaid or redeemed prior to maturity. The Units were issued in connection with a restructuring ("the Restructuring") of the indebtedness of Funding, the Partnership and TCHI through a prepackaged plan of reorganization (the "Plan") under chapter 11 of title 11 of the United States Code, as amended, which was consummated on May 29, 1992. The Plan was designed to alleviate a liquidity problem which the Partnership began to experience in 1990. The Recapitalization On December 28, 1993, the Partnership and Funding consummated the first step in the Recapitalization, an exchange offer (the "Exchange Offer") pursuant to which each $1,000 principal amount of Bonds accepted for exchange was exchanged for $750 principal amount of Funding's 11-3/4% Mortgage Notes due 2003 (the "Mortgage Notes"), $120 principal amount of Funding's Increasing Rate Subordinated Pay-in-Kind Notes due 2005 (the "PIK Notes") and a cash payment of $6.19, plus accrued interest to the date of exchange. The 3.8% of Bonds not validly tendered in the Exchange Offer were defeased, and pursuant to their terms, called for redemption at a price equal to 75% of the principal amount thereof, plus accrued interest to the date of redemption. On December 28, 1993, Funding issued, through a private placement, $27 million principal amount of its 11-1/2% Series A Senior Secured Notes due 2000 (the "Series A Notes"). The net proceeds from the sale of the Series A Notes were used by the Partnership (i) to fund the redemption of the Bonds not exchanged in the Exchange Offer and (ii) to repay a portion of the Partnership's outstanding indebtedness. Pursuant to the terms of a Registration Rights Agreement with the purchasers of the Series A Notes, Funding and the Partnership have filed a registration statement with the Securities and Exchange Commission (the "SEC") for the issuance of $27 million principal amount of Funding's 11-1/2% Series B Senior Secured Notes (the "Series B Notes") in exchange for the $27 million outstanding principal amount of the Series A Notes. The Series B Notes have terms which are virtually identical to those of the Series A Notes. There can be no assurance that such offering will be consummated. On December 30, 1993, the second step in the Recapitalization was consummated, a merger (the "Merger") of Trump's Castle Holding, Inc. ("Holding"), a Delaware corporation wholly owned by the Partnership, with and into TC/GP. Pursuant to the terms of the Merger, each holder of TC/GP Common Stock, other than those who exercised their statutory appraisal rights, received $35 principal amount of PIK Notes for each share of TC/GP Common Stock. The Partnership, as the holder of all of the outstanding common stock of Holding immediately prior to consummation of the Merger, acquired all of the outstanding common stock of TC/GP as a result of the Merger. Upon consummation of the Merger, the Partnership distributed all of the TC/GP common stock to Trump, and the partnership agreement of the Partnership was amended and restated to alter certain governance procedures and to otherwise reflect the Recapitalization. As a result of the Recapitalization, TC/GP has a 37.5% interest in the Partnership, Trump has a 61.5% interest in the Partnership, TCHI has a 1% interest in the Partnership and Trump is the beneficial owner of 100% of the common equity interests in the Partnership (subject to the Litigation Warrants). Also as a consequence of the Recapitalization, the principal amount of the Partnership's debt has been reduced, and, initially, the Partnership's cash charges have been reduced. Upon consummation of the Recapitalization, Funding's outstanding debt consisted of the $27 million principal amount outstanding of its Senior Notes, the approximately $242 million principal amount outstanding of its Mortgage Notes (which are subordinated to the Senior Notes) and the approximately $50 million principal amount outstanding of its PIK Notes (which are subordinated to both the Senior Notes and the Mortgage Notes). Funding has also guaranteed the Midlantic Term Loan (as defined below). In addition, upon consummation of the Recapitalization, the Partnership had outstanding approximately $357 million principal amount of indebtedness, including a term loan due to Midlantic National Bank, which had an aggregate principal amount outstanding of $38 million as of December 31, 1993 (the "Midlantic Term Loan") and the intercompany notes securing the Senior Notes, the Mortgage Notes, and the PIK Notes, which had an aggregate principal amount outstanding of approximately $319 million as of December 31, 1993. The Restructuring In 1990, the Partnership began experiencing a liquidity problem. The Partnership believes that its 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, which at the time was wholly-owned by Trump (the "Taj Mahal"), in April 1990, may also have contributed to the Partnership's liquidity problem. As a result of the Partnership's liquidity problem, Funding failed to make interest and sinking fund payments on its public debt securities. In 1990, the Partnership also failed to pay interest installments on certain indebtedness due Midlantic, although the Partnership subsequently made payment to Midlantic of all unpaid interest on such debt and met its debt service obligations to Midlantic. In order to alleviate its liquidity problem, on May 29, 1992, TCHI, Funding and the Partnership (collectively, the "Debtors") restructured their indebtedness through the Plan under chapter 11 of the Bankruptcy Code. The purpose of the Restructuring was to improve the amortization schedule and extend the maturity of the Partnership's indebtedness by reducing and deferring the Debtor's annual debt service requirements by (1) lowering the interest rate on the Partnership's and Funding's long term indebtedness to Midlantic and (2) by issuing the Bonds with an overall lower rate of interest as compared with Funding's then outstanding public debt securities. Upon consummation of the Plan, each $1,000 principal amount, or accreted amount, of Funding's public debt securities were exchanged for $1,000 in principal amount of Bonds, together with one share of the common stock of TC/GP and certain other payments. By virtue of TC/GP's interest in the Partnership, the holders of Funding's public debt securities prior to consummation of the Plan became the beneficial owners of 50% of the Partnership after consummation of the Plan. The terms of the Bonds and the partnership agreement executed upon consummation of the Restructuring were designed to provide Trump with incentives to cause the Bonds to be repaid or redeemed prior to maturity. Under the terms of the indenture pursuant to which the Bonds were issued, the Bonds were initially redeemable at a redemption price equal to 70% of the outstanding principal amount thereof, together with accrued and unpaid interest to the date of redemption. Such redemption price, however, increased over time to par on or after January 1, 1996. In addition, the partnership agreement provided that upon a redemption of the Bonds, the interest of TC/GP in the Partnership would be decreased, and the interest of Trump in the Partnership would be increased, based upon the redemption date of the Bonds and the redemption price paid with respect thereto. The earlier the redemption and the greater the redemption price paid with respect to the Bonds, the greater the adjustment to TC/GP's and Trump's partnership interests. As a result of the Exchange Offer, 96.2% of the Bonds were exchanged for Mortgage Notes, PIK Notes, and a cash payment, and 3.8% of the Bonds were redeemed for cash at 75% of their principal amount. In addition, upon consummation of the Merger, each share of TC/GP common stock was converted into the right to receive $35 principal amount of PIK Notes. See "The Recapitalization" above. (b) Financial Information About Industry Segments The Partnership operates in only one industry segment. See "SELECTED CONSOLIDATED FINANCIAL DATA" below. (c) Narrative Description of the Business Casino Hotel Operations. The Partnership owns and operates Trump's Castle, a luxury casino hotel located in the Marina District of Atlantic City, New Jersey, seven miles from New Jersey's Garden State Parkway. With its 70,000 square foot casino, first-class guest rooms and other luxury amenities, Trump's Castle has been awarded a "Four Star" Mobil Travel Guide rating in each of the last three years. Management believes that the "Four Star" rating reflects the high quality amenities and services that Trump's Castle provides to its casino patrons and hotel guests. Trump's Castle's casino offers 94 table games (including 13 poker tables) and 2,098 slot machines. During 1993, Trump's Castle completed a 10,000 square foot expansion to its casino which has enabled Trump's Castle to increase the number of slot machines on the casino floor by 300 units, to provide more space between slot machines, and to place stools in front of additional slot machines, all of which are designed to provide the gaming patron with a more comfortable gaming experience. Presently, Trump's Castle is undertaking a 3,000 square foot expansion to accommodate the addition of simulcast race-track wagering. The expansion will also increase casino access and casino visibility for hotel patrons. In addition, Trump's Castle recently completed the construction of a Las Vegas style marquee and reader board, the largest of its kind on the East Coast. See "PROPERTIES OF THE PARTNERSHIP" below. Trump's Castle has identified exceptional service as a means of differentiating itself from and competing with other casinos in Atlantic City. It has invested significant resources to the development of its 700 managers and 3,000 employees to insure that the corporate culture meets its service strategies. In addition, Trump's Castle's annual capital expenditures are designed to insure that room accommodations, restaurants, public areas, the casino and all other areas of the hotel are maintained in first-class "Four Star" condition. Trump's Castle's primary marketing strategy focuses on attracting and retaining middle and upper middle market "drive-in" patrons who visit Atlantic City frequently and have proven to be the most profitable market segment. Trump's Castle has also recently implemented an aggressive overseas marketing plan designed to broaden its patron base by seeking to attract "high roller" table game patrons who tend to wager large sums of money. Recently, Trump's Castle has recruited several senior level casino marketing executives who have extensive experience in overseas marketing and a proven track record of attracting profitable international "high rollers". This new strategy will also include promotions and offer special events aimed at the overseas market and is designed to offset the decline of table games play by the domestic market. Trump's Castle also intends to capitalize on its first-class facilities, particularly its luxury suite tower and on-site helipad to attract international patrons. Casino gaming in Atlantic City is strictly regulated under the New Jersey Casino Control Act and the regulations promulgated thereunder (the "Casino Control Act") and other applicable laws, which affect virtually all aspects of the Partnership's operations. See "Gaming and Other Laws and Regulations" below. Marketing 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 of the Taj Mahal, which at the time was wholly-owned by Trump. Management believes that the opening of the Taj Mahal had a disproportionately adverse effect on Trump's Castle due to the common use of the "Trump" name, and the fact that Trump's Castle is reached via the same access road as the Taj Mahal. The Partnership believes that results in 1991 were also affected by the weakness in the economy throughout the Northeast and the adverse impact on tourism and consumer spending in 1991 of the war in the Middle East. See "Competition" below. In 1991, the Partnership retained the services of Nicholas L. Ribis, as Chief Executive Officer, and Roger P. Wagner, as President and Chief Operating Officer. At such time, Mr. Ribis was also retained as the chief executive officer of the partnerships which operate the Taj Mahal and Trump Plaza Hotel and Casino, which at the time was wholly owned by Trump ("Trump Plaza", and together with the Taj Mahal, the "Other Trump Casinos"). Trump and this new management team implemented a new business strategy designed to capitalize on Trump's Castle's first-class facilities and improve operating results. Key elements of the new business strategy consist of differentiating Trump's Castle from other Atlantic City casinos based on its level of service, gaming environment and location, redirecting marketing efforts and continually monitoring operations to adapt to, and anticipate, industry trends. After establishing the new marketing strategy in 1991, the Partnership in 1992 implemented an aggressive plan to regain the patrons it had lost in 1990 and 1991 and to attract new patrons by increasing its promotional activities and complimentaries offered. Trump's Castle improved its market share by the end of 1992 and continues to improve operating margins by directing complimentaries and promotional activities to attract the most profitable patrons in each market segment. In addition, Trump's Castle has recently implemented an aggressive overseas marketing plan designed to broaden its patron base by seeking to attract high-end table game patrons. This new strategy will include promotions and offer special events and is designed to offset the decline of table games play by the domestic market. Service The Partnership has identified service as a means of differentiating itself from and competing with other Atlantic City casinos, and has adopted the slogan "Trump's Castle Where Service Is King." In 1990, the Partnership created a new service enhancement department designed to increase the quality of service provided to casino patrons, and create a service oriented culture. The Partnership believes that in the past most casino services were directed at high rollers and middle market patrons who wagered at table games. By providing a high level of service to all patrons, including middle market slot patrons, the Partnership seeks to foster loyalty among its patrons and repeat play. Gaming Environment In 1993, the Partnership completed a 10,000 square foot expansion of its main casino floor space bringing the total casino floor space to 70,000 square feet. This expansion enabled the Partnership to introduce live poker games and at the same time to increase the number of slot machines, to provide more space between slot machines, and to place stools in front of additional slot machines. These changes are designed to provide the gaming patron with a more comfortable gaming experience. In addition, Trump's Castle has also introduced a separate non-smoking area on its casino floor. See "PROPERTIES OF THE PARTNERSHIP" below. The Partnership continuously monitors the configuration of the casino floor and the games it offers to patrons with a view towards making changes and improvements. Trump's Castle's casino floor was the first in Atlantic City to feature live poker. 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's Castle experienced a similar increase, with slot revenue increasing from 52.5% of gaming revenue in 1988 to 70.2% of gaming revenue in 1993. In response to this trend, Trump's Castle has devoted more of its casino floor space to slot machines and has replaced 900 of its slot machines with newer machines. In the next six months Trump's Castle intends to acquire an additional 100 slot machines to replace less popular, older models. Moreover, as part of its program to attract middle market slot patrons, the Partnership has created "Castle Square", a section of the casino floor devoted to one dollar slot machines, and "Monte Carlo", a section of the casino floor devoted to high denomination slot machines (most of which provide for $5 or more per play). The Partnership is currently considering introducing another high denomination slot machine area next to the "King of Clubs" lounge and intends to introduce "keno" in the second quarter of 1994, subject to approval by the CCC. "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"). In 1991 and 1992, Trump's Castle increased promotional activities and complimentaries to its targeted patrons in order to regain lost market share. Currently, the policy at Trump's Castle is to focus promotional activities, including complimentaries, on a middle and upper middle market "drive-in" patrons who visit Atlantic City frequently and have proven to be the most profitable market segment. Entertainment and Special Events The Partnership pursues a coordinated program of headline entertainment and special events. Trump's Castle offers headline entertainment approximately twelve times a year which, in 1993, included performances by Joan Rivers, Johnny Cash, Ann Margaret, Frankie Avalon, Bobby Rydell, and The Neville Brothers. Headliners who are scheduled to appear at Trump's Castle in 1994 include Tom Jones, Sheena Easton, The Everly Brothers, The Pointer Sisters and The Beach Boys. During 1994, Trump's Castle will also produce a series of review-style shows with up to 12 shows per week for 30 weeks over the year. The review-style shows will focus on attracting mass market customers and will also be used to reward loyal high frequency middle market customers. As a part of its overseas marketing plan, Trump's Castle offers special events aimed at the overseas market. In 1993, for example, Trump's Castle held an Italian Christmas celebration targeted toward the European Market. In addition, Trump's Castle hosts over 100 special events on an invitation only basis in an effort to attract middle market gaming patrons and build loyalty among patrons. These special events include boxing, golf tournaments, birthday parties and theme parties. Headline entertainment is scheduled so as not to overlap with any of these special events. Player Development and Casino Hosts The Partnership has contracts with approximately ten sales representatives in New Jersey, New York and other states to promote Trump's Castle. Trump's Castle has sought to attract more middle market slot machine gaming patrons, as well as high rollers, through its "junket" marketing operations, which involves attracting groups of patrons by providing airfare, gifts and room accommodations. Trump's Castle has also recently undertaken a marketing effort aimed at developing patronage from the high-end table gaming markets in Europe, Asia, Canada and Latin America. The Partnership also has contracts with two international sales representatives and has recruited several senior level casino marketing executives who have extensive experience in overseas marketing and a proven track record of attracting profitable high-end table gaming patrons. Trump's Castle's casino hosts assist table game patrons, and Trump's Castle's slot sales representatives assist slot patrons on the casino floor, make room and dinner reservations and provide general assistance. Slot sales representatives also solicit Castle Card (the frequent player slot card) sign-ups in order to increase the Partnership's marketing base. Promotional Activities The Castle Card (the frequent player identification slot card) constitutes a key element in Trump's Castle's direct marketing program. Slot machine players are encouraged to register for and utilize their personalized Castle Card to earn various complimentaries based upon their level of play. The Castle 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. Slot sales and management personnel are able to monitor the identity and location of the cardholder and the frequency and denomination of his slot play. They also use this information to provide attentive service to the cardholder while he is on the casino floor. Trump's Castle 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 Castle Card and on table wagering by the casino games supervisor. Trump's Castle also utilizes a special events calendar (e.g., birthday parties, sweepstakes and special competitions) to promote its gaming operations. Credit Policy Historically, Trump's Castle has extended credit to certain qualified patrons. For the years ended December 31, 1991 and 1992, credit play at Trump's Castle as a percentage of total dollars wagered was approximately 31% and 28%, respectively. In recognition of the general economic conditions in the Northeast and consistent with a more focused marketing strategy, Trump's Castle also imposed stricter standards on applications for new or additional credit. Although Trump's Castle has successfully attracted high-end table games patrons, who in general tend to use a higher percentage of credit in their wagering, through its "junket" marketing operations and has recently undertaken a marketing effort aimed at high-end international table game patrons, who also tend to use a higher percentage of credit in their wagering, credit play as a percentage of total dollars wagered increased to only 29% for the year ended December 31, 1993. Bus Program Trump's Castle has a bus program which transports approximately 2,100 gaming patrons per day during the week and 2,600 per day on the weekends. The Partnership's bus program offers incentives and discounts to certain scheduled and chartered bus customers. Based on historical surveys, the Partnership has determined that gaming patrons who arrive by scheduled bus line as opposed to special charter or who travel distances of 60 miles or more are more likely to create higher gaming revenue for Trump's Castle. Accordingly, Trump's Castle's marketing efforts are focused on such bus patrons. Risks Inherent in an International Marketing Strategy The potential benefit derived from the Partnership's recently implemented overseas marketing plan designed to attract "high rollers", may not outweigh the high costs associated with attracting such players. In addition, the large sums of money wagered by "high rollers" may result in substantial gains or losses by individual patrons, which could increase the volatility of Trump's Castle's results of operations and thus increase the Partnership's need for liquidity. There may also be difficulties presented in collecting from such players. 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 at the beginning of 1994, 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 2.6% 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. Competition. Competition in the Atlantic City casino hotel market is intense. Trump's Castle 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's Castle faces competition from cruise lines, riverboat gaming and 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. At present, there are 12 casino hotels located in Atlantic City, including Trump's Castle, 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, or on which existing casino hotels could expand, including the property commonly known as the "Trump Regency Hotel" on which Trump Plaza has an option. Total Atlantic City gaming revenues have increased over the past three 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's Castle). The Partnership believes that results in 1991 were affected by the weakness in the economy throughout the Northeast and the adverse impact in 1991 on tourism and consumer spending of the Persian Gulf War. 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 (including Trump's Castle) experienced increased casino revenues, as compared to 1992, while three casinos 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 decline in 1990 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. The profitability of Trump's Castle could be affected by its proximity to Harrah's Marina Hotel Casino, which is owned and operated by a third party not affiliated with the Partnership. Trump's Castle and Harrah's Marina Hotel Casino are the only casino hotels located in the Marina area of Atlantic City. The remaining Atlantic City casino hotels are located on The Boardwalk. The Partnership believes that the concentration of casino hotels on The Boardwalk has resulted in a significant number of patrons being attracted to that area and away from the vicinity of Trump's Castle. The Partnership further believes that the location of Trump's Castle has adversely affected its ability to attract walk-in patrons, although the Partnership believes that its location away from The Boardwalk area serves as an attractive feature to visitors seeking to avoid the congested downtown area. The Partnership also believes that Trump's Castle benefits, to some extent, from its relative geographic isolation by virtue of the fact that patrons do not have the option of walking from one casino to another once they arrive at Trump's Castle. 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's Castle, 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 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. Trump's Castle'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. The State of Louisiana recently approved casino gaming in the city of New Orleans, and a developer has been selected. Currently, casino gaming, other than Native American gaming, is not allowed in other areas of New Jersey or in New York or Pennsylvania. However, Trump's Castle expects that proposals may be introduced to legalize riverboat or other forms of gaming in Philadelphia and one or more other locations in Pennsylvania. 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 statewide legalized gaming, such as video games with small wagers. To date, no such legislation, which may require a state constitutional amendment, has been enacted. The Partnership is unable to predict whether any such legislation, if enacted, would have a material adverse impact on the results of operations or financial condition of the Partnership. 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. In addition, in the summer months, Trump's Castle may be adversely affected by the desire of certain patrons to wager at a location which is readily accessible to The Boardwalk. The Conflicting Interests of Certain Officers and Directors of the Partnership and its Affiliates. Trump is the beneficial owner of Trump Plaza and a 50% beneficial owner of the Taj Mahal and is the sole owner of Trump Plaza Management Corp. ("TPM"), an entity that provides management services to Trump Plaza. In addition, Trump has a personal services agreement with the partnership that owns the Taj Mahal ("TTMA") pursuant to which he receives substantial compensation based, in part, on the financial results of the Taj Mahal. Under certain circumstances, Trump could increase his beneficial interest in the Taj Mahal to 100%. Trump could under certain circumstances have an incentive to operate the Other Trump Casinos to the competitive detriment of the Partnership. However, the Services Agreement entered into between the Partnership and TC/GP provides that Trump and his affiliates will not engage in any activity, transaction or action which would result in the Other Trump Casinos realizing a competitive advantage over Trump's Castle. The Other Trump Casinos compete directly with each other and with other Atlantic City casino hotels, including Trump's Castle. 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, and Messrs. Ernest E. East and John P. Burke, officers of the Partnership, are also executive officers of the partnerships that own the Other Trump Casinos. In addition, Messrs. Trump, Ribis, East and Burke 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, the common chief executive officer, and other common officers, 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. Although no specific procedures have been devised for resolving conflicts of interest confronting, or which may confront, Trump, such persons and the Other Trump Casinos, Messrs. Trump, Ribis, East and Burke do not engage in any activity which they reasonably expect will harm Trump's Castle or is otherwise inconsistent with their fiduciary obligations to the Partnership. Employees and Labor Relations. As of December 31, 1993, the Partnership employed approximately 3,700 full and part time employees for the operation of Trump's Castle, of whom approximately 932 were subject to collective bargaining agreements. The Partnership's collective bargaining agreement with Local No. 54 affiliated with the Hotel Employees and Restaurant Employees International Union AFL-CIO expires on September 14, 1994. Such agreement extends to approximately 820 employees. Preparation for negotiations for a new collective bargaining agreement with Local No. 54 are currently underway. In addition, three other collective bargaining agreements which expire in 1996 cover approximately 112 maintenance employees. The Partnership believes that its relationships with its employees are satisfactory. Funding has no employees. All of the Partnership's employees are required to be registered with or licensed by the Casino Control Commission (the "CCC") pursuant to the Casino Control Act. Casino employees are subject to more stringent licensing requirements than non-casino employees, and must meet applicable standards pertaining to such matters as financial responsibility, good character, ability, casino training, experience and New Jersey residency. Such regulations have resulted in significant competition for employees who meet these requirements. 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 in June 1985. During April 1993, the CCC renewed the Partnership's casino license and approved Trump as a natural person qualifier through May 1995. No assurance can be given that the CCC will renew the Partnership's casino license or, if it does so, as to the conditions it may impose, if any, with respect thereto. Casino License 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 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 "Employees" below. Pursuant to conditions of the Partnership's casino license, payments by the Partnership to or for the benefit of any related entity or any partner are subject to prior CCC approval; and, if the Partnership's cash position falls below $5 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 TC/GP, TCHI and Funding, 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 each 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: (a) 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 (b) if (i) 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 (x) 20% or less of the total outstanding debt of the company or (y) 50% or less of any issue of outstanding debt of the company, (ii) the securities are equity securities and represent less than 10% of the equity securities of a casino licensee's holding or intermediary companies or (iii) if 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 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. Funding and the Partnership are each 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 any 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 conditions 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: 1) statements of compliance have been issued pursuant to the Casino Control Act; 2) the casino hotel is an approved hotel in accordance with the Casino Control Act; 3) the trustee satisfies qualification criteria applicable to key casino employees, except for residency and casino experience; and 4) 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: (a) 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 (b) 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. Trump's Castle will not be required to add any additional sleeping units in connection with its 3,000 square foot expansion for simulcast race track wagering. 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 $19 million and $19.7 million, respectively, and its license, investigations, and other fees and assessments totalled approximately $3.2 million and $2.6 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 Casino Reinvestment Development Authority ("CRDA"). CRDA bonds may have terms as long as 50 years and bear interest at below market rates, resulting in a value lower than the face value of such CRDA bonds. For the first 10 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 is required to 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 is required to 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 licensees 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 TC/GP, TCHI, Funding or the Partnership 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. Such events could result in an event of default under the indentures pursuant to which the Senior Notes, Mortgage Notes and PIK Notes were issued. 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's Castle 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 cameras to monitor the casino floor and money counting areas. The count of moneys from gaming is also 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 "Service"). 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 adopted further regulations, the effectiveness of which has been suspended until 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 nonresident 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 the gaming practices of certain of its patrons. In the past, the Service had taken the position that gaming winnings from table games by nonresident aliens were subject to a 30% withholding tax; however, the Service subsequently adopted a practice of not collecting such tax. Recently enacted legislation exempts from withholding tax table game winnings by nonresident 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 Office of Financial Enforcement of the Department of the Treasury, the Partnership was alleged to have failed to timely file the "Currency Transaction Report by Casino" in connection with currency transactions in excess of $10,000 during the period from May 7, 1985 to December 31, 1988. The Partnership entered into a settlement agreement and without admitting to any wrongdoing agreed to pay a civil monetary penalty of $175,500. 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. The Partnership 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 OF THE PARTNERSHIP. The Casino Parcel. Trump's Castle is located in the Marina area of Atlantic City on an approximately 14.7 acre triangular-shaped parcel of land, which is owned by the Partnership in fee, located at the intersection of Huron Avenue and Brigantine Boulevard directly across from the Marina, approximately two miles from The Boardwalk. Trump's Castle has 70,000 square feet of casino space, which accommodates 94 table games (including 13 poker tables) and 2,098 slot machines. In addition to the casino, Trump's Castle consists of a 27 story hotel with 725 guest rooms, including 185 suites, of which 99 are "Crystal Tower" luxury suites. Renovation of 300 of the guest rooms was completed in 1993 and 250 more guest rooms are scheduled to be renovated by April of 1994. The facility also offers nine restaurants, a 460 seat cabaret theater, two cocktail lounges, 58,000 square feet of convention, ballroom and meeting space, a swimming pool, tennis courts and a sports and health club facility. Trump's Castle has been designed so that it can be enlarged in phases into a facility containing 2,000 rooms, a 1,600 seat cabaret theater and additional recreational amenities. Trump's Castle also has a nine-story garage providing on-site parking for approximately 3,000 vehicles, and a helipad which is located atop the parking garage making Trump's Castle the only Atlantic City casino with access by land, sea and air. During 1993, Trump's Castle completed a 10,000 square foot expansion to its casino which has enabled Trump's Castle to increase the number of slot machines on the casino floor by 300 units, to provide more space between slot machines and to place stools in front of additional slot machines, all of which are designed to provide the gaming patron with a more comfortable gaming experience. Presently, Trump's Castle is undertaking a 3,000 square foot expansion to accommodate the addition of simulcast race track wagering. The expansion will also increase casino access and casino visibility for hotel patrons. In addition, Trump's Castle recently completed the construction of a Las Vegas style marquee and reader board, the largest of its kind on the East Coast. The Marina. Pursuant to an agreement (the "Marina Agreement") with the New Jersey Division of Parks and Forestry, the Partnership in 1987 began operating and renovating the Marina, including docks containing approximately 600 slips. An elevated pedestrian walkway connecting Trump's Castle to a two story building at the Marina was completed in 1989. The Partnership has reconstructed the two-story building, which contains a 240 seat restaurant and offices as well as a snack bar and a large nautical theme retail store. Any improvements made to the Marina (which is owned by the State of New Jersey), excluding the elevated pedestrian walkway, automatically become the property of the State of New Jersey upon their completion. Pursuant to the Marina Agreement and pursuant to a certain lease between the State of New Jersey, as landlord, and the Partnership as tenant, dated as of September 1, 1990, the Partnership commenced leasing the Marina and the improvements thereon for an initial term of twenty-five years. The lease is a net lease pursuant to which the Partnership, in addition to the payment of annual rent equal to the greater of (i) a certain percentage of gross revenues and (ii) minimum base rent of $300,000 annually (increasing every five years to $500,000 in 2011), is responsible for all costs and expenses related to the premises, including but not limited to, all maintenance and repair costs, insurance premiums, real estate taxes, assessments and utility charges. Parking Parcel. The Partnership also owns an employee parking lot located on Route 30, approximately two miles from Trump's Castle, which can accommodate approximately 1,000 cars. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Partnership, its partners, certain members of the former Executive Committee, Funding, and certain of their employees are involved in various legal proceedings, some of which are described below. The Partnership and Funding have agreed to indemnify such persons and entities 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. Bondholder Litigation. Since June 1990, various purported class actions were commenced on behalf of the holders of Funding's Old Bonds which were outstanding prior to the consummation of the prepackaged plan of reorganization under chapter 11 of the Bankruptcy Code, and the publicly traded bonds of the Other Trump Casinos. By an order of the Judicial Panel on Multidistrict Litigation dated December 4, 1990, the United States District Court for the District of New Jersey (the "Court") was given jurisdiction over these class actions for coordinated consolidated pretrial proceedings. Pursuant to an Order of the New Jersey District Court, on or about March 1, 1991, plaintiffs in the class filed an amended and consolidated complaint (the "Complaint") that superseded the complaints originally filed in those actions. On March 5, 1992, the parties executed a Stipulation and Agreement of Compromise and Settlement (the "Stipulation of Settlement"), which embodied the agreement contained in a Memorandum of Understanding, dated July 30, 1991. On March 10, 1992, the Court preliminarily approved the terms and conditions of the Settlement proposed in the Stipulation of Settlement (the "Settlement") and certified a settlement class (the "Settlement Class"). On May 21, 1992 a settlement hearing was held before the Court and the Court approved the Settlement and determined that the Settlement was fair, reasonable, adequate, and in the best interest of the Settlement Class. Under the terms of the Settlement, the holders of Funding's publicly traded bonds outstanding prior to the Restructuring will receive: (1) the Litigation Warrants, giving holders thereof the right to purchase common stock reflecting an indirect .50% of the equity of the Partnership on a fully diluted basis, which Litigation Warrants contain an option, pursuant to which for a six month period commencing March 2000 the holders thereof can require the issuer to repurchase such Litigation Warrants at an aggregate exercise price of $4 million, subject to certain terms and conditions set out more fully in the Memorandum of Understanding, but which include payment in full of the Bonds (which condition has been satisfied), satisfaction of the mortgage securing the Midlantic Term Loan, the Partnership earning net income of $20 million in the aggregate for the years 1997, 1998 and 1999, and holders of at least 60% of the Litigation Warrants electing to exercise the option; and (2) a settlement in the amount of $1,350,000 in cash, which will be used to satisfy the costs of notice and administration as well as to compensate plaintiffs. Other Litigation. Various legal proceedings are now pending against the Partnership. The Partnership considers all such proceedings to be ordinary litigation incident to the character of its business. The majority of such claims are covered by liability insurance (subject to applicable deductibles), and the Partnership believes that the resolution of these claims, to the extent not covered by insurance, will not, individually or in the aggregate, have a material adverse effect on the financial condition or results of operations of the Partnership. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. On December 28, 1993, Funding obtained the consent of the holders of $322,855,072 outstanding principal amount of Bonds (96.2%) to an amendment of the indenture pursuant to which the Bonds were issued shortening the notice period for the redemption of the Bonds. The holders of $173,000 principal amount of Bonds (.05%) voted against such amendment and the holders of $12,698,321 principal amount of Bonds (3.8%) abstained. PART II ITEM 5. ITEM 5. MARKET FOR FUNDING'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) There is no established public trading market for Funding's outstanding Common Stock. (b) As of December 31, 1993, there was one holder of record of the outstanding Common Stock of Funding. (c) Funding has paid no cash dividends on its Common Stock. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL INFORMATION. The following sets forth certain selected consolidated financial information from Funding's and the Partnership's Consolidated Statements of Operations for the years ended December 31, 1989, 1990, 1991, 1992 and 1993 respectively, and the Consolidated Balance Sheets as of December 31, 1989, 1990, 1991, 1992 and 1993 respectively: Notes: (1) On May 29, 1992, Funding, the Partnership and TCHI consummated the Plan, which materially affects the comparability of the information set forth above. (2) On December 28, 1993, the Partnership and its affiliated entities consummated the Recapitalization, which materially affects the comparability of the information set forth above. (3) The extraordinary gain of $128,187,000, for year ended December 31, 1992 reflects a $96,896,000 accounting adjustment to carry the Bonds at fair market value based on current rates of interest at the date of issuance, an $18,000,000 forgiveness of bank borrowings, $22,805,000 representing discharge of accrued interest and net of the write-off of $9,514,000 of unamortized Bond issuance costs. (4) Long-term debt of $337,649,000 and $340,553,000 as of December 31, 1990 and 1991 had been classified as a current liability. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. General. In 1990, the Partnership began experiencing a liquidity problem that culminated in the Restructuring, which was consummated on May 29, 1992. Results of operations of the Partnership through December 31, 1992 were affected by the Restructuring, which resulted in an extraordinary gain of approximately $128.2 million for the year ended December 31, 1992. The Partnership's business is highly competitive, and any future expansions by the Mashantucket Pequot Nation or new gaming ventures by other Native American tribes or other persons in the Northeastern or mid-Atlantic regions of the United States could have a material adverse effect on the Partnership's future financial condition and results of operations. See "Competition" above. The financial information presented below reflects the results of operations of the Partnership. Since Funding has no business operations, its results of operations are not discussed below. Results of Operations for the Years Ended December 31, 1993 and 1992. The Partnership's net revenues (gross revenues less promotional expenses) for the years ended December 31, 1993 and 1992 totaled approximately $273.2 million and $268.7 million, respectively, representing a $4.5 million (1.7%) increase. Gaming revenues were approximately $246.4 million for the year ended December 31, 1993 and $242.0 million for the comparable period in 1992. Management believes the $4.4 million (1.8%) increase in gaming revenues is attributable primarily to a continuing emphasis on customer service and a repositioning by Trump's Castle to expand profitable market segments. Gaming revenue is comprised of table game win and slot machine win. For the years ended December 31, 1993 and 1992, slot win at Trump's Castle approximated $173.0 million and $164.3 million, respectively. Dollars wagered on slot machines totaled approximately $1,851.4 million and $1,682.9 million for the years ended December 31, 1993 and 1992, respectively, with a win percentage of 9.3% in 1993 and 9.8% in 1992, respectively. The lower slot win percentage (slot win as a percentage of dollars wagered on slot machines) of 9.3% was largely intentional and designed by Trump's Castle in order to remain competitive and stimulate patron play. Slot machine wagerings increased 10.0% and slot win increased 5.3% for the year ended December 31, 1993 over the comparable period in 1992. For the years ended December 31, 1993 and 1992, table game win at Trump's Castle approximated $73.4 million and $77.7 million, respectively. During these periods, dollars wagered on table games totaled approximately $492.1 million with a win percentage of 14.9% in 1993 and $504.5 million with a win percentage of 15.4% in 1992. For the years ended December 31, 1993 and 1992, gaming credit extended to customers was approximately 28.9% and 28.1% of overall table play, respectively. At December 31, 1993, gaming receivables amounted to approximately $7.3 million, net of allowances for doubtful gaming receivables of approximately $1.9 million, an increase of approximately $2.5 million over gaming receivables of $4.8 million, net of allowances for doubtful gaming receivables of approximately $2.7 million as of December 31, 1992. Nongaming revenues at Trump's Castle increased approximately $1.2 million from $57.3 million for the twelve months ended December 31, 1992, to $58.5 million for the comparable period in 1993. This improvement was attributable primarily to an increase in rooms revenue of $ 1.9 million (10.5%) to approximately $19.6 million for the year ended December 31, 1993, of which $12.2 million consisted of complimentary rooms. This increase was partially offset by a decline in food and beverage revenues of $0.8 million (-2.4%), to $30.6 million for the year ended December 31, 1993, of which approximately $15.9 million consisted of complimentary food and beverage. Room occupancy at Trump's Castle was 88.0% and 85.8%, including occupancy of 55.3% and 50.7% of the available rooms by patrons receiving complimentary rooms, and the average rate was approximately $78 and $76 for the years ended December 31, 1993 and 1992, respectively. The average rate showed modest growth primarily from pricing casino room promotional allowances at competitive levels in the Atlantic City market. While the number of customers served in the food and beverage outlets increased in 1993, food and beverage revenues declined as a result of a decrease in the average guest check. As a percentage of gaming revenues, promotional allowances did not vary significantly from year to year. General and administrative expenses decreased approximately $2.9 million (5.5%) for the year ended December 31, 1993 as compared to the prior year. While gaming revenues improved in 1993, gaming costs and expenses decreased for the year ended December 31, 1993 by $1.0 million (.6%) and all other costs and expenses excluding Depreciation and Amortization and Reorganization costs decreased $2.1 million (6.3%). The reduction in operating expenses was due to previously established cost containment measures including the discontinuance of certain marketing programs. Such measures were implemented to improve overall operating efficiencies while remaining competitive and focusing on long range marketing goals. For the year ended December 31, 1993, depreciation and amortization decreased $3.4 million (-17.1%) over the comparable period in 1992, primarily as a result of the impact of fully depreciated assets as well as the discharge of the outstanding deferred bond costs which were eliminated as a result of the Plan of Reorganization. Reorganization costs were not incurred in 1993, compared to costs of $6.0 million for the same period in 1992 due to the Plan of Reorganization, which was completed on May 29, 1992. Income from Trump's Castle's operations improved $19.8 million (or $13.8 million excluding restructuring costs) as a result of increased revenues, previously implemented cost containment measures and a continued emphasis on customer service for the year ended December 31, 1993 as compared to the same period in 1992. Interest expense increased for the twelve month period ended December 31, 1993 by approximately $11.6 million. The $11.6 million increase includes nonrecurring recapitalization costs of approximately $9.0 million. The Partnership experienced a net loss of $28.4 million for the year ended December 31, 1993 and a profit of $91.4 million, primarily as a result of the Plan of Reorganization, during the comparable period in 1992. Results of Operations for the Years Ended December 31, 1992 and 1991. Net revenues (gross revenues, less promotional expenses) for the years ended December 31, 1992 and 1991 totalled approximately $268.7 million and $220.1 million, respectively. Gaming revenues were approximately $242.0 million and $194.8 million in 1992 and 1991, respectively. Management believes the increase in gaming revenues in 1992 of 24.3% is attributable to improved customer service and a refocusing of marketing efforts to reduce unprofitable market segments. For the years ended December 31, 1992 and 1991, table game win approximated $77.7 million and $67.6 million and slot win approximated $164.3 million and $127.2 million, respectively. During these periods, table game win percentage was 15.4% in 1992 and 15.3% in 1991. Slot win percentage in 1992 was 9.8% and 9.9% in 1991. The lower slot win percentage in 1992 was largely intentional and designed to remain competitive and stimulate patron play. Slot machine wagerings increased 31.6% for the twelve months ended December 31, 1992 over the comparable period in 1991, while slot machine revenue increased 29.2%. The Partnership elected to discontinue certain Progressive Slot Jackpot Programs which positively impacted slot revenue by $1.8 million for the year ended December 31, 1992. During the year ended December 31, 1992, gaming credit extended to customers was approximately 28.1% of overall table play. At December 31, 1992, gaming receivables amounted to approximately $4.8 million, net of allowances for doubtful gaming receivables of approximately $2.7 million. Nongaming revenues increased approximately $4.1 million from $53.2 million in 1991 to $57.3 million in 1992. This improvement was attributable primarily to an increase in food and beverage revenues of 10.8% in 1992 as compared to 1991 and an increase in revenues from hotel rooms of 7.1% in 1992 as compared to 1991. Revenues from food and beverage sales for this period amounted to approximately $31.4 million, of which approximately $16.1 million consisted of complimentary food and beverage. Revenues from hotel rooms during this period amounted to approximately $17.8 million, of which $11.0 million consisted of complimentary rooms. Trump's Castle's average hotel occupancy rate, based on available rooms, was 85.8% in 1992, including occupancy of 50.7% of the available rooms by patrons receiving complimentary rooms. The average rate remained constant primarily from pricing casino room promotional allowances at competitive levels in the Atlantic City market. Food and beverage revenues improved as the marketing emphasis was shifted from attracting large numbers of mass market gaming patrons to upscale patrons with higher gaming budgets. Offsetting the nongaming revenue increase was an increase in promotional allowances of $2.8 million. Promotional allowances as a percentage of gaming revenues declined to 12.7% in 1992 from 14.3% in 1991. Gaming costs and expenses increased for the year ended December 31, 1992 by $29.6 million (or 24.8%) and all other operating expenses, excluding depreciation and amortization and restructuring costs, increased $7.3 million (or 9.5%). The comparatively lower percentage increase in other expenses (as compared to the percentage increase in gaming expenses) was due to cost containment measures, including payroll reductions and discontinuance of unprofitable marketing programs. Such measures were implemented to improve overall operating efficiencies while remaining competitive and dedicated to long range marketing goals. Depreciation and amortization declined $1.6 million (7.5%) due primarily to the implementation of cost containment measures related to capital expenditures. Income from operations improved $11.7 million primarily as a result of revenue improvements and the continuation of cost containment measures. The Partnership generated a net income of $91.4 million for the year ended December 31, 1992 and incurred a net loss of $50.2 million for the comparable period in 1991. The net income of $91.4 million includes an extraordinary gain, as a result of the Plan of Reorganization, of $128.2 million offset by litigation expenses of $1.4 million. Inflation. There was no significant impact on the Partnership's operations as a result of inflation during 1993, 1992 and 1991. Liquidity and Capital Resources. Cash flow from operating activities is the Partnership's principal source of liquidity. For the year ended December 31, 1993, the Partnership's net cash flow provided by operating activities before cash debt service obligations was $24.7 million and cash debt service was $33.8 million, resulting in net cash used by operating activities of $9.1 million. Cash and cash equivalents of $20.4 million at December 31, 1993 reflects a reduction of $3.0 million from $23.6 million at December 31, 1992. The $3.2 million reduction in cash was due to the $9.1 million used by operating activities, $10.4 million used to acquire capital assets and $3.0 million used to purchase CRDA investments ($22.3 million in the aggregate) offset by a net $19.3 million provided by financing activities. Upon consummation of the Recapitalization in December 1993, the Partnership had a working capital surplus of $2.2 million which amount is adequate to meet its needs for cash. The Partnership believes that this level of working capital is adequate to sustain existing operations in the foreseeable future. The effect of the Recapitalization on the Partnership's capital structure has been to increase the Partnership's weighted average cost of debt from approximately 9.43% to approximately 11.74%. The increase in the weighted average cost of debt capital will be offset, at least initially, by an approximately $23 million decrease in the principal amount of the Partnership's outstanding indebtedness and by a reduction in the cash required to meet the Partnership's debt service obligations in the near future. As a result of the Recapitalization, the Partnership's consolidated indebtedness has been reduced from $381 million to $358 million. The pay-in-kind feature of the PIK Notes could, however, result in an additional $130 million of indebtedness over the next ten years, assuming all accrued interest on the PIK Notes is paid in additional PIK Notes. It is projected that the Partnership will require approximately $31.4 million in 1994 and $36.1 million in 1995 in operating cash flow to meet its debt service obligations. If necessary, the Partnership may seek to obtain a credit facility of up to $10 million in principal amount to fund any shortfall in cash available to meet debt service obligations. Capital expenditures of $11.0 million for the year ended December 31, 1993 increased approximately $2.4 million due primarily to the expansion of the casino floor and the construction of an electronic graphic sign affixed to the front of the building. Capital expenditures were $8.6 million for the year ended December 31, 1992 and included the Partnership's remaining obligation on the Marina Roadway and the acquisition of new slot machines. The lower level of capital expenditures for 1992 and 1991 of $8.6 million and $5.1 million, respectively, reflected the Partnership's liquidity problems. Anticipated capital expenditures for 1994 are approximately $8 million and include casino floor improvements, renovation of certain hotel rooms and the purchase of additional slot machines for the casino expansion. Management believes that currently planned future levels of capital expenditures would be sufficient to maintain the attractiveness of Trump's Castle and the aesthetics of its casino, hotel rooms and other public areas. The Partnership intends to finance its capital expenditures in the future with existing cash on hand and cash flow from operations. Management also believes, based upon its current level of operations, that although the Partnership is highly leveraged, it will continue to have the ability to pay interest on its indebtedness and to pay other liabilities with funds from operations for the foreseeable future. However, there can be no assurance to that effect. In the event that circumstances change, the Partnership may seek to obtain a working capital facility of up to $10 million, although there can be no assurance that such financing will be available on terms acceptable to the Partnership. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. An index to 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. All decisions affecting the business and affairs of the Partnership, including the operation of Trump's Castle, are decided by the general partners acting by and through a Board of Partner Representatives, which includes a minority of Representatives elected indirectly by the holders of the Mortgage Notes and PIK Notes (the "Board of Partner Representatives"). As currently constituted, the Board of Partner Representatives consists of Donald J. Trump, Chairman, Nicholas L. Ribis, Roger P. Wagner, Ernest E. East, Asher O. Pacholder, Thomas F. Leahy and Wallace B. Askins. Messrs. Trump, Ribis and East also serve on the governing boards of Trump Taj Mahal Associates ("TTMA") and Trump Plaza Associates ("TPA"). The Partnership also has an Audit Committee on which Mr. Ribis serves with Mr. Leahy and Mr. Askins, who have been appointed thereto in accordance with the requirements of the CCC. The Audit Committee reviews matters of policy, purpose, responsibilities and authority and makes recommendations with respect thereto on the basis of reports made directly to the Audit Committee. The Surveillance Department is responsible for the surveillance, detection and video-taping of unusual and illegal activities in the casino hotel. The Internal Audit Department is responsible for the review of, reporting instances of noncompliance with, and recommending procedures to eliminate weakness in internal controls. The sole director of Funding is Trump. Trump also serves as its Chairman of the Board, President and Treasurer. Patricia M. Wild serves as its Secretary, and Robert E. Schaffhauser serves as its Assistant Treasurer. Set forth below are the names, ages, positions and offices held with Funding and the Partnership and a brief account of the business experience during the past five years of each member of the Board of Partner Representatives, the executive officers of Funding and the Partnership, and the director of Funding. Donald J. Trump -- Trump, 47 years old, has been the managing general partner of the Partnership and Chairman of the Board of Partner Representatives since May 1992 and Chairman of the Board, President and sole director of Funding since June 1985. Trump has been the President and sole director of TC/GP since December 1993. Trump served as Chairman of the Executive Committee of the Partnership from June 1985 to May 1992 and as President and sole director of TC/GP from November 1991 to May 1992. Trump has been a director and Treasurer of TCHI since April 17, 1985. Trump is the sole shareholder, Chairman of the Board of Directors, President and Treasurer of Trump Plaza Funding, Inc. ("TPFI"), the managing general partner of TPA. Trump was President and Chairman of the Board of Directors and a 50% shareholder of TP/GP Corp. ("TP/GP"), the former managing general partner of TPA, from May 1992 through June 1993; and Chairman of the Executive Committee and President of TPA from May 1986 to May 1992. Trump has been a director and President of Trump Plaza Holding, Inc. ("TPHI") and a partner in Trump Plaza Holding Associates ("TPHA") since February 1993. Trump was Chairman of the Executive Committee of 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; 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 a partner representative on the Board of Partner Representatives since May 1992 and Chief Executive Officer of the Partnership since March 1991. Mr. Ribis has served as Vice President and Assistant Secretary of TCHI since December 1993 and January 1991, respectively. Mr. Ribis served as a member of the Executive Committee of the Partnership from April 1991 to May 1992 and as Secretary of TC/GP from November 1991 to May 1992. Mr. Ribis has served as Vice President of TC/GP since December 1993. Mr. Ribis has served as a director of TPHI since June 1993 and of TPFI since July 1993; as a director and Vice President of TP/GP from May 1992 to June 1993; Chief Executive Officer of TPA since February 1991; and a member of the Executive Committee of TPA from April 1991 to May 1992. He has been Chief Executive Officer of TTMA since March 1991; a member of the Executive Committee of TTMA from April 1991 to October 1991; and a 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. Mr. Ribis serves as the Chairman of the Atlantic City Casino Association and is a member of the Board of Trustees of the CRDA. Ernest E. East -- Mr. East, 51 years old, has been a partner representative on the Board of Partner Representatives since May 1992 and has been Senior Vice President -- Administrative and Corporate Affairs of the Partnership since July 1991. Mr. East has served as Secretary of TC/GP since December 1993. Mr. East has been a director of TPHI since June 1993; Secretary of TPFI since July 1992; Senior Vice President -- Administrative and Corporate Affairs of TPA since July 1991; Senior Vice President -- Administrative and Corporate Affairs of TTMA since July 1991; and a 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. Roger P. Wagner -- Mr. Wagner, 46 years old, has been a partner representative on the Board of Partner Representatives since May 1992 and President and Chief Operating Officer of the Partnership since January 1991. Mr. Wagner served as a member of the Executive Committee of the Partnership from January 1991 to May 1992. Mr. Wagner has been a director and president of TCHI since January 1991. Prior to joining the Partnership, Mr. Wagner served as President of the Claridge Hotel Casino from June 1985 to January 1991. Asher O. Pacholder -- Dr. Pacholder, 56 years old, has been a partner representative of the Board of Partner Representatives since May 1992. Dr. Pacholder served as a director and the President of TC/GP from May 1992 to December 1993. Dr. Pacholder has served as Chairman of the Board and Managing Director of Pacholder Associates, Inc., an investment advisory firm, since 1987. In addition, Dr. Pacholder serves on the Board of Directors of The Southland Corporation, United Gas Holding Corp., ICO, Inc., an oil field services company, UF&G Pacholder Fund, Inc., a publicly traded closed end mutual fund, U.S. Trails, Inc., a recreational facility company, and Forum Group, Inc., a retirement community managerial company. Wallace B. Askins -- Mr. Askins, 63 years old, has been a partner representative of the Board of Partner Representatives since May 1992. Mr. Askins served as a director of TC/GP from May 1992 to December 1993. From 1987 to November 1992, Mr. Askins served as Executive Vice President, Chief Financial Officer and as a director of Armco Inc. Mr. Askins also serves as a director of EnviroSource, Inc. Thomas F. Leahy -- Mr. Leahy, 56 years old, has been a Member of the Board of Partner Representatives since June 1993. Mr. Leahy served as a director and Treasurer of TC/GP from May 1992 to December 1993. From 1987 to July 1992, Mr. Leahy served as Executive Vice President of CBS Broadcast Group, a unit of CBS, Inc. Since November 1992, Mr. Leahy has served as President of the Theater Development Fund, a service organization for the performing arts. From July 1992 through November 1992, Mr. Leahy served as chairman of VT Properties, Inc., a privately-held corporation which invests in literary, stage and film properties. Patrick R. Dennehy -- Mr. Dennehy, 45 years old, has been Executive Vice President of Operations of the Partnership since November 1992. Prior to joining the Partnership, Mr. Dennehy was with Harrah's Atlantic City from 1980 until 1992 in the capacity of Director of Gaming Operations, Director of Casino Marketing, Director of Casino Credit and Cashier Manager. Patricia M. Wild -- Ms. Wild, 41 years old, has been Secretary of Funding and Senior Vice President and General Counsel of the Partnership and Secretary of TCHI since December 1993. Ms. Wild served as Assistant Secretary of TPFI and Vice President, General Counsel of TPA from February 1991 to December 1993; Vice President and General Counsel of TPFI from July 1992 through December 1993; and Associate General Counsel of TPA from May 1989 through January 1991. From December 1986 to April 1989, Ms. Wild served as 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. Thomas P. Venier -- Mr. Venier, 42 years old, has been Senior Vice President of Strategic Development and Planning of the Partnership since January 1994 and was Senior Vice President of Finance of the Partnership from September 1991 to January 1994. Mr. Venier has been Chief Financial Officer of TC/GP since May 1992. Mr. Venier has been Assistant Treasurer of TCHI since March 1992. Previously, Mr. Venier served as Vice President of Finance of the Partnership from May 1988 to September 1991 and Director of Financial Accounting from July 1985 to April 1988. Nicholas J. Niglio -- Mr. Niglio joined the Partnership as Executive Vice President-Marketing in October 1993. Mr Niglio previously served as Senior Vice President of Eastern Operations of Caesars World Marketing Corporation for three years. Prior to that he served as Vice President-Casino Manager at Caesars Atlantic City for three years. Robert E. Schaffhauser -- Mr. Schaffhauser, 47 years old, joined the Partnership as Senior Vice President of Finance in January 1994 and also became an Assistant Treasurer, Chief Financial Officer and Chief Accounting Officer of Funding and an Assistant Treasurer of TCHI and TC/GP in January 1994. He served as a consultant to Trump during the immediately preceding year. Mr. Schaffhauser previously served as Senior Vice President of Finance and Administration for the Sands Hotel & Casino in Atlantic City for four years. For a period of 13 years prior thereto, he served as the Chief Financial Officer and Secretary for Metex Corporation, a publicly held manufacturer of engineered products. Mr. Schaffhauser also served as a member of Metex Corporation's Board of Directors. John P. Burke -- Mr. Burke, 46 years old, has been the Corporate Treasurer of the Partnership and TPA since October 1991. Mr. Burke has been Chief Accounting Officer of TC/GP since May 1992. Mr. Burke has been a Vice President of TCHI, TC/GP, Funding and the Partnership since December 1993. Mr. Burke has been Vice President of The Trump Organization since September 1990. He is a member of the Board of Directors of the managing general partner of TTMA. Mr. Burke was an Executive Vice President and Chief Administrative Officer of Imperial Corporation of America ("Imperial") from April 1989 through September 1990. Previously he was Executive Vice President and Chief Financial Officer of Tamco Enterprises, Inc. from May 1980 through April 1989. Each member of the Board Partner of Representatives, of the Audit Committee and all of the other persons listed above have been licensed or found qualified by the CCC. The employees of the Partnership serve at the pleasure of the Board of Partner Representatives subject to any contractual rights contained in any employment agreement. The officers of Funding serve at the pleasure of Donald J. Trump, the sole director of Funding. 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 served as executive committee members, officers, and/or directors of TPA 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 April 30, 1992, and declared effective on May 29, 1992. Donald J. Trump, Nicholas L. Ribis, Ernest E. East, Roger P. Wagner 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 May 5, 1992, and was declared effective on May 29, 1992. Donald J. 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 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, 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. Executive officers of Funding do not receive any additional compensation for serving in such capacity. In addition, Funding 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, 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. Also included in the table is information regarding Robert Pickus, who served as General Counsel of the Partnership for eleven months of 1993. 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 salary and bonus for that officer. (2) Represents vested and unvested contributions made by the Partnership under the Trump's Castle Hotel & 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) Messrs. Ribis and East devote approximately one-third of their professional time to the affairs of the Partnership; the compensation for their positions at Other Trump Casinos has not been included. (4) Effective December 6, 1993, Mr. Pickus resigned as General Counsel of the Partnership and from all other positions with the Partnership and its affiliated entities to become General Counsel to TPA. Employment Agreements. In September 1993, the Partnership entered into 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 also acts as Chief Executive Officer of TTMA and TPA, the Partnerships that own the Other Trump Casinos, and receives additional compensation from such entities. 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, on January 17, 1991, entered into an employment agreement with Roger P. Wagner, with an amendment thereto dated January 17, 1991, and a second amendment thereto dated July 18, 1992, pursuant to which Mr. Wagner serves as the Partnership's and TCHI's President and Chief Operating Officer. Mr. Wagner's employment agreement, which terminates on January 16, 1997, provides for an annual salary beginning at a minimum of $400,000 until January 16, 1994, thereafter $500,000 per year until January 16, 1995, thereafter $600,000 per year until January 16, 1996, and thereafter $750,000 per year from January 17, 1996 until January 16, 1997 and, subject to CCC approval, 1% of the Partnership's Income from Operations (as defined in such agreement) in excess of $40.0 million. The Partnership has an employment agreement with Ernest E. East, Esq., who is Senior Vice President -- Administration and Corporate Affairs of the Partnership. The agreement, which expires in June 1995, provides for an annual salary of $100,000 and a discretionary bonus. Mr. East also has similar employment agreements with each of TTMA and TPA. Mr. East devotes approximately one-third of his professional time to the affairs of the Partnership. Pursuant to an employment agreement dated January 31, 1992, as amended March 31, 1993 and December 30, 1993, Thomas P. Venier serves as Senior Vice President of Strategic Development and Planning of the Partnership. The agreement provides for an annual salary of $148,000, which is subject to review. As of April 23, 1993, and on the last day of each week thereafter, the term of the agreement has been automatically extended for one (1) week so that at all times the term during the duration of the agreement is an unexpired period of twelve (12) months. Notwithstanding such provision, Mr. Venier has the right to terminate his employment by giving 30 days written notice to the Partnership of his intent to do so. Compensation of Directors. Each Partner Representative of the Partnership (other than Trump) receives an annual fee of $50,000 and $2,500 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the Board. Compensation Committee Interlocks and Insider Participation. In general, the compensation of executive officers of the Partnership is determined by the Board of Partner Representatives, which is composed of Donald J. Trump, Nicholas L. Ribis, Roger P. Wagner, Ernest E. East, Asher O. Pacholder, Thomas F. Leahy and Wallace B. Askins. The compensation of Nicholas L. Ribis and Roger P. Wagner is set forth in their employment agreements with the Partnership. The Partnership has delegated the responsibility over certain matters, such as the bonus of Mr. Ribis, to Trump. Executive officers of Funding 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, Wagner and Burke, executive officers of the Partnership, serve on the Board of Directors of other entities in which members of the Board of Partner Representatives (namely, Messrs. Trump and Ribis) serve as executive officers. The Partnership believes that such relationships have not affected the compensation decisions made by the Board of Partner Representatives in the last fiscal year. Mr. Wagner serves as a director of TCHI, of which Messrs. Trump and Ribis serve as executive officers. 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. 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. Messrs. Trump and Ribis serve on the Board of Directors of TPFI, the managing general partner of TPA, of which Messrs. Trump, Ribis and East are executive officers. Messrs. Trump, Ribis and East also serve on the Board of Directors of TPHI, of which such persons are also executive officers. Mr. Ribis is compensated by TPA for his services as chief executive officer. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table sets forth information with respect to the amount of Funding's Common Stock owned by beneficial owners of more than 5% of Funding's Common Stock. Funding has no other class of equity securities outstanding. Title or Class Name and address of Amount and Nature of Percent of Beneficial Owners beneficial Ownership class - -------------- ------------------- -------------------- ---------- Common Stock Trump's Castle 200 Shares 100% Associates Huron Avenue and Brigantine Blvd. Atlantic City, New Jersey 08401 Currently, Trump, TC/GP and TCHI hold 61.5%, 37.5% and 1.0% interests, respectively, in Trump's Castle Associates and therefore are the beneficial owners of all of the outstanding shares of Common Stock of Funding. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Other Trump Casinos. The following table sets forth the amounts due to the Partnership from Trump and his Affiliates as of December 31, 1993. For a more detailed description of the Partnership's transactions with Trump and his Affiliates, see "Other Transactions with Affiliates" below. Amount Due and Outstanding to the Partnership as of December 31, 1993 -------------------------- Trump Plaza Associates .......................... $321,000 Trump Taj Mahal Associates ...................... 69,000 The Trump Organization .......................... 225,000 Total Due from Affiliates as of December 31, 1993 .................... $615,000 Other Transactions With Affiliates. In December 1990, Fred Trump, the father of Donald J. Trump, placed $3.5 million in cash on deposit with the Partnership's casino cage, which was recorded by the Partnership as a gaming patron deposit. Counter check(s) totalling $3.5 million were issued against the deposit, for which Fred Trump received gaming chips valued at $3.5 million. These gaming chips were included in the outstanding chip liability on the Partnership's books at September 30, 1992. In each of October 1992 and December 1993, in accordance with the indenture pursuant to which the Bonds were issued, Fred Trump redeemed $1.0 million in gaming chips for cash. The Partnership has engaged in transactions with TPA, TTMA, Plaza Operating Partners, Ltd. ("Plaza Hotel"), the partnership which operates The Plaza Hotel in New York City, and The Trump Organization. TPA, Plaza Hotel, The Trump Organization and TTMA are affiliates of Donald J. Trump. These transactions include certain shared payroll costs, fleet maintenance and limousine services, as well as complimentary services offered to customers, for which the Partnership makes the initial payment and is then reimbursed by the Affiliates. During 1993, the Partnership incurred expenses of approximately $1.3 million in corporate salaries, and $1.0 million of other transactions on behalf of these related entities. In addition, the Partnership received payments totalling $2.0 million for services rendered and had $0.4 million of deductions for similar services incurred by these related entities on behalf of the Partnership. In connection with the 1993 Recapitalization, the Partnership purchased the Midlantic Grid Note. Payment of the Midlantic Grid Note was guaranteed by Trump, which guaranty was secured by a pledge of his direct and indirect equity interest in the Partnership. In addition, Winton Associates, Inc. ("Winton") was retained by a holder of Units to negotiate the terms of the Recapitalization on behalf of the Unitholders. The Partnership paid Winton a non-refundable fee of $100,000 as well as its out-of-pocket expenses, and an additional fee of $400,000 upon consummation of the Recapitalization. Winton, in turn, retained Prudential Securities, Inc. to assist it in representing Putnam Investment Management, and paid Prudential one-half of the fees described above and reimbursed Prudential for its out-of-pocket expenses. Winton is a wholly owned subsidiary of Pacholder Associates, Inc., of which Dr. Asher Pacholder, a member of the Board of Partner Representatives, is the Chairman of the Board and Managing Director. Pursuant to the terms of the Partnership Agreement, the Partnership paid a $1.5 million cash bonus to Trump on February 16, 1994. Services Agreement. On December 28, 1993, the Partnership cancelled its existing management agreement with a corporation wholly owned by Trump and entered into a Services Agreement with TC/GP (the "Services Agreement"). In general, the Services Agreement obligates TC/GP 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 related services (the "Services") with respect to the business and operations of the Partnership, in exchange for certain fees to be paid only in those years in which EBITDA (EBITDA represents income from operations before depreciation, amortization, restructuring costs and the non-cash write-down of CRDA investments) exceeds prescribed amounts. In consideration for the Services to be rendered by TC/GP, the Partnership will pay an annual fee (which is identical to the fee which was payable under the management agreement) to TC/GP in the amount of $1.5 million for each year in which EBITDA exceeds the following amounts for the years indicated: 1993-$40.5 million; 1994-$45.0 million; 1995 and thereafter-$50.0 million. If EBITDA in any fiscal year does not exceed the applicable amount, the annual fee will be $0. In addition, TC/GP will be entitled to an incentive fee beginning with the fiscal year ending December 31, 1994 in an amount equal to 10% of EBITDA in excess of $45.0 million for such fiscal year. The Partnership will also be required to advance to TC/GP $125,000 a month which will be applied toward the annual fee, provided, however, that no advances will be made during any year if and for so long as the Managing Partner (defined in the Services Agreement as Trump) determines, in his good faith reasonable judgment, that the Partnership's budget and year-to-date performance indicate that the EBITDA target for such year will not be met. If for any year during which annual fee advances have been made it is determined that the annual fee was not earned, TC/GP will be obligated to promptly repay any amounts previously advanced. For purposes of calculating EBITDA under the Services Agreement, any incentive fees paid in respect of 1994 or thereafter shall not be deducted in determining net income. Unless sooner terminated pursuant to its terms, the Services Agreement will expire on December 31, 2005. 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. Funding did not file any reports on form 8-K during the last quarter of the year ended December 31, 1993. (C) Exhibits. All exhibits listed below are filed with this Annual Report on Form 10-K unless specifically stated to be incorporated by reference to other documents previously filed with the Securities and Exchange Commission. Exhibit 3(15) -Amended and Restated Certificate of Incorporation of Funding. 3.1(15) -Bylaws of Funding. 3.2-3.6 -Intentionally omitted. 3.7(14) -Second Amended and Restated Partnership Agreement of the Partnership. 4.1-4.10 -Intentionally omitted. 4.11(14) -Indenture, among Funding, as issuer, the Partnership, as guarantor, and the Mortgage Note Trustee, as trustee. 4.12(14) -Indenture of Mortgage between the Partnership, as Mortgagor, and Funding, as Mortgagee. 4.13(14) -Assignment Agreement between Funding and the Mortgage Note Trustee. 4.14(14) -Partnership Note. 4.15 -Form of Mortgage Note (included in Exhibit 4.11). 4.16 -Form of Partnership Guarantee (included in Exhibit 4.11). 4.17(14) -Indenture between Funding, as issuer, the Partnership, as guarantor, and the PIK Note Trustee, as trustee. 4.18(14) -Pledge Agreement between Funding and the PIK Note Trustee. 4.19(14) -Subordinated Partnership Note. 4.20 -Form of PIK Note (included in Exhibit 4.17). 4.21 -Form of Subordinated Partnership Guarantee (included in exhibit 4.17). 4.22(15) -Letter Agreement between the Partnership and the Proposed Senior Secured Note Purchasers regarding the Senior Secured Notes. 4.23(14) -Note Purchase Agreement for 11-1/2% Series A Senior Secured Notes of the Partnership due 1999. 4.24(14) -Indenture, among Funding, as issuer, the Partnership, as guarantor, and the Senior Secured Note Trustee, as trustee. 4.25(14) -Indenture of Mortgage and Security Agreement between the Partnership, as mortgagor/debtor, and Funding as mortgagee/secured party. (Senior Note Mortgage). 4.26(14) -Registration Rights Agreement by and among the Partnership and certain purchasers. 4.27 -Intentionally omitted. 4.28(14) -Guarantee Mortgage. 4.29(14) -Senior Partnership Note. 4.30(14) -Indenture of Mortgage and Security Agreement between the Partnership as mortgagor/debtor and the Senior Note Trustee as mortgagee/secured party. (Senior Guarantee Mortgage). 4.31(14) -Assignment Agreement between Funding, as assignor, and the Senior Note Trustee, as assignee. (Senior Assignment Agreement). 4.32(14) -Amended and Restated Nominee Agreement. 10.1-10.2 -Intentionally omitted. 10.3(7) -Employment Agreement dated January 17, 1991, between the Partnership and Roger P. Wagner. 10.4(2) -Second Amendment to Employment Agreement dated January 17, 1991 between the Partnership, TCHI, and Roger P. Wagner. 10.5(3) -Form of License Agreement between the Partnership and Donald J. Trump. 10.6 -Intentionally Omitted. 10.7(5) -Lease, dated June 25, 1986, between the Partnership and Trump Plaza, as the nominee of the Trump Organization. 10.8-10.10 -Intentionally omitted. 10.11(14) -Employment Agreement, between the Partnership and Nicholas Ribis. 10.12(5) -Trump's Castle Hotel & Casino Retirement Savings Plan, effective as of September 1, 1986. 10.13-10.16 -Intentionally omitted. 10.17(9) -Agreement, dated June 1, 1987, between Marina Associates, GNAC Corp., and the Partnership, individually and as assignee of Hilton New Jersey Corporation and the New Jersey Department of Transportation and the New Jersey Department of Environmental Protection. 10.18(9) -Agreement, dated June 1, 1987, between Marina Associates, the Partnership, individually and as assignee and successor of Hilton New Jersey Corporation and Golden Nugget, Inc., individually and on behalf of all of its past, present and future subsidiaries. 10.19(7) -Lease Agreement by and between State of New Jersey acting through its Department of Environmental Protection, Division of Parks and Forests, as Landlord, and the Partnership, as tenant, dated September 1, 1990. 10.20-10.21 -Intentionally omitted. 10.22(1) -Memorandum of Understanding, dated July 30, 1991, between Willkie Farr & Gallagher, Clapp & Eisenberg and Goodkind Labaton & Rudoff. 10.23(2) -Form of Employment Agreement between the Partnership and Ernest E. East. 10.24A(3) -Employment Agreement, dated January 31, 1992 between Thomas P. Venier and the Partnership. 10.24B(13) -Amendment to Employment Agreement, dated March 19, 1993, between Thomas P. Venier and the Partnership. 10.25(3) -Stipulation and Agreement of Compromise and Settlement, between Willkie Farr & Gallagher, Clapp & Eisenberg and Goodkind, Labaton, Rudoff & Sucharow. 10.26A(10) -Employment Agreement, dated November 2, 1992, between Patrick Dennehy and the Partnership. 10.26B(15) -Amendment of Employment Agreement, dated May 13, 1993, between Patrick Dennehy and the Partnership. 10.27(15) -Services Agreement. 10.28-10.29 -Intentionally omitted. 10.30(15) -Employment Agreement, dated October 4, 1993, between Nicholas Niglio and the Partnership. 10.31(11) -Employment Agreement, dated January 3, 1994, between Robert E. Schaffhauser and the Partnership. 10.32(11) -Employment Agreement dated December 20, 1993, between Patricia M. Wild and the Partnership 10.33(11) -Amendment of Employment Agreement, dated December 30, 1993, between Thomas Venier and the Partnership. 10.34(11) -Amended and Restated Credit Agreement, dated as of December 28, 1993, among Midlantic, the Partnership and Funding. 10.35(11) -Amendment No. 1 to Amended and Restated Indenture of Mortgage, between the Partnership, as Mortgagor and Midlantic, as Mortgagee. 10.36(11) -Amended and Restated Indenture of Mortgage, between the Partnership, as Mortgagor and Midlantic, as Mortgagee, dated as of May 29, 1992. 10.37(11) -Amendment No. 1 to Amended and Restated Assignment of Leases and Rents, between the Partnership, as assignor, and Midlantic, as assignee. 10.38(11) -Amended and Restated Assignment of Leases and Rents, between the Partnership, as assignor, and Midlantic, as assignee, dated as of May 29, 1992. 10.39(11) -Amendment No. 1 to Amended and Restated Assignment of Operating Assets, between the Partnership, as assignor and Midlantic, as assignee. 10.40(11) -Amended and Restated Assignment of Operating Assets, between the Partnership, as assignor, and Midlantic, as assignee, dated as of May 29, 1992. 10.41(11) -Intercreditor Agreement, by and among Midlantic, the Senior Note Trustee, the Mortgage Note Trustee, the PIK Note Trustee, Funding and the Partnership. - -------------- (1) Incorporated herein by reference to the identically numbered Exhibit to Funding's Registration Statement on Form S-4, Registration No. 33-41759, declared effective on January 23, 1992. (2) Incorporated herein by reference to the Exhibit to Funding's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. (3) Incorporated herein by reference to the Exhibit to Funding's Annual Report on Form 10-K for the year ended December 31, 1991. (4) Incorporated herein by reference to the Exhibit to Funding's Annual Report on Form 10-K for the year ended December 31, 1987. (5) Incorporated herein by reference to the Exhibit to Funding's Annual Report on Form 10-K for the year ended December 31, 1986. (6) Incorporated herein by reference to Exhibit 10.12 to Funding's Annual Report on Form 10-K for the year ended December 31, 1989. (7) Incorporated herein by reference to the Exhibit to Funding's Annual Report on Form 10-K for the year ended December 31, 1990. (8) Incorporated herein by reference to Exhibit 10.2 to Funding's Registration Statement on Form S-1, Registration No. 2-99088, declared effective on September 20, 1985. (9) Incorporated herein by reference to the Exhibit to Funding's Registration Statement on Form S-1, Registration No. 33-14907, declared effective on July 21, 1987. (10) Incorporated herein by reference to the Exhibit to Funding's Annual Report on Form 10-K for the year ended December 31, 1992. (11) Incorporated herein by reference to the identically numbered Exhibit to Funding's Registration Statement on Form S-4, Registration Number 33-52309 filed with the SEC on February 17, 1994. (12) Incorporated herein by reference to the Exhibit to TC/GP's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. (13) Incorporated herein by reference to the Exhibit to Funding's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. (14) Incorporated herein by reference to the Exhibit to Amendment No. 5 to the Schedule 13E-3 of TC/GP and the Partnership, File No. 5-36825, filed with the SEC on January 11, 1994. (15) Incorporated herein by reference to the Exhibit to Funding's and the Partnership's Registration Statement on Form S-4, Registration No. 33-68038. Report of Independent Public Accountants Consolidated Balance Sheets of Trump's Castle Associates and Subsidiary as of December 31, 1993 and 1992 Consolidated Statements of Operations of Trump's Castle Associates and Subsidiary for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Capital (Deficit) of Trump's Castle Associates for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows of Trump's Castle Associates and Subsidiary for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements of Trump's Castle Associates and Subsidiary Other Schedules are omitted for the reason that they are not required or are not applicable, or the required information is included in the combined financial statements or notes thereto. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Trump's Castle Associates and Subsidiary: We have audited the accompanying consolidated balance sheets of Trump's Castle Associates (a New Jersey general partnership) and Subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of operations, partners' capital (deficit) 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 Partnership's management. Our responsibility is to express an opinion on these consolidated 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's Castle Associates and Subsidiary 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 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 basic financial statements taken as a whole. Arthur Andersen & Co. Roseland, New Jersey February 11, 1994 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 30th day of March, 1994. TRUMP'S CASTLE FUNDING, INC. By: /s/Donald J. Trump ---------------------------- By: Donald J. Trump Title: President Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Annual 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 TRUMP'S CASTLE FUNDING, INC. By:/s/Donald J. Trump Chairman of the Board, President, March 30, 1994 - --------------------- Chief Executive Officer (Principal Donald J. Trump Executive Officer), Treasurer (Principal Financial Officer) and sole Director of the Registrant. By:/s/Robert E. Schaffhauser Assistant Treasurer of the March 30, 1994 - ---------------------------- Registrant (Principal Accounting Robert E. Schaffhauser Officer) TRUMP'S CASTLE ASSOCIATES AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS -- DECEMBER 31, 1993 AND 1992 The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. TRUMP'S CASTLE ASSOCIATES AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. TRUMP'S CASTLE ASSOCIATES AND SUBSIDIARY CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL (DEFICIT) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. TRUMP'S CASTLE ASSOCIATES AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. TRUMP'S CASTLE ASSOCIATES AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Organization and Operations: The accompanying consolidated financial statements include those of Trump's Castle Associates, a New Jersey general partnership (the "Partnership") and its wholly-owned subsidiary, Trump's Castle Funding, Inc., a New Jersey corporation (the "Company"). All significant intercompany balances and transactions have been eliminated in the consolidated financial statements. The Partnership was formed as a limited partnership in 1985 for the sole purpose of acquiring and operating Trump's Castle Casino Resort ("Trump's Castle"). The Partnership converted to a general partnership in February 1992. As a result of a recapitalization involving the Partnership, the Company and TC/GP, Inc. ("TC/GP") in December, 1993 (Note 2), the Partnership is wholly owned by Donald J. Trump, and his wholly owned companies, TC/GP and Trump's Castle Hotel & Casino Inc. ("TCHC"). Donald J. Trump has pledged his direct and indirect ownership interest in the Partnership as collateral under various personal debt agreements. The Company was incorporated on May 28, 1985 solely to serve as a financing company to raise funds through the issuance of bonds to the public (Note 4). Since the Company has no business operations, its ability to repay the principal and interest on 11-3/4% Mortgage Notes due 2003 (the "Mortgage Notes") and its Increasing Rate Subordinated Pay-in-Kind Notes due 2005 (the "PIK Notes") is completely dependent upon the operations of the Partnership. (2) Plan of Reorganization and Subsequent Recapitalization: Plan of Reorganization On March 9, 1992, the Partnership, the Company, and TCHC filed a voluntary petition for relief under chapter 11, title 11 of the United States Bankruptcy Code (the "Bankruptcy Code") and filed a Plan of Reorganization (the "Plan"). The Plan was confirmed by the Bankruptcy Court on May 5, 1992 and the Plan was consummated on May 29, 1992 (the "Effective Date"). Pursuant to the terms of the Plan, the Company's then outstanding bonds (the "Old Bonds") were exchanged for new bonds and common stock of TC/GP (Note 4) and certain modifications were made to the terms of bank borrowings (Note 5) and amounts owed to Donald J. Trump (Note 6). The issuance of the common stock of TC/GP resulted in approximately 50% of the beneficial ownership interest in the Partnership being transferred to the holders of the bonds. In accordance with AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code," the Bonds issued at the time of the reorganization were stated at the present value of amounts to be paid, determined at current interest rates (effective rate of approximately 17.4%). The effective interest rate of these bonds was determined based on the trading price of these bonds for a specific period. Stating the debt at its approximate present value resulted in a reduction in the $322,987,000 initial face amount of these bonds of approximately $96,896,000. This gain will be offset by increased interest costs over the period of the bonds to accrete such bonds to their face value at maturity. On the Effective Date, TC/GP received a 49.995% Partnership interest in the Partnership and was admitted as a partner. TC/GP also received a 50% beneficial interest in TCHC, a partner in the Partnership, which held a .01% partnership interest, thereby giving TC/GP a 50% beneficial interest in the Partnership. On the Effective Date the partners executed the Amended and Restated Partnership Agreement (the "Partnership Agreement"), which provided for, among other things, a Board of Partner Representatives (the "Board") to oversee the business and operations of the Partnership. Pursuant to the terms of the Partnership Agreement, Donald J. Trump was appointed the Managing General Partner of the Partnership responsible for its day-to-day operations and appointed four of the seven members of the Board. The remaining members of the Board were appointed by TC/GP through the holders of its Common Stock. The Plan resulted in an extraordinary gain totaling approximately $128,187,000, including the $96,896,000 discussed above, $18,000,000 representing the forgiveness of bank debt (Note 5), and $22,805,000 representing a discharge of accrued interest and accretion on indebtedness less the write-off of unamortized loan issuance costs of $9,514,000. On the Effective date, 35,447 of additional units were issued in lieu of the Bond Carryforward Amount, as defined and the Effective Date Amount, as defined. Additionally, the Plan resulted in a discharge of related party indebtedness in the approximate amount of $33,325,000 which has been accounted for as a contribution to capital (Note 6). Recapitalization On December 28, 1993, the Partnership, the Company and TC/GP consummated a Recapitalization Plan whereby each $1,000 of principal of the 9.5% Mortgage Bonds issued as part of the Plan was exchanged for $750 principal amount of the Company's 11-3/4% Mortgage Notes due 2003 (the "Mortgage Notes"), $120 principal amount of the Company's Increasing Rate Subordinated Pay-in-Kind Notes due 2005 (the "PIK Notes") and a cash payment of $6.19 plus all accrued and unpaid interest. Those bondholders who did not elect to exchange their bonds received a cash payment of $750 for each $1,000 of principal amount of bonds plus accrued and unpaid interest. In addition, each share of TC/GP common stock was exchanged for $35 principal amount of PIK Notes. As a result of the Recapitalization Plan, approximately 96% of the principal amount of the previously issued bonds were exchanged for Mortgage and PIK Notes and the TC/GP common stock was redeemed. Those bonds that were redeemed for cash were purchased at an amount which approximated their net book value at the date of purchase. The net book value of the exchanged bonds has been carried forward and allocated to the Mortgage and PIK Notes in proportion to the principal amount of Notes issued. The difference between the principal amount and net book value of these Notes will be accreted as a charge to interest expense over the life of the Notes using the effective interest method. In addition to the Mortgage and PIK Notes, the Company issued $27 million of 11-1/2% Senior Secured Notes, due 2000 (the "Senior Notes"). A portion of the proceeds from the Senior Notes were used to repay the $7 million Grid Note (Note 5). Transaction costs related to the Recapitalization Plan of approximately $9,000,000 are included in interest expense. Included in these costs is a $1,500,000 bonus to Donald J. Trump for the services he provided in connection with the recapitalization. (3) Accounting Policies: Gaming Revenues The Partnership records as gross gaming revenues the differences between amounts wagered and amounts won by casino patrons. During 1992, certain Progressive Slot Jackpot Programs were discontinued which resulted in $1,767,000 of related accruals being taken into income. Promotional Allowances Gross revenues include the retail value of the complimentary food, beverage and hotel services furnished to patrons. The retail value of these promotional allowances is deducted from gross revenues to arrive at net revenues. The cost of such complimentaries have been included as casino expenses in the accompanying consolidated statements of operations. The cost of complimentaries allocated from rooms, food and beverage departments to the casino department during the years ended December 31, 1993, 1992 and 1991 are as follows: 1993 1992 1991 ----------- ----------- ----------- Rooms $ 5,834,000 $ 5,390,000 $ 4,304,000 Food and Beverage 17,332,000 17,351,000 13,694,000 Other 2,073,000 1,954,000 1,360,000 ----------- ----------- ----------- $25,239,000 $24,695,000 $19,358,000 =========== =========== =========== Income taxes The accompanying consolidated financial statements do not include a provision for Federal income taxes of the Partnership, since any income or losses allocated to the partners are reportable for Federal income tax purposes by the Partners. Under the Casino Control Act (the "Act") and the regulations promulgated thereunder, the Partnership and the Company are required to file a consolidated New Jersey corporation business tax return. However, no provision for State income taxes has been reflected in the accompanying consolidated financial statements, since the Partnership has experienced cumulative net operating losses. As of December 31, 1993, the Partnership had New Jersey State net operating losses of approximately $144,000,000, which are available to offset taxable income through 2000. Inventories Inventories of provisions and supplies are carried at the lower of cost (first-in, first-out basis) or market. Property and equipment Property and equipment is recorded at cost and is depreciated on the straight-line method over the estimated useful lives of the assets. Estimated useful lives for furniture, fixtures and equipment and buildings are from three to eight years and forty years, respectively. Statements of cash flows For purposes of the statements of cash flows, the Company 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 (net of amounts capitalized) $44,857,000 $8,172,000 $7,902,000 =========== ========== ========== (4) Mortgage Bonds and Notes: Upon consummation of the Plan on May 29, 1992, each $1,000 principal amount of the Company's then outstanding Series A-1 Bonds or $1,000 accreted amount as of December 15, 1990 of Series A-2 Bonds were exchanged for $1,000 in principal amount of the Company's 9.50% Bonds (the "Bonds"), together with one share of the Common Stock of TC/GP and certain other payments. The New Bonds and Common Stock traded together as a unit (the "Unit") and could not be transferred separately, except upon the occurrence of certain events. The Bonds had a scheduled maturity of August 15, 1998 and bore interest at 9.50% per annum from the date of issuance, payable semi-annually on each February 15 and August 15, commencing August 15, 1992. The Company was required to pay interest in cash to the holders of the Bonds outstanding on the immediately preceding August 1 or February 1 at varying rates per annum (the "Mandatory Cash Amounts") as follows: Mandatory Cash Rate Interest Payment Date (Per Annum) - --------------------- ----------- August 15, 1992 5.00% February 15, 1993 6.00% August 15, 1993 7.00% February 15, 1994 8.00% August 15, 1994 and thereafter 9.50% For interest payment dates on or before February 15, 1994, the difference between interest calculated at the rate of 9.50% per annum and the Mandatory Cash Amount (the "Additional Amount") was required to be payable to holders of the Bonds in cash to the extent that Excess Available Cash, as defined, of the Partnership was available for such purpose and in additional Units to the extent that Excess Available Cash was less than the Additional Amount, as defined. Through August 15, 1993, interest was paid to the bondholders at the mandatory cash rate, with the balance paid in additional units. As discussed in Note 2, On December 28, 1993 all of the outstanding Mortgage Bonds and TC/GP Common stock were either redeemed or exchanged for Mortgage and PIK Notes. The Mortgage Notes bear interest, payable in cash, semi-annually, commencing May 15, 1994 at 11-3/4% and mature on November 15, 2003. As discussed in Note 2, Recapitalization, the net book value of the exchanged bonds has been carried forward and allocated to the Mortgage and PIK Notes in proportion to the principal amount of Notes issued. Accordingly, as of December 31, 1993, the Mortgage and PIK Notes outstanding are reflected on the balance sheet net of unamortized discount of $39,589,000 and $8,257,000 respectively. In the event the PIK Notes are redeemed prior to November 15, 1998, the interest rate on the Mortgage Notes will be reduced to 11-1/2%. The Mortgage Notes may be redeemed at the Company's option at a specified percentage of the principal amount commencing in 1998. The PIK Notes bear interest, payable at the Company's option in whole or in part in cash and through the issuance of additional PIK Notes, semi-annually commencing May 15, 1994 at the rate of 7% through September 30, 1994 and 13-7/8% through November 15, 2003. Thereafter interest on these Notes is payable in cash, semi-annually at the rate of 13-7/8%. The PIK Notes mature on November 15, 2005. The PIK Notes may be redeemed at the Company's option at 100% of the principal amount under certain conditions, as defined in the PIK Note Indenture, and are required to be redeemed from a specified percentage of any equity offering which includes the Partnership. The terms of both the Mortgage Notes and PIK Notes include limitations on the amount of additional indebtedness the Partnership may incur, distributions of Partnership capital, investments and other business activities. The Mortgage Notes are secured by a promissory note of the Partnership to the Company (the "Partnership Note") in an amount and with payment terms necessary to service the Mortgage Notes. The Partnership Note is secured by a mortgage on Trump's Castle and substantially all of the other assets of the Partnership. The Partnership Note has been assigned by the Company to the Trustee to secure the repayment of the Mortgage Notes. In addition, the Partnership has guaranteed (the "Guaranty") the payment of the Mortgage Notes, which Guaranty is secured by a mortgage on Trump's Castle. The Partnership Note and the Guaranty are expressly subordinated to the indebtedness described in Note 5 (the "Senior Indebtedness") and the liens of the mortgages securing the Partnership Note and the Guaranty are subordinate to the liens securing the Senior Indebtedness. The PIK Notes are secured by a subordinated promissory note of the Partnership to the Company (the "Subordinated Partnership Note"), which has been assigned to the Trustee for the PIK Notes, and the Partnership has issued a subordinated guaranty (the "Subordinated Guaranty") of the PIK Notes. The Subordinated Partnership Note and the Subordinated Guaranty are expressly subordinated to the Senior Indebtedness, the Partnership Note and the Guaranty. (5) Other Borrowings: Bank Borrowings In February 1988, the Company and the Partnership entered into a $50,000,000 revolving credit facility with Midlantic National Bank ("Midlantic") which was later converted to a term loan in August 1990 ("Term Loan"). In addition, in June 1990, the Partnership borrowed $13,000,000 from Midlantic under an unsecured line of credit pursuant to a grid note ("Grid Note"). Pursuant to the Plan, the terms of both of these loans were modified. The principal amount of the amended Term Loan (the "Amended Term Loan") was reduced to $38,000,000. The Amended Term Loan has an initial maturity of three years from the Effective Date and bears interest at 9% per annum over such period. In accordance with its terms, the Partnership has the option, subject to certain conditions, to extend the Amended Term Loan an additional five years. Upon such an extension, the interest rate on such loan will adjust to a market rate, but not less than a minimum rate of 9%. The Amended Term Loan is secured by a mortgage lien on Trump's Castle that is prior to the lien securing the Mortgage Notes (Note 4) and the Senior Notes described below. The amended Grid Note (the "Amended Grid Note") bore interest at 8.5% and the outstanding principal amount was reduced to $7,000,000 payable on demand. On December 28, 1993, the Amended Grid Note was paid in full. Senior Notes On December 28, 1993, the Company issued 11-1/2% Senior Secured Notes, due 2000. Similar to the Mortgage Notes, the Senior Notes are secured by an assignment of a promissory note of the Partnership (the "Senior Partnership Note") which is in turn secured by a mortgage on Trump's Castle and substantially all of the other assets of the Partnership. In addition, the Partnership has guaranteed (the "Senior Guaranty") the payment of the Senior Notes, which Senior Guaranty is secured by a mortgage on Trump's Castle. The Senior Partnership Note is subordinated to the Amended Term Loan described above. Interest on the Senior Notes is payable semiannually commencing May 15, 1994 at the rate of 11-1/2%; however in the event that the PIK Notes are redeemed prior to November 15, 1998, the interest rate will be reduced to 11-1/4%. The Senior Notes are subject to a required partial redemption commencing on June 1, 1998 at 100% of the principal amount. (6) Related Party Transactions: Trump Priority Interest During 1990, the Partnership borrowed $28,265,000 from Donald J. Trump, one of its general partners, which included $9,889,000 of Series A-1 Bonds (face value $12,480,000), the proceeds of which were used to partially satisfy the June 1990 interest and sinking fund requirements of the Old Bonds. Pursuant to the Plan, the above obligations and related accrued interest of $5,060,000 were canceled and contributed to capital and Donald J. Trump received in exchange therefor a priority interest in the Partnership (the "Trump Priority Interest"). The Trump Priority Interest was initially $15,000,000 and pursuant to the terms of the Partnership Agreement, the Partnership was required to pay a priority return thereon semi-annually at a rate per annum of up to 9.50%. Pursuant to the terms of the Recapitalization Plan, the Partnership Agreement was amended to provide, among other things, that Trump will be entitled to receive a priority distribution equal to the Trump Priority Interest upon liquidation and to eliminate the priority return. For the year ended December 31, 1993 and 1992, no amounts were paid as priority return on capital. Trump Management Fee The Partnership had a management agreement with Trump's Castle Management Corp. ("TCMC"), a corporation wholly owned by Donald J. Trump (the "Management Agreement"). The Management Agreement provided that the day-to-day operation of Trump's Castle and all ancillary properties and businesses of the Partnership was to be under the exclusive management and supervision of TCMC. Pursuant to the Management Agreement, the Partnership was required to pay an annual fee in the amount of $1,500,000 to TCMC for each year in which Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"), as defined, exceeds certain levels. In addition, TCMC, beginning with the fiscal year ended December 31, 1994, was to receive an incentive fee equal to 10% of the excess EBITDA over $45,000,000 for such fiscal year. During the years ended 1993 and 1992, the Partnership incurred fees and expenses of $1,647,000 and 888,000 respectively, under the Management Agreement. As a result of the Recapitalization Plan described in Note 2, on December 28, 1993, the Partnership terminated the Management Agreement with TCMC and entered into a Services Agreement with TC/GP. Pursuant to the terms of the services agreement, TC/GP is obligated to provide 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 with respect to the business and operations of the Partnership, including such other services as the Managing Partner may reasonably request. In consideration for the services to be rendered, the Partnership will pay TC/GP an annual fee on the same basis as that of the previous Management Agreement, discussed above. The Services Agreement expires on December 31, 2005. Fred Trump Gaming Chip Liability In December 1990, Fred Trump, the father of Donald J. Trump, placed $3,500,000 in cash on deposit with the Partnership's casino cage, which was recorded by the Partnership as a gaming patron deposit. Counter checks totaling $3,500,000 were issued against the deposit, for which Fred Trump received gaming chips valued at $3,500,000. On October 8, 1992, in accordance with the indenture, Fred Trump redeemed $1,000,000 in gaming chips for cash. In December 1993, Fred Trump redeemed $1,000,000 in gaming chips and placed the same amount on deposit in the casino cage. This amount was included in Patrons Deposits as of December 31, 1993 and was subsequently redeemed on January 6, 1994. The remaining liability may be redeemed at any time provided there shall exist no Event of Default, the Partnership shall have achieved EBITDA for any period of four consecutive fiscal quarters in an amount not less than $45,000,000 and or if approved by a unanimous vote of the Board of Partner Representatives with the unanimous consent of the Noteholder Representatives. The remaining gaming chip liability to Fred Trump of $1,500,000 is included in unredeemed chip liability as of December 31, 1993. Due from Affiliates Amounts due from affiliates were $615,000 and $742,000 as of December 31, 1993 and 1992, respectively. The Partnership has engaged in some limited intercompany transactions with Trump's Plaza Associates (TPA), Trump Taj Mahal Associates, (TTMA), Plaza Operating Partners, Ltd. (Plaza Hotel --the partnership which operates The Plaza Hotel in New York City) and the Trump Organization (TO). TPA, TTMA, Plaza Hotel and TO are affiliates of Donald J. Trump. These transactions include certain shared payroll costs as well as complimentary services offered to customers, for which the Partnership makes initial payments and is then reimbursed by the affiliates. During 1993, the Partnership incurred expenses of approximately $1,332,000 in corporate salaries and $952,000 of other transactions on behalf of these related entities. In addition, the Partnership received payments totaling $2,004,000 for services rendered and had $407,000 of deductions for similar costs incurred by these related entities on behalf of the Partnership. During 1992, the Partnership incurred expenses of approximately $1,240,000 in corporate salaries and $513,000 of other transactions on behalf of these related entities. In addition, the Partnership received payments totaling $1,372,000 for services rendered and had $202,000 of deductions for similar costs incurred by these related entities on behalf of the Partnership. During 1991, the Partnership incurred expenses of approximately $898,000 in corporate salaries, $1,294,000 in fleet maintenance/limousine services and $623,000 of other transactions on behalf of these related entities. In addition, the Partnership received payments totaling $2,721,000 for services rendered and had $642,000 of deductions for similar costs incurred by these related entities on behalf of the Partnership. Partnership Distribution Under the terms of the Partnership Agreement, the Partnership was required to pay all costs incurred by TC/GP. For the year ended December 31, 1993 and for the period from May 29, 1992 through December 31, 1992, the Partnership paid $736,000 and $473,000, respectively of expenses on behalf of TC/GP, which has been reflected as a partnership distribution. (7) Commitments and Contingencies: Casino License Renewal The Partnership is subject to regulation and licensing by the New Jersey Casino Control Commission (the "CCC"). The Partnership's casino license must be renewed periodically, is not transferable, is dependent upon the financial stability of the Partnership and can be revoked at any time. Due to the uncertainty of any license renewal application, there can be no assurance that the license will be renewed. Upon revocation, suspension for more than 120 days, or failure to renew the casino license due to the Partnership's financial condition or for any other reason, the Casino Control Act ("the Act") provides that the CCC may appoint a conservator to take possession of and title to the hotel and casino's business and property, subject to all valid liens, claims and encumbrances. The CCC renewed the casino license of the Partnership through May 31, 1995 subject to certain continuing reporting and compliance conditions. Employment Agreements The Partnership has entered into employment agreements with certain key employees which expire at various dates through January 16, 1997. Total minimum commitments on these agreements at December 31, 1993 were approximately $6,507,000. Legal Proceedings The Partnership is involved in legal proceedings incurred in the normal course of business. In the opinion of management and its counsel, if adversely decided, none of these proceedings would have a material effect on the consolidated financial position of the Partnership. Casino Reinvestment Development Authority Obligations Pursuant to the provisions of the Act, the Partnership, commencing twelve months after the date of opening of Trump's Castle in June 1985 and continuing for a period of twenty-five years thereafter, must either obtain investment tax credits (as defined in the Act), in an amount equivalent to 1.25% of its gross casino revenues (as defined in the Act) or pay an alternative tax of 2.5% of its gross casino revenues. Investment tax credits may be obtained by making qualified investments, as defined, 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 to satisfy its investment obligations. In April 1990, the Partnership modified its agreement with the CRDA under which it was required to purchase CRDA bonds to satisfy the investment alternative tax. Under the terms of the agreement, the Partnership donated $9,589,000 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 used to satisfy substantial portions of the Partnership's future investment alternative tax obligations over the following four to six quarters. As a result of this agreement, the Partnership charged $1,588,000 to operations in 1990 to reduce deposits previously made to the amount of the future tax credits received. For the years ended December 31, 1993, 1992, and 1991, the Partnership charged to operations, $115,000, $679,000 and $1,959,000, respectively, which represents amortization of a portion of the tax credits discussed above. In addition, for the years ended December 31, 1993, 1992, and 1991, the Partnership charged to operations $953,000, $656,000 and $137,000, respectively, to give effect to the below market interest rates associated with purchased CRDA bonds. (8) Employee Benefits 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 up to the maximum amount permitted by law, 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 approximately $846,000, $764,000 and $343,000 for matching contributions for the years ended December 31, 1993, 1992 and 1991, respectively. The Partnership makes payments to various trusteed pension plans under industry-wide union agreements. The payments are based on the hours worked by or gross wages paid to covered employees. It is not practical to determine the amount of payments ultimately used to fund pension benefit plans or the current financial condition of the plans. Under the Employee Retirement Income Security Act, the Partnership may be liable for its share of the plans' unfunded liabilities, if any, if the plans are terminated. Pension expense for the years ended December 31, 1993, 1992 and 1991 were $407,000, $397,000 and $308,000, respectively. The Partnership provides no other material post employment benefits. (9) Financial Information of the Company: Financial information relating to the Company as of and for the years ended December 31, 1993 and 1992 is as follows: 1993 1992 ---- ---- Total Assets (including $319,876,000 $337,771,000 Mortgage Notes Receivable ============ ============ Of $242,141,000, PIK Notes Receivable of $50,499,000 and Senior Notes Receivable of $27,000,000 in 1993 and Mortgage Bonds Receivable of $326,056,000 in 1992.) Total Liabilities and $319,876,000 $337,771,000 Capital (including ============ ============ Mortgage Notes payable of $242,141,000, PIK Notes payable of $50,499,000 and Senior Notes Payable of $27,000,000 in 1993 and Mortgage Bonds Payable of $326,056,000 in 1992 Interest Income $ 42,008,000 $ 34,866,000 Interest Expense $ 42,008,000 $ 34,866,000 ------------ ------------ Net Income $ - $ - ============ ============ (10) Fair Value of Financial Instruments The carrying amount of the following financial instruments of the Partnership and the Company approximate fair value, as follows: (a) cash and cash equivalents and accrued interest receivables and payables based on the short term nature of the financial instruments, (b) CRDA bonds and deposits based on the allowances to give effect to the below market interest rates (c) the Senior Notes based on the recently negotiated terms as of December 28, 1993. The fair values of the Mortgage Notes and PIK Notes are based on quoted market prices. The fair value of the Mortgage Bonds was based on quoted market prices obtained by the Partnership from its investment advisor. The estimated fair values of other financial instruments are as follows: December 31, 1993 ----------------------------- Carrying Amount Fair Value --------------- ------------- 11-3/4% Mortgage Notes............ $ 202,552,000 $ 232,456,000 Increasing Rate PIK Notes.......... $ 42,242,000 $ 42,419,000 December 31, 1992 ----------------------------- Carrying Amount Fair Value --------------- ------------- 9-1/2% Mortgage Bonds............. $ 234,445,000 $ 233,945,000 There are no quoted market prices for the Partnership Amended Term Loan and a reasonable estimate of its value could not be made without incurring excessive costs. SCHEDULE II TRUMP'S CASTLE ASSOCIATES AND SUBSIDIARY SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 All of the above amounts are noninterest bearing and are due on demand.

50104_1993.txt

50104_1993

1993

50104

ITEM 1. BUSINESS Tesoro Petroleum Corporation, together with its subsidiaries ('Tesoro' or the 'Company'), is a natural resource company engaged in refining and marketing, exploration and production of natural gas, and wholesale marketing of fuel and lubricants. The Company was incorporated in Delaware in 1968 (a successor by merger to a California corporation incorporated in 1939). For financial information relating to industry segments, see Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and Note N of Notes to Consolidated Financial Statements in Item 8. RECENT EVENTS In February 1994, the Company completed a recapitalization plan ('Recapitalization') which was approved by the Board of Directors during 1993. Among other things, the Recapitalization included the exchange by holders of $44.1 million principal amount of the Company's 12 3/4% Subordinated Debentures ('Subordinated Debentures') for a like amount of new 13% Exchange Notes and the approval by holders of the Company's $2.16 Cumulative Convertible Preferred Stock ('$2.16 Preferred Stock') to reclassify such stock (including accrued and unpaid dividends thereon of approximately $9.5 million) into an aggregate of 6,465,859 shares of the Company's Common Stock. In addition, the Company also agreed to issue 131,956 shares of its Common Stock on behalf of the holders of $2.16 Preferred Stock to pay certain of their legal fees and expenses in connection with the settlement of the litigation discussed below. In connection with the Recapitalization, the Company also entered into an agreement with MetLife Security Insurance Company of Louisiana ('MetLife') ('Amended MetLife Memorandum'), pursuant to which MetLife, the sole holder of the outstanding shares of the Company's $2.20 Cumulative Convertible Preferred Stock ('$2.20 Preferred Stock'), agreed, among other things, to waive the annual $2.20 Preferred Stock mandatory redemption requirements, to consider all accrued and unpaid dividends on the $2.20 Preferred Stock as of the effective date of the Recapitalization (aggregating approximately $21.2 million) to have been paid, to allow the Company to pay future dividends on the $2.20 Preferred Stock in Common Stock in lieu of cash, to waive or refrain from the exercise of other rights under the $2.20 Preferred Stock, and to grant the Company a three-year option to purchase all shares of $2.20 Preferred Stock and Common Stock held by MetLife as of the effective date of the Recapitalization for an aggregate option price of $53 million at February 9, 1994, subject to certain adjustments. The unpaid option price will be increased by 3% on the first day of each calendar quarter through December 31, 1995 and by 3 1/2% of the unpaid option price on the first day of each quarter thereafter. Pursuant to the Amended MetLife Memorandum, the Company agreed to issue MetLife 1,900,075 shares of Common Stock at the time of the reclassification of the $2.16 Preferred Stock. Upon shareholders' approval of the Recapitalization, MetLife owned 2,875,000 shares of $2.20 Preferred Stock and 4,084,160 shares of Common Stock, including the 1,900,075 shares of Common Stock issued to MetLife in connection with the Recapitalization. Consummation of the Recapitalization has improved the short-term and long-term liquidity of the Company and has increased the Company's equity capital. The exchange of the $44.1 million principal amount of Subordinated Debentures will satisfy annual sinking fund requirements on the Subordinated Debentures for approximately four years. The Recapitalization is also intended to improve the financial condition of the Company and allow the Company to continue its new strategy of improving its refining and marketing operations and accelerating its oil and gas exploration and development activities, as discussed in more detail below. For information on the pro forma effects of the Recapitalization, see Note B of Notes to Consolidated Financial Statements in Item 8. In October 1993, Croyden Associates, a holder of shares of the Company's $2.16 Preferred Stock, filed a class action suit in Delaware Chancery Court on behalf of itself and all other holders of the $2.16 Preferred Stock. The suit alleged that the Company and its directors breached their fiduciary duties to the holders of the $2.16 Preferred Stock based on the terms of the proposed recapitalization as described in the Company's Proxy Statement, Prospectus and Consent Solicitation ('Proxy Statement -- Prospectus') as originally filed with the Securities and Exchange Commission on September 2, 1993, which provided for the reclassification of each share of $2.16 Preferred Stock into 3.5 shares of Common Stock or, at the holder's option, 2.75 shares of Common Stock and .25 share of a new issue of preferred stock. The suit sought, among other things, monetary damages and to enjoin the recapitalization. After Croyden Associates filed the lawsuit, representatives of the Company and representatives of Croyden Associates, including the attorneys for the holders of $2.16 Preferred Stock, had numerous discussions over a period of four months concerning the possible settlement of the litigation. During the course of such discussions, various rates for exchanging the $2.16 Preferred Stock into Common Stock were proposed by the parties, ranging from four shares to six shares of Common Stock for each share of $2.16 Preferred Stock. In addition, the parties discussed the possibility of issuing shares of Common Stock based on the market price for such shares during a period immediately before or after consummation of the Recapitalization. During the course of such discussions, Croyden Associates proposed a fixed rate of five shares of Common Stock per share of $2.16 Preferred Stock and the parties ultimately reached agreement on such rate. Discussions then took place between attorneys for the Company and the attorneys for the holders of the $2.16 Preferred Stock with respect to payment of fees and expenses of the attorneys for the holders of the $2.16 Preferred Stock, which fees and expenses are the obligations of the holders of the $2.16 Preferred Stock, the class benefiting from the services of such counsel. As a result of these discussions, the Company agreed to pay up to $500,000 in cash of the fees and expenses awarded by the Chancery Court, and the attorneys for the holders of the $2.16 Preferred Stock agreed to limit their fee application to $500,000 in cash plus .1 share of Common Stock for each share of $2.16 Preferred Stock. Out of the five shares of Common Stock the Company agreed to issue for each share of $2.16 Preferred Stock, the Company agreed to issue .1 share on behalf of the holders of $2.16 Preferred Stock so that such shares will be available to pay the fees and expenses of such attorneys if awarded by the Chancery Court. On February 4, 1994, Croyden Associates and the Company entered into an agreement seeking court approval of a settlement based upon the terms set forth in the Proxy Statement -- Prospectus. By order dated February 7, 1994, the Delaware Chancery Court scheduled a hearing, to be held on April 13, 1994, to determine whether to approve the terms of the settlement and enter a final judgment dismissing the action. In March 1994, the Company's Board of Directors authorized management of the Company to investigate the feasibility of a future equity offering of additional shares of the Company's Common Stock together with a future public debt offering. The proceeds from these offerings would be used to finance the Company's option to acquire all of the Company's outstanding Common Stock and $2.20 Preferred Stock held by MetLife and to refinance all or a portion of the Company's outstanding long-term debt. The Company transports its crude oil and a substantial portion of its refinery products over Kenai Pipe Line Company's ('KPL') pipeline and marine terminal facilities in Nikiski, Alaska. KPL's common carrier pipeline is subject to rate regulation by the Federal Energy Regulatory Commission ('FERC') and the Alaska Public Utilities Commission. On March 1, 1994, KPL filed a revised tariff with the FERC, with a proposed effective date of April 1, 1994, to regulate certain dock loading services KPL had previously provided pursuant to a private contract with the Company which KPL has terminated. KPL's proposed FERC rate for this dock loading service would have increased the Company's annual cost of transporting products through KPL's facilities from $1.2 million to $11.2 million or an increase of $10 million per year. The Company considered the proposed KPL rate clearly excessive and on March 21, 1994, filed a motion to reject or suspend the rate with the FERC. On March 29, 1994, the FERC rejected KPL's revised tariff; however, under FERC regulations, KPL has the right to file a new tariff. The Company has recently initiated discussions with KPL to acquire the facilities or an interest therein. In connection therewith, KPL has agreed not to file a new tariff with the FERC for a period of at least 30 days and the Company has agreed to negotiate a rate with KPL for that period. While the Company is unable to predict the purchase price for the facility, or an interest therein, if a purchase with KPL is negotiated, the Company does not believe that any negotiated purchase price will have a material effect on the Company's financial condition or liquidity. The Company also cannot predict (i) whether it will ultimately be able to negotiate the acquisition of the facilities or an interest therein, (ii) the rate of any new tariff that may be filed by KPL, or approved by the FERC, if the Company is unable to negotiate an acquisition of the facilities or an interest therein, and (iii) whether any new rate that may be filed by KPL or the ultimate resolution of this matter by the FERC if the Company is unable to negotiate an acquisition of the facilities or an interest therein will have a material adverse effect upon the financial condition of the Company. REFINING AND MARKETING REFINING AND MARKETING The Company conducts refining operations in Alaska and sells products to a wide variety of customers in Alaska, in the area west of the Rocky Mountains and in certain Far Eastern markets. During 1993, products from the Company's Alaska refinery accounted for approximately 75% of such sales, including products received on exchange in the West Coast market, with the remaining 25% being purchased from other refiners and suppliers. The refinery, which is located in Kenai, Alaska, has a rated throughput capacity of 72,000 barrels per day and is capable of producing liquefied petroleum gas, gasoline, jet fuel, diesel fuel, heating oil and residual fuel oil. The refinery is designed to process crude oil with a sulphur content of up to 1%. Alaska North Slope ('ANS') and Cook Inlet crude oils, the primary crude oils currently used as feedstock for the refinery, are below this limit. To assure the availability of crude oil to the refinery, the Company has a royalty crude oil purchase contract with the State of Alaska ('State')(see 'Crude Oil Supply' discussed below). During the second quarter of 1993, the Company implemented a market-driven operational strategy for its refining and marketing operations. This strategy includes reducing refinery throughput and upgrading the mix of feedstocks, which is intended to enable the Company to match its refined product yield more closely to the product demand in Alaska, its primary market, and reduce shipments of refined products to less profitable markets. The strategy is also intended to reduce the Company's working capital requirements and reduce the volume of residual fuel oil produced by the Company's Alaska refinery. Implementation of this strategy has resulted in a decrease in total refinery production from 60,900 barrels per day in 1992 to 49,000 barrels per day during 1993, including a decrease in the level of residual fuel oil production from approximately 23,400 barrels per day in 1992 to approximately 17,600 barrels per day during 1993. The Company's ability to further reduce production of residual fuel oil, other than by further reducing total refinery production, is currently limited by the availability of lighter feedstocks and by the configuration of the refinery hardware. There can be no assurance that the new strategy will ultimately prove successful. See 'Government Regulation and Legislation -- Environmental Controls' for a discussion of the effect of governmental regulations on the production of low sulphur diesel fuel for on-highway use in Alaska. In March 1994, the Company's Board of Directors approved the construction of a vacuum processing unit at the refinery. This unit, estimated to cost approximately $24 million, will reduce the amount of residual fuel oil by further processing this product into additional higher-valued products. During 1993, the refinery processed approximately 72% ANS crude oil, 22% Cook Inlet crude oil and 6% of other refinery feedstocks, which yielded refined products consisting of approximately 25% gasoline, 25% jet fuel, 14% diesel fuel and other distillates and 36% residual fuel oil. Of the refinery production in 1993, the Company distributed approximately 89% of the gasoline to end-users in the State, either by retail sales through 33 of its 7-Eleven convenience store locations, by wholesale sales through 68 branded and 25 unbranded dealers and jobbers or by exchange deliveries to major oil companies, with the remaining 11% being transported to the West Coast. Virtually all of the jet fuel production is marketed in Alaska to commercial airlines through sales or exchange deliveries. Substantially all of the diesel fuel and other distillates production is marketed through exchange deliveries or sales in Alaska. In recent years, sales of residual fuel oil have been increasingly unprofitable. During 1993, under its new marketing strategy, the Company commenced selling and transporting a substantial volume of its residual fuel oil production to customers on the West Coast. In addition to its own refining capacity, the Company estimates the other refiners in Alaska have the capacity to process approximately 156,000 barrels of crude oil per day, all of which is ANS crude oil. After processing the crude oil and removing the lighter-end products, such as gasoline and jet fuel, which represent approximately 30% of each barrel processed, these refiners are permitted, by paying a fee and because of their proximity to the Trans Alaska Pipeline System, to return the remainder of the processed crude back into the pipeline system as 'return oil.' During 1993, the production of gasoline by all refiners in Alaska, including the Company, exceeded the market demand by approximately 1,400 barrels per day. The excess production was exported from Alaska, generally during the winter months when the demand for gasoline in Alaska is lowest. The demand for jet fuel in Alaska currently exceeds the production of the refiners in the State, and several marketers, including the Company, import jet fuel into the State to meet this excess demand. The primary market for diesel fuel in Alaska is the commercial fishing fleet. Generally, the production of diesel fuel by refiners in Alaska and the demand for such diesel fuel is in balance; however, because of the high variability of the demand, there are occasions when diesel fuel is imported into or exported from the State. The Company is the only producer in Alaska of residual fuel oil for sale. Since there is no current demand for residual fuel oil in Alaska, the residual fuel oil was exported from the State, primarily to other refiners on the West Coast during 1993, where it was generally used as a refinery feedstock. The Company conducts domestic wholesale marketing operations primarily in California, Oregon and Washington, with its principal office in Long Beach, California. During 1993, this operation sold approximately 27,800 barrels per day of refined products, of which approximately 30% was received from major oil companies in exchange for refined products from the Company's Alaska refinery, approximately 5% was received directly from the Company's Alaska refinery and the balance was purchased from other suppliers. The Company sells these refined products in the bulk market and through 25 terminal locations, of which four are owned by the Company. The Company holds an exclusive license agreement for all 7-Eleven convenience stores in Alaska and operates such stores in 39 locations, 33 of which sell Company branded gasoline. During 1993, these convenience stores sold a total of 63,000 gallons of gasoline per day. The following table summarizes the Company's refinery throughput and product sales for the years ended December 31, 1993, December 31, 1992 and September 30, 1991: 1993 1992 1991 (AVERAGE DAILY BARRELS) Refinery Throughput------------------ 49,753 61,425 68,192 Refining and Marketing Product Sales: Gasoline------------------------- 22,466 25,196 25,883 Jet fuel------------------------- 11,305 19,060 15,055 Other distillates---------------- 18,049 19,253 20,488 Residual fuel oil---------------- 16,945 23,931 28,729 Total------------------------ 68,765 87,440 90,155 CRUDE OIL SUPPLY The Company has a contract through 1994 with the State which provides for the purchase of certain quantities of the State's Prudhoe Bay North Slope royalty crude oil, based on a percentage of all Prudhoe Bay North Slope royalty crude oil produced. At current levels of Prudhoe Bay production, this contract provides for the purchase of approximately 37,500 barrels per day at the weighted average net-back price of all North Slope producers at Pump Station No. 1. In connection with its anticipated reduction in refinery throughput, effective January 1, 1993, the Company exercised its right under this contract to reduce purchases to approximately 27,500 barrels per day. The Company's present and certain past contracts with the State contained provisions which would have required the Company to pay the State additional retroactive amounts if the State prevailed in the ANS ROYALTY LITIGATION against the producers of North Slope crude oil ('Producers'). The State settled with each of the Producers, with the last settlement occurring in April 1992. As a result of the settlements between the State and the Producers, the State claimed that the crude oil it sold to the Company and others was undervalued to the extent that the Producers undervalued their oil. The State's claim against the Company amounted to $141.9 million (including interest), of which $44.8 million (the 'Chevron Portion') was reimbursable to the Company under a crude oil purchase/sale agreement with Chevron U.S.A. Inc. ('Chevron'). In January 1993, the Company entered into an agreement with the State ('ANS Agreement') that settled this contractual dispute. The ANS Agreement provided that $97.1 million (which did not include the Chevron Portion) was owed to the State by the Company and that the Company would cooperate with the State in seeking to recover the Chevron Portion. Under the ANS Agreement, the State released the Company from liability for the Chevron Portion. Under the ANS Agreement, the Company paid the State $10.3 million in January 1993 and agreed to make variable monthly payments to the State over the nine years following the date of the settlement based on a per barrel charge that increases over the nine-year term from 16 cents to 33 cents on the volume of feedstock processed at the Company's Alaska refinery. In 1993, the Company's variable payments to the State totaled $2.6 million. At the end of the nine-year period, the Company is obligated to pay the State $60 million; provided, however, that such payment may be deferred indefinitely by continuing the variable monthly payments to the State beginning at 34 cents per barrel and increasing one cent per barrel annually thereafter. Variable monthly payments made after the nine-year period will not reduce the $60 million obligation to the State. The $60 million obligation is evidenced by a security bond, and the bond and the variable monthly payments are secured by a second mortgage on the Alaska refinery. The Company's obligations under the ANS Agreement and the mortgage may be subordinated to current and future senior debt obligations (including, without limitation, principal, interest and related expenses) of up to $175 million, plus any indebtedness incurred in the future to improve the Alaska refinery. For further information concerning the Company's settlement with the State, see Note I of Notes to Consolidated Financial Statements in Item 8. Additional ANS crude oil, other than that which is purchased from the State, is acquired by the Company through various purchase and exchange agreements with the Producers. All ANS crude oil is delivered to the refinery by tanker through the Kenai Pipeline Company marine terminal. In addition, the Company obtains available Cook Inlet crude oil, which is delivered by tanker or through an existing pipeline to the refinery. This Cook Inlet crude oil is acquired through term contracts and spot purchases. From time to time the Company evaluates the economic viability of processing foreign crude oil in its Alaska refinery and occasionally purchases spot quantities to supplement its normal crude oil supply. This foreign crude oil is also delivered to the refinery by tanker through the Kenai Pipeline Company marine terminal. TRANSPORTATION The Company charters an American flag vessel, the OVERSEAS WASHINGTON, under an agreement expiring in 1994 with a two-year renewal option. The OVERSEAS WASHINGTON is used primarily to transport North Slope crude oil from the Trans Alaska Pipeline System terminal at Valdez, Alaska to the Company's Alaska refinery. The Company also has a charter for an American flag vessel, the BALTIMORE TRADER, under a six-month agreement expiring in July 1994 with a six-month renewal option remaining. The BALTIMORE TRADER is used primarily to transport residual fuel oil to California and occasionally to transport feedstocks to the Company's Alaska refinery. From time to time, the Company also charters tankers and ocean-going barges to transport petroleum products to its customers within Alaska, on the West Coast and in the Far East. The Company operates a common carrier petroleum products pipeline from the Company's Alaska refinery to its terminal in Anchorage. This ten-inch diameter pipeline removes the uncertainty of transporting light products in the winter months when icing conditions in the Cook Inlet restrict marine transportation. During 1993, the pipeline transported an average of approximately 22,300 barrels of petroleum products per day, all of which were transported for the Company. The pipeline has a capacity of approximately 40,000 barrels of petroleum products per day. For further information on transportation in Alaska, see 'Government Regulation and Legislation -- Environmental Controls.' EXPLORATION AND PRODUCTION UNITED STATES During 1993, the Company concentrated its activities in the Bob West Field, which is located in the southern part of the Wilcox Trend, Starr and Zapata Counties, Texas. Continued successful development of this field, discovered in 1990, has resulted in net proven natural gas reserves increasing from 74 billion cubic feet at December 31, 1992 to 120 billion cubic feet at December 31, 1993. Fifteen development wells were drilled and completed in this field during 1993, bringing the number of producing wells to 25 at December 31, 1993 with an additional two wells being drilled and one well awaiting completion at year-end. Thirty-nine additional well locations have been selected for further development of this 4,000 acre field, of which 25 are expected to be drilled during 1994. At 1993 year-end, net production from the Bob West Field wells averaged 58 million cubic feet per day. The Company, which does not operate the field, owns an average 50% revenue interest in approximately two-thirds of the field and a 28% revenue interest in the remainder. The Company owns a 70% interest in the central gas processing facility which is currently capable of handling approximately 120 million cubic feet of production per day. The Company owns a 70% interest in Starr County Gathering System's two ten-inch diameter pipelines which transport gas eight miles from the field to common carrier pipeline facilities. In February 1994, the common carrier pipeline facilities were at capacity and production subject to spot market prices was being curtailed. New common carrier pipeline facilities are being constructed by Coastal States Gas Transmission Company which will provide transportation for increased gas production from the Bob West Field in the second quarter of 1994. In addition to the continued development of the Bob West Field, during 1993 the Company also participated in the drilling of four exploratory wells in other areas of South Texas. The first exploratory well was completed as a producing gas well, the second was a dry hole and, at December 31, 1993, the third was awaiting completion and has subsequently been evaluated as a gas discovery. The fourth well was still being drilled at 1993 year-end but was subsequently evaluated as a dry hole in January 1994. A delineation well, which was drilling at December 31, 1993 on the acreage where the first exploratory well was drilled, was evaluated as a dry hole in January 1994. Two producing acreage units within the Bob West Field, each consisting of 352 acres, are subject to a gas purchase contract expiring in January 1999 with Tennessee Gas Pipeline Company ('Tennessee Gas') pursuant to which Tennessee Gas is currently paying in excess of $7.70 per mcf of gas, which is greatly in excess of the spot market price for natural gas ($2.31 per mcf for the month of December 1993). The gas purchase contract is presently the subject of litigation with Tennessee Gas. See Legal Proceedings in Item 3 and Notes K and P of Notes to Consolidated Financial Statements in Item 8. BOLIVIA The Company is the operator of a joint venture which holds two Contracts of Operation with YPFB, the Bolivian state-owned oil and gas company. The Company has a 75% interest in a Contract of Operation, which expires in 2007, covering approximately 93,000 acres in Block XVIII. The Company and its joint venture participant are entitled to receive a quantity of hydrocarbons equal to 40% of the total production, net of Bolivian taxes on production. After payment of taxes on production, YPFB is entitled to the remainder. Under the sales contract with YPFB covering hydrocarbons produced from the La Vertiente, Escondido and Taiguati Fields in this block, the Company and its joint venture participant have contracted to sell approximately 18,000 mcf, after Bolivian taxes, of natural gas per day to YPFB. At December 31, 1993, the Company was receiving $1.25 per mcf for gas sold under this contract. This contract, including the pricing provision, is subject to renegotiation in April 1994 for another two-year period. During 1993, the condensate produced in association with the natural gas was sold to YPFB. The Company's natural gas production from Bolivia as presented in 'Operating Statistics' below represents the Company's net production before Bolivian taxes. The Company has a 72.6% interest in a Contract of Operation, which expires in 2008, covering approximately 1.2 million acres in Block XX. The Company and its joint venture participant are entitled to receive a quantity of hydrocarbons equal to 50% of the total production, net of Bolivian taxes on production, with YPFB receiving the remainder. Prior to 1993, one successful commercial gas discovery well, the Los Suris No. 1, was drilled on the block and is shut-in pending the approval by the Government of Bolivia of a commercialization agreement. A plan of development for Block XX has been approved by YPFB and the Government of Bolivia. Under the plan of development, the Company drilled a well, the Los Suris No. 2, which was completed in February 1994 and tested gross production potential of approximately 9 million cubic feet of gas per day and approximately 120 barrels of condensate per day from two intervals. The Los Suris No. 2 is also shut-in pending the approval of the commercialization agreement. The plan provides that, in order to postpone the relinquishment of inactive acreage until July 15, 1995, the drilling of a second exploratory well must be completed by September 30, 1994, and the drilling of a third exploratory well must be started no later than the fourth quarter of 1994 and completed by April 30, 1995. The Company may further postpone the relinquishment of inactive acreage until July 15, 1996, by submitting no later than July 1, 1995, an additional two-well drilling program that is acceptable to YPFB. To guarantee the drilling of the first three exploratory wells, in July 1993 the Company submitted a bank guarantee in the amount of $2 million to YPFB for the drilling of the first exploratory well and, prior to the January 15, 1994 deadline, the Company submitted bank guarantees to YPFB in the aggregate amount of $4 million for the drilling of the second and third wells. Since the Los Suris No. 2 has now been completed, YPFB has released the first $2 million guarantee. For further information regarding Tesoro Bolivia, see Note F of Notes to Consolidated Financial Statements in Item 8. OPERATING STATISTICS The following table summarizes the Company's exploration and production activities for the years ended December 31, 1993, December 31, 1992 and September 30, 1991. Effective May 1, 1992, the Company sold its Indonesian operations. [CAPTION] 1993 1992 1991 [S] [C] [C] [C] Net Natural Gas Production (average daily mcf): United States-------------------- 38,767 13,960 7,435 Bolivia-------------------------- 19,232 19,421 19,322 Total------------------------ 57,999 33,381 26,757 Net Crude Oil Production (average daily barrels): Bolivia (condensate)------------- 663 660 663 Indonesia------------------------ -- 2,714 3,315 Total------------------------ 663 3,374 3,978 Average Realized Sales Prices -- Natural Gas (dollars per mcf): United States-------------------- $ 3.55* 3.68* 1.88 Bolivia-------------------------- $ 1.22 1.67 3.06 Average Realized Sales Prices -- Crude Oil (dollars per barrel): Bolivia (condensate)------------- $ 14.26 17.65 21.11 Indonesia------------------------ $ -- 18.20 24.39 Average Production Cost (dollars per net equivalent mcf): United States-------------------- $ .48 .74 .44 Bolivia-------------------------- $ .14 .08 .09 Indonesia------------------------ $ -- 1.94 1.35 Depletion Rates (dollars per net equivalent mcf): United States-------------------- $ .78 .95 1.06 Indonesia------------------------ $ -- .15 .22 Net Exploratory Wells Drilled: United States -- Net productive wells------------- .38 1.00 1.46 Net dry holes-------------------- .50 .50 -- Net Development Wells Drilled: Net productive wells -- United States-------------------- 7.87 3.85 1.43 Indonesia------------------------ -- -- 3.00 Total------------------------ 7.87 3.85 4.43 Net dry holes -- United States-------------------- -- -- 1.00 Indonesia------------------------ -- -- 2.00 Total------------------------ -- -- 3.00 * SEE LEGAL PROCEEDINGS IN ITEM 3 AND NOTE K OF NOTES TO CONSOLIDATED FINANCIAL STATEMENTS IN ITEM 8 REGARDING LITIGATION CONCERNING THE TENNESSEE GAS CONTRACT. ACREAGE AND WELLS The following table sets forth the Company's gross and net acreage and productive wells at December 31, 1993: DEVELOPED UNDEVELOPED ACREAGE ACREAGE ACREAGE (IN THOUSANDS) GROSS NET GROSS NET United States------------------------ 3 2 11 4 Bolivia------------------------------ 38 29 1,210 880 Total---------------------------- 41 31 1,221 884 OIL GAS GROSS AND NET PRODUCTIVE WELLS GROSS NET GROSS NET United States------------------------ -- -- 26 14.8 Bolivia------------------------------ -- -- 14 10.5 Total*--------------------------- -- -- 40 25.3 * INCLUDED IN TOTAL PRODUCTIVE WELLS ARE 1 GROSS (.6 NET) WELL IN THE UNITED STATES AND 8 GROSS (6.0 NET) WELLS IN BOLIVIA WITH MULTIPLE COMPLETIONS. AT DECEMBER 31, 1993, THE COMPANY WAS PARTICIPATING IN THE DRILLING OF 6 GROSS (2.3 NET) WELLS IN THE UNITED STATES AND 1 GROSS (.7 NET) WELL IN BOLIVIA. For further information regarding the Company's exploration and production activities, see Note P of Notes to Consolidated Financial Statements in Item 8. OIL FIELD SUPPLY AND DISTRIBUTION WHOLESALE MARKETING OF FUEL AND LUBRICANTS The Company sells lubricants, fuels and specialty petroleum products primarily to onshore and offshore drilling contractors. The Company's products are sold through six land terminals and 13 marine terminals located in various cities in Texas and Louisiana. These products are used to power and lubricate machinery on drilling and production locations. The Company also provides products for marine, commercial and industrial applications. ENVIRONMENTAL REMEDIATION PRODUCTS AND SERVICES The Company's environmental remediation products and services operation continues to experience losses and is being evaluated as to its long-term economic viability. COMPETITION The oil and gas industry is highly competitive in all phases, including the refining and marketing of crude oil and petroleum products and the search for and development of oil and gas reserves. This industry also competes with industries that supply the energy and fuel requirements of industrial, commercial, individual and other consumers. The Company competes with a substantial number of major integrated oil companies and other companies having materially greater financial and other resources. These competitors have a greater ability to bear the economic risks inherent in all phases of this industry. In addition, unlike the Company, many competitors also produce large volumes of crude oil which may be used in connection with their operations. OTHER A portion of the Company's operations are conducted in foreign countries where the Company is also subject to risks of a political nature and other risks inherent in foreign operations. The Company's operations outside the United States in recent years have been, and in the future may be, materially affected by host governments through increases or variations in taxes, royalty payments, export taxes and export restrictions and adverse economic conditions in the foreign countries, the future effects of which the Company is unable to predict. GOVERNMENT REGULATION AND LEGISLATION UNITED STATES NATURAL GAS REGULATIONS Historically, all domestic natural gas sold in so-called 'first sales' was subject to federal price regulations under the Natural Gas Policy Act of 1978 (the 'NGPA'), the Natural Gas Act (the 'NGA'), and the regulations and orders issued by the Federal Energy Regulatory Commission (the 'FERC') in implementing such Acts. Under the Natural Gas Wellhead Decontrol Act of 1989, all remaining natural gas wellhead pricing, sales, certificate and abandonment regulation of first sales by the FERC was terminated on January 1, 1993. The FERC also regulates interstate natural gas pipeline transportation rates and service conditions, which affect the marketing of gas produced by the Company, as well as the revenues received by the Company for sales of such natural gas. Since the latter part of 1985, through its Order Nos. 436, 500 and 636 rulemakings, the FERC has endeavored to make natural gas transportation more accessible to gas buyers and sellers on an open and non-discriminatory basis, and the FERC's efforts have significantly altered the marketing and pricing of natural gas. A related effort has been made with respect to intrastate pipeline operations pursuant to the FERC's authority under Section 311 of the NGPA, under which the FERC establishes rules by which intrastate pipelines may participate in certain interstate activities without becoming subject to full NGA jurisdiction. These Orders have gone through various permutations, but have generally remained intact as promulgated. The FERC considers these changes necessary to improve the competitive structure of the interstate natural gas pipeline industry and to create a regulatory framework that will put gas sellers into more direct contractual relations with gas buyers than has historically been the case. The FERC's latest action in this area, Order No. 636, issued April 8, 1992, reflected the FERC's finding that under the current regulatory structure, interstate pipelines and other gas merchants, including producers, do not compete on an equal basis. The FERC asserted that Order No. 636 was designed to equalize that marketplace. This equalization process is being implemented through negotiated settlements in individual pipeline service restructuring proceedings, designed specifically to 'unbundle' those services (e.g., gathering, transportation, sales and storage) provided by many interstate pipelines so that producers of natural gas may secure services from the most economical source, whether interstate pipelines or other parties. In many instances, the result of the FERC initiatives has been to substantially reduce or bring to an end the interstate pipelines' traditional role as wholesalers of natural gas in favor of providing only gathering, transportation and storage services for others which will buy and sell natural gas. The FERC has issued final orders in all of the individual pipeline restructuring proceedings and all of the interstate pipelines are now operating under new open access tariffs. Although Order No. 636 does not regulate gas producers, such as the Company, the FERC has stated that Order No. 636 is intended to foster increased competition within all phases of the natural gas industry. It is unclear what impact, if any, increased competition within the natural gas industry under Order No. 636 will have on the Company and its gas marketing efforts. In addition, numerous petitions seeking judicial review of Orders Nos. 636, 636A and 636B and seeking review of FERC's orders approving open access tariffs for the individual pipelines have already been filed. Because the restructuring requirements that emerge from this lengthy process may be significantly different from those of Order No. 636 as originally promulgated, it is not possible to predict what, if any, effect the final rule resulting from Order No. 636 will have on the Company. The Company does not believe, however, it will be affected by any action taken with respect to Order No. 636 any differently than other gas producers and marketers with which it competes. In late 1993, FERC initiated a proceeding seeking industry-wide comments about its role in regulating natural gas gathering performed by interstate pipelines or their affiliates. Numerous written and oral comments have been received by the FERC concerning whether and how it should regulate gathering activities, but the Company cannot predict what, if any, action the FERC may take or whether such action will affect access to markets of its gas or its own gas gathering facilities and activities. The oil and gas exploration and production operations of the Company are subject to various types of regulation at the state and local levels. Such regulation includes requiring drilling permits and the maintenance of bonds in order to drill or operate wells; the regulation of the location of wells, the method of drilling and casing of wells and the surface use and restoration of properties upon which wells are drilled; and the plugging and abandoning of wells. The operations of the Company are also subject to various conservation regulations, including regulation of the size of drilling and spacing units or proration units, the density of wells that may be drilled in a given area and the unitization or pooling of oil and gas properties. In this regard, some states allow the forced pooling or integration of lands and leases. In addition, state conservation laws establish maximum rates of production from oil and gas wells, generally prohibit the venting or flaring of gas and impose certain requirements regarding the ratability of production. The effect of these regulations is to limit the amounts of crude oil, condensate and natural gas the Company can produce from its wells and the number of wells or the locations at which the Company can drill. More recently, the enactment of the North American Free Trade Agreement has further streamlined and simplified procedures for the importation and exportation of gas between and among Mexico, the United States and Canada. These changes could provide additional opportunities to export gas to Mexico, but will more likely enhance the ability of Canadian and Mexican producers to export natural gas to the United States, thereby increasing competition in the domestic natural gas market. Additional proposals and proceedings that might affect the natural gas industry are considered from time to time by Congress, the FERC, state regulatory bodies and the courts. The Company cannot predict when or if any such proposals might become effective, or their effect, if any, on the Company's operations. The natural gas industry historically has been very heavily regulated; therefore, there is no assurance that the less stringent regulatory approach recently pursued by the FERC and Congress will continue indefinitely into the future. ENVIRONMENTAL CONTROLS Federal, state, area and local laws, regulations and ordinances relating to the protection of the environment affect all operations of the Company to some degree. One example of a federal environmental law that would require operational additions and modifications is the Clean Air Act, which was amended in 1990. While the Company believes that its facilities generally are in substantial compliance with current regulatory standards for air emissions, over the next several years the Company's facilities may be required to comply with new requirements being adopted and to be promulgated by the U.S. Environmental Protection Agency (the 'EPA') and the states in which the Company operates. These regulations may necessitate the installation of additional controls or other modifications or changes in use for certain emission sources. At this time, the Company cannot estimate when new standards will be imposed by the EPA or relevant state agencies or what technologies or changes in processes the Company may have to install or undertake to achieve compliance with any applicable new requirements. The passage of the federal Clean Air Act Amendments of 1990 prompted adoption of regulations by the State obligating the Company to produce oxygenated gasoline for delivery to the Anchorage and Fairbanks, Alaska markets starting on November 1, 1992. Controversies surrounding the potential health effects in arctic regions of oxygenated gasoline containing methyl tertiary butyl ether ('MTBE') prompted the early discontinuance of the program in Fairbanks in December 1992. On October 21, 1993, the United States Congress granted the State one additional year of exemption from requiring the use of oxygenated gasoline. However, state and local officials may still require the use of these fuels at their option. In addition, the EPA has been directed to conduct additional studies of potential health effects of oxygenated fuel in Alaska. Additional federal regulations promulgated on August 21, 1990, and scheduled to go into effect on October 1, 1993, set limits on the quantity of sulphur in on-highway diesel fuels which the Company produces. The State filed an application with the federal government in February 1993 for a waiver from this requirement since only 5% of the diesel fuel sold in Alaska is for on-highway vehicles. The EPA supported the State's position and the formalities for obtaining the exemption were completed on September 27, 1993. The EPA, in a letter to the State dated September 30, 1993, indicated that the EPA was completing the final documentation regarding the waiver and that Alaska would have a low priority for enforcement of the diesel fuel regulations, pending the publication of the final decision. The Company estimates that substantial capital expenditures would be required to enable the Company to produce low-sulphur diesel fuel to meet these federal regulations. If the State is unable to obtain a waiver from the federal regulations, the Company would discontinue the sales of diesel fuel for on-highway use. The Company estimates that such sales accounted for less than 1% of its refined product sales in Alaska during 1993. The Company is unable to predict the outcome of these matters; however, the Company believes that the ultimate resolution of these matters will not have a material impact on the Company's operations. Regulations promulgated by the EPA on September 23, 1988, require that all underground storage tanks used for storing gasoline or diesel fuel either be closed or upgraded not later than December 22, 1998, in accordance with standards set forth in the regulations. The Company's service stations subject to the upgrade requirements are limited to locations within the State of Alaska, the majority of which are located in non-residential areas. Although the Company continues to monitor, test and make physical improvements in its current operations which result in a cleaner environment, the Company was not required to make any material capital expenditures for environmental control purposes during 1993. The Company may be required to make significant expenditures for removal or upgrading of underground storage tanks at several of its current and former service station locations by December 22, 1998; however, the Company does not expect to make any material capital expenditures for such purposes during 1994 and 1995 and does not expect that such expenditures subsequent to 1995 will have a material adverse effect on the financial condition of the Company. See Legal Proceedings, Item 3(e). The Company currently charters a vessel to transport crude oil from the Valdez, Alaska pipeline terminal through Prince William Sound and Cook Inlet to its Alaska refinery. In addition, the Company routinely charters, on a term or spot basis, additional tankers and barges for the shipment of crude oil and refined products through Cook Inlet. The Federal Oil Pollution Act of 1990 requires, as a condition of operation, that the Company submit an oil spill contingency plan for its Alaska refinery terminal facility located on Cook Inlet that demonstrates the capability to respond to the 'worst case discharge' to the maximum extent practicable. Alaska law requires a contingency plan for that terminal providing for containment or control, and cleanup, within 72 hours, of a spill equal to the volume of the terminal's largest storage tank. With respect to the charter vessels employed by the Company to transport crude oil through Prince William Sound and Cook Inlet to the Company's Alaska refinery, federal and Alaska law both require contingency plans as a condition of navigation. The Company has obtained State approval for its Cook Inlet Oil Discharge Contingency Plan and conditional approval, which allows operations pending final State review, for a Tanker Spill Prevention and Response Plan for Prince William Sound. The federal plan must demonstrate the capability to respond to the 'worst case discharge' to the maximum extent practicable, while the Alaska plan must be based on containment or control, and cleanup, of a 50,000 barrel discharge within 72 hours. To meet those standards, the Company has entered into a contract with Alyeska Pipeline Service Company ('Alyeska') to provide the initial spill response services in Prince William Sound with the Company to assume those responsibilities after mutual agreement with Alyeska and the State and Federal On-Scene Spill Response Coordinators. The Alaska legislature passed legislation in 1992, providing limited immunity for spill response contractors, which has facilitated access to contract extensions that will not be dependent on further legislative action. The Company has also entered into an agreement with Cook Inlet Spill Prevention & Response Inc. for oil spill response services in Cook Inlet. The Company believes these contracts provide the additional services necessary to meet the spill response requirements established by Alaska and federal law. For further information regarding environmental matters, see Legal Proceedings in Item 3. BOLIVIA The Company's operations in Bolivia are subject to the Bolivian General Law of Hydrocarbons and various other laws and regulations. The General Law of Hydrocarbons imposes certain limitations on the Company's ability to conduct its operations in Bolivia. In the Company's opinion, neither the General Law of Hydrocarbons nor other limitations imposed by governmental laws, regulations and practices will have a material adverse effect upon its Bolivian operations. TAXES UNITED STATES The Revenue Reconciliation Act of 1993 imposed a new 4.3 cents per gallon 'transportation fuels tax' effective October 1, 1993, and a tax on commercial aviation fuel effective October 1, 1995. The Company does not believe such taxes will have a material adverse effect on the Company's future operations. BOLIVIA The Company is subject to Bolivian taxation at the rate of 30% of the gross production of hydrocarbons at the wellhead which is retained and paid by YPFB for the Company's account. In 1987, the Bolivian General Corporate Income Tax Law was replaced by a tax system, including a Value Added Tax, which is not imposed on net income. As a result, it is uncertain whether or not the Company can treat the Bolivian hydrocarbons tax as creditable in the United States for federal income tax purposes. However, due to the Company's net operating loss carryforwards, the Company does not now, or in the near future, expect to use these taxes as credits for federal income tax purposes. In 1990, the Bolivian Government passed a new General Law of Hydrocarbons containing provisions designed to ensure the creditability, for United States federal income tax purposes, of these hydrocarbon taxes if the Company makes an election which may subject it to a higher Bolivian tax rate in the future. Regulations under this new law have not been issued; however, the Company does not anticipate that this new law will have a material effect on the Company's Bolivian operations. EMPLOYEES As of December 31, 1993, the Company employed approximately 900 persons, of which approximately 40 employees are located in foreign countries. None of the Company's employees are represented by a union for collective bargaining purposes. The Company considers its relations with its employees to be satisfactory. EXECUTIVE OFFICERS OF THE REGISTRANT The following is a list of the Company's executive officers, their ages and their positions with the Company as of March 1, 1994. 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. Officers are elected annually by the Board of Directors at its first meeting following the Annual Meeting of Stockholders, each to hold office until the corresponding meeting of the Board in the next year or until his successor shall have been elected or shall have qualified. All of the Company's executive officers have been employed by the Company or its subsidiaries in an executive capacity for at least the past five years, except for those named below who have had the business experience indicated during that period. Positions, unless otherwise specified, are with the Company. ITEM 2. ITEM 2. PROPERTIES See information appearing under Item 1, Business herein and Schedules V and VI of Financial Statement Schedules in Item 14. ITEM 3. ITEM 3. LEGAL PROCEEDINGS (a) The Company is selling gas from its Bob West Field to Tennessee Gas under a 1979 Gas Purchase and Sales Agreement ('Gas Contract') which expires in January 1999. The Gas Contract provides that the price of gas shall be the maximum price as calculated in accordance with the then effective Section 102 (b) (2) ('Contract Price') of the NGPA. In August 1990, Tennessee Gas filed a civil action in the District Court of Bexar County, Texas against the Company and several other companies, seeking a Declaratory Judgment that the Gas Contract is not applicable to the Company's properties. Tennessee Gas claimed, among other things, that certain leases covered by the Gas Contract had terminated and therefore were automatically released from the Gas Contract, eliminating the obligation of Tennessee Gas to purchase gas from the Company. Tennessee Gas also challenged the quantity of gas which can be sold under the Gas Contract and contended that the gas sales price was to be calculated under the provisions of Section 101 of the NGPA rather than the Contract Price. At December 31, 1993, the Section 101 price of $5.01 per mcf was $2.71 per mcf less than the Contract Price, but $2.75 per mcf above spot market prices. On June 24, 1992, the District Court trial judge returned a verdict in favor of the Company. The District Court's judgment, entered on July 8, 1992, ruled that Tennessee Gas must honor the Gas Contract pursuant to its terms. Tennessee Gas filed a motion for reconsideration in the District Court on the issue of the price to be paid for the gas under the Gas Contract, which was denied by the court. On September 11, 1992, Tennessee Gas appealed the judgment to the Court of Appeals for the Fourth Supreme Judicial District of Texas. On August 25, 1993, the Court of Appeals affirmed the validity of the Gas Contract as to the Company's properties and held that the price payable by Tennessee Gas for the gas was the Contract Price. The Court of Appeals determined, however, (i) that the trial court erred in its summary judgment ruling that the Gas Contract was not an output contract under the Texas Business and Commerce Code ('TBCA') and (ii) that a fact issue exists as to whether the increases in the volumes of gas tendered to Tennessee Gas under the Gas Contract were made in bad faith or were unreasonably disproportionate to prior tenders in contravention of the provisions of Section 2.306 of the TBCA. Accordingly, the Court of Appeals directed that this issue be remanded to the trial court in Bexar County, Texas. The Company filed a motion for rehearing with the appellate court regarding its decision that the Gas Contract creates an output contract governed by the TBCA. Tennessee Gas also filed a motion for rehearing with the appellate court regarding the portions of its decision upholding the judgment of the trial court. On January 26, 1994, the appellate court rendered its judgment denying all motions for rehearing in this matter and affirming its earlier ruling. The Company has appealed the appellate court ruling on the output contract issue to the Supreme Court of Texas. Tennessee Gas has also appealed to the Supreme Court of Texas that portion of the appellate court ruling denying the remaining Tennessee Gas claims. If the Supreme Court of Texas does not grant the Company's petition for writ of error and affirms the appellate court ruling, then the only issue for trial will be whether the increases in the volumes of gas tendered to Tennessee Gas from the Company's properties may have been made in bad faith or were unreasonably disproportionate. Management of the Company believes its tenders were reasonable under the Gas Contract and the market conditions at the time and will vigorously defend on this issue if put to trial. The Company continues to receive payment from Tennessee Gas based on the Contract Price. Although the outcome of any litigation is uncertain, management believes that the Tennessee Gas claims are without merit and, based upon advice from outside legal counsel, is confident that the decision of the trial court will ultimately be upheld as to the validity of the Gas Contract and the Contract Price; and that with respect to the output contract issue, the Company believes that, if this issue is tried, the development of its gas properties and the resulting increases in volumes tendered to Tennessee Gas will be found to have been reasonable and in good faith. Accordingly, the Company has recognized revenues, net of production taxes and marketing charges, for natural gas sales through December 31, 1993, under the Gas Contract based on the Contract Price, which net revenues aggregated $16.8 million more than the Section 101 prices and $31.0 million in excess of the spot market prices. An adverse judgment in this case could have a material adverse effect on the Company. If Tennessee Gas ultimately prevails in this litigation, the Company could be required to return to Tennessee Gas $31.0 million, excluding any interest that may be awarded by the court, representing the difference between the spot price for gas and the Contract Price. (b) In March 1991, the Company entered into a Consent Order with the Alaska Department of Environmental Conservation ('ADEC'), substantially similar to the Consent Orders reached with the EPA in September 1989. These Consent Orders provide for the investigation and cleanup of hydrocarbons in the soil and groundwater at the Company's Alaska refinery which resulted from sewer hub seepage associated with the underground oil/water sewer system. The Consent Orders formalized efforts, which commenced in 1987, to remedy the presence of hydrocarbons in the soil and groundwater and provide for the performance of additional future work. The Company has replaced or rebuilt the drainage hubs and has initiated a subsurface monitoring and interception system designed to identify the extent of hydrocarbons present in the groundwater and to remove the hydrocarbons. The Company estimates that annual expenditures of approximately $1.5 million will be required in the future to operate these subsurface monitoring and interception systems, the majority of which will be covered by insurance through 1995. (c) In March 1992, the Company received a Compliance Order and Notice of Violation ('Notice') from the EPA alleging possible violations by the Company of the New Source Performance Standards under the Clean Air Act at its Alaska refinery. The Notice alleges that the Company (i) failed to install a fuel gas combustion monitoring device by October 2, 1991; (ii) failed to keep documentation on two storage vessels reflecting quantities of petroleum liquid stored, the period of storage and the maximum true vapor pressure of the liquid stored; (iii) failed to submit documentation on two gas turbines (a) verifying the accuracy of the monitoring system for recording fuel consumption and ratio of fuel to water being fired in the turbines and (b) monitoring sulphur and nitrogen content of the fuel being fired in the turbines; (iv) failed to conduct a monitoring and repair program under the Standards for Equipment Leaks of Volatile Organic Compounds with respect to one of the refinery units; and (v) failed to (a) equip the Company's south bulk gasoline terminal with a vapor recovery system, (b) assure the loading of liquid products into tanks with a compatible vapor collection system, and (c) conduct performance tests and submit subsequent written reports to the EPA to determine compliance with vapor collection systems installed at the Company's south bulk terminal. The EPA has the statutory authority to assess civil penalties for the alleged violations of up to $25,000 per day for each violation, but the EPA has not assessed a penalty against the Company for its alleged violations to date. The Company is continuing in its efforts to resolve these issues with the EPA; however, no final resolution has been reached. The Company believes that the ultimate resolution of this matter will not have a material adverse effect upon the Company's business or financial condition. (d) The Company has been identified by the EPA as a potentially responsible party ('PRP') pursuant to the Comprehensive Environmental Response, Compensation and Liability Act ('CERCLA') for the D.L. Mud, Inc. ('Mud') and Gulf Coast Vacuum Services ('Gulf Coast') Superfund sites in Abbeville, Louisiana. These sites are contiguous and at one time were owned by the same company. Over 100 parties have been identified as PRPs for these sites. The Company arranged for the disposal of a minimal amount of materials at these locations. CERCLA imposes joint and several liability on PRPs; each PRP is therefore responsible for 100% of the costs of the response actions necessary to remediate the sites in the event a settlement with the EPA cannot be reached. The EPA is seeking reimbursement for its response costs incurred to date at each site, as well as a commitment from PRPs either to conduct future remedial activities or to finance such activities. The EPA has completed its investigation of the Gulf Coast site to determine the type and extent of contamination. The EPA issued the Record of Decision and sent out notice letters to PRPs. The Company has entered into a DE MINIMIS settlement with the EPA at the Gulf Coast site. The Company's total liability under the settlement was $2,500. One of the larger PRPs in the Mud site has taken the lead in investigating the site to determine the extent of contamination. Initial technical reports have been reviewed by the EPA and are undergoing further preparation; however, the reports are not yet available. At this time, the Company is unable to determine the extent of the Company's liability related to the Mud site; however, based on its settlement in the Gulf Coast site, the Company believes that the aggregate amount of such liability, if any, would not have a material adverse effect on the Company. (e) In September 1990, the Company was identified by the Department of Environmental Resources of Stanislaus County, California ('DER') as a responsible party for hydrocarbon contamination present at a service station location formerly leased and operated by the Company. In February 1993, the DER demanded that the Company and three other entities named as responsible parties undertake action to remediate the contamination. The owner of the location, Briggsmore Plaza Co. ('Briggsmore'), instituted litigation in the California state court seeking compensation from the Company for damages resulting from the contamination. Also named as a defendant was a third party which became the operator of the service station in 1985, and which filed for protection under the federal bankruptcy laws a short time after the lawsuit commenced. In November 1993, a settlement agreement was entered into by the Company and Briggsmore, which provides that the Company will assume responsibility for the management and expense of remediating the location in accordance with DER requirements. It is estimated that remediation to closure will cost the Company $300,000 to $500,000. In addition, the Company has agreed to pay Briggsmore approximately $48,000, representing past-due rent and property taxes. Briggsmore has released all claims against the Company except the remediation obligations arising under the settlement agreement. 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 Common stock market prices are included in Note O of Notes to Consolidated Financial Statements in Item 8. The principal markets on which the Company's Common Stock is traded are the New York Stock Exchange and the Pacific Stock Exchange. In February 1994, all of the Company's outstanding shares of $2.16 Preferred Stock were reclassified into 6,465,859 shares of Common Stock and the holder of the Company's $2.20 Preferred Stock was issued 1,900,075 shares of Common Stock, all pursuant to the Recapitalization. See Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and Note B of Notes to Consolidated Financial Statements in Item 8 for the pro forma effects of the Recapitalization on Common Stock and Other Stockholders' Equity. As of March 1, 1994, after the Recapitalization, there were approximately 3,800 holders of record of the Company's 22,456,055 outstanding shares of Common Stock. The Company discontinued paying dividends on Common Stock at the end of fiscal 1986. For information regarding restrictions on future dividend payments, see Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAPITAL RESOURCES AND LIQUIDITY In 1993, the Company achieved significant improvement in profitability resulting primarily from the implementation of a market-driven operational strategy along with favorable industry conditions in its refining and marketing segment; higher natural gas production resulting from concentration on the development of the Bob West Field; and a reduction of general and administrative expenses. The improvement in profitability together with the completion of a recapitalization plan during February 1994, as discussed below, have improved the Company's liquidity and enhanced its capital resources. During February 1994, the Company completed a plan of recapitalization (the 'Recapitalization'), the purpose of which was to improve the Company's short-term and long-term liquidity and increase the Company's equity capital. The Recapitalization, which deferred $44 million of debt service requirements and increased stockholders' equity by approximately $80 million, has provided the Company greater financial flexibility to meet its near-term capital expenditure programs and finance working capital, which are expected to further enhance the Company's operating results. Significant components of the Recapitalization, which will be recorded in February 1994, are as follows: * 12 3/4% Subordinated Debentures ('Subordinated Debentures') in the principal amount of $44.1 million were tendered in exchange for a like amount of new 13% Exchange Notes ('Exchange Notes'), which will satisfy approximately four years of sinking fund requirements for the Subordinated Debentures. The Exchange Notes bear interest at 13% and will mature on December 1, 2000. * The 1,319,563 outstanding shares of $2.16 Cumulative Convertible Preferred Stock ('$2.16 Preferred Stock') of the Company, together with accrued and unpaid dividends of $9.5 million at February 9, 1994, were reclassified into 6,465,859 shares of Common Stock of the Company. The Company also agreed to issue 131,956 shares of Common Stock on behalf of the holders of $2.16 Preferred Stock to pay certain of their legal fees and expenses in connection with the settlement of litigation. * The agreement between the Company and MetLife Security Insurance Company of Louisiana ('MetLife'), the holder of all the Company's outstanding $2.20 Cumulative Convertible Preferred Stock ('$2.20 Preferred Stock'), was amended with regard to such preferred shares to waive all existing mandatory redemption requirements, to consider all accrued and unpaid dividends thereon (aggregating approximately $21.2 million as of February 9, 1994) to have been paid, to allow the Company to pay future dividends in Common Stock in lieu of cash, to waive or refrain from exercising other rights of the $2.20 Preferred Stock and to grant to the Company an option to purchase during the next three years all shares of the $2.20 Preferred Stock and Common Stock held by MetLife for approximately $53 million (amount at February 9, 1994, increasing by 12% to 14% annually), all in consideration for, among other things, the issuance by the Company to MetLife of 1,900,075 shares of Common Stock. Such additional shares will be subject to the option granted by MetLife. The Company will be required to pay dividends when due on the $2.20 Preferred Stock in order for the option to remain outstanding. The following table presents the capitalization of the Company as of December 31, 1993 as reported and on a pro forma basis assuming the Recapitalization had occurred on that date (in millions): DECEMBER 31, 1993 AS REPORTED PRO FORMA Long-Term Debt and Other Obligations, Including Current Portion----------- $ 185.5 189.7 $2.20 Preferred Stock (Redeemable)----------------------- 78.1 -- Common Stock and Other Stockholders' Equity----------------------------- 58.5 137.7 Total Capitalization------------- $ 322.1 327.4 Ratio of Long-Term Debt and Redeemable Preferred Stock to Total Capitalization--------------------- 82% 58% For further information regarding the pro forma effects of the Recapitalization, refer to Note B of Notes to Consolidated Financial Statements in Item 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders Tesoro Petroleum Corporation We have audited the accompanying consolidated balance sheets of Tesoro Petroleum Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, common stock and other stockholders' equity and cash flows for the years ended December 31, 1993, December 31, 1992 and September 30, 1991 and for the three-month period ended December 31, 1991. Our audits also included the consolidated financial statement schedules listed in the Index at Item 14. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Tesoro Petroleum Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for the years ended December 31, 1993, December 31, 1992 and September 30, 1991 and for the three-month period ended December 31, 1991, in conformity with generally accepted accounting principles. Also, 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. As discussed in Note A of Notes to Consolidated Financial Statements, in 1992 the Company changed its methods of accounting for postretirement benefits other than pensions and accounting for income taxes. DELOITTE & TOUCHE San Antonio, Texas February 10, 1994 TESORO PETROLEUM CORPORATION STATEMENTS OF CONSOLIDATED OPERATIONS (DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS) The accompanying notes are an integral part of these consolidated financial statements. TESORO PETROLEUM CORPORATION CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) DECEMBER 31, 1993 1992 ASSETS Current Assets: Cash and cash equivalents (includes restricted cash of $25,420 in 1993 as collateral for letters of credit)--------- $ 36,596 46,869 Short-term investments----------- 5,952 20,021 Receivables, less allowance for doubtful accounts of $2,487 ($2,587 in 1992)--------------- 69,637 77,173 Inventories: Crude oil, refined products and merchandise------------ 71,011 70,875 Materials and supplies------- 3,175 3,636 Prepaid expenses and other------- 10,136 9,803 Total Current Assets--------- 196,507 228,377 Property, Plant and Equipment: Refining and marketing----------- 282,286 275,213 Exploration and production, full-cost method of accounting: Properties being amortized------------------ 74,684 45,182 Properties not yet evaluated------------------ 1,959 1,482 Oil field supply and distribution------------------- 15,413 16,365 Corporate------------------------ 11,121 10,431 385,463 348,673 Less accumulated depreciation, depletion and amortization----- 172,312 150,191 Net Property, Plant and Equipment------------------ 213,151 198,482 Other Assets: Investment in Tesoro Bolivia Petroleum Company-------------- 6,310 2,786 Other---------------------------- 18,554 17,077 Total Other Assets----------- 24,864 19,863 $ 434,522 446,722 The accompanying notes are an integral part of these consolidated financial statements. TESORO PETROLEUM CORPORATION CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS) DECEMBER 31, 1993 1992 LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable----------------- $ 43,192 49,120 Accrued liabilities-------------- 24,017 30,387 Current portion of long-term debt and other obligations---------- 4,805 26,287 Total Current Liabilities---- 72,014 105,794 Other Liabilities-------------------- 45,272 43,107 Long-Term Debt and Other Obligations, Less Current Portion--------------- 180,667 175,461 Commitments and Contingencies (Note K) $2.20 Redeemable Cumulative Convertible Preferred Stock and Accrued Dividends; $1 stated value; 2,875,000 shares issued and outstanding; redemption and liquidation value of $78,056 ($71,731 in 1992)------------------ 78,051 71,695 Common Stock and Other Stockholders' Equity: Preferred stock, no par value; authorized 5,000,000 shares including redeemable preferred shares: $2.16 Cumulative convertible preferred stock; $1 stated value; 1,319,563 shares issued and outstanding; liquidation value of $42,134 ($39,283 in 1992)---------------------- 1,320 1,320 Common stock, par value $.16 2/3; authorized 50,000,000 shares; 14,089,236 shares issued and outstanding (14,071,040 in 1992)-------------------------- 2,348 2,345 Additional paid-in capital------- 86,985 86,992 Retained earnings (deficit)------ (31,898) (39,647) 58,755 51,010 Less deferred compensation------- 237 345 58,518 50,665 $ 434,522 446,722 The accompanying notes are an integral part of these consolidated financial statements. TESORO PETROLEUM CORPORATION STATEMENTS OF CONSOLIDATED COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS) TESORO PETROLEUM CORPORATION STATEMENTS OF CONSOLIDATED CASH FLOWS (DOLLARS IN THOUSANDS) TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION AND PRESENTATION The Consolidated Financial Statements include the accounts of Tesoro Petroleum Corporation and its subsidiaries (collectively the 'Company' or 'Tesoro') after elimination of significant intercompany balances and transactions. Certain prior period amounts have been reclassified to conform with the 1993 presentation. Effective January 1, 1992, the Company changed its fiscal year-end from September 30 to December 31. Unless otherwise indicated, the information contained herein addresses the Company's results of operations for the year ended December 31, 1993, compared to the year ended December 31, 1992 and the year ended September 30, 1991 and its financial condition as of December 31, 1993 and December 31, 1992. The results of operations for the three-month period ended December 31, 1991 are discussed separately. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. During 1992, the Company began investing in short-term debt securities with original maturities in excess of 90 days. These investments are classified as short-term investments in the Company's Consolidated Balance Sheets. Cash equivalents and short-term investments are stated at cost, which approximates market value. For information regarding restricted cash, see Note I. INVENTORIES The Company follows the lower of cost (last-in, first-out basis -- LIFO) or market method for valuing inventories of crude oil and wholesale refined products. All other inventories are valued principally at the lower of cost (generally on a first-in, first-out or weighted average basis) or market. FUTURES AND OPTIONS HEDGE CONTRACTS The Company uses commodity futures and options contracts primarily to hedge the impact of price fluctuations on anticipated purchases of crude oil. Gains and losses on commodity futures and options hedge contracts are deferred until recognized in income when the related crude oil is charged to costs of sales. PROPERTY, PLANT AND EQUIPMENT The Company uses the full-cost method of accounting for oil and gas properties. Under this method, all costs associated with property acquisition and exploration and development activities are capitalized into cost centers that are established on a country-by-country basis. For each cost center, the capitalized costs are subject to a limitation so as not to exceed the present value of future net revenues from estimated production of proved oil and gas reserves net of income tax effect plus the lower of cost or estimated fair value of unproved properties included in the cost center. Capitalized costs within a cost center, together with estimates of costs for future development, dismantlement and abandonment, are amortized on a unit-of-production method using the proved oil and gas reserves for each cost center. The Company's investment in certain oil and gas properties is excluded from the amortization base until the properties are evaluated. No gain or loss is recognized on the sale of oil and gas properties except in the case of the sale of properties involving significant remaining reserves. Proceeds from the sale of insignificant reserves and undeveloped properties are applied to reduce the costs in the cost centers. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Assets recorded under capital leases have been capitalized in accordance with promulgations from the Financial Accounting Standards Board. Amortization of such assets is recorded over the shorter of lease terms or useful lives under methods which are consistent with the Company's depreciation policy for owned assets. Depreciation of other property is provided using primarily the straight-line method with rates based on the estimated useful lives of the properties and with an estimated salvage value of 20% for refinery assets and generally 10% for other assets. Amortization of leasehold improvements is provided using the straight-line method over the term of the respective lease or the useful life of the asset, whichever period is less. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company accounts for postretirement benefits other than pensions in accordance with Statement of Financial Accounting Standards No. 106, 'Employers' Accounting for Postretirement Benefits Other Than Pensions' ('SFAS No. 106'). The projected future cost of providing postretirement benefits other than pensions, such as health care and life insurance, are expensed as employees render service instead of when benefits are paid. Prior to the adoption of SFAS No. 106, the Company had expensed these benefits on a pay-as-you-go basis. The adoption of SFAS No. 106, effective January 1, 1992, resulted in a net charge of $21.6 million, or $1.54 per share, for the cumulative effect of the change in accounting principle for periods prior to 1992, which were not restated. In addition, the adoption of SFAS No. 106 resulted in an increase of $1.2 million, or $.09 per share, in the 1992 net loss before cumulative effect of accounting changes. INCOME TAXES The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes' ('SFAS No. 109'). Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Measurement of deferred tax assets and liabilities is based on enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company adopted SFAS No. 109 effective January 1, 1992 by recognizing a net benefit of $1.0 million, or $.07 per share, for the cumulative effect of the accounting change. Periods prior to 1992 were not restated. The adoption of SFAS No. 109 did not have a significant effect on 1992 results of operations. ENVIRONMENTAL EXPENDITURES Environmental expenditures 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 and/or remedial efforts are probable, and the cost can be reasonably estimated. Generally, the timing of these accruals coincides with completion of a feasibility study or the Company's commitment to a formal plan of action. DEFERRED COMPENSATION Deferred compensation represents the excess of market value over the sales price of restricted common stock awarded to certain employees of the Company. The deferred compensation is being amortized over the period from the date of award to the dates the shares become unrestricted (the period for which the payment for services is being made). TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED EARNINGS (LOSS) PER SHARE Primary earnings (loss) per share is calculated on net earnings (loss) after deducting dividend requirements on preferred stocks and is based on the weighted average number of common and common equivalent shares outstanding during the period. Fully diluted earnings (loss) per share is the same as primary earnings (loss) per share since the assumed conversion of preferred stocks to common shares would be anti-dilutive. NOTE B -- SUBSEQUENT EVENT -- RECAPITALIZATION In February 1994, the Company consummated exchange offers and adopted amendments to its Restated Certificate of Incorporation pursuant to which the Company's outstanding debt and preferred stock were restructured (the 'Recapitalization'). The objectives of the Recapitalization were to improve the Company's financial condition, facilitate the development of long-term financing and allow the Company to execute its strategy for further improving its refining and marketing operations and accelerating the development of its South Texas natural gas field. The significant components of the Recapitalization, together with the applicable accounting effects, are as follows: * The Company offered to exchange up to $54.5 million aggregate principal amount of new 13% Exchange Notes ('Exchange Notes') due December 1, 2000 for a like amount of 12 3/4% Subordinated Debentures ('Subordinated Debentures') due March 15, 2001. Holders of $44.1 million principal amount of Subordinated Debentures accepted this offer resulting in the issuance of $44.1 million of Exchange Notes. This exchange will satisfy approximately four years of sinking fund requirements of the Subordinated Debentures. The exchange of the Subordinated Debentures will be accounted for as an early extinguishment of debt in the first quarter of 1994 and the Company will recognize a charge of $4.8 million as an extraordinary loss on this transaction, representing the excess of the estimated market value of the Exchange Notes over the carrying value of the Subordinated Debentures. The carrying value of the Subordinated Debentures exchanged has been reduced by applicable unamortized debt issue costs. No tax benefit is available to offset the extraordinary loss as the Company has provided a 100% valuation allowance to the extent of its deferred tax assets. * Each outstanding share of the Company's $2.16 Cumulative Convertible Preferred Stock ('$2.16 Preferred Stock'), which has a $25 per share liquidation preference plus accrued and unpaid dividends aggregating $9.5 million at February 9, 1994, was reclassified into 4.9 shares of the Company's Common Stock resulting in the issuance of 6,465,859 of the Company's Common Stock in 1994. In addition, the Company agreed to issue .1 share of Common Stock for each share of $2.16 Preferred Stock, or an aggregate of 131,956 shares of Common Stock, on behalf of the holders of $2.16 Preferred Stock to pay certain of their legal fees and expenses in connection with the settlement of litigation. The issuance of the Common Stock in connection with the reclassification and settlement of litigation will be recorded in 1994 as an increase of approximately $1 million in Common Stock equal to the aggregate par value of the Common Stock to be issued and an increase in Additional Paid-In Capital of approximately $9 million. * The agreement between the Company and MetLife Security Insurance Company of Louisiana ('MetLife'), the holder of the Company's outstanding $2.20 Cumulative Convertible Preferred Stock ('$2.20 Preferred Stock'), was amended with regard to the $2.20 Preferred Stock to waive all existing mandatory redemption requirements, to consider all accrued and unpaid dividends thereon (aggregating $21.2 million at February 9, 1994) to have been paid, to allow TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED the Company to pay future dividends on such Preferred Stock in Common Stock in lieu of cash, to waive or refrain from exercising other rights of the $2.20 Preferred Stock, and to grant to the Company an option to purchase, during the next three years, all shares of the $2.20 Preferred Stock and Common Stock held by MetLife for approximately $53 million (amount at February 9, 1994, increasing by 12% to 14% annually), all in consideration for, among other things, the issuance by the Company to MetLife of 1,900,075 shares of Common Stock. Such additional shares will be subject to the option granted by MetLife. These actions have resulted in the reclassification of the $2.20 Preferred Stock into equity capital at its aggregate liquidation preference of $57.5 million and the recording of an increase in Additional Paid-In Capital of approximately $21 million in February 1994. The following table presents the capitalization of the Company as of December 31, 1993 as reported and on a pro forma basis assuming the Recapitalization had occurred on that date (in millions): DECEMBER 31, 1993 AS REPORTED PRO FORMA (UNAUDITED) Long-Term Debt and Other Obligations, Including Current Portion: Subordinated Debentures---------- $ 98.2 58.3 Exchange Notes------------------- -- 44.1 Liability to State of Alaska----- 61.7 61.7 Liability to Department of Energy------------------------- 13.2 13.2 Other---------------------------- 12.4 12.4 Total Long-Term Debt and Other Obligations---------- 185.5 189.7 $2.20 Preferred Stock (Redeemable)----------------------- 78.1 -- Common Stock and Other Stockholders' Equity: $2.20 Preferred Stock------------ -- 57.5 $2.16 Preferred Stock------------ 1.3 -- Common Stock--------------------- 2.3 3.7 Additional Paid-In Capital------- 87.0 113.4 Accumulated Deficit-------------- (31.9) (36.7) Deferred Compensation------------ (.2) (.2) Total Common Stock and Other Stockholders' Equity------- 58.5 137.7 Total Capitalization------------- $ 322.1 327.4 Ratio of Long-Term Debt and Redeemable Preferred Stock to Total Capitalization--------------------- 82% 58% TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED The pro forma effects of the Recapitalization on the Company's results of operations assuming the Recapitalization had occurred on January 1, 1993, are as follows (in millions except per share amounts): YEAR ENDED DECEMBER 31, 1993 AS REPORTED PRO FORMA (UNAUDITED) Total Revenues----------------------- $ 834.9 834.9 Earnings Before Extraordinary Loss------------------------------- $ 17.0 16.9 Extraordinary Loss------------------- -- 4.8 Net Earnings------------------------- 17.0 12.1 Preferred Stock Dividend Requirements----------------------- 9.2 6.3 Net Earnings Applicable to Common Stock------------------------------ $ 7.8 5.8 Earnings (Loss) Per Primary and Fully Diluted* Share: Earnings Before Extraordinary Loss--------------------------- $ .54 .46 Extraordinary Loss--------------- -- (.21) Net Earnings--------------------- $ .54 .25 Average Common and Common Equivalent Shares Outstanding: Primary-------------------------- 14,290 22,788 Fully Diluted-------------------- 19,065 25,288 * ANTI-DILUTIVE See Notes I, L and M for further information on the Company's long-term debt and equity, including restrictions on dividend payments. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED NOTE C -- CHANGE IN FISCAL YEAR-END The Company changed its fiscal year-end from September 30 to December 31, effective January 1, 1992. The Statement of Consolidated Operations and the Statement of Consolidated Cash Flows for the three months ended December 31, 1991 are presented in the accompanying Consolidated Financial Statements. Comparative financial information is presented below (in thousands except per share amounts): STATEMENTS OF CONSOLIDATED OPERATIONS THREE MONTHS ENDED DECEMBER 31, 1991 1990 (UNAUDITED) Revenues: Gross operating revenues--------- $ 240,586 334,098 Interest income------------------ 682 1,410 Gain on sales of assets---------- 9 177 Other---------------------------- 2,596 499 Total Revenues--------------- 243,873 336,184 Costs and Expenses: Costs of sales and operating expenses----------------------- 228,569 312,047 General and administrative------- 2,849 4,033 Depreciation, depletion and amortization------------------- 4,225 3,058 Interest expense----------------- 4,966 4,639 Other---------------------------- 722 761 Total Costs and Expenses----- 241,331 324,538 Earnings before Income Taxes--------- 2,542 11,646 Income Tax Provision----------------- 2,958 6,793 Net Earnings (Loss)------------------ $ (416) 4,853 Net Earnings (Loss) Applicable to Common Stock----------------------- $ (2,717) 2,552 Earnings (Loss) Per Primary and Fully Diluted* Share--------------------- $ (.19) .18 * ANTI-DILUTIVE TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED STATEMENTS OF CONSOLIDATED CASH FLOWS THREE MONTHS ENDED DECEMBER 31, 1991 1990 (UNAUDITED) Cash Flows From (Used In) Operating Activities: Net earnings (loss)-------------- $ (416) 4,853 Adjustments to reconcile net earnings (loss) to net cash used in operating activities: Depreciation, depletion and amortization--------------- 4,225 3,058 Gain on sales of assets------ (9) (177) Other------------------------ 599 836 Changes in assets and liabilities: Receivables-------------- 6,524 14,313 Inventories-------------- (10,620) (24,687) Investment in Tesoro Bolivia Petroleum Company---------------- 8,756 (4,383) Other assets------------- (4,748) (3,325) Accounts payable and other current liabilities------------ (3,877) (8,307) Other liabilities and obligations------------ (774) 1,105 Net cash used in operating activities------------- (340) (16,714) Cash Flows From (Used In) Investing Activities: Capital expenditures------------- (3,858) (6,136) Proceeds from sales of assets---- 35 692 Other---------------------------- 1 (829) Net cash used in investing activities------------- (3,822) (6,273) Cash Flows From (Used In) Financing Activities: Payments of long-term debt------- (512) (409) Issuance of long-term debt------- 3,000 -- Dividends on preferred stocks---- -- (2,294) Other---------------------------- (7) 2 Net cash from (used in) financing activities------------- 2,481 (2,701) Decrease in Cash and Cash Equivalents------------------------ (1,681) (25,688) Cash and Cash Equivalents at Beginning of Period---------------- 62,710 78,785 Cash and Cash Equivalents at End of Period----------------------------- $ 61,029 53,097 Supplemental Cash Flow Disclosures: Interest paid-------------------- $ 234 218 Income taxes paid---------------- $ 3,425 2,663 NOTE D -- INVENTORIES Inventories valued by the LIFO method amounted to approximately $63.0 million and $63.7 million at December 31, 1993 and 1992, respectively. At December 31, 1993, inventories valued using LIFO approximated replacement cost. At December 31, 1992 inventories valued using LIFO were lower than replacement cost by approximately $9.6 million. NOTE E -- PROPERTY, PLANT AND EQUIPMENT Effective May 1, 1992, the Company's subsidiaries, Tesoro Indonesia Petroleum Company and Tesoro Tarakan Petroleum Company (collectively 'Tesoro Indonesia'), sold their 100% interest in TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED two separate contracts of operations with Pertamina, the state-owned petroleum company of Indonesia. The sales included all of Tesoro Indonesia's interests in fixtures, wells, pipelines, tanks, compressors, rigs and other equipment in the contract areas, and inventories of crude oil and materials and supplies. The consideration received by Tesoro Indonesia totaled $6.6 million in cash and the assumption by the purchaser of liabilities of approximately $6.3 million and all remaining expenditure commitments. During 1992, these sales transactions resulted in pretax net gains to the Company of approximately $5.8 million after related expenses. In 1992, the Company sold its corporate airplane and related assets for $3.3 million in cash with no significant pretax gain to the Company. The Company also sold certain oil and gas properties in South Texas for $2.1 million in cash, which proceeds reduced the carrying value of the Company's oil and gas properties and no gain or loss was recognized. In addition, the Company sold its remaining drilling rigs for cash proceeds of $1.6 million resulting in a pretax loss of $1.1 million during 1992. NOTE F -- INVESTMENT IN TESORO BOLIVIA PETROLEUM COMPANY The Company's subsidiary, Tesoro Bolivia Petroleum Company ('Tesoro Bolivia'), holds an interest in a joint venture agreement to explore for and produce hydrocarbons in Bolivia. The joint venture has an agreement with the Bolivian Government and YPFB, the Bolivian state-owned oil company, for collection of receivables for sales of natural gas and condensate to YPFB, which in turn sells the natural gas to the Republic of Argentina. The agreement provided, among other things, that receipts from natural gas sales subsequent to December 31, 1987 would be placed in a restricted bank account ('Restricted Account') from which only payments for investments and expenses in Bolivia could be made until April 1992, or until cumulative deposits to the Restricted Account equal $90.0 million. Cumulative deposits to the Restricted Account have totaled $90.0 million and receipts for natural gas sales are now free of restrictions to the joint venture. The increase in the book value of this investment during 1993 represented earnings and cash invested in Tesoro Bolivia reduced by cash received free of restrictions. NOTE G -- ACCRUED LIABILITIES The Company's current accrued liabilities as shown in the Consolidated Balance Sheets include the following (in thousands): DECEMBER 31, 1993 1992 Accrued Interest--------------------- $ 5,185 14,401 Accrued Environmental Costs---------- 6,171 4,632 Other-------------------------------- 12,661 11,354 Accrued Liabilities-------------- $ 24,017 30,387 Other liabilities classified as noncurrent in the Consolidated Balance Sheets consist of the following (in thousands): DECEMBER 31, 1993 1992 Accrued Postretirement Benefits------ $ 27,270 25,088 Accrued Dividends on $2.16 Preferred Stock------------------------------ 9,145 6,294 Deferred Income Taxes---------------- 3,792 7,402 Other-------------------------------- 5,065 4,323 Other Liabilities---------------- $ 45,272 43,107 TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED NOTE H -- INCOME TAXES The income tax provision includes the following (in thousands): During 1993, the Company resolved several outstanding issues with state taxing authorities resulting in a reduction of $3.0 million in state income tax expense and $5.2 million in related interest expense. Deferred income taxes and benefits are provided for differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Temporary differences and the resulting deferred tax assets and liabilities are summarized as follows (in thousands): DECEMBER 31, 1993 1992 Deferred Tax Assets: Net operating losses available for utilization through the year 2008---------------------- $ 24,890 21,501 Settlement with the State of Alaska------------------------- 21,583 24,476 Accrued postretirement benefits----------------------- 8,359 6,947 Settlement with Department of Energy------------------------- 4,443 4,616 Other---------------------------- 7,220 12,137 Total Deferred Tax Assets---- 66,495 69,677 Deferred Tax Liabilities: Accelerated depreciation and property-related items--------- (45,965) (42,475) Deferred Tax Assets Before Valuation Allowance-------------------------- 20,530 27,202 Valuation Allowance------------------ (20,530) (27,202) Other-------------------------------- (442) (6,660) State Income and Alternative Minimum Taxes------------------------------ (3,350) (742) Net Deferred Tax Liability------- $ (3,792) (7,402) TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED The following table sets forth the components of the Company's results of operations and a reconciliation of the normal statutory federal income tax with the provision for income taxes (in thousands): At December 31, 1993, the Company's net operating loss carryforwards were approximately $71.1 million for regular tax and approximately $56.1 million for alternative minimum tax. These tax loss carryforwards are available for future years and, if not used, will begin to expire in the year 2004. Also at December 31, 1993, the Company had approximately $8.2 million of investment tax credits and employee stock ownership credits available for carryover to subsequent years. These credits, if not used, will begin to expire in the year 2001. If the Company has an 'ownership change' as defined by the Internal Revenue Code of 1986, the Company's use of its net operating loss carryforwards and general business credits after such ownership change will be subject to an annual limit. Under certain interpretations of existing Internal Revenue Service (IRS) regulations, the Recapitalization, as discussed in Note B, will result in an ownership change. The Company intends to take the position that an ownership change under existing law did not occur prior to the Recapitalization and did not occur as a result thereof. Because there are substantial interpretive questions concerning such IRS regulations and there is uncertainty as to events which may occur after the Recapitalization, there can be no assurance that an ownership change did not occur as a result of the Recapitalization or will not occur as a result of future events. If an ownership change is ultimately deemed to have occurred at the time of the Recapitalization, the Company's use of its net operating loss carryforwards and general business credits would be limited to approximately $14.5 million per year. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED NOTE I -- LONG-TERM DEBT AND OTHER OBLIGATIONS Long-term debt and other obligations consist of the following (in thousands): DECEMBER 31, 1993 1992 12 3/4% Subordinated Debentures due 2001-------------------------------- $ 98,154 107,510 Liability to State of Alaska--------- 61,666 71,989 Liability to Department of Energy---- 13,194 13,194 Exploration and Production Loan------ 5,000 -- Industrial Revenue Bonds------------- 2,752 3,483 Capital Lease Obligations (interest at 11%)---------------------------- 3,934 4,368 Other-------------------------------- 772 1,204 185,472 201,748 Less Current Portion----------------- 4,805 26,287 $ 180,667 175,461 Based on the closing market price, the fair value of the Subordinated Debentures, exclusive of accrued interest, was approximately $108.3 million at December 31, 1993. The carrying value of the other long-term debt and obligations approximated the Company's estimate of the fair value of such items. As discussed in Note B, approximately four years of sinking fund requirements on the Subordinated Debentures will be satisfied by the exchange offer included in the Recapitalization. After giving effect to the Recapitalization, sinking fund requirements and aggregate maturities of long-term debt and obligations for each of the five years following December 31, 1993 are as follows (in thousands): LETTER OF CREDIT REQUIREMENTS On October 29, 1993, the Company elected to terminate its secured Letter of Credit Facility Agreement ('Credit Facility') dated July 27, 1989, which was scheduled to expire in March 1994 and which provided for the issuance of up to $40 million in letters of credit at the date of termination. In the latter half of 1993, the Company negotiated several interim credit arrangements collateralized by either cash or inventory to permit the Company to secure the purchases of crude oil feedstocks and to meet other operating and corporate credit requirements. With respect to these interim credit arrangements, the Company has entered into several uncommitted letter of credit facilities which provide for the issuance of letters of credit on a cash-secured basis. Total availability pursuant to the uncommitted letter of credit arrangements was in excess of $80 million. At December 31, 1993, the Company had arranged for the issuance of $25 million of outstanding letters of credit which were secured by restricted cash deposits. At 1992 year-end, under the terms of the previous Credit Facility, the Company was required to maintain a minimum $30 million cash balance and specified levels of equity and working capital. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED In addition, effective September 30, 1993, the Company entered into a waiver and substitution of collateral agreement ('Substitution Agreement') with the State of Alaska, the Company's largest supplier of crude oil. Under the Substitution Agreement, the Company has pledged the capital stock of Tesoro Alaska Petroleum Company ('Tesoro Alaska'), a wholly-owned subsidiary of the Company, and substantially all of its crude oil and refined product inventory in Alaska to secure its purchases of royalty crude oil. The Substitution Agreement has allowed the Company to reduce its letter of credit requirements to $25 million as of December 31, 1993. This agreement extends through January 1, 1995 and contains various covenants and restrictions customary to inventory financing transactions. EXPLORATION AND PRODUCTION FINANCING Effective October 29, 1993, Tesoro Exploration and Production Company ('Tesoro E&P'), a wholly-owned subsidiary of the Company, entered into a $30 million reducing revolving credit facility ('E&P Facility') secured by the capital stock of Tesoro E&P and its natural gas properties in the Bob West Field in South Texas. At December 31, 1993, $5.0 million was outstanding under this facility. The E&P Facility, which expires December 31, 1996, is guaranteed by the Company, contains certain financial covenants that must be maintained by Tesoro E&P and bears interest at prime plus 1% or, at Tesoro E&P's option, Libor plus 2.5%. The E&P Facility contains restrictions that prohibit borrowings under the facility to be used by Tesoro E&P or the Company for debt service, including interest and principal on the Company's 12 3/4% Subordinated Debentures, or for payment of common or preferred dividends. 12 3/4% SUBORDINATED DEBT AND 13% EXCHANGE NOTES In 1983, the Company issued $120 million of 12 3/4% Subordinated Debentures at a price of 84.559% of the principal amount, due March 15, 2001. The debentures are redeemable at the option of the Company at 100% of principal amount plus accrued interest. Sinking fund payments sufficient to retire $11.25 million principal amount of debentures annually commenced on March 15, 1993. The Company satisfied the initial sinking fund requirement by purchasing $11.25 million principal amount of debentures at market value on January 26, 1993. The exchange of $44.1 principal amount of Subordinated Debentures for Exchange Notes in February 1994 will satisfy nearly four years of sinking fund requirements (see Note B). At December 31, 1993 and 1992, subordinated debt amounted to $98.2 million (net of discount of $10.6 million) and $107.5 million (net of discount of $12.5 million), respectively. The indenture contains restrictions on payment of dividends on the Company's common stock and purchases or redemptions of common or preferred stocks. Due to losses which have been incurred, the Company must generate approximately $131 million of future net earnings applicable to common stock or from the issuance of capital stock before future dividends can be paid on common stock or before purchases or redemptions can be made of common or preferred stocks. As part of the Recapitalization discussed in Note B, in February 1994, Subordinated Debentures in the principal amount of $44.1 million were exchanged for a like amount of new 13% Exchange Notes. The Exchange Notes mature on December 1, 2000, and have no sinking fund requirements. The Exchange Notes are redeemable at the option of the Company at 100% of principal amount plus accrued interest except that no optional redemption may be made unless an equal principal amount of, or all the outstanding, Subordinated Debentures, are concurrently redeemed. The Exchange Notes rank PARI PASSU with the other senior debt of the Company and with the Subordinated Debentures, and senior in right of payment of the obligation to the State of Alaska (discussed below) and all other subordinated indebtedness of the Company. The indenture governing the Exchange Notes contains TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED limitations on dividends which are less restrictive than the limitation under the Subordinated Debentures. For information on the pro forma effects of the exchange, see Note B. STATE OF ALASKA In January 1993, the Company and its subsidiary, Tesoro Alaska Petroleum Company ('Tesoro Alaska'), entered into an agreement ('Agreement') with the State of Alaska ('State') that settled Tesoro Alaska's contractual dispute with the State. In addition to $62 million accrued through September 30, 1992, a charge of $10.5 million for the settlement was included in the Company's operations during the fourth quarter of 1992. Under the Agreement, Tesoro Alaska paid the State $10.3 million in January 1993 and agreed to make variable monthly payments to the State over the next nine years following the date of the settlement based on a per barrel charge that increases over the nine-year term from 16 cents to 33 cents on the volume of feedstock processed at the Company's Alaska refinery. In 1993, the Company's variable payments to the State totaled $2.6 million. At the end of the nine-year period, Tesoro Alaska is obligated to pay the State $60 million; provided, however, that such payment may be deferred indefinitely by continuing the variable monthly payments to the State beginning at 34 cents per barrel and increasing one cent per barrel annually thereafter. Variable monthly payments made after the nine-year period will not reduce the $60 million obligation to the State. The imputed rate of interest used by the Company on the $60 million obligation was 13%. The $60 million obligation is evidenced by a security bond, and the bond and the throughput barrel obligations are secured by a second mortgage on the Company's Alaska refinery. Tesoro Alaska's obligations under the Agreement and the mortgage are subordinated to current and future senior debt of up to $175 million plus any indebtedness incurred in the future to improve the Company's Alaska refinery. The State's claim against Tesoro Alaska arose out of certain provisions in present and past contracts with the State that required Tesoro Alaska to pay the State additional retroactive amounts if the State prevailed in litigation against the producers of North Slope crude oil ('Producers'). As a result of settlements between the State and the Producers, the State claimed that the royalty oil it sold Tesoro Alaska and others was undervalued to the extent that the Producers undervalued their oil. DEPARTMENT OF ENERGY A Consent Order entered into by the Company with the Department of Energy ('DOE') in 1989 settled all issues relating to the Company's compliance with federal petroleum price and allocation regulations from 1973 through decontrol in 1981. The Company has paid $41.3 million to the DOE since 1989. The Company's remaining obligation is to pay $13.2 million, exclusive of interest at 6%, over the next eight years. INDUSTRIAL REVENUE BONDS AND OTHER The industrial revenue bonds mature in 1998 and require semiannual payments of approximately $365,000. The bonds bear interest at a variable rate (4 1/2% at December 31, 1993) which is equal to 75% of the National Bank of Alaska's prime rate. The bonds are collateralized by the Company's Alaska refinery sulphur recovery unit which had a carrying value of approximately $6.9 million at December 31, 1993. CAPITAL LEASE OBLIGATIONS The Company is the lessee of certain buildings and equipment under capital leases with remaining lease terms of 4 to 25 years. These buildings and equipment are used in the Company's convenience store operations in Alaska. The assets and liabilities under capital leases are recorded at TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED the present value of the minimum lease payments. Property, plant and equipment at December 31, 1993 included assets held under capital leases of $6.0 million with a net book value of $2.6 million. NOTE J -- EMPLOYEE BENEFIT PLANS RETIREMENT PLAN For all eligible employees, the Company provides a qualified noncontributory retirement plan. Plan benefits are based on years of service and compensation. It is the Company's policy to fund costs accrued to the extent such costs are tax deductible. The components of net pension expense (income) for the Company's retirement plan are presented below (in thousands): YEARS ENDED YEAR ENDED DECEMBER 31, SEPTEMBER 30, 1993 1992 1991 Service Costs------------------------ $ 931 717 762 Interest Cost------------------------ 3,513 3,492 3,482 Actual Return on Plan Assets--------- (5,695) (1,763) (7,646) Net Amortization and Deferral-------- 1,488 (2,231) 3,167 Net Pension Expense (Income)----- $ 237 215 (235) For the three months ended December 31, 1991, net pension expense for the Company's retirement plan totaled $90,000. In addition to the retirement plan pension expense above, during 1992 the Company recognized a curtailment gain of $1.0 million for employee terminations in conjunction with a cost reduction program. The funded status of the Company's retirement plan and amounts included in the Company's Consolidated Balance Sheets are set forth in the following table (in thousands): DECEMBER 31, SEPTEMBER 30, 1993 1992 1991 Actuarial Present Value of Benefit Obligation: Vested benefit obligation-------- $ 41,200 34,806 33,959 Accumulated benefit obligation--------------------- $ 43,694 36,460 35,556 Plan Assets at Fair Value------------ $ 40,718 39,326 39,772 Projected Benefit Obligation--------- 48,700 40,989 40,305 Plan Assets Less Than Projected Benefit Obligation----------------- (7,982) (1,663) (533) Unrecognized Net Loss---------------- 11,997 7,222 5,889 Unrecognized Prior Service Costs----- (518) (588) (779) Unrecognized Net Transition Asset---- (6,883) (8,120) (9,664) Accrued Pension Expense Liability---------------------- $ (3,386) (3,149) (5,087) Retirement plan assets are primarily comprised of common stock and bond funds. Actuarial assumptions used to measure the projected benefit obligation at December 31, 1993 included a discount rate of 7% and a compensation increase rate of 4 1/2%. At December 31, 1992, the discount rate used was 9% and the compensation increase rate used was 6%. The expected long-term rate of return on assets was 9% for 1993 and 1992. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED EXECUTIVE SECURITY PLAN The Company's executive security plan ('ESP') provides executive officers and other key personnel with supplemental death or retirement benefits in addition to those benefits available under the Company's group life insurance and retirement plans. These supplemental retirement benefits are provided by a nonqualified, noncontributory plan and are based on years of service and compensation. Funding is provided based upon the estimated requirements of the plan. The components of net pension expense for the ESP are presented below (in thousands): YEARS ENDED YEAR ENDED DECEMBER 31, SEPTEMBER 30, 1993 1992 1991 Service Costs------------------------ $ 426 293 581 Interest Cost------------------------ 291 353 546 Actual Return on Plan Assets--------- (256) (1,004) (628) Net Amortization and Deferral-------- 295 994 590 Net Pension Expense-------------- $ 756 636 1,089 For the three months ended December 31, 1991, net pension expense for the ESP totaled $242,000. During 1993 and 1992, the Company incurred additional ESP expense of $.5 million and $3.5 million, respectively, for settlement losses and other benefits resulting from a cost reduction program, other employee terminations and sales of assets. The funded status of the ESP and amounts included in the Company's Consolidated Balance Sheets are set forth in the following table (in thousands): DECEMBER 31, SEPTEMBER 30, 1993 1992 1991 Actuarial Present Value of Benefit Obligation: Vested benefit obligation-------- $ 2,394 2,410 6,368 Accumulated benefit obligation--------------------- $ 2,792 2,464 6,420 Plan Assets at Fair Value------------ $ 3,139 2,924 6,658 Projected Benefit Obligation--------- 3,069 2,738 6,420 Plan Assets in Excess of Projected Benefit Obligation----------------- 70 186 238 Unrecognized Net Loss---------------- 1,177 1,409 2,147 Unrecognized Prior Service Costs----- 619 679 1,287 Unrecognized Net Transition Obligation------------------------- 1,110 1,254 2,412 Prepaid Pension Asset------------ $ 2,976 3,528 6,084 Assets of the ESP consist of a group annuity contract. Actuarial assumptions used to measure the projected benefit obligation at December 31, 1993 included a discount rate of 7% and a compensation rate increase of 4 1/2%. At December 31, 1992, the discount rate used was 9% and the compensation rate increase used was 5%. The expected long-term rate of return on assets was 9% for 1993 and 1992. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In addition to providing pension benefits, the Company provides health care and life insurance benefits to retirees and eligible dependents who were participating in the Company's group insurance program at retirement. These benefits are provided through unfunded defined benefit plans. The TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED health care plans are contributory, with retiree contributions adjusted periodically, and contain other cost-sharing features such as deductibles and coinsurance. The life insurance plan is noncontributory. As discussed in Note A, the Company adopted SFAS No. 106 effective January 1, 1992 and incurred a net charge of $21.6 million ($16.1 million for health care benefits and $5.5 million for life insurance benefits) for the cumulative effect of the change in accounting principle. The components of net periodic postretirement benefits expense, other than pensions, for 1993 and 1992 included the following (in thousands): Prior to 1992, the costs of providing health care and life insurance benefits to retired employees were expensed as claims were paid. In 1991, the costs of providing retirees with health care benefits amounted to $751,000 and life insurance benefits amounted to $299,000. For the three months ended December 31, 1991, retiree health care and life insurance benefits totaled $191,000 and $59,000, respectively. The Company continues to fund the cost of postretirement health care and life insurance benefits on a pay-as-you-go basis. The following table shows the status of the plans reconciled with the amounts in the Company's Consolidated Balance Sheets (in thousands): The weighted average annual assumed rate of increase in the per capita cost of covered health care benefits was assumed to be 12% for 1994 decreasing gradually to 7% by the year 2010 and remains at that level thereafter. This health care cost trend rate assumption has a significant effect on the amount of the obligation and periodic cost reported. For example, an increase in the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement obligation as of December 31, 1993 by $2.9 million and the aggregate of service cost and interest cost components of net periodic postretirement benefits for the year then ended by $.4 million. Actuarial assumptions used to measure the accumulated postretirement benefit obligation at December 31, 1993 included a discount rate of 7% and a compensation rate increase of 4 1/2%. At December 31, 1992, the discount rate was 8 1/2% and the compensation rate increase was 6%. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED THRIFT PLAN The Company's employee thrift plan provides for contributions by eligible employees into designated investment funds with a matching contribution by the Company of 50% of the employee's basic contribution. The Company's contributions amounted to $482,000, $474,000 and $439,000 during 1993, 1992 and 1991, respectively. For the three months ended December 31, 1991, the Company's contributions amounted to $107,000. COST REDUCTION PROGRAM AND OTHER EMPLOYEE TERMINATIONS In addition to the ESP settlement losses and other benefits and the retirement plan curtailment gain discussed above, during 1992 the Company incurred charges of $6.6 million for expenses to implement a cost reduction program and other employee terminations. NOTE K -- COMMITMENTS AND CONTINGENCIES OPERATING LEASES The Company has various noncancellable operating leases related to convenience stores, equipment, property, vessels and other facilities. Lease terms range from one year to 40 years and generally contain multiple renewal options. Future minimum annual payments for operating leases, as of December 31, 1993, are as follows (in thousands): 1994--------------------------------- $ 17,157 1995--------------------------------- 4,946 1996--------------------------------- 3,860 1997--------------------------------- 3,265 1998--------------------------------- 3,125 Thereafter--------------------------- 13,885 Total---------------------------- $ 46,238 Total rental expense was approximately $32.5 million, $24.3 million and $19.9 million for 1993, 1992 and 1991, respectively. Rental expense for 1993, 1992 and 1991 included $22.9 million, $12.0 million and $9.9 million, respectively, related to the lease of vessels used to transport crude oil to or refined products from the Company's Alaska refinery. The lease for one of these vessels extends through October 1994 with a renewal option available through October 1996. The lease for the second vessel extends through July 1994 with a renewal option available through January 1995. For the three months ended December 31, 1991, rental expense amounted to $6.0 million, of which $2.9 million related to the lease of a vessel. GAS PURCHASE AND SALES CONTRACT The Company is selling gas from its Bob West Field to Tennessee Gas Pipeline Company ('Tennessee Gas') under a 1979 Gas Purchase and Sales Agreement ('Gas Contract') which expires in January 1999. The Gas Contract provides that the price of gas shall be the maximum price as calculated in accordance with the then effective Section 102(b)(2) ('Contract Price') of the Natural Gas Policy Act of 1978 ('NGPA'). In August 1990, Tennessee Gas filed a civil action in the District Court of Bexar County, Texas against the Company and several other companies, seeking a Declaratory Judgment that the Gas Contract is not applicable to the Company's properties. Tennessee Gas claimed, among other things, that certain leases covered by the Gas Contract terminated and therefore were automatically released from the Gas Contract, eliminating the obligation of Tennessee Gas to purchase gas from the TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Company. Tennessee Gas also challenged the quantity of gas which can be sold under the Gas Contract and contended that the gas sales price was to be calculated under the provisions of Section 101 of the NGPA rather than the Contract Price. At December 31, 1993, the Section 101 price of $5.01 per mcf was $2.71 per mcf less than the Contract Price, but $2.75 per mcf above spot market prices. On June 24, 1992, the District Court trial judge returned a verdict in favor of the Company. The District Court's judgment, entered on July 8, 1992, ruled that Tennessee Gas must honor the Gas Contract pursuant to its terms. Tennessee Gas filed a motion for reconsideration in the District Court on the issue of the price to be paid for the gas under the Gas Contract, which was denied by the court. On September 11, 1992, Tennessee Gas appealed the judgment to the Court of Appeals for the Fourth Supreme Judicial District of Texas. On August 25, 1993, the Court of Appeals affirmed the validity of the Gas Contract as to the Company's properties and held that the price payable by Tennessee Gas for the gas was the Contract Price. The Court of Appeals determined, however, (i) that the trial court erred in its summary judgment ruling that the Gas Contract was not an output contract under the Texas Business and Commerce Code ('TBCA') and (ii) that a fact issue exists as to whether the increases in the volumes of gas tendered to Tennessee Gas under the Gas Contract were made in bad faith or were unreasonably disproportionate to prior tenders in contravention of the provisions of Section 2.306 of the TBCA. Accordingly, the Court of Appeals directed that this issue be remanded to the trial court in Bexar County, Texas. The Company filed a motion for rehearing with the appellate court regarding its decision that the Gas Contract creates an output contract governed by the TBCA. Tennessee Gas also filed a motion for rehearing with the appellate court regarding the portions of its decision upholding the judgment of the trial court. On January 26, 1994, the appellate court rendered its judgment denying all motions for rehearing in this matter and affirming its earlier ruling. The Company has appealed the appellate court ruling on the output contract issue to the Supreme Court of Texas. Tennessee Gas has also appealed to the Supreme Court of Texas that portion of the appellate court ruling denying the remaining Tennessee Gas claims. If the Supreme Court of Texas does not grant the Company's petition for writ of error and affirms the appellate court ruling, then the only issue for trial will be whether the increases in the volumes of gas tendered to Tennessee Gas from the Company's properties may have been made in bad faith or were unreasonably disproportionate. Management of the Company believes its tenders were reasonable under the Gas Contract and the market conditions at the time and will vigorously defend on this issue if put to trial. The Company continues to receive payment from Tennessee Gas based on the Contract Price. Although the outcome of any litigation is uncertain, management believes that the Tennessee Gas claims are without merit and, based upon advice from outside legal counsel, is confident that the decision of the trial court will ultimately be upheld as to the validity of the Gas Contract and the Contract Price; and that with respect to the output contract issue, the Company believes that, if this issue is tried, the development of its gas properties and the resulting increases in volumes tendered to Tennessee Gas will be found to have been reasonable and in good faith. Accordingly, the Company has recognized revenues, net of production taxes and marketing charges, for natural gas sales through December 31, 1993, under the Gas Contract based on the Contract Price, which net revenues aggregated $16.8 million more than the Section 101 prices and $31.0 million in excess of the spot market prices. An adverse judgment in this case could have a material adverse effect on the Company. If Tennessee Gas ultimately prevails in this litigation, the Company could be required to return to Tennessee Gas $31.0 million, excluding any interest that may be awarded by the court, representing the difference between the spot price for gas and the Contract Price. For further information concerning the effect of the Gas Contract on certain of the Company's revenues and cash flows, see Note P. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED OTHER In March 1992, the Company received a Compliance Order and Notice of Violation from the U.S. Environmental Protection Agency ('EPA') alleging possible violations by the Company of the New Source Performance Standards under the Clean Air Act at its Alaska refinery. The Company is continuing in its efforts to resolve these issues with the EPA; however, no final resolution has been reached. The Company believes that the ultimate resolution of this matter will not have a material adverse effect upon the Company's business or financial condition. The Company is subject to extensive federal, state and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites. The Company is currently involved with two waste disposal sites in Louisiana at which it has been named a potentially responsible party under the Federal Superfund law. Although this law might impose joint and several liability upon each party at any site, the extent of the Company's allocated financial contribution to the cleanup of these sites is expected to be limited based on the number of companies and the volumes of waste involved. At each site, a number of large companies have also been named as potentially responsible parties and are expected to cooperate in the cleanup. The Company is also involved in remedial response and has incurred cleanup expenditures associated with environmental matters at a number of other sites including certain of its own properties. At December 31, 1993, the Company had accrued $6.2 million for environmental costs. Based on currently available information, including the participation of other parties or former owners in remediation actions, the Company believes these accruals are adequate. Conditions which require additional expenditures may exist for various Company sites, including, but not limited to, the Company's refinery, service stations (current and closed locations) and petroleum product terminals, and for compliance with the Clean Air Act. The amount of such future expenditures cannot presently be determined by the Company. NOTE L -- REDEEMABLE PREFERRED STOCK In March 1983, the Company sold 2,875,000 shares of a series of redeemable preferred stock at $20 per share. The stock is held by MetLife which is a subsidiary of Metropolitan Life Insurance Company. The class of stock, of which there were 2,875,000 shares authorized, issued and outstanding at December 31, 1993 and 1992, has been designated the $2.20 Cumulative Convertible Preferred Stock ('$2.20 Preferred Stock'). This series has one vote per share, is convertible into .8696 shares of Common Stock for each share of Preferred Stock, has a stated value of $1 per share and a liquidation price of $20 per share plus accrued dividends. The $2.20 Preferred Stock ranks in parity with the $2.16 Cumulative Convertible Preferred Stock as to liquidation and dividends. The redeemable preferred stock was recorded at fair value on the date of issuance less issue costs. The excess of the redemption value over the carrying value is being accreted by periodic charges to retained earnings over the life of the issue. During 1993 and 1992, the carrying value of the redeemable preferred stock was increased for mandatorily redeemable accumulated dividends, not declared or paid, by charges to retained earnings. As of December 31, 1993, dividends in arrears on the $2.20 Preferred Stock amounted to approximately $19.8 million, or $6.87 1/2 per share. As discussed in Note B, in February 1994, the agreement between the Company and MetLife was amended with regard to such preferred shares to waive all existing mandatory redemption requirements, to consider all accrued and unpaid dividends (aggregating $21.2 million at February 9, 1994) to have been paid, to allow the Company to pay future dividends in Common Stock in lieu of cash, to waive or refrain from exercising other rights of the $2.20 Preferred Stock and to grant to the TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Company an option to purchase, during the next three years, all shares of the $2.20 Preferred Stock and Common Stock held by MetLife for approximately $53 million (amount at February 9, 1994, increasing by 12% to 14% annually) subject to certain conditions, in consideration for, among other things, the issuance by the Company to MetLife of 1,900,075 shares of Common Stock. Such additional shares will be subject to the option granted by MetLife. After giving effect to the Recapitalization, MetLife's Common and Preferred Stock holdings approximated 27% of the Company's voting securities. For information on the pro forma effects of these amendments, see Note B. NOTE M -- COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY For information regarding the effects of the Recapitalization on the Company's Common Stock and Other Stockholders' Equity, refer to Note B. $2.16 CUMULATIVE CONVERTIBLE PREFERRED STOCK The Company has designated a class of preferred stock, of which there were 1,319,563 shares outstanding at December 31, 1993 and 1992 and 200,000 shares reserved for the granting of options under a stock option plan of the Company. This class, designated the $2.16 Cumulative Convertible Preferred Stock ('$2.16 Preferred Stock'), has voting rights, is convertible into Common Stock at the rate of 1.7241 shares of Common Stock for each share of Preferred Stock, has a stated value of $1 per share and a liquidation value of $25 per share, and is repurchasable at the option of the Company at liquidation value plus accrued dividends. The $2.16 Preferred Stock ranks in parity with the $2.20 Preferred Stock as to liquidation and dividends. During 1993 and 1992, the liability for accumulated dividends, not declared or paid, on the $2.16 Preferred Stock was accrued by charges to retained earnings. As of December 31, 1993, dividends in arrears on the $2.16 Preferred Stock amounted to approximately $8.9 million, or $6.75 per share. As discussed in Note B, in February 1994, the outstanding shares of the Company's $2.16 Preferred Stock, plus accrued and unpaid dividends thereon (aggregating $9.5 million at February 9, 1994), were reclassified into shares of the Company's Common Stock. AMENDED INCENTIVE STOCK PLAN OF 1982 ('1982 PLAN') The Company's 1982 Plan provides for the granting of stock incentives in the form of stock options, stock appreciation rights and stock awards to officers and key employees. The stock options are exercisable in accordance with the option plans and expire no later than ten years from the date of grant. Stock appreciation rights are exercisable in three to five annual installments, normally beginning with the first anniversary date of the grant, and expire ten years from the date of grant. The stock appreciation rights entitle the employee to receive, without payment to the Company, the incremental increase in market value of the related stock from date of grant to date of exercise, payable in cash. Related compensation expense is charged to earnings over periods earned. During 1993, 1992 and 1991 and the three months ended December 31, 1991, no compensation expense was recognized since the market value of the Company's Common Stock remained below the exercise price. Stock awards totaling 83,015 common shares, 100,000 common shares and 12,000 common shares were granted at par value to certain employees of the Company in 1993, 1992 and 1991, respectively. Related compensation expense is charged to earnings over the periods that the shares are earned and amounted to $572,000, $142,000, $135,000 and $28,000 for 1993, 1992 and 1991 and the three months ended December 31, 1991, respectively. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED At December 31, 1993 and 1992 and September 30, 1991, the Company had 60,002, 392,566 and 852,381 unoptioned shares, respectively, available for granting of options, rights and awards under the 1982 Plan and 6,064,809, 6,084,809 and 6,093,231 shares of unissued Common Stock, respectively, reserved for conversion of preferred stock and the 1982 Plan. During 1988, an amendment to the 1982 Plan was approved which increased the number of shares of Common Stock which may be granted or transferred from 1,500,000 to 2,000,000. The additional shares will be registered with the Securities and Exchange Commission in 1994. The 1982 Plan expires on February 24, 1994 as to issuance of options, rights and awards; however, grants made before such date that have not been fully exercised will remain outstanding pursuant to their terms. A summary of activity in the 1982 Plan and a prior plan is set forth below: EXECUTIVE LONG-TERM INCENTIVE PLAN (THE '1993 PLAN') On February 9, 1994, the Company's shareholders approved the 1993 Plan which permits the issuance of awards in a variety of forms, including restricted stock, incentive stock options, nonqualified stock options, stock appreciation rights and performance share and performance unit awards. The 1993 Plan provides for the grant of up to 1,250,000 shares of the Company's Common Stock and, unless earlier terminated, will expire as to the issuance of awards on September 15, 2003. No grants have been made pursuant to the 1993 Plan. PREFERRED STOCK PURCHASE RIGHTS In November 1985, the Company's Board of Directors declared a distribution of one preferred stock purchase right for each share of the Company's Common Stock. Each right will entitle the holder to buy 1/100 of a share of a newly authorized Series A Participating Preferred Stock at an exercise price of $35 per right. The rights become exercisable on the tenth day after public announcement that a person or group has acquired 20% or more of the Company's Common Stock. The rights may be redeemed by the Company prior to becoming exercisable by action of the Board of Directors at a redemption price of $.05 per right. If the Company is acquired by any person after the rights become exercisable, each right will entitle its holder to purchase stock of the acquiring company having a market value of twice the exercise price of each right. At December 31, 1993, there were 14,089,236 rights outstanding which will expire in December 1995. In conjunction with the Recapitalization in 1994 discussed in Note B, the Company issued an additional 8,365,934 rights. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED NOTE N -- FINANCIAL INFORMATION BY BUSINESS SEGMENT Tesoro is primarily engaged in three business segments: crude oil refining and marketing of refined petroleum products; the exploration and production of natural gas; and oil field supply and distribution of fuels and lubricants. Geographically, the refining and marketing operations are concentrated in Alaska and on the West Coast, the exploration and production operations are located in South Texas and Bolivia, and the wholesale marketing of fuel and lubricants is conducted along the Texas and Louisiana Gulf Coast area. The Company sold its Indonesian exploration and production operations in May 1992. Income taxes, interest, general and administrative expenses and certain other corporate items are not allocated to the operating segments. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED NOTE O -- QUARTERLY FINANCIAL DATA (UNAUDITED) The 1993 second and fourth quarters included benefits of $3.0 million and $5.2 million, respectively, for resolution of several state tax issues. A $5.0 million charge for an inventory erosion was recorded in the 1993 third quarter. Included in the 1993 fourth quarter, however, was a $5.7 million offset to the inventory adjustment taken earlier in the year. Inventory levels at the 1993 year-end were greater than projected earlier in the year due to changing market conditions. The 1993 fourth quarter benefited from the decline in crude oil prices, while the Company's refined product margins held steady or improved. The 1992 first quarter included charges of $20.6 million for the cumulative effect of accounting changes, $2.4 million for a cost reduction program and $1.0 million for asset write-downs. The 1992 third quarter included a $5.8 million gain from the sales of the Company's Indonesian operations. The fourth quarter of 1992 included revenues and operating profit of $5.4 million ($.38 per share) resulting from a change in estimate of the Company's revenues from natural gas production in the South Texas field (see Note K) and additional charges of $10.5 million for the settlement with the State of Alaska and $5.6 million for the cost reduction program and other employee terminations. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED NOTE P -- OIL AND GAS PRODUCING ACTIVITIES The following information regarding the Company's exploration and production activities should be read in conjunction with Notes E and K. CAPITALIZED COSTS RELATING TO OIL AND GAS PRODUCING ACTIVITIES DECEMBER 31, SEPTEMBER 30, 1993 1992 1991 (IN THOUSANDS) Capitalized Costs: Proved properties---------------- $ 60,489 34,050 29,100 Unproved properties: Properties being amortized------------------ 12,856 11,132 8,511 Properties not being amortized------------------ 1,959 1,482 8,242 75,304 46,664 45,853 Accumulated depreciation, depletion and amortization----- 26,118 15,006 15,713 Net Capitalized Costs-------- $ 49,186 31,658 30,140 COSTS INCURRED IN OIL AND GAS PROPERTY ACQUISITION, EXPLORATION AND DEVELOPMENT ACTIVITIES The Company's investment in oil and gas properties included $2.0 million in unevaluated properties which have been excluded from the amortization base as of December 31, 1993. The TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Company anticipates that the majority of these costs, substantially all of which were incurred in 1993, will be included in the amortization base during 1994. RESULTS OF OPERATIONS FROM OIL AND GAS PRODUCING ACTIVITIES The following table sets forth the results of operations for oil and gas producing activities, in the aggregate by geographic area, with income tax expense computed using the statutory tax rate for the period adjusted for permanent differences, tax credits and allowances. (1) SEE NOTE K REGARDING LITIGATION INVOLVING A NATURAL GAS SALES CONTRACT. (2) EXCLUDES CORPORATE GENERAL AND ADMINISTRATIVE AND FINANCING COSTS. (3) REPRESENTS GAIN FROM THE SALES OF THE COMPANY'S INDONESIAN OPERATIONS EFFECTIVE MAY 1, 1992. (4) INCLUDES A $2.0 MILLION CHARGE FOR AN ARBITRATION AWARD INVOLVING A ROYALTY DISPUTE ON INDONESIAN CRUDE OIL PRODUCTION. (5) INCLUDES A $1.3 MILLION CREDIT FOR BOLIVIAN TRANSACTION TAXES. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED RESERVES (UNAUDITED) The following table sets forth the computation of the standardized measure of discounted future net cash flows relating to proved reserves and the changes in such cash flows in accordance with Statement of Financial Accounting Standards No. 69 ('SFAS No. 69'). The standardized measure is the estimated excess future cash inflows from proved reserves less estimated future production and development costs, estimated future income taxes and a discount factor. Future cash inflows represent expected revenues from production of year-end quantities of proved reserves based on year-end prices and any fixed and determinable future escalation provided by contractual arrangements in existence at year-end. Escalation based on inflation, federal regulatory changes and supply and demand are not considered. Estimated future production costs related to year-end reserves are based on year-end costs. Such costs include, but are not limited to, production taxes and direct operating costs. Inflation and other anticipatory costs are not considered until the actual cost change takes effect. Estimated future income tax expenses are computed using the appropriate year-end statutory tax rates. Consideration is given for the effects of permanent differences, tax credits and allowances. A discount rate of 10% is applied to the annual future net cash flows after income taxes. The methodology and assumptions used in calculating the standardized measure are those required by SFAS No. 69. The standardized measure is not intended to be representative of the fair market value of the Company's proved reserves. The calculations of revenues and costs do not necessarily represent the amounts to be received or expended by the Company. As indicated in Note K, certain of the Company's South Texas production activities are involved in litigation pertaining to a natural gas sales contract with Tennessee Gas. Although the outcome of any litigation is uncertain, based upon advice from outside legal counsel, management believes that the Company will ultimately prevail in this dispute. Accordingly, the Company has based its calculation of the standardized measure of discounted future net cash flows on the Contract Price which it is currently receiving. However, if Tennessee Gas were to prevail, the impact on the Company's future revenues and cash flows would be significant. Based on the Contract Price, the standardized measure of discounted future net cash flows relating to proved reserves in the United States at December 31, 1993 was $103 million compared to $59 million at spot market prices. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED (1) SEE NOTE K REGARDING LITIGATION INVOLVING A NATURAL GAS SALES CONTRACT. TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED CHANGES IN STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS (UNAUDITED) TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED RESERVE QUANTITY INFORMATION (UNAUDITED) The following estimates of the Company's proved oil and gas reserves are based on evaluations prepared by Netherland, Sewell & Associates, Inc. (except for estimates of reserves at December 31, 1991 for properties in Bolivia and for all periods for properties in Indonesia, which estimates were prepared by the Company's in-house engineers). Reserves were estimated in accordance with guidelines established by the Securities and Exchange Commission and Financial Accounting Standards Board, which require that reserve estimates be prepared under existing economic and operating conditions with no provision for price and cost escalations except by contractual arrangements. UNITED STATES(2) BOLIVIA TOTAL Proved Gas Reserves (millions of cubic feet)(1): At September 30, 1990------------ 11,118 85,040 96,158 Revisions of previous estimates---------------------- (1,217) 696 (521) Purchase of minerals in-place---- -- 36,545 36,545 Extensions, discoveries and other additions---------------------- 25,950 -- 25,950 Production----------------------- (2,710) (7,052) (9,762) At September 30, 1991------------ 33,141 115,229 148,370 Revisions of previous estimates---------------------- 1,054 (35) 1,019 Extensions, discoveries and other additions---------------------- 3,585 -- 3,585 Production----------------------- (896) (1,729) (2,625) At December 31, 1991------------- 36,884 113,465 150,349 Revisions of previous estimates---------------------- (9,601) 651 (8,950) Extensions, discoveries and other additions---------------------- 53,952 -- 53,952 Production----------------------- (5,110) (7,108) (12,218) Sales of minerals in-place------- (2,372) -- (2,372) At December 31, 1992------------- 73,753 107,008 180,761 Revisions of previous estimates---------------------- 16,304 (693) 15,611 Extensions, discoveries and other additions---------------------- 44,291 -- 44,291 Production----------------------- (14,150) (7,020) (21,170) At December 31, 1993(3)---------- 120,198 99,295 219,493 Proved Developed Gas Reserves included above (millions of cubic feet): At September 30, 1990------------ 5,046 79,623 84,669 At September 30, 1991------------ 18,011 107,765 125,776 At December 31, 1991------------- 21,187 106,036 127,223 At December 31, 1992------------- 34,160 91,376 125,536 At December 31, 1993(3)---------- 65,652 99,295 164,947 TESORO PETROLEUM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED (1) THE COMPANY WAS NOT REQUIRED TO FILE RESERVE ESTIMATES WITH FEDERAL AUTHORITIES OR AGENCIES DURING THE PERIODS PRESENTED. (2) SEE NOTE K REGARDING LITIGATION INVOLVING A NATURAL GAS SALES CONTRACT. (3) NO MAJOR DISCOVERY OR ADVERSE EVENT HAS OCCURRED SINCE DECEMBER 31, 1993 THAT WOULD CAUSE A SIGNIFICANT CHANGE IN PROVED RESERVES. 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 will be contained in the Company's 1994 Proxy Statement which is incorporated herein by reference. See also Executive Officers of the Registrant under Business in Item 1. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information required under this Item will be contained in the Company's 1994 Proxy Statement which is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required under this Item will be contained in the Company's 1994 Proxy Statement which is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required under this Item will be contained in the Company's 1994 Proxy Statement which is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) 1. FINANCIAL STATEMENTS The following Consolidated Financial Statements of Tesoro Petroleum Corporation and its subsidiaries are included in Part II, Item 8 of this Form 10-K: PAGE Independent Auditors' Report----------------------- 33 Statements of Consolidated Operations -- Years Ended December 31, 1993, December 31, 1992 and September 30, 1991 and Three Months Ended December 31, 1991------------ 34 Consolidated Balance Sheets -- December 31, 1993 and December 31, 1992-------- 35 Statements of Consolidated Common Stock and Other Stockholders' Equity -- Years Ended December 31, 1993, December 31, 1992 and September 30, 1991 and Three Months Ended December 31, 1991------------------------- 37 Statements of Consolidated Cash Flows -- Years Ended December 31, 1993, December 31, 1992 and September 30, 1991 and Three Months Ended December 31, 1991------------ 38 Notes to Consolidated Financial Statements--------- 39 2. FINANCIAL STATEMENT SCHEDULES [CAPTION] PAGE Schedule II -- Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties -- Years Ended December 31, 1993, December 31, 1992 and September 30, 1991 and Three Months Ended December 31, 1991-------- 75 Schedule V -- Consolidated Property, Plant and Equipment -- Years Ended December 31, 1993, December 31, 1992 and September 30, 1991 and Three Months Ended December 31, 1991-------- 76 Schedule VI -- Consolidated Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment -- Years Ended December 31, 1993, December 31, 1992 and September 30, 1991 and Three Months Ended December 31, 1991-------- 77 Schedule VIII -- Consolidated Valuation and Qualifying Accounts and Reserves -- Years Ended December 31, 1993, December 31, 1992 and September 30, 1991 and Three Months Ended December 31, 1991-------- 78 All other schedules are omitted because of the absence of the conditions under which they are required or because the required information is included in the Consolidated Financial Statements or notes thereto. 3. EXHIBITS SCHEDULE II SCHEDULE V SCHEDULE VI SCHEDULE VIII SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.

6201_1993.txt

6201_1993

1993

6201

ITEM 1. BUSINESS AMR Corporation (AMR or the Company) was incorporated in October 1982. AMR's principal subsidiary, American Airlines, Inc. (American), was founded in 1934. With the expansion of, and increased strategic focus on, its information technology businesses, AMR formed The SABRE Technology Group -- later renamed The SABRE Group -- during 1993 to capitalize on the synergies of combining these businesses under common management. To highlight the Company's non-airline activities, this report, for the first time, presents their financial results separately from those of the airline. For financial reporting purposes, AMR's operations fall within three major lines of business: the Air Transportation Group, The SABRE Group and the AMR Management Services Group. AIR TRANSPORTATION GROUP The Air Transportation Group consists primarily of American's Passenger and Cargo divisions and AMR Eagle, Inc., a subsidiary of AMR. AMERICAN'S PASSENGER DIVISION is one of the largest scheduled passenger airlines in the world. At the end of 1993, American provided scheduled jet service to 106 cities in the U.S. mainland and Hawaii, 28 in Latin America, 14 in Europe and 24 other destinations worldwide, including service to six cities provided through cooperative agreements with other airlines. AMERICAN'S CARGO DIVISION provides a full range of freight and mail services to shippers throughout the airline's system. In addition, through cooperative agreements with other carriers, it has the ability to transport shipments to virtually any country in the world. AMR EAGLE, INC. owns the four regional airlines which operate as "American Eagle" -- Flagship Airlines, Inc., Simmons Airlines, Inc., Executive Airlines, Inc., and Wings West Airlines, Inc. The Eagles' turboprop service complements American's jet service with nearly 1,700 scheduled flights per day, transporting passengers and cargo to 170 cities in the continental U.S., the Bahamas and the Caribbean. THE SABRE GROUP The SABRE Group includes SABRE Travel Information Network (STIN), SABRE Computer Services (SCS) and SABRE Development Services (SDS), which are divisions of American, and AMR Information Services (AMRIS) and American Airlines Decision Technologies (AADT), which are subsidiaries of AMR. STIN provides travel reservation services through its computer reservation system, SABRE -- one of the largest privately owned, real-time computer systems in the world. SCS manages AMR's data processing centers, voice and data communications networks and local-area computer networks worldwide. SDS provides applications development, software solutions, consulting, and other technology services to other AMR units. AMRIS offers a full range of information management services, including complete systems development, network design and management, telemarketing, reservations services and systems, technical training and data management services. AADT specializes in providing decision support systems, software packages, systems development and consulting services to companies in the transportation and travel industries, as well as other industries worldwide. In 1994, SABRE Decision Technologies was formed with the combination of AADT, SDS and certain other business units within The SABRE Group. AMR MANAGEMENT SERVICES GROUP The AMR Management Services Group consists of five AMR subsidiaries -- AMR Services Corporation, AMR Leasing Corporation, Americas Ground Services, Inc. (AGS), AMR Investment Services, Inc. and AMR Training & Consulting Group, Inc. (AMRTCG). AMR SERVICES CORPORATION has three major operating divisions: Airline Services, AMR Combs and AMR Distribution Systems. The Airline Services Division performs airline ground and cargo handling, cabin service and an array of other air transportation-related services for numerous carriers around the world. AMR Combs provides comprehensive executive aviation services at 11 fixed-base operations. AMR Distribution Systems serves the logistics marketplace and specializes in contract warehousing, trucking and multi- modal freight forwarding services. AMR LEASING CORPORATION, a financing subsidiary, leases regional aircraft to subsidiaries of AMR Eagle. AGS was incorporated in 1993. It provides airline ground and cabin service handling in 13 locations in the Caribbean and Central and South America. AMR INVESTMENT SERVICES, INC. serves as an investment advisor to AMR and other institutional investors. It also manages the American AAdvantage Funds, which have both institutional shareholders, including pension funds and bank and trust companies, and individual shareholders. AMR Investment Services is responsible for management of approximately $12.2 billion in assets, including direct management of approximately $5.2 billion in short-term investments. AMRTCG was formed in 1992. It provides a full range of training and management consulting services for the aviation and transportation industries worldwide. Additional information regarding business segments is included in Management's Discussion and Analysis on pages 16 through 21 and in Note 13 to the consolidated financial statements. ROUTES AND COMPETITION AIR TRANSPORTATION Service over almost all of the Air Transportation Group's routes is highly competitive. Currently, any carrier deemed fit by the U.S. Department of Transportation (DOT) is free to operate scheduled passenger service between any two points within the U.S. and its possessions. On most of its routes, American competes with at least one, and usually more than one, major domestic airline including: America West Airlines, Continental Airlines, Delta Airlines, Northwest Airlines, Southwest Airlines, Trans World Airlines, United Airlines, and USAir. American also competes with national, regional, all-cargo, and charter carriers and, particularly on shorter segments, ground transportation. Most major air carriers have developed hub-and-spoke systems and schedule patterns in an effort to maximize revenue potential of their service. American currently operates six domestic hubs: Dallas/Fort Worth, Chicago O'Hare, Miami, Raleigh/Durham, Nashville, and San Juan, Puerto Rico. During 1993, American closed its hub operation at San Jose, California. United Airlines and Delta Airlines have large operations at American's Chicago and Dallas/Fort Worth hubs, respectively. The American Eagle carriers increase the number of markets the Air Transportation Group serves by providing connections to American at its hubs and certain other major airports. Simmons Airlines, Inc. serves Dallas/Fort Worth and Chicago. Flagship Airlines, Inc. serves Miami, Raleigh/Durham, Nashville, and New York John F. Kennedy International Airport. Executive Airlines, Inc. serves San Juan. Wings West Airlines, Inc. serves Los Angeles, Orange County and selected other airports in the western U.S. American's competitors also own or have marketing agreements with regional carriers which provide service at their major hubs. In addition to its extensive domestic service, American provides service to and from cities in various other countries, primarily across North, Central and South America and Europe. In 1991, American added service to 20 cities in 15 countries in Latin America with the acquisition of route authorities from Eastern Air Lines. In 1992, American added service from several U.S. gateway cities to London's Heathrow Airport with the acquisition of Trans World Airlines' route authorities. American's operating revenues from foreign operations were approximately $3.9 billion in 1993, $3.7 billion in 1992 and $2.7 billion in 1991. Additional information about the Company's foreign operations is included in Note 12 to the consolidated financial statements. Competition in international markets is generally subject to more extensive government regulation than domestic markets. In these markets, American competes with foreign-investor owned and national flag carriers and U.S. carriers that have been granted authority to provide scheduled passenger and cargo service between the U.S. and various overseas locations. American's operating authority in these markets is subject to aviation agreements between the U.S. and the respective countries, and in some cases, fares and schedules require the approval of the DOT and the relevant foreign governments. Because international air transportation is governed by bilateral or other agreements between the U.S. and the foreign country or countries involved, changes in U.S. or foreign government aviation policy could result in the alteration or termination of such agreements, diminish the value of such route authorities, or otherwise affect American's international operations. Bilateral relations between the U.S. and various foreign countries served by American are currently being renegotiated. On all of its routes, the Air Transportation Group's pricing decisions are affected by competition from other airlines, some of which have cost structures significantly lower than American's and can therefore operate profitably at lower fare levels. American and its principal competitors use inventory and yield management systems that permit them to vary the number of discount seats offered on each flight in an effort to maximize revenues. The Air Transportation Group believes that it has several advantages relative to its competition. Its fleet is young, efficient and quiet. It has a comprehensive domestic and international route structure, anchored by efficient hubs, which permit it to take full advantage of whatever traffic growth occurs. The Company believes American's AAdvantage frequent flyer program, which is the largest program in the industry, and its superior service also give it a competitive advantage. The major domestic carriers have some advantage over foreign competitors in their ability to generate traffic from their extensive domestic route systems. In many cases, however, U.S. carriers are limited in their rights to carry passengers beyond designated gateway cities in foreign countries. Some of American's foreign competitors are owned and subsidized by foreign governments. To improve their access to each others markets, various U.S. and foreign carriers have made substantial equity investments in, or established marketing relationships with, other carriers. COMPUTER RESERVATION SYSTEMS The complexity of the various schedules and fares offered by air carriers has fostered the development of electronic distribution systems. Travel agents and other subscribers access travel information and book airline, hotel and car rental reservations and issue airline tickets using these systems. American developed the SABRE computer reservation system (CRS), which is the one of the largest CRSs in the world. Competition among the CRS vendors is strong. Services similar to those offered through SABRE are offered by several air carriers and other companies in the U.S. and abroad, including: the Covia Partnership, owned by United Airlines, USAir and various foreign carriers; Worldspan, owned by Delta Airlines, Northwest Airlines, Trans World Airlines, and ABACUS Distribution Systems; and System One, owned by Continental Airlines. The SABRE CRS has several advantages relative to its competition. The Company believes that SABRE ranks first in market share among travel agents in the U.S. The SABRE CRS is furthering its expansion into international markets and continues to be in the forefront of technological innovation in the CRS industry. REGULATION GENERAL The Airline Deregulation Act of 1978 (Act) and various other statutes amending the Act, eliminated most domestic economic regulation of passenger and freight transportation. However, the DOT and the Federal Aviation Administration (FAA) still exercise certain regulatory authority over air carriers under the Federal Aviation Act of 1958, as amended. The DOT maintains jurisdiction over international route authorities and certain consumer protection matters, such as advertising, denied boarding compensation, baggage liability, and computer reservations systems. The DOT issued certain rules governing the CRS industry which became effective on December 7, 1992, and expire on December 31, 1997. The FAA regulates flying operations generally, including establishing personnel, aircraft and security standards. In addition, the FAA has implemented a number of requirements that the Air Transportation Group is incorporating into its maintenance program. These matters relate to, among other things, inspection and maintenance of aging aircraft, corrosion control, collision avoidance and windshear detection. Based on its current implementation schedule, the Air Transportation Group expects to be in compliance with the applicable requirements within the required time periods. The U.S. Department of Justice has jurisdiction over airline antitrust matters. The U.S. Postal Service has jurisdiction over certain aspects of the transportation of mail and related services. Labor relations in the air transportation industry are regulated under the Railway Labor Act, which vests in the National Mediation Board certain regulatory powers with respect to disputes between airlines and labor unions arising under collective bargaining agreements. FARES Airlines are permitted to establish their own domestic fares without governmental regulation, and the industry is characterized by substantial price competition. The DOT maintains authority over international fares, rates and charges. International fares and rates are also subject to the jurisdiction of the governments of the foreign countries which American serves. While air carriers are required to file and adhere to international fare and rate tariffs, many international markets are characterized by substantial commissions, overrides, and discounts to travel agents, brokers and wholesalers. Fare discounting by competitors has historically had a negative effect on American's financial results because American is generally required to match competitors' fares to maintain passenger traffic. During recent years, a number of new low-cost airlines have entered the domestic market and several major airlines have begun to implement efforts to lower their cost structures. Further fare reductions, domestic and international, may occur in the future. If fare reductions are not offset by increases in passenger traffic or changes in the mix of traffic that improves yields, the Air Transportation Group's operating results will be negatively impacted. AIRPORT ACCESS The FAA has designated four of the nation's airports -- Chicago O'Hare, New York Kennedy, New York LaGuardia, and Washington National - -- as "high density traffic airports" and has limited the number of take-offs and landings per hour, known as slots, during peak demand time periods at these airports. Currently, the FAA permits the purchasing, selling and trading of these slots by airlines and others, subject to certain restrictions. During 1993, the DOT issued final rules allowing air carriers to convert up to 50 percent of their commuter slots at Chicago O'Hare for use by jets with fewer than 110 seats. Certain foreign airports, including London Heathrow, a major European destination for American, also have slot allocations. The Air Transportation Group currently has sufficient slot authorizations to operate its existing flights and has generally been able to obtain slots to expand its operations and change its schedules. There is no assurance, however, that the Air Transportation Group will be able to obtain slots for these purposes in the future, because, among other factors, slot allocations are subject to changes in government policies. ENVIRONMENTAL MATTERS The Company is subject to various laws and government regulations concerning environmental matters and employee safety and health in the U.S. and other countries. U.S. federal laws that have a particular impact on the Company include the Airport Noise and Capacity Act of 1990 (ANCA), the Clean Air Act, and the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA or the Superfund). The Company is also subject to the oversight of Occupational Safety and Health Administration (OSHA) concerning employee safety and health matters. The U.S. Environmental Protection Agency (EPA), OSHA, and other federal agencies have been authorized to promulgate regulations that have an impact on the Company's operations. In addition to these federal activities, various states have been delegated certain authorities under the aforementioned federal statutes. Many state and local governments have adopted environmental and employee safety and health laws and regulations, some of which are similar to federal requirements. As a part of its continuing environmental program, the Company has maintained compliance with such requirements without any material adverse effect on its business. The ANCA requires the phase-out by December 31, 1999, of Stage II aircraft operations, subject to certain exceptions. Under final regulations issued by the FAA in 1991, air carriers are required to reduce, by modification or retirement, the number of Stage II aircraft in their fleets 25 percent by December 31, 1994; 50 percent by December 31, 1996; 75 percent by December 31, 1998, and 100 percent by December 31, 1999. Alternatively, a carrier may satisfy the regulations by operating a fleet that is at least 55 percent, 65 percent, 75 percent, and 100 percent Stage III by the dates set forth in the preceding sentence, respectively. The ANCA recognizes the rights of airport operators with noise problems to implement local noise abatement programs so long as they do not interfere unreasonably with interstate or foreign commerce or the national air transportation system. Authorities in several cities have promulgated aircraft noise reduction programs, including the imposition of night-time curfews. The ANCA generally requires FAA approval of local noise restrictions on Stage III aircraft first effective after October 1990, and establishes a regulatory notice and review process for local restrictions on Stage II aircraft first proposed after October 1990. At December 31, 1993, approximately 83 percent of American's fleet was Stage III. While American has had sufficient scheduling flexibility to accommodate local noise restrictions imposed to date, American's operations could be adversely affected if locally- imposed regulations become more restrictive or widespread. The Clean Air Act provides that state and local governments may not adopt or enforce aircraft emission standards unless those standards are identical to the federal standards. The engines on American's aircraft meet the EPA's turbine engine emissions standards. American has been identified by the EPA as a potentially responsible party (PRP) with respect to the following Superfund Sites: Operating Industries, Inc., California; Cannons, New Hampshire; Byron Barrel and Drum, New York; Palmer PSC, Massachusetts; Frontier Chemical, New York and Duffy Brothers, Massachusetts. American has settled the Operating Industries, Cannons and Byron Barrel and Drum matters, and all that remains to complete these matters are administrative tasks. With respect to the Palmer PSC, Frontier Chemical and Duffy Brothers sites, American is one of several PRPs named at each site. Although they are Superfund Sites, American's alleged waste disposal is minor compared to the other PRPs. AMR Combs Memphis, an AMR Services subsidiary, has been named a PRP at an EPA Superfund Site in West Memphis, Tennessee. AMR Combs Memphis' alleged involvement in the site is minor relative to the other PRPs. Flagship Airlines, Inc. an AMR Eagle subsidiary, has been notified of its potential liability under New York law at an Inactive Hazardous Waste site in Poughkeepsie, New York. AMR does not expect these matters, individually or collectively, to have a material impact on its financial condition, operating results or cash flows. LABOR The airline business is labor intensive. On December 31, 1993, AMR had approximately 118,900 employees, approximately 95,800 of whom were American's employees. Wages, salaries and benefits represented nearly 36 percent of AMR's consolidated operating expenses for the year ended December 31, 1993. To improve its competitive position, American has undertaken various steps to reduce its unit labor costs, including workforce reductions. The majority of American's employees are represented by labor unions and covered by collective bargaining agreements. American's relations with such labor organizations are governed by the Railway Labor Act. Under this act, the collective bargaining agreements among American and these organizations become amendable upon the expiration of their stated term. If either party wishes to modify the terms of any such agreement, it must notify the other party before the contract becomes amendable. After receipt of such notice, the parties must meet for direct negotiations, and if no agreement is reached, either party may request that a federal mediator be appointed. If no agreement is reached in mediation, the National Mediation Board may determine, at any time, that an impasse exists and may proffer arbitration. Either party may decline to submit to arbitration. If arbitration is rejected, a 30-day "cooling-off" period commences, following which the labor organization may strike and the airline may resort to "self-help," including the imposition of its proposed amendments and the hiring of replacement workers. American's collective bargaining agreement with the Association of Professional Flight Attendants became amendable on December 31, 1992. The National Mediation Board declared a cooling-off period in the negotiations in September 1993, following a long period of negotiation and mediation. After enduring a five-day strike by the union in November, American agreed to resolve the remaining issues through binding arbitration. American imposed certain contract amendments after the union declared the strike. The arbitration process is expected to be complex and will likely not be decided for several months. While the ultimate outcome is uncertain, the new contract will likely result in higher unit labor costs in 1994. American's collective bargaining agreements with the Allied Pilots Association and Flight Engineers International Association become amendable on August 31, 1994. American's collective bargaining agreement with the Transport Workers Union becomes amendable on March 1, 1995. A majority of the workforces at the four AMR Eagle carriers is represented by labor unions and covered by a number of different collective bargaining agreements. Certain of these agreements are currently in negotiation. In addition, a proceeding is pending before the National Mediation Board in which the issue is whether the four American Eagle carriers should be treated as a single carrier for labor relations purposes. If such a finding ultimately is made, each unionized employee classification would have all members of all four carriers represented for collective bargaining purposes as a single unit. A determination by the National Mediation Board is not likely before late 1994 or early 1995. The ultimate outcome of this proceeding and its effect, if any, on costs is uncertain. FUEL The Air Transportation Group's operations are significantly affected by the availability and price of jet fuel. American's fuel costs and consumption for the years 1989 through 1993 were: Percent of Based upon American's 1993 fuel consumption, a one-cent change in the average annual price-per-gallon of jet fuel caused a change of approximately $2.5 million in American's monthly fuel costs. AMR's fuel cost in 1993 decreased 1.7 percent over the prior year, primarily due to a 4.9 percent decrease in American's average price per gallon, offset by a 2.7 percent increase in gallons consumed by American. Changes in fuel prices have industry-wide impact and benefit or harm American's competitors as well as American. Accordingly, lower fuel prices may be offset by increased price competition and lower revenues for all air carriers. Fuel prices may increase in the future. There can be no assurance that American will be able to pass such cost increases on to its customers by increasing fares in the future. Most of American's fuel is purchased pursuant to contracts which, by their terms, may be terminated upon short notice. While American does not anticipate a significant reduction in fuel availability, dependency on foreign imports of crude oil and the possibility of changes in government policy on jet fuel production, transportation and marketing make it impossible to predict the future availability of jet fuel. If there were major reductions in the availability of jet fuel, American's business would be adversely affected. FREQUENT FLYER PROGRAM American established the AAdvantage frequent flyer program (AAdvantage) to develop passenger loyalty by offering awards to travelers for their continued patronage. AAdvantage members earn mileage credits for flights on American, American Eagle, or certain flights on participating airlines, or by utilizing services of other program participants, including hotels, car rental companies and bank credit card issuers. In addition, American periodically offers special short-term promotions which allow members to earn additional free travel awards or mileage credits. American reserves the right to change the AAdvantage program rules, regulations, travel awards and special offers at any time. American may initiate changes impacting, for example, participant affiliations, rules for earning mileage credit, mileage levels and awards, blackout dates and limited seating for travel awards, and the features of special offers. American reserves the right to end the AAdvantage program with six months notice. Mileage credits can be redeemed for free, discounted or upgraded travel on American, American Eagle or participating airlines, or for other travel industry awards. Once a member accrues sufficient mileage for an award, the member may request an award certificate from American. Award certificates may be redeemed up to one year after issuance. Most travel awards are subject to blackout dates and capacity control seating. All miles earned after July 1989 must be redeemed within three years or they expire. American accounts for its frequent flyer obligation on an accrual basis using the incremental cost method. American's frequent flyer liability is accrued each time a member accumulates sufficient mileage in his or her account to claim the lowest level of free travel award (20,000 miles) and such award is expected to be used for free travel on American. American includes fuel, food, and reservations/ticketing costs, but not a contribution to overhead or profit, in the calculation of incremental cost. The cost for fuel is estimated based on total fuel burn traced by day by various categories of markets, with an amount allocated to each passenger. Food costs are tracked monthly by market category, with an amount allocated to each passenger. Reservation/ticketing costs are based on the total number of passengers, including those traveling on free awards, divided into American's total expense for these costs. No accounting is performed for non-travel awards redeemed since the cost to American, if any, is de minimis. At December 31, 1993 and 1992, American estimated that approximately 3.9 million and 3.7 million free travel awards, respectively, were eligible for redemption. At December 31, 1993 and 1992, American estimated that approximately 3.6 million and 3.4 million free travel awards, respectively, were expected to be redeemed for free travel on American. In making this estimate, American has excluded mileage in inactive accounts, mileage related to accounts that have not yet reached the lowest level of free travel award, mileage that is not expected to ever be redeemed for free travel, and mileage related to accounts that have reached the lowest level of free travel award but are estimated based on historical data to be redeemed for discounts and upgrades, free travel on participating airlines other than American, or services other than free travel, for which American has no obligation to pay the provider of those services. The liability for the program mileage that has reached the lowest level of free travel award and is expected to be redeemed for free travel on American and deferred revenues for mileage sold to others participating in the program was $380 million and $285 million, representing 8.6 percent and 6.0 percent of AMR's total current liabilities, at December 31, 1993 and 1992, respectively. The number of free travel awards used for travel on American during the years ended December 31, 1993, 1992 and 1991, was approximately 2,163,000, 1,474,000, and 1,237,000, respectively, representing 9.5 percent, 6.0 percent and 5.3 percent of total revenue passenger miles for each period, respectively. American believes displacement of revenue passengers is insignificant given American's load factors, its ability to manage frequent flyer seat inventory, and the relatively low ratio of free award usage to revenue passenger miles. Effective February 1, 1995, the lowest level of free travel award will increase from 20,000 to 25,000 miles. OTHER MATTERS SEASONALITY AND OTHER FACTORS The Air Transportation Group's results of operations for any interim period are not necessarily indicative of those for the entire year, since the air transportation business is subject to seasonal fluctuations. Higher demand for air travel has traditionally resulted in more favorable operating results for the second and third quarters of the year than for the first and fourth quarters. The results of operations in the air transportation business have also significantly fluctuated in the past in response to general economic conditions. In addition, fare initiatives, fluctuations in fuel prices, labor strikes and other factors could impact this seasonal pattern. Unaudited quarterly financial data for the two-year period ended December 31, 1993, is included in Note 14 to the consolidated financial statements. No material part of the business of AMR and its subsidiaries is dependent upon a single customer or very few customers. Consequently, the loss of the Company's largest few customers would not have a materially adverse effect upon AMR. INSURANCE American carries insurance for public liability, passenger liability, property damage and all-risk coverage for damage to its aircraft, in amounts which, in the opinion of management, are adequate. OTHER GOVERNMENT MATTERS In time of war or during an unlimited national emergency or civil defense emergency, American and other major air carriers may be required to provide airlift services to the Military Airlift Command under the Civil Reserve Air Fleet program. ITEM 2. ITEM 2. PROPERTIES FLIGHT EQUIPMENT Owned and leased aircraft operated by AMR's subsidiaries at December 31, 1993, included: For information concerning the estimated useful lives and residual values for owned aircraft, lease terms and amortization relating to aircraft under capital leases, and acquisitions of aircraft, see Notes 1, 3 and 4 to the consolidated financial statements. See Management's Discussion and Analysis for discussion of the retirement of certain widebody aircraft from the fleet. Lease expirations for leased aircraft operated by AMR's subsidiaries and included in the above table as of December 31, 1993, were: The table excludes leases for 15 Boeing 767-300 Extended Range aircraft which can be canceled with 30 days' notice during the first 10 years of the lease term. At the end of that term in 1998, the leases can be renewed for periods ranging from 10 to 12 years. The table also excludes leases for 12 Saab 340A aircraft and ten Saab 340B aircraft which can be canceled with 30 days' notice. In addition, the table excludes one Boeing 737-200 and four Boeing 737-300 aircraft which have been subleased and one McDonnell Douglas DC-10-30 aircraft which has been grounded. Substantially all of the Air Transportation Group's aircraft leases include an option to purchase the aircraft or to extend the lease term, or both, with the purchase price or renewal rental to be based essentially on the market value of the aircraft at the end of the term of the lease or at a predetermined fixed rate. GROUND PROPERTIES American leases, or has built as leasehold improvements on leased property, most of its airport and terminal facilities; certain corporate office, maintenance and training facilities in Fort Worth, Texas; its principal overhaul and maintenance base and computer facility at Tulsa International Airport, Tulsa, Oklahoma; its regional reservation offices; and local ticket and administration offices throughout the system. American has entered into agreements with the Tulsa Municipal Airport Trust; the Alliance Airport Authority, Fort Worth, Texas; and the Dallas/Fort Worth, Chicago O'Hare, Raleigh/Durham, Nashville, San Juan, New York, and Los Angeles airport authorities to provide funds for, among other things, additional facilities and equipment, and improvements and modifications to existing facilities, which equipment and facilities are or will be leased to American. American also utilizes public airports for its flight operations under lease arrangements with the municipalities or governmental agencies owning or controlling them and leases certain other ground equipment for use at its facilities. For information concerning the estimated lives and residual values for owned ground properties, lease terms and amortization relating to ground properties under capital leases, and acquisitions of ground properties, see Notes 1, 3 and 4 to the consolidated financial statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In December 1992, the U.S. Department of Justice filed an antitrust lawsuit in the U.S. District Court for the District of Columbia under Section 1 of the Sherman Act against several airlines, including the Company, alleging price fixing based upon the industry's exchange of fare information through the Airline Tariff Publishing Company. In March 1994, the Company and the remaining defendants in the case agreed to settle the lawsuit without admitting liability by entering into a stipulated final judgment that prohibits or restricts certain pricing practices including the announcement of fare increases before their effective date. The proposed final judgment is subject to approval by the Court following a public notice and comment period prescribed by statute. The Company does not anticipate a material financial impact from the settlement or compliance with the stipulated judgment. Private class action claims with similar allegations were settled by the Company and other airlines which became final in March 1993. Prior to the private class action settlement becoming final, the Company and several other airlines voluntarily altered certain pricing practices at issue in the lawsuits to avoid exposure to additional claims. American has been sued in two class action cases that have been consolidated in the Circuit Court of Cook County, Illinois, in connection with certain changes made to American's AAdvantage frequent flyer program in May, 1988. (Wolens, et al v. American Airlines, Inc., No. 88 CH 7554, and Tucker v. American Airlines, Inc., No. 89 CH 199.) In both cases, the plaintiffs seek to represent all persons who joined the AAdvantage program before May 1988. The complaints allege that, on that date, American implemented changes that limited the number of seats available to participants traveling on certain awards and established holiday blackout dates during which no AAdvantage seats would be available for certain awards. The plaintiffs allege that these changes breached American's contracts with AAdvantage members and were in violation of the Illinois Consumer Fraud and Deceptive Business Practices Act (Consumer Fraud Act). Plaintiffs seek money damages of an unspecified sum, punitive damages, costs, attorneys fees and an injunction preventing the Company from making any future changes that would reduce the value of AAdvantage benefits. American moved to dismiss both complaints, asserting that the claims are preempted by the Federal Aviation Act and barred by the Commerce Clause of the U.S. Constitution. The trial court denied American's preemption motions, but certified its decision for interlocutory appeal. In December 1990, the Illinois Appellate Court held that plaintiffs' claims for an injunction are preempted by the Federal Aviation Act, but that plaintiffs' claims for money damages could proceed. On March 12, 1992, the Illinois Supreme Court affirmed the decision of the Appellate Court. American sought a writ of certiorari from the U.S. Supreme Court; and on October 5, 1992, that Court vacated the decision of the Illinois Supreme Court and remanded the cases for reconsideration in light of the U.S. Supreme Court's decision in Morales v. TWA, et al, which interpreted the preemption provisions of the Federal Aviation Act very broadly. On December 16, 1993, the Illinois Supreme Court rendered its decision on remand, holding that plaintiffs' claims seeking an injunction were preempted, but that identical claims for compensatory and punitive damages were not preempted. On February 8, 1994, American filed petition for a writ of certiorari in the U.S. Supreme Court. The Illinois Supreme Court granted American's motion to stay the state court proceeding pending disposition of American's petition in the U.S. Supreme Court. The Company and American are vigorously defending all of the above claims. 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. EXECUTIVE OFFICERS OF THE REGISTRANT Robert L. Crandall Mr. Crandall became Chairman and Chief Executive Officer of AMR and American in March 1985. He has been President of American since 1980 and of AMR since its formation in 1982. Age 58. Robert W. Baker Mr. Baker was elected Executive Vice President in September 1989. He was elected Senior Vice President in July 1987. He served as Senior Vice President - Operations of American since November 1985. From April 1985 to October 1985, he served as Senior Vice President - Information Systems of American. From 1982 to March 1985, he served as Vice President - Marketing Automation Systems of American. Age 49. Donald J. Carty Mr. Carty was elected Executive Vice President and Chief Financial Officer of AMR in October 1989. He served as Senior Vice President and Chief Financial Officer of AMR and Senior Vice President - Finance and Planning of American since January 1988. He served as Senior Vice President - Planning of American since April 1987. From March 1985 until March 1987, he was President of Canadian Pacific Air. He served as Senior Vice President and Controller of both AMR and American since March 1983. Age 47. Gerard J. Arpey Mr. Arpey was elected Senior Vice President in April 1992. He served as Vice President - Financial Planning and Analysis of American since October 1989. He served as Managing Director - Financial Planning from September 1988 to September 1989. From March 1988 to September 1988 he served as Managing Director - Financial Analysis. He served as Managing Director - Airline Profitability from July 1987 to March 1988. Age 35. Michael J. Durham Mr. Durham was elected Senior Vice President and Treasurer of AMR in October 1989 as well as Senior Vice President - Finance and Chief Financial Officer of American. He served as Vice President and Treasurer of American from March 1989 to September 1989, Vice President - Corporate Planning and Finance of American from 1987 to 1989, and Vice President - Financial Analysis and Corporate Development of American from 1985 through 1987. Age 43. Michael W. Gunn Mr. Gunn was elected Senior Vice President of AMR in May 1991 and Senior Vice President - Marketing for American Airlines in November 1986. From October 1985 to November 1986 he was Senior Vice President - Passenger Marketing for American. From July 1982 to October 1985, he was Vice President - Passenger Sales and Advertising. Age 48. Max D. Hopper Mr. Hopper was elected Senior Vice President of AMR in May 1986 and Chairman of The SABRE Group in April 1993. He was elected Senior Vice President - Information Systems of American in November 1985. From September 1982 until November 1985, he was an Executive Vice President of Bank of America. Age 59. Anne H. McNamara Mrs. McNamara was elected Senior Vice President and General Counsel in June 1988. She served as Vice President - Personnel since January 1988, and as Corporate Secretary since 1979 for American and held the same position with AMR since its inception in 1982. Age 46. Charles D. MarLett Mr. MarLett was elected Corporate Secretary in January 1988. He served as an attorney with American beginning in June 1984 and, prior to that, was associated with the law firm of Drinker, Biddle & Reath, Philadelphia, Pennsylvania, from 1982 to 1984. Age 39. Kathleen M. Misunas Mrs. Misunas was elected Senior Vice President of AMR and American and President and Chief Executive Officer of The SABRE Group in April 1993. She served as President of SABRE Travel Information Network and Vice President of American since July 1988. Age 43. There is no family relationship (blood, marriage or adoption, not more remote than first cousin) between any of the officers named above. There have been no events under any bankruptcy act, no criminal proceedings, and no judgments or injunctions material to the evaluation of the ability and integrity of any director or executive officer during the past five years. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the New York Stock Exchange (symbol AMR). The approximate number of recordholders of the Company's common stock at March 1, 1994, was 17,800. The market range of AMR's common stock on the New York Stock Exchange was: No cash dividends were declared for any period during 1993 or 1992. Payment of dividends is subject to the restrictions described in Note 5 to the consolidated financial statements. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA (in millions, except per share amounts) No dividends were declared on common shares during any of the periods above. Effective January 1, 1992, AMR adopted Statements of Financial Accounting Standards No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," and No. 109, "Accounting for Income Taxes." Information on the comparability of quarterly results is included in Management's Discussion and Analysis and the 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 SUMMARY AMR's net loss in 1993 was $110 million, or $2.23 per common share (primary and fully diluted). The 1993 results reflect the negative impact of a five-day strike by the union representing American's flight attendants in November. The results also include a $125 million charge ($79 million after tax) for the retirement of certain DC-10 aircraft, a positive $115 million adjustment to revenues ($67 million net of related commission expense and taxes) for a change in estimate related to certain earned passenger revenues, and a $71 million provision ($46 million after tax) for losses associated with a reservations system project and resolution of related litigation. In 1992, AMR recorded a net loss of $935 million, or $12.49 per common share (primary and fully diluted). The loss for 1992, before the effect of the adoption of two new mandatory accounting standards, was $475 million. The Company's 1992 results were also affected by a $165 million provision ($109 million after tax) related to the suspension of the reservations system project. The Company's 1993 operating income was $690 million, compared to an operating loss of $25 million in 1992. In the first quarter of 1993, the Company created and began implementing a new strategic framework, known as the Transition Plan. The Plan has three parts, each intended to improve the Company's results. First, make the core airline business bigger and stronger where economically justified. Second, and conversely, shrink the airline where it cannot compete profitably. Third, reallocate resources and effort to the growing information and management services businesses which are more profitable than the airline. Major events relating to the Transition Plan in 1993 included: -- The SABRE Technology Group -- later renamed The SABRE Group -- was formed during the second quarter of 1993. -- American announced its decision to retire 42 widebody DC-10 jets to reduce the airline's capacity and lower operating expenses. -- American shifted domestic capacity to its major hubs in Dallas/Fort Worth and Miami. With the acquisition of certain assets from Metroflight, Inc., Simmons Airlines, Inc. opened and rapidly expanded a major hub at Dallas/Fort Worth. The Eagles also added or increased service in certain other markets as American reduced or withdrew jet service. -- American significantly reduced, and Wings West Airlines, Inc. eliminated, service at San Jose, California. -- To provide increased value to business customers, American expanded its successful three-class transcontinental service to new markets, added more frequent flights on business routes such as Dallas/Fort Worth - Chicago, and added more first class seats on some narrowbody aircraft. - -- American increased capacity in Latin America by 17.5 percent over 1992. American's 1993 results benefited from strengthened domestic revenues in comparison to 1992. American's 1992 domestic revenues suffered from competitive fare reductions below the levels American established in its Value Pricing Plan in April 1992. European revenues, however, were negatively impacted in 1993 by aggressive fare discounting by competitors, weak European economies and a stronger U.S. dollar. The Company's 1993 results also reflect the dramatic adverse impact of a five-day strike by American's flight attendants' union in November. The strike's after-tax impact on fourth quarter results, estimated at $190 million, offset earnings generated earlier in the year. With the downsizing of unprofitable operations, American's workforce began to decline following years of double-digit percentage increases. In 1993, AMR provided $25 million for employee severance, primarily management/specialist and operations employees. To reduce interest expense, the Company repurchased and retired prior to maturity $802 million in carrying value of long- term debt. The repurchases and retirements resulted in an extraordinary loss of $21 million ($14 million after tax) in 1993. BUSINESS SEGMENTS The following sections provide a discussion of AMR's results by reporting segment. A description of the businesses in each reporting segment is included on pages 1 and 2. Additional segment information is included in Note 13 to the consolidated financial statements. AIR TRANSPORTATION GROUP FINANCIAL HIGHLIGHTS (dollars in millions) REVENUES 1993 COMPARED TO 1992 Air Transportation Group revenues of $14.8 billion in 1993 were up $1.3 billion, 9.7 percent, versus 1992. American's passenger revenues rose 8.4 percent, $1.0 billion, primarily as a result of an 8.8 percent increase in passenger yield (the average amount one passenger pays to fly one mile), offset by a 0.3 percent decline in passenger traffic. American's passenger yield in 1993 increased to 13.28 cents, primarily as a result of a very weak comparison base of 1992, when revenues were negatively impacted by competitors' drastic discounting of domestic fares. For the year, domestic yield increased 13.5 percent. International yield was mixed, increasing 13.9 percent in the Pacific, unchanged in Latin America and declining 10.1 percent in Europe. In 1993, American derived 73.8 percent of its passenger revenues from domestic operations and 26.2 percent from international operations. Although American's system capacity, as measured by available seat miles (ASMs), increased 5.2 percent, its traffic, as measured by revenue passenger miles (RPMs), decreased 0.3 percent. The drastic fare discounting drove traffic up to record levels in 1992. Traffic suffered in 1993 from American's inability to carry passengers during the flight attendants' union strike in November and the adverse effect of the strike on passenger demand during the month of December. American's domestic traffic decreased 3.5 percent, to 69.7 billion RPMs, while domestic capacity grew 2.9 percent. International traffic grew 9.1 percent, to 27.5 billion RPMs on capacity growth of 12.1 percent. The increase in international traffic was led by a 14.7 percent increase in Latin America on capacity growth of 17.5 percent, and a 7.4 percent increase in Europe on capacity growth of 10.8 percent. Passenger revenues of the AMR Eagle carriers increased 43.6 percent, $216 million, primarily due to the opening and expansion of regional operations at Dallas/Fort Worth with assets acquired from Metroflight, Inc. Traffic on the AMR Eagle carriers increased 47.6 percent, to 2.1 billion RPMs, while capacity grew 41.6 percent to 3.8 billion ASMs. Passenger yield decreased 2.7 percent. Cargo revenues increased 10.7 percent, $62 million, driven by a 22.5 percent increase in American's domestic and international cargo volumes, partially offset by decreasing yields brought about by strong price competition resulting from excess industry capacity. Other revenues, consisting of service fees, liquor revenues, duty-free sales, tour marketing and miscellaneous other revenues, increased 5.6 percent, $28 million, primarily as a result of increased capacity. 1992 COMPARED TO 1991 Air Transportation Group revenues of $13.5 billion in 1992 were up 12.2 percent, $1.5 billion, from 1991. American's passenger revenues rose 11.0 percent, $1.2 billion, primarily as a result of an 18.3 percent increase in American's passenger traffic, offset by a 6.1 percent decline in American's passenger yield. The increase in RPMs was due to capacity growth of 14.6 percent and greater demand for air travel, generated in part by the various fare promotions during 1992. American's domestic traffic increased 13.3 percent, to 72.2 billion RPMs. International traffic grew 35.4 percent, to 25.2 billion RPMs. American's passenger yield in 1992 declined to 12.21 cents. Domestic yield experienced a sharp decline of 8.3 percent due to various fare promotions during 1992. International yield was mixed, increasing 2.1 percent in Latin America and 14.1 percent in the Pacific, but declining 6.6 percent in Europe. In 1992, American derived 73.1 percent of its passenger revenues from domestic operations and 26.9 percent from international operations. Passenger revenues of the AMR Eagle carriers increased 17.6 percent, $74 million. Traffic on those carriers increased 33.2 percent, to 1.4 billion RPMs, while capacity grew 28.5 percent, to 2.7 billion ASMs. Passenger yield decreased 11.7 percent due principally to various fare promotions in 1992. Cargo revenues increased 22.3 percent, $106 million, driven by a 30.0 percent increase in American's domestic and international cargo volume. Other revenues, consisting of service fees, liquor revenues, duty-free sales, tour marketing and miscellaneous other revenues, increased 26.4 percent, $105 million. The increase resulted from $22 million in revenues from the introduction of service fees on ticket changes and increased traffic. EXPENSES 1993 COMPARED TO 1992 Air Transportation Group operating expenses increased 4.5 percent, $627 million. American's capacity increased 5.2 percent, to 160.9 billion ASMs, due primarily to the addition of new aircraft. American's Passenger Division cost per ASM decreased by 2.0 percent, to 8.25 cents. Wages, salaries and benefits rose 5.3 percent, $245 million, due to wage and salary adjustments for existing employees, rising health-care costs and a 1.7 percent increase in the average number of equivalent employees. In addition, during the fourth quarter, the Air Transportation Group recorded a $13 million severance provision in conjunction with layoffs and voluntary terminations of management/specialist and operations personnel. Aircraft fuel expense decreased 1.7 percent, $33 million, due to a 4.9 percent decrease in American's average price per gallon, partially offset by a 2.7 percent increase in gallons consumed by American. American's average price per gallon decreased from $0.65 per gallon in 1992 to $0.62 per gallon in 1993. American consumed an average of 245 million gallons of fuel each month. A one-cent decline in fuel prices saves approximately $2.5 million per month. Commissions to agents increased 11.3 percent, $147 million, due principally to increased passenger revenues and increased incentives for travel agents. Depreciation and amortization increased 19.9 percent, $167 million, primarily due to the addition of 44 owned jet aircraft, 24 owned turboprop aircraft and other capital equipment. Other operating expenses, consisting of aircraft rentals, other rentals and landing fees, food service costs, maintenance expenses, and miscellaneous operating expenses, increased 2.0 percent, $101 million. Aircraft rentals increased 8.8 percent, $65 million, primarily due to the full-year impact of 1992 operating-leased aircraft additions and the addition of operating-leased aircraft during 1993. Other rentals and landing fees increased 4.4 percent, $33 million, due primarily to increased rentals resulting from additions, improvements and renovations to facilities owned by airport authorities and leased to American. Food service cost increased 0.6 percent, $4 million, reflecting the 9.1 percent increase in international traffic, where food costs are greater, offset by the 3.5 percent decrease in domestic traffic. Maintenance materials and repairs expense decreased 3.5 percent, $24 million, due principally to the retirement of older aircraft and increased operational efficiencies. Miscellaneous operating expenses (including crew travel expenses, booking fees, purchased services, communications charges, credit card fees and advertising) increased 1.0 percent, $23 million, primarily due to the increase in capacity. 1992 COMPARED TO 1991 Air Transportation Group operating expenses increased 12.5 percent, $1.5 billion. American's capacity increased 14.6 percent, to 153.0 billion ASMs, due primarily to the addition of new aircraft. American's Passenger Division cost per ASM decreased 1.8 percent, to 8.42 cents. Wages, salaries and benefits rose 17.1 percent, $672 million, due in part to wage and salary increases, as well as to a 4.4 percent increase in the average number of equivalent employees. In addition, during 1992, the Air Transportation Group recorded a $22 million severance provision in conjunction with layoffs and voluntary terminations of airline management/specialist personnel. Aircraft fuel expense increased 4.8 percent, $87 million, primarily due to a 13.3 percent increase in gallons consumed by American, partially offset by a 7.7 percent decrease in American's average price per gallon. American's average price per gallon decreased from $0.70 per gallon in 1991 to $0.65 per gallon in 1992. Commissions to agents increased 13.3 percent, $153 million, due principally to increased passenger revenues and increased incentives for travel agents. The 1992 commissions expense also reflects the fact that American protected agent commissions for domestic tickets that were sold at higher, pre-summer sale levels and reissued at special 50-percent-off fares. Depreciation and amortization increased 20.1 percent, $140 million, due to additions to the fleet and the acquisition of other capital equipment. Other operating expenses, consisting of aircraft rentals, other rentals and landing fees, food service costs, maintenance expenses and miscellaneous operating expenses, increased 10.3 percent, $482 million. Aircraft rentals increased 10.9 percent, $72 million, due to the full-year impact of 1991 operating-leased aircraft additions and the addition of operating-leased aircraft during 1992. Other rentals and landing fees increased 38.9 percent, $211 million, due primarily to increased rentals resulting from additions, improvements and renovations to facilities owned by airport authorities and leased to American. Landing fees increased, reflecting the Company's additional capacity and rate increases charged by airports. Food service cost increased 11.4 percent, $71 million, due primarily to the increased number of passengers. Maintenance materials and repairs expense increased 2.3 percent, $15 million, due to the increase in the fleet, offset by operating efficiencies and retirement of several inefficient fleet types. Miscellaneous operating expenses (including crew travel expenses, bookings fees, purchased services, communications charges, credit card fees and advertising) increased 5.2 percent, $113 million, primarily due to the increase in capacity and traffic. OTHER INCOME (EXPENSE) Other Income (Expense) consists of interest income and expense, interest capitalized and miscellaneous - net. 1993 COMPARED TO 1992 Interest expense, net of interest income, increased 10.1 percent, $53 million, as a result of additional external financings, offset in part by interest savings generated from declining interest rates, interest rate swap transactions and repurchases and retirement of long-term debt. In addition, interest capitalized decreased 48.0 percent, $47 million, as a result of the decrease in the average balance during the year of purchase deposits for flight equipment and the decline in interest rates. Miscellaneous - net for 1993 includes a $125 million charge related to the retirement of 31 DC-10 aircraft. Included in Miscellaneous - net for 1992 is a $14 million provision for a cash payment representing American's share of a multi-carrier antitrust settlement and an $11 million charge associated with the retirement of the CASA aircraft fleet of Executive Airlines, Inc., one of the AMR Eagle carriers. 1992 COMPARED TO 1991 Interest expense, net of interest income, increased 41.2 percent, $153 million, primarily as a result of additional external financings. In addition, interest capitalized decreased 35.9 percent, $55 million, due to the decrease in the average balance during the year of purchase deposits for flight equipment and the decline in interest rates. Miscellaneous - net for 1992 includes a $14 million provision for a cash payment representing American's share of a multi- carrier antitrust settlement and an $11 million charge associated with the retirement of Executive Airlines, Inc.'s CASA aircraft fleet. Included in Miscellaneous - net for 1991 are charges of $77 million related to the retirement of American's British Aerospace BAe 146, and Boeing 737 and 747SP aircraft and the Fairchild Metro III aircraft of certain AMR Eagle carriers. THE SABRE GROUP FINANCIAL HIGHLIGHTS (dollars in millions) REVENUES 1993 COMPARED TO 1992 Revenues for The SABRE Group increased 7.8 percent, $99 million, primarily due to increased booking fees resulting from growth in booking volumes and average fees collected from participating vendors. 1992 COMPARED TO 1991 Revenues for The SABRE Group increased 8.2 percent, $96 million, primarily due to increased booking fees resulting from higher average fees and growth in booking volumes driven by fare initiatives and special promotions and the expansion of STIN in international markets. EXPENSES 1993 COMPARED TO 1992 Wages, salaries and benefits increased 12.4 percent, $48 million, due to wage and salary increases, a 3.8 percent increase in the average number of equivalent employees and a $12 million severance provision for workforce reductions associated with the formation of SABRE Decision Technologies. Other operating expenses increased 9.7 percent, $39 million, due to higher incentive payments to travel agents, outsourcing services related to product line expansion and costs associated with international expansion. 1992 COMPARED TO 1991 Wages, salaries and benefits increased 15.2 percent, $51 million, due to wage and salary increases and an 11.8 percent increase in the average number of equivalent employees. Depreciation and amortization increased 7.6 percent, $12 million, due to the addition of capital equipment. OTHER INCOME (EXPENSE) Other Income (Expense) for 1993 includes a $71 million provision for losses associated with a reservations system project and resolution of related litigation. Other Income (Expense) for 1992 includes a $165 million provision related to the suspension of the reservations system project. AMR MANAGEMENT SERVICES GROUP FINANCIAL HIGHLIGHTS (dollars in millions) REVENUES 1993 COMPARED TO 1992 Revenues for the AMR Management Services Group increased 34.5 percent, $116 million. AMR Services' revenues increased 15.2 percent, $37 million, primarily as a result of strong domestic fuel and deicing sales, expansion of European operations, and the acquisition of an additional domestic fixed-base operator in November. AMR Leasing's revenues increased 73.2 percent, $59 million, with additional turboprop aircraft under rental to subsidiaries of AMR Eagle. In addition, Americas Ground Services ended 1993, its first year, with over $10 million in revenues. 1992 COMPARED TO 1991 Revenues for the AMR Management Services Group increased 12.4 percent, $37 million. AMR Leasing's revenues increased 62.0 percent, $31 million, due to additional turboprop aircraft under rental to subsidiaries of AMR Eagle. EXPENSES 1993 COMPARED TO 1992 Wages, salaries and benefits increased 23.9 percent, $21 million, due primarily to a 37.5 percent increase in the average number of equivalent employees. Aircraft rentals increased 86.4 percent, $38 million, and depreciation and amortization increased 30.3 percent, $10 million, with additional operating-leased and owned aircraft in AMR Leasing's turboprop fleet. Other operating expenses increased 19.7 percent, $28 million, due primarily to the expansion of AMR Services and Americas Ground Services' first year of operations. 1992 COMPARED TO 1991 Wages, salaries and benefits increased 4.8 percent, $4 million, due primarily to a 1.4 percent increase in the average number of equivalent employees. Aircraft rentals increased 57.1 percent, $16 million, and depreciation and amortization increased 22.2 percent, $6 million, due to additional operating-leased and owned aircraft in AMR Leasing's turboprop fleet. INFLATION Adjustment of historical cost data to reflect the impact of general inflation and specific price changes would lower AMR's operating results, principally because of the increased depreciation and amortization resulting from the replacement, at current cost, of equipment and property with assets that have the same service potential. However, because AMR's monetary liabilities exceed monetary assets, the reduced operating results would be partially offset by the gain from the decline in purchasing power of the net amounts owed. LIQUIDITY AND CAPITAL RESOURCES Operating activities provided net cash of $1.4 billion in 1993, $843 million in 1992 and $744 million in 1991. Capital expenditures in 1993 totaled $2.1 billion, compared to $3.3 billion in 1992 and $3.5 billion in 1991. In 1993, The Company took delivery of 44 owned jet aircraft - one Airbus A300-600R, six Boeing 757-200s, six Boeing 767-300ERs, 23 Fokker 100s and eight McDonnell Douglas MD-11s. The Company also took delivery of 24 turboprop aircraft - one ATR-42, six Super ATRs and 17 Saab 340Bs. CAPITAL COMMITMENTS FIRM DELIVERIES At December 31, 1993, AMR had 58 aircraft on order, aggregating approximately $1.5 billion, for delivery through 1996. The Company had firm orders for 16 Boeing 757-200s, seven Boeing 767-300ERs, 13 Fokker 100s, 19 Super ATRs and three Saab 340Bs. In 1994, the Company will take delivery of 22 jet aircraft -- six Boeing 757-200s, three Boeing 767-300ERs, 13 Fokker 100s and 17 turboprop aircraft -- 14 Super ATRs and three Saab 340Bs. Total expenditures for 1994 for aircraft acquisitions and related equipment will be approximately $800 million. OTHER The Company also has planned capital expenditures in 1994 of approximately $900 million for aircraft modifications, renovations of, and additions to, airport and office facilities and various other equipment and assets. In addition, AMR and PWA Corporation, the parent company of Canadian Airlines International Ltd. (CAIL), have entered into a series of agreements which provide for a 20-year services contract under which AMR will furnish a comprehensive package of airline services to CAIL. In addition, AMR will make an investment of approximately $246 million (Canadian) in mandatorily redeemable convertible preferred stock of CAIL. The agreements are subject to significant conditions including approval by the U.S. and Canadian governments, conditions relating to CAIL's capital restructuring program and various conditions related to labor matters. AMR intends to finance its capital asset acquisitions through the use of internally generated funds as well as external financing. At December 31, 1993, no borrowings were outstanding and approximately $1.8 billion was available under American's credit facilities, including American's $1.0 billion credit facility expiring in 1994. American expects to replace the $1.0 billion credit facility with a $750 million credit agreement. At February 15, 1994, borrowings of $400 million were outstanding under the credit facilities. AMR continually reviews its need for additional aircraft and ground properties and determines its requirements based on return-on-investment analyses and both short-term and long-term profitability forecasts. AMR has several ways to adjust its plans, including terminating certain operating leases, scaling back or canceling planned facility expansions and delaying other planned expenditures. AIRCRAFT OPTIONS In addition to aircraft on firm order at December 31, 1993, American has 119 jet aircraft available on option - 21 Boeing 757-200s, eight Boeing 767-300ERs, 15 McDonnell Douglas MD-11s and 75 Fokker 100s. The Company also has 160 turboprop aircraft available on option - 20 Saab 340Bs, 40 Saab 2000s, 20 British Aerospace Jetstream 41s, 10 ATR-42s and 70 Super ATRs. OTHER INFORMATION WORKING CAPITAL AMR (principally American Airlines) historically operates with a working capital deficit as do most other airline companies. The existence of such a deficit has not in the past impaired the Company's ability to meet its obligations as they become due and is not expected to do so in the future. DEFERRED TAX ASSETS As of December 31, 1993, the Company had deferred tax assets aggregating approximately $2.3 billion, including approximately $267 million of alternative minimum tax (AMT) credit carryforwards. The Company believes substantially all the deferred tax assets, other than the AMT credit carryforwards, will be realized through reversal of existing taxable temporary differences. The Company anticipates using its AMT credit carryforwards, which are available for an indefinite period of time, against its future regular tax liability within the next 10 years for several reasons. Although the Company incurred net losses in 1990 through 1993, it recorded substantial income before taxes and taxable income during the seven-year period 1983 through 1989 of approximately $3.4 billion and $2.0 billion, respectively. The Company is aggressively pursuing revenue enhancement and cost reduction initiatives to restore profitability. The Company has also substantially curtailed its planned capital spending program, which will accelerate the reversal of depreciation differences between financial and tax income, thus increasing taxable income. ENVIRONMENTAL MATTERS Subsidiaries of AMR have been notified of potential liability with regard to several environmental cleanup sites. At sites where remedial litigation has commenced, potential liability is joint and several. AMR's alleged volumetric contributions at the sites are minimal. AMR does not expect these actions, individually or collectively, to have a material impact on its financial condition, operating results or cash flows. DISCOUNT RATE Due to the decline in interest rates during 1993, the discount rate used to determine the Company's pension obligations as of December 31, 1993 and the related expense for 1994, has been reduced. The impact on 1994 pension expense of the change in the discount rate will be substantially offset by the significant appreciation in the market value of pension plan assets experienced during 1993. PROPOSED SETTLEMENT OF LITIGATION During 1992, American and certain other carriers agreed to settle various class action claims, subject to approval by the U.S. District Court for the Northern District of Georgia. Under the terms of the agreement, the carriers paid a total of approximately $50 million in cash and will jointly issue and distribute approximately $408 million in face amount of certificates for discounts of approximately 10 percent on future air travel on any of the carriers. A liability has not been established for the certificate portion of the settlement since American expects that, in the aggregate, future revenues received upon redemption of the certificates will exceed the related cost of providing the air travel. American anticipates that the share of the certificates redeemed on American may represent, but is not limited to, American's 26 percent market share among the carriers. The ultimate impact of the settlement on American's revenues, operating margins and earnings is not reasonably estimable since both the portion of certificates to be redeemed on American and the stimulative or depressive effect of the certificate redemption on revenues is not known. OUTLOOK FOR 1994 During 1993, AMR completed a comprehensive review of the competitive realities of its businesses and determined that the Company must change significantly to generate sufficient earnings. The fundamental problems of the airline -- increasing competition from low-cost, low-fare carriers, its inability to reduce labor costs to competitive levels, and the changing values of its customers -- demand new solutions. As an initial response to that need, the Company created and began implementing a new strategic framework known as the Transition Plan. The plan has three parts, each intended to improve the Company's results. First, make the core airline business bigger and stronger where economically justified. Second, and conversely, shrink the airline where it cannot compete profitably. Third, reallocate resources and effort to the growing information and management services businesses, which are more profitable than the airline. The Transition Plan recognizes the unfavorable and uncertain economics which have characterized the core airline business in recent years, acknowledges the airline cost problem and seeks to maximize the contribution of the Company's more profitable businesses. In 1994, the Company will continue the course of change initiated in 1993 under the Transition Plan. Over the long term, the Company will continue its best efforts to reduce airline costs and to restore the airline operations to profitability. Based upon the success or failure of those efforts, the Company will make ongoing determinations as to the appropriate degree of reallocation of resources from the airline operations to the Company's other businesses, which may include, if the airline cannot be run profitably, the disposition or termination, over the long term, of a substantial part or all of the airline operations. AIR TRANSPORTATION GROUP During 1993, American closed its hub and dramatically reduced operations at San Jose, California, and expanded its Dallas/Fort Worth and Miami hubs. The airline will continue to reduce or eliminate service where it cannot operate profitably. American's regional airline affiliates, subsidiaries of AMR Eagle, have added turboprop service on some routes where jet service has been canceled, and they will continue to pursue these opportunities in 1994. In 1993, American removed 21 McDonnell Douglas DC-10 and 28 Boeing 727 aircraft from service. In 1994, an additional 14 DC- 10s and 31 727s will be retired. As a result, in 1994 American's available seat miles are expected to decrease by almost five percent. Domestic capacity will drop by almost seven percent, while international capacity will increase slightly. The capacity reduction will be the first at American since 1981. Aircraft retirements have necessitated the furlough of about 3,700 American employees since late 1992. The Company anticipates further workforce reductions in 1994 and, accordingly, made a provision for the cost of these reductions in 1993. Fewer aircraft deliveries will also translate into lower capital spending. American's revenue plan for 1994 reflects continued emphasis on producing premium yields by attracting more full fare passengers than its competitors. As part of this plan, American will expand its successful three-class domestic transcontinental service, add more first class seats on some narrowbody aircraft and increase frequencies in business-oriented markets. In addition, American will seek to grow its cargo revenues again in 1994. In 1993, American's cost per available seat mile declined by 2.0 percent, largely due to a 4.9 percent drop in the cost of jet fuel. In 1994, though American will continue its rigorous program of cost control, it expects units costs, excluding fuel, to rise modestly. This increase will be driven by higher unit labor costs due to pay scale and average seniority escalations. On August 10, 1993, the Omnibus Budget Reconciliation Act was signed into law, imposing a new 4.3 cents per gallon tax on commercial aviation jet fuel for use in domestic operations. The new tax will become effective October 1, 1995, and is scheduled to continue until October 1, 1998. American estimates the resulting annual increase in fuel taxes will be approximately $90 million. The Company instituted a program in the latter half of 1993 to reduce interest costs. At year-end interest rates, the Company anticipates that this program, which involves such things as interest rate swaps and the repurchase and retirement of long-term debt, will produce significant interest cost savings. This savings is expected to largely offset the additional interest cost of new financings in 1994. In November 1993, American endured a five-day strike by its flight attendants' union; the strike ended when both sides agreed to binding arbitration. The arbitration process is expected to be complex and will likely not be decided for several months. While the ultimate outcome is uncertain, the new contract will likely result in higher unit labor costs in 1994. American's labor contract with its pilots' union becomes amendable in August 1994. The Company and the union leadership are pursuing opportunities to streamline the negotiation and settlement process. The ultimate outcome of these negotiations cannot be estimated at this time. THE SABRE GROUP The integration of AMR's information services businesses will continue in 1994 with the integration of SDS, AADT and other units in The SABRE Group into SABRE Decision Technologies (SDT). SDT will develop and market The SABRE Group's expanding array of information systems products and services to a growing list of customers throughout the world. STIN will seek to sustain its revenue growth through continued geographical expansion of the SABRE computerized reservation system and the sale of its leading-edge automated reservations products such as SABRExpress, SABRExpress Ticketing and SABRE TravelBase, a new travel agency accounting system. Other SABRE Group units, providing telemarketing and reservations services, data capture and management services and information systems training, will continue to pursue opportunities to market these services, both domestically and internationally. AMR MANAGEMENT SERVICES GROUP AMR Management Services' growth in 1994 will be driven primarily by revenue increases at AMR Services Corporation and AMR Leasing. AMR Services' performance in 1994 will benefit from the full-year operation of AMR Combs' Dallas aviation service center acquired in late 1993 and the continued growth and development of AMR Services' international operations, the majority of which were begun or acquired in 1993. AMR Leasing's revenues will increase in 1994 due to the acquisition of additional turboprop aircraft to be leased to subsidiaries of AMR Eagle. AMR Leasing is also exploring opportunities to lease aircraft to external customers. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders AMR Corporation We have audited the accompanying consolidated balance sheets of AMR Corporation 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 Item 14(a) on page 55. 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 AMR Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 7 and 10 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. ERNST & YOUNG 2121 San Jacinto Dallas, Texas 75201 February 15, 1994 AMR CORPORATION CONSOLIDATED STATEMENT OF OPERATIONS (in millions, except per share amounts) Continued on next page. AMR CORPORATION CONSOLIDATED STATEMENT OF OPERATIONS (CONTINUED) The accompanying notes are an integral part of these financial statements. AMR CORPORATION CONSOLIDATED BALANCE SHEET (in millions) The accompanying notes are an integral part of these financial statements. AMR CORPORATION CONSOLIDATED BALANCE SHEET (in millions, except shares and par value) The accompanying notes are an integral part of these financial statements. AMR CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS (in millions) The accompanying notes are an integral part of these financial statements. AMR CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (in millions, except shares and per share amounts) The accompanying notes are an integral part of these financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF ACCOUNTING POLICIES BASIS OF CONSOLIDATION The consolidated financial statements include the accounts of AMR Corporation (AMR or the Company) and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated. Certain amounts from prior years have been reclassified to conform with the 1993 presentation. INVENTORIES Spare parts, materials and supplies relating to flight equipment are carried at average cost and are expensed when used in operations. Allowances for obsolescence are provided, over the estimated useful life of the related aircraft and engines, for spare parts expected to be on hand at the date aircraft are retired from service. EQUIPMENT AND PROPERTY The provision for depreciation of operating equipment and property is computed on the straight-line method applied to each unit of property, except that spare assemblies are depreciated on a group basis. The depreciable lives and residual values used for the principal depreciable asset classifications are: * In connection with a review of its fleet plan, American changed, effective October 1, 1991, the estimated useful lives of its Boeing 727-200 aircraft and engines from a common retirement date of December 31, 1994, to projected retirement dates by aircraft, which results in an average depreciable life of approximately 21 years. ** During 1993, American announced its intention to retire a total of 36 McDonnell Douglas DC-10-10 and six McDonnell Douglas DC-10-30 aircraft. At December 31, 1993, 21 of those aircraft had been grounded. *** Approximate common retirement date. Equipment and property under capital leases are amortized over the term of the leases and such amortization is included in depreciation and amortization. Lease terms vary but are generally 10 to 25 years for aircraft and 7 to 40 years for other leased equipment and property. MAINTENANCE AND REPAIR COSTS Maintenance and repair costs for owned and leased flight equipment are charged to operating expense as incurred, except engine overhaul costs incurred by AMR's regional carriers, which are accrued on the basis of hours flown. 1. SUMMARY OF ACCOUNTING POLICIES (CONTINUED) INTANGIBLE ASSETS The Company continually evaluates intangible assets to determine whether current events and circumstances warrant adjustment of the carrying values or amortization periods. Route acquisition costs and airport operating and gate lease rights represent the purchase price attributable to route authorities, airport take-off and landing slots and airport gate leasehold rights acquired and are being amortized on a straight-line basis over 10 to 40 years. PASSENGER REVENUES Passenger ticket sales are initially recorded as a current liability. Revenue derived from the sale is recognized at the time transportation is provided. FREQUENT FLYER PROGRAM The estimated incremental cost of providing free travel awards is accrued when such award levels are reached. Revenues received for miles sold to others participating in the program are deferred and recognized over a period approximating the time transportation is provided. INCOME TAXES AMR and its eligible subsidiaries file a consolidated federal income tax return. Deferred income taxes reflect the net tax effects of temporary differences between the financial reporting carrying amounts of assets and liabilities and the income tax amounts. DEFERRED GAINS Gains on the sale and leaseback of equipment and property are deferred and amortized over the terms of the related leases as a reduction of rent expense. FOREIGN EXCHANGE CONTRACTS AMR enters into foreign exchange contracts as a hedge against certain amounts payable or receivable in foreign currencies. Market value gains or losses are recognized and offset against foreign exchange gains or losses on those obligations or receivables. FUEL SWAP CONTRACTS American enters into swap contracts to hedge against market price fluctuations of jet fuel. Gains or losses on these contracts are included in fuel expense when the underlying fuel being hedged is used. STATEMENT OF CASH FLOWS Short-term investments, without regard to remaining maturity at acquisition, are not considered as cash equivalents for purposes of the statement of cash flows. LOSS PER COMMON SHARE Loss per share computations are based upon the loss applicable to common shares and the average number of shares of common stock outstanding and dilutive common stock equivalents (stock options, warrants and deferred stock) outstanding. The convertible preferred stock is not a common stock equivalent. The number of shares used in the computations of primary and fully diluted loss per common share for the years ended December 31, 1993, 1992 and 1991, was 76.0 million, 74.9 million and 67.8 million, respectively. 2. SHORT-TERM INVESTMENTS Short-term investments consisted of (in millions): The fair value of short-term investments at December 31, 1993, by contractual maturity was (in millions): All short-term investments were classified as available-for-sale and stated at fair value. 3. COMMITMENTS AND CONTINGENCIES The Company has on order 36 jet aircraft - 16 Boeing 757-200s, seven Boeing 767-300ERs and 13 Fokker 100s scheduled for delivery through 1996, and 22 turboprop aircraft - 19 Super ATRs and three Saab 340Bs scheduled for delivery through 1995. Deposits of $350 million have been made toward the purchase of these aircraft. Future payments, including estimated amounts for price escalation through anticipated delivery dates for these aircraft and related equipment, will be approximately $800 million in 1994, $500 million in 1995 and $150 million in 1996, a portion of which is payable in foreign currencies. In addition to these commitments for aircraft, the Company has authorized expenditures of approximately $1.2 billion for aircraft modifications, renovations of, and additions to, airport and office facilities and various other equipment and assets. AMR expects to spend approximately $800 million of this amount in 1994. AMR and PWA Corporation, the parent company of Canadian Airlines International Ltd. (CAIL), have entered into a series of agreements which provide for a 20-year services contract under which AMR will furnish a comprehensive package of airline services to CAIL. In addition, AMR will make an investment of approximately $246 million (Canadian) in mandatorily redeemable convertible preferred stock of CAIL. The agreements are subject to significant conditions, including approval by the U.S. and Canadian governments, conditions relating to CAIL's capital restructuring program, and various conditions relating to labor matters. AMR and American have included an event risk covenant in approximately $397 million of debentures and approximately $2.9 billion of lease agreements. The covenant permits the holders of such instruments to receive a higher rate of return (between 50 and 700 basis points above the stated rate) if a designated event, as defined, should occur and the credit rating of the debentures or the debt obligations underlying the lease agreements is downgraded below certain levels. In July 1991, American entered into a five-year agreement whereby American transfers, on a continuing basis and with recourse to the receivables, an undivided interest in a designated pool of receivables. Undivided interests in new receivables are transferred daily as collections reduce previously transferred receivables. At December 31, 1993 and 1992, Receivables are presented net of approximately $300 million of such transferred receivables. American maintains an allowance for uncollectible receivables based upon expected collectibility of all receivables, including the receivables transferred. 3. COMMITMENTS AND CONTINGENCIES (CONTINUED) Special facility revenue bonds have been issued by certain municipalities, primarily to purchase equipment and improve airport facilities which are leased by American. In certain cases, the bond issue proceeds were loaned to American and are included in Long-Term Debt. Certain bonds have rates that are periodically reset and are remarketed by various agents. In certain circumstances, American may be required to purchase up to $413 million of the special facility revenue bonds prior to maturity, in which case American has the right to resell the bonds or to use the bonds to offset its lease or debt obligations. American may borrow the purchase price of these bonds under standby letter-of-credit agreements. At American's option, these letters of credit are secured by funds held by bond trustees and by approximately $448 million of short-term investments. 4. LEASES AMR's subsidiaries lease various types of equipment and property, including aircraft, passenger terminals, equipment and various other facilities. The future minimum lease payments required under capital leases, together with the present value of net minimum lease payments, and future minimum lease payments required under operating leases that have initial or remaining non- cancelable lease terms in excess of one year as of December 31, 1993, were (in millions): * Future minimum payments required under capital leases and operating leases include $384 million and $6.0 billion, respectively, guaranteed by AMR relating to special facility revenue bonds issued by municipalities. ** The present value of future minimum lease payments includes $132 million guaranteed by American. At December 31, 1993, the Company had 235 jet aircraft and 144 turboprop aircraft under operating leases and 80 jet aircraft and 63 turboprop aircraft under capital leases. The aircraft leases can generally be renewed at rates based on fair market value at the end of the lease term for one to five years. Most aircraft leases have purchase options at or near the end of the lease term at fair market value, but generally not to exceed a stated percentage of the defined lessor's cost of the aircraft. Of the aircraft American has under operating leases, 15 Boeing 767-300ERs are cancelable upon 30 days' notice during the initial 10-year lease term. At the end of that term in 1998, the leases can be renewed for periods ranging from 10 to 12 years. In 1993, American agreed to forfeit its right to cancel leases for 25 Airbus A300-600R aircraft upon 30 days' notice and extended the terms of the leases for periods ranging from 18 to 19 years. Rent expense, excluding landing fees, was $1.3 billion for 1993 and 1992 and $1.0 billion for 1991. 5. INDEBTEDNESS Short-term borrowings at December 31, 1992, consisted of commercial paper. Long-term debt (excluding amounts maturing within one year) consisted of (in millions): Maturities of long-term debt (including sinking fund requirements) for the next five years are: 1994 - $200 million; 1995 - $566 million; 1996 - $226 million; 1997 - $412 million; 1998 - $433 million. Certain debt is secured by aircraft, engines, equipment and other assets having a net book value of approximately $1.5 billion. During 1993, AMR repurchased and retired prior to maturity the zero coupon subordinated convertible notes due 2006 and certain other long-term debt with a total carrying value of $802 million. The repurchases and retirements resulted in an extraordinary loss of $21 million ($14 million after tax). Additional borrowings and cash from operations provided the funding for the repurchases and retirements. American has a $500 million short-term credit facility agreement which expires in 1995 and a $1.0 billion credit facility expiring in 1994. American expects to replace the $1.0 billion credit facility with a $750 million credit agreement. American also has $335 million available under a multiple option facility which expires in 1995. Interest on these agreements is calculated at floating rates based upon the London Interbank Offered Rate (LIBOR). At December 31, 1993, no borrowings were outstanding and approximately $1.8 billion was available under these facilities. As of February 15, 1994, borrowings of $400 million were outstanding under the credit facilities. American's debt and credit facility agreements contain certain restrictive covenants, including a cash flow coverage test, a minimum net worth requirement and limitations on indebtedness and the declaration of dividends on shares of its capital stock. Certain of these restrictions could affect AMR's ability to pay dividends. At December 31, 1993, under the most restrictive provisions of those agreements, approximately $1.3 billion of American's retained earnings were available for payment of cash dividends to AMR. Certain of AMR's debt agreements contain restrictive covenants, including a limitation on the declaration of dividends on shares of capital stock. At December 31, 1993, under the terms of such agreements, all of AMR's retained earnings were available for payment of dividends. 6. FINANCIAL INSTRUMENTS The fair values of the Company's long-term debt were estimated using quoted market prices, where available. For long-term debt not actively traded, fair values were estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The fair values of the Company's long-term debt, including current maturities, at December 31, 1993, were (in millions): During 1993, American entered into interest-rate swap agreements with a number of major financial institutions. Under these swap agreements, American receives fixed-rate payments (4.25% to 6.44%) in exchange for floating-rate payments (3.25% to 4.00% at December 31, 1993) on a total notional principal amount of $1.4 billion. The swap agreements expire over three to 15 years. American is exposed to credit risk in the event of default by the counterparties; however, American does not anticipate such default. Under agreements with certain counterparties, American or the counterparty may be required to post collateral based on certain credit limits and ratings. As of December 31, 1993, no collateral was required under these agreements. The fair value of the Company's interest-rate swap agreements is estimated based on the market prices for similar agreements. The net fair value of the Company's interest rate swap agreements at December 31, 1993, representing the estimated net amount the Company would have to pay to terminate the agreements, was $6 million. To hedge against the risk of future currency exchange rate fluctuations on certain debt and lease obligations and related interest payable in foreign currencies, AMR has entered into various foreign currency exchange agreements. Changes in the value of the agreements due to exchange rate fluctuations are offset by changes in the value of the foreign currency denominated debt and lease obligations translated at the current rate. In the event of default by the counterparties, AMR is exposed to risk for periodic settlements due under the agreements; however, AMR does not anticipate such default. The fair value of the Company's foreign currency exchange agreements is estimated based on quoted market prices of comparable agreements. The net fair values of the Company's foreign currency exchange agreements at December 31, 1993, representing the estimated net amount that AMR would receive to terminate the agreements, were as follows: 6. FINANCIAL INSTRUMENTS (CONTINUED) American has sold options enabling two major banks to put Dutch guilders to American at a fixed rate of guilders per U.S. dollar at periodic intervals through 1994. At December 31, 1993, approximately 680 million guilders remain subject to the put options. The market risk associated with the put options is offset by American's ability, under a purchase agreement, to pay for certain equipment in U.S. dollars or, at American's option, in Dutch guilders, at the same exchange rate as the put options. At dates where American does not have a liability under the equipment purchase agreement due to changes in delivery schedules, American has purchased options to put approximately 50 million guilders to a major bank at the same rate of exchange. American's credit risk is limited to failure of the manufacturer to perform under the purchase agreement or the failure of the bank to perform under the purchased put option agreement; however, American does not anticipate non-performance. The proceeds from the sales of the put options, net of the cost of the put options purchased, were deferred and are being offset against the cost of the equipment acquired under the purchase agreement. The net fair value of these guilder put options was de minimis at December 31, 1993. 7. INCOME TAXES The significant components of the income tax benefit were (in millions): The income tax benefit includes federal income tax benefit of $30 million, $219 million and $105 million for the years ended December 31, 1993, 1992, and 1991, respectively. Effective January 1, 1992, AMR adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," (FAS 109), changing its method of accounting for income taxes. As permitted under the new rules, prior years' financial statements have not been restated to reflect the change in accounting method. The cumulative effect of adopting FAS 109 decreased the net loss for the year ended December 31, 1992, by $135 million, or $1.81 per share. In addition, a deferred tax benefit of $322 million was recognized in the year ended December 31, 1992, upon adoption of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," (FAS 106). The income tax benefit differed from amounts computed at the statutory federal income tax rate as follows (in millions): 7. INCOME TAXES (CONTINUED) The components of AMR's deferred tax assets and liabilities were (in millions): At December 31, 1993, AMR had available for federal income tax purposes approximately $267 million of alternative minimum tax credit carryforwards available for an indefinite period, and approximately $1.8 billion of net operating loss carryforwards for regular tax purposes, with $970 million expiring in 2007 and $877 million expiring in 2008. The sources of deferred income taxes and the tax effect of each for the year ended December 31, 1991, before AMR adopted FAS 109, were (in millions): 8. PREFERRED STOCK AND COMMON STOCK RIGHTS In 1993, AMR issued 22 million depositary shares, each representing 1/10th of a share of 6% Series A cumulative convertible preferred stock, resulting in net proceeds of approximately $1.1 billion. At the holder's option, each preferred share is convertible into 6.3492 shares of common stock at any time. At the Company's option after February 1, 1996, the preferred shares are redeemable at specified redemption prices. Each outstanding share of common stock has one preferred stock purchase right which entitles stockholders to purchase 1/100th of a share of an authorized series of preferred stock. Generally, the rights will not be exercisable until a party either acquires beneficial ownership of 10% of AMR's common stock or makes a tender offer for at least 30% of its common stock. The rights, which expire in 1996, do not have voting rights and may be redeemed by AMR at $0.05 per right at any time prior to the time that 10% or more of AMR's shares have been accumulated by a single acquirer or group. If AMR is acquired in a merger or business combination, each right has an exercise price of $200 and can be used to purchase the common stock of the surviving company having a market value of twice the exercise price of each right. As a result, the Board has reserved 1,000,000 shares of preferred stock for possible conversion of these rights. 9. STOCK AWARDS AND OPTIONS Under the 1988 Long Term Incentive Plan (1988 Plan), officers and key employees of AMR and its subsidiaries may be granted stock options, stock appreciation rights, restricted stock, deferred stock, stock purchase rights and/or other stock-based awards. The total number of common shares reserved for distribution under the 1988 Plan is 4,500,000 shares plus, 7.65% of any increase (other than any increase due to awards under this plan or other plans) in the number of authorized and issued shares of common stock outstanding at December 31, 1987. The 1988 Plan will terminate no later than May 18, 1998. Options granted are exercisable at the market value of the stock upon grant, generally becoming exercisable in equal annual installments over one to five years following the date of grant and expiring 10 years from the date of grant. Stock appreciation rights may be granted in tandem with options awarded. At December 31, 1993, 462,500 stock appreciation rights were outstanding. Stock option activity was: * At prices ranging from $39.6875 to $65.75 in 1993, $27.6875 to $68.25 in 1992 and $12.00 to $58.25 in 1991. ** Includes 21,000, 20,000 and 18,500 options canceled upon exercise of stock appreciation rights for 1993, 1992 and 1991, respectively. The aggregate purchase price of outstanding options, number of exercisable options outstanding and stock awards available for grant were: Shares of deferred stock are awarded at no cost to officers and key employees under the 1988 Plan and will be issued upon the individual's retirement from AMR or, in certain circumstances, will vest on a pro rata basis. Deferred stock activity was: AMR has a restricted stock incentive plan, under which officers and key employees may be awarded, through 1995, shares of its common stock at no cost. In connection with the plan, 250,000 shares have been authorized for issuance; and at December 31, 1993, all authorized shares had been granted. Vesting of the shares occurs generally over a five-year period. 9. STOCK AWARDS AND OPTIONS (CONTINUED) A new performance share plan was implemented in 1993 under which shares of deferred stock are awarded at no cost to officers and key employees under the 1988 Plan. The shares vest over a three-year performance period based upon AMR's ratio of operating cash flow to net assets. During 1993, 246,650 performance shares were granted; none were issued or canceled. At December 31, 1993, 19,064,488 shares of AMR's common stock were reserved for the issuance of stock upon the conversion of convertible preferred stock, the exercise of options and the issuance of restricted stock and deferred stock. 10. RETIREMENT BENEFITS Substantially all employees of American and employees of certain other subsidiaries are eligible to participate in pension plans. The defined benefit plans provide benefits for participating employees based on years of service and average compensation for a specified period of time before retirement. Airline pilots and flight engineers also participate in defined contribution plans for which company contributions are determined as a percentage of participant compensation. Costs for all pension plans were approximately $288 million, $247 million and $187 million in 1993, 1992 and 1991, respectively. Net periodic pension cost of the defined benefit plans was (in millions): The funded status and actuarial present value of benefit obligations of the defined benefit plans were (in millions): * AMR's funding policy is to make contributions equal to, or in excess of, the minimum funding requirements of the Employee Retirement Income Security Act of 1974. 10. RETIREMENT BENEFITS (CONTINUED) Plan assets consist primarily of government and corporate debt securities, marketable equity securities, and money market and mutual fund shares, of which approximately $99 million and $86 million of plan assets at December 31, 1993 and 1992, respectively, were invested in shares of mutual funds managed by a subsidiary of AMR. The projected benefit obligation was calculated using weighted average discount rates of 7.50%, 9.00% and 9.25% at December 31, 1993, 1992 and 1991, respectively; rates of increase for compensation of 4.40% at December 31, 1993, and 4.90% in December 31, 1992 and 1991; and the 1983 Group Annuity Mortality Table. The weighted average expected long-term rate of return on assets was 10.50% in 1993 and 11.25% in 1992 and 1991. The vested benefit obligation and plan assets at fair value at December 31, 1993, for plans whose benefits are guaranteed by the Pension Benefit Guaranty Corporation are $3.1 billion and $3.5 billion, respectively. Pension costs for defined contribution plans were approximately $118 million, $108 million and $90 million in 1993, 1992 and 1991, respectively. In addition to pension benefits, other postretirement benefits, including certain health care and life insurance benefits, are also provided to retired employees. The amount of health care benefits is limited to lifetime maximums as outlined in the plan. Substantially all employees of American and employees of certain other subsidiaries may become eligible for these benefits if they satisfy eligibility requirements during their working lives. Effective January 1, 1990, AMR's non-union employees that are covered by the health care and life insurance plan, as well as employees who are represented by the Transport Workers Union, began making contributions toward funding a portion of their retiree health care benefits during their working lives. AMR funds benefits as incurred and began, effective January 1993, to match employee prefunding. Effective January 1, 1992, AMR adopted FAS 106, changing the method of accounting for these benefits. Prior to 1992, other postretirement benefit expense was recognized by expensing health care claims incurred and annual life insurance premiums. Such expense was $31 million in 1991 and has not been restated. The cumulative effect of adopting FAS 106 as of January 1, 1992, was a charge of $917 million ($595 million after tax, or $7.95 per share). This change also increased other postretirement benefit expense by approximately $90 million ($58 million after tax, or $0.77 per share) for the year ended December 31, 1992. Net other postretirement benefit cost was (in millions): 10. RETIREMENT BENEFITS (CONTINUED) The funded status of the plan, reconciled to the accrued other postretirement benefit cost recognized in AMR's balance sheet, was (in millions): Plan assets consist primarily of shares of a mutual fund managed by a subsidiary of AMR. For 1993, future benefit costs were estimated assuming per capita cost of covered medical benefits would increase at an 11% annual rate, decreasing gradually to a 4% annual growth rate in 2000 and thereafter. A 1% increase in this annual trend rate would have increased the accumulated other postretirement benefit obligation at December 31, 1993, by approximately $118 million and 1993 other postretirement benefit cost by approximately $17 million. In 1992, future benefit costs were estimated assuming per capita cost of covered medical benefits would increase at a 12% annual rate, decreasing gradually to a 5% annual growth rate in 1999 and thereafter. The weighted average discount rate used in estimating the accumulated other postretirement benefit obligation was 7.50% and 9.00% at December 31, 1993 and 1992, respectively. 11. REVENUE AND OTHER EXPENSE ITEMS Revenues for the second quarter of 1993 include a $115 million positive adjustment resulting from a change in estimate relating to certain earned passenger revenues. Miscellaneous - net in 1993 and 1992 includes provisions of $71 million and $165 million, respectively, for losses associated with a reservations system project and resolution of related litigation. Also included in 1993 is a $125 million charge related to the retirement of 31 McDonnell Douglas DC-10 aircraft. The charge represents the Company's best estimate of the expected loss based upon the anticipated method of disposition. However, should the ultimate method of disposition differ, the actual loss could be different than the amount estimated. Also included in Miscellaneous - net for 1992 are charges aggregating $25 million for a cash payment representing American's share of a multi-carrier antitrust settlement and the retirement of the CASA aircraft fleet of Executive Airlines, Inc., one of the AMR Eagle carriers. Miscellaneous - net for 1991 includes a provision of $42 million for the anticipated cost of lease terminations and aircraft dispositions relating to the retirement of American's Boeing 737 and British Aerospace BAe 146 aircraft fleets. Also included in 1991 are provisions aggregating $35 million for the retirement of American's Boeing 747SP aircraft and the Fairchild Metro III aircraft of certain of the AMR Eagle carriers. 12. FOREIGN OPERATIONS American conducts operations in various foreign countries. American's operating revenues from foreign operations were (in millions): 13. OTHER FINANCIAL INFORMATION AMR's operations fall within three industry segments: the Air Transportation Group, The SABRE Group, and the AMR Management Services Group. For a description of each of these groups, refer to Business on pages 1 and 2. Revenues of the industry segments for each of the three years in the period ended December 31, 1993, are included in the Consolidated Statement of Operations. Intergroup revenues were (in millions): Operating income (loss), depreciation and amortization and capital expenditures for each of the industry segments for each of the three years in the period ended December 31, 1993, are included in Management's Discussion and Analysis on pages 16, 20 and 21. Identifiable assets of the industry segments were (in millions): Identifiable assets are gross assets used by a business segment, including an allocated portion of assets used jointly by more than one business segment. General corporate and other consists primarily of income tax assets. The adoption of FAS 106 reduced the 1992 operating income of the Air Transportation Group and The SABRE Group by $85 million and $5 million, respectively. The impact on the AMR Management Services Group was de minimis. 13. OTHER FINANCIAL INFORMATION (CONTINUED) Supplemental disclosures of cash flow information and non-cash activities (in millions): 14. QUARTERLY FINANCIAL DATA (UNAUDITED) Unaudited summarized financial data by quarter for 1993 and 1992 (in millions, except per share amounts): * Results for the first quarter of 1992 have been restated for the cumulative effect of the adoption of FAS 106 and FAS 109, which resulted in a net charge of $460 million after tax. Results for the first three quarters of 1992 have also been restated by the ratable portion of the $90 million current year effect of the accounting change for FAS 106, net of tax benefit. 14. QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED) Results for the second quarter of 1993 include a $125 million charge related to the retirement of 31 McDonnell Douglas DC-10 aircraft. Results for the fourth quarter of 1993 reflect the adverse impact of a five-day strike by American's flight attendants' union and include a $71 million charge for losses associated with a reservations system project and resolution of related litigation and a $25 million charge for the cost of severance of certain employees. Results for the second quarter of 1992 include a $165 million provision for losses related to the suspension of the reservations system project and a $14 million provision for a cash payment representing American's share of a multi-carrier antitrust settlement. Results for the fourth quarter of 1992 include a $22 million charge for the cost of severance of certain employees and an $11 million charge associated with the retirement of the CASA aircraft fleet of Executive Airlines, Inc. ITEM 9. ITEM 9. 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 18, 1994. Information concerning the executive officers is included in Part I of this report on pages 12 and 13. 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 18, 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 18, 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 18, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) The financial statements listed in the accompanying index to financial statements and schedules are filed as part of this report. (2) The schedules listed in the accompanying index to financial statements and schedules are filed as part of this report. (3) Exhibits required to be filed by Item 601 of Regulation S-K. (Where the amount of securities authorized to be issued under any of AMR's long-term debt agreements does not exceed ten percent of AMR's assets, pursuant to paragraph (b)(4) of Item 601 of Regulation S-K, in lieu of filing such as an exhibit, AMR hereby agrees to furnish to the Commission upon request a copy of any agreement with respect to such long-term debt.) EXHIBIT 3(a) Composite of the Certificate of Incorporation of AMR, incorporated by reference to Exhibit 3(a) to AMR's report on Form 10-K for the year ended December 31, 1982, file number 1-8400. 3(b) Amended Bylaws of AMR, incorporated by reference to Exhibit 3(b) to AMR's report on Form 10-K for the year ended December 31, 1990, file number 1-8400. 10(a) Purchase Agreement, dated as of February 12, 1979, between American and the Boeing Company, relating to the purchase of Boeing Model 767-323 aircraft, incorporated by reference to Exhibit 10(b)(3) to American's Registration Statement No. 2-76709. 10(b) Description of American's Split Dollar Insurance Program, dated December 28, 1977, incorporated by reference to Exhibit 10(c)(1) to American's Registration Statement No. 2-76709. 10(c) American's 1992 Incentive Compensation Plan. 10(d) 1979 American Airlines (AMR) Stock Option Plan, as amended, incorporated by reference to Exhibit 10(d) to American's report on Form 10-K for the year ended December 31, 1982, file number 1-8400. 10(e) 1979 American Airlines (AMR) Stock Option Plan, as amended, incorporated by reference to Exhibit 10(e) to American's report on Form 10-K for the year ended December 31, 1982, file number 1-8400. 10(f) Form of Stock Option Agreement for Corporate Officers under the 1979 American Airlines (AMR) Stock Option Plan, incorporated by reference to Exhibit 10(c)(5) to American's Registration Statement No. 2-76709. 10(g) Form of Stock Option Agreement under the 1974 and 1979 American Airlines (AMR) Stock Option Plans, incorporated by reference to Exhibit 10(c)(6) to American's Registration Statement No. 2-76709. 10(h) Deferred Compensation Agreement, dated April 14, 1973, as amended March 1, 1975, between American and Robert L. Crandall, incorporated by reference to Exhibit 10(c)(7) to American's Registration Statement No. 2-76709. 10(i) Deferred Compensation Agreement, dated October 18, 1972, as amended March 1, 1975, between American and Gene E. Overbeck, incorporated by reference to Exhibit 10(c)(9) to American's Registration Statement No. 2-76709. 10(j) Deferred Compensation Agreement, dated June 3, 1970, between American and Francis H. Burr, incorporated by reference to Exhibit 11(d) to American's Registration Statement No. 2-39380. 10(k) Description of informal arrangement relating to deferral of payment of directors' fees, incorporated by reference to Exhibit 10(c)(11) to American's Registration Statement No. 2-76709. 10(l) Purchase Agreement, dated as of February 29, 1984, between American and the McDonnell Douglas Corporation, relative to the purchase of McDonnell Douglas Super 80 aircraft, incorporated by reference to Exhibit 10(l) to AMR's report on Form 10-K for the year ended December 31, 1983, file number 1-8400. 10(m) Purchase Agreement, dated as of June 27, 1983, between American and the McDonnell Douglas Corporation, relative to the purchase of McDonnell Douglas Super 80 aircraft, incorporated by reference to Exhibit 4(a)(8) to American's Registration Statement No. 2-84905. 10(n) AMR Corporation Restricted Stock Incentive Plan, adopted May 15, 1985, incorporated by reference to Exhibit 10(n) to AMR's report on Form 10-K for the year ended December 31, 1985, file number 1-8400. 10(o) AMR Corporation Preferred Stock Purchase Rights Agreement, adopted February 13, 1986, incorporated by reference to Exhibit 10(o) to AMR's report on Form 10-K for the year ended December 31, 1985, file number 1-8400. 10(p) Form of Executive's Termination Benefits Agreement incorporated by reference to Exhibit 10(p) to AMR's report on Form 10-K for the year ended December 31, 1985, file number 1-8400. 10(q) Amendment, dated June 4, 1986, to Purchase Agreement in Exhibit 10(l) above, incorporated by reference to Exhibit 10(q) to AMR's report on Form 10-K for the year ended December 31, 1986, file number 1-8400. 10(r) Acquisition Agreement, dated as of March 1, 1987, between American and Airbus Industrie relative to the lease of Airbus A300-600R aircraft, incorporated by reference to Exhibit 10(r) to AMR's report on Form 10-K for the year ended December 31, 1986, file number 1-8400. 10(s) Acquisition Agreement, dated as of March 1, 1987, between American and the Boeing Company relative to the lease of Boeing 767-323ER aircraft, incorporated by reference to Exhibit 10(s) to AMR's report on Form 10-K for the year ended December 31, 1986, file number 1-8400. 10(t) AMR Corporation 1988 Long-Term Incentive Plan, incorporated by reference to Exhibit 10(t) to AMR's report on Form 10-K for the year ended December 31, 1988, file number 1-8400. 10(u) Acquisition Agreement, dated as of July 21, 1988, between American and the Boeing Company relative to the purchase of Boeing Model 757-223 aircraft, incorporated by reference to Exhibit 10(u) to AMR's report on Form 10-K for the year ended December 31, 1988, file number 1-8400. 10(v) Acquisition Agreement, dated as of February 4, 1989, among American and Delta Airlines, Inc. and others relative to operation of a computerized reservations system incorporated by reference to Exhibit 10(v) to AMR's report on Form 10-K for the year ended December 31, 1988, file number 1-8400. 10(w) Purchase Agreement, dated as of May 5, 1989, between American and the Boeing Company relative to the purchase of Boeing 757-223 aircraft, incorporated by reference to Exhibit 10(w) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(x) Purchase Agreement, dated as of June 9, 1989, between American and Fokker Aircraft U. S. A., Inc. relative to the purchase of Fokker 100 aircraft, incorporated by reference to Exhibit 10(x) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(y) Agreement for Sale and Purchase, dated as of June 12, 1989, between AMR Leasing Corporation and SAAB Aircraft of America, Inc. relative to the purchase of Saab 340B aircraft, incorporated by reference to Exhibit 10(y) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(z) Purchase Agreement, dated as of June 23, 1989, between American and the Boeing Company relative to the purchase of Boeing 767-323ER aircraft, incorporated by reference to Exhibit 10(z) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(aa) Lease Agreement, dated as of June 29, 1989, between AMR Leasing Corporation and British Aerospace, Inc. relative to the lease of Jetstream Model 3201 aircraft, incorporated by reference to Exhibit 10(aa) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(bb) Purchase Agreement, dated as of August 3, 1989, between American and the McDonnell Douglas Corporation relative to the purchase of MD-11 aircraft, incorporated by reference to Exhibit 10(bb) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(cc) Amendment, dated as of August 3, 1989, to the Purchase Agreement in Exhibit 10(l) above, incorporated by reference to Exhibit 10(cc) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1- 8400. 10(dd) Amendment, dated as of August 11, 1989, to AMR's Preferred Stock Purchase Rights Agreement in Exhibit 10(o) above, incorporated by reference to Exhibit 10(dd) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(ee) Purchase Agreement, dated as of October 25, 1989, between American and AVSA, S. A. R. L. relative to the purchase of Airbus A300-600R aircraft, incorporated by reference to Exhibit 10(ee) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(ff) Amendment, dated as of November 16, 1989, to Employment Agreement among AMR, American Airlines and Robert L. Crandall, incorporated by reference to Exhibit 10(ff) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(gg) Directors Stock Equivalent Purchase Plan, incorporated by reference to Exhibit 10(gg) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(hh) Deferred Compensation Agreement, dated as of January 31, 1990, between AMR and Edward A. Brennan, incorporated by reference to Exhibit 10(hh) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(ii) Deferred Compensation Agreement, dated as of January 31, 1990, between AMR and Thomas S. Carroll, incorporated by reference to Exhibit 10(ii) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(jj) Deferred Compensation Agreement, dated as of January 31, 1990, between AMR and Antonio Luis Ferre, incorporated by reference to Exhibit 10(jj) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(kk) Deferred Compensation Agreement, dated as of January 31, 1990, between AMR and John D. Leitch, incorporated by reference to Exhibit 10(kk) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1- 8400. 10(ll) Deferred Compensation Agreement, dated as of January 31, 1990, between AMR and Charles H. Pistor, Jr., incorporated by reference to Exhibit 10(ll) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(mm) Deferred Compensation Agreement, dated as of January 31, 1990, between AMR and Edward O. Vetter, incorporated by reference to Exhibit 10(mm) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(nn) Amendment, dated as of February 1, 1990, to the Deferred Compensation Agreement, dated December 19, 1984, between AMR and Charles H. Pistor, Jr., incorporated by reference to Exhibit 10(nn) to AMR's report on Form 10- K for the year ended December 31, 1989, file number 1-8400. 10(oo) Management Severance Allowance, dated as of February 23, 1990, for levels 1-4 employees of American Airlines, Inc., incorporated by reference to Exhibit 10(oo) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(pp) Management Severance Allowance, dated as of February 23, 1990, for level 5 and above employees of American Airlines, Inc., incorporated by reference to Exhibit 10(pp) to AMR's report on Form 10-K for the year ended December 31, 1989, file number 1-8400. 10(qq) Purchase Agreement, dated as of October 25, 1990, between AMR Leasing Corporation and Avions de Transport Regional relative to the purchase of ATR 42 and Super ATR aircraft, incorporated by reference to Exhibit 10(qq) to AMR's report on Form 10-K for the year ended December 31, 1990, file number 1-8400. 10(rr) Form of Stock Option Agreement for Corporate Officers under the AMR 1988 Long-Term Incentive Plan, incorporated by reference to Exhibit 10(rr) to AMR's report on Form 10-K for the year ended December 31, 1990, file number 1-8400. 10(ss) Form of Career Equity Program Deferred Stock Award Agreement under the AMR 1988 Long-Term Incentive Plan, incorporated by reference to Exhibit 10(ss) to AMR's report on Form 10-K for the year ended December 31, 1990, file number 1-8400. 10(tt) Amendment, dated as of December 3, 1990, to Employment Agreement among AMR, American Airlines and Robert L. Crandall incorporated by reference to Exhibit 10(tt) to AMR's report on Form 10-K for the year ended December 31, 1990, file number 1-8400. 10(uu) Amendment, dated as of May 1, 1992, to Employment Agreement among AMR, American Airlines and Robert L. Crandall incorporated by reference to Exhibit 10(uu) to AMR's report on Form 10-Q for the period ended June 30, 1992, file number 1-8400. 10(vv) Irrevocable Executive Trust Agreement, dated as of May 1, 1992, between AMR and Wachovia Bank of North Carolina N.A. 10(ww) Deferred Compensation Agreement, dated as of December 23, 1992, between AMR and Howard P. Allen. 10(xx) Deferred Compensation Agreement, dated as of February 5, 1993, between AMR and Charles T. Fisher, III. 10(yy) Deferred Compensation Agreement, dated as of February 10, 1993, between AMR and Edward O. Vetter. 10(zz) Deferred Compensation Agreement, dated as of March 8, 1993, between AMR and John D. Leitch. 10(aaa) Amendment No. 2 to the Rights Agreement, dated as of February 13, 1986, between AMR Corporation and First Chicago Trust Company of New York. 10(bbb) Form of Performance Share Program Deferred Stock Award Agreement under the 1988 Long-Term Incentive Plan. 10(ccc) Form of Guaranty to Career Equity Program under the AMR 1988 Long-Term Incentive Plan. 10(ddd) Amendment, dated as of July 26, 1993, to Career Equity Program Deferred Stock Award Agreements. 10(eee) Second Amendment, dated as of July 26, 1993, to Career Equity Program Deferred Stock Award Agreements. 10(fff) Deferred Compensation Agreement, dated as of February 10, 1994, between AMR and Charles T. Fisher, III. 10(ggg) Deferred Compensation Agreement, dated as of February 11, 1994, between AMR and Howard P. Allen. 11(a) Computation of primary loss per share for the years ended December 31, 1993, 1992 and 1991. 11(b) Computation of loss per share assuming full dilution for the years ended December 31, 1993, 1992 and 1991. 12 Computation of ratio of earnings to fixed charges for the years ended December 31, 1989, 1990, 1991, 1992 and 1993. 19 The 1974 and 1979 American Airlines (AMR) Stock Option plans as amended March 16, 1983, incorporated by reference to Exhibit 19 to AMR's report on Form 10-K for the year ended December 31, 1983, file number 1-8400. Refer to Exhibits 10(d) and 10(e). 22 Significant subsidiaries of the registrant. 23 Consent of Independent Auditors appears on page 56 hereof. (b) Reports on Form 8-K: None. AMR CORPORATION INDEX TO FINANCIAL STATEMENTS AND SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (ITEM 14(A)) All other schedules are omitted since the required information is included in the financial statements or notes thereto, or since the required information is either not present or not present in sufficient amounts. Exhibit 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in Registration Statements (Form S-8 No. 2-68366), (Form S-8 No. 33-27866), (Form S-3 No. 33-35953), (Form S-3 No. 33-42027), (Form S-3 No. 33-46325), and (Form S-3 No. 33-52121) of AMR Corporation, and in the related Prospectuses, of our report dated February 15, 1994, with respect to the consolidated financial statements and schedules of AMR Corporation included in this Annual Report (Form 10-K) for the year ended December 31, 1993. ERNST & YOUNG 2121 San Jacinto Dallas, Texas 75201 March 29, 1994 AMR CORPORATION Schedule V - Property, Plant and Equipment Year Ended December 31, 1993 (in millions) Addtions to Flight Equipment includes amounts tranferred from Purchase Deposits upon delivery of aircraft. AMR CORPORATION Schedule V - Property, Plant and Equipment Year Ended December 31, 1992 (in millions) Addtions to Flight Equipment includes amounts tranferred from Purchase Deposits upon delivery of aircraft. Net Transfers and Other Adjustments includes the sale and subsequent leaseback of two Boeing 757 aircraft, six Boeing 767 aircraft, three Fokker aircraft and one McDonnell Douglas MD-80 aircraft. Seven of these agreements are accounted for as capital leases. AMR CORPORATION Schedule V - Property, Plant and Equipment Year Ended December 31, 1991 (in millions) Addtions to Flight Equipment includes amounts tranferred from Purchase Deposits upon delivery of aircraft. Net Transfers and Other Adjustments includes the sale and subsequent leaseback of 13 Boeing 757 aircraft, two Boeing 767 aircraft, six Fokker aircraft and 29 McDonnell Douglas MD-80 aircraft. Six of these agreements are accounted for as capital leases. AMR CORPORATION Schedule VI - Accumulated Depreciation, Amortization and Obsolescence of Property, Plant and Equipment Year Ended December 31, 1993 (in millions) AMR CORPORATION Schedule VI - Accumulated Depreciation, Amortization and Obsolescence of Property, Plant and Equipment Year Ended December 31, 1992 (in millions) Net transfers and other adjustments includes accumulated depreciation related to sale-leaseback transactions. See Schedule V. AMR CORPORATION Schedule VI - Accumulated Depreciation, Amortization and Obsolescence of Property, Plant and Equipment Year Ended December 31, 1991 (in millions) ========== Net transfers and other adjustments includes accumulated depreciation related to sale-leaseback transactions. See Schedule V. AMR CORPORATION Schedule VII - Guarantees of Securities of Other Issuers December 31, 1993 (in millions) AMR CORPORATION Schedule VII - Guarantees of Securities of Other Issuers - Continued December 31, 1993 (in millions) n AMR CORPORATION Schedule VIII - Valuation and Qualifying Accounts and Reserves (deducted from asset to which applicable) Year ended December 31, 1993 (in millions) (a) See Schedule VI. (b) Transfer to Allowance for obsolescence of inventories. AMR CORPORATION Schedule VIII - Valuation and Qualifying Accounts and Reserves (deducted from asset to which applicable) Year ended December 31, 1992 (in millions) (a) See Schedule VI. AMR CORPORATION Schedule VIII - Valuation and Qualifying Accounts and Reserves (deducted from asset to which applicable) Year ended December 31, 1991 (in millions) (a) See Schedule VI. AMR CORPORATION Schedule IX - Short-Term Borrowings Year ended December 31, 1993 (in millions) (a) Computed based on monthly amount outstanding during the year. (b) Computed by dividing total interest expense by the average amount outstanding during the year. (c) Commercial paper generally matures within 120 days after issue with no provisions for renewal. AMR CORPORATION Schedule IX - Short-Term Borrowings Year ended December 31, 1992 (in millions) (a) Computed based on monthly amount outstanding during the year. (b) Computed by dividing total interest expense by the average amount outstanding during the year. (c) Commercial paper generally matures within 120 days after issue with no provisions for renewal. AMR CORPORATION Schedule IX - Short-Term Borrowings Year ended December 31, 1991 (in millions) (a) Computed based on monthly amount outstanding during the year. (b) Computed by dividing total interest expense by the average amount outstanding during the year. (c) Commercial paper generally matures within 120 days after issue with no provisions for renewal. Facility agreement borrowings generally mature within 100 days after issue, with renewal option available over the term of the facility agreement. AMR CORPORATION Schedule X - Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 (in millions) PART I - Exhibit 11 (a) AMR CORPORATION Computation of Primary Loss per Share (in millions, except per share amounts) PART I - Exhibit 11 (b) AMR CORPORATION Computation of Loss per Share Assuming Full Dilution (in millions, except per share amounts) Exhibit 12 AMR CORPORATION COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES * Previously restated. 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. AMR CORPORATION /s/ Robert L. Crandall Robert L. Crandall Chairman, President and Chief Executive Officer (Principal Executive Officer) /s/ Donald J. Carty Donald J. Carty Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Date: 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 on the dates noted: Date: March 16, 1994

59527_1993.txt

59527_1993

1993

59527

Item 1. BUSINESS As used in Item 1 of this report, the term "Company", except as otherwise indicated by the context, means The Lincoln Electric Company and its subsidiaries. The Lincoln Electric Company was incorporated under the laws of the State of Ohio in 1906. The Company is engaged primarily in the design, manufacture and sale of arc welding products which constitutes 88% of the Company's business. The Company also designs, manufactures and sells integral horsepower industrial electric motors, and some subsidiaries also sell industrial gases, regulators, and torches. The arc welding machines, power sources and automated wire feeding systems manufactured by the Company range in technology from basic units used for light manufacturing and maintenance to highly sophisticated machines for robotic applications, high production welding and fabrication. Three primary types of arc welding electrodes are produced: (1) coated manual or stick electrodes, (2) solid electrodes produced in coil form for continuous feeding in mechanized welding, and (3) cored electrodes produced in coil form for continuous feeding in mechanized welding. The integral horsepower electric motors manufactured by the Company range in size from 1/3 to 250 horsepower. See Note H to the consolidated financial statements with respect to acquisitions by the Company. The Company's products are sold in both domestic and international markets. In the domestic market, they are sold directly by the Company's own sales organization as well as by distributors. In the international markets, the Company's products are sold principally by foreign subsidiary companies. The Company also has an international sales organization comprised of international direct sales distributors, agents and dealers that operate in more than eighty-seven countries. The Company has manufacturing facilities located in the United States, Australia, Canada, Japan, Mexico, England, France, Ireland, Italy, the Netherlands, Norway and Spain. See Note G to the consolidated financial statements with respect to information concerning the Company's geographic segments. The Company is not dependent on a single customer or a few customers. The loss of any one customer would not have a material adverse effect on its business. The Company's business is not seasonal. Conditions in the arc welding industry are highly competitive. The Company is one of the largest manufacturers of consumables and machinery in a field of three or four major domestic competitors and numerous smaller competitors covering the industry. The Company continues to pursue strategies to heighten its competitiveness in international markets. Competition in the electric arc welding industry is on the basis of price, brand preference, product quality and performance, warranty, delivery, service and technical support. All of these factors have contributed to the Company's position as one of the leaders in the industry. Virtually all of the Company's products may be classified as standard commercial articles and are manufactured for stock. Normally, customer orders are filled directly from finished product stock and, therefore, the backlog of orders at any particular time is relatively negligible. The principal raw materials essential to the Company's business are various chemicals, steel, copper and aluminum, all of which are normally available for purchase in the open market. Item 1. BUSINESS (Continued) The Company's operations are not materially dependent upon patents, licenses, franchises or concessions. The Company's facilities are subject to federal, state and local environmental control regulations. To date, compliance with these environmental regulations has not had a material effect on the Company's earnings nor has it required the Company to make significant capital expenditures. Research activities relating to the development of new products and the improvement of existing products in 1993 were all Company-sponsored. These activities were primarily related to the development of new products utilizing the latest electronic technology. The number of professional employees engaged full-time in these research activities was 142. Refer to Note A to the consolidated financial statements with respect to costs of research and development. The number of persons employed by the Company worldwide, as an average for the year ended December 31, 1993, was 6,036. Effects of plant closures will reduce worldwide employment levels in 1994. Geographic segment information is included in Note G to the consolidated financial statements. Item 2. Item 2. PROPERTIES The Company's corporate headquarters and principal United States manufacturing facilities are located in the Cleveland, Ohio area. Total Cleveland area property consists of 230 acres, of which present manufacturing facilities comprise an area of approximately 2,698,000 square feet. Current utilization of existing facilities is estimated to be 91% of capacity. Item 2. PROPERTIES (Continued) Manufacturing facilities located in Germany, Venezuela, and Brazil were closed under the Company's restructuring program. All property relating to the Company's Cleveland, Ohio headquarters and manufacturing facilities is owned outright by the Company and is unencumbered. In addition, the Company maintains leases for its distribution centers. See Note K to the consolidated financial statements with respect to leases. Most of the Company's foreign subsidiaries own manufacturing facilities in the foreign country where they are located. Some of these subsidiaries' properties are encumbered by mortgage loans. See Note D to the consolidated financial statements with respect to long-term debt. Item 3. Item 3. LEGAL PROCEEDINGS The Company is subject, from time to time, to a variety of civil and administrative proceedings arising out of its normal operations including, without limitation, intellectual property related actions, employment-related actions and health, safety and environmental claims and proceedings under the laws governing workers' compensation. The Company does not believe that the outcome of such legal proceedings, solely or in aggregate, will have a material adverse effect upon the financial condition of the Company. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 1993. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON CAPITAL STOCK AND RELATED STOCKHOLDER MATTERS The Company's Common Capital Stock is traded on the over-the-counter market. The number of record holders of Common Capital Stock at December 31, 1993 was 2,497. There is a limited public trading market for Common Capital Stock purchased through the Company's Employees' Stock Purchase Plan and for Class A Common Stock distributed under the Company's Employee Stock Ownership Plan. Shares purchased are subject to a right of refusal and other restrictions as set forth in the Employees' Stock Purchase Plan. Refer to Note B to the consolidated financial statements with respect to the rights of Class A Common Stock. Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS (Continued) Future dividends, which are subject to limitations under the Credit Agreement and the Senior Note Agreement, will be based on financial performance of the Company (see Note D to the consolidated financial statements for a further description of these limitations.) Item 6. Item 6. SELECTED FINANCIAL DATA See Note C to the consolidated financial statements with respect to restructuring charges in 1993 and 1992. All per share amounts have been adjusted for the ten-for-one stock split in 1993. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--(all dollar amounts are in thousands of dollars) RESULTS OF OPERATIONS Net sales decreased by less than 1% to $846,000 in 1993 from $853,000 in 1992 and increased 1.4% from 1991 sales of $833,900. Sales in 1993 for domestic companies were up 9.7% while sales of foreign companies were down 18.3% from 1992. Excluding sales resulting from acquisitions, 1992 domestic and foreign sales increased 6.0% and decreased 10.2%, respectively, from 1991. Approximately 45% of the increase in domestic sales in 1993 (90% in 1992) was attributable to an increase in volume. The remaining 55% in 1993 (10% in 1992) was due to increases in selling prices. Gross margin increased to $313,200 in 1993 (37.0% of sales) as compared to $299,900 in 1992 (35.2% of sales) and $312,100 in 1991 (37.4% of sales). The improvement of gross margin was attributable to price increases coupled with the effect of increased volume, which included the effect of domestic market share gains. These effects, however, were partially offset by diminishing gross margins of the non-U.S. operations. Distribution cost/selling, general and administrative expenses were $277,000 in 1993 (32.7% of sales) as compared to $299,200 in 1992 (35.1% of sales) and 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--(Continued) $270,500 in 1991 (32.4% of sales). The reduction in distribution cost/selling, general and administrative expenses in 1993 was principally the result of management's response to the recessionary pressures existing throughout Europe. Additionally, comparable results were affected by the incurrence of certain nonrecurring and non-continuing operating costs. Such costs included asset write-downs, relocation costs, various other charges relating to cost reduction efforts totaling $3,700 and $18,900 in 1993 and 1992, respectively. In 1992, the increase in distribution cost/selling, general and administrative expenses was principally caused by a full year of operations of the Company's German subsidiary versus nine months in 1991, increased pension expense, and various adjustments discussed above. In 1991, distribution costs/selling, general and administration expenses were offset partially by the reversal of $6,200 of prior year charges relating to The Lincoln Electric Company 1988 Incentive Equity Plan. The Company's net loss was $38,100 in 1993 as compared with $45,800 in 1992 and net income of $14,400 in 1991. Results were affected adversely by restructuring charges relating principally to the European and South American operations. These charges totaled $40,900 net-of-tax ($3.77 per share) and $23,900 without tax benefit ($2.21 per share) for 1993 and 1992, respectively (see discussion below). The 1991 results of operations included no restructuring charges. Results for 1993 have also benefited from the cumulative effect of a change in method of accounting for income taxes, which increased net income $2,468 or $.23 per share. See Note A, "Accounting Policies," for additional information regarding the effects of the change in method in accounting for income taxes. The provision for income taxes reflects a net benefit of $6,400 on a loss before income taxes of $46,900 for 1993 which principally reflects tax benefits attributable to the plant closure and liquidation of a German subsidiary (see discussion below). For 1992, the provision for income taxes was $11,400 on a loss before income taxes of $34,400 compared to a provision of $20,000 on income before income taxes of $34,400 in 1991. The higher effective rates experienced in 1992 and 1991 were due principally to losses of foreign subsidiaries that were in net operating loss carryover positions. RESTRUCTURING CHARGES In 1992, the Company's restructuring program was initiated to improve efficiency and future financial results for its non-U.S. operations, principally its European markets. This decision resulted in a restructuring charge to 1992 operations of $23,900, without tax benefit. It became evident in 1993 that the 1992 restructuring charges were not sufficient to reverse operating results in Germany, as the Company's principal German subsidiary continued to incur significant losses, experiencing eroding sales levels within the context of depressed market conditions. Accordingly, the Board of Directors decided in early 1994 to terminate the manufacturing and sales operations of its Messer Lincoln subsidiary in Germany. The intent of the action was to eliminate substantial costs in manufacturing overhead and distribution expenses in Europe, and to enable the Company to redirect its resources toward more efficient and competitive facilities that will serve the European market. Similarly, the Board of Directors decided in early 1994 that overcapacity in the weak and turbulent economies of Brazil and Venezuela required the curtailment of production operations in such markets, even though sales, marketing and distribution activities in those countries will continue. 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--(Continued) The above-referenced decisions, which will result in the termination of approximately 800 employees, resulted in pretax restructuring charges of $70,100 for 1993 ($40,900 after tax). See Note C to the consolidated financial statements, "Restructuring Charges," for additional information. As indicated earlier, operating results of the Company's highly efficient U.S. and Canadian operations showed increased levels of profitability and market share in 1993. Although consolidated results were affected adversely in 1992 and 1993 by restructuring charges, management believes the Company is well positioned now to maximize its opportunities in the worldwide markets it serves. RESEARCH AND DEVELOPMENT The Company decreased its expenditures for research activities during both 1993 and 1992. However, the Company believes the current level of research and development is adequate to maintain its product lines and introduce new products at an appropriate rate to sustain future growth. Excellence in research and development is a key success factor for the Company. LIQUIDITY AND CAPITAL RESOURCES In March 1993, the Company entered into a $230,000 three-year, unsecured, multi-currency Credit Agreement with ten banks. The funds were used to replace the Company's then existing revolving credit agreement, its long-term borrowing arrangements with foreign banks, and to refinance and consolidate certain other foreign short-term and long-term obligations. See Note D to the consolidated financial statements, "Short-Term and Long-Term Debt," for additional information regarding the borrowing arrangement. The Credit Agreement was amended in November 1993 in order to provide for more flexible terms to accommodate the Company's restructuring program. Total debt at December 31, 1993 was $250,300 compared to $248,600 at December 31, 1992. At December 31, 1993, debt was 64% of total capitalization (shareholders' equity and debt) compared with 56% at year-end 1992. Interest expense incurred was $17,600 in 1993 compared with $18,700 in 1992, reflecting slightly lower interest rates as compared with the prior year. This compares to interest expense of $15,700 in 1991, reflecting an increase in the average debt level. The Company's cash flows for the years 1991 through 1993 are presented in the consolidated statements of cash flows. Cash provided from operating activities during 1993 amounted to $28,700, an increase of $5,100 as compared with $23,600 for 1992. In addition to financing, certain operating losses in Europe, cash flows from operations and additional borrowings were used primarily for investments, capital expenditures and dividends to shareholders. In 1992, expenditures by the Company for the purchase of a small Mexican company and the additional investment in its Lincoln Norweld subsidiary totaled $37,300, compared to $48,700 in 1991 for the purchase of a German business. The ratio of current assets to current liabilities was 1.9 at the end of 1993, compared with 2.2 at the end of 1992 reflecting a satisfactory liquidity position. Net working capital was $149,900 at December 31, 1993, as compared with $172,700 at December 31, 1992. The reduction in working capital was primarily the result of the reduction of the carrying value of assets to their net realizable value and the increases in other current liabilities in connection with the restructuring expenses. Notes payable to banks increased to $23,200 at the end of 1993, from $12,600 at the end of 1992. 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--(Continued) Capital expenditures in 1993 for property, plant and equipment totaled $19,100 (1992 - $34,800). These expenditures for property, plant and equipment represent the Company's commitment to its long-range objectives to enhance product quality and development, advance technology, expand capacity and reduce manufacturing costs. The Company is closely monitoring its capital outlays and commitments with such expenditures restricted to include only those projects showing potential for high internal rate of return with accelerated cash payback. In 1993, consistent with the prior year, the Company did not pay a special dividend, paying regular dividends of $7,800 for the full year. Future dividends, which are subject to limitations under the Credit Agreement and the Senior Note Agreement, will be based upon the financial performance of the Company (see Note D to the consolidated financial statements). The Credit Agreement and 8.98% Senior Note Agreement contain various financial covenants that place limitations on the payments of dividends, the purchase of unrestricted stock, capital expenditures, and the incurrence of additional indebtedness. While the operating losses for 1993 and 1992 have placed constraints on the Company's financial flexibility, the Company was in compliance with the financial covenants of the agreements at the end of 1993 and management believes that the Company will continue to meet such covenants throughout 1994. Management believes that the current financing arrangement and cash flow generated from operations will provide adequate funds to support the operations of the Company and satisfy both its capital requirements and regular dividend practices throughout the term of the Credit Agreement. ENVIRONMENTAL MATTERS The Company's U.S. facilities are subject to Federal, state and local environmental control regulations. To date, compliance with these environmental regulations has not had a material effect on the Company's earnings nor has it required the Company to make significant capital expenditures. It is the opinion of management that the Company is in material compliance with all regulatory requirements. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS 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." This statement requires companies to present certain investments in marketable equity securities and many debt securities at fair value. SFAS No.115 is effective for fiscal years beginning after December 15, 1993. As the Company does not hold significant portfolios of debt and marketable equity securities nor is it the Company's principal business purpose to actively acquire and sell debt and equity securities to make a profit from short-term movements in market prices, adoption of SFAS No. 115 is not expected to have any substantial impact on the financial statements. In December 1990, the FASB issued new rules in SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective in 1993 domestically and effective for non-U.S. plans in 1995. In November 1992, the FASB issued Statement No. 112, "Employers' Accounting for Postemployment Benefits." The Company is required to implement the Statement in the first quarter of 1994. These statements have no impact on the consolidated financial position or results of operations because the Company does not provide for any postretirement or postemployment benefits other than pensions. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to this item is submitted in a separate section of this report following the signature page. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III A definitive proxy statement will be filed pursuant to Regulation 14A of the Securities Exchange Act prior to April 29, 1994. Therefore, information required under this part will be incorporated herein by reference from such definitive proxy statement. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) FINANCIAL STATEMENTS The following consolidated financial statements of the Company are included in a separate section of this report following the signature page: Statements of Consolidated Financial Condition--December 31, 1993 and 1992 Statements of Consolidated Operations--Years ended December 31, 1993, 1992 and 1991 Statements of Consolidated Shareholders' Equity--Years ended December 31, 1993, 1992 and 1991 Statements of Consolidated Cash Flows--Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements--December 31, 1993 Reports of Independent Auditors (a) (2) FINANCIAL STATEMENT SCHEDULES The following consolidated financial statement schedules of the Company are included in a separate section of this report following the signature page: 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 IX--Short-Term Borrowings Schedule X--Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore, have been omitted. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) Upon request, The Lincoln Electric Company will furnish to security holders copies of any exhibit to the Form 10-K report upon payment of a reasonable fee. Any requests should be made in writing to: Mr. Ellis F. Smolik, Secretary-Treasurer, The Lincoln Electric Company, 22801 St. Clair Avenue, Cleveland, Ohio 44117, Phone: (216) 481-8100. 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 LINCOLN ELECTRIC COMPANY ---------------------------- (Registrant) /s/ Ellis F. Smolik -------------------------- Ellis F. Smolik, Senior Vice President, Chief Financial Officer, Secretary-Treasurer 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 indicated on March 30, 1994. ANNUAL REPORT ON FORM 10-K ITEM 8, ITEM 14(a)(1) AND (2) AND ITEM 14(d) FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES REPORT OF INDEPENDENT AUDITORS Shareholders and Board of Directors The Lincoln Electric Company We have audited the consolidated financial statements of The Lincoln Electric Company and subsidiaries listed in the accompanying index to financial statements Item 14(a1). Our audits also included the financial statement schedules listed in the Index at Item 14 (a2). 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 did not audit the consolidated financial statements of The Lincoln Electric Company (Australia) Proprietary Limited and subsidiaries and, for 1992 and 1991, the consolidated financial statements of Lincoln-Norweld B.V. and subsidiaries and the financial statements of Messer Lincoln GmbH and its subsidiary, all consolidated subsidiaries, which statements reflect total assets constituting 5% in 1993 and 41% in 1992 and total revenues constituting 5% in 1993 and 36% in 1992 and 1991 of the related consolidated totals. Those statements were audited by other auditors whose reports have been furnished to us, and our opinion, insofar as it relates to data included for The Lincoln Electric Company (Australia) Proprietary Limited and subsidiaries and, for 1992 and 1991, Lincoln-Norweld B.V. and subsidiaries and Messer Lincoln GmbH and its subsidiary, is based solely on the reports of the other auditors. 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 and the reports of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Lincoln Electric 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. As discussed in Note A to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. /s/ Ernst & Young ------------------------------ ERNST & YOUNG Cleveland, Ohio March 25, 1994 To the Board of Directors of The Lincoln Electric Company (Australia) Proprietary Limited REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- In our opinion, the consolidated balance sheets and the related consolidated statements of income and retained earnings and of cash flows (none of which are presented separately herein) present fairly, in all material respects, the financial position of The Lincoln Electric Company (Australia) Proprietary Limited 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. /s/ Price Waterhouse Parramatta, Australia March 9, 1994 See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars except per share data) December 31, 1993 NOTE A--ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of The Lincoln Electric Company and its subsidiaries (the "Company") after elimination of all significant intercompany accounts and transactions. CASH EQUIVALENTS: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. INVENTORIES: Inventories are valued at the lower of cost or market. The Company determines cost by the last-in, first-out (LIFO) method, and subsidiary companies determine cost by the first-in, first-out (FIFO) method. At December 31, 1993 and 1992, approximately 45% and 34%, respectively, of total inventories were valued using the LIFO method. The excess of current cost over LIFO cost amounted to $48,490 at December 31, 1993 and $48,555 at December 31, 1992. During 1992, certain LIFO inventories were reduced, resulting in liquidations of LIFO inventory quantities carried at the lower costs of prior years, as compared with their 1992 costs. The effect of these liquidations was to reduce the 1992 net loss after tax, by $1,018 ($.09 per share). PROPERTY, PLANT AND EQUIPMENT: Property, plant and equipment, including facilities and equipment under capital leases, are stated at cost and include improvements which significantly extend the useful lives of existing plant and equipment. Depreciation and amortization are computed by both the accelerated and straight-line methods. In 1993, property, plant and equipment for manufacturing facilities that were closed were written down to their estimated net realizable value. RESEARCH AND DEVELOPMENT: Research and development costs, which are expensed as incurred, were $17,762 in 1993, $20,540 in 1992 and $21,311 in 1991. GOODWILL: The excess of the purchase price over the fair value of net assets acquired (goodwill) is amortized on a straight-line basis over periods not exceeding 40 years. Amounts are stated net of accumulated amortization of $2,363 and $2,170 in 1993 and 1992, respectively. TRANSLATION OF FOREIGN CURRENCIES: For subsidiaries in countries which do not have highly inflationary economies, asset and liability accounts are translated to U.S. dollars using exchange rates in effect at the balance sheet date and revenue and expense accounts are translated at average exchange rates. Translation adjustments are reflected as a component of shareholders' equity. For subsidiaries in countries with highly inflationary economies (Venezuela and Brazil) inventories, property, plant and equipment and related depreciation are translated to U.S. dollars at historical exchange rates. Other asset and liability accounts are translated at exchange rates in effect at the balance sheet date and revenues and expenses, excluding depreciation, are translated at average exchange rates. Translation adjustments for these subsidiaries, as well as transaction gains and losses of all other subsidiaries, are included in the statements of consolidated operations in distribution cost/selling, general and administrative expenses. The Company recorded transaction losses in 1993 of $228 and $859 in 1992. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars except per share data) December 31, 1993 NOTE A--ACCOUNTING POLICIES-(Continued) ACCOUNTING CHANGE: Effective January 1, 1993, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes." Under Statement No. 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Prior to the adoption of Statement No. 109, income tax expense was determined using the deferred method under which 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 No. 109, the Company has elected not to restate the financial statements of any prior year. The cumulative effect of the change decreased the loss for 1993 by $2,468 or $.23 per share. NET INCOME (LOSS) PER SHARE: Net income (loss) per share is based on the average number of shares outstanding during the year as adjusted for the ten-for-one stock split discussed in Note B. RECLASSIFICATIONS: Certain reclassifications have been made to amounts previously presented to conform with the current reporting presentation. NOTE B--SHAREHOLDERS' EQUITY On May 25, 1993, the Company's shareholders approved an increase in the number of authorized shares to 17 million without par value in conjunction with a ten-for-one stock split of the Company's Common Capital and Class A Common Stock. This action became effective on June 1, 1993, for shareholders of record as of that date. A total of 9,343,305 shares of Common Capital Stock and 405,558 shares of Class A Common Capital Stock were issued in connection with the stock split. Additionally, 4,031,451 shares were issued for stock held in treasury. The stated value of the Common Capital and Class A Common Capital Stock remains unchanged at $.20 per share. As a result of the stock split, all per share and appropriate share amounts have been adjusted to reflect the stock split. The Lincoln Electric Company Employees' Stock Purchase Plan ("Plan") provides that employees may purchase shares of the Company's Common Capital Stock, when offered, at its estimated fair value. The Company also has the option to repurchase shares issued under the Plan at their estimated fair value. In 1992, the Company instituted a temporary suspension on the repurchase of all shares of stock issued and outstanding. Future repurchase of stock by the Company will be contingent upon authorization and resolution of the Board of Directors. At December 31, 1993, all unissued shares (4,618,550) were available for sale under the Plan of which 774,656 shares were reserved or subscribed. The Lincoln Electric Company 1988 Incentive Equity Plan ("Incentive Equity Plan") provided for the award or sale of Common Capital Stock to officers and other key employees of the Company and its subsidiaries. The first program, implemented under the Plan in 1988, which provided for deferred stock awards, was completed as of December 31, 1991. Shares remain available under the Incentive Equity Plan to officers and other key employees. Distribution of shares was based on certain specified performance and other conditions being satisfied. As a result of such conditions being fulfilled with respect to certain of the Company's subsidiaries, the Company awarded 32,000 shares; 10,660 distributed in each April of 1992 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars except per share data) December 31, 1993 NOTE B--SHAREHOLDERS' EQUITY--(Continued) and 1993, and 10,680 shares in April of 1994. Based on criteria established under the Plan, $7,000 of compensation expense was accrued in 1990, of which $6,219 was reversed into income in 1991. The Lincoln Electric Company Employee Stock Ownership Plan (the "ESOP") is a non-contributory profit-sharing plan established to provide deferred compensation benefits for all eligible employees. The cost of the plan is borne by the Company through contributions to an employee stock ownership trust. In May 1989, shareholders authorized 2,000,000 shares of new Class A Common Stock ("Class A Common Stock"), without par value. The Company's Common Capital Stock and Class A Common Stock are identical in all respects, except that holders of Class A Common Stock are subject to certain transfer restrictions and the Class A Common Stock is only issued to the ESOP. In 1993, the Company issued 49,220 shares (92,680 shares in 1992) of Class A Common Stock to the ESOP which were allocated to all eligible employees. The estimated fair value of the contributed shares, $916, was recorded as compensation expense ($2,060 in 1992 and $2,003 in 1991). The difference between the total stated capital amount of $.20 per share and the estimated fair value totaled $906 ($2,058 in 1992 and $2,001 in 1991) was recorded as additional paid-in-capital. At December 31, 1993, 1,500,160 authorized but unissued shares (1,549,380 shares at December 31, 1992) are available for issuance to the ESOP. NOTE C--RESTRUCTURING CHARGES The Company has substantially completed its plan to downsize and streamline certain foreign operations (principally in Europe) and close certain manufacturing facilities (principally in Europe and South America). Closings of the manufacturing facilities have been announced and the closings and redundancies will be completed in 1994. These decisions resulted in a restructuring charge of $70,100 ($40,900 after tax, or $3.77 per share) in 1993, which was comprised of (1) asset write-downs to net realizable value in the amount of $45,900 including goodwill of $8,900; (2) the recording of severance and other redundancy costs of $27,500; and (3) the recording of additional net settlement assets and liabilities of $3,300 including estimated losses through the final closing date. The cash outlays required to fund the restructuring will be substantially incurred in 1994, and will be funded by the liquidation of the affected companies' receivables, inventory and real estate and by the Company's other operations and outside sources of funding. Proceeds from the sale of certain of the property, plant and equipment with a net carrying value of approximately $11,000 is not expected to be realized until after 1994. In 1992, the Company recorded a restructuring charge of $23,900 (without tax benefit, or $2.21 per share) as a result of decisions that were made at that time to downsize and streamline certain foreign operations (principally in Europe). The 1992 restructuring charge was principally for severance pay, redundancies and other liabilities relating to the reorganization of the sales and distribution operations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) In March 1993, the Company entered into a $230,000 three-year, unsecured, multi-currency Credit Agreement with ten banks. The Credit Agreement, which expires January 1, 1996, replaced the Company's previous $75,000 revolving line of credit, and amounts outstanding at December 31, 1992 under the previous revolving line of credit ($30,000), certain notes payable to foreign banks ($25,000), various short-term borrowings of subsidiaries ($39,100), and various other long-term borrowings ($17,300). Borrowings outstanding at December 31, 1992 that were repaid from the proceeds of the Credit Agreement were classified in the consolidated balance sheet to reflect the terms of the Credit Agreement. Under the terms of the Credit Agreement, several pricing options are available and the interest rate on outstanding borrowings is determined based upon defined leverage rates for the pricing option selected. The interest rate can range from the LIBOR plus 1% to LIBOR plus 2% depending upon the defined leverage rate. The agreement also provides for commitment fees ranging from .375% to .5% per annum on the unused credit lines. Simultaneously, with the signing of the Credit Agreement, the interest rate on the $75,000 8.73% Senior Note due in 2003 was increased to 8.98% and the Senior Note Agreement was amended to change the financial covenants to conform to the covenants of the Credit Agreement, which requires a 1.6 to 1 consolidated current ratio at all times and the maintenance of consolidated tangible net worth of $125,000, plus 50% of net income, subsequent to January 1, 1993. In addition, there are requirements with respect to interest coverage and debt to tangible net worth ratios, and limitations on capital expenditures. Purchases of unrestricted stock and the payment of dividends are limited to 50% of cumulative net income from January 1, 1993, plus $25,000. At December 31, 1993, $17,200 was available for dividends and purchases of unrestricted stock, providing the Company complies with the other financial covenants of the agreements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTE D--SHORT-TERM AND LONG-TERM DEBT--(Continued) In November 1993, a number of the financial covenants contained in the Credit Agreement and in the Senior Note Agreement, were amended to allow for the costs of restructuring certain of the Company's foreign operations. The covenant related to consolidated tangible net worth was amended to require a minimum of $110,000 prior to June 30, 1994; $115,000 prior to September 30, 1994; $120,000 prior to December 31, 1994; and $125,000 plus 50% of net income subsequent to January 1, 1995, and the covenant related to the ratio of consolidated debt to consolidated tangible net worth was amended to require a ratio of 2.45 to 1 at December 31, 1993, reducing to 1.85 to 1 at July 1, 1994 and 1.35 to 1 at July 1, 1995 and thereafter. Maturities of long-term debt for the five years succeeding December 31, 1993 are $10,200 in 1994, $128,200 in 1995, $10,700 in 1996, $11,400 in 1997; $9,600 in 1998 and $57,000 thereafter. At December 31, 1993, certain foreign loans were collateralized by property and equipment which have a carrying value of approximately $21,400. In 1992, the Company terminated its interest rate swap agreement with a notational borrowing amount of $75,000 and received $2,586 which is being amortized over the original swap term (December 1994) as a yield adjustment to interest expense of the underlying $75,000 debt. Interest expense capitalized to property, plant and equipment was $71 in 1993 and $320 in 1992. Total interest paid was $19,000 in 1993, $17,500 in 1992, and $15,700 in 1991. In connection with the Company's expansion of its motor plant, which is expected to cost $19,800, the Company has received low interest rate loan commitments from certain governmental entities in the amount of $6,000, of which, $2,000 was received in March 1994. The Company has also applied for and expects to receive, $2,300 in governmental grants for the same project. NOTE E--INCOME TAXES Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting For Income Taxes". As permitted under the new Statement, prior years' financial statements have not been restated. The cumulative effect of adopting this statement as of January 1, 1993 is reported separately in the Statement of Consolidated Operations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTE E--INCOME TAXES--(Continued) Total income tax payments, net of refunds, were $19,387 in 1993, $16,542 in 1992 and $12,668 in 1991. At December 31, 1993, the Company's foreign subsidiaries had net operating loss carryforwards of approximately $44,875. The loss carryforwards expire in various years from 1994 through 2002, except for certain loss carryforwards of $571 for which there are no expiration dates. Income taxes currently payable amounted to approximately $8,698 at December 31, 1993. Income taxes currently refundable amounted to $1,400 at December 31, 1992. The Company does not provide deferred income taxes on unremitted earnings of foreign subsidiaries as such funds are deemed permanently reinvested to finance foreign expansion and meet operational needs on an ongoing basis. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes subject to an adjustment for foreign tax credits and withholding taxes payable to the various foreign countries. Determination of the amount of unrecognized deferred U.S. income tax liability is not practicable because of the complexities associated with its calculation; however, unrecognized foreign tax credits and foreign withholding taxes paid upon distribution would be available to reduce some portion of the U.S. liability. NOTE F--RETIREMENT ANNUITY AND GUARANTEED CONTINUOUS EMPLOYMENT PLANS The Company and its subsidiaries maintain a number of defined benefit and defined contribution plans to provide retirement benefits for their employees in the United States as well as their employees in foreign countries. These plans are maintained and contributions are made in accordance with the Employee Retirement Income Security Act of 1974, local statutory law or as determined by the Board of Directors. The plans generally provide benefits based upon years of service and compensation. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 The increase in the actuarial present value of accumulated benefit obligations ("ABO") for the domestic plans is largely due to the change in the discount rate from 8.0% to 7.5% as well as the normal one year's accrual of benefits. In addition the increase in the ABO for the foreign plans is also primarily due to the change in the discount rate from 8.9% to 7.5%. Plan assets for the domestic plans consist principally of deposit administration contracts and an investment contract with an insurance company. Other assets held by the domestic plans not under insurance contracts are invested in equity and fixed income securities. Plan assets for the foreign plans are invested in foreign insurance contracts and foreign equity and fixed income securities. The Cleveland, Ohio area operations have a Guaranteed Continuous Employment Plan covering substantially all employees, which, in general, provides that the Company will provide work for at least 75% of every standard work week (presently 40 hours). This plan does not guarantee employment when the Company's ability to continue normal operations is seriously restricted by events beyond the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTE F--RETIREMENT ANNUITY AND GUARANTEED CONTINUOUS EMPLOYMENT PLANS (Continued) control of the Company. The Company has reserved the right to terminate this plan effective at the end of a calendar year by giving notice of such termination not less than six months prior to the end of such year. In December 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which was effective in 1993 domestically and will be effective for non-U.S. plans in 1995. In November 1992, the Financial Accounting Standards Board issued Statement No. 112, "Employers' Accounting for Postemployment Benefits." The Company is not required to implement this Statement until the first quarter of 1994. These Statements have no impact on the consolidated financial position or results of operations as the Company does not provide for any postretirement or postemployment benefits other than pensions. NOTE G--INDUSTRY AND GEOGRAPHIC SEGMENT INFORMATION Intercompany sales between geographic regions are accounted for at prices comparable to normal, customer sales and are eliminated in consolidation. NOTE H--ACQUISITIONS In June 1993, the Company acquired the outstanding minority interest in its subsidiary in Spain for approximately $8,500. In January and May of 1992, respectively, the Company purchased the remaining 29 percent interest in Lincoln Norweld and a small Mexican company for an aggregate of $37,000. In April 1991, the Company purchased the material assets of the German arc welding business (except orbital welding) of Messer Griesheim GmbH. All the above transactions NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTE H--ACQUISITIONS (Continued) and increases in equity ownership were accounted for as purchases and their results of operations and the increased interest in their results of operations, were included in the consolidated statements of operations from their respective dates of acquisition. NOTE I--FAIR VALUES OF FINANCIAL INSTRUMENTS The Company has various financial instruments, including cash and cash equivalents, forward exchange contracts for currencies, and short and long-term debt. The Company has determined the estimated fair value of these financial instruments by using available market information and appropriate valuation methodologies which require judgment. Accordingly, the use of different market assumptions or estimation methodologies could have a material effect on the estimated fair value amounts. The Company believes the carrying values of their financial instruments approximate their fair value. NOTE J--NOTES RECEIVABLE FROM EMPLOYEES Notes receivable from employees, which currently bear interest at 9%, include $294 ($532 in 1992) from officers of the Company. Loans are limited to 65% of the aggregate value of the pledged stock determined by the current offering price of the stock under the Employees' Stock Purchase Plan. NOTE K--0PERATING LEASES The Company leases sales offices, warehouses, office equipment and data processing equipment. Such leases, some of which are noncancellable, and in many cases, include renewals, expire at various dates. The Company pays most maintenance, insurance and tax expenses relating to leased assets. Rental expense was $9,864 in 1993, $9,840 in 1992 and $6,444 in 1991.

833079_1993.txt

833079_1993

1993

833079

ITEM 1. BUSINESS INTRODUCTION Homeplex Mortgage Investments Corporation (the "Company") seeks to generate income from the Net Cash Flows on Mortgage Assets as described herein consisting of Mortgage Interests (commonly known as "residuals") and Mortgage Instruments. Mortgage Instruments include mortgage loans ("Mortgage Loans") and mortgage certificates representing interests in pools of mortgage loans ("Mortgage Certificates"). Mortgage Interests represent the right to receive the cash flows on Mortgage Instruments. Mortgage Interests which are created through the purchase of interests (which may include interests in REMICs as described herein) in or from entities ("Mortgage Finance Companies") which own or finance Mortgage Instruments. Substantially all of the Company's Mortgage Instruments and the Mortgage Instruments underlying the Company's Mortgage Interests currently secure or underlie mortgage-collateralized bonds ("CMOs" or "Bonds"), mortgage pass-through certificates ("MPCs" or "Pass-Through Certificates") or other mortgage securities (collectively "Mortgage Securities") including Mortgage Securities issued by the Company or by one or more trusts or corporate subsidiaries organized by the Company or by other entities ("Issuers"). The Company's Net Cash Flows result primarily from the difference between (i) the cash flows on Mortgage Instruments (including those securing or underlying various series of Mortgage Securities as described herein) together with reinvestment income thereon and (ii) the amount required for debt service payments on such Mortgage Securities, the costs of issuance and administration of such Mortgage Securities and other borrowing and financing costs of the Company. The revenues received by the Company are derived from the Net Cash Flows received directly by the Company as well as any Net Cash Flows received by subsidiaries of the Company and paid to the Company as dividends and any Net Cash Flows received by trusts in which the Company has a beneficial interest to the extent of distributions to the Company as the owner of such beneficial interest. See "Business -- Operating Policies and Strategies" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The Company is actively considering the pursuit of various activities other than those traditionally pursued by the Company. These activities may include mortgage banking, the purchase of or loans on real estate, the securitization of various real estate assets, and other real estate and mortgage related activities. At this time, the Company has not determined those additional activities, if any, that it will pursue. Any additional activities that the Company pursues will take into account the Company's available capital, the potential risks and rewards, and the requirements applicable to the Company as a real estate investment trust. The Company increases the amount of funds available for its activities with the proceeds of borrowings including borrowings under loan agreements, repurchase agreements and other credit facilities. The Company's borrowings generally are secured by Mortgage Assets owned by the Company. The Company also may increase its funds through the issuance of debt securities and additional equity securities. See "Business -- Operating Policies and Strategies" and "Management's Discussion and analysis of Financial Condition and Results of Operations." The Company is a party to a subcontract (the "Subcontract Agreement") with American Southwest Financial Services, Inc. ("ASFS") pursuant to which ASFS performs certain services for the Company in connection with the structuring, issuance and administration of Mortgage Securities issued by the Company or by any Issuer affiliated with ASFS which issues Mortgage Securities with respect to which the Company acquires Mortgage Interests or owns the underlying Mortgage Instruments. See "Business -- The Subcontract Agreement." ASFS is affiliated with American Southwest Financial Corporation, American Southwest Finance Co., Inc. and Westam Mortgage Financial Corporation (together with their affiliates sometimes referred to as the "ASW Companies"). Other than the Subcontract Agreement, the Company has no affiliations, agreements or relationships with the ASW Companies or ASFS, except as described herein under "Certain Relationships and Related Transactions -- Certain Relationships." The Company was incorporated in the State of Maryland in May 1988 and commenced operations on July 27, 1988. The Company changed its name from Emerald Mortgage Investments Corporation to Homeplex Mortgage Investments Corporation in April 1990. Emerald Mortgage Advisors Limited Partnership (the "Manager") managed the day-to-day operations of the Company subject to the supervision of the Company's Board of Directors pursuant to the terms of a management agreement (the "Management Agreement") from the commencement of the Company's operations through April 30, 1990. On March 1, 1990, the Company gave notice to the Manager of its intention not to renew the Management Agreement on its termination on April 30, 1990. Beginning May 1, 1990, management of the Company assumed the performance of the functions formerly performed for the Company by the Manager. The Company has elected to be taxed as a real estate investment trust ("REIT") pursuant to Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"). The Company generally will not be subject to tax on its income to the extent that it distributes its earnings to stockholders and maintains its qualification as a REIT. See "Business -- Federal Income Tax Considerations." The Internal Revenue Service has sent the Company a Proposed Adjustment of taxes due of $10,890,000 and penalties totaling $2,260,000 for the three years ending December 31, 1991. The Proposed Adjustment does not include any amounts for interest which might be owed by the Company. The IRS claimed that the Company did not meet the statutory requirements to be taxed as a REIT for the three-year period because the Company did not demand certain shareholder information set forth in a regulation under the Internal Revenue Code within the specified 30-day period following each of such years. The information consists of sending standardized request letters to a total of 19 shareholders. The Company has filed a protest with the District Director of the IRS challenging the Proposed Adjustment. The Company believes that it has complied with the requirements to be treated as a REIT and that the Proposed Adjustment is without merit. See "Legal Proceedings" and Note 9 to Consolidated Financial Statements. The Company's Common Stock is listed on the New York Stock Exchange. Unless the context otherwise requires, the term Company means Homeplex Mortgage Investments Corporation and its subsidiaries. Reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations" for certain recent information with respect to the Company. OPERATING POLICIES AND STRATEGIES GENERAL The Company currently generates income primarily from the Net Cash Flows on its Mortgage Assets as described herein. The Company's Net Cash Flows result primarily from the difference between (i) the cash flows on Mortgage Instruments (including those securing or underlying various series of Mortgage Securities as described herein) together with reinvestment income thereon and (ii) the amount required for debt service payments on such Mortgage Securities, the costs of issuance and administration of such Mortgage Securities and other borrowing and financing costs of the Company. Mortgage Interests are created through the purchase of interests (which may include interests in REMICs) in or from Mortgage Finance Companies which own or finance Mortgage Instruments. Mortgage Instruments include Mortgage Certificates and Mortgage Loans, each as more fully described herein. Substantially all of the Company's Mortgage Instruments and the Mortgage Instruments underlying the Company's Mortgage Interests currently secure or underlie Mortgage Securities, including Mortgage Securities issued by the Company or by one or more other Issuers, including subsidiaries of the Company. The Company may seek to increase its Net Cash Flows by purchasing Mortgage Assets both from its equity and from the proceeds of borrowings including borrowings under loan agreements, repurchase agreements and other credit facilities. The Company's borrowings generally are secured by Mortgage Assets owned by the Company. See "Business -- Operating Policies and Strategies -- Capital Resources." Net Cash Flows will be increased through the use of such borrowings if the cost of such borrowings is less than the Net Cash Flows on the Mortgage Assets purchased with or securing such funds. However, a loss could result if the cost of such borrowings increases to the extent that it exceeds the Net Cash Flows of the Mortgage Assets purchased with or securing such funds. In connection with its objective to generate income from the Net Cash Flows on its Mortgage Assets, the Company may acquire Mortgage Interests with respect to Mortgage Instruments securing or underlying Mortgage Securities issued by one or more Issuers, or, alternatively, the Company may transfer or pledge Mortgage Instruments it acquires to one or more Issuers (which may include subsidiaries of the Company), which, in turn, will transfer or pledge their rights in such Mortgage Instruments to secure or underlie Mortgage Securities issued by such Issuers. Mortgage Securities (consisting of Bonds or CMOs and Pass-Through Certificates or MPCs) typically are issued in series. Each such series generally consists of several serially maturing classes secured by or representing interests in Mortgage Instruments. Generally, principal payments received on the Mortgage Instruments securing a series of Bonds or included in the pool underlying a series of Pass-Through Certificates, including prepayments on such Mortgage Instruments, are applied to principal payments on one or more classes of the Bonds or Pass-Through Certificates of such series on each principal payment date for such Bonds or Pass-Through Certificates. Scheduled payments of principal of and interest on the Mortgage Instruments and other collateral securing a series of Bonds or included in the pool underlying a series of Pass-Through Certificates are intended to be sufficient to make timely payments of interest on such Bonds or Pass-Through Certificates and to retire each class of such Bonds or Pass- Through Certificates by its stated maturity or final payment date. Bonds and Pass-Through Certificates differ in certain respects. Bonds are debt instruments of the issuer thereof which are secured by Mortgage Instruments. Pass-Through Certificates represent interests in pools of Mortgage Instruments entitling the holders thereof to receive their share of the payments made on such Mortgage Instruments. The ability of the Company to issue Bonds and Pass- Through Certificates directly or through subsidiaries or trusts established by it is subject to certain limitations imposed by the Code. See "Business -- Federal Income Tax Considerations." The Company is actively considering the pursuit of various activities other than those traditionally pursued by the Company. These activities may include mortgage banking, the purchase of or loans on real estate, the securitization of various real estate assets, and other real estate and mortgage related activities. At this time, the Company has not determined those additional activities, if any, that it will pursue. Any additional activities that the Company pursues will take into account the Company's available capital, the potential risks and rewards, and the requirements applicable to the Company as a REIT. The Company from time to time hedges its borrowings and Mortgage Assets in whole or in part to limit its exposure to changes in interest rates. See "Business -- Operating Policies and Strategies -- Hedging." However, no hedging strategy can completely insulate the Company from such risks. In addition, certain of the federal income tax requirements that the Company must satisfy to qualify as a REIT limit the Company's ability to hedge. In this regard, sudden increases in interest rates could result in unexpected amounts of hedging income which could jeopardize the Company's qualification as a REIT. On the other hand, certain losses incurred in connection with hedging activities may be capital losses and would not offset ordinary REIT income, resulting in "phantom" income (income without cash) on which dividends must be paid. For a description of the Company's current hedging activities, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 7 to the Company's Consolidated Financial Statements. The Company's operations from time to time may generate taxable income in excess of its net income for financial reporting purposes. It also is possible that the Company could experience a situation in which its taxable income is in excess of the actual receipt of Net Cash Flows. See "Business -- Federal Income Tax Considerations -- Activities of the Company." To the extent the Company does not otherwise have funds available, such a situation may result in the Company's inability to distribute 95% of its taxable income as required in order to maintain its REIT status. See "Business -- Federal Income Tax Considerations." In evaluating Mortgage Assets for purchase, the Company considers the anticipated tax effects of the purchase including the possibility of any excess of taxable income over projected cash receipts of Net Cash Flows. The officers of the Company manage the day-to-day operations of the Company, subject to the supervision of the Company's Board of Directors. The Company has entered into a Subcontract Agreement with ASFS pursuant to which ASFS performs certain services for the Company in connection with the issuance and administration of Mortgage Securities issued by the Company or by any Issuer affiliated with ASFS which issues Mortgage Securities with respect to which the Company acquires Mortgage Interests or with respect to which the Company owns the underlying Mortgage Instruments. See "Business -- The Subcontract Agreement." MORTGAGE INSTRUMENTS The Company may purchase Mortgage Instruments, some or all of which may secure or underlie Mortgage Securities, including Mortgage Securities issued by the Company. The types and amounts of Mortgage Instruments which the Company acquires are determined by various factors, including market conditions and the availability of such Mortgage Instruments for purchase and other criteria established from time to time by the Company's Board of Directors. The Company may purchase and retain Mortgage Instruments or may sell such Mortgage Instruments. However, the Company's ability to sell Mortgage Instruments for gain is restricted by the Code and the rules, regulations and interpretations of the Internal Revenue Service thereunder. See "Business -- Federal Income Tax Considerations -- Qualification of the Company as a REIT." The Company may purchase Mortgage Instruments from a variety of sources ("Mortgage Suppliers"). The Mortgage Instruments purchased by the Company and the Mortgage Instruments underlying the Company's Mortgage Interests may be acquired from investment bankers, mortgage bankers, banks, savings and loan associations, home builders, insurance companies and other concerns involved in mortgage finance. The Company does not have any contracts with any Mortgage Suppliers entitling it to purchase Mortgage Instruments in the future, and there can be no assurance that the Company will be able to purchase Mortgage Instruments in the future from any Mortgage Suppliers or that the terms of any such purchases will be favorable to the Company. In addition, there can be no assurance that Mortgage Suppliers will continue to originate Mortgage Instruments in amounts comparable to prior periods or that changes in market conditions or applicable laws will not adversely affect the availability for purchase or purchase terms of certain types of Mortgage Instruments. Mortgage Loans acquired by the Company may be originated by various lenders throughout the United States. Originators may include savings and loan associations, banks, mortgage bankers and other mortgage lenders. In addition to acquiring Mortgage Loans from Mortgage Suppliers, the Company may acquire Mortgage Loans both directly from originators and from entities holding Mortgage Loans originated by others. There are no limits upon the geographic concentration of Mortgage Loans to be acquired by the Company. The Company may acquire Mortgage Loans which comply with the requirements for inclusion in a loan guarantee program sponsored by either the Federal Home Loan Mortgage Corporation ("FHLMC") or the Federal National Mortgage Association ("FNMA") ("Conforming Mortgage Loans") (including mortgage loans ("FHA Loans") insured by the Federal Housing Administration (the "FHA") and mortgage loans ("VA Loans") partially guaranteed by the Department of Veterans Affairs (the "VA")) and Mortgage Loans which do not comply with such requirements or with the requirements for inclusion in a loan guarantee program sponsored by the Government National Mortgage Association ("GNMA") ("Nonconforming Mortgage Loans") as well as Mortgage Interests relating to Conforming Mortgage Loans and Nonconforming Mortgage Loans. In addition to the interest rate risk incurred by the Company before it uses such Mortgage Loans to secure or underlie Mortgage Securities, the Company will be subject to the risks of borrower defaults and hazard losses with respect to any Mortgage Loans that it acquires. These risks should be lessened with respect to the Company's Mortgage Loans to the extent such Mortgage Loans are used to secure or underlie Mortgage Securities, are securitized in the form of Mortgage Certificates or are covered by various forms of mortgage or hazard insurance. It may not be possible or economic, however, for the Company to obtain insurance for all Mortgage Loans which the Company acquires, especially during the period of accumulation prior to the issuance of Mortgage Securities which will be secured by or will represent interests in such Mortgage Loans. In addition, standard hazard insurance may not cover certain types of losses such as those attributable to war, earthquakes or floods. See "Business -- Servicing and Insurance on Mortgage Loans." If the Board of Directors determines that market conditions warrant, the Company may issue commitments ("Commitments") to originators and other sellers of Mortgage Loans which follow policies and procedures which generally comply with FNMA and FHLMC regulations and guidelines and which comply with all applicable federal and state laws and regulations for loans secured by single- family (one-to-four units) residential properties. In addition, Commitments may be issued for Mortgage Certificates. These Commitments will obligate the Company to purchase Mortgage Instruments from the holder of the Commitment for a specific period of time, in a specific aggregate principal amount and bearing a specified interest rate and price. Although the Company may commit to acquire Mortgage Loans prior to funding, all loans are to be fully funded prior to their acquisition by the Company. Following the issuance of Commitments, the Company will be exposed to risks of interest rate fluctuations. See "Business -- Special Considerations." Mortgage Instruments purchased pursuant to Commitments will be purchased at the prices set forth in such Commitments. Such prices will be determined on the basis of certain market criteria as determined from time to time by the Company's Board of Directors including a majority of its Unaffiliated Directors (as defined herein). Mortgage Instruments purchased other than pursuant to Commitments will be purchased at prices determined at the time of purchase in accordance with guidelines established from time to time by the Company's Board of Directors. Such prices will be no less favorable to the Company than are then available from certain nationally recognized dealers in Mortgage Instruments identified by the Company's Board of Directors unless the Board of Directors determines that purchases at higher prices will benefit the Company. The Board of Directors establishes criteria that each Mortgage Instrument must satisfy. The officers of the Company must use such criteria in determining whether to acquire Mortgage Instruments on behalf of the Company. The criteria are subject to change by the Company's Board of Directors. See "Business -- Mortgage Instruments -- The Mortgage Loans." As of December 31, 1993, the Company owned approximately $93,107,000 in principal amount of Mortgage Instruments which have been pledged in a long- term financing transaction. MORTGAGE INTERESTS General The Company may purchase Mortgage Interests commonly known as "residuals" from Mortgage Suppliers. The Company does not have any contracts with any Mortgage Suppliers entitling it to purchase Mortgage Interests in the future, and there can be no assurance that the Company will be able to purchase Mortgage Interests from any Mortgage Suppliers or that the terms of any such purchases will be favorable to the Company. The ability to acquire Mortgage Interests depends upon the volume of issuance of and the market for Mortgage Securities as well as the demand for Mortgage Interests by other prospective purchasers. The Company may find it difficult to acquire Mortgage Interests satisfying its criteria in the event Mortgage Securities are not issued in sufficient quantities or the demand for Mortgage Interests by others increases. There is no limitation as to the amount of Mortgage Interests which the Company may acquire from any person. The Company, through public offerings or privately negotiated transactions, may purchase Mortgage Interests through the purchase of interests in or from Mortgage Finance Companies which own or finance Mortgage Instruments. Such Mortgage Finance Companies may issue Mortgage Securities or pledge or sell Mortgage Instruments which secure or underlie Mortgage Securities. An election to treat any such Mortgage Finance Company or the Mortgage Instruments owned or financed by such Mortgage Finance Company as a real estate mortgage investment conduit ("REMIC") for federal income tax purposes may be made. The Company purchases Mortgage Interests only to the extent that ownership of such Mortgage Interests is consistent with the Company's objective of maximizing income for distribution to its stockholders and maintaining its qualification as a REIT. Mortgage Interests may take any one of a number of forms. The Company may enter into contractual arrangements with Mortgage Finance Companies that entitle it to receive the Net Cash Flows from one or more series of Mortgage Securities. In the alternative, the Company may purchase all or a portion of the equity interest in a Mortgage Finance Company which is a corporation, partnership or trust that has the right to receive the Net Cash Flows from one or more series of Mortgage Securities issued by such Mortgage Finance Company or other Issuer. The Company also may acquire Mortgage Interests that are securities representing the residual interest in the Mortgage Instruments and other collateral pledged to secure or included in the pool underlying a series of Mortgage Securities or that are subordinated to the other classes of such series of Mortgage Securities. The subordination may be for all payment failures on the Mortgage Instruments securing or underlying such series of Mortgage Securities or it may be limited to those resulting from certain types of risks, such as those resulting from war, earthquake or flood, or the bankruptcy of a mortgagor. The subordination may be for the entire amount of the series of Mortgage Securities or may be limited in amount. The market for Mortgage Interests is not extensive, and the Company may not find a ready market for any Mortgage Interests it desires to sell. In addition, the Company's ability to sell Mortgage Interests will be limited by the provisions of the Code. Accordingly, the Company purchases Mortgage Interests for investment purposes only. Publicly offered Mortgage Interests generally are rated by a nationally recognized statistical rating agency. However, the risks of ownership will be substantially the same as the ownership of unrated Mortgage Interests because the rating does not address the possibility that the Company might suffer a lower than anticipated yield or fail to recover its initial investment. Publicly offered Mortgage Interests purchased from FHLMC or FNMA generally are not rated. The Company complies with the following criteria when it purchases a Mortgage Interest: (i) any publicly issued Mortgage Securities secured by or representing interests in Mortgage Instruments owned or financed by the Mortgage Finance Company which created such Mortgage Interest generally will be rated in one of the two highest rating categories accorded Mortgage Securities by at least one nationally recognized statistical rating agency (although, as discussed above, such rating does not provide any assurance as to whether the Company will receive a return on its investment in the related Mortgage Interest) or will be issued by FHLMC or FNMA; (ii) such purchase will not disqualify the Company as a REIT; and (iii) such purchase will not subject the Company to regulation as an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act"). Current Mortgage Interests On July 27, 1988, the Company purchased all of the Mortgage Assets of Capital American Mortgage Investments Limited Partnership ("Capital American"), an Arizona limited partnership. The Mortgage Assets purchased from Capital American entitle the Company to receive the Net Cash Flows on the Mortgage Instruments pledged to secure the following four series of Bonds: (i) the Series 1 Mortgage-Collateralized Bonds issued by Westam Mortgage Financial Corporation ("Westam") (the "Series 1 Bonds" or "Westam 1"), (ii) the Series 3 Mortgage-Collateralized Bonds issued by Westam (the "Series 3 Bonds" or "Westam 3"), (iii) the Series 65 Mortgage-Collateralized Bonds issued by American Southwest Financial Corporation ("ASW") (the "Series 65 Bonds" or "ASW 65") and (iv) the Series 5 Mortgage-Collateralized Bonds issued by Westam (the "Series 5 Bonds" or "Westam 5"). Each of these series of Bonds are CMOs, and an election has been made to treat the Mortgage Instruments and other collateral securing such series of Bonds as REMICs. From July 27, 1988 through October 26, 1988, the Company purchased the residual interest in the REMIC with respect to the Series 17 Multi-Class Mortgage Participation Certificates (Guaranteed) issued by FHLMC ("FHLMC 17") and 20.2% and 45.07%, respectively, of the residual interests in the REMICs with respect to the FNMA REMIC Trust 1988-24 Guaranteed REMIC Pass-Through Certificates ("FNMA 24") and the FNMA REMIC Trust 1988-25 Guaranteed REMIC Pass-Through Certificates ("FNMA 25") issued by FNMA. An election has been made to treat the Mortgage Instruments and other collateral underlying each of the above series of Mortgage Securities as REMICs. The Company has not purchased any additional Mortgage Interests since it purchased 20.20% of the residual interest in the REMIC with respect to FNMA 24 on October 26, 1988. As of December 31, 1993, the Company owned Mortgage Interests with respect to seven separate series of Mortgage Securities with a net amortized cost balance of approximately $17,685,000 (representing the aggregate purchase price paid for such Mortgage Interests less the amount of distributions on such Mortgage Interests received by the Company representing a return of investment). All of the series described above collectively are referred to herein as the "Specified Mortgage Securities." For purposes of the remainder of this section entitled "Acquisition of Mortgage Interests" only, "Bonds," "Pass- Through Certificates," "Mortgage Securities," "Net Cash Flows" and "Mortgage Instruments" refer to the Bonds issued by ASW and Westam, the Pass-Through Certificates issued by FHLMC and FNMA, the Specified Mortgage Securities, the Net Cash Flows generated by the Mortgage Instruments securing or underlying the Specified Mortgage Securities, and the Mortgage Instruments securing or underlying the Specified Mortgage Securities, respectively. Unless otherwise specified, information as to the Specified Mortgage Securities is as of their respective closing dates. The Specified Mortgage Securities were issued during the period from April 29, 1988 through October 26, 1988 in an aggregate original principal amount of $2,700,200,000, and all are collateralized by or represent interests in Mortgage Instruments. Subject to the availability of funding and other factors described herein, the Company may acquire or enter into commitments to acquire additional Mortgage Assets. Any such acquisition would be intended to complement the Net Cash Flows to be received by the Company from the Mortgage Instruments securing or underlying the Mortgage Securities in a manner consistent with the Company's operating policies and strategies. No assurance can be given that the Company will acquire any such Mortgage Assets. See "Operating Policies and Strategies -- Capital Resources" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The Mortgage Instruments Securing or Underlying the Specified Mortgage Securities The Mortgage Instruments pledged as collateral for the Bonds are beneficially owned by the Issuers of such Bonds, and the Company owns the residual interests in the REMICs with respect to the Bonds. The Mortgage Instruments contained in the pools underlying the Pass-Through Certificates are beneficially owned by the holders of the Pass-Through Certificates (including the holders of the residual interests relating thereto), and the Company owns 100%, 20.2% and 45.07% of the residual interest in the REMICs with respect to FHLMC 17, FNMA 24 and FNMA 25, respectively. The Mortgage Instruments securing or underlying the Mortgage Securities consist of mortgage-backed certificates guaranteed by GNMA ("GNMA Certificates"), mortgage participation certificates issued by FHLMC ("FHLMC Certificates") and guaranteed mortgage pass-through certificates issued by FNMA ("FNMA Certificates"). As of December 31, 1993, the GNMA Certificates had an aggregate principal balance of $339,922,000, the FHLMC Certificates had an aggregate principal balance of $111,870,000 and the FNMA Certificates had an aggregate principal balance of $261,670,000. The following table sets forth the remaining principal balances, the weighted average pass-through rates, the weighted average mortgage coupon rates and the weighted average remaining terms to maturity of the Mortgage Instruments pledged as collateral for each series of Bonds or contained in the pool underlying each series of Pass-Through Certificates. The information presented in the table was provided to the Company by the respective Issuer of each series of Mortgage Securities. The Company did not issue such Mortgage Securities and is relying on the respective Issuers regarding the accuracy of the information provided. The prepayment experience on the Mortgage Instruments securing or underlying the Mortgage Securities will significantly affect the average life of such Mortgage Securities because all or a portion of such prepayments will be paid to the holders of the related Mortgage Securities as principal payments on such Mortgage Securities. Prepayments on mortgage loans commonly are measured by a prepayment standard or model. The model used herein (the "Prepayment Assumption Model") is based on an assumed rate of prepayment each month of the unpaid principal amount of a pool of new mortgage loans expressed on an annual basis. 100% of the Prepayment Assumption Model assumes that each mortgage loan underlying a Mortgage Certificate and each Mortgage Loan (regardless of interest rate, principal amount, original term to maturity or geographic location) prepays at an annual compounded rate of 0.2% per annum of its outstanding principal balance in the first month after origination, that this rate increases by an additional 0.2% per annum in each month thereafter until the thirtieth month after origination and in the thirtieth month and in each month thereafter prepays at a constant prepayment rate of 6% per annum. The Prepayment Assumption Model does not purport to be either a historical description of the prepayment experience of any pool of mortgage loans or a prediction of the anticipated rate of prepayment of any pool of mortgage loans, including the mortgage loans underlying the Mortgage Certificates, and there is no assurance that the prepayment of the mortgage loans underlying the Mortgage Certificates or the Mortgage Loans will conform to any of the assumed prepayment rates. The rate of principal payments on pools of mortgage loans is influenced by a variety of economic, geographic, social and other factors. In general, however, Mortgage Instruments are likely to be subject to higher prepayment rates if prevailing interest rates fall significantly below the interest rates on the mortgage loans underlying the Mortgage Certificates or the Mortgage Loans. Conversely, the rate of prepayment would be expected to decrease if interest rates rise above the interest rate on the mortgage loans underlying the Mortgage Certificates or the Mortgage Loans. Other factors affecting prepayment of mortgage loans include changes in mortgagors' housing needs, job transfers, unemployment, mortgagors' net equity in the mortgaged properties, assumability of mortgage loans and servicing decisions. Description of the Specified Mortgage Securities Each series of Bonds constitutes a nonrecourse obligation of the Issuer of such series of Bonds payable solely from the Mortgage Instruments and any other collateral pledged to secure such series of Bonds. All of the Bonds are rated "AAA" by Standard & Poor's Corporation. All of the Bonds have been issued in series pursuant to indentures (the "Indenture") between the Issuer and a bank trustee (the "Trustee") which holds the underlying Mortgage Instruments and other collateral pledged to secure the related series of Bonds. Each series of the Bonds is structured so that the monthly payments on the Mortgage Instruments pledged as collateral for such series of Bonds, together (in certain cases) with reinvestment income on such monthly payments at the rates required to be assumed by the rating agencies rating such Bonds or at the rates provided pursuant to a guaranteed investment contract, will be sufficient to make timely payments of interest on each class of Bonds of such series (each a "Bond Class"), to begin payment of principal on each Bond Class not later than its "first mandatory principal payment date" or "first mandatory redemption date" (as defined in the related Indenture) and to retire each Bond Class no later than its "stated maturity" (as defined in the related Indenture). Each series of Pass-Through Certificates represents beneficial ownership interests in a pool ("Mortgage Pool") of Mortgage Instruments formed by the Issuer thereof and evidences the right of the holders of such Pass-Through Certificates to receive payments of principal and interest at the pass-through rate with respect to the related Mortgage Pool. Pass-Through Certificates issued by FHLMC or FNMA generally are not rated by any rating agency. The Pass-Through Certificates issued by FHLMC have been issued pursuant to an agreement ("Pooling Agreement") which generally provides for the formation of the Mortgage Pool and the performance of administrative and servicing functions. The Pass-Through Certificates issued by FNMA have been issued pursuant to a trust agreement ("Trust Agreement") between FNMA in its corporate capacity and in its capacity as trustee which generally provides for the formation of the Mortgage Pool and the performance of administrative and servicing functions. The Pass-Through Certificates are not obligations of the Issuers thereof. Each series of Pass-Through Certificates is structured so that the monthly payments of principal and interest on the Mortgage Instruments in the Mortgage Pool underlying such series of Pass-Through Certificates are passed through on monthly payment dates to the holders of each class of Pass-Through Certificates of such series (each a "Pass-Through Class") as payments of principal and interest, respectively, and each Pass-Through Class is retired no later than its "final payment date" or "final distribution date" (as defined in the related Pooling Agreement or Trust Agreement, respectively). With respect to FHLMC 17, FHLMC guarantees to each holder of a Pass- Through Certificate that bears interest the timely payment of interest at the applicable interest rate on such Pass-Through Certificates. FHLMC also guarantees to each holder of a Pass-Through Certificate the payment of the principal amount of such holder's Pass-Through Certificates as payments are made on the underlying FHLMC Certificates. Such guarantees, however, do not assure the Company any particular return on its Mortgage Interests with respect to these Mortgage Securities. The FHLMC 17 Pass-Through Certificates have been issued pursuant to agreements between the holders of the Pass- Through Certificates and FHLMC, which holds and administers, or supervises the administration of, the pool of Mortgage Instruments underlying the Pass- Through Certificates. With respect to FNMA 24 and FNMA 25, FNMA is obligated to distribute on a timely basis to the holders of the Pass-Through Certificates required installments of principal and interest and to distribute the principal balance of each Class of Pass-Through Certificate in full no later than its applicable "final distribution date," whether or not sufficient funds are available in the "certificate account" (as defined in the offering circular). The guarantee of FNMA is not backed by the full faith and credit of the United States. The FNMA 24 and FNMA 25 Pass-Through Certificates represent beneficial ownership interests in trusts created pursuant to a Trust Agreement. FNMA is responsible for the administration and servicing of the mortgage loans underlying the FNMA Certificates, including the supervision of the servicing activities of lenders, if appropriate, the collection and receipt of payments from lenders, and the remittance of distributions and certain reports to holders of the Pass-Through Certificates. Interest payments on the Bond Classes and the Pass-Through Classes (together "Classes") are due and payable on specified payment dates, except with respect to principal only or zero coupon Classes ("Principal Only Classes") which do not bear interest and with respect to compound interest Classes ("Compound Interest Classes") as to which interest accrues but generally is not paid until other designated Classes in the same series of Mortgage Securities are paid in full. The payment dates for the Mortgage Securities are monthly. Each Class of Mortgage Securities, except the Principal Only Classes, provides for the payment of interest either at a fixed rate, or at an interest rate which resets periodically based on a specified spread from (i) the arithmetic mean of quotations of the London interbank offered rates ("LIBOR") for one-month Eurodollar deposits, subject to a specified maximum interest rate, (ii) the Monthly Weighted Average Cost of Funds Index for Eleventh District Savings Institutions (the "COF Index"), as published by the Federal Home Loan Bank of San Francisco (the "FHLB/SF"), subject to a specified maximum interest rate or (iii) other indexes specified in the prospectus supplement or offering circular for a series of Mortgage Securities. According to information furnished by the FHLB/SF, the COF Index is based on financial reports submitted monthly to the FHLB/SF by Eleventh District savings institutions and is computed by the FHLB/SF for each month by dividing the cost of funds (interest paid during the month by Eleventh District savings institutions on savings, advances and other borrowings) by the average of the total amount of those funds outstanding at the end of that month and at the end of the prior month, subject to certain adjustments. According to such FHLB/SF information, the COF Index reflects the interest cost paid on all types of funds held by Eleventh District savings institutions, and is weighted to reflect the relative amount of each type of funds held at the end of the particular month. The COF Index has been reported each month since August 1981. Unlike most other interest rate measures, the COF Index does not necessarily reflect current market rates. A number of factors affect the performance of the COF Index which may cause the COF Index to move in a manner different from indices tied to specific interest rates, such as United States Treasury Bills or LIBOR. Because of the various maturities of the liabilities upon which the COF Index is based (which may be more or less sensitive to market interest rates), the COF Index may not necessarily reflect the average prevailing market interest rates on new liabilities of similar maturities. Additionally, the COF Index may not necessarily move in the same direction as market interest rates, because as longer term deposits or borrowings mature and are renewed at prevailing market interest rates, the COF Index is influenced by the differential between the prior rates on such deposits or borrowings and the cost of new deposits or borrowings. Moreover, the COF Index represents the weighted average cost of funds for Eleventh District savings institutions for the month prior to the month in which the COF Index is customarily published, and therefore lags current rates. Movement of the COF Index, as compared to other indices tied to specific interest rates, also may be affected by changes instituted by the FHLB/SF in the method used to calculate the COF Index. Principal payments on each Class of the Mortgage Securities are made on monthly payment dates. Payments of principal generally are allocated to the earlier maturing Classes until such Classes are paid in full. However, in certain series of Mortgage Securities, principal payments on certain Classes are made concurrently with principal payments on other Classes of such series of Mortgage Securities in certain specified percentages (as described in the prospectus supplement or offering circular for such series of Mortgage Securities). In addition, payments of principal on certain Classes (referred to as "SAY," "PAC," "SMRT" or "SPPR" Classes) occur pursuant to a specified repayment schedule to the extent funds are available therefor, regardless of which other Classes of the same series of Mortgage Securities remain outstanding. Each of the Principal Only Classes has been issued at a substantial discount from par value and receives only principal payments. Certain Classes of the Mortgage Securities will be subject to redemption at the option of the Issuer of such series (in the case of FHLMC 17) or upon the instruction of the Company (as the holder of the residual interest in the REMICs with respect to the other Mortgage Securities Classes subject to redemption) on the dates specified herein in accordance with the specific terms of the related Indenture, Pooling Agreement or Trust Agreement, as applicable. Certain Classes which represent the residual interest in the REMIC with respect to a series of Mortgage Securities (referred to as "Residual Interest Classes") generally also are entitled to additional amounts, such as the remaining assets in the REMIC after the payment in full of the other Classes of the same series of Mortgage Securities and any amount remaining on each payment date in the account in which distributions on the Mortgage Instruments securing or underlying the Mortgage Securities are invested after the payment of principal and interest on the related Mortgage Securities and the payment of expenses. The table below sets forth certain information regarding the Mortgage Securities with respect to which the Company owns all or a part of the Mortgage Interest. Net Cash Flows The Net Cash Flows available from the Company's Mortgage Interests are derived principally from three sources: (i) the favorable spread between the interest or pass-through rates on the Mortgage Instruments securing or underlying the Mortgage Securities and the interest or pass-through rates of the Mortgage Securities Classes, (ii) reinvestment income in excess of the assumptions used in pricing the Mortgage Securities, and (iii) any amounts available from prepayments on the Mortgage Instruments securing or underlying the Mortgage Securities that are not necessary for the payments on the Mortgage Securities. The amount of Net Cash Flows generally decreases over time as the Classes are retired. Distributions of Net Cash Flows represent both the return on and the return of the investment on the Mortgage Assets purchased. The principal factors which may be expected to influence Net Cash Flows are as follows: (1) Other factors being equal, Net Cash Flows in each payment period tend to decline over the life of a series of Mortgage Securities, because (a) as normal amortization of principal and principal prepayments occur on the Mortgage Instruments securing or underlying such Mortgage Securities, the principal balances of earlier, lower-yielding Classes of such Mortgage Securities are reduced, thereby resulting in a reduction of the favorable spread between the weighted average interest or pass-through rate on outstanding Classes and the interest or pass-through rates on the Mortgage Instruments securing or underlying such Mortgage Securities and (b) the higher coupon Mortgage Instruments are likely to be prepaid faster, reinforcing the same effect. (2) The rate of prepayments on the Mortgage Instruments securing or underlying a series of Mortgage Securities will significantly affect the Net Cash Flows. Because prepayments shorten the life of the mortgage loans underlying the Mortgage Instruments securing or underlying a series of Mortgage Securities, a higher rate of prepayments normally reduces overall Net Cash Flows. However, with respect to Discount Collateral (as defined herein), without regard to the interest rate payable on Classes of such Mortgage Securities, prepayments will tend to increase Net Cash Flows. The rate of prepayments may be expected to vary over the life of a series of Mortgage Securities, and the timing of prepayments will further affect their significance. The rate of prepayments is affected by mortgage interest rates and other factors. Generally, increases in mortgage interest rates reduce prepayment rates, while decreases in mortgage interest rates increase prepayment rates. Because an important component of Net Cash Flows derives from the spread between the weighted average interest or pass-through rate on the Mortgage Instruments securing or underlying a series of Mortgage Securities and the weighted average interest or pass-through rate on the outstanding classes of such Mortgage Securities Classes, a higher than expected level of prepayments concentrated during the early life of such Mortgage Securities (thereby reducing the weighted average life of the earlier, lower-yielding Classes) has a more negative effect on Net Cash Flows than the same volume of prepayments have at a constant rate over the life of such Mortgage Securities. (3) With respect to Variable Rate Classes of Mortgage Securities, increases in the level of the index on which the interest rate for such Variable Rate Classes are based will increase the interest or pass-through rate payable on Variable Rate Classes and thus reduce or, in some instances, eliminate Net Cash Flows, while decreases in the level of the relevant index will decrease the interest or pass-through rate payable on Variable Rate Classes and thus increase Net Cash Flows. (4) The interest rate at which the monthly cash flow from the Mortgage Instruments securing or underlying a series of Mortgage Securities may be reinvested until payment dates for such Mortgage Securities influences the amount of reinvestment income contributing to the Net Cash Flows unless such reinvestment income is not paid to the owner of the related Mortgage Interest. (5) The administrative expenses of a series of Mortgage Securities (if any) may increase as a percentage of Net Cash Flows as the outstanding balances of the Mortgage Instruments securing or underlying such Mortgage Securities decline, if some of such administrative expenses are fixed. In later years, it can be expected that fixed expenses will exceed the available cash flow. Although reserve funds generally are established to cover such shortfalls, there can be no assurance that such reserves will be sufficient to cover such shortfalls. In addition, although each series of Mortgage Securities (other than FNMA 24 or FNMA 25) generally has an optional redemption provision that allows the Issuer thereof (in the case of FHLMC 17) or the Company (as the holder of the residual interest in the REMICs with respect to the other series of Mortgage Securities) to retire the remaining Classes that are subject to redemption or retirement after a certain date, there can be no assurance that the Issuer or the Company will exercise such options and, in any event, in a high interest rate environment the market value of the remaining Mortgage Instruments securing or underlying the Mortgage Securities may be less than the amount required to retire the remaining outstanding Classes. The Company may be liable for or its return subject to administrative expenses relating to a series of Mortgage Securities if reserves prove to be insufficient. Moreover, any unanticipated liability or expenses with respect to the Mortgage Securities could adversely affect Net Cash Flows. ACQUISITION OF STRIPPED MORTGAGE SECURITIES The Company may acquire Stripped Mortgage Securities as market conditions warrant. Stripped Mortgage Securities provide for the holder to receive interest only, principal only, or interest and principal in amounts that are disproportionate to those payable on the underlying Mortgage Instruments. Payments on Stripped Mortgage Securities are highly sensitive to the rate of prepayments on the mortgage loans included in or underlying the related Mortgage Instruments. In the event of more rapid than anticipated prepayments on such mortgage loans, the rates of return on interests in Stripped Mortgage Securities representing the right to receive interest only or a disproportionately large amount of interest would be likely to decline. Conversely, the rates of return on Stripped Mortgage Securities representing the right to receive principal only or a disproportionate amount of principal would be likely to increase in the event of rapid prepayments. ISSUANCE OF MORTGAGE SECURITIES The issuance of Mortgage Securities as described below depends upon the demand for these securities, the cost of issuing securities, the relative strength of issuers and other market participants active in such securities, rating agency requirements and other factors affecting the structure, cost, rating and benefits of such securities relative to each other and to other investment alternatives. The market for Mortgage Securities has developed rapidly within recent years and continues to generate new structures, issuers, buyers and products. Developments in the market which affect the factors mentioned below or which change the Company's assessment of the market for such securities may cause the Company to revise the financing strategy described herein. Any such revision in strategy would require the approval of the Board of Directors, including a majority of the Unaffiliated Directors. Bonds To the extent consistent with its objective of generating income from the Net Cash Flows on its Mortgage Assets and to the extent consistent with maintaining its REIT status, the Company may issue, itself or through one or more other Issuers, including subsidiaries of the Company or trusts in which the Company is a beneficiary, or may acquire Mortgage Interests with respect to, various series of Bonds secured by collateral which may include Mortgage Instruments, debt service funds, reserve funds, insurance policies, servicing agreements and a master servicing agreement (the "Collateral"). Each series of Bonds will be structured to be fully payable from the principal and interest payments on the Mortgage Instruments (net of applicable servicing, administration and guaranty fees and insurance premiums) securing such series of Bonds, any other collateral required to be pledged as a condition to receiving the desired rating on such series of Bonds, plus, in certain cases, any reinvestment income on the Collateral. In certain cases, series of Bonds may be recourse obligations of the Company or the other Issuer issuing such Bonds, and purchasers of any such Bonds also may look to any other assets of the Company or such Issuer, as applicable, for payments on such Bonds. The Company or other Issuer will seek a rating for each series of publicly issued Bonds in one of the two highest rating categories established by a nationally recognized statistical rating agency. The amount of Collateral or level of credit enhancement which may be required to obtain such a rating for a series of Bonds will depend upon factors such as the type of Mortgage Instruments securing such series of Bonds and the interest rates paid thereon, the geographic concentration of the mortgaged properties securing the mortgage loans included in or underlying such Mortgage Instruments and other criteria established by the rating agency rating such series of Bonds. The greater the amount of Collateral or level of credit enhancement required by the rating agency rating a series of Bonds to obtain the necessary rating, the less capacity the Company will have to raise additional funds through issuing additional Bonds or obtaining short-term secured borrowings and the less ability the Company will have to expand its Mortgage Assets. As a result, it is anticipated that Collateral will be pledged to secure the Bonds of a series only in the amount required to obtain a rating for such Bonds in one of the two highest rating categories of a nationally recognized statistical rating agency. No assurance can be given that the amount of Collateral or level of credit enhancement required by a rating agency to obtain a rating for a series of Bonds may not increase in the future as the result of changes in the requirements of such rating agency. This may adversely affect the ability of the Company or other Issuers to issue Bonds. The Company believes that, under prevailing market conditions, a series of publicly issued Bonds receiving a rating other than in one of the two highest rating categories would require payment of an excessive yield to attract investors. No assurance can be given that the Company or other Issuer will obtain the ratings it plans to seek for its Bonds. The Company may form, acquire or enter into contractual arrangements with one or more Issuers. An Issuer will be structured as a trust or as a corporation. Each Issuer that is structured as a trust will be a single purpose trust with respect to which the Company will be a beneficiary. Each Issuer that is structured as a corporation will be a single purpose corporation and may be a wholly-owned subsidiary of the Company or may deal with the Company on a contractual basis. The Company anticipates that any Issuers organized by the Company will be structured as corporations. The Company may transfer or pledge Mortgage Instruments to an Issuer, which then will pledge such Mortgage Instruments to secure a series of Bonds. It is expected that a series of Bonds issued by any Issuer will not be guaranteed by the Company and the sole recourse of purchasers of such obligations will be limited to the Mortgage Instruments and other collateral pledged to secure their payment and, in certain circumstances, to the other assets of the Issuer. The Company may contribute to any Issuer a demand note in a principal amount and bearing interest at a rate to be determined upon advice of counsel in order to provide credit enhancement with respect to a series of Bonds or to otherwise obtain the desired rating. Following the issuance of Bonds of a series, the proceeds of such series of Bonds either will be distributed to the Company as a beneficiary or sole stockholder of, as the case may be, or pursuant to a contractual arrangement with, the Issuer or will be used to discharge indebtedness incurred to acquire the Mortgage Instruments and other Collateral pledged to secure such series of Bonds. The Issuers may make certain representations and warranties with respect to a series of Bonds including representations and warranties concerning various aspects of the Mortgage Instruments securing such series of Bonds, such as loan-to-value ratios, dollar limitations on amounts loaned and other characteristics of the loans included in or underlying Mortgage Instruments securing such series of Bonds. The Issuer in turn may require similar representations and warranties from the Company with respect to any Mortgage Instruments that the Company pledges or sells to the Issuer to secure such series of Bonds. In making such representations and warranties, the Company may rely on comparable representations and warranties from any Mortgage Supplier from which it acquires Mortgage Instruments. If any representation or warranty is materially breached with respect to any Mortgage Instrument, the Issuer and the Company could be obligated to repurchase or replace such Mortgage Instrument. Pass-Through Certificates The Company may issue itself, or through one or more other Issuers including subsidiaries of the Company or trusts in which the Company is a beneficiary, or may acquire Mortgage Interests with respect to, Pass-Through Certificates. The issuance of Pass-Through Certificates may be undertaken by the Company or subsidiaries or trusts organized by it, however, only if the Board of Directors has received an opinion of counsel or other satisfactory evidence that the issuance of such securities will not cause the Company to fail to qualify for treatment as a REIT under the Code and that the income, if any, realized by the Company in connection with the issuance and sale or acquisition of such mortgage-backed securities will not constitute income from a prohibited transaction under the Code. See "Business -- Federal Income Tax Considerations." The holders of Pass-Through Certificates receive their pro rata share of the principal payments made on the Mortgage Pool underlying such Pass-Through Certificates and interest at a pass-through rate that is specified at the time of offering. The Company may choose to retain part of the undivided interest in the Mortgage Pool underlying such Pass-Through Certificates. The retained interest, if any, also may be subordinated so that, in the event of a loss, payments to certificate holders will be made before the Company receives its payments. Unlike the issuance of Bonds, the issuance of Pass-Through Certificates will not create an obligation of the Company or other Issuer of such Pass-Through Certificates to security holders in the event of a borrower default. However, as in the case of Bonds, the Company or other Issuer may be required to obtain various forms of credit enhancements in order to obtain a rating for a series of Pass-Through Certificates in one of the two highest rating categories established by a nationally recognized statistical rating agency. As with the issuance of Bonds, the Issuer of a series of Pass-Through Certificates may make certain representations and warranties concerning various aspects of the Mortgage Instruments underlying such Pass-Through Certificates. The Issuer in turn may require similar representations and warranties from the Company with respect to any Mortgage Instruments that the Company sells to the Issuer to underlie such series of Pass-Through Certificates. In making such representations and warranties, the Company may rely on comparable representations and warranties from any Mortgage Supplier from which it acquires Mortgage Instruments. If any representation or warranty is materially breached with respect to any Mortgage Instrument, the Issuer and the Company could be obligated to repurchase or replace such Mortgage Instrument. Other Mortgage-Backed Securities The Company may participate in other mortgage-backed securities including long-term structured financings. Long-term structured financings take a number of forms including loan agreements, notes and debentures secured by Mortgage Assets owned by the Company. Long-term structured financings require the payment of fixed or variable interest and scheduled payments of principal from the collateral securing the obligations or from other assets of the Company. Long-term structured financings may be convertible into Common Stock of the Company or may includes warrants to purchase shares of the Company's Common Stock. Costs Various expenses are incurred in connection with the issuance of Mortgage Securities. These may include legal and accounting fees, printing expenses, underwriters' compensation or other sales commissions, expenses of registration or qualification under state and federal securities laws, trustee and servicing fees, rating agency fees and other related costs. If the Company does not issue the Mortgage Securities itself or through a subsidiary or trust established by it, but purchases a Mortgage Interest with respect to Mortgage Instruments which secure or underlie Mortgage Securities, it is anticipated that the Company will not pay such costs directly, but will pay to the Issuer an amount that may include such costs. OTHER OPERATING STRATEGIES In addition to the purchase of Mortgage Assets or the issuance and sale of Mortgage Securities, the Company may originate Mortgage Loans, retain or purchase servicing or excess servicing rights or engage in other similar activities, but only to the extent consistent with its qualification as a REIT. The purchase of excess servicing is subject to many of the same risks as the Company's current activities (see "Business -- Special Considerations"), as well as the general credit of the Servicer and the risk that the Servicer selling such rights could be terminated. The Company also may purchase or sell other assets that behave in a manner similar to its current Mortgage Assets, but are not backed by Mortgage Instruments. The purchase of such assets generally would expose the Company to the general credit of the entity providing the investment. The Company is actively considering the pursuit of various activities other than those traditionally pursued by the Company. These activities may include mortgage banking, the purchase of or loans on real estate, the securitization of various real estate assets, and other real estate and mortgage related activities. At this time, the Company has not determined those additional activities, if any, that it will pursue. Any additional activities that the Company pursues will take into account the Company's available capital, the potential risks and rewards, and the requirements applicable to the Company as a REIT. HEDGING The Company from time to time hedges its Mortgage Assets and indebtedness in whole or in part so as to provide protection from interest rate fluctuations or other market movements. With respect to assets, hedging can be used either to increase the liquidity or decrease the risk of holding an asset by guaranteeing, in whole or in part, the price at which such asset may be disposed of prior to its maturity. With respect to indebtedness, hedging can be used to limit, fix or cap the interest rate on variable interest rate indebtedness. The Company's hedging activities may include the purchase of interest rate cap agreements, the consummation of interest rate swaps, the purchase of Stripped Mortgage Securities, the maintenance of short positions in financial futures contracts, the purchase of put options on such contracts and the trading of forward contracts. For a description of the Company's current hedging activities and the costs associated therewith, see "Management's Discussion and Analysis of Financial Condition and Results of Operations." Certain of the federal income tax requirements that the Company must satisfy to qualify as a REIT may limit the Company's ability to hedge. See "Business -- Federal Income Tax Considerations -- Qualification of the Company as a REIT." Therefore, the Company may be prevented from adequately hedging its Mortgage Assets or indebtedness. In addition, hedging strategies that may not endanger REIT qualification in a slowly rising interest rate environment could jeopardize the Company's REIT qualification in a market in which interest rates rise rapidly. CAPITAL RESOURCES Subject to the terms of the Company's Bylaws, the availability and cost of borrowings, various market conditions and restrictions that may be contained in the Company's financing arrangements from time to time and other factors as described herein, the Company may increase the amount of funds available for its activities with the proceeds of borrowings including borrowings under loan agreements, repurchase agreements and other credit facilities. Subject to the foregoing, the Company's borrowings may bear fixed or variable interest rates, may require additional collateral in the event that the value of existing collateral declines on a market value basis and may be due on demand or upon the occurrence of certain events. Repurchase agreements are agreements pursuant to which the Company sells Mortgage Assets for cash and simultaneously agrees to repurchase such Mortgage Assets on a specified date for the same amount of cash plus an interest component. The Company also may increase the amount of funds available for investment through the issuance of debt securities (including Mortgage Securities). In general, the Company may make use of short-term borrowings to provide funds for the purchase of Mortgage Assets when it is able to borrow at interest rates lower than the yields expected to be earned on the Mortgage Assets to be purchased with such funds. The Company also may incur such short-term borrowings in accumulating sufficient Mortgage Instruments to support the periodic issuance of Mortgage Securities. In such cases, the proceeds received from the issuance of any Mortgage Securities may be used to repay all or a portion of the Company's short-term borrowings. If borrowing costs are higher than the yields on the Mortgage Assets purchased with such funds, the Company's ability to acquire Mortgage Assets may be substantially reduced and it may experience losses. A substantial portion of the assets of the Company are pledged to secure indebtedness incurred by the Company. Accordingly, such assets will not be available for distribution to the stockholders of the Company in the event of the Company's liquidation except to the extent that the value of such assets exceeds the amount of such indebtedness. On December 17, 1992, a wholly owned, limited-purpose subsidiary of the Company issued $31,000,000 of Secured Notes under an Indenture to several institutional investors. The Secured Notes bear interest at 7.81% per annum which is payable quarterly. Scheduled principal repayments are $1,532,000 per quarter during the first four quarters, $991,000 per quarter for the next 12 quarters, $901,000 per quarter for the next eight quarters and $721,000 per quarter thereafter through February 15, 2001. The Secured Notes are secured by the Company's Mortgage Assets with respect to Westam 1, Westam 3, Westam 5, ASW 65, FNMA 1988-24 and FNMA 1988-25 and by a reserve fund in an initial amount of $3,100,000 with a specified maximum amount of $7,750,000. The reserve fund will be used to make the scheduled principal and interest payments on the Secured Notes if the cash flow available from the pledged Mortgage Assets is not sufficient to make the scheduled payments. Under the Indenture, the cash flow from the Mortgage Assets pledged to secure the Secured Notes is used to make payments of interest and scheduled principal on the Secured Notes and to pay expenses in connection therewith. Any excess cash flow will be applied to prepay the Secured Notes at par or to increase the reserve fund up to its $7,750,000 maximum amount or will be remitted to the Company, in each case depending on the level of certain specified financial ratios set forth in the Indenture. The Company used the proceeds from the issuance of the Secured Notes to repay a term loan, to repay its short-term borrowings under a repurchase agreement, to establish the reserve fund and for working capital. The Company's Bylaws provide that it may not incur indebtedness if, after giving effect to the incurrence thereof, aggregate indebtedness (other than Mortgage Securities and any loans between the Company and its trusts or corporate subsidiaries), secured and unsecured, would exceed 300% of the Company's net assets, on a consolidated basis, unless approved by a majority of the Unaffiliated Directors. For this purpose, the term "net assets" means the total assets (less intangibles) of the Company at cost, before deducting depreciation or other non-cash reserves, less total liabilities, as calculated at the end of each quarter in accordance with generally accepted accounting principles. The Company in the future may increase its capital resources by making additional offerings of its Common Stock or securities convertible into Common Stock. The effect of such offerings may be the dilution of the equity of stockholders of the Company or the reduction of the market price of shares of the Company's Common Stock, or both. The Company is unable to estimate the amount, timing or nature of future sales of its Common Stock as such sales will depend upon the Company's need for additional funds, market conditions and other factors. EMPLOYEES The Company currently has three full time salaried employees. THE SUBCONTRACT AGREEMENT The Company and ASFS are parties to the Subcontract Agreement pursuant to which ASFS has agreed to perform certain services for the Company in connection with the structuring, issuance and administration of Mortgage Securities issued by the Company or by any Issuer affiliated with ASFS with respect to which the Company acquires Mortgage Interests. Under the Subcontract Agreement, ASFS will charge for any series of CMOs an issuance fee of .1% of the principal amount for such series, generally subject to a minimum fee of $10,000 and a maximum fee of $100,000, and for any series of Pass- Through Certificates an issuance fee not to exceed .125% of the principal amount of such series. In addition, ASFS will charge the Company or such Issuer an administration fee for each series of CMOs equal to a maximum of $20,000 per year and for any series of Pass-Through Certificates an administration fee equal to up to .025% of the amount of the series outstanding at the beginning of each year. The Subcontract Agreement had an initial term expiring on December 31, 1989 and continuing from year to year thereafter until terminated by the parties. The Subcontract Agreement may be terminated by either party upon six months prior written notice. In addition, the Company has the right to terminate the Subcontract Agreement upon the happening of certain specified events, including a breach by ASFS of any provision contained in the Subcontract Agreement. ASFS is a privately-held Arizona corporation which is indirectly beneficially owned by the Class A shareholders of American Southwest Financial Corporation and American Southwest Finance Co., Inc. Based on reports received by the Company from ASFS, ASFS received administration fees of $294,000 for the year ended December 31, 1989, $286,000 for the year ended December 31, 1990, $235,000 for the year ended December 31, 1991, $227,000 for the year ended December 31, 1992 and $201,000 for the year ended December 31, 1993. Based on reports received by the Company from ASFS, ASFS received issuance fees of $450,000 for the period from July 27, 1988 through December 31, 1988 but did not receive any issuance fees in the years ended December 31, 1989, December 31, 1990, December 31, 1991, December 31, 1992 or December 31, 1993. Pursuant to the Subcontract Agreement, ASFS will not assume any responsibility other than to render the services called for therein. ASFS and its directors, officers, stockholders and employees will not be liable to the Company or any of its directors or stockholders for any acts or omissions by ASFS, its directors, officers, stockholders or employees under or in connection with the Subcontract Agreement, except by reason of acts constituting bad faith, willful misconduct, gross negligence or reckless disregard of their duties under the Subcontract Agreement. SPECIAL CONSIDERATIONS MARKET RISKS General The results of the Company's operations are affected by various factors, most of which are beyond the control of the Company. The results of the Company's operations depend, among other things, on the level of Net Cash Flows generated by the Company's Mortgage Assets. The Company's Net Cash Flows vary primarily as a result of changes in mortgage prepayment rates, short-term interest rates, reinvestment income and borrowing costs, all of which involve various risks and uncertainties as set forth below. Prepayment rates, interest rates, reinvestment income and borrowing costs depend upon the nature and terms of the Mortgage Assets, the geographic location of the properties securing the mortgage loans included in or underlying the Mortgage Assets, conditions in financial markets, the fiscal and monetary policies of the United States Government and the Board of Governors of the Federal Reserve System, international economic and financial conditions, competition and other factors, none of which can be predicted with any certainty. Because interest rates significantly affect the Company's activities, the operating results of the Company depend, in large part, upon the ability of the Company to utilize appropriate strategies to maximize returns to the Company while attempting to minimize risks. See "Business -- Special Considerations -- Market Risks -- Interest Rate Fluctuation Risks," "Business -- Special Considerations -- Ability of the Company to Acquire Mortgage Assets," "Management's Discussion and Analysis of Financial Conditions and Results of Operations -- General" and "Business -- Operating Policies and Strategies -- Mortgage Interests -- Net Cash Flows." To the extent that the Company's Mortgage Instruments or the Mortgage Instruments underlying the Company's Mortgage Interests secure or underlie Mortgage Securities, the projected rates of return to the Company on such Mortgage Assets will be based upon assumed constant levels of prepayments on the mortgage loans included in or underlying such Mortgage Instruments, assumed rates of interest or pass-through rates on such Mortgage Securities that bear variable interest or pass-through rates, and assumed rates of reinvestment income and expenses with respect to such Mortgage Securities. The actual levels of interest or pass-through rates on Mortgage Securities bearing variable interest or pass-through rates, prepayment rates, reinvestment income and administration expenses will affect the level of the Company's Net Cash Flows. To the extent that the assumptions employed by the Company vary from actual experience, the actual Net Cash Flows received by the Company may vary significantly from those projected by the Company as to timing and amount over the lives of such Mortgage Securities and from one period to another, and such returns could be negative under certain circumstances. The Company's Net Cash Flows on such Mortgage Assets also may be affected by the cost and availability of credit enhancement devices (such as overcollateralization, primary mortgage insurance, mortgage pool insurance, special hazard insurance and guaranteed investment contracts) necessary to obtain the desired rating on such Mortgage Securities. Prepayment Risks Mortgage prepayment rates vary from time to time and may cause declines in the amount and duration of the Company's Net Cash Flows. Prepayments of fixed- rate mortgage loans included in or underlying Mortgage Instruments generally increase when then current mortgage interest rates fall below the interest rates on the fixed-rate mortgage loans included in or underlying such Mortgage Instruments. Conversely, prepayments of such mortgage loans generally decrease when then current mortgage interest rates exceed the interest rates on the mortgage loans included in or underlying such Mortgage Instruments. See "Business -- Special Considerations -- Market Risks -- Interest Rate Fluctuation Risks." Prepayment experience also may be affected by the geographic location of the mortgage loans included in or underlying Mortgage Instruments, the types (whether fixed or adjustable rate) and assumability of such mortgage loans, conditions in the mortgage loan, housing and financial markets, and general economic conditions. In general, without regard to the interest or pass-through rates payable on classes of a series of Mortgage Securities, prepayments on Mortgage Instruments bearing a net interest rate higher than or equal to the highest interest rate on the series of Mortgage Securities secured by or representing interests in such Mortgage Instruments ("Premium Mortgage Instruments") will have a negative impact on the Net Cash Flows of the Company because such principal payments eliminate or reduce the principal balance of the Premium Mortgage Instruments upon which premium interest was earned. Conversely, prepayments on Mortgage Instruments bearing a lower net interest rate than the highest interest rate on the series of Mortgage Securities secured by or representing interests in such Mortgage Instruments ("Discount Mortgage Instruments") will have a positive impact on the Net Cash Flows of the Company because such principal prepayments will be greater than the principal amount of Mortgage Securities supported by such Discount Mortgage Instruments. Net Cash Flows on Mortgage Instruments securing or underlying a series of Mortgage Securities also tend to decline over the life of such Mortgage Securities because the classes of such Mortgage Securities with earlier stated maturities or final payment dates tend to have lower interest rates. In addition, because an important component of the Net Cash Flows on Mortgage Instruments securing or underlying a series of Mortgage Securities derives from the spread between the weighted average interest rate on such Mortgage Instruments and the weighted average interest or pass-through rate on the outstanding amount of such Mortgage Securities, a given volume of prepayments concentrated during the early life of a series of Mortgage Securities would reduce the weighted average lives of the earlier maturing classes of such Mortgage Securities bearing lower interest or pass-through rates. Thus, an early concentration of prepayments would be more likely to have a negative impact on the Net Cash Flows of the Company than the same volume of prepayments at a constant rate over the life of a series of Mortgage Securities. Mortgage prepayments also shorten the life of the Mortgage Instruments securing or underlying Mortgage Securities, thereby generally reducing overall Net Cash Flows and causing an inherent decline in the Company's income as described under "Business -- Special Considerations -- Risks of Decline in Net Cash Flows." No assurance can be given as to the actual prepayment rate of mortgage loans included in or underlying the Mortgage Instruments in which the Company has an interest. Interest Rate Fluctuation Risks Changes in interest rates affect the performance of the Company and its Mortgage Assets. A portion of the Mortgage Securities secured by the Company's Mortgage Instruments and a portion of the Mortgage Securities with respect to which the Company holds Mortgage Interests bear variable interest or pass- through rates based on short-term interest rates (primarily LIBOR). As of December 31, 1993, $119,660,000 of the $561,200,000 of the Company's proportionate share of Outstanding Mortgage Securities associated with the Company's Mortgage Assets consisted of variable interest rate Mortgage Securities. Consequently, changes in short-term interest rates significantly influence the Company's net income. Increases in short-term interest rates increase the interest cost on variable rate Mortgage Securities and, thus, tend to decrease the Company's Net Cash Flows. Conversely, decreases in short-term interest rates decrease the interest cost on the variable rate Mortgage Securities and, thus, tend to increase the Company's Net Cash Flows. As stated above, increases in mortgage interest rates generally tend to increase the Company's Net Cash Flows by reducing mortgage prepayments, and decreases in mortgage interest rates generally tend to decrease the Company's Net Cash Flows by increasing mortgage prepayments. Therefore, the negative impact on the Company's Net Cash Flows of an increase in short-term interest rates generally will be offset in whole or in part by a corresponding increase in mortgage interest rates while the positive impact on the Company's Net Cash Flows of a decrease in short-term interest rates generally will be offset in whole or in part by a corresponding decrease in mortgage interest rates. See "Business -- Special Considerations - -- Market Risks -- Prepayment Risks." However, although short-term interest rates and mortgage interest rates normally change in the same direction and therefore generally offset each other as described above, they may not change proportionally or may even change in opposite directions during a given period of time (as occurred during portions of 1989) with the result that the adverse effect from an increase in short-term interest rates may not be offset to a significant extent by a favorable effect on prepayment experience and visa versa. Thus, the net effect of changes in short-term and mortgage interest rates may vary significantly between periods resulting in significant fluctuations in Net Cash Flows. Changes in interest rates also affect the Company's reinvestment income. See "Business -- Special Considerations -- Market Risks -- Reinvestment Income and Expense Risks." Changes in interest rates after the Company acquires Mortgage Assets can result in a reduction in the value of such Mortgage Assets and could result in losses in the event of a sale. See "Business -- Special Considerations -- Ability of the Company to Acquire Mortgage Assets." To the extent consistent with its election to qualify as a REIT, the Company from time to time utilizes hedging techniques to mitigate against fluctuations in market interest rates. However, no hedging strategy can completely insulate the Company from such risks, and certain of the federal income tax requirements that the Company must satisfy to qualify as a REIT severely limit the Company's ability to hedge. Even hedging strategies permitted by the federal income tax laws could result in hedging income which, if excessive, could result in the Company's disqualification as a REIT for failing to satisfy certain REIT income tests. See "Business -- Federal Income Tax Considerations -- Qualification of the Company as a REIT." In addition, hedging involves transaction costs, and such costs increase dramatically as the period covered by the hedging protection increases. Therefore, the Company may be prevented from effectively hedging its investments. See "Business -- Operating Policies and Strategies -- Hedging." No assurances can be given as to the amount or timing of changes in interest rates or their effect on the Company's Mortgage Assets or income therefrom. Reinvestment Income and Expense Risks In the event that actual reinvestment rates decrease over the term of a series of Mortgage Securities, reinvestment income will be reduced, which in turn will adversely affect the Company's Net Cash Flows. As a result of the issuance by the Company of any Mortgage Securities or the acquisition of Mortgage Interests with respect to Mortgage Securities, the Company may be liable for or its return may be subject to the expenses relating to such Mortgage Securities including administrative, trustee, legal and accounting costs and, in certain cases, for any liabilities under indemnifications granted to the underwriters, trustees or other Issuers. These expenses are used in projecting Net Cash Flows; however, to the extent that these expenses are greater than those assumed, such Net Cash Flows will be adversely affected. Moreover, in later years, Mortgage Instruments securing or underlying a series of Mortgaged Securities may not generate sufficient cash flows to pay all of the expenses incident to such Mortgaged Securities. Although reserve funds generally are established to cover such future expenses, there can be no assurance that such reserves will be sufficient. In addition, the Company may be liable for the amount of the obligations represented by any Mortgage Securities issued by it. No assurance can be given as to the actual reinvestment rates or the actual expenses incurred with respect to such Mortgage Securities. Borrowing Risks Subject to the terms of the Company's Bylaws, the availability and cost of borrowings, various market conditions, restrictions that may be contained in the Company's financing arrangements from time to time and other factors, the Company increases the amount of funds available for its activities with funds from borrowings including borrowings under loan agreements, repurchase agreements and other credit facilities. The Company's borrowings generally are secured by Mortgage Assets owned by the Company. The Company's borrowings may bear fixed or variable interest rates, may require additional collateral in the event that the value of existing collateral declines on a market value basis and may be due on demand or upon the occurrence of certain events. To the extent that the Company's borrowings bear variable interest rates, changes in short-term interest rates will significantly influence the cost of such borrowings and could result in losses in certain circumstances. See "Business - -- Special Considerations -- Market Risks -- Interest Rate Fluctuation Risks." The Company also may increase the amount of its available funds through the issuance of debt securities. The income available for distribution to stockholders will be increased by using borrowings to purchase Mortgage Assets if the costs of such borrowings are less than the Net Cash Flows on such Mortgage Assets. The Company's Bylaws limit borrowings, excluding the liability represented by CMOs, to no more than 300% of the amount of its Average Invested Assets (as described herein) unless borrowings in excess of that amount are approved by a majority of the Unaffiliated Directors (as defined herein). See "Business -- Operating Policies and Strategies -- Capital Resources." If, after the Company purchases Mortgage Assets utilizing borrowed funds, the cost of such borrowings increases to the extent that such cost exceeds the Net Cash Flows on such Mortgage Assets, such an increase would reduce the income available for distribution to stockholders and could result in losses in certain circumstances. No assurance can be given as to the cost or continued availability of any such borrowings by the Company. As of December 31, 1993, the Company's long-term debt represented by its Secured Notes (as described herein) totalled $19,926,000 or 89.05% of stockholders' equity. No assurance can be given as to the actual effect of borrowings by the Company. Inability to Predict Effects of Market Risks Because none of the above factors including changes in prepayment rates, interest rates, reinvestment income, expenses and borrowing costs are susceptible to accurate projection, the Net Cash Flows generated by the Company's Mortgage Assets cannot be predicted. DECLINE IN NET CASH FLOWS The Company's income derives primarily from the Net Cash Flows received on its Mortgage Assets. The rights to receive such Net Cash Flows ("Net Cash Flow Interests") result from the Company's ownership of Mortgage Instruments and Mortgage Interests with respect to Mortgage Instruments. Because the Company's Net Cash Flows derive principally from the difference between the cash flows on the Mortgage Instruments underlying Mortgage Securities and the required cash payments on the Mortgage Securities, Net Cash Flows are the greatest in the years immediately following the purchase of Mortgage Assets and decline over time unless the Company reinvests its Net Cash Flows in additional Mortgage Assets. This decline in Net Cash Flows over time occurs as (i) interest rates on Mortgage Securities classes receiving principal payments first generally are lower than those on later classes thus effectively increasing the relative interest cost of the Mortgage Securities over time and (ii) mortgage prepayments on Mortgage Instruments with higher interest rates tend to be higher than on those with lower interest rates thus effectively lowering the relative interest income on the Mortgage Instruments over time. See "Business -- Operating Policies and Strategies -- Mortgage Interests -- Net Cash Flows." ABILITY OF THE COMPANY TO ACQUIRE MORTGAGE ASSETS The Company does not have any contracts with any Mortgage Suppliers entitling it to purchase Mortgage Assets in the future, and there can be no assurance that the Company will be able to purchase additional Mortgage Assets from any Mortgage Suppliers. In addition, there can be no assurance that the volume of origination of Mortgage Instruments and issuance of Mortgage Securities and the demand therefor by prospective purchasers will be in amounts comparable to prior periods or that changes in market conditions or applicable laws will not adversely affect the availability for purchase of certain types of Mortgage Assets. See "Business -- Operating Policies and Strategies -- Mortgage Instruments" and "Business -- Operating Policies and Strategies -- Mortgage Interests." The ability to acquire Mortgage Interests depends upon the volume of issuance of and the market for Mortgage Securities as well as the demand for Mortgage Interests by prospective purchasers. It may be difficult to acquire Mortgage Interests satisfying desired criteria in the event Mortgage Securities are not issued in sufficient quantities or the demand for Mortgage Interests by others increases. In the event that the Company is unable to purchase Mortgage Assets from Mortgage Suppliers on terms favorable to the Company, the Company may be unable to otherwise acquire Mortgage Assets, issue Mortgage Securities, purchase interests with respect to Mortgage Securities or otherwise profitably utilize its funds including borrowed funds, funds raised by the sale of securities and funds generated on a monthly basis as a result of principal payments on the Company's Mortgage Assets. In such event, the returns available to the Company's stockholders could be adversely affected. See "Business -- Special Considerations -- Decline in Net Cash Flows." CERTAIN OTHER RISKS IN ACQUIRING MORTGAGE ASSETS In general, the Company has purchased Mortgage Instruments simultaneously with or within a short time prior to the issuance of the Mortgage Securities to be secured by or which represent interests in such Mortgage Instruments. However, to the extent that the Company accumulates Mortgage Instruments, the Mortgage Instruments so acquired will yield less than prevailing market rates if market interest rates increase subsequent to the acquisition of such Mortgage Instruments. Consequently, such Mortgage Instruments may have a market value that is less than their outstanding principal amounts. In such event, the Company may be required to provide additional Mortgage Instruments to secure or underlie such Mortgage Securities which may reduce the Company's capacity to raise funds through the issuance of Mortgage Securities secured by or representing interests in such Mortgage Instruments and the potential expansion of its Mortgage Assets. The Company also may be required to sell Mortgage Instruments at a one-time loss or to retain such Mortgage Instruments until market conditions change, resulting in an interest rate return to the Company below prevailing market yields or subjecting the Company to interest rate risks and the possibility of economic loss. The Company may be subject to risks of borrower defaults and hazard losses with respect to any Mortgage Loans that it acquires. These risks should be lessened to the extent such Mortgage Loans are used to secure or underlie Mortgage Securities, are securitized in the form of Mortgage Certificates or are covered by various forms of mortgage or hazard insurance. It may not be possible or economic, however, for the Company to obtain insurance for all Mortgage Loans which the Company acquires. No assurance can be given that any such mortgage or hazard insurance will adequately cover a loss suffered by the Company. In addition, standard hazard insurance may not cover certain types of losses such as those attributable to war, earthquakes or floods. See "Business - -- Operating Policies and Strategies -- Mortgage Instruments." The risks of borrower default and hazard losses are particularly inherent in any Mortgage Interests which are subordinated as to such losses. It is anticipated that any such Mortgage Interests acquired by the Company will be limited in amount and bear yields which the Company believes are commensurate with the risks involved. PLEDGED ASSETS Substantially all of the Company's Mortgage Assets and the Net Cash Flows therefrom currently are and in the future can be expected to be pledged to secure or underlie Mortgage Securities, bank borrowings, repurchase agreements or other credit arrangements. Therefore, such Mortgage Assets and Net Cash Flows will not be available to the stockholders in the event of the liquidation of the Company except to the extent that the market value thereof exceeds the amounts due to the senior creditors. However, the market value of the Mortgage Assets is uncertain because the market for Mortgage Assets of the type owned by the Company is not well developed and fluctuates rapidly as the result of numerous market factors (including interest rates and prepayment rates) as well as the supply of and demand for such assets. COMPETITION In purchasing Mortgage Assets and in issuing Mortgage Securities, the Company competes with other REITs, investment banking firms, savings and loan associations, banks, mortgage bankers, insurance companies, other lenders, GNMA, FHLMC and FNMA and other entities purchasing Mortgage Assets or issuing Mortgage Securities, many of which have greater financial resources than the Company. MARKET PRICE OF COMMON STOCK The market price of the Company's Common Stock has been and may be expected to continue to be extremely sensitive to a wide variety of factors including the Company's income or dividend payments, actual or perceived changes in short-term and mortgage interest rates and their relationship to each other, actual or perceived changes in mortgage prepayment rates, and any variation between the net yield on the Company's Mortgage Assets and prevailing market interest rates. Any actual or perceived unfavorable changes in the Company's income or dividend payments, interest rates, mortgage prepayment rates, variations in the yield on the Company's Mortgage Assets and prevailing interest rates or other factors resulting from the circumstances described herein or other circumstances may adversely affect the market price of the Company's Common Stock. FUTURE OFFERINGS OF COMMON STOCK The Company in the future may increase its capital resources by making additional offerings of its Common Stock or securities convertible into its Common Stock. The actual or perceived effect of such offerings may be the dilution of the book value or earnings per share of the Company's Common Stock which may result in the reduction of the market price of the Company's Common Stock. The Company anticipates that it will make additional offerings of its Common Stock although it is unable to estimate the amount, timing or nature of future sales of its Common Stock as such sales will depend upon market conditions and other factors such as its need for additional equity, its ability to apply or invest the proceeds of such sales of its Common Stock, the terms upon which its Common Stock could be sold, and any restrictions on its ability to sell its Common Stock contained in any credit facility or other agreements. POTENTIAL CONFLICTS OF INTEREST The Company's Articles of Incorporation limit the liability of its directors and officers to the Company and its stockholders to the fullest extent permitted by Maryland law, and both the Company's Articles and Bylaws provide for indemnification of the directors and officers to such extent. See "Directors and Executive Officers of the Registrant -- Directors and Executive Officers." In addition, the Subcontract Agreement limits the responsibilities of ASFS and provides for the indemnification of ASFS, its affiliates and their directors and officers against various liabilities. See "Business -- The Subcontract Agreement." Counsel to the Company has furnished, and in the future may furnish, legal services to certain Issuers (including those affiliated with ASFS), certain Mortgage Suppliers and certain Mortgage Finance Companies. There is a possibility that in the future the interests of certain of such parties may become adverse, and counsel may be precluded from representing one or all of such parties. If any situation arises in which the interests of the Company appear to be in conflict with those of others, additional counsel may be retained by one or more of the parties. CERTAIN CONSEQUENCES OF AND FAILURE TO MAINTAIN REIT STATUS In order to maintain its qualification as a REIT for federal income tax purposes, the Company must continually satisfy certain tests with respect to the sources of its income, the nature and diversification of its assets, the amount of its distributions to stockholders and the ownership of its stock. See "Business -- Federal Income Tax Considerations -- Status of the Company as a REIT" and "Business -- Federal Income Tax Considerations -- Qualification of the Company as a REIT." Among other things, these restrictions may limit the Company's ability to acquire certain types of assets that it otherwise would consider desirable, limit the ability of the Company to dispose of assets that it has held for less than four years if the disposition would result in gains exceeding specified amounts, limit the ability of the Company to engage in hedging transactions that could result in income exceeding specified amounts, and require the Company to make distributions to its stockholders at times that the Company may deem it more advantageous to utilize the funds available for distribution for other corporate purposes (such as the purchase of additional assets or the repayment of debt) or at times that the Company may not have funds readily available for distribution. The Company's operations from time to time generate taxable income in excess of its net income for financial reporting purposes. The Company also may experience a situation in which its taxable income is in excess of the actual receipt of Net Cash Flows. See "Business -- Federal Income Tax Considerations -- Activities of the Company." To the extent that the Company does not otherwise have funds available, either situation may result in the Company's inability to distribute substantially all of its taxable income as required to maintain its REIT status. See "Business -- Federal Income Tax Considerations." Alternatively, the Company may be required to borrow funds to make the required distributions which could have the effect of reducing the yield to its stockholders, to sell a portion of its assets at times or for amounts that are not advantageous, or to distribute amounts that represent a return of capital which would reduce the equity of the Company. In evaluating mortgage assets for purchase, the Company considers the anticipated tax effects of the purchase including the possibility of any excess of taxable income over projected cash receipts. In 1993, the Internal Revenue Service sent the Company a Proposed Adjustment of taxes due of $10,890,000 and penalties totaling $2,260,000 for the three years ending December 31, 1991. The Proposed Adjustment did not include any amounts for interest which might be owed by the Company. The IRS claimed that the Company did not meet the statutory requirements to be taxed as a REIT for the three-year period because the Company did not demand certain shareholder information set forth in a regulation under the Internal Revenue Code within the specified 30-day period following each of such years. The requirement consists of making standardized requests to a total of 19 shareholders. The Company has filed a protest with the District Director of the IRS challenging the Proposed Adjustment. The Company believes that it has complied with the requirements to be treated as a REIT and that the Proposed Adjustment is without merit. See "Legal Proceedings" and Note 9 to the Consolidated Financial Statements. If the Company should not qualify as a REIT in any tax year, it would be taxed as a regular domestic corporation and, among other consequences, distributions to the Company's stockholders would not be deductible by the Company in computing its taxable income. Any such tax liability could be substantial and would reduce the amount of cash available for distributions to the Company's stockholders. See "Business -- Federal Income Tax Considerations." In addition, the unremedied failure of the Company to be treated as a REIT for any one year would disqualify the Company from being treated as a REIT for the four subsequent years. EXCESS INCLUSIONS A portion of the dividends paid by the Company constitutes unrelated business taxable income to certain otherwise tax-exempt stockholders, will constitute a floor for the taxable income of stockholders not exempt from tax, and will not be eligible for any reduction (by treaty or otherwise) in the rate of income tax withholding in the case of nonresident alien stockholders. The portion of the Company's dividends subject to such treatment is the stockholder's allocable share of that portion of the Company's "excess inclusions" that exceeds the Company's REIT Taxable Income as described herein (excluding net capital gain). Generally, excess inclusions are the excess of the quarterly net income from a residual interest in a REMIC over the product of the adjusted issue price of the residual interest and 120% of the applicable long-term federal rate. In addition, to the extent provided in Treasury Regulations, all the income from a residual interest in a REMIC may constitute excess inclusions if that residual interest does not have significant value. The portion of the Company's dividends that constitutes excess inclusions typically will rise as the degree of leveraging of the Company's activities increases. Additionally, excess inclusion income cannot be offset by net operating losses generated by the Company and therefore may set a minimum taxable income amount for the Company. This amount would be subject to the same REIT distribution requirements, even if cash was unavailable. See "Business -- Federal Income Tax Considerations -- Tax Consequences of Common Stock Ownership -- Excess Inclusion Rule." MARKETABILITY OF SHARES OF COMMON STOCK AND RESTRICTIONS ON OWNERSHIP The Company's Articles of Incorporation prohibit ownership of its Common Stock by tax-exempt entities that are not subject to tax on unrelated business taxable income and by certain other persons (collectively "Disqualified Organizations"). Such restrictions on ownership exist so as to avoid imposition of a tax on a portion of the Company's income from excess inclusions. Provisions of the Company's Articles of Incorporation also are designed to prevent concentrated ownership of the Company which might jeopardize its qualification as a REIT under the Code. Among other things, these provisions provide (i) that any acquisition of shares that would result in the disqualification of the Company as a REIT under the Code will be void, and (ii) that in the event any person acquires, owns or is deemed, by operation of certain attribution rules set out in the Code, to own a number of shares in excess of 9.8% of the outstanding shares of the Company's Common Stock ("Excess Shares"), the Board of Directors, at its discretion, may redeem the Excess Shares. In addition, the Company may refuse to effectuate any transfer of Excess Shares and certain stockholders, and proposed transferees of shares, may be required to file an affidavit with the Company setting forth certain information relating, generally, to their ownership of the Company's Common Stock. These provisions may inhibit market activity and the resulting opportunity for the Company's stockholders to receive a premium for their shares that might otherwise exist if any person were to attempt to assemble a block of shares of the Company's Common Stock in excess of the number of shares permitted under the Articles of Incorporation. Such provisions also may make the Company an unsuitable investment vehicle for any person seeking to obtain (either alone or with others as a group) ownership of more than 9.8% of the outstanding shares of Common Stock. Investors seeking to acquire substantial holdings in the Company should be aware that this ownership limitation may be exceeded by a stockholder without any action on such stockholder's part in the event of a reduction in the number of outstanding shares of the Company's Common Stock. See "Executive Compensation -- Stock Option Plans." On December 13, 1993, the Board of Directors approved the adoption of a program to repurchase up to 2,000,000 shares of the Company's common stock in open market conditions. The decision to repurchase shares pursuant to the program, and the timing and amount of such purchases, will be based upon market conditions then in effect and other corporate considerations. Through March 23, 1994, 1,600 shares of common stock have been repurchased under such program. INVESTMENT CONSEQUENCES OF EXEMPTION FROM INVESTMENT COMPANY ACT The Company conducts its business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act"). Accordingly, the Company does not expect to be subject to the restrictive provisions of the Investment Company Act. The Investment Company Act exempts entities that are "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate." Under current interpretations of the staff of the Securities and Exchange Commission, in order to qualify for this exemption, the Company must maintain at least 55% of its assets directly in Mortgage Loans, certain Mortgage Certificates and certain other qualifying interests in real estate. The Company's ownership of certain Mortgage Assets therefore may be limited by the Investment Company Act. In addition, certain Mortgage Certificates may be treated as securities separate from the underlying Mortgage Loans and, thus, may not qualify as "mortgages and other liens on and interests in real estate" for purposes of the 55% requirement, unless such Mortgage Certificates represent all the certificates issued with respect to an underlying pool of mortgages. If the Company failed to qualify for exemption from registration as an investment company, its ability to use investment leverage would be substantially reduced, it would be prohibited from engaging in certain transactions with affiliates, and it would be unable to conduct its business as described herein. Such a failure to qualify could have a material adverse effect on the Company. See "Business -- Operating Policies and Strategies -- Operating Restrictions." FEDERAL INCOME TAX CONSIDERATIONS STATUS OF THE COMPANY AS A REIT The Company has made an election to be treated as a real estate investment trust ("REIT"). Thus, if the Company satisfies certain tests in each taxable year with respect to the nature of its income, assets, share ownership and the amount of its distributions, among other things, it generally should not be subject to tax at the corporate level on its income to the extent that it distributes cash in the amount of such income to its stockholders. In 1993, the Internal Revenue Service completed an audit of the Company and the revenue agent conducting the audit issued a report in which he recommended that the Company lose its REIT election commencing with the 1989 taxable year. The Company disagreed with the revenue agent's report and filed a protest with the District Director of the IRS challenging the proposed adjustment in that report. See "Legal Proceedings" and Note 9 to the Consolidated Financial Statements. The unremedied failure of the Company to be treated as a REIT for any taxable year could materially and adversely affect the stockholders. For instance, the net income of the Company would be taxed at the ordinary corporate rate (currently a maximum of 34%). The Company would not receive a deduction for any dividends to the stockholders and those dividends would be treated as ordinary income to the stockholders to the extent of the Company's earnings and profits. As a result of such taxes, a material reduction would occur in the cash available for distribution to the stockholders as dividends. Further, the unremedied failure of the Company to be treated as a REIT for any one year would disqualify the Company from being treated as a REIT for the four subsequent years. QUALIFICATION OF THE COMPANY AS A REIT General In order to qualify as a REIT for federal income tax purposes and to maintain such qualification, the Company must elect to be so treated and must continually satisfy certain tests with respect to the sources of its income, the nature and diversification of its assets, the amount of its distributions, and the ownership of the Company. The following is a discussion of those various tests. Sources of Income The Company must satisfy three separate income tests for each taxable year with respect to which it intends to qualify as a REIT: (i) the 75% income test, (ii) the 95% income test, and (iii) the 30% income test. Under the first test, at least 75% of the Company's gross income for the taxable year must be derived from certain qualifying real estate related sources. Under the 95% test, 95% of the Company's gross income for the taxable year must be derived from the items of income that either qualify under the 75% test or are from certain other types of passive investments. Finally, the 30% income test requires the Company to derive less than 30% of its gross income for the taxable year from the sale or other disposition of (1) real property, including interests in real property and interests in mortgages on real property, held for less than four years, other than foreclosure property or property involuntarily converted through destruction, condemnation or similar events, (2) stock, securities, or swap agreements held for less than one year, and (3) property in "prohibited transactions." A prohibited transaction is a sale or disposition of dealer property that is not foreclosure property or, under certain circumstances, a real estate asset held for at least four years. If the Company inadvertently fails to satisfy either the 75% income test or the 95% income test, or both, and if the Company's failure to satisfy either or both tests is due to reasonable cause and not willful neglect, the Company may avoid loss of REIT status by satisfying certain reporting requirements and paying a tax equal to 100% of any excess nonqualifying income. See "Business -- Federal Income Tax Considerations -- Taxation of the Company." There is no comparable safeguard that could protect against REIT disqualification as a result of the Company's failure to satisfy the 30% income test. The composition and sources of the Company's income should allow the Company to satisfy the income tests during each year of its existence. If the Company causes issuances of interests in REMICs (see "Business -- Federal Income Tax Considerations -- Activities of the Company"), however, the Company may recognize income that, if excessive, could result in the Company's failure to meet one or more of the income tests or, if from transactions in which the Company is deemed to be a dealer, could be subject to a 100% tax. See "Business -- Federal Income Tax Considerations -- Taxation of the Company, and - -- Activities of the Company." Further, certain short-term reinvestments may generate qualifying income for purposes of the 95% income test but nonqualifying income for purposes of the 75% income test, and certain hedging transactions could give rise to income that, if excessive, could result in the Company's disqualification as a REIT for failing to satisfy the 30% income test, the 75% income test, and/or the 95% income test. The Company intends to monitor its reinvestments and hedging transactions closely to attempt to avoid disqualification as a REIT. Nature and Diversification of Assets At the end of each quarter of the Company's taxable year, at least 75% of the value of the Company's assets must be cash and cash items (including receivables), federal government securities and qualifying real estate assets. Qualifying real estate assets include interests in real property and mortgages, equity interests in other REITs, any stock or debt instrument for so long as the income therefrom is qualified temporary investment income and, subject to certain limitations, interests in REMICs. The balance of the Company's assets may be invested without restriction, except that holdings of the securities of any one non-governmental issuer may not exceed 5% of the value of the Company's assets or 10% of the outstanding voting securities of that issuer. Securities that are qualifying assets for purposes of the 75% asset test will not be treated as securities of a non-governmental issuer for purposes of the 5% and 10% asset tests. Although the Company believes that such anticipated asset holdings will allow it to satisfy the asset tests necessary to qualify as a REIT, the Company intends to monitor its activities to assure satisfaction of the asset tests. If the Company fails to satisfy the 75% asset test at the end of any quarter of its taxable year as a result of its acquisition of securities or other property during that quarter, the failure can be cured by a disposition of sufficient nonqualifying assets within 30 days after the close of that quarter. The Company has represented that it will maintain adequate records of the value of its assets and take such action as may be required to cure any failure to satisfy the 75% asset test within 30 days after the close of any quarter. The Company may not be able to cure any failure to satisfy the 75% asset test, however, if assets that the Company believes are qualifying assets for purposes of the 75% asset test are later determined to be nonqualifying assets. Distributions Each taxable year, the Company 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 noncash income (as determined under the Code). Generally, a distribution must be made in the taxable year to which it relates. A portion of the required distribution, however, may be made in the following year if (i) a dividend is declared in October, November or December of any year, is payable to stockholders of record on a specified date in October, November or December and is actually paid in January of the following year or (ii) a dividend is declared before the Company timely files its tax return for the taxable year to which the distribution relates and is paid on or before the first regular dividend payment date after such declaration. Further, if the Company fails to meet the 95% distribution requirement as a result of an adjustment to the Company's tax returns by the IRS, the Company may, if the deficiency is not due to fraud with intent to evade tax or a willful failure to file a timely tax return, retroactively cure the failure by paying a deficiency dividend to stockholders and certain interest and penalties to the IRS. The Company intends to make distributions to its stockholders on a basis that will allow the Company to satisfy the distribution requirement. In certain instances, however, the Company's pre-distribution taxable income may exceed its cash flow and the Company may have difficulty satisfying the distribution requirement. See "Business -- Federal Income Tax Considerations - -- Activities of the Company." The Company intends to monitor closely the relationship between its pre-distribution taxable income and its cash flow and intends to borrow funds or liquidate investments in order to overcome any cash flow shortfalls if necessary to satisfy the distribution requirement. It is possible, although unlikely, that the Company may decide to terminate its REIT status as a result of any such cash shortfall. Such a termination would have adverse consequences to the stockholders. See "Business -- Federal Income Tax Considerations -- Status of the Company as a REIT." Ownership of the Company Shares of the Company's Common Stock must be held by a minimum of 100 persons for at least 335 days in each taxable year after the Company's first taxable year. Further, at no time during the second half of any taxable year after the Company's first taxable year may more than 50% of the Company's shares be owned, actually or constructively, by five or fewer individuals (including pension funds and certain other types of tax-exempt entities). To evidence compliance with these requirements, the Company is required to maintain records that disclose the actual ownership of its outstanding shares. In order to satisfy that requirement, the Company will demand written statements from record holders owning designated percentages of Common Stock disclosing, among other things, the identities of the actual owners of such shares. The Company's Articles of Incorporation contain repurchase provisions and transfer restrictions designed to prevent violation of the latter requirement. Therefore, the Company believes that its shares of Common Stock currently are owned by a sufficient number of unrelated persons to allow the Company to satisfy the ownership requirements for REIT qualification. ACTIVITIES OF THE COMPANY The Company expects to continue to generate income primarily from the Net Cash Flows on Mortgage Instruments and Mortgage Interests (i.e., interests in or from Mortgage Finance Companies which own and finance Mortgage Instruments). As discussed below, it is possible that in any particular year the reportable taxable income associated with Net Cash Flows may exceed the cash received in that year, making it difficult for the Company to satisfy the dividend requirements. The Company also expects to generate income by (i) making commitments to acquire Mortgage Assets, (ii) earning interest on qualified temporary investments and (iii) earning interest on short-term reinvestments and entering into hedging transactions. As explained below, there are holding period requirements with respect to qualifying real estate assets held by the Company as well as certain federal income tax risks associated with hedging transactions and with the generation of income from Net Cash Flows on Mortgage Instruments securing or underlying Mortgage Securities. The Company expects that a substantial portion of its income from Net Cash Flows will continue to come through its ownership of "residual" interests in REMICs. A REMIC is a tax entity through which multiple classes of Mortgage Securities are issued. A REMIC generally is considered a pass-through entity (similar in some respects to a partnership) for federal income tax purposes. Interests in a REMIC consist of a single class of residual interests and one or more classes of "regular" interests. A regular interest resembles, though it need not be in the form of, debt. A residual interest in a REMIC is any interest in the REMIC that is not a regular interest and that is designated as a residual interest by the REMIC. For purposes of maintaining its status as a REIT, the Company anticipates that its ownership of residual interests in REMICs generally will be qualifying real estate assets for purposes of the 75% asset test and that its income with respect to such residual interests generally will be qualifying income for purposes of the 75% income test. The Company has obtained residual interests in REMICs by purchasing those residual interests from other entities. The Code does not provide a method for the Company to amortize any premium paid for a residual interest in excess of its initial issue price. The lack of such an adjustment could reduce the Company's yield on REMIC residual interests purchased at a premium. Although the legislative history of the REMIC provisions recognizes this problem and notes that certain modifications of the rules governing taxation of holders of residual interests may be appropriate, no further guidance is provided. The Company also has purchased Mortgage Instruments, transferred those Mortgages Instruments to an entity that has made a REMIC election, and caused that entity to issue Mortgage Securities backed by those Mortgage Instruments. In that instance, the issuance of regular interests in that REMIC was treated, for federal income tax purposes, as a sale of those Mortgage Instruments by the Company. Although the Company intends to continue to enter into such transactions, gain on such transactions, if any, would be income included for purposes of calculating the 30% prohibited income test. Further, the Company's gain on any such issuance, if the Company were deemed to be a dealer of Mortgage Instruments, would be income from a prohibited transaction and subject to a 100% tax. The Company will not cause an issuance of regular or residual interests in a REMIC if that issuance would cause disqualification of the Company as a REIT or would be a prohibited transaction. In addition to owning interests in REMICs, the Company anticipates that it may generate income from Net Cash Flows through ownership of non-REMIC Mortgage Interests. Without jeopardizing its qualification as a REIT, however, the Company generally may not own a non-REMIC interest unless that interest is an equity-type interest. The Company, therefore, does not intend to own non- REMIC interests that have rights to Net Cash Flows unless (i) such rights flow from equity or ownership interests in Mortgage Instruments that either are directly acquired by the Company or indirectly acquired by the Company through its ownership interests in other entities or (ii) the Company has received an opinion of counsel that the acquisition of such rights will not cause disqualification of the Company as a REIT. Ownership by the Company of rights to Net Cash Flows in the forms of REMIC residual interests and non-REMIC interests in other entities, particularly those structured as partnerships or as trusts, pose certain risks to the Company. First, the failure of an entity for which a REMIC election has been made to qualify as a REMIC or the possession by an entity, such as a partnership or a trust, of an excessive number of corporate characteristics could result in treatment of the entity as a corporation for federal income tax purposes. If the Company owns an interest in an entity that is taxed as a corporation, the Company's REIT status could be jeopardized under the 75% income test and certain of the asset tests. Second, with respect to its interest in any REMIC, partnership or trust, the Company's income under certain circumstances may exceed its cash receipts and thus make it difficult for the Company to satisfy the cash distribution test. Third, distributions received by the Company from any REMIC, partnership or trust in excess of the Company's basis in its interest in that REMIC, partnership or trust could result in recognition by the Company of nonqualifying income under the 30% prohibited income test. The Company also has engaged in certain hedging transactions, and may engage in future hedging transactions. See "Business -- Operating Policies and Strategies -- Other Operating Strategies," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 7 to the Company's Consolidated Financial Statements. Hedging transactions, including those transactions into which the Company has already entered, pose risks to the Company. For example, the income from hedging transactions could result in the Company violating the 95% income test, the 75% income test, and/or the 30% income test. Also, certain losses incurred in connection with hedging transactions could be characterized as capital losses, which cannot offset ordinary REIT income, resulting in "phantom" income (income without cash) on which dividends must be paid. TAXATION OF THE COMPANY For any taxable year in which the Company qualifies and elects to be treated as a REIT under the Code, the Company will be taxed at regular corporate rates (or, if less, at alternative rates in any taxable year in which the Company has an undistributed net capital gain) on its real estate investment trust taxable income ("REIT Taxable Income"). REIT Taxable Income is computed by making certain adjustments to a REIT's taxable income as computed for regular corporations. Dividends paid by a REIT to its stockholders with respect to a taxable year are deducted to the extent those dividends are not attributable to net income from foreclosure property. In computing REIT Taxable Income, taxable income also is adjusted by (i) disallowing the deduction for dividends received, (ii) disregarding any tax otherwise applicable as a result of a change of accounting period, (iii) excluding the net income from foreclosure property, (iv) deducting any tax resulting from the REIT's failure to satisfy either of the 75% or 95% income tests, and (v) excluding net income from prohibited transactions. Thus, in any year in which the Company qualifies as a REIT, it generally will not be subject to federal income tax on that portion of its taxable income that is distributed to its stockholders in or with respect to that year. Regardless of distributions to stockholders, the Company will be subject to a tax at the highest corporate rate (currently 34%) on its net income from foreclosure property, a 100% tax on its net income from prohibited transactions, and a 100% tax on the greater of the amount by which it fails either the 75% income test or the 95% income test, less associated expenses, if the failure to satisfy either or both of such tests is due to reasonable cause and not willful neglect and if certain other requirements are satisfied. In addition, the Company will be subject to an excise tax (currently at the rate of 4%) for any taxable year in which, and on the amount by which, distributions actually made by the Company in that taxable year fail to exceed a certain amount determined with reference to its REIT Taxable Income. Finally, although the minimum tax on items of tax preference will apply to the Company, the Company does not expect to have any significant amounts of tax preference items. The Company uses the calendar year both for tax purposes and for financial reporting purposes. Due to the differences between tax accounting rules and generally accepted accounting principles, the Company's REIT Taxable Income will vary from its net income for financial reporting purposes. TAX CONSEQUENCES OF COMMON STOCK OWNERSHIP Dividend Income Distributions to stockholders out of the Company's current or accumulated earnings and profits will constitute dividends to the stockholders generally taxable as ordinary income. Generally, distributions by the Company will be out of current or accumulated earnings and profits and, therefore, will be taxable. Generally, dividends are taxable to stockholders in the year received. With respect to any dividend declared by the Company in October, November or December of any calendar year and payable to stockholders of record as of a specified date in October, November or December, however, that dividend will be deemed to have been paid by the Company and received by the stockholder on December 31 if the dividend is actually paid in January of the following calendar year. The Company's dividends will not be eligible for the dividends-received deduction for corporations. If the Company'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, reducing a stockholder's basis in his shares (but not below zero), and then as capital gain in the event such distributions are in excess of a stockholder's adjusted basis in his shares. Distributions properly designated by the Company as "capital gain dividends" will be taxable to the stockholders as long-term capital gain, to the extent those dividends do not exceed the Company's actual net capital gain for the taxable year, without regard to the stockholder's holding period for his shares. A REIT is not required to offset its net capital gain for any taxable year with its net operating loss for that year or from a prior year in determining the maximum amount of capital gain dividends that it can pay for that year. Any loss on the sale or exchange of shares of Common Stock held by a stockholder for one year or less will be treated as long-term capital loss to the extent of any capital gain dividends received on that Common Stock by that stockholder. The Company will notify stockholders after the close of its taxable year regarding the portions of the distributions that constitute ordinary income, return of capital and capital gain. Stockholders may not deduct any net operating losses or capital losses of the Company. The Company will also notify stockholders regarding their reportable share of excess inclusion income. See "Excess Inclusion Rule" below. Dividends As Portfolio Income Dividends paid by the Company will be "portfolio income" to stockholders. Therefore, a stockholder subject to the passive activity limitations will not be able to offset income earned with respect to his or her investment in the Company with passive activity losses or deductions, except to the extent that suspended passive activity losses or deductions have been made available by taxable dispositions of interests in the passive activities that generated those losses or deductions. Excess Inclusion Rule Ownership by the Company of residual interests in REMICs may adversely affect the federal income taxation of the Company and of certain stockholders to the extent those residual interests generate "excess inclusion income." The Company's excess inclusion income during a calendar quarter generally will equal the excess of its taxable income from residual interests in REMICs over its "daily accruals" with respect to those residual interests for the calendar quarter. The daily accruals are calculated by multiplying the adjusted issue price of the residual interest by 120% of the long-term federal interest rate in effect on the REMIC's startup date. It is possible that the Company will have excess inclusion income without associated cash. In taxable years in which the Company has both a net operating loss and excess inclusion income, it will still have to report a minimum amount of taxable income equal to its excess inclusion income. In order to maintain its REIT status, the Company will be required to distribute at least 95% of its taxable income, even if its taxable income is comprised exclusively of excess inclusion income and otherwise has a net operating loss. In general, each stockholder is required to treat the stockholder's allocable share of the portion of the Company's excess inclusions that is not taxable to the Company as an excess inclusion received by such stockholder. The portion of the Company's dividends that constitute excess inclusions typically will rise as the degree of leveraging of the Company's activities increase. Therefore, all or a portion of the dividends received by the stockholders may be excess inclusion income. Excess inclusion income will constitute unrelated business taxable income for tax-exempt entities and may not be used to offset deductions or net operating losses from other sources for most other taxpayers. TAX-EXEMPT ORGANIZATIONS AS STOCKHOLDERS The Code requires a tax-exempt stockholder of the Company to treat as unrelated business taxable income its allocable share of the Company's excess inclusions. The Company is likely to receive excess inclusion income. See "Business -- Federal Income Tax Considerations -- Tax Consequences of Common Stock Ownership -- Excess Inclusion Rule." The Common Stock of the Company may not be held by tax-exempt entities which are not subject to tax on unrelated business taxable income. TAXATION OF FOREIGN STOCKHOLDERS Gain from the sale of the Company's shares by a nonresident alien individual or foreign corporation ("foreign persons") generally will not be subject to United States taxation unless that gain is effectively connected with that foreign person's United States trade or business or, in the case of an individual foreign person, that person is present within the United States for more than 182 days in the taxable year in question or otherwise is considered a resident alien. If a foreign person holds more than 5% of the shares of the Company, however, gain from the sale of that person's shares could be subject to full United States taxation if the Company ever held any real property interests and was not a domestically controlled REIT. Distributions of cash generated by the Company's operations that are paid to foreign persons generally will be subject to United States withholding tax at a rate of 30% or at a lower rate if a foreign person can claim the benefits of a tax treaty. Notwithstanding the foregoing, distributions made to foreign stockholders will not be subject to treaty withholding reductions to the extent of their allocable shares of the portion of the Company's excess inclusion that is not taxable to the Company for the period under review. It is expected that the Company will have excess inclusions. See "Business -- Federal Income Tax Considerations -- Tax Consequences of Common Stock Ownership -- Excess Inclusion Rule." Distributions to foreign persons of cash attributable to gain on the Company's sale or exchange of real properties, if any, generally will be subject to full United States taxation and withholding. The federal income taxation of foreign persons is a highly complex matter that may be affected by many considerations. Accordingly, foreign investors in the Company should consult their own tax advisors regarding the income and withholding tax considerations with respect to their investments in the Company. Foreign governments and organizations, and their instrumentalities, may not invest in the Company. BACKUP WITHHOLDING The Company is required by the Code to withhold from dividends 20% of the amount paid to stockholders, unless the stockholder (i) files a correct taxpayer identification number with the Company, (ii) certifies as to no loss of exemption from backup withholding and (iii) otherwise complies with the applicable requirements of the backup withholding rules. The Company will report to its stockholders and the IRS the amount of dividends paid during each calendar year and the amount of tax withheld, if any. Stockholders should consult their tax advisors as to the procedure for insuring that Company dividends to them will not be subject to backup withholding. STATE AND LOCAL TAXES The discussion herein concerns only the federal income tax treatment likely to be accorded the Company and its stockholders. No discussion has been provided regarding the state or local tax treatment of the Company and its stockholders. The state and local tax treatment may not conform to the federal income tax treatment described above and each stockholder should discuss such treatment with his state and local tax adviser. MORTGAGE INSTRUMENTS THE MORTGAGE CERTIFICATES The Mortgage Certificates acquired by the Company or underlying the Company's Mortgage Interests (including those Mortgage Certificates pledged to secure Mortgage Securities) may include GNMA Certificates, FHLMC Certificates, FNMA Certificates and Other Mortgage Certificates. Government National Mortgage Association GNMA is a wholly-owned corporate instrumentality of the United States within the Department of Housing and Urban Development ("HUD"). Section 306(g) of Title III of the National Housing Act of 1934, as amended (the "Housing Act"), authorizes GNMA to guarantee the timely payment of the principal of and interest on certificates which represent an interest in a pool of mortgages insured by the FHA under the Housing Act or Title V of the Housing Act of 1949, or partially guaranteed by the VA under the Servicemen's Readjustment Act of 1944, as amended, or Chapter 37 of Title 38, United States Code and other loans eligible for inclusion in mortgage pools underlying GNMA Certificates. 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." An opinion, dated December 12, 1969, of an Assistant Attorney General of the United States, states that such guarantees under Section 306(g) of mortgage-backed certificates of the type which may be purchased by the Company or pledged as security for a series of Mortgage Securities are authorized to be made by GNMA and "would constitute general obligations of the United States backed by its full faith and credit." In order to meet its obligation under any such guaranty, GNMA may, under Section 306(d) of the Housing Act, issue its general obligations to the United States Treasury in an amount which is at any time sufficient to enable GNMA, with no limitations as to amount, to perform its obligations under its guaranty. GNMA represents that, in the event it is called upon at any time to make good its guaranty, it has the full power and authority to borrow from the Treasury of the United States, if necessary, amounts sufficient to make payments of principal and interest on GNMA Certificates and that the Secretary of the Treasury has agreed to lend such amounts. GNMA Certificates Each GNMA Certificate (which may be a GNMA I Certificate or a GNMA II Certificate as referred to by GNMA, a project certificate or a certificate backed by loans secured by manufactured housing) will be a "fully-modified pass-through" mortgage-backed certificate issued and serviced by a mortgage banking company or other financial concern ("GNMA Issuer") approved by GNMA and by FNMA as a seller-servicer of FHA Loans and VA Loans. The mortgage loans underlying GNMA Certificates may consist of FHA Loans secured by mortgages on single family (one-to-four units) residential properties (including manufactured home contracts), VA Loans partially guaranteed by the VA and other mortgage loans eligible for inclusion in mortgage pools underlying GNMA Certificates. Such mortgage loans may be level payment mortgage loans (including "buydown" mortgage loans) or graduated payment mortgage loans, each secured by a first lien on a single family (one-to-four units) residential property. Each GNMA Certificate will provide for the payment by or on behalf of the GNMA Issuer to the registered holder of such GNMA Certificate of fixed (or graduated in the case of pools of graduated payment mortgage loans) monthly payments of principal and interest equal to the registered holder's proportionate interest in the aggregate amount of the monthly scheduled principal and interest payments on the underlying eligible mortgage loans, less servicing and guarantee fees of 0.5% and up to 1.5% per annum of the outstanding principal balance for GNMA I Certificates and GNMA II Certificates, respectively. In addition, each payment will include proportionate pass-through payments to the registered holders of the GNMA Certificate of any prepayments of principal on the mortgage loans underlying such GNMA Certificate and the registered holder's proportionate interest in the remaining principal balance in the form of liquidation proceeds in the event of a foreclosure or other disposition of any such mortgage loans. GNMA will approve the issuance of each such GNMA Certificate in accordance with a guaranty agreement (the "Guaranty Agreement") between GNMA and the GNMA Issuer. Pursuant to the Guaranty Agreement, the GNMA Issuer will be required to advance its own funds in order to make timely payments of all amounts due on each such GNMA Certificate, even if the payments received by the GNMA Issuer on the mortgage loans underlying each such GNMA Certificate are less than the amounts due on each such GNMA Certificate. The full and timely payment of principal of and interest on each GNMA Certificate will be guaranteed by GNMA, which obligation will be backed by the full faith and credit of the United States. Each such GNMA Certificate will have an original maturity of not more than 30 years, but may have an original maturity of substantially less than 30 years. In general, GNMA requires that at least 90% of the original principal amount of the mortgage pool underlying a GNMA Certificate must be mortgage loans with maturities of at least 20 years. However, in certain circumstances, GNMA Certificates may be backed by pools of mortgage loans at least 90% of the original principal amount of which have original maturities of at least 15 years. Each mortgage loan underlying a GNMA Certificate, at the time GNMA issues its guarantee commitment, must be originated no more than one year prior to such commitment date. No GNMA Issuer will insure or guarantee any series of Mortgage Securities or the GNMA Certificates securing any series of Mortgage Securities. Each GNMA Issuer's obligation with respect to payment on the Mortgage Securities of a series will be limited to the obligations of a servicer of GNMA Certificates to provide funds to assure the timely payment of principal and interest on GNMA Certificates and to service the underlying mortgage loans according to GNMA guidelines. Each GNMA Issuer will perform the routine functions required for the servicing of mortgage loans underlying the GNMA Certificates, including mortgagor billings, receipt and posting of payments, payments made by borrowers toward escrows established for taxes and insurance premiums, payment of property taxes and hazard insurance premiums, institution of all actions necessary to foreclose on, or take other appropriate action with respect to, loans in default, collection of FHA insurance and VA guaranty benefits, and remittances, collections and customer service. Each GNMA Issuer will be obligated under its Guaranty Agreement with GNMA to service the pooled mortgage loans in accordance with FHA and VA requirements and with generally accepted practices in the mortgage lending industry. If a GNMA Issuer is unable to make the payments on a GNMA Certificate securing a series of Mortgage Securities as it becomes due, it is required to promptly notify GNMA and request GNMA to make such payment. Upon notification and request, GNMA will make such payments directly to the registered holder of such GNMA Certificate. In the event no payment is made by a GNMA Issuer and the GNMA Issuer fails to notify and request GNMA to make such payment, the holder of such GNMA Certificate will have recourse only against GNMA to obtain such payment. The registered holder of the GNMA Certificate securing a series of Mortgage Securities will have the right to proceed directly against GNMA under the terms of the Guaranty Agreements relating to such GNMA Certificates for any amounts that are not paid when due. Regular monthly installment payments on each GNMA Certificate will be comprised of interest due as specified on such GNMA Certificate plus the scheduled principal payments on the mortgage loans underlying such GNMA Certificate due on the first day of the month in which the scheduled monthly installment on such GNMA Certificate is due. Such regular monthly installments on each such GNMA Certificate will be paid to the registered holder by the 15th day of each month in the case of a GNMA I Certificate and will be mailed by the 20th day of each month in the case of a GNMA II Certificate. Any principal prepayments on any mortgage loans underlying a GNMA Certificate or any other early recovery of principal on such loans will be passed through to the registered holder of such GNMA Certificate and a portion of such prepayments will be paid to holders of Mortgage Securities as additional principal payments. Pools of non-graduated payment mortgages evidenced by certain of the GNMA Certificates may consist of level payment mortgages for which funds have been provided (and deposited in escrow accounts) by one or more persons to reduce the borrowers' monthly payments during the early years of such mortgage loans. Payments due the registered holders of such "buy-down" GNMA Certificates, however, will be computed the same as payments derived from level payment non-buy-down GNMA Certificates and will include amounts to be collected from both the borrowers and the escrow accounts under the control of the GNMA Issuer. The obligations of GNMA and the GNMA Issuer with respect to such buy- down GNMA Certificates will be the same as with respect to non-buy-down GNMA Certificates. The Company also may purchase GNMA Certificates which represent undivided ownership interests in pools consisting of fixed-rate, first-lien, conventional, residential, multi-family mortgage loans or participations therein or GNMA Certificates which represent undivided ownership interests in pools of manufactured homes within the meaning of 42 United States Code, Section 5402(6) or participations therein. In addition, the Company may acquire GNMA Certificates with respect to other programs developed by GNMA from time to time. Federal Home Loan Mortgage Corporation FHLMC is a corporate instrumentality of the United States created on July 24, 1970 pursuant to Title III of the Emergency Home Finance Act of 1970, as amended, 12 U.S.C. (S)(S)1451-1459 (the "FHLMC Act"). FHLMC was established primarily for the purpose of increasing the availability of mortgage credit for the financing of urgently needed housing. It seeks to provide an enhanced degree of liquidity for residential mortgage investments primarily by assisting in the development of secondary markets for conventional mortgages. The principal activity of FHLMC currently consists of the purchase of first- lien conventional mortgage loans or participation interests in such mortgage loans and the resale of the mortgage loans so purchased in the form of mortgage securities, primarily FHLMC Certificates. All mortgage loans (including manufactured housing contracts) purchased by FHLMC must meet certain standards set forth in the FHLMC Act. FHLMC is confined to purchasing, so far as practicable, mortgage loans which it deems to be of such quality, type and class as to meet generally the purchase standards imposed by private institutional mortgage investors. All of the mortgage loans evidenced by a FHLMC Certificate are conventional mortgages and therefore do not have the benefit of any guaranty or insurance by, and are not obligations of, the United States or any agency or instrumentality of the United States. FHLMC Certificates Each FHLMC Certificate will represent (i) an undivided interest in a group ("FHLMC Certificate group") of (a) fixed or variable rate conventional mortgage loans with original terms to maturity of between 10 and 30 years secured by first liens on single family (one-to-four units) residential properties or five- or more family residential properties, or (b) fixed rate conventional manufactured housing retail installment contracts secured by manufactured homes, or (ii) an undivided percentage interest in the principal distributions or interest distributions on such group ("Stripped FHLMC Certificates"). A FHLMC Certificate group may include whole loans, participation interests in whole loans and undivided interests in whole loans and/or participations comprising another FHLMC Certificate group. Each such FHLMC Certificate will be issued under the terms of a Mortgage Participation Certificate Agreement. A FHLMC Certificate may be issued under programs created by FHLMC, including its Cash Program or Guarantor Program. FHLMC will guarantee to the registered holder of each FHLMC Certificate the timely payment of interest by each mortgagor to the extent of the applicable certificate rate on the registered holder's pro rata share of the unpaid principal balance outstanding on the mortgage loans underlying such FHLMC Certificate. FHLMC also will guarantee to the registered holder of such a FHLMC Certificate collection by such holder of all principal on the underlying mortgage loans, without any offset or deduction, to the extent of such holder's pro rata share thereof, but will not guarantee the timely payment of scheduled principal, except under certain programs. Pursuant to its guaranty, FHLMC will indemnify the holder of such FHLMC Certificates against any diminution in principal by reason of charges for property repairs, maintenance and foreclosure. FHLMC may remit the amount due on account of its guaranty of collection of principal at any time after default on an underlying mortgage loan, but not later than (i) 30 days following foreclosure sale, (ii) 30 days following payment of the claim by any mortgage insurer, or (iii) 30 days following the expiration of any right of redemption, whichever occurs later, but in any event no later than one year after demand has been made upon the mortgagor for accelerated payment of principal. In taking actions regarding the collection of principal after default on the mortgage loans underlying FHLMC Certificates, including the timing of demand for acceleration, FHLMC reserves the right to exercise its judgment in the same manner as for mortgage loans which it has purchased but not sold. The FHLMC Certificates will not be guaranteed by the United States or by any Federal Home Loan Bank and will not constitute debts or obligations of the United States or any Federal Home Loan Bank. If FHLMC were unable to satisfy such obligations, distributions on FHLMC Certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, delinquencies and defaults would impact monthly distributions on such FHLMC Certificates. Holders of FHLMC Certificates are entitled to receive their pro rata share of all principal payments on the underlying mortgage loans received by FHLMC, including any scheduled principal payments, full and partial repayments of principal and principal received by FHLMC by virtue of condemnation, insurance, liquidation or foreclosure, including repayments of principal resulting from acquisition by FHLMC of the real property securing the mortgage. FHLMC is required to remit each registered FHLMC Certificate holder's pro rata share of principal payments on the underlying mortgage loans, interest at the FHLMC Certificate rate and, except in the case of FHLMC Certificates representing interests in multi-family mortgage loans, any other sums such as prepayment fees, within 60 days of the date on which such payments are deemed to have been received by FHLMC. Under FHLMC's Cash Program, with respect to pools formed prior to June 1, 1987, there is no limitation on the amount by which interest rates on the mortgage loans underlying a FHLMC Certificate may exceed the interest rate on the FHLMC Certificate. With respect to FHLMC Certificates issued on or after June 1, 1987, the maximum interest rate on the mortgage loans underlying such FHLMC Certificates cannot exceed the interest rate on such FHLMC Certificates by more than two percentage points. Under such program, FHLMC purchases groups of whole mortgage loans from sellers at specified percentages of their unpaid principal balances, adjusted for accrued or prepaid interest, which, when applied to the interest rate of the mortgage loans purchased, results in the yield (expressed as a percentage) required by FHLMC. The required yield, which includes a minimum servicing fee retained by the servicer, is calculated using the outstanding principal balance of the mortgage loans, an assumed term and a prepayment period as determined by FHLMC. No loan is purchased by FHLMC at greater than 100% of its outstanding principal balance. The range of interest rates on the mortgage loans in a FHLMC Certificate group under the Cash Program will vary since mortgage loans are purchased and identified to a FHLMC Certificate group based upon their yield to FHLMC rather than on the interest rate on the mortgage loans, but the range between the lowest and highest annual interest rates on the mortgage loans in a FHLMC Certificate group under the FHLMC Cash Program may not exceed 100 basis points. Under FHLMC's Guarantor Program, the interest rate on a FHLMC Certificate is established based upon the lowest interest rate on the underlying mortgage loans, minus a minimum servicing fee and the amount of FHLMC's management and guaranty income as agreed upon between the seller and FHLMC. For FHLMC Certificate groups formed before May 2, 1988 under the Guarantor Program, the range between the lowest and highest annual interest rates on the mortgage loans in the related FHLMC Certificate group may not exceed one percentage point. For FHLMC Certificate groups formed under such program on or after May 2, 1988, this restriction will no longer apply. The maximum interest rate of any mortgage loan in a FHLMC Certificate group under FHLMC's Guarantor Program formed on or after May 2, 1988 may be up to 250 basis points greater than the interest rate of the related FHLMC Certificate. Requests for registration of ownership of FHLMC Certificates made on or before the last business day of a month are made effective as of the first day of that month. With respect to FHLMC Certificates sold by FHLMC on or after January 2, 1985, a Federal Reserve Bank which maintains book-entry accounts with respect thereto will make payments of interest and principal each month to holders in accordance with the holders' instructions. The first payment to a holder of a FHLMC Certificate will normally be received by the 15th day of the second month following the month in which the purchaser became a holder of the FHLMC Certificate. Thereafter, payments will normally be received by the 15th day of each month. The Company also may purchase FHLMC Certificates which represent undivided ownership interests in pools consisting of fixed-rate, first-lien, conventional, residential, multi-family mortgage loans or participations therein. These FHLMC Certificates also are guaranteed as to the full and timely payment of interest and as to ultimate collection of principal by FHLMC, which obligation is not backed by the full faith and credit of the United States. Such loans and participations will be purchased by FHLMC through its Multi-Family Cash Program, pursuant to which FHLMC buys multi- family mortgage loans at prescribed yields. The mortgage loans will be secured by properties containing five or more units and designed primarily for residential use. These properties may include high-rise and low-rise buildings, garden apartments and townhouse complexes. Under certain conditions, the mortgage loans may be secured by dwellings subject to subordinate or superior ground or similar leases or to subordinate liens. FHLMC also may purchase blanket first-lien mortgages secured by multi-family dwellings owned by cooperative corporations or associations. Mortgagors may be partnerships, corporations, individuals or other entities. At the time of delivery of a mortgage loan to FHLMC, at least 80% of the units in the multi- family dwelling must be occupied, and the rents receivable on the occupied units must be sufficient to meet debt service requirements on the mortgage loan and to pay all other normal operating expenses as well as to support the appraised value. The mortgages underlying the FHLMC Certificates may contain "lock-out" provisions which would prohibit prepayments by the mortgagors for a period immediately following the loan origination date. Federal National Mortgage Association FNMA is a federally chartered and privately owned corporation organized and existing under the Federal National Mortgage Association Charter Act (12 U.S.C. 1716 et seq). FNMA was originally established in 1938 as a United States government agency to provide supplemental liquidity to the mortgage market and was transformed into a stockholder-owned and privately managed corporation by legislation enacted in 1968. FNMA provides funds to the mortgage market primarily by purchasing home mortgage loans from local lenders, thereby replenishing their funds for additional lending. FNMA acquires funds to purchase home mortgage loans from many capital market investors that may not ordinarily invest in mortgages, thereby expanding the total amount of funds available for housing. Operating nationwide, FNMA helps to redistribute mortgage funds from capital-surplus to capital-short areas. Although the Secretary of the Treasury of the United States has discretionary authority to lend funds to FNMA, neither the United States nor any agency thereof is obligated to finance FNMA's operations or to assist FNMA in any other manner. FNMA Certificates FNMA Certificates are either Guaranteed Mortgage Pass-Through Certificates ("FNMA MBS") or Stripped Mortgage-Backed Securities ("FNMA SMBS"). The following discussion of FNMA Certificates applies equally to both FNMA MBS and FNMA SMBS, except as otherwise indicated. Each FNMA Certificate will represent a fractional undivided interest in a pool of mortgage loans formed by FNMA. Each such pool will consist of mortgage loans of one of the following types: (i) fixed or variable rate level installment conventional mortgage loans, or (ii) fixed or variable rate level installment mortgage loans that are insured by FHA or partially guaranteed by the VA. Each mortgage loan must meet the applicable standards set forth under the FNMA purchase program. Each such mortgage loan will be secured by a first lien on a single family (one-to-four units) residential property or on a five- or more family residential property. The original maturities of substantially all of the conventional, level payment mortgage loans are expected to be between either eight to 15 years or 20 to 30 years. Each FNMA Certificate will be issued pursuant to a trust indenture. FNMA will guarantee to the registered holder of each FNMA Certificate that it will distribute amounts representing scheduled principal and interest (at the rate provided for by such FNMA Certificate) on the mortgage loans in the pool represented by such FNMA Certificate, whether or not received, and the full principal amount of any foreclosed or other finally liquidated mortgage loan, whether or not such principal amount is actually received. The obligations of FNMA under its guaranty will be obligations solely of FNMA and will not be backed by, nor entitled to, the full faith and credit of the United States. If FNMA were unable to satisfy such obligations, distributions on FNMA Certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, delinquencies and defaults would impact monthly distributions on such FNMA Certificates. The mortgage loans underlying a FNMA Certificate may have annual interest rates that vary by as much as two percentage points from each other. The rate of interest payable on a FNMA MBS (and the series pass-through rate payable with respect to a FNMA SMBS) is equal to the lowest interest rate of any mortgage loan in the related pool, less a specified minimum annual percentage representing servicing compensation and FNMA's guaranty fee. Under a regular servicing option (pursuant to which the mortgagee or other servicer assumes the risk of foreclosure losses), the annual interest rates on the mortgage loans underlying a FNMA Certificate will be between one-half percentage point and two and one-half percentage points greater than the annual interest rate if a FNMA MBS, or the series pass-through rate if a FNMA SMBS; and under a special servicing option (pursuant to which FNMA assumes the entire risk of foreclosure losses), the annual interest rates on the mortgage loans underlying a FNMA Certificate will be between 55/100ths percentage point and two and 55/100ths percentage points greater than the annual FNMA Certificate interest rate if a FNMA MBS, or the series interest rate if a FNMA SMBS (or between one-half percentage point and two and one-half percentage points greater than the annual FNMA Certificate interest rate for pools that contain mortgage loans with first payment dates no more than 12 months prior to the date of the issuance of the related FNMA Certificate). FNMA SMBS are issued in a series of two or more classes, with each class representing a specified undivided fractional interest in principal distributions and interest distributions (adjusted to the series pass-through rate) on the underlying pool of mortgage loans. The fractional interests of each class in principal and interest distributions are not identical, but the classes in the aggregate represent 100% of the principal distributions and interest distributions (adjusted to the series pass-through rate) on the respective pool. Because of such difference between the fractional interests in principal and interest of each class, the effective rate of interest on the principal of each class of FNMA SMBS may be significantly higher or lower than the series pass-through rate and/or the weighted average interest rate of the underlying mortgage loans. Unless otherwise specified by FNMA, FNMA Certificates evidencing interests in pools of mortgages formed on or after May 1, 1985 will be available in book-entry form only. Distributions of principal and interest on each FNMA Certificate will be made by FNMA on the 25th day of each month to the person in whose name the FNMA Certificate is entered in the books of a Federal Reserve Bank which maintains such accounts (or registered on the FNMA Certificate register in the case of fully registered FNMA Certificates) as of the close of business on the last day of the preceding month. Distributions will be made by wire on FNMA Certificates in book-entry form and by check on FNMA Certificates in fully registered form. Regular monthly installment payments on each FNMA Certificate will be comprised of interest due as specified by such FNMA Certificate plus the scheduled principal payments on the mortgage loans underlying such FNMA Certificate due during the period beginning on the second day of the month prior to the month in which the scheduled monthly installment on such FNMA Certificate is due and ending on the first day of such month in which the scheduled monthly installment on such FNMA Certificate is due. Such regular monthly installments on each such FNMA Certificate will be distributed to the holder of record on the 25th day of each month. Any principal prepayments on the mortgage loans underlying any FNMA Certificate securing a series of Mortgage Securities or any other early recovery of principal on such mortgage loans will be passed through to the holder of record of such FNMA Certificate on the 25th day of the second month next following such prepayment or recovery and a portion of such amounts will be paid to holders of Mortgage Securities as additional principal prepayments. Other Mortgage Certificates The Company may acquire Other Mortgage Certificates or interests therein if the Company determines that it will be beneficial to do so and if acquiring Other Mortgage Certificates or interests therein will not adversely affect qualification of the Company as a REIT. Such Other Mortgage Certificates may include mortgage pass-through certificates, certificates and other securities collateralized by or representing equity interests in manufactured housing contracts and certain loans secured by multi-family projects, other mortgage- collateralized obligations, mortgage securities representing fractional interests in principal and/or interest distributions and other mortgage-backed instruments as determined by the Company. THE MORTGAGE LOANS The Company may acquire Mortgage Loans which are secured by first liens on single-family (one-to-four units) residential properties. Each loan generally will be a permanent loan, as opposed to a construction or development loan, will have a term to maturity not in excess of 30 years and will be fully amortizing over its term. Although the Company's Mortgage Loans generally will be secured by a first lien on such properties, this lien may be subject to liens for taxes, assessments which are not delinquent or remain payable without penalty, certain contracts or leases, and other liens and claims normally deemed in the locality where the property is located not to abrogate the priority of a first lien mortgage or deed of trust. The single-family (one-to-four units) residences securing each Mortgage Loan may consist of (i) detached homes, (ii) attached homes (single-family units having a common wall), (iii) units located in condominiums and (iv) other types of homes or units. Each such detached or attached home will be constructed on land owned in fee simple by the mortgagor or on land leased by the mortgagor for a term at least two years greater than the term of the applicable Mortgage Loan. The fee interest in any leased land will be subject to the lien securing the applicable Mortgage Loan. Attached homes may consist of duplexes, triplexes and four-plexes (multi-family structures where the entire lot on which each structure is built is owned by the owners of the units) or townhouses (multi- family structures in which each mortgagor owns the land upon which the unit is built with the remaining adjacent land owned in common). The Mortgage Loans may be secured by single-family residences which (a) are owner-occupied, (b) are owned by investors or (c) serve as second residences. Certain Mortgage Loans will provide for the payment of interest and full repayment of principal in level monthly installments over an original term to maturity of up to 30 years, with a fixed rate of interest computed on the declining principal balance of the Mortgage Loan. Other Mortgage Loans, however, may consist of level payment loans for which funds have been provided by one or more Mortgage Suppliers selling the loans, their affiliates or other persons to reduce the borrowers' monthly payments during the early period of such Mortgage Loans ("Buy-Down Mortgage Loans"). Payments due on such Buy-Down Mortgage Loans will be the same as payments due on level payment Mortgage Loans, except that the former will include amounts to be collected from the mortgagors and withdrawn from applicable service funds. Such a Buy-Down Mortgage Loan generally either will (i) provide for a reduction in monthly interest payments by the mortgagor for a certain period of time or (ii) provide for a reduction or elimination of monthly principal and interest payments by the mortgagor for certain periods of time. Most of the Mortgage Loans will be fully amortizing over their respective terms, but some may require a "balloon" payment upon maturity. Mortgage Loans that are not fully amortizing over their terms are generally riskier than other Mortgage Loans because the ability of the mortgagor to repay such Mortgage Loans at maturity frequently will be dependent upon his ability to refinance the Mortgage Loans. Mortgage Loans also may include loans which provide for graduated payments during a portion of their term which are less than the actual amount of principal and interest which would be payable on a level debt service basis ("Graduated Payment Mortgage Loans"). The interest not paid in the early years of such a Graduated Payment Mortgage Loan will be added to the principal balance of such Graduated Payment Mortgage Loan and will be paid, together with interest thereon in the later years of such Mortgage Loan. Mortgage Loans also may include adjustable rate mortgage loans ("ARMs"). The interest rate on ARMs is typically tied to an index (such as the interest rate on United States Treasury Notes) and is adjustable periodically at various intervals. There is usually an interest rate cap and floor. ARMs are a comparatively new form of Mortgage Loan, and experience with prepayments and typical rates of default with respect to ARMs has not been extensive, so it is not possible to generate a meaningful comparison between ARMs and fixed-rate Mortgage Loans. In addition, the performance of ARMs in an environment characterized by rising interest rates has not been established. Mortgage Loans also may include loans which provide for annual increases in the amount of the monthly payments ("Growing Equity Mortgage Loans"). Monthly payments for the first year of such a Growing Equity Mortgage Loan are based on a 25- to 30-year amortization schedule, but are increased in each subsequent year at a predetermined rate. In addition, Mortgage Loans may include such other types of loans which the Company determines will be advantageous to acquire. Any Mortgage Loans held by the Company may be covered by insurance. See "Business -- Servicing and Insurance on Mortgage Loans." Conforming Mortgage Loans Conforming Mortgage Loans will comply with the requirements for inclusion in a loan guarantee program sponsored by either FHLMC or FNMA in the case of a conventional Conforming Mortgage Loan. The Company may acquire FHA Loans or VA Loans, which qualify for inclusion in a pool of mortgage loans guaranteed by GNMA. Under current requirements, Conforming Mortgage Loans must be loans on single-family (one-to-four units) residential properties located in the continental United States, having original outstanding principal amounts and loan-to-value ratios not exceeding the amounts and percentages shown in the table below: The FHA Loans will be insured by the Federal Housing Administration of the United States Department of Housing and Urban Development as authorized under the National Housing Act of 1934, as amended, and the United States Housing Act of 1937, as amended. Such FHA Loans will be insured under various FHA programs including the standard FHA 203-b program to finance the acquisition of one-to-four family housing units and the FHA 245 graduated payment mortgage program. FHA Loans generally require a minimum down payment of 3% to 5% of the original principal amount of the FHA Loan. No FHA Loan may have an interest rate or original principal amount exceeding the applicable FHA limits at the time of origination of such FHA Loan. The VA Loans will be partially guaranteed by the VA under the Servicemen's Readjustment Act of 1944, as amended. The Servicemen's Readjustment Act of 1944, as amended, permits a veteran (or in certain instances the spouse of a veteran) to obtain a mortgage loan guarantee by VA covering mortgage financing of the purchase of a one-to-four family dwelling unit at interest rates permitted by VA. The program has no mortgage loan limits, requires no down payment from the purchaser and permits the guarantee of mortgage loans of up to 30 years' duration. However, no VA Loan with an original principal amount greater than five times the partial VA guarantee for such VA Loan will be accepted for purchase by GNMA. As of December 1992, the maximum guarantees that may be issued by VA under this program are the lesser of: (1) as to loans with an original principal amount of not more than $45,000, 50% of the original principal amount of such loan; (2) as to loans with an original principal balance of more than $45,000 but not more than $56,250, $22,500; (3) as to loans with an original principal balance of more than $56,250, the lesser of $36,000 or 40% of the original principal amount of such loan; or (4) as to certain loans, including loans or refinancings of loans for the purchase or construction of a veteran occupied home, condominium unit or farm residence, with an original principal balance of more than $144,000, the lesser of $46,000, or 25% of the loan. Notwithstanding the foregoing, the maximum guarantee shall in no event exceed: (i) $36,000 less the amount of entitlement previously used by the veteran that has not been restored; or (ii) $46,000 less the amount of entitlement previously used by the veteran that has not been restored, as to certain loans, including loans or refinancings of loans for the purchase or construction of a veteran occupied home, condominium unit or farm residence, with an original principal balance of more than $144,000. Nonconforming Mortgage Loans If market conditions warrant, the Company may acquire Nonconforming Mortgage Loans. Nonconforming Mortgage Loans will not qualify for purchase by FHLMC or FNMA or for inclusion in a loan guarantee program sponsored by GNMA. Nonconforming Mortgage Loans generally have outstanding principal balances in excess of program guidelines or are issued based upon different underwriting criteria than that required by such programs. The Company expects to acquire Nonconforming Mortgage Loans only if it determines that the benefits to the Company from the purchase of such Nonconforming Mortgage Loans will equal or exceed the benefits derived from the purchase of Conforming Mortgage Loans. If the Company purchases Nonconforming Mortgage Loans, the Company anticipates that such Nonconforming Mortgage Loans generally will have maximum loan-to- value ratios as follows: 95% for loans up to $150,000; 90% for loans up to $250,000; 85% for loans up to $350,000; and 80% for loans of more than $350,000. In general, the Company does not plan to acquire Nonconforming Mortgage Loans with original outstanding principal amounts of more than $500,000, but the Company may increase such loan amounts in the future generally in proportion to any increase in the FNMA or FHLMC loan amount limits. Except with respect to their outstanding principal amounts, Nonconforming Mortgage Loans acquired by the Company generally will comply with the requirements for participation in FNMA or FHLMC guaranty programs. SERVICING AND INSURANCE ON MORTGAGE LOANS SERVICING The Company does not anticipate purchasing the servicing or excess servicing rights to any Mortgage Loans it acquires, although it is not prohibited from purchasing such rights. The Company expects that the terms of any purchase of Mortgage Loans would permit the seller/servicer to retain a portion of the interest payments on the Mortgage Loans, generally ranging from 1/4 to 3/8 of 1%, and in certain instances, with respect to higher interest rate Mortgage Loans, to retain "excess servicing" in the form of greater portions of the interest payments on Mortgage Loans. The Company will enter into agreements (the "Servicing Agreements") with various servicers (the "Servicers") to service the Mortgage Loans purchased by the Company. Each Servicing Agreement will require the Servicer to service the Company's Mortgage Loans in a manner generally consistent with FNMA and FHLMC guidelines and procedures and with any servicing guidelines promulgated by the Company. Each Servicer will collect and remit principal and interest payments, administer mortgage escrow accounts, submit and pursue insurance claims and initiate and supervise foreclosure proceedings on the Mortgage Loans so serviced. Each Servicer also will be required to follow such collection procedures as are customary in the industry. The Servicer may, in its discretion, arrange with a defaulting borrower a schedule for the liquidation of delinquencies, provided primary mortgage insurance coverage is not adversely affected. In connection with an issuance of Mortgage Securities, such Servicers will provide such additional services as the trustee of such Mortgage Securities or the rating agency rating such Mortgage Securities may require. The servicing may be retained by the Servicer if Mortgage Loans are exchanged for issuance of GNMA Certificates, sold to FHLMC or FNMA or exchanged for issuance of their respective Mortgage Certificates. Each Servicing Agreement will provide that the Servicer may not assign any of its obligations with respect to the Mortgage Loans serviced for the Company, except with the consent of the Company. Expenses and Advances Each Servicer will be required to pay all expenses related to the performance of its duties under its Servicing Agreement. The Servicer will be required to make advances of principal and interest, taxes and required insurance premiums which are not collected from borrowers with respect to any Mortgage Loan, only if the Servicer determines that such advances are recoverable from insurance or liquidation proceeds with respect to such Mortgage Loan. If such advances are made, the Servicer generally will be reimbursed prior to the Company receiving the remaining proceeds. The Servicer also is entitled to reimbursement by the Company for expenses incurred by it in connection with the liquidation of defaulted Mortgage Loans and in connection with the restoration of mortgaged property. If claims are not made or paid under applicable insurance policies or if coverage thereunder has ceased, the Company will suffer a loss to the extent that the proceeds from liquidation of the mortgaged property, after reimbursement of the Servicer's expenses in the sale, are less than the principal balance of the related Mortgage Loan, together with accrued but unpaid interest thereon. The Servicer will be responsible to the Company for any loss suffered as a result of the Servicer's failure to make and pursue timely claims or as a result of actions taken or omissions made by the Servicer which cause the policies to be cancelled by the insurer. Each Servicer will represent and warrant that the Mortgage Loans it services comply with any loan servicing guidelines promulgated by the Company and will agree in certain circumstances to repurchase, at the request of the Company, any Mortgage Loan it services in the event that the Servicer breaches its representations or warranties or any such representation or warranty is found to be untrue. Termination of Servicing Agreement The Company may terminate a Servicing Agreement with any Servicer without payment of a fee upon the happening of one or more of the events specified in the Servicing Agreement. Such events generally will relate to the Servicer's proper and timely performance of its duties and obligations under the Servicing Agreement and the Servicer's financial stability. In addition, the Company may terminate a Servicing Agreement without cause upon payment of the fee set forth in such Servicing Agreement. To the extent that the Servicer is servicing mortgage loans underlying Mortgage Certificates, the Company will not be able to terminate the Servicer without the approval of GNMA, FHLMC or FNMA and such entities will be entitled to terminate the Servicer in accordance with their own regulations. With respect to Mortgage Loans which secure or underlie a series of Mortgage Securities, the Company may not be able to terminate the Servicing Agreement without the approval of the trustee and the Master Servicer as described below for such series of Mortgage Securities. Master Servicing In connection with the issuance of a series of Mortgage Securities secured by or representing interests in Mortgage Loans owned or financed by the Company, the Company or other Issuer generally will be required to enter into a Master Servicing Agreement with respect to such series of Mortgage Securities with an entity acceptable to the rating agency rating such series of Mortgage Securities (the "Master Servicer"). Under the terms of the Master Servicing Agreement, the Master Servicer generally will advance and remit to the trustee any payment of principal and interest and any principal prepayments which a Servicer fails to advance or remit on a timely basis, excluding certain nonrecoverable advances. In addition, if a Servicer defaults in the performance of its servicing duties or, with the consent of the Company or other Issuer, assigns such duties to the Company, the Master Servicer will assume the servicing function of that Servicer and all responsibilities set forth in the related Servicing Agreement, for the same fee that the Servicer was receiving at the time of such default. Master Servicer Fees Pursuant to the terms of the Master Servicing Agreement for a series of Mortgage Securities, the Master Servicer for such series will receive a monthly administrative service fee which will be in an amount negotiated between the Company or other Issuer and the Master Servicer. Termination of Master Servicing Agreement The Company or other Issuer generally will be able to terminate the Master Servicing Agreement for a series of Mortgage Securities without the payment of a fee upon 30 days' notice following the happening of one or more events specified in the Master Servicing Agreement. Such events generally will relate to the Master Servicer's proper and timely performance of its duties and obligations under the Master Servicing Agreement and its financial condition. In addition, the Company or other Issuer generally will have the right to terminate the Master Servicing Agreement without cause upon payment of a predetermined fee. INSURANCE If the Board of Directors determines that it is beneficial to accumulate Mortgage Loans prior to the issuance of the Mortgage Securities which will be secured by or will represent interests in such Mortgage Loans, the Company will maintain insurance on any such Mortgage Loans held by it. In connection with the issuance of a series of Mortgage Securities, the Company or other Issuer which issues the Mortgage Securities of such series generally will be required to obtain additional insurance on the Mortgage Loans securing or underlying such series of Mortgage Securities. Set forth below is a description of the insurance anticipated to be maintained on the Company's Mortgage Loans and the additional insurance which may be required if Mortgage Loans are pledged or transferred to secure or underlie a series of Mortgage Securities. Primary Mortgage Insurance Primary mortgage insurance insures the payment of certain portions of the principal and interest on Mortgage Loans. Based on current conditions, the Company generally will require that a primary mortgage insurance policy be obtained on conventional Conforming Mortgage Loans with loan-to-value ratios in excess of 80% and that such policy cover the amount by which the loan balance exceeds 75% of the lesser of the sales price or appraised fair market value of the mortgaged property. The cost of this insurance will be borne by the borrower or the concern selling the Mortgage Loans to the Company. Primary mortgage insurance is not likely to be obtained for FHA Loans and VA Loans. FHA insurance covers substantially all of the mortgage loan amount and is available on those loans with principal balances that do not exceed the maximum FHA loan amounts for the region in which the property securing the loan is located. As of December 1993, the maximum guarantees that may be issued by VA are the lesser of: (1) as to loans with an original principal amount of not more than $45,000, 50% of the original principal amount of such loan; (2) as to loans with an original principal balance of more than $45,000 but not more than $56,250, $22,500; (3) as to loans with an original principal balance of more than $56,250, the lesser of $36,000 or 40% of the original principal amount of such loan; or (4) as to certain loans, including loans or refinancings of loans for the purchase or construction of a veteran occupied home, condominium unit or farm residence, with an original principal balance of more than $144,000, the lesser of $46,000, or 25% of the loan. Notwithstanding the foregoing, the maximum guarantee shall in no event exceed: (i) $36,000 less the amount of entitlement previously used by the veteran that has not been restored; or (ii) $46,000 less the amount of entitlement previously used by the veteran that has not been restored, as to certain loans, including loans or refinancings of loans for the purchase or construction of a veteran occupied home, condominium unit or farm residence, with an original principal balance of more than $144,000. The Company intends to obtain the maximum available insurance on its FHA Loans and the maximum available guarantees on its VA Loans. Consistent with competitive conditions and perceived costs, the Company may obtain primary mortgage insurance on Nonconforming Mortgage Loans, either at its own cost or by requiring the borrowers or the sellers of such loans to bear all or a portion of such cost. If a claim is made under a primary mortgage insurance policy, the mortgage insurer will have the option either (i) to purchase the defaulted mortgage loan at a price equal to its principal balance plus accrued and unpaid interest to the date of purchase and allowable expenses or (ii) to pay the claim on the policy. Typically, a claim may not be made until any physical loss or damage to the property has been repaired and the property has been restored to at least as good a condition as existed at the time the policy became effective, ordinary wear and tear excepted. Standard Hazard Insurance Standard hazard insurance policies cover physical damage to or destruction of the improvements on mortgaged property by fire, lightning, explosion, smoke, wind storm and hail, riot, strike and civil commotion, subject to the conditions and exclusions of such policies. The Company will require standard hazard insurance coverage on the properties securing Mortgage Loans. Such policies may contain different terms and conditions depending upon the insurers and the laws of the states where the mortgaged properties are located. When a mortgaged property is located in a flood area identified by the United States Department of Housing and Urban Development pursuant to the National Flood Insurance Act of 1968, the borrower or seller will be required to obtain flood insurance. Because residential properties securing the Mortgage Loans in various states may appreciate in value over time, hazard insurance proceeds may be insufficient to fully restore appreciated property if damaged. Other Insurance In order to obtain the desired ratings on a series of Mortgage Securities which will be secured by or will represent interests in conventional Mortgage Loans, the Company generally will be required to obtain insurance coverage in addition to that described above. Such insurance may include (i) increased primary mortgage insurance and standard hazard insurance coverage, (ii) mortgage pool insurance, which covers loss by reason of default in payments not covered by primary mortgage insurance, in an amount equal to a percentage of the aggregate principal balance of the Mortgage Loans within the pool, (iii) special hazard insurance which covers certain losses from physical damage to or destruction of the improvements on mortgaged property not covered by standard hazard insurance, (iv) additional insurance protection against the loss or reduction of payments on a Mortgage Loan in connection with the bankruptcy or other insolvency of the borrower, and (v) such other insurance as may be necessary to meet rating agency criteria. Recovery under any such insurance will be subject, as a matter of course, to certain conditions and exclusions. In some cases, the cost of such insurance will be paid by the Company. CERTAIN LEGAL ASPECTS OF MORTGAGE LOANS The following discussion contains summaries of certain legal aspects of Mortgage Loans which are general in nature. Because such legal aspects are governed by applicable state law (which laws may differ substantially), the summaries do not purport to be complete nor to reflect the laws of any particular state, nor to encompass the laws of all states in which the security for the Mortgage Loans is situated. The summaries are qualified in their entirety by reference to the applicable federal and state laws governing Mortgage Loans. In this regard, the following discussion does not reflect federal regulations with respect to FHA Loans and VA Loans. Moreover, the following discussion is not relevant to Mortgage Loans underlying Mortgage Certificates because the Company will rely upon the payment guarantees of the applicable federal agency or instrumentality and not the payments by borrowers with respect to the underlying Mortgage Loans. GENERAL The Mortgage Loans will be secured by first liens on the related mortgaged properties, represented by first mortgages or deeds of trust, depending upon the prevailing practice in the state in which such mortgaged property is located. A mortgage creates a lien upon the real property encumbered by the mortgage. There are two parties to a mortgage: the mortgagor, who is the borrower and owner; and the mortgagee, who is the lender. Under the mortgage instrument, the mortgagor delivers to the mortgagee a note or bond and the mortgage. Although a deed of trust is similar to a mortgage, a deed of trust has three parties: the borrower-owner called the trustor (similar to a mortgagor), a lender called the beneficiary (similar to a mortgagee), and a third-party grantee called the trustee. Under a deed of trust, the trustor grants the property, irrevocably until the debt is paid, in trust for the benefit of the beneficiary, generally with a power of sale, to the trustee, the effect of which is to create a lien to secure payment of the obligation. The trustee's authority under a deed of trust and the mortgagee's authority under a mortgage are governed by law, the express provisions of the deed of trust or mortgage, and, in some cases, with respect to the deed of trust, the directions of the beneficiary. FORECLOSURE Foreclosure of a mortgage is generally accomplished by judicial action. Generally, the action is initiated by the service of legal pleadings upon all parties having an interest of record in the real property. Delays in completion of the foreclosure occasionally may result from difficulties in locating necessary parties defendant. When the mortgagee's right to foreclosure is contested, the legal proceedings necessary to resolve the issue can be time consuming. The court may issue a judgment of foreclosure and appoint a receiver or other officer to conduct the sale of the property. In some states, mortgages also may be foreclosed by advertisement, pursuant to a power of sale provided in the mortgage documents. Foreclosure of a mortgage by advertisement is essentially similar to foreclosure of a deed of trust by non- judicial sale. Enforcement of a deed of trust is generally accomplished by a non-judicial trustee's sale under a specific provision in the deed of trust which authorizes the trustee to sell the property to a third party upon any default by the trustor under the terms of the note or deed of trust. In certain states, sale of the property upon any default by the trustor under the terms of the note or deed of trust also may be accomplished by judicial action in the manner provided for foreclosure of mortgages. In some states, the trustee must record a notice of default and send a copy to the trustor and to any person who has recorded a request for a copy of a notice of default and notice of sale. In addition, in some states the trustee must provide notice to any other individual having an interest of record in the real property, including any junior lienholders. If the deed of trust is not reinstated within the cure period, a notice of sale must be posted in a public place and, in most states, published for a specified period of time in one or more newspapers. In addition, some state laws require that a copy of the notice of sale be posted on the property and sent to all parties having an interest of record in the property. In some states, the trustor under a deed of trust has the right to reinstate the loan at any time following default until shortly before the trustee's sale. In general, the trustor, or any other person having a junior encumbrance on the real estate, may, during a reinstatement period, cure the default by paying the entire amount in arrears plus the costs and expenses incurred in enforcing the obligation. Certain state laws control the amount of expenses and costs, including attorneys' fees and trustee's fees, which may be recovered by a beneficiary upon the enforcement of the trustee's power of sale. In case of judicial foreclosure under a mortgage or deed of trust or power of sale foreclosure under a deed of trust, the sale by the receiver or other designated officer, or by the trustee, is a public sale. However, because of the difficulty a potential buyer at the sale would have in determining the exact status of title and because the physical condition of the property may have deteriorated during the foreclosure proceedings, it is uncommon for a third party to purchase the property at the foreclosure sale. Rather, in many instances the lender will purchase the property from the trustee or receiver for an amount equal to the unpaid principal amount of the note, accrued and unpaid interest and the expenses of foreclosure. Thereafter, subject to the right of the borrower in some states to remain in possession during the redemption period, the lender will assume the burdens of ownership, including obtaining hazard insurance and making such repairs at its own expense as are necessary to render the property suitable for sale. The lender commonly will obtain the services of a real estate broker and pay the broker a commission in connection with the sale of the property. Depending upon market conditions, the ultimate proceeds of the sale of the property may not equal the lender's investment in the property. Any loss may be reduced by the receipt of mortgage insurance proceeds. RIGHTS OF REDEMPTION In some states, the borrower has an equitable right to redeem the property prior to foreclosure or non-judicial sale. In addition, in some states, after sale pursuant to a non-judicial power of sale under a deed of trust or judicial foreclosure of a mortgage or deed of trust, the borrower and certain foreclosed junior lienors are given a statutory period in which to redeem the property from the sale. In certain other states, this right of statutory redemption applies only to sale following judicial foreclosure, and not to sale pursuant to a non-judicial power of sale. In most states where the right of redemption is available, statutory redemption may occur upon payment of the purchase price at the sale, accrued interest and taxes. The effect of a right of redemption is to diminish the ability of the lender to re-sell the property. The rights of redemption would defeat the title of any purchaser at sale, or of any purchaser from the lender subsequent to judicial foreclosure of a mortgage or deed of trust or sale pursuant to a non-judicial power of sale under a deed of trust. Consequently, the practical effect of the redemption right is to force the lender to maintain the property and pay the expenses of ownership until the redemption period has run. ANTI-DEFICIENCY LEGISLATION AND OTHER LIMITATIONS ON LENDERS Certain states have imposed statutory prohibitions which limit the remedies of a beneficiary under a deed of trust or a mortgagee under a mortgage relating to a single-family residence. In some states, statutes limit the right of the beneficiary or mortgagee to obtain a deficiency judgment against the borrower following foreclosure or sale under a deed of trust. A deficiency judgment is a personal judgment against the former borrower equal in most cases to the difference between the amount due to the lender and the net amount realized upon the public sale of the real property. Some state statutes may require the beneficiary or mortgagee to exhaust the security afforded under a deed of trust or mortgage by foreclosure or sale under a deed of trust in an attempt to satisfy the full debt before bringing a personal action against the borrower. In certain other states, the lender has the option of bringing a personal action against the borrower on the debt without first exhausting such security; however, in some of these states, the lender, following judgment on such personal action, may be deemed to have elected a remedy and may be precluded from exercising remedies with respect to the security. Consequently, the practical effect of the election requirement, when applicable, is that lenders will usually proceed against the security rather than bringing a personal action against the borrower. Other statutory provisions may limit any deficiency judgment against the former borrower following a judicial sale or sale pursuant to the trustee's power of sale to the excess of the outstanding debt over the fair market value of the property at the time of the public sale. The purpose of these statutes is to prevent a beneficiary or a mortgagee from obtaining a large deficiency judgment against the former borrower as a result of low or no bids at the judicial sale or sale pursuant to the trustee's power of sale. In some states, exceptions to the anti-deficiency statutes are provided for in certain instances where the value of the lender's security has been impaired by acts or omissions of the borrower, for example, in the event of waste of the property. In addition to anti-deficiency and related legislation, numerous other federal and state statutory provisions, including the federal bankruptcy laws, the federal Soldiers' and Sailors' Civil Relief Act of 1940 and state laws affording relief to debtors, may interfere with or affect the ability of the secured mortgage lender to realize upon its security. For example, in a Chapter 13 proceeding under the United States Bankruptcy Code (11 U.S.C. (S)101 et. seq.) (the "Bankruptcy Code"), when a court determines that the value of a home is less than the principal amount of the loan, the court may prevent a lender from foreclosing on the home, and, as part of the rehabilitation plan, if the home is not the debtor's principal residence, may reduce the amount of the secured indebtedness to the value of the home as it exists at the time of the proceeding, leaving the lender as a general unsecured creditor for the difference between that value and the amount of outstanding indebtedness. In addition, a bankruptcy court may grant the debtor a reasonable time to cure a payment default, and in the case of a mortgage loan in a Chapter 11 proceeding under the Bankruptcy Code, or in the case of a mortgage loan not secured by the debtor's principal residence in a Chapter 13 proceeding, also may reduce the monthly payments due under such mortgage loan, change the rate of interest and alter the mortgage loan repayment schedule. Some bankruptcy courts also have held that a sale pursuant to a mortgage or deed of trust foreclosure may be voided if it is found that the proceeds of the sale were not reasonably equivalent to the value of the property sold. The laws of some states provide priority to certain tax liens over the lien of the mortgage or deed of trust. Numerous federal and state consumer protection laws and regulations impose substantive requirements upon mortgage lenders in connection with the origination, servicing and the enforcement of mortgage loans. These laws include the federal Truth-in-Lending Act, Real Estate Settlement Procedures Act, Equal Credit Opportunity Act, Fair Credit Reporting Act, Federal Trade Commission's Credit Practices Rule, and related statutes and regulations. These federal laws and state laws impose specific liabilities upon lenders who originate or service mortgage loans and who fail to comply with the provisions of the law. In some cases, this liability may affect assignees of the mortgage loans. "DUE-ON-SALE" CLAUSES The forms of note, mortgage and deed of trust relating to the Mortgage Loans may contain a "due-on-sale" clause permitting acceleration of the maturity of the loan if the borrower transfers its interest in the property. In recent years, court decisions and legislative actions placed substantial restrictions on the right of lenders to enforce such clauses in many states. However, effective October 15, 1982, Congress enacted the Garn-St. Germain Depository Institutions Act of 1982 (the "Garn-St. Germain Act") which purports to preempt state laws which prohibit the enforcement of "due-on-sale" clauses by providing, among other matters, that "due-on-sale" clauses in certain loans (which loans will include conventional Mortgage Loans) made after the effective date of the Garn-St. Germain Act are enforceable, within certain limitations as set forth in the Garn-St. Germain Act and the regulations promulgated thereunder. By virtue of the Garn-St. Germain Act, acceleration of any conventional Mortgage Loan which contains a "due-on-sale" clause may be permitted upon transfer of an interest in the property subject to the mortgage or deed of trust. With respect to any Mortgage Loan secured by a residence occupied or to be occupied by the borrower, this ability to accelerate will not apply to certain types of transfers, including (i) the granting of a leasehold interest which has a term of three years or less and which does not contain an option to purchase, (ii) a transfer in which the transferee is a person who occupies or will occupy the real property, which is a transfer to a relative resulting from the death of a borrower, or a transfer where the spouse or child(ren) becomes an owner of the property, (iii) a transfer resulting from a decree of dissolution of marriage, legal separation agreement or from an incidental property settlement agreement by which the spouse becomes an owner of the property, (iv) the creation of a lien or other encumbrance subordinate to the lender's security interest which does not relate to a transfer of rights of occupancy in the property (provided that such lien or encumbrance is not created pursuant to a contract for deed), (v) a transfer by devise, descent or operation of law on the death of a joint tenant or tenant by the entirety, and others as set forth in the Garn-St. Germain Act and the regulations thereunder. As a result, a lesser number of the Mortgage Loans which contain "due-on-sale" clauses may extend to full maturity than recent experience would indicate with respect to single-family mortgage loans. The extent of the impact of the Garn-St. Germain Act on the average lives and delinquency rates of the Mortgage Loans, however, cannot be predicted. ENFORCEABILITY OF CERTAIN PROVISIONS The standard forms of note, mortgage and deed of trust utilized with respect to the Mortgage Loans generally contain provisions obligating the borrower to pay a late charge if payments are not timely made and in some circumstances may provide for prepayment fees or penalties if the obligation is paid prior to maturity. In certain states, there are or may be specific limitations upon late charges which a lender may collect from a borrower in the event payments are not made on time. Certain states also limit the amounts which a lender may collect from a borrower as an additional charge if the loan is prepaid. Under the Servicing Agreements, late charges and prepayment fees (to the extent permitted by law and not waived) may be retained by the Master Servicer or the Servicers, as applicable, as additional compensation. Courts have imposed general equitable principles upon foreclosure. These equitable principles are generally designed to relieve the borrower from the legal effect of defaults under the loan documents. Examples of judicial remedies that may be fashioned include judicial requirements that the lender undertake affirmative and expensive actions to determine the causes for the borrower's default and the likelihood that the borrower will be able to reinstate the loan. In some cases, courts have substituted their judgment for the lender's judgment and have required lenders to reinstate loans or recast payment schedules to accommodate borrowers who are suffering from temporary financial disability. In some cases, courts have limited the right of lenders to foreclose if the default under the mortgage instrument is not monetary, such as the borrower failing to adequately maintain the property or the borrower executing a second mortgage or deed of trust affecting the property. In other cases, some courts have been faced with the issue of whether or not federal or state constitutional provisions reflecting due process concerns for adequate notice require that borrowers under deeds of trust receive notices in addition to the statutorily-prescribed minimum requirements. For the most part, these cases have upheld the notice provisions as being reasonable or have found that the sale by a trustee under a deed of trust or under a mortgage having a power of sale does not involve sufficient state action to afford constitutional protection to the borrower. Applicability of Usury Laws Title V of the Depository Institutions Deregulation and Monetary Control Act of 1980, enacted in March 1980 ("Title V"), provides that state usury limitations will not apply to certain types of residential first mortgage loans originated by certain mortgagees after March 31, 1980. Title V authorized any state to reimpose limitations on interest rates and finance charges by adopting before April 1, 1983 a law or constitutional provision which expressly rejects application of the federal law. Fifteen states and Puerto Rico adopted such a law prior to the April 1, 1983 deadline. In addition, even where Title V was not so rejected, any state is authorized by the law to adopt a provision limiting discount points or other charges on loans covered by Title V. ENVIRONMENTAL LEGISLATION Certain states impose a statutory lien for associated costs on property that is the subject of a cleanup action by the state on account of hazardous wastes or hazardous substances released or disposed of on the property. Such a lien generally will have priority over all subsequent liens on the property and, in certain of these states, will have priority over prior recorded liens, including the lien of a mortgage. In addition, under federal environmental legislation and possibly under state law in a number of states, a secured party that takes a deed in lieu of foreclosure or acquires a mortgaged property at a foreclosure sale may be liable for the costs of cleaning up a contaminated site. Although such costs could be substantial, it is unclear whether they would be imposed on a secured lender on residential properties. ITEM 2. ITEM 2. PROPERTIES The principal executive offices of the Company are located at 5333 North Seventh Street, Suite 219, Phoenix, Arizona 85014, telephone (602) 265-8541. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On February 18, 1993, the Internal Revenue Service sent to the Company a proposed adjustment (the "Proposed Adjustment") to the amount of taxes owed by the Company for the years ending December 31, 1989, December 31, 1990 and December 31, 1991 as indicated below: PENALTIES ---------------------------------- YEAR TAX SECTION 6661 SECTION 6662 - ------------------------- -------------- ---------------- ---------------- December 31, 1989 $1,646,582 $411,645 December 31, 1990 $3,852,589 $ 770,518 December 31, 1991 $5,391,042 $1,078,203 The Proposed Adjustment did not include any amounts for interest which might be owed by the Company. The Internal Revenue Service claimed that the Company did not meet the statutory requirements to be taxed as a REIT for the years ending December 31, 1989, 1990 and 1991 because the Company did not demand certain shareholder information pursuant to Regulation Section 1.857-8 under the Internal Revenue Code within the specified 30 day period of each of the Company's year-ends. On March 18, 1993, the Company filed a protest with the District Director of the Internal Revenue Service challenging the proposed adjustments (the "Protest"). In the Protest, the Company has stated that (i) the Company has made all the requisite demands of its shareholders for each applicable year and has thus complied with Regulation Section 1.857-8, (ii) Regulation Section 1.857-8(e), under which the revenue agent relied upon to revoke the Company's REIT status, was incorrectly applied, and (iii) the Company substantially complied with Regulation Section 1.857-8. The Company also has requested relief under Regulation Section 301.9100-1 from the requirement in Regulation Section 1.857-8 that certain shareholder demands be made within 30 days from the end of a calendar year. The Company also has stated in the Protest that the penalties imposed under the Proposed Adjustment were incorrectly applied. The Company has not yet received a final response to its protest. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS None PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is listed on the New York Stock Exchange under the symbol "HPX." The high and low sales prices of shares of the Common Stock on the New York Stock Exchange and the dividends per share paid by the Company for the periods indicated were as follows: DIVIDENDS HIGH LOW PER SHARE --------- --------- --------- First quarter....................... $ 7 5/8 $ 4 5/8 $ .25 Second quarter...................... 6 5/8 4 3/4 .15 Third quarter....................... 5 1/8 1 7/8 0 Fourth quarter...................... 3 3/8 1 3/4 0 First quarter....................... 2 5/8 1 5/8 0 Second quarter...................... 2 1 1/2 0 Third quarter....................... 1 5/8 1 0 Fourth quarter...................... 1 1/2 3/4 .03 On March 23, 1994, the closing sales price of the Common Stock of the Company on the New York Stock Exchange was $13/8. On December 31, 1993, the Company had outstanding 9,731,717 shares of Common Stock which were held by approximately 920 stockholders of record. Based upon information available to the Company, the Company believes that there are approximately 6,000 beneficial owners of its Common Stock. 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 generally intends that the cash dividends paid each year to its stockholders will equal or exceed the Company's taxable income. The actual amount and timing of dividend payments, however, will be at the discretion of the Board of Directors and will depend upon the financial condition of the Company in addition to the requirements of the Code. The Company has, in the past, distributed 100% of its taxable income to its shareholders. However, primarily as a result of the significant mortgage refinancing activity in both 1992 and 1993, the Company has accumulated a net operating loss carryforward, for income tax purposes, of approximately $49,300,000 as of December 31, 1993. This tax loss may be carried forward, with certain restrictions, for up to 15 years to offset future taxable income, if any. Until the tax loss carryforward is fully utilized, the Company will not be required to distribute dividends to its stockholders except to the extent of its "excess inclusion income." See "Business -- Federal Income Tax Considerations -- Taxation of Common Stock Ownership -- Excess Inclusion Income." The Company may apply the principal from repayments, sales and refinancings of the Company's Mortgage Assets to reduce the unpaid principal balance of its Secured Notes. The Company also may, under certain circumstances, and subject to the distribution requirements referred to in the immediately preceding paragraph, make distributions of principal. Such distributions of principal, if any, will be made at the discretion of the Board of Directors and only to the extent permitted by the Company's Indenture with respect to the Secured Notes. Although a portion of the dividends may be designated by the Company as capital gain or may constitute a return of capital, it is anticipated that dividends generally will be taxable as ordinary income to taxpaying stockholders of the Company. With respect to tax-exempt organizations, it is likely that a significant portion of the dividends will be treated as unrelated business taxable income ("UBTI"). Dividends received by a corporation will not be eligible for the dividends-received deduction so long as the Company qualifies as a REIT. The Company furnishes annually to each of its stockholders a statement setting forth distributions paid during the preceding year and their characterization as ordinary income, return of capital or capital gains. For a discussion of the federal income tax treatment of distributions by the Company, see "Business -- Federal Income Tax Considerations -- Taxation of the Company, -- Tax Consequences of Common Stock Ownership, and -- Tax-Exempt Organizations as Stockholders." The taxable income of the Company from its Mortgage Assets is increased by non-cash income from, among other things, the accretion of market discount on the Mortgage Instruments securing or underlying Mortgage Securities and is decreased by non-cash expenses, including, among other things, the amortization of the issuance costs of Mortgage Securities and the accretion of original issue discount on certain Classes of Mortgage Securities. The taxable income of the Company will differ from its net income for financial reporting purposes principally as a result of the different method used to determine the effect and timing of recognition of such non-cash income and expenses. Because the Company must distribute to its stockholders an amount equal to substantially all of its net taxable income (computed after taking into account any net operating loss carryforwards that are available) in order to qualify as a REIT the Company may be required to distribute a portion of its working capital to its stockholders, borrow funds or sell assets to make required distributions in years in which the non-cash items of taxable income exceed the Company's non-cash expenses. In the event that the Company is unable to pay dividends equal to substantially all of its taxable income, it will not continue to qualify as a REIT. The Company's Articles of Incorporation, as amended to date (the "Articles of Incorporation"), prohibit ownership of its Common Stock by tax-exempt entities that are not subject to tax on unrelated business taxable income and by certain other persons (collectively "Disqualified Organizations"). Such restriction on ownership exists so as to avoid imposition of a tax on a portion of the Company's income from excess inclusions. Provisions of the Company's Articles of Incorporation also are designed to prevent concentrated ownership of the Company which might jeopardize its qualification as a REIT under the Code. Among other things, these provisions provide (i) that any acquisition of shares that would result in the disqualification of the Company as a REIT under the Code will be void, and (ii) that in the event any person acquires, owns or is deemed, by operation of certain attribution rules set out in the Code, to own a number of shares in excess of 9.8% of the outstanding shares of the Company's Common Stock ("Excess Shares"), the Board of Directors, at its discretion, may redeem the Excess Shares. In addition, the Company may refuse to effectuate any transfer of Excess Shares and certain stockholders and proposed transferees of shares may be required to file an affidavit with the Company setting forth certain information relating, generally, to their ownership of the Company's Common Stock. These provisions may inhibit market activity and the resulting opportunity for the Company's stockholders to receive a premium for their shares that might otherwise exist if any person were to attempt to assemble a block of shares of the Company's Common Stock in excess of the number of shares permitted under the Articles of Incorporation. Such provisions also may make the Company an unsuitable investment vehicle for any person seeking to obtain (either alone or with others as a group) ownership of more than 9.8% of the outstanding shares of Common Stock. Investors seeking to acquire substantial holdings in the Company should be aware that this ownership limitation may be exceeded by a stockholder without any action on such stockholder's part if the number of outstanding shares of the Company's Common Stock is reduced. On December 13, 1993, the Board of Directors approved the adoption of a program to repurchase up to 2,000,000 shares of the Company's common stock in open market conditions. The decision to repurchase shares pursuant to the program, and the timing and amount of such purchases, will be based upon market conditions then in effect and other corporate considerations. Through March 23, 1994, 1,600 shares of common stock have been repurchased under such program. 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 elsewhere herein. The data has been derived from the financial statements of the Company audited by Kenneth Leventhal & Company, independent certified public accountants, as indicated by their report thereon as specified therein which also appears elsewhere herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION, RESULTS OF OPERATIONS AND INTEREST RATES AND OTHER INFORMATION RESULTS OF OPERATIONS -- 1993 COMPARED TO 1992 The Company incurred a net loss of $31,988,000 or $3.29 per share in 1993 compared to a net loss of $19,133,000 or $1.93 per share in 1992. The 1993 loss included in a charge of $6,078,000 or $.63 per share from the cumulative effect of an accounting change. See Note 10 to the financial statements. The Company's loss from mortgage assets increased from $14,068,000 in 1992 to $21,814,000 in 1993 primarily due to continuing increases in both actual and projected mortgage prepayment speeds. The negative impact on income of increased mortgage prepayment speeds more than offset the positive effect on income from lower LIBOR rates on floating rate CMO classes and lower LIBOR and COFI rates on floating rate MPC classes related to the Company's Mortgage Interests. See "Interest Rates and Prepayments." The Company's interest expense declined from $2,750,000 in 1992 to $2,274,000 in 1993 due to a reduction of the average aggregate long-term debt and short-term borrowings outstanding. General and administrative expenses declined from $2,246,000 in 1992 to $1,684,000 in 1993 primarily as a result of a reduction in payroll and payroll related expenses that are tied to the level of the Company's net income and dividends. RESULTS OF OPERATIONS -- 1992 COMPARED TO 1991 The Company incurred a net loss of $19,133,000 or $1.93 per share in 1992 compared to a net income of $8,027,000 or $.81 per share in 1991. The Company's income (loss) from mortgage assets decreased from income of $15,507,000 in 1991 to a loss of $14,068,000 in 1992 primarily due to continuing increases in both actual and projected mortgage prepayment speeds. The negative impact on income of increased mortgage prepayment speeds more than offset the positive effect on income from lower LIBOR rates on floating rate CMO classes and lower LIBOR and COFI rates on floating rate MPC classes related to the Company's Mortgage Interests. See "Interest Rates and Prepayments." The Company's interest expense declined from $4,535,000 in 1991 to $2,750,000 in 1992 due to a combination of reducing the average aggregate long-term debt and short-term borrowings outstanding and also a reduction in short-term rates. General and administrative expenses declined from $2,681,000 in 1991 to $2,246,000 in 1992 primarily as a result of a reduction in payroll and payroll related expenses that are tied to the level of the Company's net income and dividends. LIQUIDITY, CAPITAL RESOURCES AND COMMITMENTS The Company raised $80,593,000 in connection with its initial public offering on July 27, 1988. The proceeds were immediately utilized to purchase Mortgage Interests. Subsequently, through October 1988, the Company purchased an additional $59,958,000 of Mortgage Interests which were initially financed using a combination of borrowings under repurchase agreements and the Company's bank line of credit. The Company has not purchased any Mortgage Interests since October 1988. On December 17, 1992, a wholly-owned limited-purpose subsidiary of the Company issued $31,000,000 of Secured Notes under an Indenture to a group of institutional investors. The Notes bear interest at 7.81% and require quarterly payments of principal and interest with the balance due on February 15, 2001. The Notes are secured by the Company's residual interests in Westam 1, Westam 3, Westam 5, Westam 6 and ASW 65 (see Note 3 to the financial statements), by the Company's Interests relating to mortgage participation certificates FNMA 1988-24 and FNMA 1988-25 (see Note 4 to the financial statements), and by funds held by Trustee. The Company used $3,100,000 of the proceeds to establish a reserve fund. The reserve fund has a specified maximum balance of $7,750,000, and is to be used to make the scheduled principal and interest payments on the Notes if the cash flow available from the collateral is not sufficient to make the scheduled payments. Depending on the level of certain specified financial ratios relating to the collateral, the cash flow from the collateral is required to either repay the Notes at par, increase the reserve fund up to its $7,750,000 maximum or is remitted to the Company. At December 31, 1993, $8,761,000 of funds held by Trustee are pledged under the Indenture. At December 31, 1993, the Company does not have any used or unused short- term debt or line of credit facilities. The Company has historically used its cash flow from operations for payment of dividends, operating expenses and payment of interest and principal on its short and long-term indebtedness. As a real estate investment trust (REIT), the Company is not subject to income tax at the corporate level as long as it distributes 95% of its taxable income to its shareholders. The Company has, in the past, distributed 100% of its taxable income to its shareholders. However, primarily as a result of the significant mortgage refinancing activity in both 1992 and 1993 (see "Interest Rates and Prepayments") the Company has accumulated a net operating loss carryforward, for income tax purposes, of approximately $49,300,000 as of December 31, 1993. This tax loss may be carried forward, with certain restrictions, for up to 15 years to offset future taxable income, if any. Until the tax loss carryforward is fully utilized the Company will not be required to distribute dividends to its stockholders. The Company anticipates that future cash flow from operations will be used for payment of operating expenses and debt service with the remainder, if any, available for investment in mortgage or real estate related assets. At December 31, 1993, the Company has $16,247,000 of cash and cash equivalents available for investment purposes. INTEREST RATES AND PREPAYMENTS One of the Company's major sources of income is its income from Mortgage Interests which consists of the Company's net investment in eight real estate mortgage investment conduits ("REMICs") as described in Notes 3, 4 and 10 to the financial statements. The Company's cash flow and return on investment from its Mortgage Interests are highly sensitive to the prepayment rate on the related Mortgage Certificates and the variable interest rates on variable rate CMOs and MPCs. At December 31, 1993, the Company's proportionate share of floating-rate CMOs and MPCs in the eight REMICs is $111,254,000 in principal amount that pays interest based on LIBOR and $8,406,000 in principal amount that pays interest based on COFI. Consequently, absent any changes in prepayment rates on the related Mortgage Certificates, increases in LIBOR and COFI will decrease the Company's net income, and decreases in LIBOR and COFI will increase the Company's net income. The average LIBOR and COFI rates were as follows: 1993 1992 1991 --------- --------- --------- LIBOR..................................... 3.22% 3.86% 6.11% COFI...................................... 4.16% 5.45% 7.37% The LIBOR and COFI rates as of December 31, 1993, were 3.25% and 3.82%, respectively. On May 12, 1992, the Company entered into a LIBOR ceiling rate agreement with a bank for a fee of $245,000. The agreement, which has a term of two years beginning July 1, 1992, requires the bank to pay a monthly amount to the Company equal to the product of $175,000,000 multiplied by the percentage, if any, by which actual one-month LIBOR (measured on the first business day of each month) exceeds 9.0%. Through December 31, 1993 LIBOR has remained under 9.0% and, accordingly, no amounts have been payable under the agreement. The Company's cash flow and return on investment from Mortgage Interests also is sensitive to prepayment rates on the Mortgage Certificates securing the CMOs and underlying the MPCs. In general, slower prepayment rates will tend to increase the cash flow and return on investment from Mortgage Interests and faster prepayment rates will tend to decrease the cash flow and return on investment from Mortgage Interests. The rate of principal prepayments on Mortgage Certificates is influenced by a variety of economic, geographic, social and other factors. In general, prepayments of the Mortgage Certificates should increase when the current mortgage interest rates fall below the interest rates on the fixed rate mortgage loans underlying the Mortgage Certificates. Conversely, to the extent that then current mortgage interest rates exceed the interest rates on the mortgage loans underlying the Mortgage Certificates, prepayments of such Mortgage Certificates should decrease. Prepayment rates also may be affected by the geographic location of the mortgage loans underlying the Mortgage Certificates, conditions in mortgage loan, housing and financial markets, the assumability of the mortgage loans and general economic conditions. The national average contract interest rate for major lenders on purchase of previously occupied homes, as published by the Federal Housing Finance Board, decreased from an average of 9.04% in 1991 to an average of 7.84% in 1992 to an average of 6.96% in 1993. This resulted in a significant increase in refinancing activity beginning in the fourth quarter of 1991 and continuing throughout 1992 and 1993. As a result, the Company income (loss) from mortgage assets declined from income of $15,507,000 in 1991 to a loss of $14,068,000 in 1992 and a loss of $21,814,000 in 1993. The negative impact on income from these increased prepayment speeds on the Company's income from Mortgage Interests more than offset the positive effect of lower LIBOR and COFI rates. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the financial statements, the report thereon, the notes thereto and supplementary data commencing at page of this report, which financial statements, report, notes and data 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 REGISTRANT DIRECTORS AND EXECUTIVE OFFICERS The directors and executive officers of the Company are as follows: NAME AGE POSITION(S) HELD - ---- --- ---------------- Alan D. Hamberlin 45 Chairman of the Board of Directors, Director, President and Chief Executive Officer Jay R. Hoffman 39 Vice President, Secretary, Treasurer and Chief Financial and Accounting Officer Mike Marusich 68 Director Mark A. McKinley 47 Director Gregory K. Norris 43 Director Alan D. Hamberlin has been a Director and the President and Chief Executive Officer of the Company since its organization and Chairman of the Board of Directors of the Company since January 1990. Mr. Hamberlin also served as the President and Chief Executive Officer of the managing general partner of the Company's former Manager. Mr. Hamberlin has been President of Courtland Homes, Inc. since July 1983. Mr. Hamberlin served as Financial Vice President of Coventry Homes, Inc. from June 1981 to June 1983. Mr. Hamberlin has served as a Director of American Southwest Financial Corporation and American Southwest Finance Co., Inc. since their organization in September 1982 and served as a Vice President of such companies from September 1982 to February 1987, as Treasurer of such companies from September 1982 to February 1985 and from February 1986 until February 1987 and as Principal Financial and Accounting Officer from September 1982 to April 1984 and from October 1984 until February 1987. Mr. Hamberlin also has served as a Director of American Southwest Affiliated Companies since its organization in March 1985. Jay R. Hoffman has been a Vice President and the Secretary, Treasurer and Chief Financial and Accounting Officer of the Company since July 1988. Mr. Hoffman, a certified public accountant, engaged in the practice of public accounting with Kenneth Leventhal & Company from March 1987 through June 1988 and with Arthur Andersen & Co. from June 1976 through March 1987. Mike Marusich has been a Director of the Company since June 1990. Mr. Marusich has been a business consultant since 1980. Mr. Marusich, a certified public accountant for 34 years, engaged in the practice of public accounting with Ernst & Whinney (now Ernst & Young) for 15 years and was partner-in- charge of that firm's Phoenix, Arizona office from 1976 until his retirement in 1980. Mark A. McKinley has been a Director of the Company since May 1988. Mr. McKinley has been the President and a Director of Cypress Financial Corporation, a full service California mortgage banking corporation, since its organization in April 1983, and a managing director of Rancho Margarita Mortgage Corp. since March 1990. Mr. McKinley served as the Senior Vice President of The Colwell Company, a California based corporation which offers full service national mortgage banking services, from 1968 to May 1983. Mr. McKinley was directly responsible for the administration of secondary marketing, hedging operations and loan sales and purchases at The Colwell Company. Mr. McKinley has been involved at the local, state and national levels of the Mortgage Bankers Association. Gregory K. Norris has been a Director of the Company since June 1990. Mr. Norris has been the President of Norris & Benedict Associates P.C., certified public accountants, or its predecessor firms since November 1979. Mr. Norris previously was engaged in the practice of public accounting with Bolan, Vassar and Borrows, certified public accountants, from December 1978 until November 1979 and with Ernst & Whinney (now Ernst & Young) from July 1974 until December 1978. Messrs. Marusich, McKinley and Norris are members of the Company's Audit Committee. The Board of Directors held a total of three meetings during the fiscal year ended December 31, 1993, which were attended by all of the directors. The Audit Committee met separately at one formal meeting during the year ended December 31, 1993. All directors are elected at each annual meeting of the Company's stockholders for a term of one year, and hold office until their successors are elected and qualified. All officers serve at the discretion of the Board of Directors. On November 1, 1992, the Company entered into an employment agreement with Alan D. Hamberlin which superseded the previous employment agreement that was to expire on April 30, 1993. The term of the employment agreement is for the period from November 1, 1992 through April 30, 1996. The employment agreement provides for the employment of Mr. Hamberlin as the President and Chief Executive Officer of the Company and for Mr. Hamberlin to perform such duties and services as are customary for such a position. The employment agreement provides for Mr. Hamberlin to receive an annual base salary of $250,000 and an annual performance bonus in an amount equal to $1,500 for each $.01 per share of taxable income (computed in accordance with the Code) distributed to the Company's stockholders with respect to each calendar year beginning with 1992. A corporation owned by Mr. Hamberlin also is entitled to the payment of $15,000 annually as reimbursement for expenses incurred by such company in providing support to Mr. Hamberlin in connection with the performance of his duties. The employment agreement provides for Mr. Hamberlin to receive his fixed and bonus compensation to the date of the termination of his employment by reason of his death, disability or resignation and for Mr. Hamberlin to receive his fixed compensation to the date of the termination of his employment by reason of the termination of his employment for cause as defined in the agreement. The employment agreement also provides for Mr. Hamberlin to receive his fixed compensation in a lump sum and bonus payments that would have been payable through the term of the agreement as if his employment had not been terminated in the event that Mr. Hamberlin or the Company terminates Mr. Hamberlin's employment following any "change in control" of the Company as defined in the agreement. Section 280G of the Code may limit the deductibility of such payments for federal income tax purposes. A change in control would include a merger or consolidation of the Company, a sale of all or substantially all of the assets of the Company, changes in the identity of a majority of the members of the Board of Directors of the Company or acquisitions of more than 9.8% of the Company's Common Stock subject to certain limitations. The employment agreement also restricts the Company from entering into a separate management agreement or arrangement without Mr. Hamberlin's consent. On August 1, 1991 the Company entered into a three-year employment agreement with Jay R. Hoffman, the Vice President, Secretary, Treasurer and Chief Financial and Accounting Officer of the Company. The employment agreement provides that Mr. Hoffman will be entitled to an annual base salary of $175,000. Mr. Hoffman may also be entitled to a bonus in the sole discretion of the President of the Company. The Company may terminate Mr. Hoffman's employment only for cause. Mr. Hoffman may terminate his employment without cause upon 90 days' written notice to the Company. The Bylaws of the Company provide that, if the Company elects to be treated as a REIT, the majority of the members of the Board of Directors and of any committee of the Board of Directors will at all times be persons who are not "Affiliates" of "Advisors of the Company," except in the case of a vacancy. An Advisor is defined in the Bylaws as a person or entity responsible for directing or performing the day to day business affairs of the Company, including a person or entity to which an Advisor subcontracts substantially all such functions. An "Affiliate" of another person is defined in the Bylaws to mean any person directly or indirectly owning, controlling, or holding the power to vote 5% or more of the outstanding voting securities of such other person or of any person directly or indirectly controlling, controlled by or under common control with such other person; 5% or more of whose outstanding voting securities are directly or indirectly owned, controlled or held with power to vote by such other person; any person directly or indirectly controlling, controlled by or under common control with such other person; and any officer, director, partner or employee of such other person. The term "person" includes a natural person, a corporation, partnership, trust company or other entity. Vacancies occurring on the Board of Directors among the Unaffiliated Directors may be filled by the vote of a majority of the directors, including a majority of the Unaffiliated Directors, on nominees selected by the Unaffiliated Directors. All transactions involving the Company in which an Advisor has an interest must be approved by a majority of the Unaffiliated Directors. The Articles of Incorporation and Bylaws of the Company provide for the indemnification of the directors and officers of the Company to the fullest extent permitted by Maryland law. Maryland law generally permits indemnification of directors and officers against certain costs, liabilities and expenses which such persons may incur by reason of serving in such positions unless it is proved that: (i) the act or omission of the director or officer was material to the cause of action adjudicated in the proceeding and was committed in bad faith or was the result of active and deliberate dishonesty; (ii) the director or officer actually received an improper personal benefit in money, property or services; or (iii) in the case of criminal proceedings, the director or officer had reasonable cause to believe that the act or omission was unlawful. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers or persons controlling the Company pursuant to the foregoing provisions, the Company has been informed 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. The Articles of Incorporation of the Company provide that the personal liability of any director or officer of the Company to the Company or its stockholders for money damages is limited to the fullest extent allowed by the statutory or decisional law of the State of Maryland as amended or interpreted. Maryland law authorizes the limitation of liability of directors and officers to corporations and their stockholders for money damages except (a) to the extent that it is proved that the person actually received an improper benefit in money, property, or services for the amount of the benefit or profit in money, property or services actually received; or (b) to the extent that a judgment or other final adjudication adverse to the person is entered in a proceeding based on a finding that the person's action, or failure to act, was the result of active and deliberate dishonesty and was material to the cause of action adjudicated. The Maryland statute permitting limitation of the liability of directors and officers for money damages as described above was enacted on February 18, 1988, and applies only to acts occurring on or after that date, and has not been interpreted in any judicial proceeding. Maryland law does not affect the potential liability of directors and officers to third parties, such as creditors of the Company. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION COMPENSATION OF OFFICERS The following table sets forth compensation received by the Company's Chief Executive Officer and its other executive officer for the Company's last three fiscal years ending December 31, 1993. Officers and key personnel of the Company are eligible to receive stock options under the Company's stock option plan. Officers serve at the discretion of the Board of Directors. COMPENSATION OF DIRECTORS The Company pays an annual director's fee to each Unaffiliated Director equal to $20,000, a fee of $1,000 for each regular meeting of the Board of Directors attended by each Unaffiliated Director and reimbursement of costs and expenses for attending such meetings. During 1993, the Unaffiliated Directors also accrued dividend equivalent rights, in the amounts of 1,070 with respect to Mr. McKinley, 262 with respect to Mr. Norris, and 788 with respect to Mr. Marusich. The dividend equivalent rights accrued to Messrs. Hamberlin and Hoffman during 1993 are included in the table on options granted to the Company's executive officers below. In addition, the Company's Directors are eligible to participate in the Company's stock option plan described below. EMPLOYEE BENEFIT PLANS Stock Option Plan In May 1988, the Company's Board of Directors adopted a stock option plan (the "Plan") which was amended on July 18, 1990 to limit the redemption price available to optionholders as described below. Under the terms of the Plan, both qualified incentive stock options ("ISOs"), which are intended to meet the requirements of Section 422A of the Code, and non-qualified stock options may be granted. ISOs may be granted to the officers and key personnel of the Company. Non-qualified stock options may be granted to the Company's directors and key personnel, and to the key personnel of the Manager. The purpose of the Plan is to provide a means of performance-based compensation in order to attract and retain qualified personnel and to provide an incentive to others whose job performance affects the Company. Under the Plan, options to purchase shares of the Company's Common Stock may be granted to the Company's directors, officers and key personnel, as well as to the key personnel of the Manager. The maximum number of shares of the Company's Common Stock which may be covered by options granted under the Plan is limited to 5% of the number of shares outstanding. An option granted under the Plan may be exercised in full or in part at any time or from time to time during the term of the option, or provide for its exercise in stated installments at stated times during the term of the option. The exercise price for any option granted under the Plan may not be less than 100% of the fair market value of the shares of Common Stock at the time the option is granted. The optionholder may pay the exercise price in cash, bank cashier's check, or by delivery of previously acquired shares of Common Stock of the Company. No option may be granted under the Plan to any person who, assuming exercise of all options held by such person, would own directly or indirectly more than 9.8% of the total outstanding shares of Common Stock of the Company. An optionholder also will receive at no additional cost "dividend equivalent rights" to the extent that dividends are declared on the outstanding shares of Common Stock of the Company on the record dates during the period between the date an option is granted and the date such option is exercised. The number of dividend equivalent rights which an optionholder receives on any dividend declaration date is determined by application of a formula whereby the number of shares subject to the option is multiplied by the dividend per share and divided by the fair market value per share (as determined in accordance with the Plan) to arrive at the total number of dividend equivalent rights to which the optionholder is entitled. The dividend equivalent rights earned will be distributed to the optionholder (or his successor in interest) in the form of shares of the Company's Common Stock when the option is exercised. Dividend equivalent rights will be computed both with respect to the number of shares under the option and with respect to the number of dividend equivalent rights previously earned by the optionholder (or his successor in interest) and not issued during the period prior to the dividend record date. Shares of the Company's Common Stock issued pursuant to the exchange of dividend equivalent rights will not qualify for the favored tax treatment afforded shares issued upon exercise of an ISO, notwithstanding the character of the underlying option with respect to which the dividend equivalent rights were earned. The number of shares issuable upon exchange of dividend equivalent rights is not subject to the limit of the number of shares which are issuable upon exercise of options granted under the Plan. Under the Plan, an exercising optionholder has the right to require the Company to purchase some or all of the optionholder's shares of the Company's Common Stock. That redemption right is exercisable by the optionholder only with respect to shares (including the related dividend equivalent rights) that he has acquired by exercise of an option under the Plan. Furthermore, the optionholder can only exercise his redemption rights within six months from the last to expire of (i) the two year period commencing with the grant date of an option, (ii) the one year period commencing with the exercise date of an option, or (iii) any restriction period on the optionholder's transfer of the shares of Common Stock he acquires through exercise of his option. The price for any shares repurchased as a result of an optionholder's exercise of his redemption right is the lesser of the book value of those shares at the time of redemption or the fair market value of the shares on the date the options were exercised. The Plan is administered by the Board of Directors which will determine whether such options will be granted, whether such options will be ISOs or non-qualified stock options, which directors, officers and key personnel will be granted options, and the number of options to be granted, subject to the aggregate maximum amount of shares issuable under the Plan set forth above. Each option granted must terminate no more than 10 years from the date it is granted. Under current law, ISOs cannot be granted to directors who are not also employees of the Company, or to directors or employees of entities unrelated to the Company. The Board of Directors may amend the Plan at any time, except that approval by the Company's stockholders is required for any amendment that increases the aggregate number of shares of Common Stock that may be issued pursuant to the Plan, increases the maximum number of shares of Common Stock that may be issued to any person, changes the class of persons eligible to receive such options, modifies the period within which the options may be granted, modifies the period within which the options may be exercised or the terms upon which options may be exercised, or increases the material benefits accruing to the participants under the Plan. Unless previously terminated by the Board of Directors, the Plan will terminate in May 1998. The following table provides information on options granted to the Company's executive officers during 1993. The following table provides information on options exercised in 1993 by the Company's executive officers and the value of such officer's unexercised options at December 31, 1993. SEP-IRA On June 27, 1991, the Company established a simplified employee pension- individual retirement account pursuant to Section 408(k) of the Code (the "SEP-IRA"). Annual contributions may be made by the Company under the SEP-IRA to employees. Such contributions will be excluded from each employee's gross income and will not exceed the lesser of 15% of such employee's compensation or $30,000. The Company did not make any contributions to the SEP-IRA during 1993. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT At March 23, 1994, there were 9,731,717 shares of Common Stock outstanding. The table below sets forth, as of March 23, 1994, those persons known by the Company to own beneficially five percent or more of the outstanding shares of Common Stock, the number of shares of Common Stock beneficially owned by each director and executive officer of the Company and the number of shares beneficially owned by all of the Company's executive officers and directors as a group, which information as to beneficial ownership is based upon statements furnished to the Company by such persons. NUMBER OF NAME AND ADDRESS OF SHARES BENEFICIALLY PERCENT OF - ------------------- OWNED (1) COMMON STOCK(2) BENEFICIAL OWNER ----------------------- -------------------- Alan D. Hamberlin* 269,967(3) 2.71% Jay R. Hoffman* 75,813(4) ** Mark A. McKinley* 45,662(5) ** Mike Marusich* 33,601(5) ** Gregory K. Norris* 11,199(5) ** All directors and executive officers as a group (five persons) 436,242(6) 4.31% - -------------- * Each director and executive officer of the Company may be reached through the Company at 5333 North Seventh Street, Suite 219, Phoenix, Arizona 85014. ** Less than 1% of the outstanding shares of Common Stock. (1) Includes, where applicable, shares of Common Stock owned of record by such person's minor children and spouse and by other related individuals and entities over whose shares of Common Stock such person has custody, voting control or the power of disposition. (2) The percentages shown include the shares of Common Stock actually owned as of March 23, 1994 and the shares of Common Stock which the person or group had the right to acquire within 60 days of such date. In calculating the percentage of ownership, all shares of Common Stock which the identified person or group had the right to acquire within 60 days of March 23, 1994 upon the exercise of options are deemed to be outstanding for the purpose of computing the percentage of the shares of Common Stock owned by such person or group, but are not deemed to be outstanding for the purpose of computing the percentage of the shares of Common Stock owned by any other person. (3) Includes 37,900 shares of Common Stock indirectly beneficially owned by Mr. Hamberlin through a partnership and 232,067 shares of Common Stock which Mr. Hamberlin had the right to acquire within 60 days of March 23, 1994 by the exercise of stock options (including dividend equivalent rights). (4) Includes 15,000 shares of Common Stock owned by Mr. Hoffman and 60,813 shares of Common Stock which Mr. Hoffman had the right to acquire within 60 days of March 23, 1994 by the exercise of stock options (including dividend equivalent rights). (5) All of such shares of Common Stock are shares which Mr. McKinley, Mr. Marusich, and Mr. Norris had the right to acquire within 60 days of March 23, 1994 by the exercise of stock options (including dividend equivalent rights). (6) Includes 383,342 shares of Common Stock which such persons had the right to acquire within 60 days of March 23, 1994 by the exercise of stock options (including dividend equivalent rights). Other than options and dividend equivalent rights granted under the Company's stock option plan, there are no outstanding warrants, options or rights to purchase any shares of Common Stock of the Company, and no outstanding securities convertible into Common Stock of the Company. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS POTENTIAL CONFLICTS OF INTEREST The Company was subject to potential conflicts of interest arising from its relationship with the Manager and its affiliates. See "Certain Relationships and Related Transactions -- Certain Relationships" below. With a view toward protecting the interests of the Company's stockholders, the Bylaws of the Company provide that a majority of the Board of Directors (and a majority of each committee of the Board of Directors) must not be "Affiliates" of "Advisors," as these terms are defined in the Bylaws, and that the investment policies of the Company must be reviewed annually by these directors (the "Unaffiliated Directors"). Counsel to the Company has furnished, and in the future may furnish, legal services to ASFS, certain Issuers (including American Southwest Financial Corporation, American Southwest Finance Co., Inc. and Westam Mortgage Financial Corporation), certain Mortgage Suppliers and certain Mortgage Finance Companies. There is a possibility that in the future the interests of certain of such parties may become adverse, and counsel may be precluded from representing one or all of such parties. If any situation arises in which the interests of the Company appear to be in conflict with those of ASFS, any Issuer, Mortgage Supplier or Mortgage Finance Company, additional counsel may be retained by one or more of the parties. CERTAIN RELATIONSHIPS Alan D. Hamberlin directly and indirectly owns a total of 8% of the voting stock of American Southwest Financial Corporation and American Southwest Finance Co., Inc. and indirectly owns 8% of the voting stock of ASFS and Westam Mortgage Financial Corporation. Alan D. Hamberlin, the Chairman of the Board of Directors of the Company and President, Chief Executive Officer and a Director of the managing general partner of the Company's former Manager and of the Company, also is a director of American Southwest Financial Corporation, American Southwest Finance Co., Inc. and American Southwest Affiliated Companies. American Southwest Affiliated Companies owns all of the outstanding Common Stock of ASFS and Westam Mortgage Financial Corporation. Philip J. Polich also is a director of American Southwest Financial Corporation, American Southwest Finance Co., Inc. and American Southwest Affiliated Companies. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Exhibits 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. HOMEPLEX MORTGAGE INVESTMENTS CORPORATION Date: March 30, 1994 By: /s/ Alan D. Hamberlin --------------------------------------- Alan D. Hamberlin, Chairman of the Board of Directors and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated. HOMEPLEX MORTGAGE INVESTMENTS CORPORATION Page ---- Independent Auditors' Report........................................... Consolidated Balance Sheets as of December 31, 1993 and 1992........... Consolidated Statements of Net Income (Loss) for the Years Ended December 31, 1993, 1992 and 1991......................... Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991......................... Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991......................... Notes to Consolidated Financial Statements............................. Schedule III -- Supplemental Parent Company Condensed Financial Information................................................ S-1 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Homeplex Mortgage Investments Corporation We have audited the accompanying consolidated balance sheets of Homeplex Mortgage Investments Corporation as of December 31, 1993 and 1992, and the related consolidated statements of net income (loss), stockholders' equity, and cash flows for the years ended December 31, 1993, 1992 and 1991. 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 Homeplex Mortgage Investments Corporation 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 discussed in Note 10 to the financial statements, the Company changed its method for accounting for mortgage interests as of December 31, 1993. Our audits were made for the purpose of forming an opinion on the consolidated financial statements taken as a whole. In connection with our audits, we also audited the additional financial statement schedule presented in Schedule III. 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. KENNETH LEVENTHAL & COMPANY Phoenix, Arizona March 18, 1994 HOMEPLEX MORTGAGE INVESTMENTS CORPORATION CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1993 AND 1992 (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) 1993 1992 --------- --------- ASSETS Cash and cash equivalents............................... $ 16,247 $ 14,172 Residual interest certificates (Notes 3 and 10)......... 14,025 48,081 Funds held by Trustee (Note 5).......................... 8,761 5,130 Interests relating to mortgage participation certificates (Notes 4 and 10)...................................... 3,710 18,687 Other assets (Note 5)................................... 819 993 Mortgage loan receivable (Note 2)....................... 320 -- --------- --------- Total Assets............................................ $ 43,882 $ 87,063 ========= ========= LIABILITIES Long-term debt (Note 5)................................. $ 19,926 $ 31,000 Accounts payable and other liabilities.................. 1,093 1,222 Dividend payable........................................ 292 -- Accrued interest payable................................ 194 135 --------- --------- Total Liabilities....................................... 21,505 32,357 --------- --------- Contingencies (Note 9) STOCKHOLDERS' EQUITY Common stock, par value $.01 per share; 50,000,000 shares authorized; issued and outstanding -- 9,875,655 shares (Note 8)....................................... 99 99 Additional paid-in-capital.............................. 84,046 84,046 Cumulative net income (loss)............................ (20,330) 11,658 Cumulative dividends.................................... (41,045) (40,753) Treasury stock -- 143,938 shares in 1993 and 123,570 shares in 1992........................................ (393) (344) --------- --------- Total Stockholders' Equity.............................. 22,377 54,706 --------- --------- Total Liabilities and Stockholders' Equity.............. $ 43,882 $ 87,063 ========= ========= See notes to consolidated financial statements. HOMEPLEX MORTGAGE INVESTMENTS CORPORATION CONSOLIDATED STATEMENTS OF NET INCOME (LOSS) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) 1993 1992 1991 ---------- ---------- --------- INCOME (LOSS) FROM MORTGAGE ASSETS Income (loss) from residual interest certificates (Notes 3 and 10)............ $ (14,367) $ (876) $ 13,847 Income (loss) from interests relating to mortgage participation certificates (Notes 4 and 10)......................... (7,945) (13,374) 1,347 Other income............................... 498 182 313 ---------- ---------- --------- (21,814) (14,068) 15,507 ---------- ---------- --------- INTEREST EXPENSE Long-term borrowings....................... 2,274 1,720 2,001 Short-term borrowings...................... -- 1,030 2,534 ---------- ---------- --------- 2,274 2,750 4,535 ---------- ---------- --------- Income (Loss) Before Other Expenses and Cumulative Effect of Accounting Change... (24,088) (16,818) 10,972 ---------- ---------- --------- OTHER EXPENSES General and administrative (Note 8)........ 1,684 2,246 2,681 Hedging expense............................ 138 69 264 ---------- ---------- --------- Total Other Expenses....................... 1,822 2,315 2,945 ---------- ---------- --------- Net Income (Loss) Before Cumulative Effect of Accounting Change..................... (25,910) (19,133) 8,027 Cumulative Effect of Accounting Change (Note 10)................................ (6,078) -- -- ---------- ---------- --------- Net Income (Loss).......................... $ (31,988) $ (19,133) $ 8,027 ========== ========== ========= PER SHARE DATA Net Income (Loss) Per Share Before Cumulative Effect of Accounting Change... $ (2.66) $ (1.93) $ .81 Cumulative Effect of Accounting Change Per Share.................................... (.63) -- -- ---------- ---------- --------- Net Income (Loss) Per Share................ $ (3.29) $ (1.93) $ .81 ========== ========== ========= Dividends Declared Per Share............... $ .03 $ .40 $ 1.70 ========== ========== ========= Weighted Average Number Of Shares Of Common Stock And Common Stock Equivalents Outstanding.............................. 9,732,056 9,897,406 9,952,844 ========== ========== ========= See notes to consolidated financial statements. HOMEPLEX MORTGAGE INVESTMENTS CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 INCREASE (DECREASE) IN CASH (DOLLARS IN THOUSANDS) 1993 1992 1991 ---------- ---------- --------- CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss).......................... $ (31,988) $ (19,133) $ 8,027 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Cumulative effect of accounting change. 6,078 -- -- Amortization of debt discount, issuance costs and fees ...................... 230 1,053 1,277 Write-downs on interests relating to mortgage participation certificates.. 7,945 15,057 8,000 Write-downs and non-cash losses on residual interest certificates....... 14,367 5,876 -- Increase (decrease) in accrued interest payable.............................. 59 41 (18) (Increase) decrease in other assets.... (169) 466 53 Increase (decrease) in accounts payable and other liabilities................ (129) 246 (919) Amortization of hedging costs.......... 138 69 264 ---------- ---------- --------- Net Cash Provided By (Used In) Operating Activities............................... (3,469) 3,675 16,684 ---------- ---------- --------- CASH FLOWS FROM INVESTING ACTIVITIES Amortization of residual interest certificates............................. 15,319 16,320 4,360 Amortization of interests relating to mortgage participation certificates...... 5,324 8,966 6,016 Increase in funds held by Trustee.......... (3,631) (5,130) -- Mortgage loan receivable................... (320) -- -- ---------- ---------- --------- Net Cash Provided By Investing Activities.. 16,692 20,156 10,376 ---------- ---------- --------- CASH FLOWS FROM FINANCING ACTIVITIES Principal payments made on long-term debt.. (11,074) (16,450) (3,550) Proceeds from issuance of stock, net of repurchases.............................. (49) (252) 552 Capitalized debt costs..................... (25) (610) -- Proceeds from long-term debt............... -- 31,000 -- Net increase (decrease) in short-term borrowings............................... -- (22,000) 1,380 Dividends paid............................. -- (7,891) (22,949) Purchase of hedging instruments............ -- (245) (235) ---------- ---------- --------- Net Cash Used In Financing Activities...... (11,148) (16,448) (24,802) ---------- ---------- --------- Net Increase In Cash....................... 2,075 7,383 2,258 Cash and Cash Equivalents At Beginning Of Period................................... 14,172 6,789 4,531 ---------- ---------- --------- Cash And Cash Equivalents At End Of Period. $ 16,247 $ 14,172 $ 6,789 ========== ========== ========= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid for interest..................... $ 2,103 $ 1,738 $ 3,240 ========== ========== ========= See notes to consolidated financial statements. HOMEPLEX MORTGAGE INVESTMENTS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 NOTE 1 -- ORGANIZATION AND BASIS OF PRESENTATION Homeplex Mortgage Investments Corporation, a Maryland corporation, (the Company) seeks to generate income primarily through the origination or acquisition of mortgage loans and mortgage certificates and the acquisition of mortgage interests in or from entities which own and finance mortgage loans and mortgage certificates. As described in Notes 3 and 4, the Company has purchased interests in mortgage certificates securing collateralized mortgage obligations (CMOs) and interests relating to mortgage participation certificates (MPCs) (collectively Mortgage Interests). NOTE 2 -- GENERAL AND SUMMARY OF ACCOUNTING POLICIES Basis of Presentation The consolidated financial statements include the accounts of the Homeplex Mortgage Investments Corporation and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Income Taxes The Company has elected to be taxed as a real estate investment trust (REIT) under the Internal Revenue Code. As a REIT, the Company must distribute annually at least 95% of its taxable income to its stockholders. The dividend declared in 1991 represents ordinary income to the recipients for federal income tax purposes. The $.40 dividend declared in 1992 consisted of $.3166 of ordinary income and $.0834 of return of capital and the $.03 dividend declared in 1993 consisted of $.0276 of ordinary income and $.0024 of return of capital to the recipients for federal income tax purposes. The income reported in the accompanying financial statements is different than taxable income because some income and expense items are reported in different periods for income tax purposes. The principal differences relate to reserves on and the amortization of Mortgage Interests and the treatment of stock option expense. At December 31, 1993, the Company has available, for income tax purposes, a net operating loss carryforward of approximately $49,300,000. Such loss may be carried forward, with certain restrictions, for up to 15 years to offset future taxable income, if any. Until the tax loss carryforward is fully utilized the Company will not be required to pay dividends to its stockholders except for income that is deemed to be excess inclusion income. See Note 9 for a description of the current status of an Internal Revenue Service Proposed Adjustment. Mortgage Loan Receivable The mortgage loan receivable was funded on December 30, 1993 and is secured by a First Deed of Trust on land with interest payable monthly at a rate of 16% per annum. All principal is due on December 30, 1994, however, the loan may be extended under the same terms and conditions for an additional year as long as at least $75,000 of principal has been repaid and the borrower pays a 2% extension fee. Interests Relating To Mortgage Participation Certificates and Residual Interest Certificates Interests relating to mortgage participation certificates and residual interest certificates are accounted for as described in Notes 3, 4 and 10. Cash and Cash Equivalents Cash and cash equivalents include demand deposits and certificates of deposit with maturities of less than three months. Amortization of Hedging The cost of the Company's LIBOR ceiling rate agreements (see Note 7) is amortized using the straight-line method over the lives of the agreements. Net Income (Loss) Per Share Primary net income (loss) per share is calculated using the weighted average shares of common stock outstanding and common stock equivalents. Common stock equivalents consist of dilutive stock options. Net income (loss) per share is the same for both primary and fully diluted calculations. Reclassifications Certain balances in prior periods have been reclassified to conform to the current year's presentation. NOTE 3 -- RESIDUAL INTEREST CERTIFICATES The Company owns 100% of the residual interest certificates in five real estate mortgage investment conduits (REMICs). The assets of these five REMICs consist of mortgage certificates, accrued interest thereon and cash funds held by a Trustee. The liabilities consist of collateralized mortgage obligations (CMOs), accrued interest thereon and administrative expenses payable. The CMOs have been issued through Westam Mortgage Financial Corporation (Westam) or American Southwest Financial Corporation (ASW). The mortgage certificates securing the CMOs all have fixed interest rates. Certain of the classes of CMOs have fixed interest rates and certain have interest rates that are determined monthly based on the London Interbank Offered Rates (LIBOR) for one month Eurodollar deposits, subject to specified maximum interest rates. Each series of CMOs consists of several serially maturing classes collateralized by mortgage certificates. Generally, principal payments received on the mortgage certificates, including prepayments on such mortgage certificates, are applied to principal payments on the classes of CMOs in accordance with the respective indentures. Scheduled payments of principal and interest on the mortgage certificates securing each series of CMOs and reinvestment earnings thereon are intended to be sufficient to make timely payments of interest on such series and to retire each class of such series by its stated maturity. Certain series of CMOs are subject to redemption according to the specific terms of the respective indentures. The following summarizes the Company's investment at December 31, 1993: COMPANY'S AMORTIZED CMO SERIES COST (SEE NOTE 10) ------- -------------------- (IN THOUSANDS) Westam 1........................................... $ 3,353 Westam 3........................................... 1,361 Westam 5........................................... 1,212 Westam 6........................................... 51 ASW 65............................................. 8,048 ----------------- $ 14,025 ================= The following summarizes the combined assets and liabilities of the five REMICs at December 31, 1993 (in thousands): Assets: Outstanding Principal Balance of Mortgage Certificates........................... $ 433,029 Funds Held By Trustee............................. 28,969 Accrued Interest Receivable....................... 3,475 ------------ $ 465,473 ============ Range of Stated Coupon Rate of Mortgage Certificates...... 9.0%-10.5% Liabilities: Outstanding Principal Balance of CMOs: Fixed Rate................................. $ 357,405 Floating Rate -- LIBOR Based............... 99,339 ------------ Total CMO Principal Balance................ $ 456,744 Accrued Interest Payable..................... 3,964 ------------ $ 460,708 ============ Range of Stated Interest Rates on CMOs...................... 0% to 9.45% The Company's 100% residual interests entitle the Company to receive the excess of payments received from the pledged mortgage certificates together with reinvestment income thereon over amounts required to make debt service payments on the related CMOs and to pay related administrative expenses of the REMICs. The Company also has the right, under certain conditions, to cause an early redemption of the CMOs. Under the early redemption feature, the mortgage certificates are sold at the then current market price and the CMOs repaid at par value. The Company is entitled to any excess cash flow from such early redemptions. The conditions under which such early redemptions may be elected vary but generally cannot be done until the remaining outstanding CMO balance is less than 10% of the original balance. Effective December 31, 1993, the Company has adopted the prospective net level yield method with respect to these investments (see Note 10). The cumulative effect of the change has been recorded as of December 31, 1993. The consolidated financial statements have been reclassified on a basis consistent with the prospective net level yield method, with no effect on previously reported net income (loss). Prior to December 31, 1993 (see Note 10), the Company accounted for its investment in these five REMICs using the equity method of accounting. Accordingly, the Company consolidated the financial statements of the REMICs in its financial statements and included the respective REMICs income or loss in its consolidated statement of net income (loss). In the event the undiscounted estimated future net cash flows from the residual interest were less than the Company's financial reporting basis, the residual interest was considered to be impaired and the Company established a reserve for the difference. The reserves were then amortized to income as the loss actually occurred. Because of the continuing low interest rate environment, beginning in the quarter ended September 30, 1993, the Company incorporated redemption proceeds into the undiscounted cash flow estimates used to establish reserves. The estimated redemption proceeds were adjusted each quarter as part of the Company's undiscounted cash flow estimates. These redemption proceeds estimates were calculated assuming that the current interest rate environment exists at the time redemptions are possible. The following summarizes the Company's combined income (loss) from these REMICs for the three years ended December 31, 1993, 1992 and 1991 (in thousands) prior to the cumulative effect of the change in accounting principle described in Note 10: The average LIBOR-reset rates on the floating rate CMO classes were 3.22%, 3.86% and 6.11%, respectively, for the years ended December 31, 1993, 1992 and 1991. At December 31, 1993, LIBOR was 3.25%. NOTE 4 -- INTERESTS RELATING TO MORTGAGE PARTICIPATION CERTIFICATES The Company owns interests in REMICs with respect to three separate series of Mortgage Participation Certificates (MPCs) issued by the Federal Home Loan Mortgage Corporation (FHLMC) or by the Federal National Mortgage Association (FNMA). The certificates entitle the Company to receive its proportionate share of the excess (if any) of payments received from the mortgage certificates underlying the MPCs over amounts required to make principal and interest payments on such MPCs. The Company is not entitled to reinvestment income earned on the underlying mortgage certificates, is not required to pay any administrative expenses of the MPCs and does not have the right to elect early redemption of any of the MPC classes. The mortgage certificates underlying the MPCs all have fixed interest rates. Certain of the classes of the MPCs have fixed interest rates and certain have interest rates that are determined monthly based on LIBOR or based on the Monthly Weighted Average Cost of Funds (COFI) for Eleventh District Savings Institutions as published by the Federal Home Loan Bank of San Francisco, subject to specified maximum interest rates. The Company accounts for its interests relating to these mortgage participation certificates using the prospective net level yield method as described in Note 10. In the event the undiscounted estimated future net cash flows from the MPC Series is less than the Company's financial reporting basis, the Company reduces its financial reporting basis. The Company has taken charges of $7,945,000, $15,057,000 and $8,000,000, respectively, for the years ended December 31, 1993, 1992 and 1991 to reduce the MPC Series to their undiscounted estimated future net cash flows. Effective December 31, 1993 the Company changed its method of accounting for impairment on these investments to the method described in Note 10. The following summarizes the Company's investment at December 31, 1993: COMPANY'S AMORTIZED COMPANY'S PERCENTAGE COST AT OWNERSHIP OF INTERESTS MPC SERIES DEC. 31, 1993 RELATING TO MPCS ---------------------------- ------------------- ---------------------- (IN THOUSANDS) FHLMC 17.................... $ 359 100.00% FNMA 1988-24................ 2,309 20.20% FNMA 1988-25................ 1,042 45.07% --------------- $3,710 =============== The following summarizes the Company's proportionate interest in the aggregate mortgage certificates and MPCs at December 31, 1993 (in thousands): Mortgage Certificates Underlying MPCs: Outstanding Principal Balance............................... $202,882 Range of Stated Coupon Rates................................ 9.5%-10.0% MPCs: Outstanding Principal Balance: Fixed Rate................................................ $182,561 Floating Rate -- LIBOR Based.............................. 11,915 Floating Rate -- COFI Based............................... 8,406 ------------ Total MPCs Principal Balance.............................. $202,882 ============ Range of Stated Interest Rates on MPCs...................... 1.67%-9.9% The average LIBOR and COFI rates used to determine income from the interests relating to the above MPCs were as follows: 1993 1992 1991 --------- --------- --------- LIBOR.................................... 3.22% 3.86% 6.11% COFI..................................... 4.16% 5.45% 7.37% The LIBOR and COFI rates as of December 31, 1993 were 3.25% and 3.82%, respectively. NOTE 5 -- LONG-TERM DEBT In December 1990, the Company borrowed $20,000,000 under a three-year term loan agreement with a bank. The agreement required monthly principal amortization and interest payments at LIBOR plus .75%. In connection with the agreement, the Company paid fees of $375,000 which were amortized to interest expense over the term of the agreement. Additionally, the Company paid a fee of $1,160,000 to obtain a three year letter of credit from other financial institutions, which upon certain conditions, could be drawn upon to repay the term loan. Such fee was amortized to interest expense over the life of the agreement. The Company's residual interests in Westam 1, Westam 5 and ASW 65 (see Note 3) were pledged as collateral under the agreement. The balance outstanding under the agreement was repaid and the agreement terminated on December 17, 1992. On December 17, 1992, a wholly owned limited-purpose subsidiary of the Company issued $31,000,000 of Secured Notes under an Indenture to a group of institutional investors. The Notes bear interest at 7.81% and require quarterly payments of principal and interest with the balance due on November 14, 1998. In connection with the agreement the Company paid fees of $635,000 which are included in other assets in the accompanying consolidated balance sheet and are being amortized to interest expense over the life of the agreement. The Notes are secured by the Company's residual interests in Westam 1, Westam 3, Westam 5, Westam 6 and ASW 65 (see Note 4), by the Company's Interests relating to mortgage participation certificates FNMA 1988-24 and FNMA 1988-25 (see Note 4), and by Funds held by Trustee. The Company used $3,100,000 of the proceeds to establish a reserve fund which is included in Funds held by Trustee in the accompanying consolidated balance sheets. The reserve fund, which has a specified maximum balance of $7,750,000, is to be used to make the scheduled principal and interest payments on the Notes if the cash flow available from the collateral is not sufficient to make the scheduled payments. Depending on the level of certain specified financial ratios relating to the collateral, the cash flow from the collateral is required to either prepay the Notes at par, increase the reserve fund up to its $7,750,000 maximum or is remitted to the Company. At December 31, 1993, Funds held by Trustee consist of $5,911,000 in the Reserve Fund and $2,850,000 of other funds pledged under the Indenture. At December 31, 1993, scheduled principal payments are as follows (thousands): 1994........................................................... $ 4,505 1995........................................................... 3,964 1996........................................................... 3,964 1997........................................................... 3,694 1998........................................................... 3,604 1999........................................................... 195 ----------- $ 19,926 =========== NOTE 6 -- SHORT-TERM BORROWINGS The Company's short-term borrowings have consisted primarily of repurchase agreements. Such agreements were at both fixed and floating rates, were secured by various Mortgage Interests and required the maintenance of certain collateral levels. At December 31, 1993 and 1992, there were no borrowings outstanding under repurchase agreements. Interest rates and balances related to the Company's short term borrowings, in the aggregate, were as follows: NOTE 7 -- HEDGING On May 12, 1992, the Company entered into a LIBOR ceiling rate agreement with a bank for a fee of $245,000. The agreement, which has a term of two years beginning July 1, 1992, requires the bank to pay a monthly amount to the Company equal to the product of $175,000,000 multiplied by the percentage, if any, by which actual one-month LIBOR (measured on the first business day of each month) exceeds 9.0%. Through December 31, 1993 LIBOR has remained under 9.0% and, accordingly, no amounts have been payable under the agreement. NOTE 8 -- STOCK OPTIONS The Company has a Stock Option Plan which is administered by the Board of Directors. The plan provides for qualified stock options which may be granted to key personnel of the Company and non-qualified stock options which may be granted to the Directors and key personnel of the Company. The purpose of the plan is to provide a means of performance-based compensation in order to attract and retain qualified personnel whose job performance affects the Company. Options to acquire a maximum (excluding dividend equivalent rights) of 437,500 shares of the Company's common stock may be granted under the plan. The exercise price may not be less than the fair market value of the common stock at the date of grant. The options expire ten years after date of grant. Optionholders also receive, at no additional cost, dividend equivalent rights which entitle them to receive, upon exercise of the options, additional shares calculated based on the dividends declared during the period from the grant date to the exercise date. For the years ended December 31, 1993, 1992 and 1991, approximately $0, $182,000 and $683,000, respectively, of non-cash expense related to dividend equivalent rights is included in general and administrative expenses in the accompanying consolidated statements of net income (loss). Under the plan, an exercising optionholder also has the right to require the Company to purchase some or all of the optionholder's shares of the Company's common stock. That redemption right is exercisable by the optionholder only with respect to shares (including the related dividend equivalent rights) that the optionholder has acquired by exercise of an option under the Plan. Furthermore, the optionholder can only exercise his redemption rights within six months from the last to expire of (i) the two year period commencing with the grant date of an option, (ii) the one year period commencing with the exercise date of an option, or (iii) any restriction period on the optionholder's transfer of the shares of common stock he acquires through exercise of his option. The price for any shares repurchased as a result of an optionholder's exercise of his redemption right is the lesser of the book value of those shares at the time of redemption or the fair market value of the shares on the original date the options were exercised. During 1993 and 1992, 20,368 and 123,570 shares, respectively, were repurchased by the Company in connection with this provision of the plan. For the years ended December 31, 1993 and 1992, approximately $66,000 and $441,000, respectively, related to the repurchase of the shares is included in general and administrative expenses in the accompanying consolidated statements of net income (loss). The following summarizes stock option activity: AT DECEMBER 31, 1993 1992 - --------------------------------------------------------- --------- -------- Options outstanding...................................... 231,769 231,769 Dividend equivalent rights outstanding................... 157,174 148,059 -------- -------- Total options and dividend equivalent rights outstanding. 388,943 379,828 ======== ======== At December 31, 1993, all of the options, including dividend equivalent rights, are exercisable. At December 31, 1993 and 1992, 54,357 common shares are reserved for future grants. NOTE 9 -- CONTINGENCIES On February 18, 1993, following a routine audit of the Company by the Internal Revenue Service (IRS) for the year 1990, the IRS sent to the Company a Proposed Adjustment (the Proposed Adjustment) of taxes due of $10,890,000 and penalties totaling $2,260,000 for the tax years ending December 31, 1991, 1990 and 1989. The Proposed Adjustment does not include any amounts for interest which might be owed by the Company. The IRS claimed that the Company did not meet the statutory requirements to be taxed as a REIT for the years ending December 31, 1991, 1990 and 1989 because the Company did not demand certain shareholder information pursuant to Regulation Section 1.857-8 under the Internal Revenue Code within the specified 30 day period of each of the Company's year-ends. The information required consisted of sending standardized request letters to six shareholders in 1989, five shareholders in 1990 and eight shareholders in 1991. On March 18, 1993, the Company filed a protest with the District Director of the IRS challenging the Proposed Adjustment (the Protest). In the Protest, the Company stated that it has made all the required demands of its shareholders for each year and has thus complied with Regulation Section 1.857-8. Additionally, the Company stated that Regulation Section 1.857-8(e), under which the IRS relied upon to revoke the Company's REIT status, was incorrectly applied and Regulation Section 1.857-8 was substantially complied with by the Company. The Company also requested relief under Regulation Section 301.9100-1 from the requirement in Regulation Section 1.857-8 that certain shareholder demands be made within 30 days from the end of the calendar year. The Company also has stated in the Protest that the penalties under the Proposed Adjustment were incorrectly applied. The Company will vigorously defend this action. The Company believes that it has substantially complied with the applicable Regulations. NOTE 10 -- ACCOUNTING MATTERS Accounting principles and disclosure practices for Mortgage Interests have historically varied throughout the industry. At the May 1990 meeting, the Emerging Issues Task Force (EITF) reached a consensus (Issue Number 89-4) that certain Mortgage Interests should be accounted for using a prospective net level yield method. Under this method, a Mortgage Interest would be recorded at cost and amortized over the life of the related CMO issuance. The total expected cash flow would be allocated between principal and interest as follows: 1. An effective yield is calculated as of the date of purchase based on the purchase price and anticipated future cash flows. 2. In the initial accounting period, interest income is accrued on the investment balance using the effective yield calculated as of the date of purchase. 3. Cash received on the investment is first applied to accrued interest with any excess reducing the recorded principal balance of the investment. 4. At each reporting date, the effective yield is recalculated based on the amortized cost of the investment and the then-current estimate of the remaining future cash flows. 5. The recalculated effective yield is then used to accrue interest income on the investment balance in the subsequent accounting period. 6. The above procedure continues until all cash flows from the investment have been received. At the end of each period, the amortized balance of the investment should equal the present value of the estimated cash flows discounted at the newly- calculated effective yield. In the event that the yield is negative, the investment is to be written down to an amount equal to the undiscounted estimated future cash flows. As described in Note 4, the Company's investments in the REMICs relating to three separate series of MPCs (FHLMC 17, FNMA 24 and FNMA 25) entitle the Company to receive its proportionate share of the excess (if any) of payments received from the mortgage certificates underlying MPCs over amounts required to pass through principal and interest to the holders of such MPCs. The Company is not entitled to reinvestment income earned on the underlying mortgage certificates, is not required to pay administrative expenses of the MPCs and does not have the right to elect early termination of any of the MPC classes. The Company's investments in FHLMC 17, FNMA 24 and FNMA 25 are accounted for using the prospective net level yield method. As described in Note 3, the Company's residual interest certificates with respect to five separate series of CMOs (Westam 1, 3, 5, 6 and ASW 65) entitle the Company to receive 100% of the excess of payments received from the pledged mortgage certificates together with reinvestment income thereon over amounts required to make debt service payments on such CMOs and to pay related administrative expenses relating to such CMOs. The Company also has the right, under certain conditions, to cause an early redemption of the CMOs. The Company previously used the equity method of accounting for its investments in Westam 1, 3, 5, 6 and ASW 65 and consolidated the accounts of these REMICs in the Company's consolidated financial statements. Effective December 31, 1993, the Company has adopted the prospective net level yield method with respect to these investments to be consistent with the change in accounting for impaired assets as described below. The consolidated financial statements have been reclassified on a basis consistent with the prospective net level yield method, with no effect on previously reported net income (loss). 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". SFAS No. 115 is applicable to debt and equity securities including investments in REMICs and requires all investments to be classified into one of three categories; held to maturity, available for sale, or trading. The Company acquired its residual interest certificates and interests relating to mortgage participation certificates without the intention to resell the assets. The Company has both the intent and ability to hold these investments to maturity and believes these investments meet the "held to maturity" criteria of SFAS No. 115. The primary difference between SFAS No. 115 and the method of accounting previously used by the Company relates to accounting for impairment of both residual interest certificates (see Note 3) and interests relating to mortgage participation certificates (see Note 4) (collectively Mortgage Interests). Previously, if the undiscounted estimated future net cash flows from these Mortgage Interests were less than the Company's financial reporting basis, the Mortgage Interest was considered to be impaired and the Company would establish a reserve for the difference so that the Mortgage Interest's projected yield would be 0%. Under SFAS No. 115, if a security is determined to have other than temporary impairment, the security is to be written down to fair value. The Company has reviewed all of its impaired Mortgage Interests and recorded a charge of $6,078,000 to record impaired Mortgage Interests at their fair value at December 31, 1993 in accordance with SFAS No. 115. Under SFAS No. 115 net income (loss) of prior years is not restated. In determining fair value at December 31, 1993 the Company considered that the market for Mortgage Interests is volatile and thinly traded. Moreover, the Company acquired its Mortgage Interests without intention to resell those assets. Generally, Mortgage Interests are priced by discounting projected net cash flows from the Mortgage Interests at an assumed internal rate of return. Projected net cash flows have been estimated using the Public Securities Association median projected prepayment speeds and using current short-term interest rates in effect for floating rate CMO or MPC classes and assuming such short-term rates will stay in effect over the lives of the floating rate classes. The internal rates of return then used to discount the cash flows vary but management believes a reasonable rate for its Mortgage Interests at December 31, 1993 to be 20% if early redemptions are not considered. Using these assumptions, a comparison of the amortized cost (after the SFAS No. 115 charge) and market value of the Company's Mortgage Interests at December 31, 1993, is as follows (in thousands): AMORTIZED ESTIMATED FAIR COST VALUE ---------- -------------- Residual Interest Certificates.......... $ 14,025 $ 13,302 Interests Relating to Mortgage Participation Certificates............ 3,710 3,710 ---------- ---------- Total Mortgage Interests................ $ 17,735 $ 17,012 ========== ========== The estimated prospective net level yield at December 31, 1993 of the Company's Mortgage Interests based on the amortized cost balance of $17,735,000, in the aggregate, is 17% without early redemptions being considered and 29% if early redemptions are considered. The timing and amount of redemption cash flows is highly uncertain because it is dependent upon levels of prepayments, interest rates and other factors. Effective January 1, 1994 the prospective net level yield method of accounting will be used for both residual interest certificates and interests relating to mortgage participation certificates. The provisions of SFAS No. 115 will be used to determine impairment of these Mortgage Interests on a quarterly basis. The assumptions used in calculating the above net cash flows and the prospective net level yield were the December 31, 1993 LIBOR and COFI rates of 3.25% and 3.82%, respectively, and the December 31, 1993 Public Securities Association Prepayment median projected prepayment speeds for particular collateral as follows: PREPAYMENT ASSUMPTIONS ------------------------------------------------------------ MORTGAGE INTEREST COLLATERAL COUPON PSA % ------------------------- ---------- ---------- --------- Westam 1 GNMA I 10.5% 385 Westam 3 GNMA I 9.5% 445 Westam 5 GNMA I 9.0% 402 Westam 6 GNMA 1 9.5% 445 ASW 65 GNMA I 10.0% 412 FHLMC 17 FHLMC 10.0% 510 FNMA 24 FNMA 10.0% 510 FNMA 25 FNMA 9.5% 510 The projected yield and discounted present values of projected net cash flows are based on the assumptions at December 31, 1993 as described above. There will be differences, which may be material, between the projected yields and the actual yields and between the present values of projected net cash flows and the present values of actual net cash flows. NOTE 11 -- QUARTERLY FINANCIAL DATA (UNAUDITED) (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) NET INCOME NET INCOME (LOSS) PER DIVIDENDS PER 1991 (LOSS) SHARE SHARE ------------------------------ ------------- -------------- ------------- First $ 3,786 $ .39 $ .50 Second 4,306 .43 .40 Third 4,378 .43 .40 Fourth (4,443) (.45) .40 ---- First $ 2,555 $ .25 $ .25 Second (3,248) (.33) .15 Third (15,368) (1.56) -- Fourth (3,072) (.31) -- ---- First $ (10,824) $ (1.11) -- Second (8,148) (.84) -- Third (4,050) (.42) -- Fourth (1) (8,966) (.93) .03 - -------------- (1) Net loss in the fourth quarter of 1993 includes a charge of $6,078,000 or $.63 per share, for the cumulative effect of an accounting change (see Note 10). SCHEDULE III HOMEPLEX MORTGAGE INVESTMENTS CORPORATION PARENT COMPANY BALANCE SHEETS AS OF DECEMBER 31, 1993 AND DECEMBER 31, 1992 (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) 1993 1992 -------- -------- ASSETS Cash and cash equivalents................................. $ 16,225 $ 14,163 Investment in and advances to subsidiaries................ 6,441 39,974 Other assets.............................................. 417 387 Interests relating to mortgage participation certificates. 359 1,310 Mortgage loan receivable.................................. 320 -- -------- -------- Total Assets.............................................. $ 23,762 $ 55,834 ======== ======== LIABILITIES Accounts payable and other liabilities.................... 1,093 1,094 Dividend payable.......................................... 292 -- Accrued interest payable.................................. -- 34 -------- -------- Total Liabilities......................................... 1,385 1,128 -------- -------- Contingencies STOCKHOLDERS' EQUITY Common stock, par value $.01 per share; 50,000,000 shares authorized; issued and outstanding -- 9,875,655 shares.. 99 99 Additional paid-in-capital................................ 84,046 84,046 Cumulative net income (loss).............................. (20,330) 11,658 Cumulative dividends...................................... (41,045) (40,753) Treasury stock-143,938 shares in 1993 and 123,570 shares in 1992.................................. (393) (344) -------- -------- Total Stockholders' Equity................................ 22,377 54,706 -------- -------- Total Liabilities and Stockholders' Equity................ $ 23,762 $55,834 ======== ========

75641_1993.txt

75641_1993

1993

75641

Item 1. Business. GENERAL Pacific Bell (the "Company") was incorporated in 1906 under the laws of the State of California and has its principal executive offices at 140 New Montgomery Street, San Francisco, California 94107 (telephone number (415) 542-9000). Through December 31, 1983, the Company was a subsidiary of American Telephone and Telegraph Company ("AT&T"). Effective January 1, 1984, the Company became a subsidiary of Pacific Telesis Group ("Telesis" or the "Corporation"), one of the seven regional holding companies (the "RHCs") formed in connection with the 1984 divestiture by AT&T of its 22 wholly owned operating telephone companies ("Bell Operating Companies" or "BOCs") pursuant to a consent decree settling antitrust litigation ("Consent Decree") approved by the United States District Court for the District of Columbia (the "Court") which has retained jurisdiction over the interpretation and enforcement of the Consent Decree. Under the terms of the Consent Decree, all territory served by the BOCs was divided into geographical areas called "Local Access and Transport Areas" ("LATAs", also referred to as "service areas"). The Consent Decree generally prohibits BOCs and their affiliates* from providing communications services that cross service area boundaries; however, the networks of the BOCs interconnect with carriers that provide such services (commonly referred to as "interexchange carriers"). The Company and its wholly owned subsidiaries, Pacific Bell Directory and Pacific Bell Information Services, provide a variety of communications services in California. These services include: (1) dial tone and usage services, including local service (both exchange and private line), message toll services within a service area, Wide Area Toll Service (WATS)/800 services, Centrex service (a central office-based switching service) and various special and custom calling services; (2) exchange access to interexchange carriers and information service providers for the origination and termination of switched and non-switched (private line) voice and data traffic; (3) billing services for interexchange carriers and information service providers; (4) various operator services; (5) installation and maintenance of customer premises wiring; (6) public communications services (including service for coin telephones); (7) directory publishing; and (8) selected information services, such as voice mail and electronic mail (See also "Pacific Bell Information Services," below). Efforts to develop additional advanced services are described below. - ------------------- * The terms of the Consent Decree, with certain exceptions, apply generally to all the BOCs and their affiliates. LINE OF BUSINESS RESTRICTIONS The Consent Decree provides that the RHCs shall not engage in certain lines of business. The principal restrictions initially prohibited the provision of interexchange telecommunications, information services and telecommunications equipment. As described below, the information services prohibition was lifted in 1991. The telecommunications businesses permitted by the Consent Decree include the provision of exchange telecommunications* and exchange access services, customer premises equipment ("CPE") and printed directory advertising. The RHCs are prohibited from manufacturing telecommunications equipment and CPE. On December 3, 1987, the Court interpreted the manufacturing restriction to mean that the RHCs are prohibited from designing and developing telecommunications equipment and CPE as well as from fabricating them. The Consent Decree provides that the Court may waive the line of business restrictions (i.e., grant a "Waiver") upon a showing that there is no substantial possibility that the RHCs could use their monopoly power to impede competition in the market they seek to enter. The Court has placed certain conditions on the Waivers it has granted and may do so again on future Waivers. In May 1993, the U.S. Court of Appeals for the District of Columbia affirmed the Court's removal of the ban on the provision of information services by the Corporation. The removal of this ban in July 1991 allowed the Company to offer a variety of new information services, subject to regulatory approvals, such as enhanced voice mail and electronic yellow pages. In November 1993, the U.S. Supreme Court declined to review the Appeals Court decision. In November 1993, legislation was introduced in Congress that would simplify the procedures under which BOCs seek relief from provisions of the Consent Decree that prohibit the Company from manufacturing telephone equipment or providing long-distance service. The legislation would set conditions and establish waiting periods of up to five years before the RHCs could seek authority to enter all aspects of these businesses. One of the bills would also impose stringent separate subsidiary requirements on RHC electronic publishing ventures. - ------------------- * "Exchange telecommunications" includes toll or long-distance services within a service area as well as local service. SPIN-OFF OF THE CORPORATION'S WIRELESS OPERATIONS In December 1992, Telesis' Board of Directors approved a plan to spin off the Corporation's wireless operations. Telesis will continue to own the Company and its directory publishing and information services subsidiaries, Nevada Bell, and several smaller diversified entities, including real estate assets. Telesis will spin off AirTouch Communications ("AirTouch"), formerly PacTel Corporation, and its domestic and international wireless operations as a separate entity. On March 10, 1994, the Telesis Board gave final approval to the spin-off of AirTouch. The spin-off will be effected April 1, 1994. In February 1993, the California Public Utilities Commission ("CPUC") instituted an investigation of the proposed spin-off of the Corporation's wireless businesses for the purpose of assessing any effects it might have on telephone customers of the Company and regulated cellular and paging firms in California. On November 2, 1993, the CPUC adopted a decision permitting the spin-off to proceed. The CPUC further ordered a refund by Telesis of approximately $50 million (including interest) of cellular pre-operational and development expenses. Further proceedings will determine how the refund will be disbursed. The CPUC decision was effective immediately. Two parties to the CPUC investigation filed Applications for Rehearing by the CPUC of its treatment of the claims for compensation owed to the Company's customers. The CPUC's Division of Ratepayer Advocates filed a Petition for Modification of the CPUC's decision. In March 1994 the CPUC denied these requests. One of these parties further stated that if it were unsuccessful with the CPUC it would seek review by the California Supreme Court. In the event the California Supreme Court were to review and reverse the CPUC's decision, no assurance can be given that the CPUC might not reach a new decision materially less favorable to Telesis or AirTouch with respect to the compensation issues. In addition, a substantial period of time could elapse before final resolution of these issues should a review be granted. The Company believes that the California Supreme Court will deny a review. Upon the spin-off of AirTouch, Telesis and AirTouch will have no common directors, officers or employees. Philip J. Quigley will become Chairman and Chief Executive Officer of the Corporation and will remain as President and Chief Executive Officer of the Company. Sam Ginn, currently Chairman and Chief Executive Officer of the Corporation, will leave Telesis but will continue as Chairman and Chief Executive Officer of AirTouch. Pacific Bell Directory Pacific Bell Directory ("Directory") is a publisher of the Company's SMART Yellow Pages(R). Directory is the oldest and largest publisher of directory information products in California and is among the largest Yellow Pages publishers in the United States. Directory has enhanced the content, organization and visual appeal of the local information in its directories and improved other features to make the SMART Yellow Pages even more helpful and easier to use. Most recently, a "Government Officials" section was added that contains the names, address, telephone numbers and photographs of elected officials, along with a map identifying congressional and state representative boundaries. An audiotext feature called "Local Talk" is planned for 60 markets statewide by the end of 1994. In addition, government, business and residential listings have been divided into separate sections in the White Pages for faster accessibility, with colored tabs on the outer edges of the pages identifying each section. As part of its ongoing small business advocacy efforts, Directory also produces Small Business Success in partnership with the U.S. Small Business Administration. Small Business Success is an annual publication now in its seventh year that addresses subjects of critical importance to entrepreneurs. Pacific Bell Information Services Effective January 1, 1993, the Company transferred its Information Services Group to Pacific Bell Information Services ("PBIS"). PBIS provides business and residential voice mail and other selected information services. Current products include The Message Center for home use, Pacific Bell Voice Mail for businesses, and Pacific Bell Call Management, a service that routes incoming business calls and connects computer data bases to answer routine customer questions. (See "Information Services Subsidiary" in Item 7 below, "Management's Discussion and Analysis of Results of Operations" ("MD&A") for discussion of CPUC proceeding concerning PBIS). RESEARCH AND DEVELOPMENT Bell Communications Research, Inc. ("Bellcore") furnishes the BOCs, including the Company, with technical and consulting assistance to support their provision of exchange telecommunications and exchange access services. Each of the other six RHCs or their BOCs, including the Company, holds one-seventh of the voting stock of Bellcore, which serves as a central point of contact for coordinating the efforts of the RHCs in meeting the national security and emergency preparedness requirements of the federal government. In addition, the Company conducts research and development internally. The Company has spent approximately $25 million, $30 million and $30 million in 1993, 1992 and 1991, respectively, on research and development activities. FINANCING ACTIVITIES In 1993, the Company redeemed $2.55 billion and issued $2.65 billion of long-term debt. As of December 31, 1993, the Company had remaining authority to issue up to $1.25 billion in long- and intermediate-term debt pursuant to a CPUC order issued in September 1993. As of December 31, 1993, the Company had authority to issue up to $650 million in long- and intermediate-term debt through a shelf registration statement on file with the Securities and Exchange Commission (the "SEC"). Proceeds from debt issuances in 1993 and future issuances will be used to refund maturing debt and to refinance other debt issues. Effective April 23, 1993, AT&T redeemed $300 million in long- term debt for which the Company was a secondary obligor. This debt was assumed by AT&T at divestiture. Additional discussion of the Company's financing activities is in Note F to the Consolidated Financial Statements below. The following are bond and commercial paper ratings for the Company: | Long- and |Intermediate-Term Commercial Paper | Debt - ----------------------------------------------------------|----------------- | Pacific | Pacific Bell | Bell - ----------------------------------------------------------|----------------- Moody's Investors Service, Inc. Prime-1 | Aa3 Standard & Poor's Corporation A-1+ | AA- Duff and Phelps, Inc. Duff 1+ | AA - ----------------------------------------------------------------------------- No recapitalization of the Company is planned as a result of Telesis' spin-off of AirTouch. After the Telesis Board announced its decision in December 1992 to spin off AirTouch and its wireless operations, Duff and Phelps, Inc. ("D&P") reaffirmed its rating of the Company's debt. Standard & Poor's ("S&P") affirmed its rating on the commercial paper programs and the Company's outstanding long-term debt of the Company. S&P also revised its ratings outlook for the Company's long-term debt from "stable" to "positive." Additionally, Moody's stated that the Company's debt rating is unlikely to be affected by the spin-off. The ratings noted above reflect the views of the rating agencies; they should be evaluated independently of one another and are not recommendations to buy, sell or hold the securities of the Company. There is no assurance that such ratings will continue for any period of time or that they will not be changed or withdrawn. PRINCIPAL SERVICES: Significant components of the Company's operating revenues are depicted in the chart below: % of Total Operating Revenues ----------------------------- Revenues by Major Category 1993 1992 - --------------------------------------------------------------------------- Local Service Recurring .............................. 22% 21% Other Local ............................ 17% 17% Network Access Carrier Access Charges ................. 18% 18% End User & Other ....................... 7% 7% Toll Service* Message Toll Service.................... 21% 20% Other................................... 2% 4% Other Service Revenues Directory Advertising .................. 11% 11% Other .................................. 4% 4% Uncollectibles (2%) (2%) ------ ------ TOTAL ...................................... 100% 100% =========================================================================== * Percentages for 1993 are not comparable to prior year's percentages due to reclassifications in the current presentation. The percentages of total operating revenues attributable to interstate and intrastate telephone operations are displayed below: % of Total Operating Revenues ----------------------------- 1993 1992 - --------------------------------------------------------------------------- Interstate telephone operations ............ 18% 18% Intrastate telephone operations ............ 82% 82% ------ ------ TOTAL ...................................... 100% 100% =========================================================================== As of December 31, 1993 about 33 percent of the network access lines of the Company were in Los Angeles and vicinity and about 25 percent were in San Francisco and vicinity. The Company provided approximately 77 percent of the total access lines in California on December 31, 1993. The Company does not furnish local service in certain sizeable areas of California which are served by non-affiliated telephone companies. MAJOR CUSTOMER Payments from AT&T for access charges and other services accounted for 11 percent of the Company's operating revenues during 1993. No other customer accounted for more than 10 percent of the Company's operating revenues in 1993. STATE REGULATION As a provider of telecommunications services in California, the Company is subject to regulation by the CPUC with respect to intrastate rates and services, the issuance of securities and other matters. The CPUC adopted a new regulatory framework, which is a form of "price cap" or "incentive" regulation, for the Company and one other large local exchange carrier in California in October 1989. The authorized market-based rate of return under the CPUC's new regulatory framework is 11.5 percent. If the Company's rate of return exceeds 13 percent, earnings above the 13 percent benchmark must be shared 50-50 with customers. Earnings above 16.5 percent must be returned 100 percent to customers. The third phase of the CPUC's ongoing investigation into alternative regulatory frameworks has addressed competition for intra-service area toll and related services. The CPUC's formal authorization of competition into the Company's intra-service area toll market is expected in 1994. (See "Toll Services Competition" below.) Under incentive-based regulation, the CPUC requires the Company to submit an annual price cap filing to determine prices for categories of services for each new year. Price adjustments reflect the effects of any change in the Gross National Product Price Index ("GNPPI") less 4.5 percent, the productivity factor established by the CPUC under the new incentive regulation. The annual price adjustments also reflect the effects on the Company's costs of exogenous events beyond its control. In December 1993, the CPUC approved the Company's annual price cap filing for 1994 in which the Company had proposed a $105 million rate reduction. This reduction includes a decrease of $85 million because the 4.5 percent productivity factor of the price cap formula exceeded the increase in the GNPPI by 1.3 percent. The filing also included several additional factors which will decrease revenues* by an additional $20 million. In 1992, the CPUC began its scheduled review of the current incentive-based regulatory framework. Among other issues, this review has examined elements of the price cap formula, including the productivity factor and the benchmark rate of return on investment adopted in the 1989 New Regulatory Framework ("NRF") order. The Company proposed no significant changes to the new framework because its experience to date suggests that it is working as intended. - ---------------- * Unless otherwise indicated, revenue changes from CPUC price cap orders are estimated on an annual basis and may be more or less than the amount ordered, due to later changes in volumes of business. In March 1994, a CPUC Administrative Law Judge issued a proposed decision in the NRF review. The proposed decision would eliminate an element of the regulatory framework which requires equal sharing with customers of earnings exceeding a benchmark rate of return. Earnings above a rate of return of 16.5 percent would continue to be returned to customers. The proposed decision also recommends increasing the productivity factor of the price cap formula from 4.5 percent to 6.0 percent for the period 1994 through 1996. If adopted by the CPUC, the change in the productivity factor would reduce annualized revenues by approximately $100 million each year through 1996. The Company plans to file comments objecting to the proposed increase in the productivity factor. The Company is unable to predict the final outcome of these proceedings or the effective date of any rate reductions. In August 1993, the CPUC issued a proposal to allow competition in the provision of intrastate switched transport services. The CPUC proposes to allow competitors to locate transmission facilities in the Company's central offices; adopt a new transport rate structure that includes pricing flexibility for dedicated traffic; and authorize competition for switched transport services within the state. Revenues from intrastate switched transport services represent approximately four percent of the Company's total revenues. The Company is unable to predict the outcome of this proceeding. In April 1993, the CPUC initiated an investigation to establish a framework to govern open network access; i.e., access to so-called "bottleneck" services. The CPUC proposes to adopt specific requirements for the unbundling and nondiscriminatory provision of functions underlying services provided by dominant telecommunications providers. Functions considered bottleneck and subject to open access for competitive telecommunications providers include all transport, switching, call processing and call management. In comments filed in February 1994, the Company urged the CPUC to recognize that widespread competition exists throughout the telecommunications industry and asked the CPUC to consider rules for local competition immediately. The Company's proposal calls for the separation of the loop (the telephone line between a customer's location and the telephone company's central office) from the switch (the central office equipment that selects the paths to be used for transmission of information.) The Company has filed an application for authority to conduct tests and trials with a variety of industry participants to test the feasibility of unbundling the loop from the switch and of various points of interconnection. The trials would allow competitors to connect to the Company's network to carry calls. Eventually, customers would be able to decide whether they want the Company to provide all of their telecommunications services, including local service, or if they want to subscribe to another provider for dialtone and other services. The Company also believes it should be given the opportunity to compete in other markets, such as long-distance, cable television programming and manufacturing. The Company's entry into these markets would benefit consumers by providing them alternatives to existing sources of products and services. The Company is unable to predict the outcome of this proceeding. In December 1993, the CPUC released a report to the Governor proposing streamlined regulation of telecommunications companies. The report states that the benefits of deregulation and fostering advanced telecommunications in California would be substantial. It predicts that expanded use of telecommunications will create new products, services and job opportunities, and could increase the productivity of the state's businesses. The CPUC proposes that within the next year California should: streamline regulation where markets are workably competitive; continue the CPUC's focus on consumer protection in all markets; develop policies and partnerships that encourage consumer demand and the increased use of advanced telecommunications networks; and, establish a grant program to enhance development and use of advanced telecommunications in schools and libraries. The report recommends that disincentives to investments (such as the current cap on earnings and sharing mechanisms) be removed, that restrictions on the Company's ability to provide certain services be removed and that interconnection and interoperability among competing networks be required to expand customer choice. Additionally, the CPUC proposed that within three years California open all markets to all competitors, thereby making the state an "open competition zone." It would also restructure universal service funding, and gradually redefine the concept of basic service to ensure that all residents benefit from advanced telecommunications technologies. In addition, it would make digital access to networks available as a prelude to making switched video and mobile services available throughout the state by the end of the decade. By opening markets to competition, the policies proposed by the CPUC would increase demand for and stimulate the private development of new types of telecommunications and video services, bringing innovative new products into businesses, homes, and communities. Various elements of these proposals require consideration by the California Legislature as well as formal review by the CPUC. The Company continues to support changes in public policy and regulation that will allow it to offer the products and services that customers want. Discussion of other CPUC proceedings, including regulatory and ratemaking treatment for postretirement benefits in connection with the adoption of Financial Accounting Standard No. 106, and the limited rehearing of a decision involving certain erroneous late payment charges, is included in Item 7 below, MD&A. FEDERAL REGULATION The Company is subject to the jurisdiction of the Federal Communications Commission (the "FCC") with respect to interstate access charges and other matters. The FCC prescribes a Uniform System of Accounts and interstate depreciation rates for operating telephone companies. The FCC also prescribes "separations procedures," which are the principles and standard procedures used to separate plant investment, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC, and intrastate services under the jurisdiction of state regulatory authorities. The Company is also required to file tariffs with the FCC for the services it provides. In addition, the FCC establishes procedures for allocating costs and revenues between regulated and unregulated activities. Beginning in 1991, the FCC adopted a price cap system of incentive-based regulation for local exchange carriers. The Company's access rates were retargeted to a new 11.25 percent rate of return on rate base assets. The FCC's price cap system provides a formula for adjusting rates annually for changes in the GNPPI, less a productivity factor, and changes in certain costs that are triggered by administrative, legislative or judicial action beyond the control of the local exchange carriers. The FCC's price cap plan allows the Company to choose between two productivity offset factors of 3.3 or 4.3 percent on an annual basis. This choice affects both the sharing threshold and the threshold above which all earnings must be returned to customers. In its third annual access filing, the Company again chose the productivity factor of 3.3 percent, which the FCC approved in June 1993. This choice sets the benchmark rate of return for sharing of earnings at 12.25 percent. If earnings for 1993 are determined to exceed this threshold, the Company must share the excess earnings with customers. Earnings above 16.25 percent must be returned entirely to customers. New annual access rates became effective July 1, 1993. The Company's access rates were decreased by $17 million for the 12 months July 1993 through June 1994. The reductions reflect the net effects of inflation, productivity gains and other required cost adjustments. In February 1994, the FCC issued a notice of proposed rulemaking to review its "price cap" alternative regulatory framework. Parties, including the Company, will file comments with the FCC in April 1994. The FCC is looking for comments on three main sets of issues: (1) refining the goals of price caps to better meet the public interest and the purposes of the Communications Act; (2) whether to revise the current plan (which became effective January 1, 1991) to help it better meet the FCC's goals, or to adjust the plan to changes in circumstances; and (3) possible transition from the baseline price cap plan toward reduced or streamlined regulation of services by local exchange carriers ("LECs") as competition grows. The FCC released a Notice of Inquiry in December 1991 "to open public debate on the interrelationship of Open Network Architecture with emerging network design" and to gather information on future network capabilities. The FCC stated that its goal is to encourage development of future local exchange networks that are as open, responsive and procompetitive as possible, consistent with the FCC's other public interest goals. The Company filed comments on March 3, 1993, stating that market forces must drive network evolution. In August 1993, the FCC issued a notice of proposed rulemaking to require Tier I local telephone companies implementing intelligent networks to offer third party mediated access to their networks. In comments filed with the FCC, the Company asserted that access to intelligent networks should not be mandated because market forces are sufficient to bring about open access. Effective in June 1993, the FCC ordered expanded network interconnection for interstate special access services. Special access services are used primarily by large businesses to connect to their branch offices or to interexchange carriers. The decision requires large LECs, including the Company, to offer expanded interconnection to customers, including other access providers. The decision permits these customers to locate their transmission facilities in the LECs' central offices. The FCC granted additional, but limited, pricing flexibility to the LECs to respond to the increased competition that will result. Along with other LECs, the Company has filed a petition for review of this FCC decision with the U.S. Court of Appeals for the D.C. Circuit. We are unable to predict the outcome of this appeal. The Company currently has orders from Competitive Access Providers to locate facilities in more than 20 of its central offices, with more requests expected to follow. Interstate special access revenues subject to increased competition represent less than three percent of the Company's total revenues. Effective in February 1994, the FCC ordered LECs, including the Company, to provide all interested customers, including competitors, with expanded interconnection for interstate switched transport services. The LECs must allow interconnectors to physically locate their transmission facilities in the LECs' central offices, and certain other LEC locations, in order to terminate their own switched transport facilities. Along with other LECs, the Company has filed a petition for review of this FCC decision with the U.S. Court of Appeals for the D.C. Circuit. The Court has held this case in abeyance pending the Court's decision in the appeal of the FCC's special access collocation order. Switched transport services help connect a business or residential customer with an interexchange carrier. One of the FCC's goals is to promote increased competition for these services. The FCC also granted additional, but limited, pricing flexibility for these services so that the LECs can better respond to the competition that will result. Revenues from interstate switched transport services represent approximately three percent of the Company's total revenues. Rates reflecting the new rules became effective in early 1994. To facilitate expanded interconnection for switched transport services, the FCC ordered a new interim rate structure effective December 1993. Under the new structure, interexchange carriers pay different rates based on volume, distance and other factors. The FCC intends these interim rates to be revenue neutral. The Company and others have petitioned the FCC for reconsideration of this decision, contending that the interim rate structure will cause revenue losses. The Company is unable to predict the outcome of this proceeding. In August 1992, the FCC modified its rules to permit LECs, including the Company, to provide a tariffed basic platform ("video dialtone") that will deliver video programming developed by others on a nondiscriminatory basis. (See "Video Services," below, for a discussion of the Company's four applications to provide video dialtone services.) The FCC's order has been appealed but the appeals are stayed pending the FCC's reconsideration decision. The FCC also recommended that Congress repeal the statutory cross- ownership restriction imposed on cable and telephone companies. Until Congress acts, additional services authorized by the FCC rules include video gateways, interactive enhanced services, video transport, video customer premises equipment, and billing and collection. In July 1993, five of the RHCs, including the Corporation, filed a petition with the FCC asking for new rules governing the provision of long-distance services. The RHCs are currently prohibited from providing long-distance services by the terms of the Consent Decree. Even with a favorable ruling from the FCC, the RHCs must still obtain relief from the Consent Decree from Congress, or the courts, before providing long-distance services. During 1993, the Company joined other members of the United States Telephone Association ("USTA") in a petition to the FCC to establish a rulemaking for the purpose of reforming regulation of interstate access services. USTA urges the FCC to address several major matters needing reform including existing subsidy funding and recovery mechanisms, the need for greater pricing flexibility as competition increases and the need to revise current price cap rules. NEW TECHNOLOGY AND ADVANCED SERVICES The Company continues to modernize and expand its telephone networks to meet customer demands for faster and more reliable services as well as demands for new products and services. New technologies being deployed include optical fiber, digital switches and Signaling System 7 ("SS-7"). Digital switches and optical fiber, a technology using thin filaments of glass or other transparent materials to transmit coded light pulses, greatly increase the capacity and reliability of transmitted data while reducing maintenance costs. SS-7 permits faster call setup and new custom calling features. Investments in key technologies are summarized in Item 7 below, MD&A. SS-7 has made it possible for the Company to offer many new custom calling features, subject to regulatory approvals. New custom calling features include call return, priority ringing, call trace and other Custom Local Area Signaling Services ("CLASS"). The Company began offering priority ringing, repeat dialing and select call forwarding services in selected areas in 1992. The Company introduced call trace, call screen and call return services in 1993. Over half a million customers subscribed to these new services in 1993. The Company will introduce additional features and expand the availability of the "CLASS" Services in 1994. However, as a result of a CPUC decision in November 1992, the Company has decided not to offer caller identification ("Caller ID"). The stringent number blocking requirements placed on the service by the CPUC prevent the Company from offering customers a viable service at a reasonable price. The Company continues to work with the CPUC in this area, with the goal of providing California customers the benefits of Caller ID service. In March 1994, the FCC adopted free per call blocking as the national standard for the offering of Caller ID on interstate calls, effective April, 1995. The Company, either directly or through its subsidiary, Pacific Bell Information Services, also offers voice mail, electronic messaging and interactive voice response services. (See "Pacific Bell Information Services," above.) Other enhanced services may be offered in the future. The Company does not expect revenues from enhanced services to have a material effect on reported earnings in 1994 but the new services are expected to increase the use of the Company's network. In November 1993, the Company announced a capital investment plan totaling $16 billion over the next seven years to upgrade its core network infrastructure and to begin building California's "communications superhighway." This will be an integrated telecommunications, information and entertainment network providing advanced voice, data and video services. Using a combination of fiber optics and coaxial cable, the Company expects to provide broadband services to more than 1.5 million homes by the end of 1996 and more than 5.0 million homes by the end of the decade. As part of its current plan, the Company has made purchase commitments totaling nearly $600 million in accordance with its previously announced $1 billion program for deploying an all digital switching platform with ISDN (Integrated Services Digital Network) and SS-7 capabilities. The advanced network will make possible capital and operational cost savings, service quality improvements and new revenues from the array of new service possibilities. The offering of any new advanced services will depend upon their economic and technological feasibility. Construction of the portions of the network that are not video- specific will begin early in the second quarter of 1994. (See "Video Services," below.) The network should be capable of offering fully interactive digital telephone services by the end of 1996. In order to offer the new products and services customers want, the Company has been making substantial investments to improve its telephone network. During 1993, the Company invested $1.8 billion in its network. Capital expenditures in 1994 for the Company are forecast to be $1.8 billion including $1,111 million for projects designed to generate revenues and $580 million for projects designed to reduce costs. Capital expenditures under the Company's seven year investment plan are not expected to increase until 1996 due to the timing of capital expenditures associated with the construction of the broadband network. CHANGING INDUSTRY ENVIRONMENT The new information services industry is being shaped by advances in digital and fiber-optic technologies that will make possible the provision of interactive broadband services by the Company as well as others. Although the convergence of the telecommunications, computer and video industries will bring further competition, it also should mean unprecedented reasons to enter new businesses from which we have been barred historically. The Clinton administration has indicated it will support legislation to remove many of the legal restrictions that have prevented telephone companies from offering video services. The administration has also indicated it will support the removal of restrictions which prevent the RHCs from providing long-distance services. Similar proposals have been made by the CPUC to the Governor of California. The public policy initiatives discussed below will determine the terms and conditions under which the Company may offer new services in this dynamic marketplace. Video Services As described above, the FCC currently permits LECs, including the Company, to provide a tariffed basic platform that will deliver video programming developed by others ("video dialtone") and to provide certain other services to customers of this basic platform. In December 1993, the Company filed an application with the FCC seeking authority to offer video dialtone services in specific locations in four of its service areas: the San Francisco Bay Area; Los Angeles; San Diego; and Orange County. The advanced integrated broadband telecommunications network which the Company plans to build over the next seven years will be capable of delivering an array of services including traditional voice, data and video services. Once FCC approval is obtained, the Company will deploy the video exclusive components of the advanced network. In addition to providing advanced telecommunications services, the new network will also serve as a platform for other information providers, and will offer customers an alternative to existing cable television providers. The integrated network is also expected to spur the development of new interactive consumer services in education, entertainment, government and health care. In November 1993, the Corporation sued to overturn the 1984 Cable Act provision barring telephone companies from providing video programming in their own service areas. The Cable Act bars telephone companies from having more than a de minimis ownership stake in video programming services, although it permits them to carry other companies' programs. The Company believes that video programming is a form of speech protected by the First Amendment of the United States Constitution. If the suit is successful, the Corporation plans to begin providing programming in California as soon as Pacific Bell's video dialtone network is deployed. In November 1993, legislation was introduced in Congress that would permit LECs, including the Company, to provide video programming to subscribers in their own service areas, subject to separate subsidiary requirements and other safeguards. The legislation would also permit competition in the provision of local telephone service and allow access to LEC facilities by competitors. In January 1994, Pacific Telesis Video Services, a newly created Pacific Telesis subsidiary, announced an advanced interactive television services trial with AT&T that will test consumer acceptance of sophisticated services such as multi-player games, interactive home shopping and educational programs, movies-on-demand, and time-shifted television programs. PTVS will purchase transport from the Company when video dialtone tariffs are approved. Electronic Publishing Services In November 1993, legislation was introduced in Congress that would simplify the procedures under which BOCs may seek relief from provisions of the Consent Decree. However, the bill would also impose stringent separate subsidiary requirements on RHC electronic publishing ventures. In November 1993, the Company filed an application with the CPUC stating its intent to enter the electronic publishing business, either by itself or through an affiliate. Personal Communications Services In October 1993, the FCC issued an order allocating radio spectrum and setting forth licensing requirements to provide PCS. PCS relies on a network of transceivers that may be placed throughout a neighborhood, business complex or community to provide customers with mobile voice and data communications. The FCC established two different sizes of service areas nationwide for PCS: 47 large areas referred to as Major Trading Areas ("MTAs") and 487 smaller areas. The MTA licenses are for 30 megahertz of spectrum. In any given area, there will be as many as seven licenses, including two MTA licenses. Most of the licenses will be awarded by competitive bidding in auctions expected in late 1994 or early 1995. The Corporation plans to aggressively pursue PCS licenses at these auctions and is well-placed to be part of the expected multi-billion dollar market for PCS. (See discussion of the FCC's award of pioneer preferences for PCS in Item 7 below, MD&A.) A wholly owned subsidiary of Telesis, Telesis Technologies Laboratory, Inc. ("TTL"), has been conducting PCS experiments and investigating various technological issues under an experimental license granted by the FCC. With a spin-off of AirTouch, Telesis will be eligible to bid on PCS licenses in the service areas of the Company. Some of the assets that have been engaged in PCS research and development work were transferred to AirTouch in late 1993 in accordance with the terms of the Separation Agreement between Telesis and AirTouch. The Company will form a new subsidiary to receive the remaining assets of TTL that have been engaged in PCS research and development work. It will provide PCS services if Telesis wins a license at auction. COMPETITION Regulatory, legislative and judicial actions since the Consent Decree, as well as advances in technology, have expanded the types of available communications services and products and the number of companies offering such services. Various forms of competition are growing steadily and are already having a significant effect on the Company's earnings. An increasing amount of this competition is from large companies with substantial capital, technological and marketing resources. There is also increased competition among existing and new common carriers, including subsidiaries of the RHCs and AT&T, for the provision of voice and data communications services. Toll Services Competition In 1993, the CPUC continued Phase III of its ongoing investigation into alternative regulatory frameworks (See "State Regulation" above). In Phase III, the CPUC is considering how to lift its current ban on intra- service area competition for toll and toll-related services and how to rebalance the Company's rates. In September 1993, the CPUC announced a decision providing that, beginning in 1994, long-distance and other telecommunications companies would be allowed to compete with the Company and other local telephone companies in providing toll service, among other services. The decision would have also lowered local exchange company toll and switched access rates, while increasing basic rates, bringing each closer to cost. Other rates would have also changed. Overall, the CPUC's order was intended to be revenue neutral; that is, the effect of rate decreases would be offset by the effect of rate increases. In October 1993, the CPUC rescinded its September decision after questions were raised about its decision-making process. The CPUC has requested additional comments on its original decision. The Company expects a final decision in 1994, but is unable to predict the revenue impacts of the decision and the increased competition that will follow. In a future proceeding, the CPUC intends to address whether to require LECs to provide a way for customers to presubscribe to their carrier of choice for intra-service area toll services. In 1993, the Company experienced a decline in revenues from services subject to competition, while revenues from other services continued to grow. The total impact of competition on revenues, however, cannot be quantified separately from the effects of the recession in California. (See "California Economy" in Item 7 below, MD&A.) Interstate Special Access Competition Expanded interconnection for interstate special access services became effective on June 16, 1993. Special access services are used primarily by large businesses to connect to their branch offices or to connect directly to interexchange carriers. Expanded interconnection allows customers, including other access providers, to collocate their transmission facilities in an LEC central office. This allows interexchange carriers ("IECs") to choose among competing providers for transport into the LECs' central offices. (See "Federal Regulation" above.) Switched Transport Competition Effective February 15, 1994, expanded interconnection became available for the transport portion of interstate switched access services under similar price, terms and conditions as for special access services. Switched access services link IECs with most residential and business customers. In recognition of the local transport competition which exists today and the increased competition that will result from expanded interconnection, the FCC has approved limited rate deaveraging by zones of central offices and volume and term discounts for LEC access transport services, once certain conditions are met. In August 1993, the CPUC also issued a proposal to allow competition in the provision of intrastate switched transport services. The CPUC proposes to allow competitors to locate transmission facilities in the Company's central offices; adopt a new transport rate structure that includes pricing flexibility for dedicated traffic; and authorize competition for switched transport services within the state. (See "State Regulation" and "Federal Regulation" above.) Open Network Access/Local Competition Early in 1993, the CPUC initiated a rulemaking proceeding and set forth a number of proposed policies, rules and issues for comment on ways to establish a receptive environment for competitive providers of telecommunications services. The rulemaking focuses on one approach: Requiring local exchange carriers to unbundle "bottleneck" elements of their network and make those elements available to unaffiliated providers on an open and non-discriminatory basis. The Company's response to this rulemaking urges the CPUC to examine the full set of issues that result from a competitive local exchange market. Among such issues are: the need to establish a new universal service mechanism that spreads the subsidy burden to all telecommunications providers, to reform pricing rules to be consistent with increasing competition, to remove entry barriers including current in-state long distance restrictions on the Company, to remove investment disincentives such as sharing and to establish standards for interconnection, interoperability and unbundling of essential facilities that apply to all competing networks and not just those of the LECs. (See "State Regulation" above.) Bypass Artificially high prices for toll and access services create an economic incentive for large business users (and IECs) to use alternative communications systems capable of originating and/or terminating calls and thus bypass the local exchange network. This bypass reduces the revenues that the Company collects from toll and access services to support the total costs of the local exchange network and increases the amounts the Company has to recover from other services, notably basic exchange services. The Company is unable to determine precisely to what extent bypass has occurred and may continue to occur in the future. (See preceding sections, from "Toll Services Competition" through "Open Network Access/Local Competition" above.) To reduce the threat of bypass of the local network, the Company has strongly supported the use of cost-based pricing policies before both its state regulatory commission and the FCC. (See "State Regulation" and "Federal Regulation" above.) Centrex The Company provides Centrex service to business customers in California. Centrex is a central office-based switching system for customers who require sophisticated call transport and management capabilities as part of their business communication systems. Businesses not using Centrex service generally use Private Branch Exchange ("PBX") and other systems provided by other companies. The Company offers Centrex by contract, as approved by the CPUC, as well as pursuant to tariff. The ability to offer Centrex by contract gives the Company pricing flexibility as well as the opportunity to tailor the specific features and conditions of a given transaction. The market for multi-line business telephone products is very competitive and includes large well-financed competitors. Directory Publishing Other producers of printed directories offer products that compete with certain Pacific Bell Directory SMART Yellow Pages products. Competitors include large companies that have significant resources. Competition is not limited to directory publishers, but includes newspapers, radio, television and increasingly, direct mail. In addition, new advertising and information products may compete directly or indirectly with the SMART Yellow Pages. The Company is unable to predict the extent to which these competitors may affect future revenues of the Company. EMPLOYEES As of December 31, 1993, the Company and its subsidiaries employed 54,026 persons. About 70 percent of the Company's employees are represented by unions. In September 1992, the unions which represent these employees ratified labor contracts for a three-year term. The agreements provide for a 12 percent increase in wages, including job upgrades and a 13 percent increase in pensions over the three-year term. In addition, the contracts include incentives for early retirement, enhanced employment security, improvements in work and family life benefits and increases in health and dental care coverage. In 1993, the Company reduced the number of employees by 1,516. Looking ahead, the Company has begun a major effort to reengineer its internal business processes. This effort confronts an increasingly competitive and complex telecommunications environment by streamlining and consolidating operations, including business offices, network, installation and collection centers, as well as other facilities. As a result, the Company has announced a force reduction program that will result in a net reduction of 10,000 positions from 1994 through 1997. (See Item 7 below, MD&A, for discussion of related 1993 restructuring charge.) The Company has also deferred salary increases for all managers, including officers, for an indefinite period of time pending a review of 1994 business needs. Item 2. Item 2. Properties. The properties of the Company do not lend themselves to description by character and location of principal units. At December 31, 1993, the percentage distribution of total telephone plant by major category for the Company was as follows: Telephone Property, Plant and Equipment 1993 - ------------------------------------------------------------------------- Land and buildings (occupied principally by central offices) ..... 10% Cable and conduit ................................................ 40% Central office equipment ......................................... 37% Other ............................................................ 13% ---- Total ............................................................ 100% ========================================================================= At December 31, 1993, the Company's central office equipment was utilized to approximately 90 percent of capacity. Substantially all of the installations of central office equipment and administrative offices are in owned buildings on land held in fee. Many garages, business offices and telephone service centers are in rented quarters. Item 3. Item 3. Legal Proceedings. Contingent Liabilities Related to Predivestiture Events The Plan of Reorganization ("Plan") approved by the Court in connection with the Consent Decree provides for the recognition and payment of liabilities of the BOCs and AT&T (collectively, the former "Bell System") that are attributable to predivestiture events (including transactions to implement the divestiture), which were not certain and hence not recorded in the books of account until after divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). The Plan provides various rules for the sharing of such contingent liabilities among the BOCs and AT&T which have been followed since divestiture. AT&T, its subsidiaries and the BOCs, including the Company, may have liability under the contingent liabilities provisions of the Plan in a number of tax matters relating to the audit by various taxing authorities of predivestiture periods and in a number of tort, contract and environmental proceedings relating to predivestiture Bell System operations. While complete assurance cannot be given as to the outcome of any litigation, with respect to such tax matters and tort, contract and environmental proceedings, in the opinion of the Company, the likelihood is remote that any liability resulting from them under the contingent liabilities provisions of the Plan would have a material effect on the reported earnings of the Company. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Company has 224,504,982 shares of common stock outstanding without par value. Pacific Telesis Group, incorporated in 1983 under the laws of the State of Nevada, holds all the Company's outstanding shares. Additional information about the Company's common shares and dividends paid thereon, is in the Consolidated Financial Statements under "Item 8. Financial Statements and Supplementary Data," incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Results of Operations. OVERVIEW Pacific Bell (the "Company"), a wholly owned subsidiary of Pacific Telesis Group (the "Corporation"), provides telecommunications services including local exchange, network access and toll services; directory advertising through its wholly owned subsidiary, Pacific Bell Directory ("Directory"); and selected information services through its wholly owned subsidiary, Pacific Bell Information Services ("PBIS"). PLANNED SPIN-OFF To meet the challenges facing our industry, the Board of Directors (the "Board") of the Company's parent, Pacific Telesis Group, approved a plan in December 1992 to spin off the Corporation's wireless operations. The Corporation will continue to own the Company and its directory publishing and information services subsidiaries, Nevada Bell, and several smaller diversified entities, including real estate assets. The Corporation will spin off AirTouch Communications ("AirTouch"), formerly PacTel Corporation, and its domestic and international operations as a separate entity. On March 10, 1994, the Board gave final approval to the spin-off of AirTouch. The spin-off will be effected April 1, 1994. In November 1993, the California Public Utilities Commission (the "CPUC") adopted a decision permitting the spin-off to proceed (see "Pending Regulatory Issues" on page 40.) In connection with the separation, AirTouch completed an initial public offering in December 1993 of 14 percent of its common stock, raising about $1.5 billion. As of the spin-off date, the remaining 86 percent of AirTouch common stock currently held by the Corporation will be distributed to the Corporation's shareowners in proportion to their shares in the Corporation. Each shareowner will receive one share of AirTouch common stock for each Pacific Telesis Group share held prior to the spin-off. The Internal Revenue Service (the "IRS") has ruled that the distribution qualifies as a tax-free transaction to shareowners. The distribution will be accounted for as a stock dividend by the Corporation. CHALLENGES The Company is facing difficult challenges ahead -- increasing competition for existing services; a changing environment for the provision of new services; and the stagnant California economy. These challenges, along with our strategies to remain the customer's choice, are discussed below. o Competition ----------- The most significant challenge facing the Company in 1994 is increasing competition for existing services. The Company welcomes the opportunity to compete if public policies allow for a level playing field. Although facing increased competition, the Company expects to be a strong competitor in terms of price, service, and use of advanced technologies. Revenues from the services discussed below will be subject to increased competition. Toll Services Competition In September 1993, the CPUC announced a decision in Phase III of its investigation into alternative regulatory frameworks for local exchange carriers in California. The decision provided that, beginning in 1994, long distance and other telecommunications companies would be allowed to compete with the Company and other local telephone companies in providing toll service, among other services. The decision would have also lowered local exchange company toll and switched access rates, while increasing basic rates, bringing each closer to cost. Other rates would have also changed. Overall, the CPUC's order was intended to be revenue neutral; that is, the effect of rate decreases would be offset by the effect of rate increases. In October 1993, the CPUC rescinded its September decision after questions were raised about its decision-making process. The CPUC has requested additional comments on its original decision. The Company expects a final decision in 1994, but is unable to predict the revenue impacts of the decision and the increased competition that will follow. The CPUC intends to address, in a future proceeding, whether to require LECs to provide presubscription for intra-service area toll services. Interstate Special Access Competition Effective in June 1993, the Federal Communications Commission (the "FCC") ordered expanded network interconnection for interstate special access services. Special access services are used primarily by large businesses to connect to their branch offices or to interexchange carriers. The decision requires large local exchange carriers ("LECs"), including the Company, to offer expanded interconnection to customers, including other access providers. The decision permits these customers to locate their transmission facilities in the LEC's central offices. Along with other LECs,the Company has filed a petition for review of this FCC decision with the U.S. Court of Appeals for the D.C. Circuit. The Company is unable to predict the outcome of this appeal. The Company currently has orders from Competitive Access Providers to locate facilities in at least 20 of its central offices, with more requests expected to follow. The FCC also granted additional, but limited, pricing flexibility to the LECs to respond to the increased competition that will result. Interstate special access revenues subject to increased competition represent less than three percent of total revenues. Switched Transport Competition Effective in February 1994, the FCC ordered LECs, including the Company, to provide all interested customers, including competitors, with expanded interconnection for interstate switched transport services. The LECs must allow interconnectors to physically locate their transmission facilities in the LECs' central offices, and certain other LEC locations, in order to terminate their own switched transport facilities. Along with other LECs, the Company has filed a petition for review of this FCC decision with the U.S. Court of Appeals for the D.C. Circuit. The Court has held this case in abeyance pending the Court's decision in the appeal of the FCC's special access collocation order. Switched transport services help connect a business or residential customer with an interexchange carrier. One of the FCC's goals is to promote increased competition for these services. The FCC also granted additional, but limited, pricing flexibility for these services so that the LECs can better respond to the competition that will result. Revenues from interstate switched transport services represent approximately three percent of total revenues. Rates reflecting the new rules became effective in early 1994. To facilitate expanded interconnection for switched transport services, the FCC ordered a new interim rate structure effective December 1993. Under the new structure, interexchange carriers pay different rates based on volume, distance and other factors. The FCC intends these interim rates to be revenue neutral. The Company and others have petitioned the FCC for reconsideration of this decision, contending that the interim rate structure will cause revenue losses. The Company is unable to predict the outcome of this proceeding. In August 1993, the CPUC issued a proposal to allow competition in the provision of intrastate switched transport services. The CPUC proposes to allow competitors to locate transmission facilities in the Company's central offices; adopt a new transport rate structure that includes pricing flexibility for dedicated traffic; and authorize competition for switched transport services within the state. Revenues from intrastate switched transport services represent approximately four percent of total revenues. The Company is unable to predict the outcome of this proceeding. Open Network Access/Local Competition In April 1993, the CPUC initiated an investigation to establish a framework to govern open network access; i.e., access to services labeled "bottleneck." The CPUC proposes to adopt specific requirements for the unbundling and nondiscriminatory provision of functions underlying services provided by dominant telecommunications providers. Functions considered bottleneck and subject to open access for competitive telecommunications providers include all transport, switching, call processing and call management. In comments filed in February 1994, the Company urged the CPUC to recognize that widespread competition exists throughout the telecommunications industry and asked the CPUC to consider rules for local competition immediately. The Company's proposal calls for the separation of the loop (the telephone line between a customer's location and the telephone company's central office) from the switch (the central office equipment that selects the paths to be used for transmission of information). Pacific Bell has filed an application for authority to conduct tests and trials with a variety of industry participants to test the feasibility of unbundling the loop from the switch and of various points of interconnection. The trials would allow competitors to connect to the Company's network to carry calls. Eventually, customers would be able to decide whether they want the Company to provide all of their telecommunications services, including local service, or if they want to subscribe to another provider for dialtone and other services. The Company also believes it should be given the opportunity to compete in other markets, such as long-distance, cable television programming and manufacturing. This could bring great benefits to consumers by offering additional alternatives. The Company is unable to predict the outcome of this proceeding. Streamlined Regulation in California In December 1993, the CPUC released a report to the Governor proposing streamlined regulation of telecommunications companies. The report states that the benefits of deregulation and fostering advanced telecommunications in California would be substantial. It predicts that expanded use of telecommunications will create new products and services, new job opportunities and could increase the productivity of the state's businesses. The CPUC proposes that within the next year California should: streamline regulation where markets are workably competitive; continue the CPUC's focus on consumer protection in all markets; develop policies and partnerships that encourage consumer demand and the increased use of advanced telecommunications networks; and, establish a grant program to enhance development and use of advanced telecommunications in schools and libraries. The report recommends that disincentives to investments (such as the current cap on earnings and sharing mechanisms) be removed, that restrictions on the Company's ability to provide certain services be removed and that interconnection and interoperability among competing networks be required to expand customer choice. Additionally, the CPUC proposed that within three years California open all markets to all competitors, thereby making the state an "open competition zone." It would also restructure universal service funding, and gradually redefine the concept of basic service to ensure that all residents benefit from advanced telecommunications technologies. In addition, it would make digital access to networks available as a prelude to making switched video and mobile services available throughout the state by the end of the decade. By opening markets to competition, the policies proposed by the CPUC would increase demand for and stimulate the private development of new types of telecommunications and video services, bringing innovative new products into businesses, homes, and communities. Various elements of these proposals require consideration by the California Legislature as well as formal review by the CPUC. The Company continues to support changes in public policy and regulation that will allow it to offer the products and services that our customers want. o Changing Industry Environment ----------------------------- Another challenge facing the Company is the accelerating convergence of the telecommunications, computer and video industries. The new information services industry is being shaped by advances in digital and fiber-optic technologies that will make possible the provision of interactive broadband services by the Company as well as others. Although this convergence will bring further competition, it also should mean unprecedented reasons to enter new businesses from which we have been barred historically. The Clinton administration has indicated it will support legislation to remove many of the legal restrictions that have prevented telephone companies from offering video services. The administration has also indicated it will support the removal of restrictions which prevent the Regional Holding Companies ("RHC"s) from providing long-distance services. Similar proposals have been made by the CPUC to the Governor. The public policy initiatives discussed below will determine the terms and conditions under which the Company may offer new services in this dynamic marketplace. Video Services The FCC currently permits LECs, including the Company, to provide a tariffed basic platform that will deliver video programming developed by others ("video dialtone") and to provide certain other services to customers of this basic platform. Services authorized by the current FCC rules are primarily limited to video gateways, video customer premises equipment, and billing and collection. In December 1993, the Company filed an application with the FCC seeking authority to offer video dialtone services in specific locations in four of its service areas: the San Francisco Bay Area; Los Angeles; San Diego; and Orange County. The advanced integrated broadband telecommunications network which the Company plans to build over the next seven years will be capable of delivering an array of services including traditional voice, data and video services. Once FCC approval is obtained, the Company will deploy the video exclusive components of the advanced network. In addition to providing advanced telecommunications services, the new network will also serve as a platform for other information providers, and will offer customers an alternative to existing cable television providers. The integrated network is also expected to spur the development of new interactive consumer services in education, entertainment, government and health care. In November 1993, the Corporation sued to overturn the 1984 Federal Cable Act's provision barring telephone companies from providing video programming in their own service areas. The Cable Act bars telephone companies from having more than a de minimis ownership stake in video programming services, although it permits them to carry other companies' programs. The Company believes that video programming is a form of speech protected by the First Amendment of the United States Constitution. If the suit is successful, the Corporation plans to begin providing programming as soon as its video dialtone network is deployed. In November 1993, legislation was introduced in Congress that would permit LECs, including the Company, to provide video programming to subscribers in their own service areas, subject to separate subsidiary requirements and other safeguards. The legislation would also permit competition in the provision of local telephone service and allow access to LEC facilities by competitors. Information and Long-Distance Services In July 1991, the U.S. District Court for the District of Columbia removed the information services prohibition of the 1982 Consent Decree related to the divestiture of AT&T (the "Consent Decree"). In May 1993, the U.S. Court of Appeals for the District of Columbia affirmed the removal of this ban. In November 1993, the U.S. Supreme Court declined to review the Appeals Court decision. The removal of this ban allows the Company to offer a variety of new information services, subject to regulatory approvals, such as enhanced voice mail and electronic yellow pages. In November 1993, the Company filed an application with the CPUC stating its intent to enter the electronic publishing business, either by itself or through an affiliate. In July 1993, five of the RHCs, including the Corporation, filed a petition with the FCC asking for new rules governing the provision of long-distance services. The RHCs are currently prohibited from providing long-distance services by the terms of the Consent Decree. Even with a favorable ruling from the FCC, the RHCs must still obtain relief from the Consent Decree from Congress, or the courts, before providing long-distance services. During 1993, the Company joined other members of the United States Telephone Association ("USTA") in a petition to the FCC to establish a rulemaking for the purpose of reforming regulation of interstate access services. USTA urges the FCC to address several major matters needing reform including existing subsidy funding and recovery mechanisms, the need for greater pricing flexibility as competition increases and the need to revise current price cap rules. In November 1993, legislation was introduced in Congress that would simplify the procedures under which BOCs may seek relief from provisions of the Consent Decree. However, the bill would also impose stringent separate subsidiary requirements on RHC electronic publishing ventures. In November 1993, the Company filed an application with the CPUC stating its intent to enter the electronic publishing business, either by itself or through an affiliate. o California Economy ------------------ In contrast to the national economy, California's economy did not rebound in 1993. At best, the California recession started to ease near year-end as the unemployment rate dipped. However, with the state's jobless rate two to three percentage points above the nation's rate for most of the year, job seekers left or were deterred from coming to California. This caused the state's population growth rate to slow. The recession continued to dampen demand for the Company's services. Access line growth was about 2.2 percent in 1993, somewhat improved from the 2.0 percent increase in 1992. However, in the late 1980s access line growth was more than 4.0 percent annually. Minutes of use rose 6.1 percent in 1993, down from a 6.7 percent growth rate in 1992. In 1994, the California economy is expected to slowly reorient toward growth, but at a far less rapid pace than in other modern recessions. The opportunities for economic growth in 1995 and 1996 will continue to be constrained by the ongoing cutbacks in defense spending, base closings, and slow state and local government spending. These weaknesses may limit the scope of any recovery for 1994. However, California's telecommunications markets remain among the nation's most attractive. STRATEGIC RESPONSE As discussed below, the Company is focusing on several key strategies in response to the challenges it faces. As the industry environment changes and competition intensifies, the Company is taking the steps necessary to remain the customer's choice. These strategies include reducing costs by reengineering core processes, lowering prices for existing competitive services, and offering new products and services customers want. o Reduce Costs ------------ To remain the customer's choice, the Company must increase productivity and reduce costs. In 1993, the Company reduced its workforce by about 1,500 employees. As a result, employees per ten thousand access lines decreased 4.6 percent, while revenues per employee increased 4.4 percent. Looking ahead, the Company has begun a major effort to reengineer its internal business processes. This effort confronts an increasingly competitive and complex telecommunications environment by streamlining and consolidating operations, including business offices, network, installation, and collection centers, as well as other facilities. This will result in a more efficient company through the closure and abandonment of redundant operations. As a result, the Company has announced a force reduction program that will result in a net reduction of 10,000 positions from 1994 through 1997. (See page 36 for discussion of related 1993 restructuring charge.) Reengineering is a bold step by the Company to provide reliable, powerful and yet competitively-priced telecommunications services to its customers in California. Based on current estimates, the future expense savings as a result of reengineering and the associated force reduction program should be about $170 million in 1994, with savings growing to nearly $1 billion annually in four years. In addition, effective in December 1993, the Company deferred management salary increases for an indefinite period pending review of 1994 business needs. o Lower Prices for Competitive Services ------------------------------------- The CPUC's formal authorization of competition into the Company's intra- service area toll market is expected in 1994. To be competitive, the Company has proposed price reductions in toll services of up to 60 percent. The proposed revenue decrease would be essentially offset by increased basic rates, moving both toll and basic rates closer to the actual cost of providing those services. (See also "Toll Services Competition" discussion on page 25.) o Offer New Products and Services Customers Want ---------------------------------------------- In order to offer the new products and services customers want, the Company has been making substantial investments to improve the telephone network. During 1993, the Company invested $1.8 billion in the network. In addition, the Company has been conducting personal communications services ("PCS") experiments since June 1991 with help from an affiliate, Telesis Technologies Laboratory, Inc. Advanced Network Services To meet customer demand for faster and more reliable services as well as demand for new products and services, the Company has made substantial investments in advanced digital technologies. The focus of these investments has been in the key technologies summarized below: December 31, ---------------- Technology Deployment 1993 1992 - ------------------------------------------------------------------------- Access lines served by digital switches................. 51% 43% Access lines with SS-7 capability....................... 79% 66% Access lines with ISDN capability....................... 60% 44% Miles of installed optical fiber (thousands)............ 364 304 - ------------------------------------------------------------------------- Digital switches and optical fiber, a technology using thin filaments of glass or other transparent materials to transmit coded light pulses, increase the capacity and reliability of transmitted data while reducing maintenance costs. ISDN (Integrated Services Digital Network) allows simultaneous voice, video and data over a single telephone line. Signaling System 7 ("SS-7") permits faster call setup and new custom calling features. In November 1993, the Company announced a capital investment plan totaling $16 billion over the next seven years to upgrade its core network infrastructure and to begin building California's "communications superhighway." This will be an integrated telecommunications, information and entertainment network providing advanced voice, data and video services. Using a combination of fiber optics and coaxial cable, the Company expects to provide broadband services to more than 1.5 million homes by the end of 1996 and more than 5.0 million homes by the end of the decade. As part of its current plan, the Company has made purchase commitments totaling nearly $600 million in accordance with its previously announced $1 billion program for deploying an all digital switching platform with ISDN and SS-7 capabilities. The advanced network will make possible capital and operational cost savings, service quality improvements and new revenues from the array of new service possibilities. Construction of the portions of the network that are not video-specific will begin early in the second quarter of 1994. The network should be capable of offering fully interactive digital telephone services by the end of 1996. In January 1994, an affiliate, Pacific Telesis Video Services, announced an advanced interactive television services trial that will let participants help decide what will be on California's communications superhighway. The trial will test consumer acceptance of sophisticated services such as multi-player games, interactive home shopping and educational programs, movies-on-demand and time shifted television programs. Capital expenditures in 1994 are forecast to be $1.8 billion including $1,111 million for projects designed to generate revenues and $580 million for projects designed to reduce costs. Capital expenditures under the Company's seven-year investment plan are not expected to increase until 1996 due to the timing of capital expenditures associated with the construction of the broadband network. Personal Communications Services In October 1993, the FCC issued an order allocating radio spectrum and setting forth licensing requirements to provide PCS. PCS relies on a network of small, low-powered transceivers that may be placed throughout a neighborhood, business complex or community to provide customers with mobile voice and data communications. The FCC established two different sizes of service areas nationwide for PCS: 47 large areas referred to as Major Trading Areas ("MTAs") and 487 smaller areas. The MTA licenses are for 30 megahertz of spectrum. In any given area, there will be as many as seven licenses, including two MTA licenses. Most of the licenses will be awarded by competitive bidding in auctions expected in late 1994 or early 1995. The Corporation plans to aggressively pursue PCS licenses at these auctions and is well placed to be part of the expected multi-billion dollar market for PCS. A wholly owned subsidiary of the Corporation, Telesis Technologies Laboratory, Inc. ("TTL"), has been conducting PCS experiments and investigating various technological issues under an experimental license granted by the FCC. With a spin-off of AirTouch, the Corporation will be eligible to bid on PCS licenses in the service areas of the Company. Some of the assets that have been engaged in PCS research and development work were transferred to AirTouch in late 1993 in accordance with the terms of the Separation Agreement between the Corporation and AirTouch. The Company will form a new subsidiary to receive the remaining assets of TTL that have been engaged in PCS research and development work. It will provide PCS services if the Corporation wins a license at auction. On December 23, 1993, the FCC awarded a "pioneer preference" to another company for one of the two larger MTA licenses covering the Los Angeles, San Diego, and Las Vegas market area. That company will receive the license without charge. This is expected to place the successful bidder for the remaining MTA license in that area at a significant competitive disadvantage because of its higher cost structure. Winning bids in major PCS markets are expected to require large capital expenditures. The Corporation has filed a letter with the FCC asserting that improper contacts were made with the FCC by the parties who were awarded pioneer preferences. RESULTS OF OPERATIONS Change ---------------- Operating Statistics 1993 1992 Amount Percent - --------------------------------------------------------------------------- Return on average common equity .... (2.1%) 15.5% (17.6) - Operating ratio .................... 93.4% 73.7% 19.7 - Total employees .................... 54,026 55,542 (1,516) (2.7) Revenues per employee (thousands) .. $165 $158 $ 7 4.4 Employees per ten thousand access lines* .................... 35.3 37.0 (1.7) (4.6) - --------------------------------------------------------------------------- * Excludes Directory employees Change ---------------- ($ millions) 1993 1992 Amount Percent - -------------------------------------------------------------------------- Net income (loss) ................. $ (130) $1,131 (1,261) (111.5) - -------------------------------------------------------------------------- The 1993 reported loss of $130 million reflects a restructuring charge relating to planned force reductions, associated curtailment, and the adoption of new accounting rules for postemployment benefits. (See "Operating Expenses" and "Cumulative Effect of Accounting Change" on pages 36 and 39, respectively.) After tax, the charge for the restructuring reduced earnings by $576 million. The Company also recorded a $348 million after-tax curtailment charge to accelerate recognition of a portion of its embedded postretirement benefits costs that would otherwise have been recorded over the next 19 years. In addition, the Company restated first quarter 1993 results to recognize an after-tax charge totaling $148 million due to the adoption of new accounting rules for postemployment benefits. 1993 earnings were also reduced by several other one-time items totaling $53 million, and by about $33 million as the net impact of adopting new accounting rules for postretirement benefits. (See - "Change in Accounting for Postretirement and Postemployment Costs" on page 51.) 1992 earnings were increased by several one-time items totaling $25 million which contributed to the comparative decrease. Looking ahead, short-term results are expected to continue to be affected by increasing competition and a continuing recession in California. However, long-term growth prospects and recovery of the California economy should provide opportunity for stronger earnings. Operating Revenues - ------------------ Change ---------------- Volume Indicators 1993 1992 Amount Percent - -------------------------------------------------------------------------- Customer switched access lines in service at December 31 (thousands) .................... 14,617 14,306 311 2.2 Carrier access minutes-of-use (millions) ..................... 48,657 45,881 2,776 6.1 Interstate ..................... 28,318 26,538 1,780 6.7 Intrastate ..................... 20,339 19,343 996 5.1 Toll messages (millions)* ........ 4,230 4,132 98 2.4 - --------------------------------------------------------------------------- * Toll messages include Message Telecommunications Services, Optional Calling Plans, WATS and terminating 800 messages. Toll messages for 1992 have been restated to conform to the current presentation. Change ---------------- ($ millions) 1993 1992 Amount Percent - -------------------------------------------------------------------------- Total operating revenues ........ $8,894 $8,749 $145 1.7 - -------------------------------------------------------------------------- In 1993, total operating revenues increased reflecting a net growth in customer demand of $207 million and a CPUC order granting partial recovery of higher costs due to the new accounting rules for postretirement benefits ("PBOPs"). (See - "Other Postretirement Benefits Costs" on page 40.) Also contributing to the year-over-year increase was a refund in 1992 ordered by the CPUC related to the treatment of enhanced services development costs (the "Product Development Refund") which lowered comparative 1992 revenues by $38 million. These increases were partially offset by a $120 million rate reduction for productivity and other factors from the 1993 CPUC price cap order, the annual rate adjustment determination under incentive-based regulation. In December 1993, the CPUC approved the Company's annual price cap filing for 1994 in which the Company had proposed a $105 million rate reduction. This reduction includes a decrease of $85 million because the 4.5 percent productivity factor of the price cap formula exceeded the increase in the Gross National Product Price Index by 1.3 percent. The filing also included several additional factors which will decrease revenues by an additional $20 million. Factors affecting 1993 revenue growth are summarized below: CPUC Price Cap Product ---------------- Total Develop- Produc- Misc. Change ment tivity Rates Customer from ($ millions) Refund PBOPs & Other & Other Demand 1992 - --------------------------------------------------------------------------- Local service ..... $18 $52 $(58) $17 $66 $ 95 Network access Interstate ...... (56) 94 38 Intrastate ...... 5 14 (16) (17) 30 16 Toll service ...... 15 42 (46) (16) (42) (47) Other revenues .... (16) 44 28 Less: Provision for uncollectibles .. 15 15 -------- ------- ------- -------- -------- ------- Total operating revenues ....... $38 $108 $(120) $(88) $207 $145 - --------------------------------------------------------------------------- Local service revenues include basic monthly service fees and usage charges. Fees and charges for custom calling features, coin phones, installation, and service connections are also included in this category. The 1993 increase in local service revenues due to customer demand in the above table reflects a 2.2 percent increase from a year ago in customer access lines. It also includes $13 million for new custom calling features introduced in 1993. Network access revenues reflect charges to interexchange carriers and to business and residential customers for access to the local network. The increase in interstate network access revenues due to customer demand reported above reflects a 6.7 percent increase in carrier access minutes-of-use over 1992, as well as increased access lines. The increase in intrastate network access revenues due to customer demand reflects 5.1 percent growth in minutes- of-use. Toll services revenues include charges for long-distance services within service area boundaries. Competition and the California recession combined to reduce toll service revenues due to customer demand in 1993. Other revenues are generated from a variety of services including directory advertising, information services, and billing and collection. Other revenues for 1993 includes an increase in information services revenues of $25 million chiefly due to the success of the Company's business and residential voice mail products. The increase was partially offset by a $14 million decrease in directory advertising revenues over the year due to the continuing recession in California. Operating Expenses - ------------------ Change ---------------- ($ millions) 1993 1992 Amount Percent - -------------------------------------------------------------------------- Total operating expenses ......... $8,309 $6,447 $1,862 28.9 - -------------------------------------------------------------------------- The increase in total operating expenses for 1993 reflects pre-tax restructuring and curtailment charges recorded by the Company during the fourth quarter totaling $1.57 billion. The Company recorded a pre-tax restructuring charge of $977 million to recognize the incremental cost of force reductions associated with restructuring its internal business processes through 1997. This restructuring is necessary to reduce future costs to respond to increasing competition. (See "Competition" beginning on page 24) One component of this charge is for incremental costs of severance benefits associated with terminating approximately 14,400 employees from 1994 through 1997. A net reduction of 10,000 positions is expected by the end of 1997. A second component is for information systems reengineering expenses which will allow force reduction through the use of information technology to radically redesign and streamline existing business practices. The consolidation of facilities will also be necessary to support this downsizing initiative. The Company expects to relocate 10,600 employees due to the consolidation of business offices, network, installation and collection centers, as well as other facilities. The components of the restructuring charge and the projected costs (cash outflows) which will be charged to the related reserve are displayed below: Restructuring 1994 1995 1996 1997 Total - --------------------------------------------------------------------------- ($ millions) Severance ..................... $ 120 $241 $174 $115 $ 650 Information systems reengineering ............... 94 167 97 38 396 Consolidation of facilities ... 12 28 9 2 51 ------- ------- ------- ------- ------- Projected costs to be charged to the reserve....... 226 436 280 155 1,097 1991 restructuring reserve..... (77) - - - (77) Capitalized to construction ... (8) (16) (12) (7) (43) ------- ------- ------- ------- ------- 1993 restructuring charge ..... $141 $420 $268 $148 $ 977 ======= ======= ======= ======= ======= Associated force reductions ... 2,700 5,500 3,800 2,400 14,400 - -------------------------------------------------------------------------- Based on current estimates, future expenses will be reduced by about $170 million in 1994 as a result of the restructuring, with expense reductions expected to grow to nearly $1 billion annually in four years. Actual Cash outflows for severance and other expenditures required to effect the restructuring will be substantially offset by cash savings in 1994. These savings are also expected to grow to nearly $1 billion annually in four years. In 1991, the Company recorded a $201 million pre-tax restructuring charge which included $166 million for the cost of force reduction programs through 1994 and $35 million for associated pension expense. After reduction for incremental force reduction costs in 1993 and 1992, the remaining balance of this reserve as of December 31, 1993 and 1992 was approximately $77 million and $101 million, respectively. The 1993 restructuring charge is net of the $77 million remaining balance in the 1991 restructuring reserve. In addition, the Company recorded a $590 million pre-tax charge to accelerate recognition of a portion of the embedded postretirement benefits costs that would otherwise have been recorded over the next 19 years. Accelerated recognition of these costs is required under the curtailment provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits other than Pensions" ("SFAS 106") because the Company expects to significantly reduce its workforce. Without the effects of the restructuring and curtailment charges, total operating expenses would have increased by $295 million compared to 1992. Higher costs for postretirement benefits under the new accounting rules were responsible for the largest portion of this increase. Miscellaneous one-time items accounted for $75 million of the increase and salaries and wages increased $74 million. Expense increases were partially offset by a decrease of $51 million in Signaling System 7 ("SS-7") licensing fees because of the substantial progress made on the upgrade program in 1992. The completion of the amortization of CPUC equal access costs in 1992 also lowered 1993 expenses by $23 million. In January 1994, an earthquake damaged 31 Company buildings in the Los Angeles area. The Company estimates repair costs may approach $25 million. The Company is insured for property damage exceeding this amount. Salary and Wage Expense Change ---------------- ($ millions) 1993 1992 Amount Percent - -------------------------------------------------------------------------- Salary and wage expense .......... $2,169 $2,095 $74 3.5 Employees-Average during year .... 55,038 56,805 (1,767) (3.1) Employees-End of year ............ 54,026 55,542 (1,516) (2.7) - -------------------------------------------------------------------------- Salary and wage expense is the largest component of total operating expenses. Higher compensation rates increased salary and wages by $73 million primarily due to a nonsalaried wage increase. In September 1992, labor contracts were reached with unions which represent about 70 percent of the Company's employees. The agreements provide a 12 percent increase in wages, including job upgrades, and a 13 percent increase in pensions over the three-year term. In addition, the contracts include incentives for early retirement, enhanced employment security, improvements in work and family life benefits, and increases in health care and dental care coverage. Salaries and wages increased $38 million due to overtime pay for extended customer service hours. In December, the Company scaled back these extended hours due to a lack of customer demand. These increases were partially offset by a $55 million decrease due to fewer employees. Depreciation and Amortization Change ---------------- ($ millions) 1993 1992 Amount Percent - -------------------------------------------------------------------------- Depreciation and amortization ..... $1,703 $1,674 $29 1.7 Depreciation as a percent of average depreciable plant (%) ... 6.9 7.0 (0.1) - - -------------------------------------------------------------------------- Depreciation expense increased primarily due to an expanded plant base resulting from accelerated network modernization. The Company's planned capital expenditures are expected to further increase plant levels causing higher depreciation expense in future years. Other Employee-Related Expenses Change ---------------- ($ millions) 1993 1992 Amount Percent - -------------------------------------------------------------------------- Postretirement Benefits ........... $338 $103 $235 228.2 Healthcare and life insurance benefits of active employees** .. $221 $231 (10) (4.3) Other benefits** .................. $126 $142 (16) (11.3) Payroll taxes ..................... $175 $169 6 3.6 Pensions ......................... 0 5 (5) (100.0) -------------------------------------- Total* ............................ $860 $650 $210 32.3 - --------------------------------------------------------------------------- * Excludes SFAS 106 curtailment and postemployment benefits accounting change (See - "Cumulative effect of Accounting Change" on page 39) ** 1992 amounts have been revised to conform to the current presentation. Other employee-related expense increased primarily due to the adoption of SFAS 106 effective January 1, 1993. The adoption of SFAS 106 increased postretirement benefits expense by $173 million. Prior to 1993, all postretirement benefits were charged to general, administrative, and other expense. Beginning in 1993, these costs were also allocated to all line items on the income statement that include salaries and wages expense. This caused employee benefits in cost of products and services to increase by $121 million, customer operations and selling expenses to increase by $148 million and general and administrative expense to decrease by $90 million. Income Taxes - ------------ Change ---------------- ($ millions) 1993 1992 Amount Percent - -------------------------------------------------------------------------- Income taxes ...................... $(57) $607 $(664) (109.4) Effective tax rate (%) ............ 132.4 36.1 96.3 - - -------------------------------------------------------------------------- Income tax expense decreased $683 million due to lower pre-tax income caused by restructuring and the 1993 adoption of SFAS 106. Income tax expense also decreased due to the 1992 adoption of a new income tax accounting standard which increased comparative expense $10 million in 1992. Partially offsetting these decreases was an increase of $21 million due to the realization of less tax benefit in 1993 from the reversal of deferred tax liabilities. During August 1993, new tax provisions were enacted under the Omnibus Budget Reconciliation Act of 1993 which included an increase in the corporate tax rate from 34 to 35 percent retroactive to January 1, 1993. The cumulative effect of the new tax provisions was recognized in third quarter 1993 increasing tax expense by $15 million. However, this increase was offset by the tax benefit recognized in the 4th quarter due to restructuring and curtailment. Overall, the new tax provisions did not affect the Company's tax expense for the year. The effective tax rate increased due to lower pretax income caused by the restructuring charge and the postretirement benefits curtailment. (See also Footnote C - "Income Taxes.") Interest Expense - ---------------- Change ---------------- ($ millions) 1993 1992 Amount Percent - -------------------------------------------------------------------------- Interest expense ................. $429 $460 $(31) (6.7) - -------------------------------------------------------------------------- Interest expense decreased $37 million due to lower interest rates on long- term debt. During 1993, the Company issued $2.65 billion of long-term debt to refinance higher interest rate issues. This refinancing is expected to save $36 million annually. Other Income (Expense) - ---------------------- Change ---------------- ($ millions) 1993 1992 Amount Percent - -------------------------------------------------------------------------- Other income (expense) ............. $(14) $83 $(97) (116.9) - -------------------------------------------------------------------------- Other income (expense) is a net expense in 1993 due to decreases in miscellaneous income and increases in miscellaneous expenses. Income from this category decreased primarily due to a $44 million after tax gain recorded in 1992 for interest on a favorable tax settlement. The interstate portion of costs related to the early retirement of long-term debt increased $13 million after tax. Cumulative Effect of Accounting Change - -------------------------------------- Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112 ("SFAS 112"), "Employer's Accounting for Postemployment Benefits." SFAS 112 requires a change from cash to accrual accounting by recording a cumulative catch-up-charge at implementation. A one-time, noncash charge was recorded against earnings of $148 million, which is net of a deferred income tax benefit of $103 million. In subsequent years, the Company expects that periodic expense will not differ materially from expense under the prior method. PENDING REGULATORY ISSUES Spin-off of AirTouch In February 1993, the CPUC instituted an investigation of the spin-off of the Corporation's wireless operations for the purpose of assessing any effects it might have on the telephone customers of the Company. On November 2, 1993, the CPUC adopted a decision permitting the spin-off to proceed. The CPUC further ordered a refund by the Corporation of approximately $50 million (including interest) of cellular pre-operational and development expenses. Further proceedings will determine how the refund will be disbursed. The CPUC decision was effective immediately. Two parties to the CPUC investigation have filed Applications for Rehearing by the CPUC of its treatment of the claims for compensation owed to the Company's customers. One of these parties has further stated that if it is unsuccessful with the CPUC it will seek review by the California Supreme Court. Another party has filed a Petition for Modification of the CPUC's decision. In March 1994, the CPUC denied these requests. In the event the California Supreme Court were to review and reverse the CPUC's decision, no assurance can be given that the CPUC might not reach a new decision materially less favorable to the Corporation with respect to the compensation issues. In addition, a substantial period of time could elapse before final resolution of these issues should a review be granted. The Corporation believes that the California Supreme Court will deny a review. Other Postretirement Benefits Costs In December 1992, the CPUC issued a decision adopting, with modification, SFAS 106 for regulatory accounting purposes. The CPUC decision also granted the Company $108 million for partial recovery of 1993 SFAS 106 costs. The Company is required to file annually for recovery in conjunction with its price cap filing, and therefore such recovery will vary. The 1994 CPUC price cap decision grants Pacific Bell $100 million for partial recovery of SFAS 106 costs. Two ratepayer advocacy groups have each challenged certain aspects of the decision adopting SFAS 106, which could affect rate recovery. The Company is unable to predict the outcome of these pending challenges. Universal Lifeline Telephone Service ("ULTS") Trust Audit In October 1992, the CPUC's Commission Advisory and Compliance Division released an audit report recommending that the Company return $36 million to the ULTS trust. This trust reimburses local telephone companies for revenues lost and expenses incurred as a result of providing subsidized telephone service to low income Californians. In November 1993, the Company and the CPUC's Division of Ratepayer Advocates jointly filed a settlement agreement with the CPUC. Subject to CPUC approval, the Company will return approximately $8 million to the ULTS trust via installments over one year and additionally reduce future billings to the trust by about $1 million annually. The Company recorded this liability in 1993. Information Services Subsidiary Effective January 1, 1993, the Company transferred its Information Services Group to a wholly owned subsidiary, Pacific Bell Information Services ("PBIS"). PBIS provides business and residential voice mail and other selected information services. In July 1992, the CPUC issued a decision which would require the Company to reduce rates by the difference between the "going concern" value of PBIS and its adjusted net book value. In October 1992, the CPUC denied the Company's Application for Rehearing of this decision but invited the Company to file a Petition for Modification. The Company filed a petition in January 1993 based on its belief that the decision results in a double reduction in rates to customers. The Company believes that, at a minimum, any reduction in rates should be further offset by $111 million: $57 million previously granted customers in the Product Development Refund and $54 million provided by shareowners for PBIS. Further, any remainder should be prorated according to proportionate risks borne by shareowners and the Company's customers. The Company is unable to predict the outcome of this issue. Late Payment Charge Complaint In March 1991, a consumer advocacy group filed a complaint with the CPUC against the Company alleging that erroneous late payment charges were assessed against some customers. In May 1993, the CPUC ordered the Company to refund about $35 million in late payment and reconnection charges which resulted from problems with its payment processing system. The CPUC also imposed penalties totaling $15 million on the Company for improperly assessing late payment charges and disconnecting customers between 1986 and February 1991. The Company believes the decision misinterprets California law. In November 1993, the CPUC granted the Company a limited rehearing of the decision. The rehearing will examine the legal basis for the penalties, the statute of limitations on refunds, and whether unclaimed refunds must escheat to the state. A resolution of this issue is expected in 1994; however, the Company is unable to predict the final outcome. Two shareowner derivative lawsuits were filed in San Francisco Superior Court in July 1993 against directors and officers in connection with the same allegations made in the late payment charge complaint filed with the CPUC. These suits were dismissed in February 1994; however, the cases are subject to rehearing and possible appeal. In addition, a consumer class action seeking refunds, with interest, of late payment charges erroneously collected from the Company's customers was filed in San Diego Superior Court in February 1992. The Company has argued that the court lacks jurisdiction while the CPUC is reviewing the same issues. The court rejected this argument. However, a stay of this action has been ordered pending the outcome of the CPUC proceedings. The Company is unable to predict the outcome of this case or whether any damages awarded by the court would be duplicative of any penalties imposed by the CPUC. CPUC Regulatory Framework In 1992, the CPUC began its scheduled review of the current incentive-based regulatory framework. Among other issues, this review has examined elements of the price cap formula, including the productivity factor and the rate of return on investment, adopted in the 1989 New Regulatory Framework ("NRF") order. The Company proposed no significant changes to the current framework because it has resulted in lower prices for customers and our experience to date suggests the framework is working as intended. In March 1994, a CPUC Administrative Law Judge issued a proposed decision in the NRF review. The proposed decision would eliminate an element of the NRF which requires equal sharing with customers of earnings exceeding a benchmark rate of return. Earnings above a rate of return of 16.5 percent would continue to be returned to customers. The proposed decision also recommends increasing the productivity factor of the price cap formula from 4.5 percent to 6.0 percent for the period 1994 through 1996. If adopted by the CPUC, the change in the productivity factor would reduce annualized revenues approximately $100 million each year through 1996. The Company plans to file comments objecting to the proposed increase in the productivity factor. The Company is unable to predict the final outcome of these proceedings or the effective date of any rate reductions. FCC Regulatory Framework In 1994, the FCC will review its "Price Cap" alternative regulatory framework. The FCC is looking for comments on three main sets of issues: (1) refining the goals of price caps to better meet the public interest and the purposes of the Communications Act; reduced or streamlined regulation of LEC services as competition grows; (2) whether to revise the current plan (which became effective Jan. 1, 1991) to help it better meet the FCC's goals, or to adjust the plan to changes in circumstances; and (3) possible transition from the baseline price cap plan toward relaxation of regulatory oversight and rate regulation as competition develops in the local loop. ACCOUNTING UNDER REGULATION The Company currently accounts for the economic effects of regulation under Statement of Financial Accounting Standards No. 71 ("SFAS 71"), "Accounting for the Effects of Certain Types of Regulation." If it becomes no longer reasonable to assume the Company will recover its costs through rates charged to customers, whether resulting from the effects of increased competition or specific regulatory actions, SFAS 71 would no longer apply. If the Company were no longer to qualify for the provisions of SFAS 71, the financial effects would be material. Item 8. Item 8. Financial Statements and Supplementary Data. REPORT OF MANAGEMENT The management of Pacific Bell is responsible for preparing the accompanying financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles applied on a consistent basis and are not misstated due to material fraud or error. In instances where exact measurement is not possible, the financial statements include amounts based on management's best estimates and judgments. Management also prepared the other information contained in this annual financial review and is responsible for its accuracy and consistency with the financial statements. The Company's financial statements have been audited by Coopers & Lybrand, independent accountants. Management has made available to Coopers & Lybrand all the Company's financial records and related data, as well as the minutes of directors' meetings. Furthermore, management believes that all of its representations made to Coopers & Lybrand during their audit were valid and appropriate. Management 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 are updated as necessary. Management continually monitors the system of internal control for compliance and maintains a strong internal auditing program that independently assesses the effectiveness of the internal controls and recommends improvements when necessary. In addition, as part of their audit of the Company's financial statements, Coopers & Lybrand have obtained a sufficient understanding of the internal control structure to determine the nature, timing and extent of audit tests to be performed. Management has considered the internal auditors' and Coopers & Lybrand's recommendations concerning the Company's system of internal control and has taken actions that it believes are cost-effective under the circumstances to respond appropriately to these recommendations. Management believes that the Company's system of internal control is adequate to accomplish the objectives discussed. Management also recognizes its responsibility to foster a strong ethical climate that enables the Company to conduct its affairs according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in the Company's code of corporate conduct, which is publicized throughout the Company. The code of conduct addresses, among other things: potential conflicts of interests; compliance with all domestic laws, including those relating to foreign transactions and financial disclosure; and the confidentiality of proprietary information. The Company maintains a systematic program to assess compliance with these policies. Financial Statements and Supplementary Data (continued) The Audit Committee of the Board of Directors is responsible for overseeing the Company's financial reporting process on behalf of the Board. In fulfilling its responsibility, the Committee recommends to the Board, subject to shareowner ratification, the selection of the Company's independent accountants. The Committee consists of six members of the Board who are neither officers nor employees of the Company. It meets regularly with representatives of management, internal audit and the independent accountants to review internal accounting controls and accounting, auditing and financial reporting matters. In 1993, the Committee held five meetings. The Company's internal auditors and independent accountants periodically meet alone with the Committee to discuss the matters previously noted and have direct access to it for private communication at any time. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowner of Pacific Bell: We have audited the consolidated financial statements and financial statement schedules of Pacific Bell (a wholly owned subsidiary of Pacific Telesis Group) and Subsidiaries (the "Company") 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. As discussed in Note A to the Consolidated Financial Statements, the Company adopted new accounting rules for postretirement and postemployment benefits during 1993. 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 consolidated financial position of Pacific Bell 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. /s/ Coopers & Lybrand San Francisco, California March 3, 1994 PACIFIC BELL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME For the year ended December 31, ---------------------------- (Dollars in millions) 1993 1992 1991 - --------------------------------------------------------------------------- OPERATING REVENUES: Local service ............................ $3,411 $3,316 $3,279 Network access Interstate ............................. 1,572 1,534 1,467 Intrastate ............................. 679 663 773 Toll service ............................. 2,035 2,082 2,159 Other revenues............................ 1,358 1,330 1,312 Less: provision for uncollectibles ....... 161 176 136 ------- ------- ------- Total Operating Revenues ................... 8,894 8,749 8,854 ------- ------- ------- OPERATING EXPENSES: Cost of products and services ............ 1,945 1,870 1,916 Depreciation and amortization ............ 1,703 1,674 1,706 Customer operations and selling expense .. 1,796 1,512 1,466 General, administrative and other expense. 1,298 1,391 1,395 Restructuring and curtailment ............ 1,567 - 201 ------- ------- ------- Total Operating Expenses ................... 8,309 6,447 6,684 ------- ------- ------- Net Operating Revenues ..................... 585 2,302 2,170 ------- ------- ------- Operating Taxes: Income taxes ............................. (57) 607 573 Other taxes .............................. 181 187 205 ------- ------- ------- Total Operating Taxes ...................... 124 794 778 ------- ------- ------- OPERATING INCOME ........................... 461 1,508 1,392 ------- ------- ------- Other Income (Expense) (14) 83 35 ------- ------- ------- Income before interest expense and cumulative effect of change in accounting principle ................................ 447 1,591 1,427 Interest expense ........................... 429 460 485 ------- ------- ------- Income before cumulative effect of change in accounting principle .................. 18 1,131 942 Cumulative effect of change in accounting principle ................................ (148) - - ------- ------- ------- NET INCOME (LOSS) .......................... $ (130) $1,131 $ 942 =========================================================================== The accompanying Notes are an integral part of the Consolidated Financial Statements. PACIFIC BELL AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, (Dollars in millions) 1993 1992 - --------------------------------------------------------------------------- ASSETS Cash and cash equivalents ........................ $ 57 $ 57 Accounts receivable-net of allowances for uncollectibles of $136 and $127 ................ 1,518 1,447 Prepaid expenses and other current assets ........ 862 836 -------- -------- Total current assets ............................. 2,437 2,340 -------- -------- Property, plant, and equipment ................... 25,660 25,064 Less: accumulated depreciation ................ 9,708 9,276 -------- -------- Property, plant, and equipment - net ............. 15,952 15,788 -------- -------- Deferred charges and other noncurrent assets ..... 989 1,054 -------- -------- TOTAL ASSETS ..................................... $19,378 $19,182 =========================================================================== LIABILITIES AND SHAREOWNER'S EQUITY Accounts payable: Trade .......................................... 245 $ 224 Other .......................................... 1,010 874 -------- -------- Total accounts payable ........................... 1,255 1,098 Debt maturing within one year .................... 542 410 Other current liabilities ........................ 1,136 1,017 -------- -------- Total current liabilities ........................ 2,933 2,525 -------- -------- Long-term obligations ............................ 4,753 4,805 -------- -------- Deferred Credits: Accumulated deferred income taxes .............. 2,280 2,761 Other noncurrent liabilities and deferred credits ..................................... 3,258 1,800 -------- -------- Total deferred credits ........................... 5,538 4,561 -------- -------- Common shares ($1.00 stated value, 300,000,000 shares authorized, 224,504,982 shares issued and outstanding) ............................... 225 225 Additional paid-in capital ....................... 5,168 5,168 Reinvested earnings .............................. 761 1,898 -------- -------- Total shareowner's equity ........................ 6,154 7,291 -------- -------- TOTAL LIABILITIES AND SHAREOWNER'S EQUITY ........ $19,378 $19,182 =========================================================================== The accompanying Notes are an integral part of the Consolidated Financial Statements. PACIFIC BELL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREOWNER'S EQUITY For the year ended December 31, ----------------------------- (Dollars in millions) 1993 1992 1991 - --------------------------------------------------------------------------- COMMON STOCK Balance at beginning of year ............. $ 225 $ 225 $ 225 ------- ------- ------- Balance at end of year ................... 225 225 225 ------- ------- ------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of year ............. 5,168 5,168 4,946 Equity investment by parent .............. - - 222 ------- ------- ------- Balance at end of year ................... 5,168 5,168 5,168 ------- ------- ------- REINVESTED EARNINGS Balance at beginning of year ............. 1,898 1,824 1,916 Net Income (Loss) ........................ (130) 1,131 942 Common dividends declared ................ (1,007) (1,057) (1,034) ------- ------- ------- Balance at end of year ................... 761 1,898 1,824 ------- ------- ------- TOTAL SHAREOWNER'S EQUITY................... $6,154 $7,291 $7,217 =========================================================================== The accompanying Notes are an integral part of the Consolidated Financial Statements. PACIFIC BELL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the year ended December 31, ---------------------------- (Dollars in millions) 1993 1992 1991 - --------------------------------------------------------------------------- CASH FROM (USED FOR) OPERATING ACTIVITIES Net Income (loss) ......................... $ (130) $1,131 $ 942 Adjustments to reconcile net income for items currently not affecting operating cash flows: Depreciation and amortization .......... 1,703 1,674 1,706 Restructuring and curtailment........... 1,567 - 201 Deferred income taxes .................. (525) (686) (75) Unamortized investment tax credits ..... (48) (61) (68) Allowance for funds used during construction ......................... (34) (31) (30) Changes in operating assets and liabilities: Accounts receivable ................ (78) 74 (22) Prepaid expenses and other current assets ........................... 23 108 (61) Deferred charges and other noncurrent assets ................ 76 (6) 12 Accounts payable ................... 128 18 (199) Other current liabilities .......... (71) 66 (86) Other noncurrent liabilities and deferred credits ................. 129 452 121 Other adjustments, net ................. 31 12 17 -------- -------- -------- Cash from operating activities ............... 2,771 2,751 2,458 -------- -------- -------- CASH FROM (USED FOR) INVESTING ACTIVITIES Additions to property, plant, and equipment ................................ (1,802) (1,669) (1,601) Other investing activities, net ............ (11) (3) 4 -------- --------- -------- Cash used for investing activities............ (1,813) (1,672) (1,597) =========================================================================== The accompanying Notes are an integral part of the Consolidated Financial Statements. PACIFIC BELL AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) For the year ended December 31, ---------------------------- (Dollars in millions) 1993 1992 1991 - --------------------------------------------------------------------------- CASH FROM (USED FOR) FINANCING ACTIVITIES Proceeds from issuance of long-term debt ... $ 2,578 $ 925 $ 425 Retirements of long-term debt .............. (2,669) (972) (517) Equity infusion from parent ................ - - 222 Dividends paid ............................. (1,007) (1,057) (1,034) Increase in short-term borrowings, net ..... 133 116 80 Principal payments under capital lease obligations .............................. (5) (5) - Other financing activities, net ............ 12 (74) (55) -------- -------- -------- Cash used for financing activities ......... (958) (1,067) (879) -------- -------- -------- Increase (decrease) in cash and cash equivalents .............................. 0 12 (18) Cash and cash equivalents at January 1 ..... 57 45 63 -------- -------- -------- Cash and cash equivalents at December 31 ... $ 57 $ 57 $ 45 =========================================================================== The accompanying Notes are an integral part of the Consolidated Financial Statements. PACIFIC BELL AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation Pacific Bell, (the "Company"), a wholly owned subsidiary of Pacific Telesis Group, provides telecommunications services including local exchange, network access and toll services; directory advertising through its wholly owned subsidiary, Pacific Bell Directory ("Directory"); and selected information services through its wholly owned subsidiary, Pacific Bell Information Services ("PBIS"). The Consolidated Financial Statements include the accounts of Pacific Bell, Directory, and PBIS. All significant intercompany balances and transactions have been eliminated. The Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles. In accordance with the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation," the Company is required to reflect rate actions of regulators in the financial statements when appropriate. Change in Accounting for Postretirement and Postemployment Costs. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"). This new rule requires a change from the cash to accrual method of accounting for these costs. Previously, the Company expensed these retiree benefits as they were paid. The Company is amortizing the transition obligation over 20 years. The transition obligation represents the unrecognized cost of benefits that had already been earned by retirees and active employees when the new standard was adopted. This treatment is consistent with a CPUC decision which granted Pacific Bell $108 million for partial recovery of 1993 SFAS 106 costs. The CPUC requires that any recoveries granted be used solely to pay for future postretirement benefits. Therefore, the Company contributes these recoveries to Voluntary Employee Benefit Association trusts. The Company is required to file annually for recovery in conjunction with the price cap filing, and therefore such recovery will vary. The 1994 CPUC price cap decision grants Pacific Bell $100 million for partial recovery of SFAS 106 costs. Two ratepayer advocacy groups have each challenged certain aspects of the decision adopting SFAS 106 for ratemaking, which could affect recovery. The Company is unable to predict the outcome of these pending challenges. The ongoing periodic expense recognized by the Company under SFAS 106 during 1993 amounted to $338 million before taxes. The $338 million represents an increase of about $183 million over the previous method. A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112 ("SFAS 112"), "Employer's Accounting for Postemployment Benefits." SFAS 112 establishes accounting standards for benefits that are provided to former or inactive employees after employment but before retirement (e.g., workers' compensation, long-term disability benefits and disability pensions.) The new Statement requires immediate recognition of the cumulative effect of applying the new rule to prior years. The Company restated first quarter 1993 results to recognize a postemployment benefit liability of $251 million. The net income impact of adopting this accounting standard was $148 million, net of a deferred income tax benefit of $103 million. In subsequent years, the Company expects that periodic expense will not differ materially from expense under the prior method. Cash and Cash Equivalents The Company considers all highly liquid monetary instruments with maturities of 90 days or less from the date of purchase to be cash equivalents. Income Taxes Pacific Telesis Group allocates consolidated taxes as if the Company were a separate taxpayer. The Company records its share of the consolidated taxes as tax liabilities and pays amounts due to tax authorities through Pacific Telesis Group. Deferred income taxes are provided to 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 tax purposes. Investment tax credits earned prior to their repeal by the Tax Reform Act of 1986 are amortized as reductions in tax expense over the lives of the assets which gave rise to the credits. Property, Plant, and Equipment Property, plant, and equipment, (which consists primarily of telephone plant dedicated to providing telecommunications services) is carried at cost. The cost of self-constructed plant includes employee wages and benefits, materials and other costs. Regulators allow the Company to accrue an allowance for funds used during construction as a cost of constructing certain plant and as an item of income. This income is not realized in cash currently, but will be realized over the service lives of the related plant. Depreciation of telephone plant is computed primarily using the remaining- life method, essentially a form of straight-line depreciation, using depreciation rates prescribed by state and federal regulatory agencies. When retired, the original cost of depreciable telephone plant is charged to accumulated depreciation. A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Expenditures in excess of $500 that increase the capacity, operating efficiency or useful life of an individual asset are capitalized. Expenditures for maintenance and repairs are charged to expense. Premium on Debt Retirement When debt is refinanced before maturity, the Company recognizes as expense any difference between net book value and redemption price evenly over the term of the replacing issue for intrastate operations, in accordance with the ratemaking treatment of such costs. These costs are expensed as incurred for interstate operations. B. RESTRUCTURING AND CURTAILMENT During 1993, the Company recorded a pre-tax restructuring charge of $977 million to recognize the incremental cost of force reductions associated with reengineering its internal business processes through 1997. This charge will cover the incremental severance costs associated with terminating approximately 14,400 employees from 1994 through 1997. It will also cover the incremental costs of consolidating and streamlining operations and facilities to support this downsizing initiative. In addition, the Company recorded a $590 million pre-tax expense to accelerate recognition of a portion of its embedded post-retirement benefits costs that would otherwise have been recorded over the next 19 years. Accelerated recognition of these costs is required under the curtailment provisions of SFAS 106 because the Company expects to significantly reduce its workforce. Because Pacific Telesis Group already recognized all of its post-retirement benefit transition costs in the first quarter 1993, this additional charge did not affect its consolidated financial statements. In 1991 the Company recorded a $201 million pre-tax restructuring charge which included $166 million for the cost of management force reduction programs through 1994 and $35 million for associated pension expense. C. INCOME TAXES Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes." This standard requires companies to record all deferred tax liabilities or assets for the deferred tax consequences of all temporary differences, and requires ongoing adjustments for enacted changes in tax rates and regulations. Specific provisions of SFAS 109 require regulated companies to record an asset or a liability when recognizing deferred income taxes, if it is probable that these deferred taxes will be reflected in future rates. The components of income tax expense for continuing operations for each year are as follows: (Dollars in millions) 1993 1992 1991 ---------------------------------------------------------------------- Current: Federal.................................. $519 $649 $552 State and local income taxes............. 156 170 163 -------------------------- Total current.............................. 675 819 715 Deferred: Federal.................................. (548) (107) (83) State and local income taxes............. (148) (12) (6) -------------------------- Total deferred............................. (696) (119) (89) -------------------------- Amortization of investment tax credits - net........................ (51) (61) (53) -------------------------- Total income taxes......................... (72) 639 573 Less: Non-operating income tax expense..... (15) 32 - -------------------------- Operating income taxes..................... (57) $607 $573 ========================== Significant components of the Company's deferred tax assets and liabilities as of December 31, 1993 are as follows: December 31 ----------------------- (Dollars in millions) 1993 1992 ---------------------------------------------------------------------- Deferred tax (assets)/liabilities - due to: Depreciation and amortization ............ $2,971 $2,837 Restructuring ............................ (401) - Employee Benefits ........................ (321) - Customer rate reductions ................. (126) (218) Other, net ............................... (189) (160) --------- ---------- Net deferred tax liabilities ................ $1,934 $2,459 ========= ========== Amounts recorded in consolidated balance sheet: Deferred tax assets* .................. $1,449 $ 597 ========= ========== Deferred tax liabilities* ............. $3,383 $3,056 ========= ========== ---------------------------------------------------------------------- * Reflects reclassification of certain current and noncurrent amounts to a net presentation. The components of deferred income taxes for 1991 are as follows: (Dollars in millions) 1991 ------------------------------------------------------------------------ Deferred tax - due to: Depreciation and amortization ....................... $ (58) Revenue refunds ..................................... 20 Advance funding of VEBA employee benefit trust ..................................... (14) Restructuring reserves .............................. (50) Other ............................................... 13 ------ Total deferred taxes .................................. $(89) ====== During August 1993, new tax provisions were enacted under the Omnibus Budget Reconciliation Act of 1993 which included an increase in the corporate tax rate from 34 to 35 percent retroactive to January 1, 1993. The cumulative effect of the new tax provisions was recognized in third quarter 1993 increasing tax expense by $15 million. However, this increase was offset by the tax benefit recognized in the fourth quarter due to restructuring and curtailment. Overall, the new tax provisions did not affect the Company's tax expense for the year. The reasons for differences each year between the effective income tax rate and the statutory federal income tax rate are provided in the following reconciliation: 1993 1992 1991 ----------------------------------------------------------------------- Federal statutory rate ..................... 35.0% 34.0% 34.0% Increase (decrease) in taxes resulting from: Plant basis differences - net of applicable depreciation ................ (63.6) 2.0 2.2 Amortization of investment tax credits ... 92.9 (3.5) (3.5) State income taxes - net of federal income tax benefit ..................... (9.2) 5.9 6.9 Excess deferred taxes due to rate change.. 70.1 (3.6) (3.1) Other differences ........................ 7.2 1.3 1.6 -------------------------- Effective income tax rate .................. 132.4% 36.1% 38.1% ----------------------------------------------------------------------- The effective tax rate increased due to lower pre-tax income caused by the restructuring charge and the postretirement benefits curtailment. In 1987, the company paid $113 million to the Internal Revenue Service ("IRS") under a Summary Assessment relating to contested issues for pre- divestiture tax years 1979 and 1980. In 1992, the IRS refunded the above $113 million plus accrued interest of approximately $68 million. The Company recorded an after-tax gain of approximately $44 million during first quarter 1992. D. EMPLOYEE RETIREMENT PLANS Defined Benefit Plans The Company provides pension, death and survivor benefits to substantially all of its employees through participation in certain Pacific Telesis Group defined benefit pension plans. For some of these plans, benefits are based on a flat dollar amount which varies according to employee job classification and years of service. For other plans, benefits are based on a percentage of final five-year average pay and vary according to years of service. The Company is responsible for contributing enough to the pension plans, while the employee is still working, to ensure that adequate funds are available to provide the benefit payments upon the employee's retirement. These contributions are made to an irrevocable trust fund in amounts determined using the aggregate cost actuarial method, one of the actuarial methods specified by the Employee Retirement Income Security Act of 1974 ("ERISA"), subject to ERISA and IRS limitations. The Company records pension costs and related obligations under the provisions of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" and Statement of Financial Accounting Standards No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits". Specific provisions for regulated enterprises require the Company to recognize pension cost consistent with its ratemaking treatment. Pension costs recognized reflect a California Public Utilities Commission ("CPUC") order requiring the continued use of the aggregate cost method subject to ERISA and IRS limitations, for intrastate operations and a Federal Communications Commission ("FCC") requirement to use SFAS 87 and SFAS 88 for interstate operations. During 1992, the Company amended its nonsalaried pension plan to increase benefits for specified groups of employees who elected early retirement under incentive plans. Approximately 1,000 employees elected early retirement under these amendments. During 1991, approximately 4,400 eligible management employees elected early retirement or voluntary severance under management force reduction programs offered by the Company. (See "Note B - Restructuring and Curtailment" on page 53). D. EMPLOYEE RETIREMENT PLANS (Continued) Components of pension costs and the funded status of the plans are not presented because the structure of the Pacific Telesis plans does not permit this data to be disaggregated by subsidiary. Pension amounts recognized in the financial statements during each year presented are: Pension Cost 1993 1992 1991 --------------------------------------------------------------------- ($ millions) Current year pension cost ................ $ 10 $ 0 $(6) Settlements & curtailments ............... (10) 5 35 -------------------------- Pension cost recognized .................. $ 0 $ 5 $29 --------------------------------------------------------------------- Accrued pension cost liability recognized in the consolidated balance sheets ......................... $620 $573 -- --------------------------------------------------------------------- The amounts shown above for annual pension cost reflect the effects of strong fund asset performance and IRS funding limitations. The assets of the plans are primarily composed of common stocks, U.S. Government and corporate obligations, index funds, and real estate investments. The plans' projected benefit obligations for employee service to date reflect the Corporation's expectations of the effects of future salary progression and benefit increases. As of December 31, 1993 and 1992, the actuarial present values of the plans' accumulated benefit obligations, which do not anticipate future salary increases, were $8,537 and $7,570 million, respectively. Of these amounts, $7,668 and $6,777 million, respectively, were vested. The assumptions used in computing the present values of benefit obligations include a discount rate of 7.5 percent for 1993 and 8.5 percent for 1992 and 1991. An 8.0 percent long-term rate of return on assets is assumed in calculating pension costs. On March 28, 1994, there will be a special pension window benefit which removes any age discount from pensions for employees eligible to retire with a service pension on that date. This window benefit will only apply to those who are eligible for a service pension that is normally subject to a discount and who retire on March 28, 1994. As of March 21, 1994, about 300 employees had submitted an election form for this offering. Effective December 31, 1993, the Company permanently removed the age discount from the normal pension for salaried employees who have 30 or more years of net credited service. It is estimated that approximately 400 employees are affected by this amendment. D. EMPLOYEE RETIREMENT PLANS (Continued) The Company has entered into labor negotiations with union-represented employees in the past and expects to do so in the future. Pension benefits have been included in these negotiations and improvements in benefits have been made periodically. Additionally, the Company has increased benefits to pensioners on an ad hoc basis. While no assurance can be offered with respect to future increases, the Company's expectations for future benefit increases have been reflected in determining pension costs. Defined Contribution Plans The Company also participates in certain Pacific Telesis Group-sponsored defined contribution retirement plans covering substantially all employees. These plans include the Pacific Telesis Group Supplemental Retirement and Savings Plan for Salaried Employees and the Pacific Telesis Group Supplemental Retirement and Savings Plan for Nonsalaried Employees (collectively, the "Savings Plans"). The Company's contributions to the Savings Plans are based on matching a portion of eligible employee contributions. All matching employer contributions to the Savings Plans are made through a leveraged employee stock ownership ("ESOP") trust. Total Company contributions to these plans, including contributions allocated to participant accounts through the leveraged ESOP trust, were $64 million, $61 million and $66 million in 1993, 1992 and 1991, respectively. E. OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS Substantially all retirees and their dependents are covered under the Company's plans for medical, dental and life insurance benefits. Approximately 40,000 retirees were eligible to receive these benefits as of January 1, 1993. Employees become eligible upon retirement with eligibility for a service pension. The Company retains the right, subject to applicable legal requirements, to amend or terminate these benefits. Currently, the Company pays the full cost of retiree benefits; however, future cost sharing provisions are reflected in the current postretirement benefit cost and liability. Beginning in 1999, employees retiring in 1991 onward will pay a share of the costs of medical coverage that exceed a defined dollar medical cap. E. OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS (Continued) Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"). The standard requires that the cost of retiree benefits be recognized in the financial statements from an employee's date of hire until the employee becomes eligible for these benefits. Previously, the Company expensed these retiree benefits as they were paid. The Company is amortizing the transition obligation over 20 years. The transition obligation represents the unrecognized cost of benefits that had already been earned by retirees and active employees when the new standard was adopted. This treatment is consistent with a CPUC decision which granted Pacific Bell $108 million for partial recovery of 1993 SFAS 106 costs. The CPUC requires that any recoveries granted be used solely to pay for future postretirement benefits. Therefore, the Company contributes these recoveries to Voluntary Employee Benefit Association trusts. The Company is required to file annually for recovery in conjunction with the price cap filing, and therefore such recovery will vary. The 1994 CPUC price cap decision grants Pacific Bell $100 million for partial recovery of SFAS 106 costs. Two ratepayer advocacy groups have each challenged certain aspects of the decision adopting SFAS 106 for ratemaking, which could affect recovery. The Company is unable to predict the outcome of these pending challenges. The ongoing periodic expense recognized by the Company under SFAS 106 during 1993 amounted to $338 million before taxes. The $338 million represents an increase of about $183 million over the previous method. Prior to 1993, postretirement health care costs were expensed as claims were incurred. Postretirement life insurance benefits were expensed on an advance-funded basis for retirees and certain active employees. The costs of these benefits recognized in 1992 and 1991 were $103 and $107 million, respectively. Plan assets are invested primarily in domestic and international stocks and domestic investment-grade bonds. The assumed long-term rate of return on plan assets is 8.5 percent. The assumed discount rate, used to measure the accumulated postretirement benefit obligation was 7.5 percent at December 31, 1993. The components of net periodic postretirement benefit cost for 1993 are as follows: (Dollars in millions) 1993 --------------------------------------------------------------------- Service cost ......................................... $ 40 Interest cost on accumulated postretirement benefit obligation ................................. 242 Actual return on plan assets ......................... (79) Net amortization and deferral......................... 160 Curtailment due to force reduction ................... 632 ------ Postretirement periodic benefit cost ................. $995 ===================================================================== E. OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS (continued) The funded status of the plans is as follows: December 31, (Dollars in millions) 1993 --------------------------------------------------------------------- Accumulated postretirement benefit obligation at September 30, 1993: Retirees .......................................... $2,314 Eligible active employees ......................... 207 Other active employees ............................ 919 -------- Total accumulated postretirement benefit obligation ......................................... 3,440 Less: Fair value of plan assets at September 30, 1993*... (708) Contributions during fourth quarter 1993........... (78) Transition obligation ............................. (1,799) Unrecognized net loss**............................ (328) -------- Accrued net postretirement benefit obligation recognized in the consolidated balance sheets at December 31, 1993................................ $ 527 ===================================================================== * Estimated allocation of the Company's portion of Pacific Telesis Group plans. ** The unrecognized net loss is amortized over time and reflects differences between actuarial assumptions and actual experience. It also includes the impact of changes in actuarial assumptions. An annual increase in health care costs of approximately 14 percent is assumed for retirees in 1993. A 13 percent increase is assumed for 1994, declining to an ultimate rate of 6 percent by the year 2002. Should the health care cost trend rate increase by one percent each year, the 1993 increase would be $416 million for the accumulated postretirement benefit obligation and $38 million for the combined service and interest cost components of net periodic cost. As of January 1, 1993, the Company adopted SFAS 112 for accounting for postemployment benefits. Postemployment benefits offered by the Company include workers' compensation, disability benefits, disability-related pensions, medical benefit continuation, and severance pay. These benefits are paid to former or inactive employees not yet retired. SFAS 112 requires a change from cash to accrual accounting by recording a cumulative catch-up-charge at implementation. A one-time, noncash charge was recorded against earnings applicable to continuing operations of $148 million, which is net of a deferred income tax benefit of $103 million. In subsequent years, the Company expects that periodic expense will not differ materially from expense under the prior method. F. DEBT AND LEASE OBLIGATIONS Long-Term obligations as of December 31, 1993 and 1992 consist principally of debentures of $4,047 and $4,170 million, respectively, and corporate notes of $1,161 and $936 million, respectively. Maturities and interest rates of long-term obligations follow: December 31 ------------------------- Maturities and Interest Rates 1993 1992 -------------------------------------------------------------------- (Dollars in millions) 1996 7.625%................ $ 0 $ 100 1999-2043 4.625% to 8.700% ..... 5,208 5,006 ------------------------- Long-term debt 5,208 5,106 Unamortized discount-net of premium ..... (475) (325) Long-term capital lease obligations ..... 20 24 -------------------------- Total long-term obligations ............. $4,753 $4,805 ==================================================================== The Company has remaining authority from the CPUC to issue up to $1.25 billion of long and intermediate-term debt from a total of $1.8 billion authorized in September 1993. The proceeds may be used to redeem maturing debt and to refinance other debt issues. The Company has remaining authority from the SEC to issue up to $650 million of long- and intermediate-term debt through a shelf registration filed in April 1993. Debt maturing within one year consists of short-term borrowings and the portion of long-term obligations that matures within one year as follows: December 31 ------------------------- 1993 1992 -------------------------------------------------------------------- (Dollars in millions) Advances from Pacific Telesis Group....... - 2 Notes payable to banks ................... $ 4 $ 11 Commercial paper ......................... 534 392 ------------------------- Total short-term borrowings .............. 538 405 ------------------------- Current maturities of long-term obligations .................. 4 5 ------------------------- Total debt maturing within one year ...... $ 542 $410 ====================================================================== F. DEBT AND LEASE OBLIGATIONS (continued) Lines of Credit The Company has various formal and informal lines of credit with certain banks. For the most part, these arrangements do not require compensating balances or commitment fees and, accordingly, are subject to continued review by the lending institutions. At December 31, 1993 and 1992, the total unused lines of credit available were approximately $1.6 and $1.3 billion, respectively. Issuances and redemptions of long-term debentures and notes during 1993 are described in the tables below. Issuances Issue Principal Interest Due Date Amount Rate Date Price** Yield ----------------------------------------------------------------------- (Dollars in millions) 2/09/93 $ 400* 7.500% 2/01/33 96.913% 7.751% 3/11/93 325 6.250% 3/01/05 97.939% 6.500% 3/23/93 625 7.125% 3/15/26 98.106% 7.277% 6/30/93 350 7.375% 6/15/25 98.797% 7.474% 7/23/93 300 7.375% 7/15/43 99.373% 7.423% 8/18/93 100 6.875% 8/15/23 96.262% 7.180% 10/20/93 550 6.625% 10/15/34 96.523% 6.880% --------- Total $2,650 ======================================================================= Redemptions Call Principal Interest Due Call Related Date Amount Rate Date Price** Issuance ----------------------------------------------------------------------- (Dollars in millions) 3/01/93 $ 300 9.625% 11/01/14 105.28% 2/09/93 4/01/93 175 8.750% 10/01/06 102.50% 3/11/93 4/01/93 150 8.650% 4/01/05 102.02% 3/11/93 4/14/93 350 9.250% 3/01/26 106.16% 3/23/93 4/14/93 250 9.500% 6/15/11 104.16% 3/23/93 7/19/93 350 8.750% 8/15/25 103.47% 6/30/93 8/16/93 300 9.000% 1/15/18 105.29% 7/23/93 8/20/93 100 7.625% 11/15/96 100.75% - 9/10/93 100 8.625% 4/15/23 103.61% 8/18/93 10/12/93 123 9.125% 12/15/30 114.32% 10/20/93 11/08/93 200 8.625% 4/15/23 103.61% 10/20/93 11/12/93 150 8.375% 2/01/17 105.02% 10/20/93 --------- Total $2,548 ======================================================================= * A portion of the proceeds of this issue were used to refinance $72 million of debentures which had been redeemed in 1992. ** Percent of principal amount. G. FINANCIAL INSTRUMENTS The following table presents information required by SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." The estimated fair value amounts have been determined by the Company, using available market information and appropriate valuation methods. However, considerable judgment enters into estimates of fair value. Accordingly, the estimates presented may not be indicative of the amounts that the Company could realize in a current market exchange. December 31, 1993 December 31, 1992 - ---------------------------------------------------------------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value (Dollars in Millions) - ---------------------------------------------------------------------------- Assets: Cash and short-term investments............... $ 60 $ 60 $ 48 $ 48 Notes receivable............ 2 2 8 8 Liabilities: Debt maturing within one year excluding current portion of capital leases.................... 538 538 402 402 Deposit liabilities......... 290 290 266 266 Long-term debt.............. 5,208 5,302 5,106 5,183 - ----------------------------------------------------------------------------- Cash, other current assets, notes receivable and current obligations: Amounts are a reasonable estimate of fair value. Long-term debt: Interest rates that are currently available to the Company for issuance of debt with similar terms and remaining maturities are used to estimate fair value for debt issues that are not quoted on an exchange. H. RELATED PARTY TRANSACTIONS The Company receives certain services associated with corporate functions, e.g., legal, financial, external affairs and governmental relations, human resources and corporate strategy, performed on the Company's behalf by its parent, Pacific Telesis Group. Costs incurred by Pacific Telesis Group which are attributable to the Company are charged directly to the Company. The Company is also charged for its proportionate share of other indirect costs incurred by Pacific Telesis Group. Total costs charged by Pacific Telesis Group and included in general, administrative, and other expenses were $76 million, $65 million and $64 million in 1993, 1992 and 1991, respectively. The Company provides nontelecommunications and telecommunications services including local, toll and access services to certain Pacific Telesis Group affiliated companies. Revenues recorded for these services totaled $30 million, $30 million and $33 million in 1993, 1992 and 1991, respectively. I. ADDITIONAL FINANCIAL INFORMATION December 31 --------------------- (Dollars in millions) 1993 1992 - --------------------------------------------------------------------------- Prepaid expenses and other current assets: Prepaid directory expenses .................. $336 $332 Miscellaneous prepaid expenses .............. 23 25 Notes and other receivables ................. 45 73 Materials and supplies ...................... 68 70 Current deferred income tax benefits ........ 346 302 Pacific Telesis Group and subsidiaries ...... 17 9 Other ....................................... 27 25 ------ ------ Total ........................................... $862 $836 =========================================================================== Property, plant, and equipment - net: Land and buildings ......................... $ 2,538 $ 2,417 Cable, conduit, and connections ............. 10,251 9,878 Central office equipment .................... 9,396 9,358 Furniture, equipment, and other ............. 2,906 2,897 Construction in progress .................... 569 514 -------- -------- 25,660 25,064 Less: accumulated depreciation 9,708 9,276 -------- -------- Total ........................................... $15,952 $15,788 ========================================================================== Deferred charges and other noncurrent assets: Deferred charges ............................ $ 107 $ 225 Deferred compensated absence ................ 226 223 SFAS 87 pension deferral .................... 367 330 Investments ................................. 79 67 VEBA III .................................... 176 181 Other ....................................... 34 28 -------- -------- Total ........................................... $ 989 $1,054 =========================================================================== Other accounts payable: Pacific Telesis Group and subsidiaries ...... $ 23 $ 15 AT&T and subsidiaries ....................... 214 240 Payroll ..................................... 52 42 Checks outstanding .......................... 177 235 Switch replacements ......................... 132 - Incentive awards payable .................... 188 182 Bellcore .................................... 19 19 Other ....................................... 205 141 ------ ------ Total ........................................... $1,010 $874 ========================================================================== I. ADDITIONAL FINANCIAL INFORMATION (continued) December 31 --------------------- (Dollars in millions) 1993 1992 - --------------------------------------------------------------------------- Other current liabilities: Taxes accrued ................................ $ 25 $ 94 Interest accrued ............................. 114 119 Advance billing customers' deposits .......... 269 247 Accrued compensated absence .................. 284 272 Accrued refunds .............................. - 40 Deferred regulatory liabilities (SFAS 109) ... 120 150 Restructuring ................................ 274 70 Other ........................................ 50 25 ------ ------ Total ............................................ $1,136 $1,017 =========================================================================== Other noncurrent liabilities and deferred credits: Unamortized investment tax credits ........... $ 526 $ 574 Accrued pension cost liability ............... 620 573 Deferred regulatory liabilities (SFAS 109) ... 108 356 Workers' compensation ........................ 175 68 Restructuring ................................ 823 31 SFAS 106 Liability............................ 703 - Other ........................................ 303 198 ------ ------ Total ............................................ $3,258 $1,800 ========================================================================== For the Year Ended December 31 ---------------------------------- (Dollars in millions) 1993 1992 1991 - --------------------------------------------------------------------------- Other revenues: Directory advertising ............. $ 989 $1,003 $1,002 Billing and collections ............ 79 86 96 Non-regulated revenue .............. 169 112 82 Other .............................. 121 129 132 ------- ------- ------- Total .................................. $1,358 $1,330 $1,312 =========================================================================== Other income (expense): Allowance for funds used during construction ..................... $ 35 $ 31 $ 30 Interest income .................... 5 103 33 Other .............................. (54) (52) (28) ------- ------- ------- Total .................................. $ (14) $ 83 $ 35 =========================================================================== Maintenance and repairs ................ $1,396 $1,369 $1,386 Property tax expenses .................. $ 173 $ 176 $ 195 =========================================================================== Cash payments for: Interest ........................... $ 614 $ 529 $ 517 Income taxes ....................... $ 744 $ 829 $ 732 =========================================================================== Major Customer Nearly all of the Company's revenues were from telecommunications and related services. Approximately 11 percent, 12 percent and 12 percent of operating revenues were earned for services provided to AT&T in 1993, 1992 and 1991, respectively. No other customer accounted for more than 10 percent of operating revenues. J. QUARTERLY FINANCIAL INFORMATION (Unaudited) (Dollars in millions) ----------------------------------------- 1993 First Second Third Fourth ---------------------------------------------------------------------- Total Operating Revenues.... $2,200 $2,237 $2,251 $2,206 Operating Income............ $ 356 $ 368 $ 361 $ (624) Cumulative effect of accounting changes........ $ (148) - - - Net Income.................. $ 96 $ 263 $ 257 $ (746) ---------------------------------------------------------------------- 1992 First Second Third Fourth ---------------------------------------------------------------------- Total Operating Revenues.... $2,156 $2,209 $2,213 $2,171 Operating Income............ $ 354 $ 384 $ 396 $ 374 Net Income.................. $ 287 $ 284 $ 286 $ 274 ---------------------------------------------------------------------- First quarter 1993 results have been restated to reflect the adoption of SFAS 112, "Employers' Accounting for Postemployment Benefits" effective January 1, 1993. Adoption of the new standard reduced first quarter net income by $148 million. Fourth quarter 1993 net income was reduced by a restructuring charge of $576 million to recognize the cost of force reductions associated with reengineering internal business processes through 1997. Also as a result of force reductions, fourth quarter 1993 net income was further reduced by $348 million to accelerate recognition of a portion of post-retirement benefits costs in accordance with the curtailment provisions of SFAS 106. First and second quarter 1992 results reflect restatements made in 1992 for the adoption, effective January 1, 1992, of SFAS 109, "Accounting for Income Taxes," and a customer refund (the "Product Development Refund"). The adoption of the new accounting rules reduced first quarter net income by $10 million. The restatements made for the Product Development Refund reduce first and second quarter net income by $28 million and $3 million, respectively. First quarter 1992 results also reflect one-time after-tax gains of $44 million from the settlement of a pre-divestiture tax matter and $15 million from a court order regarding interstate access earnings. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. No disagreements with accountants on any accounting or financial disclosure matters occurred during the period covered by this report. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Documents filed as part of the report: (1) Financial Statements: Report of Management ............................... 43 Report of Independent Accountants .................. 45 Financial Statements: Consolidated Statements of Income ............. 46 Consolidated Balance Sheets ................... 47 Consolidated Statements of Shareowner's Equity ........................................ 48 Consolidated Statements of Cash Flows ......... 49 Notes to Consolidated Financial Statements..... 51 (2) Financial Statement Schedules: V - Property, Plant, and Equipment ......... 73 VI - Accumulated Depreciation ............... 77 VIII - Valuation and Qualifying Accounts ...... 80 IX - Short-Term Borrowings .................. 81 Financial statement schedules other than those listed above have been omitted because the required information is contained in the Consolidated Financial Statements and Notes thereto, or because such schedules are not required or applicable. (3) Exhibits: Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. EXHIBIT INDEX Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. All other exhibits are provided as part of the electronic transmission. Exhibit Number Description ------- ----------- 2a Modification of Final Judgment (Exhibit (28) to Form 8-K, date of report August 24, 1982, File No. 1-1105). 2b Plan of Reorganization (Exhibit (2) to Form 8-K, date of report December 16, 1982, File No. 1-1105). 2c March 14, 1983 Motion to Approve Amended Plan of Reorganization (Exhibit (2)a to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2d March 25, 1983 Motion to Approve Plan of Reorganization as Further Amended (Exhibit (2)b to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2e April 7, 1983 Motion to Approve Plan of Reorganization as Further Amended (Exhibit (2)c to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2f Order issued April 20, 1983 in "U.S. v. Western Electric Company, Incorporated et al.," by the United States District Court for the District of Columbia, Civil Action No. 82-0192 (Exhibit (2) to Form 8- K, date of report April 20, 1983, File No. 1-1105). 2g August 5, 1983 Memorandum and Order of United States District Court for the District of Columbia approving Plan of Reorganization as Amended (Exhibit (2) to Form 8-K, date of report July 8, 1983, File No. 1-1105). 2h September 10, 1987 Opinion and Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated, et. al.," Civil Action No. 82-0192 (Exhibit 2h to Form SE filed November 10, 1987 in connection with Pacific Telesis Group's Form 10-Q, for the quarter ended September 30, 1987, File No. 1-8609). 2i March 7, 1988 Opinion and Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated et al.," Civil Action No. 82-0192 (Exhibit 2h to Form SE filed March 29, 1988 in connection with Pacific Telesis Group's Form 10-K for 1987, File No. 1-8609). 2j April 3, 1990 Opinion of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case Nos. 87-5388 et al. (Exhibit 2j to Form SE filed May 11, 1990 for the quarter ended March 31, 1990 in connection with Pacific Telesis Group's Form 10-Q, File No. 1-8609). 2k July 25, 1991 Opinion & Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Civil Action No. 82-0192 (Exhibit 2k to Form SE filed August 12, 1991 in connection with Pacific Telesis Group's Form 10-Q for the quarter ended June 30, 1991, File No. 1-8609). 2l October 7, 1991 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case No. 91-5262, et al. (Exhibit 2l to Form SE filed March 26, 1992, as part of Pacific Telesis Group's Form 10-K for 1991, File No. 1-8609). 2m May 28, 1993, Order of the United States Court of Appeals, District of Columbia in "U.S v. Western Electric Company, Incorporated, et al., and National Assn. of Broadcasters, et al.," Case Bis, 81-5263, et al. (Exhibit 2m filed August 12, 1993, in connection with Pacific Telesis Group's Form 10-Q for the quarter ended June 30, 1993, File No. 1- 8609). 2n December 28, 1993 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case Nos. 92-5111, et al. (Exhibit 2n to Pacific Telesis Group's Form 10-K for 1993, File No. 1-8609). 3a Articles of Incorporation of Pacific Bell, as amended and restated to January 11, 1993 (Exhibit (3)a to Form SE filed March 26, 1993 in connection with the Company's Form 10-K for 1992). 3b By-Laws of Pacific Bell, as amended to March 10, 1994. 4 No instrument which defines the rights of holders of long- and intermediate-term debt of Pacific Bell and its subsidiaries is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, Pacific Bell hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Reorganization and Divestiture Agreement dated as of November 1, 1983 between American Telephone and Telegraph Company, Pacific Telesis Group and its affiliates (Exhibit (10)a to Form 10-K for 1983, File No. 1-8609). 10b Agreement Concerning Patents, Technical Information and Copyrights dated as of November 1, 1983 between American Telephone and telegraph Company and Pacific Telesis Group (Exhibit (10)g to Form 10-K for 1983, File No. 1-8609). 10c Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements dated as of November 1, 1983 among American Telephone and Telegraph Company, Bell System Operating Companies and Regional Holding Companies (including Pacific Telesis Group and affiliates) (Exhibit (10)j to Form 10-K for 1983, File No. 1-8609). 10d Agreement Regarding Allocation of Contingent Liabilities dated as of January 28, 1985 between American Telephone and Telegraph Company, American Information Technologies Corporation, Bell Atlantic Corporation, BellSouth Corporation, NYNEX Corporation, Pacific Telesis Group and Southwestern Bell Corporation (Exhibit 10c to Form SE filed March 26, 1986 in connection with Pacific Telesis Group's Form 10-K, File No. 1-8609). 12 Computation of Ratio of Earnings to Fixed Charges. 23 Consent of Coopers & Lybrand. 24 Powers of Attorney executed by Directors and Officers who signed this Form 10-K. The Corporation will furnish to a security holder upon request a copy of any exhibit at cost. (b) Reports on Form 8-K: Form 8-K, Date of Report October 5, 1993, was filed with the SEC containing the Underwriting Agreement between the Company and the Underwriters, together with a form of Certificate, in connection with the Company's 6 5/8% Debentures due October 15, 2034. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PACIFIC BELL BY /s/ William E. Downing ------------------------- William E. Downing, Vice President, Chief Financial Officer, Treasurer and Controller 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 date indicated. Sam Ginn,* Chairman of the Board P. J. Quigley,* President, Chief Executive Officer and Director William Downing,* Vice President, Chief Financial Officer, Treasurer and Controller Ivan J. Houston,* Director Toni Rembe,* Director Herman E. Gallegos,* Director J. R. Harvey,* Director S. Donley Ritchey,* Director William Clark,* Director Paul Hazen,* Director Donald E. Guinn,* Director Frank C. Herringer,* Director Mary S. Metz,* Director Lewis E. Platt,* Director *BY /s/ Richard W. Odgers ------------------------- Richard W. Odgers, attorney-in-fact DATE March 29, 1994 Sheet 1 of 4 PACIFIC BELL AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance Additions Other Balance at at Cost Retirements Changes at Classification 12/31/92 (a) (b) (c) 12/31/93 - --------------------------------------------------------------------------- Year 1993 Land and buildings.. $2,417 $ 155 $ 34 $ - $ 2,538 Cable and conduit... 9,878 493 120 - 10,251 Central office equipment ........ 9,358 779 743 2 9,396 Furniture, equipment and other......... 2,897 367 356 (2) 2,906 Construction in progress.......... 514 58 3 - 569 -------------------------------------------------------- Total property, plant, and equipment ........ $25,064 $1,852 $1,256 $ - $25,660 =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 2 of 4 PACIFIC BELL AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance Additions Other Balance at at Cost Retirements Changes at Classification 12/31/91 (a) (b) (c) 12/31/92 - --------------------------------------------------------------------------- Year 1992 Land and buildings.. $2,328 $ 105 $ 16 - $ 2,417 Cable and conduit... 9,499 480 101 - 9,878 Central office equipment ........ 9,114 634 390 - 9,358 Furniture, equipment and other......... 2,824 387 314 - 2,897 Construction in progress.......... 457 59 2 - 514 -------------------------------------------------------- Total property, plant, and equipment ........ $24,222 $1,665 $823 - $25,064 =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 3 of 4 PACIFIC BELL AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance Additions Other Balance at at Cost Retirements Changes at Classification 12/31/90 (a) (b) (c) 12/31/91 - --------------------------------------------------------------------------- Year 1991 Land and buildings.. $2,170 $175 $ 17 - $2,328 Station connections. 1,546 19 1,565 - - Cable and conduit... 9,141 465 107 - 9,499 Central office equipment ........ 8,663 770 319 - 9,114 Furniture, equipment and other......... 2,809 280 265 - 2,824 Construction in progress.......... 492 (31) 4 - 457 -------------------------------------------------------- Total property, plant, and equipment ........ $24,821 $1,678 $2,277 - $24,222 =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 4 of 4 PACIFIC BELL AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT - ------------------- (a) Property, plant, and equipment, (which consists primarily of telephone plant dedicated to providing telecommunications services) is carried at cost. The cost of self-constructed plant includes employee wages and benefits, materials and other costs. Regulators allow the Company to accrue an allowance for funds used during construction as a cost of constructing certain plant and as an item of income. Additions to property, plant, and equipment under construction are reported net of amounts transferred to in-service classifications upon completion and, as a result, may be negative. (b) When the Company retires or sells property, plant and equipment, the original cost is credited to the corresponding plant accounts and charged to accumulated depreciation. (c) Primarily reflects the reclassification of amounts within asset categories. - ------------------- The Company's provision for depreciation is computed primarily using the remaining-life method, essentially a form of straight-line depreciation, using depreciation rates prescribed by state and federal regulatory agencies. The remaining-life method provides for the full recovery of the investment in telephone plant. For the years 1993, 1992 and 1991 depreciation expressed as a percentage of average depreciable plant was 6.9 percent, 7.0 percent, and 7.1 percent, respectively. - ------------------- Sheet 1 of 3 PACIFIC BELL AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance Additions (a) Balance at Charged to Retire- Other at Classification 12/31/92 Expense ments Changes 12/31/93 - --------------------------------------------------------------------------- Year 1993 Land and buildings.. $ 399 $ 82 $ 16 $(26) $ 439 Cable and conduit... 3,358 488 120 (34) 3,692 Central office equipment ........ 4,005 781 743 36 4,079 Furniture, equipment and other......... 1,514 356 356 (16) 1,498 -------------------------------------------------------- Total accumulated depreciation ..... $9,276 $1,707 $1,235 $(40) $9,708 =========================================================================== (a) Other changes for 1993 primarily reflect salvage, cost of removal and reclassifications of amounts within asset categories. Sheet 2 of 3 PACIFIC BELL AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance Additions (a) Balance at Charged to Retire- Other at Classification 12/31/91 Expense ments Changes 12/31/92 - --------------------------------------------------------------------------- Year 1992 Land and buildings.. $ 350 $ 74 $ 15 $(10) $ 399 Cable and conduit... 3,025 451 99 (19) 3,358 Central office equipment ........ 3,643 796 387 (47) 4,005 Furniture, equipment and other......... 1,422 353 323 62 1,514 -------------------------------------------------------- Total accumulated depreciation ..... $8,440 $1,674 $824 $(14) $9,276 =========================================================================== (a) Other changes for 1992 primarily reflect salvage, cost of removal and reclassifications of amounts within asset categories. Sheet 3 of 3 PACIFIC BELL AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance Additions Other Balance at Charged to Retire- Changes at Classification 12/31/90 Expense ments (a) 12/31/91 - --------------------------------------------------------------------------- Year 1991 Land and buildings.. $ 315 $ 61 $ 21 $(5) $ 350 Station connections. 1,565 - 1,565 - - Cable and conduit... 2,617 495 88 1 3,025 Central office equipment ........ 3,139 791 330 43 3,643 Furniture, equipment and other......... 1,319 359 263 7 1,422 -------------------------------------------------------- Total accumulated depreciation ..... $8,955 $1,706 $2,267 $46 $8,440 =========================================================================== (a) Other changes primarily include salvage and amortization deferred to 1992 relating to a depreciation reserve deficiency per FCC order. PACIFIC BELL AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Dollars in millions) - --------------------------------------------------------------------------- Col. A Col. B Col. C Col. D Col. E - --------------------------------------------------------------------------- Allowance for Doubtful Accounts - ------------------------------- Additions ---------------------- (1) (2) Booked as Charged Balance at Reductions to Other Balance at End of Prior to Revenues Accounts Deductions End of Period (a) (b) (c) Period - --------------------------------------------------------------------------- Year 1993 $127 $147 $140 $278 $136 Year 1992 $ 95 $159 $164 $291 $127 Year 1991 $ 81 $123 $125 $234 $ 95 =========================================================================== (a) Provision for uncollectibles as stated in the Consolidated Statements of Income includes certain direct write-offs which are not reflected in this account. (b) Amounts in this column reflect items of uncollectible interstate and intrastate accounts receivable purchased from and billed for AT&T and other interexchange carriers under contract arrangements. (c) Amounts in this column include items written off, net of amounts that had previously been written off but subsequently recovered. Reserve for Restructuring - ------------------------- Additions ---------------------- (1) (2) Charged Charged Balance at to Costs to Other Balance at End of Prior and Expenses Accounts Deductions End of Period (d) (e) Period - --------------------------------------------------------------------------- Year 1993 $101 $977 $43 $24 $1097 Year 1992 $165 $0 $0 $64 $101 Year 1991 $0 $166 $21 $22 $165 =========================================================================== (d) In 1993 and 1991 respectively, Pacific Bell recorded pre-tax restructuring charges to recognize the incremental cost of force reductions. (e) Amounts in this column reflect items capitalized to construction. Sheet 1 of 4 PACIFIC BELL AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Dollars in millions) - --------------------------------------------------------------------------- Col. A Col. B Col. C Col. D Col. E Col. F - --------------------------------------------------------------------------- Weighted Weighted Average Average Average Interest Daily Interest Rate Maximum Amount Rate at the Amount Outstanding During Balance End of Outstanding During the the at End the at any Period - Period - Description of Period Period Month-End (a) (b) - --------------------------------------------------------------------------- Year 1993 Advances and notes from Pacific Telesis Group and subsidiaries. - - $ 22 $ 4 3.20% Notes payable to banks (c). $ 4 6.12% $ 18 $ 8 5.79% Commercial paper (d).... $534 3.23% $597 $259 3.22% ------ Total ......... $538 =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 2 of 4 PACIFIC BELL AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Dollars in millions) - --------------------------------------------------------------------------- Col. A Col. B Col. C Col. D Col. E Col. F - --------------------------------------------------------------------------- Weighted Weighted Average Average Average Interest Daily Interest Rate Maximum Amount Rate at the Amount Outstanding During Balance End of Outstanding During the the at End the at any Period - Period - Description of Period Period Month-End (a) (b) - --------------------------------------------------------------------------- Year 1992 Advances and notes from Pacific Telesis Group and subsidiaries. $ 2 3.46% $181 $52 3.95% Notes payable to banks (c). 11 5.55% $ 17 $13 6.07% Commercial paper (d).... 392 3.42% $392 $26 3.47% ------ Total ......... $405 =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 3 of 4 PACIFIC BELL AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Dollars in millions) - --------------------------------------------------------------------------- Col. A Col. B Col. C Col. D Col. E Col. F - --------------------------------------------------------------------------- Weighted Weighted Average Average Average Interest Daily Interest Rate Maximum Amount Rate at the Amount Outstanding During Balance End of Outstanding During the the at End the at any Period - Period - Description of Period Period Month-End (a) (b) - --------------------------------------------------------------------------- Year 1991 Advances and notes from Pacific Telesis Group and subsidiaries. $223 4.73% $223 $200 6.05% Notes payable to banks (c). 12 7.30% $ 23 $ 14 8.33% Commercial paper (d).... 54 4.62% $622 $180 5.82% ------ Total ......... $289 =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 4 of 4 PACIFIC BELL AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS - ----------------------------- (a) Computed by dividing the aggregate daily face amount of advances and notes outstanding by the number of days in the year. (b) Computed by dividing the aggregate related interest expense by the average daily amount outstanding. (c) Comprised primarily of borrowings under informal lines of credit with original maturities of 180 days or less. (d) Original maturities of 120 days or less. - ----------------------------- EXHIBIT INDEX Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. All other exhibits are provided as part of the electronic transmission. Exhibit Number Description - ------- ----------- 2a Modification of Final Judgment (Exhibit (28) to Form 8-K, date of report August 24, 1982, File No. 1-1105). 2b Plan of Reorganization (Exhibit (2) to Form 8-K, date of report December 16, 1982, File No. 1-1105). 2c March 14, 1983 Motion to Approve Amended Plan of Reorganization (Exhibit (2)a to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2d March 25, 1983 Motion to Approve Plan of Reorganization as Further Amended (Exhibit (2)b to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2e April 7, 1983 Motion to Approve Plan of Reorganization as Further Amended (Exhibit (2)c to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2f Order issued April 20, 1983 in "U.S. v. Western Electric Company, Incorporated et al.," by the United States District Court for the District of Columbia, Civil Action No. 82-0192 (Exhibit (2) to Form 8- K, date of report April 20, 1983, File No. 1-1105). 2g August 5, 1983 Memorandum and Order of United States District Court for the District of Columbia approving Plan of Reorganization as Amended (Exhibit (2) to Form 8-K, date of report July 8, 1983, File No. 1-1105). 2h September 10, 1987 Opinion and Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated, et. al.," Civil Action No. 82-0192 (Exhibit 2h to Form SE filed November 10, 1987 in connection with Pacific Telesis Group's Form 10-Q, for the quarter ended September 30, 1987, File No. 1-8609). 2i March 7, 1988 Opinion and Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated et al.," Civil Action No. 82-0192 (Exhibit 2h to Form SE filed March 29, 1988 in connection with Pacific Telesis Group's Form 10-K for 1987, File No. 1-8609). 2j April 3, 1990 Opinion of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case Nos. 87-5388 et al. (Exhibit 2j to Form SE filed May 11, 1990 for the quarter ended March 31, 1990 in connection with Pacific Telesis Group's Form 10-Q, File No. 1-8609). 2k July 25, 1991 Opinion & Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Civil Action No. 82-0192 (Exhibit 2k to Form SE filed August 12, 1991 in connection with Pacific Telesis Group's Form 10-Q for the quarter ended June 30, 1991, File No. 1-8609). 2l October 7, 1991 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case No. 91-5262, et al. (Exhibit 2l to Form SE filed March 26, 1992, as part of Pacific Telesis Group's Form 10-K for 1991, File No. 1-8609). 2m May 28, 1993, Order of the United States Court of Appeals, District of Columbia in "U.S v. Western Electric Company, Incorporated, et al., and National Assn. of Broadcasters, et al.," Case Bis, 81-5263, et al. (Exhibit 2m filed August 12, 1993, in connection with Pacific Telesis Group's Form 10-Q for the quarter ended June 30, 1993, File No. 1- 8609). 2n December 28, 1993 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case Nos. 92-5111, et al. (Exhibit 2n to Pacific Telesis Group's Form 10-K for 1993, File No. 1-8609). 3a Articles of Incorporation of Pacific Bell, as amended and restated to January 11, 1993 (Exhibit (3)a to Form SE filed March 26, 1993 in connection with the Company's Form 10-K for 1992). 3b By-Laws of Pacific Bell, as amended to March 10, 1994. 4 No instrument which defines the rights of holders of long- and intermediate-term debt of Pacific Bell and its subsidiaries is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, Pacific Bell hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Reorganization and Divestiture Agreement dated as of November 1, 1983 between American Telephone and Telegraph Company, Pacific Telesis Group and its affiliates (Exhibit (10)a to Form 10-K for 1983, File No. 1-8609). 10b Agreement Concerning Patents, Technical Information and Copyrights dated as of November 1, 1983 between American Telephone and telegraph Company and Pacific Telesis Group (Exhibit (10)g to Form 10-K for 1983, File No. 1-8609). 10c Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements dated as of November 1, 1983 among American Telephone and Telegraph Company, Bell System Operating Companies and Regional Holding Companies (including Pacific Telesis Group and affiliates) (Exhibit (10)j to Form 10-K for 1983, File No. 1-8609). 10d Agreement Regarding Allocation of Contingent Liabilities dated as of January 28, 1985 between American Telephone and Telegraph Company, American Information Technologies Corporation, Bell Atlantic Corporation, BellSouth Corporation, NYNEX Corporation, Pacific Telesis Group and Southwestern Bell Corporation (Exhibit 10c to Form SE filed March 26, 1986 in connection with Pacific Telesis Group's Form 10-K, File No. 1-8609). 12 Computation of Ratio of Earnings to Fixed Charges. 23 Consent of Coopers & Lybrand. 24 Powers of Attorney executed by Directors and Officers who signed this Form 10-K. The Corporation will furnish to a security holder upon request a copy of any exhibit at cost. (b) Reports on Form 8-K: Form 8-K, Date of Report October 5, 1993, was filed with the SEC containing the Underwriting Agreement between the Company and the Underwriters, together with a form of Certificate, in connection with the Company's 6 5/8% Debentures due October 15, 2034.

24011_1993.txt

24011_1993

1993

24011

Item 1. Business General Information The Continental Corporation ("Continental"), a New York corporation incorporated in 1968, is an insurance holding company. Its best known subsidiary, The Continental Insurance Company, was organized in 1853. The principal business of Continental is the ownership of a group of property and casualty insurance companies. Continental's other principal subsidiaries and affiliates provide investment management, claims adjusting and risk management services. In 1993, Continental sold its premium financing operations; in 1992, Continental instituted a plan to withdraw from the traditional assumed reinsurance and marine reinsurance businesses and the indigenous international and international marine insurance businesses. The results of these operations are now reported as discontinued and previously reported information has been restated accordingly. Financial Information Relating to Business Segments Continental's revenues from insurance operations accounted for approximately 97% of Continental's consolidated revenues for each of the three years ended December 31, 1993, 1992, and 1991. The following table sets forth certain information with respect to Continental's business segments for each of the last three years: The following table sets forth certain information with respect to Continental's domestic, Canadian, other foreign and consolidated operations for each of the last three years: General Information Relating to Business Segments Continental's insurance operations (the "Insurance Operations") are comprised of three segments: Agency & Brokerage Commercial, Agency & Brokerage Personal and Specialized Commercial. These operations are conducted by Continental's property and casualty insurance subsidiaries. One or more of these companies is licensed or admitted to conduct business in each state or territory of the United States and in each province or territory of Canada. Continental's other segment is Corporate & Other Operations, which principally includes investment management, claims adjusting and risk management services. Agency & Brokerage Commercial Continental's Agency & Brokerage Commercial segment focuses on the production of property and casualty insurance coverage in the United States and Canada through independent insurance agents and brokers, almost all of whom also represent other companies. The Agency & Brokerage Commercial segment includes: (1) Agency and Brokerage operations; (2) Continental Risk Management Services operations (formerly Special Risk operations); (3) Continental Canada's operations; and (4) First Insurance Company of Hawaii, Ltd., a 60%-owned Continental subsidiary ("First of Hawaii"). For the fiscal year ended December 31, 1993, the Agency & Brokerage Commercial segment produced 47.7% of Continental's consolidated written premiums. Premiums on its commercial multi-peril policies represented 59.2% of the segment's written premiums. Other principal lines written by the Agency & Brokerage Commercial segment include workers' compensation, commercial automobile, general liability, boiler and machinery, and fire & allied lines. Continental's Agency and Brokerage operations concentrate their marketing efforts on selected markets through specially designed programs and products and selected local and national producers. Agency and Brokerage operations consist of 10 regional offices containing underwriters and support personnel and a network of approximately 90 territorial offices responsible for sales and underwriting. Agency and Brokerage operations also have two automated business centers which handle underwriting and processing of personal and small commercial lines. In addition, such operations have a custom markets unit devoted specifically to developing small to mid-sized commercial business from national brokers, special programs for specific business segments, and employee accounts. Continental Risk Management Services operations market custom-tailored casualty coverages to Continental's large commercial accounts, including primary and excess coverage for workers' compensation, general liability and commercial automobile risks. Such operations also provide claims management, loss control and actuarial services for its clients. Continental Canada's operations, which are considered part of North American operations and which write commercial and personal property and casualty coverages in Canada, include: (1) The Dominion Insurance Corporation, a Continental subsidiary; (2) The Continental Insurance Company of Canada, a Continental subsidiary; and (3) branch offices of two of Continental's U.S. property and casualty companies. Together, they are one of the leading underwriters of commercial property and casualty coverages in Canada. These operations are managed by Continental Insurance Management Ltd., a Continental subsidiary. First of Hawaii is the largest property and casualty insurer in the Hawaiian Islands. The Tokio Marine and Fire Insurance Company, Ltd., a Japanese insurance company, owns the remaining 40% of the outstanding shares of First of Hawaii. The Agency & Brokerage Commercial segment's premiums earned increased $201 million from 1992. Commercial package premiums earned increased $132 million due to both price increases and acceptance of new risks. Workers' compensation premiums earned increased $20 million due to price increases substantially offset by deliberate reductions in the amount of risk accepted. In addition, the segment's 1992 premiums earned were reduced by a $39 million charge, which did not recur in 1993, to reinstate catastrophe reinsurance coverage. The segment's underwriting results improved $46 million from 1992, primarily due to a $20 million decrease in net catastrophe-related charges and growth in business written without a proportionate increase in operating expenses. Losses and loss expenses increased $102 million, primarily due to inflation in loss costs, the increase in the amount of risk accepted and a $19 million increase in net catastrophe losses. Insurance operating expenses increased $53 million, primarily due to growth in business written and a $32 million decrease in servicing carrier income, which is recorded as a reduction in commission expenses. Agency & Brokerage Personal Continental's Agency & Brokerage Personal segment also focuses on the production of property and casualty insurance coverage in the United States and Canada through independent insurance agents and brokers, almost all of whom also represent other companies. The Agency & Brokerage Personal segment includes: (1) Agency and Brokerage operations; (2) Continental Canada's operations; and (3) First of Hawaii, each of which is discussed above. For the fiscal year ended December 31, 1993, the Agency & Brokerage Personal segment produced 19.6% of Continental's consolidated written premiums. Premiums on its personal package policies represented 58.2% of the segment's written premiums. Other principal lines written by the Agency & Brokerage Personal segment include automobile, homeowners, and fire & allied lines. The Agency & Brokerage Personal segment's premiums earned increased $85 million from 1992. Personal package premiums earned increased $30 million due to price increases, despite a small reduction in the amount of risk accepted. Monoline automobile premiums earned increased $39 million due to an increase in assignments from involuntary risk pools, primarily from New Jersey. In addition, the segment's 1992 premiums earned were reduced by a $25 million charge, which did not recur in 1993, to reinstate catastrophe reinsurance coverage. The segment's underwriting results improved $49 million from 1992, primarily due to a $50 million decrease in net catastrophe-related charges. Losses and loss expenses increased $44 million, despite a $25 million decrease in net catastrophe losses, primarily due to inflation in loss costs and an increase in losses from involuntary risk pools resulting from the increase in assignments. Insurance operating expenses improved $8 million primarily resulting from cost reductions implemented in 1991. Specialized Commercial Continental's Specialized Commercial segment provides specialized commercial coverages, principally in marine and aviation, workers' compensation, fidelity & surety, excess and specialty, accident and health, medical malpractice, customized financial coverage and multinational lines. This segment accounted for 32.7% of Continental's consolidated written premiums for the 1993 fiscal year. The Specialized Commercial segment includes: (1) Marine Office of America Corporation, a Continental subsidiary ("MOAC"); (2) Associated Aviation Underwriters, a 50%-owned Continental affiliate ("AAU"); (3) Continental Excess & Select operations; (4) Casualty Insurance Company, a Continental subsidiary ("Casualty"); (5) Continental Financial Institutions operations; (6) Continental Guaranty operations; (7) Continental Credit operations; (8) Continental Insurance HealthCare operations; (9) The Continental Insurance Company of Puerto Rico ("Continental Puerto Rico"); and (10) The Continental Insurance Company (Europe) Limited, a Continental subsidiary ("Continental Insurance (Europe)"). MOAC underwrites and manages ocean and inland marine insurance coverages, automobile warranty coverages and service repair warranty coverages for technical equipment through branch offices located throughout the United States. It also concentrates on developing package policies for the transportation, distribution and manufacturing industries. MOAC supports all of these coverages with specialized claims handling, surveying, loss control and recovery services. AAU writes insurance for many segments of the aviation industry through branch offices located throughout the United States. Continental Excess & Select operations are active in the excess and specialty lines markets. Their principal types of coverage are stop-loss protection on group health insurance programs, professional liability insurance for lawyers, accountants and other classes of professionals, excess liability insurance, directors' and officers' liability insurance and industry targeted programs of liability insurance for the railroad, mining, skiing, biotechnology and pharmaceutical industries. Continental Excess & Select operations also provide support services to Continental's other excess liability and specialty lines operations. Casualty and its subsidiary, Workers' Compensation and Indemnity Company of California, write certain preselected classes of workers' compensation exposures in Illinois, Wisconsin, Indiana, Michigan and southern California. Continental Financial Institutions operations provide highly specialized coverages for financial institutions, from fidelity bonds to directors' and officers' liability and professional liability insurance, as well as a range of fidelity products for commercial businesses. Continental Guaranty operations are a major provider of surety coverages. Continental Credit operations provide credit insurance. The financial institutions, guaranty and credit operations were previously divisions of a Continental subsidiary, Continental Guaranty & Credit Corporation, which is no longer doing business as a separate corporate entity. Continental Insurance HealthCare operations primarily provide medical malpractice insurance. Such operations also provide claims and risk management services to insureds and other clients. Continental Puerto Rico writes business in Puerto Rico, primarily by way of a quota- share reinsurance agreement with an unaffiliated entity, Puerto-Rican American Insurance Company ("PRAICO"). In 1993, the quota-share participation of Continental Puerto Rico was 12.1% of the net premiums written by PRAICO. Continental Insurance (Europe) writes multinational programs in Europe. The Specialized Commercial segment's premiums earned increased $232 million from 1992 due to both price increases and acceptance of new risks. Premiums earned increased $51 million in domestic marine, $49 million in workers' compensation in selected markets, $49 million in customized financial coverages, $41 million in specialty casualty and $25 million in fidelity & surety insurance. In addition, the segment's 1992 premiums earned were reduced by an $11 million charge, which did not recur in 1993, to reinstate catastrophe reinsurance coverage. The segment's underwriting results improved $82 million from 1992, primarily due to better experience in domestic marine and specialty casualty insurance, an $18 million decrease in net catastrophe-related charges and growth in business written without a proportionate increase in operating expenses. Losses and loss expenses increased $106 million, despite better experience in certain lines and a $7 million decrease in net catastrophe losses, primarily due to inflation in loss costs and the increase in the amount of risk accepted. Insurance operating expenses increased $44 million, primarily due to growth in business written. Corporate & Other Operations The Corporate & Other Operations segment includes Continental's corporate operating expenses and the operations of Continental's non-insurance subsidiaries. Continental's non-insurance subsidiaries primarily include: (1) Continental Asset Management Corp. ("CAM"); (2) Continental Loss Adjusting Services, Inc. ("CLAS"); (3) Continental Rehabilitation Resources, Inc. ("CRR"); (4) Ctek, Inc. ("Ctek"); (5) California Central Trust Bank Corporation "CalTrust"); and (6) Settlement Options, Inc. ("Settlement Options"). CAM, a Continental subsidiary registered under the Investment Advisers Act of 1940, as amended, provides investment advisory services to Continental, its subsidiaries, its employee benefit plans, certain affiliates and unrelated parties under investment advisory agreements. CLAS provides claims services for Continental's subsidiaries and other customers. Its wholly-owned subsidiary, CRR, provides medical and vocational rehabilitation for injured employees of insureds and other clients. Ctek engages in risk evaluation and improvement activities designed to help insureds and other clients reduce or control losses to property, equipment, materials and human resources. CalTrust is a limited service bank whose activities are restricted to the acceptance of deposits, investment of depository funds and acting as trustee and/or third party administrator for employee benefit plans. The following table sets forth certain information with respect to CalTrust's deposit liabilities for each of the last three years: Settlement Options is a general insurance agency which consults with property and casualty claim organizations on personal injury losses to reduce settlement costs by arranging structured claim settlements, and purchases annuities to fund these future periodic payment obligations. In 1993, Continental sold its premium financing operations as well as its computer systems subsidiary, Insurnet, Incorporated, both of which were previously included in the Corporate & Other Operations segment. The results of the premium financing operations are now reported as discontinued. (For information concerning the sale of the premium financing operations, see "Discontinued Operations" below.) Discontinued Operations In 1993, Continental completed the sale of its premium financing subsidiaries, AFCO Credit Corporation, AFCO Acceptance Corporation and CAFO Inc. (collectively, "AFCO"), to Mellon Bank Corporation ("Mellon"). Continental realized a $36 million gain from this sale, net of income taxes. In addition, the sale agreement provides for a contingent payment to Continental based on growth in AFCO's premiums financed over the next five years, for a potential maximum payment of up to $78 million. No provision has been made in Continental's Consolidated Financial Statements for any potential gain from this contingent payment from Mellon. The 1993 results and net assets of the premium financing operations, which were previously reported in the Corporate & Other Operations segment, have been classified in Continental's Consolidated Financial Statements as discontinued. Previously reported information has been restated accordingly. The following table sets forth certain information with respect to operating results of the discontinued premium financing operations for each of the last three years: The following table sets forth certain information with respect to net assets of the discontinued premium financing operations for each of the last two years: December 31 ---------------------- 1993 1992 ---- ---- (millions) Assets: Premium Financing Loans Receivable...... $-- $1,083.3 Other Assets............................ -- 32.9 ---- -------- -- 1,116.2 ---- -------- Liabilities: Short-Term Debt......................... -- 873.5 Long-Term Debt.......................... -- 26.5 Other Liabilities....................... -- 48.9 ---- -------- -- 948.9 ---- -------- Net Assets:............................... $-- $ 167.3 ==== ======== During 1992, Continental instituted a program to withdraw from the traditional assumed reinsurance and marine reinsurance businesses as well as the indigenous international and international marine insurance businesses. These businesses had premiums earned of $339 million and $458 million and underwriting losses of $304 million and $196 million in 1992 and 1991, respectively. Continental failed to develop a sustainable competitive advantage in these businesses as evidenced by their poor operating performances. In addition, these businesses had subjected Continental to unmanageable concentrations of exposures to catastrophes. For example, $28 million of Continental's $70 million total net loss from hurricane Andrew arose from reinsurance operations. As a result, Continental withdrew from these businesses to further concentrate Insurance Operations in their areas of competitive strength. Continental has been accomplishing this withdrawal by running off the insurance reserves of certain of these operations and selling the remaining operations. The results and net assets of the aforementioned operations have been classified in Continental's Consolidated Financial Statements as discontinued. Previously reported information has been restated accordingly. Discontinued Insurance Operations include Continental's subsidiaries: Continental Reinsurance Corporation (U.K.) Limited, Lombard General Insurance Limited and Lombard Insurance Company Limited, which are either expected to be sold or dissolved. Continental's subsidiaries, Continental Reinsurance Corporation International Limited ("CRC-I") and East River Insurance Company (Bermuda) Ltd. ("ERIC"), both of which are continuing entities, are managing the assets and reserves of the discontinued operations. In 1992, substantially all of the business of Continental's reinsurance subsidiary, Continental Reinsurance Corporation, was discontinued, and substantially all of its insurance reserves, along with an equivalent amount of assets, were transferred to CRC-I and ERIC. In 1993, Continental sold Unionamerica Insurance Company, Limited for $95 million in cash and $15 million face value of redeemable preferred stock. The traditional assumed reinsurance and marine reinsurance businesses were autonomous from Continental's primary Insurance Operations. The product, customer base and distribution system also varied significantly from Continental's primary Insurance Operations. Before discontinuance, these businesses generally included proportional and non-proportional, facultative and treaty, and property and casualty insurance and reinsurance. The primary method of reinsurance distribution was through the broker market and the customer base consisted of other insurance and reinsurance companies. Indigenous international insurance was comprised of risks that are located in countries outside the United States and Canada, underwritten by companies domiciled or branches licensed outside the United States or Canada, where the insured is a person or company located outside the United States or Canada. This business was generally written and reported on a monoline basis. In contrast, Continental's United States and Canadian operations focus generally on package business, and Continental's multinational operations (now included in the Specialized Commercial segment) write monoline coverage. Continental's United States and Canadian operations and multinational operations (other than Casualty) write monoline coverages, such as workers' compensation insurance, generally as an accommodation to obtain package business or as specialized coverages like railroad and surety. Monoline personal lines coverages, such as secure home policies, were usually distributed and marketed by savings institutions as part of a mortgage package. Thus, it was only through prearranged participation, or brokered after mortgage sales that such a product was sold. For commercial risks, the distribution and marketing of indigenous international insurance was primarily on a co-insurance basis taking a participation percentage from a lead underwriter. Due to this standard overseas distribution system, the nature of selling this product was vastly different from the domestic practice of more direct links to insureds. Therefore, Continental's focus was on developing relationships with the various underwriters and brokers, rather than directly marketing to the insureds' agents. The servicing of the business was also substantially different, as the claims adjusting services were not administered directly by Continental. The international marine business was underwritten by companies domiciled or branches licensed outside the United States and Canada. The international marine business had a different class of customer and marketing structure, which relied upon the syndication procedures used by the Institute for London Underwriting ("ILU"). The distribution and servicing of such business was also unique. The international marine operations consisted of a small group of underwriters and a collection group using third-party claims services. The ILU is an underwriting center as well as a funds clearing house for claims processing and settlement. Continental acted as a participant in part of a layer of each policy, rather than as a direct underwriter and claims servicer. Thus, systems needs and direct expenses associated with the production of business are different from Continental's domestic marine business. This difference in the method of marketing and distribution for international marine insurance substantially reduces Continental's records keeping requirements. In contrast, domestic marine insurance is underwritten in a similar manner to other domestic lines of business and has similar reporting requirements. The following table sets forth certain information with respect to operating results of the discontinued insurance operations for each of the last three years: The following table sets forth certain information with respect to net assets of the discontinued insurance operations for each of the last two years: December 31 ---------------------- 1993 1992 ---- ---- (millions) Assets: Cash and Investments........... $1,166.5 $1,461.0 Other Assets................... 528.4 924.3 -------- -------- 1,694.9 2,385.3 -------- -------- Liabilities: Outstanding Losses and Loss Expenses................ 1,346.0 2,022.2 Unearned Premiums.............. 3.0 91.1 Other Liabilities.............. 261.3 128.8 -------- -------- 1,610.3 2,242.1 -------- -------- Net Assets:...................... $ 84.6 $ 143.2 ======== ======== Of the $1,346 million in Outstanding Losses and Loss Expenses at December 31, 1993, Continental currently plans the following: (1) $36 million of Outstanding Losses and Loss Expenses are recorded by operations that Continental intends to sell (these reserves are carried at their nominal amounts, in accordance with the regulations of the country where such reserves are recorded); (2) $968 million of Outstanding Losses and Loss Expenses are recorded by ERIC and CRC-I (Continental intends to run off these insurance reserves, and to support the reserves, which are carried at economic value in accordance with Bermuda law (the jurisdiction in which such reserves are reinsured), with an equal amount of earning assets held in trust by ERIC and CRC-I); and (3) $342 million of Outstanding Losses and Loss Expenses are recorded by other operations that Continental intends to run off (these reserves are carried at their nominal amounts, in accordance with the regulations of the countries where such reserves are recorded). Additional Business Information Each of Continental's insurance segments principally provides its own claims service through internal loss-adjusting operations. Designated employees of these operations have authority to settle claims, subject to limits on authority and, in large cases, to review by senior officers. Continental's Insurance Operations purchase reinsurance on certain risks which they insure, principally to (1) reduce liability on individual risks; (2) protect against catastrophe losses; (3) enable them to write additional insurance in order to diversify risks; and (4) reduce their total liability in relation to statutory surplus. The costs of reinsurance, including catastrophe coverages, are generally increased by adverse loss experience in prior periods. (For additional information concerning Continental's reinsurance arrangements, see "Reinsurance" commencing on page 21 herein.) The industry as a whole has experienced underwriting losses for the past several years. These losses are generally attributable to price competition, which has prevented premium rate increases from keeping pace with losses and loss expenses, and to an unusually high level of catastrophe losses. According to A.M. Best Company's Review and Preview, which follows and reports on the industry's financial results, the industry's aggregate underwriting loss for 1993 was $23 billion. The underwriting profitability of property and casualty insurers is affected by many factors, including price competition; the cost and availability of reinsurance; administrative and other expenses; the incidence of natural disasters; and insurance regulators' willingness to grant increases in those rates which they control. Loss frequency and severity trends are influenced by economic factors, such as a company's business mix; inflation rates; medical cost inflation; employment levels; crime rates; general business conditions; regulatory measures; and court decisions that define and expand the risks and damages covered by insurance. The incidence of natural disasters has adversely affected the underwriting profitability primarily of multi-peril, homeowners, and fire & allied lines of business. The underwriting profitability of workers' compensation and commercial and personal automobile business is adversely affected by (1) lower price levels and higher assumed risks due to mandated participation in state involuntary programs by companies writing such business; and (2) rapidly rising medical care costs. Generally, Continental prices insurance coverages at levels management considers adequate in relation to costs, including anticipated claims liability. The Insurance Operations have attempted to control their costs by (1) implementing technological advances; (2) changing their distribution systems and marketing methods; (3) instituting policies designed to increase employees' productivity; (4) changing the mix of agency and brokerage relationships; (5) reducing writings of certain less profitable classes of risks; and (6) becoming more selective in the acceptance of risks. An indicator of underwriting profitability of property and casualty insurers is a company's "combined ratio". The combined ratio is the sum, expressed as a percentage, of (i) the ratio of incurred losses and loss expenses to premiums earned (the "loss ratio"); and (ii) the ratio of sales commissions, premium taxes, and administrative and other underwriting expenses to premiums written (the "expense ratio"). When the combined ratio is below 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. Because the combined ratio does not reflect net investment income, which is a significant component of an insurance company's operating results, an insurance company's operating results for a line of business may be profitable even though the combined ratio for that line of business exceeds 100%. (For information concerning net investment income, see "Investment and Finance" commencing on page 22 herein.) The following table sets forth certain information (presented in accordance with statutory accounting practices) with respect to the underwriting results of the Insurance Operations for the commercial and personal lines of insurance written by them for each of the last three years. Information as to premiums written includes premiums on insurance policies directly written and on policies assumed from other insurers, pools and associations, in each case net of premiums ceded to others in connection with reinsurance purchased. Approximately 61.4% of direct premiums written by the Insurance Operations during 1993 were written in nine states and Canada. Canada accounted for 9.9% of those premiums; New York, 9.8%; California, 8.8%; Illinois, 8.7%; New Jersey, 5.2%; Texas, 4.7%; Pennsylvania, 4.2%; Ohio, 4.2%; Florida, 3.1%; and Hawaii, 2.8%. No other state, country or political subdivision accounted for more than 2.8% of such premiums. The percentages do not reflect premiums received or paid in connection with reinsurance transactions. During the past several years, Continental has shifted its business mix to emphasize commercial and personal package policies and speciality commercial lines, while decreasing the amount of business generated from monoline coverages, such as monoline personal automobile insurance, that have historically proven to be unprofitable to Continental. In 1993, the loss and expense ratios for the Insurance Operations decreased 2.6 percentage points from the prior year, primarily as a result of lower net catastrophe-related charges. Underwriting results for the Insurance Operations produced statutory combined ratios for their personal and commercial lines of 108.8% and 108.4%, respectively, in 1993. These percentages reflected an improvement in personal and commercial lines from the prior year of 5.4% and 4.2%, respectively. Many states require property and casualty insurers to participate in "plans", "pools" or "facilities" which provide coverages for defined risks at rates required by regulators which insurers otherwise would be unwilling to underwrite in view of the nature of the risks and the claims experience of the insureds or the insurance classes of which they are members. Continental provides for its share from its participation in these pools and associations, as well as its participation in voluntary pools and associations, based upon results reported to it by these organizations. In 1993, these involuntary writings totaled approximately $228.4 million, or more than 5.1% of Insurance Operations' total premiums written. The statutory underwriting loss on this business was $67 million during 1993, accounting for approximately 16.3% of Insurance Operations' statutory underwriting loss. In 1993, 52.3%, and 47.7% of these writings were attributable to automobile and workers' compensation businesses, respectively. (For additional information concerning such pools and associations, see "Regulation" commencing on page 13 herein.) Competition The property and casualty insurance industry is highly competitive. Continental's Insurance Operations compete with other stock companies, specialty insurance organizations, mutual insurance companies, and other underwriting organizations. As reported by the Insurance Information Institute, an educational, fact-finding and communications organization, the property and casualty industry in the United States is comprised of approximately 900 leading insurance organizations, none of which has a market share larger than 15% and the top ten of which account in the aggregate for less than 45% of the market. Companies in the United States also face competition from foreign insurance companies and from "captive" insurance companies and "risk retention" groups (i.e., entities established by insureds to provide insurance for themselves). In the future, the industry, including Continental's Insurance Operations, may face increasing insurance underwriting competition from banks and other financial institutions. Based upon the 1993 edition of Best's Aggregates and Averages for the calendar year 1992, Continental's domestic property and casualty companies collectively ranked twelfth in overall premium volume among United States property and casualty insurers. In addition, such companies are among the leading twenty in such categories as commercial multi-peril, aircraft, fidelity & surety, farmowners, homeowners, fire & allied lines, workers' compensation, ocean marine and inland marine lines, and among the leading twenty-five in commercial automobile lines. Because of the relatively large size and underwriting capacity of Continental's property and casualty companies, many opportunities are available to them that are not available to smaller companies. The competitive focus of Continental's Insurance Operations is to (1) offer combinations of superior products, services and premium rates; (2) distribute their products efficiently; and (3) market them effectively. Reliance upon these factors varies from line to line of insurance and from product to product within lines of insurance. Rates are not uniform for all insurers and vary according to the respective types of insurers and methods of operation. Continental's Insurance Operations have traditionally marketed their products principally through independent agents and brokers. This system of marketing is facing increased competition from financial institutions and other companies that market their insurance products directly to the consumer. In response to this competition, Continental has implemented several programs designed to develop a more concentrated and productive agency and brokerage force by eliminating duplication of functions, terminating producers of unprofitable business and providing added incentives and improved support to its more productive producers. Such incentives include assurances of continuing representation; expanded promotional and marketing assistance; specialized account handling; training; and, in certain cases, financial assistance in connection with agency and brokerage expansion. Consequently, Continental's Insurance Operations have, over the past several years, placed computer terminals with many of their most productive producers, which permit producers to transmit information directly to Continental's computer centers and to receive policies, endorsements and other personal lines services overnight. In response to market conditions, Continental has also developed package personal and commercial policies for customers having standard risk exposures, customized products for certain classes of business and industries, and a strong distribution network comprised largely of selected producers with professional sales skills and product knowledge in Continental's targeted markets. Regulation Continental's property and casualty companies are subject to regulation by government agencies in the states and foreign jurisdictions in which they do business. The nature and extent of such regulation vary from jurisdiction to jurisdiction, but typically involve the establishment of premium rates for many lines of insurance; standards of solvency and minimum amounts of capital and surplus which must be maintained; limitations on types of investments; restrictions on the size of risks which may be insured by a single company; licensing of insurers and their agents; deposits of securities for the benefit of policyholders; approval of policy forms; methods of accounting; mandating reserves for losses and loss expenses; and filing of annual and other reports with respect to financial condition and other matters. In addition, state regulatory examiners perform periodic examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than security holders. Most states also require property and casualty insurers to become members of insolvency associations or guaranty funds, which generally protect policyholders against the insolvency of an insurer writing insurance in the state. Members of the associations must contribute to the payment of certain claims made against insolvent insurers. Maximum contributions required by law in any one year vary generally between 1% and 2% of annual premiums written by a member in that state. Continental's insurance subsidiaries are subject to various state statutory and regulatory restrictions, applicable generally to each insurance company in its state of incorporation, which limit the amount of dividends and other distributions that those subsidiaries may pay to Continental. The restrictions are generally based on certain levels of surplus, investment income and operating income, as determined under statutory insurance accounting practices. Some restrictions require that dividends, loans, and advances in excess of stated levels be approved by state regulatory authorities. During 1993, Continental's insurance subsidiaries paid it $120 million in dividends. Recently, several states in which these insurance subsidiaries are domiciled enacted more stringent dividend restrictions based on percentages of surplus and net income from operations. These restrictions will, under certain circumstances, significantly reduce the maximum amount of dividends and other distributions payable to Continental by its insurance subsidiaries without approval by state regulatory authorities. To the extent that its insurance subsidiaries do not generate amounts available for distribution sufficient to meet Continental's cash requirements without regulatory approval, Continental would seek approval for additional distributions. Under the restrictions currently in effect, the maximum amount available for payment of dividends to Continental by its insurance subsidiaries during the year ending December 31, 1994 without regulatory approval is estimated to be $304 million. (See Note 10 to Consolidated Financial Statements included in Continental's 1993 Annual Report to Shareholders.) Continental anticipates that dividends from its insurance subsidiaries, together with cash from other sources, will enable it to meet its obligations for interest and principal payments on debt, corporate expenses, declared shareholder dividends and taxes in 1994. Although the federal government does not directly regulate the business of insurance, federal initiatives often affect the insurance business in a variety of ways. Some form of universal health care may be enacted in the near future. The effect of such a system on certain of Continental's lines of business, including workers' compensation and automobile insurance, could be significant, although any such potential effect cannot presently be evaluated. Other current and proposed federal measures which may significantly affect the insurance business include federal government participation in asbestos and other product liability claims, the extension or modification of the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") in 1994, pension regulation (ERISA), examination of the taxation of insurers and reinsurers, minimum levels of liability insurance for air carriers, and air carrier and automobile safety regulations. (For information concerning matters relating to environmental claims, see "Reserves for Unpaid Losses and Loss Expenses" commencing on page 15 herein.) In view of financial difficulties in the savings and loan and banking industries and recent insurance insolvencies, several congressional inquiries are considering the adequacy of existing state regulations related to the financial health of insurance companies. In addition, congressional committees are currently reviewing the McCarran-Ferguson Act of 1945, which presently provides a limited exemption from federal antitrust laws for the "business of insurance". A number of states have repealed or are reviewing their statutory exemptions for the "business of insurance" from their antitrust laws. Continental believes that some cooperative activity among insurers is essential for a sound industry and is in the public interest, but that limitation or elimination of the McCarran-Ferguson or state statutory antitrust exemptions would not have a significant effect upon Continental's financial results. The National Association of Insurance Commissioners ("NAIC") has developed several proposals to strengthen the existing state regulatory system, including uniform accreditation of state insurance regulatory systems; limitations on the payment of dividends by property and casualty insurance companies; adoption of risk-based capital standards; actuarial certification of reserves; and independent audits of insurer financial statements. Adoption of these proposals will be on a state-by-state basis. Continental favors stronger solvency standards, but recognizes that more regulation, at either the state or federal level, will increase the cost of providing insurance coverage. In the fourth quarter of 1993, the NAIC adopted a risk based capital ("RBC") standard for use by state insurance regulators. RBC is intended to be a "tool" for regulators to assess the capital adequacy of property and casualty insurers and to take action when capital under the standard is judged to be inadequate. The NAIC developed a model law which can be adopted on a state-by-state basis and may be applied, if adopted by the relevant state regulatory authorities, to Continental's 1994 statutory financial statements. Based upon the RBC standards developed by the NAIC as applied to Continental's 1993 statutory financial statements, Continental believes that its insurance subsidiaries have sufficient levels of capital for their respective operations. Insurance companies, including Continental's property and casualty companies, are also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include redefinitions of risk exposure in areas such as product liability; environmental damage; and employee benefits, including pensions, workers' compensation and disability benefits. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may result in short-term adverse effects on the profitability of various lines of insurance. Longer-term adverse effects on profitability can be minimized, when possible, only through repricing of coverages or limitation or cessation of the affected business. A Continental subsidiary has been involved in continuing disputes with the State of New Jersey concerning such subsidiary's ultimate share of the residual private passenger automobile insurance market during 1984-1993. The lawsuit filed by the New Jersey State Attorney General's office in 1990 against this subsidiary and thirteen other servicing carriers of the now-defunct New Jersey Joint Underwriting Association ("JUA") for recovery of alleged residual market deficits from 1984 to 1988 was settled in 1992. Also in 1992, the State commenced proceedings to recover penalties it assessed against certain carriers participating in the JUA's residual automobile market successor, the Market Transition Facility ("MTF"). Those proceedings and all of the penalty assessments were dismissed by the New Jersey Supreme Court in 1993. Also in 1993, the State announced the first statutory assessment for the deficit of the now-discontinued MTF; Continental's subsidiary's market share was approximately 2%, or approximately $10 million, of such first year deficit. As part of the 1992 JUA settlement, Continental's subsidiary paid $3.5 million; and an additional $6 million to the State with respect to such subsidiary's ultimate MTF deficit assessment. As a result, Continental's subsidiary's first year MTF deficit was reduced to approximately $4 million. That amount has been paid into court pending the resolution of an American Insurance Association legal challenge to the assessments filed on behalf of all affected New Jersey insurers. Reinsurers and international insurance companies are subject to licensing requirements and other regulation in the jurisdictions in which they do business. United States regulation of licensed reinsurers is similar to the regulation of domestic property and casualty insurers, except that regulation of reinsurers does not extend to rates, policy forms, or, generally, participation in insolvency funds. Countries outside of the United States have varying levels of regulation of insurance and reinsurance companies. Reserves for Unpaid Losses and Loss Expenses Continental's insurance subsidiaries establish reserves to cover their ultimate liability for losses and loss expenses with respect to reported and unreported claims incurred (except as noted below with respect to "environmental claims") as of the end of each accounting period, after taking into effect salvage and subrogation claims. In establishing such reserves with respect to the period then ended, loss reserves recorded in prior periods are updated to reflect improved estimates of ultimate losses and loss expenses as actual experience develops and payments are made. The losses and loss expense reserves of Continental's insurance subsidiaries are estimates of the ultimate liability determined by using both individual case-basis estimates on reported claims and statistical projections. The statistical projection models reflect changes in the volume of business written, as well as claim frequency and severity. Adjustments to these models are also made for changes in the mix of business, claims processing and other items which affect the development patterns over time. Such statistical projections of ultimate net costs are used to adjust the amount estimated for individually established case reserves, as well as to establish estimates for the amount needed for unreported claims. For more mature accident years, inflation is implicitly considered in such projections based on actual patterns of reported claims, loss payments and case-basis reserves. For relatively immature accident years, in addition to actual loss patterns, explicit assumptions are made for changes in claim severity and frequency based on the type of claims, nature of the related risks, industry trends and related cost indices. Continental's reserves for losses and loss adjustment expenses include reserves for reported "environmental claims" (as such term is described in the next succeeding paragraph). The table on page 17 sets forth information regarding the amounts of these reserves at December 31, 1993, 1992 and 1991 and payments of losses and loss expenses on such claims in each of those years. These reserves represent Continental's estimates of the probable ultimate cost to resolve such reported claims, either through settlement, litigation or alternative dispute resolution. The amounts in the table reflect gross and net undiscounted estimated liability, and do not include any reserves for unreported claims. (For information concerning reinsurance relating to environmental claims, see "Reinsurance" commencing on page 21 herein.) Such reserves incorporate factors specifically relevant to environmental claims, including the nature and scope of policy coverage; the number of claimants, defendants and co-insurers; the timing and severity of injuries or damage; and the relevant jurisdiction and case law. Continental has managed its environmental claims from its centralized Environmental Claims Department since 1981. Continental believes that its centralized approach to handling environmental claims gives Continental the best practicable ability to determine its liability. Continental employs what it believes to be a broad definition of "environmental claims" to classify those types of claims which are handled out of its centralized Environmental Claims Department. "Environmental claims" include claims or lawsuits, for which coverage is alleged, arising from exposure to hazardous substances or materials originating from a site, which is the subject of an investigation or cleanup pursuant to state or federal environmental legislation; claims or lawsuits involving allegations of bodily injury or property damage arising out of the discharge or escape of a pollutant or contaminant; and claims or lawsuits alleging bodily injury or property damage as a result of exposure over a period of time to products or substances alleged to be harmful or toxic. Claims falling under the above categories are classified into two general claim types: (1) asbestos-related and other toxic torts; and (2) environmental pollution. The nature of Continental's business that has resulted in these claim-types is addressed below. Continental has not marketed nor been in the business of providing environmental pollution coverages, with the exception of a program which was in effect from 1981 to 1985, which provided such coverage on a claims-made basis. There are currently three claims pending under policies written under this program, for which Continental has established case reserves which reflect Continental's estimate of the probable ultimate cost of these claims. The allowable reporting period under all policies written under this program has expired. The 1980 enactment of CERCLA, as well as similar state statutes, resulted in environmental pollution claims brought thereafter under standard form general liability policies. While most environmental pollution claims have arisen out of policyholders' obligations under federal and state regulatory statutes, claims have also been brought against policyholders by private third-parties, alleging pollution- related property damage and/or bodily injury. Consistent with the broad range of entities which may become subject to designation as "Potentially Responsible Parties" under state and federal environmental statutes, insureds presenting such claims for coverage under general liability policies span a broad spectrum of commercial policyholders. Most of Continental's environmental pollution claims result from general liability policies written prior to 1986. Certain provisions of Continental's, and the industry's, standard form general liability policies written prior to 1986 have been subject to wide-ranging challenges by policyholders and/or differing interpretations by courts in various jurisdictions, with inconsistent conclusions as to the applicability of coverage for environmental pollution claims. Policies written after 1986 have not been subject to such wide-ranging challenges by policyholders and/or differing interpretations by the courts. Continental has consistently maintained in coverage litigation that its general liability policies did not provide coverage for environmental pollution liability. Asbestos-related claims have generally arisen out of product liability coverage provided by Continental under general liability policies written prior to 1983. Thereafter, asbestos-product exclusions were included in general liability policies. Asbestos-related bodily injury litigation developed during the late 1970's. Initially, the majority of defendant-insureds making claims under general liability policies were involved in the mining, processing, distribution and sale of raw asbestos. By 1985, the category of defendants grew to include companies which produced a variety of products containing asbestos, including roofing materials, tile, refractory products, asbestos-containing clothing, and brake and clutch friction products. Continental had written primary general liability coverage for only two major asbestos manufacturers, and had settled all liabilities under those policies by 1989. Continental had written excess insurance coverage for several other asbestos manufacturers. In addition, Continental had written primary general liability coverage for companies which produce products containing asbestos. Claims which fall in the other toxic tort category have generally arisen out of product liability coverage under general liability policies. These claims involve a variety of allegations of bodily injury as a result of exposure over a period of time to products alleged to be harmful or toxic, such as silica, lead-based paint, pesticides, dust, acids, gases, chemicals, silicone breast implants and pharmaceutical products. Typically, the time period of coverage provided by Continental for all of the above claim-types represents a portion of the overall coverage available to a policyholder to pay these claims. Whenever appropriate, Continental actively seeks out opportunities to participate in cost-sharing agreements with other insurance carriers, stipulating to an equitable allocation of expenses and indemnity payments. Cost-sharing agreements are presently in effect with respect to a large majority of Continental's policyholders involved in asbestos and other toxic tort litigation. As of December 31, 1993, there were approximately 3,600 pending environmental pollution claims involving approximately 800 policyholders, and environmental pollution-related coverage disputes involving approximately 290 policyholders in 340 actions. Approximately 1,550 environmental pollution claims closed or settled during 1993. Continental defines a "claim" as a reserved file which represents the potential financial exposure to a policy year based on an analysis of relevant factors, and which arises out of a policyholder's potential liability at a single site or multiple sites. A three-year asbestos-related, other toxic tort and environmental pollution loss reserve activity analysis is set forth below: As of December 31, 1993, Continental's gross loss and loss adjustment expense reserves for reported asbestos-related, other toxic tort and environmental pollution claims included gross loss adjustment expense reserves of $54.4 million, or 21% of such total reserves (as of December 31, 1992, $55.0 million, or 22% of such total reserves). The amount of Continental's gross loss adjustment expense reserves for reported asbestos-related, other toxic tort and environmental pollution claims, as of December 31, 1993, constituted less than 5% of Continental's total gross loss adjustment expense reserves. Continental does not establish reserves for unreported asbestos-related, other toxic tort and environmental pollution claims because of significant uncertainties, which do not allow liabilities to be reasonably estimated. Such uncertainties include difficulties in determining the frequency and severity of such potential claims and in predicting the outcome of judicial decisions, as case law evolves regarding liability exposure, insurance coverage and interpretation of policy language. The changes in the last three years in Continental's estimates of its liability for insured events of prior years are set forth in the Components of Reserve Development table on page 21 herein. At this time, the future financial impact of unreported asbestos-related, other toxic tort and environmental pollution claims can not be reasonably estimated, and no assessment can be made with respect to the ultimate impact thereof on Continental's results of operations or financial condition in the future. The actuarial profession is addressing unquantifiable liabilities (e.g., unreported asbestos-related, other toxic tort and environmental pollution claims) and is in the initial stage of developing standards, but has not yet scheduled publication of a discussion draft. Other uncertainties may be clarified through the debate, extension or modification of CERCLA in 1994. These developments will continue to be monitored and assessed by Continental. In accordance with individual state insurance laws, certain of the property and casualty subsidiaries discount certain workers' compensation pension reserves. The rate of discount varies by jurisdiction and ranges from 3.0% to 5.0%. The statutory discount on workers' compensation reserves at December 31, 1993, 1992 and 1991 is $525 million, or 7.9% of statutory reserves; $522 million, or 8.0% of statutory reserves; and $505 million, or 7.7% of statutory reserves, respectively. The discount includes an additional discount on the reserves at December 31, 1993, 1992 and 1991 for incurred but not reported claims of $127 million, $187 million and $185 million, respectively, for losses reported to Continental through its participation in joint reinsurance pools. In addition, for the purpose of reporting on a generally accepted accounting principles basis, these subsidiaries have discounted workers' compensation pension reserves since 1984 at a rate of 7% to reflect assumed market yields. Discounting at a rate of 7% in 1993, 1992 and 1991 reduced total reserves for losses at the end of such years by $696 million, or 10.5%; $693 million, or 10.6%; and $676 million, or 10.3%, respectively. As a result of the discounting of such reserves, the ultimate net cost of the losses would, without taking other factors into account, be projected to exceed the amount of the carried reserves by the amount of the discount. The total amount of this excess will emerge as current year incurred losses develop over many years. If such excess had been reflected in the table on page 19 as development of prior year reserves, it would have added $20 million, or 0.4%; $35 million, or 0.6%; and $44 million, or 0.7%, respectively, to the 1992, 1991 and 1990 cumulative deficiencies as of December 31, 1993. However, the yields on these subsidiaries' investment portfolios have historically been greater than the discount rate, and any deficiency due to the discounting of such reserves should be more than offset by investment income. The table on page 19 shows the annual adjustment to historical reserves for each year since 1983. The reserves for unpaid losses and loss expenses are set forth on a cumulative basis for the year specified and all prior years. Although amounts paid for any year are reflected in the re-estimated ultimate net loss at the end of such year, there is no direct correlation in the development patterns between the two portions of the table because the re-estimated ultimate net loss includes adjustments for unpaid losses and loss expenses as well. Finally, an adjustment to an unpaid claim for a prior year will also be reflected in the adjustments for all subsequent years. For example, an adjustment made in 1989 for 1983 loss reserves will be reflected in the re-estimated ultimate net loss for each of the years 1984 through 1988. Reconciliation of Net Reserves for Losses and Loss Expenses from a Statutory Accounting Principles Basis to a Generally Accepted Accounting Principles Basis for the Last Two Years With Supplemental Gross Data 1993 1992 ---- ---- (millions) Total Net Statutory Reserves.......................... $7,029.0 $7,339.0 Less: Net Reserves of Discontinued Operations......... 936.6 1,355.2 -------- -------- Net Statutory Reserves of Continuing Operations....... 6,092.4 5,983.8 Adjustments to a Generally Accepted Accounting Principles Basis, Principally Discounting of Workers' Compensation Pension Reserves.............. (176.6) (177.3) -------- -------- Net Reserves on a Generally Accepted Accounting Principles Basis......................... 5,915.8 5,806.5 Reinsurance Receivables............................... 3,152.9 3,259.7 -------- -------- Gross Reserves on a Generally Accepted Accounting Principles Basis......................... $9,068.7 $9,066.2 ======== ======== Reconciliation of Net Reserves for Losses and Loss Expenses for the Last Three Years With Supplemental Gross Data (1) 1993 1992 1991 -------- --------- -------- (millions) Net Reserves as of January 1............... $5,806.5 $5,901.9 $5,963.1 Incurred Related to: Current Year............................ 3,413.0 3,036.3 2,986.5 Prior Years............................. 1.1 125.3 96.5 -------- -------- -------- Total Incurred............................. 3,414.1 3,161.6 3,083.0 --------- -------- -------- Paid Related to: Current Year............................ 1,291.1 1,031.9 1,071.1 Prior Years............................. 2,013.7 2,225.1 2,073.1 -------- -------- -------- Total Paid................................. 3,304.8 3,257.0 3,144.2 -------- -------- -------- Net Reserves as of December 31............. 5,915.8 5,806.5 $5,901.9 ======== ======== ======== Reinsurance Receivables.................... 3,152.9 3,259.7 -------- -------- Gross Reserves............................. $9,068.7 $9,066.2 ======== ======== __________________________ (1) 1991 information has been restated to reflect accounting for Continen- tal's traditional assumed reinsurance and marine reinsurance businesses and indigenous international and international marine insurance businesses as discontinued operations. See "Discontinued Operations" commencing on page 6 herein. The following table shows the changes in the last three years in Continental's estimates of its liability for insured events of prior years, including the extent to which such changes relate to asbestos-related, other toxic tort and environmental pollution claims: Components of Reserve Development For the Last Three Years (1) Reserve Increase (Decrease) at December 31 ------------------------------ 1993 1992 1991 ------- ------ -------- (net basis, millions) Asbestos-related and Other Toxic Tort........................ $22.4 $ 33.3 $ 42.6 Environmental Pollution............. 33.5 47.6 66.4 ----- ------ ------ Subtotal............................ 55.9 80.9 109.0 All Other........................... (54.8) 44.4 (12.5) ----- ------ ------ Total............................... $ 1.1 $125.3 $ 96.5 ===== ====== ====== __________________________ (1) Prior years' information has been restated to reflect accounting for Continental's traditional assumed reinsurance and marine reinsurance businesses and indigenous international and international marine insurance businesses as discontinued operations. See "Discontinued Operations" commencing on page 6 herein. The increases in Continental's estimate of its liabilities for insured events of prior years for total asbestos-related, other toxic tort and environmental pollution claims during each of the years 1993, 1992 and 1991 was 1.6%, 2.6% and 3.5%, respectively, of Continental's net reported incurred losses and loss expenses for such years. Reinsurance In the ordinary course of business, Continental cedes business to other insurers and reinsurers. Purchasing reinsurance enables Continental to limit its exposure to catastrophic events and other concentrations of risk. However, purchasing reinsurance does not relieve Continental of its obligations to its insureds. Continental reviews the creditworthiness of its reinsurers on an ongoing basis. To minimize potential problems, Continental's policy is to purchase reinsurance only from carriers who meet its credit quality standards. It has also taken and is continuing to take steps to settle existing reinsurance arrangements with reinsurers which do not meet its credit quality standards. Continental does not believe that there is a significant solvency risk concerning these reinsurance claims. In addition, Continental regularly evaluates the adequacy of its reserves for uncollectible reinsurance. Continental believes that it makes adequate provisions for the ultimate collectibility of its reinsurance claims and therefore believes these net recoveries to be probable. (See Note 6 to Consolidated Financial Statements included in Continental's 1993 Annual Report to Shareholders for additional information regarding reinsurance.) Continental has in place various reinsurance arrangements with respect to its current operations. These arrangements are subject to retentions, coverage limits and other policy terms. Some of the principal treaty arrangements which are presently in effect are: (1) an excess-of-loss treaty reducing Continental's liability on individual property losses; (2) a blanket casualty program reducing Continental's liability on third party liability losses; (3) a clash casualty program reducing Continental's liability on multiple insured/single event losses; and (4) a property catastrophe program, with a net retention of $50 million in 1993, increased from $20 million in 1992, reducing its liability from catastrophic events. Continental also uses individual risk facultative and other facultative agreements to further reduce its liabilities. In 1993, Continental's gross incurred losses from catastrophic events were $166 million, and its net incurred losses from catastrophic events were $153 million. Included in both gross and net incurred catastrophe losses in 1993 is a $44 million loss from the March east coast blizzard. Continental also has in place, for future potential adverse reserve development, an aggregate excess-of-loss reinsurance contract with a full limit of $400 million. This agreement was purchased from National Indemnity Company. It covers losses and allocated loss expenses for 1991 and prior policy years. The business covered includes all lines of business written by Continental's domestic property and casualty insurance subsidiaries, with specific exclusions for nuclear exposure, war risks, business written through the Workers' Compensation Reinsurance Bureau and involuntary market pools, insolvency and guarantee fund assessments, taxes, unallocated loss adjustment expenses, and extra-contractual obligations. Continental does not maintain any reinsurance arrangements whose coverage is limited solely to asbestos-related, other toxic tort and environmental pollution claims. The amounts of reinsurance receivables and recoverables that are reflected in Continental's Consolidated Financial Statements arose under a variety of reinsurance arrangements put in place generally from 1963 through 1986, which generally are the years in which Continental's general liability policies were alleged to provide coverage for those types of claims. As most of Continental's reserves for asbestos-related, other toxic tort and environmental pollution claims have arisen out of general liability policies written prior to 1986 (after which such policies have not generally been subject to wide-ranging challenges by policyholders and/or differing interpretations by courts in various jurisdictions), a majority of reinsurance receivables and recoverables arising out of such claims in 1991, 1992 and 1993 related to reinsurance arrangements put into place prior to 1986. These reinsurance arrangements include primary casualty treaty arrangements, excess of loss and umbrella casualty treaty arrangements, property treaty arrangements and various facultative agreements. Investment and Finance Reserves and surplus balances constitute a pool of funds which are invested by insurance companies. Investment results combined with underwriting results produce operating income or losses. Continental's overall operating results in the insurance business are significantly affected by the performance of its investment portfolio. The following table sets forth the investment results of Continental and its subsidiaries for each of the past three years: Average Net Investment Current Realized Year Investments(1)(3) Income (2) (3) Yield(3) Capital Gains(3) - ---- ----------------- -------------- -------- ---------------- (millions, except percentages) 1993........ $8,817.0 $542.3 6.2% $124.5 1992........ $8,314.4 $589.9 7.1% $215.6 1991........ $8,009.7 $637.2 8.0% $111.2 ____________ (1) Average of investments at beginning and end of calendar year, excluding operating cash, but including cash equivalents. Bonds and redeemable preferred stocks are reported at market, except for those investments intended to be held to maturity, which are reported at cost. (2) Net investment income after deduction of investment expenses, but before realized capital gains and applicable income taxes. (3) Certain reclassifications, primarily for discontinued operations, have been made to the prior years' financial information to conform to the 1993 presentation. Investment strategies are developed based on a variety of factors including business needs, regulatory requirements and tax considerations. It is Continental's objective to maximize real economic surplus by actively managing all investable assets to ensure a maximum after-tax "total return". The total return concept employs an integrated approach of tailoring investment strategies to ensure proper asset/liability management. An asset/liability study is performed by management to determine the ideal duration of the investment portfolio, taking into consideration the optimal risk and return preferences of management. Continental continually monitors the mix between its fixed maturities and equity securities portfolios. It is management's preference to limit equity investments to a percentage of economic surplus. This equity limit is further reduced by any current commitments to "high yield" bonds and non-dollar bonds supporting dollar-based activities. Considering risk and return parameters, common stock commitments have been limited to no more than 100% of Continental's property and casualty statutory surplus. The percentage of Continental's consolidated property and casualty statutory surplus invested in common stocks at the end of each of the past three years has ranged between 33% and 39%, and at the end of 1993, was approximately 33%. Fixed maturities are further managed to ensure maximum profitability by balancing the portfolio between taxable and tax-exempt securities. Continental also uses international investment programs to match its non-dollar business exposures and to enhance the risk and return parameters of the portfolio backing its U.S.-based business. All investments are made in accordance with applicable state investment laws; further, Continental employs strict internal guidelines limiting its investments in any particular issue and in any particular industry. Continental also maintains short-term investments and cash equivalents for the current and anticipated near-term liquidity needs of its operations. When maximizing total return, management recognizes that some capital losses are inevitable. Fixed maturities available-for-sale consist of certain bonds and redeemable preferred stocks that management may not hold until maturity and which have an average Standard & Poor's rating of AA+ (or its Moody's equivalent). Continental's fixed maturities available-for-sale had a balance sheet fair value of $6,916 million at December 31, 1993 (compared with a fair value of $6,240 million at December 31, 1992) and included mortgage-backed securities with a fair value of $1,270 million and an amortized cost of $1,255 million at December 31, 1993 (compared with a fair value of $1,338 million and an amortized cost of $1,300 million at December 31, 1992). Continental's mortgage-backed securities have an average Standard & Poor's rating of AAA (or its Moody's equivalent) and an average of life of 6.0 years. Continental has an insignificant investment in collateralized mortgage obligations which put the return of principal at risk if interest rates or prepayment patterns fluctuate. At December 31, 1993, Continental's bond portfolio classified by Moody's rating was as follows: Percentage of Bond Moody's Rating Portfolio ------------------ ------------- Aaa........................ 62.0% Aa......................... 15.7 A.......................... 11.2 Baa........................ 9.6 Below Baa.................. 1.5 ----- 100.0% At December 31, 1993, the fixed maturities portfolio included an insignificant amount of securities, the fair value of which is expected to be lower than its carrying value for more than a temporary period; such investments have been recorded in Continental's Consolidated Balance Sheets at their net realizable value. Continental also maintains an equity securities portfolio, the fair value of which was $759 million at December 31, 1993. At December 31, 1993, Continental also had a $112 million investment in privately-placed direct mortgages, which are included in "Other Long-Term Investments" in Continental's Consolidated Balance Sheets. The NAIC is currently developing an Investments of Insurers Model Act, which, if adopted by state regulatory authorities, would establish uniform limitations upon the type and amounts of investments insurers may hold. Based upon the current proposals of this Model Act, which are subject to review and change, Continental does not believe a uniform standard would significantly affect the current investment mix or operations of its insurance subsidiaries. Unrealized appreciation on investments available-for-sale increased $170 million, before income taxes, from December 31, 1992. Unrealized appreciation on fixed maturities increased $152 million. Unrealized appreciation on common stocks decreased $1 million, while unrealized appreciation on nonredeemable preferred stocks increased $11 million. Unrealized appreciation on other long-term assets increased $8 million. In addition, unrealized appreciation on investments held by discontinued operations increased $15 million, before income taxes, from December 31, 1992. In recent years, a small portion of Continental's investment funds has been committed to alternative areas of investment (i.e., other than Continental's traditional areas). Continental currently invests in alternative areas including venture capital partnerships, high-yield bonds, international diversification investments and emerging markets. As of December 31, 1993, the total investment in these areas represented less than 5% of Continental's investment portfolio. Continental, through its former participation in the Municipal Bond Insurance Association, issued guarantees of financial obligations. During 1986, this association was reorganized as a corporation named MBIA, Inc. Continental's net par value exposure at December 31, 1993 on guarantees issued before the reorganization is $1.4 billion (1992 - $1.7 billion), all of which has been reinsured by MBIA, Inc. In addition, Continental has issued financial guarantees of limited partners' obligations, municipal lease obligations, industrial development bonds and other obligations. Continental's net par value exposure on these guarantees at December 31, 1993 was $151.0 million (1992 - $173.0 million). The maturity dates of these obligations range between one and twelve years. Continental continually monitors its exposure relating to financial guarantees. Continental does not believe that its exposures relating to financial guarantees are material. Miscellaneous In 1992 and 1993, Continental sold a total of $350 million in Notes (which provided $346 million to Continental, net of offering and underwriting costs) under its shelf registration of up to $400 million of debt securities with the Securities and Exchange Commission. During 1993, Continental used $282 million of net proceeds from these sales to retire its outstanding 9 3/8% Notes due July 1, 1993 and $50 million of net proceeds from these sales to reduce corporate short-term borrowings. Continental intends to sell an additional $50 million of debt securities under its existing shelf registration and to register for the sale of up to an additional $100 million of debt securities. Continental plans to use the net proceeds from these sales to further reduce its short-term borrowings. As of December 31, 1993, Continental and its subsidiaries had approximately 12,255 employees, compared with 13,100 at December 31, 1992. Continental and its subsidiaries consider their employee relations to be satisfactory. Item 2. Item 2. Properties Continental's subsidiaries lease office space in various cities throughout the United States and in other countries. The following table sets forth certain information with respect to the principal office buildings owned or leased by Continental's subsidiaries: Amount of Building Owned and Occupied or Leased by Continental's Size Subsidiaries (in square (in square Location feet) (1) feet) Principal Usage Operations - --------------------- ---------- --------- ------------------- ---------- 180 Maiden Lane, 1,091,570 572,514 Principal Executive Corporate/ New York, New York(2) Offices of Insurance Continental Operations/ Asset Management 1 Continental Drive, 490,993 490,993 Property, Casualty Insurance Cranbury, New Jersey Insurance Offices Operations 200 S. Wacker Drive, 336,390 245,466 Property, Casualty Insurance Chicago, Illinois Insurance Offices Operations 1111 E. Broad St., 197,537 197,537 Property, Casualty Insurance Columbus, Ohio Insurance Offices Operations 1100 Ward Avenue, 186,492 97,831 First Insurance Insurance Honolulu, Hawaii(2) Company of Hawaii, Operations Ltd. Headquarters 333 Glen Street, 158,700 158,700 Property, Casualty Insurance Glens Falls, New York Insurance Offices; Operations Residual Market Center 3501 State Highway 129,965 129,965 Data Processing Systems No. 66, Neptune, Facilities New Jersey - ----------------------- (1) Represents the amount of space owned and occupied by or leased to Continental's subsidiaries. To the extent not occupied by Continental's subsidiaries, such space is or is intended to be subleased to third parties. (2) Represents property owned in fee by Continental's subsidiaries and held subject to mortgages. (See Note 7 to Consolidated Financial Statements included in Continental's 1993 Annual Report to Shareholders.) Item 3. Item 3. Legal Proceedings Continental's subsidiaries are routinely party to litigation incidental to their business, as well as other litigation of a nonmaterial nature. Management regularly evaluates the liability of Continental and its subsidiaries associated with such litigation. The status of such litigation is reviewed in consultation with Continental's in-house legal staff, Corporate Claims Department and Environmental Claims Department, and their respective outside counsel, all of whom have extensive experience in handling such matters. Based upon the foregoing evaluative process, Continental makes a determination as to the effect that such litigation may have upon its financial condition on a consolidated basis. In the opinion of Continental, no individual item of litigation, or group of related items of litigation (including asbestos-related, other toxic tort and environmental pollution matters), taken net of claims reserves established therefore and giving effect to reinsurance, is likely to result in judgments for amounts material to the financial condition of Continental and its subsidiaries on a consolidated basis. Item 4. Item 4. Submission of Matters to a Vote of Security Holders During the fourth quarter of 1993, no matter was submitted to a vote of Continental's shareholders. Item 4(A). Executive Officers of the Registrant Name Title Age John P. Mascotte Director, Chairman of the Board, Chief Executive 54 Officer and President Charles A. Parker Director and Executive Vice President, 59 Investments Wayne H. Fisher Executive Vice President and President, 49 Special Operations Group Fredric G. Marziano Executive Vice President and President, 51 The Continental Insurance Companies and Agency and Brokerage Group Steven J. Smith Executive Vice President, Office of the 49 Chairman Adrian M. Tocklin Executive Vice President and President, 42 Continental Risk Management Services Bruce B. Brodie Senior Vice President and Chief 39 Information Officer J. Heath Fitzsimmons Senior Vice President and Chief 51 Financial Officer James P. Flood Senior Vice President, Corporate Claims 43 William F. Gleason, Jr. Senior Vice President, General Counsel and Secretary 57 John F. Kirby Senior Vice President 47 Arthur J. O'Connor Senior Vice President, Corporate 41 Communications and Investor Relations Sheldon Rosenberg Senior Vice President and Chief Actuary 44 Kenneth B. Zeigler Senior Vice President, Human Resources 45 Francis M. Colalucci Vice President and Treasurer 49 William A. Robbie Vice President and Chief Accounting Officer 42 All Executive Officers of Continental are elected to serve for terms to expire at the meeting of the Board of Directors following the next Annual Meeting of Shareholders and until their successors shall have been elected. John P. Mascotte has been a Director since February 1981, Chairman of the Board and Chief Executive Officer of Continental since December 1982 and President since December 1992. Charles A. Parker has been a Director since May 1989 and Executive Vice President, Investments, of Continental since May 1983. Wayne H. Fisher has been an Executive Vice President of Continental since December 1990 and has been President, Special Operations Group, since January 1988. Before that time, he was a Senior Vice President of Continental (December 1988-December 1990). Fredric G. Marziano has been an Executive Vice President and President, Agency and Brokerage Group, since January 1987 and President of The Continental Insurance Companies since November 1992. Steven J. Smith has been an Executive Vice President, Office of the Chairman, of Continental since February 1983. Adrian M. Tocklin has been Executive Vice President of Continental and President, Continental Risk Management Services, since November 1992. Before that time, she served as Senior Vice President, Corporate Claims, of Continental (July 1988 - November 1992). Bruce B. Brodie has been Senior Vice President and Chief Information Officer of Continental since October 1993. Before that time, he served as Chief Financial Officer for the Special Operations Group (April 1990 - October 1993) and Vice President, Office of the Chairman, of Continental (January 1989 - April 1990). J. Heath Fitzsimmons has been Senior Vice President and Chief Financial Officer of Continental since January 1990. Before that time, he was Vice President, Finance, of Continental (February 1989-December 1989). James P. Flood has been Senior Vice President, Corporate Claims, of Continental since November 1992. Before that time, he served as Vice President, Environmental Claims, of Continental (March 1988 - October 1992). William F. Gleason, Jr. has been Senior Vice President, General Counsel and Secretary of Continental since January 1983. John F. Kirby has been a Senior Vice President of Continental since January 1990 and a Senior Vice President of The Continental Insurance Company since March 1987. Arthur J. O'Connor has been Senior Vice President, Corporate Communications and Investor Relations, of Continental since November 1992 and served as Vice President, Corporate Communications and Investors Relations, of Continental (January 1988 - November 1992). Sheldon Rosenberg has been Senior Vice President and Chief Actuary of Continental since February 1994. Before that time, he served as Vice President and Chief Actuary of The Continental Insurance Company (April 1992 - February 1994), Vice President and Actuary of The Continental Insurance Company (April 1990-March 1992) and Vice President and Chief Financial Officer of the Special Operations Group (April 1988 - March 1990). Kenneth B. Zeigler has been Senior Vice President, Human Resources, of Continental since December 1991. Before that time, he served as Senior Vice President and President of the Marine and International Group (January 1990-November 1991). Previously, he had been President of Continental International (July 1988-December 1990). Francis M. Colalucci has been Vice President and Treasurer of Continental since May 1991. Before that time, he was Vice President and Controller of The Continental Insurance Company (November 1980-May 1991). William A. Robbie has been Vice President and Chief Accounting Officer since June 1992 and served as Vice President, Financial Reporting (June 1990 - June 1992). Before that time, he served as Vice President and Treasurer of Monarch Life Insurance Co. and Vice President and Corporate Controller of Monarch Capital Corp. (August 1988 - June 1990). PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters Material appearing under the captions "Shareholder Information", "Summarized Consolidated Quarterly Financial Data (Unaudited), "Selected Consolidated Financial Data" and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Resources and Liquidity", and Notes 9 and 10 to Consolidated Financial Statements included in Continental's 1993 Annual Report to Shareholders (the "Annual Report") is incorporated herein by reference. Item 6. Item 6. Selected Financial Data Material appearing under the caption "Selected Consolidated Financial Data" included in the Annual Report is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Material appearing under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in the Annual Report is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data Consolidated Financial Statements and related Notes, and material appearing under the captions "Independent Auditors' Report", "Report on Financial Statements" and "Summarized Consolidated Quarterly Financial Data (Unaudited)" included in the Annual Report are incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Within the 24 months prior to the date of its most recent financial statements, Continental did not file a report on Form 8-K reporting a change of accountants. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Information concerning Executive Officers of Continental appears under Item 4(A) of this Report. Information as to Directors of Continental appearing under the caption "Election of Directors" included in Continental's Proxy Statement in connection with its 1994 Annual Meeting of Shareholders (the "Proxy Statement") is incorporated herein by reference. Item 11. Item 11. Executive Compensation Material appearing under the captions "Directors' Compensation" and "Executive Compensation" included in the Proxy Statement is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Material appearing under the captions "Election of Directors", "Security Ownership of Directors and Executive Officers" and "Other Ownership of Continental Stock" included in the Proxy Statement is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions Material appearing under the caption "Election of Directors" included in 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) The following documents are filed as part of this Report. (1) The following is a list of financial statements, together with schedules thereto, filed as part of this Report, all of which have been incorporated herein by reference to the material in the Annual Report as described under Item 8 of this Report. Report on Financial Statements Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Independent Auditors' Report Selected Consolidated Financial Data Summarized Consolidated Quarterly Financial Data (Unaudited) (2) The following is a list of financial statement schedules filed with this Report. Independent Auditors' Report Consolidated: Page No. Schedule I -- Summary of Investments Other Than Investments in Related Parties at December 31, 1993..................... 34 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...... 35 III -- Condensed Parent Financial Statements: -- Statements of Income for the years ended December 31, 1993, 1992 and 1991..................... 36 -- Balance Sheets at December 31, 1993 and 1992.............................. 37 -- Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991..................... 38 IV -- Not Applicable........................ -- V -- Supplementary Insurance Information for the years ended December 31, 1993, 1992 and 1991............................... 39 VI -- Reinsurance Information for the years ended December 31, 1993, 1992 and 1991................................... 40 VII -- Not Applicable......................... -- VIII -- Valuation and Qualifying Accounts for the years ended December 31, 1993, 1992 and 1991............................... 41 IX -- Short-Term Borrowings for the years ended December 31, 1993, 1992 and 1991................................... 42 X -- Supplemental Information for Property- Casualty Insurance Underwriters for the years ended December 31, 1993, 1992 and 1991................................... 43 (3) The following is a list of exhibits hereto required to be filed by Item 601 of Regulation S-K of the Securities and Exchange Commission (the "SEC"). 3(a)-- Certificate of Incorporation of Continental, as amended, as filed with the Secretary of the State of New York on April 6, 1989. (b)-- By-Laws of Continental, as amended through December 17, 1992. 4(a)-- The following document filed with the SEC on March 3, 1993 as Exhibit 1 to Report on Form 8-K is incorporated herein by reference: Supplemental Indenture No. 3 dated as of March 1, 1993 from Continental to The Bank of New York, as Trustee, with respect to the issuance of $150 million of 7.25% Notes due March 1, 2003. (10)(a)-- The Long Term Incentive Plan of Continental (amended and restated as of December 1, 1993). (b)-- The Annual Management Incentive Plan of Continental (amended and restated as of January 1, 1993). (c)-- The Incentive Savings Plan of Continental (amended and restated as of January 1, 1994). (d)-- The Retirement Plan of Continental (amended and restated as of January 1, 1994). (e)-- Receivables Purchase and Sale Agreement dated as of December 14, 1993, among The Continental Insurance Company ("Continental Insurance"), Boston Old Colony Insurance Company ("Boston"), The Buckeye Union Insurance Company ("Buckeye"), Casualty Insurance Company ("Casualty"), Commercial Insurance Company of Newark, N.J. ("Commercial"), The Continental Insurance Company of New Jersey ("Continental - NJ"), Continental Lloyd's Insurance Company ("Lloyd's"), The Fidelity and Casualty Company of New York ("Fidelity"), Continental Reinsurance Corporation ("Continental Re"), Firemen's Insurance Company of Newark, New Jersey ("Firemen's"), The Glens Falls Insurance Company ("Glens Falls"), Kansas City Fire and Marine Insurance Company ("Kansas City"), The Mayflower Insurance Company, Ltd. ("Mayflower"), National-Ben Franklin Insurance Company of Illinois ("N-BF"), Niagara Fire Insurance Company ("Niagara"), Pacific Insurance Company ("Pacific") and Workers' Compensation and Indemnity Company of California ("Workers'"), collectively as Sellers, and Corporate Asset Funding Company, Inc. ("Asset Funding"), CIESCO, L.P., Falcon Asset Securitization Corporation ("Falcon"), Sheffield Receivables Corporation ("Sheffield"), Atlantic Asset Securitization Corp. and Credit Lyonnais, collectively as Purchasers, and Citicorp North America, Inc. ("Citicorp"), as Agent. (f)-- Stock Purchase Agreement dated as of June 30, 1993, among Continental, Continental Insurance, Continental Re and Mellon. (g)-- Share Purchase Agreement dated as of June 30, 1993 (the "Unionamerica Stock Purchase Agreement"), among Unionamerica Acquisition Company Ltd. ("Unionamerica"), Unionamerica Holdings Ltd. ("Unionamerica Holdings") and Continental. (h)-- Amendment dated September 1, 1993 to the Unionamerica Share Purchase Agreement, among Unionamerica, Unionamerica Holdings and Continental. (i)-- Stock Purchase Agreement dated as of July 28, 1993 (the "Alleghany Stock Purchase Agreement"), among Alleghany Corporation ("Alleghany"), Continental, Goldman, Sachs & Co. ("Goldman") and certain funds which Goldman either controls or of which it is a general partner (together, the "GS Investors"; Continental and the GS Investors together referred to as the "URHC Stockholders"), Underwriters Re Holdings Corp. ("Underwriters Holdings") and Underwriters Re Corporation ("Underwriters"). (j)-- Amendment dated October 7, 1993, to the Alleghany Stock Purchase Agreement, among Alleghany, Continental, the GS Investors, Underwriters Holdings and Underwriters. (k)-- Stock Purchase Agreement dated as of July 28, 1993 (the "GS Investors Stock Purchase Agreement"), among Continental and the GS Investors. (l)-- Letter Agreement dated October 6, 1993, among Continental and the GS Investors, relating to the GS Investors Stock Purchase Agreement. (m)-- Management Stock Purchase Agreement dated as of July 28, 1993 (the "Management Agreement"), among Continental, Underwriters Holdings, Underwriters and certain Management Stockholders, as supplemented. (n)-- Amendment dated as of October 7, 1993, to the Management Agreement, among Continental, Underwriters Holdings, Underwriters and certain Management Stockholders. The following document filed under Exhibit 10 to Continental's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated herein by reference: Receivables Purchase and Sale Agreement dated as of December 14, 1992, among Continental Insurance, Boston, Buckeye, Casualty, Commercial, Continental-NJ, Lloyd's, Fidelity, Firemen's, Glens Falls, Kansas City, Mayflower, N-BF, Niagara, Pacific and Workers', collectively as Sellers, and Asset Funding, Falcon, Receivables Capital Corporation, Sheffield and Credit Lyonais, collectively, as Purchasers, and Citicorp, as Agent. (11) -- Continental's Statement re Computation of Per Share Earnings. (13) -- Continental's 1993 Annual Report to Shareholders (filed with the SEC only to the extent incorporated herein by reference). (21) -- Subsidiaries of Continental. (23) -- Consent of KPMG Peat Marwick. (28) -- Statutory Loss Development of Property and Casualty Insurance and Reinsurance Subsidiaries. (b) No Report on Form 8-K was filed by Continental 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. Date: March 17, 1994 THE CONTINENTAL CORPORATION By /s/ JOHN P. MASCOTTE (John P. Mascotte) 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 the Registrant and in the capacities and on the dates indicated. Signature Title Date Senior Vice President /s/ J. HEATH FITZSIMMONS and Chief Financial Officer March 17, 1994 (J. Heath Fitzsimmons) Vice President /s/ WILLIAM A. ROBBIE and Chief Accounting Officer March 17, 1994 (William A. Robbie) /s/ IVAN A. BURNS Director March 17, 1994 (Ivan A. Burns) /s/ ALEC FLAMM Director March 17, 1994 (Alec Flamm) /s/ IRVINE O. HOCKADAY, JR. Director March 17, 1994 (Irvine O. Hockaday, Jr.) /s/ JOHN E. JACOB Director March 17, 1994 (John E. Jacob) /s/ JOHN P. MASCOTTE Director March 17, 1994 (John P. Mascotte) /s/ JOHN F. McGILLICUDDY Director March 17, 1994 (John F. McGillicuddy) /s/ RICHARD de J. OSBORNE Director March 17, 1994 (Richard de J. Osborne) /s/ CHARLES A. PARKER Director March 17, 1994 (Charles A. Parker) ________________________________ Director (L. Edwin Smart) /s/ JOHN W. ROWE, M.D. Director March 17, 1994 (John W. Rowe, M.D.) /s/ PATRICIA CARRY STEWART Director March 17, 1994 (Patricia Carry Stewart) ________________________________ Director (Francis T. Vincent, Jr.) ________________________________ Director (Michael Weintraub) /s/ ANNE WEXLER Director March 17, 1994 (Anne Wexler) INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders THE CONTINENTAL CORPORATION: Under date of February 10, 1994, we reported on the consolidated balance sheets of The Continental Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in Item 14(a)(2). These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 2 to the consolidated financial statements, The Continental Corporation and subsidiaries changed their methods of accounting for multiple-year retrospectively rated reinsurance contracts and for the adoption of the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," and No. 115, "Accounting for Certain Investments in Debt and Equity Securities," in 1993. The Continental Corporation and subsidiaries 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," in 1992. /s/ KPMG PEAT MARWICK KPMG Peat Marwick New York, New York February 10, 1994 SCHEDULE I THE CONTINENTAL CORPORATION SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES (1) December 31, 1993 (millions) - -------------------------------------------------------------------------- Column A Column B Column C Column D - -------------------------------------------------------------------------- Type of Investment Cost Value Balance Sheet - -------------------------------------------------------------------------- FIXED MATURITIES: BONDS: United States Government and Government Agencies . . . . . . . . . $2,832.8 $2,908.6 $2,908.6 States, Municipalities and Political Subdivisions. . . . . . . . 1,325.2 1,418.6 1,418.6 Foreign Governments . . . . . . . . . . 879.2 943.2 943.2 Public Utilities. . . . . . . . . . . . 132.0 137.8 137.8 All Other Corporate . . . . . . . . . . 1,397.8 1,456.3 1,456.3 -------- -------- -------- Total Bonds . . . . . . . . . . . . . 6,567.0 6,864.5 6,864.5 -------- -------- -------- REDEEMABLE PREFERRED STOCKS. . . . . . . . 48.9 51.9 51.9 -------- -------- -------- Total Fixed Maturities. . . . . . . . . 6,615.9 6,916.4 6,916.4 -------- -------- -------- EQUITY SECURITIES: COMMON STOCKS: Public Utilities. . . . . . . . . . . . 72.8 85.1 85.1 Banks, Trusts and Insurance Companies . 77.5 131.4 131.4 All Other Corporate . . . . . . . . . . 350.5 437.2 437.2 -------- -------- -------- Total Common Stocks . . . . . . . . . 500.8 653.7 653.7 -------- -------- -------- OTHER PREFERRED STOCKS . . . . . . . . . . 99.2 105.4 105.4 -------- -------- -------- Total Equity Securities . . . . . . . . 600.0 759.1 759.1 -------- -------- -------- OTHER LONG-TERM INVESTMENTS: Mortgages Receivable . . . . . . . . . . . 112.2 112.2 Certificates of Deposit. . . . . . . . . . 35.5 35.5 Venture Capital Investments. . . . . . . . 42.7 42.7 Investment in Minority Affiliates. . . . . 1.1 1.1 Other Notes and Participations . . . . . . 10.9 10.9 Investments in Limited Partnerships. . . . 185.5 193.5 -------- -------- Total Other Long-Term Investments. . . . . . . . . . . . . . . . 387.9 395.9 -------- -------- OTHER SHORT-TERM INVESTMENTS: Money Market Instruments . . . . . . . . . 1,071.0 1,071.0 -------- -------- Total:. . . . . . . . . . . . . . . . . $8,674.8 $9,142.4 ======== ======== _____________________ (1) All fixed maturities are carried at market. SCHEDULE III THE CONTINENTAL CORPORATION - PARENT STATEMENTS OF INCOME (1) (2) Year Ended December 31 (millions) 1993 1992 1991 ------- ------- ------- REVENUES: Net Investment Income . . . . . . . . . $ 15.2 $ 17.7 $ 14.2 Realized Capital Losses . . . . . . . . (3.0) (6.0) (3.0) Equity in Earnings of Subsidiaries Dividends: $120.0; 1992 - $168.0; 1991 - $140.0. . . . 177.8 221.1 124.7 Equity in Earnings (Loss) of Discontinued Operations, Net of Income Taxes (Benefits)......... . . . . . . . . 48.7 (174.7) (54.9) Other Revenues. . . . . . . . . . . . . 61.4 6.4 8.8 ----- ----- ----- Total Revenues. . . . . . . . . . . 300.1 64.5 89.8 ----- ----- ----- EXPENSES: Interest Expense. . . . . . . . . . . . 48.6 49.5 43.8 Other Expenses. . . . . . . . . . . . . 24.9 59.0 4.7 ----- ----- ----- Total Expenses. . . . . . . . . . . 73.5 108.5 48.5 ----- ----- ----- Income (Loss) before Income Taxes and Net Cumulative Effect of Changes in Accounting Principles. . 226.6 (44.0) 41.3 ----- ----- ----- Total Income Taxes (Benefits) (3) . . . 18.2 28.7 (15.1) ----- ----- ----- Income (Loss) Before Net Cumulative Effect of Changes in Accounting Principles . . . . . . . 208.4 (72.7) 56.4 Net Cumulative Effect of Changes in Accounting Principles. . . . . . 1.6 (11.0) -- ----- ----- ----- Net Income (Loss) . . . . . . . . . . . $210.0 $(83.7) $56.4 ====== ====== ===== _______________________ (1) See Notes to Consolidated Financial Statements included in Continental's 1993 Annual Report to Shareholders. (2) Certain reclassifications, primarily for discontinued operations, have been made to the prior years' financial information to conform to the 1993 presentation. (3) Represents Income Taxes (Benefits) for continuing operations. SCHEDULE III (Continued) THE CONTINENTAL CORPORATION - PARENT BALANCE SHEETS (1) (2) DECEMBER 31 (millions, except par values and share amounts) 1993 1992 ---- ---- ASSETS: Fixed Maturities at Market (Amortized Cost - $40.2; 1992 - $98.4) . . . . . . . . . . $ 39.8 $ 98.0 Equity Securities at Market (Cost - $15.2; 1992 - $0.2). . . . . . . . . . . 15.3 0.2 Short-Term Investments . . . . . . . . . . 9.0 107.3 Other Long-Term Investments. . . . . . . . 6.1 58.6 Investment in Stocks of Subsidiaries: Insurance Subsidiaries - Equity Basis . 2,697.7 2,126.3 Discontinued Operations - Equity Basis . 84.6 310.5 Other Subsidiaries - Equity Basis . . . 146.6 147.4 Cash and Cash Equivalents. . . . . . . . . 0.1 3.1 Other Assets . . . . . . . . . . . . . . . 19.1 6.8 -------- -------- Total Assets. . . . . . . . . . . . . . $3,018.3 $2,858.2 ======== ======== LIABILITIES: Short-Term Debt. . . . . . . . . . . . . . $ 223.5 $ 554.0 Notes Payable. . . . . . . . . . . . . . . 346.8 198.6 Intercompany Balances. . . . . . . . . . . 94.9 96.3 Other Liabilities. . . . . . . . . . . . . 170.0 78.2 ----- ---- Total Liabilities . . . . . . . . . . . 835.2 927.1 ----- ----- Commitments and Contingencies -- -- ----- ----- Series C, Redeemable Preferred Stock . . . . . -- 20.5 ----- ----- SHAREHOLDERS' EQUITY: Preferred Stock, $4 Par Value. . . . . . . 0.3 0.3 Common Stock, $1 Par Value . . . . . . . . 65.7 65.7 Authorized Shares: 100,000,000 Issued Shares: 65,720,419; 1992 - 65,717,409 Outstanding Shares: 55,331,060; 1992 - 54,925,639 Paid-in Capital. . . . . . . . . . . . . . 613.2 616.2 Retained Earnings. . . . . . . . . . . . . 1,612.5 1,461.9 Net Unrealized Appreciation of Investments. . . . . . . . . . . . . . . 322.1 202.0 Cumulative Foreign Currency Translation Adjustment . . . . . . . . . . . . . . . (61.1) (52.4) Common Stock in Treasury, at Cost (10,389,359 Shares: 1992 - 10,790,770 Shares). . . . . . . . . . . (369.6) (383.1) -------- -------- Total Shareholders' Equity. . . . . . . 2,183.1 1,910.6 -------- -------- Total Liabilities, Commitments and Contingencies, Redeemable Preferred Stocks and Shareholders' Equity. . . $3,018.3 $2,858.2 ======== ======== __________________ (1) See Notes to Consolidated Financial Statements included in Continental's 1993 Annual Report to Shareholders. (2) Certain reclassifications, primarily for discontinued operations, have been made to the prior years' financial information to conform to the 1993 presentation. SCHEDULE III (Continued) THE CONTINENTAL CORPORATION - PARENT STATEMENTS OF CASH FLOWS (1) (2) Year Ended December 31 (millions) 1993 1992 1991 ------ ------- ------ CASH FLOWS FROM OPERATING ACTIVITIES: Net Income (Loss). . . . . . . . . . . $210.0 $(83.7) $ 56.4 Adjustments to Reconcile Net Income (Loss) to Net Cash provided from Operating Activities: Realized Capital Losses . . . . . . 3.0 6.0 3.0 Equity in Earnings of Subsidiaries. . . . . . . . . . (177.8) (221.1) (124.7) Equity in (Earnings) Loss of Discontinued Operations . . . . (48.7) 174.7 54.9 Other-Net . . . . . . . . . . . . . 74.1 78.8 (7.4) ----- ----- ----- Net Cash Provided from (Used in) Operating Activities. . . . . . . . . . . . 60.6 (45.3) (17.8) ----- ----- ----- CASH FLOWS FROM INVESTING ACTIVITIES: Cost of Investments Purchased . . . . . (72.0) (197.8) (35.5) Proceeds from Investments Sold. . . . . 111.9 94.8 37.1 Proceeds from Investments Matured . . . 0.2 3.0 0.1 Proceeds from Sales of Subsidiaries . . 330.0 -- 3.6 Investment in Subsidiaries. . . . . . . (399.3) -- -- Net Decrease (Increase) in Long-Term Investments . . . . . . . . . . . . . 0.4 2.8 (5.4) Net Decrease (Increase) in Short-Term Investments . . . . . . . . . . . . . 98.3 (103.8) 3.5 Dividends Paid by Subsidiaries. . . . . 120.0 168.0 140.0 ----- ----- ----- Net Cash Provided from (Used in) Investing Activities. . . . . . . . . . . . . 189.5 (33.0) 143.4 ----- ----- ----- CASH FLOWS FROM FINANCING ACTIVITIES: Cash Borrowings from (Repayments to) Subsidiaries. . . . . . . . . . . . (1.4) 22.3 (38.6) Decrease in Long-Term Debt. . . . . . . (1.8) (301.4) -- (Decrease) Increase in Short-Term Debt. (48.8) 275.2 51.9 Issuance of Long-Term Debt. . . . . . . 150.0 200.0 -- Retirement of Debt. . . . . . . . . . . (281.7) -- -- Sale of Treasury Shares . . . . . . . . 10.5 8.0 6.2 Dividends to Shareholders . . . . . . . (59.4) (123.1) (145.5) Redemption of Redeemable Preferred Stock. . . . . . . . . . . . . . . . (20.5) -- -- ----- ------ ----- Net Cash Provided from (Used in) Financing Activities. . . . . . . (253.1) 81.0 (126.0) ------ ------ ----- Net Increase (Decrease) in Cash and Cash Equivalents . . . . . . . . . . . . . . (3.0) 2.7 (0.4) Cash and Cash Equivalents at Beginning of Year. . . . . . . . . . . . . . . . . 3.1 0.4 0.8 ----- ----- ----- Cash and Cash Equivalents at End of Year . . . . . . . . . . . . . . . $ 0.1 $ 3.1 $ 0.4 ===== ===== ====== Supplemental Cash Flow Information: Federal, Foreign and State Taxes Paid . $ 4.5 $ 11.0 $ 5.6 ====== ======= ======= Interest Paid . . . . . . . . . . . . . $ 56.9 $ 45.6 $ 48.2 ====== ======= ======= _______________________ (1) See Notes to Consolidated Financial Statements included in Continental's 1993 Annual Report to Shareholders. (2) Certain reclassifications, primarily for discontinued operations, have been made to the prior years' financial information to conform to the 1993 presentation.

21665_1993.txt

21665_1993

1993

21665

ITEM 1. BUSINESS (a) General Development of the Business Colgate-Palmolive Company (the "Company") is a corporation which was organized under the laws of the State of Delaware in 1923. The Company manufactures and markets a wide variety of products throughout the world for use by consumers. For recent business developments, refer to the information set forth under the captions "Results of Operations" and "Liquidity and Capital Resources" in Part II, Item 7 of this report. (b) Financial Information About Industry Segments For information about industry segments see Note 1 to the Consolidated Financial Statements included on page 22 of this report. (c) Narrative Description of the Business For information regarding description of the business refer to the caption "Scope of Business" on page 13; "Average number of employees" appearing under "Historical Financial Summary" on page 45; and "Research and development" expenses appearing in Note 13 to the Consolidated Financial Statements on page 31 of this report. The Company's products are generally marketed by a sales force employed by each individual subsidiary or business unit. In some instances outside jobbers and brokers are used. Most raw materials used worldwide are purchased from others, are available from several sources and are generally available in adequate supply. Products and commodities such as tallow and essential oils are subject to wide price variations. No one of the Company's raw materials represents a significant portion of total material requirements. Trademarks are considered to be of material importance to the Company's business; consequently the practice is followed of seeking trademark protection by all available means. Although the Company owns a number of patents, no one patent is considered significant to the business taken as a whole. The Company has programs for the operation and design of its facilities which meet or exceed applicable environmental rules and regulations. Compliance with such rules and regulations has not significantly affected the Company's capital expenditures, earnings or competitive position. Capital expenditures for environmental control facilities totaled $9.4 million in 1993 and are budgeted at $13.9 million for 1994. For future years, expenditures are expected to be in the same range. (d) Financial Information About Foreign and Domestic Operations and Export Sales For information concerning geographic area financial data see Note 1 to the Consolidated Financial Statements on page 22 of this report. ITEM 2. ITEM 2. PROPERTIES The Company owns and leases a total of 266 manufacturing, distribution, research and office facilities worldwide. Corporate headquarters is housed in leased facilities at 300 Park Avenue, New York, New York. In the United States, the Company operates 68 facilities, of which 29 are owned. Major U.S. manufacturing and warehousing facilities used by the Oral, Personal and Household Care segment are located in Kansas City, Kansas; Morristown, New Jersey; Jeffersonville, Indiana; and Cambridge, Ohio. The Company is transforming its former facilities in Jersey City, New Jersey into a mixed-use complex with the assistance of developers and other investors. The Specialty Marketing segment has major facilities in Bowling Green, Kentucky; Topeka, Kansas; and Richmond, Indiana. Research facilities are located throughout the world, with the research center for Oral, Personal and Household Care products located in Piscataway, New Jersey. Overseas, the Company operates 198 facilities, of which 81 are owned, in over 50 countries. Major overseas facilities used by the Oral, Personal and Household Care segment are located in Australia, Brazil, Canada, Colombia, France, Germany, Italy, Mexico, Thailand, the United Kingdom and elsewhere throughout the world. In some areas outside the United States, products are either manufactured by independent contractors under Company specifications or are imported from the United States or elsewhere. All facilities operated by the Company are, in general, well maintained and adequate for the purpose for which they are intended. The Company conducts continuing reviews of its facilities with the view to modernization and cost reduction. ITEM 3. ITEM 3. LEGAL PROCEEDINGS For information regarding legal matters see Note 15 to the Consolidated Financial Statements included on page 33 of this report. 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 STOCK AND RELATED SHAREHOLDER MATTERS Refer to the information regarding the market for the Company's Common Stock and the quarterly market price information appearing under the caption "Market and Dividend Information" on page 15; the information under "Common Stock" in Note 6 to the Consolidated Financial Statements on page 24; and the "Number of shareholders of record" and "Cash dividends declared per common share" under the caption "Historical Financial Summary" on page 45 of this report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Refer to the information set forth under the caption "Historical Financial Summary" on page 45 of this report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations Net Sales Worldwide sales in 1993 increased 2% to $7,141.3 from $7,007.2 in 1992. Sales would have grown 7%, excluding the negative effects of foreign currency declines. Volume increased 5% for the year, including 1% resulting from increased ownership of the Company's Indian operation to majority control. Sales in the Oral, Personal and Household Care segment were $6,243.2, up 1% from $6,162.0 in 1992, and would have increased 7%, excluding the impact of unfavorable currency translation. Sales in the Asia/Africa region grew 20% on particularly strong volume gains led by Malaysia, Thailand and Hong Kong along with the volume contribution from the Indian consolidation. This sales increase was tempered by results in Australia/New Zealand and the Philippines, which were impacted by foreign currency declines, and in Africa, which was affected by poor economic conditions. Sales in the European region decreased 12% primarily due to currency translation. Volume declines of 3% in Western Europe, due to difficult economic conditions, were offset by volume increases in Central Europe led by Poland, Romania, and Turkiye. Latin America sales increased 16% due to selling price increases and overall volume growth of 7%. Sales increased in every country in Latin America with particularly strong increases in Mexico, Colombia, Ecuador and Central America. United States and Canada sales were down 4% due primarily to the effects of disinflationary pricing in the United States. Sales in the Specialty Marketing segment increased 6% to $898.1 versus $845.2 in 1992. Most of this growth came from Hill's Pet Nutrition, where sales increased 11% on volume growth of 8% reflecting continued growth in pet foods in both the domestic and international markets, particularly in Europe and Japan. Hill's accounts for over 80% of the Specialty Marketing segment's sales. Sales relating to non-core businesses continued to decline in 1993. Colgate's 1992 sales reflected a 16% increase over 1991 sales. The increase reflects sales growth in both industry segments. Overall unit volume increased 11%, including 5% contributed by the Mennen acquisition. Sales in the Oral, Personal and Household Care segment grew 17% with all geographic regions contributing to this growth. In the Asia/Africa region, sales increased 18% versus 1991. Sales in Europe, despite recessionary conditions, grew 10%, including expansion into Central Europe. Latin America and USA/Canada sales increased over 20% through internally generated new product activity and the addition of the Mennen personal care business. Sales in the Specialty Marketing segment were 6% higher than 1991, reflecting an 8% sales increase at Hill's Pet Nutrition. Gross Profit Gross profit margin improved to 47.8% from 47.1% in 1992 and 45.6% in 1991. The continuing improvement in gross profit reflects the Company's strategy to shift product mix to higher margin personal care product categories, reduce overhead and improve manufacturing efficiency by focusing investments in high-return capital projects. Improvement in the profitability of sales enables the Company to generate more cash from operations to reinvest in its existing businesses in the form of research and development and advertising, to launch new products, to expand geographically, to invest in strategic acquisitions within its core businesses, and to pay dividends. Selling, General and Administrative Expenses Selling, general and administrative expenses as a percent of sales decreased to 34% in 1993 as compared with 36% in 1992 and 35% in 1991. The decrease in 1993 expenditures reflects the continued efforts of the Company to reduce overhead expenses, offset in part by higher advertising and product promotion spending as well as increased research and development activity. The increase in 1992 reflects increases in advertising and research and development as these expenditures support current business growth levels and are investments to maintain the Company's competitive advantage in introducing new and improved products in its strategic core businesses. In September 1991, the Company announced a manufacturing and organizational restructuring program designed to capitalize on opportunities created by movement to common markets in Europe and North America, more sophisticated and efficient manufacturing techniques, and consolidation opportunities created by several acquisitions around the world. The program included organizational realignments, manufacturing reconfigurations and the write-down of certain property, plant and equipment. As a result, the Company recorded a pretax charge of $340.0 ($243.0 aftertax or $1.80 per share) in 1991. Other Expense and Income Other expense and income consists principally of earnings from equity investments, amortization of goodwill and other intangible assets, and minority interest in earnings of less-than-100%-owned consolidated subsidiaries. Amortization expense in 1993 and 1992 increased from 1991 due to higher levels of intangible assets stemming from the Company's recent acquisitions, most notably Mennen, which continued the Company's expansion into high-margin personal care businesses. The decrease in equity earnings and increase in minority interest primarily results from increased ownership in the Company's Indian operation to majority control. Earnings Before Interest and Taxes Earnings before interest and taxes (EBIT) increased 14% to $883.0 in 1993 as compared with $777.9 in the prior year. The Oral, Personal and Household Care segment reported 12% growth in EBIT to $731.5 versus $653.2 in 1992, with gains in the developing regions offsetting declines in the developed world, which were impacted by difficult business climates. Within this segment, United States and Canada EBIT decreased 5% to $177.8 as compared with the prior year primarily due to lower selling prices. EBIT in Europe decreased 9% due to the negative impact of foreign currency translation and difficult economic conditions. In Latin America, EBIT improved 30% to $249.6 in 1993 versus the prior year while Asia/Africa increased 50%, including the consolidation of India. Overall, the higher margin product mix and reduced selling, general and administrative expenses allowed for increased investment in advertising and product promotion and in research and development, as well as the achievement of a higher level of EBIT. In the Specialty Marketing segment, EBIT was $156.9 in 1993 as compared with $142.9 in 1992. The improvement results principally from higher domestic unit volume growth and expanded international distribution at Hill's Pet Nutrition, particularly in Europe and Japan. EBIT was $777.9 in 1992 as compared with $282.6 in 1991, which included the effects of a restructuring charge. Excluding the impact of the 1991 restructuring charge, EBIT increased 25%. The Oral, Personal and Household Care segment reported EBIT of $653.2 versus $202.8 in 1991. EBIT in this segment improved 32%, excluding the effects of the 1991 charge, with all geographic regions contributing to this increase. The 17% increase in sales and the move to a higher margin product mix allowed for increased advertising and the achievement of a higher level of EBIT. In the Specialty Marketing segment, EBIT was $142.9 in 1992 as compared with $100.4 in 1991, which included the effects of the restructuring charge. Excluding the 1991 provision for restructuring, results in this segment improved 11%, principally from higher unit volume growth and expanded European distribution at Hill's Pet Nutrition. Net Interest Expense Interest expense, net of interest income, was $46.8 in 1993 compared with $50.0 in 1992 and $64.7 in 1991. The decrease in net interest expense in 1993 in spite of higher debt, primarily to finance share repurchases, reflects a general decline in interest rates and the Company's refinancing of higher rate long-term debt during the year. The decrease in net interest expense in 1992 included the effect of the Company's equity offering late in the fourth quarter of 1991, the proceeds of which were used to reduce borrowings, as well as a decline in interest rates and the Company's refinancings early in 1992 of higher rate long-term debt. Income Taxes In 1993 and 1992, the effective tax rate on income was 34.5%. The increase in the U.S. statutory tax rate in 1993 was in part offset by statutory rate reductions in several overseas jurisdictions. In 1991, the effective tax rate was 43%, which reflected the lower tax benefits recognized on certain elements of the restructuring provision outside the United States. Excluding the effect of the restructuring provision, the effective tax rate in 1991 was 34%. Global tax savings strategies benefited the effective rate in 1993, 1992 and 1991. Net Income Net income was $189.9 in 1993 or $1.08 per share on a primary basis compared with $477.0 or $2.92 per share in 1992. Included in 1993 net income and per share amounts is the cumulative one-time impact on prior years of adopting new mandated accounting standards effective January 1, 1993 for income taxes, other postretirement benefits and postemployment benefits. Before the changes in accounting, 1993 income increased 15% to $548.1 or $3.38 per share on a primary basis. Net income was $124.9 or $.77 per share in 1991. Included in 1991 net income and per share amounts is the provision for restructuring of $243.0 net of tax or $1.80 per share on a primary basis. Return on sales was 7.7% in 1993 (excluding the impact of accounting changes) compared with 6.8% in 1992 and 6.1% in 1991 (2.1% including the restructuring charge), reflecting the Company's shift to higher margin categories and focus on cost containment. Liquidity and Capital Resources Net cash provided by operations increased to $710.4 in 1993 compared with $542.7 in 1992 and $485.7 in 1991. The improvement in cash generated by operating activities from 7.7% of sales in 1992 to 9.9% of sales in 1993 reflects the Company's improving profitability and continued management emphasis on working capital. Cash generated from operations was used to finance acquisitions, repurchase shares and fund an increased dividend level. The Company has additional sources of liquidity available in the form of lines of credit maintained with various banks. Such lines of credit amounted to $1,303.2 at December 31, 1993. The Company also has the ability to issue commercial paper at favorable interest rates to meet short-term liquidity needs. These borrowings carry a Standard & Poor's rating of A1 and a Moody's rating of P1. During the 1993 first quarter, the Company repaid outstanding debt totaling $85.7 which included $50.0 of 8.9% Swiss franc notes due in 1993. During the third quarter, the Company redeemed $79.0 of its 9.625% debentures issue due 2017. During 1992, the Company increased the amount available under its shelf registration from $150.0 to $400.0. In the fourth quarter of 1993, $230.0 of medium term notes were issued under this registration in addition to $169.2 issued in the fourth quarter of 1992. These notes are rated A1/A+ by Moody's and Standard & Poor's, respectively. During the third quarter of 1993, the Company participated in the formation of a business which purchases receivables, including Company receivables. Outside institutions invested $60.0 in this entity. The Company consolidates this entity and the amounts invested by the outside institutions are classified as a minority interest. Colgate's reputation, global presence and strong capital position afford it access to debt and equity markets around the world, enabling the Company to raise funds with a low effective cost. The Company manages its exposure related to foreign currency borrowings through the use of various currency agreements. The Company also actively manages its debt position to optimize the maturities of debt issues as well as the mix of fixed and floating rate debt. At December 31, 1993, the Company had in place interest rate agreements with banks having a notional principal amount of $447.0. Capital expenditures in 1993 were $364.3 or 5.1% of sales as compared with $318.5 in 1992 and $260.7 in 1991. The increase in 1993 spending was focused primarily on projects that yield high aftertax returns, thereby reducing the Company's cost structure. Capital expenditures for 1994 are expected to continue at or slightly above the current rate of approximately 5% of sales. Other investing activities in 1993, 1992 and 1991 included strategic acquisitions and equity investments worldwide. In October 1993, the Company acquired the liquid hand and body soap brands of S.C. Johnson Wax in Europe, the South Pacific and other international locations. During the year the Company also acquired the Cristasol glass cleaner business in Spain, increased ownership of its Indian operation to majority control and made other investments. The aggregate purchase price of all 1993 acquisitions was $222.5. Acquisitions totaled $718.4 in 1992 and $339.4 in 1991 and included businesses in the household care, fabric care, personal care and oral care categories. In March 1992, the Company acquired The Mennen Company for an aggregate purchase price of approximately $670.0. The purchase price was paid with 11.6 million unregistered shares of the Company's common stock and $127.0 in cash. Other acquisitions included significant ownership positions in joint ventures in China and Eastern Europe, The Murphy-Phoenix Company and the Plax worldwide business excluding the United States, Canada and Puerto Rico. Goodwill and other intangible assets increased as a result of these acquisitions. During 1993, the Company repurchased common shares in the open market and private transactions to provide for employee benefit plans and to maintain its target capital structure. Aggregate repurchases for the year approximated 12 million shares with a total purchase price of $673.0. In the first quarter of 1994, the Board of Directors authorized the repurchase of up to an additional five million shares. The ratio of debt to total capitalization (defined as the ratio of debt to debt plus equity) increased to 48% during 1993 from 30% in 1992. The return on average shareholders' equity, before accounting changes, increased to 24% from 21% during the same period as this shift towards targeted capitalization benefited overall shareholder return. The decrease in debt to total capitalization in 1992 from the 1991 level of 36% reflects the issuance of shares in connection with the acquisition of The Mennen Company. Dividend payments were $240.8 in 1993 ($231.4 aftertax), up from $211.1 ($200.7 aftertax) in 1992, reflecting a 16% increase in the common dividend effective in the third quarter of 1993. Common dividend payments increased to $1.34 per share in 1993 from $1.15 per share in 1992. The Series B Preference Stock dividends were declared and paid at the stated rate of $4.88 per share. The increase in dividend payments in 1992 over 1991 reflects a 17% increase in the common dividend effective in the third quarter of 1992. Internally generated cash flows appear to be adequate to support currently planned business operations and capital expenditures. However, certain events, such as significant acquisitions, could require external financing. The Company is a party to various superfund and other environmental matters and is contingently liable with respect to lawsuits, taxes and other matters arising out of the normal course of business. While it is possible that the Company's cash flows and results of operations in particular quarterly or annual periods could be affected by the one- time impacts of the resolution of such contingencies, it is the opinion of management that the ultimate disposition of these matters, to the extent not previously provided for, will not have a material impact on the Company's financial condition or ongoing cash flows and results of operations. New Accounting Standards In May 1993, the Financial Accounting Standards Board issued Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. The Company will adopt the provisions of this new standard effective January 1, 1994, and prior periods will not be restated. The effect of adoption will not be material to financial condition, results of operations or cash flows. Outlook As the Company enters 1994, continued recessionary conditions in certain major markets present some uncertainty in the near term while further expansion into the markets of the developing world presents strong opportunity for growth. The global economic situation for 1994 is not expected to be materially different from that experienced in 1993. Historically, the consumer products industry has been less susceptible to changes in economic growth than many other industries. Over the long term, Colgate's continued focus on its consumer products business and the strength of its global brand names, its broad international presence in both developed and developing markets, and its strong capital base all position the Company to take advantage of growth opportunities and to continue to increase profitability and shareholder value. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See the "Index to Financial Statements" which is located on page 12 of this report in the section entitled "Financial Statements for the year ended December 31, 1993 and Other Supplementary Data". 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 directors and executive officers of the registrant set forth in the Proxy Statement for the 1994 Annual Meeting is incorporated herein by reference. The following is a list of executive officers as of March 24, 1994: Date First Elected Name Age Officer Present Title Reuben Mark 55 1974 Chairman of the Board and Chief Executive Officer William S. Shanahan 53 1983 President and Chief Operating Officer Robert M. Agate 58 1985 Senior Executive Vice President and Chief Financial Officer William G. Cooling 49 1981 Chief of Operations, Specialty Marketing and International Business Development Lois D. Juliber 45 1991 Chief Technological Officer Silas M. Ford 56 1983 Executive Vice President Office of the Chairman Andrew D. Hendry 46 1991 Senior Vice President General Counsel and Secretary Douglas M. Reid 59 1990 Senior Vice President Global Human Resources John E. Steel 64 1991 Senior Vice President Global Business Development Edgar J. Field 54 1991 President, International Business Development Edward T. Fogarty 57 1991 President, Colgate- USA/Canada/Puerto Rico David A. Metzler 51 1991 President, Colgate-Europe Michael J. Tangney 49 1993 President, Colgate-Latin America Craig B. Tate 48 1989 President, Colgate-Asia Robert C. Wheeler 52 1991 President, Hill's Pet Nutrition, Inc. Date First Elected Name Age Officer Present Title Steven R. Belasco 47 1991 Vice President Taxation Brian J. Heidtke 53 1986 Vice President Finance and Corporate Treasurer Peter D. McLeod 53 1984 Vice President Manufacturing Engineering Technology Stephen C. Patrick 44 1990 Vice President Corporate Controller Michael S. Roskothen 57 1993 Vice President Global Business Development - Oral Care Each of the executive officers listed above has served the registrant or its subsidiaries in various executive capacities for the past five years, except Douglas M. Reid and Andrew D. Hendry. Douglas M. Reid served as Senior Vice President and Senior Staff Officer at Xerox prior to joining the Company in 1990. Andrew D. Hendry was Vice President, General Counsel for UNISYS prior to joining the Company in 1991. The Company By-Laws, paragraph 38, states: The officers of the corporation shall hold office until their respective successors are chosen and qualified in their stead, or until they have resigned, retired or been removed in the manner hereinafter provided. Any officer elected or appointed by the Board of Directors may be removed at any time by the affirmative vote of a majority of the whole Board of Directors. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information set forth in the Proxy Statement for the 1994 Annual Meeting is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Security ownership of management set forth in the Proxy Statement for the 1994 Annual Meeting is incorporated herein by reference. (b) There are no arrangements known to the registrant that may at a subsequent date result in a change in control of the registrant. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Election of Directors" in the Proxy Statement for the 1994 Annual Meeting is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial Statements and Financial Statement Schedules See the "Index to Financial Statements" which is located on page 12 of this report in the section entitled "Financial Statements for the year ended December 31, 1993 and Other Supplementary Data". (b) Exhibits. See the exhibit Index which is located on Page 47. (c) 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. COLGATE-PALMOLIVE COMPANY (Registrant) Date March 24, 1994 By /s/ REUBEN MARK Reuben Mark 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. (a) Principal Executive Officer (c)Principal Accounting Officer /s/ REUBEN MARK /s/ STEPHEN C. PATRICK Reuben Mark Stephen C. Patrick Chairman of the Board Vice President and Chief Executive Officer Corporate Controller Date March 24, 1994 Date March 24, 1994 (b) Principal Financial Officer (d)Directors: /s/ ROBERT M. AGATE Vernon R. Alden, Jill K. Conway, Robert M. Agate Ronald E. Ferguson, Ellen M. Hancock, Senior Executive Vice President David W. Johnson, John P. Kendall, and Chief Financial Officer Delano E. Lewis, Reuben Mark, Howard B. Wentz, Jr. Date March 24, 1994 By /s/ ANDREW D. HENDRY Andrew D. Hendry as Attorney-in-Fact Date March 24, 1994 United States Securities and Exchange Commission Washington , D.C. 20549 FORM 10-K FINANCIAL STATEMENTS For The Year Ended December 31, 1993 and Other Supplementary Data COLGATE-PALMOLIVE COMPANY NEW YORK, NEW YORK 10022 COLGATE-PALMOLIVE COMPANY Page Supplementary Data Scope of Business 13 Geographic Area Data 13 Industry Segment Data 14 Market and Dividend Information 15 Quarterly Financial Data 16 Financial Statements Consolidated Statement of Income for the years ended December 31, 1993, 1992 and 1991 17 Consolidated Balance Sheet at December 31, 1993 and 1992 18 Consolidated Statement of Retained Earnings and Changes in Capital Accounts for the years ended December 31, 1993, 1992 and 1991 19 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 20 Notes to Consolidated Financial Statements 21 - 33 Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991: V Property, Plant and Equipment 34 - 36 VI Accumulated Depreciation of Property, Plant and Equipment 37 - 39 VIII Valuation and Qualifying Accounts 40 - 42 IX Short-Term Borrowings 43 Report of Independent Public Accountants 44 Selected Financial Data Historical Financial Summary 45 All other financial statements and schedules not listed have been omitted since the required information is included in the financial statements or the notes thereto or is not applicable or required. COLGATE-PALMOLIVE COMPANY Scope of Business The Company manufactures and markets a wide variety of products in the U.S. and around the world in two distinct business segments: Oral, Personal and Household Care, and Specialty Marketing. Oral, Personal and Household Care products include toothpastes, oral rinses and toothbrushes, bar and liquid soaps, shampoos, conditioners, deodorants and antiperspirants, baby and shave products, laundry and dishwashing detergents, fabric softeners, cleansers and cleaners, bleach, and other similar items. Specialty Marketing products include pet dietary care products, crystal tableware, and portable fuel for warming food. Principal global trademarks and tradenames include Colgate, Palmolive, Mennen, Ajax, Fab and Science Diet in addition to various regional tradenames. The Company's principal classes of products accounted for the following percentages of worldwide sales for the past three years: Company products are marketed under highly competitive conditions. Products similar to those produced and sold by the Company are available from competitors in the U.S. and overseas. Product quality, brand recognition and acceptance, and marketing capability largely determine success in the Company's business segments. As shown in the geographic area data that follow, more than half of the Company's net sales, operating profit and identifiable assets are attributable to overseas operations. Export sales and transfers between geographic areas are not significant. COLGATE-PALMOLIVE COMPANY COLGATE-PALMOLIVE COMPANY Market and Dividend Information The Company's common stock and $4.25 Preferred Stock are listed on the New York Stock Exchange. The trading symbol for the common stock is CL. Dividends on the common stock have been paid every year since 1895, and the amount of dividends paid per share has increased for 31 consecutive years. COLGATE-PALMOLIVE COMPANY Quarterly Financial Data (Unaudited) Dollars in Millions Except Per Share Amounts COLGATE-PALMOLIVE COMPANY Consolidated Statement of Income Dollars in Millions Except Per Share Amounts See Notes to Consolidated Financial Statements. COLGATE-PALMOLIVE COMPANY Consolidated Balance Sheet Dollars in Millions Except Per Share Amounts See Notes to Consolidated Financial Statements. COLGATE-PALMOLIVE COMPANY Consolidated Statement of Retained Earnings Consolidated Statement of Changes in Capital Accounts See Notes to Consolidated Financial Statements. COLGATE-PALMOLIVE COMPANY Consolidated Statement of Cash Flows Dollars in Millions See Notes to Consolidated Financial Statements. COLGATE-PALMOLIVE COMPANY Notes to Consolidated Financial Statements Dollars in Millions Except Per Share Amounts 1. Summary of Significant Accounting Policies Principles of Consolidation The Consolidated Financial Statements include the accounts of Colgate- Palmolive Company and its majority-owned subsidiaries. Intercompany transactions and balances have been eliminated. Investments in companies in which the Company's interest is between 20% and 50% are accounted for using the equity method. The Company's share of the net income from such investments is recorded as equity earnings and is classified as other income in the Consolidated Statement of Income. Revenue Recognition Sales are recorded at the time products are shipped to trade customers. Net sales reflect units shipped at selling list prices reduced by trade promotion allowances. Cash and Cash Equivalents The Company considers all highly liquid investments with maturities of three months or less when purchased to be cash equivalents for purposes of the Consolidated Balance Sheet and the Consolidated Statement of Cash Flows. Investments in short-term securities that do not meet the definition of cash equivalents are classified as marketable securities in the Consolidated Balance Sheet. Marketable securities are reported at cost, which approximates market. Inventories Inventories are valued at the lower of cost or market. The last-in, first-out (LIFO) method is used to value substantially all inventories in the U.S. as well as in certain overseas locations. The remaining inventories are valued using the first-in, first-out (FIFO) method. Property, Plant and Equipment Land, buildings, and machinery and equipment are stated at cost. Depreciation is provided, primarily using the straight-line method, over estimated useful lives ranging from 3 to 40 years. Goodwill and Other Intangibles Goodwill represents the excess of purchase price over the fair value of identifiable tangible and intangible net assets of businesses acquired. Goodwill and other intangibles are amortized on a straight-line basis over periods not exceeding 40 years. Income Taxes Effective January 1, 1993, deferred taxes are recognized for the expected future tax consequences of temporary differences between the amounts carried for financial reporting and tax purposes. Provision is made currently for taxes payable on remittances of overseas earnings; no provision is made for taxes on overseas retained earnings that are deemed to be permanently reinvested. Postretirement and Postemployment Benefits Effective January 1, 1993, the cost of postretirement health care and other benefits is actuarially determined and accrued over the service period of covered employees. Translation of Overseas Currencies The assets and liabilities of subsidiaries, other than those operating in highly inflationary environments, are translated into U.S. dollars at year-end exchange rates, with resulting translation gains and losses accumulated in a separate component of shareholders' equity. Income and expense items are converted into U.S. dollars at average rates of exchange prevailing during the year. For subsidiaries operating in highly inflationary environments, inventories and property, plant and equipment are translated at the rate of exchange on the date the assets were acquired, while other assets and liabilities are translated at year-end exchange rates. Translation adjustments for these operations are included in net income. Geographic Areas and Industry Segments The financial and descriptive information on the Company's geographic area and industry segment data, appearing on pages 13 and 14 of this report, is an integral part of these financial statements. 2. Acquisitions In October 1993, the Company acquired the liquid hand and body soap brands of S.C. Johnson Wax in Europe, the South Pacific and other international locations. During the year, the Company also acquired the Cristasol glass cleaner business in Spain, increased ownership of its Indian operation to majority control and made other investments. The aggregate purchase price of all 1993 acquisitions was $222.5. In March 1992, the Company acquired The Mennen Company ("Mennen") for an aggregate purchase price of $670.0, paid with 11.6 million unregistered shares of the Company's common stock and $127.0 in cash. The acquisition included Mennen's personal care products business and businesses held for sale that were sold in August 1992. The results of operations of Mennen have been included in the Consolidated Financial Statements since March 27, 1992. During 1992, the Company also acquired the remaining interest in Viset, an Italian manufacturer of consumer products, and established significant ownership positions in joint ventures in China and Eastern Europe. The aggregate purchase price of all 1992 acquisitions was $718.4. During 1991, the Company acquired the Murphy-Phoenix Company, which owned an all-purpose cleaner business. Internationally, the Company acquired the Plax antiplaque mouthwash business for worldwide markets excluding the U.S., Canada and Puerto Rico, the remaining interest in the Unisol Group of Companies in Portugal, the personal care business of ICI in Australia, a majority interest in Haci Sakir, a soap and body care business in Turkiye, and the Brazilian Pinesol household cleaner business. The aggregate purchase price of 1991 acquisitions was $339.4. All of these acquisitions have been accounted for as purchases, and, accordingly, the purchase prices were allocated to the net tangible and intangible assets acquired based on estimated fair values at the dates of the respective acquisitions. The results of operations have been included in the Consolidated Financial Statements since the respective acquisition dates. The inclusion of pro forma financial data for these acquisitions prior to the dates of acquisition would not have materially affected reported results. 3. Restructured Operations In September 1991, the Company announced a manufacturing and organizational restructuring program designed to capitalize on opportunities created by movement to common markets in Europe and North America, more sophisticated and efficient manufacturing techniques, and consolidation opportunities created by several acquisitions around the world. The program included organizational realignments, manufacturing reconfigurations and the write-down of certain property, plant and equipment. As a result, the Company recorded a pretax charge of $340.0 ($243.0 aftertax or $1.80 per share) in 1991. 4. Long-Term Debt and Credit Facilities Long-term debt consists of the following at December 31: Other debt consists of capitalized leases and individual fixed and floating rate issues of less than $50.0 with various maturities. Scheduled maturities of debt outstanding at December 31, 1993, exclusive of capitalized lease obligations, are as follows: 1994 - $13.5; 1995 - $37.5; 1996 - $38.1; 1997 - $46.8, and 1998 - $52.4. Commercial paper is classified as long-term debt in accordance with the Company's intent and ability to refinance such obligations on a long-term basis. At December 31, 1993, the Company had unused credit facilities amounting to $1,303.2. Included in this total is a $460.0 revolving credit facility that provides for general corporate borrowings and expires in March 1995. Interest on borrowings under the agreement is based on Base (Prime) rates, Certificate of Deposit rates or Eurodollar rates. No borrowings were outstanding under this credit agreement at December 31, 1993. Commitment fees related to credit facilities are not material. The Company has entered into various foreign exchange contracts to hedge currency exposures associated with its net investment in foreign operations, intercompany loans and other foreign currency transactions. At December 31, 1993, the outstanding net face amounts of these contracts totaled approximately $440.7. The Company has also entered into a series of interest rate swap agreements with banks having a total notional principal amount of $447.0 with maturity dates through 2023. The contracts enable the Company to change the effective interest rate on its debt according to corporate needs and market conditions. 5. Leases At December 31, 1993, future minimum rental payments under capital and operating leases were as follows: Rent expense for all operating leases totaled $91.5 in 1993 and $80.3 in 1992 and 1991. 6 Capital Stock and Stock Option Plans Preferred Stock Preferred Stock consists of 250,000 authorized shares without par value. It is issuable in series, of which one series of 125,000 shares, designated $4.25 Preferred Stock, with a stated and redeemable value of $100 per share, has been issued and is outstanding. Dividends on the $4.25 Preferred Stock are cumulative. Under the provisions of the Certificate of Incorporation, the Preferred Stock is subject to redemption only at the option of the Company. Preference Stock In 1988, the Company's Certificate of Incorporation was amended to authorize the issuance of a new class of preferred stock consisting of 50,000,000 shares of Preference Stock, without par value. The Preference Stock, which is convertible into two shares of common stock, ranks junior to all series of the Preferred Stock with respect to the payment of dividends and the distribution of assets of the Company. At December 31, 1993 and 1992, 6,181,480 and 6,242,765 shares of Preference Stock, respectively, were outstanding and issued to the Company's ESOP. Common Stock In March 1992, the Company issued 11,648,693 unregistered shares of its common stock in connection with acquiring Mennen. Certain registration rights were granted for a portion of the shares issued in connection with the transaction. In November 1991, the Company issued an additional 11,500,000 common shares through a public offering and simultaneously retired 11,500,000 shares of treasury stock. In connection with acquiring The Murphy-Phoenix Company, the Company also issued 1,571,730 shares of its common stock. At December 31, 1993 and 1992, 507,855 and 476,185 shares, respectively, were held for distribution under the Executive Incentive Compensation Plan, which provides for cash and common stock awards for officers and other executives of the Company and its major subsidiaries. The cost of these shares totaled $22.7 at December 31, 1993 and $17.0 at December 31, 1992. In October 1988, the Board of Directors authorized the redemption of the then outstanding common stock purchase rights for a total of $6.9. A new rights plan was adopted, and stockholders received a distribution of one Preference Share Purchase Right ("Right") for each outstanding share of the Company's common stock. Each Right entitles stockholders to buy one two-hundredth interest in a share of a new series of preference stock at an exercise price of $87.50. Each interest is designed to make it the economic equivalent of one share of common stock. A Right is exercisable only if a person or group acquires 20% or more of the Company's common stock or announces a tender offer, the consummation of which would result in ownership by a person or group of 20% or more of the common stock. If the Company is acquired in a merger or other business combination transaction, each Right will entitle its holder to purchase, at the Right's then current exercise price, a number of the acquiring company's common shares having a market value at that time of twice the Right's exercise price. In addition, if a person or group acquires 30% or more of the Company's outstanding common stock, otherwise than pursuant to a cash tender offer for all shares in which such person or group increases its stake from below 20% to 80% or more of the outstanding shares, each Right will entitle its holder (other than such person or members of such group) to purchase, at the Right's then current exercise price, a number of shares of the Company's common stock having a market value of twice the Right's exercise price. Further, at any time after a person or group acquires 30% or more (but less than 50%) of the Company's outstanding common stock, the Board of Directors may, at its option, exchange part or all of the Rights (other than Rights held by the acquiring person or group) for shares of the Company's common stock on a one-for-one basis. Prior to the acquisition by a person or group of beneficial ownership of 20% or more of the Company's common stock, each Right is redeemable at the option of the Board of Directors at a price of $.005. The Board of Directors is also authorized to reduce the 20% and 30% thresholds referred to above to not less than 15%. The new Rights will expire on October 24, 1998. There were 149,256,603 Preference Share Purchase Rights outstanding at December 31, 1993 and 160,240,404 at December 31, 1992. Stock Option Plans The Company's 1987 Stock Option Plan provides for the issuance of non- qualified stock options to officers and key employees. The non-qualified stock options permit optionees to acquire common stock of the Company upon payments of cash or stock. Options are granted at prices not less than the fair market value on the date of grant. At December 31, 1993, 6,726,478 shares were available for future grants. The Company's 1977 Stock Option Plan terminated during 1987, except as to options granted. During 1992, an Accelerated Ownership feature was added to the 1987 Stock Option Plan. The Accelerated Ownership feature provides for the grant of new options when previously owned shares of Company stock are used to exercise existing options. The number of new options granted under this feature is equal to the number of shares of previously owned Company stock used to exercise the original options and to pay the related required U.S. income tax. The new options are granted at a price equal to the fair market value on the date of the new grant and have the same expiration date as the original options exercised. Stock option plan activity is summarized below: 7. Employee Stock Ownership Plan In 1989, the Company expanded its employee stock ownership plan (ESOP) through the introduction of a leveraged ESOP covering employees who have met certain eligibility requirements. The ESOP issued $410.0 of long- term notes due through 2009 bearing an average interest rate of 8.6%. The long-term notes, which are guaranteed by the Company, are recorded on the accompanying Consolidated Balance Sheet. The ESOP used the proceeds of the notes to purchase 6.3 million shares of Series B Convertible Preference Stock from the Company. The Stock has a minimum redemption price of $65 per share and pays semi-annual dividends equal to the higher of $2.44 or the current dividend paid on two common shares for the comparable six-month period. Each share may be converted by the Trustee into two shares of common stock. Dividends on these preferred shares, as well as common shares also held by the ESOP, are paid to the ESOP trust and, together with Company contributions, are used by the ESOP to repay principal and interest on the outstanding notes. Preferred shares are released for allocation to participants based upon the ratio of the current year's debt service to the sum of total principal and interest payments over the life of the loan. At December 31, 1993, 860,469 shares were allocated to participant accounts. Dividends on these preferred shares are deductible for income tax purposes and, accordingly, are reflected net of their tax benefit in the Consolidated Statement of Retained Earnings. Annual expense related to the leveraged ESOP, determined as interest incurred on the notes, less dividends received on the shares held by the ESOP, plus the higher of either principal repayments on the notes or the cost of shares allocated, was $7.9 in 1993, $8.1 in 1992 and $6.9 in 1991. Similarly, unearned compensation, shown as a reduction in shareholders' equity, is reduced by the higher of principal payments or the cost of shares allocated. Interest incurred on the ESOP's notes amounted to $34.5 in 1993, $35.1 in 1992 and $35.3 in 1991. The Company paid dividends on the stock held by the ESOP of $32.7 in 1993, $32.8 in 1992 and $34.0 in 1991. Company contributions to the ESOP were $5.7 in 1993, $5.6 in 1992 and $4.9 in 1991. 8. Retirement Plans and Other Postretirement Benefits Retirement Plans The Company, its U.S. subsidiaries and a majority of its overseas subsidiaries maintain pension plans covering substantially all of their employees. Most plans provide pension benefits that are based primarily on years of service and employees' career earnings. In the Company's principal U.S. plans, funds are contributed to trustees as necessary to provide for current service and for any unfunded projected benefit obligation over a reasonable period. To the extent these requirements are exceeded by plan assets, a contribution may not be made in a particular year. Plan assets consist principally of common stocks, deposit administration contracts with insurance companies, investments in real estate funds and U.S. Government obligations. Net periodic pension expense includes the following components: The following table sets forth the funded status of the plans at December 31: The actuarial assumptions used to determine the above data were as follows: Other Postretirement and Postemployment Benefits The Company and certain of its subsidiaries provides health care and life insurance benefits for retired employees to the extent not provided by government-sponsored plans. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106). SFAS 106 requires the Company to change its method of accounting for its postretirement life and health care benefits provided to retirees from the "pay-as-you-go" basis to accruing such costs over the working lives of the employees. The Company elected to recognize this change in accounting on the immediate recognition basis and utilizes a portion of its leveraged ESOP, in the form of future retiree contributions, to reduce its obligation to provide these postretirement benefits. Postretirement benefits currently are not funded. The Company also adopted SFAS 112, "Employers' Accounting for Postemployment Benefits." SFAS 112 requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. The cumulative effect on prior years of adopting SFAS 106 and 112 as of January 1, 1993 resulted in a pretax charge of $195.7 ($129.2 aftertax or $.83 per share) of which $189.5 related to SFAS 106 and $6.2 related to SFAS 112. This non-cash charge represents the accumulated benefit obligation net of related accruals previously recorded by the Company. Postretirement benefits expense for 1993 included the following components: The cash cost to the Company for postretirement benefits in 1992 and 1991, excluding acquisitions, approximated $11.2 and $11.8, respectively. The pro forma effects of retroactive application of this mandated change in accounting were not determinable. The postretirement benefit obligation included in Other liabilities in the Consolidated Balance Sheet at December 31, 1993 was comprised of the following components: The principal actuarial assumptions used in the measurement of the accumulated benefit obligation were as follows: The cost of these postretirement medical benefits is dependent upon a number of factors, the most significant of which is the rate at which medical costs increase in the future. The effect of a 1% increase in the assumed medical cost trend rate would increase the accumulated postretirement benefit obligation by approximately $20.2; annual expense would not be materially affected. 9. Income Taxes Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). The one-time non-cash charge for the recalculation of income taxes was $229.0 ($1.47 per share), primarily as a result of the 1992 acquisition of Mennen. Prior years' financial statements have not been restated to apply the provisions of SFAS 109. The provision for income taxes on income before changes in accounting consists of the following for the years ended December 31: Differences between accounting for financial statement purposes and accounting for tax purposes result in taxes currently payable (lower) higher than the total provision for income taxes as follows: In addition, tax benefits of $21.3 in 1993 were recorded directly through equity. The components of income before income taxes are as follows for the three years ended December 31: The difference between the statutory United States federal income tax rate and the Company's global effective tax rate as reflected in the Consolidated Statement of Income is as follows: The components of deferred taxes at December 31, 1993 are as follows: 10. Foreign Currency Translation Cumulative translation adjustments, which represent the effect of translating assets and liabilities of the Company's non-U.S. entities, except those in highly inflationary economies, were as follows: Foreign currency charges, resulting from the translation of balance sheets of subsidiaries operating in highly inflationary environments and from foreign currency transactions, were not material in 1993, 1992 and 1991. 11. Earnings Per Share Primary earnings per share are determined by dividing net income, after deducting preferred stock dividends net of related tax benefits ($21.6 net in 1993, $20.7 net in 1992 and $20.8 net in 1991), by the weighted average number of common shares outstanding (155.9 million in 1993, 156.5 million in 1992 and 135.3 million in 1991). Fully diluted earnings per common share are calculated assuming the conversion of all potentially dilutive securities, including convertible preferred stock and outstanding options, unless the effect of such conversion is antidilutive. This calculation also assumes, if applicable, reduction of available income by pro forma ESOP replacement funding, net of income taxes. 12. Supplemental Cash Flow Information 13. Other Income Statement Information Other expense (income), consists of the following for the years ended December 31: The following is a comparative summary of certain expense information for the years ended December 31: 14. Balance Sheet Information Supplemental balance sheet information is as follows: Inventories valued under LIFO amounted to $170.8 at December 31, 1993 and $207.3 at December 31, 1992. The excess of current cost over LIFO cost at the end of each year was $23.1 and $28.5, respectively. In 1993, certain inventory quantities were reduced, which resulted in liquidations of LIFO inventory quantities. The effect was to increase income by $1.7. Fair Value of Financial Instruments The Company estimates that the aggregate fair value of all financial instruments at December 31, 1993 does not differ materially from the aggregate carrying values of its financial instruments recorded in the Consolidated Balance Sheet. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. Considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value, and accordingly, the estimates are not necessarily indicative of the amounts that the Company could realize in a current market exchange. In May 1993, the Financial Accounting Standards Board issued Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. The Company will adopt the provisions of this new standard effective January 1, 1994, and prior periods will not be restated. The effect of adoption will not be material to financial condition, results of operations or cash flows. 15. Commitments and Contingent Liabilities The Company has various contractual commitments to purchase raw materials, products and services totaling $282.4 million which expire through 1998. The Company is a party to various superfund and other environmental matters and is contingently liable with respect to lawsuits, taxes and other matters arising out of the normal course of business. While it is possible that the Company's cash flows and results of operations in particular quarterly or annual periods could be affected by the one-time impacts of the resolution of such contingencies, it is the opinion of management that the ultimate disposition of these matters, to the extent not previously provided for, will not have a material impact on the Company's financial condition or ongoing cash flows and results of operations. COLGATE-PALMOLIVE COMPANY SCHEDULE V-PROPERTY, PLANT AND EQUIPMENT For the Year Ended December 31, 1993 (Dollars in Millions) COLGATE-PALMOLIVE COMPANY SCHEDULE V-PROPERTY, PLANT AND EQUIPMENT For the Year Ended December 31, 1992 (Dollars in Millions) COLGATE-PALMOLIVE COMPANY SCHEDULE V-PROPERTY, PLANT AND EQUIPMENT For the Year Ended December 31, 1991 (Dollars in Millions) COLGATE-PALMOLIVE COMPANY SCHEDULE VI-ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT For the Year Ended December 31, 1993 (Dollars in Millions) COLGATE-PALMOLIVE COMPANY SCHEDULE VI-ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT For the Year Ended December 31, 1992 (Dollars in Millions) COLGATE-PALMOLIVE COMPANY SCHEDULE VI-ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT For the Year Ended December 31, 1991 (Dollars in Millions) COLGATE-PALMOLIVE COMPANY SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS For the Year Ended December 31, 1993 (Dollars in Millions) COLGATE-PALMOLIVE COMPANY SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS For the Year Ended December 31, 1992 (Dollars in Millions) COLGATE-PALMOLIVE COMPANY SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS For the Year Ended December 31, 1991 (Dollars in Millions) COLGATE-PALMOLIVE COMPANY SCHEDULE IX-SHORT-TERM BORROWINGS For the Three Years Ended December 31, 1993 (Dollars in Millions) Report of Independent Public Accountants To the Board of Directors and Shareholders of Colgate-Palmolive Company: We have audited the accompanying consolidated balance sheets of Colgate- Palmolive Company (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, changes in capital accounts and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Colgate-Palmolive 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 the accompanying notes to the consolidated financial statements, in 1993, the Company adopted three new accounting standards promulgated by the Financial Accounting Standards Board, changing its methods of accounting for income taxes, postretirement benefits other than pensions, and postemployment benefits. Our audit was 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 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. New York, New York /s/ ARTHUR ANDERSEN & CO. February 2, 1994 COLGATE-PALMOLIVE COMPANY Historical Financial Summary (1) Dollars in Millions Except Per Share Amounts (1)All share and per share amounts have been restated to reflect the 1991 two-for-one stock split. (2)Income in 1993 includes a one-time impact of adopting new mandated accounting standards, effective in the first quarter of 1993, of $358.2 ($2.30 per share on a primary basis or $2.10 on a fully diluted basis). (3)Income in 1991 includes a net provision for restructured operations of $243.0 ($1.80 per share on a primary basis or $1.75 per share on a fully diluted basis). (4)Income in 1988 includes Hill's service agreement renegotiation net charge of $42.0 ($.30 per share on both a primary and fully diluted basis). (5)Income in 1987 includes a net provision for restructured operations of $144.8 ($1.06 per share on a primary basis or $1.05 per share on a fully diluted basis). (6)Due to timing differences, 1988 includes three dividend declarations while all other years include four dividend declarations. (7)Income in 1984 includes a net provision for restructured operations of $89.0 ($.54 per share on both a primary and fully diluted basis). COLGATE-PALMOLIVE COMPANY EXHIBITS TO FORM 10-K YEAR ENDED DECEMBER 31, 1993 Commission File No. 1-644-2 COLGATE-PALMOLIVE COMPANY INDEX TO EXHIBITS Exhibit Description Page No. No. 3-A Restated Certificate of Incorporation, as amended. - (Registrant hereby incorporates by reference Exhibit 1 to its Form 8-K dated October 17, 1991, File No. 1-644-2.) 3-B By-laws. (Registrant hereby incorporates by - reference Exhibit 3-B to its Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-644-2.) 4-A Rights agreement dated as of October 13, 1988 - between registrant and Morgan Shareholder Services Trust Company. (Registrant hereby incorporates by reference Exhibit I to its Form 8-A dated October 21, 1988, File No. 1-644-2.) 4-B a) Other instruments defining the rights of security - holders, including indentures.* b) Colgate-Palmolive Company Employee Stock Ownership - Trust Note Agreement dated as of June 1, 1989. (Registrant hereby incorporates by reference Exhibit 4-B(b) to its Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-644-2.) 10-A Colgate-Palmolive Company 1977 Stock Option Plan, - as amended. (Registrant hereby incorporates by reference Exhibit 10-A to its Annual Report on Form 10-K for the year ended December 31, 1986, File No. 1-644-2.) 10-B a) Colgate-Palmolive Company Executive Incentive - Compensation Plan. (Registrant hereby incorporates by reference Exhibit 10-B(a) to its Annual Report on Form 10-K for the year ended December 31, 1987, File No. 1-644-2.) b) Colgate-Palmolive Company Executive Incentive - Compensation Plan Trust. (Registrant hereby incorporates by reference Exhibit 10-B(b) to its Annual Report on Form 10-K for the year ended December 31, 1987, File No. 1-644-2.) 10-C a) Colgate-Palmolive Company Supplemental Salaried - Employees Retirement Plan. (Registrant hereby incorporates by reference Exhibit 10-E (Plan only) to its Annual Report on Form 10-K for the year ended December 31, 1984, File No. 1-644-2.) b) Colgate-Palmolive Company Supplemental Spouse's - Benefit Trust. (Registrant hereby incorporates by reference Exhibit 10-C(b) to its Annual Report on Form 10-K for the year ended December 31, 1987, File No. 1-644-2.) 10-D Lease dated August 15, 1978 between Harold Uris, - d/b/a Uris Holding Company, and Colgate-Palmolive Company. (Registrant hereby incorporates by reference Exhibit 2(b) to its Annual Report on Form 10-K for the year ended December 31, 1978, File No. 1-644-2.) 10-E a) Colgate-Palmolive Company Executive Severance Plan. - (Registrant hereby incorporates by reference Exhibit 10-E(a) to its Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-644-2.) Exhibit Description Page No. No. b) Colgate-Palmolive Company Executive Severance Plan - Trust. (Registrant hereby incorporates by reference Exhibit 10-E(b) to its Annual Report on Form 10-K for the year ended December 31, 1987, File No. 1-644-2.) 10-F Colgate-Palmolive Company Pension Plan for Outside - Directors. (Registrant hereby incorporates by reference Exhibit 10-F to its Annual Report on Form 10-K for the year ended December 31, 1988, File No. 1-644-2.) 10-G Colgate-Palmolive Company Stock Purchase Plan for - Non-Employee Directors. (Registrant hereby incorporates by reference Exhibit 10-G to its Annual Report on Form 10-K for the year ended December 31, 1988, File No. 1-644-2.) 10-H Colgate-Palmolive Company Restated and Amended - Deferred Compensation Plan for Non-Employee Directors. (Registrant hereby incorporates by reference Exhibit 10-H to its Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-644-2.) 10-I Career Achievement Plan. (Registrant hereby - incorporates by reference Exhibit 10-I to its Annual Report on Form 10-K for the year ended December 31, 1986, File No. 1-644-2.) 10-J Colgate-Palmolive Company 1987 Stock Option Plan, - as amended. (Registrant hereby incorporates by reference Exhibit 10-J to its Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-644-2.) 10-K Sale agreement between Colgate-Palmolive Company - and CDK Holding Company dated September 13, 1988 relating to the sale of The Kendall Company. (Registrant hereby incorporates by reference Exhibit 2 to its Form 8-K dated September 23, 1988, File No. 1-644-2.) 10-L U.S. $460,000,000 Credit Agreement dated as of - March 30, 1990. (Registrant hereby incorporates by reference Exhibit 10-M to its Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-644-2.) 10-M Colgate-Palmolive Company Stock Compensation Plan - for Non-Employee Directors, as amended. (Registrant hereby incorporates by reference Exhibit A to its Proxy Statement dated March 30, 1990, File No. 1-644-2.) 10-N Stock incentive agreement between Colgate-Palmolive 50-51 Company and Reuben Mark, Chairman and Chief Executive Officer, dated January 13, 1993 pursuant to the Colgate-Palmolive Company 1987 Stock Option Plan, as amended. 11 Statement re Computation of Earnings Per Common 52-53 Share. 12 Statement re Computation of Ratio of Earnings to 54 Fixed Charges. 21 Subsidiaries of the Registrant. 55-56 23 Consent of Independent Public Accountants. 57 24 Power of Attorney. 58-66 *Registrant hereby undertakes upon request to furnish the Commission with a copy of any instrument with respect to long-term debt where the total amount of securities authorized hereunder does not exceed 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. Exhibits 3-A through 10-M inclusive, indicated above, are not included with the Form 10-K. They are available upon request and payment of a reasonable fee approximating the registrant's cost of providing and mailing the exhibits. Inquiries should be directed to: Colgate-Palmolive Company Office of the Secretary (10-K Exhibits) 300 Park Avenue New York, New York 10022-7499 EXHIBIT 10-N Page 1 of 2 STOCK INCENTIVE AGREEMENT COLGATE-PALMOLIVE COMPANY NON-QUALIFIED STOCK OPTION Date: January 13, 1993 Mr. Reuben Mark Colgate-Palmolive Company 300 Park Avenue New York, NY 10022-7499 Dear Mr. Mark: This will confirm the following Agreement made today between you and the Colgate-Palmolive Company (the "Company") pursuant to the Company's 1987 Stock Option Plan as amended (the "Plan"). If you have not received copies of the Plan and the Plan Prospectus, they are available from the Company at 300 Park Avenue, New York, NY 10022, Attention: Mr. Andrew D. Hendry, Senior Vice President, General Counsel and Secretary. The Company hereby grants you non-qualified options (the "Options") to purchase from the Company up to a total of one million (1,000,000) shares of common stock of the Company in the amounts and at the exercise prices set forth below. Groups 1 through 6 of the Options, as set forth below, shall each become exercisable as follows: (a) on and after January 13, 1994, with respect to a total for that Group of 33,333 shares, (b) on and after January 13, 1995, with respect to a total for that Group of 66,666 shares, and (c) on and after January 13, 1996, with respect to a total for that Group of 100,000 shares. Group 7 of the Options, as set forth below, shall become exercisable as follows: (a) on and after January 13, 1994, with respect to a total for that Group of 133,333 shares, (b) on and after January 13, 1995, with respect to a total for that Group of 266,666 shares, and (c) on and after January 13, 1996, with respect to a total for that Group of 400,000 shares. The Options will be exercisable as set forth above in the following amounts, at the following prices: Group 1 100,000 shares at $60.98125 per share; Group 2 100,000 shares at $66.525 per share; Group 3 100,000 shares at $72.06875 per share; Group 4 100,000 shares at $77.6125 per share; Group 5 100,000 shares at $83.15625 per share; Group 6 100,000 shares at $88.70 per share; and Group 7 400,000 shares at $99.7875 per share. The Options shall expire at 11:59 p.m. (Eastern Standard Time) on January 12, 2003, or possibly sooner (for example, in the event of your death or termination of employment) as provided in the Plan or under the circumstances set forth herein. In order to encourage you further to promote the growth of the Company and, consequently, more rapid growth in the value of the common stock of the Company, this option shall expire prior to January 12, 2003 as follows: EXHIBIT 10-N Page 2 of 2 (a) If the closing price per share of common stock of the Company shall not have exceeded $88.70 (as such price may be adjusted from time to time, as set forth herein, the "60% Hurdle") at some time prior to January 13, 1999, then on such date the term of the Options, to the extent then unexercised, shall automatically expire, without any further action on your part or the part of the Company. (b) If the closing price per share of common stock of the Company shall not have exceeded $99.7875 (as such price may be adjusted from time to time, as set forth herein, the "80% Hurdle") at some time prior to January 13, 2001, then on such date the term of the Options, to the extent then unexercised, shall automatically expire, without any further action on your part or the part of the Company. For the purpose of determining the 60% Hurdle and the 80% Hurdle, closing price shall mean the daily closing price, as reported by the New York Stock Exchange Composite Transactions or other reporting system acceptable to the Personnel and Organization Committee of the Board of Directors of the Company. The Options may be exercised only in accordance with the terms and conditions of the Plan, as supplemented by this Agreement, and not otherwise. Nothing herein contained shall obligate the Company or any subsidiary of the Company to continue your employment for any particular period or on any particular basis of compensation. This Agreement is subject to all terms, conditions,limitations and restrictions contained in the Plan and may not be assigned or transferred in whole or in part except as therein provided. You shall not have any rights of a shareholder with respect to any of the shares which are the subject of this Agreement until such shares are actually issued to you. The number of shares and the exercise price per share are subject to adjustment as provided in the Plan. In the event of any recapitalization, reclassification, stock dividend, stock split or extraordinary distribution with respect to the common stock of the Company or other change in corporate structure affecting the common stock of the Company, the Committee shall make an appropriate adjustment to the 60% Hurdle and the 80% Hurdle to reflect the effect of such transaction on the market price of the common stock of the Company. You assume all risks incident to any change hereafter in the applicable laws or regulations or incident to any change in the market value of the stock after the exercise of these incentives in whole or in part. To confirm the foregoing, kindly sign and return one copy of this Agreement as soon as possible. Very truly yours, COLGATE-PALMOLIVE COMPANY By:/s/ ANDREW D. HENDRY Andrew D. Hendry Senior Vice President and Secretary CONFIRMED: /s/ REUBEN MARK Reuben Mark EXHIBIT 11 Page 1 of 2 COLGATE-PALMOLIVE COMPANY COMPUTATION OF EARNINGS PER COMMON SHARE Dollars in Millions Except Per Share Amounts (Unaudited) EXHIBIT 11 Page 2 of 2 COLGATE-PALMOLIVE COMPANY COMPUTATION OF EARNINGS PER COMMON SHARE Dollars in Millions Except Per Share Amounts (Unaudited) EXHIBIT 12 COLGATE-PALMOLIVE COMPANY COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Dollars in Millions (Unaudited) In June 1989, the Company's leveraged employee stock ownership plan (ESOP) issued $410.0 long-term notes due through 2009 bearing an average interest rate of 8.6%. These notes are guaranteed by the Company. Interest incurred on the ESOP's notes was $34.5 in 1993. This interest is funded through preferred and common stock dividends. The fixed charges presented above include interest on ESOP indebtedness to the extent it is not funded through preferred and common stock dividends. EXHIBIT 21 Page 1 of 2 SUBSIDIARIES OF THE REGISTRANT State in which Incorporated or Country in which Name of Company Organized Colgate Juncos, Inc. Delaware Colgate-Palmolive, Inc. Delaware Colgate-Palmolive (Caribbean), Inc. Delaware Colgate-Palmolive (Central America), Inc. Delaware Colgate-Palmolive Cia. Delaware Colgate-Palmolive Development Corp. Delaware Colgate-Palmolive (Dominican Republic), Inc. Delaware Colgate-Palmolive Global Trading Company Delaware Colgate-Palmolive International Incorporated Delaware Colgate-Palmolive (P.R.) Inc. Delaware Colgate Oral Pharmaceuticals, Inc. Delaware CPC Funding Company Delaware Southampton-Hamilton Company Delaware Purity Holding Company Delaware Hill's Pet Nutrition, Inc. Delaware Mennen Limited Delaware Mennen de Puerto Rico, Ltd Delaware Mission Hill's Property Corporation Delaware Norwood International Incorporated Delaware Vipont Pharmaceutical, Inc. Delaware Princess House, Inc. Massachusetts Softsoap Enterprises, Inc. Minnesota The Mennen Company New Jersey Veterinary Companies of America, Inc. New York The Murphy-Phoenix Company Ohio Colgate-Palmolive Sociedad Anonima Industrial Y Commercial Argentina Colgate-Palmolive Pty. Limited Australia Hill's Pet Products Pty. Ltd. Australia Colgate-Palmolive Gesellschaft m.b.H. Austria Colgate-Palmolive Belgium S.A. Belgium Colgate-Palmolive Europe S.A. Belgium Hill's Pet Products (Benelux) S.A. Belgium ELM Company Limited Bermuda Colgate-Palmolive (Botswana) (Proprietary) Ltd. Botswana Colgate-Palmolive, Ltda. Brazil CP Textil Industria e Comercia Ltd. Brazil Hawley & Hazel (BVI) Company Ltd British Virgin Islands Colgate-Palmolive Cameroun S.A. Cameroon Colgate-Palmolive Canada, Inc. Canada Hill's Distribution Services Ltd. Canada Mennen Canada, Inc. Canada Mennen de Chile Limitada Chile Colgate (Guangzhou) Limited China Mennen de Costa Rica, S.A. Costa Rica Colgate-Palmolive (Czechoslovakia) SRO Czech Republic Colgate-Palmolive A/S Denmark Colgate-Palmolive del Ecuador, S.A. Ecuador Colgate-Palmolive (Egypt) S.A.E. Egypt Colgate-Palmolive (Fiji) Limited Fiji Islands Colgate-Palmolive France Cotelle, S.A. France Hill's Pet Products SNC France Colgate-Palmolive G.m.b.H. Germany Hill's Pet Products G.m.b.H. Germany Colgate-Palmolive (Hellas) S.A. Greece EXHIBIT 21 Page 2 of 2 SUBSIDIARIES OF THE REGISTRANT State in which Incorporated or Country in which Name of Company Organized Colgate-Palmolive (Centro America) S.A. Guatemala Mennen Guatemala, S.A. Guatemala Colgate-Palmolive (H.K.) Limited Hong Kong Colgate-Palmolive (Hungary) Kft. Hungary Colgate-Palmolive (India) Limited India P.T. Colgate-Palmolive Indonesia Indonesia Colgate-Palmolive (Ireland) Limited Ireland Newgrange Financial Services Company Ireland Colgate-Palmolive S.p.A. Italy Hill's Pet Products S.p.A. Italy Viset S.A.L. Italy Colgate-Palmolive Cote. d'lvoire, S.A. Ivory Coast Colgate-Palmolive Co. (Jamaica) Ltd. Jamaica Hill's-Colgate (Japan) Ltd. Japan Colgate-Palmolive (East Africa) Limited Kenya Colgate-Palmolive (Malaysia) SDN. BHD. Malaysia Colgate-Palmolive (Malaysia) Marketing SDN. BHD. Malaysia Colgate-Palmolive, S.A. de C.V. Mexico Hill's Pet Products de Mexico, S.A. de C.V. Mexico Mennen de Mexico, S.A. Mexico Colgate-Palmolive Morocco Colgate-Palmolive (Mocambique) Limitada Mozambique CKR Nederland B.V. Netherlands Hill's International Sales FSC B.V. Netherlands Colgate-Palmolive Limited New Zealand Colgate-Palmolive Investments (PNG) Pty Ltd. Papua, New Guinea Colgate-Palmolive Philippines, Inc. Philippines Colgate-Palmolive (Poland) Sp.z O.O. Poland Colgate-Palmolive, S.A. Portugal Sonadel - Sociedad Nacional de Detergents, S.A. Portugal Colgate-Palmolive (Romania) Ltd. Romania A/O Colgate-Palmolive (Russia) Russia Societe Africaine de Detergents, S.A. Senegal Colgate-Palmolive (Eastern) Pte. Ltd. Singapore Colgate-Palmolive (Pty) Limited South Africa Colgate-Palmolive, S.A.E. Spain Cristasol S.A. Spain Colgate-Palmolive A.G. Switzerland Colgate-Palmolive (Tanzania) Limited Tanzania Siam Purity Distribution (Thailand) Ltd. Thailand Colgate-Palmolive (Thailand) Ltd. Thailand Colgate-Palmolive Haci Sakir Sabun Sanayi ve Ticaret Anonim Sirketi Turkiye Colgate-Palmolive (Uganda) Limited Uganda Colgate-Palmolive SP Ukraine Colgate-Palmolive (Ukraine) A/O Ukraine Colgate Holdings (U.K.) Limited United Kingdom Colgate-Palmolive Limited United Kingdom Colgate-Palmolive Mennen Limited United Kingdom Hill's Pet Products Limited United Kingdom Hill's Pet Nutrition Ltd. United Kingdom Alexandril S.A. Uruguay Colgate-Palmolive Compania Anonima Venezuela Mennen Venezolana, S.A. Venezuela Colgate-Palmolive (Zambia) Ltd. Zambia Colgate-Palmolive (Zimbabwe) (Private) Limited Zimbabwe EXHIBIT 23 Consent of Independent Public Accountants As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K, into the Company's previously filed Registration Statement File Nos. 2-76922, 2-96982, 33-17136, 33-27227, 33-34952, 33-48832, 33-48840, 33-58746 and 33-61038. New York, New York /s/ ARTHUR ANDERSEN & CO. March 24, 1994 EXHIBIT 24 Page 1 of 9 COLGATE-PALMOLIVE COMPANY ANNUAL REPORT ON FORM 10-K POWER OF ATTORNEY WHEREAS, COLGATE-PALMOLIVE COMPANY is filing with the Securities and Exchange Commission its Annual Report on Form 10-K for the year ended December 31, 1993 ("Annual Report") pursuant to Section 13 of the Securities Exchange Act of 1934; NOW, THEREFORE, the undersigned in his capacity as a director or officer, or both, of COLGATE-PALMOLIVE COMPANY hereby appoints REUBEN MARK, ANDREW HENDRY and ROBERT AGATE, and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place and stead, in his capacity as a director, officer, or both, of COLGATE-PALMOLIVE COMPANY, its Annual Report and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument on February 17, 1994. /s/ VERNON R. ALDEN Vernon R. Alden EXHIBIT 24 Page 2 of 9 COLGATE-PALMOLIVE COMPANY ANNUAL REPORT ON FORM 10-K POWER OF ATTORNEY WHEREAS, COLGATE-PALMOLIVE COMPANY is filing with the Securities and Exchange Commission its Annual Report on Form 10-K for the year ended December 31, 1993 ("Annual Report") pursuant to Section 13 of the Securities Exchange Act of 1934; NOW, THEREFORE, the undersigned in her capacity as a director or officer, or both, of COLGATE-PALMOLIVE COMPANY hereby appoints REUBEN MARK, ANDREW HENDRY and ROBERT AGATE, and each of them severally, her true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in her name, place and stead, in her capacity as a director, officer, or both, of COLGATE-PALMOLIVE COMPANY, its Annual Report and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument on February 17, 1994. /s/ JILL K. CONWAY Jill K. Conway EXHIBIT 24 Page 3 of 9 COLGATE-PALMOLIVE COMPANY ANNUAL REPORT ON FORM 10-K POWER OF ATTORNEY WHEREAS, COLGATE-PALMOLIVE COMPANY is filing with the Securities and Exchange Commission its Annual Report on Form 10-K for the year ended December 31, 1993 ("Annual Report") pursuant to Section 13 of the Securities Exchange Act of 1934; NOW, THEREFORE, the undersigned in his capacity as a director or officer, or both, of COLGATE-PALMOLIVE COMPANY hereby appoints REUBEN MARK, ANDREW HENDRY and ROBERT AGATE, and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place and stead, in his capacity as a director, officer, or both, of COLGATE-PALMOLIVE COMPANY, its Annual Report and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument on February 16, 1994. /s/ RONALD E. FERGUSON Ronald E. Ferguson EXHIBIT 24 Page 4 of 9 COLGATE-PALMOLIVE COMPANY ANNUAL REPORT ON FORM 10-K POWER OF ATTORNEY WHEREAS, COLGATE-PALMOLIVE COMPANY is filing with the Securities and Exchange Commission its Annual Report on Form 10-K for the year ended December 31, 1993 ("Annual Report") pursuant to Section 13 of the Securities Exchange Act of 1934; NOW, THEREFORE, the undersigned in her capacity as a director or officer, or both, of COLGATE-PALMOLIVE COMPANY hereby appoints REUBEN MARK, ANDREW HENDRY and ROBERT AGATE, and each of them severally, her true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in her name, place and stead, in her capacity as a director, officer, or both, of COLGATE-PALMOLIVE COMPANY, its Annual Report and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument on February 17, 1994. /s/ ELLEN M. HANCOCK Ellen M. Hancock EXHIBIT 24 Page 5 of 9 COLGATE-PALMOLIVE COMPANY ANNUAL REPORT ON FORM 10-K POWER OF ATTORNEY WHEREAS, COLGATE-PALMOLIVE COMPANY is filing with the Securities and Exchange Commission its Annual Report on Form 10-K for the year ended December 31, 1993 ("Annual Report") pursuant to Section 13 of the Securities Exchange Act of 1934; NOW, THEREFORE, the undersigned in his capacity as a director or officer, or both, of COLGATE-PALMOLIVE COMPANY hereby appoints REUBEN MARK, ANDREW HENDRY and ROBERT AGATE, and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place and stead, in his capacity as a director, officer, or both, of COLGATE-PALMOLIVE COMPANY, its Annual Report and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument on February 17, 1994. /s/ DAVID W. JOHNSON David W. Johnson EXHIBIT 24 Page 6 of 9 COLGATE-PALMOLIVE COMPANY ANNUAL REPORT ON FORM 10-K POWER OF ATTORNEY WHEREAS, COLGATE-PALMOLIVE COMPANY is filing with the Securities and Exchange Commission its Annual Report on Form 10-K for the year ended December 31, 1993 ("Annual Report") pursuant to Section 13 of the Securities Exchange Act of 1934; NOW, THEREFORE, the undersigned in his capacity as a director or officer, or both, of COLGATE-PALMOLIVE COMPANY hereby appoints REUBEN MARK, ANDREW HENDRY and ROBERT AGATE, and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place and stead, in his capacity as a director, officer, or both, of COLGATE-PALMOLIVE COMPANY, its Annual Report and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument on February 17, 1994. /s/ JOHN P. KENDALL John P. Kendall EXHIBIT 24 Page 7 of 9 COLGATE-PALMOLIVE COMPANY ANNUAL REPORT ON FORM 10-K POWER OF ATTORNEY WHEREAS, COLGATE-PALMOLIVE COMPANY is filing with the Securities and Exchange Commission its Annual Report on Form 10-K for the year ended December 31, 1993 ("Annual Report") pursuant to Section 13 of the Securities Exchange Act of 1934; NOW, THEREFORE, the undersigned in his capacity as a director or officer, or both, of COLGATE-PALMOLIVE COMPANY hereby appoints REUBEN MARK, ANDREW HENDRY and ROBERT AGATE, and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place and stead, in his capacity as a director, officer, or both, of COLGATE-PALMOLIVE COMPANY, its Annual Report and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument on February 17, 1994 /s/ DELANO E. LEWIS Delano E. Lewis EXHIBIT 24 Page 8 of 9 COLGATE-PALMOLIVE COMPANY ANNUAL REPORT ON FORM 10-K POWER OF ATTORNEY WHEREAS, COLGATE-PALMOLIVE COMPANY is filing with the Securities and Exchange Commission its Annual Report on Form 10-K for the year ended December 31, 1993 ("Annual Report") pursuant to Section 13 of the Securities Exchange Act of 1934; NOW, THEREFORE, the undersigned in his capacity as a director or officer, or both, of COLGATE-PALMOLIVE COMPANY hereby appoints ANDREW HENDRY and ROBERT AGATE, and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place and stead, in his capacity as a director, officer, or both, of COLGATE-PALMOLIVE COMPANY, its Annual Report and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument on February 17, 1994. /s/ REUBEN MARK Reuben Mark EXHIBIT 24 Page 9 of 9 COLGATE-PALMOLIVE COMPANY ANNUAL REPORT ON FORM 10-K POWER OF ATTORNEY WHEREAS, COLGATE-PALMOLIVE COMPANY is filing with the Securities and Exchange Commission its Annual Report on Form 10-K for the year ended December 31, 1993 ("Annual Report") pursuant to Section 13 of the Securities Exchange Act of 1934; NOW, THEREFORE, the undersigned in his capacity as a director or officer, or both, of COLGATE-PALMOLIVE COMPANY hereby appoints REUBEN MARK, ANDREW HENDRY and ROBERT AGATE, and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place and stead, in his capacity as a director, officer, or both, of COLGATE-PALMOLIVE COMPANY, its Annual Report and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument on February 17, 1994. /s/ HOWARD B. WENTZ, JR. Howard B. Wentz, Jr.

40729_1993.txt

40729_1993

1993

40729

ITEM 1. BUSINESS General Motors Acceptance Corporation (the "Company" or "GMAC"), a wholly-owned subsidiary of General Motors Corporation ("General Motors" or "GM"), was incorporated in 1919 under the New York Banking Law relating to investment companies. GMAC and its affiliated companies offer a wide variety of automotive financial services to and through franchised General Motors dealers in many countries throughout the world. GMAC also offers financial services to other automobile dealerships in which GM dealers have an interest and to the customers of those dealerships. GMAC's other financial services include insurance, mortgage banking and investment services. The Company operates directly and through its subsidiaries and through associated companies in which it has equity investments. In its principal markets, GMAC offers automotive financing and other services as described below. The Company operates its automotive financing services similarly outside North America, subject to local laws or other circumstances that may modify procedures. The automotive financing field is highly competitive. The Company's principal competitors are a large number of banks, credit unions and other finance companies. The business of the Company is influenced by the general economic climate in the areas in which it operates as well as the level of interest rates. RETAIL FINANCING GMAC conducts its retail automotive financing business under the trade name GMAC Financial Services. The Company provides financing services to customers through dealers who have established relationships with GMAC. GMAC purchases retail instalment obligations from dealers for new and used products directly from dealers. These obligations must first meet GMAC's credit standards. Thereafter, GMAC collects and administers the obligations. Retail obligations are generally secured by lien notation on vehicles and/or other forms of security interest in the products financed. GMAC acquires the security interest when it purchases the instalment obligations. After satisfying state requirements, GMAC can repossess the product if the instalment buyer fails to meet the obligations of the contract. The interests of both GMAC and the retail buyer usually are protected by automobile physical damage insurance. WHOLESALE FINANCING Using GMAC's wholesale financing, dealers can finance new and used vehicles held in inventory pending sale or lease to retail or fleet buyers. When a dealer uses GMAC's Wholesale Finance Plan to acquire vehicles from a manufacturer, GMAC is granted a security interest in those vehicles. GMAC can repossess the product if the dealer does not pay the amount advanced or fails to comply with other conditions specified in the security agreement. GMAC also makes term loans to dealers and their affiliates for acquisitions, refurbishing, real estate purchases and working capital. The Company generally secures the loans with liens on real estate, other dealership assets or the personal guarantee of the dealer. I-1 ITEM 1. BUSINESS (continued) LEASING Dealers, their affiliates and other companies also may obtain GMAC financing to buy vehicles that they lease or rent to others. In most cases, GMAC has a security interest in these products. The loan agreements usually state that the rent is payable to GMAC if the lessors default. More than half of GMAC's lease financing receivables are covered by General Motors programs which provide that, under certain conditions and with certain limitations, General Motors will absorb the loss realized by the participating financing institutions as long as the vehicles are repossessed and returned to the selling dealer. GMAC uses several leasing plans to lease vehicles. SmartLease is the primary plan GMAC uses to lease GM vehicles to retail customers. With SmartLease, dealers originate the leases and offer them for purchase by GMAC, which then assumes ownership of the vehicle. Dealers are not responsible for the customer's performance during the lease period or for the value of the vehicle at the time of lease maturity. INSURANCE Motors Insurance Corporation and its subsidiaries ("MIC") conduct insurance operations in the United States, Canada and Europe. MIC insures and reinsures selected personal, mechanical, commercial and credit insurance coverages. Personal lines coverages, which include automobile, homeowners and umbrella liability insurance, are offered primarily on a direct response basis. MIC insures mechanical coverage for new and used vehicles sold by GM dealers and others. MIC also provides credit life and disability coverage through dealerships to vehicle purchasers. Commercial lines include product liability and other coverages written for General Motors, insurance for dealer vehicle inventories and other dealer property and casualty coverages. MIC also provides collateral protection coverage to GMAC on vehicles securing GMAC retail instalment contracts. Additionally, MIC is a reinsurer of diverse property and casualty risks, primarily in the domestic market. MORTGAGE BANKING GMAC Mortgage Corporation and its subsidiaries ("GMACM") conduct mortgage banking operations in the United States. GMACM originates and markets single-family and commercial mortgage loans to investors and services these loans on behalf of investors. GMACM also offers home equity loans in some states. GMACM, through its wholly-owned subsidiary, Residential Funding Corporation ("RFC"), is also engaged in the residential wholesale mortgage conduit business. RFC purchases high balance, single-family residential mortgages from mortgage lenders throughout the United States, securitizes such mortgages into AA or AAA rated mortgage pass-through certificates, sells the certificates to investors and performs master servicing of these securities on behalf of investors. RFC also provides warehouse lending facilities to certain mortgage banking customers, with advances secured by mortgage collateral. SERVICING GMAC services the retail instalment obligations it has sold to third parties in GMAC's asset-backed securities program. I-2 ITEM 1. BUSINESS (concluded) ITEM 2. ITEM 2. PROPERTIES The Company and its subsidiaries have 301 finance branches, 27 insurance offices and 116 mortgage offices. Of the number of finance branches, 225 are in the United States and the Commonwealth of Puerto Rico, 25 in Canada and 51 in other countries. There are 19 insurance offices in the United States, 2 in Canada and 6 in Europe. Mortgage offices are all located in the United States. All premises are generally occupied under lease. Automobiles, office equipment and real estate properties owned and in use by the Company are not significant in relation to the total assets of the Company. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are various claims and pending actions against the Company and its subsidiaries with respect to commercial and consumer financing matters, taxes and other matters arising out of the conduct of the business. Certain of these actions are or purport to be class actions, seeking damages in very large amounts. The amounts of liability on these claims and actions at December 31, 1993, were not determinable but, in the opinion of management, the ultimate liability resulting therefrom should not have a material adverse effect on the Company's consolidated financial position. -------------------- I-3 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company is a wholly-owned subsidiary of General Motors Corporation and, accordingly, all shares of the Company's common stock are owned by General Motors Corporation. There is no market for the Company's common stock. The Company paid cash dividends to General Motors Corporation of $1,250 million in 1993, $1,100 million in 1992 and $850 million in 1991. (continued) II-1 ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FIVE-YEAR SUMMARY OF CONSOLIDATED OPERATIONS - ------------------------------------------------------------------------------- (in millions of dollars) 1993 1992 1991 1990 1989 - --------------------- ---------- ---------- ---------- ---------- ---------- INCOME AND NET INCOME RETAINED FOR USE IN THE BUSINESS Gross revenue and other income ....... $12,483.5 $ 13,739.3 $ 14,503.1 $ 14,815.8 $ 14,503.8 ---------- ---------- ---------- ---------- ---------- Interest and discount 4,721.2 5,828.6 6,844.7 7,965.8 7,908.3 Depreciation on operating leases ... 2,702.0 2,429.6 1,902.4 1,387.9 1,477.5 Operating expenses .. 1,949.0 1,900.1 1,907.1 1,677.9 1,670.2 Insurance losses and loss adjustment expenses ........... 1,096.6 987.9 1,061.6 1,014.1 991.3 Provision for financing losses ... 300.8 371.0 1,047.9 843.2 841.9 Amortization of intangible assets .. 141.1 121.1 91.2 78.5 63.1 ---------- ---------- ---------- ---------- ---------- Total expenses ...... 10,910.7 11,638.3 12,854.9 12,967.4 12,952.3 ---------- ---------- ---------- ---------- ---------- Income before income taxes .............. 1,572.8 2,101.0 1,648.2 1,848.4 1,551.5 United States, foreign and other income taxes 591.7 882.3 610.0 658.3 440.8 ---------- ---------- ---------- ---------- ---------- Income before cumul- ative effect of accounting changes . 981.1 1,218.7 1,038.2 1,190.1 1,110.7 Cumulative effect of accounting changes . -- (282.6) 331.5 -- -- ---------- ---------- ---------- ---------- ---------- Net income .......... 981.1 936.1 1,369.7 1,190.1 1,110.7 Cash dividends ...... 1,250.0 1,100.0 850.0 1,000.0 600.0 ---------- ---------- ---------- ---------- ---------- Net income retained in the year ........ $ (268.9) $ (163.9) $ 519.7 $ 190.1 $ 510.7 ========== ========== ========== ========== ========== ASSETS Cash and cash equivalents ... $ 4,028.1 $ 3,871.1 $ 2,412.5 $ 205.1 $ 258.6 Earning assets ...... 74,783.8 87,198.7 98,614.3 103,407.9 102,353.1 Other assets ........ 1,938.9 1,738.4 1,607.7 1,477.9 1,125.7 ---------- ---------- ---------- ---------- ---------- Total ............... $80,750.8 $ 92,808.2 $102,634.5 $105,090.9 $103,737.4 ========== ========== ========== ========== ========== NOTES, LOANS AND DEBENTURES Payable within one yr $35,084.4 $ 41,364.4 $ 51,018.6 $ 53,715.8 $ 54,415.4 Payable after one year 27,688.8 33,174.2 34,480.9 34,185.4 32,453.0 ---------- ---------- ---------- ---------- ---------- Total ............... $62,773.2 $ 74,538.6 $ 85,499.5 $ 87,901.2 $ 86,868.4 ========== ========== ========== ========== = ======== II-2 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Industry deliveries of new passenger cars and trucks in the United States in the 1993 calendar year increased by 8% to 14.2 million units from prior-year deliveries of 13.1 million units. Deliveries of new General Motors vehicles in the U.S. increased to 4.7 million units in 1993 from 4.5 million units in 1992. GMAC financed 28% of new General Motors vehicles delivered by GM dealers in the U.S. during 1993, down 5 percentage points from 1992. The decline in penetration primarily reflects the use of fewer factory-supported finance programs by General Motors as well as intense competitive pressures as a result of the reduction in market interest rates. The decline also reflects liquidity and cost driven pricing actions taken by GMAC earlier in the year that dampened volume, which actions were moderated by mid-year in line with improving liquidity conditions. Since March, U.S. market penetration has trended upward, reaching 31% in December, 1993. RESULTS OF OPERATIONS Consolidated net income totaled $981.1 million in 1993, or $45.0 million above and $388.6 million below income reported in 1992 and 1991, respectively. In this regard, 1992 income reflects a cumulative unfavorable adjustment of $282.6 million related to implementation of the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions; 1991 income reflects a favorable cumulative adjustment of $331.5 million due to the adoption of SFAS No. 109 - Accounting for Income Taxes. The following table summarizes the earnings of GMAC's financing and insurance businesses on a reported and comparable year-to-year basis: - ---------------------------------------------------------------------- Income Cumulative Before Effect of (in millions of dollars Accounting Accounting Net after tax) Changes Changes Income - ---------------------------------------------------------------------- ---- Financing Operations $ 790.6 $ -- $ 790.6 Insurance Operations* 190.5 -- 190.5 ----------- ----------- ----------- Total $ 981.1 $ -- $ 981.1 ---- Financing Operations $ 1,011.6 $ (232.8) $ 778.8 Insurance Operations* 207.1 (49.8) 157.3 ----------- ----------- ----------- Total $ 1,218.7 $ (282.6) $ 936.1 ---- Financing Operations $ 865.9 $ 299.1 $ 1,165.0 Insurance Operations* 172.3 32.4 204.7 ----------- ----------- ----------- Total $ 1,038.2 $ 331.5 $ 1,369.7 * Motors Insurance Corporation II-3 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(continued) The Company has disclosed in the financial statements certain amounts associated with estimated future postretirement benefits other than pensions and characterized such amounts as "accumulated postretirement benefit obligations," "liabilities" or "obligations." Notwithstanding the recording of such amounts and the use of these terms, the Company does not admit or otherwise acknowledge that such amounts or existing postretirement benefit plans of the Company (other than pensions) represent legally enforceable liabilities of the Company. FINANCE VOLUME GMAC financed or leased worldwide 1.9 million new passenger cars and trucks during 1993, down 14% from 2.2 million last year. In the United States, GMAC financed or leased 1.4 million new vehicles during the year, 277,000 fewer than in 1992. Outside the United States, GMAC financed or leased 527,000 new vehicles in 1993, down 34,000 units from a year ago. The decrease was primarily the result of a decline in GMAC of Canada's retail penetration from 35.3% in 1992 to 33.7% in 1993, due primarily to competitive pressures brought about by aggressive bank competition. The average new passenger car contract purchased by GMAC in the United States during 1993 was $16,400, up from $15,900 in 1992. The average term for new car contracts was 54 months in 1993, compared to 52 months in 1992, while the average monthly payment on new retail contracts decreased slightly to $302 in 1993 from $305 in 1992. Leasing volume worldwide, primarily acquired under GMAC's SmartLease program, remained strong during 1993, with 347,000 units leased. This was 11% above the prior year. In addition, GMAC financed 106,000 units during 1993 under its SmartBuy program. This product offers consumers many of the advantages of leasing, namely lower monthly payments, with consumers retaining ownership of the vehicles. GMAC financed 60,000 units under SmartBuy during 1992. GMAC, in conjunction with General Motors, also provides financing for GM and other dealers' new and used vehicle inventories. In the United States, inventory financing was provided on 3.6 million and 3.4 million new GM vehicles, representing 77% and 78% of all GM sales to dealers during 1993 and 1992, respectively. EARNING ASSETS Total assets of the Company at December 31, 1993, were $80.8 billion, $12.0 billion below the previous year. Earning assets, which comprised $74.8 billion of the total assets, declined $12.4 billion from 1992 year-end levels. The reduction was primarily due to sales of retail receivables as well as asset liquidations in excess of acquisitions in the United States. Cash and Cash Equivalents, which primarily include short term borrowed funds in excess of requirements invested in short-term marketable securities, increased $157 million in 1993 to $4,028.1 million from $3,871.1 million at the end of 1992. The consolidated investment portfolio, primarily attributable to MIC, with equity securities valued at market and bonds, notes and other securities at amortized cost, totaled $3.4 billion at year-end II-4 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(continued) 1993, compared with $3.3 billion at the end of 1992. The composition of MIC's portfolio at year-end 1993 consisted of 26% taxable bonds, 59% tax-favored bonds, 14% common stocks and 1% preferred stocks. The balance of retail, lease financing and leasing receivables, net of unearned income, worldwide amounted to $29.8 billion at December 31, 1993, a $9.7 billion decrease from the prior year-end. The lower receivable levels reflect sales of retail receivables during 1993 in the United States and Canada aggregating $13.6 billion of principal sold. The Company's servicing portfolio reflected a principal balance of retail sold receivables amounting to $14.9 billion at year-end 1993, up $4.0 billion from $10.9 billion at year-end 1992. Wholesale receivables of $20.7 billion at year-end were up $6.5 billion from 1992, principally attributable to GMAC resuming the financing of dealer wholesale inventory previously financed by General Motors, partially offset by lower levels of GM dealer stocks financed. Term loans to GM dealers and others were $4.4 billion at the close of 1993, a decrease of 4% from the prior year end. These loans provide dealers and their affiliates with a source of funds to help finance dealership acquisitions, building improvements and seasonal working capital requirements. Receivables from General Motors Corporation decreased to $1.4 billion at the end of 1993, compared with $11.6 billion at the end of 1992. This reduction reflects the resumption by GMAC of dealer wholesale inventory financing which had previously been provided by General Motors. Such General Motors financing had been supported by a financing agreement under which GMAC had extended loans to General Motors. This financing agreement has been terminated. GMAC's operating lease assets, net of depreciation, totaled $11.4 billion at year-end 1993, an increase of $1.5 billion when compared to 1992. These assets primarily represent vehicles purchased by GMAC for lease to dealers' retail customers. In the United States and Canada, such leases are offered principally under the SmartLease program which encourages shorter customer trading cycles and allows greater flexibility in dealers' retail lease transactions. Similar leasing programs are also available in Germany and 14 other countries. From time-to-time, General Motors Corporation may elect to sponsor retail leasing programs using residual values in excess of published residual guide books used by GMAC. Under these programs, General Motors agrees to reimburse or otherwise compensate GMAC for the additional risk associated with such increased residual values, subject to certain conditions and limitations. Payments received from General Motors are included in the determination of gain or loss on vehicle disposition. Real estate mortgage inventory held for sale was $1.8 billion, down $711.1 million from the prior year-end level. This decrease is primarily due to accelerated sales of real estate mortgages inventory held for sale resulting from favorable secondary market conditions. The Company's net investment in sold receivables pools increased $539.7 million to $1,857.6 million at year-end 1993 compared to $1,317.9 million at December 31, 1992, primarily as a result of the 1993 receivable sale activity. Other earning assets declined $428.0 million to $795.2 million at December 31, 1993. This decrease is primarily the result of a lower inventory of off-lease vehicles purchased from General Motors, which are held for resale, in line with GM's reduced reliance on fleet sales. II-5 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(continued) Intangible assets included in other assets totaled $360.9 million at the end of 1993, compared with $514.9 million in the prior year. Other nonearning assets, comprised primarily of repossessed vehicles, foreclosed loans or loans otherwise classified as nonearning and insurance premium receivables, increased $354.5 million to $1.6 billion. This increase can be primarily attributed to the requirement to record reinsurance receivable and prepaid reinsurance premiums as assets in accordance with SFAS No. 113 - Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. This statement, which was adopted effective January 1, 1993, eliminated the prior practice of reporting assets and liabilities related to reinsured contracts net of the effects of reinsurance. LIQUIDITY The Company's liquidity, as well as its ability to profitably effect ongoing acquisition activity, is in large part dependent upon its timely access to and the costs associated with raising funds in different segments of the capital markets. In this regard, GMAC regularly accesses the short-, medium-, and long- term debt markets, principally through commercial paper, medium-term notes and underwritten transactions. As of December 31, 1993, GMAC's total borrowings were $62.8 billion compared with $74.5 billion at December 31, 1992. The year-end ratio of total borrowings to equity capital was 8.0 to 1, compared with 9.0 to 1 at year-end 1992. The decrease in total borrowings has been accomplished primarily through increased use of asset securitization, a strategy which will continue to be monitored during 1994 to reflect market conditions and funding requirements. Approximately 80% of borrowings represent funding for United States operations, while 20% relates to International and Canadian operations. Germany and Canada account for 32% and 30%, respectively, of the total non-U.S. borrowings. GMAC continued its strategy of reducing its funding from short-term notes in 1993, with the total of such debt amounting to $17.7 billion at December 31, 1993, as compared with $21.0 billion at December 31, 1992. This reflects a planned strategy to reduce liquidity risk. Longer-term funding is provided through the sale of medium-term notes, which are offered by prospectus worldwide on a continuous basis, and the issuance of underwritten debt. GMAC sells medium-term notes worldwide through dealer agents and directly to the public in either book-entry or physical note form for any maturity ranging from nine months to thirty years. In the U.S. and Euro markets, sales of medium-term notes totaled $5.2 billion in 1993, compared with $9.9 billion in 1992. Medium-term notes outstanding in the U.S. and Euro markets totaled $21.1 billion at December 31, 1993, a decrease of $2.8 billion over the prior-year period. Underwritten debt issues in the United States totaling $1.1 billion were completed during 1993, compared with $3.0 billion in 1992. Total underwritten debt issues outstanding in the U.S. at December 31, 1993, was $12.4 billion, a decrease of $3.5 billion from year-end 1992. Outside the United States, funding needs are met primarily by a combination of short- and medium-term loans from banks and other financial institutions. The Company also issues commercial paper and medium- and long-term debt, where cost-effective, to fund certain non-U.S. operations. During 1993, GMAC and its affiliates completed agreements to establish syndicated bank credit facilities in the U.S. and Europe. Footnote 2 in the Notes to Financial Statements includes a description of such facilities. II-6 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(continued) GMAC maintains substantial bank lines of credit and sells finance receivables in the public market. At December 31, 1993, GMAC maintained or had access to approximately $21.8 billion of unused credit lines with banks worldwide, an increase of $4.6 billion from 1992. Additionally, GMAC held approximately $7.5 billion of U.S. finance receivables considered eligible for sale. As discussed in Note 4 in the Notes to the Financial Statements, GMAC sold to investors retail receivables with principal balances amounting to $13.6 billion and $12.0 billion during 1993 and 1992, respectively, through several special purpose bankruptcy-remote subsidiaries. GMAC continues to service sold receivables for a fee and earns other related ongoing income. These subsidiaries generally retain a subordinated or restricted cash interest in the total receivable pools, which are included in other earning assets as due and deferred from receivable sales. Such subsidiaries also retain limited recourse for credit losses in the underlying receivables to the extent of their investments. These special purpose subsidiaries are consolidated for financial reporting purposes, while the transfer of underlying assets to the issuing trusts and subsequent sale of securities to investors represents a sale for financial reporting purposes. During 1993, New Center Asset Trust (NCAT), a special purpose entity which issues asset-backed commercial paper, was established. NCAT enables the Company to diversify funding sources, establish incremental liquidity, and achieve cost savings (relative to its existing funding alternatives) by accessing both the A-1+/P-1 and A-1/P-1 commercial paper markets. NCAT purchases certain qualifying asset-backed securities from special purpose subsidiaries of GMAC and finances the purchases through the issuance of commercial paper and equity certificates, the majority of which have been sold to unrelated third parties. GMAC is highly reliant in the U.S. on funding generated in the capital markets. The scope of GMAC's capability to tap the capital markets for unsecured debt is linked to both its term debt and commercial paper ratings. This is particularly true with respect to the Company's commercial paper ratings. Lower ratings generally result in higher borrowing costs as well as reduced access to capital markets. A security rating is not a recommendation to buy, sell, or hold securities and may be subject to revision or withdrawal at any time by the assigned rating organization. Each rating should be evaluated independently of any other rating. As of March 10, 1994, the agencies had assigned the following ratings to GMAC: Medium & Long Term Commercial Debt Paper --------- ---------- Duff & Phelps Credit Rating Co. A- D-1 Fitch Investors Service, Inc. A- Moody's Investor Service, Inc. Baa1 P-2 Standard & Poor's Corporation BBB+ A-2 At this date, GMAC is not under review by any of the above agencies. Furthermore, since the most recent downgrade of GMAC's debt securities on February 3, 1993, the Company has maintained good access to the capital markets. GMAC also utilizes a variety of interest rate contracts including interest rate swaps and caps in the normal course of managing its interest rate exposures as further described in Note 16 in the Notes to Financial II-7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(continued) Statements. At December 31, 1993, the total notional amount of off-balance sheet instruments outstanding was $8.6 billion, an increase of $4.1 billion over 1992. This increase is due almost entirely to interest rate agreements entered into during 1993. CASH FLOWS Net cash provided by operating and investing activities in 1993 totaled $4.9 billion and $7.8 billion, respectively. Such cash flow was used to reduce debt levels by $11.3 billion and pay dividends to General Motors Corporation of $1.25 billion, with the net increase in cash and cash equivalents for 1993 totaling $157.0 million. In comparison, 1992 cash provided by operating and investing activities amounted to $5.2 billion and $7.2 billion respectively, which was also used to reduce debt by $9.8 billion, pay dividends of $1.1 billion and increased cash and cash equivalents by $1.5 billion. BORROWING COSTS An easing of short-term interest rates, which began in mid-1989, continued throughout 1993. The U.S. bank prime rate remained at 6.0% throughout the year, its lowest level since 1977. GMAC's cost of short-term debt in the United States decreased during 1993, averaging 3.75%, down 35 basis points from 4.10% in 1992. Medium- and long-term money costs decreased 44 basis points from 1992 to average 7.83% for the year. The composite cost of debt for United States operations averaged 6.51% in 1993, down from 6.75% in the prior year. GMAC's worldwide cost of short-term debt averaged 4.86% in 1993 compared with 5.31% in 1992, while the overall cost of funds averaged 6.94% in 1993, down 36 basis points from 7.30% recorded in the previous year. COLLECTION RESULTS Delinquency and repossession rates on retail and fleet leasing accounts serviced worldwide were relatively unchanged during 1993. Accounts past due over 30 days averaged 2.5% as a percent of accounts outstanding during 1993, up from 2.4% in 1992. Repossessions of new vehicles averaged 1.7%, down from 2.0% a year ago, while repossessions of used vehicles declined to 2.3% from 2.5% in 1992. In total, the number of repossessed vehicles decreased to 121,000 units in 1993 from 151,000 units in 1992. Retail losses were 0.63% of total serviced assets in 1993, down from 0.89% in 1992. Losses as a percent of total serviced assets liquidated decreased to 0.89% in 1993 from 1.38% in 1992. Allowance for financing losses, including the allowance for off-balance sheet sold receivables, amounted to $855.3 million at December 31, 1993, down $158.5 million from year-end 1992 balance. This reduction reflects a decrease in the level of assets serviced, net transfer to non-earning assets and improved loss experience, primarily in the U.S. At this level, the loss allowance represented 1.2% of net serviced assets, down from 1.3% in 1992. INSURANCE OPERATIONS Net premiums written by Motors Insurance Corporation and its subsidiaries totaled $1.2 billion in 1993, essentially unchanged from 1992. For the year, MIC contributed $190.5 million to consolidated net income, down $16.6 million from the comparable $207.1 million reported in 1992 excluding the cumulative effect of the 1992 charge for SFAS No. 106. The year-to-year decrease II-8 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(continued) reflects unfavorable underwriting results, which were partially offset by higher capital gains. MORTGAGE OPERATIONS GMAC Mortgage Corporation continued to be one of the leading mortgage bankers in the United States. For the 1993 calendar year, loan origination, purchased mortgage servicing and correspondent loan volume totaled $23.9 billion, a decrease of $4.3 billion from 1992 reflecting reduced purchased mortgage servicing activity. At December 31, 1993, the combined mortgage servicing portfolio, including $21.6 billion of loans master-serviced by Residential Funding Corporation (RFC), was $53.8 billion, down $4.9 billion from a year earlier reflecting heavy run-offs associated with high levels of refinancing activity. RFC is a wholesale mortgage banker specializing in securitization of jumbo mortgages and warehouse lending to its mortgage banking customers. FINANCIAL REVIEW Consolidated net income totaled $981.1 million in 1993, or $45.0 million above and $388.6 million below the income reported in 1992 and 1991, respectively. Income from financing operations, including mortgage results, totaled $790.6 million in 1993. 1993 results were unfavorable relative to the $1,011.6 billion earned in 1992 (excluding the $232.8 million unfavorable impact due to the adoption of SFAS No. 106.) and to the $865.9 million earned in 1991 (excluding a $299.1 million favorable impact of SFAS No. 109 - Accounting for Income Taxes). The decrease from 1992 earnings is primarily attributable to lower asset levels and tighter net interest rate margins in North America, partially offset by higher earnings outside North America. 1992 results compared favorably with 1991 due to a special wholesale loss provision reported in 1991. Income from insurance operations decreased 8% to $190.5 million in 1993. These results compare with $207.1 million in 1992 (excluding the $49.8 million unfavorable impact of SFAS No. 106) and $172.3 million in 1991 (excluding the $32.4 million favorable impact of SFAS No. 109). Income earned in 1993, in comparison to 1992, reflects unfavorable underwriting results, which were partially offset by higher capital gains. Insurance operations in 1992 compared favorably to 1991, due to higher capital gains along with improved underwriting results. GMAC's return on equity capital was 11.9% in 1993, up from 11.1% reported in 1992 (or down from 14.2% excluding the cumulative effect of the accounting change) and down from 16.3% in 1991 (or down from 12.8% excluding the cumulative effect of the accounting change). Total cash dividends paid to General Motors Corporation in 1993 were $1.25 billion, compared with $1.1 billion in 1992 and $850 million in 1991. The year-end ratio of total borrowings to equity capital was 8.0 to 1, compared with 9.0 to 1 and 10.0 to 1 in 1992 and 1991, respectively. FINANCING REVENUES Gross financing revenue totaled $8.8 billion in 1993, down $1.7 billion from 1992 and $2.4 billion from 1991. The decrease is primarily due to lower earning rates on a lower level of average retail receivables, partially II-9 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(continued) offset by an increase in leasing revenues resulting from continued growth in operating lease activity. Retail and lease financing revenue, at $3.7 billion for 1993, was $1.8 billion and $3.3 billion lower than 1992 and 1991 respectively. Contributing to these declines were lower asset levels, primarily due to net asset liquidations through the sale of retail finance receivables since December 1990. Leasing revenue reached $3.9 billion in 1993, compared to $3.5 billion in 1992 and $2.7 billion in 1991, as leasing continues to gain consumer acceptance. In 1993, wholesale and term loan financing revenue amounted to $1.2 billion, compared with $1.4 billion in 1992 and $1.5 billion in 1991, with the decrease primarily attributed to lower interest rates and lower dealer stocks. As a result of the continued downward trend in United States interest rates as well as the lower level of total borrowings, interest and discount expense decreased to $4.7 billion in 1993 from $5.8 billion reported in 1992 and $6.8 billion in 1991. Depreciation expense on SmartLease and Direct Lease Plan vehicles, totaled $2.7 billion in 1993, in comparison to $2.4 billion in 1992 and $1.9 billion in 1991. The increase was primarily attributable to the continued successful marketing of the SmartLease program in the United States and Canada. Net pre-tax margin from financing operations after interest and discount and depreciation expense totaled $1.3 billion in 1993, down $815.1 million from 1992, and down $1,077.6 million from 1991. The decline reflects lower asset levels and tightening net spreads. Insurance premiums earned by MIC in 1993 were relatively stable and amounted to $1.1 billion, compared with $1.2 billion in both 1992 and 1991. Other income, primarily interest and fees earned on the financing arrangement with General Motors Corporation, interest earned on marketable securities, gains on the sale of receivables and ongoing servicing and other income from receivable sales, totaled $2.6 billion for 1993, as compared to $2.2 billion in both 1992 and 1991. The 1993 increase reflects higher ongoing income from receivable sales, due primarily to the higher level of serviced receivables off-balance sheet. Pre-tax gains on sold receivables, excluding the related limited recourse loss provision, which are recorded in other income, totaled $436.4 million during 1993 compared with $588.8 million for the previous year and $140.3 million in 1991. Receivables sales generally accelerate the recognition of income on retail contracts, net of servicing fees and other related deferrals, into the period the receivables are sold. The amount of such gains is affected by a number of factors and may create variability in quarterly earnings depending on the type and amount of receivables sold, the structure used to effect the sale, as well as the prevailing financial market conditions. This acceleration results in the pre-tax gains reflected above, and can create variability in annual earnings depending on the amount, timing and the net margin between the average yield on and all-in-cost of the sold receivables. The acceleration also reduces profit potential in future periods. Although this acceleration can significantly impact quarterly or year-to-year comparisons, it should be noted that the Company historically recognizes approximately 70% of interest II-10 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(concluded) and discount revenue in the first two years of a retail contract (reflecting the term of the underlying contracts, revenue recognition methods and historical prepayment experience). As such, depending on the timing of receivables sales in a given year, the net impact on annual earnings may be substantially less than the gains indicated. EXPENSES Salaries and benefits declined slightly in 1993 to $825.8 million from $854.4 million in 1992, but increased $52.9 million from $772.9 million in 1991. The lower salary costs in 1993, when compared to 1992, were a result of the non-recurring voluntary retirement program reflected in 1992, partially offset by increased benefit costs primarily for retirement and post-retirement benefits. Operating expenses, excluding salaries and benefits, were $1.1 billion in 1993, an increase of $77.5 million from 1992 and down $11.0 million from 1991. Insurance losses and loss adjustments were $1.1 billion for 1993, essentially unchanged from the 1992 and 1991 levels. The provision for financing losses amounted to $300.8 million in 1993, a decrease of $70.2 million and $747.1 million from 1992 and 1991, respectively. The decline reflects improved year-to-year loss performance in all segments of GMAC's business. United States, foreign and other income taxes amounted to $591.7 million for 1993, $290.6 million and $18.3 million less than 1992 and 1991, respectively. The year-to-year decline primarily reflects a lower pre-tax earnings level. The unusually high level in 1992 includes a non-recurring state and local deferred tax adjustment. -------------------- II-11 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA RESPONSIBILITIES FOR CONSOLIDATED FINANCIAL STATEMENTS The following consolidated financial statements of General Motors Acceptance Corporation and subsidiaries were prepared by management, which is responsible for their integrity and objectivity. The statements have been prepared in conformity with generally accepted accounting principles and, as such, include amounts based on judgments of management. Financial information elsewhere in Part II is consistent with that in the financial statements. Management is further responsible for maintaining a system of internal accounting controls, designed to provide reasonable assurance that the books and records reflect the transactions of the companies and that its established policies and procedures are carefully followed. Perhaps the most important feature in the system of control is that it is continually reviewed for its effectiveness and is augmented by written policies and guidelines, the careful selection and training of qualified personnel and a strong program of internal audit. Deloitte & Touche, an independent auditing firm, is engaged to audit the consolidated financial statements of General Motors Acceptance Corporation and its subsidiaries and issue reports thereon. The audit is conducted in accordance with generally accepted auditing standards which comprehend a review of internal accounting controls and a test of transactions. The Independent Auditors' Report appears on the next page. The Board of Directors, through its Audit Committee (the "Committee"), is responsible for: (1) assuring that management fulfills its responsibilities in the preparation of the consolidated financial statements and (2) engaging the independent auditors. The Committee reviews the scope of the audits and the accounting principles being applied in financial reporting. The independent auditors, representatives of management and the internal auditors meet regularly (separately and jointly) with the Committee to review the activities of each, to ensure that each is properly discharging its responsibilities and to assess the effectiveness of the system of internal accounting controls. It is management's conclusion that the system of internal accounting controls at December 31, 1993, provides reasonable assurance that the books and records reflect the transactions of the companies and that its established policies and procedures are complied with. To ensure complete independence, Deloitte & Touche has full and free access to meet with the Committee, without management representatives present, to discuss the results of the audit, the adequacy of internal accounting controls and the quality of the financial reporting. s\ R. T. O'Connell s\ J. D. Finnegan - -------------------- ------------------------------------- Robert T. O'Connell John D. Finnegan, Executive Vice Chairman President and Chief Financial Officer II-12 INDEPENDENT AUDITORS' REPORT General Motors Acceptance Corporation: We have audited the Consolidated Balance Sheet of General Motors Acceptance Corporation and subsidiaries as of December 31, 1993 and 1992 and the related Consolidated Statement of Income and Net Income Retained for Use in the Business and Consolidated Statement of Cash Flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of General Motors Acceptance 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. As discussed in Note 14, the Company changed its method of accounting for postretirement benefits other than pensions effective January 1, 1992. As discussed in Note 11, effective January 1, 1991, the Company also changed its method of accounting for income taxes. s\ DELOITTE & TOUCHE - -------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243-1704 February 9, 1994 II-13 CONSOLIDATED BALANCE SHEET ASSETS - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 - ---------------------------------------------------- - ----------- --------- Cash and Cash Equivalents (Note 1) ................. $ 4,028.1 $ 3,871.1 - ----------- --------- EARNING ASSETS INVESTMENTS IN SECURITIES (Note 3) Bonds, notes and other securities, at amortized cost (market value, 1993--$3,124.9; 1992--$2,749.7) .................................. 2,928.7 2,618.7 Equity securities, at market value (cost, 1993--$266.2; 1992--$291.1) ............... 521.0 657.2 - ----------- --------- Total investments in securities .................... 3,449.7 3,275.9 - ----------- --------- FINANCE RECEIVABLES (Notes 4 and 5) Finance receivables ................................ 54,882.8 58,244.3 Allowance for financing losses ..................... (748.0) (817.0 - ----------- --------- Finance receivables (net)........................... 54,134.8 57,427.3 - ----------- --------- OTHER EARNING ASSETS Receivables General Motors Corporation (Note 15) ... 1,355.5 11,563.2 Net equipment on operating leases (Note 6) ......... 11,363.5 9,852.6 Real estate mortgages held for sale, at lower of cost or market ................................ 1,827.5 2,538.6 Due and deferred from receivable sales (net) (Note 4) 1,857.6 1,317.9 Other (Note 15) .................................... 795.2 1,223.2 - ----------- --------- Total earning assets ............................... 74,783.8 87,198.7 - ----------- --------- OTHER ASSETS Intangible assets, at cost less amortization (Note 1) 360.9 514.9 Other nonearning assets (Note 7) ................... 1,578.0 1,223.5 - ----------- --------- Total other assets ................................. 1,938.9 1,738.4 - ----------- --------- TOTAL ASSETS ....................................... $ 80,750.8 $ 92,808.2 = =========== ========= II-14 CONSOLIDATED BALANCE SHEET (concluded) LIABILITIES AND STOCKHOLDER'S EQUITY - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 - ---------------------------------------------------- - ----------- --------- NOTES, LOANS AND DEBENTURES PAYABLE WITHIN ONE YEAR (Notes 2 and 8) ............................. $ 35,084.4 $ 41,364.4 - ----------- --------- ACCOUNTS PAYABLE AND OTHER LIABILITIES General Motors Corporation and affiliated companies (Note 15) .............................. 2,487.5 2,827.1 Interest ........................................... 1,006.6 1,194.8 Unpaid insurance losses and loss adjustment expenses ......................................... 1,569.4 1,265.8 Unearned insurance premiums ........................ 1,337.4 1,174.9 Deferred income taxes (Note 11) .................... 1,193.2 914.7 United States and foreign income and other taxes payable .............................. 35.5 239.2 Other postretirement benefits ...................... 524.9 486.2 Other .............................................. 1,970.8 1,916.9 - ----------- --------- Total accounts payable and other liabilities ....... 10,125.3 10,019.6 - ----------- --------- NOTES, LOANS AND DEBENTURES PAYABLE AFTER ONE YEAR (Note 9) .......................... 27,688.8 33,174.2 - ----------- --------- STOCKHOLDER'S EQUITY Common stock, $100 par value (authorized and outstanding, 21,650,000 shares) .................. 2,165.0 2,165.0 Net income retained for use in the business ........ 5,609.0 5,877.9 Net unrealized gains on equity securities .......... 164.3 241.6 Unrealized accumulated foreign currency translation adjustments .......................... (86.0) (34.5 - ----------- --------- Total stockholder's equity ......................... 7,852.3 8,250.0 - ----------- --------- TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY ......... $ 80,750.8 $ 92,808.2 = =========== ========= Reference should be made to the Notes to Financial Statements. II-15 CONSOLIDATED STATEMENT OF INCOME AND NET INCOME RETAINED FOR USE IN THE BUSINESS - ------------------------------------------------------------------------------- (in millions of dollars) For the Years 1993 1992 1991 - ----------------------------------------- - ----------- ----------- --------- FINANCING REVENUE (Note 1) Retail and lease financing ............ $ 3,673.4 $ 5,507.0 $ 6,924.8 Leasing ............................... 3,870.9 3,527.9 2,730.6 Wholesale and term loans .............. 1,207.7 1,367.2 1,498.1 - ----------- ----------- --------- Total financing revenue ................. 8,752.0 10,402.1 11,153.5 Interest and discount ................. (4,721.2) (5,828.6) (6,844.7 Depreciation on operating leases ...... (2,702.0) (2,429.6) (1,902.4 - ----------- ----------- --------- Net financing revenue ................... 1,328.8 2,143.9 2,406.4 Insurance premiums earned ............... 1,107.2 1,159.7 1,187.7 Other income (Notes 4 and 15) ........... 2,624.3 2,177.5 2,161.9 - ----------- ----------- --------- NET FINANCING REVENUE AND OTHER ......... 5,060.3 5,481.1 5,756.0 - ----------- ----------- --------- EXPENSES Salaries and benefits ................. 825.8 854.4 772.9 Other operating expenses .............. 1,123.2 1,045.7 1,134.2 Insurance losses and loss adjustment expenses ............................ 1,096.6 987.9 1,061.6 Provision for financing losses (Note 5) 300.8 371.0 1,047.9 Amortization of intangible assets (Note 1) ............................ 141.1 121.1 91.2 - ----------- ----------- --------- Total expenses .......................... 3,487.5 3,380.1 4,107.8 - ----------- ----------- --------- Income before income taxes .............. 1,572.8 2,101.0 1,648.2 United States, foreign and other income taxes (Note 11) ................ 591.7 882.3 610.0 - ----------- ----------- --------- Income before cumulative effect of accounting changes .................... 981.1 1,218.7 1,038.2 Cumulative effect of accounting changes ............................... -- (282.6) 331.5 - ----------- ----------- --------- NET INCOME .............................. 981.1 936.1 1,369.7 Net income retained for use in the business at beginning of the year ..... 5,877.9 6,041.8 5,522.1 - ----------- ----------- --------- Total ................................... 6,859.0 6,977.9 6,891.8 Cash dividends .......................... 1,250.0 1,100.0 850.0 - ----------- ----------- --------- NET INCOME RETAINED FOR USE IN THE BUSINESS AT END OF THE YEAR ........... $ 5,609.0 $ 5,877.9 $ 6,041.8 = =========== =========== ========= Reference should be made to the Notes to Financial Statements. II-16 CONSOLIDATED STATEMENT OF CASH FLOWS - ------------------------------------------------------------------------------- (in millions of dollars) For the Years 1993 1992 1991 - ----------------------------------------- - ----------- ----------- --------- CASH FLOWS FROM OPERATING ACTIVITIES Income before cumulative effect of accounting changes .................... $ 981.1 $ 1,218.7 $ 1,038.2 Depreciation ............................ 2,751.5 2,474.4 1,944.9 Taxes payable and deferred .............. 123.4 337.1 166.5 Provision for financing losses .......... 300.8 371.0 1,047.9 General Motors Corporation and affiliated companies .................. (333.9) 812.6 (810.5 Origination/purchase of mortgage loans .. (21,583.7) (17,232.9) (10,311.9 Proceeds on sale of mortgage loans ...... 22,309.5 16,859.0 10,486.9 Interest payable ........................ (180.7) (106.4) (15.5 Other assets ............................ (97.0) 100.4 (487.8 Other liabilities ....................... 222.0 187.3 480.9 Other ................................... 408.8 145.6 57.5 - ----------- ----------- --------- Net cash provided by operating activities 4,901.8 5,166.8 3,597.1 - ----------- ----------- --------- CASH FLOWS FROM INVESTING ACTIVITIES Finance receivables-acquisitions ........ ********** ********** ********* -liquidations ........ 92,808.6 119,453.1 112,682.4 Notes receivable General Motors Corporation ........................... 10,207.7 2,303.0 660.0 Operating leases-acquisitions ........... (6,971.3) (6,182.8) (5,562.3 -liquidations ........... 2,572.7 1,912.7 1,406.9 Investments in securities-acquisitions .. (10,976.1) (9,714.8) (10,287.5 -liquidations .. 10,676.7 9,717.7 10,095.8 Proceeds from sales of receivables ...... 13,072.2 11,201.8 2,926.9 Due and deferred from receivable sales .. (618.4) (854.3) (372.8 Other ................................... 449.1 224.7 (1,281.6 - ----------- ----------- --------- Net cash provided by investing activities .................. 7,824.9 7,231.3 1,999.4 - ----------- ----------- --------- CASH FLOWS FROM FINANCING ACTIVITIES Debt with original maturities 90 days and over-proceeds ..................... 38,577.4 50,507.6 56,293.8 -liquidations ................. (45,148.0) (54,475.9) (50,442.8 Debt with original maturities less than 90 days-net change .................... (4,744.0) (5,866.1) (8,391.4 Dividends paid .......................... (1,250.0) (1,100.0) (850.0 - ----------- ----------- --------- Net cash used in financing activities.... (12,564.6) (10,934.4) (3,390.4 - ----------- ----------- --------- Effect of exchange rate changes on cash and cash equivalents .......... (5.1) (5.1) 1.3 - ----------- ----------- --------- Net increase in cash and cash equivalents .................. 157.0 1,458.6 2,207.4 Cash and cash equivalents at the beginning of the year ................. 3,871.1 2,412.5 205.1 - ----------- ----------- --------- Cash and cash equivalents at the end of the year ....................... $ 4,028.1 $ 3,871.1 $ 2,412.5 =========== =========== =========== SUPPLEMENTARY CASH FLOWS INFORMATION Interest paid ......................... $ 4,819.1 $ 5,824.0 $ 6,659.6 Income taxes paid ..................... $ 430.5 $ 541.8 $ 426.9 II-17 NOTES TO FINANCIAL STATEMENTS NOTE 1. SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of General Motors Acceptance Corporation and its domestic and foreign subsidiaries (the Company). The Company, a wholly-owned subsidiary of General Motors Corporation, was incorporated in 1919 under the New York Banking Law relating to investment companies. FINANCE INCOME: In the case of finance receivables in which the face amount includes the finance charge (principally retail financing), earnings are recorded in income over the terms of the receivables using the interest method. On finance receivables in which the face amount represents the principal (principally wholesale, interest-bearing financing and fleet leasing), the interest is taken into income as earned. Certain loan origination costs are deferred and amortized to financing revenue over the life of the related loans using the interest method. Income from operating leases, included in leasing revenues, is recognized as scheduled payments become due. SALES OF RECEIVABLES: The Company sells retail receivables through special purpose subsidiaries which absorb all losses related to sold receivables to the extent of their subordinated investments, as well as certain segregated restricted cash flows. Appropriate limited recourse loss provisions associated with sold receivables are included in the Company's provision for financing losses. Normal servicing fees on sold receivables are earned over time on a level yield basis. Pre-tax gains on sold receivables are recorded in other income. In determining the gain or loss for each qualifying sale of retail receivables, the investment in the sold receivable pool is allocated between the portion sold and the portion retained based on their relative fair values on the date of sale. The receivables sold are removed from the balance sheet caption "Finance receivable (net)", and the Company's retained interests in such receivables are included in "Due and deferred from receivable sales (net)". PROVISION FOR FINANCING LOSSES: An allowance for credit losses is generally established during the period in which receivables are acquired and is maintained in amounts considered by management to be appropriate in relation to receivables outstanding. Losses arising from repossession of the collateral supporting doubtful accounts are recognized upon repossession of the collateral. Repossessed collateral is recorded at estimated realizable value in other nonearning assets and adjustments to the related valuation allowance are included in operating expense. Where repossession has not been effected, losses are charged off as soon as it is determined that the collateral cannot be repossessed, generally not more than 150 days after default. CASH EQUIVALENTS: Cash equivalents are defined as short-term, highly liquid investments with original maturities of 90 days or less. Due to the short duration of these instruments, the carrying value of cash equivalents are assumed to approximate fair value. (continued) II-18 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 1. SIGNIFICANT ACCOUNTING POLICIES (continued) RECLASSIFICATIONS: Certain amounts for prior year's financial statements have been reclassified to conform with 1993 classifications. INSURANCE OPERATIONS: Insurance premiums are earned on a basis related to coverage provided over the terms of the policies (principally based on anticipated loss experience). Commission costs and premium taxes incurred in acquiring new business are deferred and amortized over the terms of the related policies on the same basis as premiums are earned. Acquisition costs associated with direct mail programs are amortized over a three year period. The liability for losses and claims includes a provision for unreported losses, based on past experience, net of the estimated salvage and subrogation recoverable. INTANGIBLE ASSETS: Intangible assets representing purchased mortgage servicing rights are being amortized over periods that generally match future net mortgage servicing revenues, while goodwill is being amortized on a straight-line basis over 40 years. Amortization is applied directly to the asset account. DEPRECIATION: The Company and its subsidiaries provide for depreciation of vehicles and other equipment on operating leases or in Company use generally on a straight-line basis. The difference between the net book value and the proceeds of sale or salvage on items disposed of is included in income as a charge against or credit to the provision for depreciation. PENSION PROGRAM: The Company and certain of its subsidiaries participate in various pension plans of General Motors Corporation and its domestic and foreign subsidiaries, which cover substantially all of their employees. Benefits under the plans are generally related to an employee's length of service, salary and, where applicable, contributions. GMAC Mortgage Corporation and NAVCO Corp., two wholly-owned subsidiaries, have separate retirement plans which provide for pension payments to their eligible employees upon retirement. ACCOUNTING STANDARDS: In November 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 112, Employers' Accounting for Postemployment Benefits, which established a new accounting principle for the cost of benefits provided to former or inactive employees after employment but before retirement. The Statement is effective for the fiscal years beginning after December 15, 1993, with earlier voluntary adoption encouraged. The Company intends to adopt this Statement effective January 1, 1994. The effect of this Statement will not be material to the financial results of the Company. In December 1992, SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, which amends SFAS No. 60, Accounting and Reporting by Insurance Enterprises, was issued by the FASB. This statement eliminated the practice of reporting assets and liabilities relating to reinsured contracts net of the effects of reinsurance and required reinsurance receivables and prepaid reinsurance premiums to be reported as assets. SFAS No. 113 applies to financial statements for fiscal years beginning after December 15, 1992. The Company adopted SFAS No. 113 effective January 1, 1993 and the resultant increase in assets and liabilities was not material to the consolidated financial statements. (continued) II-19 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 1. SIGNIFICANT ACCOUNTING POLICIES (continued) In May 1993, the FASB issued SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which amends FASB Statement No. 5, Accounting for Contingencies, to clarify that a creditor should evaluate the collectibility of both contractual interest and principal of all receivables when assessing the need for a loss accrual. SFAS No. 114 also amends FASB Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, to require creditors to measure all loans that are restructured in a troubled debt restructuring involving modification of terms to reflect the time value of money. SFAS No. 114 applies to financial statements for fiscal years beginning after December 15, 1994, with earlier adoption encouraged. The Company has not determined if it will adopt this Standard early, however, since the Company's policy with regard to loan loss accruals generally conforms with this Standard, adoption will have no material effect on the consolidated financial statements. In May 1993, the FASB also issued SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, that addresses the accounting and reporting for investments in debt and equity securities that have readily determinable fair values and for all investments in debt securities. These investments are categorized as follows: "Held-to-Maturity Securities" - debt securities that the enterprise has the positive intent and ability to hold to maturity. Reported at amortized cost. "Trading Securities" - debt and equity securities that are bought and held principally for the purpose of selling them in the near term. Reported at fair value, with unrealized gains and losses included in earnings. "Available-for-Sale" - debt and equity securities not classified as either held-to-maturity securities or trading securities. Reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of stockholder's equity. This Statement is effective for fiscal years beginning after December 15, 1993. The Company intends to adopt this Statement, which will have a minor favorable effect (approximately $125 million) on stockholder's equity, effective January 1, 1994. FINANCIAL INSTRUMENTS: The Company is party to a variety of interest rate and foreign exchange forward contracts (e.g., swap agreements) in the management of its interest rate and foreign exchange exposure. The Company enters into interest rate forward contracts as a means of managing its interest rate exposure. The differential to be paid or received under these agreements is accrued consistent with the terms of the agreements and market interest rates. (continued) II-20 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 1. SIGNIFICANT ACCOUNTING POLICIES (concluded) In accordance with the requirements of SFAS No. 107, Disclosures about Fair Value of Financial Instruments, the Company has provided fair value estimates and information about valuation methodologies in various notes to the financial statements. The estimated fair value amounts have been determined using available market information or appropriate valuation methodologies. However, considerable judgment is required in interpreting market data to develop estimates of fair value, so the estimates are not necessarily indicative of the amounts that could be realized in a current market exchange. The effect of using different market assumptions and/or estimation methodologies may materially impact the estimated fair value amounts. Fair value information presented herein for the years ended December 31, 1993 and 1992, is based on information available at their respective dates. Such amounts have not been updated since those dates and, therefore, estimates of fair value at dates subsequent to December 31, 1993 and 1992 may differ significantly from the amounts presented herein. NOTE 2. LINES OF CREDIT WITH BANKS On May 19, 1993, agreements were put in place which establish four syndicated bank credit facilities in the U.S. and Europe. The new syndicated credit agreements replaced various individual bank credit facilities maintained by GMAC. In the U.S., the syndicated bank credit facilities include a four year, $10.0 billion revolving credit facility, as well as a $5.0 billion 364-day asset backed commercial paper liquidity and receivables credit facility to a non-consolidated special purpose entity established to issue asset backed commercial paper. These facilities serve primarily as back-up for GMAC's unsecured and asset backed commercial paper programs, respectively. On January 26, 1994, the size of the asset backed commercial paper liquidity and receivables credit facility was increased to $8.3 billion. In Europe, the syndicated facilities will be used as needed to fund GMAC's financing operations in line with the Company's historical reliance on bank debt outside the U.S. and Canada. In this regard, the syndicated facilities include a four year, $500 million revolving credit facility to GMAC International Finance in the Netherlands and a 400 million pound sterling revolving credit facility to GMAC (UK) plc. In these syndicated agreements, GMAC has agreed to a covenant such that, so long as the commitments remain in effect or any amount is owing to any lender under such commitments, the ratio of consolidated debt to total stockholder's equity at the last day of any fiscal quarter shall not exceed 11.0 to 1.0. At December 31, 1993, this ratio amounted to 8.0 to 1.0. Inclusive of these syndicated agreements, credit facilities maintained worldwide totaled $29,203.2 million at December 31, 1993, compared to $26,081.4 million at December 31, 1992. Facilities available for use as commercial paper back-up in the United States amounted to $15,000.0 million and $12,259.3 million at December 31, 1993 and 1992, respectively, all of which were unused. GMAC Mortgage had $1,255.0 million of bank lines of credit at December 31, 1993, compared with $1,055.0 million at December 31, 1992, which are utilized in the normal course of business. Of these lines, $480.0 million and $150.0 million were unused at December 31, 1993 and 1992, respectively. (continued) II-21 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 2. LINES OF CREDIT WITH BANKS (concluded) An additional $12,948.2 million at December 31, 1993 and $12,767.1 million at December 31, 1992, in credit facilities support operations in Canada, Europe, Latin America and Asia Pacific, of which $6,314.3 million and $4,761.6 million were unused at December 31, 1993 and 1992, respectively. As of December 31, 1993, the committed and uncommitted portion of such credit facilities totaled $4,350.2 million and $8,598.0 million, respectively. Due to the short duration of these instruments, or the floating rate nature of the liabilities, the carrying value of lines of credit are assumed to approximate fair value. NOTE 3. INVESTMENTS IN SECURITIES Bonds, notes, certificates of deposit, other investments and preferred stocks with mandatory redemption terms are carried at amortized cost. Other stocks are carried at market (fair) value, for which the aggregate excess of market value over cost, net of related income taxes, is included as a separate component of stockholder's equity. The fair value of the other financial instruments presented herein is based on quoted market prices. - ------------------------------------------------------------------------------- (in millions of dollars) December 31, 1993 Fair Unrealized Unrealized Type of Security Cost Value Gains Losses - ------------------------------ - --------- - ----------- ----------- --------- Bonds, notes and other securities United States government and governmental agencies and authorities .............. $ 195.1 $ 206.3 $ 11.4 $ (0.2 States, municipalities and political subdivisions ... 1,997.7 2,137.6 146.2 (6.3 Other ...................... 731.1 776.2 48.3 (3.2 Preferred stocks with mandatory redemption terms . 4.8 4.8 -- -- - --------- - ----------- ----------- --------- Total bonds, notes and other securities ................. $ 2,928.7 $ 3,124.9 $ 205.9 $ (9.7 ========== =========== =========== =========== - ------------------------------------------------------------------------------- (in millions of dollars) December 31, 1992 Fair Unrealized Unrealized Type of Security Cost Value Gains Losses - ------------------------------ - --------- - ----------- ----------- --------- Bonds, notes and other securities United States government and governmental agencies and authorities .............. $ 360.9 $ 368.2 $ 7.5 $ (0.2 States, municipalities and political subdivisions ... 1,231.1 1,310.3 85.6 (6.4 Other ...................... 1,021.5 1,066.0 47.3 (2.8 Preferred stocks with mandatory redemption terms . 5.2 5.2 -- -- - --------- - ----------- ----------- --------- Total bonds, notes and other securities ................. $ 2,618.7 $ 2,749.7 $ 140.4 $ (9.4 ========== =========== =========== =========== II-22 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 3. INVESTMENTS IN SECURITIES (concluded) The distribution of maturities of debt securities outstanding at December 31, 1993 and 1992 is summarized as follows: - ------------------------------------------------------------------------------- (in millions of dollars) December 31, 1993 December 31, 1992 Fair Fair Maturity Cost Value Cost Value - ------------------------------ - --------- - ----------- ----------- --------- Due in one year or less ...... $ 168.0 $ 173.5 $ 179.8 $ 181.4 Due after one year through five years ................. 621.6 663.7 760.4 792.9 Due after five years through ten years .................. 876.6 931.8 649.6 682.2 Due after ten years .......... 1,080.0 1,162.2 638.8 686.7 Mortgage-backed securities ... 182.5 193.7 390.1 406.5 - --------- - ----------- --------- - --------- Total debt securities ........ $ 2,928.7 $ 3,124.9 $ 2,618.7 $ 2,749.7 ========== =========== =========== =========== Proceeds from the sale of debt securities amounted to $2,093.4 million in 1993, $1,690.3 million in 1992 and $1,693.2 million in 1991. Gross realized gains amounted to $58.6 million in 1993, $54.7 million in 1992 and $41.3 million in 1991. Gross realized losses amounted to $13.3 million, $5.4 million and $2.1 million in 1993, 1992 and 1991, respectively. - ------------------------------------------------------------------------------- (in millions of dollars) December 31, 1993 December 31, 1992 Fair Fair Type of Security Cost Value Cost Value - ------------------------------ - --------- - ----------- ----------- --------- Equity securities-common stocks Public utilities ........... $ 19.8 $ 46.1 $ 22.7 $ 46.7 Banks, trust and insurance companies ................ 10.4 22.1 6.6 25.8 Industrial and miscellaneous 236.0 452.8 261.8 584.7 - --------- - ----------- --------- - --------- Total equity securities ...... $ 266.2 $ 521.0 $ 291.1 $ 657.2 ========== =========== =========== =========== The difference between fair (market) value and cost of equity securities at December 31, 1993, 1992 and 1991, consisted of gross unrealized profits (excess of market value over cost) of $270.9 million, $386.6 million and $420.5 million and gross unrealized losses (excess of cost over market value) of $16.1 million, $20.5 million and $7.7 million, respectively. Net gains realized from the sale of equity securities amounted to $158.2 million in 1993, $73.0 million in 1992 and $37.7 million in 1991. II-23 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 4. SALE OF FINANCE RECEIVABLES The Company sold retail finance receivables through two special purpose subsidiaries aggregating (in principal balance) $13.6 billion in 1993, $12.0 billion in 1992 and $3.2 billion in 1991. These subsidiaries generally retain a subordinated investment of no greater than 9% of the total receivables pool and market the remaining portion. The subsidiaries absorb all losses related to sold receivables to the extent such subordinated interests, excess cash flows or cash reserves are insufficient to cover such losses. Pre-tax net gains on such sales (excluding limited recourse loss provisions which are generally provided for at the time contracts are acquired), which are recorded in "Other income", amounted to $436.4 million in 1993, $588.8 million in 1992 and $140.3 million in 1991. The Company continues to service these receivables for a fee. The Company's retail instalment obligation servicing portfolio (in principal balance) amounted to $14.9 billion, $10.9 billion and $3.6 billion at December 31, 1993, 1992 and 1991, respectively. The Company's interest in excess servicing cash flows, subordinated interest in trusts, cash deposits and other related amounts are generally restricted assets and subject to the aforementioned limited recourse provisions. The following is a summary of amounts included in "Due and deferred from receivable sales (net)." - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 - ---------------------------------------------------- - ----------- --------- Excess servicing ................................... $ 319.9 $ 395.6 Other restricted amounts: Subordinated interests in trusts ................. 726.8 773.2 Cash deposits held by trusts ..................... 557.5 167.5 Other ............................................ 360.7 178.4 Allowance for estimated credit losses on sold receivables .............................. (107.3) (196.8 - ----------- --------- Total .............................................. 1,857.6 1,317.9 = =========== ========= The fair values of retained subordinated interests in trusts as of December 31, 1993 and 1992 were $757.8 million and $822.1 million, respectively. Excess servicing assets, net of deferred costs, have fair values of $477.4 million and $438.6 million at December 31, 1993 and 1992, respectively. The foregoing market valuations were derived by discounting expected cash flows using current market rates. The fair value of cash deposits approximates their carrying value. The following table presents an analysis of the allowance for estimated credit losses on sold receivables for 1993 and 1992: - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 - ---------------------------------------------------- - ----------- --------- Allowance for estimated credit losses at beginning of the year ............................ $ 196.8 $ 100.9 Transfers (to) from finance receivables loss reserve (33.8) 124.0 Losses charged to reserve .......................... (55.7) (28.1 - ----------- --------- Allowance for estimated credit losses at end of the year .................................. $ 107.3 $ 196.8 = =========== ========= II-24 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 5. FINANCE RECEIVABLES The composition of finance receivables outstanding at December 31, 1993 and 1992 is summarized as follows: - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 - ---------------------------------------------------- - ----------- --------- United States Retail ........................................... $ 22,322.2 $ 30,060.4 Wholesale ........................................ 16,290.3 8,617.9 Leasing and lease financing ...................... 2,372.1 3,816.9 Term loans to dealers and others ................. 3,984.4 4,229.1 - ----------- --------- Total United States ................................ 44,969.0 46,724.3 Canada and International Retail ........................................... 6,846.4 8,066.6 Wholesale ........................................ 4,383.3 5,520.6 Leasing and lease financing ...................... 1,491.3 1,831.9 Term loans to dealers and others ................. 387.9 316.4 - ----------- --------- Total Canada and International ..................... 13,108.9 15,735.5 - ----------- --------- Total finance receivables .......................... 58,077.9 62,459.8 - ----------- --------- Deductions Unearned income .................................. 3,195.1 4,215.5 Allowance for financing losses ................... 748.0 817.0 - ----------- --------- Total deductions ................................... 3,943.1 5,032.5 - ----------- --------- Finance receivables (net) .......................... $ 54,134.8 $ 57,427.3 = =========== ========= The fair values of finance receivables at December 31, 1993 and 1992 were $54,906.4 million and $58,640.1 million, respectively, estimated by discounting the future cash flows using applicable spreads to approximate current rates applicable to each category of finance receivables. The carrying values of wholesale receivables and other receivables whose interest rates adjust on a short-term basis with applicable market indices (generally the prime rate) were assumed to approximate fair value either due to their short maturities or due to the interest rate adjustment feature. Retail, lease financing and leasing receivable instalments past due over 30 days amounted to $79.2 million and $72.3 million at December 31, 1993 and 1992, respectively. Instalments on term loans to dealers and others past due over 30 days aggregated $82.0 million at December 31, 1993 and $145.9 million at December 31, 1992. The aggregate amount of total finance receivables maturing in each of the five years following December 31, 1993, is as follows: 1994 - $34,482.6 million; 1995 - $9,125.5 million; 1996 - $6,463.0 million; 1997 - $3,625.4 million; 1998 - $1,547.0 million; 1999 and thereafter - $2,834.4 million. (continued) II-25 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 5. FINANCE RECEIVABLES (concluded) The following table presents an analysis of the allowance for financing losses for 1993 and 1992: - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 - ---------------------------------------------------- - ----------- --------- Allowance for financing losses at beginning of the year ......................... $ 817.0 $ 1,261.0 - ----------- --------- Charge-offs United States: Retail ......................................... (319.1) (498.6 Wholesale and term loans ....................... (39.3) (72.3 Leasing and lease financing .................... (6.9) (2.7 - ----------- --------- Total United States ............................ (365.3) (573.6 Canada and International Retail ......................................... (49.5) (83.5 Wholesale and term loans ....................... (18.9) (28.2 Leasing and lease financing .................... (4.2) (10.3 - ----------- --------- Total Canada and International ................. (72.6) (122.0 - ----------- --------- Total charge-offs .................................. (437.9) (695.6 Recoveries and other ............................... 74.5 139.6 Transfers to other nonearning assets ............... (40.2) (135.0 Transfers from (to) sold receivables allowance ..... 33.8 (124.0 Provisions charged to income ....................... 300.8 371.0 - ----------- --------- Allowance for financing losses at end of the year ............................... $ 748.0 $ 817.0 = =========== ========= NOTE 6. EQUIPMENT ON OPERATING LEASES The gross book value of equipment on operating leases was $15,727.9 million at the end of 1993 and $13,679.6 million at the end of 1992. The accumulated depreciation for equipment on operating leases was $4,364.4 million at the end of 1993 and $3,827.0 million at the end of 1992. The lease payments applicable to equipment on operating leases maturing in each of the five years following December 31, 1993, are as follows: 1994 - $3,694.5 million; 1995 - $2,609.7 million; 1996 - $1,155.3 million; 1997 - $167.6 million and 1998 - $1.3 million. II-26 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 7. OTHER NONEARNING ASSETS - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 - ----------------------------------------------------- - ----------- --------- Property and equipment at cost Automobiles ....................................... $ 107.6 $ 98.5 Other ............................................. 141.9 141.1 - ----------- --------- Total property - at cost ............................ $ 249.5 $ 239.6 = =========== ========= Accumulated depreciation Automobiles ....................................... $ 25.0 $ 16.3 Other ............................................. 95.2 89.5 - ----------- --------- Total accumulated depreciation ...................... $ 120.2 $ 105.8 = =========== ========= Net property ........................................ $ 129.3 $ 133.8 Nonperforming assets (net of valuation reserves) .... 319.5 372.3 Insurance premiums receivable ....................... 224.3 242.1 Deferred charges and other assets ................... 904.9 475.3 - ----------- --------- Total ............................................... $ 1,578.0 $ 1,223.5 = =========== ========= The fair value of nonperforming assets at December 31, 1993 and 1992, with recorded book values of $319.5 million and $372.3 million, respectively were not estimated because it is not practicable to reasonably assess the credit adjustment that would be applied in the marketplace for such assets. Due to the valuation reserves established for such assets, further adjustments would not be material. NOTE 8. NOTES, LOANS AND DEBENTURES PAYABLE WITHIN ONE YEAR - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 - ----------------------------------------------------- - ----------- --------- Short-term notes Commercial paper .................................. $ 14,521.1 $ 16,871.9 Master notes ...................................... 467.8 873.1 Demand notes ...................................... 2,161.0 2,608.2 Other ............................................. 645.5 695.0 - ----------- --------- Total principal amount .............................. 17,795.4 21,048.2 Unamortized discount ................................ (61.6) (75.1 - ----------- --------- Total ............................................... 17,733.8 20,973.1 - ----------- --------- Bank loans and overdrafts ........................... 5,716.6 6,642.3 - ----------- --------- Other notes, loans and debentures payable within one year Medium-term notes .............................. 8,569.0 8,102.4 Other .......................................... 3,065.0 5,646.6 - ----------- --------- Total ............................................... 11,634.0 13,749.0 - ----------- --------- Total payable within one year ....................... $ 35,084.4 $ 41,364.4 = =========== ========= (continued) II-27 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 8. NOTES, LOANS AND DEBENTURES PAYABLE WITHIN ONE YEAR (concluded) At December 31, 1993 and 1992, the fair values of the debt portfolio payable within one year were $35,266.4 million and $41,554.3 million, respectively, which were determined by using quoted market prices, if available, or calculating the estimated bond price of each bank loan, note or debenture in the portfolio at the applicable rate in effect during December 1993. Due to the short-term duration of commercial paper, master notes and demand notes, the carrying amount of these liabilities is considered fair value. Commercial paper is offered in the United States and Europe in varying terms ranging up to 270 days. The weighted average interest rates on commercial paper at December 31, 1993, 1992 and 1991 were 3.56%, 4.47% and 5.44%, respectively. Master notes represent borrowings on a demand basis arranged generally under agreements with trust departments of certain banks. The weighted average interest rates on master notes at December 31, 1993, 1992 and 1991 were 3.30%, 4.18% and 4.24%, respectively. GMAC's Variable Rate Demand Note Program is made available to employees and retirees of General Motors Corporation and their participating subsidiaries and affiliates, and their immediate family members, GM dealers and their employees and affiliates, and stockholders of General Motors Corporation. Bank loans are generally made on a demand basis. Medium-term notes are offered in the United States, Canada, Europe and Asia in varying terms ranging from more than nine months to thirty years. On a consolidated basis, short-term borrowing amounts during the prior three years were as follows: - ------------------------------------------------------------------------------- (in millions of dollars) 1993 1992 1991 - -------------------------------------------- --------- --------- --------- Maximum amount outstanding at any month-end $28,439.4 $36,914.0 $40,570.7 Average borrowings outstanding during the year ..................................... $23,462.9 $30,731.1 $37,829.0 Weighted average short-term interest rates* 4.86% 5.31% 6.94% Weighted average commercial paper rates* Worldwide ................................ 3.67% 4.33% 6.55% United States ............................ 3.44% 4.01% 6.20% * Rates have been determined by relating short-term interest costs for each year to the daily average dollar amounts outstanding. II-28 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 9. NOTES, LOANS AND DEBENTURES PAYABLE AFTER ONE YEAR - ------------------------------------------------------------------------------- (in millions of dollars) Weighted average interest rates at December 31 Maturity December 31, 1993 1993 1992 - ------------------------------------ ----------------- - ----------- --------- NOTES, LOANS AND DEBENTURES United States currency 1994 ........................... -- $ -- $ 9,914.7 1995 ........................... 7.1% 6,040.1 4,178.0 1996 ........................... 7.1% 5,173.1 3,972.3 1997 ........................... 7.5% 4,391.6 4,123.7 1998 ........................... 6.5% 1,455.7 200.0 1999 ........................... 7.5% 1,600.0 1,600.0 2000 - 2004 .................... 8.6% 3,249.1 2,400.0 2005 - 2009 .................... 8.8% 200.0 800.0 2010 - 2014 .................... 10.2% 1,203.5 1,203.5 2015 - 2049 .................... 8.7% 748.7 748.7 - ----------- --------- Total United States currency ..... 24,061.8 29,140.9 Other currencies 1994 - 1998 ....... ............ 8.0% 4,442.4 4,871.5 - ----------- --------- Total notes, loans and debentures. 28,504.2 34,012.4 Unamortized discount ............. (815.4) (838.2 - ----------- --------- Total notes, loans and debentures. payable after one year ......... $ 27,688.8 $ 33,174.2 = =========== ========= The aggregate principal amounts of notes, loans and debentures with terms of more than one year from dates of issue, maturing in each of the five years following December 31, 1993, are as follows: 1994 - $11,542.1 million; 1995 - $7,502.6 million; 1996 - $6,777.2 million; 1997 - $5,278.2 million; and 1998 - $1,649.1 million. The Company has issued warrants to subscribe for up to $125 million aggregate principal amount of 7.00% Notes due August 15, 2001. The warrants are exercisable up to and including August 15, 2000. The Company has issued warrants to subscribe for up to $300 million aggregate principal amount of 6.50% Notes due October 15, 2009. The warrants are exercisable up to and including October 15, 2007. The fair values of the debt portfolio payable after one year, inclusive of warrants, were $29,112.9 million and $34,034.9 million at December 31, 1993 and 1992, respectively, based on December 31, 1993 and 1992, quoted market rates for the same or similar issues or based on current rates offered to the Company for debt with similar credit ratings and remaining maturities. II-29 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 10. SEGMENT INFORMATION INDUSTRY SEGMENTS: The business of the Company and its subsidiaries is comprised primarily of financing and insurance operations. Gross revenue, income before income taxes and assets applicable to financing and insurance operations are as follows: - ------------------------------------------------------------------------------- (in millions of dollars) 1993 1992 1991 - ----------------------------------------- - ----------- ----------- --------- Gross revenue Financing operations .................. $ 10,871.2 $ 12,248.0 $ 13,028.8 Insurance operations .................. 1,651.2 1,540.2 1,518.3 Eliminations (a) ...................... (38.9) (48.9) (44.0 - ----------- ----------- --------- Total ................................... $ 12,483.5 $ 13,739.3 $ 14,503.1 = =========== =========== ========= Income before income taxes and cumulative effect of accounting changes Financing operations .................. $ 1,324.1 $ 1,798.2 $ 1,411.1 Insurance operations .................. 248.7 302.8 237.1 - ----------- ----------- --------- Total ................................... $ 1,572.8 $ 2,101.0 $ 1,648.2 = =========== =========== ========= Assets at end of the year Financing operations .................. $ 76,394.6 $ 88,959.9 $ 98,824.0 Insurance operations .................. 4,415.0 3,898.9 3,859.8 Eliminations (b) ...................... (58.8) (50.6) (49.3 - ----------- ----------- --------- Total ................................... $ 80,750.8 $ 92,808.2 $ 102,634.5 = =========== =========== ========= (a) Primarily intersegment insurance premiums earned. (b) Intersegment insurance receivables. (continued) II-30 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 10. SEGMENT INFORMATION (concluded) GEOGRAPHIC SEGMENTS: Although the majority of its business is done in the United States, the Company also operates directly or through subsidiaries in many other countries around the world. Gross revenue, income before income taxes and assets applicable to the United States and other countries are as follows: - ------------------------------------------------------------------------------- (in millions of dollars) 1993 1992 1991 - ----------------------------------------- - ----------- ----------- --------- Gross revenue United States ......................... $ 9,472.1 $ 10,516.7 $ 11,388.8 Other countries ....................... 3,015.7 3,223.6 3,191.2 Eliminations (a) ...................... (4.3) (1.0) (76.9 - ----------- ----------- --------- Total ................................... $ 12,483.5 $ 13,739.3 $ 14,503.1 = =========== =========== ========= Income before income taxes and cumulative effect of accounting changes United States ......................... $ 1,229.8 $ 1,709.2 $ 1,271.8 Other countries ....................... 343.0 391.8 376.4 - ----------- ----------- --------- Total ................................... $ 1,572.8 $ 2,101.0 $ 1,648.2 = =========== =========== ========= Assets at end of the year United States ......................... $ 64,755.2 $ 74,620.6 $ 83,800.2 Other countries ....................... 16,156.5 18,388.2 19,672.1 Eliminations (b) ...................... (160.9) (200.6) (837.8 - ----------- ----------- --------- Total ................................... $ 80,750.8 $ 92,808.2 $ 102,634.5 = =========== =========== ========= (a) Intersegment interest income. (b) Intersegment finance receivables. II-31 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 11. UNITED STATES, FOREIGN AND OTHER INCOME TAXES SFAS No. 109, Accounting for Income Taxes, which was issued by the FASB in February 1992, required that deferred tax liabilities or assets at the end of each period be determined using the tax rate expected to be in effect when taxes are actually paid or recovered. Accordingly, income tax expense will increase or decrease in the same period in which a change in tax rates is enacted. Previous rules required that deferred taxes be established using rates in effect when the tax asset or liability was first recorded, without subsequent adjustment for tax-rate changes. The Company elected to adopt this standard effective January 1, 1991. The favorable cumulative effect as of January 1, 1991, was $331.5 million. Deferred income taxes reflect the impact of "temporary differences" between values recorded for assets and liabilities for financial reporting purposes and values utilized for measurement in accordance with tax laws. The tax effects of the primary temporary differences giving rise to the Company's deferred tax assets and liabilities for 1993 and 1992 are as follows: - ------------------------------------------------------------------------------- (in millions of dollars) December 31, 1993 Deferred Income Taxes Asset Liability - ---------------------------------------------------- ----------- ----------- Lease transactions ................................. $ -- $ 1,100.5 Provision for financing losses ..................... 330.6 -- Debt transactions .................................. -- 332.2 Recognition of income on non-recourse receivables ...................................... -- 179.5 Unrealized gain on securities ...................... -- 88.5 Sales of finance receivables ....................... 29.1 -- State and local taxes .............................. -- 126.5 Insurance loss reserve discount .................... 85.6 -- Unearned insurance premiums ........................ 82.1 -- Other postretirement benefits ...................... 182.4 -- Other .............................................. 150.1 225.9 - ----------- --------- Total deferred income taxes ........................ $ 859.9 $ 2,053.1 = =========== ========= (continued) II-32 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 11. UNITED STATES, FOREIGN AND OTHER INCOME TAXES (continued) - ------------------------------------------------------------------------------- (in millions of dollars) December 31, 1992 Deferred Income Taxes Asset Liability - ---------------------------------------------------- ----------- ----------- Lease transactions ................................. $ -- $ 887.1 Provision for financing losses ..................... 328.8 -- Debt transactions .................................. -- 309.4 Recognition of income on non-recourse receivables ...................................... -- 218.2 Unrealized gain on securities ...................... -- 126.3 Sales of finance receivables ....................... 105.6 -- State and local taxes .............................. -- 108.3 Insurance loss reserve discount .................... 82.0 -- Unearned insurance premiums ........................ 75.8 -- Other postretirement benefits ...................... 176.7 -- Other .............................................. 76.3 110.6 - ----------- --------- Total deferred income taxes ........................ $ 845.2 $ 1,759.9 = =========== ========= The significant components of income tax expense are as follows: - ------------------------------------------------------------------------------- (in millions of dollars) For the Years 1993 1992 1991 - ----------------------------------------- -- ----------- ----------- --------- Income taxes estimated to be payable currently: United States Federal ................. $ 32.9 $ 535.9 $ 194.0 Foreign ............................... 162.8 125.8 128.0 United States state and local ......... 28.9 63.8 12.2 - ----------- ----------- --------- Total income taxes payable currently .... 224.6 725.5 334.2 - ----------- ----------- --------- Deferred income taxes: United States Federal ................. $ 343.7 $ 10.7 $ 219.0 Foreign ............................... (3.0) 55.1 39.2 United States state and local ......... 26.4 91.0 17.6 - ----------- ----------- --------- Total deferred income taxes (credits) ... 367.1 156.8 275.8 - ----------- ----------- --------- Income tax expense ...................... $ 591.7 $ 882.3 $ 610.0 = =========== =========== ========= (continued) II-33 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 11. UNITED STATES, FOREIGN AND OTHER INCOME TAXES (concluded) The Company and its domestic subsidiaries join with General Motors Corporation in filing a consolidated United States Federal income tax return. The portion of the consolidated tax recorded by the Company and its subsidiaries included in the consolidated tax return generally is equivalent to the liability that would have been incurred on a separate return basis. Provisions are made for estimated United States and foreign income taxes, less available tax credits and deductions, which may be incurred on remittance of the Company's share of subsidiaries' undistributed earnings less those deemed to be indefinitely reinvested. Income tax provisions recorded by the Company differ from the computed amounts developed by applying the statutory United States Federal income tax rate to income before income taxes. The following schedule reconciles income tax expense at the statutory rate and actual income tax expense: - ------------------------------------------------------------------------------- (in millions of dollars) For the Years 1993 1992 1991 - ----------------------------------------- - ----------- ----------- --------- Computed income tax expense at statutory United States Federal income tax rate on income ............................. $ 550.5 $ 714.3 $ 560.4 State and local income taxes (net of Federal income tax effect) ............ 43.3 133.6 18.4 Effect of tax-exempt interest and dividends received which are not fully taxable ......................... (29.7) (25.9) (28.3 Adjustment to taxes on foreign income ... 53.4 7.8 15.1 Foreign rates other than 35% (34% prior to 1993) ................... (6.5) 40.3 22.3 Effect of increase in U.S. Federal income tax rate .............................. 16.4 -- -- Other ................................... (35.7) 12.2 22.1 - ----------- ----------- --------- Total income tax expense ................ $ 591.7 $ 882.3$ 610. = =========== =========== ========= - ----------- * Excluding taxes related to cumulative effect of accounting change. NOTE 12. MORTGAGE BANKING The Company, through its wholly-owned subsidiary, GMAC Mortgage Corporation (GMACM), performs mortgage banking activities which generally consist of the origination or acquisition of mortgage loans, the sale of such loans to investors and the continual long-term servicing of the loans. In addition, GMACM (through a wholly-owned subsidiary) provides short-term secured lines of credit to mortgage originators to finance mortgage loans until such loans are purchased by permanent investors (warehouse lines). The right to service loans is contracted under primary or master servicing agreements. Under primary servicing agreements, GMACM collects the monthly principal, interest and escrow payments from individual mortgagors and performs certain investor accounting and remittance processing, escrow disbursement and reporting and collection services. As master servicer, GMACM collects monthly payments from various sub-servicers and performs certain accounting and reporting functions on behalf of the mortgage investors. The servicing portfolio and its related escrow balances are not reflected in the Company's financial statements, since GMACM does not own the mortgages or the related escrow balances. As compensation for such servicing activities, GMACM earns a servicing fee. (continued) II-34 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 12. MORTGAGE BANKING (concluded) The fair values of real estate mortgages held for sale (including warehouse lines) and loans held for investment approximated their carrying values of $1,842.8 million and $172.1 million, respectively, at December 31, 1993 in comparison to $2,568.6 million and $136.4 million at December 31, 1992. The fair value of excess servicing fees, determined by discounting net cash flows at current market rates, approximated the $89.9 million and $71.1 million carrying values at December 31, 1993 and 1992, respectively. The cost of purchased mortgage servicing rights acquired is capitalized and amortized in proportion to and over the period of the projected net servicing income. Similarly, GMACM capitalizes excess servicing fees on the sale of certain mortgage loans to permanent investors. Excess servicing fees represent the present value of the difference between the estimated future servicing revenues and normal servicing revenues. The deferred charge is amortized over the expected life of the servicing rights in proportion to projected servicing revenues, which approximates a level yield. On certain transactions, GMACM will retain full or limited recourse for credit or other losses incurred by the purchaser of the loans sold. GMACM establishes allowances for estimated future losses related to the outstanding recourse obligations which management considers adequate. In addition, GMACM provides appropriate loss allowances on warehouse lines and other loans held as investments. Following are selected financial and statistical information of GMACM as of December 31, 1993 and 1992: - ------------------------------------------------------------------------------- (in millions of dollars) For the Years 1993 1992 - ----------------------------------------------------- - ----------- --------- Servicing portfolio Residential ....................................... $ 30,676.4 $ 38,581.4 Commercial ........................................ 3,837.2 3,770.5 Master Servicing* ................................. 19,312.8 16,380.4 - ----------- --------- Total ............................................... $ 53,826.4 $ 58,732.3 - ----------- --------- * Represents loans for which GMACM performs solely a master servicing function. Purchased mortgage servicing rights and excess servicing fees ......................... $ 281.0 $ 404.1 - ----------- --------- Loans sold with recourse ............................ $ 10,405.7 $ 16,637.1 - ----------- --------- Maximum exposure on loans sold Full recourse ..................................... $ 324.8 $ 537.8 Limited recourse .................................. 882.2 1,003.6 - ----------- --------- Total ............................................... $ 1,207.0 $ 1,541.4 Allowance for losses on loans sold - ----------- --------- with recourse ..................................... $ 79.8 $ 94.9 - ----------- --------- The maximum recourse exposure shown above is net of amounts reinsured with third parties which totaled $215.0 million and $226.6 million at December 31, 1993 and 1992, respectively. II-35 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 13. PENSION PROGRAM The Company and certain of its subsidiaries participate in various pension plans of General Motors Corporation and its domestic and foreign subsidiaries, which cover substantially all of their employees. Pension expense of the Company and its subsidiaries amounted to $38.9 million in 1993, $3.4 million in 1992 and $0.6 million in 1991. During 1992, the Company offered voluntary early retirement to certain employees. Under the provision of SFAS No. 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, this early retirement opportunity resulted in a 1992 expense of $51.5 million. NOTE 14. OTHER POSTRETIREMENT BENEFITS The Company and certain of its subsidiaries participate in various postretirement medical, dental, vision and life insurance plans of General Motors Corporation. These benefits are funded as incurred from the general assets of the Company. In December 1990, the FASB issued SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, which requires the accrual of future retiree benefit costs over the active service period of employees to the date of full eligibility for such benefits. The Company elected to adopt this standard effective January 1, 1992. The unfavorable cumulative effect of this accounting change as of January 1, 1992, was $282.6 million (net-of-tax). The ongoing incremental impact in 1992 of SFAS No. 106 related to the previous method of recording net expense amounted to $18.1 million after tax. Prior years financial statements have not been restated. The Company has disclosed in the financial statements certain amounts associated with estimated future postretirement benefits other than pensions and characterized such amounts as "accumulated postretirement benefit obligations," "liabilities" or "obligations." Notwithstanding the recording of such amounts and the use of these terms, the Company does not admit or otherwise acknowledge that such amounts or existing postretirement benefit plans of the Company (other than pensions) represent legally enforceable liabilities of the Company. The total non-pension postretirement benefits expense of the Company, other than the cumulative effect of adopting SFAS No. 106, on a pre-tax basis amounted to $65.8 million and $51.4 million in 1993 and 1992, respectively, and included the components set forth below: - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 - ---------------------------------------------------- - ----------- --------- Benefits attributed to the current year ............. $ 14.7 $ 10.8 Interest accrued on benefits attributed to prior years 51.1 40.6 - ----------- --------- Total non-pension postretirement benefits expense ... $ 65.8 $ 51.4 = =========== ========= II-36 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 15. TRANSACTIONS WITH AFFILIATES Under special rate programs sponsored by General Motors, an interest rate differential is received. These payments are included in unearned income and are recognized over the life of the related contracts. The earned portion of such payments constituted 6.1% of gross revenue in 1993, compared with 5.1% in 1992 and 3.6% in 1991. Over the periods ended December 31, 1993, 1992 and 1991, the Company, under a financing agreement, extended loans to General Motors Corporation up to a maximum of $17 billion. Loans under the agreement were provided at floating market rates to General Motors when it assumed part of the dealer inventory financing previously provided by the Company. GMAC serviced all such receivables for General Motors for a fee. The financing agreement ensured that GMAC's ongoing funding activities continued to return to GMAC the approximate amount of interest and fees it would have earned had it retained the dealer inventory financing. The amount of interest and fees under this agreement, which are included in other income for the years ended December 31, 1993, 1992 and 1991 were $604.4 million, $662.7 million and $972.6 million, respectively, and the interest rates were 6.0% at December 31, 1993 and 1992 and 6.5% at December 31, 1991. The carrying value of these receivables approximates fair value. As of December 1, 1993, the Company resumed the financing of wholesale receivables previously owned by General Motors. The aforementioned financing agreement has been terminated. The amounts due General Motors Corporation and affiliated companies relate principally to wholesale financing of sales of General Motors products. To the extent that wholesale settlements with General Motors are made in advance of transit time (which may occur from time-to-time due to seasonal or other factors), interest is received from General Motors. During 1993, the Company purchased certain vehicles which General Motors acquired from its fleet and rental customers. The cost of these vehicles held for resale, which is included in other earning assets, was $607.7 million at December 31, 1993, compared with $1,056.9 million at December 31, 1992. From time to time, the Company and one of its subsidiaries have made interest-bearing loans to National Car Rental Systems, Inc. (NCRS), a consolidated subsidiary of General Motors Corporation since December 31, 1992. Effective December 31, 1992, $1.5 billion of GMAC earnings assets relating to NCRS, previously reflected in finance receivables, were reclassified to Receivables from General Motors Corporation. The Company also extends loans to other GM subsidiaries and affiliates. At December 31, 1993 and 1992, $1,355.5 million and $1,938.2 million, respectively, of such loans (including NCRS) were outstanding. The fair values of these loans at December 31, 1993 and 1992, were $1,382.8 million and $1,976.1 million, respectively. The Company and certain of its subsidiaries lease capital equipment to various units of General Motors in the ordinary course of business. At December 31, 1993 and 1992, leasing receivables relating to such leases amounted to $5.4 million and $14.0 million, respectively. II-37 NOTES TO FINANCIAL STATEMENTS (continued) NOTE 15. TRANSACTIONS WITH AFFILIATES (concluded) The Company purchases data processing and communications services from Electronic Data Systems Corporation, a subsidiary of General Motors Corporation. Such purchases, which are included in operating expenses, amounted to $272.5 million in 1993, compared with $266.6 million in 1992 and $260.6 million in 1991. Insurance premiums earned in 1993, 1992 and 1991 include $322.1 million, $390.8 million and $486.7 million, respectively, earned by Motors Insurance Corporation on certain insurance coverages provided to General Motors. NOTE 16. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK Financial Instruments with Off-Balance Sheet Risk GMAC utilizes a variety of interest rate contracts including interest rate swaps and caps in the normal course of managing its interest rate exposures. Interest rate swaps are contractual agreements between the Company and another party to exchange the net difference between a fixed and floating interest rate over the life of the contract without the exchange of the underlying principal amount. The Company uses swaps as part of its ongoing interest rate management program. As such, the majority of swaps are executed as an integral element of a specific debt transaction. In a limited number of cases, swaps are executed on a portfolio basis to achieve specific interest rate management objectives. The differential paid or received on such swaps is recorded as an adjustment to interest expense over the term of the underlying debt agreement. Interest rate cap agreements provide the holder protection against interest rate movements above the established rate. In exchange for assuming this risk, the writer receives a premium at the outset of the agreement. The Company also utilizes foreign exchange agreements to manage its exposure to foreign exchange rate fluctuations. In this regard, currency swaps and forward foreign exchange contracts are used to hedge foreign exchange exposure on foreign currency denominated debt by converting the funding currency to the currency of the assets being financed. As such, these currency swaps and foreign exchange contracts include agreements to purchase or sell specific amounts of foreign currencies at specific rates on specific future dates. II-38 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 16. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK (continued) The Company does not require nor place collateral for any off-balance sheet financial instruments, except to require collateral for interest rate futures and lines of credit. At December 31, 1993 and 1992, the total notional amount of off-balance-sheet instruments and the unrealized gains and losses associated with these instruments were as follows: - ------------------------------------------------------------------------------- (in millions of dollars) December 31, 1993 December 31, 1992 Notional Unrealized Notional Unrealize Amount G ain/(Loss) Amount G ain/(Loss - --------------------------------- --------- - ----------- ----------- --------- Interest rate instruments .... $ 7,059.0 $ 26.4 $ 3,585.6 $ (7.5 Currency instruments ......... 1,564.9 (3.3) 957.4 65.3 - --------- - ----------- --------- - --------- Total ........................ $ 8,623.9 $ 23.1 $ 4,543.0 $ 57.8 ========== =========== =========== =========== In addition, the Company's mortgage subsidiary has commitments to sell mortgages or mortgage-backed securities at December 31, 1993 and 1992, comprised of mandatory delivery contracts with investors totaling $2,139.0 million and $2,065.4 million, respectively. Also outstanding at December 31, 1993 and 1992, were commitments to purchase/fund first mortgage loans at fixed prices totaling $1,795.6 million and $1,187.8 million, respectively. These aforementioned instruments contain an element of risk in the event the counterparties are unable to meet the terms of the agreements. In such an event, the cost to the Company to replace the positions at market rates in effect on December 31, 1993 would be $83.1 million, compared to $67.3 million at December 31, 1992. However, the Company minimizes the risk exposure by limiting the counterparties to those major banks and financial institutions who meet established credit guidelines. Management does not expect any counterparty to default on its obligations and, therefore, does not expect to incur any cost due to counterparty default. The Company has granted revolving lines of credit to dealers with unused amounts of $301.1 million and $458.1 million at December 31, 1993 and 1992, respectively. Commitments supported by collateral, generally dealer inventories and real estate, were approximately 44% and 55% of the contract amounts at December 31, 1993 and 1992, respectively. The unused amount of warehouse lending revolving credit lines amounted to $1,081.7 million and $1,146.1 million at December 31, 1993 and 1992, respectively. Concentrations of Credit Risk The Company's primary business is to provide vehicle financing for GM products and GM dealers. Wholesale and dealer loan financing relates primarily to GM dealers, with collateral primarily GM vehicles (for wholesale) and GM dealership property (for loans). In wholesale financing, GMAC is also provided further protection by GM factory repurchase programs. Retail contracts and operating lease assets relate primarily to the secured sale and lease, respectively, of vehicles (primarily GM). II-39 NOTES TO FINANCIAL STATEMENTS (concluded) NOTE 16. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK (concluded) Automotive lease financing represents a concentration inasmuch as 19 customers comprised over 50% of the total $2.1 billion U.S. balance at December 31, 1993. A significant portion of these receivables are also protected by various GM factory support programs, programs that afford GMAC protection against loss under certain specified circumstances and with limitations. In terms of geographic concentrations as of December 31, 1993, 76.8% of GMAC's consolidated financing assets were U.S. based; 6.4% were in Canada; 13.8% were in Europe (of which 8.0% reside in Germany); 1.2% were in Latin America; and 1.8% were in Asia Pacific (of which Australia represents 1.5%). Reflecting general U.S. population patterns and GM sales activities, GMAC's five largest U.S. state concentrations, which in aggregate total 37.4% of U.S. financing assets, are as follows: 8.9% in Texas; 8.4% in California; 7.2% in New York; 6.6% in Florida; and 6.3% in Michigan. NOTE 17. COMMITMENTS AND CONTINGENT LIABILITIES Minimum future commitments under operating leases having noncallable lease terms in excess of one year, primarily for real property, aggregating $162.2 million, are payable $51.3 million in 1994, $41.0 million in 1995, $29.2 million in 1996, $17.7 million in 1997, $10.0 million in 1998 and $13.0 million in 1999 and thereafter. Certain of the leases contain escalation clauses and renewal or purchase options. Rental expenses under operating leases were $55.4 million in 1993, $56.3 million in 1992 and $53.1 million in 1991. There are various claims and pending actions against the Company and its subsidiaries with respect to commercial and consumer financing matters, taxes and other matters arising out of the conduct of the business. Certain of these actions are or purport to be class actions, seeking damages in very large amounts. The amounts of liability on these claims and actions at December 31, 1993, were not determinable but, in the opinion of management, the ultimate liability resulting should not have a material adverse effect on the Company's consolidated financial position. ------------------------ II-40 SUPPLEMENTARY FINANCIAL DATA SUMMARY OF CONSOLIDATED QUARTERLY EARNINGS 1993 QUARTERS - --------------------------------------------------------------------------- (in millions of dollars) FIRST SECOND THIRD FOURTH - ---------------------------------- -------- -------- -------- -------- Total financing revenue .......... $2,267.8 $2,219.8 $2,187.2 $2,077.2 Interest and discount expense .... 1,300.0 1,221.5 1,114.1 1,085.6 Net financing revenue and other income ................... 1,267.0 1,378.9 1,313.3 1,101.1 Provision for financing losses ... 57.0 118.9 116.7 8.2 Net income ....................... 284.1 285.4 204.8 206.8 - --------------------------------------------------------------------------- 1992 QUARTERS - --------------------------------------------------------------------------- (in millions of dollars) FIRST SECOND THIRD FOURTH - ---------------------------------- -------- -------- -------- -------- Total financing revenue .......... $2,552.7 $2,548.9 $2,816.0 $2,484.5 Interest and discount expense .... 1,581.6 1,470.0 1,406.3 1,370.7 Net financing revenue and other income ................... 1,343.8 1,324.6 1,422.4 1,390.3 Provision for financing losses .... 130.1 163.4 101.5 (24.0) Income before cumulative effect of accounting change ........... 349.1* 282.4* 296.9* 290.3 Cumulative effect of accounting change ......................... (282.6)* -- -- -- Net income ....................... 66.5* 282.4* 296.9* 290.3 - --------------------------------------------------------------------------- * Effective January 1, 1992, the Company adopted SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. First quarter income was restated for the cumulative effect of this change, and all quarters have been restated to reflect the 1992 adoption of this statement. 1991 QUARTERS - --------------------------------------------------------------------------- (in millions of dollars) FIRST SECOND THIRD FOURTH - ---------------------------------- -------- -------- -------- -------- Total financing revenue .......... $2,845.2 $2,788.2 $2,789.5 $2,730.6 Interest and discount expense .... 1,867.4 1,711.8 1,646.9 1,618.6 Net financing revenue and other income ................... 1,387.7 1,412.9 1,491.9 1,463.5 Provision for financing losses ... 183.7 213.6 211.7 438.9 Income before cumulative effect of accounting change ........... 305.7 283.6 346.3 102.6* Cumulative effect of accounting change ......................... 331.5** -- -- -- Net income ....................... 637.2 283.6 346.3 102.6* - --------------------------------------------------------------------------- * Includes $275.0 ($171 million after taxes) provision for potential wholesale loan loss. **Effective January 1, 1991, the Company adopted SFAS No. 109, Accounting for Income Taxes. First quarter income was restated for the cumulative effect of this change. II-41 SUPPLEMENTARY FINANCIAL DATA (continued) FIVE-YEAR SUMMARY OF FINANCING OPERATIONS* - ------------------------------------------------------------------------------- (in millions of dollars) For the Years 1993 1992 1991 1990 1989 - ------------------- - ---------- --------- - --------- - ----------- --------- INCOME Financing revenue . $ 8,754.6 $ 10,404.2 $ 11,155.9 $ 11,787.8 $ 11,217.8 Interest and discount ....... (4,721.2) (5,828.6) (6,844.7) (7,965.8) (7,908.3 Depreciation on operating leases (2,702.0) (2,429.6) (1,902.4) (1,387.9) (1,477.5 - ---------- --------- - ----------- ----------- --------- Net financing revenue ........ 1,331.4 2,146.0 2,408.8 2,434.1 1,832.0 Other income ...... 2,116.6 1,843.8 1,872.9 1,715.6 1,870.3 - ---------- --------- - ----------- ----------- --------- Net financing revenue and other 3,448.0 3,989.8 4,281.7 4,149.7 3,702.3 - ---------- --------- - ----------- ----------- --------- Expenses Salaries and benefits ........ 697.2 749.0 674.6 632.7 587.8 Other operating expenses ........ 994.9 960.4 1,066.6 907.0 910.5 Provision for financing losses. 300.8 371.0 1,047.9 843.2 841.9 Amortization of intangible assets 131.0 111.2 81.5 78.4 63.1 - ---------- --------- - ----------- ----------- --------- Total expenses .... 2,123.9 2,191.6 2,870.6 2,461.3 2,403.3 - ---------- --------- - ----------- ----------- --------- Income before income taxes ..... 1,324.1 1,798.2 1,411.1 1,688.4 1,299.0 United States, foreign and other income taxes ..... 533.5 786.6 545.2 643.7 391.0 - ---------- --------- - ----------- ----------- --------- Income before cumulative effect of accounting changes .......... 790.6 1,011.6 865.9 1,044.7 908.0 Cumulative effect of accounting changes .......... -- (232.8) 299.1 -- -- - ---------- --------- - ----------- ----------- --------- Income from financing operations ....... $ 790.6 $ 778.8 $ 1,165.0 $ 1,044.7 $ 908.0 = ========== ========= = =========== =========== ========= (continued) II-42 SUPPLEMENTARY FINANCIAL DATA (continued) FIVE-YEAR SUMMARY OF FINANCING OPERATIONS* (concluded) - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 1991 1990 1989 - ------------------- - ---------- --------- - --------- - ----------- --------- ASSETS Cash and cash equivalents ...... $ 3,980.6 $ 3,834.8 $ 2,396.4 $ 193.5 $ 247.2 - ---------- --------- - ----------- ----------- --------- Earning Assets Investments in securities ....... 18.4 48.2 71.6 112.9 58.3 - ---------- --------- - ----------- ----------- --------- Finance receivables 54,882.8 58,244.3 71,596.6 80,365.8 80,410.9 Less-Allowance for financing losses (748.0) (817.0) (1,261.0) (1,292.5) (1,290.8 - ---------- --------- - ----------- ----------- --------- Finance receivables (net) 54,134.8 57,427.3 70,335.6 79,073.3 79,120.1 Receivable General Motors Corporation ...... 1,355.5 11,563.2 12,358.0 13,018.0 14,635.5 Other earning assets 15,843.8 14,933.7 12,599.5 8,308.5 5,713.5 - ---------- --------- - ----------- ----------- --------- Total earning assets 71,352.5 83,972.4 95,364.7 100,512.7 99,527.4 Other assets ...... 1,061.5 1,152.7 1,062.9 928.6 793.0 - ---------- --------- - ----------- ----------- --------- Total assets ...... $ 76,394.6 $ 88,959.9 $ 98,824.0 $ 101,634.8 $ 100,567.6 - ---------- --------- - ----------- ----------- --------- LIABILITIES Notes, loans and debentures payable within one year .. $ 35,084.4 $ 41,364.4 $ 51,018.6 $ 53,715.8 $ 54,415.4 - ---------- --------- - ----------- ----------- --------- Accounts payable and other liabilities General Motors Corporation and affiliated companies 2,514.0 2,860.1 2,032.4 2,870.1 3,090.5 Other post employment benefits 436.9 405.8 -- -- -- Other ............ 3,991.9 3,993.0 3,873.6 3,780.6 3,632.8 - ---------- --------- - ----------- ----------- --------- Total accounts payable and other liabilities 6,942.8 7,258.9 5,906.0 6,650.7 6,723.3 - ---------- --------- - ----------- ----------- --------- Notes, loans and debentures payable after one year ... 27,688.8 33,174.2 34,480.9 34,185.4 32,453.0 - ---------- --------- - ----------- ----------- --------- Total liabilities . $ 69,716.0 $ 81,797.5 $ 91,405.5 $ 94,551.9 $ 93,591.7 - ---------- --------- - ----------- ----------- --------- Net assets of financing operations ....... $ 6,678.6 $ 7,162.4 $ 7,418.5 $ 7,082.9 $ 6,975.9 = ========== ========= = =========== =========== ========= * Before elimination of intercompany amounts. II-43 SUPPLEMENTARY FINANCIAL DATA (continued) FIVE-YEAR SUMMARY OF INSURANCE OPERATIONS* - ------------------------------------------------------------------------------- (in millions of dollars) For the Years 1993 1992 1991 1990 1989 - ------------------- - ---------- --------- - --------- - ----------- --------- INCOME Net premiums written Commercial lines, reinsurance and miscellaneous ... $ 337.2 $ 436.0 $ 577.2 $ 501.0 $ 528.9 Personal lines.... 458.7 405.4 364.0 177.8 216.1 Mechanical ....... 323.2 342.0 308.2 342.1 294.0 Life and disability 85.7 66.0 50.1 49.2 42.6 - ---------- --------- - ----------- ----------- --------- Net premiums written 1,204.8 1,249.4 1,299.5 1,070.1 1,081.6 Changes in unearned premiums ......... (61.3) (43.6) (72.4) (5.1) 91.7 - ---------- --------- - ----------- ----------- --------- Premiums earned ... 1,143.5 1,205.8 1,227.1 1,065.0 1,173.3 Investment and other income ..... 507.7 334.4 291.2 272.4 261.6 - ---------- --------- - ----------- ----------- --------- Total ............. 1,651.2 1,540.2 1,518.3 1,337.4 1,434.9 - ---------- --------- - ----------- ----------- --------- Expenses Salaries and benefits ........ 128.6 105.4 98.3 84.6 83.0 Other operating expenses ........ 203.8 134.2 111.6 78.6 108.1 Losses and loss adjustment expenses ........ 1,060.0 987.9 1,061.6 1,014.1 991.3 Amortization of intangible assets 10.1 9.9 9.7 0.1 -- - ---------- --------- - ----------- ----------- --------- Total expenses .... 1,402.5 1,237.4 1,281.2 1,177.4 1,182.4 - ---------- --------- - ----------- ----------- --------- Income before income taxes ..... 248.7 302.8 237.1 160.0 252.5 Income taxes ...... 58.2 95.7 64.8 14.6 49.8 - ---------- --------- - ----------- ----------- --------- Income before cumulative effect of accounting change 190.5 207.1 172.3 145.4 202.7 Cumulative effect of accounting changes -- (49.8) 32.4 -- -- - ---------- --------- - ----------- ----------- --------- Income from insurance operations ....... $ 190.5 $ 157.3 $ 204.7 $ 145.4 $ 202.7 = ========== ========= = =========== =========== ========= (continued) II-44 SUPPLEMENTARY FINANCIAL DATA (concluded) FIVE-YEAR SUMMARY OF INSURANCE OPERATIONS* (concluded) - ------------------------------------------------------------------------------- (in millions of dollars) December 31 1993 1992 1991 1990 1989 - ------------------- -- ---------- --------- - ----------- ----------- --------- NET ASSETS ASSETS Cash .............. $ 47.5 $ 36.3 $ 16.1 $ 11.6 $ 11.4 Investments in securities ....... 3,431.3 3,227.7 3,263.9 2,895.2 2,825.7 Premiums and other receivables ...... 262.5 291.4 261.7 300.2 248.3 Deferred policy acquisition cost . 77.0 65.5 48.5 35.9 43.2 Prepaid reinsurance premiums ......... 105.5 -- -- -- -- Reinsurance recoverable on unpaid insurance losses and loss adjustment expense 220.3 -- -- -- -- Other assets ...... 270.9 278.0 269.6 271.2 76.9 - ---------- --------- - ----------- ----------- --------- Total assets ...... $ 4,415.0 $ 3,898.9 $ 3,859.8 $ 3,514.1 $ 3,205.5 - ---------- --------- - ----------- ----------- --------- LIABILITIES Unpaid insurance losses and loss adjustment expenses $ 1,569.4 $ 1,265.8 $ 1,263.4 $ 1,235.7 $ 1,143.1 Unearned insurance premiums ......... 1,337.4 $ 1,174.9 $ 1,130.5 $ 1,054.7 $ 1,001.4 Deferred federal income taxes ..... (11.3) 30.7 54.6 27.9 84.3 Other post employment benefits 88.0 80.4 -- -- -- Other ............. 257.8 259.5 245.0 276.5 170.6 - ---------- --------- - ----------- ----------- --------- Total liabilities . $ 3,241.3 $ 2,811.3 $ 2,693.5 $ 2,594.8 $ 2,399.4 - ---------- --------- - ----------- ----------- --------- Net assets of insurance operations ....... $ 1,173.7 $ 1,087.6 $ 1,166.3 $ 919.3 $ 806.1 = ========== ========= = =========== =========== ========= * Before elimination of intercompany amounts. II-45 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 IV of this report). Page ---- 12 -- Statement of Ratio of Earnings to Fixed Charges IV-5 for the years 1993, 1992, 1991, 1990 and 1989. 24.1 -- Consent of Independent Auditors. IV-6 (b) REPORTS ON FORM 8-K. No current reports on Form 8-K have been filed by the Company during the fourth quarter ended December 31, 1993. ITEMS 4, 9, 10, 11, 12 and 13 are inapplicable and have been omitted. ----------------- IV-1 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. GENERAL MOTORS ACCEPTANCE CORPORATION ------------------------------------- (Registrant) By s/ R. T. O'Connell ------------------------------------------- Date: March 10, 1994 (Robert T. O'Connell, Chairman of the Board) -------------- Pursuant to the Requirements of the Securities Exchange Act of 1934, this report has been signed below on the 9th day of March, 1994, by the following persons on behalf of the Registrant and in the capacities indicated. Signature Title --------- ----- s/ R. T. O'Connell - ----------------------- (Robert T. O'Connell) Chairman of the (Chief Board of Directors Executive Officer) s/ J. R. Rines - ----------------------- (John R. Rines) President and (Chief Director Operating Officer) s/ J. D. Finnegan - ----------------------- (John D. Finnegan) Executive Vice (Chief President and Director Financial Officer) s/ G. E. Gross - ----------------------- (Gerald E. Gross) Comptroller (Chief Accounting Officer) s/ W. G. Binns, Jr. - ----------------------- (W. Gordon Binns, Jr.) Director s/ R. J. S. Clout - ------------------------- (Richard J. S. Clout) Director (continued) IV-2 SIGNATURES (concluded) Signature Title --------- ----- s/ J. E. Gibson - ------------------------- (John E. Gibson) Director s/ F. A. Henderson - ------------------------- (Frederick A. Henderson) Director s/ L. J. Krain - ------------------------- (Leon J. Krain) Director s/ H. Kunz - ------------------------- (Heidi Kunz) Director s/ J. M. Losh - ------------------------- (J. Michael Losh) Director s/ J. J. Pero - ------------------------- (Joseph J. Pero) Director s/ G. C. Thomas - ------------------------- (Geoffrey C. Thomas) Director s/ G. R. Wagoner, Jr. - ------------------------- (G. Richard Wagoner, Jr.) Director IV-3 EXHIBIT INDEX Exhibit Number Exhibit Name ------- ----------------------------------- 12 Ratio of Earnings to Fixed Charges 24.1 Consent of Independent Auditors, Deloitte & Touche IV-4 EXHIBIT 12 GENERAL MOTORS ACCEPTANCE CORPORATION RATIO OF EARNINGS TO FIXED CHARGES (in millions of dollars) Years Ended December 31 --------------------------------------------------------- 1993 1992 1991 1990 1989 - -------------------- - ----------- ----------- --------- Consolidated net income* ......... $ 981.1 $ 1,218.7 $ 1,038.2 $ 1,190.1 $ 1,110.7 Provision for income taxes .... 591.7 882.3 610.0 658.3 440.8 - -------------------- - ----------- ----------- --------- Consolidated income before income taxes ........... 1,572.8 2,101.0 1,648.2 1,848.4 1,551.5 - -------------------- - ----------- ----------- --------- Fixed charges Interest, debt discount and expense ....... 4,721.2 5,828.6 6,844.7 7,965.8 7,908.3 Portion of rentals representative of the interest factor ........ 43.6 31.7 30.3 29.5 27.1 - -------------------- - ----------- ----------- --------- Total fixed charges 4,764.8 5,860.3 6,875.0 7,995.3 7,935.4 - -------------------- - ----------- ----------- --------- Earnings available for fixed charges .$ 6,337.6 7,961.3 $ 8,523.2 $ 9,843.7 $ 9,486.9 = ==================== = =========== =========== ========= Ratio of earnings to fixed charges 1.33 1.35 1.23 1.23 1.19 ==== ==== ==== ==== ==== - ---------- * Before cumulative effect of accounting change of ($282.6) million in 1992 and $331.5 million in 1991. IV-5 EXHIBIT 24.1 CONSENT OF INDEPENDENT AUDITORS GENERAL MOTORS ACCEPTANCE CORPORATION: We consent to the incorporation by reference of our report dated February 9, 1994, appearing in this Annual Report on Form 10-K of General Motors Acceptance Corporation for the year ended December 31, 1993, in the following Registration Statements: Registration Form Statement No. Description ---- ------------- ------------------------------- S-3 33-12059, $3,000,000,000 General Motors 33-26057 and Acceptance Corporation GMAC 33-31596 Variable Denomination Adjustable Rate Demand Notes S-3 33-45308 and $5,000,000,000 General Motors 33-49133 Acceptance Corporation Debt Securities S-3 33-49609 and $10,000,000,000 General Motors 33-51381 Acceptance Corporation Medium-Term Notes s/ DELOITTE & TOUCHE - -------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243-1704 March 10, 1994 IV-6

822697_1993.txt

822697_1993

1993

822697

Item 1. Business GENERAL Shoreline Financial Corporation ("Shoreline" or the "Corporation") is a bank holding company. Shoreline was formed on April 23, 1987, for the purpose of affecting the affiliation of Inter-City Bank ("Inter-City") of Benton Harbor, Michigan, and Citizens Trust and Savings Bank ("Citizens") of South Haven, Michigan. On December 31, 1993, these banks represented Shoreline's only operating subsidiaries. Shoreline had assets at December 31, 1993, totaling $620.6 million, deposits of $557.4 million and shareholders' equity of $52.6 million. Shoreline's business is concentrated exclusively in the commercial banking industry segment. Shoreline's subsidiary banks offer individuals, businesses, institutions and government agencies a full range of commercial banking services including time, savings and demand deposits; commercial, consumer and real estate financing; bank credit cards; safe deposit services; automated transaction machine services and trust services. The business of Citizens is mildly seasonal due to the recreational and agricultural components of the local economy. No material part of the business of Shoreline and its subsidiaries is dependent upon a single customer or very few customers, the loss of which would have a materially adverse effect on Shoreline. The principal markets for Shoreline's financial services are presently the Michigan communities in which Inter-City and Citizens are located, and the areas immediately surrounding these communities. Shoreline and its subsidiaries serve these markets through 23 offices located in and around these communities. Shoreline and its subsidiaries have no material foreign assets or income. During 1993, Shoreline expanded its branch network with the acquisition of four branches from Standard Federal Bank located in Berrien Springs, Three Oaks, Edwardsburg and Hartford. This acquisition was completed in July 1993. On May 5, 1993, Shoreline announced its intention to affect a merger between its two subsidiary banks, Inter-City and Citizens. The resulting single bank will be named Shoreline Bank. It is believed that the merger of the two banks will allow Shoreline to further realize operational efficiencies and provide more consistent and improved service to the market areas that Shoreline currently services. Completion of the transaction is subject to regulatory approval and is anticipated to be consummated during the second quarter of 1994. On December 7, 1993, the Corporation announced an agreement with Great Lakes Bancorp, Ann Arbor, Michigan, under which Shoreline will purchase and assume from Great Lakes Bancorp certain assets and liabilities associated with its branch located in South Haven, Michigan. This branch has deposits totaling approximately $13 million. Completion of the transaction, which will be accounted for as a purchase, is subject to regulatory approval and a number of other conditions, and is anticipated to be consummated during the second quarter of 1994. The principal source of revenue for Shoreline and its subsidiaries is interest and fees on loans. On a consolidated basis, interest and fees on loans accounted for 70.7 percent of Shoreline's total revenues in 1993, 69.2 percent in 1992 and 71.2 percent in 1991. Interest on investment securities accounted for 17.8 percent of Shoreline's total revenues in 1993, 21.4 percent in 1992 and 20.3 percent in 1991. COMPETITION The business of banking is highly competitive. Banks face significant competition from other commercial banks and, in some product lines, saving and loan associations, credit unions, finance companies, insurance companies and investment and brokerage firms. The principal forms of competition for financial services are price and the convenience and quality of services rendered to customers. SUPERVISION AND REGULATION A state or national bank may generally open a branch office anywhere in the State of Michigan without regard to its proximity to that bank's home office. Regulatory approval is required, but approval is based primarily upon the adequacy of the bank's capital and the prospects for success of the branch. Michigan banks or bank holding companies may acquire or be acquired by banks or bank holding companies located in any state that passes a banking statute granting reciprocal privileges. Banks and bank holding companies are extensively regulated. Inter- City and Citizens are chartered under state law and are supervised, examined and regulated by both the Financial Institutions Bureau of the Michigan Department of Commerce and the Federal Deposit Insurance Corporation. Shoreline is regulated by the Federal Reserve System. The business activities of Inter-City Bank and Citizens are significantly limited in a number of respects by federal and state laws governing banks. Deposits of both banks are insured by the Federal Deposit Insurance Corporation to the extent provided by law. Prior approval of the Federal Reserve Board, and in some cases various other government agencies, will be required for Shoreline to acquire control of any additional banks or other operating subsidiaries. The business activities of Shoreline and its subsidiaries will be limited to banking and other activities which are determined by the Federal Reserve Board to be closely related to banking. Banks are subject to a number of federal and state laws and regulations which have a significant impact upon their business. These include among others: state usury laws, state laws relating to fiduciaries, the Truth in Lending Act, the Truth in Savings Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Community Reinvestment Act, the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the FDIC Improvement Act of 1991, electronic funds transfer laws, redlining laws, antitrust laws and privacy laws. The instruments of monetary policy of authorities, such as the Federal Reserve System, may be used to influence the growth and distribution of bank loans, investments and deposits, and may also affect interest rates on loans and deposits. These policies may have a significant effect on the operating results of banks. Shoreline and its subsidiaries employ approximately 320 persons. A detailed discussion and statistical presentation of certain financial aspects of Shoreline's business is contained in Items 6 and 7. Item 2. Item 2. Properties Shoreline maintains its offices and conducts its business operations from the principal banking office of Inter-City in Benton Harbor, Michigan. The holding company neither owns nor has any present plan to acquire any real property. Inter-City's principal office is located at 823 Riverview Drive, Benton Harbor, Michigan. The Riverview Drive premises encompass approximately 21,000 square feet on three floors, all of which are occupied by Inter-City and Shoreline. Inter-City owns the premises occupied by each of its 15 branch offices. During 1994, Inter-City will construct an 8,000- square-foot addition to its Pleasant Street location, St. Joseph, Michigan, to house the consolidated mortgage, consumer loan, collections and trust departments upon the merger of Inter-City and Citizens. The cost of this project is estimated to be $1.2 million. Citizens' principal office is located at 433 Phoenix Street, South Haven, Michigan. The principal office occupies approximately 36,000 square feet, all of which is occupied by Citizens' banking operations and Shoreline's EDP operations. In addition to its principal office, Citizens owns each of its seven branch offices. Item 3. Item 3. Legal Proceedings Shoreline's subsidiaries are parties, as plaintiff or as defendant, to a number of legal proceedings, none of which is considered material and, all of which arise in the normal course of operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders during the three months ended December 31, 1993. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Shoreline common stock is traded in the over-the-counter market and quoted on the National Association of Securities Dealers Automated Quotation System (NASDAQ) under the trading symbol SLFC. Prices are based on reports published for representative quotations in the over-the-counter market supplied by the National Association of Securities Dealers, Inc. In all periods, the prices shown reflect interdealer prices and do not include retail markups, markdowns or commissions, and may not necessarily represent actual transactions. There may have been transactions or quotations at higher or lower prices of which management is not aware. Market prices have been adjusted to give retroactive effect to the three-for-two stock split paid in April of 1992 and the 5 percent stock dividend paid in April of 1993. A proposed three-for-two stock split payable on May 31, 1994 to shareholders of record on May 16, 1994 has been declared, subject to shareholder approval of an increase in authorized capital. The prices shown have not been adjusted for this future stock split. As of February 28, 1994, there were approximately 1,260 shareholders of record owning common stock of Shoreline. The following table summarizes the quarterly cash dividends paid to common shareholders during the last two years, adjusted for the 5 percent stock dividend paid in April of 1993 and the three-for two stock split paid in April of 1992: Shoreline's principal source of funds to pay cash dividends is the earnings of its subsidiary banks. State and federal laws and regulations limit the amount of dividends that banks can pay. Cash dividends are dependent upon the earnings, capital needs, regulatory constraints and other factors affecting each of the banks. Based on projected earnings, management expects Shoreline to declare and pay regular quarterly dividends on its common shares in 1994. Item 6. Item 6. Selected Financial Data. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion provides additional information about the Corporation's financial condition and results of operations. This discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing in Item 8. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT AUDITORS Shareholders and Board of Directors Shoreline Financial Corporation Benton Harbor, Michigan We have audited the accompanying consolidated balance sheets of SHORELINE FINANCIAL CORPORATION as of December 31, 1993 and 1992 and the related consolidated 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 Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SHORELINE FINANCIAL CORPORATION 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. CROWE, CHIZEK AND COMPANY South Bend, Indiana February 11, 1994, except for Note 1 (stock splits and dividends) as to which the date is February 16, 1994 See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. Supplementary information: Supplemental Schedule of Non-Cash Investing Activities: During 1993, 1992 and 1991, $19,989,527, $13,168,469 and $6,680,154, respectively, was reclassified from investment securities to securities held for sale, on a net basis. The branch acquisitions in 1993 resulted in an increase in loans of $41,986,783, premises and equipment of $782,800, core deposit intangibles of $2,429,413 and deposits of $56,568,954. See accompanying notes to consolidated financial statements. Notes To Consolidated Financial Statements Note 1. Summary of Accounting Policies The accounting and reporting policies and practices of Shoreline Financial Corporation and its subsidiaries conform with generally accepted accounting principles and prevailing practices within the banking industry. The following summaries describe the significant accounting and reporting policies which are employed in the preparation of the financial statements. Principles of Consolidation. The accompanying consolidated financial statements include the accounts of Shoreline Financial Corporation and its wholly owned subsidiaries, Inter-City Bank and Citizens Trust and Savings Bank (together referred to as "the Corporation"). All material inter- company accounts and transactions have been eliminated in consolidation. Investment Securities. Investment securities are those securities which the Corporation has the ability to hold to maturity and the intent to hold for the foreseeable future. These securities are stated at cost adjusted for amortization of premium and accretion of discount, both computed by methods approximating the interest method. Gains and losses on the sale or disposal of investment securities are computed on the basis of specific identification of the adjusted cost of each security. Securities Held for Sale. Securities held for sale are those securities which management does not intend to hold for the foreseeable future. These securities are carried at the lower of amortized cost or estimated market value in the aggregate. Net unrealized losses are recognized in a valuation allowance by charges to income. Loans Held for Sale. Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are recognized in a valuation allowance by charges to income. Allowance for Loan Losses. Because some loans may not be repaid in full, an allowance for loan losses is recorded. Increases to the allowance are recorded by a provision for loan losses charged to expense. Estimating the risk of loss and the amount of loss on any loan is necessarily subjective. Accordingly, the allowance is maintained by management at a level considered adequate to cover possible losses that are currently anticipated based on past loss experience, general economic conditions, information about specific borrower situations including their financial position and collateral values, and other factors and estimates which are subject to change over time. While management may periodically allocate portions of the allowance for specific problem loan situations, the whole allowance is available for any loan charge-offs that occur. A problem loan is charged-off by management as a loss when deemed uncollectible, although collection efforts continue and future recoveries may occur. Interest and Fees on Loans. Interest on loans is accrued over the term of the loans based on principal amounts outstanding except, where serious doubt exists as to the collectibility of a loan, in which case the accrual of interest is discontinued. Loan origination and commitment fees and related lending costs are deferred, and the net amount is amortized as an adjustment of the related loan's yield using the level yield method over its original term. The net amount of deferred income ($676,918 and $732,923 at December 31, 1993 and 1992, respectively) is reported in the consolidated balance sheet as part of loans. Premises and Equipment. Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed using a combination of straight-line and accelerated methods for book purposes and accelerated methods for income tax purposes with useful lives ranging primarily from 10 to 50 years for bank premises, and 5 to 20 years for furniture and fixtures. Maintenance, repairs and minor alterations are charged to current operations as expenditures occur, and major improvements are capitalized. Other Real Estate. Other real estate represents properties acquired through a foreclosure proceeding, acceptance of a deed in lieu of foreclosure, or loans which have been deemed to be in substance foreclosed. Other real estate is initially recorded at fair value at the date of acquisition. Any excess of the loan balance over fair value is charged against the allowance for loan losses when the loan is transferred to other real estate. After acquisition, a valuation allowance is recorded through a charge to income for the amount of estimated selling costs. Valuations are periodically performed by management, and valuation allowances are adjusted through a charge to income for changes in fair value or estimated costs to sell. Subsequent declines in value, and gains and losses on sales, are recognized in current earnings. Other real estate owned amounted to approximately $1,026,000 and $640,000 at December 31, 1993 and 1992, respectively. Intangible Assets. Intangible assets consist of goodwill representing the excess of the purchase price over the net value of tangible assets acquired and related core deposit intangibles identified in branch acquisitions. Goodwill is amortized on a straight-line basis for a period of 10 years. The related core deposit intangibles are amortized on an accelerated basis over the estimated life of the deposits acquired. As of December 31, 1993, the remaining unamortized goodwill and core deposit intangibles totaled $262,103 and $2,593,564, respectively. Trust Income. Trust income is recognized as income when received. The amounts recognized under this method are not significantly different from amounts that would have been recognized on the accrual basis. Employee Benefits. The Corporation maintains a noncontributory pension plan covering all eligible employees. The Corporation accounts for its pension costs under Statement of Financial Accounting Standards (SFAS) No. 87. The Corporation's policy is to fund the plan based upon annual actuarial computations and within Internal Revenue Service guidelines. The Corporation also maintains a profit sharing plan and 401(k) salary reduction plan for which contributions are made and expensed annually. In addition, the Corporation sponsors a postretirement health care plan that covers both salaried and nonsalaried employees. Effective January 1, 1993, the Corporation adopted the provisions of SFAS No. 106, "Employers' Accounting For Post Retirement Benefits Other Than Pensions." SFAS No. 106 requires the accrual, during the years that employees render the necessary service, of the expected cost of providing postretirement health care benefits to employees and their beneficiaries and covered dependents. The Corporation's postretirement health care plan provides that retired employees may remain on the Corporation's health care plan with each retiree's out-of-pocket contribution to the Corporation equal to their premium expense determined exclusively on the loss experience of the retirees in the plan. The impact of adopting the new standard was not material. Income Taxes. The Corporation files annual consolidated federal income tax returns. For periods prior to January 1, 1993, income tax expense was calculated using the deferred method (APB 11). Under APB 11, the Corporation computed deferred taxes for the tax effects of timing differences between financial reporting and tax return taxable income. Effective January 1, 1993, the Corporation applied the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." Accordingly, income tax expense for the year ended December 31, 1993 is based upon the asset and liability method. The asset and liability method requires the Corporation to record income tax expense based on the amount of taxes due on its consolidated tax return plus deferred taxes computed based on the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, using enacted tax rates. The effect of the adoption of SFAS No. 109 was not material to the Corporation's consolidated financial position or results of operations. Earnings and Dividends Per Share. Earnings per share are computed by dividing net income by the weighted average number of common shares outstanding and common equivalent shares with a dilutive effect. Common equivalent shares are shares which may be issuable to employees upon exercise of outstanding stock options. Earnings and dividends per share are restated for all stock splits and dividends paid. After restatement, the average number of shares used in this calculation was 3,276,137 in 1993, 3,261,290 in 1992, and 3,242,839 in 1991. Stock Splits and Dividends. In 1993, the Corporation declared a 5 percent stock dividend. Stock dividends are accounted for by transferring the fair market value of the stock from retained earnings to common stock and additional paid-in capital. In 1992, the Corporation declared a three- for-two stock split in the form of a stock dividend. This stock split was accounted for by transferring the par value of the stock from retained earnings to common stock. The Corporation declared a 10 percent stock dividend in 1991. Fractional shares were paid in cash for all stock splits and dividends. On February 16, 1994 the Board of Directors declared a three-for-two stock split, effective May 31, 1994 to shareholders of record on May 16, 1994 subject to shareholder approval of an increase in authorized capital. Earnings and dividends per share have not been restated for the three-for-two stock split to be effective May 31, 1994. Statement of Cash Flows. For purposes of reporting cash flows, cash and cash equivalents is defined to include the Corporation's cash on hand, its demand deposits in other institutions, and its federal funds sold with a maturity of 90 days or less. The Corporation reports net cash flows for customer loan transactions, deposit transactions, short-term borrowings with a maturity of 90 days or less and interest-bearing balances with other financial institutions. Concentrations of Credit Risk. The Corporation grants commercial, real estate, and consumer loans to customers primarily in the Michigan communities in which the banks are located and in areas immediately surrounding these communities. The majority of loans are secured by specific items of collateral, primarily residential properties and other types of real estate, but are also secured by business assets and consumer assets. Financial Instruments with Off-Balance-Sheet Risk. The Corporation, in the normal course of business, makes commitments to extend credit which are not reflected in the financial statements. See Note 12 for a summary of these commitments. Business Segment. The Corporation is engaged in the business of commercial and retail banking, which accounts for more than 90% of its revenues, operating income and assets. There are no foreign loans. NOTE 2. RESTRICTIONS ON CASH AND DUE FROM BANKS A summary of the Corporation's subsidiary banks' legal cash reserve requirements established by the Federal Reserve System as of December 31 follows: NOTE 3. INVESTMENT SECURITIES The amortized cost and estimated market value of investments in debt securities are as follows: The amortized cost and estimated market value of debt securities at December 31, 1993, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Proceeds, gross gains and gross losses realized from sales and calls of investments in debt securities for the years ending December 31, 1993, 1992 and 1991 are as follows: Debt securities having an amortized cost of approximately $22,273,000 at December 31, 1993, were pledged to secure public and trust deposits, securities sold under agreements to repurchase, advances from Federal Home Loan Bank and for other purposes as required by law. NOTE 4. SECURITIES HELD FOR SALE The amortized cost and estimated market value of debt securities held for sale are as follows: The amortized cost and estimated market value of debt securities held for sale at December 31, 1993, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Proceeds, gross gains and gross losses realized from sales and calls of debt securities held for sale for the years ending December 31, 1993, 1992 and 1991, are as follows: NOTE 5. LOANS At December 31, 1993 and 1992, the Corporation had approximately $l,962,000 and $2,934,000, respectively, of loans for which no interest income was being recognized due to the uncertainty of the collectibility of the loans. If interest on such loans had been accrued, the income would have approximated $131,000, $162,000 and $245,000 in 1993, 1992 and 1991, respectively. Certain directors, executive officers and principal shareholders of the Corporation, including associates of such persons, were loan customers of the Corporation during 1993. A summary of aggregate related party loan activity, for loans aggregating $60,000 or more to any one related party, is as follows for the year ended December 31, 1993: Other changes include adjustments for persons included in one reporting period that are not included in the other reporting period. At December 31, 1993 and 1992, the Corporation had approximately $1,800,000 and $730,000, respectively, of mortgage loans with an estimated market value of $1,820,000 and $743,000, respectively, which were held for sale. NOTE 6. ALLOWANCE FOR LOAN LOSSES A summary of the activity in the allowance for loan losses is as follows: NOTE 7. PREMISES AND EQUIPMENT The following is a summary of premises and equipment: Depreciation and amortization expense charged to operations was $1,154,280, $1,127,939 and $874,182 in 1993, 1992 and 1991, respectively. NOTE 8. DEPOSITS Certificates of deposit in denominations of $100,000 or more totaled approximately $37,991,000 and $36,921,000 at December 31, 1993 and 1992, respectively. Interest expense on deposits for the years ended December 31 is as follows: NOTE 9. LONG-TERM DEBT At December 31, 1993, the Corporation had advances from the Federal Home Loan Bank of Indianapolis (FHLB) totaling $5,000,000. The terms of the advances include monthly interest payments at annual percentage rates of 5.05%. Prepayment options exist on the anniversary dates of the advances, without incurring penalty. The principal balances mature in September of 1998. The FHLB advances are collateralized by U.S. Government agency mortgage-backed securities with a book value of approximately $7,600,000 as of December 31, 1993. NOTE 10. INCOME TAXES Components of the provision for federal income taxes are as follows: Taxes allocated to securities transactions were $125,937 in 1993, $79,776 in 1992 and $27,275 in 1991. The sources and related tax effects of the components of the deferred federal income tax benefits are as follows: The difference between the provision in these financial statements and amounts computed by applying the statutory federal income tax rate to pretax income is as follows: The components of the net deferred tax asset recorded in the balance sheet as of December 31, 1993 are as follows: NOTE 11. EMPLOYEE BENEFITS The Corporation has a defined benefit, noncontributory pension plan which provides retirement benefits for substantially all employees. The following sets forth the plan's funded status and amounts recognized in the balance sheet at December 31. Net pension cost included the following: The weighted average discount rate was 7.25 percent for 1993, 7.5 percent for 1992, and 8.25 percent for 1991, and the rate of increase in future compensation used in determining the actuarial present value of the projected benefit obligation was 4.75 percent for 1993, 5 percent for 1992, and 5.5 percent for 1991. The expected long-term rate of return on assets was 7.75 percent for 1993, and 8 percent for 1992. Unrecognized prior service cost is amortized on a straight-line basis, based on the expected future service years of plan participants to receive benefits. OTHER EMPLOYEE BENEFIT PLANS In 1988, the Corporation established a profit-sharing plan for qualified employees with at least two years of service. Contributions equal 3 percent of "Net Profits" before federal income taxes and securities gains or losses, or as determined at the discretion of the Board of Directors of the Corporation limited to the maximum permitted by the Internal Revenue Code. Under this plan, $248,878, $206,496 and $199,600 was expensed in 1993, 1992 and 1991, respectively. In 1989, the Corporation established a 401(k) salary reduction plan for qualified employees with at least one year of service. Participants may make deferrals up to 15 percent of compensation. The Corporation matches 50 percent of elective deferrals on the first 4 percent of the participants' compensation. Expense under this plan was $97,467, $91,736 and $78,889 in 1993, 1992 and 1991, respectively. On May 16, 1989, the shareholders approved a stock-option plan under which options may be issued at market prices to officers and other key employees. The right to exercise the options vests over a five-year period. The options outstanding at December 31, 1993, are as follows: The following is a summary of the transactions for the period January 1,1991 through December 31, 1993: NOTE 12. COMMITMENTS, OFF-BALANCE-SHEET RISK AND CONTINGENCIES The Corporation is a party to financial instruments with off-balance- sheet risk in the normal course of business to meet financing needs of its customers. These financial instruments include commitments to make loans, unused lines of credit and standby letters of credit. The Corporation's exposure to credit loss in the event of nonperformance by the other party to financial instruments for commitments to make loans, unused lines of credit and standby letters of credit is represented by the contractual amount of those instruments. The Corporation follows the same credit policy to make such commitments as it uses for on-balance-sheet items. As of December 31, 1993, commitments to make loans and unused lines of credit amounted to approximately $72,820,000 and commitments under outstanding standby letters of credit amounted to approximately $2,632,000. Since many commitments to make loans expire without being used, the amount does not necessarily represent future cash commitments. No losses are anticipated as a result of these transactions. Collateral obtained upon exercise of commitments is determined using management's credit evaluation of the borrowers and may include real estate, business assets, deposits and other items. Rental expense for the years ended December 31, 1993, 1992 and 1991 totaled $90,650, $82,333 and $45,078, respectively. As of December 31, 1993, there were no significant future rental commitments. NOTE 13. FAIR VALUES OF FINANCIAL INSTRUMENTS The following table shows the estimated fair values and the related carrying values of the Corporation's financial instruments at December 31, 1993 and 1992. Items which are not financial instruments are not included. For purposes of the above disclosures of estimated fair value, the following assumptions were used as of December 31, 1993 and 1992. The estimated fair value for cash and cash equivalents is considered to approximate cost. The estimated fair value for investment securities and securities held for sale is based on quoted market values for the individual securities or for equivalent securities. The estimated fair value for commercial loans is based on estimates of the difference in interest rates the Corporation would charge the borrowers for similar such loans with similar maturities made at December 31, 1993 and 1992, applied for an estimated time period until the loan is assumed to reprice or be paid. The estimated fair value for other loans is based on estimates of the rate the Corporation would charge for similar such loans at December 31, 1993 and 1992, applied for the time period until estimated repayment. The estimated fair value for demand and savings deposits, is based on their carrying value. The estimated fair value for time deposits, securities sold under agreements to repurchase and long-term debt, is based on estimates of the rate the Corporation would pay on such deposits or borrowings at December 31, 1993 and 1992, applied for the time period until maturity. The estimated fair value of other financial instruments and off-balance-sheet loan commitments approximate cost and are not considered significant to this presentation. While these estimates of fair value are based on management's judgment of the most appropriate factors, there is no assurance that were the Corporation to have disposed of such items at December 31, 1993 and 1992, the estimated fair values would necessarily have been achieved at that date, since market values may differ depending on various circumstances. The estimated fair values at December 31, 1993 and 1992, should not necessarily be considered to apply at subsequent dates. In addition, other assets and liabilities of the Corporation that are not defined as financial instruments are not included in the above disclosures, such as property and equipment. Also, non-financial instruments typically not recognized in financial statements nevertheless may have value but are not included in the above disclosures. These include, among other items, the estimated earnings power of core deposit accounts, the earnings potential of loan servicing rights, the earnings potential of the Corporation's subsidiary banks' trust departments, the trained work force, customer goodwill and similar items. NOTE 14. CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY The condensed financial information of the parent company, Shoreline Financial Corporation, is summarized below. NOTE 14. CONDENSED FINANCIAL INFORMATION ON PARENT COMPANY (Continued) Shoreline Financial Corporation's primary source of revenue is its wholly owned subsidiaries, Inter-City Bank and Citizens Trust and Savings Bank. The payment of dividends by these banks is restricted to "net profits" as defined by the Michigan Banking Code, then on hand after deducting their losses and "bad debts," as also defined by the Michigan Banking Code. Accordingly, in 1994, the subsidiary banks may distribute to Shoreline, in addition to their 1994 "net profits," approximately $24,000,000 in dividends without prior approval from bank regulatory agencies. NOTE 15. FUTURE TRANSACTIONS On May 5, 1993, the Corporation announced its intention to effect a merger between its two subsidiary banks, Inter-City Bank and Citizens Trust & Savings Bank. The resulting single bank will be named Shoreline Bank. Completion of the transaction is subject to regulatory approval and is anticipated to be consummated during the second quarter of 1994. On December 7, 1993, the Corporation announced an agreement with Great Lakes Bancorp, Ann Arbor, Michigan under which the Corporation will purchase and assume from Great Lakes Bancorp certain assets and liabilities associated with its branch located in South Haven, Michigan. This branch has deposits totaling approximately $13 million. Completion of the transaction, which will be accounted for as a purchase, is subject to regulatory approval and a number of other conditions, and is anticipated to be consummated during the second quarter of 1994. NOTE 16. IMPACT OF NEW ACCOUNTING STANDARD In May 1993, the Financial Accounting Standards Board issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 focuses on the accounting and reporting treatment of investment securities. Securities classified as "available for sale" will be those the Corporation does not have the positive intent and ability to hold to maturity. These securities will be accounted for at fair value with unrealized gains and losses, net of deferred income taxes, reported as a separate component of shareholders' equity. Securities classified as "held to maturity" will be those the Corporation has the positive intent and ability to hold to maturity. These securities will be accounted for at amortized cost. Securities classified as "trading securities" include those purchased and held principally to sell in the near term. These securities will be accounted for at fair value with unrealized gains and losses included in current earnings. SFAS No. 115 is effective for fiscal years beginning after December 15, 1993. The Corporation plans to adopt SFAS No. 115, as required, on January 1, 1994. The effect of adopting the new standard will be to increase shareholders' equity by approximately $2.4 million on January 1, 1994. QUARTERLY FINANCIAL DATA (Unaudited) The following is a summary of selected quarterly results of operations for the years ended December 31, 1993 and 1992. The per share data for the first quarter of 1992 has been restated to reflect the three-for-two stock split paid in April of 1992. Additionally, the per share data for 1992 and the first quarter of 1993 have been restated to reflect the 5 percent stock dividend paid in April of 1993. The per share data has not been restated to reflect the proposed three-for-two stock split payable May 31, 1994. 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 set forth under the caption "Directors and Executive Officers" in the registrant's definitive Proxy Statement for its May 5, 1994, annual meeting of shareholders is here incorporated by reference. Item 11. Item 11. Executive Compensation. The information set forth under the caption "Compensation of Executive Officers and Directors" in the registrant's definitive Proxy Statement for its May 5, 1994, annual meeting of shareholders is here incorporated by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information set forth under the caption "Voting Securities" in the registrant's definitive Proxy Statement for its May 5, 1994, annual meeting of shareholders is here incorporated by reference. Item 13. Item 13. Certain Relationships and Related Transactions. The information set forth under the caption "Certain Relationships and Related Transactions" in the registrant's definitive Proxy Statement for its May 5, 1994, annual meeting of shareholders is here incorporated 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 independent auditors' report of Shoreline Financial Corporation and its subsidiaries are filed as part of this report: Report of Independent Auditors dated February 11, 1994, except for Note 1 (Stock Splits and Dividends) as to which the date is February 16,1994 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 Shareholders' Equity for the years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991 Notes to Consolidated Financial Statements The financial statements, the notes to financial statements, and the report of independent auditors listed above are set forth in Item 8 of this report. (2) Financial Statement Schedules. Not applicable. (3) Exhibits. The following exhibits are filed as part of this report: Shoreline will furnish a copy of any exhibit listed above to any shareholder of the registrant without charge upon written request to Secretary, Shoreline Financial Corporation, 823 Riverview Drive, Benton Harbor, Michigan 49022. (b) Reports on Form 8-K. Shoreline filed no Current Reports on Form 8-K 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. SHORELINE FINANCIAL CORPORATION (registrant) Date: March 23, 1994 By /s/ Dan L. Smith Dan L. Smith 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. March 23, 1994 /s/ Louis A. Desenberg* Louis A. Desenberg Director March 23, 1994 /s/ Merlin Hanson* Merlin Hanson Director March 23, 1994 /s/ Thomas T. Huff* Thomas T. Huff Director March 23, 1994 /s/ Ronald F. Kinney* Ronald F. Kinney Director March 23, 1994 /s/ James E. LeBlanc* James E. LeBlanc Director March 23, 1994 /s/ L. Richard Marzke* L. Richard Marzke Director March 23, 1994 /s/ James F. Murphy* James F. Murphy Director March 23, 1994 /s/ Dan L. Smith Dan L. Smith Chairman, President and Chief Executive Officer and Director (Principal Executive Officer) March 23, 1994 /s/ Robert L. Starks* Robert L. Starks Director March 23, 1994 /s/ Harry C. Vorys* Harry C. Vorys Director March 23, 1994 /s/ Hyman Warshawsky* Hyman Warshawsky Director March 23, 1994 /s/ Ronald L. Zile* Ronald L. Zile Vice Chairman of the Board and Director March 23, 1994 /s/ Wayne R. Koebel Wayne R. Koebel Chief Financial Officer, Secretary and Treasurer (Principal Financial Officer and Principal Accounting Officer) *By /s/ Dan L. Smith Dan L. Smith Attorney-in-Fact for the indicated persons Commission File No. 0-16444 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 EXHIBITS TO FORM 10-K For the Fiscal Year Ended December 31, 1993 SHORELINE FINANCIAL CORPORATION 823 Riverview Drive Benton Harbor, Michigan 49022

770975_1993.txt

770975_1993

1993

770975

ITEM 1. BUSINESS GENERAL First Republic Bancorp Inc. ("First Republic" and with its subsidiaries, the "Company") is a financial services holding company operating in California and Nevada. First Republic conducts its business primarily through a California- chartered, FDIC-insured, thrift and loan subsidiary, First Republic Thrift & Loan ("First Thrift"), and also a Nevada-chartered, FDIC-insured thrift and loan subsidiary, First Republic Savings Bank (together the "Thrifts") and a real estate loan origination subsidiary in Las Vegas, Nevada. The Company operates both as an originator of loans for its balance sheet and as a mortgage company, originating, holding or selling, and servicing mortgage loans. The Company is engaged in originating real estate secured loans for retention in the portfolios of the Thrifts. In addition, the Company operates as a mortgage banking company originating mortgage loans for sale to institutional investors in the secondary market. The Company also generates fee income by servicing mortgage loans for such institutional investors and other third parties. First Thrift's depository activities and advances from the Federal Home Loan Bank (the "FHLB") are its principal source of funds with loan principal repayments, sales of loans and capital contributions and advances from First Republic as supplemental sources. The Company's deposit gathering activities are conducted in the San Francisco Bay Area, Los Angeles, and San Diego County, California and its lending activities are concentrated in the San Francisco, Los Angeles and Las Vegas areas. The San Francisco Bay Area, Los Angeles and San Diego County are among the wealthiest areas in California as measured by average housing costs and income per family. Las Vegas has been growing rapidly and has experienced significant inward migration as well as internal business growth. On December 10, 1993, First Republic acquired First Republic Savings Bank (formerly Silver State Thrift and Loan), when all of its outstanding common stock was acquired for a total purchase price of $1,414,000 in cash. As a result of this acquisition, accounted for as a purchase transaction, the Company has recorded goodwill of $105,000 at December 31, 1993. At the date of acquisition, First Republic Savings Bank's assets consisted primarily of cash of $684,000 and loans of $1,416,000 and its deposits were $762,000. On January 18, 1994, this entity relocated to Las Vegas, Nevada and was renamed First Republic Savings Bank. LENDING ACTIVITIES The Company's loan portfolio primarily consists of loans secured by single family residences, multifamily buildings and seasoned commercial real estate properties. Currently, the Company's strategy is to focus on the origination of single family and multifamily mortgage loans and to limit the origination of commercial mortgage loans. A substantial portion of single family loans is originated for sale in the secondary market, whereas historically a small percentage of apartment and commercial loans has been sold. From its inception in 1985 through December 31, 1993, the Company originated approximately $3.6 billion of loans, of which approximately $1.5 billion were sold to investors. The Company has emphasized the retention of adjustable rate mortgages ("ARMs") in its loan portfolio. At December 31, 1993, over 87% of the Company's loans were adjustable rate or were due within one year. If interest rates rise, payments on ARMs increase, which may be financially burdensome to some borrowers. Subject to market conditions, however, the Company's ARMs generally provide for a life cap that is 5% to 6% above the initial interest rate as well as periodic caps on the rates to which an ARM can increase from its initial interest rate, thereby protecting borrowers from unlimited interest rate increases. Also, the ARMs offered by the Company often carry fixed rates of interest during the initial three-, six- or twelve-month periods which are below the rate determined by the index at the time of origination plus the contractual margin. Certain ARMs contain provisions for the negative amortization of principal in the event that the amount of interest and principal due is greater than the required monthly payment. The amount of any shortfall is added to the principal balance of the loan to be repaid through future monthly payments, which could cause increases in the amount of principal owed by the borrower from that which was originally advanced. At December 31, 1993, the amount of loans with the potential for negative amortization held by the Company was approximately 4.8% of total loans and the amount of loans which had experienced increases in principal balance was approximately 0.5% of total loans. The Company focuses on originating loans secured by a limited number of property types, located in specific geographic areas. The Company's loans are of sufficient average size to justify executive management's involvement in most transactions. The Company's executive loan committee reviews all loan applications and approves all lending decisions. Substantially all properties are visited by the originating loan officer, and generally, an additional visit is made by one of the members of the Executive Loan Committee, either the President, the Executive Vice President, or another Vice President who is an underwriting officer prior to loan closing. Approximately 80% of the Company's loans are secured by properties located within 20 miles of one of the Company's offices. The Company utilizes third-party appraisers for appraising the properties on which it makes loans. These appraisers are chosen from a small group of appraisers approved by the Company for specific types of properties and geographic areas. In the case of single family home loans in excess of $1,500,000, two appraisals are generally required and the Company utilizes the lower of the two appraised values for underwriting purposes. The Company's focus on loans secured by a limited number of property types located in specific geographic areas enables management to maintain a continually updated knowledge of collateral values in the areas in which the Company operates. The Company's policy generally is not to exceed an 80% loan-to-value ratio on single family loans without mortgage insurance. The Company applies stricter loan-to-value ratios as the size of the loan increases. Under the Company's policies, an appraisal is obtained on all multifamily and commercial loans and the loan-to-value ratios generally do not exceed 75% for multifamily loans and 70% for commercial real estate loans. The Company applies its collection policies uniformly to both its portfolio loans and loans serviced for others. It is the Company's policy to discuss each loan with one or more past due payments at a weekly meeting of all lending personnel. The Company has policies requiring rapid notification of delinquency and the prompt initiation of collection actions. The Company primarily utilizes loan officers and senior management in its collection activities in order to maximize attention and efficiency. In 1992, the Company implemented procedures requiring annual or more frequent asset reviews of its multifamily and commercial real estate loans. As part of these asset review procedures, recent financial statements on the property and/or borrower are analyzed to determine the current level of occupancy, revenues and expenses as well as to investigate any deterioration in the value of the real estate collateral or in the borrower's financial condition since origination or the last review. Upon completion, an evaluation or grade is assigned to each loan. These asset review procedures provide management with additional information for assessing its asset quality. Also, since September 1992, the Company has maintained an insurance policy to cover a portion of the risk of loss that might result from earthquake damage to properties securing real estate mortgage loans in its loan portfolio. Under a policy extending until August 1994, the Company is self-insuring for the first $12,500,000 of any loss as a result of damages to underlying collateral and the insurance policy covers up to an additional $8,000,000. In connection with obtaining this insurance coverage, the Company was assisted by an engineering consulting firm which analyzed the location and construction attributes of certain of the properties that secure the Company's loans. For additional information regarding the effect of the January 17, 1994 earthquake on the Company's loans in the Los Angeles area, see "Asset Quality--Event Subsequent to December 31, 1993." At December 31, 1993, single family real estate secured loans, including home equity loans, represented $608,489,000, or 48% of the Company's loan portfolio. Approximately 72% of these loans were in the San Francisco Bay Area, and approximately 22% were in the Los Angeles area. The Company's strategy has been to lend to borrowers who are successful professionals, business executives, or entrepreneurs and who are buying or refinancing homes in metropolitan communities. Many of the borrowers have high liquidity and substantial net worths, and are not first-time home buyers. These are loans secured by single family detached homes, condominiums, cooperative apartments, and two-to-four unit properties. At December 31, 1993, the average single family loan amount was approximately $613,000 and the approximate average loan- to-value ratio was 65%, using appraised values at the time of loan origination and current loan balances outstanding. Due to the Company's focus on upper-end home mortgage loans, the number of single family loans originated is limited (approximately 1,450 for 1993), allowing the loan officers and executive management to apply the Company's underwriting criteria to each loan. Repeat customers or their direct referrals account for the most important source of the loans originated by the Company. At December 31, 1993, loans secured by multifamily properties totaled $387,757,000, or 31% of the Company's loan portfolio. The loans are predominantly on older buildings in the urban neighborhoods of San Francisco and Los Angeles. Approximately 39% of the properties securing the Company's multifamily loans were in the San Francisco Bay Area, approximately 27% were in Los Angeles County, approximately 6% were in other California areas and approximately 28% were in Clark County (Las Vegas). The buildings are generally seasoned operating properties with proven occupancy, rental rates and expense levels. The neighborhoods tend to be densely populated; the properties are generally close to employment opportunities; and rent levels are generally low to moderate. Typically, the borrowers are property owners who are experienced at operating such type of buildings. At December 31, 1993, the average multifamily mortgage loan size was approximately $1,212,000 and the approximate loan-to-value ratio was 64%, using appraised values at the time of origination and current loan balances outstanding. The Company actively engaged in commercial real estate lending from its formation in 1985; however, from May 1992 through December 31, 1993, in response to economic conditions, the Company entered into a limited number of commitments to make new commercial real estate loans. The Company has not made and does not make commercial real estate construction and development loans. The real estate securing the Company's existing commercial real estate loans includes a wide variety of property types, such as office buildings, smaller shopping centers, owner-user office/warehouses, residential hotels, motels, mixed-use residential/commercial, and retail properties. At the time of loan closing, the properties are generally completed and occupied. They are generally older properties located in metropolitan areas with approximately 74% in the San Francisco Bay Area, approximately 13% in Los Angeles County, approximately 4% in other California areas and approximately 7% in Las Vegas. At December 31, 1993, the average loan size was less than $1,000,000 and the approximate average loan-to-value ratio was 56%, using appraised values at the time of loan origination and current balances outstanding. The total amount of such loans outstanding on December 31, 1993, was $229,914,000, or 18% of the Company's loan portfolio, compared to $204,611,000, or 19% at December 31, 1992. Since May 1990, the Company has originated construction loans secured by single family and multifamily residential properties and permanent mortgage loans primarily secured by multifamily and single family properties in the Las Vegas, Nevada vicinity. In 1993, such loan originations were approximately $146,200,000 and approximately $102,400,000 of such loans were repaid, compared to approximately $128,100,000 of loan originations and $73,300,000 of such loans that were repaid in 1992. Generally, residential construction loans are short-term in nature and are repaid upon completion or ultimate sale of the properties. At December 31, 1993, the outstanding balance of the Company's construction loans was $20,219,000, or 2% of total loans. Construction loans are made only in Las Vegas by an experienced lending team. As a method for limiting this type of business, the Company's Board of Directors has approved a current limit of $78,710,000 of total commitments on single family for sale tracts and a maximum outstanding balance of $3,500,000 at any time per development. Total outstanding single family construction loans on 38 separate projects were $14,512,000 at December 31, 1993 with total additional committed loan amounts of $25,896,000. The Company also has loans to four separate borrowers on four separate multifamily properties under construction in Las Vegas totalling $5,707,000 and has issued permanent take-out commitments of up to $20,770,000 on these multifamily projects, conditioned upon the completion of construction, satisfactory occupancy and rental rates, and certain other requirements. For construction loans, a voucher system is used for all disbursements. For each disbursement, an independent inspection service is utilized to report the progress and percentage of completion of the project. In addition to these inspections, regular biweekly inspections of all projects are performed by senior management of First Republic Savings Bank. Checks are made payable to the various subcontractors and material suppliers, after they have waived their labor and/or material lien release rights. The request for payment, via vouchers, is compared to the individual line item in the approved construction budget to ensure that the disbursements do not exceed the percentage of completion as reported by a third party inspection service. All vouchers must be approved by management prior to being processed for payment. In 1991, the Company began purchasing seasoned performing multifamily and commercial real estate loans. Such loans met the Company's normal underwriting standards, were generally located in the Company's primary lending areas, and were purchased at a discount to their face value. Prior to the purchase of these loans, management conducted a property visit and applied the Company's underwriting procedures as if a new loan were being originated. The Company purchased loans totalling $70,307,000 in 1991, $12,342,000 in the first quarter of 1992, including some single family real estate loans, and $5,440,000 in 1993. The Company currently has no specific plans to make additional purchases of loans, but may do so in the future if attractive opportunities are presented. Since 1989, First Thrift has offered a home equity line of credit program, with loans secured by first or second deeds of trust on owner-occupied primary residences. At December 31, 1993, the outstanding balance due under home equity lines of credit was $31,213,000 and the unused remaining balance was $39,243,000. These loans carry interest rates which vary with the prime rate and may be drawn down and repaid during the first 10 years, after which the outstanding balance converts to a fully-amortizing loan for the next 15 years. Commercial business loans are generally secured by a mix of real estate, equipment, inventory and receivables, are primarily adjustable rate in nature, and are typically made to small businesses. These loans generally have maturities of 60 months. The yields on these small business loans are typically greater than the yields on real estate secured loans, and the difference in such yields reflects a marketplace assessment of the relative risks to the lender associated with each type of loan. At December 31, 1993, the Company had approximately 139 commercial business loans with an aggregate balance of $8,346,000, which accounted for less than 1% of the Company's loan portfolio. Additionally, certain of the Company's deposit customers have obtained loans which are fully secured by their thrift certificate balances. These loans totalled $812,000 at December 31, 1993. The following table presents an analysis of the Company's loan portfolio at December 31, 1993 by property type and geographic location. The table does not include amounts which the Company is committed to lend but which are undisbursed. - -------- (1) Includes equity lines of credit secured by single family residences and single family loans held for sale. MORTGAGE BANKING OPERATIONS In addition to originating loans for its own portfolio, the Company participates in secondary mortgage market activities by selling whole loans and participations in loans to FNMA and FHLMC and various institutional purchasers such as insurance companies, mortgage conduits and savings and loan associations. Mortgage banking operations are conducted primarily by First Thrift, and to a lesser extent, by First Republic Mortgage, Inc. Secondary market sales allow the Company to make loans during periods when deposit flows decline, or are not otherwise available, and at times when customers prefer loans with long-term fixed interest rates which the Company does not choose to retain in its loan portfolio. The following table sets forth the amount of loans originated and purchased by the Company and the amount of loans sold to institutional investors in the secondary market. The secondary market for mortgage-backed loans is comprised of institutional investors who purchase loans meeting certain underwriting specifications with respect to loan-to-value ratios, maturities and yields. Subject to market conditions, the Company tailors certain real estate loan programs to meet the specifications of particular institutional investors. The Company retains a portion of the loan origination fee (points) paid by the borrower and receives annual servicing fees as compensation for retaining responsibility for the servicing of all loans sold to institutional investors. See "--Loan Servicing." The sale of substantially all loans to institutional investors is nonrecourse to the Company; however, the Company has on one occasion retained a subordinated interest in loans sold to an institutional investor of which at December 31, 1993, $431,000 remained outstanding. From its inception, through December 31, 1993, the Company has sold approximately $1.5 billion of loans to investors, substantially all nonrecourse, and has retained the servicing on all such loans except for a limited amount of FHA/VA loans sold servicing released. The Company sold loans to six institutional investors in 1991, to ten institutional investors in 1992 and to eight institutional investors in 1993. The terms and conditions under which such sales are made depend upon, among other things, the specific requirements of each institutional investor, the type of loan, the interest rate environment and the Company's relationship with the institutional investor. The majority of the Company's sales of multifamily and commercial real estate loans have been made pursuant to individually negotiated whole loan or participation sales agreements for individual loans or for a package of such loans. In the case of single family residential loans, the Company obtains in advance formal commitments under which the investors are committed to purchase up to a specific dollar amount of whole loans over a specified period of time. The terms of the commitments vary with each institutional investor and generally range from two months to one year. The fees paid for such commitments also vary with each investor and by the length of such commitment. Informal commitments are normal in the industry for multifamily and commercial loans, although the Company did not sell any new loans secured by multifamily or commercial properties in 1993 or 1992. Management expects to enter into additional formal and informal commitments in the future as it develops working relationships with additional institutional investors; however, an unstable interest rate environment could make it difficult for the Company to obtain commitments for the sale of loans with acceptable terms on a timely basis. Loans are classified as held for sale when the Company is waiting for purchase by an investor under a flow program or is negotiating for the sale of specific loans which meet selected criteria to a specific investor. Underwriting criteria established by investors in adjustable and fixed rate single family residential loans generally include the following: maturities of 15 to 30 years, a loan-to-value ratio no greater than 90% (which percentage generally decreases as the size of the loan increases and is limited to 80% unless there is mortgage insurance on the loan), the liquidity of the borrower's other assets and the borrower's ability to service the debt out of income. Interest rates on adjustable rate loans are adjusted semiannually or annually primarily on the basis of either the One-Year Treasury Constant Maturity Index or the Eleventh District Federal Home Loan Bank Board Cost of Funds Index. Some loans may be fixed for an initial period of up to several years and become adjustable thereafter. Except for the amount of the loan, the underwriting standards of the investors generally conform to certain requirements established by the Federal National Mortgage Association ("FNMA") or the Federal Home Loan Mortgage Corporation ("FHLMC"). Underwriting criteria established by investors in multifamily and commercial real estate loans generally include the following: maturities of 10 to 30 years, with a 25 to 30 year amortization schedule, a loan-to-value ratio no greater than 75% and a debt coverage ratio (based on the property's cash flow) of 1-to-1. Loans sold in the secondary market are generally secured by a first deed of trust. LOAN SERVICING The Company has retained the servicing on all non-government loans sold to institutional investors, thereby generating ongoing servicing revenues. Also, in 1990 and, to a lesser extent, in 1991, it purchased mortgage servicing rights on the open market. The Company's mortgage servicing portfolio was $814.5 million and $781.6 million at December 31, 1993 and 1992, respectively. Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, holding escrow (impound) funds for payment of taxes and insurance, making inspections as required of the mortgaged property, collecting amounts due from delinquent mortgagors, supervising foreclosures in the event of unremedied defaults and generally administering the loans for the investors to whom they have been sold. Management believes that the quality of its loan servicing capability is a factor which permits it to sell its loans in the secondary market and to purchase servicing rights at competitive prices. The Company receives fees for servicing mortgage loans, ranging generally from 0.125% to 1.25% per annum on the declining principal balances of the loans. The average service fee collected by the Company was 0.38% for 1993, 0.41% for 1992 and 0.42% for 1991. Servicing fees are collected and retained by the Company out of monthly mortgage payments. The Company's servicing portfolio is subject to reduction by reason of normal amortization and prepayment or liquidation of outstanding loans. A significant portion of the loans serviced by the Company have outstanding balances of greater than $200,000, and at December 31, 1993 approximately 55% were adjustable rate mortgages. The weighted-average mortgage loan note rate of the Company's servicing portfolio at December 31, 1993 was 6.54% for ARMs and 7.90% for fixed rate loans. Many of the existing servicing programs provide for full payments of principal and interest to be remitted by the Company, as servicer, to the investor, whether or not received from the borrower. Upon ultimate collection, including the sale of foreclosed property, the Company is entitled to recover any such advances plus late charges prior to payment to the investor. The Company accounts for revenue from the sale of loans where servicing is retained in conformity with the requirements of Statement of Financial Accounting Standards No. 65. Gains and losses are recognized at the time of sale by comparing sales price with carrying value. A premium results when the interest rate on the loan, adjusted for a normal service fee, exceeds the pass- through yield to the buyer. Premiums are calculated as the present value of excess service fees expected to be collected in future periods and are amortized over the estimated life of the loans, based on market factors, including estimated prepayments. The Company adjusts the premium on the sale of loans on a quarterly basis to reflect actual prepayments on the underlying loan portfolio. At December 31, 1993, this asset (reported as "premium on sale of loans" and included in the Company's balance sheet as "Other Assets") was $903,000 as compared to $1,454,000 at December 31, 1992. "Purchased servicing rights" represent the carrying cost of bulk purchases of servicing rights and are also included in the Company's balance sheet as "Other Assets." These carrying costs are amortized in proportion to, and over the period of, estimated net servicing income. No significant servicing rights were purchased in bulk prior to June 1990. Servicing rights on $443,000,000 of loans were purchased at a cost of $4,417,000 in early 1991 and the last half of 1990. No servicing rights were purchased in 1993 or 1992. At purchase, the underlying loans had an average balance of approximately $200,000, and approximately 75% carried fixed interest rates averaging 10.2%. The purchases were made to expand the Company's portfolio of loans serviced for others, allowing the more effective use of the existing servicing capacity and resulting in increased efficiency on a per loan basis. In order to hedge against the possible loss of servicing income that might result from a more rapid than anticipated prepayment of the underlying loans in the event of a significant decline in interest rates from purchase until May 1993, the Company purchased call options on $20 million of ten-year U.S. Treasury Notes, which became more valuable in a declining interest rate environment. At December 31, 1993 and 1992, the carrying cost of purchase servicing rights, net of amortization, was $251,000 and $1,502,000, respectively. Amortization of the carrying value of premium on sale of loans and the carrying cost on purchased servicing rights totalled $1,753,000 in 1993, $1,960,000 in 1992 and $1,820,000 in 1991. A declining and relatively low interest rate environment has existed for most of 1992 and 1993. When interest rates are low, the rate at which mortgage loans are prepaid tends to increase as borrowers refinance fixed rate loans to lower rates or convert from adjustable rate to fixed rate loans. Low rates also increase housing affordability, stimulating purchases by first time home buyers and trade up transactions by existing homeowners. The level and value of the Company's loan servicing portfolio, including purchased servicing rights, have been adversely affected by low mortgage interest rates, leading to higher loan prepayments and lower income generated from the Company's loan servicing portfolio. This negative effect on the Company's income has been offset somewhat by a rise in origination and servicing income attributable to new loan originations, which have increased during the recent period of low mortgage interest rates. From 1991 to 1993, the Company closed its loan servicing hedge position, resulting in total gains of approximately $1,200,000 which were used by the Company to reduce the recorded value of its purchased servicing rights. In addition, the Company has amortized, as a reduction of servicing fee revenues, the cost of purchased servicing rights at a rate generally consistent with the actual repayment experience. The Company believes its carrying basis of $251,000 has been reduced to a modest amount, which approximates the market value of such rights. See "--Asset and Liability Management." The following table sets forth the dollar amounts of the Company's mortgage loan servicing portfolio at the dates indicated, the portion of the Company's loan servicing portfolio resulting from loan originations and purchases, respectively, and the carrying value as a percentage of loans serviced. Although the Company intends to continue to increase the size of its servicing portfolio, such growth will depend on market conditions including the future level of loan originations, sales and prepayments. INVESTMENTS The Company purchases short-term money market instruments as well as U.S. Government securities and other mortgage-backed securities ("MBS") in order to maintain a reserve of liquid assets to meet liquidity requirements and as alternative investments to loans. The Company has generated agency MBS by originating qualifying adjustable rate mortgage loans for sale to the agencies and pooling such loans into securities. At December 31, 1993, the Company's investment portfolio included the following securities in the proportions listed: U.S. Government--30%; agency MBS 16%; and other MBS--53%. At December 31, 1993, the Company's investment portfolio totalled $84,208,000 (6% of total assets) as compared to $40,638,000 (3% of total assets) at December 31, 1992. The securities in the Company's investment portfolio at December 31, 1993 had maturities ranging from seven months to twenty-nine years. As of December 31, 1993, the market value of securities in the portfolio were $855,000 above cost consisting of total gross unrealized gains of $731,000 on U.S. Government securities, gross unrealized gains of $266,000 on agency MBS and gross unrealized losses of $16,000 and $155,000 on agency MBS and other MBS, respectively. The following summarizes by category the carrying value and approximate market value of investment securities at the dates indicated: - -------- (1) As of December 31, 1991 the Company reclassified a $6,000,000 nonaccruing investment as a nonaccruing commercial real estate loan participation. The Company sold that asset in May 1992 and recorded a loss of $2,220,000. At December 31, 1993, the Company's intent is to hold all investments other than the one corporate bond owned until maturity and management believes that the Company has the ability to do so. The following table summarizes the maturities of the Company's investment securities and their weighted average yields at December 31, 1993: - -------- (1) Represents one nonaccruing asset. At December 31, 1993, all of the investment securities were due in one year or were adjustable, with rates which were generally subject to change monthly, quarterly or semiannually and varied according to several interest rate indices. Yields have been calculated by dividing the projected interest income at current interest rates, including discount or premium, by the carrying value. Most of the securities having maturities exceeding 10 years are adjustable U.S. Government guaranteed loan pools, agency MBS and other MBS which, as a class, have actual maturities substantially shorter than their face maturities. At December 31, 1993, the net book value of the Company's securities of an unsecured, below investment grade nature was $361,000. At December 31, 1993, First Thrift owned redeemable FHLB stock having a par value of $22,927,000. At December 31, 1993, no other asset and no investment in the Company's portfolio had an aggregate book value exceeding 10% of stockholders' equity. FUNDING SOURCES The Thrifts obtain funds from depositors by offering passbook accounts and term investment certificates or term deposits. The Thrifts' accounts are federally insured by the FDIC up to the legal maximum. First Thrift has typically offered somewhat higher interest rates to its depositors than do most full service financial institutions. At the same time, it minimizes the cost of maintaining these accounts by not offering transaction accounts or high operating cost services such as checking, safe deposit boxes, money orders, ATM access and other traditional retail services. This limited product operation results in substantial cost savings which more than exceed the differential interest rates paid. The Thrifts effect deposit withdrawals by issuing checks rather than disbursing cash, which minimizes operating costs associated with handling and storing cash, of which it does none. In addition, the Thrifts do not actively solicit deposit accounts of less than $5,000. The Thrifts advertise in local newspapers to attract deposits; and since 1988, First Thrift has performed a limited direct telephone solicitation of potential institutional depositors such as credit unions, small commercial banks, and pension plans. At December 31, 1993, no individual depositor represents 0.7% or more of First Thrift's deposits. Prior to mid-1992, First Thrift utilized certificates with a balance of $100,000 or more, generally having maturities in excess of six months, to fund a portion of its assets. Existing bank regulations define brokered deposits, jumbo certificates and borrowings with a maturity of less than one year as "volatile liabilities." Volatile liabilities are compared to cash, short-term investment and investments which mature within one year ("liquid assets") to calculate the volatile liability "dependency ratio," a measure of regulatory liquidity. The level of such liquid assets should generally be higher in comparison with volatile liabilities if a financial institution has large negotiable liabilities like checking accounts, substantial future lending or off-balance sheet commitments, or a history of significant asset growth. In the last six months of 1992 and continuing throughout 1993, First Thrift significantly altered its volatile liability dependency ratio by maintaining a higher level of cash and investments relative to its short-term borrowings and a reduced level of larger certificates. At December 31, 1993, First Thrift's cash and investments exceeded its volatile liabilities by $64,573,000. First Thrift has adopted a policy to discontinue accepting most larger certificates and, upon maturity, to return a portion or all of the funds on existing larger certificates. At year end 1993, First Thrift had not accepted brokered deposits for more than four years and the balance of $989,000 of brokered deposits at December 31, 1993, represented less than 0.2% of total deposits. Management does not plan to renew such deposits upon their scheduled maturity. At December 31, 1993, First Thrift's time certificates $100,000 or more totalled $44,847,000 of which $31,653,000, or 70.6%, were from retail consumer depositors. At December 31, 1993, First Republic Savings Bank had one time certificate over $100,000, totalling $112,000. For First Thrift, average maturity of all time certificates was 8.8 months and the average certificate amount per depositor was approximately $42,000 at December 31, 1993. The following table shows the maturity of the Thrifts' certificates of $100,000 or more at December 31, 1993. First Thrift also utilizes term FHLB advances and, to a lesser extent, bank lines of credit as funding sources. Since August 1990, the Company has utilized term FHLB advances as an alternative to deposit gathering to fund its assets. FHLB advances must be collateralized by the pledging of mortgage loans which are assets of First Thrift. At December 31, 1993, total FHLB advances outstanding were $468,530,000. Of this amount, $414,530,000, or 88%, had an original maturity of 10 years or longer. Of the remaining, $10,000,000 was repaid in January 1994 and $44,000,000 was due between one and two years. The longer-term advances provide the Company with a stable and well-matched funding source for assets with longer lives. See "--Asset and Liability Management." First Republic Savings Bank will apply for FHLB membership in 1994 and, if approved, it is expected that term adjustable rate advances will be used to fund a portion of its assets. The following table sets forth certain information with respect to the Company's short-term borrowings at the dates indicated. - -------- (1) The amounts shown at the dates indicated are not necessarily reflective of the Company's activity in short-term borrowings during the periods. (2) See Note 7 of Notes to Consolidated Financial Statements for a discussion of general terms relating to repurchase agreements. ASSET AND LIABILITY MANAGEMENT Management seeks to manage its asset and liability portfolios to help reduce any adverse impact on the Company's net interest income caused by fluctuating interest rates. To achieve this objective, the Company's strategy is to manage the rate sensitivity and maturity balance of its interest-earning assets and interest-bearing liabilities by emphasizing the origination and retention of adjustable interest rate or short-term fixed rate loans and the matching of adjustable rate repricings with short- and intermediate-term investment certificates and adjustable rate borrowings. The Company has established a program to obtain deposits by offering six month to five-year term investment certificates for the purpose of providing funds for adjustable rate mortgage loans with repricing periods of six months or more and for other matching term maturities. The following table summarizes the differences between the Company's maturing or rate adjusting assets and liabilities at December 31, 1993. Generally, an excess of maturing or rate adjusting assets over maturing or rate adjusting liabilities during a given period will serve to enhance earnings in a rising rate environment and inhibit earnings when rates decline; this is the Company's cumulative position as of December 31, 1993 for the six month and twelve month categories in accordance with its policy of having more assets than liabilities reprice for these periods. Conversely, when maturing or rate adjusting liabilities exceed maturing or rate adjusting assets during a given period, a rising rate environment generally will inhibit earnings and declining rates will serve to enhance earnings. The table illustrates projected maturities or interest rate adjustments based upon the contractual maturities or adjustment dates at December 31, 1993. ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY MATURING OR ADJUSTING DURING PERIODS SUBSEQUENT TO DECEMBER 31, 1993 - -------- (1) Adjustable rate loans consist principally of real estate secured loans with a maximum term of 30 years. Such loans are generally adjustable semiannually based upon changes in the One Year Treasury Constant Maturity Index, the Federal Reserve's Six Month CD Index, or the FHLB 11th District Cost of Funds Index, subject generally to a maximum increase of 2% annually and 5% over the lifetime of the loan. (2) Passbook maturities and rate adjustments are allocated based upon management's experience of historical interest rate volatility and passbook erosion rates. However, all passbook accounts are contractually subject to immediate withdrawal. In evaluating the Company's exposure to interest rate risk, certain shortcomings inherent in the method of analysis presented in the foregoing table must be considered. For example, although certain assets and liabilities may have similar maturities or periods to reprice, they may react differently to changes in market interest rates. Additionally, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Further, certain assets, such as adjustable rate mortgages, have features which restrict changes in interest rates on a short- term basis and over the life of the asset. The Company considers the anticipated effects of these various factors in implementing its interest rate risk management activities, including the utilization of interest rate caps. First Thrift has entered into interest rate cap transactions in the aggregate notional principal amount of $945,000,000 which terminate in periods ranging from March 1994 through September 2000. Under the terms of these transactions, which have been entered into with nine different commercial or investment banking institutions or their affiliates, First Thrift will be reimbursed quarterly for increases in the London Inter-Bank Offer Rate ("LIBOR") for any quarter during the term of the applicable transaction in which such rate exceeds a rate ranging from 9% to 13% as established for the applicable transaction. The interest rate cap transactions are intended to act as hedges for the interest rate risk created by restrictions on the maximum yield of certain variable rate loans and investment securities held by First Thrift which may, therefore, at times be exposed to the effect of unrestricted increases in the rates paid on the liabilities which fund these assets. The cost of these interest rate cap transactions is amortized over their lives and totalled $850,000 in 1993, $672,000 in 1992 and $539,000 in 1991. Although these costs reduce current earnings, the Company believes that the cost is justified by the protection these interest rate cap transactions provide against increased interest rates. Additionally, $37,400,000 of First Thrift's advances with the FHLB contain interest rate caps of 12% as part of the borrowing agreement. The effect of these interest rate cap transactions is not factored into the determination of interest rate adjustments provided in the table above. The Company has entered into interest rate swaps with the FHLB for $45,000,000 of FHLB advances and with an investment banking firm for $20,000,000 of FHLB advances to convert the fixed rate on long-term FHLB advances to semi-annual adjustable liabilities. Under these swaps, the Company has collected and recorded as a reduction in interest expense on borrowings $3,151,000 in 1993, $2,562,000 in 1992 and $1,227,000 in 1991. The availability of long-term, adjustable rate FHLB advances, with a weighted average maturity of 12 years at December 31, 1993, reduces the repricing volatility in the Company's balance sheet and the Company's dependence upon retail deposits, which generally have a shorter maturity than the contractual life of mortgage loans. The Company will continue to consider the utilization of FHLB advances as an integral part of its asset and liability management program. Additionally, in January 1992, the Company entered into $50,000,000 of interest rate swaps with the FHLB and a commercial bank to fix the cost of certain adjustable rate borrowings at an average rate of 4.90% for a period which ended in July 1993. Under these swaps, the Company paid and recorded as an increase in interest expense on borrowings $442,000 in 1993 and $501,000 in 1992. The Company is exposed to credit and market losses if the counterparties to its interest rate cap and swap agreements fail to perform; however, the Company does not anticipate such nonperformance. FIRST REPUBLIC AND SUBSIDIARIES First Republic was incorporated in February 1985. First Republic, which owns all of the capital stock of First Thrift, First Republic Savings Bank, and First Republic Mortgage, Inc., provides executive management to each of its subsidiaries and formulates and directs the implementation of an integrated business strategy for the Company. First Republic is also directly engaged in the mortgage lending, originating and servicing businesses. In June 1985, First Republic purchased all of the outstanding capital stock of an inactive California-chartered thrift and loan company which had begun operations in California in 1953. Upon its acquisition by First Republic, the company was renamed First Republic Thrift & Loan. On December 31, 1985, First Republic acquired, for $1.00, all of the outstanding capital stock of a California-chartered thrift and loan company, which was subsequently named First Republic Thrift & Loan of San Diego. At the time of the acquisition, First Republic Thrift & Loan of San Diego was operating at a loss, had a regulatory capital deficiency of approximately $3,000,000 and had a significant amount of delinquent net receivables. On December 31, 1991, pursuant to regulatory approval obtained from the FDIC and the Commissioner of Corporations of the State of California, the Company effected a combination of its two California thrifts by the merger of First Republic Thrift & Loan of San Diego into First Republic Thrift & Loan. In December 1993, First Republic acquired in a purchase transaction all of the common stock in a Nevada state chartered thrift and loan. Upon approval by federal and state regulatory agencies, this institution was relocated to Las Vegas, Nevada in January 1994 and renamed First Republic Savings Bank. The purpose of this acquisition was to enable the Company to gather deposits in the Las Vegas, Nevada area and to continue its lending activities under a full service financial institution. In January 1994, the employees responsible for construction and income property lending were transferred to First Republic Savings Bank. It is expected that upon approval by FHA/VA and other governmental agencies, all permanent single family lending and related employees will be transferred from First Republic Mortgage Inc. to First Republic Savings Bank. In May 1990, First Republic established a wholly-owned mortgage originating subsidiary, First Republic Mortgage, Inc., which commenced operations from its office in Las Vegas. Until January 1994, First Republic Mortgage, Inc. originated construction loans for First Thrift on low- and moderate-income single family homes and multifamily units and originated permanent mortgage loans on low- and moderate-income multifamily units and on commercial real estate properties, all of which properties are located in and proximate to Las Vegas. It continues to be an approved FHA-insured and VA guaranteed lender for permanent mortgage loans on single family homes. Upon receipt of all governmental agency approvals, First Republic intends to transfer in 1994 the remaining employees of First Republic Mortgage Inc. to First Republic Savings Bank and, ultimately, to dissolve First Republic Mortgage Inc. COMPETITION The Company faces strong competition both in the attraction of deposits and in the making of real estate secured loans. The Company competes for deposits and loans by advertising, by offering competitive interest rates and by seeking to provide a higher level of personal service than is generally offered by larger competitors. The Company does not have a significant market share of the deposit-taking or lending activities in the areas in which it conducts operations. Management believes that its most direct competition for deposits comes from savings and loan associations, other thrift and loan companies, commercial banks and credit unions. The Company's cost of funds fluctuates with market interest rates and also has been affected by higher rates being offered by certain institutions. During certain interest rate environments, additional significant competition for deposits may be expected to arise from corporate and governmental debt securities as well as money market mutual funds. The Company's competition in making loans comes principally from savings and loan associations, mortgage companies, other thrift and loan companies, commercial banks, and, to a lesser degree, credit unions and insurance companies. Aggressive pricing policies of the Company's competitors, especially during a declining period of mortgage loan originations could in the future result in a decrease in the Company's mortgage loan origination volume and/or a decrease in the profitability of the Company's loan originations. Many of the nation's largest savings and loan associations, mortgage companies and commercial banks have a significant number of branch offices in the areas in which the Company operates. Increased competition for mortgage loans from larger institutional lenders may result in a decrease in the Company's mortgage loan originations. The Company competes for loans principally through the quality of service it provides to borrowers, real estate brokers and loan agents, while maintaining competitive interest rates, loan fees and other loan terms. REGULATION The Thrifts are subject to regulation, supervision and examination under both federal and state law. First Thrift is subject to supervision and regulation by the Commissioner of Corporations of the State of California (the "California Commissioner") and, as a member institution, by the FDIC. First Republic Savings Bank is subject to supervision and regulation by the Commissioner, Financial Institutions Division, Department of Commerce, State of Nevada (the "Nevada Commissioner") and, as a member institution, by the FDIC. Neither First Republic, nor the Thrifts are regulated or supervised by the Office of Thrift Supervision, which regulates savings and loan institutions. First Republic is not directly regulated or supervised by the California Commissioner, the Nevada Commissioner, the FDIC, the Federal Reserve Board or any other bank regulatory authority, except with respect to the general regulatory and enforcement authority of the California Commissioner, the Nevada Commissioner and the FDIC over transactions and dealings between First Republic and the Thrifts, and except with respect to both the specific limitations regarding ownership of the capital stock of the parent company of any thrift and the specific limitations regarding the payment of dividends from the Thrifts discussed below. Future federal legislation could cause First Republic to become subject to direct federal regulatory oversight; however, the full impact of any such legislation and subsequent regulation cannot be predicted. California Law The thrift and loan business conducted by First Thrift is governed by the California Industrial Loan law and the rules and regulations of the California Commissioner which, among other things, regulate in certain limited circumstances the maximum interest rates payable on certain thrift deposits as well as the collateral requirements and maximum maturities of the various types of loans that are permitted to be made by California-chartered industrial loan companies, i.e., thrift and loan companies or thrifts. Subject to restrictions imposed by applicable California law, First Thrift is permitted to make secured and unsecured consumer and non-consumer loans. The maximum term for repayment of loans made by thrift and loan companies range up to 40 years and 30 days depending upon collateral and priority of secured position, except that loans with repayment terms in excess of 30 years and 30 days may not in the aggregate exceed 5% of total outstanding loans and obligations of the thrift. Although secured loans may generally be repayable in unequal periodic payments during their respective terms, consumer loans secured by real property with terms in excess of three years must be repayable in substantially equal periodic payments unless such loans are covered under the Garn-St. Germain Depository Institutions Act of 1982 which applies primarily to single family residential loans. Loans made to persons who reside outside California or who do not have a place of business in California are limited to a maximum 30% of a thrift and loan's portfolio; however, effective January 1, 1994, this limitation ceased to apply to loans (i) made to purchase or refinance single family or multifamily residential property, (ii) that are saleable in the secondary market, evidenced by a commitment therefor, and (iii) that are owned by the thrift for 90 days or less. Effective January 1, 1994, upon application to and approval by the California Commissioner, thrifts may operate loan production offices outside California, subject to certain conditions as may be imposed by the California Commissioner. California law contains extensive requirements for the diversification of the loan portfolios of thrift and loan companies. A thrift and loan with outstanding investment certificates may not, among other things: (i) place more than 25% of its loans or other obligations in loans or obligations which are secured only partially, but not primarily, by real property; (ii) may not make any one loan secured primarily by improved real property that exceeds 20% of its paid-up and unimpaired capital stock and surplus not available for dividends; (iii) may not lend an amount in excess of 5% of its paid-up and unimpaired capital stock and surplus not available for dividends upon the security of the stock of any one corporation; (iv) may not make loans to, or hold the obligations of, any one person as primary obligor in an aggregate principal amount exceeding 20% of its paid-up and unimpaired capital stock and surplus not available for dividends; and (v) may have no more than 70% of its total assets in loans which have remaining terms to maturity in excess of seven years and are secured solely or primarily by real property. After January 1, 1994, any loan guaranteed or insured by a federal or state agency is deemed to have a term less than seven years. At December 31, 1993, First Thrift satisfied all of these requirements. Management believes that First Thrift can maintain compliance with these statutory requirements by managing the mix of its assets and loans without any material adverse impact on earnings or liquidity. Under California law, a thrift and loan generally may not make any loan to, or hold an obligation of, any of its directors or officers, except in specified cases and subject to regulation by the California Commissioner. In addition, a thrift and loan may not make any loan to, or hold an obligation of, any of its shareholders or any shareholder of its holding company or affiliates, except that this prohibition does not apply to persons who own less than 10% of the stock of a holding company or affiliate which is listed on a national securities exchange, such as First Republic. Any person who wishes to acquire 10% or more of the capital stock of a California thrift and loan company or 10% or more of the voting capital stock or other securities giving control over management of its parent company must obtain the prior written approval of the California Commissioner. If a stockholder failed to obtain the required approval and engaged in a proxy contest in opposition to management of First Republic, First Republic might seek to utilize the provisions of California law described above to invalidate that stockholder's votes. It is not certain that such an attempt by First Republic would be successful under California law. A thrift is subject to certain leverage limitations that are not generally applicable to commercial banks or savings and loan associations. In particular, thrifts which have been in operation in excess of 60 months may, with written approval of the California Commissioner, have outstanding at any time investment certificates not to exceed 20 times paid-up and unimpaired capital and surplus. Increases in leverage under California law must also meet specified minimum standards for liquidity reserves in cash, loan loss reserves, minimum capital stock levels and minimum unimpaired paid-in surplus levels. First Thrift satisfied all of these standards at December 31, 1993. Thrift and loan companies are not permitted to borrow, except by the sale of investment or thrift certificates, in an amount exceeding 300% of outstanding capital stock, surplus and undivided profits, without the California Commissioner's prior consent. All sums borrowed in excess of 150% of outstanding capital stock, surplus and undivided profits must be unsecured borrowings or, if secured, approved in advance by the California Commissioner, and be included as investment or thrift certificates for purposes of computing the above ratios; however, collateralized FHLB advances are excluded for this test of secured borrowings and are not specifically limited by California law. Under California law, thrift and loan companies are generally limited to investments which are legal investments for California commercial banks. In general, California commercial banks are prohibited from investing an amount exceeding 15% of shareholders' equity in the securities of any one issuer, except for specified obligations of the United States, California and local governments and agencies. A thrift and loan company may acquire real property only in satisfaction of debts previously contracted, pursuant to certain foreclosure transactions or as may be necessary as premises for the transaction of its business, in which case such investment is limited to one-third of a thrift and loan's paid in capital stock and surplus not available for dividends. The Thrifts are also governed by various state and federal consumer protection laws including Truth in Lending, Truth in Saving and the Real Estate Settlement Procedures Act. Effective January 1, 1991, the California Industrial Loan Law allowed a thrift to increase its secondary capital by issuing interest-bearing capital notes in the form of subordinated notes and debentures. Such notes are not deposits and are not insured by the FDIC or any other governmental agency, generally are required to have an initial maturity of at least seven years, and are subordinated to deposit holders, general creditors and secured creditors of the issuing thrift. Nevada Law The Nevada Thrift Companies Act ("Nevada Act") governs the licensing and regulations of Nevada thrift companies in much the manner the California Industrial Loan Law does for California thrift and loan companies. The Nevada Commissioner is charged with the supervision and regulation of First Republic Savings Bank ("FRSB"). The Nevada Commissioner approved the change of name from Silver State Thrift and Loan to FRSB concurrently with the approval of the acquisition of FRSB by the Company in 1993. Under the Nevada Act, there is no interest rate limitation on loans; however any loan in excess of $50,000 must be secured by collateral having a market value of at least 115 percent of the amount due. The net amount of advance on loans secured by deposits may not exceed 90 percent of the amount of said deposit collateral. There are no terms or amortization restrictions on loans. FRSB is required to invest its funds as set forth in the Nevada Act and in investments which are legal investments for banks and savings associations subject to any limitation under federal law (See--"Federal Law"). Secured loans to one person as primary obligor may not exceed 25 percent of capital and surplus and, except as to limitations on loans to one borrower, loans secured by real or personal property, may be made to any person without regard to the location or nature of the collateral. Substantially as under the California Industrial Loan Law for California thrift and loan companies, the Nevada Act restricts transactions with officers, directors and shareholders as well as transactions with regard to holding, developing and carrying real property. In 1985, the Nevada Act was amended to prohibit issuance of thrift certificates and required insurance for deposits. Therefore, FRSB accepts deposits rather than issuing investment certificates. However, by order of the Nevada Commissioner when FRSB was acquired by the Company, FRSB is not authorized to accept demand deposits. The total number of deposits which FRSB may accept is governed by limits which may be imposed by the Federal Deposit Insurance Corporation ("FDIC"). Under the Nevada Act, changes in stock ownership of a thrift company require notifications to the Nevada Commissioner if ownership of 5 percent or more of the outstanding voting stock changes. Additionally, if 25 percent or more thereof changes ownership or there is a change in control resulting from a change in ownership, then an approval must be first obtained from the Nevada Commissioner. In addition to remedies available to the FDIC, the Nevada Commissioner may take possession of a thrift company if certain conditions exist. Federal Law The Thrifts' deposits are insured by the FDIC to the full extent permissible by law. As an insurer of deposits, the FDIC issues regulations, conducts examinations, requires the filing of reports and generally supervises the operations of institutions to which it provides deposit insurance. The Thrifts are subject to the rules and regulations of the FDIC to the same extent as other financial institutions which are insured by that entity. The approval of the FDIC is required prior to any merger, consolidation or change in control, or the establishment or relocation of any branch office of the Thrifts. This supervision and regulation is intended primarily for the protection of the depositors and to ensure services for the public's convenience and advantage. On August 6, 1992, First Thrift entered into a Memorandum of Understanding (the "Memorandum") with the FDIC regarding certain concerns arising out of the FDIC's 1992 examination of First Thrift, primarily related to the rapid loan growth of First Thrift. First Thrift agreed to limit its net loan growth, excluding loans held for resale in the secondary markets, to not more than 2.5% in any one calendar quarter, beginning with the quarter that began on October 1, 1992, to enhance certain operating policies and procedures, including its internal asset review practice, and to provide certain reports to the FDIC. In May 1993, the FDIC rescinded in full the Memorandum. In the last half of 1992 and in 1993, the Company took actions to meet the requirements of the Memorandum. The Company has always functioned partially as a balance sheet lender and partially as a mortgage banker, which sells loans to investors and retains servicing. An increased emphasis was placed on mortgage banking activity, continuing a trend already begun in early 1992. In 1992, the Company shifted its new loan originations primarily towards single family mortgages at a time when demand for loans in the secondary market was high. In 1992, the Company sold $373,551,000 of loans to secondary market investors, including $132,974,000 of adjustable rate mortgages which generally met the Company's underwriting and pricing criteria for retention on its balance sheet. In 1993, the Company sold $425,475,000 of loans, including $85,822,000 of ARMs. First Thrift also took steps to enhance its compliance and loan administration functions, including the annual revision of its policies and procedures, the hiring or reallocation of personnel, and the implementation of a more systematic loan review function. Pursuant to FDIC regulations, at least 30 days prior to embarking on any special funding arrangement designed to increase assets of an insured institution by more than 7.5% in any consecutive three month period, notice must be given to the FDIC. A special funding arrangement means a specific effort to increase assets through solicitation and acceptance of fully insured deposits from or through brokers or affiliates, outside an institution's normal traffic area, or secured or unsecured borrowings (other than through repurchase agreements). If a thrift is determined to be undercapitalized, other restrictions apply to its asset growth. Previously, the Company has given notice of its intent to increase assets in excess of 7.5% during the following three months. The FDIC has acknowledged these notices without objection. If additional notices are required for subsequent periods, there can be no assurance that future approval from the FDIC will be obtained. Objection by the FDIC could lead to the requirement that the thrifts limit future asset growth. In 1989, the FDIC and the other Federal regulatory agencies adopted final risk-based capital adequacy standards applicable to financial institutions like the thrifts whose deposits are insured by the FDIC and bank holding companies. These guidelines provide a measure of capital adequacy and are intended to reflect the degree of risk associated with both onand off-balance sheet items, including residential loans sold with recourse, legally binding loan commitments and standby letters of credit. Under these regulations, financial institutions are required to maintain capital to support activities which in the past did not require capital. Unlike the Thrifts, at the present time First Republic is not directly regulated by any bank regulatory agency and is not subject to any minimum capital requirements. If First Republic were to become subject to direct federal regulatory oversight, there can be no assurance that First Republic's existing senior subordinated debentures would be considered as Tier 2 capital. A financial institution's risk-based capital ratio is calculated by dividing its qualifying capital by its risk-weighted assets. Commencing December 31, 1992, financial institutions generally are expected to meet a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 50% of qualifying total capital must be in the form of core capital (Tier 1)-- common stock, noncumulative perpetual preferred stock, minority interests in equity capital accounts of consolidated subsidiaries and allowed mortgage servicing rights less all intangible assets other than allowed mortgage servicing rights. Supplementary capital (Tier 2) consists of the allowance for loan losses up to 1.25% of risk-weighted assets, cumulative preferred stock, term preferred stock, hybrid capital instruments and term subordinated debt. The maximum amount of Tier 2 capital that may be recognized for risk-based capital purposes is limited to 100% of Tier 1 capital (after any deductions for disallowed intangibles). The aggregate amount of term subordinated debt and intermediate term preferred stock that may be treated as Tier 2 capital is limited to 50% of Tier 1 capital. Certain other limitations and restrictions apply as well. At December 31, 1993, the Tier 2 capital of First Thrift consisted of $15,000,000 of capital notes issued to First Republic and its allowance for loan losses. The following table presents First Thrift's regulatory capital position at December, 1993 under the risk-based capital guidelines: The FDIC has adopted a 3% minimum leverage ratio that is intended to supplement risk- based capital requirements and to ensure that all financial institutions, even those that invest predominantly in low risk assets, continue to maintain a minimum level of core capital. The FDIC adopted final regulations, applicable to First Thrift as of April 10, 1991, which provide that a financial institution's minimum leverage ratio is determined by dividing its Tier 1 capital by its quarterly average total assets, less intangibles not includable in Tier 1 capital. The leverage ratio represents a minimum standard affecting the ability of financial institutions, including First Thrift, to increase assets and liabilities without increasing capital proportionately. The following table presents First Thrift's leverage ratio at December 31, 1993: Subsequent to the acquisition of First Republic Savings Bank and prior to December 31, 1993, First Republic contributed additional capital, resulting in Tier 1 and total capital of that entity equaling $5.1 million on a total asset base of $5.9 million. At December 31, 1993, the capital ratios of First Republic Savings Bank exceed all requirements. Under FDIC regulations, First Thrift has been required to pay annual insurance premiums of 23 cents per $100 of eligible domestic deposits from July 1, 1991 until December 31, 1992, at which time the premium rate of 23 cents per $100 became a minimum rate. The rate at which the Thrifts will be required to pay insurance premiums to the FDIC for the first six months of 1994 will be the minimum rate. The FDIC has the authority to assess additional premiums to cover losses and expenses associated with insuring deposits maintained at financial institutions. See "--Federal Deposit Insurance Reform." In addition, subject to certain exceptions, under federal law no person, acting directly or indirectly or through or in concert with one or more persons, may acquire control of any insured depository institution such as the Company, unless the FDIC has been given 60 days' prior written notice of the proposed acquisition and within that time period the FDIC has not issued a notice disapproving the proposed acquisition, or extended the period of time during which a disapproval may be issued. For purposes of these provisions, "control" is defined as the power, directly or indirectly, to direct the management or policies of an insured depository institution or to vote 25% or more of any class of voting securities of an insured depository institution. The purchase, assignment, transfer, pledge, or other disposition of voting stock through which any person will acquire ownership, control, or the power to vote 10% or more of a class of voting securities of the Company would be presumed to be an acquisition of control. An acquiring person may request an opportunity to contest any such presumption of control. No assurance can be given that the FDIC would not disapprove a notice of proposed acquisition as described above. The Competitive Equality Banking Act of 1989 ("CEBA") subjects certain previously unregulated companies to regulations as bank holding companies by expanding the definition of the term "bank" in the Bank Holding Company Act of 1956. First Republic is, however, exempt from regulation as a bank holding company and will remain so, while the Thrifts continue to fit within one or more exceptions to the term "bank" as defined by CEBA. The Thrifts currently have no plans to engage in any operational practice that would cause them to fall outside one or more exceptions to the term "bank" as defined by CEBA. The Thrifts may cease to comply with those exceptions if they engage in certain operational practices, including accepting demand deposit accounts. Because of these limitations, the Thrifts currently offer only passbook accounts and term investment certificates or deposits and do not offer checking accounts. CEBA does provide that First Republic and its affiliates will be treated as if First Republic were a bank holding company for the limited purposes of applying certain restrictions on loans to insiders and anti-tying provisions. LIMITATIONS ON DIVIDENDS Under California law, a thrift is not permitted to declare dividends on its capital stock unless it has at least $750,000 of unimpaired capital plus additional capital of $50,000 for each branch office maintained. In addition, no distribution of dividends is permitted unless: (i) such distribution would not exceed a thrift's retained earnings, (ii) any payment would not result in a violation of the approved minimum capital to thrift and loan investment certificates ratio and (iii) after giving effect to the distribution, either (y) the sum of a thrift's assets (net of goodwill, capitalized research and development expenses and deferred charges) would be not less than 125% of its liabilities (net of deferred taxes, income and other credits), or (z) current assets would be not less than current liabilities (except that if a thrift's average earnings before taxes for the last two years had been less than average interest expenses, current assets must be not less than 125% of current liabilities). In addition, a thrift is prohibited from paying dividends from that portion of capital which its board of directors has declared restricted for dividend payment purposes. The amount of restricted capital maintained by a thrift provides the basis for establishing the maximum amount that a thrift may lend to one single borrower. Accordingly, a thrift typically restricts as much capital as necessary to achieve its desired loan to one borrower limit, which in turn restricts the funds available for the payment of dividends. Exclusive of any other limitations which may apply, at December 31, 1993, First Thrift could have paid additional dividends aggregating approximately $9,400,000. Under regulations issued by the Nevada Commissioner, a Nevada thrift company may not pay dividends from its capital surplus account. Dividends may only be payable from undivided profits. Once funds have been credited to the capital surplus account, those funds may not be transferred unless (1) such transfer represents payment for the redemption of shares and (2) the Nevada Commissioner has acquiesced to the transfer in writing. Further no dividends may be declared or paid if such would reduce the undivided profits account below 10 percent of the balance in the capital stock account. Dividend payment authority is subject to a thirft being current on payments to holders of debt securities and payments of interest on deposits. As a matter of practice, the FDIC customarily advises insured institutions that the payment of cash dividends in excess of current earnings from operations is inappropriate and may be cause for supervisory action. As a result of this policy, the Thrifts may find it difficult to pay dividends out of retained earnings from historical periods prior to the most recent fiscal year or to take advantage of earnings generated by extraordinary items. Under the Financial Institutions Supervisory Act and FIRREA, federal regulators also have authority to prohibit financial institutions from engaging in business practices which are considered to be unsafe or unsound. It is possible, depending upon the financial condition of the Thrifts and other factors, that such regulators could assert that the payment of dividends in some circumstances might constitute unsafe or unsound practices and prohibit payment of dividends even though technically permissible. Federal Deposit Insurance Reform As a consequence of the extensive regulation of commercial banking activities in the United States, the business of the Company is particularly susceptible to being affected by enactment of federal and state legislation which may have the effect of increasing or decreasing the cost of doing business, modifying permissible activities, or enhancing the competitive position of other financial institutions. In response to various business failures in the savings and loan industry and more recently in the banking industry, in December 1991, Congress enacted and the President signed significant banking legislation entitled the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). FDICIA 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 provides increased funding for the Bank Insurance Fund (the "BIF") of the FDIC, primarily by increasing the authority of the FDIC to borrow from the United States Treasury Department. It also provides for expanded regulation of depository institutions and their affiliates. A significant portion of the borrowings would be repaid by insurance premiums assessed on BIF members, including the Company. In addition, FDICIA generally mandates that the FDIC achieve a ratio of reserves to insured deposits of 1.25% within the next 15 years, also to be financed by insurance premiums. The result of these provisions could be a significant increase in the assessment rate on deposits of BIF members. FDICIA also provides authority for special assessments against insured deposits. No assurance can be given at this time as to what the future level of premiums will be. As required by FDICIA, the FDIC adopted a transitional risk-based assessment system for deposit insurance premiums effective January 1, 1993. Under this system, depository institutions will be charged anywhere from 23 cents to 31 cents for every $100 in insured domestic deposits, based on such institutions' capital levels and supervisory ratings. The FDIC adopted amendments to this assessment system which become effective with the assessment period commencing January 1, 1994 which makes limited changes to the transitional risk-based system. FDICIA prohibits assessment rates from falling below the current annual assessment rate of 23 cents per $100 of eligible deposits if the FDIC has outstanding borrowings from the United States Treasury Department or the 1.25% designated reserve ratio has not been met. The ultimate effect of this risk- based assessment system cannot be determined until the permanent system becomes effective in 1994. FDICIA also requires the federal banking agencies to revise their risk-based capital guidelines to take into account interest-rate risk, concentration of credit risk, and the risks associated with nontraditional activities. It also requires the guidelines to reflect the actual performance and expected risk of loss on multifamily mortgages. Effective December 31, 1993, the risk based capital rules were revised to allow certain multifamily loans for BIF members to be included in the 50% risk weighted category instead of the 100% risk weighted category. In order to qualify for this lower category, multifamily loans must meet certain eligibility criteria, including (i) being a first lien; (ii) having a loan-to-value ratio below 75% for adjustable rate mortgages and a debt coverage ratio of at least 1.15 times; (iii) having a minimum original maturity of seven years and a maximum amortization period of 30 years; and (iv) have a history of timely payments for at least one year and not currently be on nonaccrual or past due 90 days or more. The effect on the Company and First Thrift of these new guidelines was to reduce total risk adjusted assets by approximately $65 million at December 31, 1993 and to increase their total capital ratios by approximately 1.06% and 0.89%, respectively. The ultimate effect of the remaining FDICIA risk-based capital provisions cannot be determined until implementing regulations are adopted. FDICIA requires the federal banking regulators to take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements. In response to this requirement, the FDIC adopted final rules based upon FDICIA's five capital tiers. The FDIC's rules provide that an institution is "well capitalized" if its risk-based capital ratio is 10% or greater; its Tier 1 risk-based capital ratio is 6% or greater; its leverage ratio is 5% or greater; and the institution is not subject to a capital directive. A depository institution is "adequately capitalized" if its risk- based capital ratio is 8% or greater; its Tier 1 risk-based capital ratio is 4% or greater; and its leverage ratio is 4% or greater (3% or greater for the highest rated institutions). An institution is considered "undercapitalized" if its risk-based capital ratio is less than 8%; its Tier 1 risk-based capital ratio is less than 4%, or its leverage ratio is 4% or less (less than 3% for the highest rated institutions). An institution is "significantly undercapitalized" if its risk-based capital ratio is less than 6%; its Tier 1 risk-based capital ratio is less than 3%; or its leverage ratio is less than 3%. An institution is deemed to be "critically undercapitalized" if its ratio of tangible equity (Tier 1 capital) to total assets is equal to or less than 2%. An institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it engages in unsafe or unsound banking practices. Under this standard, First Thrift and First Republic Savings Bank are "well capitalized" at December 31, 1993. No sanctions apply to institutions which are "well" or "adequately" capitalized under the prompt corrective action requirements. Undercapitalized institutions are required to submit a capital restoration plan for improving capital. In order to be accepted, such plan must include a financial guaranty from each company having control of such under capitalized institution that the institution will comply with the capital plan until the institution has been adequately capitalized on average during each of four consecutive calendar quarters. If such a guarantee were deemed to be a commitment to maintain capital under the Federal Bankruptcy Code, a claim for a subsequent breach of the obligations under such guarantee in a bankruptcy proceeding involving the holding company would be entitled to a priority over third party general unsecured creditors of the holding company. Undercapitalized institutions are prohibited from making capital distributions or paying management fees to controlling persons; may be subject to growth limitations; and acquisitions, branching and entering into new lines of business are restricted. Finally, the institution's regulatory agency has discretion to impose certain of the restrictions generally applicable to significantly undercapitalized institutions. In the event an institution is deemed to be significantly undercapitalized, it may be required to: sell stock; merge or be acquired; restrict transactions with affiliates; restrict interest rates paid; restrict growth; restrict compensation to officers; divest a subsidiary; or dismiss specified directors or officers. If the institution is a bank holding company, it may be prohibited from making any capital distributions without prior approval of the Federal Reserve Board and may be required to divest a subsidiary. A critically undercapitalized institution is generally prohibited from making payments on subordinated debt and may not, without the approval of the FDIC, enter into a material transaction other than in the ordinary course of business; engage in any covered transaction (as defined in Section 23 A (b) of the Federal Reserve Act); or pay excessive compensation or bonuses. Critically undercapitalized institutions are subject to appointment of a receiver or conservator. FDICIA also restricts the acceptance of brokered deposits by certain insured depository institutions and contains a number of consumer banking provisions, including disclosure requirements and substantive contractual limitations with respect to deposit accounts. FDICIA contains numerous other provisions, including reporting, examination and auditing requirements, termination of the "too big to fail" doctrine except in special cases, limitations on the FDIC's payment of deposits at foreign branches, and revised regulatory standards for, among other things, real estate lending and capital adequacy. Implementation of the various provisions of FDICIA are subject to the adoption of regulations by the various banking agencies or to certain phase-in periods. The FDIC is the federal banking agency which regulates the Thrifts. The effect of FDICIA on the Company cannot be determined until complete implementing regulations are adopted. FDICIA also contains provisions which: (i) require that a receiver or conservator be appointed immediately for an institution whose tangible capital falls below certain levels; (ii) increase assessments for deposit insurance premiums; (iii) require the FDIC to establish a risk- based assessment system for insurance premiums; (iv) require federal banking agencies to revise their risk-based capital guidelines to take into account interest rate risk, concentration of credit risk and the risk associated with non-traditional activities; (v) give the FDIC the right to examine bank affiliates such as First Republic and make assessments for the cost of such examination; and (vi) limit the availability of brokered deposits. The effectiveness of this statute is subject to adoption of implementing regulations which are being issued on a timely basis as required by FDICIA. EMPLOYEES As of December 31, 1993, the Company had 148 full-time employees. Management believes that its relations with employees are satisfactory. The Company is not a party to any collective bargaining agreement. STATISTICAL DISCLOSURE REGARDING THE BUSINESS OF THE COMPANY The following statistical data relating to the Company's operations 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 to Consolidated Financial Statements. Average balances are determined on a daily basis. DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY; INTEREST RATES AND DIFFERENTIALS The following table presents for the periods indicated the distribution of consolidated average assets, liabilities and stockholders' equity as well as the total dollar amounts of interest income from average interest-earning assets and the resultant yields, and the dollar amounts of interest expense and average interest-bearing liabilities, expressed both in dollars and in rates. Nonaccrual loans are included in the calculation of the average balances of loans and interest not accrued is excluded. Beginning with the purchase of tax exempt securities in 1989, the yield on short-term investments has been adjusted upward to reflect the effects of certain income thereon which is exempt from federal income tax, assuming an effective rate of 34% prior to 1993 and 35% for 1993. - -------- (1) Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average earning assets. Rate and Volume Variances Net interest income is affected by changes in volume and changes in rates. Volume changes are caused by differences in the level of interest-earning assets and interest-bearing liabilities. Rate changes result from differences in yields earned on assets and rates paid on liabilities. The following table sets forth, for the periods indicated, a summary of the changes in interest earned and interest paid resulting from changes in average asset and liability balances (volume) and changes in average interest rates. Where significant, the changes in interest due to both volume and rate have been allocated to the changes due to volume and rate in proportion to the relationship of absolute dollar amounts in each. Tax-exempt income from short- term investments is presented on a tax-equivalent basis. Types of Loans The following table sets forth by category the total loan portfolio of the Company at the dates indicated: The following table shows the maturity distribution of the Company's real estate construction loans and commercial business loans outstanding as of December 31, 1993, which, based on remaining scheduled repayments of principal, were due within the periods indicated. All such loans are adjustable rate in nature. ASSET QUALITY The Company places an asset on nonaccrual status when one of the following events occurs: any installment of principal or interest is over 90 days past due (except for single family loans which are well secured and in the process of collection), management determines the ultimate collection of principal or interest to be unlikely, management deems a loan to be an in- substance foreclosure, or the Company takes possession of the collateral. Real estate collateral obtained by the Company or deemed to be foreclosed in substance is collectively referred to as "REO." Since the inception of operations in 1985 through December 31, 1993, the Company has originated approximately $3.6 billion of loans both for sale and retention in its loan portfolio, on which the Company has experienced $14.6 million of losses, primarily as a result of the economic recession which has affected the California economy commencing in late 1990 and continue in parts of the state through 1993. Currently management of the Company believes that the adverse effects of the recession are substantially diminished in the San Francisco Bay Area, while the effects of the recession are more severe on the Company's loans in the Los Angeles area. The Company's loss experience since inception represents an aggregate total of 0.40% of loans originated in over eight years. The Company has experienced a higher level of chargeoffs during 1991, 1992 and 1993 in connection with the resolution of delinquent loans and sale of REO than in prior years. The ratio of the Company's net loan chargeoffs to average loans was 0.30% for 1991, 0.74% for 1992 and 0.44% for 1993. The Company recorded REO costs and losses related to the disposition of delinquent loans totaling $3,477,000 in 1993; such costs increased from $309,000 in 1992 and $330,000 in 1991 because substantially all of these costs were reflected as chargeoffs against the Company's loss reserves prior to 1993. The Company's general policy is to attempt to resolve problem assets quickly and to sell such problem assets when acquired as rapidly as possible at prices available in the prevailing market. The following table presents nonaccruing loans and investments, REO, restructured performing loans and accruing single family loans more than 90 days past due at the dates indicated. In February 1993, the Company restructured the terms of a $6,258,000 first trust deed loan secured by a 208 unit multifamily complex in Los Angeles. This loan was made by the Company in connection with the REO sale of the property by the Company to the borrower in March 1992 for $7,000,000. In order to facilitate the stabilization of the occupancy level at monthly rents appropriate for long-term tenants, the Company agreed to reduce the interest rate on its adjustable rate loan for a two year period. At December 31, 1993, there were no other loans that constituted troubled debt restructurings as defined in Statement of Financial Accounting Standards No. 15. The Company resolves problem assets by restructuring a loan when it determines the benefits of such a workout exeed the value of any concessions granted, it believes the borrower is committed to the terms of the new loan and it believes a successful outcome is likely. The following table provides certain information with respect to the Company's reserve position and provisions for losses as well as chargeoff and recovery activity. All chargeoff and recovery transactions during 1989 in the table above resulted only from loans acquired in a transaction occurring in 1985. The Company's reserve for possible losses is maintained at a level estimated by management to be adequate to provide for losses that can be reasonably anticipated based upon specific conditions as determined by management, historical loan loss experience, the results of the Company's ongoing loan grading process, the amount of past due and nonperforming loans, observations of auditors, legal requirements, recommendations or requirements of regulatory authorities, prevailing economic conditions and other factors. These factors are essentially judgmental and may not be reduced to a mathematical formula. As a percentage of nonaccruing loans, the reserve for possible losses was 109% at December 31, 1993 and 133% at December 31, 1992. While this ratio declined, management considers the $12,657,000 reserve at December 31, 1993 to be adequate as an allowance against foreseeable losses in the loan portfolio. Management's continuing evaluation of the loan portfolio and assessment of economic conditions will dictate future reserve levels. The adequacy of the Company's total reserves is reviewed quarterly. Management closely monitors all past due loans in assessing the adequacy of its total reserves. In addition, the Company has instituted procedures for reviewing and grading all of the larger income property loans in its portfolio on at least an annual basis. Based upon that continuing review and grading process, among other factors, the Company will determine appropriate levels of total reserves in response to its assessment of the potential risk of loss inherent in its loan portfolio. Management currently anticipates that it will continue to provide additional recession reserves so long as, in its judgement, the effects of the recessionary conditions on its assets continue. When management determines that the effects of the recessionary conditions have diminished, management currently anticipates that it would reduce or eliminate such future provisions to the recession reserve, although the Company may continue to maintain total reserves at a level higher than existed prior to this recession. Management does not intend to increase earnings in future periods by reversing amounts in the recession reserve. The following table sets forth management's historical allocation of the reserve for possible losses by loan category and the percentage of loans in each category to total loans at the dates indicated: At December 31, 1993, management had allocated from its recession reserve $2,600,000 to the multifamily loan category and $1,300,000 to the commercial real estate loan category, based upon management's estimate of the risk of loss inherent in its nonaccruing or other possible problem loans in those categories. The allocation of such reserve will change whenever management determines that the risk characteristics of its assets or specific assets have changed. The amount available for future chargeoffs that might occur within a particular category is not limited to the amount allocated to that category, since the allowance is a general reserve available for all loans in the Company's portfolio. In addition, the amounts so allocated by category may not be indicative of future chargeoff trends. Event Subsequent to December 31, 1993 On January 17, 1994, the greater Los Angeles area experienced an earthquake which caused significant damage to the freeway system and real estate throughout the area. Some of the Company's borrowers were adversely affected by this event, with direct property damage or loss of tenants, or are expected to be affected in the future as a result of lower rental revenues or further economic difficulties. First Republic is currently working with those borrowers who have been identified to assist them with obtaining available disaster relief funding or to assist them by modifying the terms of loans. Such loan modifications may defer the timing of payments, reduce the rate of interest collected or possibly lower the principal balance. As of March 18, 1994, approximately $35 million of the Company's loans, secured primarily by larger multifamily properties, appeared to be adversely impacted by the earthquake. Based upon the Company's best estimate as of such date of damage or related economic impact to borrowers and their properties, a special loan valuation reserve of $4,000,000 will be provided in the quarter ended March 31, 1994. Because of this earthquake, management of the Company expects the level of loan delinquencies and REO to increase during 1994 as problems related to this natural disaster are addressed and resolved. FINANCIAL RATIOS The following table shows certain key financial ratios for the Company for the periods indicated. ITEM 2. ITEM 2. PROPERTIES First Republic does not own any real property. In 1990, First Republic entered into a 10-year lease, with three 5-year options to extend, for headquarters space at 388 Market Street, mezzanine floor, in the San Francisco financial district. Management believes that the Company's current and planned facilities are adequate for its current level of operations. First Republic's subsidiaries lease offices at the following locations, with terms expiring at dates ranging from April 1994 to December 2002: ITEM 3. ITEM 3. LEGAL PROCEEDINGS There is no pending proceeding, other than ordinary routine litigation incidental to the Company's business, to which the Company is a party or to which any of its property is subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the year ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS This information is incorporated by reference to page 44 of the Company's Annual Report to Stockholders for the year ended December 31, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA This information is incorporated by reference to the inside front cover of the Company's Annual Report to Stockholders for the year ended December 31, 1993. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This information is incorporated by reference to pages 34 through 41 of the Company's Annual Report to Stockholders for the year ended December 31, 1993. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA This information is incorporated by reference to pages 20 through 33 and to page 44 of the Company's Annual Report to Stockholders for the year ended December 31, 1993. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES There have been no changes in or disagreements with Accountants during the Company's two most recent fiscal years. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The following table sets forth the directors and executive officers of First Republic and certain pertinent information about them. - -------- (1) Member of the Executive Committee. (2) Member of the Compensation Committee. (3) Member of the Audit Committee. The directors of First Republic serve three-year terms. The terms are staggered to provide for the election of approximately one-third of the Board members each year. Each director (except Mr. Cox-Johnson who was elected in October 1986 and Ms. August who was elected in April 1988) has served in such capacity since the inception of First Republic. Messrs. Walther and Herbert have served as officers of First Republic since its inception. Ms. August has served as an officer since July 1985 and as a director since April of 1988, while Ms. Moulds has served as an officer since June 1985. Mr. Newton became an officer of First Republic in August 1988 and Ms. Coulston became an officer in 1990. The backgrounds of the directors and executive officers of First Republic are as follows: Roger O. Walther is Chairman of the Board of Directors and a director of First Republic serving until 1994. Mr. Walther is Chairman and Chief Executive Officer of ELS Educational Services, Inc., the largest teacher of English as a second language in the United States. He is a director of Charles Schwab & Co., Inc. From 1980 to 1984, Mr. Walther served as Chairman of the Board of San Francisco Bancorp. He is a graduate of the United States Coast Guard Academy, B.S. 1958, and the Wharton School, University of Pennsylvania, M.B.A. 1961 and is a member of the Graduate Executive Board of the Wharton School. James H. Herbert, II is President, Chief Executive Officer and a director of First Republic, serving until 1994, and has held such positions since First Republic's inception in 1985. From 1980 to July 1985, Mr. Herbert was President, Chief Executive Officer and a director of San Francisco Bancorp, as well as Chairman of the Board of its operating subsidiaries in California, Utah and Nevada. He is a past president of, a director of and a Legislative Committee member of the California Association of Thrift and Loan Companies and is on the California Commissioner of Corporations' Industrial Loan Law Advisory Committee. He is a graduate of Babson College, B.S., 1966, and New York University, M.B.A., 1969. Katherine August is Executive Vice President and a director of First Republic serving until 1995. She joined the Company in June 1985 as Vice President and Chief Financial Officer. From 1982 to 1985, she was Senior Vice President and Chief Financial Officer at PMI Mortgage Insurance Co., a subsidiary of Sears/Allstate. She is a graduate of Goucher College, A.B., 1969, and Stanford University, M.B.A., 1975. Willis H. Newton, Jr. has been Senior Vice President and Chief Financial Officer of First Republic since August 1988. From 1985 to August 1988, he was Vice President and Controller of Homestead Financial Corporation. He is a graduate of Dartmouth College, B.A., 1971 and Stanford University, M.B.A., 1976. Mr. Newton is a Certified Public Accountant. Linda G. Moulds is Vice President, Secretary and Controller of First Republic, serving with the Company since inception. From 1980 to July 1985, Ms. Moulds was Secretary and Controller of San Francisco Bancorp and a director of First United. She is a graduate of Temple University B.S., 1971. Christina L. Coulston has been Vice President, Loan Administration at First Republic since July 1989. From 1985 to June 1989, she was in charge of the loan servicing function for Atlantic Financial Savings. She is a graduate of Oregon State University B.S., 1969. Edward J. Dobranski joined the company in August 1992 as Corporate Counsel and was appointed a Vice President in 1993. He also serves as the Company's Compliance Officer and Community Reinvestment Officer. From 1990 to 1992, Mr. Dobranski was Of Counsel at Jackson Cole & Black in San Francisco, specializing in banking, real estate and corporate law, and from 1987 to 1990 he was a partner in the San Francisco office of Rose Wachtell & Gilbert. Mr. Dobranski is a graduate of Coe College--Iowa, B.A. 1972 and Creighton University-- Nebraska, J.D. 1975. David B. Lichtman was appointed Vice President, Credit Administration, in January 1994. Mr. Lichtman served as a loan processor with First Thrift from 1986 to 1990, as a loan officer with First Republic Mortgage Inc. from 1990 through 1991, and as a credit officer with First Thrift from 1992 through December 1993. Mr. Lichtman is a graduate of Vassar College, B.A. 1985 and the University of California, Berkeley, M.B.A. 1990. Richard M. Cox-Johnson is a director of First Republic serving until 1996. Mr. Cox-Johnson is a director of Premier Consolidated Oilfields PLC and Marine and General Mutual Life Assurance Society. He is a graduate of Oxford University 1955. Kenneth W. Dougherty is a director of First Republic serving until 1996. He was President of Gill & Duffus International Inc. from November 1981 to May 1984, and was an executive of Farr Man & Co., Inc. prior to that, serving as President of that corporation from 1978 to 1981. Both Gill & Duffus and Farr Man & Co. are international commodity trading companies. He was a director of San Francisco Bancorp from 1982 to 1984. Mr. Dougherty is a graduate of the University of Pennsylvania, B.A. 1948. Frank J. Fahrenkopf, Jr., is a director of First Republic serving until 1996. Since 1985, Mr. Fahrenkopf has been a partner in the Washington, D.C. law firm of Hogan & Hartson. From January 1983 until January 1989, he was Chairman of the Republican National Committee. Mr. Fahrenkopf is a graduate of the University of Nevada-Reno, B.A. 1962, and the University of California- Berkeley, L.L.B. 1965. L. Martin Gibbs is a director of First Republic serving until 1995. Mr. Gibbs has been a partner with the law firm of Rogers & Wells, counsel to the Company, since November 1987. For the five years prior to joining Rogers & Wells, Mr. Gibbs was the President and sole stockholder of a professional corporation which was a partner in the law firm of Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey ("Finley Kumble"). Finley Kumble rendered legal services to the Company from 1985 to 1987. He is a graduate of Brown University, B.A. 1959 and Columbia University, J.D. 1962. James F. Joy is a director of First Republic serving until 1994. Mr. Joy is Director--European Business Development--CVC Capital Partners-Europe, and a non-executive director of Sylvania Lighting International. Formerly, he was Chairman of Real Estate Research Corporation, President of Stanger Joy Associates, financial consultants, and Vice-President--Corporate Finance at Thomson McKinnon Securities, Inc. In May 1989, Mr. Joy filed a petition under Chapter 11 of the U.S. Bankruptcy Code and in 1990, on consent of all parties, the court dismissed the case. He is a graduate of Trinity College, B.S. 1959, B.S.E.E. 1960 and New York University, M.B.A. 1964. John F. Mangan is a director of First Republic serving until 1995. Mr. Mangan is an investor and was previously President of Prudential-Bache Capital Partners, Inc. (a wholly owned subsidiary of Prudential-Bache Securities, Inc.). Prior to that, he was the managing general partner of Rose Investment Company, a venture capital partnership. Mr. Mangan was a member of the New York Stock Exchange for over 13 years and was previously vice president and a partner of Pershing & Co., Inc. He has been a director of Noel Group, Inc., New York, N.Y., and the Hutton-Deutsch Collection Ltd., London. Mr. Mangan is a graduate of the University of Pennsylvania, B.A. 1959. Barrant V. Merrill is a director of First Republic serving until 1994. Mr. Merrill has been Managing Partner of Sun Valley Partners, a private investment company, since July 1982. From 1984 until January 1989, he was a general partner of Dakota Partners, a private investment partnership. From 1980 to 1984, Mr. Merrill was a director of San Francisco Bancorp. From 1978 until 1982, he was Chairman of Pershing & Co. Inc., a division of Donaldson, Lufkin & Jenrette. Mr. Merrill is a graduate of Cornell University, B.A. 1953. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION This information is incorporated by reference to the Company's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information is incorporated by reference to the Company's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This information is incorporated by reference to the Company's definitive proxy statement under the caption "Executive Compensation" to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 10-K (a) Financial Statements and Schedules. The following financial statements are contained in registrant's 1993 Annual Report to Stockholders and are incorporated in this Report on Form 10-K by this reference: All schedules are omitted as not applicable. (b) Reports on Form 8-K. The Company filed a report dated October 20, 1993 on Form 8-K reporting the Company's earnings for the quarter and nine months ended September 30, 1993. The Company filed a report dated February 7, 1994 on Form 8-K reporting the Company's earnings for the quarter and year ended December 31, 1993, and the declaration of a 3% stock dividend to stockholders of record on February 18, 1994. The Company filed a report dated March 18, 1994 on Form 8-K reporting the impact on the Company's earnings from the January 17, 1994 earthquake in the Los Angeles, California area. (c) Exhibits. NOTE: Exhibits marked with a plus sign (+) are incorporated by reference to the Registrant's Registration Statement on Form S-1 (No. 33-4608); Exhibits marked with two plus signs (++) are incorporated by reference to the Registrant's Form 10-Q for the quarter ended September 30, 1987; Exhibits marked with three plus signs (+++) are incorporated by reference to the Registrant's Registration Statement on Form S-1 (No. 33-18963); Exhibits marked with a diamond (q) are incorporated by reference to the Registrant's Form 10-K for the year ended December 31, 1988; Exhibits marked with two diamonds (qq) are incorporated by reference to the Registrant's Form 10-K for the year ended December 31, 1989; Exhibits marked with three diamonds (qqq) are incorporated by reference to the Registrant's Form 10-K for the year ended December 31, 1990; Exhibits marked with two asterisks (**) are incorporated by reference to Registrant's Registration Statement on Form S-2 (No. 33-40182); Exhibits marked with three asterisks (***) are incorporated by reference to Registrant's Registration Statement on Form S-2 (No. 33-42426); Exhibits marked with one pound sign (#) are incorporated by reference to Registrant's Registration Statement on Form S-2 (No. 33-43858); Exhibits marked with two pound signs (##) are incorporated by reference to the Registrant's Registration Statement on Form S-2 (No. 33- 45435). Exhibits marked with three pound signs (###) are incorporated by reference to the Registrant's Registration Statement on Form S- 2 (No. 33-54136). Exhibits marked with four pound signs (####) are incorporated by reference to Registrant's Form 10-K for the year ended December 31, 1992. Exhibits marked with one dagger (-) are incorporated by reference to the Registrant's Registration Statement on Form S-3 (No. 33-60958). Exhibits marked with two daggers (--) are incorporated by reference to the Registrant's Registration Statement on Form S-3 (No. 33-66336). Each such Exhibit had the number in parentheses immediately following the description of the Exhibit herein. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. First Republic Bancorp Inc. /s/ Willis H. Newton, Jr. By:__________________________________ Willis H. Newton, Jr. Senior Vice President and Chief Financial Officer March 30, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. FIRST REPUBLIC BANCORP INC. 1993 ANNUAL REPORT EDGAR VERSION DESCRIPTION OF PHOTOS AND GRAPHS COVER PAGE: Photos are presented of landmarks in the Company's four geographical operating markets -San Francisco, San Diego and Los Angeles, California and Las Vegas, Nevada. INSIDE FRONT COVER: Three graphs are presented as follows, left to right: 1) Net income for the last five years in millions of dollars, as included in the table above. 2) Total assets in millions of dollars as presented in the table above. 3) Total capital in millions of dollars for the past five years, which was $52 million at the end of 1989, $62 million at the end of 1990, $104 million at the end of 1991, $160 million at the end of 1992 and $179 million at the end of 1993. PAGE 2: A bar chart is presented, representing the tangible book value per share of the Company's common stock for the past five years, which was $7.11 at the end of 1989, $7.71 at the end of 1990, $9.59 at the end of 1991, $11.94 at the end of 1992 and $13.58 at the end of 1993. This chart represents a plus 16% per annum rate of growth for the past five years. PAGE 3: A photo is presented of the Company's President and Chief Executive Officer and the Company's Chairman of the Board of Directors. PAGE 5: A bar chart is presented, representing the Company's return on equity as a percent of average equity for the past five years, which was 4.7% for 1989, 12.8% for 1990, 17.2% for 1991, 14.1% for 1992 and 12.7% for 1993. PAGE 6: A bar chart is presented, representing the Company's risk adjusted capital ratios in comparison with the minimum required amount. First Republic is shown as having 17.6% total risk adjusted capital, compared to 8.0% required. PAGE 7: A photo is presented, representing a street scene in the Chinatown District of San Francisco, California, where the Company maintains a branch, plus a smaller picture of a depositor, Dr. Godwin S. Wong, who was quoted on page 6 and materials used in the retail deposit gathering function of the Company. First Republic Bancorp Inc. 1993 Annual Report Edgar Version PAGE 8 AND CARRY OVER TO PAGE 9: A photo appears here of the Company's Vice President of Savings and some of her customers. Additionally, small photos of the three of the Company's branch locations are included. PAGE 10: A bar chart appears, representing loans originated in dollars (millions) for the last five years, which were $324 million in 1989, $341 million in 1990, $445 million in 1991, $826 million in 1992 and $945 million 1993. PAGE 11: A photo appears, representing one of the Company's mortgage loan borrowers, Mr. Barry Bonds of the San Francisco Giants baseball team, who was quoted on page 10. Mr. Bonds appears in his home. Additionally, there is a smaller photo of Mr. Bonds on a baseball card and a mortgage loan advertisement for the Company. PAGE 12: A bar chart appears here, representing the Company's loan service for others in dollars (million) at the end of the last five years, which was $426 million at the end of 1989, $797 million at the end of 1990, $795 million at the end of 1991, $782 million at the end of 1992 and $814 million at the end of 1993. PAGE 13: Photo appears on page 13 with carryover to page 12. One of the Company's borrowers, Mr. Lenore Conroy, is pictured in front of her home with the family dog. Additionally, small photos appear of her husband and author, Mr. Pat Conroy, and the cover of his novel, The Prince of Tides. PAGE 14: A pie chart appears, representing the composition of the Company's loan portfolio at December 31, 1993, which was 48% secured by single family residences, 31% secured by multifamily properties, 18% secured by commercial real estate properties and 3% related to other types of loans. PAGE 15: A photo appears of a single family residential housing tract under construction, along with a smaller photo of a family of one of the Company's borrowers who is quoted on page 14. Additionally, there is a photo representing an advertisement by Federal National Mortgage Association. First Republic Bancorp Inc. 1993 Annual Report Edgar Version PAGE 16: A photo appears here and carries over to page 17, depicting one of the Company's borrowers in front of his low to moderate income apartment building with several of his tenants. Additionally, smaller photos are presented of the property and the First Republic Thrift & Loan Fair Lending Statement. PAGE 17: A pie chart appears, representing the Company's residential loan profile by housing units. 63% of the Company's loans are located in low to moderate income census tracts, as measured by housing units, while 37% of the Company's loans are located in all other census tracts. PAGE 18: A bar chart appears, which represents the total loans in dollars (millions) at the end of the last five years, which was $409 million at the end of 1989, $601 million at the end of 1990, $872 million at the end of 1991, $1.068 billion at the end of 1992 and $1.256 billion at the end of 1993. PAGE 19: A photo appears here of a historic landmark building in San Francisco called The Flood Building. This property was renovated with the assistance of First Republic. Also included are small photos representing newspaper articles on the renovation and the owner-developer, Mr. James C. Flood, at the ribbon cutting ceremony with the mayor of San Francisco, Mr. Frank Jordan. PAGE 42: A photo appears here depicting the Company's Board of Directors as described in the caption below the photo, in front of a single family home in the process of construction by one of the Company's borrowers. PAGE 44: Three bar charts are presented, representing the following: 1. The left chart represents average assets per employee in dollars (millions) for the last five years, which were $6.0 million for 1989, $7.1 million for 1990, $8.3 million for 1991, $9.6 million for 1992 and $9.8 million for 1993. 2. The middle chart represents net income earned per employee in dollars (thousands), which was $15,000 for 1989, $44,000 for 1990, $79,000 for 1991, $101,000 for 1992, and $94,000 for 1993. First Republic Bancorp Inc. 1993 Annual Report Edgar Version 3. The right-hand chart represents the Company's trend in general and administrative expenses as a percent of average assets, which was 1.67% in 1989, 1.49% in 1990, 1.44% in 1991, 1.30% in 1992 and 1.33% in 1993.

69659_1993.txt

69659_1993

1993

69659

Item 1. BUSINESS THE SYSTEM SYSTEM ORGANIZATION New England Electric System (NEES) is a voluntary association created under Massachusetts law on January 2, 1926, and is a registered holding company under the Public Utility Holding Company Act of 1935 (the 1935 Act). NEES owns voting stock in the amounts indicated of the following companies, which together constitute the System. % Voting Securities State of Type of Owned by Name of Company Organization Business NEES --------------- ------------ --------- ---------- Subsidiaries: Granite State Electric Company N.H. Retail 100 (Granite State) Electric Massachusetts Electric Company Mass. Retail 100 (Mass. Electric) Electric The Narragansett Electric Company R.I. Retail 100 (Narragansett) Electric Narragansett Energy Resources R.I. Wholesale 100 Company (Resources) Electric Generation New England Electric Resources, Inc. Mass. Consulting 100 (NEERI) Services New England Electric Transmission N.H. Electric 100 Corporation (NEET) Transmission New England Energy Incorporated Mass. Oil and Gas 100 (NEEI) Exploration & Development New England Hydro-Transmission N.H. Electric 53.97(a) Corporation (N.H. Hydro) Transmission New England Hydro-Transmission Mass. Electric 53.97(a) Electric Company, Inc. Transmission (Mass. Hydro) New England Power Company (NEP) Mass. Wholesale 98.80(b) Electric Generation & Transmission New England Power Service Company Mass. Service 100 (Service Company) Company (a) The common stock of these subsidiaries is owned by NEES and certain participants (or their parent companies) in Phase II of the Hydro-Quebec project. See Interconnection with Quebec, page 21. (b) Holders of common stock and 6% Cumulative Preferred Stock of NEP have general voting rights. The 6% Cumulative Preferred Stock represents 1.20% of the total voting power. In 1993, the System was realigned into two strategic business units, a wholesale business unit and a retail business unit. The facilities of NEES' three retail electric subsidiaries, Mass. Electric, Narragansett, and Granite State (collectively referred to as the Retail Companies), and of its principal wholesale electric subsidiary, NEP, constitute a single integrated electric utility system that is directly interconnected with other utilities in New England and New York State, and indirectly interconnected with utilities in Canada. See ELECTRIC UTILITY OPERATIONS, page 3. NEET owns and operates a portion of an international transmission interconnection between the electric systems of Hydro-Quebec and New England. Mass. Hydro and N.H. Hydro own and operate facilities in connection with an expanded second phase of this interconnection. See Interconnection with Quebec, page 21. NEEI is engaged in various activities relating to fuel supply for the System. These activities presently include participation (principally through a partnership with a non-affiliated oil company) in domestic oil and gas exploration, development, and production (see OIL AND GAS OPERATIONS, page 43) and the sale to NEP of fuel purchased in the open market. Resources is a general partner, with a 20% interest, in each of two partnerships formed in connection with the Ocean State Power project. See Ocean State Power, page 21. The Service Company has contracted with NEES and its subsidiaries to provide, at cost, such administrative, engineering, construction, legal, and financial services as the companies request. The Service Company also provides maintenance and construction services under contract to certain non-affiliated utility customers. Profits from these contracts are used to reduce the cost of services to affiliated companies. NEERI is a wholly-owned, non-utility subsidiary of NEES which provides consulting services domestically and internationally to non-affiliates. EMPLOYEES As of December 31, 1993, NEES subsidiaries had approximately 5,000 employees. As of that date, the total number of employees was approximately 840 at NEP, 1,800 at Mass. Electric, 760 at Narragansett, 80 at Granite State, and 1,500 at the Service Company. Of the 5,000 employees, approximately 3,300 are members of labor organizations. Collective bargaining agreements with the Brotherhood of Utility Workers of New England, Inc., the International Brotherhood of Electrical Workers, and the Utility Workers Union of America, AFL-CIO expire in May 1995. FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS The business of the System is conducted in two primary business segments, electric utility operations and oil and gas operations. The financial information with respect to Electric Utility Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $2,187,040 $2,138,302 $2,056,798 Operating income 332,843 341,650 317,487 Total assets 4,460,652 4,177,781 3,964,569 Capital expenditures 304,659 241,872 209,674 The financial information with respect to Oil and Gas Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $ 46,938 $ 43,374 $ 37,580 Pre-tax loss passed (46,355) (54,607) (39,303) on to customers Total assets 335,226 407,015 485,508 Capital expenditures 18,965 21,262 32,969 ELECTRIC UTILITY OPERATIONS GENERAL NEP's business is principally generating, purchasing, transmitting, and selling electric energy in wholesale quantities. In 1993, 95% of NEP's revenue from the sale of electricity was derived from sales for resale to affiliated companies and 5% from sales for resale to municipal and other utilities. NEP is the wholesale supplier of the electric energy requirements of the Retail Companies. Narragansett, however, receives credits against its purchases of power from NEP for the cost of generation from its Providence units, which are integrated with NEP's facilities to achieve maximum economy and reliability. Discussions of NEP's generating properties, load growth, energy mix, and fuel supplies include the related properties of Narragansett. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 28 of the New England Power Company 1993 Annual Report to Stockholders (the NEP 1993 Annual Report). The combined service area of the Retail Companies constitutes the retail service area of the System and covers more than 4,400 square miles with a population of about 3,000,000 (1990 census). See Map, page 17. The largest cities served are Worcester, Mass. (population 170,000) and Providence, R.I. (population 161,000). Mass. Electric and Narragansett are engaged principally in the distribution and sale of electricity at retail. Mass. Electric provides approximately 930,000 customers with electric service at retail in a service area comprising approximately 43% of the area of The Commonwealth of Massachusetts. The population of the service area is about 2,160,000 or 36% of the total population of the Commonwealth (1990 Census). Mass. Electric's territory consists of 149 cities and towns including rural, suburban, and urban communities with Worcester, Lawrence, Lowell, and Quincy being the largest cities served. The economy of the area is diversified. Principal industries served by Mass. Electric include electrical and industrial machinery, computer manufacturing and related products, plastic goods, fabricated metals and paper, and chemical products. In addition, a broad range of professional, banking, high-technology, medical, and educational concerns is served. During 1993, 41% of Mass. Electric's revenue from the sale of electricity was derived from residential customers, 36% from commercial customers, 22% from industrial customers, and 1% from others. In 1993, the 20 largest customers of Mass. Electric accounted for less than 8% of its electric revenue. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 26 of Mass. Electric's 1993 Annual Report to Stockholders (the Mass. Electric 1993 Annual Report). Narragansett provides approximately 323,000 customers with electric service at retail. Its service territory, which includes urban, suburban, and rural areas, covers about 839 square miles or 80% of the area of Rhode Island, and encompasses 27 cities and towns including the cities of Providence, East Providence, Cranston, and Warwick. The population of the area is about 725,000 (1990 Census) which represents about 72% of the total population of the state. The economy of the territory is diversified. Principal industries served by Narragansett produce fabricated metal products, jewelry, silverware, electrical and industrial machinery, transportation equipment, textiles, and chemical and allied products. In addition, a broad range of professional, banking, medical, and educational institutions is served. During 1993, 42% of Narragansett's revenue from the sale of electricity was derived from residential customers, 40% from commercial customers, 16% from industrial customers, and 2% from others. In 1993, the 20 largest customers of Narragansett accounted for approximately 11% of its electric revenue. For details of sales of energy and operating revenue for the last five years see OPERATING STATISTICS on page 23 of Narragansett's 1993 Annual Report to Stockholders (the Narragansett 1993 Annual Report). Granite State provides approximately 35,000 customers with electric service at retail in the State of New Hampshire in an area having a population of about 73,000 (1990 Census), including the city of Lebanon and the towns of Hanover, Pelham, Salem and surrounding communities. During 1993, 48% of Granite State's revenue from the sale of electricity was derived from commercial customers, 39% from residential customers, 12% from industrial customers, and 1% from others. In 1993, the 10 largest customers of Granite State accounted for about 20% of its electric revenue. Granite State is not subject to the reporting requirements of the Securities Exchange Act of 1934, and its financial impact on the System is relatively small. Information on Granite State is provided herein solely for the purpose of furnishing a more complete description of System operations. The electric utility business of NEP and the Retail Companies is not highly seasonal. For NEP and the Retail Companies, industrial customers are broadly distributed among standardized industrial classifications. No single industrial classification exceeds 4% of operating revenue, and no single customer of the System contributes more than 1% of operating revenue. Kilowatthour (KWH) sales billed to ultimate customers in 1993 increased by 1.4% over 1992. A return to more normal weather conditions in 1993 was largely offset by the fact that 1992 included an extra day for leap year. KWH sales billed to ultimate customers increased 0.4% in 1992. COMPETITIVE CONDITIONS The electric utility business is being subjected to increasing competitive pressures, stemming from a combination of increasing electric rates, improved technologies and new regulations, and legislation intended to foster competition. Recently, this competition has been most prominent in the bulk power market in which non-utility generating sources have noticeably increased their market share. For example, in 1984, less than 1% of NEP's capacity was supplied by non-utility generation sources. By the end of 1993, non-utility power purchases accounted for 380 MW or 7% of NEP's total capacity. In addition to competition from non- utility generators, the presence of excess generating capacity in New England has resulted in the sale of bulk power by utilities at prices less than the total costs of owning and operating such generating capacity. Electric utilities are also facing increased competition in the retail market. Currently, retail competition comes from alternative fuel suppliers (principally natural gas companies) for heating and cooling, customer-owned generation to displace purchases from electric utilities, and direct competition among electric utilities to attract major new manufacturing facilities to their service territories. In the future, the potential exists for electric utilities and non-utility generators to sell electricity to retail customers of other electric utilities. The NEES companies are responding to current and anticipated competitive pressures in a variety of ways including cost control and a corporate reorganization into separate retail and wholesale business units. The wholesale business unit is positioning itself for increased competition through such means as terminating certain purchased power contracts, past and future shutdowns of uneconomic generating stations, and rapid amortization of certain plant assets. NEP's rates currently include approximately $100 million per year associated with the recovery of certain Seabrook Nuclear Generating Station Unit 1 (Seabrook 1) costs under a 1988 rate settlement and coal conversion expenditures at NEP's Salem Harbor station. The recovery of these costs will be completed prior to the end of 1995. The retail business unit's response to competition includes the development of value-added services for customers and the offering of economic development rates to encourage businesses to locate in our service territory. In its recent rate settlement, Mass. Electric was able to change the standard terms under which it offers service to commercial and industrial customers to extend the notice period a customer must give from one to two years before purchasing electricity from others or generating any additional electricity for the customer's own use. In addition, Mass. Electric began offering a discount from base rates in return for a contract requiring the customer to provide five years written notice before purchasing electricity from others or generating any additional electricity for the customer's own use. The discount is available to customers with average monthly peak demands over 500 kilowatts. Electric utility rates are generally based on a utility's costs. Therefore, electric utilities are subject to certain accounting standards that are not applicable to other business enterprises in general. These accounting rules allow regulated entities, in appropriate circumstances, to establish regulatory assets and to defer the income statement impact of certain costs that are expected to be recovered in future rates. The effects of competition could ultimately cause the operations of the NEES companies, or a portion thereof, to cease meeting the criteria for application of these accounting rules. While the NEES companies do not expect to cease meeting these criteria in the near future, if this were to occur, accounting standards of enterprises in general would apply and immediate recognition of any previously deferred costs would be necessary in the year in which these criteria were no longer applicable. RATES General In 1993, 74% of the System's electric utility revenues was attributable to NEP, whose rates are subject to regulation by the Federal Energy Regulatory Commission (FERC). The rates of Mass. Electric, Narragansett, and Granite State are subject to the respective jurisdictions of the state regulatory commissions in Massachusetts, Rhode Island, and New Hampshire. The rates of each of the Retail Companies contain a purchased power cost adjustment clause (PPCA). The PPCA is designed to allow the Retail Companies to pass on to their customers increases in purchased power expense resulting from increases allowed by the FERC in NEP's rates. The Retail Companies are also required to reflect rate decreases or refunds. PPCA changes become effective on the dates specified in the filing of the adjustments with the state regulatory commission (not earlier than 30 days after such filing) unless the state regulatory commission orders otherwise. There have been, on occasion, regulatory delays in permitting PPCA increases. Effective March 1, 1993, Narragansett and Granite State received approval for PPCA clauses that fully reconcile on an annual basis purchased power expenses incurred by the companies against purchased power related revenues. Under the doctrine of Narragansett v. Burke, a case decided by the Rhode Island Supreme Court in 1977, NEP's wholesale rates must be accepted as allowable expenses for rate-making purposes by state commissions in retail rate proceedings. In 1986 and 1988 the U.S. Supreme Court reaffirmed this doctrine in two cases that did not involve NEP. However, the Narragansett v. Burke doctrine has been indirectly challenged by a number of state regulatory commissions which have held that federal preemption of the regulation of wholesale electric rates does not preclude the state commission from reviewing the prudence of a utility's decision to purchase power under a FERC-approved rate, and from disallowing costs if it finds that the purchase was an imprudent choice among alternative sources. In a 1985 opinion, the New Hampshire Supreme Court took this position on the issue of state regulation of wholesale power purchases. Also, legislation has been filed from time to time in Congress that would have eroded or repealed the doctrine. If state commissions were to refuse to allow the Retail Companies to include the full cost of power purchased from NEP in their rates, System earnings could be adversely affected. The rates of NEP and the Retail Companies contain fuel adjustment clauses that allow the rates to be adjusted to reflect changes in the cost of fuel. NEP's fuel clause is on a current basis. Mass. Electric has a fuel clause billing procedure that provides for monthly billing of estimated quarterly fuel costs, while Narragansett's and Granite State's fuel costs are estimated on a semi-annual basis. Billings are adjusted in the subsequent period for any excess or deficiency in fuel cost recovery. The FERC rules allow up to 50% of construction work in progress (CWIP) to be included in rate base in addition to CWIP already allowed in rate base for fuel conversion projects or pollution control facilities. This rule allows NEP the option of recovering currently through rates a portion of the costs of financing its construction program, rather than recording allowance for funds used during construction (AFDC) on that portion. The FERC rules with regard to canceled plants provide that utilities may recover in rates only 50% of prudently incurred canceled plant costs. However, the FERC allows utilities to include the recoverable amount in rate base and earn a return on the unamortized balance. NEP is recovering the cost of the conversion to coal of three units at Salem Harbor Station by means of an oil conservation adjustment (OCA), a FERC-approved rate. The OCA is designed to amortize the conversion costs by the mid-1990s. Through 1993, NEP has recovered approximately 84% of the conversion costs. The Retail Companies have OCA provisions designed to pass on to their customers amounts billed through NEP's OCA, which totaled $24.6 million for 1993. NEP Rates No NEP rate cases were filed with the FERC during 1993. Seabrook 1 Nuclear Unit NEP owns approximately 10% of Seabrook 1, a 1,150 MW nuclear generating unit, that entered commercial service on June 30, 1990. NEP's rate recovery of its investment in Seabrook 1 was resolved through two separate rate settlement agreements. The pre-1988 portion of NEP's investment is being recovered over a period of seven years and five months ending in July 1995. NEP's investment in Seabrook 1 since January 1, 1988, which amounts to approximately $50 million at December 31, 1993, is being recovered over its useful life. W-92 Rate Case In May 1992, the FERC approved a settlement of NEP's W-92 rate case under which base rates were increased by $39.7 million, effective March 1992. The entire increase was attributable to costs associated with the commercial operation of Unit 2 of the Ocean State Power (OSP) generating facility. These costs had been collected through NEP's fuel clause since the unit entered service in late 1991. The settlement also incorporated new depreciation rates proposed in NEP's filing, which reduced NEP's overall revenue requirement by $18 million. Mass. Electric Rates Rate schedules applicable to electric services rendered by Mass. Electric are on file with the Massachusetts Department of Public Utilities (MDPU). In November 1993, the MDPU approved a rate agreement filed by Mass. Electric, the Massachusetts Attorney General, and two groups of large commercial and industrial customers. Under the agreement, Mass. Electric began implementing an 11- month general rate decrease effective December 1, 1993 of $26 million (on an annual basis) from the level of rates then in effect. This rate reduction will continue in effect until October 31, 1994, after which rates will increase to the previously approved levels. The agreement also provided for rate discounts of up to $4 million available for the period ending October 31, 1994 for large commercial and industrial customers who agree to give a five-year notice to Mass. Electric before they purchase power from another supplier or generate any additional power themselves. These discounts will increase after October 31, 1994 to a level of $11 million per year if all eligible customers participate. Mass. Electric also agreed not to increase its base rates above currently approved levels before October 1, 1995. The decrease in revenues will be offset by the recognition for accounting purposes of revenues for electricity delivered but not yet billed. The agreement also resolved all issues associated with providing funds and securing rate recovery for environmental cleanup costs of Massachusetts manufactured gas waste sites formerly owned by Mass. Electric and its affiliates, as well as certain other Mass. Electric environmental cleanup costs (see Hazardous Substances, page 30). The rate agreement allows for these costs to be met by establishing a special interest bearing fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. Annual contributions of $3 million, adjusted for inflation, will be added to the fund by Mass. Electric and will be recoverable in rates. In addition, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Lastly, the agreement provided for the rate recovery of $8 million of certain storm restoration and other costs previously charged to expense. Effective October 1992, the MDPU authorized a $45.6 million annual increase in rates for Mass. Electric. This general rate increase included $2.5 million representing the first step of a four-year phase-in of Mass. Electric's tax deductible costs associated with post-retirement benefits other than pensions (PBOPs). A second $2.5 million increase took effect October 1, 1993. Narragansett Rates Rate schedules applicable to electric services rendered by Narragansett are on file with the Rhode Island Public Utilities Commission (RIPUC) and the Rhode Island Division of Public Utilities and Carriers. Effective March 1993, Narragansett implemented a new rate design which reallocated costs among its various rate classes, but which are not expected to affect total revenues over a twelve month period. Among other things, the new rates reduced the seasonality of the rates applicable to Narragansett's larger commercial and industrial customers. This change will result in lower revenues in summer months and higher revenues in other months when compared to Narragansett's prior rate design. Effective May 1992, the RIPUC authorized a $3.5 million annual increase in rates for Narragansett. In addition, effective January 1993, the RIPUC approved a $1.5 million increase in rates for Narragansett representing the first step of a three-year phase-in of Narragansett's recovery of costs associated with PBOPs. A second $1.5 million increase took effect in January 1994. Effective April 1991, the RIPUC approved Narragansett's settlement of a $13 million rate increase. Granite State Rates Effective March 1993, the New Hampshire Public Utilities Commission (NHPUC) authorized a $2.0 million rate increase for Granite State, with a retroactive adjustment to September 15, 1992 to reflect the difference between the authorized amount and the $1.4 million Granite State had been collecting on an interim basis since September 15, 1992. Effective July 1, 1993, the NHPUC approved a $0.7 million increase in rates for Granite State to recover costs associated with PBOPs. Recovery of Demand-Side Management Expenditures The three Retail Companies offer conservation and load management programs, usually referred to in the industry as Demand- Side Management (DSM) programs, which are designed to help customers use electricity efficiently, as a part of meeting the System's future resource needs and customers' needs for energy services. See RESOURCE PLANNING, page 36. The Retail Companies file their DSM programs regularly with their respective regulatory agencies and have received approval to recover in rates estimated DSM expenditures on a current basis. The rates provide for reconciling estimated expenditures to actual DSM expenditures, with interest. Mass. Electric's expenditures subject to the reconciliation mechanism were $47 million, $44 million, and $55 million in 1993, 1992, and 1991, respectively. Narragansett's expenditures subject to the reconciliation mechanism were $12 million, $12 million, and $19 million in 1993, 1992, and 1991, respectively. Since 1990, the Retail Companies have been allowed to earn incentives based on the results of their DSM programs. The Retail Companies must be able to demonstrate the electricity savings produced by their DSM programs to their respective state regulatory agencies before incentives are recorded. Mass. Electric recorded $6.7 million, $8.6 million, and $6.0 million of before-tax incentives in 1993, 1992, and 1991, respectively. Narragansett recorded $0.5 million, $1.3 million, and $1.6 million of before-tax incentives in 1993, 1992, and 1991, respectively. The Retail Companies have received regulatory approvals that will give them the opportunity to continue to earn incentives based on 1994 DSM program results. GENERATION Energy Mix The following table displays the contributions of various fuel sources and other generation to total net generation of electricity by NEP during the past three years, as well as an estimate for 1994: % of Net Generation -------------------------- Estimated Actual --------- ---------------- 1994 1993 1992 1991 ---- ---- ---- ---- Coal 37 38 41 44 Nuclear 18 18 18 18 Gas (1) 16 16 15 11 Oil 11 11 10 11 Hydroelectric 6 6 6 7 Hydro-Quebec 6 5 4 3 Renewable Non-Utility Generation (2) 6 6 6 6 --- --- --- --- 100 100 100 100 (1) Gas includes both utility and non-utility generation. (2) Waste to energy and hydro. Electric Utility Properties The electric utility properties of the System companies consist of NEP's and Narragansett's fossil-fuel base load and intermediate load steam generating units, conventional and pumped storage hydroelectric stations, internal combustion peaking units, portions of fossil fuel and nuclear generating units, the ownership interests of NEET, Mass. Hydro, and N.H. Hydro in the Hydro-Quebec Interconnection, and an integrated system of transmission lines, substations, and distribution facilities. See MAP - ELECTRIC UTILITY PROPERTIES, page 17. NEP's integrated system consists of 2,290 circuit miles of transmission lines, 116 substations with an aggregate capacity of 13,265,588 kVA, and 7 pole or conduit miles of distribution lines. The properties of Mass. Electric and Narragansett include substations and distribution and transmission lines, which are interconnected with transmission and other facilities of NEP. At December 31, 1993, Mass. Electric owned 282 substations, which had an aggregate capacity of 2,859,309 kVA, 147,090 line transformers with the capacity of 7,489,447 kVA, and 15,948 pole or conduit miles of distribution lines. Mass. Electric also owns 81 circuit miles of transmission lines. At December 31, 1993, Narragansett owned 248 substations, which had an aggregate capacity of 2,838,927 kVA, 53,100 line transformers with the capacity of 2,239,554 kVA, and 4,492 pole or conduit miles of distribution lines. Narragansett, in addition, owns 325 circuit miles of transmission lines. Substantially all of the properties and franchises of Mass. Electric, Narragansett, and NEP are subject to the liens of indentures under which mortgage bonds have been issued. For details of the mortgage liens on these properties see the long-term debt note in Notes to Financial Statements in each of these companies' respective 1993 Annual Report. The properties of NEET are subject to a mortgage under its financing arrangements. (a) These units currently burn coal, but are also capable of burning oil. (b) For a discussion of the Manchester Street Station repowering project, see Manchester Street Station Repowering on page 37. (c) Includes (i) an interest in a jointly owned oil-fired unit in Yarmouth, Maine, and (ii) diesel units at various locations. (d) See Hydroelectric Project Licensing, page 28. (e) See Nuclear Units, page 21. (f) Capability includes contracted purchases (1,312 MW) less contract sales (164 MW). Net generation includes the effects of the above contracted purchases and economy interchanges through the New England Power Exchange (including Hydro-Quebec purchases and purchases from non-utility generation). For further information see Non-Utility Generation Sources, page 20. NEP and Narragansett are members of the New England Power Pool (NEPOOL), a group of over 90 New England utilities that comprises virtually all of New England's electric generation. Mass. Electric and Granite State participate in NEPOOL through NEP. The NEPOOL Agreement provides for coordination of the planning and operation of the generation and transmission facilities of its members. The NEPOOL Agreement incorporates generating capacity reserve obligations, provisions regarding the use of major transmission lines, and provisions for payment for facilities usage. The NEPOOL Agreement further provides for New England-wide central dispatch of generation through the New England Power Exchange. Through NEPOOL, operating and capital economies are achieved and reserves are established on a region-wide rather than an individual company basis. The electric energy available to NEES subsidiaries and other members is determined by the aggregate available to NEPOOL. The 1993 NEPOOL peak demand of 19,570 MW occurred on July 8, 1993. The maximum demand to date of 19,742 MW occurred on July 19, 1991. The 1993 summer peak for the System of 4,081 MW occurred on July 8, 1993. This was below the previous all time peak load of 4,250 MW which occurred on July 19, 1991. The 1993-1994 winter peak of 4,121 MW occurred on January 19, 1994. For a discussion of resource planning, see RESOURCE PLANNING, page 36. MAP (Displays electric utility properties of NEES subsidiaries) Fuel for Generation NEP burned the following amounts of coal, residual oil, and gas during the past three years: 1993 1992 1991 ---- ---- ---- Coal (in millions of tons) 3.2 3.3 3.6 Oil (in millions of barrels) 5.0 4.9 6.4 Natural Gas (in billions of cubic feet) 0.7 3.2 1.7 Coal Procurement Program Depending on coal-fired generating unit availability and the degree to which the units are dispatched, NEP's 1994 coal requirements should range between 3.0 and 3.2 million tons. NEP obtains its domestic coal under contracts of varying lengths and on a spot basis from domestic coal producers in Kentucky, West Virginia, and Pennsylvania, and from mines in Colombia and Venezuela. Three different rail systems (CSX, Norfolk Southern, and Conrail) transport coal from domestic sources to loading ports on the east coast. NEP's coal is transported from east coast ports by ocean-going collier to Brayton Point and Salem Harbor. NEP has a term charter with the Energy Independence, a self-unloading collier, which carries all of NEP's U.S. coal and a portion of foreign coal. NEP also charters other coal-carrying vessels for the balance of foreign coal. As protection against interruptions in coal deliveries, NEP maintained coal inventories at its generating stations during 1993 in the range of 40 to 60 days. A United Mine Workers strike lasting the second half of 1993 interrupted one long-term contract which was replaced prior to its 1994 expiration. To meet environmental requirements, NEP uses coal with a relatively low sulphur and ash content. NEP's average price for coal burned, including transportation costs, calculated on a 26 million Btu per ton basis, was $44.72 per ton in 1991, $44.15 in 1992, and $43.53 per ton in 1993. Based on a 42 gallon barrel of oil producing 6.3 million Btu's, these coal prices were equivalent to approximately $10.83 per barrel of oil in 1991, $10.70 in 1992 and $10.57 per barrel of oil in 1993. Oil Procurement Program The System's 1994 oil requirements are expected to be approximately 5.0 million barrels. The System obtains its oil requirements through contracts with oil suppliers and purchases on the spot market. Current contracts provide for minimum annual purchases of 2.6 million barrels at market related prices. The System currently has a total storage capacity for approximately 2.3 million barrels of residual and diesel fuel oil. The System's average cost of oil burned, calculated on a 6.3 million Btu per barrel basis, was $11.82 in 1991, $12.68 in 1992, and $13.30 in 1993. Natural Gas NEP uses natural gas at both Brayton 4 and Manchester Street Stations when gas is priced less than residual fuel oil. At Brayton 4, natural gas currently displaces 2.2% sulphur residual fuel oil. At Manchester Street Station, gas currently displaces 1.0% sulphur residual fuel oil. In 1993, approximately 0.7 billion cubic feet of gas were consumed at an average cost of $2.58 per thousand cubic feet excluding pipeline demand charges. This gas price was equivalent to approximately $16.25 per barrel of oil. Firm year-round gas deliveries to Manchester Street Station are planned as part of its repowering project. The repowered facility would use up to 95 million cubic feet of natural gas per day. See Manchester Street Station Repowering, page 37. NEP has contracted with six pipeline companies for transportation of natural gas from supply regions to these two generating stations: (1) 60 million cubic feet per day from Western Canada via TransCanada PipeLines, Ltd. (TransCanada), Iroquois Gas Transmission System, Tennessee Gas Pipeline Company and Algonquin Gas Transmission Company, and (2) 60 million cubic feet per day from the U.S. Mid-Continent region via ANR Pipeline Company, Columbia Gas Transmission Company and Algonquin. (a) NEP has entered into a firm service agreement with TransCanada. Service commenced on November 1, 1992. (b) NEP has entered into a firm service agreement with Iroquois. Service commenced on November 1, 1993. (c) NEP has entered into a firm service agreement with Tennessee. Service commenced on November 1, 1993. (d) NEP has entered into a firm service agreement with Algonquin for delivery of Canadian gas. Service commenced on November 1, 1993. Additional service for a portion of the domestic gas is expected to commence in December 1994. NEP has also entered into a firm service agreement for deliveries of gas to its Brayton Point Station. All facilities for this service have been constructed and in service since December of 1991. (e) ANR has constructed substantially all facilities necessary to serve NEP. NEP has entered into a firm service agreement with ANR. Service is expected to commence in December 1994. (f) Columbia has received and accepted a FERC certificate to construct facilities for service to NEP. NEP has entered into a firm service agreement with Columbia. Service is expected to commence in December 1994. NEP has also signed contracts with four Canadian gas suppliers for a total of 60 million cubic feet per day. NEP has not yet signed supply arrangements with Mid-Continent producers. The pipeline agreements require minimum fixed payments. NEP's minimum net payments are currently estimated to be approximately $45 million in 1994, $65 million in 1995, and $70 million each in 1996, 1997, and 1998. The amount of the fixed payments are subject to FERC regulation and will depend on FERC actions affecting the rates on each of the pipelines. As part of its W-12 rate settlement, NEP is recovering 50% of the fixed pipeline capacity payments through its current fuel clause and deferring the recovery of the remaining 50% until the Manchester Street repowering project is completed. NEP has deferred payments of approximately $13 million as of December 31, 1993. Nuclear Fuel Supply As noted above, NEP participates with other New England utilities in the ownership of several nuclear units. See Nuclear Units, page 21. The utilities responsible for supply for these units are not experiencing any difficulty in obtaining commitments for the supply of each element of the nuclear fuel cycle. Non-Utility Generation Sources The System companies purchase a portion of the electricity generated by, or provide back-up or standard service to, 139 small power producers or cogenerators (a total of 3,185,101 MWh of purchases in 1993). As of December 31, 1993, these non-utility generation sources include 32 low-head hydroelectric plants, 51 wind or solar generators, seven waste to energy facilities, and 49 cogenerators. The total capacity of these sources is as follows: In Service Future Projects (12/31/93) Under Contract Source (MW) (MW) ------ ---------- --------------- Hydro 43 - Wind - 20 Waste to Energy 169 33 Cogeneration 303 40 Independent Power Producers - 83* ---- --- Total 515 176 * Milford Power was accepted for dispatch by NEPOOL on January 20, 1994. The in-service amount includes 377 MW of capacity and 138 MW treated as load reductions and excludes the Ocean State Power contracts discussed below. Ocean State Power Ocean State Power (OSP) and Ocean State Power II (OSP II) are general partnerships that own and operate a two unit gas-fired combined cycle electric power plant in Burrillville, R.I. Resources is a general partner with a 20% interest in both OSP and OSP II and had an equity investment of approximately $40 million at December 31, 1993. The first unit began commercial operation on December 31, 1990 and the second unit went into service on October 1, 1991. The two units have a combined winter net electrical capability of approximately 562 MW. Each unit's capacity and energy output is sold under 20-year unit power agreements to a group of New England utilities, including NEP, which has contracts for 48.5% of the output of each unit. NEP is required to make certain minimum fixed payments to cover capital and fixed operating costs of these units in amounts estimated to be $70 million per year. Interconnection with Quebec NEET, Mass. Hydro, and New Hampshire Hydro own and operate, on behalf of NEPOOL participants in the project, a 450 kV direct current (DC) transmission line and related terminals to interconnect the New England and Quebec transmission systems (the Interconnection). The transfer capability of the Interconnection is 2,000 MW. NEPOOL members purchase from and sell energy to Hydro-Quebec pursuant to several agreements. The principal agreement calls for NEPOOL members to purchase 7 billion KWH of energy each year for ten years (the Firm Energy Contract). Purchases under the Firm Energy Contract totaled over 6.4 billion KWH in 1993. NEP is a participant in both the Phase I and Phase II projects of the Interconnection. NEP's participation percentage in both projects is approximately 18%. NEP and the other participants have entered into support agreements that end in 2020, to pay monthly their proportionate share of the total cost of constructing, owning, and operating the transmission facilities. NEP accounts for these support agreements as capital leases and accordingly recorded approximately $78 million in utility plant at December 31, 1993. Under the support agreements, NEP has agreed, in conjunction with any Phase II project debt financing, to guarantee its share of project debt. At December 31, 1993, NEP had guaranteed approximately $34 million. In the event any Interconnection facilities are abandoned for any reason, each participant is contractually committed to pay its pro-rata share of the net investment in the abandoned facilities. Nuclear Units General NEP is a stockholder of Yankee Atomic Electric Company (Yankee Atomic), Vermont Yankee Nuclear Power Corporation (Vermont Yankee), Maine Yankee Atomic Power Company (Maine Yankee), and Connecticut Yankee Atomic Power Company (Connecticut Yankee). Each of these companies (collectively referred to as the Yankee Companies) owns a single nuclear generating unit. In addition, NEP is a joint owner of the Millstone 3 nuclear generating unit in Connecticut and the Seabrook 1 nuclear generating unit in New Hampshire. Millstone 3 and Seabrook 1 are operated by subsidiaries of Northeast Utilities (NU). NEP pays its proportionate share of costs and receives its proportionate share of each unit's output. NEP's interest and investment in each of the Yankee Companies, Millstone 3, and Seabrook 1 and the net capability of each plant are as follows: Equity Net Investment Capability (12/31/93) Interest (MW) (in millions) -------- ---------- ------------- Yankee Atomic 30.0% * $ 7 Vermont Yankee 20.0% 93 10 Maine Yankee 20.0% 158 14 Connecticut Yankee 15.0% 87 15 ---- ---- Subtotal 338 $ 46 Net Investment in Plant** (12/31/93) (in millions) ------------- Millstone 3 12.2% 140 $405 Seabrook 1 9.9% 115 149 ---- Subtotal 255 ---- Total 593 ==== *Operations ceased **Excludes nuclear fuel NEP has a 30% ownership interest in Yankee Atomic which owns a 185 megawatt nuclear generating station in Rowe, Massachusetts. The station began commercial service in 1960. In February 1992, the Yankee Atomic board of directors decided to permanently cease power operation of, and in time, decommission the facility. In March 1993, the FERC approved a settlement agreement that allows Yankee Atomic to recover all but $3 million of its approximately $50 million remaining investment in the plant over the period extending to July 2000, when the plant's Nuclear Regulatory Commission (NRC) operating license would have expired. Yankee Atomic recorded the $3 million before-tax write-down in 1992. The settlement agreement also allows Yankee Atomic to earn a return on the unrecovered balance during the recovery period and to recover other costs, including an increased level of decommissioning costs, over this same period. Decommissioning cost recovery increased from $6 million per year to $27 million per year for the period 1993 to 1995. This level of recovery is subject to review in 1996. NEP has recorded an estimate of its entire future payment obligations to Yankee Atomic as a liability on its balance sheet and an offsetting regulatory asset reflecting its expected future rate recovery of such costs. This liability and related regulatory asset amounted to approximately $104 million each at December 31, 1993. NEP purchases the output of the other Yankee nuclear electric generating plants in the same percentages as its stock ownership of the Yankee Companies, less small entitlements taken by municipal utilities for Maine Yankee and Vermont Yankee. NEP has power contracts with each Yankee Company that require NEP to pay an amount equal to its share of total fixed and operating costs (including decommissioning costs) of the plant plus a return on equity. The stockholders of three Yankee Companies (Vermont Yankee, Maine Yankee and Connecticut Yankee) have agreed, subject to regulatory approval, to provide capital requirements in the same proportion as their ownership percentages of the particular Yankee Company. Pursuant to the terms of a lending agreement, Yankee Atomic will not pay dividends to its shareholders, including NEP, until such lender is paid in full. There is widespread concern about the safety of nuclear generating plants. The NRC regularly reviews the adequacy of its comprehensive requirements for nuclear plants. Many local, state, and national public officials have expressed their opposition to nuclear power in general and to the continued operation of nuclear power plants. It is possible that this controversy will result in cost increases and modifications to, or premature shutdown of, the operating nuclear units in which NEP has an interest. On three occasions (most recently in 1987), referenda appeared on the ballot in Maine that, if passed, would have required the prompt shutdown of Maine Yankee. All the referenda were defeated. There is no assurance that similar measures will not appear on future ballots. Pending before FERC is an initial decision of an administrative law judge disallowing full rate recovery for the unamortized portion of a nuclear plant to be retired before the end of its operating license. The decision, if affirmed, would result in rate recovery of less than the full investment in a nuclear plant retired from service prior to the end of its operating license. The amount of the disallowance would depend upon the plant's historic capacity factor and the number of years remaining on its operating license. Decommissioning Each of the Yankee Companies includes charges for all or a portion of decommissioning costs in its cost of energy. These charges vary depending upon rate treatment, the method of decommissioning assumed, economic assumptions, site and unit specific variables, and other factors. Any increase in these charges is subject to FERC approval. Each of the operating nuclear units has established decommissioning trust funds or escrow funds into which payments are being made to meet the projected cost of decommissioning its plant. If any of the units were shut down prior to the end of its operating license, the funds collected for decommissioning to that point would be insufficient. Estimates of NEP's pro-rata share (based on ownership) of decommissioning costs, NEP's share of the actual book values of decommissioning fund balances set aside for each unit at December 31, 1993 (in millions of dollars), and the expiration date of the operating license of each plant are as follows: NEP's share of ----------------------------- Estimated Decommissioning Fund License Costs Balances (1) Expiration Unit (in 1993 $) (12/31/93) Date ---- --------------- ------------ ---------- Yankee Atomic (2) $78 $26 -- Connecticut Yankee $49 $18 2007 Maine Yankee $63 $19 2008 Vermont Yankee $57 $20 2012 Millstone 3 $50 $10 2025 Seabrook 1 $36 $ 3 2026 (1) Certain additional amounts are anticipated to be available through tax deductions. (2) The estimated cost of decommissioning for Yankee Atomic does not reflect the benefit of the component removal project (CRP) for which decommissioning funds were spent in 1993. Additional expenditures for CRP will be made in 1994. NEP is currently collecting through rates amounts for decommissioning based upon cost estimates and funding methodologies authorized by FERC. Such estimates are determined periodically for each plant and may not reflect the current projected cost of decommissioning. There is no assurance that decommissioning costs actually incurred by the Yankee Companies, Millstone 3 or Seabrook 1 will not substantially exceed these amounts. For example, current decommissioning cost estimates assume the availability of permanent repositories for both low-level and high-level nuclear waste which do not currently exist. NRC rules require that reasonable assurance be provided that adequate funds will be available for the decommissioning of commercial nuclear power plants. The rule establishes minimum funding levels that licensees must satisfy. Each of the units in which NEP has an interest has filed a report with the NRC providing assurance that funds will be available to decommission the facility. A Maine statute provides that if both Maine Yankee and its decommissioning trust fund have insufficient assets to pay for the plant decommissioning, the owners of Maine Yankee are jointly and severally liable for the shortfall. The definition of owner under the statute covers NEP and may cover companies affiliated with it. NEP and the Retail Companies cannot determine, at this time, the constitutionality, applicability, or effect of this statute. If NEP or the Retail Companies were required to make payments under this statute, they would assess their legal remedies at that time. In any event, NEP and the Retail Companies would attempt to recover through rates any payments required. If any claim in excess of NEP's ownership share were enforced against a NEES company, that company would seek reimbursement from any other Maine Yankee stockholder which failed to pay its share of such costs. The Energy Policy Act of 1992 assesses the domestic nuclear power industry for a portion of costs associated with the decontamination and decommissioning of the Department of Energy's (DOE) uranium enrichment facilities. An annual assessment of $150 million (escalated for inflation) on the domestic nuclear power industry will be allocated to each plant based upon the amount of DOE uranium enrichment services utilized in the past. The total DOE assessment, which began in October 1992, will remain in place for up to 15 years and will amount to $2.25 billion (escalated). The Yankees, Millstone 3 and Seabrook have been assessed and initial billings indicate NEP's obligation for such costs over the next 14 years will be approximately $29 million. In accordance with the provisions of the Energy Policy Act, these costs are being recovered through NEP's fuel clause. High-Level Waste Disposal The Nuclear Waste Policy Act of 1982 provides a framework and timetable for selection of sites for repositories of high-level radioactive waste (spent nuclear fuel) from United States nuclear plants. The DOE has entered into contracts with the Yankee Companies, the Millstone 3 joint owners, and the Seabrook 1 joint owners for acceptance of title to, and transportation and storage of, this waste. Under these contracts, each operating unit will pay fees to the DOE to cover the development and creation of waste repositories. Fees for fuel burned since April 1983 have been collected by the DOE on an ongoing basis at the rate of one tenth of a cent per KWH of net generation. Fees for generation up through April 1983 were determined by the DOE as follows: $13.2 million for Yankee Atomic, $48.7 million for Connecticut Yankee, $50.4 million for Maine Yankee, and $39.3 million for Vermont Yankee. Neither Millstone 3 nor Seabrook 1 has been assessed any fees for fuel burned through April 1983, because they did not enter commercial operation until 1986 and 1990, respectively. The Yankee Companies had several options to pay these fees. Yankee Atomic paid its fee to the DOE for the period through April 1983. The other three Yankee Companies elected to defer payment until a future date, thereby incurring interest expense. However, payment to the DOE must occur prior to the first delivery of spent fuel. Connecticut, Maine, and Vermont Yankee have segregated a portion of their respective DOE obligations in external accounts. The remainder of the funds have been used to support general capital requirements. All expect to separately fund in full in external accounts their DOE obligation (including accrued interest) prior to payment to the DOE. To the extent that any of the three Yankee Companies is unable to fully meet its DOE obligation at the prescribed time, NEP might be required to provide additional funds. Prior to such time that the DOE takes delivery of a plant's spent nuclear fuel, it is stored on site in spent fuel pools. Connecticut Yankee and Maine Yankee have adequate existing storage through the late 1990's. Millstone 3 will be able to maintain a full core discharge capability through the end of its current license. Seabrook 1's current licensed storage capacity is adequate until at least 2010. Vermont Yankee is able to maintain a full core discharge capability until 2001. Yankee Atomic has adequate on-site storage capacity for all its spent fuel. Federal legislation enacted in December 1987 directed the DOE to proceed with the studies necessary to develop and operate a permanent high-level waste disposal site at Yucca Mountain, Nevada. There is local opposition to development of this site. Although originally scheduled to open in 1998, the DOE announced in November 1989 that the permanent disposal site is not expected to open before 2010, a date the DOE has defined as optimistic. The legislation also provides for the development of a Monitored Retrievable Storage (MRS) facility and abandons plans to identify and select a second, permanent disposal site. An MRS facility would provide temporary storage for high-level waste prior to eventual permanent disposal. It is not known when an MRS facility would begin accepting deliveries. Additional delays due to political and technical problems are likely. It is extremely unlikely deliveries would be accepted prior to 1999. Federal authorities have deferred indefinitely the commercial reprocessing of spent nuclear fuel. Low-Level Waste Disposal In 1986, the Low-Level Radioactive Waste Policy Amendments Act was enacted by Congress. This statute sets a time limit of December 31, 1992, beyond which disposal of low-level waste at any of the three existing sites is impermissible. Under the statute, individual states are responsible for finding local sites for disposal or forming regional disposal compacts by defined milestone dates. As of December 1991, all of the states in which NEP holds an interest in a nuclear facility had met the 1990 milestone which required the filing of a facility operating license application or Governor's certification that the state will provide for storage, disposal, and management of waste generated after 1992. Although New Hampshire met the 1990 milestone, the arrangements made by the state did not encompass low-level waste generated by Seabrook 1 and it is currently prohibited from shipping its low-level waste out of the state. Connecticut Yankee, Millstone 3, Vermont Yankee, Maine Yankee and Yankee Atomic are currently allowed to ship low-level radioactive waste to the existing disposal site in South Carolina. The 1992 milestone required each state to file a facility operating license application. None of the states in which NEP holds an interest in a nuclear facility has met this milestone. Failure to meet this milestone means that those states may be subject to surcharges on waste shipped out of state. Disposal costs could increase significantly. Since January 1, 1993, the South Carolina low-level waste disposal site has been the only site open to accept low-level waste from NEP's units. The South Carolina site will remain open until June 30, 1994 to generators whose states are making progress toward developing their own disposal facilities. Effective June 30, 1994, the South Carolina low-level waste disposal site will be closed permanently to non- regional wastes. However, all of the nuclear facilities in which NEP has an interest have temporary storage facilities on site to meet short-term low-level radioactive waste storage requirements. Price-Anderson Act The Price-Anderson Act limits the amount of liability claims that would have to be paid in the event of a single incident at a nuclear plant to $9.2 billion (based upon 114 licensed reactors). The maximum amount of commercially available insurance coverage to pay such claims is only $200 million. The remaining $9.0 billion would be provided by an assessment of up to $79.3 million per incident levied on each of the nuclear units in the United States, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. The maximum assessment, which was most recently calculated in 1993, is to be adjusted at least every five years to reflect inflationary changes. NEP's current interest in the Yankees, Millstone 3, and Seabrook 1 would subject NEP to an $81.8 million maximum assessment per incident. NEP's payment of any such assessment would be limited to a maximum of $10.3 million per incident per year. As a result of the permanent cessation of power operation of the Yankee Atomic plant, Yankee Atomic has petitioned the NRC for an exemption from obligations under the Price-Anderson Act. Other Items Federal legislation requires emergency response plans, approved by federal authorities, for nuclear generating units. The Yankee Companies, Seabrook 1, and Millstone 3 are not currently experiencing difficulty in maintaining approval of their emergency response plans. REGULATORY AND ENVIRONMENTAL MATTERS Regulation Numerous activities of NEES and its subsidiaries are subject to regulation by various federal agencies. Under the 1935 Act, many transactions of NEES and its subsidiaries are subject to the jurisdiction of the Securities and Exchange Commission (SEC). Under the Federal Power Act, certain electric subsidiaries of NEES are subject to the jurisdiction of the FERC with respect to rates, accounting, and hydroelectric facilities. In addition, the NRC has broad jurisdiction over nuclear units and federal environmental agencies have broad jurisdiction over environmental matters. The electric utility subsidiaries of NEES are also subject to the jurisdiction of regulatory bodies of the states and municipalities in which they operate. For more information, see: RATES, page 8, Nuclear Units, page 21, RESOURCE PLANNING, page 36, Fuel for Generation, page 18, Environmental Requirements, page 29, and OIL AND GAS OPERATIONS, page 43. Hydroelectric Project Licensing NEP is the largest operator of conventional hydroelectric facilities in New England. NEP's hydroelectric projects are licensed by the FERC. These licenses expire periodically and the projects must be relicensed at that time. NEP's present licenses expire over a period from 2001 to 2020 excluding the Deerfield River Project discussed below. Upon expiration of a FERC license for a hydro project, the project may be taken over by the United States or licensed to the existing, or a new licensee. If the project were taken over, the existing licensee would receive an amount equal to the lesser of (i) fair value of the project or (ii) original cost less depreciation and amounts held in amortization reserves, plus in either case severance damages. The net book value of NEP's hydroelectric projects was $245 million as of December 31, 1993. In the event that a new license is not issued when the existing license expires, FERC must issue annual licenses to the existing licensee which will allow the project to continue operation until a new license is issued. A new license for a project may incorporate operational restrictions and requirements for additional non-power facilities (e.g., recreational facilities) that could affect operation of the project, and may also require additional capital investment. For example, NEP has previously received new licenses for projects on the Connecticut River that involved construction of an extensive system of fish ladders. The license for the 84 MW Deerfield River Project expired at the end of 1993. NEP filed an application for a new license in 1991, which is still under review. Several advocacy groups have intervened proposing operational modifications which would reduce the energy output of the project substantially. FERC has issued NEP an annual license to continue operation of the project under the terms and conditions of the expired license until a new license issues or other disposition of the project takes place. The next NEP project to require a new license will be the 368 MW Fifteen Mile Falls Project on the Connecticut River in New Hampshire and Vermont. This license expires in 2001. The formal process of preparing an application for a new license will begin in 1996. FERC has recently issued a Notice of Inquiry regarding the decommissioning of licensed hydroelectric projects. Responses to this notice are still under review at FERC. Some parties have advocated positions in this docket that would draw into question recovery of investment and severance damages in the event of project decommissioning. Depending upon the scope of any project decommissioning regulations, the associated costs could be substantial. Environmental Requirements Existing Operations The NEES subsidiaries are subject to federal, state, and local environmental regulation of, among other things: wetlands and flood plains; air and water quality; storage, transportation, and disposal of hazardous wastes and substances; underground storage tanks; and land-use. It is likely that the stringency of environmental regulation affecting the System and its operations will increase in the future. Siting and Construction Activities for New Facilities All New England states require, in certain circumstances, regulatory approval for site selection or construction of electric generating and major transmission facilities. Connecticut, Maine, Massachusetts, New Hampshire, and Rhode Island also have programs of coastal zone management that might restrict construction of power plants and other electrical facilities in, or potentially affecting, coastal areas. All agencies of the federal government must prepare a detailed statement of the environmental impact of all major federal actions significantly affecting the quality of the environment. The New England states have environmental laws which require project proponents to prepare reports of the environmental impact of certain proposed actions for review by various agencies. Except for the planned Manchester Street Repowering Project, the System is not currently constructing generating plants or major transmission facilities. Environmental Expenditures Total System capital expenditures for environmental protection facilities have been substantial. System capital expenditures for such facilities amounted to approximately $29 million in 1991, $31 million in 1992, and $23 million in 1993, including expenditures by NEP of $25 million, $28 million, and $14 million, respectively, for those years. The System estimates that total capital expenditures for environmental protection facilities will be approximately $65 million in 1994 ($50 million by NEP) and $25 million in 1995 ($15 million by NEP). Hazardous Substances The United States Environmental Protection Agency (EPA) has established a comprehensive program for the management of hazardous waste. The program allows individual states to establish their own programs in coordination with the EPA; Massachusetts, New Hampshire, Vermont, and Rhode Island have established such programs. Both the EPA and Massachusetts regulations cover certain operations at Brayton Point and Salem Harbor. Other System activities, including hydroelectric and transmission and distribution operations, also involve some wastes that are subject to EPA and state hazardous waste regulation. In addition, numerous System facilities are subject to federal and state underground storage tank regulations. The EPA regulates the manufacture, distribution, use, and disposal of polychlorinated biphenyls (PCB), which are found in dielectric fluid used in some electrical equipment. The System has completed the removal from service of all PCB transformers and capacitors. Some electrical equipment contaminated with PCBs remains in service. At sites where PCB equipment has been operated, removal, disposal, and replacement of contaminated soils may be required. The Federal Comprehensive Environmental Response, Compensation and Liability Act, more commonly known as the "Superfund" law, imposes strict, joint and several liability, regardless of fault, for remediation of property contaminated with hazardous substances. Parties liable include past and present site owners and operators, transporters that brought wastes to the site, and entities that generated or arranged for disposal or treatment of wastes ultimately disposed of at the site. A number of states, including Massachusetts, have enacted similar laws. The electric utility industry typically utilizes and/or generates in its operations a range of potentially hazardous products and by-products. These products or by-products may not have previously been considered hazardous, and may not currently be considered hazardous, but may be identified as such by federal, state, or local authorities in the future. NEES subsidiaries currently have in place an environmental audit program intended to enhance compliance with existing federal, state, and local requirements regarding the handling of potentially hazardous products and by-products. Federal and state environmental agencies, as well as private parties, have contacted or initiated legal proceedings against NEES and certain subsidiaries regarding liability for cleanup of sites alleged to contain hazardous waste or substances. NEES and/or its subsidiaries have been named as a potentially responsible party (PRP) by either the EPA or the Massachusetts Department of Environmental Protection (DEP) for 18 sites (6 for NEP, 13 for Mass. Electric, and 2 for Narragansett) at which hazardous waste is alleged to have been disposed. NEES and its subsidiaries are also aware of other sites which they may be held responsible for remediating and it is likely that, in the future, NEES and its subsidiaries will become involved in additional proceedings demanding contribution for the cost of remediating additional hazardous waste sites. The most prevalent types of hazardous waste sites that NEES and its subsidiaries have been connected with are former manufactured gas locations. Until the early 1970s, NEES was a combined electric and gas holding company system. Gas was manufactured from coal and oil until the early 1970s to supply areas in which natural gas was not yet available or for peaking purposes. Among the waste byproducts of that process were coal and oil tars. The NEES companies are currently aware of approximately 40 locations at which gas may have been manufactured and/or stored. Of the manufactured gas locations, 17 have been listed for investigation by the DEP. Two manufactured gas plant locations that have been the subject of extensive litigation are discussed in more detail below: the Pine Street Canal Superfund site in Burlington, Vermont and a site located in Lynn, Massachusetts. Approximately 18 parties, including NEES, have been notified by the EPA that they are PRPs for cleanup of the Pine Street Canal site, at which coal tar and other materials were deposited. Between 1931 and 1951, NEES and its predecessor owned all of the common stock of Green Mountain Power Corporation. Prior to, during, and after that time, gas was manufactured at the Pine Street Canal site. The EPA had brought a lawsuit against NEES and other parties to recover all of the EPA's past and future response costs at this site. In 1990, the litigation ended with the filing of a final consent decree with the court. Under the terms of the settlement, to which 14 entities were party, the EPA recovered its past response costs. NEES recorded its share of these costs in 1989. NEES remains a PRP for ongoing and future response costs. In November 1992, the EPA proposed a cleanup plan estimated by the EPA to cost $50 million. In June 1993, the EPA withdrew this cleanup plan in response to public concern about the plan and the cost. It is not known at this time what the ultimate cleanup plan will be, how much it will cost, or what portion NEES will have to pay. On May 26, 1993, the United States Court of Appeals for the First Circuit affirmed on appeal an earlier adverse decision against NEES and two of its subsidiaries, Mass. Electric and New England Power Service Company, with respect to the Lynn, Massachusetts site which was once owned by an electric and gas utility formerly owned by NEES. The electric operations of this subsidiary were merged into Mass. Electric. The decision held NEES and these subsidiaries liable for cleanup of the properties involved in the case. Although the circumstances differ from location to location, the Court of Appeals opinion has adverse implications for the potential liability of NEES and its subsidiaries with respect to other gas manufacturing locations operated by gas utilities once owned by NEES. In November 1993, the MDPU approved a rate agreement filed by Mass. Electric (see RATES, page 8) that resolved all rate recovery issues related to Massachusetts manufactured gas sites formerly owned by NEES or its subsidiaries as well as certain other Massachusetts hazardous waste sites. The agreement allows for these costs to be met by establishing a special fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. NEES had previously established approximately $40 million of reserves related to Massachusetts manufactured gas locations earlier in 1993 and in prior years. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. The agreement also provides that contributions of $3 million, adjusted for inflation, be added to the fund each year by Mass. Electric and be recoverable in rates. Under the agreement, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Predicting the potential costs to investigate and remediate hazardous waste sites continues to be difficult. Factors such as the evolving nature of remediation technology and regulatory requirements and the particular characteristics of each site, including, for example the size of the site, the nature and amount of waste disposed at the site, and the surrounding geography and land use, make precise estimates difficult. There are also significant uncertainties as to the portion, if any, of the investigation and remediation costs of any particular hazardous waste site that may ultimately be borne by NEES or its subsidiaries. At year end 1993, NEES had total reserves for environmental response costs of $56 million and a related regulatory asset of $19 million. NEES and each of its subsidiaries believe that hazardous waste liabilities for all sites of which each is aware, and which are not covered by a rate agreement, will not be material (10% of common equity) to their respective financial positions. Where appropriate, the NEES companies intend to seek recovery from their insurers and from other PRPs, but it is uncertain whether, and to what extent, such efforts would be successful. NEP, in burning coal and oil to produce electricity, produces approximately 308,000 tons per year of coal ash and other coal combustion by-products and 18,500 tons per year of oil ash. In August 1993, the EPA determined that coal combustion byproducts would not be regulated as a hazardous waste. The EPA is expected to issue regulations regarding oil ash treatment in 1997. The EPA and the New England states in which System companies operate regulate the removal and disposal of material containing asbestos. Asbestos insulation is found extensively on power plant equipment and, to a lesser extent, in buildings and underground electric cable. System companies routinely remove and dispose of asbestos insulation during equipment maintenance. Electric and Magnetic Fields (EMF) In recent years, concerns have been raised about whether EMF, which occur near transmission and distribution lines as well as near household wiring and appliances, cause or contribute to adverse health effects. Numerous studies on the effects of these fields, some of them sponsored by electric utilities (including NEES companies), have been conducted and are continuing. Some of the studies have suggested associations between certain EMF and various types of cancer, while other studies have not substantiated such associations. In February 1993, the EPA called for significant additional research on EMF. It is impossible to predict the ultimate impact on NEES subsidiaries and the electric utility industry if further investigations were to demonstrate that the present electricity delivery system is contributing to increased risk of cancer or other health problems. Several state courts have recognized a cause of action for damage to property values in transmission line condemnation cases based on the fear that power lines cause cancer. It is difficult to predict what impact there would be on the NEES companies if this cause of action is recognized in the states in which NEES companies operate and in contexts other than condemnation cases. Bills have been introduced in the Rhode Island Legislature to require transmission lines to be placed underground. In July 1993, two bills passed by the legislature restricting the construction of overhead transmission lines were vetoed by the governor. EMF- related legislation has also been introduced in Massachusetts. Air Under federal regulations, each New England state has issued a state implementation plan that limits air pollutants emitted from facilities such as generating stations. These implementation plans are intended to ensure continued maintenance of national and state ambient air quality standards, where such standards are currently met. The plans are also intended to bring areas not currently meeting standards into compliance. In 1985, the Massachusetts legislature enacted an acid rain law that requires that sulphur dioxide (SO2) emissions from fossil fuel generating stations be reduced. Regulations implementing the statute were adopted in 1989. Emission reductions required by the regulations must be fully implemented by January 1, 1995, and will require NEP to use more costly lower sulphur oil and coal and make capital expenditures. Use of natural gas at Brayton 4 is one of NEP's methods for helping to meet the requirements of the acid rain law. See Fuel for Generation - Natural Gas, page 19. NEP may also use emission credits for conservation from non-combustion energy sources and cogeneration technology toward meeting the law's requirements. NEP produces approximately 50% of its electricity at eight older thermal generating units located in Massachusetts. The 1990 amendments to the federal Clean Air Act require a significant reduction in the nation's SO2 and nitrogen oxide (NOx) emissions by the year 2000. Under the amendments, NEP is not subject to Phase 1 of the acid rain provisions of the federal law that will become effective in 1995. However, NEP is subject to the Massachusetts SO2 acid rain law that will become effective in 1995. Phase 2 of the federal acid rain requirements, effective in 2000, will apply to NEP and its units. Under the federal Clean Air Act, state environmental agencies in ozone non-attainment areas were required to develop regulations (also known as Reasonably Available Control Technology requirements, or RACT) that will become effective in 1995 to address the first phase of ozone air quality attainment. These regulations were adopted in Massachusetts in September 1993. The RACT regulations require control technologies (such as low NOx burners) to reduce NOx emissions, an ozone precursor. Additional control measures may be necessary to ensure attainment of the ozone standard. These measures would have to be developed by the states in 1994 and fully implemented no later than 1999. The extent of these additional control measures is unknown at this time, but could range from minor additions to the RACT requirements to extensive emission reduction requirements, such as costly add-on controls or fuel switching. To date, NEP has expended approximately $7 million of one-time operation and maintenance costs and $50 million of capital costs in connection with Massachusetts and federal Clean Air Act compliance requirements. NEP expects to incur additional one-time operation and maintenance costs of approximately $18 million and capital costs of approximately $70 million in 1994 and 1995 to comply with the federal and state clean air requirements that will become effective in 1995. In addition, as a result of federal and state clean air requirements, NEP will begin incurring increased fuel costs which are estimated to reach an annual level of $13 million by 1995. The generation of electricity from fossil fuels may emit trace amounts of hazardous air pollutants as defined in the Clean Air Act Amendments of 1990. The Act mandates a study of the potential dangers of hazardous air pollutant emissions from electric utility plants. Such research is currently under way and is expected to be complete in 1995. The study conclusions could result in new emission standards and the need for additional costly controls on NEP plants. At this time, NEES and its subsidiaries cannot estimate the impact that findings of this research might have on operations. The federal Clean Air Act Amendments of 1990 and the Rio Convention on global climate change have increased the public focus on industrial emissions to the air. Electric utilities' use of fossil fuels is a significant source of emissions which evoke concerns about such issues as acid rain, ozone levels, global warming, small particulates, and hazardous air pollutants. Should the 1999 ozone attainment requirements be extensive or additional Clean Air Act Amendments or other environmental requirements be imposed, continued operation of certain existing generating units of NEP beyond 1999 could be uneconomical. NEP believes that premature retirement of substantially all of its older thermal generating units would cause substantial rate increases. Water The federal Clean Water Act prohibits the discharge of any pollutant (including heat), except in compliance with a discharge permit issued by the states or the EPA for a term of no more than five years. NEP and Narragansett have received required permits for all their steam-generating plants. NEET has received its required surface water discharge permits for all of its current operations. Occasional violations of the terms of these permits have occurred. NEES facilities store substantial amounts of oil and are required to have spill prevention control and counter-measure (SPCC) plans. Currently, major System facilities such as Brayton Point and Salem Harbor have up-to-date SPCC plans. A comprehensive study of smaller facilities has been completed to determine the appropriate plans for these facilities and a five-year implementation plan has been developed. Nuclear The NRC, along with other federal and state agencies, has extensive regulations pertaining to environmental aspects of nuclear reactors. Safety aspects of nuclear reactors, including design controls and inspection programs to mitigate any possibility of nuclear accidents and to reduce any damages therefrom, are also subject to NRC regulation. See Nuclear Units, page 21. RESOURCE PLANNING Load Forecasts and History The Retail Companies currently forecast an increase in KWH sales of 1.4% in 1994. The System has been projecting that, in the absence of significant energy conservation by its customers, annual weather-normalized peak load growth over the next 15 years will average approximately 2.3%. Peak load growth would be limited to about 1.1% annually over this period if planned DSM programs described below are successfully implemented. These projections are being updated. During the late 1980s unusually high load growth caused a tight capacity situation to develop for both the System and the New England region. More recently, the sluggish regional economy plus the addition of new generating facilities in the region alleviated concerns about inadequate resources for the next several years. Future resource additions from the Manchester Street repowering project described below and contracts with non-utility generators along with the continued demand-side management programs are expected to meet NEP's resource needs until approximately 2000. Additional new capacity may be required in that time frame. A return to the high load growth of the late 1980s, the cancellation of future planned capacity, or the shutdown of existing capacity could necessitate additional generation or power purchase contracts on the supply-side, or demand-side conservation and load management programs, in order to meet customer demands. Corporate Plans NEES has a history of planning for change to meet resource requirements and other goals. NEES' current plan, called NEESPLAN 4, was completed in 1993. NEESPLAN 4 attempts to reconcile the increasing importance and cost of environmental impact mitigation and utilities' traditional obligation to serve, with growing competition at all levels in the industry. NEESPLAN 4 also addresses planning methodology and implements a resource strategy that restricts commitments to those necessary to meet highly certain loads, and develops options on future resources to meet less certain loads and meet future fuel diversity needs. The new plan also strengthens the emission reduction goals previously established by the System and calls for CO2, SOx, and NOx reductions by 2000 to 20%, 60%, and 60%, respectively, below 1990 levels. Most of this reduction will come from current plans and commitments, including demand-side management, the Manchester Street repowering, increased use of natural gas and lower sulphur fuels, the installation of emission control equipment, low NOx burners, combustion controls, and other new power sources entering the energy mix through the year 2000. Many of these actions are being taken to comply with state and federal environmental laws. See Environmental Requirements, page 29. The remaining improvement will come from actions beyond current commitments. They may include further fuel conversions or efficiency improvements in power plants and the transmission and distribution system, as well as competitively acquired renewable resources and greenhouse gas offsets. NEP is currently participating in an experimental project investigating greenhouse gas offsets which involves funding the use of improved forestry techniques in Malaysia to limit unnecessary destruction of forests. Past NEES plans have concerned similar challenging issues the System faced and continues to address. In 1979, NEES instituted NEESPLAN, the key objectives of which were to keep customer costs to a minimum and to reduce the System's reliance on foreign oil. In 1985, NEES announced an updated plan, NEESPLAN II, the objectives of which were to provide an adequate supply of electricity to customers at the lowest possible cost and to encourage customers to use electricity efficiently. NEESPLAN 3, announced in 1990, continued these objectives and directly addressed the environmental impacts of providing electricity service. Demand-Side Management As mentioned above, the System believes that DSM programs are an important part of meeting its resource goals. Since 1987, the System has put in place a series of customer programs for encouraging electric conservation and load management. Through these DSM programs, the System has achieved over 825,000 MWh of annual energy savings. During 1993, the System spent a total of $76 million on DSM programs and related expenses. The System has budgeted to spend up to $103 million in 1994. Recovery of these expenditures through rates on a current, as incurred, basis has been approved by the various regulatory commissions. See RATES, page 8. Manchester Street Station Repowering The NEES subsidiaries' major construction project is the repowering of the Manchester Street Station, a 140 MW electric generating station in Providence, R.I. During 1993, construction continued on the joint Narragansett/NEP project. The project began in 1992 and remains on schedule and within budget, with an expected in-service date of late 1995. Narragansett and NEP operate three steam electric generating units of approximately 50 MW each which went into service at Manchester Street Station in the 1940s. During 1992, NEP acquired a 90% interest in the site and the Station in anticipation of the repowering project. As part of the repowering project, three new combustion turbines and heat recovery steam generators will be added to the Station, replacing the existing boilers. The existing steam turbines will be replaced with new and more efficient turbines of slightly larger capacity. The fuel for generation, which is now primarily residual oil, will be replaced with natural gas, using distillate oil as an emergency backup. See Fuel for Generation, page 18. Repowering will more than triple the power generation capacity of Manchester Street Station, and substantially increase the plant's thermal efficiency. It is expected that the plant's capacity factor will also increase. Certain air emissions are projected to decrease relative to historical levels because of the change in fuels and the increase in efficiency. Substantial additions to Narragansett's high voltage transmission network will be necessary in order to accommodate the output of the plant. Two 7-mile 115 kV underground transmission cables (located primarily in public ways) are under construction to connect the repowered station to existing 115 kV lines at a new substation. Total cost for the generating station, scheduled for completion in late 1995, is estimated to be approximately $525 million, including AFDC. In addition, related transmission work, which is principally the responsibility of Narragansett, is estimated to cost approximately $75 million and is scheduled for completion in late 1994. At December 31, 1993, $161 million, including AFDC, has been spent on the project which includes the related transmission work. Substantial commitments have been made relative to future planned expenditures for this project. Regulation The activities and specific projects in the System's resource plans are subject to regulation by state and federal authorities. Approval by these agencies is necessary to site and license new facilities and to recover the costs for new DSM programs and non- utility resources. See Regulation, page 28. Research and Development Expenditures for the System's research and development activities totaled $9.5 million, $8.9 million, and $8.8 million in 1993, 1992, and 1991, respectively. Total expenditures are expected to be about $12 million in 1994. About 50% of these expenditures support the Electric Power Research Institute, which conducts research and development activities on behalf of its sponsors and provides NEES companies with access to a wide range of relevant research results at minimum cost. The System also directly funds research projects of a more site-specific concern to the System and its customers. These projects include: - creating options to allow the use of economically-priced fossil fuels without adversely affecting plant performance, and to insure safe, reliable and environmentally sound production of electric energy at the lowest cost; - developing and assessing new information and methods to understand and reduce the environmental impacts of System operations including investigation of offset methods for counterbalancing greenhouse gas emissions away from the source; - developing, assessing and demonstrating new generation technologies and fuels that will ensure economic, efficient and environmentally sound production of electric energy in the future; - creating options to maintain electric service quality and reliability for customers at the lowest cost; and - developing conservation, load control, and rate design measures that will help customers use electric energy more efficiently. Construction and Financing Estimated construction expenditures (including nuclear fuel) for the System's electric utility companies are shown below for 1994 through 1996. The System conducts a continuing review of its construction and financing programs. These programs and the estimates shown below are subject to revision based upon changes in assumptions as to System load growth, rates of inflation, receipt of adequate and timely rate relief, the availability and timing of regulatory approvals, new environmental and legal or regulatory requirements, total costs of major projects, and the availability and costs of external sources of capital. The anticipated capital requirements for oil and gas operations are not included in the table below. See OIL AND GAS OPERATIONS page 43. Estimated Construction Expenditures ----------------------------------- 1994 1995 1996 Total ---- ---- ---- ----- (In Millions - excluding AFDC) NEP - --- Manchester St. Station Generation $145 $ 95 $ 40 $ 280 Manchester St. Station Substation 10 0 0 10 Other Generation (1) 70 50 60 180 Other Transmission 15 15 20 50 ---- ---- ---- ------ Total NEP $240 $160 $120 $ 520 ---- ---- ---- ------ Mass. Electric - -------------- Distribution $ 90 $ 90 $ 95 $ 275 Narragansett - ------------ Manchester St. Station Generation $ 15 $ 15 $ 5 $ 35 Manchester St. Station Transmission/ 30 0 0 30 Substation Other Transmission 15 15 15 45 Distribution 20 25 25 70 ---- ---- ---- ------ Total Narragansett $ 80 $ 55 $ 45 $ 180 ---- ---- ---- ------ Granite State - ------------- Distribution $ 5 $ 5 $ 5 $ 15 ---- ---- ---- ------ Other $ 10 $ 0 $ 0 $ 10 - ----- ---- ---- ---- ------ Combined Total - -------------- Manchester St. Station Generation $160 $110 $ 45 $ 315 Manchester St. Station Transmission/ 40 0 0 40 Substation Other Generation (1) 70 50 60 180 Other Transmission 40 30 35 105 Distribution 115 120 125 360 ---- ---- ---- ------ Grand Total $425 $310 $265 $1,000 ---- ---- ---- ------ (1) Includes Nuclear Fuel Financing The proportion of construction expenditures estimated to be financed by internally generated funds during the period from 1994 to 1996 is: NEP 80% Mass. Electric 80% Narragansett 70% Granite State 80% The general practice of the operating subsidiaries of NEES has been to finance construction expenditures in excess of internally generated funds initially by issuing unsecured short-term debt. This short-term debt is subsequently reduced through sales by such subsidiaries of long-term debt securities and preferred stock, and through capital contributions from NEES to the subsidiaries. NEES, in turn, generally has financed capital contributions to the operating subsidiaries through retained earnings and the sale of additional NEES shares. Since April 1991, NEES has been meeting all of the requirements of its dividend reinvestment and common share purchase plan and employee share plans through open market purchases. Under these plans, NEES may revert to the issuance of new common shares at any time. The ability of NEP and the Retail Companies to issue short-term debt is limited by regulatory restrictions, by provisions contained in their charters, and by certain debt and other instruments. Under the charters or by-laws of NEP, Mass. Electric, and Narragansett, short-term debt is limited to 10% of capitalization. The preferred stockholders authorized these limitations to be increased to 20% of capitalization until the late 1990's, at which time the limits will revert to 10% of capitalization. The following table summarizes the short-term debt limits at December 31, 1993, and the amount of outstanding short-term debt at such date. ($ millions) Limit Outstanding ----- ----------- NEP 315 51 Mass. Electric 139 38 Narragansett 75 20 Granite State 10 - In order to issue additional long-term debt and preferred stock, NEP and the Retail Companies must comply with earnings coverage requirements contained in their respective mortgages, note agreements, and preference provisions. The most restrictive of these provisions in each instance generally requires (1) for the issuance of additional mortgage bonds by NEP, Mass. Electric, and Narragansett, for purposes other than the refunding of certain outstanding mortgage bonds, a minimum earnings coverage (before income tax) of twice the pro forma annual interest charges on mortgage bonds, and (2) for the issuance of additional preferred stock by NEP, Mass. Electric, and Narragansett, minimum gross income coverage (after income tax) of one and one-half times pro forma annual interest charges and preferred stock dividends, in each case for a period of twelve consecutive calendar months within the fifteen calendar months immediately preceding the proposed new issue. The respective long-term debt and preferred stock coverages of NEP and the Retail Companies under their respective mortgage indentures, note agreements, and preference provisions, are stated in the following table for the past three years: Coverage ----------------------- 1993 1992 1991 ---- ---- ---- NEP - --- General and Refunding Mortgage Bonds 4.66 4.15 4.02 Preferred Stock 2.76 2.80 2.71 Mass. Electric - -------------- First Mortgage Bonds 3.15 3.60 3.07 Preferred Stock 2.02 2.14 2.12 Narragansett - ------------ First Mortgage Bonds 2.47 3.79 2.98 Preferred Stock 1.78 2.52 2.06 Granite State - ------------- Notes (1) 2.41 2.53 1.98 (1) As defined under the most restrictive note agreement. OIL AND GAS OPERATIONS GENERAL Since 1974, NEEI has engaged in oil and gas exploration and development, primarily through a partnership with Samedan Oil Corporation (Samedan), a subsidiary of Noble Affiliates, Inc. NEEI's oil and gas activities are regulated by the SEC under the 1935 Act. Under the terms of the Samedan-NEEI partnership agreement, Samedan is the managing partner and oversees all partnership operations including the sale of production. Effective January 1, 1987, NEEI decided not to acquire new oil and gas prospects due to prevailing and expected oil and natural gas market conditions. This decision did not affect NEEI's interests and commitments in oil and gas properties owned as of December 31, 1986 by the Samedan-NEEI partnership. Samedan continues to explore, develop, and manage these properties on behalf of the partnership. Thus, the results of NEEI's operations are substantially affected by the performance of Samedan. Samedan may elect to terminate the partnership at the end of any calendar year upon one year's prior notice. NEEI is required to obtain SEC approval for further investment in these oil and gas properties. On December 21, 1993, the SEC issued an order authorizing NEEI to invest up to $10 million in its partnership with Samedan during 1994. The SEC has reserved jurisdiction over an additional $5 million of spending authority. NEEI is winding down its oil and gas program. The level of expenditures for exploration and development of existing properties has declined as a result of the decision not to acquire new oil and gas prospects after December 31, 1986. NEEI's activities are primarily rate-regulated and consist of all prospects entered into prior to 1984. Savings and losses from this rate-regulated program are being passed on to NEP and ultimately to retail customers, under an intercompany pricing policy (Pricing Policy) approved by the SEC. Due to precipitate declines in oil and gas prices, NEEI has incurred operating losses since 1986 and expects to generate substantial additional losses in the future. NEP's ability to pass such losses on to its customers was favorably resolved in NEP's 1988 FERC rate settlement. This settlement covered all costs incurred by or resulting from commitments made by NEEI through March 1, 1988. Other subsequent costs incurred by NEEI are subject to normal regulatory review. NEEI follows the full cost method of accounting for its oil and gas operations, under which capitalized costs (including interest paid to banks) relating to wells and leases determined to be either commercial or non-commercial are amortized using the unit of production method. Due to the Pricing Policy, NEEI's rate-regulated program has not been subject to certain SEC accounting rules, applicable to non-rate-regulated companies, which limit the costs of oil and gas property that can be capitalized. The Pricing Policy has allowed NEEI to capitalize all costs incurred in connection with fuel exploration activities of its rate regulated program, including interest paid to banks of which $9 million, $14 million, and $22 million was capitalized in 1993, 1992, and 1991, respectively. In the absence of the Pricing Policy, the SEC's full cost "ceiling test" rule requires non-rate regulated companies to write-down capitalized costs to a level which approximates the present value of their proved oil and gas reserves. Based on NEEI's 1993 average oil and gas selling prices and NEEI's proved reserves at December 31, 1993, if this test were applied, it would have resulted in a write-down of approximately $138 million after-tax. RESULTS OF OPERATIONS Revenues from natural gas sales were approximately 13% higher in 1993 than 1992 even though NEEI's natural gas production declined by about 9%. NEEI expects 1994 natural gas revenues to be slightly higher than 1993 revenues on slightly lower total production. NEEI's 1993 oil and gas exploration and development expenditures were $9 million. NEEI's estimated proved reserves decreased from 17.3 million barrels of oil and gas equivalent at December 31, 1992, to 15.1 million barrels of oil and gas equivalent at December 31, 1993. Production, primarily from offshore Gulf properties, decreased reserves by 3.8 million equivalent barrels. Additions and revisions primarily on offshore Gulf properties increased reserves by 1.6 million equivalent barrels. Prices received by NEEI for its natural gas varied considerably during 1993, from approximately $1.31/MCF to $2.90/MCF, due principally to seasonal fluctuations and regional variations in gas prices. NEEI's overall average gas price in 1993 was $1.96/MCF. The results of NEEI's oil and gas program will continue to be affected by developments in the world oil market and the domestic market for natural gas, including actions by the federal government and by foreign governments, which may affect the price of oil and gas, the terms of contracts under which gas is sold, and changes in regulation of the domestic interstate gas pipelines. The following table summarizes NEEI's crude oil and condensate production in barrels, natural gas production in MCF, and the average sales price per barrel of oil and per MCF of natural gas produced by NEEI during the years ended December 1993, 1992, and 1991, and the average production (lifting) cost per dollar of gross revenues. Years Ended December 31, ---------------------------------- 1993 1992 1991 ---- ---- ---- Crude oil and condensate production (barrels) 477,545 506,428 435,890 Natural gas production 19,696,944 21,514,986 17,904,015 (MCF) Average sales price per barrel of oil and $17.05 $19.34 $22.80 condensate Average sales price per MCF of natural gas $1.96 $1.59 $1.61 Average production cost (including severance taxes) per dollar of gross revenue $0.14 $0.17 $0.18 OIL AND GAS PROPERTIES During 1993, principal producing properties, representing 58% of NEEI's 1993 revenues, were (i) a 50% working interest in Brazos Blocks A-52, A-53, A-65, and A-37 located in federal waters offshore Texas, (ii) a 12% working interest in Main Pass Blocks 107 and 108, located in federal waters offshore Louisiana, (iii) a 25% working interest in Main Pass Blocks 93, 102, and 90, located in federal waters offshore Louisiana, (iv) a 20% working interest in Matagorda Island 587, located in federal waters offshore Texas, and (v) a 15% working interest in Eugene Island Block 28, located in federal waters offshore Louisiana. Other major producing properties during 1993 included a 20% working interest in Vermilion Block 114, located in federal waters offshore Louisiana, a 15% working interest in High Island Blocks 21, 22, and 34, located in federal waters offshore Texas, and a 15% working interest in West Delta 18/33, located in federal waters offshore Louisiana. As used in the tables below, (i) a productive well is an exploratory or a development well that is not a dry well, (ii) a dry well is an exploratory or development well found to be incapable of producing either oil or gas in commercial quantities, (iii) "gross" refers to the total acres or wells in which NEEI has a working interest, and (iv) "net," as applied to acres or wells, refers to gross acres or wells multiplied by the percentage working interest owned by NEEI. The following table shows the approximate undeveloped acreage held by NEEI as of December 31, 1993. Undeveloped acreage is acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and gas, regardless of whether such acreage contains proved reserves. Location Gross Acres Net Acres -------- ----------- --------- Offshore-Gulf of Mexico 124,209 21,676 Other 278,203 49,756 ------- ------ Total 402,412 71,432 During the years ended December 31, 1993, 1992, and 1991 NEEI participated in the completion of the following net exploratory and development wells: Net Exploratory Wells Net Development Wells --------------------- --------------------- Year Ended Productive* Dry Productive* Dry ---------- ---------- --- ---------- --- December 31, 1993 0 2 0 0 December 31, 1992 2 0 0 0 December 31, 1991 1 4 3 5 * Includes depleted wells The following table summarizes the total gross and net productive wells and the approximate total gross and net developed acres, both as of December 31, 1993: Oil Gas Developed Acres --- --- --------------- Gross Net Gross Net Gross Net ----- --- ----- --- ----- --- 139 16 557 64 312,492 57,400 At December 31, 1993, NEEI was in the process of drilling or completing 4 gross and 0 net wells. CAPITAL REQUIREMENTS AND FINANCING Estimated expenditures in 1994 for NEEI's exploration and development program are approximately $10 million which is the amount authorized by the SEC. In addition, NEEI's estimated 1994 interest costs are approximately $10 million. Internal funds are expected to provide 100% of NEEI's capital requirements for 1994. In 1989, NEEI refinanced its outstanding borrowings through a credit agreement which currently provides for borrowings of up to $275 million. Borrowings under this credit agreement are principally secured by a pledge of NEEI's rights with respect to NEP under the Pricing Policy covering the rate-regulated program. The amount available for borrowing under the revolving credit agreement decreases by varying amounts annually, beginning December 31, 1995 and expiring December 31, 1998. NEEI MAP Major Oil and Gas Properties EXECUTIVE OFFICERS NEES - ---- All executive officers are elected to continue in office subject to Article 19 of the Agreement and Declaration of Trust until the first meeting of the Board of Directors following the next annual meeting of shareholders, or the special meeting of shareholders held in lieu of such annual meeting, and until their successors are chosen and qualified. The executive officers also serve as officers and/or directors of various subsidiary companies. John W. Rowe - Age: 48 - President and Chief Executive Officer since 1989 - Elected Chairman of NEP in 1993 - President of NEP from 1991 to 1993 - Chairman of NEP from 1989 to 1991 - President and Chief Executive Officer of Central Maine Power Company from 1984 to 1989. Frederic E. Greenman - Age: 57 - Senior Vice President since 1987 - General Counsel since 1985 - Secretary since 1984 - Vice President of NEP since 1979. Alfred D. Houston - Age: 53 - Elected Executive Vice President in 1994 - Senior Vice President-Finance from 1987 to 1994 - Vice President-Finance from 1985 to 1987 - Vice President of NEP since 1987 - Vice President of Narragansett since 1976 - Treasurer of Narragansett since 1977. John W. Newsham - Age 61 - Vice President since 1991 - Executive Vice President of NEP since 1993 - Vice President of NEP and Director of Thermal Production from 1987 to 1993. Richard P. Sergel - Age: 44 - Vice President since 1992 - Treasurer from 1990 to 1991 - Chairman of Mass. Electric and Narragansett since 1993 - Treasurer of NEP and Mass. Electric from 1990 to 1991 - Vice President of the Service Company since 1988 - Director of Rates from 1982 to 1990. Jeffrey D. Tranen - Age: 47 - Vice President since 1991 - President of NEP since 1993 - Vice President of NEP from 1984 to 1993 - Vice President of Mass. Hydro, N.H. Hydro, and NEET from 1987 to 1991 - President of Mass. Hydro, N.H. Hydro, and NEET since 1991. Michael E. Jesanis - Age: 37 - Treasurer since 1992 - Director of Corporate Finance from 1990 to 1991 - Manager, Financial Planning from 1986 to 1990. NEP - --- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the Board of Directors to hold office subject to the pleasure of the directors and until the first meeting of directors after the next annual meeting of stockholders and until their successors are duly chosen and qualified. Certain officers of NEP are, or at various times in the past have been, officers and/or directors of the System companies with which NEP has entered into contracts and had other business relations. Jeffrey D. Tranen* - President since 1993 - Vice President from 1984 to 1993. John W. Rowe* - Chairman since 1993 - President from 1991 to 1993 - Chairman from 1989 to 1991. John W. Newsham* - Executive Vice President since 1993 - Vice President from 1987 to 1993. Lawrence E. Bailey - Age: 50 - Vice President since 1989 - Plant Manager of Brayton Point Station from 1987 to 1991. Jeffrey A. Donahue - Age: 35 - Vice President since 1993 - various engineering positions with the Service Company since 1983 - Director of Construction since 1992 - Chief Electrical Engineer since 1991. Frederic E. Greenman* - Vice President since 1979. Alfred D. Houston* - Vice President since 1987 - Treasurer from 1983 to 1987. John F. Malley - Age: 45 - Vice President since 1992 - Manager of Generation Planning for the Service Company from 1986 to 1991. Arnold H. Turner - Age: 53 - Vice President since 1989 - Director of Planning and Power Supply since 1985. Jeffrey W. VanSant - Age: 40 - Vice President since 1993 - Manager of Oil and Gas Exploration and Development for the Service Company from 1985 to 1993 - Manager of Oil and Gas Procurement from 1992 to 1993 - Manager of Natural Gas Supply from 1989 to 1992. Michael E. Jesanis* - Treasurer since 1992. Howard W. McDowell - Age: 50 - Controller since 1987 - Controller of Mass. Electric and Narragansett since 1987 - Treasurer of Granite State since 1984. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding this officer. Mass. Electric - -------------- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the board of directors to hold office subject to the pleasure of the directors and until the first meeting of the directors after the next annual meeting of stockholders. Certain officers of Mass. Electric are, or at various times in the past have been, officers and directors of System companies with which Mass. Electric has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. John H. Dickson - Age: 51 - President since 1990 - Treasurer from 1985 to 1990 - Treasurer of NEES from 1985 to 1990 - Treasurer of NEP from 1987 to 1990 - Vice President of NEEI from 1982 to 1990 - Treasurer of NEEI from 1983 to 1990. David L. Holt - Age: 45 - Executive Vice President since 1993 - Vice President of NEP from 1992 to 1993 - Chief Engineer and Director of Engineering for the Service Company since 1991 - Chief Electrical Engineer for the Service Company from 1986 to 1991. John C. Amoroso - Age: 55 - Vice President since 1993 - District Manager, Southeast District from 1992 to 1993 - Manager, Southeast District from 1985 to 1992. Gregory A. Hale - Age: 43 - Vice President since 1993 - Senior Counsel for the Service Company from 1988 to 1993. Cheryl A. LaFleur - Age: 39 - Vice President since 1993 - Vice President of the Service Company from 1992 to 1993 - Assistant to the NEES Chairman and President from 1990 to 1991 - Senior Counsel for the Service Company from 1989 to 1991. Charles H. Moser - Age: 53 - Vice President since 1993 - Chief Protection and Planning Engineer for the Service Company from 1984 to 1993. Lydia M. Pastuszek - Age: 40 - Vice President since 1993 - Vice President of NEP from 1990 to 1993 - President of Granite State since 1990 - Assistant to the President of Granite State from 1989 to 1990 - Director of Demand Planning for the Service Company from 1985 to 1989. Anthony C. Pini - Age: 41 - Vice President since 1993 - Assistant Controller for the Service Company from 1985 to 1993. Nancy H. Sala - Age: 42 - Vice President since 1992 - Central District Manager since 1992 - Assistant to the President of Mass. Electric from 1990 to 1992 - Manager of the Central District for Mass. Electric from 1989 to 1990 - Manager of Petroleum Supply and NEEI Shipping for the Service Company from 1986 - 1989. Dennis E. Snay - Age: 52 - Vice President and Merrimack Valley District Manager since 1990 - Assistant to President of Mass. Electric from 1984 to 1990. Michael E. Jesanis - Treasurer since 1992 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Jesanis. Howard W. McDowell - Controller since 1987 and Assistant Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Narragansett - ------------ Officers are elected by the board of directors or appointed, as appropriate, to serve until the meeting of directors following the annual meeting of stockholders, and until their successors are chosen and qualified. Officers other than the President, Treasurer, and Secretary, serve also at the pleasure of the directors. Certain officers of Narragansett are, or at various times in the past have been, officers and directors of System companies with which Narragansett has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. Robert L. McCabe - Age: 53 - President since 1986. William Watkins, Jr. - Age 61 - Executive Vice President since 1992 - Vice President of the Service Company from 1981 to 1992. Francis X. Beirne - Age: 50 - Vice President since 1993 - Manager, Southern District from 1988 to 1993 - District Manager, Customer Service from 1983 - 1988. Richard W. Frost - Age: 54 - Vice President since 1993 - Division Superintendent of Transmission and Distribution from 1986 to 1990 - District Manager - Southern District from 1990 to 1993. Alfred D. Houston - Vice President since 1976 - Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Houston. James V. Mahoney - Age: 48 - Vice President and Director of Business Services since 1993 - President of NEEI from 1992 to 1993 - Vice President of the Service Company from 1989 to 1993 - Director of Fuel Supply for the Service Company from 1985 to 1993. Howard W. McDowell - Controller since 1987 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Item 2. Item 2. PROPERTIES See Item 1. Business - ELECTRIC UTILITY PROPERTIES, page 13 and OIL AND GAS PROPERTIES, page 45. Item 3. Item 3. LEGAL PROCEEDINGS In February 1993, a jury in Salem Massachusetts Superior Court assessed damages of $7.5 million, including interest, against Mass. Electric in a case arising from the installation by Mass. Electric of an allegedly undersized transformer for the plaintiff's manufacturing facility. Mass. Electric settled this case with its general liability insurance carrier and the plaintiff in 1993. See Item 1. RATES, page 8; Nuclear Units, page 21; Hydro Electric Project Licensing, page 28; Environmental Requirements, page 29; OIL AND GAS OPERATIONS, page 43. 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 last quarter of 1993. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS NEES information in response to the disclosure requirements specified by this Item 5. appears under the captions in the NEES Annual Report indicated below: Required Information Annual Report Caption -------------------- --------------------- (a) Market Information Shareholder Information (b) Holders Shareholder Information (c) Dividends Financial Highlights The information referred to above is incorporated by reference in this Item 5. NEP, Mass. Electric, and Narragansett - The information required by this item is not applicable as the common stock of all these companies is held solely by NEES. Information pertaining to payment of dividends and restrictions on payment of dividends is incorporated herein by reference to each company's 1993 Annual Report. Item 6. Item 6. SELECTED FINANCIAL DATA NEES ---- The information required by this item is incorporated herein by reference to page 21 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to page 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to page 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to page 24 of the Narragansett 1993 Annual Report. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. NEES ---- The information required by this item is incorporated herein by reference to pages 12 through 20 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 4 through 9 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 4 through 10 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 4 through 9 of the Narragansett 1993 Annual Report. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NEES ---- The information required by this item is incorporated herein by reference to pages 21 through 40 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 3, 10 through 27, and 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 3, 11 through 25, and 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 3, 10 through 22, and 24 of the Narragansett 1993 Annual Report. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NEES, NEP, Mass. Electric, and Narragansett - None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption ELECTION OF DIRECTORS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. Reference is also made to the information under the caption EXECUTIVE OFFICERS - NEES in Part I of this report. NEP --- The names of the directors of NEP, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - NEP in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok - Director since 1979 - Age: 64 - Chairman of the Board of NEES - Vice Chairman of the Company from 1993 to 1994 - Chairman or Vice Chairman of the Company from 1988 to 1994 - Vice Chairman of the Company from 1989 to 1991 - Chairman of NEES from 1984 to 1994 (Chairman, President, and Chief Executive Officer from July 26, 1988 until February 13, 1989). Directorships of NEES System companies: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. Other directorships: Avery Dennison Corporation, John Hancock Mutual Life Insurance Company, Monsanto Company, and the Federal Reserve Bank of Boston. Frederic E. Greenman* - Director since 1986. Directorships of NEES System companies and affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, Yankee Atomic Electric Company, Connecticut Yankee Atomic Power Company, Maine Yankee Atomic Power Company, and Vermont Yankee Nuclear Power Corporation. Alfred D. Houston* - Director since 1984. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. John W. Newsham* - Director since 1991. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Resources, Inc., and New England Power Service Company. John W. Rowe* - Director since 1989. Directorships of NEES System companies and affiliates: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, and Maine Yankee Atomic Power Company. Other directorships: Bank of Boston Corporation and UNUM Corporation. Jeffrey D. Tranen* - Director since 1991. Directorships of NEES System affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES and EXECUTIVE OFFICERS - NEP in Part I of this report for other information regarding this director. Mass. Electric -------------- The names of the directors of Mass. Electric, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Mass. Electric in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Urville J. Beaumont - Director since 1984 - Age: 61 - Treasurer and Director, law firm of Beaumont & Campbell, P.A. Joan T. Bok* - Director since 1979. Sally L. Collins - Director since 1976 - Age: 58 - Health Services Administrator at Kollmorgen Corporation EOD since January 1989 - Former Director of Medical Services at Oxbow Health Associates, Inc., Hadley, Mass. - Former member of Mass. Electric Customer Advisory Council. John H. Dickson - Director since 1990 - Reference is made to material supplied under the caption EXECUTIVE OFFICERS - Mass. Electric for other information regarding Mr. Dickson. Other directorship: Worcester Business Development Corporation. Charles B. Housen - Director since 1979 - Age: 61 - Chairman, President, and Director of Erving Industries, Inc., Erving, Mass. Dr. Kathryn A. McCarthy - Director since 1973 - Age: 69 - Research Professor of Physics at Tufts University, Medford, Mass. - Senior Vice President and Provost at Tufts from 1973 to 1979 - Other directorships: State Mutual Life Assurance Company of America. Patricia McGovern - Elected Director in 1994 - Age: 52 - Of Counsel to law firm of Goulston & Storrs, P.C. since 1993 - Massachusetts State Senator and Chair of the Senate Ways and Means Committee from 1984 to 1992. John F. Reilly - Director since 1988 - Age: 61 - President and CEO of Fred C. Church, Inc., Lowell, Mass. - Other as directorships: Colonial Gas Company and NE Insurance Co., Ltd. John W. Rowe* - Director since 1989. Richard P. Sergel* - Director since 1993. Richard M. Shribman - Director since 1979 - Age: 68 - Treasurer of Norick Realty Corporation, Salem, Mass. - President of Norick Realty Corporation until 1992 - Other directorships: Eastern Bank. Roslyn M. Watson - Director since 1992 - Age: 44 - President of Watson Ventures (commercial real estate development and management) Boston, Mass. - Vice President of the Gunwyn Company (commercial real estate development) Cambridge, Mass. from 1990 - 1993 and Project Manager from 1986 - 1990 - Other directorships: The Boston Company Funds. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES in Part I of this report and/or the material supplied under the caption DIRECTORS AND OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Narragansett ------------ The names of the directors of Narragansett, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Narragansett in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok* - Director since 1979. Stephen A. Cardi - Director since 1979 - Age: 52 - Treasurer and Director of Cardi Corporation (construction), Warwick, R.I. Frances H. Gammell - Director since 1992 - Age: 44 - Director, Vice President of Finance, and Secretary of Original Bradford Soap Works, Inc. Joseph J. Kirby - Director since 1988 - Age: 62 - President of Washington Trust Bancorp, Inc., Westerly, R.I. and President and Director of the Washington Trust Company. Robert L. McCabe - President and Director of Narragansett since 1986 - Other directorship: Citizens Savings Bank - Please refer to the material supplied under the caption EXECUTIVE OFFICERS - Narragansett in Part I of this report for other information regarding Mr. McCabe. John W. Rowe* - Director since 1989. Richard P. Sergel* - Chairman and Director since 1993. William E. Trueheart - Director since 1989 - Age: 50 - President of Bryant College, Smithfield, Rhode Island - Executive Vice President of Bryant College from 1986 to 1989 - Other directorships: Fleet National Bank. John A. Wilson, Jr. - Director since 1971 - Age: 62 - Former Consultant to and President of Wanskuck Co., Providence, R.I., - Former Consultant to Hinckley, Allen, Snyder & Comen (attorneys), Providence, R.I. *Please refer to the material supplied under the caption DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Section 16(a) of the Securities Exchange Act of 1934 requires the System's officers and directors, and persons who own more than 10% of a registered class of the System's equity securities, to file reports on Forms 3, 4, and 5 of share ownership and changes in share ownership with the SEC and the New York Stock Exchange and to furnish the System with copies of all Section 16(a) forms they file. Based solely on Mass. Electric's and Narragansett's review of the copies of such forms received by them, or written representations from certain reporting persons that such forms were not required for those persons, Mass. Electric and Narragansett believe that, during 1993, all filing requirements applicable to its officers, directors, and 10% beneficial owners were complied with, except that one report on Form 3 was filed late for each of Mr. Beirne, Mr. Frost, and Mr. Mahoney. Item 11. Item 11. EXECUTIVE COMPENSATION NEES ---- The information required by this item is incorporated herein by reference to the material under the captions BOARD STRUCTURE AND COMPENSATION, EXECUTIVE COMPENSATION, PAYMENTS UPON A CHANGE IN CONTROL, PLAN SUMMARIES, and RETIREMENT PLANS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, MASS. ELECTRIC, AND NARRAGANSETT ------------------------------------- EXECUTIVE COMPENSATION The following tables give information with respect to all compensation (whether paid directly by NEP, Mass. Electric, or Narragansett or billed to it as hourly charges) for services in all capacities for NEP, Mass. Electric, or Narragansett for the years 1991 through 1993 to or for the benefit of the Chief Executive Officer and the four other most highly compensated executive officers for each company. NEP SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- John W. 1993 181,269 112,095 2,318 54,256 2,386(g) Rowe 1992 184,532 69,205 2,318 56,479 2,340 Chairman 1991 160,202 67,618 2,188 58,394 2,153 Joan T. 1993 154,428 92,949 3,323 46,245 3,444(h) Bok 1992 157,705 59,310 2,899 48,274 3,326 Vice 1991 155,392 66,005 3,135 56,641 3,615 Chairman Jeffrey D. 1993 159,936 112,105 2,974 32,753 3,563(i) Tranen 1992 120,843 52,286 2,307 23,732 2,670 President 1991 129,725 45,832 2,240 20,970 2,595 Frederic E. 1993 123,648 75,058 2,131 22,811 3,110(j) Greenman 1992 133,223 50,258 2,361 26,960 3,298 Vice 1991 125,237 43,804 2,516 24,028 3,145 President Lawrence E. 1993 135,123 61,283 101 21,286 3,790(k) Bailey 1992 129,711 47,737 101 20,985 2,594 Vice 1991 122,928 32,588 102 14,474 2,459 President (a) Certain officers of NEP are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by NEP. See description under Plan Summaries. (d) Includes amounts reimbursed by NEP for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Rowe 11,807 shares, $461,949 value; Mrs. Bok 10,241 shares, $400,679 value; Mr. Greenman 3,220 shares, $125,983 value; Mr. Tranen 2,193 shares, $85,019 value; and Mr. Bailey 1,369 shares, $53,562 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes NEP contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by NEP. (g) For Mr. Rowe, the amount and type of compensation in 1993 is as follows: $1,879 for contributions to the thrift plan and $507 for life insurance. (h) For Mrs. Bok, the amount and type of compensation in 1993 is as follows: $1,937 for contributions to the thrift plan and $1,507 for life insurance. (i) For Mr. Tranen, the amount and type of compensation in 1993 is as follows: $3,198 for contributions to the thrift plan and $365 for life insurance. (j) For Mr. Greenman, the amount and type of compensation in 1993 is as follows: $2,478 for contributions to the thrift plan and $637 for life insurance. (k) For Mr. Bailey, the amount and type of compensation in 1993 is as follows: $2,702 for contributions to the thrift plan and $1,088 for life insurance. MASS. ELECTRIC SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 93,628 71,187 1,657 20,713 2,036(h) Sergel (g) Chairman John H. 1993 156,900 116,399 3,005 28,103 3,623(i) Dickson 1992 150,469 61,561 3,087 27,801 3,442 President 1991 141,720 51,451 2,389 23,606 3,255 and CEO Nancy H. 1993 102,860 43,386 103 13,370 2,378(j) Sala (g) 1992 96,785 20,508 103 8,326 1,936 Vice President Dennis E. 1993 105,768 29,175 101 11,173 3,025(k) Snay 1992 101,208 28,448 103 12,207 2,024 Vice 1991 94,862 23,320 103 10,001 1,897 President Cheryl A. 1993 71,488 43,373 68 13,206 1,575(l) LaFleur (g) Vice President (a) Certain officers of Mass. Electric are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Mass. Electric. See description under Plan Summaries. (d) Includes amounts reimbursed by Mass. Electric for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. Dickson 2,190 shares, $85,683 value; Ms. Sala 360 shares, $14,085 value; Mr. Snay 859 shares, $33,608 value; and Ms. LaFleur 824 shares, $32,239 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Mass. Electric contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Mass. Electric. (g) Mr. Sergel and Ms. LaFleur were elected as officers of Mass. Electric in 1993, and Ms. Sala was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $1,873 for contributions to the thrift plan and $163 for life insurance. (i) For Mr. Dickson, the type and amount of compensation in 1993 is as follows: $3,138 for contributions to the thrift plan and $485 for life insurance. (j) For Ms. Sala, the type and amount of compensation in 1993 is as follows: $2,057 for contributions to the thrift plan and $321 for life insurance. (k) For Mr. Snay, the type and amount of compensation in 1993 is as follows: $2,115 for contributions to the thrift plan and $910 for life insurance. (l) For Ms. LaFleur, the type and amount of compensation in 1993 is as follows: $1,430 for contributions to the thrift plan and $145 for life insurance. NARRAGANSETT SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 48,207 36,653 854 10,665 1,048(h) Sergel (g) Chairman Robert L. 1993 139,632 98,654 2,408 22,617 3,771(i) McCabe 1992 134,536 54,109 2,041 25,076 2,603 President 1991 128,863 40,428 1,306 18,024 2,388 and CEO William 1993 118,501 39,403 101 13,370 5,847(j) Watkins, 1992 65,586 17,315 66 7,350 1,312 Jr. (g) Executive Vice President Richard W. 1993 96,408 28,667 103 11,211 2,628(k) Frost (g) Vice President Francis X. 1993 87,300 10,580 113 2,462 1,859(l) Beirne (g) Vice President (a) Certain officers of Narragansett are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Narragansett. See description under Plan Summaries. (d) Includes amounts reimbursed by Narragansett for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. McCabe 2,082 shares, $81,458 value; Mr. Watkins 954 shares, $37,325 value; Mr. Frost 942 shares, $36,855 value; and Mr. Beirne 206 shares, $8,059 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Narragansett contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Narragansett. (g) Messrs. Sergel, Frost, and Beirne were elected as officers of Narragansett in 1993, and Mr. Watkins was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $964 for contributions to the thrift plan and $84 for life insurance. (i) For Mr. McCabe, the type and amount of compensation in 1993 is as follows: $2,682 for contributions to the thrift plan and $1,089 for life insurance. (j) For Mr. Watkins, the type and amount of compensation in 1993 is as follows: $2,370 for contributions to the thrift plan and $3,477 for life insurance. (k) For Mr. Frost, the type and amount of compensation in 1993 is as follows: $1,928 for contributions to the thrift plan and $700 for life insurance. (l) For Mr. Beirne, the type and amount of compensation in 1993 is as follows: $1,746 for contributions to the thrift plan and $113 for life insurance. Directors' Compensation Members of the Mass. Electric and Narragansett Boards of Directors, except Dickson, McCabe, Rowe, and Sergel receive a quarterly retainer of $1,250, a meeting fee of $600 plus expenses, and 50 NEES common shares each year. Since all members of the NEP Board are employees of NEES System companies, no fees are paid for service on the Board except as noted below for Mrs. Bok. Mrs. Bok retired as an employee of the NEES companies on January 1, 1994 (remaining as Chairman of NEES and a director for NEES subsidiaries). Mrs. Bok has agreed to waive the normal fees and annual retainers otherwise payable for services by non- employees on NEES subsidiary boards and will receive in lieu thereof a single annual stipend of $60,000. Mrs. Bok also became a consultant to NEES as of January 1, 1994. Under the terms of her contract, she will receive an annual retainer of $100,000. No payments were made in 1993 pursuant to these arrangements. Mass. Electric and Narragansett permit directors to defer all or a portion of their retainers and meeting fees. Special accounts are maintained on Mass. Electric's and Narragansett's books showing the amounts deferred and the interest accrued thereon. Other NEP, Mass. Electric, and Narragansett do not have any share option plans. The NEES Compensation Committee administers certain of the incentive compensation plans, and the Management Committee administers the others (including the incentive share plan). Retirement Plans The following table shows estimated annual benefits payable to executive officers under the qualified pension plan and the supplemental retirement plan, assuming retirement at age 65 in 1994. PENSION TABLE Five-Year Average 15 Years 20 Years 25 Years 30 Years 35 Years 40 Years Compensa- of of of of of of tion Service Service Service Service Service Service - --------- -------- -------- -------- -------- -------- -------- $100,000 28,000 36,600 45,000 53,400 58,900 61,600 $150,000 43,000 56,300 69,300 82,200 90,300 94,800 $200,000 58,000 76,000 93,500 111,000 122,100 128,100 $250,000 73,000 95,700 117,800 139,800 153,800 161,300 $300,000 88,100 115,400 142,000 168,600 185,500 194,500 $350,000 103,100 135,100 166,300 197,400 217,200 227,700 $400,000 118,100 154,800 190,500 226,200 249,000 261,000 $450,000 133,100 174,500 214,800 255,000 280,700 294,200 For purposes of the retirement plans, Messrs. Rowe, Tranen, Greenman, and Bailey currently have 16, 24, 30, and 25 credited years of service, respectively. Mr. Sergel, Mr. Dickson, Ms. Sala, Mr. Snay, and Ms. LaFleur currently have 15, 20, 24, 30, and 7 credited years of service, respectively. Messrs. McCabe, Watkins, Frost, and Beirne currently have 25, 21, 31, and 22 credited years of service, respectively. At the time she retired from NEP, Mrs. Bok had 38 credited years of service, and she commenced receiving the described benefits under the pension plans and the life insurance program. As a non-employee, she no longer accrues service credit or additional benefits under these plans. Benefits under the pension plans are computed using formulae based on percentages of highest average compensation computed over five consecutive years. The compensation covered by the pension plan includes salary, bonus, and restricted share awards. The benefits listed in the pension table are not subject to deduction for Social Security and are shown without any joint and survivor benefits. The Pension Table above does not include annuity payments to be received in lieu of life insurance. The policies are described above under Plan Summaries. In February 1993, NEP announced a voluntary early retirement program available to all non-union employees over age 55 with 10 or more years of service as of June 30, 1993. Mrs. Bok accepted the offer. The program offered either an annuity or a lump sum equal to the greater value of either one week's base pay times the number of years of service plus two weeks base pay or an additional five years of service and five years of age. In accordance with the terms of the offer, Mrs. Bok received an additional annuity of $12,611 from a supplemental pension plan and a lump sum of $110,896 from the qualified plan. Mrs. Bok had not been eligible for a bonus under the prior incentive compensation plan. In lieu thereof she will receive a limited cost of living (consumer price index) adjustment to her benefits from the qualified pension plan and the supplemental retirement plan. Since this plan serves to adjust the pension benefit only after retirement, there will be no supplement paid under the plan until at least 1995. Senior executives receive the same post-retirement health benefits as those offered non-union employees who retire with a combination of age and years of service equal to 85. PAYMENTS UPON A CHANGE OF CONTROL The incentive compensation plans would provide a payment of 40% of base compensation in the event of a "change in control" as defined in the plans. This payout would be made in lieu of any cash bonuses under the plans for the year in which the "change in control" occurs. A similar payment is provided for the previous plan year if awards for that year had not yet been distributed. A "change in control" is defined, generally, as an occurrence of certain events that either evidence a merger or acquisition of NEES or cause a significant change in the makeup of the NEES board of directors over a short period of time. Upon the occurrence of a "change in control," restrictions on all shares issued to participants under the incentive share plan would cease and the participants would receive an award of shares for that year, determined in the usual manner, based upon the cash awards described in the preceding paragraph. NEP, MASS. ELECTRIC, AND NARRAGANSETT PLAN SUMMARIES A brief description of the various plans through which compensation and benefits are provided to the named executive officers is presented below to better enable shareholders to understand the information presented in the tables shown earlier. The amounts of compensation and benefits provided to the named executive officers under the plans described below (and charged to NEP, Mass. Electric, or Narragansett) are presented in the Summary Compensation Tables. Goals Program The goals program covers all employees who have completed one year of service with any NEES subsidiary. Goals are established annually. For 1993, these goals related to earnings per share, customer costs, safety, absenteeism, conservation, generating station availability, transmission reliability, environmental and OSHA compliance, and customer favorability attitudes. Some goals apply to all employees, while others apply to particular functional groups. Depending upon the number of goals met, and provided the minimum goal for earnings per share is met, employees may earn a cash bonus of 1% to 4-1/2% of their compensation. Incentive Thrift Plan The incentive thrift plan (a 401(k) program) provides for a match of one-half of up to the first 4% of base compensation contributed to the System's incentive thrift plan (shown under All Other Compensation in the Summary Compensation Tables) and, based on an incentive formula tied to earnings per share, may fully match the first 4% of base compensation contributed (the additional amount, if any, is shown under Bonus in the Summary Compensation Tables). Under Federal law, contributions to these plans are restricted. In 1993, the salary reduction amount was limited to $8,994. Life Insurance NEES has established for certain senior executives life insurance plans funded by individual policies. The combined death benefit under these insurance plans is three times the participant's annual salary. After termination of employment, participants may elect, commencing at age 55 or later, to receive an annuity income equal to 40% of annual salary. In that event, the life insurance is reduced over fifteen years to an amount equal to the participant's final annual salary. Due to changes in the tax law, this plan was closed to new participants, and an alternative was established with only a life insurance benefit. The individuals listed in the NEP summary compensation table are in one or the other of these plans. Mass. Electric and Narragansett each have two executive officers eligible to participate in one or the other of these plans. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption TOTAL COMMON EQUITY BASED HOLDINGS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, Mass. Electric, and Narragansett ------------------------------------- NEES owns 100% of the voting securities of Mass. Electric and Narragansett. NEES owns 98.80% of the voting securities of NEP. SECURITY OWNERSHIP The following tables list the holdings of NEES common shares as of March 10, 1994 by NEP, Mass. Electric, and Narragansett directors, the executive officers named in the Summary Compensation Tables, and all directors and executive officers, as a group. NEP --- Name Shares Beneficially Owned (a) ---- ----------------------------- Lawrence E. Bailey 1,953 Joan T. Bok 25,162 Frederic E. Greenman 10,632 Alfred D. Houston 10,953 John W. Newsham 10,270 John W. Rowe 20,419 Richard P. Sergel 6,702 Jeffrey D. Tranen 6,604 All directors and executive officers, as a group (13 persons) 115,340 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Mass. Electric -------------- Name Shares Beneficially Owned ---- ------------------------- Urville J. Beaumont 104 (a) Joan T. Bok 25,162 (b) Sally L. Collins 105 John H. Dickson 7,883 (b) Charles B. Housen 52 Cheryl A. LaFleur 1,796 (b) Kathryn A. McCarthy 100 Patricia McGovern 0 John F. Reilly 105 John W. Rowe 20,419 (b) Nancy H. Sala 5,459 (b),(c) Richard P. Sergel 6,702 (b) Richard M. Shribman 105 Dennis E. Snay 3,720 (b) Roslyn M. Watson 205 All directors and executive officers, as a group (23 persons) 105,713 (d) (a) Mr. Beaumont disclaims a beneficial ownership interest in these shares held under an irrevocable trust. (b) Includes restricted shares and allocated shares in employee benefit plans. (c) Ms. Sala disclaims a beneficial ownership interest in 205 shares held under the Uniform Gift to Minors Act. (d) This is less than 1% of the total number of shares of NEES outstanding. Narragansett ------------ Name Shares Beneficially Owned ---- ------------------------- Francis X. Beirne 2,956 (a) Joan T. Bok 25,162 (a) Stephen A. Cardi 104 Richard W. Frost 4,521 (a) Frances H. Gammell 105 Joseph J. Kirby 105 Robert L. McCabe 7,671 (a) John W. Rowe 20,419 (a) Richard P. Sergel 6,702 (a) William E. Trueheart 105 William Watkins, Jr. 7,143 (a) John A. Wilson, Jr. 508 All directors and executive officers, as a group (15 persons) 95,477 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The construction company of Mr. Stephen A. Cardi, a director of Narragansett, was awarded two contracts by New England Power Company for construction work at its Brayton Point Station. The contract amounts totalled $600,000 and $1,000,000, respectively. Reference is made to Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT and Item 11. EXECUTIVE COMPENSATION. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K List of Exhibits Unless otherwise indicated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Commission file numbers indicated in parentheses. NEES ---- (3) Agreement and Declaration of Trust dated January 2, 1926, as amended through April 28, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 1-3446). (4) Instruments Defining the Rights of Security Holders (a) Massachusetts Electric Company First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 Form 10-K, File No. 1-3446; Twentieth Supplemental Indenture dated as of September 1, 1993 (filed herewith). (b) The Narragansett Electric Company First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4 to 1991 Form 10-K, File No. 0-898); Exhibit 4(b) to 1992 Form 10-K, File No. 1-3446; Twenty-First Supplemental Indenture dated as of October 1, 1993 (filed herewith). (c) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (filed herewith). (d) New England Power Company Indentures General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 Form 10-K, File No. 1-3446; Nineteenth Supplemental Indenture dated as of August 1, 1993 (filed herewith). (10) Material Contracts (a) Boston Edison Company et al. and New England Power Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and New England Power Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986; (Exhibit 10(b), to 1990 Form 10-K, File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to NEP with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and New England Power Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-23006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 1-3446); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to 1979 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and New England Power Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to 1983 Form 10-K, File No. 1-3446), October 1, 1984, and August 1, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20, File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446). (e) New England Energy Incorporated Contracts (i) Capital Funds Agreement with NEES dated November 1, 1974 (Exhibit 10-29(b), File No. 2-52969); Amendment dated July 1, 1976, and Amendment dated July 26, 1979 (Exhibit 10(g)(i) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(i) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10 (e)(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(i) to 1990 Form 10-K, File No. 1-3446). (ii) Loan Agreement with NEES dated July 19, 1978 and effective November 1, 1974, and Amendment dated July 26, 1979 (Exhibit 10(g)(iii) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(ii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(ii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(ii) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(ii) to 1990 Form 10-K, File No. 1-3446). (iii) Fuel Purchase Contract with New England Power Company dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 Form 10-K, File No. 1-3446). (iv) Partnership Agreement with Samedan Oil Corporation as Amended and Restated on February 5, 1985 (Exhibit 10(e)(iv) to 1984 Form 10-K, File No. 1-3446); Amendment dated as of January 14, 1992 (Exhibit 10(e)(iv) to 1991 Form 10-K, File No. 1-3446). (v) Credit Agreement dated as of April 28, 1989 (Exhibit 10(e)(v) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(v) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1992 (Exhibit 10(e)(v) to 1992 Form 10-K, File No. 1-3446). (vi) Capital Maintenance Agreement dated November 15, 1985, and Assignment and Security Agreement dated November 15, 1985 (Exhibit 10(e)(vi) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(vi) to 1989 Form 10-K, File No. 1-3446). (f) New England Power Company and New England Electric Transmission Corporation et al.: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit (10)(f) 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of New England Power Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Upper Development - Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446). (g) New England Electric Transmission Corporation and PruCapital Management, Inc. et al: Note Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Mortgage, Deed of Trust and Security Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Equity Funding Agreement with New England Electric System dated as of December 1, 1985 (Exhibit 10(g) to 1991 Form 10-K, File No. 1-3446). (h) Vermont Electric Transmission Company, Inc. et al. and New England Power Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(g) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to 1986 Form 10-K, File No. 1-3446). (i) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 Form 10-K, File No. 1-3446). (j) Public Service Company of New Hampshire et al. and New England Power Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, December 31, 1980 (Exhibit 10(i) to 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, June 15, 1984 (Exhibit 10(j) to 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986 and September 19, 1986 (Exhibit 10(j) to 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of November 1, 1990 (Exhibit 10(j) to 1991 Form 10-K, File No. 1- 3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to NEP with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 10-16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent (Exhibit 10(j) to 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446); Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, and amendment to Seabrook Project Managing Agent Agreement dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446). (k) Vermont Yankee Nuclear Power Corporation et al. and New England Power Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968, and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972 and April 15, 1983 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446) and April 24, 1985 (Exhibit 10(k) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(k) to 1987 Form 10-K, File No. 1-3446); Amendments dated as of May 6, 1988 (Exhibit 10(k) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to 1981 Form 10-K, File No. 1-3446). (l) Yankee Atomic Electric Company et al. and New England Power Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10 (l) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 Form 10-K, File No. 1- 3446). *(m) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to 1986 Form 10-K, File No. 1-3446). *(n) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to 1991 Form 10-K, File No. 1-3446). *(o) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to 1991 Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(q) to 1992 Form 10-K, File No. 1-3446). *(q) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to 1991 Form 10-K, File No. 1- 3446). *(r) New England Electric Companies' Incentive Compensation Plan II as amended dated September 3, 1992 (Exhibit 10(r) to 1992 Form 10-K, File No. 1-3446). *(s) New England Electric System Directors Deferred Compensation Plan as amended dated November 24, 1992 (Exhibit 10(s) to 1992 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program (Exhibit 10(s) to 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to 1991 Form 10-K, File No. 1-3446). (u) New England Power Company and New England Hydro-Transmission Electric Company, Inc. et al: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10(u) to 1990 Form 10-K, File No. 1-3446). (v) New England Power Company and New England Hydro-Transmission Corporation et al: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1,1988 (Exhibit 10(v) to 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10(v) to 1990 Form 10-K, File No. 1-3446). (w) New England Power Company et al: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to 1988 Form 10-K, File No. 1-3446). (x) New England Hydro-Transmission Electric Company, Inc. and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(x) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(x) to 1988 Form 10-K, File No. 1-3446). (y) New England Hydro-Transmission Corporation and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(y) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(y) to 1988 Form 10-K, File No. 1-3446). (aa) Ocean State Power, et al., and Narragansett Energy Resources Company: Equity Contribution Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power, et al., and New England Electric System: Equity Contribution Support Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K, File No. 1-3446); Ocean State Power II, et al., and Narragansett Energy Resources Company:Equity Contribution Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power II, et al., and New England Electric System: Equity Contribution Support Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446). *(bb) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 Form 10-K, File No. 1-3446). *(cc) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 Form 10-K, File No. 1-3446). *(dd) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (13) 1993 Annual Report to Shareholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (filed herewith). (22) Subsidiary list appears in Part I of this document. (25) Power of Attorney (filed herewith). NEP --- (3) (a) Articles of Organization as amended through June 27, 1987 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-1229). (b) By-laws of the Company as amended June 25, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 0-1229). (4) General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1988 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and the Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986 (Exhibit 10(b) to NEES' 1990 Form 10-K File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to the Company with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and the Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-2006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 0-1229); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to NEES' 1979 Form 10-K, File No. 1-3446); Five Year Capital Contribution Agreement dated November 1, 1980 (Exhibit 10(e) to NEES' 1980 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to NEES' 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to NEES' 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and the Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to NEES' 1983 Form 10-K, File No. 1-3446); October 1, 1984, and August 1, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20; File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446). (e) Mass. Electric and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated June 22, 1983 (Exhibit 10(b) to Mass. Electric's 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (f) The Narragansett Electric Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 4(f) to New England Power Company's 1990 Form 10-K, File No. 0-1229). Amendment of Service Agreement dated July 24, 1991 (Exhibit 10(f) to 1991 Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (g) Time Charter between Intercoastal Bulk Carriers, Inc., and New England Power Company dated as of December 27, 1989 (Exhibit 10(g) to 1989 Form 10-K, File No. 1-3446). (h) New England Electric Transmission Corporation et al. and the Company: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(f) to NEES' 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of the Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Upper Development-Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446). (i) Vermont Electric Transmission Company, Inc. et al. and the Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(g) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to NEES' 1986 Form 10-K, File No. 1-3446). (j) New England Energy Incorporated and the Company: Fuel Purchase Contract dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 NEES Form 10-K, File No. 1-3446). (k) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, March 1, 1973 (Exhibit 10-15, File No. 2-48543);Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10 (i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (l) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(l) to 1988 Form 10-K, File No. 0-1229). (m) Public Service Company of New Hampshire et al. and the Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, and December 31, 1980 (Exhibit 10(i) to NEES' 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, and June 15, 1984 (Exhibit 10(j) to NEES' 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986, and September 19, 1986 (Exhibit 10(j) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to NEES' 1990 Form 10-K, File No. 1-3446); Seventh Amendment as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to the Company with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). Settlement Agreement dated as of July 19, 1990 between Northeast Utilities Service Company and the Company (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, Amendment to Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). (n) Vermont Yankee Nuclear Power Corporation et al. and the Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968 and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972, April 15, 1983 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 0-1229) and April 24, 1985 (Exhibit 10(n) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendments dated May 6, 1988 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 NEES Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to NEES' 1981 Form 10-K, File No. 1-3446). (o) Yankee Atomic Electric Company et al. and the Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10(l) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 NEES Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(q) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(r) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(s) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446); New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(u) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10 (r) to NEES' 1992 Form 10-K, File No. 1-3446). (v) New England Hydro-Transmission Electric Company, Inc. et al. and the Company: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10 (u) to NEES' 1990 Form 10-K, File No. 1-3446). (w) New England Hydro-Transmission Corporation et al. and the Company: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to NEES' 1987 Form 10-K, File No. 1-3446). Amendment dated as of August 1, 1988 (Exhibit 10(v) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10 (v) to NEES' 1990 Form 10-K, File No. 1-3446). (x) Vermont Electric Power Company et al. and the Company: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446). Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to NEES' 1988 Form 10-K, File No. 1-3446). (y) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of January 6, 1992; Amendments dated as of March 2, 1992 and October 30, 1992 (Exhibit 10(y) to 1992 Form 10-K, File No. 0-1229). (z) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of October 30, 1992 (Exhibit 10(z) to 1992 Form 10-K, File No. 0-1229). (aa) Algonquin Gas Transmission Company and the Company: X-38 Service Agreement for Firm Transportation of natural gas dated July 3, 1992; Amendment dated July 31, 1992 (Exhibit 10(aa) to 1992 Form 10-K, File No. 0-1229). (bb) ANR Pipeline Company and the Company: Gas Transportation Agreement dated July 18, 1990 (Exhibit 10(bb) to 1992 Form 10-K, File No. 0-1229). (cc) Columbia Gas Transmission Corporation and the Company: Service Agreement for Service under FTS Rate Schedule dated June 13, 1991 (filed herewith). (dd) Iroquois Gas Transmission System, L.P. and the Company: Gas Transportation Contract for Firm Reserved Service dated as of June 5, 1991 (Exhibit 10(dd) to 1992 Form 10-K, File No. 0-1229). (ee) Tennessee Gas Pipeline Company and the Company: Firm Natural Gas Transportation Agreement dated July 9, 1992 (Exhibit 10(ee) to 1992 Form 10-K, File No. 0-1229). *(ff) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 NEES Form 10-K, File No. 1-3446). *(gg) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 NEES Form 10-K, File No. 1-3446). *(hh) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into NEP registration statements on Form S-3, Commission File Nos. 33-48257, 33-48897, and 33-49193 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (22) Subsidiary list (filed herewith). (25) Power of Attorney (filed herewith). Mass. Electric -------------- (3) (a) Articles of Organization of the Company as amended March 5, 1993, August 11, 1993, September 20, 1993, and November 15, 1993 (filed herewith). (b) By-Laws of the Company as amended February 4, 1993, July 30, 1993, and September 15, 1993 (filed herewith). (4) First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464); Exhibit 4 to 1988 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated July 22, 1983 (Exhibit 10(b) to 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(e) to 1993 NEP Form 10-K, File No. 0- 1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1988 Form 10-K, File No. 0-5464). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 4(e), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Mass. Electric registration statement on Form S-3, Commission File No. 33-49251 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (Exhibit 18 to 1993 NEES Form 10-K, File No. 1-3446). (25) Power of Attorney (filed herewith). Narragansett ------------ (3) (a) Articles of Incorporation as amended June 9, 1988 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-898). (b) By-Laws of the Company (Exhibit 3 to 1980 Form 10-K, File No. 0-898). (4) (a) First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4(b) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1993 NEES Form 10-K, File No. 1-3446). (b) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1- 3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 10(f) to 1990 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement dated July 24, 1991 (Exhibit 4(f) to 1991 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(f) to 1993 NEP Form 10-K, File No. 0-1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10 (i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES' Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to NEES' 1992 Form 10-K, File No. 1-3446. (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1989 Form 10-K, File No. 0-898). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 3(d), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan for Officers, as amended December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan, as amended April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan, as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Companies' Incentive Compensation Plan, as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Narragansett registration statement on Form S-3, Commission File No. 33-45052 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (25) Power of Attorney (filed herewith). Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules for NEES, NEP, Mass. Electric, and Narragansett on pages 100, 109, 115, and 121, respectively. Reports on Form 8-K NEES ---- NEES filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. NEP --- None. Mass. Electric -------------- Mass. Electric filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. Narragansett ------------ None. NEW ENGLAND ELECTRIC SYSTEM 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. NEW ENGLAND ELECTRIC SYSTEM* s/John W. Rowe John W. Rowe President and Chief Executive Officer 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. (Signature and Title) Principal Executive Officer s/John W. Rowe John W. Rowe President and Chief Executive Officer Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Executive Vice President and Chief Financial Officer Principal Accounting Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Directors (a majority) Joan T. Bok Paul L. Joskow John M. Kucharski Edward H. Ladd Joshua A. McClure s/John G. Cochrane Malcolm McLane All by: Felix A. Mirando, Jr. John G. Cochrane John W. Rowe Attorney-in-fact George M. Sage Charles E. Soule Anne Wexler James Q. Wilson James R. Winoker Date (as to all signatures on this page) March 28, 1994 *The name "New England Electric System" means the trustee or trustees for the time being (as trustee or trustees but not personally) under an agreement and declaration of trust dated January 2, 1926, as amended, which is hereby referred to, and a copy of which as amended has been filed with the Secretary of the Commonwealth of Massachusetts. Any agreement, obligation or liability made, entered into or incurred by or on behalf of New England Electric System binds only its trust estate, and no shareholder, director, trustee, officer or agent thereof assumes or shall be held to any liability therefor. NEW ENGLAND POWER COMPANY SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company. NEW ENGLAND POWER COMPANY s/Jeffrey D. Tranen Jeffrey D. Tranen President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Jeffrey D. Tranen Jeffrey D. Tranen President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Frederic E. Greenman Alfred D. Houston s/John G. Cochrane John W. Newsham All by: John W. Rowe John G. Cochrane Jeffrey D. Tranen Attorney-in-fact Date (as to all signatures on this page) March 28, 1994 MASSACHUSETTS ELECTRIC COMPANY SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company. MASSACHUSETTS ELECTRIC COMPANY s/John H. Dickson John H. Dickson President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/John H. Dickson John H. Dickson President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Urville J. Beaumont Joan T. Bok Sally L. Collins John H. Dickson s/John G. Cochrane Charles B. Housen All by: Kathryn A. McCarthy John G. Cochrane Patricia McGovern Attorney-in-fact John F. Reilly John W. Rowe Richard P. Sergel Richard M. Shribman Roslyn M. Watson Date (as to all signatures on this page) March 28, 1994 THE NARRAGANSETT ELECTRIC COMPANY SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company. THE NARRAGANSETT ELECTRIC COMPANY s/Robert L. McCabe Robert L. McCabe President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Robert L. McCabe Robert L. McCabe President Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Vice President and Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Stephen A. Cardi Frances H. Gammell s/John G. Cochrane Joseph J. Kirby All by: Robert L. McCabe John G. Cochrane John W. Rowe Attorney-in-fact Richard P. Sergel William E. Trueheart John A. Wilson, Jr. Date (as to all signatures on this page) March 28, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of New England Electric System on Form S-3 of the Dividend Reinvestment and Common Share Purchase Plan (File No. 33-12313) and on Forms S-8 of the New England Electric System Companies Employees' Share Ownership Plan (File No. 2-89648), the New England Electric System Companies Incentive Thrift Plan (File No. 33-26066), the New England Electric System Companies Incentive Thrift Plan II (File No. 33-35470), the NEES Goals Program (File No. 2-94447) and the Yankee Atomic Electric Company Thrift Plan (File No. 2-67531) of our reports dated February 25, 1994 on our audits of the consolidated financial statements and financial statement schedules of New England Electric System and subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. We also consent to the incorporation by reference in the registration statements of New England Power Company on Forms S-3 (File Nos. 33-48257, 33-48897, and 33-49193), Massachusetts Electric Company on Form S-3 (File No. 33-49251) and The Narragansett Electric Company on Form S-3 (File No. 33-45052) of our reports dated February 25, 1994 on our audits of the financial statements and financial statement schedules of New England Power Company, Massachusetts Electric Company and The Narragansett Electric Company, respectively, as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. s/ Coopers & Lybrand Boston, Massachusetts COOPERS & LYBRAND March 25, 1994 REPORT OF INDEPENDENT ACCOUNTANTS Our reports on the consolidated financial statements of New England Electric System and subsidiaries and on the financial statements of certain of its subsidiaries, listed in item 14 herein, which financial statements and reports are included in the respective 1993 Annual Reports to Shareholders, have been incorporated by reference in this Form 10K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14 herein. In our opinion, the financial statement schedules referred to above, when considered in relation to the corresponding 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 COOPERS & LYBRAND February 25, 1994 NEW ENGLAND ELECTRIC SYSTEM AND SUBSIDIARIES CONSOLIDATED --------------------------------------------------------- SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, 1993, 1992, and 1991

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ITEM 1. BUSINESS CPC International Inc. and its consolidated subsidiaries (the "Company") is a worldwide group of businesses, principally engaged in two major industry segments: consumer foods and corn refining. The development of the Company's business since the beginning of 1993 and financial information on business segments and geographical divisions are described in the 1993 Annual Report to Stockholders (the "Annual Report"), the following portions of which are incorporated herein by reference: - Text on pages 4 through 16 under the heading "Consumer Foods Business". - Text on pages 16 through 20 under the heading "Corn Refining". - Text on pages 20 through 24 under the heading "New Frontiers". - Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 27 through 30. - Business Segment and Geographic Financial Information on pages 46 and 47. - Financial Statements and Notes to Financial Statements on pages 31 through 44. The Company employs approximately 39,000 people of whom approximately 31,100 are located outside the United States. Total employee costs amounted to $1.3 billion in 1993 compared with $1.2 billion and $1.1 billion in 1992 and 1991, respectively. The Company's products are manufactured from raw materials, including soybean and other vegetable oils, peanuts, corn and wheat, all of which are, and are expected to continue to be, in adequate supply. As prices of these materials depend upon a number of such unpredictable factors as farm plantings and weather, and as the Company engages in only limited price hedging, fluctuations in raw material prices may have an effect on the Company's earnings. The Company's products are sold primarily by the sales organizations of its various operating units and subsidiaries. Exports represent a small portion of total net sales. Mayonnaise sales accounted for 11.7 percent, 11.5 percent and 11.8 percent of consolidated net sales in 1993, 1992 and 1991, respectively. The Company has approximately 1,600 trademarks, some of which are of significant importance to the Company, particularly in the consumer foods business. The Company also has over 1,600 patents of various durations, some of which are licensed to affiliates and joint ventures in which the Company or an affiliate participates. No individual patent has a material effect on the earnings of the Company. The Company's products, both within the United States and abroad, generally face strong competition, and as a result, the Company engages in extensive marketing, advertising and promotional activities, particularly with respect to its consumer products. The Company also conducts continuous market research to assist in determining consumer preferences. The amount spent on these activities was $643 million in 1993, $663.5 million in 1992, and $624.2 million in 1991. In addition, the Company conducts product and process research and development activities. Research related to food and food technology is conducted at facilities in Somerset, New Jersey, Heilbronn, Germany, and Thayngen, Switzerland, and corn refining research and product support activities are provided from facilities at Argo, Illinois and Beloit, Wisconsin. Research has resulted in the development of new and improved products based on studies in nutrition, food technology, vegetable oils, enzymes, carbohydrates, and carbohydrate-derived products, as well as developments and improvements in process technology. The amount spent for research and development in 1993, 1992, and 1991 was $49.3 million, $45.7 million, and $39.6 million, respectively. Research and development expenditures increased by $3.6 million in 1993 reflecting mostly additional spending for consumer foods research. Approximately 600 full-time professional employees were engaged in such activities during 1993. The Company operates in 58 countries, and accordingly, operations are subject to varying degrees of political risk and uncertainty. Loss of earnings from any one country other than the United States would not have a material adverse effect on the Company as a whole. ITEM 2. ITEM 2. PROPERTIES The Company's headquarters buildings in Englewood Cliffs, New Jersey are held under a lease which, including all renewal terms, expires in May 2019. The Company owns or leases other property appropriate to its business, including distribution centers and warehouses. None of the leases involved is considered to be a material lease. The Company has a total of 134 operating plants, of which 29 are in the United States, 8 in Canada, 38 in Europe, 14 in Africa and the Middle East, 34 in Latin America and 11 in Asia. These include seven plants owned by joint ventures in Hong Kong, Malaysia, Philippines, Taiwan and Thailand in which the Company owns fractionally more than 50% of the equity. The Company has a 50% interest in other joint ventures which operate three plants, one of which is located in each of Asia (consumer foods products), Latin America (corn refining products), and the United States (fuel ethanol). Of the Company's 134 plants, 112 plants are engaged solely in the manufacture of consumer food products, 21 are engaged in the manufacture of corn refining products, 8 of which also produce consumer food products; and 1 plant is engaged in the manufacture of other products. In general, it is the Company's belief that its plants are suitable and adequate for its needs, and, subject to fluctuations in market demand, are fully utilized. Included on the following page is a complete listing of all plants owned and operated by the Company and its consolidated subsidiaries as of December 31, 1993. Based on past loss experience, the Company believes it is adequately insured in respect of these assets, and for liabilities which are likely to arise from its operations. THE CONSUMER FOODS FACILITIES ARE AS FOLLOWS: UNITED STATES: ARKANSAS-Little Rock; CALIFORNIA-Placentia, Santa Fe Springs; CONNECTICUT-Greenwich; FLORIDA-Riviera Beach, West Palm Beach; ILLINOIS-Argo, Chicago, Franklin Park; INDIANA-Indianapolis; MASSACHUSETTS-Weymouth; MARYLAND-Frederick; NORTH CAROLINA- Asheboro, Gastonia; NEW JERSEY-Bayonne, Jersey City, Totowa; NEW YORK-Bronx; TEXAS-Irving; WASHINGTON-Seattle; WISCONSIN-Germantown, Milwaukee (2), Oconomowoc; PUERTO RICO-Arecibo CANADA: ONTARIO-Cardinal; QUEBEC-Baie d'Urfe, Boisbriand, Pointe Claire(2) EUROPE: AUSTRIA-Wels; CZECH REPUBLIC-Hradec, Zabreh; DENMARK-Copenhagen, Frederiksberg, Levring, Rodovre, Vadum; FRANCE-Duppigheim (2), Faverolles, Ludres (Nancy), Verneuil; GERMANY-Auerbach, Bremen, Heilbronn, Krefeld, Reinbek, Wittingen; GREECE-Schimatari; HUNGARY-Roszke; IRELAND-Dublin; ITALY-Acerra, Calderara (Bologna), Sanguinetto; NETHERLANDS-Baarn, Loosdrecht; POLAND-Poznan (2); PORTUGAL-Carregado; SPAIN-Martorell; SWEDEN-Simrishamn; SWITZERLAND-Carouge, Thayngen; UNITED KINGDOM-Burton-on-Trent, Lifton, Paisley, Redditch LATIN AMERICA: ARGENTINA-Barracas, Florida, Mendoza, Pilar, Tucuman; BRAZIL-Anastacio, Campina Grande, Garanhuns, Pouso Alegre, Resende; COLOMBIA-Barranquilla (2), Cali; COSTA RICA-Ala Juela; DOMINICAN REPUBLIC-Santo Domingo; MEXICO-Aguascalientes, Aguida, Lerma; PERU-Callao; URUGUAY-San Carlos; VENEZUELA-Maracay, Valencia AFRICA & MIDDLE EAST: ISRAEL-Arad, Arara, Beit-Yitzak, Hadera, Haifa, Zefat; KENYA-Nairobi, Nakuru; LA REUNION-Bras-Panon; MOROCCO- Casablanca; SAUDI ARABIA-Yanbu; TUNISIA-Grombalia; TURKEY-Cayirova, ASIA: HONG KONG-Tai Po; INDIA-Dharwad, Thane; MALAYSIA-Kuala Lumpur; PHILIPPINES-Las Pinas, Paranaque; TAIWAN-Hsin Chu Hsien, Tu-Cheng; THAILAND-Bangpoo THE CORN REFINING FACILITIES ARE AS FOLLOWS: UNITED STATES: CALIFORNIA-Stockton; ILLINOIS-Argo; NORTH CAROLINA-Winston-Salem CANADA: ONTARIO-Cardinal, London, Port Colborne LATIN AMERICA: ARGENTINA-Baradero*, Rio Segundo; BRAZIL-Balsa Nova, Cabo*, Mogi-Guacu*; CHILE-Llay-Llay*; COLOMBIA-Barranquilla, Cali*, Medellin; HONDURAS-San Pedro Sula*; MEXICO-Guadalajara*, San Juan del Rio ASIA: MALAYSIA-Petaling Jaya; PAKISTAN-Faisalabad* AFRICA: KENYA-Eldoret The OTHER PRODUCTS facility which produces enzymes is located in Beloit, Wisconsin. __________ * Indicates corn refining plant that also produce consumer foods products. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There have been no material developments in the legal proceedings as previously reported on Form 10-Q for the quarter ended June 30, 1993. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below are the names and ages of all elected officers of the Registrant, as of December 31, 1993, indicating their positions and offices with the Registrant and the period during which each has served as such: All of the above officers, except Lawrence K. Hathaway who joined the Company in May 1989, have been executives of the Company for at least five years. Mr. Hathaway joined CPC in May 1989 as president of the Best Foods Grocery Products Unit. Prior to that, he was president of the convenience food division and then the cereals division of the Quaker Oats Company. Before joining Quaker in 1986, he was division president and general manager - health and beauty products for Chesebrough-Pond's Inc. All officers serve at the pleasure of the Board of Directors. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTER Information regarding the principal markets for the Company's common stock and market prices for each quarterly period during the past two years is set forth on pages 48 and 49 of the Annual Report and is incorporated herein by reference. The approximate number of equity stockholders as of December 31, 1993 was 31,400. The history of the Company's dividends declared for the last two years on pages 48 and 49 of the Annual Report is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected financial data for the eleven years ended December 31, 1993 for the Company, as set forth on pages 48 and 49 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 Management's discussion and analysis of financial condition and results of operations of the Company for the three years ended December 31, 1993, is set forth on pages 27 through 30 of the Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements comprising the consolidated balance sheets at December 31, 1993, 1992, and 1991, consolidated statements of income, stockholders' equity and cash flows, and notes to financial statements for the years then ended, are set forth on pages 31 through 44 of the Annual Report. Selected quarterly financial data for the years ended December 31, 1993 and December 31, 1992, set forth on pages 48 and 49 of the Annual Report is incorporated herein by reference. 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 The Company's Proxy Statement dated March 16, 1994 (the "1994 Proxy Statement") has been filed pursuant to Regulation 14A and is incorporated herein by reference. Information regarding directors of the registrant is set forth on pages 14 through 19 of the 1994 Proxy Statement under the caption "Election of Directors". Information regarding executive officers of the registrant is set forth on pages 4 and 5 of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation is set forth on pages 9 through 13 of the 1994 Proxy Statement under the caption "Executive Compensation and Stock Ownership Tables". ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding security ownership of certain beneficial owners and management is set forth on pages 9 and 13 of the 1994 Proxy Statement under the caption "Executive Compensation and Stock Ownership Tables". 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 - See index on page 8. b) Reports on Form 8-K - There was one report filed on Form 8-K during the fourth quarter of 1993 discussing under Item 5 "Other Events" the Company's termination of its agreement to form a joint venture in Europe. c) Exhibits - Exhibits to this report are filed as part of this report as set forth in the Index to Exhibits on pages 15 and 16 hereof. 1. The consolidated financial statements and reports of the independent auditors are included in Part II of this report through incorporation by reference from the Annual Report which is enclosed as Exhibit 13. The documents referred to above can be found on the following pages in the Annual Report. 2. The following financial statement schedules and documents are submitted herein on pages indicated below: All other schedules have been omitted either because the information is not required or is otherwise included in the financial statements 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, on the 15th day of March, 1994. CPC INTERNATIONAL INC. By /s/ CHARLES R. SHOEMATE ----------------------------------------- Charles R. Shoemate, 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 indicated, on the 15th day of March, 1994. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders CPC International Inc.: Under date of February 4, 1994, we reported on the consolidated balance sheets of CPC International Inc. and Subsidiaries as of December 31, 1993, 1992 and 1991 and the related consolidated statements of income, stockholders' equity, and cash flows for the years then ended, as contained in the 1993 Annual Report to Stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the Annual Report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG Peat Marwick New York, New York February 4, 1994 SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS) _________ (A) Includes the following amounts related to acquisitions of businesses: 1993 - $ 18.4 million 1992 - $124.5 million 1991 - $ 12.5 million (B) Includes currency translation adjustments and other reclassifications. SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS) ___________ (A) Depreciation is generally computed on the straight-line method over the estimated useful lives of depreciable assets at rates ranging from 2% to 10% for buildings and 5% to 20% for all other assets. (B) Includes currency translation adjustments and other reclassifications. SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN MILLIONS) Amortization of intangible assets, preoperating costs and similar deferrals, in addition to taxes, other than payroll and income taxes and royalties have been omitted as none of these items exceed one percent of the Company's total sales. INDEX TO EXHIBITS Exhibit No. - ----------- 3(a) The Certificate of Incorporation as restated April 22, 1993 is filed herewith as Exhibit 3(a). 3(b) The By-Laws as amended on September 21, 1993 are filed herewith as Exhibit 3(b). 4(a) No instruments defining rights of holders of debts securities are included as exhibits because each authorized issue of debt securities is less than 10% of total assets. The Company agrees that it will furnish a copy of any such instrument upon request. 4(b) Rights Agreement dated March 19, 1991 between the Company and First Chicago Trust Company of New York is incorporated by reference to Exhibit 4(b) of Form 10-K for the year ended December 31, 1991. 10(a) The 1984 Stock and Performance Plan is incorporated by reference from Exhibit A to the prospectus contained in Post-Effective Amendment No. 1 to the Registration Statement on Form S-8, File No. 2-92248. 10(b) The 1993 Stock and Performance Plan is incorporated by reference to The Registration Statement filed on Form S-8, File No. 33-49847. 10(c) Deferred Compensation Plan for Outside Directors and Retirement Income Plan for Outside Directors i) An amendment to the Deferred Compensation Plan for Outside Directors, dated January 19, 1988 is incorporated by reference to Exhibit 10(b)i Form 10-K for the year ended December 31, 1988. ii) The Retirement Income Plan for Outside Directors as amended March 15, 1988, is incorporated by reference to Exhibit 10(b)ii of Form 10-K for the year ended December 31, 1987. 10(d) Employment agreements for those directors and the five most highly compensated executive officers who have such contracts, including amendments thereto. Employment agreement for Mr. C.R. Shoemate dated January 2, 1986, is incorporated by reference to Exhibit 10(c) of Form 10-K for the year ended December 31, 1988, along with amendments dated January 19, 1989, February 21, 1989, and January 21, 1992 are incorporated by reference to Exhibit 10(c) of Form 10-K for the year ended December 31, 1991. Employment agreement for Mr. R.J. Gillespie, dated January 2, 1986, as amended, is incorporated by reference to Exhibit 10(c) of Form 10-K for the year ended December 31, 1988. Amendments dated January 19, 1989 and February 21, 1989 are incorporated by reference to Exhibit 10 (c) of Form 10- K for the year ended December 31, 1992. 10(d) Employment agreement for Mr. C.B. Storms dated January 2, 1986, along with amendments dated November 21, 1986, September 20, 1988, February 13, 1989, and February 21, 1989 are incorporated by reference to Exhibit 10(c) of Form 10-K for the year ended December 31, 1989. Employment agreement for Mr. K. Schlatter, dated January 2, 1986, along with amendments dated November 21, 1986, November 13, 1987, September 20, 1988, February 21, 1989 and July 5, 1990 are incorporated by reference to Exhibit 10 (c) of Form 10-K for the year ended December 31, 1992. 10(e) Indemnification agreements for all directors and five most highly compensated executive officers who have such contracts are incorporated by reference to Exhibit 10(d) of Form 10-K for the year ended December 31, 1986. 10(f) Deferred Compensation Plan for senior executives, dated November 10, 1988 is incorporated by reference to Exhibit 10(e) of Form 10-K for the year ended December 31, 1988. 10(g) Special Severance Program for Salaried Employees, dated January 17, 1989 is incorporated by reference to Exhibit 10(f) Form 10-K for the year ended December 31, 1988. An amendment dated March 19, 1991 to the Special Severance Program for Salaried Employees is incorporated by reference to Exhibit 10 (f) of Form 10-K for the year ended December 31, 1991. 11 Schedule of computation of earnings per share filed herewith. 13 1993 Annual Report to Stockholders filed herewith except for such parts thereof as are expressly incorporated by reference in this Form 10-K (graphic material contained in the Annual Report is not included in the electronic filing of this report). This exhibit is furnished for the information of the Securities and Exchange Commission and is not deemed filed as a part of hereof. 21 Subsidiaries of the Registrant Filed herewith. 23 Consent of Independent Auditors Filed herewith. 24 Powers of Attorney Filed under separate cover with the SEC.

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Item 1. Business. General Development of Business - Halliburton Company (the Company) was established in 1919 and incorporated under the laws of the state of Delaware in 1924. The Company provides energy services, engineering and construction services, and property and casualty insurance services. Information related to acquisitions and dispositions is set forth under Acquisitions and Dispositions in Note 18 to the financial statements of this Annual Report. Financial Information About Business Segments - The Company is comprised of three business segments. See Note 12 to the financial statements of this Annual Report for financial information about these three business segments. Energy Services product sales were $414.4 million in 1993, $437.0 million in 1992 and $443.7 million in 1991. Description of Services and Products - The following is a summary which briefly describes the Company's services and products for each business segment. Energy Services: Halliburton Energy Services (Energy Services) provides a wide range of services and products used in the exploration, development and production of oil and natural gas. Energy Services operates worldwide serving major oil companies, independent operators and national oil companies. The services and products provided by Energy Services include cementing, casing equipment and water control services; completion and production products; drilling systems, measurement while drilling, logging while drilling and mud logging services; sales of advanced technology software, turnkey workstations and information technology solutions for energy and minerals exploration and development; open and cased hole logging and perforating services and logging and perforating products; well testing, reservoir description and evaluation services, tubing conveyed well completion systems and reservoir engineering services; stimulation and sand control services and tools and coiled tubing services; wellhead pressure control equipment, leasing of natural gas compressors and gas processing equipment, well control, hydraulic workover and downhole video services. In January, 1994, the Company sold its geophysical business. During 1993, the geophysical business included sales of seismic equipment, seismic data collection and data processing services for both land and marine seismic exploration activities. Engineering and Construction Services: Engineering and Construction Services includes services for both land and marine activities. Included are technical and economic feasibility studies, site evaluation, licensing, conceptual design, detailed engineering, procurement, project and construction management, construction and start-up assistance of electric utility plants, chemical and petrochemical plants, refineries, pulp and paper mills, metal processing plants, highways and bridges, subsea construction, fabrication and installation of subsea pipelines, offshore platforms, production platform facilities, marine engineering and other marine related projects, contract maintenance and operations and maintenance services for both industry and government, engineering and environmental consulting and waste management services for industry, utilities and government, and remedial engineering and construction services for hazardous waste sites (Brown & Root). Insurance Services: Insurance Services provides property and casualty insurance products and services (Highlands Insurance Company). Markets and Competition - The Company is one of the world's largest diversified energy services and engineering and construction services companies. The Company's services and products are sold in highly competitive markets throughout the world. Competition in both services and products is based on a combination of price, service (including the ability to deliver services and products on an "as needed where needed" basis), product quality, warranty and technical proficiency. Some Energy Services' and Engineering and Construction Services' customers have indicated a preference for packaged services. These packaged services, in the case of Energy Services, relate to all phases of exploration and production of oil and gas, and, in the case of Engineering and Construction Services, relate to all phases of design, construction, project management and maintenance of a facility. Demand for these types of packaged services is based primarily upon quality of service, technical proficiency and overall price. The Company conducts business worldwide in over 100 countries. Since the market for the Company's services and products is so large and crosses many geographic lines, a meaningful estimate of the number of competitors cannot be made. The markets are, however, highly competitive with many substantial companies operating in each market. Generally, the Company's services and products are marketed through its own servicing and sales organizations. A small percentage of sales of Energy Services' products is made by supply stores and third-party representatives. Operations in some countries may be affected by unsettled political conditions, expropriation or other governmental actions, and exchange control and currency problems. The Company believes the diversification of these activities reduces the risk that loss of any one country's operations would be material to the conduct of its operations taken as a whole. Customers and Backlog - Substantially all of the Company's Energy Services and a significant portion of Engineering and Construction Services are related to the energy industries. In 1993, 1992 and 1991, respectively, 77%, 79% and 78% of the Company's revenues were derived from services to, including construction for, the energy industries. The following schedule summarizes the backlog of engineering and construction projects at December 31, 1993 and 1992: It is estimated that nearly 44% of the backlog existing at December 31, 1993 will be completed during 1994. The Company does not believe that engineering and construction backlog should necessarily be relied on as an indication of future operating results since such backlog figures are subject to substantial fluctuations. Arrangements included in backlog are in many instances extremely complex, nonrepetitive in nature and may fluctuate in contract value. Many contracts do not provide for a fixed amount and are subject to modification or termination by the customer. Due to the size of certain contracts, the termination or modification of any one or more contracts or the addition of other contracts may have a substantial and immediate effect on backlog. Orders for Energy Services are generally placed by customers on the basis of current need. Therefore, backlog of orders for these services and products are either insignificant or not material. Raw Materials - All raw materials essential to the Company's business are normally readily available. Where the Company is dependent on a single supplier for any materials essential to its business, the Company is confident that it could make satisfactory alternative arrangements in the event of interruption in the supply of such materials. Research, Development and Patents - The Company maintains an active research and development program to assist in the improvement of existing products and processes, the development of new products and processes and the improvement of engineering standards and practices that serve the changing needs of its customers. Information relating to expenditures for research and development is included in Note 13 to the financial statements of this Annual Report. The Company owns a large number of patents and has pending a substantial number of patent applications, covering various products and processes. It is also licensed under patents owned by others. The Company does not consider a particular patent or group of patents to be material to the Company's business. Seasonality - Weather and natural phenomena can temporarily affect the performance of the Company's services. Winter months in the Northern Hemisphere tend to affect operations negatively, but the widespread geographical locations of such services serve to reduce the seasonal nature of the business. Employees - At December 31, 1993 the Company employed approximately 64,700 people of which 22,300 were located outside the United States. Regulation - The Company is subject to various environmental laws and regulations. Compliance with such requirements has neither substantially increased capital expenditures or adversely affected the Company's competitive position, nor materially affected the Company's earnings. The Company does not anticipate any such material adverse effects in the foreseeable future as a result of such existing laws and regulations. Note 14 to the financial statements of this Annual Report discusses the Company's involvement as a potentially responsible party in remedial activities to clean up various "Superfund" sites. Item 2. Item 2. Properties. Information relating to lease payments is included in Note 14 to the financial statements of this Annual Report. The Company's owned and leased facilities, as described below, are suitable and adequate for their intended use. Energy Services - Energy Services owns manufacturing facilities covering approximately 3,600,000 square feet. Principal locations of these manufacturing facilities are Davis and Duncan, Oklahoma; Alvarado, Amarillo, Carrollton, Cisco, Fort Worth, Garland, Houston and Mansfield, Texas; Arbroath, Scotland; Reynosa, Mexico; and Jurong, Singapore. The manufacturing facilities at Davis, Amarillo, Cisco, Mansfield and one of two facilities in Carrollton were inactive at the end of 1993. Energy Services also leases manufacturing facilities covering approximately 138,000 square feet. Principal locations of these facilities are Norwich, England; Voorschoten, Holland; Reynosa, Mexico; and Kilwinning, Scotland. The Company will lease 103,000 square feet of owned manufacturing space in Houston, Texas to another company in 1994. Research, development and engineering activities are carried out in owned facilities covering approximately 385,000 square feet in Duncan, Oklahoma; Houston and Carrollton, Texas; and Aberdeen, Scotland; and leased facilities covering approximately 30,000 square feet in Houston, Texas; Bedford, England and Leiderdorp, Holland. In addition, service centers, sales offices and field warehouses are operated at approximately 260 locations in the United States, almost all of which are owned, and at approximately 300 locations outside the United States in both the Eastern and Western Hemispheres. Engineering and Construction Services - Engineering and Construction Services owns manufacturing facilities covering approximately 454,000 square feet in Houston, Texas, Edmonton, Canada and Aberdeen, Scotland. The Company will lease 388,000 square feet of this manufacturing space in Houston, Texas to another company in 1994. Engineering and Construction Services also owns marine fabrication facilities covering approximately 930 acres in Belle Chasse, Louisiana; Harbor Island and Greens Bayou, Texas; Sunda Strait, Indonesia (35% owned); and Nigg and Wick, Scotland. The marine fabrication facility at Harbor Island, Texas was leased to another company in 1993 and was sold in the first quarter of 1994. The facility at Belle Chasse, Louisiana was idle during 1993. Engineering and design, project management and procurement services activities are carried out in owned facilities covering approximately 1,750,000 square feet in Houston, Texas; Edmonton, Canada; and Aberdeen, Scotland; and leased facilities covering approximately 1,700,000 square feet in Mobile, Alabama; Alhambra, California; Gaithersburg, Maryland; London, England; Kuala Lumpur, Malaysia; Singapore; and Aberdeen, Scotland. In addition, laboratories, service centers, and sales offices are operated at approximately 50 locations in the United States, almost all of which are leased by the Company, and at approximately 5 foreign locations in both Eastern and Western Hemispheres. Insurance Services - Insurance Services operates from leased facilities in Houston, Texas and London, England covering approximately 130,000 square feet. Insurance Services also operates out of approximately 10 sales and services centers in the United States which are leased by the Company and 2 international locations in the Eastern Hemisphere. General Corporate - General Corporate operates from leased facilities in Dallas, Texas covering approximately 55,000 square feet. In addition, computer and data processing services are provided to the rest of the Company out of owned and leased facilities in Arlington, Texas covering approximately 85,000 and 36,000 square feet, respectively. Item 3. Item 3. Legal Proceedings. Information relating to various commitments and contingencies is described in Note 14 to the financial statements of this Annual Report. 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. Item 4(A). Executive Officers of the Registrant. The following table indicates the names and ages of the executive officers of the registrant along with a listing of all offices held by each during the past five years: Name and Age Offices Held and Term of Office - ------------ ------------------------------- * Alan A. Baker (Age 61) Chairman and Chief Executive Officer of Halliburton Energy Services (formerly Energy Services Group), since September 1991 President of Energy Services Group, December 1989 to September 1991 President of Halliburton Services (Division of the Registrant), April 1987 to December 1989 Jerry H. Blurton Vice President - Finance, since September 1991 (Age 49) Vice President and Controller, October 1989 to September 1991 Partner in international accounting firm of Deloitte Haskins & Sells for more than 5 years * Lester L. Coleman Executive Vice President and General Counsel, since (Age 51) May 1993 President of Energy Services Group, September 1991 to May 1993 Executive Vice President of Finance and Corporate Development, January 1988 to September 1991 * Thomas H. Cruikshank Director of Registrant, since May 1977 (Age 62) Chairman of the Board, since June 1989 Chief Executive Officer, since May 1983 President, November 1981 to June 1989 * Dale P. Jones Director of Registrant, since December 1988 (Age 57) President, since June 1989 Executive Vice President - Oil Field Services, November 1987 to June 1989 * Tommy E. Knight President and Chief Executive Officer of Brown & (Age 55) Root, Inc., since May 1992 Executive Vice President - Operations of Brown & Root, Inc, January 1990 to May 1992 Executive Vice President of Marine Group (business unit of Brown & Root, Inc.), March 1986 to January 1990 * Kenneth R. LeSuer President and Chief Operating Officer of Halliburton (Age 58) Energy Services, since May 1993 President and Chief Executive Officer of Halliburton Services, December 1989 to May 1993 President of Halliburton Reservoir Services, September 1988 to December 1989 * W. Bernard Pieper Vice Chairman, since May 1992 (Age 62) President and Chief Executive Officer of Brown & Root, Inc. (Subsidiary of the Registrant), July 1990 to May 1992 President and Chief Operating Officer of Brown & Root, Inc., January 1989 to July 1990 Senior Executive Vice President of Operations of Brown & Root, Inc., July 1979 to January 1989 * Members of the Executive Committee of the registrant There are no family relationships between the executive officers of the registrant. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters. The Company's common stock is traded on the New York Stock Exchange, the Toronto Stock Exchange, the Stock Exchange of London, and the Swiss Stock Exchanges at Zurich, Geneva, Basel and Lausanne. Information relating to market prices of common stock and quarterly dividend payments is included under the caption "Quarterly Data and Market Price Information" on page 44 of this Annual Report. At December 31, 1993, there were approximately 18,677 shareholders of record. In calculating the number of shareholders, the Company considers clearing agencies and security position listings as one shareholder for each agency or listing. Item 6. Item 6. Selected Financial Data. Information relating to selected financial data is included on page 45 of this Annual Report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Information relating to management's discussion and analysis of financial condition and results of operations is included on pages 8 to 16 of this Annual Report. Item 8. Item 8. Financial Statements and Supplementary Data. Page No. -------- Responsibility for Financial Reporting 17 Report of Arthur Andersen & Co., Independent Public Accountants 18 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 19 Consolidated Balance Sheets at December 31, 1993 and 1992 20 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 21 Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 22 Notes to Financial Statements 23 to 43 Quarterly Data and Market Price Information 44 The related financial statement schedules are included under Part IV, Item 14 of this Annual Report. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION BUSINESS ENVIRONMENT The business of the Company is significantly affected by worldwide expenditures of the energy industry. The operations of Halliburton Energy Services are impacted quickly by short-term increases and decreases in oil and natural gas development activities in major producing areas throughout the world. These development activities are sensitive to the legislative environment in the United States and other major countries, developments in the Middle East and the impact of these and other events on the pricing of oil and natural gas. During the latter part of 1993, the price of oil declined significantly due, in part, to excess supply worldwide. Reductions in the prices of oil and natural gas negatively impact the cash flows of the Company's customers which may cause customers to reduce expenditures for exploration and development until prices return to more economic levels. The reduction of oil prices may negatively impact the demand for the Company's energy services in 1994. However, activity in the United States for natural gas drilling has been strong and that should continue if current natural gas prices are sustained. The operations of Engineering and Construction Services are subject to longer-term economic trends in the United States and other major countries. The major factor is the capital spending plans for hydrocarbon processing of major oil, natural gas and chemical companies throughout the world. Other factors include the capital spending plans of the pulp and paper industry, environmental laws which require emission standards performance of existing and new facilities and governmental defense spending by the United States and especially by the United Kingdom. The worldwide economic slowdown has caused some existing and future capital spending plans to be deferred until economic factors improve and will likely have a negative impact on the near-term operating results of this group. Recent economic indicators show improvement in the United States economy and slow improvement in the economies of Europe. At the present rate of economic recovery, any significant impact on the operating results of Engineering and Construction Services is not expected until the latter part of 1995 or 1996. The operations of Insurance Services are impacted by the legislative environment in the United States and catastrophic events. The United States Congress is currently considering various healthcare plans, some of which may impact workers' compensation coverages which provided approximately 50% of earned premiums of Insurance Services in 1993. The Company operates in over 100 countries. Operations in some countries may be affected by unsettled political conditions, expropriation or other governmental actions, and exchange control and currency problems. The Company believes the diversification of these activities reduces the risk that loss of any one country's operations would be material to the conduct of its operations taken as a whole. Results of operations include operating income relating to work performed in Libya by foreign subsidiary companies of $44.7 million, $10.5 million and $8.0 million in 1993, 1992 and 1991, respectively. In December 1993 the United Nations imposed sanctions on certain transactions between its member nations and Libya. Foreign subsidiaries of the Company are continuing to work in Libya in compliance with these sanctions. Although implementation of the sanctions has caused delay in collection of receivables for such work, payment of such receivables is permitted under the sanctions and the Company expects payments to continue. RESULTS OF OPERATIONS Consolidated Highlights Revenues in 1993 were $6,350.8 million, a decrease of 3% from 1992 revenues of $6,565.9 million and a 10% decrease from 1991 revenues of $7,018.8 million. Energy Services revenues increased in 1993 compared to 1992 and 1991. Revenues from Engineering and Construction Services and Insurance Services declined from 1992 and 1991. Operating income in 1993 was a loss of $132.6 million, compared with an operating loss of $101.4 million in 1992 and operating income of $95.9 million in 1991. Excluding special items noted below, operating income in 1993 increased 28% over 1992 and 10% over 1991. Most of the increase in operating income, excluding special items, was from Energy Services. In 1993, the Company recognized a $301.8 million charge against Energy Services operating income ($263.8 million net of income taxes) to reflect the net realizable value of the Company's geophysical business which was disposed of in January 1994. See Note 18 to the consolidated financial statements. The Company also provided a $20.0 million charge in the fourth quarter of 1993 ($13.0 million net of income taxes) related to Energy Services non-geophysical employee severance costs. In addition, the Company also provided a $46.3 million charge in 1993 and a $21.0 million charge in 1992 ($33.9 million net of income taxes in 1993 and $17.4 million in 1992) related to claims loss reserves on its United Kingdom insurance business in each year and expenses for the suspension of underwriting activities in 1993 of the United Kingdom Insurance Services subsidiary. See Note 11 to the consolidated financial statements. See Note 17 to the financial statements for a description of special charges in 1992 and 1991, which provided for the cost of closing and consolidation of certain operating facilities; globalizing employee benefits and personnel reductions, relocations and associated employee benefit costs; technological obsolescence of certain inventories and equipment related to the introduction of new technologies; realignment of worldwide manufacturing capabilities; writedown of certain investments in operations which are no longer in the Company's long-term strategic interest; reduction in value of certain intangible assets; and other items primarily related to the cost of relocating equipment due to the above actions. Consolidated net income for 1993 was a loss of $161.0 million compared to a net loss of $137.3 million in 1992 and net income of $26.6 million in 1991. Excluding special items, net income would have been $102.9 million in 1993, $64.0 million in 1992 and $90.4 million in 1991. Net income per share in 1993 was a loss of $1.43, compared to a loss per share of $1.28 in 1992 and income per share of $.25 in 1991. Excluding the special items, net income per share would have been $.92 per share in 1993, $.59 in 1992 and $.85 in 1991. Excluding the special items noted above and the results of operations of the geophysical business sold in January 1994, revenues, operating income, net income and earnings per share would have been as follows: Energy Services In the latter part of 1991 and throughout 1992, a number of the Company's major customers began reducing the size and spending plans of their United States operations and moving into markets in other countries. In 1993, however, some of the Company's major customers increased spending plans in their United States operations with corresponding decreases in other spending plans, due primarily to the incentive of higher sustained natural gas prices. In addition, throughout this period, Energy Services has experienced an increased demand from its customers for packaged services and products. These packaged services and products relate to all phases of oil and natural gas exploration and development, from the initial exploration, throughout production, and to the retirement of the wells. In response to evolving customer demands and the desire to deliver services and products more focused on the specific needs of its customers in each geographical area, Energy Services, in 1993, reorganized the ten separate business units that constituted the Company's Energy Services segment into a single division of Halliburton Company named Halliburton Energy Services. The new organization provides a broad range of services and products used for the exploration, development and production of oil and natural gas. Managerial control of these services and products is provided by regional offices responsible for five geographic regions of the world, plus an additional group that focuses on emerging opportunities in the former Soviet Union and in China. Revenues in 1993 were $2,953.4 million, an increase of 8% from 1992 revenues of $2,726.3 million and a slight increase from 1991 revenues of $2,939.0 million. Approximately one-half of the increase over 1992 was from the acquisition of the drilling systems business in 1993. After falling to a post-World War II low in the first part of 1992, the United States average rotary rig count increased 5% in 1993 over 1992, but was still 13% below the 1991 level. The increase in the average rotary rig count favorably impacted United States revenues, which increased 22% in 1993 over 1992, but declined by 3% from 1991. In addition, higher levels of completion activity were experienced in the early part of 1993 on wells drilled prior to the December 31, 1992 expiration of section 29 tight sands gas tax credits. Revenues per average rotary rig in the United States, excluding the geophysical operations, increased by 15% in 1993 over 1992 and by 12% over 1991. The average United States rotary rig count is normally affected by seasonal declines early in the year. However, lower oil prices may reduce the number of working rotary rigs in 1994 below 1993 levels. The impact of lower oil prices may be mitigated by higher natural gas prices and an increase in the number of offshore rotary rigs. Offshore rotary rigs tend to be committed for longer-term periods than land-based rotary rigs. The average rotary rig count outside the United States increased 1% in 1993 compared to 1992 after four straight years of decline. This reversal of the trend was primarily due to the significant increase in the Canadian rig count as a result of higher sustained natural gas prices. There were declines in rig activity in Latin America, the North Sea and Africa. Energy Services experienced pricing pressures in the declining regions due to increased competition for the available business. Overall, 1993 revenues outside the United States were the same level as 1992, but 3% above 1991 revenues. Revenues per average rotary rig, excluding the geophysical operations, increased in 1993 by 6% over 1992 and 20% over 1991. Operating income in 1993 was a loss of $147.7 million, compared to a loss of $63.6 million in 1992 and income of $36.1 million in 1991. Excluding special items, operating income would have been $174.1 million in 1993, $118.4 million in 1992 and $154.6 million in 1991. The increase in 1993 operating income, excluding special items, is due primarily to increased United States business activities, partially offset by declines in profit margins related to industry overcapacity in other countries. Operating income, excluding special items, includes operating losses from the geophysical business of $20.1 million in 1993 compared to $26.6 million in 1992 and $12.0 million in 1991. Operating income in 1993 also includes $31.0 million resulting from a combination of ongoing operations and improved collections on work performed in Libya by foreign subsidiaries of the Company, compared to $10.5 million in 1992 and $4.8 million in 1991. Engineering and Construction Services Revenues were $3,140.7 million in 1993, a decrease of 12% from 1992 revenues of $3,563.7 million and a 16% decrease from 1991 revenues of $3,728.0 million. United States revenues in 1993 declined 14% from 1992 and 17% from 1991 as a result of the continuing economic slowdown. Most of the decrease in 1993 was due to the reduction of available engineering and construction work on downstream energy and forest products related projects. There were increases in revenues for all three years for environmental consulting. The decrease of available engineering work on future projects in 1993 is an indication of slow engineering and construction activity in the near-term in the United States. There was some evidence in 1993 of a slowly improving United States economy. However, many industrial customers continue to defer some spending plans for expansion and overhaul of existing facilities until sustained growth in the economy stimulates sufficient demand. Two areas that may increase available engineering work in the United States would be infrastructure reinvestment and compliance of existing industrial facilities with environmental emission standards. Revenues from engineering and construction projects outside the United States in 1993 decreased by 7% from 1992 and by 14% from 1991. The decrease in revenues in 1993 is due primarily to uncertainty in long-term oil prices and United Kingdom tax policies on North Sea development activity and the completion of several large oil and gas construction contracts in the Middle East in 1991, partially offset by the award of additional long-term privatization service agreements internationally. Operating income was $79.3 million, compared with a loss of $12.0 million in 1992 and income of $73.7 million in 1991. Excluding special items, operating income would have been $79.3 million in 1993, $70.6 million in 1992 and $73.7 million in 1991. Operating income in 1993 includes profits from a major gas compressor station project in Asia Pacific, support services for relief efforts in Somalia and construction of a gas pipeline in the North Sea. Increased operating income outside the United States in 1993 was partially offset by reduced profit margins on lower United States activity levels. Operating income in 1992 includes losses on an environmental services contract completed in California, partially offset by higher marine activities in Europe and government munitions clean up and damage assessment in Saudi Arabia and Kuwait. Included in 1991 is an $18.7 million loss provision relating to an oil and gas facility contract in the Middle East. Operating income includes income of $13.7 million in 1993 resulting primarily from improved collections on work performed in Libya by foreign subsidiaries of the Company. The backlog of unfilled firm orders on engineering and construction projects was down 6% in 1993 from 1992. Backlog may not be a reliable indicator of future profitability or activity levels due to the duration of many projects and the complexity of various contract terms. Management expects overall Engineering and Construction Services' revenues in 1994 to be slightly higher than 1993, but aggregate operating margins will be difficult to maintain. Insurance Services The Company announced in July 1992, that it would pursue divestiture of its wholly owned Highlands Insurance Company subsidiary and its related companies (Highlands). The Company concluded its effort to sell Highlands without securing a satisfactory transaction. The Company is now concentrating on improving the financial results of Highlands' operations. Revenues were $256.7 million in 1993, a decrease of 7% from 1992 revenues of $275.9 million, and a 27% decrease from 1991 revenues of $351.8 million. The reduced revenues in 1992 are primarily the result of a stop loss reinsurance agreement executed in 1992. Insurance Services had an operating loss of $42.2 million in 1993 compared with a loss in 1992 of $4.8 million and income in 1991 of $7.9 million. Excluding provisions for claim loss reserves on United Kingdom business and suspension of underwriting activities in the United Kingdom, operating income would have been $4.1 million in 1993, $16.2 million in 1992 and $7.9 million in 1991. The decrease in operating income is due primarily to losses on discontinued lines of businesses and additional loss development relating to Hurricane Andrew, the World Trade Center bombing and winter storms in the northeast. These losses were partially offset by a refund from the Texas Workers' Compensation Assigned Risk Pool and premium adjustments. Investment income was lower in 1993 due primarily to lower yields on available investments and reductions in invested balances along with the realization in 1992 of gains from the sale of certain investments. The Company's insurance subsidiaries have numerous reinsurance agreements with other insurance companies. See Note 11 to the financial statements. Prior to June 30, 1993, Highlands wrote property insurance (including homeowners) in Florida through a reinsurance facility under which it ceded 93.5% of this line of business to various reinsurance companies retaining 6.5% of the risk of such policies. In January 1993, Highlands was notified by its reinsurers that reinsurance would not be available for policies written or renewed after June 30, 1993. Highlands then withdrew from its property business in Florida in accordance with Florida's withdrawal statute and rules. In May 1993, Florida enacted a moratorium law which the Florida Department of Insurance (DOI) has construed as revoking Highlands' ability to non-renew homeowners policies as a means of effecting such withdrawal. Highlands is contesting the applicability of the moratorium law to it and its withdrawal, the constitutionality of the moratorium law and a DOI order seeking to impose penalties and sanctions for certain notices of non-renewal issued by Highlands. In November 1993, the Florida legislature extended the moratorium for three years, allowed insurance companies to reduce the number of their homeowners policies by 5% per annum and established a catastrophe fund to reimburse insurance companies in the event of a hurricane or other catastrophe for 75% of losses in excess of two times annual property premiums written in the prior year. The protection offered by the catastrophe fund significantly reduces Highlands exposure to risk of hurricane related losses. Nonoperating Items Interest income decreased in 1993 to $13.9 million from $42.0 million in 1992 and $62.3 million in 1991. Excluding interest on income tax refunds, interest income decreased in 1993 primarily due to lower interest rates available on invested cash and equivalents and lower levels of invested cash. Foreign currency losses in 1993 were $21.0 million compared with 1992 losses of $32.7 million and 1991 losses of $11.1 million. The losses relate primarily to various Latin American and African currency exposures in 1993 and to European, African and Latin American currency exposures in 1992. The Latin American and African currencies have been prohibitively expensive to hedge and losses there are likely to continue. Nonoperating income in 1992 includes a $13.6 million gain on sale of the Company's wholly owned healthcare cost management services company. Income taxes were reduced in 1993 by $40.4 million due to a settlement with the Internal Revenue Service relating to tax assessments for the 1980-1987 taxable years. See Note 7 to the financial statements. Income taxes were further reduced an additional $6.4 million in 1993 due to changes in Federal income tax laws. The effective income tax rates, excluding special items, for the years 1993, 1992 and 1991 were 43%, 48% and 49%, respectively. The effective income tax rates are negatively impacted by lower United States taxable earnings, shifts of profitable activities to foreign countries with higher effective income tax rates, and the occurrence of losses in certain countries where these losses could not be fully deducted for tax purposes. The Company reviews the probable realizability of deferred tax assets and liabilities of each taxing jurisdiction utilizing historical and forecast information. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before the Company is able to realize their benefit, or that future deductibility is statutorily prohibited or uncertain. Approximately 90% of the deferred tax assets at December 31, 1993 relates to United States Federal temporary differences. The Company believes it has sufficient taxable income in carryback years, future reversals of taxable temporary differences and anticipated future taxable income to utilize the future deductions represented in the deferred tax assets. In addition, the Company can implement certain tax planning strategies to accelerate taxable amounts to utilize any expiring carryforwards not offset by a valuation allowance. The Company changed its methods of accounting for income taxes and postretirement benefits other than pensions in 1992. See Notes 7 and 16 to the financial statements for a description of changes in accounting methods. LIQUIDITY AND CAPITAL RESOURCES The Company ended the year 1993 with cash and equivalents of $48.8 million, a decrease of $184.5 million from 1992 and a decrease of $82.8 million from 1991. Excluding cash and equivalents of Insurance Services, which are restricted from general corporate purposes unless paid to the parent as a dividend, cash and equivalents at the end of the year 1993 were $7.5 million, a decrease of $138.9 million from 1992 and a decrease of $69.5 million from 1991. The Company will benefit from the sale of the geophysical business not only from the proceeds of the sale but also by eliminating a source of historically negative cash flows and operating results. The Company received $100 million cash in January 1994 as proceeds of sale of the geophysical business and will make payments of approximately $50 million during 1994 on a note issued in connection with the sale in the amount of $73.8 million. The Company also received notes of $90.0 million, which it intends to convert to cash in 1994. These net cash flows may increase or decrease due to additional asset sales and settlements of certain lease and employee obligations retained by the Company. Over the past three years, the geophysical business used cash of $106.0 million in 1993, $57.1 million in 1992 and $56.7 million in 1991. Most of the cash was used for acquisitions of new equipment for land and marine seismic activities and the acquisition of proprietary seismic data information to be licensed or sold. This cash outflow includes capital expenditures over the past three years of $51.3 million in 1993, $32.0 million in 1992 and $30.8 million in 1991 and expenditures for the acquisition of proprietary seismic data information, which was included in other investing activities, of $38.7 million in 1993, $38.2 million in 1992 and $60.9 million in 1991. Operating Activities Cash flows from operating activities in 1993 were $243.1 million, down from $381.6 million in 1992 and $286.2 million in 1991. Cash flows from operating activities in 1993, excluding Insurance Services, were $269.6 million, down from $435.0 million in 1992 and $286.3 million in 1991. The decrease in cash flows from operating activities in 1993 is due primarily to increases in accounts receivable related to increased revenues from services provided by Energy Services and smaller cash distributions from unconsolidated Engineering and Construction Services companies. Investing Activities Acquisitions of property, plant and equipment were $246.9 million in 1993, down from $315.9 million in 1992 and $425.9 million in 1991. The reduction in the Company's expenditures for property, plant and equipment in 1993 reflects, in part, Energy Services optimizing resources to support the most profitable product lines and geographical regions, while targeting other product lines and geographic regions for strategic positioning in the future. The Company anticipates higher expenditures for property, plant and equipment in 1994, unless market conditions deteriorate significantly. The Company believes that current levels of expenditures for property, plant and equipment related to Energy Services, while reduced from historical levels, are adequate to support current and anticipated replacement requirements. Most capital expenditures are for Energy Services. These expenditures are primarily to add equipment specialized for certain locations, to respond to new business opportunities and to replace or upgrade existing equipment. Engineering and Construction Services generally requires capital equipment for specific contract needs. Insurance Services and general corporate requirements are not significant. Receipts from sales of property, plant and equipment were $29.9 million in 1993, down from $47.9 million in 1992, but up from $29.5 million in 1991. Payments made for acquisitions of businesses, net of cash acquired, were $26.7 million in 1993, $15.7 million in 1992 and $23.0 million in 1991. The Company also received cash of $21.7 million in 1992. See Note 18 to the financial statements for a description of the Company's acquisitions and dispositions. The Company had net payments for purchases of marketable securities in 1993 of $17.0 million, compared to net sales or maturities of $211.5 million in 1992 and payments for purchases of marketable securities of $115.4 million in 1991. The net payments in 1993 are primarily due to investment activities by Insurance Services. The net receipts for 1992 are primarily due to the maturities of the Company's investment of cash available for general corporate use in short-term securities which, at the time of purchase had maturities in excess of 90 days. The 1991 net payments are primarily due to the initial purchase of those same short-term investments. Other investing activities were $81.8 million in 1993, down from $88.0 million in 1992 but up from $72.3 million in 1991. Other investing activities include investments in inventories of proprietary information to be licensed or sold, such as seismic data, video training course materials, and computer software. Financing Activities Long-term debt was $623.9 million at the end of 1993, compared to $656.7 million at the end of 1992 and $653.2 million at the end of 1991. In 1993 the Company redeemed $56.5 million principal amount of its debentures. The Company also issued $42 million of short-term debt in the fourth quarter of 1992, which was refinanced as long-term debt in 1993. In addition, in 1992 the Company redeemed $55.8 million principal amount of its debentures. During 1991, the Company issued two series of debentures which raised approximately $490 million in cash, and repaid $54.0 million principal amount of its debentures. See Note 8 to the financial statements for information about the two series of debentures. Proceeds from the debt issues were used to supplement cash flow from operations, which was impacted by increases in accounts receivable and inventory in late 1990 and 1991, and for acquisitions of property, plant and equipment. Total debt was 27%, 26% and 23% of total capitalization at the end of 1993, 1992 and 1991, respectively. Each holder of the Company's zero coupon convertible subordinated debentures has the option to require the Company to purchase the debentures on March 13, 1996 for a purchase price equal to the issue price plus accrued original issue discount to date of purchase. Under the current market conditions, redemption of the debentures by each holder would be likely. See Note 8 to the financial statements regarding the Company's various short-term lines of credit. In July 1993, the Company filed a registration statement with the Securities and Exchange Commission covering a proposed public offering of the Company's debt securities with an aggregate initial public offering price not to exceed $500 million. The Company may offer and sell from time-to-time one or more series of its debt securities on terms to be determined at the time of the offering. The Company has sufficient ability to borrow additional short-term and long-term funds if necessary. Management anticipates that an additional $24 million of debentures will be repaid during 1994. In 1993, in connection with the acquisition of Smith International Inc.'s Directional Drilling Systems and Services business, the Company issued 6,857,000 shares of Common Stock previously held as treasury stock. See Note 18 to the financial statements. ENVIRONMENTAL MATTERS The Company is involved as a potentially responsible party in remedial activities to clean up various "Superfund" sites under applicable Federal law which imposes joint and several liability, if the harm is indivisible, on certain persons without regard to fault, the legality of the original disposal, or ownership of the site. Although it is very difficult to quantify the potential impact of compliance with environmental protection laws, management of the Company believes that any liability of the Company with respect to all but two of such sites will not have a material adverse effect on the results of operations of the Company. See Note 14 to the financial statements for a description of these two sites and a further discussion of the possible impact on the results of operations and the financial condition of the Company. EXPORT MATTERS See Note 14 to the financial statements concerning certain export and export related matters, including a United States government investigation of exports and re-exports by a former subsidiary of the Company. RESPONSIBILITY FOR FINANCIAL REPORTING Halliburton Company is responsible for the preparation, integrity and fair presentation of its published financial statements. The financial statements have been prepared in accordance with generally accepted accounting principles and, as such, include amounts based on judgements and estimates made by management. The Company also prepared the other information included in the annual report and is responsible for its accuracy and consistency with the financial statements. The financial statements have been audited by the independent accounting firm, Arthur Andersen & Co., which was given unrestricted access to all financial records and related data, including minutes of all meetings of stockholders, the board of directors and committees of the board. The Company believes that all representations made to the independent auditors during their audit were valid and appropriate. The Company maintains a system of internal control over financial reporting, which is designed to provide reasonable assurance to the Company's management and board of directors regarding the preparation of reliable published financial statements. The system includes a documented organizational structure and division of responsibility, established policies and procedures including a code of conduct to foster a strong ethical climate, which are communicated throughout the Company, and the careful selection, training and development of our people. Internal auditors monitor the operation of the internal control system and report findings and recommendations to management and the board of directors, and corrective actions are taken to address control deficiencies and other opportunities for improving the system as they are identified. The board, operating through its audit committee, which is composed entirely of directors who are not officers or employees of the Company, provides oversight to the financial reporting process. There are inherent limitations in the effectiveness of any system of internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even an effective internal control system can provide only reasonable assurance with respect to the reliability of financial reporting. Furthermore, the effectiveness of an internal control system can change with circumstances. The Company assessed its internal control system as of December 31, 1993 in relation to criteria for effective internal control over financial reporting described in "Internal Control-Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on its assessment, the Company believes that, as of December 31, 1993, its system of internal control over financial reporting met those criteria in all significant respects. (Thomas H. Cruikshank) (Jerry H. Blurton) Thomas H. Cruikshank Jerry H. Blurton Chairman of the Board Vice President- and Chief Executive Officer Finance REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors, Halliburton Company: We have audited the accompanying consolidated balance sheets of Halliburton Company (a Delaware corporation) and subsidiary companies as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows and shareholders' equity for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of Halliburton 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 Halliburton Company and subsidiary companies as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 2 and 11 to the financial statements, as required by generally accepted accounting principles, the Company changed its methods of accounting for certain investments in debt and equity securities and reinsurance of short-duration and long-duration contracts effective December 31, 1993 and January 1, 1993, respectively. In addition, as discussed in Notes 7 and 16 to the financial statements, as required by generally accepted accounting principles, the Company changed its methods of accounting for income taxes and accounting for postretirement benefits, respectively, effective January 1, 1992. (Arthur Andersen & Co.) ARTHUR ANDERSEN & CO. Dallas, Texas February 4, 1994 Note 1. Significant Accounting Policies Principles of Consolidation. The consolidated financial statements include the accounts of the Company and all majority-owned subsidiaries. All material intercompany accounts and transactions are eliminated. Investments in other affiliated companies in which the Company has at least 20 percent ownership and does not have management control are accounted for on the equity method. Certain prior year amounts including cost of revenues and general and administrative expenses have been reclassified to conform with the current organizational structure of the Company. Cash Equivalents. The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Investments. In 1993, the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115), which requires the classification of debt and equity securities into the following categories: held-to-maturity, available-for-sale, or trading. Investments classified as held-to-maturity are measured at amortized cost. This classification is based upon the Company's intent and ability to hold these securities to full maturity. Investments classified as available-for-sale or trading are measured at fair value at the balance sheets dates. Unrealized gains and losses for available-for-sale investments are reported as a separate component of shareholders' equity. Investments primarily relate to the activities of the Company's insurance subsidiaries, and consist of commercial paper, bonds and equity securities. Prior to 1993 bonds were carried at amortized cost and equity securities were carried at quoted market. The difference between quoted market and cost was credited or charged to shareholders' equity as unrealized gains or losses on investments. Reinsurance Recoverables. In 1993, the Company adopted Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" (SFAS 113) which requires reinsurance receivables (including amounts related to claims incurred but not reported) and prepaid reinsurance premiums to be classified as assets. Amounts recoverable from reinsurers are estimated consistent with the determination of the claim liability associated with the reinsured policy. Inventories. Inventories are stated at cost which is not in excess of market. Cost represents invoice or production cost for new items and original cost less allowance for condition for used material returned to stock. Production cost includes material, labor and manufacturing overhead. About one-half of all sales items (including related work in process and raw materials) are valued on a last-in, first-out (LIFO) basis. Inventories of sales items owned by foreign subsidiaries and inventories of operating supplies and parts are generally valued at average cost. Depreciation and Maintenance. Depreciation for financial reporting purposes is provided primarily on the straight-line method over the estimated useful lives of the assets. Expenditures for maintenance and repairs are expensed; expenditures for renewals and improvements are generally capitalized. Upon sale or retirement of property, plant and equipment, the related cost and accumulated depreciation are removed from the accounts and any gain or loss is recognized. Excess of Cost Over Net Assets Acquired. The excess of cost over the fair value of net assets acquired is generally amortized on the straight-line basis over periods not exceeding 40 years. Income Taxes. In 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Prior to 1992, the provision for income taxes was based upon the differences between the statement of income for financial reporting and the taxes computed and taxes payable under applicable statutes. Reserves for Insurance Losses and Claims and Unearned Premiums. The reserves for insurance losses and claims include estimates of amounts required to settle losses incurred but not reported. Changes in estimates and differences between estimates and ultimate payments are reflected in income in the period in which such changes and differences become known. Unearned premiums are determined by prorating policy premiums over the terms of the policies. Revenues and Income Recognition. The Company recognizes revenues as services are rendered or products are shipped. The distinction between services and product sales is based upon the overall business intent of the particular business operation. Revenues from construction contracts are reported on the percentage of completion method of accounting using measurements of progress toward completion appropriate for the work performed. All known or anticipated losses on any contracts are provided for currently. Claims for additional compensation are recognized during the period such claims are resolved. Foreign Currency Translation. The Company's primary functional currency is the U.S. dollar. Most foreign entities translate monetary assets and liabilities at year-end exchange rates while non-monetary items are translated at historical rates. Income and expense accounts are translated at the average rates in effect during the year, except for depreciation and cost of product sales which are translated at historical rates. Gains or losses from changes in exchange rates are recognized in consolidated income in the year of occurrence. The remaining entities use the local currency as the functional currency and translate net assets at year-end rates while income and expense accounts are translated at average exchange rates. Adjustments resulting from these translations are reflected in the Shareholders' equity section titled "Cumulative translation adjustment". Income Per Share. Income per share is based on the weighted average number of common shares and common share equivalents outstanding during each year. Common share equivalents included in the computation represent shares issuable upon assumed exercise of stock options which have a dilutive effect. Note 2. Investments In 1993, the Company adopted SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities." Investments, which are primarily held by the Company's insurance subsidiaries, at December 31, 1993 are as follows: The Company is not a trader in bonds and has classified investments into two categories: available-for-sale and held-to-maturity. Investments classified as held-to-maturity include bonds in which the Company has the ability and intent to hold until contractual maturity is reached. All other investments are classified as available-for-sale. These investments may be sold to fund liquidity requirements, assist in meeting regulatory capital requirements and other operating needs, as well as reflect a change in credit worthiness of the issuer. The fair value of investments is based on quoted market prices, where available, or quotes from external pricing sources such as brokers for those or similar investments and issues. No individual security issue exceeds 2% of total assets. Contractual maturities of bonds held at December 31, 1993 are as follows: Net unrealized gains and losses on investments available-for-sale included in shareholders' equity at December 31, 1993 were $9.3 million, net of income taxes of $2.3 million. Note 3. Receivables The Company's receivables are generally not collateralized. Notes and accounts receivable at December 31, 1993 include $36.3 million ($39.0 million at December 31, 1992) not currently due from customers in accordance with applicable retainage provisions of engineering and construction contracts. Of the December 31, 1993 amount, about $28.5 million is expected to be collected during 1994 and the remainder is due in subsequent years. Unbilled work on uncompleted contracts generally represents work currently billable and such work is usually billed during normal billing processes in the next month. Note 4. Inventories Consolidated inventories at December 31, 1993 and 1992 consist of the following: About one-half of all sales items (including related work in process and raw materials) are valued using the LIFO method. If the average cost method had been in use for inventories on the LIFO basis, total inventories would have been about $37.0 million and $45.9 million higher than reported at December 31, 1993 and 1992, respectively. Note 5. Property, Plant and Equipment Major classes of fixed assets at December 31, 1993 and 1992 are as follows: Contractual obligations for construction and purchase of facilities and equipment at December 31, 1993 are approximately $203.5 million. Note 6. Related Companies The Company conducts some of its operations through various joint venture and other partnership forms which are principally accounted for on the equity method. Summarized financial statements for the combined jointly-owned operations which are not consolidated are as follows: Included in the Company's revenues for 1993, 1992 and 1991 are equity in income of related companies of $76.3 million, $40.5 million and $43.3 million, respectively. When the Company sells or transfers assets to an affiliated company that is accounted for on the equity basis and the affiliated company records the assets at fair value, the excess of the fair value of the assets over the Company's net book value is deferred and amortized over the expected lives of the assets. Deferred gains included in the Company's other liabilities were $22.8 million and $29.3 million at December 31, 1993 and 1992, respectively. Note 7. Income Taxes In 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), which recognizes deferred tax assets and liabilities for the expected future tax consequences of existing differences between the financial reporting and tax reporting bases of assets and liabilities and operating loss and tax credit carryforwards for tax purposes. The cumulative impact of adoption of SFAS 109 was a benefit of $15.5 million, or 14 cents per share. The components of the benefit (provision) for income taxes are: Included in deferred income taxes are foreign tax credits of $28.3 million and $23.5 million in 1992 and 1991, respectively, and net operating loss carryforwards utilized of $9.1 million and $7.3 million in 1993 and 1992, respectively. The U.S. and foreign components of income (loss) before income taxes, minority interest and changes in accounting methods are as follows: The primary components of the Company's deferred tax assets and liabilities and the related valuation allowances are as follows: The Company has foreign tax credits which expire in 1997 of $14.0 million. Benefit (provision) for deferred taxes, which results from temporary differences between financial and tax reporting, in 1991 consisted of benefits of $15.7 million of accrual of special charges, $7.0 million of insurance loss reserves discounted for tax purposes, $2.9 million related to construction contract accounting methods, partially offset by provisions of $2.0 million for depreciation, inventory and other net items. The Company has net foreign operating loss carryforwards which expire as follows: 1994, $8.8 million; 1995, $9.1 million; 1996, $24.0 million; 1997, $13.8 million; 1998 through 2003, $44.2 million; and indefinite, $54.9 million. Reconciliations between the actual benefit (provision) for income taxes and that computed by applying the U.S. statutory rate to income or loss before income taxes, minority interest and changes in accounting methods are as follows: During 1990 through 1993, the Company received notices from the Internal Revenue Service (IRS) asserting deficiencies in Federal corporate income taxes for the Company's 1980-1989 taxable years. Many of the more than 200 proposed separate adjustments to the Company's tax returns were settled in 1992 with no adverse impact to the Company's results of operations or financial position. In 1993, the Company reached a settlement with the IRS for the 1980-1987 taxable years. As a result of the settlement, as well as significant prepayments of taxes in prior years, the Company will receive a refund and net income is increased by $40.4 million in 1993. The Company believes the ultimate resolution of the asserted deficiencies for the 1988 and 1989 taxable years will result in no material adverse impact on the Company's consolidated results of operations or financial position. Note 8. Lines of Credit and Long-Term Debt The Company has short-term lines of credit totaling $445.0 million with several U.S. banks. No borrowings were outstanding at December 31, 1993 under these credit facilities. At December 31, 1993, $90.0 million of commercial paper and $2.0 million of other short-term debt were outstanding. Long-term debt at December 31, 1993 and 1992 consists of the following: At December 31, 1993, the fair value of long-term debt, based upon quotes from brokers, was $662.0 million. On February 20, 1991, the Company issued $200.0 million of 8.75% debentures due February 15, 2021. There is no sinking fund applicable to the debentures and the debentures are not redeemable prior to maturity. On March 13, 1991, the Company received net proceeds of $294.0 million from issuance of $728.2 million principal amount at maturity of zero coupon convertible subordinated debentures due 2006. No periodic interest payments are to be made on the debentures. The issue price represents an annual yield to maturity of 6.00%. Each $1,000 principal amount at maturity debenture is convertible into 6.824 shares of Common Stock of the Company. Each debenture holder has the option to require the Company to purchase the debentures on March 13, 1996 and March 13, 2001 for a purchase price equal to the issue price of the debentures plus accrued original issue discount to the date of purchase, which amount may be paid by the Company in cash or shares of the Company's Common Stock. Five million shares of the Company's Common Stock have been reserved in the event of conversion and are presently antidilutive for earnings per share purposes. Since March 13, 1993 the debentures are redeemable for cash at any time at the option of the Company at redemption price equal to the issue price of the debentures plus accrued original issue discount to the date of redemption. Maturities of long-term debt are as follows: 1994, $26.4 million; 1995, $.4 million; 1996, $11.4 million; 1997, $10.6 million; and $21.1 million in 1998. Note 9. Common Stock In 1993, shareholders of the Company approved the 1993 Stock and Long-Term Incentive Plan (1993 Plan). The 1993 Plan provides for the grant of any or all of the following types of awards: (1) Stock options, including incentive stock options and non-qualified stock options; (2) stock appreciation rights, in tandem with stock options or freestanding; (3) restricted stock; (4) performance share awards; and (5) stock value equivalent awards. Under the terms of the 1993 Plan, 5.5 million shares of the Company's Common Stock were reserved for issuance to key employees. At December 31, 1993, 4.7 million shares were available for future grants. During 1993, grants for stock options were made for 327,000 shares and 371,500 shares at option prices per share of $40.25 and $30.50, respectively. All stock options are granted at fair market value of the Common Stock at the grant date and generally expire ten years from the grant date or three years after date of retirement, if earlier. Stock options vest over a three year period, with one-third of the shares becoming exercisable on each of the first three anniversaries of the grant date. None of the stock options were exercisable at December 31, 1993. In addition, 107,000 restricted shares were issued under the 1993 Plan. In 1993, shareholders of the Company also approved the Restricted Stock Plan for Non-Employee Directors (Restricted Stock Plan). Under the terms of the Restricted Stock Plan, each non-employee director receives an annual award of 200 restricted shares of Common Stock as a part of compensation. The Company reserved 50,000 shares of Common Stock for issuance to non-employee directors. At December 31, 1993, 48,200 shares were available for future issuance. Under the terms of the Company's career executive incentive stock plan adopted by the Company in 1969, 7.5 million shares of the Company's Common Stock were reserved for issuance to officers and key employees at a purchase price not to exceed par value of $2.50 per share. At December 31, 1993, 6.1 million shares (net of .8 million shares forfeited) have been issued under the plan. No further grants will be made under the career executive incentive stock plan. Restricted shares issued under the 1993 Plan, Restricted Stock Plan and the career executive incentive stock plan are limited as to sale or disposition with such restrictions lapsing periodically over an extended period of time. The fair market value of the stock, on the date of issuance, is being amortized and charged to income (with similar credits to paid-in capital in excess of par value) generally over the average period during which the restrictions lapse. At December 31, 1993, the unamortized amount is $26.1 million. See Note 8 for other shares of Common Stock reserved for possible issuance. Note 10. Series A Junior Participating Preferred Stock In 1986, the Company declared a dividend of one preferred stock purchase right (a Right) on each outstanding share of Common Stock, par value $2.50 per share (the Common Shares). The terms of the outstanding Rights were subsequently modified by the Company's Board of Directors as of February 15, 1990 (the Amended Rights Agreement). Pursuant to the Amended Rights Agreement, each Right will entitle the holder thereof to buy one one-hundredth of a share of the Company's Series A Junior Participating Preferred Stock, without par value (the Preferred Shares), at an exercise price of $70, subject to certain antidilution adjustments. The Rights will not be exercisable or transferable apart from the Common Shares, until the tenth business day after a person or group (i) acquires 20% or more of the Common Shares or (ii) announces an intention to make a tender or exchange offer for 20% or more of the Common Shares. The Rights will not have any voting rights or be entitled to dividends. If, after the Rights become exercisable, the Company (i) merges into another entity, (ii) an acquiring entity merges into the Company and the Common Shares of the Company are exchanged for other securities or assets, or (iii) the Company sells more than 50% of its assets or earning power, then each Right will entitle its holder to purchase, at the exercise price of the Right, that number of shares of common stock of the acquiring company having a current market value of two times the exercise price of the Right. Alternatively, if a holder acquires 20% or more of the Company's Common Shares, then each Right not owned by such acquiring person or group will entitle the holder to purchase, for the exercise price, the number of Common Shares, having a current market value of two times the exercise price of the Right. The Rights are redeemable at the Company's option for $.05 per Right at any time prior to the time that a person or group acquires beneficial ownership of 20% or more of the Common Shares. At any time after a person or group acquires 20% or more of the Common Shares, but prior to the time such acquiring person acquires 50% or more of the Common Shares, the Company's Board of Directors may redeem the Rights (other than those owned by the acquiring person), in whole or in part, by exchanging one Common Share for each two Common Shares for which a Right is then exercisable (subject to adjustment). The Rights will expire on the earlier to occur of (i) June 1, 1996, or (ii) the exchange or redemption of the Rights. Note 11. Insurance Subsidiaries The consolidated financial statements include property and casualty insurance subsidiaries and a health care management subsidiary sold effective September 30, 1992. Undistributed earnings of $200.0 million were restricted as to payment of dividends by the insurance subsidiaries at December 31, 1993. Assets of the insurance subsidiaries, with the exception of dividend payments to the parent company, are not available for general corporate use. Insurance Services written premiums are as follows: A United Kingdom subsidiary of the Company suspended further underwriting activities due to unacceptable loss experience in recent years. The Company recognized a $46.3 million and a $21.0 million charge to operating income in 1993 and 1992, respectively, for additional claim loss reserves and for future administrative expenses of claims processing and other activities related to insurance coverage previously written in the United Kingdom. The subsidiary may resume underwriting activities in the future if market conditions improve. The Company's insurance subsidiaries have numerous reinsurance agreements with other insurance companies. To the extent that any reinsurance company is unable to meet its obligations under the reinsurance agreements, the Company's insurance subsidiaries would remain obligated. Total reinsurance recoverables primarily relate to ceded losses and incurred but not reported claims. Major reinsurers include American Re-Insurance Company, General Reinsurance Corporation and Cigna Property and Casualty Company with A.M. Best ratings of A+, A++ and A-, respectively. In 1993, the Company adopted SFAS 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," which requires reinsurance receivables (including amounts related to claims incurred but not reported) and prepaid reinsurance premiums to be classified as assets. Note 12. Business Segment Information The Company operates in three segments - Energy Services, Engineering and Construction Services, and Insurance Services. See Item 1. Business on page 2 for a description of each business segment. The Company's equity in income or losses of related companies is included in revenues and operating income of each applicable segment. Insurance Services revenues include $52.1 million, $41.0 million and $158.8 million in intersegment sales for the years ended December 31, 1993, 1992 and 1991, respectively. Intersegment revenues included in the revenues of the other business segments are immaterial. Sales between geographic areas and export sales are also immaterial. Depreciation and amortization expenses were increased in 1993 by the loss for the sale of the geophysical business in 1994 discussed in Note 18 by $128.9 million. In addition, depreciation and amortization expenses were increased in 1992 and 1991 by the special charges discussed in Note 17 as follows: General corporate assets are primarily comprised of cash and equivalents and certain other investments. Note 13. Research and Development Research and development expenses are charged to income as incurred. Such charges were $126.5 million in 1993, $112.1 million in 1992 and $117.0 million in 1991. In addition, the Company capitalized software development costs related primarily to integrated information technologies and project management of $39.8 million in 1993, $44.8 million in 1992 and $7.8 million in 1991. Note 14. Commitments and Contingencies At December 31, 1993, the Company was obligated under noncancelable operating leases, expiring on various dates to 2023, principally for the use of land, offices, equipment and field facilities. Aggregate rentals charged to operations for such leases totaled $133.6 million in 1993, $137.4 million in 1992 and $133.8 million in 1991. Future aggregate rentals on noncancelable operating leases are as follows: 1994, $123.0 million; 1995, $76.1 million; 1996, $48.2 million; 1997, $32.5 million; 1998, $25.3 million; and thereafter, $108.8 million. The Company is involved as a potentially responsible party (PRP) in remedial activities to clean up various "Superfund" sites under applicable Federal law which imposes joint and several liability, if the harm is indivisible, on certain persons without regard to fault, the legality of the original disposal, or ownership of the site. Although it is very difficult to quantify the potential impact of compliance with environmental protection laws, management of the Company believes that any liability of the Company with respect to all but two of such sites will not have a material adverse effect on the results of operations of the Company. With respect to a site in Jasper County, Missouri (Jasper County Superfund Site), and a site in Nitro, West Virginia (Fike/Artel Chemical Superfund Site), sufficient information has not been developed to permit management to make such a determination and management believes the process of determining the nature and extent of remediation at each site and the total costs thereof will be lengthy. Brown & Root, Inc. (Brown & Root), a subsidiary of the Company, has been named as a PRP with respect to the Jasper County Superfund Site by the Environmental Protection Agency (EPA). The Jasper County Superfund Site includes areas of mining activity that occurred from the 1800's through the mid 1950's in the Southwestern portion of Missouri. The site contains lead and zinc mine tailings produced from mining activity. Brown & Root is one of nine participating PRPs which have agreed to perform a Remedial Investigation/Feasibility Study (RI/FS) which is not expected to be completed until March, 1995. Although the entire Jasper County Superfund Site comprises 237 square miles, as listed on the National Priorities List in the RI/FS scope of work, the EPA has only identified seven areas, or subsites, within this area that need to be studied and then possibly remediated by the PRPs. Additionally, the Administrative Order on Consent for the RI/FS only requires Brown & Root to perform RI/FS work at one of the subsites within the site, the Neck/Alba subsite, which only comprises 3.95 square miles. Brown & Root's share of the cost of such a study is not expected to be material. Brown & Root cannot determine the extent of its liability, if any, for remediation costs on any reasonably practicable basis. Halliburton Services Division of the Company (HSD) is one of 32 companies that have been designated as PRPs at the Fike/Artel Chemical Superfund Site. Five "Operable Units" have been established by the EPA in connection with remediation activities for the site. The EPA recently instituted litigation in the U.S. District Court for the Southern District of West Virginia (United States v. American Cyanamid Co., Inc. et al.) against all PRPs seeking recovery of its past response costs in Operable Unit 1. The PRPs are subject to a Consent Decree with respect to the remediation of Operable Unit 2. In June 1993, the EPA issued a Unilateral Administrative Order requiring all PRPs to implement remediation of Operable Unit 3. The PRPs are negotiating an Administrative Order on Consent that will allow them to perform a site-wide RI/FS. Past response costs alleged by the EPA for Operable Unit 1, remediation costs estimates for Operable Units 2 and 3 and cost estimates to perform the RI/FS range in the aggregate from approximately $43 million to approximately $70 million. The Company does not believe that HSD's share of response and remediation costs for Operable Units 1, 2 and 3 and the RI/FS is likely to be material to the Company's financial statements. There are at present no reliable estimates of costs to remediate Operable Units 4 and 5, because the EPA has not yet proposed any remediation methodology. Those costs may, however, be significantly larger than the estimates thereof for the other units. Although the liability associated with this site could possibly be significant to the results of operations of some future reporting period, management believes, based on current knowledge, that HSD's share of costs at this site is unlikely to have a material adverse impact on the Company's consolidated financial condition. In April 1991, the U.S. Customs Service initiated an investigation of a subsidiary of the Company, Halliburton Logging Services, Inc. (HLS), and in October 1991, as a result of its own internal inquiry, HLS provided information to the U.S. Departments of Commerce and Justice, in each case regarding the export and re-export of certain oil field tools. The tools were exported by HLS and its predecessors to certain foreign affiliates and were re-exported by them to an HLS foreign affiliate in Libya without a validated re-export license. The shipments involved thermal multigate decay tools used in oil field logging operations and occurred between December 1987 and June 1989. During 1992, HLS received subpoenas to produce documents related to the foregoing matter before a Federal grand jury. The Company believes the U.S. Government will take the position that such shipments violated Presidential Executive Orders imposing sanctions against Libya (the Orders) as well as export regulations of the Department of Commerce (the Regulations). Halliburton Geophysical Services, Inc. (HGS), a subsidiary acquired by the Company in 1988, in an unrelated matter, advised the U.S. Departments of Commerce and Justice in March 1992 that the United Kingdom subsidiary of HGS, as a small part of its business, shipped to Libya, during the period from March 1987 through April 1991, United States origin spare parts, primarily for equipment of various types, and performed certain repairs and training on the equipment. The consignee was a Libyan-based geophysical company in which HGS owns an indirect, minority interest. Moreover, certain items validly shipped to this consignee in a third country were subsequently re-exported by it to Libya without specific re-export authorization. After discovering these matters, the U.K. subsidiary terminated all activities in support of Libyan companies and operations. Although no communication has been received from the U.S. Government regarding this matter, it is possible the U.S. Government will take the position that such actions violated the Orders and the Regulations. On July 1, 1993, HLS and HGS, as well as certain other subsidiaries of the Company, were merged into the Company. In January 1994 the Company disposed of its geophysical business which included substantially all of the business of HGS. The privilege of exporting oil field tools and other products to its affiliates is important to the Company in order to support its worldwide logging services. Sanctions against corporations for violations of the Orders and the Regulations range from civil penalties, including denial of export privileges and monetary penalties, to significant criminal fines. The Company has no information regarding, and cannot predict, the nature or type of sanctions, if any, which the U.S. Government may seek with respect to either of these matters. The Company and its subsidiaries are parties to various other legal proceedings. Although the ultimate disposition of such proceedings is not presently determinable, in the opinion of the Company any liability that might ensue would not be material in relation to the consolidated financial position of the Company. Note 15. Financial Instruments and Risk Concentration The Company enters into foreign currency exchange contracts, including forward, option, and swap contracts, in its selective hedging of its exposure to foreign currency fluctuations. As of December 31, 1993, the Company had approximately $24.2 million net outstanding in such contracts. The market value gains or losses arising from foreign currency exchange contracts offset foreign exchange gains or losses on the underlying hedged assets and liabilities. The Company's exposure to credit and currency risks in these contracts is considered to be negligible. Financial instruments which potentially subject the Company to concentrations of credit risk are primarily cash equivalents and investments and trade receivables. It is the Company's practice to place its cash equivalents and investments in high quality securities with various investment institutions. The Company derives the majority of its revenues from sales and services to, including engineering and construction for, the energy industry. Within the energy industry, trade receivables are generated from a broad and diverse group of customers. There are concentrations of receivables in the United States and the United Kingdom. The Company maintains an allowance for losses based upon the expected collectibility of all trade accounts receivable. Note 16. Retirement Plans The Company offers a postretirement medical plan to certain of its employees that qualify for retirement and, on the last day of active employment, are enrolled as participants in the Company's active employee medical plan. The Company's liability is limited to a fixed contribution amount for each participant or dependent. Effective in September 1993, coverage under this plan ceases when the participant reaches age 65. However, those participants aged 65 or over on January 1, 1994, have the option to participate in an expanded prescription drug program in lieu of the medical coverage. The plan participants share the total cost for all benefits provided above the fixed Company contribution and participants' contributions are adjusted as required to cover benefit payments. The Company has made no commitment to adjust the amount of its contributions; therefore, the computed accumulated postretirement benefit obligation amount is not affected by the expected future healthcare cost inflation rate. In 1992, the Company adopted Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS 106), which requires accrual, during the years that the employee renders the services, of the expected cost of providing postretirement benefits. As of January 1, 1992, the Company recognized the transition obligation of $29.3 million as a charge to the net loss, net of income taxes of $16.0 million, or 27 cents per share. Prior to adoption of SFAS 106, the Company expensed its contributions as incurred. The amount expensed in 1991 was $4.9 million. Net periodic postretirement benefit cost included the following components: The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7% in 1993 and 8% in 1992. The Company's postretirement medical plan's funded status reconciled with the amounts included in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992 is as follows: The Company is not required to fund its future obligation under the plan. The Company has various retirement plans which cover a significant number of its employees. The major pension plans are defined contribution plans, which provide pension benefits in return for services rendered, provide an individual account for each participant, and have terms that specify how contributions to the participant's account are to be determined rather than the amount of pension benefits the participant is to receive. Contributions to these plans are based on pre-tax income and/or discretionary amounts determined on an annual basis. The Company's expense for the defined contribution plans totaled $56.1 million, $73.7 million, and $60.6 million in 1993, 1992, and 1991, respectively. Other pension plans include defined benefit plans, which define an amount of pension benefit to be provided, usually as a function of one or more factors such as age, years of service, or compensation. These plans are funded to operate on an actuarially sound basis. Assumed long-term rates of return on plan assets, discount rates and rates of compensation increases vary for the different plans according to the local economic conditions. The assumed long-term return on plan assets for U.S. plans was 8.5% in 1993, 1992 and 1991; for international plans the assumed long-term return was 9% for 1993 and between 9% and 10% for 1992 and 1991. The discount rate used in estimating benefit obligations for the U.S. plans was 7.5% in 1993 and 8.5% in 1992; for the international plans the discount rate was between 4% and 8.5% for 1993 and between 4% and 10% for 1992. The rate of compensation increase assumed for the U.S. plans was 4.25% in 1993 and 5.5% in 1992; for the international plans the rate of compensation increase was between 1% and 6% for 1993 and between 1% and 7% for 1992. The net periodic pension cost for defined benefit plans is as follows: The reconciliation of the funded status for defined benefit plans where assets exceed accumulated benefits is as follows: The reconciliation of the funded status for defined benefit plans where accumulated benefits exceed assets is as follows: Note 17. Special Charges In November 1992, the Company announced additional restructuring and reorganization actions within Energy Services and Engineering and Construction Services designed to enable the Company to more effectively provide services and products, as well as to better meet the changing needs of its customers throughout the world. The Company, through the implementation of certain strategic initiatives, recorded special charges of $264.6 million in 1992. These special charges include $59.7 million for the closing and consolidation of certain operating facilities; $57.6 million for globalizing employee benefits and personnel reductions, relocations and associated employee benefits costs from the above actions; $53.5 million for the technological obsolescence of certain inventories and equipment related to the introduction of new technologies; $35.5 million for the realignment of worldwide manufacturing capabilities, which includes outsourcing of some items previously manufactured by the Company and the consolidation of existing capacity; $23.0 million for certain investments in operations which are no longer in the Company's long-term strategic interest; $17.9 million from the reduction in value of certain intangible assets related primarily to geophysical speculative data; and $17.4 million of other items primarily related to the cost of relocating equipment as a result of the above actions. In November 1991, the Company announced a restructuring program within Energy Services designed to enhance profit opportunities, improve operating efficiencies, and respond to the changing needs of its customers. Driven primarily by a decline in the United States energy markets, the plans include restructuring its business units, consolidating some of its administrative functions, closing or consolidating certain field locations, and reducing employment primarily in the United States. As a result of these plans, the Company recorded special charges of $118.5 million in 1991. The charges include $56.0 million for early retirement and severance benefits, employee relocations, and other employee, organizational and transition related items; $44.1 million for closing or consolidating facilities and impairment of asset values for inventories, leases, property, equipment and certain investments in unconsolidated joint ventures whose value was impaired due to the restructuring or permanent changes in market conditions; $13.3 million for various environmental efforts primarily involving the removal of underground storage tanks, testing and remediation activities to comply with wastewater discharge and stormwater runoff standards; and $5.1 million for other items. Note 18. Acquisitions and Dispositions In January 1994, the Company sold substantially all of the assets of its geophysical services and products business, to Western Atlas International Inc. for $190.0 million in cash and notes subject to certain adjustments. The notes of $90.0 million are payable in two equal installments in 1997 and 1998 at a rate of interest of 5.65%. The Company intends to sell the $90.0 million notes for cash in the first quarter of 1994. In addition, the Company issued $73.8 million in notes to Western Atlas to cover some of the costs of reducing certain geophysical operations, including the cost of personnel reductions, leases of geophysical marine vessels and closing of duplicate facilities. The Company's notes to Western Atlas are payable over two years at a rate of interest of 4% with an initial installment of $33.8 million in February 1994, and quarterly installments of $5 million thereafter. The Company recognized a $301.8 million charge ($263.8 million after tax) in 1993. This charge includes $120.7 million for writedown to the net realizable value of equipment and other assets; $54.0 million for anticipated operating and contract losses through the dates of disposition or completion; $43.4 million for marine vessel leases and mobilization; $35.1 million for facility leases and closures; $34.4 million for personnel and severance; and $14.2 million for transition costs and other related matters. The sale includes some international business locations, the closings of which have been deferred pending certain approvals and consents. The approvals and consents are expected to be received within the next several months and such closings will result in some additional consideration. The Company retains ownership of certain assets and liabilities of the geophysical business including some accounts receivable, real estate properties, lease obligations, certain employee obligations, and a majority interest in an international joint venture company. It is expected that these remaining assets and liabilities will be sold or settled over the next several months. Services and products provided through the geophysical business include seismic data collection and data processing services for both land and marine seismic exploration activities and manufacturing and sales of seismic equipment. The revenues, operating loss and net loss of the geophysical operations, excluding the charge in 1993, change in accounting method and special charges in 1992 and 1991 are as follows: In March 1993, the Company acquired the assets of Smith International, Inc.'s Directional Drilling Systems and Services business for 6,857,000 shares of Halliburton Company Common Stock previously held as treasury stock, valued at approximately $247 million. The Company recorded $135.8 million as excess of cost over net assets acquired. The excess of cost over net assets acquired will be amortized over 40 years. The Company announced in July 1992, that it would pursue divestiture alternatives for its wholly owned Highlands Insurance Company subsidiary and its related companies. The Company concluded its effort to sell Highlands in 1993 without securing a satisfactory transaction. The Company is now concentrating on improving the financial results of Highlands operations. In March 1992, a subsidiary of the Company completed the purchase of substantially all of the business assets of a manufacturer of products to serve the gas lift portion of the artificial lift market for $10.7 million in cash. The Company completed the sale of its subsidiary engaged in healthcare cost management services, Health Economics Corporation, effective September 30, 1992. The sales price was $24 million and resulted in a pretax gain of $13.6 million, or 8 cents per share after tax, reflected in the Company's 1992 third quarter earnings. In September 1992, the Company announced it was acquiring the remaining 50% interest of Rockwater Offshore Contractors (Rockwater), previously owned by Smit International Group. Rockwater was formed in 1990 by a merger of the Company's 2W Taylor subsidiary with Smit International Group's Smit Offshore Contractors to provide underwater construction and maintenance services worldwide. The Rockwater acquisition was accounted for as a purchase and used internal cash resources of $4.6 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 Registrant. The information required for the directors of the Registrant is incorporated by reference to the Halliburton Company Proxy Statement dated March 22, 1994, under the caption "Election of Directors." The information required for the executive officers of the Registrant is included under Part I, page 6 of this Annual Report. Item 11. Item 11. Executive Compensation. This information is incorporated by reference to the Halliburton Company Proxy Statement dated March 22, 1994, under the captions "Compensation Committee Report on Executive Compensation," "Corporate Performance Graph," "Summary Compensation Table," "Option Grants in Last Fiscal Year," "Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values," "Retirement Plan" and "Directors' Compensation, Restricted Stock Plan and Retirement Plan." Item 12(a). Security Ownership of Certain Beneficial Owners. This information is incorporated by reference to the Halliburton Company Proxy Statement dated March 22, 1994, under the caption "Stock Ownership of Certain Beneficial Owners and Management." Item 12(b). Security Ownership of Management. This information is incorporated by reference to the Halliburton Company Proxy Statement dated March 22, 1994, under the caption "Stock Ownership of Certain Beneficial Owners and Management." Item 12(c). Changes in Control. Not applicable. Item 13. Item 13. Certain Relationships and Related Transactions. This information is incorporated by reference to the Halliburton Company Proxy Statement dated March 22, 1994, under the caption "Certain Transactions." PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements: The report of Arthur Andersen & Co., Independent Public Accountants, and the financial statements required by Part II, Item 8, are included on pages 18 through 43 of this Annual Report. See index on page 7. 2. Financial Statement Schedules: Halliburton Company Page No. ------------------- -------- Report on Supplemental Schedules of Arthur Andersen & Co., Independent Public Accountants 52 Schedules Included: V Property, Plant and Equipment for the Three Years Ended December 31, 1993 53 VI Accumulated Depreciation of Property, Plant and Equipment for the Three Years Ended December 31, 1993 54 IX Short-Term Borrowings for the Three Years Ended December 31, 1993 55 X Supplementary Income Statement Information for the Three Years Ended December 31, 1993 56 Note: All schedules not filed herein for which provision is made under rules of Regulation S-X have been omitted as not applicable or not required or the information required therein has been included in the notes to financial statements. 3. Exhibits: Exhibit Number Exhibits ------- -------- 3 By-laws of the Company, as amended through September 30, 1992, incorporated by reference to Exhibit 4.3 of the Second Amendment to the Company's Registration Statement on Form S-3 dated as of March 29, 1993. 4(a) Credit Agreement dated as of February 25, 1993 between Avalon Financial Services, Ltd. and NationsBank of Texas, N.A., incorporated by reference to Exhibit 4(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 4(b) Form of debt security of Zero Coupon Convertible Subordinated Debentures due March 13, 2006 of the registrant incorporated by reference to Exhibit 4(a) to the Company's Form 8-K dated as of March 13, 1991. 4(c) Resolutions of the Board of Directors of the registrant adopted at a meeting held on February 11, 1991 and of the special pricing committee of the Board of Directors of the registrant adopted at a meeting held on March 6, 1991 incorporated by reference to Exhibit 4(c) to the Company's Form 8-K dated as of March 13, 1991. 4(d) Subordinated Indenture dated as of January 2, 1991 between the Company and Texas Commerce Bank National Association, as Trustee, incorporated by reference to Exhibit 4(b) to the Company's Form 8-K dated as of March 13, 1991. 4(e) Form of debt security of 8.75% Debentures due February 15, 2021 incorporated by reference to Exhibit 4(a) to the Company's Form 8-K dated as of February 20, 1991. 4(f) Senior Indenture dated as of January 2, 1991 between the Company and Texas Commerce Bank National Association, as Trustee, incorporated by reference to Exhibit 4(b) to the Company's Form 8-K dated as of February 20, 1991. 4(g) Resolutions of the Company's Board of Directors adopted at a meeting held on February 11, 1991 and of the special pricing committee of the Board of Directors of the Registrant adopted at a meeting held on February 11, 1991 and the special pricing committee's consent in lieu of meeting dated February 12, 1991, incorporated by reference to Exhibit 4(c) to the Company's Form 8-K dated as of February 20, 1991. 4(h) Composite Certificate of Incorporation filed May 26, 1987 with the Secretary of State of Delaware and that certain Certificate of Designation, Rights and Preferences related to the authorization of the Company's Junior Participating Preferred Stock, Series A, incorporated by reference to Exhibit 4(d) to the Company's Registration Statement on Form S-3 dated as of December 21, 1990. 4(i) Amended and Restated Rights Agreement dated as of February 15, 1990 between the Company and NCNB Texas National Bank, as Rights Agent, which includes the form of Right Certificate as Exhibit A, incorporated by reference to Exhibit 1 to the Company's Form 8 dated as of February 23, 1990. 4(j) Copies of instruments which define the rights of holders of miscellaneous long-term notes of the Registrant and its subsidiaries, totaling $4.0 million in the aggregate at December 31, 1993, have not been filed with the Commission. The registrant agrees herewith to furnish copies of such instruments upon request. 10(a) Halliburton Company Career Executive Incentive Stock Plan as amended November 15, 1990, incorporated by reference to Exhibit 10(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(b) Halliburton Company Senior Executives' Deferred Compensation Plan as amended and restated effective October 1, 1990, incorporated by reference to Exhibit 10(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(c) Retirement Plan for the Directors of Halliburton Company adopted and effective January 1, 1990, incorporated by reference to Exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(d) Halliburton Company Directors' Deferred Compensation Plan as amended and restated effective May 15, 1990, incorporated by reference to Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(e) Halliburton Company Annual Incentive Compensation Plan as amended and restated December 4, 1990, incorporated by reference to Exhibit 10(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(f) Form of criteria for determination of Brown and Root recommendations for incentive awards to Brown and Root management dated as of March 2, 1992, incorporated by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(g) Summary Plan Description of the Executive Split-Dollar Life Insurance Plan, incorporated by reference to Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(h) Halliburton Company 1993 Stock and Long-Term Incentive Plan incorporated by reference to Appendix A of the Company's proxy statement dated March 23, 1993. 10(i) Asset acquisition agreement between Smith and the Company dated as of January 14, 1993 incorporated by reference to the Second Amendment of the Company's Registration Statement on Form S-3 dated as of March 29, 1993. 10(j) Halliburton Company Restricted Stock Plan for Non-Employee Directors, incorporated by reference to Appendix B of the Company's proxy statement dated March 23, 1993. 11* Computation of Earnings per share. 21* Subsidiaries of the registrant. 24(a) The powers of attorney signed in March 1992, incorporated by reference to Exhibit 25 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. 24(b)* Form of power of attorney for C. J. Silas. * Filed with this Annual Report - ------------------------------------------------------------------------------- (b) Reports on Form 8-K: A report was filed on Form 8-K dated October 18, 1993, reporting on Item 5. Other Events regarding a press release announcing plans to sell its geophysical business, an increase in certain insurance reserves and the settlement of a dispute with the United States Internal Revenue Service. A report was filed on Form 8-K dated January 14, 1994, reporting on Item 5. Other events regarding a press release announcing the sale of the geophysical business. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To Halliburton Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Halliburton Company's 1993 Annual Report in this Form 10-K, and have issued our report thereon dated February 4, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the change in the methods of accounting for investments, income taxes, reinsurance and accounting for postretirement benefits as discussed in Notes 2, 7, 11 and 16 to the consolidated financial statements, respectively. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The supplemental schedules (Schedules V, VI, IX and X), which are the responsibility of Halliburton Company's management, 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 basic financial statements taken as a whole. (Arthur Andersen & Co.) ARTHUR ANDERSEN & CO. Dallas, Texas February 4, 1994 HALLIBURTON COMPANY HALLIBURTON COMPANY HALLIBURTON COMPANY HALLIBURTON 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, on this 7th day of March, 1994. HALLIBURTON COMPANY By (Thomas H. Cruikshank) Thomas H. Cruikshank, 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 in the capacities indicated on this 7th day of March, 1994. Signature Title - --------- ----- (Thomas H. Cruikshank) Chairman of the Board and Thomas H. Cruikshank Chief Executive Officer and Director (Jerry H. Blurton) Vice President-Finance and Jerry H. Blurton Principal Financial Officer (Scott R. Willis) Controller and Principal Scott R. Willis Accounting Officer Signature Title - --------- ----- (ANNE L. ARMSTRONG) Director Anne L. Armstrong (ROBERT W. CAMPBELL) Director Robert W. Campbell (LORD CLITHEROE) Director Lord Clitheroe (EDWIN L. COX) Director Edwin L. Cox (ROBERT L. CRANDALL) Director Robert L. Crandall (WILLIAM R. HOWELL) Director William R. Howell (DALE P. JONES) President and Director Dale P. Jones (C. J. SILAS) Director C. J. Silas (ROGER T. STAUBACH) Director Roger T. Staubach (E. L. WILLIAMSON) Director E. L. Williamson (SUSAN S. KEITH) Susan S. Keith, Attorney-in-fact INDEX TO EXHIBITS 11 Computation of Earnings per share 21 Subsidiaries of the registrant 24(b) Form of power of attorney for C. J. Silas

96935_1993.txt

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1993

96935

Item 1. Business - ----------------- (a) Teledyne, Inc. (Registrant) was incorporated in the state of Delaware in 1960. Registrant is a diversified corporation, the operations of which are comprised of companies which manufacture a wide variety of products. Realignment/Restructure In July 1993, Teledyne undertook a major realignment for the company which consolidated its operating companies to 21 from 65 and eliminated 1,200 management and support positions. The intent of the realignment was to streamline operations in order to take full advantage of the opportunities available to the Company, address the increasingly complex business environment of the 1990's and beyond and better serve customers through more robust operating units. The intent of the 1991-1992 restructure plan was to focus on the Company's technology-based businesses in which it has significant leadership roles. Included in the plan for sale or closure were certain operations in energy exploration, drilling and supply, engine manufacture or overhaul, aviation related components, hydraulic devices and instrumentation, metal forming tools and equipment, welding systems and equipment, metal, wood and paper businesses, semiconductors and electrical equipment manufacturing. The restructure plan for operations which were to be closed or sold has been substantially completed. Distribution of Unitrin In 1990, the Registrant distributed to its shareholders all of the outstanding common stock of Unitrin, Inc. (Unitrin), the parent company of Registrant's former insurance subsidiaries. The units involved were United Insurance Company and subsidiaries, Trinity Universal Insurance Company and subsidiaries and Fireside Securities Corporation and subsidiaries. (b) and (c)(1)(i) Information regarding business segments is presented in Note 10 on pages 13-20 through 13-22 in Exhibit 13 - Teledyne, Inc. annual report to shareholders for the year ended December 31, 1993. Teledyne's individual divisions are responsible for marketing their products. Additional information regarding the Company's products and services is presented in the Outline of Products and Activities on pages 13-43 through 13-48 in Exhibit 13 - Teledyne, Inc. annual report to shareholders for the year ended December 31, 1993. (c)(1)(ii) There has been no public announcement about a new product or industry segment that would require the investment of a material amount of assets of the Registrant or that otherwise is material. Item 1. Business (Continued) - ----------------------------- (c)(1)(iii) Substantially all parts and materials required in the manufacture of Registrant's products are available from more than one supplier and, in Registrant's opinion, the sources and availability of raw materials essential to its business are adequate. (c)(1)(iv) Registrant owns a number of patents and trademarks and is a party to numerous patent, trademark and technical information license agreements. Although these have been and are expected to be of value, in the opinion of Registrant the loss of any single such item or technically related group of such items would not materially affect the conduct of its business. (c)(1)(v) and (c)(1)(vi) Not applicable. (c)(1)(vii) For the year ended December 31, 1993, approximately 39 percent of Registrant's revenues was attributable to U.S. government business. Registrant's sales to the U.S. government by the aviation and electronics segment were $742.9 million in 1993, $772.8 million in 1992 and $859.6 million in 1991. Companies engaged in supplying goods and services to the U.S. government are dependent on congressional appropriations and administrative allotment of funds, and may be affected by changes in U.S. government policies resulting from various domestic and international military and political developments. While Registrant's subsidiaries perform work on a substantial number of defense contracts, spanning many defense programs, a material reduction in U.S. government appropriations for defense may have an adverse effect on the Registrant's business, depending upon the defense programs affected. In addition, U.S. government contracts are terminable at the convenience of the government or for default. In the event of termination, the affected contractor is entitled to payment for allowable costs incurred through the date of termination and, in general, to a proportionate share of the profit or fee for the work done. The U.S. government may terminate a contract for default if the contractor materially breaches the contract. In the event of a material breach, traditional contract remedies apply. Additional information regarding business with the U.S. government is included in Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 13-28 through 13-36 in Exhibit 13 - Teledyne, Inc. annual report to shareholders for the year ended December 31, 1993. (c)(1)(viii) Registrant's backlog of confirmed orders was approximately $1.4 billion at December 31, 1993 and $1.6 billion at December 31, 1992. During the year ending December 31, 1994, it is anticipated that approximately 78.5 percent of confirmed orders on hand at December 31, 1993 will be filled. Backlog of confirmed orders of the aviation and electronics segment was $1.0 billion at December 31, 1993 and $1.1 billion at December 31, 1992. During the year ending December 31, 1994, it is anticipated that approximately 74.2 percent of the confirmed orders on hand at December 31, 1993 for this segment will be filled. (c)(1)(ix) See (c)(1)(vii) above. (c)(1)(x) Intense competition exists with respect to most of Registrant's products and services in each of its principal business segments. During the year ended December 31, 1993, there were no material changes in the competitive conditions in the various industries in which Registrant competes. In view of the number and variety of its products and services, Registrant believes that it Item 1. Business (Continued) - ----------------------------- is not meaningful to state its relative position with respect to the market for any particular product or service, or group of products or services. (c)(1)(xi) Research and development is conducted by Registrant at its various operating locations both for its own account and for customers on a contract basis. Estimates of the components of research and development for the years ended December 31, 1993, 1992 and 1991 included the following in millions: 1993 1992 1991 ------ ------ ------ Customer-Sponsored: Aviation and electronics segment $291.6 $295.5 $293.1 Industrial segment 85.5 119.1 58.6 Other 1.9 2.1 1.5 ------ ------ ------ 379.0 416.7 353.2 ------ ------ ------ Company-Sponsored: Aviation and electronics segment 20.3 22.3 22.2 Other 18.9 26.2 28.7 ------ ------ ------ 39.2 48.5 50.9 ------ ------ ------ Total Research and Development $418.2 $465.2 $404.1 ====== ====== ====== (c)(1)(xii) In the opinion of Registrant, compliance with existing federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, will not have a material effect on the capital expenditures, earnings or competitive position of Registrant and its subsidiaries. Additional information regarding laws and regulations concerning the environment is included in Management's Discussion and Analysis of Financial Condition and Results of Operations on page 13-36 in Exhibit 13 - Teledyne, Inc. annual report to shareholders for the year ended December 31, 1993. (c)(1)(xiii) Registrant and its subsidiaries employ approximately 21,000 persons, 10,400 of whom are employed at companies in the aviation and electronics segment. (d)(1) During the years ended December 31, 1993, 1992, and 1991, Registrant and its subsidiaries did not engage in material manufacturing operations in foreign countries. Export sales by U.S. operations to customers in foreign countries represented approximately 15 percent in 1993 and 17 percent in 1992 and 1991 of Registrant's sales. (d)(1)(i) and (d)(1)(ii) Not applicable. (d)(2) In the opinion of Registrant, there is no significant risk attendant to its foreign operations. (d)(3) Not applicable. Item 2. Item 2. Properties - ------------------- Registrant owns manufacturing and research facilities at numerous locations as follows: aviation and electronics segment (2.8 million square feet), primarily in California and Alabama; specialty metals segment (4.0 million square feet), primarily in Oregon, Indiana and Pennsylvania; industrial segment (2.6 million square feet), primarily in Michigan and Pennsylvania; consumer segment (1.2 million square feet), primarily in Colorado and California. Registrant leases facilities as follows: aviation and electronics segment (4.0 million square feet), primarily in Alabama and California; specialty metals segment (0.8 million square feet), primarily in Massachusetts; industrial segment (0.1 million square feet); consumer segment (0.2 million square feet). The terms of these leases range from monthly tenancies to several years, and many may be renewed for additional periods at the option of Registrant. Registrant believes that its property and equipment, most of which is fully utilized in its operations, are well maintained and in good operating condition. Item 3. Item 3. Legal Proceedings - -------------------------- Registrant is subject to ongoing examination of its federal tax returns by the Internal Revenue Service (IRS). The IRS has proposed the disallowance of deductions claimed by Registrant of $48.7 million in 1984 and $38.2 million in 1985 for contributions to Registrant's pension plans. The IRS may take the same position in its audit of tax years 1986 and 1987, where the claimed deductions for contributions to the pension plans totaled $37.7 million. Registrant believes the IRS position on this issue is without merit and will defend the matter vigorously. The IRS has also proposed the disallowance of deductions claimed by Registrant on behalf of a former wholly-owned insurance subsidiary with respect to insurance loss reserves of $269 million in 1984 and $115 million in 1985. Registrant believes the proposed disallowances are unjustified and will contest the matter vigorously. Moreover, any such reserve adjustments would be timing adjustments which would result in the realization of offsetting tax benefits subsequent to the tax years at issue. Accordingly, pursuant to the tax agreement between Registrant and its former subsidiary, Registrant would bear only the interim interest cost and any costs resulting from a difference in tax rates with respect to the adjustments sustained, if any. On October 29, 1992, Eugene J. Bass, a shareholder purporting to act derivatively on behalf of Registrant, commenced an action in the United States District Court for the Central District of California against certain of Registrant's directors and executive officers, a former employee of Registrant's Teledyne Relays unit, and the Registrant as a "nominal" defendant. Subsequently, Herman and Lillian Krangel and Marshall Wolf joined the action as plaintiffs. On February 26, 1993, plaintiffs filed a consolidated second amended complaint in the action which alleged, among other things, violations of RICO and the Securities Exchange Act of 1934, and breaches of fiduciary duty, in connection with the management and administration of the affairs of Registrant with respect to its Teledyne Controls, Teledyne Electro-Mechanisms, Teledyne Electronics, Teledyne Firth Sterling, Teledyne Neosho, Teledyne Relays, Teledyne Ryan Aeronautical, Teledyne Solid State, Teledyne Systems, Teledyne Thermatics and Teledyne Wah Chang Albany units, and with respect to Registrant's foreign military sales effort in Egypt and Saudi Arabia. The action seeks a declaratory judgment, treble the damages allegedly sustained by Registrant as a result of the alleged conduct, return of salaries and other remuneration received by the Item 3. Legal Proceedings (Continued) - ------------------------------------- defendants, a declaration that the election of directors at Registrant's annual meetings in 1987 through 1992 is null and void, plaintiffs' costs and expenses, including attorneys' fees, and other appropriate relief. On August 19, 1993, the Court issued a memorandum decision dismissing plaintiffs' state law claims without prejudice to refiling in state court, dismissing plaintiffs' RICO and Securities Exchange Act claims without prejudice, and ordering plaintiffs to show cause why their RICO and Securities Exchange Act claims should not be dismissed with prejudice. After briefing by the parties, the Court entered an order on September 30, 1993, dismissing plaintiffs' RICO and Securities Exchange Act claims with prejudice. Plaintiffs filed a notice of appeal on October 4, 1993. Registrant does not believe that the outcome of this action will have a material adverse effect on its financial condition. On December 7, 1993, following dismissal of their consolidated second amended complaint in the above-described action, Eugene J. Bass, Herman Krangel, Lillian Krangel and Marshall Wolf, shareholders purporting to act derivatively on behalf of Registrant, commenced an action in the Superior Court of the State of California, County of Los Angeles, against certain of Registrant's directors and executive officers, a former employee of Teledyne Relays, and Registrant as a "nominal" defendant. The complaint in this action alleges, among other things, breaches of fiduciary duty and gross mismanagement in connection with the management and administration of the affairs of Registrant with respect to its Teledyne Controls, Teledyne Electro-Mechanisms, Teledyne Electronics, Teledyne Firth Sterling, Teledyne Neosho, Teledyne Relays, Teledyne Ryan Aeronautical, Teledyne Solid State, Teledyne Systems, Teledyne Thermatics and Teledyne Wah Chang Albany units, and with respect to Registrant's foreign military sales effort in Egypt and Saudi Arabia. The action seeks a declaratory judgment, damages allegedly sustained by Registrant as a result of the alleged conduct, return of salaries and other remuneration received by the defendants, plaintiffs' costs and expenses, including attorneys' fees, and other appropriate relief. Registrant does not believe that the outcome of this action will have a material adverse effect on its financial condition. On February 11, 1993, Moise Katz and Harry Lewis, shareholders purporting to act derivatively on behalf of Registrant, commenced an action in the Superior Court of the State of California, County of Los Angeles, against certain of Registrant's directors and Registrant as a "nominal" defendant. The complaint alleges, among other things, gross negligence and breaches of fiduciary duty in connection with the management and administration of the affairs of Registrant with respect to its Teledyne Controls, Teledyne Relays and Teledyne Systems units, each of which has been subject to investigation by the U.S. government, and with respect to Registrant's foreign military sales effort in Egypt and Saudi Arabia. The complaint seeks damages sustained by Registrant as a result of the alleged conduct, plaintiffs' costs and expenses, including attorneys' fees, and other appropriate relief. Registrant does not believe that the outcome of this action will have a material adverse effect on its financial condition. Registrant has been and is subject from time to time to various audits, reviews and investigations relating to Registrant's compliance with federal and state laws, including those discussed in Note 11 to the accompanying consolidated financial statements. Should any unit involved be charged with wrongdoing, or should the U.S. government determine that the unit is not a "presently responsible contractor," that unit, and conceivably Registrant, could be temporarily suspended or, in the event of a conviction, could be debarred for up to three years from receiving new government contracts or government-approved subcontracts. A suspension or debarment of Registrant would have a material Item 3. Legal Proceedings (Continued) - ------------------------------------- adverse effect on the future operating results and consolidated financial condition of Registrant. However, except as otherwise discussed in Note 11 to the accompanying consolidated financial statements, Registrant does not possess sufficient information to determine whether it will sustain a loss as a result of any of the investigations discussed in Note 11, or to reasonably estimate the amount of any such loss, and has not been able to identify the existence of a material loss contingency arising therefrom. Registrant is defending a civil action filed on behalf of the U.S. government pursuant to the False Claims Act in the United States District Court for the Central District of California, entitled United States of America, ex rel., Taxpayers Against Fraud, Klaus Kirchhoff and Max Killingsworth v. Teledyne Industries, Inc. and Teledyne Systems Company, Inc., in which the government intervened on November 28, 1990. The action alleges that Registrant's Teledyne Systems unit violated the False Claims Act in connection with proposals for twenty-seven sole source, fixed-price contracts, which the government preliminarily estimated resulted in damages to the United States of approximately $90 million. On June 24, 1993, Registrant's motion for partial summary judgment was granted in part and denied in part, reducing the estimate to approximately $70 million. Subsequently, on January 10, 1994, the government filed its Memorandum of Contentions of Fact and Law, contending that damages to the United States total $40.9 million. The government seeks treble the damages allegedly sustained by the United States together with civil penalties of up to $10,000 for any false claim made. Trial of this matter is presently scheduled to commence March 8, 1994. The allegations of this suit were initially the subject of a federal grand jury investigation, which to Registrant's knowledge has been inactive for almost two years. Based on an internal review, and after consultation with counsel, Registrant does not possess sufficient information to determine whether it will sustain a loss in these matters, or to reasonably estimate the amount of any such loss. Consequently, Registrant has not been able to identify the existence of a material loss contingency arising therefrom. Registrant is defending a civil action filed on behalf of the U.S. government pursuant to the False Claims Act in the United States District Court for the Central District of California, entitled United States of America, ex rel., Marianne D. Gendron v. Teledyne Controls and Teledyne, Inc. The action alleges defects in the procurement and quality control systems of Registrant's Teledyne Controls unit. The U.S. government intervened in this matter on June 18, 1991, but withdrew following Registrant's February 18, 1993, agreement to pay $2.15 million in partial settlement of the matter without admission of wrongdoing. The allegations of this suit gave rise to an investigation of Teledyne Controls by a federal grand jury, the Defense Criminal Investigative Service and other federal agencies. The settlement resolves all outstanding investigations regarding the claims encompassed by the agreement. The plaintiff was granted leave to pursue the remaining allegations in the case alone, and on April 23, 1993, filed a second amended complaint. Plaintiff alleges that the actual damages to the United States cannot be ascertained, but estimates that the total damages to the United States exceed $120 million. Plaintiff seeks treble the damages allegedly sustained by the United States together with civil penalties of up to $10,000 for any false claim made. Based on an internal review, and after consultation with counsel, Registrant does not possess sufficient information to determine whether Registrant will sustain a further loss in this matter, or to reasonably estimate the amount of any such loss. Consequently, Registrant has not been able to identify the existence of a material loss contingency arising from this matter. Item 3. Legal Proceedings (Continued) - ------------------------------------- Registrant is defending a civil action filed on behalf of the U.S. government under the False Claims Act in the United States District Court for the Central District of California, entitled United States of America, ex rel., Taxpayers Against Fraud, Almon Muelhausen II and Emil Stache v. Teledyne Industries, Inc. Plaintiffs allege that Registrant's Teledyne Relays unit falsified test certifications for relays supplied to the government. The government intervened in the action on April 22, 1992, and the complaint and first amended complaint were served on Registrant on August 19, 1992. In addition to the claims alleged under the False Claims Act, the first amended complaint alleges various statutory and common law causes of action, including claims for trademark infringement, unfair competition, breach of contract and fraud. The government seeks treble the damages allegedly sustained by the United States (the government has preliminarily estimated such damages at $76.2 million), profits of not less than $41.6 million allegedly derived by Teledyne Relays from the sales at issue, and civil penalties of up to $10,000 for any false claim made. In November of 1992, Registrant pled guilty to making false statements and paid a $17.5 million fine to resolve a related criminal investigation. It is likely that resolution of this suit will result in the recognition of a loss contingency which is not currently estimable. On April 13, 1993, the Defense Logistics Agency (DLA) debarred Teledyne Relays from receiving awards of new government contracts or government-approved subcontracts for a period of one year. Thereafter, on April 16, 1993, the Defense Electronics Supply Center (DESC) suspended Teledyne Relays from shipping all products qualified to military specifications, and rescinded its October 30, 1992, authorization permitting Teledyne Relays to fill any orders for such products accepted by Teledyne Relays as of October 30, 1992. On December 22, 1993, the DLA terminated the debarment, and on January 6, 1994, DESC approved for sale certain product qualified to military specifications and manufactured by Teledyne Relays prior to the debarment. Teledyne Relays is now eligible to seek readmission to the Qualified Products List Program. On May 26, 1993, a grand jury impaneled by the United States District Court for the Southern District of Florida returned an indictment in connection with a U.S. government investigation of alleged violations of the U.S. export control laws. The indictment includes charges against Registrant's Teledyne Wah Chang Albany unit and two of its employees relating to the sale of zirconium to a South American industrialist. Registrant believes that the government's evidence does not support the allegations contained in the indictment, and is vigorously defending itself. At an arraignment on June 14, 1993, Registrant entered a plea of not guilty. If Registrant were found guilty, it could face fines of up to $1 million for each of the four alleged violations of the Arms Export Control Act, five times the value of the export involved or $1 million, whichever is greater ($1.55 million or $1 million) for each of the two violations of the Export Administration Act, and $500,000 for each of the three alleged violations of the False Statements Act. As a result of the indictment, the United States Department of State temporarily suspended Teledyne Wah Chang Albany, effective July 26, 1993, from receiving licenses for export of products and services on the munitions list. This suspension will not have a material adverse affect on the financial condition of Registrant. However, in the event of a conviction, Teledyne Wah Chang Albany and conceivably Registrant would be subject to debarment for a period of up to three years from receiving such export licenses, and could be suspended for up to ten years from eligibility for commercial export licenses. In addition, should the U.S. government determine that Teledyne Wah Chang Albany is not a "presently responsible contractor," Teledyne Wah Chang Albany and Item 3. Legal Proceedings (Continued) - ------------------------------------- conceivably Registrant could be temporarily suspended or, in the event of a conviction, could be debarred for up to three years from receiving new government contracts or government-approved subcontracts. Based on an ongoing internal review, and after consultation with counsel, Registrant does not possess sufficient information to determine whether Registrant will sustain a loss in this matter, or to reasonably estimate the amount of any such loss. Consequently, Registrant has not been able to identify the existence of a material loss contingency arising therefrom. Registrant is defending a civil action filed on behalf of the U.S. government under the False Claims Act in the United States District Court for the Central District of California, entitled United States of America, ex rel., Almon Muelhausen II and Emil Stache v. Teledyne, Inc., Teledyne Industries, Inc. and Teledyne Solid State. The government declined to intervene in the action on August 23, 1993, and the complaint was served on Registrant on October 29, 1993. Plaintiffs allege that Registrant's Teledyne Solid State unit falsified test certifications for solid state relays supplied to the government. Plaintiffs seek treble the damages allegedly sustained by the United States, and civil penalties of up to $10,000 for any false claim made. Based on an internal review, and after consultation with counsel, Registrant does not possess sufficient information to determine whether Registrant will sustain a loss in this matter, or to reasonably estimate the amount of any such loss. Consequently, Registrant has not been able to identify the existence of a material loss contingency arising therefrom. Registrant is informed that it has been named as a defendant in three civil actions filed pursuant to the False Claims Act in the U.S. District Court for the Central District of California. Two of these cases concern Registrant's Teledyne Electronics unit, of which one reportedly alleges damages in a material amount. The third concerns Registrant's Teledyne Solid State and Teledyne Relays units. Registrant is further informed that it has been named as a defendant in a fourth action filed pursuant to the False Claims Act in the U.S. District Court for the Western District of Missouri concerning Registrant's former Teledyne Neosho unit. All of these cases remain under seal. Registrant does not possess sufficient information to determine whether Registrant will sustain a loss in these matters, or to reasonably estimate the amount of any such loss. Consequently, Registrant has not been able to identify the existence of a material loss contingency arising therefrom. On August 3, 1993, the United States of America filed an action against Registrant in the United States District Court for the Southern District of California alleging that Registrant's Teledyne Ryan Aeronautical unit violated its wastewater discharge permit by exceeding its discharge limitations from August 1, 1988 to February 22, 1991, and by diluting its wastewater on numerous occasions from 1988 through 1992. The government sought civil penalties of up to $25,000 per day for each alleged violation. On November 24, 1993, Registrant reached agreement with the government to settle this matter for $500,000, subject to final government approvals and execution of a mutually acceptable settlement agreement. 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 - ------- This information is presented on pages 13-39 and 13-42 in Exhibit 13 - Teledyne, Inc. annual report to shareholders for the year ended December 31, 1993. Item 6. Item 6. Selected Financial Data - -------------------------------- This information is presented on pages 13-40 and 13-41 in Exhibit 13 - Teledyne, Inc. annual report to shareholders for the year ended December 31, 1993. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and - ------------------------------------------------------------------------ Results of Operation - -------------------- This information is presented on pages 13-28 through 13-36 in Exhibit 13 - Teledyne, Inc. annual report to shareholders for the year ended December 31, 1993. Item 8. Item 8. Financial Statements and Supplementary Data - ---------------------------------------------------- This information is presented on pages 13-1 through 13-39 in Exhibit 13 - Teledyne, Inc. annual report to shareholders for the year ended December 31, 1993. 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 - ------------------------------------------------------------ This information will be included in the Teledyne, Inc. proxy statement for 1994 which will be filed within 120 days of Registrant's year end and is hereby incorporated by reference to such proxy statement. Item 11. Item 11. Executive Compensation - -------------------------------- This information will be included in the Teledyne, Inc. proxy statement for 1994 which will be filed within 120 days of Registrant's year end and is hereby incorporated by reference to such proxy statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - ------------------------------------------------------------------------ This information will be included in the Teledyne, Inc. proxy statement for 1994 which will be filed within 120 days of Registrant's year end and is hereby incorporated by reference to such proxy statement. Item 13. Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------- This information will be included in the Teledyne, Inc. proxy statement for 1994 which will be filed within 120 days of Registrant's year end and is hereby incorporated by reference to such proxy statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------------------------------------------------------------------------- (a)(1) Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Report of Independent Public Accountants Notes to Consolidated Financial Statements (a)(2) See the index preceding the financial statement schedule. Financial Statement Schedule A - schedule supporting the consolidated financial statements of Teledyne, Inc. and subsidiaries. (a)(3) See the exhibit index. (b) Registrant did not file any reports on Form 8-K during the quarter ended December 31, 1993 (c) Included in 14(a)(3) above. (d) Included in 14(a)(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 annual report to be signed on its behalf by the undersigned, thereunto duly authorized. TELEDYNE, INC. (Registrant) Date: January 26, 1994 By /S/ William P. Rutledge _____________________________ William P. Rutledge Director, 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 Registrant and in the capacities and as of the date indicated. Date: January 26, 1994 By /S/ William P. Rutledge ____________________________ William P. Rutledge Director, Chairman of the Board and Chief Executive Officer Date: January 26, 1994 By /S/ Donald B. Rice ____________________________ Donald B. Rice Director, President and Chief Operating Officer Date: January 26, 1994 By /S/ George A. Roberts ____________________________ George A. Roberts Director Date: January 26, 1994 By /S/ Arthur Rock ____________________________ Arthur Rock Director Date: January 26, 1994 By /S/ Henry E. Singleton ____________________________ Henry E. Singleton Director Date: January 26, 1994 By /S/ Douglas J. Grant ____________________________ Douglas J. Grant Treasurer (Principal Financial and Accounting Officer) TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- FINANCIAL STATEMENT SCHEDULE A ------------------------------ SCHEDULE SUPPORTING THE CONSOLIDATED FINANCIAL STATEMENTS OF ------------------------------------------------------------ TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- INDEX ----- Page ---- Report of Independent Public Accountants A-2 Schedule I - Marketable Securities - Other Investments A-3 All other schedules are not submitted because they are not applicable or not required or because the required information is included in the consolidated financial statements of Teledyne, Inc. and subsidiaries or notes thereto. A-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO TELEDYNE, INC.: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of Teledyne, Inc.and subsidiaries included in this Form 10-K, and have issued our report thereon dated January 12, 1994. Our audit was made for the purpose of forming an opinion on those financial statements taken as a whole. The schedule listed in the accompanying index is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states 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. Los Angeles, California January 12, 1994 A-2 TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS ------------------------------------------------------ December 31, 1993 ----------------- (In millions except share amounts) A-3 TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- INDEX TO EXHIBITS ----------------- Number ------ Restated Certificate of Incorporation of Teledyne, Inc. as amended and 3(i) previously filed with Securities and Exchange Commission ("Commission") as Exhibit 3 to the Company's Form 10-K Report for the year ended December 31, 1991, File No. 1-5212, and incorporated herein by reference. By-Laws of Teledyne, Inc., as restated and amended and previously filed 3(ii) with the Commission as Exhibit 3 to the Company's Form 10-K Report for the year ended December 31, 1991, File No. 1-5212, and incorporated herein by reference. Indenture dated as of June 1, 1969 between Continental Motors Corporation 4.1 and Bank of America National Trust and Savings Association, as supplemented by First Supplemental Indenture dated as of October 31, 1969 between Continental Motors Corporation and Bank of America National Trust and Savings Association and Second Supplemental Indenture dated as of December 16, 1969 between Teledyne, Inc. and Continental Motors Corporation and Security Pacific National Bank. Indenture was previously filed with the Commission as Exhibit 4 to the Company's Form 10-K Report for the year ended December 31, 1992, File No. 1-5212, and incorporated herein by reference. Indenture dated as of June 1, 1974 between Teledyne, Inc. and Union Bank, 4.2 as supplemented by Second Supplemental Indenture dated as of May 5, 1980 between Teledyne, Inc. and Union Bank, previously filed with the Commission as Exhibit 4 to the Company's Form 10-K Report for the year ended December 31, 1992, File No. 1-5212, and incorporated herein by reference. Teledyne, Inc. 1990 Stock Option Plan, previously filed with the 10.1 Commission as Exhibit 10 to the Form 10-K Report for the year ended December 31, 1990, File No. 1-5212, and incorporated herein by reference. Summary of Teledyne, Inc. Deferred Compensation Plan, previously filed 10.2 with the Commission as Exhibit 10 to the Company's Form 10-K Report for the year ended December 31, 1992, File No. 1-5212 and incorporated herein by reference. Financial information from the Teledyne, Inc. annual report to shareholders 13 for the year ended December 31, 1993. Subsidiaries of registrant. 21 Consent of independent public accountants. 23 All other exhibits are not submitted because they are not applicable or not required or because the required information is included in the consolidated financial statements of Teledyne, Inc. and subsidiaries or notes thereto. EXHIBIT 13 TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- CONSOLIDATED BALANCE SHEETS --------------------------- December 31, 1993 and 1992 -------------------------- (In millions except share and per share amounts) 1993 1992 -------- -------- ASSETS Current Assets: Cash and marketable securities $ 155.0 $ 231.3 Receivables 332.4 369.9 Inventories 172.6 197.8 Deferred income taxes 123.0 145.7 Prepaid expenses 20.5 15.3 -------- -------- Total current assets 803.5 960.0 Property and Equipment 318.8 317.5 Prepaid Pension Cost 280.3 222.1 Deferred Income Taxes 24.0 - Other Assets 51.2 36.3 -------- -------- $1,477.8 $1,535.9 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------ Current Liabilities: Accounts payable $ 106.9 $ 98.1 Accrued liabilities 341.4 373.7 -------- -------- Total current liabilities 448.3 471.8 Long-Term Debt 356.6 449.7 Accrued Postretirement Benefits 277.5 - Deferred Income Taxes - 55.8 Other Long-Term Liabilities 114.9 117.5 -------- -------- 1,197.3 1,094.8 -------- -------- Shareholders' Equity: Common stock, $1.00 par value, 100,000,000 shares authorized, 55,439,048 shares in 1993 and 55,412,845 shares in 1992 issued and outstanding 55.4 55.4 Additional paid-in capital 34.9 34.5 Retained earnings 186.7 347.5 Currency translation adjustment 3.5 3.7 -------- -------- Total shareholders' equity 280.5 441.1 -------- -------- $1,477.8 $1,535.9 ======== ======== The accompanying notes are an integral part of these statements. 13-1 EXHIBIT 13 TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- CONSOLIDATED STATEMENTS OF OPERATIONS ------------------------------------- For the Years Ended December 31, 1993, 1992 and 1991 ---------------------------------------------------- (In millions except per share amounts) 1993 1992 1991 --------- --------- --------- Sales $ 2,491.7 $ 2,887.6 $ 3,206.8 --------- --------- --------- Costs and Expenses*: Cost of sales 1,917.9 2,243.2 2,571.5 Selling and administrative expenses 466.4 528.8 508.6 Interest expense 45.1 56.2 61.9 Realignment/restructure 1.4 (24.4) 107.6 --------- --------- --------- 2,430.8 2,803.8 3,249.6 --------- --------- --------- Earnings before Other Income 60.9 83.8 (42.8) Other Income 52.4 3.2 11.0 --------- --------- --------- Income (Loss) before Income Taxes, Extraordinary Loss and Cumulative Effect of Accounting Changes 113.3 87.0 (31.8) Provision (Credit) for Income Taxes 40.5 41.1 (6.4) --------- --------- --------- Income (Loss) before Extraordinary Loss and Cumulative Effect of Accounting Changes 72.8 45.9 (25.4) Extraordinary Loss on Redemption of Debt (3.7) (2.7) - Cumulative Effect of Accounting Changes (185.6) (10.0) - --------- --------- --------- Net Income (Loss) $ (116.5) $ 33.2 $ (25.4) ========= ========= ========= Income (Loss) Per Share: Income (loss) before extraordinary loss and cumulative effect of accounting changes $ 1.32 $ 0.83 $ (0.46) Extraordinary loss on redemption of debt (0.07) (0.05) - Cumulative effect of accounting changes (3.35) (0.18) - --------- --------- --------- Net Income (Loss) Per Share $ (2.10) $ 0.60 $ (0.46) ========= ========= ========= *Includes a credit of non-cash pension income of $66.2 million in 1993, $37.9 million in 1992 and $28.2 million in 1991. The accompanying notes are an integral part of these statements. 13-2 EXHIBIT 13 TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- For the Years Ended December 31, 1993, 1992 and 1991 ---------------------------------------------------- (In millions) 1993 1992 1991 -------- -------- ------- Operating activities: Net income (loss) $ (116.5) $ 33.2 $ (25.4) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Increase in accrued postretirement benefits 299.2 - - Depreciation and amortization of property and equipment 72.7 79.1 84.1 Increase in prepaid pension cost (58.2) (47.3) (38.6) Decrease (increase) in deferred income taxes (57.1) 59.0 (64.6) Decrease in accounts payable and accrued liabilities (46.0) (100.7) (20.3) Gain on sale of Litton common stock (40.4) - - Decrease in inventories 21.8 29.5 38.0 Decrease in receivables 17.4 77.9 32.2 Realignment/restructure 1.4 (4.0) 107.6 Increase (decrease) in accrued income taxes - (17.9) 12.9 Other, net (3.0) (2.2) 32.8 -------- -------- ------- Net cash provided by operating activities 91.3 106.6 158.7 -------- -------- ------- Investing activities: Proceeds from the sale of marketable securities 163.5 54.4 63.8 Purchases of marketable securities (70.4) (47.2) (85.0) Net decrease (increase) in short-term investments 28.5 (41.5) 8.0 -------- -------- ------- Net sale (purchase) of marketable securities 121.6 (34.3) (13.2) Purchases of property and equipment (81.2) (69.6) (97.6) Collection of notes receivable from the sales of businesses 17.1 - - Proceeds from the sales of businesses 9.2 95.8 - Other, net (5.9) 7.3 10.5 -------- -------- ------- Net cash provided by (used in) investing activities 60.8 (0.8) (100.3) -------- -------- ------- Financing activities: Reduction of long-term debt (101.6) (60.0) (17.2) Cash dividends (44.3) (44.4) (44.3) Other, net 0.4 0.3 1.6 -------- -------- ------- Net cash used in financing activities (145.5) (104.1) (59.9) -------- -------- ------- Increase (decrease) in cash $ 6.6 $ 1.7 $ (1.5) ======== ======== ======= Noncash transactions: Receivables from the sales of businesses $ 4.2 $ 19.0 $ - ======== ======== ======= Income taxes paid (received) $ (2.6) $ 26.5 $ 36.3 ======== ======== ======= Interest paid on long-term debt $ 41.7 $ 50.7 $ 55.2 ======== ======== ======= The accompanying notes are an integral part of these statements. 13-3 The accompanying notes are an integral part of these statements. 13-4 EXHIBIT 13 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- To the Shareholders and Board of Directors of Teledyne, Inc.: We have audited the accompanying consolidated balance sheets of Teledyne, Inc. (a Delaware corporation) and subsidiaries (the Company) as of December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the 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 Teledyne, 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 discussed further in Note 11 to the consolidated financial statements, the Company is defending a suit filed under the False Claims Act at the Company's Teledyne Relays unit. It is likely that resolution of the civil suit will result in the recognition of a loss contingency which is not currently estimable. Accordingly, no provision for any liability has been made in the accompanying consolidated financial statements. As explained in Notes 6 and 8 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109 in 1992 and SFAS No. 106 in 1993. Arthur Andersen & Co. Los Angeles, California January 12, 1994 13-5 EXHIBIT 13 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ Note 1. Summary of Significant Accounting Policies - Principles of Consolidation. The consolidated financial statements of Teledyne, Inc. include the accounts of all its subsidiaries. All material intercompany accounts and transactions have been eliminated. Certain amounts for 1992 and 1991 have been reclassified to conform with the 1993 presentation. Receivables. Receivables are presented net of a reserve for doubtful accounts of $9.2 million at December 31, 1993 and $8.0 million at December 31, 1992. Inventories. Inventories are stated at the lower of cost (last-in, first-out and first-in, first-out methods) or market, less progress payments. Costs include direct material, direct labor and applicable manufacturing and engineering overhead, and other direct costs. Any foreseeable losses are charged to income when determined. Cost in Excess of Net Assets of Purchased Businesses. Other assets include cost in excess of net assets of purchased businesses of $25.6 million at December 31, 1993 and $22.8 million at December 31, 1992. Substantially all of this cost relates to businesses purchased prior to November 1970 and is not being amortized. Financial Instruments. The fair value of financial instruments, except for long-term debt, approximated their carrying values at December 31, 1993. Fair values have been determined through information obtained from quoted market sources and management estimates. Revenue Recognition. Commercial sales and revenue from U.S. government fixed- price type contracts are generally recorded as deliveries are made or as services are rendered. For certain fixed-price type contracts that require substantial performance over a long time period before deliveries begin, sales are recorded based upon attainment of scheduled performance milestones. Sales under cost-reimbursement contracts are recorded as costs are incurred and fees are earned. Depreciation and Amortization. Buildings and equipment are depreciated primarily on declining balance methods over their estimated useful lives. Leasehold improvements are amortized on a straight-line basis over the life of the lease. Maintenance and repair costs ($60.1 million in 1993, $71.4 million in 1992 and $83.1 million in 1991) are charged to income as incurred, and betterments and major renewals are capitalized. Cost and accumulated depreciation of property sold, retired or fully depreciated are removed from the accounts, and any resultant gain or loss is included in income. Research and Development. Company-funded research and development costs, which excludes bid and proposal costs, ($39.2 million in 1993, $48.5 million in 1992 and $50.9 million in 1991) are expensed as incurred. Costs related to customer-funded research and development contracts are charged to costs and expenses as the related sales are recorded. A portion of the cost incurred for company-funded research and development is recoverable through overhead cost allowances on government contracts. 13-6 EXHIBIT 13 Note 1. Summary of Significant Accounting Policies - (Continued) Environmental. Costs that mitigate or prevent future environmental contamination or extend the life, increase the capacity or improve the safety or efficiency of property utilized in current operations are capitalized. Other costs that relate to current operations or an existing condition caused by past operations are expensed. Liabilities are recorded when the Company's liability is probable and the costs are reasonably estimable. Liabilities are estimated and evaluated independently of possible recoveries, if any, from insurance carriers and other third parties. The measurement of environmental liabilities by the Company is based on currently available facts, existing technology and presently enacted laws and regulations taking into consideration the Company's prior experience in site remediation and data concerning clean-up costs available from other companies and regulatory authorities. Income Taxes. In 1992, the Company changed its method of accounting for income taxes to comply with the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, as discussed in Note 6. Provision (credit) for income taxes includes federal, state and foreign income taxes. Deferred income taxes are provided for temporary differences (timing differences prior to 1992) in the recognition of income and expenses. Deferred income taxes reflect enacted income tax rates expected to be in effect rather than historical rates. Net Income (Loss) Per Share. The weighted average number of shares of common stock used in the computation of net income per share was 55,420,654 in 1993 and 55,412,845 in 1992 and 1991. The potential dilution of common stock equivalents is not material and, therefore, is not included in the computation of per share data. 13-7 EXHIBIT 13 Note 2. Inventories - Inventories at December 31, 1993 and 1992 were as follows (in millions): 1993 1992 ------- ------- Raw materials and work-in-process $ 257.1 $ 277.1 Finished goods 49.0 47.6 ------- ------- 306.1 324.7 Progress payments (133.5) (126.9) ------- ------- $ 172.6 $ 197.8 ======= ======= Inventories, before progress payments, determined on the last-in, first-out method were $233.1 million at December 31, 1993 and $258.1 million at December 31, 1992. The remainder of the inventories was determined using the first-in, first-out method. Inventories stated on the last-in, first-out basis were $184.0 million and $208.4 million less than their first-in, first-out values at December 31, 1993 and 1992, respectively. These first-in, first-out values do not differ materially from current cost. During 1993, 1992 and 1991 inventory usage resulted in liquidations of last-in, first-out inventory quantities. These inventories were carried at the lower costs prevailing in prior years as compared with the cost of current purchases. The effect of these last-in, first-out inventory liquidations was to increase net income by $11.4 million in 1993, $11.5 million in 1992 and $7.5 million in 1991. Inventories, before progress payments, related to long-term contracts were $129.3 million and $132.6 million at December 31, 1993 and 1992, respectively. Progress payments related to long-term contracts were $116.0 million and $116.7 million at December 31, 1993 and 1992, respectively. 13-8 EXHIBIT 13 Note 3. Long-Term Debt - Long-term debt at December 31, 1993 and 1992 was as follows (in millions): 1993 1992 ------ ------ 10% Subordinated Debentures, due 2004, Series A and C (net of unamortized discount of $30.9 in 1993 and $40.1 in 1992) $329.1 $419.8 7% Subordinated Debentures, due 1999, $1.9 payable annually 26.7 26.7 Other 4.1 4.5 ------ ------ 359.9 451.0 Current portion (3.3) (1.3) ------ ------ $356.6 $449.7 ====== ====== At December 31, 1993, the market value of the 10% Subordinated Debentures was $370.7 million and the 7% Subordinated Debentures was $26.7 million. In 1993, the Company redeemed at par $100 million of its 10% Subordinated Debentures due 2004, Series C resulting in an extraordinary loss of $6.0 million or $3.7 million, net of tax. In 1992, the Company redeemed at par $50 million ($46.7 million, net of treasury) of its 10% Subordinated Debentures due 2004, Series A resulting in an extraordinary loss of $4.4 million, or $2.7 million, net of tax. Long-term debt payable is $3.3 million in 1994, $3.1 million in 1995, $2.7 million in 1996, $2.2 million in 1997 and $2.2 million in 1998. The Company's pension and savings plans held Teledyne 10% Subordinated Debentures with a par value of $86.6 million and $113.9 million at December 31, 1993 and 1992, respectively. The Company has domestic credit lines with various banks totaling $125.0 million at December 31, 1993; no amounts were borrowed under these lines during 1993 or 1992. Commitments under standby letters of credit outstanding were $105.9 million at December 31, 1993. Compensating balance arrangements of an informal nature exist. Such arrangements had no material effect on the Company's consolidated financial statements at December 31, 1993. 13-9 EXHIBIT 13 Note 4. Supplemental Balance Sheet Information - Cash and marketable securities at December 31, 1993 and 1992 were as follows (in millions): 1993 1992 ------- ------- Cash $ 14.7 $ 8.1 United States Treasury notes, at amortized cost (market: 1993-$119.0; 1992-$124.4) 115.3 122.0 Repurchase agreements, at cost which approximates market 25.0 53.5 Litton common stock, at cost (market: 1992-$75.2) - 45.1 Other marketable securities, at amortized cost - 2.6 ------- ------- $ 155.0 $ 231.3 ======= ======= In 1993, the Company sold its investment in Litton common stock resulting in a $40.4 million gain, included in other income. Property and equipment at December 31, 1993 and 1992 were as follows (in millions): 1993 1992 ------- ------- Land $ 30.2 $ 29.5 Buildings 233.4 231.1 Equipment and leasehold improvements 563.7 529.8 ------- ------- 827.3 790.4 Accumulated depreciation and amortization (508.5) (472.9) ------- ------- $ 318.8 $ 317.5 ======= ======= Accounts payable included $22.1 million at December 31, 1993 and $14.2 million at December 31, 1992 for checks outstanding in excess of cash balances. Accrued liabilities at December 31, 1993 and 1992 were as follows (in millions): 1993 1992 ------- ------- Salaries and wages $ 66.5 $ 64.3 Advances and billings in excess of costs 61.7 69.5 Other 213.2 239.9 ------- ------- $ 341.4 $ 373.7 ======= ======= 13-10 EXHIBIT 13 Note 5. Shareholders' Equity - The Company is authorized to issue 15 million shares of preferred stock, $1 par value. No preferred shares were issued or outstanding. In 1988, the Board of Directors authorized the purchase of up to five million shares of the Company's common stock. As of December 31, 1993, the Company had purchased 1,432,000 shares. In 1990, the Company's Board of Directors adopted the 1990 Stock Option Plan covering an aggregate of 2,500,000 shares of the Company's common stock. Under the 1990 Stock Option Plan, options to purchase shares of the Company's common stock may be granted to certain key employees. The options may be incentive stock options, non-qualified stock options, or stock appreciation rights. If incentive stock options are granted, the exercise price of the options is the fair market value of the shares on the date of the grant. Non-qualified stock options may be granted with an exercise price below the fair market value of the shares on the date of the grant. Options are nontransferable and are exercisable in installments. Stock option activity for the year ended December 31, 1993 was as follows: Number Exercise Of Shares Price Per Share --------- ----------------- Outstanding at December 31, 1992 1,450,000 $19.625 - $25.125 Granted 1,108,000 $20.250 - $26.875 Exercised (27,000) $19.625 Canceled (137,500) $19.625 - $26.875 Outstanding at December 31, 1993 2,393,500 $19.625 - $26.875 The options granted to date are exercisable in installments beginning two years from the date of grant and expiring 10 years from the date of grant. As of December 31, 1993, options for 79,500 common shares were available for future grant and 331,200 of the stock options were exercisable. In 1993, the Company's Board of Directors approved, subject to shareholder approval, a 2,500,000 increase in the number of shares of the Company's common stock available under the 1990 Stock Option Plan. 13-11 EXHIBIT 13 Note 6. Income Taxes - Effective January 1, 1992, the Company changed its method of accounting for income taxes to comply with the provisions of SFAS No. 109. As a result, net income for 1992 included a charge of $10.0 million or $0.18 per share for cumulative effect of accounting change. Prior year financial statements have not been restated. Under SFAS No. 109, deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the enacted marginal tax rate in effect for the year in which the differences are expected to reverse. Deferred income tax expenses or credits are based on the changes in the asset or liability from period to period. Prior to 1992, deferred taxes were provided on timing differences between the income or loss determined for financial reporting and income tax reporting at income tax rates in effect when the differences arose. The components of the net deferred tax asset at December 31, 1993 and 1992 were as follows (in millions): 1993 1992 ------- ------ Postretirement benefits $ 117.2 $ - Pension income (100.3) (72.2) Long-term contracts 38.7 65.3 Self-insurance reserves 16.9 16.1 Vacation benefits 12.0 11.2 Inventory valuations 10.3 12.1 Other deferred assets 72.8 79.9 Other deferred liabilities (20.6) (22.5) ------- ------ $ 147.0 $ 89.9 ======= ====== 13-12 EXHIBIT 13 Note 6. Income Taxes (Continued) - Provision (credit) for income taxes for the years ended December 31, 1993, 1992 and 1991 was as follows (in millions): 1993 1992 1991 ------- ------ ------ Current - Federal $ (20.1) $ (6.3) $ 46.2 - State 0.4 4.2 9.2 - Foreign 1.5 0.8 2.8 ------- ------ ------ - Total (18.2) (1.3) 58.2 ------- ------ ------ Deferred - Federal 49.3 36.1 (53.5) - State 9.4 6.3 (11.1) ------- ------ ------ - Total 58.7 42.4 (64.6) ------- ------ ------ Provision (credit) for income taxes $ 40.5 $ 41.1 $ (6.4) ======= ====== ====== Income (loss) before income taxes, extraordinary loss and cumulative effect of accounting changes included income (loss) from domestic operations of $113.7 million in 1993, $86.7 million in 1992 and $(37.8) million in 1991. Provision (credit) for deferred income taxes for the years ended December 31, 1993, 1992 and 1991 was as follows (in millions): 1993 1992 1991 ------- ------ ------ Pension income $ 28.1 $ 16.9 $ 11.4 Long-term contracts 26.6 11.9 (22.6) Securities transactions 5.5 - 3.4 Realignment/restructure 1.4 31.7 (39.0) Inventory valuation 1.8 7.7 (6.7) Interest on income tax assessments (0.8) (2.7) (6.3) Vacation benefits (0.8) 2.7 (4.1) Other, net (3.1) (25.8) (0.7) ------- ------ ------ $ 58.7 $ 42.4 $(64.6) ======= ====== ====== Differences between the provision (credit) for income taxes and income taxes at the statutory federal income tax rate for the years ended December 31, 1993, 1992 and 1991 were as follows (in millions): 1993 1992 1991 ------- ------ ------ Income tax at statutory federal rate $ 39.6 $ 29.6 $(10.8) State and local income taxes, net of federal income tax effect 6.4 6.9 (1.3) Effect of tax rate change (4.6) - - Foreign sales corporation exemption (2.5) (2.4) (3.1) Non-deductible expense 0.5 6.0 - Revisions to prior years' estimated income tax liabilities - 0.4 5.8 Goodwill write-offs - 0.2 1.9 Other, net 1.1 0.4 1.1 ------- ------ ------ Provision (credit) for income taxes $ 40.5 $ 41.1 $ (6.4) ======= ====== ====== 13-13 EXHIBIT 13 Note 6. Income Taxes (Continued) - The Omnibus Budget Reconciliation Act of 1993 increased the corporate federal income tax rate to 35 percent in 1993 from 34 percent in 1992. The tax law change resulted in the recognition of additional income by the Company due primarily to revaluing the Company's net deferred tax asset. 13-14 EXHIBIT 13 Note 7. Pension Benefits The Company sponsors defined benefit pension plans covering substantially all of its employees. Benefits are generally based on years of service and/or final average pay. The Company funds the pension plans in accordance with the requirements of the Employee Retirement Income Security Act of 1974, as amended. The Company made cash contributions to the pension plans of $0.6 million in 1993, $1.8 million in 1992 and $1.2 million in 1991. Components of pension expense (income) for the years ended December 31, 1993, 1992 and 1991 included the following (in millions): Expense (Income) ---------------------------- 1993 1992 1991 ------ ------ ------ Service cost - benefits earned during the year $ 29.6 $ 42.6 $ 36.8 Interest cost on benefits earned in prior years 68.4 67.6 65.6 Expected return on plan assets (106.1) (102.6) (92.4) Net amortization of unrecognized amounts (58.9) (41.8) (39.3) ------ ------ ------ Pension income for defined benefit plans (67.0) (34.2) (29.3) Other 0.8 (3.7) 1.1 ------ ------ ------ Pension income $(66.2) $(37.9) $(28.2) ====== ====== ====== Actual return on plan assets was $174.1 million in 1993, $136.3 million in 1992 and $230.5 million in 1991. Actuarial assumptions used to develop the components of pension expense (income) for the years ended December 31, 1993, 1992 and 1991 were as follows: 1993 1992 1991 ---- ---- ---- Discount rate 8.00% 6.75% 7.50% Rate of increase in future compensation levels 4.50% 4.50% 4.50% Expected long-term rate of return on assets 6.00% 6.00% 6.00% 13-15 EXHIBIT 13 Note 7. Pension Benefits (Continued) - Plan assets in excess of projected benefit obligation at December 31, 1993 and 1992 were as follows (in millions): 1993 1992 -------- -------- Plan assets at fair value $1,893.2 $1,798.8 -------- -------- Actuarial present value of benefit obligations: Vested benefit obligation 893.8 799.3 Non-vested benefit obligation 8.6 12.6 -------- -------- Accumulated benefit obligation 902.4 811.9 Additional benefits related to future compensation levels 133.6 115.3 -------- -------- Projected benefit obligation 1,036.0 927.2 -------- -------- Plan assets in excess of projected benefit obligation $ 857.2 $ 871.6 ======== ======== Plan assets in excess of projected benefit obligation: Included in balance sheet: Prepaid pension cost $ 280.3 $ 222.1 Accrued pension liability (25.3) (34.2) Not included in balance sheet: Unrecognized net gain due to experience different from that assumed and changes in the discount rate 353.4 395.4 Unrecognized net asset at adoption of SFAS No. 87, net of amortization 273.5 312.5 Unrecognized prior service cost (24.7) (24.2) -------- -------- Plan assets in excess of projected benefit obligation $ 857.2 $ 871.6 ======== ======== Any reversion of pension plans' assets to the Company would be subject to federal and state income taxes, substantial excise tax and other possible claims. At December 31, 1993 and 1992, the plans' assets, which consisted primarily of fixed maturities, included debt obligations of the Company (primarily Teledyne 10% Subordinated Debentures) with a market value of $81.0 million and $101.6 million, respectively. A discount rate of 7.00 percent at December 31, 1993 and 8.00 percent at December 31, 1992 and a rate of increase in future compensation levels of 4.50 percent at December 31, 1993 and 1992 were used for the valuation of pension obligations. 13-16 EXHIBIT 13 Note 8. Postretirement and Postemployment Benefits - The Company provides postretirement health care and life insurance benefits, which are paid as incurred, to certain employees and their dependents meeting eligibility requirements. Most of the plans are of a defined benefit nature and are subject to deductibles, co-payment provisions and other limitations. Retiree contributions to the premium cost are generally required based on coverage type, plan and medicare eligibility. In many plans, company contributions toward premiums are capped based on the cost as of a certain date thereby creating a defined contribution. The Company generally reserves the right to change or eliminate the plans. Non-represented employees who commenced employment after January 1, 1986 and union represented employees who commence employment after the most recently negotiated labor agreement are not eligible for medical benefits upon retirement. Effective January 1, 1993, the Company changed its method of accounting for postretirement health care and life insurance benefits, as required by SFAS No. 106. This statement requires that the expected cost of providing postretirement health care and life insurance benefits be charged to expense during the years that the employees render service. Prior to 1993, the Company expensed the cost of these benefits as they were paid. The annual expense was $23.0 million in 1992 and $20.2 million in 1991, which has not been restated. As a result of adopting SFAS No. 106, the Company recorded a charge of $301.7 million or $185.6 million, net of tax, to recognize the accumulated postretirement benefit obligation at the date of adoption. The new accounting method will have no effect on the Company's cash outlays for postretirement health care benefits. Components of postretirement expense for the year ended December 31, 1993 included the following (in millions): Expense (Income) -------- Service cost - benefits earned during the year $ 1.3 Interest cost on benefits earned in prior years 23.4 Other (1.8) ------ Postretirement expense $ 22.9 ====== There were approximately 14,000 retirees and dependents associated with postretirement benefit plans. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 11.5 percent in 1993, gradually declining to 6.5 percent in the year 2011 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 by $33.9 million and the 1993 postretirement benefit expense by $3.1 million. A discount rate of 8.0 percent was used in determining the postretirement expense. A discount rate of 7.0 percent was used to determine the postretirement benefit obligation at December 31, 1993. 13-17 EXHIBIT 13 Note 8. Postretirement and Postemployment Benefits (Continued) - Accumulated postretirement benefit obligation at December 31, 1993 was as follows (in millions): ------- Accumulated present value of benefit obligations: Retirees $ 278.1 Other fully eligible plan participants 30.2 Other active plan participants 27.7 ------- Accumulated benefit obligation $ 336.0 ======= Accumulated benefit obligation: Included in balance sheet: Current portion included in accrued liabilities $ 21.7 Accrued postretirement benefits 277.5 Not included in balance sheet: Unrecognized net loss due to experience different from that assumed and changes in the discount rate 36.8 ------- Accumulated benefit obligation $ 336.0 ======= In 1992, SFAS No. 112 was issued which requires a change in accounting for postemployment benefits. This statement, effective in 1994, requires that the expected cost of benefits provided to former or inactive employees and their dependents before retirement, generally expensed when paid, be charged to expense during the years that the employees render service, if certain conditions are met. The adoption of the statement by the Company in 1993 did not have a material effect on the consolidated financial statements. 13-18 EXHIBIT 13 Note 9. Realignment/Restructure - In 1993, Teledyne undertook a major realignment which consolidated its operating companies to 21 from 65 and eliminated 1,200 management and support positions at an estimated cost of $16.4 million. The realignment builds on the 1991-1992 restructure which focused the Company on those businesses in which it has significant leadership roles. The 1991-1992 restructure consisted of the sale, closure or transfer of certain operations. The cost of restructuring included the estimated loss for those operations where the disposal or transfer was expected to result in a loss. For those operations where the disposal was expected to result in a gain, no gain was recognized until realized. For 1993, the estimated restructure cost decreased $15.0 million. The net effect of realignment/restructure was a charge of $1.4 million in 1993, income of $24.4 million in 1992 and a charge of $107.6 million in 1991. 13-19 EXHIBIT 13 Note 10. Business Segments - Teledyne is a diversified corporation comprised of companies which manufacture a wide variety of products. The Company's major business segments include aviation and electronics, specialty metals, industrial and consumer. Companies in the aviation and electronics segment produce piston and turbine engines for aircraft and land based vehicle applications, airframe structures, unmanned aerial vehicles, target drone systems, and equipment and subsystems for spacecraft and avionics. Other activities in this segment include the manufacture of electronic equipment, aircraft-monitoring and control systems for military and commercial applications, relays and other related products and systems. Products in the specialty metals segment include zirconium, titanium, high temperature nickel based alloys, high-speed and tool steels, tungsten and molybdenum. Other operations in this segment consist of processing, casting, rolling and forging metals. The industrial segment is comprised of companies that are involved in the design and/or manufacture of combat vehicles, diesel engines, material handling equipment, machine tools, dies and consumable tooling. The consumer segment manufactures oral hygiene products, shower massages, water and air purification systems, swimming pool and spa heaters, and provides other products and services. Information on the Company's business segments for the years ended December 31, 1993, 1992 and 1991 was as follows (in millions): 1993 1992 1991 -------- -------- -------- Sales: Aviation and electronics: Continuing $1,138.7 $1,280.7 $1,306.4 Discontinued 18.3 76.3 105.1 -------- -------- -------- 1,157.0 1,357.0 1,411.5 -------- -------- -------- Specialty metals: Continuing 626.3 628.7 692.6 Discontinued 8.0 24.1 27.4 -------- -------- -------- 634.3 652.8 720.0 -------- -------- -------- Industrial: Continuing 338.7 311.7 277.7 Discontinued 48.6 243.1 463.9 -------- -------- -------- 387.3 554.8 741.6 -------- -------- -------- Consumer: Continuing 313.1 303.0 307.0 Discontinued - 20.0 26.7 -------- -------- -------- 313.1 323.0 333.7 -------- -------- -------- Total: Continuing 2,416.8 2,524.1 2,583.7 Discontinued 74.9 363.5 623.1 -------- -------- -------- $2,491.7 $2,887.6 $3,206.8 ======== ======== ======== The Company's backlog of confirmed orders was approximately $1.4 billion at December 31, 1993 and $1.6 billion at December 31, 1992. Backlog of the aviation and electronics segment was $1.0 billion at December 31, 1993 and $1.1 billion at December 31, 1992. 13-20 EXHIBIT 13 Note 10. Business Segments (Continued) - The Company's sales to the U.S. government were $1.0 billion in 1993 and 1992 and $1.1 billion in 1991, including direct sales as prime contractor and indirect sales as subcontractor. Most of these sales were in the aviation and electronics segment. Sales by operations in the United States to customers in other countries were $363.9 million in 1993, $481.4 million in 1992 and $535.6 million in 1991. Sales between business segments, which were not material, generally were priced at prevailing market prices. 1993 1992 1991 -------- ------- -------- Income (Loss) before Taxes, Extraordinary Loss and Cumulative Effect of Accounting Changes: Aviation and electronics: Continuing $ 43.5 $ 82.2 $ 43.7 Discontinued (7.6) 13.1 (48.5) Pension income 14.0 (1.1) 0.1 -------- ------- -------- 49.9 94.2 (4.7) -------- ------- -------- Specialty metals: Continuing 33.9 28.0 58.7 Discontinued 4.0 (6.9) (16.2) Pension income 9.7 3.9 (2.5) -------- ------- -------- 47.6 25.0 40.0 -------- ------- -------- Industrial: Continuing 15.1 11.6 17.8 Discontinued 1.6 9.5 (24.8) Pension income 38.8 34.1 27.5 -------- ------- -------- 55.5 55.2 20.5 -------- ------- -------- Consumer: Continuing 21.5 27.3 26.8 Discontinued 2.0 4.0 (8.5) Pension income 0.5 (0.6) 1.1 -------- ------- -------- 24.0 30.7 19.4 -------- ------- -------- Total: Continuing 114.0 149.1 147.0 Discontinued - 19.7 (98.0) -------- ------- -------- 114.0 168.8 49.0 -------- ------- -------- Corporate expense (74.3) (66.7) (58.1) Interest expense (45.1) (56.2) (61.9) Pension income 66.2 37.9 28.2 Other income 52.5 3.2 11.0 -------- ------- -------- $ 113.3 $ 87.0 $ (31.8) ======== ======= ======== Discontinued results include the estimated realignment/restructure cost before pension income and results of operations sold at a gain, as well as those gains. Operating profit in the aviation and electronics segment was adversely affected by approximately $20.0 million in 1993, $25.0 million in 1992 and $55.0 million in 1991 due to losses on fixed-price development and initial production contracts. Aviation and electronics segment operating profit for 1993 included a charge of $10.0 million for the settlement of certain issues raised by the Company's 13-21 EXHIBIT 13 Note 10. Business Segments (Continued) - initial Voluntary Disclosure Report to the government relating to its Teledyne Electronics unit and $6.6 million related to resolution of several other matters. Operating profit for 1992 included a charge of $17.5 million recorded in connection with the resolution of a criminal investigation of the Company's Teledyne Relays unit. Teledyne's non-cash pension income results from the amortization into income of the excess of plan assets over the estimated obligation. The amount recorded reflects the extent to which this non-cash income exceeds the current year's net cost of providing benefits. 1993 1992 1991 -------- -------- -------- Depreciation and Amortization: Aviation and electronics $ 22.0 $ 23.3 $ 24.7 Specialty metals 27.9 28.5 27.1 Industrial 9.0 12.8 18.1 Consumer 6.9 6.8 6.5 Corporate 6.9 7.7 7.7 -------- -------- -------- $ 72.7 $ 79.1 $ 84.1 ======== ======== ======== Capital Expenditures: Aviation and electronics $ 22.8 $ 20.5 $ 18.1 Specialty metals 35.0 29.3 41.3 Industrial 5.2 8.8 19.5 Consumer 9.9 7.8 8.0 Corporate 8.3 3.2 10.7 -------- -------- -------- $ 81.2 $ 69.6 $ 97.6 ======== ======== ======== Identifiable Assets: Aviation and electronics $ 284.6 $ 296.2 $ 389.1 Specialty metals 288.0 283.6 294.2 Industrial 113.1 145.3 265.7 Consumer 105.4 100.8 108.9 Corporate 686.7 710.0 661.5 -------- -------- -------- $1,477.8 $1,535.9 $1,719.4 ======== ======== ======== 13-22 EXHIBIT 13 Note 11. Commitments and Contingencies - Rental expense under operating leases was $27.0 million in 1993, $27.9 million in 1992 and $29.9 million in 1991. Future minimum rental commitments under operating leases with non-cancelable terms of more than one year as of December 31, 1993, are as follows: $15.5 million in 1994 and in 1995, $12.4 million in 1996, $8.4 million in 1997, $7.0 million in 1998 and $26.7 million thereafter. The Company is subject to ongoing examination of its federal tax returns by the Internal Revenue Service (IRS). The IRS has proposed the disallowance of deductions claimed by the Company of $48.7 million in 1984 and $38.2 million in 1985 for contributions to the Company's pension plans. The IRS may take the same position in its audit of tax years 1986 and 1987, where the claimed deductions for contributions to the pension plans totaled $37.7 million. The Company believes the IRS position on this issue is without merit and will defend the matter vigorously. The IRS has also proposed the disallowance of deductions claimed by the Company on behalf of a former wholly-owned insurance subsidiary with respect to insurance loss reserves of $269 million in 1984 and $115 million in 1985. The Company believes the proposed disallowances are unjustified and will contest the matter vigorously. Moreover, any such reserve adjustments would be timing adjustments which would result in the realization of offsetting tax benefits subsequent to the tax years at issue. Accordingly, pursuant to the tax agreement between the Company and its former subsidiary, the Company would bear only the interim interest cost and any costs resulting from a difference in tax rates with respect to the adjustments sustained, if any. The Company has been and is subject from time to time to various audits, reviews and investigations relating to the Company's compliance with federal and state laws. Should any unit involved be charged with wrongdoing, or should the U.S. government determine that the unit is not a "presently responsible contractor," that unit, and conceivably the Company, could be temporarily suspended or, in the event of a conviction, could be debarred for up to three years from receiving new government contracts or government-approved subcontracts. A suspension or debarment of the Company would have a material adverse effect on the future operating results and consolidated financial condition of the Company. However, except as otherwise discussed below, the Company does not possess sufficient information to determine whether it will sustain a loss as a result of any of the investigations discussed below, or to reasonably estimate the amount of any such loss, and has not been able to identify the existence of a material loss contingency arising therefrom. On August 15, 1990, federal agents executed a search warrant on and removed a number of documents relating to government-furnished materials from the Company's former Teledyne Neosho unit. In addition, several Teledyne Neosho employees received subpoenas to testify before a federal grand jury. On October 26, 1990, the Company's Teledyne Electronics unit sought admission into the Department of Defense Voluntary Disclosure Program, and was accepted into the program on March 5, 1991. Teledyne Electronics subsequently filed a Voluntary Disclosure Report with the U.S. government disclosing material handling practices at variance with military 13-23 EXHIBIT 13 Note 11. Commitments and Contingencies (Continued) - requirements in one of its military transponder programs. Teledyne Electronics later filed an Ancillary Report to its Voluntary Disclosure Report disclosing allegations relating to product quality in two other transponder programs for the military. On February 14, 1992, Teledyne Electronics received three grand jury subpoenas for production of documents relating to Department of Defense programs for the supply of military transponders, one of which was subsequently withdrawn. On October 5, 1992, Teledyne Electronics received a fourth grand jury subpoena relating to a military program for the supply of a transponder programming device. On July 28, 1993, the Company concluded a settlement with the U.S. government of claims arising out of the initial Voluntary Disclosure Report requiring the Company to pay $5 million and to provide screening and repair service of at least $5 million in value with respect to military transponder equipment delivered to the military. On June 18, 1992, the Company's Teledyne Firth Sterling unit sought admission into the Department of Defense Voluntary Disclosure Program. Teledyne Firth Sterling was accepted into the program on August 10, 1992, and subsequently submitted a Voluntary Disclosure Report disclosing failures to conform with contractual testing requirements on certain U.S. government munitions programs. On December 15, 1993, the Company concluded its agreement with the U.S. government to settle all claims arising from this matter for $275,000. By letters dated November 12 and November 30, 1992, the Company's Teledyne Electro-Mechanisms unit sought admission into the Department of Defense Voluntary Disclosure Program. Teledyne Electro-Mechanisms was accepted into the program on January 28, 1993, and subsequently submitted a Voluntary Disclosure Report disclosing design and test practices at variance from military specifications. On December 13, 1993, the Company reached agreement with the U.S. government to settle all claims arising from this matter for $400,000, subject to final government approvals and execution of a mutually acceptable settlement agreement. On January 13, 1993, the Company's Teledyne Thermatics unit sought admission into the Department of Defense Voluntary Disclosure Program. Teledyne Thermatics was accepted into the program on April 2, 1993. On April 5, 1993, the Company submitted an interim Voluntary Disclosure Report which described a number of testing practices at variance from military specifications. On February 16, 1993, the Company received a subpoena from the National Aeronautics and Space Administration, Office of Inspector General, requesting documents relating to all aspects of the manufacture, test, sale and reliability of solid state relays at the Company's Solid State unit. On February 22, 1993, the Company's Teledyne Electronics unit received a subpoena from the Department of Defense, Office of Inspector General, for production of documents relating to contract pricing and labor charging practices. On March 19, 1993, the Company's Teledyne Wah Chang Albany unit received a subpoena for documents from a federal grand jury impaneled in Washington, D.C. investigating alleged violations of the U.S. export control laws. The 13-24 EXHIBIT 13 Note 11. Commitments and Contingencies (Continued) - subpoena relates to Teledyne Wah Chang Albany's sale of zirconium to a Greek business entity. Should the U.S. government bring criminal charges in this matter, Teledyne Wah Chang Albany and conceivably the Company could be temporarily suspended from receiving licenses for export of products and services on the munitions list. In the event of a conviction, Teledyne Wah Chang Albany and conceivably the Company would be subject to debarment for a period of up to three years from receiving such licenses, and could be suspended for up to ten years from eligibility for commercial export licenses. On May 19, 1993, the Company and its Teledyne Electronics unit each received a subpoena from the Air Force Office of Special Investigations. One requested documents relating to military transponder contracts for the governments of Egypt and Saudi Arabia, and the second requested documents relating to a military transponder program for the Egyptian government. The Company is defending a civil action filed on behalf of the U.S. government pursuant to the False Claims Act, in which the government intervened in November of 1990. The case concerns the cost estimating practices of the Company's Teledyne Systems unit, which the government preliminarily estimated resulted in damages to the United States of approximately $90 million. On June 24, 1993, the Company's motion for partial summary judgment was granted in part and denied in part, reducing the estimate to approximately $70 million. Subsequently, on January 10, 1994, the government filed its Memorandum of Contentions of Fact and Law, contending that damages to the United States total $40.9 million. The government seeks treble the damages allegedly sustained by the United States, together with civil penalties of up to $10,000 for any false claim made. Trial of this matter is presently scheduled to commence March 8, 1994. The allegations of this suit were initially the subject of a federal grand jury investigation, which to the Company's knowledge has been inactive for almost two years. Based on an internal review, and after consultation with counsel, the Company does not possess sufficient information to determine whether the Company will sustain a loss in these matters, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existance of a material loss contingency arising therefrom. The Company is defending a civil action filed on behalf of the U.S. government pursuant to the False Claims Act concerning the procurement and quality control systems of the Company's Teledyne Controls unit. The U.S. government intervened in this matter on June 18, 1991, but withdrew following the Company's February 18, 1993 agreement to pay $2.15 million in partial settlement of the matter without admission of wrongdoing. The allegations of this suit gave rise to an investigation of Teledyne Controls by a federal grand jury, the Defense Criminal Investigative Service and other federal agencies. The settlement resolves all outstanding investigations regarding the claims encompassed by the agreement. The plaintiff was granted leave to pursue the remaining allegations in the case alone, and on April 23, 1993, filed a second amended complaint. Plaintiff alleges that the actual damages to the United States cannot be ascertained, but estimates that the total damages to the United States exceed $120 million. Plaintiff seeks treble the damages allegedly sustained by the United States together with civil penalties of up to $10,000 13-25 EXHIBIT 13 Note 11. Commitments and Contingencies (Continued) - for any false claim made. Based on an internal review, and after consultation with counsel, the Company does not possess sufficient information to determine whether the Company will sustain a further loss in these matters, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existence of a material loss contingency arising from this matter. The Company is defending a civil action filed on behalf of the U.S. government under the False Claims Act charging that the Company's Teledyne Relays unit falsified test certifications for relays supplied to the government. The government intervened in the action on April 22, 1992, and the complaint and first amended complaint were served on the Company on August 19, 1992. In addition to the claims alleged under the False Claims Act, the first amended complaint alleges various statutory and common law causes of action, including claims for trademark infringement, unfair competition, breach of contract and fraud. The government seeks treble the damages allegedly sustained by the United States (the government has preliminarily estimated such damages at $76.2 million), profits of not less than $41.6 million allegedly derived by Teledyne Relays from the sales at issue, and civil penalties of up to $10,000 for any false claim made. In November of 1992, the Company pled guilty to making false statements and paid a $17.5 million fine to resolve a related criminal investigation. It is likely that resolution of this suit will result in the recognition of a loss contingency which is not currently estimable. On April 13, 1993, the Defense Logistics Agency (DLA) debarred Teledyne Relays from receiving awards of new government contracts or government-approved subcontracts for a period of one year. Thereafter, on April 16, 1993, the Defense Electronics Supply Center (DESC) suspended Teledyne Relays from shipping all products qualified to military specifications, and rescinded its October 30, 1992, authorization permitting Teledyne Relays to fill any orders for such products accepted by Teledyne Relays as of October 30, 1992. On December 22, 1993, the DLA terminated the debarment, and on January 6, 1994, DESC approved for sale certain product qualified to military specifications and manufactured by Teledyne Relays prior to the debarment. Teledyne Relays is now eligible to seek readmission to the Qualified Products List Program. On May 26, 1993, a grand jury impaneled by the United States District Court for the Southern District of Florida returned an indictment in connection with a U.S. government investigation of alleged violations of the U.S. export control laws. The indictment includes charges against the Company's Teledyne Wah Chang Albany unit and two of its employees relating to the sale of zirconium to a South American industrialist. The Company believes that the government's evidence does not support the allegations contained in the indictment, and is vigorously defending itself. At an arraignment on June 14, 1993, the Company entered a plea of not guilty. If the Company were found guilty, it could face fines of up to $1 million for each of the four alleged violations of the Arms Export Control Act, five times the value of the export involved or $1 million, whichever is greater ($1.55 million or $1 million) for each of the two alleged violations of the Export Administration Act, and $500,000 for each of the three alleged violations of the False Statements Act. As a result of the indictment, the United States Department of State temporarily suspended Teledyne Wah Chang Albany, effective July 26, 1993, from 13-26 EXHIBIT 13 Note 11. Commitments and Contingencies (Continued) - receiving licenses for export of products and services on the munitions list. This suspension will not have a material adverse affect on the financial condition of the Company. However, in the event of a conviction, Teledyne Wah Chang Albany and conceivably the Company would be subject to debarment for a period of up to three years from receiving such export licenses, and could be suspended for up to ten years from eligibility for commercial export licenses. In addition, should the U.S. government determine that Teledyne Wah Chang Albany is not a "presently responsible contractor," Teledyne Wah Chang Albany and conceivably the Company could be temporarily suspended or, in the event of a conviction, could be debarred for up to three years from receiving new government contracts or government-approved subcontracts. Based on an ongoing internal review, and after consultation with counsel, the Company does not possess sufficient information to determine whether the Company will sustain a loss in this matter, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existence of a material loss contingency arising therefrom. The Company is defending a civil action filed on behalf of the U.S. government under the False Claims Act charging that the Company's Teledyne Solid State unit falsified test certifications for solid state relays supplied to the government. The government declined to intervene in the action on August 23, 1993, and the complaint was served on the Company on October 29, 1993. Plaintiffs seek treble the damages allegedly sustained by the United States, and civil penalties of up to $10,000 for any false claim made. Based on an ongoing internal review, and after consultation with counsel, the Company does not possess sufficient information to determine whether the Company will sustain a loss in this matter, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existence of a material loss contingency arising therefrom. The Company is informed that it has been named as a defendant in three civil actions filed pursuant to the False Claims Act in the U.S. District Court for the Central District of California. Two of these cases concern the Company's Teledyne Electronics unit, of which one reportedly alleges damages in a material amount. The third concerns the Company's Teledyne Solid State and Teledyne Relays units. The Company is further informed that it has been named as a defendant in a fourth action filed pursuant to the False Claims Act in the U.S. District Court for the Western District of Missouri concerning the Company's former Teledyne Neosho unit. All of these cases remain under seal. The Company does not possess sufficient information to determine whether the Company will sustain a loss in these matters, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existance of a material loss contingency arising therefrom. 13-27 EXHIBIT 13 Management's Discussion and Analysis of Financial Condition and Results of Operations Teledyne is a diversified manufacturing corporation serving customers worldwide through 21 operating companies focused in four business segments: Aviation and Electronics; Specialty Metals; Industrial; and Consumer. REALIGNMENT/RESTRUCTURE In 1993, Teledyne undertook a major realignment which consolidated its operating companies to 21 from 65 and eliminated 1,200 management and support positions at an estimated cost of $16.4 million. The realignment builds on the 1991-1992 restructure which focused the Company on those businesses in which it has significant leadership roles. The 1991-1992 restructure consisted of the sale, closure or transfer of certain operations. The net effect of realignment/restructure was a charge of $1.4 million in 1993, income of $24.4 million in 1992 and a charge of $107.6 million in 1991. RESULTS OF OPERATIONS Sales and operating profit for the Company's four business segments are presented separately in the tables below for continuing results, discontinued results and pension income (in millions): Aviation and Electronics - ------------------------ 1993 1992 1991 ---------- ---------- ---------- Sales: Continuing $ 1,138.7 $ 1,280.7 $ 1,306.4 Discontinued 18.3 76.3 105.1 ---------- ---------- ---------- $ 1,157.0 $ 1,357.0 $ 1,411.5 ========== ========== ========== Operating Profit (Loss): Continuing $ 43.5 $ 82.2 $ 43.7 Discontinued (7.6) 13.1 (48.5) Pension income 14.0 (1.1) 0.1 ---------- ---------- ---------- $ 49.9 $ 94.2 $ (4.7) ========== ========== ========== Sales from continuing operations decreased $142.0 million in 1993 and $25.7 million in 1992, primarily in electronic systems and components, as a result of winding down of certain U.S. and foreign military programs, declining orders due to reduced defense spending and softness in non-military markets. Operating profit from continuing operations decreased $38.7 million in 1993 primarily due to the decrease in sales discussed above and higher costs related to government contracting issues. The 1993 year included a charge of $10.0 million for the settlement of certain issues raised by the Company's initial Voluntary Disclosure Report to the government relating to its Teledyne Electronics unit and $6.6 million related to resolution of several other matters. For 1992, operating profit increased $38.5 million despite the decline in sales for the year due primarily to improved performance on fixed-price development and initial production contracts and increased sales of unmanned aerial vehicles and airframe structures. Operating profit and net income for 1992 included a charge of $17.5 million recorded in connection with the resolution of a criminal investigation of the Company's Teledyne Relays unit. Operating profit was adversely affected by approximately $20 million in 1993, $25 million in 1992 and $55 million in 1991 due to losses on fixed-price development and initial production contracts. 13-28 EXHIBIT 13 Management's Discussion and Analysis of Financial Condition and Results of Operations - (Continued) Specialty Metals - ---------------- 1993 1992 1991 ---------- ---------- ---------- Sales: Continuing $ 626.3 $ 628.7 $ 692.6 Discontinued 8.0 24.1 27.4 ---------- ---------- ---------- $ 634.3 $ 652.8 $ 720.0 ========== ========== ========== Operating Profit (Loss): Continuing $ 33.9 $ 28.0 $ 58.7 Discontinued 4.0 (6.9) (16.2) Pension income 9.7 3.9 (2.5) ---------- ---------- ---------- $ 47.6 $ 25.0 $ 40.0 ========== ========== ========== Sales from continuing operations declined $2.4 million in 1993 primarily due to reduced sales of nickel based products due to the depressed aerospace market partially offset by improved sales of zirconium for a naval ship propulsion program and increased sales at start-up facilities. For 1992, sales declined $63.9 million primarily as a result of a decline in sales of tungsten carbide products and the general economic slowdown. Despite the decline in sales, operating profit from continuing operations improved $5.9 million in 1993 primarily as a result of improved performance at start-up facilities and increased sales of zirconium. Operating profit declined $30.7 million in 1992 due primarily to the decline in sales discussed above and increased start-up costs of new plants. Industrial - ---------- 1993 1992 1991 ---------- ---------- ---------- Sales: Continuing $ 338.7 $ 311.7 $ 277.7 Discontinued 48.6 243.1 463.9 ---------- ---------- ---------- $ 387.3 $ 554.8 $ 741.6 ========== ========== ========== Operating Profit (Loss): Continuing $ 15.1 $ 11.6 $ 17.8 Discontinued 1.6 9.5 (24.8) Pension income 38.8 34.1 27.5 ---------- ---------- ---------- $ 55.5 $ 55.2 $ 20.5 ========== ========== ========== Sales from continuing operations increased $27.0 million in 1993 and $34.0 million in 1992. Sales of tank engines and sales related to military vehicle development increased in 1993. In addition, both nitrogen cylinder systems for the metal stamping industry and materials handling equipment for major retailers and distributors provided strong performance in 1993. For 1992, the increase in sales primarily resulted from increased sales related to military vehicle development. Operating profit from continuing operations increased $3.5 million in 1993 primarily as a result of the changes in sales discussed above. For 1992, operating profit decreased $6.2 million due to the effects of the general economic slowdown partially offset by increased sales of lower margin products. 13-29 EXHIBIT 13 Management's Discussion and Analysis of Financial Condition and Results of Operations - (Continued) Consumer - -------- 1993 1992 1991 ---------- ---------- ---------- Sales: Continuing $ 313.1 $ 303.0 $ 307.0 Discontinued - 20.0 26.7 ---------- ---------- ---------- $ 313.1 $ 323.0 $ 333.7 ========== ========== ========== Operating Profit (Loss): Continuing $ 21.5 $ 27.3 $ 26.8 Discontinued 2.0 4.0 (8.5) Pension Income 0.5 (0.6) 1.1 ---------- ---------- ---------- $ 24.0 $ 30.7 $ 19.4 ========== ========== ========== Sales from continuing operations increased $10.1 million in 1993 but decreased $4.0 million in 1992. Sales improved in 1993 primarily due to increased sales of pool heaters, residential and commercial heating systems, promotional drinkware and filtration products. For 1992, sales declines were primarily experienced in oral health and metal tube products. Operating profit from continuing operations decreased $5.8 million for 1993 primarily due to new product start-up costs and increased promotional expenses. Operating profit for 1992 was comparable with 1991. Discontinued Results - -------------------- Discontinued results include the estimated cost of realignment/restructure before pension income and results of operations sold at a gain, as well as those gains. CORPORATE EXPENSE Corporate expense increased $7.6 million in 1993 and $8.6 million in 1992. In 1993, increased insurance, legal, international marketing and contract compliance audit expenses partially offset recoveries from insurance carriers for environmental matters. For 1992, increased legal and international marketing expenses were partially offset by a decline in insurance costs. LITTON GAIN In 1993, the Company sold its investment in Litton common stock resulting in a $40.4 million gain, included in other income. PENSION INCOME Teledyne's non-cash pension income results from the amortization into income of the excess of plan assets over the estimated obligation. The amount recorded reflects the extent to which this non-cash income exceeds the current year's net cost of providing benefits. Pension income before tax increased to $66.2 million in 1993 from $37.9 million for 1992 and $28.2 million for 1991. The increase in 1993 was due primarily to a change in the discount rate used to calculate the pension benefit obligation in accordance with Financial Accounting Standards Board guidelines and to be consistent with the discount rate used for computing the retiree medical obligation. Any reversion of pension plans' assets to the Company would be subject to federal and state income taxes, substantial excise tax and other possible claims. 13-30 EXHIBIT 13 Management's Discussion and Analysis of Financial Condition and Results of Operations - (Continued) PROVISION (CREDIT) FOR INCOME TAXES The Omnibus Budget Reconciliation Act of 1993 increased the corporate federal income tax rate to 35 percent in 1993 from 34 percent in 1992. The tax law change resulted in the recognition of additional income of $4.6 million by the Company due primarily to revaluing the Company's net deferred tax asset. The Company's effective income tax rate increased in 1992 primarily as a result of a payment, which was not deductible for tax purposes, made in connection with the resolution of a criminal investigation of the Company's Teledyne Relays unit. During 1992, the Company changed its method of accounting for income taxes, effective January 1, 1992, to comply with the provisions of Statement of Financial Accounting Standards (SFAS) No. 109. The effect of this change for 1992 was the restatement of previously reported net income for the quarter ended March 31, 1992 to include a charge of $10.0 million or $0.18 per share for the cumulative effect of the accounting change. Prior year consolidated financial statements were not restated. For 1991, the effective tax rate included a $5.8 million increase in the Company's estimate of prior years' tax liabilities. The Company has determined, based on its history of operating earnings, available carrybacks, expectations of future operating earnings and potential tax planning strategies, as well as the extended period of time over which the postretirement benefits obligation will be paid, that it is more likely than not that the deferred tax assets at December 31, 1993 will be realized. POSTRETIREMENT BENEFITS Effective January 1, 1993, the Company changed its method of accounting for postretirement health care and life insurance benefits, as required by SFAS No. 106. This statement requires that the expected cost of providing postretirement health care and life insurance benefits be charged to expense during the years that the employees render service. Prior to 1993, the Company expensed the cost of these benefits as they were paid. As a result of adopting SFAS No. 106, the Company recorded a charge of $301.7 million or $185.6 million, net of tax, to recognize the accumulated postretirement benefit obligation at the date of adoption. The new accounting method will have no effect on the Company's cash outlays for postretirement health care and life insurance benefits. MARKETABLE SECURITIES In 1993, SFAS No. 115 was issued which will require companies in 1994 to change their accounting for marketable securities. The statement requires certain investments in debt and equity securities be classified as either held-to- maturity, trading or available-for-sale. Securities classified as held-to- maturity are to be reported at amortized cost. Securities classified as trading securities are to be reported at fair value, with unrealized gains and losses included in earnings. Securities classified as available-for-sale are to be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity. The adoption of this statement by the Company is not expected to have a material effect on the consolidated financial statements. 13-31 EXHIBIT 13 Management's Discussion and Analysis of Financial Condition and Results of Operations - (Continued) FINANCIAL CONDITION Shareholders' equity decreased $160.6 million in 1993 as a result of the net loss of $116.5 million and cash dividends of $44.3 million. Shareholders' equity decreased in 1992 primarily as a result of cash dividends in excess of net income. The Company has been able to meet all cash requirements during the past five years with cash generated from operations, and except for the potential effects of the matters discussed below, is not aware of any impending cash requirements or capital commitments which could not be met by internally generated funds. The Company has domestic credit lines with various banks totaling $125.0 million at December 31, 1993; no amounts were borrowed under these lines during 1993 or 1992. The Company redeemed at par $100 million in 1993 and $50 million in 1992 of its 10% Subordinated Debentures. OTHER MATTERS The Company is subject to ongoing examination of its federal tax returns by the Internal Revenue Service (IRS). The IRS has proposed the disallowance of deductions claimed by the Company of $48.7 million in 1984 and $38.2 million in 1985 for contributions to the Company's pension plans. The IRS may take the same position in its audit of tax years 1986 and 1987, where the claimed deductions for contributions to the pension plans totaled $37.7 million. The Company believes the IRS position on this issue is without merit and will defend the matter vigorously. The IRS has also proposed the disallowance of deductions claimed by the Company on behalf of a former wholly-owned insurance subsidiary with respect to insurance loss reserves of $269 million in 1984 and $115 million in 1985. The Company believes the proposed disallowances are unjustified and will contest the matter vigorously. Moreover, any such reserve adjustments would be timing adjustments which would result in the realization of offsetting tax benefits subsequent to the tax years at issue. Accordingly, pursuant to the tax agreement between the Company and its former subsidiary, the Company would bear only the interim interest cost and any costs resulting from a difference in tax rates with respect to the adjustments sustained, if any. Company subsidiaries perform work on a substantial number of defense contracts with the U.S. government. Many of these contracts include price redetermination clauses, and most are terminable at the convenience of the government. Certain of these contracts are fixed-price or fixed-price incentive development contracts. There is substantial risk on such contracts that costs may exceed those expected when the contracts were negotiated. Absent modification of these contracts, any costs incurred in excess of the fixed or ceiling prices must be borne by the Company. In addition, virtually all defense programs are subject to curtailment or cancellation due to the annual nature of the government appropriations and allocations process. A material reduction in U.S. government appropriations for defense programs may have an adverse effect on the Company's business, depending upon the specific defense programs affected by any such reduction. 13-32 EXHIBIT 13 Management's Discussion and Analysis of Financial Condition and Results of Operations - (Continued) The Company has been and is subject from time to time to various audits, reviews and investigations relating to the Company's compliance with federal and state laws, including those discussed in Note 11 to the accompanying consolidated financial statements. Should any unit involved be charged with wrongdoing, or should the U.S. government determine that the unit is not a "presently responsible contractor," that unit, and conceivably the Company, could be temporarily suspended or, in the event of a conviction, could be debarred for up to three years from receiving new government contracts or government-approved subcontracts. A suspension or debarment of the Company would have a material adverse effect on the future operating results and consolidated financial condition of the Company. However, except as otherwise discussed in Note 11 to the accompanying consolidated financial statements, the Company does not possess sufficient information to determine whether it will sustain a loss as a result of any of the investigations discussed in Note 11, or to reasonably estimate the amount of any such loss, and has not been able to identify the existence of a material loss contingency arising therefrom. The Company is defending a civil action filed on behalf of the U.S. government pursuant to the False Claims Act, in which the government intervened in November of 1990. The case concerns the cost estimating practices of the Company's Teledyne Systems unit, which the government preliminarily estimated resulted in damages to the United States of approximately $90 million. On June 24, 1993, the Company's motion for partial summary judgment was granted in part and denied in part, reducing the estimate to approximately $70 million. Subsequently, on January 10, 1994, the government filed its Memorandum of Contentions of Fact and Law, contending that damages to the United States total $40.9 million. The government seeks treble the damages allegedly sustained by the United States, together with civil penalties of up to $10,000 for any false claim made. Trial of this matter is presently scheduled to commence March 8, 1994. The allegations of this suit were initially the subject of a federal grand jury investigation, which to the Company's knowledge has been inactive for almost two years. Based on an internal review, and after consultation with counsel, the Company does not possess sufficient information to determine whether the Company will sustain a loss in these matters, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existence of a material loss contingency arising therefrom. The Company is defending a civil action filed on behalf of the U.S. government pursuant to the False Claims Act concerning the procurement and quality control systems of the Company's Teledyne Controls unit. The U.S. government intervened in this matter on June 18, 1991, but withdrew following the Company's February 18, 1993 agreement to pay $2.15 million in partial settlement of the matter without admission of wrongdoing. The allegations of this suit gave rise to an investigation of Teledyne Controls by a federal grand jury, the Defense Criminal Investigative Service and other federal agencies. The settlement resolves all outstanding investigations regarding the claims encompassed by the agreement. The plaintiff was granted leave to pursue the remaining allegations in the case alone, and on April 23, 1993, filed a second amended complaint. Plaintiff alleges that the actual damages to the United States cannot be ascertained, but estimates that the total damages to the United States exceed $120 million. Plaintiff seeks treble the damages allegedly sustained by the United States together with civil penalties of up to $10,000 13-33 EXHIBIT 13 Management's Discussion and Analysis of Financial Condition and Results of Operations - (Continued) for any false claim made. Based on an internal review, and after consultation with counsel, the Company does not possess sufficient information to determine whether the Company will sustain a loss in these matters, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existence of a material loss contingency arising from this matter. The Company is defending a civil action filed on behalf of the U.S. government under the False Claims Act charging that the Company's Teledyne Relays unit falsified test certifications for relays supplied to the government. The government intervened in the action on April 22, 1992, and the complaint and first amended complaint were served on the Company on August 19, 1992. In addition to the claims alleged under the False Claims Act, the first amended complaint alleges various statutory and common law causes of action, including claims for trademark infringement, unfair competition, breach of contract and fraud. The government seeks treble the damages allegedly sustained by the United States (the government has preliminarily estimated such damages at $76.2 million), profits of not less than $41.6 million allegedly derived by Teledyne Relays from the sales at issue, and civil penalties of up to $10,000 for any false claim made. In November of 1992, the Company pled guilty to making false statements and paid a $17.5 million fine to resolve a related criminal investigation. It is likely that resolution of this suit will result in the recognition of a loss contingency which is not currently estimable. On April 13, 1993, the Defense Logistics Agency (DLA) debarred Teledyne Relays from receiving awards of new government contracts or government-approved subcontracts for a period of one year. Thereafter, on April 16, 1993, the Defense Electronics Supply Center (DESC) suspended Teledyne Relays from shipping all products qualified to military specifications, and rescinded its October 30, 1992, authorization permitting Teledyne Relays to fill any orders for such products accepted by Teledyne Relays as of October 30, 1992. On December 22, 1993, the DLA terminated the debarment, and on January 6, 1994, DESC approved for sale certain product qualified to military specifications and manufactured by Teledyne Relays prior to the debarment. Teledyne Relays is now eligible to seek readmission to the Qualified Products List Program. On May 26, 1993, a grand jury impaneled by the United States District Court for the Southern District of Florida returned an indictment in connection with a U.S. government investigation of alleged violations of the U.S. export control laws. The indictment includes charges against the Company's Teledyne Wah Chang Albany unit and two of its employees relating to the sale of zirconium to a South American industrialist. The Company believes that the government's evidence does not support the allegations contained in the indictment, and is vigorously defending itself. At an arraignment on June 14, 1993, the Company entered a plea of not guilty. If the Company were found guilty, it could face fines of up to $1 million for each of the four alleged violations of the Arms Export Control Act, five times the value of the export involved or $1 million, whichever is greater ($1.55 million or $1 million) for each of the two alleged violations of the Export Administration Act, and $500,000 for each of the three alleged violations of the False Statements Act. 13-34 EXHIBIT 13 Management's Discussion and Analysis of Financial Condition and Results of Operations - (Continued) As a result of the indictment, the United States Department of State temporarily suspended Teledyne Wah Chang Albany, effective July 26, 1993, from receiving licenses for export of products and services on the munitions list. This suspension will not have a material adverse affect on the financial condition of the Company. However, in the event of a conviction, Teledyne Wah Chang Albany and conceivably the Company would be subject to debarment for a period of up to three years from receiving such export licenses, and could be suspended for up to ten years from eligibility for commercial export licenses. In addition, should the U.S. government determine that Teledyne Wah Chang Albany is not a "presently responsible contractor," Teledyne Wah Chang Albany and conceivably the Company could be temporarily suspended or, in the event of a conviction, could be debarred for up to three years from receiving new government contracts or government-approved subcontracts. Based on an ongoing internal review, and after consultation with counsel, the Company does not possess sufficient information to determine whether the Company will sustain a loss in this matter, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existence of a material loss contingency arising therefrom. The Company is defending a civil action filed on behalf of the U.S. government under the False Claims Act charging that the Company's Teledyne Solid State unit falsified test certifications for solid state relays supplied to the government. The government declined to intervene in the action on August 23, 1993, and the complaint was served on the Company on October 29, 1993. Plaintiffs seek treble the damages allegedly sustained by the United States, and civil penalties of up to $10,000 for any false claim made. Based on an ongoing internal review, and after consultation with counsel, the Company does not possess sufficient information to determine whether the Company will sustain a loss in this matter, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existence of a material loss contingency arising therefrom. The Company is informed that it has been named as a defendant in three civil actions filed pursuant to the False Claims Act in the U.S. District Court for the Central District of California. Two of these cases concern the Company's Teledyne Electronics unit, of which one reportedly alleges damages in a material amount. The third concerns the Company's Teledyne Solid State and Teledyne Relays units. The Company is further informed that it has been named as a defendant in a fourth action filed pursuant to the False Claims Act in the U.S. District Court for the Western District of Missouri concerning the Company's former Teledyne Neosho unit. All of these cases remain under seal. The Company does not possess sufficient information to determine whether the Company will sustain a loss in these matters, or to reasonably estimate the amount of any such loss. Consequently, the Company has not been able to identify the existence of a material loss contingency arising therefrom. 13-35 EXHIBIT 13 Management's Discussion and Analysis of Financial Condition and Results of Operations - (Continued) The Company is subject to federal, state and local laws and regulations concerning the environment, and is currently participating in administrative proceedings at a number of sites under these laws. Many of these proceedings are at a preliminary stage, and it is difficult to estimate with any certainty the total cost of remediation, the timing and extent of remedial actions required by governmental authorities, and the amount of the Company's liability, if any, in proportion to that of any other responsible parties. As further discussed in Note 1 to the accompanying consolidated financial statements, when it is possible to reasonably estimate the Company's liability with respect to these matters, provisions are made as appropriate. Based on facts presently known to it, the Company does not believe that the outcome of any one of these administrative proceedings will have a material adverse effect on its financial condition. 13-36 EXHIBIT 13 SELECTED QUARTERLY FINANCIAL DATA --------------------------------- (In millions except per share and share amounts) Quarterly financial data for 1993 and 1992 were as follows: Quarter Ended ---------------------------------------------------- March 31 June 30 September 30 December 31 ---------- ---------- ------------ ----------- 1993 - Sales $ 636.5 $ 624.4 $ 597.9 $ 632.9 ========== ========== ========== ========== Gross profit $ 144.6 $ 146.2 $ 138.4 $ 144.6 ========== ========== ========== ========== Income, after tax, before extraordinary loss and cumulative effect of accounting change $ 33.8 $ 8.1 $ 15.2 $ 15.7 Extraordinary loss on redemption of debt (3.7) - - - Cumulative effect of accounting change (185.6) - - - ---------- ---------- ---------- ---------- Net income (loss) $ (155.5) $ 8.1 $ 15.2 $ 15.7 ========== ========== ========== ========== Income (loss) per share: Income, after tax, before extraordinary loss and cumulative effect of accounting change $ 0.61 $ 0.15 $ 0.27 $ 0.28 Extraordinary loss on redemption of debt (0.07) - - - Cumulative effect of accounting change (3.35) - - - ---------- ---------- ---------- ---------- Net income (loss) per share $ (2.81) $ 0.15 $ 0.27 $ 0.28 ========== ========== ========== ========== Average shares outstanding 55,412,889 55,413,845 55,418,265 55,437,619 ========== ========== ========== ========== 13-37 EXHIBIT 13 SELECTED QUARTERLY FINANCIAL DATA (Continued) --------------------------------- Quarter Ended --------------------------------------------------- March 31 June 30 September 30 December 31 ---------- ---------- ------------ ------------ 1992 - Sales $ 718.5 $ 744.8 $ 708.6 $ 715.7 ========== ========== ========== ========== Gross profit $ 153.9 $ 165.0 $ 164.2 $ 161.3 ========== ========== ========== ========== Income, after tax, before extraordinary loss and cumulative effect of accounting change $ 11.8 $ 7.4 $ 16.3 $ 10.4 Extraordinary loss on redemption of debt (2.7) - - - Cumulative effect of accounting change (10.0) - - - ---------- ---------- ---------- ---------- Net income (loss) $ (0.9) $ 7.4 $ 16.3 $ 10.4 ========== ========== ========== ========== Income (loss) per share: Income, after tax, before extraordinary loss and cumulative effect of accounting change $ 0.21 $ 0.14 $ 0.29 $ 0.19 Extraordinary loss on redemption of debt (0.05) - - - Cumulative effect of accounting change (0.18) - - - ---------- ---------- ---------- ---------- Net income (loss) per share $ (0.02) $ 0.14 $ 0.29 $ 0.19 ========== ========== ========== ========== Average shares outstanding 55,412,845 55,412,845 55,412,845 55,412,845 ========== ========== ========== ========== 13-38 EXHIBIT 13 SELECTED QUARTERLY FINANCIAL DATA (Continued) --------------------------------- The Company paid cash dividends of $0.20 per share for each quarter in 1993 and 1992. Operating profit before tax for 1993 included a realignment/restructure charge of $8.2 million in the second quarter and income of $6.8 million in the fourth quarter. For 1992, operating profit before tax included income related to gains on sales of operations and adjustments to the estimated cost of restructure as follows: first quarter $2.9 million, second quarter $5.6 million, third quarter $7.5 million and fourth quarter $8.4 million. Non-cash pension income before tax increased to $16.7 million in the 1993 first quarter from $8.7 million in 1992, $16.1 million in the 1993 second quarter from $8.4 million in 1992, $16.7 million in the 1993 third quarter from $9.3 million in 1992, and $16.7 million in the 1993 fourth quarter from $11.5 million in 1992 due primarily to a change in the discount rate used to calculate the pension benefit obligation. Operating profit before tax included provisions for losses on fixed-priced development and initial production contracts of approximately $20 million in 1993, of which $15 million was recorded in the fourth quarter, and approximately $25 million in 1992, of which $20 million was recorded in the fourth quarter. Operating profit before tax for the second quarter of 1993 was reduced by a charge of $10.0 million for the settlement of certain issues raised by the Company's initial Voluntary Disclosure Report to the government relating to its Teledyne Electronics unit. Operating profit before tax for the fourth quarter of 1993 included a charge of $5.1 million related to resolution of several other matters. For 1992, operating profit before tax and net income included a charge of $12.0 million in the second quarter and $5.5 million in the third quarter recorded in connection with the resolution of a criminal investigation of the Company's Teledyne Relays unit. Net loss for the first quarter of 1993 includes a gain on sale of Litton common stock of $24.2 million or $0.44 per share. The Omnibus Budget Reconciliation Act of 1993, enacted in the third quarter retroactive to January 1, 1993, increased the corporate federal income tax rate to 35 percent from 34 percent. The tax law change resulted in the recognition in the third quarter of $3.9 million of additional income by the Company due primarily to revaluing the Company's net deferred tax asset. During the first quarter of 1993, the Company redeemed at par $100 million of its 10% Subordinated Debentures resulting in an extraordinary loss of $3.7 million. In the 1992 first quarter, the Company redeemed at par $50 million ($46.7 net of treasury) of its 10% Subordinated Debentures resulting in an extraordinary loss of $2.7 million. During the first quarter of 1993, the Company changed its method of accounting for post-retirement health care and life insurance benefits to comply with the provisions of SFAS No. 106. The cumulative effect of the accounting change resulted in a charge to net income of $185.6 million, or $3.35 per share. Effective January 1, 1992, the Company changed its method of accounting for income taxes to comply with SFAS No. 109. The cumulative effect of the accounting change was to restate the previously reported net income for the quarter ended March 31, 1992 to include a charge of $10.0 million, or $0.18 per share. 13-39 EXHIBIT 13 SELECTED FINANCIAL DATA ----------------------- For the Five Years Ended December 31, 1993 ------------------------------------------ (In millions except per share amounts) 1993 1992 1991 1990 1989 -------- --------- -------- -------- -------- Sales: Continuing $2,416.8 $ 2,524.1 $2,583.7 $2,665.8 $2,681.7 Discontinued 74.9 363.5 623.1 780.0 849.5 -------- --------- -------- -------- -------- $2,491.7 $ 2,887.6 $3,206.8 $3,445.8 $3,531.2 ======== ========= ======== ======== ======== Income (loss), after tax, before extraordinary loss, cumulative effect of accounting changes and discontinued insurance operations $ 72.8 $ 45.9 $ (25.4) $ 69.2 $ 150.3 Extraordinary loss on redemption of debt (3.7) (2.7) - - - Cumulative effect of accounting changes (185.6) (10.0) - - - Income of discontinued insurance operations - - - 25.6 108.6 -------- --------- -------- -------- -------- Net income (loss) $ (116.5) $ 33.2 $ (25.4) $ 94.8 $ 258.9 ======== ========= ======== ======== ======== Income (loss) per share: Income (loss), after tax, before extraordinary loss, cumulative effect of accounting changes and discontinued insurance operations $ 1.32 $ 0.83 $ (0.46) $ 1.25 $ 2.71 Extraordinary loss on redemption of debt (0.07) (0.05) - - - Cumulative effect of accounting changes (3.35) (0.18) - - - Discontinued insurance operations - - - 0.46 1.95 -------- --------- -------- -------- -------- Net income (loss) per share $ (2.10) $ 0.60 $ (0.46) $ 1.71 $ 4.66 ======== ========= ======== ======== ======== Working capital $ 355.2 $ 488.2 $ 505.0 $ 601.8 $ 629.5 ======== ========= ======== ======== ======== Long-term debt $ 356.6 $ 449.7 $ 497.1 $ 510.6 $ 571.3 ======== ========= ======== ======== ======== Assets $1,477.8 $ 1,535.9 $1,719.4 $1,676.3 $3,468.2 ======== ========= ======== ======== ======== Net assets of discontinued insurance operations $ - $ - $ - $ - $1,880.8 ======== ========= ======== ======== ======== Shareholders' equity $ 280.5 $ 441.1 $ 453.9 $ 523.5 $2,326.9 ======== ========= ======== ======== ======== 13-40 EXHIBIT 13 SELECTED FINANCIAL DATA (Continued) ----------------------- In 1993, Teledyne undertook a major realignment which consolidated its operating companies to 21 from 65. The restructure plan announced by the Company in the third quarter of 1991 included the sale, closure or transfer of certain operations. Income before tax included a charge of $1.4 million in 1993, income of $24.4 million in 1992 and a charge of $107.6 million in 1991 for the effect of realignment/restructure. Net income (loss) included non-cash pension income after tax of $40.1 million in 1993, $23.3 million in 1992, $17.3 million in 1991, $14.3 million in 1990 and $14.1 million in 1989. Net loss for 1993 included a charge of $185.6 million or $3.35 per share for the cumulative effect of a change in accounting for postretirement health care and life insurance benefits and a gain on sale of Litton common stock of $24.2 million or $0.44 per share. During 1993, the Company redeemed at par $100 million of its 10% Subordinated Debentures resulting in an extraordinary loss of $3.7 million. In 1992, the Company redeemed at par $50 million ($46.7 million net of treasury) of its 10% Subordinated Debentures resulting in an extraordinary loss of $2.7 million. Effective January 1, 1992, the Company changed its method of accounting for income taxes to comply with the provisions of SFAS No. 109. The cumulative effect of the accounting change was a charge of $10.0 million or $0.18 per share. In 1990, Teledyne distributed to its shareholders all of the outstanding common stock of Unitrin, Inc., the parent company of Teledyne's former insurance and finance subsidiaries. The Company has paid cash dividends of $0.80 per share for all years presented. 13-41 EXHIBIT 13 Common Stock Price - -------------------------------------------------------------------------------- Quarters 1st 2nd 3rd 4th - -------------------------------------------------------------------------------- High $23 1/8 $22 3/4 $27 3/4 $27 3/8 Low $18 1/8 $18 1/2 $20 1/2 $24 3/8 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Quarters 1st 2nd 3rd 4th - -------------------------------------------------------------------------------- High $28 3/4 $28 3/8 $20 1/2 $20 1/2 Low $19 3/8 $18 1/2 $17 3/8 $17 - -------------------------------------------------------------------------------- Teledyne, Inc. common stock is listed on the New York and Pacific Stock Exchanges. As of December 31, 1993, there were approximately 14,000 record holders of common stock. - -------------------------------------------------------------------------------- 13-42 EXHIBIT 13 OUTLINE OF PRODUCTS AND ACTIVITIES Aviation and Electronics: Products in the closely related fields of aviation and electronics range from the microscopic world of semiconductor devices to full- scale air frames and complete aircraft. Teledyne's hybrid microcircuits are widely used in military, space, industrial and medical applications. These compact and complex electronic building blocks combine multiple transistors and integrated circuits in multi- chip modules where small packaging sizes, reliability and light weight are of paramount importance. Thousands of these microcircuits, the size of postage stamps, have been produced, and are providing the precise control required for heart pacemakers and interplanetary missions, as well as many other uses. On a still larger scale are Teledyne's high power traveling wave tubes, used to simultaneously transmit thousands of telephone conversations--or a dozen television channels--around the world via satellite networks. Similar types of traveling wave tubes are used in the latest airborne and groundbased electronic counter measure equipment. In the microwave industry, Teledyne is a leading supplier of ferrite components and switching devices, as well as filters, oscillators and integrated subsystems. Monolithic microwave integrated circuits are provided for both commercial and military applications. A wireless local area network is being produced for commercial applications. Other components include operational amplifiers, digital-analog converters, miniature relays, hybrid switching devices, radar augmenters, lower power microwave tubes, flexible printed-circuit interconnections, high reliability wire and cable, switches, terminals and a line of aircraft, military tank and truck batteries. At the systems level, Teledyne produces equipment for telemetering data from remote sources, for electronic counter measures, and for information processing, as well as the aircraft integrated data systems used by dozens of major airlines to record in-flight performance and maintenance data on their jumbo jets. Teledyne also performs systems engineering and integration for ballistic missile defense, space defense, shuttle payloads, computer software, and designs and produces military airborne training and evaluation systems. Cargo tracking software has been developed for use by freight forwarders. Computing and inertial systems are also produced for the control and guidance of aircraft and space vehicles. Teledyne on-board computers have successfully controlled the launching of dozens of spacecraft, including both Viking missions to Mars. Teledyne is heavily involved in electronic navigation systems. Doppler radar systems produced by Teledyne were used on 24 successful space landings and guided each Apollo lander to the surface of the moon. Doppler, aided by inertial and/or Global Positioning Satellite (GPS) receivers is used in military aircraft for antisubmarine warfare and search-and-rescue missions. 13-43 EXHIBIT 13 OUTLINE OF PRODUCTS AND ACTIVITIES - (Continued) Teledyne avionic instruments and electronic systems contribute substantially to flight safety on both military and general aviation aircraft. The use of the latest microcircuit technology and modern cryptographic algorithms permit Teledyne to supply very advanced identification equipment (IFF) used on military and commercial aircraft for peacetime air traffic control and for safe operation in a wartime environment. Commercial products providing data security are being developed. Among Teledyne's many non-electronic products for aviation are controlled explosive devices that precisely time, sequence and actuate aircraft escape systems, and similar pyrotechnic devices used to separate the stages of space vehicles and to eject or deploy instrument packages. This technology is being used in automobile airbag deployment systems. Teledyne also produces parachute delivery systems for accurate airdrop of military cargo or emergency supplies. Continental's piston engines have been powering airplanes for sixty years, and today about half of the general aviation piston engines produced in the United States are built by Teledyne and used worldwide. Teledyne turbine engines also power remotely piloted aircraft, military trainers and, in small, expendable versions, provide power for the Harpoon and other cruise missiles. The Company's expertise in airframe manufacture goes back to Charles Lindbergh's Spirit of St. Louis which was built by Ryan Airlines, Inc., forerunner of today's Teledyne Ryan Aeronautical. More than twenty-five types of remotely piloted aircraft--usually called Unmanned Air Vehicles (UAVs)--have been built by Teledyne, in both supersonic and sub-sonic versions. These recoverable and reusable vehicles are used for sophisticated military missions, such as reconnaissance, with the pilots safely flying them from remote control centers. Through the production of sophisticated UAVs, Teledyne has also developed broad expertise in the use of advanced materials such as graphite composites, and has facilities for the numerically-controlled machining of airfoils from honeycomb materials. Teledyne also builds the airframe for the Army's Apache attack helicopter and has produced thousands of feet of tapered, roll-formed stringers used in wide-body aircraft. Teledyne's participation in all these diverse areas of aviation, space and electronics has given the Company highly developed expertise in some of the most advanced technologies of our time. 13-44 EXHIBIT 13 OUTLINE OF PRODUCTS AND ACTIVITIES - (Continued) Specialty Metals: The products of this business segment are representative of the practical application of metallurgical science and technology as it is known and practiced throughout the world. Their unique characteristics are derived from the nature of the metals produced, the particular properties of the alloys melted, and the various processes, methods, forms, shapes and end products manufactured. In specialty metals, Teledyne is the most diversified producer of reactive and refractory metals in the United States. Teledyne produces all of the larger volume, commercially important metals and their alloys. Reactive metals production includes titanium, zirconium and hafnium; refractory metals consist of tungsten, molybdenum, niobium, tantalum and vanadium. Teledyne is the leading U.S. producer of zirconium, a highly corrosion- resistant metal that is transparent to neutrons. It is used for fuel tubes and structural parts in nuclear power reactors and for corrosion-resistant chemical industry applications. Hafnium, derived as a by-product of zirconium, is used for control rods in nuclear reactors due to its ability to absorb neutrons. Teledyne is a producer of tungsten, starting from a large number of different tungsten bearing raw materials resulting in tungsten and tungsten carbide powders and mill products. Previously used cemented carbide parts are also recycled into tungsten carbide powder. Wrought or ductile tungsten products are used in diverse applications including light bulb filaments, inert gas welding electrodes, electrical contacts and aircraft counterweights. Molybdenum, a sister metal to tungsten that also has a very high melting point, is produced by Teledyne in powder form and then shaped into solid forms through powder metallurgy techniques. It is an important alloying element for steels and is used for plasma arc spraying of piston rings, for electrodes in glass melting and for structural parts in high temperature furnaces. Niobium, also known as columbium, is a high technology metal produced by Teledyne in various forms and alloys. It is used as an alloying element in the manufacture of many steels. The higher quality grades produced by Teledyne are used in superalloys for jet engines and special alloys for aerospace applications such as rocket nozzles. When alloyed with titanium, niobium is used in applications requiring superconducting characteristics for high-strength magnets. This area includes medical devices for bodyscanning, accelerators for high-energy physics and fusion energy projects for future generation of electricity. Tantalum, one of the most corrosion resistant metals, is produced by Teledyne for medical implants, chemical process equipment, and aerospace engine components. Specialty metals also include the special alloys that are central to the production of virtually every modern metal product available today. 13-45 EXHIBIT 13 OUTLINE OF PRODUCTS AND ACTIVITIES - (Continued) Teledyne high-speed steels provide the high temperature hardness required for lathe bits, drills, milling cutters, taps and dies and other cutting tools. Related alloy steels, including a cobalt-free maraging grade, are produced for bearings, gears, special aerospace hardware and high-strength applications. For the metalworking, mining and other industries requiring tools with extra hardness, Teledyne produces a line of sintered tungsten carbide products, made from tungsten carbide and various other metals under heat, to produce a material that approaches diamond in hardness. These cemented carbide products are used as super-hard cutters in the high-speed machining and cutting of steel and other applications where hardness and wear resistance are important. Technical developments related to ceramics, coatings and other disciplines are incorporated in these products. With a state-of-the-art computer-controlled bar and rod rolling mill, Teledyne is able to produce a wide range of premium grade, nickel-base, cobalt- base and titanium alloys that are used worldwide to meet the high performance requirements of the aircraft, aerospace, gas turbine, nuclear energy and chemical process industries. These products, in various forms, are engineered to retain exceptional strength and corrosion resistance at temperatures through 2,000 degrees F and are used in critical, high-stress applications. Notably, this manufacturing facility installed one of the largest high precision rotary forging presses in the U.S. for more efficient working of these products. Teledyne also processes metals by a variety of methods, including casting, forging, rolling, drawing and extruding, into finished forms used in a diverse number of industries. With the latest screw-type forging presses, the company is a major U.S. producer of carbon and alloy steel forgings in sizes ranging from one pound to more than 200 pounds. The company has the ability to forge the more difficult alloys which are used in aerospace and other critical applications. For example, Teledyne is a specialist in the cold rolling of thin and ultra-thin metal strip in over 60 different metals and alloys for applications ranging from watch springs to aerospace honeycomb materials and camera products. Teledyne also casts a variety of metals into forms ranging from diesel locomotive engine blocks to light-weight aluminum and magnesium aircraft parts. Housings and parts are made for business machines, tools and automobiles. Cold- drawn stainless and custom fabricated tubing is also produced. Other Teledyne companies are involved in roll-forming metals, forging heavy parts for construction and earth moving machinery and precision investment casting of difficult to produce parts. 13-46 EXHIBIT 13 OUTLINE OF PRODUCTS AND ACTIVITIES - (Continued) Industrial Products: Engines of many sorts--air and liquid cooled, gasoline and diesel fueled--are products in this category. Teledyne engines include heavy-duty turbo-charged diesel engines approaching 1,750 horsepower for use in military tanks, and engines for aircraft ground support. Another category of industrial products includes machine tools, dies and consumable tooling of all types. These include a great variety of machines designed for the high speed production of precision machine threads by cutting, grinding and roll-forming methods, and a variety of similar equipment for the production of precision roll-formed gears. Teledyne also produces automated bakery production equipment and mixing and processing equipment for a variety of chemical, food and pharmaceutical products. Included in the industrial product category are nitrogen pressure systems which are resistant force components used in the metal forming industry and a series of valve products. Hydraulic and pneumatic valves and pumps serve the transportation and aerospace industries, and pressure relief valves are used in process industries such as the petrochemical and pharmaceutical industries. Teledyne pressure relief valves are being used in some international offshore oil exploration projects such as the Hibernia Project off the coast of Newfoundland. Material handling is another industrial category with a number of Teledyne products. Teledyne has developed a series of specialty forklifts that ride as outriggers on delivery trucks. This saves valuable cargo space and the product's stability makes it an asset at rough construction sites. A version of this same product line also has applications in agriculture. Another series of products within the material handling category provide protective structures such as cabs, ROPS and FOPS for off highway equipment. We also build components for and install structures for service vehicle outfitting. 13-47 EXHIBIT 13 OUTLINE OF PRODUCTS AND ACTIVITIES - (Continued) Consumer: The Teledyne name is widely represented through its consumer products. Teledyne's best known consumer products are sold under the brand name of Teledyne Water Pik. The Water Pik oral hygiene appliance line includes a family of dental hygiene devices for use in the home, including oral irrigators, electric toothbrushes and an oral hygiene center combining both products. Teledyne Water Pik also manufactures and markets a complete line of showerheads, including the Shower Massage line of invigorating, pulsating showerheads and the Super Saver line of water saving, multi-mode spray showerheads. The Instapure line includes both faucet mounted and under-the-counter water filters for improving the quality of water used in the home, as well as a line of air filtration appliances for the home and office that utilize a patented, low-temperature catalyst material to remove carbon monoxide and other noxious gases from the air. Teledyne is also developing large-scale water purification systems for operation in remote, unregulated areas. In an entirely different consumer area are Teledyne Laars swimming pool and spa heaters. The company also produces a full line of water heating equipment that provides hot water for commercial, residential and industrial space heating. Teledyne also makes supplies and equipment for dentists and dental laboratories. Among these are dental cements, impression compounds, filling materials, air and electric drills, and articulators. Teledyne produces collapsible metal tubes, injection molded closures and laminate tubes. Products often sold directly to consumers are plastic cups and containers. 13-48 EXHIBIT 21 TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- SUBSIDIARIES OF REGISTRANT -------------------------- December 31, 1993 ----------------- The following table shows the name and place of incorporation of each subsidiary, except those subsidiaries which, when considered in the aggregate, would not constitute a significant subsidiary. Unless otherwise indicated, each subsidiary is wholly-owned as to voting securities. Also shown are the names under which each subsidiary does business. Name and Place of Incorporation Names Under Which Subsidiaries Do Business - ----------------------------------------- ---------------------------------- Teledyne Industries, Inc. (California) Teledyne Air Centers subsidiary of Teledyne, Inc. Teledyne Advanced Materials Teledyne Firth Sterling Teledyne Powder Alloys Teledyne Wah Chang Huntsville Teledyne Aircraft Products Teledyne Battery Products Teledyne Cast Products Teledyne Picco Teledyne Thermatics Teledyne Allvac/Vasco Teledyne Brown Engineering Teledyne Analytical Instruments Teledyne Geotech Teledyne Hastings-Raydist Teledyne Casting Service Teledyne Continental Motors Teledyne Continental Motors - General Products Teledyne Controls Teledyne Coordinators Teledyne Economic Development Teledyne Electronic Systems Teledyne Electronics Teledyne Ryan Electronics Teledyne Electronic Technologies Teledyne Electro-Mechanisms Teledyne Kinetics Teledyne MEC Teledyne Microelectronics Teledyne Microwave Teledyne Relays Teledyne Solid State Teledyne Fluid Systems Teledyne Farris Engineering Teledyne Hyson Teledyne Republic/Sprague 21-1 EXHIBIT 21 TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- SUBSIDIARIES OF REGISTRANT -------------------------- December 31, 1993 ----------------- Name and Place of Incorporation Names Under Which Subsidiaries Do Business - --------------------------------------- -------------------------------- Teledyne Industries, Inc. - Continued Teledyne International Offices Teledyne Laars Teledyne Still-Man Teledyne Minerals Teledyne Packaging Teledyne Pittsburgh Tool Steel Teledyne Portland Forge Teledyne Power Systems Teledyne Rodney Metals Teledyne Metal Forming Teledyne Summerill Tube Teledyne Ryan Aeronautical Teledyne CAE Teledyne McCormick Selph Teledyne Specialty Equipment Teledyne Efficient Industries Teledyne Howell Penncraft Teledyne Landis Machine Teledyne Penn-Union Teledyne Readco Teledyne Wah Chang Albany Teledyne SC Teledyne Water Pik Teledyne Getz Teledyne Hanau Teledyne Mecca 21-2 EXHIBIT 21 TELEDYNE, INC. AND SUBSIDIARIES ------------------------------- SUBSIDIARIES OF REGISTRANT -------------------------- December 31, 1993 ----------------- Name and Place of Incorporation Names Under Which Subsidiaries Do Business - --------------------------------------- -------------------------------- Teledyne Canada, Limited (Ontario) Teledyne Canada Firth Sterling subsidiary of Teledyne, Industries Canada Teledyne Canada Harfac Limited (Ontario) Teledyne Canada Metal Products Teledyne Canada Mining Products Teledyne Industries Canada Limited (Ontario) Farris Industries Canada subsidiary of Teledyne, Inc. Teledyne Industries Canada Ltd. Teledyne Still-Man Canada Teledyne Water Pik Canada Teledyne Isotopes, Inc. (California) Teledyne Energy Systems subsidiary of Teledyne, Inc. Teledyne Isotopes Teledyne Princeton Inc. Teledyne Princeton subsidiary of Teledyne Canada, Limited Teledyne Systems Company, Inc. Teledyne Systems Company subsidiary of Teledyne Industries, Inc. Teledyne Transport Limited Teledyne Canada Transport Group subsidiary of Teledyne Canada, Limited 21-3 EXHIBIT 23 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS ----------------------------------------- As independent public accountants, we hereby consent to the incorporation of our reports included in this Form 10-K, into the Company's previously filed Registration Statements File No.'s 2-52617, 33-41372 and 33-47219. ARTHUR ANDERSEN & CO. Los Angeles, California January 26, 1994 23-1

22698_1993.txt

22698_1993

1993

22698

Item 1. Business GENERAL INFORMATION Business Segments COMSAT Corporation (COMSAT, the Corporation or Registrant) has four business segments: International Communications, Mobile Communications, Video Enterprises and Technology Services. International Communications consists of COMSAT World Systems, which provides satellite communications services using the satellite system of the International Telecommunications Satellite Organization (INTELSAT), and COMSAT International Ventures, which invests in telecommunications opportunities internationally. Mobile Communications consists of COMSAT Mobile Communications, which provides satellite communications services using the satellite system of the International Maritime Satellite Organization (Inmarsat). Video Enterprises, which consists of COMSAT Video Enterprises, Inc., and the Corporation's majority ownership interest in On Command Video Corporation, provides entertainment services to the hospitality industry throughout the United States and domestic video distribution services to television networks. Technology Services consists of COMSAT Technology Services, which provides communications networks and products, information services, and applied research and technology throughout the world. The Corporation also owns the Denver Nuggets, a franchise of the National Basketball Association. The revenues, operating income (loss) and assets of the Corporation, by business segment, for each of the last three years are shown in Note 13 to the 1993 Financial Statements. The Corporation had 1,527 employees on December 31, 1993. None of the employees is represented by a labor union. Communications Satellite Act of 1962 COMSAT was incorporated in 1963 under District of Columbia law, as authorized by the Communications Satellite Act of 1962 (the Satellite Act). Effective June 1, 1993, COMSAT changed its corporate name from "Communications Satellite Corporation" to "COMSAT Corporation." COMSAT is not an agency or establishment of the U.S. Government. The U.S. Government has not invested funds in COMSAT, guaranteed funds invested in COMSAT or guaranteed the payment of dividends by COMSAT. Although COMSAT is a private corporation, the Satellite Act governs certain aspects of COMSAT's structure, ownership and operations, most significantly the following: three of COMSAT's 15 directors are appointed by the President of the United States with the advice and consent of the United States Senate; COMSAT's issuances of capital stock and borrowings of money must be authorized by the Federal Communications Commission (FCC); there are limitations on the classes of persons that may hold shares of COMSAT's Common Stock and on the number of shares a person or class of persons may hold; and, on matters that may affect the national interest and foreign policy of the United States, COMSAT's representatives to INTELSAT and Inmarsat receive instructions from the U.S. Government. Congress has reserved the right to amend the Satellite Act, and amendments, if any, could materially affect the Corporation. Government Regulation Under the Satellite Act and the Communications Act of 1934, as amended (the Communications Act), COMSAT is subject to regulation by the FCC with respect to its COMSAT World Systems and COMSAT Mobile Communications communications services and the rates charged for those services. FCC decisions and policies have had and will continue to have a significant impact on the Corporation. For a discussion of these matters, see Note 7 to the 1993 Financial Statements. INTERNATIONAL COMMUNICATIONS The International Communications segment consists of the FCC- rate-regulated business of COMSAT World Systems, and COMSAT International Ventures. COMSAT World Systems Services. COMSAT World Systems provides telephone, data, video and audio communications services between the United States and the rest of the world using the global network of INTELSAT satellites. COMSAT World Systems customers include U.S. international communications common carriers, private network providers, multinational corporations, U.S. and international broadcasters, newsgathering organizations and digital audio companies. The largest portion of COMSAT World Systems revenues comes from leasing full-time voice grade half-circuits (two-way communications links between an earth station and an INTELSAT satellite) to U.S. international communications common carriers. The three largest carrier customers are American Telephone & Telegraph Company (AT&T), MCI International Inc. (MCI) and Sprint Communications Company (Sprint). COMSAT World Systems offers significant discounts to customers entering into long-term commitments for full-time voice-grade half-circuits. More than 95.5% of all eligible voice-grade half-circuits are now under such commitments. COMSAT World Systems voice and data services are primarily digital, which ensures high-quality transmissions. COMSAT World Systems International Digital Route (IDR) service, for example, makes it possible for communications carriers to provide digital public-switched telephone network circuits. The carriers apply techniques to such circuits that permit a single digital circuit to handle multiple telephone calls simultaneously. For private line customers, COMSAT World Systems offers an all-digital International Business Service (IBS), as well as an international VSAT (Very Small Aperture Terminal) service. IBS offers customers high-speed, digital communications for voice, data, facsimile and video-conferencing using on-premise earth stations that eliminate the need for costly land-line connections. At year-end 1993, approximately 58% of COMSAT World Systems IBS traffic was covered by multi-year agreements. In 1992, COMSAT World Systems established international VSAT networks to both Latin America and Europe. Using on-premise antennas as small as 1.8 meters in combination with the high-power satellites in the INTELSAT network, international corporations can deliver communications to multiple sites. Used primarily for data transmissions, VSATs can also accommodate voice and video communications. To the growing international broadcasting community, COMSAT World Systems provides both digital and analog transmission services on a long-term, short-term or occasional as-needed basis. With the launch in 1992 of the INTELSAT K satellite over the Atlantic Ocean, COMSAT World Systems has expanded the availability of high-power, flexible capacity for broadcasters and satellite newsgatherers. In anticipation of the adoption of digital compression in the broadcast industry, COMSAT World Systems introduced a flexible digital television service and a digital audio service in 1992, attracting new customers to satellite broadcasting. To maintain the quality of the INTELSAT network, COMSAT World Systems provides tracking, telemetry, control and monitoring services to INTELSAT and engages in a program of research and development to ensure that the satellite system accommodates the latest communications technologies, including both broadband and integrated services digital networks (ISDN). Tariffs and Revenues. Under the Satellite Act and the Communications Act, COMSAT is subject to regulation by the FCC with respect to COMSAT World Systems communications services, the rates charged for those services and earnings levels. COMSAT World Systems provides its services on a non-discriminatory basis to all customers, either under tariffs filed with the FCC or on the basis of inter-carrier contracts. Effective January 1, 1992, COMSAT World Systems introduced a regional growth plan through which customers can benefit from rate reductions as certain threshold traffic levels are attained in each of four geographic regions: Europe, Latin America, Pacific and Mid-East/Other. In addition, COMSAT World Systems reduced its rates by 10% on 10- and 15-year IDR and Time Division Multiple Access (TDMA) digital "base" circuits activated prior to January 1, 1992. In May 1992, rates for all multi-year "base" circuits with transmissions between large Standard A earth stations were also reduced by 10%. During 1992, COMSAT World Systems also introduced rates for Digital Television Service coupled with transitional rates for customers who commenced service in an analog mode and opted to convert to digital modulation techniques within the same lease period. In January 1992, COMSAT World Systems filed a petition for rulemaking with the FCC seeking incentive-based regulation of its multi-year, switched-voice services for carriers. The petition requests a regulatory framework to replace traditional rate-base regulation and enable COMSAT World Systems to respond more effectively to competitive market forces. This framework would have three parts: (1) COMSAT World Systems would agree to cap its prices for existing multi-year, switched-voice services at the reduced rates that went into effect on January 1, 1992; (2) COMSAT World Systems could lower its rates for these services on 14 days notice, and those rates would be presumed lawful as long as they were above its average variable costs; and (3) multi-year, switched-voice services would no longer be subject to annual rate- of-return reviews, although they would still be subject to review in the event of a customer complaint. The FCC has not yet taken action on this petition. In 1993, COMSAT World Systems entered into new inter-carrier contracts with each of its three largest customers, AT&T, MCI and Sprint. Pursuant to those contracts, COMSAT World Systems further reduced its rates for 10- and 15-year IDR and TDMA digital "base" circuits activated prior to January 1, 1992, and also reduced its rates beginning in 1996 for 7-year and longer IDR and TDMA circuits activated after January 1, 1992. In addition, the contracts provided AT&T and Sprint with leases and with options to lease capacity from COMSAT World Systems in 36 MHz increments under specified rates, terms and conditions. Approximately 39% of the Corporation's consolidated revenues in 1993 were derived from COMSAT World Systems services (45% in 1992, 47% in 1991). Approximately 13% of the Corporation's consolidated revenues in 1993 were derived from COMSAT World Systems services to AT&T. Competition. COMSAT World Systems competes with operators of high capacity fiber-optic and other submarine cables in service along major traffic routes worldwide. COMSAT World Systems' major carrier customers (including its three largest customers, AT&T, MCI and Sprint) are co-owners of submarine cables. Under the Satellite Act and FCC orders, COMSAT is the only U.S. entity that may provide international space segment services to customers using INTELSAT satellites. In 1985 the FCC authorized the establishment of separate international communications satellite systems that would provide certain services in competition with INTELSAT, subject to certain restrictions that are being phased out. For a discussion of separate satellite systems competition to COMSAT World Systems, see Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 7 to the 1993 Financial Statements. INTELSAT. INTELSAT is a 131-nation organization headquartered in Washington, D.C. It operates under two agreements: (1) an intergovernmental agreement; and (2) an operating agreement signed by each nation's government or designated telecommunications entity (Signatory). COMSAT is the U.S. Signatory. It represents the United States in INTELSAT, subject to instructions from the Department of State (in concert with the Department of Commerce and the FCC) on matters that may affect the national interest and foreign policy of the United States. Each Signatory has rights and obligations in INTELSAT analogous to those of a partner. Each owns an investment share, makes proportionate contributions to INTELSAT's capital costs, and receives proportionate distributions of INTELSAT's net revenues after deductions for operating expenses. The investment shares are readjusted as of March 1 of each year to approximate the Signatories' respective portions of the total use of the INTELSAT space segment for the previous six months. COMSAT's investment share, the largest in INTELSAT, was 20.2% as of March 1, 1994 (21.8% as of March 1, 1993; 21.9% as of March 1, 1992). Signatories also pay INTELSAT for their use of the satellite system. Charges for such use are computed to provide a pretax cumulative rate of return of between 16% to 18% on a Signatory's capital used by another Signatory or from non-owners who use the satellite system. COMSAT World Systems realized revenue from its INTELSAT ownership, net of use charges paid, of $26 million in 1993. This net revenue is reflected in COMSAT World Systems revenue requirements for ratemaking purposes. At December 31, 1993, total INTELSAT Owners' Equity was approximately $1,687 million, and INTELSAT's outstanding contractual commitments totaled approximately $1,725 million. In each of 1989 through 1993, the Corporation entered into agreements with INTELSAT to place COMSAT World Systems FM, digital bearer, IBS and video traffic on the INTELSAT system under long- term commitments. During 1990, INTELSAT initiated certain reforms to its process for coordinating with separate satellite systems. These reforms were superseded in November 1992. Under the streamlined procedures approved in 1992, carriage by separate systems of any amount of traffic or services not interconnected to the public switched network and of up to 1,250 circuits of public switched traffic per satellite is presumed not to cause significant economic harm to the INTELSAT system. In addition, the recommendations approved called for further liberalization of coordination procedures with a view toward eliminating the economic harm test in the 1996-98 timeframe. COMSAT International Ventures COMSAT International Ventures (CIV) forms venture companies with strategic and operating partners to provide a variety of telecommunications services and equipment, and also operates overseas companies that are wholly or majority owned. These companies provide international and domestic (non-U.S.) private- line voice and data services, including IBS, VSAT and single channel per carrier services, as well as equipment leasing and technical services. Customers for these services include U.S. and foreign multinational corporations, and domestic (non-U.S.) companies operating in their own countries. CIV continued to develop new investment opportunities around the world in 1993. CIV ventures are providing services in the Latin American countries of Chile, Argentina, Bolivia, Colombia and Guatemala. A CIV operating unit in Argentina is wholly owned. During 1993, CIV formed a joint venture company in Brazil and its new Venezuelan company continued to explore opportunities to provide communications services in that country. CIV also expanded its European and Middle Eastern presence by investing in a U.S. company providing communications services in Russia and other newly independent states. This venture joins CIV's existing operations in Turkey. CIV continues to expand its investments to other regions of the world besides Latin America, and several new investments are expected to start operations during 1994. The level of competition in each of the joint ventures in which CIV invests varies considerably from country to country. In some countries there is full competition, and in others competition is limited. The competitive conditions faced by each joint venture are the result of differing regulatory policies, as well as economic and market conditions, in the particular country in which that joint venture operates. MOBILE COMMUNICATIONS The Mobile Communications segment consists of the FCC- regulated business of COMSAT Mobile Communications. COMSAT Mobile Communications COMSAT Mobile Communications provides satellite telecommunications services for maritime, aeronautical and land mobile applications, using the Inmarsat satellites and COMSAT's land earth stations in Connecticut, California and Turkey, which serve the Atlantic, Pacific and Indian Ocean Regions, respectively. These stations enable COMSAT Mobile Communications to offer global coverage for its services. There are currently more than 34,000 mobile terminals operating in the Inmarsat system. As described below, COMSAT Mobile Communications provides a full range of voice, facsimile, data and telex services, as well as certain value-added services. Maritime Services. COMSAT Mobile Communications provides satellite services for communications to and from ships and other vessels. Customers for these services include transport ship operators, cruise ships and their passengers, fishing vessel operators, oil and mining interests, pleasure boat operators, U.S. Navy ships and foreign telecommunications administrations. Services include group call messaging to a fleet of ships, an electronic mail service, a direct-dial telephone service for passengers and crew on board ships, a news summary distribution service, access to data bases through personal computers and other office communications services for facsimile transmissions, worldwide teleconferencing and current financial news reports. In 1992, COMSAT Mobile Communications initiated its two new digital services, Inmarsat-B and Inmarsat-M, in the Atlantic and Pacific Ocean Regions. These services provide more efficient use of the Inmarsat satellite capacity, help to significantly lower the cost of using satellite communications, and expand the potential customer base for maritime and land mobile services. COMSAT Mobile Communications also introduced a multi-channel version of Inmarsat- M service that will allow cruise ships and other high-volume users to increase their channel capacity and offer lower rates to their customers. In 1993, COMSAT Mobile Communications announced plans for a new land earth station in Malaysia to provide these new digital services to the Indian Ocean Region. The Malaysian earth station is expected to be operational in 1994. Aeronautical Services. COMSAT Mobile Communications provides satellite telecommunications services for aeronautical applications, including airline operational and administrative communications, passenger telephone service and, prospectively, air traffic control. By an FCC Report and Order issued in 1989, COMSAT was authorized (1) to be the sole U.S. provider of Inmarsat space segment capacity for aeronautical services; (2) to provide ground segment aeronautical services in connection with the Inmarsat space segment on a nonexclusive basis; and (3) to provide such aeronautical services only to aircraft engaged in international flights, including international flights over U.S. airspace. Another entity, the American Mobile Satellite Corporation (AMSC), was designated as the sole provider of certain domestic aeronautical satellite services. However, COMSAT Mobile Communications has been authorized by the FCC to provide domestic aeronautical satellite services on an interim basis until the deployment of AMSC's satellite, which AMSC expects to occur in late 1994 or early 1995. Customers of COMSAT Mobile Communications for aeronautical services include airline service providers, commercial airlines, government aircraft and owners and operators of corporate aircraft. COMSAT Mobile Communications began providing aeronautical services in 1990 with a data service for cockpit communications on commercial flights under a 10-year agreement with Aeronautical Radio, Inc., an airline-owned service organization. In 1991, COMSAT Mobile Communications began providing aeronautical voice services in the Atlantic and Pacific Ocean Regions through its earth stations at Southbury, Connecticut and Santa Paula, California. There are currently more than 300 aircraft equipped to use the Inmarsat aeronautical system, equally split between voice and data services. A service agreement with Kokusai Denshin Denwa Co., Ltd. (KDD), the Japanese Signatory to Inmarsat, provides that COMSAT Mobile Communications may use KDD's ground earth station serving the Indian Ocean Region to serve COMSAT Mobile Communications' aeronautical customers. COMSAT Mobile Communications may serve KDD's customers flying in the Atlantic Ocean Region, and COMSAT Mobile Communications and KDD will provide mutual back-up in the Pacific Ocean Region for aeronautical customers of both companies. Service agreements with GTE Airfone, Incorporated, Claircom and In-Flight Phone, Inc., all of which are providers of air-to- ground passenger telephone service using terrestrial facilities, enable these providers to extend their current service to transoceanic flights by acquiring satellite and ground earth station services from COMSAT Mobile Communications. In 1993, COMSAT signed a service agreement with United Airlines to provide satellite communications services for passengers, including telephone, fax and data transmission on approximately 74 aircraft, once such aircraft are equipped with satellite terminals. Land Mobile Services. COMSAT Mobile Communications provides telecommunications services for international land mobile applications, using mobile and portable terminals located outside of the United States. Customers for these services include broadcasters, foreign telecommunications authorities and U.S. and foreign corporations and government agencies. COMSAT Mobile Communications land mobile services are currently available using transportable versions of Inmarsat's Standard-A mobile earth station (telephone, facsimile, data, and telex), a briefcase-size Inmarsat-M terminal and a smaller data- only Standard-C terminal through COMSAT Mobile Communications' C- Link(sm) service. The briefcase-size Inmarsat-M terminals provide a more portable and less expensive telephone service for international travelers, the news media, government officials and others who travel to remote parts of the world where reliable communications services are often not available. C-Link service is a low-cost text messaging service that permits smaller vessels and land mobile units to use the global satellite network. COMSAT Mobile Communications is continuing to modify its land earth stations to interconnect this service with public and private data networks. COMSAT is not generally authorized to provide domestic land mobile services directly to end users. However, it is providing Inmarsat satellite capacity to AMSC, the authorized U.S. domestic land mobile entity, for an interim service pending the launch of AMSC's own satellite, and it is providing interim domestic service to certain other end users under special temporary authority from the FCC. Revenues. Approximately 30% of the Corporation's consolidated revenues in 1993 were derived from COMSAT Mobile Communications (28% in 1992, 24% in 1991). No single customer of COMSAT Mobile Communications provided more than 10% of the Corporation's consolidated revenues in 1993. Competition. Under the Satellite Act and FCC orders, COMSAT is the only U.S. entity that may provide space segment services to customers using the Inmarsat satellites. COMSAT Mobile Communications competes for maritime, land mobile and aeronautical communications business with other Inmarsat Signatories operating land earth stations and with IDB Aero-Nautical Communications, Inc. (IDB), another U.S. carrier which provides maritime, land mobile and aeronautical services through its own U.S. coast earth stations, using Inmarsat satellite capacity obtained from COMSAT Mobile Communications. COMSAT Mobile Communications also competes for maritime communications business with operators of cellular radio services, high frequency radio services and fixed C-band satellites, domestic and international. These competitive forces continue to exert downward pressure on COMSAT Mobile Communication's pricing for services provided through the Inmarsat system. In November 1993, the FCC authorized AT&T to provide shore-to- ship Inmarsat service under an agreement with COMSAT Mobile Communications whereby COMSAT Mobile Communications is indicated in AT&T's tariff as a "participating carrier" and pursuant to which COMSAT Mobile Communications reduced its charge for space and ground segment to AT&T by more than 20%. In December 1993, AT&T filed a new application to provide "branded end-to-end" Standard A mobile satellite service in the ship-to-shore direction. In February 1994, COMSAT opposed this application, arguing that it is contrary to the Satellite Act. The FCC has not acted on this matter. In March 1993, the FCC granted COMSAT's petition seeking waivers of the structural separation requirements, subject to COMSAT's establishing certain accounting and non-structural safeguards. This relief allows COMSAT to provide equipment, software and value-added services to customers directly through COMSAT Mobile Communications, rather than through a separate subsidiary that would require substantial duplication of personnel and other costs. In satisfaction of conditions placed on COMSAT by the FCC in granting the COMSAT application, in January 1994, COMSAT filed with the FCC its new Cost Allocation Manual, and in February 1994, COMSAT filed its plan for implementing certain non-structural safeguards desired by the FCC. Both filings are subject to FCC approval before the FCC waivers take effect. Inmarsat. Inmarsat is a 72-nation organization headquartered in London, England. It operates under two agreements: (1) an intergovernmental convention; and (2) an operating agreement signed by each nation's government or designated telecommunications entity (Signatory). COMSAT is the U.S. Signatory. It represents the United States in Inmarsat, subject to instructions from the Department of State (in concert with the Department of Commerce and the FCC) on matters that may affect the national interest and foreign policy of the United States. Each Signatory has rights and obligations in Inmarsat analogous to those of a partner. Each owns an investment share, makes proportionate contributions to Inmarsat's capital costs, and receives proportionate distributions of Inmarsat's space segment charges after deductions for operating expenses. The investment shares are readjusted as of February 1 of each year to approximate the Signatories' respective portions of the total use of the Inmarsat space segment for the previous year. COMSAT's investment share, the largest in Inmarsat, was 22.5% as of February 1, 1994 (23.1% as of February 1, 1993; 25.0% as of February 1, 1992). At December 31, 1993, total Inmarsat Owners' Equity was approximately $672 million, including undistributed compensation for use of capital totaling approximately $136 million, and Inmarsat's outstanding contractual commitments totaled approximately $380 million. VIDEO ENTERPRISES The Video Enterprises segment consists of COMSAT Video Enterprises, Inc. (CVE), a wholly owned subsidiary of the Corporation, and On Command Video Corporation (OCV), a California- based company that developed and markets a proprietary video entertainment system to hotels. CVE is the majority owner of OCV. This segment provides entertainment services to the hospitality industry throughout the United States, as well as domestic video distribution services to television networks. CVE and OCV services to hotels consist of pay-per-view feature films, free-to-guest programming (such as Showtime, HBO, ESPN, The Disney Channel, CNN and TBS, among others), and pay-per-view sports and entertainment special events. OCV's pay-per-view film service is on-demand and its system also provides interactive in-room services such as folio review and guest check out. At December 31, 1993, CVE and OCV had a customer base installed or under contract of approximately 2,200 hotels and approximately 490,000 rooms, including hotels in each major hospitality chain. In 1993, CVE raised its ownership of OCV from 65.7% to 73.5% through purchases of common stock from minority stockholders and of additional common stock from OCV. Beginning with the third quarter of 1992, OCV's financial results have been consolidated with CVE. Previously, this investment was accounted for using the equity method. For a further discussion of this investment, see Note 4 to the 1993 Financial Statements. CVE's hotel business was restructured in 1992. For a discussion of the restructuring, see Note 12 to the 1993 Financial Statements. All of the Corporation's domestic video distribution services and products have been consolidated within CVE. This includes the distribution of network television programming of the National Broadcasting Company (NBC) via satellite to NBC affiliate stations nationwide pursuant to a service contract which runs to 1999. CVE operates in a highly competitive and rapidly changing environment in which the principal methods of competition are service, product features and price. Several competing companies, principally Spectradyne, Inc., provide hotels with in-room video entertainment. TECHNOLOGY SERVICES The Technology Services segment consists of COMSAT Technology Services (CTS), which was created in 1992 by restructuring the former COMSAT Systems Division and combining its activities with those of COMSAT Laboratories, the Corporation's research and development organization. For a discussion of the restructuring, see Note 12 to the 1993 Financial Statements. CTS provides turnkey voice, video and data communications networks and products, information services and applied research and technology worldwide. CTS's services include: information systems design, development, engineering, installation, testing and operations and maintenance; program management, applications engineering and software; integrated voice, video and data networks; and systems engineering and technical assistance services. CTS's customers include the U.S. Government, foreign governments and a variety of commercial customers. Major new CTS contracts awarded or begun in 1993 include: a contract with the Cote d'Ivoire (Ivory Coast) government to provide a national television and radio distribution system for Radio Television Ivorian; a contract with the Guatemalan telephone company (Guatel) to provide a VSAT network for rural telephony voice service; and contracts to provide various systems and services for U.S. government classified customers. On-going contracts being implemented in 1993 included: a contract with the Defense Information System Agency for a commercial satellite communications study; a contract to provide earth station management services to the Saudi Arabian government; a contract with a government agency in Korea to install earth stations to connect with the Inmarsat Indian Ocean Region satellites; contracts to provide consulting services for Koreasat and Asiasat satellite construction and launches; a contract with the Voice of America for earth station implementation; and contracts to provide various systems and services for government agencies in Italy, Korea, Japan and Turkey. COMSAT Laboratories, part of CTS, conducts research and development on a broad range of telecommunications devices, subsystems, transmission systems, technologies and techniques in support of CTS and other COMSAT businesses, as well as for outside customers. Customers include U.S. and foreign government agencies, commercial entities, INTELSAT and Inmarsat. COMSAT Laboratories also licenses new technology it develops to other companies for commercialization of such technology. During 1993, COMSAT Laboratories successfully delivered its portion of NASA's Advanced Communications Technology Satellite (ACTS) and is currently providing operations and maintenance support. The ACTS satellite was launched in 1993 and NASA is currently conducting its experiments program. COMSAT Laboratories also continued work under a subcontract with Magnavox Electronic Systems Company to develop satellite communications control software and a computer interface to a new satellite ground terminal system for the U.S. Army. Support of COMSAT Laboratories from outside sources was 46% of total funding in 1993. The Corporation's total expenditures for research and development were $13 million in 1993, $15 million in 1992, and $18 million in 1991. CTS also includes the activities of COMSAT General Corporation (COMSAT General), a wholly owned subsidiary of the Corporation. COMSAT General owns an 86.3% interest in and manages the MARISAT Joint Venture, which owns and operates three satellites and leases capacity in the satellites to Inmarsat and the U.S. Navy. In addition, CTS manages the Corporation's minority investment in Plexsys International Corporation, a manufacturer of cellular telephone equipment. Effective December 31, 1993, the Microwave Electronics Division (MED) of CTS, which designs and manufactures certain electronic components primarily for use in satellite communications systems, was sold to AMP Incorporated. No material portion of CTS's business is subject to renegotiation of profits or termination of contracts or subcontracts with the U.S. Government. CTS competes with major companies around the world in the broad areas of systems engineering and integration of telecommunications and information systems and services. CTS competes principally on the basis of service, product, price, reputation and capabilities. In January 1994, the Corporation entered into a definitive agreement to acquire Radiation Systems, Inc. (RSi), a company which designs, manufactures and integrates satellite earth stations, advanced antennas and other turnkey systems for telecommunications, radar, air traffic control and military uses, by merging RSi with a wholly owned subsidiary of the Corporation. Following the merger, the Corporation expects to combine CTS with RSi. For a further discussion of the acquisition of RSi, see Note 15 to the 1993 Financial Statements. INVESTMENTS The Corporation owns a limited partnership which owns the Denver Nuggets, a franchise of the National Basketball Association. As a result of the Corporation's acquiring all of the remaining interests in the partnership in 1992, the partnership's financial results have been consolidated with the Corporation's financial statements beginning with the third quarter of 1992. Previously, this investment was accounted for using the equity method. For a further discussion of the Corporation's investments, see Note 4 to the 1993 Financial Statements. Item 2. Item 2. Properties COMSAT Properties Effective in 1993, the headquarters of the Corporation and the headquarters of the International Communications and Video Enterprises segments are located in a building in Bethesda, Maryland which the Corporation leases from a limited partnership in which it holds a 50% interest, primarily as a limited partner. The managing general partner also owns a 50% interest in the partnership. An affiliate of the managing general partner owns the building site and has leased this site to the partnership. The Corporation has entered into a 15-year lease with the partnership for the new building. For a further discussion of the Corporation's ownership interest and lease of this property, see Notes 4 and 6 to the 1993 Financial Statements. The Corporation owns buildings and land at Clarksburg, Maryland that serve as the headquarters of the businesses of the Mobile Communications and Technology Services segments. The Corporation owns two satellites that are used by the Video Enterprises segment in its video distribution services and its television distribution network for NBC. The Corporation, through the 86.3%-owned MARISAT Joint Venture, also operates three satellites, capacity of which is leased by the Technology Services segment to Inmarsat and the U.S. Navy. The Corporation leases an earth station in Turkey and owns earth stations at Santa Paula, California and Southbury, Connecticut that are used by COMSAT Mobile Communications to provide mobile communications services. In addition, a land earth station is planned in Malaysia. The California and Connecticut earth stations are also used by the businesses of the Technology Services segment to provide communications services and tracking, telemetry and command (TT&C) services. The Corporation also owns earth stations at Clarksburg, Maryland and Paumalu, Hawaii that are used by COMSAT World Systems to provide TT&C services to INTELSAT. The Corporation's properties are suitable and adequate for the Corporation's business operations. INTELSAT Satellites COMSAT World Systems uses the satellites of INTELSAT, an organization in which COMSAT owns a 20.9% interest. The INTELSAT satellites currently used and under construction are described below. The INTELSAT V series consists of eight satellites having an average capacity of at least 15,000 voice-grade bearer circuits or 51 television channels. The INTELSAT V-A series consists of five satellites having an average capacity of at least 16,000 bearer circuits or 57 television channels. The INTELSAT VI series consists of five satellites, constructed by Hughes Aircraft Company, a subsidiary of General Motors Corporation, having an average capacity of at least 24,000 bearer circuits or 87 television channels. The INTELSAT-K satellite, constructed by General Electric Technical Services Company, Inc., a subsidiary of General Electric Company, has an average capacity of 7,000 bearer circuits or 32 television channels. The INTELSAT VII series consists of six satellites that are being constructed by Space Systems/Loral (formerly Ford Aerospace and Communications Company). These satellites will have an average capacity of at least 17,050 bearer circuits or 62 television channels. The first INTELSAT VII satellite was launched on October 22, 1993. The INTELSAT VII-A series, also being constructed by Space Systems/Loral, consists of three satellites having an average capacity of at least 19,250 bearer circuits or 70 television channels. The first INTELSAT VII-A satellite is expected to be launched in 1995. The INTELSAT VII satellite launches are expected to be insured. No decision has been made regarding launch insurance for the INTELSAT VII-A series, however. The INTELSAT VIII series consists of four satellites that are being constructed by Martin Marietta Astro Space, a division of the Martin Marietta Corporation. These satellites will have an average capacity of 21,000 bearer circuits or 76 television channels. The first INTELSAT VIII satellite is expected to be launched in 1996. No decision has been made regarding launch insurance for the INTELSAT VIII series. COMSAT has applied to the FCC for authorization to participate in the procurement of one INTELSAT VIII-A spacecraft. This satellite, which is being constructed by Martin Marietta Astro Space, will have an average capacity of at least 11,600 bearer circuits, or 38 television channels, and is expected to be launched in 1997. No decision has been made regarding launch insurance for the INTELSAT VIII-A spacecraft. Inmarsat Satellites COMSAT Mobile Communications uses the satellites of Inmarsat, an organization in which COMSAT owns a 22.5% interest. The Inmarsat satellites currently used and under construction are described below. The first-generation Inmarsat satellite system consists of satellite capacity leased from INTELSAT, the European Space Agency and the MARISAT Joint Venture for periods expiring at various times through January 1996. The second-generation Inmarsat satellite system, known as the Inmarsat II series, consists of four satellites constructed by an international consortium led by British Aerospace Dynamics Corporation. A financing arrangement with respect to the first three Inmarsat II satellites is discussed in Note 5 to the 1993 Financial Statements. The third-generation Inmarsat satellite system, known as the Inmarsat III series, consists of four satellites which are being constructed by General Electric Technical Services Company, Inc. These satellites will use spot-beam technology, which allows reuse of the scarce frequency resources allocated for mobile satellite communications. Their capacity will be more than 20 times that of the largest satellites in the first-generation Inmarsat system and about eight times more powerful than the Inmarsat II series. In March 1994, Inmarsat decided to procure a fifth Inmarsat III spacecraft as a contingency against possible loss of a satellite. No decision has been made regarding launch insurance for the Inmarsat III series. A financing arrangement with respect to the first three Inmarsat III satellites is discussed in Note 5 to the 1993 Financial Statements. Item 3. Item 3. Legal Proceedings Neither COMSAT nor any of its subsidiaries is a party to, and none of their property is the subject of, material pending legal proceedings, and no such proceedings are known to be contemplated by governmental authorities, except the matters described in Notes 6, 7 and 15 to the Corporation's 1993 Financial Statements. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. Executive Officers of The Registrant Age as of Name Officer March 31, 1994 Bruce L. Crockett President and Chief Executive Officer 50 Betty C. Alewine President, COMSAT World Systems 45 John V. Evans President, COMSAT Laboratories 60 Charles Lyons President, COMSAT Video Enterprises, Inc. 39 Ronald J. Mario President, COMSAT Mobile Communications 50 Jerome W. Breslow Vice President and Secretary 60 C.Thomas Faulders, III Vice President and Chief Financial Officer 44 Steven F. Bell Vice President, Human Resources and Organization Development 44 Arthur R. Sando Vice President, Corporate Affairs 46 Warren Y. Zeger Vice President and General Counsel 47 Allen E. Flower Controller 50 Wesley D. Minami Treasurer 37 Normally, the officers are elected annually by the Board of Directors, at its first meeting following the Annual Meeting of Shareholders, to serve until their successors are elected and qualified. There is no family relationship between an officer and any other officer or director and no arrangement or understanding between an officer and any other person pursuant to which he or she was selected as an officer. The following is a brief account of each executive officer's experience for the past five years: Mr. Crockett has been President and Chief Executive Officer of the Corporation since February 1992. He was President and Chief Operating Officer of the Corporation from April 1991 to February 1992. He was President, World Systems Division from February 1987 to April 1991. Ms. Alewine has been President, COMSAT World Systems since May 1991. She was Vice President and General Manager, INTELSAT Satellite Services from January 1989 to May 1991. She was Vice President, Sales and Marketing, World Sysite Services from January 1989 to May 1991. She was Vice President, Sales and Marketing, World Systems Division from March 1987 to January 1989. Dr. Evans has been President, COMSAT Laboratories since September 1991. He was Vice President and Director, COMSAT Laboratories from October 1983 to September 1991, and Vice President and Director of Research from April 1983 to October 1983. Mr. Lyons has been President, COMSAT Video Enterprises, Inc. (CVE) since February 1992. He was Vice President and General Manager, CVE from October 1990 to January 1992. Prior to joining the Corporation, he was with Marriott Corporation, serving as National Director of Group Marketing from September 1989 to October 1990, Regional Director of Operations and National Director of Group Sales from September 1988 to September 1989, and Director of Marketing from September 1986 to September 1988. Mr. Mario has been President, COMSAT Mobile Communications (CMC) since May 1991. He was Vice President and General Manager, CMC from April 1988 to May 1991. He was Vice President, Corporate Services from September 1985 to April 1988. Mr. Breslow has been Vice President and Secretary since June 1987. Mr. Faulders has been Vice President and Chief Financial Officer since February 1992. Prior to joining the Corporation, he was with MCI Communications Corporation (MCI), serving as Senior Vice President of Business Marketing from August 1991 to February 1992, Senior Vice President of Government Systems and Enterprise Group from August 1990 to August 1991, Vice President of National Accounts for MCI Southeast from August 1988 to August 1990, and Vice President and Treasurer of MCI from December 1985 to August 1988. Mr. Sando has been Vice President, Corporate Affairs since September 1991. He was Vice President, Marketing and Communications, COMSAT Video Enterprises, Inc. from May 1990 to September 1991. Prior to joining the Corporation, he was with Turner Broadcasting System, Inc., serving as Vice President, Marketing and Communications from February 1989 to April 1990 and Vice President, Corporate Communications from May 1984 to February 1989. Mr. Zeger has been Vice President and General Counsel since March 1992. He was Acting General Counsel from September 1991 to March 1992. He was Associate General Counsel of the Corporation and Vice President, Law, World Systems Division (WSD) from February 1988 to September 1991. He was Vice President and General Counsel, WSD, from August 1987 to February 1988. Mr. Flower has been Controller since June 1992. He was Vice President, Finance and Administration, CVE from May 1990 to June 1992. He was Vice President, Finance and Administration, World Systems Division from August 1987 to May 1990. Mr. Bell has been Vice President of Human Resources and Organization Development since October 1993. Prior to joining the Corporation, he was with American Express Worldwide Technologies, serving as Vice President of Human Resources from September 1992 to September 1993; with US Sprint, serving as Regional Director of Human Resources from October 1987 to August 1992; and with Martin Marietta Data Systems Division, serving as Manager, Employment from July 1985 to October 1987. Mr. Minami has been Treasurer since May 1993. Prior to joining the Corporation, he was with Oxford Realty Services Corp., a privately held $1.5 billion investment/property management company, serving as Senior Vice President, Finance and Administration and Chief Financial Officer from December 1989 to April 1993 and Vice President and Treasurer from April 1988 to November 1989. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters. As of December 31, 1993, there were 40,226,475 shares of Common Stock, without par value, of the Corporation (COMSAT Common Stock) outstanding: 40,205,587 were Series I shares, held by 42,345 holders of record other than communications common carriers; and 20,888 were Series II shares, held by 35 common carriers. The principal market for COMSAT Common Stock is the New York Stock Exchange, where it is traded under the symbol "CQ." COMSAT Common Stock is also traded on the Chicago Stock Exchange and the Pacific Stock Exchange. The Corporation's Transfer Agent, Registrar and Dividend Disbursing Agent is The Bank of New York, 101 Barclay Street, New York, New York. The high and low sales prices of, and the dividends declared on, each share of COMSAT Common Stock for the last two years are as follows: COMSAT Common Stock* High Low Dividend Calendar Year 1992 First Quarter 21 1/2 17 1/8 .175 Second Quarter 21 1/4 18 3/4 .175 Third Quarter 21 5/8 19 5/8 .175 Fourth Quarter 24 1/2 19 7/8 .175 Calendar Year 1993 First Quarter 27 7/8 23 3/4 .185 Second Quarter 31 5/8 27 1/4 .185 Third Quarter 31 7/8 26 3/4 .185 Fourth Quarter 35 1/4 27 1/2 .185 * Prices reflect the two-for-one stock split which occurred in June 1993. Item 6. Item 6. Selected Financial Data for the Registrant for Each of the Last Five Fiscal Years. FIVE YEAR FINANCIAL SUMMARY Notes: 1. Per share amounts have been restated for a 2-for-1 stock split in 1993. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. ANALYSIS OF OPERATIONS Consolidated Operations Consolidated revenues totaled $640 million, an increase of $77 million above record 1992 revenues and $118 million above 1991. Revenue increases resulted from improved operating performance, particularly in COMSAT Mobile Communications, which had higher traffic volumes, and in COMSAT Video Enterprises, where On Command Video product installations grew rapidly. In addition, revenues rose due to the consolidation of Denver Nuggets results for the full year, versus the six months' revenues included in 1992. Operating income was $138 million, an improvement of $50 million over 1992 ($11 million, excluding restructuring charges) and $11 million better than 1991. Results from operations improved over 1992 based on the strong performance from COMSAT Mobile Communications and on cost benefits resulting from the restructuring in 1992 that formed COMSAT Technology Services and consolidated video entertainment and distribution services within COMSAT Video Enterprises. Some of this improvement was offset by the inclusion of a full year of consolidated losses from the Denver Nuggets. Other income improved in 1993 due to proceeds from company- owned life insurance policies, inclusion of profits from equity investments, and the inclusion of the Denver Nuggets losses in other income in the first half of 1992. Interest costs declined slightly from the levels of the prior two years on lower borrowings and lower interest rates. Capitalized interest increased over 1992, but remained below the 1991 level, as plant under-construction balances have continued to increase following the heavy satellite launch schedule in 1990 and 1991. The corporation adopted Statement of Financial Accounting Standards (SFAS) No. 109 in 1993. The new standard requires that deferred tax assets and liabilities be adjusted to reflect current tax rates. The cumulative effect of adopting this standard was to increase income by $1 million in 1993. In addition, the corporation recorded a charge to income tax expense of $3 million under the new standard to reflect the impact on the prior year's deferred tax accounts of the recent change in Federal income tax rate to 35% from 34%. The corporation adopted SFAS No. 106 in 1991, which required recognition of $27 million in expenses after taxes for the expected cost of postretirement benefits. Net income was a record $75 million, a 13% increase over 1992 excluding restructuring charges. Primary earnings per share were $1.85, a 9% increase over 1992, excluding the effects of restructuring. Operating Results International Communications In millions 1993 1992 1991 - - - ------------------------------------------------------------ Revenues $ 250 $ 253 $ 245 Operating Income* $ 89 $ 96* $ 92* *Excludes restructuring charges of $7 million in 1992 and SFAS No. 106 costs of $24 million in 1991. International Communications includes the FCC-regulated and non-regulated businesses of COMSAT World Systems (CWS), as well as COMSAT International Ventures (CIV). CWS provides international voice, data, video and audio communications. Revenues declined slightly, but the business continued its solid performance as demand for services remained strong. CIV invests in telecommunications opportunities internationally. CWS revenues declined by 3% from 1992 levels and were flat compared to 1991. Revenues for full-time voice circuits declined 11% due to the anticipated conversion from analog circuits to more efficient digital service. Additionally, CWS entered into new long- term carrier agreements with ATT, MCI and Sprint, its three major international carrier customers, that provide significant rate reductions in exchange for additional service commitments. CWS share of revenues from the INTELSAT system declined as expected with the 1% reduction in the corporation's ownership share in 1993. Revenues from full-time leased television services increased over 50% as customers benefitted from implementing highly efficient networks with smaller, less expensive antennas that operate with the high-power INTELSAT-K and INTELSAT VI satellites. Operating income for CWS declined 5% from 1992 results, before charges for restructuring, and were about the same as 1991 results. The decrease from 1992 is due to the reduction in revenues. Operating expenses for CWS were below 1992 levels (before restructuring charges) due to cost controls and lower INTELSAT system expenses resulting from the lower ownership share. This was partially offset by higher depreciation expense. CIV has business interests in eight countries in Central America, South America, Eastern Europe and the Commonwealth of Independent States. CIV continues to screen new opportunities carefully as it manages its existing portfolio of operating ventures and investments. Revenues from owned or controlled ventures were consolidated for the first time in 1993, adding 2% to segment revenues. As anticipated, CIV incurred operating losses of $6 million in 1993. Results in 1992 were $2 million better, and included a $2 million gain from the sale of a venture in Venezuela. Mobile Communications In millions 1993 1992 1991 - - - ----------------------------------------------------------------- Revenues $ 190 $ 158 $ 128 Operating Income* $ 48 $ 37* $ 40 *Excludes restructuring charges of $3 million in 1992. COMSAT Mobile Communications (CMC) provides maritime, aeronautical and land mobile communications services. Revenues and operating income grew in excess of 20% over 1992 levels. The maritime business remains strong while undergoing a transition to less expensive, more efficient digital service. Digital Standard-M terminals currently represent only about 3% of commissioned telephony terminals. However, the lower cost associated with digital service versus comparable analog terminals has produced significant increases in traffic volume on passenger ships. Continued significant traffic growth is expected as the digital Standard-M dominates new terminal commissionings over the next few years. Overall, CMC revenues grew by slightly better than 20% in 1993. Demand continued to be strong for telephone service, particularly in the land mobile and government market segments, while the fishing and offshore oil segments declined. Telex revenue declined from 1992 levels, but this decline was mostly offset by revenue growth from smaller, less expensive Standard-C digital terminals. Aeronautical communication services have continued to develop slowly due to airline industry conditions. Revenues remained even with 1992 levels. With several airlines already having committed to install aircraft terminals, it is anticipated that this market will begin to grow in the near future. Operating income improved year to year by almost 30%, excluding 1992 restructuring charges. Operating expenses increased 17% as higher satellite use charges associated with higher traffic volumes were only partially offset by a reduced share of Inmarsat system revenues and expenses. Depreciation on new earth station and satellite equipment installed to meet traffic demand increased expenses by $5 million. Video Enterprises In millions 1993 1992 1991 - - - ----------------------------------------------------------------- Revenues $ 96 $ 78 $ 82 Operating Income* $ 10 $ 6* $ 3 *Excludes restructuring charges of $14 million in 1992. COMSAT Video Enterprises (CVE) provides video distribution and on-demand video entertainment services to the hospitality industry and video distribution services to television networks. The corporation increased its ownership of On Command Video Corporation (OCV) to 74% from 66% during 1993, and has consolidated OCV results since July 1992. Through the investment in OCV, CVE has grown to become the major supplier of on-demand video entertainment to the hospitality industry. Revenues from video programming provided to the hospitality industry grew by almost 34% in 1993, as OCV and CVE continued to equip existing and new hotel rooms with on-demand video systems from OCV. A revenue decline of almost 11% in the mid-priced hotel market was more than offset by a six-fold increase in revenues from OCV 's upscale hotels and from CVE hotels converted to the OCV system. OCV tripled the number of rooms equipped during 1993, and increased the backlog of rooms to be installed by 290%. Demand remains high for this state-of-the-art product. Revenue from the video distribution services provided to the National Broadcasting Corporation (NBC) remained flat, as did operating income. Operating income in 1993 improved by 76% over 1992, excluding charges for restructuring. While the CVE hotel business continued to incur modest losses, these were more than offset by operating income from OCV. CVE improved performance over 1992 due to lower costs achieved through the restructuring and to improved performance from rooms converted to the OCV system. Technology Services In millions 1993 1992 1991 - - - ----------------------------------------------------------------- Revenues $ 88 $ 81 $ 93 Operating Income (Loss)* $ 1 $ (3)* $ - *Excludes restructuring charges of $10 million in 1992. COMSAT Technology Services (CTS) provides turnkey voice, video and data communications networks and products, technology consulting services and applied research services. Revenues in 1993 increased by 9% over 1992. Improvements came from new infrastructure programs such as a major VSAT rural telephony program in Guatemala and a television and radio distribution network in Cote d'Ivoire (Ivory Coast), as well as from new consulting programs. Reductions in overhead and refocused marketing efforts which followed the 1992 restructuring have helped make operating income positive. This represents an improvement of $4 million over 1992 operating losses, before restructuring charges. Corporate In millions 1993 1992 1991 - - - ----------------------------------------------------------------- Revenues* $ 30 $ 11 $ 3 Operating Loss* $ (10) $ (9)* $ (8) *Revenues exclude elimination of intra-company revenues. The 1992 operating loss excludes $4 million of restructuring charges. Revenues increased in 1993 due to the Denver Nuggets' improved attendance, ticket sales and sponsor revenues, and a full year of consolidation versus six months in 1992. Revenues in 1991 came primarily from office space sub-leased by the corporation at its former headquarters building in Washington. These rents have increased only slightly since 1991. Operating losses for all years include costs for proprietary research programs undertaken by COMSAT Laboratories. In 1992, losses for the Denver Nuggets were included for half the year, while in 1993 a full year is reflected. Increases in operating losses of $1 million in 1993 compared to 1992, excluding restructuring charges, were attributable to the full year of consolidated Denver Nugget losses. Outlook The corporation has advocated the privatization of both INTELSAT and Inmarsat. Privatization would change these treaty- based international organizations into commercial enterprises that are responsive to marketplace forces and accountable to shareholders. The corporation believes that the existing organizational structures of INTELSAT and Inmarsat are ill-suited to the competitive, fast-paced marketplace of today, and supports the transfer of ownership holdings at market valuations. Privatization would represent a fundamental change in how the corporation operates in a regulated environment. The corporation will continue to pursue its advocacy of privatization for each of these organizations, but does not expect to see major changes implemented in the near term. COMSAT World Systems continues to adjust to an increasingly competitive environment. In late 1993, the Federal Communications Commission (FCC) substantially eliminated prior restrictions on access of separate system satellite operators to the public switched telephone network. This action, along with the FCC's stated goal of eliminating all restrictions on separate satellite systems by 1997, will increase competition for the provision of satellite services and result in some loss of market share. During 1994, two new satellites scheduled to be launched by PanAmSat will offer additional competition for INTELSAT and CWS. Increased satellite competition and continued competition from fiber optic cables will put increased pressure on service revenues and operating margins. CWS is well-positioned with new long-term agreements with the major international carriers to provide new cost-competitive services for bulk usage beyond the year 2000. In addition, several emerging markets are expected to continue growing, including international television distribution, international VSAT and digital audio services. INTELSAT currently has 13 satellites on order. The first satellite in the INTELSAT VII series, launched in the fourth quarter of 1993, was placed in service early in 1994. There are three more INTELSAT VII launches planned for 1994. The new INTELSAT VII satellites, along with the INTELSAT VIII series satellites, will offer new higher-power capabilities, enabling CWS to remain competitive in an increasingly crowded international telecommunications market. COMSAT International Ventures anticipates strong traffic growth and expansion of business from its existing ventures and will continue efforts to expand to new markets internationally. Existing ventures as a group are expected to reach profitability by the end of 1994. However, CIV anticipates incurring small additional losses for 1994 due to management and administrative costs and losses from new start-up ventures. COMSAT Mobile Communications will continue to expand its service offerings to meet customer needs. An increasing number of digital terminals with improved operating efficiency and reduced service charges should keep traffic growth strong. Smaller digital terminals should facilitate growth in the land mobile, small commercial and pleasure boat, and business traveler markets. Additionally, CMC has signed agreements to provide multi-channel terminals to major airline customers to help expand aeronautical service. CMC is facing competitive changes that will increase pressure on service prices and operating margins. AT&T has petitioned the FCC to allow competitive service offerings for ship-to-shore traffic which, if approved, could lead to lower CMC rates for those services. In early 1994, CMC reached agreement with AT&T to lower the rates the corporation charges AT&T for shore-to-ship traffic and the rates AT&T charges the corporation for ship-to-shore traffic termination. It is anticipated that these new CMC rates will be offered to all long distance carriers. These new agreements could lead to slower revenue growth in the future. The impact on future revenues and expenses will depend on the volume of calls generated and the percentage of that traffic committed to the corporation by the carriers. CMC entered into a carrier agreement with Sprint International. The agreement provides for the exchange of traffic and is expected to lead to additional traffic in the future. In 1993, the FCC initiated an audit of the corporation's role as the United States signatory to Inmarsat and of CMC's earnings as a provider of international mobile services. Although the corporation cannot predict the ultimate disposition of this audit, it believes the impact on service rates, if any, would be prospective and should not be materially different from anticipated rate actions required to respond to market pressure and competition. CMC is studying alternatives for providing new worldwide, satellite-delivered, hand-held telephony services by the end of the decade. These services would be provided by technically complex global systems that would have to compete with existing cellular services, as well as with planned satellite systems such as the Iridium system to be built by Motorola. The corporation has not yet determined the best technical or business approach to this new expanded opportunity, but anticipates that decisions will be made in 1994 and preliminary expenditures could begin before year end. COMSAT Video Enterprises, Inc. will continue efforts to convert existing qualified customers to the OCV product and to retain hotel customers whose contracts expire in 1994. OCV will continue to install new systems, working to address a rapidly growing backlog that, at year end, exceeded its installed base. Continued revenue and income growth is expected as a result of the increasing market share. CVE's video distribution business is expected to remain stable with little change to the NBC services. As in prior years, earnings in 1994 are expected to come primarily from the television network distribution business, with an increasingly larger part from the hospitality industry video distribution business. COMSAT Technology Services emerged from the 1992 restructuring as a more competitive business and entered 1994 with a substantial improvement in its backlog compared to the beginning of 1993. In January 1994, the corporation announced an agreement to acquire, by means of merger, Radiation Systems, Inc. (RSi). RSi designs, manufactures and integrates satellite earth stations, advanced antennas and other turnkey systems for telecommunications, radar, air traffic control and military uses. If approved by RSi's shareholders, the corporation will exchange newly issued common stock for RSi's outstanding common stock, at an exchange value of about $18.25 per RSi share. Each share of RSi common stock will be exchanged for a portion of COMSAT common stock determined by dividing $18.25 by the average closing price of COMSAT stock for the 20 days ending five trading days prior to the effective date of the merger. The exchange ratio shall not be less than 0.638 or greater than 0.780. The transaction will have a total value of approximately $150 million, and is expected to be completed in the second quarter of 1994. Following the merger, which is expected to be treated as a pooling of interests, CTS will be combined with RSi to form a wholly owned subsidiary of the corporation. The new subsidiary, COMSAT RSI, will pursue opportunities in the high- growth wireless communications market by offering integrated systems and products. COMSAT RSI will target international and domestic markets that include cellular, personal communications systems and VSAT antenna technologies. The corporation expects that COMSAT RSI operations, while profitable, may have a small dilutive effect on earnings in 1994, excluding the non-recurring transaction costs. The newly combined entity plans to leverage the technical expertise of COMSAT Laboratories and to maintain the competitive cost structure that prevails in RSi. The corporation anticipates continued improvement in the financial performance of the Denver Nuggets, and expects that the team will reach break-even in 1994. The corporation will adopt SFAS No. 112, "Employer's Accounting for Postemployment Benefits," in 1994. This statement requires that the estimated cost of benefits provided to former or inactive employees be accrued over their active service lives. The effect of adopting the statement is not expected to have a material effect on the corporation's 1994 financial results. The corporation will also adopt SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," in 1994. This statement requires that certain investments in debt or equity securities be carried on the balance sheet at fair value. The effect of this statement is not expected to be material to the corporation as of December 31, 1993. ANALYSIS OF BALANCE SHEETS Assets The corporation ended 1993 with $1,653 million of assets, an increase of $110 million over 1992. International Communications In millions 1993 1992 1991 - - - ----------------------------------------------------------------- Assets $ 827 $ 803 $ 765 Property and Equipment Additions $ 117 $ 121 $ 174 Property and equipment additions are almost exclusively related to COMSAT World Systems' share of INTELSAT's satellite programs for the VII, VII A and VIII series of satellites. These new satellites will offer higher power and deliver greater performance characteristics to meet increasing demand from customers worldwide. CIV invested $7 million for new communications plant and equipment in 1993. The majority of the investments are to meet specific customer requirements for technologically advanced applications in developing countries. The corporation anticipates investing up to an additional $15 million in 1994 to meet demand in existing ventures, and may invest additional amounts if warranted by new opportunities. Mobile Communications In millions 1993 1992 1991 - - - ----------------------------------------------------------------- Assets $ 404 $ 397 $ 320 Property and Equipment Additions $ 51 $ 83 $ 90 Property and equipment were added to provide needed capacity for CMC worldwide services. Ground station plant and equipment were improved in 1993 to be able to handle traffic volumes in all four service regions. A second CMC ground station in the Indian Ocean region was begun in Malaysia to provide digital Standard-M and -B service. The station is expected to be operational in the second quarter of 1994. Stations in California and Connecticut were also upgraded to handle digital traffic under the new digital standards for Inmarsat M, B and C terminals. Assets of $16 million were transferred to this business from CTS in the first quarter of 1993 as part of the restructuring effort begun in 1992; assets for prior years have been restated. The transferred assets are facilities and equipment at the earth stations in California and Connecticut. The first of the Inmarsat III series satellites, currently under construction, is scheduled for launch in 1996. These satellites will provide increased capacity to meet growing demand for all services in all four service regions. Video Enterprises In millions 1993 1992 1991 - - - ----------------------------------------------------------------- Assets $ 187 $ 122 $ 120 Property and Equipment Additions $ 64 $ 18 $ 9 The additions to property and equipment are primarily installations of video entertainment systems for new hotel customers. OCV has a large backlog of hotels waiting to have systems installed. The corporation is expected to make additional investments in these systems during 1994 for new hotel installations. The corporation will also continue to purchase video entertainment systems from OCV for installation in a limited number of hotels in CVE's existing hotel base. The business reduced some asset balances as a result of the 1992 restructuring. Technology Services In millions 1993 1992 1991 - - - ----------------------------------------------------------------- Assets $ 46 $ 49 $ 62 Property and Equipment Additions $ 3 $ 10 $ 7 Property and equipment additions for 1992 and 1993 were primarily purchases of test equipment for research and development work by COMSAT Laboratories and equipment to support CTS' work in communication systems design, demonstration and installation. Requirements for new capital in 1994 are expected to be minimal. Corporate In millions 1993 1992 1991 - - - ----------------------------------------------------------------- Assets $ 189 $ 172 $ 102 Property and Equipment Additions $ 4 $ 1 $ 2 Assets increased in 1993 primarily due to the purchase of RSi equity shares and increases in the cash value of company-owned life insurance policies. The purchase of the remaining share and subsequent consolidation of the Denver Nuggets in 1992 was the primary cause of the increase in assets over 1991. Liabilities During 1993, the corporation's share of long-term debt issued by INTELSAT increased by $31 million as INTELSAT issued 6.75% Eurobonds due in January 2000. Proceeds from this issue were used to prepay $30 million of the corporation's 9.55% notes; $70 million remains due in April 1994. The corporation redeemed its 11.625% unsecured debentures in March 1992. In April 1992 the corporation issued $160 million of new debentures at 8.125% due in April 2004. The proceeds were used to redeem its 7.75% convertible subordinated debentures and to repay commercial paper. ANALYSIS OF CASH FLOWS Operating Activities CWS generated the majority of the corporation's cash from operations. The corporation made interest payments of $25 million and tax payments of $22 million. Investing Activities The corporation made cash investments of $230 million for property and equipment in 1993. Of this, $117 million was invested by the International Communications businesses, $46 million by CMC and $60 million by CVE and OCV. The corporation received approximately $16 million when its share of INTELSAT declined from 21.8% to 20.9% in 1993. The corporation expects its share of INTELSAT to decrease slightly during 1994. The corporation received approximately $5 million when its share of Inmarsat declined from 24.6% to 23.0% in 1993. The corporation's share of Inmarsat declined to 22.5% in February 1994. A total of $14 million was used to purchase equity interests, principally shares of RSi and the CIV ventures. An additional $13 million was used to purchase shares of OCV from minority shareholders. The corporation increased its ownership share of OCV to 73.5% at December 31, 1993. The corporation's investment in property and equipment in 1994 will be somewhat higher than in 1993. Investments in INTELSAT satellites, international ventures, aeronautical service equipment and OCV systems will increase over 1993 levels. Financing Activities Quarterly dividends were $.18-1/2 per share in 1993. The corporation received in early 1993 $33 million in proceeds from long-term debt issued by INTELSAT, all of which was used to redeem or repay other debt obligations. INTELSAT intends to issue bonds in the first quarter of 1994. The corporation will record its share of the borrowings as long-term debt of approximately $42 million. INTELSAT will use the proceeds to redeem or repay their short-term debt obligations. Liquidity and Capital Resources The corporation enjoys access to short- and long-term financing at favorable rates. A $125 million commercial paper program has $43 million of borrowings outstanding at an average interest rate of 3.4%. A $200 million revolving credit agreement with a group of banks is currently not being utilized and extends to 1998. This facility is a back-up to the corporation's commercial paper program. The corporation enjoys access to capital markets at favorable costs with an A rating from Standard and Poor's and an A-2 from Moody's. The corporation's funding activities, as regulated by the FCC, allow long-term financing up to 45% of total capital, as well as $200 million of short-term borrowings. The corporation expects operations to fund almost all 1994 cash requirements. Any additional working capital requirements will be funded using commercial paper. Taxes Taxes were paid on an Alternative Minimum Tax basis due to a net operating loss carryforward from the 1987 discontinued operations. Item 8. Item 8. Financial Statements and Supplementary Data. INDEPENDENT AUDITORS' REPORT To the Shareholders of COMSAT Corporation: We have audited the accompanying consolidated balance sheets of COMSAT Corporation and subsidiaries as of December 31, 1993, 1992 and 1991, and the related consolidated statements of income, stockholders' equity, and cash flow for the years then ended. Our audit also included the financial statement schedules listed in the Index at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of COMSAT Corporation and subsidiaries at December 31, 1993, 1992 and 1991, and the results of their operations and their cash flows for the years then ended 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 10 to the consolidated financial statements, in 1991 the corporation changed its method of accounting for postretirement health and life insurance benefits to conform with Statement of Financial Accounting Standards No. 106. Also, as discussed in Note 11 to the consolidated financial statements, in 1993 the corporation changed its methods of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. Deloitte & Touche Washington, D.C. February 16, 1994 COMSAT CORPORATION AND SUBSIDIARIES CONSOLIDATED INCOME STATEMENTS For the Years Ended December 31, 1993, 1992, and 1991 (In thousands, except per share amounts) The accompanying notes are an integral part of these financial statements. COMSAT CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993, 1992, and 1991 (In thousands) The accompanying notes are an integral part of these financial COMSAT CORPORATION AND SUBSIDIARIES STATEMENTS OF CHANGES IN CONSOLIDATED STOCKHOLDERS' EQUITY For the Years Ended December 31, 1993, 1992, and 1991 (In thousands) The accompanying notes are an integral part of these financial statements. COMSAT CORPORATION AND SUBSIDIARIES CONSOLIDATED CASH FLOW STATEMENTS For the Years Ended December 31, 1993, 1992, and 1991 (In thousands) The accompanying notes are an integral part of these financial statements. COMSAT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The significant accounting policies that have guided the preparation of these financial statements are: Principles of Consolidation Accounts of COMSAT Corporation and its majority-owned subsidiaries (the corporation) have been consolidated. Significant intercompany transactions have been eliminated. The corporation has consolidated its share of the accounts of the International Telecommunications Satellite Organization (INTELSAT), Inmarsat and the MARISAT Joint Venture (MARISAT). The corporation's ownership interests in INTELSAT and Inmarsat are based primarily on the corporation's usage of these systems. As of December 31, 1993, the corporation owned 20.9% of INTELSAT, 23.0% of Inmarsat and 86.3% of MARISAT. The corporation's investments in the Denver Nuggets Limited Partnership (the Nuggets) and On Command Video Corporation (OCV) (see Note 4) were accounted for using the equity method until the third quarter of 1992. Since July 1992, the accounts of these investments have been consolidated in the accompanying financial statements. The interest of other shareholders in the net assets of OCV is shown as Minority Interest in the accompanying balance sheet. The minority interest share of the net income of OCV, which is not significant, is included in Other Income (Expense). Revenue Recognition Revenue from satellite services is recognized over the period during which the satellite services are provided. Revenue from technical and other service contracts is accounted for using the percentage-of-completion method. Revenue from other services is recorded as services are provided. Income Taxes and Investment Tax Credits The corporation adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," effective January 1, 1993. This accounting standard requires the use of the asset and liability approach for financial accounting and reporting for income taxes. The provision for income taxes includes taxes currently payable and those deferred because of differences between the financial statement and tax bases of assets and liabilities. The corporation has earned investment tax credits on certain INTELSAT and Inmarsat satellite costs. These tax credits have been deferred and are being recognized as reductions to the tax provision over the estimated service lives of the related assets. Earnings Per Share Primary earnings per share are computed using the average number of shares outstanding during each period, adjusted for outstanding stock options and restricted stock units. Fully diluted earnings per share also assume the conversion of the corporation's convertible debentures, which were redeemed in March 1992 (see Note 5). The calculation of the weighted average number of shares outstanding and all per share amounts have been adjusted for a two-for-one stock split on June 1, 1993 (see Note 8). The weighted average number of shares for each year is: Goodwill The balance sheet includes goodwill related primarily to the acquisitions of OCV and the Nuggets. Nuggets goodwill is amortized over 25 years and OCV goodwill is amortized over 15 years. Accumulated goodwill amortization was $2,343,000, $875,000 and $105,000 at December 31, 1993, 1992 and 1991, respectively. Net goodwill of $6,740,000 for the Nuggets and OCV was included in the Investments line on the balance sheet for 1991 because these investments were accounted for using the equity method at that time. Franchise Rights and Other Assets Franchise rights were recorded in connection with the consolidation of the Nuggets in 1992 and are being amortized over 25 years. The amounts shown on the balance sheets are net of accumulated amortization of $2,955,000 and $990,000 at December 31, 1993 and 1992, respectively. The cash surrender values of life insurance policies (net of loans) totalling $40,849,000, $33,350,000 and $23,419,000 at December 31, 1993, 1992 and 1991, respectively, are included in Other Assets. Other Income (Expense) on the income statement includes the increases in the cash surrender values of these policies. Additionally, the corporation recorded income of $4,131,000 ($3,137,000 net of tax) from the death benefit proceeds of certain policies in 1993. Cash Flow Information The corporation considers highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents. Statement Presentation Certain prior period amounts have been reclassified to conform with the current year's presentation. New Accounting Pronouncements SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," was issued in May 1993 and must be adopted by the corporation in 1994. This statement requires that certain investments in debt or equity securities be carried on the balance sheet at fair value. The effect of this statement is not material to the corporation as of December 31, 1993. SFAS No. 112, "Employers' Accounting for Postemployment Benefits," was issued in November 1992 and must be adopted by the corporation in 1994. This statement requires that the estimated cost of benefits provided to former or inactive employees be accrued over the term of their active service as employees. Although the corporation has not completed its analysis, the effect of adopting this statement is not expected to be material. 2. RECEIVABLES Receivables at each year-end are composed of: Unbilled receivables consist principally of revenues recorded on long-term contracts, which are billable and collectible within the next year. Related party customer receivables are primarily amounts due from INTELSAT and Inmarsat. 3. PROPERTY AND EQUIPMENT Property and equipment include the corporation's shares of INTELSAT, Inmarsat and MARISAT property and equipment. Depreciation is calculated using the straight-line method over the estimated service life of each asset. The service life for satellites and furniture, fixtures and equipment is 3 to 15 years. The service life for buildings and improvements is 6 to 40 years. Costs of satellites which are lost at launch or that fail in orbit are carried, net of any insurance proceeds, in the property accounts. The remaining net amounts are depreciated over the estimated service life of a satellite of the same series. 4. ACQUISITIONS AND INVESTMENTS Denver Nuggets Limited Partnership In November 1989, the corporation acquired a 62.5% interest in a limited partnership which acquired the Denver Nuggets, a franchise of the National Basketball Association. In 1991, the corporation acquired an additional interest, bringing its ownership to 65.3% as of December 31, 1991. In 1992, the corporation acquired the remaining interests in the partnership. The total cost of this investment was $71,500,000 including liabilities assumed of $33,900,000. The partnership's assets, liabilities, revenues and expenses have been consolidated with the corporation's financial statements since July 1, 1992. Prior to this date, the corporation was the majority owner in the partnership, but was not its managing general partner. Accordingly, the financial results of the partnership in prior periods were accounted for using the equity method. The corporation's shares of the partnership's losses accounted for under the equity method were $6,603,000 in 1991 and $2,857,000 for the first six months of 1992. Had the financial results been consolidated throughout 1992 or 1991, the effect on the corporation's financial statements would not have been material. On Command Video In 1991, the corporation acquired a 47% interest in On Command Video Corporation (OCV), a California-based company that developed and markets a proprietary video entertainment system to hotels. The corporation purchased additional shares of OCV stock throughout 1992 and 1993. OCV's financial statements have been consolidated since the third quarter of 1992, when the corporation's ownership increased to 50.4%. The corporation's ownership share was 65.7% at December 31, 1992 and 73.5% at December 31, 1993. Had the financial results been consolidated throughout 1992 or 1991, the effect on the corporation's financial statements would not have been material. The total cost of the corporation's investment in OCV was $77,282,000 as of December 31, 1993. Rock Spring II Limited Partnership The corporation entered into a limited partnership to build and lease a new headquarters facility. The corporation holds a 50% interest in the partnership, primarily as a limited partner. The managing general partner, a regional real estate investment company, owns the remaining 50% interest in the partnership. An affiliate of the managing general partner owns the building site and has leased this site to the partnership. The corporation relocated its headquarters operations to the new building during the second quarter of 1993. The corporation has entered into a 15-year lease with the partnership for the building starting April 1993 (see Note 6). The partnership borrowed $27,000,000 in the form of a 26-year mortgage at a fixed interest rate of 9.45% to cover construction costs. As of December 31, 1993, the corporation has guaranteed repayment of this loan. The corporation's guarantee will be reduced to $2,700,000 after satisfaction of certain contractual requirements which are expected to be completed in 1994. Subsequently, the corporation's guarantee will be reduced as the principal balance is paid down and completely eliminated once the outstanding loan balance is less than $24,300,000. 5. DEBT The corporation, as regulated by the Federal Communications Commission (FCC), is allowed to undertake long-term borrowings of up to 45% of its total capital (long-term debt plus equity) and $200,000,000 in short-term borrowings. Commercial Paper The corporation has a $125,000,000 commercial paper program. Throughout 1993, 1992 and 1991, the corporation issued short-term commercial paper with repayment terms of 90 days or less. The corporation had $43,233,000 and $47,795,000 in borrowings outstanding at December 31, 1993 and December 31, 1992, respectively. There were no short-term borrowings outstanding at December 31, 1991. Credit Facilities The corporation has a $200,000,000 revolving credit agreement which will expire in December 1998. There have been no borrowings under this agreement. Long-Term Debt Long-term debt at each year-end consists of: The corporation redeemed its 11.625% debentures ($92,935,000) in March 1992, using cash on hand and commercial paper proceeds. In April 1992, the corporation issued $160,000,000 of 8.125% debentures due April 1, 2004. The corporation used $110,000,000 of the proceeds to redeem its 7.75% convertible subordinated debentures in April 1992. The balance of the proceeds was used to repay outstanding commercial paper borrowings. In August 1992, INTELSAT issued $200,000,000 of 7.375% Eurobonds. Interest is payable annually in August, and the bonds are due August 6, 2002. The corporation received its share of the proceeds and recorded long-term debt totalling $43,685,000. In January 1993, INTELSAT issued $150,000,000 of 6.75% Eurobonds. Interest is payable annually in January, and the notes are due January 19, 2000. The corporation received its share of the proceeds and recorded long-term debt. The corporation's share of this debt at December 31, 1993 was $31,344,000. The corporation prepaid $30,000,000 of its 9.55% notes with the proceeds. The remaining $70,000,000 balance of the 9.55% notes is due in April 1994 and has been classified as a current liability on the December 31, 1993 balance sheet. The principal amount of debt (excluding the Inmarsat lease financing obligation) maturing over the next five years is $71,204,000 in 1994, $817,000 in 1995, $208,000 in 1996 and none in 1997 or 1998. Inmarsat Lease Financing Obligations Inmarsat borrowed 140,400,000 pounds sterling under a capital lease agreement to finance the construction of second- generation Inmarsat satellites. Inmarsat also entered into another capital lease arrangement to finance the construction costs of its third-generation satellites. As of December 31, 1993, 65,500,000 pounds sterling of the 197,000,000 pounds sterling available for this purpose has been borrowed. The corporation's share of these lease obligations is included in long-term debt. Inmarsat has hedged its obligations through various foreign exchange transactions to minimize the effect of fluctuating interest and exchange rates (see Note 14). The corporation's share of the payments under these lease obligations for each of the next five years from 1994 through 1998 is $9,166,000, $11,486,000, $12,490,000, $13,637,000 and $14,895,000 and $87,451,000 thereafter. These payments include interest totalling $50,466,000 and current maturities of $3,700,000. 6. COMMITMENTS AND CONTINGENCIES Property and Equipment As of December 31, 1993, the corporation had commitments to acquire property and equipment totalling $379,649,000. Of this total, $353,371,000 is payable over the next three years. These commitments are related principally to the purchase of INTELSAT and Inmarsat satellites. Employment and Consulting Agreements The Nuggets have employment and consulting agreements with certain officers, coaches and players. Virtually all of these agreements provide for guaranteed payments. Other contracts provide for payments contingent upon the fulfillment of certain terms and conditions. Amounts required to be paid under such agreements total $17,682,000 in 1994, $17,906,000 in 1995, $18,243,000 in 1996, $14,158,000 in 1997, $10,484,000 in 1998 and $4,536,000 thereafter. Leases As discussed in Note 4, the corporation has a 15-year lease which started April 1993 on its new headquarters building in Bethesda, Maryland, and the corporation has a ten-year lease ending in 1996 on its former headquarters building in Washington, D.C. The corporation also has leases of other property and equipment. Annual rent expense was $6,600,000 in 1993, $3,000,000 in 1992 and $2,900,000 in 1991. These amounts are net of the $3,921,000 annual amortization of the deferred gain from the sale and leaseback of the Washington, D.C. building in 1986. Annual rental income from noncancelable subleases totals approximately $3,800,000. The corporation's payments under all operating leases for 1994 through 1998 are $12,747,000, $12,418,000, $11,877,000, $5,186,000, $5,259,000 and thereafter, $45,697,000. Environmental Issue The corporation is engaged in a program to monitor a toxic solvent spill of limited scope that occurred in 1986 at the site of its former manufacturing subsidiary in California. The corporation believes that it has complied with remediation requirements. Management believes that the corporation has sufficient accruals to cover the monitoring costs. 7. REGULATORY ENVIRONMENT AND LITIGATION Regulatory Environment Under the Communications Act of 1934 and the Satellite Act, the corporation is subject to regulation by the FCC with respect to communications services provided through the INTELSAT and Inmarsat systems and the rates charged for those services. In 1993, the FCC initiated an audit of the corporation's role as the United States signatory to Inmarsat and as a provider of international mobile satellite services. In the opinion of management, the ultimate outcome of the audit will not have a material effect on the accompanying financial statements. Until 1985, the corporation was, with minor exceptions, the sole United States provider of international satellite communications services using the INTELSAT system. Since then, the FCC has authorized several international satellite systems separate from INTELSAT. These U.S. separate systems currently compete against the corporation for voice, video and data traffic. In 1993, the FCC substantially eliminated prior restrictions on the ability of separate systems to offer public switched telephony services, thereby potentially increasing competition to the corporation in the voice market. The United States government has established a goal to eliminate all restrictions on competitive systems by 1997. Litigation In 1989, Pan American Satellite (PanAmSat) filed an antitrust suit against the corporation alleging interference with PanAmSat's efforts to compete in the international satellite communications market and seeking trebled damages of approximately $1.5 billion. In 1991, a United States Court of Appeals ruled that the corporation is immune from antitrust suits in its role as a signatory to INTELSAT. In February 1992, the United States Supreme Court denied PanAmSat's request for a review of the lower court's decision. An amended complaint was filed alleging that the corporation violated antitrust laws in its business activities purportedly outside of its role as a signatory to INTELSAT. In March 1993, a Federal district court denied the corporation's motion to dismiss the amended complaint and allowed PanAmSat to proceed with discovery. A U.S. magistrate has extended the discovery process from November 1993 to June 1994. In February 1994, PanAmSat submitted a report estimating its alleged damages (before trebling) at a 1994 present value of $227,436,000. Also in February 1994, PanAmSat filed a motion with the district court for acceptance of a third amended and supplemental complaint that would add 15 new defendants to the suit, primarily as alleged co-conspirators with the corporation. Generally, the 15 proposed defendants are international telecommunications companies or telecommunications entities owned by foreign governments. The corporation has opposed the motion which is pending before the court. In the opinion of management, the complaint against the corporation is without merit, and the ultimate disposition of this matter will not have a material effect on the corporation's financial statements. The corporation is defending an intellectual property infringement suit brought by Spectradyne, Inc. against its COMSAT Video Enterprises, Inc. and On Command Video Corporation subsidiaries. The initial patent claims were dismissed. However, Spectradyne amended its complaint to substitute new patent infringement claims along with claims that the corporation's subsidiaries induced unnamed third parties to infringe a copyrighted software interface. Subsequently, Spectradyne further amended its complaint by substituting direct copyright infringement claims for the inducement to infringe claims. Spectradyne is seeking damages in an unspecified amount and injunctive relief. The corporation believes that these claims are without merit and that the ultimate disposition of this matter will not have a material effect on the corporation's financial statements. 8. STOCKHOLDERS' EQUITY Effective June 1, 1993, the corporation's Articles of Incorporation were amended to increase the number of authorized shares of the corporation's common stock from 40,000,000 shares to 100,000,000 shares and to split each share of common stock outstanding on June 1, 1993 into two shares of common stock. Earnings per share and share amounts for all prior periods have been restated to reflect this stock split. The corporation's Articles of Incorporation were also amended to increase the number of authorized shares of the corporation's preferred stock from 1,000 shares to 5,000,000 shares and to permit preferred stock to be convertible into any other class of stock. No preferred stock is currently outstanding. 9. INCENTIVE STOCK PLANS The corporation has stock plans for officers, directors and employees. These plans provide for the issuance of restricted stock awards, stock appreciation rights, restricted stock units and stock options. Under the current plans, grants for up to 5,550,000 shares may be made. As of December 31, 1993, 5,589,000 shares of the corporation's authorized common stock were reserved for these plans. As of December 31, 1993, no stock appreciation rights were outstanding. Restricted Stock Awards Restricted stock awards are shares of stock that are subject to restrictions on their sale or transfer. These restrictions are lifted over six years. During 1993, 1992 and 1991, respectively, 348,000, 68,000 and 134,000 restricted stock awards were granted, net of awards forfeited. Restricted Stock Units Restricted stock units entitle the holder to receive a combination of stock and cash equal to the market price of common stock for each unit, when vested. These units vest over three years. During 1993, 1992 and 1991, respectively, 49,000, 42,000 and 56,000 restricted stock units were granted. At December 31, 1993, 124,000 partially vested restricted stock units were outstanding. Stock Options Under the current plans, the exercise price for stock options may not be less than 50% of the fair market value of the stock when granted. Options vest over three years and expire after 15 years. Stock option activity was as follows: The corporation is recognizing an expense over three years equal to the exercise price of the 1991 and 1992 options, since they were granted at 50% of the market price. The exercise price for options awarded in 1993 is equal to the fair market value on the grant date. Employee Stock Purchase Plan Employees may purchase stock at a discount through the corporation's Employee Stock Purchase Plan. The purchase price of the shares is the lower of 85% of the fair market value of the stock on the offering date, or 85% of the fair market value of the stock on the last business day of each month throughout the following year. The offering date for 1994 purchases was November 19, 1993, when 85% of the fair market value was $25.87. A total of 2,426,000 shares of the corporation's unissued common stock has been reserved for this plan. 10. PENSION AND OTHER BENEFIT PLANS The corporation has a non-contributory, defined benefit pension plan which covers substantially all of its employees. Pension benefits are based on years of service and compensation prior to retirement. The corporation's funding policy is to make the contributions when required by law. The net pension expense for each year includes the following components: In September 1992, the corporation offered an early retirement program to certain employees in connection with its restructuring of certain operations (see Note 12). This program provided enhanced retirement benefits and an option for a lump sum payment of all benefits. The additional pension expense for this program was $6,582,000 and is included in the provision for restructuring in the accompanying income statement. The following table shows the pension plan's obligations and assets as well as the amount recognized in the corporation's balance sheets at each year end. The corporation made a $4,100,000 cash contribution to the plan in 1993. No contributions were required in 1992 and 1991. Supplemental Executive Retirement Plan The corporation has an unfunded supplemental pension plan for executives. The expense for this plan was $2,058,000, $1,917,000 and $4,243,000 for 1993, 1992 and 1991, respectively. As of December 31, 1993, the corporation recorded an additional minimum liability of $5,740,000 for this plan. This amount is the excess of the accumulated benefit obligation over the previously recorded plan liability. The corporation also recorded an intangible asset of $2,128,000 which represents the unrecognized transition obligation and a charge of stockholders equity of $2,301,000, net of tax. The corporation's accrued liabilities for this plan were $15,679,000, $10,661,000 and $9,814,000 at December 31, 1993, 1992 and 1991, respectively. As of December 31, 1993, the accumulated benefit obligation was approximately $15,679,000, and the projected benefit obligation was approximately $16,449,000, assuming a discount rate of 7% and future salary increases of 5%. 401(k) Plan The corporation has a 401(k) plan for qualifying employees. A portion of employee contributions is matched by the corporation. The corporation's matching contributions for the years ended December 31, 1993, 1992 and 1991 were $3,237,000, $2,860,000 and $2,585,000, respectively. Postretirement Benefits The corporation provides health and life insurance benefits to employees and retirees. Effective January 1, 1991, the corporation adopted the provisions of SFAS No. 106, which requires that the expected cost of these benefits be recognized during the years in which employees render service. Prior to 1991, the cost of such benefits was expensed as paid by the corporation. The corporation recognized the full obligation attributable to the cost of prior years' service in 1991. The cumulative effect to January 1, 1991 was $40,314,000, less taxes of $13,707,000, and is shown separately in the 1991 income statement. The net postretirement benefit expense for each year included the following components: The early retirement program discussed earlier in this note resulted in an additional postretirement benefit expense of $2,107,000 in 1992. The following table shows the plan's obligations as well as the liability recognized in the corporation's balance sheet at each year end. In 1993, the corporation made several modifications to its postretirement benefits program including higher participant premium payments, higher deductibles and out-of-pocket maximums and reduced benefits for certain participants. Additionally, the corporation implemented a managed health care program to better control costs. These changes, which are effective January 1, 1994, resulted in a reduction in the accumulated postretirement benefit obligation and an unrecognized gain of $12,873,000 as of December 31, 1993. An 11% increase in health care costs was assumed for 1993 with the rate decreasing 0.5% each year to an ultimate rate of 6%. Increasing the assumed trend rate by 1% each year would have increased the accumulated postretirement benefit obligation as of December 31, 1993 by $6,115,000 and the benefit expense for 1993 by $900,000. 11. INCOME TAXES The corporation adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993. This accounting statement changed the method for the recognition and measurement of deferred tax assets and liabilities. The cumulative effect of adopting SFAS No. 109 on the corporation's financial statements was to increase income by $1,238,000 ($.03 per share) and was recorded in the first quarter of 1993. Prior year financial statements have not been restated. The components of income tax expense for each year are: The difference between tax expense computed at the statutory Federal tax rate and the corporation's effective tax rate is: SFAS No. 109 requires that deferred tax liabilities and assets be adjusted for the effect of a change in tax laws or rates. Accordingly, the corporation recorded a charge to income tax expense of $2,977,000 in the third quarter of 1993 to adjust prior years' deferred tax assets and liabilities for an increase in the Federal income tax rate from 34% to 35%. The net current and net non-current components of deferred tax accounts as shown on the balance sheet at December 31, 1993 are: The deferred tax assets and liabilities at December 31, 1993 are: The corporation s investment tax credit carryforwards expire in years 2002 through 2007. The Internal Revenue Service (IRS) is currently examining Federal income tax returns for 1990 and 1991 and has completed examinations of the Federal income tax returns of the corporation through 1989. The corporation has also amended its returns and filed claims for refunds for 1979 through 1987. The IRS has denied these claims. The corporation is contesting this denial by the IRS and other adjustments proposed by the IRS on the 1980 through 1987 income tax returns. In the opinion of the corporation, adequate provision has been made for income taxes for all periods through 1993. 12. PROVISION FOR RESTRUCTURING In September 1992, the corporation recorded a $38,961,000 charge for restructuring costs. At that time, the corporation announced its plans to realign business activities, downsize certain functions, and reposition COMSAT Video Enterprises, Inc. to capitalize on the growing market for on-demand entertainment. The restructuring costs relate to headcount reductions throughout the corporation and the elimination of the former COMSAT Systems Division and the consolidation of its operations with those of COMSAT Laboratories into a new division, COMSAT Technology Services, as well as the transfer of television distribution services from COMSAT Systems Division to CVE. This charge consists of $12,644,000 for early retirement and reduction in force costs related to the reorganization, and $26,317,000 for equipment, property and other items. 13. BUSINESS SEGMENT INFORMATION The corporation reports operating results and financial data in four business segments: International Communications, Mobile Communications, Video Enterprises and Technology Services. The International Communications segment consists of activities undertaken by the corporation in its COMSAT World Systems business, including INTELSAT services. This segment also includes the activities of the corporation's international ventures, which are accounted for as consolidated subsidiaries. The Mobile Communications segment consists of activities undertaken by the corporation in its COMSAT Mobile Communications (CMC) business, including Inmarsat services. The Video Enterprises segment includes entertainment services provided to the hospitality industry as well as video distribution services to television networks. The Technology Services segment includes voice and data communications networks and products, systems integration services, and applied research and technology services. The financial results of the Denver Nuggets Limited Partnership are included in Other Corporate activities. The corporation has redefined its reporting segments. Prior to 1993, CMC was included in the International Communications segment. In the first quarter of 1993, the operations of the corporation's earth stations in Connecticut and California were transferred from the Technology Services segment to the Mobile Communications segment. As discussed in Note 12, business activities within the Technology Services and Video Enterprises segments were realigned in 1992. The financial results presented below for prior periods have been restated consistent with these changes. (1) Technology Services segment revenues include intersegment sales totalling $10,132,000 in 1993, $19,500,000 in 1992 and $29,780,000 in 1991. (2) Operating results for 1992 are net of the $38,961,000 provision for restructuring (see Note 12). The amounts recorded in each segment were International Communications - $6,955,000; Mobile Communications - $3,332,000; Video Enterprises - $14,146,000; Technology Services - $10,240,000; and Other Corporate - $4,288,000. (3) The identifiable assets of the Video Enterprises segment include the corporation's equity investment in On Command Video Corporation totalling $13,655,000 at December 31, 1991. Related Party Transactions and Significant Customers The corporation provides support services to INTELSAT and support services and satellite capacity to Inmarsat. The revenues from these services were $23,190,000 in 1993, $21,477,000 in 1992 and $24,000,000 in 1991. These revenues were recorded primarily in the International Communications and Technology Services segments. A significant amount of the corporation's revenues were received from AT&T. These revenues totalled $117,036,000 in 1993, $134,293,000 in 1992 and $148,525,000 in 1991. Substantially all of these revenues were generated by the International Communications and Mobile Communications segments. 14. FINANCIAL INSTRUMENTS AND OFF BALANCE SHEET RISKS SFAS No. 107, which became effective in 1992, requires disclosures about the fair value of financial instruments. In these disclosures, fair values are estimates and do not necessarily represent the amounts that would be received or paid in an actual sale or settlement of the financial instruments. At December 31, 1993, the corporation was contingently liable to banks for $8,533,000 for outstanding letters of credit securing performance of certain contracts. As discussed in Note 4, the corporation has guaranteed repayment of the construction loan related to its headquarters building. The corporation has other financial guarantees totalling approximately $3,000,000 as of December 31, 1993. The estimated fair value of these instruments is not significant. Inmarsat has entered into foreign currency contracts designed to minimize exposure to exchange rate fluctuations on foreign currency transactions. At December 31, 1993, Inmarsat had several contracts maturing in 1994 to purchase 12,500,000 pounds sterling for a total of $18,392,000. The corporation's share of the estimated fair value of these contracts, as determined by a bank, is an unrealized gain of approximately $13,000 at December 31, 1993. Inmarsat has entered into interest rate and foreign currency swap arrangements to minimize the exposure to interest rate and foreign currency exchange fluctuations related to its satellite financing obligations. Inmarsat borrowed and is obligated to repay pounds sterling. The pounds sterling borrowed were swapped for U.S. dollars with an agreement to exchange the dollars for pounds sterling in order to meet the future lease payments. Inmarsat pays interest on the dollars at an average fixed rate of 9.0% and it receives variable interest on the sterling amounts based on short- term rates. The differential to be paid or received is accrued as interest rates change and is recognized over the life of the agreements. The currency swap arrangements have been designated as hedges, and any gains or losses are included in the measurement of the debt. The effect of these swaps is to change the sterling lease obligation into fixed interest rate dollar debt. As of December 31, 1993, Inmarsat had $352,327,000 of swaps to be exchanged for 211,400,000 pounds sterling at various dates through 2005. Inmarsat is exposed to loss if one or more of the counterparties defaults. However, Inmarsat does not anticipate non-performance by the counterparties as they are major financial institutions. The corporation's share of the estimated fair value of these swaps is an unrealized loss of $18,500,000 at December 31, 1993. The fair value was estimated by computing the present value of the dollar obligations using current rates available for issuance of debt with similar terms, and the current value of the sterling at year-end exchange rates. The fair value of long-term debt (excluding capitalized leases) was estimated by computing present values of the related cash flows using risk adjustments to Treasury rates obtained from investment bankers. The fair values of the corporation's other financial instruments are approximately equal to their carrying values. 15. SUBSEQUENT EVENTS Merger Agreement In January 1994, the corporation entered into a definitive merger agreement for the acquisition of Radiation Systems, Inc. (RSi), based in Sterling, Virginia. RSi designs, manufactures and integrates satellite earth stations, advanced antennas and other turnkey systems for telecommunications, radar, air traffic control and military uses. Following the merger, the corporation expects to combine its existing systems integration business, COMSAT Technology Services, with RSi. Under the merger agreement, RSi will be merged into a wholly owned subsidiary of the corporation, and each share of RSi's common stock will be exchanged for $18.25 in the corporation's common stock, based on the average closing price of the corporation's stock during the 20 trading days ending five trading days before the closing of the transaction. However, in no event will a share of RSi common stock be exchanged for less than 0.638 or more than 0.780 shares of the corporation's common stock. RSi has approximately eight million shares outstanding. During 1993, the corporation purchased 404,500 shares of RSi on the open market for $5,098,000. The corporation's ownership represented 4.9% of RSi stock with a market value of $6,042,000 at December 31, 1993. The merger is subject to the approval of RSi's shareholders, receipt of all required government approvals and compliance with other customary conditions. RSi shareholders are expected to vote on the merger during the second quarter of 1994. It is a condition of the merger that it be treated as a pooling of interests for accounting purposes. The merger is expected to be completed in 1994. In February 1994, two shareholder class-action lawsuits were filed in Nevada state court challenging the merger. Plaintiffs in the lawsuits allege, among other things, that the proposed merger consideration is unfair and inadequate. The lawsuits seek, among other things, to enjoin the merger and, in the event the merger is consummated, to recover damages. Management believes that the lawsuits are without merit and that the ultimate disposition of these matters will not have a material effect on the merger or on the corporation's financial statements. Debt INTELSAT intends to issue $200 million of bonds in the first quarter of 1994. INTELSAT will use the proceeds to repay its short-term borrowings. The corporation will record its share of the borrowings as long-term debt of approximately $42 million when the bonds are issued. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure. None. PART III Except for the portion of Item 10 Item 10. Directors and 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. 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. Consolidated Financial Statements and Supplementary Data of Registrant. Page a. Independent Auditors' Report . . . . . . . . . . . . . . . . 34 b. Consolidated Financial Statements of COMSAT Corporation and Subsidiaries (i) Consolidated Income Statements for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . 35 (ii)Consolidated Balance Sheets as of December 31 1993, 1992 and 1991. . . . . . . . . . . . . . . . . . . 36 (iv)Consolidated Cash Flow Statements for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . 37 (v) Statements of Changes in Consolidated Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . . . 38 (vi)Notes to Consolidated Financial Statements for Each of the Three Years in the Period Ended December 31, 1993. . . . . . . . . . . . . . . . . . .39-60 2. Financial Statement Schedules Relating to the Consolidated Financial Statements of COMSAT Corporation for Each of the Three Years in the Period Ended December 31, 1993. Page a. Independent Auditors' Report . . . . . . . . . . . . . . . . 34 b. Schedule II -- Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties. . . . . . . . . . . . . . . . . . . . . . . . . . . 73 c. Schedule V -- Property, Plant and Equipment. . . . . . . . . 74 d. Schedule VI -- Accumulated Depreciation of Property, Plant and Equipment. . . . . . . . . . . . . . . . . . . . . . . . 76 e. Schedule VIII -- Valuation and Qualifying Accounts . . . . . 78 f. Schedule IX -- Short-Term Borrowings . . . . . . . . . . . . 79 g. Schedule X -- Supplementary Income Statement Information . . 79 All Schedules except those listed above have been omitted because they are not applicable or not required or because the required information is included elsewhere in the financial statements in this filing. Separate financial statements and schedules of COMSAT Corporation are omitted because the Corporation is primarily an operating corporation and all subsidiaries included in the consolidated financial statements, in the aggregate, do not have minority equity interests and indebtedness to any person other than the Corporation and its consolidated subsidiaries in amounts which together exceed 5 percent of the total assets shown by the consolidated statements in this filing. (b) Reports on Form 8-K. A report on Form 8-K dated January 31, 1994 was filed by the Registrant to file the press release reporting the Registrant's entering into a definitive merger agreement for the acquisition of Radiation Systems, Inc. A report on Form 8-K dated March 7, 1994 was filed by the Registrant to file the press release reporting purported class action shareholder lawsuits which were filed in Nevada to challenge the Registrant's acquisition of Radiation Systems, Inc. A report on Form 8-K dated March 11, 1994 was filed by the Registrant to file the Registrant's 1993 Financial Statements. (c) Exhibits (listed according to the number assigned in the table in Item 601 of Regulation S-K). Exhibit No. 2 - Plan of Acquisition, Reorganization, Arrangement, Liquidation or Succession. a. Agreement and Plan of Merger among Registrant, CTS America, Inc. and Radiation Systems, Inc. dated as of January 30, 1994. b. Stock Option Agreement between Registrant and Radiation Systems, Inc. dated as of January 30, 1994. Exhibit No. 3 - Articles of Incorporation and By-laws. a. Articles of Incorporation of Registrant, composite copy, as amended through June 1, 1993. (Incorporated by reference from Exhibit No. 4(a) to Registrant's Registration Statement on Form S-3 (No. 33-51661) filed on December 22, 1993). b. By-laws of Registrant, as amended through March 15, 1991. (Incorporated by reference from Exhibit No. 3(b) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1991.) c. Regulations adopted by Registrant's Board of Directors pursuant to Section 5.02(c) of Registrant's Articles of Incorporation. (Incorporated by reference from Exhibit No. 3(c) to Registrant's Report on Form 10-K for the fiscal year ended 1992.) Exhibit No. 4 - Instruments defining the rights of security holders, including indentures. a. Specimen of a certificate representing Series I shares of Registrant's Common Stock, without par value, registered under Section 12 of the Securities Exchange Act of 1934, which are held by citizens of the United States. b. Specimen of a certificate representing Series I shares of Registrant's Common Stock, without par value, registered under Section 12 of the Securities Exchange Act of 1934, which are held by aliens. (Incorporated by reference from Exhibit No. 4(b) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1982.) c. Specimen of a certificate representing Series II shares of Registrant's Common Stock, without par value, registered under Section 12 of the Securities Exchange Act of 1934. (Incorporated by reference from Exhibit No. 4(c) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1982.) d. Indenture dated as of August 1, 1988 between Registrant and The Chase Manhattan Bank, N.A. (Incorporated by reference from Exhibit No. 4 to Registrant's Report on Form 10-Q for the quarter ended June 30, 1988.) e. Standard Multiple-Series Indenture Provisions, dated March 15, 1991. (Incorporated by reference from Exhibit No. 4(a) to Registrant's Registration Statement on Form S-3 (No. 33-39472) filed on March 15, 1991.) f. Indenture dated as of March 15, 1991 between Registrant and The Chase Manhattan Bank, N.A. (Incorporated by reference from Exhibit No. 4(b) to Registrant's Registration Statement on Form S-3 (No. 33-39472) filed on March 15, 1991.) g. Officers' Certificate pursuant to Section 3.01 of the Indenture, dated as of March 15, 1991, from the Registrant to the Chase Manhattan Bank (National Association), as Trustee, relating to the authorization of $75,000,000 aggregate principal amount of Registrant's 8.95% Notes Due 2001 (with form of Note attached). (Incorporated by reference from Exhibit No. 4 to Registrant's Current Report on Form 8-K filed on May 15, 1991.) h. Officers' Certificate pursuant to Section 3.01 of the Indenture, dated as of March 15, 1991, from the Registrant to the Chase Manhattan Bank (National Association), as Trustee, relating to the authorization of $160,000,000 aggregate principal amount of Registrant's 8.125% Debentures Due 2004 (with form of Debenture attached). (Incorporated by reference from Exhibit No. 4 to Registrant's Current Report on Form 8-K filed on April 9, 1992.) Exhibit No. 10 - Material Contracts a. Agreement Relating to the International Telecommunications Satellite Organization (INTELSAT) by Governments, which entered into force on February 12, 1973. (Incorporated by reference from Exhibit No. 10(a) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1980.) b. Operating Agreement Relating to the International Telecommunications Satellite Organization (INTELSAT) by Governments which entered into force on February 12, 1973. (Incorporated by reference from Exhibit No. 10(b) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1980.) c. Agreement dated August 15, 1975, among COMSAT General Corporation, RCA Global Communications, Inc., Western Union International, Inc. and ITT World Communications, Inc. relating to the establishment of a joint venture for the purpose of participating in the ownership and operation of a maritime communications satellite system and Amendment Nos. 1-4 and Amendment No. 5 dated March 24, 1980. (Incorporated by reference from Exhibit No. 10(p) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1980.) (i) Amendment No. 6 dated September 1, 1981. (Incorporated by reference from Exhibit No. 10(p)(ii) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1981.) d. Convention on the International Maritime Satellite Organization (INMARSAT) dated September 3, 1976. (Incorporated by reference from Exhibit No. 11 to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1978.) e. Operating Agreement on the International Maritime Satellite Organization (INMARSAT) dated September 3, 1976. (Incorporated by reference from Exhibit No. 12 to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1978.) f.* Registrant's 1982 Stock Option Plan. (Incorporated by reference from Exhibit No. 10(x) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1981.) g. Agreement dated October 6, 1983, between COMSAT General Corporation and National Broadcasting Company for the provision of satellite distribution network programming. (Incorporated by reference from Exhibit No. 10(r) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1983.) (i) Amendment dated September 1, 1992. (Incorporated by reference from Exhibit No. 10(j)(i) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1992.) h.* Registrant's Insurance and Retirement Plan for Executives adopted by Registrant's Board of Directors on June 21, 1985, as amended by the Board of Directors on July 15, 1993. i.* Registrant's 1986 Key Employee Stock Plan. (Incorporated by reference from Exhibit No. 10(g) to Registrant's Registration Statement on Form S-4 (File No. 33-9966) filed on November 4, 1986.) j. Lease dated November 6, 1986, between Registrant and VMS 1985-299 Limited Partnership for the lease of Registrant's former headquarters at 950 L'Enfant Plaza, S.W., Washington, D.C. (Incorporated by reference from Exhibit No. 10(kk) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1986.) k.* Registrant's Non-Employee Directors Stock Option Plan adopted by Registrant's Board of Directors on January 15, 1988 and approved by Registrant's shareholders on May 20, 1988. (Incorporated by reference from Exhibit No. 10(h) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1987.) (i) Amendment No. 1 dated March 16, 1990. (Incorporated by reference from Exhibit No. 10 (g)(i) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) (ii) Amendment No. 2 dated January 15, 1993. l.* Registrant's 1988 Annual Incentive Plan adopted by Registrant's Board of Directors on June 17, 1988, as amended by the Board of Directors on September 16, 1988. (Incorporated by Reference from Exhibit No. 3(a) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1988.) m. Memorandum of Understanding between Registrant and National Aeronautics and Space Administration (NASA), dated July 21, 1988 and amended through February 22, 1990. (Incorporated by reference from Exhibit No. 10(aa) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) n. Agreement to Acquire and Lease (and Supplemental Agreements thereto) dated September 28 and October 10, 1988, respectively, among the International Maritime Satellite Organization (Inmarsat), the North Sea Marine Leasing Company, British Aerospace Public Limited Company, the European Investment Bank, Kreditanstalt Fuer Wiederaufbau, European Investment Bank (as Agent and as Trustee), Instituto Mobiliare Italiano, Credit National, Hellenic Industrial Development Bank, and Society Nationale de Credit a L'Industrie relating to the financing of three Inmarsat spacecraft. (Incorporated by Reference from Exhibit No. 3(a) to Registrant's Report on Form 10-k for the fiscal year ended December 31, 1988.) o. Service Agreement, dated September 14, 1989, between Registrant and Aeronautical Radio, Inc. relating to satellite-based communications services. (Incorporated by reference from Exhibit No. 10(y) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) p. Second Amended and Restated Agreement of Limited Partnership of The Denver Nuggets Limited Partnership, dated November 29, 1989. (Incorporated by reference from Exhibit No. 10(x) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) (i) Asset Purchase Agreement, dated October 20, 1989, between Denver Nuggets, Incorporated and Denver Nuggets Limited Partnership, and First Amendment to Asset Purchase Agreement, dated November 30, 1989. (Incorporated by reference from Exhibit No. 10(x)(i) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) q. Agreement, dated January 22, 1990, between Registrant and Kokusai Denshin Denwa Co., Ltd. for provision of aeronautical services. (Incorporated by reference from Exhibit No. 10(z) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1990.) (i) Amendment No. 1 dated May 20, 1993. r.* Registrant's 1990 Key Employee Stock Plan adopted by the Board of Directors on March 16, 1990. (Incorporated by reference from Exhibit No. 10 (p) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) (i) Amendment No. 1 dated January 15, 1993. s. Agreement, dated May 25, 1990, between Registrant and IDB Communications Group, Inc. (Incorporated by reference from Exhibit No. 10(bb) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1990.) t. Amended and Restated Agreement, dated November 14, 1990, of Limited Partnership of Rock Spring II Limited Partnership. (Incorporated by reference from Exhibit No. 10(a) to Registrant's Current Report on Form 8-K filed on February 24, 1992.) (i) Amended and Restated Lease Agreement, dated November 14, 1990, by and between Rock Spring II Limited Partnership and Registrant. (Incorporated by reference from Exhibit No. 10(b) to Registrant's Current Report on Form 8-K filed on February 24, 1992.) (ii) Amended and Restated Ground Lease Indenture, dated November 14, 1990, between Anne D. Camalier (Landlord) and Rock Spring II Limited Partnership (Tenant). (Incorporated by reference from Exhibit No. 10(c) to Registrant's Current Report on Form 8-K filed on February 24, 1992.) u. Finance Facility Contract (and Supplemental Agreements thereto), dated December 20, 1991, among the International Maritime Satellite Organization (Inmarsat), Abbey National plc, General Electric Technical Services Company, Inc., European Investment Bank, Kreditanstalt Fuer Wiederaufbau, Instituto Mobiliare Italiano S.p.A., Credit National, Societe Nationale de Credit a L'Industrie, Finansieringsinstituttet for Industri OG Haandvaerk A/S, De Nationale Investeringsbank NV, and Osterreichische Investitionkredit Aktiengesellschaft relating to the financing of three Inmarsat spacecraft. (Incorporated by reference from Exhibit No. 10 (dd) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1991.) v.* Registrant's Directors and Executives Deferred Compensation Plan, as amended by the Board of Directors on July 15, 1993. w. Service Agreement, dated April 2, 1992, between Registrant and GTE Airfone, Incorporated, for the provision of aeronautical satellite services. (Incorporated by reference from Exhibit No. 10(r) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1990.) x. Fiscal Agency Agreement, dated as of August 6, 1992, between International Telecommunications Satellite Organization and Morgan Guaranty Trust Company of New York. (Incorporated by reference from Exhibit No. 10 (dd) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1992.) y. Agreement dated as of January 18, 1993 between the government of Cote d'Ivoire and Registrant to provide a national television and radio distribution system. (i) Amendment No. 1 dated January 1994. z. Fiscal Agency Agreement, dated as of January 19, 1993, between International Telecommunications Satellite Organization and Morgan Guaranty Trust Company of New York. (Incorporated by reference from Exhibit No. 10 (ee) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1992.) aa. Lease Agreement, dated June 8, 1993, between GTE Airfone, Incorporated, United Airlines, Inc. and Registrant for the provision and financing of aeronautical satellite equipment. bb. Agreement dated July 1, 1993, between Registrant and AT&T Easylink Services relating to exchange of telex traffic. cc. Agreement dated July 27, 1993, between the Registrant and American Telephone & Telegraph Company relating to utilization of space segment. dd. Agreement dated September 1, 1993, between Registrant and MCI International, Inc. relating to exchange of traffic. ee. Agreement dated November 30, 1993, between the Registrant and Sprint Communications Company L.P. relating to utilization of space segment. ff. Agreement dated December 10, 1993, between Registrant and Sprint International relating to the exchange of traffic. gg. Credit Agreement dated as of December 17, 1993 among Registrant, NationsBank of North Carolina, N.A., Bank of America National Trust and Savings Association, The First National Bank of Chicago, The Chase Manhattan Bank, N.A., The Sumitomo Bank, Limited, New York Branch, Swiss Bank Corporation, New York Branch, as lenders, and NationsBank of North Carolina, N.A., as agent. hh. Schedule of Commitments between Registrant and INTELSAT, as of December 31, 1993, relating to FM, digital bearer, International Business Service and video traffic. ii. Agreement dated January 24, 1994, between MCI International, Inc. and Registrant relating to utilization of space segment. jj. Agreement dated February 18, 1994, between Registrant and AT&T relating to exchange of traffic. kk. Fiscal Agency Agreement between International Telecommunications Satellite Organization, Issuer, and Bankers Trust Company, Fiscal Agent and Principal Paying Agent, dated as of 22 March 1994. *Compensatory plan or arrangement. Exhibit No. 11 - Statement re computation of per share earnings. Exhibit No. 22 - Subsidiaries of the Registrant as of March 31, 1994. Exhibit No. 24 - Consents of experts and counsel. Consent of Independent Auditors dated March 29, 1994. Exhibit No. 27 - Financial Data Schedule. 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. COMSAT CORPORATION (Registrant) Date: March 31, 1994 By /s/ BRUCE L. CROCKETT -------------------------------------- (Bruce L. Crockett, President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by each of the following persons on behalf of the Registrant and in the capacity and on the date indicated. (1) Principal executive officer Date: March 31, 1994 By /s/ BRUCE L. CROCKETT -------------------------------------- (Bruce L. Crockett, President and Chief Executive Officer) (2) Principal financial officer Date: March 31, 1994 By /s/ C. THOMAS FAULDERS, III ------------------------------------- (C. Thomas Faulders, III, Vice President and Chief Financial Officer) (3) Principal accounting officer Date: March 31, 1994 By /s/ ALLEN E. FLOWER ------------------------------------- (Allen E. Flower, Controller) (4) Board of Directors Date: March 31, 1994 By /s/ MELVIN R. LAIRD (Melvin R. Laird, Chairman and Director) By /s/ LUCY WILSON BENSON (Lucy Wilson Benson, Director) By /s/ RUDY E. BOSCHWITZ (Rudy E. Boschwitz, Director) By /s/ EDWIN I. COLODNY (Edwin I. Colodny, Director) By /s/ BRUCE L. CROCKETT (Bruce L. Crockett, Director) By /s/ FREDERICK B. DENT (Frederick B. Dent, Director) By (James B. Edwards, Director) By /s/ NEAL B. FREEMAN (Neal B. Freeman, Director) By /s/ BARRY M. GOLDWATER (Barry M. Goldwater, Director) By /s/ ARTHUR HAUSPURG (Arthur Hauspurg, Director) By /s/ PETER W. LIKINS (Peter W. Likins, Director) By /s/ HOWARD M. LOVE (Howard M. Love, Director) By /s/ ROBERT G. SCHWARTZ (Robert G. Schwartz, Director) By /s/ C. J. SILAS (C. J. Silas, Director) By (Dolores D. Wharton, Director) (a) An interest-free note receivable from Robert J. Wussler, a former employee of the corporation, was repaid in 1991. (b) An interest-free note receivable from Richard Fenwick, Jr., and employee of On Command Video Corporation, was repaid in 1993. (c) A note receivable at a 10% interest rate from Mark Macon, a player of the Denver Nuggets, was repaid in 1992. SCHEDULE V (CONTINUED) (a) Includes the effect of changes in COMSAT's investment share in INTELSAT which was 23.9%, 22.9%, 21.8% and 20.9% as of December 31, 1990, 1991, 1992 and 1993, respectively. These changes resulted in increases to plant retired and other of $30,096 in 1991, $35,515 in 1992 and $36,343 in 1993. Also includes the effect of changes in COMSAT's investment share in Inmarsat which was 24.9%, 25.0%, 24.6% and 23.0% as of December 31, 1990, 1991, 1992 and 1993, respectively. These changes resulted in decreases to plant retired and other of $290 in 1991, and increases to plant retired and other of $2,681 in 1992 and $15,510 in 1993. (b) Net of transfers to property in-service. (c) Includes property of $20,046 for the Denver Nuggets Limited Partnership and On Command Video Corporation as of July 1, 1992, when the corporation began consolidating the financial statements of these businesses. (a) Includes the effect of changes in COMSAT's investment share in INTELSAT which was 23.9%, 22.9%, 21.8% and 20.9% as of December 31, 1990, 1991, 1992, and 1993, respectively. These changes resulted in decreases of $10,075 in 1991, $11,808 in 1992 and $12,801 in 1993. Also includes the effect of changes in COMSAT's investment share in Inmarsat which was 24.9%, 25.0%, 24.6% and 23.0% as of December 31, 1990, 1991, 1992 and 1993, respectively. These changes resulted in an increase of $10 in 1991 and decreases of $290 in 1992, and $1,986 in 1993. (b) Depreciation and amortization as reported in the consolidated income statement for 1992 and 1993 includes amortization of intangibles of $2,399 and $4,254, respectively. SCHEDULE VI (CONTINUED) (c) Includes accumulated depreciation of $5,004 for the Denver Nuggets Limited Partnership and On Command Video Corporation as of July 1, 1992, when the corporation began consolidating the financial statements of these businesses. (d) Includes an addition to accumulated depreciation of $16,755 related to the 1992 restructuring provision discussed in Note 12 to the financial statements. (a) Uncollectible amounts written off, recoveries of amounts previously reserved, and other adjustments. (a) Calculated using the average daily balance method. Items omitted are less than one percent of revenues. EXHIBIT INDEX Exhibit No. Description Page 2(a) Agreement and Plan of Merger among Registrant, CTS America, 88 Inc. and Radiation Systems, Inc. dated as of January 30, 1994. 2(b) Stock Option Agreement between Registrant and Radiation 135 Systems, Inc. dated as of January 30, 1994. 3(a) Articles of Incorporation of Registrant, composite copy, as - amended through June 1, 1993. (Incorporated by reference from Exhibit No. 4(a) to Registrant's Registration Statement on Form S-3 (No. 33-51661) filed on December 22, 1993). 3(b) By-laws of Registrant, as amended through March 15, 1991. - (Incorporated by reference from Exhibit No. 3(b) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1991.) 3(c) Regulations adopted by Registrant's Board of Directors - pursuant to Section 5.02(c) of Registrant's Articles of Incorporation. (Incorporated by reference from Exhibit No. 3(c) to Registrant's Report on Form 10-K for the fiscal year ended 1992.) 4(a) Specimen of a certificate representing Series I shares of 144 Registrant's Common Stock, without par value, registered under Section 12 of the Securities Exchange Act of 1934, which are held by citizens of the United States. 4(b) Specimen of a certificate representing Series I shares of - Registrant's Common Stock, without par value, registered under Section 12 of the Securities Exchange Act of 1934, which are held by aliens. (Incorporated by reference from Exhibit No. 4(b) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1982.) 4(c) Specimen of a certificate representing Series II shares of - Registrant's Common Stock, without par value, registered under Section 12 of the Securities Exchange Act of 1934. (Incorporated by reference from Exhibit No. 4(c) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1982.) 4(d) Indenture dated as of August 1, 1988 between the Registrant - and The Chase Manhattan Bank, N.A. (Incorporated by reference from Exhibit No. 4 to Registrant's Report on Form 10-Q for the quarter ended June 30, 1988.) 4(e) Standard Multiple-Series Indenture Provisions, dated March - 15, 1991. (Incorporated by reference from Exhibit No. 4(a) to Registrant's Registration Statement on Form S-3 (No. 33- 39472) filed on March 15, 1991.) 4(f) Indenture dated as of March 15, 1991 between Registrant and - The Chase Manhattan Bank, N.A. (Incorporated by reference from Exhibit No. 4(b) to Registrant's Registration Statement on Form S-3 (No. 33-39472) filed on March 15, 1991. 4(g) Officers' Certificate pursuant to Section 3.01 of the - Indenture, dated as of March 15, 1991, from the Registrant to the Chase Manhattan Bank (National Association), as Trustee, relating to the authorization of $75,000,000 aggregate principal amount of Registrant's 8.95% Notes Due 2001 (with form of Note attached). (Incorporated by reference from Exhibit No. 4 to Registrant's Current Report on Form 8-K filed on May 15, 1991.) 4(h) Officers' Certificate pursuant to Section 3.01 of the - Indenture, dated as of March 15, 1991, from the Registrant to the Chase Manhattan Bank (National Association), as Trustee, relating to the authorization of $160,000,000 aggregate principal amount of the Registrant's 8.125% Debentures Due 2004 (with form of Debenture attached). (Incorporated by reference from Exhibit No. 4 to Registrant's Current Report on Form 8-K filed on April 9, 1992.) 10(a) Agreement Relating to the International - Telecommunications Satellite Organization (INTELSAT) by Governments, which entered into force on February 12, 1973. (Incorporated by reference from Exhibit No. 10(a) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1980.) 10(b) Operating Agreement Relating to the International - Telecommunications Satellite Organization (INTELSAT) by Governments which entered into force on February 12, 1973. (Incorporated by reference from Exhibit No. 10(b) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1980.) 10(c) Agreement dated August 15, 1975, among COMSAT General - Corporation, RCA Global Communications, Inc., Western Union International, Inc. and ITT World Communications, Inc. relating to the establishment of a joint venture for the purpose of participating in the ownership and operation of a maritime communications satellite system and Amendment Nos. 1-4 and Amendment No. 5 dated March 24, 1980. (Incorporated by reference from Exhibit No. 10(p) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1980.) 10(c)(i) Amendment No. 6 dated September 1, 1981. (Incorporated - by reference from Exhibit No. 10(p)(ii) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1981.) 10(d) Convention on the International Maritime Satellite - Organization (INMARSAT) dated September 3, 1976. (Incorporated by reference from Exhibit No. 11 to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1978.) 10(e) Operating Agreement on the International Maritime - Satellite Organization (INMARSAT) dated September 3, 1976. (Incorporated by reference from Exhibit No. 12 to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1978.) 10(f)* Registrant's 1982 Stock Option Plan. (Incorporated by - reference from Exhibit No. 10(x) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1981.) 10(g) Agreement dated October 6, 1983, between COMSAT General - Corporation and National Broadcasting Company for the provision of satellite distribution network programming. (Incorporated by reference from Exhibit No. 10(r) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1983.) 10(g)(i) Amendment dated September 1, 1992. (Incorporated by - reference from Exhibit No. 10(j)(i) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1992.) 10(h)* Registrant's Insurance and Retirement Plan for 147 Executives adopted by Registrant's Board of Directors on June 21, 1985, as amended by the Board of Directors on July 15, 1993. 10(i)* Registrant's 1986 Key Employee Stock Plan. - (Incorporated by reference from Exhibit No. 10(g) to Registrant's Registration Statement on Form S-4 (File No. 33-9966) filed on November 4, 1986.) 10(j) Lease dated November 6, 1986, between Registrant and - VMS 1985-299 Limited Partnership for the lease of Registrant's former headquarters at 950 L'Enfant Plaza, S.W., Washington, D.C. (Incorporated by reference from Exhibit No. 10(kk) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1986.) 10(k)* Registrant's Non-Employee Directors Stock Option Plan - adopted by Registrant's Board of Directors on January 15, 1988 and approved by Registrant's shareholders on May 20, 1988. (Incorporated by reference from Exhibit No. 10(h) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1987.) 10(k)(i)* Amendment No. 1 dated March 16, 1990. (Incorporated by - reference from Exhibit No. 10 (g)(i) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) 10(k)(ii)*Amendment No. 2 dated January 15, 1993. 167 10(l)* Registrant's 1988 Annual Incentive Plan adopted by - Registrant's Board of Directors on June 17, 1988, as amended by the Board of Directors on September 16, 1988. (Incorporated by Reference from Exhibit No. 3(a) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1988.) 10(m) Memorandum of Understanding between Registrant and - National Aeronautics and Space Administration (NASA), dated July 21, 1988 and amended through February 22, 1990. (Incorporated by reference from Exhibit No. 10(aa) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) 10(n) Agreement to Acquire and Lease (and Supplemental - Agreements thereto) dated September 28 and October 10, 1988, respectively, among the International Maritime Satellite Organization (Inmarsat), the North Sea Marine Leasing Company, British Aerospace Public Limited Company, the European Investment Bank, Kreditanstalt Fuer Wiederaufbau, European Investment Bank (as Agent and as Trustee), Instituto Mobiliare Italiano, Credit National, Hellenic Industrial Development Bank, and Society Nationale de Credit a L'Industrie relating to the financing of three Inmarsat spacecraft. (Incorporated by Reference from Exhibit No. 3(a) to Registrant's Report on Form 10-k for the fiscal year ended December 31, 1988.) 10(o) Service Agreement, dated September 14, 1989, between - Registrant and Aeronautical Radio, Inc. relating to satellite-based communications services. (Incorporated by reference from Exhibit No. 10(y) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) 10(p) Second Amended and Restated Agreement of Limited - Partnership of The Denver Nuggets Limited Partnership, dated November 29, 1989. (Incorporated by reference from Exhibit No. 10(x) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) 10(p)(i) Asset Purchase Agreement, dated October 20, 1989, between Denver Nuggets, Incorporated and Denver Nuggets - Limited Partnership, and First Amendment to Asset Purchase Agreement, dated November 30, 1989. (Incorporated by reference from Exhibit No. 10(x)(i) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) 10(q) Agreement, dated January 22, 1990, between Registrant - and Kokusai Denshin Denwa Co., Ltd. for provision of aeronautical services. (Incorporated by reference from Exhibit No. 10(z) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1990.) 10(q)(i) Amendment No. 1 dated May 20, 1993. 169 10(r)* Registrant's 1990 Key Employee Stock Plan adopted by Registrant's Board of Directors on March 16, 1990. (Incorporated by reference from Exhibit No. 10 (p) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989.) 10(r)(i)* Amendment No. 1 dated January 15, 1993. 172 10(s) Agreement, dated May 25, 1990, between Registrant and - IDB Communications Group, Inc. (Incorporated by reference from Exhibit No. 10(bb) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1990.) 10(t) Amended and Restated Agreement, dated November 14, - 1990, of Limited Partnership of Rock Spring II Limited Partnership. (Incorporated by reference from Exhibit No. 10(a) to Registrant's Current Report on Form 8-K filed on February 24, 1992.) 10(t)(i) Amended and Restated Lease Agreement, dated November - 14, 1990, by and between Rock Spring II Limited Partnership and Registrant. (Incorporated by reference from Exhibit No. 10(b) to Registrant's Current Report on Form 8-K filed on February 24, 1992.) 10(t)(ii) Amended and Restated Ground Lease Indenture, dated - November 14, 1990, between Anne D. Camalier (Landlord) and Rock Spring II Limited Partnership (Tenant). (Incorporated by reference from Exhibit No. 10(c) to Registrant's Current Report on Form 8-K filed on February 24, 1992.) 10(u) Finance Facility Contract (and Supplemental Agreements - thereto), dated December 20, 1991, among the International Maritime Satellite Organization (Inmarsat), Abbey National plc, General Electric Technical Services Company, Inc., European Investment Bank, Kreditanstalt Fuer Wiederaufbau, Instituto Mobiliare Italiano S.p.A., Credit National, Societe Nationale de Credit a L'Industrie, Finansieringsinstituttet for Industri OG Haandvaerk A/S, De Nationale Investeringsbank NV, and Osterreichische Investitionkredit Aktiengesellschaft relating to the financing of three Inmarsat spacecraft. (Incorporated by reference from Exhibit No. 10 (dd) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1991.) 10(v)* Registrant's Directors and Executives Deferred 174 Compensation Plan, as amended by the Board of Directors on July 15, 1993. 10(w) Service Agreement, dated April 2, 1992, between - Registrant and GTE Airfone, Incorporated, for the provision of aeronautical satellite services. (Incorporated by reference from Exhibit No. 10(r) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1990.) 10(x) Fiscal Agency Agreement, dated as of August 6, 1992, - between International Telecommunications Satellite Organization and Morgan Guaranty Trust Company of New York. (Incorporated by reference from Exhibit No. 10 (dd) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1992.) 10(y) Agreement dated as of January 18, 1993 between the 191 government of Cote d'Ivoire and Registrant to provide a national television and radio distribution system. 10(y)(i) Amendment No. 1 dated January 1994. 236 10(z) Fiscal Agency Agreement, dated as of January 19, 1993, - between International Telecommunications Satellite Organization and Morgan Guaranty Trust Company of New York. (Incorporated by reference from Exhibit No. 10 (ee) to Registrant's Report on Form 10-K for the fiscal year ended December 31, 1992.) 10(aa) Lease Agreement, dated June 8, 1993, between GTE 243 Airfone, Incorporated, United Airlines, Inc. and Registrant for the provision and financing of aeronautical satellite equipment. 10(bb) Agreement dated July 1, 1993, between Registrant and 254 AT&T Easylink Services relating to exchange of telex traffic. 10(cc) Agreement dated July 27, 1993, between Registrant and 261 American Telephone & Telegraph Company relating to utilization of space segment. 10(dd) Agreement dated September 1, 1993, between Registrant 299 and MCI International, Inc. relating to exchange of traffic. 10(ee) Agreement dated November 30, 1993, between Registrant 316 and Sprint Communications Company L.P. relating to utilization of space segment. 10(ff) Agreement dated December 10, 1993, between Registrant 347 and Sprint International relating to the exchange of traffic. 10(gg) Credit Agreement dated as of December 17, 1993 among 364 Registrant, NationsBank of North Carolina, N.A., Bank of America National Trust and Savings Association, The First National Bank of Chicago, The Chase Manhattan Bank, N.A., The Sumitomo Bank, Limited, New York Branch, Swiss Bank Corporation, New York Branch, as lenders, and NationsBank of North Carolina, N.A., as agent. 10(hh) Schedule of Commitments between Registrant and 434 INTELSAT, as of December 31, 1993, relating to FM, digital bearer, International Business Service and video traffic. 10(ii) Agreement dated January 24, 1994, between Registrant 436 and MCI International Inc. relating to utilization of space segment. 10(jj) Agreement dated February 18, 1994, between Registrant 488 and AT&T relating to exchange of traffic. 10(kk) Fiscal Agency Agreement between International 490 Telecommunications Satellite Organization, Issuer, and Bankers Trust Company, Fiscal Agent and Principal Paying Agent, dated as of 22 March 1994. *Compensatory plan or arrangement. 11 Statement re computation of per share earnings. 22 Subsidiaries of the Registrant as of March 31, 1994. 24 Consent of Independent Auditors dated March 29, 1994. 27 Financial Data Schedule EXHIBIT 2(a) AGREEMENT AND PLAN OF MERGER AGREEMENT AND PLAN OF MERGER ("Agreement") made as of January 30, 1994, by and among COMSAT Corporation, a District of Columbia corporation ("COMSAT"), CTS America, Inc., a Delaware corporation and a wholly owned subsidiary of COMSAT ("CTS"), and Radiation Systems, Inc., a Nevada corporation ("RSI"). WHEREAS, COMSAT desires to acquire RSI by a merger of RSI with and into CTS, and RSI desires the same, pursuant and subject to the terms and conditions of this Agreement; WHEREAS, the Boards of Directors of each of COMSAT and RSI have determined that the proposed merger of RSI with and into CTS is in the best interests of their respective corporations and shareholders; WHEREAS, COMSAT, CTS and RSI intend that the transactions contemplated by this Agreement qualify as a reorganization within the meaning of Section 368 of the Internal Revenue Code of 1986, as amended (the "Code"), and that such transactions will be accounted for by the pooling of interests method of accounting for financial reporting purposes; and WHEREAS, pursuant to such merger, CTS shall be the merging or surviving corporation (sometimes hereinafter referred to as the "Surviving Corporation") and RSI shall be the merged or disappearing corporation (sometimes hereinafter referred to as the "Merged Corporation"); NOW THEREFORE, in consideration of the premises, the mutual benefits to be derived from this Agreement and the representations, warranties, conditions and promises hereinafter set forth, the parties hereby agree as follows: ARTICLE I THE MERGER Section 1.1 The Merger. Upon the Effective Date (as defined in Section 1.2 herein) and subject to and upon the terms of this Agreement, the General Corporation Law of the State of Delaware ("Delaware Corporation Law") and the General Corporation Law of the State of Nevada ("Nevada Corporation Law"), RSI shall be merged with and into CTS, the separate corporate existence of RSI shall cease, and CTS shall continue as the Surviving Corporation (the "Merger"). CTS and RSI are hereinafter sometimes referred to jointly as the "Constituent Corporations." 1.1.1 Nevada Articles of Merger. At the Closing (as defined in Article II herein), CTS and RSI shall execute and acknowledge Nevada Articles of Merger in the form of Exhibit A hereto ("Nevada Articles of Merger"), providing for the Merger pursuant to Section 78.458 of the Nevada Corporation Law. 1.1.2 Delaware Certificate of Merger. At the Closing, CTS and RSI shall execute and acknowledge a Delaware Certificate of Merger in the form of Exhibit B hereto ("Delaware Certificate of Merger") providing for the Merger pursuant to Section 252 of the Delaware Corporation Law. 1.1.3 Filings. Immediately upon completion of the Closing, CTS and RSI shall cause the Merger to be consummated by filing or causing to be filed the original Delaware Certificate of Merger with the Secretary of the State of Delaware, by recording or causing to be recorded a second original of the Delaware Certificate of Merger in the Office of the Recorder of the County of New Castle of the State of Delaware (being the county in which the registered office of the Surviving Corporation is located), and by filing or causing to be filed the original Nevada Articles of Merger with the Secretary of the State of Nevada, pursuant to Sections 103 and 252 of the Delaware Corporation Law and Section 78.458 of the Nevada Corporation Law, respectively. Section 1.2 Effective Date. The Effective Date of the Merger ("Effective Date") shall be the later of the day when the Delaware Certificate of Merger is duly filed with the Secretary of State of the State of Delaware or the day when the Nevada Articles of Merger are duly filed with the Secretary of the State of Nevada as provided in Subsection 1.1.3 herein, the parties intending the Merger to be deemed as having been consummated at the close of business upon the Effective Date, which for purposes of this Agreement, shall be deemed to be 5:00 p.m. local time in Reno, Nevada on the Effective Date. It is the intent of the parties that the Effective Date be the same day as the Closing Date (as defined in Article II herein) or, if not practicable, the earliest practicable day immediately thereafter. Section 1.3 Effect of the Merger. At the close of business on the Effective Date, the effect of the Merger shall be as provided under all applicable provisions of the Delaware Corporation Law and the Nevada Corporation Law. Without limiting the generality of the foregoing, and subject thereto, at the close of business on the Effective Date any and all assets, rights, privileges, powers and franchises of the Constituent Corporations, individually and collectively, shall vest in the Surviving Corporation, and any and all debts, liabilities, duties and obligations of the Constituent Corporations, individually and collectively, shall vest in, be deemed to be assumed by and become debts, liabilities, duties and obligations of the Surviving Corporation. Section 1.4 The Surviving Corporation. 1.4.1 Certificate. The Certificate of Incorporation of CTS as in effect upon the Effective Date shall be the Certificate of Incorporation of the Surviving Corporation, until thereafter amended as provided by law and such Certificate. A copy of such Certificate is attached hereto as Exhibit C. 1.4.2 Bylaws. The Bylaws of CTS as in effect upon the Effective Date shall be the Bylaws of the Surviving Corporation until thereafter amended as provided by law, the Certificate of Incorporation of the Surviving Corporation, and such Bylaws. A copy of such Bylaws is attached hereto as Exhibit D. 1.4.3 Directors and Officers. The directors and officers of CTS upon the Effective Date will be the initial directors and officers of the Surviving Corporation. In the event a vacancy shall exist on the Board of Directors or in any office of CTS upon the Effective Date, such vacancy may thereafter be filled in the manner provided by law, the Certificate of Incorporation and the Bylaws of the Surviving Corporation. 1.4.4 Surrender. At the Closing, the Merged Corporation shall surrender its stock registry, minute book and corporate seal to the Surviving Corporation. At the Effective Date the stock transfer books of RSI shall be closed, and there shall be no registration of transfers of shares of capital stock of RSI thereafter. Section 1.5 Additional Actions. If, at any time after the Closing, the Surviving Corporation shall consider or be advised that any further assignments or assurances in law or any other acts are necessary or desirable to (a) vest, perfect or confirm, of record or otherwise, in the Surviving Corporation its rights, title or interest in, to or under any of the rights, properties or assets of the Merged Corporation acquired or to be acquired by the Surviving Corporation as a result of, or in connection with, the Merger, or (b) otherwise carry out the purposes of this Agreement and the transactions contemplated hereby, the Merged Corporation shall be deemed to have granted to the Surviving Corporation an irrevocable power of attorney to execute and deliver all such proper deeds, assignments, novations and assurances in law and to do all acts necessary or proper to vest, perfect or confirm title to and possession of such rights, properties or assets in the Surviving Corporation and otherwise to carry out the purposes of this Agreement and the transactions contemplated hereby; and the proper officers and directors of the Surviving Corporation are fully authorized in the name of the Merged Corporation or otherwise to take any and all such actions. ARTICLE II CLOSING; CONSIDERATION Section 2.1 The Closing. The closing of the transactions contemplated by this Agreement (the "Closing") shall be held at the offices of Crowell & Moring, 1001 Pennsylvania Avenue, N.W., Washington, D.C. 20004 at 11:00 a.m. immediately following a special meeting of the RSI shareholders to approve the Merger, or otherwise on the first business day after all of the conditions to the Closing set out in Articles VI and VII herein have been met or waived, or at such other place and date and time as the parties may designate in writing (the date and time agreed upon for Closing hereinafter the "Closing Date"). Section 2.2 Consideration and Conversion of Stock. At the close of business on the Effective Date: 2.2.1 Conversion. Each share of RSI common stock, par value $1.00 per share (the "RSI Stock"), other than shares specified in Subsection 2.2.2, that is issued and outstanding on the Effective Date shall be converted without any action on the part of the holder thereof into that fraction of a share, rounded to the nearest thousandth (the "Conversion Fraction"), of common stock, without par value, of COMSAT (the "COMSAT Stock") determined by dividing Eighteen Dollars and twenty-five cents ($18.25) by the average closing price of a whole share of COMSAT Stock on the New York Stock Exchange Composite Tape for the twenty (20) Trading Days ending with the Trading Day which precedes the Closing Date by five (5) Trading Days (a "Trading Day" being any day on which the New York Stock Exchange is open for business and on which shares of COMSAT Stock are traded on that Exchange), provided that the Conversion Fraction shall not be less than .638 and shall not be greater than .780. The issuance and voting of the COMSAT Stock shall be subject to any restrictions set forth in the Communications Satellite Act of 1962, as amended, 47 U.S.C. sections 701 et seq., the COMSAT Articles of Incorporation, and such actions that have been taken by the Board of Directors of COMSAT pursuant to authority granted by section 5.05 of the COMSAT Articles of Incorporation. 2.2.2 Cancellation of Certain Shares. All shares of RSI Stock which are (i) held in the treasury of RSI or owned by any subsidiary of RSI on the Effective Date, or (ii) owned by COMSAT or any subsidiary of COMSAT, including CTS, on the Effective Date shall be cancelled without payment of any consideration therefor. Section 2.3 Exchange of and Payment for RSI Stock. 2.3.1 Notice. Promptly after the Effective Date COMSAT will cause the exchange agent selected by COMSAT (the "Exchange Agent") to send to each holder of record of shares of RSI Stock which shall have been converted into shares of COMSAT Stock in the Merger an appropriate letter of transmittal for purposes of surrendering such holder's certificates for such shares for exchange into certificates of shares of COMSAT Stock as provided in this Section 2.3. 2.3.2 Certificates. As soon as practicable after the Effective Date and after surrender to the Exchange Agent of any certificate which prior to the Effective Date shall have represented any shares of RSI Stock, subject to the provisions of Subsection 2.3.4 herein, COMSAT shall cause to be distributed to the person in whose name such certificate shall have been registered certificates registered in the name of such person representing the shares of COMSAT Stock into which any shares previously represented by the surrendered certificate shall have been converted as of the close of business on the Effective Date and a check payable to such person representing the payment of cash in lieu of fractional shares determined in accordance with Subsection 2.3.5 herein. Until surrendered as contemplated by the preceding sentence, each certificate which immediately prior to the Effective Date shall have represented any shares of RSI Stock shall be deemed at and after the Effective Date to represent only the right to receive upon such surrender a certificate representing the COMSAT Stock and the payment as so contemplated. 2.3.3 Dividends. No dividends or other distributions declared after the date of this Agreement with respect to shares of COMSAT Stock and payable to the holders of record thereof on or after the Effective Date shall be paid to the holder of any unsurrendered certificates which prior to the Effective Date shall have represented shares of RSI Stock with respect to which the shares of COMSAT Stock shall have been issued in the Merger until such certificates shall be surrendered as provided herein, unless otherwise agreed in writing by COMSAT, but (i) upon such surrender there shall be paid to the person in whose name the certificates representing such shares of COMSAT Stock shall be issued the amount of dividends or other distributions theretofore paid or made with a record date on or after the Effective Date but prior to surrender with respect to such shares of COMSAT Stock and the amount of any cash payable to such person in lieu of fractional shares pursuant to Subsection 2.3.5 herein, and (ii) at the appropriate payment date or as soon as practicable thereafter, there shall be paid or made to such person the amount of dividends or other distributions with a record date on or after the Effective Date but prior to surrender and a payment date subsequent to surrender payable with respect to such shares of COMSAT Stock. No interest shall be payable with respect to the payment of such dividends or other distributions or cash in lieu of fractional shares on surrender of outstanding certificates. 2.3.4 Prior Transfer. If any cash, dividend, other distribution or certificate representing shares of COMSAT Stock is to be paid or made to or issued in a name other than that in which the certificate surrendered in exchange therefor is registered, it shall be a condition of the payment or issuance thereof that the certificate so surrendered shall be properly endorsed and otherwise in proper form for transfer and that the person requesting such exchange shall pay to the Exchange Agent any transfer or other taxes required by reason of the issuance of a certificate representing shares of COMSAT Stock in any name other than that of the registered holder of the certificate surrendered, or otherwise required, or shall establish to the satisfaction of the Exchange Agent that such tax has been paid or is not payable. 2.3.5 Cash in Lieu of Fractional Shares. Notwithstanding any other provision of this Agreement, no certificates or scrip representing fractional shares of COMSAT Stock shall be issued upon the surrender for exchange of certificates which prior to the Merger shall have represented any shares of RSI Stock, no dividend or other distribution of COMSAT shall relate to any fractional share and such fractional share interests will not entitle the owner thereof to vote or to any rights of a shareholder of COMSAT. In lieu of any fractional shares, there shall be paid to each holder of shares of RSI Stock who otherwise would be entitled to receive a fractional share of COMSAT Stock an amount of cash (without interest) determined by multiplying such fraction by the closing price of a whole share of COMSAT Stock on the New York Stock Exchange Composite Tape on the last full trading day prior to the Effective Date. 2.3.6 Full Satisfaction. Subject to COMSAT's obligation to pay or make previously declared dividends and other distributions which remain unpaid or unmade, all rights to receive cash, if any, other distributions and shares of COMSAT Stock into which shares of RSI Stock shall have been converted in the Merger shall be deemed when paid, made or issued hereunder to have been paid, made or issued, as the case may be, in full satisfaction of all rights pertaining to such shares of RSI Stock. 2.3.7 Escheat Laws. Notwithstanding any provision of this Section 2.3, neither the Exchange Agent nor any party to this Agreement shall be liable to a holder of a certificate for RSI Stock for any shares of COMSAT Stock, dividends or other distributions thereon, or proceeds in lieu of issuance of any fractional shares thereof, delivered to a public official pursuant to applicable escheat or unclaimed property laws. Section 2.4 Adjustments. If, between the date of this Agreement and the Effective Date (inclusive), the outstanding shares of COMSAT Stock or RSI Stock shall have been changed into a different number of shares or a different class by reason of any reclassification, recapitalization, reorganization, split-up, combination, exchange of shares or readjustment, or a stock dividend or other extraordinary distribution (other than a nonliquidating cash dividend) thereon shall be declared with a record date within said period, the number of shares of COMSAT Stock into which shares of RSI Stock are to be converted shall be correspondingly adjusted after negotiations conducted in good faith and promptly concluded between the parties, and the Nevada Articles of Merger and the Delaware Certificate of Merger shall be amended to reflect the same. Section 2.5 Other Deliveries. At the Closing, each of COMSAT, CTS and RSI shall use its best efforts to deliver or cause to be delivered the opinions, certificates and other documents respectively required to be delivered pursuant to Articles VI and VII hereunder. ARTICLE III REPRESENTATIONS AND WARRANTIES OF RSI RSI hereby represents and warrants to COMSAT and CTS as of the date hereof and as of the Closing Date as set forth in this Article III. RSI is making all these representations and warranties on behalf of itself and each RSI Subsidiary (as defined in Subsection 3.1.2 herein), unless the context otherwise plainly requires. In determining whether an event, condition or matter would have an effect on or be material to RSI, RSI shall be deemed to include RSI and the RSI Subsidiaries, taken as a whole. The "Disclosure Letter" referred to in the representations and warranties of RSI contained in this Article III refers to a letter which has heretofore been delivered by RSI to COMSAT and CTS, and which may be updated periodically and shall be updated immediately prior to the Closing Date pursuant to Section 5.12. The Disclosure Letter (and any update thereof) may include more information than is required to be disclosed therein and such inclusions are not an admission that any matter referred to therein is material. Whenever a representation and warranty contained in this Article III is made to the knowledge of RSI, it shall mean all facts and conditions referred to in or omitted from such representation and warranty, and which are known by, or which should have been known by (in light of circumstantial evidence made available to them on or prior to the date on which such representation and warranty is made), the following individuals: (i) as of the date of this Agreement, Richard E. Thomas, Mark D. Funston, R. Doss McComas, Marvin D. Shoemake, William A. Thomas, Harold A. Siegel, and the directors of RSI; and (ii) as of the Closing Date each of the individuals referred to in clause (i) of this sentence plus those officers and employees of RSI and the RSI division presidents and general managers so listed in the Disclosure Letter. Section 3.1 Organization and Standing. 3.1.1 Organization. RSI is a corporation duly incorporated, validly existing and in good standing under the laws of the State of Nevada. 3.1.2 Subsidiaries. Except for those entities identified in the Disclosure Letter (hereinafter termed the "RSI Subsidiaries"), RSI has no subsidiaries or affiliated companies, is not a partner or co-venturer with any other entity, and does not otherwise directly or indirectly control any other business entity. Except as identified in the Disclosure Letter, each RSI Subsidiary is a corporation duly organized, validly existing and in good standing under the laws of the jurisdiction in which it was formed, as indicated in the Disclosure Letter. Except as identified in the Disclosure Letter, RSI is the sole record and beneficial owner of all of the outstanding capital stock of each RSI Subsidiary, free and clear of any liens, pledges, mortgages or encumbrances. 3.1.3 Qualification. RSI and each RSI Subsidiary is duly qualified or licensed as a foreign corporation to do business, and is in good standing, in each jurisdiction where the nature of its activities makes such qualification or license necessary, except where the failure to be so qualified or licensed would not have a material adverse effect on the business, assets or results of operations of RSI. The Disclosure Letter identifies: (i) each state in which RSI and each RSI Subsidiary is qualified or licensed to do business as a foreign corporation; and (ii) the name and address of the registered agent for RSI and each RSI Subsidiary in each such state. 3.1.4 Corporate Power. RSI and each RSI Subsidiary has all requisite corporate power (i) to carry on its business as it is now being conducted and to own and operate the properties and assets it now owns and operates, and (ii) in the case of RSI, to carry out the provisions of this Agreement and the transactions contemplated hereby. 3.1.5 Corporate Documents. True, correct and complete copies of the Restated Articles of Incorporation of RSI and each RSI Subsidiary and all amendments thereto, and of the By-laws of RSI and each RSI Subsidiary and all amendments thereto, have been delivered to COMSAT. Section 3.2 Capitalization. 3.2.1 Authorized and Outstanding RSI Stock. The total authorized capital stock of RSI is 25,000,000 shares of common stock, par value $1.00 per share, of which, as of the date hereof, (i) 8,285,187 shares are issued and outstanding, (ii) 514,750 shares are subject to issuance upon the exercise of outstanding options, and (iii) 471,432 shares are issued and held in treasury. As of the Closing Date, the total number of issued and outstanding shares of the capital stock of RSI shall not exceed the sum of (i) and (ii). There exist no other shares of capital stock of RSI, securities which are convertible into shares of capital stock of RSI, or any options, warrants, contracts, commitments or other arrangements which subject RSI to the issuance of any shares of capital stock upon the exercise thereof or after the passage of time. 3.2.2 Due Authorization and Issuance. All issued and outstanding shares of the capital stock of RSI have been duly authorized and validly issued and are fully paid and nonassessable. Section 3.3 Authorization. 3.3.1 RSI. RSI has all requisite corporate power and authority to execute and deliver this Agreement and, subject with respect to consummation of the Merger to approval of this Agreement by a majority of all votes entitled to be cast by holders of shares of RSI Stock (the "RSI Vote"), to perform the transactions contemplated hereby. The execution and delivery of this Agreement, the performance by RSI of its obligations hereunder and the consummation of the transactions contemplated hereby have been duly authorized by RSI's Board of Directors and, except for the RSI Vote, no other corporate proceedings are necessary to authorize this Agreement and the transactions contemplated hereby. RSI's Board of Directors has unanimously (a) determined that the Merger is in the best interests of RSI and its stockholders, (b) approved all of the transactions contemplated by this Agreement, including without limitation, the Merger, a Stock Option Agreement of even date herewith between RSI and COMSAT (the "Stock Option Agreement"), and (c) voted to recommend this Agreement to RSI stockholders. As of the date of this Agreement, RSI has received the written opinion of Alex. Brown & Sons Incorporated ("Alex. Brown"), its financial adviser, that in the opinion of Alex. Brown the consideration to be received by RSI stockholders in the Merger is fair, from a financial point of view, to RSI stockholders. Assuming the valid authorization, execution and delivery of this Agreement by COMSAT and CTS, this Agreement is a valid and binding obligation of RSI and is enforceable in accordance with its terms, except as limited by applicable bankruptcy, insolvency, reorganization, moratorium or other laws of general application referring to or affecting enforcement of creditors' rights, or by general equitable principles. 3.3.2 No Breach or Violation by RSI. Execution, delivery and performance of this Agreement by RSI and consummation of the transactions contemplated hereby will not lead to or cause a violation, breach, or default or result in the termination of, or accelerate the performance required by, or result in the creation or imposition of any Encumbrance (as defined in Section 3.7.1 hereof) on any property or assets of RSI, whether by notice or lapse of time or both, or otherwise conflict with any term or provision of the following: (a) RSI's Restated Articles of Incorporation and By-laws, as amended; (b) Any note, bond, mortgage, contract, indenture, pledge or agreement to lease, license or other instrument or obligation to which RSI or any of the RSI Subsidiaries is a party or is bound: (i) where such violation, breach, default, termination, acceleration or Encumbrance would have a material adverse effect on the business, operations or financial condition of RSI; or (ii) as to which required consents, amendments or waivers shall not have been obtained by RSI prior to the Closing for any such violation, breach, default, termination, acceleration or Encumbrance; or (c) Any court or administrative order, writ or injunction or process, or any permit, license, or consent decree to which RSI or any RSI Subsidiary is a party or is bound: (i) where such violation, breach, default, termination, acceleration or Encumbrance would have a material adverse effect on the business, operations or financial condition of RSI; or (ii) as to which required consents, amendments or waivers shall not have been obtained by RSI prior to the Closing for any such violation, breach, default, termination, acceleration or Encumbrance. Section 3.4 SEC Filings. RSI has furnished to COMSAT and CTS a true and complete copy of (i) each final prospectus and definitive proxy statement filed by RSI with the Securities and Exchange Commission (the "SEC") since June 30, 1989 and (ii) each report on Form 10-K, 8-K or 10-Q (and any amendments thereto) filed by RSI with the SEC since June 30, 1989 (collectively, the "RSI SEC Documents"). Each of the RSI SEC Documents complied as to form in all material respects with the published rules and regulations of the SEC with respect thereto and none of the RSI SEC Documents as of the dates they were filed with the SEC contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading in each case as of the date when made. Section 3.5 Financial Statements. 3.5.1 SEC Filings. Each of the consolidated financial statements included in the RSI SEC Documents (including any related notes thereto) complied as to form in all material respects with the published rules and regulations of the SEC with respect thereto and fairly presents the earnings, financial position, cash flows and stockholders' equity, as the case may be, of RSI and its subsidiaries on a consolidated basis as of its date or for the respective periods set forth therein (subject, in the case of unaudited statements, to normal recurring year-end audit adjustments and when read in conjunction with the relevant audited financial statements and the notes thereto), in each case, in accordance with generally accepted accounting principles ("GAAP") consistently applied during the periods involved, except as set forth therein or, in the case of the unaudited statements, as permitted by Rule 10-01 of Regulation S-X as in effect at the relevant time. 3.5.2 Absence of Changes. Since June 30, 1993, there has not been: (a) Any material adverse change in the assets, working capital, reserves, financial condition, accounting methods or results of operations of RSI (provided that expenses incurred in connection with the transactions contemplated hereby shall be excluded in making such determination); (b) Any material change in the con- tingent obligations or liabilities of RSI by way of guaranty, documentary credit, standby credit, endorsement, indemnity, warranty or otherwise; (c) Any waiver or cancellation by RSI of valuable rights or of debts owed to any of them which, taken as a whole, are material to the business or financial condition of RSI; (d) Any damage, destruction or loss, whether or not covered by insurance, materially and adversely affecting the properties or business of RSI; (e) Any increase in the rate or terms of compensation payable, or potentially payable, by RSI to any director, officer or employee, except increases occurring in the ordinary course of business in accordance with RSI's customary practices (which shall include normal periodic performance reviews and related compensation and benefit increases); (f) Any increase in the rate or terms, or establishment, of any bonus, insurance, severance, stock option, pension or other employee benefit plan, payment or arrangement made to, for or with any of the employees of RSI except increases occurring in the ordinary course of business in accordance with RSI's customary practices (which shall include normal periodic performance reviews and related compensation and benefit increases); (g) Any loan to, or guarantee or assumption of any loan or obligation on behalf of, any officer or director of RSI except advances occurring in the ordinary course of business in accordance with RSI's customary practices; or (h) Any declaration, setting aside or payment of any dividend (other than as permitted by Section 5.7 herein) by RSI (in cash, properties or securities) or other distribution of assets by RSI in respect of the shares of its capital stock, or issuance, sale, transfer by RSI, or commitment to issue, sell or transfer any shares of its capital stock other than pursuant to the Stock Option Agreement, employee stock options, director stock options and other agreements or commitments existing on June 30, 1993, or any redemption, purchase or other acquisition of any of its securities; provided that for purposes of paragraphs (a), (b), (c) and (d) of this Subsection 3.5.2, a material adverse change or effect shall be deemed to occur if as a result of the events described in such paragraphs there is a decrease in the aggregate in the stockholders' equity of RSI as reflected on RSI's consolidated statement of financial position at June 30, 1993, of five percent or greater, to the date of this Agreement or the Closing Date, as applicable. 3.5.3 No Undisclosed Liabilities. RSI has no liabilities or obligations, secured or unsecured (absolute, accrued, or unaccrued, liquidated or unliquidated, executory, contingent or otherwise and whether due or to become due), of a nature required to be reflected in a balance sheet prepared in accordance with GAAP applied on a basis consistent with prior years, which were not disclosed in the RSI SEC Documents, except for those liabilities and obligations of RSI incurred since June 30, 1993 in the ordinary course of business. Section 3.6 Forecasts. Notwithstanding any disclaimers to the contrary (whether oral or in writing) made by or on behalf of RSI, all forward looking statements made in writing (including but not limited to forecasts and projections of revenues, income or losses, capital expenditures, or other financial items, management plans and objectives for future operations, statements of future economic performance and state- ments of the assumptions underlying or relating to any of the foregoing) by RSI in the "Bid and Proposal Schedule" delivered to COMSAT prior to the date hereof or updated prior to the Closing Date, or in any Form 10-K or Form 10-Q (and any amendments thereto) filed with the SEC after June 30, 1992, were made based upon reasonable grounds (in the case of the "Bid and Proposal Schedule" delivered to COMSAT prior to the date hereof, taking into account RSI's procedure for assembling the schedule as described in the Disclosure Letter) and disclosed in good faith. Section 3.7 Properties; Leases; Tangible Assets. 3.7.1 Title. The Disclosure Letter contains a list of all real property which RSI purports to own. To RSI's knowledge, RSI has good and valid title to or, in the case of leased properties, a good and valid leasehold interest in, all of the assets which it purports to own or lease, including all assets (real, personal or mixed, tangible or intangible) reflected in the June 30, 1993 consolidated financial statements of RSI, or acquired by RSI thereafter, except those assets disposed of in the ordinary course of business after June 30, 1993 and the title to each such property and asset of RSI is free and clear of any title defects, objections, liens, mortgages, security interests, pledges, charges and encumbrances, adverse claims, equities or other adverse interests of any kind including without limitation, leases, chattel mortgages, conditional sales contracts, collateral security arrangements and other title or interest retention arrangements (collectively the "Encumbrances"), except as follows: (a) Any lien for taxes or other governmental charges not yet delinquent, or the validity of which is being contested in good faith by appropriate proceedings and as to which adequate reserves have been established by RSI; (b) Any Encumbrances reflected on the financial statements contained in the RSI SEC Documents, with such changes in the amount thereof as may have occurred since June 30, 1993 in the ordinary course of business and which changes will not materially reduce the aggregate value of the property and assets held by RSI; (c) Such other imperfections of title or Encumbrances which, as of the Closing Date, will not mate- rially reduce the aggregate value of the property and assets of RSI; (d) Any progress payment liens arising from progress payments made by the United States Government or any agency thereof on contracts affecting the assets of RSI; and (e) Any Encumbrances or other matters identified in the Disclosure Letter. 3.7.2 Use Restrictions. With respect to any real property owned or leased by RSI, to RSI's knowledge there exists no applicable zoning ordinance, building code, use or occupancy restriction, or any material violation of any such ordinance, code or restriction, or any condemnation action or proceeding with respect thereto, that materially detracts from the aggregate value of the real property as reflected in the June 30, 1993 consolidated statement of financial position of RSI. 3.7.3 Condition. To RSI's knowledge, all tangible properties and assets of RSI that are necessary or useful to the business of RSI are in good operating condition and repair, ordinary wear and tear excepted, and are adequate for the uses to which they are put. 3.7.4 Leases. The Disclosure Letter identifies all leases with a remaining term of more than one year and aggregate remaining lease payments due of $100,000 or more to which RSI is a party or is otherwise bound for the lease of real property or personal property or equipment pursuant to which RSI leases real or personal property or equipment either as the lessor or as the lessee. With respect to such leases, to RSI's knowledge there exist no defaults by RSI, or defaults by a lessor or any third party, or misrepresentations with respect to such leases made by RSI, any lessor and/or any third party, that materially and adversely affect in the aggregate the business, operations or financial condition of RSI. 3.7.5 Government Furnished Equipment. RSI's materials management systems relating to inventories of equipment and other materials procured or held by RSI for the performance of any contracts (prime or sub) with the U.S. Government are adequate and appropriately maintained for the uses to which they are put or required to be put under the terms of such contracts. All items of inventory, equipment and other materials procured or held by RSI for the performance of any contracts (prime or sub) with the U.S. Government have been maintained in the condition they were when loaned, or bailed to, or procured by RSI, ordinary wear and tear excepted, or used or processed for the purposes for which they were intended and if such items of inventory, equipment and other materials were returned to the U.S. Government or its designee at any time prior to the Closing Date, there is no basis for a claim for loss, damage, negligence or reckless disregard of use or care of such items of inventory, equipment and other materials to be asserted by the U.S. Government that if successful would have a material adverse effect on the business, results of operations or financial condition of RSI. Section 3.8 Backlog. 3.8.1 Amount. The Disclosure Letter sets forth a schedule of the backlog by contract of RSI (excluding, for purposes of the Disclosure Letter prior to execution of this Agreement, the backlog by contract of the Mark Antennas, PG Technologies, and CSA Antenna Systems Division), as of December 31, 1993, for products and services to be provided by RSI, for those contracts having a value of at least $25,000, including (i) the aggregate dollar amount of firm and funded backlog, (ii) the aggregate dollar amount of unfunded backlog (including without limitation unexercised options), and (iii) the aggregate dollar amount of backlog for which RSI has received notice of program selection but final contract terms have not been negotiated. At the Closing Date, the Disclosure Letter shall set forth on a consistent basis (except that contracts having a value of less than $25,000 may be included) a schedule of the backlog of RSI by contract or, in the case of the Mark Antenna and PG Technology divisions, by division for contracts having a value of less than $100,000, which schedule shall show an aggregate contract backlog for categories (i), (ii), and (iii), above, of at least $118,500,000. For purposes of this Subsection 3.8.1, where the contract or applicable law or regulation would prohibit identification of the customer, the Disclosure Letter will omit such identification. 3.8.2 Ordinary Course. All of the contracts constituting the backlog of RSI (i) have been entered into in the ordinary course of business, and (ii) are capable of performance by RSI in accordance with the terms and conditions of each such contract, without materially and adversely affecting the financial condition or results of operations of RSI. Since June 30, 1993, RSI has not changed in any material respects its pricing policies, practices or objectives with respect to return on sales in connection with its outstanding bids and proposals, when considered in the aggregate. Section 3.9 Accounts Receivable. RSI's accounts receivable, unbilled costs and accrued profits (less customer progress payments), notes receivable, contracts in progress, accounts payable and notes payable (collectively, the "Receivables and Unbilled Costs") as of the Closing Date shall be or were recorded on its books and records in the ordinary course of business in accordance with GAAP applied on a basis consistent with prior years. Since June 30, 1993, RSI's consolidated financial statements include reserves with respect to the Receivables and Unbilled Costs reflected therein against doubtful collection or billings which in the opinion of RSI, its officers or directors, are adequate. Section 3.10 Inventories. All inventories of RSI (i) reflected in its June 30, 1993 consolidated statement of financial position, or (ii) to be held as of the Closing Date, have been or will have been acquired or manufactured, and are in amounts RSI reasonably believes to be adequate to fill customer orders, in the ordinary course of business in accordance with RSI's normal inventory practices. For purposes of preparing its June 30, 1993 and any subsequent consolidated statement of financial position, the inventories held by RSI were valued at cost, and as to classes of items inventoried and methods of accounting and pricing determined in a manner consistent with prior years. Section 3.11 Intellectual Property. 3.11.1 Patents and Know-How. The Disclosure Letter sets forth a complete and accurate list of each patent, patent application and docketed invention, by date and germane case or docket number and country of origin, and each license or licensing agreement, by date, term and the parties thereto, for each of the patents, patent applications, inventions, trade-secrets, rights to know-how, processes, computer programs or use of technology, held or employed by RSI (each such patent, patent application, license or licensing agreement listed thereon hereinafter termed the "Patents and Licenses"). With respect to the Patents and Licenses, and with respect to all other technology including but not limited to research and development results, computer programs, processes, trade secrets, know-how, formulae, chip designs, mask works, inventions and manufacturing, engineering, quality control, testing, operational, logistical, maintenance and other technical information and technology held or employed by RSI ("RSI's Technology") and except as set forth in the Disclosure Letter: (a) RSI owns, free and clear of all liens, pledges or other encumbrances, all right, title and interest in the Patents and Licenses and in RSI's Technology, with all rights to make, use, and sell the property embodied in or described in the Patents and Licenses and in RSI's Technology and which are material to the business or operations of RSI. To RSI's knowledge, its use of the Patents and Licenses and RSI's Technology does not conflict with, infringe upon or violate any patent, patent license, patent application, mask work, mask work registration, or any pending application relating thereto, or any trade secret, know-how, programs or processes of any third person, firm or corporation; (b) RSI either owns the entire right, title and interest in, to and under, has an express license to use, or has acquired in connection with the acquisition of equipment or inventory an implied license to use, any and all inventions, processes, computer programs, know-how, formulae, trade secrets, patents, chip designs, mask works, trademarks, trade names, brand names and copyrights which are material to the business or operations of RSI. (c) The U.S. government has no rights with respect to any "technical data" or "computer software" that are owned by RSI and are material to the business or operations of RSI. 3.11.2 Trademarks and Copyrights. The Disclosure Letter sets forth a complete and accurate list of each trademark, trade name, and trademark and trade name registration or application, and copyright registration and application for copyright registration, by date and germane case or docket number and country of origin, and each license or licensing agreement, by date and the parties thereto, for each trademark and copyright license or licensing agreement, held or employed by RSI (each such trademark, copyright, application, and license or licensing agreement hereafter termed the "Trademarks and Licenses"). Except as set forth in the Disclosure Letter, RSI owns, free and clear of all liens, pledges or other encumbrances, all right, title and interest in the Trademarks and Licenses which are material to the business or operations of RSI. To RSI's knowledge, its use of the Trademarks and Licenses does not conflict with, infringe upon or violate any trademark, trade name, trademark or trade name registration or application, copy- right, copyright registration or application, service mark, brand mark or brand name or any pending application relating thereto, of any third person, firm or corporation. Section 3.12 Contracts and Obligations. 3.12.1 Identification. The Disclosure Letter includes an accurate and complete list as of the date indicated therein of: (a) All agreements and contracts between RSI and (i) its vendors or suppliers the termination of which would have a material adverse effect on the business, operations or financial condition of RSI, and (ii) its customers (each U.S. government agency deemed to be a separate customer and where the contract or applicable law or regulation would prohibit identification of the customer, the Disclosure Letter will omit such identification) where the backlog for such contract is $25,000 or more; (b) All loan agreements and other evidences of indebtedness, and all letters of credit or other documentary credits, having in each case a total liability of $50,000 or more; (c) All distributorship, non-employee commission or marketing agent, representative or franchise agreements providing for the marketing and/or sale of the products or services of RSI; (d) All partnership agreements for the organization of limited or general partnerships in which RSI is a partner, all limited liability company agreements, and all joint ventures to which RSI is a party; (e) All agreements or arrangements for the sale of any of the assets of RSI except in the ordinary course of business; (f) All employment contracts or consulting contracts reflecting an RSI commitment of $100,000 or more, or agreements with respect to severance or similar arrangements; and (g) To RSI's knowledge, all contracts or agreements with any officer, director or employee of RSI or any member of their immediate families, or with any entity under the control of any officer, director or employee of RSI or any member of their immediate families, whether individually or in combination with any other such person or persons. 3.12.2 Full Force and Effect. Except as may be limited by applicable bankruptcy, insolvency, reorganization, moratorium or other laws of general application referring to or affecting enforcement of creditors' rights, and by general equitable principles, each agreement, contract and obligation having a total value of $100,000 or more identified in the Disclosure Letter pursuant to Subsection 3.12.1 is valid and binding on each other party thereto in accordance with their respective terms. 3.12.3 No Default. With respect to each con- tract, agreement and obligation having a total value of $100,000 or more identified in the Disclosure Letter pursuant to Subsection 3.12.1, neither RSI nor any other party thereto is in material breach thereof or material default thereunder, and to RSI's knowledge, no notice has been received from the other party thereto of any such material breach or material default (whether by lapse of time or notice or both). 3.12.4 No Commitments. RSI has no commitment or undertaking to retain after Closing any attorneys, accountants, actuaries, appraisers, investment bankers, or management consultants. Section 3.13 Employees; Compensation; Labor. 3.13.1 Employees and Compensation. Prior to the Closing, RSI will provide to COMSAT and CTS a list dated within 15 days prior to the Closing Date of all persons who are employed by RSI, together with their base salary and bonus paid or payable for the most recent fiscal year, and the date upon which such compensation was last varied or increased, title, original date of hire and vacation benefits, and any agreed to current or future benefits or compensation of such employees. The Disclosure Letter contains a true, correct and complete list of all employment policies, procedures, manuals, and other similar rules or regulations of RSI currently in effect regarding the general conduct, compensation, labor relations and employment and severance of RSI's employees, copies or descriptions of which have heretofore been provided to COMSAT and CTS. 3.13.2 Certain Labor Matters. Except as set forth in the Disclosure Letter: (a) To RSI's knowledge, none of its division managers or executive officers has indicated to any director, officer, or manager of RSI his or her intention to cancel or otherwise terminate his relationship with RSI or his relationship with CTS if CTS retains such person after Closing; (b) There is no union representing the interests of any of RSI employees and, to the knowledge of RSI, there are no RSI employees seeking or attempting to organize union representation; (c) There are neither pending nor, to the knowledge of RSI, threatened any strikes, work stoppages, work disruptions or employment disruptions by any of the RSI employees that would materially impair RSI's business, operations or financial condition; (d) To RSI's knowledge, there are neither pending nor threatened any suits, actions, administrative proceedings, hearings, arbitrations or other proceedings between RSI and any of its employees involving a claim of $50,000 or more; (e) With respect to its employees, to RSI's knowledge, during the past five (5) years RSI (i) has complied in all material respects with all Federal, state and local laws and regulations relating to the employment of labor, including any provisions thereof relating to wages, hours, collective bargaining and the payment of social security and similar taxes, (ii) is not liable for any material arrears of wages or any taxes or penalties for failure to comply with any of the foregoing, (iii) has not committed any material unfair labor practices, and (iv) has complied in all material respects with all applicable provisions of the Occupational Safety and Health Act of 1970, as amended, and regulations promulgated pursuant thereto; (f) To RSI's knowledge, RSI is not required to make any capital or other expenditures of $100,000 or more to comply with the Americans With Disabilities Act of 1990, as amended, and the rules and regulations promulgated thereunder; and (g) To RSI's knowledge, since June 30, 1993, none of its employees has filed any complaint relating to RSI's employment of its employees with any governmental or regulatory authority or brought any action in law or in equity with respect thereto. 3.13.3 Employee Benefit Plans; ERISA. (a) Prior to Closing and with adequate time for review, RSI will provide COMSAT an accurate and complete list of each bonus, deferred compensation, incentive compensation, severance or termination pay agreement, hospitalization or other fringe, medical, dental, retiree medical, dental or other welfare benefit plan, stock purchase, stock option, pension, life or other insurance, profit-sharing or retirement plan or arrangement, and each other employee benefit plan or arrangement maintained or contributed to by RSI, whether formal or informal, whether legally binding or not (the "Plans"), and which either required or are expected to require expenditures or contributions by RSI in the fiscal year ended June 30, 1993 or the fiscal year ended June 30, 1994, as applicable, of $100,000 or more. Such list will set forth the annual amount of employer contributions accrued, paid or payable for Employees of RSI (domestic or foreign) during fiscal 1993 pursuant to each of the Plans. The amount of employer contributions accrued, paid or payable for all Employees of RSI (domestic or foreign) during fiscal 1993 pursuant to the Plans did not exceed $7,000,000. RSI does not have any plan or commitment, whether formal or informal and whether legally binding or not, to create any additional Plan or modify or change any existing Plan. RSI has heretofore delivered or will promptly deliver to COMSAT true and complete copies of (i) the documents governing all such Plans and their related trusts, (ii) the most recent actuarial reports or accountants' reports prepared with respect to each such Plan, (iii) the latest Form 5500 filed with the Internal Revenue Service with respect to each such Plan, and (iv) the most recent determination letter issued by the Internal Revenue Service for each such Plan which has received a determination letter. (b) RSI does not have and has not in the past five years had a Plan to which Title IV of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), applies or has applied. (c) Prior to Closing and with sufficient time for review the Disclosure Letter will list each Plan in existence since June 30, 1989 that is an "employee benefit plan," as such term is defined in Section 3(3) of ERISA and the rules and regulations promulgated thereunder, which at any time covered any employee of RSI (each such Plan is hereinafter referred to as an "ERISA Plan"), and which required contributions or expenditures by RSI in any given fiscal year since June 30, 1989 of $100,000 or more, and copies of such Plans will be made available to COMSAT. (d) Except as set forth in the Disclosure Letter: (i) No ERISA Plan is a "multiemployer plan" as that term is defined in Section 3(37) of ERISA; (ii) to RSI's knowledge neither RSI, any ERISA Plan, any trust created thereunder, nor any trustee or administrator thereof, has engaged in a transaction in connection with which RSI, any ERISA Plan, any such trust, or any trustee or administrator thereof, or any party dealing with any ERISA Plan or any such trust, could be subject to either a material civil penalty assessed pursuant to Section 502(i) of ERISA, or a material tax imposed by Section 4975 of the Code; (iii) full payment has been made of all amounts which RSI is required to pay under the terms of each ERISA Plan as a contribution to such ERISA Plan as of the last day of the fiscal year of each such ERISA Plan ended prior to the date of this Agreement, and no ERISA Plan nor any trust established thereunder has incurred any "accumulated funding deficiency" (as defined in Section 302 of ERISA and Section 412 of the Code), whether or not waived, as of the last day of the most recent fiscal year of each ERISA Plan ended prior to the date of this Agreement; (iv) as to each ERISA Plan which is intended to be qualified under Section 401(a) and 501(a) of the Code, to RSI's knowledge there is no fact, condition or set of circumstances that would adversely affect the qualified status of any such ERISA Plan; (v) to RSI's knowledge each Plan has been operated and administered in all material respects in accordance with its terms and all applicable laws, including but not limited to ERISA; (vi) there are no pending or, to RSI's knowledge, threatened or anticipated material claims against any Plan or any fiduciary thereof, by any employee or beneficiary covered under any Plan, or otherwise involving any Plan (other than routine claims for benefits) and there are no pending or, to RSI's knowledge, threatened or anticipated claims by or on behalf of any Plan; and (vii) there is no liability or penalty under ERISA or otherwise relating to the Plans which would have a material adverse effect on RSI's financial condition. Section 3.14 Litigation. 3.14.1 Litigation Pending or Threatened. Except as set forth in the Disclosure Letter: (i) there are no claims, actions, suits, hearings, arbitrations, disputes, proceedings (public or private) or governmental investigations pending or, to the knowledge of RSI, threatened, against RSI, at law or in equity, before or by any Federal, state, municipal or other governmental or nongovernmental department, commission, board, bureau, agency, court or other instrumentality, or by any private person or entity, which seek damages, contributions, expenditures or other penalties of $25,000 or more; (ii) to RSI's knowledge, there is no basis for any action, suit or proceeding which, if successful, would, individually or in the aggregate, have a material adverse effect on the assets, results of operations or financial condition of RSI; and (iii) there are no existing or, to the knowledge of RSI, threatened, orders, judgments or decrees of any court or governmental agency to which RSI is subject or which are materially affecting RSI. 3.14.2 This Transaction. Except as set forth in the Disclosure Letter there are no legal, administrative, arbitration or other proceedings or governmental investigations pending, or, to the knowledge of RSI threatened, against RSI which seek to enjoin or rescind the transactions contemplated by this Agreement or otherwise prevent RSI from complying with the terms and provisions of this Agreement. Section 3.15 Insurance. The Disclosure Letter sets forth (i) a true and correct list of all insurance policies of any kind or nature whatsoever maintained by RSI, indicating the type of coverage, name of insured, the insurer, the premium, the expiration date of each policy and the amount of coverage, and (ii) a general description of RSI's self-insurance practices. The policies of insurance and practices of self-insurance as so described evidence insurance against all risks of a character and in such amounts as RSI has determined is prudent and to RSI's knowledge are usually insured against by similarly situated companies in the same or similar business as RSI, and all of such insurance policies are in full force and effect and will remain so until at least thirty (30) days after the Closing Date. RSI will notify COMSAT in writing within 15 days of the date hereof whether it has any reason to believe that the policies of insurance currently in effect and held by RSI and all pending claims, rights or causes of action made or held by RSI under any policies of insurance will not transfer by operation of law to the Surviving Corporation in the Merger. Section 3.16 Permits; Compliance; Reports; Clearances. 3.16.1 Necessary Permits. RSI holds all material approvals, authorizations, certificates, consents, licenses, orders and permits of all governmental agencies, whether Federal, state or local, necessary to the operation of its business, or for its owned and leased real and personal property in the manner currently operated by RSI, including, without limitation, all necessary permits and approvals for the discharge of by-products and waste material into a public waste discharge system, and all such material approvals, authoriza- tions, certificates, consents, licenses, orders and permits are in full force and effect. 3.16.2 FCC Licenses. The Disclosure Letter identifies all licenses granted by the Federal Communications Commission to RSI. RSI holds all licenses required by the Communications Act of 1934, as amended, and the rules and regulations promulgated thereunder, necessary for the operation of its business as presently conducted. 3.16.3 Compliance with Law. To RSI's knowledge, the operations of RSI as presently conducted do not violate in any material respect any Federal law (including, without limitation, any that relate to health and safety, individual disabilities, environmental protection and pollution control, sale and distribution of products and services, anti-competitive practices, collective bargaining, equal opportunity and improper or corrupt payments) or any foreign, state, local or other laws, statutes, ordinances, regulations, or any order, writ, injunction or decree of any court, commission, board, bureau, agency or instrumentality. 3.16.4 FCPA. RSI is in full compliance with the Foreign Corrupt Practices Act, as amended, 15 U.S.C. sections 78m, 78dd-1, 78dd-2 and 78ff (the "FCPA"), and no pending contracts, bids or proposals of RSI were obtained or made in violation of the FCPA. 3.16.5 Reports. All material reports, documents and notices (not relating to Taxes or Tax Returns as defined in Subsection 3.20.2) required to be filed, maintained or furnished with or to all governmental regulatory authorities, including, without limitation, all Federal, state and local governmental authorities have been so filed, maintained or furnished. To RSI's knowledge all such reports, documents and notices are true and correct in all material respects as of the dates when legally required to be true and correct (and all required amendments and updates have been made) and, to the extent required to be kept in the public inspection files of RSI, are kept in such files. 3.16.6 Clearances. To the extent permitted by law, the Disclosure Letter sets forth all security clearances held by RSI and personal security clearances held by officers, directors or employees of RSI with respect to the operation of RSI's business. Section 3.17 Government Contracts. 3.17.1 Government Contracts Compliance. RSI is not, and consummation of this Agreement and the transactions contemplated hereby will not result, in any material violation, breach or default of any term or provision of (i) any contract, subcontract or agreement between the United States Government and RSI or (ii) any bid, proposal or quote submitted to the United States Government by RSI. RSI is not, and consummation of this Agreement and the transactions contemplated hereby will not result, in any violation, breach or default in any material respect of any provision of any Federal order, statute, rule or regulation governing any contract, subcontract, bid, proposal, quote, arrangement or transaction of any kind between the United States Government and RSI. The representations in the two foregoing sentences of this Subsection 3.17.1 are made after consideration of, but are not limited to, the following laws, regulations, standards, and agreements to the extent, if any, they are applicable to or incorporated into contracts, subcontracts, agreements, bids, proposals or quotes of RSI: (a) The Truth in Negotiations Act of 1962, as amended; (b) The Service Contract Act of 1965, as amended; (c) The Contract Disputes Act of 1978, as amended; (d) The Federal Acquisition Regulations and any applicable agency supplements thereto, as well as applicable predecessor procurement regulations; (e) The Cost Accounting Standards; (f) Agreements with the Defense Contract Audit Agency; (g) Relevant rules and arrangements governing the allowance of costs charged to overhead and general and administrative cost pools allocable to government contracts; (h) The Byrd Amendment, Pub. L. No. 101-121, section 319 (September 23, 1989); and (i) The Defense Industrial Security Manual (DOD 5220.22-M), the Defense Industrial Security Regulation (DOD 5220.22-R) and related security regulations. With respect to bids or proposals by RSI for contracts covered by P.L. 87-653, all required "cost or pricing data" provided to the United States Government were current, accurate, and complete when price negotiations were concluded and price agreement reached. 3.17.2 Investigations and Claims. The Disclosure Letter sets forth descriptions of all audit reports, final decisions, determinations of noncompliance, claims, consent orders in effect, outstanding Forms 1, ongoing Government investigations or prosecutions, or internal investigations con- ducted by or initiated by RSI and identifies any corrective action, restitution or disciplinary action initiated or taken by RSI relating in any sense to the subjects listed below in paragraphs (a) through (g) of this Subsection 3.17.2. Except as set forth in the Disclosure Letter, RSI has not engaged in and has not been charged with, received a claim related to, or been under investigation or conducted or initiated any internal inves- tigation, or had reason to conduct, initiate or report any inter- nal investigation or made a voluntary disclosure, with regard to any of the following, within the past five (5) years: (a) "defective pricing" within the meaning of P.L. 87-653, as amended; (b) Failure to correct accounting, inventory, material requirements planning, material management and accounting systems, government property records, or purchasing system deficiencies; (c) Mischarging of direct and/or indirect costs in connection with U.S. Governmental contracts or subcontracts; (d) Delivery to the U.S. Government or to a U.S. Government prime or subcontractor of material, components, items or services that do or did not meet specifications or standards therefor, or delivery to the U.S. Government or to a U.S. Government prime or subcontractor of foreign-made material, components or items where domestic-made material, components or items were required; (e) Improper payments or any payments or activities for obtaining non-public source selection information; (f) Unallowable costs, including unallowable direct or indirect costs; (g) Violations of any of the following statutes, as amended, or the regulations promulgated thereunder: (i) False Statements Act (18 U.S.C. 1001), (ii) False Claims Act (18 U.S.C. 287), (iii) False Claims Act (31 U.S.C. 3729), (iv) Bribery, Gratuities and Conflicts of Interest (18 U.S.C. 201), (v) Anti-Kickback Act (41 U.S.C. 51, 54), (vi) Anti-Kickback Enforcement Act of 1986 (P.L. 99-634), (vii) Arms Export Control Act (22 U.S.C. 277 et seq.), (viii) Foreign Corrupt Practices Act (15 U.S.C. 78 m, 78 dd-1, 78 ff), (ix) Export Administration Act (P.L. 99-64), (x) War and National Defense Act (18 U.S.C. 793), (xi) Racketeer Influenced and Corrupt Organizations Act (18 U.S.C. 1901-68), (xii) Conspiracy to Defraud the Government (18 U.S.C. 371), (xiii) Program Fraud Civil Remedies Act (Pub. L. No. 99-509), (xiv) "Revolving Door" Legislation (18 U.S.C. 207, 18 U.S.C. 218, 18 U.S.C. 281 (a)(11), 10 U.S.C. 2397, et seq.) 37 U.S.C. 801, 41 U.S.C. 423, (xv) Defense Production Act (50 U.S.C. App. 2061), (xvi) The Byrd Amendment, Pub. L. No. 101-121, section 319 (September 23, 1989), and (xvii) U.S. antiboycott laws (the Ribicoff Amendment to the 1976 Tax Reform Act, and the 1979 Export Administration Act). 3.17.3 No Debarment or Suspension. RSI has not been debarred or suspended or, to RSI's knowledge, informed that it will be subject to any proceeding contemplating possible debarment or suspension from contracting with the U.S. Government. 3.17.4 Test and Inspection Results. All test and inspection results RSI has provided to any government agency pursuant to any government contract or subcontract or as a part of the delivery to the U.S. Government of any article or system designed, engineered or manufactured by RSI were true, complete and correct except where any inaccuracy or omission does not or will not have a material adverse effect on the results of operations, business, assets or financial condition of RSI. RSI has provided all material test and inspection results to government agencies as required by law or pursuant to the terms of the applicable government contracts or subcontracts, or as may have been required by law or government contracts or subcontracts as a part of the delivery to the government of any article or system RSI designed, engineered or manufactured. Section 3.18 Product Warranties. RSI has provided COMSAT and CTS true, correct and complete copies of the currently used standard forms and statements of product warranties and guaranties adopted by RSI with respect to any product or service provided prior to Closing. RSI reasonably believes that its reserves for product warranty and other post-sale services reflected on its consolidated financial statements at and subsequent to June 30, 1993 are adequate. Section 3.19 Environmental Protection. 3.19.1 Environmental Permits. Except where the failure to do so would not have a material adverse effect on its business or operations, RSI has obtained all permits, licenses and other authorizations which are required under Federal, state, local and foreign laws relating to pollution or protection of the environment, including laws relating to emissions, discharges, releases or threatened releases of pollutants, contaminants, chemicals, or industrial, toxic or hazardous substances or wastes into the environment (including, without limitation, ambient air, surface water, ground water, land surface or subsurface strata) or otherwise relating to the manufacture, processing, distribution, use, treatment, storage, disposal, transport or handling of pollutants, contaminants, chemicals, or industrial, toxic or hazardous substances or wastes or any regulation, code, plan, order, decree, judgment, injunction, notice or demand letter issued, entered, promulgated or approved thereunder including without limitation the following statutes, as amended, (i) Resource Conservation and Recovery Act, 42 U.S.C. section 6901 ("RCRA"); (ii) Comprehensive Environmental Response, Compensation and Liability Act of 1980, 26 U.S.C. section 4611; 42 U.S.C. section 9601; (iii) Superfund Amendments and Reauthorization Act of 1984 ("Superfund"); (iv) Clean Air Act, 42 U.S.C. section 7401; (v) The Clean Water Act, 33 U.S.C. section 1251; (vi) Safe Drinking Water Act, 42 U.S.C. section 300f; and (vii) Toxic Substances Control Act, 15 U.S.C. section 2601 (collectively, the "Environmental Laws"). The Disclosure Letter will set forth prior to Closing (i) all such permits, licenses and other authorizations issued under the Environmental Laws obtained by RSI, and (ii) a description and good faith estimate by RSI of the cost of capital expenditures (if any) that may be necessary to maintain or qualify for each such permit, license or other authorization. 3.19.2 No Violation. RSI is in compliance in all material respects with all terms and conditions of the required permits, licenses and authorizations, and RSI also is in compliance in all material respects with all other limitations, restrictions, conditions, standards, requirements, schedules and timetables contained or referenced by or in the Environmental Laws. Any single omission or act of non-compliance shall be deemed to be "material" under this Subsection 3.19.2 if such omission or act would result in any liabilities for RSI or the Surviving Corporation equal to or greater than One Hundred Thousand Dollars ($100,000), and all omissions or acts of non- compliance shall be deemed to be "material" under this Subsection 3.19.2 if the aggregate of all such omissions or acts would result in any liabilities for RSI or the Surviving Corporation equal to or greater than Five Hundred Thousand Dollars ($500,000). 3.19.3 Certain Matters. Except as set forth in the Disclosure Letter, no properties or facilities owned or leased by RSI contain any (i) underground tanks as defined by any Environmental Law except for fully-inspectable vault tanks, (ii) to RSI's knowledge, any polychlorinated biphenyls ("PCB") or PCB contaminated electrical equipment except light ballasts, and (iii) to RSI's knowledge, any friable structural asbestos or asbestos-containing material. 3.19.4 No Litigation or Proceedings. With respect to or affecting RSI, its business or operations, there is no pending civil or criminal litigation, notice of violation or administrative proceeding relating in any way to the Environmental Laws including, but not limited to, notices, demand letters, claims, litigations or proceedings based upon or relating to any Environmental Law, where such litigation, notice or claim could result in any liability to RSI or the Surviving Corporation in excess of Fifty Thousand Dollars ($50,000). 3.19.5 No Notice. Except as set forth in the Disclosure Letter, RSI has no knowledge of any threatened or potential civil or criminal litigation, notice of violation or administrative action relating in any way to the Environmental Laws and involving RSI, its business or operations. 3.19.6 No Basis for Liability. To the knowledge of RSI, except as set forth in the Disclosure Letter, with respect to RSI, its business or operations, there are no past or present events, conditions, circumstances, activities, practices, incidents, actions or plans which may interfere with or prevent continued compliance with the Environmental Laws, or which may give rise to any common law or legal liability, or otherwise form the basis of any claim, action, demand, suit, proceeding, hearing, study, or investigation, based on or related to the manufacture, processing, distribution, use, treatment, storage, disposal, transport or handling, or the emission, discharge, release or threatened release into the environment, of any pollutant, contaminant, chemical, or industrial, toxic or hazardous substance or waste, including, without limitation, any liability arising, or any claim, action, demand, suit, proceeding, hearing, study or investigation which may be brought under any Environmental Laws. 3.19.7 No Expenditures. To the knowledge of RSI, except as set forth in the Disclosure Letter, with respect to RSI, its business or operations, there are no past or present conditions, circumstances, activities, practices, incidents, actions or plans which may interfere with or prevent continued compliance with the Environmental Laws, which may require RSI to make any capital or other expenditures to comply with any Environmental Law existing as of Closing, nor is there any reasonable basis on which any governmental or regulatory body or agency could take any action that would require any such capital or other expenditures. Section 3.20 Taxes. 3.20.1 Representation. Except as set forth in the Disclosure Letter, to RSI's knowledge: (i) the reserves reflected on RSI's June 30, 1993 consolidated statement of financial position are sufficient for the payment of all unpaid Taxes of RSI whether or not disputed for all periods through the date thereof or based on any state of facts existing on or prior to June 30, 1993; (ii) there has been no audit by the Internal Revenue Service or any state, local or foreign tax authority of any Tax Return of RSI resulting in a proposed, asserted or assessed deficiency, there is no audit that is not closed, and there are no outstanding agreements or waivers signed or agreed to by RSI extending the statutory period of limitation applicable to any Taxes or Tax Return; (iii) there are no outstanding deficiencies or claims for Taxes asserted or threatened against RSI; (iv) RSI has duly and timely filed all Tax Returns required to be filed by it (all such returns being true, correct and complete in all material respects) with the United States, the United Kingdom, and the states of California, Virginia, Georgia, Texas, Florida, New Jersey, Illinois and West Virginia; (v) with respect to Tax Returns not referenced in (iv) above, RSI has duly and timely filed all Tax Returns required to be filed by it (all such returns being true, correct and complete in all material respects); (vi) none of the Tax Returns referred to in clauses (iv) and (v) above contain, and RSI has never filed with or provided to the Internal Revenue Service, a disclosure statement with respect to any member of the RSI Group under Section 6662 of the Code (or any predecessor statute); (vii) RSI has duly paid or set aside reserves or otherwise made provisions for the payment of all Taxes attributable to the periods covered by the Tax Returns referenced in (iv) and (v) above; (viii) there are no liens with respect to Taxes (except statutory liens for Taxes not yet due or delinquent) upon any of the assets of RSI; (ix) all Taxes required to be collected or withheld by RSI have been duly collected or withheld and timely paid to the appropriate tax authorities; (x) no payments made or that may, as a result of the Merger, be made by RSI (expressly excluding any payments made pursuant to agreements entered into after the Merger or arrangements offered by CTS, COMSAT or any of their affiliates) will be treated as excess parachute payments within the meaning of Section 280G of the Code; and (xi) no member of the RSI Group has applied for a ruling relating to Taxes from any taxing authority or entered into any closing agreement with any taxing authority which could affect any member of the RSI Group; provided, however, that with respect to the representations set forth in (i), (v), (vii) and (ix), above, any failure or failures on the part of RSI with respect to any such representation will constitute a breach of such representation only if such failure or failures would, in the aggregate, have a material adverse effect on the business, results of operations or financial condition of RSI. 3.20.2 Definitions. As used herein, "Taxes" and all derivations thereof means any federal, state, local or foreign income, gross receipts, license, payroll, employment, excise, severance, stamp, occupation, premium, windfall profits, environmental, customs, duties, capital stock, franchise, profits, withholding, social security (or similar), unemployment, disability, real property, personal property, sales, use, ad valorem, transfer, registration, value added, alternative or add-on minimum, estimated, or other tax of any kind whatsoever, including any interest, penalty, or addition thereto with respect to which any member of the RSI Group could be held liable. The term "Tax Returns" shall include all federal, state, local and foreign returns, declarations, statements, reports, schedules, and information returns required to be filed with any taxing authority in connection with any Tax or Taxes. The term "RSI Group" means RSI and every member of an affiliated group (as defined in Section 1504 (without regard to Section 1504(b)) of the Code, provided that for purposes of this Section 3.20, references to provisions of the Code also include references to comparable provisions of state, local, or foreign law) which includes RSI or which has included any RSI subsidiary. Section 3.21 No Brokers. RSI has not paid or become obligated to pay any fee or commission to any broker, finder, investment banker or other intermediary in connection with the transactions contemplated by this Agreement, other than Alex. Brown. Section 3.22 Proxy Statement; Registration Information. The proxy statement ("Proxy Statement") including any amendments or supplements thereto with respect to the special meeting of RSI shareholders contemplated by Section 5.1 herein will comply as to form in all material respects with the applicable provisions of the Securities Exchange Act of 1934, as amended, 15 U.S.C. section 78, and the rules and regulations promulgated thereunder (the "Exchange Act"), and the information supplied by RSI for inclusion by COMSAT in the Registration Statement (as defined in Section 4.4 herein) including any amendments or supplements thereto with respect to the COMSAT Stock to be issued pursuant to the Merger, will comply as to form in all material respects with the applicable provisions of the Securities Act of 1933, as amended, 15 U.S.C. section 77, and the rules and regulations promulgated thereunder (the "Securities Act"), and neither the Proxy Statement nor the information provided by RSI for inclusion in the Registration Statement will, on the date of filing thereof with the SEC, on the date of dissemination thereof to holders of RSI Stock or at any time prior to the special meeting of RSI shareholders contemplated by Section 5.1 herein, as the case may be, contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements made therein, in light of the circumstances under which they are made, not misleading; provided, however, that the foregoing representation and warranty shall not include or relate to any information either furnished by COMSAT for the Proxy Statement or contained in COMSAT's filings with the SEC (other than the information provided by RSI for inclusion in the Registration Statement) and which, in either such case, is included, incorporated by reference or referred to in the Proxy Statement or the Registration Statement. If at any time prior to the Effective Date any event relating to RSI should occur which is required to be described in an amendment of or supplement to the Registration Statement or the Proxy Statement, RSI shall promptly so inform COMSAT and will prepare, or cooperate in the preparation of, such amendment or supplement. Section 3.23 Certain Stock Ownership. RSI does not own any COMSAT Stock or any options or other arrangements to acquire COMSAT Stock. Section 3.24 Material Disclosures. No statement, representation or warranty made by RSI in this Agreement, in any Exhibit hereto, in the Disclosure Letter, or in any certificate, written statement, list, schedule or other document delivered or to be delivered to COMSAT or CTS hereunder, contains any untrue statement of a material fact, or fails to state a material fact necessary to make the statements contained herein or therein, in light of the circumstances in which they are made, not misleading. ARTICLE IV REPRESENTATIONS AND WARRANTIES OF COMSAT AND CTS COMSAT and CTS hereby jointly and severally represent and warrant to RSI, as of the date hereof, and as of the Closing Date, as follows: Section 4.1 Organization. COMSAT is a corporation duly incorporated, validly existing and in good standing under the laws of the District of Columbia. CTS is a corporation duly incorporated, validly existing and in good standing under the laws of the State of Delaware. Section 4.2 Corporate Authorization. 4.2.1 Authority. Each of COMSAT and CTS have all requisite corporate power and authority to enter into and perform this Agreement and to consummate the transactions contem- plated hereby. The execution and delivery of this Agreement, the performance by COMSAT and CTS of their respective obligations hereunder and the consummation of the transactions contemplated hereby have been duly authorized by COMSAT's and CTS's Boards of Directors and no other corporate proceedings are necessary to authorize this Agreement and the transactions contemplated hereby. Assuming the valid authorization, execution and delivery of this Agreement by RSI, this Agreement is a valid and binding obligation of COMSAT and CTS, enforceable in accordance with its terms, except as limited by applicable bankruptcy, insolvency, reorganization, moratorium or other laws of general application referring to or affecting enforcement of creditor's rights, or by general equitable principles. 4.2.2 No Breach or Violation. Execution, delivery and performance of this Agreement by COMSAT and CTS and consummation of the transactions contemplated hereby will not cause a violation, breach or default or result in the termination of, or accelerate the performance required by, or result in the creation or imposition of any Encumbrance on any property or assets of COMSAT or CTS, whether by notice or lapse of time or both or otherwise conflict with any term or provision of the following: (a) Their respective Articles or Certificate of Incorporation and By-laws, as amended; (b) Any note, bond, mortgage or indenture to which COMSAT or CTS is a party or is bound (i) where such violation, breach, default, termination, acceleration or Encumbrance would have a material adverse effect on the business, results of operations or financial condition of COMSAT and its subsidiaries, considered as a whole, or (ii) as to which required consents, amendments or waivers shall not have been obtained by COMSAT or CTS prior to the Closing for any such violation, breach, default termination, acceleration or Encumbrance; or (c) Any court or administrative order, writ or injunction or process, or any consent decree to which COMSAT or CTS is a party or is bound (i) where such violation, breach, default, termination, acceleration or Encumbrance would have a material adverse effect on the business, results of operations or financial condition of COMSAT, or (ii) as to which required consents, amendments or waivers shall not have been obtained by COMSAT prior to the Closing for any such violation, breach, default, termination, acceleration or Encumbrance. Section 4.3 SEC Filings. COMSAT has furnished to RSI a true and complete copy of (i) each final prospectus and definitive proxy statement filed by COMSAT with the SEC since December 31, 1992, and each report on Form 10-K, 8-K or 10-Q (and any amendments thereto) filed by COMSAT with the SEC since December 31, 1992 (collectively, the "COMSAT SEC Documents"). All of the COMSAT SEC Documents complied as to form in all material respects with the published rules and regulations of the SEC with respect thereto and none of the COMSAT SEC Documents as of the dates they were filed with the SEC contained any untrue statements of a material fact or omitted to state a material fact required to be stated therein or necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading in each case as of the date when made. Section 4.4 Registration Statement; Proxy Information. The Registration Statement ("Registration Statement") including any amendments or supplements thereto with respect to the issuance of the COMSAT Stock pursuant to the Merger contemplated by Section 5.2 herein will comply as to form in all material respects with the applicable provisions of the Securities Act and the information supplied by COMSAT for inclusion by RSI in the Proxy Statement including any amendments or supplements thereto with respect to the special meeting of RSI shareholders contemplated by Section 5.1 herein will comply as to form in all material respects with the applicable provisions of the Exchange Act, and neither the Registration Statement nor the information provided by COMSAT for inclusion in the Proxy Statement will, on the date of filing thereof with the SEC, on the date of dissemination thereof to holders of RSI Stock or at any time prior to the special meeting of RSI shareholders contemplated by Section 5.1 herein, as the case may be, contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements made therein, in light of the circumstances under which they are made, not misleading; provided, however, that the foregoing representation and warranty shall not include or relate to any information either furnished by RSI for the Registration Statement or contained in RSI's filings with the SEC (other than information provided by COMSAT for inclusion in the Proxy Statement) and which, in either such case, is included, incorporated by reference or referred to in the Registration Statement or the Proxy Statement. If at any time prior to the Effective Date any event relating to COMSAT should occur which is required to be described in an amendment of or supplement to the Proxy Statement or the Registration Statement, COMSAT shall promptly so inform RSI and will prepare, or cooperate in the preparation of, such amendment or supplement. Section 4.5 Capitalization. The total authorized capital stock of COMSAT is 100,000,000 shares of common stock, without par value, and 5,000,000 shares of preferred stock, without par value, of which, as of December 31, 1993, (a) 40,226,475 shares of common stock were validly issued and outstanding and were fully paid and nonassessable and free of preemptive rights, (b) 2,521,780 shares of common stock were subject to issuance upon the exercise of outstanding options or warrants, and (c) 1,348,003 shares of common stock were issued and held in treasury. Other than 1,019,350 options and 222,000 restricted stock awards granted between December 31, 1993 to the date of this Agreement, there are no other issued and outstanding or issued and not outstanding shares of capital stock of COMSAT, or any other securities which are convertible into or exercisable for capital stock of COMSAT. Section 4.6 COMSAT Stock. Upon issuance as contemplated by this Agreement or pursuant to the exercise of options into which the RSI Options were converted pursuant to Section 5.10 herein, each share of COMSAT Stock shall be validly issued, fully paid and nonassessable, and free and clear of any liens, pledges, mortgages or encumbrances. Section 4.7 No Brokers. Neither COMSAT nor CTS has paid or become obligated to pay any fee or commission to any broker, finder, investment banker or other intermediary in connection with the transactions contemplated by this Agreement, other than Goldman, Sachs & Co. Section 4.8 Material Disclosures. No statement, representation or warranty made by COMSAT or CTS in this Agreement, in any Exhibit hereto, or in any certificate, written statement, list, schedule or other document delivered or to be delivered to RSI hereunder, contains any untrue statement of a material fact, or fails to state a material fact necessary to make the statements contained herein or therein, in light of the circumstances in which they are made, not misleading. ARTICLE V COVENANTS Section 5.1 Shareholder Meeting. RSI will call a special meeting of its shareholders to be held as promptly as practicable (but no earlier than 30 business days after the date hereof) for the purpose of obtaining shareholder approval of this Agreement and the Merger. COMSAT will cooperate with RSI in the preparation and filing with the SEC as promptly as practicable of the Proxy Statement for such special meeting, and will cooperate in the prompt filing of such amendments or supplements to the Proxy Statement as may be reasonably requested by the SEC or its staff in order to comply in all material respects with the Exchange Act. The Proxy Statement shall include the recommendation of the Board of Directors of RSI that the RSI shareholders approve this Agreement and authorize the Merger, unless such recommendation shall have been withdrawn in the exercise of the fiduciary duties of the RSI Board of Directors to the RSI shareholders under the Nevada Corporation Law. RSI shall have no obligation to mail the Proxy Statement to its shareholders until the Registration Statement is declared effective by the SEC, as contemplated by Section 5.2 herein. Section 5.2 Registration Statement. COMSAT will prepare as promptly as practicable the Registration Statement on Form S-4 for the issuance of the COMSAT Stock as contemplated hereunder, and RSI will cooperate with COMSAT in its preparation. Subject to Section 5.13 herein, COMSAT will file the Registration Statement with the SEC and shall use all reasonable efforts, including the filing of amendments with respect thereto, to have the Registration Statement declared effective by the SEC, and to maintain the effectiveness of the Registration Statement through the Effective Date, including the filing of any post-effective amendments thereto as may reasonably be requested by the SEC staff or as otherwise required by the Securities Act. COMSAT shall also take any action required to be taken under state "Blue Sky" or securities laws in connection with the offering of the COMSAT Stock to the RSI shareholders and the issuance of the COMSAT Stock pursuant to the Merger. Section 5.3 Affiliates' Letters. As soon as practicable after the date hereof, RSI shall deliver to COMSAT a list of names and addresses of those persons who are, to the knowledge of RSI, reasonably anticipated to be at the time of RSI's special meeting of stockholders convened pursuant to Section 5.1 hereof, "affiliates" of RSI within the meaning of Rule 145 (each such person, together with the persons identified below, being hereinafter referred to as an "Affiliate") promulgated under the Securities Act ("Rule 145"). RSI shall use its best efforts to provide COMSAT such information and documents as COMSAT shall reasonably request for purposes of reviewing such list. There shall be added to such list the names and addresses of any other person (within the meaning of Rule 145) which COMSAT reasonably identifies (by written notice to RSI within three business days after COMSAT's receipt of such list) as being a person who may be deemed to be an Affiliate of RSI within the meaning of Rule 145; provided, however, that no such person identified by COMSAT shall be added to the list of Affiliates of RSI if COMSAT shall receive from RSI, on or before the Effective Date, an opinion of counsel reasonably satisfactory to COMSAT to the effect that such person is not an Affiliate. RSI shall use its best efforts to deliver or cause to be delivered to COMSAT, at least 30 days prior to the anticipated date of RSI's special meeting, from each of the Affiliates of RSI identified in the foregoing list (as the same may be supplemented as aforesaid), a letter dated as of the Effective Date in the form of Exhibit E attached hereto. Section 5.4 Acquisition Proposals. RSI shall not (nor will it permit any of its officers, directors, agents or affiliates to) directly or indirectly (i) solicit, encourage, initiate or participate in any negotiations or discussions with respect to any offer or proposal to acquire all or substantially all of its business and properties or capital stock, whether by merger, purchase of assets, tender offer or otherwise, or (ii) except as contemplated by this Agreement disclose any information not customarily disclosed to any person concerning its business and properties, afford to any person or entity access to its properties, books or records or otherwise assist or encourage any person or entity in connection with any of the activities referred to in clause (i) above; unless in the case of either clause (i) or (ii) above, RSI shall have received a firm written offer relating to such transaction, not conditioned upon financing, from a reputable buyer, which offer, in the written opinion of Alex. Brown, RSI's financial advisers, appears to be on terms financially superior to those offered by the transactions contemplated by this Agreement and which, in the written opinion of legal counsel to RSI reasonably acceptable to COMSAT, RSI's Board of Directors is legally obligated to consider by principles of fiduciary duty to shareholders under the Nevada Corporation Law. Section 5.5 HSR Act Filings. COMSAT and RSI shall promptly make their respective filings, and shall thereafter promptly make any required submissions or responses to second requests for information, under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, 15 U.S.C. section 18a (the "HSR Act"), with respect to the Merger and shall cooperate with each other with respect to the foregoing. Section 5.6 Consents. Each of COMSAT and RSI agrees to use all reasonable efforts expeditiously to (i) obtain all actions, non-actions, consents, authorizations, orders and approvals from Federal, state, local and other governmental and regulatory bodies, and from third parties, as may be required in connection with, and waivers of any violations, breaches, defaults, accelerations, terminations or Encumbrances that may be caused by, the consummation of the Merger or the other transactions contemplated by this Agreement and the Merger, including the facilities clearance requirements of the Defense Investigative Service of the United States Department of Defense ("DIS"), as set forth in the DIS Industrial Security Regulation (DOD 5220.22-4) and the DIS Industrial Security Manual (DOD 5220.22-M), as may be amended from time to time, and (ii) resolve favorably any action, suit, proceeding or investigation which shall have been instituted or which a governmental agency shall have indicated its intention to institute which could lead to an order making the Merger unlawful. Section 5.7 Interim Operations of RSI. During the period from the date of this Agreement through the Effective Date, RSI shall operate its businesses only in the usual and ordinary course and consistent with past practice and shall use all reasonable efforts to (i) preserve intact its business organization and goodwill in all material respects, (ii) keep available the services of its key officers and employees and (iii) maintain its relationships with significant customers, suppliers, distributors and others having significant business relationships with it, and, subject to the provisions of this Agreement, except as mutually agreed to in writing by COMSAT, RSI shall not (A) amend or otherwise change its Restated Articles of Incorporation or Bylaws; (B) other than pursuant to outstanding option or other agreements or commitments existing at June 30, 1993, issue, sell or authorize for issuance or sale, shares of any class of its securities (including, without limitation, by way of stock split or dividend) or any subscriptions, options, warrants, rights, convertible securities or other agreements or commitments of any character obligating it or any of its subsidiaries to issue such securities, or directly or indirectly redeem, purchase or otherwise acquire any of its securities; (C) declare, set aside, make or pay any dividend or other distribution (whether in cash, stock or property) with respect to its capital stock other than its regular semi-annual cash dividends, which in each case shall not be greater than the highest semi-annual cash dividend paid to its shareholders during its fiscal year ended June 30, 1993; (D) make any acquisitions or any dispositions other than in the ordinary course of business; (E) guarantee employment to or commit to retain any Employee after the Closing Date; (F) take any action that would cause the Merger not to qualify as a reorganization within the meaning of Section 368 of the Code; or (G) take any action that could result in the Merger not being accounted for by the pooling of interests method for financial reporting purposes. Section 5.8 Interim Operations of COMSAT. Commencing from the date of this Agreement and through the Effective Date and thereafter, COMSAT shall not (i) take any action that would cause the Merger not to qualify as a reorganization within the meaning of Section 368 of the Code, or (ii) take any action that could result in the Merger not being accounted for by the pooling of interests method for financial reporting purposes. Section 5.9 Access. Subject to reasonable notice and as permitted by law, RSI shall afford to COMSAT and its accountants, counsel and other agents and representatives full access during normal business hours throughout the period prior to the Effective Date to all of its properties, books, contracts, commitments and records and, during such period, RSI shall furnish promptly to COMSAT and its representatives (i) a copy of each report, schedule and other document filed or received by it pursuant to the requirements of Federal or state securities laws, and (ii) access to all other information concerning its business, properties and personnel as COMSAT may reasonably request, provided that no investigation pursuant to this Section 5.9 shall affect or be deemed to modify any representation or warranty contained herein or the conditions to the obligations of the parties to consummate the Merger. Without limiting the generality of the foregoing, RSI shall permit COMSAT and its representatives to conduct a "Phase I" and "Phase II" environmental audit on properties owned or leased by RSI or any RSI Subsidiary, including the taking of soil samples and the sinking of monitoring wells at COMSAT's expense, and will cooperate with COMSAT and its representatives in any environmental investigation it or they reasonably deem appropriate in the circumstances. RSI shall promptly upon request provide COMSAT and CTS access to a complete and correct copy of each written agreement or other instrument, together with all amendments or clarifications thereto, and a true and complete summary of the terms and conditions of each oral agreement, identified in the Disclosure Letter pursuant to Subsection 3.12.1 or relied upon by RSI in compiling and disclosing its backlog pursuant to Subsection 3.8.1. If access is restricted due to a term in the agreement or by applicable law or regulation, RSI shall use all reasonable efforts to secure consent from the other party(ies) to the Agreement to provide such access prior to Closing with sufficient time for COMSAT and CTS review. COMSAT will treat the documents and other material and information referred to in this Section 5.9 which constitute "Confidential Information" as defined in the Confidentiality Agreement between COMSAT and RSI dated January 16, 1994 (the "Confidentiality Agreement") as "Confidential Information" in accordance with the terms of the Confidentiality Agreement. For purposes of this Agreement, material and information supplied in connection with a "Phase II" environmental audit shall be treated as "Confidential Information." Section 5.10 RSI Options. 5.10.1 No Acceleration. RSI shall not, from the date hereof to the close of business on the Effective Date, take any action to accelerate or agree or commit to accelerate the vesting of any options or rights to acquire RSI Stock (the "RSI Options"); provided however, that any unvested RSI Options which shall automatically vest on or prior to the Closing Date in accordance with the terms by which options were granted, and without any further action on the part of RSI, shall so vest and become exercisable in accordance with such terms. 5.10.2 Conversion to COMSAT Options. At the close of business on the Effective Date, each outstanding RSI Option shall be converted into an option to acquire that number of shares of COMSAT Stock in an amount and at an exercise price determined as provided below and otherwise having the same duration and other terms as the original RSI Option: (a) The number of shares of COMSAT Stock to be subject to the new option shall be equal to the product of the number of shares of RSI Stock subject to the original RSI Option times the Conversion Fraction; provided that any fractional shares resulting from such multiplication shall be rounded down to the nearest share; and (b) The exercise price per share for COMSAT Stock under the new option shall be equal to the product of the per share exercise price for RSI Stock under the original RSI Option times the number, rounded to the nearest thousandth, obtained by dividing one (1) by the Conversion Fraction; provided that such exercise price shall be rounded up to the nearest cent. 5.10.3 Plans and Registration. The Board of Directors of COMSAT, or the appropriate committee thereof, shall, under the terms of the COMSAT 1990 Key Employee Stock Plan, cause the options converted pursuant to Subsection 5.10.2 herein, other than any RSI Option held by directors of RSI, to be assumed under such plan, and COMSAT shall, if such shares are not otherwise registered, file a registration statement on Form S-8 (or any successor form thereto) with respect to the shares of COMSAT Stock underlying such options. COMSAT shall, if reasonably required to permit resale without restrictions other than those contemplated by Section 5.3, file a registration statement on Form S-8 (or any successor form thereto) with respect to shares of COMSAT Stock underlying RSI Options held by directors of RSI. Section 5.11 NYSE Listing. COMSAT shall use its best efforts to obtain, prior to the Effective Date, approval for listing on the New York Stock Exchange, upon official notice of issuance, of the COMSAT Stock to be issued pursuant to the Merger. Section 5.12 Disclosure Letter. RSI shall deliver to COMSAT an update of the Disclosure Letter prior to Closing with time sufficient for COMSAT's and CTS's review. Section 5.13 Interim Review. COMSAT may, in its sole discretion and at its expense, retain Deloitte & Touche to conduct a review of the consolidated financial statements of RSI at December 31, 1993. RSI shall cooperate in any such review and shall use its best efforts to cause such review to be completed prior to the filing by COMSAT of the Registration Statement with the SEC. COMSAT shall be under no obligation to file the Registration Statement with the SEC unless and until such review has been completed. Section 5.14 Confidentiality. RSI will treat all documents and other material and information furnished to it by COMSAT which constitute "Confidential Information" as defined in the Confidentiality Agreement as "Confidential Information" in accordance with the terms of the Confidentiality Agreement. Section 5.15 Notice. COMSAT agrees to notify RSI promptly upon COMSAT, CTS or its authorized representatives having received actual knowledge, as part of COMSAT's due diligence review of RSI, of a material breach of an RSI representation or warranty made herein, to the extent RSI has not already disclosed such material breach to COMSAT or the material breach is otherwise open and notorious. Section 5.16 ESOP; Certain Benefits. Simultaneously with the execution and delivery of this Agreement, COMSAT is executing and delivering to the Board of Directors of RSI the letter attached hereto as Exhibit F concerning the RSI Employee Stock Ownership Plan and certain other benefits for the employees and directors of RSI. Section 5.17 Further Assurances. Each of the parties hereto agrees to use all reasonable efforts to take, or cause to be taken, all action and to do, or cause to be done, all things necessary, proper or advisable under applicable laws and regulations expeditiously to consummate and make effective the Merger and the other transactions contemplated by this Agreement. ARTICLE VI CONDITIONS PRECEDENT TO OBLIGATIONS OF COMSAT AND CTS Section 6.1 Conditions. The obligations of COMSAT and CTS to consummate the Merger under this Agreement shall be subject to the fulfillment, to their reasonable satisfaction, on or prior to the Closing Date, of all of the following conditions precedent: 6.1.1 Disclosure Letter. As provided under Section 5.12 herein, the Disclosure Letter shall have been updated to the date closest as practicable to the Closing Date and shall have been delivered with time sufficient for COMSAT's and CTS's review. 6.1.2 Absence of Changes. The representations and warranties contained in Subsections 3.5.2 and 3.16.4 herein shall be true and correct on the Closing Date. The Disclosure Letter schedule referred to in the penultimate sentence in Subsection 3.8.1 shall show at the Closing Date an aggregate contract backlog for RSI in all categories of at least $118,500,000 as required by Subsection 3.8.1. 6.1.3 No Adverse Facts Revealed. No audit, investigation or due diligence review by COMSAT or its representatives of RSI with respect to the representations and warranties contained in Article III, shall have revealed in the aggregate liabilities of RSI not previously disclosed as of the date hereof (whether then existing or arising after the date hereof) which exceed the product of five percent (5%) multiplied by (i) $18.25 and (ii) the number of shares of RSI common stock issued and outstanding on the date of this Agreement. 6.1.4 HSR Act Waiting Period. All waiting periods under the HSR Act with respect to the Merger shall have been terminated or expired. 6.1.5 Performance by RSI. RSI shall have performed and complied in all material respects with all agreements, covenants, obligations and conditions required by this Agreement to be performed or complied with by RSI on or before the Closing Date. 6.1.6 Obtaining of DIS Consents and Approvals. RSI shall have obtained and delivered to COMSAT all necessary consents, approvals or waivers on or prior to the Closing Date as required pursuant to the DIS Industrial Security Regulation, DOD 5220.22-R, and the DIS Industrial Security Manual DOD 5220.22-M (as either may be amended from time to time), for the purpose of retaining any necessary facilities clearances and/or personnel clearances as the case may be after the Closing Date. 6.1.7 Obtaining of Consents and Approvals. RSI shall have executed and delivered to COMSAT and CTS, or shall have caused to be executed and delivered, any consents, waivers, approvals, permits, licenses or authorizations which, if not obtained on or prior to the Closing Date, would have a material adverse effect on the Surviving Corporation's ability to conduct business as conducted by RSI on the Closing Date. 6.1.8 Absence of Litigation. There shall not be in effect any order enjoining or restraining the transactions contemplated by this Agreement, and there shall not be instituted or pending any action or proceeding before any Federal, state or foreign court or governmental agency or other regulatory or administrative agency or instrumentality challenging the Merger or the issuance of the COMSAT Stock in connection therewith, or otherwise seeking to restrain or prohibit consummation of the transactions contemplated by this Agreement, or seeking to impose any material limitations on any provision of this Agreement. 6.1.9 Authorization of Merger. The requisite shareholders of RSI shall have duly voted their shares approving this Agreement and authorizing the Merger. 6.1.10 Pooling. COMSAT shall have received an opinion from Deloitte & Touche, dated the Closing Date, that the Merger as contemplated by this Agreement will be accounted for as a pooling of interests for financial reporting purposes. 6.1.11 Employment Agreement. RSI shall have used its best efforts to cause, on or prior to the Closing Date, Richard E. Thomas to execute and deliver an Employment Agreement (the "Employment Agreement") in substantially the form of Exhibit G attached hereto. 6.1.12 RSI Officers' Certificates. COMSAT and CTS shall have received certificates, dated the Closing Date, executed on behalf of RSI by appropriate officers, stating that the representations and warranties set forth in Article III hereof are true and correct on the Closing Date (unless specified to be made as of another date, in which case on such specified date) in all material respects and that the conditions set forth in Sections 6.1.1 through 6.1.9. 6.1.13 Comfort Letter. COMSAT and CTS shall have received a letter, dated as of a date not more than two days prior to the date that the Registration Statement is declared effective, and shall have received a subsequent letter, dated as of a date not more than two days prior to the Effective Date, from Deloitte & Touche, independent auditors of RSI, addressed to COMSAT and CTS, to the effect that (i) they are independent accountants within the meaning of the Securities Act and the Exchange Act; (ii) in their opinion, the financial statements of RSI included in the Registration Statement comply as to form in all material respects with the applicable accounting requirements of the Securities Act and the Exchange Act, (iii) on the basis of limited procedures specified in their letter, which need not constitute an audit, nothing has come to their attention which would give them reason to believe that (A) since December 31, 1993, to the date of such letter there has been any increase in the outstanding capital stock or rights, securities, options or obligations exercisable for or convertible into shares of capital stock, or in the consolidated indebtedness, of RSI, (B) there has been any change in specified balance sheet items of RSI since the date of the most recent financial statements included in the Registration Statement and the Proxy Statement or (C) since December 31, 1993 to the date of such letter, there has been any decrease in the net income of RSI as compared with the corresponding period for the prior year, except with respect to each of clauses (A), (B) and (C) for any such increase, change or decrease referred to in or contemplated by the Registration Statement and the Proxy Statement or specified in such letter. 6.1.14 Opinion of RSI's Counsel. RSI shall have furnished COMSAT and CTS with an opinion of Shaw, Pittman, Potts & Trowbridge, special counsel for RSI, dated the Closing Date, substantially in the form of Exhibit H. 6.1.15 Other Documents. The execution and delivery to COMSAT and CTS by RSI of such other certificates, documents and instruments as COMSAT may reasonably request. Section 6.2 Waiver. COMSAT and CTS may, at their sole discretion, waive in writing fulfillment of any or all of the conditions set forth in Section 6.1 of this Agreement, provided that such waiver granted by COMSAT and CTS pursuant to this Section 6.2 shall have no effect upon or as against any of the other conditions not so waived. To the extent that at the Closing RSI delivers to COMSAT a written notice specifying in reasonable detail the failure of any of such conditions or the breach by RSI of any of the representations or warranties of RSI herein, and nevertheless COMSAT proceeds with the Closing, COMSAT shall be deemed to have waived for all purposes any rights or remedies it may have against RSI or, except in the case of fraud or gross negligence, any of its directors, officers or employees by reason of the failure of any such conditions or the breach of any such representations or warranties to the extent described in such notice. Following the Closing, no claims for breach of any representations, warranties or agreements shall be brought against any director or officer, or any employee listed in the Disclosure Letter as providing "knowledge" with respect to RSI's representations and warranties as of the Closing Date as referenced in clause (ii) of the last sentence in the introductory paragraph in Article III, if and to the extent such person did not have actual knowledge or had no reason to know (in light of circumstantial evidence made available to them on or prior to Closing) of the facts material to such breach of any representation, warranty or agreement. ARTICLE VII CONDITIONS PRECEDENT TO OBLIGATIONS OF RSI Section 7.1 Conditions. The obligations of RSI to consummate the Merger under this Agreement herein shall be subject to the fulfillment, to its reasonable satisfaction, on or prior to the Closing Date, of all of the following conditions precedent: 7.1.1 HSR Act Waiting Period. All waiting periods under the HSR Act with respect to the Merger shall have been terminated or expired. 7.1.2 Performance by COMSAT and CTS. Each of COMSAT and CTS shall have performed and complied in all material respects with all agreements, covenants, obligations and condi- tions required by this Agreement to be performed or complied with by COMSAT and CTS on or before the Closing Date. 7.1.3 Obtaining of DIS Consents and Approvals. COMSAT shall have obtained and delivered to RSI all necessary consents, approvals or waivers on or prior to the Closing Date as required pursuant to the DIS Industrial Security Regulation. DOD 5220.22-R, and the DIS Industrial Security Manual DOD 5220.22-M (as either may be amended from time to time), for the purpose of retaining any necessary facilities clearances and/or personnel clearances as the case may be after the Closing Date. 7.1.4 Obtaining of Consents and Approvals. COMSAT and CTS shall have executed and delivered to RSI, or shall have caused to be executed and delivered, any consents, waivers, approvals, permits, licenses or authorizations which, if not obtained on or prior to the Closing Date, would have a material adverse effect on the Surviving Corporation's ability to conduct business as conducted by RSI on the Closing Date. 7.1.5 Pooling. RSI shall have received an opinion from Deloitte & Touche, dated the Closing Date, that the Merger as contemplated by this Agreement will be accounted for as a pooling of interests for financial reporting purposes. 7.1.6 Absence of Litigation. There shall not be in effect any order enjoining or restraining the transactions contemplated by this Agreement. 7.1.7 Registration Statement; NYSE Listing. The Registration Statement shall have become effective under the Securities Act prior to the first mailing of the Proxy Statement to shareholders of RSI and the Registration Statement shall, at the date of the meeting of RSI shareholders called pursuant to Section 5.1 of this Agreement and at all times thereafter to and including the Effective Date, have been effective and no stop order suspending the effectiveness thereof shall have been issued during such period and not withdrawn and no stop order shall be pending at the Effective Date. The COMSAT Stock to be issued pursuant to the Merger shall have been approved for listing on the New York Stock Exchange, upon official notice of issuance. 7.1.8 Authorization of Merger. The requisite shareholders of RSI shall have duly voted their shares approving this Agreement and authorizing the Merger. 7.1.9 Officers' Certificates. RSI shall have received certificates, dated the Closing Date, executed on behalf of COMSAT by appropriate officers stating that the representations and warranties set forth in Article IV hereof are true and correct on the Closing Date (unless specified to be made as of another date, in which case on such specified date) in all material respects and that the conditions set forth in Sections 7.1.1 through 7.1.8 hereof have been satisfied. 7.1.10 Other Documents. The execution and delivery to RSI by COMSAT and CTS of such other certificates, documents and instruments as RSI may reasonably request. 7.1.11 Opinion of COMSAT's Counsel. COMSAT shall have furnished RSI with the opinion of Crowell & Moring, special counsel for COMSAT, dated the Closing Date, substantially in the form of Exhibit I. Section 7.2 Waiver. RSI may, in its sole discretion, waive in writing fulfillment of any or all of the conditions set forth in Section 7.1 of this Agreement, provided that such waiver granted pursuant to this Section 7.2 shall not constitute a waiver by RSI of any other conditions not so waived. ARTICLE VIII TERMINATION Section 8.1 Termination Events. Subject to the provisions of Section 8.2, this Agreement may, by written notice given at or prior to the Closing (in the manner provided by Section 9.9 herein) be terminated and abandoned only as follows: 8.1.1 Breach. By either COMSAT or RSI upon written notice if a material default or breach shall be made by the other, with respect to the due and timely performance of any of the other party's respective covenants and agreements contained herein, or with respect to the due compliance with any of the other party's respective representations and warranties contained in Article III or IV herein, as applicable, and such default cannot be cured prior to Closing and has not been waived; 8.1.2 Mutual Consent. By mutual written consent of the parties hereto; or 8.1.3 Failure of Conditions to Close. By either COMSAT or RSI, if by reason of failure of their respective conditions to close contained in Article VI or VII herein, as applicable, and such conditions have not been satisfied or waived by December 31, 1994, or such later date as may be agreed upon by the parties hereto, provided that the right to terminate this Agreement under this Subsection 8.1.3 shall not be available to a party whose failure to fulfill any obligation or perform any covenant under this Agreement has been the cause of or resulted in the failure of any of the conditions to close of the other party hereto by such date. Section 8.2 Effect of Termination. In the event this Agreement is terminated pursuant to Section 8.1 herein, all further rights and obligations of the parties hereunder shall terminate, provided that if RSI at any time prior to December 31, 1994 is acquired by, merges, effectuates a business combination with, or sells substantially all of its assets to any person or entity not controlled by COMSAT, or agrees to do any of the foregoing, RSI shall immediately upon such action or agreement pay to COMSAT Five Million Dollars ($5,000,000), plus all of COMSAT's costs, fees and expenses incurred in connection with this Agreement and the Merger as contemplated hereby, including fees and expenses of its accountants, investment advisers and counsel, and provided further that the total payment RSI shall pay to COMSAT immediately upon such action or agreement shall not in any event exceed Seven Million, Five Hundred Thousand Dollars ($7,500,000). Section 8.3 Fees and Expenses; Damages. Except as otherwise provided in Section 8.2 herein, in the event this Agreement is terminated for any reason and the Merger is not consummated each party shall be responsible for its own costs, fees and expenses, including fees and expenses of its accountants, investment advisers and counsel, provided, however, that if the termination is caused by the breach of COMSAT and CTS on the one hand, or the breach of RSI on the other hand, the breaching party(ies) shall pay to the non-breaching party(ies) as liquidated damages (and as its sole and exclusive remedy) the actual costs and expenses of the non-breaching party(ies), including the fees and expenses of its accountants, investment advisers and counsel, not to exceed Two Million Five Hundred Thousand Dollars ($2,500,000). ARTICLE IX MISCELLANEOUS Section 9.1 Construction. 9.1.1 Words. All references in this Agreement to the singular shall include the plural where appli- cable, and all references to gender shall include both genders and neuter. 9.1.2 Cross-References. References in this Agreement to any Article shall include all Sections, Subsections and Paragraphs in such Article; references in this Agreement to any Section shall include all Subsections and Paragraphs in such Section; and references in this Agreement to any Subsection shall include all Paragraphs in such Subsection. 9.1.3 No Presumption. In interpreting any provision of this Agreement no presumption shall be drawn against the party drafting the provision. 9.1.4 Headings. Article, Section and Subsection headings of this Agreement are for convenience only and are not to be construed as part of this Agreement or as defining or limiting in any way the scope or intent of the provisions hereof. 9.1.5 Exhibits. Exhibits and the Disclosure Letter referred to herein are hereby incorporated into and made a part of this Agreement. Any material disclosed in any part of the Disclosure Letter shall be deemed disclosed for purposes of all of the representations and warranties of RSI contained in Article III herein. 9.1.6 Time. Time shall be of the essence in the performance of each party's respective obligations under this Agreement. Section 9.2 Severability. If any part of this Agreement for any reason shall be declared invalid, such decision shall not affect the validity of any remaining portion, which shall remain in full force and effect. Section 9.3 Further Assurances. Each party shall at its own expense furnish, execute and deliver such documents, instru- ments, certificates, notices or other further assurances as the other party may reasonably require as necessary or appropriate to effect the purposes of this Agreement or to confirm the rights created or arising hereunder. Section 9.4 Benefit. Unless otherwise specified herein, no person who is not a party to this Agreement shall have any rights or derive any benefit hereunder. No provision of this Agreement except Exhibit G shall constitute an agreement of employment. Section 9.5 Scope and Modification. This Agreement, the Stock Option Agreement, and Sections 1 through 4 and Section 7 of the Confidentiality Agreement, constitute the entire agreement between the parties and supersede all prior oral or written agreements (including the Confidentiality Agreement except as specifically referenced in this Section 9.5) or understandings of the parties with regard to the subject matter hereof. No interpretation, modification, termination or waiver of any provision hereof shall be binding upon a party unless in writing and executed by the other parties. No modification, waiver, termination, rescission, discharge or cancellation of any right or claim under this Agreement shall affect the right of any party hereto to enforce any other claim or right hereunder. Section 9.6 Delays or Omissions. Except as expressly pro- vided in this Agreement, no delay or omission to exercise any right, power or remedy accruing to a party hereunder, upon any breach or default of any party under this Agreement, shall impair any such right, power or remedy, nor shall it be construed to be a waiver of any such breach or default, or an acquiescence therein, or a waiver of or acquiescence in any similar breach or default thereafter occurring; nor shall any waiver of any single breach or default be deemed a waiver of any other breach or default theretofore or thereafter occurring. Section 9.7 Successors and Assigns. This Agreement may not be assigned by any party without the written consent of the other parties. Except as otherwise expressly provided herein, the provisions of this Agreement shall inure to the benefit of, and be binding upon, the successors and permitted assigns of the parties hereto. Section 9.8 Governing Law. The terms and provisions of this Agreement shall be interpreted in accordance with and gov- erned by the laws of the State of Maryland and the United States of America, without giving effect to the doctrine of conflict of laws. Section 9.9 Notices. Any notice under this Agreement shall be in writing and shall be delivered by personal service or by United States certified or registered mail, with postage prepaid, or by facsimile or overnight express courier, addressed to a party at the address set forth beneath its name, below, or at such other address as one party may give written notice of to the other parties. (a) If to COMSAT or CTS: C. Thomas Faulders, III Vice President and Chief Financial Officer COMSAT Corporation 6560 Rock Spring Drive Bethesda, MD 20817 Fax: (301) 214-7131 With a copy to: Warren Y. Zeger, Esq. Vice President and General Counsel COMSAT Corporation 6560 Rock Spring Drive Bethesda, MD 20817 Fax: (301) 214-7128 And to: William P. O'Neill, Esq. Crowell & Moring 1001 Pennsylvania Avenue, N.W. Washington, D.C. 20004-2505. Fax: (202) 628-5116 (b) If to RSI: Richard E. Thomas Chairman, Chief Executive Officer and President Radiation Systems Inc. 1501 Moran Road Sterling, VA 20166 Fax: (703) 450-2701 With a copy to: John L. Sullivan, III, Esq. Shaw, Pittman, Potts & Trowbridge 1501 Farm Credit Drive Suite 4400 McLean, VA 22102-5000 Fax: (703) 821-2397 And to: Lynn A. Soukup, Esq. Shaw, Pittman, Potts & Trowbridge 2300 N Street, N.W. Washington, D.C. 20037-1128 Fax: (202) 663-8007 The designation of the person(s) to be so notified, or the address or facsimile of such person(s) for the purposes of such notice, may be changed from time to time by means of a similar notice. Copies to counsel shall not constitute notice. Section 9.10 Duplicates. This Agreement may be executed in one or more counterparts, each of which shall constitute an original document. Section 9.11 Cooperation. The parties shall consult and cooperate with one another regarding, and shall use their respective reasonable efforts to seek and obtain, the approvals, consents and other documents contemplated by this Agreement, and shall use their respective best efforts to cause the statutory and other conditions to their respective obligations hereunder to be satisfied. Section 9.12 Public Announcements. RSI and COMSAT agree that they will not issue any press release or otherwise make any public statement or respond to any press inquiry with respect to this Agreement or the transactions contemplated hereby, without the prior approval of the other party, except as may be required by law; if any such disclosure is required by law the disclosing party shall use its best efforts to give notice and an opportunity to consult to the other party prior to such required disclosure. EXECUTION AND DELIVERY IN WITNESS WHEREOF, the parties hereto have executed and delivered this Agreement with the express intent that it be effective, legal and binding as of the date and year first-above written. COMSAT CORPORATION By: /s/ Bruce L. Crockett ----------------------- Name: Bruce L. Crockett Title: President CTS AMERICA, INC. By: /s/ C. Thomas Faulders, III ----------------------------- Name: C. Thomas Faulders, III Title: President RADIATION SYSTEMS, INC. By: /s/ Richard E. Thomas ------------------------- Name: Richard E. Thomas Title: Chairman EXHIBIT 2(b) STOCK OPTION AGREEMENT STOCK OPTION AGREEMENT dated as of January 30, 1994, by and between COMSAT CORPORATION, a District of Columbia corporation ("COMSAT"), and RADIATION SYSTEMS, INC., a Nevada corporation (the "Company"). WHEREAS, the Company, COMSAT and CTS America, Inc., a Delaware corporation and a wholly owned subsidiary of COMSAT ("CTS"), propose to enter into an Agreement and Plan of Merger, dated as of the date hereof (the "Merger Agreement"), which provides, among other things, upon the terms and subject to the conditions thereof, that the Company will be merged with and into CTS, with CTS to be the surviving corporation, and that each outstanding share of common stock, par value $1.00 per share of the Company (the "Company Common Stock") will be converted into the right to receive that fraction of a share, rounded to the nearest thousandth (the "Conversion Fraction"), of common stock, without par value, of COMSAT (the "COMSAT Stock") determined by dividing Eighteen Dollars and twenty- five cents ($18.25) by the average closing price of a whole share of COMSAT Stock on the New York Stock Exchange Composite Tape for the twenty (20) Trading Days ending with the Trading Day which precedes the Closing Date by five (5) Trading Days (a "Trading Day" being any day on which the New York Stock Exchange is open for business and on which shares of COMSAT Stock are traded on that Exchange), provided that the Conversion Fraction shall not be less than .638 and shall not be greater than .780; and WHEREAS, as a condition to its willingness to enter into the Merger Agreement, COMSAT has required that the Company agree, and in order to induce COMSAT to enter into the Merger Agreement the Company has agreed, to grant the COMSAT Option (as hereinafter defined). NOW THEREFORE, in consideration of the foregoing and the mutual covenants and agreements set forth herein and in the Merger Agreement, the parties hereto agree as follows: 1. Grant of Option. The Company hereby grants to COMSAT an unconditional, irrevocable option (the "COMSAT Option") to purchase a number of shares of Company Common Stock equal to Fifteen Percent (15%) of the shares of Company Common Stock outstanding on the date hereof (the "Option Shares") at an exercise price of Eighteen Dollars and twenty-five cents ($18.25) per Option Share (the "COMSAT Option Exercise Price"). 2. Exercise of Option. Provided that COMSAT or CTS is not then in material breach of its obligations under the Merger Agreement, COMSAT may exercise the COMSAT Option, in whole or in part, at any time, in the event that any corporation, partnership, person, other entity or group (as defined in Section 13(d)(3) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) (collectively, a "Person"), other than COMSAT or any of its subsidiaries, (i) acquires beneficial ownership (as such term is defined in Rule 13d-3 under the Exchange Act) of at least Fifteen Percent (15%) of the outstanding shares of Company Common Stock, (ii) enters into an agreement with the Company or any of its material subsidiaries to merge or consolidate with the Company or any of its subsidiaries, or to purchase all or substantially all of the consolidated assets of the Company (or effects any such merger, consolidation or purchase) and the Merger Agreement is terminated, or (iii) has commenced or commences (as such terms are defined in Rule 14d-2 under the Exchange Act) a tender or exchange offer for at least Fifteen Percent (15%) of the outstanding shares of Company Common Stock that is not opposed by the Company and the Company is no longer supporting the Merger Agreement and the transactions contemplated thereby. In the event COMSAT wishes to exercise the COMSAT Option for some or all of the Option Shares, COMSAT shall send a written notice to the Company stating the number of Option Shares that it wishes to purchase and setting forth a place and date not earlier than one nor, subject to Section 8 herein, later than ten business days from the date such notice is given for the closing of such purchase (a "COMSAT Option Closing"). 3. Payment and Delivery of Certificates. (a) At a COMSAT Option Closing, COMSAT will make payment to the Company of the aggregate price for the Option Shares being purchased at the COMSAT Option Closing by delivery of immediately available funds to the Company, and the Company will deliver to COMSAT a certificate or certificates representing the Option Shares being so purchased, registered in the name of COMSAT. (b) Certificates for the Option Shares delivered at each COMSAT Option Closing shall be endorsed with a restrictive legend which shall read substantially as follows: THE TRANSFER OF THE STOCK REPRESENTED BY THIS CERTIFICATE IS SUBJECT TO RESTRICTIONS ARISING UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND PURSUANT TO THE TERMS OF A STOCK OPTION AGREEMENT DATED AS OF JANUARY __, 1994. A COPY OF SUCH AGREEMENT WILL BE PROVIDED TO THE HOLDER HEREOF WITHOUT CHARGE UPON RECEIPT BY THE ISSUER OF A WRITTEN REQUEST THEREFORE. It is understood and agreed that the above legend shall be removed by delivery of substitute certificate(s) without such legend if COMSAT shall have delivered to the Company a copy of a letter from the staff of the SEC, or an opinion of counsel in form and substance reasonably satisfactory to the Company and its counsel, to the effect that such legend is not required for purposes of the Securities Act. 4. Option Value. In the event that the COMSAT Option becomes exercisable pursuant to paragraph 2 hereof, and COMSAT so requests in lieu of exercise of the COMSAT Option, then the Company shall promptly, and in no event later than five (5) business days after receipt of such request, pay to COMSAT an amount in cash (the "COMSAT Option Value") equal to the product of (x) the excess, if any, of (A) the highest price per share paid or proposed to be paid in connection with any transaction specified in Section 2 or Section 10(b)(ii), as applicable, herein for any shares of Company Common Stock, or the greatest aggregate consideration paid or proposed to be paid in connection with any transaction specified in Section 2 or Section 10(b)(ii), as applicable, herein for the purchase of assets of the Company divided by the number of shares of Company Common Stock then outstanding, as the case may be (the value of any such price or consideration other than cash to be determined, in the case of consideration with a readily ascertainable market value, by reference to such market value and, in the case of any other consideration, by agreement in good faith between COMSAT and the Company), over (B) the COMSAT Option Exercise Price, multiplied by (y) the total number of shares still subject to the COMSAT Option. Such payment shall be made by delivery of immediately available funds to COMSAT and shall extinguish all other rights of COMSAT under this Agreement. 5. Representations and Warranties of the Company. The Company hereby represents and warrants to COMSAT as follows: (a) Authority Relative to this Agreement. The Company has full corporate power and authority to execute and deliver this Agreement and to consummate the transactions contemplated hereby. The execution and delivery of this Agreement and the consummation of the transactions contemplated hereby have been duly and validly authorized by the Board of Directors of the Company and no other corporate proceedings on the part of the Company are necessary to authorize this Agreement or to consummate the transactions so contemplated. This Agreement has been duly and validly executed and delivered by the Company and, assuming this Agreement and the Merger Agreement constitute valid and binding obligations of COMSAT, this Agreement constitutes a valid and binding agreement of the Company, enforceable against the Company in accordance with its terms. (b) Option Shares. The Company has taken all necessary corporate action to authorize and reserve and to permit it to issue, and at all times from the date hereof through the Termination Date (as hereinafter defined) will have reserved for issuance upon exercise of the COMSAT Option, a number of shares of Company Common Stock equal to the number of Option Shares to permit the exercise in full of the COMSAT Option, all of which shares, upon issuance pursuant hereto, shall be duly authorized, validly issued, fully paid and nonassessable, and shall be delivered free and clear of all claims, liens, encumbrances and security interests and not subject to any preemptive rights. 6. Representations and Warranties of COMSAT. COMSAT hereby represents and warrants to the Company as follows: (a) Authority Relative to this Agreement. COMSAT has full corporate power and authority to execute and deliver this Agreement and to consummate the transactions contemplated hereby. The execution and delivery of this Agreement and the consummation of the transactions contemplated hereby have been duly and validly authorized by the Board of Directors of COMSAT and no other corporate proceedings on the part of COMSAT are necessary to authorize this Agreement or to consummate the transactions so contemplated. This Agreement has been duly and validly executed and delivered by COMSAT and, assuming this Agreement and the Merger Agreement constitute valid and binding obligations of the Company, this Agreement constitutes a valid and binding agreement of COMSAT, enforceable against COMSAT in accordance with its terms. (b) Distribution. COMSAT will acquire the Option Shares for its own account and not with a view to any resale or distribution thereof, and will not sell the Option Shares unless such shares are registered under the Securities Act of 1933 or unless an exemption from registration is available. 7. Adjustment Upon Changes in Capitalization. In the event of any change in the shares of Company Common Stock by reason of stock dividends, split-ups, mergers, recapitalizations, combinations, conversions, exchanges of shares or the like, the number and kind of shares of Company Common Stock subject to the COMSAT Option and the purchase price per share shall be appropriately adjusted. 8. Consents. The Company will use its best efforts to obtain any approvals and consents, and otherwise to satisfy any requirements, of all governmental authorities and laws necessary to the consummation of the transactions contemplated by this Agreement. The consummation of such transactions shall be subject to, and, if delayed pursuant to this Section 8, shall occur promptly after (whether before or after the Termination Date) the receipt of such necessary approvals or consents and satisfaction of such requirements. 9. Registration Rights; Listing. The Company shall, if reasonably requested by COMSAT within three years of the first exercise of the COMSAT Option (or any portion thereof), as expeditiously as possible prepare and file a registration statement under the Securities Act regarding the offer and sale or other disposition of any or all shares of Company Common Stock or other securities that have been acquired by or are issuable to COMSAT upon exercise of the COMSAT Option in accordance with the intended method of sale or other disposition by COMSAT, and the Company shall use its best efforts to qualify such shares or other securities under any applicable state securities laws. COMSAT agrees to use all reasonable efforts to cause, and to cause any underwriters of any sale or disposition to cause, any sale or other disposition pursuant to such registration statement to be effected on a widely distributed basis so that upon consummation thereof no purchaser or transferee shall own beneficially more than 5% of the then outstanding voting power of the Company. The Company shall use its best efforts to cause such registration statement to become effective, to obtain all consents or waivers of other parties that are required therefor and to keep such registration statement effective for a period not in excess of 180 days from the day such registration statement first becomes effective as may be reasonably necessary to effect such sale or other disposition. The obligations of the Company hereunder to file a registration statement and to maintain its effectiveness may be suspended for one or more periods of time not exceeding 45 days in the aggregate if the Board of Directors of the Company shall determined that the filing of such registration statement or the maintenance of its effectiveness would require disclosure of nonpublic information that would materially and adversely affect the Company. Any registration statement prepared and filed under this Section 9, and any sale covered thereby, shall be at the Company's expense except for underwriting discounts or commissions, brokers' fees and the fees and disbursements of COMSAT's counsel related thereto. COMSAT shall provide all information reasonably requested by the Company for inclusion in any registration statement to be filed hereunder. If during the time period referred to in the first sentence of this Section 9 the Company effects a registration under the Securities Act of Company Common Stock for its own account or for any other stockholders of the Company (other than on Form S-4 or Form S-8, or any successor form), it shall allow COMSAT the right to participate in such registration; provided that, if the managing underwriters of such offering advise the Company in writing that in their opinion the number of shares of Company Common Stock requested to be included in such registration exceeds the number which can be sold in such offering, the Company shall include the shares requested to be included therein by COMSAT pro rata with the shares intended to be included therein by the Company (and by no others). In connection with any registration pursuant to this Section 9, the Company and COMSAT shall provide each other and any underwriter of the offering with the customary representations, warranties, covenants, indemnification and contribution in connection with such registration. The Company will use its best efforts promptly to list on the NASDAQ National Market System or a national securities exchange, whichever is the principal trading market for the Company Common Stock on the date of exercise of the COMSAT Option, upon official notice of issuance, the Option Shares issued upon exercise of the COMSAT Option. 10. Termination; Certain Protection. (a) Except as otherwise contemplated hereby, all the provisions of this Agreement shall terminate upon the date (the "Termination Date") which is thirty (30) days after the termination of the Merger Agreement. (b) In the event that (i) prior to the Termination Date any Person, other than COMSAT or any of its affiliates, shall publicly announce or communicate to the Company a proposal (A) to merge or consolidate with the Company or any of its subsidiaries, or to purchase all or substantially all of the assets of or otherwise to acquire the Company, or (B) to make any tender or exchange offer for shares of Company Common Stock and (ii) within one year after the Termination Date such Person or a related Person (x) acquires at least Fifteen Percent (15%) of the outstanding shares of Company Common Stock, (y) enters into an agreement with the Company or any of its subsidiaries to merge or consolidate with the Company or any of its subsidiaries or to purchase all or substantially all of the assets of the Company (or effects any such merger, consolidation or purchase) or (z) commences a tender offer or exchange offer for at least Fifteen Percent (15%) of the outstanding shares of Company Common Stock that is supported by the Company, then the Company shall promptly pay to COMSAT the COMSAT Option Value. 11. Assignment. COMSAT shall not sell, assign, convey or transfer the COMSAT Option other than to any wholly owned subsidiary of COMSAT. This Agreement shall be binding upon and inure to the benefit of each party's successors and assigns. 12. Specific Performance. The parties hereto acknowledge that damages would be an inadequate remedy for a breach of this Agreement and that the obligations of the parties hereto shall be specifically enforceable. Accordingly, it is agreed that COMSAT shall be entitled to injunctive relief to prevent breaches of this Agreement by the Company and specifically to enforce the terms and provisions hereof, in addition to any other remedy to which it may be entitled, at law or in equity. 13. Entire Agreement. This Agreement and the Merger Agreement constitute the entire agreement among the parties with respect to the subject matter hereof and supersede all other prior agreements and understandings, both written and oral, among the parties or any of them with respect to the subject matter hereof. 14. Validity. The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provisions of this Agreement, which shall remain in full force and effect. 15. Notices. All notices, requests, claims, demands and other communications hereunder shall be deemed to have been duly given when delivered in person, by registered or certified mail (postage prepaid, return receipt requested) or by facsimile to the respective parties at their respective addresses set forth in the Merger Agreement, or at such other address as the person to whom notice is given may have previously furnished to the others in writing in the manner set forth in the Merger Agreement (provided that notice of any change of address shall be effective only upon receipt thereof). 16. Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of Maryland. 17. Descriptive Headings. The descriptive headings herein are inserted for convenience of reference only and are not intended to be part of or to affect the meaning or interpretation of this Agreement. 18. Counterparts. This Agreement may be executed in two or more counterparts, each of which shall be deemed to be an original, but all of which shall constitute one and the same agreement. 19. Expenses. All costs and expenses incurred in connection with the transactions contemplated by this Agreement shall be paid by the party incurring such expenses. 20. Benefit. No person who is not a party to this Agreement shall have any rights or derive any benefit hereunder. 21. Transfer. If COMSAT has exercised the COMSAT Option, COMSAT shall not sell, transfer, pledge, or hypothecate the Option Shares except pursuant to a bona fide third party offer (the "Third Party Offer"), and without first tendering the Option Shares to the Company at the price or equivalent value as that provided for in the Third Party Offer. Such tender shall be made in writing and be held open for 15 days. Notwithstanding the above, COMSAT shall have no obligation to tender the Option Shares if the Third Party Offer is made by any member or members of a group (as defined in Section 13(d)(3) of the Exchange Act) to which COMSAT is also member. IN WITNESS WHEREOF, each of the parties has caused this Agreement to be executed on its behalf by its officers thereunto duly authorized, all as of the day and year first above written. COMSAT CORPORATION By: /s/ Bruce L. Crockett ------------------------- Name: Bruce L. Crockett Title: President RADIATION SYSTEMS, INC. By: /s/ Richard E. Thomas ------------------------- Name: Richard E. Thomas Title: Chairman EXHIBIT 4(a) __________ __________ NUMBER SHARES CS __________ __________ THE TRANSFERABILITY OF THESE THE TRANSFERABILITY OF THESE SHARES IS SUBJECT TO THE SHARES IS SUBJECT TO THE CONDITIONS SET FORTH ON THE CONDITIONS SET FORTH ON THE REVERSE SIDE. REVERSE SIDE. DOMESTIC SHARE CERTIFICATE SERIES [PICTURE] SERIES I I INCORPORATED UNDER THE SEE REVERSE FOR DISTRICT OF COLUMBIA CERTAIN DEFINITIONS BUSINESS CORPORATION ACT CUSIP 20564D 10 7 COMSAT CORPORATION ___________________________________________________________________________ This is to Certify that SPECIMEN is the owner of ___________________________________________________________________________ FULLY PAID AND NON-ASSESSABLE SHARES, WITHOUT PAR VALUE, OF SERIES I COMMON STOCK OF COMSAT Corporation, transferable on the books of the Corporation by the holder hereof in person or by duly authorized attorney on surrender of this Certificate properly endorsed. This Certificate and the shares represented hereby are issued and shall be subject to the provisions of the Communications Satellite Act of 1962, the Articles of Incorporation and By- laws of the Corporation, and all amendments thereto (copies of which are on file with the Transfer Agent), to all of which the holder hereof by acceptance of this Certificate assents. This Certificate is not valid until countersigned by the Transfer Agent and registered by the Registrar. In Witness Whereof, the Corporation has caused this Certificate to be signed by its duly authorized officers and its corporate seal to be hereunto affixed. [CORPORATE SEAL] Dated: COUNTERSIGNED AND REGISTERED: THE BANK OF NEW YORK \S\ Bruce L. Crockett (NEW YORK) TRANSFER AGENT ______________________ AND REGISTRAR PRESIDENT AND CHIEF EXECUTIVE OFFICER BY \S\ Jerome W. Breslow ______________________ AUTHORIZED SIGNATURE VICE PRESIDENT AND SECRETARY __________________________ American Bank Note Company __________________________ [Back of Certificate] The following abbreviations, when used in the inscription on the face of this certificate, shall be construed as though they were written out in full according to applicable laws or regulations: TEN COM -- as tenants in common TEN ENT -- as tenants by the entireties JT TEN -- as joint tenants with right of survivorship and not as tenants in common UNIF GIFT MIN ACT -- .............. Custodian.............. (Cust) (Minor) under Uniform Gifts to Minors Act ................. (State) Additional abbreviations may also be used though not in the above list. For value received, __________ hereby sell, assign and transfer unto PLEASE INSERT SOCIAL SECURITY OR OTHER TAXPAYER IDENTIFYING NUMBER OF ASSIGNEE _____________________________ _____________________________ ___________________________________________________________________________ PLEASE PRINT OR TYPEWRITE NAME AND ADDRESS OF ASSIGNEE ___________________________________________________________________________ ___________________________________________________Shares of the capital stock represented by the within Certificate, and do hereby irrevocably constitute and appoint__________________________________________Attorney, to transfer the said stock on the books of the within-named Corporation with full power of substitution in the premises. Dated,_________________________ __________________________________________ NOTICE: THE SIGNATURE TO THIS ASSIGNMENT MUST CORRESPOND WITH THE NAME AS WRITTEN UPON THE FACE OF THE CERTIFICATE IN EVERY PARTICULAR, WITHOUT ALTERATION OR ENLARGEMENT, OR ANY CHANGE WHATEVER. COMSAT CORPORATION The Corporation will furnish without charge to each shareholder who so requests a statement of the designations, preferences, restrictions, limitations and relative rights of the shares of each class of stock or series thereof which the Corporation is authorized to issue. RESTRICTIONS ON OWNERSHIP AND TRANSFER OF SHARES OF COMMON STOCK The ownership and transfer of shares of Common Stock of the Corporation are subject to the provisions of the Communications Satellite Act of 1962 (the Act) and the Articles of Incorporation of the Corporation (the Articles). A summary of such provisions of the Act and the Articles is set forth below and is qualified by reference thereto. Persons Ineligible to Own Shares at Any Time. Shares of Common Stock may not at any time be owned by any of the following persons (unless such person is a communications common carrier authorized by the Federal Communications Commission to own shares of stock of the Corporation (an Authorized Carrier)): (1) a communications common carrier; (2) a subsidiary or affiliated company of a communications common carrier; (3) an officer, director or trustee of a communications common carrier or of a subsidiary or affiliated company thereof (except as provided in Sections 5.02(a) and (b) of the Articles); or (4) a person who will hold such shares as nominee of, or subject to the direction and control of, any of the foregoing. In general, the term "communications common carrier" includes (a) any person (other than the Corporation) engaged as a common carrier for hire, in interstate or foreign communication by wire or radio or in interstate or foreign radio transmission of energy, and (b) any person that owns or controls, or is under common control with, any such person. Persons engaged in radio broadcasting are not, insofar as so engaged, deemed to be communications common carriers. Limitation on Ownership of Shares of Aliens and Certain Other Alien Interests. Not more than an aggregate of 20% of the total number of shares of stock owned or held by persons other than Authorized Carriers may be owned or held by any of the following persons (collectively, Alien Persons): (1) any alien or the representative of any alien; (2) any foreign government or the representative thereof; (3) any corporation organized under the laws of any foreign government; (4) any corporation of which any officer or director is an alien or of which more than one-fifth of the capital stock is owned of record or voted by aliens or their representatives or by a foreign government or representative thereof or by any corporation organized under the laws of a foreign country; or (5) any corporation directly or indirectly controlled by any other corporation of which any officer or more than one-fourth of the directors are aliens, or of which more than one-fourth of the capital stock is owned of record or voted by aliens, their representatives, or by a foreign government or representative thereof, or by any corporation organized under the laws of a foreign country. Limitation on Ownership of Shares by Persons Other Than Authorized Carriers. In accordance with procedures set forth in the Articles (including the giving of notice to shareholders of record), the Board of Directors of the Corporation is authorized to establish a percentage limitation on the ownership, and the incidents of ownership such as voting, of shares of stock by any shareholder (other than an Authorized Carrier) or by any syndicate or affiliated group of shareholders, provided that such percentage limitation may not exceed 10% of the shares of stock issued and outstanding. Pursuant to this authority, the Board of Directors has fixed (a) 10% as the maximum percentage of shares of stock issued and outstanding that may be owned by any shareholder (other than an Authorized Carrier) or by any syndicate or affiliated group of shareholders; and (b) 5% as the maximum percentage of shares of stock issued and outstanding that may be voted by any shareholder (other than an Authorized Carrier) or by any syndicate or affiliated group of shareholders. For purposes of these limitations, (a) a person shall be considered a shareholder if he is the record holder of any shares of stock, or is the economic owner of any shares, or has voting power over any shares, but not if he has only investment discretion in respect of shares; and (b) there shall be attributed to such a person shares of which he is the holder of record (unless the attribution of such shares is excepted by Section 5.02(h) of the Articles), shares of which he is the economic owner, and shares over which he has voting power, provided that shares in respect of which he has only investment discretion shall not be attributed to him. Limitation on Ownership and Disposition of Shares by Authorized Carriers. The number of shares of Common Stock owned by Authorized Carriers may not at any time exceed 50% of the total number of shares of Common Stock issued and outstanding. No Authorized Carrier (or affiliated group of such carriers) may effect sales or other dispositions of shares of Common Stock owned by them (except dispositions to Authorized Carriers) totaling, in any consecutive 12-month period, more than 2% of the greatest number of shares of Common Stock held by all Authorized Carriers at any time during such period, except pursuant to a general public offering or another method approved by the Board of Directors. Procedures Relating to Ownership and Transfer of Shares. The Board of Directors is authorized to establish procedures, consistent with applicable law and the Articles, relating to the ownership and transfer of shares of stock. _________________________________________________________________ NO TRANSFER OF THE SHARES REPRESENTED BY THIS CERTIFICATE WILL BE REGISTERED ON THE BOOKS OF THE CORPORATION UNLESS AN APPLICATION FOR TRANSFER OF SHARES HAS BEEN EXECUTED BY THE ASSIGNEE. THE APPLICATION FOR TRANSFER OF SHARES SET FORTH BELOW MAY BE EXECUTED BY THE ASSIGNEE IF HE (OR SHE) IS A UNITED STATES CITIZEN AND THE STATEMENTS IN THE APPLICATION ARE CORRECT AS TO SUCH ASSIGNEE. ANY OTHER ASSIGNEE MUST EXECUTE AN APPLICATION IN ANOTHER APPROVED FORM, WHICH THE TRANSFER AGENT WILL FURNISH ON REQUEST AND WITHOUT CHARGE. ________________________________________________________________ APPLICATION FOR TRANSFER OF SHARES OF COMMON STOCK THE UNDERSIGNED ASSIGNEE HEREBY MAKES APPLICATION FOR THE TRANSFER TO THE NAME OF THE UNDERSIGNED OF THE SHARES OF COMMON STOCK REPRESENTED BY THE WITHIN CERTIFICATE (THE "SHARES") AND HEREBY CERTIFIES TO COMSAT CORPORATION THAT: (1) I AM A UNITED STATES CITIZEN AND AM NOT THE REPRESENTATIVE OF AN ALIEN OR OF A FOREIGN GOVERNMENT. (2) I AM NOT A "COMMUNICATIONS COMMON CARRIER" OR A SUBSIDIARY OR AFFILIATED COMPANY OF A "COMMUNICATIONS COMMON CARRIER", OR A TRUSTEE, OFFICER OR DIRECTOR OF ANY OF THE FOREGOING. THE OWNERSHIP, ISSUANCE AND TRANSFER OF SHARES OF STOCK OF THE CORPORATION ARE SUBJECT TO THE PROVISIONS OF THE COMMUNICATIONS SATELLITE ACT OF 1962 AND THE ARTICLES OF INCORPORATION OF THE CORPORATION. A SUMMARY OF SUCH PROVISIONS OF THE ACT AND THE ARTICLES IS SET FORTH ABOVE. DATED SIGNATURE OF ASSIGNEE EXHIBIT 10(h) COMSAT CORPORATION INSURANCE AND RETIREMENT PLAN FOR EXECUTIVES Restated effective January 1, 1994 (except as otherwise stated) Section 1 - Name and Purpose 1.1 Name. The name of this plan is the COMSAT Corporation Insurance and Retirement Plan for Executives. 1.2 Purpose. The purpose of this plan is to provide key executives of the Corporation with supplemental retirement income and death benefits in order to assist the Corporation in attracting and retaining executives of outstanding ability. Section 2 - Definitions and Construction 2.1 Definitions. For purposes of the Plan, unless a different meaning is plainly required by the context, the following definitions are applicable: (a) "Accrued Benefit" means an amount equal to the Normal Retirement Benefit of a Participant, as of any date, as though that date were the date of termination of his employment. (b) "Administrator" means the person appointed by the Board in accordance with Section 12.1. (c) "Age" means the number of full years which have elapsed since the Participant's date of birth. (d) "Beneficiary" means a person designated by a Participant, in a written instrument filed with and in a form satisfactory to the Administrator, to receive the lump sum death benefit payable under Section 10.1 or 10.2 upon the death of a Participant. (e) "Board" means the Board of Directors of COMSAT Corporation or any successor to such Corporation. (f) "Corporation" means COMSAT Corporation or any successor thereto, and any subsidiary of such Corporation. (g) "Disability" means total disability as defined in the Corporation's Long-Term Disability Plan. (h) "Disabled Participant" means a Participant who incurs a Disability while he is an Employee and who continues to accrue Credited Service under the Retirement Plan. (i) "Early Retirement Date" means the date on which a Participant retires pursuant to Section 5.1. (j) "Early Retirement Supplement" means the amount of annual income equal to the Primary Social Security Benefit of the Participant used in determining his Normal Retirement Benefit under the Retirement Plan. (k) "Earnings" means (i) the regular, basic salary received by a Participant from the Corporation, before any salary reductions, (ii) Incentive Compensation, (iii) dividend equivalents from Restricted Stock Units, and (iv) cash proceeds from vested Restricted Stock Units. Incentive Compensation, dividend equivalents from Restricted Stock Units, and cash proceeds from vested Restricted Stock Units shall be included in Earnings at the earliest time they could have been paid to the Participant in cash, whether or not he elects to receive such payment then or defer it to a later date. (l) "Employee" means any person who is employed by the Corporation. (m) "Highest Average Earnings Period" means the 48 consecutive months in which a Participant's Earnings were the greatest. If a Participant has completed less than 48 consecutive months of employment with the Corporation as of any date, "Highest Average Earnings Period" shall mean all of the consecutive months of employment with the Corporation as of that date. (n) "Highest Average Annual Earnings" means the amount determined by dividing the total Earnings earned by a Participant during his Highest Average Earnings Period by the number of years (including fractions of years) included in the Highest Average Earnings Period. (o) "Inactive Participant" means a Participant who is no longer an Employee but who has an interest in the Plan which has not been fully paid. (p) "Incentive Compensation" means the additional compensation awarded a Participant under the Corporation's Annual Incentive Plan, as amended from time to time. (q) "Late Retirement Date" means the date on which a Participant retires pursuant to Section 6.1. (r) "Normal Retirement Benefit" means the amount of annual income payable from and after a Participant's Normal Retirement Date, as calculated as provided in Section 4.2. (s) "Normal Retirement Date" means the first day of the month coincident with or next following a Participant's 65th birthday. The "normal retirement age" under the Plan shall be age 65. (t) "Participant" means an Employee participating in the Plan in accordance with Section 3, an Inactive Participant, and a Disabled Participant. (u) "Participation Commencement Date" means the date on which an Employee becomes a Participant in the Plan in accordance with Section 3. (v) "Plan" means the COMSAT Corporation Insurance and Retirement Plan for Executives, as amended from time to time. (w) "Restricted Stock Units" (RSUs) means stock units awarded to a Participant under the Corporation's 1986 or 1990 Key Employee Stock Plans or any successors thereto. (x) "Retirement Plan" means the Corporation's qualified defined benefit pension plan, currently known as the COMSAT Corporation Retirement Plan, as amended from time to time, or any successor thereto. (y) "Spouse" means the person who is married to a Participant on the date of the Participant's death. (z) "Years of Service" means the number of full years which a Participant has been employed by the Corporation. (aa) Any term used in the Plan in capitalized form which is not defined in one of the preceding paragraphs shall have the same meaning as in the Retirement Plan. 2.2 Construction. Wherever applicable, the masculine pronoun shall mean or include the feminine pronoun, and words used in the singular shall include the plural, and vice versa. Section 3 - Participation 3.1 Initial Participation. An Employee shall become a Participant in the Plan upon being designated as such by the Board. There is no minimum age or service requirement to become a Participant. 3.2 Continued Participation. An Employee who becomes a Participant shall remain a Participant as long as he is an Employee. He shall thereafter be an Inactive Participant as long as he has an interest in the Plan which has not been fully paid. 3.3 Disabled Participant. A Disabled Participant shall remain a Participant for all purposes of the Plan. Section 4 - Normal Retirement 4.1 Normal Retirement Age. A Participant who has not retired earlier pursuant to Section 5.1 shall retire on his 65th birthday, except as provided in Section 6.1. 4.2 Normal Retirement Benefit. (a) Subject to the provisions of Section 8.1, a Participant retiring at the Normal Retirement Age of 65 shall receive a Normal Retirement Benefit, beginning on his Normal Retirement Date, in an amount equal to 60 percent (65 percent in the case of the President of COMSAT Corporation, and 70 percent in the case of the Chairman and/or Chief Executive Officer of COMSAT Corporation) of his Highest Average Annual Earnings, reduced by the following: (i) the Normal Retirement Income of the Participant under the Retirement Plan, provided that in the case of a Participant who retires under the Retirement Plan on or after March 1, 1993, the amount of the reduction shall be the amount of annual retirement income which the Participant is actually receiving under the Retirement Plan; (ii) the Primary Social Security Benefit of the Participant used in determining his Normal Retirement Income under the Retirement Plan; (iii) vested age 65 retirement benefits of the Participant from the qualified defined benefit pension plans of prior employers, including any lump sum retirement benefit previously received, expressed in the form of a single life annuity, whether or not actually paid in that form; and (iv) retirement benefits of the Participant from government and military pensions, expressed in the form of a single life annuity, whether or not actually paid in that form. (b) Except as provided in Section 11.2, the Normal Retirement Benefit of a Participant who retires at the Normal Retirement Age of 65 shall be nonforfeitable. Section 5 - Early Retirement 5.1 Early Retirement Date. A Participant may elect to retire on the first day of any month between his 55th and 65th birthdays, provided that a Participant may retire before his 62nd birthday only with the Board's consent, and provided further that a Participant eligible for early retirement under the Retirement Plan may retire early under this Plan only if he also elects early retirement under the Retirement Plan on the same date. 5.2 Retirement Benefit. (a) A Participant retiring on an Early Retirement Date shall, unless he makes the election provided for in paragraph (b), receive an annual retirement benefit, beginning on his Normal Retirement Date, in an amount equal to his Accrued Benefit at his Early Retirement Date. (b) Such Participant may, by a written statement filed with the Administrator at least 30 days before the date on which he wishes payment to begin, elect that payment of his annual retirement benefit shall begin on the first day of any month between his Early Retirement Date and his Normal Retirement Date. The amount of annual retirement benefit shall be equal to (i) his Accrued Benefit at his Early Retirement Date plus (ii) the Early Retirement Supplement, provided that if payment of such annual retirement benefit commences before the Participant's 62nd birthday, the amount of the Accrued Benefit shall be reduced by 1/4 of one percent for each complete month between the date the retirement benefit payments commence and his 62nd birthday. (c) Participants eligible for the Early Retirement Supplement are those who either retire on or after January 1, 1988, or who are receiving an Early Retirement Benefit as of that date. Section 6 - Late Retirement 6.1 Late Retirement Date. A Participant shall retire not later than the earlier of: (a) his 70th birthday; or (b) the earliest day upon which he meets all of the following tests: (i) he has attained age 65; (ii) his Normal Retirement Benefit under this Plan plus his Normal Retirement Income under the Retirement Plan would be at least $44,000; provided, however, that no Participant shall be required to retire before the earliest date upon which he may be required to retire under the applicable laws of the state or other jurisdiction in which he is employed. 6.2 Retirement Benefit. A Participant retiring on a Late Retirement Date pursuant to Section 6.1 shall receive an annual retirement benefit, beginning on the first day of the month coincident with or next following his Late Retirement Date, in an amount equal to his Accrued Benefit at his Late Retirement Date. Section 7 - Termination of Employment 7.1 Retirement Benefit. A Participant whose employment with the Corporation terminates for any reason other than death or retirement under this Plan shall be entitled to receive an annual retirement benefit, payable as provided in Section 7.3, in an amount equal to his Accrued Benefit at his date of termination multiplied by a fraction, the numerator of which is the number of complete months of his employment before his termination date, and the denominator of which is the number of complete months of employment he would have had if he had retired at the normal retirement age of 65. 7.2 Death Before Payment Commencement. If a Participant entitled to an annual retirement benefit pursuant to Section 7.1 dies before payment of such retirement benefit has begun pursuant to Section 7.3, no payment shall be made under any provision of this Plan for the benefit of such Participant. 7.3 Payment Commencement Date. Payment of the annual retirement benefit to which a Participant is entitled under Section 7.1 shall begin on his Normal Retirement Date, if he shall be living on that date. Section 8 - Vesting 8.1 Vesting - Participation Commencement Date Prior to June 21, 1985. Notwithstanding any other provision of this Plan except Sections 11, 12.3, and 13, a Participant whose Participation Commencement Date is any time before June 21, 1985, shall be fully vested at all times in the annual retirement benefit and the Early Retirement Supplement to which he is entitled under the Plan. 8.2 Vesting - Participation Commencement Date After June 20, 1985, and Prior to January 1, 1993. Notwithstanding any other provision of this Plan except Sections 11, 12.3, and 13, in the case of a Participant whose Participation Commencement Date is after June 20, 1985, and prior to January 1, 1993, the annual retirement benefit and the Early Retirement Supplement to which such a Participant is otherwise entitled under this Plan shall be multiplied by a fraction (not to exceed 1.0), the numerator of which is the number of complete months of employment with the Corporation before his retirement or termination date, and the denominator of which is 60. 8.3 Vesting - Participation Commencement Date After December 31, 1992. Notwithstanding any other provision of this Plan except Sections 11, 12.3, and 13, a Participant whose Participation Commencement Date is after December 31, 1992, shall be entitled to receive retirement income equal to a percentage of the annual retirement benefit and the Early Retirement Supplement to which the Participant is otherwise entitled under this Plan, computed in accordance with the following schedule once the sum of the Participant's Age and the Participant's Years of Service equals 60: Years of Service Vested Percentage 0-4 0% 5 50 6 60 7 70 8 80 9 90 10 100 8.4 Death Benefits. Any benefits payable pursuant to Section 10 on account of a Participant's death shall not be reduced because the Participant had completed less than five years of employment with the Corporation at the time of his death. Section 9 - Form of Payment of Retirement Benefits 9.1 Normal Form of Payment. The normal form of payment of retirement benefits shall be in equal monthly installments for the life of the Participant. 9.2 Optional Forms of Payment. (a) At any time prior to the date on which payment of retirement benefits is to begin, a Participant may by an instrument in writing delivered to the Administrator elect to receive, in lieu of the normal form of payment provided in Section 9.1, a retirement benefit which is the actuarial equivalent of the benefit specified in Section 9.1, in one of the forms provided for the payment of retirement benefits under the Retirement Plan. (b) Notwithstanding paragraph (a), with respect to a Participant who (i) retires on an Early Retirement Date, (ii) elects to begin payment of his retirement benefits before his Normal Retirement Date, and (iii) elects an optional form of payment pursuant to paragraph (a), the portion of his retirement benefits specified in Section 5.2 (b) (ii) shall be paid in equal monthly installments. (c) Notwithstanding paragraph (a), the retirement benefit of a Participant who retires on a Late Retirement Date and who elects an optional form of payment pursuant to paragraph (a) shall not be actuarially increased to take account of the commencement of such benefits after the Participant's Normal Retirement Date. 9.3 1991 Lump Sum Payment Option (a) For purposes of this Section 9.3: (i) "Lump Sum Payment" means a single payment, payable on January 1, 2000, equal to the actuarial equivalent of the retirement benefits otherwise payable to a Participant under the Plan after December 31, 2000, based on the Participant's Accrued Benefit as of March 31, 1991. In the case of a Participant who has not begun receiving retirement benefits before January 1, 2000, such actuarial equivalence shall be computed on the basis as if the Participant's retirement benefits were to begin on the later of January 1, 2001, or the first day of the month coincident with or next following his 62nd birthday. (ii) "Electing Participant" means an Employee who: (1) was a Participant on April 1, 1991 and (2) by an instrument in writing filed with the Administrator no later than August 31, 1991, elects to receive a Lump Sum Payment. (b) On January 1, 2000, a Lump Sum Payment shall be made to each Electing Participant who as of that date: (i) has begun receiving retirement benefits pursuant to Section 4.2, 5.2 or 6.2; (ii) has retired on an Early Retirement Date and has not begun to receive his annual retirement benefit pursuant to Section 5.2; or (iii) is an Employee. The annual retirement benefit payable after December 31, 2000, to the Electing Participant pursuant to Section 4.2, 5.2 or 6.2, whichever may be applicable, shall be reduced to reflect his receipt of the Lump Sum Payment. 9.4 1992 Lump Sum Payment Option. (a) For purposes of this Section 9.4: (i) "Lump Sum Payment" means a single payment, payable on January 1, 2001, equal to the actuarial equivalent of the retirement benefits otherwise payable to a Participant under the Plan after December 31, 2001, based on the amount equal to (1) the Participant's Accrued Benefit as of March 31, 1992, less (2) if the Participant made the election provided in Section 9.3, the Participant's Accrued Benefit as of March 31, 1991. In the case of a Participant who has not begun receiving retirement benefits before January 1, 2001, such actuarial equivalence shall be computed on the basis as if the Participant's retirement benefits were to begin on the later of January 1, 2002, or the first day of the month coincident with or next following his 62nd birthday. (ii) "Electing Participant" means an Employee who: (1) was a Participant on January 1, 1992, and (2) by an instrument in writing filed with the Administrator no later than May 31, 1992, elects to receive a Lump Sum Payment. (b) On January 1, 2001, a Lump Sum Payment shall be made to each Electing Participant who as of that date: (i) has begun receiving retirement benefits pursuant to Section 4.2, 5.2 or 6.2; (ii) has retired on an Early Retirement Date and has not begun to receive his annual retirement benefit pursuant to Section 5.2; or (iii) is an Employee. The annual retirement benefit payable after December 31, 2001, to the Electing Participant pursuant to Section 4.2, 5.2 or 6.2, whichever may be applicable, shall be reduced to reflect his receipt of the Lump Sum Payment. 9.5 Actuarial Equivalent. Wherever in the Plan a benefit is required to be the actuarial equivalent of another benefit, such actuarial equivalence shall be computed on the basis of (a) Table V in section 1.72-9 of the Treasury Department Regulations and (b) the Pension Benefit Guaranty Corporation's interest rate for immediate annuities, both as in effect for the month preceding the date of distribution of such benefit. Section 10 - Death Benefits 10.1 Death Benefits While Employed. If a Participant dies while an active Employee: (a) His Spouse shall receive an annual death benefit in an amount equal to 50% of his Accrued Benefit at the date of his death. Such benefit shall be payable in equal monthly installments beginning on the first day of the month coincident with or next following the date of the Participant's death, and continuing until the earlier of (i) the completion of 120 months or (ii) the date of the Spouse's death. (b) His Beneficiary shall receive a lump sum death benefit in the amount of $200,000 as soon as practicable after the date of his death. 10.2 Death Benefits After Retirement. If a Participant dies after retirement, his Beneficiary shall receive a lump sum death benefit in the amount of $200,000 as soon as practicable after the date of his death. 10.3 Death Benefits Offset. If a Participant dies before January 1, 2000, any payments made to the Participant's Spouse or Beneficiary pursuant to life insurance policies on the life of the Participant which are purchased in connection with this Plan shall be offset against, and shall to that extent reduce the payments otherwise required to be made to such Spouse or Beneficiary pursuant to Section 10.1 or 10.2. Section 11 - Forfeiture of Benefits 11.1 Termination for Cause. A Participant whose employment with the Corporation is terminated for cause shall forfeit all right to any benefits under the provisions of this Plan. For this purpose, a Participant's employment with the Corporation shall be considered to be terminated for cause only if: (a) the Participant is convicted of a felony, without regard to his right to appeal, which involves the Corporation's real, tangible or intellectual property, any of its personnel or any person with whom the Corporation has a business relationship, and (b) at least two-thirds of the members of the Board affirmatively vote, in their sole discretion, to terminate the Participant's employment with the Corporation because of such conviction. 11.2 Employment With a Competitor. A Participant who, without the written consent of the Administrator, becomes employed with a competitor of the Corporation, shall forfeit all rights to any further benefits under the provisions of this Plan; provided, however, that the benefits of a Participant whose Participation Commencement Date is prior to January 1, 1993, and who retires at the normal retirement age of 65, or who retires at a later date upon meeting all of the tests of Section 6.1 (a)(ii), shall be nonforfeitable. For this purpose, a Participant shall be considered to be employed with a competitor of the Corporation only if, within the period ending two years after the date of his termination of employment with the Corporation: (a) there is a final judgement by a court of competent jurisdiction, in an action brought by the Corporation, that the Participant is liable for an act of unfair competition or the misappropriation of trade secrets or confidential information; or (b) (i) the Participant is employed in a management position with another employer in a line of business that is classified under the same four-digit industry code of the Standard Industrial Classification as is a line of business operated by the Corporation, and (ii) such line of business generated revenues for the Corporation during the previous 12-month period exceeding the greater of (1) $10,000,000 or (2) two percent of the total revenues generated during such period by the Corporation. Section 12 - Administration 12.1 Appointment of Administrator. The Board shall appoint a person to serve as Administrator of the Plan. The initial Administrator shall be the Vice President for Human Resources and Organization Development. 12.2 Responsibility and Authority of Administrator. The Plan shall be administered by the Administrator, who shall have the responsibility and authority to, among other things, (a) interpret and construe the terms of the Plan and (b) adopt such regulations, rules, procedures and forms consistent with the Plan as he considered necessary or desirable for the administration of the Plan. In all cases the determination of the Administrator shall be final, conclusive and binding on all persons, subject to Section 12.3. 12.3 Exceptions Under Board Authority. Notwithstanding any other provision of this Plan, the Board in its sole discretion shall have the authority to make exceptions to the normal application and administration of any and all provisions of the Plan in individual cases; provided, however, that no such exception shall, without the written consent of the person involved, deprive any Participant, Beneficiary or Spouse of any part of his benefits under the Plan accrued as of the time such exception is made. Section 13 - Amendment or Termination of Plan 13.1 Right to Amend or Terminate. The Board reserves in its sole discretion the right, at any time and from time to time, to amend or terminate the Plan. 13.2 Effect on Benefits Accrued. No amendment or termination of the Plan pursuant Section 13.1 shall, without the written consent of the person involved, deprive any Participant, Beneficiary, or Spouse of any part of his benefits under the Plan accrued as of the time of such amendment or termination. Section 14 - Miscellaneous Provisions 14.1 No Implied Rights. Nothing in this Plan shall be deemed to: (a) give to any Employee the right to be retained in the employ of the Corporation or to interfere with the right of the Corporation to dismiss any Employee at any time, or (b) give to any Participant, Beneficiary, or Spouse (i) any right to any payments except as specifically provided for in the Plan or (ii) any interest in any insurance policies acquired by the Corporation in accordance with Section 14.2. 14.2 Insurance Policies. The Corporation in its discretion may, but shall not be required to, provide for its obligations under the Plan through the purchase of one or more life insurance policies on the life of a Participant. Each Participant agrees, as a condition to receiving any benefits under this Plan, to cooperate in securing life insurance on his life by furnishing such information as the Corporation or any insurer may require, by submitting to such physical examinations as may be necessary, and by taking such other actions as may be requested by the Corporation or any insurer to obtain and maintain such insurance coverage. 14.3 No Assignment or Alienation. To the extent permitted by law, no benefit provided under the Plan shall be anticipated, assigned (either at law or in equity), alienated or subject to attachment, garnishment, levy, execution or other process. Any attempt to perform any such action shall be void. 14.4 Expenses. The Corporation shall pay all expenses incident to the operation and administration of the Plan. 14.5 Applicable Laws. Except as otherwise required by federal law, the provisions of the Plan and the rules, regulations, and decisions of the Board and the Administrator shall be construed and enforced according to the laws of the District of Columbia. EXHIBIT 10(k)(ii) AMENDMENT AMENDMENT to the COMSAT Corporation Non-Employee Directors Stock Option Plan (the "Plan"), as approved by the shareholders of COMSAT Corporation (the "Corporation") on May 20, 1988. WHEREAS, on January 15, 1993, the Corporation's Board of Directors approved this Amendment, subject to approval by the shareholders of the Corporation; and WHEREAS, on May 21, 1993, the shareholders of the Corporation approved this Amendment. NOW, THEREFORE, the Plan is hereby amended as follows: 1. Section 4(b) of the Plan is hereby amended to read as follows: "4(b) Automatic Grants. An Option to purchase 2,000 shares of Common Stock, subject to adjustment under Section 6, shall be granted annually at a meeting of the Board held in March (or the next succeeding meeting date if no March meeting is held), beginning in 1993, to each Non-Employee Director who was a director as of the date of the Annual Meeting of Shareholders for the prior year, provided the Non-Employee Director continues in office after the Board meeting date on which the Option is granted." 2. Subsection 4(d) of the Plan is hereby amended to read as follows: "4(d) Option Price. The purchase price for each share of Common Stock subject to an Option shall be the fair market value of the Common Stock on the date the Option is granted. For this purpose, as well as other purposes under the Plan, fair market value shall be deemed to be the average of the highest and lowest selling prices of Common Stock as reported under New York Stock Exchange-Composite Transactions on the date on which the Option was granted or, if there were no sales of Common Stock on that date, then on the next preceding date on which there were sales." All other terms and provisions of the Plan are hereby expressly confirmed and restated, and all Options previously issued under the Plan shall remain in full force and effect pursuant to their terms and the terms of the Plan at the time of issuance. - - - ---------------------- (1) Pursuant to the operation of Section 6 of the Plan, the number of shares subject to such Options became 4,000 shares effective upon the 2-for-1 stock split effected by the Corporation on June 1, 1993. EXHIBIT 10(g)(i) This Amendment No. 1 to the Agreement for Inmarsat Aeronautical Services is entered into this 20th day of May 1993 by and between COMSAT Mobile Communications, a Division of COMSAT Corporation, a corporation organized and existing under the laws of the District of Columbia in the United States of America and having its principal office at 950 L'Enfant Plaza, S.W., Washington, D.C. 20024 ("COMSAT") and KOKUSAI DENSHIN DENWA CO., LTD., a company organized and existing under the laws of Japan and having its principal office at No. 3-2, Nishi-Shinjuku 2-Chome, Shinjuku-ku, Tokyo 163, Japan ("KDD"). WHEREAS, COMSAT and KDD have entered into an Agreement dated 22 January 1990 under which COMSAT and KDD agreed to jointly provide aeronautical mobile satellite services to aviation users on a global basis; and WHEREAS, COMSAT and KDD have agreed upon a rate schedule for voice calls originated by COMSAT's Customer In-Flight Phone ("In-Flight") in the ocean regions served by KDD (IOR, POR). NOW, THEREFORE, in accordance with Article 16 and in consideration of the foregoing and the mutual covenants contained herein, the Parties hereto agree to supplement and amend the Agreement by adding Annex 1 "Rate Schedule for Voice Calls Originated by In-Flight Phone". Except as expressly provided herein, all other terms and conditions of the Agreement shall remain unchanged and in full force and effect. IN WITNESS WHEREOF, the Parties hereto have executed this Amendment. COMSAT Corporation KOKUSAI DENSHIN DENWA CO., LTD. By: /s/Elizabeth L. Young By: /s/Seiichi Inoue Name: Elizabeth L. Young Name: Seiichi Inoue Vice Pres. & General Manager Title: COMSAT Aeronautical Services Title: Senior Managing Director Date: 22 April 1993 Date: 10 May 1993 /s/Kari Schoonhoven Kari Schoonhoven Director, Contracts 5/20/93 ANNEX 1 Rate Schedule for Voice Calls Originated by In-Flight Phone For all air-to-ground voice traffic generated by customers of In-Flight through the KDD Ground Earth Stations ("GESs") in the IOR and POR which terminates outside of Japan, KDD will charge the rate of 3.95SDR per minute for space segment and use of KDD's GES. For all air-to-ground voice traffic generated by In-Flight customers through the KDD GESs in the IOR and POR which terminates within Japan, KDD will charge the rate of 4.44SDR per minute for space segment and use of KDD's GES. These rates will be exclusive of Land-line charges which shall be charged in addition by KDD. KDD shall provide to COMSAT on a weekly basis call record data for all calls originated from each aircraft. Accounting and settlements shall be made on a monthly basis. EXHIBIT 10(r)(i) AMENDMENT AMENDMENT to the COMSAT Corporation 1990 Key Employee Stock Plan (the "Plan"), as approved by the shareholders of COMSAT Corporation (the "Corporation") on May 18, 1990. WHEREAS, on January 15, 1993, the Corporation's Board of Directors approved this Amendment, subject to approval by the shareholders of the Corporation; and WHEREAS, on May 21, 1993, the shareholders of the Corporation approved this Amendment. NOW, THEREFORE, Section 3 of the Plan is hereby amended to read as follows: "3. Shares Subject to the Plan. The aggregate number of shares of Common Stock which may be covered by stock options (Options), stock appreciation rights (SARs), restricted stock units (Restricted Stock Units) and restricted stock awards (Restricted Stock Awards) granted pursuant to the Plan is 2,400,000 shares, subject to adjustment under Section 9. Shares which may be delivered on exercise or settlement of Options, SARs, Restricted Stock Units or Restricted Stock Awards may be previously issued shares reacquired by the Corporation or authorized but unissued shares. Shares covered by Restricted Stock Units and Restricted Stock Awards that are forfeited and shares covered by Options that expire unexercised (without having been surrendered upon the exercise of SARs, whether settled in cash or Common Stock) shall again be available for grant under the Plan." All other terms and provisions of the Plan are hereby expressly confirmed and restated, and all Options, SARs, Restricted Stock Units and Restricted Stock Awards previously issued under the Plan shall remain in full force and effect pursuant to their terms and the terms of the Plan at the time of issuance. EXHIBIT 10(v) COMSAT CORPORATION DIRECTORS AND EXECUTIVES DEFERRED COMPENSATION PLAN Restated effective January 1, 1994 (except as otherwise stated) Section 1 - Purpose and Effective Date 1.1 Purpose. The purpose of this Plan is to provide Directors and key executives of the Corporation with supplemental retirement income and death benefits in order to assist the Corporation in attracting and retaining Directors and executives of outstanding ability. 1.2 Effective Date. The Plan shall become effective upon approval by the Board. Section 2 - Definitions and Construction 2.1 Definitions. For purposes of the Plan, unless a different meaning is plainly required by the context, the following definitions are applicable: (a) "Beneficiary" means the person designated by a Participant, in accordance with Section 5.4(a), to receive benefits payable under the Plan upon the death of the Participant. (b) "Board" means the Board of Directors of COMSAT Corporation or any successor to such Corporation. (c) "Change of Control" means, with respect to COMSAT Corporation: (i) A stock purchase by any "person" (as such term is used in Sections 13(d) and 14(d) (2) of the Securities and Exchange Act of 1934, as amended) who then owns or by virtue of such purchase becomes the beneficial owner of, directly or indirectly, voting securities of COMSAT Corporation representing 50 percent or more of the combined voting power of such Corporation's then outstanding voting securities, which purchase is not approved by such Corporation pursuant to a resolution of the Board, or (ii) Any change of two or more Directors in any one year in the composition of the Board not recommended by the management of COMSAT Corporation or the Board. (d) "Committee" means the Committee on Compensation and Management Development of the Board. (e) "Compensation" means: (i) In the case of an Employee, the following amounts payable or awarded to the Employee by the Corporation with respect to a Plan Year: (1) base salary, (2) Incentive Compensation, (3) dividend equivalents from Restricted Stock Units, and (4) cash proceeds from vested Restricted Stock Units, or (ii) In the case of a Director, the fees and retainer payable to the Director by the Corporation with respect to a Plan Year, before reduction for any amounts deferred pursuant to this Plan or any other plan of the Corporation, and not including any expense reimbursements or any form of non-cash compensation and benefits. (f) "Corporation" means COMSAT Corporation or any successor thereto, and any subsidiary of such Corporation. (g) "Deferral Election" means an election made by the Participant, in accordance with Section 3.2 or 3.3, to defer an amount of Compensation payable or awarded to the Participant with respect to a Plan Year. (h) "Deferred Compensation Account" means the account maintained for a Participant by the Corporation, in accordance with Section 4.1, with respect to the Compensation for which the Participant has made a Deferral Election. (i) "Determination Date" means the last Friday of each biweekly payroll period of the Corporation. (j) "Director" means any member of the Board who is not an Employee. (k) "Disability" means total disability as defined in the Corporation's Long-Term Disability Plan. (l) "Employee" means any person who is employed by the Corporation. (m) "Hardship" means the immediate and heavy financial need of a Participant as determined by the Committee in accordance with uniform standards established by the Committee. (n) "Incentive Compensation" means the additional compensation awarded a Participant with respect to a Plan Year under the Corporation's Annual Incentive Plan and such other incentive plans or arrangements of the Corporation as designated by the Committee from time to time as such plans or arrangements may be amended from time to time. (o) "Participant" means an Employee or Director participating in the Plan in accordance with Section 3. (p) "Plan" means the COMSAT Corporation Directors and Executives Deferred Compensation Plan, as amended from time to time. (q) "Plan Year" means the period beginning as soon as practicable after the effective date of the Plan and ending December 31, 1986, and each calendar year thereafter. (r) "Restricted Stock Units" means restricted stock units awarded to a Participant under the Corporation's 1986 and 1990 Key Employee Stock Plans. (s) "Retirement Plan" means the Corporation's qualified defined benefit pension plan, currently known as the COMSAT Corporation Retirement Plan, as amended from time to time, or any successor thereto. (t) "Rollover Election" means an election made by the Participant in accordance with Section 3.5. 2.2 Construction. Wherever applicable, the masculine pronoun shall mean or include the feminine pronoun, and the words used in the singular shall include the plural, and vice versa. Section 3 - Eligibility and Participation 3.1 Eligibility. Eligibility to participate in the Plan is limited to (a) Directors and (b) Employees who are designated as eligible by the Board. 3.2 Participation; Deferral Elections. An eligible Employee or Director may elect to participate in the Plan with respect to any Plan Year by filing a Deferral Election, in the form and manner prescribed by the Committee, by December 15 of the immediately preceding Plan Year, except that a Deferral Election with respect to the first Plan Year shall be filed at such time before the commencement of such Plan Year as the Committee shall determine. The Participant may elect in the Deferral Election to defer Compensation with respect to the Plan Year as follows: (a) If the Participant is an Employee, he may elect to defer, subject to a minimum deferral of $1,000, (i) base salary payable during the Plan Year in increments of 5 percent up to a maximum of 25 percent, (ii) Incentive Compensation awarded with respect to the Plan Year in increments of 25 percent up to a maximum of 100 percent, (iii) dividend equivalents from Restricted Stock Units payable during the Plan Year in increments of 25 percent up to a maximum of 100 percent, and (iv) cash proceeds from vested Restricted Stock Units payable during the Plan Year in increments of 25 percent up to a maximum of 100 percent. (b) If the Participant is a Director, he may elect to defer any amount or percentage of fees and retainer payable with respect to the Plan Year, subject to a minimum deferral of $1,000. 3.3 Initial Eligibility During the Plan Year. If an Employee or Director first becomes eligible to participate in the Plan during a Plan Year, he may elect to participate with respect to such Plan Year by filing a Deferral Election for such Plan Year not later than 30 days after notification to him by the Committee of his eligibility to participate in the Plan. the Plan. The Participant may elect in such Deferral Election to defer Compensation with respect to the Plan Year which is payable or awarded following the filing of the Deferral Election, in accordance with the limitations of Section 3.2(a) and (b) as if such period were an entire Plan Year. 3.4 Modification of Deferral Election. A Deferral Election made pursuant to Section 3.2 or 3.3 shall be irrevocable, except that the Committee in its discretion may at any time reduce, or waive the remainder of , the amount to be deferred under the Deferral Election upon determining that the Participant has suffered a Hardship. 3.5 Rollover Election. When an Employee or Director first becomes eligible to participate in the Plan, but not thereafter, he may elect to rollover to the Plan all, but not less than all, of his then-current account balance of any amounts previously deferred, plus interest credited, under the Corporation's Annual Incentive Plan or its Insurance and Retirement Plan for Directors. Such Rollover Election shall be made at the time, and in the form and manner prescribed by the Committee. If the eligible Employee or Director makes a Rollover Election, he shall become a Participant in the Plan, whether or not he also files a Deferral Election pursuant to Section 3.2 or 3.3, and the amount rolled over shall thereafter be subject in full to the provisions of this Plan. Section 4 - Deferred Compensation Accounts 4.1 Maintenance of Accounts. The Corporation shall maintain, for record-keeping purposes only, a Deferred Compensation Account for each Participant who files a Deferral Election or Rollover Election. The Compensation deferred pursuant to a Deferral Election shall be credited to the Participant's Deferred Compensation Account as it otherwise would become payable to the Participant. The amount rolled over pursuant to a Rollover Election shall be credited to the Participant's Deferred Compensation Account upon the filing of the Rollover Election. 4.2 Interest. Each Participant's Deferred Compensation Account shall be credited with interest as of each Determination Date based upon the balance of the Participant's Deferred Compensation Account as of the immediately preceding Determination Date. The rate of interest to be credited during a Plan Year shall be Moody's plus 6 percent. For this purpose, "Moody's" means the effective annual yield on Moody's Seasoned Corporate Bond Yield Index as determined during the first week of the Plan Year from Moody's Bond Record published by Moody's Investors Service, Inc., or any successor thereto. If Moody's annual yield is no longer published, the rate of interest for purposes of the Plan shall be based on a substantially similar annual yield selected by the Committee. Notwithstanding the foregoing, amounts credited to a Participant's Deferred Compensation Account after January 30, 1994 pursuant to a Deferral Election or Rollover Election shall be credited with interest as of each Determination Date at a rate equal to the Corporation's Cost of Capital. For this purpose, "Cost of Capital" means the cost of funds employed in the Corporation's business as determined by the Corporation's Chief Financial Officer effective as of the first day of each Plan Year. Section 5 - Payment of Benefits 5.1 Payment Upon Termination of Service. (a) A Participant whose service with the Corporation terminates for any of the following reasons shall be entitled to receive an amount equal to the balance of his Deferred Compensation Account, payable as provided in Section 5.4 and 5.5: (i) retirement under the Corporation's Retirement Plan or its Insurance and Retirement Plan for Executives, as those plans may be amended from time to time; (ii) Disability; (iii) the convenience of the Corporation as determined by the Committee; (iv) a Change of Control, provided that the Participant's service terminates within 24 months after the occurrence of such Change of Control; or (v) if the Participant is a Director, termination of service for any reason other than death. (b) A Participant whose service with the Corporation terminates for any reason other than death or the reasons specified in paragraphs (a) or (c) shall be entitled to receive an amount, payable as provided in Sections 5.4 and 5.5, equal to the balance of his Deferred Compensation Account, calculated by recomputing all interest credited to such Deferred Compensation Account at a rate equal to Moody's plus 2 percent, provided that all interest credited to the portion of such Deferred Compensation Account attributable to amounts deferred after January 30, 1994 shall be recomputed at a rate equal to the Cost of Capital minus 4 percent. (c) A Participant, other than a Director, whose service with the Corporation is terminated for cause shall be entitled to receive an amount, payable as provided in Sections 5.4 and 5.5, equal to the balance of his Deferred Compensation Account, calculated by recomputing all interest credited to such Deferred Compensation Account at a rate equal to Moody's, provided that all interest credited to the portion of such Deferred Compensation Account attributable to amounts deferred after January 30, 1994 shall be recomputed at a rate equal to the Cost of Capital minus 6 percent. For this purpose, a Participant's service with the Corporation shall be considered to be terminated for cause only if: (i) the Participant is convicted of a felony, without regard to his right to appeal, which involves the Corporation's real, tangible or intellectual property, any of its personnel or any person with whom the Corporation has a business relationship, and (ii) at least two- thirds of the members of the Board affirmatively vote, in their sole discretion, to terminate the Participant's employment with the Corporation because of such conviction. 5.2 Payments Upon Death. (a) Each Participant may designate a Beneficiary or Beneficiaries to receive payment of the amounts provided in paragraph (b) in the event of his death. Each Beneficiary designation: (i) shall be made on a form filed in the manner prescribed by the Committee, (ii) shall be effective when, and only if made and filed in such manner during the Participant's lifetime, and (iii) upon such filing, shall automatically revoke all previous Beneficiary designations. (b) Upon the death of a Participant, the Participant's Beneficiary shall be entitled to receive an amount equal to the balance of the Participant's Deferred Compensation Account payable as provided in Section 5.4 and 5.5. (c) If the payments to be made pursuant to paragraph (b) are not subject to a valid Beneficiary designation at the time of the Participant's death (because the designated Beneficiary predeceased the Participant or for any other reason), the estate of the Participant shall be the Beneficiary. If a Beneficiary designated by the Participant to receive all or any part of the Participant's Deferred Compensation Account dies after the Participant but before complete distribution of that portion of that Deferred Compensation Account, and at the time of the Beneficiary's death there is no valid designation of a contingent Beneficiary, the estate of such Beneficiary shall be the Beneficiary of the portion in question. (d) Any payments made to a Participant's Beneficiary pursuant to life insurance policies on the life of the Participant which are purchased in connection with this Plan shall be offset against, and shall to that extent reduce the payments otherwise required to be made to such Beneficiary pursuant to Section 5.2(b). 5.3 Hardship Distributions. The Committee may, in its sole discretion, make distributions to a Participant from his Deferred Compensation Account prior to his termination of service with the Corporation if the Committee determines that the Participant has suffered a Hardship. The amount of any such distribution shall be limited to the amount reasonable necessary to meet the Participant's needs created by the Hardship. 5.4 Form of Payment. (a) Except as provided in paragraph (c), the amount which a Participant or Beneficiary becomes entitled to receive pursuant to Sections 5.1 or 5.2 shall be paid either (i) as a lump sum or (ii) in equal annual installments annuitized over a period of time not to exceed 15 years, computed by using the rate of interest applicable to the Participant's Deferred Compensation Account at the time the first installment becomes payable. (b) Except as provided below in this paragraph (b), the Participant shall elect, at the time and in the manner prescribed by the Committee, the form specified in paragraph (a) in which payment shall be made. If the Participant fails to elect the form of payment, payment shall be made in accordance with paragraph (a) (ii) over a period of 15 years, provided that in the case of such a Participant's death, the Participant's Beneficiary may elect the form of payment. In the case of a Participant who becomes entitled to receive payment pursuant to Section 5.1(a)(iii), the Committee shall determine the form specified in paragraph (a) in which payment shall be made. (c) Notwithstanding any other provision of this Plan, the amount which a Participant becomes entitled to receive pursuant to paragraph (b) or (c) of Section 5.1 shall be paid in a lump sum. 5.5 Commencement of Payments. (a) Payment which a Participant or Beneficiary becomes entitled to receive in the event of the Participant's death, Disability or termination of service pursuant to paragraph (b) or (c) of Section 5.1 shall commence or be made, as the case may be, as soon as practicable after the occurrence of such event. (b) Payment which a Participant becomes entitled to receive upon termination of service pursuant to Section 5.1(a)(iii) shall commence or be made, as determined by the Committee, on the first day of any month between the date the Participant's service terminates and his 66th birthday. (c) Payment which a Participant becomes entitled to receive upon termination of service for any other reason shall commence or be made, as elected by the Participant at the time and in the manner prescribed by the Committee, on the first day of any month between the date his service terminates and (i) in the case of an Employee, his 66th birthday, or (ii) in the case of a Director, his 73rd birthday. 5.6 Payment as of January 1, 2000 (a) An Employee or Director who is an active Participant on April 1, 1991 may, by an instrument in writing filed with the Vice President of Human Resources and Organization Development no later than August 31, 1991, elect that the amount described in paragraph (b) shall be paid to him or, if applicable, to his Beneficiary on January 1, 2000. (b) Notwithstanding any other provision of this Plan: (i) a Participant whose service with the Corporation has not terminated before January 1, 2000, or (ii) a Participant or Beneficiary who is receiving installment payments pursuant to Section 5.4 as of January 1, 2000, shall, if the Participant has made the election provided for in paragraph (a), be entitled to receive an amount, payable on January 1, 2000 as a lump sum, equal to the portion of the Participant's Deferred Compensation Account, to the extent such portion has not previously been distributed to the Participant, or, if applicable, his Beneficiary pursuant to Sections 5.3 and 5.4, which consists of the balance of the Participant's Deferred Compensation Account as of March 31, 1991 together with interest credited to such balance pursuant to Section 4.2 from April 1, 1991 to December 31, 2000. Solely for purposes of this Section 5.6, interest on such balance from January 1, 2000 to December 31, 2000 shall be credited as of January 1, 2000. (c) Any balance remaining in the Participant's Deferred Compensation Account on January 1, 2000 after payment of the amount described in paragraph (b), together with any amounts credited to his Deferred Compensation Account after such date, shall continue to be payable in accordance with the provisions of Sections 5.1 through 5.5. Section 6 - Administration 6.1 Committee; Duties. The Plan shall be administered by the Committee, which shall have the responsibility and authority to, among other things, (a) interpret and construe the terms of the Plan and (b) adopt such regulations, rules, procedures and forms consistent with the Plan as it considers necessary or desirable for the administration of the Plan. In all cases the determination of the Committee shall be final, conclusive and binding on all persons. 6.2 Appointment of Agents. The Committee shall appoint the Vice President of Human Resources and Organization Development to be the Committee's agent and shall delegate to him its duties with respect to the day-to-day administration of the Plan. The Committee may from time to time appoint other agents and delegate to them such administrative duties as it sees fit. Notwithstanding the above, the Committee may not delegate to any agent its duties under the Plan provided in Sections 2.1(n), 3.4, 4.2, 5.1(a)(iii) and 5.3. Section 7 - Amendment or Termination of Plan 7.1 Right to Amend or Terminate. The Board reserves in its sole discretion the right, at any time and from time to time, to amend or terminate the Plan. 7.2 Effect of Amendment or Termination. No amendment or termination of the Plan pursuant to Section 7.1 shall deprive any Participant or Beneficiary of any part of his benefits under the Plan accrued as of the time of such amendment or termination. If the Plan is terminated, each Participant shall be paid the full amount of his Deferred Compensation Account in a lump sum within 90 days of the date of termination. Section 8 - Miscellaneous Provisions 8.1 No Implied Rights. Nothing in his Plan shall be deemed to: (a) give to any Employee the right to be retained in the employ of the Corporation or to interfere with the right of the Corporation to dismiss any Employee at any time, or (b) give to any Participant or Beneficiary (i) any right to any payments except as specifically provided for in the Plan or (ii) any interest in any insurance policies acquired by the Corporation in accordance with Section 8.2 8.2 Insurance Policies. The Corporation in its discretion may, but shall not be required to, provide for its obligations under this Plan through the purchase of one or more life insurance policies on the life a Participant. Each Participant agrees, as a condition to receiving any benefits under this Plan, to cooperate in securing life insurance on his life by furnishing such information as the Corporation or any insurer may require, by submitting to such physical examinations as may be necessary, and by taking such other actions as may be required by the Corporation or any insurer to obtain and maintain such insurance coverage. 8.3 No Assignment or Alienation. To the extent permitted by law, no benefit provided under the Plan shall be anticipated, assigned (either at law or in equity), alienated or subject to attachment, garnishment, levy, execution, or other process. Any attempt to perform any such action shall be void. 8.4 Expenses. The Corporation shall pay all expenses incident to the operation and administration of the Plan. 8.5 Applicable Laws. Except as otherwise required by federal law, the provisions of the Plan and the rules, regulations and decisions of the Board and the Committee shall be construed and enforced according to the laws of the District of Columbia. EXHIBIT 10(y) [TRANSLATED FROM THE ORIGINAL DOCUMENT IN FRENCH] Agreement dated as of January 18, 1993 between the State of Cote D'Ivoire Represented by the Minister of Communications herein called: "Employer" and "The Communications Satellite Corporation (COMSAT)" Registered Offices: 22300 COMSAT Drive, Clarksburg, Maryland 20871, U.S.A. Legal Status: Corporation existing under American Law hereby represented by Mr. Kenneth Hoch, Vice President, Acting on behalf of the Company under power of attorney annexed to this contract and hereinafter called "CONTRACTOR". It has been agreed and decided as follows: Chapter I - General Conditions Article 1.1 Object of the Contract and Scope of Works 1.1.1 Object of the Contract The object of the contract for: The renovation of the equipment and installations of existing radio and television broadcast stations and creation of new satellite transmission stations for one television and channel and two radio channels. Hereinafter called "Countrywide Sound and Television Broadcast Coverage." 1.1.2 Scope of works In accordance with the terms and conditions of the Technical Specifications (TS) of this contract, works shall comprize: 1.1.2.1 Firm Phase 1.1.2.1.1 Lot A 1. Supply, delivery, installation and commissioning of the entire set of telecommunications equipment needed for the works. 2. Rehabilitation of existing equipment. 3. quipping of new transmission stations. 4. Supply of a mobile earth station. 5. Supply of a stock of spare parts. 6. Supply of ten (10) maintenance vehicles. 7. Technical assistance and training of personnel necessary for future operation of installations. 8. Obligation to maintain public service during the entire duration of works described in this contract. 1.1.2.1.2 Lot B All works, infrastructure and utilities: for the construction of new transmission centers, - for the renovation of existing centers. 1.1.2.2 Optional Phase 1.1.2.2.1 Lot A 1. Supply, delivery, installation and start of function of the set of equipment needed for the works. 2. Equipping of new transmission stations. 3. Obligation to maintain public service during the entire duration of works described in this contract. 1.1.2.2.2 Lot B All works, infrastructure and utilities for the construction of a new transmission station. Article 1.2 - Knowledge of Sites and Working Conditions For works For LOT A works, the CONTRACTOR hereby testifies to his complete knowledge of: - the nature and geographic location of works, - the meteorological and climatic conditions, - general conditions for execution of works, especially equipment needed for them, - existence of possible nearby constructions that could affect the mode of execution of the works, - plans, technical specifications, and operation manuals of existing installations, - the exact plan location as well as the nature of all utilities requiring either a diversion or special precautions related to the works, - local conditions, as a rule and more particularly conditions of supply and stocking of equipment and tools, - means of communication, transport, possibilities of water, electricity and fuel supplies, - availability of labour, - all constraints and obligations resulting from social, tax and customs laws in COTE D'IVOIRE, - all the conditions and circumstances likely to have an influence on the delivery of supplies, execution of works or prices, - techniques and modes of execution of works in force in COTE D'IVOIRE. The main contractor shall assist the CONTRACTOR in the collection, verification and analysis of these information items. The CONTRACTOR shall, however, be responsible for the adequacy of these information items needed for the execution of services put in his charge. The CONTRACTOR shall be entirely liable for any lack, error or omission by him of the knowledge of the sites and working condition. The parties agree that all the plans, characteristics, operational schedules provided by the ADMINISTRATION concerning the existing installations shall only be given as information and shall not be binding on the ADMINISTRATION. Article 1.3 - Interpretation of Terms Used The following explanations are provided for terms used in this contract: 1.3.1 The term "EMPLOYER" means "THE MINISTRY OF COMMUNICATIONS" 1.3.2 The term "MAIN CONTRACTOR" means "the DIRECTEUR GENERAL DE LA DIRECTION ET CONTROLE DES GRANDS TRAVAUX (DCGTx)". 1.3.3 The term "ENGINEER" means the duly accredited representative of the "MAIN CONTRACTOR" for the monitoring and supervision of the works. The ENGINEER shall carry out, on behalf of the ADMINISTRATION, duties of technical and administrative monitoring of the works. In this regard, he shall, inter alia, be responsible for: - approval of specification plans and execution schedules set up by the "CONTRACTOR", - regular monitoring of the execution of actual works in accordance with approved plans comprizing, if necessary, possible modifications to the basic project made by the ADMINISTRATION, - checks and other in-situ tests to ensure that the quality of materials and their installation are in conformity with the technical specifications stipulated in the contract, - verification and certification of invoices of the CONTRACTOR, - establishment of counter-measurements, architect's log, provisional monthly breakdown and final detailed account, - writing and notifying directives and any other note sent to the CONTRACTOR, necessary for the appropriate execution of works and their supervision, - factory acceptance, - visits prior to provisional and final acceptance of works. 1.3.4 The term "ADMINISTRATION" broadly means the various STATE agents. 1.3.5 The term "CONTRACTOR" means the holder of this contract or his duly appointed representative. 1.3.6 The "PRICE OF THE CONTRACT" means the amount mentioned under Article 2.1 of this PARTICULAR TERMS AND CONDITIONS (PTC) or THIRTY SIX MILLION UNITED STATES DOLLARS excluding VAT - excluding custom duty. 1.3.7 The term "WORKS BY FORCE ACCOUNT" means works executed by the "MAIN CONTRACTOR" using the material and human resources of the "CONTRACTOR". 1.3.8 The term "CONTROLLED EXPENSE WORKS" means works executed by the CONTRACTOR and paid for on the basis of actual disbursements. 1.3.9 The term "MISCELLANEOUS REIMBURSEMENTS - CONTRACTOR AUTHORIZED" means expenses directly related to execution of contract which MAIN CONTRACTOR could request CONTRACTOR to pay his appointed suppliers on behalf of the EMPLOYER. Article 1.4 - Listing of Contract Documents The contract comprizes, by order of priority the following documents: - Document 1: DEED OF EMPLOYMENT - Document 2: THE PARTICULAR TERMS AND CONDITIONS (PTC) - Document 3: TECHNICAL SPECIFICATIONS (TS) - Document 4: BREAKDOWN OF TOTAL CONTRACT PRICE OF LOT A - Document 5: PROVISIONAL BILL OF QUANTITIES FOR LOT B. In case of any discrepancy among the documents of the contract, such documents shall be considered in the order in which they are listed above. In case of discrepancy between the provisions of the same document, the most restrictive provisions for the CONTRACTOR shall carry. Contractual documents shall be those which are listed above which represent the entire agreement between the parties and stipulate all their respective rights, obligations and responsibilities. Article 1.5 - Document Preparation and Submission-Assistance of Employer 1.5.1 Documents to be Issued to the Contractor Following the notification of approval of the contract, the EMPLOYER shall issue, at no cost to the CONTRACTOR and against a receipt, a certified true copy of contractual documents listed under Article 1.4 of the aforementioned PTC. 1.5.2 Documents to be Prepared and Submitted by Contractor Within a period of ONE HUNDRED AND TWENTY (120) days starting from the day of commencement of works, the CONTRACTOR shall provide: - the organizational chart of the local site management and supervisors indicating their names, dates of arrival and qualification of various supervisors, - detailed implementation schedules(s) of all the works, pert type, established on the basis of the contract. It (they) shall be regularly up-dated. To facilitate its (their) use, it (they) shall be in the form of implementation charts. This schedule shall notably comprize all the relevant information on: - general programme of supply delivery - planning for end of deliveries as partially or completely set out in general programme, - methods and mode of execution proposed by the CONTRACTOR for the execution of works - execution rate, - works (or part of works) for which several work posts shall be necessary and their relevant corresponding periods, - site manpower needs, - provisional payment schedules, - one month preceding each quarter, or at any moment, the ENGINEER shall deem it necessary, especially if schedules are not met, the CONTRACTOR shall submit to the MAIN CONTRACTOR a detailed week to week quarterly programme per work or nature of works comprizing the following four items: - future tasks, - corresponding rates of implementation, - manpower needed, - supplies needed. Any modification of installation, construction materials or implementation schedules shall be subject to the prior approval of the ENGINEER. The MAIN CONTRACTOR shall present his comments on the programmes submitted to him. Studies carried out by Sub-contractors must bear their stamp and be presented to the ENGINEER by the CONTRACTOR. The latter shall be solely liable for them. The ENGINEER shall sign each plan or make relevant modifications thereof known within THIRTY (30) days. Beyond this period, the plan shall be deemed to have been approved. The approval stamp of the ENGINEER shall not diminish in any way the liabilities of the CONTRACTOR. The CONTRACTOR shall therefore submit to the ENGINEER within FOURTEEN (14) days, FIVE (5) copies of implementation documents and TWO (2) counter-drawings on white tracing cloth. The CONTRACTOR shall strictly adhere to the implementation drawings. 1.5.2.3 During Project Completion Phase The CONTRACTOR shall constitute a complete file of drawings during the execution of the project. All plans, including those provided by the CONTRACTOR shall be as detailed as necessary to provide complete details on the installation of partially or completely finished infrastructures. Within THREE (3) months of the provisional delivery the CONTRACTOR shall submit to the ENGINEER: - TWO (2) complete collections of reversed tracings of all documents prepared by him, updated and in conformity with the execution, - FIVE (5) copies of each tracing, - TWO (2) 35 mm microfilms on cards with windows of all the drawings. 1.5.3 Assistance by Employer The EMPLOYER shall be under the obligation to provide all reasonably possible assistance to the CONTRACTOR in the accomplishment of various administrative procedures: responsibility for their success shall rest entirely on the CONTRACTOR. The EMPLOYER shall notably: a) provide any assistance which may be required of him in order to facilitate the clearing of equipment through customs; b) assist the CONTRACTOR to obtain at the appropriate time, the authorizations required for the temporary importation into the Republic of Cote d'Ivoire of measuring instruments and other equipment which the CONTRACTOR shall deem useful for the carrying out of services stipulated in the contract; c) assist the CONTRACTOR to obtain authorization to re-export equipment temporarily imported into the country as soon as their use in Cote d'Ivoire shall be over; d) undertake all the necessary steps to ensure that the staff of the CONTRACTOR has access to the various sites; e) enable the CONTRACTOR's staff to have the free use of available measuring instruments; f) facilitate the immediate obtention of any medical assistance and necessary medical evacuation facilities in case of serious accident with the cost being borne by the CONTRACTOR; g) freely making available to the CONTRACTOR and on each site throughout the period of the project an office with a lock and key and equipped with a telephone. The CONTRACTOR shall be responsible for the bills accruing from the use of the latter; h) provide adequate shelter and protection for equipment delivered to various sites and not yet checked and signed for; i) obtain the approval from INTELSAT for access to the system and participation of his staff in antenna testing and putting into operation. The CONTRACTOR shall assist the EMPLOYER to obtain space sector capacity in the operation of the network; j) avail the CONTRACTOR of sites and premises under lock and key, air conditioning and primary power for the installation and operation of equipment as well as the necessary pylons, whenever responsibility for such facilities is not attributed to the CONTRACTOR in the Technical Specifications (TS); k) assist the CONTRACTOR, when the need arises to obtain entry and exit visas, work permits and /or residence permits and laisser-passers for his expatriate staff; l) assist the CONTRACTOR to obtain accommodation for his staff on the various sites; m) obtain any other license and/or permit required in Cote d'Ivoire. Article 1.6 - French Language-Metric System Contract Currency Any written documents from or to the CONTRACTOR for the purpose of the execution of this contract shall be exclusively: - in the French Language, - in the metric system, - with reference to the US Dollar. The CONTRACTOR shall have on the site an adequate number of qualified REPRESENTATIVES and INTERPRETERS speaking the French Language in order to facilitate the work of the ENGINEER and his REPRESENTATIVES; in particular, the approved REPRESENTATIVE of the CONTRACTOR as well as his supervising staff should have a fair knowledge of the French language. Article 1.7 - Laws and Legislation Governing the Contract 1.7.1 Contract Governed by Ivorian Law The CONTRACT is governed by the laws of the Republic of Cote d'Ivoire. The LEGISLATION in force in Cote d'Ivoire is the only one applicable to this contract except for American Legislation on the export of the technology mentioned in Article 1.7.2 below. The CONTRACTOR must comply with any laws or regulations issued by Ivorian Authorities and applicable to his activities. He shall notably safeguard the EMPLOYER against any penalties or liabilities resulting from the non compliance with these laws and regulations. The CONTRACTOR and his staff shall be subjected to the social and tax laws of the Cote d'Ivoire. 1.7.2 American Legislation Concerning Technology Export The contract shall be subjected to the regulations applicable in the United States of America on the exportation of equipment and related documentation using certain technologies. The EMPLOYER shall undertake to ensure that goods and documents exported from the United States for the execution of this contract shall only be used for the installation and operation of this broadcast network and shall not directly or indirectly be re-exported to another country without the prior written authorization of the United States Government. The EMPLOYER shall indemnify the CONTRACTOR for the consequences of any violation of this commitment. The provisions of this Article and other restrictions or conditions imposed by the United States Government on this contract shall be binding on the two parties after the termination of the contract. Article 1.8 - Labor 1.8.1 The CONTRACTOR shall be compelled to observe existing work regulations and social legislation as well as those that shall be published in the OFFICIAL GAZETTE OF THE REPUBLIC OF COTE D'IVOIRE. 1.8.2 The CONTRACTOR shall comply with the legislation of the Republic of Cote d'Ivoire in matters relating to foreign labour. Article 1.9 - Legislation and Social Regulation - Application to Company Staff and Payment of Salaries 1.9.1 The CONTRACTOR shall, at his own expense, apply Ivorian social regulations on housing, health and safety to all his employees. The CONTRACTOR shall observe any new legislation or regulation that shall apply in this regard. Notwithstanding the obligations stipulated by the laws and regulations on labour, the CONTRACTOR shall convey to the ENGINEER, at his request, the updated list of names of employees and their qualifications. He shall also convey at the request of the ENGINEER all the payslips of the company employees. The ENGINEER can at any time request the CONTRACTOR for evidence of his application of social legislation to his employees, notably in matters concerning salaries and wages, health and safety. The CONTRACTOR shall be responsible for hiring the staff needed for the execution of the project. The CONTRACTOR shall refrain from enticing workmen away from other companies working for the EMPLOYER. The number of workers of each profession must be proportional to the quantity of structures to be built, taking into consideration time schedules required. The CONTRACTOR can, if he deems it necessary and with the agreement of the MAIN CONTRACTOR or ENGINEER, request derogations of laws, regulations and collective agreements stipulated in texts on the duration of work, weekly breaks, overtime, night shift and public holidays. The prior approval of the MAIN CONTRACTOR or ENGINEER can only be given if the CONTRACTOR shall have presented his request at least five (5) days before the day(s) for which the derogation is sought. No increase in price nor additional payment shall be given the CONTRACTOR because of the above-mentioned derogations. The MAIN CONTRACTOR or ENGINEER can demand the departure from the site of any executive, supervisor or worker deemed to be incompetent or guilty of repeated negligence, carelessness or dishonesty and, generally, of any employee whose behaviour is inimical to the proper execution of the project. The CONTRACTOR shall be solely liable for damages arising from any fraud or poor workmanship committed by his employees in the execution of the project. 1.9.2 The CONTRACTOR shall be solely liable for the application of all labour legislations and regulation, notably concerning health and social regulations. 1.9.3 Notwithstanding liabilities stipulated by current labour regulations and laws, the CONTRACTOR shall also provide the ENGINEER with the list of members of his local staff. He shall also be bound to furnish the ENGINEER and any other Administrative Authority upon the request hereof, all payslips of the CONTRACTOR's local staff. One or several agents of the ENGINEER or ADMINISTRATIVE AUTHORITIES may observe the payment of salaries and wages whenever they deem it necessary. The ENGINEER may at any moment request from the CONTRACTOR evidence of the latter's compliance with labour regulations and social regulations, notably in matters relating to salaries and wages, health and safety. The CONTRACTOR may, if he deems it useful, request and utilize derogations from stipulated laws and regulations on working hours and weekly breaks (overtime, night shifts and holidays). No additional payment will be made to the CONTRACTOR as a result of the aforementioned derogations. The CONTRACTOR shall comply with Ivorian laws on foreign labor. 1.9.4 The CONTRACTOR shall hire the necessary labour for the project under conditions stipulated in current regulations. The number of workers of each profession shall always be proportional to the quantity of structures to be constructed and on the basis of deadlines set. The CONTRACTOR shall refrain from enticing workmen away from other companies working for the EMPLOYER. The CONTRACTOR shall take great care in hiring his employees; the EMPLOYER shall reserve the right to reject entry or residence visa to any person whose presence, in his view, would be inimical to public good. The EMPLOYER may demand the departure from the site of any executive, agent or workers under the CONTRACTOR's orders for repeated insubordination, incompetence, negligence, carelessness or dishonesty. The application of this right shall not in any way serve as an excuse for delays and poor workmanship and claims of any kind by the CONTRACTOR. The CONTRACTOR shall be liable for acts of fraud and poor workmanship committed by his supervisors and workers in the supply and use of materials and other services. 1.9.5 The CONTRACTOR shall comply with work safety regulations, in this regard, he shall notably: - appoint an officer in charge of safety at the start of works and with the approval of the ENGINEER, - undertake all the necessary steps to avoid occupational accidents for which he shall solely be responsible, - insure all his employees against occupational accidents. The attention of the CONTRACTOR is particularly drawing to regulations in force on workers' accommodation and health. The CONTRACTOR shall be responsible for the housing of all his employees in Cote d'Ivoire. Article 1.10 - Health Surveillance of Sites The CONTRACTOR shall provide at no extra cost first-aid and rapid evacuation facilities for any victim of accident either to the nearest health center or home depending on the seriousness of the victim's condition. He must have someone on the spot capable of providing first-aid care and must ensure adequate pharmaceutical products. The CONTRACTOR shall inform the EMPLOYER of any suspicious disease on the sites in accordance with Ivorian health laws. Article 1.11 - Presence of Contractor on Work Sites - Service Orders 1.11.1 Presence of Contractor on Work Sites The CONTRACTOR shall permanently ensure the on-site supervision of the conduct and execution of works in accordance with the implementation plan. He must appoint a Representative, approved of by the MAIN CONTRACTOR, and who shall have the necessary power to: - take necessary immediate decisions on the progress of the work, - receive service orders. The MAIN CONTRACTOR reserves the right to withdraw the approval of the CONTRACTOR's Representative and demand his replacement. The CONTRACTOR shall report to the offices of the MAIN CONTRACTOR or ENGINEER and accompany them on their tour of the site whenever this shall be required. If need be, he shall be accompanied by his SUB-CONTRACTORS. 1.11.2 Service Orders The service orders shall be written, dated and numbered by the MAIN CONTRACTOR. They shall take immediate effect. They shall be issued in TWO (2) copies to the CONTRACTOR who shall sign, date and return one copy to the MAIN CONTRACTOR. When the CONTRACTOR shall deem that the service order calls for reservation on his part, he must under penalty of preclusion, make this known in writing to MAIN CONTRACTOR within TEN (10) days. The CONTRACTOR shall strictly comply with service orders which are notified him, regardless of any reservation on his part. The service orders concerning sub-contracted jobs shall be addressed only to the CONTRACTOR who shall be responsible for receiving them. Article 1.12 - Authorization to Sub-Let The CONTRACTOR, holder of the contract, may sub-let some works of the contract. For local jobs, he must obtain the prior authorization from the MAIN CONTRACTOR who, in case of refusal must provide reasons. To support his request, the CONTRACTOR shall specify: - the nature of the services to be sub-let, - the name, address, qualification, insurance certificates and references of the proposed SUB-CONTRACTOR. The authorization application for a SUB-CONTRACTOR presented to the MAIN CONTRACTOR, shall imply that the services, for which sub-contract is requested shall be ascribed within the confines of the terms of the contract as set out under Article 1.4 of the PTC. Authorization to sub-let shall not diminish in any way the liabilities of the CONTRACTOR, who shall remain responsible of the entire execution of the contract, to the EMPLOYER. The appointment of a SUB-CONTRACTOR is subjected to conditions stipulated under this Article. The Contractor shall be responsible for the payment of SUB-CONTRACTORS, and shall not in any way default in this. In case of default, the EMPLOYER may substitute for him without any appeal. Article 1.13 - Subjection Arising from Closeness of Sites Unknown to the Company The CONTRACTOR shall not, under any circumstances, claim the right to shirk his contractual obligations, nor lay claims as a result of subjections arising from jobs that the ADMINISTRATION or any other company may have him carry out on the site, except if he shall have given prior notice to the ADMINISTRATION and provided evidence of the inconvenience this may have subjected him to. Article 1.14 - Night Work and Public Holidays Work carried out at night or on public holidays shall be subjected to authorization by the ENGINEER. This approval shall only be granted if the CONTRACTOR shall have taken the relevant steps and if the request shall have been made early enough to enable the ENGINEER to ensure the supervision and monitoring of the works. No additional cost shall be granted for work done at night and public holidays. Chapter II - Financial and Administrative Clauses Article 2.1 - Price of Contract 2.1.1 Firm Phase 2.1.1.1 Lot A The value of LOT A amounts to a total and fixed price of: TWENTY SEVEN MILLION US DOLLARS (US $27,000,000) (excluding VAT and duty). The total value of LOT A of the contract, excluding fees, registration charges, VAT, "TPS", at prices prevailing in October 1992 and under conditions stipulated in this contract and notably tax and customs levies specified under Articles 2.19 and 2.20 of the particular terms and conditions amounts to the following: Total value excluding taxes and duties: US $27,000,000 Total customs duty: US $ 6,451,772 Registration charges: US $ 1,600 VAT at 25%: US $ 8,362,943 Total value including taxes: US $41,816,315 FORTY-ONE MILLION EIGHT HUNDRED AND SIXTEEN THOUSAND THREE HUNDRED AND FIFTEEN DOLLARS. 2.1.1.2 Lot B The estimated total amount of Lot B is a sum of: 9,000,000 USD tax and duty free (Nine million US Dollars). The total amount of the market Lot B without harbor, stamp, and registration fees and without interior V.A.T. [value added tax] and T.P.S., under the conditions defined in all the clauses of the current transaction, particularly the fiscal and customs clauses specified in Articles 2.19 and 2.20 of the Schedule of Clauses and Special Conditions rises then to a sum of: Total amount without duties and taxes: 9,000,000 US dollars Total amount of harbor fees (customs duty): 1,350,000 US dollars Total amount of V.A.T. at a rate of 25%: 2,587,000 US dollars Total amount, all taxes included: 12,937,500 US dollars Twelve million nine hundred thirty-seven thousand five hundred US dollars (A.T.I.). 2.1.2 Optional Section 2.1.2.1 Lot A The total amount of Lot A is a total, inclusive, firm and fixed sum of: 1,111,000 USD tax and duty free (One million one hundred and eleven, thousand US Dollars). The total amount of the market Lot A without harbor, stamp, and registration fees, without interior V.A.T. [value added tax] and T.P.S. under conditions defined by all the clauses of the current transaction, particularly the fiscal and customs clauses specified in Articles 2.19 and 2.20 of the Schedule of Clauses and Special Conditions rises then to a sum of: Total amount without duties and taxes: 1,111,000 US dollars Total amount of customs duties: 265,086 US dollars Total amount of V.A.T. at a rate of 25%: 344,022 US dollars Total amount, all taxes included: 1,720,108 US dollars One million seven hundred twenty thousand one hundred eight US dollars (A.T.I.). 2.1.2.2 Lot B The provisional value of LOT B amounts to SEVEN HUNDRED THOUSAND DOLLARS (US $700,000). The total value of LOT B of the contract, excluding customs and registration charges, excluding VAT and professional taxes and under conditions specified in the terms and conditions of this contract, notably regarding taxes and customs levies specified under Articles 2.19 and 2.20 of the PTC amounts to the following: Total value excluding taxes and duties: US $ 700,000 Customs: US $ 105,000 VAT at 25%: US $ 201,250 Total value: US $1,006,250 ONE MILLION SIX THOUSAND TWO HUNDRED AND FIFTY DOLLARS. Article 2.2 - Price Variations Without object. Article 2.3 - Breakdown of Total Fixed Price The price of this contract for LOT A is total and lumpsum for LOT A. The items which appear in the breakdown of the total and lump price are given for information and do not in any way bind the MAIN CONTRACTOR/EMPLOYER. The unit value of the breakdown may only be used for provisional detailed account and payment of possible modification works ordered by MAIN CONTRACTOR. The total and contractual price excluding taxes and duties of the project comprizes all the expenses, of the CONTRACTOR in implementing the entire project. The overall and lump price exclusive of taxes and duties shall be deemed to have been established with the understanding that no part shall be carried out by the EMPLOYER except those specified under Article 1.5.3. The price shall comprize notably: - design, - technical execution surveys, - technical coordination of the project and supervision - of SUBCONTRACTORS, - salaries and social benefits, - staff accommodation expenses, - amortization and operation of his equipment, - supplies, materials and consumable items of all kinds, - freight, transport and transit charges, - insurance fees as stipulated under Article 2.5 of PTC, - suretyship and guarantees, - patents, fees, taxes, charges and levies of all sorts owed as a result of the execution of this contract, - taxes, and notably: - taxes on incomes, - national contribution (CN), - apprentice's tax (T.A.), - national solidarity tax (SN), - land-tax, - professional and merchant taxes, - scheduled taxes on industrial and commercial profits, - management and site changes, - overheads, - risks and profits. This price shall include all the subjection and constraints arising from the application of administrative, technical and financial provisions stipulated in the contractual documents. It shall take into account risks and subjections of all kinds relating to the works specified in the contract which the CONTRACTOR shall be deemed to have full knowledge. The nature and difficulties. The price shall also include expenses related to special conditions of the project notably: natural phenomena (excluding Acts of God), utilization of public property and functioning of public services, simultaneous construction of other structures. Furthermore, it shall be specified that the price of the contract shall also include all expenses outside Cote d'Ivoire which are the necessary and direct consequence of the project (supplies, works, services, etc.), and notably, all fees, taxes, insurance, charges, overheads, false claims underwritten by the CONTRACTOR and for which he shall in any case be liable. In case of sub-contracting, the prices of the contract shall be deemed to have adequately covered the general expenses of the project, especially those relating to the coordination and supervision by the CONTRACTOR and his SUB-CONTRACTOR as well as the consequences of their possible default. The overall lumpsum price stipulated above is labeled as follows: excluding customs fee (special entry fee, fiscal entry fee, custom levy and statistical fee) only for the entry of materials, equipment and components inextricably bound to the project, excluding VAT and professional tax (TPS), excluding registration fees and stamps levies. Under the understanding that the purchase of fuel, lubricants and hydrocarbonate binders shall be purchased locally and shall be affected by the tax laws of Cote d'Ivoire without any restriction or exception. The value of stamp levy and registration fees to be paid by the CONTRACTOR for the purpose of the contract shall be reimbursed under conditions outlined under Article 2.19 of the PTC. All other relevant fees and taxes to be paid by the CONTRACTOR for the purpose of the contract or any other purpose and which shall be in force at the date of the signing of the contract shall be deemed to be included in the total and contractual price of the project. Furthermore, the total project shall be financed by a financing agreement between the State of Cote d'Ivoire, an American Bank and EXIMBANK as guarantor. Article 2.4 - Final Nature of Prices The CONTRACTOR shall not revise the overall price of works pertaining to LOT A of the contract signed by him, except in the following cases: If the rehabilitation of transmitters requires replacement of parts other than those specified in overall contractual breakdown, he shall do so at no extra cost provided the required parts are available on the market and can be obtained within the implementation schedules of the project. If the transmitter cannot be repaired under these conditions, any increase in price or deadline shall be subject to a special negotiation. Article 2.5 - Liabilities and Insurance 2.5.1 General Liability Clause Notwithstanding the insurance liabilities imposed hereunder, the CONTRACTOR shall be solely responsible for safeguarding the EMPLOYER, MAIN CONTRACTOR and ENGINEER against any claims by third parties for damages of all kinds or body injuries resulting from the preparation and (or) execution of the contract by the CONTRACTOR, his SUB-CONTRACTORS and their agents. This liability also covers damages resulting from the transportation of his materials. Compensations that shall be due shall be paid by the CONTRACTOR without prejudice to possible appeal against the culprits of the accident. Under no circumstances shall the EMPLOYER, MAIN CONTRACTOR and ENGINEER be held liable for damages mentioned in the above paragraph. The CONTRACTOR shall not be liable for any intangible or indirect damages except in case of negligence or unintended error. 2.5.2 Insurance 2.5.2.1 Protection of Persons and Liabilities The CONTRACTOR should apply for: 2.5.2.1.1 Civil liability Insurance A third party CIVIL LIABILITY INSURANCE that covers all bodily and material damages that might occur to their parties during execution of all the transactions as well as during the guarantee time limit. This insurance will be applied for in the CONTRACTOR's name of and on his behalf and will cover all the contributors, namely the CONTRACTOR, the OWNER, the PROJECT MANAGER, and the ENGINEER as well as the SUBCONTRACTORS for their on site activities: they will thus all be the coinsured. The insurance policy should specify that the OWNER's, ENGINEER's, or PROJECT MANAGER's personnel as well as those of other on site BUSINESSES are considered as third parities with regard to the insurers. The so-called "OVERLAPPING LIABILITY" clause is related to both material damages and bodily injuries suffered by the coinsured. This insurance excludes the work accidents suffered by the Contractor's personnel mentioned in section 2.5.2.1.2 below. This insurance must be unlimited for bodily injuries. This insurance must cover especially the liability of the CONTRACTOR acting as the company manger. 2.5.2.1.2 Work Accidents Insurance In accordance with Cote d'Ivoire law, the Contractor will apply for all insurance necessary to cover this. He will monitor to see that the SUBCONTRACTORS do the same. He protects the OWNER, the PROJECT MANAGER, and the ENGINEER against all claims that its personnel or those of its SUBCONTRACTORS might file against the latter both in the Cote d'Ivoire and abroad. For this permanent expatriated personnel, the CONTRACTOR will also conform to the law and regulations of the original country. 2.5.2.1.3 Automobile Liability Insurance (C.L.) The CONTRACTOR will apply for insurance that conforms to Cote d'Ivoire law for all vehicles that have access to the public highway and will monitor to see that his SUBCONTRACTORS do the same. 2.5.2.1.4 Insurance Covering Risks at Work Site The CONTRACTOR must effect and maintain an insurance against work site risks, covering the EMPLOYER as well as the CONTRACTOR extending continuously from the start of the project to the provisional acceptance and covering all the goods of the project. The insurance must carry widest possible guarantees and, consequently, cover all physical damage affecting the goods specified in the contract, including those caused by an error in design, planning, construction or execution material, without excluding the vitiating party. From the provisional acceptance, the guarantees of this insurance shall run during a "maintenance" period and, at least, during the guarantee period. The guarantees shall cover damages attributable to the CONTRACTOR's interventions on the site while carrying out his contractual duties, especially checking, maintenance, adjustment, repairs or damages caused by factors which were anterior to the provisional acceptance. 2.5.2.2 Subscription and Production of Policies The CONTRACTOR must, before the start of the project, effect insurances stipulated in paragraphs 2.5.2.1.1, 2.5.2.1.2, 2.5.2.1.3 and 2.5.2.1.4 of Article 2.5.2.1 above. The corresponding policies must be presented within FOURTEEN (14) days following the request by the MAIN CONTRACTOR or ENGINEER. All the policies must bear a clause subjecting their annulment to the prior approval of the insurance company, EMPLOYER and MAIN CONTRACTOR. They must be effected with insurance companies recognized in Cote d'Ivoire. 2.5.2.3 Sanctions Apart from the copies of policies taken, the CONTRACTOR must provide the MAIN CONTRACTOR's certificates showing that the said insurance policies are indeed in force. Failure to produce these documents shall prohibit any payment relating to the contract to the CONTRACTOR. Article 2.6.1 Execution Period The CONTRACTOR shall take all the necessary steps to complete the entire project within a maximum period of eighteen (18) months beginning from the service note ordering the commencement of work which can only be given after the entry into force of the contract. 2.6.2 Delay Penalties 2.6.2.1 Delay in the completion of the project, except for reasons Act of God or delays unattributable to the CONTRACTOR, shall result in the full payment of penalties without prior formal notice. The value of the penalty shall be fixed at ONE THOUSAND (1/1000th) of the initial value (less taxes) of uncompleted jobs expressed in US Dollars per calendar day of delay. The term "uncompleted structures" mentioned above shall apply to each of the 27 centers numbered from 1 to 27 in the BREAKDOWN OF THE TOTAL AND LUMPSUM PRICE OF LOT A and BILL OF QUANTITIES AND PROVISIONAL ESTIMATES OF LOT B undelivered at the expiry of the contract. The value of penalties shall be deducted from amounts owed the CONTRACTOR and shall be deducted from the project. Any delay for reasons of Act of God or not attributable to the CONTRACTOR shall be equally compensated for by extension of completion time. 2.6.2.2 The parties agree that when penalties reach (5%) of the value of the contract, the following consequences shall apply: The CONTRACTOR shall, by notification, inform the EMPLOYER of causes and reasons for this delay as soon as the percentage stated above reaches 4.5%. In case of default by the CONTRACTOR to inform the above-mentioned, the penalties shall continue to apply. 2.6.2.3 The penalties shall be stopped as soon as the EMPLOYER receives the notification indicated under 2.6.2.2 and for thirty (30) days during which the CONTRACTOR and EMPLOYER shall attempt to negotiate a solution which shall be subjected to a written agreement. Agreement from these negotiations shall put forward solutions for the delay and a new completion time for the project which shall not be more than 90 days after the initial completion date set in 2.6.1. Penalties outlined under Article 2.6.2.1 shall apply to the new completion date and their value shall be linked to the value of the contract. 2.6.2.4 If by the end of negotiation period stipulated under 2.6.2.3 an agreement has not been reached, the penalties shall begin to apply and linked to the value of the contract. 2.6.3 Specifications on Time Limit Any time limit specified in the contract to the EMPLOYER, MAIN CONTRACTOR or CONTRACTOR shall take effect from the date of notification of commencement of work sent to the CONTRACTOR. When the time limit is set in days, this shall mean calendar days and it shall expire at the end of the last day of the completion time specified. When the time limit is in months, it shall be counted from day to day. It there is no corresponding day in the month ending the period, the latter shall expire at the end of the last day of the month hereof. When the last day falls on a Sunday or public holiday, the time limit shall be extended to the end of the following working day. When, in executing the terms of the contract, a document must be provided, within a set period, by the CONTRACTOR to the EMPLOYER or vice versa, or when the dispatch of a document must run a certain period, the document shall be delivered to the addressee and a receipt issued. The date of the receipt shall be the official date of delivery of the document. Article 2.7 - Acceptance in Factory - Provisional and Final Acceptance - Guarantee Period - Anticipated Utilization of Some Installations or Parts of Installations 2.7.1 ACCEPTANCE 2.7.1.1 BACKGROUND For the execution of pre-delivery testing, the CONTRACTOR shall provide the necessary personnel and instruments, but he may freely use available measuring instruments belonging to the EMPLOYER for tests carried out on the site. 2.7.1.2 Factory Acceptance One month before the date scheduled for the start of necessary tests, the CONTRACTOR shall provide the MAIN CONTRACTOR with the test plans describing the intended tests and comprizing: - a description of the principles to be applied and conditions for the tests, - installation and description of instruments to be used, - expected result of each test. The CONTRACTOR shall inform the MAIN CONTRACTOR by letter, telex or cable the date scheduled for the test. This notification shall reach the MAIN CONTRACTOR at least one month before the set date. The latter shall decide whether or not to appoint his representatives to witness the testing. During the tests, the CONTRACTOR shall complete the necessary measurement and test sheets. After the representatives of the EMPLOYER shall have attended the testing sessions, the CONTRACTOR shall provide them with sheets for their signature and observations to be completed on the site. The CONTRACTOR shall transmit them to the MAIN CONTRACTOR as soon as possible. Otherwise, the CONTRACTOR shall send them to the MAIN CONTRACTOR as soon as they are filled in. If the results of the factory tests indicate that the equipment can be dispatched, a certificate of factory acceptance shall be issued to the CONTRACTOR within fourteen (14) days beginning from the end of the said tests. These certificates issued on a site per site basis may include a list of reservations concerning elements that do not conform with the contractual specifications which the CONTRACTOR must rectify before presentation for provisional acceptance. The factory tests and measurement sheets shall not in any way absolve the CONTRACTOR of his overall responsibilities for the performance of the equipment. 2.7.1.3 PROVISIONAL ACCEPTANCE Two months before the start of tests on the site, the CONTRACTOR shall submit to the MAIN CONTRACTOR for approval an acceptance log book describing all the measures to be carried out on each site. The MAIN CONTRACTOR shall approve an acceptance book within thirty (30) days following the acceptance. Beyond this period the MAIN CONTRACTOR shall be deemed to have approved of the delivery. Acceptance tests shall be carried out in the presence of representatives of the MAIN CONTRACTOR after installation on each site and the measurement and test sheets shall be submitted to the representatives for signature and comments. In this regard, the CONTRACTOR shall, one month before hand, inform the MAIN CONTRACTOR by registered letter, telex or cable for the scheduled date for the start of the tests and the relevant programme. The tests shall be conducted to the satisfaction of the MAIN CONTRACTOR before the provisional acceptance. If the tests should be postponed or repeated through the exclusive fault of the CONTRACTOR, the latter shall refund to the MAIN CONTRACTOR the entire expenses incurred as a result, such as consultant and expert fees and additional travel expenses. If the results of the tests carried out on a given site indicate that the latter can be commissioned, a provisional acceptance certificate shall be issued to the CONTRACTOR within fourteen (14) days beginning from the end of the said tests. These certificates issued on site by site basis may contain a list of reservations on the components that do not conform with the contractual specifications but shall not prevent the operation of the network and in such a case shall indicate the time limit agreed upon for the withdrawal of these reservations. If the results of the tests do not conform with the specifications, hampering the operation of the site, the provisional acceptance certificate shall not be issued, and if the time set for the installation stipulated under Article 2.6.2 shall continue to apply. A list of materials not conforming to specifications shall be submitted to the CONTRACTOR within the week following the trials. The CONTRACTOR shall then undertake to replace or repair the equipment concerned within the shortest possible time and present them again for testing in accordance with the procedures outlined above. If provisional acceptance is granted. the MAIN CONTRACTOR shall draft and sign the minutes of the provisional acceptance which shall indicate the project completion date on which the various guarantee periods shall then be based. The transfer of full property of the systems, tools and measuring equipment shall take place on the day of handing over of provisional acceptance for each site. 2.7.1.4 GUARANTEE PERIOD The guarantee period of one (1) year starting from the date of the provisional acceptance of each station. The CONTRACTOR shall be bound, during the guarantee period by a liability called "PERFECT COMPLETION LIABILITY" by which he shall, at his own expense: - rectify all the defects indicated by the MAIN CONTRACTOR or EMPLOYER such that the installation shall conform with the state in which it was during the provisional acceptance, - undertake, if need be, adjustments or modifications that may appear necessary, - hand over to the MAIN CONTRACTOR plans of installations conforming with the implementation. The obligation of perfect completion covers jobs needed to remedy effects of normal wear and tear with the exception of consumable items, cleaning and regular maintenance which are incumbent upon the EMPLOYER. Any default by the CONTRACTOR to meet his obligations shall, after formal notice, result in the MAIN CONTRACTOR undertaking the adjustments, modifications or repairs at the expense and risks of the CONTRACTOR. The guarantee period shall be extended until the total completion of jobs and services whether the latter are carried out by the CONTRACTOR or officially in conformity with the conditions stated above. The CONTRACTOR shall undertake notably to have all necessary repairs of substandard equipment done at his expense, on the site or in a factory of his choice. This guarantee does not cover consumable items, but it includes the obligation to supply spare parts needed after normal wear and tear during the guarantee period. The CONTRACTOR shall guarantee the repair or replacement of components under conditions stipulated above until the final acceptance; however, when these components shall have been installed six months before this date, the guarantee can be extended six months after their installation and specialty mentioned in the final acceptance certificate. The guarantee does not however apply to damages resulting from violation of rules and directives given by the CONTRACTOR for the maintenance or misuse, negligence or any other omission attributable to the EMPLOYER or a third party. 2.7.2 FINAL ACCEPTANCE At the expiry of the guarantee, final acceptance operations shall be undertaken in the same manner as the provisional acceptance. Final acceptance shall take place under the same conditions as the provisional acceptance mentioned above after the expiry of the guarantee period of the last site. If during the guarantee period, the MAIN CONTRACTOR detects a defect of non-conformity with the technical specifications of the contract, he shall request the CONTRACTOR to carry out at his own expense, the necessary repairs. The certificate of final acceptance shall only be issued after the CONTRACTOR shall have completed the repair of the established defects. Otherwise, the MAIN CONTRACTOR shall issue the certificate of final acceptance within the thirty days following the end of the guarantee. 2.7.3 ANTICIPATED USE OF SOME INSTALLATIONS OR PART OF INSTALLATIONS The EMPLOYER may, with the approval of the CONTRACTOR, dispose of some structure or parts of structures as they are completed and before the jobs stipulated in the contract are completed. In this case, the transfer of ownership of the structures involved shall be made. 2.7.4 REPLACEMENT PARTS During a period of ten (10) years starting from the final acceptance, the CONTRACTOR shall undertake to supply within reasonable lengths of periods and at reasonable prices any replacement part or material which shall be requested of him for the maintenance of installations described in the contract. In case of stoppage of manufacture of spare parts, the CONTRACTOR shall inform the EMPLOYER early enough to enable him to take the necessary measures. The CONTRACTOR undertakes, however, to refrain from interfering in possible relationship between SUB-CONTRACTORS and the EMPLOYER in the direct procurement of components manufactured by the latter after the expiry of the contract. Article 2.8 - Construction Defects If the MAIN CONTRACTOR is of the opinion that there is a construction defect in a given installation, he shall, during or before the final acceptance direct, through a service order, the measures to be taken to identify this defect. These measures shall comprize, if need be, the demolition and partial or complete reconstruction of the structure presumed defective. The MAIN CONTRACTOR may carry out these measures himself or by a third party, but the operation must be done in the presence of the CONTRACTOR, or after duly summoning him. If a construction defect is observed, the expenses needed for the repairs or total rectification in accordance with the provisions of the contract as well as expenses resulting from possible defection operations, shall be borne by the CONTRACTOR with prejudice to the compensation which the MAIN CONTRACTOR may lay claim to. If no defect is detected, the CONTRACTOR shall be reimbursed the expenses outlined in the preceding paragraph, if he had borne them. Article 2.9 - Logging of Jobs Completed 2.9.1 For the evaluation of possible modifications ordered by the CONTRACTOR, jobs carried out in this regard shall be logged by the ENGINEER or his approved representative in the presence of the CONTRACTOR, summoned for the purpose or his approved representative. If the CONTRACTOR does not respond to the summons and does not send his representative, the logging shall take place in his absence. 2.9.2 The CONTRACTOR may not, under any pretext, for measurements invoke habits and traditions in his favor. 2.9.3 The logs shall be presented for acceptance to the CONTRACTOR who may have it copied in the ENGINEER's offices. 2.9.4 Acceptance of logs by the CONTRACTOR shall concern quantities and unit prices. The latter should be designated by the numbers of the memorandum of unit prices. When the log is limited to quantities, special mention must be made by the CONTRACTOR who shall express his reservations in writing. 2.9.5 If the CONTRACTOR refuses to sign the log book or signs them with reservation, minutes shall be written on the presentation and accompanying circumstances; the minutes shall be annexed to the unsigned documents. In this latter case, a time limit of ten (10) days starting from the date of presentation of documents shall be allowed him to put his comments into writing. Beyond this period, the logs shall be deemed to have been accepted by him as if had been signed without reservation. 2.9.6 The systematic conditional logging shall be considered as constituting a non observance of contractual obligations with all the administrative and legal consequences such an attitude may have. 2.9.7 Conflicting observations may be agreed to in the course of the project, either at the request of the CONTRACTOR or initiative of the MAIN CONTRACTOR without the observations prejudicing, on principle, neither admission, claim, nor right to payment. Article 2.10 - Basis of Payment 2.10.1 Provisional Detailed Accounts At the end of each month, the ENGINEER shall establish a provisional detailed account, a copy of which shall be sent to the CONTRACTOR at his request. This provisional monthly detailed account shall take into account sums owed the CONTRACTOR since the beginning of the project. It shall notably comprize: - contractual starting advance, - the CIF value of goods stripped and for which partial payment shall have been requested, - value of supplies made on the site, - the value of jobs based on bills of quantity of jobs carried out under contract conditions and unit prices included in the breakdown of the total cost, - value of works by force account, - value of jobs under controlled expenditure, - value of various repayments, - value of refund of customs duty, - value of refund of registration and stamp fees, - value of penalties and deductions, - value of VAT. The monthly installments to be paid the CONTRACTOR shall be determined by the difference between the value of the monthly deduction and that of the deduction of the previous month. 2.10.2 Final Detailed Account A final detailed account shall be established at the end of the project. The final account shall include all the items mentioned under Article 2.10.1 above on provisional detailed account. The value of project shall be the same as the total and lumpsum price. However, if necessary, this amount shall be revised: - downward to the value of jobs that the MAIN CONTRACTOR shall have expressly called off by service order, - upward to the value of additional jobs expressly ordered during the construction work. The final detailed account shall be binding on the EMPLOYER only after receiving the approval of the MAIN CONTRACTOR. Within three (3) months following the completion of the project and its provisional acceptance, the CONTRACTOR shall be invited by a duly notified service order, to come to the offices of the ENGINEER to inspect the final detailed account and sign it for approval. He may request to see the vouchers and have copies made as well as copies of the account. In case of refusal, minutes of the presentation shall be taken and circumstances of the refusal noted. The acceptance of the final detailed account by the CONTRACTOR shall be binding in respect of unit prices and quantities. If the CONTRACTOR does not reject the service order or refuses to accept the final account, or signs the latter conditionally, he shall explain in writing the reasons for his refusal and inform the ENGINEER the value of his possible claims before the end of a sixty (60) day period starting from the date of notification of the said service order. It shall be expressly stipulated that the CONTRACTOR shall have no recourse to any claims relating to the final account after inspecting it and at the end of the aforementioned sixty (60) days. Beyond this time limit the final account shall be deemed to have been accepted by him even if he shall have signed it with reservation the reasons for which shall have no been explained as specified in the foregoing paragraph. Payment of the balance, after the necessary deductions from the guarantee deposit, shall be made within ninety (90) days from the date of acceptance of the final account by the CONTRACTOR of the aforementioned expiry date of sixty (60) days. Article 2.11 - Unforseen Jobs and Their Price Elevation The EMPLOYER can order jobs not included in the contractual price under the financing condition of the project in accordance with Article 2.3 above. If the nature of the jobs does not feature in the total price breakdown, the CONTRACTOR shall immediately conform with service orders he shall receive on the subject. New prices shall be prepared without delay following market trends or by assimilation to similar jobs in the contract. Where assimilation cannot be possible, current prices on the international market shall be used as reference. If mutual consent cannot be attained, the CONTRACTOR may refer to the provisions of Article 2.25 of the PTC. While awaiting the final decision on the litigation, the CONTRACTOR shall be provisionally paid on the basis of prices proposed by the MAIN CONTRACTOR. Article 2.12 - Variations of Volume of Project For the purpose of application of this Article, "volume" of the project means the value of actual jobs, evaluated from the breakdown of the total and lumpsum price taking account possible modifications formally ordered by the MAIN CONTRACTOR and new prices fixed in application of Article 2.11 above. The "initial volume" of the project shall be the value of jobs resulting from estimates of the contract, i.e., initial contract modified or supplemented with intervening additions. The CONTRACTOR shall complete the construction of jobs indicated in the contract, irrespective of the increase or decrease of the volume of jobs resulting from technical subjections, evaluation of quantities estimated or any cause of increase or decrease thereof. 2.12.1 Increase in the Volume of Works In the event of an increase in the volume of works, the CONTRACTOR shall not raise any objection. 2.12.2 Decrease in the Volume of Works In the event of a decrease in the volume of works, the CONTRACTOR shall raise no objection so long as the decrease does not exceed Twenty Five Percent (25%) of the initial volume of works and so long as he shall have not incurred any losses. Article 2.13 - Domiciliation of Payments Payments shall be effected in accordance with accounting regulations in force in Cote d'Ivoire. Payments shall be made: 1. by the Register General of the CAISSE AUTONOME D'AMORTISSEMENT of COTE D'IVOIRE for the sums excluding entry duties (special entry duty, fiscal entry fee, customs fees and statistical charges), registration and stamp duties, VAT "TPS", by bank transfers in US Dollars to Account No............. opened on behalf of COMSAT CITIBANK NA NEW YORK, 2. by the AGENT COMPTABLE DU TRESOR PUBLIC for entry, stamps and registration fees, VAT, TPS by special checks payable to the Treasury in accordance with the provisions of Decree No 305 of 2 September 1989. Article 2.14 - Payments Payment of installments must be effected within Ninety (90) days following the end of the month of implementation of contract. In case of delay in the payment of monthly installations beyond the 90 day period, the CONTRACTOR shall have the right to claim the payment of interest on the unpaid amounts. Interest rates shall be based on the discount rate of the WEST AFRICAN CENTRAL BANK augmented by one point. Interest rates shall be calculated on amounts excluding VAT of unpaid amounts with annual capitalization (365 days). Payment of interest rate delays shall not be subjected to VAT nor TPS. The period of application to be used in the calculation of delay interest shall be the number of days between the two dates below less the statutory payment period. 1. end of month of execution of works, 2. date of payment by BANK. Article 2.15 - Definitive Suretyship The CONTRACTOR shall produce definitive suretyship to guarantee the proper execution of his contractual commitments and recovery of amounts for which he shall be deemed debtor in respect of the contract. The value of definitive suretyship shall be fixed at Three Percent (3%) of the initial price less VAT and customs duties of the contract plus, if necessary, the value of amendments. The CONTRACTOR shall effect the definitive suretyship within Twenty (20) days from the date of notification of approval of the contract (or amendments in the case of an increase). The suretyship can be replaced with an individual and joint guarantee underwritten by a bank approved by the Minister in charge of Economy, Finance and Planning under conditions specified by regulations in force on public contracts. The absence of suretyship, or, its increase, shall hamper payment of amounts owed the CONTRACTOR, including the start-up advance. In case of deduction made on the suretyship, for whatever reason, the CONTRACTOR shall have to reconstitute it. The suretyship shall remain assigned to the guarantee of contractual obligations by the CONTRACTOR until the provisional acceptance of the works. The definitive suretyship shall be refunded, or the guarantee in support of it released in so far as the holder shall have met his obligations and following its release by the MAIN CONTRACTOR within Thirty (30)days after the final acceptance of the project. Article 2.16 - Retention Money Retention money is a provision meant to guarantee the perfect completion of the structure and rectify, if necessary, the defaults of the CONTRACTOR during the guarantee period. The value of the retention money is fixed at Seven Percent (7%) of the initial value of the works. It shall be made up through successive deductions on the monthly installments. The replacement of this bond with a joint guarantee furnished by a bank approved by the Minister responsible for Economy, Finance and Planning may be effected either with the progress of the works or at the provisional acceptance, in which case the joint guarantee shall be furnished within Ten (10) days following the date of stoppage of the said installment. In so far as the CONTRACTOR shall have met his obligations in this regard the retention money shall be refunded or the guarantee replacing it released within Thirty (30) days following the expiry of the guarantee. Article 2.17 - Contractual Advance A contractual advance at the start of the project may be granted the CONTRACTOR provided he formally requests it. It shall be fully backed (100%) with a joint guarantee issued by a bank approved by the Minister responsible for Economy, Finance and Planning. This advance shall be fixed at twenty percent (20%) of the (pre-tax) basic value of the contract. Payment of starting advance shall be subjected to the aforementioned request and the furnishing of guarantees (start up advance and final suretyship) must be effected within sixty (60) days starting from the date of the notification ordering the CONTRACTOR to begin works or the acceptance of the latter of the two aforementioned guarantees if the acceptance follows the notification. Repayments shall be made by installments and regularly beginning with the first installment on the basis of a 20% deduction of the pre-tax value of the project and shall be completed at the end of the implementation period or at the drafting of the final account. The advance and relevant repayments shall not be revised. Article 2.18 - Embarkation Instalment The CONTRACTOR may request that the provisional monthly breakdown includes an embarkation deposit representing ninety percent (90%) of the CIF value of the goods on board upon the presentation to the ENGINEER of the following documents: - bills of lading, - invoices of goods embarked, - packing list. This deposit shall be fully backed (100%) with a joint guarantee from a bank approved by the Minister responsible for Finance. The release of the said guarantee shall be effected by the MAIN CONTRACTOR at the inspection of the delivered goods at the site. Article 2.19 - Tax and Customs System The CONTRACTOR shall be deemed to have full knowledge of tax and customs laws in force in Cote d'Ivoire. The contract shall be eligible for special check procedures in accordance with the provisions of Decree No 305 of 2 September 1989. The breakdown for pre-tax portion authorized by the MAIN CONTRACTOR shall be conveyed to the Caisse Autonome d'Amortissement which shall initiate the procedure required for the settlement of the said portion. The value of customs and entry duties based solely on materials and equipment and components incorporated definitively into the units and the VAT shall be paid by the Public Treasury by special checks. Such checks with special serial numbers that shall be non-endorsable and non-compensable shall be issued in favor of the Controller of Customs and Taxes, according to the procedures described below, and given to the CONTRACTOR. The said non-endorsable checks shall be used exclusively for the intended payments and no other payment except those pertaining to customs and taxes on turnover. The breakdown established for fees and taxes above by the MAIN CONTRACTOR on the basis of vouchers (customs liquidation vouchers or special VAT declarations) shall be presented by the CONTRACTOR to the Office of the Director General of Customs or Taxes for inspection. The inspection of these documents shall be carried out as an emergency. The breakdowns thus signed by these offices shall then be forwarded by the CONTRACTOR to the Directorate of Public Investments for entry into the special account of the Treasury. The Directorate of Public Investments shall transmit payment orders to the Treasury with relevant supporting document for issue by special checks. The claims shall be supported with any details furnished by the CONTRACTOR on the possible withdrawal of credit and the special modalities for payment. Article 2.20 - Registration The CONTRACTOR shall undertake registration procedures to which the contract is subjected. Stamp levies and registration fees shall be paid as under Article 2.19 above by special checks issued by the Public Treasury in favor of the Registrar and given to the CONTRACTOR for presentation at the Registry. Article 2.21 - Contract Security In order to ensure the security of the contract under conditions stipulated by regulations in force on the financing of State and Public Contracts, it is stated that: - the Department responsible for ordering payment of sums owed in the implementation of the contract shall be Direction et Controle des Grands Travaux, - the Accountant responsible for payments shall be Caissier General of the Caisse Autonome d'Amortissement de la Cote d'Ivoire for the pre-tax portion of entry (customs, entry fee and special entry fee) exclusive of stamps, registration, VAT and "TPS" and the Agent Comptable du Tresor Public for the portion on entry, stamp, registration, VAT and TPS, - the Officer responsible for providing the contract holder and beneficiaries of security or subrogation information and certificates stipulated under Article 6 of Decree of 6 September 1938 shall be the Director General of Direction et Controle des Grands Travaux, - the MAIN CONTRACTOR shall issue at no cost to the CONTRACTOR and at his request, an original copy of the contract with the words "single copy issued for security" on it. Article 2.22 - Complete Termination or Suspension of Works When the Employer orders the complete stoppage of works, the contract shall be immediately terminated. When he orders their suspension for more than six (6) months, either before or after start of works, the CONTRACTOR shall have a right to the termination of the contract, if he makes the request in writing, without prejudicing the indemnity which in either case he shall be entitled to if need be. The same shall hold for successive suspension, the total duration of which shall exceed a total of six (6) months and suspensions of any duration which would require modifications in the financing mechanisms and which shall not have been obtained within sixty (60) days following the notification of the said suspension. If the works shall have started, the CONTRACTOR may request an immediate provisional acceptance of completed structures, which are liable to be accepted, and their final acceptance after the expiry of the guarantee period. When the CONTRACTOR has no right to a cancellation, he may, if he shall have incurred proven prejudice, lay claims for compensation within the limitations of the prejudice. As soon as the notification of termination or suspension is received, the CONTRACTOR shall: - stop or suspend the work on the date indicated on the notice, - terminate or suspend any sub-contract, orders for equipment and materials except those needed for the continuation of work up to the date of termination or suspension, - undertake all the necessary conservation measures within the limitation and conditions outlined by the MAIN CONTRACTOR. Article 2.23 - Termination by Right The contract shall be terminated by right by the Minister responsible for Public Contracts without any recourse to legal intervention and without compensation in the following cases: 2.23.1 BANKRUPTCY - LEGAL SETTLEMENT 1. In case of bankruptcy of the CONTRACTOR, it shall be incumbent upon the Employer to accept, if need be, offers to be made by a group of creditors for the continuation of the project. 2. In case of the legal liquidation, if the CONTRACTOR is not authorized by the Courts to continue operations. 2.23.2 Unauthorized Sub-Contracting If a sub-contract is effected in breach of Article 1.12, the Employer who approved the contract may request the termination of the project or have sub-contractual jobs carried out at the expense and risks of the CONTRACTOR by State control or through a duly signed contract. 2.23.3 Long Delays in Works In the event of long delays and irrespective of the application of penalties indicated under Article 2.6, the Employer may impose, at the expense of the CONTRACTOR, additional work teams. If the above measures prove t be unsatisfactory, the Employer may request the termination of the contract after the mandatory thirty (30) day prior notice. 2.23.4 Default of Firm Suretyship In the case of default by the CONTRACTOR in effecting the firm suretyship within the time limit stipulated under Article 2.15 of the PTC. Article 2.24 Coercive Measures The CONTRACTOR does not comply with either the provisions of the contract or written service orders given him the MAIN CONTRACTOR or his Representatives shall notify him to comply with the said orders within a determined period of time. Beyond this period, if the CONTRACTOR has not implemented the prescribed provisions the Employer may, at the risk of the CONTRACTOR. request the outright termination of the contract. order control by the force account at the expense of the CONTRACTOR. This control many be partial. There shall therefore be, in his presence or to his knowledge an immediate inspection of completed works, materials supplied as the inventory of equipment belonging to the CONTRACTOR and the handing over of the part of the equipment not used by the Administration for the completion of the works. In the case of force account, the CONTRACTOR shall be authorized to monitor the operations with hampering the execution of the orders of the Representatives of the Employer. He may be released from force account if he demonstrates the necessary ability to continue the works to their completion. Supplementary expenses resulting from force account or fresh contract shall be at the expense of the CONTRACTOR. They shall be deducted from amounts owed him without prejudice to rights exercised against him in case of inadequacies. If the force account or fresh contract entails a decrease in expenses, the CONTRACTOR shall not claim any part of the profit which shall belong to the Administration. When fraudulent acts, repeated shortcomings in the working conditions or serious errors in duty shall be noticed and attributed to the CONTRACTOR the relevant authority can, without prejudice to legal proceedings and sanctions to which the CONTRACTOR shall be answerable, ban him for a determined period or definitively from contracts of his Administration. Article 2.25 Avoidance and Settlement of Disputes 2.25.1 Out of Court Settlement The CONTRACTOR and Employer shall agree to endeavor to settle all the disputes that may arise from the application of this contract out of court by exhausting a mandatory reconciliatory procedure. 2.25.2 Mandatory conciliatory procedure 2.25.2.1 As soon as one party shall feel that there is a dispute, he shall notify this to the other party in accordance with Article 2.3.1 by requesting the application of the mandatory conciliatory procedure. The notification shall include a statement indicating the causes of the dispute and, possibly, the value of claims. 2.25.2.2 The mandatory conciliatory procedure shall be conducted by three (3) arbitrators appointed by the CONTRACTOR and Employer within thirty (30) days after the notification of the dispute. Each part shall appoint one arbitrator and both parties shall jointly appoint the third arbitrator. 2.25.2.3 If within fourteen (14) days following the expiration of the said thirty (30) day period. following the notification either or both parties shall not have appointed the second and/or the third arbitrator; the latter shall be appointed by the President of the Abidjan Magistrate Court sitting upon petition of one of the parties. 2.25.2.4 The mandatory conciliatory procedure shall take place in Abidjan. 2.25.2.5 The arbitrators shall proceed in the settlement of the dispute solely as arbitrators. They shall not be bound by any rule of procedure. They shall be entitled to undertake any off-site or on-site investigation and summon any person to appear before them. 2.25.2.6 The deliberations of the arbitrators shall lead to a decision stating the grounds of the said decision. If the latter is not unanimous, it shall reproduce the position of each of the arbitrators. 2.25.2.7 If within sixty (60) days after the notification of the dispute, no out of court settlement shall have been made, the dispute may be referred for court arbitration in accordance with Clause 2.25.3 hereafter. 2.25.3 COURT ARBITRATION In default of an out of court settlement, any dispute arising from this contract shall be finally settled under the Rules of Conciliation and Arbitration of the International Chamber of Commerce by one or more arbitrators appointed under such rules. 2.25.3.1 The place of the said arbitration shall be Abidjan, Cote d'Ivoire. 2.25.3.2 The French Language shall be used. 2.25.3.3 Ivorian Law shall be applicable. Article 2.26 - Act of God Special Risks 2.26.1 ACT OF GOD An event shall only be deemed to be an Act of God if it is unforseen, irresistible, beyond the control of the parties, it can neither be anticipated nor prevented and if it makes it absolutely impossible for the parties to fulfill their commitments. None of the parties shall default in his contractual obligations in so far as the execution of the latter shall have been delayed or prevented by an Act of God. If an event of Act of God is deemed by the Employer to have occurred, the CONTRACTOR shall be authorized to request a fair compensation supported with all the corresponding supporting documents. Any dispute over the occurrence of an Act of God shall be settled in accordance with the provisions of Article 2.25 of the PTC. If the CONTRACTOR should invoke the Act of God Clause, he shall notify the Employer in writing within ten (10) days after the event which led to his notification; the Employer shall, at all events, have a period of thirty (30) days to make his view known. 2.26.2 OTHER PROVISIONS The CONTRACTOR shall not be entitled to any indemnification on losses, damage or injury caused through negligence, improvidence. lack of resources or fraud. The CONTRACTOR must take all the necessary steps, and at his own expense, to ensure that his supplies, equipment and field installations are not carried away or damaged by storms, floods and any atmospheric phenomena. The CONTRACTOR shall not avail himself of the right, either to forego his contractual obligations or lay any claims, any subjections which may result from the simultaneous execution of other works. 2.26.3 Special Risks Notwithstanding all the provisions of the PTC the CONTRACTOR shall not be liable to nor pay compensation for injuries, death, destruction or damages of structures, temporary structures or properties of the Employer or a third party directly or indirectly resulting from acts of war (declared or otherwise), hostility, invasion, enemy operation, revolution, rebellion, insurrection, military or civilian usurpation of power, civil war, uprising or disorders (excluding the CONTRACTOR's employees). These risks are generally defined hereinafter by the term "Special Risks". The Employer shall safeguard the CONTRACTOR against the special risks indicated hereof. He shall indemnify the latter for any real losses or damages caused to his property intended for the execution of the works. Article 2.27 - Works and Supplies by Force Account 2 27.1 BASIS FOR REMUNERATION OF WORKS BY FORCE ACCOUNT The CONTRACTOR shall furnish the MAIN CONTRACTOR, if the need should arise, workers and tools as well as necessary materials and equipment for works by force account. Expenses taken into account shall be the following: a) Salaries and Wages Salaries and wages shall be refunded to the CONTRACTOR on the basis of actual hours done, including overtime at rates applicable to professional categories specified in the Interprofessional Collective Agreement of Cote d'Ivoire of 20 July 1977, including social benefits and legal entitlements. b) Supplies Supplies expenses shall be reimbursed upon the production of vouchers established without VAT in so far as the CONTRACTOR shall be able to get a refund for the tax. c) Equipment The equipment shall only be taken into account for hours of actual work. The cost of the equipment shall be repaid in the form of a lease using rates established by the Direction du Materiel des Travaux Publics (DMTP) of Cote d'Ivoire. Bare equipment shall be paid for in accordance with coefficients of posts 1-2-3-4-8 established for a normal 8-hour working day. These coefficients apply to the purchase value of new equipment prevailing at the main place of use, possibly including the tax and customs provisions in this contract. The leasing rates thus calculated shall be updated on January 1 of each year to take into account variations in the purchase price of the equipment. Each effective overtime hour shall be paid as one-eighth (1/8th) of the cost of a normal day of lease. Salaries and wages of the controlling staff shall be refunded according to the provisions of paragraph a) Salaries and Wages. d) Fuel and Constituents Expenses shall be reimbursed on the basis of purchase value in so far as the CONTRACTOR can reclaim the VAT. e) Lumpsum Increase A lumpsum increase of six point twenty-five percent (6.25%) shall be applied to expenses under paragraphs a), b), c) and d) above to cover all overheads (notably accident insurance on workers and third parties) and entitlements. f) VAT All expenses for works by force account shall attract VAT at rates in force on the date of the establishment of the corresponding detailed account. 2.27.2 Limitation of Works by Force Account The obligation of the CONTRACTOR to carry out works by force account shall only apply within the constraints of total expenditure not exceeding two percent (2%) of the basic price of the contract. Sums paid to the CONTRACTOR as a result of the application of this Article shall not apply to articles of these particular terms and conditions concerning variations in the volume and nature of works. In case of exceeding the limitation of two percent (2%) fixed above, the contractual increase of six point twenty-five percent (6.25%) shall be carried beyond this limit to ten percent (10%). Article 2.28 - Works Under Controlled Expenses The expenses concerned shall be the following: a) Salaries Special expenses on senior expatriate staff with a hundred percent (100%) which shall cover all related expenses: travel, housing, miscellaneous allowances, leave, insurance, gratification, social expenses, etc. This increase shall be applied on the basic staff salary. Salaries of the staff not considered under the previous category shall be reimbursed to the CONTRACTOR on the basis of actual hours of work done, including possible overtimes at the rates applicable to professional categories specified in the Interprofessional Collective Agreement of Cote d'Ivoire of 20 July 1977, including social benefits and legal entitlements. b) Supplies Expenses for supplies shall be reimbursed upon production of invoices established without VAT in so far as the CONTRACTOR may reclaim the tax. c) Equipment Equipment shall only be considered in terms of actual hours done. The cost of equipment shall be repaid in the form of a lease using rates established by the Direction du Materiel des Travaux Publics (DMTP) of Cote d'Ivoire. Bare equipment shall be paid for in accordance with coefficients 1-2-3-4 established for a normal 8-hour working day. These coefficients apply to the purchase value of new equipment at the place of use, possibly including the tax and customs provisions in this contract. The leasing rates thus calculated shall be updated on January 1 of each year to take into account variations in the purchase price of the equipment. Each effective overtime hour shall be paid as one-eighth (1/8th) of the cost of a normal day of lease. Salaries and wages of the controlling staff shall be refunded according to the provisions of paragraph a) Salaries and Wages. d) Fuel and Constituents Expenses shall be reimbursed on the basis of basic purchase value in so far as the CONTRACTOR can reclaim the VAT. e) Lumpsum Increase A lumpsum increase of six point twenty-five percent (6.25%) shall apply to expenses under paragraphs a), b) and c) above to cover all overheads (notably accident insurance on workers and third parties) and entitlements. f) VAT All expenses for works by controlled expenses shall attract a VAT at rates in force on the date of establishment of corresponding detailed account. Article 2.29 - Miscellaneous Reimbursements - Authority to Contractor The MAIN CONTRACTOR may request the CONTRACTOR to substitute for the Employer in the payment of suppliers appointed by the MAIN CONTRACTOR for a number of expenses which are directly related to the contract and limited to the following. - installation of inspection mission (construction of offices by a company other than the holder of the contract, procurement of office supplies and furniture, procurement of laboratory equipment), - purchase of vehicles, - studies on current site, - works pertaining to LOT B. To this end, the MAIN CONTRACTOR shall give prior authority to the CONTRACTOR to pay the bills concerned, or place orders and follow up on them in his behalf. The bills shall be made in the name of the MAIN CONTRACTOR. The MAIN CONTRACTOR shall fully reimburse on the basis of authority, under a separate heading called Miscellaneous Reimbursements in the provisional breakdowns. For his substitution duties, the CONTRACTOR shall receive a remuneration of six point twenty-five percent (6.25%) of the value of the invoice. The total miscellaneous reimbursements shall be inclusive of VAT at rates applicable at the time of establishment of the corresponding detailed account. Article 2.31 - Domicile - Correspondence For the execution of this contract, the CONTRACTOR and Employer shall elect domicile at their respective head offices. Within fourteen (14) days following the contract, the CONTRACTOR shall convey the MAIN CONTRACTOR the address of a Representative in Cote D'Ivoire who shall receive all correspondence relating to the contract. He shall reserve the right to change this Representative by notifying the MAIN CONTRACTOR but shall undertake to keep the Representative in Cote D'Ivoire until the final acceptance. All correspondence between parties concerned with this contract should be made either by a letter signed by a person duly authorized by the initiating party or by telegram, fax or telex immediately confirmed by letter. Such correspondence must be written in French or accompanied by a translation in French. Correspondence shall be sent to the following addresses or any other that the parties shall notify each other and, notably, for the CONTRACTOR, to the address of the representative in Cote d'Ivoire. For EMPLOYER Ministere de la Communication 01 BP V 138, Abidjan 01 Republic of Cote d'Ivoire Telex: 23501 Fax (225) 22-22-97 ATTN: Honorable Minister of Communications For the CONTRACTOR Communications Satellite Corporation COMSAT Systems Division 22300 Comsat Drive Clarksburg, Maryland 20871 United States of America Telex 44-06-96 Fax: (1) (301) 428-7747 ATTN: Vice President Contracts To establish that a prior notice, notice, notification or other correspondence shall have been duly made, it shall be necessary to prove its reception by the other party which may be presumed on the basis of an acknowledgment of receipt, or delivery certificate for registered mail or a delivery receipt signed and dated by a person who shall be authorized by the addressee, regardless of the form. Article 2.32 - Entry into Force and Validity of Contract This contract for the rehabilitation and extension of the radio and television broadcast network shall only enter into force when all the precedent conditions outlined below shall have been fulfilled: a) signing of a financing agreement between the State of Cote d'Ivoire, an American Bank acting as lender and EXIMBANK as guarantor; b) signing of an agreement between the CONTRACTOR and Employer on the modalities of execution of and payment for works of LOT B which shall take account of the provisions of the aforementioned financing agreement; c) fulfillment of the set of conditions prior to the use of financing, notably handing over to the lending bank the certificate indicating the EXIMBANK approval of the mode of disbursement chosen. Parties to the contract shall undertake to ensure severally and collectively to work towards the timely implementation of the conditions listed above. In the event of non-fulfillment of all the conditions by January 31, 1993 and, unless the parties agree to an extension time or forgo the unexecuted conditions, this contract shall be deemed to be null and void. It shall be valid only after notification by the MAIN CONTRACTOR of its approval by the rightful authority. Done in Abidjan January 20, 1993 Read and Approved (in writing) The CONTRACTOR The MINISTER OF COMMUNICATION By: /s/P. Serrey-Eiffel P. Serrey-Eiffel /s/Kenneth Hoch Le Directeur General de la DCGTx for The Minister of Communication Stamped by Approved under No 93.0001 The DIRECTOR GENERAL OF MINISTER RESPONSIBLE FOR IVORIAN RADIO AND TELEVISION ECONOMY, FINANCE TRADE BROADCAST AND PLANNING EXHIBIT 10(y)(i) [TRANSLATED FROM THE ORIGINAL DOCUMENT IN FRENCH] REPUBLIC OF THE IVORY COAST Union - Discipline - Labor - - - - - - MINISTRY OF COMMUNICATION NATIONWIDE RADIO AND TELEVISION BROADCASTING COVERAGE AMENDMENT NO. 1 IVORY COAST RADIO AND TELEVISION BROADCASTING MANAGEMENT AND SUPERVISION OF LARGE-SCALE WORKS JANUARY 1994 REPUBLIC OF THE IVORY COAST Union - Discipline - Labor MINISTRY OF COMMUNICATION Contract No. : 93.0001 Contracting Company : COMSAT Signed on : Approved on : 01/18/93 Notification given on : Starting date of work : 10/06/93 Turn-around time : 18 mos. Term of guarantee : 1 yr. Amount of initial contract exclusive of tax & customs : $36,000,000 Amount of Amendment No. 1 exclusive of tax & customs : $ 1,768,562 Total amount exclusive of tax & customs : $37,768,562 Amount of customs duties : $ 8,165,492 Amount of VAT (25% rate) : $11,483,514 Amount of stamp duties and registration fees : $ 1,600 Amount of contract all taxes included : $57,419,168 Escrow : 7% Definitive security : 3% NATIONWIDE RADIO AND TELEVISION BROADCASTING COVERAGE AMENDMENT NO. 1 TO CONTRACT NO. 93.0001 OF JANUARY 18, 1993 DOCUMENT NO. 1 IVORY COAST RADIO AND TELEVISION BROADCASTING MANAGEMENT AND SUPERVISION OF LARGE-SCALE WORKS BETWEEN THE IVORY COAST GOVERNMENT Represented by the MINISTER OF COMMUNICATION hereinafter referred to as: "SPONSOR", ON THE ONE HAND, AND The Company "Communications Satellite Corporation (COMSAT)". Main office: 22300 COMSAT DRIVE, CLARKSBURG, MARYLAND 20871 USA Legal form: Incorporated Company under United States Law Represented for the purposes of these presents by Mr. Kenneth HOCH, Vice-President, Acting in the name of and on behalf of this COMPANY by virtue of a power of attorney dated .......1992 attached to the present contract, hereinafter referred to as: "THE CONTRACTOR", ON THE OTHER HAND THE FOLLOWING HAS BEEN AGREED AND DECIDED: ARTICLE 1 - OBJECT OF THE AMENDMENT The object of the present Amendment No. 1 to the Nationwide Radio and Television Broadcasting Coverage Contract is: 1) The decision to execute the optional section already provided for in Article 1.1.2.2 of the CCCP (Particular Clauses and Conditions, Doc. No. 2) of the initial contract. Execution of the optional section comprises installing the Transmitting Station at ZOUKOUGBEU to replace that of ISSIA. 2) The amount of Lot B, the methods of payment of which were governed in the initial contract by Article 2.29, has been changed to a fixed, non-revisable, total lump-sum of 9,657,562 (nine million six-hundred fifty seven thousand, five hundred sixty two) US Dollars and will be paid in pursuance of Article 2.10 of the initial contract. ARTICLE 2 - CONTRACT DOCUMENTS Documents No. 4 and 5 of the initial contract are cancelled and replaced with Document No. 5 and 6 of the present Amendment. The list below enumerates in order of importance the contract documents constituting the amendment: Document No. 1: The present amendment. Document No. 2: Documents No. 1 and 2 listed under Article 1.4 of the CCCP (Particular Clauses and Conditions) of the initial contract. Document No. 3: The CPTP (Technical Specifications) of the initial contract to the extent that they do not depart from the data sheets approved by the Architect. Document No. 4: Specifications for all elements of the new transmitting stations and overhauling of existing stations. Document No. 5: Breakdown of the new total lump-sum price of Lot A. Document No. 6: Breakdown of the new total lump-sum price of Lot B. Document No. 7: All plans of project buildings and sites. ARTICLE 3 - AMOUNT OF AMENDMENT TO CONTRACT The amount of Amendment No. 1 is 1,768,562 (one million, seven hundred sixty-eight thousand, five hundred sixty two) US Dollars, broken down as follows: - optional section of Lot A : $1,111,000 - optional section of Lot B : $ 657,562 ---------- TOTAL : $1,768,562 ARTICLE 4 - AMOUNT OF INITIAL CONTRACT AND ITS AMENDMENT NO. 1 The amount of the contract and its Amendment No. 1 comes out to 37,768,562 (thirty-seven million, seven hundred sixty-eight thousand, five hundred sixty two) US Dollars, broken down as follows: 1) Lot A : $28,111,000 2) Lot B : $ 9,657,562 ----------- TOTAL $37,768,562 1) The breakdown of the total lump-sum price of Lot A is contained in Document No. 5 attached to the present amendment. 2) The breakdown of the total lump-sum price of Lot B is contained in Document No. 6 attached to the present amendment, - New buildings : $5,212,891 - Renovations : $1,162,118 - COCODY electricity : $ 154,755 - Foundations : $1,074,325 - Studies and Management : $2,053,473 ---------- TOTAL : $9,657,562 ARTICLE 5 - TURN-AROUND TIME The turn-around time and penalties for lateness laid down in Article 2.6 of the contract remain unchanged. ARTICLE 6 - DEFINITIVE SECURITY Article 2.15 of the CCCP (Particular Clauses and Conditions) setting the amount of the definitive security at 3% of the amount of the contract increased by the amount of the amendments remains unchanged. The Contractor is requested to make up the security within twenty (20) days after the date of notification of the present amendment. ARTICLE 7 - ESCROW Article 2.16 of the CCCP (Particular Clauses and Conditions) setting the amount of escrow at 7% of the amount of the work remains unchanged. ARTICLE 8 - STAMP DUTIES AND REGISTRATION FEES The present Amendment is subject to stamp and registration formalities. The CONTRACTOR will be responsible for paying the stamp duties and registration fees to which the contract is subject. ARTICLE 9 - OTHER CLAUSES The clauses of the initial contract remain applicable in all points that do not depart from the prescriptions of the present Amendment. ARTICLE 10 - (LAST): APPROVAL OF AMENDMENT NO. 1 The present Amendment will be definitive only after notification is given of the competent AUTHORITY's approval thereof. Drawn up at Abidjan on January 1994 Read and approved (handwritten endorsement) THE CONTRACTOR THE MINISTER OF COMMUNICATION /s/Kenneth Hoch Approved under No. Initialed by the GENERAL THE DEPUTY MINISTER UNDER THE MANAGER OF IVORY COAST MINISTER OF ECONOMY, FINANCES, RADIO AND TELEVISION TRADE AND PLANNING BROADCASTING EXHIBIT 10(aa) UAL Contract No. 115990 LEASE AGREEMENT THIS LEASE made and entered into this 8th day of June, 1993, by and between COMSAT CORPORATION, through its COMSAT Mobile Communications business unit, a District of Columbia corporation, having its principal place of business at 22300 Comsat Drive, Clarksburg, MD 20871, (hereinafter referred to as "LESSOR"), GTE AIRFONE INCORPORATED, a Delaware corporation, having its principal place of business at 2809 Butterfield Road, Oak Brook, IL 60522 (hereinafter referred to as "Lessee's Contract Administrator") and UNITED AIR LINES INC., a Delaware corporation, having its principal place of business at 1200 East Algonquin Road, Elk Grove Township, IL 60007, (hereinafter referred to as "LESSEE"). WITNESSETH: WHEREAS, Lessor shall have available for lease 74 shipsets of satellite communications equipment (hereinafter referred to as "Equipment"); and WHEREAS, Lessor desires to lease the Equipment to Lessee under the terms and provisions set forth below; and WHEREAS, Lessee desires to lease the Equipment from Lessor under the terms and provisions set forth below; and WHEREAS, Lessee has appointed GTE Airfone to be Lessee's Contract Administrator of this Agreement; and WHEREAS, Lessee's Contract Administrator has been selected by Lessee to provide air-ground telecommunications service to Lessee's passengers aboard certain of Lessee's aircraft; and WHEREAS, Lessee's Contract Administrator has agreed to provide certain equipment for telephony services over its system and to assist in the procurement of the Equipment (as defined herein) for telephony services over the INMARSAT System. NOW THEREFORE, in consideration of the foregoing and the mutual promises and covenants contained herein, Lessor and Lessee hereby agree as follows: SECTION 1. EQUIPMENT PROCUREMENT. 1.01 The Lessor hereby leases to the Lessee and the Lessee hereby leases from the Lessor, the Equipment, together with all accessories attached thereto or used in connection therewith. (Equipment list is attached hereto as Exhibit A.) 1.02 The initial term ("Initial Term") of this Lease shall commence on the date the Equipment is first installed under the regular installation schedule on Lessee's aircraft (the "Effective Date") and shall continue for a period of nine (9) years thereafter, provided that in the event there is a deviation from the installation schedule such that more than 10% of the aircraft hereunder will remain unequipped beyond the first two years of the Initial Term (the "Later Installed Aircraft") then the parties shall agree on a mutually acceptable extension of the Initial Term with respect to the Later Installed Aircraft. 1.03 Lessor shall purchase the equipment listed on Exhibit B, at Lessee's cost set forth therein, from Lessee for inclusion in the shipsets of Equipment provided hereunder. SECTION 2. RENTAL. 2.01 Lessor shall provide up to seventy four (74) complete shipsets (as identified in Exhibit A) of Equipment at a maximum cost to Lessor of two hundred seventy thousand dollars ($270,000.00) per shipset. Procurement beyond 74 shipsets is an option if desired by Lessee. On an aircraft by aircraft basis upon installation of the Equipment, and upon receipt from Lessee of notice of Lessee's installation of the Equipment and identifying the Equipment to be installed on each aircraft, Lessor shall forward payment to the equipment supplier for that shipset of Equipment. SECTION 3. PAYMENT OF RENTAL. 3.01 Upon installation of the Equipment on each aircraft, Lessee's Contract Administrator shall program Lessor as highest priority choice in all ocean regions served by Lessor on the "Owner's Preference Table" for the Equipment on that equipped aircraft. 3.02 Upon installation of the Equipment on each aircraft, Lessee's Contract Administrator shall pay to Lessor, as rental for the Equipment, on behalf of Lessee, an amount equal to the previously agreed rental amount. Such rental shall be the sole liability of Lessee's Contract Administrator and shall at no time become a liability of Lessee. 3.03 All rental payments shall be due and payable on a quarterly basis in accordance with the terms of the carrier to carrier agreement between Lessee's Contract Administrator and Lessor. 3.04 It is agreed between the parties that the Lessor shall sell such Equipment to Lessee (at Lessee's option) at any time during the lease period, for a sum equal to the net book value (as defined in Exhibit C attached hereto) of such Equipment at the time of the exercise of this option. In the event Lessee exercises this option prior to the end of the lease term, Lessee shall be responsible for any early pay-back penalty required by Lessor's financing arrangement. It is further stipulated that Lessee must, to exercise this option, inform Lessor, in writing, of its intent to purchase the Equipment ninety (90) days prior to the date Lessee wishes to exercise the option. 3.05 If Lessee's Contract Administrator does not make the quarterly rental payments when due, Lessor may charge Lessee's Contract Administrator an additional sum of EIGHTEEN (18%) PERCENT per annum or the maximum amount allowed by law, whichever is less, for each and every late rental payment. Such interest shall be the liability of Lessee's Contract Administrator and shall at no time become a liability of Lessee. SECTION 4. INSTALLATION, MAINTENANCE & REPAIR. 4.01 Lessee shall be responsible for performing all installations of the Equipment on Lessee's aircraft and for all expenses associated therewith. 4.02 As between Lessor and Lessee, Lessee accepts the Equipment in its delivered condition and, during the term of this Lease and until return and delivery of the Equipment to Lessor or until purchase of Equipment by Lessee pursuant to Section 3.04 above, Lessee shall maintain and keep the Equipment on each aircraft in good repair and operating order and shall repair, at its own expense, any damage to the Equipment. Lessee shall maintain a sufficient number of spare parts to properly maintain the Equipment. SECTION 5. EXPENSES. 5.01 Lessee shall bear all operating and maintenance costs including, but not limited to: Equipment maintenance, replacement and repair, and insurance premiums for all insurance coverage required by this Lease. Lessee further agrees to keep the Equipment in (a) fully operational, duly certified and airworthy condition at all times; and (b) mechanical condition adequate to comply with all regulations of the FCC, FAA, INMARSAT, and any other Federal, state or local governing body, domestic or foreign, having jurisdiction over the maintenance, use or operation of the Equipment. All replacement parts supplied by Lessee shall be of the same quality as the replaced part and type approved by the manufacturer. Lessee shall also cause the Equipment to be regularly inspected by qualified experts of its choice and to immediately correct, repair of replace any dangerous condition, malfunction or worn part which may be discovered at any time. Lessor shall bear the costs of modifications or upgrades mandated by airworthiness directives and mandatory operational modifications. SECTION 6. LAWFUL USE. 6.01 Lessee shall during the term of this Lease and until return and delivery of the Equipment to Lessor, abide by and conform to, and cause others to abide by and conform to all laws, governmental orders, and rules and regulations, including future amendments thereto pertaining to or affecting operations or use of said Equipment. Further, the Equipment will not be maintained, used or operated in violation of any law or any rule, regulation or order of any government or governmental authority having jurisdiction (domestic or foreign), or in violation of any airworthiness certificate, license or registration relating to the Equipment or its use, or in violation or breach of any representation or warranty made with respect to obtaining insurance on the Equipment or any term or condition of such insurance policy. SECTION 7. MISCELLANEOUS PROVISIONS. 7.01 Alterations. Excepting modifications required under manufacturer's service bulletins, Lessee shall not in any way alter, modify, remove or make additions or improvements to the Equipment without the prior written consent of Lessor. All alterations, modifications, additions and improvements which are made shall become the sole and exclusive property of Lessor and shall be subject to all terms of this Lease. 7.02 Liens. The Lessee shall not directly or indirectly create, incur, assume or suffer to exist any liens on or with respect to (a) the Equipment or any part thereof, (b) the Lessor's title thereto or, (c) any interest of the Lessor therein. The Lessee shall promptly, at its own expense, take such action as may be necessary to duly discharge any such lien, except (a) the respective rights of the Lessor and the Lessee as herein provided, and (b) liens created by the Lessor. 7.03 Inspection. Lessor or its designee shall have the right, but not the duty, to inspect the Equipment at any reasonable time and upon reasonable notice, wherever the aircraft on which the Equipment is installed may then be located. Upon Lessor's request, Lessee shall advise Lessor of the aircraft's location and, within a reasonable time, shall furnish Lessor with all information, documents and Lessee's records regarding or in respect to the Equipment and its use, maintenance or condition. SECTION 8. TITLE TO EQUIPMENT. 8.01 (a) Lessor shall at all times retain the sole and exclusive right, title and possessory interest in and to any and all Equipment installed on any of the aircraft or otherwise in Lessee's possession. Notwithstanding the foregoing, Lessor shall transfer to Lessee, upon payment therefore in accordance with Section 3.04 above, the sole and exclusive right, title and possessory interest in and to the Equipment and all items that are permanently affixed to any aircraft as a result of any alteration, modification, addition or improvement, as provided for in Section 7.01 above. (b) Upon any termination of this Lease or disposition of an aircraft on which any Equipment is installed prior to expiration of the term hereof, Lessee shall provide written notice to Lessor of any disposition of an equipped aircraft, as soon as reasonably possible. Lessor shall, within thirty (30) days thereof, notify Lessee and Lessee's Contract Administrator in writing of its desire to remove such Equipment from the aircraft to which such termination of disposition relates and Lessor and Lessee shall cooperate in good faith in the removal of such Equipment. (c) Upon receipt by Lessee or Lessee's Contract Administrator of the notice provided for in Subsection 8.01 (b), Lessee shall, during a period commencing upon the date of receipt of the notice and ending one hundred and twenty (120) days thereafter, provide Lessor with a reasonably sufficient amount of continuous, uninterrupted access to the relevant aircraft on which such Equipment is installed, to permit Lessor to remove any or all of the Equipment aboard such aircraft. Such access will be at such times and locations as Lessor and Lessee shall mutually agree upon in writing. If Lessor and Lessee agree upon a schedule for removal of the Equipment and Lessor fails to remove the Equipment from such aircraft and such failure is not caused, directly or indirectly, by Lessor and Lessor and Lessee cannot in good faith agree upon a new schedule within the one hundred and twenty (120) day period referred to above, Lessor shall forfeit its right to remove any Equipment from the relevant aircraft. Notwithstanding the foregoing, nothing herein shall be construed or interpreted as a waiver or forfeiture by Lessor of any rights to, or interest in, any trade secrets, patents, intellectual property, Confidential Information, or other intangible right or interest represented by or embodied in any Equipment. Lessor and Lessee shall each bear their respective costs and expenses of removal of any Equipment, unless such removal is due to an Event of Default, as specified in Section 13, in which case the Lessee shall be solely responsible for the reasonable costs and expenses of both parties related to such removal. 8.02 Lessee shall have the obligation to ensure that any leasing agreements between Lessee and any third party, which are applicable to any of the aircraft upon which the shipsets of Equipment will be installed, are modified to reflect that the sole and exclusive right, title and possessory interests in and to such Equipment on any aircraft by aircraft basis remains with Lessor until such time as termination of this Lease or purchase of the Equipment by the Lessee. Lessor shall have the further right to review pertinent parts of amendments to all such leasing agreements between Lessee and any third party prior to installation of Equipment on such aircraft. 8.03 Neither Lessee nor others shall have the right to incur any mechanic's or other lien in connection with the repair or maintenance of said Equipment and Lessee agrees that neither it nor others will attempt to convey or mortgage or create any lien of any kind or character against the Equipment or do anything to take any action that might mature into such a lien. SECTION 9. RISK OF LOSS AND INSURANCE. 9.01 Lessee shall provide and maintain insurance on the Equipment in such company or companies as Lessor shall approve, with Lessor being named as an additional insured, (a) against loss or damage from any cause or causes to the Equipment in the amount of the replacement cost of the Equipment, and (b) against liability for personal injuries, death or property damages, or any of them, under Lessee's presently existing standard policy. 9.02 In the event a claim is made with regard to an insured event, Lessee agrees to pay Lessor any deductible amounts as provided in such policies. Such insurance shall not be subject to any offset by any other insurance carried by the Lessor or the Lessee. 9.03 In the event of loss or of damage to the Equipment, Lessee shall immediately report such loss or damage to Lessor, to the insurance companies underwriting such risk and to all applicable governmental agencies, Federal and state, and Lessee shall furnish such information and execute such documents as may be required to collect the proceeds from the insurance policies. The rights, liabilities and obligations of the parties regarding such proceeds shall be as set forth in Subsection 9.04 below. 9.04 In the event that, in the opinion of the Lessor, the Equipment is lost, stolen, damaged beyond repair, confiscated, seized or its use appropriated by any government or instrumentality thereof, the proceeds of the insurance policy or policies shall be payable to Lessor. In the event Lessor does not receive insurance proceeds in an amount equal to the replacement cost within one hundred twenty (120) days from the date of the event of loss or damage, Lessee shall promptly pay Lessor the full amount of the replacement cost, and provided that (a) no Event of Default shall have occurred hereunder, and (b) Lessee shall not have breached any of its representations, warranties or agreements under such insurance policy or policies, Lessee shall be subrogated to the rights of Lessor to the extent, but only to the extent, of such payment. For purposes of this Subsection 9.04 only, Lessee's Contract Administrator will not be required to make rental payments for the period the Equipment is not available. Lessor will allow Lessee to cancel the Agreement in this eventuality as to the affected Equipment or, at the option of the Lessor, Lessee will be provided with another shipset of Equipment within a reasonable time thereafter. 9.05 In the event the Equipment is partially damaged, in the opinion of the Lessor, then this Lease shall remain in full force and effect and Lessor shall use the insurance proceeds to repair the Equipment. Lessor shall direct and must approve all repairs made to the Equipment. 9.06 Lessee hereby appoints Lessor as Lessee's attorney-in-fact to make proof of loss and claim for and to receive payment of and to execute or endorse all documents, checks or drafts in connection with all policies of insurance in respect of the Equipment. SECTION 10. LESSOR'S WARRANTIES. 10.01 Lessor warrants that it has the right to lease the Equipment to Lessee, and that Lessor will do nothing to disturb Lessee's full right of possession and enjoyment thereof and the exercise of all the Lessee's rights with respect thereto as provided by this Agreement. HOWEVER, LESSOR MAKES NO WARRANTIES OR REPRESENTATIONS, EXPRESS OR IMPLIED, AS TO ANY MATTER WHATSOEVER, INCLUDING, WITHOUT LIMITATION, THE CONDITION OF THE EQUIPMENT, ITS MERCHANTABILITY OR ITS FITNESS FOR ANY PARTICULAR PURPOSE. LESSOR SHALL PASS THROUGH TO LESSEE ANY AND ALL WARRANTIES LESSOR RECEIVES FROM THE EQUIPMENT MANUFACTURER. SECTION 11. ASSIGNMENT AND SUBLEASE. 11.01 The Lessee may not sublet the Equipment nor shall Lessee assign this Agreement without the prior written consent of Lessor. Once installed in an aircraft, the Equipment may only be transferred to other aircraft providing the same service within Lessee's fleet unless otherwise agreed to in writing by Lessor. Such limitation shall not prevent Lessee from replacing equipment for maintenance. SECTION 12. INDEMNITY. 12.01 Lessee shall be responsible and liable for, indemnify Lessor against, hold Lessor free and harmless from any claim or claims of any kind whatsoever for or from, and promptly pay any judgment for, any and all liability for personal injuries, death or property damages, or any of them, which arise or in any manner are occasioned by the intentional acts or negligence of the Lessee or others in the custody, operation or use of said Equipment during the term of this Lease. SECTION 13. LESSEE'S DEFAULT. 13.01 The following events shall constitute "Events of Default" on the part of the Lessee hereunder: (a) Any breach or failure of the Lessee to observe or perform any of the obligations specifically required of Lessee hereunder and the failure to correct such default within thirty (30) days after written notice hereof by Lessor to Lessee, or Lessee's Contract Administrator; or (b) If any writ or order of attachment or execution or other legal process is levied on or charged against said Equipment and is not vacated or satisfied within thirty (30) days; or (c) The making of an assignment by Lessee for the benefit of its creditors or the admission of Lessee, in writing, of its inability to pay its debts as they become due; or (d) The insolvency of Lessee or the filing by or against Lessee of a petition in bankruptcy; or (e) The adjudication of lessee as bankrupt; or (f) The filing by Lessee of any petition seeking for itself a reorganization, arrangement, composition, readjustment of its debts, liquidation, dissolution or similar relief under any law relating to the relief of debtors or insolvents. SECTION 14. LESSOR'S REMEDIES. 14.01 Upon the happening of any Event of Default hereunder, Lessor may, at its sole election, declare a default under the Lease and take possession of said Equipment wherever located, with court order or other process of Law, Lessee hereby consenting to entry upon its premises for such purpose and waiving all damages related to the AES equipment caused by such taking of possession and agreeing that such taking does not constitute termination of this Lease as to any other Equipment unless Lessor expressly notifies Lessee thereof in writing. The above waiver of damages shall not include a waiver of Lessee's rights in the event Lessor damages the aircraft on which the Equipment is located while taking possession of the Equipment. SECTION 15. WAIVER. 15.01 No covenant or condition of this Lease can be waived except by the written consent of Lessor. Forbearance or indulgence by Lessor in any regard whatsoever shall not constitute a waiver of the covenant or condition to be performed by Lessee to which the same may apply, and, until complete performance by Lessee of such covenant or condition, Lessor shall be entitled to invoke any remedy available to Lessor under this Lease despite such forbearance or indulgence. Upon Lessee's failure to perform any of its duties hereunder, Lessor may, but shall not be obligated to, perform any or all such duties, and Lessee shall pay an amount equal to the expense thereof to Lessor forthwith upon demand by Lessor. SECTION 16. ADDITIONAL DOCUMENTS. 16.01 If Lessor shall so request, Lessee shall execute and deliver to Lessor such documents as Lessor shall deem necessary or desirable for purposes of recording or filing to protect the interest of Lessor in the said Equipment. SECTION 17. AMENDMENTS. 17.01 This Lease shall not be amended, altered or changed except by a written agreement signed by both Lessor and Lessee. SECTION 18. TIME OF THE ESSENCE. 18.01 Time is of the essence in this Lease. SECTION 19. ENTIRE AGREEMENT. 19.01 The terms and conditions of this Lease constitute the entire agreement between the parties and supersedes all prior written and oral negotiations, representations and agreements, if any, between the parties and upon execution hereof, this Lease shall be binding upon them, their successors, assigns and legal representatives. SECTION 20. NOTICES. 20.01 Any notices required to be given under this Agreement shall be sufficient if in writing and given personally or mailed, by registered or certified mail, return receipt requested, directed to the attention of the party involved at its respective address set forth below, or at such address as such party may provide in writing from time to time: LESSOR: COMSAT Corporation COMSAT Mobile Communications 22300 COMSAT Drive Clarksburg, MD 20871 ATTN: Vice President - Human Resources, Contracts and Administration LESSEE'S AGENT: GTE Airfone Incorporated 3809 Butterfield Road Oak Brook, IL 60522 ATTN: Vice President - Marketing LESSEE: United Air Lines Inc. Maintenance Operations Center San Francisco International Airport San Francisco, CA 94128 Attn: Designated Contract Representative: Director of Maintenance Purchasing Designated Marketing Representative: Manager-System Aircraft Maintenance & Control OR: United Air Lines Inc. P.O. Box 66100 Chicago, IL 60666 Attn: Designated Marketing Representative: Staff Executive - Aircraft Interiors SECTION 21. APPLICABLE LAW. 21.01 This Lease is made, executed and delivered in the State of Illinois and shall be governed and construed for all purposes under and in accordance with the laws of the State of Illinois, without giving effect to conflict of laws principles which might refer such interpretation to the laws of a different State of jurisdiction. SECTION 22. SEVERABILITY. 22.01 In the event that any one or more of the provisions of this Lease shall for any reason be held invalid, illegal or unenforceable, the remaining provisions of this Lease shall be unimpared. SECTION 23. RETURN OF EQUIPMENT. 23.01 At the termination of this Lease, whether by expiration of time or for any other cause, in the event that the option contained in Section 3.04 is not exercised by the Lessee, the Equipment shall be delivered by Lessee to Lessor at Lessor's address in Section 20.01, or to such other address as Lessee is authorized to deliver the Equipment by an officer of Lessor. 23.02 Lessee will return the Equipment to Lessor in the same condition as received, normal wear and tear excepted, and upon return any Lessee corporate identification or logo in or on the Equipment shall be removed by Lessee. In the event Lessee does not return the Equipment in such condition, Lessor may make any repairs necessary to restore the Equipment to such condition, and Lessee agrees, upon demand, to reimburse Lessor for any expense related to such restoration. SECTION 24. SUCCESSION. 24.01 This Lease shall be binding upon Lessee, its successors, assigns and/or any other entity which may succeed to the assets, operations or consolidation by merger of such parties, sale or the transfer of substantially all the assets of Lessee for any reason whatsoever. IN WITNESS WHEREOF, the duty authorized representatives of the parties hereto have executed this Agreement effective as of the date first above written. GTE AIRFONE INCORPORATED COMSAT CORPORATION BY: COMSAT Mobile Communications /s/Horace A. Lindsay /s/Arthur E. Gelven BY:______________________ BY:______________________ President Vice President, Human Resources, Contracts and Administration TITLE:___________________ TITLE:____________________ Horace A. Lindsay Arthur E. Gelven PRINTED NAME:____________ PRINTED NAME:_____________ /s/Brenda A. McNabb June 3, 1993 BY:______________________ DATE:_____________________ Assistant Secretary TITLE:___________________ Brenda A. McNabb PRINTED NAME:____________ 6/8/93 DATE:____________________ UNITED AIR LINES, INC. /s/C. E. Doyle BY:______________________ Director, Maintenance Purchasing TITLE:___________________ C. E. Doyle PRINTED NAME:____________ 6/4/93 DATE:____________________ EXHIBIT C For the purposes of Section 3.04 of this Lease Agreement, "Net Book Value" is defined as: cost less accumulated depreciation, depreciated over an eight (8) year period. EXHIBIT 10(bb) TELEX SERVICES AGREEMENT This Agreement No. CMC-SA-93/167 is hereby entered into this first day of July, 1993, by and between COMSAT Mobile Communications of COMSAT Corporation, a corporation organized and existing under the laws of the District of Columbia and having its principal office located at 22300 COMSAT Drive, Clarksburg, MD 20871 ("COMSAT"), and American Telephone and Telegraph company, a corporation of the State of New York, doing business as AT&T Easylink Services, with a place of business at 400 Interpace Parkway, Parsippany, New Jersey 07054 ("AT&T"). WITNESSETH WHEREAS, COMSAT offers mobile satellite communications services to and from mobile stations via the Inmarsat satellite system and COMSAT's land earth stations and switching facilities; and WHEREAS, AT&T provides, among other thinks, telex communication services worldwide; and WHEREAS, COMSAT and AT&T desire jointly to interconnect their facilities to as to permit the exchange of telex traffic between mobile earth stations and land points within the United States and international points served by AT&T; NOW, THEREFORE, in consideration of the foregoing and the covenants hereinafter set forth, COMSAT and AT&T agree as follows: 1. Interconnection of Facilities A. COMSAT and AT&T agree to interconnect their telex facilities to permit users of AT&T telex searches to send and receive messages via the Inmarsat system provided by COMSAT, including any traffic from AT&T which originates from any domestic connecting carrier's subscribers in the United States and is routed via AT&T's facilities for delivery to a mobile earth station. B. In connection with traffic originating from an international point that transits the U.S. and is destined for a mobile earth station, AT&T and COMSAT shall jointly make appropriate interconnection arrangements with foreign administrations to implement and facilitate the use of COMSAT's services as provided for herein. C. For traffic originating at mobile earth stations, COMSAT shall honor routing designated by the originating caller, except that COMSAT shall transmit to any interconnecting carrier all traffic from mobile earth stations destined to subscribers of that carrier's network. For international calls whose routing has not been designated by the originating caller ("undesignated traffic"), AT&T shall receive from COMSAT a minimum of twenty (20) percent of such undesignated traffic per month, such percentage reflecting the fact that, as of the date of execution of this Agreement by both Parties, AT&T is one of five carriers interconnecting with COMSAT for such traffic. Should the number of interconnected carriers change, AT&T shall receive from COMSAT a minimum of such undesignated traffic equivalent to AT&T's representative share of the total number of carriers interconnected with COMSAT. Should the Federal Communications Commission ("FCC") subsequently approve the implementation of a proportionate return mechanism for the allocation of undesignated traffic, COMSAT shall deliver such traffic to AT&T in accordance with a mutually agreed upon proportionate return formula. D. AT&T shall maintain COMSAT as its preferred choice for all fixed-to-mobile traffic. E. AT&T shall deliver domestic originating telex traffic destined for termination through the Inmarsat system to United States land earth stations, as required by FCC regulatory policy. F. Each Party shall be responsible for providing and maintaining, at its own expense, the equipment and circuits located on its side of the point of interconnection. The Parties shall cooperate in the detection and correction of problems which may not be capable of being immediately isolated to a specified segment of a circuit. G. AT&T shall provide prompt assistance, as needed, to customers using or attempting to use the COMSAT mobile satellite communications services on a priority not less than that which they accord their other service activities and their customers for those services. H. Each Party shall be responsible for (a) the transmission to the other Party of signals in accordance with CCITT Recommendations, and (b) for the transmission of signals received from the other Party over its facilities and to any interconnecting carrier, foreign administration or subscriber, as appropriate. 2. Charges A. For the services provided by AT&T hereunder, COMSAT agrees to pay those charges set forth in Article 3 B.(i) below. B. For those services provided by COMSAT hereunder, AT&T agrees to pay those charges set forth in Article 3 B.(ii) below. C. Telex rates to customers of COMSAT or AT&T are the sole responsibility of the billing carrier. Any tariff changes affecting services provided in conjunction with this Agreement shall be provided by the Party making the changes to the other Party prior to the filing of such changes with the FCC. 3. Accounting and Settlement A. The Parties shall exchange accounting statements on a monthly basis within thirty (30) days after the end of the traffic month. Settlement of net balances shall be made on a quarterly basis within thirty (30) days following the end of the traffic quarter. No allowance shall be made in the accounts for uncollectible amounts. Settlement of net balances for overseas originated traffic will be on a quarterly basis within thirty (30) day following the end of the traffic quarter. B. The procedures for settlement between AT&T and COMSAT for traffic terminating or originating at mobile earth stations shall be as follows: i. For mobile-to-fixed telex traffic billable by COMSAT to mobile subscribers, COMSAT shall credit to AT&T the amounts due at AT&T's normal terminating interconnect rates less twenty percent (20%). ii. For fixed-to-mobile telex traffic chargeable at U.S. land points, AT&T shall credit to COMSAT the amounts due at COMSAT's terminating interconnect rate of $3.50 per minute. iii. For telex traffic chargeable at overseas land points, AT&T will arrange for connecting overseas correspondents to collect the applicable charges for the combined services and to credit AT&T with AT&T's share of the applicable international charges plus an amount equal to COMSAT's share of the interconnect rate, which latter amount AT&T shall credit to COMSAT. AT&T shall use reasonable efforts to identify such mobile satellite communications traffic by ocean region and traffic month in the accounting statements exchanged. 5. Term This Agreement shall become effective as of the date set forth above and shall continue in full force and effect until terminated by either Party by not less than six months notice in writing to the other Party, or is replaced by a superseding Agreement between the Parties. 6. Publicity During the term of this Agreement, COMSAT and AT&T will entertain proposals by each to the other for joint advertising of the services provided under this Agreement under terms and conditions mutually acceptable to both Parties. 7. Liability Neither Party nor its parent corporation, subsidiaries, affiliates, or suppliers, or any of its parent corporation's subsidiaries or affiliates shall be liable to the other for incidental, special, indirect or consequential damages or loss of revenues or profits resulting from failure to provide telecommunications services or facilities as called for hereunder, or for any loss of damage sustained by reason of any failure in or breakdown of the communications facilities or interruption of the same associated with functioning of the services covered by this Agreement no matter what the cause. 8. Assignment Neither Party may assign this Agreement without the prior written consent of the other Party, except to its parent, an affiliate or subsidiary in connection with the transfer of responsibility for the service provided under this Agreement. 9. Trademarks Nothing in this Agreement shall create in either Party any rights in the trademarks, tradenames, insignia, symbols, identification and logotypes used by the other Party. Before either Party uses any such marks of the other Party, it shall obtain the prior, written consent of the other Party. 10. Confidentiality Except as required by governmental agency, neither Party shall disclose customer and billing information or its participation in this undertaking or any terms and condition of this Agreement or any other agreement between the Parties without the prior written consent of the other Party. 11. Notices Any notices required or permitted to be given pursuant to this Agreement shall be considered properly given when sent via registered courier, telex, or fax to the following addresses, respectively, or to such other addresses as the Party concerned may hereafter designate in writing. To COMSAT: COMSAT Mobile Communications 22300 COMSAT Drive Clarksburg, MD 20024 Attention: Director, Contracts To AT&T: AT&T EasyLink Services 400 Interpace Parkway Parsippany, New Jersey 07054 Attention: Robert Jones Vice President & General manager AT&T Easylink Telex SBU 12. Governing Law This Agreement shall be governed by and construed according to the law of Maryland, United States of America. 13. Severability If any term or provision of this Agreement shall be found to be illegal or unenforceable, then such term or provision shall be deemed stricken, and the remainder of this Agreement shall continue in full force and effect. 14. Waiver No term or provision hereof shall be deemed waived by either Party unless such waiver shall be in writing and signed by that Party. 15. Amendment Any amendment to this Agreement shall be in writing and shall be executed by authorized representatives of the Parties hereto. 16. Entire Agreement This Agreement and the Attachments hereto constitute the complete and entire understanding of the Parties with respect to the subject matter hereof, superseding all prior oral and written negotiations, representations and agreement. IN WITNESS WHEREOF, the Parties hereto have caused this Agreement to be executed as of the day and year first shown above. AT&T Easylink Services Communications Satellite Corporation COMSAT Mobile Communications /s/Robert F. Jones /s/Arthur E. Gelven By:____________________ By:____________________ Robert F. Jones Arthur E. Gelven Name:__________________ Name:__________________ V.P. & Gen. Mgr. Vice President, Human Resources, Contracts and Administration Title:_________________ Title:_________________ 7-28-93 August 3, 1993 Date:__________________ Date:__________________ EXHIBIT 10(cc) A G R E E M E N T This Agreement is made by and between American Telephone and Telegraph Company ("AT&T"), a United States International Service Carrier ("USISC"), and COMSAT Corporation ("COMSAT"), the U.S. Signatory to the International Telecommunications Satellite Organization ("INTELSAT") (hereinafter jointly referred to as the "Parties"). WHEREAS, AT&T is engaged in the provision of international telecommunications services via satellite; and WHEREAS, COMSAT offers INTELSAT space segment capacity to USISCs for international telecommunications services; and WHEREAS, COMSAT and AT&T entered into an inter-carrier contract on October 8, 1987, specifying the rates, terms and conditions relating to AT&T's long-term commitment for utilization of COMSAT's INTELSAT space segment capacity for IMTS circuits ("1987 Agreement"); and WHEREAS, the 1987 Agreement was filed with the Federal Communications Commission ("FCC") pursuant to Section 211 of the Communications Act and as part of CC Docket 87-67; and WHEREAS, the 1987 Agreement was accepted by the FCC in all material respects as consistent with the public interest, and was relied upon by the FCC as a basis for withdrawing all loading guidelines applicable to AT&T's IMTS circuits; and WHEREAS, the 1987 Agreement was amended on May 16, 1988, and that amendment was also filed with and accepted by the FCC; and WHEREAS, the Parties continue to believe, as stated in the 1987 Agreement, that marketplace forces rather than regulatory determinations can and should govern the relationship between them; and WHEREAS, the Parties have decided to replace the 1987 Agreement, as amended, with a new inter-carrier contract based upon AT&T's current and future utilization of COMSAT's INTELSAT space segment capacity for telecommunications services, and have decided to maintain certain prior commitments arising from the 1987 Agreement, as amended, as specified herein; NOW, THEREFORE, in consideration of and in reliance upon the mutual promises set forth below, AT&T and COMSAT hereby agree as follows: ARTICLE I PURPOSE AND INTENT The purpose of this Agreement is to implement the Parties' mutual understanding with respect to AT&T's current and future utilization of COMSAT's INTELSAT space segment capacity for telecommunications services. It is the intent of COMSAT and AT&T that this Agreement comply with all laws and international obligations of the United States. Consistent with that intent, nothing herein shall preclude COMSAT from reaching similar agreements for circuits with other USISCs, and nothing herein shall preclude AT&T from placing traffic not covered by this Agreement on whatever telecommunications facilities it should select. ARTICLE II DEFINITIONS The terms used in this Agreement are defined as follows: 1. Additional Circuits. Digital Bearer Circuits activated by AT&T on the INTELSAT system via COMSAT on or after January 1, 1992 for 10-year lease terms, including, but not limited to, circuits other than Base Circuits that AT&T committed to take pursuant to the 1987 Agreement, as amended. 2. Base Circuits. The 5,716 Digital Bearer Circuits activated by AT&T on the INTELSAT system via COMSAT prior to January 1, 1992, each of which circuits AT&T committed to take for 10-year lease terms pursuant to the 1987 Agreement, as amended. 3. Bulk Offering. The offering by COMSAT to AT&T of three 36 MHz allotments pursuant to the rates, terms and conditions specified in this Agreement. 4. Date of Activation. The month, day and year on which a particular FM Circuit or Digital Bearer Circuit is placed in service. 5. Derived Circuits. Circuits created from Digital Bearer Circuits by means of Digital Circuit Multiplication Equipment (DCME). 6. Digital Bearer Circuits. 64 Kbps equivalent circuits used to carry public-switched traffic (including IDR and TDMA circuits, but excluding private line circuits); these circuits may or may not be aggregated into larger digital carriers, e.g., 2.048 Mbps. 7. Efficiency Factor. The maximum number of Derived Circuits that may be provided through a Digital Bearer Circuit. 8. FM Circuits. 4 Khz analog circuits associated with analog carriers using Frequency Division Multiple Access and Frequency Modulation. 9. Growth Traffic. Voice-Grade Circuits above and beyond those existing at a given point in time. 10. IDR Circuits. 64 Kbps equivalent international digital route circuits associated with digital carriers using Quadrature Phase Shift Keying (QPSK) modulation. 11. IMTS (International Message Telecommunications Service). International switched-voice service, as defined by the FCC to include AT&T's 800 service-overseas, but excluding dedicated private line service. 12. Large Standard A Earth Station. An earth station having a gain-to-noise temperature ratio ("G/T") at least equal to 40.7 dB/K (in the U.S.) and at least equal to 39 dB/K (at the foreign end). 13. Revised Standard A Earth Station. An earth station having a gain-to-noise temperature ratio ("G/T") at least equal to 35 dB/K. 14. Satellite Circuits. Voice-Grade Circuits provided by COMSAT to AT&T and carried on the INTELSAT system. 15. TDMA/DNI Circuits. 64 Kbps equivalent digital circuits providing Time Division Multiple Access service using digital non-interpolation equipment providing a clear 64 Kbps channel. 16. TDMA/DSI Circuits. 64 Kbps equivalent digital circuits providing Time Division Multiple Access service using digital speech interpolation equipment with encoding at both ends. 17. Voice-Grade Circuits. IMTS circuits on any long- haul transmission medium consisting of FM Circuits, Digital Bearer Circuits not using DCME, and Derived Circuits. ARTICLE III PREVIOUSLY-COMMITTED CIRCUITS A. The Parties agree that certain obligations under the 1987 Agreement, as amended, shall be incorporated into this Agreement and shall continue to apply. The Parties agree that the provisions of Articles VI-A and VI-B of the 1987 Agreement, as amended (which Articles placed limits on the percentage of digital circuits relative to total IMTS traffic that could be activated by AT&T) shall not be among those that continue to apply, and COMSAT hereby waives any claim it might have based on such limits having been previously exceeded. The obligations under the 1987 Agreement, as amended, that shall continue to apply are set forth in Paragraphs B through J of this Article. B. In addition to the Growth Traffic that AT&T has already placed on the INTELSAT system via COMSAT pursuant to the 1987 Agreement, as amended, AT&T shall place on the INTELSAT system via COMSAT at least 30% of its Voice-Grade Circuits from Growth Traffic during each of the following time periods: July 1, 1993 through June 30, 1994, and July 1, 1994 through June 30, 1995. AT&T shall activate Satellite Circuits during each of these time periods in such a way as to achieve an even growth of such circuits throughout the time period, or its mathematical equivalent in terms of satellite circuit months. C. Except as provided in Paragraph D of this Article, at no time during the period from the effective date of this Agreement through June 30, 1995 shall AT&T reduce the total number of Voice-Grade Circuits obtained from COMSAT below the levels required by Paragraph B of this Article. However, subject to Paragraph H of this Article, AT&T shall have the flexibility to redistribute its circuits geographically among the regions of the world in order to meet its operational needs without cancellation penalty. D. In the event of a net decrease in AT&T's total requirements for Voice-Grade Circuits during either the period from July 1, 1993 through June 30, 1994 or the period from July 1, 1994 through June 30, 1995, and only to the extent of that net decrease, AT&T may remove cable and Satellite Circuits from service in direct proportion to the percentage which cable and Satellite Circuits represent of the total number of AT&T circuits in service at the time, subject to the following conditions: (i) AT&T shall first promptly notify COMSAT of its intent to remove circuits from service and provide COMSAT with appropriate verification of the net decreases in AT&T's total requirements for Voice-Grade Circuits; (ii) AT&T shall remove cable and Satellite Circuits from service in an even manner throughout the year so as to assure that deactivations are equitably distributed between the two media; (iii) AT&T shall only remove Satellite Circuits from service in sequence, beginning with the earliest activated AT&T Satellite Circuits and proceeding on a "first in, first out basis"; (iv) Satellite Circuits removed from service shall be subject to the cancellation penalties set forth in Article IV-C of this Agreement; and (v) once AT&T again begins to have Growth Traffic for any July through June period, such growth shall be activated by means of cable and Satellite Circuits in the same manner in which the circuits were removed from service until such time as the number of Satellite Circuits is equal to the levels achieved before AT&T experienced the net decrease referred to above. At such time, the provisions of Paragraph B of this Article shall reapply. E. The Efficiency Factors used by AT&T to determine the maximum number of Derived Circuits that can be provided through Digital Bearer Circuits shall not exceed the following: (i) from July 1, 1993 through June 30, 1994, 4.28:1; and (ii) from July 1, 1994 through June 30, 1995, 4.29:1. Examples of the applications of Paragraphs B and E of this Article are provided in Paragraph I below. F. Should AT&T elect to activate more Voice-Grade Circuits on the INTELSAT system than are required under Paragraph B of this Article for the time period from July 1, 1993 through June 30, 1994 (by, for example, placing 35% of Growth Traffic on COMSAT's INTELSAT space segment during that time period rather than the 30% required by Paragraph B), such circuits may be in any combination of FM and Digital Bearer Circuits necessary to meet AT&T's operational needs and will not be subject to Paragraph E of this Article for that time period. AT&T will identify such circuits in the semi-annual report referred to in Paragraph G of this Article. If such circuits are short-term (e.g., monthly), they may be canceled at any time without penalty, but may not be credited against the number of Voice- Grade Circuits that would be required under Paragraph B of this Article to be placed on the INTELSAT system via COMSAT during the succeeding time period from July 1, 1994 through June 30, 1995. If such circuits are multi-year circuits, they may either (1) be canceled at any time subject to the cancellation penalties set forth in Article IV-C of this Agreement, or (2) be credited against the number of Voice-Grade Circuits that would be required under Paragraph B of this Article to be placed on the INTELSAT system via COMSAT during the succeeding time period from July 1, 1994 through June 30, 1995, provided that such circuits when activated shall be subject to Paragraph E of this Article, and shall otherwise be treated in the same manner as regular Satellite Circuits under Paragraphs B and H of this Article. G. AT&T shall provide COMSAT through June 30, 1995 with semi-annual reports, certified by an appropriate representative of AT&T, showing (on a regional basis, and in the same form as it has since implementation of the 1987 Agreement, as amended) the total number of Voice-Grade Circuits on cable, satellite and any other media, and their further apportionment into FM, Digital Bearer Circuits not using DCME and Derived Circuits. H. All IDR and TDMA/DNI Bearer Circuits activated by AT&T in fulfillment of the requirements of Paragraph B of this Article shall be subject to a 10-year lease commitment. The 10-year lease term for IDR and TDMA/DNI Bearer Circuits shall run from the Date of Activation of such circuit, and that term shall apply in full both to new IDR and TDMA/DNI Bearer Circuits and to IDR and TDMA/DNI Bearer Circuits converted from FM Circuits. However, the geographical substitution of one circuit for another in order to accommodate AT&T's operational needs shall not trigger the start of a new lease term or cancellation penalty. I. Consistent with and subject to the foregoing Paragraphs, following is an explanation summarizing the methodology to be used in determining the number of Satellite Circuits to be maintained by AT&T during each of the time periods July 1, 1993 through June 30, 1994 and July 1, 1994 through June 30, 1995: 1. The starting point for the calculations will be the total AT&T Voice-Grade Circuits on all facilities as of June 30, 1993 (assuming that, as of that date, AT&T has met its commitment under the 1987 Agreement, as amended, to place at least 30% of its Voice Grade Circuits from Growth Traffic on the INTELSAT system via COMSAT during the period from July 1, 1992 through June 30, 1993; if it has not, AT&T will add enough Satellite Circuits to meet that commitment and such added circuits will be included in the calculation of the starting point, but this will not delay this Agreement from going into effect and will not affect the expiration date specified in Paragraph J below). 2. The total Growth Traffic in AT&T's IMTS circuits during the period from July 1, 1993 through June 30, 1994 will be multiplied by 30% to determine the portion of such growth that will be placed on the INTELSAT system via COMSAT. 3. The satellite Growth Traffic obtained in 2 above (i.e., 30% of total Growth Traffic) is then added to the number of Satellite Circuits as of June 30, 1993 to determine the minimum number of Satellite Circuits as of June 30, 1994. 4. The number of FM Satellite Circuits as of June 30, 1994 is subtracted from the total number of Satellite Circuits as of that date. 5. The number of Satellite Circuits not including FM Circuits as of June 30, 1994 is then divided by the Efficiency Factor of 4.28:1 to determine the minimum number of Digital Bearer Circuits (to be billed) that must be activated by June 30, 1994. 6. The above methodology also will be applied for the period from July 1, 1994 through June 30, 1995, using a 30% growth percentage and an Efficiency Factor of 4.29:1. J. The provisions set forth in Paragraphs B through I of this Article shall expire on June 30, 1995, provided, however, that: (1) consistent with Article IX of this Agreement, all applicable rates, terms and conditions for each circuit leased pursuant to the provisions of this Article shall survive until the expiration of that circuit's lease term; and (2) if AT&T removes any Satellite Circuits from the INTELSAT system prior to June 30, 1995 pursuant to Paragraph D of this Article, AT&T's obligation to restore those circuits once it again begins to have growth traffic shall not expire until December 31, 2003. ARTICLE IV BASE AND ADDITIONAL CIRCUITS A. COMSAT's rates for AT&T's Base Circuits shall be reduced as of July 1, 1993 to the levels specified in Attachment A, which is appended hereto and made part of this Agreement. The rates in Attachment A are for Base Circuits provided via INTELSAT Revised Standard A Earth Stations. Base Circuits transmitted through standard earth stations with lower G/T values shall be subject to the rate adjustment factors specified in Attachment B, which is also appended hereto and made part of this Agreement. In addition, the Parties agree that, from July 1, 1993 through December 31, 1997, a discount of 10% below the rates specified in Attachment A shall be applied to Base Circuits transmitted through Large Standard A Earth Stations at both ends. B. COMSAT's rates for AT&T's Additional Circuits shall be reduced to the levels specified in Attachment C, which is appended hereto and made part of this Agreement. The rates in Attachment C are for Additional Circuits provided via all INTELSAT Standard A earth stations. Additional Circuits transmitted through standard earth stations with lower G/T values shall be subject to the rate adjustment factors specified in Attachment B. C. As of July 1, 1993, COMSAT's charge for early termination of Base Circuits and Additional Circuits shall be a flat fee of $6,880 per 64 Kbps equivalent circuit, plus 45% of the balance due at the time of early termination. D. Notwithstanding Paragraph C of this Article, AT&T reaffirms that it will not cancel any Digital Bearer Circuits committed pursuant to Article III of this Agreement or already in place under the 1987 Agreement, as amended, until July 1, 1995 at the earliest, except as provided under Article III-D above. E. The Parties agree that the rates and early termination charges set forth in this Article and in Attachments A through C supersede any conflicting provisions in COMSAT World Systems Tariff F.C.C. No. 1. All other terms and conditions for AT&T's Base Circuits and Additional Circuits shall be the same as those specified in COMSAT World Systems Tariff F.C.C. No. 1 as of the effective date of this Agreement, and those tariff provisions are hereby incorporated into this Agreement. ARTICLE V BULK OFFERING A. COMSAT hereby agrees to provide, and AT&T commits and agrees to lease from COMSAT for a 10-year term commencing as of July 1, 1993, the following 36 MHz bandwidth allotments to be used for U.S. traffic: [blank space intended] B. COMSAT's rates for each of the three 36 MHz allotments provided pursuant to the Bulk Offering described in this Article shall be $189,000 per month from January 1, 1994 through December 31, 1996, and $165,000 per month for the remainder of the lease term. As of the effective date of this Agreement, however, there is substantial non-AT&T traffic located in these allotments that will constrain AT&T's ability to utilize them fully. The parties recognize that it will take some time to relocate this non-AT&T traffic consistent with INTELSAT's standard relocation procedures. Therefore, until this relocation is complete, COMSAT will prorate its lease price such that, if there are X non-AT&T circuits being leased from COMSAT in a given allotment, the lease price for that allotment will be ((540-X)/540) x $189,000 (or $165,000, as applicable) per month. C. For the purpose of converting part of the traffic requirements under Article III above to the leasing of the three 36 MHz allotments described in this Article, and for the additional purpose of establishing termination charges for those allotments, each 36 MHz allotment lease will be considered the equivalent of 540 64 Kbps circuits. Consistent therewith, COMSAT and AT&T hereby agree that, by the end of 1993, the three 36 MHz allotment leases may absorb up to 827 of AT&T's existing 10-year Additional Circuits. The conversion of up to 827 Additional Circuits under this Paragraph shall not be considered early termination, and early termination charges shall not apply thereto. Existing circuits outside the allotments that have not been leased for multi-year terms may be moved into the allotments at any time, and new circuits (including Additional Circuits not yet activated as of the effective date of this Agreement) may be activated inside the allotments at any time. Once inside the allotments, circuits may not be counted in determining the appropriate block rates for AT&T under Article IV-B and Attachment C of this Agreement. D. The Parties agree that, in consideration of AT&T's total commitment under this Agreement, COMSAT shall provide the three 36 MHz allotments described in this Article free of charge for the period from July 1, 1993 through December 31, 1993. Beginning January 1, 1994, the charges specified in Paragraph B of this Article will apply. E. COMSAT's charge for early termination for each of the 36 MHz allotments described in this Article shall be a flat fee of 540 x $6,880 per 64 Kbps equivalent circuit, plus 45% of the balance due at the time of early termination. F. Notwithstanding Paragraph E of this Article, AT&T agrees that it will not cancel any of the 36 MHz allotments committed pursuant to this Article until July 1, 1998 at the earliest. G. INTELSAT's technical lease definitions, as set forth in the IESS documents that COMSAT routinely provides to AT&T, will apply to the lease of the three 36 MHz allotments described in this Article, and COMSAT and INTELSAT must approve transmission plans for each circuit located in the allotments in advance of service activation. H. The Parties recognize that, during the lease term of the three 36 MHz allotments described in this Article, the particular satellites listed in paragraph A of this Article may be replaced by other INTELSAT satellites. In such cases, a transponder of different connectivity may be substituted for the replaced transponder upon mutual agreement of the Parties. I. The Parties agree that the rates, early termination charges, and other terms and conditions specified in this Article supersede any conflicting provisions in COMSAT World Systems Tariff F.C.C. No. 1. All other terms and conditions for the circuits provided pursuant to the Bulk Offering described in this Article shall be the same as those specified in COMSAT World Systems Tariff F.C.C. No. 1 as of the effective date of this Agreement, and those tariff provisions are hereby incorporated into this Agreement. J. Any request by AT&T during the term of this Agreement for additional allotments beyond the three 36 MHz allotments specified in this Article shall be the subject of a separate agreement with respect to price and terms when and if such a request is made. ARTICLE VI MOST FAVORED CARRIER A. To the extent permitted by law, COMSAT agrees that, during the term of this Agreement, it will offer AT&T rates, terms and conditions for Base Circuits that are no less favorable than the rates, terms and conditions it makes available, after the effective date of this Agreement, to any other USISC for Digital Bearer Circuits activated prior to January 1, 1992. In the event that, during the term of this Agreement, COMSAT makes available to another USISC rates, terms and conditions for Digital Bearer Circuits activated prior to January 1, 1992 that are more favorable than those applicable under this Agreement, then such more favorable rates, terms and conditions shall be offered by COMSAT to AT&T in writing and, if accepted by AT&T in writing, shall be automatically incorporated into this Agreement as an amendment thereto, and shall be effective as of the date made available to such other USISC. B. To the extent permitted by law, COMSAT agrees that, during the term of this Agreement, it will offer AT&T rates, terms and conditions for Additional Circuits that are no less favorable than the rates, terms and conditions it makes available, after the effective date of this Agreement, to any other USISC for Digital Bearer Circuits activated or on after January 1, 1992. In the event that, during the term of this Agreement, COMSAT makes available to another USISC rates, terms and conditions for Digital Bearer Circuits activated on or after January 1, 1992 that are more favorable than those applicable under this Agreement, then such more favorable rates, terms and conditions shall be offered by COMSAT to AT&T in writing and, if accepted by AT&T in writing, shall be automatically incorporated into this Agreement as an amendment thereto, and shall be effective as of the date made available to such other USISC. ARTICLE VII CUSTOMER/SUPPLIER RELATIONSHIP In recognition of COMSAT's unique expertise and experience in international satellite telecommunications, the high quality of its services, its performance as U.S. Signatory to INTELSAT, and the Parties' good working relationship over the past three decades, AT&T agrees that it shall treat COMSAT as a preferred supplier and shall give it an opportunity to supply additional satellite capacity not covered by this agreement, provided however that, consistent with Article I above, nothing shall preclude AT&T from placing such traffic on other facilities. ARTICLE VIII REMEDIES A. In the event that COMSAT materially breaches Article IV- A or IV-B of this Agreement, AT&T shall be entitled to damages in an amount equal to the difference between the rates AT&T paid and the rates specified in Attachments A and C for the number of Base Circuits or Additional Circuits involved. B. In the event that COMSAT materially breaches Article V-B or V-D of this Agreement, AT&T shall be entitled to damages in an amount equal to the difference between the rates AT&T paid and the rates specified in Article V-B and V-D for the number of 36 MHz allotments involved. C. In the event that COMSAT materially breaches Article VI of this Agreement, AT&T shall be entitled to damages in an amount equal to the difference between the rates AT&T paid for the circuits covered by this Agreement and the rates AT&T would have paid for those circuits if COMSAT had not breached Article VI. D. In the event that AT&T materially breaches Article III or IV-D of this Agreement, COMSAT shall be entitled to damages in an amount equal to the revenues that COMSAT would have realized if AT&T had activated Base and Additional Circuits in accordance with its prior commitments to COMSAT and then canceled those circuits on July 1, 1995. E. In the event that AT&T materially breaches Article V-A or V-F of this Agreement, COMSAT shall be entitled to damages in an amount equal to the revenues that COMSAT would have realized if AT&T had activated the three 36 MHz allotments in accordance with the provisions of this Agreement and then canceled those allotments on July 1, 1998. F. In the event that AT&T materially breaches Article VII of this Agreement, COMSAT shall be entitled prospectively to charge AT&T for Base Circuits and Additional Circuits at the highest rate specified for such circuits in COMSAT World Systems Tariff F.C.C. No. 1 as of the effective date of this Agreement. G. In no event shall either Party be entitled to damages or other remedies under this Article unless it provides the other Party with notice and a reasonable opportunity to cure within sixty (60) days of the date when the Party claiming breach either knew or should have known of the event giving rise to the alleged breach. ARTICLE IX TERM OF AGREEMENT The term of this Agreement shall commence upon execution of the Agreement by both Parties and shall run through December 31, 2003, provided, however, that all applicable rates, terms and conditions for each circuit leased pursuant to the provisions of this Agreement (or its predecessor, the 1987 Agreement, as amended) shall survive until the expiration of that circuit's lease term. Thus, for example, the rates, terms and conditions for an Additional Circuit activated on January 1, 1995 would remain in effect until December 31, 2004. ARTICLE X FCC REVIEW The Parties shall jointly submit this Agreement to the FCC within thirty (30) days of execution pursuant to Section 211(a) of the Communications Act, and shall request confidential treatment for any competitively sensitive information contained herein. If any FCC proceeding is initiated with respect to the entry into force of this Agreement, the Parties agree to cooperate fully in seeking a prompt and favorable resolution of such proceeding. Although this Agreement is effective as of its signing date in order to implement rate reductions beneficial to the public as soon as practicable, the Parties recognize that the FCC has reserved the right within ninety (90) days to take actions affecting the provisions herein, and accordingly, the Parties agree that any FCC-mandated changes shall be retroactive to the effective date of this Agreement. However, in the event that such changes materially alter the substance of this Agreement, the Parties shall promptly seek to renegotiate the affected provisions thereof. ARTICLE XI DISPUTE RESOLUTION If any dispute arises with respect to the interpretation, implementation or termination of this Agreement, the Parties will use their best efforts to resolve the matter amicably, including recourse to the highest levels of management in their respective organizations. If such efforts fail to resolve the dispute within a reasonable time, the Parties agree to present that dispute to the American Arbitration Association in Washington, D.C. for binding resolution in accordance with that Association's Commercial Rules of Arbitration, or in lieu of arbitration, to utilize another mutually agreeable means of alternative dispute resolution (ADR). Each Party shall bear all of its own costs incurred in utilizing arbitration or other ADR mechanism. ARTICLE XII ENTIRE AGREEMENT This Agreement (including its attachments and those portions of COMSAT's tariffs which are incorporated by reference) replaces the 1987 Agreement, as amended, and constitutes the entire agreement between the Parties as to AT&T's utilization of COMSAT's INTELSAT space segment capacity for telecommunications services; it is intended as the complete and exclusive statement of the terms of the agreement between the Parties, and supersedes all previous understandings, commitments or representations by or between the Parties with respect to its subject matter. ARTICLE XIII REPRESENTATIONS OF AUTHORITY Each Party to this Agreement hereby represents and warrants to the other that it is a corporation duly organized, validly existing, and in good standing under the laws of its jurisdiction of incorporation; that it has appropriate approvals and direction from its Board of Directors to empower it to enter into and perform its obligations under this Agreement; and that it has taken all requisite corporate action to approve the execution, delivery, and performance of this Agreement. ARTICLE XIV BINDING OBLIGATION A. This Agreement, when executed and delivered, shall be a legal, valid and binding obligation of COMSAT and AT&T, and shall bind all successors, permitted assigns and U.S. subsidiaries of the Parties. B. The provisions of this Agreement are for the benefit only of the Parties hereto and their subsidiaries, successors and permitted assigns, and no other party may seek to enforce, or benefit from, any provision of this Agreement. C. Neither Party shall assign or transfer its rights and obligations under this Agreement without the other Party's express written consent, which consent shall not be unreasonably withheld. D. The Parties agree that neither of them shall take any action, either directly or indirectly, that would interfere or be inconsistent with the terms of this Agreement. ARTICLE XV NOTICES All written notices required under this Agreement shall be considered properly given only when sent by registered or certified mail, return receipt requested, to the following addresses, respectively, or to such other addresses as the receiving party may hereafter designate in writing: To AT&T: Arthur N. Sparks Director, IFM AT&T 412 Mt. Kemble Ave. Morristown, NJ 07960 To COMSAT: Patricia S. Benton Vice President and General Manager COMSAT World Systems 6560 Rock Spring Drive Bethesda, MD 20817 Any period of time referred to herein which is to commence upon notice shall be counted from the date such notice is received as aforesaid. ARTICLE XVI WAIVERS The waiver by either Party of a breach of, or default under, any of the provisions of this Agreement, or the failure of either Party, on one or more occasions, to enforce any of the provisions of this Agreement or to exercise any right or privilege hereunder, shall not thereafter be construed as a waiver of any subsequent breach or default of a similar nature, or as a waiver of any provision, right or privilege hereunder. ARTICLE XVII MISCELLANEOUS A. The article headings and table of contents in this Agreement are inserted for convenience only and do not constitute a part of this Agreement. B. This Agreement may be amended only in writing by an instrument signed by authorized representatives of both Parties. C. This Agreement shall be construed according to the laws of the State of New Jersey. D. This Agreement may be executed in counterparts, each of which shall be deemed an original, and all such counterparts together shall constitute one and the same instrument. E. This Agreement shall become effective immediately upon execution by both Parties. IN WITNESS WHEREOF, each of the Parties hereto has executed this Agreement. AMERICAN TELEPHONE AND COMSAT CORPORATION TELEGRAPH COMPANY /s/ Frank P. Fahey /s/ Patricia Benton By:___________________________ By:___________________________ V.P. and G.M. COMSAT Deputy Director World Systems Title: _______________________ Title:________________________ July 27, 1993 July 23, 1993 Date:_________________________ Date:_________________________ ATTACHMENT A BASE CIRCUIT RATES Per month per activated carrier(1) 10-Year Term Carrier Size 1993-94(2) 1995(3) 1996(4) 1997(5) - - - ------------ ------- ------- ------- ------- 64 Kbps $ 600 $ 540 $ 465 $ 365 512 Kbps 4,800 4,320 3,720 2,920 1.544 Mbps 13,920 12,480 10,800 8,400 2.048 Mbps 17,400 15,600 13,500 10,500 6.312 Mbps 49,215 44,125 38,185 29,700 8.448 Mbps 65,625 58,835 50,915 39,600 Per 64 Kbps equivalent in a fully-activated 2.048 Mbps carrier $ 580 $ 520 $ 450 $ 350 - - - ------------------------ (1) The rates specified in this Attachment are for services to INTELSAT Revised Standard A Earth Stations. (2) The rates in this column shall take effect on July 1, 1993. (3) The rates in this column shall take effect on January 1, 1995. (4) The rates in this column shall take effect on January 1, 1996. (5) The rates in this column shall take effect on January 1, 1997, and shall remain in effect for the duration of each circuit's lease term unless further reduced. ATTACHMENT B RATE ADJUSTMENT FACTORS for Base and Additional Circuits Earth Station Frequency Minimum Rate Adjustment Standard Band G/T Factor(1) - - - ------------- --------- ------- --------------- Std. B C 31.7 dB/K 1.36 Std. C 29.0 dB/K 2.05 Std. C 27.0 dB/K 2.92 Std. E-3 Ku 34.0 dB/K 1.68 Std. E-2 Ku 29.0 dB/K 4.94 - - - ------------------ (1) In the event that COMSAT tariffs rate adjustment factors that are more favorable than those listed in this Attachment, the factors tariffed shall be incorporated automatically into this Agreement. ATTACHMENT C ADDITIONAL CIRCUIT RATES Per month per 64 Kbps equivalent in a fully-activated 2.048 Mbps carrier(1) 10-Year term Block 1993-94(2) 1995(3) 1996(4) 1997(5) - - - ------ ------- ---- ---- ---- Block 1(6) $495 $495 $450 $350 Block 2(7) 445 445 445 350 Block 3(8) 395 395 395 350 Block 4(9) 350 350 350 350 - - - --------------- (1) The rates specified in this Attachment are for service to all INTELSAT Standard A earth stations. Rates for fully activated 2.048 Mbps carriers shall be 30 times the numbers shown above. Rates for carrier sizes other than 2.048 Mbps shall bear the same relationships to the 2.048 Mbps rate as those shown in Attachment A. (2) The rates in this column are currently in effect. (3) The rates in this column are currently in effect. (4) The rates in this column shall take effect on January 1, 1996. (5) The rates in this column shall take effect on January 1, 1997, and shall remain in effect for the duration of each circuit's lease term unless further reduced. (6) The rates in Block 1 apply to Additional Circuits included among the first 270 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. The regions are those specified in COMSAT World Systems Tariff F.C.C. No.1 as of the effective date of this Agreement, i.e.: (1) (Western) Europe; (2) Pacific; (3) Latin America; and (4) Near and Middle East, Africa and other Europe. (7) The rates in Block 2 apply to Additional Circuits included among the next 360 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (8) The rates in Block 3 apply to Additional Circuits included among the next 450 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (9) The rates in Block 4 apply to Additional Circuits included among the Digital Bearer Circuits above 1080 (excluding Base Circuits) leased in a given region for terms of at least five years. EXHIBIT 10(dd) This Agreement is hereby entered into this 1 day of September 1993 by and between COMSAT Mobile Communications of COMSAT Corporation with offices located at 22300 COMSAT Drive, Clarksburg, MD 20871 (hereinafter referred to as "COMSAT"), AND MCI International, Inc. With offices at 2 International Drive, Rye Brook, New York 10573 on behalf of itself and its affiliated entities, (hereinafter referred to as "MCI"). WITNESSETH: WHEREAS, COMSAT and MCI are communications common carriers and are each subject to the jurisdiction of the Federal Communications Commission ("FCC"); and WHEREAS, COMSAT and MCI agree to exchange services between the various regions covered by the International Maritime Satellite Organization ("Inmarsat") served by COMSAT and points in the United States and international points served by MCI; NOW, THEREFORE, in consideration of the foregoing and the covenants hereinafter set forth, COMSAT and MCI agree as follows: 1. Interconnection of Facilities (a) COMSAT and MCI agree to interconnect their facilities to permit the exchange of traffic for the services covered under this Agreement. Such services to be covered are described in Annex I and II hereto, which is hereby incorporated into and made part of this Agreement. The Annex to this Agreement may be modified from time to time subject to mutual agreement of the Parties, and additional Annexes may be added if the Parties so choose. (b) MCI shall provide prompt assistance, as needed, to customers using or attempting to use the COMSAT mobile satellite communications services on a basis not less than that which they accord their other service activities and their customers for those services. (c) Each Party shall be responsible for: o the transmission to the other Party of signals in accordance with CCITT Recommendations, and o the transmission of signals received from the other Party over its facilities and to any interconnecting carrier, foreign administration or subscriber, as appropriate. 2. Charges (a) Rates for services provided hereunder are set forth in Annex I and II, hereto. (b) Rates to customers of COMSAT or MCI are the sole responsibility of the billing carrier. Any tariff changes affecting services provided in conjunction with this Agreement shall be provided by the Party making the changes to the other Party not later than the day of filing of such changes with the FCC. 3. Payment, Accounting and Settlement Payment, accounting and settlement shall be accomplished in accordance with the procedures set forth in Annexes I and II. 4. Existing Agreements This Agreement shall supersede and replace the existing negotiated Agreement between COMSAT and MCI International for maritime satellite telephone services dated February 8, 1988, the Agreement between COMSAT and Western Union International dated January 19, 1982, the Agreement between COMSAT and RCA Global Communications, Inc. dated October 26, 1981, and all other existing agreements between COMSAT and MCI International pertaining to the services covered by this Agreement. 5. Term The term of this Agreement shall as set forth in Annexes I and II. 6. Joint Marketing and Promotion During the term of this Agreement COMSAT and MCI will entertain proposals by each to the other for joint marketing and promotion of the services provided under this Agreement under terms and conditions mutually acceptable to both Parties. 7. Liability Neither Party nor its parent corporation, subsidiaries, affiliates, or suppliers, or any of its parent corporation's subsidiaries or affiliates shall be liable to the other for incidental, special, indirect or consequential damages or loss of revenues or profits resulting from failure to provide services or facilities as called for hereunder, or for any loss or damage sustained by reason of any failure in or breakdown of the communications facilities or interruption to same associated with functioning of the services covered by this Agreement no matter what the cause, or from any other causes arising out of this Agreement. 8. Assignment Neither Party may assign this Agreement without the prior written consent of the other Party, except to its parent, an affiliate or subsidiary in connection with the transfer of responsibility for the services provided under this Agreement. 9. Trademarks Nothing in this Agreement shall create in either Party any rights in the trademarks, tradenames, insignia, symbols, identification and logotypes used by the other Party. Before either Party uses any such marks of the other Party, it shall obtain the prior, written consent of the other Party. 10. Confidentiality Except as required by law, or where such information becomes Public without the fault of the disclosing party, neither Party shall disclose customer and billing information or its participation in this undertaking or any of the terms and conditions of this Agreement or any other agreement between the Parties without the prior written consent of the other Party. If disclosure is required by law, the Disclosing Party shall provide advance written notice of such disclosure to the other Party. In connection with the provision of services pursuant to this Agreement, COMSAT and MCI may each disclose to the other, certain business, technical, and other information which has been identified to be propriety to the disclosing party of its affiliated companies (hereinafter referred to as "INFORMATION"). For purposes of this Agreement, such INFORMATION shall include, but not be limited to, engineering information, hardware, software, drawings, models, samples, tools, technical specifications, or documentation, in whatever form recorded or orally provided. The Receiving Party shall hold the INFORMATION in confidence during the term of this Agreement or until such time as the INFORMATION has been made publicly available without a breach of this Agreement, or any other agreement by either the Disclosing Party or the Receiving Party or the Disclosing Party requested return thereof. The Receiving Party shall use such INFORMATION only for the purpose of performing this Agreement, shall reproduce such INFORMATION only to the extent necessary for such purpose, shall restrict disclosure of such INFORMATION to its employees or contractor itself, or affiliate companies, with a need to know and inform such employees of the obligations assumed herein, and shall not disclose such INFORMATION to any third party without prior written approval of the other party. The Receiving Party shall apply a standard of care to preserve the confidentiality of the INFORMATION which is no less rigorous than that which it applies to protect the confidential nature of its own confidential material. All customer information exchanged by the Parties shall be used only for the purposes agreed upon by the Parties. 11. Government Approvals and Compliance with Regulations All undertakings and obligations assumed herein by either Party are subject to all necessary governmental licenses and approvals. Moreover, each Party hereby assures the other that it does not intend to, and will not knowingly, violate the laws and regulations applicable to the services provided under this Agreement, including, but not limited to, those pertaining to the provision of telecommunications services and to export control. 12. Additional Services Should COMSAT elect to subscribe to new MCI Services that are not covered by this Agreement, MCI and COMSAT agree to incorporate into this Agreement such new MCI Services at mutually agreeable discount structures based on aggregate usage of MCI Services. 13. Technical Descriptions and Performance Definitions For each and any particular service contemplated and/or implemented hereunder, MCI and COMSAT agree that prior to installation or commencement of said service, technical discussions will be held by appropriate representatives of MCI and COMSAT. These discussions will entail, at a minimum, definition of specifications of the interconnections, transmission performance and standards, signalling standards, billing arrangements, traffic routing, and any other operational characteristics and technical items requiring clarification. Technical performance standards criteria which must be met will be cited for each service. Results of these discussions shall be confirmed in writing and summarized as technical attachments hereto in a Technical Annex for each service described herein, or any future services which may be added to this Agreement. Should COMSAT and MCI fail to reach timely agreement on the technical issues as described above pertaining to any service contemplated under this Agreement, COMSAT may decline to take part in such service, and COMSAT may seek such services form other suppliers without penalty or claim of violation of any provision of this Agreement. Agreement to the contents of each Technical Annex for each service described must be reached in accordance with the above in order for COMSAT to be eligible for the discounts for that respective service. (a) Order for Services Furthermore, notwithstanding anything to the contrary contained in the Agreement, nothing in this Agreement is to be construed as an order for any particular service, nor shall be so construed, without formal notification to MCI by COMSAT of an order for each specific service described herein and Agreement reached in accordance with this Paragraph 16. 14. Notices Any notices required or permitted to be given pursuant to this Agreement shall be considered properly given when sent via registered courier, telex, or fax to the following addresses, respectively, or to such other addresses as the Party concerned may hereafter designate in writing. TO COMSAT: COMSAT Mobile Communications 22300 COMSAT Drive Clarksburg, MD 20871 Attention: Director, Contracts TO MCI: MCI International, Inc. 2 International Drive Rye Brook, New York 10573 Attention: Vice President, Finance 15. Publicity Neither Party may issue any press release or other public statement concerning this Agreement or the relationship of the Parties in connection herewith without obtaining the prior written consent of the other Party. 16. Governing Law This Agreement shall be governed by and construed according to the laws of New York, United States of America. 17. Equal Treatment COMSAT agrees to exchange services covered by this Agreement with MCI on terms and conditions substantially similar to those given other carriers providing substantially equivalent service. MCI agrees to exchange services covered by this Agreement with COMSAT on terms and conditions substantially similar to those given other carriers providing substantially similar mobile services. 18. Severability If any term or provision of this Agreement shall be found to be illegal or unenforceable, then such term or provision shall be deemed stricken and replaced by a mutually agreeable substitute provision which is legal and enforceable and the remainder of this Agreement shall continue in full force and effect. 19. Waiver No term or provision hereof shall be deemed waived by either Party unless such waiver shall be in writing and signed by that Party. 20. Amendment Any amendment to this Agreement shall be in writing and shall be executed by authorized representatives of the Parties hereto. 21. Entire Agreement This Agreement and the attachments hereto constitute the complete and entire understanding of the Parties with respect to the subject matter hereof, superseding all prior oral and written negotiations, representations and agreement. In WITNESS WHEREOF, the Parties hereto have caused this Agreement to execute as of the day and year first shown above. COMSAT Corporation MCI International, Inc COMSAT Mobile Communication By: /s/William A. Paquin By: /s/Arthur E. Gelven -------------------- ------------------- Name: William A. Paquin Name: Arthur E. Gelven Vice President, Human Resources, Vice President Contracts and Administration Title: ___________________ Title:____________________ Date: 9 September 1993 Date: September 10, 1993 ANNEX I MOBILE SATELLITE TELEPHONE SERVICE 1. PROVISION OF SERVICE COMSAT and MCI agree to interconnect COMSAT's facilities and MCI's network, and agree to provide telecommunications services between the various Inmarsat-system regions and points throughout the world served by MCI. COMSAT and MCI shall cooperate to make arrangements with foreign telecommunications administrations to originate and terminate such services at international points. Mobile satellite telephony service shall be accorded equal priority with MCI's other telephony services for purposes of maintenance and access to MCI's network. 2. Term The term of this Annex shall be for a period of one year, commencing October 1, 1993, and shall be automatically renewable for additional periods of one (1) year. Either Party may terminate this Annex upon furnishing six (6) months written notice at any time after the initial one (1) year term. 3. Value Added Services to be Provided It is understood that from time to time COMSAT and/or MCI may wish to introduce new or enhanced value-added services (including, for example, directory assistance and credit card/calling card service) to supplement the mobile satellite telephony service covered by this Agreement. Such introduction of new services shall be accommodated by each party by mutual agreement. Other services may also include such services as the provision of private leased lines to and/or from COMSAT's land earth stations, such lines provided by MCI to MCI customers, or to COMSAT subject to mutual agreement between the parties. 4. Service Structure (a) MCI will tariff fixed-to-mobile service for Inmarsat traffic originating in its network, and COMSAT will concur in MCI's tariff. (b) COMSAT will continue to tariff its mobile-to-fixed service for Inmarsat traffic originating in its network, and MCI will concur in COMSAT Corporation - COMSAT Mobile Communications Tariff F.C.C. No. 1 and future COMSAT tariffs for mobile-to-fixed service for Inmarsat traffic originating in COMSAT's network. (c) MCI and COMSAT shall cooperate diligently and in good faith to develop and implement procedures and mechanisms to ensure, to the greatest extent feasible, that all end users have an opportunity to express a preference for a specific ground station service provider and that all customers who express a preference for COMSAT's services are given access to those services. (d) The interconnecting circuits to be used in providing the services covered by this Annex shall be direct circuits between COMSAT's Mobile Satellite Switching Centers (MSSC) and MCI's International Switching Centers (ISC). Each party shall provide and maintain, at its own expense, the circuits located on its side of the point of interconnection at COMSAT's MSSC. Each party shall inform the other party, as soon as possible of any facility failure in its network that is expected to cause protracted interruption of service and the party experiencing the failure shall take reasonable actions to implement restoration procedures. 5. Exchange of Traffic (a) COMSAT and MCI agree to route designated traffic in accordance with the customer's instructions, including the following: (i) fixed-to-mobile routed to COMSAT: all foreign originating (transit) traffic for which a Foreign Administration has requested to have its traffic routed to COMSAT, and all other traffic for which a customer has indicated a preference for COMSAT. (ii) mobile-to-fixed routed to MCI: all traffic for which the customer has designated MCI as the carrier through COMSAT's carrier selection program, whether by presubscription or direct-dialed selection, MCI specific services (MCI calling card, country direct, or calls requested to be routed through MCI), or other means. (b) COMSAT and MCI agree to route undesignated traffic as follows: (i) fixed-to-mobile routed to COMSAT: MCI agrees to meet with COMSAT each year to establish a mutually agreed upon traffic forecast for the following calendar year. MCI shall use its reasonable best efforts to deliver to COMSAT fixed-to-mobile traffic consistent with the mutually agreed upon traffic forecasts. (ii) mobile-to-fixed routed to MCI: COMSAT shall transmit to MCI traffic originating at mobile earth stations and designated for delivery by MCI. o Mobile originated traffic destined for domestic or international points, for which no routing has been designated by the originating caller, shall be allocated to MCI on a proportionate return basis. o COMSAT shall compute the proportion based upon traffic recorded through COMSAT's switch. (iii) Proportionate Return Procedures o To implement the proportionate return agreement, the parties agree that a "data capture period" shall be established, for the calculation of proportionate return percentages to be applied to total ship-shore minutes. The proportionate return percentages will be calculated based on the total shore-ship minutes as recorded through COMSAT's switch and as reported in the monthly statements of account for that period. The first "data capture period" hereunder will be the first quarter subsequent to the signing of this agreement. Each subsequent quarter will represent a new "data capture period". o The proportionate return percentages developed during the "data capture period" shall be used to return traffic for the "designated return period". The first "designated return period" hereunder will commence three months after the data capture period. o The "designated return period" will be separated from the "data capture period" by three calendar months to allow for "collection and confirmation" of the traffic data and the calculation of market shares and return traffic requirements using the proportionate return principle as defined in this agreement. The time periods are: Data Capture Period Collection Designated Return (Settlement Months) & Confirmation Period ___________________ ________________ _________________ Three (3) Months Three (3) Months Three (3) Months o Prior to each "designated return period", COMSAT will inform the U.S. Carriers of the proportionate return percentage it has calculated for each new "data capture period" to be sent during the "designated return period". o At the end of each "designated return period" COMSAT shall inform the carriers of any deviations in the actual minutes returned as compared to the proportionate return owed and the reasons therefore. (c) QUARTERLY reviews will be conducted to discuss the items in (b) (iii) above as well as the following items to compare actual traffic data against the forecast: o Adjustments will be made in the proportion to be returned for the following year if necessary. o Traffic levels quarterly for the previous period for all traffic will be reviewed to determine if revised volume discounts are applicable. o Updated forecasts for the new year will exchanged at the October 1 review. 6. Rates Rates for services provided hereunder are set forth in Attachments 1,2. Such rates shall be effective on September 1, 1993. 7. Payment Accounting and Settlement (a) Monthly Accounts (i) For sent paid calls, each party shall be responsible for the billing and collection of charges to its respective subscribers. (ii) Each party shall render to the other a monthly statement of the minutes carried, at rates in U.S. currency, for services rendered during the month to which the account relates showing the portion of revenues due to the other party. Such accounts shall be forwarded to the other party promptly after the calendar month to which the account relates but in no event later than the end of the second calendar month following the month to which the account relates. The monthly statements shall include accounting information received through international accounts. (iii) No allowances shall be made in the accounts for uncollectible amounts. However, each party will have the right to make adjustments as may be proper with respect to periods when transmission is defective. A party may deduct such credits from the monthly accounts submitted to the other party, provided that such deductions are made before the monthly account involved is forwarded to the other party. (iv) An account shall be deemed to have been accepted by the party to whom it is rendered if that party does not object in writing thereto before the end of the calendar month following the month in which the account is transmitted by the party rendering it. Objections shall be transmitted in writing to the party which rendered the account promptly after receipt of the account. Agreed adjustment shall be included in the next monthly account. (b) Establishment of Balance - Payment of Account The sum due each month from one party to the other as covered by the rendered accounts shall be reduced to a net balance by each party. Net balances due from one party to the other shall be paid monthly by the debtor party to the creditor party in United States currency. Payment will be made promptly, but in no event later than six (6) weeks after each monthly account is received from the creditor party. The payment of a balance due on an account shall not be delayed pending agreement to the adjustment of disputed items of that account. (c) Transit Traffic If the call is chargeable at the international point where COMSAT has an agreed transit rate with the originating Administration, then MCI shall be entitled to its transit fee, and COMSAT shall be entitled to an amount determined in accordance with its agreed transit rate to the originating Administration. If COMSAT does not have an agreed transit rate with the originating Administration, then MCI shall pay to COMSAT an amount equal to the shore-to-ship per minute rate established in Annex I, Attachment 1 of this Agreement. Attachment 1 to Annex I 7.21.93 COMSAT Mobile Communications PRICE SCHEDULE FOR FIXED-MOBILE INMARSAT SERVICES Prices Effective January 1, 1994(3) STANDARD-A TELEPHONE TRAFFIC VOLUME STANDARD-A PRESENTED TO TRAFFIC COMSAT ANNUALLY PRICE PER (A,M,B, AERO) MINUTE (minutes) - - - ------------------------------------ 0 to 500,000 $8.00 500,000 to 3,500,000 $7.25 Over 3,500,000 $7.20 GROWTH INCENTIVE SCHEDULE CUMULATIVE INCREMENTAL STANDARD-A TRAFFIC GROWTH OVER TRAFFIC INITIAL BASE FORECAST(1) PRICE PER (percent) MINUTE(2) - - - ------------------------------------ 20% to 30% $7.15 30% to 50% $7.10 50% to 70% $6.95 Greater than 70% $6.95 DIGITAL SERVICES SERVICE PRICE PER MINUTE - - - ----------------------------------- STANDARD-M $4.95 STANDARD-B $6.45 AERONAUTICAL $7.40 (1) INITIAL BASE FORECASE = First Two Year's Traffic Forecast. (2) Price applies to incremental minutes over BASE FORCAST. (3) Interim Price for Standard-A fixed-mobile Telephone service until January 1, 1994 will be at the rate of $7.25 per minute. ANNEX II INMARSAT TELEX SERVICES 1. Service To Be Provided (a) COMSAT and MCI agree to interconnect their telex facilities to permit user of MCI telex services to send and receive messages via the Inmarsat system provided by COMSAT, including any traffic from MCI which originates from any domestic connecting carrier's subscribers in the United States and is routed via MCI's facilities for delivery to a mobile earth station. (b) For traffic originating from an international point that transits the U.S. and is destined for a mobile earth station, MCI and COMSAT shall jointly make appropriate interconnection arrangements with foreign administrations to implement and facilitate the use of COMSAT's services as provided for herein. (c) For traffic originating at mobile earth stations, COMSAT shall honor routing designated by the originating caller, except that COMSAT shall transmit to any interconnecting carrier all traffic from mobile earth stations destined to subscribers of that carrier's network. For international calls whose routing has not been designated by the originating caller ("undesignated traffic"), MCI shall receive from COMSAT a minimum of twenty (20) percent of such undesignated traffic per month, such percentage reflecting the fact that, as of the date of execution of this Agreement by both Parties, MCI is one of five carriers interconnecting with COMSAT for such traffic. Should the number of interconnected carriers change, MCI shall receive from COMSAT a minimum of such undesignated traffic equivalent to MCI's representative share of the total number of carriers interconnected with COMSAT. Should the Federal Communications Commission ("FCC") subsequently approve the implementation of a proportionate return mechanism for the allocation of undesignated traffic, COMSAT shall deliver such traffic to MCI in accordance with a mutually agreed upon proportionate return formula. (d) MCI shall deliver domestic originating telex traffic destined for termination through the Inmarsat system to United States land earth stations, as required by FCC regulatory policy. 2. Term The term of the Annex shall be for one (1) year, commencing September 1, 1993, and shall automatically renewable for additional periods of one (1) year. Either Party may terminate this Annex upon furnishing six (6) months written notice at any time after the initial one year term. 3. Charges (a) For the services provided by COMSAT hereunder, MCI agrees to pay those charges set forth in Attachment 1 hereto. (b) For those services provided by MCI hereunder, COMSAT agrees to pay those charges set forth in Attachment 2 hereto. (c) Telex rates to customers of COMSAT or MCI are the sole responsibility of the billing carrier. 4. Accounting and Settlement (a) The Parties shall exchange accounting statements on a monthly basis within thirty (30) days after the end of the traffic month. Settlement of net balances shall be made on a quarterly basis within thirty (30) days following the end of the traffic quarter. No allowance shall be made in the accounts for uncollectible amounts. Settlement of net balances for overseas originated traffic will be on a quarterly basis within thirty (30) days following the end of the traffic quarter. (b) The procedures for settlement between MCI and COMSAT for traffic terminating or originating at mobile earth stations shall be as follows: (i) For traffic billable by COMSAT to mobile subscribers, COMSAT shall credit to MCI the amounts due at MCI's terminating interconnect rates specified in Attachment 2 to this Annex. (ii) For traffic chargeable at U.S. land points, MCI shall credit to COMSAT the amounts due at COMSAT's terminating interconnect rate specified in Attachment 1 to this Annex. (iii) For traffic chargeable at overseas land points, MCI will arrange for connecting overseas correspondents to collect the applicable charges for the combined services and to credit MCI with MCI's share of the applicable international charges plus an amount equal to COMSAT's share of the interconnect rate, which latter amount MCI shall credit to COMSAT. MCI shall use reasonable efforts to identify such mobile satellite communications traffic by ocean region and traffic month in the accounting statements exchanged. 5. Promotion of Traffic COMSAT will implement a carrier selection code for MCI and promote the availabilty of MCI telex carrier selection. Attachment 1 to Annex II COMSAT Mobile Communications Price Schedule for INMARSAT Telex Services Standard A Telex(1) Annual Commitment Price per Minute (000's of Minutes) 0 - 200 $3.80 201 - 500 $3.75 501 - 750 $3.70 751 - 1,000 $3.60 Over 1,000 Annually $3.50 Standard B Telex(2) Notes 1. Minutes are bi-directionally accumulative; i.e. total of minutes in Fixed-to-Mobile, Mobile-to-Fixed, domestic and foreign originating, apply. 2. Minutes of Digital Services Telex (Standard B) traffic apply toward Standard A Telex traffic commitment levels, but are volume insensitive until such time that traffic levels warrant volume-commitment discounts. MCII PRICING SCHEDULE TELEX TRAFFIC (UNDESIGNATED) DOMESTIC DOMESTIC RATE PER WUI TARIFF #22 INTL INTL COMPONENT RATE PER WUI TARIFF #5 TELEX CARRIER SELECT TRAFFIC (DESIGNATED) GROSS MONTHLY INTERNATIONAL REVENUE* $0 - $10,000 5.0% $10,001 - $30,000 10.0% >$30,000 15.0% *DOMESTIC DESIGNATED SETTLED AT SAME RATE AS UNDESIGNATED ======================================================== MCII TERMINATION CHARGES ** INMARSAT VOICE SERVICES U.S. TERMINATION $0.35/MINUTE INTERNATIONAL TERMINATION 75,000 MINUTES/MONTH PRISM 1 RATES >75,000 MINUTES/MONTH 10% OFF PRISM 1 RATES **UNDESIGNATED TRAFFIC EXHIBIT 10(ee) A G R E E M E N T This Agreement is made by and between Sprint Communications Company L.P., a Delaware limited partnership ("SPRINT"), a United States International Service Carrier ("USISC"), and COMSAT Corporation ("COMSAT"), the U.S. Signatory to the International Telecommunications Satellite Organization ("INTELSAT") (hereinafter jointly referred to as the "Parties"). WHEREAS, SPRINT is engaged in the provision of telecommunications services via satellite; and WHEREAS, COMSAT offers INTELSAT space segment capacity to USISCs for telecommunications services; and WHEREAS, the Parties have decided to enter into an inter- carrier contract based on SPRINT's utilization of COMSAT's INTELSAT space segment capacity for telecommunications services; NOW, THEREFORE, in consideration of and in reliance upon the mutual promises set forth below, SPRINT and COMSAT hereby agree as follows: ARTICLE I PURPOSE AND INTENT The purpose of this Agreement is to implement the Parties' mutual understanding with respect to SPRINT's utilization of COMSAT's INTELSAT space segment capacity for telecommunications services. It is the intent of COMSAT and SPRINT that this Agreement comply with all laws and international obligations of the United States. Consistent with that intent, nothing herein shall preclude COMSAT from reaching similar agreements for circuits with other USISCs, and nothing herein shall preclude SPRINT from placing traffic not covered by this Agreement on whatever telecommunications facilities it should select. ARTICLE II DEFINITIONS The terms used in this Agreement are defined as follows: 1. Additional Circuits. Digital Bearer Circuits activated by SPRINT on the INTELSAT system via COMSAT on or after January 1, 1992 for lease terms of at least seven (7) years. 2. Base Circuits. Digital Bearer Circuits activated by SPRINT on the INTELSAT system via COMSAT prior to January 1, 1992 for lease terms of at least ten (10) years, or otherwise treated as Base Circuits pursuant to this Agreement. 3. Bulk Offering. The offering by COMSAT to SPRINT of one 36 MHz bandwidth allotment pursuant to the rates, terms and conditions specified in this Agreement. 4. Digital Bearer Circuits. 64 Kbps equivalent circuits used to carry public-switched traffic (including IDR and TDMA circuits, but excluding private line circuits); these circuits may or may not be aggregated into larger digital carriers. 5. Revised Standard A Earth Station. An earth station having a gain-to-temperature ratio ("G/T") at least equal to 35 dB/K. ARTICLE III BASE AND ADDITIONAL CIRCUITS A. As of the date of this Agreement, SPRINT had activated _____ Base Circuits on the INTELSAT system via COMSAT for 10-year lease terms. SPRINT hereby agrees by this inter-carrier agreement to replace each individual lease term for these _____ Base Circuits with a new 10-year lease term that will begin on December 1, 1993 and end on November 30, 2003. B. As of the date of this Agreement, SPRINT had also activated _____ Base Circuits on the INTELSAT system via COMSAT for 15-year lease terms. COMSAT hereby agrees that these __ circuits may be converted to 10-year Base Circuits, each with a new lease term that will begin on December 1, 1993 and end on November 30, 2003. In consideration for this adjustment, SPRINT agrees to convert [an equivalent number] of its existing 7-year Additional Circuits to 10-year Base Circuits, also with a new lease term that will begin on December 1, 1993 and end on November 30, 2003. Thus, for purposes of this Agreement, SPRINT's total number of Base Circuits is _____. C. As of December 1, 1993, COMSAT's rates for SPRINT's _____ Base Circuits shall be as specified in Attachment A, which is appended hereto and made part of this Agreement. The rates in Attachment A are for Base Circuits provided via INTELSAT Revised Standard A Earth Stations. Base Circuits transmitted through standard earth stations with lower G/T values shall be subject to the rate adjustments specified in Attachment B, which is also appended hereto and made part of this Agreement. D. As of December 1, 1993, COMSAT's rates for SPRINT's Additional Circuits shall be as specified in Attachment C, which is appended hereto and made part of this Agreement. The rates in Attachment C are for Additional Circuits provided via INTELSAT Revised Standard A earth stations. Additional Circuits transmitted through standard earth stations with lower G/T values shall be subject to the rate adjustment factors specified in Attachment B. E. As of December 1, 1993, COMSAT's charge for early termination of SPRINT's Base Circuits and Additional Circuits shall be a flat fee of $6,880 per 64 Kbps equivalent circuit, plus 45% of the balance due at the time of early termination. F. The Parties agree that the rates and early termination charges set forth in this Article and in Attachments A through C supersede any conflicting provisions in COMSAT World Systems Tariff F.C.C. No. 1. All other terms and conditions for SPRINT's Base Circuits and Additional Circuits shall be the same as those specified in COMSAT World Systems Tariff F.C.C. No. 1 as of the effective date of this Agreement, and those tariff provisions are hereby incorporated into this Agreement. G. Notwithstanding Paragraph F above, COMSAT agrees that, during the term of this Agreement, it will offer SPRINT rates, terms and conditions for Base Circuits that are no less favorable than the rates, terms and conditions it makes available pursuant to tariff for Digital Bearer Circuits activated prior to January 1, 1992. Upon written acceptance by SPRINT, such rates, terms and conditions shall be automatically incorporated into this Agreement. H. Notwithstanding Paragraph F above, COMSAT agrees that, during the term of this Agreement, it will offer SPRINT rates, terms and conditions for Additional Circuits that are no less favorable than the rates, terms and conditions it makes available pursuant to tariff for Digital Bearer Circuits activated or on after January 1, 1992. Upon written acceptance by SPRINT, such rates, terms and conditions shall be automatically incorporated into this Agreement. ARTICLE IV BULK OFFERING A. COMSAT hereby agrees to provide, and SPRINT commits and agrees to lease from COMSAT for a 10-year term commencing on December 1, 1993 and ending on November 30, 2003, one (1) 36 MHz bandwidth allotment providing __________________________________ connectivity in the __________ Ocean Region. As of the date of this Agreement, this allotment will be in ______________________ ________________________________________________________________ __________________________________________. B. COMSAT's rate for the 36 MHz allotment provided pursuant to the Bulk Offering described in this Article shall be $189,000 per month from January 1, 1994 through the remainder of the lease term. The Parties anticipate, however, that for some period of time after January 1, 1994 there will be substantial non-SPRINT traffic located in this allotment that will constrain SPRINT's ability to utilize it fully. The Parties recognize that it will take some time to relocate this non-SPRINT traffic consistent with INTELSAT's standard relocation procedures. Therefore, until this relocation is complete, COMSAT will prorate its lease price such that, if there are X non-SPRINT circuits being leased from COMSAT in this allotment, the lease price for the allotment will be ((540-X)/540) x $189,000 per month. C. The 36 MHz allotment provided pursuant to the Bulk Offering described in this Article shall be considered the equivalent of 540 64 Kbps circuits. Consistent therewith, COMSAT and SPRINT hereby agree that, during the six-month period commencing with the effective date of this Agreement, the 36 MHz allotment may absorb up to 270 of SPRINT's existing 7-year or 10- year Additional Circuits. (Base Circuits already located within the allotment may be substituted for Additional Circuits, but only if equivalent numbers of Additional Circuits outside the allotment are redesignated as Base Circuits, so that SPRINT's total number of Base Circuits remains constant at _____.) The conversion of up to 270 Additional Circuits under this Paragraph shall not be considered early termination, and early termination charges shall not apply thereto. Existing circuits outside the allotment that have not been leased for multi-year terms may be moved into the allotments at any time, and new circuits may be activated inside the allotment at any time. Once an existing circuit is designated as part of the allotment, all other charges for that circuit shall cease, and that circuit may not be counted in determining the appropriate block rates for SPRINT under Article IV-B and Attachment C of this Agreement. D. SPRINT hereby agrees that it will not cancel the 36 MHz allotment committed pursuant to this Article until November 30, 1998 at the earliest. E. After November 30, 1998, COMSAT's charge for early termination for the 36 MHz allotment described in this Article shall be a flat fee of $6,880 x 540 64 Kbps equivalent circuits, plus 45% of the balance due at the time of early termination. F. The 36 MHz allotment provided pursuant to this Article shall be non-preemptible. In case of space segment failure, this allotment shall be restored in accordance with the procedures set forth in INTELSAT SSOG 103, Section 6, as may be amended from time to time. This allotment may be used for any type of U.S. traffic, including both public-switched and private line traffic and both analog and digital traffic, provided, however, that: (1) INTELSAT's technical lease definitions, as set forth in the IESS documents that COMSAT routinely provides to SPRINT, shall apply to the use of this allotment, and (2) COMSAT and INTELSAT must approve transmission plans for each circuit in the allotment in advance of service activation. G. The Parties recognize that, during the lease term of the 36 MHz allotment described in this Article, the particular satellite listed in paragraph A of this Article may be replaced by another INTELSAT satellite. In such cases, a transponder of different connectivity may be substituted for the replaced transponder under the same terms and conditions upon mutual agreement of the Parties. H. The Parties agree that the rates, early termination charges, and other terms and conditions specified in this Article supersede any conflicting provisions in COMSAT World Systems Tariff F.C.C. No. 1. All other terms and conditions for the circuits contained in the 36 MHz allotment provided pursuant to this Article shall be the same as those specified in COMSAT World Systems Tariff F.C.C. No. 1 as of the effective date of this Agreement, and those tariff provisions are hereby incorporated into this Agreement. I. During the twelve months immediately following the effective date of this Agreement, SPRINT shall have the option of leasing up to two (2) additional 36 MHz bandwidth allotments from COMSAT, subject to the availability of mutually agreeable capacity. The rates, terms and conditions for the lease of such additional 36 MHz allotments shall be the same as those set forth in Paragraphs A through H of this Article, except that if SPRINT leases a total of three (3) 36 MHz allotments by the end of this twelve-month period, the rate for each such allotment shall be $165,000 per month beginning on January 1, 1997. After twelve months from the date of this Agreement, any request by SPRINT during the term of this Agreement for additional allotments beyond the one 36 MHz allotment specified in this Article shall be the subject of a separate agreement with respect to price and terms when and if such a request is made. K. COMSAT shall be responsible for coordinating the movement of circuits in and out of the 36 MHz allotment described in this Article. It is the intent of both Parties that at least nine (9) of SPRINT's 2.048 Mbps carriers be located in this allotment within ninety (90) days after the effective date of this Agreement, and COMSAT agrees to use its best efforts to ensure that this schedule is met. L. The Parties agree that, in consideration of SPRINT's total commitment under this Agreement, COMSAT shall provide the 36 MHz allotment described in this Article free of charge for the period from December 1, 1993 through December 31, 1993. Beginning January 1, 1994, the charges specified in Paragraph B of this Article will apply to the 36 MHz allotment described in this Article. ARTICLE V REMEDIES A. In the event that COMSAT materially breaches Article III-C or III-D of this Agreement, SPRINT shall be entitled to damages in an amount equal to the difference between the rates SPRINT actually paid and the rates specified in Attachments A and C for the number of Base Circuits or Additional Circuits involved. B. In the event that COMSAT materially breaches Article IV-B or IV-E of this Agreement, SPRINT shall be entitled to damages in an amount equal to the difference between the rates SPRINT actually paid and the rates specified in Articles IV-B and IV-D for the 36 MHz allotment involved. C. In the event that SPRINT materially breaches Article III-A or III-B of this Agreement, COMSAT shall be entitled to damages in an amount equal to the difference between the charges SPRINT actually paid and the revenues that COMSAT would have realized if SPRINT had begun a new lease term for each of its 1,434 Base Circuits as of December 1, 1993. D. In the event that SPRINT materially breaches Article IV-A or IV-D of this Agreement, COMSAT shall be entitled to damages in an amount equal to the difference between the charges SPRINT actually paid and the revenues that COMSAT would have realized if SPRINT had activated the 36 MHz allotment in accordance with the provisions of this Agreement and then prematurely canceled that allotment on November 30, 1998. E. In no event shall either Party be entitled to damages or other remedies under this Article unless it provides the other Party with notice and a reasonable opportunity to cure within sixty (60) days of the date when the Party claiming breach either knew or should have known of the event giving rise to the alleged breach. ARTICLE VI CUSTOMER/SUPPLIER RELATIONSHIP In recognition of COMSAT's unique expertise and experience in international satellite telecommunications, the high quality of its services, its performance as U.S. Signatory to INTELSAT, and the Parties' good working relationship over many years, SPRINT agrees that it shall give COMSAT an opportunity to supply additional satellite capacity not covered by this agreement, provided however that, consistent with Article I above, nothing shall preclude SPRINT from placing such traffic on other facilities. ARTICLE VII TERM OF AGREEMENT The term of this Agreement shall commence on December 1, 1993 and shall run through November 30, 2003, provided, however, that all applicable rates, terms and conditions for each circuit leased pursuant to the provisions of this Agreement shall survive until the expiration of that circuit's lease term. Thus, for example, the rates, terms and conditions for a 10-year Additional Circuit activated on January 1, 1995 would remain in effect until December 31, 2004. ARTICLE VIII FCC REVIEW The Parties shall jointly submit this Agreement to the FCC within thirty (30) days of execution pursuant to Section 211(a) of the Communications Act, and shall request confidential treatment for any competitively sensitive information contained herein. If any FCC proceeding is initiated with respect to the entry into force of this Agreement, the Parties agree to cooperate fully in seeking a prompt and favorable resolution of such proceeding. ARTICLE IX DISPUTE RESOLUTION If any dispute arises with respect to the interpretation, implementation or termination of this Agreement, the Parties will use their best efforts to resolve the matter amicably, including recourse to the highest levels of management in their respective organizations. If such efforts fail to resolve the dispute within a reasonable time, the Parties agree to present that dispute to the American Arbitration Association in Washington, D.C. for binding resolution in accordance with that Association's Commercial Rules of Arbitration, or in lieu of arbitration, to utilize another mutually agreeable means of alternative dispute resolution (ADR). Each Party shall bear all of its own costs incurred in utilizing arbitration or other ADR mechanism. ARTICLE X ENTIRE AGREEMENT This Agreement (including its attachments and those portions of COMSAT's tariffs which are incorporated by reference) constitutes the entire agreement between the Parties as to SPRINT's utilization of COMSAT's INTELSAT space segment capacity for the telecommunications services specified herein; it is intended as the complete and exclusive statement of the terms of this agreement between the Parties, and supersedes all previous understandings, commitments or representations by or between the Parties with respect to its subject matter. ARTICLE XI REPRESENTATIONS OF AUTHORITY A. COMSAT hereby represents and warrants to SPRINT that it is a corporation duly organized, validly existing, and in good standing under the laws of its jurisdiction of incorporation; that it has appropriate approvals and direction from its Board of Directors to empower it to enter into and perform its obligations under this Agreement; and that it has taken all requisite corporate action to approve the execution, delivery, and performance of this Agreement. B. SPRINT hereby represents and warrants to COMSAT that it is duly organized, validly existing, and in good standing under the laws of the State of Kansas; that it has appropriate approvals and direction to empower it to enter into and perform its obligations under this Agreement; and that it has taken all requisite action to approve the execution, delivery and performance of this Agreement. ARTICLE XII BINDING OBLIGATION A. This Agreement, when executed and delivered, shall be a legal, valid and binding obligation of COMSAT and SPRINT, and shall bind all successors and assigns of the Parties. B. The provisions of this Agreement are for the benefit only of the Parties hereto and their successors and assigns, and no other party may seek to enforce, or benefit from, any provision of this Agreement. C. Neither Party may assign this Agreement without the other Party's express written consent, except that each Party may assign its rights and obligations hereunder to a legal entity which is successor, assign, subsidiary or affiliate of that Party or its parent without notice or consent. ARTICLE XIII NOTICES All written notices required under this Agreement shall be considered properly given only when sent by registered or certified mail, return receipt requested, or by an overnight courier such as Federal Express, to the following addresses, respectively, or to such other addresses as the receiving party may hereafter designate in writing: To SPRINT: Ericka Officer Contract Negotiator Sprint Communications Company L.P. 9350 Metcalf KSOPKC0802 Overland Park, KS 66212 To COMSAT: M. Brent Bohne Director, Contracts and Procurement COMSAT World Systems 6560 Rock Spring Drive Bethesda, MD 20817 Any period of time referred to herein which is to commence upon notice shall be counted from the date such notice is received as aforesaid. ARTICLE XIV WAIVERS The waiver by either Party of a breach of, or default under, any of the provisions of this Agreement, or the failure of either Party, on one or more occasions, to enforce any of the provisions of this Agreement or to exercise any right or privilege hereunder, shall not thereafter be construed as a waiver of any subsequent breach or default of a similar nature, or as a waiver of any provision, right or privilege hereunder. ARTICLE XV MISCELLANEOUS A. The article headings and table of contents in this Agreement are inserted for convenience only and do not constitute a part of this Agreement. B. This Agreement may be amended only in writing by an instrument signed by authorized representatives of both Parties. C. This Agreement shall be construed according to the laws of the State of Maryland. D. This Agreement may be executed in counterparts, each of which shall be deemed an original, and all such counterparts together shall constitute one and the same instrument. E. This Agreement shall become effective on December 1, 1993 following execution by both Parties. IN WITNESS WHEREOF, each of the Parties hereto has executed this Agreement. SPRINT COMMUNICATIONS COMSAT CORPORATION COMPANY L.P. /s/Michael Robinson /s/Patricia Benton By:___________________________ By:___________________________ V.P. and G.M. COMSAT AVP Network World Systems Title: _______________________ Title:________________________ 11/30/93 November 16, 1993 Date:_________________________ Date:_________________________ ATTACHMENT A BASE CIRCUIT RATES Per month per activated carrier(1) 10-Year Term Carrier Size 1993(2) 1994(3) 1995(4) 1996(5) 1997(6) - - - ------------ ------- ------ ------ ------ ------ 1.544 Mbps $ 8,496 13,920 12,480 10,800 8,400 2.048 Mbps $10,620 17,400 15,600 13,500 10,500 Per 64 Kbps equivalent in a fully-activated 2.048 Mbps carrier $354 580 520 450 350 - - - ------------------- (1) The rates specified in this Attachment are for service to INTELSAT Revised Standard A Earth Stations. (2) The rates in this column shall take effect on December 1, 1993 and are provided in consideration for SPRINT's agreement to start a new 10-year lease term for each of its _____ Base Circuits. (3) The rates in this column shall take effect on January 1, 1994. (4) The rates in this column shall take effect on January 1, 1995. (5) The rates in this column shall take effect on January 1, 1996. (6) The rates in this column shall take effect on January 1, 1997, and shall remain in effect for the duration of each circuit's lease term unless further reduced. ATTACHMENT B RATE ADJUSTMENT FACTORS for Base and Additional Circuits Earth Station Frequency Minimum Rate Adjustment Standard Band G/T Factor(1) - - - ------------- --------- ------- ------------- Std. B C 31.7 dB/K 1.36 Std. C 29.0 dB/K 2.05 Std. C 27.0 dB/K 2.92 Std. E-3 Ku 34.0 dB/K 1.68 Std. E-2 Ku 29.0 dB/K 4.94 - - - --------------- (1) In the event that COMSAT tariffs rate adjustment factors that are more favorable than those listed in this Attachment, the factors tariffed shall be incorporated automatically into this Agreement. ATTACHMENT C ADDITIONAL CIRCUIT RATES Per month per 64 Kbps equivalent in a fully-activated 2.048 Mbps carrier(1) 10-Year term Block 1993-94(2) 1995(3) 1996(4) 1997(5) - - - ----- ------- ---- ---- ---- Block 1(6) $495 $495 $450 $350 Block 2(7) 445 445 445 350 Block 3(8) 395 395 395 350 Block 4(9) 350 350 350 350 - - - -------------- (1) The rates specified in this Attachment are for service to INTELSAT Revised Standard A earth stations. Rates for fully activiated 2.048 Mbps carriers shall be 30 times the numbers shown INTELSAT Standard A earth stations. Rates for fully activated 2.048 Mbps carriers shall be 30 times the numbers shown above. Rates for carrier sizes other than 2.048 Mbps shall bear the same relationships to the 2.048 Mbps rate as those shown in Attachment A. (2) The rates in this column are currently in effect. (3) The rates in this column are currently in effect. (4) The rates in this column shall take effect on January 1, 1996. (5) The rates in this column shall take effect on January 1, 1997, and shall remain in effect for the duration of each circuit's lease term unless further reduced. (6) The rates in Block 1 apply to Additional Circuits included among the first 270 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. The regions are those specified in COMSAT World Systems Tariff F.C.C. No.1 as of the effective date of this Agreement, i.e.: (1) (Western) Europe; (2) Pacific; (3) Latin America; and (4) Near and Middle East, Africa and other Europe. (7) The rates in Block 2 apply to Additional Circuits included among the next 360 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (8) The rates in Block 3 apply to Additional Circuits included among the next 450 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (9) The rates in Block 4 apply to Additional Circuits included among the Digital Bearer Circuits above 1080 (excluding Base Circuits) leased in a given region for terms of at least five years. ADDITIONAL CIRCUIT RATES Per month per 64 Kbps equivalent in a fully-activated 2.048 Mbps carrier(1) 7-Year term Block 1993-94(2) 1995(3) 1996(4) 1997(5) - - - ------ ------- ---- ---- ---- Block 1 $615 $615 $559 $455 Block 2 555 555 555 455 Block 3 505 505 505 455 Block 4 455 455 455 455 __________________ (1) The rates specified in this Attachment are for service to INTELSAT Revised Standard A earth stations. Rates for fully activiated 2.048 Mbps carriers shall be 30 times the numbers shown INTELSAT Standard A earth stations. Rates for fully activated 2.048 Mbps carriers shall be 30 times the numbers shown above. Rates for carrier sizes other than 2.048 Mbps shall bear the same relationships to the 2.048 Mbps rate as those shown in Attachment A. (2) The rates in this column are currently in effect. (3) The rates in this column are currently in effect. (4) The rates in this column shall take effect on January 1, 1996. (5) The rates in this column shall take effect on January 1, 1997, and shall remain in effect for the duration of each circuit's lease term unless further reduced. (6) The rates in Block 1 apply to Additional Circuits included among the first 270 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. The regions are those specified in COMSAT World Systems Tariff F.C.C. No.1 as of the effective date of this Agreement, i.e.: (1) (Western) Europe; (2) Pacific; (3) Latin America; and (4) Near and Middle East, Africa and other Europe. (7) The rates in Block 2 apply to Additional Circuits included among the next 360 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (8) The rates in Block 3 apply to Additional Circuits included among the next 450 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (9) The rates in Block 4 apply to Additional Circuits included among the Digital Bearer Circuits above 1080 (excluding Base Circuits) leased in a given region for terms of at least five years. EXHIBIT 10(ff) This agreement is hereby entered into this 10th day of December 1993 by and between COMSAT Mobile Communications of COMSAT Corporation with offices located at 22300 COMSAT Drive, Clarksburg, MD 20871 (hereinafter referred to as "COMSAT"), and Sprint International with offices at 12490 Sunrise Valley Drive, Reston, Virginia 22096 on behalf of itself, Sprint Communications Company, L.P. and its, affiliated entities, (hereinafter referred to as "SPRINT"). WITNESSETH: WHEREAS, COMSAT and SPRINT are communications common carriers and are each subject to the jurisdiction of the Federal Communications Commission ("FCC"); and WHEREAS, COMSAT and SPRINT agree to exchange services between the various regions covered by the International Maritime Satellite Organization ("Inmarsat") served by COMSAT and points in the United States and international points served by SPRINT: NOW, THEREFORE, in consideration of the foregoing and the covenants hereinafter set forth, COMSAT and SPRINT agree as follows: 1. Interconnection of Facilities (a) COMSAT and SPRINT agree to interconnect their facilities to permit the exchange of traffic for the services covered under this Agreement. Such services to be covered are described in Annex I hereto entitled "Mobile Satellite Telephone Service", which is hereby incorporated into and made a part of this Agreement. The Annexes to this Agreement may be modified from time to time subject to mutual written agreement of the Parties, and additional Annexes may be added if the Parties so choose. (b) SPRINT shall provide prompt assistance, as needed, to customers using or attempting to use the COMSAT mobile satellite communications services on a priority basis not less than that which they accord their other service activities and their customers for those services. (c) Each Party shall be responsible for: o the transmission to the other Party of signals in accordance with TSS Recommendations, and o the transmission of signals received from the other Party over its facilities and to any interconnecting carrier, foreign administration or subscriber, as appropriate. (d) Consistent with the terms and conditions of this Agreement, each Party shall have the right to interconnect with the other telecommunications service providers to exchange services, including, but not limited to, those covered by this Agreement. 2. Charges (a) Settlement Rates for services provided hereunder are set forth in Annex I hereto. (b) Rates to customers of COMSAT or SPRINT are the sole responsibility of the billing carrier. Any tariff changes affecting services provided in conjunction with this Agreement shall be provided by the Party making the changes to the other Party three (3) days prior to the filing of such changes with the FCC. 3. Payment, Accounting and Settlement Payment, accounting and settlement shall be accomplished in accordance with the procedures set forth in Annex I. 4. Term The term of this Agreement shall be for a period of five (5) years commending on Dec. 10, 1993, with subsequent renewal periods of one year. This Agreement may be terminated by either Party after five (5) years with not less than six (6) months notice in writing to the other Party. 5. Joint Marketing and Promotion During the term of this Agreement COMSAT and SPRINT will entertain proposals by each to the other for joint marketing and promotion of the services provided under this Agreement under terms and conditions mutually acceptable to both Parties. 6. Liability Neither Party nor its parent corporation, subsidiaries, affiliates, or suppliers, or any of its parent corporation's subsidiaries or affiliates shall be liable to the other for incidental, special, indirect or consequential damages or loss of revenues or profits resulting from failure to provide services or facilities as called for hereunder, or for any loss or damage sustained by reason of any failure in or breakdown of the communications facilities or interruption to same associated with functioning of the services covered by this Agreement no matter what the cause. 7. Assignment Neither Party may assign this Agreement without the prior written consent of the other Party, except to its parent, an affiliate or subsidiary in connection with the transfer of responsibility for the services provided under this Agreement. 8. Trademarks Nothing in this Agreement shall create in either Party any rights in the trademarks, tradenames, insignia, identification and logotypes used by the other Party. Before either Party uses any such marks of the other Party, it shall obtain the prior, written consent of the other Party. 9. Confidentiality Except as required by law, neither Party shall disclose customer and billing information or its participation in this undertaking or any of the terms and conditions of this Agreement or any other agreement between the Parties without the prior written consent of the other Party. If disclosure is required by law, the Disclosing Party shall provide advance written notice of such disclosure to the other Party. In connection with the provision of services pursuant to this Agreement COMSAT and SPRINT may each disclose to the other, certain business, technical, and other information which has been identified in writing to be proprietary to the disclosing party or its affiliated companies (hereinafter referred to as "INFORMATION"). For purposes of this Agreement, such INFORMATION shall include, but not be limited to, engineering information, hardware, software, drawings, models, samples, tools, technical specifications, or documentation, in whatever form recorded or orally provided. The Receiving Party shall hold the INFORMATION in confidence during the term of this Agreement or until such time as the INFORMATION has been made publicly available without a breach of this Agreement, or any other agreement or the Disclosing Party requests return thereof. The Receiving Party shall use such INFORMATION only for the purpose of performing this Agreement, and in support of the services provided hereunder, shall reproduce such INFORMATION only to the extent necessary for such purpose, shall restrict disclosure of such INFORMATION to its employees with a need to know (and inform such employees of the obligations assumed herein), and shall not disclose such INFORMATION to any third party without prior written approval of the other party. The Receiving Party shall apply a standard of care to preserve the confidentiality of the INFORMATION which is no less rigorous than that which it applies to protect the confidential nature of its own confidential material. 10. Export Control Each party hereby assures the other that it does not intend to and will not knowingly, without the prior written consent, if required, of the Office of Export Administration of the U.S. Department of Commerce, Washington, DC 20230, transmit directly or indirectly: (a) any INFORMATION received hereunder; or (b) any immediate product (including processes and services) produced directly by the use of such INFORMATION; or (c) any commodity produced by such immediate product if the immediate product of such INFORMATION is a plant capable of producing a commodity or is a major component of such plant; to Afghanistan, the People's Republic of China or any Group Q, S, W, Y or Z country specified in Supplement No. 1 to Section 770 of the Export Administration Regulations issued by the U.S. Department of Commerce. Each Party agrees that all of its obligations undertaken in Articles 10 and 11 herein as a Party receiving INFORMATION shall survive and continue after termination of this Agreement. 11. Government Approvals All undertakings and obligations assumed herein by either party are subject to all necessary governmental licenses and approvals. 12. Letter of Agency When circumstances so require, COMSAT agrees to appoint SPRINT as its agent with provisions typically authorized as shown in the example letter of Agency attached hereto and incorporated herein as Exhibit A. 13. Special Access Surcharge Where applicable, COMSAT will certify that any special access lines terminate in a device not capable of interconnecting SPRINT's service with the local exchange network and thus are surcharge exempt from the special access surcharge. The form shown in Exhibit B is an example of the means to be used for such certification. 14. Additional Services Should COMSAT elect to subscribe to other SPRINT Services that are not covered by this Agreement, SPRINT and COMSAT agree to incorporate into this Agreement such other SPRINT Services at similar discount structures based on aggregate usage of SPRINT Services. 15. Technical Descriptions and Performance Definitions For each and any particular service contemplated and/or implemented hereunder, SPRINT and COMSAT agree that prior to installation or commencement of said service, technical discussions will be held by appropriate representatives of SPRINT and COMSAT. These discussions will entail, at a minimum, definition of specifications of the interconnections, transmission performance and standards, signaling standards, billing arrangements, traffic routing, and any other operational characteristics and technical items requiring clarification. Technical performance standards criteria which must be met will be cited for each service. Results of these discussions shall be confirmed in writing and summarized as technical attachments hereto in a Technical Annex for each service described herein, or any future services which may be added to this Agreement. Should COMSAT and SPRINT fail to reach timely agreement on the technical issues as described above pertaining to any service contemplated under this Agreement, COMSAT may decline to take up such service, and COMSAT may seek such service form other suppliers without penalty or claim of violation of any provision of this Agreement. Agreement to the contents of each Technical Annex for each service described must be reached in accordance with the above in order for COMSAT to be eligible for the discounts for that respective service. 16. Notices Any notices required or permitted to be given pursuant to this Agreement shall be considered properly given when sent via registered courier, telex, or fax to the following addresses, respectively, or to such other addresses as the Party concerned may hereafter designate in writing. To COMSAT: COMSAT Mobile Communications 22300 Comsat Drive Clarksburg, Maryland 20871 Attention: Director, Contracts To SPRINT: SPRINT 12490 Sunrise Valley Drive Reston, Virginia 22096 Attention: General Counsel 17. Governing Law This Agreement shall be governed by and construed according to the laws of Maryland, United States of America. 18. Equal Treatment COMSAT agrees to exchange services with SPRINT on terms and conditions substantially similar to those given other carriers providing substantially equivalent service. SPRINT agrees to exchange services with COMSAT on terms and conditions substantially similar to those given other carriers providing substantially similar mobile services. 19. Severability If any term or provision of this Agreement shall be found to be illegal or unenforceable, then such term or provision shall be deemed stricken, and the remainder of this Agreement shall continue in full force and effect. 20. Waiver No term or provision hereof shall be deemed waived by either Party unless such waiver shall be in writing and signed by that Party. 21. Amendment Any amendments, attachments, or orders to or stemming from this Agreement shall be in writing and shall be executed by authorized representatives of the Parties hereto. 22. Entire Agreement This Agreement and the attachments hereto constitute the complete and entire understanding of the Parties with respect to the subject matter hereof, superseding all prior oral and written negotiations, representations and agreement. IN WITNESS WHEREOF, the Parties hereto have caused this Agreement to be executed as of the day and year first shown above. COMSAT Corporation SPRINT International COMSAT Mobile Communication /s/J. Allen /s/Chris J. Leber By:_____________________________ By:__________________________ J. Allen Chris J. Leber Name:___________________________ Name:________________________ Assistant Vice President V.P. & G.M. Operations Title:__________________________ Title:_______________________ Dec. 10, 1993 12-10-93 Date:___________________________ Date:________________________ Exhibit A COMSAT Mobile Communications 22300 COMSAT Drive Clarksburg, MD 20871 Telephone 301 428 4000 Fax 301 428 7747 Telex 197800 LETTER OF AGENCY Dear Sir: COMSAT Mobile Communications of Communications Satellite Corporation (COMSAT), hereby appoints Sprint International on behalf of Sprint Communications Company, L.P. or any of its affiliated companies; as agent (Agent) to order changes in, or maintenance on, specific telecommunications service you provide to the undersigned, including, without limitation, removing, adding to, or rearranging such telecommunications service. This specific service is to provide interconnection between Agent's facilities and COMSAT facilities. You are hereby released from any and all liability for making pertinent information available to the Agent and for following the Agent's instructions with reference to any additions changes to, or maintenance on, the undersign's telecommunications service. You may deal directly with the Agent on all matters pertaining to said telecommunications service and should follow its instructions with reference thereto. This authorization will remain in effect until otherwise notified. Sincerely, EXHIBIT B SURCHAGE EXEMPTION FORM I certify that my special access lines, circuit numbers ______________________________________ ______________________________________ provided by SPRINT, a) terminate in a device not capable of interconnecting* SPRINT service with the local exchange network, or b) are associated with Switched Access Service that is subject to Carrier Common Line Charges (applies to Foreign Exchange (FX) open ends), or c) the private line facility is used for Telex service or radio or television program transmissions. * "Not capable of interconnecting" or "leaking" has been interpreted by the FCC to mean "prevented from interconnecting special access lines with the local exchange lines due to either hardware or software restrictions." Sincerely, ______________________________________ COMPANY NAME ______________________________________ CUSTOMER ACCOUNT ID ______________________________________ SIGNATURE ______________________________________ TITLE ______________________________________ DATE ANNEX I MOBILE SATELLITE TELEPHONE SERVICE 1. Provision of Service COMSAT and SPRINT agree to interconnect OMSAT's facilities and SPRINT's terrestrial network, and agree to provide telecommunications services between the various Inmarsat-system regions and points throughout the world served by SPRINT. COMSAT an SPRINT shall cooperate to make arrangements with foreign telecommunications administrations to originate such services at international points. Mobile satellite telephony service shall be accorded equal priority with SPRINT's other telephony services for purposes of maintenance and access to SPRINT's network. 2. Services to be Provided DIRECTORY ASSISTANCE. All mobile directory assistance such as mobile station listing, locations, etc., will be provided by COMSAT's mobile operators. SPRINT will direct its customers requiring mobile station listings to call the COMSAT Directory Assistance number: 1 (800) 826-8680. CONFERENCE CALLS. Conference calls will be permitted in both the shore-to-ship and ship-to-shore directions. PERSON/STATION. Person and station calls will be permitted in both directions for maritime and international and mobile satellite service. Only station calls will be permitted for aeronautical satellite telephone service. CREDIT CARD AND CALLING CARD. SPRINT calling cards will be accepted on calls from the United States to mobile earth stations. Recognized SPRINT and foreign telecommunications authorities' credit cards will be accepted by COMSAT for mobile originated calls to U.S. or overseas termination points, providing that systems needed to perform such acceptance are in place. If, in the ship-to-shore usage, there is evidence of fraud, alleged misuse, or substantial uncollectibles, COMSAT and SPRINT shall cooperate to investigate the nature and extent of the incident, and if no reconciliation of the problem can be found, COMSAT and SPRINT will share in an equitable and fair manner the losses incurred. In the event fraud levels prevent either party from providing a profitable calling card or credit card service, either Party may, pursuant to Article 16 of this Agreement "Notices", discontinue said service. Any call carried by COMSAT which is billed to a SPRINT Foncard shall be routed to SPRINT's network. THIRD NUMBER. Third number calls will be permitted in the shore-to-ship direction only, at SPRINT's discretion with the understanding that SPRINT will accept liability for the charge. Third number calls will not be permitted in the ship-to-shore direction. PUBLIC AND SEMI-PUBLIC COIN TELEPHONES. Collect calls and credit card calls will be permitted from a coin telephone. Collect calls will not be permitted to a coin telephone. If a collect call is inadvertently placed to a coin telephone, resulting in an uncollectible charge for the call, COMSAT and SPRINT shall cooperate to investigate the nature an extent of the incident, and if no reconciliation of the problem can be found, COMSAT and SPRINT will agree to negotiate proportional share in an equitable and fair restitution process for losses which might be incurred. COLLECT CALLS. Collect calls will be permitted in both directions between mobile stations and the 50 states and U.S. possessions and territories, where applicable, except to coin telephones. Collect calls will also be permitted to U.S. offshore and overseas points, providing an agreement has been reached with the respective overseas administration. OTHER SERVICES. It is understood that from time to time COMSAT and/or SPRINT may wish to introduce new or enhanced services. Such introduction of new services shall be accommodated by each party by mutual agreement. Other services can include such services as the provision of private leased lines to and/or from COMSAT's land earth stations, such lines provided by SPRINT to SPRINT customers, or to COMSAT subject to mutual agreement between the parties. 3. Service Structure (a) SPRINT will tariff fixed-to-mobile service for Inmarsat traffic originating in its network, and COMSAT will concur in SPRINT's tariff. (b) COMSAT will continue to tariff its mobile-to-fixed service for Inmarsat traffic originating in its network, and SPRINT will concur in COMSAT's tariff. (c) SPRINT shall deliver originated traffic destined for termination through the Inmarsat system to United States land earth stations, as required by FCC regulatory policy. (d) SPRINT will recognize and accept COMSAT's requirement to maintain its identity with customers which express a preference for COMSAT's high quality ground station services. (e) The interconnecting circuits to be used in providing the services covered by this Annex shall be direct circuits between COMSAT's Mobile Satellite Switching Centers (MSSC) and SPRINT's International Switching Centers (ISC). Each party shall provide and maintain, at its own expense, the circuits located on its side of the point of interconnection at COMSAT's MSSC. Each party shall inform the other party, as soon as possible of any facility failure in its network that is expected to cause protracted interruption of service and the party experiencing the failures shall take reasonable actions to implement restoration procedures. 4. Exchange of Traffic (a) COMSAT and SPRINT agree to route designated traffic in accordance with the customer's instructions, including the following: (i) fixed-to-mobile routed to COMSAT: all foreign originating (transit) traffic for which a Foreign Administration has requested to have its traffic routed to COMSAT, and all other traffic for which a customer has indicated a preference for COMSAT. (ii) mobile-to-fixed routed to SPRINT: all traffic for which the customer has designated SPRINT as the terminating carrier through COMSAT's carrier selection program, whether by presubscription or direct-dialed selection, SPRINT specific services (SPRINT calling card, country direct, or calls requested to be routed through SPRINT), or other means. (b) COMSAT and SPRINT agree to route undesignated traffic as follows: (i) fixed-to-mobile routed to COMSAT: SPRINT agrees to meet with COMSAT each year to establish a mutually agreed upon traffic forecast for the following calendar year. SPRINT shall use its reasonable best efforts to deliver to COMSAT fixed-to-mobile traffic consistent with the mutually agreed upon traffic forecasts. (ii) mobile-to-fixed routed to SPRINT: COMSAT shall transmit to SPRINT traffic originating at mobile earth stations and designated for delivery by SPRINT. o Mobile originated traffic destined for domestic or international points, for which no routing has been dsignated by the originating caller, shall be allocated to SPRINT on a proportionate return basis. o COMSAT shall compute the proportion based upon traffic recorded through COMSAT's switch. o For the initial twelve (12) month period of service, SPRINT's proportion of undesignated traffic will be ten (10) percent. COMSAT will recompute SPRINT's proportion of undesignated traffic transmitted beginning day one of month thirteen (13) based upon traffic data captured during the initial period. Such recomputation shall not adjust for any shortfall between the percentage of traffic delivered by SPRINT during the initial twelve (12) month period and the percentage to which the ten percent minimum guaranteed return would ordinarily correspond if the return traffic was based upon proportionate return during the initial twelve (12) month period. Thereafter, COMSAT will calculate SPRINT's proportion in accordance with Paragraph 4(b)(iii). (iii) Proportionate Return Procedures o To implement the proportionate return agreement, the parties agree that a "data capture period" shall be established, for the calculation of proportionate return percentages to be applied to total ship-shore minutes. The proportionate return percentages will be calculated based on the total shore-ship minutes as recorded through COMSAT's switch and as reported in the monthly statements of account for that period. The first "data capture period" hereunder will be the first quarter subsequent to the signing of this agreement. Each subsequent quarter will represent a new "data capture period". o The proportionate return percentages developed during the "data capture period" shall be used to return traffic for the "designated return period". The first "designated return period" hereunder will commence three (3) months after the data capture period. o The "designated return period" will be separate from the "data capture period" by three (3) calendar months to allow for "collection and confirmation" of the traffic data and the calculation of market shares and return traffic requirements using the proportionate return principle as defined in this agreement. The time periods are Data Capture Period Collection Designated (Settlement Months) & Confirmation Return Period ___________________ ______________ _____________ Three (3) months Three (3) Months Three (3) Months o Prior to each "designated return period", COMSAT will inform the U.S. Carriers of the return percentage it has calculated for each new "data capture period" to be sent during the designated return period". o At the end of each "designated return period" COMSAT shall inform the carriers of any deviations in the actual minutes returned as compared to the proportionate return owed and the reasons therefore. (c) QUARTERLY reviews will be conducted to discuss the items in (b)(iii) above as well as the following items to compare actual traffic data against the forecast: o Adjustments will be made in the proportion to be returned for the following quarter if necessary, except during the initial twelve (12) month service period as specified in Paragraph 4(b)(ii) above. o Traffic levels quarterly for the previous period for all traffic will be reviewed to determine if revised volume discounts are applicable. o Updated forecasts for the new year will be exchanged during the last month of each year to compare actual traffic data against the forecast, except after year one owing to the two year nature of the initial base forecast 5. Rates Rates for services provided hereunder are set forth in Attachments 1 and 2 hereto. 6. Payment Accounting and Settlement (a) Monthly Accounts (i) For sent paid calls, each party shall be responsible for the billing and collection of charges to its respective subscribers. (ii) Each party shall render to the other a monthly statement of the minutes carried, at accounting rates in U.S. currency, for services rendered during the month to which the account relates showing the portion of revenues due to the other party. Such accounts shall be forwarded to the other party promptly after the calendar month to which the account relates but in no event later than the end of the second calendar month following the month to which the account relates. The monthly statements shall include accounting information received through international accounts. (iii) No allowances shall be made in the accounts for uncollectible amounts. However, each party will have the right to make adjustments as may be proper with respect to periods when transmission is defective or when fraud has been established in accordance with Paragraph 2 above. A party may deduct such credits from the monthly accounts submitted to the other party, provided that such deductions are made before the monthly account involved is forwarded to the other party. (iv) An account shall be deemed to have been accepted by the party to whom it is rendered if that party does not object in writing thereto before the end of the calendar month in which the account is transmitted by the party rendering it. Objections shall be transmitted in writing to the party which rendered the account promptly after receipt of the account. Agreed adjustments shall be included in the next monthly account. (b) Establishment of Balance - Payment of Account The sum due each month form one party to the other as covered by the rendered accounts shall be reduced to a net balance by each party. Net balances due from one party to the other shall be paid monthly by the debtor party to the creditor party in United States currency. Payment will be made promptly, but in no event later than six (6) weeks after each monthly account is received from the creditor party. The payment of a balance due on an account shall not be delayed pending agreement to the adjustment of disputed items of that account. (c) Transit Traffic If the call is chargeable at the international point, SPRINT shall be entitled to its rate agree with the originating Administration for service via the U.S. to CVOMSAT's facilities, plus its terrestrial interconnection fees, and COMSAT shall be entitled to an amount determined in accordance with the agreed rate to the originating Administration. Attachment 1 to Annex 1 COMSAT Mobile Communications PRICE SCHEDULE FOR FIXED-MOBILE INMARSAT SERVICES STANDARD-A TELEPHONE TRAFFIC VOLUME STANDARD-A PRESENTED TO TRAFFIC COMSAT ANNUALLY PRICE PER MINUTE (A,M,B, AERO) (minutes) 0 to 500,000 $8.00 500,000 to 3,500,000 $7.25 Over 3,500,000 $7.20 GROWTH INCENTIVE SCHEDULE CUMULATIVE INCREMENTAL TRAFFIC GROWTH OVER INITIAL BASE FORECAST STANDARD-A TRAFFIC (percent) PRICE PER MINUTE 20% to 30% $7.15 30% to 50% $7.10 50% to 70% $7.05 Greater than 70% $6.95 DIGITAL SERVICES SERVICE PRICE PER MINUTE STANDARD-M $4.95 STANDARD-B $6.45 AERONAUTICAL $7.40 TERMS AND CONDITIONS FOR GROWTH INCENTIVE SCHEDULE 1. Eligibility for discounts under the Growth Incentive Schedule will be based upon Sprint's performance in a particular quarter as compared to the annualized base forecast. COMSAT will utilize Sprint's initial base forecast over a two year period in its evaluations. 2. Incentive discounts will be available in accordance with the schedule for readjusting proportional return percentages as explained in Paragraph 4(b)(iii) of Annex 1. COMSAT will endeavor to adjust any applicable discount level in a more expeditious manner should such action prove feasible. Attachment 2 to Annex 1 Sprint International's PRICE SCHEDULE FOR MOBILE-FIXED TERMINATION RATES for COMSAT Mobile Communications' INMARSAT SERVICES STANDARD-A TELEPHONE REGION Price Per Minute(1) North America North American Dialing Plan $0.35 (Plus 809 Countries) Region 1 Western Europe, Japan $1.13 Central and South America Region 2 Pacific Rim and Asia $1.67 (Excluding Japan) Region 3 Remainder of Countries $1.62 World-wide 1 Volume discounts are applicable to per-minute rates per TABLE below. VOLUME DISCOUNT TABLE Monthly Volume North American International of Service ($) Region Regions (1,2, & 3) 0 to 9,999 0 0 10,000 to 17,999 8% 2% 18,000 to 24,999 9% 3% 25,000 to 39,999 10% 4% 40,000 to 49,999 11% 5% 50,000 to 74,999 12% 6% Over 75,000 13% 7% EXHIBIT 10(gg) CREDIT AGREEMENT Dated as of December 17, 1993 Among COMSAT CORPORATION as Borrower and THE BANKS NAMED HEREIN as Banks and NATIONSBANK OF NORTH CAROLINA, N.A. as Agent CREDIT AGREEMENT Dated as of December 17, 1993 COMSAT Corporation, a District of Columbia corporation (the "Borrower"), the banks (the "Banks") listed on the signature pages hereof, and NationsBank of North Carolina, N.A. ("NationsBank"), as agent (the "Agent") for the Lenders (as hereinafter defined) hereunder, agree as follows: ARTICLE I DEFINITIONS AND ACCOUNTING TERMS SECTION 1.01. Certain Defined Terms. As used in this Agreement, the following terms shall have the following meanings (such meanings to be equally applicable to both the singular and plural forms of the terms defined): "A Advance" means an advance by a Lender to the Borrower as part of an A Borrowing and refers to a Base Rate Advance or a Eurodollar Rate Advance, each of which shall be a "Type" of A Advance. "A Borrowing" means a borrowing consisting of simultaneous A Advances of the same Type made by each of the Lenders pursuant to Section 2.01. "A Note" means a promissory note of the Borrower payable to the order of any Lender, in substantially the form of Exhibit A-1 hereto, evidencing the aggregate indebtedness of the Borrower to such Lender resulting from the A Advances made by such Lender. "Advance" means an A Advance, a B Advance or a Swingline Advance. "Affiliate" means, as to any Person, any other Person that, directly or indirectly, controls, is controlled by or is under common control with such Person or is a director or executive officer of such Person. "Applicable Fee Percentage" shall mean on any date, with respect to the Facility Fees, the applicable percentage set forth below based upon the ratings applicable on such date to any senior unsecured debt of the Borrower then outstanding: Facility Fee Percentage ------------ Category 1 ---------- AA- or higher by S&P .125% and Aa3 or higher by Moody's Category 2 ---------- A+ by S&P and .125% A1 by Moody's Category 3 ---------- A by S&P and A2 .125% by Moody's Category 4 ---------- A- by S&P and .125% A3 by Moody's Category 5 ---------- BBB+ by S&P and .15% Baa1 by Moody's Category 6 ---------- BBB by S&P and .1875% Baa2 by Moody's Category 7 ---------- BBB- by S&P and .25% Baa3 by Moody's Category 8 ---------- BB+ or lower by .375% S&P and Ba1 or lower by Moody's For purposes of the foregoing, (i) if no rating for any senior unsecured debt of the Borrower shall be available from either Moody's or S&P, such rating agency shall be deemed to have established a rating for the senior unsecured debt of the Borrower in Category 8, (ii) if the ratings established or deemed to have been established by Moody's and S&P shall fall within different Categories, the Applicable Fee Percentage shall be based upon the inferior (or numerically highest) Category and (iii) if any rating established or deemed to have been established by Moody's or S&P shall be changed (other than as a result of a change in the rating system of either Moody's or S&P), such change shall be effective as of the date on which such change is first announced by the rating agency making such change. Each such change shall apply to all Facility Fees thataccrue at any time during the period commencing on the effective date of such change and ending on the date immediately preceding the effective date of the next such change. If the rating system of either Moody's or S&P shall change prior to the Termination Date, the Borrower and the Lenders shall negotiate in good faith to amend the references to specific ratings in this definition to reflect such changed rating system. "Applicable Lending Office" means, with respect to each Lender, such Lender's Domestic Lending Office in the case of a Base Rate Advance and such Lender's Eurodollar Lending Office in the case of a Eurodollar Rate Advance and, in the case of a B Advance, the office of such Lender notified by such Lender to the Agent as its Applicable Lending Office with respect to such B Advance. "Applicable Margin" shall mean on any date, with respect to A Advances which are Eurodollar Rate Advances, the applicable spread set forth below based upon the ratings applicable on such date to any senior unsecured debt of the Borrower then outstanding: Eurodollar Rate Advance Spread --------------- Category 1 ---------- AA- or higher by S&P .25% and Aa3 or higher by Moody's Category 2 ---------- A+ by S&P and .275% A1 by Moody's Category 3 ---------- A by S&P and A2 .275% by Moody's Category 4 ---------- A- by S&P and .275% A3 by Moody's Category 5 ---------- BBB+ by S&P and .30% Baa1 by Moody's Category 6 ---------- BBB by S&P and .3125% Baa2 by Moody's Category 7 ---------- BBB- by S&P and .375% Baa3 by Moody's Category 8 ---------- BB+ or lower by .50% S&P and Ba1 or lower by Moody's For purposes of the foregoing, (i) if no rating for any senior unsecured debt of the Borrower shall be available from either Moody's or S&P, such rating agency shall be deemed to have established a rating for the senior unsecured debt of the Borrower in Category 8, (ii) if the ratings established or deemed to have been established by Moody's and S&P shall fall within different Categories, the Applicable Margin applicable to any A Advance which is a Eurodollar Rate Advance shall be based upon the inferior (or numerically highest) Category and (iii) if any rating established or deemed to have been established by Moody's or S&P shall be changed (other than as a result of a change in the rating system of either Moody's or S&P), such change shall be effective as of the date on which such change is first announced by the rating agency making such change. Each such change shall apply to all A Advances which are Eurodollar Rate Advances that are outstanding at any time during the period commencing on the effective date of such change and ending on the date immediately preceding the effective date of the next such change. If the rating system of either Moody's or S&P shall change prior to the Termination Date, the Borrower and the Lenders shall negotiate in good faith to amend the references to specific ratings in this definition to reflect such changed rating system. "Assignment and Acceptance" means an assignment and acceptance agreement entered into by a Lender and an Eligible Assignee, and accepted by the Agent, in substantially the form of Exhibit C hereto. "B Advance" means an advance by a Lender to the Borrower as part of a B Borrowing resulting from the auction bidding procedure described in Section 2.03. "B Borrowing" means a borrowing consisting of simultaneous B Advances from each of the Lenders whose offer to make one or more B Advances as part of such borrowing has been accepted by the Borrower under the auction bidding procedure described in Section 2.03. "B Note" means a promissory note of the Borrower payable to the order of any Lender, in substantially the form of Exhibit A-2 hereto, evidencing the indebtedness of the Borrower to such Lender resulting from a B Advance made by such Lender. "B Reduction" has the meaning specified in Section 2.01. "Base Rate" means a fluctuating interest rate per annum equal at all times to the higher of: (a) the rate of interest announced publicly by NationsBank of North Carolina, N.A. in Charlotte, North Carolina, from time to time, as NationsBank of North Carolina, N.A.'s prime rate; or (b) for any day 1/2 of one percent per annum above the weighted average of the rates on overnight Federal funds transactions with members of the Federal Reserve System arranged by Federal funds brokers, as published for such day (or, if such day is not a Business Day, for the next preceding Business Day) by the Federal Reserve Bank of New York, or, if such rate is not so published for any day which is a Business Day, the average of the quotations for such day on such transactions received by NationsBank of North Carolina, N.A. from three Federal funds brokers of recognized standing selected by it. "Base Rate Advance" means an A Advance which bears interest as provided in Section 2.07(a). "Borrowing" means an A Borrowing or a B Borrowing. "Business Day" means a day of the year on which banks are not required or authorized to close in New York City and, if the applicable Business Day relates to any Eurodollar Rate Advances, on which dealings are carried on in the London interbank market. "Closing Date" means the date on which the conditions set forth in Section 3.01 applicable to the making of the initial Advances under this Agreement have been fulfilled. "Commitment" has the meaning specified in Section 2.01. "Commitment Percentage" means, with respect to each Lender, the percentage that such Lender's Commitment constitutes of the aggregate amount of the Commitments. "Convert", "Conversion" and "Converted" each refers to a conversion of Advances of one Type into Advances of another Type pursuant to Section 2.09 or 2.10. "Debt" means (i) indebtedness for borrowed money, however evidenced, including obligations under letters of credit, (ii) obligations to pay the deferred purchase price of property or services (other than trade indebtedness incurred in the ordinary course of business), (iii) obligations as lessee under leases recorded as capital leases in accordance with generally accepted accounting principles, and (iv) obligations under direct or indirect guaranties in respect of, and obligations (contingent or otherwise) to assure a creditor against loss in respect of, indebtedness or obligations of others of the kinds referred to in clauses (i) through (iii) above. "Domestic Lending Office" means, with respect to any Lender, the office of such Lender specified as its "Domestic Lending Office" opposite its name on Schedule I hereto or in the Assignment and Acceptance pursuant to which it became a Lender, or such other office of such Lender as such Lender may from time to time specify to the Borrower and the Agent. "Eligible Assignee" means (i) a commercial bank organized or licensed to operate under the laws of the United States, or any State thereof, and having a combined capital and surplus of at least $50,000,000, or (ii) a commercial bank organized under the laws of any other country which is a member of the Organization for Economic Cooperation and Development or has concluded special lending arrangements with the International Monetary Fund associated with its General Arrangements to Borrow and having a combined capital and surplus of at least $50,000,000, provided that such bank is acting through a branch or agency located in the United States. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended from time to time, and the regulations promulgated and rulings issued thereunder. "ERISA Affiliate" of any Person means any other Person that for purposes of Title IV of ERISA is a member of such Person's controlled group, or under common control with such Person, within the meaning of Section 414 of the Internal Revenue Code of 1986, as amended, and the regulations promulgated and rulings issued thereunder. "ERISA Event" means (a) a reportable event, within the meaning of Section 4043 of ERISA, unless the 30-day notice requirement with respect thereto has been waived by the Pension Benefit Guaranty Corporation; (b) the provision by the administrator of any Plan of a notice of intent to terminate such Plan, pursuant to Section 4041(a)(2) of ERISA (including any such notice with respect to a plan amendment referred to in Section 4041(e) of ERISA; (c) the cessation of operations at a facility in the circumstances described in Section 4068(f) of ERISA; (d) the withdrawal by the Borrower or any of its ERISA Affiliates from a Multiple Employer Plan during a plan year for which is was a substantial employer, as defined in Section 4001(a)(2) of ERISA; (e) the failure by the Borrower or any of its ERISA Affiliates to make a payment to a plan required under Section 302(f)(1) of ERISA; (f) the adoption of an amendment to a Plan requiring the provision of security to such Plan, pursuant to Section 307 of ERISA; or (g) the institution by the PBGC of proceedings to terminate a Plan, pursuant to Section 4042 of ERISA, or the occurrence of any event or condition that might constitute grounds under Section 4042 of ERISA for the termination of, or the appointment of a trustee to administer, a Plan. "Eurocurrency Liabilities" has the meaning assigned to that term in Regulation D of the Board of Governors of the Federal Reserve System, as in effect from time to time. "Eurodollar Lending Office" means, with respect to any Lender, the office of such Lender specified as its "Eurodollar Lending Office" opposite its name on Schedule I hereto or in the Assignment and Acceptance pursuant to which it became a Lender (or, if no such office is specified, its Domestic Lending Office), or such other office of such Lender as such Lender may from time to time specify to the Borrower and the Agent. "Eurodollar Rate" means, for the Interest Period for each Eurodollar Rate Advance comprising part of the same A Borrowing, an interest rate per annum equal to the average (rounded upward to the nearest whole multiple of 1/16 of 1% per annum, if such average is not such a multiple) of the rate per annum at which deposits in U.S. dollars are offered by the principal office of each of the Reference Banks in London, England to prime banks in the London interbank market at 11:00 A.M. (London time) two Business Days before the first day of such Interest Period in an amount substantially equal to such Reference Bank's Eurodollar Rate Advance comprising part of such A Borrowing and for a period equal to such Interest Period. The Eurodollar Rate for the Interest Period for each Eurodollar Rate Advance comprising part of the same A Borrowing shall be determined by the Agent on the basis of applicable rates furnished to and received by the Agent from the Reference Banks two Business Days before the first day of such Interest Period, subject, however, to the provisions of Section 2.09. "Eurodollar Rate Advance" means an A Advance which bears interest as provided in Section 2.07(b). "Eurodollar Rate Reserve Percentage" of any Lender for the Interest Period for any Eurodollar Rate Advance means the reserve percentage applicable during such Interest Period (or if more than one such percentage shall be so applicable, the daily average of such percentages for those days in such Interest Period during which any such percentage shall be so applicable) under regulations issued from time to time by the Board of Governors of the Federal Reserve System (or any successor) for determining the maximum reserve requirement (including, without limitation, any emergency, supplemental or other marginal reserve requirement) for such Lender with respect to liabilities or assets consisting of or including Eurocurrency Liabilities having a term equal to such Interest Period. "Events of Default" has the meaning specified in Section 6.01. "Extension Date" has the meaning specified in Section 2.17. "Facility Fee" shall have the meaning assigned to such term in Section 2.04(a). "Federal Funds Rate" means, for any period, a fluctuating interest rate per annum equal for each day during such period to the weighted average of the rates on overnight Federal funds transactions with members of the Federal Reserve System arranged by Federal funds brokers, as published for such day (or, if such day is not a Business Day, for the next preceding Business Day) by the Federal Reserve Bank of New York, or, if such rate is not so published for any day which is a Business Day, the average of the quotations for such day on such transactions received by the Agent from three Federal funds brokers of recognized standing selected by it. "Insufficiency" means, with respect to any Plan, the amount, if any, of its unfunded benefit liabilities within the meaning of Section 4001(a)(18) of ERISA. "Interest Period" means, for each A Advance comprising part of the same A Borrowing, the period commencing on the date of such A Advance or the date of the Conversion of any A Advance into such an A Advance and ending on the last day of the period selected by the Borrower pursuant to the provisions below and, thereafter, each subsequent period commencing on the last day of the immediately preceding Interest Period and ending on the last day of the period selected by the Borrower pursuant to the provisions below. The duration of each such Interest Period shall be 1, 3 or 6 months in the case of a Eurodollar Rate Advance, in each case as the Borrower may, upon notice received by the Agent not later than 11:00 A.M. (New York City time) on the third Business Day prior to the first day of such Interest Period, select; provided, however, that: (i) the duration of any Interest Period which commences before the Termination Date and otherwise ends after such date shall end on such date; (ii) the duration of any Interest Period which commences before an assignment pursuant to Section 8.07 and otherwise ends after the date of such assignment shall end on such date and all accrued and unpaid interest shall be due and payable on such date; (iii) Interest Periods commencing on the same date for A Advances comprising part of the same A Borrowing shall be of the same duration; and (iv) whenever the last day of any Interest Period would otherwise occur on a day other than a Business Day, the last day of such Interest Period shall be extended to occur on the next succeeding Business Day, provided, in the case of any Interest Period for a Eurodollar Rate Advance, that if such extension would cause the last day of such Interest Period to occur in the next following calendar month, the last day of such Interest Period shall occur on the next preceding Business Day. "Lenders" means the Banks listed on the signature pages hereof and each Eligible Assignee that shall become a party hereto pursuant to Section 8.07. "Majority Lenders" means at any time Lenders holding at least 51% of the then aggregate unpaid principal amount of the A Notes held by Lenders, or, if no such principal amount is then outstanding, Lenders having at least 51% of the Commitments (provided that, for purposes hereof, neither the Borrower, nor any of its Affiliates, if a Lender, shall be included in (i) the Lenders holding such amount of the A Advances or having such amount of the Commitments or (ii) determining the aggregate unpaid principal amount of the A Advances or the total Commitments). "Margin Regulations" means the margin stock regulations issued by the Board of Governors of the Federal Reserve System applicable to the Lenders and/or to the Borrower. "Moody's" shall mean Moody's Investors Service, Inc. "Moody's Rating" means the rating assigned to the Borrower's senior unsecured debt by Moody's Investors Service, Inc. "Multiemployer Plan" means a multiemployer plan, as defined in Section 4001(a)(3) of ERISA, to which the Borrower or any of its ERISA Affiliates is making or accruing an obligation to make contributions, or has within any of the preceding five plan years made or accrued an obligation to make contributions, such plan being maintained pursuant to one or more collective bargaining agreements. "Multiple Employer Plan" means a single employer plan, as defined in Section 4001(a)(15) of ERISA, that (a) is maintained for employees of the Borrower or any of its ERISA Affiliates and at least one Person other than the Borrower and its ERISA Affiliates or (b) was so maintained and in respect of which the Borrower or any of its ERISA Affiliates could have liability under Section 4064 or 4069 of ERISA in the event such plan has been or were to be terminated. "Note" means an A Note, a B Note or the promissory note executed by the Borrower in favor of the Swingline Lender to evidence the Swingline Advances. "Notice of an A Borrowing" has the meaning specified in Section 2.02(a). "Notice of a B Borrowing" has the meaning specified in Section 2.03(a). "Person" means an individual, partnership, corporation (including a business trust), joint stock company, trust, unincorporated association, joint venture or other entity, or a government or any political subdivision or agency thereof. "Plan" means a Single Employer Plan or a Multiple Employer Plan. "Rating Event" means any of the following: (i) the Borrower's senior unsecured debt is rated by both S&P and Moody's and the Standard & Poor's Rating is lower than or equal to BBB+ or the Moody's Rating is lower than or equal to Baa1 or (ii) the Borrower's senior unsecured debt is rated by only one of S&P or Moody's and the Standard & Poor's Rating is lower than or equal to BBB+ or the Moody's Rating is lower than or equal to Baa1, as the case may be, or (iii) the Borrower's senior unsecured debt is not rated by either S&P or Moody's. "Reference Banks" means NationsBank of North Carolina, N.A., Bank of America National Trust and Savings Association, The First National Bank of Chicago and The Chase Manhattan Bank, N.A. "Register" has the meaning specified in Section 8.07(c). "S&P" shall mean Standard and Poor's Corporation. "Single Employer Plan" means a single employer plan, as defined in Section 4001(a)(15) of ERISA, that (a) is maintained for employees of the Borrower or any of its ERISA Affiliates and no Person other than the Borrower and its ERISA Affiliates or (b) was so maintained and in respect of which the Borrower or any of its ERISA Affiliates could have liability under Section 4069 of ERISA in the event such plan has been or were to be terminated. "Standard & Poor's Rating" means the rating assigned to the Borrower's senior unsecured debt by Standard & Poor's Corporation. "Swingline Advances" shall have the meaning given to such term in Section 2.18 hereof. "Swingline Lender" shall mean NationsBank. "Swingline Reduction" has the meaning specified in Section 2.01. "Termination Date" means (i) December 17, 1998 or such later date determined in accordance with the provisions of Section 2.17, provided, however, that the Termination Date shall not be in any event later than December 17, 2000 or (ii) the earlier date of termination in whole of the Commitments pursuant to Section 2.05 or 6.01. "Type" means, with respect to any Advance, a Base Rate Advance or a Eurodollar Rate Advance. "Withdrawal Liability" has the meaning assigned to such term under Part 1 of Subtitle E or Part IV of ERISA. SECTION 1.02. Computation of Time Periods. In this Agreement in the computation of periods of time from a specified date to a later specified date, the word "from" means "from and including" and the words "to" and "until" each means "to but excluding". SECTION 1.03. Accounting Terms. All accounting terms not specifically defined herein shall be construed in accordance with generally accepted accounting principles consistent with those applied in the preparation of the financial statements referred to in Section 4.01(e). ARTICLE II AMOUNTS AND TERMS OF THE ADVANCES SECTION 2.01. The A Advances. Each Lender severally agrees, on the terms and conditions hereinafter set forth, to make A Advances to the Borrower from time to time on any Business Day during the period from the date hereof until the Termination Date in an aggregate amount not to exceed at any time outstanding the amount set forth opposite such Lender's name on the signature pages hereof or, if such Lender has entered into any Assignment and Acceptance, set forth for such Lender in the Register maintained by the Agent pursuant to Section 8.07(c), as such amount may be reduced or increased pursuant to Section 2.05 (such Lender's "Commitment"), provided that the aggregate amount of the Commitments of the Lenders shall be deemed used from time to time to the extent of the aggregate amount of the B Advances then outstanding and such deemed use of the aggregate amount of the Commitments shall be applied to the Lenders ratably according to their respective Commitments (such deemed use of the aggregate amount of the Commitments being a "B Reduction"), provided further, that the aggregate amount of the Commitments of the Lenders shall be deemed used from time to time to the extent of the aggregate amount of the Swingline Advances then outstanding and such deemed use of the aggregate amount of the Commitments shall be applied to the Lenders ratably according to their respective Commitments (such deemed use of the aggregate amount of the Commitments being a "Swingline Reduction"). Each A Borrowing shall be in an aggregate amount not less than $10,000,000 or an integral multiple of $1,000,000 in excess thereof and shall consist of A Advances of the same Type made on the same day by the Lenders ratably according to their respective Commitments. Within the limits of each Lender's Commitment, the Borrower may from time to time borrow, prepay pursuant to Section 2.11(b) and reborrow from time to time under this Section 2.01. SECTION 2.02. Making the A Advances. (a) Each A Borrowing shall be made on notice, given not later than 11:00 A.M. (New York City time) on the third Business Day prior to the date of the proposed A Borrowing, by the Borrower to the Agent, which shall give to each Lender prompt notice thereof by telecopier, telex or cable; provided, however, that in the event such notice is with respect to a proposed Base Rate Advance, such notice shall be given not later than 10:00 A.M. (New York City time) on the Business Day of the proposed Base Rate Advance. Each such notice of an A Borrowing (a "Notice of A Borrowing") shall be by telecopier, telex or cable, confirmed immediately in writing, in substantially the form of Exhibit B-1 hereto, specifying therein the requested (i) date of such A Borrowing, (ii) Type of A Advances comprising such A Borrowing, (iii) aggregate amount of such A Borrowing, and (iv) in the case of an A Borrowing comprised of Eurodollar Rate Advances, initial Interest Period for each such A Advance. Each Lender shall, before 11:00 A.M. (New York City time) on the date of such A Borrowing, make available for the account of its Applicable Lending Office to the Agent at its address referred to in Section 8.02, in same day funds, such Lender's ratable portion of such A Borrowing, provided, however, that upon any assignment pursuant to Section 8.07, the assignee shall therewith make available to the Agent, and the Borrower shall immediately reborrow upon the same terms and conditions, the Advances of the assignor repaid in connection with such assignment. After the Agent's receipt of such funds and upon fulfillment of the applicable conditions set forth in Article III, the Agent will make such same day funds available to the Borrower at the Borrower's account maintained with the Agent. (b) Each Notice of A Borrowing shall be irrevocable and binding on the Borrower. In the case of any A Borrowing which the related Notice of A Borrowing specifies is to be comprised of Eurodollar Rate Advances, the Borrower shall indemnify each Lender against any loss, cost or reasonable expense incurred by such Lender as a result of any failure to fulfill on or before the date specified in such Notice of A Borrowing for such A Borrowing the applicable conditions set forth in Article III, including, without limitation, any loss (other than the loss of anticipated profits), cost or reasonable expense incurred by reason of the liquidation or reemployment of deposits or other funds acquired by such Lender to fund the A Advance to be made by such Lender as part of such A Borrowing when such A Advance, as a result of such failure, is not made on such date. The amount of such loss, cost or expense shall be determined by such Lender and notified to the Borrower through the Agent in the form of a certificate of such Lender stating that the calculations set forth therein are in accordance with the terms of this Agreement and setting forth in reasonable detail the basis of such calculations, such certificate being conclusive and binding for all purposes absent manifest error and unless contested by the Borrower within 10 Business Days of its receipt of such certificate, and the amount set forth therein being payable in any event by the Borrower to such Lender on or before the 10th Business Day following delivery of such certificate to the Borrower. (c) Unless the Agent shall have received notice from a Lender prior to the date of any A Borrowing that such Lender will not make available to the Agent such Lender's ratable portion of such A Borrowing, the Agent may assume that such Lender has made such portion available to the Agent on the date of such A Borrowing in accordance with subsection (a) of this Section 2.02 and the Agent may, in reliance upon such assumption, make available to the Borrower on such date a corresponding amount. If and to the extent that such Lender shall not have so made such ratable portion available to the Agent, such Lender and the Borrower severally agree to repay to the Agent forthwith on demand such corresponding amount together with interest thereon, for each day from the date such amount is made available to the Borrower until the date such amount is repaid to the Agent, at (i) in the case of the Borrower, the interest rate applicable at the time to A Advances comprising such A Borrowing and (ii) in the case of such Lender, the Federal Funds Rate. If such Lender shall repay to the Agent such corresponding amount, such amount so repaid shall constitute such Lender's A Advance as part of such A Borrowing for purposes of this Agreement. (d) The failure of any Lender to make the A Advance to be made by it as part of any A Borrowing shall not relieve any other Lender of its obligation, if any, hereunder to make its A Advance on the date of such A Borrowing, but no Lender shall be responsible for the failure of any other Lender to make the A Advance to be made by such other Lender on the date of any A Borrowing. SECTION 2.03. The B Advances. (a) Each Lender severally agrees that the Borrower may make B Borrowings under this Section 2.03 from time to time on any Business Day during the period from the date hereof until the date occurring 30 days prior to the Termination Date in the manner set forth below; provided that, following the making of each B Borrowing, the aggregate amount of the Advances then outstanding shall not exceed the aggregate amount of the Commitments of the Lenders (computed without regard to any B Reduction). (i) The Borrower may request a B Borrowing under this Section 2.03 by delivering to the Agent, by telecopier, telex or cable, confirmed immediately in writing, a notice of a B Borrowing (a "Notice of B Borrowing"), in substantially the form of Exhibit B-2 hereto, specifying the date and aggregate amount of the proposed B Borrowing, the maturity date for repayment of each B Advance to be made as part of such B Borrowing (which maturity date may not be earlier than the date occurring 10 days after the date of such B Borrowing or later than the Termination Date), the interest payment date or dates relating thereto, and any other terms to be applicable to such B Borrowing, not later than 10:00 A.M. (New York City time) (A) at least one Business Day prior to the date of the proposed B Borrowing, if the Borrower shall specify in the Notice of B Borrowing that the rates of interest to be offered by the Lenders shall be fixed rates per annum and (B) at least four Business Days prior to the date of the proposed B Borrowing, if the Borrower shall instead specify in the Notice of B Borrowing the basis to be used by the Lenders in determining the rates of interest to be offered by them. The Agent shall in turn promptly notify each Lender of each request for a B Borrowing received by it from the Borrower by sending such Lender a copy of the related Notice of B Borrowing. (ii) Each Lender may, if, in its sole discretion, it elects to do so, irrevocably offer to make one or more B Advances to the Borrower as part of such proposed B Borrowing at a rate or rates of interest specified by such Lender in its sole discretion, by notifying the Agent (which shall give prompt notice thereof to the Borrower), before 10:00 A.M. (New York City time) (A) on the date of such proposed B Borrowing, in the case of a Notice of B Borrowing delivered pursuant to clause (A) of paragraph (i) above and (B) three Business Days before the date of such proposed B Borrowing, in the case of a Notice of B Borrowing delivered pursuant to clause (B) of paragraph (i) above, of the minimum amount and maximum amount of each B Advance which such Lender would be willing to make as part of such proposed B Borrowing (which amounts may, subject to the proviso to the first sentence of this Section 2.03(a), exceed such Lender's Commitment), the rate or rates of interest therefor and such Lender's Applicable Lending Office with respect to such B Advance; provided that if the Agent in its capacity as a Lender shall, in its sole discretion, elect to make any such offer, it shall notify the Borrower of such offer before 9:00 A.M. (New York City time) on the date on which notice of such election is to be given to the Agent by the other Lenders. If any Lender shall elect not to make such an offer, such Lender shall so notify the Agent, before 10:00 A.M. (New York City time) on the date on which notice of such election is to be given to the Agent by the other Lenders, and such Lender shall not be obligated to, and shall not, make any B Advance as part of such B Borrowing; provided that the failure by any Lender to give such notice shall not cause such Lender to be obligated to make any B Advance as part of such proposed B Borrowing. (iii) The Borrower shall, in turn, (A) before 11:00 A.M. (New York City time) on the date of such proposed B Borrowing, in the case of a Notice of B Borrowing delivered pursuant to clause (A) of paragraph (i) above and (B) before 1:00 P.M. (New York City time) three Business Days before the date of such proposed B Borrowing, in the case of a Notice of B Borrowing delivered pursuant to clause (B) of paragraph (i) above, either (x) cancel such B Borrowing by giving the Agent notice to that effect, or (y) accept one or more of the offers made by any Lender or Lenders pursuant to paragraph (ii) above, in its sole discretion, by giving notice to the Agent of the amount of each B Advance (which amount shall be equal to or greater than the minimum amount, and equal to or less than the maximum amount, notified to the Borrower by the Agent on behalf of such Lender for such B Advance pursuant to paragraph (ii) above) to be made by each Lender as part of such B Borrowing, and reject any remaining offers made by Lenders pursuant to paragraph (ii) above by giving the Agent notice to that effect. (iv) If the Borrower notifies the Agent that such B Borrowing is cancelled pursuant to paragraph (iii)(x) above, the Agent shall give prompt notice thereof to the Lenders and such B Borrowing shall not be made. (v) If the Borrower accepts one or more of the offers made by any Lender or Lenders pursuant to paragraph (iii)(y) above, the Agent shall in turn promptly notify (A) each Lender that has made an offer as described in paragraph (ii) above, of the date and aggregate amount of such B Borrowing and whether or not any offer or offers made by such Lender pursuant to paragraph (ii) above have been accepted by the Borrower, (B) each Lender that is to make a B Advance as part of such B Borrowing, of the amount of each B Advance to be made by such Lender as part of such B Borrowing, and (C) each Lender that is to make a B Advance as part of such B Borrowing, upon receipt, that the Agent has received forms of documents appearing to fulfill the applicable conditions set forth in Article III. Each Lender that is to make a B Advance as part of such B Borrowing shall, before 12:00 noon (New York City time) on the date of such B Borrowing specified in the notice received from the Agent pursuant to clause (A) of the preceding sentence or any later time when such Lender shall have received notice from the Agent pursuant to clause (C) of the preceding sentence, make available for the account of its Applicable Lending Office to the Agent at its address referred to in Section 8.02 such Lender's portion of such B Borrowing, in same day funds. Upon fulfillment of the applicable conditions set forth in Article III and after receipt by the Agent of such funds, the Agent will make such funds available to the Borrower at the Agent's aforesaid address. Promptly after each B Borrowing the Agent will notify each Lender of the amount of the B Borrowing, the consequent B Reduction and the dates upon which such B Reduction commenced and will terminate. (b) Each B Borrowing shall be in an aggregate amount not less than $10,000,000 or an integral multiple of $1,000,000 in excess thereof and, following the making of each B Borrowing, the Borrower shall be in compliance with the limitation set forth in the proviso to the first sentence of subsection (a) above. (c) Within the limits and on the conditions set forth in this Section 2.03, the Borrower may from time to time borrow under this Section 2.03, repay or prepay pursuant to subsection (d) below, and reborrow under this Section 2.03, provided that a B Borrowing shall not be made within five Business Days of the date of any other B Borrowing. (d) The Borrower shall repay to the Agent for the account of each Lender which has made a B Advance, or each other holder of a B Note, on the maturity date of each B Advance (such maturity date being that specified by the Borrower for repayment of such B Advance in the related Notice of B Borrowing delivered pursuant to subsection (a)(i) above and provided in the B Note evidencing such B Advance), the then unpaid principal amount of such B Advance. The Borrower shall have no right to prepay any principal amount of any B Advance unless, and then only on the terms, specified by the Borrower for such B Advance in the related Notice of B Borrowing delivered pursuant to subsection (a)(i) above and set forth in the B Note evidencing such B Advance. (e) The Borrower shall pay interest on the unpaid principal amount of each B Advance from the date of such B Advance to the date the principal amount of such B Advance is repaid in full, at the rate of interest for such B Advance specified by the Lender making such B Advance in its notice with respect thereto delivered pursuant to subsection (a)(ii) above, payable on the interest payment date or dates specified by the Borrower for such B Advance in the related Notice of B Borrowing delivered pursuant to subsection (a)(i) above, as provided in the B Note evidencing such B Advance. (f) The indebtedness of the Borrower resulting from each B Advance made to the Borrower as part of a B Borrowing shall be evidenced by a separate B Note of the Borrower payable to the order of the Lender making such B Advance. SECTION 2.04. Fees. (a) Facility Fee. The Borrower agrees to pay to the Agent, for the account of each Lender, a facility fee (the "Facility Fee") from the date hereof in the case of each Bank and from the effective date specified in the Assignment and Acceptance pursuant to which it became a Lender in the case of each other Lender until the Termination Date, payable on the first day of each March, June, September and December during the term of such Lender's Commitment, commencing March 1, 1994, and on the Termination Date, in an amount equal to the Applicable Fee Percentage multiplied by the daily average Commitment (whether used or unused) of such Lender. (b) Agent's Fees. The Borrower shall pay to the Agent for its own account such fees as may from time to time be agreed between the Borrower and the Agent. SECTION 2.05. Reduction of the Commitments. (a) Reduction. The Borrower shall have the right, upon at least 10 Business Days' notice to the Agent, to terminate in whole or reduce ratably in part the unused portions of the respective Commitments of the Lenders, provided that the aggregate amount of the Commitments of the Lenders shall not be reduced to an amount which is less than the aggregate principal amount of the B Advances and Swingline Advances then outstanding, provided, further, that each partial reduction shall be in the aggregate amount of $10,000,000 or an integral multiple of $5,000,000 in excess thereof and provided, further, that the aggregate amount of the Commitments of the Lenders, after giving effect to the B Reductions and the Swingline Reductions, shall not be reduced below $100,000,000. (b) [intentionally left blank]. SECTION 2.06. Repayment of A Advances. The Borrower shall repay the principal amount of each A Advance made by each Lender in accordance with the A Note to the order of such Lender. SECTION 2.07. Interest on A Advances. The Borrower shall pay interest on the unpaid principal amount of each A Advance made by each Lender from the date of such A Advance until such principal amount shall be paid in full, at the following rates per annum: (a) Base Rate Advances. If such A Advance is a Base Rate Advance, a rate per annum equal at all times to the Base Rate in effect from time to time, payable monthly in arrears on the first Business Day of each month during such periods and on the date such Base Rate Advance shall be Converted or paid in full; provided that any amount of principal which is not paid when due (whether at stated maturity, by acceleration or otherwise) shall bear interest, from the date on which such amount is due until such amount is paid in full, payable on demand, at a rate per annum equal at all times to 2% per annum above the Base Rate in effect from time to time. (b) Eurodollar Rate Advances. If such A Advance is a Eurodollar Rate Advance, a rate per annum equal at all times during the Interest Period for such A Advance to the Eurodollar Rate for such Interest Period plus the Applicable Margin, payable on the last day of such Interest Period and, if such Interest Period has a duration of more than three months, on each day which occurs during such Interest Period every three months from the first day of such Interest Period; provided that any amount of principal which is not paid when due (whether at stated maturity, by acceleration or otherwise) shall bear interest, from the date on which such amount is due until such amount is paid in full, payable on demand, at a rate per annum equal at all times to the greater of (x) 2% per annum above the Base Rate in effect from time to time and (y) 2% per annum above the rate per annum required to be paid on such A Advance immediately prior to the date on which such amount became due. SECTION 2.08. Additional Interest on Eurodollar Rate Advances. The Borrower shall pay to each Lender, so long as such Lender shall be required under regulations of the Board of Governors of the Federal Reserve System to maintain reserves with respect to liabilities or assets consisting of or including Eurocurrency Liabilities, additional interest on the unpaid principal amount of each Eurodollar Rate Advance of such Lender, from the date of such A Advance until such principal amount is paid in full, at an interest rate per annum equal at all times to the remainder obtained by subtracting (i) the Eurodollar Rate for the Interest Period for such A Advance from (ii) the rate obtained by dividing such Eurodollar Rate by a percentage equal to 100% minus the Eurodollar Rate Reserve Percentage of such Lender for such Interest Period, payable on each date on which interest is payable on such A Advance. Such additional interest shall be determined by such Lender and notified to the Borrower through the Agent in the form of a certificate of such Lender stating that the calculations set forth therein are in accordance with the terms of this Agreement and setting forth in reasonable detail the basis of such calculation, such certificate being conclusive and binding for all purposes absent manifest error and unless contested by the Borrower within 10 Business Days of its receipt of such certificate, and such amounts being payable by the Borrower in any event on or before the 10th Business Day following delivery of such certificates to the Borrower. SECTION 2.09. Interest Rate Determination. (a) Each Reference Bank agrees to furnish to the Agent timely information for the purpose of determining each Eurodollar Rate. If any one or more of the Reference Banks shall not furnish such timely information to the Agent for the purpose of determining any such interest rate, the Agent shall determine such interest rate on the basis of timely information furnished by the remaining Reference Banks. (b) The Agent shall give prompt notice to the Borrower and the Lenders of the applicable interest rate determined by the Agent for purposes of Section 2.07(a) or (b), and the applicable rate, if any, furnished by each Reference Bank for the purpose of determining the applicable interest rate under Section 2.07(b). (c) If fewer than two Reference Banks furnish timely information to the Agent for determining the Eurodollar Rate for any Eurodollar Rate Advance, the Eurodollar Rate for such Eurodollar Rate Advance shall be a rate of interest determined on the basis of at least two offered rates for deposits in United States dollars for a period equal to the Interest Period applicable to such Eurodollar Rate Advance commencing on the first day of such Interest Period appearing on the Reuters Screen LIBO Page as of 11:00 a.m. (London time) on the day that is two Business Days prior to the first day of such Interest Period. If at least two such offered rates appear on the Reuters Screen LIBO Page, the rate with respect to each Interest Period will be the arithmetic average (rounded upwards to the next 1/16th of 1%) of such offered rates. If fewer than two offered rates appear: (i) the Agent shall forthwith notify the Borrower and the Lenders that the interest rate cannot be determined for such Eurodollar Rate Advances, as the case may be, (ii) each such Advance will automatically, on the last day of the then existing Interest Period therefor, Convert into a Base Rate Advance, and (iii) the obligation of the Lenders to make, or to Convert Base Rate Advances into, Eurodollar Rate Advances shall be suspended until the Agent shall notify the Borrower and the Lenders that the circumstances causing such suspension no longer exist. Each Reference Bank shall use its best efforts to provide timely information to the Agent for the purpose of determining the Eurodollar Rate. (d) If, with respect to any Eurodollar Rate Advances, the Majority Lenders notify the Agent that the Eurodollar Rate for any Interest Period for such Advances will not adequately reflect the cost to such Majority Lenders of making, funding or maintaining their respective Eurodollar Rate Advances for such Interest Period, the Agent shall forthwith so notify the Borrower and the Lenders, whereupon (i) each Eurodollar Rate Advance will automatically, on the last day of the then existing Interest Period therefor, Convert into a Base Rate Advance, and (ii) the obligation of the Lenders to make, or to Convert A Advances into, Eurodollar Rate Advances shall be suspended until the Agent shall notify the Borrower and the Lenders that the circumstances causing such suspension no longer exist. (e) If the Borrower shall fail to select the duration of any Interest Period for any Eurodollar Rate Advances in accordance with the provisions contained in the definition of "Interest Period" in Section 1.01, the Agent will forthwith so notify the Borrower and the Lenders and such advances will automatically, on the last day of the then existing Interest Period therefor, Convert into Base Rate Advances. (f) On the date on which the aggregate unpaid principal amount of A Advances comprising any A Borrowing shall be reduced, by payment or prepayment or otherwise, to less than $10,000,000, such A Advances shall, if they are Advances of a Type other than Base Rate Advances, automatically Convert into Base Rate Advances, and on and after such date the right of the Borrower to Convert such A Advances into Advances of a Type other than Base Rate Advances shall terminate; provided, however, that if and so long as each such A Advance shall be of the same Type and have the same Interest Period as A Advances comprising another A Borrowing or other A Borrowings, and the aggregate unpaid principal amount of all such A Advances shall equal or exceed $10,000,000, the Borrower shall have the right to continue all such A Advances as, or to Convert all such A Advances into, Advances of such Type having such Interest Period. SECTION 2.10. Voluntary Conversion of A Advances. The Borrower may on any Business Day, upon notice given to the Agent not later than 11:00 A.M. (New York City time) on the third Business Day prior to the date of the proposed Conversion and subject to the provisions of Sections 2.09 and 2.13, Convert all A Advances of one Type comprising the same A Borrowing into Advances of another Type; provided, however, that any Conversion of any Eurodollar Rate Advances into Base Rate Advances shall be made on, and only on, the last day of an Interest Period for such Eurodollar Rate Advances. Each such notice of a Conversion shall, within the restrictions specified above, specify (i) the date of such Conversion, (ii) the A Advances to be Converted, and (iii) if such Conversion is into Eurodollar Rate Advances, the duration of the Interest Period for each such A Advance. SECTION 2.11. Prepayment of A Advances. (a) The Borrower shall have no right to prepay any principal amount of any A Advances other than as provided in subsection (b) below. (b) The Borrower may, upon at least 1 Business Day's notice to the Agent stating the proposed date and aggregate principal amount of the prepayment, and if such notice is given the Borrower shall, prepay the outstanding principal amounts of the Advances comprising part of the same A Borrowing in whole or ratably in part, together with accrued interest to the date of such prepayment on the principal amount prepaid; provided, however, that (x) each partial prepayment shall be in an aggregate principal amount not less than $1,000,000 and (y) in the case of any such prepayment of a Eurodollar Rate Advance, the Borrower shall be obligated to reimburse the Lenders in respect thereof pursuant to Section 8.04(b). SECTION 2.12. Increased Costs. (a) If, due to either (i) the introduction after the date of this Agreement of or any change (other than any change by way of imposition or increase of reserve requirements, in the case of Eurodollar Rate Advances, included in the Eurodollar Rate Reserve Percentage) in or in the interpretation of any law or regulation or (ii) the compliance with any guideline or request from any central bank or other governmental authority after the date of this Agreement (whether or not having the force of law), there shall be any increase in the cost to any Lender of agreeing to make or making, funding or maintaining Eurodollar Rate Advances under this Agreement, then the Borrower shall from time to time pay to the Agent for the account of such Lender, to the extent that such Lender reasonably determines such increase to be allocable to the existence of such Lender's commitment to lend hereunder, additional amounts sufficient to compensate such Lender for such increased cost. The amount of such increased cost shall be determined by such Lender and notified to the Borrower through the Agent in the form of a certificate of such Lender stating that the calculations set forth therein are in accordance with the terms of this Agreement and setting forth in reasonable detail the basis of such calculations, such certificate being conclusive and binding for all purposes absent manifest error and unless contested by the Borrower within 10 Business Days of its receipt of such certificate, and the amount set forth therein being payable in any event by the Borrower to such Lender on or before the 10th Business Day following delivery of such certificate to the Borrower. (b) If any Lender determines that compliance with any law or regulation or any guideline or request from any central bank or other governmental authority (whether or not having the force of law) affects or would affect the amount of capital required or expected to be maintained by such Lender or any corporation controlling such Lender and that the amount of such capital is increased by or based upon the existence of such Lender's commitment to lend hereunder and other commitments of this type or such Lender's Advances, then, on or before 10 Business Days after a demand by such Lender (with a copy of such demand to the Agent), the Borrower shall immediately pay to the Agent for the account of such Lender, from time to time as specified by such Lender, additional amounts sufficient to compensate such Lender or such corporation in the light of such circumstances, to the extent that such Lender reasonably determines such increase in capital to be allocable to the existence of such Lender's commitment to lend hereunder or such Lender's Advances. Such additional amounts shall be determined by such Lender and notified to the Borrower through the Agent in the form of a certificate of such Lender stating that the calculations set forth therein are in accordance with the terms of this Agreement and setting forth in reasonable detail the basis of such calculations, such certificate being conclusive and binding for all purposes absent manifest error and unless contested by the Borrower within 10 Business Days of its receipt of such certificate, and the amount set forth therein being payable in any event by the Borrower to such Lender on or before the 10th Business Day following delivery of such certificate to the Borrower. (c) Notwithstanding the foregoing, any Lender making written demand on Borrower for indemnification or compensation pursuant to paragraphs (a) or (b) of this Section 2.12 shall make such demand as soon as practicable after the Lender receives actual notice or obtains actual knowledge of the promulgation of a law, rule, order or interpretation or occurrence of another event giving rise to a claim pursuant to such paragraphs. In the event that such Lender fails to give Borrower the notice within the time limitation set forth in the preceding sentence, the Borrower shall have no obligation to pay such claim for indemnification or compensation accruing prior to the ninetieth day preceding such written demand. (d) Each Lender agrees that it will use reasonable efforts to designate an alternate lending office with respect to any of its Advances affected by the matters or circumstances described in paragraphs (a) or (b) of this Section 2.12, Section 2.13 or Section 2.14 to reduce the liability of Borrower or avoid the results provided thereunder, so long as such designation is not disadvantageous to such Lender as reasonably determined by such Lender. (e) If a Lender has notified the Borrower of any material increased costs pursuant to paragraph (a) or (b) of this Section 2.12, Borrower may, within 10 Business Days after such notice and upon at least 5 Business Days notice to such Lender, terminate the Commitment of such Lender; provided, that (i) any such termination shall be accompanied by prepayment in full of the aggregate principal amount of the Advances made by such Lender then outstanding, together with accrued interest thereon to the date of such prepayment, any other amounts owing to the Lender pursuant to this Agreement and reasonable costs and expenses incurred by such Lender in effecting such Commitment termination and (ii) no Event of Default, or an event which would constitute an Event of Default but for the requirement that notice be given or time elapse or both, shall exist as of the date of any such termination; provided, further, that the Borrower may terminate the Commitment of a Lender pursuant to this paragraph even if an Event of Default, or an event which would constitute an Event of Default but for the requirement that notice be given or time elapse or both, exists at the time of such termination, if the Lender's Commitment is assigned in accordance with Section 8.07. SECTION 2.13. Illegality. Notwithstanding any other provision of this Agreement, if any Lender or Lenders shall notify the Agent that after the date of this Agreement the introduction of or any change in or in the interpretation of any law or regulation makes it unlawful, or any central bank or other governmental authority asserts that it is unlawful, for any Lender or its Eurodollar Lending office to perform its obligations hereunder to make Eurodollar Rate Advances or to fund or maintain Eurodollar Rate Advances hereunder, (i) the obligation of the Lenders to make, or to Convert A Advances into, Eurodollar Rate Advances shall be suspended until the Agent shall notify the Borrower and the Lenders that the circumstances causing such suspension no longer exist and (ii) the Borrower shall either (A) forthwith prepay in full all Eurodollar Rate Advances of all Lenders then outstanding, together with interest accrued thereon, unless the Borrower, within five Business Days of notice from the Agent, Converts all Eurodollar Rate Advances of all Lenders then outstanding into Advances of another Type in accordance with Section 2.10 or (B) forthwith prepay in full all Eurodollar Rate Advances of such Lender or Lenders so notifying the Agent and reduce the Commitments of such Lenders by such amount. SECTION 2.14. Payments and Computations. (a) The Borrower shall make each payment hereunder and under the Notes not later than 11:00 A.M. (New York City time) on the day when due in U.S. dollars to the Agent at its address referred to in Section 8.02 in same day funds. The Agent will promptly thereafter cause to be distributed like funds relating to the payment of principal or interest or commitment fees ratably (other than amounts payable pursuant to Section 2.03, 2.08, 2.12, 2.13(ii)(B) or 2.15) to the Lenders for the account of their respective Applicable Lending Offices, and like funds relating to the payment of any other amount payable to any Lender to such Lender for the account of its Applicable Lending Office, in each case to be applied in accordance with the terms of this Agreement. Upon its acceptance of an Assignment and Acceptance and recording of the information contained therein in the Register pursuant to Section 8.07(d), from and after the effective date specified in such Assignment and Acceptance, the Agent shall make all payments hereunder and under the Notes in respect of the interest assigned thereby to the Lender assignee thereunder, and the parties to such Assignment and Acceptance shall make all appropriate adjustments in such payments for periods prior to such effective date directly between themselves. (b) All computations of interest based on the Base Rate and of fees set forth in Sections 2.04(a) shall be made by the Agent on the basis of a year of 365 or 366 days, as the case may be, and all computations of interest based on the Eurodollar Rate or the Federal Funds Rate shall be made by the Agent, and all computations of interest pursuant to Section 2.08 shall be made by a Lender, on the basis of a year of 360 days, in each case for the actual number of days including the first day but excluding the last day) occurring in the period for which such interest or commitment fees are payable. Each determination by the Agent (or, in the case of Section 2.08, by a Lender) of an interest rate hereunder shall be conclusive and binding for all purposes, absent manifest error. (c) Whenever any payment hereunder or under the Notes 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 payment of interest or commitment fee, as the case may be; provided, however, if such extension would cause payment of interest on or principal of Eurodollar Rate Advances to be made in the next following calendar month, such payment shall be made on the next preceding Business Day. (d) Unless the Agent shall have received notice from the Borrower prior to the date on which any payment is due to the Lenders hereunder that the Borrower will not make such payment in full, the Agent may assume that the Borrower has made such payment in full to the Agent on such date and the Agent may, in reliance upon such assumption, cause to be distributed to each Lender on such due date an amount equal to the amount then due such Lender. If and to the extent that the Borrower shall not have so made such payment in full to the Agent, each Lender shall repay to the Agent forthwith on demand such amount distributed to such Lender together with interest thereon, for each day from the date such amount is distributed to such Lender until the date such Lender repays such amount to the Agent, at the Federal Funds Rate. SECTION 2.15. Taxes. (a) Any and all payments by the Borrower hereunder or under the A Notes shall be made, in accordance with Section 2.14, free and clear of and without deduction for any and all present or future taxes, levies, imposts, deductions, charges or withholdings, and all liabilities with respect thereto, excluding, in the case of each Lender and the Agent, taxes imposed on its income, and franchise taxes imposed on it, by the jurisdiction under the laws of which such Lender or the Agent (as the case may be) is organized or any political subdivision thereof and, in the case of each Lender, taxes imposed on its income, and franchise taxes imposed on it, by the jurisdiction of such Lender's Applicable Lending Office or any political subdivision thereof (all such non-excluded taxes, levies, imposts, deductions charges, withholdings and liabilities being hereinafter referred to as "Taxes"). If the Borrower shall be required by law to deduct any Taxes from or in respect of any sum payable hereunder or under any A Note to any Lender or the Agent, (i) the sum payable shall be increased as may be necessary so that after making all required deductions (including deductions applicable to additional sums payable under this Section 2.15) such Lender or the Agent (as the case may be) receives an amount equal to the sum it would have received had not such deductions been made, (ii) the Borrower shall make such deductions and (iii) the Borrower shall pay the full amount deducted to the relevant taxation authority or other authority in accordance with applicable law. (b) In addition, the Borrower agrees to pay any present or future stamp or documentary taxes or any other excise or property taxes, charges or similar levies which arise from any payment made hereunder or under the A Notes or from the execution, delivery or registration of, or otherwise with respect to, this Agreement or the A Notes (hereinafter referred to as "Other Taxes"). (c) The Borrower will indemnify each Lender and the Agent for the full amount of Taxes or Other Taxes (including, without limitation, any Taxes or Other Taxes imposed by any jurisdiction on amounts payable under this Section 2.15) paid by such Lender or the Agent (as the case may be) and any liability (including penalties, interest and expenses) arising therefrom or with respect thereto, whether or not such Taxes or Other Taxes were correctly or legally asserted. Such indemnification shall be made within 30 days from the date the Lender or the Agent (as the case may be) makes written demand therefor. The Borrower may contest whether such Taxes or Other Taxes were correctly or legally asserted within 30 days from the date of such demand. In the event that subsequent to the Borrower's indemnification of a Lender or the Agent it is determined that such Taxes or Other Taxes were incorrectly asserted and such Lender or the Agent receives a refund of such Taxes or Other Taxes, such Lender or the Agent shall, within 10 days of receiving such refund, pay to the Borrower the amount of such refund allocable to this Agreement together with any interest received by such Lender or the Agent on account thereof. (d) Prior to the date of the initial Borrowing in the case of each Bank, and on the date of the Assignment and Acceptance pursuant to which it became a Lender in the case of each other Lender, and from time to time thereafter if requested by the Borrower or the Agent, each Lender organized under the laws of a jurisdiction outside the United States shall provide the Agent and the Borrower with the forms prescribed by the Internal Revenue Service of the United States certifying as to such Lender's status for purposes of determining exemption from United States withholding taxes with respect to all payments to be made to such Lender hereunder and under the Notes or other documents satisfactory to the Borrower and the Agent indicating that all payments to be made to such Lender hereunder and under the Notes are subject to such taxes at a rate reduced by an applicable tax treaty. Unless the Borrower and the Agent have received forms or other documents satisfactory to them indicating that payments hereunder or under any Note are not subject to United States withholding tax or are subject to such tax at a rate reduced by an applicable tax treaty, the Borrower or the Agent shall withhold taxes from such payments at the applicable statutory rate in the case of payments to or for any Lender organized under the laws of a jurisdiction outside the United States. (e) Any Lender claiming any additional amounts payable pursuant to this Section 2.15 shall use its best efforts (consistent with its internal policy and legal and regulatory restrictions) to change the jurisdiction of its Applicable Lending Office if the making of such a change would avoid the need for, or reduce the amount of, any such additional amounts which may thereafter accrue and would not, in the reasonable judgment of such Lender, be otherwise disadvantageous to such Lender. (f) Without prejudice to the survival of any other agreement hereunder, the agreements and obligations contained in this Section 2.15 shall survive the payment in full of principal and interest hereunder and under the A Notes. SECTION 2.16. Sharing of Payments, Etc. If any Lender shall obtain any payment (whether voluntary, involuntary, through the exercise of any right of set-off, or otherwise) on account of the A Advances made by it (other than pursuant to Section 2.08, 2.12, 2.13(ii)(B), 2.15 or 8.07) in excess of its ratable share of payments on account of the A Advances obtained by all the Lenders, such Lender shall forthwith purchase from the other Lenders such participations in the A Advances made by them as shall be necessary to cause such purchasing Lender to share the excess payment ratably with each of them, provided, however, that if all or any portion of such excess payment is thereafter recovered from such purchasing Lender, such purchase from each Lender shall be rescinded and such Lender shall repay to the purchasing Lender the purchase price to the extent of such recovery together with an amount equal to such Lender's ratable share (according to the proportion of (i) the amount of such Lender's required repayment to (ii) the total amount so recovered from the purchasing Lender) of any interest or other amount paid or payable by the purchasing Lender in respect of the total amount so recovered. The Borrower agrees that any Lender so purchasing a participation from another Lender pursuant to this Section 2.16 may, to the fullest extent permitted by law, exercise all its rights of payment (including the right of set- off) with respect to such participation as fully as if such Lender were the direct creditor of the Borrower in the amount of such participation. SECTION 2.17. Extension of Maturity. So long as no Event of Default shall have occurred and be continuing or if any Event of Default shall have occurred and shall have been waived, the Borrower may, prior to each of December 17, 1998 and December 17, 1999 (each, an "Extension Date"), request an extension of the Termination Date for a one-year period by giving notice of such request not less than 90 days nor more than 120 days prior to such Extension Date to the Agent and executing and delivering to each Lender a completed Extension Letter in the form of Exhibit "F" hereto, requesting the extension of the Termination Date. Each Lender may, in its sole discretion, execute such letter and return copies thereof to the Agent and the Borrower. Any Lender which fails to execute and return its copies of the Extension Letter on or before the date 60 days prior to the applicable Extension Date shall be deemed to have denied the Borrower's request. If, on the date 60 days before the applicable Extension Date, the Agent has received Extension Letters from Lenders holding at least 60% but less than 100% in aggregate principal amount of the Commitments, the Borrower may (i) require each Lender who has denied the Borrower's request to transfer all such Lender's rights and obligations under this Agreement to another financial institution or institutions, which shall be in each case (A) an Eligible Assignee selected by the Borrower willing to assume such rights and obligations and to consent to the extension of the Termination Date, in accordance with the provisions of Section 8.07 and (B) assuming a Commitment in an amount not less than $10,000,000 or an integral multiple of $1,000,000 in excess thereof or (ii) repay in whole or in part accrued and unpaid principal, interest and fees with respect to the Commitments and Advances of each Lender who has denied the Borrower's request and terminate in whole or in part the Commitments of such Lenders, provided (i) that the termination of such Commitments would not result in the aggregate remaining Commitments being reduced below the limit set forth in Section 2.05 and (ii) that the Borrower shall have obtained the consent of such Lender with respect to the remaining portion of such Lender's Commitment. If on the date 30 days prior to the applicable Extension Date the Agent has received Extension Letters from each Lender (after giving effect to the assignments pursuant to Section 8.07, if any) the Termination Date shall be extended by one year. SECTION 2.18 Swingline Advances. (a) Subject to the terms and conditions hereof, and in reliance on the representations and warranties set forth herein, the Swingline Lender agrees to make swingline loans (the "Swingline Advances") to the Borrower from time to time during the period from the Closing Date to but not including the Termination Date, in an amount not to exceed Twenty Million Dollars ($20,000,000) at any time outstanding; provided, the obligation of the Lenders to make A Advances under Section 2.01 shall be reduced from time to time by the outstanding principal balance of the Swingline Advances. Notwithstanding the foregoing, the Swingline Lender shall not make any Swingline Advances after the date on which the Agent or the Majority Lenders notify the Swingline Lender and the Borrower that an Event of Default, or an event which would constitute an Event of Default but for the requirement that notice be given or time elapse or both, has occurred. The Swingline Lender may resume the making of Swingline Advances after the Swingline Lender shall have received, and acknowledged in writing, notice from the Majority Lenders or the Agent that an Event of Default, or an event which would constitute an Event of Default but for the requirement that notice be given or time elapse or both, is no longer continuing or has been waived in accordance with the terms of this Agreement. (b) (i) Each Swingline Advance shall have a maturity of no greater than 7 days and shall bear interest at the rate offered by the Swingline Lender and accepted by the Borrower for the applicable period prior to maturity. Interest on all Swingline Advances shall be due and payable in arrears on March 31, June 30, September 30 and December 31 of each year and on the Termination Date. (ii) All Swingline Advances shall be denominated in Dollars. Swingline Advances and all payments thereof shall be in the aggregate minimum amount of $1,000,000 and integral multiples of $500,000 in excess of that amount. (c) Whenever the Borrower desires to borrow or repay under this Section 2.18, it shall deliver to the Agent a notice of such borrowing or repayment not later than 11:00 a.m. (Charlotte, North Carolina time) on the date of each Swingline Advance. (d) (i) Promptly after receipt of such notice under Section 2.18(c), the Agent shall notify the Swingline Lender by facsimile or other similar form of transmission, of the date, type, amount and interest period of the proposed borrowing. The Swingline Lender shall make the amount of its Swingline Advances available to the Agent in immediately available, freely transferable funds, to such account of the Agent as the Agent may designate, by the date and time specified in the notice of borrowing delivered pursuant to Section 2.18(c) provided that the Swingline Lender and the Borrower have agreed as to the interest rate for such Swingline Advance. After the Agent's receipt of the proceeds of such Swingline Advances and upon satisfaction of the applicable conditions set forth in Section 3.02, the Agent shall make the proceeds of such Swingline Advance on such date by transferring immediately available, freely transferable funds equal to the proceeds of all such Swingline Advances received by the Agent to an account of the Borrower with the Agent. (ii) All Swingline Advances shall be subject to all the terms and conditions applicable to Advances generally, provided that all interest thereon shall be payable to the Agent solely for the account of the Swingline Lender except as provided herein and in subsection (e) below. (iii) Notwithstanding the foregoing, not more than (A) two (2) Business Days after demand is made by the Swingline Lender (if such demand is made by 10:00 a.m. (Charlotte, North Carolina time) on any Business Day) or (B) three (3) Business Days after demand is made by the Swingline Lender (if such demand is made after 10:00 a.m. (Charlotte, North Carolina time) on any Business Day) (in each case whether before or after the occurrence of an Event of Default or an event which would constitute an Event of Default but for the requirement that notice be given or time elapse or both), each Lender shall irrevocably and unconditionally purchase and receive from the Swingline Lender, without recourse or warranty, an undivided interest and participation in each Swingline Advance to the extent of such Lender's Commitment Percentage thereof by paying to the Agent for the account of the Swingline Lender, in same day funds, an amount equal to the product of such Swingline Advance multiplied by such Lender's Commitment Percentage. If such amount is not in fact made available by any Lender, the Agent shall be entitled to recover such amount on demand from such Lender together with interest thereon, for each day from the date of such demand, if made prior to 10:00 a.m. (Charlotte, North Carolina time) on any Business Day, or, if made at any other time, from the next Business Day following the date of such demand, until the date such amount is paid to the Agent by such Lender, at the Federal Funds Rate. (e) From and after the date, if any, on which any Lender purchases an undivided interest and participation in any Swingline Advance pursuant to Section 2.18(d)(iii) above, the Agent shall promptly distribute to such Lender at its address set forth on the signature pages hereof, or at such other address as such Lender may request in writing, such Lender's pro rata share of all payments of principal and interest received by the Agent in respect of such Swingline Advance. ARTICLE III CONDITIONS OF LENDING SECTION 3.01. Condition Precedent to Initial Advances. The obligation of each Lender to make its initial Advance is subject to the condition precedent that the Agent shall have received on or before the day of the initial Borrowing the following, each dated such day, in form and substance satisfactory to the Agent and (except for the Notes) in sufficient copies for each Lender: (a) The A Notes payable to the order of the Lenders, respectively. (b) Certified copies of the resolutions of the Board of Directors of the Borrower approving this Agreement and the Notes, and of all documents evidencing other necessary corporate action and governmental approvals, if any, with respect to this Agreement and the Notes. (c) A certificate of the Secretary or an Assistant Secretary of the Borrower certifying the names and true signatures of the officers of the Borrower authorized to sign this Agreement and the Notes and the other documents to be delivered hereunder. (d) A favorable opinion of Warren Y. Zeger, Esq., Vice President and General Counsel for the Borrower, substantially in the form of Exhibit D hereto and as to such other matters as any Lender through the Agent may reasonably request. (e) The Borrower shall have paid all accrued fees and expenses of the Agent (including the accrued fees and disbursements of counsel to the Agent). SECTION 3.02. Conditions Precedent to Each A Borrowing. The obligation of each Lender to make an A Advance on the occasion of each A Borrowing (including the initial Borrowing if an A Borrowing) shall be subject to the further conditions precedent that on the date of such A Borrowing the following statements shall be true (and each of the giving of the applicable Notice of A Borrowing and the acceptance by the Borrower of the proceeds of such A Borrowing shall constitute a representation and warranty by the Borrower that on the date of such A Borrowing such statements are true): (i) The representations and warranties contained in paragraphs (a) and (d) of Section 4.01 are correct on and as of the date of such A Borrowing, before and after giving effect to such A Borrowing and to the application of the proceeds therefrom, as though made on and as of such date, and (ii) No event has occurred and is continuing, or would result from such A Borrowing or from the application of the proceeds therefrom, which constitutes an Event of Default or would constitute an Event of Default but for the requirement that notice be given or time elapse or both. SECTION 3.03. Conditions Precedent to Each B Borrowing. The obligation of each Lender which is to make a B Advance on the occasion of a B Borrowing (including the initial Borrowing if a B Borrowing) to make such B Advance as part of such B Borrowing is subject to the conditions precedent that (i) the Agent shall have received the written confirmatory Notice of B Borrowing with respect thereto, (ii) on or before the date of such B Borrowing, but prior to such B Borrowing, the Agent shall have received a B Note payable to the order of such Lender for each of the one or more B Advances to be made by such Lender as part of such B Borrowing, in a principal amount equal to the principal amount of the B Advance to be evidenced thereby and otherwise on such terms as were agreed to for such B Advance in accordance with Section 2.03, and (iii) on the date of such B Borrowing the following statements shall be true (and each of the giving of the applicable Notice of B Borrowing and the acceptance by the Borrower of the proceeds of such B Borrowing shall constitute a representation and warranty by the Borrower that on the date of such B Borrowing such statements are true): (a) The representations and warranties contained in paragraphs (a) and (d) of Section 4.01 are correct on and as of the date of such B Borrowing, before and after giving effect to such B Borrowing and the application of the proceeds therefrom, as though made on and as of such date, and (b) No event has occurred and is continuing, or would result from such B Borrowing or from the application of the proceeds therefrom, which constitutes an Event of Default or which would constitute an Event of Default but for the requirement that notice be given or time elapse or both. ARTICLE IV REPRESENTATIONS AND WARRANTIES SECTION 4.01. Representations and Warranties of the Borrower. The Borrower represents and warrants as follows ((i) as of the date hereof and as of the date of the making of each Advance in the case of the representations and warranties contained in Sections 4.01(a) and (d) and (ii) as of the date hereof in the case of each other representation and warranty contained in this Section 4.01): (a) The Borrower is a corporation duly organized, validly existing and in good standing under the laws of the jurisdiction indicated at the beginning of this Agreement. (b) The execution, delivery and performance by the Borrower of this Agreement and the Notes are within the Borrower's corporate powers, have been duly authorized by all necessary corporate action, and do not contravene (i) the Borrower's charter or by-laws or (ii) law or any contractual restriction binding on or affecting the Borrower except, in the case of (ii), for any contravention which would not have a materially adverse effect on Borrower's business, assets or financial condition. (c) Section 4.01(c) of the Disclosure Schedule lists each material authorization or approval or other action by, and notice to or filing with, any governmental authority or regulatory body (including, without limitation, the Federal Communications Commission) required for the due execution, delivery and performance by the Borrower of this Agreement or the Notes, and Borrower has obtained each such authorization or approval and has given each such notice and made each such filing. (d) This Agreement is, and the Notes when delivered hereunder will be, legal, valid and binding obligations of the Borrower enforceable against the Borrower in accordance with their respective terms, subject to the effect of any applicable bankruptcy, insolvency, reorganization, moratorium or similar law affecting creditors' rights generally and subject to general rules of equity. (e) The balance sheets of the Borrower and its consolidated subsidiaries as at December 31, 1992, and the related statements of income and retained earnings of the Borrower and its consolidated subsidiaries for the fiscal year then ended, copies of which have been furnished to each Bank, fairly present the financial condition of the Borrower and its consolidated subsidiaries as at such date and the results of the operations of the Borrower and its consolidated subsidiaries for the period ended on such date, all in accordance with generally accepted accounting principles consistently applied, and since December 31, 1992, there has been no material adverse change in the business, financial condition or performance, operations, or properties of the Borrower and any of its consolidated subsidiaries, taken as a whole. (f) Section 4.01(f) of the Disclosure Schedule contains a brief description of each material action, suit, investigation, litigation or proceeding pending or, to the knowledge of Borrower, threatened in any court or before any arbitrator or governmental instrumentality to which the Borrower is a party, none of which (i) would have a material adverse effect on the business, financial condition, operations or properties of the Borrower and any of its consolidated subsidiaries, taken as a whole or (ii) would be likely to have a material adverse effect on the ability of Borrower to fulfill its obligations under this Agreement or any Note. (g) All transactions contemplated hereby are permissible in accordance with Regulation U and the Margin Regulations issued by the Board of Governors of the Federal Reserve System, after giving effect to each of the Advances made hereunder. (h) To the knowledge of the Borrower, no representation or warranty by the Borrower in this Agreement or in any certificate or other document that has been delivered pursuant to the terms of this Agreement contained any untrue statement of a material fact or omitted to state a material fact or any fact necessary to make the statements contained herein or therein not misleading at such time and in light of the circumstances under which such information was furnished. (i) Neither the Borrower nor any of its consolidated subsidiaries is an "investment company," or an "affiliated person" of, or "promoter" or "principal underwriter" for, an "investment company," as such terms are defined in the Investment Company Act of 1940, as amended. Neither the making of any Advances, nor the application of the proceeds or repayment thereof by the Borrower, nor the consummation of the other transactions contemplated hereby will violate any provision of such Act or rule, regulation or order of the Securities Exchange Commission thereunder. ARTICLE V COVENANTS OF THE BORROWER SECTION 5.01. Affirmative Covenants. So long as any Note shall remain unpaid or any Lender shall have any Commitment hereunder, the Borrower will, unless the Majority Lenders shall otherwise consent in writing: (a) Compliance with Laws, Etc. Comply, and cause each of its consolidated subsidiaries to comply, with (i) the requirements of all applicable laws, rules, regulations and orders of any governmental authority (including, without limitation, the regulations of the Federal Communications Commission), non-compliance with which would materially adversely affect the business or credit of the Borrower and its consolidated subsidiaries, taken as a whole, and (ii) the Margin Regulations (which compliance shall include the furnishing to any Lender of a Federal Reserve Form U-1 provided for in Regulation U issued by the Board of Governors of the Federal Reserve System upon the reasonable request of any Lender). (b) Reporting Requirements. Furnish to the Lenders: (i) as soon as available and in any event within 60 days after the end of each fiscal quarter, quarterly consolidated balance sheets, income statements and statements of changes in financial position of the Borrower and its consolidated subsidiaries, certified by the Borrower's Chief Financial Officer or Treasurer (which certification shall indicate that the reported results present fairly the combined financial positions of the Borrower and its consolidated subsidiaries at the end of such quarter in conformity with generally accepted accounting principles applied on a consistent basis and which may be subject to year-end audit adjustments) and stating that, to such officer's knowledge, the Borrower is in compliance with the covenants contained in Sections 5.01, and 5.02 and, if applicable, 5.03 of this Agreement; (ii) as soon as available and in any event within 90 days after the end of each fiscal year, furnish audited annual consolidated financial statements of the Borrower and its consolidated subsidiaries prepared in accordance with generally accepted accounting principles consistently applied and certified in a manner acceptable to the Majority Lenders by Deloitte & Touche or other independent certified public accountants reasonably acceptable to the Majority Lenders; (iii) as soon as possible and in any event within five Business Days after the Borrower becomes aware of the occurrence of each Event of Default and each event which, with the giving of notice or lapse of time, or both, would constitute an Event of Default, continuing on the date of such statement, a statement of the Chief Financial Officer of the Borrower setting forth details of such Event of Default or event and the action which the Borrower has taken and proposes to take with respect thereto; (iv) promptly after the sending or filing thereof, copies of all reports which the Borrower sends to any of its security holders, and copies of all reports and registration statements, other than Form S-8 and other similar reports, which the Borrower or any subsidiary files with the Securities and Exchange Commission or any national securities exchange; and (v) such other information respecting the financial condition or operations of the Borrower or any of its consolidated subsidiaries as any Lender through the Agent may from time to time reasonably request. (c) Insurance. Maintain, and cause each of its consolidated subsidiaries to maintain, insurance with responsible and reputable insurance companies or associations in such amounts and covering such risks as is usually carried by companies engaged in similar businesses and owning similar properties in the same general areas in which the Borrower or such subsidiary operates. (d) Preservation of Corporate Existence, Etc. Preserve and maintain, and cause each of its consolidated subsidiaries to preserve and maintain, its corporate existence, rights (charter and statutory), and franchises; provided, however, that the Borrower or any of its consolidated subsidiaries shall not be required to preserve any right or franchise and any such consolidated subsidiary shall not be required to preserve its corporate existence, if the Board of Directors or an appropriate executive officer of the Borrower or the Board of Directors or an appropriate executive officer of such consolidated subsidiary shall determine that the preservation thereof is no longer desirable in the conduct of the business of the Borrower or such consolidated subsidiary, as the case may be, and that the loss thereof is not disadvantageous in any material respect to the Lenders. (e) Visitation Rights. At any reasonable time and from time to time, permit the Agent or any of the Lenders or any agents or representatives thereof, upon written notice given to the Borrower, to examine and make copies of and abstracts from the records and books of account of, and visit the properties of, the Borrower and any of its consolidated subsidiaries, and to discuss the affairs, finances and accounts of the Borrower and any of its consolidated subsidiaries with any of their respective officers or directors. (f) Keeping of Books. Keep, and cause each of its consolidated subsidiaries to keep, proper books of record and account, in which full and correct entries shall be made of all financial transactions and the assets and business of the Borrower and each of its consolidated subsidiaries in accordance with generally accepted accounting principles consistently applied. (g) Maintenance of Properties, Etc. Maintain and preserve, and cause each of its consolidated subsidiaries to maintain and preserve, in the ordinary course of business consistent with past practice, all of its properties which are used in the conduct of its business in good working order and condition, ordinary wear and tear excepted. SECTION 5.02. Negative Covenants. So long as any Note shall remain unpaid or any Lender shall have any Commitment hereunder, the Borrower will not, without the written consent of the Majority Lenders: (a) Liens, Etc. Create or suffer to exist, or permit any of its consolidated subsidiaries to create or suffer to exist, any lien, security interest or other charge or encumbrance, or any other type of preferential arrangement, upon or with respect to any of its properties, whether now owned or hereafter acquired, or assign, or permit any of its consolidated subsidiaries to assign, any right to receive income, in each case to secure or provide for the payment of any Debt of any Person, other than (i) purchase money liens or purchase money security interests upon or in any property acquired or held by the Borrower or any consolidated subsidiary in the ordinary course of business to secure the purchase price of such property or to secure indebtedness incurred solely for the purpose of financing the acquisition of such property, (ii) liens or security interests existing on such property at the time of its acquisition (other than any such lien or security interest created in contemplation of such acquisition), (iii) liens or security interests existing on the date of this Credit Agreement, (iv) liens for taxes not yet due, or liens for taxes being contested in good faith and by appropriate proceedings for which adequate reserves have been established in accordance with generally accepted accounting principles, (v) liens in respect of property or assets of the Borrower or any consolidated subsidiary imposed by law, which were incurred in the ordinary course of business, such as carriers', warehousemen's and mechanics' liens and other similar liens arising in the ordinary course of business and (x) which do not in the aggregate materially detract from the value of such property or assets or materially impair the use thereof in the operation of the business of the Borrower or any consolidated subsidiary or (y) which are being contested in good faith by appropriate proceedings for which adequate reserves have been established in accordance with generally accepted accounting principles and which proceedings have the effect of preventing the forfeiture or sale of the property or assets subject to any such lien, (vi) any lien arising by reason of deposits with, or the giving of any form of security to, any governmental agency or any body created or approved by law or governmental regulation, which is required by law or governmental regulation as a condition to the transaction of any business, or the exercise of any privilege or license, or to enable the Borrower or a consolidated subsidiary to maintain self-insurance or to participate in any arrangements established by law to cover any insurance risks or in connection with workmen's compensation, unemployment insurance, old age pensions, social security or similar matters, (vii) judgment liens, so long as the finality of such judgment is being contested in good faith and execution thereon is stayed and adequate reserves have been established in accordance with generally accepted accounting principles, (viii) easements or similar encumbrances, the existence of which does not impair the use or value of the property subject thereto for the purposes for which it is held or was acquired or (ix) leases and landlords' liens on fixtures and movable property located on premises leased in the ordinary course of business, so long as the rent secured by said fixtures and movable property is not in default; provided that the aggregate principal amount of the indebtedness secured by the liens or security interests referred to in clauses (i) and (ii) above shall not exceed the lesser of (A) $400 million or (B) 40% of the Borrower's consolidated tangible net worth as of the date of the Borrower's last financial statement submitted to the Agent pursuant to Section 5.01(b). In the event that such indebtedness secured by liens or security interests would be permitted but for the limitation in clause (B) above, the Borrower may nevertheless incur such indebtedness and grant such liens or security interests, provided that the amount of such indebtedness shall not exceed 40% of the Borrower's consolidated tangible net worth as reflected in a pro forma balance sheet giving effect to such transaction delivered to the Agent and certified by the Treasurer or Assistant Treasurer of the Borrower as to the basis of such determinations and, upon the reasonable request of the Majority Lenders, upon the Borrower's delivery to the Agent of a letter from a firm reasonably satisfactory to the Majority Lenders as to the fairness of the consideration paid and the indebtedness and liens incurred by the Borrower in connection with such acquisition. (b) Mergers, Etc. Merge or consolidate with any Person or acquire all or substantially all of the assets of any Person provided that the Borrower may engage in any such proposed transaction so long as the Borrower is the surviving corporation and immediately after giving effect to such proposed transaction, no Event of Default or event which, with the giving of notice or lapse of time, or both, would constitute an Event of Default would exist. (c) Sales, Etc. of Assets. Sell, lease, transfer or otherwise dispose of, or permit any consolidated subsidiary to sell, lease, transfer or otherwise dispose of, fixed assets of the Borrower or its consolidated subsidiaries in an aggregate amount in excess of 15% of the Borrower's consolidated tangible net worth as of the date of the Borrower's last financial statement submitted to the Agent pursuant to Section 5.01(b) during any calendar year, other than (i) in the ordinary course of business or (ii) pursuant to an order of the Federal Communications Commission. (d) Change in Nature of Business. Make, or permit any consolidated subsidiary to make, any material change in the nature of its business, taken as a whole, as carried on at the date hereof; provided, however, that the Borrower may make, or permit any consolidated subsidiary to make, any such change so long as it does not constitute a material change of the nature of the Borrower's operations conducted with not less than 40% of its total consolidated assets. (e) Accounting Changes. Make, or permit any consolidated subsidiary to make, any material change in accounting policies or reporting practices, except as required by generally accepted accounting principles or by any law, rule or regulation applicable to the Borrower or any of its consolidated subsidiaries. SECTION 5.03. Special Financial Covenant. So long as any Note shall remain unpaid or any Lender shall have any Commitment hereunder and in the event that a Rating Event shall have occurred and be continuing, the Borrower will, unless the Majority Lenders shall otherwise consent in writing,maintain at all times a ratio of (A) the sum of the Borrower's total consolidated Debt to (B) the sum of the Borrower's total consolidated Debt plus the Borrower's total stockholders' equity not in excess of .60 to 1.0. ARTICLE VI EVENTS OF DEFAULT SECTION 6.01. Events of Default. If any of the following events ("Events of Default") shall occur and be continuing: (a) The Borrower shall fail to pay (i) any principal of any Note when the same becomes due and payable or (ii) interest on any Note when the same becomes due and payable and such failure to pay interest continues for five (5) Business Days; or (b) Any representation or warranty made or deemed made by the Borrower herein or by the Borrower (or any of its officers) to the Agent or any Lender in connection with the negotiation of this Agreement or any representation or warranty deemed to have been made pursuant to Section 3.02(i) or 3.03(a) in connection with any Borrowing shall prove to have been incorrect in any material respect when made; or (c) The Borrower shall fail to perform or observe (i) any term, covenant or agreement contained in Section 5.01(b)(iii), (ii) any term, covenant or agreement contained in Section 5.02 if the failure to perform or observe any such term, covenant or agreement shall remain unremedied for 5 Business Days after written notice thereof shall have been given to the Borrower by the Agent or any Lender; or (iii) any other term, covenant or agreement contained in this Agreement on its part to be performed or observed if the failure to perform or observe such other term, covenant or agreement shall remain unremedied for 30 days after written notice thereof shall have been given to the Borrower by the Agent or any Lender; or (d) The Borrower or any of its consolidated subsidiaries shall fail to pay any principal of or premium or interest on any Debt which is outstanding in a principal amount of at least $25,000,000 in the aggregate (but excluding Debt evidenced by the Notes) of the Borrower or such subsidiary (as the case may be), when the same becomes due and payable (whether by scheduled maturity, required prepayment, acceleration, demand or otherwise), and such failure shall continue after the applicable grace period, if any, specified in the agreement or instrument relating to such Debt; or any other event shall occur or condition shall exist under any agreement or instrument relating to any such Debt and shall continue after the applicable grace period, if any, specified in such agreement or instrument, if the effect of such event or condition is to accelerate, or to permit the acceleration of, the maturity of such Debt; or any such Debt shall be declared to be due and payable, or required to be prepaid (other than by a regularly scheduled required prepayment), prior to the stated maturity thereof; or (e) The Borrower or any of its consolidated subsidiaries shall generally not pay its debts as such debts become due, or shall admit in writing its inability to pay its debts generally, or shall make a general assignment for the benefit of creditors; or any proceeding shall be instituted by or against the Borrower or any of its consolidated subsidiaries seeking to adjudicate it a bankrupt or insolvent, or seeking liquidation, winding up, reorganization, arrangement, adjustment, protection, relief, or composition of it or its debts under any law relating to bankruptcy, insolvency or reorganization or relief of debtors, or seeking the entry of an order for relief or the appointment of a receiver, trustee, custodian or other similar official for it or for any substantial part of its property and, in the case of any such proceeding instituted against it (but not instituted by it), either such proceeding shall remain undismissed or unstayed for a period of 60 days, or any of the actions sought in such proceeding (including, without limitation, the entry of an order for relief against, or the appointment of a receiver, trustee, custodian or other similar official for, it or for any substantial part of its property) shall occur; or the Borrower or any of its consolidated subsidiaries shall take any corporate action to authorize any of the actions set forth above in this subsection (e); or (f) Any judgment or order for the payment of money in excess of $10,000,000 in the aggregate or individually (except for any judgment or order which is not final and is appealable by the Borrower and the enforcement of which is stayed by reason of pending appeal or otherwise and for which the Borrower has provided adequate reserves) shall be rendered against the Borrower or any of its consolidated subsidiaries and there shall be any period of 30 consecutive days during which a stay of enforcement of such judgment or order, by reason of a pending appeal or otherwise, shall not be in effect; or (g) (i) any Person or two or more Persons acting in concert shall have acquired beneficial ownership (within the meaning of Rule 13d-3 of the Securities and Exchange Commission under the Securities Exchange Act of 1934), directly or indirectly, of securities of the Borrower (or other securities convertible into such securities) representing 20% or more of the combined voting power of all securities of the Borrower entitled to vote in the election of directors, other than securities having such power only by reason of the happening of a contingency; or (ii) any Person or two or more Persons acting in concert shall have acquired by contract or otherwise, or shall have entered into a contract or arrangement that, upon consummation, will result in its or their acquisition of, the power to exercise, directly or indirectly, control over securities of the Borrower (or other securities convertible into such securities) representing 20% or more of the combined voting power of all securities of the Borrower entitled to vote in the election of directors, other than securities having such power only by reason of the happening of a contingency; or (h) Any ERISA Event shall have occurred with respect to a Plan and, 30 days after notice thereof shall have been given to the Borrower by the Agent, (i) such ERISA Event shall still exist and (ii) the sum (determined as of the date of occurrence of such ERISA Event) of the Insufficiency of such Plan and the Insufficiency of any and all other Plans with respect to which a ERISA Event shall have occurred and then exist (or in the case of a Plan with respect to which a Termination Event described in clause (iii) through (vi) of the definition of ERISA Event shall have occurred and then exist, the liability related thereto) is equal to or greater than $25,000,000; or (i) The Borrower or any of its ERISA Affiliates shall have been notified by the sponsor of a Multiemployer Plan that it has incurred Withdrawal Liability to such Multiemployer Plan in an amount that, when aggregated with all other amounts required to be paid to Multiemployer Plans by the Borrower and its ERISA Affiliates in connection with Withdrawal Liabilities (determined as of the date of such notification), exceeds $25,000,000; or (j) The Borrower or any of its ERISA Affiliates shall have been notified by the sponsor of a Multiemployer Plan that such Multiemployer Plan is in reorganization or is being terminated, within the meaning of Title IV of ERISA, if as a result of such reorganization or termination the aggregate annual contributions of the Borrower and its ERISA Affiliates to all Multiemployer Plans that are then in reorganization or being terminated have been or will be increased over the amounts contributed to such Multiemployer Plans for the plan year of each such Multiemployer Plan immediately preceding the plan year in which such reorganization or termination occurs by an amount exceeding $25,000,000; or (k) The Borrower or any of its ERISA Affiliates shall have committed a failure described in Section 302(f)(1) of ERISA and the amount determined under Section 302(f)(3) of ERISA is equal to or greater than $25,000,000; then, and in any such event, the Agent (i) shall at the request, or may with the consent, of the Majority Lenders, by notice to the Borrower, declare the obligation of each Lender to make Advances to be terminated, whereupon the same shall forthwith terminate, and (ii) shall at the request, or may with the consent, of the Majority Lenders, by notice to the Borrower, declare the Notes, all interest thereon and all other amounts payable under this Agreement to be forthwith due and payable, whereupon the Notes, all such interest and all such amounts shall become and be forthwith due and payable, without presentment, demand, protest or further notice of any kind, all of which are hereby expressly waived by the Borrower; provided, however, that in the event of an actual or deemed entry of an order for relief with respect to the Borrower or any of its consolidated subsidiaries under the Federal Bankruptcy Code, (A) the obligation of each Lender to make Advances shall automatically be terminated and (B) the Notes, all such interest and all such amounts shall automatically become and be due and payable, without presentment, demand, protest or any notice of any kind, all of which are hereby expressly waived by the Borrower. ARTICLE VII THE AGENT SECTION 7.01. Authorization and Action. Each Lender hereby appoints and authorizes the Agent to take such action as agent on its behalf and to exercise such powers under this Agreement as are delegated to the Agent by the terms hereof, together with such powers as are reasonably incidental thereto. As to any matters not expressly provided for by this Agreement (including, without limitation, enforcement or collection of the Notes), the Agent shall not be required to exercise any discretion or take any action, but shall be required to act or to refrain from acting (and shall be fully protected in so action or refraining from acting) upon the instructions of the Majority Lenders, and such instructions shall be binding upon all Lenders and all holders of Notes; provided, however, that the Agent shall not be required to take any action which exposes the Agent to personal liability or which is contrary to this Agreement or applicable law. The Agent agrees to give to each Lender prompt notice of each notice given to it by the Borrower pursuant to the terms of this Agreement. SECTION 7.02. Agent's Reliance, Etc. Neither the Agent nor any of its directors, officers, agents or employees shall be liable for any action taken or omitted to be taken by it or them under or in connection with this Agreement, except for its or their own gross negligence or willful misconduct. Without limitation of the generality of the foregoing, the Agent: (i) may treat the payee of any Note as the holder thereof until the Agent receives and accepts an Assignment and Acceptance entered into by the Lender which is the payee of such Note, as assignor, and an Eligible Assignee, as assignee, as provided in Section 8.07; (ii) may consult with legal counsel (including counsel for the Borrower), independent public accountants and other experts selected by it and shall not be liable for any action taken or omitted to be taken in good faith by it in accordance with the advice of such counsel, accountants or experts; (iii) makes no warranty or representation to any Lender and shall not be responsible to any Lender for any statements, warranties or representations (whether written or oral) made in or in connection with this Agreement; (iv) shall not have any duty to ascertain or to inquire as to the performance or observance of any of the terms, covenants or conditions of this Agreement on the part of the Borrower or to inspect the property (including the books and records) of the Borrower; (v) shall not be responsible to any Lender for the due execution, legality, validity, enforceability, genuineness, sufficiency or value of this Agreement or any other instrument or document furnished pursuant hereto; and (vi) shall incur no liability under or in respect of this Agreement by acting upon any notice, consent, certificate or other instrument or writing (which may be by telecopier, telegram, cable or telex) believed by it to be genuine and signed or sent by the proper party or parties. SECTION 7.03. NationsBank and Affiliates. With respect to its Commitment, the Advances made by it and the Notes issued to it, NationsBank shall have the same rights and powers under this Agreement as any other Lender and may exercise the same as though it were not the Agent; and the term "Lender" or "Lenders" shall, unless otherwise expressly indicated, include NationsBank in its individual capacity. NationsBank and its affiliates may accept deposits from, lend money to, act as trustee under indentures of, and generally engage in any kind of business with, the Borrower, any of its subsidiaries and any Person who may do business with or own securities of the Borrower or any such subsidiary, all as if NationsBank were not the Agent and without any duty to account therefor to the Lenders. SECTION 7.04. Lender Credit Decision. Each Lender acknowledges that it has, independently and without reliance upon the Agent or any other Lender and based on the financial statements referred to in Section 4.01 and such other documents and information as it has deemed appropriate, made its own credit analysis and decision to enter into this Agreement. Each Lender also acknowledges that it will, independently and without reliance upon the Agent or any other Lender and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit decisions in taking or not taking action under this Agreement. SECTION 7.05. Indemnification. The Lenders agree to indemnify the Agent (to the extent not reimbursed by the Borrower), ratably according to the respective principal amounts of the A Notes then held by each of them (or if no A Notes are at the time outstanding or if any A Notes are held by Persons which are not Lenders, ratably according to the respective amounts of their Commitments), from and against any and all liabilities, obligations, losses, damages, penalties, actions, judgments, suits, costs, expenses or disbursements of any kind or nature whatsoever which may be imposed on, incurred by, or asserted against the Agent in any way relating to or arising out of this Agreement or any action taken or omitted by the Agent under this Agreement, provided that no Lender shall be liable for any portion of such liabilities, obligations, losses, damages, penalties, actions, judgments, suits, costs, expenses or disbursements resulting from the Agent's gross negligence or willful misconduct. Without limitation of the foregoing, each Lender agrees to reimburse the Agent promptly upon demand for its ratable share of any out-of-pocket expenses (including counsel fees) incurred by the Agent and reimbursable by the Borrower in accordance with Section 8.04 to the extent that the Agent is not reimbursed for such expenses by the Borrower. SECTION 7.06. Successor Agent. The Agent may resign at any time by giving 30 days' written notice thereof to the Lenders and the Borrower and may be removed at any time with or without cause by the Majority Lenders. Upon any such resignation or removal, the Majority Lenders shall have the right to appoint a successor Agent with the consent of the Borrower, such consent not to be unreasonably withheld, provided, however, that the consent of the Borrower shall not be required for the appointment of any Lender as Agent. If no successor Agent shall have been so appointed by the Majority Lenders, and shall have accepted such appointment, within 30 days after the retiring Agent's giving of notice of resignation or the Majority Lenders' removal of the retiring Agent, then the retiring Agent may, on behalf of the Lenders, appoint a successor Agent, which shall be a commercial bank organized under the laws of the United States of America or of any State thereof and having a combined capital and surplus of at least $50,000,000. Upon the acceptance of any appointment as Agent hereunder by a successor Agent, such successor Agent shall thereupon succeed to and become vested with all the rights, powers, privileges and duties of the retiring Agent, and the retiring Agent shall be discharged from its duties and obligations under this Agreement. After any retiring Agent's resignation or removal hereunder as Agent, the provisions of this Article VII shall inure to its benefit as to any actions taken or omitted to be taken by it while it was Agent under this Agreement. ARTICLE VIII MISCELLANEOUS SECTION 8.01. Amendments, Etc. No amendment or waiver of any provision of this Agreement or the A Notes, nor consent to any departure by the Borrower therefrom, shall in any event be effective unless the same shall be in writing and signed by the Majority Lenders, and then such waiver or consent shall be effective only in the specific instance and for the specific purpose for which given; provided, however, that no amendment, waiver or consent shall, unless in writing and signed by all the Lenders, do any of the following: (a) waive any of the conditions specified in Section 3.01, 3.02 or 3.03, (b) except pursuant to Section 2.05, increase the Commitments of the Lenders or subject the Lenders to any additional obligations, (c) reduce the principal of, or interest on, the A Notes or any fees or other amounts payable hereunder, (d) postpone any date fixed for any payment of principal of, or interest on, the A Notes or any fees or other amounts payable hereunder, (e) change the percentage of the Commitments or of the aggregate unpaid principal amount of the A Notes, or the number of Lenders, which shall be required for the Lenders or any of them to take any action hereunder, (f) change the percentage of the Commitments which shall be required to extend the Termination Date pursuant to Section 2.17 or (g) amend this Section 8.01; and provided, further, that no amendment, waiver or consent shall, unless in writing and signed by the Agent in addition to the Lenders required above to take such action, affect the rights or duties of the Agent under this Agreement or any Note. SECTION 8.02. Notices, Etc. All notices and other communications provided for hereunder shall be in writing (including telecopier, telegraphic, telex or cable communication) and mailed, telecopied, telegraphed, telexed, cabled or delivered, if to the Borrower, at its address at 6560 Rock Spring Drive, Bethesda, Maryland, 20817, Attention: Treasurer; if to any Bank, at its Domestic Lending Office specified opposite its name on Schedule I hereto; if to any other Lender, at its Domestic Lending Office specified in the Assignment and Acceptance pursuant to which it became a Lender; and if to the Agent, at its address at NationsBank Plaza, NC1002-06-19, Charlotte, North Carolina 28255 Attention: Kevin Stephens; or, as to the Borrower or the Agent, at such other address as shall be designated by such party in a written notice to the other parties and, as to each other party, at such other address as shall be designated by such party in a written notice to the Borrower and the Agent. All such notices and communications shall, when mailed, telecopied, telegraphed, telexed or cabled, be effective when deposited in the mails, telecopied, delivered to the telegraph company, confirmed by telex answerback or delivered to the cable company, respectively, except that notices and communications to the Agent pursuant to Article II or VII shall not be effective until received by the Agent. SECTION 8.03. No Waiver; Remedies. No failure on the part of any Lender or the Agent to exercise, and no delay in exercising, any right hereunder or under any Note shall operate as a waiver thereof; nor shall any single or partial exercise of any such right preclude any other or further exercise thereof or the exercise of any other right. The remedies herein provided are cumulative and not exclusive of any remedies provided by law. SECTION 8.04. Costs, Expenses and Taxes. (a) The Borrower agrees to pay on demand all reasonable out-of-pocket costs and expenses of the Agent in connection with the preparation, execution, delivery, waiver, modification and amendment of this Agreement, the Notes and the other documents to be delivered hereunder, including, without limitation, the reasonable out-of-pocket fees and expenses of counsel for the Agent with respect thereto; provided, however, such costs and expenses of the Agent in connection with the preparation, execution and delivery of this Agreement, the Notes and the other documents to be delivered hereunder shall not exceed $10,000.00. The Borrower further agrees to pay on demand all reasonable out- of-pocket costs and expenses, if any (including without limitation, reasonable counsel fees and expenses), in connection with the enforcement (whether through negotiations, legal proceedings or otherwise) of this Agreement, the Notes and the other documents to be delivered hereunder, including, without limitation, reasonable out-of-pocket counsel fees and expenses in connection with the enforcement of rights under this Section 8.04(a). (b) If any payment of principal of, or Conversion of, any Eurodollar Rate Advance is made other than on the last day of the Interest Period for such A Advance, as a result of a payment or Conversion pursuant to Section 2.13 or 2.09(f) or acceleration of the maturity of the Notes pursuant to Section 6.01 or for any other reason, the Borrower shall, upon demand by any Lender (with a copy of such demand to the Agent), pay to the Agent for the account of such Lender any amounts required to compensate such Lender for any additional losses, costs or expenses which it may reasonably incur as a result of such payment or Conversion, including, without limitation, any loss (other than loss of anticipated profits), cost or expense incurred by reason of the liquidation or reemployment of deposits or other funds acquired by any Lender to fund or maintain such A Advance. The amount of such loss, cost or expense shall be determined by such Lender and notified to the Borrower through the Agent in the form a certificate of such Lender stating that the calculations set forth therein are in accordance with the terms of this Agreement and setting forth in reasonable detail the basis of such calculations, such certificate being conclusive and binding for all purposes absent manifest error and unless contested by the Borrower within 10 Business Days of its receipt of such certificate, and the amount set forth therein being payable in any event by the Borrower to such Lender on or before the 10th Business Day following delivery of such certificate to the Borrower. SECTION 8.05. Right of Set-off. Upon (i) the occurrence and during the continuance of any Event of Default and (ii) the making of the request or the granting of the consent specified by Section 6.01 to authorize the Agent to declare the Notes due and payable pursuant to the provisions of Section 6.01, each Lender is hereby authorized at any time and from time to time, to the fullest extent permitted by law, to set off and apply any and all deposits (general or special, time or demand, provisional or final) at any time held and other indebtedness at any time owing by such Lender to or for the credit or the account of the Borrower against any and all of the obligations of the Borrower now or hereafter existing under this Agreement and any Note held by such Lender, whether or not such Lender shall have made any demand under this Agreement or such Note and although such obligations may be unmatured. Each Lender agrees promptly to notify the Borrower after any such set-off and application made by such Lender, provided that the failure to give such notice shall not affect the validity of such set-off and application. The rights of each Lender under this Section are in addition to other rights and remedies (including, without limitation, other rights of set-off) which such Lender may have. SECTION 8.06. Binding Effect. This Agreement shall become effective when it shall have been executed by the Borrower and the Agent and when the Agent shall have been notified by each Bank that such Bank has executed it and thereafter shall be binding upon and inure to the benefit of the Borrower, the Agent and each Lender and their respective successors and assigns, except that the Borrower shall not have the right to assign its rights hereunder or any interest herein without the prior written consent of the Lenders. SECTION 8.07. Assignments and Participations. (a) No Lender may assign any portion of its rights and obligations under this Agreement (including, without limitation, all or a portion of its Commitment, the A Advances owing to it and the A Note or Notes held by it, the B Advances owing to it and the B Note or Notes held by it), except with the approval of the Borrower and the Agent, which approval may not be unreasonably withheld, or otherwise pursuant to the terms of this Section 8.07; provided, however, any Lender may pledge or assign any of its rights (including, without limitation, rights to payment of principal and/or interest under the Notes) under this Credit Agreement to any Federal Reserve Bank in accordance with applicable law without the consent of or prior notice to the Borrower or the Agent. If, pursuant to the terms of Section 2.17, the Borrower shall have given notice of its request to extend the Termination Date and on the date 60 days prior to the applicable anniversary date Lenders holding at least 60% but less than 100% in aggregate principal amount of the Commitments have consented to such extension, each Lender who has denied the Borrower's request for an extension of the Termination Date shall, upon the written demand of the Borrower, execute an Assignment and Acceptance for all or a portion of such Lender's rights and obligations under this Agreement (including, without limitation, all or a portion of its Commitment, the A Advances owing to it and the A Note held by it, the B Advances owing to it and the B Note or Notes held by it); provided, however, that the Borrower shall have delivered to such Lender not less than 5 Business Days prior to such demand, an Assignment and Acceptance executed by an Eligible Assignee for the portion of such Lender's Commitment not terminated by the Borrower or retained and consented to by such Lender. All accrued and unpaid principal, interest and fees with respect to any assigning Lender's Commitment and Advances that have not been terminated by the Borrower or retained by such Lender shall be due and payable by the Borrower to such Lender upon the assignment. Notwithstanding such assignment, the obligations of the Borrower under Sections 2.02, 2.12, 8.04 and 8.08 shall survive such assignment and be enforceable by such Lender. The parties to each Assignment and Acceptance shall deliver to the Agent, for its acceptance and recording in the Register, the Assignment and Acceptance, together with any A Note and/or B Note or Notes subject to such assignment and a processing and recordation fee of $2,500, payable by the assigning Lender. Upon such execution, delivery, acceptance and recording, from and after the effective date specified in each Assignment and Acceptance, (x) the assignee thereunder shall be a party hereto and, to the extent that rights and obligations hereunder have been assigned to it pursuant to such Assignment and Acceptance, have the rights and obligations of a Lender hereunder and (y) the Lender assignor thereunder shall, to the extent that rights and obligations hereunder have been assigned by it pursuant to such Assignment and Acceptance, relinquish its rights and be released from its obligations under this Agreement (and, in the case of an Assignment and Acceptance covering all or the remaining portion of an assigning Lender's rights and obligations under this Agreement, such Lender shall cease to be a party hereto). (b) By executing and delivering an Assignment and Acceptance, the Lender assignor thereunder and the assignee thereunder confirm to and agree with each other and the other parties hereto as follows: (i) other than as provided in such Assignment and Acceptance, such assigning Lender makes no representation or warranty and assumes no responsibility with respect to any statements, warranties or representations made in or in connection with this Agreement or the execution, legality, validity, enforceability, genuineness, sufficiency or value of this Agreement or any other instrument or document furnished pursuant hereto; (ii) such assigning Lender makes no representation or warranty and assumes no responsibility with respect to the financial condition of the Borrower or the performance or observance by the Borrower of any of its obligations under this Agreement or any other instrument or document furnished pursuant hereto; (iii) such assignee confirms that it has received a copy of this Agreement, together with copies of the financial statements referred to in Section 4.01 and such other documents and information as it has deemed appropriate to make its own credit analysis and decision to enter into such Assignment and Acceptance; (iv) such assignee will, independently and without reliance upon the Agent, such assigning Lender or any other Lender and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit decisions in taking or not taking action under this Agreement; (v) such assignee confirms that it is an Eligible Assignee; (vi) such assignee appoints and authorizes the Agent to take such action as agent on its behalf and to exercise such powers under this Agreement as are delegated to the Agent by the terms hereof, together with such powers as are reasonably incidental thereto; and (vii) such assignee agrees that it will perform in accordance with their terms all of the obligations which by the terms of this Agreement are required to be performed by it as a Lender. (c) The Agent shall maintain at its address referred to in Section 8.02 a copy of each Assignment and Acceptance delivered to and accepted by it and a register for the recordation of the names and addresses of the Lenders and the Commitment of, and principal amount of the A Advances owing to, each Lender from time to time (the "Register"). The entries in the Register shall be conclusive and binding for all purposes, absent manifest error, and the Borrower, the Agent and the Lenders may treat each Person whose name is recorded in the Register as a Lender hereunder for all purposes of this Agreement. The Register shall be available for inspection by the Borrower or any Lender at any reasonable time and from time to time upon reasonable prior notice. (d) Upon its receipt of an Assignment and Acceptance executed by an assigning Lender and an assignee representing that it is an Eligible Assignee, together with any A Note and/or B Notes subject to such assignment, the Agent shall, if such Assignment and Acceptance has been completed and is in substantially the form of Exhibit C hereto, (i) accept such Assignment and Acceptance, (ii) record the information contained therein in the Register and (iii) give prompt notice thereof to the Borrower. Within five Business Days after its receipt of such notice, the Borrower, at its own expense, shall execute and deliver to the Agent in exchange for the surrendered A Note and/or B Note or Notes, a new A Note and/or B Note or Notes to the order of such Eligible Assignee in an amount equal to the Commitment assumed by it pursuant to such Assignment and Acceptance and, if the assigning Lender has retained a Commitment hereunder, a new A Note to the order of the assigning Lender in an amount equal to the Commitment retained by it hereunder. Such new A Note and/or B Note or Notes shall be in an aggregate principal amount equal to the aggregate principal amount of such surrendered A Note and/or B Note or Notes, shall be dated the effective date of such Assignment and Acceptance and shall otherwise be in substantially the form of Exhibit A-1 hereto. (e) Each Lender may sell participations to one or more banks or other entities in or to all or a portion of its rights and obligations under this Agreement (including, without limitation, all or a portion of its Commitment, the Advances owing to it and the Note or Notes held by it); provided, however, that (i) such Lender's obligations under this Agreement (including, without limitation, its Commitment to the Borrower hereunder) shall remain unchanged, (ii) such Lender shall remain solely responsible to the other parties hereto for the performance of such obligations, (iii) such Lender shall remain the holder of any such Note for all purposes of this Agreement, and (iv) the Borrower, the Agent and the other Lenders shall continue to deal solely and directly with such Lender in connection with such Lender's rights and obligations under this Agreement. (f) Any Lender may, in connection with any assignment or participation or proposed assignment or participation pursuant to this Section 8.07, disclose to the assignee or participant or proposed assignee or participant, any information relating to the Borrower furnished to such Lender by or on behalf of the Borrower; provided that, prior to any such disclosure, the assignee or participant or proposed assignee or participant shall agree to preserve the confidentiality of any confidential information relating to the Borrower received by it from such Lender. SECTION 8.08. Indemnification by Borrower. The Borrower shall indemnify and hold harmless the Agent, each Lender and their respective affiliates, officers, directors, employees, agents and advisors (each, an "Indemnified Party") from and against any and all claims, damages, losses, liabilities and expenses (including, without limitation, reasonable out-of-pocket fees and disbursements of counsel) which may be incurred by or asserted or awarded against any Indemnified Party, in each case arising out of or in connection with or by reason of, or in connection with the preparation for a defense of, any investigation, litigation or proceeding arising out of, related to or in connection with this Agreement or the Notes, whether or not an Indemnified Party is a party thereto and whether or not any Advance has been made under this Agreement, except to the extent such claim, damage, loss, liability or expensehas been caused by such Indemnified Party's gross negligence or willful misconduct. SECTION 8.09. Governing Law. This Agreement and the Notes shall be governed by, and construed in accordance with, the laws of the State of New York. SECTION 8.10. Confidentiality of Financial Information. The Agent and the Lenders agree that they will not disclose Financial Information (as defined below) without the prior consent of the Borrower (other than to their directors, employees, auditors or counsel); provided that the Agent and any Lender is authorized to make such disclosure of Financial Information without any consent of the Borrower (a) as may be required by law (such as pursuant to any subpoena or civil investigative demand) and as may be requested or required by any state or federal authority, examiner, or regulatory body or agency having jurisdiction over the Agent or any Lender, (b) during the course of any action, suit, investigation, litigation or proceeding in any court or before any arbitrator or governmental instrumentality to which the Borrower and any Lender is a party, provided such Financial Information is submitted under seal and (c) as permitted by Section 8.07(f). The term "Financial Information" means any information delivered by the Borrower under Section 5.01(b)(v), that is marked "Confidential" that relates to the business, operations or financial condition of the Borrower or its consolidated subsidiaries other than information (a) that is, or generally becomes, available to the public, (b) was available to the Agent or any Lender on a nonconfidential basis prior to its disclosure to the Agent or such Lender (as the case may be) by the Borrower or any Affiliate or (c) becomes available to the Agent or any Lender from a Person or other sources that is not, to the best knowledge of the Agent or such Lender (as the case may be) otherwise bound by a confidentiality agreement with the Borrower. SECTION 8.11. WAIVER OF JURY TRIAL. THE BORROWER AND EACH LENDER EACH HEREBY IRREVOCABLY WAIVES ALL RIGHT TO TRIAL BY JURY IN ANY ACTION, PROCEEDING OR COUNTERCLAIM ARISING OUT OR RELATING TO THIS AGREEMENT OR ANY OF THE OTHER LOAN DOCUMENTS. SECTION 8.12. Effect of Headings and Table of Contents. The Article and Section headings herein and the Table of Contents are for convenience only and shall not affect the construction hereof. SECTION 8.13. Execution in Counterparts. This Agreement may be executed in any number of counterparts and by different parties hereto in separate counterparts, each of which when so executed shall be deemed to be an original and all of which taken together shall constitute one and the same agreement. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their respective officers thereunto duly authorized, as of the date first above written. COMSAT CORPORATION By: /s/Wesley D. Minami ------------------------ Title: Treasurer NATIONSBANK OF NORTH CAROLINA, N.A., as Agent By: /s/Michael R. Williams --------------------------- Title: Senior Vice President Banks ----- Commitment - - - ---------- $45,000,000 NATIONSBANK OF NORTH CAROLINA, N.A. By: /s/Michael R. Williams -------------------------- Title: Senior Vice President $35,000,000 BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION By: /s/Doug Bontemps ------------------------ Title: Vice President $25,000,000 THE FIRST NATIONAL BANK CHICAGO By: /s/Ted Wozniak ------------------------ Title: Vice President $35,000,000 THE CHASE MANHATTAN BANK, N.A. By: /s/Robert T. Smith ------------------------ Title: Vice President $35,000,000 THE SUMITOMO BANK, LIMITED, NEW YORK BRANCH By: /s/Yoshinori Kawamura ------------------------- Title: Joint General Manager $25,000,000 SWISS BANK CORPORATION, NEW YORK BRANCH By: /s/Jane A. Majeski ---------------------- Title: Director Merchant Banking By: /s/Alois Mueller ---------------------- Title: Associate Director Merchant Banking _____________ $200,000,000 Total of the Commitments EXHIBIT A-1 FORM OF A NOTE U.S. $______________ Dated: December 17, 1993 FOR VALUE RECEIVED, the undersigned, Comsat Corporation, a District of Columbia corporation (the "Borrower"), HEREBY PROMISES TO PAY to the order of ____________________________ (the "Lender") for the account of its Applicable Lending Office (as defined in the Credit Agreement referred to below) the principal sum of U.S. $[amount of the Lender's Commitment in figures] or, if less, the aggregate principal amount of the A Advances (as defined below) made by the Lender to the Borrower pursuant to the Credit Agreement outstanding on the Termination Date (as defined in the Credit Agreement) or upon earlier maturity, as provided in the Credit Agreement. The Borrower promises to pay interest on the unpaid principal amount of each A Advance from the date of such A Advance until such principal amount is paid in full, at such interest rates, and payable at such times, as are specified in the Credit Agreement. Both principal and interest are payable in lawful money of the United States of America to NationsBank of North Carolina, N.A., as Agent, at _________________________________, in same day funds. Each A Advance made by the Lender to the Borrower pursuant to the Credit Agreement, and all payments made on account of principal thereof, shall be recorded by the Lender and, prior to any transfer hereof, endorsed on the grid attached hereto which is part of this Promissory Note. This Promissory Note is one of the A Notes referred to in, and is entitled to the benefits of, the Credit Agreement dated as of December 17, 1993 (the "Credit Agreement") among the Borrower, the Lender and certain other banks parties thereto, and NationsBank of North Carolina, N.A., as Agent for the Lender and such other banks. The Credit Agreement, among other things, (i) provides for the making of advances (the "A Advances") by the Lender to the Borrower from time to time in an aggregate amount not to exceed at any time outstanding the U.S. dollar amount first above mentioned, the indebtedness of the Borrower resulting from each such A Advance being evidenced by this Promissory Note, and (ii) contains provisions for acceleration of the maturity hereof upon the happening of certain stated events and also for prepayments on account of principal hereof prior to the maturity hereof upon the terms and conditions therein specified. COMSAT CORPORATION By______________________ Title: EXHIBIT A-2 FORM OF B NOTE U.S. $______________ Dated: ________, 19__ FOR VALUE RECEIVED, the undersigned, Comsat Corporation, a District of Columbia corporation (the "Borrower"), HEREBY PROMISES TO PAY to the order of _______________________ (the "Lender") for the account of its Applicable Lending Office (as defined in the Credit Agreement referred to below), on __________, 19__, the principal amount of _____________ Dollars ($___________). The Borrower promises to pay interest on the unpaid principal amount hereof from the date hereof until such principal amount is paid in full, at the interest rate and payable on the interest payment date or dates provided below: Interest Rate: ___% per annum (calculated on the basis of a year of ____ days for the actual number of day s elapsed). Interest Payment Date or Dates: ____________________ Both principal and interest are payable in lawful money of the United States of America to __________________ or the account of the Lender at the office of _____________________, at ____________________________________, in same day funds, free and clear of and without any deduction, with respect to the payee named above, for any and all present and future taxes, deductions, charges or withholdings, and all liabilities with respect thereto. This Promissory Note is one of the B Notes referred to in, and is entitled to the benefits of, the Credit Agreement dated as of December 17, 1993 (the "Credit Agreement") among the Borrower, the Lender and certain other banks parties thereto, and NationsBank of North Carolina, N.A., as Agent for the Lender and such other banks. The Credit Agreement, among other things, contains provisions for acceleration of the maturity hereof upon the happening of certain stated events. COMSAT CORPORATION By__________________________ Title: EXHIBIT B-1 NOTICE OF A BORROWING NationsBank of North Carolina, N.A., as Agent for the Lenders parties to the Credit Agreement referred to below _______________________ _______________________ [Date] Attention: __________________ Gentlemen: The undersigned, Comsat Corporation, refers to the Credit Agreement, dated as of December 17, 1993 (the "Credit Agreement", the terms defined therein being used herein as therein defined), among the undersigned, certain Lenders parties thereto and NationsBank of North Carolina, N.A., as Agent for said Lenders, and hereby gives you notice, irrevocably, pursuant to Section 2.02 of the Credit Agreement that the undersigned hereby requests an A Borrowing under the Credit Agreement, and in that connection sets forth below the information relating to such A Borrowing (the "Proposed A Borrowing") as required by Section 2.02(a) of the Credit Agreement: (i) The Business Day of the Proposed A Borrowing is _____________, 19___. (ii) The Type of A Advances comprising the Proposed A Borrowing is [Base Rate Advances] [Eurodollar Rate Advances]. (iii) The aggregate amount of the Proposed A Borrowing is $____________ [an amount not less than $10,000,000]. (iv) The Interest Period for each A Advance made as part of the Proposed A Borrowing is [____ days] [____ month[s]]. The undersigned hereby certifies that the following statements are true on the date hereof, and will be true on the date of the Proposed A Borrowing: (A) the representations and warranties contained in paragraphs (a) and (d) of Section 4.01 are correct, before and after giving effect to the Proposed A Borrowing and to the application of the proceeds therefrom, as though made on and as of such date; and (B) no event has occurred and is continuing, or would result from such Proposed A Borrowing or from the application of the proceeds therefrom, which constitutes an Event of Default or would constitute an Event of Default but for the requirement that notice be given or time elapse or both. Very truly yours, COMSAT CORPORATION By_________________________ Title: EXHIBIT B-2 NOTICE OF B BORROWING NationsBank of North Carolina, N.A., as Agent for the Lenders parties to the Credit Agreement referred to below _________________________ _________________________ [Date] Attention: ___________________ Gentlemen: The undersigned, Comsat Corporation, refers to the Credit Agreement, dated as of December 17, 1993 (the "Credit Agreement", the terms defined therein being used herein as therein defined), among the undersigned, certain Lenders parties thereto and NationsBank of North Carolina, N.A., as Agent for said Lenders, and hereby gives you notice pursuant to Section 2.03 of the Credit Agreement that the undersigned hereby requests a B Borrowing under the Credit Agreement, and in that connection sets forth the terms on which such B Borrowing (the "Proposed B Borrowing") is requested to be made: (A) Date of B Borrowing _________________________ (B) Amount of B Borrowing _________________________ (C) Maturity Date _________________________ (D) Interest Rate Basis _________________________ (E) Interest Payment Date(s) _________________________ (F) _____________________ _________________________ (G) _____________________ _________________________ (H) _____________________ _________________________ The undersigned hereby certifies that the following statements are true on the date hereof, and will be true on the date of the Proposed B Borrowing: (a) the representations and warranties contained in paragraphs (a) and (d) of Section 4.01 are correct, before and after giving effect to the Proposed B Borrowing and to the application of the proceeds therefrom, as though made on and as of such date; and (b) no event has occurred and is continuing, or would result from the Proposed B Borrowing or from the application of the proceeds therefrom, which constitutes an Event of Default or would constitute an Event of Default but for the requirement that notice be given or time elapse or both. The undersigned hereby confirms that the Proposed B Borrowing is to be made available to it in accordance with Section 2.03(a)(v) of the Credit Agreement. Very truly yours, COMSAT CORPORATION By_________________________ Title: EXHIBIT C ASSIGNMENT AND ACCEPTANCE Dated______, 19___ Reference is made to the Credit Agreement dated as of December 17, 1993 (the "Credit Agreement") among Comsat Corporation, a District of Columbia corporation (the "Borrower"), the Lenders (as defined in the Credit Agreement) and NationsBank of North Carolina, N.A., as Agent for the Lenders (the "Agent"). Terms defined in the Credit Agreement are used herein with the same meaning. _______________ (the "Assignor") and _______________ (the "Assignee") agree as follows: 1. The Assignor hereby sells and assigns to the Assignee, and the Assignee hereby purchases and assumes from the Assignor, that interest in and to all of the Assignor's rights and obligations under the Credit Agreement as of the date hereof which represents the percentage interest specified on Schedule 1 of all outstanding rights and obligations under the Credit Agreement, including, without limitation, such interest in the Assignor's Commitment. After giving effect to such sale and assignment, the Assignee's Commitment will be set forth in Section 2 of Schedule 1. 2. The Assignor (i) represents and warrants that it is the legal and beneficial owner of the interest being assigned by it hereunder and that such interest is free and clear of any adverse claim; (ii) makes no representation or warranty and assumes no responsibility with respect to any statements, warranties or representations made in or in connection with the Credit Agreement or the execution, legality, validity, enforceability, genuineness, sufficiency or value of the Credit Agreement or any other instrument or document furnished pursuant thereto; and (iii) makes no representation or warranty and assumes no responsibility with respect to the financial condition of the Borrower or the performance or observance by the Borrower of any of its obligations under the Credit Agreement or any other instrument or document furnished pursuant thereto. 3. The Assignee (i) confirms that it has received a copy of the Credit Agreement, together with copies of the financial statements referred to in Section 4.01 thereof and such other documents and information as it has deemed appropriate to make its own credit analysis and decision to enter into this Assignment and Acceptance; (ii) agrees that it will, independently and without reliance upon the Agent, the Assignor or any other Lender and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit decisions in taking or not taking action under the Credit Agreement; (iii) confirms that it is an Eligible Assignee; (iv) appoints and authorizes the Agent to take such action as Agent on its behalf and to exercise such powers under the Credit Agreement as are delegated to the Agent by the terms thereof, together with such powers as are reasonably incidental thereto; (v) agrees that it will perform in accordance with their terms all of the obligations which by the terms of the Credit Agreement are required to be performed by it as a Lender; (vi) specifies as its Domestic Lending Office (and address for notices) and Eurodollar Lending Office the offices set forth beneath its name on the signature pages hereof; and [(vii) attaches its executed Extension Letter consenting to the extension of the Termination Date] [and (viii) attaches the forms prescribed by the Internal Revenue Service of the United States certifying as to the Assignee's status for purposes of determining exemption from United States withholding taxes with respect to all payments to be made to the Assignee under the Credit Agreement and the Notes or such other documents as are necessary to indicate that all such payments are subject to such rates at a rate reduced by an applicable tax treaty](1). 4. Following the execution of this Assignment and Acceptance by the Assignor and the Assignee, it will be delivered to the Agent for acceptance and recording by the Agent. The effective date of this Assignment and Acceptance shall be the date of acceptance thereof by the Agent[, which shall be an anniversary date of the Credit Agreement] (the "Effective Date"). 5. Upon such acceptance and recording by the Agent, as of the Effective Date, (i) the Assignee shall be a party to the Credit Agreement and, to the extent provided in this Assignment and Acceptance, have the rights and obligations of a Lender thereunder and (ii) the Assignor shall, to the extent provided in this Assignment and Acceptance, relinquish its rights and be released from its obligations under the Credit Agreement. 6. Upon such acceptance and recording by the Agent, from and after the Effective Date the Agent shall make all payments under the Credit Agreement assigned hereby (including, without limitation, all payments of principal, interest and commitment fees with respect thereto) to the Assignee. The Assignor and Assignee shall make all appropriate adjustments in payments under the Credit Agreement for periods prior to the Effective Date directly between themselves. 7. This Assignment and Acceptance shall be governed by, and construed in accordance with, the laws of the State of New York. - - - ----------- (1) If the Assignee is organized under the laws of a jurisdiction outside the Unites States. IN WITNESS WHEREOF, the parties hereto have caused this Assignment and Acceptance to be executed by their respective officers thereunto duly authorized, as of the date first above written, such execution being made on Schedule 1 hereto. Schedule 1 to Assignment and Acceptance Dated _______, 19___ Section 1. Percentage Interest: ____% Section 2. Assignee's Commitment: Aggregate Outstanding Principal $________ Amount of A Advances owing to the Assignee: $________ An A Note payable to the order of the Assignee Dated: _______, 19__ Principal amount: _______ Section 3. Effective Date*: __________, 19__ [NAME OF ASSIGNOR] By:_________________________ Title: [NAME OF ASSIGNEE] By:_________________________ Title: Domestic Lending Office (and address for notices): [Address] Eurodollar Lending Office: [Address] ___________________ * This date should be no earlier than the date of acceptance by the Agent, and in the case of an assignment pursuant to Section 2.07, shall be an anniversary date of the Credit Agreement. Accepted this ____ day of ____________, 19___ NATIONSBANK OF NORTH CAROLINA, N.A. By:__________________________ Title: EXHIBIT D FORM OF OPINION OF COUNSEL FOR THE BORROWER [Date of initial Borrowing] To each of the Banks parties to the Revolving Credit and Term Loan Agreement dated as of December 17, 1993 among Comsat Corporation, said Banks and NationsBank of North Carolina, N.A., as Agent for said Banks, and to NationsBank of North Carolina, N.A., as Agent COMSAT CORPORATION $200,000,000 Credit Agreement Gentlemen: This opinion is furnished to you pursuant to Section 3.01(d) of the Credit Agreement, dated as of December 17, 1993 (the "Credit Agreement"), among Comsat Corporation (the "Borrower"), the Banks parties thereto and NationsBank of North Carolina, N.A., as Agent for said Banks. Terms defined in the Credit Agreement are used herein as therein defined. We have acted as counsel for the Borrower in connection with the preparation, execution and delivery of, and the initial Borrowing made under, the Credit Agreement. In that connection, we have examined: (1) The Credit Agreement. (2) The documents furnished by the Borrower pursuant to Article II of the Credit Agreement. (3) The Certificate of Incorporation of the Borrower and all amendments thereto (the "Charter"). (4) The by-laws of the Borrower and all amendments thereto (the "By-laws"). (5) A certificate of the Department of Consumer and Regulatory Affairs of the District of Columbia, dated __________, 19___, attesting to the continued corporate existence and good standing of the Borrower in the District of Columbia. We have also examined the originals, or copies certified to our satisfaction, of the documents listed in a certificate of the chief financial officer of the Borrower, dated the date hereof (the "Certificate"), certifying that the documents listed in such certificate are all of the indentures, loan or credit agreements, leases, guarantees, mortgages, security agreements, bonds, notes and other agreements or instruments, and all of the orders, writs, judgments, awards, injunctions and decrees, which affect or purport to affect the Borrower's right to borrow money or the Borrower's obligations under the Credit Agreement or the Notes. In addition, we have examined the originals, or copies certified to our satisfaction, of such other corporate records of the Borrower, certificates of public officials and of officers of the Borrower, and agreements, instruments and other documents, as we have deemed necessary as a basis for the opinions expressed below. As to questions of fact material to such opinions, we have, when relevant facts were not independently established by us, relied upon certificates of the Borrower or its officers or of public officials. We have assumed the due execution and delivery, pursuant to due authorization, of the Credit Agreement by the Banks and the Agent. We are qualified to practice law in the District of Columbia and we do not purport to be experts on any laws other than the laws of the District of Columbia and the Federal laws of the United States. Based upon the foregoing and upon such investigation as we have deemed necessary, we are of the following opinion: 1. The Borrower is a corporation duly organized, validly existing and in good standing under the laws of the District of Columbia. 2. The execution, delivery and performance by the Borrower of the Credit Agreement and the Notes are within the Borrower's corporate powers, have been duly authorized by all necessary corporate action, and do not contravene (i) the Charter or the By-laws or (ii) any law, rule or regulation applicable to the Borrower (including, without limitation, the margin stock regulations issued by the Board of Governors of the Federal Reserve System applicable to the Borrower and the regulations of the Federal Communications Commission) or (iii) any contractual or legal restriction contained in any document listed in the Certificate or, to the best of our knowledge, contained in any other similar document. The Credit Agreement and the Notes have been duly executed and delivered on behalf of the Borrower. 3. No authorization, approval or other action by, and no notice to or filing with, any governmental authority or regulatory body is required for the due execution, delivery and performance by the Borrower of the Credit Agreement and the Notes. 4. To the best of our knowledge, there are no pending or overtly threatened actions or proceedings against the Borrower or any of its subsidiaries before any court, governmental agency or arbitrator which purport to affect the legality, validity, binding effect or enforceability of the Credit Agreement or any of the Notes or which are likely to have a materially adverse effect upon the financial condition or operations of the Borrower and its consolidated subsidiaries, taken as a whole. 5. In any action or proceeding arising out of or relating to the Credit Agreement or the Notes in any court of the District of Columbia or in any federal court sitting in the District of Columbia, such court would recognize and give effect to the provisions of Section 8.09 of the Credit Agreement wherein the parties thereto agree that the Credit Agreement and the Notes shall be governed by, and construed in accordance with, the laws of the State of New York. Without limiting the generality of the foregoing, a court of the District of Columbia or a federal court sitting in the District of Columbia would apply the usury law of the State of New York, and would not apply the usury law of the District of Columbia, to the Credit Agreement and the Notes. However, if a court were to hold that the Credit Agreement and the Notes are governed by, and to be construed in accordance with, the laws of the District of Columbia, the Credit Agreement and the Notes would be, under the laws of the District of Columbia, legal, valid and binding obligations of the Borrower enforceable against the Borrower in accordance with the respective terms. The opinions set forth above are subject to the following qualifications: (a) Our opinion in paragraph 5 above is subject to the effect of any applicable bankruptcy, insolvency, reorganization, moratorium or similar law affecting creditors' rights generally. (b) Our opinion in paragraph 5 above is subject to the effect of general principles of equity, including (without limitation) concepts of materiality, reasonableness, good faith and fair dealing (regardless of whether considered in a proceeding in equity or at law). Very truly yours, EXHIBIT E Form of Extension Letter _______________, 199_ [Name and address of Lender] Re: Proposed Extension of the Termination Date Ladies and Gentlemen: We make reference to the Credit Agreement dated as of December 17, 1993 among the undersigned, the Lenders parties thereto and NationsBank of North Carolina, N.A., as Agent for said Lenders (the "Credit Agreement," the terms defined therein being used herein as therein defined). The current Termination Date is ______________, 199_. The Borrower desires to extend the Termination Date by one year and accordingly requests hereby that the Bank agree to extend the Termination Date to ______________, 199_. If the foregoing proposed extension of the Termination Date meets with your approval, please so indicate by executing and returning to the Agent and the Borrower the accompanying copies of this letter. Upon the approval of at least 60% of the Lenders in accordance with Section 2.17 of the Credit Agreement, the Termination Date under the Credit Agreement shall hereafter be _______________, 199_. Very truly yours, COMSAT CORPORATION By: Title: ACCEPTED AND AGREED TO: [NAME OF BANK] By:____________________________ Title:_________________________ Date:__________________________ EXHIBIT 10hh EXHIBIT 10(ii) A G R E E M E N T This Agreement is made by and between MCI International, Inc. ("MCI"), a United States International Service Carrier ("USISC"), and COMSAT Corporation ("COMSAT"), the U.S. Signatory to the International Telecommunications Satellite Organization ("INTELSAT") (hereinafter jointly referred to as the "Parties"). WHEREAS, MCI is engaged in the provision of telecommunications services via satellite; and WHEREAS, COMSAT offers INTELSAT space segment capacity to USISCs for telecommunications services; and WHEREAS, COMSAT and MCI entered into an inter-carrier contract on October 27, 1988, specifying the rates, terms and conditions relating to MCI's long-term commitment for utilization of COMSAT's INTELSAT space segment capacity for international voice-grade switched circuits ("1988 Agreement"); and WHEREAS, the 1988 Agreement was filed with the Federal Communications Commission ("FCC") pursuant to Section 211 of the Communications Act, and was allowed to become effective by the FCC; and WHEREAS, COMSAT and MCI entered into a new inter-carrier contract on April 8, 1993, specifying rates, terms and conditions relating to MCI's utilization of COMSAT's INTELSAT space segment capacity for international switched telecommunications services ("1993 Agreement"); and WHEREAS, the 1993 Agreement was also filed with the FCC pursuant to Section 211 of the Communications Act, and was also allowed to become effective by the FCC; and WHEREAS, the Parties have decided to replace the 1993 Agreement with a new inter-carrier contract based upon MCI's current and future utilization of COMSAT's INTELSAT space segment capacity for telecommunications services, and have decided to maintain certain prior commitments arising from the 1988 Agreement and the 1993 Agreement, as specified herein; NOW, THEREFORE, in consideration of and in reliance upon the mutual promises set forth below, MCI and COMSAT hereby agree as follows: ARTICLE I PURPOSE AND INTENT The purpose of this Agreement is to implement the Parties' mutual understanding with respect to MCI's current and future utilization of COMSAT's INTELSAT space segment capacity for telecommunications services. It is the intent of COMSAT and MCI that this Agreement comply with all laws and international obligations of the United States. Consistent with that intent, nothing herein shall preclude COMSAT from reaching similar agreements for circuits with other USISCs, and nothing herein shall preclude MCI from placing traffic not covered by this Agreement on whatever telecommunications facilities it should select. ARTICLE II DEFINITIONS The terms used in this Agreement are defined as follows: 1. Additional Circuits. Digital Bearer Circuits activated by MCI on the INTELSAT system via COMSAT on or after January 1, 1992 for 7-year, 10-year or 15-year lease terms, including but not limited to the 7-year circuits that MCI committed to take pursuant to the 1993 Agreement and the 10-year circuits that MCI has committed to take pursuant to this Agreement. 2. Analog-to-Digital Conversions. Digital Bearer Circuits converted from FM Circuits. 3. Base Circuits. The Digital Bearer Circuits activated by MCI on the INTELSAT system via COMSAT prior to January 1, 1992, each of which circuits MCI committed to take for 15-year lease terms pursuant to the 1988 Agreement. 4. Circuit Month. The utilization by MCI of one 64 Kbps equivalent Digital Bearer Circuit for thirty (30) consecutive days as part of the First Bulk Offering provided under this Agreement. 5. Date of Activation. The month, day and year on which a particular FM Circuit or Digital Bearer Circuit is placed in service. 6. Derived Circuits. Circuits created from Digital Bearer Circuits by means of Digital Circuit Multiplication Equipment (DCME). 7. Digital Bearer Circuits. 64 Kbps equivalent circuits used to carry public-switched traffic (including IDR and TDMA circuits, but excluding private line circuits such as IBS); these circuits may or may not be aggregated into larger digital carriers, e.g., 2.048 Mbps. 8. Efficiency Factor. The maximum number of Derived Circuits that may be provided through a Digital Bearer Circuit. 9. First Bulk Offering. The offering by COMSAT to MCI of a total of Circuit Months of service on a take-or-pay basis pursuant to the rates, terms and conditions initially specified in the 1993 Agreement and subsequently revised in this Agreement. 10. FM Circuits. 4 Khz analog circuits associated with analog carriers using Frequency Division Multiple Access and Frequency Modulation. 11. Global Traffic Meeting. INTELSAT's annual Global Traffic Meeting, at which USISCs and their foreign correspondents forecast their requirements for INTELSAT satellite circuits. 12. Growth Circuits. Digital Bearer Circuits (excluding Analog-to-Digital Conversions) activated after the effective date of this Agreement. 13. IDR Circuits. 64 Kbps equivalent international digital route circuits associated with digital carriers using Quadrature Phase Shift Keying (QPSK) modulation. 14. Large Standard A Earth Station. An earth station having a gain-to-noise temperature ratio ("G/T") at least equal to 40.7 dB/K in the U.S. and at least equal to 39 dB/K at the foreign end. 15. Revised Standard A Earth Station. An earth station having a gain-to-noise temperature ratio ("G/T") at least equal to 35 dB/K. 16. Second Bulk Offering. The offering by COMSAT to MCI of options to lease up to three (3) 36 MHz allotments pursuant to the rates, terms and conditions specified in this Agreement. 17. Tariff No. 1. COMSAT World Systems Tariff F.C.C. No. 1. 18. TDMA Circuits. 64 Kbps equivalent digital circuits providing Time Division Multiple Access service. 19. Voice-Grade Circuits. Circuits on any long-haul transmission medium consisting of FM Circuits, Digital Bearer Circuits not using DCME, and Derived Circuits. ARTICLE III BASE AND ADDITIONAL CIRCUITS A. MCI hereby reaffirms the prior commitment it made to COMSAT under the 1988 Agreement (and affirmed in the 1993 Agreement) to place at least Voice-Grade Circuits on the INTELSAT system via COMSAT by December 31, 1998. In fulfillment of that commitment, as of the date of this Agreement MCI had taken Digital Bearer Circuits from COMSAT for 15-year lease terms. Those circuits were all activated before January 1, 1992, and are referred to herein as Base Circuits. MCI also reaffirms its prior commitment to COMSAT under the 1988 Agreement and 1993 Agreement not to cancel any of its existing 15- year Digital Bearer Circuits until January 1, 1999, at the earliest. B. MCI also committed under the 1993 Agreement to place on the INTELSAT system via COMSAT at least 7-year Digital Bearer Circuits between January 1, 1992 and December 31, 1993. In exchange for this commitment, which has also been fulfilled, COMSAT affirms that it will allow MCI to deactivate any or all of its FM Circuits in existence as of the effective date of the 1993 Agreement (up to a maximum of FM Circuits) at any time during the term of the present Agreement without incurring early termination charges. C. COMSAT hereby agrees to provide, and MCI commits and agrees to lease from COMSAT, an additional 64 Kbps equivalent IDR Growth Circuits. At least of these circuits must be leased within one (1) year after the effective date of this Agreement and the remainder within two (2) years after the effective date of this Agreement. The lease term for each of these circuits shall be ten (10) years. D. In addition to the 15-year Digital Bearer Circuits described in Paragraph A of this Article, the 7-year Digital Bearer Circuits described in Paragraph B of this Article, and the 10-year IDR Growth Circuits described in Paragraph C of this Article, MCI may order other long-term Digital Bearer Circuits from COMSAT. For purposes of this Agreement, all 7- year, 10-year and 15-Year Digital Bearer Circuits activated by MCI after January 1, 1992 (including the 7-year circuits described in Paragraph B and the 10-year circuits described in Paragraph C) are referred to as Additional Circuits. E. MCI affirms its prior commitment to maintain for the duration of their respective lease terms at least Voice- Grade Circuits in the combined Europe/Latin America Region and at least Voice-Grade Circuits in the Pacific Region pursuant to its written notification availing itself of COMSAT's 1989 promotional regional tariff. Above those specified circuit levels, MCI shall have the flexibility to redistribute its Base and Additional Circuits geographically consistent with the procedures specified in Tariff No. 1 (which provisions are hereby incorporated into this Agreement), without incurring early termination charges for such redistribution or triggering the start of a new lease term. F. COMSAT will permit MCI to redesignate Base Circuits as Additional Circuits and vice versa, and will also permit MCI to redesignate the Circuit Months provided under the First Bulk Offering described in Article V below as Base or Additional Circuits and vice versa. Such redesignation is subject to the following conditions, however: (1) a circuit may not be redesignated more than once every thirty (30) days; (2) MCI's total number of 15-year Base Circuits may not be reduced below before January 1, 1999 at the earliest and thereafter may be reduced only upon payment of early termination charges; (3) MCI's commitment of Circuit Months pursuant to Article V below may not be reduced; and (4) except as provided in Article VI below, MCI's total number of Additional Circuits may not be reduced without payment of early termination charges. ARTICLE IV RATES FOR BASE AND ADDITIONAL CIRCUITS A. COMSAT's rates for MCI's Base Circuits shall be reduced as of December 1, 1993 to the levels specified in Attachment A, which is appended hereto and made part of this Agreement. The rates in Attachment A are for Base Circuits provided via INTELSAT Revised Standard A Earth Stations at the U.S. end. Base Circuits transmitted through standard earth stations with lower G/T values at the U.S. end shall be subject to the rate adjustment factors specified in Attachment B, which is also appended hereto and made part of this Agreement. In addition, the Parties agree that, from December 1, 1993 through December 31, 1997, a discount of 10% below the rates specified in Attachment A shall be applied to Base Circuits transmitted through Large Standard A Earth Stations at both ends. B. COMSAT's rates for MCI's Additional Circuits are specified in Attachments C and D, which are appended hereto and made part of this Agreement. The rates in Attachments C and D are for Additional Circuits provided via INTELSAT Large Standard A and Revised Standard A earth stations at the U.S. end. Additional Circuits transmitted through standard earth stations with lower G/T values at the U.S. end shall be subject to the rate adjustment factors specified in Attachment B. however, that MCI must accept or reject the amended terms and conditions in their entirety. ARTICLE V FIRST BULK OFFERING A. The Parties hereby affirm that COMSAT shall provide, and that MCI shall place on the INTELSAT system via COMSAT, Digital Bearer Growth Circuits equivalent to Circuit Months during the period from April 8, 1993 through December 31, 1999. The Parties also affirm that COMSAT shall provide these Circuit Months to MCI on a take-or-pay basis as a Bulk Offering at special rates within the framework of this Agreement. B. The Bulk Offering described in this Article (hereafter "First Bulk Offering") is designed to accommodate MCI's varying growth traffic requirements during the period from April 8, 1993 through December 31, 1999, in a flexible manner consistent with reasonable operational constraints. Accordingly, MCI previously agreed to pay for at least the following numbers of 64 Kbps equivalent Digital Bearer Circuit Months within the following calendar years: Calendar Year Circuit Month Commitment 1996 C. MCI recognizes that COMSAT and INTELSAT may be unable to accommodate spikes in MCI's traffic. For this reason, COMSAT's commitment under Articles III-C, III-D, V-A and V-B of this Agreement is limited to meeting circuit orders: (1) that have been included in MCI's then-current Global Traffic Meeting forecast for the relevant calendar year; (2) that have been matched by a foreign correspondent; (3) in amounts up to 270 64 Kbps equivalent Digital Bearer Circuits in a given calendar month and up to 1,710 64 Kbps equivalent Digital Bearer Circuits in a given calendar year. However, COMSAT will attempt to fill any MCI order, and circuits in excess of the limits specified herein will be provided if available. If MCI orders circuits within the limits specified herein under Articles V-A and V-B of this Agreement, and such circuits cannot be accommodated by the sixtieth (60th) day from the date a matched order is placed with COMSAT, such circuits will be subtracted from MCI's commitment under Articles V-A and V-B for the calendar year after the sixtieth (60th) day during which they were unavailable. Circuits ordered in excess of the limits specified herein that cannot be accommodated will not be subtracted from MCI's commitments under Articles V-A and V-B for the applicable calendar year. If MCI orders circuits within the limits specified herein under Article III-C of this Agreement, and such circuits cannot be accommodated by the sixtieth (60th) day from the date a matched order is placed with COMSAT, such circuits will not be subtracted from MCI's total commitment of circuits under Article III-C, but their activation may be postponed until the following calendar year. D. Except as provided in Paragraph J below, COMSAT's rates for Circuit Months provided pursuant to the First Bulk Offering described in this Article shall be set at $10 per month per 64 Kbps equivalent Digital Bearer Circuit above the Block 1 step rate specified in Attachment D (or the Block 1 step rate specified in Tariff No. 1, if that rate is lower) that would have been applicable if the same circuit had been taken for a seven (7) year lease term. E. Billing for each circuit activated pursuant to this First Bulk Offering shall commence as of the Date of Activation, and shall continue until the circuit is deactivated. Charges will be billed on a calendar month basis. There shall be no early termination charges associated with this First Bulk Offering. However, each circuit provided pursuant to this First Bulk Offering must be activated for at least thirty (30) consecutive days and may be deactivated only on ten (10) days' prior written notice. During both the first and last calendar months of service for each circuit, MCI shall be charged for one- half month of service if the circuit is utilized for fifteen (15) days or less, and for a full month of service if the circuit is utilized for more than fifteen (15) days. F. Except as provided in Paragraph J below, if, at the end of a given calendar year, the Circuit Month volume committed to by MCI exceeds its actual use, MCI shall pay for the difference within sixty (60) days at the rate of $10 per month per 64 Kbps equivalent Digital Bearer Circuit above the Block 1 step rate specified in Attachment D (or the Block 1 step rate specified in Tariff No. 1, if that rate is lower) that would have been applicable if the same circuit had been taken for a seven (7) year lease term. If MCI's actual use of Circuit Months exceeds its commitment during a given calendar year, the overage may be applied against MCI's commitment for the subsequent calendar year or, alternatively, MCI may receive a credit for the overage up to the amount of any shortfall it has paid for that occurred during the previous calendar year. G. Except as otherwise specified in this Agreement, all Digital Bearer Circuits provided pursuant to the First Bulk Offering described in this Article shall be subject to the same terms and conditions as those specified in Tariff No. 1 as of the effective date of this Agreement, and those tariff provisions are hereby incorporated into this Agreement. If such tariff terms and conditions are amended during the term of this Agreement, the amended terms and conditions shall also be automatically incorporated into this Agreement and shall be effective as of the effective date of the tariff amendment, unless MCI notifies COMSAT in writing within thirty (30) days of such effective date that it does not accept the amended terms and conditions, in which case the prior terms and conditions will continue to apply to MCI; provided, however, that MCI must accept or reject the amended terms and conditions in their entirety. H. Any request by MCI during the period through December 31, 1999, for additional Circuit Months beyond the Circuit Months specified in this Article shall be the subject of a separate agreement with respect to price and terms when and if such requests are made. I. To the extent MCI orders Digital Bearer Circuits from COMSAT over and above the 7-year circuits described in Article III-B and the 10-year circuits described in Article III-C for terms of seven (7) years or more, the Circuit Months (out to December 31, 1999) represented by such circuits, up to a maximum of Circuit Months, may be counted prospectively toward the fulfillment of MCI's commitment under Articles V-A and V-B of this Agreement. J. As of the effective date of this Agreement, it appears that MCI placed Digital Bearer Growth Circuits equivalent to only Circuit Months with COMSAT during 1993. In consideration of MCI's other traffic commitments reflected in this Agreement, the Parties agree that Paragraph F of this Article shall not be invoked, and that MCI shall make up the 1993 shortfall of Circuit Months completely in 1994. The price for these Circuit Months, and only these Circuit Months, shall be $465 per month per 64 Kbps equivalent circuit. The price for the Circuit Months originally committed to for 1994 under Paragraph B of this Article shall be $625 per month per 64 Kbps equivalent circuit. If MCI fails by year-end 1994 to place with COMSAT the total of Circuit Months ( ) committed to for 1994, then the provisions of Paragraph F of this Article will apply. MCI hereby reaffirms its commitment either to place the remainder of its Circuit Months with COMSAT according to the schedule set forth in Paragraph B of this Article or to follow the procedures set forth in Paragraph F of this Article. MCI also reaffirms its agreement that the price for all Circuit Months other than the Circuit Months referenced in this Paragraph shall be as specified in Paragraph D of this Article. ARTICLE VI SECOND BULK OFFERING A. The Parties agree that MCI shall have options to lease up to three (3) 36 MHz bandwidth allotments from COMSAT for U.S. traffic. Two (2) of these options shall expire one (1) year after the effective date of this Agreement, and the third option shall expire two (2) years after the effective date of this Agreement. The designation of the specific capacity to be leased shall be subject to mutual agreement. All three (3) 36 MHz allotments offered pursuant to the Second Bulk Offering described in this Article shall be subject to the availability of capacity for the entire lease term as of the start date requested by MCI, and shall be leased pursuant to the rates, terms and conditions described in Paragraphs B-L below. B. MCI must lease each 36 MHz bandwidth allotment for a 10- year term, which term must commence before the expiration of the option date specified in Paragraph A above. C. COMSAT's rates for each 36 MHz allotment provided pursuant to the Second Bulk Offering described in this Article shall initially be $189,000 per month. If MCI leases three (3) 36 Mhz allotments within one (1) year after the effective date of this Agreement, the rate for each of the three allotments shall be $165,000 per month from January 1, 1997 through the remainder of the lease term for each allotment. If MCI leases two (2) 36 MHZ allotments within one (1) year after the effective date of this Agreement and a third 36 MHz allotment within two (2) years after the effective date of this Agreement, the rate for each of the three allotments shall be $165,000 per month from January 1, 1998 through the remainder of the lease term for each allotment. D. The Parties recognize that, even after COMSAT and MCI agree on specific capacity to be leased as part of the Second Bulk Offering described in this Article, there is still likely to be substantial non-MCI traffic located in these allotments that will constrain MCI's ability to utilize them fully. The parties also recognize that it will take some time to relocate this non- MCI traffic consistent with INTELSAT's standard relocation procedures. Therefore, until this relocation is complete, COMSAT will prorate its lease price such that, if there are X non-MCI circuits being leased from COMSAT in a given allotment, the lease price for that allotment will be ((540-X)/540) x $189,000 (or $165,000, as applicable) per month. E. Each of the 36 MHz allotments described in this Article may accommodate up to 540 64 Kbps equivalent circuits. Consistent therewith, COMSAT and MCI hereby agree that, during the two-year period following the effective date of this Agreement, MCI's 36 MHz allotment(s) may absorb any or all of the 10-year Additional Circuits committed by MCI pursuant to Article III-C of this Agreement. In addition, the Parties agree that, during the six-month period following the commencement of each lease for a 36 MHz allotment, that allotment may absorb up to 270 of MCI's other existing Additional Circuits (except circuits ordered under Article V-I of this Agreement), provided, however, that the total number of 64 Kbps equivalent circuits in any one 36 MHz allotment shall not exceed 540. (Base Circuits within the allotment may be substituted for Additional Circuits, but only if equivalent numbers of Additional Circuits outside the allotment are redesignated as Base Circuits, so that MCI's total number of Base Circuits remains constant at .) The movement of the 10-year Additional Circuits into the 36 MHz allotments, and of up to 270 other Additional Circuits (excluding Article V-I circuits) into a given 36 MHz allotment, subject to the limits set forth in this Paragraph, shall not be considered early termination, and early termination charges shall not apply thereto. However, if MCI moves more than the permitted number of existing Additional Circuits into 36 MHz allotments, MCI must replace those circuits with Growth Circuits of equal lease term; otherwise, early termination charges will be applied. F. Existing circuits outside the allotment(s) that have not been leased for multi-year terms (including circuits leased pursuant to the First Bulk Offering described in Article V of this Agreement) may be moved into the allotments at any time, and new circuits (including Additional Circuits not yet activated as of the effective date of this Agreement) may be activated inside the allotments at any time. Once a circuit is designated as part of an allotment, all other charges for that circuit shall cease, and that circuit may not be counted either in determining the appropriate block rates for MCI under Article IV-B and Attachments C and D of this Agreement, or in determining the number of Circuit Months placed with COMSAT under Article V of this Agreement. G. MCI agrees that it will not cancel any 36 MHz allotment taken pursuant to this Article until at least five (5) years after the commencement of the lease term for such allotment. H. Beginning five (5) years after the commencement of the lease term for any 36 MHz allotment taken pursuant to this Article, COMSAT's charge for early termination for that allotment shall be a flat fee of $6,880 x 540 64 Kbps equivalent circuits, plus 45% of the balance due at the time of early termination. I. Any 36 MHz allotment provided pursuant to this Article shall be non-preemptible. In case of space segment failure, such allotment(s) shall be restored in accordance with the procedures set forth in INTELSAT SSOG 103, Section 6, as may be amended from time to time. The allotment(s) may be used for any type of U.S. traffic, provided, however, that: (1) INTELSAT's technical lease definitions, as set forth in the IESS documents that COMSAT routinely provides to MCI, shall apply to the use of the allotment(s), and that (2) COMSAT and INTELSAT must approve transmission plans for each circuit located in the allotment(s) in advance of service activation. J. The Parties recognize that, during the lease term of the 36 MHz allotment(s) described in this Article, the particular satellites on which the allotments are initially located may be replaced by other INTELSAT satellites. In such cases, a transponder of different connectivity may be substituted for the replaced transponder upon mutual agreement of the Parties. K. The Parties agree that the rates, early termination charges, and other terms and conditions specified in this Article supersede any conflicting provisions in Tariff No. 1. In addition, the circuits provided pursuant to the Second Bulk Offering described in this Article shall be subject to the terms and conditions specified in Sections 2.1, 2.2, 2.3, 2.4.3, 2.5.1, 2.6, 2.7, 2.10, 2.11 and 9 of Tariff No. 1 as of the date of this Agreement, and those tariff provisions are hereby incorporated into this Agreement. If such tariff terms and conditions are amended during the term of this Agreement, the amended terms and conditions shall also be automatically incorporated into this Agreement and shall be effective as of the effective date of the tariff amendment, unless MCI notifies COMSAT in writing within thirty (30) days of such effective date that it does not accept the amended terms and conditions, in which case the prior terms and conditions will continue to apply to MCI; provided, however, that MCI must accept or reject the amended terms and conditions in their entirety. L. Any request by MCI during the term of this Agreement for additional allotments (or options for allotments) beyond the number of exercisable options specified in this Article shall be the subject of a separate agreement with respect to price and terms when and if such a request is made. ARTICLE VII SEMI-ANNUAL REPORTS A. To ensure compliance with the terms of this Agreement, MCI agrees to provide COMSAT with semi-annual reports, certified by a responsible officer of MCI or that officer's authorized designate. These reports will be provided at mid-year and year- end and will be subject to appropriate non-disclosure agreements. B. With respect to the First Bulk Offering described in Article V above, MCI shall specify in its semi-annual reports: (1) the number of 64 Kbps Digital Bearer Circuits activated and deactivated during the preceding six-month period; (2) the total number of Circuit Months utilized during the preceding six-month period; and (3) the total number of Circuit Months utilized up to the date of the report. C. With respect to the 10-year Digital Bearer Circuits described in Article III-C above, MCI shall specify the number of 64 Kbps equivalent Digital Bearer Circuits activated during the preceding six-month period on a regional basis. If MCI activates Additional Circuits over and above the 10-year circuits described in Article III-C above (and the 7-year circuits described in Article III-B above), it shall specify the number of 64 Kbps equivalent Digital Bearer Circuits activated during the preceding six-month period on a regional basis, and shall also indicate (in the case of circuits leased for seven (7) years or longer) whether it wishes those circuits to be counted prospectively toward the fulfillment of MCI's commitment under Articles V-A and V-B of this Agreement. D. To the extent that MCI exercises any of its options under the Second Bulk Offering described in Article VI above, MCI shall specify in its semi-annual reports: (1) the number of 64 Kbps Digital Bearer Circuits moved into and out of the allotment(s) within the previous six-month period, and (2) whether those circuits are (or were) existing long-term circuits, existing short-term circuits, or new circuits. E. The Parties will meet as needed to review and verify the semi-annual reports provided pursuant to this Article. In addition, and if undertaken at COMSAT's own expense, MCI agrees that COMSAT shall have the annual right to retain an independent firm to audit MCI's compliance with the circuit commitments made under this Agreement, and MCI agrees to cooperate fully with the independent auditors. F. The semi-annual reports provided for in this Article are not a substitute for COMSAT's standard ordering and billing procedures. Thus, nothing in this Article shall relieve MCI of its obligation to inform COMSAT of what service it wishes to take prior to activation, movement or designation of any circuit. ARTICLE VIII MOST FAVORED CARRIER A. To the extent permitted by law, COMSAT agrees that, during the term of this Agreement, it will offer MCI rates, terms and conditions for Base Circuits that are no less favorable than the rates, terms and conditions it makes available, after the effective date of this Agreement, to any other USISC for Digital Bearer Circuits activated prior to January 1, 1992. In the event that, during the term of this Agreement, COMSAT makes available to another USISC rates, terms and conditions for Digital Bearer Circuits activated prior to January 1, 1992 that are more favorable than those applicable under this Agreement, then such more favorable rates, terms and conditions shall be offered by COMSAT to MCI in writing and, if accepted by MCI in writing, shall be automatically incorporated into this Agreement as an amendment thereto, and shall be effective as of the date made available to such other USISC. B. To the extent permitted by law, COMSAT agrees that, during the term of this Agreement, it will offer MCI rates, terms and conditions for Additional Circuits that are no less favorable than the rates, terms and conditions it makes available, after the effective date of this Agreement, to any other USISC (including potentially any carrier subsidiary or affiliate of COMSAT) for Digital Bearer Circuits activated on or after January 1, 1992. In the event that, during the term of this Agreement, COMSAT makes available to another USISC rates, terms and conditions for Digital Bearer Circuits activated on or after January 1, 1992 that are more favorable than those applicable under this Agreement, then such more favorable rates, terms and conditions shall be offered by COMSAT to MCI in writing and, if accepted by MCI in writing, shall be automatically incorporated into this Agreement as an amendment thereto, and shall be effective as of the date made available to such other USISC. C. To the extent permitted by law, COMSAT agrees that, during the term of this Agreement, it will offer MCI rates, terms and conditions for Circuit Month bulk offerings that are no less favorable than the rates, terms and conditions it makes available to any other USISC for any such offerings leased after the effective date of this Agreement. In the event that, during the term of this Agreement, COMSAT makes available to another USISC rates, terms and conditions for Circuit Month bulk offerings leased after the effective date of this Agreement that are more favorable than those applicable under this Agreement, then such more favorable rates, terms and conditions shall be offered by COMSAT to MCI in writing and, if accepted by MCI in writing, shall be automatically incorporated into this Agreement as an amendment thereto, and shall be effective as of the date made available to such other USISC. D. To the extent permitted by law, COMSAT agrees that, during the term of this Agreement, it will offer MCI rates, terms and conditions for 36 MHz frequency allotments that are no less favorable than the rates, terms and conditions it makes available to any other USISC for any such allotments leased after the effective date of this Agreement. In the event that, during the term of this Agreement, COMSAT makes available to another USISC rates, terms and conditions for 36 MHz frequency allotments leased after the effective date of this Agreement that are more favorable than those applicable under this Agreement, then such more favorable rates, terms and conditions shall be offered by COMSAT to MCI in writing and, if accepted by MCI in writing, shall be automatically incorporated into this Agreement as an amendment thereto, and shall be effective as of the date made available to such other USISC. ARTICLE IX CUSTOMER/SUPPLIER RELATIONSHIP In recognition of COMSAT's unique expertise and experience in international satellite telecommunications, the high quality of its services, its performance as U.S. Signatory to INTELSAT, and the Parties' good working relationship over the past decade, MCI agrees that it shall give COMSAT an opportunity to supply additional satellite capacity not covered by this agreement, provided however that, consistent with Article I above, nothing shall preclude MCI from placing such traffic on other facilities. ARTICLE X NEW ENTRANTS A. It is the intent of the Parties under this Article that MCI shall not be placed at a market disadvantage by virtue of paying Base Circuit rates in comparison to other USISCs that did not take Digital Bearer Circuits from COMSAT in substantial numbers prior to January 1, 1992. Accordingly, if any USISC increases the number of 64 Kbps equivalent Digital Bearer Circuits it takes from COMSAT from fewer than in a particular region as of January 1, 1992, to more than in that region during the term of this Agreement (other than by merger with, or acquisition of, another USISC), and thereby achieves a lower average cost per circuit to that region than MCI, COMSAT shall, at its discretion, either: (1) adjust its rates for MCI's Base Circuits so that MCI's average cost per circuit, as billed by COMSAT, for Digital Bearer Circuits to the same region for the same term is no greater than the average cost per circuit available to such other USISC; or (2) adjust its rates for MCI's Base Circuits to the region in question so that those rates are no higher than the highest applicable step rate specified in Tariff No. 1 for 15-year circuits activated after January 1, 1992; or (3) subject to Article III-E above, permit MCI to cancel without penalty enough Base Circuits to the region in question to ensure that its average cost per circuit to that region for the same term is no greater than the average cost per circuit available to such other USISC. B. For purposes of this Article, the regions referred to are those specified in Tariff No. 1, as may be amended from time to time. As of the date of this Agreement, those regions are: (1) (Western) Europe; (2) Pacific; (3) Latin America; and (4) Near and Middle East, Africa and other Europe. C. For purposes of calculating average cost per circuit in connection with this Article, any 36 MHz frequency allotment leased by MCI pursuant to Article VI of this Agreement (or by another USISC pursuant to a similar bulk offering) shall be deemed the equivalent of 540 Digital Bearer Circuits. D. As part of the review process described in Article VII of this Agreement, a responsible officer of COMSAT, or that officer's designee, shall certify to MCI whether any USISC has met the criteria set forth in Paragraph A of this Article. Such certification shall not require COMSAT to disclose to MCI the identity of such USISC, or any other confidential or competitively sensitive information with respect to such USISC. ARTICLE XI INCENTIVE REGULATION Notwithstanding any other provision of this Agreement, Article X of this Agreement (entitled "New Entrants") shall not take effect unless and until the Federal Communications Commission issues a final Memorandum Opinion and Order, which is no longer subject to Commission or court review, granting COMSAT's specific request, as described in its Petition for Rulemaking, RM-7913, filed January 30, 1992, for incentive-based regulation of its multi-year fixed-price carrier-to-carrier contract-based switched-voice INTELSAT services. ARTICLE XII REMEDIES A. In the event that COMSAT materially breaches Article IV- A, IV-B, or V-D of this Agreement, MCI shall be entitled to damages in an amount equal to the difference between the rates MCI actually paid and the rates specified in Attachments A, C and D and in Article V-D for the number of Base Circuits, Additional Circuits or Circuit Months involved. B. In the event that MCI exercises its option to lease one or more 36 MHz transponders pursuant to Article VI of this Agreement, and COMSAT then materially breaches Article VI-C of this Agreement, MCI shall be entitled to damages in an amount equal to the difference between the rates MCI paid and the rates specified in Article VI-C for the number of 36 MHz allotments involved. C. In the event that COMSAT materially breaches Article VIII of this Agreement, MCI shall be entitled to damages in an amount equal to the difference between the rates MCI paid for the circuits covered by this Agreement and the rates MCI would have paid for those circuits if COMSAT had not breached Article VIII. D. In the event that MCI materially breaches Article III-A of this Agreement, COMSAT shall be entitled to damages in an amount equal to the revenues that COMSAT would have realized if MCI had left Base Circuits in place in accordance with its commitments to COMSAT and then canceled those circuits on January 1, 1999. E. In the event that MCI materially breaches Article III-C of this Agreement, COMSAT shall be entitled to damages in an amount equal to the termination charges that COMSAT would have realized if MCI had activated circuits on the last possible day consistent with its commitments and then canceled those circuits immediately. Alternatively, MCI may notify COMSAT that it wishes to commence payment for those circuits and activate them up to six (6) months later. If those circuits then are not activated within six (6) months, termination charges will apply to the remaining balance. F. In the event that MCI exercises its option to lease one or more 36 MHz frequency allotments pursuant to Article VI of this Agreement, and MCI then materially breaches Article VI-G of this Agreement with respect to such allotment(s), COMSAT shall be entitled to damages in an amount equal to the difference between the rates MCI paid and the revenues that COMSAT would have realized if MCI had not canceled such allotment(s) until five (5) years after commencement of the lease term for each allotment and had then canceled those leases. G. In no event shall either Party be entitled to damages or other remedies under this Article unless it provides the other Party with notice and a reasonable opportunity to cure within sixty (60) days of the date when the Party claiming breach either knew or should have known of the event giving rise to the alleged breach. ARTICLE XIII TERM OF AGREEMENT The term of this Agreement shall commence upon execution of the Agreement by both Parties and shall run through December 31, 2003, provided, however, that all applicable rates, terms and conditions for each circuit leased pursuant to the provisions of this Agreement (or its predecessors, the 1988 Agreement and the 1993 Agreement) shall survive until the expiration of that circuit's lease term. Thus, for example, the rates, terms and conditions for a 10-year Additional Circuit activated on January 1, 1995 would remain in effect until December 31, 2004. ARTICLE XIV FCC REVIEW The Parties shall jointly submit this Agreement to the FCC within thirty (30) days of execution pursuant to Section 211(a) of the Communications Act, and shall request confidential treatment for any competitively sensitive information contained herein. If any FCC proceeding is initiated with respect to the entry into force of this Agreement, the Parties agree to cooperate fully in seeking a prompt and favorable resolution of such proceeding. ARTICLE XV DISPUTE RESOLUTION If any dispute arises with respect to the interpretation, implementation or termination of this Agreement, the Parties will use their best efforts to resolve the matter amicably, including recourse to the highest levels of management in their respective organizations. If such efforts fail to resolve the dispute within a reasonable time, the Parties agree to present that dispute to the American Arbitration Association in Washington, D.C. for binding resolution in accordance with that Association's Commercial Rules of Arbitration, or in lieu of arbitration, to utilize another mutually agreeable means of alternative dispute resolution (ADR). Each Party shall bear all of its own costs incurred in utilizing arbitration or other ADR mechanism. ARTICLE XVI ENTIRE AGREEMENT This Agreement (including its attachments and those portions of COMSAT's tariffs which are incorporated by reference) replaces the 1993 Agreement between the Parties, and constitutes the entire agreement between the Parties as to MCI's utilization of COMSAT's INTELSAT space segment capacity for the telecommunications services specified herein; it is intended as the complete and exclusive statement of the terms of the agreement between the Parties, and supersedes all previous understandings, commitments or representations by or between the Parties with respect to its subject matter. ARTICLE XVII REPRESENTATIONS OF AUTHORITY Each Party to this Agreement hereby represents and warrants to the other that it is a corporation duly organized, validly existing, and in good standing under the laws of its jurisdiction of incorporation; that it has appropriate approvals and direction from its Board of Directors to empower it to enter into and perform its obligations under this Agreement; and that it has taken all requisite corporate action to approve the execution, delivery, and performance of this Agreement. ARTICLE XVIII BINDING OBLIGATION A. This Agreement, when executed and delivered, shall be a legal, valid and binding obligation of COMSAT and MCI, and shall bind all successors, permitted assigns and U.S. subsidiaries of the Parties. B. The provisions of this Agreement are for the benefit only of the Parties hereto and their subsidiaries, successors and permitted assigns, and no other party may seek to enforce, or benefit from, any provision of this Agreement. C. Neither Party shall assign or transfer its rights and obligations under this Agreement without the other Party's express written consent, which consent shall not be unreasonably withheld. ARTICLE XIX NOTICES All written notices required under this Agreement shall be considered properly given only when sent by registered or certified mail, return receipt requested, to the following addresses, respectively, or to such other addresses as the receiving party may hereafter designate in writing: To MCI: William A. Paquin Vice President - Finance/Information Services MCI International, Inc. 2 International Drive Rye Brook, New York 10573 To COMSAT: Patricia S. Benton Vice President and General Manager COMSAT World Systems 6560 Rock Spring Drive Bethesda, MD 20817 Any period of time referred to herein which is to commence upon notice shall be counted from the date such notice is received as aforesaid. ARTICLE XX WAIVERS The waiver by either Party of a breach of, or default under, any of the provisions of this Agreement, or the failure of either Party, on one or more occasions, to enforce any of the provisions of this Agreement or to exercise any right or privilege hereunder, shall not thereafter be construed as a waiver of any subsequent breach or default of a similar nature, or as a waiver of any provision, right or privilege hereunder. ARTICLE XXI MISCELLANEOUS A. The article headings and table of contents in this Agreement are inserted for convenience only and do not constitute a part of this Agreement. B. This Agreement may be amended only in writing by an instrument signed by authorized representatives of both Parties. C. This Agreement shall be construed according to the laws of the State of Maryland. D. This Agreement may be executed in counterparts, each of which shall be deemed an original, and all such counterparts together shall constitute one and the same instrument. E. This Agreement shall become effective as of the last date written below. IN WITNESS WHEREOF, each of the Parties hereto has executed this Agreement. MCI INTERNATIONAL, INC. COMSAT CORPORATION /s/William A. Paquin /s/Patricia Benton By:___________________________ By:___________________________ Vice President and General Manager Vice President COMSAT World Systems Title: _______________________ Title:________________________ 24 January 1994 January 21, 1994 Date:_________________________ Date:_________________________ ATTACHMENT A BASE CIRCUIT RATES Per month per activated carrier(1) 15-Year Term Carrier Size 1993(2) 1994(3) 1995(4) 1996(5) 1997(6) 64 Kbps $470 $595 $535 $465 $360 512 Kbps 3,760 4,760 4,280 3,720 2,880 1.024 Mbps 7,520 9,520 8,560 7,440 5,760 1.544 Mbps 10,370 13,130 11,760 10,175 7,920 2.048 Mbps 12,960 16,410 14,700 12,720 9,900 6.312 Mbps 36,530 46,250 41,430 35,850 27,900 8.448 Mbps 48,710 61,670 55,240 47,800 37,200 Per 64 Kbps equivalent in a fully-activated 2.048 Mbps carrier $432 $547 $490 $424 $330 - - - --------------------- (1) The rates specified in this Attachment are for services to INTELSAT Revised Standard A Earth Stations at the U.S. end. (2) The rates in this column shall be in effect only for the month of December 1993. (3) The rates in this column shall take effect on January 1, 1994. (4) The rates in this column shall take effect on January 1, 1995. (5) The rates in this column shall take effect on January 1, 1996. (6) The rates in this column shall take effect on January 1, 1997, and shall remain in effect for the duration of each circuit's lease term unless further reduced. ATTACHMENT B RATE ADJUSTMENT FACTORS for Base and Additional Circuits Earth Station Frequency Minimum Rate Adjustment Standard Band G/T Factor(1) Std. B C 31.7 dB/K 1.36 Std. C 29.0 dB/K 2.05 Std. C 27.0 dB/K 2.92 Std. E-3 Ku 34.0 dB/K 1.68 Std. E-2 Ku 29.0 dB/K 4.94 - - - ----------------------- (1) In the event that COMSAT tariffs rate adjustment factors that are more favorable than those listed in this Attachment, the factors tariffed shall be incorporated automatically into this Agreement. ATTACHMENT C ADDITIONAL CIRCUIT RATES Per month per 64 Kbps equivalent in a fully-activated 2.048 Mbps carrier(1) 10-Year term Block 1993-94(2) 1995(3) 1996(4) 1997(5) Block 1(6) $495 $495 $450 $350 Block 2(7) 445 445 445 350 Block 3(8) 395 395 395 350 Block 4(9) 350 350 350 350 - - - ----------------- (1) The rates specified in this Attachment are for service to all INTELSAT Standard A earth stations. Rates for fully activated 2.048 Mbps carriers shall be 30 times the numbers shown above. Rates for carrier sizes other than 2.048 Mbps shall bear the same relationships to the 2.048 Mbps rate as those shown in Attachment A. (2) The rates in this column are currently in effect. (3) The rates in this column are currently in effect. (4) The rates in this column shall take effect on January 1, 1996. (5) The rates in this column shall take effect on January 1, 1997, and shall remain in effect for the duration of each circuit's lease term unless further reduced. (6) The rates in Block 1 apply to Additional Circuits included among the first 270 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. The regions are those specified in COMSAT World Systems Tariff F.C.C. No.1 as of the effective date of this Agreement, i.e.: (1) (Western) Europe; (2) Pacific; (3) Latin America; and (4) Near and Middle East, Africa and other Europe. (7) The rates in Block 2 apply to Additional Circuits included among the next 360 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (8) The rates in Block 3 apply to Additional Circuits included among the next 450 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (9) The rates in Block 4 apply to Additional Circuits included among the Digital Bearer Circuits above 1080 (excluding Base Circuits) leased in a given region for terms of at least five years. ATTACHMENT D ADDITIONAL CIRCUIT RATES Per month per 64 Kbps equivalent in a fully-activated 2.048 Mbps carrier(1) 7-Year term Block 1993-94(2) 1995(3) 1996(4) 1997(5) Block 1(6) $615 $615 $559 $455 Block 2(7) 555 555 555 455 Block 3(8) 505 505 505 455 Block 4(9) 455 455 455 455 - - - ------------------------ (1) The rates specified in this Attachment are for service to all INTELSAT Standard A earth stations. Rates for fully activated 2.048 Mbps carriers shall be 30 times the numbers shown above. Rates for carrier sizes other than 2.048 Mbps shall bear the same relationships to the 2.048 Mbps rate as those shown in Attachment A. (2) The rates in this column are currently in effect. (3) The rates in this column are currently in effect. (4) The rates in this column shall take effect on January 1, 1996. (5) The rates in this column shall take effect on January 1, 1997, and shall remain in effect for the duration of each circuit's lease term unless further reduced. (6) The rates in Block 1 apply to Additional Circuits included among the first 270 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. The regions are those specified in COMSAT World Systems Tariff F.C.C. No.1 as of the effective date of this Agreement, i.e.: (1) (Western) Europe; (2) Pacific; (3) Latin America; and (4) Near and Middle East, Africa and other Europe. (7) The rates in Block 2 apply to Additional Circuits included among the next 360 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (8) The rates in Block 3 apply to Additional Circuits included among the next 450 Digital Bearer Circuits (excluding Base Circuits) leased in a given region for terms of at least five years. (9) The rates in Block 4 apply to Additional Circuits included among the Digital Bearer Circuits above 1080 (excluding Base Circuits) leased in a given region for terms of at least five years. EXHIBIT 10(jj) AT&T Maritime Services 650 Liberty Avenue Union, NJ 07083 FAX 908 851-4002 February 18, 1994 Christopher J. Leber Vice President & General Manager CMC Operations COMSAT Mobile Communications 22300 COMSAT Drive Clarksburg, Maryland 20871 Chris, The following outlines the agreement in principle we have reached regarding pricing and volumes for AT&T's branded shore-to-ship mobile satellite service and COMSAT's branded ship-to-shore service to be effective February 1, 1994. AT&T plans to route 1.8 million minutes annually of domestic U.S. originating shore-to-ship Standard A traffic to COMSAT, prorated during the period beginning February 1, 1994 and ending December 31, 1994. AT&T will settle with COMSAT at the rate of $6.70 per minute. Furthermore, for all Standard M and Standard B traffic that AT&T routes to COMSAT during the above period, COMSAT will settle with AT&T at the rate of $4.95 per minute for Standard M traffic and $6.45 per minute for Standard B traffic. COMSAT plans to route 3.6 million minutes annually of ship-to- shore traffic to AT&T, prorated during the period beginning February 1, 1994 and ending December 31, 1994. COMSAT will also return to AT&T all calls designated by the customer for termination over the AT&T network. COMSAT will settle with AT&T at the rate of $.25 per minute for calls terminating in the United States and, for call terminating to all other points, at an amount equal to a 10 percent discount off of AT&T's prevailing published ILD rates. Neither AT&T nor COMSAT commits to traffic volumes, but will make a good faith effort to send the above-described traffic to the other. Each party will review volumes quarterly to verify that these proposed volumes are being satisfied. There will be no shortfall obligation, charge, or penalty for the failure to deliver the planned volumes. The parties agree also to exchange written proposals on or before November 30, 1994 with respect to prices for calendar year 1995. Subject to any appropriate regulatory approvals, this informal letter of understanding will form the basis for a formal contract based upon these principles. The parties will use reasonable best efforts to incorporate the above understanding into a formal contract by the earliest possible date. Please indicate your acceptance in the appropriate space below. Sincerely, /s/Paula Goldstein - - - ------------------ Paula Goldstein Product Manager Maritime Services /s/Cheryl Lynn Schneider Agreed to and accepted by: ________________________________ EXHIBIT 10(kk) ______________________________________________________________________________ FISCAL AGENCY AGREEMENT Between INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION, Issuer and BANKERS TRUST COMPANY Fiscal Agent and Principal Paying Agent _________________________ Dated as of 22 March 1994 _________________________ U.S. $200,000,000 6 5/8% Notes Due 2004 ______________________________________________________________________________ FISCAL AGENCY AGREEMENT, dated as of 22 March 1994 (the "Agreement"), between International Telecommunications Satellite Organization ("INTELSAT"), an international organization established by the Agreement Relating to the International Telecommunications Satellite Organization and the Operating Agreement relating thereto, entered into force on 12 February 1973, and Bankers Trust Company, a bank organized under the laws of New York, United States, as Fiscal Agent and Principal Paying Agent. 1. INTELSAT has, by a Subscription Agreement, dated 7 March 1994, between INTELSAT and Goldman Sachs (Asia) Limited ("GSAL"), and the other Managers named therein (the "Managers"), agreed to issue U.S. $200,000,000 aggregate principal amount of its 6 5/8% Notes Due 2004 (the "Notes"). The Notes shall be issued initially in the form of a temporary global note in bearer form, without interest coupons, substantially in the form of Exhibit A hereto (the "Global Note"). The Global Note will be exchangeable, as provided below, for definitive Notes issuable in bearer form, in denominations of U.S. $10,000 and U.S. $100,000 (the "Bearer Notes") with interest coupons attached (the "coupons"), substan- tially in the forms set forth in Exhibit B hereto. The term "Notes" as used herein includes the Global Note. The term "Holder", when used with respect to a Bearer Note or any coupon, means the bearer thereof. 2. INTELSAT hereby appoints Bankers Trust Company acting through its office at London, United Kingdom, as its fiscal agent and principal paying agent in respect of the Notes upon the terms and subject to the conditions herein set forth (Bankers Trust Company and its successor or successors as such fiscal agent or principal paying agent qualified or appointed in accordance with Section 8 hereof are herein collectively called the "Fiscal Agent"), and Bankers Trust Company hereby accepts such appointment. The Fiscal Agent shall have the powers and authority granted to and conferred upon it herein and in the Notes and such further powers and authority to act on behalf of INTELSAT as may be mutually agreed upon by INTELSAT and the Fiscal Agent. As used herein, "paying agents" shall mean paying agents (including the Fiscal Agent) maintained by INTELSAT as provided in Section 8(b) hereof. 3. (a) The Notes shall be executed on behalf of INTELSAT by the Director General and Chief Executive Officer or by any other officer of INTELSAT specifically identified in a certificate of incumbency and specimen signatures as having the requisite authority to execute the Notes (the "Executive Officers"), any of whose signatures may be manual or facsimile, under a facsimile of its seal reproduced thereon and attested by its General Counsel or an Assistant General Counsel, any of whose signatures may be manual or facsimile. Notes bearing the manual or facsimile signatures of persons who were at any time the proper officers of INTELSAT shall bind INTELSAT, notwithstanding that such persons or any of them ceased to hold such office or offices prior to the authentication and delivery of such Notes or did not hold such office or offices at the date of issue of such Notes. (b) The Fiscal Agent is hereby authorized, in accordance with the provisions of Paragraph 9 of the definitive Notes and this Section, from time to time to authenticate (or to arrange for the authentication on its behalf) and deliver a new Note in exchange for or in lieu of any Note which has become, or the coupons appertaining thereto which have become, mutilated, lost, stolen or destroyed. Each Note authenticated and delivered in exchange for or in lieu of any such Note shall carry all the rights to interest accrued and unpaid and to accrue which were carried by such Note. 4. (a) INTELSAT initially shall execute and deliver, on 22 March 1994 (the "Closing Date"), a Global Note for an aggregate principal amount of U.S. $200,000,000 to the Fiscal Agent, and the Fiscal Agent by a duly authorized officer or an attorney-in-fact duly appointed pursuant to a valid power of attorney shall, upon the order of INTELSAT signed by an Executive Officer of INTELSAT, authenticate the Global Note and deliver the Global Note to The Chase Manhattan Bank, N.A., as common depositary (the "Common Depositary") for the benefit of the operator of the Euroclear System ("Euroclear") and Cedel S.A. ("Cedel"), for credit to the respective account of the purchasers (or to such other accounts as it may direct). (b) For the purposes of this Agreement, "Exchange Date" shall mean a date which is not earlier than the day immediately following the expiration of the 40-day period beginning on the later of the commencement of the offering and the Closing Date. Without unnecessary delay, but in any event not less than 14 days prior to the Exchange Date, in such denominations as are specified by the Fiscal Agent, except in the event of earlier redemption or acceleration, INTELSAT shall execute and deliver to the Fiscal Agent U.S. $200,000,000 principal amount of definitive Bearer Notes. (c) Not earlier than the Exchange Date, the interest of a beneficial owner of the Notes in the Global Note shall only be exchanged for Bearer Notes after the account holder instructs Euroclear or Cedel, as the case may be, to request such exchange on his behalf and presents to Euroclear or Cedel, as the case may be, a certificate substantially in the form set forth in Exhibit C hereto, copies of which certificate shall be available from the offices of Euroclear and Cedel, the Fiscal Agent and each other paying agent of INTELSAT. Any exchange pursuant to this paragraph shall be made free of charge to beneficial owners of the Global Note, except that a person receiving definitive Notes must bear the cost of insurance, postage, transportation and the like in the event that such person does not take delivery of such definitive Notes in person at the offices of Euroclear or Cedel. In no event shall any such exchange occur prior to the Exchange Date. (d) Upon request for issuance of Bearer Notes, on or after the Exchange Date, the Global Note shall be surrendered by the Common Depositary to the Fiscal Agent, as INTELSAT's agent, for purposes of the exchange of Notes described below. Following such surrender and upon presentation by Euroclear or Cedel, acting on behalf of the beneficial owners of Bearer Notes, to the Fiscal Agent at its principal office in London, United Kingdom (the "Principal Office") of a certificate or certificates substantially in the form set forth in Exhibit D hereto, the Fiscal Agent shall authenticate (or arrange for the authentication on its behalf) and deliver to Euroclear or Cedel, as the case may be, for the account of such owners, the Bearer Notes in exchange for an aggregate principal amount equal to the principal amount of the Global Note beneficially owned by such owners. The presentation to the Fiscal Agent by Euroclear or Cedel of such a certificate may be relied upon by INTELSAT and the Fiscal Agent as conclusive evidence that a related certificate or certificates has or have been presented to Euroclear or Cedel, as the case may be, as contemplated by the terms of Section 4(c) hereof. Upon any exchange of a portion of the Global Note for Bearer Notes, the Global Note shall be endorsed by the Fiscal Agent to reflect the reduction of the principal amount evidenced thereby, whereupon its remaining principal amount shall be reduced for all purposes by the amount so exchanged; provided, that when the Global Note is exchanged in full, the Fiscal Agent shall cancel it. Until so exchanged in full, the Global Note shall in all respects be entitled to the same benefits under this Agreement as the definitive Notes authenticated and delivered hereunder, except that none of Euroclear, Cedel or the beneficial owners of the Global Note shall be entitled to receive payment of interest thereon. Notwithstanding the foregoing, in the event of redemption or acceleration of the Global Note prior to the issue of the Bearer Notes, Bearer Notes will be issuable in respect of such Global Note on or after the later of (i) the date fixed for such redemption or on which such acceleration occurs and (ii) the Exchange Date, and all of the foregoing in this subsection (d) shall be applicable to the issuance of such Bearer Notes. (e) No Note or coupon shall be entitled to any benefit under this Agreement or be valid or obligatory for any purpose unless there appears on such Note or coupon a certificate of authentication substantially in the forms provided for herein and executed by the Fiscal Agent by manual signature, and such certificate upon any Note or coupon shall be conclusive evidence, and the only evidence, that such Note or coupon has been duly authenticated and delivered hereunder. 5. (a) INTELSAT will pay or cause to be paid to the Fiscal Agent the amounts required to be paid by it herein and in the Notes, at the times and for the purposes set forth herein and in the Notes and in the manner set forth below, and INTELSAT hereby authorizes and directs the Fiscal Agent to make payment of the principal of and interest and additional amounts pursuant to Paragraph 5 of the definitive Notes ("Additional Amounts"), if any, on the Notes in accordance with the terms of the Notes. (i) INTELSAT shall initiate a wire transfer for payment to the Fiscal Agent at its Principal Office in London, United Kingdom, by no later than 10:00 a.m. (New York time) on the applicable Interest Payment Date, any redemption date and the maturity date of the Notes, in such coin or currency of the United States of America as at the time of payment is legal tender for the payment of public and private debts, of amounts sufficient (with any amounts then held by the Fiscal Agent and available for the purpose) to pay the interest on, the redemption price of an accrued interest (if the redemption date is not an Interest Payment Date) on, and the principal of, the Notes due and payable on such an Interest Payment Date, redemption date or maturity date, as the case may be. (ii) INTELSAT will supply to the Fiscal Agent by 10:00 a.m. (New York time) on the second business day prior to the due date for any such payment a confirmation (by tested telex or authenticated SWIFT message or by facsimile transmission with an original to follow by mail) that such payment will be made, which confirmation shall identify the bank from which the wire transfer constituting payment will be made. (iii) The Fiscal Agent will forthwith notify by telex each of the other paying agents and INTELSAT if it has not (A) by the time specified for its receipt, received the confirmation referred to above or (B) by the due date for any payment due, received the full amount so payable on such date. (iv) In the absence of the notification from the Fiscal Agent referred to in sub-clause (iii) of this Clause, each such paying agent shall be entitled to assume that the Fiscal Agent has received the full amount due in respect of the Notes or the Coupons on that date and shall be entitled: (A) to pay maturing Notes and Coupons in accordance with their terms; and (B) to claim any amounts so paid by it from the Fiscal Agent (notwithstanding anything herein to the contrary). (v) Without prejudice to the obligations of INTELSAT to make payments in accordance with the provisions of this Clause, if payment of the appropriate amount shall be made by or on behalf of INTELSAT later than the time specified, but otherwise in accordance with the provisions hereof, the Fiscal Agent shall forthwith notify the paying agents and give notice to holders of the Notes, that the Fiscal Agent has received such amount and the paying agents will act as such for the Notes and Coupons and make or cause to be made payments as provided herein. (vi) The Fiscal Agent shall apply the amounts so paid to it to the payment of such interest, redemption price and principal in accordance with the terms of the Notes. Any monies paid by INTELSAT to the Fiscal Agent for the payment of the principal of and interest on any Notes and remaining unclaimed at the end of two years after such principal or interest shall have become due and payable (whether at maturity, upon call for redemption or otherwise) shall then be repaid to INTELSAT upon its written request, and upon such repayment all liability of the Fiscal Agent with respect thereto shall thereupon cease, without, however, limiting in any way any obligation INTELSAT may have to pay the principal of and interest on this Note as the same shall become due. (b) Notwithstanding any other provision hereof (other than the last sentence of this Section 5(b)) or of the Notes, no payment with respect to principal of or interest or Additional Amounts, if any, on any Bearer Note may be made at any office of the Fiscal Agent or any other paying agent maintained by INTELSAT in the United States of America (including the States and the District of Columbia), its territories or possessions and other areas subject to its jurisdiction (the "United States"). No payment with respect to a Bearer Note shall be made by transfer to an account in, or by mail to an address in, the United States. Notwithstanding the foregoing, payment of principal of and interest and Additional Amounts, if any, on Bearer Notes shall be made at the paying agent in the Borough of Manhattan, The City of New York, if (but only if) payments in United States dollars of the full amount of such principal, interest or Additional Amounts at all offices or agencies outside the United States through which payment is to be made in accordance with the terms of the Notes is illegal or effectively precluded by exchange controls or other similar restrictions. (c) If INTELSAT becomes liable to pay additional amounts pursuant to Section 5 of the Notes, then, at least ten business days prior to the date of any such payment of principal or interest to which such payment of additional amounts relates, INTELSAT shall furnish the Fiscal Agent, the Paying Agent and each other paying agent of INTELSAT with a certificate which specifies, by country, the rates of withholding, if any, applicable to such payment to Holders of the Notes, and shall pay to the Paying Agent such amounts as shall be required to be paid to Holders of the Notes. INTELSAT hereby agrees to indemnify the Fiscal Agent, the Paying Agent and each other paying agent of INTELSAT for, and to hold them harmless against, any loss, liability or expense incurred without negligence or bad faith on their part arising out of or in connection with actions taken or omitted by any of them in reliance on any certificate furnished pursuant to this Section 5(c). (d) In the case of any redemption of Notes, INTELSAT shall give notice, not less than 45 or more than 75 days prior to any date set for redemption (as provided for in Paragraph 6 of the definitive Notes), to the Fiscal Agent of its election to redeem the Notes on such redemption date specified in such notice. The Fiscal Agent shall cause notice of redemption to be given in the name and at the expense of INTELSAT in the manner provided in Paragraph 6(e) of the definitive Notes. 6. All Notes and coupons surrendered for payment, redemption or exchange shall, if surrendered to anyone other than the Fiscal Agent, be cancelled and delivered to the Fiscal Agent. All cancelled Notes and coupons held by the Fiscal Agent shall be destroyed, and the Fiscal Agent shall furnish to INTELSAT a certificate with respect to such destruction, except that the cancelled Global Note and the certificates as to beneficial ownership required by Section 4 hereof shall not be destroyed but shall be delivered to INTELSAT. 7. The Fiscal Agent accepts its obligations set forth herein and in the Notes upon the terms and conditions hereof and thereof, including the following, to all of which INTELSAT agrees and to all of which the rights hereunder of the Holders from time to time of the Notes and coupons shall be subject: (a) The Fiscal Agent and each other paying agent of INTELSAT shall be entitled to the compensation to be agreed upon with INTELSAT for all services rendered by it, and INTELSAT agrees promptly to pay such compensation and to reimburse the Fiscal Agent and each other paying agent of INTELSAT for its reasonable out-of- pocket expenses (including reasonable advertising expenses and counsel fees) incurred by it in connection with the services rendered by it hereunder. INTELSAT also agrees to indemnify each of the Fiscal Agent and each other paying agent of INTELSAT hereunder for, and to hold it harmless against, any loss, liability or expense incurred without negligence or bad faith on the part of the Fiscal Agent or such other paying agent, arising out of or in connection with its acting as such Fiscal Agent or other paying agent of INTELSAT hereunder, including the costs and expenses of defending against any claim of liability. For purposes of this Section, the obligations of INTELSAT shall survive the payment of the Notes and the resignation or removal of the Fiscal Agent or any other paying agent of INTELSAT hereunder. (b) In acting under this Agreement and in connection with the Notes, the Fiscal Agent and each other paying agent of INTELSAT are acting solely as agents of INTELSAT and do not assume any obligation or relationship of agency or trust for or with any of the Holders of the Notes or coupons, except that all funds held by the Fiscal Agent or any other paying agent of INTELSAT for payment of principal of or interest or Additional Amounts, if any, on the Notes shall be held in trust, but need not be segregated from other funds except as required by law, and shall be applied as set forth herein and in the Notes; provided, however, that monies paid by INTELSAT to the Fiscal Agent or any other paying agent of INTELSAT for the payment of principal of or interest or Additional Amounts, if any, on Notes remaining unclaimed at the end of two years after such principal or interest or Additional Amounts, if any, shall have become due and payable shall be repaid to INTELSAT, promptly upon its request, as provided and in the manner set forth in the Notes, whereupon the aforesaid trust shall terminate and all liability of the Fiscal Agent or such other paying agent of INTELSAT with respect thereto shall cease and the Holder of such Note or unpaid coupon must thereafter look solely to INTELSAT for payment thereof. (c) The Fiscal Agent and each other paying agent of INTELSAT hereunder may consult with counsel (who may also be counsel to INTELSAT) satisfactory to such Fiscal Agent or paying agent in its reasonable judgment, and the written opinion of such counsel shall be full and complete authorization and protection in respect of any action taken, omitted or suffered by it hereunder in good faith and in reliance thereon. (d) The Fiscal Agent and each other paying agent of INTELSAT hereunder shall be protected and shall incur no liability to any person for or in respect of any action in good faith taken, omitted or suffered by it in reliance upon any Note, coupon, notice, direction, consent, certificate, affidavit, statement or other paper or document reasonably believed by the Fiscal Agent or such other paying agent in good faith to be genuine and to have been signed by the proper parties. (e) The Fiscal Agent and each other paying agent of INTELSAT hereunder and its directors, officers and employees may become the owner of, or acquire an interest in, any Notes or coupons, with the same rights that it or they would have if it were not the Fiscal Agent or such other paying agent of INTELSAT hereunder, may engage or be interested in any financial or other transaction with INTELSAT and may act on, or as depositary, trustee or agent for, any committee or body of Holders of Notes or coupons or holders of other obligations of INTELSAT as freely as if it were not the Fiscal Agent or a paying agent of INTELSAT hereunder. (f) Neither the Fiscal Agent nor any other paying agent of INTELSAT hereunder shall be under any liability to any person for interest on any monies at any time received by it pursuant to any of the provisions of this Agreement or of the Notes except as may be otherwise agreed with INTELSAT. (g) The recitals contained herein and in the Notes (except the Fiscal Agent's certificates of authentication) and in the coupons shall be taken as the statements of INTELSAT, and the Fiscal Agent assumes no responsibility for their correctness. The Fiscal Agent makes no representation as to the validity or sufficiency of this Agreement or the Notes or coupons, except for the Fiscal Agent's due authorization to execute and deliver this Agreement; provided, however, that the Fiscal Agent shall not be relieved of its duty to authenticate Notes (or to arrange for authentication on its behalf) as authorized by this Agreement. The Fiscal Agent shall not be accountable for the use or application by INTELSAT of the proceeds of Notes. (h) The Fiscal Agent and each other paying agent of INTELSAT hereunder shall be obligated to perform such duties and only such duties as are herein and in the Notes specifically set forth and no implied duties or obligations shall be read into this Agreement or the Notes against the Fiscal Agent or any other paying agent of INTELSAT. The Fiscal Agent shall not be under any obligation to take any action hereunder which may tend to involve it in any undue expense or liability, the payment of which within a reasonable time is not, in its reasonable opinion, assured to it. (i) Unless herein or in the Notes otherwise specifically provided, any order, certificate, notice, request, direction or other communication from INTELSAT under any provision of this Agreement shall be sufficient if signed by an Executive Officer of INTELSAT. (j) No provision of this Agreement shall be construed to relieve the Fiscal Agent from liability for its own negligent action, its own negligent failure to act, or its own willful misconduct or that of its directors, officers or employees. 8. (a) INTELSAT agrees that, until all Notes or coupons (other than coupons the surrender of which has been waived under Paragraphs 3 and 6 of the definitive Notes and coupons which have been replaced or paid as provided in Paragraph 9 of the definitive Notes) authenticated and delivered hereunder (i) shall have been delivered to the Fiscal Agent for cancellation or (ii) become due and payable, whether at maturity or upon redemption, and monies sufficient to pay the principal thereof and interest, and Additional Amounts, if any, thereon shall have been made available to the Fiscal Agent and either paid to the persons entitled thereto or returned to INTELSAT as provided herein and in the Notes, there shall at all times be a Fiscal Agent hereunder which shall be appointed by INTELSAT, shall be authorized under the laws of its place of organization to exercise corporate trust powers and shall have a combined capital and surplus of at least U.S. $50,000,000. (b) INTELSAT hereby appoints the Principal Office of the Fiscal Agent as its agent where, subject to any applicable laws or regulations, Notes and coupons may be presented or surrendered for payment, where the Global and Bearer Notes may be surrendered for exchange and where notices and demands to or upon INTELSAT in respect of the Notes and coupons and this Agreement may be served. In addition, INTELSAT hereby appoints the main office of Bankers Trust Luxembourg S.A. in Luxembourg, Bankers Trust Company in Hong Kong, Credit Suisse in Zurich, Switzerland and DBS Bank in Singapore as additional paying agencies for the payment of principal of, and interest and Additional Amounts, if any, on, the Notes. INTELSAT may at any time and from time to time vary or terminate the appointment, upon thirty days prior written notice, of any such agent or appoint any additional agents for any or all of such purposes; provided, however, that, (i) so long as INTELSAT is required to maintain a Fiscal Agent hereunder, INTELSAT will maintain in London, United Kingdom an office or agency where Notes and coupons may be presented or surrendered for payment, where the Global and Bearer Notes may be presented for exchange and where notices and demands to or upon INTELSAT in respect of the Notes and coupons and this Agreement may be served and (ii) in the event the circumstances described in Section 5(b) hereof require, it will designate a paying agent in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., where Bearer Notes and coupons may be presented or surrendered for payment in such circumstances (and not otherwise); and provided, further, that so long as the Notes are listed on the respective stock exchanges, INTELSAT will maintain a paying agent in Hong Kong and Singapore. INTELSAT will give prompt written notice to the Fiscal Agent, of the appointment or termination of any such agency and of the location and any change in the location of any such office or agency and shall give notice thereof to Holders in the manner described in the first sentence of Paragraph 6(d) of the definitive Notes. (c) The Fiscal Agent may at any time resign as such Fiscal Agent by giving written notice to INTELSAT of such intention on its part, specifying the date on which its desired resignation shall become effective; provided, however, that such date shall never be less than three months after the receipt of such notice by INTELSAT unless INTELSAT agrees to accept less notice. The Fiscal Agent may be removed at any time by the filing with it of an instrument in writing signed on behalf of INTELSAT and specifying such removal and the date when it is intended to become effective. Any resignation or removal of the Fiscal Agent or other paying agent of INTELSAT, if such other paying agent is the only paying agent of INTELSAT then maintained outside the United States, shall take effect upon the date of the appointment by INTELSAT as hereinafter provided of a successor and the acceptance of such appointment by such successor. Upon its resignation or removal, such agent shall be entitled to the payment by INTELSAT of its compensation for the services rendered hereunder and to the reimbursement of all reasonable out-of-pocket expenses incurred in connection with the services rendered hereunder by such agent. (d) In case at any time the Fiscal Agent or other paying agent of INTELSAT, if such other paying agent is the only paying agent of INTELSAT then maintained outside the United States, shall resign, or shall be removed, or shall become incapable of acting or shall be adjudged a bankrupt or insolvent, or if a receiver of it or of its property shall be appointed, or if any public officer shall take charge or control of it or of its property or affairs for the purpose of rehabilitation, conservation or liquidation, a successor agent, eligible as aforesaid, shall be appointed by INTELSAT by an instrument in writing. Upon the appointment as aforesaid of a successor agent and the acceptance by it of such appointment, the agent so superseded shall cease to be such agent hereunder. If no successor Fiscal Agent or other paying agent of INTELSAT shall have been so appointed by INTELSAT and shall have accepted appointment as hereinafter provided, and if such other paying agent is the only paying agent of INTELSAT then maintained outside the United States, and if INTELSAT shall have otherwise failed to make arrangements for the performance of the duties of the Fiscal Agent or other paying agent, then any Holder of a Note who has been a bona fide Holder of a Note for at least six months, on behalf of himself and all others similarly situated, or the Fiscal Agent, may petition any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., for the appointment of a successor agent. (e) Any successor Fiscal Agent appointed hereunder shall execute, acknowledge and deliver to its predecessor and to INTELSAT an instrument accepting such appointment hereunder, and thereupon such successor Fiscal Agent, without any further act, deed or conveyance, shall become vested with all the authority, rights, powers, trusts, immunities, duties and obligations of such predecessor with like effect as if originally named as such Fiscal Agent hereunder, and such predecessor, upon payment of its charges and disbursements then unpaid, shall simultaneously therewith become obligated to transfer, deliver and pay over, and such successor Fiscal Agent shall be entitled to receive, all monies, securities or other property on deposit with or held by such predecessor, as such Fiscal Agent hereunder. INTELSAT will give prompt written notice to each other paying agent of INTELSAT of the appointment of a successor Fiscal Agent and shall give notice thereof to Holders at least once, in the manner described in Paragraph 6(e) of the definitive Notes. (f) Any corporation, bank or trust company into which the Fiscal Agent may be merged or converted, or with which it may be consolidated, or any corporation, bank or trust company resulting from any merger, conversion or consolidation to which the Fiscal Agent shall be a party, or any corporation, bank or trust company succeeding to all or substantially all the assets and business of the Fiscal Agent, shall be the successor to the Fiscal Agent under this Agreement; provided, however, that such corporation shall be otherwise eligible under this Section, without the execution or filing of any document or any further act on the part of any of the parties hereto. 9. INTELSAT will pay all stamp taxes and other duties, if any, which may be imposed by the United States, the United Kingdom or any political subdivision or taxing authority of or in the foregoing with respect to (i) the execution or delivery of this Agreement, (ii) the issuance of the Global Note, or (iii) the exchange from time to time of the Global Note for Bearer Notes (other than any such tax or duty which would not have been imposed on such exchange had such exchange occurred on or before the first anniversary of the initial issuance of the Notes which shall be payable by the Holders). 10. (a) A meeting of Holders of Notes may be called at any time and from time to time to make, give or take any request, demand, authorization, direction, notice, consent, waiver or other action provided by this Agreement or the Notes to be made, given or taken by Holders of Notes. The Fiscal Agent may, upon request from, and at the expense of, INTELSAT, direct to convene a single meeting of the Holders of Notes and the holders of debt securities of other series. (b) INTELSAT may at any time call a meeting of Holders of Notes for any purpose specified in Section 10(a) hereof to be held at such time and at such place in London, United Kingdom or in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., as INTELSAT shall determine. Notice of every meeting of Holders of Notes, setting forth the time and the place of such meeting and in general terms the action proposed to be taken at such meeting, shall be given, in the same manner as provided in Paragraph 6(e) of the definitive Notes, not more than 180 days nor less than 21 days prior to the date fixed for the meeting. In case at any time the Holders of at least 10% in principal amount of the Outstanding (as defined in Paragraph 3 of the definitive Notes) Notes shall have requested INTELSAT to call a meeting of the Holders of Notes for any purpose specified in Section 10(a) hereof, by written request setting forth in reasonable detail the action proposed to be taken at the meeting, and INTELSAT shall not have caused to be published the notice of such meeting within 21 days after receipt of such request or shall not thereafter proceed to cause the meeting to be held as provided herein, then the Holders of Notes in the amount above-specified, as the case may be, may determine the time and the place in London, United Kingdom or in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., for such meeting and may call such meeting for such purposes by giving notice thereof as provided in this subsection (b). (c) To be entitled to vote at any meeting of Holders of Notes, a person shall be a Holder of an Outstanding Note or a person appointed by an instrument in writing as proxy for such a Holder. (d) The persons entitled to vote a majority in aggregate principal amount of the Outstanding Notes shall constitute a quorum. In the absence of a quorum within 30 minutes of the time appointed for any such meeting, the meeting shall, if convened at the request of the Holders of Notes, be dissolved. In any other case the meeting may be adjourned for a period of not less than 10 days as determined by the chairman of the meeting prior to the adjournment of such meeting. In the absence of a quorum at any such adjourned meeting, such adjourned meeting may be further adjourned for a period of not less than 10 days as determined by the chairman of the meeting prior to the adjournment of such adjourned meeting. Notice of the reconvening of any adjourned meeting shall be given as provided in Section 10(b) hereof, except that such notice need be given only once not less than five days prior to the date on which the meeting is scheduled to be reconvened. Notice of the reconvening of an adjourned meeting shall state expressly the percentage of the principal amount of the Outstanding Notes which shall constitute a quorum. Subject to the foregoing, at the reconvening of any meeting adjourned for a lack of a quorum, the persons entitled to vote 25% in principal amount of the Outstanding Notes shall constitute a quorum for the taking of any action set forth in the notice of the original meeting. Any meeting of Holders of Notes at which a quorum is present may be adjourned from time to time by vote of a majority in principal amount of the Outstanding Notes represented at the meeting, and the meeting may be held as so adjourned without further notice. At a meeting or an adjourned meeting duly reconvened and at which a quorum is present as aforesaid, any resolution and all matters shall be effectively passed or decided if passed or decided by the persons entitled to vote a majority in principal amount of the Outstanding Notes represented and voting. (e) INTELSAT may make such reasonable regulations as it may deem advisable for any meeting of Holders of Notes in regard to proof of the holding of Notes and of the appointment of proxies and in regard to the appointment and duties of inspectors of votes, the submission and examination of proxies, certificates and other evidence of the right to vote, and such other matters concerning the conduct of the meeting as it shall deem appropriate. INTELSAT or the Holders calling the meeting, as the case may be, shall, by an instrument in writing, appoint a temporary chairman. A permanent chairman and a permanent secretary of the meeting shall be elected by vote of the persons entitled to vote a majority in principal amount of the Outstanding Notes represented and voting at the meeting. The chairman of the meeting shall have no right to vote, except as a Holder of Notes or a proxy. A record, at least in duplicate, of the proceedings of each meeting of Holders of Notes shall be prepared, and one such copy shall be delivered to INTELSAT and another to the Fiscal Agent to be preserved by the Fiscal Agent. 11. All notices hereunder shall be deemed to have been given when deposited in the mails as first-class mail, registered or certified mail, return receipt requested, postage prepaid, or, if electronically communicated, then when delivered, or when hand delivered, addressed to either party hereto as follows: INTELSAT . . . . . . . . . . . International Telecommunications Satellite Organization 3400 International Drive, N.W. Washington, D.C. 20008-3098, U.S.A. Attention: Vice President & Chief Financial Officer Facsimile No.: (202) 944-7860 Fiscal Agent . . . . . . . . . . Bankers Trust Company 1 Appold Street, Broadgate London EC2A 2HE, England Attention: Corporate Trust and Agency Group Facsimile No.: 011-4471-982-2271 or at any other address of which either of the foregoing shall have notified the other in writing. All notices to Holders of Notes shall be given in the manner provided in Paragraph 6(e) of the definitive Notes. 12. This Agreement and the terms and conditions of the Notes and coupons may be modified or amended by INTELSAT and the Fiscal Agent, without the consent of the Holder of any Note or coupon, for the purpose of (a) adding to the covenants of INTELSAT for the benefit of the Holders of Notes or coupons, or (b) surrendering any right or power conferred upon INTELSAT, or (c) securing the Notes pursuant to the requirements of the Notes or otherwise, or (d) permitting the payment of principal, interest and Additional Amounts, if any, in respect of Notes in the United States, or (e) curing any ambiguity or correcting or supplementing any defective provision contained herein or in the Notes or coupons, or (f) evidencing the succession of another organization or entity to INTELSAT and the assumption by any such successor of the covenants and obligations of INTELSAT herein and in the Notes and coupons as permitted by the Notes, or (g) providing for issuances of further debt securities as contemplated by Section 13, or (h) in any manner which the parties may mutually deem necessary or desirable and which in any such case shall not adversely affect the interests of the Holders of the Notes or the coupons. 13. INTELSAT may from time to time without the consent of the Holder of any Note or coupon issue further debt securities having the same terms and conditions as the Notes in all respects (or in all respects except for the first payment of interest thereon) or having such terms as INTELSAT may determine at the time of their issuance, in either case so that any such further debt securities shall be consolidated and form a single series with the outstanding securities of any series (including the Notes). Unless the context requires otherwise, references herein and in the Notes and coupons to the Notes or coupons shall include any other debt securities issued in accordance with this Section that are intended by INTELSAT to form a single series with the Notes. Any further debt securities forming a single series with the outstanding securities of any series (including the Notes) shall be issued pursuant to this Agreement as amended pursuant to Section 12 for the purpose of providing for the issuance of such debt securities. 14. This Agreement and each of the Notes and coupons shall be governed by and construed in accordance with the laws of the State of New York, U.S.A. 15. INTELSAT hereby appoints CT Corporation System, 1633 Broadway, New York, New York 10019, as its authorized agent (the "Authorized Agent") upon which process may be served in any action arising out of or based on this Agreement, the Notes or any coupons which action may be instituted in any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., by the Fiscal Agent or the Holder of any Note or coupon and INTELSAT and each such Holder by acceptance of a Note or coupon expressly accepts the exclusive jurisdiction of any such court in respect of any such action. Such appointment shall be irrevocable until two years after the Notes shall have matured and been paid or moneys for the payment thereof shall have been made available unless and until a successor Authorized Agent shall have been appointed and shall have accepted such appointment. INTELSAT hereby irrevocably waives any immunity to service of process in respect of any such action to which it might otherwise be entitled in any action arising out of or based on this Agreement or the Notes or coupons which may be instituted by the Fiscal Agent or any Holder of a Note or coupon in any State or Federal court in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. Service of process upon the Authorized Agent at the address indicated above, as such address may be changed within the Borough of Manhattan, The City of New York, the State of New York, U.S.A., by notice given by the Authorized Agent to each party hereto, shall be deemed, in every respect, effective service of process upon INTELSAT. INTELSAT irrevocably waives, to the fullest extent permitted by applicable law, any sovereign or other immunity from jurisdiction or from execution (except that INTELSAT does not waive immunity from execution prior to judgment and any similar defense) to which it might otherwise be entitled in any such action which may be instituted by the Fiscal Agent or any Holder of a Note or coupon in any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. 16. This Agreement, the Notes and the coupons appertaining thereto will constitute obligations of INTELSAT and not of any Signatory or Party (each as defined in the Agreement Relating to the International Telecommunications Satellite Organization, entered into force on 12 February 1973). No Signatory or Party will waive any immunity to which it may be entitled in any suit on this Agreement or the Notes or coupons, and neither the Fiscal Agent nor Holders of Notes or coupons will have any recourse against any Signatory or Party with respect to any obligations of INTELSAT under this Agreement or the Notes and the coupons appertaining thereto. 17. This Agreement may be executed in any number of counterparts, each of which when so executed shall be deemed to be an original but all such counterparts shall together constitute but one and the same instrument. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first above written. INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION /s/Margarita K. Dilley By _____________________________ Name: Margarita K. Dilley Title: Treasurer BANKERS TRUST COMPANY as Fiscal Agent and Principal Paying Agent /s/Shiela Ajimal By _____________________________ Name: Shiela Ajimal Title: Authorized Signatory INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION U.S. $200,000,000 6 5/8% Notes Due 2004 TEMPORARY GLOBAL NOTE INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION, an international organization established by the Agreement Relating to the International Telecommunications Satellite Organization and the Operating Agreement relating thereto, entered into force on 12 February 1973, for value received, hereby promises to pay to bearer upon presentation and surrender of this Temporary Global Note the principal sum of Two Hundred Million United States Dollars (U.S. $200,000,000) on 22 March 2004 and to pay interest thereon, from the date hereof, annually in arrears on 22 March in each year, commencing 22 March 1995, at the rate of 6 5/8% per annum, until the principal hereof is paid or made available for payment; provided, however, that interest on this Temporary Global Note shall be payable only after the issuance of Bearer Notes for which this Temporary Global Note is exchangeable, and only upon presentation and surrender of the interest coupons thereto attached as they severally mature. This Temporary Global Note is one of a duly authorized issue of Notes of INTELSAT designated as specified in the title hereof, entitled to the benefits of the Fiscal Agency Agreement, dated as of 22 March 1994, between INTELSAT and Bankers Trust Company as Fiscal Agent. This Note is a temporary note and is exchangeable in whole or from time to time in part without charge upon request of the Holder hereof for Bearer Notes with coupons attached in denominations of U.S. $10,000 and $100,000 as promptly as practicable following presentation of certification, in the form required by the Fiscal Agency Agreement for such purpose, that the beneficial owner or owners of this Temporary Global Note (or, if such exchange is only for a part of this Temporary Global Note, of such part) are not citizens or residents of the United States, a corporation, partnership or other entity created or organized in or under the laws of the United States or any political subdivision thereof, or an estate or trust the income of which is subject to United States Federal income taxation regardless of its source ("United States Person"). The Bearer Notes are expected to be available 40 days after the Closing Date. Bearer Notes to be delivered in exchange for any part of this Temporary Global Note shall be delivered only outside the United States. Upon any exchange of a part of this Temporary Global Note for Bearer Notes, the portion of the principal amount hereof so exchanged shall be endorsed by the Fiscal Agent on the Schedule hereto, and the principal amount hereof shall be reduced for all purposes by the amount so exchanged. Until exchanged in full for Bearer Notes, this Temporary Global Note shall in all respects be entitled to the same benefits and subject to the same terms and conditions as those of the definitive Notes and those contained in the Fiscal Agency Agreement (including the forms of Notes attached thereto), except that neither the Holder hereof nor the beneficial owners of this Temporary Global Note shall be entitled to receive payment of interest hereon. This Temporary Global Note shall be governed by and construed in accordance with the laws of the State of New York, U.S.A. All terms used in this Temporary Global Note which are defined in the Fiscal Agency Agreement or the definitive Notes shall have the meanings assigned to them therein. Unless the certificate of authentication hereon has been executed by the Fiscal Agent by the manual signature of one of its duly authorized officers, this Temporary Global Note shall not be valid or obligatory for any purpose. This Temporary Global Note constitutes an obligation of INTELSAT and not of any Signatory or Party (each as defined in the INTELSAT Agreement). No Signatory or Party will waive any immunity to which it may be entitled in any suit on this Temporary Global Note, and Holders of this Temporary Global Note will have no recourse against any Signatory or Party with respect to any obligations of INTELSAT under this Temporary Global Note. IN WITNESS WHEREOF, INTELSAT has caused this Temporary Global Note to be duly executed and its seal to be hereunto affixed and attested. Dated as of 22 March 1994 INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION By______________________________ Attest: _____________________ This is the Temporary Global Note referred to in the within-mentioned Fiscal Agency Agreement. BANKERS TRUST COMPANY as Fiscal Agent By_________________________ Authorized Signatory SCHEDULE OF EXCHANGES Remaining principal Principal amount amount Notation Date exchanged for following made on behalf Made definitive Bearer Notes such exchange of the Fiscal Agent ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ EXHIBIT B [FORM OF BEARER NOTES] [Form of Face] ANY UNITED STATES PERSON WHO HOLDS THIS OBLIGATION WILL BE SUBJECT TO LIMITATIONS UNDER THE UNITED STATES INCOME TAX LAWS, INCLUDING THE LIMITATIONS PROVIDED IN SECTIONS 165(j) AND 1287(a) OF THE INTERNAL REVENUE CODE. INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION 6 5/8% Notes Due 2004 No. B-_________ U.S.$[10,000] [100,000] INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION ("INTELSAT"), an international organization established by the Agreement Relating to the International Telecommunications Satellite Organization and the Operating Agreement relating thereto, entered into force on 12 February 1973, for value received, hereby promises to pay to bearer upon presentation and surrender of this Note the principal sum of [10,000][100,000] United States dollars on 22 March 2004 and to pay interest thereon, from the date hereof, annually in arrears on 22 March in each year ("Interest Payment Date"), commencing 22 March 1995 at the rate of 6 5/8% per annum (calculated on the basis of a year of twelve 30- day months), until the principal hereof is paid or made available for payment. Such payments shall be made subject to any laws or regulations applicable thereto and to the right of INTELSAT (limited as provided below) to terminate the appointment of any such paying agency, at the principal office of Bankers Trust Company in London, United Kingdom or at such other offices or agencies outside the United States (as defined in Paragraph 5 on the reverse hereof) as INTELSAT may designate and notify the Holder (as defined in Paragraph 2 on the reverse hereof) as provided in Paragraph 6(e) hereof, at the option of the Holder, by United States dollar check, or (ii) by wire transfer to a United States dollar account maintained by the Holder with a bank located outside the United States. Payments with respect to this Note shall be payable only at an office or agency located outside the United States and only upon presentation and surrender at such office of this Note in the case of principal or the coupons attached hereto (the "coupons") as they severally mature in the case of interest (but not in the case of Additional Amounts payable as defined and provided for in Paragraph 5 on the reverse hereof). No payment with respect to this Note shall be made by transfer to an account in, or by mail to an address in, the United States. Notwithstanding the foregoing, payment of principal of and interest on Bearer Notes and Additional Amounts, if any, may, at INTELSAT's option, be made at an office designated by INTELSAT in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. if (but only if) the full amount of such payments at all offices and agencies located outside the United States through which payment is to be made in accordance with the terms of the Notes is illegal or effectively precluded by exchange controls or other similar restrictions as determined by INTELSAT. INTELSAT covenants that until this Note has been delivered to the Fiscal Agent for cancellation or monies sufficient to pay the principal of and interest on this Note have been made available for payment and either paid or returned to INTELSAT as provided herein, it will at all times maintain offices or paying agents in London, United Kingdom and, so long as the Notes are listed on the respective stock exchanges, in Hong Kong and Singapore for the payment of the principal of and interest on the Notes as herein provided. Reference is hereby made to the further provisions of this Note set forth on the reverse hereof, including but not limited to the provisions for redemption of the Notes, which further provisions shall for all purposes have the same effect as though fully set forth at this place. Unless the certificate of authentication hereon has been executed by the Fiscal Agent by the manual signature of one of its authorized officers, neither this Note nor any coupon appertaining hereto shall be valid or obligatory for any purpose. IN WITNESS WHEREOF, INTELSAT has caused this Note to be duly executed and its seal to be hereunto affixed and attested and duly executed coupons to be annexed hereto. Dated as of 22 March 1994 INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION By______________________________ [Seal] Attest: [FORM OF FISCAL AGENT'S CERTIFICATE OF AUTHENTICATION] This is one of the Notes referred to in the within- mentioned Fiscal Agency Agreement. For and on behalf of BANKERS TRUST COMPANY as Fiscal Agent By _____________________________________________ Authorized Signatory [Form of Reverse] 1. This Note is one of a duly authorized issue of Notes of INTELSAT in the aggregate principal amount of Two Hundred Million United States Dollars (U.S.$200,000,000), designated as its 6 5/8% Notes Due 2004 (the "Notes"). INTELSAT, for the benefit of the Holders from time to time of the Notes, has entered into a Fiscal Agency Agreement, dated as of 22 March 1994 (the "Fiscal Agency Agreement"), between INTELSAT and Bankers Trust Company, as Fiscal Agent, copies of which Fiscal Agency Agreement are on file and available for inspection at the Principal Office of the Fiscal Agent in London, United Kingdom and the main offices of the paying agencies named on the face of this Note. (Bankers Trust Company and its respective successors as Fiscal Agent are herein collectively called the "Fiscal Agent".) As long as any of the Notes shall be outstanding and unpaid, but only up to the time all amounts of principal and interest have been placed at the disposal of the Fiscal Agent, INTELSAT will not cause or permit to be created on any of its property or assets any mortgage, pledge or other lien or charge as security for any bonds, notes or other evidences of indebtedness heretofore or hereafter issued, assumed or guaranteed by INTELSAT for money borrowed (other than purchase money mortgages, sale and leaseback transactions in connection with spacecraft, or other pledges or liens on property purchased by INTELSAT as security for all or part of the purchase price thereof; liens incidental to an investment transaction, but not a borrowing, of INTELSAT; or mechanics', landlords', tax or other statutory liens), unless the Notes shall be secured by such mortgage, pledge or other lien or charge equally and ratably with such other bonds, notes or evidences of indebtedness. 2. The Notes are issuable in bearer form, with interest coupons attached (the "coupons"), in denominations of U.S. $10,000 and $100,000. As used herein, the term "Holder" when used with respect to any Bearer Note or coupon, means the bearer thereof. 3. INTELSAT has appointed the main offices of Bankers Trust Luxembourg S.A. in Luxembourg, Bankers Trust Company in Hong Kong, Credit Suisse in Zurich, Switzerland and DBS Bank in Singapore as additional agencies where Notes may be surrendered for exchange. INTELSAT reserves the right to vary or terminate the appointment of any agent or to appoint additional or other transfer agents or to approve any change in the office through which any transfer agent acts, provided that there will at all times be a transfer agent in London, United Kingdom. All Notes issued upon any exchange of Notes shall be the valid obligations of INTELSAT evidencing the same debt, and entitled to the same benefits, as the Notes surrendered upon such exchange. No service charge shall be made for any exchange, but INTELSAT may require payment of a sum sufficient to cover any tax or other governmental charge payable in connection therewith. Title to Bearer Notes and coupons shall pass by delivery. INTELSAT, the Fiscal Agent, and any paying agent of INTELSAT may deem and treat the bearer of any Bearer Note or coupon as the owner thereof for all purposes, whether or not such Note or coupon shall be overdue. For purposes of the provisions of this Note and the Fiscal Agency Agreement, any Note authenticated and delivered pursuant to the Fiscal Agency Agreement shall, as of any date of determination, be deemed to be "Outstanding", except: (i) Notes theretofore cancelled by the Fiscal Agent or delivered to the Fiscal Agent for cancellation and not reissued by the Fiscal Agent; (ii) Notes which have been surrendered for redemption in accordance with Paragraph 6 hereof or which have become due and payable at maturity or otherwise and with respect to which monies sufficient to pay the principal thereof and interest thereon shall have been made available to the Fiscal Agent; or (iii) Notes in lieu of or in substitution for which other Notes shall have been authenticated and delivered pursuant to the Fiscal Agency Agreement; provided, however, that in determining whether the Holders of the requisite principal amount of Outstanding Notes are present at a meeting of Holders of Notes for quorum purposes or have given any request, demand, authorization, direction, notice, consent or waiver hereunder, Notes owned by INTELSAT shall be disregarded and deemed not to be Outstanding. 4. (a) INTELSAT shall pay to the Fiscal Agent at its Principal Office in London, United Kingdom, in accordance with the terms of the Fiscal Agency Agreement on each Interest Payment Date, any redemption date and the maturity date of the Notes, in such coin or currency of the United States of America as at the time of payment is legal tender for the payment of public and private debts, amounts sufficient (with any amounts then held by the Fiscal Agent and available for the purpose) to pay the interest on, the redemption price of and accrued interest (if the redemption date is not an Interest Payment Date) on, and the principal of, the Notes due and payable on such an Interest Payment Date, redemption date or maturity date, as the case may be. The Fiscal Agent shall apply the amounts so paid to it to the payment of such interest, redemption price and principal in accordance with the terms of the Notes. Any monies paid by INTELSAT to the Fiscal Agent for the payment of the principal of and interest on any Notes and remaining unclaimed at the end of two years after such principal or interest shall have become due and payable (whether at maturity, upon call for redemption or otherwise) shall then be repaid to INTELSAT upon its written request, and upon such repayment all liability of the Fiscal Agent with respect thereto shall thereupon cease, without, however, limiting in any way any obligation INTELSAT may have to pay the principal of and interest on this Note as the same shall become due. (b) In any case where the date for the payment of the principal of or interest on any Note or the date fixed for redemption of any Note shall be at any place of payment a day on which banking institutions are authorized or obligated by law or executive order to close, or are not carrying out transactions in United States dollars in The City of New York, the State of New York, U.S.A., or the city of the paying agent to which the Note or coupon is surrendered for payment, then payment of principal or interest need not be made on such date at such place but may be made on the next succeeding day at such place of payment which is not a day on which banking institutions are authorized or obligated by law or executive order to close, or which is a day on which banking institutions are carrying out transactions in United States dollars in The City of New York, the State of New York, U.S.A., or the city of the paying agent to which the Note or coupon is surrendered for payment, with the same force and effect as if made on the date for the payment of the principal or interest or the date fixed for redemption, and no interest shall accrue for the period after such date. 5. (a) INTELSAT will pay to the Holder of this Note or any coupon appertaining hereto who is a United States Alien (as defined below) such Additional Amounts as may be necessary in order that every net payment of the principal of, and interest on, this Note, after withholding for or on account of any present or future tax, assessment or governmental charge imposed upon, or as a result of, such payment by the United States (or any political subdivision or taxing authority thereof or therein), will not be less than the amount provided for in this Note or in such coupon to be then due and payable; provided, however, that the foregoing obligation to pay Additional Amounts shall not apply to any one or more of the following: (i) any tax, assessment or other governmental charge which would not have been so imposed but for (A) the existence of any present or former connection between such Holder (or between a fiduciary, settlor, or beneficiary of, or a possessor of a power over, such Holder, if such Holder is an estate or trust, or a member or shareholder of such holder, if such Holder is a partnership or corporation) and the United States, including, without limitation, such Holder (or such fiduciary, settlor, beneficiary, possessor, member or shareholder) being or having been a citizen, resident or treated as a resident thereof or being or having been engaged in a trade or business or present therein or having or having had a permanent establishment therein or (B) such Holder's present or former status as a personal holding company, controlled foreign corporation, foreign personal holding company or passive foreign investment company with respect to the United States or as a corporation which accumulates earnings to avoid United States federal income tax, all under existing United States Federal income tax law or successor provisions; (ii) any tax, assessment or other governmental charge which would not have been so imposed but for the presentation by the Holder of this Note or any coupon appertaining hereto for payment on a date more than 10 calendar days after the date on which such payment became due and payable or the date on which payment thereof is duly provided for and notice thereof is given to Holders, whichever occurs later; (iii) any estate, inheritance, gift, sales, transfer, personal property tax or any similar tax, assessment or other governmental charge; (iv) any tax, assessment or other governmental charge which is payable otherwise than by withholding from payments on or in respect of this Note or any coupon appertaining hereto; (v) any tax, assessment or other governmental charge imposed by reason of such Holder's past or present status as the actual or constructive owner of 10 per cent. or more of the capital or profits interest of INTELSAT within the meaning of Section 871(h)(3) of the United States Internal Revenue Code of 1986, as amended, and any regulations thereunder; (vi) any tax, assessment or other governmental charge imposed because a Holder of a Note is a bank that receives interest on such Note pursuant to a loan agreement entered into in the ordinary course of its trade or business; (vii) any tax, assessment or other governmental charge imposed as a result of the failure to comply with applicable certification, information, documentation or other reporting requirements concerning the nationality, residence, identity or connection with the United States of the Holder or beneficial owner of this Note, or any coupon appertaining hereto if such compliance is required by statute or by regulation of the United States as a precondition to relief or exemption from such tax, assessment or other government charge; (viii) any tax, assessment or other governmental charge required to be withheld by any paying agent from any payment on this Note or any coupon appertaining hereto if such payment can be made without such withholding by at least one other paying agent; or (ix) any combination of items (i) through (viii) above; nor will Additional Amounts be paid with respect to any payment of principal or interest on this Note or any coupon appertaining hereto to a Holder who is a fiduciary or partnership or other than the sole beneficial owner of this Note or any coupon appertaining hereto to the extent a beneficiary or settlor with respect to the fiduciary or a member of the partnership or the beneficial owner would not have been entitled to payment of the Additional Amounts had such beneficiary, settlor, member or beneficial owner been the Holder of this Note or any coupon appertaining hereto. The term "United States Alien" means any person who, for United States federal income tax purposes, is a foreign corporation, a nonresident alien individual, a nonresident fiduciary of a foreign estate or trust, or a foreign partnership, one or more of the members of which is, for United States federal income tax purposes, a foreign corporation, a nonresident alien individual or a nonresident fiduciary of a foreign estate or trust. The term "United States" means the United States of America (including the States and the District of Columbia), its territories, its possessions and other areas subject to its jurisdiction. (b) Except as specifically provided in this Note and in the Fiscal Agency Agreement, INTELSAT shall not be required to make any payment with respect to any tax, assessment or other governmental charge imposed by any government or any political subdivision or taxing authority thereof or therein. Whenever in this Note there is a reference, in any context, to the payment of the principal of or interest on, or in respect of, any Note or any coupon, such mention shall be deemed to include mention of the payment of Additional Amounts provided for in this Paragraph to the extent that, in such context, Additional Amounts are, were or would be payable in respect thereof pursuant to the provisions of this Paragraph and express mention of the payment of Additional Amounts (if applicable) in any provisions hereof shall not be construed as excluding Additional Amounts in those provisions hereof where such express mention is not made. 6. (a) The Notes are subject to redemption at the option of INTELSAT, as a whole but not in part, at any time at a redemption price equal to the principal amount thereof, together with accrued and unpaid interest to the date fixed for redemption (except if the redemption date is an Interest Payment Date) under the circumstances described in the next three Paragraphs. (b) The Notes may be redeemed, as a whole but not in part, at the option of INTELSAT, upon not more than 60 days' nor less than 30 days' prior notice in the manner provided in clause (e) of this Paragraph 6 at a redemption price equal to the principal amount thereof together with accrued and unpaid interest to the date fixed for redemption, if (x) INTELSAT determines that, without regard to any immunities that may be available to it, (1) as a result of any change in or amendment to the laws (or any regulations or rulings promulgated thereunder) of the United States or of any political subdivision or taxing authority thereof or therein affecting taxation, or any change in official position regarding application or interpretation of such laws, regulations or rulings (including a holding by a court of competent jurisdiction in the United States), which change or amendment is announced or becomes effective on or after 22 March 1994, INTELSAT has or will become obligated to pay Additional Amounts (as provided in Paragraph 5(a) hereof) or (2) on or after 22 March 1994, any action has been taken by any taxing authority of, or any decision has been rendered by a court of competent jurisdiction in, the United States or any political subdivision or taxing authority thereof or therein, including any of those actions specified in (1) above, whether or not such action was taken or decision was rendered with respect to INTELSAT, or any change, amendment, application or interpretation shall be officially proposed, which, in any such case, in the written opinion to INTELSAT of independent legal counsel of recognized standing, will result in a material probability that INTELSAT will become obligated to pay Additional Amounts with respect to the Notes, and (y) in any such case INTELSAT, in its business judgment, determines that such obligation cannot be avoided by the use of reasonable measures available to INTELSAT (provided that INTELSAT shall not be required to assert any immunities that may be available to it); provided, however, that (i) no such notice of redemption shall be given earlier than 90 days prior to the earliest date on which INTELSAT would but for such redemption be obligated to pay Additional Amounts and (ii) at the time such notice of redemption is given, such obligation to pay Additional Amounts remains in effect. Prior to the publication of notice of redemption pursuant to this Paragraph 6(b), INTELSAT shall deliver to the Fiscal Agent a certificate of INTELSAT stating the date of redemption and that INTELSAT is entitled to effect such redemption and setting forth in reasonable detail a statement of facts showing that the conditions precedent to the right of INTELSAT to so redeem the Notes have occurred. (c) In addition, if INTELSAT shall determine that any payment made outside the United States by INTELSAT or any paying agent of principal or interest due in respect of any Bearer Note or coupon would, under any present or future laws or regulations of the United States and without regard to any immunities that may be available to INTELSAT, be subject to any certification, information or other reporting requirement of any kind, the effect of which requirement is the disclosure to INTELSAT, any paying agent or any governmental authority of the nationality, residence or identity (as distinguished from, for example, status as a United States Alien) of a beneficial owner of such Note or coupon who is a United States Alien (other than such a requirement (i) which would not be applicable to a payment made by INTELSAT or any paying agent (A) directly to the beneficial owner, or (B) to a custodian, nominee or other agent of the beneficial owner, or (ii) which can be satisfied by such custodian, nominee or other agent certifying to the effect that such beneficial owner is a United States Alien, provided that in each case referred to in clauses (i)(B) and (ii), payment by such custodian, nominee or agent to such beneficial owner is not otherwise subject to any such requirement or (iii) would not be applicable to a payment made by at least one other paying agent of INTELSAT), INTELSAT, at its election, shall either (x) redeem the Bearer Notes, as a whole but not in part, at a redemption price equal to the principal amount thereof, together with accrued and unpaid interest to the date fixed for redemption or (y) if the conditions set forth in Paragraph 6(d) hereof are satisfied, pay the additional amounts specified in such Paragraph. INTELSAT shall make such determination and election as soon as practicable and give prompt notice thereof (the "Determination Notice") in the manner provided in clause (e) of this Paragraph 6, stating the effective date of such certification, information or other reporting requirement, whether INTELSAT has elected to redeem the Bearer Notes or to pay the additional amounts specified in Paragraph 6(d) hereof, and (if applicable) the last date by which the redemption of the Bearer Notes must take place, as provided in the next succeeding sentence. If INTELSAT elects to redeem the Bearer Notes, such redemption shall take place on such date, not later than one year after the publication of the Determination Notice, as INTELSAT shall elect by notice to the Fiscal Agent given not less than 45 nor more than 75 days before the date fixed for redemption. Notice of such redemption of the Bearer Notes will be given to the Holders of the Bearer Notes not less than 30 nor more than 60 days prior to the date fixed for redemption. Notwithstanding the foregoing, INTELSAT shall not so redeem the Bearer Notes if INTELSAT shall subsequently determine, not less than 30 days prior to the date fixed for redemption, that subsequent payments would not be subject to any such requirement, in which case INTELSAT shall give prompt notice of such determination in the manner provided in clause (e) of this Paragraph 6 and any earlier redemption notice shall be revoked and of no further effect. (d) If and so long as the certification, information or other reporting requirements referred to in Paragraph 6(c) would be fully satisfied by payment of a withholding tax, backup withholding tax or similar charge, INTELSAT may elect to pay, without regard to any immunities that may be available to it, such additional amounts (regardless of clause (vii) in Paragraph 5(a)) as may be necessary so that every net payment made outside the United States following the effective date of such requirements by INTELSAT or any paying agent of principal or interest due in respect of any Bearer Note or any coupon the beneficial owner of which is a United States Alien (but without any requirement that the nationality, residence or identity of such beneficial owner be disclosed to INTELSAT, any paying agent or any governmental authority), after deduction or withholding for or on account of such withholding tax, backup withholding tax or similar charge (other than a withholding tax, backup withholding tax or similar charge that (i) is the result of a certification, information or other reporting requirement described in the second parenthetical clause of the first sentence of Paragraph 6(c), (ii) is imposed as a result of the fact that INTELSAT or any of its paying agents have actual knowledge that the beneficial owner of such Bearer Note or coupon is within the category of persons described in Clauses (i) or (v) of Paragraph 5(a), or (iii) is imposed as a result of presentation of such Bearer Note or coupon for payment more than 10 calendar days after the date on which such payment becomes due and payable or on which payment thereof is duly provided for and notice thereof is given to Holders, whichever occurs later), will not be less than the amount provided for in such Bearer Note or coupon to be then due and payable. In the event INTELSAT elects to pay such additional amounts, INTELSAT will have the right, at its sole option, at any time, to redeem the Bearer Notes as a whole, but not in part, at a redemption price equal to the principal amount thereof, together with accrued and unpaid interest to the date fixed for redemption. If INTELSAT has made the determination described in Paragraph 6(c) with respect to certification, information or other reporting requirements applicable only to interest and subsequently makes a determination in the manner and of the nature referred to in such Paragraph 6(c) with respect to such requirements applicable to principal, INTELSAT will redeem the Bearer Notes in the manner and on the terms described in Paragraph 6(c) unless INTELSAT elects to have the provisions of this Paragraph apply rather than the provisions of Paragraph 6(c). If in such circumstances the Bearer Notes are to be redeemed, INTELSAT shall have no obligation to pay additional amounts pursuant to this Paragraph with respect to principal or interest accrued and unpaid after the date of the notice of such determination indicating such redemption, but will be obligated to pay such additional amounts with respect to interest accrued and unpaid to the date of such determination. If INTELSAT elects to pay additional amounts pursuant to this Paragraph and the condition specified in the first sentence of this Paragraph should no longer be satisfied, then INTELSAT shall promptly redeem such Bearer Notes. (e) The Fiscal Agent shall cause, on behalf of INTELSAT, notices to be given to redeem Bearer Notes to Holders by publication at least once in a leading daily newspaper in the English language of general circulation in South East Asia and, so long as the Notes are listed on the respective stock exchanges and such exchanges shall so require, in a daily newspaper of general circulation in Hong Kong and Singapore or, if publication in either Hong Kong or Singapore is not reasonably practicable, elsewhere in South East Asia. The term "daily newspaper" as used herein shall be deemed to mean a newspaper customarily published on each business day, whether or not it shall be published in Saturday, Sunday or holiday editions. If by reason of the suspension of publication of any newspaper, or by reason of any other cause, it shall be impracticable to give notice to the Holders of Notes in the manner prescribed herein, then such notification in lieu thereof as shall be made by INTELSAT or by the Fiscal Agent on behalf of and at the instruction and expense of INTELSAT shall constitute sufficient provision of such notice, if such notification shall, so far as may be practicable, approximate the terms and conditions of the publication in lieu of which it is given. Neither the failure to give notice nor any defect in any notice given to any particular Holder of a Note shall affect the sufficiency of any notice with respect to other Notes. Such notices will be deemed to have been given on the date of such publication or mailing or, if published in such newspapers on different dates, on the date of the first such publication in South East Asia. Notices to redeem Notes shall be given at least once not more than 60 days nor less than 30 days prior to the date fixed for redemption and shall specify the date fixed for redemption, the redemption price, the place or places of payment, that payment will be made upon presentation and surrender of the Notes to be redeemed, together with all appurtenant coupons, if any, maturing subsequent to the date fixed for redemption, that interest accrued and unpaid to the date fixed for redemption (unless the redemption date is an Interest Payment Date) will be paid as specified in said notice, and that on and after said date interest thereon will cease to accrue. If the redemption is pursuant to Paragraph 6(b) or 6(c) hereof, such notice shall also state that the conditions precedent to such redemption have occurred and state that INTELSAT has elected to redeem all the Notes. (f) If notice of redemption has been given in the manner set forth in Paragraph 6(e) hereof, the Notes so to be redeemed shall become due and payable on such redemption date specified in such notice and upon presentation and surrender of the Notes at the place or places specified in such notice, together with all appurtenant coupons, if any, maturing subsequent to the redemption date, the Notes shall be paid and redeemed by INTELSAT at the places and in the manner and currency herein specified and at the redemption price together with accrued and unpaid interest (unless the redemption date is an Interest Payment Date) to the redemption date; provided, however, that interest due on or prior to the redemption date on Bearer Notes shall be payable only upon the presentation and surrender of coupons for such interest (at an office or agency outside the United States except as otherwise provided on the face of the Bearer Note). If any Bearer Note surrendered for redemption shall not be accompanied by all appurtenant coupons maturing after the redemption date, such Note may be paid after deducting from the amount otherwise payable an amount equal to the face amount of all such missing coupons, or the surrender of such missing coupon or coupons may be waived by INTELSAT and the Fiscal Agent if they are furnished with such security or indemnity as they may require to save each of them and each other paying agency of INTELSAT harmless. From and after the redemption date, if monies for the redemption of Notes surrendered for redemption shall have been made available at the Principal Office of the Fiscal Agent for redemption on the redemption date, the Notes surrendered for redemption shall cease to bear interest, the coupons for interest appertaining to Bearer Notes maturing subsequent to the redemption date shall be void (unless the amount of such coupons shall have been deducted from the redemption price at the time of surrender of the Bearer Note to which such coupons appertained, as aforesaid), and the only right of the Holders of such Notes shall be to receive payment of the redemption price together with accrued and unpaid interest (unless the redemption date is an Interest Payment Date) to the redemption date as aforesaid. If monies for the redemption of the Notes are not made available for payment until after the redemption date, the Notes surrendered for redemption shall not cease to bear interest until such monies have been so made available. (g) Notes redeemed or otherwise acquired by INTELSAT will forthwith be delivered to the Fiscal Agent for cancellation and may not be reissued or resold, except that Bearer Notes delivered to the Fiscal Agent may, at the written request of INTELSAT, be reissued by the Fiscal Agent in replacement of mutilated, lost, stolen or destroyed Notes pursuant to Paragraph 9 hereof. 7. In the event of: (a) default in the payment of any installment of interest upon any Note for a period of 30 days after the date when due; or (b) default in the payment of the principal of any Note when due (whether at maturity or redemption or otherwise); or (c) default in the performance or breach of any covenant or warranty contained in the Notes or the Fiscal Agency Agreement (other than as specified in clauses (a) and (b) of this Paragraph 7) for a period of 90 days after the date on which written notice of such failure, requiring INTELSAT to remedy the same and stating that such notice is a "Notice of Default", shall first have been given to INTELSAT and the Fiscal Agent by any Holder of a Note; or (d) involuntary acceleration of the maturity of other indebtedness of INTELSAT for money borrowed with a maturity of one year or more in excess of U.S. $50,000,000 which acceleration shall not be rescinded or annulled, or which indebtedness shall not be discharged, within 45 days after notice; or (e) INTELSAT is dissolved or the INTELSAT Agreement or the Operating Agreement ceases to be in full force and effect; provided, however, that no default shall occur if INTELSAT's obligations under the Fiscal Agency Agreement and the Notes are assumed by a successor who maintains a business which is substantially similar to that of INTELSAT; the Holder of this Note may, at such Holder's option, unless such Event of Default has been waived as described in Paragraph 10(b) hereof, declare the principal of this Note and accrued and unpaid interest hereon to be due and payable immediately by written notice to INTELSAT, with a copy to the Fiscal Agent at its Principal Office, and unless all such defaults shall have been cured by INTELSAT prior to receipt of such written notice, the principal of this Note and accrued and unpaid interest hereon shall become and be immediately due and payable. 8. (a) INTELSAT will conduct and operate its business diligently and in the ordinary manner in compliance with the INTELSAT Agreement and the Operating Agreement, and will use all reasonable efforts to maintain in full force and effect its existing international registration of orbital locations and frequency spectrum for the operation of its global commercial telecommunications satellite system; provided, however, that INTELSAT shall not be prevented from making any change with respect to its manner of conducting or operating its business or with respect to such registration if such change, in the judgment of INTELSAT, is desirable and does not materially impair INTELSAT's ability to perform its obligations under the Notes. (b) INTELSAT will cause all properties used or useful in the conduct of its business to be maintained and kept in good condition, repair and working order and supplied with all necessary equipment and will cause to be made all necessary repairs, renewals, replacements, betterments and improvements thereof, all as in the judgment of INTELSAT may be necessary so that the business carried on in connection therewith may be properly and advantageously conducted at all times (except for ordinary wear and tear and deterioration); provided, however, that INTELSAT shall not be prevented from discontinuing the operation or maintenance of any of such properties if such discontinuance, in the judgment of INTELSAT, is desirable in the conduct of its business and does not materially impair INTELSAT's ability to perform its obligations under the Notes. 9. If any mutilated Note or a Note with a mutilated coupon appertaining to it is surrendered to the Fiscal Agent, INTELSAT shall execute, and the Fiscal Agent shall authenticate (or arrange for authentication on its behalf) and deliver in exchange therefor, a new Note of like tenor and principal amount, bearing a number not contemporaneously outstanding, with coupons corresponding to the coupons, if any, appertaining to the surrendered Note. If there be delivered to INTELSAT and the Fiscal Agent (i) evidence to their satisfaction of the destruction, loss or theft of any Note or coupon, and (ii) such security or indemnity as may be required by them to save each of them and any agent of each of them harmless, then, in the absence of notice to INTELSAT or the Fiscal Agent that such Note or coupon has been acquired by a bona fide purchaser, INTELSAT shall execute, and upon its request the Fiscal Agent shall authenticate (or arrange for authentication on its behalf) and deliver in lieu of any such destroyed, lost or stolen Note or in exchange for the Note to which such coupon appertains (with all appurtenant coupons not destroyed, lost or stolen), a new Note of like tenor and principal amount and bearing a number not contemporaneously outstanding, with coupons corresponding to the coupons, if any, appertaining to such destroyed, lost or stolen Note or to the Note to which such destroyed, lost or stolen coupon appertains. Upon the issuance of any new Note under this Paragraph, INTELSAT may require the payment by the Holder of a sum sufficient to cover any tax or other governmental charge that may be imposed in relation thereto and any other expenses (including the fees and the expenses of the Fiscal Agent and INTELSAT) connected therewith. Every new Note with its coupons, if any, issued pursuant to this Paragraph in lieu of any destroyed, lost or stolen Note, or in exchange for a Note to which a destroyed, lost or stolen coupon appertains, shall constitute an original additional contractual obligation of INTELSAT, whether or not the destroyed, lost or stolen Note and its coupons, if any, or the destroyed, lost or stolen coupon shall be at any time enforceable by anyone. Any new Note delivered pursuant to this Paragraph shall be so dated, or have attached thereto such coupons, that neither gain nor loss in interest shall result from such exchange. The provisions of this Paragraph 9 are exclusive and shall preclude (to the extent lawful) all other rights and remedies with respect to the replacement or payment of mutilated, destroyed, lost or stolen Notes or coupons. 10. (a) The Fiscal Agency Agreement and the terms and conditions of the Notes may be modified or amended by INTELSAT and the Fiscal Agent, without the consent of the Holder of any Note or coupon, in any manner which does not adversely affect the interests of the Holders, to provide for issuances of further debt securities as contemplated by Paragraph 11 hereof and by the Fiscal Agency Agreement, and to cure any ambiguity or to cure, correct or supplement any defective provision contained herein or in any coupon appertaining hereto or in the Fiscal Agency Agreement, or in certain other circumstances as described in the Fiscal Agency Agreement, to all of which each Holder of any Note or coupon shall, by acceptance thereof, consent. (b) The Fiscal Agency Agreement and the terms and conditions of the Notes may also be modified or amended by INTELSAT and the Fiscal Agent, and future compliance therewith or past default by INTELSAT may be waived, either with the consent of the Holders of not less than a majority in aggregate principal amount of the Notes at the time Outstanding or by the adoption of a resolution at a meeting of Holders duly convened and held in accordance with the provisions of the Fiscal Agency Agreement at which a quorum (as defined below) is present by at least a majority in aggregate principle amount of Notes represented at such meeting; provided, however, that no such modification, amendment or waiver may, without the written consent or affirmative vote of the Holder of each Note affected thereby: (i) change the stated maturity of the principal of or any installment of interest on any such Note, or (ii) reduce the principal amount thereof or the rate of interest on any such Note, or (iii) change the obligation of INTELSAT to pay Additional Amounts, or (iv) change the coin or currency in which any such Note or the interest thereon is payable, or (v) modify the obligation of INTELSAT to maintain offices or agencies outside the United States, or (vi) reduce the percentage in principal amount of the Outstanding Notes necessary to modify or amend the Fiscal Agency Agreement or the terms and conditions of the Notes or the coupons, or to waive any future compliance or past default, or (vii) reduce the requirements for voting for the adoption of a resolution or the quorum required at any meeting of Holders of Notes at which a resolution is adopted. The quorum at any meeting called to adopt a resolution will be a majority in aggregate principal amount of Notes Outstanding, except that at any meeting which is reconvened for lack of a quorum, the Holders entitled to vote 25 per cent. in aggregate principle amount of Notes Outstanding shall constitute a quorum for the taking of any action set forth in the notice of the original meeting. It shall not be necessary for the Holders of Notes to approve the particular form of any proposed amendment, but it shall be sufficient if they approve the substance thereof. (c) Any modifications, amendments or waivers to the Fiscal Agency Agreement or to the terms and conditions of the Notes in accordance with the foregoing provisions will be conclusive and binding on all Holders of Notes, whether or not they have given such consent, and on all Holders of coupons, whether or not notation of such modifications, amendments or waivers is made upon the Notes or coupons, and on all future Holders of Notes and coupons. (d) Promptly after the execution of any amendment to the Fiscal Agency Agreement or the effectiveness of any modification or amendment of the terms and conditions of the Notes, notice of such modification or amendment shall be given by INTELSAT or by the Fiscal Agent on behalf of and at the expense of INTELSAT, to Holders of the Notes in the manner provided in Paragraph 6(e) hereof. The failure to give such notice on a timely basis shall not invalidate such modification or amendment, but INTELSAT shall cause the Fiscal Agent to give such notice as soon as practicable upon discovering such failure or upon any impediment to the giving of such notice being overcome. 11. INTELSAT may from time to time, without the consent of the Holder of any Note or coupon, issue further debt securities having the same terms and conditions as the Notes in all respects (or in all respects except for the first payment of interest thereon) or having such terms as INTELSAT may determine at the time of their issuance, in either case so that any such further debt securities shall be consolidated and form a single series with outstanding securities of any series (including the Notes). Unless the context requires otherwise, references in the Notes and coupons and in the Fiscal Agency Agreement to the Notes or coupons shall include any other debt securities issued in accordance with the Fiscal Agency Agreement that are intended by INTELSAT to form a single series with the Notes. Any further debt securities forming a single series with the outstanding securities of any series (including the Notes) shall be issued pursuant to the Fiscal Agency Agreement as amended for the purpose of providing for the issuance of such debt securities. 12. Subject to the authentication of this Note by the Fiscal Agent, INTELSAT hereby certifies and declares that all acts, conditions and things required to be done and performed and to have happened precedent to the creation and issuance of the Notes and any coupons, and to constitute the same the valid obligations of INTELSAT, have been done and performed and have happened in due compliance with all applicable laws. 13. INTELSAT hereby appoints CT Corporation System, 1633 Broadway, New York, New York 10019, as its authorized agent ("Authorized Agent") upon which process may be served in any action arising out of or based on the Notes or any coupons which action may be instituted in any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., by the Holder of any Note or coupon, and INTELSAT and each Holder by acceptance hereof expressly accepts the exclusive jurisdiction of any such court in respect of any such action. Such appointment shall be irrevocable until two years after the Notes shall have matured and been paid or moneys for the payment thereof shall have been made available unless and until a successor Authorized Agent shall have been appointed and shall have accepted such appointment. INTELSAT hereby irrevocably waives any immunity to service of process in respect of any such action to which it might otherwise be entitled in any action arising out of or based upon the Notes or coupons which may be instituted by any Holder of a Note or coupon in any State or Federal court in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. Service of process upon the Authorized Agent at the address indicated above, as such address may be changed within the Borough of Manhattan, The City of New York, the State of New York, U.S.A., by notice given by the Authorized Agent to each party hereto, shall be deemed, in every respect, effective service of process upon INTELSAT. INTELSAT irrevocably waives, to the fullest extent permitted by applicable law, any sovereign or other immunity from jurisdiction or from execution (except that INTELSAT does not waive immunity from execution prior to judgment and any similar defense) to which it might otherwise be entitled in any such action which may be instituted by any Holder of a Note or coupon in any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. 14. The Notes and coupons will constitute an obligation of INTELSAT and not of any Signatory or Party (each as defined in the INTELSAT Agreement). No Signatory or Party will waive any immunity to which it may be entitled in any suit on the Notes or coupons, and Holders of Notes or coupons will have no recourse against any Signatory or Party with respect to any obligations of INTELSAT under the Notes or coupons. [Form of coupon] [Face of coupon] ANY UNITED STATES PERSON WHO HOLDS THIS OBLIGATION WILL BE SUBJECT TO LIMITATIONS UNDER THE UNITED STATES INCOME TAX LAWS, INCLUDING THE LIMITATIONS PROVIDED IN SECTIONS 165(j) AND 1287(a) OF THE INTERNAL REVENUE CODE. [B-][1] ... [10] U.S.$[662.50] [6625.00] Due March 22 [1995]....[2004] INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION 6 5/8 Notes Due 2004 On the date set forth hereon, INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION ("INTELSAT") will pay to bearer upon surrender hereof, the amount shown hereon (together with any additional amounts in respect thereof which INTELSAT may be required to pay according to the terms of said Note) at the paying agencies set out on the reverse hereof or at such other places outside the United States of America (including the States and the District of Columbia), its territories and possessions and other areas subject to its jurisdiction as INTELSAT may determine from time to time, at the option of the Holder, by United States dollar check drawn on a bank in The City of New York, the State of New York, U.S.A. or by transfer to a United States dollar account maintained by the payee with a bank located in a city in Western Europe, being the interest then payable on said Note. INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION By_______________________________________ [Reverse of coupon] Bankers Trust Company 1 Appold Street Broadgate London EC2A 2HE England Bankers Trust Luxembourg S.A. 14 Boulevard F.D. Roosevelt L-2450 Luxembourg Bankers Trust Company 38/F Two Pacific Place 88 Queensway Hong Kong Credit Suisse Paradeplatz 8 8001 Zurich Switzerland DBS Bank 24 Raffles Place #81-00 Clifford Centre Singapore 0104 EXHIBIT C [FORM OF CERTIFICATION TO BE GIVEN TO EUROCLEAR OR CEDEL S.A. BY ACCOUNT HOLDER] CERTIFICATE INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION 6 5/8% Notes Due 2004 (the "Notes") This is to certify that as of the date hereof, and except as set forth below, interests in the temporary Global Note representing the above-captioned Notes held by you for our account (i) are owned by person(s) that are not citizens or residents of the United States, domestic partnerships, domestic corporations or any estate or trust the income of which is subject to United States Federal income taxation regardless of its source ("United States person(s)"), (ii) are owned by United States person(s) that (a) are foreign branches of United States financial institutions (as defined in U.S. Treasury Regulations Section 1.165-12(c)(1)(v) ("financial institutions")) purchasing for their own account or for resale or (b) acquired the Notes through foreign branches of United States financial institutions and who hold the Notes through such United States financial institutions on the date hereof (and in either case (a) or (b), each such United States financial institution hereby agrees, on its own behalf or through its agent, that you may advise INTELSAT or INTELSAT's agent that it will comply with the requirements of Section 165(j)(3)(A), (B) or (C) of the U.S. Internal Revenue Code of 1986, as amended, and the regulations thereunder), or (iii) are owned by a United States or foreign financial institution for purposes of resale during the restricted period (as defined in U.S. Treasury Regulations Section 1.163-5(c)(2)(i)(D)(7)), and in addition if the owner of the Notes is a United States or foreign financial institution described in clause (iii) above (whether or not also described in clause (i) or (ii)) this is to further certify that such financial institution has not acquired the Notes for purposes of resale directly or indirectly to a United States person or to a person within the United States or its possessions. As used herein, "United States" means the United States of America (including the States thereof and the District of Columbia); and its "possessions" include Puerto Rico, the U.S. Virgin Islands, Guam, American Samoa, Wake Island and the Northern Mariana Islands. We undertake to advise you promptly by tested telex on or prior to the date on which you intend to submit your certification relating to the Notes held by you for our account in accordance with your Operating Procedures if any applicable statement herein is not correct on such date, and in the absence of any such notification it may be assumed that this certification applies as of such date. This certification excepts and does not relate to U.S. $______ of such interest in the above Notes in respect of which we are not able to certify and as to which we understand exchange and delivery of definitive Notes (or, if relevant, exercise of any rights or collection of any interest) cannot be made until we do so certify. We understand that this certification is required in connection with certain tax laws or, if applicable, certain securities laws of the United States. In connection therewith, if administrative or legal proceedings are commenced or threatened in connection with which this certification is or would be relevant, we irrevocably authorize you to produce this certification to any interested party in such proceedings. Dated: _____________, 199_ By:_______________________________________ As, or as agent for, the beneficial owner(s) of the Notes to which this certificate relates. EXHIBIT D [FORM OF CERTIFICATION TO BE GIVEN BY THE EUROCLEAR OPERATOR OR CEDEL S.A.] CERTIFICATION INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION 6 5/8% Notes Due 2004 (the "Notes") This is to certify that, based solely on certifications we have received in writing, by tested telex or by electronic transmission from member organizations appearing in our records as persons being entitled to a portion of the principal amount set forth below (our "Member Organizations") substantially to the effect set forth in the Fiscal Agency Agreement, as of the date hereof, U.S. $_______ principal amount of the above-captioned Notes (i) is owned by persons that are not citizens or residents of the United States, domestic partnerships, domestic corporations or any estate or trust the income of which is subject to United States Federal income taxation regardless of its source ("United States persons"), (ii) is owned by United States persons that are (a) foreign branches of United States financial institutions (as defined in U.S. Treasury Regulations Section 1.165-12(c)(1)(v) ("financial institutions")) purchasing for their own account or for resale or (b) United States persons who acquired the Notes through foreign branches of United States financial institutions and who hold the Notes through such United States financial institutions on the date hereof (and in either case (a) or (b), each such United States financial institution has agreed, on its own behalf or through its agent, that we may advise INTELSAT or INTELSAT's agent that it will comply with the requirements of Section 165(j)(3)(A), (B) or (C) of the U.S. Internal Revenue Code of 1986, as amended, and the regulations thereunder), or (iii) is owned by a United States or foreign financial institution for purposes of resale during the restricted period (as defined in U.S. Treasury Regulations Section 1.163-5(c)(2)(i)(D)(7)), and to the further effect that United States or foreign financial institutions described in clause (iii) above (whether or not also described in clause (i) or (ii)) have certified that they have not acquired the Notes for purposes of resale directly or indirectly to a United States person or to a person within the United States or its possessions. We further certify (i) that we are not making available herewith for exchange (or, if relevant, exercise of any rights or collection of any interest) any portion of the Temporary Global Note excepted in such certifications and (ii) that as of the date hereof we have not received any notification from any of our Member Organizations to the effect that the statements made by such Member Organizations with respect to any portion of the part submitted herewith for exchange (or, if relevant, exercise of any rights or collection of any interest) are no longer true and cannot be relied upon as of the date hereof. We understand that this certification is required in connection with certain tax laws and, if applicable, certain securities laws of the United States. In connection therewith, if administrative or legal proceedings are commenced or threatened in connection with which this certification is or would be relevant, we irrevocably authorize you to produce this certification to any interested party in such proceedings. Dated: __________, 1994 Yours faithfully, [Morgan Guaranty Trust Company of New York, Brussels Office as operator of the Euroclear System] or [Cedel S.A.] By_______________________ EXHIBIT 10(jj) AT&T Maritime Services 650 Liberty Avenue Union, NJ 07083 FAX 908 851-4002 February 18, 1994 Christopher J. Leber Vice President & General Manager CMC Operations COMSAT Mobile Communications 22300 COMSAT Drive Clarksburg, Maryland 20871 Chris, The following outlines the agreement in principle we have reached regarding pricing and volumes for AT&T's branded shore-to-ship mobile satellite service and COMSAT's branded ship-to-shore service to be effective February 1, 1994. AT&T plans to route 1.8 million minutes annually of domestic U.S. originating shore-to-ship Standard A traffic to COMSAT, prorated during the period beginning February 1, 1994 and ending December 31, 1994. AT&T will settle with COMSAT at the rate of $6.70 per minute. Furthermore, for all Standard M and Standard B traffic that AT&T routes to COMSAT during the above period, COMSAT will settle with AT&T at the rate of $4.95 per minute for Standard M traffic and $6.45 per minute for Standard B traffic. COMSAT plans to route 3.6 million minutes annually of ship-to- shore traffic to AT&T, prorated during the period beginning February 1, 1994 and ending December 31, 1994. COMSAT will also return to AT&T all calls designated by the customer for termination over the AT&T network. COMSAT will settle with AT&T at the rate of $.25 per minute for calls terminating in the United States and, for call terminating to all other points, at an amount equal to a 10 percent discount off of AT&T's prevailing published ILD rates. Neither AT&T nor COMSAT commits to traffic volumes, but will make a good faith effort to send the above-described traffic to the other. Each party will review volumes quarterly to verify that these proposed volumes are being satisfied. There will be no shortfall obligation, charge, or penalty for the failure to deliver the planned volumes. The parties agree also to exchange written proposals on or before November 30, 1994 with respect to prices for calendar year 1995. Subject to any appropriate regulatory approvals, this informal letter of understanding will form the basis for a formal contract based upon these principles. The parties will use reasonable best efforts to incorporate the above understanding into a formal contract by the earliest possible date. Please indicate your acceptance in the appropriate space below. Sincerely, /s/Paula Goldstein - - - ------------------ Paula Goldstein Product Manager Maritime Services /s/Cheryl Lynn Schneider Agreed to and accepted by: ________________________________ EXHIBIT 10(kk) ______________________________________________________________________________ FISCAL AGENCY AGREEMENT Between INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION, Issuer and BANKERS TRUST COMPANY Fiscal Agent and Principal Paying Agent _________________________ Dated as of 22 March 1994 _________________________ U.S. $200,000,000 6 5/8% Notes Due 2004 ______________________________________________________________________________ FISCAL AGENCY AGREEMENT, dated as of 22 March 1994 (the "Agreement"), between International Telecommunications Satellite Organization ("INTELSAT"), an international organization established by the Agreement Relating to the International Telecommunications Satellite Organization and the Operating Agreement relating thereto, entered into force on 12 February 1973, and Bankers Trust Company, a bank organized under the laws of New York, United States, as Fiscal Agent and Principal Paying Agent. 1. INTELSAT has, by a Subscription Agreement, dated 7 March 1994, between INTELSAT and Goldman Sachs (Asia) Limited ("GSAL"), and the other Managers named therein (the "Managers"), agreed to issue U.S. $200,000,000 aggregate principal amount of its 6 5/8% Notes Due 2004 (the "Notes"). The Notes shall be issued initially in the form of a temporary global note in bearer form, without interest coupons, substantially in the form of Exhibit A hereto (the "Global Note"). The Global Note will be exchangeable, as provided below, for definitive Notes issuable in bearer form, in denominations of U.S. $10,000 and U.S. $100,000 (the "Bearer Notes") with interest coupons attached (the "coupons"), substan- tially in the forms set forth in Exhibit B hereto. The term "Notes" as used herein includes the Global Note. The term "Holder", when used with respect to a Bearer Note or any coupon, means the bearer thereof. 2. INTELSAT hereby appoints Bankers Trust Company acting through its office at London, United Kingdom, as its fiscal agent and principal paying agent in respect of the Notes upon the terms and subject to the conditions herein set forth (Bankers Trust Company and its successor or successors as such fiscal agent or principal paying agent qualified or appointed in accordance with Section 8 hereof are herein collectively called the "Fiscal Agent"), and Bankers Trust Company hereby accepts such appointment. The Fiscal Agent shall have the powers and authority granted to and conferred upon it herein and in the Notes and such further powers and authority to act on behalf of INTELSAT as may be mutually agreed upon by INTELSAT and the Fiscal Agent. As used herein, "paying agents" shall mean paying agents (including the Fiscal Agent) maintained by INTELSAT as provided in Section 8(b) hereof. 3. (a) The Notes shall be executed on behalf of INTELSAT by the Director General and Chief Executive Officer or by any other officer of INTELSAT specifically identified in a certificate of incumbency and specimen signatures as having the requisite authority to execute the Notes (the "Executive Officers"), any of whose signatures may be manual or facsimile, under a facsimile of its seal reproduced thereon and attested by its General Counsel or an Assistant General Counsel, any of whose signatures may be manual or facsimile. Notes bearing the manual or facsimile signatures of persons who were at any time the proper officers of INTELSAT shall bind INTELSAT, notwithstanding that such persons or any of them ceased to hold such office or offices prior to the authentication and delivery of such Notes or did not hold such office or offices at the date of issue of such Notes. (b) The Fiscal Agent is hereby authorized, in accordance with the provisions of Paragraph 9 of the definitive Notes and this Section, from time to time to authenticate (or to arrange for the authentication on its behalf) and deliver a new Note in exchange for or in lieu of any Note which has become, or the coupons appertaining thereto which have become, mutilated, lost, stolen or destroyed. Each Note authenticated and delivered in exchange for or in lieu of any such Note shall carry all the rights to interest accrued and unpaid and to accrue which were carried by such Note. 4. (a) INTELSAT initially shall execute and deliver, on 22 March 1994 (the "Closing Date"), a Global Note for an aggregate principal amount of U.S. $200,000,000 to the Fiscal Agent, and the Fiscal Agent by a duly authorized officer or an attorney-in-fact duly appointed pursuant to a valid power of attorney shall, upon the order of INTELSAT signed by an Executive Officer of INTELSAT, authenticate the Global Note and deliver the Global Note to The Chase Manhattan Bank, N.A., as common depositary (the "Common Depositary") for the benefit of the operator of the Euroclear System ("Euroclear") and Cedel S.A. ("Cedel"), for credit to the respective account of the purchasers (or to such other accounts as it may direct). (b) For the purposes of this Agreement, "Exchange Date" shall mean a date which is not earlier than the day immediately following the expiration of the 40-day period beginning on the later of the commencement of the offering and the Closing Date. Without unnecessary delay, but in any event not less than 14 days prior to the Exchange Date, in such denominations as are specified by the Fiscal Agent, except in the event of earlier redemption or acceleration, INTELSAT shall execute and deliver to the Fiscal Agent U.S. $200,000,000 principal amount of definitive Bearer Notes. (c) Not earlier than the Exchange Date, the interest of a beneficial owner of the Notes in the Global Note shall only be exchanged for Bearer Notes after the account holder instructs Euroclear or Cedel, as the case may be, to request such exchange on his behalf and presents to Euroclear or Cedel, as the case may be, a certificate substantially in the form set forth in Exhibit C hereto, copies of which certificate shall be available from the offices of Euroclear and Cedel, the Fiscal Agent and each other paying agent of INTELSAT. Any exchange pursuant to this paragraph shall be made free of charge to beneficial owners of the Global Note, except that a person receiving definitive Notes must bear the cost of insurance, postage, transportation and the like in the event that such person does not take delivery of such definitive Notes in person at the offices of Euroclear or Cedel. In no event shall any such exchange occur prior to the Exchange Date. (d) Upon request for issuance of Bearer Notes, on or after the Exchange Date, the Global Note shall be surrendered by the Common Depositary to the Fiscal Agent, as INTELSAT's agent, for purposes of the exchange of Notes described below. Following such surrender and upon presentation by Euroclear or Cedel, acting on behalf of the beneficial owners of Bearer Notes, to the Fiscal Agent at its principal office in London, United Kingdom (the "Principal Office") of a certificate or certificates substantially in the form set forth in Exhibit D hereto, the Fiscal Agent shall authenticate (or arrange for the authentication on its behalf) and deliver to Euroclear or Cedel, as the case may be, for the account of such owners, the Bearer Notes in exchange for an aggregate principal amount equal to the principal amount of the Global Note beneficially owned by such owners. The presentation to the Fiscal Agent by Euroclear or Cedel of such a certificate may be relied upon by INTELSAT and the Fiscal Agent as conclusive evidence that a related certificate or certificates has or have been presented to Euroclear or Cedel, as the case may be, as contemplated by the terms of Section 4(c) hereof. Upon any exchange of a portion of the Global Note for Bearer Notes, the Global Note shall be endorsed by the Fiscal Agent to reflect the reduction of the principal amount evidenced thereby, whereupon its remaining principal amount shall be reduced for all purposes by the amount so exchanged; provided, that when the Global Note is exchanged in full, the Fiscal Agent shall cancel it. Until so exchanged in full, the Global Note shall in all respects be entitled to the same benefits under this Agreement as the definitive Notes authenticated and delivered hereunder, except that none of Euroclear, Cedel or the beneficial owners of the Global Note shall be entitled to receive payment of interest thereon. Notwithstanding the foregoing, in the event of redemption or acceleration of the Global Note prior to the issue of the Bearer Notes, Bearer Notes will be issuable in respect of such Global Note on or after the later of (i) the date fixed for such redemption or on which such acceleration occurs and (ii) the Exchange Date, and all of the foregoing in this subsection (d) shall be applicable to the issuance of such Bearer Notes. (e) No Note or coupon shall be entitled to any benefit under this Agreement or be valid or obligatory for any purpose unless there appears on such Note or coupon a certificate of authentication substantially in the forms provided for herein and executed by the Fiscal Agent by manual signature, and such certificate upon any Note or coupon shall be conclusive evidence, and the only evidence, that such Note or coupon has been duly authenticated and delivered hereunder. 5. (a) INTELSAT will pay or cause to be paid to the Fiscal Agent the amounts required to be paid by it herein and in the Notes, at the times and for the purposes set forth herein and in the Notes and in the manner set forth below, and INTELSAT hereby authorizes and directs the Fiscal Agent to make payment of the principal of and interest and additional amounts pursuant to Paragraph 5 of the definitive Notes ("Additional Amounts"), if any, on the Notes in accordance with the terms of the Notes. (i) INTELSAT shall initiate a wire transfer for payment to the Fiscal Agent at its Principal Office in London, United Kingdom, by no later than 10:00 a.m. (New York time) on the applicable Interest Payment Date, any redemption date and the maturity date of the Notes, in such coin or currency of the United States of America as at the time of payment is legal tender for the payment of public and private debts, of amounts sufficient (with any amounts then held by the Fiscal Agent and available for the purpose) to pay the interest on, the redemption price of an accrued interest (if the redemption date is not an Interest Payment Date) on, and the principal of, the Notes due and payable on such an Interest Payment Date, redemption date or maturity date, as the case may be. (ii) INTELSAT will supply to the Fiscal Agent by 10:00 a.m. (New York time) on the second business day prior to the due date for any such payment a confirmation (by tested telex or authenticated SWIFT message or by facsimile transmission with an original to follow by mail) that such payment will be made, which confirmation shall identify the bank from which the wire transfer constituting payment will be made. (iii) The Fiscal Agent will forthwith notify by telex each of the other paying agents and INTELSAT if it has not (A) by the time specified for its receipt, received the confirmation referred to above or (B) by the due date for any payment due, received the full amount so payable on such date. (iv) In the absence of the notification from the Fiscal Agent referred to in sub-clause (iii) of this Clause, each such paying agent shall be entitled to assume that the Fiscal Agent has received the full amount due in respect of the Notes or the Coupons on that date and shall be entitled: (A) to pay maturing Notes and Coupons in accordance with their terms; and (B) to claim any amounts so paid by it from the Fiscal Agent (notwithstanding anything herein to the contrary). (v) Without prejudice to the obligations of INTELSAT to make payments in accordance with the provisions of this Clause, if payment of the appropriate amount shall be made by or on behalf of INTELSAT later than the time specified, but otherwise in accordance with the provisions hereof, the Fiscal Agent shall forthwith notify the paying agents and give notice to holders of the Notes, that the Fiscal Agent has received such amount and the paying agents will act as such for the Notes and Coupons and make or cause to be made payments as provided herein. (vi) The Fiscal Agent shall apply the amounts so paid to it to the payment of such interest, redemption price and principal in accordance with the terms of the Notes. Any monies paid by INTELSAT to the Fiscal Agent for the payment of the principal of and interest on any Notes and remaining unclaimed at the end of two years after such principal or interest shall have become due and payable (whether at maturity, upon call for redemption or otherwise) shall then be repaid to INTELSAT upon its written request, and upon such repayment all liability of the Fiscal Agent with respect thereto shall thereupon cease, without, however, limiting in any way any obligation INTELSAT may have to pay the principal of and interest on this Note as the same shall become due. (b) Notwithstanding any other provision hereof (other than the last sentence of this Section 5(b)) or of the Notes, no payment with respect to principal of or interest or Additional Amounts, if any, on any Bearer Note may be made at any office of the Fiscal Agent or any other paying agent maintained by INTELSAT in the United States of America (including the States and the District of Columbia), its territories or possessions and other areas subject to its jurisdiction (the "United States"). No payment with respect to a Bearer Note shall be made by transfer to an account in, or by mail to an address in, the United States. Notwithstanding the foregoing, payment of principal of and interest and Additional Amounts, if any, on Bearer Notes shall be made at the paying agent in the Borough of Manhattan, The City of New York, if (but only if) payments in United States dollars of the full amount of such principal, interest or Additional Amounts at all offices or agencies outside the United States through which payment is to be made in accordance with the terms of the Notes is illegal or effectively precluded by exchange controls or other similar restrictions. (c) If INTELSAT becomes liable to pay additional amounts pursuant to Section 5 of the Notes, then, at least ten business days prior to the date of any such payment of principal or interest to which such payment of additional amounts relates, INTELSAT shall furnish the Fiscal Agent, the Paying Agent and each other paying agent of INTELSAT with a certificate which specifies, by country, the rates of withholding, if any, applicable to such payment to Holders of the Notes, and shall pay to the Paying Agent such amounts as shall be required to be paid to Holders of the Notes. INTELSAT hereby agrees to indemnify the Fiscal Agent, the Paying Agent and each other paying agent of INTELSAT for, and to hold them harmless against, any loss, liability or expense incurred without negligence or bad faith on their part arising out of or in connection with actions taken or omitted by any of them in reliance on any certificate furnished pursuant to this Section 5(c). (d) In the case of any redemption of Notes, INTELSAT shall give notice, not less than 45 or more than 75 days prior to any date set for redemption (as provided for in Paragraph 6 of the definitive Notes), to the Fiscal Agent of its election to redeem the Notes on such redemption date specified in such notice. The Fiscal Agent shall cause notice of redemption to be given in the name and at the expense of INTELSAT in the manner provided in Paragraph 6(e) of the definitive Notes. 6. All Notes and coupons surrendered for payment, redemption or exchange shall, if surrendered to anyone other than the Fiscal Agent, be cancelled and delivered to the Fiscal Agent. All cancelled Notes and coupons held by the Fiscal Agent shall be destroyed, and the Fiscal Agent shall furnish to INTELSAT a certificate with respect to such destruction, except that the cancelled Global Note and the certificates as to beneficial ownership required by Section 4 hereof shall not be destroyed but shall be delivered to INTELSAT. 7. The Fiscal Agent accepts its obligations set forth herein and in the Notes upon the terms and conditions hereof and thereof, including the following, to all of which INTELSAT agrees and to all of which the rights hereunder of the Holders from time to time of the Notes and coupons shall be subject: (a) The Fiscal Agent and each other paying agent of INTELSAT shall be entitled to the compensation to be agreed upon with INTELSAT for all services rendered by it, and INTELSAT agrees promptly to pay such compensation and to reimburse the Fiscal Agent and each other paying agent of INTELSAT for its reasonable out-of- pocket expenses (including reasonable advertising expenses and counsel fees) incurred by it in connection with the services rendered by it hereunder. INTELSAT also agrees to indemnify each of the Fiscal Agent and each other paying agent of INTELSAT hereunder for, and to hold it harmless against, any loss, liability or expense incurred without negligence or bad faith on the part of the Fiscal Agent or such other paying agent, arising out of or in connection with its acting as such Fiscal Agent or other paying agent of INTELSAT hereunder, including the costs and expenses of defending against any claim of liability. For purposes of this Section, the obligations of INTELSAT shall survive the payment of the Notes and the resignation or removal of the Fiscal Agent or any other paying agent of INTELSAT hereunder. (b) In acting under this Agreement and in connection with the Notes, the Fiscal Agent and each other paying agent of INTELSAT are acting solely as agents of INTELSAT and do not assume any obligation or relationship of agency or trust for or with any of the Holders of the Notes or coupons, except that all funds held by the Fiscal Agent or any other paying agent of INTELSAT for payment of principal of or interest or Additional Amounts, if any, on the Notes shall be held in trust, but need not be segregated from other funds except as required by law, and shall be applied as set forth herein and in the Notes; provided, however, that monies paid by INTELSAT to the Fiscal Agent or any other paying agent of INTELSAT for the payment of principal of or interest or Additional Amounts, if any, on Notes remaining unclaimed at the end of two years after such principal or interest or Additional Amounts, if any, shall have become due and payable shall be repaid to INTELSAT, promptly upon its request, as provided and in the manner set forth in the Notes, whereupon the aforesaid trust shall terminate and all liability of the Fiscal Agent or such other paying agent of INTELSAT with respect thereto shall cease and the Holder of such Note or unpaid coupon must thereafter look solely to INTELSAT for payment thereof. (c) The Fiscal Agent and each other paying agent of INTELSAT hereunder may consult with counsel (who may also be counsel to INTELSAT) satisfactory to such Fiscal Agent or paying agent in its reasonable judgment, and the written opinion of such counsel shall be full and complete authorization and protection in respect of any action taken, omitted or suffered by it hereunder in good faith and in reliance thereon. (d) The Fiscal Agent and each other paying agent of INTELSAT hereunder shall be protected and shall incur no liability to any person for or in respect of any action in good faith taken, omitted or suffered by it in reliance upon any Note, coupon, notice, direction, consent, certificate, affidavit, statement or other paper or document reasonably believed by the Fiscal Agent or such other paying agent in good faith to be genuine and to have been signed by the proper parties. (e) The Fiscal Agent and each other paying agent of INTELSAT hereunder and its directors, officers and employees may become the owner of, or acquire an interest in, any Notes or coupons, with the same rights that it or they would have if it were not the Fiscal Agent or such other paying agent of INTELSAT hereunder, may engage or be interested in any financial or other transaction with INTELSAT and may act on, or as depositary, trustee or agent for, any committee or body of Holders of Notes or coupons or holders of other obligations of INTELSAT as freely as if it were not the Fiscal Agent or a paying agent of INTELSAT hereunder. (f) Neither the Fiscal Agent nor any other paying agent of INTELSAT hereunder shall be under any liability to any person for interest on any monies at any time received by it pursuant to any of the provisions of this Agreement or of the Notes except as may be otherwise agreed with INTELSAT. (g) The recitals contained herein and in the Notes (except the Fiscal Agent's certificates of authentication) and in the coupons shall be taken as the statements of INTELSAT, and the Fiscal Agent assumes no responsibility for their correctness. The Fiscal Agent makes no representation as to the validity or sufficiency of this Agreement or the Notes or coupons, except for the Fiscal Agent's due authorization to execute and deliver this Agreement; provided, however, that the Fiscal Agent shall not be relieved of its duty to authenticate Notes (or to arrange for authentication on its behalf) as authorized by this Agreement. The Fiscal Agent shall not be accountable for the use or application by INTELSAT of the proceeds of Notes. (h) The Fiscal Agent and each other paying agent of INTELSAT hereunder shall be obligated to perform such duties and only such duties as are herein and in the Notes specifically set forth and no implied duties or obligations shall be read into this Agreement or the Notes against the Fiscal Agent or any other paying agent of INTELSAT. The Fiscal Agent shall not be under any obligation to take any action hereunder which may tend to involve it in any undue expense or liability, the payment of which within a reasonable time is not, in its reasonable opinion, assured to it. (i) Unless herein or in the Notes otherwise specifically provided, any order, certificate, notice, request, direction or other communication from INTELSAT under any provision of this Agreement shall be sufficient if signed by an Executive Officer of INTELSAT. (j) No provision of this Agreement shall be construed to relieve the Fiscal Agent from liability for its own negligent action, its own negligent failure to act, or its own willful misconduct or that of its directors, officers or employees. 8. (a) INTELSAT agrees that, until all Notes or coupons (other than coupons the surrender of which has been waived under Paragraphs 3 and 6 of the definitive Notes and coupons which have been replaced or paid as provided in Paragraph 9 of the definitive Notes) authenticated and delivered hereunder (i) shall have been delivered to the Fiscal Agent for cancellation or (ii) become due and payable, whether at maturity or upon redemption, and monies sufficient to pay the principal thereof and interest, and Additional Amounts, if any, thereon shall have been made available to the Fiscal Agent and either paid to the persons entitled thereto or returned to INTELSAT as provided herein and in the Notes, there shall at all times be a Fiscal Agent hereunder which shall be appointed by INTELSAT, shall be authorized under the laws of its place of organization to exercise corporate trust powers and shall have a combined capital and surplus of at least U.S. $50,000,000. (b) INTELSAT hereby appoints the Principal Office of the Fiscal Agent as its agent where, subject to any applicable laws or regulations, Notes and coupons may be presented or surrendered for payment, where the Global and Bearer Notes may be surrendered for exchange and where notices and demands to or upon INTELSAT in respect of the Notes and coupons and this Agreement may be served. In addition, INTELSAT hereby appoints the main office of Bankers Trust Luxembourg S.A. in Luxembourg, Bankers Trust Company in Hong Kong, Credit Suisse in Zurich, Switzerland and DBS Bank in Singapore as additional paying agencies for the payment of principal of, and interest and Additional Amounts, if any, on, the Notes. INTELSAT may at any time and from time to time vary or terminate the appointment, upon thirty days prior written notice, of any such agent or appoint any additional agents for any or all of such purposes; provided, however, that, (i) so long as INTELSAT is required to maintain a Fiscal Agent hereunder, INTELSAT will maintain in London, United Kingdom an office or agency where Notes and coupons may be presented or surrendered for payment, where the Global and Bearer Notes may be presented for exchange and where notices and demands to or upon INTELSAT in respect of the Notes and coupons and this Agreement may be served and (ii) in the event the circumstances described in Section 5(b) hereof require, it will designate a paying agent in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., where Bearer Notes and coupons may be presented or surrendered for payment in such circumstances (and not otherwise); and provided, further, that so long as the Notes are listed on the respective stock exchanges, INTELSAT will maintain a paying agent in Hong Kong and Singapore. INTELSAT will give prompt written notice to the Fiscal Agent, of the appointment or termination of any such agency and of the location and any change in the location of any such office or agency and shall give notice thereof to Holders in the manner described in the first sentence of Paragraph 6(d) of the definitive Notes. (c) The Fiscal Agent may at any time resign as such Fiscal Agent by giving written notice to INTELSAT of such intention on its part, specifying the date on which its desired resignation shall become effective; provided, however, that such date shall never be less than three months after the receipt of such notice by INTELSAT unless INTELSAT agrees to accept less notice. The Fiscal Agent may be removed at any time by the filing with it of an instrument in writing signed on behalf of INTELSAT and specifying such removal and the date when it is intended to become effective. Any resignation or removal of the Fiscal Agent or other paying agent of INTELSAT, if such other paying agent is the only paying agent of INTELSAT then maintained outside the United States, shall take effect upon the date of the appointment by INTELSAT as hereinafter provided of a successor and the acceptance of such appointment by such successor. Upon its resignation or removal, such agent shall be entitled to the payment by INTELSAT of its compensation for the services rendered hereunder and to the reimbursement of all reasonable out-of-pocket expenses incurred in connection with the services rendered hereunder by such agent. (d) In case at any time the Fiscal Agent or other paying agent of INTELSAT, if such other paying agent is the only paying agent of INTELSAT then maintained outside the United States, shall resign, or shall be removed, or shall become incapable of acting or shall be adjudged a bankrupt or insolvent, or if a receiver of it or of its property shall be appointed, or if any public officer shall take charge or control of it or of its property or affairs for the purpose of rehabilitation, conservation or liquidation, a successor agent, eligible as aforesaid, shall be appointed by INTELSAT by an instrument in writing. Upon the appointment as aforesaid of a successor agent and the acceptance by it of such appointment, the agent so superseded shall cease to be such agent hereunder. If no successor Fiscal Agent or other paying agent of INTELSAT shall have been so appointed by INTELSAT and shall have accepted appointment as hereinafter provided, and if such other paying agent is the only paying agent of INTELSAT then maintained outside the United States, and if INTELSAT shall have otherwise failed to make arrangements for the performance of the duties of the Fiscal Agent or other paying agent, then any Holder of a Note who has been a bona fide Holder of a Note for at least six months, on behalf of himself and all others similarly situated, or the Fiscal Agent, may petition any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., for the appointment of a successor agent. (e) Any successor Fiscal Agent appointed hereunder shall execute, acknowledge and deliver to its predecessor and to INTELSAT an instrument accepting such appointment hereunder, and thereupon such successor Fiscal Agent, without any further act, deed or conveyance, shall become vested with all the authority, rights, powers, trusts, immunities, duties and obligations of such predecessor with like effect as if originally named as such Fiscal Agent hereunder, and such predecessor, upon payment of its charges and disbursements then unpaid, shall simultaneously therewith become obligated to transfer, deliver and pay over, and such successor Fiscal Agent shall be entitled to receive, all monies, securities or other property on deposit with or held by such predecessor, as such Fiscal Agent hereunder. INTELSAT will give prompt written notice to each other paying agent of INTELSAT of the appointment of a successor Fiscal Agent and shall give notice thereof to Holders at least once, in the manner described in Paragraph 6(e) of the definitive Notes. (f) Any corporation, bank or trust company into which the Fiscal Agent may be merged or converted, or with which it may be consolidated, or any corporation, bank or trust company resulting from any merger, conversion or consolidation to which the Fiscal Agent shall be a party, or any corporation, bank or trust company succeeding to all or substantially all the assets and business of the Fiscal Agent, shall be the successor to the Fiscal Agent under this Agreement; provided, however, that such corporation shall be otherwise eligible under this Section, without the execution or filing of any document or any further act on the part of any of the parties hereto. 9. INTELSAT will pay all stamp taxes and other duties, if any, which may be imposed by the United States, the United Kingdom or any political subdivision or taxing authority of or in the foregoing with respect to (i) the execution or delivery of this Agreement, (ii) the issuance of the Global Note, or (iii) the exchange from time to time of the Global Note for Bearer Notes (other than any such tax or duty which would not have been imposed on such exchange had such exchange occurred on or before the first anniversary of the initial issuance of the Notes which shall be payable by the Holders). 10. (a) A meeting of Holders of Notes may be called at any time and from time to time to make, give or take any request, demand, authorization, direction, notice, consent, waiver or other action provided by this Agreement or the Notes to be made, given or taken by Holders of Notes. The Fiscal Agent may, upon request from, and at the expense of, INTELSAT, direct to convene a single meeting of the Holders of Notes and the holders of debt securities of other series. (b) INTELSAT may at any time call a meeting of Holders of Notes for any purpose specified in Section 10(a) hereof to be held at such time and at such place in London, United Kingdom or in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., as INTELSAT shall determine. Notice of every meeting of Holders of Notes, setting forth the time and the place of such meeting and in general terms the action proposed to be taken at such meeting, shall be given, in the same manner as provided in Paragraph 6(e) of the definitive Notes, not more than 180 days nor less than 21 days prior to the date fixed for the meeting. In case at any time the Holders of at least 10% in principal amount of the Outstanding (as defined in Paragraph 3 of the definitive Notes) Notes shall have requested INTELSAT to call a meeting of the Holders of Notes for any purpose specified in Section 10(a) hereof, by written request setting forth in reasonable detail the action proposed to be taken at the meeting, and INTELSAT shall not have caused to be published the notice of such meeting within 21 days after receipt of such request or shall not thereafter proceed to cause the meeting to be held as provided herein, then the Holders of Notes in the amount above-specified, as the case may be, may determine the time and the place in London, United Kingdom or in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., for such meeting and may call such meeting for such purposes by giving notice thereof as provided in this subsection (b). (c) To be entitled to vote at any meeting of Holders of Notes, a person shall be a Holder of an Outstanding Note or a person appointed by an instrument in writing as proxy for such a Holder. (d) The persons entitled to vote a majority in aggregate principal amount of the Outstanding Notes shall constitute a quorum. In the absence of a quorum within 30 minutes of the time appointed for any such meeting, the meeting shall, if convened at the request of the Holders of Notes, be dissolved. In any other case the meeting may be adjourned for a period of not less than 10 days as determined by the chairman of the meeting prior to the adjournment of such meeting. In the absence of a quorum at any such adjourned meeting, such adjourned meeting may be further adjourned for a period of not less than 10 days as determined by the chairman of the meeting prior to the adjournment of such adjourned meeting. Notice of the reconvening of any adjourned meeting shall be given as provided in Section 10(b) hereof, except that such notice need be given only once not less than five days prior to the date on which the meeting is scheduled to be reconvened. Notice of the reconvening of an adjourned meeting shall state expressly the percentage of the principal amount of the Outstanding Notes which shall constitute a quorum. Subject to the foregoing, at the reconvening of any meeting adjourned for a lack of a quorum, the persons entitled to vote 25% in principal amount of the Outstanding Notes shall constitute a quorum for the taking of any action set forth in the notice of the original meeting. Any meeting of Holders of Notes at which a quorum is present may be adjourned from time to time by vote of a majority in principal amount of the Outstanding Notes represented at the meeting, and the meeting may be held as so adjourned without further notice. At a meeting or an adjourned meeting duly reconvened and at which a quorum is present as aforesaid, any resolution and all matters shall be effectively passed or decided if passed or decided by the persons entitled to vote a majority in principal amount of the Outstanding Notes represented and voting. (e) INTELSAT may make such reasonable regulations as it may deem advisable for any meeting of Holders of Notes in regard to proof of the holding of Notes and of the appointment of proxies and in regard to the appointment and duties of inspectors of votes, the submission and examination of proxies, certificates and other evidence of the right to vote, and such other matters concerning the conduct of the meeting as it shall deem appropriate. INTELSAT or the Holders calling the meeting, as the case may be, shall, by an instrument in writing, appoint a temporary chairman. A permanent chairman and a permanent secretary of the meeting shall be elected by vote of the persons entitled to vote a majority in principal amount of the Outstanding Notes represented and voting at the meeting. The chairman of the meeting shall have no right to vote, except as a Holder of Notes or a proxy. A record, at least in duplicate, of the proceedings of each meeting of Holders of Notes shall be prepared, and one such copy shall be delivered to INTELSAT and another to the Fiscal Agent to be preserved by the Fiscal Agent. 11. All notices hereunder shall be deemed to have been given when deposited in the mails as first-class mail, registered or certified mail, return receipt requested, postage prepaid, or, if electronically communicated, then when delivered, or when hand delivered, addressed to either party hereto as follows: INTELSAT . . . . . . . . . . . International Telecommunications Satellite Organization 3400 International Drive, N.W. Washington, D.C. 20008-3098, U.S.A. Attention: Vice President & Chief Financial Officer Facsimile No.: (202) 944-7860 Fiscal Agent . . . . . . . . . . Bankers Trust Company 1 Appold Street, Broadgate London EC2A 2HE, England Attention: Corporate Trust and Agency Group Facsimile No.: 011-4471-982-2271 or at any other address of which either of the foregoing shall have notified the other in writing. All notices to Holders of Notes shall be given in the manner provided in Paragraph 6(e) of the definitive Notes. 12. This Agreement and the terms and conditions of the Notes and coupons may be modified or amended by INTELSAT and the Fiscal Agent, without the consent of the Holder of any Note or coupon, for the purpose of (a) adding to the covenants of INTELSAT for the benefit of the Holders of Notes or coupons, or (b) surrendering any right or power conferred upon INTELSAT, or (c) securing the Notes pursuant to the requirements of the Notes or otherwise, or (d) permitting the payment of principal, interest and Additional Amounts, if any, in respect of Notes in the United States, or (e) curing any ambiguity or correcting or supplementing any defective provision contained herein or in the Notes or coupons, or (f) evidencing the succession of another organization or entity to INTELSAT and the assumption by any such successor of the covenants and obligations of INTELSAT herein and in the Notes and coupons as permitted by the Notes, or (g) providing for issuances of further debt securities as contemplated by Section 13, or (h) in any manner which the parties may mutually deem necessary or desirable and which in any such case shall not adversely affect the interests of the Holders of the Notes or the coupons. 13. INTELSAT may from time to time without the consent of the Holder of any Note or coupon issue further debt securities having the same terms and conditions as the Notes in all respects (or in all respects except for the first payment of interest thereon) or having such terms as INTELSAT may determine at the time of their issuance, in either case so that any such further debt securities shall be consolidated and form a single series with the outstanding securities of any series (including the Notes). Unless the context requires otherwise, references herein and in the Notes and coupons to the Notes or coupons shall include any other debt securities issued in accordance with this Section that are intended by INTELSAT to form a single series with the Notes. Any further debt securities forming a single series with the outstanding securities of any series (including the Notes) shall be issued pursuant to this Agreement as amended pursuant to Section 12 for the purpose of providing for the issuance of such debt securities. 14. This Agreement and each of the Notes and coupons shall be governed by and construed in accordance with the laws of the State of New York, U.S.A. 15. INTELSAT hereby appoints CT Corporation System, 1633 Broadway, New York, New York 10019, as its authorized agent (the "Authorized Agent") upon which process may be served in any action arising out of or based on this Agreement, the Notes or any coupons which action may be instituted in any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., by the Fiscal Agent or the Holder of any Note or coupon and INTELSAT and each such Holder by acceptance of a Note or coupon expressly accepts the exclusive jurisdiction of any such court in respect of any such action. Such appointment shall be irrevocable until two years after the Notes shall have matured and been paid or moneys for the payment thereof shall have been made available unless and until a successor Authorized Agent shall have been appointed and shall have accepted such appointment. INTELSAT hereby irrevocably waives any immunity to service of process in respect of any such action to which it might otherwise be entitled in any action arising out of or based on this Agreement or the Notes or coupons which may be instituted by the Fiscal Agent or any Holder of a Note or coupon in any State or Federal court in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. Service of process upon the Authorized Agent at the address indicated above, as such address may be changed within the Borough of Manhattan, The City of New York, the State of New York, U.S.A., by notice given by the Authorized Agent to each party hereto, shall be deemed, in every respect, effective service of process upon INTELSAT. INTELSAT irrevocably waives, to the fullest extent permitted by applicable law, any sovereign or other immunity from jurisdiction or from execution (except that INTELSAT does not waive immunity from execution prior to judgment and any similar defense) to which it might otherwise be entitled in any such action which may be instituted by the Fiscal Agent or any Holder of a Note or coupon in any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. 16. This Agreement, the Notes and the coupons appertaining thereto will constitute obligations of INTELSAT and not of any Signatory or Party (each as defined in the Agreement Relating to the International Telecommunications Satellite Organization, entered into force on 12 February 1973). No Signatory or Party will waive any immunity to which it may be entitled in any suit on this Agreement or the Notes or coupons, and neither the Fiscal Agent nor Holders of Notes or coupons will have any recourse against any Signatory or Party with respect to any obligations of INTELSAT under this Agreement or the Notes and the coupons appertaining thereto. 17. This Agreement may be executed in any number of counterparts, each of which when so executed shall be deemed to be an original but all such counterparts shall together constitute but one and the same instrument. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first above written. INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION /s/Margarita K. Dilley By _____________________________ Name: Margarita K. Dilley Title: Treasurer BANKERS TRUST COMPANY as Fiscal Agent and Principal Paying Agent /s/Shiela Ajimal By _____________________________ Name: Shiela Ajimal Title: Authorized Signatory INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION U.S. $200,000,000 6 5/8% Notes Due 2004 TEMPORARY GLOBAL NOTE INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION, an international organization established by the Agreement Relating to the International Telecommunications Satellite Organization and the Operating Agreement relating thereto, entered into force on 12 February 1973, for value received, hereby promises to pay to bearer upon presentation and surrender of this Temporary Global Note the principal sum of Two Hundred Million United States Dollars (U.S. $200,000,000) on 22 March 2004 and to pay interest thereon, from the date hereof, annually in arrears on 22 March in each year, commencing 22 March 1995, at the rate of 6 5/8% per annum, until the principal hereof is paid or made available for payment; provided, however, that interest on this Temporary Global Note shall be payable only after the issuance of Bearer Notes for which this Temporary Global Note is exchangeable, and only upon presentation and surrender of the interest coupons thereto attached as they severally mature. This Temporary Global Note is one of a duly authorized issue of Notes of INTELSAT designated as specified in the title hereof, entitled to the benefits of the Fiscal Agency Agreement, dated as of 22 March 1994, between INTELSAT and Bankers Trust Company as Fiscal Agent. This Note is a temporary note and is exchangeable in whole or from time to time in part without charge upon request of the Holder hereof for Bearer Notes with coupons attached in denominations of U.S. $10,000 and $100,000 as promptly as practicable following presentation of certification, in the form required by the Fiscal Agency Agreement for such purpose, that the beneficial owner or owners of this Temporary Global Note (or, if such exchange is only for a part of this Temporary Global Note, of such part) are not citizens or residents of the United States, a corporation, partnership or other entity created or organized in or under the laws of the United States or any political subdivision thereof, or an estate or trust the income of which is subject to United States Federal income taxation regardless of its source ("United States Person"). The Bearer Notes are expected to be available 40 days after the Closing Date. Bearer Notes to be delivered in exchange for any part of this Temporary Global Note shall be delivered only outside the United States. Upon any exchange of a part of this Temporary Global Note for Bearer Notes, the portion of the principal amount hereof so exchanged shall be endorsed by the Fiscal Agent on the Schedule hereto, and the principal amount hereof shall be reduced for all purposes by the amount so exchanged. Until exchanged in full for Bearer Notes, this Temporary Global Note shall in all respects be entitled to the same benefits and subject to the same terms and conditions as those of the definitive Notes and those contained in the Fiscal Agency Agreement (including the forms of Notes attached thereto), except that neither the Holder hereof nor the beneficial owners of this Temporary Global Note shall be entitled to receive payment of interest hereon. This Temporary Global Note shall be governed by and construed in accordance with the laws of the State of New York, U.S.A. All terms used in this Temporary Global Note which are defined in the Fiscal Agency Agreement or the definitive Notes shall have the meanings assigned to them therein. Unless the certificate of authentication hereon has been executed by the Fiscal Agent by the manual signature of one of its duly authorized officers, this Temporary Global Note shall not be valid or obligatory for any purpose. This Temporary Global Note constitutes an obligation of INTELSAT and not of any Signatory or Party (each as defined in the INTELSAT Agreement). No Signatory or Party will waive any immunity to which it may be entitled in any suit on this Temporary Global Note, and Holders of this Temporary Global Note will have no recourse against any Signatory or Party with respect to any obligations of INTELSAT under this Temporary Global Note. IN WITNESS WHEREOF, INTELSAT has caused this Temporary Global Note to be duly executed and its seal to be hereunto affixed and attested. Dated as of 22 March 1994 INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION By______________________________ Attest: _____________________ This is the Temporary Global Note referred to in the within-mentioned Fiscal Agency Agreement. BANKERS TRUST COMPANY as Fiscal Agent By_________________________ Authorized Signatory SCHEDULE OF EXCHANGES Remaining principal Principal amount amount Notation Date exchanged for following made on behalf Made definitive Bearer Notes such exchange of the Fiscal Agent ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ ____ _______________________ _____________ ___________________ EXHIBIT B [FORM OF BEARER NOTES] [Form of Face] ANY UNITED STATES PERSON WHO HOLDS THIS OBLIGATION WILL BE SUBJECT TO LIMITATIONS UNDER THE UNITED STATES INCOME TAX LAWS, INCLUDING THE LIMITATIONS PROVIDED IN SECTIONS 165(j) AND 1287(a) OF THE INTERNAL REVENUE CODE. INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION 6 5/8% Notes Due 2004 No. B-_________ U.S.$[10,000] [100,000] INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION ("INTELSAT"), an international organization established by the Agreement Relating to the International Telecommunications Satellite Organization and the Operating Agreement relating thereto, entered into force on 12 February 1973, for value received, hereby promises to pay to bearer upon presentation and surrender of this Note the principal sum of [10,000][100,000] United States dollars on 22 March 2004 and to pay interest thereon, from the date hereof, annually in arrears on 22 March in each year ("Interest Payment Date"), commencing 22 March 1995 at the rate of 6 5/8% per annum (calculated on the basis of a year of twelve 30- day months), until the principal hereof is paid or made available for payment. Such payments shall be made subject to any laws or regulations applicable thereto and to the right of INTELSAT (limited as provided below) to terminate the appointment of any such paying agency, at the principal office of Bankers Trust Company in London, United Kingdom or at such other offices or agencies outside the United States (as defined in Paragraph 5 on the reverse hereof) as INTELSAT may designate and notify the Holder (as defined in Paragraph 2 on the reverse hereof) as provided in Paragraph 6(e) hereof, at the option of the Holder, by United States dollar check, or (ii) by wire transfer to a United States dollar account maintained by the Holder with a bank located outside the United States. Payments with respect to this Note shall be payable only at an office or agency located outside the United States and only upon presentation and surrender at such office of this Note in the case of principal or the coupons attached hereto (the "coupons") as they severally mature in the case of interest (but not in the case of Additional Amounts payable as defined and provided for in Paragraph 5 on the reverse hereof). No payment with respect to this Note shall be made by transfer to an account in, or by mail to an address in, the United States. Notwithstanding the foregoing, payment of principal of and interest on Bearer Notes and Additional Amounts, if any, may, at INTELSAT's option, be made at an office designated by INTELSAT in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. if (but only if) the full amount of such payments at all offices and agencies located outside the United States through which payment is to be made in accordance with the terms of the Notes is illegal or effectively precluded by exchange controls or other similar restrictions as determined by INTELSAT. INTELSAT covenants that until this Note has been delivered to the Fiscal Agent for cancellation or monies sufficient to pay the principal of and interest on this Note have been made available for payment and either paid or returned to INTELSAT as provided herein, it will at all times maintain offices or paying agents in London, United Kingdom and, so long as the Notes are listed on the respective stock exchanges, in Hong Kong and Singapore for the payment of the principal of and interest on the Notes as herein provided. Reference is hereby made to the further provisions of this Note set forth on the reverse hereof, including but not limited to the provisions for redemption of the Notes, which further provisions shall for all purposes have the same effect as though fully set forth at this place. Unless the certificate of authentication hereon has been executed by the Fiscal Agent by the manual signature of one of its authorized officers, neither this Note nor any coupon appertaining hereto shall be valid or obligatory for any purpose. IN WITNESS WHEREOF, INTELSAT has caused this Note to be duly executed and its seal to be hereunto affixed and attested and duly executed coupons to be annexed hereto. Dated as of 22 March 1994 INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION By______________________________ [Seal] Attest: [FORM OF FISCAL AGENT'S CERTIFICATE OF AUTHENTICATION] This is one of the Notes referred to in the within- mentioned Fiscal Agency Agreement. For and on behalf of BANKERS TRUST COMPANY as Fiscal Agent By _____________________________________________ Authorized Signatory [Form of Reverse] 1. This Note is one of a duly authorized issue of Notes of INTELSAT in the aggregate principal amount of Two Hundred Million United States Dollars (U.S.$200,000,000), designated as its 6 5/8% Notes Due 2004 (the "Notes"). INTELSAT, for the benefit of the Holders from time to time of the Notes, has entered into a Fiscal Agency Agreement, dated as of 22 March 1994 (the "Fiscal Agency Agreement"), between INTELSAT and Bankers Trust Company, as Fiscal Agent, copies of which Fiscal Agency Agreement are on file and available for inspection at the Principal Office of the Fiscal Agent in London, United Kingdom and the main offices of the paying agencies named on the face of this Note. (Bankers Trust Company and its respective successors as Fiscal Agent are herein collectively called the "Fiscal Agent".) As long as any of the Notes shall be outstanding and unpaid, but only up to the time all amounts of principal and interest have been placed at the disposal of the Fiscal Agent, INTELSAT will not cause or permit to be created on any of its property or assets any mortgage, pledge or other lien or charge as security for any bonds, notes or other evidences of indebtedness heretofore or hereafter issued, assumed or guaranteed by INTELSAT for money borrowed (other than purchase money mortgages, sale and leaseback transactions in connection with spacecraft, or other pledges or liens on property purchased by INTELSAT as security for all or part of the purchase price thereof; liens incidental to an investment transaction, but not a borrowing, of INTELSAT; or mechanics', landlords', tax or other statutory liens), unless the Notes shall be secured by such mortgage, pledge or other lien or charge equally and ratably with such other bonds, notes or evidences of indebtedness. 2. The Notes are issuable in bearer form, with interest coupons attached (the "coupons"), in denominations of U.S. $10,000 and $100,000. As used herein, the term "Holder" when used with respect to any Bearer Note or coupon, means the bearer thereof. 3. INTELSAT has appointed the main offices of Bankers Trust Luxembourg S.A. in Luxembourg, Bankers Trust Company in Hong Kong, Credit Suisse in Zurich, Switzerland and DBS Bank in Singapore as additional agencies where Notes may be surrendered for exchange. INTELSAT reserves the right to vary or terminate the appointment of any agent or to appoint additional or other transfer agents or to approve any change in the office through which any transfer agent acts, provided that there will at all times be a transfer agent in London, United Kingdom. All Notes issued upon any exchange of Notes shall be the valid obligations of INTELSAT evidencing the same debt, and entitled to the same benefits, as the Notes surrendered upon such exchange. No service charge shall be made for any exchange, but INTELSAT may require payment of a sum sufficient to cover any tax or other governmental charge payable in connection therewith. Title to Bearer Notes and coupons shall pass by delivery. INTELSAT, the Fiscal Agent, and any paying agent of INTELSAT may deem and treat the bearer of any Bearer Note or coupon as the owner thereof for all purposes, whether or not such Note or coupon shall be overdue. For purposes of the provisions of this Note and the Fiscal Agency Agreement, any Note authenticated and delivered pursuant to the Fiscal Agency Agreement shall, as of any date of determination, be deemed to be "Outstanding", except: (i) Notes theretofore cancelled by the Fiscal Agent or delivered to the Fiscal Agent for cancellation and not reissued by the Fiscal Agent; (ii) Notes which have been surrendered for redemption in accordance with Paragraph 6 hereof or which have become due and payable at maturity or otherwise and with respect to which monies sufficient to pay the principal thereof and interest thereon shall have been made available to the Fiscal Agent; or (iii) Notes in lieu of or in substitution for which other Notes shall have been authenticated and delivered pursuant to the Fiscal Agency Agreement; provided, however, that in determining whether the Holders of the requisite principal amount of Outstanding Notes are present at a meeting of Holders of Notes for quorum purposes or have given any request, demand, authorization, direction, notice, consent or waiver hereunder, Notes owned by INTELSAT shall be disregarded and deemed not to be Outstanding. 4. (a) INTELSAT shall pay to the Fiscal Agent at its Principal Office in London, United Kingdom, in accordance with the terms of the Fiscal Agency Agreement on each Interest Payment Date, any redemption date and the maturity date of the Notes, in such coin or currency of the United States of America as at the time of payment is legal tender for the payment of public and private debts, amounts sufficient (with any amounts then held by the Fiscal Agent and available for the purpose) to pay the interest on, the redemption price of and accrued interest (if the redemption date is not an Interest Payment Date) on, and the principal of, the Notes due and payable on such an Interest Payment Date, redemption date or maturity date, as the case may be. The Fiscal Agent shall apply the amounts so paid to it to the payment of such interest, redemption price and principal in accordance with the terms of the Notes. Any monies paid by INTELSAT to the Fiscal Agent for the payment of the principal of and interest on any Notes and remaining unclaimed at the end of two years after such principal or interest shall have become due and payable (whether at maturity, upon call for redemption or otherwise) shall then be repaid to INTELSAT upon its written request, and upon such repayment all liability of the Fiscal Agent with respect thereto shall thereupon cease, without, however, limiting in any way any obligation INTELSAT may have to pay the principal of and interest on this Note as the same shall become due. (b) In any case where the date for the payment of the principal of or interest on any Note or the date fixed for redemption of any Note shall be at any place of payment a day on which banking institutions are authorized or obligated by law or executive order to close, or are not carrying out transactions in United States dollars in The City of New York, the State of New York, U.S.A., or the city of the paying agent to which the Note or coupon is surrendered for payment, then payment of principal or interest need not be made on such date at such place but may be made on the next succeeding day at such place of payment which is not a day on which banking institutions are authorized or obligated by law or executive order to close, or which is a day on which banking institutions are carrying out transactions in United States dollars in The City of New York, the State of New York, U.S.A., or the city of the paying agent to which the Note or coupon is surrendered for payment, with the same force and effect as if made on the date for the payment of the principal or interest or the date fixed for redemption, and no interest shall accrue for the period after such date. 5. (a) INTELSAT will pay to the Holder of this Note or any coupon appertaining hereto who is a United States Alien (as defined below) such Additional Amounts as may be necessary in order that every net payment of the principal of, and interest on, this Note, after withholding for or on account of any present or future tax, assessment or governmental charge imposed upon, or as a result of, such payment by the United States (or any political subdivision or taxing authority thereof or therein), will not be less than the amount provided for in this Note or in such coupon to be then due and payable; provided, however, that the foregoing obligation to pay Additional Amounts shall not apply to any one or more of the following: (i) any tax, assessment or other governmental charge which would not have been so imposed but for (A) the existence of any present or former connection between such Holder (or between a fiduciary, settlor, or beneficiary of, or a possessor of a power over, such Holder, if such Holder is an estate or trust, or a member or shareholder of such holder, if such Holder is a partnership or corporation) and the United States, including, without limitation, such Holder (or such fiduciary, settlor, beneficiary, possessor, member or shareholder) being or having been a citizen, resident or treated as a resident thereof or being or having been engaged in a trade or business or present therein or having or having had a permanent establishment therein or (B) such Holder's present or former status as a personal holding company, controlled foreign corporation, foreign personal holding company or passive foreign investment company with respect to the United States or as a corporation which accumulates earnings to avoid United States federal income tax, all under existing United States Federal income tax law or successor provisions; (ii) any tax, assessment or other governmental charge which would not have been so imposed but for the presentation by the Holder of this Note or any coupon appertaining hereto for payment on a date more than 10 calendar days after the date on which such payment became due and payable or the date on which payment thereof is duly provided for and notice thereof is given to Holders, whichever occurs later; (iii) any estate, inheritance, gift, sales, transfer, personal property tax or any similar tax, assessment or other governmental charge; (iv) any tax, assessment or other governmental charge which is payable otherwise than by withholding from payments on or in respect of this Note or any coupon appertaining hereto; (v) any tax, assessment or other governmental charge imposed by reason of such Holder's past or present status as the actual or constructive owner of 10 per cent. or more of the capital or profits interest of INTELSAT within the meaning of Section 871(h)(3) of the United States Internal Revenue Code of 1986, as amended, and any regulations thereunder; (vi) any tax, assessment or other governmental charge imposed because a Holder of a Note is a bank that receives interest on such Note pursuant to a loan agreement entered into in the ordinary course of its trade or business; (vii) any tax, assessment or other governmental charge imposed as a result of the failure to comply with applicable certification, information, documentation or other reporting requirements concerning the nationality, residence, identity or connection with the United States of the Holder or beneficial owner of this Note, or any coupon appertaining hereto if such compliance is required by statute or by regulation of the United States as a precondition to relief or exemption from such tax, assessment or other government charge; (viii) any tax, assessment or other governmental charge required to be withheld by any paying agent from any payment on this Note or any coupon appertaining hereto if such payment can be made without such withholding by at least one other paying agent; or (ix) any combination of items (i) through (viii) above; nor will Additional Amounts be paid with respect to any payment of principal or interest on this Note or any coupon appertaining hereto to a Holder who is a fiduciary or partnership or other than the sole beneficial owner of this Note or any coupon appertaining hereto to the extent a beneficiary or settlor with respect to the fiduciary or a member of the partnership or the beneficial owner would not have been entitled to payment of the Additional Amounts had such beneficiary, settlor, member or beneficial owner been the Holder of this Note or any coupon appertaining hereto. The term "United States Alien" means any person who, for United States federal income tax purposes, is a foreign corporation, a nonresident alien individual, a nonresident fiduciary of a foreign estate or trust, or a foreign partnership, one or more of the members of which is, for United States federal income tax purposes, a foreign corporation, a nonresident alien individual or a nonresident fiduciary of a foreign estate or trust. The term "United States" means the United States of America (including the States and the District of Columbia), its territories, its possessions and other areas subject to its jurisdiction. (b) Except as specifically provided in this Note and in the Fiscal Agency Agreement, INTELSAT shall not be required to make any payment with respect to any tax, assessment or other governmental charge imposed by any government or any political subdivision or taxing authority thereof or therein. Whenever in this Note there is a reference, in any context, to the payment of the principal of or interest on, or in respect of, any Note or any coupon, such mention shall be deemed to include mention of the payment of Additional Amounts provided for in this Paragraph to the extent that, in such context, Additional Amounts are, were or would be payable in respect thereof pursuant to the provisions of this Paragraph and express mention of the payment of Additional Amounts (if applicable) in any provisions hereof shall not be construed as excluding Additional Amounts in those provisions hereof where such express mention is not made. 6. (a) The Notes are subject to redemption at the option of INTELSAT, as a whole but not in part, at any time at a redemption price equal to the principal amount thereof, together with accrued and unpaid interest to the date fixed for redemption (except if the redemption date is an Interest Payment Date) under the circumstances described in the next three Paragraphs. (b) The Notes may be redeemed, as a whole but not in part, at the option of INTELSAT, upon not more than 60 days' nor less than 30 days' prior notice in the manner provided in clause (e) of this Paragraph 6 at a redemption price equal to the principal amount thereof together with accrued and unpaid interest to the date fixed for redemption, if (x) INTELSAT determines that, without regard to any immunities that may be available to it, (1) as a result of any change in or amendment to the laws (or any regulations or rulings promulgated thereunder) of the United States or of any political subdivision or taxing authority thereof or therein affecting taxation, or any change in official position regarding application or interpretation of such laws, regulations or rulings (including a holding by a court of competent jurisdiction in the United States), which change or amendment is announced or becomes effective on or after 22 March 1994, INTELSAT has or will become obligated to pay Additional Amounts (as provided in Paragraph 5(a) hereof) or (2) on or after 22 March 1994, any action has been taken by any taxing authority of, or any decision has been rendered by a court of competent jurisdiction in, the United States or any political subdivision or taxing authority thereof or therein, including any of those actions specified in (1) above, whether or not such action was taken or decision was rendered with respect to INTELSAT, or any change, amendment, application or interpretation shall be officially proposed, which, in any such case, in the written opinion to INTELSAT of independent legal counsel of recognized standing, will result in a material probability that INTELSAT will become obligated to pay Additional Amounts with respect to the Notes, and (y) in any such case INTELSAT, in its business judgment, determines that such obligation cannot be avoided by the use of reasonable measures available to INTELSAT (provided that INTELSAT shall not be required to assert any immunities that may be available to it); provided, however, that (i) no such notice of redemption shall be given earlier than 90 days prior to the earliest date on which INTELSAT would but for such redemption be obligated to pay Additional Amounts and (ii) at the time such notice of redemption is given, such obligation to pay Additional Amounts remains in effect. Prior to the publication of notice of redemption pursuant to this Paragraph 6(b), INTELSAT shall deliver to the Fiscal Agent a certificate of INTELSAT stating the date of redemption and that INTELSAT is entitled to effect such redemption and setting forth in reasonable detail a statement of facts showing that the conditions precedent to the right of INTELSAT to so redeem the Notes have occurred. (c) In addition, if INTELSAT shall determine that any payment made outside the United States by INTELSAT or any paying agent of principal or interest due in respect of any Bearer Note or coupon would, under any present or future laws or regulations of the United States and without regard to any immunities that may be available to INTELSAT, be subject to any certification, information or other reporting requirement of any kind, the effect of which requirement is the disclosure to INTELSAT, any paying agent or any governmental authority of the nationality, residence or identity (as distinguished from, for example, status as a United States Alien) of a beneficial owner of such Note or coupon who is a United States Alien (other than such a requirement (i) which would not be applicable to a payment made by INTELSAT or any paying agent (A) directly to the beneficial owner, or (B) to a custodian, nominee or other agent of the beneficial owner, or (ii) which can be satisfied by such custodian, nominee or other agent certifying to the effect that such beneficial owner is a United States Alien, provided that in each case referred to in clauses (i)(B) and (ii), payment by such custodian, nominee or agent to such beneficial owner is not otherwise subject to any such requirement or (iii) would not be applicable to a payment made by at least one other paying agent of INTELSAT), INTELSAT, at its election, shall either (x) redeem the Bearer Notes, as a whole but not in part, at a redemption price equal to the principal amount thereof, together with accrued and unpaid interest to the date fixed for redemption or (y) if the conditions set forth in Paragraph 6(d) hereof are satisfied, pay the additional amounts specified in such Paragraph. INTELSAT shall make such determination and election as soon as practicable and give prompt notice thereof (the "Determination Notice") in the manner provided in clause (e) of this Paragraph 6, stating the effective date of such certification, information or other reporting requirement, whether INTELSAT has elected to redeem the Bearer Notes or to pay the additional amounts specified in Paragraph 6(d) hereof, and (if applicable) the last date by which the redemption of the Bearer Notes must take place, as provided in the next succeeding sentence. If INTELSAT elects to redeem the Bearer Notes, such redemption shall take place on such date, not later than one year after the publication of the Determination Notice, as INTELSAT shall elect by notice to the Fiscal Agent given not less than 45 nor more than 75 days before the date fixed for redemption. Notice of such redemption of the Bearer Notes will be given to the Holders of the Bearer Notes not less than 30 nor more than 60 days prior to the date fixed for redemption. Notwithstanding the foregoing, INTELSAT shall not so redeem the Bearer Notes if INTELSAT shall subsequently determine, not less than 30 days prior to the date fixed for redemption, that subsequent payments would not be subject to any such requirement, in which case INTELSAT shall give prompt notice of such determination in the manner provided in clause (e) of this Paragraph 6 and any earlier redemption notice shall be revoked and of no further effect. (d) If and so long as the certification, information or other reporting requirements referred to in Paragraph 6(c) would be fully satisfied by payment of a withholding tax, backup withholding tax or similar charge, INTELSAT may elect to pay, without regard to any immunities that may be available to it, such additional amounts (regardless of clause (vii) in Paragraph 5(a)) as may be necessary so that every net payment made outside the United States following the effective date of such requirements by INTELSAT or any paying agent of principal or interest due in respect of any Bearer Note or any coupon the beneficial owner of which is a United States Alien (but without any requirement that the nationality, residence or identity of such beneficial owner be disclosed to INTELSAT, any paying agent or any governmental authority), after deduction or withholding for or on account of such withholding tax, backup withholding tax or similar charge (other than a withholding tax, backup withholding tax or similar charge that (i) is the result of a certification, information or other reporting requirement described in the second parenthetical clause of the first sentence of Paragraph 6(c), (ii) is imposed as a result of the fact that INTELSAT or any of its paying agents have actual knowledge that the beneficial owner of such Bearer Note or coupon is within the category of persons described in Clauses (i) or (v) of Paragraph 5(a), or (iii) is imposed as a result of presentation of such Bearer Note or coupon for payment more than 10 calendar days after the date on which such payment becomes due and payable or on which payment thereof is duly provided for and notice thereof is given to Holders, whichever occurs later), will not be less than the amount provided for in such Bearer Note or coupon to be then due and payable. In the event INTELSAT elects to pay such additional amounts, INTELSAT will have the right, at its sole option, at any time, to redeem the Bearer Notes as a whole, but not in part, at a redemption price equal to the principal amount thereof, together with accrued and unpaid interest to the date fixed for redemption. If INTELSAT has made the determination described in Paragraph 6(c) with respect to certification, information or other reporting requirements applicable only to interest and subsequently makes a determination in the manner and of the nature referred to in such Paragraph 6(c) with respect to such requirements applicable to principal, INTELSAT will redeem the Bearer Notes in the manner and on the terms described in Paragraph 6(c) unless INTELSAT elects to have the provisions of this Paragraph apply rather than the provisions of Paragraph 6(c). If in such circumstances the Bearer Notes are to be redeemed, INTELSAT shall have no obligation to pay additional amounts pursuant to this Paragraph with respect to principal or interest accrued and unpaid after the date of the notice of such determination indicating such redemption, but will be obligated to pay such additional amounts with respect to interest accrued and unpaid to the date of such determination. If INTELSAT elects to pay additional amounts pursuant to this Paragraph and the condition specified in the first sentence of this Paragraph should no longer be satisfied, then INTELSAT shall promptly redeem such Bearer Notes. (e) The Fiscal Agent shall cause, on behalf of INTELSAT, notices to be given to redeem Bearer Notes to Holders by publication at least once in a leading daily newspaper in the English language of general circulation in South East Asia and, so long as the Notes are listed on the respective stock exchanges and such exchanges shall so require, in a daily newspaper of general circulation in Hong Kong and Singapore or, if publication in either Hong Kong or Singapore is not reasonably practicable, elsewhere in South East Asia. The term "daily newspaper" as used herein shall be deemed to mean a newspaper customarily published on each business day, whether or not it shall be published in Saturday, Sunday or holiday editions. If by reason of the suspension of publication of any newspaper, or by reason of any other cause, it shall be impracticable to give notice to the Holders of Notes in the manner prescribed herein, then such notification in lieu thereof as shall be made by INTELSAT or by the Fiscal Agent on behalf of and at the instruction and expense of INTELSAT shall constitute sufficient provision of such notice, if such notification shall, so far as may be practicable, approximate the terms and conditions of the publication in lieu of which it is given. Neither the failure to give notice nor any defect in any notice given to any particular Holder of a Note shall affect the sufficiency of any notice with respect to other Notes. Such notices will be deemed to have been given on the date of such publication or mailing or, if published in such newspapers on different dates, on the date of the first such publication in South East Asia. Notices to redeem Notes shall be given at least once not more than 60 days nor less than 30 days prior to the date fixed for redemption and shall specify the date fixed for redemption, the redemption price, the place or places of payment, that payment will be made upon presentation and surrender of the Notes to be redeemed, together with all appurtenant coupons, if any, maturing subsequent to the date fixed for redemption, that interest accrued and unpaid to the date fixed for redemption (unless the redemption date is an Interest Payment Date) will be paid as specified in said notice, and that on and after said date interest thereon will cease to accrue. If the redemption is pursuant to Paragraph 6(b) or 6(c) hereof, such notice shall also state that the conditions precedent to such redemption have occurred and state that INTELSAT has elected to redeem all the Notes. (f) If notice of redemption has been given in the manner set forth in Paragraph 6(e) hereof, the Notes so to be redeemed shall become due and payable on such redemption date specified in such notice and upon presentation and surrender of the Notes at the place or places specified in such notice, together with all appurtenant coupons, if any, maturing subsequent to the redemption date, the Notes shall be paid and redeemed by INTELSAT at the places and in the manner and currency herein specified and at the redemption price together with accrued and unpaid interest (unless the redemption date is an Interest Payment Date) to the redemption date; provided, however, that interest due on or prior to the redemption date on Bearer Notes shall be payable only upon the presentation and surrender of coupons for such interest (at an office or agency outside the United States except as otherwise provided on the face of the Bearer Note). If any Bearer Note surrendered for redemption shall not be accompanied by all appurtenant coupons maturing after the redemption date, such Note may be paid after deducting from the amount otherwise payable an amount equal to the face amount of all such missing coupons, or the surrender of such missing coupon or coupons may be waived by INTELSAT and the Fiscal Agent if they are furnished with such security or indemnity as they may require to save each of them and each other paying agency of INTELSAT harmless. From and after the redemption date, if monies for the redemption of Notes surrendered for redemption shall have been made available at the Principal Office of the Fiscal Agent for redemption on the redemption date, the Notes surrendered for redemption shall cease to bear interest, the coupons for interest appertaining to Bearer Notes maturing subsequent to the redemption date shall be void (unless the amount of such coupons shall have been deducted from the redemption price at the time of surrender of the Bearer Note to which such coupons appertained, as aforesaid), and the only right of the Holders of such Notes shall be to receive payment of the redemption price together with accrued and unpaid interest (unless the redemption date is an Interest Payment Date) to the redemption date as aforesaid. If monies for the redemption of the Notes are not made available for payment until after the redemption date, the Notes surrendered for redemption shall not cease to bear interest until such monies have been so made available. (g) Notes redeemed or otherwise acquired by INTELSAT will forthwith be delivered to the Fiscal Agent for cancellation and may not be reissued or resold, except that Bearer Notes delivered to the Fiscal Agent may, at the written request of INTELSAT, be reissued by the Fiscal Agent in replacement of mutilated, lost, stolen or destroyed Notes pursuant to Paragraph 9 hereof. 7. In the event of: (a) default in the payment of any installment of interest upon any Note for a period of 30 days after the date when due; or (b) default in the payment of the principal of any Note when due (whether at maturity or redemption or otherwise); or (c) default in the performance or breach of any covenant or warranty contained in the Notes or the Fiscal Agency Agreement (other than as specified in clauses (a) and (b) of this Paragraph 7) for a period of 90 days after the date on which written notice of such failure, requiring INTELSAT to remedy the same and stating that such notice is a "Notice of Default", shall first have been given to INTELSAT and the Fiscal Agent by any Holder of a Note; or (d) involuntary acceleration of the maturity of other indebtedness of INTELSAT for money borrowed with a maturity of one year or more in excess of U.S. $50,000,000 which acceleration shall not be rescinded or annulled, or which indebtedness shall not be discharged, within 45 days after notice; or (e) INTELSAT is dissolved or the INTELSAT Agreement or the Operating Agreement ceases to be in full force and effect; provided, however, that no default shall occur if INTELSAT's obligations under the Fiscal Agency Agreement and the Notes are assumed by a successor who maintains a business which is substantially similar to that of INTELSAT; the Holder of this Note may, at such Holder's option, unless such Event of Default has been waived as described in Paragraph 10(b) hereof, declare the principal of this Note and accrued and unpaid interest hereon to be due and payable immediately by written notice to INTELSAT, with a copy to the Fiscal Agent at its Principal Office, and unless all such defaults shall have been cured by INTELSAT prior to receipt of such written notice, the principal of this Note and accrued and unpaid interest hereon shall become and be immediately due and payable. 8. (a) INTELSAT will conduct and operate its business diligently and in the ordinary manner in compliance with the INTELSAT Agreement and the Operating Agreement, and will use all reasonable efforts to maintain in full force and effect its existing international registration of orbital locations and frequency spectrum for the operation of its global commercial telecommunications satellite system; provided, however, that INTELSAT shall not be prevented from making any change with respect to its manner of conducting or operating its business or with respect to such registration if such change, in the judgment of INTELSAT, is desirable and does not materially impair INTELSAT's ability to perform its obligations under the Notes. (b) INTELSAT will cause all properties used or useful in the conduct of its business to be maintained and kept in good condition, repair and working order and supplied with all necessary equipment and will cause to be made all necessary repairs, renewals, replacements, betterments and improvements thereof, all as in the judgment of INTELSAT may be necessary so that the business carried on in connection therewith may be properly and advantageously conducted at all times (except for ordinary wear and tear and deterioration); provided, however, that INTELSAT shall not be prevented from discontinuing the operation or maintenance of any of such properties if such discontinuance, in the judgment of INTELSAT, is desirable in the conduct of its business and does not materially impair INTELSAT's ability to perform its obligations under the Notes. 9. If any mutilated Note or a Note with a mutilated coupon appertaining to it is surrendered to the Fiscal Agent, INTELSAT shall execute, and the Fiscal Agent shall authenticate (or arrange for authentication on its behalf) and deliver in exchange therefor, a new Note of like tenor and principal amount, bearing a number not contemporaneously outstanding, with coupons corresponding to the coupons, if any, appertaining to the surrendered Note. If there be delivered to INTELSAT and the Fiscal Agent (i) evidence to their satisfaction of the destruction, loss or theft of any Note or coupon, and (ii) such security or indemnity as may be required by them to save each of them and any agent of each of them harmless, then, in the absence of notice to INTELSAT or the Fiscal Agent that such Note or coupon has been acquired by a bona fide purchaser, INTELSAT shall execute, and upon its request the Fiscal Agent shall authenticate (or arrange for authentication on its behalf) and deliver in lieu of any such destroyed, lost or stolen Note or in exchange for the Note to which such coupon appertains (with all appurtenant coupons not destroyed, lost or stolen), a new Note of like tenor and principal amount and bearing a number not contemporaneously outstanding, with coupons corresponding to the coupons, if any, appertaining to such destroyed, lost or stolen Note or to the Note to which such destroyed, lost or stolen coupon appertains. Upon the issuance of any new Note under this Paragraph, INTELSAT may require the payment by the Holder of a sum sufficient to cover any tax or other governmental charge that may be imposed in relation thereto and any other expenses (including the fees and the expenses of the Fiscal Agent and INTELSAT) connected therewith. Every new Note with its coupons, if any, issued pursuant to this Paragraph in lieu of any destroyed, lost or stolen Note, or in exchange for a Note to which a destroyed, lost or stolen coupon appertains, shall constitute an original additional contractual obligation of INTELSAT, whether or not the destroyed, lost or stolen Note and its coupons, if any, or the destroyed, lost or stolen coupon shall be at any time enforceable by anyone. Any new Note delivered pursuant to this Paragraph shall be so dated, or have attached thereto such coupons, that neither gain nor loss in interest shall result from such exchange. The provisions of this Paragraph 9 are exclusive and shall preclude (to the extent lawful) all other rights and remedies with respect to the replacement or payment of mutilated, destroyed, lost or stolen Notes or coupons. 10. (a) The Fiscal Agency Agreement and the terms and conditions of the Notes may be modified or amended by INTELSAT and the Fiscal Agent, without the consent of the Holder of any Note or coupon, in any manner which does not adversely affect the interests of the Holders, to provide for issuances of further debt securities as contemplated by Paragraph 11 hereof and by the Fiscal Agency Agreement, and to cure any ambiguity or to cure, correct or supplement any defective provision contained herein or in any coupon appertaining hereto or in the Fiscal Agency Agreement, or in certain other circumstances as described in the Fiscal Agency Agreement, to all of which each Holder of any Note or coupon shall, by acceptance thereof, consent. (b) The Fiscal Agency Agreement and the terms and conditions of the Notes may also be modified or amended by INTELSAT and the Fiscal Agent, and future compliance therewith or past default by INTELSAT may be waived, either with the consent of the Holders of not less than a majority in aggregate principal amount of the Notes at the time Outstanding or by the adoption of a resolution at a meeting of Holders duly convened and held in accordance with the provisions of the Fiscal Agency Agreement at which a quorum (as defined below) is present by at least a majority in aggregate principle amount of Notes represented at such meeting; provided, however, that no such modification, amendment or waiver may, without the written consent or affirmative vote of the Holder of each Note affected thereby: (i) change the stated maturity of the principal of or any installment of interest on any such Note, or (ii) reduce the principal amount thereof or the rate of interest on any such Note, or (iii) change the obligation of INTELSAT to pay Additional Amounts, or (iv) change the coin or currency in which any such Note or the interest thereon is payable, or (v) modify the obligation of INTELSAT to maintain offices or agencies outside the United States, or (vi) reduce the percentage in principal amount of the Outstanding Notes necessary to modify or amend the Fiscal Agency Agreement or the terms and conditions of the Notes or the coupons, or to waive any future compliance or past default, or (vii) reduce the requirements for voting for the adoption of a resolution or the quorum required at any meeting of Holders of Notes at which a resolution is adopted. The quorum at any meeting called to adopt a resolution will be a majority in aggregate principal amount of Notes Outstanding, except that at any meeting which is reconvened for lack of a quorum, the Holders entitled to vote 25 per cent. in aggregate principle amount of Notes Outstanding shall constitute a quorum for the taking of any action set forth in the notice of the original meeting. It shall not be necessary for the Holders of Notes to approve the particular form of any proposed amendment, but it shall be sufficient if they approve the substance thereof. (c) Any modifications, amendments or waivers to the Fiscal Agency Agreement or to the terms and conditions of the Notes in accordance with the foregoing provisions will be conclusive and binding on all Holders of Notes, whether or not they have given such consent, and on all Holders of coupons, whether or not notation of such modifications, amendments or waivers is made upon the Notes or coupons, and on all future Holders of Notes and coupons. (d) Promptly after the execution of any amendment to the Fiscal Agency Agreement or the effectiveness of any modification or amendment of the terms and conditions of the Notes, notice of such modification or amendment shall be given by INTELSAT or by the Fiscal Agent on behalf of and at the expense of INTELSAT, to Holders of the Notes in the manner provided in Paragraph 6(e) hereof. The failure to give such notice on a timely basis shall not invalidate such modification or amendment, but INTELSAT shall cause the Fiscal Agent to give such notice as soon as practicable upon discovering such failure or upon any impediment to the giving of such notice being overcome. 11. INTELSAT may from time to time, without the consent of the Holder of any Note or coupon, issue further debt securities having the same terms and conditions as the Notes in all respects (or in all respects except for the first payment of interest thereon) or having such terms as INTELSAT may determine at the time of their issuance, in either case so that any such further debt securities shall be consolidated and form a single series with outstanding securities of any series (including the Notes). Unless the context requires otherwise, references in the Notes and coupons and in the Fiscal Agency Agreement to the Notes or coupons shall include any other debt securities issued in accordance with the Fiscal Agency Agreement that are intended by INTELSAT to form a single series with the Notes. Any further debt securities forming a single series with the outstanding securities of any series (including the Notes) shall be issued pursuant to the Fiscal Agency Agreement as amended for the purpose of providing for the issuance of such debt securities. 12. Subject to the authentication of this Note by the Fiscal Agent, INTELSAT hereby certifies and declares that all acts, conditions and things required to be done and performed and to have happened precedent to the creation and issuance of the Notes and any coupons, and to constitute the same the valid obligations of INTELSAT, have been done and performed and have happened in due compliance with all applicable laws. 13. INTELSAT hereby appoints CT Corporation System, 1633 Broadway, New York, New York 10019, as its authorized agent ("Authorized Agent") upon which process may be served in any action arising out of or based on the Notes or any coupons which action may be instituted in any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A., by the Holder of any Note or coupon, and INTELSAT and each Holder by acceptance hereof expressly accepts the exclusive jurisdiction of any such court in respect of any such action. Such appointment shall be irrevocable until two years after the Notes shall have matured and been paid or moneys for the payment thereof shall have been made available unless and until a successor Authorized Agent shall have been appointed and shall have accepted such appointment. INTELSAT hereby irrevocably waives any immunity to service of process in respect of any such action to which it might otherwise be entitled in any action arising out of or based upon the Notes or coupons which may be instituted by any Holder of a Note or coupon in any State or Federal court in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. Service of process upon the Authorized Agent at the address indicated above, as such address may be changed within the Borough of Manhattan, The City of New York, the State of New York, U.S.A., by notice given by the Authorized Agent to each party hereto, shall be deemed, in every respect, effective service of process upon INTELSAT. INTELSAT irrevocably waives, to the fullest extent permitted by applicable law, any sovereign or other immunity from jurisdiction or from execution (except that INTELSAT does not waive immunity from execution prior to judgment and any similar defense) to which it might otherwise be entitled in any such action which may be instituted by any Holder of a Note or coupon in any New York State or United States Federal court sitting in the Borough of Manhattan, The City of New York, the State of New York, U.S.A. 14. The Notes and coupons will constitute an obligation of INTELSAT and not of any Signatory or Party (each as defined in the INTELSAT Agreement). No Signatory or Party will waive any immunity to which it may be entitled in any suit on the Notes or coupons, and Holders of Notes or coupons will have no recourse against any Signatory or Party with respect to any obligations of INTELSAT under the Notes or coupons. [Form of coupon] [Face of coupon] ANY UNITED STATES PERSON WHO HOLDS THIS OBLIGATION WILL BE SUBJECT TO LIMITATIONS UNDER THE UNITED STATES INCOME TAX LAWS, INCLUDING THE LIMITATIONS PROVIDED IN SECTIONS 165(j) AND 1287(a) OF THE INTERNAL REVENUE CODE. [B-][1] ... [10] U.S.$[662.50] [6625.00] Due March 22 [1995]....[2004] INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION 6 5/8 Notes Due 2004 On the date set forth hereon, INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION ("INTELSAT") will pay to bearer upon surrender hereof, the amount shown hereon (together with any additional amounts in respect thereof which INTELSAT may be required to pay according to the terms of said Note) at the paying agencies set out on the reverse hereof or at such other places outside the United States of America (including the States and the District of Columbia), its territories and possessions and other areas subject to its jurisdiction as INTELSAT may determine from time to time, at the option of the Holder, by United States dollar check drawn on a bank in The City of New York, the State of New York, U.S.A. or by transfer to a United States dollar account maintained by the payee with a bank located in a city in Western Europe, being the interest then payable on said Note. INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION By_______________________________________ [Reverse of coupon] Bankers Trust Company 1 Appold Street Broadgate London EC2A 2HE England Bankers Trust Luxembourg S.A. 14 Boulevard F.D. Roosevelt L-2450 Luxembourg Bankers Trust Company 38/F Two Pacific Place 88 Queensway Hong Kong Credit Suisse Paradeplatz 8 8001 Zurich Switzerland DBS Bank 24 Raffles Place #81-00 Clifford Centre Singapore 0104 EXHIBIT C [FORM OF CERTIFICATION TO BE GIVEN TO EUROCLEAR OR CEDEL S.A. BY ACCOUNT HOLDER] CERTIFICATE INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION 6 5/8% Notes Due 2004 (the "Notes") This is to certify that as of the date hereof, and except as set forth below, interests in the temporary Global Note representing the above-captioned Notes held by you for our account (i) are owned by person(s) that are not citizens or residents of the United States, domestic partnerships, domestic corporations or any estate or trust the income of which is subject to United States Federal income taxation regardless of its source ("United States person(s)"), (ii) are owned by United States person(s) that (a) are foreign branches of United States financial institutions (as defined in U.S. Treasury Regulations Section 1.165-12(c)(1)(v) ("financial institutions")) purchasing for their own account or for resale or (b) acquired the Notes through foreign branches of United States financial institutions and who hold the Notes through such United States financial institutions on the date hereof (and in either case (a) or (b), each such United States financial institution hereby agrees, on its own behalf or through its agent, that you may advise INTELSAT or INTELSAT's agent that it will comply with the requirements of Section 165(j)(3)(A), (B) or (C) of the U.S. Internal Revenue Code of 1986, as amended, and the regulations thereunder), or (iii) are owned by a United States or foreign financial institution for purposes of resale during the restricted period (as defined in U.S. Treasury Regulations Section 1.163-5(c)(2)(i)(D)(7)), and in addition if the owner of the Notes is a United States or foreign financial institution described in clause (iii) above (whether or not also described in clause (i) or (ii)) this is to further certify that such financial institution has not acquired the Notes for purposes of resale directly or indirectly to a United States person or to a person within the United States or its possessions. As used herein, "United States" means the United States of America (including the States thereof and the District of Columbia); and its "possessions" include Puerto Rico, the U.S. Virgin Islands, Guam, American Samoa, Wake Island and the Northern Mariana Islands. We undertake to advise you promptly by tested telex on or prior to the date on which you intend to submit your certification relating to the Notes held by you for our account in accordance with your Operating Procedures if any applicable statement herein is not correct on such date, and in the absence of any such notification it may be assumed that this certification applies as of such date. This certification excepts and does not relate to U.S. $______ of such interest in the above Notes in respect of which we are not able to certify and as to which we understand exchange and delivery of definitive Notes (or, if relevant, exercise of any rights or collection of any interest) cannot be made until we do so certify. We understand that this certification is required in connection with certain tax laws or, if applicable, certain securities laws of the United States. In connection therewith, if administrative or legal proceedings are commenced or threatened in connection with which this certification is or would be relevant, we irrevocably authorize you to produce this certification to any interested party in such proceedings. Dated: _____________, 199_ By:_______________________________________ As, or as agent for, the beneficial owner(s) of the Notes to which this certificate relates. EXHIBIT D [FORM OF CERTIFICATION TO BE GIVEN BY THE EUROCLEAR OPERATOR OR CEDEL S.A.] CERTIFICATION INTERNATIONAL TELECOMMUNICATIONS SATELLITE ORGANIZATION 6 5/8% Notes Due 2004 (the "Notes") This is to certify that, based solely on certifications we have received in writing, by tested telex or by electronic transmission from member organizations appearing in our records as persons being entitled to a portion of the principal amount set forth below (our "Member Organizations") substantially to the effect set forth in the Fiscal Agency Agreement, as of the date hereof, U.S. $_______ principal amount of the above-captioned Notes (i) is owned by persons that are not citizens or residents of the United States, domestic partnerships, domestic corporations or any estate or trust the income of which is subject to United States Federal income taxation regardless of its source ("United States persons"), (ii) is owned by United States persons that are (a) foreign branches of United States financial institutions (as defined in U.S. Treasury Regulations Section 1.165-12(c)(1)(v) ("financial institutions")) purchasing for their own account or for resale or (b) United States persons who acquired the Notes through foreign branches of United States financial institutions and who hold the Notes through such United States financial institutions on the date hereof (and in either case (a) or (b), each such United States financial institution has agreed, on its own behalf or through its agent, that we may advise INTELSAT or INTELSAT's agent that it will comply with the requirements of Section 165(j)(3)(A), (B) or (C) of the U.S. Internal Revenue Code of 1986, as amended, and the regulations thereunder), or (iii) is owned by a United States or foreign financial institution for purposes of resale during the restricted period (as defined in U.S. Treasury Regulations Section 1.163-5(c)(2)(i)(D)(7)), and to the further effect that United States or foreign financial institutions described in clause (iii) above (whether or not also described in clause (i) or (ii)) have certified that they have not acquired the Notes for purposes of resale directly or indirectly to a United States person or to a person within the United States or its possessions. We further certify (i) that we are not making available herewith for exchange (or, if relevant, exercise of any rights or collection of any interest) any portion of the Temporary Global Note excepted in such certifications and (ii) that as of the date hereof we have not received any notification from any of our Member Organizations to the effect that the statements made by such Member Organizations with respect to any portion of the part submitted herewith for exchange (or, if relevant, exercise of any rights or collection of any interest) are no longer true and cannot be relied upon as of the date hereof. We understand that this certification is required in connection with certain tax laws and, if applicable, certain securities laws of the United States. In connection therewith, if administrative or legal proceedings are commenced or threatened in connection with which this certification is or would be relevant, we irrevocably authorize you to produce this certification to any interested party in such proceedings. Dated: __________, 1994 Yours faithfully, [Morgan Guaranty Trust Company of New York, Brussels Office as operator of the Euroclear System] or [Cedel S.A.] By_______________________ EXHIBIT 11 EXHIBIT 22 SUBSIDIARIES OF THE REGISTRANT AS OF MARCH 31, 1994 Subsidiary State of Incorporation - - - -------------------------------------------------------------- Bethesda Real Property, Inc. Delaware COMSAT Earth Stations, Inc. Delaware COMSAT General Corporation Delaware COMSAT Technology, Inc. Delaware COMSAT General Telematics, Inc. Delaware COMSAT International N.V. Delaware COMSAT Investments, Inc. Delaware COMSAT Mobile Investments, Inc. Delaware COMSAT Overseas, Inc. Delaware COMSAT Video Enterprises, Inc. Delaware COMSAT Denver, Inc. Delaware On Command Video Corporation Delaware CTS America, Inc. Delaware CTS Transnational, Inc. Delaware EXHIBIT 24 EXHIBIT 24 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in COMSAT Corporation's Registration Statement No. 2-83319 on Form S-8, Registration Statement No. 2-87942 on Form S-8, Registration Statement No. 33-5259 on Form S-8, Registration Statement No. 33-25124 on Form S-8, Registration Statement No. 33-35364 on Form S-8, Registration Statement No. 33-53610 on Form S-8, and Registration Statement No. 33-51661 on Form S-3 of our report dated February 16, 1994, appearing in this Annual Report on Form 10-K of COMSAT Corporation for the year ended December 31, 1993. Deloitte & Touche Washington D.C. March 29, 1994 EXHIBIT 27 EXHIBIT 27 COMSAT CORPORATION CONSOLIDATED FINANCIAL DATA SCHEDULE (in thousands, except per share amounts) Items omitted are not material. This schedule contains summary financial information extracted from the statements and notes for the years ended December 31, 1993, 1992 and 19 in its entirety by reference to such financial statements.

76744_1993.txt

76744_1993

1993

76744

Item 1. BUSINESS. - ------ --------- GENERAL Payless Cashways, Inc. ("Payless" or the "Company") is the third largest retailer of building materials and home improvement products in the United States as measured by sales. The Company operates 197 full-line retail stores in 26 states located in the Midwest, Southwest, Pacific Coast, Rocky Mountain and New England areas under the names of Payless Cashways Building Materials, Furrow Building Materials, Lumberjack Building Materials, Hugh M. Woods Building Materials, Knox Lumber and Somerville Lumber. Each full-line store is designed as a one-stop source that provides customers with a complete selection of quality products and services needed to build, improve, and maintain their home, business, farm or ranch properties. The Company's merchandise assortment includes approximately 22,000 items in the following categories: lumber and building materials, millwork, tools, hardware, electrical and plumbing products, paint, lighting, home decor, kitchens, decorative plumbing, heating, ventilating and cooling (HVAC), and seasonal items. The Company believes that the combination of a full-line lumberyard, a broad product mix, a high level of in- store customer assistance concerning product usage and installation, and competitive prices distinguishes Payless from many competitors. The Company's primary customers include serious do-it-yourselfers and professionals. Serious Do-It-Yourselfers ("DIY'ers") are those that engage in more frequent and complex repair or improvement projects and typically spend in excess of $1,000 annually on home improvement products. Professionals ("Pros") include remodelers, residential contractors, and specialty tradesmen along with enterprises which purchase large quantities of building materials for facility maintenance, such as property management firms, commercial and industrial accounts, and government institutions. Due to its product mix (especially the advantage provided by its full-line lumberyard) and customer service approach, the Company believes that it is well positioned to increase its penetration of these segments of the building materials and home improvement products market. Payless also serves the needs of the moderate and light DIY'er. INDUSTRY OVERVIEW Building materials and home improvement products are sold through two distribution channels -- retail units and wholesale supply outlets. According to a study prepared by DRI/McGraw-Hill in October 1993, the retail channel of the industry was estimated to be $115.4 billion in 1993, and is forecast to exceed $151.9 billion by 1998. The Company estimates the wholesale supply channel for products sold by the Company represented approximately $86 billion in 1992, based on the most recently available unpublished data from the U.S. Department of Commerce for 1992. Retail distribution channels include neighborhood hardware stores, home centers, warehouse stores, specialty stores (such as paint and tile stores) and lumberyards. Although the industry remains highly fragmented, the retail distribution channel has consolidated somewhat in the last ten years, particularly in metropolitan areas. Warehouse, home center and building materials chains have grown while the number of local independent merchants has declined. The top 25 chains accounted for approximately 28% of industry sales in 1992. In general terms, customers can be characterized as either retail-oriented (consumer) or wholesale-oriented (professional). The consumer segments, as defined by the Company, include light DIY'ers who spend less than $200 annually on building materials and home improvements products; moderate DIY'ers who make annual purchases of $200 to $1,000; and serious DIY'ers who make annual purchases in excess of $1,000. Consumer purchases tend to be self-service and paid for with cash or credit cards. Purchases by professionals tend to be larger in volume and require specialized merchandise assortments, competitive market pricing, superior lumber quality, telephone order placement, commercial credit and job-site delivery. BUSINESS STRATEGY OBJECTIVES The Company's principal objectives are to (i) increase its market share in the Pro and serious DIY segments through its existing stores, (ii) continue to increase Pro sales as a percentage of total sales to approximately 50% and (iii) acquire new customers through the implementation of a store expansion program and development of new, complementary retail concepts. The Company believes that demographic and lifestyle factors (such as the aging baby boomers, the increase in home-centered activities and the aging housing stock) will result in a growing demand for its products. The Company also believes that the rate of growth in the professional segment will continue to exceed the consumer or DIY segment due to the lack of discretionary time of many homeowners and the reluctance of an aging homeowner population to engage in major repair or remodeling projects. As a national chain, the Company believes it enjoys economies of scale, buying power and professional management that the traditional outlets supplying the professional commonly do not have. These advantages, along with the broad product assortment and full service package, make the Company well suited to supply the professional's needs. Based on the Company's most recent Spring 1993 surveys from ten stores, which the Company believes are representative of its stores, the Company's business mix as a percentage of sales was approximately 54% DIY and 46% Pro. Approximately 58% of the DIY sales were derived from the serious DIY'er and the remainder from the light and medium DIY'er. Due to the Company's focus on expanding its Pro business and the higher rate of increase anticipated for the professional segment, the Company expects the Pro business to contribute approximately 50% of its total sales by the end of 1994. The Company's goal is to maintain this balance once it is achieved. The Company also believes that there are significant market opportunities for specialty store concepts which complement its full-line building material stores. PROFESSIONAL STRATEGY After a strategic review of the industry in 1988, the Company determined there was a significant opportunity to expand the portion of its business derived from the professional customers because the Company concluded this market was underpenetrated by full-service distributors. As a result, the Company implemented a strategy beginning in late 1988 and early 1989 to increase its sales to the professional customer. These initiatives included: (i) the addition of a dedicated sales staff, currently numbering approximately 1,400, many of whom call on professional customers at their places of business and job sites; (ii) construction of a separate commercial sales area in each store; (iii) implementation of an enhanced delivery program which guarantees next-day job-site delivery; and (iv) the offering of special services such as roof-top delivery, commercial credit and a telephone ordering service. The Company also enhanced its merchandise assortment to reflect the increased emphasis on the Pro customer. This included the addition of contractor preferred brands, commercial grade items, contractor packs and more top-of-the-line products. The Company also improved the quality of the lumber offered. Surveys conducted by the Company in fiscal 1988 from ten stores which the Company believes were representative of its stores indicated a business mix of approximately 75% DIY and 25% Pro based on sales. Following implementation of the initiatives outlined above, the Company's business mix has shifted to approximately 54% DIY and 46% Pro in fiscal 1993. Several additional initiatives were implemented to support the continued growth and profitability of Pro sales. These include the following: . Account Management. Each Pro customer is assigned to a sales representative who has responsibility for servicing and ensuring the profitability of each account. The sales representatives have detailed information regarding account purchases (what was purchased and when) and the profitability of their accounts. The Company believes that this level of customer service and type of sales management system is effective in increasing purchases and improving profitability from current professional customers and building customer loyalty. . Customer Segmentation for Profitability. Each retail store prepares an annual business plan which targets customers by Standard Industry Code and purchase potential. This focus is intended to create more sales in the higher margin hardware and decorative products without impairing the growth in sales of lumberyard products. . Enhanced Service Capabilities. The Company implemented a number of enhanced service capabilities intended to increase sales to current customers and make stores more appealing to new customers. The Company, through its On- Property Total Inventory Control ("OPTIC") program, offers on-site product replenishment service to over 1,700 large property owners and managers. Additionally, all stores offer automated blueprint estimating services featuring 48-hour turnaround. This estimating system is unique in that it utilizes a digitizer which ensures accuracy in the measurement process and it is fully integrated into the store's point-of-sale ("POS") system. The Company also supports its professional customer with joint marketing programs such as its contractor referral data base. . National Accounts Program. The Company initiated a national accounts program in 1992 which targets businesses with major facilities or multiple locations and which utilize large amounts of building materials and improvement products for facility maintenance. The primary focus of this program is to emphasize sales of hardware and decorative items. This program is designed to provide incremental sales from national accounts at current store locations. The Company had 278 national accounts at the end of 1993. . Differentiation through Product Offering. Payless has actively worked to offer professional and commercial products previously available to customers only through authorized wholesale distributors. These additions are intended to generate increased sales and increase customer perception of the wider selection of quality products offered. DIY STRATEGY The Company's strategy to increase market share with the DIY customer focuses primarily on the serious DIY'er. In fiscal 1993, sales to serious DIY'ers represented approximately 58% of the sales to DIY'ers while accounting for approximately 49% of the DIY'er transactions based on Company surveys of ten stores which the Company believes are representative of its stores. Quality products, a wide assortment, in-stock position, competitive pricing and service assistance on more complex projects are important to the serious DIY customer and have been the foundation upon which the Company has built its business with these customers. Since 1988, the Company has upgraded its assortment and displays in product categories which represent a significant portion of the purchases by serious DIY'ers. These upgraded product categories include paint, decorative plumbing, kitchen cabinets, power tools, builders' hardware, millwork, and home decor. Serious DIY'ers are similar to the professional customer with regard to the brands preferred and the importance of stocking high quality lumber. The Company believes that many of the steps it has taken to serve the professional customer have also had a positive impact on sales to the serious DIY customer. Several additional initiatives were implemented to support the continued growth and profitability of DIY sales. These include the following: . Improved Customer Service. In 1992, the Company increased the number of sales personnel available to assist customers. Improved productivity in support areas such as receiving rooms and offices allowed this re-allocation of personnel. The Company also has an employee recognition and reward program to promote outstanding customer service. Improved customer service is intended to increase the average sales ticket size and the number of repeat purchasers. . Design Services. The Company has also expanded the project design services offered to its customers. A computer design system for kitchens, baths and closet systems is located in each of the store's kitchen design centers. Design Works, a building packages design system focusing initially on decks, garages and post-frame buildings, was installed in all stores (except Somerville) in 1993. Both of these systems are integrated into the store's POS system, providing on-line pricing, confirmation of inventory availability and immediate conversion of an estimate into an order. . Lumberyard Improvements. Serious DIY'ers are frequent purchasers of the lumber and building material products stocked in the lumberyard. Currently, DIY customers are not provided a single location in the store at which they can complete a purchase of lumberyard products. The Company has completed changes to one pilot store and is currently in various stages of design or implementation for an additional 55 stores in 1994 as part of a plan that is designed to facilitate the purchase of lumberyard products, saving the customer time and increasing customer satisfaction. The Company believes these changes position it for increased future sales. . Special Events. The Company offers the serious DIY'er special buying opportunities through after-hours sales and other preferred customer programs. EXPANSION STRATEGY Payless grew substantially in the 1980's prior to a 1988 leveraged buyout by certain members of Payless' senior management and a group of investors, with a net increase of 77 full-line stores during the 1984-1988 period. The Company has added one (net) store since 1988. An important part of the Company's business strategy is an expansion program, which will include seven additional full-line stores in 1994, approximately six new stores annually thereafter and new, complementary retail concepts in new and existing markets. Implementation of this program is dependent on a number of factors, including availability of cash flow from operations and site availability. Although there is no assurance that future growth will take place as anticipated, the Company believes that its prior experience in site selection and acquisition and demographic analysis provides a solid base for its future expansion activities. The Company's expansion program is designed to broaden the Company's penetration into new and existing markets. Although existing market expansion may initially adversely affect sales at existing stores, the Company believes that expansion into existing markets will increase market penetration by attracting new customers to more convenient locations and allow the Company to increase operating margins by achieving economies of scale in certain areas such as management supervision, advertising and distribution. Expansion in the Company's current market is also less uncertain because of its experience in those markets with existing store locations. Typically, the Company plans to enter new markets with multiple store locations. The Company expects that the additional stores will generally be located in trade areas which have high housing density and above-average household income. The Company estimates that the time required to open a new full-line store, from site selection to opening the doors for business is approximately 12 to 15 months. The Company also estimates that capital investment for new stores will average $6.5 to $7.0 million per store, with land costs being the greatest variable, and that the initial net inventory investment will average $1.9 million per store. In addition to opening traditional full-line stores, the Company expects to increase its market share with new, complementary retail concepts piloted in 1993 which require significantly less capital outlay than traditional full-line stores: . Remote Contractor Sales Office (CSO). CSO's, which include an order desk and selected, high-demand products, are located generally within 50 miles of a full-line store in an underserved area and are designed to significantly expand a full-line store's trade area for the professional and commercial customer. The Company currently operates 21 CSO's. . Home & Room Designs (HRD). HRD showrooms feature kitchens, baths, millwork, lighting, flooring, wall covering, window treatments and builders' hardware. HRD's are designed to serve the professional home builder, remodeler, architect, interior designer and their customers. The Company currently operates two HRD's. . Tool Site. Tool Site specialty stores feature approximately 6,500 tools and related products in a facility with an average size of 15,000 square feet. The Company opened two pilot units in 1993. The mix of the number of CSO's, HRD's and Tool Sites that the Company expects to open each year will depend on a variety of factors, including financial performance as well as economic factors beyond the Company's control. Also, at the end of 1993 the Company announced its first, international expansion into Mexico through the creation of a joint venture, with plans to build a chain of at least 25 stores within the next five to six years. The stores will offer customers, both DIYer's and Pros, a complete line of building materials and home improvement products and services in a customized retail setting. The first retail facility is currently scheduled to open in late 1994 or early 1995. MERCHANDISING AND MARKETING Payless' full-line stores sell a broad range of building material products totaling approximately 22,000 items, many of which are nationally advertised brand-name items. Payless categorizes its product offerings into the classes described below: LUMBERYARD - Dimensional lumber, plywood, sidings, roofing materials, fencing materials, windows, doors and moldings, insulation materials and drywall. HARDWARE - Electrical wire and wiring materials, plumbing materials, power and hand tools, paint and painting supplies, lawn and garden products, door locks, fasteners, and heating and cooling products. SHOWROOM - Interior and exterior lighting, bathroom fixtures and vanities, kitchen cabinets, flooring, panelling, wallcoverings and ceiling tiles. During the three fiscal years ended November 27, 1993, the three product classifications accounted for the following percentages of Payless' sales: During the past five years the Company has remerchandised its retail showroom in order to maximize space utilization. This has contributed to an increase in space productivity as sales per square foot of retail space have risen from $327 in fiscal 1988 to $435 in fiscal 1993. Payless addresses its primary target customers through a mix of newspaper, direct mail, radio and television advertising methods. The primary media vehicle is newspaper advertisements, both freestanding inserts and run-of-press ads. Television and radio advertising are used in support of major promotional events. Additionally, the Company participates in or hosts a variety of home shows, customer hospitality events, contractor product shows and national trade association shows and conferences. During fiscal 1993, the Company's expenditures (net of vendor allowances) on all forms of advertising totaled approximately $36 million or 1.4% of sales. The Company utilizes data base marketing techniques to increase the effectiveness of its marketing programs. The data base allows the Company to track purchases of individual customers at the stock keeping unit ("SKU") level if desired. This purchase history data is used in targeted marketing campaigns and to develop distinct customer profiles for various product categories. In addition, the Company conducts its own market research, including customer intercepts, phone surveys and customer focus groups. STORE LOCATIONS The Company's 197 full-line stores are located in the following states: Payless owns 173 of its full-line store facilities and 161 of the 197 sites on which such stores are located. The remaining 24 stores and 36 sites are leased. Additionally, 21 CSO's, two Tool Sites, and two Home & Room Designs units are leased. Mortgages or deeds of trust on 167 store parcels secure existing indebtedness. Payless has generally located retail stores adjacent to residential areas of major metropolitan cities or adjacent to major arteries in smaller communities which are convenient to the DIY and Pro customer. Operation of multiple stores in a trade area permits more effective supervision of stores and provides certain economies in distribution expenses and advertising costs. Each of Payless' 197 existing stores has an average of approximately 30,000 square feet of indoor display space and 52,000 square feet of warehouse space. The prototype stores being built in 1994 will average approximately 60,000 square feet of retail selling space with an attached 17,000 square foot warehouse and a 150,000 square foot lumberyard. The average Payless Store occupies approximately eight acres of land. An average Payless store currently carries approximately $1.7 million of inventory, and during fiscal 1993 sales at Payless stores averaged approximately $13.3 million per store. During fiscal 1993, one full-line store, 17 CSO's, two Tool Sites and one Home & Room Designs unit were opened. No full-line stores were opened in fiscal 1991 or 1992. However, four CSO's and one Home & Room Designs unit were opened in 1992. STORE MANAGEMENT AND PERSONNEL Payless recently reorganized the coordination of its 197 full-line-store operations. The structure includes 101 Group Store Directors and Store Managers reporting to one of six Regional Vice Presidents. Supervision and control over the individual stores are facilitated by means of detailed operating reports. All of Payless' Group Store Directors, Store Managers, and Regional Vice Presidents have been promoted from within Payless or from within the stores Payless has acquired. To obtain candidates for store supervisory and management positions, Payless recruits both recent college graduates and persons with business experience. These employees are placed in a formal training program administered by Payless. In addition, Payless maintains an ongoing training program for existing store personnel. Group Store Directors and Store Managers typically have more than ten years of experience with the Company. The stores utilize a departmental management structure designed to provide a superior level of service to customers. Sales associates are trained in product knowledge, selling skills and systems and procedures. Formal classroom training sessions are supplemented with product clinics, rallies and special assignments. Department sales managers typically have more than five years of experience with the Company. The Company utilizes a sales tracking system at the store level to set individual sales and gross margin goals for each of its sales associates. Information is available on a weekly basis to monitor performance against those goals. Incentive compensation systems reward employees for store performance above goal. In addition to management personnel, all sales and support personnel in the retail stores participate in incentive compensation programs. In fiscal 1993, the Company paid $5.6 million in incentive compensation to its nonmanagement store personnel. Group Store Directors and Store Managers can earn in excess of 40% of base salary in incentive compensation. The Company paid approximately $10.8 million in incentive compensation to its store management personnel for fiscal 1993. The Company believes that its incentive compensation systems are key to employee performance and motivation. INFORMATION SYSTEMS During the past five years, Payless has spent over $101 million in information systems technology (consisting of capital expenditures and operating expenses) providing timely operational and management information. All of the Company's 197 full-line stores have point-of-sale terminals equipped with scanning that transmit daily information on sales at the SKU level via a satellite network. This information is used to support merchandising, inventory replenishment and promotional decisions. The satellite network is also utilized for on-line credit card processing and check authorization. The Company has developed or purchased software packages to support numerous integrated systems in such areas as finance, merchandising, marketing, distribution, store operations and human resources. The Company continues to evaluate information systems usage and architecture, including such things as data base and client/server processing, hand-held registers, and other applications to enhance customer service. DISTRIBUTION AND SUPPLIERS The Company operates a total of eight distribution centers and three manufacturing locations. The distribution centers maintain inventories and tag and ship product to stores on a weekly basis. Of the eight, two (Sedalia, Missouri and Bellingham, Massachusetts) handle small-sized, conveyable, high value items such as hardware, plumbing and electrical supplies, and hand tools. The other six distribution centers handle commodity products and bulky manufactured products such as tubs, paneling and ceiling tile. The manufacturing locations assemble pre-hung doors and customized windows. In fiscal 1993, 54% of merchandise was channeled through the distribution centers for redistribution to individual stores. This benefits the Company in the areas of product costs, in-stock positions and inventory turnover. The Sedalia Distribution Center commenced operations in April 1988 and now serves 187 stores. The 495,000 square foot facility utilizes computerized receiving, storage and selection technology. The Bellingham Distribution Center was opened in May 1989 with similar automation. The facility has 453,000 square feet and serves the Somerville Lumber stores. Excluding the Sedalia and Bellingham operations, the Company's regional distribution centers average 18 acres with 154,000 square feet of warehouse space, operating with manual storage and selection systems. In addition, the Company uses third-party operations for specialized needs. Payless purchases substantially all of its merchandise from approximately 3,500 suppliers, no one of which accounted for more than 5% of the Company's purchases during fiscal 1993. CREDIT The Company offers credit to both its DIY and Pro customers. Purchases under national credit cards and the Company's private label credit card program as a percentage of sales represented 25.1% in fiscal 1993, 25.6% in fiscal 1992, and 26.4% in fiscal 1991. Purchases under the Company's private label commercial credit program as a percentage of sales represented 22.1% in fiscal 1993, 16.7% in fiscal 1992, and 14.3% in fiscal 1991. The Company's private- label credit card program and commercial credit program are administered by a large finance and asset management company. Accounts written off (net of recoveries) under the commercial credit program in fiscal 1993 were approximately $2.8 million or .5% of net commercial credit sales. The cost of the private label credit card program represents a fixed percentage fee of charge sales. The fees on the commercial credit program consist of administrative fees which are primarily tied to commercial credit sales and fees for accounts written off, which are substantially all absorbed by the Company. COMPETITION The business of Payless is highly competitive. Payless encounters competition from national and regional chains, including those with a warehouse format, and from local independent wholesalers, supply houses and distributors. Certain of its competitors are larger in terms of capital and sales volume and have been operating longer than Payless in particular areas. Although Payless' competition varies by geographical area, Payless believes that it generally has a favorable competitive position as a result of its full-line lumberyard, broad product mix, customer service, product availability and price. As a result of the Company's shift in marketing focus to the market for professional customers, the Company competes with local independent lumberyards, independent wholesalers, supply houses and distributors who market primarily to commercial and professional users. EMPLOYEES At November 27, 1993, Payless employed approximately 18,100 persons, approximately 29% of whom were part-time, although the number of employees may fluctuate seasonally. Payless believes its employee relations are satisfactory. Payless' employees are primarily nonunion with less than 2% being represented by a union. A substantial portion of the administrative, purchasing, advertising and accounting functions are centralized at Payless' headquarters in Kansas City, Missouri. EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------ The following table sets forth the name and age of all executive officers of Payless and their present positions and recent business experience. There is no family relationship among Payless' current directors and executive officers. Item 2. Item 2. PROPERTIES. - ------ ---------- Payless owns 173 of its full-line store facilities and 161 of the 197 sites on which such stores are located. The remaining 24 facilities and 36 sites are leased. Additionally, 21 CSO's, two Tool Sites, and two Home & Room Design units are leased. The leases provide for various terms. Mortgages or deeds of trust on 167 store parcels secure existing indebtedness. Six of the Company's eight distribution centers are owned and, of the remaining two, one is leased for land only and the facility and land are leased for the other. Mortgages or deeds of trust on six distribution center parcels secure existing indebtedness. Payless leases its corporate office in Kansas City, Missouri, under a lease expiring on November 30, 2002. The administrative offices occupy several floors (approximately 204,000 square feet) of a multi-story building. See also "Store Locations" and "Distribution and Suppliers" in Item 1, above. Item 3. Item 3. LEGAL PROCEEDINGS. - ------ ----------------- There are presently no material legal proceedings to which Payless 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. - ------ --------------------------------------------------- None. PART II ------- Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER - ------ ----------------------------------------------------------------- MATTERS. ------- Payless Common Stock has been traded on the New York Stock Exchange (ticker symbol PCS) since March 9, 1993. Prior to that date there was no established trading market for Payless' Common Stock. Therefore, high and low bid quotations are only available from that date. At February 4, 1994, there were 835 holders of record of Payless' Voting Common Stock and one holder of Class A Non-Voting Common Stock. No cash dividends have been declared on the Common Stock since 1988. Certain of Payless' debt instruments contain restrictions on the declaration and payment of dividends on, or the making of any distribution to the holders of, or the acquisition of, any shares of Common Stock or Convertible Preferred Stock. Item 6. Item 6. SELECTED FINANCIAL DATA. - ------ ----------------------- The Five-Year Financial Summary, page 34 of the Annual Report to Shareholders for the fiscal year ended November 27, 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 the Financial Condition and Results of Operations on pages 8 through 12 of the Annual Report to Shareholders for the fiscal year ended November 27, 1993, is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - ------ ------------------------------------------- The financial statements and independent auditors' report included on pages 14 through 32 of the Annual Report to Shareholders for the fiscal year ended November 27, 1993, are incorporated herein by reference. The Quarterly Consolidated Statements of Operations on pages 6 and 7 of the Annual Report to Shareholders for the fiscal year ended November 27, 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. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. - ------- -------------------------------------------------- The information required by this item with respect to directors and compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated herein by reference to the Registrant's Proxy Statement for the 1994 Annual Meeting of Shareholders, dated February 25, 1994, to be filed pursuant to Regulation 14A. The required information as to executive officers is set forth in Part I hereof. Item 11. Item 11. EXECUTIVE COMPENSATION. - ------- ---------------------- The information required by this item is incorporated herein by reference to the Registrant's Proxy Statement for the 1994 Annual Meeting of Shareholders, dated February 25, 1994, to be filed pursuant to Regulation 14A. 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 Registrant's Proxy Statement for the 1994 Annual Meeting of Shareholders, dated February 25, 1994, to be filed pursuant to Regulation 14A. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. - ------- ---------------------------------------------- The information called for by this item is incorporated herein by reference to the Registrant's Proxy Statement for the 1994 Annual Meeting of Shareholders, dated February 25, 1994, to be filed pursuant to Regulation 14A. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. - ------- ---------------------------------------------------------------- (a) Document list. 1. and 2. The response to this portion of Item 14 is submitted as a separate section of this report. 3. List of exhibits. 3.1 Restated Articles of Incorporation of the Company (incorporated by reference to Exhibit 3.1 filed as part of Amendment No. 1 to Registration Statement No. 33-58008 on Form S-2 on March 8, 1993). 3.2 By-laws of the Company (incorporated by reference to Exhibit 3.2 filed as part of Registration Statement No. 33-58008 on Form S-2 on February 8, 1993). 4.0 Long-term debt instruments of the Registrant in amounts not exceeding ten percent (10%) of the total assets of the Registrant and its subsidiary on a consolidated basis will be furnished to the Commission upon request. 4.1 Indenture dated as of April 20, 1993 by and between Payless and United States Trust Company of New York, pursuant to which the 9 1/8% Senior Subordinated Notes of Payless due April 15, 2003 were issued (incorporated by reference to Exhibit 4.2 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 29, 1993). 4.2(a) 1993 Credit Agreement, dated as of March 8, 1993, among Payless, the Banks listed on the signature pages thereof and Canadian Imperial Bank of Commerce, New York Agency, as Administrative Agent (incorporated by reference to Exhibit 4.1(b) filed as part of Amendment No. 1 to Registration Statement No. 33-58008 on Form S-2 on March 8, 1993). 4.2(b) First Amendment dated as of March 15, 1993, to the 1993 Credit Agreement, dated as of March 8, 1993, among Payless, the Banks listed on the signature pages thereof and Canadian Imperial Bank of Commerce, New York Agency, as Administrative Agent (incorporated by reference to Exhibit 4.2(b) filed as part of Registration Statement No. 33-59854 on Form S-2 on March 19, 1993). 4.2(c) Second Amendment dated as of March 19, 1993, to the 1993 Credit Agreement, dated as of March 8, 1993, among Payless, the Banks listed on the signature pages thereof and Canadian Imperial Bank of Commerce, New York Agency, as Administrative Agent (incorporated by reference to Exhibit 4.2(c) filed as part of Amendment No. 1 to Registration Statement No. 33-59854 on Form S-2 on April 9, 1993). 4.2(d) Third Amendment dated as of April 14, 1993, to the 1993 Credit Agreement, dated as of March 8, 1993, among Payless, the Banks listed on the signature pages thereof and Canadian Imperial Bank of Commerce, New York Agency, as Administrative Agent (incorporated by reference to Exhibit 4.1(b) filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 29, 1993). 4.2(e) Fourth Amendment dated as of September 17, 1993, to the 1993 Credit Agreement, dated as of March 8, 1993, among Payless, the Banks listed on the signature pages thereof and Canadian Imperial Bank of Commerce, New York Agency, as Administrative Agent (incorporated by reference to Exhibit 4.1 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended August 28, 1993). 4.2(f) Fifth Amendment dated as of February 14, 1994, to the 1993 Credit Agreement, dated as of March 8, 1993, among Payless, the Banks listed on the signature pages thereof and Canadian Imperial Bank of Commerce, New York Agency, as Administrative Agent. 4.3 Amended and Restated Warrant Agreement, dated as of January 1, 1993, to Warrant Agreement dated as of November 1, 1988, between Payless and Bank of New York (incorporated by reference to Exhibit 4.1(b) of Payless' Annual Report on Form 10-K for the fiscal year ended November 28, 1992, as amended by Form 8, dated February 1, 1993). 4.4(a) Loan Agreement dated June 20, 1989, by and among Payless Cashways, Inc., Knox Home Centers, Inc., Somerville Lumber and Supply Co., Inc., and The Prudential Insurance Company of America (incorporated by reference to Exhibit 4.2 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(b) Guaranty effective June 20, 1989, given by Somerville Lumber and Supply Co., Inc. to The Prudential Insurance Company of America, guaranteeing certain indebtedness of Payless Cashways, Inc. (incorporated by reference to Exhibit 4.7 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(c) Promissory Note dated June 20, 1989 from Payless to The Prudential Insurance Company of America, Tranche A (AR, MA, NH, RI) (incorporated by reference to Exhibit 4.10 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(d) Promissory Note dated June 20, 1989 from Payless to The Prudential Insurance Company of America, Tranche A (LA) (incorporated by reference to Exhibit 4.11 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(e) Promissory Note dated June 20, 1989 from Payless to The Prudential Insurance Company of America, Tranche B (MN) (incorporated by reference to Exhibit 4.12 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(f) Promissory Note dated June 20, 1989 from Payless to The Prudential Insurance Company of America, Tranche B (MT) (incorporated by reference to Exhibit 4.13 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(g) Promissory Note dated June 20, 1989 from Payless to the Prudential Insurance Company of America, Tranche B (ND) (incorporated by reference to Exhibit 4.14 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(h) Promissory Note dated June 20, 1989 from Payless to The Prudential Insurance Company of America, Tranche B (NV) (incorporated by reference to Exhibit 4.15 filed a part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(i) Promissory Note dated June 20, 1989 from Payless to The Prudential Insurance Company of America, Tranche B (AZ, CA) (incorporated by reference to Exhibit 4.16 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(j) Promissory Note dated June 20, 1989 from Payless to The Prudential Insurance Company of America, Tranche C (IN, KY, NM, OH, TN)(incorporated by reference to Exhibit 4.17 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(k) Promissory Note dated June 20, 1989 from Payless to The Prudential Insurance Company of America, Tranche D (CO, IA, IL, KS, NE, MO, TX, OR, OK) (incorporated by reference to Exhibit 4.18 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(l) Form of Deed of Trust, Mortgage and Security Agreement effective June 20, 1989, given to The Prudential Insurance Company of America (incorporated by reference to Exhibit 4.19 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(m) Form of Deed of Trust, Security Agreement and Assignment of Leases dated June 20, 1989 given to Morgan Bank (Delaware), as Collateral Agent (incorporated by reference to Exhibit 4.20 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 27, 1989). 4.4(n) First Modification Agreement dated as of October 18, 1991, by and among Payless, Knox, Somerville and The Prudential Insurance Company of America (incorporated by reference to Exhibit 4.9(r) filed as part of Payless' Annual Report on Form 10-K for fiscal year ended November 30, 1991). 4.4(o) Second Modification Agreement dated as of December 17, 1991, by and among Payless, Knox, Somerville and The Prudential Insurance Company of America (incorporated by reference to Exhibit 4.9(s) filed as part of Payless' Annual Report on Form 10-K for fiscal year ended November 30, 1991). 4.4(p) Third Modification Agreement dated as of December 31, 1991, by and among Payless, Knox, Somerville and the Prudential Insurance Company of America (incorporated by reference to Exhibit 4.9(t) filed as part of Payless' Annual Report on Form 10-K for fiscal year ended November 30, 1991). 4.4(q) Fourth Modification Agreement dated as of March 8, 1993, by and among Payless, Somerville and The Prudential Insurance Company of America (incorporated by reference to exhibit 4.6(v) filed as part of Amendment No. 1 to Registration Statement No. 33-58008 on Form S-2 on March 8, 1993). 4.4(r) Letter dated March 12, 1993 modifying Fourth Modification Agreement dated as of March 8, 1993 by and among Payless, Somerville and The Prudential Insurance Company of America (incorporated by reference to Exhibit 4.5(w) filed as part of Registration Statement No. 33-59854 on Form S-2 on March 19, 1993). 4.5 Security Agreement, dated October 7, 1988, executed by Payless for the benefit of Morgan Bank (Delaware) as Collateral Agent (incorporated by reference to Exhibit 4.15 filed as part of Post-Effective Amendment No. 1 on Form S-2 to Form S-1 Registration Statement No. 33-23893 filed August 8, 1989). 4.6 Acknowledgement and Release of Current Banks, dated as of March 8, 1993, among Morgan Guaranty Trust Company of New York, Payless and the banks party to the 1988 Credit Assignment (incorporated by reference to Exhibit 4.8 filed as part of Registration Statement No. 33-59854 on Form S-2 on March 19, 1993). 4.7 Assignment Agreement, dated as of March 8, 1993, among J.P. Morgan Delaware, Canadian Imperial Bank of Commerce, New York Agency ("CIBC"), Payless and Somerville (incorporated by reference to Exhibit 4.9 filed as part of Registration Statement No. 33-59854 on Form S-2 on March 19, 1993). 4.8 Subsidiary Security Agreement, dated as of March 8, 1993, made by Somerville in favor of CIBC, as Collateral Agent, for the benefit of the banks and other financial institutions party to the 1993 Credit Agreement (incorporated by reference to Exhibit 4.10 filed as part of Registration Statement No. 33-59854 on Form S-2 on March 19, 1993). 4.9 Amended and Restated Note Pledge Agreement, dated as of March 8, 1993, between Payless and CIBC, as Collateral Agent, for the benefit of the banks and other financial institutions party to the 1993 Credit Agreement (incorporated by reference to Exhibit 4.11 filed as part of Registration Statement No. 33-59854 on Form S-2 on March 19, 1993). 4.10(a) Amended and Restated Inter-Facility Agreement, dated as of March 8, 1993, between Payless, Somerville and CIBC, as Administrative Agent and Collateral Agent for the benefit of the banks and other financial institutions listed on the signature pages thereto (incorporated by reference to Exhibit 4.12 filed as part of Registration Statement No. 33-59854 on Form S-2 on March 19, 1993). 4.10(b) Joinder Agreement dated February 14, 1994 among Payless, Somerville Lumber and Supply Co., Inc. the Banks listed on the signature pages thereof and Canadian Imperial Bank of Commerce, New York Agency, as Administrative Agent. 4.11 Amended and Restated Borrower Security Agreement, dated as of March 8, 1993, between Payless and CIBC, as Collateral Agent, for the benefit of the banks and other financial institutions party to the 1993 Credit Agreement (incorporated by reference to Exhibit 4.13 filed as part of Registration Statement No. 33- 59854 on Form S-2 on March 19, 1993). 4.12 Amended and Restated Guarantee, dated as of March 8, 1993, between Somerville and CIBC, as Collateral Agent, for the benefit of the banks and other financial institutions party to the 1993 Credit Agreement (incorporated by reference to Exhibit 4.14 filed as part of Registration Statement No. 33-59854 on Form S-2 on March 19, 1993). 4.13 Amended and Restated Pledge Agreement, dated as of March 8, 1993, between Payless and CIBC, as Collateral Agent, for the benefit of the banks and other financial institutions party to the 1993 Credit Agreement (incorporated by reference to Exhibit 4.15 filed as part of Registration Statement No. 33-59854 on Form S-2 on March 19, 1993). 4.14 Form of First amendment to Mortgage and Assignment of Mortgage, dated as of March 15, 1993, among Payless, CIBC, as Collateral Agent, and J.P. Morgan Delaware (incorporated by reference to Exhibit 4.16 filed as part of Registration Statement No. 33 -59854 on Form S-2 on March 19, 1993). 10.1 Supply Agreement dated as of August 4, 1988, between Masco Corporation and Payless (incorporated by reference to Exhibit 10.1 filed as part of Registration Statement No.33-23893 on Form S-1 filed August 19, 1988). 10.2 Indemnification Agreement (incorporated by reference to Exhibit 10.2 filed as part of Amendment No. 2 to Registration Statement No. 33-49772 filed August 26, 1992). 10.3 Payless Cashways, Inc. Corporate Management Incentive Compensation Program, dated as of December 1991 (incorporated by reference to Exhibit 10.2 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 30, 1992). 10.4(a) Employment Agreement dated as of December 1, 1988 between Payless and Larry P. Kunz (incorporated by reference to Exhibit 10.12 filed as part of Post Effective Amendment No. 1 on Form S-2 to Form S-1 Registration Statement No. 33-23893 filed August 8, 1989). 10.4(b) Amendment dated March 10, 1992 to Employment Agreement between Payless and Larry Kunz (incorporated by reference to Exhibit 10.1 filed as part of the Payless' Quarterly Report on Form 10-Q for the quarter ended February 29, 1992). 10.4(c) Amendment dated as of February 8, 1993 to Employment Agreement between Payless and Larry Kunz (incorporated by reference to Exhibit 10.4(c) filed as part of Registration Statement No. 33- 58008 on Form S-2 on March 8, 1993). 10.4(d) Amendment dated June 23, 1993 to Employment Agreement between Payless and Larry Kunz (incorporated by reference to Exhibit 10.1 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 29, 1993). 10.4(e) Employment Agreement dated as of September 22, 1993 between Payless and Larry Kunz (incorporated by reference to Exhibit 10.1 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended August 28, 1993). 10.5(a) Employment Agreement dated as of December 1, 1988 between Payless and David Stanley (incorporated by reference to Exhibit 10.13 filed as part of Post Effective Amendment No. 1 on Form S-2 to Form S-1 Registration Statement No. 33-23893 filed August 8, 1989). 10.5(b) Amendment dated March 10, 1992 to Employment Agreement between Payless and David Stanley, (incorporated by reference to Exhibit 10.2 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended February 29, 1992). 10.5(c) Amendment dated June 23, 1993 to Employment Agreement between Payless and David Stanley (incorporated by reference to Exhibit 10.2 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended May 29, 1993). 10.6(a) Employment Agreement dated as of December 1, 1988 between Payless and Harold Cohen (incorporated by reference to Exhibit 10.14 filed as part of Post Effective Amendment No. 1 on Form S-2 to Form S-1 Registration Statement No. 33-23893 filed August 8, 1989). 10.6(b) Amendment dated March 10, 1992 to Employment Agreement between Payless and Harold Cohen (incorporated by reference to Exhibit 10.3 filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended February 29, 1992). 10.6(c) Retirement Agreement dated as of November 14, 1993 between Payless and Harold Cohen. 10.7 Employment Agreement dated as of February 8, 1993 between Payless and Ronald H. Butler (incorporated by reference to Exhibit 10.24 files as part of Registration Statement No. 33- 58008 on Form S-2 on February 8, 1993). 10.8 Employment Agreement dated as of February 8, 1993 between Payless and Stephen A. Lightstone (incorporated by reference to Exhibit 10.25 filed as part of Registration Statement No. 33- 58008 on Form S-2 on February 8, 1993). 10.9 Employment Agreement dated as of February 8, 1993 between Payless and Susan M. Stanton (incorporated by reference to Exhibit 10.26 filed as part of Registration Statement No. 33- 58008 on Form S-2 on February 8, 1993). 10.10(a) Payless Cashways, Inc. Wealth-Op Deferred Compensation Plan (incorporated by reference to Exhibit 10.8 filed as part of Post-Effective Amendment No. 7 to Registration Statement No. 33- 23893 on Form S-2 filed May 26, 1992). 10.10(b) Amendment to Payless' Wealth-Op Deferred Compensation Plan. 10.11(a) Payless Cashways, Inc. 1988 Deferred Compensation Plan. 10.11(b) Amendment to Payless' 1988 Deferred Compensation Plan. 10.12 Payless Cashways, Inc. Supplemental Death Benefit Plan. 10.13 Payless Cashways, Inc. Supplemental Disability Plan. 10.14(a) Payless Cashways, Inc. Supplemental Retirement Plan. 10.14(b) First Amendment to the Payless Cashways, Inc. Supplemental Retirement Plan effective June 22, 1989. 10.15(a) Registration Rights Agreement dated as of August 4, 1988 among PCI Acquisition Corp. and certain of its shareholders. 10.15(b) Agreement and Amendment dated as of November 11, 1988 to Registration Rights Agreement dated as of August 4, 1988 among Payless and certain of its shareholders. 10.15(c) Addendum to Shareholders' Agreement and Registration Rights Agreement dated February 22, 1989 by and among Payless and certain of its shareholders. 10.16(a) Amended and Restated Shareholders' Agreement, dated as of February 22, 1990, by and among PCI Acquisition Corp. and certain of its shareholders (incorporated by reference to Exhibit 10.47 filed as part of Post-Effective Amendment No. 3 to Registration Statement No. 33-23893 on Form S-2 filed March 23, 1990). 10.16(b) Amendment No. 1 dated as of March 18, 1991, to the Amended and Restated Shareholders' Agreement dated as of February 22, 1990, by and among Payless and certain of its shareholders (incorporated by reference to Exhibit 10.43(b) filed as part of Post-Effective Amendment No. 5 to Registration Statement No. 33-23893 on Form S-2 filed March 21, 1991). 10.17(a) 1988 Payless Cashways, Inc. Employee Stock Plan (incorporated by reference to Annex 1 filed as part of Registration Statement No. 33-24368 on Form S-8 filed September 9, 1988). 10.17(b) First Amendment to the 1988 Payless Cashways, Inc. Employee Stock Plan, dated November 11, 1988 (incorporated by reference to Exhibit 10.1(b) filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended February 25, 1989). 10.17(c) Second Amendment to the 1988 Payless Cashways, Inc. Employee Stock Plan, dated February 22, 1989 (incorporated by reference to Exhibit 10.1(c) filed as part of Payless' Quarterly Report on Form 10-Q for the quarter ended February 25, 1989). 10.17(d) Third Amendment to the 1988 Payless Cashways, Inc. Employee Stock Plan, dated March 6, 1990 (incorporated by reference to Exhibit 10.2 of Payless' Quarterly Report on Form 10-Q for the quarter ended February 24, 1990). 10.17(e) Form of Performance Stock Option Agreement pursuant to the 1988 Payless Cashways, Inc. Employee Stock Option Plan amended on June 20, 1991 (incorporated by reference to Exhibit 10.21(e) filed as part of Payless' Annual Report on Form 10-K for fiscal year ended November 30, 1991). 10.17(f) Amendment to the 1988 Payless Cashways, Inc. Employee Stock Plan, dated as of May 1, 1992 (incorporated by reference to Exhibit 10.26 filed as part of Post-Effective Amendment No. 7 to Form S-2 Registration Statement No. 33-23893 filed May 26, 1992). 10.18 Payless Cashways 1992 Incentive Stock Program (incorporated by reference to Exhibit 10.24 filed as part of Amendment No. 2 to Registration Statement No. 33-49772 on Form S-2 filed August 26, 1992). 10.19 Payless Cashways Director Option Plan (incorporated by reference to Exhibit 10.23 filed as part of Registration Statement No. 33- 59854 on Form S-2 on March 19, 1993). 11.1 Computation of per share earnings. 13.1 Annual Report to Shareholders. 21.1 Subsidiary of the Registrant (incorporated by reference to Exhibit 22.1 filed as part of Payless' Annual Report on Form 10-K for fiscal year ended November 30,1991). 23.1 Consent of KPMG Peat Marwick. Copies of any or all Exhibits will be furnished upon written request and payment of Payless' reasonable expenses in furnishing the Exhibits. (b) Reports on Form 8-K. No reports on Form 8-K have been filed by the Registrant during the quarter ended November 27, 1993. (c) Exhibits. The response to this portion of Item 14 is submitted as a separate section of this report. (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, Payless has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PAYLESS CASHWAYS, INC. (Registrant) By s/David Stanley ------------------------------------------ David Stanley, Principal Executive Officer Dated: February 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 Payless and in the capacities and on the dates indicated. ANNUAL REPORT ON FORM 10-K ITEM 14(a) (1) and (2), (c) and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENT SCHEDULES EXHIBITS YEAR ENDED NOVEMBER 27, 1993 PAYLESS CASHWAYS, INC., and subsidiary KANSAS CITY, MISSOURI PAYLESS CASHWAYS, INC., and subsidiary FORM 10-K--ITEM 14(a) (1) and (2) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Payless Cashways, Inc., and subsidiary included in Payless' Annual Report to the Shareholders for the year ended November 27, 1993, are incorporated by reference in Item 8: Consolidated Balance Sheets--November 27, 1993 and November 28, 1992. Consolidated Statements of Operations--fiscal years ended November 27, 1993, November 28, 1992 and November 30, 1991. Consolidated Statements of Shareholders' Equity--fiscal years ended November 27, 1993, November 28, 1992 and November 30, 1991. Consolidated Statements of Cash Flows--fiscal years ended November 27, 1993, November 28, 1992 and November 30, 1991. Notes to Consolidated Financial Statements. The following financial statement schedules of Payless Cashways, Inc., and subsidiary are included in Item 14(d): V - Property, Plant and Equipment VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts IX - Short-Term Borrowings 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. [Letterhead of KPMG Peat Marwick] INDEPENDENT AUDITORS' REPORT The Board of Directors Payless Cashways, Inc.: Under date of January 7, 1994, we reported on the consolidated balance sheets of Payless Cashways, Inc. and subsidiary as of November 27, 1993 and November 28, 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the fiscal years in the three-year period ended November 27, 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 fiscal year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such 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 Kansas City, Missouri January 7, 1994 SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT PAYLESS CASHWAYS, INC., and subsidiary (In thousands) SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT PAYLESS CASHWAYS, INC., and subsidiary (In thousands) SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS PAYLESS CASHWAYS, INC., and subsidiary (In thousands) SCHEDULE IX - SHORT-TERM BORROWINGS PAYLESS CASHWAYS, INC., and subsidiary (In thousands, except interest rates) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION PAYLESS CASHWAYS, INC., and subsidiary (In thousands)

230463_1993.txt

230463_1993

1993

230463

ITEM 1. BUSINESS. Pogo Producing Company (the 'Company'), incorporated in 1970, is engaged in oil and gas exploration, development and production activities on its properties located offshore in the Gulf of Mexico and onshore in the United States. The Company is also engaged in exploration of its license concession in the Gulf of Thailand, and is evaluating a development program in connection with its recently announced oil and gas discoveries on that concession. The Company has interests in 76 lease blocks offshore Louisiana and Texas, approximately 93,000 gross acres onshore in the United States, approximately 2,635,000 gross acres offshore in the Kingdom of Thailand, and approximately 1,965,000 gross acres in Australia. DOMESTIC OFFSHORE OPERATIONS Historically, the Company's interests have been concentrated in the Gulf of Mexico, where approximately 81% of the Company's domestic proved reserves and 68% of its total proved reserves are now located. During 1993, approximately 75% of the Company's natural gas equivalent production was from its domestic offshore properties, contributing approximately 75% of consolidated oil and gas revenues. Four offshore producing areas, Eugene Island, South Marsh Island, Main Pass and East Cameron, account for approximately 52% of the Company's net proved natural gas reserves and approximately 56% of the Company's proved crude oil, condensate and natural gas liquids reserves. Eugene Island is the Company's largest producing area with 1993 average net revenue interest production (net to the Company's interest and net of royalty burdens) of 24 million cubic feet ('MMcf') per day of natural gas and 4,600 barrels ('Bbls') per day of oil, condensate and natural gas liquids. The table in Item 2 ITEM 2. PROPERTIES. The information appearing in Item 1 of this Annual Report is incorporated herein by reference. PRINCIPAL PROPERTIES As of January 1, 1994, approximately 81% of the Company's domestic proved oil and gas equivalent reserves and approximately 68% of the Company's total proved oil and gas equivalent reserves were located on properties in the Gulf of Mexico. Five significant producing areas, of which four are located in the Gulf of Mexico and the fifth is located in New Mexico, accounted for approximately 59% of the estimated proved natural gas reserves and approximately 74% of the estimated oil, condensate and natural gas liquids reserves of the Company as of January 1, 1994. These producing areas accounted for approximately 60% of natural gas production and 90% of oil, condensate and natural gas liquids production for 1993. Reserves and production data for the five principal producing areas, as estimated by Ryder Scott, are shown in the following table. No other major producing area accounted for more than 5% of the estimated discounted future net revenues attributable to the Company's estimated proved reserves as of January 1, 1994. However, the Company's Thailand concession, which is currently not a producing property, accounts for approximately 14% of the Company's total estimated net proved reserves of natural gas, approximately 19% of the Company's total estimated net proved reserves of oil, condensate and natural gas liquids and approximately 16% of the Company's total net proved oil and gas equivalent reserves. Set forth below are descriptions of certain of the Company's significant producing areas. Contained in certain of these descriptions and elsewhere in this Annual Report are production rate test results with regard to certain wells and fields in which the Company has an interest. Such production rate tests, while accurate, are never indicative of actual sustained production rates. EUGENE ISLAND The Company's most significant reserves are in the Eugene Island area located off the Louisiana coast in the Gulf of Mexico. The Eugene Island area has been an important part of the Company's operations since the first lease in that area was purchased in 1970 and production began in 1973. The Company currently holds interests in 13 blocks in the Eugene Island area. These comprise eight fields containing 90 gross oil and gas wells producing from multiple reservoirs and horizons. The Eugene Island Block 330 field is the Company's most significant asset, with 28 productive Pleistocene horizons between 4,000 and 8,000 feet, containing multiple reservoirs. The field, located in 245 feet of water, contains three drilling and production platforms in which the Company holds a 35% working interest, as well as an additional platform in which the Company holds a 30% working interest. There are currently 18 wells producing primarily natural gas and 35 wells producing primarily oil on the block. In 1993, a successful five well drilling program was completed in the field which included one horizontal and four vertical wells. A multi-well program off of the field's 'D' platform commenced in early January 1994. Since initial production in 1973, the Eugene Island Block 330 field has produced approximately 619 billion cubic feet ('Bcf') of natural gas and 122 million barrels ('MMBbls') of oil and condensate (167 Bcf and 35 MMBbls, attributable to the Company's net revenue interest). Reserves have been added to this field consistently since production commenced. These increases have been derived from new exploratory horizons, infill drilling, field expansions and higher than anticipated recovery efficiencies. Another significant field to the Company is Eugene Island Block 295. In production since 1973, this block has recorded gross production of over 387 Bcf of natural gas and over 2.9 MMBbls of oil and condensate during its twenty-year life. In August 1993, the Company effected an exchange of working interests in Eugene Island Block 295 with another working interest owner in such block. Pursuant to this exchange, the Company increased its working interest in Eugene Island Block 295 to 100% on 3,125 acres above 3,000 feet, to 20% on 1,875 acres above 3,000 feet and to 20% on all of the block below 3,000 feet. During the fourth quarter of 1993, the Company successfully drilled and completed five horizontal wells to exploit the natural gas potential located in certain shallow reservoirs on this block in an area where it has a 100% working interest. These five wells tested at a gross calculated cumulative daily flow rate of 100 MMcf of natural gas per day, although platform compression capacity and lease burdens dictate that ultimate net production volumes will be substantially less than this amount. The Company completed construction of a production platform over these wells and commenced initial production from the first of these wells in late February 1994. The Eugene Island 212 field consists of Eugene Island Blocks 211 and 212 and Ship Shoal Block 175. The field contains eight productive horizons which have four oil wells and one natural gas well producing from a platform set in 1985. The Company and its partners drilled a successful infill development well in this field during the second half of 1993. SOUTH MARSH ISLAND The Company currently owns five blocks in the South Marsh Island area, located offshore Louisiana. Three of the leases were acquired in 1974, a fourth in 1980 and the most recent in 1992. Three blocks contain a total of five drilling and production platforms. These platforms currently have 44 oil and gas wells producing from Pleistocene age sandstone reservoirs located at depths from 5,000 to 10,000 feet. The South Marsh Island Block 128 field, in which the Company owns a 16% working interest, comprises South Marsh Island Blocks 125, 127 and 128. This field primarily produces oil, with 36 oil wells and six natural gas wells producing from 20 separate reservoirs. The first four wells in a supplemental five well drilling program in this field were completed in 1993. The current drilling program is based on the ongoing analysis of a 3-D seismic survey in conjunction with a detailed reservoir study of the field. The Company also owns a 25% working interest in the South Marsh Island Block 160 field which is producing from two oil wells at a depth of approximately 9,700 feet. A single platform was set on this block in 1983. A two-well drilling program in this field is currently being considered as a result of recent analysis of a 3-D seismic survey on the block. MAIN PASS The Company's nine blocks in the Main Pass area are located near the mouth of the Mississippi River in the Gulf of Mexico and include leases purchased from 1974 to 1992. The primary drilling objectives in these fields are Pliocene and Miocene sandstone reservoirs with productive formation depths from 5,000 to 12,000 feet. The Company's interests in the Main Pass area include 57 producing oil and gas wells producing from six platforms. A field including Main Pass Blocks 72, 73 and 72/74 was unitized in 1982 with the Company's working interest at 14%. This field contains 33 oil wells and 11 natural gas wells operated by one of the Company's joint venture partners. The field is located in 125 feet of water with 38 mapped horizons adjacent to and surrounding a salt dome. These horizons contain over 150 separate reservoirs between 5,000 and 12,000 feet. A successful three-well workover program in this field was completed in 1992. Many of the producing reservoirs in this field have consistently outperformed their initial recovery estimates. Based on the high historical recovery efficiency, it is anticipated that some of the multiple behind pipe reservoirs remaining will also outperform their existing reserve estimates. Main Pass Block 123 was acquired in the federal lease sale of 1990. Pogo Gulf Coast, for which the Company is the general partner, has a 75% working interest and is the operator on the block. Along with its non-operating joint venture partner, Pogo Gulf Coast drilled two discovery wells on the block in 1993 and is currently planning additional drilling as well as the installation of a production platform in late 1994. EAST CAMERON The original lease purchased by the Company and its partners in the East Cameron area off the Texas/Louisiana border in the Gulf of Mexico commenced production in February 1973. Presently, the Company has interests in 4 offshore blocks in this area which contain three fields and 16 producing gas wells. During 1992, the Company and its partners conducted a 3-D seismic survey of the East Cameron Block 334/335 field area where the Company has a 42% working interest. The Company currently anticipates commencing a multi-well drilling program in this field during the first half of 1994. NEW MEXICO The Company considers southeastern New Mexico to be an area of significant growth in both production and reserves as a result of recent exploration and development activities. The Company believes that during the past four years it has been one of the most active companies drilling for oil and natural gas in the southeastern New Mexico (Lea and Eddy Counties) portion of the Permian Basin where the Company has interests in over 50,000 gross acres. The Company's primary drilling objective is the Brushy Canyon (Delaware) formation. Fields in the Brushy Canyon (Delaware) formation in the southeastern New Mexico portion of the Permian Basin are generally characterized by production from relatively shallow depths (6,000 to 9,000 feet), multiple producing zones in most wells and relatively high initial rates of production (frequently equaling the top field allowables which range from of 142 Bbls to 230 Bbls per day, depending on the depth of production from the field). The Company has achieved rapid cost recovery with respect to its New Mexico wells drilled to date because of relatively low capital costs and high initial rates of production. Through December 31, 1993, the Company and its partners had drilled and completed as productive 151 consecutive wells in Lea and Eddy Counties, including, among others, 52 wells in the Sand Dunes field where the Company's working interest ranges from 4% to 89%; 27 wells in the East Loving field where the Company's working interest ranges from 33% to 98%; 43 wells in the Livingston Ridge field where the Company's working interest ranges from 41% to 83%; and 8 wells in the Red Tank field where the Company's working interest ranges from 89% to 100%. The oil fields in this area are generally developed on 40 acre spacings. The Company anticipates drilling many additional locations in these and other fields in southeastern New Mexico during 1994 and in future years. DOMESTIC OFFSHORE PROPERTIES -- The following is a listing of Pogo's domestic offshore properties as of December 31, 1993. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In 1989, a large number of exploration and production companies, including the Company, were circularized with Special Notice Letters in accordance with CERCLA from the EPA regarding a particular waste disposal site in Louisiana known as the 'Gulf Coast Vacuum Site' utilized by a trucking company. The EPA subsequently developed a list based on its investigation showing the Company bearing an approximate 1.4% responsibility for this site based on the trucking company's shipping records. The Company utilized the trucking company to dispose of salt water produced from a well in which the Company had an interest. The Company, however, believes that none of this salt water was delivered to the Gulf Coast Vacuum Site. In any event, the Company believes that the trucking company shipped only oilfield waste for the Company which is exempt pursuant to CERCLA and, further, that such shipments, if any, were sent to a properly permitted waste disposal site. The Company has learned that the EPA has recently entered a consent decree, the details of which have not been made public, with parties that are believed to be responsible for a majority of the disposal occurring at the site. The Company is a party to various other legal proceedings consisting of routine litigation incidental to its businesses, but believes that any potential liabilities resulting from these proceedings are adequately covered by insurance or are otherwise immaterial at this time. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS. Not Applicable. ITEM S-K 401(B). EXECUTIVE OFFICERS OF REGISTRANT. Executive officers of the Company are appointed annually to serve for the ensuing year or until their successors have been elected or appointed. The executive officers of the Company, their age as of February 1, 1994, and the year each was elected to his present position are as follows: Prior to assuming their present positions with the Company, the business experience of each executive officer for more than the last five years was as follows: Mr. Van Wagenen was President and Chief Operating Officer of the Company since 1990, Senior Vice President and General Counsel of the Company since 1986, Vice President and General Counsel of the Company since 1982, and General Counsel of the Company since 1979; Mr. Good was Vice President - Land of the Company since 1988 and Chief Landman of the Company since 1977; Mr. Slack was Regional Manager of Chemical Bank of New York's Southwest Energy and Minerals Division since 1982; Mr. Burbach was Vice President of Norfolk Holding Inc. since 1986 and Exploration Manager for Tricentrol Ltd. Canada and Tricentrol U.S. since 1981; Mr. Cooper was a Division Landman for the Company since 1983 and a Landman for the Company since 1979; Mr. Gold was Manager of Reservoir Engineering for the Company since 1977; Mr. Hart was Controller for the Company since 1977; Mr. Laney was International Exploration Manager for the Company since 1983 and Exploration Coordinator for the Gulf Coast Division of the Company since 1977; Mr. McCoy was Director of Personnel and Administration for the Company since 1978; Mr. McGregor was Manager of Hydrocarbon Sales and Contracts for the Company since 1981; Mr. Shaw was Operations Manager for the Company since 1981; Mr. Manning was an Associate General Counsel for the Company since 1989 and prior thereto was an attorney with the Federal Bureau of Investigation, and Chevron U.S.A., and Assistant to the General Counsel of Primary Fuels, Inc. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS. The following table shows the range of low and high sales prices of the Company's Common Stock (the 'Common Stock') on the New York Stock Exchange composite tape where the Company's Common Stock trades under the symbol PPP. The Company's Common Stock is also listed on the Pacific Stock Exchange. The Board of Directors of the Company has not declared cash dividends on the Company's Common Stock since the fourth quarter of 1986, and has no current plans to pay dividends. Pursuant to various agreements under which the Company has borrowed funds, the Company may not, subject to certain exceptions, pay any dividends on its capital stock or make any other distributions on shares of its capital stock (other than dividends or distributions payable solely in shares of such capital stock) or acquire for value any shares of its capital stock if (after giving effect to the proposed payment, distribution, or acquisition) the aggregate amount of all such payments, distributions or acquisitions on and after a specified date would exceed an amount determined based on the consolidated income or cash flow of the Company and its consolidated subsidiaries from and after such date. As of December 31, 1993, $33,803,000 was available for dividends under the most restrictive of such limitations. LOW HIGH 1st Quarter------------------------------------- 5 1/8 6 1/2 2nd Quarter------------------------------------- 5 1/8 6 3/8 3rd Quarter------------------------------------- 5 1/2 10 3/8 4th Quarter------------------------------------- 9 3/4 13 7/8 1st Quarter------------------------------------- 9 3/4 17 1/4 2nd Quarter------------------------------------- 16 1/8 21 3rd Quarter------------------------------------- 13 5/8 19 1/8 4th Quarter------------------------------------- 14 3/8 19 3/4 As of February 10, 1994, there were 4,216 holders of record of the Company's Common Stock. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. RESULTS OF OPERATIONS The Company reported net income for 1993 of $25,061,000 or $0.76 per share compared to net income for 1992 of $18,495,000 or $0.66 per share and net income for 1991 of $11,658,000 or $0.42 per share. Included in net income for 1991 are extraordinary gains of $1,336,000 or $0.05 per share in connection with purchases at less than face value of the Company's 8% Convertible Subordinated Debentures due 2005 (the 'Convertible Subordinated Debentures'). Earnings per common share are based on the weighted average number of shares of common and common equivalent shares outstanding for 1993 of 32,860,000 compared to 27,929,000 for 1992 and 27,611,000 for 1991. The increases in the weighted average number of common and common equivalent shares outstanding for 1993 primarily related to the issuance of 4,500,000 shares of common stock in December 1992 as set forth in the Consolidated Statements of Shareholders' Equity included in 'Item 8. ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1993 POGO PRODUCING COMPANY AND SUBSIDIARIES HOUSTON, TEXAS REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of Pogo Producing Company: We have audited the accompanying consolidated balance sheets of Pogo Producing Company (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, 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. These financial statements and the schedules referred to below are the responsibility of Pogo'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 Pogo Producing 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. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in 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. 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. Houston, Texas February 8, 1994 POGO PRODUCING COMPANY & SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME YEAR ENDED DECEMBER 31, 1993 1992 1991 (EXPRESSED IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Revenues: Oil and gas---------------------- $ 136,553 $ 139,128 $ 124,425 Interest on tax refund----------- 2,322 -- -- Gains on sales------------------- 679 1,702 44 Total------------------------ 139,554 140,830 124,469 Operating Costs and Expenses: Lease operating------------------ 26,633 25,842 28,192 General and administrative------- 14,550 13,129 14,555 Exploration---------------------- 2,455 3,102 2,408 Dry hole and impairment---------- 4,690 9,314 4,554 Depreciation, depletion and amortization------------------- 40,693 42,302 37,521 Total------------------------ 89,021 93,689 87,230 Operating Income--------------------- 50,533 47,141 37,239 Interest: Charges-------------------------- (10,956) (19,036) (24,946) Income--------------------------- 14 191 1,686 Capitalized---------------------- 451 391 637 Income Before Taxes and Extraordinary Item--------------------------------- 40,042 28,687 14,616 Income Tax Expense------------------- (14,981) (10,192) (4,294) Income Before Extraordinary Item----- 25,061 18,495 10,322 Extraordinary Gains on Purchase of Debt, net of tax------------------- -- -- 1,336 Net Income--------------------------- $ 25,061 $ 18,495 $ 11,658 Primary and Fully Diluted Earnings per Common Share: Before extraordinary item-------- $0.76 $0.66 $0.37 Extraordinary item--------------- -- -- 0.05 Net income----------------------- $0.76 $0.66 $0.42 The accompanying notes to consolidated financial statements are an integral part hereof. POGO PRODUCING COMPANY & SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 1992 (EXPRESSED IN THOUSANDS) ASSETS Current Assets: Cash and cash investments-------- $ 6,713 $ 5,037 Accounts receivable-------------- 18,480 22,652 Other receivables---------------- 10,123 4,173 Federal income taxes and interest receivable--------------------- 3,320 -- Inventories---------------------- 1,105 1,383 Other---------------------------- 727 367 Total current assets--------- 40,468 33,612 Property and Equipment: Oil and gas, on the basis of successful efforts accounting Proved properties being amortized------------------ 817,218 869,192 Unproved properties and properties under development, not being amortized------------------ 6,465 5,962 Other, at cost------------------- 6,961 6,851 830,644 882,005 Less -- accumulated depreciation, depletion, and amortization, including $4,452 and $4,032, respectively, applicable to other property----------------- 638,658 717,428 191,986 164,577 Other-------------------------------- 7,320 8,158 $ 239,774 $ 206,347 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Accounts payable----------------- $ 8,307 $ 9,899 Other payables------------------- 22,955 5,541 Current portion of long-term debt--------------------------- 4,000 4,000 Current portion of production payment------------------------ -- 10,517 Accrued interest payable--------- 1,202 1,122 Accrued payroll and related benefits----------------------- 1,005 942 Other---------------------------- 122 142 Total current liabilities---- 37,591 32,163 Long-Term Debt----------------------- 130,539 129,260 Production Payment------------------- -- 14,337 Deferred Federal Income Tax---------- 29,724 17,435 Deferred Credits--------------------- 8,117 7,504 Total liabilities------------ 205,971 200,699 Shareholders' Equity: Preferred stock, $1 par; 2,000,000 shares authorized---- -- -- Common stock, $1 par; 43,333,333 shares authorized, 32,449,197 and 32,103,864 shares issued, respectively------------------- 32,449 32,104 Additional capital--------------- 125,919 122,846 Retained earnings (deficit)------ (124,241) (149,302) Treasury stock, at cost---------- (324) -- Total shareholders' equity--------------------- 33,803 5,648 $ 239,774 $ 206,347 The accompanying notes to consolidated financial statements are an integral part hereof. POGO PRODUCING COMPANY & SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEAR ENDED DECEMBER 31, 1993 1992 1991 (EXPRESSED IN THOUSANDS) Cash flows from operating activities: Cash received from customers------- $ 141,012 $ 135,877 $ 125,029 Operating, exploration, and general and administrative expenses paid------------------------------ (45,051) (41,360) (46,746) Interest paid---------------------- (10,912) (21,262) (26,701) Payment of royalties and related interest on FERC Order 94-A refunds--------------------------- -- (4,872) -- Federal income taxes paid---------- (2,800) (1,500) (2,900) Federal income taxes and interest received-------------------------- -- -- 30,836 Settlement of natural gas sales contract-------------------------- -- -- 3,300 Proceeds of life insurance policy---------------------------- -- -- 2,568 Other------------------------------ 895 828 2,974 Net cash provided by operating activities------- 83,144 67,711 88,360 Cash flows from investing activities: Capital expenditures--------------- (62,353) (30,304) (51,284) Purchase of proved reserves-------- -- (8,924) (5,077) Proceeds from the sale of property and tubular stock----------------- 2,713 4,017 2,150 Net cash used in investing activities----------------- (59,640) (35,211) (54,211) Cash flows from financing activities: Net borrowings (payments) under revolving credit agreements------- 8,000 (1,000) 17,000 Principal payments of other long-term debt obligations-------- (7,000) (54,000) (42,000) Principal payments of production payment obligation---------------- (24,854) (20,621) (14,611) Proceeds from exercise of stock options--------------------------- 2,026 703 123 Proceeds from issuance of common stock----------------------------- -- 43,313 -- Debt issue expenses paid----------- -- (1,100) -- Increase in production payment----- -- -- 13,193 Purchase of 8% debentures, due 2005------------------------------ -- -- (7,621) Net cash used in financing activities----------------- (21,828) (32,705) (33,916) Net increase (decrease) in cash and cash investments-------------------- 1,676 (205) 233 Cash and cash investments at the beginning of the year--------------- 5,037 5,242 5,009 Cash and cash investments at the end of the year------------------------- $ 6,713 $ 5,037 $ 5,242 Reconciliation of net income to net cash provided by operating activities: Net income------------------------- $ 25,061 $ 18,495 $ 11,658 Adjustments to reconcile net income to net cash provided by operating activities -- Gains on purchase of 8% debentures, due 2005: Ordinary----------------------- -- -- (646) Extraordinary, net of taxes---- -- -- (1,336) Gains on sales------------------- (679) (1,702) (44) Depreciation, depletion and amortization-------------------- 40,693 42,302 37,521 Dry hole and impairment---------- 4,690 9,314 4,554 Interest capitalized------------- (451) (391) (637) Change in assets and liabilities: Decrease in United Kingdom tax escrow deposit---------------- -- -- 2,083 (Increase) decrease in accounts receivable-------------------- 4,172 (1,191) 4,799 (Increase) decrease in federal income taxes and interest receivable-------------------- (3,320) -- 29,002 Increase in other current assets------------------------ (360) (27) (32) (Increase) decrease in other assets------------------------ 838 (3,515) 1,641 Increase (decrease) in accounts payable----------------------- (1,592) 733 (1,322) Increase (decrease) in accrued interest payable-------------- 80 (2,480) (1,342) Increase (decrease) in accrued payroll and related benefits---------------------- 63 (244) 375 Increase (decrease) in other current liabilities----------- (20) (9) 62 Increase in deferred federal income taxes------------------ 13,356 8,669 1,268 Increase (decrease) in deferred credits----------------------- 613 (2,243) 756 Net cash provided by operating activities-------------------------- $ 83,144 $ 67,711 $ 88,360 The accompanying notes to consolidated financial statements are an integral part hereof. The accompanying notes to consolidated financial statements are an integral part hereof. POGO PRODUCING COMPANY & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION -- The consolidated financial statements include the accounts of Pogo Producing Company and its wholly-owned subsidiaries (the 'Company'), after elimination of all significant intercompany transactions. INVENTORIES -- Inventories consist primarily of tubular goods used in the Company's operations and are stated at the lower of average cost or market value. INTEREST CAPITALIZED -- Interest costs related to financing major oil and gas projects in progress are capitalized until the projects are evaluated. EARNINGS PER SHARE -- Earnings per common and common equivalent share are based on weighted average shares of Common Stock outstanding assuming exercise of dilutive stock options. The 8% convertible subordinated debentures, due 2005 are common stock equivalents and were anti-dilutive in all periods presented. The 10.25% convertible subordinated notes, due 1999 are not common stock equivalents and were anti-dilutive in all periods presented. The weighted average number of common and common stock equivalent shares outstanding for primary earnings per share was 32,860,000, 27,929,000, and 27,611,000 in 1993, 1992, and 1991, respectively. The additional shares which would be assumed to be outstanding in the fully diluted calculation are not sufficient to change the earnings per share amounts reported in the primary calculation. PRODUCTION IMBALANCES -- Owners of an oil and gas property often take more or less production from a property than entitled to based on their ownership percentages in the property. This results in a condition known in the industry as a production imbalance. The Company follows the 'take' (cash) method of accounting for production imbalances. Under this method, the Company recognizes revenues on production as it is taken and delivered to its purchasers. The Company's crude oil imbalances are not significant. At December 31, 1993, the Company had taken approximately 10,195 MMcf of natural gas less than it was entitled to based on its interest in those properties, and approximately 7,295 MMcf more than its entitlement on other properties placing the Company at year end in a net under-delivered position of approximately 2,900 MMcf of natural gas based on its working interest ownership in the properties. OIL AND GAS ACTIVITIES AND DEPRECIATION, DEPLETION, AND AMORTIZATION -- The Company follows the successful efforts method of accounting for its oil and gas activities. Under the successful efforts method, lease acquisition costs and all development costs are capitalized. Unproved properties are reviewed quarterly to determine if there has been impairment of the carrying value, with any such impairment charged to expense in the period. Exploratory drilling costs are capitalized until the results are determined. If proved reserves are not discovered, the exploratory drilling costs are expensed. Other exploratory costs are expensed as incurred. The provision for depreciation, depletion and amortization is determined on a field-by-field basis using the units of production method. POGO PRODUCING COMPANY & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Other properties are depreciated on a straight-line method in amounts which in the opinion of management are adequate to allocate the cost of the properties over their estimated useful lives. CONSOLIDATED STATEMENTS OF CASH FLOWS -- For the purpose of cash flows, the Company considers all highly liquid investments with a maturity date of three months or less to be cash equivalents. Significant transactions may occur which do not directly affect cash balances and as such will not be disclosed in the Consolidated Statement of Cash Flows. Certain such noncash transactions are disclosed in the Consolidated Statements of Shareholders' Equity relating to the acquisition of treasury stock in exchange for stock options exercised and the conversion of a debenture into Common Stock. In addition, the Company exchanged its working interest in thirteen Gulf of Mexico oil and gas properties for an increased working interest in five other Gulf of Mexico oil and gas properties in a noncash 'like kind' exchange. The oil and gas property and accumulated depreciation, depletion and amortization accounts as reflected in the Consolidated Balance Sheets have been adjusted to reflect the appropriate amounts to record the working interests acquired and disposed of. The oil and gas reserves acquired and disposed of are reflected as purchases and sales in the roll forward 'Estimates of Proved Reserves' included in the 'Unaudited Supplementary Financial Data' included elsewhere herein. COMMITMENTS AND CONTINGENCIES -- The Company's rent expense was $868,000, $808,000, and $1,069,000 in 1993, 1992, and 1991, respectively. The Company has lease commitments for office space of $809,000 per year in each year for 1994 through 1997 and $777,000 in 1998. (2) INCOME TAXES The components of federal income tax expense (benefit) for each of the three years in the period ended December 31, 1993, are as follows (expressed in thousands): 1993 1992 1991 United States Current-------------------------- $ 2,800 $ 1,500 $ 2,900 Deferred (a)--------------------- 12,360 8,672 1,125 Foreign Current-------------------------- (179) 20 269 Total------------------------ $ 14,981 $ 10,192 $ 4,294 (a) Excludes $688,000 of deferred taxes on a $2,024,000 extraordinary item in 1991. Total federal income tax expense (benefit) for each of the three years in the period ended December 31, 1993, differs from the amounts computed by applying the statutory federal income tax rate to income before taxes as follows (expressed as a percent of pretax income): 1993 1992 1991 Federal statutory income tax rate---- 35.0% 34.0% 34.0% Increases (reductions) resulting from: Statutory depletion in excess of tax basis---------------------- (0.4) (0.1) (0.9) Foreign taxes-------------------- 2.9 1.4 1.8 Life insurance loan proceeds----- -- -- (5.9) Other---------------------------- -- 0.2 0.4 37.5% 35.5% 29.4% POGO PRODUCING COMPANY & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The deferred federal income tax provision is the result of the difference between deferred tax liabilities determined at each balance sheet date. The deferred tax liabilities are determined by applying current tax laws to temporary differences in the recognition of revenue and expense for tax and financial purposes. Temporary differences arise primarily from the amortization of productive intangible drilling costs which are capitalized and amortized for financial statement purposes but are deducted for income tax purposes and differences in depreciation rates for tangible assets for financial and tax reporting purposes. As of December 31, 1993, the Company has general business credits of approximately $1,400,000, which can be used to reduce future income taxes. In addition, the Company has alternative minimum tax credits of approximately $4,235,000 which can be used to reduce future regular income taxes payable. (3) LONG-TERM DEBT Long-term debt and the amount due within one year at December 31, 1993 and 1992, consists of the following (dollars expressed in thousands): DECEMBER 31, 1993 1992 Senior debt -- Bank revolving credit agreements debt: Prime rate loans------------- $ 27,000 $ 9,000 LIBO Rate loans-------------- 40,000 50,000 Certificate of deposit rate loans---------------------- -- -- Total senior debt-------------------- 67,000 59,000 Subordinated debt -- 10.25% Convertible subordinated notes, due 1999, $4,000 annual sinking fund requirement-------------------- 24,000 28,000 8% Convertible subordinated debentures, due 2005, $1,540 sinking fund requirement in 1995 and a $3,000 annual sinking fund requirement thereafter--------- 43,539 46,260 Total subordinated debt-------------- 67,539 74,260 Total debt--------------------------- 134,539 133,260 Amount due within one year -- Current portion of long-term debt, consisting of sinking fund requirement on 10.25% notes---- (4,000) (4,000) Long-term debt----------------------- $ 130,539 $ 129,260 The bank revolving credit agreement entered into in December 1993, extends to the Company a $100,000,000 revolving/term credit facility which will be fully revolving until June 29, 1996 and will convert to a term loan with eight quarterly installments commencing July 31, 1996. The amount that may be borrowed under the facility may not exceed a borrowing base, determined semiannually by the lenders based on the discounted present value of the Company's oil and gas reserves and the provisions of the agreement. The borrowing base currently exceeds $100,000,000. The agreement provides that total debt and total debt for borrowed money, as defined, may not exceed $230,000,000 and $200,000,000, respectively. The facility is governed by various financial covenants including the maintenance of positive working capital (excluding current maturities of debt), a fixed charge ratio, as defined, of 1.7 or greater, a $10,000,000 limit on other senior debt, and a $10,000,000 limit on prepayment (without refinancing) of subordinated debt in any one year and $20,000,000 in total through July 31, 1996. Upon the occurrence of an event of default or certain other specified events, the banks would be entitled to a security interest in the borrowing base properties, which constitute substantially all of the Company's domestic oil and gas properties. Borrowings under the facility bear POGO PRODUCING COMPANY & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) interest at Base (Prime) rate plus 1/4%, a certificate of deposit rate plus 1 7/8%, or LIBOR plus 1 3/4%, at the Company's option. A commitment fee of 1/2 of 1% per annum of the unborrowed amount under the facility is also due. The Company incurred commitment fees of $149,000 in 1993, $80,000 in 1992, and $132,000 in 1991 under this and prior revolving credit agreements. The 10.25% convertible notes are convertible into Common Stock at $23.95 per share subject to adjustment under certain circumstances, including stock splits. The convertible debentures are redeemable at the option of the Company at 103.7% through April 1, 1994, at 102.95% through April 1, 1995, and decreasing percentages thereafter, under certain market conditions, and are subject to mandatory annual sinking fund requirements of $4,000,000 which commenced April 1, 1990. The sinking fund requirements will be sufficient to retire 90% of the issue prior to maturity. The 8% convertible debentures are convertible into Common Stock at $39.50 per share subject to adjustment under certain circumstances, including stock splits. These convertible debentures are redeemable at the option of the Company at 102.8% through December 30, 1994, and decreasing percentages thereafter, and are subject to mandatory annual sinking fund requirements of $3,000,000 which commenced December 31, 1990. Such requirements will be sufficient to retire 75% of the issue prior to maturity. To date, the Company has purchased $13,740,000 principal amount of the bonds at less than face value resulting in ordinary gains of $646,000 and $902,000 in 1991 and 1990, respectively, on the bonds purchased in satisfaction of sinking fund requirements in those years, and a $1,336,000 extraordinary gain (net of taxes) in 1991 on the bonds purchased in excess of current sinking fund requirements. The Company currently has $4,460,000 face amount of the bonds purchased in excess of current sinking fund requirements which may be tendered in satisfaction of future sinking fund requirements. The Company elected to make the December 31, 1993 sinking fund payment in cash. Current maturities and sinking fund requirements during the next five years in connection with the above long-term debt are $4,000,000 in 1994, $5,540,000 in 1995, $27,100,000 in 1996, $40,500,000 in 1997 and $20,400,000 in 1998. Included in the current maturities reflected above are $20,100,000 in 1996, $33,500,000 in 1997, and $13,400,000 in 1998 relative to bank debt. The Company has established a history of refinancing its bank debt before scheduled maturities and expects to do so again before the amortization of bank debt commences in 1996. In 1993, the Company entered into interest rate swap agreements on $15,000,000 of its bank debt, $5,000,000 of which terminated in January, 1994 and $10,000,000 of which terminates in July, 1994. The swap agreements effectively change the interest rates from variable to fixed rates which average 5.78% on the $15,000,000. (4) SALES TO MAJOR CUSTOMERS The Company is an oil and gas exploration and production company that until recently sold its production to relatively few customers. As a result of recent changes in the natural gas industry, the Company, like many other producers, now sells its natural gas to numerous customers on a month-to-month basis. The Company no longer has a significant amount of its natural gas reserves committed to long-term (multiple year) contracts at higher than prevailing market prices. Sales to the following customers exceeded 10 percent of oil and gas revenues during the years indicated (expressed in thousands): 1993 1992 1991 Scurlock Oil Company----------------- $ 38,510 $ 39,729 $ 38,554 United Gas Pipeline Company---------- $ -- $ -- $ 21,074 Enron Corp--------------------------- $ 16,437 $ -- $ -- POGO PRODUCING COMPANY & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (5) EMPLOYEE BENEFITS A total of 2,353,069 shares of Common Stock are reserved for issuance to key employees and non-employee directors under the Company's stock option plans. The stock option plans authorize the granting of options at prices equivalent to the market value at the date of grant. Options generally become exercisable in three annual installments commencing one year after the date granted and, if not exercised, expire 10 years from the date of grant. At January 1, 1993, 1,544,484 shares were issuable under stock options outstanding. Options for 291,500 shares were granted during 1993 at prices ranging from $15.13 to $19.00 per share. During 1993, 345,308 options were exercised at prices ranging from $4.38 to $16.25 per share and no options were cancelled. At December 31, 1993, options to purchase 1,490,676 shares were outstanding (1,098,815 were exercisable) at prices ranging from $4.38 to $19.00. The Company has a tax-advantaged savings plan in which all salaried employees may participate. Under such plan, a participating employee may allocate up to 10% of his salary, and the Company makes matching contributions of up to 6% thereof. Funds contributed by the employee and the matching funds contributed by the Company are held in trust by a bank trustee in six separate funds. Funds contributed by the employee and earnings and accretions thereon may be used to purchase shares of Common Stock, invest in a money market fund or invest in four stock, bond, or blended stock and bond mutual funds according to instructions from the employee. Matching funds contributed to the savings plan by the Company are invested only in Common Stock. The Company contributed $125,000 to the savings plan in 1993, $288,000 in 1992, and $265,000 in 1991. A trusteed retirement plan has been adopted by the Company for its salaried employees. The benefits are based on years of service and the employee's average compensation for five consecutive years within the final ten years of service which produce the highest average compensation. The Company makes annual contributions to the plan in the amount of retirement plan cost accrued or the maximum amount which can be deducted for federal income tax purposes. The following table sets forth the plan's funded status (in thousands of dollars) as of December 31, 1993, 1992, and 1991. 1993 1992 1991 Actuarial present value (discounted at 7 1/2, 8 1/4, and 8 1/2%, respectively) of benefit obligations: Accumulated benefit obligations -- Vested----------------------- $ 4,019 $ 3,120 $ 2,997 Nonvested-------------------- 717 701 657 Total accumulated benefit obligations------------------ 4,736 3,821 3,654 Projected salary increases (escalated at 6%) and other changes------------------------ 1,500 2,653 2,441 Projected benefit obligations for service rendered to date------- 6,236 6,474 6,095 Plan assets at fair value, primarily listed securities with an expected long-term rate of return of 8 1/4%----------------------------- 13,481 13,830 13,505 Plan assets in excess of projected benefit obligations---------------- 7,245 7,356 7,410 Unrecognized: Net overfunding being recognized over 15 years------------------ (750) (853) (957) Net gain arising from the difference between actual experience and that assumed---- (3,209) (3,956) (4,438) Prior service cost--------------- (473) (41) (45) Accrued retirement plan asset-------- $ 2,813 $ 2,506 $ 1,970 (TABLE CONTINUED ON FOLLOWING PAGE) POGO PRODUCING COMPANY & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 1993 1992 1991 Retirement plan cost (benefit) for 1993, 1992, and 1991 included the following components: Service cost, benefits accruing each year with proration for future salary increases-------- $ 611 $ 514 $ 501 Interest cost on projected benefit obligations------------ 524 451 508 Actual return on plan assets----- (1,164) (1,141) (3,882) Net amortization and deferral---- (278) (360) 2,853 Accrued retirement plan cost (benefit)---------------------- $ (307) $ (536) $ (20) Effective January 1, 1992, the Company adopted the provisions of the Statement of Financial Accounting Standards No. 106, 'Employers' Accounting for Postretirement Benefits Other Than Pensions.' The Company currently provides full medical benefits to its retired employees and dependents. For current employees, the Company assumes all or a portion of postretirement medical and term life insurance costs based on the employee's age and length of service with the Company. The postretirement medical plan has no assets and is currently funded by the Company on a pay-as-you-go basis. The following is an analysis (in thousands of dollars) of the annual expense and activity in the deferred cost and benefits obligation accounts for 1992 and 1993. The computation assumes that future increases in medical costs will trend down from 13% to 7% per year over the next 12 years for purposes of estimating future costs. The medical cost trend rate assumption has a significant effect on the amounts reported. Increasing the assumed medical cost trend rate by one percent in each year would increase the aggregate of service and interest cost components of net periodic postretirement benefits cost for 1993 by $164,000 and the accumulated postretirement benefits obligation as of December 31, 1993 by $1,171,000. ANNUAL DEFERRED BENEFITS EXPENSE COSTS OBLIGATION Transition obligation at January 1, 1992------------------------------- $ 4,263 $ (4,263) Amortization of transition cost over 14 years representing the average remaining service period of eligible employees----------------- $ 305 (305) 305 Service cost, including interest----- 303 Interest cost on transition obligation------------------------- 362 1992 expense------------------------- $ 970 (970) Current benefits paid---------------- 170 Balance at December 31, 1992--------- 3,958 (4,758) Amortization of transition costs over 14 years--------------------------- $ 305 (305) 305 Service cost, including interest----- 368 Interest cost on transition obligation------------------------- 407 1993 expense------------------------- $ 1,080 (1,080) Current benefits paid---------------- 246 Unrecognized loss-------------------- (1,400) Balance at December 31, 1993--------- $ 3,653 Plan assets at fair value------------ -- Funded status at December 31, 1993 (discounted at 7 1/2%)---- $ (6,687) POGO PRODUCING COMPANY & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The accumulated postretirement benefit obligation (in thousands of dollars) at December 31, 1993 is attributable to the following groups: Retirees and beneficiaries----------------------------------- $ 2,739 Dependents of retirees--------------------------------------- 1,188 Fully eligible active employees------------------------------ 577 Active employees, not fully eligible------------------------- 2,183 $ 6,687 (6) 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 CASH INVESTMENTS The carrying value approximates fair value because of the short maturity of these investments. DEBT INSTRUMENT BASIS OF FAIR VALUE ESTIMATE Bank revolving credit agreement debt------------------------------- Fair value is carrying value based on recent 1993 renegotiation with banks 10.25% Convertible subordinated notes, due 1999-------------------- Fair value is 103.7% of carrying value based on the redemption premium at December 31, 1993 8% Convertible subordinated debentures, due 2005--------------- Fair value is 99.5% of carrying value based on the quoted market price for this publicly traded debt at December 31, 1993 The estimated fair value of the Company's financial instruments (in thousands of dollars) are as follows: CARRYING FAIR VALUE VALUE Cash and cash investments------------ $ 6,713 $ 6,713 Debt--------------------------------- (134,539) (135,209) UNAUDITED SUPPLEMENTARY FINANCIAL DATA OIL AND GAS PRODUCING ACTIVITIES The results of operations from oil and gas producing activities excludes non-oil and gas revenues, general and administrative expenses, interest charges, interest income and interest capitalized. United States income tax expense was determined by applying the statutory rates to pretax operating results with adjustments for permanent differences. Kingdom of Thailand tax expense was determined by applying the statutory tax rate to Thailand taxable income. UNITED KINGDOM OF TOTAL STATES THAILAND (EXPRESSED IN THOUSANDS) -------------------------------------- Oil and gas revenues----------------- $ 136,553 $ 136,525 $ 28 Lease operating expense-------------- (26,633) (26,633) -- Exploration expense------------------ (2,455) (1,060) (1,395) Dry hole and impairment expense------ (4,690) (2,737) (1,953) Depreciation, depletion and amortization expense--------------- (40,224) (40,193) (31) Pretax operating results------------- 62,551 65,902 (3,351) Income tax (expense) benefit--------- (22,712) (22,891) 179 Operating results-------------------- $ 39,839 $ 43,011 $ (3,172) -------------------------------------- Oil and gas revenues----------------- $ 139,128 $ 139,128 $ -- Lease operating expense-------------- (25,842) (25,842) -- Exploration expense------------------ (3,102) (1,876) (1,226) Dry hole and impairment expense------ (9,314) (9,314) -- Depreciation, depletion and amortization expense--------------- (41,849) (41,834) (15) Pretax operating results------------- 59,021 60,262 (1,241) Income tax expense------------------- (20,510) (20,490) (20) Operating results-------------------- $ 38,511 $ 39,772 $ (1,261) -------------------------------------- Oil and gas revenues----------------- $ 124,425 $ 124,425 $ -- Lease operating expense-------------- (28,192) (28,192) -- Exploration expense------------------ (2,408) (2,261) (147) Dry hole and impairment expense------ (4,554) (4,554) -- Depreciation, depletion and amortization expense--------------- (36,970) (36,965) (5) Pretax operating results------------- 52,301 52,453 (152) Income tax expense------------------- (17,725) (17,698) (27) Operating results-------------------- $ 34,576 $ 34,755 $ (179) The following table sets forth Pogo's capitalized costs (expressed in thousands) incurred for oil and gas producing activities during the years indicated. 1993 1992 1991 Capitalized costs incurred: Property acquisition (United States)------------------------ $ 1,520 $ 11,578 $ 7,697 Exploration -- United States---------------- 8,267 3,865 3,546 Kingdom of Thailand---------- 4,583 1,412 -- Development -- United States---------------- 57,648 20,717 37,025 Kingdom of Thailand---------- -- -- -- Interest capitalized (United States)------------------------ 451 391 637 $ 72,469 $ 37,963 $ 48,905 Provision for depreciation, depletion, and amortization: United States---------------- $ 40,193 $ 41,834 $ 36,965 Kingdom of Thailand---------- 31 15 5 $ 40,224 $ 41,849 $ 36,970 UNAUDITED SUPPLEMENTARY FINANCIAL DATA -- (CONTINUED) The following information regarding estimates of the Company's proved oil and gas reserves, which are located offshore in United States waters of the Gulf of Mexico, onshore in the United States and offshore in the Kingdom of Thailand is based on reports prepared by Ryder Scott Company Petroleum Engineers. Their summary report dated January 28, 1994 is set forth as an exhibit to this Annual Report and includes definitions and assumptions that served as the basis for the discussion under the caption 'Item 1, Business -- Exploration and Production Data; Reserves'. Such definitions and assumptions should be referred to in connection with the following information. ESTIMATES OF PROVED RESERVES OIL, CONDENSATE AND NATURAL GAS LIQUIDS NATURAL GAS (BBLS.) (MMCF) Proved reserves (located in the United States) as of December 31, 1990------------------ 19,090,376 217,500 Revisions of previous estimates---------------------- 782,707 3,531 Extensions, discoveries, and other additions---------------- 1,612,983 16,157 Purchase of properties----------- 263,495 4,913 Sales of properties-------------- (5) (4) Estimated 1991 production-------- (2,931,465) (39,362) Proved reserves (located in the United States) as of December 31, 1991------------------ 18,818,091 202,735 Revisions of previous estimates---------------------- 1,721,385 20,284 Extensions, discoveries, and other additions (including 2,576,907 barrels and 10,668 MMcf located in the Kingdom of Thailand)---------------------- 5,486,273 19,126 Purchase of properties----------- 335,750 10,237 Sales of properties-------------- (194,606) (4,733) Estimated 1992 production-------- (3,611,105) (40,581) Proved reserves (located in the United States except for 2,576,907 barrels and 10,668 MMcf located in the Kingdom of Thailand) as of December 31, 1992------------------ 22,555,788 207,068 Revisions of previous estimates---------------------- 342,022 1,148 Extensions, discoveries, and other additions (including 2,847,906 barrels and 22,806 MMcf located in the Kingdom of Thailand)----------- 9,764,408 55,626 Purchase of properties----------- 182,610 13,192 Sales of properties-------------- (356,514) (11,849) Estimated 1993 production-------- (4,219,873) (32,319) Proved reserves (located in the United States except for 5,424,813 barrels and 33,474 MMcf located in the Kingdom of Thailand) as of December 31, 1993------------------ 28,268,441 232,866 Proved developed reserves (located in the United States) as of: December 31, 1990---------------- 17,841,751 202,471 December 31, 1991---------------- 17,549,830 188,090 December 31, 1992---------------- 18,798,149 175,523 December 31, 1993---------------- 20,976,194 183,139 STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATED TO PROVED OIL AND GAS RESERVES TOTAL UNITED KINGDOM OF COMPANY STATES THAILAND (EXPRESSED IN THOUSANDS) Future gross revenues---------------- $ 869,783 $ 744,201 $ 125,582 Future production costs: Lease operating expense---------- (186,464) (158,934) (27,530) Future development and abandonment costs------------------------------ (133,258) (79,735) (53,523) Future net cash flows before income taxes------------------------------ 550,061 505,532 44,529 Discount at 10% per annum------------ (146,221) (118,858) (27,363) Discounted future net cash flow Before income taxes---------------- 403,840 386,674 17,166 Future income taxes, net of discount at 10% per annum------------------- (103,580) (98,788) (4,792) Standardized measure of discounted future net cash flows relating to proved oil and gas reserves-------- $ 300,260 $ 287,886 $ 12,374 Future gross revenues---------------- $ 856,238 $ 791,865 $ 64,373 Future production costs: Lease operating expense---------- (179,721) (173,355) (6,366) Future development and abandonment costs------------------------------ (105,843) (80,887) (24,956) Future net cash flows before income taxes------------------------------ 570,674 537,623 33,051 Discount at 10% per annum------------ (165,573) (146,730) (18,843) Discounted future net cash flow before income taxes---------------- 405,101 390,893 14,208 Future income taxes, net of discount at 10% per annum------------------- (97,444) (91,848) (5,596) Standardized measure of discounted future net cash flows relating to proved oil and gas reserves-------- $ 307,657 $ 299,045 $ 8,612 Future gross revenues---------------- $ 725,360 $ 725,360 $ -- Future production costs: Lease operating expense---------- (163,262) (163,262) -- Future development and abandonment costs------------------------------ (67,671) (67,671) -- Future net cash flows before income taxes------------------------------ 494,427 494,427 -- Discount at 10% per annum------------ (144,673) (144,673) -- Discounted future net cash flow before income taxes---------------- 349,754 349,754 -- Future income taxes, net of discount at 10% per annum------------------- (76,423) (76,423) -- Standardized measure of discounted future net cash flows relating to proved oil and gas reserves-------- $ 273,331 $ 273,331 $ -- The standardized measure of discounted future net cash flows from the production of proved reserves is developed as follows: 1. Estimates are made of quantities of proved reserves and the future periods in which they are expected to be produced based on year end economic conditions. STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATED TO PROVED OIL AND GAS RESERVES -- (CONTINUED) 2. The estimated future gross revenues from proved reserves are priced on the basis of year end prices, except in those instances where fixed and determinable natural gas price escalations are covered by contracts. 3. The future gross revenue streams are reduced by estimated future costs to develop and to produce the proved reserves, as well as certain abandonment costs based on year end cost estimates, and the estimated effect of future income taxes. The standardized measure of discounted future net cash flows does not purport to present the fair market value of Pogo's oil and gas reserves. An estimate of fair value would also take into account, among other things, the recovery of reserves in excess of proved reserves, anticipated future changes in prices and costs, a discount factor more representative of the time value of money and the risks inherent in reserve estimates. The following are the principal sources of change in the standardized measure of discounted future net cash flows. All amounts are related to changes in reserves located in the United States unless otherwise noted. YEAR ENDED DECEMBER 31, 1993 TOTAL UNITED KINGDOM OF COMPANY STATES THAILAND (EXPRESSED IN THOUSANDS) Beginning balance-------------------- $ 307,657 $ 299,045 $ 8,612 Revisions to prior years' proved reserves: Net changes in prices and production costs--------------- (41,775) (34,842) (6,933) Net changes due to revisions in quantity estimates------------- 4,066 4,066 -- Net changes in estimates of future development costs------- 662 (871) 1,533 Accretion of discount------------ 40,510 39,089 1,421 Changes in production rate------- 5,134 6,728 (1,594) Other---------------------------- 2,278 3,935 (1,657) Total revisions-------------- 10,875 18,105 (7,230) New field discoveries and extensions, net of future production and development costs:----------------- 39,247 29,059 10,188 Purchases of properties-------------- 22,516 22,516 -- Sales of properties------------------ (19,633) (19,633) -- Sales of oil and gas produced, net of production costs------------------- (110,870) (110,870) -- Previously estimated development costs incurred--------------------- 56,604 56,604 -- Net change in income taxes----------- (6,136) (6,940) 804 Net change in standardized measure of discounted future net cash flows------------- (7,397) (11,159) 3,762 Ending balance----------------------- $ 300,260 $ 287,886 $ 12,374 STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATED TO PROVED OIL AND GAS RESERVES -- (CONTINUED) YEAR ENDED DECEMBER 31, 1992 1991 (EXPRESSED IN THOUSANDS) Beginning balance-------------------- $ 273,331 $ 400,937 Revisions to prior years' proved reserves: Net changes in prices and production costs--------------- 38,348 (174,464) Net changes due to revisions in quantity estimates------------- 42,829 9,940 Net changes in estimates of future development costs------- (21,015) (28,740) Accretion of discount------------ 34,975 52,517 Changes in production rate------- (5,733) (6,518) Other---------------------------- 6,607 (7,404) Total revisions-------------- 96,011 (154,669) New field discoveries and extensions, net of future production and development costs: United States---------------- 29,552 28,286 Kingdom of Thailand---------- 14,208 -- Purchases of properties-------------- 13,870 6,827 Sales of properties------------------ (7,430) (7) Sales of oil and gas produced, net of production costs------------------- (111,581) (92,895) Previously estimated development costs incurred--------------------- 20,717 37,039 Net change in income taxes: United States---------------- (15,425) 47,813 Kingdom of Thailand---------- (5,596) -- Net change in standardized measure of discounted future net cash flows------------- 34,326 (127,606) Ending balance----------------------- $ 307,657 $ 273,331 QUARTERLY RESULTS Summaries of Pogo's results of operations by quarter for the years 1993 and 1992 are as follows: QUARTER ENDED MAR. 31 JUNE 30 SEPT. 30 DEC. 31 (EXPRESSED IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Revenues----------------------------- $34,681 $ 34,533 $ 37,210 $ 33,130 Gross profit(a)---------------------- $17,331 $ 15,391 $ 17,903 $ 14,458 Net income--------------------------- $ 7,160 $ 5,596 $ 7,161 $ 5,144 Earnings per share (primary and fully diluted)-------- $ 0.22 $ 0.17 $ 0.22 $ 0.16 Revenues----------------------------- $28,347 $ 34,072 $ 34,907 $ 43,504 Gross profit(a)---------------------- $ 7,147 $ 12,646 $ 16,165 $ 24,312 Net income (loss)-------------------- $(1,216) $ 3,276 $ 5,535 $ 10,900 Earnings (loss) per share (primary and fully diluted)-------- $ (0.04) $ 0.12 $ 0.20 $ 0.38 (a) Represents revenues less lease operating, exploration, dry hole and impairment, and depreciation, depletion and amortization expenses. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information regarding nominees and continuing directors in the Company's definitive Proxy Statement for its annual meeting to be held on April 26, 1994, to be filed within 120 days of December 31, 1993 pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (the Company's '1994 Proxy Statement'), is incorporated herein by reference. See also Item S-K 401(b) appearing in Part I of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information regarding executive compensation in the Company's 1994 Proxy Statement, other than the information regarding the Compensation Committee Report on Executive Compensation, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information regarding ownership of the Company securities by management and certain other beneficial owners in the Company's 1994 Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information regarding certain relationships and related transactions with management in the Company's 1994 Proxy Statement is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA, FINANCIAL STATEMENT SCHEDULES AND EXHIBITS PAGE 1. Financial Statements and Supplementary Data: Report of Independent Public Accountants----------------- 30 Consolidated statements of income------------------------ 31 Consolidated balance sheets------------------------------ 32 Consolidated statements of cash flows-------------------- 33 Consolidated statements of shareholders' equity---------- 34 Notes to consolidated financial statements--------------- 35 2. Financial Statement Schedules: V --Property and Equipment for the Years Ended December 31, 1993, 1992 and 1991------------------- S-1 VI --Reserves for Depreciation, Depletion and Amortization of Property and Equipment For the Years Ended December 31, 1993, 1992 and 1991------- S-1 X --Supplementary Income Statement Information For the Years Ended December 31, 1993, 1992 and 1991--- S-2 Schedules other than those listed above are omitted because they are not required, are not applicable or the information required has been included elsewhere herein. 3. Exhibits: *3(a ) -- Restated Certificate of Incorporation of Pogo Producing Company. (Exhibit 3(a), Annual Report on Form 10-K for the year ended December 31, 1987, File No. 0-5468). *3(a)(1) -- Certificate of Designation, Preferences and Rights of Preferred Stock of Pogo Producing Company, dated March 25, 1987. (Exhibit 3(a)(1), Annual Report on Form 10-K for the year ended December 31, 1987, File No. 0-5468). *3(b) -- Bylaws of Pogo Producing Company, as amended and restated through July 24, 1990. (Exhibit 3(a), Quarterly Report on Form 10-Q for the quarter ended June 30, 1990, File No. 0-5468). *4(a)(i) -- Credit Agreement dated as of September 23, 1992, among Pogo Producing Company, the lenders party thereto, Bank of Montreal as Agent, and Banque Paribas as Co-Agent. (Exhibit 10(a), Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-7792). 4(a)(ii) -- First Amendment dated as of September 30, 1992 to Credit Agreement dated as of September 23, 1992, among Pogo Producing Company, the lenders party thereto, Bank of Montreal as Agent, and Banque Paribas as Co-Agent. 4(a)(iii) -- Second Amendment dated as of December 31, 1993 to Credit Agreement dated as of September 23, 1992, among Pogo Producing Company, the lenders party thereto, Bank of Montreal as Agent, and Banque Paribas as Co-Agent. *4(b) -- Indenture dated as of October 15, 1980 to Chemical Bank, as Trustee. (Exhibit 4, File No. 2-69428). The Company agrees to furnish to the Commission upon request a copy of any agreement defining the rights of holders of long-term debt of the Company and all its subsidiaries for which consolidated or unconsolidated financial statements are required to be filed under which the total amount of securities authorized does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS (comprising Exhibits 10(a) through 10(f)(14)(ii), inclusive) *10(a) -- 1977 Stock Option Plan of Pogo Producing Company, as amended as of September 28, 1981 and July 24, 1984. (Exhibit 10(a), Annual Report on Form 10-K for the year ended December 31, 1984, File No. 0-5468). *10(a)(1) -- Form of Amended Nonqualified Stock Option Agreement under 1977 Stock Option Plan (with stock appreciation rights and without employment restrictions). (Exhibit 10(a)(1), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(a)(2) -- Form of Amended Incentive Stock Option Agreement under 1977 Stock Option Plan (with stock option appreciation rights and without employment restrictions). (Exhibit 10(a)(2), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(a)(3) -- Form of Amended Nonqualified Stock Option Agreement under 1977 Stock Option Plan (without stock appreciation rights and with employment restrictions). (Exhibit 10(a)(3), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(a)(4) -- Form of Amended Incentive Stock Option Agreement under 1977 Stock Option Plan (without stock option appreciation rights and with employment restrictions). (Exhibit 10(a)(4), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(a)(5) -- Form of Amended Nonqualified Stock Option Agreement under 1977 Stock Option Plan (with stock appreciation rights and with employment restrictions). (Exhibit 10(a)(5), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(a)(6) -- Form of Amended Incentive Stock Option Agreement under 1977 Stock Option Plan (with stock option appreciation rights and with employment restrictions). (Exhibit 10(a)(6), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(a)(7) -- Form of Amended Nonqualified Stock Option Agreement under 1977 Stock Option Plan (without stock appreciation rights and without employment restrictions). (Exhibit 10(a)(7), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(a)(8) -- Form of Amended Incentive Stock Option Agreement under 1977 Stock Option Plan (without stock option appreciation rights and without employment restrictions). (Exhibit 10(a)(8), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(b) -- 1981 Stock Option Plan of Pogo Producing Company, as amended as of July 24, 1984. (Exhibit 10(b), Annual Report on Form 10-K for the year ended December 31, 1984, File No. 0-5468). *10(b)(1) -- Form of Stock Option Agreement under 1981 Nonqualified Stock Option Plan (with stock appreciation rights). (Exhibit 10(b)(1), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(b)(2) -- Form of Stock Option Agreement under 1981 Nonqualified Stock Option Plan (without stock appreciation rights). (Exhibit 10(b)(2), Annual Report on Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(c) -- 1981 Incentive and Nonqualified Stock Option Plan of Pogo Producing Com- pany, as amended as of July 24, 1984. (Exhibit 10(c), Annual Report on Form 10-K for the year ended December 31, 1984, File No. 0-5468). *10(c)(1) -- Form of Stock Option Agreement under 1981 Incentive Stock Option Plan. (Exhibit 10(c)(1), Annual Report of Form 10-K for the year ended December 31, 1981, File No. 0-5468). *10(d) -- 1989 Incentive and Nonqualified Stock Option Plan of Pogo Producing Com- pany, as amended and restated effective January 22, 1991. (Exhibit 10(d), Annual Report on Form 10-K for the year ended December 31, 1991, file No. 0-5468). *10(d)(1) -- Form of Stock Option Agreement under 1989 Incentive and Nonqualified Stock Option Plan, as amended and restated effective January 22, 1991. (Exhibit 10(d)(1), Annual Report on Form 10-K for the year ended December 31, 1991, File No. 0-5468). *10(d)(2) -- Form of Director Stock Option Agreement under 1989 Incentive and Nonqualified Stock Option Plan, as amended and restated effective January 22, 1991. (Exhibit 10(d)(2), Annual Report on Form 10-K for the year ended December 31, 1991, File No. 0-5468). *10(e) -- Form of Letter Agreement respecting treatment of options upon change in control. (Exhibit 19(f), Quarterly Report on Form 10-Q for the quarter ended June 30, 1982. File No. 0-5468). *10(f)(1) -- Employment Agreement by and between Pogo Producing Company and Stuart P. Burbach, dated February 1, 1992. (Exhibit 19(a)(1), Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 1-7792). *10(f)(2)(i) -- Extension Agreement to Continue Employment Agreement between Stuart P. Burbach and Pogo Producing Company, dated as of February 1, 1993. (Exhibit 10(f)(2), Annual report on Form 10-K for the year ended December 31, 1992, File No. 1-7792). 10(f)(2)(ii) -- Extension Agreement to Continue Employment Agreement between Stuart P. Burbach and Pogo Producing Company, dated as of February 1, 1994. *10(f)(3) -- Employment Agreement by and between Pogo Producing Company and Jerry A. Cooper, dated February 1, 1992. (Exhibit 19(a)(2), Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 1-7792). *10(f)(4)(i) -- Extension Agreement to Continue Employment Agreement between Jerry A. Cooper and Pogo Producing Company, dated as of February 1, 1993. (Exhibit 10(f)(4), Annual report on Form 10-K for the year ended December 31, 1992, File No. 1-7792). 10(f)(4)(ii) -- Extension Agreement to Continue Employment Agreement between Jerry A. Cooper and Pogo Producing Company, dated as of February 1, 1994. *10(f)(5) -- Employment Agreement by and between Pogo Producing Company and Kenneth R. Good, dated February 1, 1992. (Exhibit 19(a)(3), Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 1-7792). *10(f)(6)(i) -- Extension Agreement to Continue Employment Agreement between Kenneth R. Good and Pogo Producing Company, dated as of February 1, 1993. (Exhibit 10(f)(6), Annual report on Form 10-K for the year ended December 31, 1992, File No. 1-7792). 10(f)(6)(ii) -- Extension Agreement to Continue Employment Agreement between Kenneth R. Good and Pogo Producing Company, dated as of February 1, 1994. *10(f)(7) -- Employment Agreement by and between Pogo Producing Company and R. Phillip Laney, dated February 1, 1992. (Exhibit 19(a)(4), Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 1-7792). *10(f)(8)(i) -- Extension Agreement to Continue Employment Agreement between R. Phillip Laney and Pogo Producing Company, dated as of February 1, 1993. (Exhibit 10(f)(8), Annual report on Form 10-K for the year ended December 31, 1992, File No. 1-7792). 10(f)(8)(ii) -- Extension Agreement to Continue Employment Agreement between R. Phillip Laney and Pogo Producing Company, dated as of February 1, 1994. *10(f)(9) -- Employment Agreement by and between Pogo Producing Company and John O. McCoy, Jr., dated February 1, 1992. (Exhibit 19(a)(5), Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 1-7792). *10(f)(10)(i) -- Extension Agreement to Continue Employment Agreement between John O. McCoy, Jr. and Pogo Producing Company, dated as of February 1, 1993. (Exhibit 10(f)(10), Annual report on Form 10-K for the year ended December 31, 1992, File No. 1-7792). 10(f)(10)(ii) -- Extension Agreement to Continue Employment Agreement between John O. McCoy, Jr. and Pogo Producing Company, dated as of February 1, 1994. *10(f)(11) -- Employment Agreement by and between Pogo Producing Company and D. Stephen Slack, dated February 1, 1992. (Exhibit 19(a)(6), Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 1-7792). *10(f)(12)(i) -- Extension Agreement to Continue Employment Agreement between D. Stephen Slack and Pogo Producing Company, dated as of February 1, 1993. (Exhibit 10(f)(12), Annual report on Form 10-K for the year ended December 31, 1992, File No. 1-7792). 10(f)(12)(ii) -- Extension Agreement to Continue Employment Agreement between D. Stephen Slack and Pogo Producing Company, dated as of February 1, 1994. *10(f)(13) -- Employment Agreement by and between Pogo Producing Company and Paul G. Van Wagenen, dated February 1, 1992. (Exhibit 19(a)(7), Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 1-7792). *10(f)(14)(i) -- Extension Agreement to Continue Employment Agreement between Paul G. Van Wagenen and Pogo Producing Company, dated as of February 1, 1993. (Exhibit 10(f)(14), Annual report on Form 10-K for the year ended December 31, 1992, File No. 1-7792). 10(f)(14)(ii) -- Extension Agreement to Continue Employment Agreement between Paul G. Van Wagenen and Pogo Producing Company, dated as of February 1, 1994. *10(g) -- Undertaking by Pogo Producing Company dated as of August 8, 1977. (Exhibit 10(e), Annual Report on Form 10-K for the year ended December 31, 1980, File No. 0-5468). *10(h) -- Limited partnership agreement of Pogo Gulf Coast, Ltd. (Exhibit 19, Quarterly Report on Form 10-Q for the quarter ended June 30, 1989, File No. 0-5468). 21 -- List of Subsidiaries of Pogo Producing Company. 23(a) -- Consent of Independent Public Accountants. 23(b) -- Consent of Independent Petroleum Engineers. 24 -- Powers of Attorney from each Director of Pogo Producing Company whose signature is affixed to this Form 10-K for the year ended December 31, 1993. 28 -- Summary of Reserve Report of Ryder Scott Company Petroleum Engineers dated January 28, 1994 relating to oil and gas reserves of Pogo Producing Company. * Asterisk indicates exhibits incorporated by reference as shown. (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. POGO PRODUCING COMPANY (REGISTRANT) By: /s/ PAUL G. VAN WAGENEN PAUL G. VAN WAGENEN CHAIRMAN OF THE BOARD, PRESIDENT AND CHIEF EXECUTIVE OFFICER Date: February 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 FEBRUARY 28, 1994. SIGNATURES TITLE /s/ PAUL G. VAN WAGENEN Principal Executive PAUL G. VAN WAGENEN Officer and Director CHAIRMAN OF THE BOARD, PRESIDENT AND CHIEF EXECUTIVE OFFICER /s/ D. STEPHEN SLACK Principal Financial D. STEPHEN SLACK Officer and Director SENIOR VICE PRESIDENT, CHIEF FINANCIAL OFFICER AND TREASURER /s/ THOMAS E. HART Principal Accounting THOMAS E. HART Officer VICE PRESIDENT AND CONTROLLER TOBIN ARMSTRONG* Director TOBIN ARMSTRONG JACK S. BLANTON* Director JACK S. BLANTON W. M. BRUMLEY, JR.* Director W. M. BRUMLEY, JR. JOHN B. CARTER, JR.* Director JOHN B. CARTER, JR. WILLIAM L. FISHER* Director WILLIAM L. FISHER WILLIAM E. GIPSON* Director WILLIAM E. GIPSON GERRITT W. GONG* Director GERRITT W. GONG J. STUART HUNT* Director J. STUART HUNT FREDERICK A. KLINGENSTEIN* Director FREDERICK A. KLINGENSTEIN NICHOLAS R. PETRY* Director NICHOLAS R. PETRY JACK A. VICKERS* Director JACK A. VICKERS *By: /s/ THOMAS E. HART THOMAS E. HART ATTORNEY-IN-FACT S-1 SCHEDULE X POGO PRODUCING COMPANY AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (EXPRESSED IN THOUSANDS) 1993 1992 1991 Maintenance and repairs-------------- $ 3,658 $ 4,435 $ 6,498 Taxes, other than payroll and income taxes: Severance, ad valorem, franchise and other------------------------ $ 3,133 $ 2,423 $ 2,222 S-2

40554_1993.txt

40554_1993

1993

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ITEM 1. BUSINESS. GENERAL General Electric Capital Corporation (herein together with its consolidated affiliates called the "Corporation" or "GE Capital" unless the context otherwise requires) was incorporated in 1943 in the State of New York, under the provisions of the New York Banking Law relating to investment companies, as successor to General Electric Contracts Corporation, formed in 1932. Until November 1987, the name of the Corporation was General Electric Credit Corporation. All outstanding common stock of the Corporation is owned by General Electric Capital Services, Inc. ("GE Capital Services"), formerly General Electric Financial Services, Inc., which is in turn wholly owned by General Electric Company ("GE Company"). The business of the Corporation originally related principally to financing the distribution and sale of consumer and other products of GE Company. Currently, however, the type and brand of products financed and the financial services offered are significantly more diversified. Very little of the financing provided by GE Capital involves products that are manufactured by GE Company. The Corporation operates in four finance industry segments and in a specialty insurance industry segment. GE Capital's financing activities include a full range of leasing, loan, equipment management services and annuities. The Corporation's specialty insurance activities include providing private mortgage insurance, financial (primarily municipal) guarantee insurance, creditor insurance, reinsurance and, for financing customers, credit life and property and casualty insurance. The Corporation is an equity investor in a retail organization and certain other financial services organizations. GE Capital's operations are subject to a variety of regulations in their respective jurisdictions. Services of the Corporation are offered primarily in the United States, Canada and Europe. Computerized accounting and service centers, including those located in Connecticut, Ohio, Georgia and England, provide financing offices and other service locations with data processing, accounting, collection, reporting and other administrative support. The Corporation's principal executive offices are located at 260 Long Ridge Road, Stamford, Connecticut 06927 (Telephone number (203) 357-4000). At December 31, 1993 the Corporation employed approximately 27,000 persons. Industry segment operating data and identifiable assets for the years 1993, 1992 and 1991 are shown in Note 17 of the Notes to Financial Statements of General Electric Capital Corporation and Consolidated Affiliates included in Item 8 of this Annual Report. For accounting purposes, the Corporation's principal financing products are classified as time sales and loans, investment in financing leases or equipment on operating leases. The following table presents, by industry segment, these principal financing products which, together with investment securities and other assets, comprise the Corporation's total assets at December 31, 1993 and 1992. ITEM 1. BUSINESS (Continued). The Corporation provides a wide variety of financing and insurance products and services, which are organized into the following industry segments: o Specialized Financing -- loans and leases for major capital assets including aircraft, industrial facilities and equipment and energy-related facilities; commercial and residential real estate loans and investments; and loans to and investments in corporate enterprises. o Consumer Services -- private label and bank credit card loans, time sales and revolving credit and inventory financing for retail merchants, auto leasing and inventory financing, mortgage servicing and annuities. o Mid-Market Financing -- loans and financing and operating leases for middle-market customers including manufacturers, distributors and end-users, for a variety of equipment, including data processing equipment, medical and diagnostic equipment, and equipment used in construction, manufacturing, office applications and telecommunications activities. ITEM 1. BUSINESS (Continued). o Equipment Management -- leases, loans and asset management services for portfolios of commercial and transportation equipment including aircraft, trailers, auto fleets, modular space units, railroad rolling stock, data processing equipment, ocean-going containers and satellites. o Specialty Insurance -- financial guaranty insurance, principally on municipal bonds and structured finance issues; private mortgage insurance; creditor insurance covering international customer loan repayments; and property, casualty and life insurance. Refer to Item 7 "Management's Discussion and Analysis of Results of Operations" in this Form 10-K for discussion of the Corporation's Portfolio Quality. SPECIALIZED FINANCING Commercial Real Estate Commercial Real Estate Financing and Services (CRE) provides funds for the acquisition, refinancing or renovation of a wide range of commercial and residential properties located throughout the United States, and, to a lesser extent, in Canada, Mexico and Europe. CRE also provides selected asset management services to real estate investors. CRE has field offices located throughout the United States, as well as offices in Toronto, Canada, Mexico City, Mexico and London, England, in addition to its headquarters in Stamford, Connecticut. Lending represents a major segment of CRE's business in the form of intermediate-term senior or subordinated floating-rate loans secured by existing income-producing commercial properties such as office buildings, rental apartments, shopping centers, industrial buildings, mobile home parks and warehouses. Loans range in amount from single-property mortgages typically greater than $5 million to multi-property portfolios of several hundred million dollars, and are well dispersed geographically, covering properties located in 38 states and several foreign countries. Approximately 90% of all loans are senior mortgages. During 1993, CRE continued to broaden its investment base by acquiring certain loans and properties from both government and private institutions. CRE actively buys or provides restructuring financing for portfolios of real estate, mortgage loans, limited partnerships, REIT's, and tax-exempt bonds. CRE also offers a variety of real estate management services to outside investors, institutions, corporations and investment banks through its GE Capital Realty Group subsidiary. Services include acquisitions and dispositions, strategic asset positioning, asset restructuring, on-site property management, maintenance, and leasing and loan servicing. Global Project and Structured Finance The Corporation's Global Project and Structured Finance (GP&SF) business provides financing for major capital investments in various sectors of the economy, concentrating principally in the North American market with efforts being made toward Asia, South America and Europe. At year-end 1993, GP&SF's diversified portfolio included investments in commercial aircraft (38%), industrial facilities and equipment (24%), energy-related facilities (30%), railcar rolling stock (5%), and marine vessels (3%). GP&SF's fundings take various forms ranging from financing leases to total balance sheet recapitalizations. At December 31, 1993, GP&SF's portfolio consisted of finance leases (both direct financing and leveraged leases), operating leases, loans (both senior and subordinated) and equity investments (including collateralized, sinking fund and adjustable rate preferred stock; joint ventures; and partnerships). Fundings are adequately collateralized in the form of property liens, preferred mortgages, assignment of earnings, insurance, guarantees, cash flow streams and the financed assets. GP&SF provides lease syndication and private placement services for transactions generated by GE Capital as well as other companies. When such services are performed, GP&SF typically retains a portion of the transaction and sells off the remainder to one or more other financial institutions. In addition to its Stamford, Connecticut headquarters, GP&SF has field offices in New York City and Chicago, as well as in Canada, Mexico, England, Singapore, Hong Kong, China and India. ITEM 1. BUSINESS (Continued). Corporate Finance Group The Corporate Finance Group (CFG) provides senior and subordinated loans, on both a revolving and term basis, secured by various assets, which may include accounts receivable, inventory, property, plant and equipment and intangible assets (e.g. franchise licenses). Loans range in size from $5 million to several hundred million dollars with maturities generally between 5 and 10 years. CFG is active in the loan syndication market, selling and occasionally purchasing participations in leveraged transactions. CFG also makes preferred and common stock investments and frequently receives warrants exercisable into a certain percentage of the financed entities' common stock. In addition, with the diminished market for acquisition related transactions, CFG has expanded the scope of its business into other financing opportunities, such as providing lines of credit to bankrupt companies undergoing reorganization. The portfolio is diversified with approximately 100 accounts dispersed throughout the United States and, to a lesser degree, Canada and Europe. Industry concentration is spread among cable television, commercial and industrial, retail, financial services, media, and, to a lesser extent, healthcare, food and beverage and broadcasting. CFG has offices throughout the United States in addition to its headquarters in Stamford, Connecticut. CONSUMER SERVICES Retailer Financial Services Retailer Financial Services (RFS) provides sales financing services to the distribution chain for various consumer industries. Financing plans offered vary considerably by client (including Montgomery Ward & Co., Incorporated, through a wholly-owned affiliate Montgomery Ward Credit Corporation, "MW Credit"), but fall into three major product offerings: customized private label credit card programs with retailers, bankcard programs direct with consumers and inventory financing programs with manufacturers, distributors and retailers. RFS purchases consumer revolving charge accounts from retailers in the United States, Canada and the United Kingdom, most of whom sell a variety of products of various manufacturers on a time sales basis. The terms made available for these financing plans vary by size of contract and the credit standing of the customer. Maximum maturities ordinarily do not exceed 40 months. The Corporation generally maintains a security interest in the merchandise financed. Financing is provided to consumers under contractual arrangements both with and without recourse to retailers. RFS's wide range of financial services includes private label credit cards, credit promotion and accounting services, billing (in the store's name) and customer credit and collection services. Similar services are also provided through joint ventures in Mexico and Spain. During 1993, RFS expanded into the Scandinavian market with the purchase of Finax Finans AB which provides credit card services and consumer loans in Sweden and Norway. RFS provides consumers with Visa and Mastercard products, including the new GE Rewards Credit Card, through Monogram Bank, USA. RFS is also engaged in the home equity loan business. RFS provides inventory financing for retailers primarily in the appliance and consumer electronics industries. The majority of such financing is for products manufactured by General Electric Company. The Corporation obtains a security interest in the inventory of retailers to whom financing is provided. As part of the inventory financing agreement, retailers are required to provide insurance coverage deemed adequate by RFS on the merchandise financed (with an insurer selected by the retailer). In addition, RFS usually obtains agreements from the distributor or manufacturer obligating them to repurchase inventory repossessed by RFS from defaulting retailers. Auto Financial Services Auto Financial Services (AFS) provides lease financing for automobiles of domestic and foreign manufacture through dealers, independent leasing companies and importers of new and used cars throughout the United States, Canada and the United Kingdom. Contractual terms do not exceed 66 months and have an average expected term ranging from 30 to 45 months. Property and casualty insurance is required for all leases, with the insurer selected by the lessee. ITEM 1. BUSINESS (Continued). AFS also provides inventory financing programs and direct loans to segments of the automotive industry, including dealers, rental car companies and leasing companies located throughout the United States. AFS purchases auto lease and loan assets from financial institutions and services the outstanding accounts throughout the liquidation of the portfolios. AFS is active in the Asian market through equity investments in United Merchants Finance Ltd. (Hong Kong) and ASTRA Sedaya Finance (Indonesia) and expanded in 1993 with United Motor Works (Malaysia) and Government Savings Bank and General Finance and Securities (Thailand) which provide primarily automobile and vehicle financing in their respective markets. On January 1, 1993 AFS and Volvo of North America began a joint venture to provide financing for Volvo's customers. Mortgage Servicing GE Capital Mortgage Services, Inc. (GECMSI), wholly owned by GE Capital Mortgage Corporation (GECMC), is engaged in the business of servicing residential mortgage loans collateralized by one-to-four-family homes located throughout the United States. It obtains servicing through the purchase of mortgage loans and of servicing rights. GECMSI packages the loans it purchases into mortgage-backed securities which are sold to investors. GECMSI is also engaged in the home equity loan business. GECMC, through GECMSI and other wholly-owned affiliates, is among the nation's leading asset management, servicing and disposition organizations. GNA The Corporation acquired two companies during 1993 (GNA Corporation and United Pacific Life Insurance Company) which together comprise the Corporation's annuity business ("GNA"). GNA writes and markets tax-deferred annuities and sells proprietary and third party mutual funds through independent agents and financial institutions. MID-MARKET FINANCING Commercial Equipment Financing Commercial Equipment Financing (CEF) offers a broad line of financial products including loans, leases and municipal financing to middle-market customers including manufacturers, distributors, dealers and end-users. Products are designed to meet customers' unique equipment needs and tax requirements and are either held for CEF's own account or brokered to a third party for a fee. Generally, transactions range from $50 thousand dollars to several million dollars with financing terms from 36 to 120 months. CEF enhances the value of its leased equipment by maintaining an asset management operation that both redeploys off-lease equipment and monitors asset values. The portfolio includes vehicles, manufacturing equipment, corporate aircraft, construction equipment, medical diagnostic equipment, office equipment, telecommunications equipment and electronics. CEF operates from offices throughout the United States, Puerto Rico, Canada, Europe, Australia and through joint ventures in Mexico, Spain and Hong Kong. In 1993, Canadian operations were significantly expanded with the purchase of financing receivables and infrastructure of the National Bank of Canada. Vendor Financial Services Vendor Financial Services (VFS) provides captive financing services to equipment manufacturers and distributors in specific industries including office furniture, healthcare, franchise, information systems, manufacturing and office equipment worldwide. The captive financing programs are tailored to meet the individual needs of each vendor including sales force training, marketing support and customized financing products. Funding, billing, collections and other related services are provided by six highly automated service operations and sales offices located throughout the United States, Canada, Mexico, Asia and Europe. VFS's typical transaction size ranges from $6 thousand to $500 thousand. Security is generally provided by the asset being financed. ITEM 1. BUSINESS (Continued). During 1993, VFS acquired Digital Equipment Corporation's financing group. Digital Financial Services, the new name for the VFS unit dedicated to Digital, provides financing for the acquisition of equipment manufactured by Digital. GECC Financial -- Hawaii GECC Financial Corporation of Hawaii (GFC) operates exclusively in the state of Hawaii. Through a network of 10 branch offices, GFC offers commercial and residential real estate loans, auto and equipment leasing, inventory financing and equity lines of credit. GFC also offers thrift investment programs and loan servicing to institutional investors. Computer Leasing GE Capital Computer Leasing Corporation(GECCL), is based in Emeryville, California and offers primarily lease financing for new and used computer equipment and peripherals of all major computer manufacturers. GECCL manages these assets during their product life cycle by offering a wide range of services including remarketing and trading of used equipment. GECCL's offering of financial services and products are tailored to provide information technology solutions to its customers. EQUIPMENT MANAGEMENT Fleet Services GE Capital Fleet Services (GECFS), is the leading corporate fleet management company in North America and Europe with 620,000 cars, trucks and specialty vehicles under lease and service management. GECFS markets finance and operating leases to several thousand customers with an average lease term of 36 months. The primary product is a Terminal Rental Adjustment Clause (TRAC) lease with the customer assuming the residual risk for the difference between market and book value at termination. In addition to the services directly associated with the lease, GECFS offers value-added fleet management services designed to reduce its customers' total fleet management costs. These include maintenance management programs, accident services, national account purchasing programs, fuel programs, title and licensing services, safety programs and many other value-added programs. GECFS' customer base is well diversified across all industries and geographic locations and includes many Fortune 500 companies. Genstar Container In 1993, Genstar Container Corporation maintained a fleet of over 1,300,000 TEU ("twenty-foot equivalent units") of dry-cargo, refrigerated and specialized containers for intermodal cargo transport on a global basis. Lessees consist primarily of shipping lines who lease on a long-term or master lease basis. Genstar is the world's largest lessor of intermodal shipping containers. Railcar Services At December 31, 1993, GE Railcar Services Corporation (GERSCO) had approximately 140,000 railcars leased to others in North America (principally operating leases). Railcar maintenance and repair services are provided by GE Railcar Repair Services Corporation, a wholly-owned affiliate of GERSCO, at its 21 repair centers in the United States and Canada. GE Railcar Wheel Services Corporation, a wholly-owned affiliate of GERSCO, provides railcar refurbishing services and also remanufactures railcar parts. Polaris Aircraft Polaris Holding Company and its subsidiaries (Polaris) provide lease financing to the commercial airline industry on a worldwide basis, primarily through short-term operating leases. At December 31, 1993, Polaris' fleet of aircraft, one of the largest such fleets in the world, consisted of 250 owned or managed aircraft on lease to 50 customers around the world. In 1994, the activities of Polaris and the commercial aircraft finance and leasing assets of the Global Project and Structured Finance business will be combined to form GE Capital Aviation Services, Inc. (GECAS). GECAS will also manage the aircraft assets of GPA Group, plc. ITEM 1. BUSINESS (Continued). Transport International Pool Transport International Pool (TIP) rents, leases, sells and finances over-the-road trailers in the United States, Canada and throughout Europe from 185 locations. In June 1993, TIP acquired an extensive European network by purchasing TIP Europe plc. and its 65 branches in 10 countries. TIP also launched its trailer storage and cartage rental business by purchasing the assets of Trailerco. TIP's large diversified fleet of over 83,000 dry freight vans, refrigerated and double vans, flatbeds and specialized trailers serves the trailer needs of common and private carriers. Satellite Telecommunications Services GE American Communications (GE Americom) is a leading provider of satellite communication services (video and audio services) to the media, including the broadcast and cable TV industries, and voice, facsimile and wideband data services for various agencies of the federal government. GE Americom operates seven domestic communications satellites, which carry cable TV programming to the nation's 11,000 plus cable television systems and is also the leading satellite carrier of radio programming, serving more than 6,000 radio stations. It also maintains a supporting network of earth stations, central terminal offices, and telemetry, tracking and control facilities. Computer Services Computer Services, is a combination of four businesses (Computer Maintenance Service, Rental/Lease, Electronic Services and GE Hamilton Technology Services). Recognized for its premier service, the Computer Maintenance Service business provides comprehensive repair, maintenance and networking services for multi-vendor personal computers. The Rental/Lease business rents and leases a broad range of brand-name personal computers, workstations and test and measurement equipment. The Electronic Service business provides world-class, single-source repair and calibration services for electronic test equipment from more than 1,000 manufacturers. GE Hamilton Technology Services provides a diverse base of technology services -- computer rental, leasing, sales, support and asset management -- to customers seeking communication solutions. Modular Space GE Capital Modular Space (GECMS) maintains a fleet, at December 31, 1993, of approximately 36,000 non-residential relocatable modular structures for rental, lease and sale from over 80 facilities in the United States. GECMS' operating leases are primarily rental and short-term leases, averaging 15 months, in term and usage. SPECIALTY INSURANCE Mortgage Insurance GE Mortgage Insurance Companies (GEMICO) are engaged principally in underwriting residential mortgage guaranty insurance. Operating in 26 field locations, GEMICO is licensed in 50 states and the District of Columbia, and at December 31, 1993, was the primary insurance carrier for over 828,100 residential homes, with total insurance in force aggregating over $149 billion and total risk in force aggregating over $27 billion. When a claim is received, GEMICO proceeds by either paying a guaranteed percentage based on the specified coverage or paying the mortgage and delinquent interest, taking title to the property and arranging for its sale. Financial Guaranty Insurance FGIC Corporation (FGIC), through its wholly-owned subsidiary Financial Guaranty Insurance Company (Financial Guaranty), is an insurer of municipal bonds, including new issues and bonds traded in the secondary market, including bonds held in unit investment trusts and mutual funds. Financial Guaranty also guarantees certain structured debt issues in the taxable market. The guaranteed principal, after reinsurance, amounted to approximately $84 billion at December 31, 1993. Approximately 90% of the business written to date by Financial Guaranty has been municipal bond insurance. ITEM 1. BUSINESS (Continued). Creditor Insurance Financial Insurance Group (FIG), headquartered in Enfield, Middlesex, England, is licensed to offer creditor insurance in the United Kingdom, the Republic of Ireland and Spain. The insurance, which covers loan repayments, is sold through banks, building societies and other lenders to retail borrowers. Life, Property and Casualty Insurance Employers Reassurance Corporation (ERAC), a Kansas life insurance company, formerly Puritan Life Insurance Company, was acquired by GE Capital during 1973. ERAC is licensed to offer life, annuity and accident and health coverage in the District of Columbia and all states except New York, where it is licensed only for reinsurance. Puritan Excess & Surplus Lines Insurance Company (PESLIC), a successor to the operations of Puritan Insurance Company, began operations as a subsidiary of GE Capital during 1981. PESLIC is licensed to transact property and casualty insurance in Connecticut and Missouri. The administrative office of the combined life and property and casualty insurance operation is located in Overland Park, Kansas. ERAC and PESLIC continue to provide reinsurance and credit insurance coverage to GE Capital customers. ERAC also markets all types of life and accident and health reinsurance coverage to direct writing life insurance companies. Insurance and reinsurance operations are subject to regulation by various state insurance commissions or foreign regulatory authorities, as applicable. ALLOWANCE FOR LOSSES AND LOSS EXPERIENCE ON FINANCING RECEIVABLES The Corporation maintains an allowance for losses on financing receivables at an amount which it believes is sufficient to provide adequate protection against future losses in the portfolio. For small-balance financing receivables, the allowance for losses is determined principally on the basis of actual experience during the preceding three years. Additional allowances are also recorded to reflect management's judgment of additional loss potential. For larger-balance financing receivables, the allowance for losses is determined primarily on the basis of management's judgment of net loss potential, including specific allowances for known troubled accounts. Note 6 of the Notes to Financial Statements shows the activity in the allowance for losses on financing receivables for the years 1991 through 1993. The following table sets forth the Corporation's net loss experience on total financing receivables (time sales, loans and financing lease rentals receivable) in dollars and as a percentage of average financing receivables outstanding for each of the last three years. Recoveries on accounts written off have been netted against gross credit losses. - --------------- (a) Write-downs of in-substance repossessions, foreclosed real estate properties and other investments aggregated $135 million, $243 million and $206 million in 1993, 1992 and 1991, respectively. All accounts or portions thereof deemed to be uncollectible or to require an excessive collection cost are written off to the allowance for losses. Small-balance accounts are progressively written down (from 10% when more than three months delinquent to 100% when nine to twelve months delinquent) to record the balances at estimated realizable value. However, if at any time during that period an account is judged to be uncollectible, such as in the case of a bankruptcy, the remaining balance is written off. ITEM 1. BUSINESS (Continued). Larger-balance accounts are reviewed at least quarterly, and those accounts which are more than three months delinquent are written down, if necessary, to record the balances at estimated realizable value. RATES AND COMPETITION The Corporation's activities are subject to a variety of federal and state regulations including, at the federal level, the Consumer Credit Protection Act, the Equal Credit Opportunity Act and certain regulations issued by the Federal Trade Commission. A majority of states have ceilings on rates chargeable to customers in retail time sales transactions, installment loans and revolving credit financing. The Corporation's international operations are subject to regulation in their respective jurisdictions. To date such regulations have not had a material adverse effect on the Corporation's volume of financing operations or profitability. Common carrier services of GE Americom are subject to regulation by the Federal Communications Commission. The Corporation's charges for providing financing services are changed from time to time either on a general basis or for specific types of financing when warranted in light of competition or interest and other costs. The businesses in which the Corporation engages are highly competitive. The Corporation is subject to competition from various types of financial institutions, including banks, investment banks, credit unions, leasing companies, consumer loan companies, independent finance companies and finance companies associated with manufacturers. ITEM 2. ITEM 2. PROPERTIES. The Corporation conducts its business from various facilities, most of which are leased. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Corporation is not involved in any material pending legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. See Note 12 of the Notes to Financial Statements. The common stock of the Corporation is owned entirely by GE Capital Services and therefore there is no trading market in such stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following selected financial data should be read in conjunction with the financial statements of GE Capital and consolidated affiliates and the related Notes to Financial Statements. - ------------ (a) The Corporation adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," on December 31, 1993 resulting in the inclusion of $485 million of net unrealized gains on investment securities in equity at the end of the year. Excluding such unrealized gains on investment securities, the Corporation's equity and debt to equity ratio would have been $9,885 million and 7.96 to 1 at December 31, 1993, respectively. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS. OVERVIEW The Corporation's net earnings for 1993 were $1,478 million, which, after payment of dividends on its variable cumulative preferred stock, resulted in a contribution of $1,456 million to GE Capital Services' 1993 net earnings, an increase of 19% over 1992. Net earnings for 1992 were $1,251 million, which, after payment of dividends on its variable cumulative preferred stock, resulted in a contribution to GE Capital Services' net earnings of $1,225 million, an increase of 13% over 1991. Earnings of the Corporation's lending, leasing and equipment management businesses are significantly influenced by the level of invested assets and the financing spread on those assets, the excess of yield (rates earned) over interest rates on borrowings. In 1993, the level of invested assets increased and lower rates on borrowings resulted in improved spreads. For 1992, the level of invested assets increased and lower rates on borrowings more than offset lower yields on assets, also resulting in improved spreads. In both years, these increases were partially offset by higher administrative expenses related to the asset growth. As a result of improved asset quality, portfolio loss provisions were lower in 1993, compared with 1992, which had been higher than in 1991. In both 1993 and 1992, earnings of the Corporation's Specialty Insurance businesses were up sharply. 1993's improvement reflected strong performances by the financial guaranty insurance and creditor insurance businesses. 1992's increase was primarily the result of growth in both the private mortgage insurance and financial guaranty insurance businesses. OPERATING RESULTS EARNED INCOME from all sources increased 18% in 1993, following an 8% increase in 1992. Asset growth in each of the Corporation's financing segments, through acquisitions of businesses and portfolios as well as origination volume, was the primary reason for increased income from time sales, loans, financing leases and operating lease rentals in both 1993 and 1992. Yields on related assets were essentially flat in 1993 compared with 1992, following a decline from 1991. Earned income in 1993 from the Corporation's annuity business, formed through two current year acquisitions, was $571 million. Gains on sales of warrants and other equity interests obtained in connection with certain loans, fee income associated with syndication activities, and sales of certain assets, including real estate investments, contributed $647 million to pre-tax income in 1993, compared with $438 million in 1992 and $261 million in 1991. In addition, pre-tax income in 1992 included $65 million of gains from the disposition of partial interests in several affiliates while pre-tax income in 1991 included a $134 million gain from the disposition of a significant portion of the Corporation's auto auction affiliate. Earned income of the Corporation's Specialty Insurance segment in 1993 was 20% higher than in 1992, which in turn was 35% higher than in 1991. The 1993 increase was primarily the result of growth in premium income in the private mortgage, life reinsurance and financial guaranty insurance businesses and reflected the full year impact of the creditor insurance business which was consolidated at the end of the second quarter of 1992 when an existing equity position was converted to a controlling interest. The 1992 increase was primarily the result of growth in premium and investment income in the private mortgage and financial guaranty insurance businesses and reflected revenue from the creditor insurance business for the second half of the year. INTEREST AND DISCOUNT EXPENSE in 1993 totaled $3.5 billion, 6% lower than in 1992, which was 13% lower than in 1991. Both decreases reflected substantially lower composite interest rates which more than offset the effect of higher average borrowings required to finance the significantly higher level of invested assets. The Corporation's 1993 composite interest rate of 4.97% was 87 basis points lower than the 1992 rate, which in turn was 167 basis points lower than the 1991 rate. OPERATING AND ADMINISTRATIVE EXPENSES increased 24% to $4,894 million in 1993, compared with a 44% increase to $3,941 million in 1992, primarily reflecting operating costs associated with businesses and portfolios acquired during the past two years. Overall, provisions for losses on investments that were charged to operating and administrative expense decreased in 1993, following an increase in 1992. These ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Continued). provisions principally related to the Commercial Real Estate and highly leveraged transaction (HLT) portfolios and, in 1993, to commercial aircraft as well. INSURANCE LOSSES AND POLICYHOLDER AND ANNUITY BENEFITS increased $648 million to $1,259 million in 1993, compared with a $12 million increase to $611 million in 1992. The 1993 increase largely reflected annuity benefits credited to customers following the current year annuity business acquisitions. The remainder of the 1993 increase represented higher losses on increased volume in the life reinsurance and private mortgage insurance businesses, partially offset by reduced losses in the creditor insurance business. In 1992, lower losses in the life reinsurance business were more than offset by higher losses on increased volume in the private mortgage insurance business and the effects of the creditor insurance business for the second half of the year. PROVISION FOR LOSSES ON FINANCING RECEIVABLES decreased $69 million to $987 million in 1993, compared with a $46 million decrease to $1,056 million in 1992. These provisions principally related to the Consumer Services, Commercial Real Estate and HLT portfolios discussed below. DEPRECIATION AND AMORTIZATION OF BUILDINGS AND EQUIPMENT AND EQUIPMENT ON OPERATING LEASES increased 22% to $1.6 billion in 1993, compared with a 9% increase to $1.3 billion in 1992. Increases in both years were primarily a result of additions to equipment on operating leases through business and portfolio acquisitions. INCOME TAX PROVISION was $664 million in 1993 (an effective tax rate of 31.0%), compared with $415 million in 1992 (24.9%) and $362 million (24.3%) in 1991. The increased provision for income taxes in both 1993 and 1992 reflected the effects of additional income before taxes and, in 1993, the 1% increase in the U.S. Federal income tax rate. The higher rate in 1993 compared with 1992 reflected the 1% increase in the U.S. Federal income tax rate and a lower proportion of tax-exempt income. These items were partially offset by the effects of certain unrelated financing transactions that will result in future cash savings and reduced the Corporation's obligation for previously accrued deferred taxes. The higher rate in 1992 compared with 1991 reflected a relatively lower proportion of tax-exempt income and a 1991 adjustment for tax-deductible claims reserves of the property insurance affiliates, for which there was no 1992 counterpart. OPERATING PROFIT BY INDUSTRY SEGMENT Operating profit (pre-tax income) of the Corporation, by industry segment, is summarized in Note 17 and discussed below: CONSUMER SERVICES operating profit of $695 million in 1993 was 32% higher than that of 1992. This increase reflected lower provisions for receivable losses in Retailer Financial Services resulting from declines in consumer delinquency as well as strong asset growth and interest rate favorability in both Auto Financial Services and Retailer Financial Services. Operating profit of $525 million in 1992 was 53% higher than that of 1991 (excluding the impact in 1991 of the $134 million gain on the disposition of a significant portion of GE Capital's auto auction affiliate). This increase reflected higher financing spreads in Retailer Financial Services and increased asset levels in Auto Financial Services. EQUIPMENT MANAGEMENT operating profit increased $9 million to $377 million in 1993. This increase reflected higher volume in most businesses, largely the result of portfolio and business acquisitions, and improved trailer and railcar utilization, offset by lower average rental rates in Fleet Services and Computer Services, and the effects of lower utilization and pricing pressures at Genstar Container. Operating profit decreased $13 million to $368 million in 1992 due to lower utilization in the Railcar Services and Genstar Container businesses, partially offset by operating profit generated as a result of Fleet Services' acquisition of the fleet leasing operations of Avis-Europe. MID-MARKET FINANCING operating profit of $454 million in 1993 was 29% higher than that of 1992 and reflected higher spreads and higher levels of invested assets, primarily as a result of business and portfolio acquisitions. Operating profit increased $104 million to $352 million in 1992 compared with 1991. Operating profit for 1992 reflected higher levels of invested assets, primarily as a result of portfolio acquisitions. SPECIALTY INSURANCE operating profit of $422 million in 1993 was 40% higher than the $302 million recorded in 1992, which was 79% higher than in 1991. The 1993 increase reflected higher premium volume from bond refunding in the financial guaranty insurance business as well as reduced claims expense in the ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Continued). creditor insurance business. The 1992 gains primarily reflected higher premium volume and investment income at GE Capital's private mortgage and financial guaranty insurance businesses. SPECIALIZED FINANCING operating profit was $201 million in 1993, compared with $121 million in 1992 and $220 million in 1991. The increase in 1993 principally reflected much lower provisions for losses on Corporate Finance Group HLT investments and higher gains from sales of Commercial Real Estate assets, partially offset by higher loss provisions for Commercial Real Estate assets and expenses associated with redeployment and refurbishment of owned aircraft. The decline in 1992 principally reflected higher loss provisions, particularly reserves for Corporate Finance Group in-substance and owned investments, partially offset by higher gains on the sale of assets in both Commercial Real Estate and Corporate Finance Group. Loss provisions relating to both the Commercial Real Estate portfolio and Corporate Finance Group HLT investments are discussed below. CAPITAL RESOURCES AND LIQUIDITY The Corporation's principal source of cash is financing activities that involve continuing rollover of short-term borrowings and appropriate addition of long-term borrowings, with a reasonable balance of maturities. Over the past three years, the Corporation's borrowings with maturities of 90 days or less have increased by $10.6 billion. New borrowings of $40.2 billion having maturities longer than 90 days were added during those years, while $25.5 billion of such longer-term borrowings were paid off. The Corporation has also generated significant cash from operating activities, $15.5 billion during the last three years. The Corporation's principal use of cash has been investing in assets to grow the business. Additions to financing receivables were $16.1 billion of the $39.2 billion in net investments the Corporation has made over the past three years. Other principal investments during these years were $6.9 billion to acquire new businesses and $9.2 billion for new equipment, primarily for lease to others. GE Company has agreed to make payments to the Corporation, constituting additions to pre-tax income, to the extent necessary to cause the Corporation's consolidated ratio of earnings to fixed charges to be not less than 1.10 for each fiscal year commencing with fiscal year 1991. Three years advance written notice is required to terminate this agreement. No payments have been required under this agreement. The Corporation's ratios of earnings to fixed charges for the years 1993, 1992 and 1991, were 1.62, 1.44 and 1.34, respectively. GE Capital's total borrowings were $78.7 billion at December 31, 1993, of which $52.9 billion was due in 1994 and $25.8 billion was due in subsequent years. Comparable amounts at the end of 1992 were: $70.4 billion in total; $48.5 billion due within one year; and $21.9 billion due thereafter. Composite interest rates are discussed on page 11. Individual borrowings are structured within overall asset/liability interest rate and currency risk management strategies. Interest rate and currency swaps form an integral part of the Corporation's goal of achieving the lowest borrowing costs for particular funding strategies. Counterparty credit risk is closely monitored -- approximately 90% of the notional amount of swaps outstanding at December 31, 1993 was with counterparties having credit ratings of Aa/AA or better. The Corporation's ratio of debt to equity (leverage) was 7.59 to 1 at the end of 1993, compared with 7.91 to 1 at the end of 1992. Excluding net unrealized gains on investment securities included in equity, the Corporation's leverage was 7.96 to 1 at the end of 1993. With the financial flexibility that comes with excellent credit ratings, management believes the Corporation is well positioned to meet the global needs of its customers for capital and continue growing its diverse asset base. PORTFOLIO QUALITY THE PORTFOLIO OF FINANCING RECEIVABLES, $63.9 billion and $59.4 billion at year-ends 1993 and 1992, respectively, is the Corporation's largest asset and its primary source of revenues. Related allowances for losses aggregated $1.7 billion at the end of 1993 (2.63% of receivables -- the same level as 1992) and are, in management's judgment, appropriate given the risk profile of the portfolio. A discussion about the quality of certain elements of the portfolio of financing receivables and investments follows. Further details are included in Notes 5 and 9. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Continued). CONSUMER LOANS RECEIVABLE, primarily retailer and auto receivables, were $17.3 billion and $14.8 billion at the end of 1993 and 1992, respectively. The Corporation's investment in consumer auto finance lease receivables was $5.6 billion and $4.8 billion at the end of 1993 and 1992, respectively. Non-earning receivables, 1.7% of total loans and leases (2.1% at the end of 1992), amounted to $391 million at the end of 1993. The provision for losses on retailer and auto financing receivables was $469 million in 1993, a 19% decrease from $578 million in 1992, reflecting reduced consumer delinquencies and intensified collection efforts, particularly in Europe. Most non-earning receivables were private label credit card receivables, the majority of which were subject to various loss sharing arrangements that provide full or partial recourse to the originating retailer. COMMERCIAL REAL ESTATE LOANS classified as finance receivables by the Commercial Real Estate business, a part of the Specialized Financing segment, were $10.9 billion at December 31, 1993, up $0.4 billion from the end of 1992. In addition, the investment portfolio of the Corporation's annuity business, acquired during 1993, included $1.1 billion of commercial property loans. Commercial real estate loans are generally secured by first mortgages. In addition to loans, Commercial Real Estate's portfolio also included in other assets $2.2 billion of assets that were purchased for resale from the Resolution Trust Corporation (RTC) and other institutions and $1.4 billion of investments in real estate joint ventures. In recent years, the Corporation has been one of the largest purchasers of assets from RTC and others, growing its portfolio of properties acquired for resale by $1.1 billion in 1993. To date, values realized on these assets have met or exceeded expectations at the time of purchase. Investments in real estate joint ventures have been made as part of original financings and in conjunction with loan restructurings where management believes that such investments will enhance economic returns. Commercial Real Estate's foreclosed properties at the end of 1993 declined to $110 million from $187 million at the end of 1992. At December 31, 1993, Commercial Real Estate's portfolio included loans secured by and investments in a variety of property types that were well dispersed geographically. Property types included apartments (36%), office buildings (32%), shopping centers (14%), mixed use (8%), industrial and other (10%). These properties were located, principally across the United States, as follows: Mid-Atlantic (21%), Northeast (20%), Southwest (19%), West (15%), Southeast (12%), Central (8%), with the remainder (5%) across Canada and Europe. Reduced and non-earning receivables declined to $272 million in 1993 from $361 million in 1992, reflecting proactive management of delinquent receivables as well as write-offs. Loss provisions for Commercial Real Estate's investments were $387 million in 1993 ($248 million related to receivables and $139 million to other assets), compared with $299 million and $213 million in 1992 and 1991, respectively, as the portfolio continued to be adversely affected by the weakened commercial real estate market. HIGHLY LEVERAGED TRANSACTION (HLT) PORTFOLIO is included in the Specialized Financing segment and represents financing provided for highly leveraged management buyouts and corporate recapitalizations. The portion of those investments classified as financing receivables was $3.3 billion at the end of 1993 compared with $5.3 billion at the end of 1992, as substantial repayments reduced this liquidating portfolio. The year-end balance of amounts that had been written down to estimated fair value and carried in other assets as a result of restructuring or in-substance repossession aggregated $544 million at the end of 1993 and $513 million at the end of 1992 (net of allowances of $244 million and $224 million, respectively). Non-earning and reduced earning receivables declined to $139 million at the end of 1993 from $429 million the prior year. Loss provisions for HLT investments were $181 million in 1993 ($80 million related to receivables and $101 million to other assets), compared with $573 million in 1992 and $328 million in 1991. Non-earning and reduced earning receivables as well as loss provisions were favorably affected by the stronger economic climate during 1993 as well as by the successful restructurings implemented during the past few years. OTHER FINANCING RECEIVABLES, approximately $26 billion, consisted primarily of a diverse commercial, industrial and equipment loan and lease portfolio. This portfolio grew approximately $2 billion during 1993, while non-earning and reduced earning receivables decreased $46 million to $98 million at year end. The Corporation has loans and leases to commercial airlines that aggregated about $6.8 billion at the end of 1993, up from $6 billion at the end of 1992. At year-end 1993, commercial aircraft positions included conditional commitments to purchase aircraft at a cost of $865 million and financial guarantees ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Continued). and funding commitments amounting to $450 million. These purchase commitments are subject to the aircraft having been placed on lease under agreements, and with carriers, acceptable to the Corporation prior to delivery. Expenses associated with redeployment and refurbishment of owned aircraft totaled $112 million in 1993 compared with nominal amounts in prior years. The Corporation's increasing investment demonstrates its continued long-term commitment to the airline industry. ENTERING 1994, management believes that the diversity and strength of the Corporation's assets, along with vigilant attention to risk management, position it to deal effectively with a global and changing competitive and economic landscape. NEW ACCOUNTING STANDARDS Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan," modifies the accounting that applies when it is probable that all amounts due under contractual terms of a loan will not be collected. Management does not believe that this Statement, required to be adopted no later than the first quarter of 1995, will have a material effect on the Corporation's financial position or results of operations, although such effect will depend on the facts at the time of adoption. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEPENDENT AUDITORS' REPORT To the Board of Directors General Electric Capital Corporation We have audited the financial statements of General Electric Capital Corporation and consolidated affiliates as listed in Item 14. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in Item 14. 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 General Electric Capital Corporation and consolidated affiliates 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 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective December 31, 1993. /s/ KPMG PEAT MARWICK Stamford, Connecticut February 11, 1994 GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES STATEMENT OF CURRENT AND RETAINED EARNINGS See Notes to Consolidated Financial Statements. GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES STATEMENT OF FINANCIAL POSITION See Notes to Consolidated Financial Statements. GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES STATEMENT OF CASH FLOWS See Notes to Consolidated Financial Statements. GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION -- The consolidated financial statements represent a consolidation of General Electric Capital Corporation and all majority-owned and controlled affiliates ("consolidated affiliates"). All significant transactions among the parent and consolidated affiliates have been eliminated. Other affiliates in which the Corporation and/or its consolidated affiliates own 20% to 50% of the voting rights ("nonconsolidated affiliates") are included in other assets, valued at the appropriate share of equity plus loans and advances. CASH FLOWS -- For purposes of the Statement of Cash Flows, certificates and other time deposits are treated as cash equivalents. METHODS OF RECORDING EARNED INCOME -- Income on all loans is recognized on the interest method. Accrual of interest income is suspended when collection of an account becomes doubtful, generally after the account becomes 90 days delinquent. Financing lease income, which includes related investment tax credits and residual values, is recorded on the interest method so as to produce a level yield on funds not yet recovered. Unguaranteed residual values included in lease income are based principally on independent appraisals of the values of leased assets remaining at expiration of the lease terms. Operating lease income is recognized on a straight-line basis over the term of the underlying leases. Origination, commitment and other nonrefundable fees related to fundings are deferred and recorded in earned income on the interest method. Commitment fees related to loans not expected to be funded and line of credit fees are deferred and recorded in earned income on a straight-line basis over the period to which the fees relate. Syndication fees are recorded in earned income at the time the related services are performed unless significant contingencies exist. See "Insurance and Annuity Businesses" below for information with respect to earned income of these businesses. ALLOWANCE FOR LOSSES ON FINANCING RECEIVABLES AND INVESTMENTS -- The Corporation maintains an allowance for losses on financing receivables at an amount which it believes is sufficient to provide adequate protection against future losses in the portfolio. For small-balance receivables the allowance for losses is determined principally on the basis of actual experience during the preceding three years. Further allowances are also provided to reflect management's judgment of additional loss potential. For other receivables, principally the larger loans and leases, the allowance for losses is determined primarily on the basis of management's judgment of net loss potential, including specific allowances for known troubled accounts. All accounts or portions thereof deemed to be uncollectible or to require an excessive collection cost are written off to the allowance for losses. Small-balance accounts are progressively written down (from 10% when more than three months delinquent to 100% when nine to twelve months delinquent) to record the balances at estimated realizable value. However, if at any time during that period an account is judged to be uncollectible, such as in the case of a bankruptcy, the uncollectible balance is written off. Larger-balance accounts are reviewed at least quarterly, and those accounts which are more than three months delinquent are written down, if necessary, to record the balances at estimated realizable value. When collateral is formally or substantively repossessed in satisfaction of a loan, the receivable is written down against the allowance for losses to estimated fair value and is transferred to other assets. Subsequent to such transfer, these assets are carried at the lower of cost or estimated current fair value. This accounting has been employed principally for highly leveraged transactions (HLT) and real estate loans. INCOME TAXES -- Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," was adopted effective January 1, 1992. The effect of adopting SFAS No. 109 was not material. Deferred tax balances are stated at tax rates expected to be in effect when taxes are actually paid or recovered. INVESTMENT AND TRADING SECURITIES -- On December 31, 1993, the Corporation adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires that investments in debt securities and marketable equity securities be designated as trading, held-to-maturity or available-for-sale. Trading securities are reported at fair value, with changes in fair value included in earnings. Investment securities include both available-for-sale and held-to-maturity securities. Available-for-sale securities are reported at fair value, with net unrealized gains and losses included in equity. Held-to-maturity debt securities are reported at amortized cost. See notes 3 and 4 for a discussion of the classification and reporting of these securities at December 31, 1992. For all investment securities, unrealized losses that are other than temporary are recognized in earnings. EQUIPMENT ON OPERATING LEASES -- Equipment is amortized, principally on a straight-line basis, to estimated net salvage value over the lease term or the estimated economic life of the equipment. BUILDINGS AND EQUIPMENT -- The Corporation records depreciation principally on a sum-of-the-year's-digits basis over the lives of the assets. OTHER ASSETS -- Goodwill is amortized on a straight-line basis over periods not exceeding 30 years. FOREIGN OPERATIONS -- Assets and liabilities of foreign affiliates are translated into U.S. dollars at the year-end exchange rates while operating results are translated at rates prevailing during the year. Such adjustments are accumulated and reported as a separate component of equity. INSURANCE AND ANNUITY BUSINESSES -- Premiums on short-duration insurance contracts are reported as earned income over the terms of the related reinsurance treaties or insurance policies. In general, earned premiums are calculated on a pro-rata basis or are determined based on reports received from reinsureds. Premium adjustments under retrospectively rated assumed reinsurance contracts are recorded based on estimated losses and loss expenses, including both case and incurred-but-not-reported reserves. Premiums on long-duration insurance products are recognized as earned when due. Premiums received under annuity contracts are not reported as revenues but as annuity benefits -- a liability -- and are adjusted according to the terms of the respective policies. The estimated liability for insurance losses and loss expenses consist of both case and incurred-but-not-reported reserves. Where experience is not sufficient, industry averages are used. Estimated amounts of salvage and subrogation recoverable on paid and unpaid losses are deducted from outstanding losses. The liability for future policyholder benefits of the life insurance affiliates has been computed mainly by a net-level-premium method based on assumptions for investment yields, mortality and terminations that were appropriate at date of purchase or at the time the policies were developed, including provisions for adverse deviations. Deferred insurance acquisition costs for the property and casualty businesses are amortized pro-rata over the contract periods in which the related premiums are earned. For the life insurance business, these costs are amortized over the premium-paying periods of the contracts in proportion either to anticipated premium income or to gross profit, as appropriate. For certain annuity contracts, such costs are amortized on the basis of anticipated gross profits. For other lines of business, acquisition costs are amortized over the life of the related insurance contracts. Deferred insurance acquisition costs are reviewed for recoverability; for short-duration contracts, anticipated investment income is considered in making recoverability evaluations. NOTE 2. ACQUISITIONS The Corporation has acquired two individually non-significant entities (collectively "the Acquisitions"). The acquisition of GNA Corporation ("GNA") from Weyerhaeuser Company and Weyerhaeuser Financial Services, Inc. occurred on April 1, 1993, while the acquisition of United Pacific Life Insurance Company ("UPL") from Reliance Insurance Company and its parent company, Reliance Group Holdings, Inc. occurred on July 14, 1993. The acquisitions, accounted for as purchases, have been reflected in the accompanying consolidated financial statements of the Corporation since the respective acquisition dates. The acquired companies had assets of approximately $12.8 billion, principally investment securities. The aggregate estimated purchase price was $1,113 million and is subject to certain post-closing adjustments. Unaudited pro forma condensed results of operations of the Corporation for each of the years ended December 31, 1993 and 1992 as if the Acquisitions had occurred on January 1, 1993 and January 1, 1992, respectively, are as follows: The pro forma data have been prepared based on assumptions management deems appropriate and the results are not necessarily indicative of those that might have occurred had the transactions become effective at the beginning of the respective years, primarily due to changes in investment and other business strategies of the acquired companies. The aggregate effect of several other business acquisitions completed during 1993 was not material. NOTE 3. TRADING SECURITIES The Corporation's trading securities at December 31, 1992, included investments in equity securities held by insurance affiliates at a fair value of $812 million, with unrealized pretax gains of $30 million (net of unrealized pretax losses of $11 million) included in equity and $436 million of preferred stock issued by affiliated companies. At December 31, 1993, such securities were classified as investment securities (see note 4). NOTE 4. INVESTMENT SECURITIES At December 31, 1993, investment securities were classified as available-for-sale and reported at fair value, including net unrealized gains of $760 million before taxes. At December 31, 1992, investment securities of $5,641 million were classified as available-for-sale and were reported at the lower of aggregate amortized cost or fair value. The balance of the 1992 investment securities portfolio was carried at amortized cost. A summary of investment securities follows. - --------------- (a) December 31, 1992 amounts include gross unrealized gains of $24 million and there were no unrealized losses on investment securities carried at amortized cost. Contractual maturities of debt securities, other than mortgage-backed securities, at December 31, 1993, are shown below. It is expected that actual maturities will differ from contractual maturities because some borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Proceeds from the sales of debt securities were $4,922 million in 1993, $1,249 million in 1992 and $1,078 million in 1991. Gross realized gains were $129 million in 1993, $60 million in 1992 and $36 million in 1991. Gross realized losses were $31 million in 1993, $1 million in 1992 and $8 million in 1991. NOTE 5. FINANCING RECEIVABLES Financing receivables at December 31, 1993 and 1992 by principal category are shown below. Financing receivables classified as time sales and loans represent transactions with customers in a variety of forms, including time sales, revolving charge and credit, mortgages, installment loans, intermediate-term loans and revolving loans secured by business assets. The portfolio includes time sales and loans carried at the principal amount on which finance charges are billed periodically, and time sales and loans acquired on a discount basis carried at gross book value, which includes finance charges. At year-ends 1993 and 1992, commercial and industrial loans included $3,293 million and $5,262 million, respectively, for highly leveraged transactions. Note 7 contains information on commercial airline loans and leases. The financing lease operations consist of direct financing and leveraged leases of aircraft, railroad rolling stock, automobiles and other transportation equipment, data processing equipment, medical equipment, and other manufacturing, power generation, mining and commercial equipment and facilities. As the sole owner of assets under direct financing leases and as the equity participant in leveraged leases, the Corporation is taxed on total lease payments received and is entitled to tax deductions based on the cost of leased assets and tax deductions for interest paid to third-party participants. The Corporation is also entitled generally to any investment tax credit on leased equipment and to any residual value of leased assets. Investments in direct financing and leveraged leases represent unpaid rentals and estimated unguaranteed residual values of leased equipment, less related deferred income. Because the Corporation has no general obligation on notes and other instruments representing third-party participation related to leveraged leases, such notes and other instruments have not been included in liabilities but have been offset against the related rentals receivable. The Corporation's share of rentals receivable is subordinate to the share of such other participants who also have a security interest in the leased equipment. The Corporation's investment in financing leases at December 31, 1993 and 1992 is shown below. - ------------ (a) Total financing lease deferred income is net of deferred initial direct costs of $83 million and $73 million for 1993 and 1992, respectively. At December 31, 1993, contractual maturities for time sales and loans over the next five years and after are: $16,287 million in 1994; $6,286 million in 1995; $4,350 million in 1996; $4,104 million in 1997; $3,112 million in 1998; and $7,683 million in 1999 and later -- aggregating $41,822 million. At December 31, 1993, contractual maturities for finance lease rentals receivable over the next five years and after are: $6,417 million in 1994; $5,426 million in 1995; $3,919 million in 1996; $2,570 million in 1997; $1,720 million in 1998; and $9,630 million in 1999 and later -- aggregating $29,682 million. Experience of the Corporation has shown that a portion of receivables will be paid prior to contractual maturity. Accordingly, the contractual maturities of time sales and loans and of rentals receivable shown above are not to be regarded as forecasts of future cash collections. The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include financial guarantees and letters of credit. The Corporation's exposure to credit loss in the event of nonperformance by the other party to financial guarantees is represented by the contractual amount of those instruments. The Corporation uses the same credit policies and the same collateral requirements in making commitments and conditional obligations as it does for financing transactions. In addition, the Corporation is involved in the sales of receivables for which it is contingently liable for credit losses for a percentage of the initial face amount sold. At December 31, 1993 and 1992, the aggregate amount of such financial guarantees were $1,863 million and $1,693 million, respectively, excluding those related to commercial aircraft (see note 7). In connection with the sales of financing receivables, the Corporation received proceeds of $1,105 million in 1993, $1,097 million in 1992 and $2,316 million in 1991. At December 31, 1993 and 1992, $3,045 million and $3,473 million, respectively, of such receivables were outstanding. Under arrangements with customers, the Corporation had committed to lend funds of $2,131 million and $1,794 million at December 31, 1993 and 1992, respectively, excluding those related to commercial aircraft (see note 7). Additionally, at December 31, 1993 and 1992, the Corporation was conditionally obligated to advance $2,244 million and $2,236 million, respectively, principally under performance-based standby lending commitments. The Corporation also was obligated for $2,946 million and $2,147 million at year-ends 1993 and 1992, respectively, under standby liquidity facilities related to third-party commercial paper programs, although management believes that the prospects of being required to fund under such standby facilities are remote. Note 11 discusses financial guarantees of insurance affiliates. Nonearning consumer time sales and loans, primarily private-label credit card receivables, amounted to $391 million and $444 million at December 31, 1993 and 1992, respectively. A majority of these receivables was subject to various loss-sharing arrangements that provide full or partial recourse to the originating private-label entity. Nonearning and reduced earning receivables other than consumer time sales and loans were $509 million and $934 million at year-ends 1993 and 1992, respectively. Earnings of $11 million and $30 million realized in 1993 and 1992, respectively, were $41 million and $75 million lower than would have been reported had these receivables earned income in accordance with their original terms. Additional information regarding financing receivables is included in Management's Discussion of the Corporation's Portfolio Quality on page 13. NOTE 6. ALLOWANCE FOR LOSSES ON FINANCING RECEIVABLES The allowance for losses on financing receivables represented 2.63% of total financing receivables at both year-ends 1993 and 1992. The table below shows the activity in the allowance for losses on financing receivables during 1991 through 1993: Amounts written off in 1993 were approximately 1.46% of average financing receivables outstanding during the year, compared with 1.58% and 1.87% of average financing receivables outstanding during 1992 and 1991, respectively. NOTE 7. EQUIPMENT ON OPERATING LEASES Equipment on operating leases by type of equipment and accumulated amortization at December 31, 1993 and 1992 are shown in the following table: Amortization of equipment on operating leases was $1,395 million in 1993, $1,133 million in 1992 and $1,055 million in 1991. The Corporation acts as a lender and lessor to commercial enterprises in the airline industry; at December 31, 1993 and 1992, the aggregate amount of such loans, leases and equipment leased to others were $6,776 million and $5,978 million, respectively. In addition, the Corporation had issued financial guarantees and funding commitments of $450 million at December 31, 1993 ($645 million at year-end 1992) and had conditional commitments to purchase aircraft at a cost of $865 million. These purchase commitments are subject to the aircraft having been placed on lease under agreements, and with carriers, acceptable to the Corporation prior to delivery. Included in the Corporation's equipment leased to others at year-end 1993 is $244 million of commercial aircraft off-lease ($94 million in 1992). NOTE 8. BUILDINGS AND EQUIPMENT Buildings and equipment include office buildings, satellite communications equipment, data processing equipment, vehicles, furniture and office equipment used at the Corporation's offices throughout the world. Depreciation expense was $192 million for 1993, $164 million for 1992 and $132 million for 1991. NOTE 9. OTHER ASSETS Other assets at December 31, 1993 and 1992 are shown in the table below. Accumulated amortization of goodwill and other intangibles was $261 million and $229 million, respectively, at December 31, 1993 and $204 million and $94 million, respectively, at December 31, 1992. Miscellaneous investments included $75 million and $275 million at December 31, 1993 and 1992, respectively, of in-substance repossessions at the lower of cost or estimated fair value previously included in financing receivables. Investments in and advances to nonconsolidated affiliates include advances of $1,159 million and $687 million at December 31, 1993 and 1992, respectively. The Corporation's mortgage servicing activities include the purchase and resale of mortgages. It had open commitments to purchase mortgages totaling $5,935 million and $2,963 million at December 31, 1993 and 1992, respectively. Additionally, the Corporation had open commitments to sell mortgages totaling $6,426 million and $1,777 million, at year-ends 1993 and 1992, respectively. At December 31, 1993 and 1992, mortgages sold with full or partial recourse to the Corporation aggregated $2,526 million and $3,876 million, respectively. NOTE 10. NOTES PAYABLE Notes payable at December 31, 1993 totaled $78,712 million, consisting of $78,015 million of senior debt and $697 million of subordinated debt. The composite interest rate during 1993 was 4.97% compared with 5.84% for 1992 and 7.51% for 1991. Total short-term notes payable at December 31, 1993 and 1992 consisted of the following: The average daily balance of short-term debt, excluding the current portion of long-term debt, during 1993 was $41,450 million compared with $38,319 million for 1992 and $35,487 million for 1991. The December 31, 1993 balance of $52,903 million was the maximum balance during 1993. The December 31, 1992 balance of $48,492 million was the maximum balance during 1992. The December 27, 1991 balance of $44,412 million was the maximum balance during 1991. The average short-term interest rate, excluding the current portion of long-term debt, for the year 1993 was 3.27%, representing short-term interest expense divided by the average daily balance, compared with 3.91% for 1992 and 6.32% for 1991. On December 31, 1993, 1992 and 1991, average interest rates were 3.39%, 3.57% and 5.13%, respectively, for commercial paper and 3.10%, 3.54% and 4.90%, respectively, for notes with trust departments of banks. Outstanding balances in notes payable after one year at December 31, 1993 and 1992 are shown below. - --------------- (a) At December 31, 1993 and 1992, the Corporation had agreed to exchange currencies and related interest payments on principal amounts equivalent to U.S. $8,101 million and $6,499 million, respectively. At December 31, 1993 and 1992, the Corporation also had entered into interest rate swaps related to interest on $11,624 million and $8,549 million, respectively. To minimize borrowing costs, the Corporation has entered into multiple currency and interest rate agreements for certain notes. (b) At December 31, 1993 and 1992, counterparties held options under which the Corporation can be caused to execute interest rate swaps associated with interest payments through 1999 on $500 million and $625 million, respectively. (c) The Corporation will reset interest rates at the end of the initial and each subsequent interest period. At each interest rate-reset date, the Corporation may redeem notes in whole or in part at its option. Current interest periods range from March 1994 to May 1996. (d) The rate of interest payable on each note is a variable rate based on the commercial paper rate each month. Interest is payable at the option of the Corporation either monthly or semiannually. (e) At December 31, 1993 and 1992, subordinated notes in the amount of $697 million were guaranteed by GE Company. Long-term borrowing maturities during the next five years, including the current portion of notes payable after one year are: 1994, $6,420 million; 1995, $6,202 million; 1996, $4,805 million; 1997, $2,969 million; and 1998, $3,563 million. At December 31, 1993 the Corporation had committed lines of credit aggregating $19,045 million with 134 banks, including $6,005 million of revolving credit agreements with 69 banks pursuant to which the Corporation has the right to borrow funds for periods exceeding one year. A total of $4,627 million of these lines were also available for use by GE Capital Services. In addition, at December 31, 1993, approximately $105 million of committed lines of credit were directly available to a foreign affiliate. Also, at December 31, 1993, approximately $3,045 million of GE Company's credit lines were available for use by the Corporation. During 1993 the Corporation did not borrow under any of these credit lines. The Corporation compensates banks for credit facilities in the form of fees which were immaterial for the past three years. NOTE 11. INSURANCE RESERVES AND ANNUITY BENEFITS The Corporation adopted SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," during 1993. The principal effect of this Statement was to report reinsurance receivables and prepaid reinsurance premiums, a total of $1,012 million at December 31, 1993, as assets. Such amounts were reported as reductions of insurance reserves at the end of 1992. Insurance reserves and annuity benefits represents policyholders' benefits, unearned premiums and provisions for policy losses and benefits relating to insurance and annuity businesses. The related balances at December 31, 1993 and 1992 are as follows: Financial guarantees, principally FGIC's guarantees on municipal bonds and structured debt issued, amounted to approximately $101.4 billion and $81.3 billion at year-end 1993 and 1992, respectively, before reinsurance of $17.3 billion and $13.7 billion, respectively. Related unearned premiums amounted to $803 million and $571 million at December 31, 1993 and 1992, respectively. As of December 31, 1993 and 1992, reserves for losses and loss adjustment expenses were $96 million and $40 million, respectively. The Corporation's mortgage insurance operations underwrite residential mortgage guarantee insurance. Total risk in force aggregated $27.0 billion and $21.3 billion at December 31, 1993 and 1992, respectively; related unearned premiums amounted to $276 million at December 31, 1993 and $236 million at December 31, 1992. Case basis loss reserves and loss adjustment expense reserves are provided in an amount sufficient to pay all estimated losses in the portfolio, including those incurred but not reported. As of December 31, 1993 and 1992, reserves for losses and loss adjustment expenses were $511 million and $372 million, respectively. Interest rates credited to annuity contracts in 1993 ranged from 3.7% to 9.7%. For most annuities, interest rates to be credited are redetermined by management on an annual basis. The Corporation's Specialty Insurance businesses are involved significantly in the reinsurance business, ceding reinsurance on both a pro-rata and an excess basis. The maximum amount of individual life insurance retained on any one life is $500,000. When the Corporation cedes business to third parties, it is not relieved of its primary obligation to policyholders and reinsureds. Consequently, the Corporation establishes allowances for amounts deemed uncollectible due to the failure of reinsurers to honor their obligations. The Corporation monitors both the financial condition of individual reinsurers and risk concentrations arising from similar geographic regions, activities and economic characteristics of reinsurers. The effects of reinsurance on premiums written and earned during 1993, 1992 and 1991 were as follows: Reinsurance recoveries recognized as a reduction of insurance losses and policyholder and annuity benefits amounted to $163 million, $169 million and $225 million for the period ended December 31, 1993, 1992 and 1991, respectively. NOTE 12. EQUITY CAPITAL All Common Stock is owned by GE Capital Services, which is in turn wholly owned by GE Company. In 1993, GE Capital Services contributed the minority interest in Financial Insurance Group to the Corporation. In 1992, GE Company contributed to GE Capital Services the assets of GE Computer Services. GE Capital Services in turn contributed the GE Computer Services assets to the Corporation. These contributions were reflected as additions to the Corporation's additional paid-in capital of $25 million and $134 million in 1993 and 1992, respectively. Cash dividends paid on the Common Stock were $460 million in 1993, $300 million in 1992 and $100 million in 1991. Other equity at December 31, 1993 and 1992 consisted of: Dividend rates on the Corporation's variable cumulative preferred stock ranged from 2.33% to 2.79% during 1993, 2.44% to 3.49% during 1992. Dividends paid on such variable cumulative preferred stock were $22 million in 1993, $26 million in 1992 and $41 million in 1991. NOTE 13. EARNED INCOME Included in earned income from financing leases were gains on the sale of equipment at lease completion of $145 million in 1993, $126 million in 1992 and $147 million in 1991. Noncancelable future rentals due from customers for equipment on operating leases as of December 31, 1993 totaled $6,133 million and are due as follows: 1994, $2,036 million; 1995, $1,455 million; 1996, $879 million; 1997, $458 million; 1998, $316 million and $989 million thereafter. Amortization of deferred investment tax credit was $29 million, $26 million and $25 million in 1993, 1992 and 1991, respectively. Time sales, loan and investment and other income includes the Corporation's share of earnings from equity investees of $106 million, $72 million and $84 million for 1993, 1992 and 1991, respectively. NOTE 14. INTEREST AND DISCOUNT EXPENSES Interest and discount expenses reported in the Statement of Current and Retained Earnings are net of interest income on temporary investments of excess funds of $38 million for 1993, $42 million for 1992, and $47 million for 1991, and net of capitalized interest of $5 million for 1993, $6 million for 1992 and $8 million for 1991. For purposes of computing the ratio of earnings to fixed charges (the "ratio") in accordance with applicable Securities and Exchange Commission instructions, earnings consist of net earnings adjusted for the provision for income taxes, minority interest and fixed charges. Fixed charges consist of interest on all indebtedness and one-third of annual rentals, which the Corporation believes is a reasonable approximation of the interest factor of such rentals. The ratio was 1.62 for 1993, compared with 1.44 for 1992 and 1.34 for 1991. NOTE 15. OPERATING AND ADMINISTRATIVE EXPENSES Employees and retirees of the Corporation and its affiliates are covered under a number of pension, health and life insurance plans. The principal pension plan is the GE Company pension plan, a defined benefit plan, while employees of certain affiliates are covered under separate plans. The Corporation provides health and life insurance benefits to certain of its retired employees, principally through GE Company's benefit program. The annual cost to the Corporation of providing these benefits is not material and the net transition obligation arising from the 1991 adoption of the new accounting standard, SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pension," was not separately determinable. GE Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," in the second quarter of 1993. The Corporation adopted this standard in conjunction with its ultimate parent. This Statement requires that employers expense the costs of postemployment benefits (as distinct from postretirement pension, medical and life insurance benefits) over the working lives of their employees. This change principally affects the Corporation's accounting for severance benefits, which previously were expensed when the severance event occurred. The net transition obligation related to the Corporation's employees covered under GE Company postemployment benefit plans is not separately determinable from the GE Company plans as a whole; accordingly, there is no financial statement impact on the Corporation. The net transition obligation for employees covered under separate plans is not material. Rental expense for 1993 aggregating $413 million, compared with $272 million for 1992 and $103 million for 1991, was principally for the rental of office space, data processing equipment and railcars. Minimum future rental commitments under noncancelable leases are: 1994, $356 million; 1995, $336 million; 1996, $317 million; 1997, $302 million; 1998, $284 million and $1,802 million thereafter. The Corporation, as a lessee, has no material lease agreements classified as capital leases. NOTE 16. INCOME TAXES The income tax provision is summarized in the following table: GE Company files a consolidated Federal income tax return which includes GE Capital. The provisions for estimated taxes payable (recoverable) include the effect of the Corporation and its affiliates on the consolidated tax and the effect of tax transfer leases. Estimated income taxes payable were $15 million and $7 million at December 31, 1993 and 1992, respectively. A reconciliation of the Corporation's actual income tax rate to the U.S. Federal statutory rate is shown in the following table: The tax effects of principal temporary differences are shown in the following table: NOTE 17. INDUSTRY SEGMENT DATA Industry segment operating data and identifiable assets for the years 1993, 1992 and 1991 are shown below. NOTE 18. QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: NOTE 19. RESTRICTED NET ASSETS OF AFFILIATES Various state and foreign regulations require that the Corporation's investment in certain affiliates, without regard to net unrealized after-tax gains on investment securities which were $336 million at December 31, 1993, be maintained at specified minimum levels to provide additional protection for insurance customers, investment certificate holders and passbook savings depositors. At December 31, 1993, such minimum investment levels aggregated approximately $4,600 million. NOTE 20. SUPPLEMENTAL CASH FLOW INFORMATION Cash used or provided in 1993, 1992 and 1991 included interest paid by the Corporation of $3,298 million, $3,570 million and $4,460 million, respectively, and income taxes (paid) recovered by the Corporation of $(133) million, $(42) million and $51 million, respectively. NOTE 21. FAIR VALUES OF FINANCIAL INSTRUMENTS As required under generally accepted accounting principles, financial instruments are presented in the accompanying financial statements -- generally at either cost or fair value, based on both the characteristics of and management intentions regarding the instruments. Management believes that the financial statement presentation is the most useful for displaying the Corporation's results. However, SFAS No. 107, "Disclosure About Fair Value of Financial Instruments," requires disclosure of an estimate of the fair value of certain financial instruments. These disclosures disregard management intentions regarding the instruments, and therefore, management believes that this information may be of limited usefulness. Apart from the Corporation's own borrowings and certain marketable securities, relatively few of the Corporation's financial instruments are actively traded. Thus, fair values must often be determined by using one or more models that indicate value based on estimates of quantifiable characteristics as of a particular date. Because this undertaking is, by nature, difficult and highly judgmental, for a limited number of instruments, alternative valuation techniques indicate values sufficiently diverse that the only practicable disclosure is a range of values. Users of the following data are cautioned that limitations in the estimation techniques may have produced disclosed values different from those that could have been realized at December 31, 1993 or 1992. Moreover, the disclosed values are representative of fair values only as of the dates indicated, inasmuch as interest rates, performance of the economy, tax policies and other variables significantly impact fair valuations. Cash and cash equivalents, trading securities and other receivables have been excluded as their carrying amounts and fair values are the same, or approximately the same. Values were estimated as follows: INVESTMENT SECURITIES. Based on quoted market prices or dealer quotes for actively traded securities. Value of other such securities was estimated using quoted market prices for similar securities. TIME SALES, LOANS AND RELATED PARTICIPATIONS. Based on quoted market prices, recent transactions, market comparables and/or discounted future cash flows, using rates at which similar loans would have been made to similar borrowers. INVESTMENTS IN AND ADVANCES TO NON-CONSOLIDATED AFFILIATES. Based on market comparables, recent transactions and/or discounted future cash flows. These equity interests were generally acquired in connection with financing transactions and, for purposes of this disclosure, fair values were estimated. OTHER FINANCIAL INSTRUMENTS. Based on recent comparable transactions, market comparables, discounted future cash flows, quoted market prices, and/or estimates of the cost to terminate or otherwise settle obligations to counterparties. BORROWINGS. Based on quoted market prices or market comparables. Fair values of interest rate and currency swaps on borrowings are based on quoted market prices and include the effects of counterparty creditworthiness. ANNUITY BENEFITS. Based on expected future cash flows, discounted at currently offered discount rates for immediate annuity contracts or cash surrender value for single premium deferred annuities. FINANCIAL GUARANTIES OF INSURANCE AFFILIATES. Based on future cash flows, considering expected renewal premiums, claims, refunds and servicing costs, discounted at a market rate. The carrying amounts and estimated fair values of the Corporation's financial instruments at December 31, 1993 and 1992 are as follows: ASSETS (LIABILITIES) - --------------- (a) Swap contracts are integral to the Corporation's goal of achieving the lowest borrowing costs for particular funding strategies. The above fair values of borrowings include fair values of associated interest rates and currency swaps. At December 31, 1993, the approximate settlement values of the Corporation's swaps were $260 million. Without such swaps, estimated fair values of the Corporation's borrowings would have been $79,482 million. Approximately 90% of the notional amount of swaps outstanding at December 31, 1993, was with counterparties having credit ratings of Aa/AA or better. (b) Proceeds from borrowings are invested in a variety of activities, including both financial instruments shown in the preceding tables, as well as leases, for which fair value disclosures are not required. When evaluating the extent to which estimated fair value of borrowings exceeds the related carrying amount, users should consider that the fair value of the fixed payment stream for long-term leases would increase as well. NOTE 22. GEOGRAPHIC SEGMENT INFORMATION Geographic segment operating data and total assets for the years 1993, 1992 and 1991 are as follows: U.S. amounts were derived from the Corporation's operations located in the U.S. The Corporation manages its exposure to currency movements by committing to future exchanges of currencies at specified prices and dates. Commitments outstanding at December 31, 1993 and 1992, were $1,650 million and $1,884 million, 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. Omitted ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Omitted ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Omitted ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Omitted PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. FINANCIAL STATEMENTS Included in Part II of this report: Independent Auditors' Report Statement of Current and Retained Earnings for each of the years in the three-year period ended December 31, 1993 Statement of Financial Position at December 31, 1993 and 1992 Statement of Cash Flows for each of the years in the three-year period ended December 31, 1993 Notes to Financial Statements Incorporated by reference: The consolidated financial statements, of General Electric Company, set forth in the Annual Report on Form 10-K of General Electric Company for the year ending December 31, 1993 (pages through ) and Exhibit 12 (Ratio of Earnings to Fixed Charges) of General Electric Company. (a) 2. FINANCIAL STATEMENT SCHEDULES III. Condensed financial information of registrant All other schedules are omitted because of the absence of conditions under which they are required or because the required information is shown in the financial statements or notes thereto. (a) 3. EXHIBIT INDEX The exhibits listed below, as part of Form 10-K, are numbered in conformity with the numbering used in Item 601 of Regulation S-K of the Securities and Exchange Commission. (b) REPORTS ON FORM 8-K None. GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT GENERAL ELECTRIC CAPITAL CORPORATION CONDENSED STATEMENT OF FINANCIAL POSITION See Notes to Condensed Financial Statements. GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONTINUED) GENERAL ELECTRIC CAPITAL CORPORATION CONDENSED STATEMENT OF CURRENT AND RETAINED EARNINGS See Notes to Condensed Financial Statements. GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONTINUED) GENERAL ELECTRIC CAPITAL CORPORATION CONDENSED STATEMENT OF CASH FLOWS See Notes to Condensed Financial Statements. GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONCLUDED) GENERAL ELECTRIC CAPITAL CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS NOTES PAYABLE -- Outstanding balances in notes payable after one year at December 31, 1993 and 1992 are shown below. - --------------- (a) At December 31, 1993 and 1992, the Corporation had agreed to exchange foreign currencies on principal amounts equivalent to U.S. $8,101 million and $6,499 million, respectively, and related interest. At December 31, 1993 and 1992, the Corporation also had entered into interest rate swaps related to interest on $11,624 million and $8,549 million, respectively. To minimize borrowing costs, the Corporation has entered into multiple currency and interest rate agreements for certain notes. (b) At December 31, 1993 and 1992, counterparties held options under which the Corporation can be caused to execute interest rate swaps associated with interest payments through 1999 on $500 million and $625 million, respectively. (c) The Corporation will reset interest rates at the end of the initial and each subsequent interest period. At each interest rate-reset date, the Corporation may redeem notes in whole or in part at its option. Current interest periods range from March 1994 to May 1996. (d) The rate of interest payable on each note is a variable rate based on the commercial paper rate each month. Interest is payable at the option of the Corporation either monthly or semiannually. (e) At December 31, 1993 and 1992, subordinated notes in the amount of $697 million were guaranteed by GE Company. Long-term borrowing maturities during the next five years, including the current portion of notes payable after one year, are: 1994, $5,823 million; 1995, $4,620 million; 1996, $3,023 million; 1997, $3,253 million; and 1998, $872 million. Interest and discount expense on the Condensed Statement of Current and Retained Earnings is net of interest income on loans and advances to majority owned affiliates of $1,335 million, $1,223 million and $1,187 million for 1993, 1992 and 1991, respectively. EXHIBIT 4 (iii) March 22, 1994 Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Subject: General Electric Capital Corporation Annual Report on Form 10-K for the fiscal year ended December 31, 1993 -- File No. 1-6461 Dear Sirs: Neither General Electric Capital Corporation (the "Corporation") nor any of its subsidiaries has outstanding any instrument with respect to its long-term debt under which the total amount of securities authorized exceeds 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. In accordance with paragraph (b) (4) (iii) of Item 601 of Regulation S-K (17 CFR sec.229.601), the Corporation hereby agrees to furnish to the Securities and Exchange Commission, upon request, a copy of each instrument which defines the rights of holders of such long-term debt. Very truly yours, GENERAL ELECTRIC CAPITAL CORPORATION By: /s/ J. A. PARKE --------------------------------- J. A. Parke, Senior Vice President, Finance EXHIBIT 12(a) GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES EXHIBIT 12(b) GENERAL ELECTRIC CAPITAL CORPORATION AND CONSOLIDATED AFFILIATES COMPUTATION OF RATIO OF EARNINGS TO COMBINED FIXED CHARGES AND PREFERRED STOCK DIVIDENDS EXHIBIT 23(ii) To the Board of Directors General Electric Capital Corporation We consent to incorporation by reference in the Registration Statements on Form S-3 (Nos. 33-22974, 33-24667, 33-36601, 33-37156, 33-39376, 33-43081, 33-43420, 33-39596, 33-58506, 33-50909, 33-58508 and 33-50899) of General Electric Capital Corporation of our report dated February 11, 1994, relating to the statement of financial position of General Electric Capital Corporation and consolidated affiliates as of December 31, 1993 and 1992 and the related statements of current and retained earnings and cash flows and related schedules 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 General Electric Capital Corporation. Our report refers to a change in 1993 in the method of accounting for certain investments in securities. /s/ KPMG PEAT MARWICK Stamford, Connecticut March 23, 1994 EXHIBIT 24 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each of the undersigned, being directors and/or officers of General Electric Capital Corporation, a New York corporation (the "Corporation"), hereby constitutes and appoints Gary C. Wendt, James A. Parke, John P. Malfettone and Burton J. Kloster, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead in any and all capacities, to sign one or more Annual Reports for the Corporation's fiscal year ended December 31, 1993, on Form 10-K under the Securities Exchange Act of 1934, as amended, or such other form as such attorney-in-fact may deem necessary or desirable, any amendments thereto, and all additional amendments thereto in such form as they or any one of them may approve, and to file the same with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done to the end that such Annual Report or Annual Reports shall comply with the Securities Exchange Act of 1934, as amended, and the applicable Rules and Regulations of the Securities and Exchange Commission adopted or issued pursuant thereto, as fully and to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them or their or his substitute or resubstitute, may lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, each of the undersigned has hereunto set his hand this 23rd day of March, 1994. /s/ JOHN P. MALFETTONE --------------------------------------------- John P. Malfettone, Vice President and Comptroller (Principal Accounting Officer) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. A majority of the Board of Directors EXHIBIT INDEX

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1993

29082

ITEM 1. BUSINESS The Walt Disney Company, together with its subsidiary companies (the "Company"), is a diversified international entertainment company with operations in three business segments: Theme Parks and Resorts, Filmed Entertainment and Consumer Products. Information on revenues, operating income, identifiable assets and supplemental revenue data of the Company's business segments appears in the Consolidated Statement of Income and in Note 13 of the Notes to Consolidated Financial Statements included in Item 8 hereof. The Company employs approximately 62,000 people. THEME PARKS AND RESORTS The Company operates the Walt Disney World(R) destination resort in Florida and the Disneyland(R) theme park and Disneyland Hotel in California. The Company earns royalties on revenues generated by the Tokyo Disneyland theme park. All of the theme parks and most of the associated resort facilities are operated on a year-round basis. Historically, the greater part of their business is in the spring and summer seasons, with other peak periods during Christmas, Easter and other holidays. WALT DISNEY WORLD DESTINATION RESORT The Walt Disney World destination resort is located on approximately 29,000 acres of land owned by the Company 15 miles southwest of Orlando, Florida. The resort includes three theme parks: the Magic Kingdom, Epcot Center and the Disney-MGM Studios Theme Park; hotels and villas, an entertainment complex, a shopping village, conference centers, campgrounds, golf courses, water parks and other recreational facilities designed to attract visitors for an extended stay. The Company markets the entire Walt Disney World destination resort through a variety of national and local advertising and promotional activities. A number of attractions in each of the theme parks are sponsored by corporate participants through long-term participation agreements. The Magic Kingdom - The Magic Kingdom, which opened in 1971, consists of seven principal areas: Main Street, Liberty Square, Frontierland, Tomorrowland, Fantasyland, Adventureland and Mickey's Starland. These areas feature themed rides and attractions, restaurants, refreshments stands and merchandise shops. Epcot Center - Epcot Center, which opened in 1982, consists of two major themed areas: Future World and World Showcase. Future World dramatizes certain historical developments and addresses the challenges facing the world today through major pavilions featuring energy, communication, transportation, imagination, life and health, the land and seas. World Showcase presents a community of nations focusing on the culture, traditions and accomplishments of people around the world. World Showcase includes as a central showpiece the American Adventure pavilion, which highlights the history of the American people. Other nations represented are Canada, Mexico, Japan, China, France, the United Kingdom, Germany, Italy, Morocco and Norway. Both areas feature restaurants, refreshments stands and merchandise shops. The Disney-MGM Studios Theme Park - The Disney-MGM Studios Theme Park opened in 1989 and consists of a theme park and a production facility. The theme park portion of the project is centered around Hollywood as it was during the 1930's and 1940's and features a backstage tour of the production facilities in addition to themed food service and merchandise facilities and other attractions. The production facility portion of the park consists of three sound stages, shops and a back lot area. Both feature film and television productions are currently taking place. Resort Facilities - As of September 30, 1993, the Company owned and operated nine resort hotels and a complex of villas and suites at the Walt Disney World destination resort, with a total of approximately 10,000 rooms. Recreational activities include five championship golf courses, a zoological park, tennis, sailing, water skiing, swimming, horseback riding and a number of noncompetitive sports and leisure time activities. Several of the resort hotels contain conference centers and related facilities. In addition, Disney's Fort Wilderness camping and recreational area has approximately 1,200 sites and a water park, River Country. Two additional resort hotels, Disney's Wilderness Lodge and Disney's All-Star Sports Resort, are expected to open in 1994 with a combined capacity of more than 2,600 rooms. The occupancy rates for the Company's resort hotels and villas and Disney's Fort Wilderness are significantly higher than industry averages. The Company has also developed approximately 1,200 acres known as Disney Village Marketplace, which includes the Disney Village Resort, a shopping facility, a complete clubhouse facility and a conference center. Pleasure Island, an evening entertainment center which opened in 1989, is adjacent to Disney Village Marketplace and includes restaurants, night clubs and shopping facilities. Near Pleasure Island is Typhoon Lagoon, a themed water park. At Disney Village Marketplace Hotel Plaza, seven independently operated hotels are situated on property leased from the Company. These hotels have a capacity of approximately 3,700 rooms. Additionally, two hotels -- the Walt Disney World Swan and the Walt Disney World Dolphin, with an aggregate capacity of approximately 2,300 rooms -- are operated on property leased from the Company near Epcot Center. DISNEY VACATION CLUB Sales have commenced and construction is continuing on a 529-unit Disney Vacation Club at Lake Buena Vista. In addition, during 1993, the Company acquired property in Vero Beach, Florida on which it plans to construct a 120- room inn and 60 time-share vacation villas. Both facilities are intended to be sold under a vacation ownership plan and be operated partially as rental property until the units are completely sold. The Company is also exploring development opportunities at a hotel site recently acquired near St. Tropez in the south of France. DISNEYLAND PARK The Company owns 330 acres and has under long-term lease an additional 39 acres of land in Anaheim, California. Disneyland Park, which opened in 1955, consists of eight principal areas: Toontown, Fantasyland, Adventureland, Frontierland, Tomorrowland, New Orleans Square, Main Street and Critter Country. Each of these areas features themed rides and attractions, restaurants, refreshment stands and merchandise shops. A number of the Disneyland Park attractions are sponsored by corporate participants. The Company markets new attractions as well as the entire Disneyland Park through national and local advertising and promotional activities. The Company owns and operates the 1,100-room Disneyland Hotel near Disneyland Park. TOKYO DISNEYLAND The Company earns royalties on certain revenues generated by the Tokyo Disneyland theme park, which is owned and operated by Oriental Land Co., Ltd., an unrelated Japanese corporation, pursuant to a license agreement between Oriental Land Co., Ltd. and the Company. The park, which opened in 1983, is similar in size and concept to Disneyland Park and is located approximately six miles from downtown Tokyo, Japan. DISNEY DESIGN AND DEVELOPMENT Disney Design and Development, encompassing the Company's two major design and development organizations, Walt Disney Imagineering and Disney Development Company, provides master planning, real estate development, attraction and show design, engineering support, production support, project management and research and development services for the Company's operations. COMPETITIVE POSITION The Company's theme parks and resorts compete with all other forms of entertainment, lodging, tourism and recreational activities. The profitability of the leisure-time industry is influenced by various factors which are not directly controllable, such as economic conditions, amount of available leisure time, oil and transportation prices and weather patterns. The Company believes its theme parks and resorts benefit substantially from the Company's reputation in the entertainment industry for excellent quality and from synergy with activities in other business segments of the Company. FILMED ENTERTAINMENT The Company produces live-action and animated motion pictures for distribution to the theatrical, television and home video markets. The Company also produces original television programming for the network and first-run syndication markets. The Company provides programming for and operates The Disney Channel, a pay television programming service, and KCAL-TV, a Los Angeles, California television station. THEATRICAL FILMS Walt Disney Pictures and Television, a wholly-owned subsidiary of the Company, produces and acquires live-action motion pictures that are distributed under the names Walt Disney Pictures, Touchstone Pictures and Hollywood Pictures. In addition, the Company distributes films acquired by Miramax Film Corp. ("Miramax"), which was purchased in 1993, as well as films produced or acquired by Caravan Pictures, Cinergi Productions, Interscope Communications and Merchant-Ivory Productions. The Company also produces animated motion pictures under the name Walt Disney Pictures. The Company plans to distribute approximately 60 feature films each year under the total Walt Disney Company banner. The Company seeks to produce several live-action family feature films each year and one to two full-length animated films every twelve months under the Walt Disney Pictures name, together with fifteen to twenty teenage and adult films each year under each of the Touchstone Pictures and Hollywood Pictures names. The Company expects that Miramax will acquire and produce up to 20 films per year. In addition, the Company periodically reissues animated films from the Company's library. The Company's film library at September 30, 1993 included 257 full-length live action (primarily color) features, 32 full-length animated color features and approximately 536 cartoon shorts. The Company distributes its filmed products through its own distribution and marketing companies in the United States and most foreign markets. HOME VIDEO The Company distributes directly home video releases from each of its studios in the domestic market. In the international market, the Company distributes both directly and through foreign distribution companies. As of September 30, 1993, approximately 384 titles, including 177 feature films and 207 cartoon and animated features, were available to the home entertainment market. NETWORK TELEVISION The Company's network television operation develops, produces and distributes television programming to network and other broadcasters, under the Touchstone Television and Walt Disney Television labels. Program development is carried out in collaboration with a number of independent writers, producers and creative teams under exclusive development arrangements. Since 1991, the Company has focused on the development, production and distribution of half-hour comedies for network prime-time broadcast, including such series as Home Improvement, Empty Nest, Blossom and Dinosaurs. The Company seeks to syndicate in the domestic market those series that produce enough programs to permit syndicated "strip" broadcasting on a five-days-per-week basis. The Company licenses television series developed for United States networks in a number of foreign markets, including Canada, Italy, the United Kingdom, Spain, Germany and Australia. Walt Disney Television currently distributes two animated cartoon series for Saturday morning: The Little Mermaid and Marsupilami. The Company also offers a variety of prime-time specials for exhibition on network television. The Company believes that its television programs complement the marketing and distribution of its theatrical motion pictures, the Walt Disney World destination resort, Disneyland Park and other businesses. PAY TELEVISION AND TELEVISION SYNDICATION The Company licenses a number of feature films to pay television services, including its wholly-owned subsidiary, The Disney Channel. The Company's subsidiary, Buena Vista Television, licenses the theatrical and television film library to the domestic television syndication market. Major packages of the Company's feature films and television programming have been licensed for broadcast and basic cable continuing over several years. PAY TELEVISION AND TELEVISION SYNDICATION (CONT.) The Company currently licenses its feature films for pay television on an output basis in several geographic markets, including the United Kingdom and Scandinavia, and has an arrangement with Showtime through 1996 for the United States. In 1993, the Company entered into an agreement to license to the Encore pay television service, over a multi-year period, exclusive domestic pay television rights to Miramax films beginning in 1994 and Touchstone Pictures and Hollywood Pictures films starting in 1997. The Company also produces first-run syndication programming, including Siskel & Ebert, a weekly half-hour motion picture review program; The Crusaders, a weekly one-hour investigative news show; Countdown at the Neon Armadillo, a weekly half-hour country and western dance review; Bill Nye, The Science Guy, a weekly half-hour educational program for children; Goof Troop, Darkwing Duck, Bonkers, DuckTales and Tail Spin, all of which are animated cartoon series airing five days a week; and Live with Regis and Kathie Lee, a one-hour daily talk show. Certain of the Company's television programs are also syndicated by the Company abroad, including The Disney Club, a weekly series that the Company produces for foreign markets. The Company's television programs are telecast regularly in many countries, including Australia, Brazil, Canada, China, France, Germany, Italy, Japan, Mexico, Spain and the United Kingdom. THE DISNEY CHANNEL The Disney Channel, which has more than 7 million subscribers, is the Company's nationwide pay television programming service. New shows developed solely for original use by The Disney Channel include dramatic, adventure, comedy and educational series, as well as documentaries and first-run television movies. In addition, entertainment specials include shows originating from both the Walt Disney World destination resort and Disneyland Park. The balance of the programming consists of products acquired from third parties and products from the Company's theatrical film and television programming library. KCAL-TV The Company operates KCAL-TV, a commercial station on VHF channel 9 in the Los Angeles area. Its revenues are derived from the sale of advertising time to local, regional and national advertisers. COMPETITIVE POSITION The Company's filmed entertainment businesses (including theatrical films, product distributed through the network, syndication and pay television and home video markets, and The Disney Channel's pay television programming service) compete with all forms of entertainment. The Company also competes to obtain creative talents, story properties, advertiser support, broadcast rights and market share, which are essential to the success of all of the Company's filmed entertainment businesses. A significant number of companies produce and/or distribute theatrical and television films, exploit products in the home video market and provide pay television programming service. The Company produces and distributes films designed for family audiences and believes that it is a significant source of such films. The success of all the Company's theatrical motion pictures and television programming is heavily dependent upon public taste, which is unpredictable and subject to change without warning. CONSUMER PRODUCTS The Company licenses the name Walt Disney, as well as the Company's characters, visual and literary properties and songs and music, to various consumer manufacturers, retailers, show promoters and publishers throughout the world. The Company also engages in direct retail distribution through The Disney Stores and four consumer catalogs, and is a publisher of books, magazines and comics in the United States and Europe. In addition, the Company produces audio and computer software for all markets, as well as film and video products for the educational marketplace, and sells educational toys, play equipment and classroom furniture for children. MERCHANDISING AND PUBLICATIONS LICENSING The Company's domestic and foreign licensing activities generate royalties which are usually based on a fixed percentage of the wholesale or retail selling price of the licensee's products. Merchandise categories which have been licensed include apparel, watches, toys, gifts, housewares, stationery, sporting goods and domestic items such as sheets and towels. Publication categories which have been licensed include continuity-series books, book sets, art and picture books, magazines and newspaper comic strips. In addition to receiving licensing fees, the Company is actively involved in the development and approval of licensed merchandise and in the conceptualization, development, writing and illustration of licensed publications. The Company continually seeks to create new characters to be used in licensed products. PUBLISHING The Company has continued to expand its publishing activities in many parts of the United States and Europe. It has book imprints in the United States offering trade books for children (Disney Press and Hyperion Books for Children) and adults (Hyperion Press). In addition, the Company is a joint venture partner in Disney Hachette Editions, which produces children's books, and Disney Hachette Presse, which produces children's magazines and computer software magazines in France. In the United States, Italy and France, the Company publishes comic magazines for children. The Company also publishes the magazine for children Disney Adventures, the general science magazine Discover and the family entertainment magazine FamilyFun. THE DISNEY STORES The Company markets Disney-related products directly through its retail facilities operated under "The Disney Store" name. These facilities are generally located in leading shopping malls and similar retail complexes. The stores carry a wide variety of Disney merchandise and promote other businesses of the Company. During fiscal 1993 the Company opened 48 new Disney Stores in the United States and Canada, 9 in Europe and 5 in Japan, bringing the total number to 239 as of September 30, 1993. The Company expects to open additional stores in the future in selected markets throughout the country, as well as in Japan and other European, Asian and Latin American countries. AUDIO PRODUCTS AND MUSIC PUBLISHING The Company produces and distributes records, audio cassettes and compact discs for the children's markets in the United States and France and licenses the creation of similar products throughout the rest of the world. The Company publishes printed music exploiting the song copyrights created for the Company's records, film and television programs and develops new songs. Domestic retail sales of records, audio cassettes and related materials are the largest source of revenues, while direct marketing, which utilizes catalogs, coupon packages and television, is a secondary means of distribution for the Company. In both the United States and abroad, the Company signs, produces and promotes entertainers primarily for the children's market. OTHER ACTIVITIES The Company is a direct marketer of children's educational toys, play equipment, classroom furniture and activewear apparel through The Disney Catalog, Childcraft, Just for Kids and Playclothes. The Company produces audiovisual materials for the educational market, including videocassettes and film strips. It also licenses the manufacture and sale of posters and other teaching aids. The Company markets and distributes, through various channels, animation cel art and other animation-related artwork. In addition, the Company licenses the manufacture of software products for video game machines and publishes its own software programs for personal computers in the areas of entertainment, creativity and children's programs. COMPETITIVE POSITION The Company competes in its character merchandising and other licensing, publishing and retail activities with other licensors, publishers and retailers of character, brand and celebrity names, as well as entertainment and other licensed properties. In the record and music publishing business the Company competes with several other companies. Although public information is limited, the Company believes it is the largest worldwide producer/distributor of children's audio products, as well as the largest licensor of character- based merchandise in the world. HOLLYWOOD RECORDS The Company formed Hollywood Records in 1990 to develop and market recordings from new talent across the spectrum of popular music, as well as soundtracks from the Company's live-action motion pictures. Current artists include Yothu Yindi, Brian May (of Queen) and Brian Setzer (formerly of The Stray Cats). During 1990, the Company signed Queen, a group known worldwide since the 1970's, and acquired the U.S. and Canadian distribution rights to their 16-album catalog. In 1993, the North American rights to release material from The Dave Clark Five catalog, a 1960's British pop act, were also acquired. Distribution is handled by Elektra Entertainment, a division of Warner Communications, Inc. Hollywood Records competes in its audio business with other record labels for talent and exposure of its product. Many of its competitors are substantially larger than Hollywood Records, with greater financial resources, larger catalogues and rosters of well known and previously successful talent. The success of its products is dependent upon public taste, which is unpredictable, and upon the division's success in attracting talent. DISNEY SPORTS ENTERPRISES The Company formed Disney Sports Enterprises in 1993 to provide management and development services for the Company's National Hockey League franchise, the Mighty Ducks of Anaheim. Most of its competitors in the National Hockey League are established franchises that include rosters of well-known and previously successful talent. The Company also competes with all forms of entertainment and other sports franchises to obtain advertiser support, broadcast rights and creative talents which are essential to the success of the franchise. EURO DISNEY The Euro Disney Resort is located on a 4,800-acre site at Marne-la-Vallee, approximately 20 miles east of Paris, France. The project is being developed pursuant to a 1987 master agreement with French governmental authorities by Euro Disney S.C.A., a publicly held French company in which the Company holds a 49% equity interest and which is managed by a subsidiary of the Company. The project's first phase involved the construction of the Euro Disneyland theme park, which opened in April 1992. The park draws on a number of European traditions in its five themed lands. Six themed hotels, with a total of approximately 5,200 rooms, are part of the resort complex, together with an entertainment center with a variety of retail, dining and show facilities and a 595-space camping site. The complex is served by direct rail transport to Paris and, beginning in 1994, by high-speed TGV train service. The Company receives royalties with respect to various intellectual property rights licensed by the Company to Euro Disney S.C.A. in connection with the project. In addition, the subsidiary of the Company that manages Euro Disney S.C.A. earns management fees based on the revenues and incentive fees based on cash flows of Euro Disney S.C.A. The Company agreed to defer its base management fees relating to 1992 and 1993. Repayment of the deferred amount will be contingent upon Euro Disney attaining profitability. (See Management's Discussion and Analysis on page 13 for further information.) ITEM 2. ITEM 2. PROPERTIES The Walt Disney World destination resort, Disneyland Park and other California and Florida properties are described in Item 1 under the caption Theme Parks and Resorts. Film library properties are described in Item 1 under the caption Filmed Entertainment. The Company owns approximately 51 acres of land in Burbank, California on which are located its studios and executive offices. The studio facilities are used for the production of both live-action and animated motion pictures and television products. In addition, the Company leases office and warehouse space for certain of its studio and corporate activities. The Company's KCAL- TV facilities are located in Hollywood, California. It is the Company's practice to obtain United States and foreign legal protection for its theatrical and television product and its other original works, including the various names and designs of the animated characters and the publications and music which have been created in connection with the Company's filmed products. The Company owns all rights to the name, likeness and portrait of Walt Disney. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company, together with, in some instances, certain of its directors and officers, is a defendant or co-defendant in various legal actions involving copyright, breach of contract and various other claims incident to the conduct of its businesses. Management does not expect the Company to suffer any material liability by reason of such actions. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of stockholders during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE COMPANY The executive officers of the Company are elected each year at the organizational meeting of the Board of Directors which follows the annual meeting of the stockholders and at such other meetings as appropriate. Each of the executive officers has been employed by the Company in the position or positions indicated in the list and pertinent notes below. Messrs. Eisner, Wells, Disney, Murphy and Shapiro have been employed by the Company as executive officers for more than five years. At September 30, 1993, the executive officers were as follows. - -------- /1/ Mr. Litvack joined the Company as Senior Vice President-General Counsel in 1991. He was named to his present position in 1992. Mr. Litvack was previously a member of the executive committee and chairman of the litigation department of the law firm of Dewey Ballantine, of which he was a partner from January 1987 until April 1991. Prior to that, Mr. Litvack was a partner in the law firm of Donovan Leisure Newton & Irvine, serving as chairman of the executive committee from 1983 until December 1986. /2/ Mr. Nanula joined the Company's strategic planning operation in 1986 and was named Vice President-Treasurer of the Company in January 1990. He was named to his present position in August 1991. /3/ Mr. Garand was previously Senior Vice President and Chief Financial Officer for Morse Shoe, Inc. from April 1990 until March 1992. Prior to that, Mr. Garand served in various positions at the corporate and subsidiary offices of PepsiCo, Inc. from 1981 until March 1990. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's common stock is listed on the New York, Pacific, Swiss and Tokyo stock exchanges (NYSE symbol DIS). The following sets forth the high and low composite sale prices for the fiscal periods indicated, adjusted to reflect the four-for-one split of the common stock effective April 20, 1992. The Company declared one quarterly dividend of $.0525 per share and three quarterly dividends of $.0625 per share in 1993, and in 1992 declared one quarterly dividend of $.04375 per share and three quarterly dividends of $.0525. As of September 30, 1993, the approximate number of record holders of the Company's common stock was 408,000. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (In millions, except per share data) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OPERATIONS 1993 vs. 1992: Revenues increased in 1993 by 14% to $8.5 billion from 1992 levels. The increase resulted primarily from successful domestic home video releases, increased international theatrical distribution activities, the continued expansion of The Disney Stores worldwide and increased licensing activities. Revenues of $1.8 billion from foreign operations in all business segments increased by 25% and represented 21% of total revenues, an increase of 2 percentage points over 1992. Operating income for 1993 increased by 20% to $1.7 billion from $1.4 billion in 1992. The increase was due to the successful domestic and international home video and international theatrical release of Beauty and the Beast, the strong worldwide theatrical release of Aladdin, the domestic home video release of Pinocchio and greater product availabilities in pay television and worldwide television syndication. Theme Parks and Resorts operating income grew as a result of increased domestic theme park per capita spending and higher occupied rooms at the Florida resorts together with increased sales at the Disney Vacation Club and higher royalties from Tokyo Disneyland. Consumer Products results primarily reflected increased demand for Disney licensed products in worldwide markets. Income and earnings per share before the cumulative effect of accounting changes in 1993 (described below) decreased 18% to $671.3 million and 19% to $1.23, respectively, from $816.7 million and $1.52 in 1992. The decrease reflects the impact of a charge of $350.0 million to fully reserve the Company's current receivables and funding commitment to Euro Disney and the Company's equity share of Euro Disney's operating loss. (See Note 3 to Consolidated Financial Statements.) The Company's 1993 net income and earnings per share were significantly impacted by the change in accounting method for pre-opening costs and the impact of adoption of two new required Statements of Financial Accounting Standards, Employers' Accounting for Postretirement Benefits Other Than Pensions (SFAS 106) and Accounting for Income Taxes (SFAS 109). The cumulative effect of the change in accounting method for pre-opening costs resulted in a charge of $271.2 million or $.50 per share. In addition, the cumulative effect of adopting SFAS 106 was a charge of $130.3 million or $.24 per share, partially offset by the $30.0 million or $.06 per share benefit from adopting SFAS 109. (See Notes 1, 7, 8 and 12 to Consolidated Financial Statements.) Net income after the cumulative effect of accounting changes in 1993 decreased by 63% to $299.8 million from $816.7 million in 1992 and earnings per share fell 64% from $1.52 to $.55. 1992 vs. 1991: In 1992, the Company generated a record $7.5 billion in revenues, an increase of 23% over 1991. The increase was driven by strong performance in all three of the Company's business segments: successful home video and theatrical releases, higher theme park attendance and resort occupancy and increased merchandise licensing. Foreign-sourced revenues of $1.5 billion accounted for 19% of total revenues compared with 21% or $1.3 billion in 1991. Operating income increased 31% to $1.4 billion from $1.1 billion in 1991. The increase resulted primarily from the success of home video release of library product and strong performances from certain theatrical releases. Consumer Products operating income grew as a result of continued demand for Disney licensed products in worldwide markets and the expansion of the Company's publishing business in Europe. Theme Parks and Resorts results reflected increased park attendance and sharply higher occupied room nights at the Florida resorts. Net income for 1992 increased to $816.7 million or 28% over 1991 while earnings per share of $1.52 increased 27% over the $1.20 reported in 1991. (Earnings per share amounts reflected the Company's four-for-one stock split in April 1992.) (See Note 9 to Consolidated Financial Statements.) THEME PARKS AND RESORTS 1993 vs. 1992: Revenues for 1993 of $3.4 billion were 4% higher than 1992. This increase was primarily attributable to higher per capita spending at the theme parks and the increased number of occupied rooms at the Florida resorts. Total attendance was flat with the prior year, as the impact of the opening of Mickey's Toontown at Disneyland and the Splash Mountain attraction at Tokyo Disneyland was offset by weakness in the international tourism market at Walt Disney World due to the poor European economy. Per capita spending was higher than the prior year period due to price increases. The increase in occupied rooms resulted from the absorption of additional capacity from the Dixie Landings resort. Operating income of $746.9 million in 1993 was 16% higher than the $644.0 million generated in the prior year. The increase was driven by increased per capita spending at the parks, the increased number of occupied rooms and higher room rates at the Florida resorts and continued development and sales of ownership interests at the Disney Vacation Club. Decreased current year development spending at Walt Disney Imagineering and increased royalties at Tokyo Disneyland also contributed to higher operating income. Year-over-year comparisons were also positively impacted by the prior-year charge relating to the termination of the lease on the Queen Mary hotel and attraction. 1992 vs. 1991: Revenues of $3.3 billion increased 18% from $2.8 billion in 1991. Results reflected increased theme park attendance and higher per capita spending primarily due to price increases. An increase in occupied room nights at the Florida resorts, primarily due to additional capacity from the opening of the 1,008-room Port Orleans resort in May 1991 and the 2,048-room Dixie Landings resort in February 1992, also contributed to the increase in revenues. Operating income increased 18% to $644.0 million from the $546.6 million achieved in the prior year. Increased attendance, driven by the 20th Anniversary Celebration at the Magic Kingdom in the Walt Disney World Resort, sharply higher occupied room nights and increased resort occupancy, contributed to the increase in 1992. Partially offsetting these results were higher design and development costs. Additionally, results reflected a charge relating to the termination of the lease on the Queen Mary hotel and attraction and expenses for the 20th Anniversary Celebration. 1992 attendance at Tokyo Disneyland did not change significantly from 1991 levels. FILMED ENTERTAINMENT 1993 vs. 1992: Revenues of $3.7 billion were 18% higher and operating income of $622.2 million was 22% higher in 1993 than the $3.1 billion and the $508.3 million, respectively, reported in 1992. Operating income benefited primarily from the growth in home video and international theatrical and television distribution. Successful home video releases in 1993 included Beauty and the Beast and Pinocchio domestically and Beauty and the Beast and Cinderella internationally. Theatrical revenues and operating income in 1993 were driven by the worldwide release of Aladdin (excluding Europe) and the international release of Beauty and the Beast, Sister Act and The Jungle Book, offset by the disappointing domestic theatrical performances of certain live-action releases. Pay television and worldwide syndication revenues and operating income were also higher, reflecting increased activity as more product was made available to those markets. Results also included the positive impact of continued growth in The Disney Channel subscriber base. 1992 vs. 1991: Revenues of $3.1 billion increased 20% from $2.6 billion in 1992, reflecting the worldwide success of the Company's animated products in home video, theatrical and television markets. Significant home video sell- through releases in 1992 included Fantasia worldwide and 101 Dalmatians, The Rescuers and The Great Mouse Detective domestically. Theatrical revenues in 1992 were driven by the worldwide release of Beauty and the Beast, Father of the Bride and The Hand That Rocks the Cradle. Also included were the successful releases of Sister Act domestically and Rescuers Down Under and Snow White internationally. Domestic television revenues reflected the continued growth in network television and syndication. Operating income increased 60% to $508.3 million from the $318.1 million generated in the prior year. Results benefited primarily from the success of the home video release of the library titles Fantasia and 101 Dalmatians. Library titles generate higher operating margins because most production and distribution costs have already been amortized. Improved domestic theatrical results reflected the successes of Beauty and the Beast, Sister Act and The Hand That Rocks the Cradle. Higher domestic syndication television sales and continuing subscriber growth at The Disney Channel also contributed to the growth in operating income. Partially offsetting these results were the disappointing domestic theatrical performances of certain other live-action releases. CONSUMER PRODUCTS 1993 vs. 1992: Revenues of $1.4 billion were 31% higher than the $1.1 billion generated in 1992. Increased revenues reflected the impact of the worldwide expansion of The Disney Stores from 177 to 239 in 1993 and substantial same store sales increases, combined with higher revenues in domestic licensing, publications and records and audio entertainment. Licensing activity in Europe and the Asia/Pacific region, in addition to increased catalog circulation, also contributed to the growth. Operating income of $355.4 million was 26% greater than the $283.0 million generated in the prior year. Strong sales of Aladdin and Beauty and the Beast merchandise contributed to the growth in operating income generated by domestic publications, records and audio entertainment and The Disney Stores domestically. Additionally, increased sales of both film and standard character properties contributed to the favorable results in domestic and international licensing. Start-up costs associated with international expansion of The Disney Stores negatively impacted results. 1992 vs. 1991: Revenues of $1.1 billion increased 49% from $724.0 million in 1991. At September 30, 1992, there were 177 Disney Stores compared to 113 a year earlier. The expansion of The Disney Stores, together with the continued strength of domestic licensed product sales in apparel, toys and publications and growth in European businesses, contributed significantly to the increase in worldwide revenues. Operating income increased 23% to $283.0 million from the $229.8 million generated in the prior year. Strong sales of The Little Mermaid, 101 Dalmatians and Beauty and the Beast merchandise contributed to the growth in operating income in 1992. As expected, operating margins declined, reflecting further expansion into lower margin businesses of direct publishing, catalog merchandising and The Disney Stores. Start-up costs associated with new initiatives in publishing negatively impacted results. CORPORATE ACTIVITIES GENERAL AND ADMINISTRATIVE EXPENSES 1993 vs. 1992: General and administrative expenses for 1993 were $164.2 million, representing an 11% increase from the 1992 total of $148.2 million. While Corporate general and administrative expenses remained virtually flat, the increase reflected higher operating losses at Hollywood Records in contrast to the prior year which reflected the success of the Queen catalog. 1992 vs. 1991: General and administrative expenses for 1992 were $148.2 million, representing an 8% decrease from the 1991 total of $160.8 million. The decrease reflected reduced operating losses at Hollywood Records due to the success of the Queen catalog. INVESTMENT AND INTEREST INCOME AND INTEREST EXPENSE 1993 vs. 1992: Total investment and interest income for 1993 was $186.1 million, representing a 43% increase over the 1992 total of $130.3 million. The increase reflected higher investment balances, gains on termination of interest rate swap agreements and the favorable impact of leveraged leasing activities in the current year. Interest expense increased 24% to $157.7 million in 1993, primarily due to the write-off of unamortized issuance costs on the Company's subordinated notes (which were redeemed during the year) and higher average borrowing balances, partially offset by the impact of lower average rates. The average borrowing rate decreased from 7.2% in 1992 to 6.9% in 1993. Capitalized interest, which reduces interest expense, was flat compared to the prior year. 1992 vs. 1991: Total investment and interest income for 1992 was $130.3 million, representing a 9% increase over the 1991 total of $119.4 million. The increase reflected the favorable impact of interest rate swaps and leveraged leasing activities in the current year, partially offset by prior year gains on sales of certain marketable securities. Interest expense increased 21% to $126.8 million in 1992, primarily due to increased average borrowings. The average borrowing rate increased from 6.5% in 1991 to 7.2% in 1992. Capitalized interest, which reduces interest expense, decreased in 1992 due to the lower average balances on projects in progress, also contributing to the higher level of interest expense. INVESTMENT IN EURO DISNEY 1993 vs. 1992: For the year, the Company's investment in Euro Disney resulted in a loss of $514.7 million, including the charge referred to below, after being partially offset by royalties and gain amortization related to the investment. The operating results of Euro Disney were lower than expected due in part to the European recession affecting Euro Disney's largest markets. Euro Disney, its principal lenders and the Company are exploring a financial restructuring for Euro Disney. Throughout 1994, Euro Disney will require significant funding. The Company has agreed to help fund Euro Disney for a limited period, to afford Euro Disney time to attempt a financial restructuring, by spring 1994. Should the financial restructuring not be completed, Euro Disney would face a liquidity problem. The operating results for the fourth quarter and the year, and the need for a financial restructuring, created uncertainty regarding the Company's ability to collect its current receivables and the funding commitment to Euro Disney. Because of this, the Company recorded a charge of $350.0 million in the fourth quarter to fully reserve its current receivables and funding commitment. In 1992, the Company's investment in Euro Disney contributed income of $11.2 million. Although Euro Disney incurred a loss for 1992, the Company's 49% share of the net loss was offset by royalties and gain amortization related to its investment. 1992 vs. 1991: The Euro Disney resort, under construction since 1987, commenced operations on April 12, 1992. The Company's investment in Euro Disney contributed income of $11.2 million in 1992 compared to income from the investment of $63.8 million in 1991. Although Euro Disney incurred a loss for fiscal 1992, the Company's equity share of the net loss was offset by royalties and gain amortization related to its investment. Income from the investment in 1991 represented the Company's equity share of interest earnings and gain amortization. LIQUIDITY AND CAPITAL RESOURCES The Company generates significant cash from operations. Cash flow from operating activities amounted to $2.1 billion in 1993, an increase of 17% over 1992. In addition, during fiscal 1993, the Company raised approximately $400 million from the issuance of senior participating notes with interest partially tied to the performances of live-action feature films, $300 million from the issuance of 100-year senior debentures and $231 million from the issuance of medium-term notes. In 1993, the Company used $1 billion of funds to redeem the Company's zero coupon subordinated notes and $173 million of funds to settle matured medium- term notes. In addition, the Company used $794 million to further develop the theme parks and new resort properties, primarily construction in process on Disney's Wilderness Lodge, Disney's All Star Resorts and the Twilight Zone Tower of Terror attraction at Walt Disney World and completion of Mickey's Toontown at Disneyland. The Company also used $1.3 billion of funds in development and production of film and television properties. In previous years, a portion of the funding for film production was generated by off- balance-sheet financing. The Company's financial condition remains strong and the Company has the resources necessary to meet future anticipated funding requirements. In addition to cash flow from operations, the Company has sufficient unused debt capacity, including an unused $300 million line of credit, to finance its ongoing capital investment program and to take advantage of internal and external development and acquisition opportunities. In order to reduce the Company's exposure to risks from foreign currency and interest rate fluctuations, management has adopted an extensive hedging program and it continually monitors the status of its hedging activities. (See Notes 1, 2 and 5 to Consolidated Financial Statements.) ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Index to Financial Statements and Supplemental Data on page 20. 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 Information regarding directors appearing under the caption Election of Directors in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders (the "1994 Proxy Statement") is hereby incorporated by reference. Information regarding executive officers is included in Part I of this Form 10-K as permitted by General Instruction G(3). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information appearing under the captions Directors' Remuneration; Attendance and Executive Compensation in the 1994 Proxy Statement is hereby incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information setting forth the security ownership of certain beneficial owners and management appearing under the caption Stock Ownership of Certain Beneficial Owners and Stock Ownership of Directors and Executive Officers in the 1994 Proxy Statement is hereby incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain related transactions appearing under the caption Related Transactions in the 1994 Proxy Statement is hereby incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)Exhibits and Financial Statements and Schedules (1)Financial Statements and Schedules See Index to Financial Statements and Supplemental Data at page 20. (2)Exhibits 3(a) Restated Certificate of Incorporation of the Company, filed as Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended September 30, 1992, is hereby incorporated by reference. 3(b) Bylaws of the Company, as amended, filed as Exhibit 3(b) to the Company's Annual Report on Form 10-K for the year ended September 30, 1992, is hereby incorporated by reference. 4(a) Rights Agreement, dated as of June 21, 1989, between the Company and Security Pacific National Bank, as Rights Agent (including the form of Certificate of Designation of the Series R Preferred Stock attached as Exhibit A thereto and the form of Rights Certificate attached as Exhibit B thereto), filed as Exhibit 1 to the Company's Current Report on Form 8-K, dated June 21, 1989, is hereby incorporated by reference. 4(b) Indenture, dated as of November 30, 1990, between the Company and Bankers Trust Company, as Trustee, with respect to certain senior debt securities of the Company, filed as Exhibit 2 to the Company's Current Report on Form 8-K, dated January 14, 1991, is hereby incorporated by reference. 4(c) (i) Credit Agreement, dated as of November 22, 1991, among the Company, Citicorp U.S.A., Inc., as Agent, and certain financial institutions, filed as Exhibit 1 to the Company's Quarterly Report on Form 10-Q for the period ended December 31, 1991, and (ii) First Amendment thereto, dated as of February 16, 1993, filed as Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1993, are hereby incorporated by reference. 4(d) Other long-term borrowing instruments issued by the Company are omitted pursuant to Item 601(b) (4) (iii) of Regulation S-K. The Company undertakes to furnish copies of such instruments to the Commission upon request. 10(a) (i) Agreement on the Creation and the Operation of Euro Disneyland en France, dated March 25, 1987, and (ii) Letter relating thereto of Michael D. Eisner, Chairman of the Company, dated March 24, 1987, filed as Exhibits 10(b) and 10(a), respectively, to the Company's Current Report on Form 8-K filed April 24, 1987, are hereby incorporated by reference. 10(b) Limited Recourse Financing Facility Agreement, dated as of April 27, 1988, among the Company, Citibank Channel Island Limited and Citicorp International, filed as Exhibit (10a) to the Company's Current Report on Form 8-K filed April 29, 1988, is hereby incorporated by reference. 10(c) (i) Employment Agreement, dated as of January 10, 1989, between the Company and Michael D. Eisner, filed as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1989; (ii) Agreement, dated March 1, 1985, between the Company and Michael D. Eisner, filed as Exhibit 2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1985; and (iii) description of action by the Compensation Committee taken on November 30, 1990, filed as Exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended September 30, 1990, are hereby incorporated by reference. 10(d) (i) Employment Agreement, dated January 10, 1989, between the Company and Frank G. Wells, filed as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1989; (ii) Agreement, dated March 1, 1985, between the Company and Frank G. Wells, filed as Exhibit 3 to the Company's Quarterly Report on (2) Exhibits (cont.) Form 10-Q for the period ended June 30, 1985; and (iii) description of action by the Compensation Committee taken on November 30, 1990, filed as Exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended September 30, 1990, are hereby incorporated by reference. 10(e) Amended and Restated Employment Agreement, dated as of February 1, 1991, between the Company and Joe Shapiro, filed as Exhibit 1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1991, is hereby incorporated by reference. 10(f) (i) Contract, dated December 14, 1979, with E. Cardon Walker, to purchase a 2% interest in certain motion pictures to be produced by the Company and to acquire an additional 2% profit participation; and (ii) Amendment thereto, dated August 8, 1980, filed as Exhibits 1 and 3, respectively, to the Company's Annual Report on Form 10-K for the year ended September 30, 1980, are hereby incorporated by reference. 10(g) Form of Indemnification Agreement entered into or to be entered into by certain officers and directors of the Company as determined from time to time by the Board of Directors, included as Annex C to the Proxy Statement for the Company's 1988 Annual Meeting of Stockholders, is hereby incorporated by reference. 10(h) Loan Plan for Corporate Officers, filed as Exhibit 10(u) to the Company's Annual Report on Form 10-K for the year ended September 30, 1986, is hereby incorporated by reference. 10(i) 1990 Stock Incentive Plan and the Rules relating to Stock Options and Stock Appreciation Rights thereunder, filed as Exhibits 28(a) and 28(b), respectively, to the Company's Registration Statement on Form S-8 (No. 33-39770), dated April 5, 1991, are hereby incorporated by reference. 10(j) (i) 1987 Stock Incentive Plan and the Rules relating to Stock Options and Stock Appreciation Rights thereunder, (ii) 1984 Stock Incentive Plan and the Rules relating to Stock Options and Stock Appreciation Rights thereunder, (iii) 1981 Incentive Plan and the Rules relating to Stock Options and Stock Appreciation Rights thereunder and (iv) 1980 Stock Option Plan, all as set forth as Exhibits 1(a), 1(b), 2(a), 2(b), 3(a), 3(b) and 4, respectively, to the Prospectus contained in Part I of the Company's Registration Statement on Form S-8 (No. 33-26106), dated December 20, 1988, are hereby incorporated by reference. 10(k) Contingent Stock Award Rules under the Company's 1984 Stock Incentive Plan, filed as Exhibit 10(t) to the Company's Annual Report on Form 10-K for the year ended September 30, 1986, is hereby incorporated by reference. 10(l) Disney Salaried Retirement Plan, filed as Exhibit 10(m) to the Company's Annual Report on Form 10-K for the year ended September 30, 1989, is hereby incorporated by reference. 10(m) The Walt Disney Company and Associated Companies Key Employees Deferred Compensation and Retirement Plan, filed as Exhibit 10(u) to the Company's Annual Report on Form 10-K for the year ended September 30, 1985, is hereby incorporated by reference. 10(n) Supplemental Medical and Group Term Life Insurance Plan (summary plan description), filed as Exhibit 10(x) to the Company's Annual Report on Form 10-K for the year ended September 30, 1985, is hereby incorporated by reference. 10(o) Group Personal Excess Liability Insurance Plan (summary plan description), filed Exhibit 10(z) to the Company's Annual Report on Form 10-K for the year ended September 30, 1986, is hereby incorporated by reference. 10(p) Family Income Assurance Plan (summary plan description), filed as Exhibit 10(aa) to the Annual Report on Form 10-K for the year ended September 30, 1986, is hereby incorporated by reference. (2) Exhibits (cont.) 10(q) Disney Salaried Savings and Investment Plan, as amended and restated through June 1, 1990, filed as Exhibit 28(a) to the Company's Registration Statement on Form S-8 (No. 33-35405), filed June 14, 1990, is hereby incorporated by reference. 10(r) Disney Salaried Savings and Investment Plan Trust Agreement, dated June 30, 1992, filed as Exhibit 10 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1992, is hereby incorporated by reference. 10(s) Master Trust Agreement for Employees Savings and Retirement Plans, as amended and restated through June 1, 1990, between the Company and Bankers Trust Company, as Trustee, filed as Exhibit 28(b) to the Company's Registration Statement on Form S-8 (No. 33-35405), filed June 14, 1990, is hereby incorporated by reference. 18 Letter from the Company's independent auditors, dated August 9, 1993, regarding preferability of the change in accounting method for project-related pre-opening costs, filed as Exhibit 1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1993, is hereby incorporated by reference. 21 Subsidiaries of The Walt Disney Company. 23(a) Consent of Price Waterhouse, the Company's independent accountants, is included herein at page 21. 23(b) Consent of PSAudit, independent accountants of Euro Disney S.C.A., is included herein at page 46. 28 Financial statements required by Form 11-K with respect to the Disney Salaried Savings and Investment Plan for the year ended December 31, 1992, filed as Exhibit 28 to the Annual Report on Form 10-K for the year ended September 30, 1992, as amended by Amendment No. 1 on Form 10-K/A dated June 29, 1993, are hereby incorporated by reference. (b)Reports on Form 8-K (1) The Company filed a Current Report on Form 8-K, dated July 8, 1993, with respect to a press release of Euro Disney S.C.A. dated July 8, 1993. (2) The Company filed a Current Report on Form 8-K, dated July 29, 1993, with respect to adoption of the methods of accounting prescribed by Statement of Financial Accounting Standards (SFAS) No. 106 Employers' Accounting for Postretirement Benefits Other Than Pensions and SFAS No. 109 Accounting for Income Taxes and the change in method of accounting for project-related pre-opening costs. As a result of these changes, the Company filed amendments on Form 10-Q/A to its Quarterly Reports on Form 10-Q for the fiscal quarters ended December 31, 1992 and March 31, 1993, reflecting these changes. 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 WALT DISNEY COMPANY ----------------------------------------------------- (Registrant) Date: December 17, 1993 By: MICHAEL D. EISNER ----------------------------------------------------- (Michael D. Eisner, 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. THE WALT DISNEY COMPANY AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA Financial Statement Schedules Schedules other than those listed above are omitted for the reason that they are not applicable or the required information is included in the financial statements or related notes. Schedules other than those listed above are omitted for the reason that they are not applicable or the required information is included in the financial statements or related notes. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of The Walt Disney Company In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The Walt Disney Company and its subsidiaries (the "Company") at September 30, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 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. As discussed in Notes 1, 7, 8 and 12 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and SFAS No. 109, "Accounting for Income Taxes," and changed its method of accounting for pre-opening costs in fiscal 1993. PRICE WATERHOUSE Los Angeles, California November 22, 1993 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the prospectuses constituting part of the Registration Statements on Form S-8 (Nos. 33-26106, 33-35405 and 33-39770) and Form S-3 (No. 33-49891) of The Walt Disney Company of our report dated November 22, 1993 which appears above. PRICE WATERHOUSE Los Angeles, California December 17, 1993 CONSOLIDATED STATEMENT OF INCOME (In millions, except per share data) See Notes to Consolidated Financial Statements CONSOLIDATED BALANCE SHEET (In millions) See Notes to Consolidated Financial Statements CONSOLIDATED STATEMENT OF CASH FLOWS (In millions) See Notes to Consolidated Financial Statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Tabular dollars in millions, except per share amounts) NOTE 1 DESCRIPTION OF THE BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The Walt Disney Company, together with its subsidiary companies (the "Company"), is a diversified international entertainment company with operations in the following businesses. THEME PARKS AND RESORTS: The Company owns and operates the Disneyland(R) theme park and Disneyland Hotel in California and the Walt Disney World(R) destination resort in Florida. The Walt Disney World destination resort includes the Magic Kingdom, Epcot Center, the Disney-MGM Studios Theme Park, nine hotels and a complex of villas, a nighttime entertainment complex, a shopping village, conference centers, campgrounds, golf courses, water parks and other recreational facilities. The Company earns royalties on certain revenues generated by the Tokyo Disneyland theme park near Tokyo, Japan, which is owned and operated by an unrelated Japanese corporation. The Company's Disney Design and Development unit designs and develops new theme park concepts and attractions, as well as resort properties. The Company also manages and markets vacation ownership interests in the 529-unit Disney Vacation Club under construction at Lake Buena Vista in Florida. In addition, during 1993, the Company acquired property in Vero Beach, Florida on which it plans to construct a 120-room inn and 60 time-share vacation villas. FILMED ENTERTAINMENT: The Company produces and acquires live-action and animated motion pictures for distribution to the theatrical, television and home video markets. The Company also produces original television programming for the network and first-run syndication markets. The Company distributes its filmed product through its own distribution and marketing companies in the United States and most foreign markets. The Company provides programming for and operates The Disney Channel, a pay television programming service, and a Los Angeles television station. CONSUMER PRODUCTS: The Company licenses the name Walt Disney, its characters, visual and literary properties and songs and music to various consumer manufacturers, retailers and publishers. The Company produces audio and computer software for the children's market, as well as film and video products for the educational market. The Company also operates several catalog businesses primarily for the children's market. Licensed products are distributed throughout the world. The Company also has direct publishing operations in the United States in both the children's and adult markets, and in Europe primarily in the children's market. In addition, the Company owns and operates The Disney Stores, which are retail outlets for the Company's merchandise, in selected markets throughout the United States and in Great Britain, Japan, Canada, Puerto Rico and France. INVESTMENT IN EURO DISNEY: The Company is an equity investor in the Euro Disney Resort (see Note 3). SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements of the Company include the accounts of The Walt Disney Company and its subsidiaries after elimination of intercompany accounts and transactions. Investments in affiliated companies are accounted for using the equity method. Revenue Recognition: Revenues from the theatrical distribution of motion pictures are recognized when motion pictures are exhibited. Television licensing revenues are generally recorded when the program material is available for telecasting by the licensee and when certain other conditions are met. Revenues from video sales are recognized on the date that video units are made widely available for sale by retailers. Revenues from participants/sponsors at the theme parks are generally recorded over the period of the applicable agreements commencing with the opening of the attraction. Cash, Cash Equivalents and Investments: Cash and cash equivalents consist of cash on hand and marketable securities with original maturities of three months or less. Debt securities are carried at cost, adjusted for unamortized premium or discount. Marketable equity securities are carried at the lower of aggregate cost or market. Realized gains and losses are determined on an average cost basis. Merchandise Inventories: Carrying amounts of merchandise, materials and supplies inventories are generally determined on a moving average cost basis and are stated at the lower of cost or market. Film and Television Costs: Film production and participation costs for each production are expensed based on the ratio of the current period's gross revenues to estimated total gross revenues from all sources on an individual production basis. Estimates of total gross revenues are reviewed periodically and amortization is adjusted accordingly. Television broadcast rights are amortized principally on an accelerated basis over the estimated useful lives of the programs. Theme Parks, Resorts and Other Property: Theme parks, resorts and other property are carried at cost. Depreciation is computed on the straight-line method based upon estimated useful lives ranging from three to fifty years. Other Assets: Rights to the name, likeness and portrait of Walt Disney, goodwill and other intangible assets are being amortized over periods ranging from two to forty years. Hedging Contracts: In the normal course of business, the Company employs a variety of off-balance-sheet financial instruments to reduce its exposure to fluctuations in interest and foreign currency exchange rates, including interest rate swap agreements and foreign currency forward exchange contracts, options and option combinations. The Company designates interest rate swaps as hedges of investments and debt, and accrues the differential to be paid or received under the agreements as interest rates change over the lives of the contracts. Gains and losses arising from foreign currency forward exchange contracts and options are recognized in income as offsets of gains and losses resulting from the underlying hedged transactions. At September 30, 1993 and 1992, the Company had $2.0 billion and $2.2 billion (notional amount), respectively, of foreign currency hedge contracts outstanding, consisting principally of option strategies providing for the sale of foreign currencies. The contracts serve primarily to hedge probable, but not firmly committed, French franc, German mark, Japanese yen and other foreign currency revenues over periods extending up to five years. The fair value of foreign currency hedge contracts, determined by obtaining quotes from brokers, was immaterial at September 30, 1993. The Company continually monitors its positions with, and the credit quality of, the financial institutions which are counterparties to its off-balance- sheet financial instruments and does not anticipate nonperformance by the counterparties. Earnings Per Share: Earnings per share amounts are based upon the weighted average number of common and common equivalent shares outstanding during the year. Common equivalent shares are excluded from the computation in periods in which they have an anti-dilutive effect. Accounting Changes: During the quarter ended June 30, 1993, the Company adopted SFAS No. 106 Employers' Accounting for Postretirement Benefits Other Than Pensions (see Note 8) and SFAS No. 109 Accounting for Income Taxes (see Note 7) and changed its method of accounting for pre-opening costs (see Note 12). These changes, adopted retroactive to October 1, 1992, had no cash impact. The pro forma amounts reflect the effect of retroactive application of expensing pre-opening costs on 1992 and 1991 results. Reclassifications: Certain reclassifications have been made in the 1992 and 1991 financial statements to conform to the 1993 presentation. NOTE 2 CASH, CASH EQUIVALENTS AND INVESTMENTS At September 30, 1993, the cost and market value of marketable equity securities were $314.1 million and $329.4 million, respectively. At September 30, 1992, the cost and market value of marketable equity securities were $186.6 million and $205.3 million, respectively. For both 1993 and 1992, cost approximated market value for marketable securities other than marketable equity securities. At September 30, 1993 and 1992, interest rate swap agreements related to certain foreign currency denominated investments converted $356.5 million and $244.7 million, respectively, of fixed rate securities to variable rate investments. At September 30, 1993, the Company received interest under these agreements at the three- or six-month lira LIBOR rate and paid interest at a weighted average rate of 10.8%. The agreements expire in two to eight years. At September 30, 1993 and 1992, the Company had outstanding interest rate swaps on its investments with notional amounts totaling $350.0 million and $600.0 million, respectively, which effectively converted variable rate investment securities to fixed rate instruments. Under these swap agreements, which expire in two to three years, the Company received interest at a weighted average fixed rate of 8.4% and paid interest at the one-month commercial paper rate at September 30, 1993. The carrying amount of cash and cash equivalents approximated fair value because of the short maturity of these instruments. The fair values of debt and equity securities were based primarily on quoted market prices for those or similar instruments. The fair value of interest rate swaps was the estimated amount that the Company would receive or pay to terminate the swap agreements, taking into account current interest rates and the current creditworthiness of the swap counterparties. The fair value of investments and related interest rate swaps approximated carrying value as of September 30, 1993. NOTE 3 INVESTMENT IN EURO DISNEY Euro Disney S.C.A. ("Euro Disney"), a publicly traded French company, operates a theme park and resort complex on a 4,800-acre site near Paris, France. Euro Disney commenced operations on April 12, 1992. The Company has accounted for its 49% ownership interest in Euro Disney using the equity method of accounting. In October 1989, Euro Disney completed a public equity offering of approximately $1 billion. As a result of the offering, the Company's share of the net assets of Euro Disney exceeded its investment by approximately $375 million. The Company is recognizing this gain ratably over an eight-year period, which represents the Company's contractual obligation to manage the development and operation of the complex and maintain an ownership interest of at least 17%. In addition to recording its equity in Euro Disney's operating results and amortization of the gain, the Company earned $36.3 million and $32.9 million of royalties in 1993 and 1992, respectively, under certain agreements with Euro Disney. The Company agreed to defer its base management fees for 1992 and 1993. Payment of the deferred amounts will be contingent upon Euro Disney achieving profitability. Euro Disney, its principal lenders and the Company are exploring a financial restructuring for Euro Disney. Throughout fiscal 1994, Euro Disney will require significant funding. The Company has agreed to help fund Euro Disney for a limited period, to afford Euro Disney time to attempt a financial restructuring, by spring 1994. Should the financial restructuring not be completed, Euro Disney would face a liquidity problem. Additionally, during the fourth quarter, Euro Disney's operating results were lower than expected due in part to the European recession affecting Euro Disney's largest markets. The operating results and the need for a financial restructuring have created uncertainty regarding the Company's ability to collect its current receivables and the funding commitment to Euro Disney. Because of this, the Company recorded a $350.0 million charge to income in the fourth quarter to fully reserve its current receivables and funding commitment. Euro Disney's consolidated financial statements are prepared in accordance with accounting principles generally accepted in France (French GAAP). Under French GAAP, Euro Disney incurred a 1993 net loss of FF 5.3 billion (FF 2.1 billion before the cumulative effect of accounting change), a net loss of FF 188 million in 1992 and net income of FF 249 million in 1991. During 1993, Euro Disney changed its method of accounting for project-related pre-opening costs. Under the new method, such costs are expensed as incurred. The cumulative effect of the change in method on prior years was a charge against income of FF 3.2 billion. The effect of the change on the year ended September 30, 1993, was to decrease the loss before the cumulative effect of accounting change by FF 338 million. U.S. generally accepted accounting principles (U.S. GAAP) differ in certain significant respects from French GAAP applied by Euro Disney, principally as they relate to accounting for leases. The summarized consolidated financial statements for Euro Disney set forth below are stated in U.S. dollars in accordance with U.S. GAAP. NOTE 4 FILM AND TELEVISION COSTS Based on management's total gross revenue estimates as of September 30, 1993, approximately 84% of unamortized film production costs applicable to released theatrical and television productions are expected to be amortized during the next three years. NOTE 5 BORROWINGS - -------- (a) In March 1993, the Company called the subordinated notes at their issuance price plus accrued interest for an aggregate redemption price of $1 billion. The redemption was funded by issuance of medium-term notes and sales of securities. (b) The Company has executed interest rate swap agreements to convert $464 million of medium-term notes to commercial paper-based floating rate instruments. The effect of these swaps has been reflected in the effective interest rate. (c) The Company has available through 1996 an unsecured revolving line of bank credit of up to $300 million for general corporate purposes, including the support of commercial paper borrowings. The Company has the option to borrow at various interest rates. (d) Securities sold under agreements to repurchase are collateralized by certain marketable securities. (e) The notes pay fixed interest of 7.5% through April 1994 and 1.5% thereafter. Additional interest may be paid based on the performance of a designated portfolio of films. The Company has executed interest rate swap agreements to convert the notes to LIBOR-based floating rate instruments. The effect of these swaps has been reflected in the effective interest rate. (f) Foreign currency swaps effectively converted $120 million and $137 million at September 30, 1993 and 1992, respectively, of foreign debt issuances to Japanese yen or dollar obligations. The effect of these swaps has been reflected in the effective interest rate. The Company hedges the obligations converted to yen borrowings with a portion of its yen royalty receipts. Borrowings, excluding commercial paper and securities sold under agreements to repurchase which mature in 1994, have the following scheduled maturities. For commercial paper and securities sold under agreements to repurchase, the carrying amount is a reasonable estimate of fair value. The fair value of other borrowings and associated interest rate swaps approximated carrying value at September 30, 1993. The fair value of the Company's other borrowings is based on quoted market prices for the same or similar issues or on current rates offered to the Company for the same remaining maturities. The fair value of interest rate swaps is the estimated amount that the Company would receive or pay to terminate the swap agreements, taking into account current interest rates and the current creditworthiness of the swap counterparties. The Company capitalizes interest on assets constructed for its theme parks, resorts and other developments, and on theatrical and television productions in process. In 1993, 1992 and 1991, respectively, total interest costs incurred were $183.7, $152.1 and $142.4 million, of which $26.0, $25.3 and $37.4 million were capitalized. NOTE 6 UNEARNED ROYALTY AND OTHER ADVANCES In 1988, the Company monetized a substantial portion of its royalties through 2008 from certain Tokyo Disneyland operations. The Company has certain ongoing obligations under its contract with the owner and operator of Tokyo Disneyland, and accordingly royalty advances are being amortized through 2008. The maximum amount the Company may be required to fund under certain recourse provisions of the monetization agreement is $145 million. The Company does not anticipate funding any significant amount under this agreement. NOTE 7 INCOME TAXES As discussed in Note 1, the Company adopted SFAS 109 during the quarter ended June 30, 1993, retroactive to October 1, 1992. The adoption of SFAS 109 changed the Company's method of accounting for income taxes from the deferred method to the asset and liability method. SFAS 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized 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 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. Differences between financial reporting and tax bases arise most frequently from differences in timing of income and expense recognition and as a result of business acquisitions. Prior years' financial statements have not been restated to apply the provisions of SFAS 109. As a result of adoption, the Company recognized a benefit of $30.0 million, or $.06 per share, representing the cumulative effect of the change on results for years prior to October 1, 1992. The cumulative effect represented the adjustment of previously recorded deferred tax assets and liabilities to reflect the lower prevailing tax rates and the establishment of previously unrecorded deferred tax liabilities. The adoption had no effect on pre-tax income for the year ended September 30, 1993. For the year ended September 30, 1993, income tax benefits of $144.7 million were allocated to stockholders' equity. Such benefits are attributable to employee stock option transactions. NOTE 8 PENSION AND OTHER BENEFIT PROGRAMS The Company contributes to various pension plans under union and industry- wide agreements. Contributions are based upon the hours worked or gross wages paid to covered employees. In 1993, 1992 and 1991, the cost recognized under these plans was $16.1, $14.7 and $12.9 million, respectively. The Company's share of the unfunded liability, if any, related to these multi-employer plans is not material. The Company also maintains pension plans covering most of its domestic salaried and hourly employees not covered by union or industry-wide pension plans and a non-qualified, unfunded retirement plan for key employees. With respect to its defined benefit pension plans, the Company's policy is to fund, at a minimum, the amount necessary on an actuarial basis to provide for benefits in accordance with the requirements of ERISA. Benefits are generally based on years of service and/or compensation. Pension cost is summarized as follows. The weighted average discount rate was 9% for 1993 and 9.5% for 1992 and 1991, and the expected long-term rate of return on plan assets was 9.5% for 1993, 1992 and 1991. The assumed rate of increase in compensation for the salaried plans was 6.8% for 1993, 7% for 1992 and 6.6% for 1991. The funded status of the plans and the amounts included in the Company's consolidated balance sheets are as follows. The Company sponsors a plan to provide postretirement medical benefits to most of its domestic salaried and hourly employees, and contributes to multi- employer welfare plans to provide similar benefits to certain employees under collective bargaining agreements. Employees who have 20 years of service and attain age 62 are currently eligible to participate in the postretirement benefit plan. As discussed in Note 1, the Company adopted SFAS 106 during the quarter ended June 30, 1993, retroactive to October 1, 1992. SFAS 106 requires accrual of postretirement benefit costs to actuarially allocate such costs to the years during which employees render qualifying service. Previously, such costs were expensed as actual claims were paid. SFAS 106 also requires recognition of the unfunded and previously unrecognized accumulated postretirement benefit obligation (transition obligation) for all participants in the Company- sponsored plan. The Company elected to immediately recognize the transition obligation which resulted in a charge against income of $130.3 million or $.24 per share, after related income tax benefit of $71.7 million, which represented the cumulative effect of the change in accounting on results prior to October 1, 1992. Under the provisions of SFAS 106, the current period expense exceeded the amount under the previous accounting method by $17.0 million after-tax or $.03 per share for the year ended September 30, 1993. The status of the plan at September 30, 1993 was as follows. The net periodic postretirement benefit cost for the year ended September 30, 1993 included the following components. The annual rate of increase in the per capita cost of covered health care benefits was assumed to be 7%. The health care cost trend rate has a significant effect on the amounts reported. An increase in the assumed health care cost trend rate of 1% for each year would increase the postretirement benefit obligation by $53.3 million and the net service and interest cost components of the net periodic postretirement benefit cost for the year by $8.1 million. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 8.5%. The expected long term rate of return on plan assets was 9.5%. The Company funds its postretirement health benefit liability on a discretionary basis. In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112 Employers' Accounting for Postemployment Benefits (SFAS 112). The Company currently plans to adopt SFAS 112 in fiscal 1995 and does not anticipate the impact will be material. NOTE 9 STOCKHOLDERS' EQUITY On February 18, 1992, the Board of Directors approved a four-for-one stock split of the Company's common stock, which was approved by the Company's stockholders and became effective on April 20, 1992. The new shares were distributed on May 15, 1992 to holders of record on April 20, 1992. All share and per share data have been restated for all periods presented to reflect the stock split. In June 1989, the Company adopted a stockholders' rights plan. The plan becomes operative in certain events involving the acquisition of 25% or more of the Company's common stock by any person or group in a transaction not approved by the Company's Board of Directors. Upon the occurrence of such an event, each right, unless redeemed by the Board, entitles its holder to purchase for $350 an amount of common stock of the Company, or in certain circumstances the acquiror, having a market value of twice the purchase price. In connection with the rights plan, 7.2 million shares of preferred stock were reserved. In 1993 and 1992, the Company recorded cumulative foreign currency translation adjustments of $36.7 million and $86.9 million, net of deferred taxes of $25.0 million and $50.4 million, respectively. Treasury stock activity for the three years ended September 30, 1993 was as follows. In November 1984, the Company adopted a program to repurchase up to 56 million shares. In December 1990, the Company increased the authorized share repurchase amount to 90 million shares. Under this program, the Company repurchased 853,000 shares during the year ended September 30, 1993. Since adoption of the program, a total of 52.8 million shares have been repurchased at prevailing market prices. NOTE 10 STOCK INCENTIVE PLANS Under various plans, the Company may grant stock option and other awards to key executive, management and creative personnel. Transactions under the various stock option and incentive plans during 1993 were as follows. Stock option awards are granted at prices equal to at least market price on the date of grant. Options outstanding at September 30, 1993 and 1992 ranged in price from $3.23 to $44.06 and $3.23 to $37.39 per share, respectively. Options exercised during the period ranged in price from $3.23 to $33.35 per share in 1993, from $3.23 to $32.66 per share in 1992, and from $3.14 to $30.75 per share in 1991. Shares available for future option grants at September 30, 1993 were 24.0 million. NOTE 11 DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS NOTE 12 PRE-OPENING COSTS As discussed in Note 1, during 1993 the Company changed its method of accounting for pre-opening costs. In the past, project-related pre-opening costs were capitalized and amortized on a straight-line basis over periods of up to five years. Under the new method, project-related pre-opening costs are expensed as incurred. The cumulative effect of the change in method on prior years was a charge against income of $271.2 million, or $.50 per share, after related income tax benefit of $71.0 million, of which $233.0 million related to the impact of the accounting change on the Company's investment in Euro Disney. The effect of the change on the year ended September 30, 1993 was to increase income by $40.2 million after-tax, or $.07 per share. NOTE 13 SEGMENTS The Company records transfers between geographic areas in accordance with written contracts based upon total revenues or costs as specified in the applicable contracts. NOTE 14 COMMITMENTS AND CONTINGENCIES The Company, together with, in some instances, certain of its directors and officers, is a defendant or co-defendant in various legal actions involving antitrust, copyright, breach of contract and various other claims incident to the conduct of its businesses. Management does not expect the Company to suffer any material liability by reason of such actions. QUARTERLY FINANCIAL SUMMARY (IN MILLIONS, EXCEPT PER SHARE DATA) (UNAUDITED) THE WALT DISNEY COMPANY AND SUBSIDIARIES SCHEDULE I--MARKETABLE SECURITIES--OTHER INVESTMENTS SEPTEMBER 30, 1993 THE WALT DISNEY COMPANY AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991 - -------- /1/Loan secured by a pledge of shares acquired pursuant to the exercise of stock options; interest payable at 6% on $.3 million, with principal and interest due upon sale of the shares. THE WALT DISNEY COMPANY AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991 THE WALT DISNEY COMPANY AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991 - -------- * Amounts reclassified to conform to presentation of related assets. THE WALT DISNEY COMPANY AND SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991 - -------- (a) Maximum amount outstanding at any month-end during the period. (b) Average amount outstanding during the period is computed by dividing the total outstanding at each month-end by the number of months outstanding during the year. (c) Average interest rate for the year is computed by dividing interest expense by the average amount outstanding. THE WALT DISNEY COMPANY AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of EURO DISNEY S.C.A. We have audited the consolidated balance sheets of Euro Disney S.C.A. and its subsidiaries at September 30, 1993 and 1992, and the related consolidated statements of income and of cash flows, expressed in French francs, for each of the three years in the period ended September 30, 1993, prepared in conformity with accounting principles generally accepted in France (French GAAP) as set out on pages 47 to 65 inclusive. 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 auditing standards generally accepted in the United States of America. 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 audited by us present fairly, in all material respects, the financial position of Euro Disney S.C.A. and its subsidiaries at September 30, 1993 and 1992, and the results of their operations and their cash flows, expressed in French francs, for each of the three years in the period ended September 30, 1993, in conformity with accounting principles generally accepted in France. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for pre-opening and start-up costs in 1993. The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company will require significant funding in fiscal year 1994 and is currently exploring a financial restructuring which, if not completed, will result in liquidity problems. If the financial restructuring is not completed, there would be 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 this uncertainty. Accounting principles generally accepted in France vary in certain significant respects from accounting principles generally accepted in the United States of America. The application of the latter would have affected the determination of the consolidated net income, expressed in French francs, for each of the three years in the period ended September 30, 1993, and the determination of the consolidated shareholders' equity and consolidated financial position, also expressed in French francs, at September 30, 1993 and 1992, as summarized on the consolidated statements of income and balance sheets and in Note 28 to the consolidated financial statements. PSAudit Member of Price Waterhouse Pradeep Narain Paris, France November 15, 1993 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the prospectuses constituting part of the Registration Statements on Form S-8 (Nos. 33-26106, 33-35405 and 33-39770) and Form S-3 (No. 33-49891) of The Walt Disney Company of our reports dated November 15, 1993 which appear on pages 45 and 66. PSAudit Member of Price Waterhouse Pradeep Narain Paris, France December 17, 1993 EURO DISNEY S.C.A. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME RECONCILED TO REFLECT U.S. GAAP See Notes to Consolidated Financial Statements EURO DISNEY S.C.A. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME RECONCILED TO REFLECT U.S. GAAP See Notes to Consolidated Financial Statements EURO DISNEY S.C.A. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET RECONCILED TO REFLECT U.S. GAAP See Notes to Consolidated Financial Statements EURO DISNEY S.C.A. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS See Notes to Consolidated Financial Statements EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF THE BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES DESCRIPTION OF THE BUSINESS Euro Disney S.C.A. (the "Company") and its wholly owned subsidiaries (collectively, the "Group") commenced operations on April 12, 1992, with the official opening of the Euro Disney Resort (the "Opening"). The Group operates the Euro Disney Resort which includes the Euro Disneyland theme park (the "Theme Park"), six hotels, the Festival Disney entertainment center, the Davy Crockett Ranch and a golf course (collectively, the "Resorts") at Marne-la- Vallee, France. In addition, the Group manages the real estate development and expansion of the related infrastructure of the property. The Group owns the Disneyland Hotel, ranch, golf course and land for the hotels and leases the Theme Park and Phase 1B facilities from the Financing Companies (see terms defined below). The Company, a publicly held French company, is owned 49% by EDL Holding Company and managed by Euro Disney S.A. (the Company's Gerant), both wholly- owned, indirect subsidiaries of The Walt Disney Company. Entities included in the consolidated financial statements and their primary operations/activities are as follows: - -------- * Created in 1992 + Created in 1993 EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF THE BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) The Group has various arrangements with Euro Disneyland S.N.C. for the financing of Phase 1A, and with the six companies (S.N.C.'s) that were established for the financing of Phase 1B of the Euro Disney Resort (the "Phase 1B Financing Companies"), as described below. The Group has no ownership interest in these S.N.C.'s. Reference to the "Financing Companies" includes Euro Disneyland S.N.C. and the Phase 1B Financing Companies. PHASE I FINANCING Phase 1A In November 1989, various agreements were signed between the Company and Euro Disneyland S.N.C. for the development and financing of the Theme Park. Pursuant to a sale-leaseback agreement, the assets of the Theme Park were sold by the Company to Euro Disneyland S.N.C. and are being leased back to the Company. Phase 1B In March 1991, various agreements were signed for the development and financing of five hotels and the entertainment center (the "Phase 1B Facilities"). Pursuant to sale-leaseback agreements, the Phase 1B Facilities were sold by the Company to the Phase 1B Financing Companies and are being leased back indirectly through special purpose leasing companies to the operator, EDL Hotels S.C.A. PHASE II DEVELOPMENT The second development phase of the Euro Disney Resort primarily consists of a second theme park, Disney MGM Studio Europe ("DMSE"). In view of its operating results and the overall economic environment, the Company decided in fiscal year 1993 to delay its expansion plans, for the time being. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PREPARATION The Group's consolidated financial statements are prepared in conformity with accounting principles generally accepted in France. In order to comply with generally accepted accounting principles in the United States, certain adjustments (particularly those related to the assets of the Theme Park and the Phase 1B Facilities, which are being financed under leaseback arrangements and are accounted for as operating leases in accordance with French accounting principles rather than capitalized) and supplemental disclosures to the consolidated financial statements have been made, as described in Note 28. LIQUIDITY The Group, its principal lenders and The Walt Disney Company are exploring a financial restructuring for Euro Disney. Throughout fiscal year 1994, the Group will require significant funding. Should the financial restructuring not be completed, the Group would face a liquidity problem. The Walt Disney Company has agreed to help fund the Group for a limited period, to afford Euro Disney time to attempt a financial restructuring by spring 1994. CHANGE IN ACCOUNTING METHOD FOR PRE-OPENING AND START-UP COSTS In September 1993, the Group changed its method of accounting for pre- opening and start-up costs. Effective October 1, 1992, project-related pre- opening and start-up costs are expensed as incurred. In the past, such costs were capitalized and amortized on a straight line basis over 5 or 20 years. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF THE BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) The Group's new management has adopted revised business strategies and believes that the new accounting method is more appropriate in this context. In addition, it corresponds to a similar change in accounting method recently adopted by The Walt Disney Company. The cumulative effect of the change in method as of October 1, 1992, was FF 3,213 million and has been included as exceptional expense in 1993. The impact of the change for the year ended September 30, 1993 on operating income was to reduce the loss before exceptional income by FF 338 million. Assuming the change was applied retroactively to prior years, the 1992 consolidated net loss would have increased by FF 1,705 million and the 1991 consolidated net income would have decreased by FF 755 million. These include pre-opening and start-up costs of FF 1,893 million capitalized in 1992 and FF 755 million capitalized in 1991 offset by FF 188 million of pre-opening and start-up costs amortization recorded in 1992. FIXED ASSETS Intangible assets are carried at cost. Amortization is computed on the straight-line method over two to ten years. Tangible fixed assets are carried at cost. Depreciation is computed on the straight-line method based upon estimated useful lives, as follows: Interest costs incurred for the construction of tangible fixed assets and the acquisition and development of land are capitalized. Projects under development are capitalized to the extent technical and economic feasibility has been established. DEBT ISSUE COSTS Direct costs of the issuance of debt are capitalized and amortized on a straight-line basis over the life of the debt. Upon conversion of convertible debt, the pro-rata amount of unamortized issue costs is offset against the share premium arising from the issuance of the related shares. INVENTORIES Inventories are stated at the lower of cost or market value, on a weighted- average cost basis. SHORT-TERM INVESTMENTS AND CASH Cash and cash equivalents consist of cash on hand and short-term investments with original maturities of three months or less. Short-term investments are stated at the lower of cost or market value. INCOME TAXES The Group files a consolidated tax return. The Group provides for deferred income taxes on temporary differences between financial and tax reporting. The Group uses the liability method under which deferred taxes are calculated applying legislated tax rates expected to be in effect when the temporary differences will reverse. PARTICIPANT REVENUE Fees billed to companies ("Participants") which enter into long-term marketing agreements with the Group for the sponsorship of attractions are recognized as revenue over the period of the applicable agreements commencing with the opening of the attraction. Fees billed to Participants prior to Opening were recognized as revenue over fiscal years 1992 and 1993, reflecting the high marketing costs incurred during this period. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF THE BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) CONVERTIBLE BOND REDEMPTION PREMIUM The liability for the convertible bond redemption premium is provided for on a straight-line basis over the term of the bonds, depending on the probability that the premium will be paid. FINANCIAL INSTRUMENTS In the normal course of business, the Group employs a variety of off- balance-sheet financial instruments to reduce its exposure to fluctuations in interest and foreign currency exchange rates, including interest rate swap agreements, forward rate agreements, options on swaps, foreign currency forward exchange contracts and foreign exchange options. The Group designates interest rate instruments as hedges of debt and lease obligations, and accrues the differential to be paid or received under the agreements as interest rates change over the lives of the contracts. Gains and losses arising from foreign currency instruments are deferred and recognized in income as offsets of gains and losses resulting from underlying hedged transactions. The Group continually monitors its positions with, and the credit quality of, major international financial institutions which are counterparties to its off-balance-sheet financial instruments and does not anticipate non- performance. FOREIGN CURRENCY TRANSACTIONS Transactions denominated in foreign currencies are recorded in French francs at the exchange rate prevailing at the month-end prior to the transaction date. Receivables and liabilities denominated in foreign currencies are stated at their equivalent value in French francs at the exchange rate prevailing at the balance sheet date. Net exchange gains or losses resulting from the translation of assets and liabilities in foreign currencies at the balance sheet date are deferred as translation adjustments. Provision is made for all unrealized exchange losses to the extent not hedged. RECLASSIFICATIONS Certain reclassifications to the 1992 and 1991 comparative amounts have been made to conform to the 1993 presentation of the consolidated financial statements. 2. INTANGIBLE ASSETS Between January 1, 1992 and Opening, the Group incurred start-up costs for the marketing of the Euro Disney Resort, recruiting and training of new cast members hired for operations, as well as testing of facilities and computer systems. These costs were capitalized and amortized over 5 years. As described in Note 1, the Group changed its method of accounting for start-up costs in fiscal year 1993. Effective October 1, 1992, start-up costs are expensed as incurred. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. TANGIBLE FIXED ASSETS Fixed assets include capitalized interest costs of FF 314 million and FF 212 million, at September 30, 1993 and 1992, respectively. At September 30, 1993, construction in progress primarily represents Disney MGM Studio Europe costs (FF 1,120 million) and Euro Disneyland park expansion construction costs (FF 208 million). At September 30, 1992, construction in progress included Phase II planning and design costs (FF 848 million) and the Euro Disney golf course (FF 126 million) which opened October 3, 1992. Following a revision of the development agreement between the Company and Euro Disneyland S.N.C., FF 781 million of assets, capitalized in the Company's records at September 30, 1992, were sold at cost to Euro Disneyland S.N.C. in July 1993. 4. LONG-TERM RECEIVABLES Included in receivables are the following amounts: - -------- (a) Euro Disneyland S.N.C. Pursuant to the Theme Park financing agreements, the Group has provided long-term subordinated loans of FF 3.8 billion, including FF 1.6 billion during 1993, to Euro Disneyland S.N.C. bearing interest at a rate of 3- month PIBOR (Paris Interbank Offering Rate) which, in 1993, averaged 10.34%. The loans will be repaid during the 20-year Theme Park lease period and are pledged as a guarantee for future lease payments. At September 30, 1992, accrued interest receivable on the loans was FF 308 million and is included above. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. LONG-TERM RECEIVABLES--(CONTINUED) (b) Phase 1B Financing Companies Pursuant to the Phase 1B financing agreements, the Group has provided long- term loans of FF 1.45 billion, to the Phase 1B Financing Companies, bearing interest at 11% from the contractual completion date of the Phase 1B Facilities. FF 228 million was repaid during the year-ended September 30, 1993. The remaining loans are due over approximately 9 years, beginning in 2001. At September 30, 1993 and 1992, accrued interest receivable on these loans was FF 16 million and FF 18 million, respectively, and is included above. (c) V.A.T.--Long-term Receivable Following a change in the tax law relating to the Value-Added Tax, the Group has recorded a long-term receivable due from the tax authorities. This receivable is due over a period not exceeding 20 years and bears interest at a maximum rate of 4.5%. 5. INVENTORIES 6. ACCOUNTS RECEIVABLE FROM FINANCING COMPANIES Included in receivables at September 30, 1992, was FF 585 million, representing amounts owed to the Group by the Financing Companies for construction sales. These amounts were paid in fiscal year 1993. 7. TRADE ACCOUNTS RECEIVABLE Included in receivables at September 30, 1993 and 1992, are trade accounts receivable of FF 313 million and FF 456 million, respectively, which are due primarily from tour operators, agents and travel groups, arising from sales of theme park entrance tickets, hotel rooms and amenities, as well as billings for participant fees. At September 30, 1993 and 1992, FF 34 million and FF 20 million, respectively, were provided for uncollectible accounts. All amounts are due within one year. 8. OTHER ACCOUNTS RECEIVABLE Included in receivables at September 30, 1993 and 1992, are other accounts receivable of FF 966 million and FF 1,248 million, respectively. These amounts are due within one year and consist primarily of recoverable value-added taxes and advances to suppliers. 9. SHORT-TERM INVESTMENTS Short-term investments include money market instruments and certificates of deposit, carried at cost, which approximated market value at September 30, 1993 and 1992. At September 30, 1993 and 1992, FF 30 million and FF 60 million, respectively was pledged pursuant to the Group's financing agreements as guarantees for future construction payments, land acquisitions, and other financial transactions. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. DEFERRED CHARGES - -------- (a) Costs incurred prior to January 1, 1992, to establish the organization and operating structure of the Group, were deferred and amortized over 20 years. As described in Note 1, the Group changed its method of accounting for pre-opening costs in fiscal year 1993. Effective October 1, 1992, pre- opening costs are expensed as incurred. (b) This primarily represents a payment of FF 232 million made by the Group to the S.N.C.F. (Societe Nationale de Chemins de Fer Francais), the French national railway company, as part of its financial commitment to the construction of the T.G.V. (Train a Grande Vitesse) railway station located within the Euro Disney Resort. This contribution will be amortized over twenty years, commencing with the opening of the T.G.V. station planned during fiscal year 1995. Other contributions to public infrastructure, which are being amortized over 20 years, are stated net of accumulated amortization of FF 8 million at September 30, 1993. (c) Debt issue costs are stated net of accumulated amortization of FF 38 million and FF 26 million at September 30, 1993 and 1992, respectively. 11. STOCKHOLDERS' EQUITY Share capital consists of ordinary shares with a FF 10 par value. The numbers of shares above represent the Company's authorized, issued and outstanding shares, at the respective dates. At September 30, 1993, the Company's retained earnings include a legal reserve of FF 32 million, which is not available for distribution. Dividends of FF 173 million were paid in February 1993 related to fiscal year 1992. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. PROVISIONS FOR RISKS AND CHARGES Included in accounts payable and other accrued liabilities at September 30, 1993 and 1992, are provisions and allowances of FF 601 million and FF 234 million, respectively. These amounts primarily include the estimated cost of reorganization, including the implementation of a staff reduction program and the cost of the consolidation of all staff at one site. 13. LONG-TERM BORROWINGS At September 30, 1993 and 1992, total long-term borrowings include accrued interest of FF 360 million and FF 369 million, respectively. (a) Convertible bonds On July 15, 1991, the Company issued 28,350,000 unsecured convertible bonds in the aggregate principal amount of FF 3,969 million, at par of FF 140. Interest is payable annually beginning October 1, 1992. At September 30, 1993 and 1992, the above amounts include accrued interest of FF 272 million and FF 328 million, respectively. Each bond is convertible into one share of the Company. Through September 30, 1993, 8,212 bonds were converted. No bonds were purchased and canceled by the Company during fiscal year 1993. There were 28,341,788 bonds outstanding at September 30, 1993. Unless previously converted, redeemed or purchased by the Company, the bonds will be redeemed at 110% of their principal amount on October 1, 2001. FF 87 million and FF 47 million of the redemption premium was accrued and is included in the accounts at September 30, 1993 and 1992, respectively. (b) Caisse des Depots et Consignations loan In May 1992, the Company borrowed FF 1,403 million from the Caisse des Depots et Consignations (C.D.C.), of which 40% is senior debt and 60% is "prets participatifs" (subordinated debt), maturing 20 years from the drawing date. This loan bears interest at a weighted average rate of 7.85%. The senior debt is secured by the underlying land of the Theme Park and campground. The subordinated debt is unsecured. Principal repayments begin six years from the drawing date. (c) Phase 1A credit facility In December 1992, Euro Disney S.C.A. borrowed FF 1,295 million pursuant to a credit agreement in order to finance costs associated with the Phase 1A facilities. This borrowing bears interest at PIBOR plus 1% for FF 1,025 million and 8.35% for FF 270 million. Principal repayments begin in 1998, through 2006. In March 1993, Euro Disney S.C.A. borrowed FF 730 million under the same credit agreement, bearing interest at PIBOR plus 1.1%. Principal repayments begin in 1997 through 2006. The credit agreement contains covenants by the Company relating primarily to the use of the revenue proceeds, dividend payment restrictions, additional indebtedness, asset and revenue pledges, and other provisions including an interest coverage ratio. (d) Phase 1B credit facility Credit agreements entered into by EDL Hotels S.C.A. in 1991 provide for floating-rate borrowings of up to FF 600 million, secured by Phase 1B assets. At September 30, 1993, FF 400 million was outstanding bearing interest at 2 or 3-month PIBOR plus 1%. Principal repayments commence in 1995 through 2009. The credit agreements contain covenants by EDL Hotels S.C.A. relating primarily to additional indebtedness and asset and revenue pledges. (e) Credit Foncier de France In June 1992, the Company borrowed FF 35 million from the Credit Foncier de France for the construction of cast member housing, secured by the related assets, bearing interest at a rate of 3-month PIBOR minus 0.3%. Principal repayments begin in 1995 through 2017. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 13. LONG-TERM BORROWINGS--(CONTINUED) Borrowings have the following scheduled maturities: Fixed assets with a book value of FF 1,785 million at September 30, 1993, are mortgaged as security under Phase 1A, Phase 1B, and other loan agreements. 14. PAYABLE TO RELATED COMPANIES Included in accounts payable and other accrued liabilities are the following amounts: (a) Represents amounts incured on behalf of the Group, primarily for construction and reimbursement of operating costs. In 1993 and 1992, Euro Disney S.A. incurred reimbursable costs of FF 1.48 billion and FF 1.76 billion, respectively. (b) Represents royalties payable to The Walt Disney Company (Netherlands) B.V. pursuant to a license agreement governing intellectual property rights owned by The Walt Disney Company. (c) Represents rent due pursuant to the Theme Park and Phase 1B Facilities leases (see Note 24). All amounts are due within one year. 15. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Included in accounts payable and other accrued liabilities are the following amounts: All amounts are due within one year. 16. DEFERRED REVENUES Included in accounts payable and other accrued liabilities are deferred revenues of FF 160 million and FF 316 million as of September 30, 1993 and 1992, respectively. These consist primarily of land grants and a gain on sale of assets, recognized as income over the term which the assets are leased back to the Group. 17. CONSTRUCTION SALES AND RELATED SERVICES During the years ended September 30, 1993 and 1992, assets of the Theme Park were sold to Euro Disneyland S.N.C. for FF 781 million and FF 3 billion, respectively. The Phase 1B Facilities were sold to the Phase 1B Financing Companies in 1992 for FF 1.64 billion. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 18. EXCEPTIONAL INCOME AND LOSS (a) As described in Note 1, this represents the cumulative effect of the change in accounting for pre-opening and start-up costs as of October 1, 1992. (b) This primarily represents reorganization costs. (c) The Company is committed to pay Euro Disney S.A. an annual base management fee for services rendered, equal to 3% of the Group's annual total net revenues as defined in the Company's Charter. For the years ended September 30, 1993 and 1992, this fee, included in direct operating expenses, was FF 145 million and FF 113 million, respectively. Euro Disney S.A. has agreed to defer its base management fees for 1992 and 1993. Payment of the deferred amount will not commence before 1994 and will be contingent upon the Group achieving profitability. This amount, therefore, represents a contingent liability which may be payable in future years. 19. INCOME TAXES In 1992, the deferred tax liability of FF 151 million which was provided in 1991 was eliminated, as a credit to income tax expense, to reflect the expected future benefits of existing tax loss carryforwards. At September 30, 1993, unused and unrecognized tax loss carryforwards were FF 5.5 billion. Most of these carryforwards expire between 1994 and 1998. 20. BUSINESS SEGMENTS Resort operations comprise the operating activity of the Theme Park, six hotels, entertainment center, ranch and golf course. Construction includes the development and financing of capital assets for sale or use. 21. EXPOSURE TO INTEREST RATE RISK Since the Group's lease payments primarily correspond to the Financing Companies' related debt service payments, variation in the interest rates of the floating rate elements of that debt, which were FF 9.6 billion and FF 8.3 billion at September 30, 1993 and 1992, respectively, impact lease payments. At September 30, 1993 and 1992, the Group's exposure to the interest rate risk from borrowings and lease payments was partially hedged by interest rate swaps expiring through July 1996 of FF 5.3 billion and FF 1.1 billion, respectively, and Forward Rate Agreements and other hedging instruments expiring through June 1999 of FF 3.7 billion and FF 1 billion, respectively. Under interest rate swaps, the Group pays interest at a weighted average rate of 7.62% which includes fixed and LIBOR based variable rates, and receives interest at PIBOR based rates. Under Forward Rate Agreements, the Group pays interest at a weighted average rate of 7.29% and receives PIBOR based variable rates. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 22. EXPOSURE TO CURRENCY RISK The Group's policy is to protect itself to the extent practical from the effects of fluctuations in the foreign exchange markets. The Group's exposure to foreign currency risk relates primarily to variations in the value of the U.S. dollar, as certain liabilities and commitments to a wholly-owned subsidiary of The Walt Disney Company are denominated in this currency. At September 30, 1993 and 1992, the Group had FF 1,615 million and FF 734 million, respectively of foreign currency hedge contracts outstanding, consisting principally of forward exchange contracts and written options expiring primarily between October 1993 and August 1995. 23. COMMITMENTS AND CONTINGENCIES There are various legal proceedings and claims against the Group related to construction and other activities incident to the conduct of its business. Management does not expect the Group to suffer any material liability by reason of such actions. The Company is jointly liable for all Euro Disneyland S.N.C. obligations under the Phase 1A credit agreement with a syndicate of international banks consisting of a main facility of FF 4.35 billion. At September 30, 1993, Euro Disneyland S.N.C. had drawn FF 4.35 billion on the main facility. EDL Hotels S.C.A. has guaranteed all of the obligations of the Phase 1B Financing Companies under the Phase 1B senior credit facility with a syndicate of banks, consisting of a main facility of FF 2.3 billion. At September 30, 1993, the Phase 1B Financing Companies had drawn FF 2.29 billion on the main facility. 24. LEASED ASSETS The Group has leaseback agreements with the Financing Companies for the Theme Park and the Phase 1B Facilities. In conformity with French accounting principles, the Group has elected not to capitalize these leases and to account for them as operating leases. The rental expense under these leases approximates the Financing Companies' related debt service payments, which fluctuate with variable interest rate changes and principal repayments. The leases commenced April 12, 1992 and end when the underlying borrowings and interest are repaid in full by the Financing Companies or, at the latest, December 31, 2030, for the Theme Park and February 5, 2011, for the Phase 1B Facilities. Rental expense was FF 1,712 million and FF 716 million in 1993 and 1992, respectively. Future minimum rental commitments under the capital leases are as follows: - -------- (/1/This)information is not analyzed by asset category as the leases comprise the Theme Park and Phase 1B Facilities as a whole and not their specific assets. Rental commitments are based on an estimated interest rate of 7%. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 24. LEASED ASSETS--(CONTINUED) As operating leases, the cost and depreciation of the assets and underlying borrowings are not included in the Group's consolidated financial statements. These amounts, which are carried by the Financing Companies, are summarized as follows: Depreciation is computed on the straight-line method based upon estimated useful lives. Depreciation expense was FF 751 million and FF 384 million in 1993 and 1992, respectively. At September 30, 1993, borrowings and accrued interest specific to these assets were FF 17.7 billion, including FF 5.1 billion due to the Group. The Group has other operating leases, primarily for office space, office and computer equipment and vehicles, for which total rental expense was FF 208 million, FF 152 million and FF 51 million in 1993, 1992 and 1991, respectively. Future minimum rental commitments under non-cancelable operating leases are as follows: 25. EMPLOYEES At September 30, the number of cast members employed by the Group was: Total employee costs for 1993, 1992 and 1991 were FF 2,108 million, FF 1,971 million and FF 341 million, respectively. PENSION AND RETIREMENT BENEFITS All cast members participate in pension plans in accordance with French laws and regulations. Cadre cast members also participate in a supplemental defined contribution pension plan. Contributions to all plans, which are shared by the cast member and the Group, are based on gross wages and are expensed as incurred. The Group has no future commitments with respect to these plans. A retirement indemnity is paid to cast members who retire from the Group after completing a defined number of service years, in an amount not to exceed 1.5 months of gross wages. No provision in this respect was recorded in 1993 or 1992 as any amounts eventually due are considered to be insignificant. 26. DIRECTORS' FEES In 1993, 1992 and 1991, fees paid to members of the Company's Supervisory Board were FF 1,000,000, FF 925,000 and FF 775,000, respectively. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 27. SUBSEQUENT EVENT On October 25, 1993, Management submitted proposals for the suppression of 950 positions in mainly administrative and management functions to the employees' representatives committee. Discussions surrounding these proposals are expected to continue until December 1993. The costs related to this reorganization have been provided for in provisions for risks and charges, as mentioned in Note 12. 28. SUMMARY OF DIFFERENCES BETWEEN ACCOUNTING PRINCIPLES ADOPTED BY THE COMPANY AND GENERALLY ACCEPTED ACCOUNTING PRINCIPLES IN THE U.S. AND SUPPLEMENTAL DISCLOSURES I. RECONCILIATION TO U.S. GAAP As explained in the summary of significant accounting policies, the consolidated financial statements have been prepared in accordance with accounting principles generally accepted in France ("French GAAP"). These accounting principles differ in certain significant respects from those generally accepted in the United States ("U.S. GAAP") and therefore, the consolidated financial statements have been adjusted to reflect U.S. GAAP. The following is a summary of the adjustments to the consolidated financial statements for years ended September 30, 1993, 1992 and 1991 which would be required if U.S. GAAP had been applied instead of French GAAP. A. LEASE-RELATED ADJUSTMENTS The Theme Park and Phase 1B Facilities are leased to the Group by the Financing Companies. The Group has elected not to capitalize these leases and is accounting for them as operating leases. Under U.S. GAAP, the underlying assets and liabilities and related depreciation and interest expense are reflected in the Group's financial statements. B. PRE-OPENING COSTS Prior to October 1, 1992, the Group amortized certain pre-opening costs over a twenty-year life. Under U.S. GAAP, such costs were subject to five-year amortization, resulting in an adjustment to amortization expense for U.S. GAAP purposes. II. CHANGE IN ACCOUNTING FOR PRE-OPENING COSTS Effective October 1, 1992, the accounting method under U.S. GAAP and French GAAP was changed to reflect a preferable method for project-related pre- opening and start-up costs, which is to expense these costs as they are incurred. The cumulative effect of the change on prior years under U.S. GAAP was FF 3,177 million and has been included in the net loss for the year ended September 30, 1993. The effect of the change in accounting method was to reduce the U.S. GAAP loss before the cumulative effect of the change for the year ended September 30, 1993, by FF 646 million. Pro forma amounts on the face of the income statement reflect the effect of retroactively expensing pre-opening costs. III. THEME PARK AND RESORT ASSETS Under French GAAP, the Theme Park and Resort assets are depreciated under the straight-line method over their useful lives of two to thirty-three years. For U.S. GAAP, the equivalent useful lives range between two and forty years. IV. CONSOLIDATED STATEMENTS OF CASH FLOWS The information in the following Consolidated Statements of Cash Flows is presented in accordance with the requirements of Statement of Financial Accounting Standards No. 95 ("SFAS 95") and is based on U.S. GAAP adjusted amounts. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 28. SUMMARY OF DIFFERENCES BETWEEN ACCOUNTING PRINCIPLES ADOPTED BY THE COMPANY AND GENERALLY ACCEPTED ACCOUNTING PRINCIPLES IN THE U.S. AND SUPPLEMENTAL DISCLOSURES--(CONTINUED) CONSOLIDATED STATEMENT OF CASH FLOWS IN ACCORDANCE WITH U.S. GAAP V. DEFERRED TAXES Deferred taxes at September 30, 1991, were based on U.S. GAAP and were calculated at an effective tax rate of 37% on U.S. GAAP income. Deferred taxes were reversed at September 30, 1992, and have not been reinstated since the Group generated losses for both of the years ended September 30, 1992 and 1993. EURO DISNEY S.C.A. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 28. SUMMARY OF DIFFERENCES BETWEEN ACCOUNTING PRINCIPLES ADOPTED BY THE COMPANY AND GENERALLY ACCEPTED ACCOUNTING PRINCIPLES IN THE U.S. AND SUPPLEMENTAL DISCLOSURES--(CONTINUED) In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109 ("SFAS 109") Accounting for Income Taxes. The standard changes the method of accounting for income taxes to an asset and liability approach. The standard was adopted in 1993, retroactive to October 1, 1992. Under SFAS 109, the Group's net operating loss carryforwards generate deferred tax assets of FF 1.8 billion. The Group has established a 100% valuation allowance against these assets due to the uncertainty of ultimate realization of tax benefits. The Group has net operating loss carryforwards of FF 5.5 billion expiring through 1998. VI. FINANCIAL INSTRUMENTS At September 30, 1993, the estimated cost to the Group to terminate its interest rate hedging instruments, taking into account current interest rates and creditworthiness of counterparties, is FF 159 million. The estimated cost to terminate the Group's FF 5.1 billion of hedging contracts providing for the purchase and sale of foreign currencies, based upon quotes from brokers, is FF 77 million. The fair values of the Group's short-term investments and convertible bonds approximate carrying values based upon the short maturity of the instruments and market quotes at September 30, 1993, respectively. In view of the Group's operating results and potential liquidity problems if a financial restructuring is not completed in 1994, it is not practicable to estimate the fair value of borrowings that are not publicly traded at September 30, 1993. VII. LONG-TERM DEBT As noted earlier, the Group has elected not to capitalize the leases of the Theme Park and the Phase 1B Facilities, but rather to account for them as operating leases. Under U.S. GAAP, the leases would be capitalized. Set out below is a schedule of the long-term debt of the Financing Companies relating to the assets underlying these leases. (a) Drawn against a facility of FF 4,500 million. Collateralized by a mortgage on the Theme Park and Disneyland Hotel. The Company is a co-obligor on this facility. Quarterly repayments commence in 1994. (b) Loan consists of 40% senior debt and 60% subordinated debt. Senior debt is collateralized by the land of the Theme Park and campground. Annual repayments commence in 1995. (c) Drawn against a facility of FF 2.3 billion from a syndicate of banks and secured by the five Phase 1B hotels and entertainment center. Quarterly repayments commence in 1995. (d) Related to Phase 1A assets. Principal repayments commence in 2005. (e) Senior debt related to Phase 1B assets collateralized by Phase 1B buildings and fixtures. Principal repayments commence in 2003. Amount includes FF 288 million of bank borrowings. The borrowings have the following scheduled maturities: REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Shareholders of EURO DISNEY S.C.A. Our audits of the consolidated financial statements of Euro Disney S.C.A. referred to in our report dated November 15, 1993 appearing on page 45 of this 10-K as of September 30, 1993 and 1992 and for each of the three years in the period ended September 30, 1993 also included an audit of the Financial Statement Schedules in this 10-K on pages 67 through 70, inclusive. In our opinion, the Financial Statement Schedules present fairly, in all material respects, the information set forth therein in accordance with accounting principles generally accepted in the United States of America when read in conjunction with the related consolidated financial statements. PSAudit Member of Price Waterhouse Pradeep Narain Paris, France November 15, 1993 EURO DISNEY S.C.A. AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED SEPTEMBER 30, 1993 AND 1992 EURO DISNEY S.C.A. AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991 EURO DISNEY S.C.A. AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991 EURO DISNEY S.C.A. AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991

62996_1993.txt

62996_1993

1993

62996

ITEM 1. BUSINESS. Masco manufactures building, home improvement and home furnishings products for the home and family. Masco believes that it is the largest domestic manufacturer of faucets, plumbing supplies, kitchen and bath cabinets and furniture, and that it is a leading domestic producer of a number of other building, home improvement and home furnishings products. Masco was incorporated under the laws of Michigan in 1929 and in 1968 was reincorporated under the laws of Delaware. Except as the context otherwise indicates, the terms "Masco" and the "Company" refer to Masco Corporation and its consolidated subsidiaries. INDUSTRY SEGMENTS The following table sets forth for the three years ended December 31, 1993, the contribution of the Company's industry segments to net sales and operating profit: (1) Amounts are before general corporate expense. Additional financial information concerning the Company's operations by industry segment as of and for each of 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." BUILDING AND HOME IMPROVEMENT PRODUCTS The Company is among the country's largest manufacturers of brand-name consumer products designed for the building and improvement of the home, including faucets, kitchen and bath cabinets, kitchen appliances, bath and shower enclosure units, spas, shower and plumbing specialties, door locks and other builders' hardware, air treatment products, venting and ventilating equipment and water pumps. These products are sold for the home improvement market to consumers who purchase materials for "do-it-yourself " installation or installation by contractors or professional tradespeople as well as for the new home construction market. The Company manufactures a variety of single and double handle faucets. DELTA(R) and PEERLESS(R) single and double handle faucets are used on kitchen, lavatory and other sinks and in bath and shower installations. DELTA faucets are sold through manufacturers' representatives to distributors who sell the faucets to plumbers, building contractors, remodelers, retailers and others. PEERLESS faucets are sold primarily through manufacturers' representatives directly to retail outlets such as mass merchandisers, home centers and hardware stores and are also sold under private label. The Company's EPIC(R), ARTISTIC BRASS(R) and SHERLE WAGNER(TM) faucets and accessories produced for the decorator markets and are sold through wholesalers, distributor showrooms and other outlets. In addition to its domestic manufacturing, the Company manufactures faucets in Denmark, Italy and Canada. Sales of faucets approximated $608 million in 1993, $528 million in 1992 and $457 million in 1991. The percentage of operating profit on faucets is somewhat higher than that on products within the Building and Home Improvement Products Segment as a whole. The Company believes that the simplicity, quality and reliability of its faucet mechanisms, its marketing and merchandising activities, and the development of a broad line of products have accounted for the continued strength of its faucet sales. The Company manufactures stock, semi-custom and custom kitchen and bath cabinetry in a variety of styles and in various price ranges. The Company sells under a number of trademarks, including MERILLAT(R), KRAFTMAID(R), STARMARK(R) and FIELDSTONE(R), with sales in both the home improvement and new home construction markets. Sales of kitchen and bath cabinets were approximately $570 million in 1993, $515 million in 1992 and $425 million in 1991. The Company's brass and copper plumbing system components and other plumbing specialties are sold to plumbing, heating and hardware wholesalers and to home centers, hardware stores, building supply outlets and other mass merchandisers. These products are marketed for the wholesale trade under the BRASS-CRAFT(R) trademark and for the "do-it-yourself " market under the PLUMB SHOP(R) and HOME PLUMBER(R) trademarks and are also sold under private label. In February, 1994 the Company acquired two leading manufacturers of bath accessories and other products. Zenith Products Corporation manufactures bath medicine cabinets, shower curtain rods and rings and other bath storage products for the home. Zenith's medicine cabinets are sold primarily to "do-it-yourself " retailers, while its other products are marketed to discount retailers and other mass merchandise stores. Melard Manufacturing Corporation manufactures bath hardware, accessories, plumbing specialty products, and other products. Melard's products are primarily sold for the "do-it-yourself " and residential remodeling markets, through mass merchandise stores, hardware stores, home centers and other retail outlets. Other specialty kitchen and bath consumer products include THERMADOR(R) cooktops, ovens, ranges and related cooking equipment, which are marketed through appliance distributors and dealers. The Company's acrylic and gelcoat bath and shower units and whirlpools are sold under the AQUA GLASS(R) trademark primarily to wholesale plumbing distributors for use in the home improvement and new home construction markets. Luxury bath and shower enclosures are manufactured and sold by the Company under the HUPPE(R) trademark. The Company's spas are sold under the HOT SPRING SPA(R) and other trademarks directly to retailers for sale to residential customers. Premium quality brass rim and mortise locks, knobs and trim and other builders' hardware are manufactured and sold under the BALDWIN(R) trademark for the home improvement and new home construction markets. WEISER(R) door locks and related hardware are sold through contractor supply outlets, hardware distributors and home center retailers. SAFLOK(TM) electronic locks and WINFIELD(TM) mechanical locks are sold primarily to the hospitality market. HOME FURNISHINGS PRODUCTS The Company has become the leading domestic manufacturer of brand-name consumer products for the furnishing of the home, including furniture, upholstery and other fabrics, mirrors, lamps and other decorative accessories. The Company manufactures a broad array of home furnishings products and utilizes a variety of distribution channels to market its products. A complete line of traditional, transitional and contemporary wood and upholstered furniture is sold under the HENREDON(R) trademark through Henredon galleries located in furniture stores, designer showrooms, furniture outlets and department stores. DREXEL(R) and HERITAGE(R) wood and upholstered furniture and home furnishings accessories are marketed through Drexel Heritage galleries located in furniture stores, through showcase stores which primarily feature Drexel Heritage furniture and also through independent furniture outlets. The Lexington Furniture Industries group produces youth-correlated furniture, moderately-priced bedroom and dining room groups, occasional and upholstered furniture and woven wicker and rattan products, which are sold through national and regional chains and independent furniture dealers, department stores and interior designers. Universal Furniture Limited manufactures dining room, bedroom, occasional wood and upholstered furniture, which is sold primarily through furniture retailers and department stores under UNIVERSAL(R), BENCHCRAFT(R) and other trademarks. The Company believes that Universal is the largest supplier in the United States of wood dining room furniture, much of which is shipped in unassembled form from the Far East to assembly and distribution centers in the United States. The Company's LINEAGE(R) line of wood and upholstered furniture and home furnishings accessories are sold through exclusive Lineage Pavilions located in retail furniture stores which also feature furniture accessories manufactured by other Company operations. The Company also manufactures and sells designer upholstered products and upholstered furniture under private label to furniture stores and other retailers. In addition, certain of the Company's furniture is sold to contract accounts primarily for use in the hospitality market and in commercial and government buildings. Sales of the Company's furniture products approximated $1.34 billion in 1993, $1.19 billion in 1992 and $1.13 billion in 1991. The Company's textile group includes Robert Allen Fabrics, Inc., Ametex Fabrics, Inc., Sunbury Textile Mills, Inc. and Ramm, Son & Crocker Limited. Robert Allen markets fabrics, which are used primarily for residential furnishings, through independent sales representatives to designers and retailers. Company-operated and independent showrooms have also been established to sell fabrics and display and sell many of the Company's other home furnishings products. Ametex designs and converts moderately-priced fabrics for use in commercial and residential furnishings, which are sold through independent sales representatives to furniture and other furnishings manufacturers, fabric jobbers and the hospitality market. Sunbury manufactures high-quality Jacquard woven fabrics which are sold through sales representatives primarily to furniture manufacturers and decorative jobbers for furniture and other decorative applications. Ramm, Son & Crocker is a United Kingdom supplier of high-quality printed fabrics to the furniture and decorative fabric markets. GENERAL INFORMATION CONCERNING INDUSTRY SEGMENTS No material portion of the Company's business is seasonal or has special working capital requirements although the Company maintains a higher investment in inventories for certain of its businesses than the average manufacturing company. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Receivables and Inventories," included in Item 7 of this Report. The Company does not consider backlog orders to be a material factor in its industry segments, and no material portion of its business 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. 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 manufacturing plants in Belgium, Canada, the People's Republic of China, Denmark, France, Germany, Hong Kong, Italy, Malaysia, Mexico, the Philippines, Singapore, Sweden, Taiwan and the United Kingdom. Products manufactured by the Company outside of the United States include faucets and accessory products, bath and shower enclosures, furniture, decorative accessories, door locks and related hardware, ventilating fans and equipment and submersible water pumps. 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. Financial information concerning the Company's foreign and domestic operations, including the amounts of net sales, operating profit and assets employed which are attributable to the Company's operations in the United States and in foreign countries, 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." From 1991 through 1993, the Company's annual net export sales from the United States to other countries, as a percentage of consolidated annual net sales, approximated three percent. EQUITY INVESTMENTS In 1984, Masco transferred its industrial businesses to a newly-formed subsidiary, MascoTech, Inc. (formerly Masco Industries, Inc.), which became a separate public company in July, 1984 when Masco distributed to its stockholders shares of MascoTech common stock as a special dividend. Masco currently owns approximately 42 percent of the outstanding common stock of MascoTech. MascoTech is a diversified manufacturer of original equipment and aftermarket parts for the transportation industry and also manufactures commercial, institutional and residential building products for the construction industry as well as other diversified products principally for the defense industry. In 1993, MascoTech had sales from continuing operations of $1.58 billion. MascoTech manufactures a broad range of semi-finished components, sub-assemblies and assemblies for the transportation industry. Transportation-related products represented 76 percent of MascoTech's 1993 sales from continuing operations and primarily consist of original equipment products for the automotive and truck industries. Over half of MascoTech's 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, MascoTech 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. 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 MascoTech's net sales from continuing operations. Specialty products manufactured by MascoTech include 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. MascoTech's sales of architectural products in 1993 were $289 million. MascoTech'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. MascoTech also markets waste-water treatment services to other industrial companies principally in southern California. MascoTech's sales in 1993 of these other specialty products were $99 million. MascoTech 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, MascoTech'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 TriMas Corporation, and MascoTech expects to divest the remaining businesses in 1994. MascoTech financial information contained in this Report has been reclassified for these discontinued operations. MascoTech currently owns approximately 43 percent of the outstanding common stock of TriMas Corporation, and the Company currently owns approximately 5 percent of the outstanding common stock of TriMas. TriMas is a diversified proprietary products company with leadership positions in commercial, industrial and consumer niche markets including industrial container closures, pressurized gas cylinders, towing systems products, specialty fasteners, specialty products for fiberglass insulation, specialty tapes, specialty industrial gaskets and precision cutting tools. PATENTS AND TRADEMARKS The Company holds a number of United States and foreign patents covering various design features and valve constructions used in certain of its faucets, and also holds a number of other patents and patent applications, licenses, trademarks and trade names. As a manufacturer of brand-name consumer products, the Company views its trademarks as important, 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 performance, quality, style, service and price, with the relative importance of such factors varying among products. A number of companies of varying size compete with one or more of the Company's product lines. EMPLOYEES At December 31, 1993, the Company employed approximately 45,000 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: Note: Multiple footnotes within the same parenthesis indicate the facility is engaged in activities relating to both segments. Multiple footnotes to the same municipality denote separate facilities in that location. Industry segments in the preceding table are identified as follows: (1) Building and Home Improvement Products Segment, and (2) Home Furnishings Products Segment. The home furnishings products manufacturing facilities are located primarily in North Carolina, with principal facilities ranging in size from 700,000 to 1,074,000 square feet. The two principal faucet manufacturing plants are located in Greensburg, Indiana and Chickasha, Oklahoma. The faucet manufacturing plants and the majority of the Company's other facilities range from approximately 20,000 to 700,000 square feet. The Company owns most of its manufacturing facilities and none of the properties is subject to significant encumbrances. The Company also maintains approximately 1.5 million square feet of designer and trade showroom space at various locations throughout the United States where it coordinates the display and sale of its home furnishings products and owns 725,000 square feet of showroom space in High Point, North Carolina utilized for furniture industry trade shows. The Company's corporate headquarters are located in Taylor, Michigan and are owned by the Company. An additional building near its corporate headquarters is used by the Company's corporate research and development department. 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 location of the principal manufacturing facilities of MascoTech 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. MascoTech's largest manufacturing facility is located in Vernon, California and is a multi-plant facility of approximately 920,000 square feet. MascoTech 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, MascoTech's manufacturing facilities range in size from approximately 25,000 to 325,000 square feet, are owned by MascoTech or leased and are not subject to significant encumbrances. MascoTech's executive offices are located in Taylor, Michigan, and are provided by the Company to MascoTech under a corporate services agreement. MascoTech's 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. Between 1982 and 1989, subsidiaries of the Company sold plastic plumbing fittings used to connect plastic pipes for water supply systems in residential construction. A small percentage of these fittings have experienced leaks which the Company believes are caused by deficiencies in the resin supplied to its subsidiaries by E.I. du Pont de Nemours and Company. The Company's policy has been to repair any leaks which have been reported and, as a result, the Company has not experienced litigation of any consequence arising from this situation. Based on the terms of a recent settlement of litigation previously instituted by the Company against du Pont, the Company does not believe that these matters will result in any future material adverse effect on the Company's financial position. Civil suits were filed in December 1992 in a California state court by the California Attorney General, the Natural Resources Defense Counsel and the Environmental Law Foundation against a subsidiary of the Company and approximately 15 other manufacturers or distributors of faucets sold in that state. The suits principally allege that brass faucets unlawfully leach lead into tap water and that the defendants have failed to provide clear and reasonable warnings in violation of California law. The plaintiffs have requested, among other things, that the defendants be enjoined from selling products in California that leach lead into tap water, be ordered to offer restitution to California purchasers of defendants' products, and pay unspecified compensatory and punitive damages. Based upon the Company's present knowledge and subject to future legal and factual developments, the Company does not believe that these suits will result in any material adverse effect on the Company's financial position. The Company is subject to other claims and litigation in the ordinary course of 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 REGULATIONS S-K). Executive officers who are elected by the Board of Directors serve for a term of one year or less. Each executive officer has been employed in a managerial capacity with the Company for over five years except for Mr. Gargaro. Richard A. Manoogian, the Chairman of the Board and Chief Executive Officer of the Company, is the son of its Chairman Emeritus, Alex Manoogian. Mr. Gargaro joined the Company as its Vice President and Secretary on October 1, 1993. Prior to joining the Company, Mr. Gargaro was a partner at the Detroit law firm of Dykema Gossett PLLC. Mr. Gargaro has served as a director and Secretary of MascoTech, Inc., since 1984 and a director and Secretary of TriMas Corporation since 1989. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The New York Stock Exchange is the principal market on which the Company's Common Stock is traded. The following table indicates the high and low sales prices of the Company's Common Stock as reported on the New York Stock Exchange Composite Tape and the cash dividends declared per share for the periods indicated: On March 15, 1994, there were approximately 8,200 holders of record of the Company's Common Stock. The Company expects that its practice of paying quarterly dividends on its Common Stock will continue, although future dividends will continue to depend upon the Company's earnings, capital requirements, financial condition and other factors. 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: ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. CORPORATE DEVELOPMENT While no major acquisitions occurred in 1993, acquisitions have historically contributed significantly to Masco's long-term growth, even though generally the initial impact on earnings is minimal after deducting acquisition-related costs such as interest and added depreciation and amortization. The important earnings benefit to Masco arises from subsequent growth of acquired companies, since incremental sales are not handicapped by these expenses. PROFIT MARGINS After-tax profit margins as a percent of net sales were 5.7 percent, 5.2 percent and 1.4 percent in 1993, 1992 and 1991, respectively. After-tax profit return on shareholders' equity was 11.7 percent, 10.2 percent and 2.5 percent in 1993, 1992 and 1991, respectively. The increased profit margins for 1993, compared with the previous two years, were primarily the result of increased product sales resulting from improved market shares and the modest economic recovery, as well as increased income related to the Company's equity investments in MascoTech, Inc. LIQUIDITY AND CAPITAL RESOURCES At year-end 1993, current assets were approximately 3.4 times current liabilities. Over the years, the Company has funded its growth through a combination of cash provided by operations and long-term bank and other borrowings. During 1993, cash was provided by $261 million from operating activities, $88 million from the sale of affiliate investments to MascoTech, $100 million from the redemption of the MascoTech 10% exchangeable preferred stock and $23 million from other net cash inflows; cash decreased by $167 million for the purchase of property and equipment, $131 million for a net decrease in debt and $99 million for cash dividends paid. The aggregate of the preceding items represents a net cash inflow of $75 million in 1993. Cash provided by operating activities totalled $261 million, $204 million and $244 million in 1993, 1992 and 1991, respectively; the Company has generally reinvested a majority of these funds in its operations. During 1993, the Company issued $400 million of fixed rate debt securities, with the proceeds being used to eliminate floating-rate borrowings under its bank revolving-credit agreement. The Company's anticipated internal cash flow is 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 will be satisfied through its internal cash flow and to the extent necessary in the financial markets. RECEIVABLES AND INVENTORIES During 1993, the Company's receivables increased by $43 million. This increase is primarily the result of increased sales in the fourth quarter of 1993 compared with the same period in 1992. During 1993, the Company's inventories increased by $39 million. As compared with the average manufacturing company, the Company maintains a higher investment in inventories, which relates to the Company's business strategies of providing better customer service, establishing efficient production scheduling and benefitting from larger, more cost-effective purchasing. CAPITAL EXPENDITURES Capital expenditures totalled $167 million in 1993, compared with $118 million in 1992. These amounts primarily pertain to expenditures for additional facilities related to increased demand as well as for new Masco products. The Company continues to invest in automating its manufacturing operations and increasing its productivity, in order to be a more efficient producer and improve customer service and response time. Depreciation expense and amortization expense were $82.1 million and $33.9 million, respectively, in 1993, compared with $79.4 million and $35.1 million, respectively, in 1992. This continued high level is primarily the result of acquisitions and the Company's capital expenditures programs. The major portion of amortization expense from the excess of cost over net assets acquired, relates to companies acquired in 1986 and 1987. These companies have been successful for many years in established markets not subject to rapid technological changes. At each balance sheet date management assesses whether there has been an impairment in the carrying value of excess of cost over net assets of acquired companies by primarily comparing current and projected sales, operating income and annual cash flows with the related annual amortization expense. EQUITY AND OTHER INVESTMENTS IN AFFILIATES Equity earnings from affiliates were $18.7 million in 1993 compared with equity earnings of $17.3 million in 1992 and equity loss of $12.6 million in 1991. In March 1993, the Company and MascoTech, Inc., partially restructured their affiliate relationships through transactions that reduced the Company's common equity interest in MascoTech from 47 percent to approximately 35 percent and resulted in MascoTech's acquisition of the Company's investments in Emco Limited. The Company received $87.5 million in cash, $100 million of 10% exchangeable preferred stock and seven-year warrants to purchase 10 million common shares of MascoTech at $13 per share. MascoTech received 10 million of its common shares, $77.5 million of its 12% exchangeable preferred stock, the Company's investments in Emco Limited and a modified option expiring in 1997 to require the Company to purchase up to $200 million aggregate amount of debt securities of MascoTech. In November 1993, MascoTech redeemed for cash its $100 million of 10% exchangeable preferred stock issued in March 1993. As a result of this redemption, the Company realized a $28.3 million pre-tax gain. In December 1993, following MascoTech's call for redemption, the Company converted the 6% debentures due 2011 into MascoTech common stock, thereby increasing the Company's common equity interest in MascoTech from approximately 35 percent to 42 percent. CASH DIVIDENDS During 1993, the Company increased its dividend rate seven percent to $.17 per share quarterly. This marks the 35th consecutive year in which dividends have been increased. Dividend payments over the last five years have increased at an eight percent average annual rate. Although the Company is aware of the greater interest in yield by many investors and has maintained an increased dividend payout in recent years, the Company continues to believe that its shareholders' long-term interests are best served by investing a significant portion of its earnings in the future growth of the Company. RECENTLY ISSUED FINANCIAL ACCOUNTING STANDARDS Statement of Financial Accounting Standards No. 112, Employers' Accounting for Postemployment Benefits, became effective in January 1994. This Standard specifies that the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement be accounted for on an accrual basis. This Standard will not have a material impact on the Company's financial statements. Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan, becomes effective in January 1995. This Standard addresses the accounting for impairment of a loan by specifying how allowances for credit losses should be determined. This Standard will not have a material impact on the Company's financial statements. Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, became effective in January 1994. This Standard defines the accounting and reporting for all investments in debt securities and for investments in equity securities that have readily determinable fair values. This Standard will not have a material impact on the Company's financial statements. GENERAL FINANCIAL ANALYSIS 1993 VERSUS 1992 Net sales in 1993 increased 10 percent to $3,886 million. The sales increase was primarily due to increased shipments of kitchen, bath and home furnishings products. Cost of sales as a percentage of sales was 67.5 percent in both 1993 and 1992. Selling, general and administrative expenses as a percentage of sales decreased modestly to 22.1 percent in 1993 from 22.3 percent in 1992. Operating profit increased 13 percent in 1993 from 1992. The Company's Building and Home Improvement Products sales in 1993 increased 10 percent to $2,188 million while operating profit increased 12 percent to $412 million. Sales in 1993 of the Company's Home Furnishings Products increased 11 percent to $1,698 million and operating profit increased 15 percent to $69 million. Included in other income and expense for 1993 are equity earnings from MascoTech, Inc. of $23.2 million, prior to an approximate $10 million after-tax fourth quarter charge which reflects the Company's equity share of MascoTech's loss provision for the disposition of its energy-related businesses and extraordinary loss on the early extinguishment of debt, as compared with $12.6 million of equity earnings in 1992. MascoTech reported income from continuing operations of $70.9 million and $39 million in 1993 and 1992, respectively, and net income, after preferred stock dividends, of $32.7 million for 1993 and $29.1 million for 1992. The results of MascoTech were favorably impacted by internal cost reductions and from increased demand in its transportation industries, which more than offset its 1993 fourth quarter special charges of $26 million after-tax. Included in the fourth quarter of 1993 is a $28.3 million pre-tax gain (approximately $18 million after-tax) on the redemption of MascoTech's 10% exchangeable preferred stock. This gain was principally offset by the Company's approximate $10 million after-tax equity share of MascoTech's above-mentioned fourth quarter special charges, as well as by charges related to certain restructurings of Company operations which should result in future cost savings. The Company reported increases in net income and earnings per share of 21 percent and 20 percent, respectively, in 1993 as compared with 1992. 1992 VERSUS 1991 Net sales in 1992 increased 12 percent to $3,525 million. Cost of sales as a percentage of sales decreased to 67.5 percent in 1992 from 70.2 percent in 1991. Selling, general and administrative expenses as a percentage of sales increased to 22.3 percent in 1992 from 21.8 percent in 1991. The sales increase was primarily due to increased shipments of kitchen, bath and home furnishings products. The decrease in cost of sales as a percentage of sales resulted primarily from profit improvement programs implemented in prior years having a favorable impact on current earnings. The increase in selling, general and administrative expenses as a percentage of sales was primarily due to increased promotional and advertising costs. Operating profit increased 44 percent. The Company's Building and Home Improvement Products sales in 1992 increased 16 percent while operating profit increased 35 percent. Sales and operating profit in 1992 of the Company's Home Furnishings Products increased 7 percent and 58 percent, respectively. Included in other income and expense for 1992 are equity earnings from MascoTech, Inc. of $12.6 million as compared with $9.2 million of equity loss in 1991. MascoTech reported net income, after preferred stock dividends, of $29.1 million for 1992, as compared with net loss, after preferred stock dividends, of $18.6 million in 1991. The results of MascoTech were favorably impacted by internal cost reduction and restructuring initiatives and from modest improvement in the economy. Also, lower interest rates contributed to reduced interest expense for 1992. Included in other income and expense for 1991 is approximately $32 million pre-tax of non-operating charges attributable to write-downs of the Company's carrying value of investments in certain affiliated companies and other long-term investments. The Company reported increases in net income and earnings per share of 308 percent and 303 percent, respectively, in 1992 as compared with 1991. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Masco Corporation: We have audited the accompanying consolidated balance sheet of Masco Corporation and subsidiaries 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 Masco 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 24, 1994 MASCO CORPORATION CONSOLIDATED BALANCE SHEET DECEMBER 31, 1993 AND 1992 See notes to consolidated financial statements. MASCO CORPORATION CONSOLIDATED STATEMENT OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See notes to consolidated financial statements. MASCO CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See notes to consolidated financial statements. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ACCOUNTING POLICIES: Principles of Consolidation. The consolidated financial statements include the accounts of Masco Corporation and all majority-owned subsidiaries. All significant intercompany transactions have been eliminated. Average Shares Outstanding. The average number of common shares outstanding in 1993, 1992 and 1991 approximated 152.7 million, 151.7 million and 149.9 million, respectively. Cash and Cash Investments. The Company considers all highly liquid investments with a maturity of three months or less to be cash and cash investments. Receivables. Accounts and notes receivable are presented net of allowances for doubtful accounts of $19.1 million at December 31, 1993 and $16.3 million at December 31, 1992. Property and Equipment. Property and equipment, including significant betterments to existing facilities, are recorded at cost. Upon retirement or disposal, 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 to 10 percent, and machinery and equipment, 5 to 33 percent. Depreciation was $82.1 million, $79.4 million and $70.2 million in 1993, 1992 and 1991, respectively. The excess of cost over net assets of acquired companies is being amortized using the straight-line method over periods not exceeding 40 years; at December 31, 1993 and 1992, such accumulated amortization totalled $127.2 million and $107.3 million, respectively. At each balance sheet date management assesses whether there has been an impairment in the carrying value of excess of cost over net assets of acquired companies primarily by comparing current and projected sales, operating income and annual cash flows with the related annual amortization expense. Purchase costs of patents are being amortized using the straight-line method over their remaining lives. Amortization of intangible assets was $33.9 million, $35.1 million and $32.5 million in 1993, 1992 and 1991, respectively. Fair Value of Financial Instruments. The carrying value of financial instruments reported in the balance sheet for current assets and current liabilities approximates fair value. The fair value of financial instruments that are carried as long-term investments (other than those accounted for by the equity method) was based principally on quoted market prices for those or similar investments or by discounting future cash flows using a discount rate that approximates the risk of the investments. The fair value of the Company's long-term debt instruments was based principally on quoted market prices for the same or similar issues or the current rates offered to the Company for debt with similar terms and remaining maturities. The aggregate market value of the Company's long-term investments and long-term debt at December 31, 1993 was approximately $230 million and $1,471 million, as compared with the Company's carrying value of $200 million and $1,418 million, respectively. The aggregate market value of the Company's long-term investments and long-term debt at December 31, 1992 was approximately $530 million and $1,508 million, as compared with the Company's carrying value of $537 million and $1,487 million, respectively. Recently Issued Professional Accounting Standards. Statement 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, which become effective in 1994 and 1995, will not have a material impact on the Company's financial statements. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 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. EQUITY INVESTMENTS IN AFFILIATES: Equity investments in affiliates consist primarily of the following equity and partnership interests: Excluding the partnership interest in Hans Grohe, for which there is no quoted market value, the aggregate market value of the Company's equity investments at December 31, 1993 (which may differ from the amounts that could then have been realized upon disposition), based upon quoted market prices at that date, was $889 million, as compared with the Company's related aggregate carrying value of $315 million. The Company's carrying value in the common stock of MascoTech, Inc. (formerly Masco Industries, Inc.) exceeds its equity in the underlying net book value by approximately $63 million at December 31, 1993. This excess, substantially all of which resulted from repurchases by MascoTech of its common stock, is being amortized over a period not to exceed 40 years. The Company's carrying value in the common stock of TriMas Corporation exceeds its equity in the underlying net book value by approximately $8 million at December 31, 1993. The Company's carrying value of its investment in Hans Grohe at December 31, 1993 approximates the Company's equity in the underlying net book value in this affiliate. In March 1993, the Company and MascoTech partially restructured their affiliate relationships through transactions that reduced the Company's common equity interest in MascoTech from 47 percent to approximately 35 percent and resulted in MascoTech's acquisition of the Company's investments in Emco Limited. The Company received $87.5 million in cash, $100 million of 10% exchangeable preferred stock and seven-year warrants to purchase 10 million common shares of MascoTech at $13 per share. MascoTech received 10 million of its common shares, $77.5 million of its 12% exchangeable preferred stock, the Company's investments in Emco Limited and a modified option expiring in 1997 to require the Company to purchase up to $200 million aggregate amount of debt securities in MascoTech. In November 1993, MascoTech redeemed for cash its $100 million of 10% exchangeable preferred stock issued in March 1993. As a result of this redemption, the Company realized a $28.3 million pre-tax gain. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) EQUITY INVESTMENTS IN AFFILIATES (CONTINUED): In December 1993, following MascoTech's call for redemption, the Company converted the 6% debentures due 2011 into MascoTech common stock, thereby increasing the Company's common equity interest in MascoTech from approximately 35 percent to 42 percent. As part of the Company's efforts to de-emphasize equity investments, in addition to its disposition of its investments in Emco Limited, in July 1992 the Company sold its 49 percent equity interest in Mechanical Technology Inc. at approximate carrying value. Approximate combined condensed financial data of the above companies, excluding data subsequent to 1991 of Emco Limited and Mechanical Technology Inc. as to which the equity method was discontinued as of January 1, 1992, are summarized in U.S. dollars as follows, in thousands: Certain amounts for 1992 and 1991 have been restated to reflect MascoTech's formal plan to divest its energy-related business segment. Equity in undistributed earnings of affiliates of $132 million at December 31, 1993, $118 million at December 31, 1992 and $105 million at December 31, 1991 are included in consolidated retained earnings. OTHER INVESTMENT IN MASCOTECH, INC.: In December 1993, following MascoTech's call for redemption, the Company converted the 6% debentures into MascoTech common stock at $18 per share. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PROPERTY AND EQUIPMENT: ACCRUED LIABILITIES: LONG-TERM DEBT: At December 31, 1993, all of the outstanding notes above are nonredeemable. In March 1993, the $200 million of 8.75% notes due 1996 were redeemed at par with borrowings under the Company's bank revolving-credit agreement. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) LONG-TERM DEBT (CONTINUED): In August 1993, the Company issued $200 million of 7.125% notes due August 15, 2013. In September 1993, the Company issued $200 million of 6.125% notes due September 15, 2003. The proceeds from these financings were used to eliminate floating-rate borrowings under the Company's bank revolving-credit agreement. In June 1992, the Company issued $200 million of 6.25% notes due June 15, 1995. In September 1992, the Company issued $200 million of 6.625% notes due September 15, 1999. The proceeds from these financings were used to reduce outstanding bank indebtedness. The 5.25% subordinated debentures due February 15, 2012 are convertible into common stock at $42.28 per share. The notes payable to banks at December 31, 1992 relate to a $750 million revolving-credit agreement, with any outstanding balance due and payable in November 1995. Interest is payable on borrowings under this agreement based upon various floating rates as selected by the Company. Certain debt agreements contain limitations on additional borrowings and restrictions on cash dividend payments and common share repurchases. At December 31, 1993, the amount of retained earnings available for cash dividends and common share repurchases approximated $242 million under the most restrictive of these provisions. At December 31, 1993, the maturities of long-term debt during the next five years were approximately as follows: 1994-$8.6 million; 1995-$204.1 million; 1996-$256.9 million; 1997-$1.1 million; and 1998-$1.0 million. At December 31, 1993, the Company had shelf registration statements on file with the Securities and Exchange Commission for up to $200 million of debt securities as well as up to 9.6 million shares of its common stock. Interest paid was approximately $104 million, $121 million and $127 million in 1993, 1992 and 1991, respectively. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SHAREHOLDERS' EQUITY: In April 1991, the Company issued 3 million shares of its common stock for approximately $64 million. The proceeds from this offering were used to reduce outstanding bank indebtedness. On the basis of amounts paid (declared), cash dividends per share were $.65 ($.66) in 1993, $.61 ($.62) in 1992 and $.57 ($.58) in 1991. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 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: Pursuant to restricted stock incentive plans, the Company granted long-term incentive awards, net, for 100,000, 267,000 and 36,000 shares of common stock during 1993, 1992 and 1991, respectively, to key employees of the Company and affiliated companies. The unamortized costs of unvested awards under these plans, aggregating approximately $47 million at December 31, 1993, are being amortized over the ten-year vesting periods. At December 31, 1993, a combined total of 10,595,000 shares of common stock was available for the granting of stock options and incentive awards under the above plans. Pursuant to the 1984 Restricted Stock (MascoTech) Incentive Plan, the Company may award to key employees of the Company and affiliated companies, shares of common stock of MascoTech, Inc. held by the Company. No such awards were granted in 1993, 1992 or 1991. At December 31, 1993, there were 4,694,000 of such shares available for granting future awards under this plan. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) EMPLOYEE RETIREMENT PLANS: 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 determined annually by the Directors. Aggregate charges to income under the pension and profit-sharing plans were $19.2 million in 1993, $16.9 million in 1992 and $15.9 million in 1991. At December 31, 1993, the combined assets of the Company's defined-benefit pension plans exceed the combined accumulated benefit obligation. Net periodic pension cost for the Company's pension plans includes the following components: Major assumptions used in accounting for the Company's pension plans are as follows: The funded status of the Company's pension plans at December 31, is summarized as follows, in thousands: In January 1993, Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, became effective. The Company sponsors certain postretirement benefit plans that provide medical, dental and life insurance coverage for eligible retirees and dependents in the United States based on age and length of service. At December 31, 1993, the aggregate present value of the accumulated postretirement benefit obligation approximated $10 million pre-tax and is being amortized over 20 years. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SEGMENT INFORMATION: The Company's operations in the industry segments detailed below consisted of the manufacture and sale principally of the following products: Building and home improvement -- faucets; plumbing fittings; kitchen and bath cabinets; showertubs, whirlpools and spas; kitchen appliances; builders' hardware; venting and ventilating equipment; and water pumps. Home furnishings products -- quality furniture, fabrics and other home furnishings products. Corporate assets consisted primarily of cash, real property and other investments. Pursuant to a corporate services agreement to provide MascoTech, Inc. with certain corporate staff and administrative services, the Company charges a fee approximating .8 percent of MascoTech net sales. This fee approximated $11 million in each of 1993, 1992 and 1991 and is included as a reduction of general corporate expense. (1) Income before income taxes and net income from foreign operations for 1993, 1992 and 1991 were $92 million and $55 million, $88 million and $54 million, and $72 million and $43 million, respectively. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) OTHER INCOME (EXPENSE), NET: Other items in 1991 include write-downs aggregating approximately $32 million pre-tax in the Company's long-term investments. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) INCOME TAXES: The effective tax rate differs from the United States federal statutory rate principally due to: equity earnings (1 percent in 1992 and -7 percent in 1991), higher tax rate applicable to foreign earnings (-1 percent in 1993, -2 percent in 1992 and -5 percent in 1991), amortization in excess of tax, net (-1 percent in 1993, -2 percent in 1992 and -6 percent in 1991), dividends-received deduction (1 percent in 1993 and 1992 and 2 percent in 1991), state income tax and other (-2 percent in 1993 and -4 percent in 1992 and 1991), and -1 percent in 1993 to record the effect on deferred tax liabilities caused by the increase in the tax rate from 34 percent to 35 percent. Income taxes paid were approximately $135 million, $97 million and $54 million in 1993, 1992 and 1991, respectively. Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, which requires the use of an asset and liability method of accounting for income taxes, became effective in January 1993. Deferred income taxes result from temporary differences between the tax basis of assets MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) INCOME TAXES (CONTINUED): and liabilities and the related basis as reported in the consolidated financial statements. Prior to 1993, the Company followed the requirements of Statement of Financial Accounting Standards No. 96, Accounting for Income Taxes. COMBINED FINANCIAL STATEMENTS (UNAUDITED): The following presents the combined financial statements of the Company, MascoTech, Inc. (formerly Masco Industries, Inc.), and TriMas Corporation as one entity, with Masco Corporation as the parent company. Certain amounts for 1992 and 1991 have been restated to reflect MascoTech's formal plan to divest its energy-related business segment. Intercompany transactions have been eliminated. Amounts, except earnings per share, are in thousands. MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) MASCO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED) INTERIM FINANCIAL INFORMATION (UNAUDITED): 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 at December 31, 1993, and for the years ended December 31, 1993, 1992 and 1991, consist of the following: I. Marketable Securities -- Other Investments 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 IX. Short-Term Borrowings X. Supplementary Income Statement Information (ii) (A) MascoTech, Inc. 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 Balance Sheet Consolidated Statement of Income Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements (ii) (B) MascoTech, Inc. and Subsidiaries Financial Statement Schedules appended hereto, as required for the years ended December 31, 1993, 1992 and 1991, consist of the following: II. Amount 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 (3) Exhibits. - --------------- (1) Incorporated by reference to the Exhibits filed with Masco Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. (2) Incorporated by reference to the Exhibits filed with Masco Corporation's Annual Report on Form 10-K for the year ended December 31, 1992. (3) Incorporated by reference to the Exhibits filed with Masco Corporation's Annual Report on Form 10-K for the year ended December 31, 1991. (4) Incorporated by reference to the Exhibits filed with Masco Corporation's Annual Report on Form 10-K for the year ended December 31, 1990. (B) REPORTS ON FORM 8-K. The following Current Report on Form 8-K was filed by Masco Corporation in the calendar quarter ended March 31, 1994: Report on Form 8-K dated March 2, 1994 reporting under Item 5, "Other Events," the 1993 year end financial results of the Company. The following financial statements were filed with such Report: (1) Audited consolidated balance sheet of Masco Corporation and subsidiaries 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 (2) Audited consolidated balance sheet of MascoTech, Inc. and subsidiaries 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. 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. MASCO CORPORATION By RICHARD G. MOSTELLER RICHARD G. MOSTELLER Senior Vice President -- Finance March 24, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. MASCO CORPORATION FINANCIAL STATEMENT SCHEDULES PURSUANT TO ITEM 14(A)(2) OF FORM 10-K ANNUAL REPORT TO THE SECURITIES AND EXCHANGE COMMISSION Schedules, as required, at December 31, 1993 and 1992 and for the years ended December 31, 1993, 1992 and 1991: MASCO CORPORATION SCHEDULE I. MARKETABLE SECURITIES -- OTHER INVESTMENTS DECEMBER 31, 1993 MASCO CORPORATION 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) Amounts receivable from employees are due June 30, 1994. The stated rate of interest is 7%. (B) 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 for 1992 includes interest income of $1,555,000, discount amortization of $681,000 and, in consideration for return to the Company of assets of approximate equal value, cancellation of the receivable balances of $1,592,000 for two former employees. Activity for 1991 includes interest income of $1,733,000 and discount amortization of $545,000. MASCO CORPORATION SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Including fixed asset additions of $5,480,000 in 1992 and $5,520,000 in 1991 obtained through the purchase of companies. (B) Adjustments and reclassifications between noncurrent asset accounts and the effect of foreign currency translation. MASCO CORPORATION 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 noncurrent asset accounts and the effect of foreign currency translation. MASCO CORPORATION SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Allowance of companies acquired and companies disposed of, net. (B) Deductions, representing uncollectible accounts written off, less recoveries of accounts written off in prior years. MASCO CORPORATION SCHEDULE IX. SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Note: (A) Computed primarily using the average daily balances or interest rates. MASCO CORPORATION SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Other captions provided for under this schedule are excluded as the amounts related to such captions are not material. MASCOTECH, INC. AND SUBSIDIARIES 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)(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 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 MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 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. 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 MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 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 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: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 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 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: 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 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. 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 exempt 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.

795879_1993.txt

795879_1993

1993

795879

Item 1. Business (a) General Development of Business. Union Square Hotel Partners L.P. (the "Partnership), formerly Shearson Union Square Associates L.P. (see Item 10. "Certain Matters Involving Affiliates"), is a Delaware limited partnership formed in June 1986. The general partner of the Partnership is Union Square/GP Corp., (the "General Partner"), formerly Shearson Union Square/GP Corp. (see Item 10. "Certain Matters Involving Affiliates"), a Delaware corporation and wholly-owned subsidiary of Lehman Brothers Group, Inc., formerly Shearson Lehman Brothers Group, Inc., and an affiliate of Lehman Brothers Inc., formerly Shearson Lehman Brothers Inc. (see Item 10. "Certain Matters Involving Affiliates"). The Partnership was formed to acquire the Hyatt on Union Square (the "Property" or "Hotel") located in San Francisco, California and operated under a long-term lease (the "Operating Lease") by California Hyatt Corporation ("California Hyatt"), a subsidiary of Hyatt Corporation ("Hyatt"). The Hotel was renamed the Grand Hyatt San Francisco on February 1, 1990. See Note 3 to the Financial Statements contained herein at Item 8 for additional information concerning the Hotel and the Operating Lease. Between September 24, 1986, the date of the initial closing, and March 26, 1987, the date of the final closing, 7,174,100 depositary units of limited partnership interest ("Units", holders of Units are herein referred to as "Unitholders") were issued. The net proceeds of the offering, after payment of offering and organization costs and acquisition fees aggregated $67,650,091. The Partnership commenced operation on August 29, 1986 with the acquisition of the Hotel for a purchase price of $127,727,472. The purchase price, related costs and establishment of initial reserve accounts were funded by the issuance of (1) a first mortgage loan (the "Mortgage Loan") for $70,000,000; (2) a loan payable secured by a second mortgage on the Hotel (the "Loan Payable") for $13,325,000; and (3) a note payable (the "Note Payable") for $55,000,000. The Note Payable was issued by an affiliate of the General Partner to enable the Partnership to consummate the purchase of the Hotel and was repaid in full on January 13, 1987 from the proceeds of the offering. Renovation Plan. During 1988, the Partnership and California Hyatt mutually agreed upon a renovation program (the "Renovation Plan") which was to be effected for a cost not expected to exceed $20,000,000. During 1989 and early 1990, the Renovation Plan was completed. The Hotel was renamed The Grand Hyatt San Francisco and reopened on February 1, 1990. The total amount expended toward the Renovation Plan was $20,676,768, of which $1,886,383 came from the FF&E Reserve Fund, $1,874,379 was the California Hyatt's contribution and $16,916,006 was funded by the Partnership. For information regarding the financing of the Renovation Plan, please refer to Note 3 to the Financial Statements contained herein at Item 8. The Restructuring. Due to the funding of the Renovation Plan and the downturn in operating results of the Hotel, the Partnership has experienced decreasing levels of liquidity. As a result, the Partnership was not able to meet its January 2, 1992 debt-service payment with respect to the Mortgage Loan or the December 31, 1991 repayment of an unsecured note due to the Mortgage Lender with respect to the Renovation Plan (the "Unsecured Note"). Following the Partnership's receipt of a notice of default (the "Default Notice") and the acceleration of the Partnership's debt obligations, the Partnership consummated a restructuring of its financing and property leasing arrangements (the "Restructuring"). See Note 4 to the Financial Statements which is incorporated herein by reference thereto for information concerning the terms of the Restructuring. (b) Financial Information About Industry Segments. The Partnership's sole business is to own and lease the Hotel that is operated by California Hyatt, under the Operating Lease. All of the Partnership's revenues and assets relate solely to such industry segment. (c) Narrative Description of Business. The Partnership's principal objectives were to (i) provide quarterly cash distributions, a portion of which were anticipated to be non-taxable due to depreciation deductions, (ii) preserve and protect capital and (iii) achieve long-term appreciation in the value of the Property for distribution upon sale. Due to the poor economic conditions in the hospitality industry and the resulting decline in the Hotel's operations, objective (i) has not been achieved and it is unlikely that objectives (ii) and (iii) can be achieved. Competition. The Hotel operates in a highly competitive market. The Partnership has identified 21 existing first-class and luxury properties with a total of approximately 12,885 guest rooms which are competitive with the Hotel. The Westin St. Francis, the Hyatt Regency, the Fairmont Hotel, the Ritz Carlton and the Sheraton Palace with a total of 3,485 guest rooms are considered by the Partnership to be primary competitors. These hotels are considered primary competitors due to their size, meeting facilities and market mix relative to the Hotel. The remaining sixteen properties, with a total of approximately 9,400 rooms, are secondary competitors which compete with the Hotel to a lesser degree. Eight hotels, the Ritz Carlton, the Sheraton Palace, the Mandarin Hotel, the Pan Pacific Hotel (formerly the Portman Hotel), the Nikko Hotel, the Park Hyatt, the San Francisco Marriott and the Hyatt Fisherman's Wharf opened after the Partnership commenced operations. These hotels have a total of 4,110 rooms and compete in varying degrees with the Hotel. The continued introduction of new properties has exerted downward pressure on occupancy and room rates throughout the city. Employees. The Partnership's business is managed by the General Partner and the Partnership has no employees. The Hotel's staff are employees of California Hyatt. Item 2. Item 2. The Property The Hotel, which is located on Union Square at the center of San Francisco's downtown retail district, has 693 rooms, two restaurants, one lounge and 22,000 square feet of meeting and banquet facilities and four retail tenants. The 36-story Hotel encompasses approximately 660,000 total square feet on a 35,391 square foot site. It was built in 1973 and substantially refurbished in 1982 and 1989, at which time the Hotel was converted to a Grand Hyatt. See Note 3 to the Financial Statements incorporated herein by reference thereto for additional information regarding the Hotel. Item 3. Item 3. Legal Proceedings See Note 8 to the Financial Statements, incorporated herein by reference there to. Item 4. Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to the Unitholders for a vote during the fourth quarter of the Partnership's past fiscal year. PART II Item 5. Item 5. Market for the Partnership's Limited Partnership interests and Security Holder Matters (a) Market Information. The Partnership has issued no common stock. There is no established trading market for the units. The securities issued by the Partnership consist of units of Limited Partnership interest. (b) Holders. The number of Unitholders as of December 31, 1993 was 5,767. (c) Dividends. Beginning with the second quarter of 1988, the General Partner has deferred payment of distributions and will not resume payment until such time as the Hotel's cash flow reaches a sufficient level in excess of its debt service. The terms of the First Mortgage Loan provide that at the time of any cash distribution, a cash flow to debt service ratio of not less than 1.2:1 must have been met or exceeded for the four most recently completed quarters and that cash available for debt service immediately after such distributions must be not less than $3,500,000. As of the end of the prior fiscal year, the cash flow to debt service ratio was 0.61:1, and the Partnership's cash generated by property operations available for debt service was $4,123,417. This ratio is determined based on the contract rate of 9.699%. Pursuant to the settlement of class actions against the Partnership and others (the "Settlement"), Shearson paid cash distributions to class member Limited Partners, in the amount of $.40 per Unit on February 12, 1993, $.30 per Unit on February 14, 1992 and $.10 per Unit on March 8, 1991. See Note 8 to the Financial Statements incorporated herein by reference thereto for additional information concerning the Settlement. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources The Partnership's liquidity and capital resources have been substantially impacted by the funding of the Renovation Plan which was completed in January 1990 (the "Renovation Plan") and extensive borrowing subsequent to the initial offering. Combined with weak results from operations since 1989, these factors led to a default by the Partnership on its January 2, 1992 debt-service payment with respect to its $70 million first mortgage loan (the "Mortgage Loan"). This default created other defaults under the Partnership's subordinate financings. Effective June 30, 1992, a restructuring of the Partnership's indebtedness and property leasing arrangements was successfully executed resulting in the waiver or cure of each of the Partnership's defaults (the "Restructuring"). Please refer to Note 4 to the Financial Statements, which are incorporated herein by reference thereto for additional details regarding the Restructuring and the Mortgage Loan. The Partnership made its minimum interest payment, due on July 2, 1993, as well as the quarterly debt service payment, due on January 2, 1994 to Bank of Nova Scotia, pursuant to the terms of the Restructuring. The next quarterly debt service payment is due on April 2, 1994, and the General Partner believes the Partnership's cash flow will be sufficient to make this payment. However, there can be no assurance that the cash flow will be sufficient to satisfy future minimum debt service payments as required by the restructuring plan. On April 27, 1993, Lehman Brothers Inc. elected not to renew the Guaranty of the minimum pay rate under the restructured Mortgage Loan for the year commencing July 4, 1993. The General Partner believes that this decision does not reflect a change of position by Lehman Brothers Inc., rather only that they will evaluate the future need for additional funding on a quarterly basis. The General Partner anticipates the need for continued interest accruals and deferrals pursuant to the Restructuring to mitigate cash flow shortfalls for the foreseeable future, given the state of the economy generally and the hospitality industry in particular. However, if the Partnership continues to remit only the minimum debt service payments, interest will continue to accrue. This accrual of interest may affect the Partnership's ability to refinance and/or sell the hotel property at a price which enables the payment of the Partnership's restructured debt, including the accrued and deferred interest. At December 31, 1993, the Partnership had cash, which is held in an interest bearing account, of $1,488,632 compared to $1,933,721 at December 31, 1992. The decrease is the result of payments for interest and administrative expenses in excess of rental income. California Hyatt is required to reimburse the Partnership $3,000,000 with respect to the installation of life safety systems at the Hotel (including sprinklers) and the abatement and/or removal of asbestos where necessary. The terms of this agreement require California Hyatt to make 36 monthly payments of principal plus interest beginning in January 1991, as a deduction from the Hotel's operating profit. The Partnership reduced building costs and established a receivable from California Hyatt in the amount of $600,000 at December 31, 1990, which represented management's estimate of the portion of such reimbursements in excess of normal lease payments otherwise anticipated to be received. As a result of the amendment to the Hotel lease, completed as part of the Restructuring, California Hyatt's effective commitment to reimburse the Partnership for the installation of life safety systems at the Hotel (including sprinklers) and the abatement and/or removal of asbestos where necessary, was reduced in 1992 by $187,500. Accordingly, this amount was added to the Partnership's cost of the life safety system. As a result of payments made during the year of 1993, Receivable - life safety system declined from $75,000 at December 31, 1992 to $6,287 at December 31, 1993. Accounts payable and accrued expenses decreased to $44,718 at December 31, 1993 compared with $264,405 at December 31, 1992 primarily due to the payment of legal and other professional fee expenses incurred by the Partnership in 1992 with respect to the Restructuring. Accrued interest increased to $7,885,464 at December 31, 1993 compared with $4,701,486 at December 31, 1992, which is the net of accrued interest expense for the period less the minimum interest payments made on the Mortgage Loan. Deferred interest increased from $6,957,286 at December 31, 1992 to $7,452,135 at December 31, 1993 and Notes and Loans - Affiliate increased from $41,903,137 at December 31, 1992 to $45,209,234 at December 31, 1993. These accounts have increased due to compounding of interest on the principal balances. Due to the downturn in operating results of the Hotel, the General Partner suspended payment of cash distributions starting with the second quarter of 1988. However, a cash distribution in the amount of $.40 per unit, which represents the third and final distribution pursuant to the Settlement, was paid to class member Limited Partners on February 12, 1993. See Note 8 to the Financial Statements contained herein at Item 8. Item 8. Financial Statements and Supplementary Data See Item 14 "Exhibits, Financial Statement Schedules, and Reports on Form 8-K" for a listing of the financial statements filed with this report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure On October 16, 1992, the firm of Arthur Andersen & Co. was replaced as the principal auditors to audit the Partnership's financial statements and the firm of Coopers & Lybrand was engaged as principal auditors to audit the Partnership's financial statements. In connection with the audit of 1991, there were no disagreements with Arthur Andersen & Co. on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure. In addition, there were no disagreements with Arthur Andersen & Co. for the period subsequent to the 1991 audit, January 1, 1991 through October 16, 1992. Arthur Andersen & Co.'s report on the financial statements for 1991 was qualified as to concerns regarding the Partnership's ability to continue as a going concern. Subsequent to Arthur Anderson & Co.'s report on the financial statements for 1991, the Partnership executed the Restructuring discussed in detail in Note 4 to the Financial Statements incorporated herein by reference thereto. The decision to change accountants was approved by the Board of Directors of the General Partner. Refer to Exhibit 10.a in Item 14 "Exhibits, Financial Statement Schedules, and Reports on Form 8-K." PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The Partnership has no officers or directors. The General Partner, Union Square/GP Corp., formerly Shearson Union Square/GP Corp., is a wholly-owned subsidiary of Lehman Brothers Group Inc., and has offices at the same location as the Partnership. The General Partner manages and controls substantially all of the Partnership's affairs and has general responsibility and ultimate authority in all matters affecting the Partnership business. All of the officers and directors of the General Partner are also officers and employees of Lehman. Certain officers of the General Partner are now serving (or in the past have served) as officers or directors of entities which act as general partners of a number of real estate limited partnerships which have sought relief under the United States Bankruptcy Code. The partnerships which have filed bankruptcy petitions own real estate which has been adversely affected by the economic conditions in the markets in which that real estate is located and, consequently, the partnerships sought the protection of the bankruptcy laws primarily to protect the partnerships' assets from loss through foreclosure. The Officers and/or Directors of the General Partner are as follows: Name Office Jeffrey C. Carter Director and President Joseph J. Flannery Vice President and Chief Financial Officer Ron Hiram Director and Vice President There is no family relationship among any of the foregoing directors or officers. All of the foregoing directors have been elected to serve one year terms. The business experience during the past five years of each of the directors and officers of the General Partner of the Partnership is detailed below. Jeffrey C. Carter, 48, is a Senior Vice President of Lehman Brothers in the Capital Preservation and Restructuring Group. Mr. Carter joined Lehman Brothers in September 1988. From 1972 to 1988, Mr. Carter held various positions with Helmsley-Spear Hospitality Services, Inc. and Stephen W. Brener Associates, Inc. including Director of Consulting Services at both firms. From 1982 through 1987, Mr. Carter was President of Keystone Hospitality Services, an independent hotel consulting and brokerage company. Mr. Carter received his B.S. degree in Hotel Administration from Cornell University and his M.B.A. from Columbia University. Joseph J. Flannery, 32, is a Vice President in the Capital Preservation and Restructuring Group of Lehman Brothers focusing primarily on hotel related partnerships. Prior to joining Shearson in June of 1989, he was an investment analyst for The Prudential Property Company and a consultant for Pannell Kerr Forster. Mr. Flannery received a B.S. degree from Cornell University's School of Hotel Administration. He has also lectured undergraduate and graduate classes at numerous universities and published articles on hotel related issues. Ron Hiram, 41, serves as a Managing Director of Lehman Brothers in its Capital Preservation and Restructuring Group. From 1986 to 1987, he served as a Vice President in Shearson Lehman Brothers' Investment Banking Division and as the assistant to its Chairman and Chief Executive Officer from 1982 to 1985. Mr. Hiram is a Director of EIP Capital Corporation. Mr. Hiram received an M.B.A. degree from Columbia University in 1981 and a Bachelor of Commerce degree from the University of Natal, South Africa. Certain Matters Involving Affiliates On July 31, 1993, Shearson Lehman Brothers Inc. ("Shearson") sold certain of its domestic retail brokerage and asset management businesses to Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Subsequent to this sale, Shearson changed its name to Lehman Brothers Inc. The transaction did not affect the ownership of the Partnership or the Partnership's General Partners. However, the assets acquired by Smith Barney included the name "Shearson." Consequently, effective October 21, 1993, the General Partner changed its name to Union Square/GP Corp., and effective December 29, 1993, the Partnership changed its name to Union Square Hotel Partners Limited Partnership to delete any reference to "Shearson." Item 11. Item 11. Executive Compensation All of the directors and executive officers of the General Partner are employees of Lehman Brothers Inc. They do not receive any salaries or other compensation from the Partnership. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management To the knowledge of the General Partner, no person owns more than 5% of the outstanding Units. Item 13. Item 13. Certain Relationships and Related Transactions All of the officers and directors of the General Partner are employees of Lehman Brothers Inc. For information regarding transactions with affiliates, please refer to Note 6 to the Financial Statements incorporated herein by reference thereto. PART IV Item 14. Item 14. Exhibits, Financial Statements, and Reports on Form 8-K (a) (1) and (2) UNION SQUARE HOTEL PARTNERS LIMITED PARTNERSHIP INDEX TO FINANCIAL STATEMENTS Independent Accountant's Reports Coopers & Lybrand's Report Arthur Andersen & Co.'s Report Financial Statements: Balance Sheets - At December 31, 1993 and 1992 Statements of Operations - For the years ended December 31, 1993, 1992 and 1991 Statements of Changes in Partners' Capital (Deficit) - For the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows - For the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Independent Accountant's Report on Schedule XI Schedule XI - Real Estate and Accumulated Depreciation All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted as (1) the information required is disclosed in the financial statements and notes thereto; (2) the schedules are not required under the related instructions; or (3) the schedules are inapplicable. Exhibit Index (a)(3) Exhibits 3.a Amended and restated Agreement of Limited Partnership of Shearson Union Square Associates dated August 18, 1986 (included in Amendment No. 2 to registration Statement No. 33-6678) incorporated by reference. 10.a Stipulation and Agreement of Compromise and Settlement filed in the Court of Chancery of the State of Delaware in and for New Castle County in June 8, 1990. 10.b Documents for Restructuring of Indebtedness Encumbering the Grand Hyatt Union Square Hotel among Shearson Union Square Associates Limited Partnership, as Borrower, and The Bank of Nova Scotia, as First Lien Holder, Capital Growth Mortgage Investors, L.P., as Second Lien Holder, Hyatt Corporation, as Third Lien Holder, and California Hyatt Corporation, as Hotel Manager dated June 30, 1992. (b) Reports on form 8-K filed in the fourth quarter of fiscal 1992. On October 16, 1992, the Partnership filed a Form 8-K with the Securities and Exchange Commission pursuant to a change in its independent auditors. See Item 9. "Changes in and Disagreements with Accountants on Accounting and Financial Disclosure". 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 SQUARE HOTEL PARTNERS, L.P. BY: Union Square/GP Corp. General Partner Date: March 30, 1994 BY: s/Jeffrey C. Carter/ Name: Jeffrey C. Carter Title: 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 in the capabilities and on the dates indicated. UNION SQUARE/GP CORP. General Partner Date: March 30, 1994 BY: s/Jeffrey C. Carter/ Name: Jeffrey C. Carter Title: Director and President Date: March 30, 1994 BY: s/Ron Hiram/ Name: Ron Hiram Title: Vice President and Director Date: March 30, 1994 BY: s/Joseph J. Flannery/ Name: Joseph J. Flannery Title: Vice President and Chief Financial Officer Report of Independent Accountants The Partners Union Square Hotel Partners, L.P. We have audited the accompanying balance sheets of Union Square Hotel Partners, L.P. (formerly Shearson Union Square Associates, L.P.) as of December 31, 1993 and 1992, and the related statements of operations, partners' deficit and cash flows for the years then ended. 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. The financial statements of Union Square Hotel Partners, L.P. as of December 31, 1991, were audited by other auditors whose report dated March 3, 1992 (except with respect to the matter of a notice of default under mortgage loan, as to which the date was March 9, 1992), on those financial statements included an explanatory paragraph that described the default under the mortgage loan raising substantial doubt about the Partnership's ability to continue as a going concern. The default was cured on June 30, 1992 through a restructuring, discussed in Note 4 to the financial statements. 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 2 to the financial statements, the carrying value of the Partnership's real estate exceeds estimated fair value as of December 31, 1993 and 1992. The recovery of the carrying value of the Partnership's real estate is dependent upon the improvement of market conditions. The ultimate outcome of this matter cannot presently be determined. In accordance with generally accepted accounting principles, no provision for impairment is required. Accordingly, no provision for any asset impairment has been made in the accompanying financial statements. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Union Square Hotel Partners, L.P. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles. The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 4 to the financial statements, the Partnership has suffered recurring losses from operations and the guaranty of the Partnership's debt service payments by an affiliate of the General Partner expired during 1993, which raises substantial doubt about the Partnership's ability to continue as a going concern. The General Partner's plans in regard to these matters are also described in Note 4. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. COOPERS & LYBRAND Hartford, Connecticut February 3, 1994 Report of Independent Accountants The Partners Union Square Hotel Partners, L.P. We have audited the accompanying statements of operations, partners' deficit and cash flows of Union Square Hotel Partners, L.P. (the Partnership) for the year ended December 31, 1991. These financial statements are the responsibility of the Partnership 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 provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Union Square Hotel Partners, L.P. for the year ended December 31, 1991, in conformity with generally accepted accounting principles. The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 12 to the 1991 financial statements, the Partnership has suffered and anticipates that it will continue to suffer recurring cash losses from operations and is in default under its mortgage loan payable, which has resulted in the demand for repayment of the debt balance. In addition, on March 9, 1992, the First Mortgagee recorded a Notice of Default and Election to Sell Under Deed of Trust. Furthermore, the Partnership is in default under substantially all of its other debt, which may result in the acceleration of the scheduled repayment of debt balances. Such defaults may also result in the assessment of certain penalties and fees, as provided in the various debt agreements. These factors raise substantial doubt about the Partnership's ability to meet its cash needs and, therefore, to continue as a going concern. Management's plans in regard to these matters are also described in Note 12 to the 1991 financial statements. The accompanying financial statements do not include any adjustments related to the recoverability of asset carrying amounts or the amount of liabilities that might result should the Partnership be unable to continue as a going concern. ARTHUR ANDERSEN & CO. Boston, Massachusetts March 3, 1992 (except with respect to the matter discussed in Note 13 to the 1991 financial statements, as to which the date is March 9, 1992) Notes to Financial Statements December 31, 1993, 1992 and 1991 1. Organization Union Square Hotel Partners Limited Partnership (the "Partnership"), formerly Shearson Union Square Associates Limited Partnership (see below), was formed in June 1986 under the Delaware Revised Uniform Limited Partnership Act for the purpose of acquiring the Hyatt on Union Square (the "Hotel"), located in San Francisco, California, under a long-term operating lease. Initial capital of $1,000 was contributed by Union Square/GP Corp. (the "General Partner"), formerly Shearson Union Square/GP Corp. (see below), a Delaware corporation and wholly owned subsidiary of Lehman Brothers Group, Inc. formerly Shearson Lehman Hutton Group, Inc. The agreement of limited partnership authorized the issuance of a maximum of 7,174,100 Depository Units (the "Units") which represent Partnership interests. At March 26, 1987, an aggregate of 7,174,100 units was issued, and the offering was terminated. On July 31, 1993, Shearson Lehman Brothers Inc. sold certain of its domestic retail brokerage and asset management businesses to Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Subsequent to the sale, Shearson changed its name to Lehman Brothers Inc. ("Lehman"). The Transaction did not affect the ownership of the General Partner. However, the assets acquired by Smith Barney included the name "Shearson." Consequently, effective October 21, 1993, the General Partner changed its name to Union Square/GP Corp., and effective December 29, 1993, the Partnership changed its name to Union Square Hotel Partners Limited Partnership. 2. Significant Accounting Policies Basis of Accounting. The accompanying financial statements of the Partnership have been prepared on the accrual basis of accounting. Real Estate Depreciation. Real estate investments, which consist of land, building and personal property, are recorded at cost, less accumulated depreciation. Cost includes the initial purchase price of the property plus closing costs, acquisition and legal fees, and capital improvements. Depreciation is computed using the straight-line method based on the estimated useful life of 40 years. Depreciation of building improvements is computed over the remaining useful life of the building. Depreciation of the personal property is computed under the straight-line method over an estimated useful life of 7 years. When building and personal property are sold or otherwise disposed of, when required, the asset account and related accumulated depreciation account are relieved, and any gain or loss is included in operations. The current estimated market value of the hotel real estate investment as of December 31, 1993 continues to decline from that of prior years. While the property has not been recently appraised, management believes that the carrying value of the Partnership's real estate significantly exceeds fair market value at December 31, 1993. The Partnership's hotel real estate investments will be carried at cost, less accumulated depreciation. The Partnership's depreciated investment is exceeded by the amount of the outstanding nonrecourse indebtedness. Accordingly, no adjustment has been made to the carrying value. The ultimate outcome of this matter can not presently be determined. In accordance with generally accepted accounting principles, a provision for impairment is not required. Accordingly, no provision for any asset impairment has been made in the accompanying financial statements. Deferred Charges. The following fees and costs have been capitalized and are amortized on a straight-line basis over the following periods: Organization costs 5 years Mortgage consent fee 7 years Mortgage and loan origination fee 10-1/3 years Mortgage loan placement fee 10-1/3 years Loan negotiation fee 10-1/3 years An improvement program supervisory fee incurred in 1989 has been capitalized on a pro rata basis, based on annual improvement program expenditures in relation to the total expected expenditures during the term of the improvement program, and is depreciated using the applicable method and life. Offering Costs. Offering costs are nonamortizable and have been deducted from the Limited Partners' capital. Income Taxes. No income tax provision (benefit) has been recorded on the books of the Partnership, as the respective shares of taxable income (loss) are reportable by the partners on their individual tax returns. Partnership Agreement. Pursuant to the terms of the Partnership Agreement, all profits and losses incurred prior to the month in which Unitholders were first admitted shall be allocated 99.99% to the General Partner and .01% to the Assignor Limited Partner. Thereafter, all income, profits and losses shall be allocated 99% to the Unitholders and 1% to the General Partner, except for the profits from the sale or other disposition of all or any substantial part of the Hotel. Profits of the Partnership from the sale or other disposition of all or any substantial part of the Hotel shall be allocated to the General Partner in an amount equal to the greater of 1% of the profits or the amount distributable to the General Partner as sale or refinancing proceeds from such sale. All remaining profits shall be allocated among the Unitholders. Net cash flow shall be distributed 99% to the Unitholders and 1% to the General Partner until each Unitholder has received an aggregate cumulative compounded distribution for each fiscal year equal to 12% of their capital investment ("Preferred Return"). Thereafter, distributions shall be allocated 90% to the Unitholders and 10% to the General Partner. Sale or refinancing proceeds shall be distributed 99% to the Unitholders and 1% to the General Partner until such time as the Unitholders have received cumulative distributions of sale or refinancing proceeds in an amount equal to their unreturned original investment plus an aggregate amount of the net cash flow and sale or refinancing proceeds equal to their aggregate Preferred Return. Any remaining sale or refinancing proceeds shall first be applied to the payment to the General Partner of a subordinated disposition fee, if any, equal to 3% of sales proceeds and thereafter shall be allocated 90% to the Unitholders and 10% to the General Partner. In conjunction with the settlement agreement discussed in Note 11, the General Partner's share of the proceeds, in the event of a sale or refinancing of the property, will be reduced to 5%. Reclassifications. Certain prior year amounts have been reclassified in order to conform to the current year's presentation. 3. Real Estate The Partnership's real estate consists of a 693-room hotel known as the Grand Hyatt San Francisco (formerly "Hyatt on Union Square") located in Union Square in San Francisco, California. The Hotel was originally constructed in 1973 and was purchased by the Partnership on August 29, 1986. The Hotel was purchased subject to an operating lease with California Hyatt Corporation ("California Hyatt"), a subsidiary of Hyatt Corporation ("Hyatt"), which provides for an initial term of 20 years expiring on December 31, 1994 and two 10-year renewal options. The first 10-year renewal option has been exercised. Rent payable under the lease has been modified by the restructuring agreement effective June 30, 1992 (see note 4). Pursuant to the terms of the operating lease, California Hyatt is required to maintain a reserve fund ("FF&E Reserve Fund") for the replacement of furnishings and equipment in the Hotel. This reserve is funded by the operating revenues of the Hotel and will be funded at 3% of the Hotel's gross receipts through 1997 and 4% thereafter. Other conditions of the renovation program provide that 70% of the 1990 replacement escrow is to be applied to the Partnerships liability to California Hyatt in 1990. From January 1, 1991 to June 30, 1992, 70% of replacement escrow income is to be applied to the outstanding balance of the loan payable - Hyatt. During 1988, the Partnership and California Hyatt mutually agreed upon a renovation program which was to be effected for a cost not expected to exceed $20,000,000. During 1989 and early 1990, the renovation program was completed. The Hotel was renamed The Grand Hyatt San Francisco and reopened on February 1, 1990. As of December 31, 1990, $20,676,768 related to the renovation program was expended. In connection with the reopening of the Hotel in 1990, the Partnership has recorded a write-down in carrying value of personal property which was replaced during the renovation, based on the original purchase price allocated to such property. During 1991, the Partnership and California Hyatt reached an agreement on the revised terms of California Hyatt's contribution to the renovation program. This contribution is equal to 10% of the total renovation costs, in excess of funds provided by the FF&E Reserve, up to a maximum of $2,000,000. As a result of the revised agreement, the total contribution due from California Hyatt (which was fully funded at December 31, 1991) amounted to $1,874,379, and accordingly, a reduction in the renovation contribution in the amount of $125,621 was recorded. In addition, renovation costs in excess of $20,000,000 will be assumed and capitalized by the Partnership. At December 31, 1990, the Partnership recorded a receivable from California Hyatt in the amount of $600,000. This balance represents the net proceeds to be reimbursed to the Partnership under the second amendment to the lease relating to the costs incurred for the asbestos removal and installation of the life safety systems. Payments will be received in 36 equal monthly installments, including interest at prime plus .5%. The balance due was reduced by $187,500 as a result of the Restructuring Agreement. Asbestos was removed or abated where necessary, in conjunction with the installation of sprinklers and other life safety systems. As disclosed in the original prospectus, the Hotel contains asbestos in certain areas which were determined to be nonhazardous and in conformity with all current statutes. This situation may or may not impact the future value of the property. The following presents summarized information with respect to the operations of the Hotel provided by the lessee for the years ended December 31, 1993, 1992 and 1991. 4. Restructuring Agreement Under the terms of the Mortgage Loan, a regular installment of interest in the amount of $3,394,650 was due on January 2, 1992. Under the terms of the Note Payable, the $1 million in principal and $341,502 in accrued interest was due on December 31, 1991. None of the foregoing payments were made, and the Partnership did not have sufficient funds to make such payments. On January 9, 1992, the Partnership received a notice from the First Mortgagee that the Partnership is in default on its obligations with respect to the Mortgage Loan and Note Payable. Such defaults entitle the Mortgage Lender to accelerate the Mortgage Loan and Note Payable subject to any defenses available to the Partnership. On January 21, 1992, an affiliate of the General Partner, which guaranteed the Note Payable, fulfilled its commitment to repay the outstanding balance of the Note Payable. On March 3, 1992, the Partnership received a notice whereby the bank declared the entire principal and interest under the Mortgage Loan immediately due and payable. On March 9, 1992, the First Mortgagee recorded, with the San Francisco County Recorder, a Notice of Default and Election to Sell under Deed of Trust (the "Default Notice"). The default on the Mortgage Loan also constituted an event of default under the Loan Payable - affiliate, the Supplemental Loan and the Hyatt Loan. On March 25, 1992, the Partnership received a notice of acceleration from the holder of the Loan Payable - affiliate, which declared the entire principal and accrued interest on the loan due and payable. On June 30, 1992, Union Square Hotel Partners Limited Partnership (the "Partnership") consummated a restructuring of its financing and property leasing arrangements. Mortgage Loan Payable - First Deed of Trust Note. Under the terms of the restructuring, the outstanding principal amount of the Note - $70,000,000 - will continue to accrue interest at the annual rate of 9.699%. Payments of interest will be limited, however, to the Partnership's cash flow from the Hotel. Minimum interest payments (the "Minimum Payments") must be made semi-annually and shall be computed on the principal balance of the First Deed of Trust, less a $15,000,000 principal participation purchased by Lehman Brothers Lending Corp, formerly Shearson Lending Corp, an affiliate of the General Partner. The par rate for the Minimum Payments are as follows: 6.5% through January 2, 1994; 7.5% through January 2, 1995; 8.5% through January 2, 1996; and 9.699% thereafter until maturity on January 2, 1997. The amount of any accrued and unpaid interest is to be added to the principal of the First Deed of Trust Note. Lehman Brothers Holdings Inc. (the "Guarantor") formerly Shearson Lehman Brothers Holdings Inc., an affiliate of the General Partner, provided a payment guaranty (the "Guaranty") to the Bank with respect to the Minimum Payments required to be made through July 3, 1993. The Guarantor may, at its sole option, extend the Guaranty for successive one-year periods through the maturity date of the First Deed of Trust Note. In the event that the Guarantor does not elect to extend the Guaranty, the Partnership's interest payments thereafter will be due and payable quarterly, rather than semi-annually as previously provided. On April 27, 1993, Lehman Brothers Inc. elected not to renew the Guaranty of the minimum pay rate commencing July 4, 1993. The Bank waived immediate repayment of the Past Due Interest, but the amount will accrue interest at a the Bank's "prime" rate plus one percent. The balance is due upon maturity of the note. Loan Payable Affiliate - Second Deed of Trust Note. Capital Growth Mortgage Investors, L.P. ("Capital Growth"), the holder of the second deed of trust in the Hotel, agreed to reduce the interest rate applicable to the note from 12.5% to 11%. The reduction of the interest rate is effective from and after January 2, 1992. Capital Growth also agreed to waive the mandatory prepayments on account of interest of $261,199, $1,014,379 and $1,996,457, otherwise required to be paid on January 2, 1995, January 2, 1996 and January 2, 1997, respectively. Capital Growth also agreed to waive any prepayment (or yield maintenance) charges in connection with the prepayment of all or any portion of the principal or accrued interest under the Second Deed of Trust Note. Capital Growth also agreed to automatically extend the maturity date of the Second Deed of Trust Note to the same maturity date as the First Deed of Trust Note, so long as the maturity date is no later than January 2, 1999. Loan Payable Hyatt - Third Deed of Trust Note. Hyatt Corporation ("Hyatt") the holder of a third deed of trust note collateralized by the Hotel forgave $2,000,000 of the outstanding indebtedness under the Third Deed of Trust Note. Hyatt also reduced the interest rate from one percent above the prime rate to the lesser of (i) the prime rate or (ii) eight percent. Hyatt also agreed to a deferral of interest to the extent that the interest payments otherwise required to be paid under the note are not available from cash flow. Hyatt also agreed to extend the maturity date of the note to the maturity date of the First Deed of Trust Note-January 2, 1997. The Partnership made principal payments of $75,000 and $250,000 during 1993 and 1992, respectively and agreed to make a further prepayment of principal of $75,000 on December 1, 1994. The effect of these concessions by Hyatt is a calculated amount of $1,041,372 for the Partnership resulting in a reduction of the Third Deed of Trust Note by such amount. The amount has been recorded as the extraordinary item, gain on restructuring for $23,287, net of restructuring expenses of $1,018,085. Operating lease - California Hyatt Corporation. California Hyatt Corporation operates the Hotel under the terms of a lease agreement ("the Lease") with the Partnership. California Hyatt agreed to change the amount to be retained by California Hyatt under the terms of the lease effective July 1, 1992 through December 31, 1996, from an amount equal to 20% of the Hotel's net profit to an amount equal to (i) one percent of the Hotel's gross revenues plus (ii) 7.5% of the Hotel's net profit. California Hyatt agreed that after December 31, 1996 and until the First Deed of Trust Note matures, but in any event not after January 2, 1999, the amount to be retained by California Hyatt will be an amount equal to (i) one percent of the Hotel's gross revenues plus (ii) ten percent of the Hotel's net profit. Thereafter, the amount to be retained by California Hyatt will return to 20% of the Hotel's net profit as required by the Lease for periods prior to the restructuring. Amounts due to the Partnership will be remitted 20 days after the end of each month. Furthermore, California Hyatt agreed that the Partnership will have the unilateral right to terminate the Lease, without cause, at any time from the date of the restructuring through December 31, 1998, upon payment of a fee in a fixed amount ranging from $10,000,000 to $16,032,500, which amount increases with the passage of time. California Hyatt further agreed that upon payment of the Early Termination Fee, it would cause Hyatt to forgive the entire amount of indebtedness under the Third Deed of Trust Note. In addition, California Hyatt agreed that the Partnership may terminate the Lease, without the payment of a termination fee, in the event that (i) the Hotel generates a deficit for any calendar year and (ii) the Partnership prepays all indebtedness due under the Third Deed of Trust Note. California Hyatt may, however, cure any such deficit and avoid a termination of the Lease by paying the amount of such deficit to the Partnership. Restructuring expense note. In order to provide the Partnership with the funds to cover the costs of restructuring and ongoing administrative expenses, Shearson Lending has committed to lend the Partnership up to $1,000,000. Advances borrowed under this agreement will accrue interest at prime plus 1% and all principal and accrued interest will be due and payable on the maturity date of the Bank of Nova Scotia Note. The entire $1,000,000 is outstanding as of December 31, 1993 and 1992. 5. Note Payable In order to effect the renovation program, the Partnership has obtained the consent of the First Mortgagee for various modifications of the first Mortgage Loan that permits use of substantially all of the Partnership's reserve funds to be reinvested into the Hotel and also permits Hyatt Corporation to provide financing to the Partnership . In consideration for such consent, the Partnership will pay a fee of $1,000,000 to the First Mortgagee which is evidenced by a note, bearing interest at 9.699%, compounded annually, due either upon the sale of the Hotel or December 31, 1991, whichever occurs first (see Note 7). As a result of the Partnership's failure to pay the principal and accrued interest on December 31, 1991, the note was declared in default. The lender pursued its remedies under which, Lehman Holdings, Inc. ("LB Holdings"), formerly Shearson Lehman Holdings Inc., is required to make payment as guarantor of the note. LB Holdings fulfilled its commitment to repay the outstanding balance in January 1992. The Partnership's obligation is included in Notes & Loans - Affiliates. 6. Transactions with Affiliates Cash. Cash was held in interest-bearing accounts managed by an affiliate of the General Partner until May 1993. As of December 31, 1993 and 1992, such cash was $1,488,632 and $1,933,721. Notes Payable LB Holdings, an affiliate of the General Partner, has fulfilled it's guarantee of payment of the $1,000,000 plus interest thereon to the First Mortgagee (see Note 5). As a result, the Partnership is now obligated to LB Holdings in the amount of $1,341,502 in the form of a note which bears interest at 9.699% and becomes payable upon the sale of the property. As required under the class action settlement, on March 4, 1991, an affiliate of the General Partner and the Partnership entered into the Shearson Loan up to a maximum of $10 million, bearing interest at an annual simple interest rate of 5%. Proceeds of the loan were to be used to the extent needed to fund operating and fixed expenses. On the effective date of the loan, $8,217,302 of the proceeds were used to retire an interim loan plus accrued interest. On July 12, 1991, the remaining proceeds of $1,782,698 were drawn and used to pay a portion of the interest with respect to the First Mortgage Loan indebtedness. As of December 31, 1993 and 1992, the full principal balance of $10,000,000 remains outstanding. The outstanding principal and accrued interest matures and becomes payable upon the sale of the property or upon a refinancing which provides proceeds sufficient to repay other existing indebtedness. On July 12, 1991, a note was issued from an affiliate of the General Partner in the amount of $1,611,953 (the Supplemental Loan). The Supplemental Loan specifically provided for the proceeds to be used to pay a portion of the interest with respect to the First Mortgage Loan indebtedness. The note bears interest at an annual rate of prime plus 1%. The entire note balance remains outstanding at December 31, 1993 and 1992. The outstanding principal and accrued interest mature and become payable upon the sale of the Property or upon a refinancing which provides proceeds sufficient to repay other existing indebtedness. The letter of default issued March 3, 1992 by the Bank of Nova Scotia also constituted an event of default under the Supplemental Loan. The default was cured through the restructuring of the Mortgage Loan Payable (see Note 4). Fees and Compensation. The General Partner and its affiliates earned fees and compensation in connection with syndication and acquisition services rendered to the Partnership of approximately $10,000,000. Additionally, an affiliate of the General Partner has incurred fees for various administrative services rendered for the years ended December 31, 1993, 1992 and 1991 in the amount of $49,920, $58,474 and $89,885, respectively. As of December 31, 1993 and 1992, $17,372 and $72,453 remained unpaid. The Boston Company ("TBC") provides accounting and investor communication functions to the Partnership. TBC was a wholly owned subsidiary of Lehman Brothers until May 1993 when it was purchased by Mellon Bank Corporation. The Shareholder Services Group, a wholly owned subsidiary of American Express Company, provided transfer agent services through May 1991. Beginning in June 1991, transfer agent services are being provided by Service Data Corporation a nonaffiliate. 7. Reconciliation of Financial Statement Net Loss and Partners' Capital to Federal Income Tax Basis Net Loss and Partners' Capital 1993 1992 1991 [S] [C] [C] [C] Financial statement net loss $(12,404,566) $(13,825,960) $(15,257,829) Tax basis depreciation over financial statement deprecation (842,152) (1,032,964) (2,507,676) Tax basis amortization over financial statement amortization (14,320) (14,320) (14,320) Tax basis interest income over financial statement interest income - - 197,104 Tax basis income from forgiveness of debt over financial statement income from forgiveness of debt - 954,845 - Financial statement replacement reserve income over tax basis income (924,996) (862,498) (997,104) Financial statement legal costs over tax basis legal costs - 879,520 100,239 Other 10,878 309,964 263,561 Federal income tax basis net loss $(14,175,156) $(13,591,413) $(18,216,025) Financial statement partners' capital (deficit) $(24,569,418) $(12,164,852) $ 1,661,108 Current year financial statement net loss over federal income tax basis net loss (1,770,590) 234,547 (2,958,196) Cumulative financial statement net loss over federal income tax basis net loss (17,181,502) (17,416,049) (14,457,853) Federal income tax basis partners' deficit $(43,521,510) $(29,346,354) $(15,754,941) Because many types of transactions are susceptible to varying interpretations under Federal and state income tax laws and regulations, the amounts reported above may be subject to change at a later date upon final determination by the taxing authorities. 8. Litigation During 1989, two class actions were brought by Unitholders in the Court of Chancery of the State of Delaware (the Delaware Chancery Court) against the Partnership and others. In addition, during 1989, two class actions were filed by Unitholders in the United States District Court for the Northern District of California. Pursuant to a court order dated October 24, 1989, the Delaware Chancery Court actions were consolidated by the Delaware Chancery Court (the Consolidated Delaware Action). In all of the cases, the plaintiffs sought damages in an unspecified amount as well as attorneys' fees and costs. On December 18, 1990, the Delaware Chancery Court approved a settlement of the Consolidated Delaware Action which became effective March 4, 1991. The terms of the settlement called for Shearson to provide Unitholders cash distributions, to the extent the Hotel did not generate sufficient cash flow, of 1%, 3% and 4% of class members' capital contributions in 1990, 1991 and 1992, respectively. On March 8, 1991, the first of these distributions was paid to class member Limited Partners in the amount of $.10 per $10 Unit, on February 14, 1992, the second distribution under the settlement was paid in the amount of $.30 per $10 Unit, and on February 12, 1993 the third and final cash distribution under the settlement was paid in the amount of $.40 per $10 Unit. Shearson has also agreed to lend the Partnership up to a maximum of $10 million to cover debt service and other operating expenses through January 4, 1993, and to pay plaintiffs' attorneys' fees and expenses up to $1,350,000 and $50,000, respectively. As of December 31, 1991, the Partnership had borrowed and expended the full $10 million available under the Shearson Loan. Subsequent to the settlement of the Consolidated Delaware Action, the California complaints were dismissed pursuant to a stipulation on January 3, 1991. Report of Independent Accountants To the Partners Union Square Hotel Partners, L.P. Our report on the financial statements of Union Square Hotel Partners, L.P. (formerly Shearson Union Square Associates, L.P.), a Delaware limited partnership, is included in this Form 10-K. In connection with our audits of such financial statements, we have also audited the related financial statement schedule listed in the index of this Form 10-K. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Hartford, Connecticut February 3, 1994

50957_1993.txt

50957_1993

1993

50957

Item 1. Business - ----------------- (b) Financial Information about Industry Segments: Industry segment information is included in Note 17 to the consolidated financial statements of the Company. (c) Narrative Description of Business: (1) The Company is a manufacturer of furniture and a manufacturer and retailer of footwear. The business of the Company is represented by the following two industry segments: Furniture Segment - ----------------- Broyhill Furniture Industries, Inc. - ----------------------------------- Broyhill began in 1926 as The Lenoir Chair Company and has grown through acquisitions of local furniture factories and internally generated expansion. Broyhill was acquired by the Company in 1980 and employs approximately 6,800 people. Products - -------- Broyhill produces medium-priced bedroom, dining room, living room, occasional and stationary and reclining furniture aimed at the middle- income consumer. Its residential furniture divisions produce a wide range of furnishings in colonial, country, traditional and contemporary styles. The widely recognized Broyhill trademarks include Broyhill, Broyhill Premier, Broyhill Showcase Gallery, Broyhill Contract and Highland House. Broyhill considers these trademarks and trade names to be material to its business. The flagship Broyhill product line concentrates on bedroom, dining room and living room furniture, as well as upholstered and occasional furniture. The Broyhill Premier product line enjoys an excellent reputation for classically styled, complete furniture collections in the upper-medium price range. Highland House operates in an upper-medium to high niche with premium benchmade upholstered products. The Broyhill Contract division produces contract furnishings for hotels, motels and health care facilities (including nursing homes and retirement communities). This division concentrates on manufacturing and marketing a complete line of residentially-styled furniture in the medium to lower-medium price range. Marketing and Distribution - -------------------------- Broyhill's management has been innovative in designing new programs to promote the Broyhill line. Key elements of the marketing program include a focused effort on Broyhill's department store and national and regional chain accounts, expansion of the Broyhill Showcase Gallery dealer network, expansion of the Independent Dealer Program and development of the contract market. Broyhill furniture products are sold primarily through approximately 4,000 retail furniture dealers. Broyhill maintains showrooms in High Point, North Carolina and Chicago, Illinois. The corporate effort with national and regional chains has resulted in increased business from major regional and national accounts. New merchandise assortments and selective distribution commitments have generated promotional and advertising activities with this retailer group which have resulted in improved rates of sales. Initiatives to profile the Broyhill consumer and identify their needs, wants, lifestyles and product use habits are providing insight into activities ranging from product development to channels of distribution to communication methods. Broyhill communicates with its targeted consumers through an extensive print media campaign. Through its Consumer Assistance Center 800 number, Broyhill provides assistance to almost 100,000 consumers annually by answering product questions, supplying literature and making referrals to retailers for product presentations. The Broyhill Showcase Gallery program, which has been established for over twelve years, now has over 300 participating dealer locations. A showcase gallery displays Broyhill furniture in complete, fully- accessorized room settings. This program incorporates a core merchandise stocking program, advertising material support, in-store merchandising events and educational opportunities for the retail store sales and management personnel. New retailers are attracted to the program because it provides for continuity of product and service. Broyhill believes retailers can substantially increase their sales per square foot by conversion to a gallery format. Inventory stock turns for galleries are also normally higher than those for non-gallery programs because more complete room settings are sold from fully- accessorized displays. For the smaller Broyhill dealer unable to make a gallery commitment, the Independent Dealer Program was launched in 1987. This concept was designed to overcome some of the significant difficulties in running a small independent furniture business and to provide smaller dealers with many of the same advantages of product and service continuity available to larger competitors. Participating retailers commit to a minimum preselected lineup of Broyhill merchandise and receive a detailed advertising and merchandising plan. The program includes four major sales events per year and monthly promotional themes. Professionally- prepared advertising and promotional materials are provided to the dealer at nominal cost to help attract consumer attention at the local level. The program currently has more than 600 retail locations enrolled. During 1992, Broyhill launched an upgraded version of the Independent Dealer Program called the Broyhill Furniture Center. This program includes all the benefits of the Independent Dealer Program plus additional marketing, designing, advertising and financing assistance. Through its Contract Division, Broyhill offers a complete line of hospitality furnishings to the hotel, motel and health care industries. As hotels and health care facilities turn to residentially-styled products and move away from a commercial look, Broyhill believes it will be well positioned to serve this market as it can supply a complete project with all of the furnishings required. Many of Broyhill's large retail customers have reduced the level of furniture inventory they hold and now look to manufacturers to provide short turnaround delivery availability. Broyhill is instituting a customer sales forecasting system that is designed to enhance customer service while addressing the need for aggressive inventory management. Broyhill's business is not highly seasonal by nature. Competition - ----------- Based on published industry information, management believes Broyhill is one of the largest and best known brands in the furniture industry. The majority of furniture manufacturers in the United States are small specialty firms with limited market identity. The furniture manufacturing business is highly competitive and furniture industry sales have historically been cyclical in nature. Broyhill products compete with products made by a number of furniture manufacturers, including Masco Corporation, Armstrong World Industries, La-Z-Boy Chair Company, Ladd Furniture, Inc., Bassett Furniture Industries, Inc. and Singer Furniture, as well as numerous smaller producers. The elements of competition include pricing, styling, quality and marketing. Broyhill furniture products are priced in a popular price range and styled to appeal to the growing young to middle- aged adult population. Product quality is monitored carefully through the use of quality assurance programs and customer feedback. Broyhill designers follow the marketplace closely to detect trends in product design. Broyhill believes it is a major manufacturer in the mid-price range in terms of sales volume and product selection offered. Manufacturing - ------------- Broyhill is a leader in automated furniture manufacturing. To meet the demand for affordable quality products, Broyhill has emphasized the use of mass production techniques. Modern facilities, state-of-the-art technology and economies of scale make Broyhill an efficient producer. The mid-price range products in which it specializes are well suited to automated assembly line techniques. Short set-up times and flexible manufacturing test runs have reduced both manufacturing costs and overhead. Broyhill believes it is one of the lowest-cost producers in the industry and the most efficient producer in the medium-priced segment of the industry in which it competes because of the degree of automation in its manufacturing facilities, the close proximity of its manufacturing facilities to each other and the size of the company. Its large size enables it to negotiate more favorable agreements with suppliers for raw materials and to achieve economies of scale by utilizing longer productions runs. The high degree of automation also results in substantial additional capacity which can be utilized by adding labor to the present shift and by implementing second or third shifts. In addition to the Broyhill brand products, Broyhill also manufactures furniture-related products such as particleboard, drawer sides and veneer for internal use and limited sale within the furniture industry. Broyhill operates 16 finished goods production and warehouse facilities totalling over 4.9 million square feet of manufacturing and warehouse space. Several small supply factories are also maintained for parts production. All but one of the plants are located within 60 miles of Broyhill's Lenoir, North Carolina headquarters, which coordinates centralized accounting, purchasing, credit, traffic and data processing services. Broyhill's major raw materials include lumber products, glass, finishing materials, adhesive and upholstered goods, such as foam and fabrics. Raw materials are generally abundant and available from many suppliers. The Lane Company, Incorporated - ------------------------------ Lane was founded by E.H. Lane in 1912 as a cedar chest maker and has grown internally and by acquiring other furniture companies. Lane was acquired by the Company in 1987. It employs approximately 6,500 people. Lane designs and produces furniture through seven operating divisions -- Lane Division, Action Industries, Inc. ("Action Industries"), Hickory Chair Company ("Hickory Chair"), The Pearson Company, Lane Upholstery, Venture Furniture Company ("Venture") and Hickory Business Furniture ("HBF"). All divisions benefit from Lane's management systems, marketing expertise and well-known corporate name. Management believes this decentralized strategy allows the divisions to focus on their competitive strengths and has been a key source of Lane's historical success. Products - -------- Lane manufactures and sells wood, metal and upholstered furniture, reclining furniture and related furniture components. The collections of related groups of furniture and other products currently include more than 3,000 different items. Lane's product mix is approximately 25% wood furniture and 75% upholstered furniture and other items. Products are sold under the Lane name and other trademarks. Lane considers the Lane, Action, Hickory Chair and James River Collection trademarks and trade names to be material to its business. The Lane Division manufactures and sells cedar chests, occasional living room tables, bedroom and dining room furniture, wall systems, desks, console tables and mirrors and other occasional wood pieces. Lane Division furniture is sold in the medium to higher price ranges. In 1993, Lane Division positioned itself for future growth with the installation of a state-of-the-art finishing system that will produce excellent product quality at attractive prices. Action Industries was acquired by Lane in 1972. Action Industries manufactures and markets reclining chairs and other motion furniture in the medium price range. Based on published industry information, management believes it is the second largest manufacturer of reclining chairs in the United States, with an approximate 20% share of the market. Lane's Royal Development Company ("Royal Development") designs and manufactures the mechanisms used in Action Industries reclining furniture products. Action Industries' line of "motion furniture" which incorporates a recliner within a sofa or loveseat, has produced strong sales since its introduction in November, 1990. To meet the increasing demand for its motion furniture, Action Industries completed construction of a new 396,000 square-foot manufacturing facility in 1993. Hickory Chair manufactures and sells traditional styles of upholstered furniture, dining room chairs and occasional tables, principally in the higher price range. Hickory Chair has been crafting fine 18th century- style furniture for the past 80 years, including its James River Collection of dining room, bedroom and occasional furniture, consisting of reproductions inspired by heirlooms from historical James River plantation homes in Virginia. It also manufactures and markets the Mark Hampton Collection of fine home furnishings. Hickory Chair has recently expanded its product line to other traditional styles to appeal to a broader market. In 1993, Hickory Chair was selected as the licensee for furniture reproductions from George Washington's Mount Vernon home. The Pearson Company for over 50 years has been manufacturing and selling contemporary and traditional styles of upholstered furniture including sofas, love seats, chairs and ottomans in the upper-medium price range. In 1992, Pearson introduced the Viceroy Collection by Victoria Moreland. Lane Upholstery includes two product lines one of which is composed of contemporary and modern upholstered furniture and metal and glass occasional and dining tables and the other of which is composed of traditional and contemporary upholstered furniture, primarily sofas, love seats, chairs and ottomans. Lane Upholstery sells in the medium price range. The Venture product line is composed of upholstered furniture made from wicker, rattan and bamboo, together with tables, occasional wood pieces and other home furnishing accessories. Venture manufactures and sells an exclusive line of premium all-weather wicker and upholstered outdoor furniture under the WeatherMaster trademark. HBF manufactures and sells a line of office chairs, tables, desks and credenzas in the upper-medium price range. Marketing and Distribution - -------------------------- Lane's furniture products are distributed nationally, principally to retail outlets, including department stores, leading chain stores, individual retail furniture stores and decorating studios. Lane generally manufactures to order, so that large inventory build-ups are avoided. Lane serves a broad-based clientele of over 12,000 active accounts. Lane's sales force, which is organized by division, is comprised of approximately 220 straight-commission salesmen, most of whom represent Lane exclusively. Lane maintains showrooms for the national furniture market in High Point, North Carolina. Lane operates Lane Group Showrooms for the design trade in Chicago, Illinois; Atlanta, Georgia; and San Francisco, California. Lane has a growing gallery program in which selected dealers commit floor space to a Lane furniture gallery. The dealers own the galleries and the Lane furniture inventory, while Lane is responsible for decorating the gallery and charges dealers for this service. Approximately 120 dealers currently participate in Lane's gallery program. Lane advertises heavily in national magazines. Lane believes its long- standing Lane "Keepsake" promotional program has made the Lane cedar chest one of the best-known furniture products in the industry and contributes to the high level of consumer recognition which Lane enjoys. Lane's business is not highly seasonal in nature except for some seasonality in the retailing of recliner products with peaks in June (Father's Day) and December (Christmas). Competition - ----------- Lane competes in the medium to high price range, where styling and quality considerations are more important competitive factors than price. Lane maintains a policy of providing its customers with high quality and current styles. To meet changing consumer tastes, Lane updates its product offerings on a continuous basis, combining its line of traditional models with up-to-date styles. Lane's primary competitors are other manufacturers of furniture, including La-Z-Boy Chair Company, Thomasville Furniture Industries, Inc. (a subsidiary of Armstrong World Industries, Inc.), Masco Corporation's furniture divisions, Century Furniture Co. and Ladd Furniture, Inc. Manufacturing - ------------- Lane operates 15 finished goods production and warehouse facilities. Recent investment in advanced technology manufacturing equipment has increased factory productivity. Lane's company headquarters are located in Altavista, Virginia, with major plants located there and in Rocky Mount, Virginia and Hickory and High Point, North Carolina. Action Industries' main plant and headquarters is located in Verona, Mississippi with three other plants in Tupelo, Pontotoc and Saltillo, Mississippi. Lane's major raw materials include lumber products, glass, paints and stains, adhesives and upholstery components, such as foam and fabrics. In addition, Lane purchases finished furniture goods made to its specifications, which are then sold to Lane customers. Raw materials are generally abundant and available from many suppliers. Footwear Segment - ---------------- The Florsheim Shoe Company - -------------------------- Based on published industry information, management believes Florsheim is a leading manufacturer and retailer of quality men's dress and dress casual footwear. Florsheim was founded in 1892 and was acquired by INTERCO in 1952. Florsheim employs approximately 3,600 people worldwide. Products - -------- Florsheim offers a broad line of men's quality dress, dress casual and casual footwear in the medium to higher price range. Management estimates Florsheim holds approximately 20% of the market for men's dress and dress casual footwear in its retail price range ($60 and above). Florsheim also manufactures and sells a line of safety footwear under the Hy-Test trade name. The major trademarks and trade names under which Florsheim's men's footwear are sold are: Florsheim, Florsheim ComforTech, Florsheim Outdoorsman, Florsheim Imperial, and Florsheim Royal Imperial. Florsheim considers each of these trademarks and trade names to be material to its business. The dramatic growth in athletic footwear in the 1980's significantly altered the characteristics of the domestic footwear industry. Florsheim has maintained a significant position in the industry in spite of this change. Management has responded to changing consumer tastes by substantially expanding its product line. In addition to its traditional dress shoes, Florsheim has expanded its product line to include a complete selection of casual looks. These new products supported by increased advertising are targeted to produce market share gains in both dress and casual shoes and are positioned to attract a new generation of consumers to Florsheim. Marketing and Distribution - -------------------------- Florsheim markets its products worldwide, with domestic sales comprising approximately 85% of total sales. Florsheim distributes its products through a network of approximately 300 Florsheim-operated retail shops and outlets in the United States and through approximately 60 retail shops in Canada and Australia, primarily in major metropolitan areas, and through approximatley 5,000 thousand independent dealer locations worldwide. In addition to its existing foreign markets in Canada, Australia, Mexico and Hong Kong, Florsheim exports product to a variety of customers in many countries and is developing new markets in Europe and the Pacific Rim. Florsheim's strategy is to sell exclusively Florsheim branded products in its company operated retail shops. This strategy enhances Florsheim's image of quality and value and builds public awareness of the brand and of Florsheim's dedication to customer service. Florsheim is currently in process of updating the interiors of many of its retail shops to appeal to more of today's consumers. Florsheim is concentrating on expanding its wholesale business. These expansion plans focus on smaller independent dealers and secondary markets (strip centers and malls in mid-sized cities), and on selected department stores, mass merchandisers and men's clothing stores. Florsheim also markets its footwear through its Express Shop Program. The Express Shop is a computer console that allows a customer to select any size, style or color of footwear from Florsheim's product line. Express orders are processed at a centrally-located warehouse and can be delivered to the customer's home or office within a week. Approximately 500 Express Shop machines are now in operation. Competition - ----------- Management believes Florsheim's brand recognition, reputation for quality and value and extensive retail and wholesale distribution network will continue to provide strategic advantages over the long term. The dramatic growth in athletic footwear during the 1980's significantly altered the competitive characteristics and the retail distribution patterns in the domestic footwear industry. From 1985 through 1993 the dress and casual footwear market experienced marginal increases in revenue. Several factors lead industry observers to forecast a return to growth for the traditional dress and casual footwear industry. For example, the cost differential between athletic and traditional footwear has narrowed considerably. Also, traditional footwear manufacturers are now incorporating into their products some comfort-related features previously associated with athletic footwear. Florsheim's ComforTech line is designed to address this trend. In addition to competition from athletic footwear, traditional domestic manufacturers of men's dress and casual footwear experience significant competition from imports. Florsheim has addressed this trend by increasing foreign manufacturing and sourcing. Approximately 70% of Florsheim's sourcing requirements are currently fulfilled outside of the United States. The consolidation of the retail footwear industry since the 1970s has also affected Florsheim's operations. In response to this consolidation, Florsheim has focused on the most productive stores and eliminated stores in unprofitable or non-strategic locations. Manufacturing - ------------- Florsheim footwear products are manufactured both domestically and overseas. Florsheim owns manufacturing plants in Cape Girardeau and Kirksville, Missouri, as well as a warehouse/distribution center in Jefferson City, Missouri. Florsheim manufactures its Hy-Test product line in a leased facility in West Plains, Missouri. Approximately 70% of Florsheim's non-domestic production is performed in India, where Florsheim is a participant in a joint venture arrangement with a local operator, and the remaining 30% of non-domestic production is sourced from a variety of foreign suppliers in a number of other countries. By using a mix of domestic and overseas production, Florsheim is able to benefit from lower costs for certain labor-intensive operations while maintaining a manufacturing base close to its primary end market. Florsheim's foreign operations are subject to the usual risks of doing business abroad such as currency fluctuations, labor unrest, political instability, restrictions on transfer of funds, export duties and quotas and to United States customs and tariffs. Florsheim's major raw materials include leather uppers, linings and outsoles. Florsheim obtains raw materials and components from a wide variety of sources located throughout the world and has alternate sources for all leathers, components and other materials. Leather pricing and availability are subject to fluctuating supply and demand cycles; however, Florsheim management believes it has adequate sourcing arrangements to ensure an uninterrupted supply of raw materials. Other Information - ----------------- As a large majority of Florsheim's wholesale sales are "at once" orders, Florsheim is required to maintain substantial inventory levels. Florsheim's retail outlets generally sell products inventoried at the store location. Florsheim believes its retail outlets maintain somewhat greater inventory levels than its competitors as they carry a larger selection of shoe sizes and widths. Florsheim's retail and wholesale sales tend to be somewhat seasonal in nature, however, such sales complement each other such that seasonality is not a significant factor in its business. Converse Inc. - ------------- Converse Inc. was founded in 1908, sold its first branded athletic shoe in 1911, and was acquired by the Company in 1986. Converse employs approximately 3,100 people worldwide. Products - -------- Converse's traditional strength is its men's basketball shoes, marketed under the Converse name. Men's basketball shoes currently account for approximately 42% of its total revenues. Converse has a leading position as a provider of footwear to basketball players in the National Basketball Association (where it is the official shoe), on college basketball teams, including National Collegiate Athletic Association teams, and on high school athletic teams. Converse currently supplies approximately 35% of the athletic footwear needs of the United States college basketball teams. This visibility enhances the performance image of its product line. Management believes the Converse basketball line is recognized by consumers as one of the most technologically sound lines in the business. It is Converse's belief that a performance- oriented brand image should result in increased sales and an expansion of its distribution network. Converse's Athleisure footwear lines generated approximately 35% of Converse's total revenues in calendar 1993. The All Star line represents the vast majority of athleisure sales. This line is most popular with male and female consumers between 16 and 26 years of age. During 1993, domestic demand for the All Star product continued to surge, more than compensating for weaknesses in the international economies where the product line is sold. Converse supplements the All Star line with its Jack Purcell and One Star lines. As part of its effort to build demand for all of these products, Converse has developed seasonal and specialty collections of product. Converse's children's footwear category had a strong year in 1993, growing to approximately 12% of total revenues. This category, which typically consists of sized down versions of the popular adult models, has been targeted for growth. New footwear products, "for children only" continue to be developed and sold under the Converse name. Converse also markets a full line of athletic footwear for both men and women, including tennis, cleated, running, cross training, outdoor and walking shoes, under the Converse name. Research and Development - ------------------------ Converse has invested significantly to maintain its position as a respected manufacturer of performance athletic footwear. Its biomechanics laboratory is one of the most advanced facilities of its kind in the industry. Converse's biomechanics laboratory continually conducts extensive research on new performance enhancement technologies. The laboratory is also involved in the design stages of performance footwear to maximize the attributes required for each sport, and to help protect the athletes wearing Converse products. In 1993, Converse spent approximately $6.1 million on research and development, compared to $5.1 million in 1992 and $4.9 million in 1991. Marketing - --------- Converse markets its footwear products domestically through approximately 7,500 retail accounts consisting of sporting goods stores, specialty athletic footwear stores, shoe stores and department stores. In the United States, Converse's sales are strongest in the metropolitan areas and in the Midwest and West regions. Converse estimates that roughly 75% of its footwear products are purchased by men. Converse also sells in-line product and excess inventory through 21 company- operated factory outlet stores. Approximately 99% of domestic sales are generated by Converse's direct sales force. Converse salespeople follow a commission schedule structured to reward future-order business (orders placed four to six months before delivery). Converse has special selling arrangements that support certain large-volume accounts. Outside of the United States, Converse currently distributes its products in more than 90 countries. Generally, international sales are made through a network of independent distributors, independent licensees and, to a lesser extent, direct sales. Converse receives royalties, based on a percentage of sales, from its licensees and has final approval over all products distributed through such licensees. Western Europe, Japan, Latin America, Canada and the United Kingdom represent important markets for Converse. Converse believes it has significant international growth potential once the international economies recover from their current weakness. In 1993, international sales were approximately 30% of Converse's total revenues. As part of its long-term strategic plan, Converse is negotiating partnership arrangements in key international countries. Converse has continued its expansion of media-based advertising. The combination of exciting endorsers and creative advertising has helped to fuel Converse's growth. Converse will continue to use a blend of creative advertising and associations with professional athletes and amateur teams. Contractually-obligated professional endorsers include Larry Johnson, Kevin Johnson, and J.R. Rider, among others. Converse has contractual associations with colleges and universities including Kentucky, Kansas, Arkansas, Indiana and Louisville. Converse spends approximately 10% of net revenues on promotion and advertising. Sales of athletic footwear tend to be seasonal in nature, with the strongest sales occurring in the first and third quarters. Competition - ----------- The athletic footwear market is highly competitive. Industry participants compete with respect to performance, comfort, fashion, durability and price. The athletic footwear industry in the United States can be broken down into several groups. Two companies, Nike and Reebok, each generate worldwide revenues in excess of $3 billion annually and control approximately 50% of the domestic market. These companies have full lines of product offerings and distribute to more than 10,000 outlets. Neither Nike nor Reebok is highly leveraged. These two companies spend substantially more on product advertising than Converse. Adidas, ASICS, Fila, L.A. Gear and Stride Rite (Keds) along with Converse form a second tier of competitors with 1993 revenues of between $300 million and $1 billion. These companies, as well as Nike and Reebok, also compete with Converse for suppliers and for foreign manufacturing facilities. In addition to these competitors, there is a third tier of companies with domestic revenues of $100 to $300 million, consisting of Avia (owned by Reebok), British Knights, Etonic, K-Swiss, New Balance and Saucony, among others. Manufacturing - ------------- Converse currently sources athletic footwear almost equally on a pairage basis between its own domestic facilities and international suppliers (although Converse relies exclusively on the Far East for sourcing leather footwear requirements). Converse is the only major athletic footwear company with significant domestic manufacturing capabilities. Converse's manufacturing strategy gives it the flexibility to adjust production to reduce costs, avoid large duty-related costs on canvas products and provide insulation against disruption of the production process. Converse presently owns and operates a manufacturing facility in Lumberton, North Carolina which is used to produce canvas shoes. Converse also owns a manufacturing operation in Reynosa, Mexico which it uses to stitch footwear uppers for incorporation into footwear at the Lumberton facility. The Mexican facility has the advantage of offering Converse lower labor rates and shorter lead times than the Far East, and more efficient use of its domestic production facilities. Converse is in the process of opening a second domestic manufacturing plant to expand the production of All Star products. This new manufacturing facility is located in Mission, Texas across the border from Converse's Reynosa facility. Over twenty foreign manufacturers supply Converse, most of which are located in the Far East, particularly South Korea, Taiwan, Indonesia, and China. Products are purchased from foreign suppliers using individual purchase orders as opposed to long-term contracts. Converse competes with Nike, Reebok and other competitors for access to these foreign manufacturers. Like its major competitors, Converse's foreign operations are subject to the usual risks of doing business abroad, such as export duties, quotas, currency fluctuations, restrictions on the transfer of funds, labor unrest and political instability. In addition, products manufactured overseas are subject to United States customs duties. The principal materials used in Converse's products are canvas, rubber, nylon and leather. These materials are generally obtained from a variety of sources. Converse has elected for cost purposes to obtain certain of its raw materials from single sources, but alternative sources are available. Trademarks and Trade Names - -------------------------- Converse considers all of its trademarks and trade names to be material to its business and aggressively protects such rights. The loss of any of the Converse, All Star, Chuck Taylor, Cons, Jack Purcell, REACT, Run'N Slam, TAR MAX, Star logo or Chevron and Star logo trade names and trademarks could have a material impact on Converse's business. Backlog - ------- In the Furniture Segment, the order backlog at the end of December, 1993 aggregated approximately $152 million, compared to approximately $128 million at the end of December, 1992. In the Footwear Segment, the order backlog at the end of December, 1993 aggregated approximately $156 million, compared to approximately $135 million at the end of December, 1992. Trademarks and Trade Names - -------------------------- Each of the operating companies utilizes trademarks and trade names extensively to promote brand loyalty among consumers. The Company aggressively protects its trademarks and trade names by taking appropriate legal action against anyone who infringes upon or misuses them. Governmental Regulations - ------------------------ The Company does not believe compliance by it with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, will have a material effect upon capital expenditures, earnings or competitive position. See - "Legal Proceedings". Employees - --------- As of December 31, 1993, the Company and its subsidiaries employed approximately 20,045 people, of which approximately 13,300 and 6,700 were employed in the Furniture Segment and the Footwear Segment, respectively, with the remainder (approximately 45) employed at Company headquarters. Approximately one-half of Florsheim's work force is represented by unions. Item 2. Item 2. Properties - ------------------- The Company owns or leases the following principal plants, offices and warehouses: Floor Owned Type of Space or Division Location Facility (Sq. Ft.) Leased - -------- -------- -------- --------- ------ INTERCO St. Louis, MO Headquarters 26,800 Leased Broyhill Lenoir, NC Headquarters 136,000 Leased Broyhill Lenoir, NC Plant/Warehouse 312,632 Owned Broyhill Newton, NC Plant/Warehouse 382,626 Owned Broyhill Lenoir, NC Plant/Warehouse 628,000 Owned Broyhill Rutherfordton, NC Plant/Warehouse 575,656 Owned Broyhill Lenoir, NC Plant/Warehouse 419,000 Owned Broyhill Lenoir, NC Plant/Warehouse 364,000 Owned Broyhill Conover, NC Plant/Warehouse 313,580 Owned Broyhill Lenoir, NC Plant 345,439 Owned Broyhill Lenoir, NC Plant 165,640 Owned Broyhill Lenoir, NC Plant/Warehouse 252,380 Owned Broyhill Taylorsville, NC Plant/Warehouse 212,754 Owned Broyhill Lenoir, NC Plant 124,700 Leased Broyhill Hickory, NC Plant/Warehouse 215,500 Leased Broyhill Marion, NC Plant 22,712 Owned Broyhill Lenoir, NC Warehouse 96,000 Owned Broyhill Lenoir, NC Warehouse 503,250 Leased Lane Altavista, VA Plant/Warehouse 1,091,600 Owned Lane Altavista, VA Headquarters 62,000 Owned Lane Conover, NC Plant/Warehouse 212,000 Owned Lane Conover, NC Plant/Warehouse 348,180 Owned Lane Conover, NC Plant 150,130 Owned Lane Hickory, NC Plant/Warehouse 641,214 Owned Lane Hickory, NC Plant/Warehouse 169,902 Owned Lane High Point, NC Plant 187,162 Owned Lane High Point, NC Plant/Warehouse 156,000 Owned Floor Owned Type of Space or Division Location Facility (Sq. Ft.) Leased - -------- -------- -------- --------- ------ Lane Pontotoc, MS Plant/Warehouse 352,740 Owned Lane Rocky Mount, VA Plant/Warehouse 598,962 Owned Lane Verona, MS Plant/Warehouse 395,050 Owned Lane Saltillo, MS Plant/Warehouse 567,500 Owned Lane Tupelo, MS Plant/Warehouse 396,175 Owned Lane Rocky Mount, VA Plant 50,300 Owned Lane Smyrna, TN Plant 28,300 Owned Florsheim Chicago, IL Headquarters 285,000 Owned Florsheim Jefferson City, MO Warehouse 562,770 Owned Florsheim Cape Girardeau, MO Plant 90,000 Owned Florsheim Kirksville, MO Plant 104,203 Owned Florsheim West Plains, MO Plant 89,841 Leased Florsheim Preston, Australia Plant/Warehouse 59,300 Leased Converse North Reading, MA Headquarters 106,800 Owned Converse Lumberton, NC Plant 386,761 Owned Converse Charlotte, NC Distribution Center/ Sales Office 431,665 Leased Converse Reynosa, Mexico Plant 41,000 Owned Converse Mission, TX Plant 55,552 Leased _______________ Substantially all of the owned properties listed above are encumbered by a first priority lien and mortgage pursuant to the Company's Credit Agreement with BT Commercial Corporation, as Agent, and the banks named therein, dated as of July 16, 1992, as amended, and by subordinate liens and mortgages pursuant to the Company's Secured Term Loan Agreement, dated as of July 16, 1992, as amended, the ILGWU Fund Note, dated July 16, 1992 and the Indentures, dated as of July 16, 1992, relating to the Company's 10% Secured Notes due 2001, 9% Secured Notes due 2004 and 8.5% Secured Notes due 1997. In addition, the North Reading, Massachusetts and the Tupelo, Mississippi facilities are encumbered by mortgages and first liens securing industrial revenue bonds. The Company believes its properties are generally well maintained, suitable for its present operations and adequate for current production requirements. Productive capacity and extent of utilization of the Company's facilities are difficult to quantify with certainty because in any one facility maximum capacity and utilization varies periodically depending upon the product that is being manufactured, the degree of automation and the utilization of the labor force in the facility. In this context, the Company estimates that overall its production facilities were effectively utilized during calendar 1993 at moderate to high levels of productive capacity and believes that in general its facilities have the capacity, if necessary, to expand production to meet anticipated product requirements. Item 3. Item 3. Legal Proceedings - -------------------------- Notwithstanding the confirmation and effectiveness of the Company's Amended Joint Plan of Reorganization under Chapter 11 (the "Plan"), the Court continues to have jurisdiction to, among other things, resolve disputed pre-petition claims against the Company, resolve matters related to the assumption, assumption and assignment, or rejection of executory contracts pursuant to the Plan, and to resolve other matters that may arise in connection with or relate to the Plan. Pursuant to the Plan, the Company, on the effective date, paid into a Disputed Claims Trust the face amount of certain claims still to be resolved. Since those unresolved claims were funded at their face amounts, the Company has no further financial exposure with respect to those claims. The Company is or may become a defendant in a number of pending or threatened legal proceedings in the ordinary course of business. In the opinion of management, the ultimate liability, if any, of the Company from all such proceedings will not have a material adverse effect upon the consolidated financial position or results of operations of the Company and its subsidiaries. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ Not applicable. PART II ------- Item 5. Item 5. Market for The Registrant's Common Equity and Related Stockholder - -------------------------------------------------------------------------- Matters - ------- As of February 28, 1994, there were approximately 3,775 holders of record of Common Stock. Shares of the Company's Common Stock are traded on the New York Stock Exchange. The reported high and low sale prices for the Company's Common Stock on the New York Stock Exchange is included in Note 18 to the consolidated financial statements of the Company. The Company has not paid dividends on its Common Stock during the two years ended December 31, 1992 and December 31, 1993. A discussion of restrictions on the Company's ability to pay cash dividends is included in Note 10 to the consolidated financial statements of the Company. Employees are covered primarily by noncontributory plans, funded by Company contributions to trust funds, which are held for the sole benefit of employees. Monthly retirement benefits generally are based upon service, pay, or both, with employees generally becoming vested upon completion of five years of service. The expected long-term rate of return on plan assets was 8.0%-9.5% in calendar 1993 and calendar 1992, and 8.0%-8.5% in fiscal 1992. Measurement of the projected benefit obligation was based upon a weighted average discount rate of 7.25%, 7.75% and 7.75% and a long-term rate of compensation increase of 4.5%, 5.0% and 5.5% for calendar 1993, calendar 1992 and fiscal 1992, respectively. Other Retirement Plans and Benefits In addition to defined benefit plans, the Company makes contributions to various defined contribution, union-negotiated and foreign plans. The cost of these plans is included in the total cost for all plans reflected above. The Company also sponsors two savings plans and an Employee Stock Ownership Plan ("ESOP"). The total cost of these plans for calendar 1993 and 1992 and fiscal 1992 was $685, $453 and $508, respectively. On November 9, 1993, the Board of Directors approved the termination of the ESOP. At December 31, 1993, the ESOP held 4,463 shares of INTERCO INCORPORATED common stock and 1,772 INTERCO INCORPORATED Series 1 Warrants for the benefit of the ESOP participants. In addition to pension and other supplemental benefits, certain retired employees are currently provided with specified health care and life insurance benefits. Eligibility requirements for such benefits vary by division and subsidiary, but generally state that benefits are available to employees who retire after a certain age with specified years of service if they agree to contribute a portion of the cost. The Company has reserved the right to modify or terminate these benefits. Health care and life insurance benefits are provided to both retired and active employees through medical benefit trusts, third-party administrators and insurance companies. The following table sets forth the combined financial status of postretirement benefits other than pensions: - --------------------------------------------------------------------------- December 31, December 31, 1993 1992 Accumulated postretirement benefit obligation: Retirees $20,496 $20,118 Fully eligible active plan participants 3,597 7,052 Other active plan participants 5,871 10,359 - --------------------------------------------------------------------------- Total 29,964 37,529 Plan assets at fair value 3,952 3,800 - --------------------------------------------------------------------------- Accumulated postretirement benefit obligation in excess of plan assets 26,012 33,729 Unrecognized net gain 6,014 3,745 Unrecognized prior service gain 5,098 - - --------------------------------------------------------------------------- Accrued postretirement benefit obligation $37,124 $37,474 =========================================================================== Net periodic postretirement benefit costs include the following components: - --------------------------------------------------------------------------- Five Months Year Ended Ended December 31, December 31, 1993 1992 - --------------------------------------------------------------------------- Service cost-benefits earned during the period $ 753 $ 480 Interest cost on the postretirement benefit obligation 2,283 1,165 Actual return on plan assets (409) - Net amortization and deferral (395) - - --------------------------------------------------------------------------- Net periodic postretirement benefit cost $2,232 $1,645 =========================================================================== For measurement purposes, a 17.0% and 18.0% annual rate of increase in the cost of health care benefits for pre-age 65 retirees and 13.0% and 14.0% for post-age 65 retirees was assumed for calendar 1993 and 1992, respectively. For calendar 1993 and calendar 1992, the rates are assumed to decrease gradually to 8.0% in the year 2002 for pre-age 65 retirees and to 7.0% in 1999 for post-age 65 retirees and remain at those levels thereafter. The health care cost trend rate assumption has an effect on amounts reported. For example, increasing the 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 approximately $1,522 and the net periodic cost by $308 for the year. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.25% and 7.75% for calendar 1993 and 1992, respectively. The expected long-term rate of return on plan assets was 8.0%. 14. Lease Commitments Substantially all of the Company's retail outlets and certain other real properties and equipment are operated under lease agreements expiring at various dates through the year 2005. Leases covering retail outlets and equipment generally require, in addition to stated minimums, contingent rentals based on retail sales and equipment usage. Generally, the leases provide for renewal for various periods at stipulated rates. Rental expense under operating leases was as follows: - ---------------------------------------------------------------------------- Five Months \Five Months Year Ended Ended \ Ended Year Ended December 31, December 31,\ August 2, February 29, 1993 1992 \ 1992 1992 - --------------------------------------------------\------------------------ Basic rentals $27,817 $11,399 \ $12,085 $31,861 Contingent rentals 8,212 4,113 \ 4,339 8,367 - --------------------------------------------------\------------------------ 36,029 15,512 \ 16,424 40,228 Less: sublease rentals 479 386 \ 387 479 - --------------------------------------------------\------------------------ $35,550 $15,126 \ $16,037 $39,749 ==================================================\======================== Future minimum lease payments under operating leases, reduced by minimum rentals from subleases of $1,264 at December 31, 1993, aggregate $105,586. Annual payments under operating leases are $24,407, $20,653, $17,835, $13,201 and $9,199 for 1994 through 1998, respectively. 15. Fair Value of Financial Instruments Cash and Cash Equivalents, Receivables, Accounts Payable and Accrued Expenses The carrying amounts approximate fair value because of the short maturity of these financial instruments. Long-Term Debt The fair values of the following long-term debt instruments are based on quoted market prices as determined through discussions with various market participants, where available. - --------------------------------------------------------------------------- December 31, 1993 December 31, 1992 --------------------- --------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value - --------------------------------------------------------------------------- 10.0% secured notes due 2001$104,734 $106,043 $109,199 $107,015 9.0% secured notes due 2004 149,274 148,528 155,636 141,629 8.5% secured notes due 1997 9,334 9,334 11,208 9,863 Secured term loan 289,881 289,881 302,238 302,238 - --------------------------------------------------------------------------- The ILGWU Fund Note, Industrial Revenue Bonds and Federal Tax Obligation are considered special purpose financing for settlement of certain claims and as an incentive to acquire specific real estate. Accordingly, the Company believes the carrying amounts approximate fair value given the circumstances under which such financing was acquired. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. 16. Litigation Notwithstanding the confirmation and effectiveness of the Plan, the Court continues to have jurisdiction, among other things, to resolve disputed pre-petition claims against the Company, to resolve matters related to the assumption, assumption and assignment, or rejection of executory contracts pursuant to the Plan, and to resolve other matters that may arise in connection with or relate to the Plan. Pursuant to the Plan, the Company, on the effective date, paid into a Disputed Claims Trust the face amount of certain claims still to be resolved. Since those unresolved claims were funded at their face amounts, the Company has no further financial exposure with respect to those claims. The Company is or may become a defendant in a number of pending or threatened legal proceedings in the ordinary course of business. In the opinion of management, the ultimate liability, if any, of the Company from all such proceedings will not have a material adverse effect upon the consolidated financial position or results of operations of the Company and its subsidiaries. 17. Business Segment Information The Company's two business segments are furniture and footwear. Summarized financial information by business segment is as follows: - --------------------------------------------------------------------------- December 31, December 31, 1993 1992 - --------------------------------------------------------------------------- Identifiable assets: Furniture segment $ 819,415 $ 800,176 Footwear segment 347,509 296,267 Corporate administration 38,755 81,094 - --------------------------------------------------------------------------- $1,205,679 $1,177,537 =========================================================================== Substantially all of the Company's sales are made to unaffiliated customers. The Company has a diversified customer base with no one customer accounting for 10% or more of consolidated sales and no particular concentration of credit risk in one economic section. Foreign operations are not material. As discussed in Note 2, the Company adjusted its assets to fair value in connection with the adoption of fresh-start reporting. These adjustments were impacted by the requirement to state each operating company's total assets at its reorganization value. As a result, the depreciation and amortization expense after August 2, 1992 for each segment is not comparable to prior periods. Identifiable assets are those used by each segment in its operations. Corporate administration assets consist primarily of cash and cash equivalents, and miscellaneous real estate held for sale. 18. Quarterly Financial Information (Unaudited) Following is a summary of unaudited quarterly information: - -------------------------------------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter - -------------------------------------------------------------------------- Year ended December 31, 1993: Net sales $411,747 $423,852 $404,352 $ 416,863 Gross profit 136,660 136,261 131,432 137,594 Net earnings $ 12,875 $ 9,194 $ 8,901 $ 14,398 Net earnings per common share $ 0.25 $ 0.18 $ 0.17 $ 0.28 Common stock price range (High-Low) $ 15-3/8-13 $ 14-5/8-12 $ 15-3/4-12 $ 14-7/8- 0-3/8 ========================================================================== - ------------------------------------------------------------------------------ Third Quarter ------------------------ September 30,\ August 2, Fourth 1992 \ 1992 Second First Quarter (Two Months)\(One Month) Quarter Quarter - -----------------------------------------------\----------------------------- Year ended December 31, 1992: \ Net sales $398,090 $264,184 \$ 125,476 $355,398 $390,875 Gross profit 133,534 86,094 \ 35,102 114,600 125,411 Net earnings (loss) \ before extraordinary \ item and cumulative \ effect of accounting \ change 13,214 8,112 \ 145,978 (7,696) (8,864) Extraordinary item - - \ 1,075,466 - - Cumulative effect of \ accounting change - - \ (25,544) - - Net earnings (loss) $ 13,214 $ 8,112 \$1,195,900 $ (7,696)$ (8,864) \ Net earnings (loss) per \ common share: \ Net earnings (loss) \ before extraordinary \ item and cumulative \ effect of accounting \ change $ 0.27 $ 0.16 \$ 3.77 $ (0.20)$ (0.23) Extraordinary item - - \ 27.72 - - Cumulative effect of \ accounting change - - \ (0.66) - - Net earnings (loss)$ 0.27 $ 0.16 \$ 30.83 $ (0.20)$ (0.23) Common stock price range \ (High-Low) $ 9-3/8- $ 8-5/8-\$ 1/8- $ 5/32- $ 1-1/16 6-3/4 6-7/8 \ 1/16 3/64 ============================================================================= The Company has not paid dividends on its common stock during the two years ended December 31, 1993. The closing market price of the Company's common stock on December 31, 1993 was $13.125 per share. As a result of adopting fresh-start reporting, the Company's third quarter in calendar 1992 includes two periods - July 1, 1992 through August 2, 1992, and August 3, 1992 through September 30, 1992. Operating results after August 2, 1992 are presented on a different cost basis and reflect the adoption of SFAS No. 106 and No. 109. The quarterly results of operations for the year ended December 31, 1992 have been restated to a calendar year basis. 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 - ----------------------------------------------------------- Pages 4 to 6 of the Company's Definitive Proxy Statement for the Annual Meeting of Stockholders on May 4, 1994 are incorporated herein by reference. Executive Officers of the Registrant * Member of the Executive Committee There are no family relationships between any of the executive officers of the Registrant. The executive officers are elected at the organizational meeting of the Board of Directors which follows the annual meeting of stockholders and serve for one year and until their successors are elected and qualified. Each of the executive officers has held the same position or other executive positions with the same employer during the past five years. Item 11. Item 11. Executive Compensation - ------------------------------- Pages 6 to 14 of the Company's Definitive Proxy Statement for the Annual Meeting of Stockholders on May 4, 1994, are incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - ----------------------------------------------------------------------- Pages 2 to 4 of the Company's Definitive Proxy Statement for the Annual Meeting of Stockholders on May 4, 1994, are incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions - ------------------------------------------------------- Page 7 of the Company's Definitive Proxy Statement for the Annual Meeting of Stockholders 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: Consolidated balance sheet, December 31, 1993 and December 31, 1992. Consolidated statement of operations for the year ended December 31, 1993, for the five months ended December 31, 1992 and August 2, 1992 and for the year ended February 29, 1992. Consolidated statement of cash flows for the year ended December 31, 1993, for the five months ended December 31, 1992 and August 2, 1992 and for the year ended February 29, 1992. Consolidated statement of shareholders' equity for the year ended December 31, 1993, for the ten months ended December 31, 1992 and for the year ended February 29, 1992. Notes to consolidated financial statements. Independent Auditors' Report Financial statements of the Registrant have been omitted since there are no restrictions as to the transfer of funds from its subsidiaries and the net assets of the subsidiaries are generally not restricted. Separate financial statements and other disclosures with respect to the Company's subsidiaries are omitted as such separate financial statements and other disclosures are not deemed material to investors. 2. Financial Statement Schedules: Valuation and qualifying accounts (Schedule VIII). Supplementary income statement information (Schedule X). All other schedules are omitted as the required information is presented in the consolidated financial statements or related notes or are not applicable. 3. Exhibits: 3(a) Restated Certificate of Incorporation of the Company. (Incorporated by reference to Exhibit 2.1 to INTERCO INCORPORATED's Registration Statement on Form 8-A, dated June 29, 1992.) 3(b) By-Laws of the Company revised and amended as of November 17, 1992. (Incorporated by reference to Exhibit 3 to INTERCO INCORPORATED's Quarterly Report on Form 10-Q for the quarter ended on November 30, 1992.) 4(a) Indenture, dated as of July 16, 1992, among the Company, certain Subsidiary Obligors and The Connecticut National Bank, as Trustee, with respect to 10% Secured Notes due 2001 and 8.5% Secured Notes due 1997. (Incorporated by reference to Exhibit 4.1 to INTERCO INCORPORATED's Current Report on Form 8-K, dated August 18, 1992.) 4(b) Series A Supplemental Indenture, dated as of July 16, 1992, to Indenture, dated as of July 16, 1992, among the Company, certain Subsidiary Obligors and The Connecticut National Bank, as Trustee, with respect to 10% Secured Notes due 2001. (Incorporated by reference to Exhibit 4.2 to INTERCO INCORPORATED's Current Report on Form 8-K, dated August 18, 1992.) 4(c) Series C Supplemental Indenture, dated as of July 16, 1992, to Indenture, dated as of July 16, 1992, among the Company, certain Subsidiary Obligors and The Connecticut National Bank, as Trustee, with respect to 8.5% Secured Notes due 1997. (Incorporated by reference to Exhibit 4.3 to INTERCO INCORPORATED's Current Report on Form 8-K, dated August 18, 1992.) 4(d) First Supplement, dated as of October 22, 1992, to Indenture, dated as of July 16, 1992, among the Company, certain Subsidiary Obligors and The Connecticut National Bank, as Trustee, with respect to 10% Secured Notes Due 2001 and 8.5% Secured Notes Due 1997. (Incorporated by reference to Exhibit 4(d) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended December 31, 1993.) 4(e) Indenture, dated as of July 16, 1992, among the Company, certain Subsidiary Obligors and Security Pacific National Trust Company (New York), as Trustee, with respect to 9% Secured Notes Due 2004. (Incorporated by reference to Exhibit 4.4 to INTERCO INCORPORATED's Current Report on Form 8-K, dated August 18, 1992.) 4(f) First Supplement, dated as of October 22, 1992, to Indenture, dated as of July 16, 1992, among the Company, certain Subsidiary Obligors and Security Pacific National Trust Company (New York), as Trustee, with respect to 9% Secured Notes Due 2004. (Incorporated by reference to Exhibit 4(f) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended December 31, 1993.) 4(g) Secured Term Loan Agreement, dated as of July 16, 1992, among the Company, certain Subsidiary Obligors, Morgan Guaranty Trust Company of New York, as Agent, and as Administrative Agent, and the banks named therein. (Incorporated by reference to Exhibit 10.2 to INTERCO INCORPORATED's Current Report on Form 8-K, dated August 18, 1992.) 4(h) First Amendment, dated as of October 22, 1992, to the Secured Term Loan Agreement, dated as of July 16, 1992, among the Company, certain Subsidiary Obligors, Morgan Guaranty Trust Company of New York, as Agent, and as Administrative Agent, and the banks named therein. (Incorporated by reference to Exhibit 4(h) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended December 31, 1993.) 4(i) ILGWU Fund Note, dated July 16, 1992. (Incorporated by reference to Exhibit 10.3 to INTERCO INCORPORATED's Current Report on Form 8-K, dated August 18, 1992.) 4(j) Shared Collateral Trust Agreement, dated July 16, 1992, among the Company, certain Subsidiary Obligors, The Connecticut National Bank, as Series A and Series C Indenture Trustee, Security Pacific National Trust Company (New York), as Series B Indenture Trustee, Morgan Guaranty Trust Company of New York, as Agent and Administrative Agent under the Secured Term Loan Agreement, the ILGWU National Retirement Fund, First Fidelity Bank, National Association, as corporate trustee, and Joseph F. Ready, as individual trustee. (Incorporated by reference to Exhibit 10.4 to INTERCO INCORPORATED's Current Report on Form 8-K, dated August 18, 1992.) 4(k) Credit Agreement, dated as of July 16, 1992, among the Company and certain of its subsidiaries, BT Commercial Corporation, as Agent, and the banks named therein. (Incorporated by reference to Exhibit 10.1 to INTERCO INCORPORATED's Current Report on Form 8-K, dated August 18, 1992.) 4(l) Waiver #2, dated as of September 21, 1992, to the Credit Agreement, dated as of July 16, 1992, among the Company and certain of its subsidiaries, BT Commercial Corporation, as Agent, and the banks named therein. (Incorporated by reference to Exhibit 4 to INTERCO INCORPORATED's Quarterly Report on Form 10-Q for the quarter ended August 31, 1992.) 4(m) Waiver #3, dated as of January 25, 1993, to the Credit Agreement, dated as of July 16, 1992, among the Company and certain of its subsidiaries, BT Commercial Corporation, as Agent, and the banks named therein. 4(n) First Amendment, dated as of November 9, 1992, to the Credit Agreement, dated as of July 16, 1992, among the Company and certain of its subsidiaries, BT Commercial Corporation, as Agent, and the banks named therein. (Incorporated by reference to Exhibit 4(m) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended December 31, 1993.) 4(o) Second Amendment, dated as of May 14, 1993, to the Credit Agreement, dated as of July 16, 1992, among the Company and certain of its subsidiaries, BT Commercial Corporation, as Agent, and the banks named therein. 4(p) Third Amendment, dated as of January 31, 1994, to the Credit Agreement, dated as of July 16, 1992, among the Company and certain of its subsidiaries, BT Commercial Corporation, as agent, and the banks named therein. 4(q) Warrant Agreement, dated as of August 3, 1992, between the Company and Society National Bank, as Warrant Agent. (Incorporated by reference to Exhibit 4.5 to INTERCO INCORPORATED's Current Report on Form 8-K, dated August 18, 1992.) 4(r) Agreement to furnish upon request of the Commission copies of other instruments defining the rights of holders of long- term debt of the Company and its subsidiaries which debt does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. (Incorporated by reference to Exhibit 4(c) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended February 28, 1981.) 10(a) Employment Agreement, dated as of August 8, 1988, between the Company and Ronald J. Mueller. (Incorporated by reference to Exhibit 10.2 to INTERCO INCORPORATED's Registration Statement on Form S-4, File No. 33-34965.) 10(b) INTERCO INCORPORATED's 1992 Stock Option Plan. (Incorporated by reference to Exhibit 10(b) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(c) INTERCO INCORPORATED's PerformanceIncentive Plan. (Incorpor- ated by reference to Exhibit 10.10 to INTERCO INCORPORATED's Registration Statement on Form S-4, File No. 33-34965.) 10(d) Form of Indemnification Agreement between the Company and Richard B. Loynd, Donald E. Lasater and Lee M. Liberman. (Incorporated by reference to Exhibit 10(h) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended February 29, 1988.) 10(e) Consulting Agreement, dated as of September 23, 1992, between the Company and Apollo Advisors, L.P. (Incorporated by reference to Exhibit 10(e) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(f) Registration Rights Agreement, dated as of August 3, 1992, among the Company, Apollo Investment Fund, L.P. and Altus Finance. (Incorporated by reference to Exhibit 10(f) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(g) Registration Rights Agreement, dated as of August 3, 1992, between the Company and Apollo Interco Partners, L.P. (Incorporated by reference to Exhibit 10(g) to INTERCO INCORPORATED's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(h) Written description of bonus agreements for executive officers of the Company and retirement plan for non-employee directors. 11 Statement regarding computation of per share earnings. 21 List of Subsidiaries of the Company. 23 Consent of KPMG Peat Marwick (b) Reports on Form 8-K. A Form 8-K was not required to be filed during the three month period ended December 31, 1993. SHAREHOLDERS REQUESTING COPIES OF EXHIBITS TO FORM 10-K WILL BE SUPPLIED ANY OR ALL SUCH EXHIBITS AT A CHARGE OF TEN CENTS PER PAGE. INTERCO INCORPORATED AND SUBSIDIARIES Index to Consolidated Financial Statements and Schedules Consolidated Financial Statements: Consolidated balance sheet, December 31, 1993 and December 31, 1992. Consolidated statement of operations for the year ended December 31, 1993, for the five months ended December 31, 1992 and August 2, 1992 and for the year ended February 29, 1992. Consolidated statement of cash flows for the year ended December 31, 1993, for the five months ended December 31, 1992 and August 2, 1992 and for the year ended February 29, 1992. Consolidated statement of shareholders' equity for the year ended December 31, 1993, for the ten months ended December 31, 1992 and for the year ended February 29, 1992. Notes to consolidated financial statements. Independent Auditors' Report Consolidated Financial Statement Schedules: Schedule -------- Valuation and qualifying accounts VIII Supplementary income statement information X SCHEDULE VIII - ------------- INTERCO INCORPORATED AND SUBSIDIARIES Valuation and Qualifying Accounts (Dollars in Thousands) ------------------------------------------------------ Additions Balance at Charged to Deductions Balance at Beginning Costs and from End of of Period Expenses Reserves Period Description ---------- ---------- ---------- ---------- - ----------- Year Ended December 31, 1993 - ---------------------------- Allowances deducted from receivables on balance sheet: Allowance for doubtful accounts $ 6,307 $ 3,412 $ (3,299) (a) $ 6,420 Allowance for cash discounts and chargebacks 1,035 5,414 (5,661) (b) 788 ------- ------- -------- ------- $ 7,342 $ 8,826 $ (8,960) $ 7,208 ======= ======= ======== ======= Five Months Ended December 31, 1992 - ----------------------------------- Allowances deducted from receivables on balance sheet: Allowance for doubtful accounts $ 8,171 $ 1,272 $ (3,136) (a) $ 6,307 Allowance for cash discounts and chargebacks 1,357 2,257 (2,579) (b) 1,035 ------- ------- -------- ------- $ 9,528 $ 3,529 $ (5,715) $ 7,342 ======= ======= ======== ======= Five Months Ended August 2, 1992 - -------------------------------- Allowances deducted from receivables on balance sheet: Allowance for doubtful accounts $ 7,797 $ 3,674 $ (3,300) (a) $ 8,171 Allowance for cash discounts and chargebacks 1,300 2,402 (2,345) (b) 1,357 ------- ------- -------- ------- $ 9,097 $ 6,076 $ (5,645) $ 9,528 ======= ======= ======== ======= Year Ended February 29, 1992 - ---------------------------- Allowances deducted from receivables on balance sheet: Allowance for doubtful accounts $ 6,052 $ 9,633 $ (7,888) (a) $ 7,797 Allowance for cash discounts and chargebacks 1,374 7,770 (7,844) (b) 1,300 ------- ------- -------- ------- $ 7,426 $17,403 $(15,732) $ 9,097 ======= ======= ======== ======= (a) Uncollectible accounts written off, net of recoveries. (b) Cash discounts taken by customers. See accompanying independent auditors' report. /TABLE SCHEDULE X - ---------- INTERCO INCORPORATED AND SUBSIDIARIES Supplementary Income Statement Information (Dollars in Thousands) Charged to Costs and Expenses --------------------------------------------------------------- Year Ended Five Months Five Months Year Ended December 31, Ended Ended February 29, 1993 December 31, 1992 August 2, 1992 1992 ----------- ----------------- -------------- ----------- Advertising $82,712 $32,863 $32,505 $67,620 ======= ======= ======= ======= Maintenance and repairs $17,343 $ 6,706 $ 6,538 $16,305 ======= ======= ======= ======= See accompanying independent auditors' report. Independent Auditors' Report ---------------------------- The Board of Directors and Shareholders INTERCO INCORPORATED: We have audited the consolidated financial statements of INTERCO INCORPORATED 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 INTERCO INCORPORATED and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for the year ended December 31, 1993, five months ended December 31, 1992, five months ended August 2, 1992, and year ended February 29, 1992 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 2 to the consolidated financial statements, effective August 2, 1992, INTERCO INCORPORATED was required to adopt "fresh-start" reporting principles in accordance with AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code." As a result, the financial statements for the period subsequent to the adoption of fresh-start reporting are presented on a different cost basis than that for prior periods and, therefore, are not comparable. As discussed in Notes 2 and 5 to the consolidated financial statements, the company changed its method of accounting for postretirement benefits and income taxes in calendar year 1992. KPMG PEAT MARWICK St. Louis, Missouri February 8, 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. INTERCO INCORPORATED --------------------------------- (Registrant) By Richard B. Loynd ----------------------------- Richard B. Loynd Chairman of the Board Date: March 28, 1994 Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 28, 1994. Signature Title --------- ----- Richard B. Loynd Chairman of the Board, - ------------------------------ (Richard B. Loynd) President and Director (Principal Executive Officer) Donald E. Lasater Director - ------------------------------ (Donald E. Lasater) Lee M. Liberman Director - ------------------------------ (Lee M. Liberman) Leon D. Black Director - ------------------------------ (Leon D. Black) Craig M. Cogut Director - ------------------------------ (Craig M. Cogut) Robert H. Falk Director - ------------------------------ (Robert H. Falk) Michael S. Gross Director - ------------------------------ (Michael S. Gross) John J. Hannan Director - ------------------------------ (John J. Hannan) Bruce A. Karsh Director - ------------------------------ (Bruce A. Karsh) Signature Title John H. Kissick Director - ------------------------------ (John H. Kissick) Matthew J. Morahan Director - ------------------------------ (Matthew J. Morahan) Eric B. Siegel Director - ------------------------------ (Eric B. Siegel) Basil Vasiliou Director - ------------------------------ (Basil Vasiliou) Eugene F. Smith Executive Vice President - ------------------------------ (Principal Financial Officer) (Eugene F. Smith) David P. Howard Vice President and Controller - ------------------------------ (Principal Accounting Officer) (David P. Howard)

18792_1993.txt

18792_1993

1993

18792

Item 1. Business Central Telephone Company (Central Telephone) was incorporated December 14, 1970, under the laws of Delaware and is the successor by merger on December 1, 1971, to a Delaware corporation of the same name incorporated May 25, 1944. Central Telephone and its subsidiaries (the Company) provide local exchange telephone service in portions of Nevada, North Carolina, Florida, Illinois and Virginia. In addition, intra-LATA toll service and access by other carriers to the Company's local exchange facilities are provided. Central Telephone is a subsidiary of Centel Corporation (Centel) which, in addition to its ownership of all the common stock of Central Telephone, has a subsidiary which provides local exchange telephone service in portions of Texas, subsidiaries which provide cellular communications services in various markets, and various other subsidiaries. On March 9, 1993, Centel became a wholly-owned subsidiary of Sprint Corporation (Sprint), a holding company with subsidiaries in a number of telecommunications markets. As of December 31, 1993, the Company served more than 1.5 million access lines. All of the access lines are served through central offices equipped with switching. Over 60 percent of the access lines served are located in the following seven communities: Access Community Lines Las Vegas, Nevada 528,590 Tallahassee, Florida 163,939 Des Plaines, Illinois 73,969 Charlottesville, Virginia 62,187 Park Ridge, Illinois 45,872 Fort Walton Beach, Florida 39,582 Hickory, North Carolina 38,874 953,013 The Company is providing and continuing to introduce new services made possible by the enhancement of its facilities to a more intelligent network. A new signaling system (SS7) routes calls more efficiently and makes possible Custom Local Area Signaling Services (CLASS) features such as automatic callback, automatic recall, calling line identification/block (Caller ID), and customer initiated trace. Revenues from communications services constituted 88 percent of operating revenues in 1993, with the remainder derived largely from directory operations, equipment sales and billing and collection services. The Company recovers its costs of providing telephone services, as well as a return on investment, through a combination of local rates and access charges. Access charge tariffs are the principal means by which the Company is reimbursed for services provided to interexchange carriers. American Telephone and Telegraph (AT&T), as the dominant long distance telephone company, is the Company's largest customer for access services. In 1993, 16 percent of the Company's operating revenues was derived from services provided to AT&T. While AT&T is a significant customer, the Company does not believe its revenues are dependent upon AT&T as customers' demand for inter- LATA long distance telephone service is not tied to any one long distance carrier. Historically, as the market share of AT&T's long distance competitors increases, the percent of revenues derived from network access services provided to AT&T decreases. The Company is subject to the jurisdiction of the Federal Communications Commission (FCC) and the utilities commissions of each of the states in which it operates. In each state in which the commission exercises authority to grant certificates of public convenience and necessity, the Company has been granted such certificates of indefinite duration to provide local exchange telephone service in its current service areas. In most instances, where required by law, the Company has valid local franchises sufficient to enable it to provide local exchange telephone service in the areas in which it is operating. The absence of any such franchises should have no material adverse effect upon the Company's operations. In the communities where the Company provides local exchange telephone service, no other local exchange carrier is currently authorized to provide such facilities based service. The potential for more direct competition is, however, increasing for the Company. Illinois law allows alternative telecommunications providers to obtain certificates of local exchange telephone service authority in direct competition with existing local exchange carriers if certain showings are made to the satisfaction of the Illinois Commerce Commission. In November 1993, MFS Intelenet of Illinois, Inc. submitted an application to the Illinois Commerce Commission to operate as an alternative local exchange carrier for business customers located in portions of the Chicago metropolitan area served by Illinois Bell Telephone Company and Central Telephone's Illinois subsidiary; the application is pending. Many states, including most of the states in which the Company offers local exchange telephone service, allow competitive entry into the intra-LATA long distance service market. Illinois permits the resale of local exchange telephone service, and North Carolina allows customers to participate in the sharing and resale of local exchange telephone service 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 local exchange carriers (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 1 (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 District of Columbia Circuit. Central Telephone's Illinois subsidiary had provided physical collocation prior to the FCC's mandate. New technology, as well as changes in state law and regulatory decisions, is permitting expansion of the types of services available through the local exchange and increasing the number of competitors. Other means of communication, such as private network, satellite, cellular and cable systems permit bypass of the local exchange. Although the extent to which bypass has occurred cannot be precisely determined, management believes it has not had a material adverse effect on the Company's operating revenues. The extent and ultimate impact of competition for the Company and other LECs will continue to depend, to a considerable degree, on FCC and state regulatory 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 although it is uncertain if any of the bills will be enacted. Effective January 1, 1991, the FCC adopted a price caps regulatory format for the Bell Operating Companies (the LECs owned by AT&T prior to divestiture) and the LECs owned by GTE Corporation. Other LECs could volunteer to become subject to price caps regulation. Under price caps, prices for network 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 did not originally elect price caps, but as a result of Sprint's merger with Centel, adopted price caps effective July 1, 1993. Under the form of the plan adopted, the Company generally has an opportunity to earn up to a 14.25 percent rate of return on investment. Certain of the Company's operations have committed to produce higher than industry average productivity gains, and as a result have an opportunity to earn up to a 15.25 percent rate of return on investment. Prior to price caps, under rate of return regulation, the Company's authorized rate of return on investment was 11.25 percent, with the ability to earn 0.25 percent above the authorized return. The FCC is conducting a scheduled review of all aspects of the price caps plan; changes to the plan may be proposed by interested parties and the FCC may implement changes in 1995. Without further action by the FCC, the current price caps plan would expire in 1995 and would be replaced by rate of return regulation. In December 1992, the Florida Public Service Commission approved a stipulation giving Central Telephone's Florida subsidiary an annual revenue increase of approximately $3.5 million, effective January 1, 1993. From January 1, 1993 to June 30, 1994, any earnings in excess of an annual earned return on equity of 12.0 percent must be refunded. Also in December 1992, the Public Service Commission of Nevada authorized an annual revenue increase of approximately $6.1 million for Central Telephone's Nevada division, effective January 1, 1993. Central Telephone's Illinois subsidiary has applied for a rate increase of approximately $10.2 million from the Illinois Commerce Commission, and the final order is due in May 1994. In December 1993, the Virginia alternative regulatory plan was modified to lower the maximum rate of return on equity from 14 percent to 12.55 percent, and to include 25 percent of yellow page income in the determination of return on equity. Compliance with federal, state and local provisions relating to the protection of the environment has had no significant effect on the capital expenditures or earnings of the Company and future effects are not expected to be material. As of December 31, 1993, the Company had approximately 5,900 employees. During 1993, the Company had no material work stoppages caused by labor controversies. Item 2. Item 2. Properties The properties of the Company consist principally of land, structures, facilities and equipment and are in good operating condition. All of the central office buildings are owned, except eight which are leased. Substantially all of the telephone property, plant and equipment is subject to the liens of the indentures securing indebtedness. As of December 31, 1993, cable and wire facilities represented 50 percent of total net property, plant and equipment; central office equipment, 37 percent; land and buildings, 6 percent; and other assets, 7 percent. The following table sets forth the gross property additions and retirements or sales during each of the five years in the period ended December 31, 1993 (in millions): Gross Property Year Additions Retirements or Sales 1993 $ 163.4 $ 60.1 1992 168.1 173.1 1991 162.2 254.8 [1] 1990 214.7 54.3 1989 175.3 72.8 [1] Includes $213 million related to the sale of the Company's operations in Iowa and Minnesota. Item 3. Item 3. Legal Proceedings There are no material pending legal proceedings, and the Company is a party only to ordinary routine litigation incidental to its business. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of security holders during the fourth quarter of 1993. Item 10. Executive Officers of the Registrant Officer Name Age President and Chief Executive Officer D. Wayne Peterson (1) 58 Vice President-Chief Financial Officer John P. Meyer (2) 43 Vice President-Controller Ralph J. Hodge (3) 41 Vice President-Treasurer M. Jeannine Strandjord (4) 48 Vice President Stephen M. Bailor (5) 50 Vice President Peter W. Chehayl (6) 46 Vice President-Assistant Secretary Don A. Jensen (7) 58 Vice President A. Allan Kurtze (8) 49 Secretary Marion W. O'Neill (9) 53 President-North Carolina William E. Division McDonald (10) 51 President-Nevada Division Dianne Ursick (11) 44 (1)Mr. Peterson has been President and Chief Executive Officer since September 1993. He has also served as President-Local Telecommunications Division of Sprint since August 1993. From 1980 to 1993, he served as President of Carolina Telephone and Telegraph Company, a subsidiary of Sprint. (2)Mr. Meyer has been Vice President-Chief Financial Officer since January 1993. Mr. Meyer has also served as Senior Vice President and Controller of Sprint since April 1993. He served as Vice President and Controller of Centel from 1989 to 1993 and as Controller of Centel from 1986 to 1989. (3)Mr. Hodge has been Vice President-Controller since December 1993. He has also served as Assistant Vice President and Assistant Controller of Sprint since April 1993. He was Director of Earnings Analysis and External Reporting for Sprint from 1992 to 1993. He served as Treasurer of the companies comprising the Midwest Group of local exchange companies of Sprint from 1991 to 1992 and Controller of the companies comprising the Midwest Group from 1988 to 1991. (4)Ms. Strandjord has been Vice President-Treasurer since September 1993. She has also served as Senior Vice President and Treasurer of Sprint since 1990. She served as Vice President and Controller of Sprint from 1986 to 1990. (5)Mr. Bailor has been Vice President since December 1993. Mr. Bailor served as Vice President and Controller of Central Telephone from 1989 to December 1993. He has also served as Vice President-Financial and Local Billing Services of Sprint's Finance Division since September 1993. (6)Mr. Chehayl has been Vice President since December 1993. He has also served as Vice President and Assistant Treasurer of Sprint since 1991. He was Vice President and Treasurer of Alert Holdings, Inc., a provider of security alarm monitoring services, during part of 1990, and from 1988 to 1990 he was Treasurer of Firestone Tire & Rubber Company (now known as Bridgestone/Firestone, Inc.) , a manufacturer and retailer of tires and a retailer of automotive services. (7)Mr. Jensen has been Vice President-Assistant Secretary since September 1993. He has also served as Vice President and Secretary of Sprint since 1975. (8)Mr. Kurtze has been Vice President since 1991. Mr. Kurtze has also served as Senior Vice President of Sprint/United Management Company, a subsidiary of Sprint, since July 1993. He served as Executive Vice President of Centel from 1991 to 1993 and as Senior Vice President-Planning and Technology of Centel from 1986 to 1991. (9)Ms. O'Neill has been Secretary since July 1993. She has been an attorney for Sprint for more than five years. (10)Mr. McDonald has been President of the North Carolina Division since September 1993. He has also served as President of the other four companies comprising the Mid- Atlantic Group of local exchange companies of Sprint since August 1993. From 1988 to 1993, he served as President of the two companies comprising the Eastern Group of local exchange companies of Sprint. (11)Ms. Ursick has been President of the Nevada Division since March 1993. From 1989 to 1993, she was General Regulatory Manager of the Nevada Division. Part II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters All shares of common stock of Central Telephone, representing 97.4 percent of the aggregate outstanding capital stock of Central Telephone, are owned by Centel, a wholly-owned subsidiary of Sprint. There is no established public trading market for the common stock. One series of voting convertible junior preferred stock and four series of voting cumulative preferred stock of Central Telephone are outstanding. Since issuance, quarterly dividends have been paid on all series of the preferred stock at the respective prescribed rates. The junior preferred stock is publicly held and each share is convertible to 6.47325 shares of Sprint common stock. There were 35,528 shares outstanding as of December 31, 1993. During 1993, there were 7,290 shares converted. There is no established public trading market for this particular issue. There is no active market for shares of any of the series of cumulative preferred stock. Transfer Agent for all Conversion Agent for the Junior Preferred Stocks Preferred Stock First Chicago Trust Company of First Chicago Trust Company of New York, New York New York, New York Item 6. Item 6. Selected Financial Data Selected consolidated financial data as of and for the years ended December 31 is as follows (in millions): 1993 1992 1991 1990 1989 Operating revenues $ 868.6 $ 786.6 $ 808.9 $ 831.7 $ 771.7 Income before extraordinary item and cumulative effect of changes in accounting principles [1], [2] 41.4 71.6 143.3 100.9 88.0 Total assets 1,704.8 1,724.1 1,665.9 1,743.8 1,637.2 Long-term debt and redeemable preferred stock (including current maturities) 472.6 522.0 530.3 549.1 424.7 [1] During 1993, nonrecurring charges of $77 million were recorded related to the Company's portion of the transaction costs associated with Sprint's merger with Centel and the expenses of integrating and restructuring the operations of the companies. Such charges reduced consolidated 1993 income before extraordinary item and cumulative effect of changes in accounting principles by $48 million. [2] During 1991, gains of $92 million were recognized related to the sale of the Company's Iowa and Minnesota operations, which increased consolidated 1991 income before extraordinary item and cumulative effect of changes in accounting principles by $64 million. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Recent Development - Sprint/Centel Merger Effective March 9, 1993, Centel, the parent company of Central Telephone Company, and Sprint consummated a merger of the companies (see Note 2 of "Notes to Consolidated Financial Statements" for additional information). Sprint is a diversified telecommunications company with local exchange telephone operations in seventeen states prior to the merger, including Florida, North Carolina and Virginia. As a result of the merger, the operations of the merged companies continue to be integrated and restructured to achieve efficiencies which have begun to yield operational synergies and cost savings, particularly in the latter half of 1993. 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 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 $77 million, which reduced 1993 net income by approximately $48 million. Results of Operations As described in Note 8 of "Notes to Consolidated Financial Statements," the Company's local exchange telephone operations in Minnesota and Iowa were divested in 1991. The following comparisons and discussion exclude the effects of such divested operations. Net operating revenues increased 10 percent in 1993, following a 2 percent increase in 1992. Local service revenues, derived from providing local exchange telephone service, increased 11 percent and 9 percent in 1993 and 1992, respectively. These increases reflect continued growth in the number of access lines served, add-on services, such as custom calling, and increased Centrex revenues. Access lines grew 5.0 percent in 1993 versus 4.8 percent in 1992. Rate increases also contributed to increased local service revenue. The Florida Public Service Commission (FPSC) ordered an interim rate increase effective September 1992, which increased 1992 local service revenue by $1 million. In addition, permanent annual increases granted by the FPSC and the Public Service Commission of Nevada, effective January 1993, increased 1993 local service revenue by $10 million. Toll and access service revenues are derived from interexchange long distance carriers use of the local network to complete calls, and the provision of long distance services within specified geographical areas. These revenues increased $37 million in 1993 as a result of increased traffic volumes and the recognition of a portion of the merger, integration and restructuring costs for regulatory purposes in certain jurisdictions, partially offset by periodic reductions in network access rates charged. Toll and access service revenue decreased $3 million in 1992 principally due to reductions in network access rates charged. Other revenues increased $4 million in 1993 following a decrease of $10 million in 1992. The increase in 1993 is generally due to higher equipment sales and increased directory revenue. The decrease in other revenue in 1992 was caused by a decrease in certain billing services provided to American Telephone and Telegraph and by an inside wire maintenance settlement which resulted in refunds to the customers of the Company's Florida subsidiary. Operating expenses increased $45 million and $19 million in 1993 and 1992, respectively, primarily reflecting increases in the costs of providing services resulting from access line growth. The increases in 1993 also resulted from increases in systems development costs incurred to enhance the efficiency and capabilities of the billing processes and increases in the cost of equipment sales. The increase in operating expenses in 1992 also resulted from increases in pension costs due to a new union agreement. The increases in operating expenses in 1993 also reflect the impact of changes in accounting principles. As a result of the change in accounting for certain software costs, the Company recognized additional expense in 1993 of $7 million. In addition, increased postretirement benefits cost of approximately $7 million were recognized as a result of the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (see Notes 1 and 3 of "Notes to Consolidated Financial Statements" for additional information). Depreciation and amortization expense increased $7 million in 1993, following a $4 million decrease in 1992. The 1993 increase was generally due to plant additions. The decrease in 1992 depreciation expense was due to nonrecurring charges recorded in 1991, partially offset by plant additions. Interest expense was $44 million, $43 million and $45 million in 1993, 1992 and 1991, respectively. The increase in 1993 was generally related to increased advances from affiliates, whereas the decrease in 1992 was related to a decrease in average levels of debt outstanding and lower interest rates. The divestitures of the Company's Minnesota and Iowa operations in 1991 resulted in a gain of $92 million, which increased income from continuing operations by $64 million. The Company's income tax provisions for 1993, 1992 and 1991 resulted in effective tax rates of 25 percent, 29 percent and 30 percent, respectively. See Note 4 of "Notes to Consolidated Financial Statements" for information regarding the differences that cause the effective income tax rates to vary from the statutory federal income tax rates. Effective January 1, 1993, the Company conformed its accounting practices for certain software costs with the prevalent practice in the industry and with the accounting method used by Sprint's local communications services division. The Company now expenses these costs as incurred. The cumulative effect of this change in accounting principle reduced 1993 net income by $22 million, net of related income tax benefits of $13 million. Regulatory Activities In June 1993, the Company's Illinois subsidiary filed with the Illinois Commerce Commission a petition to adjust its rates and charges such that annual intrastate revenues would increase by approximately $10 million. This rate proceeding was required to provide revenue recovery for the added costs related to the adoption of SFAS No. 106 and to recognize the phases of the Federal Communications Commission mandated jurisdictional cost shifts from interstate to intrastate. A final order will be issued in May 1994. In addition, in December 1993, the Company's Virginia subsidiary's alternative regulatory plan was modified to lower the maximum rate of return on equity from 14 percent to 12.55 percent, and to include 25 percent of yellow page income in the determination of return on equity. Liquidity and Capital Resources Cash Flows-Operating Activities Cash flows from operating activities, which are the Company's primary source of liquidity, were $227 million, $211 million and $175 million in 1993, 1992 and 1991, respectively. The improvement in 1993 operating cash flows reflects better operating results, partially offset by expenditures of $26 million related to the merger, integration and restructuring actions. Cash Flows-Investing Activities Capital expenditures, which represent the Company's most significant investing activity, were $163 million, $168 million and $162 million in 1993, 1992 and 1991, respectively. Capital expenditures were made to accommodate access line growth and to expand the capabilities for providing enhanced telecommunications services. Investing activities in 1991 also include proceeds of $216 million from the sales of the Company's Iowa and Minnesota local telephone operations to Rochester Telephone Corporation (Rochester). In addition to cash of $116 million, the Company received shares of Rochester's common stock and ownership rights to investments in cellular franchises. The Company received $100 million in cash and $12 million in advances from Centel for the Rochester stock and cellular franchises. Cash Flows-Financing Activities The Company's financing activities used cash of $65 million, $45 million and $200 million in 1993, 1992 and 1991, respectively. Improved operating cash flows during each year, together with the proceeds from the divestitures in 1991, allowed the Company to fund capital expenditures internally and reduce total debt outstanding. In addition, the Company paid a special dividend in 1991 of $112 million to Centel with a portion of the proceeds received from the sales of the Iowa and Minnesota operations. During 1993 and 1992, a significant level of debt refinancing occurred in order to take advantage of lower interest rates. Accordingly, a majority of the proceeds from long-term borrowings in 1993 and 1992 were used to finance the redemption prior to scheduled maturities of $144 million and $148 million of debt, respectively. Financial Position, Liquidity and Capital Requirements As of December 31, 1993, the Company's total capitalization aggregated $1.09 billion, consisting of long-term debt (including current maturities), advances from affiliates, redeemable preferred stock, and common stock and other stockholder's equity. Long-term debt (including current maturities and advances from affiliates) comprised 43 percent of total capitalization as of December 31, 1993, adjusted on a proforma basis for the effects of changes in accounting principles, compared to 45 percent at year-end 1992. During 1994, the Company anticipates funding estimated capital expenditures of $190 million with cash flows from operating activities. The Company expects its external cash requirements for 1994 to be approximately $12 million which is generally required to pay scheduled long-term debt maturities. The method of financing the cash requirements will depend on prevailing market conditions during the year. The Company may also undertake additional debt refinancings during 1994 in order to take advantage of favorable interest rates. The Company, Sprint and Sprint Capital Corporation (a wholly- owned subsidiary of Sprint) have a $1.1 billion revolving credit agreement with a syndicate of domestic and international banks, under which the Company can borrow up to an aggregate of $200 million. As of December 31, 1993, the Company had no borrowings outstanding under this agreement. The revolving credit agreement expires in July 1996 and, subject to the approval of the lenders, may be extended for up to an additional two years. Recent Accounting Developments Effective January 1, 1994, the Company will adopt SFAS 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 and amortization based on estimated useful lives prescribed by regulatory commissions rather than those which might be utilized by non-regulated enterprises. Management believes the Company's operations meet the criteria for the continued application 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, noncash charge. Effects of Inflation The effects of inflation on the Company's operations were not significant during 1993, 1992 or 1991. Item 8. Item 8. Financial Statements and Supplementary Data INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Report of Independent Auditors - Ernst & Young Report of Independent Public Accountants - Arthur Andersen & Co. Consolidated Statements of Income and Retained Earnings for each of the three years ended December 31, 1993 Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Cash Flows for each of the three years ended December 31, 1993 Notes to Consolidated Financial Statements Financial Statement Schedules for each of the three years ended December 31, 1993: V - Consolidated Property, Plant and Equipment VI - Consolidated Accumulated Depreciation VIII-Consolidated Valuation and Qualifying Accounts IX - Consolidated Short-Term Borrowings X - Consolidated Supplementary Income Statement Information Certain financial statement schedules are omitted because the required information is not present, or because the information required is included in the consolidated financial statements and notes thereto. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Central Telephone Company We have audited the consolidated balance sheet of Central Telephone Company (a wholly-owned subsidiary of Sprint Corporation) as of December 31, 1993, and the related consolidated statements of income and retained earnings, and cash flows for the year then ended. Our audit also included the 1993 financial statement schedules listed in the Index to Financial Statements and Financial Statement Schedules. 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 audit. The financial statements and schedules of Central Telephone Company for the years ended December 31, 1992 and 1991, were audited by other auditors whose report dated February 3, 1993, expressed an unqualified opinion on those statements prior to restatement. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the 1993 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Central Telephone Company at December 31, 1993, and the consolidated results of its operations and its cash flows for the year 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 1 to the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes, software costs and postretirement benefits. We also audited the adjustments described in Note 1 that were applied to restate the 1992 consolidated financial statements for the change in the method of accounting for income taxes. In our opinion, such adjustments are appropriate and have been properly applied. ERNST & YOUNG Kansas City, Missouri January 21, 1994 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareowners of Central Telephone Company We have audited the consolidated balance sheet of CENTRAL TELEPHONE COMPANY (a Delaware corporation and wholly owned subsidiary of Centel Corporation) AND SUBSIDIARIES as of December 31, 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the two years in the period ended December 31, 1992, prior to the restatement (and, therefore, are not presented herein) for the change in the Company's method of accounting for income taxes as described in Note 1 to the restated financial statements. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements (prior to restatement) based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit 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 (prior to restatement) referred to above present fairly, in all material respects, the financial position of Central Telephone Company and Subsidiaries as of December 31, 1992, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1992, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements (prior to restatement) taken as a whole. In connection with our audits, certain auditing procedures were applied to the following schedules (prior to restatement) (and, therefore, are not presented herein) which are required for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements: Schedule V--Consolidated Property, Plant and Equipment Schedule VI--Consolidated Accumulated Depreciation Schedule VIII--Consolidated Valuation and Qualifying Accounts Schedule IX--Consolidated Short-Term Borrowings Schedule X--Consolidated Supplementary Income Statement Information In our opinion, the information contained in these schedules (prior to restatement) fairly states, 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 3, 1993 CENTRAL TELEPHONE COMPANY CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS Years ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 OPERATING REVENUES Local service $ 416.9 $ 375.4 $ 362.9 Toll and access service 345.8 309.1 328.4 Other 105.9 102.1 117.6 868.6 786.6 808.9 OPERATING EXPENSES Other operating expenses 558.9 514.4 511.8 Merger, integration and restructuring costs 77.2 Depreciation and amortization 134.3 127.8 138.5 770.4 642.2 650.3 OPERATING INCOME 98.2 144.4 158.6 Gain on divestiture of telephone properties 91.6 Interest expense (43.6) (43.1) (45.3) Other income (expense), net 0.5 (0.6) 0.7 Income before income taxes, extraordinary item and cumulative effect of changes in accounting principles 55.1 100.7 205.6 Income tax provision (13.7) (29.1) (62.3) Income before extraordinary item and cumulative effect of changes in accounting principles 41.4 71.6 143.3 Extraordinary losses on early extinguishments of debt, net (4.6) Cumulative effect of changes in accounting principles, net (21.6) (0.5) NET INCOME 15.2 71.1 143.3 RETAINED EARNINGS AT BEGINNING OF YEAR 257.3 216.7 259.4 Cash dividends Common stock (27.1) (30.0) (185.4) Preferred stock (0.5) (0.5) (0.6) RETAINED EARNINGS AT END OF YEAR $ 244.9 $ 257.3 $ 216.7 PRO FORMA AMOUNTS ASSUMING THE CHANGE IN ACCOUNTING FOR SOFTWARE COSTS WAS RETROACTIVELY APPLIED Income before extraordinary $ 41.4 $ 63.0 $ 138.1 item Net income $ 36.8 $ 62.5 $ 138.1 See accompanying notes to consolidated financial statements. CENTRAL TELEPHONE COMPANY CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (In Millions) 1993 1992 ASSETS CURRENT ASSETS Cash $ 9.5 $ 7.3 Receivables Customers and other, net of allowance for doubtful accounts of $0.6 million ($0.5 million in 1992) 84.0 82.9 Interexchange carriers 4.9 6.5 Affiliated companies 13.9 2.9 Advances to affiliates 3.3 7.0 Deferred income taxes 19.8 17.7 Prepaid expenses and other 13.2 13.5 Total current assets 148.6 137.8 PROPERTY, PLANT AND EQUIPMENT Land and buildings 116.4 113.0 Telephone network equipment and outside plant 2,150.1 2,037.0 Other 138.8 151.7 Construction in progress 13.9 28.3 2,419.2 2,330.0 Less accumulated depreciation (943.7) (871.2) 1,475.5 1,458.8 DEFERRED CHARGES AND OTHER ASSETS 80.7 127.5 $ 1,704.8 $ 1,724.1 CENTRAL TELEPHONE COMPANY CONSOLIDATED BALANCE SHEETS (continued) December 31, 1993 and 1992 (In Millions) 1993 1992 LIABILITIES AND STOCKHOLDER'S EQUITY CURRENT LIABILITIES Outstanding checks in excess of cash balances $ 17.5 $ 19.6 Current maturities of long-term debt 22.7 31.2 Advances from affiliates 14.4 Accounts payable Vendors and other 17.6 24.3 Interexchange carriers 13.4 30.1 Affiliated companies 32.2 5.8 Accrued merger, integration and restructuring costs 24.3 Accrued interest 17.2 13.1 Advance billings 16.2 13.0 Accrued vacation pay 15.2 16.4 Other 42.7 52.8 Total current liabilities 233.4 206.3 LONG-TERM DEBT 440.9 481.3 DEFERRED CREDITS AND OTHER LIABILITIES Deferred income taxes and investment tax credits 276.4 293.2 Postretirement benefits obligations 71.6 43.8 Regulatory liability 59.1 74.8 Other 15.1 3.5 422.2 415.3 REDEEMABLE PREFERRED STOCK 9.0 9.5 COMMON STOCK AND OTHER STOCKHOLDER'S EQUITY Common stock, no par value, authorized- 10.0 million shares, issued and outstanding-9.0 million shares 354.4 354.4 Retained earnings 244.9 257.3 599.3 611.7 $ 1,704.8 $ 1,724.1 See accompanying notes to consolidated financial statements. CENTRAL TELEPHONE COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 OPERATING ACTIVITIES Net income $ 15.2 $ 71.1 $ 143.3 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 134.3 127.8 138.5 Gain on divestiture of telephone properties (91.6) Extraordinary losses on early extinguishments of debt 7.6 Cumulative effect of changes in accounting principles 21.6 0.5 Deferred income taxes and investment tax credits (33.8) 2.1 (44.5) Changes in operating assets and liabilities Receivables, net (10.5) (2.5) 0.4 Other current assets 0.3 (2.4) 4.3 Accounts payable 0.9 12.3 (4.0) Accrued expenses and other current liabilities 32.9 (14.1) 24.1 Noncurrent assets and liabilities, net 55.6 16.2 4.5 Other, net 2.5 (0.4) (0.3) NET CASH PROVIDED BY OPERATING ACTIVITIES 226.6 210.6 174.7 INVESTING ACTIVITIES Capital expenditures (163.4) (168.1) (162.2) Proceeds from divestiture of telephone properties 215.8 (Increase) decrease in advances to affiliates 3.7 19.5 (23.7) Other, net 0.6 (17.6) (11.5) NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES (159.1) (166.2) 18.4 FINANCING ACTIVITIES Proceeds from long-term debt 118.6 157.1 88.3 Retirements of long-term debt (147.5) (190.0) (39.1) Increase (decrease) in short-term borrowings (20.0) 20.0 (70.1) Increase (decrease) in advances from affiliates 14.4 (1.5) (1.9) Dividends paid (27.6) (30.5) (176.8) Other, net (3.2) (0.1) (0.3) NET CASH USED BY FINANCING ACTIVITIES (65.3) (45.0) (199.9) INCREASE (DECREASE) IN CASH 2.2 (0.6) (6.8) CASH AT BEGINNING OF YEAR 7.3 7.9 14.7 CASH AT END OF YEAR $ 9.5 $ 7.3 $ 7.9 See accompanying notes to consolidated financial statements. CENTRAL TELEPHONE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ACCOUNTING POLICIES Central Telephone Company is engaged in the business of providing communications services, principally local, network access and toll services in portions of Florida, Illinois, Nevada, North Carolina and Virginia. The principal industries in the Company's service area include retail and wholesale trade, transportation, agriculture, manufacturing, finance and service. Basis of Presentation The accompanying consolidated financial statements include the accounts of Central Telephone Company and its wholly-owned subsidiaries, Central Telephone Company of Florida, Central Telephone Company of Virginia and Central Telephone Company of Illinois (the Company). All significant intercompany transactions have been eliminated. The Company is a wholly-owned subsidiary of Centel Corporation (Centel); accordingly, earnings per share information has been omitted. Centel became a wholly- owned subsidiary of Sprint Corporation (Sprint) on March 9, 1993, in connection with the Sprint/Centel merger (see Note 2 for additional information). 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. 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. Depreciation Depreciation expense is generally computed on a straight-line basis over the estimated useful lives as prescribed by regulatory commissions. Depreciation rate changes granted by a state commission resulted in additional depreciation expense in 1993 of $1 million. In addition, as ordered by the state commissions, the Company recorded nonrecurring charges to depreciation expense in 1991 of $5 million, which reduced net income by $1 million. Average annual composite depreciation rates, excluding the nonrecurring charges, were 5.5 percent for 1993, 5.3 percent for 1992 and 5.9 percent for 1991. Income Taxes Subsequent to the Sprint/Centel merger, operations of the Company are included in the consolidated federal income tax returns of Sprint. Prior to the merger, operations of the Company were included in the consolidated federal income tax returns of Centel. Federal income tax is calculated by the Company on the basis of its filing a separate return. In 1993, the Company retroactively 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. The new standard was adopted retroactive to January 1, 1992; accordingly, the 1992 financial statements were restated to reflect the change in 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 statement purposes. The adoption of SFAS No. 109 resulted in a decrease in the deferred income tax liabilities as previous income tax accounting standards did not permit accumulated deferred income tax amounts to be adjusted for subsequent tax rate changes. However, because this decrease will accrue to the benefit of the Company's customers it has been reflected as a regulatory liability. Additionally, upon adoption of SFAS No. 109, the Company recognized deferred income tax liabilities for those temporary differences for which deferred income taxes had not previously been provided. Corresponding regulatory assets were also recorded by the Company to reflect the anticipated recovery of such taxes in future telephone rates. The adoption of SFAS No. 109 is reflected as a change in accounting principle in the 1992 consolidated statement of income. Adoption of this standard did not significantly impact the Company's 1993 results of operations. 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. Software Costs Effective January 1, 1993, the Company changed its method of accounting for certain software costs. The change was made to conform the Company's accounting to the predominant practice among local exchange carriers. Under the new method, such costs are being expensed when incurred. The resulting nonrecurring, noncash charge of $22 million, net of related income tax benefits of $13 million, is reflected as a change in accounting principle in the 1993 consolidated statement of income. As a result of the change in accounting, the Company recognized incremental expense of $7 million in 1993. Postretirement Benefits Effective January 1, 1993, the Company modified its accrual method of accounting for postretirement benefits (principally health care and life insurance benefits) provided to certain retirees by adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." As permitted by SFAS No. 106, the Company elected to recognize its previously unrecognized obligation for postretirement benefits as of January 1, 1993 by amortizing such obligation on a straight-line basis generally over a period of 20 years, except in those jurisdictions where shorter amortization periods have been authorized for regulatory treatment. 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 statement of income. The resulting nonrecurring, noncash charge will not significantly impact the Company's 1994 net income. Adoption of this standard is not expected to significantly impact future operating expenses. Interest Charged to Construction In accordance with the Uniform System of Accounts, as prescribed by the Federal Communications Commission (FCC), interest is capitalized on those telephone plant construction projects for which the estimated construction period exceeds one year. In addition, the Public Service Commission of Nevada has ordered that the Company's Nevada operations capitalize interest during construction on short-term projects. 2. MERGER, INTEGRATION AND RESTRUCTURING COSTS Effective March 9, 1993, Sprint consummated its merger with Centel. 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 have begun to yield operational synergies and cost savings. 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 companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in nonrecurring charges to Sprint during 1993. The portion of such charges attributable to the Company was $77 million, which reduced 1993 net income by approximately $48 million. 3. EMPLOYEE BENEFIT PLANS Defined Benefit Pension Plans Substantially all employees of the Company are covered by noncontributory defined benefit pension plans sponsored by Centel. Effective December 31, 1993, such plans were merged with the defined benefit pension plan sponsored by Sprint. For participants of the plans represented by collective bargaining agreements, benefits are based upon schedules of defined amounts as negotiated by the respective parties. For participants not covered by collective bargaining agreements, the plans provide pension benefits based upon years of service and participants' compensation. The Company's policy is to make contributions to the plans 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 plans' assets consisted principally of investments in corporate equity securities and U.S. government and corporate debt securities. The components of the net pension costs (credits) and related assumptions are as follows (in millions): 1993 1992 1991 Service cost -- benefits earned during $ 10.0 $ 8.8 $ 7.2 the period Interest cost on projected benefit 20.8 18.7 14.2 obligation Actual return on plan assets (29.7) (18.3) (43.7) Net amortization and deferral 5.8 (5.2) 16.7 Net pension cost (credit) $ 6.9 $ 4.0 $ (5.6) Discount rate 8.0% 8.8% 8.8% Expected long-term rate of return on plan assets 9.5% 10.0% 10.0% Anticipated composite rate of future increases in compensation 5.5% 7.0% 7.0% In addition, the Company recognized pension curtailment losses of $5 million during 1993 as a result of the integration and restructuring actions (see Note 2 for additional information). The funded status and amounts recognized in the consolidated balance sheets for the plans, as of December 31, are as follows (in millions): 1993 1992 Actuarial present value of pension benefit obligations Vested benefit obligation $ (262.8) $ (207.4) Accumulated benefit obligation $ (304.4) $ (241.3) Projected benefit obligation $ (317.4) $ (263.7) Plan assets at fair value 279.7 262.4 Projected benefit obligation in excess of plan assets (37.7) (1.3) Unrecognized net losses 39.4 23.3 Unrecognized prior service cost 59.5 55.3 Unamortized portion of transition asset (31.9) (36.0) Prepaid pension cost $ 29.3 $ 41.3 The projected benefit obligations as of December 31, 1993 and 1992 were determined using a discount rate of 7.5 percent for 1993 and 8.0 percent for 1992, and anticipated composite rates of future increases in compensation of 4.5 percent for 1993 and 5.5 percent for 1992. Defined Contribution Plans Substantially all employees of the Company are covered by defined contribution employee savings plans. Effective December 31, 1993, the plan covering participants not represented by collective bargaining agreements was merged with a defined contribution plan sponsored by Sprint. Eligible employees may contribute a portion of their compensation to the plans, and the Company makes matching contributions up to specified levels. The Company's contributions to the plans aggregated $10 million in 1993 and 1992, and $9 million in 1991. Postretirement Benefits The Company provides other postretirement benefits (principally health care and life insurance benefits) to certain retirees. Employees who retired from the Company before specified dates became eligible for these postretirement benefits at no cost to the retirees. Employees retiring after specified dates are eligible for these benefits on a shared cost basis. 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 components of the 1993 net postretirement benefits cost are as follows (in millions): Service cost -- benefits earned during the period $ 4.5 Interest on accumulated postretirement benefits obligation 12.4 Amortization of transition obligation 5.9 Net postretirement benefits cost $ 22.8 For measurement purposes, an annual health care cost trend rate of 13 percent was assumed for 1993, gradually decreasing to 6 percent by 2000 and remaining constant thereafter. The effect of a one percent annual increase in the assumed health care cost trend rate would have increased the 1993 net postretirement benefits cost by approximately $4 million. The weighted average discount rate for 1993 was 8 percent. In addition, the Company recognized postretirement benefits curtailment losses of $10 million during 1993 as a result of the integration and restructuring actions (see Note 2 for additional information). The cost of providing health care and life insurance benefits to retirees was $11 million and $12 million in 1992 and 1991, respectively. Such costs were being accrued over the service periods of employees expected to receive the benefits, with past service costs amortized over 30 years except in those jurisdictions where shorter amortization periods had been authorized for regulatory purposes. The amount recognized in the consolidated balance sheet as of December 31, 1993 is as follows (in millions): Accumulated postretirement benefits obligation Retirees $ 79.0 Active plan participants -- fully eligible 34.3 Active plan participants -- other 64.2 177.5 Unrecognized net losses (14.9) Unrecognized transition obligation (91.0) Accrued postretirement benefits cost $ 71.6 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 obligation as of December 31, 1993 by approximately $18 million. 4. INCOME TAXES The components of the federal and state income tax provision are as follows (in millions): 1993 1992 1991 Current income tax provision Federal $ 42.7 $ 23.0 $ 91.8 State 4.8 4.0 15.0 Amortization of deferred ITC (4.5) (5.5) (8.2) 43.0 21.5 98.6 Deferred income tax provision (benefit) Federal (26.8) 6.4 (32.0) State (2.5) 1.2 (4.3) (29.3) 7.6 (36.3) Total income tax provision $ 13.7 $ 29.1 $ 62.3 On August 10, 1993, the Revenue Reconciliation Act of 1993 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. 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 millions): 1993 1992 1991 Federal income tax provision at the statutory rate $ 19.3 $ 34.2 $ 69.9 Less amortization of deferred ITC (4.5) (5.5) (8.2) Expected federal income tax provision after amortization of deferred ITC 14.8 28.7 61.7 Effect of Reversal of rate differentials (3.2) (2.9) (5.2) State income tax, net of federal income tax effect 1.5 3.4 7.0 Divestiture of telephone properties (4.7) Other, net 0.6 (0.1) 3.5 Income tax provision, including $ 13.7 $ 29.1 $ 62.3 ITC Effective income tax rate 25% 29% 30% The 1993 income tax benefits allocated to other items are as follows (in millions): Extraordinary losses on early extinguishments of debt $ 3.0 Cumulative effect of changes in accounting principles 12.5 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 millions): 1993 Deferred 1992 Deferred Income Tax Income Tax Assets Liabilities Assets Liabilities Property, plant and equipment $ 272.1 $ 255.1 Postretirement and other benefits $ 23.7 $ 16.6 Expense accruals 10.8 17.7 Integration and restructuring costs 11.0 Other, net 11.0 31.3 $ 45.5 $ 283.1 $ 34.3 $ 286.4 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 millions): Postretirement and other benefits $ (1.5) Expense accruals (5.0) Divestiture of telephone properties (26.7) Other, net (3.1) $ (36.3) 5. DEBT Long-term debt as of December 31 is as follows (in millions): 1993 1992 Weighted Average Interest Amount Rate Amount Central Telephone Company First mortgage bonds, due 1994 through 2021 $ 245.2 7.6% $ 298.1 Capital leases, due 1994 to 1996 0.2 8.5% 0.8 Short-term borrowings classified as long-term debt 20.0 Subsidiaries First mortgage bonds, due 1994 through 2021 115.5 7.9% 156.1 Notes, due 2002 through 2020 102.7 7.2% 37.5 463.6 512.5 Less current maturities 22.7 31.2 Total long-term debt, excluding current maturities $ 440.9 $ 481.3 Long-term debt maturities during each of the next five years are as follows (in millions): Amount 1994 $ 22.7 1995 3.9 1996 22.8 1997 23.8 1998 15.7 The first mortgage bonds are secured by substantially all of the Company's property, plant and equipment. Provisions in certain debt agreements and charters restrict the payment of dividends. Under the most restrictive of these provisions, at any time the ratio of equity to total capitalization falls below 50 percent, dividends are limited to a percentage, as defined, of net income for the prior twelve month period. As a result of this requirement, $115 million of retained earnings were restricted from payment of dividends as of December 31, 1993. In connection with dividend restrictions, $138 million of the related subsidiaries' $154 million of retained earnings is restricted as of December 31, 1993. Short-term borrowings of $20 million at December 31, 1992 with a weighted average interest rate of 7.3 percent are classified as long-term debt due to the Company's intent to refinance such borrowings on a long-term basis and its demonstrated ability to do so. The Company, Sprint and Sprint Capital Corporation (a wholly- owned subsidiary of Sprint) have a $1.1 billion revolving credit agreement with a syndicate of domestic and international banks, under which the Company can borrow up to an aggregate of $200 million. The revolving credit agreement expires in July 1996 and, subject to the approval of the lenders, may be extended for up to an additional two years. As of December 31, 1993, the Company did not have any borrowings outstanding under the agreement. During 1993, the Company redeemed, prior to scheduled maturities, $144 million of first mortgage bonds with interest rates ranging from 7.5 percent to 8.6 percent. During 1992, the Company redeemed, prior to scheduled maturities, $148 million of first mortgage bonds and debentures with interest rates ranging from 6.7 percent to 12.4 percent. Except for amounts deferred as allowed by the state commissions, the prepayment penalties incurred in connection with the early extinguishments of debt and the write-off of related debt issuance costs aggregated $5 million in 1993, net of related income tax benefits, and are reflected as extraordinary losses in the consolidated statement of income. Consistent with regulatory treatment, prepayment penalties incurred in 1992 are being amortized over the life of the applicable new issues. 6. COMMITMENTS AND CONTINGENCIES Minimum rental commitments as of December 31, 1993 for all non- cancelable operating leases, consisting principally of leases for data processing equipment and real estate, are as follows (in millions): Amount 1994 $ 5.3 1995 4.6 1996 3.7 1997 3.3 1998 0.9 Thereafter 1.0 Gross rental expense aggregated $22 million in 1993 and 1992, and $21 million in 1991. 7. RELATED PARTY TRANSACTIONS Under agreements with Sprint and Centel, the Company reimburses such affiliates for data processing services, other data related costs and certain management costs which are incurred for the Company's benefit. Total charges to the Company aggregated $49 million, $45 million and $43 million in 1993, 1992 and 1991, respectively. The Company enters into cash advance and borrowing transactions with such affiliates; generally, interest on such transactions is computed based on the rate at which the Company is able to obtain funds externally. Interest expense on advances from such affiliates was $1 million in 1993. Interest expense in 1992 and 1991 was not significant. Interest income on advances to such affiliates was $1 million in 1993 and 1992 and $2 million in 1991. The Company purchases telecommunications equipment, construction and maintenance equipment, materials and supplies from its affiliate, North Supply. Total purchases for 1993 were $13 million. The Company provides various services to Sprint's long distance communications services division, such as network access, billing and collection services, operator services and the lease of network facilities. The Company received $20 million in 1993 for these services The Company paid Sprint's long distance communications services division $1 million in 1993 for interexchange telecommunications services. The CenDon partnership (CenDon), a general partnership between Centel Directory Company, an affiliate, and The Reuben H. Donnelley Corporation, pays the Company a fee for the right to publish telephone directories in the Company's operating territories, a listing fee and a fee for billing and collections services performed for CenDon by the Company. CenDon paid the Company $50 million in 1993 and 1992 and $46 million in 1991. 8. ADDITIONAL FINANCIAL INFORMATION Divestiture of Telephone Properties During 1991, the sale of the Company's local telephone operations in Minnesota and Iowa were completed, pursuant to a definitive agreement reached in November 1990. Proceeds from the sales included $116 million in cash, 2,885,000 shares of Rochester Telephone Corporation (Rochester) common stock and ownership rights in various cellular partnerships. Gains of $64 million, net of related income taxes, were realized on the sale. The Company received $112 million in cash and advances from Centel for the Rochester common stock and the cellular franchises and paid a dividend in cash and advances for the same amount to Centel. 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 $464 million and $513 million, respectively, and an estimated fair values of $511 million and $526 million, respectively. The fair values are estimated based on the present value of estimated future cash flows using a discount rate commensurate with the risks involved. 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 millions): 1993 1992 1991 Cash paid for Interest, net of amounts capitalized $ 39.4 $ 40.5 $ 41.5 Income taxes 38.5 39.1 89.6 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 $137 million, $150 million and $154 million for 1993, 1992 and 1991, respectively. 9. SUPPLEMENTAL QUARTERLY INFORMATION - UNAUDITED 1993 Quarters Ended March 31 June 30 September 30 December 31 (in millions) Operating revenues $ 204.9 $ 215.4 $ 218.8 $ 229.5 Operating income (loss)[1] (38.0) 48.0 47.3 40.9 Income (loss) before extraordinary item and cumulative effect of changes in accounting principles (28.9) 25.0 24.7 20.6 Net income (loss) (50.6) 25.0 20.9 19.9 1992 Quarters Ended March 31 June 30 September 30 December 31 (in millions) Operating revenues $ 194.2 $ 198.2 $ 198.5 $ 195.7 Operating income 36.0 39.5 33.7 35.2 Income before extraordinary item and cumulative effect of changes in accounting principles 17.8 20.0 16.3 17.5 Net income 17.3 20.0 16.3 17.5 [1] During the first, third and fourth quarters 1993, the Company recognized nonrecurring charges of $68 million, $5 million and $4 million, respectively. Such charges reduced income before extraordinary item and cumulative effect of changes in accounting principles by $44 million, $2 million and $2 million, respectively. (See Note 2 for additional information.) CENTRAL TELEPHONE COMPANY SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1993 (In Millions) Balance Balance beginning Additions, Other end of of year at cost Retirements changes year Land and buildings $113.0 $ 5.3 $2.1 $ 0.2 $116.4 Other general support assets 151.7 14.8 26.9 (0.8) 138.8 Cable and wire facility assets 1,067.7 73.9 9.8 (1.2) 1,130.6 Central office assets 869.4 73.6 17.3 (12.3) 913.4 Information origination/ termination assets 99.9 10.2 4.0 106.1 Telephone plant under construction 28.3 (14.4) 13.9 $2,330.0 $ 163.4 $60.1 $ (14.1) [1] $2,419.2 [1] Primarily represents the write-off of certain software costs to conform the Company's accounting with the predominant practice in the industry and with the accounting method used by Sprint's local communications services division. CENTRAL TELEPHONE COMPANY SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1992 (In Millions) Balance Balance beginning Additions, Other end of of year at cost Retirements changes year Land and buildings $107.2 $ 6.7 $1.1 $ 0.2 $113.0 Other general support assets 140.5 22.2 11.1 0.1 151.7 Cable and wire facility assets 1,017.6 60.7 10.6 1,067.7 Central office assets 825.8 60.9 17.0 (0.3) 869.4 Information origination/ termination assets 225.5 7.8 133.3 (0.1) 99.9 Telephone plant under construction 18.4 9.8 0.1 28.3 $2,335.0 $ 168.1 $173.1 $2,330.0 CENTRAL TELEPHONE COMPANY SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1991 (In Millions) Balance Balance beginning Additions, Other end of of year at cost Retirements changes year Land and buildings $114.3 $ 4.6 $11.1 $ (0.6) $107.2 Other general support assets 143.0 16.2 22.9 4.2 140.5 Cable and wire facility assets 1,049.7 67.0 99.0 (0.1) 1,017.6 Central office assets 851.7 73.8 96.7 (3.0) 825.8 Information origination/ termination assets 242.0 8.1 25.1 0.5 225.5 Telephone plant under construction 26.9 (7.5) (1.0) 18.4 $2,427.6 $162.2 $254.8 [1] $2,335.0 [1] Retirements include approximately $213 million related to the divestiture of the Company's operations in Minnesota and Iowa. CENTRAL TELEPHONE COMPANY SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1993 (In Millions) Balance Additions Balance beginning charged Other end of of year to income Retirements changes year Buildings $ 23.4 $3.2 $ 2.1 $(0.6) $ 23.9 Other general support assets 80.9 16.1 26.9 3.3 73.4 Cable and wire facility assets 356.7 47.4 9.8 (3.0) 391.3 Central office assets 325.9 59.6 17.3 (1.0) 367.2 Information origination/ termination assets 84.3 7.0 4.0 0.6 87.9 $ 871.2 $133.3 [1] $ 60.1 $(0.7) $ 943.7 [1] Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 133.3 Amortization of intangibles 1.0 Depreciation and amortization included in consolidated statement of income $ 134.3 CENTRAL TELEPHONE COMPANY SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1992 (In Millions) Balance Additions Balance beginning charged Other end of of year to income Retirements changes year Buildings $ 21.6 $3.3 $ 1.1 $(0.4) $ 23.4 Other general support assets 80.5 10.5 11.1 1.0 80.9 Cable and wire 326.2 44.4 10.5 (3.4) 356.7 facility assets Central office 282.8 60.0 17.1 0.2 325.9 assets Information origination/ 208.4 8.9 133.3 0.3 84.3 termination assets $ 919.5 $127.1 [1] $ 173.1 $(2.3) $ 871.2 [1] Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 127.1 Amortization of intangibles 0.7 Depreciation and amortization included in consolidated statement of income $ 127.8 CENTRAL TELEPHONE COMPANY SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1991 (In Millions) Balance Additions Balance beginning charged Other end of of year to income Retirements changes year Buildings $ 23.6 $3.0 $ 4.6 $(0.4) $ 21.6 Other general 74.6 19.5 15.6 2.0 80.5 support assets Cable and wire 324.2 43.0 38.2 (2.8) 326.2 facility assets Central office 274.5 58.4 50.3 0.2 282.8 assets Information origination/ 217.0 13.9 23.4 0.9 208.4 termination assets $ 913.9 $137.8 [1] $ 132.1 [2] $(0.1) $ 919.5 [1] Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 137.8 Amortization of intangibles 0.7 Depreciation and amortization included in consolidated statement of income $ 138.5 [2] Reconciliation of retirements included in Schedule V -- Consolidated Property, Plant and Equipment: Amount charged to reserve $ 132.1 Net book value of property sold in divestiture of local companies 122.7 Total Schedule V retirements $ 254.8 CENTRAL TELEPHONE COMPANY SCHEDULE VIII -- CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In Millions) Additions Balance Charged Charged Other Balance beginning to to other additions end of of year income accounts (deductions) year Allowance for doubtful accounts $0.5 $ 4.5 $ (4.4) [1] $0.6 Allowance for doubtful accounts $0.6 $ 2.8 $ (2.9) [1] $0.5 Allowance for doubtful accounts $0.6 $ 2.4 $ (2.4) [1] $0.6 [1] Accounts charged off, net of collections. CENTRAL TELEPHONE COMPANY SCHEDULE IX -- CONSOLIDATED SHORT-TERM BORROWINGS Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 [1] 1991 Balance at end of period $ 20.0 Weighted average interest rate 3.73% Average amount outstanding during the year $28.1 $ 28.2 $25.3 Maximum amount outstanding during the year $67.0 $ 45.7 $58.1 Weighted average interest rate during the year (computed by dividing the annual interest expense by the average debt outstanding during the year) 3.17% 3.96% 6.81% [1] As of December 31, 1992, short-term borrowings were classified as long-term debt in the consolidated balance sheet due to the Company's intent to refinance such borrowings on a long-term basis. CENTRAL TELEPHONE COMPANY SCHEDULE X -- CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 Maintenance and repairs [1] $ 288.4 $ 262.7 $ 259.3 Taxes, other than payroll and income taxes: Property taxes $ 14.9 $ 15.5 $ 15.5 Gross receipts and other 11.1 9.8 8.9 $ 26.0 $ 25.3 $ 24.4 [1] Amounts represent plant operations expense as maintenance and repairs is the primary component of this total. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure As reported in Central Telephone's Current Report on Form 8-K dated April 28, 1993, following consummation of the Sprint/Centel merger, Arthur Andersen & Co. was replaced with Ernst & Young as auditors of the Company, effective April 23, 1993. Part III Item 10. Item 10. Directors and Executive Officers of the Registrant Pursuant to Instruction G(3) to Form 10-K, the information relating to Directors of Central Telephone required by Item 10 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. For information pertaining to Executive Officers of Central Telephone, as required by Instruction 3 of Paragraph (b) of Item 401 of Regulation S-K, refer to the "Executive Officers of the Registrant" section of Part I of this report. Pursuant to Instruction G(3) to Form 10-K, the information relating to compliance with Section 16(a) required by Item 10 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. Item 11. Item 11. Executive Compensation Pursuant to Instruction G(3) to Form 10-K, the information required by Item 11 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Pursuant to Instruction G(3) to Form 10-K, the information required by Item 12 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. Item 13. Item 13. Certain Relationships and Related Transactions Pursuant to Instruction G(3) to Form 10-K, the information required by Item 13 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1. The consolidated financial statements of the Company and supplementary financial information are listed in the Index to Financial Statements and Financial Statement Schedules included at Item 8 of this report. 2. The consolidated financial statement schedules of the Company are listed in the Index to Financial Statements and Financial Statement Schedules included at Item 8 of this report. 3. The following exhibits are filed as part of this report. 3(a) Certificate of Incorporation of Central Telephone, as amended. 3(b) Bylaws of Central Telephone, as amended. 4(a) Indenture dated June 1, 1944, between Central Telephone and The First National Bank of Chicago and Robert L. Grinnell, as Trustees (under which J. G. Finley is successor to Robert L. Grinnell), as amended and supplemented by indentures supplemental thereto through and including a Thirty-third Supplemental Indenture dated as of August 15, 1982 (Incorporated by reference to Exhibit No. 4A to Central Telephone's Registration Statement No. 33-10475 filed December 1, 1986). 4(b) Thirty-fourth Supplemental Indenture, dated as of December 15, 1986 (Incorporated by reference to Exhibit No. 4B to Central Telephone's Registration Statement No. 33-35411 filed June 14, 1990). 4(c) Thirty-fifth Supplemental Indenture, dated as of October 15, 1990 (Incorporated by reference to Central Telephone's Current Report on Form 8-K dated October 26, 1990). 4(d) Thirty-sixth Supplemental Indenture, dated as of March 15, 1991 (Incorporated by reference to Central Telephone's Current Report on Form 8-K dated June 14, 1991). 4(e) Thirty-seventh Supplemental Indenture dated as of August 15, 1992. 12 Ratio of Earnings to Fixed Charges 21 Subsidiaries of the Registrant. 23(a) Consent of Ernst & Young. 23(b) Consent of Arthur Andersen & Co. Central Telephone will furnish to the Securities and Exchange Commission, upon request, a copy of the instruments, other than the indentures listed as Exhibits 4(a), (b), (c), (d) and (e), defining the rights of holders of its long-term debt and the long-term debt of its subsidiaries. The total amount of securities authorized under any of said other instruments does not exceed 10 percent of the total assets of Central Telephone and its subsidiaries on a consolidated basis. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits are listed in Item 14(a). 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 TELEPHONE COMPANY (Registrant) By /s/ D. Wayne Peterson D. Wayne Peterson President and Chief Executive Officer Date: 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 indicated on the 31st day of March, 1994. /s/ D. Wayne Peterson D. Wayne Peterson President and Chief Executive Officer /s/ John P. Meyer John P. Meyer Vice President - Chief Financial Officer /s/ Ralph J. Hodge Ralph J. Hodge Vice President - Controller SIGNATURES CENTRAL TELEPHONE COMPANY (Registrant) 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 31st day of March, 1994. /s/ Stephen M. Bailor Stephen M. Bailor, Director /s/ Don A. Jensen Don A. Jensen, Director /s/ William E. McDonald William E. McDonald, Director /s/ D. Wayne Peterson D. Wayne Peterson, Director /s/ Alan J. Sykes Alan J. Sykes, Director /s/ M. Jeannine Strandjord M. Jeannine Strandjord, Director /s/ Dianne Ursick Dianne Ursick, Director

849979_1993.txt

849979_1993

1993

849979

Item 1. Description of Business BACKGROUND Weirton Steel Corporation, together with its wholly owned subsidiary Weirton Receivables, Inc., (the "Company") and its predecessor companies have been in the business of making and finishing steel products for more than eighty years at the Company's facility located in Weirton, West Virginia. From November 1929 to January 1984, the Company's business had been operated as a division of National Steel Corporation ("National"). Incorporated in Delaware in November 1982, the Company acquired the principal assets of National's former Weirton Steel Division ("the Division") in January 1984. PRINCIPAL PRODUCTS The Company is a major integrated producer of flat rolled carbon steels with principal product lines consisting of sheet products and tin mill products ("TMP"). The Company offers a full range of sheet products that include hot and cold rolled sheet steel up to 48" wide and both hot-dipped and electrolytic galvanized products. TMP includes tin plate, chrome coated, and black plate. Historically, the Company's products have emphasized the narrow to medium widths reflective of its rolling and finishing equipment and covered a broad range of gauges, finishes and performance specifications. The Company has developed significant expertise in filling orders with demanding specifications. The Company does not produce bars, wire or structural products. The Company's sales as a percentage of its total revenues for each year in the period 1989 through 1993 are shown in the following table. [TEXT] PRINCIPAL MARKETS The following table shows the percentage of total net tons of steel products shipped for each year in the period 1989 through 1993 by the Company to each of its principal markets. [TEXT] A substantial portion of the Company's revenues are derived from long-time, steady customers, although the Company actively seeks new customers and constantly seeks new markets for its products. A substantial share of the Company's TMP and sheet products are shipped to customers located in the eastern portion of the United States. The Company's products are sold through salaried Company representatives who operate from 12 district sales offices. Sales orders taken in the field are subject to home office approval. Trade orders on hand for the Company's products at December 31, 1993, 1992, and 1991 amounted to approximately 449 thousand tons, 308 thousand tons, and 307 thousand tons, respectively. Substantially all orders on hand at any time are expected to be filled within a twelve month period. Since the Company produces steel in response to orders primarily of established grades and specifications, resulting in short order processing time and relatively rapid inventory turnover, it does not believe that order backlog is a material aspect of its business. SHEET PRODUCTS. Hot rolled products are sold directly from the hot strip mill as "hot bands," or are further processed using hydrochloric acid to remove surface scale and are sold as "hot rolled pickled." Hot rolled sheet is used for unexposed parts in machinery, construction products and other durable goods. Most of the Company's sales in hot rolled have been to pipe and tube manufacturers and converters and, to a lesser extent, steel service centers. In 1993, the Company sold 658 thousand tons of hot rolled sheet, which accounted for 17.8% of its total revenues. Cold rolled sheet, which requires further processing consisting of additional rolling, annealing and tempering to enhance ductility and surface characteristics, is used in the construction, steel service center, commercial equipment and container markets, primarily for exposed parts where appearance and surface quality are important considerations. In 1993, the Company sold 169 thousand tons of cold rolled sheet, which accounted for 6.6% of its total revenues. Galvanized hot-dipped and electrolytic sheet, which is coated primarily with zinc compounds to provide extended anti- corrosive properties, is sold to the electrical, construction, automotive, container, appliance and steel service center markets. In 1993, the Company sold 642 thousand tons of galvanized products, which accounted for 28.7% of total revenues. Generally, the Company's more highly processed sheet products provide higher profit margins. The following table, based on AISI information, shows the Company's historical share of the domestic Sheet Products market. [TEXT] While the Company's presence in the overall sheet market is limited, the Company has concentrated on developing its offerings of more highly processed products and production capacity to provide the larger coils favored by most of its customers. The Company's goals for development of its sheet business are focused on increasing its percentage of coated products, such as galvanized, while capitalizing on developing specialty markets such as construction where the Company believes that its GALFAN product has potential in roofing and framing applications. As part of its sheet marketing strategy, the Company is also making efforts to enhance high quality end use of its products marketed through steel service centers, as well as developing the hot rolled market for heavier gauge and higher carbon applications for all markets. Tin Mill Products. The Company has enjoyed substantial market share and a widely held reputation as a high quality producer of TMP. TMP comprise a wide variety of light gauge coated steels. Tin plate and black plate products are sold under the Company name and under such trademarks as WEIRITE and WEIRLITE. In addition to tin plate and black plate, the Company produces electrolytic chromium coated steel under the trademark WEIRCHROME. Based upon the Company's share of the domestic market for TMP, which has remained relatively constant in recent years, the Company believes it is one of the largest domestic producers of TMP. In 1993, the Company accounted for approximately 22% of the TMP market, a slight decrease from the 23% market share it held in 1992. TMP shipments on an industry-wide basis have remained relatively steady over the same period even as plastic, aluminum, composites and other materials competed for potential growth in some applications. The TMP market is now primarily directed at food, beverage, and general line cans. The majority of the Company's TMP sales have been to can manufacturing and packaging companies, a substantial amount of whose annual requirements are established in advance. This market is characterized by a relatively low number of manufacturers. During 1993, shipments to ten major can manufacturers accounted for approximately 90% of the Company's TMP sales and its five largest TMP customers accounted for approximately 29.6% of total revenues. One customer, Crown Cork & Seal Company, a major can manufacturer, accounted for approximately 11% of total revenues. The balance of the TMP output is sold to other can manufacturers, manufacturers of caps and closures and specialty products ranging from film cartridges, lighting fixtures and battery jackets to cookie sheets and curtain rods. As a result of predictable sales patterns for TMP, the Company is able to gauge in advance a significant portion of its production requirements which allows the Company to operate its production facilities more efficiently and adjust its marketing and production efforts for other products. The following table, based on AISI information, shows the Company's historical share of the domestic TMP market. [TEXT] Steelmaking and hot rolling improvements derived from the Company's recent capital improvement program have allowed for the production of sufficient quantities of "clean" steel to fill anticipated TMP orders for the near term. Expansion of downstream annealing and tempering capacity, however, would be necessary before large TMP production increases could be effected. The Company's facilities and expertise also allow it to produce the lightest gauges of tin plate, enhancing the manufacturing efficiencies of the Company's customers and promoting the use of its steel in leading edge technology products such as thin-walled containers. The Company has been a leading innovator in the development of can making technology through its WEIRTEC research and development center. Although accounting for less than 5% of the domestic beverage container market in recent years, largely due to highly competitive prices for aluminum, the Company believes that two piece thin-walled steel beverage containers have significant potential for growth. This is primarily because of improved production efficiencies for cans and increased industry success in promoting the recycling of steel. The Company engages in other end product research and development and provides support services to its customers. The Company believes these services have been of significant assistance, particularly to its TMP customers, and promotes the consumption of the Company's products. See "Research and Development." A 1.1 million square foot Finished Products Warehouse with storage and staging areas for TMP has been located near the Company's mill to facilitate "just in time" production and delivery to several of the Company's major customers who are located in attached, or nearby, manufacturing facilities. As steel coils are needed by customers' operations, they are moved from the adjoining central storage areas and loaded directly on to their production lines. This arrangement provides significant savings for the Company and its customers. PRODUCTION AND SHIPMENTS In 1991, after three years of close to 100 million tons of raw steel production per year, the domestic steel industry's raw steel production fell to 87.3 million tons and shipments declined to 78.9 million tons. However, starting with December 1991 and continuing through 1993, the steel industry experienced a rebound in both production and shipments. Steel production for 1993 was up approximately 4.9% to 96.1 million tons compared to 1992, while shipments increased by approximately 7.4% to 88.4 million tons. Similarly, capacity utilization which had dropped to 74% in 1991 rebounded to 87.4% in 1993. During 1991 and 1992 in particular, the Company's production, and consequently its ability to sell steel products, was constrained by facilities' outages stemming from the Company's capital improvement program. See "Investment in Facilities" in Item 7 hereof for a more complete discussion of the Company's capital improvement program. Although these factors for the most part concerned the Company's primary steelmaking and first stage finishing facilities, downstream operations were also affected. In many instances, with the cooperation of its customers, the Company limited orders it would accept for finished products, rather than take orders it could not fill. The Company seeks to maximize the utilization of its production capacity. Until the Company began implementing its capital program in 1989, historically it had exceeded the industry average in that regard. However, during 1990 and 1991, outages and complications from several installations adversely affected the Company's relative position in the industry at a time when the industry itself was operating at near recessionary levels. Facilities outages, both planned and unplanned, which plagued operations during installation phases became less frequent throughout the break-in period for new equipment and, in 1993, were reduced to only one 2-day unscheduled outage due to flood water damage. In 1993, the Company produced 2.7 million tons of raw steel and shipped 2.4 million tons of finished and semi-finished steel products. The following table sets forth annual production capability, utilization rates and shipment information for the Company and the domestic steel industry (as reported by the American Iron and Steel Institute ("AISI")) for the period 1989 through 1993. [TEXT] STEELMAKING PROCESS In primary steelmaking, iron ore pellets, iron ore, coke, limestone and other raw materials are consumed in blast furnaces to produce molten iron or "hot metal." The Company then converts the hot metal into raw or liquid steel through its basic oxygen furnaces where impurities are removed, recyclable scrap is added and metallurgy for end use is determined on a batch by batch basis. The Company's basic oxygen process shop ("BOP") is one of the largest in North America, employing two vessels, each with a steelmaking capacity of 360 tons per heat. Liquid steel from the BOP is then formed into slabs through the process of continuous casting. The Company operates a multi-strand continuous caster, rebuilt in 1990, which allows the Company to cast 100% of its steel requirements. The slabs are then reheated, reduced and finished by extensive rolling, shaping, tempering and, in many cases, by the application of plating or coating at the Company's downstream operations. Finished products are normally shipped to customers in the form of coils. The Company believes that its hot rolling mill, with two walking beam reheat furnaces, reversing rougher and millstand drive and control improvements, greatly enhances its competitive capabilities. In addition, the Company has linked its steelmaking and rolling equipment with computer-control systems and is in the process of installing an integrated manufacturing control system to coordinate production and sales activities. RAW MATERIALS The Company purchases iron ore pellets, iron ore, coal, coke, limestone, scrap and other necessary raw materials in the open market. Substantially all the Company's raw materials needs are available through multiple sources where the primary concern is price rather than availability of supply; however, the Company continues to explore potential new sources of raw materials. In October 1991, the Company entered into a contract with a subsidiary of Cleveland-Cliffs Inc ("Cliffs") to purchase a substantial part of the Company's standard and/or flux grade iron ore pellet requirements for a twelve year period which began in 1992. The contract provides for a minimum tonnage of pellets to be supplied based on the production capacity of the mining source during the contract periods, and for additional tonnages of pellets in specified circumstances. Purchase prices established under the contract formulas may vary depending on whether the Company's Redeemable Preferred Stock, Series B, acquired by Cliffs at the time the supply agreement was entered into, has been redeemed. See Note 10 to the Company's Financial Statements included as Item 8 hereof for a more complete discussion of the Series B Preferred. The Company also has other contracts for iron ore pellets and iron ore through 1994. The Company and other steelmakers are installing technology calculated to achieve some reduction in the consumption of coke in blast furnace operations. However, if coke making capacity available to the industry continues to decline, future coke prices may be subject to significant escalation. Unlike many of the other major integrated producers, the Company does not have its own coke making facilities. From time to time, the Company has considered rebuilding the former coke making facilities of the Division; however, in view of the availability of metallurgical coke, its price and the emergence of alternative non-coking technologies for ironmaking, the Company does not believe an investment to rebuild those facilities is justified at this time. In July 1993, the Company entered into an agreement with USX Corporation to purchase blast furnace coke. The agreement provides for tonnages of 750,000 per calendar year in 1994 through 1996, or the actual annual requirements of the Company if less than the stated amount. The price is to be the prevailing market price for blast furnace coke determined each October prior to the delivery year. In 1990, the Company's continuous caster was rebuilt and placed back in service with enhanced capacity. Since that time, the rebuilt caster has achieved production levels which enable it to provide substantially all the Company's requirements for slabs. The increased capacity of the caster allowed the Company to close its ingot teeming and reduction operations in 1991. The Company's requirements for slabs have from time to time exceeded its caster's production ability and it has purchased and may continue to purchase slabs from other sources in order to meet the demand for its products and to maximize the overall production efficiency of its entire operations. In general, the Company does not expect to have undue difficulty in purchasing slabs as and when needed. However, in times of high capability utilization, slabs of certain required specifications may not be available from other producers. The primary sources of energy used by the Company in its steel manufacturing process are natural gas, oil, coal and electricity. The Company generates a significant amount of electricity and steam for processing operations from a mixture of excess blast furnace gas and natural fuels. The Company continually attempts to conserve and reduce the consumption of energy in its steelmaking operations. A number of the Company's facilities have alternate fuel burning capability. In recent years, due to the increased availability and sources of natural gas, the Company has entered into natural gas purchase contracts with gas suppliers and transportation contracts with transmission companies in an effort to reduce prices paid for gas. A substantial increase in the Company's energy costs or a shortage in the availability of its sources could have an adverse effect on the Company. Management believes that the Company's long term raw materials contracts are at competitive terms over the course of a business cycle. COMPETITION AND OTHER INDUSTRY FACTORS The domestic steel industry is a cyclical business with intense competition among producers. Manufacturers of products other than steel, including plastics, aluminum, cardboard, ceramics and glass, have made substantial competitive inroads into traditional steel markets. During recessionary periods, the industry's high level of production capacity relative to demand levels has resulted in a lack of ability to achieve satisfactory selling prices across a broad range of products. Integrated steelmakers also face increased competition from mini-mills. Mini-mills are relatively efficient, low-cost producers that generally produce steel from scrap in electric furnaces, utilize new technologies, have lower employment costs and target regional markets. Mini-mills historically have produced lower profit margin bars, rods, wire and other commodity-type steel products not produced by the Company. Recently developed thin cast technology has allowed mini-mills to enter certain of the sheet markets supplied by integrated producers, and certain mini-mills have built, or are building, facilities to do so. One such facility has been placed in operation and is competing in the hot rolled, cold rolled and galvanized marketplace. During the past decade, a number of domestic steelmakers have gone through reorganization under Chapter 11 of the United States Bankruptcy Code, including several of the Company's major competitors. Reorganization under Chapter 11 generally has enabled bankrupt companies to reduce costs, making them more efficient competitors. In response to increased competition, domestic steel producers have invested heavily in new plant and equipment, which has improved efficiency and increased productivity. Many of these improvements are in active service and, together with the achievement of other production efficiencies such as manning and other work rule changes, have tended to lower competitors' costs. The Company has responded to technological competitive pressures through its capital improvement program and strategies for future operating efficiencies. Foreign competition also remains a major concern. The VRAs covering 17 steel exporting nations and the European Community, which limited steel imports into the United States market, expired on March 31, 1992, and negotiations among governments in 36 countries to achieve a global multilateral steel agreement to reduce subsidies and other unfair trade practices by foreign producers have not yet resulted in any agreement being reached. The prospects of such an agreement being reached in the near future are not good. During 1993, steel imports were approximately 18% of total domestic steel consumption. Imports represent a slightly smaller percentage of consumption of sheet products and TMP, amounting to 13% and 11% of such consumption, respectively, in 1993. As a result of anti-dumping cases brought by domestic steelmakers, the Commerce Department, earlier in 1993, imposed tariffs averaging approximately 36.5% on imported, flat- rolled carbon steel from a number of countries. On July 27, 1993, however, the U.S. International Trade Commission (the "ITC") found that the domestic industry had sustained no injury from imports of hot rolled sheet, and no injury from 9 of 12 importing countries on cold rolled sheet. Several domestic producers have filed appeals of the ITC rulings. The ITC did affirm that the domestic industry had sustained injury from imports of coated sheet products, which has since reduced imports of the same and consequently improved domestic coated sheet pricing and volume. The Company's primary competitors in sheet products consist of substantially the entire steel industry. The Company's primary TMP competitors in recent years have been USX Corporation, LTV Corporation, Bethlehem Steel Corporation, National Steel Corporation, Wheeling-Pittsburgh Steel Corporation and USS-POSCO Industries. The Company experiences strong competition in all its principal markets with respect to price, service and quality. The Company believes that it competes effectively in all these categories by focusing its marketing efforts on high quality products and strong customer relationships. RESEARCH AND DEVELOPMENT The Company engages in research and devlopment for the improvement of existing products, the development of new products, and the development of product applications. It also seeks more efficient operating techniques. During 1993, 1992 and 1991, respectively, the Company spent approximately $5.4 million, $4.7 million, and $5.3 million for Company sponsored research and development activities. Expenditures for customer sponsored research have not been material to the Company. The Company operates WEIRTEC, its research and development center specializing in the advancement of steel food and beverage packaging and steel manufacturing processes. WEIRTEC maintains research and prototype steel packaging manufacturing facilities and analytical laboratory facilities located in Weirton. The facilities are engaged in improving the Company's production and finishing processes for TMP and sheet products. In recent years, WEIRTEC has played a central role in the development of thin-wall, two piece beverage can technology and other products seeking to capitalize on the Company's production expertise, particularly in coated products. See "Principal Products." The Company believes that the facilities and the scientists, engineers and technicians at WEIRTEC enhance the Company's technical excellence, product quality and customer service. The Company owns a number of patents that relate to a wide variety of products and applications and steel manufacturing processes, has pending a number of patent applications, and has access to other technology through agreements with other companies. The Company believes that none of its patents or licenses, which expire from time to time, or any group of patents or licenses relating to a particular product or process, is of material importance in its overall business. The Company also owns a number of registered trademarks for its products which, unlike patents and licenses, do not expire when they are continued in use and are properly protected. ENVIRONMENTAL CONTROL COMPLIANCE. The Company's business operations are affected by extensive federal, state and local laws and regulations governing discharges into the air and water, as well as the handling and disposal of solid and hazardous wastes. The Company is also subject to federal and state requirements governing the remediation of environmental contamination associated with past releases of hazardous substances. In recent years, environmental control regulations have been marked by increasingly strict compliance standards. Governmental authorities have the power to enforce compliance with these requirements, and violators may be subject to civil or criminal penalties, injunctions or both. Third parties also may have the right to sue to enforce compliance. Expenditures for environmental control facilities were approximately $1 million in 1993, $1 million in 1992, and $2 million in 1991. For 1994, the Company has budgeted approximately $3.3 million in capital expenditures toward environmental control facilities. Given the nature of the steelmaking industry, it can be expected that substantial additional capital expenditures will be required from time to time to permit the Company to remain in compliance with environmental regulations. In the past, the Company has entered into consent decrees with certain environmental authorities pursuant to which it has paid various fines and penalties relating to violations, or alleged violations, of laws and regulations in the environmental control area. Those payments have not been material to the Company's financial position or its cash flows. The Company believes that, at the present time, it is in substantial compliance with the various environmental control consent orders and agreements applicable to it and does not anticipate any material problems in taking required actions to remain in compliance with such orders and agreements. The Company does not operate coke making facilities and, accordingly, has not been affected by the stringent Clean Air Act limitations imposed on those installations. The Company's near-term focus for environmental compliance centers on procedures to achieve ambient air quality and water pollution control standards. In addition to improving its monitoring and study programs, the Company anticipates taking affirmative action to reduce sulfur dioxide and particulate emissions primarily by changing operating policies and by improving the quality of maintenance procedures. In an effort to improve its water pollution discharge compliance performance, the Company initiated in 1993 a full-time, round-the-clock environmental control supervisory function and is seeking to create a mobile maintenance group dedicated to high quality, environmentally safe operation. WASTE SITES AND PROCEEDINGS. Under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended ("CERCLA"), and similar state statutes, the Environmental Protection Agency (the "EPA") and state regulators generally have authority to impose joint and several liability on waste generators, owners, operators and others with respect to superfund sites as potentially responsible parties ("PRPs"), regardless of fault or the legality of the original disposal activity. The Company is entitled to indemnification from National for certain environmental liabilities, including those relating to CERCLA and similar statutes, as more fully described below. The Company believes that National has registered a number of sites as required by CERCLA, some of which had been used by the Division prior to its sale to the Company, and two of which subsequently became the property of the Company. The Company understands that National has been involved, at the request of the EPA or state agencies, in voluntary remedial activities with respect to some sites; National has declined to participate with respect to some sites; National has declined to participate with respect to others (because its records do not indicate any involvement with those sites); and National has not been notified with respect to other sites. Insofar as any of those sites involve liabilities under CERCLA or other environmental laws or regulations for prior Division activities, the Company believes it is fully indemnified by National. In March 1988 and September 1989, respectively, the Pennsylvania Department of Environmental Resources and/or the EPA notified the Company that it was considered to be among a number of PRPs for the dumping of wastes at the Municipal and Industrial Disposal Company site near Elizabeth, Pennsylvania and at the Tex Tin site near Texas City, Texas, and requested the Company's voluntary participation in certain remedial actions. The Company's records do not indicate any involvement with either site by the Company. The Company believes that National would be responsible for any remedial actions, if there had been prior involvement by the Division. The Company has given all required notices to National for the purpose of facilitating its response to this matter. During February 1991, the Company received notification under CERCLA that it may incur or may have incurred a liability as a PRP with respect to a drum site located near Avenue H in Weirton, West Virginia. According to Company records, the drum site is on property owned, but never used, by the Company. Following consultation with appropriate agencies, the Company initiated a voluntary remediation program at the site, which program has been substantially completed. The Company has entered into negotiations with the EPA to resolve all remaining issues raised by the notification. The Company believes that National, under its agreements with the Company, is responsible for any environmental liabilities involving the site, including reimbursement for the total cost of the remediation program. National has reimbursed the Company for the $761,000 spent by the Company to date on the remediation program at this site. The Company believes that any future expenditures related to the remediation program will not exceed $100,000. In May 1992, the Company received notice from the Pennsylvania Department of Environmental Resources that it was considering a closure plan and post-closure plan for a solid waste landfill facility in Hanover Township, Pennsylvania (the "Hanover Site") operated by Starvaggi Industries Inc. From at least the 1960's through mid-1983, National and, after mid-1983, the Division and the Company disposed of solid wastes at the facility. The Company believes that certain of the solid wastes disposed of at the facility by National were classified as hazardous wastes under applicable law. The Company believes that while it disposed of various materials which were residual to the steelmaking industry, such materials were not classified as hazardous wastes under applicable law. At this time, definitive closure plans and post- closure care plans have not been adopted. National's liability to the Company under the indemnification agreements for liabilities which may result from the closure of this facility is limited to $1.0 million. However, the Company does not believe that any costs associated with these plans for which it would be responsible would exceed that amount. In October 1992, the Company entered into a consent order with the West Virginia Division of Environmental Protection (the "DEP") that provided for administrative fines and penalties to be assessed against the Company for asserted spills of various substances under provisions of the Federal Clean Water Act administered by such agency. The consent order required the payment of an administrative settlement in the amount of $99,000, as well as the application of $40,000 to a "Best Management Practices" ("BMP") plan to reduce or eliminate the frequency of hazardous waste spills, which plan is being implemented. The consent order also provides for stipulated penalties upon the occurrence of future spills. The Company is seeking to improve its operating practices to minimize the occurrence of spills. In January 1993, the Company received a notification from the DEP that four ground water monitoring wells situated at the Division's former coke making facilities on Brown's Island in Hancock County, West Virginia tested in excess of maximum contaminant levels established by the EPA and DEP for certain elements specified in the notice. The DEP requested the Company to supply it with additional data regarding the site and stated that it felt additional investigation, and possible remediation, would be required. The Company and the DEP are discussing the implementation of an enhanced ground water monitoring program for the area. As required by the relevant indemnification agreements, the Company has given notice to National of the DEP communication. As described more fully below, the Company believes that National will be responsible for any required remediation. In December 1993, the Company was informed by the DEP that the EPA was considering initiating a "multimedia" enforcement action against the Company during 1994. Such a proceeding could involve coordinated enforcement proceedings relating to water, air and waste-related issues stemming from a number of federal statutes and rules. The DEP has indicated that it prefers first to issue new NPDES water discharge permits to the Company and then monitor compliance by the Company before making any recommendation to the EPA. The Company expects that such permits could be issued by April 1994. However, no assurance can be given that a permit will be issued or that improved compliance by the Company or any recommendation by West Virginia environmental authorities to the EPA not to initiate such a proceeding will result in avoiding commencement of a multimedia enforcement action by the EPA. In recent years, such actions have resulted in penalties and other commitments being obtained from many of the Company's competitors. INDEMNIFICATION. According to the agreements by which the Company acquired the assets of the Division from National, the parties determined to apportion their respective responsibilities for environmental liability claims based on two dates, May 1, 1983 (the "Purchase Date"), and January 11, 1984 (the "Closing Date"). In general, the Company is entitled to indemnification from National for liabilities, including governmental and third-party claims, arising from violations prior to the Purchase Date, and National is entitled to indemnification from the Company for such items after the Purchase Date. In addition, the Company, subject to the $1.0 million limitation applicable to the Hanover Site described above, is entitled to reimbursement for clean-up costs related to facilities, equipment or areas involved in the management of solid or hazardous wastes of the Division ("Waste Sites"), as long as the Waste Sites were not used by the Company after the Closing Date. Third-party liability claims relating to Waste Sites are likewise covered by the parties' respective indemnification undertakings, in each case based on whether the particular site was used by the Company after the Closing Date. Until 1993, National had performed in accordance with its responsibilities under the applicable agreements with the Company. However, in July 1993, National indicated that it would not reimburse the Company for approximately $210,000 expended by the Company in cleaning out tar and other bottom sludge sediments from a lagoon at National's former Brown's Island Coke Plant (acquired by the Company on the Closing Date, but never operated). The Company performed this remediation in 1990 to avoid the facility becoming an unpermitted hazardous waste disposal site, but did not submit a final invoice until February 1993. National has indicated its belief that the Company was not entitled to reimbursement for remediation at this site. The Company believes that National's interpretation of the relevant agreements as applied to this site is erroneous. As a result of these developments, the Company's ability to obtain future reimbursement or indemnification relating to environmental claims from National has become more dependent on factors beyond the Company's control. These factors include, in addition to National's continued financial viability, the nature of future claims made by the Company, whether the parties can settle their differences relating to indemnification rights and the outcome of any necessary litigation. Although it is possible that the Company's future results of operations in particular quarterly or annual periods could be materially affected by the future costs of environmental compliance, the Company does not believe the future costs of environmental compliance will have a material adverse effect on its financial position or on its competitive position with respect to other integrated domestic steelmakers that are subject to the same environmental requirements. EMPLOYEES At December 31, 1993, the Company had 6,026 employees, of whom 4,542 were engaged in the manufacture of steel products, 779 in support services, 71 in sales and marketing activities and 634 in management and administration. The number of employees at December 31, 1993 represented an 8% reduction compared to the prior year end. The Company continues to implement a program as part of its business strategy designed to reduce its workforce primarily through retirement programs and attrition. The Company's goal by 1997 is to reduce its workforce by another 15% from the 1993 year end level. The Company has new collective bargaining agreements with the Independent Steelworkers Union, which represents 4,966 employees in bargaining units covering production and maintenance workers, clerical workers, nurses, and the Independent Guard Union, which represents 39 employees. The agreements run through September 25, 1996. The Company believes that its compensation structure places a heavier emphasis on profit sharing compared to other major integrated steel producers. This tends to cause the wage portion of the Company's employment costs to be relatively higher during periods of profitability and relatively lower during periods of low earnings or losses. The agreements provide for the payment of bonuses in the gross amount of $3,500 per employee, paid in installments, but do not provide for wage increases. Through the end of the new agreements, the Company's profit sharing plan, which covers substantially all employees, provides for participants to share in the Company's profits each year at a rate equal to 1/3 of the Company's "adjusted net earnings" for that year as defined under the plan, provided its net worth exceeds $100 million. If, however, payment of the full profit sharing amount would reduce the Company's net worth below $100 million, payments are reduced to an amount necessary to maintain the $100 million threshold. If the Company's net worth is in excess of $250 million, the profit sharing rate increases to 35%. However, if payment of the full profit sharing amount would reduce the Company's net worth below $250 million, payments at this rate would be limited as necessary to maintain the $250 million threshold and the remainder of the payment would be made at the 1/3 rate. The agreements limit the Company's exposure to increased costs of healthcare while providing increased medical coverages through a mandatory managed healthcare "point of service" program and a ceiling on the Company's cash basis cost of healthcare for future retirees. Although no assurances can be given, the Company anticipates a savings of approximately $24 million over three years as a result of these healthcare programs. The agreements also contain limitations on the Company's ability to reduce its workforce by layoffs, with exceptions for adverse financial, operational, and business circumstances. In addition, the parties have agreed to certain improvements in the Company's pension plan, which the Company anticipates will increase costs on an annual basis by approximately $7.5 million. From January 1984 until June 1989, the Company was owned in its entirety by its employees through an Employee Stock Ownership Plan (the "1984 ESOP"). In June 1989, the 1984 ESOP completed a public offering of 4.5 million shares of common stock of the Company, which security is now listed and traded on the New York Stock Exchange. In connection with the public offering of common stock, the Company also sold 1.8 million shares of Convertible Voting Preferred Stock, Series A (the "Series A Preferred") to a new Employee Stock Ownership Plan which shares are entitled to ten times the number of votes of the common stock into which it is convertible. Substantially all of the Company's employees participate in the two ESOPs which, after giving effect to the above-mentioned and certain other transactions, owned approximately 52% of the combined issued and outstanding common and preferred shares of the Company at December 31, 1993. This, in turn, accounts for approximately 75% of the voting power of the Company's voting stock. Item 2. Item 2. Properties and Facilities The Company owns approximately 2,500 acres in the Weirton, West Virginia, area which are devoted to the production and finishing of steel products, research and development, storage, support services and administration. The Company owns trackage and railroad rolling stock for materials movement, water craft for barge docking, power generation facilities and numerous items of heavy industrial equipment. The Company has no material leases for property. The Company's mill and related facilities are accessible by water, rail and road transportation. The Company believes that its facilities are suitable to its needs and are adequately maintained. The Company's operating facilities include four blast furnaces; however, its current operating strategy employs a two blast furnace configuration with an annual hot metal capacity of approximately 2.5 million tons. One currently idled furnace is being refurbished and will replace one operating furnace that is nearing the end of its campaign which is estimated to be in 1995, at which time the Company will undertake a major reline of that furnace. Although the Company does not anticipate operating a three blast furnace configuration in the near term, under this operating scenario, its annual hot metal capacity could be increased to 3.2 million tons. The Company's primary steelmaking facilities also include a sinter plant, and a two vessel BOP with an annual capacity of 3.0 million tons of raw steel based on a two blast furnace operation. During December 1993, the Company began the installation of a new vessel in its BOP furnace, replacing one that had been in service for nearly 20 years. The new vessel was placed in service in early February 1994. The Company's primary steelmaking facilities also include a CAS-OB facility, two RH degassers, a four strand continuous caster with an annual slab production capacity of up to 3.0 million tons. The Company's downstream operations include a hot strip mill with a design capacity of 3.8 million tons, two continuous picklers, three tandem cold reduction mills, three hot dip galvanize lines, one electro- galvanize line, two tin platers, one chrome plater, one bi-metallic chrome/tin plating line and various annealing, temper rolling, shearing, cleaning and edge slitting lines, together with packaging, storage and shipping and receiving facilities. See the "Production and Shipments" section of Item 1 for additional information regarding production capacity and utilization rates. Item 3. Item 3. Legal Proceedings On August 7, 1992, an action entitled "Larry G. Godich, et. al. v Herbert Elish, et. al." was commenced in the West Virginia Circuit Court for Hancock County against ten current members of the Company's Board of Directors, certain officers of the Company, former Board members, the Company's outside counsel, and the Company. The suit purports to be brought derivatively by stockholders on behalf of the Company and seeks a recovery on its behalf. The plaintiffs' complaint alleges that the defendants were negligent or grossly negligent in the selection and supervision of contractors engaged by the Company to design and construct reheat furnaces for the hot mill project under the capital improvement program, thereby breaching their respective fiduciary and other duties to the Company and, as a result, that the Company incurred substantial cost overruns in connection with the specific project. The complaint seeks compensatory damages, jointly and severally, against all defendants in the amount of $30 million. In November 1992, plaintiffs dismissed the claims against outside counsel. A trial date for this suit has been scheduled for the second quarter of 1994. Following dismissal of claims against outside counsel, plaintiffs made demands on the Board of Directors to initiate legal proceedings for malpractice against outside counsel and a director who is a member of that firm, a former director and the law firm of which he is a member, and the Company's independent public accountants. In July 1993, plaintiffs reinstituted suit against outside counsel and also filed suit against an additional officer of the Company. This suit is in the early stages of discovery. Since both suits are on behalf of the Company, if the plaintiffs prevail, the Company would receive the net benefit of any recovery. The Company is involved in other litigation relating to claims arising out of its operations in the normal course of business. Such claims are generally covered by insurance. It is management's opinion that any liability resulting from existing litigation would not have a material adverse effect on the Company's business or financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders The Company scheduled a Special Meeting of Stockholders for November 11, 1993 to approve a proposal to amend the Company's Restated Certificate of Incorporation to increase its authorized capital. On November 9, 1993, the Company's Board of Directors canceled the meeting. Reference is made to Item 5 Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters As of March 15, 1994, there were 26,639,894 shares of common stock, $.01 par value ("Common Stock"), outstanding held by 2,907 stockholders of record. The principal market for the Common Stock is the New York Stock Exchange, on which that security has been listed since June 1989. Prior to that date, all Common Stock was held by the Company's 1984 ESOP and did not trade on any exchange. Dividends on the Company's Common Stock are paid when and as declared by the Company's Board of Directors. Quarterly cash dividends of $0.16 per share on Common Stock were last paid on December 15, 1990. The payment of future dividends is subject to the applicable provisions of Delaware corporate law governing the Company and the discretion of the Company's Board of Directors, which normally will take into consideration applicable provisions of the Company's Certificate of Incorporation, as well as its financial performance, and its capital requirements. Under covenants of the indenture covering the Company's 11-1/2% Senior Notes, the Company's ability to pay dividends on its Common Stock is limited as to the payment of aggregate dividends after March 31, 1993, to the greater of (i) $5.0 million or (ii) $5.0 million plus one-half of the Company's cumulative consolidated net income since March 31, 1993, plus the net proceeds from future issuances of certain capital stock less certain allowable payments. As of December 31, 1993, pursuant to this covenant, the Company's ability to pay dividends on its Common Stock was limited to $5.0 million. As of March 15, 1994, 12,826,723 shares of Common Stock, or 47.7% of the outstanding shares of Common Stock, were held by one stockholder of record, United National Bank - North, as Trustee of the 1984 ESOP. As of that date, the 1984 ESOP had approximately 7,735 participants who were active or former employees of the Company. In addition, as of March 15, 1994 there were 1,779,681 shares of Series A Preferred Stock outstanding held by 240 stockholders of record. As of that date, United National Bank - North, as Trustee of the Company's 1989 ESOP, was the record owner of 1,774,164 shares of the Series A Preferred Stock, or over 99% of the outstanding shares of Series A Preferred Stock, subject to the terms and conditions of said Plan. As of that date, the 1989 ESOP had approximately 7,829 participants who were active or former employees of the Company. The Series A Preferred Stock is not listed for trading on any exchange. The Series A Preferred Stock has a preference of $5 per share over the Common Stock on liquidation and is convertible into one share of Common Stock, subject to adjustment. Each share of Series A Preferred Stock is entitled to 10 times the number of votes as the Common Stock into which it is convertible. Participants in the Company's two ESOPs have full voting rights over all shares allocated to their accounts. See "Employees" included in Item 1. As of March 15, 1994, there were 500,000 shares of the Company's Redeemable Preferred Stock, Series B outstanding, held by one stockholder of record. The Series B Preferred Stock, which is ordinarily non-voting, was issued in October 1991 to evidence a $25 million investment in the Company by Cliffs. See Note 10 to the Financial Statements. The following table sets forth, for the periods indicated, the high and low sales prices of the Common Stock as reported in the consolidated transaction reporting system. [TEXT] Item 6. Item 6. Selected Financial Data The information required by this Item is incorporated herein by reference to "Selected Financial and Statistical Data" on page 48 of the Company's 1993 Annual Report to Stockholders. With the exception of the information specifically incorporated by reference, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this Report for purposes of this Item. 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 to pages 19 to 24, inclusive, of the Company's 1993 Annual Report to Stockholders. With the exception of the information specifically incorporated by reference, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this Report for purposes of this Item. Item 8. Item 8. Financial Statements and Supplementary Data The financial statements and supplementary data required by this Item are incorporated herein by reference to pages 25 to 46, inclusive, of the Company's 1993 Annual Report to Stockholders and are listed in "Item 14.--Exhibits, Financial Statement Schedules and Reports on Form 10-K" hereof. Item 9. Item 9. Changes in or Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Directors of the Company The information required by this item with respect to Directors of the Company is incorporated herein by reference to the caption "Election of Directors" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, said definitive Proxy Statement is not to be deemed filed as part of this report for purposes of this item. Executive Officers of the Company The executive officers of the Company as of March 15, 1994, were as follows: Age at March 15, NAME 1994 OFFICE Herbert Elish 60 President, Chairman and Chief Executive Officer Craig T. Costello 46 Vice President - Operations William C. Brenneisen 52 Vice President - Human Resources James B. Bruhn 53 Vice President - Tin Mill Products Business Thomas W. Evans 57 Vice President - Materials Management David M. Gould 55 Vice President - Sales and Marketing Sheet Products William R. Kiefer 44 Vice President - Law and Secretary Dennis R. Mangino 50 Vice President - Product Quality & WEIRTEC Narendra M. Pathipati 36 Treasurer Richard K. Riederer 50 Vice President and Chief Financial Officer Mac S. White, Jr. 61 Vice President - Engineering Unless otherwise indicated below, the executive officers of the Company have held the positions described for at least the last five years. Herbert Elish has been Chairman of the Board of Directors, President and Chief Executive Officer of the Company since July 1987. He has been a director of the Company since 1983. From April 1986 until July 1987, Mr. Elish was Senior Vice President of Dreyfus Corp., a company engaged in financial services. Previously, he served as a Senior Vice President of International Paper Company, a producer of paper, paper packaging and forest products. William C. Brenneisen has served as the Company's Vice President - Human Resources since February 1988. From September 1985 through February 1988, he was the Director of Industrial Relations for the Company. James B. Bruhn joined the Company as Vice President - Sales and Marketing - Tin Mill Products in July 1987. He has been a director of the Company since May 1990. He was appointed Vice- President Tin Mill Products Business, with added responsibility for tin finishing operations in November 1992. From May 1985 until July 1987, he served as Vice President - Sales and Marketing for Titanium Metals Corporation of America. Craig T. Costello has been Vice President - Operations since October 1993. Mr. Costello served as General Manager - Operations since 1988 and prior to that was responsible for the design, building, and operation of the Hot Mill Rebuild. Thomas W. Evans has been Vice President - Materials Management since February 1988. From April 1986 to February 1988, he was Vice President - Purchasing and Traffic. From 1979 to April 1986, he was Vice President - Material Control for Sharon Steel Corporation. David M. Gould has served as the Company's Vice President - - Sales and Marketing - Sheet Products since 1983. He was a director of the Company from February 1989 to May 1990. Mr. Gould has been employed by the Company and its predecessor for over 30 years. William R. Kiefer has been the Company's Vice President - Law and Secretary since May 1990. From March 1988 to May 1990 he was Director - Legal Affairs and Secretary. From February 1985 to March 1988, he was Corporate Attorney and Assistant Secretary for the Company. Dennis R. Mangino has served as a Vice President of the Company at WEIRTEC since November 1989. From February 1986 to October 1989, Mr. Mangino was employed by Enichem America where he served as Director - Corporate Division and General Manager - Electrical Materials Division. Narendra M. Pathipati has served as Treasurer of the Company since August 1991. From February 1990 to July 1991, he served as Director of Financial Planning and Analysis for the Company. Mr. Pathipati served as Treasurer for Century II, Inc., a multi-national capital goods manufacturer, from April 1988 to January 1990. Previous to that, he was responsible for financial planning at Harnischfeger Industries, Inc. Richard K. Riederer has been Vice President and Chief Financial Officer of the Company since January 1989. He has been a director of the Company since October 1993. From March 1986 to December 1988, he served as Vice President and Treasurer of Harnischfeger Industries, Inc., a producer of manufacturing equipment. Mr. Riederer is also a director of Portico Funds Inc. Mac S. White, Jr. has been Vice President - Engineering of the Company since May 1992. From April 1989 to April 1992, Mr. White was Director of Engineering for the Company. Prior to that, he was Director of Project Management for Italimpianti, Spa., a steel mill equipment builder. Item 11. Item 11. Executive Compensation The information required by this Item is incorporated herein by reference to the caption "Executive Compensation" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, said definitive Proxy Statement is not to be deemed to be filed as part of this report. 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 caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, said definitive Proxy Statement is not to be deemed to be filed as part of this report. Item 13. Item 13. Certain Relationships and Related Transactions The information required by this Item is incorporated herein by reference to the caption "Certain Relationships and Related Transactions" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, said definitive Proxy Statement is not to be deemed to be filed as part of this report. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 1. The list of financial statements required to be filed by "Item 8 - -Financial Statements and Supplementary Data" of this Annual Report on Form 10-K is as follows: Page Financial Statements a. Independent Public Accountants' Report * b. Statements of Income for the years ended December 31, 1993, 1992, and 1991. . . * c. Balance Sheets as of December 31, 1993 and 1992 . . . . . . . . . * d. Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991 * e. Notes to Financial Statements. . . . . * Supplementary Financial Information * * Incorporated in this Report by reference from pages 25 to 46, inclusive, of the Company's 1993 Annual Report to Stockholders referred to below. 2. The list of financial statement schedules required to be filed by "Item 8 - -Financial Statements and Supplementary Data" of this Annual Report on Form 10-K is as follows: a. Independent Accountants' Report on Financial Statement Schedules . . . . . . . . . . . . . S-1 b. Schedules: III - Condensed Financial Information of Registrant S-2 V - Property, Plant and Equipment S-3 VI - Accumulated Depreciation of Property, Plant and Equipment S-4 VIII - Valuation and Qualifying Accounts S-5 IX - Short-term Borrowings S-6 X - Supplementary Income Statement Information S-7 3. Exhibits The following listing of exhibits are included in this Report or incorporated herein by reference. Exhibit 3.1 Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 3.2 By-laws of the Company (incorporated by reference to Exhibit 3.3 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 3.3 Certificate of the Designation, Powers, Preferences and Rights of the Convertible Voting Preferred Stock, Series A (incorporated by reference to Exhibit 3.2 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 28, 1990, Commission File No. 1-10244). Exhibit 3.4 Certificate of Designation, Powers, Preferences and Rights of the Redeemable Preferred Stock, Series B (incorporated by reference to Exhibit 4.1 to the Company's Current Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 8-K filed October 9, 1991, Commission File No. 1-10244). Exhibit 4.1 Indenture dated October 17, 1989 between the Company and First Bank (N.A.) as Trustee, pursuant to which the 10-7/8% Senior Notes due October 15, 1999 Notes were issued (incorporated by reference to Exhibit 4.1 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 28, 1990, Commission File No. 1-10244). Exhibit 4.2 Form of Notes (included as Exhibit A to Exhibit 4.1). Exhibit 10.1 Pellet Sale Agreement dated June 25, 1991, between USX Corporation and the Company (incorporated by reference to Exhibit 10.2 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 27, 1992, Commission File No. 1-10244). Exhibit 10.2 1984 Employee Stock Ownership Plan, as amended and restated (incorporated by reference to Exhibit 10.3 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 28, 1990, Commission File No. 1- 10244). Exhibit 10.3 1989 Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.4 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 28, 1990, Commission File No. 1-10244). Exhibit 10.4 1987 Stock Option Plan (incorporated by reference to Exhibit 10.5 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 10.5 Employment Agreement between Herbert Elish and the Company dated as of July 1, 1990 (incorporated by reference to Exhibit 10.6 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K, filed April 1, 1991, Commission File No. 1-10244). Exhibit 10.6 Employment Agreement between Warren E. Bartel and the Company (incorporated by reference to Exhibit 10.8 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 10.7 Employment Agreement between James B. Bruhn and the Company (incorporated by reference to Exhibit 10.11 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 10.8 Employment Agreement between Thomas W. Evans and the Company dated April 21, 1987 (filed herewith). Exhibit 10.9 Employment Agreement between Richard K. Riederer and the Company (incorporated by reference to Exhibit 10.12 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 10.10 Stock Purchase and Contribution Agreement dated September 27, 1991 among the registrant and U.S. Trust Company of California, N.A., as investment manager (incorporated by reference to Exhibit 10.1 to the Company's Current Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 8-K filed October 9, 1991, Commission File No. 1- 10244). Exhibit 10.11 Preferred Stock Purchase Agreement dated as of September 30, 1991 between the registrant and Cleveland-Cliffs Inc (incorporated by reference to Exhibit 10.2 to the Company's Current Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 8-K filed October 9, 1991, Commission File No. 1- 10244). Exhibit 10.12 Registration Rights Agreement dated October 2, 1991 between the registrant and Cleveland- Cliffs Inc (incorporated by reference to Exhibit 10.3 to the Company's Current Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 8-K filed October 9, 1991, Commission File No. 1- 10244). Exhibit 10.13 Redacted Pellet Sale and Purchase Agreement dated as of September 30, 1991 between the Cleveland-Cliffs Iron Company and the Company (incorporated by reference to Exhibit 10.18 to the Company's Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-Q filed August 14, 1992, Commission File No. 1-10244). Exhibit 10.14 Deferred Compensation Plan for Directors effective as of January 1, 1991, for all directors who are not officers or other employees of the Company (incorporated by reference to Exhibit 10.19 of the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on form 10-K filed April 1, 1991, Commission File No. 1-10244). Exhibit 10.15 Registration Rights Agreement dated September 30, 1991, between the Company and U.S.Trust Company of California, N.A. (incorporated by reference to Exhibit 1 to the Company's Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-Q filed November 14, 1991, Commission File No. 1-10244). Exhibit 10.16 Amendment No. 1 dated September 30, 1992, to the Registration Rights Agreement dated September 30, 1991, among the Company and U.S. Trust Company of California, N.A. (incorporated by reference to Exhibit 10.34 of Amendment 2 to the Company's Registration Statement on Form S- 2 filed February 9, 1993, Commission File No. 33-53476). Exhibit 10.17 Stock Contribution Agreement dated September 30, 1992, between the Company and U.S. Trust Company of California, N.A., as investment manager (incorporated by reference to Exhibit 10.36 of Amendment 2 to the Company's Registration Statement on Form S-2 filed February 9, 1993, Commission File No. 33- 53476). Exhibit 10.18 Coke Sale Agreement dated January 1, 1993 and signed July 13, 1993 between the Registrant and USX Corporation (incorporated by reference to Exhibit 10.30 to the Company's quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 filed August 13, 1993, Commission File No. 1-10244). Exhibit 10.19 Employment Agreement between Craig T. Costello and the Company dated July 20, 1993 (filed herewith). Exhibit 10.20 Employment Agreement between William R. Kiefer and the Company dated July 21, 1993 (filed herewith). Exhibit 10.21 Employment Agreement between Dennis R. Mangino and the Company dated July 26, 1993 (filed herewith). Exhibit 10.22 Employment Agreement between John H. Walker and the Company dated July 21, 1993 (filed herewith). Exhibit 10.23 Employment Agreement between Narendra M. Pathipati and the Company dated December 16, 1993 (filed herewith). Exhibit 10.24 Employment Agreement between Mac S. White and the Company dated July 28, 1993 (filed herewith). Exhibit 10.25 Amendment dated August 5, 1993 to the Employment Agreement dated July 1, 1990 between Herbert Elish and the Company (filed herewith). Exhibit 10.26 Amendment dated July 19, 1993 to the Employment Agreement dated June 8, 1987 between David M. Gould and the Company (filed herewith). Exhibit 10.27 Amendment dated July 21, 1993 to the Employment Agreement dated June 8, 1987 between William C. Brenneisen and the Company (filed herewith). Exhibit 10.28 Amendment dated July 19, 1993 to the Employment Agreement dated April 21, 1987 between Thomas W. Evans and the Company (filed herewith). Exhibit 13.1 1993 Annual Report to Stockholders of Weirton Steel Corporation (filed herewith). Except for those portions of the Annual Report specifically incorporated by reference, such report is furnished for the information of the Securities and Exchange Commission and is not to be deemed filed as part of this Annual Report on Form 10-K. Exhibit 22.1 Subsidiaries of the Registrant (filed herewith). Exhibit 24.1 Consent of Arthur Andersen & Co., independent public accountants (filed herewith). (b) The Registrant filed a report on Form 8-K in reference to Item 5 thereof on November 23, 1993. (c) The exhibits as listed under Item 14.(a)(3), are filed herewith or incorporated herein by reference. (d) The financial statement schedules listed under Item 14.(a)(2), are filed herewith. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, Weirton Steel Corporation has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 28th day of March, 1994. WEIRTON STEEL CORPORATION By /s/ Herbert Elish Herbert Elish Chairman, President and Chief Executive Officer /s/ Richard K. Riederer Richard K. Riederer Vice President and Chief Financial Officer (Principal Financial and Accounting 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 Weirton Steel Corporation and in the capacities indicated on the 28th day of March, 1994. /s/ Herbert Elish /s/ F. James Rechin Herbert Elish F. James Rechin Chairman of the Board Director /s/ Richard K. Riederer /s/Richard F. Schubert Richard K. Riederer Richard F. Schubert Director Director /s/ James B. Bruhn James B. Bruhn Phillip H. Smith Director Director /s/ Harvey L. Sperry Robert J. D'Anniballe, Jr. Harvey L. Sperry Director Director Mark G. Glyptis Thomas R. Sturges Director Director /s/ Gordon C. Hurlbert /s/ David I.J. Wang Gordon C. Hurlbert David I.J. Wang Director Director Phillip A. Karber Director Arthur Andersen & Co. 2100 One PPG Place Pittsburgh, PA 15222 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Weirton Steel Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Weirton Steel Corporation's Annual Report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 24, 1994. Our audit was made for the purpose of forming an opinion on those basic financial statements taken as a whole. The schedules listed in the index in Item 14 - 2(b) of the 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 a 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. Pittsburgh, Pennsylvania January 24, 1994 S-1

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Item 1. Business -------- General ------- Maxicare Health Plans, Inc., a Delaware corporation (the "Company") is a managed health care company, with a combined enrollment of approximately 293,000 at January 1, 1994. The Company owns and operates a system of 7 health maintenance organizations ("HMOs") in 7 states including California, Indiana, Illinois, Louisiana, North Carolina, South Carolina, and Wisconsin and three preferred provider organizations ("PPOs") called Maxiselect. Through its HMO operations, the Company arranges for comprehensive health care services to its members for a predetermined prepaid fee. The Company provides these services by contracting on a prospective basis with physician groups for a fixed fee per member per month regardless of the extent and nature of services, and with hospitals and other providers under a variety of fee arrangements. The Company believes that an HMO offers certain advantages over traditional health insurance: - To the member, an HMO offers comprehensive and coordinated health care programs, including preventive services, generally without requiring claims forms. - To the employer, an HMO offers an opportunity to improve the breadth and quality of health benefit programs available to employees and their families without a significant increase in cost or administrative burdens. - To the health care provider, such as physician groups and hospitals, an HMO provides a more predictable revenue source. The Company's executive offices are located at 1149 South Broadway Street, Los Angeles, California 90015, and its telephone number is (213)765-2000. History ------- On December 5, 1990, Maxicare Health Plans, Inc., a California corporation whose shares were publicly traded and the former parent company of the Company's businesses ("MHP"), merged with and into HealthCare USA Inc., a Delaware corporation ("HealthCare"), one of its wholly-owned subsidiaries, for the purpose of reincorporating from the state of California into the state of Delaware. Except as expressly provided herein or where the context requires, references to "MHP" and the "Company" herein pertain to both pre- merger Maxicare Health Plans, Inc., a California corporation, and to post-merger Maxicare Health Plans, Inc., a Delaware corporation. The HMO business of the Company originated in California in 1973. The business was operated as a nonprofit corporation through 1980. The Company was incorporated in California on December 23, 1980, to serve as a holding company for the California HMO and related entities. At the end of 1980, the California HMO was converted to a for-profit corporation. The Company began multi-state operations in June 1982 by purchasing 100% of CNA Health Plans, Inc. As part of its expansion strategy, the Company acquired all of the stock of HealthCare and HealthAmerica Corporation ("HealthAmerica") in the fourth quarter of 1986. At that time, HealthCare owned or managed HMOs in three states and HealthAmerica owned or managed HMOs in 17 states, including 11 states not previously serviced by the Company. The business of the Company's corporate predecessor, HealthCare, commenced in December 1968 when, through a predecessor corporation, it opened its first hospital. HealthCare was initially incorporated in January 1981 under the name of Greatwest Hospitals Inc. HealthCare's first HMO was acquired on December 30, 1981 through a merger with General Medical Centers, Inc. The acquisitions of HealthCare and HealthAmerica were highly leveraged and resulted in a substantial increase in the Company's long-term debt. These acquisitions, combined with adverse industry conditions and inadequate pricing policies, produced a dramatic deterioration in the Company's operating performance and financial condition. These financial difficulties ultimately caused certain of the Company's HMOs to fall out of compliance with state regulations and its loan agreement with various banks (the "Bank Group") and to default under the terms of its public indebtedness. As a result of deteriorating financial, operational and regulatory situations, MHP and forty-seven affiliated entities filed for protection under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in March and April of 1989 (the "Petition Dates"). Hereinafter, all 48 entities which filed bankruptcy petitions may from time to time be referred to as the "Debtors". Under the Bankruptcy Code, substantially all pre-petition liabilities, contingencies and other contractual obligations of the Debtors, except those expressly assumed by them, were discharged upon emergence from Chapter 11 on December 5, 1990, the "Effective Date" of the plan of reorganization (the "Reorganization Plan"). On or shortly after the Effective Date, the Company transferred approximately $85.4 million of cash to be distributed under the Reorganization Plan to segregated bank accounts and issued global certificates evidencing $67.0 million principal amount of 13.5% Senior Notes due December 5, 2000 (the "Senior Notes"), 10,000,000 shares of Common Stock and warrants to purchase an additional 555,555 shares of Common Stock (the "Warrants") to be distributed to holders of allowed claims and interests under the Reorganization Plan. As of January 31, 1994, approximately $85.5 million in cash, $39.7 million principal amount of Senior Notes, $18.2 million of cash in lieu of the now redeemed Senior Notes (see "Item 8. Financial Statements and Supplementary Data - Note 3 to the Company's Consolidated Financial Statements"), 8.9 million shares of Common Stock and 8,858 Warrants to purchase Common Stock had been distributed to holders of allowed claims. The remaining amounts of cash and securities will be distributed to holders of allowed claims upon adjudication of the remaining disputed claims pursuant to a formula set forth in the Reorganization Plan. In addition to the foregoing, certain assets of the Debtors which were not retained by the reorganized Company were transferred to a distribution trust for liquidation on behalf of the creditors (the "Distribution Trust") after reimbursement of expenses of the Distribution Trust. As of January 31, 1994, $8.9 million has been disbursed by the Distribution Trust to the disbursing agent. The Company anticipates that future distributions will be made from the Distribution Trust. Pursuant to the Reorganization Plan, the Company is required to make distributions based on its consolidated net worth in excess of $2.0 million at December 31, 1991 and 1992 (the "Consolidated Net Worth Distribution"). In March 1992, the Company consummated the sale of $60 million of Series A Cumulative Convertible Preferred Stock (the "Series A Stock") (see "Item 8. Financial Statements and Supplementary Data - Note 6 to the Company's Consolidated Financial Statements"). The proceeds from this sale, plus internally generated cash, were utilized to redeem in April 1992 the entire outstanding Senior Notes. The sale of the Series A Stock had the effect of significantly increasing the net worth of the Company. The Company does not believe the Reorganization Plan contemplated either the issuance of the Series A Stock or the redemption of the Senior Notes, and accordingly, the Company believes the Consolidated Net Worth Distribution required by the Reorganization Plan should be calculated on a basis as if the sale of the Series A Stock had not been consummated and the Senior Notes had not been redeemed. As a result of the foregoing, the Company calculated the December 31, 1992 Consolidated Net Worth Distribution amount to be approximately $971,000, which was deposited for distribution to certain creditors under the Reorganization Plan in March 1993. In addition, the Company believes that any Consolidated Net Worth Distribution which under the Reorganization Plan is to be utilized to redeem the Senior Notes is no longer due as the Senior Notes have been fully redeemed. The committee representing the creditors (the "New Committee") has stated it does not agree with the Company's interpretation of the the Reorganization Plan and believes that additional amounts may be due under the Consolidated Net Worth Distribution provision of the Reorganization Plan. The Company has responded to various inquiries of the New Committee and may engage in future discussions in an attempt to resolve any disputed items. Notwithstanding the foregoing, the Company elected to accrue in its consolidated financial statements for the year ended December 31, 1992 the maximum potential liability of $7.2 million on this matter (see "Item 8. Financial Statements and Supplementary Data"). The Bankruptcy Court retains jurisdiction over implementation and interpretation of the Reorganization Plan and, pursuant to a stipulation with the South Carolina regulators, over the operations of the South Carolina HMO, until all regulatory approvals regarding this HMO have been obtained (see "Item 1. Business - Government Regulation"). The Managed Health Care Industry -------------------------------- The Company owns and operates a multi-state system of HMOs. An HMO is an organization that arranges for health care services to its members. For these services, the members' employers pay all or most of the predetermined fee that does not vary with the nature or extent of health care services provided to the member, and the member pays a relatively small copayment or deductible for certain services. The fixed payment distinguishes HMOs from conventional health insurance plans that contain customary copayment and deductible features and also require the submission of claims forms. An HMO receives a fixed amount from its members regardless of the nature and extent of health care services provided, and as a result, an HMO has an incentive to keep its members healthy and to manage its costs through strategies such as monitoring hospital admissions and reviewing specialist referrals by primary care physicians. The goal is to combine the delivery of and access to quality health care services with effective management controls to make the most cost- effective use of health care resources. Although HMOs have been operating in the United States for half a century, their popularity began increasing in the 1970's in response to rapidly escalating health care costs and enactment of the Federal Health Maintenance Organization Act of 1973, a federal statute designed to promote the establishment and growth of HMOs (see "Item 1. Business - Government Regulation"). There are four basic organizational models of HMOs which are the staff, group, independent practice association and network models. The distinguishing feature between models is the HMO's relationship with its physicians. In the staff model, the HMO employs the physicians directly at an HMO facility and compensates the physicians by salary and other incentive plans. In the group model, the HMO contracts with a multi-specialty physician group which provides services primarily for HMO members and receives a fixed monthly fee, known as capitation, for each HMO member, regardless of the number of physician visits. Under the independent practice association model, the HMO either contracts with a physicians' association, which in turn contracts directly with individual physicians, or contracts directly with individual physicians. In either case, these physicians provide care in their own offices. Under the network model of organization, the HMO contracts with numerous community multi-specialty physician groups, hospitals and other health care providers. The physician groups are paid on a capitation basis, as in the group model, but medical care is usually provided in the physician's own facilities. The Company's HMOs include only network, group and independent practice association models. For the year ended December 31, 1993, 58% of the Company's health care expenses represented capitation payments to providers. PPOs are generally a network of health care providers which offer their services to health care purchasers, such as employers. PPO members choose from among the various contracting physician groups and independent practice associations (the "Physician Groups") the particular group from which they desire to receive their medical care, or choose a noncontracting physician and are reimbursed on a traditional indemnity plan basis after reaching an annual deductible. Payment is based on some variation of fee-for-service reimbursement and health care services are determined by the terms of the contract. The Company's PPO business began in Indiana, California and Louisiana in the fourth quarters of 1989, 1990 and 1992, respectively. In the third quarter of 1993 the Company introduced a primary care physician network product ("PCPN") to a Louisiana employer group with a health care plan which is self- insured. Under the PCPN, eligible members of the employer group may choose the Company's contracted physician network for their primary care services for a period of one year. The Company's PPO and PCPN lines of business represent approximately five percent (5%) of the Company's combined enrollment at December 31, 1993. The Company believes that the PPO and PCPN products offered by Maxicare Life and Health Insurance Company, a wholly-owned subsidiary of the Company, expand the options for members, while maintaining the concept of managed health care and is exploring the possibility of offering the PPO business and additional products and indemnity services in other markets. Health Care Services -------------------- In exchange for a predetermined monthly payment, an HMO member is entitled to receive a broad range of health care services. Various state and federal regulations require an HMO to offer its members physician and hospital services, and permit an HMO to offer certain supplemental services such as dental care and prescription drug services at an additional cost (see "Item 1. Business - Government Regulation"). As of December 31, 1993, the Company's HMOs had contracts with approximately 300 hospitals in 7 states and the Company owns and operates 3 pharmacies in California. The Company's members generally receive the following range of health care services: Primary Care Physician Services - medical care provided by primary care physicians (typically family practitioners, general internists and pediatricians). Such care generally includes periodic physical examinations, well-baby care and other preventive health services, as well as the treatment of illnesses not requiring referral to a specialist. Specialist Physician Services - medical care provided by specialist physicians on referral from the responsible primary care physicians. The most commonly used specialist physicians include obstetrician-gynecologists, cardiologists, surgeons and radiologists. Hospital Care - inpatient and outpatient hospital care including room and board, diagnostic tests, and medical and surgical procedures. Diagnostic Laboratory Services - inpatient and outpatient laboratory tests. Diagnostic and Therapeutic Radiology Services - X-ray and nuclear medicine services, including CT scans and therapeutic radiological procedures. Home Health Services - medical and surgical procedures performed on an outpatient basis, including emergency room services where such services are medically necessary, outpatient surgical procedures, evaluation and crisis intervention, mental health services, physical therapy and other similar services in which hospitalization is not medically necessary or appropriate. Other Services - other related health care services such as ambulance, family planning and infertility services and health education (including prenatal nutritional counseling, weight- loss and stop-smoking programs). Additional optional services include in-patient psychiatric care, hearing aids, durable medical supplies and equipment, dental care, vision care, chiropractic care and prescription drug services. Delivery of Health Care Services -------------------------------- The Company's HMOs provide for a portion of the health care services to its members by contracting on a prepaid basis with physician groups. The Company's HMOs typically pay to the physician groups a monthly capitation fee for each member assigned to the group. The amount of the capitation fee does not vary with the nature or extent of services utilized. In exchange for the capitation fee, the physician groups provide professional services to members, including laboratory services and X-rays. Members choose from among the various contracting physician groups the particular group from which they desire to receive their medical care. Members select a primary care physician to serve as their personal physician from the physician group. This physician will oversee their medical care and refer them to a specialist when medically necessary. In order to attract new members and retain existing members, the Company's HMOs must retain a network of quality physician groups and develop agreements with new physician groups. The Company's HMOs contract for hospital services with various hospitals under a variety of arrangements, including fee-for- service, discounted fee-for-service, per diem and capitation. Hospitalization costs are not generally included in the capitation fee paid by the Company's HMOs to physician groups. Except in emergency situations, a member's hospitalization must be approved in advance by the utilization review committee of the member's physician group and must take place in hospitals affiliated with the Company's HMOs. When emergency situations arise, however, which require medical care by physicians or hospitals not affiliated with the Company's HMOs, the Company's HMOs assume financial responsibility for the cost of such care. In mid 1992 the Company began restructuring its provider network in the Indianapolis marketplace as a result of the termination of contract negotiations with MH Healthcare, Inc. ("MetroHealth"), a health care provider in that market. Pursuant to the contract which expired on December 31, 1992, the enrollees in Indianapolis who use the MetroHealth facilities, comprising approximately 8% of the Company's total enrollment at December 31, 1993, will continue to have access to MetroHealth providers through March 31, 1994. MetroHealth currently offers its own HMO in the Indianapolis area. The restructuring of the Company's relationships among health care providers in the Indiana marketplace contributed to an increase in health care expenses (see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations"). The provider network restructuring which began in mid 1992 has been substantially completed as of the first quarter of 1994. Total enrollment in the Indiana HMO decreased approximately 22% during the first quarter of 1994 from December 31, 1993 but the Company believes that it will ultimately be able to replace a substantial number of the members who remain with MetroHealth and that the restructuring of the provider network will not have a long-term adverse impact on the Company's operations. Premium Structure and Cost Control ---------------------------------- The Company generally sets its membership fees, or premiums, pursuant to a community rating system which means that it charges the same nominal premium per class of subscriber within a geographic area for like services; however, groups which meet certain enrollment requirements are charged premiums based on prior cost experience (see "Item 1. Business - Government Regulation"). The Company has attempted to develop uniform procedures and guidelines to manage medical care costs. These procedures and guidelines include the annual negotiation of the capitation fee paid to physician groups, hospitals, dentists and pharmacies, the negotiation of discount contracts with other health care providers and the placement of financial responsibility on the primary care physician for the initiation of specialist referrals and hospital utilization. In situations where the Company assumes the financial responsibility for specialist referrals and hospital utilization, health care providers are rewarded monetarily for specified levels of utilization through incentive programs. In addition to directing the Company's health care providers toward capitation arrangements, the Company has a variety of programs and procedures in place to effect cost containment. These programs are intended to address utilization of inpatient services, outpatient services and referral services which: (i) verify the medical necessity of inpatient nonemergency treatment or surgery, (ii) establish whether services must be performed in an inpatient setting or could be done on an outpatient basis; and (iii) determine the appropriate length of stay for inpatient services, which may involve concurrent and/or retrospective review. In addition, the Company revised the terms and procedures of its pharmacy plan which incorporates such cost containment features as drug formularies (a Company-developed listing of preferred, cost- effective drugs). The Company establishes an annual budget for each geographic area and determines the expected costs of providing services in such areas. The budget is calculated on a per member per month basis for specific components. These include professional care by the contracting Physician Groups; hospitals; prescription drug and dental care services; emergency care; other health care services; and administration. The Company budgets hospital costs on the basis of utilization experience, actual cost per member per month, expected inflation and anticipated changes in health care delivery. For further information, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Item 8. Financial Statements and Supplementary Data-Consolidated Statements of Operations" included herein. Management Information Systems ------------------------------ All of the Company's HMOs are currently linked through a network of data lines to the corporate data center, allowing the Company to prepare and make available management and accounting reports including eligibility, capitation, billing and claims information on an ongoing basis. System generated reports contain budgeted and actual monthly cost and utilization statistics relating to physician initiated services and hospitalization. Hospital reports, which are available on a daily basis, are further analyzed by the type of service, days paid, and actual and average length and cost of stay by type of admission. The corporate data center is located in Los Angeles. Quality Assurance ----------------- As required by federal and state law, the Company evaluates the quality and appropriateness of the medical care delivered to its members by its independently contracted providers in a number of ways including performing periodic medical care evaluation studies, analyzing monthly utilization of certain services, conducting periodic member satisfaction studies and reviewing and responding to member and physician grievances. The Company compiles a variety of statistical information concerning the utilization of various services, including emergency room care, outpatient care, out-of-area services, hospital services and physician visits. Under-utilization as well as over- utilization is closely evaluated in an effort to monitor the quality of care provided to the Company's members by physician groups. The Company has a member services department which deals directly with members concerning their health care questions, comments, concerns or grievances. The Company conducts annual surveys questioning members about their level of satisfaction with the services they receive. Management reviews any problems that are presented by members concerning the delivery of medical care and receives periodic reports summarizing member grievances. Marketing --------- Primary responsibility for the Company's marketing efforts rests with a marketing director and sales representatives for each HMO operated by the Company. Members typically join the Company's HMOs through an employer, who pays all or most of the monthly premium. In most instances, employers offer employees a choice of traditional health insurance or membership with HMOs such as those operated by the Company. The Company's HMOs' agreements with employers are generally for a term of 12 months subject to renewal annually. Once the Company's relationship with the employer is established, marketing efforts are then focused on employees. During an annual "open enrollment period", employees may select their desired health care coverage. The primary annual open enrollment period occurs in the month of January. By the end of January, approximately 62% of the Company's members select their desired health care coverage for the ensuing annual period. New employees make their choices at the time of employment. The Company's HMO membership is widely diverse, with no employer group comprising 10% or more of the Company's total enrollment. As of December 31, 1993, the Company's HMOs were offered by more than 1,400 employer groups. The Company has also developed a multi-state account program which offers employers having multiple locations in areas served by the Company's HMOs the opportunity to deal with one primary account manager. Billing and enrollment procedures are handled at a plan level giving the multi-state employer the opportunity to monitor individual areas within his employer group. For certain multi- state employers, the Company develops individual marketing and benefit programs for separate divisions, locations or benefit classes within the same employer. The Company believes that attracting employers is only the first step toward increasing enrollment at each of its HMOs; ultimately, the Company's ability to retain and increase membership will depend upon how users of the health care system assess its benefit package, rates, quality of service, financial condition and responsiveness to user demands. Competition ----------- The health care industry is highly competitive and the managed health care industry is becoming increasingly competitive in all markets. The HMO industry continues to gain market share, particularly at the expense of the indemnity carriers. The Company competes in its regional markets for employers and members with other HMOs, conventional health insurers and PPOs as well as employers who elect to self-insure, and for quality physician groups with other HMOs and PPOs. Many of these competitors are larger or have greater financial resources than the Company. The level of competition varies from state to state depending on the variety and size of other conventional insurance, HMO and PPO health care services offered in each state. Competitors of the Company include such well known entities as Kaiser, Health Net and Pacificare (in California), MetroHealth (in Indiana), and HMO Illinois, Partners National Health Plan, Humana and Chicago HMO (in Illinois). The Company believes the principal competitive factors it faces are premium rates, the quality of contracted providers, the variety of health care coverage options offered and the quality of service to members and providers. Competition may result in pressure to reduce rates or limit the growth potential of HMOs in any particular market. Employers, for example, are increasingly cost sensitive in selecting health care providers for their employees, which provides an incentive for the Company to keep its rates competitive. In addition to the above, the Company has recently faced increased competition from health care providers which offer not only HMO services but PPO and indemnity health care services to employer groups. In an effort to remain competitive, the Company has begun to offer a variety of health care services, including PPOs, and is actively exploring offering additional PPO and indemnity services through joint ventures or other arrangements. Competition may also be affected by mergers and acquisitions in the managed care and general health care industries as companies respond to proposed health care reform and seek to expand their operating territories to gain economies of scale and market share. Government Regulation --------------------- The federal government and each of the states in which the Company's HMOs operate have enacted statutes regulating the activities of HMOs. The most important laws affecting the Company are the Federal Health Maintenance Organization Act of 1973, as amended (the "HMO Act"), and the regulations thereunder promulgated by the Secretary of Health and Human Services, and the various state regulations mandating compliance with certain net worth and other financial tests. Federal Regulations. All of the Company's HMOs are federally qualified under the HMO Act. The HMO Act and regulations provide that, with certain exceptions, each employer of at least 25 employees must permit two "qualified" HMOs to market a health benefits plan to its employees, with the employer contributing the same amount toward the employee's HMO enrollment fee as it would otherwise have paid for conventional health care insurance. Under federal regulations, services to members must be provided substantially on a fixed prepaid monthly basis, without regard to the actual level of utilization of services. Premiums established by HMOs may vary from employer to employer through composite rate factors and special treatment of certain broad classes of members, including geographical location ("community rating"). Experience rating of accounts (i.e., setting premiums for a group account based on that group's past use of health care services) is also permitted under federal regulations in certain circumstances. From time to time, modifications to the HMO Act have been considered by Congress. The Company is unable to predict what, if any, modifications to the HMO Act will be passed into law or what effect, if any, such legislation would have upon the operations, profitability or business prospects of the Company. Among other areas regulated by federal and state law, although not necessarily by each state, are the scope of benefits available to members, the manner in which premiums are structured, procedures for review of quality assurance, enrollment requirements, the relationship between the HMO and its health care providers, procedures for resolving grievances, licensure, expansion of service area, and financial condition. The HMOs are subject to periodic review by the federal and state licensing authorities which regulate the HMOs. State Regulations. With the exception of the Company's South Carolina HMO, all of the Company's operational HMOs are licensed by pertinent state authorities. The operations of the South Carolina HMO are currently under Bankruptcy Court jurisdiction pending a reorganization of that entity as a division of one of the Company's other HMOs. The Company believes that it will be able to ultimately resolve the South Carolina HMO's licensing situation by changing its legal structure to that of a division of another one of its operating HMOs, or as a separately licensed HMO in the state of South Carolina. Presently, the Company is discussing with the North Carolina Department of Insurance the possibility of operating the South Carolina HMO as a division of the North Carolina HMO. In any event, the Company does not believe that the resolution of this situation will have a materially adverse effect on the Company taken as a whole. All of the Company's HMOs are subject to extensive state regulations which require the HMO to comply with certain net worth and other financial tests. A number of states have recently enacted legislation which increases these financial tests. To the extent an HMO fails to satisfy these regulatory requirements, MHP may need to infuse the HMO with additional capital in order to maintain the good standing of the HMO in the state. Under the HMO's business plans and in order to ensure financial compliance with state regulators, the Company is currently operating under a decentralized and segregated cash management system. The Company has implemented administrative services agreements which provide for MHP to furnish various management, financial, legal, computer and telecommunication services to the HMOs pursuant to the terms of the agreement with each HMO. The Company believes that it is currently operating in compliance with the state regulations and has obtained regulatory approval of the operational and financial plans and related administrative services agreements for its HMOs. The issue of health care reform continues to undergo intense discussion and examination by the public and private sectors. A number of proposals for health care reform have been introduced by both state and federal governments which include such concepts as universal coverage, comprehensive benefits, quality in the delivery of health care at an affordable price and portability of coverage for the insured. Many proposals are still being developed. Though the role of managed care appears to be an integral part in most proposals, the Company cannot determine the effect, if any, these proposals may have on the business or operations of the Company, if adopted. Employees --------- As of December 31, 1993, the Company employed approximately 465 full-time employees. None of the Company's employees are represented by a labor union or covered by a collective bargaining arrangement and the Company believes its employee relations are good. Directors and Executive Officers of the Registrant -------------------------------------------------- The directors and executive officers of the Company at December 31, 1993 were as follows: Peter J. Ratican was appointed Chairman of the Board of Directors, Chief Executive Officer and President of the Company in August 1988. Prior to joining the Company, Mr. Ratican was a senior executive of DeLaurentiis Entertainment Group Inc. and MCA INC. Prior to joining MCA INC., Mr. Ratican was a Senior Audit Manager for the Los Angeles Office of Price Waterhouse, specializing in the entertainment and health care industries. He is a member of the California Knox-Keene Health Care Services Advisory Committee, which assists the California Department of Corporations in regulating prepaid health plans (HMOs). Mr. Ratican has been a director of the Company since August 1983. He received a Bachelor of Science degree in Accounting from the University of California at Los Angeles and is a certified public accountant. Eugene L. Froelich was appointed Chief Financial Officer, Executive Vice President - Finance and Administration and director in March 1989. From 1984 to March 1989, Mr. Froelich was President of GFE, Inc., where he engaged in financial and business consulting for a variety of industries. Previously, Mr. Froelich was Vice President of MCA INC. Mr. Froelich graduated from Adelphi University and is a certified public accountant. Alan D. Bloom has been Senior Vice President - Secretary and General Counsel to the Company since July 1987. Mr. Bloom joined the Company as General Counsel in 1981 and from 1983 to 1987, he was Secretary and General Counsel. Mr. Bloom received a Bachelor's degree in Biology from the University of Chicago, a Master of Public Health from the University of Michigan, and a J.D. degree from American University. Aivars L. Jerumanis was appointed Senior Vice President - Management Information Systems and Chief Information Officer of the Company in January 1990. From May 1989 to January 1990, Mr. Jerumanis was a private consultant in advising companies on management information services matters and from June 1973 to May 1989 he was with MCA INC., where he served as Director of Corporate Data Processing and Vice President of Universal Studios. He received a Masters in Business Administration from Columbia University, a Masters in Civil Engineering from Rensselaer Polytechnic Institute and a Bachelor's degree in Civil Engineering from Lafayette College. Richard A. Link was appointed Chief Accounting Officer and Senior Vice President - Accounting of the Company in September 1988. Previously, Mr. Link was in the Los Angeles offices of Price Waterhouse where he had been Senior Audit Manager with an emphasis in health care. He has a Bachelor's degree in Business Administration from the University of Southern California and is a certified public accountant. Samuel W. Warburton, M.D. has been Senior Vice President - Medical Affairs of the Company since December 1988. As of April 1993, Dr. Warburton serves in this position as well as medical director of the North Carolina ACCESS program, a primary care case management program for medicaid enrollees. He has also served as Vice President of Medical Affairs of Maxicare North Carolina, Inc. since May 1985. From January 1980 to April 1985, Dr. Warburton was Chief of the Division of Family Medicine at Duke University and a Director of the Duke-Watts Family Medicine Program. Dr. Warburton has had a number of teaching and clinical appointments and published numerous articles on family medicine. He received his Bachelor of Arts from John Hopkins University and his Medical degree from the University of Pennsylvania School of Medicine. William B. Caswell was appointed Vice President, General Manager of the California HMO in February 1992. From March 1988 to January 1992 Mr. Caswell served as President of VertiHealth, a subsidiary of UniHealth America. Prior to joining VertiHealth he was Senior Vice President of California Medical Center - Los Angeles. Mr. Caswell serves on the board of directors of the University of Southern California School of Nursing as well as the Southern California Chapter of the Arthritis Foundation. He received a Master's degree in Business Administration and a Master of Public Health from the University of California at Los Angeles. David J. Hammons was appointed Vice President - Administrative Services and Chief Actuary of the Company in August 1993. From January 1988 to July 1993 Mr. Hammons was Vice President and Chief Actuary of the Company. He has a Bachelor's degree in Mathematics from the State University of New York and is a Fellow of the Society of Actuaries and a member of the American Academy of Actuaries. Robert J. Landis has served as Treasurer since November 1988. Prior to this date, he served as Assistant Treasurer since December 1983. Mr. Landis received a Bachelor's degree in Business Administration from the University of Southern California, a Master's degree in Business Administration from California State University at Northridge and is a certified public accountant. Vicki F. Perry was appointed Vice President, General Manager of Maxicare Indiana, Inc. in January 1992. From January 1990 to December 1991 she served as Executive Vice President - Plan Operations Support of the Company. Ms. Perry, who has been with the Company since 1982, previously served as Executive Director of the Indiana HMO. Ms. Perry is a graduate of Indiana University. Claude S. Brinegar is currently Vice Chairman of the board of directors of Unocal Corporation and served as Executive Vice President of Administration and Planning until May 1992. In 1985, Mr. Brinegar was elected Executive Vice President of Unocal and he became Chief Financial Officer in 1986. In 1989, Mr. Brinegar was elected as Vice Chairman of Unocal and has been a director of the Company since December 20, 1991. He is also a member of the board of directors of Consolidated Rail Corporation and a visiting scholar at Stanford University. Leon M. Clements served as Chief Administrative Officer and Associate Director of the UCLA Medical Group Practice from April 1993 to October 1993. Mr. Clements is currently self-employed as a consultant. From July 1990 to October 1992 Mr. Clements served as Chief Administrative Officer of Cleveland Clinic in Fort Lauderdale Florida. From November 1986 to June 1990 Mr. Clements was Chief Executive Officer with Browne-McHardy Clinic, a major health care provider for the Company's HMO in New Orleans, Louisiana. Mr. Clements has a Bachelor of Science degree in Economics and Finance and a Masters of Business Administration from the University of Southwestern Louisiana and served as a director of the Company from August 31, 1990 to January 28, 1994. Mr. Clements was the chairman of the Official Committee of Unsecured Creditors (the "OCC") during the Company's bankruptcy reorganization proceedings. Florence F. Courtright has been a private investor for the last five years and was elected a director of the Company on November 5, 1993. She is a founding Limited Partner of Bainco International Investors, 1.p and a Trustee of Loyola Marymount University. Further, Ms. Courtright is a former co-owner of the Beverly Wilshire Hotel and the Beverly Hills Hotel. Thomas W. Field, Jr. was appointed the Chairman of the Board of ABCO Markets in December 1991. ABCO Markets is in the grocery business. He has been President of Field & Associates, a management consulting firm, since October 1989. From 1984 to September 1989 Mr. Field was with McKesson Corporation in a number of executive capacities, most recently as Chairman of the Board, President and Chief Executive Officer. Mr. Field has been a director of the Company since April 1, 1992. Mr. Field also holds directorships at Campbell Soup Company, Bromar Inc. and Hume Medical. Charles E. Lewis has been a Professor of Medicine, Public Health and Nursing at the University of California at Los Angeles, since 1970. As of July 1993, he was appointed Director of the Center of Health Promotion and Disease Prevention. He is a member of the Institute of Medicine, National Academy of Sciences and is a graduate of the Harvard Medical School and of the University of Cincinnati School of Public Health where he received a Doctorate of Science degree. Dr. Lewis is a Regent of the American College of Physicians and a member of the Board of Commissioners of the Joint Commission on Accreditation of Health Care Organizations. Dr. Lewis has been a director of the Company since August 1983. The Board of Directors (the "Board") is classified into Class I, Class II and Class III directors. Class I directors include Dr. Lewis and Mr. Brinegar and they will serve until the 1994 annual meeting of stockholders and until their successors are duly qualified and elected. Class II directors include Mr. Froelich and Ms. Courtright and they will serve until the 1995 annual meeting of stockholders and until their successors are duly qualified and elected. Class III directors include Mr. Ratican, Mr. Field and Mr. Clements and they will serve until the 1993 annual meeting of stockholders and until their successors are duly qualified and elected. Officers are elected annually and serve at the pleasure of the Board, subject to all rights, if any, under certain contracts of employment (see "Item 11. Executive Compensation"). Pursuant to the Reorganization Plan, Mr. Clements was added to the Board as a designee of the pre-petition creditors. Dr. Lewis was added to the Board as an independent director and Messrs. Ratican and Froelich continued to serve as directors. Messrs. Brinegar and Field and Ms. Courtright were appointed to the Board. On January 28, 1994 the Company's shareholders at the 1993 Annual Meeting of Stockholders elected Alan S. Manne as a Class I director, replacing Leon Clements, and re-elected Peter Ratican and Thomas Field each for three year terms ending at the 1996 Annual Meeting of Stockholders or until his successor is duly qualified and elected. Mr. Manne is currently a professor emeritus and from 1961 to 1992 was a professor of operations research at Stanford University. He is an author, or co-author, of seven books and received his Ph.D. in economics from Harvard University. He is co- organizer of the International Energy Workshop. Item 2. Item 2. Properties ---------- The Company's operating facilities are held through leaseholds. At December 31, 1993, the Company or its HMOs leased approximately 222,000 square feet at 21 locations with an aggregate current monthly rental of approximately $250,000. These leases have remaining terms of up to eight years. In August 1990, the Company entered into a lease for new corporate office space in Los Angeles. The lease commenced in February 1991 and is for a term of sixty-four (64) months. The lease is for approximately 83,000 square feet with a monthly base rental expense of approximately $98,500 excluding the Company's percentage share of all increases in the landlord's operating cost of the building. At December 31, 1993 the Company leased other properties including administrative locations, 3 pharmacies, and other miscellaneous facilities. The Company has subleased approximately 11,000 square feet to contracting medical groups, with current monthly rentals totaling $16,000 and monthly subrental revenue of $17,000. Item 3. Item 3. Legal Proceedings ----------------- a. JURISDICTIONAL CHALLENGES AND APPEALS TO THE CHAPTER 11 REORGANIZATION PROCEEDINGS Immediately after the filing of the petitions, the Debtors were faced with several motions challenging the jurisdiction of the Bankruptcy Court over the Debtors' Chapter 11 cases. As of March 11, 1994, the only remaining jurisdictional appeals are the appeals filed by the State of Wisconsin (the "Wisconsin Appeals"), which affect the Maxicare Health Insurance Company, ("MHIC") one of the Company's HMO subsidiaries. The Wisconsin Appeals challenge MHIC's eligibility to be a debtor under the Bankruptcy Code. The Bankruptcy Court, the District Court and the United States Court of Appeals for the Ninth Circuit denied the State of Wisconsin's motions for a stay of consummation of the Reorganization Plan pending determination of the Wisconsin Appeals. On July 9, 1992, the United States District Court for the Central District of California entered a Ruling on Appeal (the "Ruling") concerning this matter. In its Ruling, the District Court held that MHIC is a domestic insurance company under Wisconsin state law and MHIC was therefore not eligible for relief under the Bankruptcy Code which excludes domestic insurance companies from entities eligible for relief thereunder. The District Court remanded the matter back to the Bankruptcy Court and ordered the Bankruptcy Court to take action consistent with the Ruling. The Company, MHIC and other affiliates filed a motion for rehearing of the Ruling and on August 27, 1992, the District Court denied the motion for rehearing. The Company has appealed the Ruling and the District Court's denial of the motion for rehearing to the United States Court of Appeals for the Ninth Circuit. In addition, the Company, MHIC and other affiliates have filed a motion in the District Court to stay implementation of the Ruling while the Ruling is on appeal. A hearing on the motion to stay the Ruling has been set for June 23, 1994. The Company has reached a settlement agreement in principle with the State of Wisconsin memorialized in a written memorandum of understanding. Pursuant to the agreement, a reorganization plan for MHIC, in accordance with Wisconsin state law, will be submitted without prejudice for approval by the Wisconsin State Court. Under the terms of the agreement in principle, the reorganization of MHIC must be on terms consistent with the Reorganization Plan. The implementation of the agreement in principle will have no material adverse impact on the Company's business or its operations. The agreement is subject to approval by the Bankruptcy Court and the non-occurrence of certain contingencies. The United States Court of Appeals for the Ninth Circuit has issued an order extending the time for the filing of briefs in connection with the Company's appeal of the Ruling in order to allow the parties an opportunity to implement and consummate the settlement. In the event the settlement cannot be fully implemented, the Company may pursue the appeal. If prosecution of the appeal resumes and the Ruling is upheld after MHIC's appellate rights have been exhausted, creditors of MHIC will likely only have the protections and recoveries afforded under applicable state law. In addition to the Wisconsin Appeals, twenty-four appeals were filed challenging various aspects of the Reorganization Plan's confirmation order. As of March 1, 1993, twenty-one of these appeals have been withdrawn or dismissed, two have been stayed subject to Bankruptcy Court and U.S. District Court approval of settlement agreements with the class action appellants discussed below and one has been stayed subject to Bankruptcy Court and United States District Court approval of the class action settlement agreements and the non-occurrence of certain other conditions. The Company believes it has a meritorious position and will prevail on its appeal of the Ruling or on the stayed appeals if prosecution of these appeals resumes. b. CLASS ACTION LITIGATIONS On July 15, 1988, a class action complaint alleging various violations of federal and state securities law arising from the purchase of the Company's old common stock was filed by Gerald D. Mirkin in the Superior Court for the County of Los Angeles against the Company, its former and current officers and directors, including Peter Ratican, and others including the Company's former accountants and investment bankers (Mirkin and Miller, et al. v. Fred W. Wasserman, et al. (Superior Court, Los Angeles County, CA) (Case No. CA 01122)). This action has been consolidated with two other actions. These other actions include (i) a class action lawsuit filed by Charles Miller against the Company and its former and current officers in the Superior Court of the State of California for the County of Los Angeles for violation of the California Corporations Code and California State common law arising from the purchase and sale of the Company's old common stock or the Company's 11 3/4% Notes, and (ii) a class action filed by William Steiner, on behalf of himself and other Company shareholders, against former and current officers and directors, and others including the Company's former accountants and investment bankers in the Superior Court of the State of California for the County of Los Angeles alleging violation of federal and state securities laws arising from the purchase and sale of the Company's old common stock. No class was certified in this consolidated action. In January, 1990, the trial court dismissed the action without leave to file an amended complaint, and the plaintiffs appealed the dismissal. In March, 1991, the Court of Appeals upheld the trial court dismissal. The plaintiffs subsequently appealed the Court of Appeals' ruling to the California Supreme Court. On September 19, 1993 the California Supreme Court affirmed the Court of Appeals' order precluding the Plaintiffs from pursuing the consolidated actions. The Plaintiffs did not seek review of the California Supreme Court's decision by the United States Supreme Court within the requisite time, rendering the California Supreme Court's decision final. Accordingly, the Company will no longer be reporting on this matter. On May 4, 1988, a class action complaint alleging violations of federal and state securities laws was filed by Murray Zucker on behalf of himself and other Company shareholders in the United States District Court for the Central District of California. Murray Zucker, et al. v. Maxicare Health Plans, Inc., et al. (United States District Court, Central District of CA) (Case No. 88 02499 LEW (TX)) (the "Zucker Action"). A class has been certified in the Zucker Action. The Company and certain of its current and former directors and officers who are named defendants have entered into a settlement agreement with respect to all of the claims in the aforementioned actions. Amounts to be paid under the settlement agreement have been funded entirely by the Company's directors and officers insurance policy with First State Insurance Company. The settlement agreement has been approved by the United States District Court, the class members and the Bankruptcy Court. The non-settling defendants appealed certain aspects of the District Court's approval of the settlement agreement (the "Zucker Appeal") which would preclude such non-settling defendants from seeking indemnification or contribution from the settling defendants, and the investment bankers appealed their exclusion from the class, to the United States Court of Appeals for the Ninth Circuit. On January 26, 1994, the Ninth Circuit Court of Appeals dismissed the Zucker Appeal for lack of jurisdiction over the appeal. Under the Reorganization Plan, former officers and directors who may have pre-petition claims against the Company for indemnification for damages in excess of insurance coverage are general unsecured creditors. An agreement has been executed between the non-settling defendants and the settling defendants, pursuant to which the non-settling defendants have agreed to waive their right to appeal the portion of the District Court's order approving the settlement agreement that precludes the non-settling defendants from seeking contribution or indemnification from the settling defendants. Under the agreement, the non-settling defendants retain the right to appeal their exclusion by the District Court from membership in the settling class. The Company does not believe that the ultimate resolution of any subsequent appeal by the non-settling defendants of their exclusion from membership in the settling class by the District Court, will impact the settlement of the Zucker Action. c. PENN HEALTH During the period from March 1, 1986 through June 30, 1989, Penn Health Corporation ("Penn Health"), a subsidiary of the Company, contracted with the Commonwealth of Pennsylvania through the Pennsylvania Department of Public Welfare (the "DPW") to provide a full range of health care services to Medicaid enrollees under the Pennsylvania Medical Assistance Program known as the HealthPass Program. The DPW was the sole subscriber group of Penn Health. These services were rendered by providers pursuant to contracts with Penn Health ("Penn Health Providers"). In consideration for these services, subject to certain adjustments, the DPW was obligated to pay to Penn Health a fixed monthly fee per enrollee based upon Penn Health's fee-for-service costs and a charge for administration. In addition, for the first two years of the contract, the DPW agreed to reimburse Penn Health for any financial losses in excess of $2 million. Under the applicable provisions of the contract, at the Petition Dates, the Company believes that the DPW owed Penn Health in excess of $24 million plus accrued interest, for reimbursement and adjustment of the cost of pre- petition services, an amount which the DPW disputes. After the Petition Dates, the DPW advanced funds directly to the Penn Health Providers for pre-petition services performed under the contracts with Penn Health. In certain cases the amount of the advanced funds may have been in excess of the amounts due to the Provider for such services. The payments made by the DPW approximated $16 million. The Penn Health Providers filed proofs of claim against Penn Health and other subsidiaries of the Company, without making deductions for the payments made by the DPW, although they noted receipt of such funds on their proofs of claim. In February, 1990, the Company filed a proceeding in the Bankruptcy Court against the DPW and the major Penn Health Providers to recover preferential transfers, to compel the turnover of property and to raise all objections to the proofs of claim of the Penn Health Providers, including that the claims asserted therein were overstated (the "Bankruptcy Action"). The disputes with the DPW and the major Penn Health Providers, in the Bankruptcy Action constitute the majority of the claims filed against Penn Health. On December 13, 1990, the Bankruptcy Court entered an order dismissing the Bankruptcy Action as against the DPW on jurisdictional grounds (the "Dismissal Order"). The Company filed an appeal of the Dismissal Order to the United States District Court for the Central District of California, which was subsequently resolved by a stipulation approved by the District Court. Pursuant to the stipulation, the jurisdictional issue was remanded to the Bankruptcy Court for redetermination in light of developments in the case law. On February 27, 1991 the Company filed a petition against the DPW in the Pennsylvania Board of Claims, seeking damages in excess of $24 million (the "Board Action"). In July 1992, the Pennsylvania Board of Claims (the "Board") denied DPW's preliminary objections to the Company's petition. In August 1992, the DPW answered the Company's petition and asserted counterclaims to recover (i) $16 million of payments that the DPW made to HealthPass healthcare providers purportedly to satisfy Penn Health's obligations to the providers; (ii) the costs the DPW incurred in processing and mailing the payments to the healthcare providers; and (iii) $6 million which the DPW alleges was distributed by Penn Health to the Company, but should have been retained by Penn Health to satisfy healthcare providers' claims. In the Company's October 14, 1992 answer to the counterclaim, the Company denied the allegations set forth in the counterclaim. The Company also asserted as an affirmative defense that Penn Health's discharge in bankruptcy under the Reorganization Plan is a complete bar to the DPW's counterclaim. In the event the DPW is successful in its counterclaims, all of which arose out of pre-petition activities of the Company and Penn Health, any recovery would be paid out of the Reorganization Plan funds and there will be no impact on the Company's cash resources. The Company believes that it has a meritorious defense to the counterclaim and will prevail on the counterclaim. On October 4, 1993 Penn Health filed a remand motion with the Bankruptcy Court for a determination that the DPW waived its sovereign immunity by asserting an offset against Penn Health. DPW opposed the remand motion and subsequently filed a motion with the Bankruptcy Court requesting that the Court abstain from adjudicating the Bankruptcy Action and require that Penn Health's claims against DPW be adjudicated by the Board in the Board Action. Pursuant to an order of the Bankruptcy Court entered on February 24, 1994, Penn Health's remand motion was granted in all respects and the Dismissal Order was vacated. Under an order entered by the Bankruptcy Court on January 24, 1994, the Court abstained on a preliminary basis from adjudicating the Bankruptcy Action and stayed all proceedings in the action until September 1, 1994 to allow the Board an opportunity to adjudicate the Board Action. The Bankruptcy Court retains jurisdiction over the Bankruptcy Action to try or hear the action on the merits in the event that the Board Action is not tried or heard by September 1, 1994, or no significant progress is made in trying or hearing the Board Action. In an order dated December 21, 1993 the Board consolidated the Board Action and two separate actions filed by Penn Health Providers against DPW to recover payment from DPW for services rendered to HealthPass members (the "Provider Actions") and set trial dates in the consolidated actions. Contractual issues pertaining to the DPW's liability to Penn Health in the Board Action and to Penn Health providers in the Provider Actions will be tried by the Board in a trial scheduled to commence on July 6, 1994. A trial to determine damages will be held by the Board on December 12, 1994. The Company has, in the past, engaged in settlement discussions with the DPW and representatives of the major Penn Health Providers but an agreement was not reached. The pre-petition amounts due to Penn Health Providers will be treated as unsecured class 11 claims under the Reorganization Plan. The Company is currently holding approximately $225,000 in an escrow account, which the Company believes will be sufficient to satisfy any remaining post-petition claims of Penn Health Providers. d. OTHER LITIGATION On March 12, 1993, MH Healthcare, Affiliate of Methodist Hospital of Indiana, Inc. ("MH") submitted a demand (the "Demand") to the American Arbitration Association (the "AAA") for arbitration of a contractual dispute between MH and Maxicare Indiana, Inc. ("Indiana") concerning interpretation of the provisions of a Master Agreement dated February 8, 1988, as subsequently amended, (the "Agreement") by and among MHP, Indiana and MH. MH Healthcare, Affiliate of Methodist Hospital of Indiana, Inc. v. Maxicare Indiana, Inc. Under the terms of the Agreement MH agreed to provide designated healthcare services to members of the health care plan operated by Indiana in exchange for the rates and fees designated in the Agreement. In the Demand MH: (i) contends that it was not paid the appropriate amounts due under the Agreement for 1992; (ii) disputes certain of the premium rates upon which Indiana based its calculation of payments made to MH under the Agreement; and (iii) contends that in accordance with the Agreement changes made by Indiana to the covered services provided to plan members have materially impacted the actuarial value of the payments due under the Agreement, entitling MH to an upward adjustment in the rates specified in the Agreement. Based on the Pre-Hearing Statement which MH submitted to the Arbitrator, the Company has been advised that MH is seeking a damage award of approximately $7.9 million plus interest. In the event MH prevails in the arbitration, there may be additional amounts due to MH for the 1993 contract year. Indiana disputes the allegations of the Demand and MH's damages computation and has asserted a counterclaim to the Demand to recover overpayments erroneously made to MH under the Agreement. The parties are currently engaged in arbitration of the allegations of the Demand by the AAA which commenced on March 21, 1994. The Company believes that Indiana has meritorious defenses to the Demand and that Indiana will prevail in the arbitration. The Company is a defendant in a number of other lawsuits arising in the ordinary course from the operations of its HMOs, including cases in which the plaintiffs assert claims against the Company or third parties that might assert indemnity or contribution claims against the Company for malpractice, negligence, bad faith in the failure to pay claims on a timely basis or denial of coverage. The Company does not believe that adverse determination in any one or more of these cases would have a material, adverse effect on the Company's business and operations. 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 three months ended December 31, 1993. PART II ------- Item 5. Item 5. Market for the Registrant's Common Stock and Related ---------------------------------------------------- Stockholder Matters ------------------- The Company emerged from Chapter 11 on December 5, 1990. Pursuant to the Reorganization Plan, its pre-petition creditors were entitled to receive 98% of the 10 million shares of Common Stock authorized for distribution under the Reorganization Plan; the remaining 2% of the Common Stock is to be distributed to equity and interest holders. (a) Market Information The Company's Common Stock appears on the National Association of Securities Dealers Automated Quotation National Market Systems ("NASDAQ-NMS") under the trading symbol MAXI. The following table sets forth the range of high and low bid and asked quotations of the Common Stock as reported by the National Quotation Bureau, Incorporated from January 1, 1992 to April 6, 1992. Thereafter, the table sets forth the high and low sale prices per share on the NASDAQ-NMS. The quotations are interdealer prices without retail mark-ups, markdowns, or commissions, and may not represent actual transactions. (b) Holders The number of holders of record of the Company's Common Stock on December 31, 1993 was 17,892. As of such date, the Company held 1,164,778 shares of Common Stock (the "Unallocated Shares") as disbursing agent for the benefit of creditors and holders of interests and equity claims under the Reorganization Plan. Of the Unallocated Shares held as of December 31, 1993, 752,236 were held for the benefit of creditors of the Company's operating subsidiaries (Reorganization Plan classes 5A through 5H), 118,400 shares were held for bank group creditors (Reorganization Plan class 7), 97,272 shares were held for bondholder creditors (Reorganization Plan classes 8A through 8D), and 196,870 were held for former stockholders (Reorganization Plan class 12). As of December 31, 1993, no shares were being held for the benefit of Maxicare Health Plans, Inc. creditors (Reorganization Plan class 9), however, certain of the shares held for the benefit of Reorganization Plan classes 7 and 8A through 8D will be reallocated to Reorganization Plan class 9 pursuant to a formula set forth in the Reorganization Plan. The Reorganization Plan provides that until such time as any share of Common Stock reserved for a holder of an allowed claim or allowed interest under the Reorganization Plan is allocated, the disbursing agent shall deliver an irrevocable proxy to vote the Unallocated Shares to the independent directors of the Board (as such term is defined by the Reorganization Plan). Currently, the independent directors are Messrs. Brinegar and Lewis (the "Independent Directors"). The Reorganization Plan provides that the Unallocated Shares shall be voted in the following manner: (i) 949,106 shares which were held in the claims reserves as of December 31, 1993 for the holders of Reorganization Plan classes 5A through 5H and Reorganization Plan class 9 allowed claims and Reorganization Plan class 12 allowed interests and equity holder claims, shall (a) as to proposals made by the Company, be voted in the same manner and the same degree as all of the allocated shares of Common Stock; and (b) as to proposals made by any person or entity other than the Company, be voted in accordance with the vote of a majority of the Independent Directors; and (ii) 215,672 shares which were held in the claims reserves as of December 31, 1993 for holders of Reorganization Plan class 7 and Reorganization Plan classes 8A through 8D allowed claims, shall be voted in the same manner and the same degree as all of the allocated shares of Common Stock. (c) Dividends The Company has not paid any cash dividends on its Common Stock. Item 6. Item 6. Selected Financial Data ----------------------- Notes to Selected Financial Data (1) Expenses were offset by $5,218 and $3,055 of investment income for the years ended December 31, 1990 and 1989, respectively, that was estimated would not have been earned but for the Chapter 11 reorganization proceedings. Subsequent to the Effective Date, investment income is no longer offset against reorganization expenses. (2) Includes a 1992 write-off of unamortized original issue discount and unamortized issuance costs on the Senior Notes that were redeemed and a 1992 accrual of a distribution payable pursuant to the Reorganization Plan based on the Company's consolidated net worth as of December 31, 1992. Includes a 1991 accrual of a distribution payable pursuant to the Reorganization Plan based on the Company's consolidated net worth as of December 31, 1991 and a write- off of original issue discount on Senior Notes that were to be redeemed. Includes a 1990 gain with respect to the Independence Health Plan of Southeastern Michigan, Inc. settlement and the discharge of pre-petition liabilities pursuant to the Reorganization Plan (see "Item 8. Financial Statements and Supplementary Data - Note 3 to the Company's Consolidated Financial Statements"). (3) As provided in the Reorganization Plan, previously outstanding common stock was cancelled, and 10,000 shares of Common Stock were issued. Accordingly, per share information for 1990 was calculated by using the 10,000 shares plus common equivalent shares of stock options and Warrants when dilutive. Net loss per common and common equivalent share previously reported for 1989 was calculated based on 34,640 shares of old common stock. Therefore, the net loss per common and common equivalent share amount for 1989 is not comparable to 1993, 1992, 1991 and 1990 and, accordingly, has been omitted. (4) Includes long-term liabilities of $504, $1,015, $63,177, $63,388 and $12,323 in 1993, 1992, 1991, 1990 and 1989, respectively, and in 1989 pre-petition liabilities of $843,713. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition ----------------------------------------------------------- and Results of Operations ------------------------- The year ended December 31, 1993 compared to the year ended December -------------------------------------------------------------------- 31, 1992. --------- Maxicare Health Plans, Inc. (the "Company") reported net income of $5.6 million for the year ended December 31, 1993, compared to a net loss of $3.1 million, including extraordinary charges of $14.2 million, for the same period of 1992. Net income per common share available to common shareholders increased to $.02 for the year ended December 31, 1993 compared to a net loss per common share available to common shareholders of $.71 for the same period in 1992. For the year ended December 31, 1993, the Company reported operating revenues of $440.2 million, a 6% increase over the $414.5 million reported for the year ended December 31, 1992. The increase in revenues primarily results from the Company experiencing an increase in membership and modest premium rate increases. The increase in year-to-date operating revenues for 1993 was more than offset by an increase in health care expenses, contributing to a decrease in income from operations to $413,000 from $7.8 million for fiscal year 1992. Health care expenses increased for the year ended December 31, 1993 primarily because of a $7.0 million one-time charge reported in the third quarter of 1993 for previously unanticipated actual and projected health care costs. These costs primarily resulted from changes in the Indiana marketplace, the restructuring of relationships among the Company and its health care providers as well as unanticipated increases in high cost health care procedures. The provider network restructuring which began in mid 1992 has been substantially completed as of the first quarter of 1994. Marketing, general and administrative expenses increased $2.2 million to $41.0 million for the year ended December 31, 1993 as compared to 1992; however, these expenses have decreased as a percentage of operating revenues. The Company's consummation of the sale of $60 million of Series A preferred stock on March 11, 1992 and the redemption on April 13, 1992 of the entire outstanding principal, plus accrued interest on, the Senior Notes resulted in the Company reporting a $14.2 million extraordinary loss in the first quarter of 1992, the payment of $5.4 million in preferred stock dividends in 1993 and a decrease in year- to-date interest expense of $2.7 million for 1993 (see "Item 8. Item 8. Financial Statements and Supplementary Data ------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Board of Directors and Shareholders of Maxicare Health Plans, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Part IV Item 14(a)(1) and (2) on page 70 present fairly, in all material respects, the financial position of Maxicare Health Plans, 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 Note 2 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1991. PRICE WATERHOUSE Los Angeles, California March 4, 1994 MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands except par value) See notes to consolidated financial statements. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in thousands except per share data) See notes to consolidated financial statements. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands) See notes to consolidated financial statements. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Amounts in thousands) See notes to consolidated financial statements. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - BUSINESS DESCRIPTION Maxicare Health Plans, Inc., a Delaware corporation ("MHP"), is a holding company which owns various subsidiaries, primarily health maintenance organizations ("HMOs"). MHP operates HMOs in California, Indiana, Illinois, Louisiana, North Carolina, South Carolina and Wisconsin. All of MHP's HMOs are federally qualified by the United States Department of Health and Human Services and are generally regulated by the Department of Insurance of the state in which they are domiciled (except Maxicare, which is regulated by the California Department of Corporations). Maxicare Life and Health Insurance Company ("MLH"), a licensed insurance company and wholly-owned subsidiary of MHP, operates preferred provider organizations ("PPOs") or primary care provider network products in Indiana, Louisiana and California and represents approximately five percent (5%) of the consolidated enrollment of MHP and subsidiaries (the "Company") at December 31, 1993. In addition, MLH writes policies for group life and accidental death and dismemberment insurance; however, these lines of business make up less than one percent (1%) of the Company's operating revenues for the year ended December 31, 1993. NOTE 2-SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The accompanying consolidated financial statements include the accounts of the Company. All significant inter-company balances and transactions have been eliminated. Cash and Cash Equivalents For purposes of the Consolidated Statements of Cash Flows, the Company considers all highly liquid investments that are both readily convertible into known amounts of cash and mature within 90 days from their date of purchase to be cash equivalents. Cash and cash equivalents consist of the following at December 31: Marketable Securities Marketable securities are stated at the lower of amortized cost, which typically approximates market, or market value. Market value is estimated using published or broker quoted prices. Gains or losses on disposal of marketable securities are determined on a specific identification basis and are included in investment income in the Consolidated Statements of Operations. Included in investment income for the year ended December 31, 1993 is $375,000 of gains recognized on the sale of marketable securities. Marketable securities consist of the following at December 31: All bonds in which the Company has invested are rated A or better by Moody's or Standard and Poor's rating agencies. Accounts Receivable Accounts receivable consist of the following at December 31: Property and Equipment Property and equipment are recorded at cost and include assets acquired through capital leases and improvements that significantly add to the productive capacity or extend the useful life of the asset. Costs of maintenance and repairs are charged to expense as incurred. Depreciation for financial reporting purposes is provided on the straight-line method over the estimated useful lives of the assets. The costs of major remodeling and improvements are capitalized as leasehold improvements. Leasehold improvements are amortized using the straight-line method over the shorter of the remaining term of the applicable lease or the life of the asset. Statutory Deposits Statutory deposits include cash investments that are limited to specific purposes as required by federal regulations, regulations in states in which the Company operates or employer groups with which the Company contracts. The Company had $12.6 million and $11.4 million in such investments limited by federal or state regulations at December 31, 1993 and 1992, respectively, and $850,000 and $500,000 in such investments limited by employer groups at December 31, 1993 and 1992, respectively. These investments are stated at the lower of amortized cost, which approximates market, or market value. Market value is estimated using published or broker quoted prices. Intangible Assets Intangible assets are amortized using the straight-line method over five years. Accumulated amortization of intangible assets at December 31, 1993 and 1992 is $1.7 million and $1.6 million, respectively. Long-term Liabilities Long-term liabilities include reserves for various legal matters, including reserves for medical malpractice claims, and various other miscellaneous long-term liabilities. Reorganization Accounting Costs incurred relating to the reorganization of the Company under Chapter 11 of Title 11 of the United States Bankruptcy Code are reflected in the accompanying consolidated financial statements as reorganization expenses. These costs consisted primarily of legal, accounting, compensatory and financial consulting expenses. Revenue Recognition Premiums are recorded as revenue in the month for which the enrollees are entitled to health care service. Premiums collected in advance are deferred. A portion of premiums is subject to possible retroactive adjustment. Provision has been made for estimated retroactive adjustments to the extent the probable outcome of such adjustments can be determined. Any other revenues are recognized as services are rendered. Cost Recognition The cost of health care services is expensed in the period the Company is obligated to provide such services. Estimated claims payable includes claims reported as of the balance sheet date and estimated (based upon utilization trends and projections of historical developments) costs of health care services rendered but not reported. Reserves are continually monitored and reviewed and as settlements are made or reserves adjusted, differences are reflected in current operations. Insurance Due to the high costs of insurance coverages, the Company's operating entities, except in South Carolina, are self-insured for risks on certain medical and hospital claims incurred by their members. The Indiana operations were reinsured through August 31, 1991 by a wholly-owned subsidiary of MHP and have been self-insured for such risks subsequent to this date. The North Carolina HMO maintained reinsurance coverage with a third party insurance carrier through December 31, 1992 but subsequently has been reinsured through MLH. The South Carolina HMO continues to maintain reinsurance coverage with a third party insurance carrier. In addition, the Company's operating entities are self-insured for medical malpractice claims. Premium Deficiencies Estimated future health care costs and maintenance expenses under a group of contracts in excess of estimated future premiums and reinsurance recoveries on those contracts are recorded as a loss when determinable. Income Taxes In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). The Company elected to adopt the Statement for the year ended December 31, 1991. This Statement requires, among other things, recognition of future tax benefits measured by enacted tax rates, attributable to deductible temporary differences between financial statement and income tax bases of assets and liabilities and to net operating loss carryforwards ("NOLs") to the extent that realization of such benefits is more likely than not. Net Income (Loss) Per Common and Common Equivalent Share Primary earnings per share is computed by adjusting the net income (loss) for the preferred stock dividends in order to determine net income (loss) attributable to common shareholders. This amount is then divided by the weighted average number of common shares and common equivalent shares for stock options and warrants (when dilutive) outstanding during the period. Earnings per share assuming full dilution is reported when the assumption that the preferred stock is converted to Common Stock is dilutive. Earnings per share assuming full dilution is determined by dividing net income (loss) by the weighted average number of common shares and common stock equivalents for stock options and warrants and for preferred stock assumed converted to Common Stock (when dilutive). Stock Options With respect to stock options granted at an exercise price which is less than the fair market value on the date of grant, the difference between the option exercise price and market value at date of grant is charged to operations over the period the options vest. Income tax benefits attributable to stock options are credited to additional paid-in capital when exercised. Restriction on Fund Transfers Certain of the Company's operating subsidiaries are subject to state regulations which require compliance with certain deposit, reserve and net worth requirements. To the extent the operating subsidiaries must comply with these regulations, they may not have the financial flexibility to transfer funds to MHP. MHP's proportionate share of net assets (after inter-company eliminations) which, at December 31, 1993, may not be transferred to MHP by subsidiaries in the form of loans, advances or cash dividends without the consent of a third party is referred to as "Restricted Net Assets". Total Restricted Net Assets of these operating subsidiaries is $23.7 million at December 31, 1993, with deposit and reserve requirements representing $13.5 million of the Restricted Net Assets and net worth requirements, in excess of deposit and reserve requirements, representing the remaining $10.2 million. Total Restricted Net Assets at December 31, 1993 of $23.9 million includes restricted cash of $225,000 held by a non-operating subsidiary of MHP. Reclassifications Certain amounts for 1992 and 1991 have been reclassified to conform to the 1993 presentation. NOTE 3 - EXTRAORDINARY ITEMS On December 5, 1990 (the "Effective Date") the Company emerged from protection under Chapter 11 pursuant to the Company's joint plan of reorganization, as modified (the "Reorganization Plan") which provides that on December 31, 1991 and 1992 or within 90 days thereafter, the Company will make additional distributions, not to exceed $20.0 million in the aggregate, in an amount equal to its then consolidated net worth (as determined in the Company's audited consolidated financial statements) less $2.0 million (the "Consolidated Net Worth Distribution"). The Consolidated Net Worth Distribution will be distributed and applied in the following manner: 40% of the Consolidated Net Worth Distribution will be distributed ratably to the holders of certain allowed claims in accordance with the terms of the Reorganization Plan and the remaining 60% will be applied ratably against mandatory redemptions of the 13.5% Senior Notes due December 5, 2000 (the "Senior Notes") as set forth in the indenture governing the Senior Notes (the "Indenture"). On March 12, 1992, MHP noticed the redemption of the Senior Notes for April 13, 1992. In anticipation of this redemption, a $7.0 million extraordinary loss was recorded in the first quarter of 1992 for the write-off of unamortized original issue discount and unamortized issuance costs on the Senior Notes and an accrual for Senior Notes redemption costs. Also, a $7.2 million extraordinary loss ($20 million * 40% less $781,000 previously recorded) was reported in the first quarter of 1992 to accrue payments which may be made pursuant to the Reorganization Plan, based on the Company's consolidated net worth at December 31, 1992, to certain holders of allowed claims. The Company does not believe the Reorganization Plan contemplated either the issuance of convertible preferred stock (see Note 6) or the redemption of the Senior Notes, and accordingly, the Company believes the Consolidated Net Worth Distribution required by the Reorganization Plan should be calculated on a basis as if the sale of convertible preferred stock had not been consummated and the Senior Notes had not been redeemed. The Company has thus determined the December 31, 1992 Consolidated Net Worth Distribution amount to be approximately $971,000, which has been deposited for distribution to certain creditors under the Reorganization Plan. In addition, the Company believes that any Consolidated Net Worth Distribution which under the Reorganization Plan is to be utilized to redeem the Senior Notes is no longer due as the Senior Notes have been fully redeemed. Notwithstanding the foregoing, the Company has elected to accrue in its consolidated financial statements the maximum potential liability pending clarification of this matter. The amount that may be ultimately payable pursuant to this Reorganization Plan provision, if any, could be less than the amount accrued. The Consolidated Net Worth Distribution will be made from the Company's available cash. The Company's consolidated net worth of $4.0 million at December 31, 1991, before the recognition of the Consolidated Net Worth Distribution, resulted in an approximate $2.0 million Consolidated Net Worth Distribution payable being recorded in the fourth quarter of 1991 ($1.2 million representing the redemption of Senior Notes and $781,000 representing the distribution to holders of certain allowed claims). Payment of the December 31, 1991 Consolidated Net Worth Distribution was made in March 1992. The $781,000 distribution to holders of certain allowed claims, along with the write-off of $124,000 in original issue discount on the Senior Notes to be redeemed, was recorded as an extraordinary item in December 1991. NOTE 4 - LITIGATION The Company has reached a settlement agreement in principle with the State of Wisconsin regarding its appeal challenging confirmation of the Reorganization Plan on jurisdictional grounds. Pursuant to the agreement, a reorganization plan for Maxicare Health Insurance Company, a Wisconsin HMO subsidiary of MHP ("MHIC"), in accordance with Wisconsin state law, will be submitted without prejudice for approval by the Wisconsin State Court. Under the terms of the agreement in principle, MHIC's reorganization under Wisconsin law must be on terms consistent with the Reorganization Plan. The Company believes the implementation of the agreement in principle will have no material adverse impact on the Company's business or its operations. The agreement is subject to approval by the United States Bankruptcy Court and the non-occurence of certain contingencies. In the event the settlement cannot be implemented, the Company may pursue the appeal. If prosecution of the appeal resumes and the United States District Court's ruling is upheld after MHIC's appellate rights have been exhausted, creditors of MHIC will likely only have the protections and recoveries afforded under applicable state law. The Company believes that it has a meritorious position and will prevail on its appeal of the United States District Court's ruling, if prosecution of the appeal resumes. On March 12, 1993, MH Healthcare, Affiliate of Methodist Hospital of Indiana, Inc. ("MH") submitted a demand (the "Demand") to the American Arbitration Association (the "AAA") for arbitration of a contractual dispute between MH and Maxicare Indiana, Inc. ("Indiana") concerning interpretation of the provisions of a Master Agreement dated February 8, 1988, as subsequently amended, (the "Agreement") by and among MHP, Indiana and MH. Based on the Pre- Hearing Statement which MH submitted to the Arbitrator and communications with MH, the Company has been advised that MH is seeking a damage award of approximately $7.9 million plus interest. In the event MH prevails in the arbitration, there may be an additional amount due to MH for the 1993 contract year. Indiana disputes the allegations of the Demand and MH's damages computation and has asserted a counterclaim to the Demand to recover overpayments erroneously made to MH under the Agreement. The Company believes that Indiana has meritorious defenses to the Demand and that Indiana will prevail in the arbitration. In the event MH is awarded damages in an amount which proximates the damages MH contends it is entitled to, and such award is upheld on review, the award could have an adverse financial impact on Indiana and the Company. The Company is involved in litigation arising in the normal course of business, which, in the opinion of management, will not adversely affect the Company's consolidated financial position. NOTE 5 - COMMITMENTS AND OTHER CONTINGENCIES Excluded Cash Claims Reserve On the Effective Date, the Company estimated that payments to administration creditors and holders of allowed priority tax claims, allowed claims of secured creditors, enrollee claims, allowed priority employee claims and allowed convenience claims (the "Excluded Cash claims") would not exceed $10.3 million; however, if required the Reorganization Plan further provides for the payment of up to $16.0 million of such claims. Pursuant to a stipulation, the creditor committees agreed, provided the creditors have received the full amount of minimum cash pursuant to the Reorganization Plan ($77.3 million), to make up to the $5.7 million differential out of cash proceeds from the sales of assets or the settlement of litigation which were transferred to a trust established for the benefit of creditors pursuant to the Distribution Trust Agreement in order to provide for the payment of these claims in excess of $10.3 million. In the event that the Company's exposure to these claims significantly exceeds $16.0 million, this could have a material adverse effect on the viability of the Reorganization Plan and the Company's business and operations. The Company believes that reserves for the Excluded Cash claims will be adequate to satisfy these claims. Leases The Company has operating leases, some of which provide for initial free rent and all of which provide for subsequent rent increases. Rental expense is recognized on a straight-line basis with rental expense of $2.7 million, $2.8 million and $2.8 million reported for the years ended December 31, 1993, 1992 and 1991, respectively. Sublease rental revenue of $209,000, $198,000, $191,000 is reported for the years ended December 31, 1993, 1992 and 1991, respectively. Assets held under capital leases at December 31, 1993 and 1992 of $153,000 and $761,000, respectively, (net of $1.6 million and $1.1 million, respectively, of accumulated amortization) are comprised primarily of equipment leases. Amortization expense for capital leases is included in depreciation expense. Future minimum lease commitments for noncancelable leases at December 31, 1993 were as follows: Total future minimum rentals to be received under noncancelable operating subleases at December 31, 1993 were as follows: NOTE 6 - CAPITAL STOCK On March 9, 1992 the shareholders voted to amend MHP's current Restated Certificate of Incorporation to increase the authorized Capital Stock of the Company from 18 million shares to 45 million shares through: (i) an increase in the amount of authorized Common Stock of the Company, par value $.01, from 18 million shares to 40 million shares, and (ii) the authorization of 5 million shares of Preferred Stock of which 2.5 million shares will be designated Series A Cumulative Convertible Preferred Stock, par value $.01, ("Series A Stock"). Preferred Stock MHP entered into Stock Purchase Agreements dated December 17, 1991 and January 31, 1992 (the "Purchase Agreements"), pursuant to which, MHP issued an aggregate of 2,400,000 shares of Series A Stock to certain institutional investors in a private placement at a purchase price of $25.00 per share. Each share of Series A Stock accrues quarterly cash dividends at an annual rate of $2.25 per share and is currently convertible into approximately 2.7548 shares of Common Stock. The stock conversion ratio is subject to adjustment upon the occurrence of certain events. The transactions contemplated by the Purchase Agreements were consummated on March 11, 1992. Upon any liquidation, dissolution or winding up of the Company, holders of the Series A Stock are entitled to receive a preferential payment equal to $25.00 per share, plus all accrued and unpaid dividends. In the event of a sale of all or substantially all of the Company's stock or assets, or under certain circumstances, if the Company merges or combines with another entity, holders of the Series A Stock, at the election of holders of at least 75% of the Series A Stock then outstanding, may request to have their Series A Stock redeemed in which case they will receive a redemption price equal to the liquidation preference amount described above. In certain circumstances, the Company will have the right to redeem the Series A Stock at a redemption price of $25.00 per share, plus all accrued and unpaid dividends. Additionally, the Company may not create, issue, or increase the authorized number of shares of any class or series of stock which will rank senior to the Series A Stock as to liquidation rights without the affirmative vote or consent of holders of at least sixty-six and two-thirds percent (66 2/3%) of the outstanding shares of Series A Stock. Common Stock On the Effective Date, the Company issued 10.0 million shares of Common Stock to itself, as disbursing agent for the benefit of holders of allowed claims, interest and equity claims under the Reorganization Plan. The shares of Common Stock will be validly issued, fully paid and nonassessable upon issuance pursuant to the Reorganization Plan in accordance with the terms thereof. The Common Stock has been recorded at a value equal to the book value of the old common stock, less issuance costs. The Certificate of Incorporation of the Company prohibits the issuance of certain non- voting equity securities as required by the United States Bankruptcy Code. Stock Option Plans Pursuant to the Reorganization Plan, Messrs. Ratican and Froelich ("Senior Management") each received options to purchase up to 277,778 shares of Common Stock at a price of $6.54 per option share. At December 31, 1991, 100% of these options were fully vested. The difference of $905,000 between the option exercise price and market value at date of grant was charged to operations and accrued as a liability during 1991. As of January 1, 1992, the Company entered into employment agreements with Senior Management. Under the terms of these employment agreements, each member of Senior Management received on February 25, 1992 options to purchase up to 150,000 shares of Common Stock at a price of $8.00 per option share. One third of the options vested on the date of grant and one third of the options vest on both the first and second anniversaries of the date of grant. In December of 1990, the Company approved the 1990 Stock Option Plan (the "Stock Option Plan"). Under the terms of the Stock Option Plan, as amended, the Company may issue up to an aggregate of 1,000,000 stock options to directors, officers and other employees. Warrants In accordance with the Reorganization Plan, the Company issued warrants to itself, as disbursing agent for the allowed interests and equity holder claims. Upon issuance of the warrants (the "Warrants"), to these holders pursuant to the terms of the Reorganization Plan, the registered holders thereof will be entitled to purchase, in the aggregate, 555,555 shares of Common Stock. Such Warrants (i) are exercisable for the period commencing 180 days after the first distribution date and ending on December 5, 1995, (ii) bear an exercise price of $9.98 per Warrant, and (iii) have such other terms and conditions (including the right of the Company, at its option, to redeem the Warrants). As of December 31, 1993, 12 Warrants have been exercised for the purchase of Common Stock. NOTE 7 - INCOME TAXES The benefit for income taxes at December 31 consisted of the following: The federal and state deferred tax liabilities (assets) are comprised of the following at December 31: The differences between the benefit for income taxes at the federal statutory rate of 34% and that shown in the Consolidated Statements of Operations are summarized as follows for the years ended December 31: Upon the Effective Date of the Reorganization Plan, the Company experienced a "change of ownership" pursuant to applicable provisions of the Internal Revenue Code. As a result of the ownership change, the Company's utilization of pre-change NOLs is limited to $6.3 million per year. In the event the annual amount is not fully utilized, the Company is allowed to carryover such amount to subsequent years during the carryover period. Should the Company experience a second "change of ownership", the annual limitations on NOLs would be recalculated. FAS 109 requires that the tax benefit of such NOLs be recorded as an asset to the extent that management assesses the utilization of such NOLs to be more likely than not. Management has estimated, based on the Company's recent history of operating results and its expectations for the future, that future taxable income of the Company will more likely than not be sufficient to utilize a minimum of approximately $15 million of NOLs. Accordingly, the Company recorded an increase of $2.8 million in 1993 to its deferred tax asset, from $3.2 million recorded as of December 31, 1992, resulting in an aggregate deferred tax asset of $6.0 million recorded as of December 31, 1993 for the recognition of anticipated future utilization of NOLs. The maximum amount of remaining NOLs that may be utilized in future years before expiring in the years 2002 to 2006 is limited to approximately $87 million. The Company's income before taxes for financial statement purposes for the period of 1991 to 1993 was impacted by the incurrence of reorganization expenses and interest expense on the Senior Notes. The Company incurred reorganization expenses of $3.7 million and $895,000 in 1991 and 1992, respectively. The Company incurred interest expense related to the Senior Notes, which were issued in December of 1990 and redeemed in March of 1992, in the amounts of $9.5 million and $2.7 million in 1991 and 1992, respectively. Excluding reorganization expenses and interest expense on the Senior Notes, the Company's cumulative pre-tax income for the period of 1991 to 1993 would have been approximately $29.4 million on a pro forma basis after reflecting these adjustments. Quarterly Results of Operations (Unaudited) The following is a tabulation of the quarterly results of operations for the years ended December 31: (1) Includes a $2.8 million tax benefit from the recording of a deferred tax asset in the fourth quarter of 1993 (see "Item 8. Financial Statements and Supplementary Data - Note 7 to the Company's Consolidated Financial Statements"). (2) Earnings per share are computed on a primary basis for the three months ended March 31, June 30 and September 30, 1993 due to the anti-dilutive effect of the assumed conversion of the Company's Preferred Stock to Common Stock. Earnings per share assuming full dilution are reported for the three months ended December 31, 1993 due to the dilutive effect of assuming conversion of the Company's Preferred Stock to Common Stock for that period. (3) Includes a $3.2 million tax benefit from the recording of a deferred tax asset in the fourth quarter of 1992 (see "Item 8. Financial Statements and Supplementary Data - Note 7 to the Company's Consolidated Financial Statements"). (4) A $7.0 million extraordinary loss was recorded in the first quarter of 1992 for the write-off of unamortized original issue discount and unamortized issuance costs on the Senior Notes and an accrual for the Senior Notes redemption costs. Also, a $7.2 million extraordinary loss was reported in the first quarter of 1992 to accrue payments which may be made pursuant to the Reorganization Plan, based on the Company's consolidated net worth at December 31, 1992, to certain holders of allowed claims (see "Item 8. Financial Statements and Supplementary Data - Note 3 to the Company's Consolidated Financial Statements"). Item 9. Item 9. Changes in and Disagreements with Accountants on ------------------------------------------------ Accounting and Financial Disclosures ------------------------------------ None PART III -------- Item 10. Item 10. Directors, Executive Officers, Promoters and Control ---------------------------------------------------- Persons of the Registrant ------------------------- The information set forth in the table, the notes thereto and the paragraphs thereunder, in Part I, Item 1. of this Form 10-K under the caption "Directors and Executive Officers of the Registrant" is incorporated herein by reference. During 1993, a report required by Section 16(a) of the Securities Exchange Act of 1934 covering the initial statement of beneficial ownership of the Company's securities for Florence F. Courtright was not filed on a timely basis; however, such report was subsequently filed. In making this statement, the Company has relied on the written representations of its incumbent directors and officers and copies of the reports that they have filed with the Commission. Item 11. Item 11. Executive Compensation ---------------------- Shown below is information concerning the annual and long-term compensation for services in all capacities to the Company for the years ended December 31, 1993, 1992 and 1991, of those persons who were, at December 31, 1992 (i) the chief executive officer and (ii) the other four most highly compensated executive officers of the Company (collectively the "Named Officers"): (1) Excludes distributions received during the year ended December 31, 1992 paid with respect to claims for pre-petition compensation paid pursuant to the Reorganization Plan. (2) These amounts are bonuses payable pursuant to the Reorganization Plan and were paid from funds held by the Disbursing Agent in a segregated account and were not paid out of the Company's available cash. (3) These amounts include contributions made by the Company on behalf of the Named Officer under the Company's 401(k) Savings Incentive Plan. (4) In accordance with the transitional provisions applicable to the revised rules on executive officer and director compensation disclosure adopted by the Securities and Exchange Commission, as informally interpreted by the Commission's Staff, amounts of Other Annual Compensation and All Other Compensation are excluded for the Company's 1991 fiscal year. (5) William B. Caswell's employment at the Company began in February 1992. Option Grants ------------- Shown below is further information on grants of stock options pursuant to the 1990 Incentive Stock Option Plan during the year ended December 31, 1993, to the Named Officers which are reflected in the Summary Compensation Table. (1) The options were granted as of December 20, 1993 and vest in one- third installments on the first, second and third anniversaries of the date of grant. If the grantee's employment is terminated under certain circumstances or there is a restructuring of the Company (as set forth in the option agreement) these options would become immediately exercisable. (2) The option exercise price is subject to adjustment in the event of a stock split or dividend, recapitalization or certain other events. (3) The actual value, if any, the Named Officer may realize will depend on the excess of the stock price over the exercise price on the date the option is exercised, so that there is no assurance the value realized by the Named Officer will be at or near the value estimated. This amount is net of the option exercise price. Option Exercises and Fiscal Year-End Values ------------------------------------------- Shown below is information with respect to the unexercised options to purchase the Company's Common Stock granted in fiscal 1993 and prior years under employment agreements and the 1990 Incentive Stock Option Plan to the Named Officers and held by them at December 31, 1993. None of the Named Officers exercised any stock options during fiscal 1993. (1) Based on the closing price on the NASDAQ-NMS on that date ($9.75), net of the option exercise price. Employment Agreements --------------------- As of January 1, 1992, the Company has entered into five-year employment agreements with Peter J. Ratican and Eugene L. Froelich ("Senior Management"). These employment agreements provide for annual base compensation of $425,000 for Mr. Ratican and $325,000 for Mr. Froelich, subject to increases and bonuses, as may be determined by the Board based on annual reviews. The employment agreements provide that upon the termination of either member of Senior Management by the Company without Cause or reasons other than death or incapacity or the voluntary termination by either member of Senior Management for certain reasons as set forth in their employment agreements, the terminated member will be entitled to receive (i) a payment equal to the balance of the terminated member's annual base salary which would have been paid over the remainder of the term of the employment agreement; (ii) an additional one year's annual base salary; (iii) payment of any performance bonus amounts which would have otherwise been payable over the remainder of the term of the agreement; (iv) immediate vesting of all stock options; (v) the continuation of the right to participate in any profit sharing, bonus, stock option, pension, life, health and accident insurance, or other employee benefits plans including a car allowance through December 31, 1996. Cause is defined as: (i) the willful or habitual failure to perform requested duties commensurate with his employment without good cause; (ii) the willful engaging in misconduct or inaction materially injurious to the Company; or (iii) the conviction for a felony or of a crime involving moral turpitude, dishonesty or theft. In the event of a Change in Control of the Company, either member may elect to terminate the employment contract in which case the electing member will be entitled to receive a payment equal to 2.99 times that member's average annualized compensation from the Company over a certain period. Change of Control is defined as: (i) any transaction or occurence which results in the Company ceasing to be publically owned with at least 300 stockholders; (ii) any person or group becoming beneficial owner of more than forty percent (40%) of the combined voting power of the Company's outstanding securities; (iii) a change in the composition of the Board, as set forth in the employment agreement; (iv) the merger or consolidation of the Company with or into any other non-affiliated entity whereby the Company's equity security holders, immediately prior to such transaction, own less than sixty percent (60%) of the equity; or (v) the sale or transfer of all or substantially all of its assets. In the event of death or incapacity, the member, or his estate, shall receive the equivalent of ninety (90) days base salary and in the case of incapacity, the continuation of health and disability benefits. The employment agreements also provide that in the event either member of Senior Management does not receive an offer for a new employment agreement containing terms at least as favorable as those contained in the existing employment agreements before the expiration of such employment agreements, such member will be entitled to receive a payment equal to one year's base salary under the terminating agreement. Under these agreements, each member of Senior Management will be entitled to receive an annual performance bonus calculated using a formula, as set forth in the employment agreements, which is based on the Company's annual pre-tax earnings, before extraordinary items, over $10 million. In addition, upon the sale of the Company, a sale of substantially all of its assets or a merger where the Company shareholders cease to own a majority of the outstanding voting capital stock, Senior Management will be entitled to a sale bonus calculated using a formula which is based on a percentage of the excess value of the Company over an initial value as set forth in the employment agreements. In addition, Senior Management remains entitled to receive certain additional compensation out of funds set aside for distribution under the Reorganization Plan on the Effective Date or from the proceeds of assets liquidated on behalf of pre-petition creditors under the Reorganization Plan. As of January 1, 1993 the Company entered into an employment agreement, effective through December 31, 1994, with Richard A. Link. As of January 1, 1994 the Company entered into an employment agreement, effective through December 31, 1994, with Alan D. Bloom and an employment agreement, effective through December 31, 1995, with William B. Caswell. The contracts provide a minimum base salary of $197,500, $203,000 and $195,000 for Messrs. Link, Bloom and Caswell, respectively, subject to increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. The contract with Mr. Caswell also provides that: (i) should he die, his estate shall receive the equivalent of thirty (30) days base salary; (ii) should the Company terminate his employment prior to the first anniversary of the contract for any reason other than death, incapacity, or Cause, he shall receive the equivalent of his annual base salary; (iii) should the Company terminate his employment on or after the first anniversary of the contract for any reason other than death, incapacity, or Cause, he shall receive the amount of the remainder of his annual base salary as would have been paid had the contract not been terminated which amount shall in no event be less than the equivalent of six (6) months base salary; and (iv) should his employment be terminated for any reason other than death, voluntary resignation, incapacity or Cause within six (6) months of a Change of Control, he shall receive the equivalent of his annual base salary. Cause is defined as (i) the willful and continued failure to perform duties pursuant to the employment agreement without good cause; (ii) the willful engaging in misconduct or inaction materially injurious to the Company; or (iii) the conviction of a felony or of a crime involving moral turpitude. Change of Control is defined as (i) the merger or consolidation of the Company with or into any other non- affiliated entity whereby the Company's equity security holders, immediately prior to such transaction, own less than fifty percent (50%) of the equity; or (ii) the sale or transfer of all or substantially all of its assets. The contracts with Messrs. Link and Bloom provide that should their employment be terminated under certain circumstances, they would receive up to the equivalent of four (4) months base salary. Compensation of Directors ------------------------- During 1993, certain members of the Board received compensation for their services as directors. These members included Claude Brinegar, Leon Clements, Florence Courtright, Thomas Field, Jr., Walter Filkowski and Charles Lewis and they received cash payments of $33,000, $29,250, $6,000, $31,500, $6,000 and $30,750, respectively. During 1994, current directors, excluding directors who are also officers of the Company, will receive compensation for their services in the amount of $24,000 per year, plus $750 per meeting. In addition, these directors are entitled to be reimbursed for all of their reasonable out-of-pocket expenses incurred in connection with their services as directors of the Company. Non-employee directors of the Company have received options to purchase shares of Common Stock which are immediately exercisable at an exercise price equal to the market price at the date of grant. Set forth below is a schedule of the outstanding options at December 31, 1993 held by each of the current and former directors, the date of grant and the exercise price of such options: Provided these directors continue to serve as directors of the Company, the exercise term of these options is five years. If the directorship is terminated, the options expire thirty (30) days from the date of such termination. Upon the expiration of his term as a director on February 10, 1993, the Board voted to extend the period in which Mr. Filkowski could exercise his options to one year from the termination date of his directorship. In February 1994, Mr. Filkowski exercised all options held. Compensation Committee Interlocks and Insider Participation ----------------------------------------------------------- Peter Ratican, the Company's President and Chief Executive Officer, served as an ex-officio member of the Compensation Committee of the Company for the year ended December 31, 1993. Although Mr. Ratican served as an ex-officio member of this Compensation Committee, he did not participate in any decisions regarding his own compensation as an executive officer. The Company's Board of Directors as a whole determines Mr. Ratican's total compensation package. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and --------------------------------------------------- Management ---------- The following table sets forth the number and percentage of the outstanding shares of Common Stock and Series A Stock owned beneficially as of December 31, 1993 by each director or nominee for director as of such date, by the Company's chief executive officer ("CEO"), by the four other most highly compensated executive officers other than the CEO, by all directors and executive officers as a group, and by each person who, to the knowledge of the Company, beneficially owned more than 5% of any class of the Company's voting stock on such date. ------------------------- * - Less than one percent ------------------------- * - less than one percent (1) Except as otherwise set forth herein, all information pertaining to the holdings of persons who beneficially own more than 5% of any class of the Company's voting stock (other than the Company or its executive officers and directors) is based on filings with the Securities and Exchange Commission and information provided by the record holders. (2) In setting forth "beneficial" ownership, the rules of the Securities and Exchange Commission require that shares underlying currently exercisable options or issuable upon conversion of the Series A Stock, including options which become exercisable within 60 days, held by a described person be treated as "beneficially" owned and further require that every person who has or shares the power to vote or to dispose of shares of stock be reported as a "beneficial" owner of all shares as to which any such sole or shared power exists. As a consequence, shares which are not yet outstanding are, if obtainable upon exercise of an option which is exercisable or will become exercisable within sixty (60) days or upon conversion of the Series A Stock, nevertheless treated as "beneficially" owned by the designated person, and several persons may be deemed to be the "beneficial" owners of the same securities if they share the power to vote or dispose of them. (3) In the event that a tender offer for the Company's shares of Common Stock is commenced prior to the final distribution of the Company's Common Stock pursuant to the Reorganization Plan, the committee elected to oversee the implementation of the Reorganization Plan after the Effective Date (the "New Committee") will have certain rights to direct the tender of the Unallocated Shares. The New Committee disclaims beneficial ownership over any such shares. (4) Assumes 10,033,345 shares of Common Stock outstanding, the conversion of all 2,400,000 shares of Series A Stock outstanding (or 6,611,520 shares) and, with respect to each listed beneficial owner, the exercise or conversion of any option, warrant or right held by each such owner exercisable or convertible within 60 days. (5) These shares are held by the Company, as disbursing agent for the benefit of holders of Reorganization Plan classes 5A through 5H, 7 and 8A through 8D allowed claims and Reorganization Plan class 12 allowed interests and equity holder claims. The Company disclaims beneficial ownership of these shares. For information concerning the voting of these shares, see "General Information - Outstanding Shares and Voting Rights". (6) Cede & Co. holds these shares as a nominee for the Depository Trust Company, which is the securities depository for various segments of the financial industry. None of these shares are owned beneficially by Cede & Co. Includes 1,228,725 shares beneficially owned by Chilmark Capital Corp. and Neil Jonathan Weisman; for further information with respect to these shares, see footnote (7), below. (7) Includes 40,000 shares of Common Stock held by the Chilmark Capital Corp. ("Chilmark") profit sharing plan, and 755,100 shares of Common Stock held in a partnership, of which, Chilmark is general partner and 433,625 shares of Common Stock held for two managed accounts for which Chilmark has investment discretion. Neil Jonathan Weisman is president and sole shareholder of Chilmark. (8) Includes 427,778 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (9) On December 5, 1990, the effective date of the Reorganization Plan, Messrs. Ratican, Lewis, Bloom and Clements held 350; 490; 150 and 2,000 shares, respectively, of common stock of Maxicare Health Plans, Inc., a California corporation ("MHP"), the Company's predecessor in interest; Mr. Ratican's shares were held in his individual retirement account. These shares were cancelled as of that date in accordance with the terms of the Reorganization Plan. As a result, Messrs. Ratican, Lewis, Bloom and Clements each holds a class 12 claim under the Reorganization Plan which will entitle Mr. Ratican to receive 2 shares of Common Stock and 5 warrants, Dr. Lewis to receive 2 shares of Common Stock and 8 warrants, Mr. Bloom to receive 2 warrants and Mr. Clements to receive 11 shares of Common Stock and 32 warrants. The total number of shares of Common Stock and warrants which these individuals will receive are excluded from the shares disclosed as beneficially owned. (10) All shares (and the calculation of the percentage owned assumes such shares are outstanding) are subject to options which are currently exercisable. (11) Includes 6,666 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (12) Includes 46,664 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (13) Includes 16,667 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (14) Includes 20,000 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. (15) Does not include the Unallocated Shares, held of record by the Company. Under certain circumstances, the Independent Directors, currently Messrs. Brinegar and Lewis and Ms. Courtright, have rights to vote the Unallocated Shares. The Independent Directors disclaim beneficial ownership of these shares. For further information on the voting of these shares, see "General Information - Outstanding Shares and Voting Rights", above. (16) Dr. Lewis, a director of the Company, is employed by a creditor and/or affiliate of a creditor which have filed claims under the Reorganization Plan which may entitle such creditor, or affiliate thereof, to receive distributions of Common Stock. The total number of shares of Common Stock which these creditors will receive has not yet been determined. Dr. Lewis disclaims beneficial ownership of these shares. (17) The shares of Common Stock and Series A Stock are held by Mellon Bank, N.A., acting as trustee (the "Trustee") under two separate trust agreements for the General Motors employee pension trusts (the "Trusts"). The Trustee may act for the Trusts with respect to such shares only pursuant to direction of one of the Trusts' applicable investment managers. General Motors Investment Management Corporation ("GMIMCo") is the investment manager with respect to 200,000 shares (in the aggregate) of Series A Stock. The shares of Series A Stock are convertible into an aggregate of 819,002 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to these holders. Investment and disposition decisions regarding the shares of Series A Stock and Common Stock managed by the Trusts' other investment managers are made by the personnel of such managers, who act independently of GMIMCo, although the continued engagement of such managers as investment managers for the Trusts is subject to the authorization of GMIMCo. Because of the Trustee's limited role, beneficial ownership of the shares of Series A Stock and Common Stock by the Trustee is disclaimed. (18) Includes 12,200 shares of Common Stock and 190,000 shares of Series A Stock held in a fiduciary capacity by J.P. Morgan and Co. Incorporated through its subsidiaries J.P. Morgan Investment Management, Inc. and Morgan Guaranty Trust Company of New York. All shares of Common Stock and Series A Stock are subject to the sole dispositive authority of these subsidiaries of J.P. Morgan and Co. Incorporated and the shares of Series A Stock are subject to the sole voting authority of these entities. The shares of Series A Stock are convertible into an aggregate of 523,412 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to these holders. (19) The shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to these holders. None of the holders currently hold shares of Common Stock. (20) All shares are held on behalf of institutional investors and are subject to the sole voting and dispositive authority of Froley, Revy Investment Co., Inc. (21) Mutual Series Fund Inc. (the "Fund") is an investment company consisting of four separate series of stock. Two of the series, namely, Mutual Beacon Fund and Mutual Qualified Fund, are the beneficial owners of 58,000 shares and 130,100 shares, respectively, of Series A Stock. The shares owned by these funds are registered in nominee name. Pursuant to investment advisory contracts with each of the series, Heine Securities Corporation ("Heine"), an investment advisor, and Michael F. Price, president of Heine, have sole investment and voting power over the securities beneficially owned by the series. However, Heine and Mr. Price disclaim any beneficial ownership in such shares owned by the Fund. (22) Linder Fund, Inc. ("Linder") is an investment company which beneficially owns 507,500 shares of Common Stock and 193,500 shares of Series A Stock. The shares owned by Linder are registered in nominee name. Pursuant to an investment advisory contract with Linder, Ryback Management Corporation, an investment advisor, shares investment and voting power over the securities beneficially owned by Linder. The shares of Series A Stock are convertible into an aggregate of 533,054 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to these holders. (23) Includes 568,000 shares of Common Stock and 100,000 shares of Series A Stock held in a fiduciary capacity by Snyder Capital Management, Inc. ("Snyder"), an investment advisor for a number of investors. No individual investor beneficially owns more than 5% of any class of the Company's voting stock. Snyder has sole voting power over 47,000 shares of Common Stock and 63,600 shares of Series A Stock. Voting power is shared by Snyder on 442,000 shares of Common Stock and 31,500 shares of Series A Stock. The shares of Series A Stock are convertible into an aggregate of 275,480 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to this holder. (24) Includes 92,199 shares of Common Stock and 328,500 shares of Series A Stock held in a fiduciary capacity by Smith Barney Shearson Inc. ("SBS"), a registered broker/dealer. Smith Barney Shearson Holdings Inc. ("SBH") is the sole common shareholder of SBS and The Travelers Inc. ("TRV") is the sole shareholder of SBH. However, SBH and TRV disclaim any beneficial ownership in such shares. The shares of Series A Stock are convertible into an aggregate of 904,952 shares of Common Stock; the shares of Common Stock issuable upon conversion of the Series A Stock are included in the number of shares of Common Stock attributable to this holder. SBS has sole voting power over approximately 915,315 shares, including those shares issuable upon conversion of Series A Stock. (25) Bear Stearns Securities Corp. is the record holder of these shares; however, all shares are held on behalf of investors. Bear Stearns Securities Corp. disclaims beneficial ownership of all shares. (26) Includes 1,093,880 shares which are subject to options which are currently exercisable or will become exercisable within 60 days. Also, on December 5, 1990, the Effective Date of the Reorganization Plan, certain officers and directors of the Company held an aggregate of 3,790 shares of common stock of MHP, the Company's predecessor in interest. These shares were cancelled as of that date in accordance with the terms of the Reorganization Plan. As a result, these executive officers and directors each holds a class 12 claim under the Reorganization Plan which entitle them to receive an aggregate of 19 shares of Common Stock and 60 warrants to purchase Common Stock. The total number of shares of Common Stock and warrants which these individuals will receive are excluded from the shares disclosed as beneficially owned. 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 The following consolidated financial statements of Maxicare Health Plans, Inc. and subsidiaries are included in this report in response to Item 8. Report of Independent Accountants Consolidated Balance Sheets - At 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 Changes in Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements (a) 2. Financial Statement Schedules Schedule I - Marketable Securities and Other Investments at December 31, 1993 Schedule III - Condensed Financial Information of Registrant - Condensed Balance Sheets at December 31, 1993 and 1992, Condensed Statements of Operations and Condensed Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991, Notes to Condensed Financial Information of Registrant Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 Schedule VIII - Valuation and Qualifying Accounts for the years ended December 31, 1993, 1992 and 1991 (a) 3. Exhibits 2.1 Joint Plan of Reorganization dated May 14, 1990, as modified on May 24 and July 12, 1990 (without schedules)* 2.2 Order Confirming Joint Plan of Reorganization dated May 14, 1990, as Modified, entered on August 31, 1990 (without exhibits or schedules)* 2.3 Amendment to Order Confirming Joint Plan of Reorganization dated May 14, 1990, as Modified, entered on August 31, 1990* 2.4 Stipulation and Order Re Conditions to Effectiveness of the Plan, entered on December 3, 1990* 2.5 Notice That The Conditions to Effectiveness of the Plan Have Been Met or Waived, filed on December 4, 1990* 2.6 Agreement and Plan of Merger of Maxicare Health Plans, Inc. and HealthCare USA Inc., dated as of December 5, 1990 (without exhibits or schedules)* 3.1 Charter of Maxicare Health Plans, Inc., a Delaware corporation* 3.3 Amendment to Charter of Maxicare Health Plans, Inc., a Delaware corporation@ 3.4 Amended Bylaws of Maxicare Health Plans, Inc., a Delaware corporation 4.1 Form of Certificate of New Common Stock of Maxicare Health Plans, Inc.* 4.2 Form of Certificate of Warrant of Maxicare Health Plans, Inc.* 4.4 Warrant Agreement by and between Maxicare Health Plans, Inc. and American Stock Transfer & Trust Company, dated as of December 5, 1990* 4.5 Stock Transfer Agent Agreement by and between Maxicare Health Plans, Inc., and American Stock Transfer & Trust Company, dated as of December 5, 1990* 4.6 Registration Undertaking by Maxicare Health Plans, Inc., dated as of December 5, 1990* 4.8 Portions of Charter of Maxicare Health Plans, Inc., relating to the rights of holders of the New Common Stock, the Warrants, or the New Senior Notes* 4.9 Portions of Bylaws of Maxicare Health Plans, Inc., relating to the rights of holders of the New Common Stock, the Warrants, or the New Senior Notes* 4.10 Series A Cumulative Convertible Preferred Stock Purchase Agreement dated as of December 17, 1991** 4.11 Series A Cumulative Convertible Preferred Stock Purchase Agreement dated as of January 31, 1992** 4.12 Form of Certificate of Preferred Stock of Maxicare Health Plans, Inc.@ 10.1 Management Incentive Program* 10.2 Incentive Compensation Agreement* 10.3b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of January 1, 1992@ 10.4b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich dated January 1, 1992@ 10.5b Employment Agreement by and between Maxicare Health Plans, Inc. and Samuel W. Warburton, dated as of January 1, 1993@@ 10.7c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of January 1, 1993@@ 10.7d Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of January 1, 1994 10.8b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of January 1, 1993@@ 10.8c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of January 1, 1994 10.9c Form of Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of January 1, 1993@@ 10.12c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of January 1, 1993@@ 10.12d Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of January 1, 1994 10.14 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of December 5, 1990* 10.15 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich, dated as of December 5, 1990* 10.16 Form of Stock Option Agreement by and between Maxicare Health Plans, Inc. and Samuel Warburton, dated as of December 5, 1990* 10.18 Form of Stock Option Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of December 5, 1990* 10.19 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of December 5, 1990* 10.20 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of December 5, 1990* 10.23 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 5, 1990* 10.28 Form of Distribution Trust Agreement* 10.29 Lease by and between Maxicare Health Plans, Inc. and Transamerica Occidental Life Insurance Company, dated as of June 1, 1990* 10.30 Maxicare Health Plans, Inc. 401(k) Plan* 10.32 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Leon M. Clements, dated as of May 20, 1991@ 10.33 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Walter J. Filkowski, dated as of May 20, 1991@ 10.35 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Charles E. Lewis, dated as of May 20, 1991@ 10.36 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Claude S. Brinegar, dated as of July 18, 1991@ 10.38 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of December 20, 1991@ 10.40 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 20, 1991@ 10.41 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Samuel W. Warburton, dated as of December 20, 1991@ 10.42 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of February 25, 1992@ 10.43 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich, dated as of February 25, 1992@ 10.44 Amended Maxicare Health Plans, Inc. 1990 Stock Option Plan@ 10.48 Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of January 8, 1992@@ 10.48a Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of January 1, 1994 10.49 Stock Option Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of February 3, 1992@@ 10.50 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Thomas W. Field, Jr., dated as of April 1, 1992@@ 10.51b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of January 1, 1993@@ 10.51c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of January 1, 1994 10.52 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 5, 1990@@ 10.53 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 20, 1991@@ 10.54 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Florence Courtright, dated as of November 5, 1993 10.55 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of December 20, 10.56 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of December 20, 10.57 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard Link, dated as of December 20, 10.58 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 20, 1993 10.59 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 20, 10.60 Stock Option Agreement by and between Maxicare Health Plans, Inc. and William Caswell, dated as of December 20, 10.61 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Thomas W. Field, Jr., dated as of December 20, 1993 10.62 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Dr. Charles E. Lewis, dated as of December 20, 1993 10.63 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Claude S. Brinegar, dated as of December 20, 1993 10.64 Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and David Hammons, dated as of January 1, 1994 10.65 Stock Option Agreement by and between Maxicare Health Plans, Inc. and David J. Hammons, dated as of May 20, 10.66 Stock Option Agreement by and between Maxicare Health Plans, Inc. and David J. Hammons, dated as of December 20, 1991 10.67 Stock Option Agreement by and between Maxicare Health Plans, Inc. and David Hammons, dated as of December 20, 21 List of Subsidiaries 23.1 Consent of Independent Accountants 28.1 Notice That The Conditions to Effectiveness of the Plan Have Been Met or Waived*** 28.2 Stipulation and Order Regarding Conditions to Effectiveness of Joint Plan of Reorganization*** ------------------- * Incorporated by reference from the Company's Registration Statement on Form 10, declared effective March 18, 1991, in which these exhibits bore the same exhibit numbers. ** Incorporated by reference from the Company's Reports on Form 8-K dated December 17, 1991 and January 31, 1992, in which these exhibits bore the same exhibit numbers. *** Incorporated by reference from the Company's Report on Form 8-K dated December 5, 1990, in which these exhibits bore the same exhibit numbers. @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. @@ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992, in which these exhibits bore the same exhibit numbers. (b) Reports on Form 8-K None. 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. March 25, 1994 /s/ PETER J. RATICAN -------------- ------------------------ Date Peter J. Ratican Chief Executive Officer March 25, 1994 /s/ EUGENE L. FROELICH -------------- ------------------------ Date Eugene L. Froelich Chief Financial Officer March 25, 1994 /s/ RICHARD A. LINK -------------- ------------------------ Date Richard A. Link 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 Date ---------- ----- ---- /s/ PETER J. RATICAN Chairman and Director March 25, 1994 -------------------- Peter J. Ratican /s/ EUGENE L. FROELICH Director March 25, 1994 ---------------------- Eugene L. Froelich Director March __, 1994 ---------------------- Claude S. Brinegar /s/ FLORENCE F. COURTRIGHT Director March 25, 1994 -------------------------- Florence F. Courtright /s/ THOMAS W. FIELD, JR. Director March 25, 1994 ------------------------ Thomas W. Field, Jr. /s/ CHARLES E. LEWIS Director March 25, 1994 -------------------- Charles E. Lewis /s/ ALAN S. MANNE Director March 25, 1994 ----------------- Alan S. Manne MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES AND OTHER INVESTMENTS (Amounts in thousands) At December 31, 1993 MAXICARE HEALTH PLANS, INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS (Amounts in thousands) See notes to condensed financial information of registrant. MAXICARE HEALTH PLANS, INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF OPERATIONS (Amounts in thousands) See notes to condensed financial information of registrant. MAXICARE HEALTH PLANS, INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF CASH FLOWS (Amounts in thousands) See notes to condensed financial information of registrant. MAXICARE HEALTH PLANS, INC. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT Note 1 - General ---------------- The condensed financial information of the registrant ("MHP") should be read in conjunction with the consolidated financial statements and the notes to consolidated financial statements which are included elsewhere herein. Note 2 - Transactions with Affiliates ------------------------------------- The Company is operating on a post-Effective Date basis under a decentralized and segregated cash management system. The operating subsidiaries currently pay monthly fees to MHP pursuant to administrative services agreements. Effective January 1, 1991 MHP acquired the stock of Maxicare Southeast Health Plans, Inc. from Maxicare (a California corporation and wholly-owned subsidiary of MHP) for $2.8 million through the issuance of a two year, 9% promissory note with principal and interest payable semi-annually. Effective July 1, 1991 MHP acquired the stock of Maxicare Health Plans of the Midwest, Inc. from Maxicare for $4.2 million through the issuance of a two year, 9% promissory note with principal and interest payable semi-annually. On October 1, 1992 MHP and HCS Computer, Inc. (a wholly-owned subsidiary of MHP that provides computer and telecommunications services to the Company) merged their operations. Accordingly, MHP's Condensed Statement of Operations for the year ended December 31, 1992 includes the results of operations of the computer and telecommunications operations for the three months ended December 31, 1992. Note 3 - Commitments and Other Contingencies -------------------------------------------- MHP's assets held under capital leases at December 31, 1993 and 1992 of $145,000 and $745,000, respectively, (net of $1.6 million and $1.1 million, respectively, of accumulated amortization) are comprised primarily of equipment leases. Future minimum lease commitments of $97,000 for noncancelable leases at December 31, 1993 are all payable in 1994; therefore, there are no long-term lease obligations. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (Amounts in thousands) For the Year Ended December 31, 1993 For the Year Ended December 31, 1992 (1) Adjustments as a result of physical inventory. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (Amounts in thousands) For the Year Ended December 31, 1991 (1) Adjustments as a result of physical inventory. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Amounts in thousands) For the Year Ended December 31, 1993 For the Year Ended December 31, 1992 (1) Adjustments as a result of physical inventory. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Amounts in thousands) For the Year Ended December 31, 1991 (1) Reclassifications as a result of physical inventory. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Amounts in thousands) For the Year Ended December 31, 1993 For the Year Ended December 31, 1992 (1) Reduction in premium revenue. (2) Write-off of aged retroactive billing adjustments. (3) Write-off of notes receivable reserve. MAXICARE HEALTH PLANS, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Amounts in thousands) For the Year Ended December 31, 1991 (1) Write-off of aged retroactive billing adjustments. (2) Write-off of fully reserved notes receivable. INDEX TO EXHIBITS Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 2.1 Joint Plan of Reorganization dated May 14, 1990, as modified on May 24 and July 12, 1990 (without schedules)* 2.2 Order Confirming Joint Plan of Reorganization dated May 14, 1990, as Modified, entered on August 31, 1990 (without exhibits or schedules)* 2.3 Amendment to Order Confirming Joint Plan of Reorganization dated May 14, 1990, as Modified, entered on August 31, 1990* 2.4 Stipulation and Order Re Conditions to Effectiveness of the Plan, entered on December 3, 1990* 2.5 Notice That The Conditions to Effectiveness of the Plan Have Been Met or Waived, filed on December 4, 1990* 2.6 Agreement and Plan of Merger of Maxicare Health Plans, Inc. and HealthCare USA Inc., dated as of December 5, 1990 (without exhibits or schedules)* 3.1 Charter of Maxicare Health Plans, Inc., a Delaware corporation* 3.3 Amendment to Charter of Maxicare Health Plans, Inc., a Delaware corporation@ 3.4 Amended Bylaws of Maxicare Health 95 of 319 Plans, Inc., a Delaware corporation 4.1 Form of Certificate of New Common Stock of Maxicare Health Plans, Inc.* 4.2 Form of Certificate of Warrant of Maxicare Health Plans, Inc.* ------------------------- * Incorporated by reference from the Company's Registration Statement on Form 10, declared effective March 18, 1991, in which these exhibits bore the same exhibit numbers. @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 4.4 Warrant Agreement by and between Maxicare Health Plans, Inc. and American Stock Transfer & Trust Company, dated as of December 5, 1990* 4.5 Stock Transfer Agent Agreement by and between Maxicare Health Plans, Inc., and American Stock Transfer & Trust Company, dated as of December 5, 1990* 4.6 Registration Undertaking by Maxicare Health Plans, Inc., dated as of December 5, 1990* 4.8 Portions of Charter of Maxicare Health Plans, Inc., relating to the rights of holders of the New Common Stock, the Warrants, or the New Senior Notes* 4.9 Portions of Bylaws of Maxicare Health Plans, Inc., relating to the rights of holders of the New Common Stock, the Warrants, or the New Senior Notes* 4.10 Series A Cumulative Convertible Preferred Stock Purchase Agreement dated as of December 17, 1991** 4.11 Series A Cumulative Convertible Preferred Stock Purchase Agreement dated as of January 31, 1992** 4.12 Form of Certificate of Preferred Stock of Maxicare Health Plans, Inc.@ 10.1 Management Incentive Program* 10.2 Incentive Compensation Agreement* 10.3b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of January 1, 1992@ ------------------------- * Incorporated by reference from the Company's Registration Statement on Form 10, declared effective March 18, 1991, in which these exhibits bore the same exhibit numbers. ** Incorporated by reference from the Company's Reports on Form 8-K dated December 17, 1991 and January 31, 1992, in which these exhibits bore the same exhibit numbers. @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.4b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich dated January 1, 1992@ 10.5b Employment Agreement by and between Maxicare Health Plans, Inc. and Samuel W. Warburton, dated as of January 1, 1993@@ 10.7c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of January 1, 1993@@ 10.7d Employment and Indemnification Agreement by 115 of 319 and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of January 1, 1994 10.8b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of January 1, 1993@@ 10.8c Employment and Indemnification Agreement 125 of 319 by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of January 1, 10.9c Form of Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of January 1, 1993@@ 10.12c Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of January 1, 1993@@ 10.12d Employment and Indemnification Agreement by 135 of 319 and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of January 1, ------------------------- @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. @@ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.14 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of December 5, 1990* 10.15 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich, dated as of December 5, 1990* 10.16 Form of Stock Option Agreement by and between Maxicare Health Plans, Inc. and Samuel Warburton, dated as of December 5, 1990* 10.18 Form of Stock Option Agreement by and between Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of December 5, 1990* 10.19 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of December 5, 1990* 10.20 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of December 5, 1990* 10.23 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 5, 1990* 10.28 Form of Distribution Trust Agreement* 10.29 Lease by and between Maxicare Health Plans, Inc. and Transamerica Occidental Life Insurance Company, dated as of June 1, 1990* 10.30 Maxicare Health Plans, Inc. 401(k) Plan* 10.32 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Leon M. Clements, dated as of May 20, 1991@ 10.33 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Walter J. Filkowski, dated as of May 20, 1991@ ------------------------- * Incorporated by reference from the Company's Registration Statement on Form 10, declared effective March 18, 1991, in which these exhibits bore the same exhibit numbers. @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.35 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Charles E. Lewis, dated as of May 20, 1991@ 10.36 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Claude S. Brinegar, dated as of July 18, 1991@ 10.38 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Richard A. Link, dated as of December 20, 1991@ 10.40 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 20, 1991@ 10.41 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Samuel W. Warburton, dated as of December 20, 1991@ 10.42 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Peter J. Ratican, dated as of February 25, 1992@ 10.43 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Eugene L. Froelich, dated as of February 25, 1992@ 10.44 Amended Maxicare Health Plans, Inc. 1990 Stock Option Plan@ 10.48 Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of January 8, 1992@@ 10.48a Employment and Indemnification Agreement 145 of 319 by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of January 1, 1994 10.49 Stock Option Agreement by and between Maxicare Health Plans, Inc. and William B. Caswell, dated as of February 3, 1992@@ ------------------------- @ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991, in which these exhibits bore the same exhibit numbers. @@ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.50 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Thomas W. Field, Jr., dated as of April 1, 1992@@ 10.51b Employment and Indemnification Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of January 1, 1993@@ 10.51c Employment and Indemnification Agreement 155 of 319 by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of January 1, 10.52 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 5, 1990@@ 10.53 Stock Option Agreement by and between Maxicare Health Plans, Inc. and Robert Landis, dated as of December 20, 1991@@ 10.54 Stock Option Agreement by and between 165 of 319 Maxicare Health Plans, Inc. and Florence Courtright, dated as of November 5, 1993 10.55 Stock Option Agreement by and between 176 of 319 Maxicare Health Plans, Inc. and Vicki F. Perry, dated as of December 20, 1993 10.56 Stock Option Agreement by and between 187 of 319 Maxicare Health Plans, Inc. and Alan D. Bloom, dated as of December 20, 1993 10.57 Stock Option Agreement by and between 198 of 319 Maxicare Health Plans, Inc. and Richard Link, dated as of December 20, 1993 10.58 Stock Option Agreement by and between 209 of 319 Maxicare Health Plans, Inc. and Aivars Jerumanis, dated as of December 20, 1993 10.59 Stock Option Agreement by and between 220 of 319 Maxicare Health Plans, Inc. and Robert Landis, dated as of December 20, 1993 10.60 Stock Option Agreement by and between 231 of 319 Maxicare Health Plans, Inc. and William Caswell, dated as of December 20, 1993 ------------------------- @@ Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992, in which these exhibits bore the same exhibit numbers. Exhibit Sequential Number Description Page Number ------ ---------------------------------------- ----------- 10.61 Stock Option Agreement by and between 242 of 319 Maxicare Health Plans, Inc. and Thomas W. Field, Jr., dated as of December 20, 10.62 Stock Option Agreement by and between 253 of 319 Maxicare Health Plans, Inc. and Dr. Charles E. Lewis, dated as of December 20, 1993 10.63 Stock Option Agreement by and between 264 of 319 Maxicare Health Plans, Inc. and Claude S. Brinegar, dated as of December 20, 1993 10.64 Employment and Indemnification Agreement 275 of 319 by and between Maxicare Health Plans, Inc. and David Hammons, dated as of January 1, 1994 10.65 Stock Option Agreement by and between 285 of 319 Maxicare Health Plans, Inc. and David J. Hammons, dated as of May 20, 1991 10.66 Stock Option Agreement by and between 296 of 319 Maxicare Health Plans, Inc. and David J. Hammons, dated as of December 20, 1991 10.67 Stock Option Agreement by and between 307 of 319 Maxicare Health Plans, Inc. and David Hammons, dated as of December 20, 1993 21 List of Subsidiaries 318 of 319 23.1 Consent of Independent Accountants 319 of 319 28.1 Notice That The Conditions to Effectiveness of the Plan Have Been Met or Waived*** 28.2 Stipulation and Order Regarding Conditions to Effectiveness of Joint Plan of Reorganization*** ------------------------- *** Incorporated by reference from the Company's Report on Form 8-K dated December 5, 1990, in which these exhibits bore the same exhibit numbers. Exhibit 3.4 MAXICARE HEALTH PLANS, INC. BYLAWS As Amended through January 28, 1994 Page ARTICLE I. OFFICES. . . . . . . . . . . . . . . . . . 4 Section 1. PRINCIPAL OFFICE. . . . . . . . . . . . 4 Section 2. OTHER OFFICES . . . . . . . . . . . . . 4 ARTICLE II. MEETINGS OF STOCKHOLDERS . . . . . . . . . 4 Section 1. PLACE OF MEETINGS. . . . . . . . . . . 4 Section 2. ANNUAL MEETINGS OF STOCKHOLDERS. . . . 4 Section 3. SPECIAL MEETINGS . . . . . . . . . . . 4 Section 4. NOTICE OF STOCKHOLDERS' MEETINGS . . . 4 Section 5. MANNER OF GIVING NOTICE; AFFIDAVIT OF NOTICE. . . . . . . . . . . . . . . 5 Section 6. QUORUM . . . . . . . . . . . . . . . . 5 Section 7. ADJOURNED MEETING AND NOTICE THEREOF . 5 Section 8. ORGANIZATION . . . . . . . . . . . . . 5 Section 9. VOTING . . . . . . . . . . . . . . . . 6 Section 10. WAIVER OF NOTICE OR CONSENT BY ABSENT STOCKHOLDERS . . . . . . . . . . . . . 6 Section 11. RECORD DATE. . . . . . . . . . . . . . 6 Section 12. PROXIES. . . . . . . . . . . . . . . . 7 Section 13. INSPECTORS OF ELECTION . . . . . . . . 7 Section 14. NOTICE OF STOCKHOLDER BUSINESS AND NOMINATIONS. . . . . . . . . . . . . . 8 ARTICLE III. DIRECTORS. . . . . . . . . . . . . . . . . 10 Section 1. POWERS . . . . . . . . . . . . . . . . 10 Section 2. NUMBERS OF DIRECTORS . . . . . . . . . 10 Section 3. RESIGNATIONS; VACANCIES. . . . . . . . 10 Section 4. PLACE OF MEETINGS AND TELEPHONIC MEETINGS . . . . . . . . . . . . . . . 11 Section 5. ANNUAL MEETINGS . . . . . . . . . . . 11 Section 6. OTHER REGULAR MEETINGS . . . . . . . . 11 Section 7. SPECIAL MEETINGS . . . . . . . . . . . 11 Section 8. DISPENSING WITH NOTICE . . . . . . . . 12 Section 9. QUORUM . . . . . . . . . . . . . . . . 12 Section 10. ADJOURNMENT. . . . . . . . . . . . . . 12 Section 11. ACTION WITHOUT MEETING . . . . . . . . 12 Section 12. FEES AND COMPENSATION OF DIRECTORS . . 12 ARTICLE IV. COMMITTEES . . . . . . . . . . . . . . . . 12 Section 1. COMMITTEES OF DIRECTORS. . . . . . . . 12 Section 2. MEETINGS AND ACTION OF COMMITTEES. . . 13 ARTICLE V. OFFICERS . . . . . . . . . . . . . . . . . 13 Section 1. OFFICERS . . . . . . . . . . . . . . . 13 Section 2. ELECTION OF OFFICERS . . . . . . . . . 13 Section 3. SUBORDINATE OFFICERS, ETC. . . . . . . 14 Section 4. REMOVAL AND RESIGNATION OF OFFICERS. . 14 Section 5. VACANCIES IN OFFICES . . . . . . . . . 14 Section 6. CHAIRMAN OF THE BOARD. . . . . . . . . 14 Section 7. VICE CHAIRMAN OF THE BOARD . . . . . . 14 Section 8. PRESIDENT. . . . . . . . . . . . . . . 14 Section 9. VICE PRESIDENTS. . . . . . . . . . . . 15 Section 10. SECRETARY. . . . . . . . . . . . . . . 15 Section 11. TREASURER. . . . . . . . . . . . . . . 15 ARTICLE VI. RECORDS AND REPORTS. . . . . . . . . . . . 16 Section 1. MAINTENANCE AND INSPECTION OF SHARE REGISTER . . . . . . . . . . . . . . . 16 Section 2. MAINTENANCE AND INSPECTION OF BYLAWS . 16 Section 3. MAINTENANCE AND INSPECTION OF OTHER CORPORATE RECORDS. . . . . . . . . . . 16 Section 4. INSPECTION BY DIRECTORS. . . . . . . . 17 ARTICLE VII. GENERAL CORPORATE MATTERS. . . . . . . . . 17 Section 1. CHECKS, DRAFTS, EVIDENCES OF INDEBTEDNESS . . . . . . . . . . . . . 17 Section 2. CORPORATE CONTRACTS AND INSTRUMENTS; HOW EXECUTED . . . . . . . . . . . . . 17 Section 3. CERTIFICATES FOR SHARES. . . . . . . . 17 Section 4 LOST CERTIFICATES. . . . . . . . . . . 17 Section 5. TRANSFER OF SHARES . . . . . . . . . . 18 Section 6. TRANSFER AND REGISTRY AGENTS . . . . . 18 Section 7. REGULATIONS. . . . . . . . . . . . . . 18 Section 8. RESTRICTION ON TRANSFER OF STOCK . . . 18 Section 9. REPRESENTATION OF SHARES OF OTHER CORPORATIONS . . . . . . . . . . . . . 19 Section 10. DIVIDENDS, SURPLUS, ETC. . . . . . . . 19 ARTICLE VIII. GENERAL. . . . . . . . . . . . . . . . . . 19 Section 1. CONSTRUCTION AND DEFINITIONS . . . . . 19 Section 2. SEAL . . . . . . . . . . . . . . . . . 19 Section 3. FISCAL YEAR. . . . . . . . . . . . . . 20 ARTICLE IX. AMENDMENTS . . . . . . . . . . . . . . . . 20 Section 1. AMENDMENT BY STOCKHOLDERS. . . . . . . 20 Section 2. AMENDMENT BY DIRECTORS . . . . . . . . 20 BYLAWS OF MAXICARE HEALTH PLANS, INC. ARTICLE I. OFFICES Section 1. PRINCIPAL OFFICE. The Board of Directors shall fix the location of the principal executive office of the Corporation at any place within or outside the State of Delaware. Section 2. OTHER OFFICES. The Board of Directors may at any time establish branch or subordinate offices at any place or places where the Corporation shall determine. ARTICLE II. MEETINGS OF STOCKHOLDERS Section 1. PLACE OF MEETINGS. Meetings of stockholders shall be held at any place within or outside the State of Delaware designated by the Board of Directors. In the absence of any such designation, stockholders' meetings shall be held at the principal executive office of the Corporation. Section 2. ANNUAL MEETINGS OF STOCKHOLDERS. The annual meeting of stockholders shall be held each year on a date and at a time designated by the Board of Directors. At each annual meeting directors shall be elected and any other proper business may be transacted. Section 3. SPECIAL MEETINGS. A special meeting of the stockholders may be called at any time for any purpose or purposes by the Board of Directors, the Chairman or Vice-President of the Board, the President of the Corporation or by a committee of the Board which has been duly designated by the Board and whose powers and authority, as provided in a resolution of the Board or in these bylaws, include the power to call such meetings, and such special meetings shall be called by the President of the Corporation at the request in writing of stockholders owning at least a majority in amount of the entire capital stock of the Corporation issued and outstanding and entitled to vote. Such stockholders' request shall state the purpose or purposes of the proposed meeting. Business transacted at any special meeting shall be limited to matters relating to the purpose or purposes stated in the notice of meeting. Section 4. NOTICE OF STOCKHOLDERS' MEETINGS. All notices of meetings of stockholders shall be sent or otherwise given in accordance with Section 5 of this Article II not less than ten (10) nor more than sixty (60) days before the date of the meeting being noticed. The notice shall specify the place, date and hour of the meeting and in the case of a special meeting, the purpose(s) for which the meeting is called. The notice of any meeting at which directors are to be elected shall include the name of any nominee or nominees. Section 5. MANNER OF GIVING NOTICE; AFFIDAVIT OF NOTICE. Notice of any meeting of stockholders shall be given either personally or by first-class mail or telegraphic or other written communication, charges prepaid, addressed to the stockholder at the address of such stockholder appearing on the books of the Corporation. If mailed, notice is given when deposited in the United States mail, postage prepaid, directed to the stockholder at his address as it appears on the records of the Corporation. An affidavit of the mailing or other means of giving an notice of any stockholders' meeting shall be executed by the Secretary, Assistant Secretary or any transfer agent of the Corporation giving such notice, and shall be filed and maintained in the minute books of the Corporation. Section 6. QUORUM. At all meetings of stockholders, except as otherwise required by statute or by the Certificate of Incorporation, the presence in person or by proxy of the holders of a majority of the shares of stock outstanding and entitled to vote at any meeting of stockholders shall constitute a quorum for the transaction of business. The stockholders present at a duly called or held meeting at which a quorum is present may continue to do business until adjournment, notwithstanding the withdrawal of enough stockholders to leave less than a quorum, if any action taken (other than adjournment) is approved by at least a majority of the shares required to constitute a quorum. Section 7. ADJOURNED MEETING AND NOTICE THEREOF. Any stockholders' meeting, annual or special, whether or not a quorum is present, may by adjourned from time to time by the vote of the majority of the shares represented at such meeting, either in person or by proxy. When any meeting of stockholders, either annual or special, is adjourned to another time or place, notice need not be given of the adjourned meeting if the time and place thereof are announced at the meeting at which the adjournment is taken, unless a new record date for the adjourned meeting is fixed, or unless the adjournment is for more than thirty (30) days from the date set for the original meeting, in which case the Board of Directors shall set a new record date. Notice of any such adjourned meeting, if required, shall be given to each stockholder of record entitled to vote at the adjourned meeting in accordance with the provisions of Sections 4 and 5 of this Article II. At any adjourned meeting the Corporation may transact any business which might have been transacted at the original meeting. Section 8. ORGANIZATION. At every meeting of stockholders, the President, or in his absence the Chairman or Vice Chairman of the Board, shall act as chairman of the meeting and the Secretary shall act as secretary of the meeting. In case none of the officers designated above to act as chairman or secretary of the meeting, respectively, shall be present, a chairman or a secretary of the meeting, as the case may be, may be chosen by a majority of the votes cast at such meeting by the holders of shares present in person or represented by proxy and entitled to vote at the meeting. Section 9. VOTING. The stockholders entitled to vote at any meeting of stockholders shall be determined in accordance with the provisions of Section 11 of this Article II, subject to the provisions of Section 217 the Delaware General Corporation Law (relating to voting rights of fiduciaries, pledgors and joint owners of stock). Any stockholder entitled to vote on any matter (other than the election of directors) may vote part of the shares in favor of the proposal and refrain from voting the remaining shares or vote them against the proposal but, if the stockholder fails to specify the number of shares such stockholder is voting affirmatively, it will be conclusively presumed that the stockholder's approving vote is with respect to all shares such stockholder is entitled to vote. If a quorum is present, the affirmative vote of the majority of the shares represented at the meeting and voting on any matter shall be the act of the stockholders, unless the vote of a greater number or voting by classes is required by these Bylaws, the Certificate of Incorporation or by statute. Directors shall be elected by a plurality of the votes of the shares represented at the meeting and entitled to vote on the election of directors. No stockholder shall be entitled to cumulate votes on any matter at any meeting of stockholders. Section 10. WAIVER OF NOTICE OR CONSENT BY ABSENT STOCKHOLDERS. Whenever notice is required to be given to the stockholders under any provision of the General Corporation Law or the Certificate of Incorporation or the Bylaws, a written waiver thereof, signed by a stockholder entitled to notice, whether before or after the time stated therein, shall be deemed equivalent to notice. Attendance of a stockholder at a meeting shall constitute a waiver of notice of such meeting, except when the stockholder attends a meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. Neither the business to be transacted at, nor the purpose of, any regular or special meeting of the stockholders need be specified in any written waiver of notice. Section 11. RECORD DATE. In order that the Corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, or to express consent to corporate action in writing without a meeting, or entitled to receive payment of any dividend or other distribution or allotment of any rights, or entitled to exercise any rights in respect of any change, conversion or exchange of stock or for the purpose of any other lawful action, the Board of Directors may fix a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted by the Board of Directors and which record date: (1) in the case of determination of stockholders entitled to vote at any meeting of stockholders or adjournment thereof, shall not be more than sixty (60) nor less than ten (10) days before the date of such meeting; (2) in the case of determination of stockholders entitled to express consent to corporate action in writing without a meeting, shall not be more than ten (10) days from the date upon which the resolution fixing the record date is adopted by the Board of Directors; and (3) in the case of any such action, shall not be more than sixty (60) days prior to such other action. If no record date is fixed: (1) the record date for determining stockholders entitled to notice of or to vote at a meeting of stockholders shall be at the close of business on the day next preceding the day on which notice is given, or, if notice is waived, at the close of business on the day next preceding the day on which the meeting is held; (2) the record date for determining stockholders entitled to express consent to corporate action in writing without a meeting when no prior action of the Board of Directors is required by law, shall be the first date on which a signed written consent setting forth the action taken or proposed to be taken is delivered to the Corporation in accordance with applicable law, or, if prior action by the Board of Directors is required by law, shall be at the close of business on the day on which the Board of Directors adopts the resolution relating to taking such prior action; and (3) the record date for determining stockholders for any other purpose shall be at the close of business on the day on which the Board of Directors adopts the resolution relating thereto. A determination of stockholders of record entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; provided, however, that the Board of Directors may fix a new record date for the adjourned meeting. Section 12. PROXIES. Each stockholder entitled to vote at a meeting of stockholders may authorize another person or persons to act for him by proxy, but no such proxy shall be voted or acted upon after three years from its date, unless the proxy provides for a longer period. Section 13. INSPECTORS OF ELECTION. The Board, in advance of any meeting of stockholders, may appoint one or more inspectors to act at the meeting or any adjournment thereof. If inspectors are not so appointed, the person presiding at such meeting may, and on the request of any stockholder entitled to vote thereat shall, appoint one or more inspectors. In case any person appointed fails to appear or act, the vacancy may be filled by appointment made by the Board in advance of the meeting or at the meeting by the person presiding thereat. Each inspector, before entering upon the discharge of his duties, shall take and sign an oath faithfully to execute the duties of inspector at such meeting with strict impartiality and according to the best of his ability. The inspector or inspectors shall determine the number of shares outstanding and the voting power of each, the shares represented at the meeting, the existence of a quorum, the validity and effect of proxies, and shall receive votes or ballots, hear and determine all challenges and questions arising in connection with the right to vote, count and tabulate all votes or ballots, determine the result, and shall do such acts as are proper to conduct the election or vote with fairness to all stockholders. On request of the person presiding at the meeting or any stockholder entitled to vote thereat, the inspector or inspectors shall make a report in writing of any challenge, question or matter determined by him or them and execute a certificate of any fact found by him or them. Any report or certificate made by the inspector or inspectors shall be prima facie evidence of the facts stated and of the vote as certified by him or them. Section 14. NOTICE OF STOCKHOLDER BUSINESS AND NOMINATIONS. (A) ANNUAL MEETING OF STOCKHOLDERS (1) Nominations of persons for election to the Board of Directors of the corporation and the proposal of business to be considered by the stockholders may be made at an annual meeting of stockholders (a) pursuant to the Corporation's notice of meeting delivered pursuant to Section 4 of Article II of these bylaws, (b) by or at the direction of the Chairman of the Board of Directors, or (c) by any stockholder who is entitled to vote at the meeting, who complied with the notice procedures set forth in clauses (2) and (3) or this subsection (A) and this bylaw and who was a stockholder of record at the time such notice is delivered to the Secretary of the Corporation. (2) For nominations or other business to be properly brought before an annual meeting by a stockholder pursuant to clause (c) of the foregoing subsection (A) (1) of this bylaw, the stockholder must have given timely notice thereof in writing to the Secretary of the Corporation. To be timely, a stockholder's notice shall be delivered to the Secretary at the principal executive officers of the Corporation not less than seventy (70) days nor more than ninety (90) days prior to the first anniversary of the preceding year's annual meeting; provided, however, that in the event that the date of the annual meeting is advanced by more than twenty (20) days or delayed by more than seventy (70) days from such anniversary date, notice by the stockholder to be timely must be so delivered not earlier than the ninetieth (90th) day prior to such annual meeting and not later than the close of business on the later of the seventieth (70th) day prior to such annual meeting or the tenth (10th) day following the day on which public announcement of the date of such meeting is first made. Such stockholder's notice shall set forth (a) as to each person who the stockholder proposes to nominate for election or reelection as a director, all information relating to such person that is required to be disclosed in solicitations of proxies for election of directors, or is otherwise required, in each case pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), including such person's written consent to being named in the proxy statement as a nominee and to serving as a director if elected; (b) as to any other business that the stockholder proposes to bring before the meeting, a brief description of the business desired to be brought before the meeting, the reasons for conducting such business at the meeting and any material interest in such business of such stockholder and the beneficial owner, if any on whose behalf the proposal is made, and (c) as to the stockholder giving the notice and the beneficial owner, if any, on whose behalf the nomination or proposal is made, (i) the name and address of such stockholder, as they appear on the Corporation's books, and of such beneficial owner, and (ii) the class and number of shares of the capital stock of the Corporation which are owned beneficially and of record by such stockholder and such beneficial owner. (3) Notwithstanding anything in the second sentence of subsection (a) (2) of this bylaw to the contrary, in the event that the number of directors to be elected to the Board of Directors of the Corporation is increased and there is no public announcement naming all of the nominees for director or specifying the size of the increased Board of Directors made by the Corporation at least eighty (80) days prior to the first anniversary of the preceding year's annual meeting, a stockholder's notice required by this bylaw shall also be considered timely, but only with respect to nominees for any new positions created by such increase, if it shall be delivered to the Secretary of the Corporation at the principal executive offices of the Corporation not later than the close of business on the tenth (10th) day following the day on which such public announcement is first made by the Corporation. (B) SPECIAL MEETINGS OF STOCKHOLDERS As set forth in Section 3 of Article II above, only such business shall be conducted at a special meeting of stockholders as shall have been brought before the meeting pursuant to Section 4 of Article II of these bylaws. Nominations of persons for election to the Board of Directors shall be made at a special meeting of stockholders at which directors are to be elected pursuant to the Corporation's notice of meeting (a) by or at the direction of the Board of Directors, or (b) by any stockholder of the Corporation who is entitled to vote at the meeting, who complies with the notice procedures set forth in this bylaw and who is a stockholder of record at the time such notice is delivered to the Secretary of the Corporation. Nominations by stockholders of person for election to the Board of Directors may be made at such a special meeting of stockholders if the stockholder's notice as required by subsection (A) (2) of this bylaw shall be delivered to the Secretary of the Corporation at the principal executive offices of the Corporation no later than the close of business on the thirtieth (30th) day prior to such special meeting or, if fewer than thirty (30) days notice of such meeting is given, no later than the fifth (5th) day following the day on which public announcement is first made of the date of the special meeting and of the nominees proposed by the Board of Directors to be elected at such meeting. (C) GENERAL (1) Only persons who are nominated in accordance with the procedures set forth in this bylaw shall be eligible to serve as directors and only such business shall be conducted at a meeting of stockholders as shall have been brought before the meeting in accordance with the procedures set forth in this bylaw. Except as otherwise provide by law, the Restated Certificate of Incorporation of the Corporation, as amended, or these bylaws, the chairman of the meeting shall have the power and duty to determine whether a nomination or any business proposed to be brought before the meeting was made in accordance with the procedures set forth in this bylaw and, if any proposed nomination or business is not in compliance with this bylaw, to declare that such defective proposal or nomination shall be disregarded. (2) For purposes of this bylaw, "public announcement" shall mean disclosure in a press release reported by the Dow Jones News Service Associated Press or comparable national news service or in a document publicly filed by the Corporation with the Securities and Exchange Commission pursuant to Section 13, 14 or 15 (d) of the Exchange Act. (3) Notwithstanding the foregoing provisions of this bylaw, a stockholder shall also comply with all applicable requirements of the Exchange Act and the rules and regulations thereunder with respect to the matters set forth in this bylaw. Nothing in this bylaw shall be deemed to affect any rights of stockholders to request inclusion of proposals in the Corporation's proxy statement pursuant to Rule 14a-8 under the Exchange Act. ARTICLE III. DIRECTORS Section 1. POWERS. The Board of Directors shall exercise all of the powers of the Corporation except such as are by law, or by the Certificate of Incorporation of the Corporation or by these Bylaws, conferred upon or reserved to the stockholders. Section 2. NUMBER OF DIRECTORS. The number of directors which shall constitute the Board of Directors of the Corporation shall initially be nine (9). The number of directors may from time to time by changed, by resolution of the Board of Directors or a majority vote of the outstanding shares entitled to vote thereon. The directors shall, except for filling vacancies (whether resulting from an increase in the number of directors, resignations, removals or otherwise), be elected at the annual meeting of the stockholders and each director shall be elected to serve until his successor is elected and qualifies. Directors need not be stockholders. Section 3. RESIGNATIONS; VACANCIES. Any director or member of a committee may resign at any time. Such resignation shall be made in writing, and shall take effect at the time specified therein, and if no time be specified, at the time of its receipt by the President or Secretary. The acceptance of a resignation shall not be necessary to make it effective. Vacancies in the Board of Directors may be filled in the manner provided in the Certificate of Incorporation. A vacancy or vacancies in the Board of Directors shall be deemed to exist in the case of the death, resignation or removal of any director, or if the authorized number of directors be increased, or if the stockholders fail, at any meeting of stockholders at which any director or directors are elected, to elect the full authorized number of directors to be voted for that meeting. No reduction of the authorized number of directors shall have the effect of removing any director prior to the expiration of his term of office. Section 4. PLACE OF MEETING AND TELEPHONIC MEETINGS. Regular meetings of the Board of Directors may be held at any place within or without the State of Delaware that has been designated from time to time by resolution of the Board of Directors. In the absence of such designation, regular meetings shall be held at the principal executive office of the Corporation. Special meetings of the Board of Directors shall be held at any place within or without the State of Delaware that has been designated in the notice of the meeting or, if not stated in the notice or there is no notice, at the principal executive office of the Corporation. Any meeting, regular or special, may be held by conference, telephone or similar communication equipment, so long as all directors participating in such meeting can hear one another, and all such directors shall be deemed to be present in person at such meeting. Section 5. ANNUAL MEETINGS. Immediately following each annual meeting of stockholders, the Board of Directors shall hold a regular meeting for the purpose of organization, any desired election of officers and the transaction of other business. Notice of this meeting shall not be required. Section 6. OTHER REGULAR MEETINGS. Other regular meetings of the Board of Directors shall be held without call at such time as shall from time to time be fixed by the Board of Directors. Such regular meetings may be held without notice. Section 7. SPECIAL MEETINGS. Special meetings of the Board of Directors for any purpose or purposes may be called at any time by the Chairman of the Board or the President or any Vice President or the Secretary or any two directors. Notice of the time and place of special meetings shall be delivered personally or by telephone to each director or sent by first-class mail, telegram or facsimile, charges prepaid, addressed to each director at his or her address as it is shown upon the records of the Corporation. In case such notice is mailed, it shall be deposited in the United States mail at least four (4) days prior to the time of the holding of the meeting. In case such notice is delivered personally, or by telephone, telegram or facsimile, it shall be delivered personally or by telephone or the telegraph company at least forty-eight (48) hours prior to the time of the holding of the meeting. Any oral notice given personally or by telephone may be communicated to either the director or to a person at the office of the director who the person giving the notice has reason to believe will promptly communicate it to the director. The notice need not specify the purpose of the meeting nor the place if the meeting is to be held at the principal executive office of the Corporation. Section 8. DISPENSING WITH NOTICE. The transaction of any business at any meeting of the Board of Directors, however called and noticed or wherever held, shall be as valid as though had at a meeting duly held after regular call and notice if a quorum be present and if, either before or after the meeting, each of the directors not present signs a written waiver of notice, a consent to holding the meeting or an approval of the minutes thereof. The waiver of notice or consent need not specify the purpose of the meeting. All such waivers, consents and approvals shall be filed with the corporate records or made a part of the minutes of the meeting. Notice of a meeting need not be given to any director who attends the meeting without protesting, prior thereto or at its commencement, the lack of notice to such director. Section 9. QUORUM. A majority of the authorized number of directors shall constitute a quorum for the transaction of business, except to adjourn as hereinafter provided. Every act or decision done or made by a majority of the directors present at a meeting duly held at which a quorum is present shall be regarded as the act of the Board of Directors, subject to the provisions of Section 144 of the Delaware General Corporation Law (approval of contracts or transactions in which a director has a financial interest), Section 141(c) (appointment of committees), and Section 145 (indemnification of directors). A meeting at which a quorum is initially present may continue to transact business notwithstanding the withdrawal of directors, if any action taken is approved by at least a majority of the required quorum of such meeting. Section 10. ADJOURNMENT. A majority of the directors present, whether or not constituting a quorum, may adjourn any meeting to another time and place. Section 11. ACTION WITHOUT MEETING. Any action required or permitted to be taken by the Board of Directors may be taken without a meeting, if all members of the Board of Directors shall individually or collectively consent in writing to such action. Such action by written consent shall have the same force and effect as a unanimous vote of the Board of Directors. Such written consent or consents shall be filed with the minutes of the proceedings of the Board of Directors. Section 12. FEES AND COMPENSATION OF DIRECTORS. Directors and members of committees may receive such compensation, if any, for their services, and such reimbursement of expenses, as may be fixed or determined by resolution of the Board of Directors. Nothing contained in these Bylaws shall be construed to preclude any director from serving the Corporation in any other capacity as an officer, agent, employee, or otherwise, and receiving compensation for such services. ARTICLE IV. COMMITTEES Section 1. COMMITTEES OF DIRECTORS. The Board of Directors may, by resolution adopted by a majority of the authorized number of directors, designate one or more committees, each consisting of two or more directors, to serve at the pleasure of the Board of Directors. The Board of Directors may designate one or more directors as alternate members of any committee, who may replace any absent member at any meeting of the committee. Any such committee, to the extent provided in the resolution of the Board of Directors, shall have all the authority of the Board of Directors, except with respect to the power or authority in reference to amending the Certificate of Incorporation, adopting an agreement of merger or consolidation, recommending to the stockholders the sale, lease or exchange of all or substantially all the Corporations's property and assets, recommending to the stockholders a dissolution of the Corporation or a revocation of a dissolution, or amending the Bylaws of the Corporation; and, unless the resolution designating such committee or the Certificate of Incorporation expressly so provide, no such committee shall have the power of authority to declare a dividend or to authorize the issuance of stock. Such committee or committees shall have such name or names as may be determined from time to time by resolution adopted by the Board of Directors. Section 2. MEETINGS AND ACTION OF COMMITTEES. Meetings and action of committees shall be governed by, and held and taken in accordance with, the provisions of Article III of these Bylaws, Section 4 (place of meetings), 6 (regular meetings), 7 (special meetings and notice), 8 (dispensing with notice), 9 (quorum), 10 (adjournment), and 11 (action without meeting), with such changes in the context of those Bylaws as are necessary to substitute the committee and its members for the Board of Directors and its members, except that the time of regular meetings of committees may be determined by resolution of the Board of Directors as well as the committee, special meetings of committees may also be called by resolution of the Board of Directors and notice of special meetings of committees shall also be given to alternate members, who shall have the right to attend all meetings of the committee. The Board of Directors and any committee may adopt rules for the government of any committee not inconsistent with the provisions of these Bylaws. ARTICLE V. OFFICERS Section 1. OFFICERS. The officers of the Corporation shall be a President, a Secretary and a Treasurer. The Corporation may also have, at the discretion of the Board of Directors, a Chairman and/or Vice Chairman of the Board, one or more Vice- Presidents, one or more Assistant Secretaries, one or more Assistant Treasurers, and such other officers as may be appointed in accordance with the provisions of Section 3 of this Article V. Any number of offices may be held by the same person. Section 2. ELECTION OF OFFICERS. The officers of the Corporation, except such officers as may be appointed in accordance with the provisions of Section 3 of this Article V, shall be chosen by the Board of Directors, and each shall serve at the pleasure of the Board of Directors, subject to the rights, if any, of an officer under any contract of employment. Section 3. SUBORDINATE OFFICERS, ETC. The Board of Directors may appoint, and may empower the President to appoint, such other officers as the business of the Corporation may require, each of whom shall hold office for such period, have such authority and perform such duties as are provided in these Bylaws or as the Board of Directors may from time to time determine. Section 4. REMOVAL AND RESIGNATION OF OFFICERS. Subject to the rights, if any, of an officer under any contract of employment, any officer may be removed, either with or without cause, by the Board of Directors, at any regular or special meeting thereof, or, except in case of an officer chosen by the Board of Directors, by any officer upon whom such power of removal may be conferred by the Board of Directors. Any officer may resign at any time by giving written notice to the Corporation. Any such resignation shall take effect at the date of the receipt of such notice or at any later time specified therein; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. Any such resignation is without prejudice to the rights, if any, of the Corporation under any contract to which the officer is a party. Section 5. VACANCIES IN OFFICES. A vacancy in any office because of death, resignation, removal, disqualification or any other cause shall be filled in the manner prescribed in these Bylaws for regular appointments to such office. Section 6. CHAIRMAN OF THE BOARD. The Chairman of the Board, if such an officer be elected, shall, if present, preside at all meetings of the Board of Directors and exercise and perform such other powers and duties as may be from time to time assigned to him by the Board of Directors or prescribed by these Bylaws. If there is no President, the Chairman of the Board shall in addition be the Chief Executive Officer of the Corporation and shall have the powers and duties prescribed in Section 8 of this Article V. Section 7. VICE CHAIRMAN OF THE BOARD. The Vice Chairman of the Board, if such an officer is elected shall, in the absence or disability of the Chairman, perform all the duties of the Chairman, and when so acting, shall have all the powers of, and be subject to all the restrictions upon the Chairman. The Vice Chairman shall exercise and perform such other powers and duties as may be from time to time assigned to him by the Board of Directors or prescribed by these Bylaws. Section 8. PRESIDENT. Subject to such supervisory powers, if any, as may be given by the Board of Directors to the Chairman or Vice Chairman of the Board, if there be such an officer or officers, the President shall be the Chief Executive Officer of the Corporation and shall, subject to the control of the Board of Directors, have general supervision, direction and control of the business and the officers of the Corporation. He shall preside at all meetings of the stockholders and, in the absence of the Chairman or Vice Chairman of the Board, or if there be none, at all meetings of the Board of Directors. He shall have the general powers and duties of management usually vested in the office of President of a corporation and shall have such other powers and duties as may be prescribed by the Board of Directors or these Bylaws. Section 9. VICE PRESIDENTS. In the absence or disability of the President, the Vice Presidents, if any, in order of their rank as fixed by the Board of Directors or, if not ranked, a Vice President designated by the Board of Directors, shall perform all the duties of the President, and when so acting shall have all the powers of, and be subject to all the restrictions upon, the President. The Vice Presidents shall have such other powers and perform such other duties as from time to time may be prescribed for them respectively by the Board of Directors, these Bylaws, or the President or the Chairman or Vice Chairman of the Board if there is no President. Section 10. SECRETARY. The Secretary shall keep or cause to be kept, at the principal executive office or such other place as the Board of Directors may order, a book of minutes of all meetings and actions of directors, committees of directors and stockholders, with the time and place of holding, whether regular or special, and, if special, how authorized, the notice thereof given, the names of those present at director's and committee meetings, the number of shares present or represented at stockholders' meetings, and the proceedings thereof. The Secretary shall keep, or cause to be kept, at the principal executive office or at the office of the Corporation's transfer agent or registrar, as determined by resolution of the Board of Directors, a share register, or a duplicate share register, showing the names of all stockholders and their addresses, the number and classes of shares held by each, the number and date of certificates issued for the same, and the number and date of cancellation of every certificate surrendered for cancellation. The Secretary shall give, or cause to be given, notice of all meetings of the stockholders and of the Board of Directors required by these Bylaws or by law to be given, and he shall keep the seal of the Corporation in safe custody, and shall have such other powers and perform such other duties as may be prescribed by the Board of Directors or by these Bylaws. Section 11. TREASURER. The Treasurer shall keep and maintain, or cause to be kept and maintained, adequate and correct books and records of accounts of the properties and business transactions of the Corporation, including accounts of its assets, liabilities, receipts, disbursements, gains, losses, capital, retained earnings and shares. The books of account shall be open at all reasonable times to inspection by any director. The Treasurer shall deposit all moneys and other valuables in the name and to the credit of the Corporation with such depositories as may be designated by the Board of Directors. He shall disburse the funds of the Corporation as may be ordered by the Board of Directors, shall render to the President and directors, whenever they request it, an account of all of his transactions as Treasurer and of the financial condition of the Corporation, and shall have other powers and perform such other duties as may be prescribed by the Board of Directors or these Bylaws. ARTICLE VI. RECORDS AND REPORTS Section 1. MAINTENANCE AND INSPECTION OF SHARE REGISTER. The Corporation shall keep at its principal executive office, or at the office of its transfer agent or registrar, if either be appointed and as determined by resolution of the Board of Directors, a record of its stockholders, giving the names and addresses of all stockholders and the number and class of shares held by each stockholder. Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose the Corporation's stock ledger and a list of its stockholders and to make copies or extracts therefrom. A proper purpose shall mean a purpose reasonably related to such person's interest as a stockholder. In every instance where an attorney or other agent shall be the person who seeks the right to inspection, the demand under oath shall be accompanied by a power of attorney or such other writing which authorizes the attorney or other agent to so act on behalf of the stockholder. The demand under oath shall be directed to the Corporation at its registered office in the State of Delaware or at its principal place of business. Section 2. MAINTENANCE AND INSPECTION OF BYLAWS. The Corporation shall keep at its principal executive office the original or a copy of these Bylaws as amended to date, which shall be open to inspection by the stockholders at all reasonable times during usual business hours. Section 3. MAINTENANCE AND INSPECTION OF OTHER CORPORATE RECORDS. The accounting books and records and minutes of proceedings of the stockholders and the Board of Directors and any committee or committees of the Board of Directors shall be kept at such place or places designated by the Board of Directors, or, in the absence of such designation, at the principal executive office of the Corporation. The minutes shall be kept in written form and the accounting books and records shall be kept either in written form in any other form capable of being converted into written form. Such minutes, accounting books and records shall be open to inspection upon the written demand of any stockholder in the same manner and subject to the same limitations specified in Section 1 of this Article VI with respect to the identities of stockholders. Section 4. INSPECTION BY DIRECTORS. Any director shall have the right to examine the Corporation's stock ledger, a list of its stockholders and its books and records for a purpose reasonably related to his position as a director. ARTICLE VII. GENERAL CORPORATE MATTERS Section 1. CHECKS, DRAFTS, EVIDENCE OF INDEBTEDNESS. All checks, drafts or other orders for payment of money, notes or other evidences of indebtedness, issued in the name of or payable by the Corporation, shall be signed or endorsed by such person or persons and in such manner as, from time to time, shall be determined by resolution of the Board of Directors. Section 2. CORPORATE CONTRACTS AND INSTRUMENTS; HOW EXECUTED. The Board of Directors, except as otherwise provided in these Bylaws, may authorize any officer or officers, agent or agents, to enter into any contract or execute any instrument in the name of and on behalf of the Corporation, and such authority may be general or confined to specific instances; and, unless so authorized or ratified by the Board of Directors or within the agency power of an officer, no officer, agent or employee shall have any power or authority to bind the Corporation by any contract or engagement or to pledge its credit or to render it liable for any purpose or to any amount. Section 3. CERTIFICATES FOR SHARES. A certificate or certificates for shares of the Common Stock of the Corporation shall be issued to each stockholder when any such shares are fully paid, and the Board of Directors may authorize the issuance of certificates or shares as partly paid provided that such certificates shall state the amount of the consideration to be paid therefor and the amount paid thereon. All certificates shall be signed in the name of the Corporation by the Chairman or Vice Chairman of the Board or the President or Vice President and by the Treasurer or an Assistant Treasurer or the Secretary or any Assistant Secretary. Any or all of the signatures on the certificate may be facsimile, if the certificate is countersigned by a transfer agent or registered by a registrar other than the Corporation itself or its employee. In case any officer, transfer agent or registrar who has signed or whose facsimile signature has been placed upon a certificate shall have ceased to be such officer, transfer agent or registrar before such certificate is issued, it may be issued by the Corporation with the same effect as if such person were an officer, transfer agent or registrar at the date of issue. Section 4. LOST CERTIFICATES. Except as hereinafter in this Section 5 provided, no new certificate for shares shall be issued in lieu of an old certificate unless the latter is surrendered to the Corporation and cancelled at the same time. The Board of Directors may in case any share certificate or certificate for any other security is lost, stolen or destroyed, authorize the issuance of a new certificate in lieu thereof, upon such terms and conditions as the Board of Directors may require, including provision for indemnification of the Corporation secured by a bond or other adequate security sufficient to protect the Corporation against any claim that may be made against it, including any expense or liability, on account of the alleged loss, theft or destruction of such certificate or the issuance of such new certificate. Section 5. TRANSFER OF SHARES. Transfers of shares of capital stock of the Corporation shall be made only on the books of the Corporation by the holder thereof or by his duly authorized attorney appointed by a power of attorney duly executed and filed with the Secretary or a transfer agent of the Corporation, and on surrender of the certificate or certificates representing such shares of capital stock properly endorsed for transfer and upon payment of all necessary transfer taxes. Every certificate exchanged, returned or surrendered to the Corporation shall be marked "Cancelled," with the date of cancellation, by the Secretary or an Assistant Secretary or the transfer agent of the Corporation. A person in whose name shares of capital stock shall stand on the books of the Corporation shall be deemed the owner thereof to receive dividends, to vote as such owner and for all other purposes as respects the Corporation, its stockholders and creditors for any purpose, until such transfer shall have been entered on the books of the Corporation by an entry showing from and to whom transferred. Section 6. TRANSFER AND REGISTRY AGENTS. The Corporation may from time to time maintain one or more transfer offices or agents and registry offices or agents at such place or places as may be determined from time to time by the Board. Section 7. REGULATIONS. The Board may make rules and regulations as it may deem expedient, not inconsistent with the Bylaws or with the Certificate of Incorporation, concerning the issue, transfer and registration of certificates representing shares of its capital stock. Section 8. RESTRICTION ON TRANSFER OF STOCK. A written restriction on the transfer or registration of transfer of capital stock of the Corporation, if permitted by Section 202 of the General Corporation Law and noted conspicuously on the certificate representing such capital stock, may be enforced against the holder of the restricted capital stock of any successor or transferee of the holder including an executor, administrator, trustee, guardian or other fiduciary entrusted with like responsibility for the person or estate of the holder. A restriction on the transfer or registration of transfer of capital stock of the Corporation may be imposed either by the Certificate of Incorporation or by an agreement among any number of stockholders or among such stockholders and the Corporation. No restriction so imposed shall be binding with respect to capital stock issued prior to the adoption of the restriction unless the holders of such capital stock are parties to an agreement or voted in favor of the restriction. Section 9. REPRESENTATION OF SHARES OF OTHER CORPORATIONS. The Chairman of the Board, the President, or any Vice President, or any other person authorized by resolution of the Board of Directors or by any of the foregoing designated officers, is authorized to vote on behalf of the Corporation any and all shares of any other corporation or corporations, foreign or domestic, standing in the name of the Corporation. The authority herein granted to said officers to vote or represent on behalf of the Corporation any and all shares held by the Corporation in any other corporation or corporations may be exercised by any such officer in person or by any person authorized to do so by proxy duly executed by said officer. Section 10. DIVIDENDS, SURPLUS, ETC. Subject to the provisions of the Certificate of Incorporation and of applicable law, the Board of Directors: (a) may declare and pay dividends or make other distributions on the outstanding shares of capital stock in such amounts and at such time or times as, in its discretion, the conditions of the affairs of the Corporation shall render advisable; (b) may use and apply, in its discretion, any of the surplus of the Corporation in purchasing or acquiring any shares of capital stock of the Corporation, or purchase warrants therefor, in accordance with law, or any of its bonds, debentures, notes, scrip or other securities or evidences indebtedness; (c) may set aside from time to time out of such surplus or net profits such sum or sums as, in its discretion, it may think proper, as a reserve fund to meet contingencies, or for equalizing dividends or for the purpose of maintaining or increasing the property or business of the Corporation, or for any other purpose it may think conducive to the best interests of the Corporation. ARTICLE VIII. GENERAL Section 1. CONSTRUCTION AND DEFINITIONS. Unless the context requires otherwise, the general provisions, rules of construction, and definitions in the Delaware General Corporation Law shall govern the construction of these Bylaws. Without limiting the generality of the foregoing, the singular number includes the plural, the plural number includes the singular, and the term "person" includes both a corporation and a natural person. Section 2. SEAL. The corporate seal of the Corporation shall bear the name of the Corporation and the words "Delaware [year]." The Corporation may also have such other seals as the Board of Directors shall deem appropriate, including "OFFICIAL CORPORATE SEAL." A corporate seal may be used by causing it or a facsimile thereof to be impressed or affixed or reproduced. Section 3. FISCAL YEAR. The fiscal year of the Corporation shall be determined, and may be changed, by resolution of the Board of Directors. ARTICLE IX. AMENDMENTS Section 1. AMENDMENT BY STOCKHOLDERS. New Bylaws may be adopted or these Bylaws may be amended or repealed by the vote of holders of a majority of the outstanding shares entitled to vote, unless, as to a particular provision, a higher vote is required by the Certificate of Incorporation or by statute; provided, however, that Section 3 of Article II, and Sections 1 and 2 of Article IX of these Bylaws may not be amended or repealed in any respect except by the affirmative vote of the holders of not less than eighty percent (80%) of the outstanding shares entitled to vote thereon ("Voting Shares"), regardless of class and voting class, and, where such action is proposed by an Interested Stockholder or by an Associate or Affiliate of an Interested Stockholder (as such capitalized terms are defined in the Certificate of Incorporation of the Corporation), the affirmative vote of the holders of a majority of all Voting Shares, regardless of class and voting together as a single class, other than shares held by the Interested Stockholder which proposed (or the Affiliate or Associate of which proposed) such action, or any Affiliate or Associate of such Interested Stockholder; provided, however, that where such action is approved by a majority of the Disinterested Directors (as defined in the Certificate of Incorporation of the Corporation), the affirmative vote of a majority of the Voting Shares, regardless of class and voting class, shall be required for approval of such action. Section 2. AMENDMENT BY DIRECTORS. Subject to the rights of the Stockholders as provided in Section 1 of this Article IX to adopt, amend or repeal bylaws, bylaws may be adopted, amended or repealed by the Board of Directors. Exhibit 10.7d EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and Vicki F. Perry, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Vice President/General Manager of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Vice President/General Manager. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $160,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 7,500 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to four (4) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed four (4) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ Vicki F. Perry Exhibit 10.8c EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and Alan D. Bloom, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Senior Vice President, Secretary and General Counsel of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Senior Vice President, Secretary and General Counsel. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $203,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 7,500 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to four (4) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed four (4) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ Alan D. Bloom Exhibit 10.12d EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and Aivars Jerumanis, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Senior Vice President, Chief Information Officer of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Senior Vice President, Chief Information Officer. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $185,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 5,000 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to three (3) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed three (3) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ Aivars Jerumanis Exhibit 10.48a EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between MAXICARE, a California corporation (the "Company"), and William B. Caswell, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Vice President - General Manager of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company or the Company's parent, Maxicare Health Plans, Inc., a Delaware corporation ("Maxicare") with or into any other person or entity other than an affiliate or subsidiary of the Company or Maxicare, as the case may be, if upon the consummation of the transaction, holders of Maxicare's or the Company's equity securities, as the case may be, immediately prior to such transaction own less than fifty percent (50%) of the equity securities of the surviving or consolidated entity; or (ii) the sale or transfer by the Company or Maxicare of all or substantially all of their respective assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of forty-five (45) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Vice President - General Manager. Subject to his continued employment as such by the Board of Directors or the President of the Company, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors and the President of the Company or such other person(s) as they may designate. Employee shall render his services at such locations as the Company's Board of Directors or the President of the Company may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee an initial base salary at the rate of $195,000 per annum, with such increases and bonuses, as may be determined from time to time by the Board of Directors of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 10,000 shares of Maxicare's Common Stock. The Stock Option shall be granted pursuant to the terms of Maxicare's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall receive an automobile allowance in the amount of $275.00 per month and shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other comparatively situated executives of the Company. Employee shall be entitled to three (3) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed three (3) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, including parking, the cost of purchase, installation and operation of a car phone, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of two (2) years, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. Subject to the provisions of 7(a) through (f) above, in the event the Company, in its sole discretion, wishes to engage Employee's services beyond the term of this Agreement, the Company agrees to notify Employee, in writing, no less than 120 days prior to the expiration of the term hereof, of the terms and conditions of such proposed ongoing employment. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4 and vacation benefits pursuant to Section 5, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), (i) prior to the first anniversary of the date of this Agreement, Employee shall be entitled to receive severance compensation in an amount equal to Employee's annual base salary; or (ii) on or after the first anniversary of the date of this Agreement, Employee shall be entitled to receive severance compensation equal to the amount of the remainder of Employee's annual base salary as would have been paid had this Agreement not been terminated which amount shall in no event be less than Employee's annual base for a six (6) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall be entitled to receive severance compensation in an amount equal to Employee's annual base salary. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of Maxicare's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform it if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE, a California Corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ William B. Caswell Exhibit 10.51c EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and Robert Landis, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Treasurer of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Treasurer. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $150,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 10,000 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to four (4) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed four (4) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ Robert Landis Exhibit 10.54 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 5th day of November, 1993, to Florence Courtright (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $10.88 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. As an officer, employee, or director with the Company, the Optionee's rights in and to the Option shall vest as of the date hereof, and the Optionee may, subject to Section 13 hereof, exercise this Option immediately for up to the total number of shares set forth in the first sentence of this Agreement. While the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), the Option may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of if Optionee is entitled to exercise any unexercised if Optionee is entitled to exercise any unexercised survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Florence Courtright Exhibit 10.55 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Vicki F. Perry (the "Optionee"), an option to purchase a maximum of 7,500 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 2,500 shares from the date hereof Two years but less than three - 2,500 shares years from the date hereof Three years but less than four - 2,500 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Vicki F. Perry Exhibit 10.56 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Alan D. Bloom (the "Optionee"), an option to purchase a maximum of 7,500 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 2,500 shares from the date hereof Two years but less than three - 2,500 shares years from the date hereof Three years but less than four - 2,500 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Alan D. Bloom Exhibit 10.57 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Richard Link (the "Optionee"), an option to purchase a maximum of 5,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 1,667 shares from the date hereof Two years but less than three - 1,667 shares years from the date hereof Three years but less than four - 1,666 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Richard Link Exhibit 10.58 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Aivars Jerumanis (the "Optionee"), an option to purchase a maximum of 5,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 1,667 shares from the date hereof Two years but less than three - 1,667 shares years from the date hereof Three years but less than four - 1,666 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Aivars Jerumanis Exhibit 10.59 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Robert Landis (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 3,333 shares from the date hereof Two years but less than three - 3,333 shares years from the date hereof Three years but less than four - 3,334 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Robert Landis Exhibit 10.60 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to William Caswell (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 3,333 shares from the date hereof Two years but less than three - 3,333 shares years from the date hereof Three years but less than four - 3,334 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ William Caswell Exhibit 10.61 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Thomas W. Field, Jr. (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. As an officer, employee, or director with the Company, the Optionee's rights in and to the Option shall vest as of the date hereof, and the Optionee may, subject to Section 13 hereof, exercise this Option immediately for up to the total number of shares set forth in the first sentence of this Agreement. While the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), the Option may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of if Optionee is entitled to exercise any unexercised if Optionee is entitled to exercise any unexercised survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Thomas W. Field, Jr. Exhibit 10.62 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Dr. Charles E. Lewis (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. As an officer, employee, or director with the Company, the Optionee's rights in and to the Option shall vest as of the date hereof, and the Optionee may, subject to Section 13 hereof, exercise this Option immediately for up to the total number of shares set forth in the first sentence of this Agreement. While the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), the Option may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of if Optionee is entitled to exercise any unexercised if Optionee is entitled to exercise any unexercised survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Dr. Charles E. Lewis Exhibit 10.63 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to Claude S. Brinegar (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. As an officer, employee, or director with the Company, the Optionee's rights in and to the Option shall vest as of the date hereof, and the Optionee may, subject to Section 13 hereof, exercise this Option immediately for up to the total number of shares set forth in the first sentence of this Agreement. While the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), the Option may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of if Optionee is entitled to exercise any unexercised if Optionee is entitled to exercise any unexercised survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ Claude S. Brinegar Exhibit 10.64 EMPLOYMENT AGREEMENT This Employment Agreement ("Agreement"), dated as of January 1, 1994, is made by and between Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), and David Hammons, an individual ("Employee"). R E C I T A L S --------------- WHEREAS, Employee is knowledgeable and skillful in the Company's business; WHEREAS, the Company wishes to retain the services of Employee as Vice President, Administrative Services of the Company and Employee has agreed to render services as such; WHEREAS, Employee is willing to be employed by the Company under the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the terms and conditions hereinafter set forth, and for other good and valuable consideration, the receipt of which is hereby acknowledged the parties hereto agree as follows: 1. DEFINITIONS. As used in this Agreement, the following capitalized terms shall have the following meanings, unless otherwise expressly provided or unless the context otherwise requires: (a) "Board of Directors" means the Board of Directors of the Company. (b) "Cause" means, as used with respect to the involuntary termination of Employee: (i) The willful and continued failure by Employee to substantially perform his duties pursuant to the terms of this Agreement without good cause; or (ii) The willful engaging by Employee in misconduct or inaction materially injurious to the Company; or (iii) The conviction of Employee for a felony or of a crime involving moral turpitude. No act, or failure to act, on the Employee's part shall be considered "willful" if done or omitted to be done by the Employee in good faith and with reasonable belief that the Employee's action or omission was in the best interest of the Company. (c) "Change of Control" means (i) the merger or consolidation of the Company with or into any other person or entity other than an affiliate or subsidiary of the Company if upon the consummation of the transaction, holders of the Company's equity securities, immediately prior to such transaction own less than fifty percent (50%) of the equity; or (ii) the sale or transfer by the Company of all or substantially all of its assets. (d) "Incapacity" means the absence of the Employee from his employment or the inability of Employee to perform his duties pursuant to this Agreement by reason of mental or physical illness, disability or incapacity for a period of thirty (30) consecutive days and such determination is based upon a certificate as to such mental or physical disability issued by a licensed physician and/or psychiatrist, as the case may be, employed by the Company. 2. EMPLOYMENT, SERVICES AND DUTIES. The Company hereby employs Employee as Senior Vice President, Administrative Services. Subject to his continued employment as such by the Board of Directors, Employee shall have and perform the duties and have the powers, authority and responsibilities ordinarily associated with a person in such position and shall be subject to the direction of the Company's Board of Directors. Employee shall render his services at such locations as the Company's Board of Directors may designate. 3. ACCEPTANCE OF EMPLOYMENT. Employee hereby accepts employment hereunder and agrees to devote his full time to the Company's business and shall in no way be involved in any activities whatsoever which might interfere with his employment with the Company. 4. COMPENSATION. As compensation for all services to be rendered by Employee hereunder, the Company agrees to provide Employee with the following: (a) BASE SALARY. The Company shall pay to Employee a base salary at the rate of $134,000.00 per annum, with such increases and bonuses, as may be determined from time to time by the Chief Executive Officer of the Company. Said salary shall be payable in equal semi-monthly installments or in such other installments as may be agreed upon between the parties. (b) STOCK OPTIONS. The Company shall grant to Employee an option (the "Stock Option") to purchase 5,000 shares of the Company's Common Stock. The Stock Option shall be granted pursuant to the terms of the Company's 1990 Stock Option Plan and a Stock Option Agreement in the form attached hereto as Exhibit A. Employee acknowledges that he is entitled to only one such Stock Option grant pursuant to this Agreement. Employee's interest in and rights to the Stock Option shall vest in accordance with the terms of the Stock Option Agreement. 5. BENEFITS. In addition to the compensation provided for in Section 4 of this Agreement, Employee shall have the right to participate in any profit-sharing, pension, life, health and accident insurance, or other employee benefit plans presently adopted or which hereafter may be adopted by the Company in a manner comparable to those offered or available to other employees of the Company. Employee shall be entitled to four (4) weeks annual vacation time, during which time his compensation will be paid in full. Unused vacation days in any year(s) may be carried over to a subsequent year(s) provided, however, the cumulative number of vacation days which may be carried over in any one year shall not exceed four (4) weeks. 6. EXPENSES. The Company shall promptly reimburse Employee for all reasonable travel, hotel, entertainment and other expenses incurred by Employee in the discharge of Employee's duties hereunder, upon receipt from Employee of vouchers, receipts or other reasonable substantiation of such expenses acceptable to the Company. 7. TERM OF EMPLOYMENT. The term of employment hereunder shall be for a period of one (1) year, commencing as of the date of this Agreement, unless earlier terminated as herein provided. This Agreement shall terminate upon the occurrence of any of the following events: (a) The death of Employee; (b) Employee voluntarily leaves the employ of the Company, with or without the consent of the Company; (c) The Incapacity of Employee; (d) The Company terminates this Agreement for Cause; (e) The Company terminates this Agreement for any reason other than as set forth in Sections 7(a), 7(c) or 7(d) hereof; or (f) The appointment of a trustee for the Company for the purpose of liquidating and winding up the Company pursuant to Chapter 7 of the Federal Bankruptcy Code. 8. COMPENSATION UPON TERMINATION. In the event this Agreement is terminated pursuant to Section 7, the Company shall pay to Employee such compensation as Employee is entitled to receive pursuant to Section 4, prorated through the date of said termination. In the event that such termination arises under Section 7(a), Employee's estate shall be entitled to receive severance compensation equal to such amount of Employee's annual base salary as would have been paid over a thirty (30) day period. In the event that such termination arises under Section 7(e), Employee shall be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. In the event that this Agreement is terminated by the Company or its successor in interest in connection with, or as a result of, a Change in Control or for any reason other than as set forth in Sections 7(a) - (d) hereof within six (6) months of a Change in Control, Employee shall, in lieu of any severance compensation payable pursuant to the immediately preceding sentence, be entitled to receive severance compensation in an amount equal to such amount of Employee's annual base salary as would have been paid over a four (4) month period. Any and all severance amounts paid pursuant to the provisions of this Section 8 shall be paid in one lump sum installment. The treatment of Employee's Stock Options shall be governed by the terms of the Company's 1990 Stock Option Plan and the Stock Option Agreement. 9. COVENANT NOT TO COMPETE. Employee covenants and agrees that during the term of his employment by the Company pursuant to this Agreement he will not, directly or indirectly, own, manage, operate, join, control or become employed by, or render any services of any advisory nature or otherwise, or participate in the ownership, management, operation or control of, any business which competes with the business of the Company or any of its affiliates. Notwithstanding the foregoing, Employee shall not be prevented from investing his assets in such form or manner as will not require any services on the part of Employee in the operation of the affairs of a company in which investments are made, provided such company is not engaged in a business competitive to the Company, or if it is in competition with the Company, provided its stock is publicly traded and Employee owns less than one percent (1%) of the outstanding stock of that company. 10. CONFIDENTIALITY. Employee covenants and agrees that he will not at any time during or after the termination of his employment by the Company reveal, divulge or make known to any person, firm or corporation any information, knowledge or data of a proprietary nature relating to the business of the Company or any of its affiliates which is not or has not become generally known or public. Employee shall hold, in a fiduciary capacity, for the benefit of the Company, all information, knowledge or data of a proprietary nature, relating to or concerned with, the operations, customers, developments, sales, business and affairs of the Company and its affiliates which is not generally known to the public and which is or was obtained by the Employee during his employment by the Company. Employee recognizes and acknowledges that all such information, knowledge or data is a valuable and unique asset of the Company and accordingly he will not discuss or divulge any such information, knowledge or data to any person, firm, partnership, corporation or organization other than to the Company, its affiliates, designees, assignees or successors or except as may otherwise be required by the law, as ordered by a court or other governmental body of competent jurisdiction, or in connection with the business and affairs of the Company. 11. EQUITABLE REMEDIES. In the event of a breach or threatened breach by Employee of any of his obligations under Sections 9 and 10 hereof, Employee acknowledges that the Company may not have an adequate remedy at law and therefore it is mutually agreed between Employee and the Company that in addition to any other remedies at law or in equity which the Company may have, the Company shall be entitled to seek in a court of law and/or equity a temporary and/or permanent injunction restraining Employee from any continuing violation or breach of this Agreement. 12. MISCELLANEOUS. (a) This Agreement shall be binding upon and inure to the benefit of the Company and any successor of the Company. This Agreement shall not be terminated by the voluntary or involuntary dissolution of the Company or by any merger, reorganization or other transaction in which the Company is not the surviving or resulting corporation or upon any transfer of all or substantially all of the assets of Company in the event of any such merger, or transfer of assets. The provisions of this Agreement shall be binding upon and shall inure to the benefit of the surviving business entity or the business entity to which such assets shall be transferred in the same manner and to the same extent that the Company would be required to perform as if no such transaction had taken place. Neither this Agreement nor any rights arising hereunder may be assigned or pledged by Employee. Employee's rights to the compensation provided for under Section 4 of this Agreement (as may be limited by Section 8 of the Agreement) and to the reimbursement for expenses under Section 6 hereof, shall continue, despite the fact that Employee may cease to be employed by the Company, and shall survive the termination of this Agreement regardless of cause. This Agreement shall inure to the benefit of and be enforceable by Employee's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. (b) Except as otherwise provided by law or elsewhere herein, Employee shall be entitled to all benefits as set forth herein notwithstanding the occurrence of the following events: (i) any act of force majeure which materially and adversely affect the Company's business and operations, including but not limited to, the Company having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, epidemic, explosion, accident, calamity or other act of God; (ii) any strike or labor dispute or court or government action, order or decree; (iii) a banking moratorium having been declared by federal or state authorities; (iv) an outbreak of major armed conflict, blockade, embargo, or other international hostilities or restraints or orders of civic, civil defense, or military authorities, or other national or international calamity having occurred; (v) any act of public enemy, riot or civil disturbance or threat thereof; or (vi) a pending or threatened legal or governmental proceeding or action relating generally to the Company's business, or a notification having been received by the Company of the threat of any such proceeding or action, which could materially adversely affect the Company. (c) Except as expressly provided herein, this Agreement contains the entire understanding between the parties with respect to the subject matter hereof, and may not be modified, altered or amended except by an instrument in writing signed by the parties hereto. This Agreement supersedes all prior agreements of the parties with respect to the subject matter hereof. In the event of termination of employment of Employee pursuant to this Agreement, the arrangements provided for by this Agreement, by any Stock Option Agreement or other written agreement between the Company or any of its affiliates and Employee in effect at the time, and by any other applicable benefit plan of the Company or any of its affiliates, will constitute the entire obligation of the Company to the Employee and performance thereof by the Company will constitute full settlement of any and all claims, whether in contract or tort, that Employee might otherwise assert against the Company or any of its affiliates on account of such termination. (d) This Agreement shall be construed in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such state and without regard to the conflict of law principals thereof. (e) Nothing in the Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability pursuant to court order to perform its obligations under this Agreement shall not constitute a breach of this Agreement. If any provision of this Agreement is invalid or unenforceable, the remainder of this Agreement shall nevertheless remain in full force and effect. If any provision is held invalid or unenforceable with respect to particular circumstances, it shall, nevertheless, remain in full force and effect in all other circumstances. (f) With the exception of disputes arising under or with respect to Sections 9 or 10 hereof, any and all disputes hereunder shall be resolved by arbitration. Any party hereto electing to commence an action shall give written notice to the other parties hereto of such election. The dispute shall be settled by arbitration in accordance with the then rules of the American Arbitration Association; provided, however, in the event the parties are unable to agree on an arbitrator within twenty (20) days after receipt of the aforementioned notice of arbitration, a single arbitrator shall be selected by the Chief Judge of the Superior Court of the State of California for the County of Los Angeles. The award of such arbitrator may be confirmed or enforced in any court of competent jurisdiction. The costs and expenses of the arbitrator, including the attorney's fees and costs of each of the parties, shall be apportioned between the parties by such arbitrator, based upon such arbitrator's determination of the merits of their respective positions. With respect to such arbitration, the parties shall have those rights of discovery as may be granted by the arbitrator in accordance with California law. (g) Any notice to the Company required or permitted hereunder shall be given in writing to the Company, either by personal service, telex, telecopier or, if by mail, by registered or certified mail return receipt requested, postage prepaid, duly addressed to the Secretary of the Company at its then principal place of business. Any such notice to Employee shall be given in a like manner, and if mailed shall be addressed to Employee at Employee's home address then shown in the files of the Company. For the purpose of determining compliance with any time limit herein, a notice shall be deemed given on the fifth day following the postmarked date, if mailed, or the date of delivery if personally delivered. (h) A waiver by either party of any term or condition of this Agreement or any breach thereof, in any one instance, shall not be deemed or construed to be a waiver of such term or condition or of any subsequent breach thereof. (i) The paragraph and subparagraph headings contained in this Agreement are solely for convenience and shall not be considered in its interpretation. (j) This Agreement may be executed in one or more counterparts, each of which shall constitute an original. IN WITNESS WHEREOF, the parties hereto have executed this Employment Agreement as of the day and year first written above. COMPANY: MAXICARE HEALTH PLANS, INC., a Delaware corporation By: /s/ Peter J. Ratican Title: Chairman, President and Chief Executive Officer EMPLOYEE: /s/ David Hammons Exhibit 10.65 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of May, 1991, to Dave Hammons (the "Optionee"), an option to purchase a maximum of 10,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") equal to the weighted average price per share for the first twenty trading days after December 5, 1990, of (i) the closing bid price of the Company's Common stock in the principal national securities exchange in which the Common Stock is traded, or (ii) if the Company's Common Stock is not traded on a national securities exchange, the last reported sale price of the Common Stock on the NASDAQ National Market List, or (iii) if the common stock is not reported on the NASDAQ National Market List, the closing bid price (or average of bid prices) last quoted by an established quotation service for over-the-counter securities (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. This Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. 2. EXTENT OF OPTION. If the Optionee has continued to serve the Company in the capacity of an officer, employee, or director with the Company on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares set forth opposite the applicable date: December 5, 1992 One-third (1/3) of the total number of shares subject to this option December 5, 1993 An additional one third (1/3) of the total number of shares subject to this option December 5, 1994 An additional one-third (1/3) of the total number of shares subject to this option The foregoing right are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company, may be exercised up to and including the earlier of the date which is 5 years from December 5, 1990 or the expiration date of the Plan (the earlier of such dates being hereinafter referred to as the "Option Expiration Date"). For purposes of this Agreement, any accrued installment shall be referred to as "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company or becomes disabled or dies while serving as an officer, director or employee of the Company. 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company, other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Option Expiration Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installment of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date, (as defined in the Plan), but in no event beyond the applicable Option Expiration Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company. 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company, or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to the Optionee shall expire and become unexercisable as of the earlier of (i) the Option Expiration Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his/her death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company during any period of leave of absence from active employment as authorized by the Company. 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be made in part at any time and from time to time with the above limits, except that this Option may be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States Dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in the amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired of the Optionee's own account and not with a view of resale or distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to tear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that neither the Option nor the Common Stock to be issued upon exercise of the Option have been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been, and the shares of Common Stock issuable upon exercise of the Option will be, issued in reliance upon certain exemptions contained therein, and that the Company's reliance on such exemption is predicated on Optionee's representations set forth herein. The Optionee further understands that because neither the Option nor the shares of Common Stock to be issued up on exercise of the Option have been registered under the 1993 Act, the Optionee may not and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such securities in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option or the Common Stock to be issued upon exercise of the Option. (b) The Optionee consents to the placing of restrictive legends in substantially the following form on any stock certificate(s) representing Common Stock issued upon exercise of the Option: "The Shares represented by this Certificate have not been registered under the Securities Act of 1933, as amended, or the blue sky laws of any state. These shares have been acquired for investment and not with a view to distribution or resale, and may not be sold, mortgaged, pledged, hypothecated or otherwise transferred without an effective registration statement for such shares under the Securities Act of 1933, as amended, or until the issuer has been furnished with an opinion of counsel for the registered owner of these shares, reasonably satisfactory to counsel for the issurer, that such sale, transfer or disposition is exempt from the registration or qualification provisions of the Securities Act of 1933, as amended, or the blue sky laws of any state having jurisdiction." (c) The Optionee also hereby consents and agrees to the placing of stop transfer instructions against any subsequent transfer(s) of shares of Common Stock issued upon exercise of the Option. The Company hereby agrees to remove the legend and stop transfer instructions upon receipt of an opinion of counsel from the registered owner of the shares of Common Stock issued upon exercises of the Option, in form and substance acceptable to counsel for the Company, to the effect that such shares may be transferred without violation of the 1933 Act or the blue sky laws of any state having jurisdiction. 8. METHOD OF EXERCISING OPTION. No Option may be exercised in whole or in part until two (2) years after December 5, 1990. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. Common Stock issued pursuant to the exercise of this Option or any interest in such Common Stock, may be sold, assigned, gifted, pledged, hypothecated, encumbered or otherwise transferred to alienated in any manner by the holder(s) thereof, subject, however, to the provisions of the Plan, including any representations or warranties requested under Section 22 thereof, and also subject to compliance with any applicable federal, state, local or other law, regulations or rule governing the sale or transfer of stock or securities, and provided, further than in all cases, the Optionee may not sell or otherwise transfer shares acquired upon the exercise of an Option for a period of six (6) months following the date of acquisition (within the meaning of Section 16-b (3) of the Security Exchange Act of 1934) of such Option without the prior written consent of the Board. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. The Company is not by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, if Optionee is entitled to exercise any unexercised installment of the Option then outstanding, then Optionee may, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's withholding obligation, the Optionee will reimburse the Company on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican President and Chief Executive Officer OPTIONEE: /s/ Dave Hammons Exhibit 10.66 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1991, to Dave Hammons (the "Optionee"), an option to purchase a maximum of 5,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $8.25 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. This Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve the Company in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares set opposite the applicable date: Less than one year from the date hereof - 0 One year but less than two years from the date hereof - 1,667 Two years but less than three years from the date hereof - 1,667 Three years but less than four years from the date hereof - 1,666 The foregoing right are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Option Expiration Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installment of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Option Expiration Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his/her death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be made in part at any time and from time to time with the above limits, except that this Option may be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States Dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in the amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired of the Optionee's own account and not with a view of resale or distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to tear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that neither the Option nor the Common Stock to be issued upon exercise of the Option have been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been, and the shares of Common Stock issuable upon exercise of the Option will be, issued in reliance upon certain exemptions contained therein, and that the Company's reliance on such exemption is predicated on Optionee's representations set forth herein. The Optionee further understands that because neither the Option nor the shares of Common Stock to be issued up on exercise of the Option have been registered under the 1993 Act, the Optionee may not and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such securities in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option or the Common Stock to be issued upon exercise of the Option. (b) The Optionee consents to the placing of restrictive legends in substantially the following form on any stock certificate(s) representing Common Stock issued upon exercise of the Option: "The Shares represented by this Certificate have not been registered under the Securities Act of 1933, as amended. These shares have been acquired for investment and not with a view to distribution or resale, and may not be sold, mortgaged, pledged, hypothecated or otherwise transferred without an effective registration statement for such shares under the Securities Act of 1933, as amended, or until the issuer has been furnished with an opinion of counsel for the registered owner of these shares, reasonably satisfactory to counsel for the issuer, that such sale, transfer or disposition is exempt from the registration or qualification provisions of the Securities Act of 1933, as amended." (c) The Optionee also hereby consents and agrees to the placing of stop transfer instructions against any subsequent transfer(s) of shares of Common Stock issued upon exercise of the Option. The Company hereby agrees to remove the legend and stop transfer instructions upon receipt of an opinion of counsel from the registered owner of the shares of Common Stock issued upon exercises of the Option, in form and substance acceptable to counsel for the Company, to the effect that such shares may be transferred without violation of the 1933 Act. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. Common Stock issued pursuant to the exercise of this Option or any interest in such Common Stock, may be sold, assigned, gifted, pledged, hypothecated, encumbered or otherwise transferred to alienated in any manner by the holder(s) thereof, subject, however, to the provisions of the Plan, including any representations or warranties requested under Section 22 thereof, and also subject to compliance with any applicable federal, state, local or other law, regulations or rule governing the sale or transfer of stock or securities, and provided, further than in all cases, the Optionee may not sell or otherwise transfer shares acquired upon the exercise of an Option for a period of six (6) months following the date of acquisition (within the meaning of Section 16-b (3) of the Security Exchange Act of 1934) of such Option without the prior written consent of the Board. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, if Optionee is entitled to exercise any unexercised installment of the Option then outstanding, then Optionee may, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, Chief Executive Officer and President OPTIONEE: /s/ Dave Hammons Exhibit 10.67 MAXICARE HEALTH PLANS, INC. STOCK OPTION AGREEMENT Maxicare Health Plans, Inc., a Delaware corporation (the "Company"), hereby grants as of this 20th day of December, 1993, to David Hammons (the "Optionee"), an option to purchase a maximum of 5,000 shares of its common stock (the "Common Stock"), at a price per share (the "Exercise Price") of $9.63 per share (the "Option"), on the following terms and conditions: 1. GRANT UNDER 1990 STOCK PLAN. The Option is granted pursuant to and is governed by the Company's 1990 Stock Option Plan (the "Plan") and, unless the context otherwise requires, terms used and/or defined herein shall have the same meaning as in the Plan. Determinations made in connection with this Option pursuant to the Plan shall be governed by the Plan as it exists on this date. This Option is not intended to be and shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code. 2. EXTENT OF OPTION. If the Optionee has continued to serve in the capacity of an officer, employee, or director with the Company (or a subsidiary thereof, as the case may be) on the following dates, the Optionee may, subject to Section 13 hereof, exercise this Option for the portion of the total number of shares subject to this Option set opposite the applicable date: Less than one year from the - 0 shares date hereof One year but less than two years - 1,667 shares from the date hereof Two years but less than three - 1,667 shares years from the date hereof Three years but less than four - 1,666 shares years from the date hereof The foregoing rights are cumulative and, while the Optionee continues to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be), may be exercised up to and including the earlier of the date which is five years from the date this Option is granted (the "Fifth Anniversary Date"). For purposes of this Agreement, any accrued installment shall be referred to as an "Accrued Installment". All of the foregoing rights are subject to Sections 3 and 4 hereof, as appropriate, if the Optionee ceases to serve as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be) or becomes disabled or dies while serving as an officer, director or employee of the Company (or a subsidiary thereof, as the case may be). 3. TERMINATION OF BUSINESS RELATIONSHIP. If the Optionee ceases to remain an officer, director or employee of the Company (or subsidiary thereof, as the case may be), other than by reason of death or disability as defined in Section 4, any unexercised Accrued Installments of the Option shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) thirty (30) days following the termination of Optionee's employment or termination of Optionee's directorship. No further installments of this Option shall become exercisable. The Board of Directors of the Company may extend such thirty (30) day period for a period not to exceed one (1) year following the Termination Date (as defined in the Plan), but in no event beyond the applicable Fifth Anniversary Date. In such a case, the Optionee's only rights hereunder shall be those which are properly exercised before the termination of this Option. Any portion of an Option that expires hereunder shall remain unexercisable and be of no effect whatsoever after such expiration notwithstanding that such Optionee may be reemployed by, or again become a director of, the Company (or a subsidiary thereof, as the case may be). 4. DEATH OR DISABILITY. In the event of the death of the Optionee while an officer, employee or director of the Company (or a subsidiary thereof, as the case may be), or in the event of termination of employment or directorship by reason of the Optionee's Disability (as defined in the Plan), any unexercised Accrued Installments of the Option granted to Optionee shall expire and become unexercisable as of the earlier of (i) the Fifth Anniversary Date, or (ii) the first anniversary date of the Optionee's death (if applicable) or (iii) the first anniversary date of the termination of employment or directorship by reason of Disability (if applicable). Any such Accrued Installments of a deceased Optionee may be exercised prior to their expiration by (and only by) the person or persons to whom the Optionee's Option rights shall pass by will or by the laws of descent and distribution. Any installments under a deceased Optionee's Option that have not accrued as of the date of his death shall expire and become unexercisable as of said date of death. For purposes of this Agreement, the Optionee shall be deemed employed by the Company (or a subsidiary thereof, as the case may be) during any period of leave of absence from active employment as authorized by the Company (or a subsidiary thereof, as the case may be). 5. PARTIAL EXERCISE. Exercise of this Option up to the extent above stated may be in part at any time and from time to time with the above limits, except that this Option may not be exercised for a fraction of a share. Upon the exercise of the final installment of this Option, the Optionee shall be entitled to receive cash with respect to the value of any fraction of a share (in lieu of any said fractional share). 6. PAYMENT OF EXERCISE PRICE. The Exercise Price is payable in United States dollars and may be paid in cash or by certified or cashier's check, or any combination of the foregoing, equal in amount to the Exercise Price. 7. INVESTMENT REPRESENTATIONS; RESTRICTIONS ON TRANSFER. (a) The Optionee represents, warrants and covenants to the Company that: (i) Any Common Stock acquired by the Optionee upon exercise of the Option will be acquired for the Optionee's own account and not with a view to resale on distribution in violation of the Securities Act of 1933, as amended (the "1933 Act"). (ii) The Optionee has such knowledge and experience in business and financial matters as to be capable of utilizing the information which is available to the Optionee to evaluate the merits and risks of an investment in the Common Stock, and is able to bear the economic risks of any Common Stock or other securities which the Optionee may acquire upon exercise of the Option. (iii) The Optionee understands that the Option has not been registered under the Securities Act of 1933, as amended (the "1933 Act"), that the Option has been issued in reliance upon certain exemptions contained therein. The Optionee further understands that because the Option has not been registered under the 1933 Act or registered or qualified pursuant to applicable "blue sky" statutes, the Optionee may not, and Optionee covenants and agrees that Optionee will not, sell, offer to sell or otherwise dispose of any such Option in violation of the 1933 Act or any applicable "blue sky" or securities law of any state. The Optionee acknowledges and understands that Optionee has no independent right to require the Company to register the Option. 8. METHOD OF EXERCISING OPTION. Subject to the terms and conditions of this Agreement, this Option may be exercised by written notice to the Company, at the principal executive office of the Company, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this Option and the number of shares in respect of which it is being exercised and shall be signed by the Optionee or person or persons entitled to so exercise this Option. Such notice shall be accompanied by payment of the full Exercise Price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice is received. The certificate or certificates for the shares as to which this Option shall have been so exercised shall be registered in the name of the person or persons so exercising this Option (or, if this Option shall be exercised by the Optionee and if the Optionee shall so request in the notice exercising this Option, shall be registered in the name of the Optionee and another person jointly, with right of survivorship) and shall be delivered to or upon the written order of the person or persons exercising this Option. In the event this Option shall be exercised, pursuant to Section 4 hereof, by any person or persons other than the Optionee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this Option. All shares that shall be purchased upon the exercise of this Option as provided herein shall be fully paid and non-assessable. 9. OPTION NOT TRANSFERABLE; TRANSFER OF STOCK. This Option is not transferable or assignable except by will or by the laws of descent and distribution. During the Optionee's lifetime, only the Optionee may exercise this Option. 10. NO OBLIGATION TO EXERCISE OPTION. The grant and acceptance of this Option imposes no obligation on the Optionee to exercise it. 11. NO OBLIGATION TO CONTINUE EMPLOYMENT. Neither the Company nor any subsidiary thereof is by the Plan or this Option obligated to continue to employ Optionee and neither the Plan nor this Option shall otherwise interfere with the Company's or any of the Company's subsidiary's right to discharge or retire any employee, including Optionee, at any time. 12. NO RIGHTS AS STOCKHOLDER UNTIL EXERCISE. The Optionee shall have no rights as a stockholder with respect to shares subject to this Agreement until a stock certificate therefore has been issued to the Optionee and is fully paid for. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to the date such stock certificate is issued. 13. REORGANIZATION OF COMPANY. (a) Upon the dissolution or liquidation of the Company, or upon a reorganization, merger or consolidation of the Company as a result of which the Company's outstanding Common Stock is changed into or exchanged for cash or property or securities not of the Company's issue, or upon a sale of all or substantially all property of the Company to, or the acquisition of all or substantially all of the stock of the Company then outstanding by, another corporation or person, the Plan shall terminate, and the Option granted hereunder shall terminate; provided, however, Optionee shall be entitled, at such time prior to the consummation of the transaction causing such termination as the Company shall designate, to exercise the unexercised installments of the Option including all unaccrued installments thereof which would, but for this subsection 13(a), not yet be exercisable. Notwithstanding the foregoing, in the event that any transaction causing such termination is not consummated, any unexercised unaccrued installments that had become exercisable solely by reason of the provisions of this subsection 13(a) shall again become unaccrued and unexercisable as of said termination of such transaction, subject, however, to such installments accruing pursuant to the normal accrual schedule provided in the terms under which the Option was granted. (b) In addition to and not in lieu of those rights granted pursuant to subsection 13(a) above, if provisions shall be made in writing in connection with such transaction for the continuance of the Plan and/or the assumption of options theretofore granted, or the substitution for such options of options covering the stock of the successor corporation, or a parent or subsidiary thereof with appropriate adjustments as to the number and kind of shares and prices, the unexercised Option shall continue in the manner and under the terms so provided. (c) The Company shall have no obligation to provide for the continuance, assumption or substitution of the Plan or the Option by any successor corporation or parent or subsidiary thereof. 14. WITHHOLDING TAXES. The Optionee hereby agrees that the Company (or a subsidiary thereof, as the case may be) may withhold from the Optionee's wages or other remuneration the appropriate amount of federal, state and local taxes attributable to the Optionee's exercise of any installment of this Option. The Optionee further agrees that, if the Company (or a subsidiary thereof, as the case may be) does not withhold an amount from the Optionee's wages or other remuneration sufficient to satisfy the Company's (or any such subsidiary's) withholding obligation, the Optionee will reimburse the Company (or any such subsidiary) on demand, in cash, for the amount underwithheld. 15. GOVERNING LAW. This Agreement shall be governed by and interpreted in accordance with the laws of the State of California applicable to agreements made and to be performed entirely within such State and without regard to the conflict of law principals thereof. 16. AMENDMENTS. No amendment, modification, termination or waiver of any provision of this Agreement shall be effective unless the same shall be in writing signed by all parties hereto. 17. COUNTERPARTS. This Agreement may be signed in one or more counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 18. SURVIVAL OF REPRESENTATIONS. All representations, covenants and warranties of the parties hereto shall survive the execution of this Agreement. IN WITNESS WHEREOF the Company and the Optionee have caused this instrument to be executed as of the date first written above, and the Optionee whose signature appears below acknowledges receipt of a copy of the Plan and acceptance of an original copy of this Agreement. THE COMPANY: MAXICARE HEALTH PLANS, INC. By: /s/ Peter J. Ratican Chairman, President and Chief Executive Officer OPTIONEE: /s/ David Hammons Exhibit 21 SUBSIDIARIES OF THE REGISTRANT Exhibit 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 33-50508) of Maxicare Health Plans, Inc. of our report dated March 4, 1994 appearing on page 37 of this Form 10-K. PRICE WATERHOUSE Los Angeles, California March 25, 1994

720032_1993.txt

720032_1993

1993

720032

Item 1. Business During the 1993 fiscal year, there have been no material changes in the manner in which the Registrant conducts its business operations. As used herein, the "Company" or the "Registrant" means, unless the context otherwise requires, Figgie International Inc., a Delaware corporation, its predecessors and its subsidiaries and divisions. The Company's operations can be grouped into five segments: (l) consumer products, (2) fire protection, safety, and security products, (3) machinery and allied products, (4) technical products and (5) services. The Company's business is generally managed at the operating division and subsidiary level. Centralized financial and budget controls and certain other staff functions are performed at the corporate offices of the Company. The Company has decided to dispose of various operations. See "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations." Fred Perry Sportswear Ltd. licenses Fred Perry* tennis and other products and casual clothing in the United States and throughout the world. Fred Perry Sportswear (U.K.) Ltd. designs, manufactures, and distributes tennis and other sports apparel and leisurewear products. Interstate Engineering manufactures Compact* and Tri-Star* vacuum cleaners and non-electrical heat-activated home fire alarms. It also operates an aluminum and zinc die cast facility. Rawlings Sporting Goods manufactures and/or distributes baseballs, baseball gloves, baseball equipment, baseball bats, basketballs, footballs, football equipment, sports clothing, athletic uniforms, and other athletic team equipment. Sherwood-Drolet Corp. Ltd. designs, manufactures and distributes Sher- Wood* and Chimo* hockey sticks, hockey gloves, and protective equipment. Taylor Environmental Instruments manufactures thermometers, barometers, and hygrometers for home use and temperature and environmental measuring devices for use in food service, HVAC, and industrial applications as well as in scientific laboratories, hospitals, and universities. * Registered or common law trademarks and service marks of Figgie International Inc. and its subsidiaries. ** Registered trademark licensed to Figgie International Inc. by Combustion Engineering, Inc. Advance Security provides security personnel, conducts investigations, and acts as a security consultant to businesses, construction sites, hospitals, public buildings, and governmental installations. The assets of this operation were sold on February 25, 1994 to U.S.A. Security Associates, a privately held firm. American LaFrance manufactures fire trucks and operates a service center that performs major maintenance, repairs, and refurbishment of fire trucks and apparatus. "Automatic" Sprinkler Corporation of America is one of the nation's largest designers and installers of sophisticated fire protection systems for commercial and industrial use and for special hazard facilities, including power stations, petrochemical plants, and other facilities. The retrofit market has expanded as stricter governmental, fire code, and insurance requirements have resulted in the upgrading of fire protection systems in many existing buildings. Figgie Fire Protection Systems manufactures regular and special hazard fire systems and devices employing various extinguishing agents under ASCOA*, Chemetron*, Range Guard*, and Safety First* brand names. It also manufactures fire protection sprinkler devices and is one of the nation's largest manufacturers of industrial and consumer fire extinguishers for use in homes, boats, automobiles, and industrial applications as well as stainless steel liquid type extinguishers for industrial and commercial buildings. Its broad line of hand-portable and wheeled extinguishers include carbon dioxide, halon, water, and multi-purpose dry chemical extinguishing agents. Brass products and fittings are produced for use in standpipe and fire sprinkler systems and for fire engines and fire-fighting equipment. Medcenter Management Services manages the joint replacement departments of hospitals in cooperation with physicians to reduce the cost and improve the care and treatment of implant patients. The manufacture of orthopaedic implant devices (under the name of Figgie Medical Systems) was discontinued in January of 1994. Safety Supply America is one of the nation's largest distributors of personal and industrial protective and other safety equipment and industrial hygiene equipment, operating nationally through a number of regional offices with branches in most major metropolitan areas. It also manufactures lumbar and other support devices. Scott Aviation is the nation's largest manufacturer of protective breathing and emergency oxygen equipment for use in commercial and military aircraft. It also manufactures the Scott Air-Pak* for fire-fighting and for personal protection against industrial contaminants. Its air purifying products provide protection against environmental and safety hazards as increasingly required under governmental regulations. Scott Aviation also produces air and oxygen breathing masks, oxygen regulating devices, canister-type gas masks, electronic gas detection instruments, and various light aircraft accessories. Snorkel-Economy manufactures powered mobile work platforms and scissorlifts for use in construction and maintenance activities. It also makes hydraulically activated aerial platforms and articulating booms that are mounted on fire apparatus to deliver large quantities of water to fires from elevated positions. This equipment is installed on new as well as on existing fire trucks. * Registered or common law trademarks and service marks of Figgie International Inc. and its subsidiaries. Alfa Packaging Equipment designs and manufactures automated rotary wet glue, hot melt, and pressure sensitive labeling machinery as well as net-weight fillers for a wide range of applications in the beverage, food, distillery, pharmaceutical, cosmetic, chemical, and other industries. Astro-Pneumatic GmbH manufactures and markets air cylinders, valves, and pneumatic equipment for use in the chemical, mining, automotive, material handling, food, and beverage industries. Essick/Mayco Pump manufactures vibrating rollers, concrete and plaster mixers, and concrete and material pumps for the construction industry. Figgie Material Handling Systems - which trades as Logan Fenamec (U.K.) Limited, and Logan Glidepath, manufactures computer controlled, high- speed sorting mini stacker cranes and package handling equipment for warehouses, airports, post offices, and distribution terminals, as well as custom-engineered and pre-engineered conveyor systems for factories, warehouses, and terminals. The companies are established leaders worldwide for airport baggage handling, industrial conveying and sortation equipment. Figgie Packaging Systems produces high-speed uncasing and packing machinery; material handling and packaging systems; automatic screw-type capping, sorting, and sealing machinery; rotary piston fillers; and high speed can closing and inspection machines. It provides processing equipment for customers in the beverage, food, distillery, dairy, pharmaceutical, chemical, cosmetic, and other industries. Its fully integrated and automated high-speed systems include uncasing, cleaning, processing, filling, capping, labeling, palletizing, conveying, inspecting, packing, and systems control machinery. It offers full line turnkey capabilities and produces a wide range of medium and high-speed labeling machinery. Figgie Power Systems manufactures bladder accumulators, piston accumulators, surge and pulsation control products, and other fluid power products for applications in the industrial fluid power, mobile equipment, petroleum and chemical processing, and water control markets. It also designs and manufactures aluminum and steel pneumatic and hydraulic linear actuators for automation and industrial applications. Safway Steel Products manufactures and distributes tubular steel scaffolding for sale or rental to building, industrial maintenance, and demolition contractors; metal and wood bleachers and risers for sale or rental to schools, auditoriums, coliseums, and others; and vertical shoring, special order scaffolding, and certain other metal products. S-P/Sheffer International designs and manufactures precision workholding products primarily for the machine tool and metalworking industries. Workholding product lines include collets/collet chucks, diaphragm chucks, flexible power chucks and integrated quick change chucking systems. It also manufactures rotary actuating cylinders and dimensional control tooling systems. SpaceGuard Products manufactures woven wire partitions for use in securing areas such as tool cribs and stockrooms for industrial use. It also manufactures ornamental iron railings and columns and metal spiral staircases for both residential and commercial applications as well as steel folding gates for commercial use. CASI-RUSCO manufactures and sells computer-based CARDENTRY* access control equipment and monitoring systems. These products are used for security and parking control, personnel access, time, attendance, and fuel management control at military and government sites, data centers, parking areas, hospitals, universities, airports, and other commercial and industrial locations. Hartman Electrical designs and manufactures high-reliability electrical components principally for use in commercial and military aircraft, missiles, and space vehicles. These components include contactors, power relays, protection relays, circuit breaker switches, and automatic control panels used to switch electrical power and to protect the electrical systems from power faults. Interstate Electronics develops and produces sophisticated telemetry, instrumentation, and data recording systems and GPS position measuring systems for the U. S. Navy's Polaris/Poseidon, TRIDENT, and TRIDENT II submarine fleet ballistic missile programs. It also designs and produces precise Global Positioning Systems (GPS) for aircraft and turnkey test ranges, commercial and business aircraft navigation and landing systems. It also designs and produces plasma, liquid crystal, and cathode ray tube display systems for a variety of shipboard and aircraft applications. Additionally it develops sophisticated bandwidth-on-demand satellite communications modems and terminals for both government and commercial applications. * Registered or common law trademarks and service marks of Figgie International Inc. and its subsidiaries. Figgie Financial Services is engaged in providing asset-based financing and vehicle management services. It leases automobiles and other equipment to small and mid-sized commercial fleet customers, including the Company's Divisions, and also leases products manufactured by the Company to others. Figgie Natural Resources is engaged in the business of acquiring, exploring, and developing oil and gas properties by acquiring producing properties and further exploring and developing them. Figgie Properties is the real estate development division of Figgie International Inc. and is active in the planning, development, construction, and management of real estate throughout the United States. Its portfolio includes office and industrial parks, recreational facilities, self-serve storage units, retail/commercial centers, and residential communities. Waite Hill Holdings is a holding subsidiary that owns Cardinal Casualty, Colony Insurance, Hamilton Insurance, Waite Hill Assurance, and Waite Hill Services. Cardinal Casualty Co. is a property/casualty insurance company that provides insurance to outside clients. It is licensed in the states of Ohio, Florida, Georgia, Indiana, and the District of Columbia. It is approved to do business in five additional states. Colony Insurance Co. is a property/casualty insurance company that provides insurance to outside clients. It is licensed in Virginia and Washington State and is approved to do business in thirty-three other states. Hamilton Insurance Co. is a property/casualty insurance company that provides insurance to outside clients. It is licensed in seventeen states and is approved to do business in three additional states. Waite Hill Assurance is a non-operating insurance company that formerly provided insurance to the Company and outside clients. Waite Hill Services performs claims investigation and other insurance related services for the Company and outside clients. Customers In 1993, no single customer accounted for more than 10% of the net sales of any segment of the Company other than the U. S. Government, which accounted for approximately 60.0% of the net sales of the Company's Technical Products segment and approximately 16.5% of the Company's total net sales. Approximately 60.0% of the Technical Products segment's net sales for the next year are expected to come from U. S. Government contracts. These net sales are subject to the standard government contract clause that permits the Government to terminate such contracts at its convenience. In the event of such termination, there are provisions to enable the division to recover its costs plus a fee. The Company does not at this time anticipate the termination of any of its major government contracts. Competition All of the Company's divisions and subsidiaries are engaged in industries characterized by substantial competition in the form of price, service, quality, and design. In many instances they compete with companies whose financial resources are greater and whose market position is stronger than that of the particular division or subsidiary. The Company believes that in the United States it is among the leading manufacturers of automatic sprinkler devices and systems, elevated booms, portable fire extinguishers, scaffolding, protective breathing apparatus, and consumer thermometers. Patents and Trademarks The Company owns and is licensed under a number of patents and trademarks that it regards as sufficient for its operations. It believes its business as a whole is not materially dependent upon any one patent, trademark, or license or technologically related group of patents or licenses. Backlog of Orders As of December 31, 1993 and 1992, the Company had a total backlog of orders from continuing operations in the approximate amounts of $229 million and $267 million, respectively. On these dates such backlog was believed to be firm. Of the backlog on December 31, 1993, approximately 85% could reasonably be expected to be filled during the twelve months commencing January 1, 1994. However, final verification of the Company's backlog estimates depends on, among other things, general economic and business conditions in 1994 that cannot be predicted due to the many uncertainties involved. Raw Materials The Company believes that the principal raw materials and purchased component parts for the manufacture of its products are available from a number of suppliers and are generally available in sufficient quantities to meet its current requirements. Effect of Environmental Compliance At the present time, compliance with Federal, state, and local provisions with respect to environmental protection and regulation has not had a material impact on the Company's capital expenditures, earnings, or competitive position. Employees As of December 31, 1993, the Company employed for continuing and discontinued operations approximately 12,600 individuals. Approximately 10,700 of these were employed in the United States, of which approximately 6,600 were hourly paid employees and approximately 4,100 were salaried employees. Approximately 1,900 employees are covered by collective bargaining agreements with various unions. The Company has generally enjoyed good relations with the unions representing its employees. Substantially all of the Company's contracts with the several unions representing its employees expire at various dates within the next three years. Two major labor negotiations were completed during 1993. Two other major union contracts are scheduled to expire in 1994. Research During the fiscal year ending December 31, 1993, the Company's research activities consisted principally of normal and customary operations of each of its divisions and subsidiaries in the improvement of its products. In 1993, approximately $26.9 million was spent on research and development versus approximately $8.3 million in 1992. Distribution The Company's products and services are marketed through most normal channels of distribution. These vary on a subsidiary and division-by- division basis and include direct sales by company salesmen, sales through independent distributors and dealers, sales through manufacturers' agents, direct sales to government agencies, and the use of licenses and joint ventures. Executive Officers of the Company The following are the present executive officers of the Company who serve in the positions indicated: HARRY E. FIGGIE, JR., Chairman of the Board and Chief Executive Officer of the Company since 1964 and served as President from 1982 to May 1989; age 70. WALTER M. VANNOY, Vice Chairman of the Company since February 16, 1994, a member of its Board of Directors since 1981, and President of Vannoy Associates, a consulting firm, since December, 1988. Prior to his retirement in 1988, he was Vice Chairman of McDermott International, the corporate parent of Babcock & Wilcox, a diversified energy equipment and services company; age 66. VINCENT A. CHIARUCCI, President of the Company since May 1989 and Group Vice President from June 1988 to May 1989. Prior to joining the Company, he worked as a business consultant from 1986 to June 1988; age 64. MARY C. CLEARY, Vice President-Assistant to the Chairman of the Board since January 1987 and Administrative Assistant to the Chairman of the Board from 1967 to 1978 and from 1984 to 1987; age 67. LUTHER A. HARTHUN, Senior Vice President-International, General Counsel and Secretary since April 1981; Vice President-International, General Counsel and Secretary since May 1979; and Vice President, General Counsel and Secretary of the Company since 1970; General Counsel since 1966; age 58. MARCQ H. KAUFMANN, Corporate Vice President and President of the Company's European Operations since September 1992 and President of the Company's Packaging Systems division since January 4, 1994. Previously served as President of the Company's Geo. J. Meyer Manufacturing division from 1990 to 1992 and Managing Director of the Company's Alfa Costruzioni Packaging Equipment division from 1988 to 1990; age 68. JERRY L. LEATH, Vice President-Human Resources and Administration since June, 1992. From 1984 to 1992 he was employed by Sabreliner Corporation, where he held the position of Vice President-Administration; age 53. CHARLES C. RIEGER, JR., Senior Vice President of the Company since September 1993 and Group Vice President from 1982 to 1993; age 60. LARRY G. SCHWARTZ, Vice President-Manufacturing since September 1989 and Director of Manufacturing when he joined the Company in December 1988. From 1986 to 1988, he was Vice President and General Manager, New England Operations, with the Robert E. Morris Company; age 45. ALAN H. BENNETT, Vice President-Sales and Distribution since September 1993 and also President of the Company's Safety Supply America division since May 1989. Previously served as President of Allied Industrial Distributors, which was acquired by the Company on May 19, 1988; age 51. KEITH V. MABEE, Vice President-Public and Government Affairs since February 1994 and Director-Public and Government Affairs since July 1993. Previously served as Vice President, Communications with Industrial Indemnity, a commercial insurance company, from 1989 to 1993 and prior to 1989 he was Senior Vice President, Corporate Communications with Amfac Inc., a diversified services company; age 46. C. WILLIAM EVERS, Vice President-Corporate Procurement since February 1994 and Director-Corporate Procurement since July 1992. Previously served as Director of Purchasing with the Company's Badger-Powhatan division from 1977 to 1992; age 54. GREGORY J. PATTON, Vice President-Operations Development/Compliance since February 1994 and Director of Audit since June 1993. From 1989 to 1993 he was a senior manager in the manufacturing consulting practice of Price Waterhouse and from 1987 to 1989 he served as Director of Manufacturing Systems with Hercules Engines; age 39. Item 2. Item 2. Properties The Company operates numerous plants in various states and foreign countries. The facilities in the United States have approximately 5,910,000 square feet of floor area for manufacturing, warehousing, and associated administrative uses. Approximately 3,200,000 square feet of this area is owned, and the balance is leased. At this time, the Company believes its facilities are suitable for its purposes, having adequate productive capacity for the Company's present and anticipated needs. The properties owned and leased in the United States are located primarily in New York (940,000 square feet), California (586,000 square feet), Ohio (549,000 square feet), Missouri (521,000 square feet), Virginia (467,000 square feet), South Carolina (280,000 square feet) and Georgia (243,000 square feet). Item 3. Item 3. Legal Proceedings As reported under Item 3 "Legal Proceedings" in the Company's Form 10-K Annual Report for the fiscal year ending December 31, 1992, the Company appealed to the United States Court of Appeals for the Ninth Circuit from a Federal District Court's summary judgement against the Company in a suit brought by the Federal Trade Commission seeking consumer redress in connection with the sale of heat detectors manufactured by the Company's Interstate Engineering division. In a Per Curiam opinion filed on May 7, 1993, the Court of Appeals affirmed in part and vacated in part the judgement of the District Court. The Court of Appeals held that the District Court had committed error in ordering the Company to pay a minimum amount of approximately $7,600,000 but held that the Company could be required to pay refunds to those buyers who, after notification, can make a valid claim for redress. The Company's subsequent petition for a writ of certiorari to the United States Supreme Court was denied and the Company is working with the Federal Trade Commission to implement a redress program. In two separate suits, three stockholders of the Company filed derivative complaints during 1993 in the Common Pleas Court of Lake County, Ohio seeking recovery on behalf of the Company for alleged self-dealing, waste of corporate assets, financial statement over-statements, gross mismanagement and participation or acquiescence in such practices by Directors of the Company, all of whom were named as defendants. The Court has consolidated the two suits and the defendants have filed motions to dismiss. The Company is involved in ordinary routine litigation incidental to its business. Management does not believe that the litigation in which the Company is involved will have a materially adverse effect upon 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 Company's Common Stock and Related Stockholder Matters The Company's Common Stock has been traded since July 19, 1983, on the over-the-counter market and quoted in the National Association of Security Dealers Automated Quotation National Market System (NASDAQ/NMS) under the following symbols: Class A Common Stock "FIGIA" and Class B Common Stock "FIGI". Prior to July 19, 1983, the Company's Common Stock was traded on the New York Stock Exchange. As of April 8, 1994, there were 6,670 holders of Class A Common Stock and 5,897 holders of Class B Common Stock. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations OPERATIONS Consolidated net sales from continuing operations in 1993 were $768.6 million, which is $23.8 million or 3.0% lower than the net sales from continuing operations of $792.4 million in 1992. Net sales in 1992 were $50.3 million lower than those in 1991. Price increases in 1993 averaged approximately 3%. The Company has elected to treat as discontinued operations certain of its operating units as part of its current strategy to reorganize the Company and restore profitability by focusing primarily on its core industrial and technical businesses. The units to be discontinued include: Advance Security, Rawlings Sporting Goods, Sherwood-Drolet, Safety Supply America, Cardinal Casualty Co., Colony Insurance Co., Hamilton Insurance Co., Waite Hill Services, American LaFrance, Medical Devices, and Huber/Essick/Mayco Pump. As a group, these discontinued units represented sales volumes of $379 million for 1993, $380 million for 1992, and $401 million for 1991, and are excluded from the reported sales amounts. During the first quarter of 1994, the Company has concluded the sale of Advance Security to a privately held corporation. The Consumer products segment's net sales dropped $11.4 million or 15.5% in 1993 from net sales of $73.5 million in 1992. Reduced sales from Fred Perry (U.K.) is the primary contributor, partially due to the deepening European recession, particularly in Spain, Germany, and the U.K. as well as reduced selling prices. The 1992 Consumer product net sales were $2.4 million or 3.2% lower than net sales in 1991, again due to reduced sales volume at Fred Perry (U.K.). Fire protection/safety/security products' 1993 net sales declined $12.2 million or 5.0% versus net sales of $241.6 million in 1992. Recessionary impacts in the construction-related markets, along with decreased industrial employment, have continued to adversely affect this segment. Automatic Sprinkler, Fire Protection, and Scott Aviation (health and safety) have been most affected. Construction-related activity in the Southeast appears to be improving, while the West Coast is still slow, and mixed results are being reported in the Northeast. In 1992, this segment's net sales decreased by $4.8 million or 2.0% versus net sales in 1991. Machinery and allied products' 1993 net sales declined $2.6 million or 1.0% when compared with net sales of $265.2 million in 1992. Increased volumes of elevating work platforms, despite the effects of the Midwest flood, were more than offset by declines in the sales of scaffolding products and material handling equipment. Sales drops in scaffolding products were caused by the generally sluggish construction industry and to a lesser degree by start-up disruptions associated with the modernization of Safway Steel's production facilities. Sales of material handling equipment have been slowed by the closing of selected operations and the weak European export market. However, the Australian and Asian markets are showing some signs of economic improvement. The 1992 net sales for this segment were $15.1 million or 5.4% less than in 1991, due primarily to the recessionary economy. The Technical products segment's net sales declined $1.3 million or .7% in 1993 when compared to net sales of $191.0 million in 1992. The reduction in sales is primarily a result of reduced billings on certain government contracts. The 1992 net sales declined $26.5 million or 12.2% when compared with 1991, also due to reduced billings on government contracts. The Services segment's 1993 net sales increased $3.7 million or 17.2% when compared to net sales of $21.3 million in 1992. Increased leasing activity at the Financial Services subsidiary is responsible for this change. The 1992 net sales decreased $1.4 million or 6.3% when compared to net sales in 1991. Reduced sales from the Natural Resources division is responsible for this decline. Other expense for 1993 was $16.3 million versus other income of $12.3 million in 1992 and other income of $.6 million in 1991. The major contributors to the increased costs in 1993 were (1) amortization of goodwill ($2 million), (2) litigation reserves ($13 million), and (3) miscellaneous items for legal/professional costs, bank fees, and exchange losses ($9 million). These items were partially offset by gains on sales of assets, legal settlement recoveries, and royalty income of approximately $8 million. Other income and expense accounts were favorably affected in 1992 by gains on sales of excess properties arising from consolidation projects and realized gains on the sale of marketable securities. Also contributing to these 1992 favorable results were payments received from the U.S. Government as a result of a favorable decision by the Armed Services Board of Contract Appeals resolving a dispute between the Department of the Army and Scott Aviation concerning the termination of a mask contract. Other income in 1991 was also favorably affected by payments received in connection with the mask contract decision. Consolidated cost of sales as a percentage of net sales was 87.6%, 74.4%, and 75.8% for 1993, 1992, and 1991, respectively. Higher costs for materials, purchased services, and employee compensation and fringe benefits added approximately 3% to 4% to the cost of goods and services in 1993. Average increases in these categories were approximately 3% to 4% in 1992 and 1991. Price adjustments generally offset these types of increases. In 1993, cost of sales was unfavorably impacted by: (1) increased expenditures, principally for new product development at Hartman Electrical, Interstate Electronics, Scott Aviation, and Snorkel of approximately $19 million over 1992; (2) the liquidation of certain equity investments and additional provisions for assets held for sale of $14 million; (3) a $7 million write-down of non-performing loans still subject to future collection efforts or litigation; and (4) increased provisions for warranty costs and inventory reserves of $12 million. Also during 1993 a number of plants were in the transition phase of installing new machinery and computer systems. This resulted in (1) a temporary need to purchase some materials outside that were previously manufactured; (2) the hiring of additional people and related costs associated with the transition; and (3) the temporary maintenance of duplicate production facilities during the transition. These costs were approximately $38 million in 1993 but are expected to drop significantly in 1994. Consolidated selling and general and administrative expenses are $163.6 million or 13.8% higher than in 1992. Higher expenses in 1993 are attributed to increased sales efforts to penetrate U.S. and foreign markets, increased advertising and market research costs to complement those selling efforts, and increased legal and professional fees. The Company expects legal and professional fees to be a significant expenditure in 1994 as a result of the restructuring of its debt and the defense of two stockholder derivative lawsuits filed in 1993. Net interest expense for 1993 of $35.0 was relatively unchanged from the $35.5 million and $36.5 million reported in 1992 and 1991, respectively. Reduced interest rates offset the costs associated with the Company's increased debt level due in part to the factory automation projects. In 1990, the Company began a modernization program at its major facilities that involved: (1) the replacement of existing manufacturing processes with state-of-the-art machining centers, fabrication equipment, and robotic welding and assembly; (2) the design and development of factory floor computer systems, and complementary support systems and procedures; (3) the re-training of personnel to schedule and run the newly automated shop floor efficiently; and (4) the consolidation of smaller plants and operations into larger, more efficient facilities to take advantage of the synergies of a larger operation. To date, the Company has reduced Company-wide machine tools from over 3,000 to approximately 280 and consolidated manufacturing plants from 83 to 31 currently, while at the same time increasing capacity by nearly 30 percent. This project was originally on a five-year timetable; however, management elected to accelerate its implementation in late 1992. Although efforts expended in 1993 reflect the largest portion of the implementation, some additional costs are expected in 1994, but at a significantly reduced level. Restructuring costs associated with the Company's modernization program were $51.0 million, $8.8 million, and $5.9 million for 1993, 1992, and 1991, respectively. These charges stem from: (1) various relocation costs of employees and equipment; (2) consolidation-related costs such as provisions for anticipated losses on sales of real estate, consulting fees to assist with the development of strategic business plans, start-up costs in the new locations; and (3) costs incurred in retooling the plants, such as first production run samples and documenting new procedures and production methods. The future benefits expected to be achieved as a result of this modernization program include (1) cost savings associated with reduced levels of personnel, lower operating costs with respect to fewer, more efficient facilities and fewer machine tools, (2) enhanced quality, better delivery times and better customer service, and (3) overall asset management through reduced inventory levels and increased cash generation. Factory automation costs associated with the Company's modernization program included machinery and equipment, software, and outside consulting services. These project costs have historically been deferred and amortized over future periods commencing at the time the equipment is placed into service. Due to a number of factors which arose in 1993, including deteriorating operating results, reduced cash flow, and financing difficulties, the Company adopted a change in accounting by expensing all project costs, as incurred, other than those for the purchase of machinery and equipment. As required by generally accepted accounting principles (GAAP), this accounting change, resulting in a charge of $77 million, has been recorded as a change in estimate and reflected in the results of operations for the fourth quarter in 1993. The Consumer products segment's operating profit margin reflects a loss of $4.5 million for 1993 versus a profit of $7.4 million in 1992. Losses at Fred Perry U.K. are responsible for the decline, primarily due to a significant drop in sales, continued highly competitive market prices, and reduced margins on the sale of seasonal and substandard quality merchandise. In 1991 the operating profit margin was $10.9 million for this segment. The Fire protection/safety/security segment's operating profit was $5.0 million in 1993, declining from $40.0 million in 1992. The decline in operating profit has been caused by (1) a 5% drop in sales volume; (2) the change in accounting estimate of approximately $10 million; (3) restructuring charges of approximately $8 million; (4) miscellaneous warranty costs, litigation, and legal and professional costs of approximately $5 million; and (5) transition costs of approximately $7 million. The 1991 operating income was $39.2 million for this segment. The Machinery and allied products segment's operating profit margin reflects a 1993 loss of $107.2 million, versus income of $8.1 million in 1992. The decline in operating profit has been caused by: (1) the change in accounting estimate of approximately $36 million; (2) restructuring charges of approximately $15 million; (3) miscellaneous warranty costs, litigation, and legal and professional costs of approximately $7 million; (4) miscellaneous costs for employee benefits, pension, insurance and inventory of approximately $7 million; and (5) amortization costs of approximately $27 million. Operating results of Packaging Systems were substantially impacted by the foregoing charges. The 1991 operating income was $5.9 million for this segment. In July of 1993, Snorkel Economy, which is part of the Machinery and allied products segment, was severely affected by Midwest flooding. Prior to the flood, the elevating platform business was well ahead of 1992 and appeared to be heading for an excellent performance year. The plants were placed back into production; however, momentum was lost. The Company has been reimbursed by the insurance carrier for the majority of the physical damage claim covering the buildings, machinery, fixtures, and inventory. Negotiations on the business interruption coverage have not as yet been fully concluded and the Company has not recognized any income in 1993 pertaining to this coverage. Known operating earnings lost during the first nine months of 1993 due to flooding are a minimum of $7 million and will most likely be significantly higher when finally determined for the full year. Claims may also be filed for 1994. The Technical products segment's operating profit margin reflects a loss of $27.4 million, versus income of $25.7 in 1992. Declines in operating margins are due to: (1) the change in accounting estimate of approximately $11 million; (2) restructuring costs of approximately $5 million; (3) increased R&D costs for product development of approximately $17 million; and (4) losses at Hartman caused by production problems. The 1991 operating income was $26.9 million for this segment. The Services segment's 1993 operating income was $2.2 million or $1.0 million less than the prior year. The primary reason for this decline was a $5 million restructuring charge in 1993 relating to the provision for anticipated loss on the sale of surplus properties that are associated with the Company's consolidation and restructuring programs. In 1991 the operating income for this segment was $5.1 million. Increases in the cost of goods and services and increases in the prices of the Company's goods and services in 1993, 1992, and 1991 have generally been in line with the prevailing rate of inflation. Because the Company has been able to pass on higher costs in the form of higher prices, inflation has had relatively little impact on the Company's operating results. The loss from continuing operations before provision for taxes on income was $250.5 million, versus income from operations of $25.5 million and $18.4 million in 1992 and 1991 respectively. The effective income tax rate from continuing operations was a benefit of 28.4% in 1993, versus provisions of 26.0% in 1992 and 18.4% in 1991. The 1993 benefit does not take into consideration various tax planning strategies available to the Company. The net loss before discontinued operations was $179.3 million, versus net income of $18.9 million in 1992 and $15.0 million in 1991. The net loss from discontinued operations was $6.3 million in 1993, versus net income of $9.4 million and $15.1 million in 1992 and 1991, respectively. In December 1990, the Financial Accounting Standards Board (FASB) issued Statement No. 106, Accounting for Post Retirement Benefits Other Than Pensions. In accordance with this new statement, the Company has adopted and incorporated this new accounting principle into its 1993 financial statements. Adoption of this statement did not have any effect on the financial statements. In February 1992, the Financial Accounting Standards Board (FASB) issued Statement No. 109, Accounting for Income Taxes. This statement is intended to supersede Accounting Principles Board Opinion No. 11 as well as FASB Statement No.96. In accordance with this new statement, the Company has adopted and incorporated this new accounting principle into its 1993 financial statements. The Company has not restated prior periods, and the adoption of this statement has had a $5.8 million favorable effect on net income in 1993. The net loss for the Company was $179.8 million in 1993, versus net income of $28.3 million and $30.1 million in 1992 and 1991, respectively. Liquidity and Capital Commitments As discussed in the Notes to the Consolidated Financial Statements, the Company was not in compliance as of December 31, 1993 with certain financial covenants contained in certain debt agreements; however it has subsequently received temporary waivers with respect to those financial covenants. The Company is currently negotiating with banks party to its revolving credit facility, other domestic and foreign banks, and other financial institutions in an effort to finalize a satisfactory restructuring of its debt. As part of its restructuring plan, the Company intends to dispose of certain businesses under a divestiture plan designed to provide liquidity to the Company and pay down debt through the use of proceeds upon sale. In the absence of the finalization of a new long-term financing package, the Company is required under generally accepted accounting principles to classify substantially all of its long-term debt as a current liability as of December 31, 1993. This results in negative working capital of $143.4 million. During the year the Company reduced key working capital (accounts receivable and inventory net of accounts payable) by $28.9 million and sold assets for $74.0 million, which, along with depreciation and amortization of $43.1 million, the write-off of factory automation project costs of $77.3 million and increased debt of $76.8 million, were used for capital expenditures of $109.6 million, dividends of $8.0 million, net repurchase of Company stock for $6.2 million, and fund a net loss of $179.8 million. The Company's ability to continue to meet its liquidity requirements is dependent upon its ability to successfully complete its restructuring efforts - specifically, finalizing a new long-term financing package and completion of its divestiture program. The Company continues to make progress in building its cash position and in implementing actions aimed at restoring profitability. Negotiations with certain of the Company's lenders continue to take place in an effort to finalize a restructuring of its debt facilities. Item 8. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders, Figgie International Inc.: We have audited the accompanying balance sheets of Figgie International Inc. (a Delaware corporation) and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ending 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 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 Figgie International Inc. and Subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ending December 31, 1993 in conformity with generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As shown in the accompanying consolidated financial statements, and as discussed in Note 2, the Company incurred a significant net loss and decrease in net worth for the year ending December 31, 1993, which resulted in violations of certain covenants of certain of its debt agreements which permit its lenders to accelerate the due date on its debt. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also discussed in Note 2. The accompanying financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern. As explained in Note 1 to the consolidated financial statements, effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 109 "Accounting For Income Taxes". In addition, as explained in Note 15 to the consolidated financial statements, the Company changed its method of accounting for certain costs associated with its factory automation project in the fourth quarter of 1993. ARTHUR ANDERSEN & CO. Cleveland, Ohio, April 15, 1994. FIGGIE INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (1) Summary of Significant Accounting Policies: PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of Figgie International Inc. and its majority- owned subsidiaries (collectively the Company). All significant intercompany transactions and accounts have been eliminated in consolidation. MARKETABLE SECURITIES. At December 31, 1993 and 1992, marketable securities consisted primarily of marketable equity securities and U.S. Treasury Notes and Bonds. The investments are carried at the lower of cost or market value. There was no significant difference between cost and market value at December 31, 1993 and 1992. ACCOUNTS RECEIVABLE. INVENTORIES. All inventories are carried at the lower of first-in first- out (FIFO) cost or market value. It is impractical to segregate inventories into major classes due to the nature of the items and the businesses carried on by the Company and its subsidiaries. CONTRACTS IN PROCESS. Contracts in process are generally accounted for under the percentage-of-completion method, using costs incurred to date in relation to estimated total costs of the contracts to measure the stage of completion. The cumulative effects of revisions of estimated total contract costs and revenues are recorded in the period in which the facts requiring the revision become known. When a loss is anticipated on a contract, the full amount thereof is provided currently. Claims, including change orders, are recorded at estimated recoverable amounts. The amounts of retainages and amounts representing claims or other similar items subject to uncertainty included in trade accounts receivable were not material. At December 31, 1993 and 1992, approximately $31,878,000 and $27,669,000, respectively, were included in trade accounts receivable but had not been billed due primarily to differences in the billing and production cycles. Other long term contract costs included in trade accounts receivable at December 31, 1992 amounted to $1,419,000. There were no other long-term contract costs included in trade accounts receivable at December 31, 1993. Included in trade accounts receivable at December 31, 1993 is $4,821,000, which is not expected to be collected within the next year. The amount of contracts in process and progress payments applied against contracts in process included in inventories was $198,094,000 and $195,138,000, respectively, at December 31, 1993, and $226,070,000 and $224,007,000, respectively, at December 31, 1992. PROPERTY, PLANT, AND EQUIPMENT. Property, plant, and equipment values are stated at cost and depreciated over the estimated useful lives of the assets, generally by the straight-line method. The principal rates of depreciation are: Buildings, 2-1/2%; Machinery and Equipment, 8- 1/3%; Rental Equipment, 12-1/2% and 25%; Leasehold Improvements, life of lease. Oil and gas properties are amortized on the unit of production method. CAPITALIZATION OF INTEREST. The Company capitalizes interest costs during the development period of certain properties. Total interest capitalized was approximately $608,288 in 1993, $2,577,000 in 1992, and $2,872,000 in 1991. INVESTMENTS. Investments in unconsolidated minority owned companies are carried on the equity basis, which approximates the Company's equity in their underlying net book value. INTANGIBLES. Goodwill accounts, which represent costs in excess of net assets of purchased businesses, are generally amortized over a 40-year period. At December 31, 1993 and 1992, accumulated amortization was $19,404,000 and $16,794,000, respectively. Management, which regularly evaluates its accounting for goodwill considering principally historical and projected operating results, believes that the asset is realizable and the amortization period appropriate. Patents are amortized over their statutory or estimated useful lives. As of December 31, 1993 and 1992, accumulated amortization was $5,178,000 and $5,054,000, respectively. RESTRUCTURING CHARGES. Restructuring charges, included in the accompanying consolidated statements of income, include costs associated with the relocation and consolidation of various Company facilities and operations, provisions for anticipated losses on sales of real estate, consulting fees to assist with the development of strategic business plans, and costs incurred in retooling its plants. RESEARCH AND DEVELOPMENT COST. During 1993, 1992, and 1991, approximately $26,897,000, $8,333,000, and $13,916,000, respectively, was included in cost of sales for research and development. FACTORY AUTOMATION COSTS. The Company has incurred certain costs directly related to its factory automation project encompassing owned and leased machinery, software, and outside consultant fees. The owned machinery component of these project costs is depreciated in accordance with the useful lives discussed above. All other project costs are expensed as incurred. Prior to December 31, 1993, all other project costs were deferred and amortized over a period not exceeding five years. See Note 15, "Accounting Change". INCOME TAXES. The provision (benefit) for income taxes is based upon results from continuing operations before the cumulative effect of change in accounting. Results from discontinued operations have been disclosed net of tax. The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109 "Accounting for Income Taxes", effective January 1, 1993. The cumulative effect of such adoption was to increase earnings by $5,839,000, or $.33 per share, for the year ended December 31, 1993. This accounting standard was adopted prospectively in 1993; all prior periods have not been restated. The 1993 benefit for federal income taxes includes a charge of $1,992,000 which represents the effect of the U.S. federal income tax rate increase from 34% to 35% on net deferred tax liabilities. Since it is not practicable to determine the tax effect of accumulated unremitted foreign earnings as of January 1, 1993, the Company has elected to prospectively provide deferred U.S. income taxes on foreign earnings which are taxed at a rate below that of the U.S. statutory rate of 35%. Management believes that any liability related to the remittance of foreign earnings from continuing operations would not be material to the financial statements. EARNINGS PER SHARE. Earnings per common share are based upon the weighted average number of shares outstanding during each year (17,774,900 in 1993, 17,539,472 in 1992, and 17,451,099 in 1991). The unallocated shares of the non-leveraged Employee Stock Ownership Plan are not considered outstanding for earnings per share purposes. For 1993, pursuant to the adoption of Statement of Position 93-6 "Employers' Accounting for Employee Stock Ownership Plans", the unallocated shares of the leveraged Employee Stock Ownership Plan are not considered outstanding for earnings per share purposes. These shares were considered outstanding for 1992 and 1991 earnings per share. FOREIGN CURRENCY TRANSLATION. CASH AND CASH EQUIVALENTS. For purposes of the consolidated statements of cash flows, the Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. The carrying amount of cash equivalents approximates their fair market value due to the short maturity of those investments. The effect of foreign currency translation on cash held by foreign divisions is not material. OTHER ASSETS. Included in other assets in the accompanying balance sheet are amounts representing the estimated net realizable value of net assets of the Company's finance subsidiary, which continues to be held for sale, approximating $38,157,000 and $62,192,000 as of December 31, 1993 and 1992, respectively. SELF-INSURANCE PROGRAMS. The Company is self-insured for certain levels of general liability and workers' compensation coverage. Estimated costs of these self-insurance programs are accrued at present values based on projected settlement dates for known and anticipated claims. Any resulting adjustments to previously recorded reserves are reflected in current operating results. RECLASSIFICATION OF AMOUNTS. Certain amounts for 1992 and 1991 have been reclassified to reflect comparability with account classifications for 1993. (2) Liquidity and Restructuring Plans: As a result of 1993 operating results, the Company was not in compliance as of December 31, 1993 with certain financial covenants contained in certain debt agreements, which permit its lenders to accelerate the due date on its debt; however the Company has subsequently received temporary waivers with respect to those financial covenants. Since permanent waivers or modifications of these covenants have not been obtained, $271 million of long-term debt has been classified as current. The Company is currently negotiating with banks party to its revolving credit facility, other domestic and foreign banks, and other financial institutions in an effort to finalize a satisfactory restructuring of its debt. As part of the restructuring plan, the Company intends to dispose of certain businesses under a divestiture program designed to pay down debt through the use of proceeds upon sale. See Note 3, "Discontinued Operations". The Company's consolidated financial statements have been presented on the basis that it is a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company's ability to continue as a going concern is dependent upon its ability to successfully complete its debt restructuring efforts. Until such debt restructuring is completed, there is substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of assets or the amounts and classification of liabilities that may result should the Company be unable to continue as a going concern. (3) Discontinued Operations: In December of 1993, the Company instituted a divestiture plan as part of its debt restructuring efforts to dispose of certain businesses through unrelated sales transactions. These entities represent separate major lines of business, class of customers, or non-reportable business segments and, accordingly, have been treated as discontinued operations as required by generally accepted accounting principles. As a result of this treatment, the accompanying consolidated financial statements have been reclassified to report separately the net assets and operating results of the following operations: Rawlings Sporting Goods, Sherwood-Drolet Corp. Ltd., Advance Security, American Lafrance, Safety Supply America, Medical Devices, Huber/Essick/Mayco Pump, Cardinal Casualty Co., Colony Insurance Co., Hamilton Insurance Co., Waite Hill Services. Net assets of the discontinued operations at December 31, 1993 consisted primarily of accounts receivable, inventory, and machinery and equipment offset by insurance loss reserves related to the insurance companies. As a group, the discontinued operations represented sales volumes of $379 million, $380 million, and $401 million for 1993, 1992, and 1991, respectively, and are excluded from the reported sales amounts. Net income from discontinued operations includes provisions for federal and state taxes at the statutory rates for the applicable period. No provision for loss on disposal of discontinued operations has been provided as the Company expects its divestiture plan to result in a net gain. During the first quarter of 1994, the Company sold Advance Security to a privately held corporation. Although the transaction is not closed, the Company is estimating a financial reporting gain of approximately $21 million, subject to any adjustments pursuant to the terms of the agreement. The Company had available a Revolving Credit Agreement (Agreement) in the amount of $150,000,000 provided by a group of nine banks, with interest at either the Base Rate, Certificate of Deposit rates, or Eurodollar rates, as defined in the Agreement, at the option of the Company. The Agreement required the Company to pay a facility fee of 1/4 of 1% on the entire commitment and a commitment fee of 1/8 of 1% on the unused portion of the commitment. The outstanding balance in the amount of $150,000,000 was converted to a two-year term loan effective December 31, 1993, requiring quarterly principal payments in equal amounts until December 31, 1995 at the current interest rate of 6.25%. As a result of the current year operating loss, the Company was not in compliance as of December 31, 1993 with certain financial covenants contained in the Agreement and did not make its first quarter scheduled principal payment. The Company subsequently received a temporary waiver with respect to the financial covenants and non-payment. Pending completion of the Company's debt restructuring efforts, the entire balance of the term loan is presented as long-term debt classified as current in the accompanying consolidated balance sheet. In October 1989, the Company completed the registration and sale of $175,000,000 of 9.875% Senior Notes due October 1, 1999. During 1990, $1,000,000 of the notes were repurchased on the open market. Interest is payable semi-annually on April 1 and October 1, commencing April 1, 1990. The net proceeds of the offering, totaling approximately $173,560,000, were used to reduce variable-rate debt that had been used to finance operations, acquisitions, and repurchases of shares. While the Company is in compliance with the Indenture Agreement, the amount due under the Senior Notes has been classified as a current liability in the accompanying consolidated balance sheet, pending completion of the Company's debt restructuring efforts. The ESOP Note is payable in equal annual installments through 1996. This note bears interest at 85% of the lender`s base rate. The December 31, 1993 payment of $2,500,000 was waived pending restructuring of the Company's total debt facility. Pending completion of the Company's debt restructuring efforts, the ESOP Note is presented as long-term debt classified as current in the accompanying consolidated balance sheet. The 10.375% subordinated debentures are redeemable at a premium prior to 1998. The Company is required to make annual payments of $1,500,000 into a sinking fund through 1997, with a $5,000,000 payment in 1998. All required redemptions have been made. While the Company is in compliance as of December 31, 1993 with the subordinated indenture agreement, the amounts due under the subordinated debentures have been presented as long-term debt classified as current in the accompanying consolidated balance sheet pending completion of the Company's debt restructuring efforts. The Company was not in compliance, as of December 31, 1993, with certain financial covenants contained in its 3.94% Notes; however, it has subsequently received temporary waivers with respect to those financial covenants. Pending completion of the Company's debt restructuring efforts, the notes are presented as long-term debt classified as current in the accompanying consolidated balance sheet. While the Company was in compliance as of December 31, 1993 with the covenants contained in the 6.75% Note Agreement, the amount due has been presented as long-term debt classified as current in the accompanying balance sheet pending completion of the Company's debt restructuring efforts. Mortgage notes payable are secured by real property and are non-recourse to the Company. The Company was in compliance at December 31, 1993 with these mortgage notes. These mortgage notes payable are classified as long-term debt in the accompanying consolidated balance sheet. Excluding the effects of any final negotiations with its lender, the scheduled principal payments on the long-term debt, excluding the obligations under capital leases, are approximately as follows: 1994 - $105.0 million; 1995 - $87.7 million; 1996 - $7.8 million; 1997 - $6.7 million; 1998 - $9.3 million; and $218.8 million thereafter. Total operating lease expense was approximately $28,292,000 in 1993, $21,666,000 in 1992, and $19,205,000 in 1991. (8) Contingent Liabilities: As reported under Item 3 "Legal Proceedings", the Company appealed to the United States Court of Appeals for the Ninth Circuit from a Federal District Court's summary judgement against the Company in a suit brought by the Federal Trade Commission seeking consumer redress in connection with the sale of heat detectors manufactured by the Company's Interstate Engineering division. In a Per Curiam opinion filed on May 7, 1993, the Court of Appeals affirmed in part and vacated in part the judgement of the District Court. The Court of Appeals held that the District Court had committed error in ordering the Company to pay a minimum amount of approximately $7,600,000 but held that the Company could be required to pay refunds to those buyers who, after notification, can make a valid claim for redress. The Company's subsequent petition for a writ of certiorari to the United States Supreme Court was denied and the Company is working with the Federal Trade Commission to implement a redress program. The Company has provided a reserve for the estimated liability related to this matter. In two separate suits, three stockholders of the Company filed derivative complaints during 1993 in the Common Pleas Court of Lake County, Ohio seeking recovery on behalf of the Company for alleged self-dealing, waste of corporate assets, asset overstatements, gross mismanagement and participation or acquiescence in such practices by Directors of the Company, all of whom were named as defendants. The Court has consolidated the two suits and the defendants have filed motions to dismiss. Additionally, the Company and its subsidiaries are defendants in various lawsuits arising in the ordinary course of business. The Company has provided a reserve for the estimated liability related to known cases. In the opinion of management, any additional liability with respect to these matters will not have a material effect on the Company's financial statements. Costs incurred by the Company in the performance of U.S. Government contracts are subject to audit. In the opinion of management, the final settlement of these costs will not result in significant adjustments to recorded amounts. (9) Pension and Employee Stock Ownership Plans The Company has pension plans covering the majority of its employees. The plan benefits for salaried employees are based on employees' earnings during their years of participation in the plan. Hourly employees' plan benefits are based on various dollar units multiplied by the number of years of eligible service as defined in each plan. The Company's policy has been to fund amounts as necessary on an actuarial basis to comply with the Employee Retirement Income Security Act of 1974. In addition, the Company has adopted a nonqualified supplemental retirement plan covering certain officers and senior executives. The plans' assets consist primarily of listed common stocks, corporate and government bonds, real estate investments, and cash and cash equivalents. The plans' assets included 28,883 and 20,742 shares of the Company's Class A Common Stock and 52,115 and 41,707 shares of the Company's Class B Common Stock as of December 31, 1993 and 1992, respectively. The Company maintains two employee stock ownership plans: a leveraged plan (the ESOP) and a non-leveraged plan (the New ESOP). The ESOP holds a $20,000,000 note that is guaranteed by the Company and bears interest at 85% of the lender's base rate. The note is currently paying interest at a 5.1% rate, which, in management's opinion, fully reflects the current market rate for a similar facility. The remaining balance outstanding of $10,000,000 as of December 31, 1993 consists of $2,500,000 past due, and the remaining $7,500,000 is payable in equal annual installments of $2,500,000 through 1996. The ESOP used the proceeds from the note to purchase 756,195 Class B shares, which are allocated to active participant accounts each December 31 on a ratable basis as the note is repaid. Contributions to fund the interest requirements of the loan are reflected as interest expense in the accompanying consolidated statements of income, approximating $365,000, $290,000, and $756,000 (net of dividends of approximately $328,000 in 1993 and $374,000 in 1992 and 1991), were made by the Company during 1993, 1992, and 1991, respectively. During 1993, the Company elected to prospectively account for the ESOP under the provisions of Statement of Position 93-6, "Employers Accounting for Employee Stock Ownership Plans." This election allows the Company to measure the compensation expense based on the market value of the shares on the date of allocation. The New ESOP was established in 1989 by the transfer of surplus assets from a terminated benefit plan. The New ESOP used the transferred funds to directly and indirectly purchase 1,124,682 Class A and 440,796 Class B shares. Under the terms of the New ESOP, no less than 12.5% of the total shares are to be annually allocated to active participant accounts based upon a formula utilizing salary and years of service. The amortization to expense of the New ESOP unearned compensation is based on the fair market value of the shares on the date of allocation. Dividends on unallocated shares are charged to expense. The Company also maintains the Figgie International Inc. Stock Bonus Trust and Plan (the Stock Plan). Under this Plan, shares of the Company's Class B Common Stock are allocated to eligible employee accounts each December 31 based on salary. The Company did not make contributions to this plan in 1993, 1992, or 1991. The Stock Plan held 378,402 and 410,809 shares of the Company's Class B Common Stock as of December 31, 1993 and 1992, respectively. In addition to providing pension benefits, the Company and its subsidiaries provide certain health care and life insurance benefits for certain retired employees. A small percent of the Company's employees become eligible for these benefits paid by the Company if they reach retirement age while working for the Company. For 1993, 1992, and 1991, those premiums approximated $20,000 annually. Most of the Company's salaried employees are eligible for medical benefits at retirement by paying the full cost of the benefits. The Company adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1993. Adoption of this statement did not have any effect on the financial statements. (10) Capital Stock: (11) Restricted Stock Purchase Plan: Under the 1993 Restricted Stock Purchase Plan for Employees (the "1993 Employees Plan"), up to 800,000 shares each of either Class A or Class B Common Stock were authorized for issuance and executive officers and other key employees were granted the right to purchase Common Stock at prices substantially below market value. The purchase of Class A and Class B Common Stock under this plan entitles the employee to full voting and dividend rights, but the shares cannot be sold, transferred, or pledged, and the certificates representing the shares are retained in the custody of the Company. At the earliest of retirement, death, or total disability of the employee, or termination of the plan, these restrictions on transferring, pledging, or selling the shares expire, and the employee or heirs take unrestricted custody of the stock. In the event the employee leaves the Company prior to any of these occurrences, the Company can repurchase the shares (or, in the case of retirement, a portion of the shares) at the lower of the original purchase price paid by the employee or the then prevailing market price. At December 31, 1993, 402,833 shares of Class A Common Stock and 156,877 shares of Class B Common Stock, respectively, subject to the above restrictions, were outstanding under the 1993 Employees Plan. At December 22, 1992, 442,978 shares of Class A Common Stock and 92,720 shares of Class B Common Stock, subject to similar restrictions, were outstanding under the predecessor 1988 Restricted Stock Purchase Plan for Employees (the "1988 Employees Plan"). On December 22, 1992, the 1988 Employees Plan was terminated and all restrictions on outstanding shares lapsed. Under the 1993 Restricted Stock Purchase Plan for Directors (the "1993 Directors Plan"), up to 75,000 shares of Class B Common Stock were authorized for possible issuance and certain Directors of the Company were granted the right to purchase shares of Class B Common Stock at prices substantially below market value. The 1993 Directors' Plan contains restrictions and other provisions similar to those of the 1993 Employees Plan. At December 31, 1993, 39,000 shares of Class B Common Stock, subject to the above restrictions, were outstanding under the Directors' Plan. At December 31, 1992, 42,000 shares of Class B Common Stock, subject to similar restrictions, were outstanding under the predecessor 1988 Restricted Stock Purchase Plan for Directors (the "1988 Directors Plan"). On July 1, 1993, the 1988 Directors Plan terminated and all restrictions on outstanding shares lapsed. (12) Land and Land Improvements: The Company's real estate subsidiary develops land for recreational, residential, and commercial purposes. Such investments in development land were $50,238,000 and $57,433,000 at December 31, 1993 and 1992, respectively. Related mortgage debt was $436,000 at December 31, 1993, and $530,000 at December 31, 1992. Excess of investment over mortgage debt was financed by the Company's Revolving Credit Agreement and borrowings of the subsidiary under its own credit agreements. (13) Purchase of Businesses: In 1993 and 1992, the Company purchased businesses for a total cash consideration of $5,892,000 and $2,913,000, respectively. All the acquisitions are included in existing product groups. All acquisitions were accounted for by the purchase method of accounting, and the difference between the fair value of net assets acquired and the purchase consideration has been allocated to goodwill. The results of operations of these purchased businesses are not material to consolidated totals and have been included in the accompanying consoli- dated statements of income since the dates of acquisition. Increases of $4,126,000 and $3,100,000 were recorded in goodwill relating to the purchases of businesses in 1993 and 1992, respectively. Additionally, in 1992 the Company purchased a 20% interest in a medical products company for $7,432,000. (14) Business Segment Data: The Company's operations are conducted through five business segments. These segments and the primary operations of each are described on pages 2 through 9. Pages 11 through 13 contain a summary of certain financial data for each business segment for 1993, 1992, and 1991. Information concerning the content of this financial data is as follows: Intersegment sales are generally at current market prices. Operating profit is total revenue less operating expenses and does not include general corporate expenses, interest expense, interest income, or federal and state income taxes. Identifiable assets are those assets used in the Company's operation for each segment. Corporate assets are principally cash and corporate property. (15) Accounting Change: In connection with its factory automation project, the Company has incurred significant costs, including machinery and equipment, software, and outside consulting fees. These project costs have historically been deferred and amortized over future periods commencing at the time the equipment is placed into service. Due to a number of factors which arose in 1993, including deteriorating operating results, cash flow and financing difficulties, the Company adopted a change in accounting by expensing all project costs, other than machinery and equipment, as incurred. As required by generally accepted accounting principles, the accounting change, amounting to an after tax charge approximating $50 million ($77 million pre-tax) or $2.80 per share, has been recorded as a change in estimate and recorded in the results of operations for the fourth quarter of 1993. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant (a) Identification of Directors Information with respect to the members of the Board of Directors of the Company is set forth under the captions "Nominees for Election as Directors to be Elected for a Term of Three Years" and "Directors Continuing in Office" in the Company's definitive proxy statement to be filed pursuant to Regulation 14A, which information is incorporated herein by reference. (b) Identification of Executive Officers Information with respect to the executive officers of the Company is set forth under the caption "Executive Officers of the Registrant" contained in Part I, Item 1 of this report, which information is incorporated herein by reference. (c) Compliance with Section 16(a) Information with respect to compliance with Section 16(a) is set forth under the caption "Compliance with Section 16(a) of the Exchange Act" in the Company's definitive proxy statement to be filed pursuant to Regulation 14A, which information is incorporated herein by reference. Item 11. Item 11. Executive Compensation Information required by this Item is set forth under the captions "Compensation of Directors" and "Executive Compensation" in the Company's definitive proxy statement to be filed pursuant to Regulation 14A, which information is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information required by this Item is set forth under the captions "Principal Stockholders" and "Stock Ownership of Directors and Officers" in the Company's definitive proxy statement to be filed pursuant to Regulation 14A, which information is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions Information required by this Item is set forth under the caption "Certain Transactions" in the Company's definitive proxy statement to be filed pursuant to Regulation 14A, which information is incorporated herein by reference. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders, Figgie International Inc.: We have audited in accordance with generally accepted auditing standards, the financial statements of Figgie International Inc. and Subsidiaries included in this Form 10K, and have issued our report thereon dated April 15, 1994. Our report on the financial statements includes an explanatory paragraph with respect to substantial doubt about the Company's ability to continue as a going concern, as discussed in Note 2 to the financial statements and an explanatory paragraph with respect to the Company's adoption of the provisions of SFAS No. 109 "Accounting for Income Taxes" in the first quarter of 1993 (as discussed in Note 1 to the financial statements) and to the change in the method of accounting for certain costs associated with its factory automation project in the fourth quarter of 1993 (as discussed in Note 15 to the financial statements). Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. 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. Cleveland, Ohio, April 15, 1994. 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. FIGGIE INTERNATIONAL INC. (Company) By_S.J. BATTAGLIA_________________________________ Date: April 13, 1994S. J. Battaglia Principal Accounting Officer By__L.A. HARTHUN__________________________________ Date: April 13, 1994L. A. Harthun, Senior Vice President-International General Counsel and Secretary

352915_1993.txt

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1993

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ITEM 2. Properties EXECUTIVE OFFICES The Company owns an office building with 68,000 square feet available for use located on 11 acres of land in King of Prussia, Pennsylvania. The Company currently uses approximately 40,000 square feet of office space in the building and the balance is leased to unrelated entities. HOSPITALS ACUTE CARE HOSPITALS -------------------- AUBURN GENERAL HOSPITAL MCALLEN MEDICAL CENTER(1) VALLEY HOSPITAL MEDICAL Auburn, Washington McAllen, Texas CENTER 149 Beds 428 Beds Las Vegas, Nevada 416 Beds CHALMETTE MEDICAL RIVER PARISHES HOSPITAL(6) CENTER(1) LaPlace and Chalmette, VICTORIA REGIONAL MEDICAL Chalmette, Louisiana Louisiana CENTER 118 Beds 216 Beds Victoria, Texas 154 Beds DALLAS FAMILY HOSPITAL SPARKS FAMILY HOSPITAL(3) Dallas, Texas Sparks, Nevada WELLINGTON REGIONAL 104 Beds 150 Beds MEDICAL CENTER(1) West Palm Beach, Florida DOCTORS' HOSPITAL OF UNIVERSAL MEDICAL CENTER 120 Beds SHREVEPORT(2) Plantation, Florida Shreveport, Louisiana 202 Beds WESTLAKE MEDICAL 180 Beds CENTER(1) Westlake Village, INLAND VALLEY REGIONAL California MEDICAL CENTER(1) 126 Beds Wildomar, California 80 Beds PSYCHIATRIC HOSPITALS --------------------- THE ARBOUR HOSPITAL HRI HOSPITAL RIVER CREST HOSPITAL Boston, Massachusetts Brookline, Massachusetts San Angelo, Texas 118 Beds 68 Beds 80 Beds THE BRIDGEWAY(1) KEYSTONE CENTER(4) RIVER OAKS HOSPITAL North Little Rock, Wallingford, Pennsylvania New Orleans, Louisiana Arkansas 84 Beds 126 Beds 70 Beds DEL AMO HOSPITAL(2) LA AMISTAD RESIDENTIAL TURNING POINT HOSPITAL(4) Torrance, California TREATMENT CENTER Moultrie, Georgia 166 Beds Maitland, Florida 59 Beds 56 Beds TWO RIVERS PSYCHIATRIC FOREST VIEW HOSPITAL MERIDELL ACHIEVEMENT HOSPITAL Grand Rapids, Michigan CENTER(1) Kansas City, Missouri 62 Beds Austin, Texas 80 Beds 114 Beds GLEN OAKS HOSPITAL Greenville, Texas 53 Beds AMBULATORY TREATMENT CENTERS ---------------------------- COLUMBIA RADIATION OUTPATIENT SURGICAL SURGERY CENTER OF ONCOLOGY CENTER OF PONCA CITY(5) LITTLETON(5) Washington, D.C. Ponca City, Oklahoma Littleton, Colorado COMPREHENSIVE CANCER SURGERY CENTER OF CENTER THE REGIONAL CANCER SPRINGFIELD(5) Westlake, California CENTER AT Springfield, Missouri WELLINGTON GOLDRING SURGICAL AND West Palm Beach, Florida SURGERY CENTER OF DIAGNOSTIC CENTER TEXAS(5) Las Vegas, Nevada ST. GEORGE SURGICAL Odessa, Texas CENTER(5) HOPE SQUARE SURGICAL St. George, Utah SURGICAL CENTER OF CENTER(5) NEW ALBANY(5) Rancho Mirage, THE SURGERY CENTER OF New Albany, Indiana California CHALMETTE Chalmette, Louisiana M.D. PHYSICIANS SURGICENTER OF MIDWEST CITY(5) Midwest City, Oklahoma - ---------- (1) Real property leased from UHT (see Item 1. Business). (2) Real property leased with an option to purchase. (3) General partnership interest in limited partnership. (4) Addictive disease facility. (5) General partnership and limited partnership interests in a limited partnership. The real property is leased from third parties. (6) Includes Chalmette Hospital, a 114-bed rehabilitation facility, the real property of which is leased from UHT. Some of these hospitals are subject to mortgages, and substantially all the equipment located at these facilities is pledged as collateral to secure long-term debt. The Company owns or leases medical office buildings adjoining certain of its hospitals. ITEM 3. ITEM 3. Legal Proceedings The Company is subject to claims and suits in the ordinary course of business, including those arising from care and treatment afforded at the Company's hospitals and is party to various other litigation. However, management believes the ultimate resolution of these pending proceedings will not have a material adverse effect on the Company. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders Inapplicable. No matter was submitted during the fourth quarter of the fiscal year ended December 31, 1993 to a vote of security holders. PART II ITEM 5. ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters See Item 6, Selected Financial Data. ITEM 6. ITEM 6. Selected Financial Data These prices are the high and low closing sales prices of the Company's Class B Common Stock as reported by the New York Stock Exchange since June 7, 1991 and NASDAQ for all periods prior to June 7, 1991. Class A, C and D Common Stock are convertible on a share-for-share basis into Class B Common Stock. A special dividend of $.20 per share or approximately $2,900,000 in the aggregate was declared and paid in 1989. No cash dividends were declared or paid in any other years. The Company's ability to repurchase its shares, redeem its convertible debentures, and pay dividends is limited by long-term debt convenants to $7.5 million plus 25% of cumulative net income since January 1992. The 1993, 1992 and 1991 earnings per share and average number of shares outstanding have been adjusted to reflect the assumed conversion of the Company's convertible debentures. The common equivalent shares and the corresponding interest savings on the assumed conversion of the convertible debentures were not included in the 1990 or 1989 earnings per share computations because the effect was anti-dilutive. Number of shareholders of record as of January 31, 1994 were as follows: - ------------------------ Class A Common 7 Class B Common 640 Class C Common 7 Class D Common 384 - ------------------------ ITEM 7. ITEM 7. Management's Discussion and Analysis of Operations and Financial Condition YEAR ENDED DECEMBER 31, 1993 COMPARED TO 1992 During 1993, net revenue growth was experienced in each of the Company's principal business groups: acute care hospitals, psychiatric hospitals and ambulatory treatment centers. Net revenues in 1993 increased 7% over 1992 at acute care hospitals owned during both years, after excluding the effects of additional revenues received from special Medicaid reimbursement programs. Despite the continued shift in the delivery of healthcare services to outpatient care, the Company's acute care hospitals experienced a slight increase in inpatient admissions in 1993 due to the expansion of service lines at many of its hospitals. Outpatient activity also increased this year and gross outpatient revenues now comprise 23% of the Company's gross revenues as compared to 21% in 1992. The increase is primarily the result of advances in medical technologies, which allow more services to be provided on an outpatient basis, and increased pressure from Medicare, Medicaid, health maintenance organizations (HMOs), preferred provider organizations (PPOs) and insurers to reduce hospital stays and provide services, where possible, on a less expensive outpatient basis. To take advantage of the trend toward increased outpatient services, the Company has continued to invest in the acquisition and development of ambulatory treatment centers. During 1993, the Company acquired a radiation treatment center and majority interests in four partnerships which own and operate ambulatory surgery facilities. The Company now operates twelve ambulatory treatment centers, which have contributed to the increase in the Company's outpatient revenues. The Company expects the growth in outpatient services to continue, although the rate of growth may be moderated in the future. Net revenues in 1993 at the Company's psychiatric hospitals increased approximately 6% over 1992. While admissions at these facilities increased 17%, patient days decreased 7% due to shorter average lengths of stay and increased emphasis on outpatient treatment programs. The shift to outpatient care was reflected in higher revenues from outpatient services, which now comprise 13% of gross revenues in the psychiatric group as compared to 10% in the prior year. The trend in outpatient treatment for psychiatric patients is expected to continue as a result of advances in patient care and continued cost containment pressures from payors. The Company received $13.5 million and $29.8 million in 1993 and 1992, respectively, from the special Medicaid reimbursement programs mentioned above. These programs are scheduled to terminate in August 1994 and the Company cannot predict whether these programs will continue beyond the scheduled termination date. An increased proportion of the Company's revenue is derived from fixed payment services, including Medicare and Medicaid which accounted for 40%, 39% and 35% of the Company's net patient revenues during 1993, 1992 and 1991, respectively, excluding the additional revenues from special Medicaid reimbursement programs. The Company expects Medicare and Medicaid revenues to continue to increase due to the general aging of the population and the expansion of state Medicaid programs. In addition to the Medicare and Medicaid programs, other payors continue to actively negotiate the amounts they will pay for services performed. In general, the Company expects the percentage of its business from managed care programs, including HMOs and PPOs, to continue to grow. The consequent growth in managed care networks and the resulting impact of these networks on the operating results of the Company's facilities vary among the markets in which the Company operates. During 1993, continuing the consolidation strategy in which the Company focuses its efforts on those markets where there is a maximum potential for continued growth, the Company sold two acute care hospitals for total proceeds of approximately $11.2 million. These dispositions resulted in a $4.4 million pre-tax loss ($2.2 million after-tax) which is included in operating expenses in the Company's 1993 consolidated statement of income. Since 1991, the Company has closed or sold a total of eight hospitals as part of this strategy. The Company also recorded a pre-tax charge of $4.4 million related to the winding down or disposition of non-strategic businesses which is included in operating expenses in the Company's 1993 consolidated statement of income. Excluding the additional revenues received from special Medicaid reimbursement programs mentioned above and the losses resulting from the disposition of two acute care hospitals and other non-strategic businesses, operating expenses as a percentage of net revenues for 1993 remained relatively flat as compared to the prior year. Although the rate of inflation has not had a significant impact on the results of operations, pressure on operating margins is expected to continue because, while Medicare fixed payment rates are indexed for inflation annually, the increases have historically lagged behind actual inflation. In addition to the trends described above that continue to have an impact on operating results, there are a number of other, more general factors affecting the Company's business. The Company and the healthcare industry as a whole face increased uncertainty with respect to the level of payor payments because of national and state efforts to reform healthcare. These efforts include proposals at all levels of government to contain healthcare costs while making quality, affordable health services available to more Americans. The Company is unable to predict which proposals will be adopted or the resulting implications for providers at this time. However, the Company believes that the delivery of primary care, emergency care, obstetrical and psychiatric services will be an integral component of any strategy for controlling healthcare costs and it also believes it is well positioned to provide these services. Interest expense decreased 24% in 1993 as compared to 1992 due to lower average outstanding borrowings. Depreciation and amortization expense decreased approximately $9.5 million in 1993 compared to 1992, due primarily to a $13.5 million amortization charge in 1992 resulting from the revaluation of certain goodwill balances. Partially offsetting this decrease was a $2.4 million increase in depreciation and amortization expense related to the Company's acquisitions of ambulatory treatment centers. The effective tax rate was 32% in 1993 as compared to 51% in 1992. The decrease in the effective rate for 1993 as compared to 1992 was due to the above-mentioned $13.5 million goodwill amortization recorded in the 1992 period, which was not deductible for income tax purposes, and a reduction in the 1993 state tax provision. The net effect of the impact of the 1993 tax law changes on the current and deferred tax provisions was immaterial. YEAR ENDED DECEMBER 31, 1992 COMPARED TO 1991 Net revenues in 1992 increased 6% over 1991 at hospitals owned during both years after excluding $29.8 million of favorable Medicaid reimbursement increases in 1992 and a $4.8 million pre-tax gain resulting from the sale of the Company's U.K. operations in 1991. The increased revenue resulted from higher utilization of outpatient and ancillary services, general price increases and increased severity of illness of patients admitted. The increase in outpatient services reflects the continuing advancements in medical technologies and pressures from payors to direct less acutely ill patients from inpatient services to outpatient care. The 1992 acquisitions of majority interests in four partnerships which own and operate ambulatory surgery facilites also contributed to an increase in the outpatient revenues. In 1992, in accordance with its consolidation strategy, the Company closed a 96-bed acute care hospital and a 48-bed psychiatric hospital. The closings did not have a material impact on the consolidated financial statements. In 1991, the Company sold its U.K. operations and sold an 88-bed acute care hospital. Admissions at the Company's hospitals which were owned during both years increased 1% in 1992 as compared to 1991. Patient days at these hospitals decreased 4% over 1991 due to a decrease in the average length of stay, particularly at the psychiatric hospitals. Excluding the nonrecurring revenue items described above, operating expenses as a percentage of net revenues remained relatively flat in 1992 compared to 1991. Excluding the $5 million reversal of an unneeded interest accrual in 1991, interest expense decreased 13% in 1992 due to lower average outstanding borrowings and lower average interest rates on floating rate debt. Depreciation and amortization expense increased in 1992 compared to 1991 as a result of a $13.5 million amortization charge recorded in 1992 resulting from the revaluation of certain goodwill balances. The effective tax rate was 51% in 1992, as compared to 34% in 1991. The higher 1992 tax resulted principally from the above-mentioned goodwill amortization which is not deductible for income tax purposes, while the 1991 provision for income taxes was reduced due to the utilization of a capital loss carryforward which offset all of the $4.8 million pre-tax gain resulting from the sale of the Company's U.K. operations. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities increased to $84.6 million in 1993 from $81.7 million in 1992. The increase resulted primarily from improved operating results at the Company's facilities during 1993 as compared to 1992. The Company received $10.3 million of cash from the disposition of two acute care hospitals in 1993 and also received $8.2 million of cash related to facilities divested in prior years. During each of the past three years, the net cash provided by operating activities substantially exceeded the scheduled maturities of long-term debt. During 1993, the Company used $47.3 million of its operating cash flow to finance capital expenditures, $11.5 million to acquire a radiation therapy center and majority interests in partnerships which own four ambulatory surgery centers, $3.2 million to acquire the real estate assets of a facility previously leased, and $3.2 million to repurchase shares of its outstanding common stock. During 1993, the Company reduced outstanding debt by $44.7 million using funds generated from operations and the proceeds from the disposition of hospitals. Total debt as a percentage of total capitalization declined to 26% at December 31, 1993 from 37% at December 31, 1992. The year-end ratio is the lowest since the Company went public in 1981. Expected capital expenditures for 1994 include approximately $21 million for capital equipment and renovations of existing facilities, $38 million for new projects and $10 million for acquisitions and development of ambulatory treatment centers. The Company believes that its capital expenditures program is adequate to expand, improve and equip its existing hospitals. During 1993, the Company entered into a commercial paper program which currently provides up to $25 million of renewable borrowings which are secured by patient accounts receivable. The Company has sufficient patient receivables to support a larger program and upon the mutual consent of the Company and the participating lending institutions, the commitment can be increased to $65 million. At December 31, 1993, there were no borrowings outstanding under this program. The Company also has a $72.4 million non-amortizing revolving credit agreement which matures in August of 1995. However, 50% of the net proceeds, in excess of $15 million annually, from the sale of assets reduce available borrowing commitments. At December 31, 1993, the Company had $72.4 million of unused borrowing capacity, and there were no borrowings outstanding under this revolving credit facility. The Company has entered into interest rate swap agreements to reduce the impact of changes in interest rates on its floating rate debt. At December 31, 1993, the Company had interest rate swap agreements with commercial banks having a total notional principal amount of $40 million. These agreements call for the payment of fixed rate interest by the Company in return for the assumption by the commercial banks of the variable rate costs, which effectively fixes the Company's interest rate on a portion of its floating rate debt at 10.4%. The interest rate swap agreements in the amounts of $10 million, $20 million and $10 million mature in 1994, 1995 and 1996 respectively. Additionally, the Company is a party to a swap agreement with a notional principal amount of $20 million expiring in 1994, from which it receives interest from a commercial bank at a fixed rate of 5.4% and pays interest at various rates to the bank. The Company is exposed to credit loss in the event of non-performance by the other parties to the interest rate swap agreements. However, the Company does not anticipate nonperformance by the counterparties. The cost to terminate the net swap obligations at December 31, 1993 is approximately $4,922,000. With internally generated funds and amounts available under its long-term debt facilities, the Company expects to have sufficient funds to meet its working capital and capital expenditure requirements. ITEM 8. ITEM 8. Financial Statements and Supplementary Data The Company's Consolidated Balance Sheets, Consolidated Statements of Income, Statements of Common Stockholders' Equity, and Consolidated Statements of Cash Flows, together with the report of Arthur Andersen & Co., independent public accountants, are included elsewhere herein. Reference is made to the "Index to 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 There is hereby incorporated by reference the information to appear under the caption "Election of Directors" in the Company's Proxy Statement, to be filed with the Securities and Exchange Commission within 120 days after December 31, 1993. See also "Executive Officers of the Registrant" appearing in Part I hereof. ITEM 11. ITEM 11. Executive Compensation There is hereby incorporated by reference the information to appear under the caption "Executive Compensation" in the Company's Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 1993. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management There is hereby incorporated by reference the information to appear under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement, to be filed with the Securities and Exchange Commission within 120 days after December 31, 1993. ITEM 13. ITEM 13. Certain Relationships and Related Transactions There is hereby incorporated by reference the information to appear under the caption "Certain Relationships and Related Transactions" in the Company's Proxy Statement, to be filed with the Securities and Exchange Commission within 120 days after December 31, 1993. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. and 2. Financial Statements and Financial Statement Schedules. See Index to Financial Statements and Financial Statement Schedules on page 18. (b) Reports on Form 8-K None (c) Exhibits 3.1 Restated Certificate of Incorporation, as amended, previously filed as Exhibit 3.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1983, Exhibit 3.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, and Exhibit 3.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987, are incorporated herein by reference. 3.2 Bylaws of Registrant as amended, previously filed as Exhibit 3.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987, is incorporated herein by reference. 4.1 Indenture, dated as of April 1, 1983, of Registrant to Manufacturers Hanover Trust Company, Trustee, previously filed as Exhibit 4.2 to Registration Statement No. 2-82718 on Form S-1, is incorporated herein by reference. 4.2 Instrument of Resignation, Appointment and Acceptance, dated as of March 23, 1988 among the Registrant, Manufacturers Hanover Trust Company and the First National Bank of Boston, previously filed as Exhibit 1 to Registrant's Report on Form 8-K dated March 23, 1988, is incorporated herein by reference. 9. Stockholders Agreement, dated September 26, 1985, among Alan B. Miller, Thomas L. Kempner, Sidney Miller, Anthony Pantaleoni and George H. Strong, previously filed as Exhibit 9 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, is incorporated herein by reference. 9.1 Amendment No. 1, dated as of November 1, 1989, to Stockholders Agreement, dated September 26, 1985, among Alan B. Miller, Thomas L. Kempner, Sidney Miller, Anthony Pantaleoni and George H. Strong, previously filed as Exhibit 9.1 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. 10.1 Amended and Restated Credit Agreement, dated as of August 21, 1992 among Universal Health Services, Inc., Certain Participating Banks, and Morgan Guaranty Trust Company of New York, as Agent, previously filed as Exhibit 10.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, is incorporated herein by reference. 10.2 Restated Purchase Agreement, dated June 22, 1981, among Registrant, its preferred stockholders and certain of its officers, previously filed as Exhibit 10.10 to Registration Statement No. 2-72393 on Form S-1, is incorporated herein by reference. 10.3 Restated Employment Agreement, dated as of July 14, 1992, by and between Registrant and Alan B. Miller. 10.4 Purchase and Sale Agreement, dated as of February 8, 1991, by and among Registrant, London Independent Hospital, Inc., UHS International, Inc., UHS Leasing Company, Inc., UHS International Limited, and Compass Group plc, previously filed with Registrant's Current Report on Form 8-K dated February 8, 1991, is incorporated herein by reference. 10.5 Form of Employee Stock Purchase Agreement for Restricted Stock Grants, previously filed as Exhibit 10.12 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, is incorporated herein by reference. 10.6 Advisory Agreement, dated as of December 24, 1986, between Universal Health Realty Income Trust and UHS of Delaware, Inc., previously filed as Exhibit 10.2 to Registrant's Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference. 10.7 Agreement, effective January 1, 1994, to renew Advisory Agreement, dated as of December 24, 1986, between Universal Health Realty Income Trust and UHS of Delaware, Inc. 10.8 Form of Leases, including Form of Master Lease Document for Leases, between certain subsidiaries of the Registrant and Universal Health Realty Income Trust, filed as Exhibit 10.3 to Amendment No. 3 of the Registration Statement on Form S-11 and Form S-2 of Registrant and Universal Health Realty Income Trust (Registration No. 33-7872), is incorporated herein by reference. 10.9 Share Option Agreement, dated as of December 24, 1986, between Universal Health Realty Income Trust and Registrant, previously filed as Exhibit 10.4 to Registrant's Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference. 10.10 Corporate Guaranty of Obligations of Subsidiaries Pursuant to Leases and Contract of Acquisition, dated December 24, 1986, issued by Registrant in favor of Universal Health Realty Income Trust, previously filed as Exhibit 10.5 to Registrant's Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference. 10.11 1989 Non-Employee Director Stock Option Plan, previously filed as Exhibit 10.23 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. 10.12 1990 Employees' Restricted Stock Purchase Plan, previously filed as Exhibit 10.24 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. 10.13 1992 Corporate Ownership Program, previously filed as Exhibit 10.24 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.14 1992 Stock Bonus Plan, previously filed as Exhibit 10.25 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.15 1992 Stock Option Plan, previously filed as Exhibit 10.16 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. 10.16 Sale and Servicing Agreement dated as of November 16, 1993, between Certain Hspitals and UHS Receivables Corp. 10.17 Servicing agreement dated as of November 16, 1993, among UHS Receivables Corp., UHS oof Delaware, Inc. and Continental Bank, National Association. 10.18 Pooling Agreement dated as of November 16, 1993, among UHS Receivables Corp., Sheffield Receivables Corporation and Continental Bank, National Association. 10.19 Guarantee dated as of November 16, 1993, by Universal Health Services, Inc. in favor of UHS Receivables Corp. 10.20 Amendment No. 1 to the 1989 Non-Employee Director Stock Option Plan. 10.21 Amendment No. 1 to the 1992 Stock Bonus Plan. 10.22 1994 Executive Incentive Plan. 11. Statement re: computation of per share earnings. 22. Subsidiaries of Registrant. 24. Consent of Independent Public Accountants. Exhibits, other than those incorporated by reference, have been included in copies of this Report filed with the Securities and Exchange Commission. Stockholders of the Company will be provided with copies of those exhibits upon written request to 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. UNIVERSAL HEALTH SERVICES, INC. By: /s/ ALAN B. MILLER ----------------------------------------- ALAN B. MILLER PRESIDENT March 23, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. UNIVERSAL HEALTH SERVICES, INC. AND FINANCIAL STATEMENT SCHEDULES (ITEM 14(A)) PAGE --------- FORM 10-K --- Consolidated Financial Statements: Report of Independent Public Accountants on Financial Statements and Schedules................................................... 19 Consolidated Statements of Income for the three years ended December 31, 1993............................................... 20 Consolidated Balance Sheets as of December 31, 1993 and 1992....... 21 Consolidated Statements of Common Stockholders' Equity for the three years ended December 31, 1993............................. 22 Consolidated Statements of Cash Flows for the three years ended December 31, 1993............................................... 23 Notes to Consolidated Financial Statements......................... 24 Supplemental Financial Statement Schedules: II Amounts Receivable from Related Parties, Underwriters, Promoters and Employees Other Than Related Parties............ 33 V Property and Equipment........................................ 34 VI Accumulated Depreciation and Amortization of Property and Equipment..................................................... 35 VIII Valuation and Qualifying Accounts............................. 35 X Supplementary Income Statement Information.................... 35 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of Universal Health Services, Inc.: We have audited the accompanying consolidated balance sheets of Universal Health Services, Inc. (a Delaware 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 and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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 Universal Health Services, 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. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the Index to Financial Statements and Financial Statement Schedules are presented for the purpose of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our 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. Philadelphia, Pennsylvania February 15, 1994 UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992 and 1991 UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS As of December 31, 1993 and 1992 UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY For the Years Ended December 31, 1993, 1992 and 1991 UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992 and 1991 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Universal Health Services, Inc. (the "Company") is primarily engaged in owning and operating acute care and psychiatric hospitals and ambulatory treatment centers. The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. The more significant accounting policies follow: NET REVENUES: Net revenues are reported at the estimated net realizable amounts from patients, third-party payors, and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. These net revenues are accrued on an estimated basis in the period the related services are rendered and adjusted in future periods as final settlements are determined. Medicare and Medicaid net revenues represented 40%, 39% and 35% of net patient revenues for the years 1993, 1992 and 1991, respectively, excluding the additional revenues from special Medicaid reimbursement programs described in Note 9. PROPERTY AND EQUIPMENT: Property and equipment are stated at cost. Expenditures for renewals and improvements are charged to the property accounts. Replacements, maintenance and repairs which do not improve or extend the life of the respective asset are expensed as incurred. The Company removes the cost and the related accumulated depreciation from the accounts for assets sold or retired and the resulting gains or losses are included in the results of operations. Depreciation is provided on the straight-line method over the estimated useful lives of buildings and improvements (twenty to forty years) and equipment (five to fifteen years). OTHER ASSETS: The excess of cost over fair value of net assets acquired in purchase transactions, net of accumulated amortization of $47,663,000 in 1993 and $43,828,000 in 1992, is amortized over periods ranging from five to forty years. During 1992 the Company recorded a $13.5 million charge to amortization expense due to a revaluation of certain goodwill balances. EARNINGS PER COMMON AND COMMON EQUIVALENT SHARE: Earnings per share are based on the weighted average number of common shares outstanding during the year adjusted to give effect to common stock equivalents. The 1993, 1992 and 1991 earnings per share have been adjusted to reflect the assumed conversion of the Company's convertible debentures. INCOME TAXES: The Company and its subsidiaries file consolidated Federal tax returns. Deferred taxes are recognized for the amount of taxes payable or deductible in future years as a result of differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. OTHER NONCURRENT LIABILITIES: Other noncurrent liabilities include the long-term portion of the Company's professional and general liability and workers' compensation reserves. STATEMENT OF CASH FLOWS: For purposes of the consolidated statements of cash flows, the Company considers all highly liquid investments purchased with maturities of three months or less to be cash equivalents. Interest expense in the consolidated statements of income is net of interest income of $498,000, $515,000 and $2,188,000 in 1993, 1992 and 1991, respectively. INTEREST RATE SWAP AGREEMENTS: The differential to be paid or received is accrued as interest expense as interest rates change and is recognized over the life of the agreements. 2) ACQUISITIONS, DISPOSITIONS AND CLOSURES 1993 -- During 1993 the Company purchased a radiation therapy center and majority interests in four separate partnerships which own and operate ambulatory surgery facilities for $11.5 million in cash and the assumption of liabilities totaling $300,000. During the fourth quarter, the Company sold the operations and fixed assets of a 124-bed acute care hospital for approximately $7.8 million in cash. The Company also sold the operations and certain fixed assets of a 134-bed acute care hospital for cash of $1.5 million. Concurrently, the Company sold certain related real property to Universal Health Realty Income Trust (the "Trust"), an affiliate and the lessor of this 134-bed acute care hospital, for $1 million in cash and a note receivable of $900,000 (see Note 8). In connection with this transaction, the Company's lease with the Trust for this property was terminated. The disposition of these two facilities resulted in a pre-tax loss of $4.4 million ($2.2 million after tax), which is included in operating expenses in the 1993 consolidated statement of income. Also during 1993, the Company recorded a pre-tax charge of $4.4 million related to the winding down or disposition of other non-strategic businesses which is included in operating expenses in the 1993 consolidated statement of income. 1992 -- During 1992 the Company purchased majority interests in four separate partnerships which own and operate ambulatory surgery facilities for $7.2 million in cash and the assumption of liabilities totaling $5.4 million. Also during 1992, the Company discontinued operations at a 96-bed acute care hospital and sold the fixed assets of this facility for $3.4 million. The closing and sale of this hospital did not have a material impact on the consolidated financial statements. 1991 -- During 1991 the Company sold its entire U.K. operations, consisting of three acute care hospitals and certain other assets. This transaction resulted in a pre-tax gain of approximately $4.8 million (including $4.3 million transferred from cumulative translation adjustment) which is included in net revenues in the 1991 financial statements. The Company received $30.2 million in cash during 1991, an additional $9 million in 1992 and $4.9 million in 1993. The Company is entitled to receive additional consideration of approximately (pounds sterling)2.5 million as well as additional amounts if certain earnings targets are achieved by one of these hospitals. Based upon the year-end exchange rate, the Company expects to receive approximately $3.6 million in 1994. In 1991 the Company entered into a 15-year operating lease agreement for a 166-bed psychiatric hospital. The lease terms include three 5-year renewal terms at the Company's option, annual base lease rentals of $1,620,000 and additional rentals beginning in 1993 based upon revenues in excess of a base year amount ($24,000 in 1993). 3) LONG-TERM DEBT A summary of long-term debt follows: During 1993, the Company commenced a commercial paper program which provides up to $25 million of renewable borrowings which are secured by patient accounts receivable. The Company has sufficient patient receivables to support a larger program, and upon the mutual consent of the Company and the participating lending institutions, the commitment can be increased to $65 million. A fee of .76% is required on this $25 million commitment. The Company has a $72.4 million non-amortizing revolving credit agreement which matures in August of 1995 and provides for interest, at the Company's option, at the prime rate, certificate of deposit rate plus 11/8% or LIBOR plus 1%. A fee of 3/8% is required on the unused portion of this commitment. There are no compensating balance requirements. The agreement contains a provision whereby 50% of the net consideration, in excess of $15 million annually, from the disposition of assets will be applied to reduce commitments. At December 31, 1993, the Company had $72.4 million of unused borrowing capacity, and there were no borrowings outstanding under this revolving credit agreement. The average amounts outstanding during 1993, 1992 and 1991 under the revolving credit notes and commercial paper program were $25,069,000, $47,318,000 and $91,770,000, respectively, with corresponding effective interest rates of 13.9%, 11.2% and 10.0% including commitment fee and interest rate swaps. The maximum amounts outstanding at any month-end were $46,800,000, $91,650,000 and $114,416,000 during 1993, 1992 and 1991 respectively. The Company has entered into interest rate swap agreements to reduce the impact of changes in interest rates on its floating rate debt. At December 31, 1993, the Company had interest rate swap agreements with commercial banks having a total notional principal amount of $40 million. These agreements call for the payment of fixed rate interest by the Company in return for the assumption by the commercial banks of the variable rate costs, which effectively fixes the Company's interest rate on a portion of its floating rate debt at 10.4%. The interest rate swap agreements in the amounts of $10 million, $20 million and $10 million mature in 1994, 1995 and 1996 respectively. Additionally, the Company is a party to a swap agreement with a notional principal amount of $20 million expiring in 1994, from which it receives interest from a bank at a fixed rate of 5.4% and pays interest at various rates to the bank. The Company is exposed to credit loss in the event of non-performance by the other parties to the interest rate swap agreements. However, the Company does not anticipate nonperformance by the counterparties. The cost to terminate the net swap obligations at December 31, 1993 is approximately $4,922,000. Covenants relating to long-term debt require maintenance of a minimum net worth and cash flows, specified debt to net worth and fixed charge coverage ratios. Covenants also limit the Company's ability to incur additional senior debt and to pay cash dividends, repurchase its shares and retire convertible debenture debt and limit capital expenditures, among other restrictions. The fair value of the Company's subordinated debentures at December 31, 1993 was approximately $31,101,000 based on quoted market prices. The Company has the option to redeem these debentures at Par value at any time upon 30 days notice. The fair value of the Company's remaining long-term debt at December 31, 1993 was approximately equal to its carrying value. Substantially all accounts receivable and the stock of subsidiary companies are pledged as collateral to secure long-term debt. Aggregate maturities follow: ---------------------------- 1994 $ 4,313,000 1995 9,671,000 1996 3,815,000 1997 2,284,000 1998 805,000 Later 58,506,000 ---------------------------- Total $79,394,000 ---------------------------- 4) COMMON STOCK During 1993, the Company repurchased 224,800 shares of its Class B Common Stock at an average purchase price of $14.39 per share or an aggregate of approximately $3.2 million. Since January 1, 1992 the Company has repurchased 454,700 shares at an aggregate purchase price of approximately $6.2 million or $13.55 per share. The Company's ability to repurchase its shares is limited by long-term debt covenants to $7.5 million plus 25% of cumulative net income since January, 1992. Under the terms of these covenants, the Company had the ability to repurchase an additional $12.3 million of its Common Stock as of December 31, 1993. The repurchased shares are treated as retired. At December 31, 1993, 3,340,350 shares of Class B Common Stock were reserved for issuance upon conversion of shares of Class A, C and D Common Stock outstanding, for issuance upon exercise of options to purchase Class B Common Stock, for issuance upon conversion of the Company's Convertible Subordinated Debentures and for issuance of stock under other incentive plans. Class A, C and D Common Stock are convertible on a share for share basis into Class B Common Stock. In 1992, the Company adopted a Stock Bonus Plan and a Corporate Ownership Program, both of which were approved by the stockholders at the 1992 annual meeting. Under the terms of the Stock Bonus Plan, eligible employees may elect to receive all or part of their annual bonuses in shares of restricted stock (the "Bonus Shares"). Those electing to receive bonus shares also receive additional restricted shares in an amount equal to 20% of their Bonus Shares (the "Premium Shares"). Restrictions on one-half of the Bonus Shares and one- half of the Premium Shares lapse after one year and the restrictions on the remaining shares lapse after two years. The Company has reserved 150,000 shares of Class B Common Stock for this plan and has issued 46,313 shares at December 31, 1993. Under the terms of the Corporate Ownership Program, eligible employees may purchase shares of common stock, directly from the Company, at the market price. The Company will loan each eligible employee an amount equal to 90% of the purchase price for the shares. The loans, which are partially recourse to the employee, bear interest at the applicable Federal rate and are due five years from the purchase date. Shares purchased under this plan are restricted from sale or transfer. Restrictions on one-half of the shares lapse after one year and restrictions on the remaining shares lapse after two years. The Company has reserved 100,000 shares of Class B Common Stock for this plan. As of December 31, 1993, 19,803 shares were sold under the terms of this plan. The Company also has a Restricted Stock Purchase Plan which allows eligible participants to purchase shares of Class B Common Stock at par value, subject to certain restrictions. Under the terms of this plan, 300,000 shares of Class B Common Stock have been reserved for purchase by officers, key employees and consultants. The restrictions lapse as to one-third of the shares on the third, fourth and fifth anniversary dates of the purchase. The Company has issued 143,000 shares under this plan, of which 45,000 became fully vested during 1993 and 5,333 were cancelled. Compensation expense, based on the difference between the market price on the date of purchase and par value, is being amortized over the restriction period and was $240,000 in 1993, $265,000 in 1992 and $278,000 in 1991. Stock options to purchase Class B Common Stock have been granted to officers, key employees and directors of the Company under various plans. All stock options were granted with an exercise price equal to the fair market value on the date of the grant. Options are exercisable ratably over a four year period beginning one year after the date of the grant. The options expire five years after the date of the grant. Information with respect to these options is summarized as follows: Options for 259,100 shares were available for grant at December 31, 1993. At December 31, 1993, options for 49,313 shares of Class B Common Stock with an aggregate purchase price of $581,273 (average of $11.79 per share) were exercisable. 5) INCOME TAXES Components of income tax expense are as follows: The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", (SFAS 109). Under SFAS 109, deferred taxes are required to be classified based on the financial statement classification of the related assets and liabilities which give rise to temporary differences. The effect of adopting SFAS 109 was not material to the Company's 1991 results of operations. The Company had previously accounted for income taxes under the provisions of Statement of Financial Accounting Standards No. 96. The net effect of the impact of the 1993 tax law changes on the current and deferred tax provisions was immaterial. Deferred taxes result from temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. The components of deferred taxes are as follows: At December 31, 1990, the Company had capital loss carryforwards of $7,800,000 which were available to offset future capital gains for financial reporting purposes. These capital loss carryforwards were fully utilized in 1991 as a result of the U.K. divestiture transaction. During the current year, the Company disposed of several hospitals and ancillary businesses resulting in the recoupment of previously non-deductible charges. During the year, the Company reviewed its deferred state tax balances and as a result reduced its current year tax provision by $780,000. The net deferred tax assets and liabilities are comprised as follows: The assets and liabilities classified as current relate primarily to the allowance for uncollectible patient accounts and the current portion of the temporary differences related to self-insurance reserves and the change in accounting method. Under SFAS 109, a valuation allowance is required when it is more likely than not that some portion of the deferred tax assets will not be realized. The Company has not provided a valuation allowance since management believes that all of the deferred tax assets will be realized through the reversal of temporary differences that result in deferred tax liabilities and through expected future taxable income. 6) LEASE COMMITMENTS Certain of the Company's hospital and medical office facilities and equipment are held under operating or capital leases which expire through 2013. Certain of these leases also contain provisions allowing the Company to purchase the leased assets during the term or at the expiration of the lease at fair market value. A summary of property under capital lease follows: Future minimum rental payments under lease commitments with a term of more than one year as of December 31, 1993 are as follows: Capital lease obligations of $5,371,000, $7,310,000 and $1,467,000 in 1993, 1992 and 1991 respectively, were incurred when the Company entered into capital leases for new equipment. 7) COMMITMENTS AND CONTINGENCIES The Company is self-insured for its general liability risks for claims limited to $5 million per occurrence and for its professional liability risks for claims limited to $25 million per occurrence. Coverage in excess of these limits up to $100 million is maintained with major insurance carriers. During 1993, the Company purchased a general and professional liability occurrence policy with a commercial insurer for one of its larger acute care facilities. This policy, which is scheduled to terminate in July, 1994, includes coverage up to $25 million per occurrence for general and professional liability risks. As of December 1993 and 1992, the reserve for professional and general liability risks was $65.2 million and $58.6 million, respectively, of which $8.3 million in 1993 and $7.4 million in 1992 is included in current liabilities. Self-insurance reserves are based upon actuarially determined estimates. The Company has outstanding letters of credit totaling $22 million related to the Company's self-insurance programs ($11.3 million), as support for various debt instruments ($2.1 million) and as support for a loan guarantee for an unaffiliated party ($8.6 million). The Company has also guaranteed approximately $2 million of loans. The Company estimates the cost to complete major construction projects in progress at December 31, 1993 will approximate $24 million. The Company has entered into a long term contract with a third party to provide certain data processing services for its acute care and psychiatric hospitals. This contract expires in 1999. Various suits and claims arising in the ordinary course of business are pending against the Company. In the opinion of management, the outcome of such claims and litigation will not materially affect the Company's consolidated financial position or results of operations. 8) RELATED PARTY TRANSACTIONS At December 31, 1993, the Company held approximately 7% of the outstanding shares of Universal Health Realty Income Trust (the "Trust"). Certain officers and directors of the Company are also officers and/or Directors of the Trust. The Company accounts for its investment in the Trust using the equity method of accounting. The Company's pre-tax share of income/(loss) from the Trust was $757,000, ($110,000) and $674,000 in 1993, 1992 and 1991, respectively, and is included in net revenues in the accompanying consolidated statements of income. The carrying value of this investment at December 31, 1993 and 1992 was $7,375,000 and $4,524,000, respectively and is included in other assets in the accompanying consolidated balance sheets. The market value of this investment at December 31, 1993 was $10,352,000. During 1993, pursuant to the terms of its lease with the Trust, the Company purchased the real property of a 48-bed psychiatric hospital located in Texas for $3.2 million. The real property of this hospital was previously leased by the Company and base rental payments continued under the existing lease until the date of sale. Operations at this hospital were discontinued during the first quarter of 1992, however, the facility is currently being utilized for outpatient services at one the Company's acute care hospitals. Also during 1993, the Company sold to the Trust certain real estate assets of a 134-bed hospital located in Illinois for approximately $1.9 million. These assets consisted of additions and improvements made to the facility by the Company since the sale of the major portion of the real estate assets to the Trust in 1986. The operations of this facility were sold during 1993 to an operator unaffiliated with the Company. As of December 31, 1993, the Company leased eight hospital facilities from the Trust with initial terms expiring in 1999 through 2003. These leases contain up to six 5-year renewal options. Future minimum lease payments to the Trust are included in Note 6. The terms of the lease provide that in the event the Company discontinues operations at the leased facility for more than one year, the Company is obligated to offer a substitute property. If the Trust does not accept the substitute property offered, the Company is obligated to purchase the leased facility back from the Trust at a price equal to the greater of its then fair market value or the original purchase price paid by the Trust. Total rent expense under these operating leases was $16,600,000 in 1993, $17,000,000 in 1992 and $16,800,000 in 1991. The Company received an advisory fee of $880,000 in 1993, $913,000 in 1992 and $909,000 in 1991 from the Trust for investment and administrative services provided under a contractual agreement which is included in net revenues in the accompanying consolidated statements of income. In connection with the exercise of stock options by certain officers, the Company agreed to lend these officers an amount equal to the Company's tax savings resulting from the exercise of these options. In 1991, $112,000 of the loan balances, and in 1992 the remaining loan balances of $352,000 were forgiven by the Board of Directors and charged to compensation expense. In 1985, shares of Class A Common Stock were granted to certain officers and key employees, primarily in exchange for notes receivable. The obligations to repay the notes, which lapsed over a seven-year period, terminated during 1992. Compensation expense charged to operations related to these stock grants was $26,000 in 1992 and $136,000 in 1991. At January 1, 1992, the Company had a non-interest bearing demand note from a principal officer which was fully forgiven during 1992. Compensation expense charged to operations related to this note was $393,000 in 1992 and $100,000 in 1991. A member of the Company's Board of Directors is a partner in the law firm used by the Company as its principal outside counsel. 9) QUARTERLY RESULTS (UNAUDITED) The following tables summarize the Company's quarterly financial data for the two years ended December 31, 1993. Net revenues in 1993 include $13.5 million of additional revenues received from special Medicaid reimbursement programs. These programs are scheduled to terminate in August, 1994. Of the amount received, $4.6 million was recorded in each of the first and second quarters, $1.0 million was recorded in the third quarter and $3.3 million was recorded in the fourth quarter. These amounts were recorded in the periods that the Company met all of the requirements to be entitled to these reimbursements. The first quarter operating results also include approximately $4.1 million of expenses related to the disposition of ancillary businesses and the second quarter operating results include a $3.2 million increase in the reserves for the Company's self-insurance programs. Net revenues in the third quarter include $3.0 million of unfavorable adjustments related to prior year reimbursement issues and the fourth quarter operating results includes a $4.7 million pre-tax loss on disposal of two acute care hospitals and the winding down or disposition of non-strategic businesses. The Company's effective tax rate in the fourth quarter was significantly lower than other quarters due to the disposition of two acute care hospitals resulting in the recoupment of previously non- deductible charges. Net revenues in 1992 include $29.8 million of favorable Medicaid reimbursements. Of this amount, $22.2 million was recorded in the first quarter, $3 million was recorded in the third quarter and $4.6 million was recorded in the fourth quarter. These amounts were recorded in the periods that the Company met all of the requirements to be entitled to these reimbursements. The first quarter's operating results also include a $13.5 million amortization charge resulting from the revaluation of certain goodwill balances. Net revenues in the second quarter include a $2.3 million favorable adjustment related to prior year reimbursement issues. UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE V -- PROPERTY AND EQUIPMENT UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION All other items are omitted since the required information is not applicable. ============================================================================== - ------------------------------------------------------------------------------ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 -------------- EXHIBITS TO FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED COMMISSION FILE NUMBER DECEMBER 31, 1993 0-10454 -------------- UNIVERSAL HEALTH SERVICES, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) - ------------------------------------------------------------------------------ ============================================================================== INDEX TO EXHIBITS Exhibit 10.3 Restated Employment Agreement, dated as of July 14, 1992, by and between Registrant and Alan B. Miller. 10.7 Agreement, effective January 1, 1994, to renew Advisory Agreement, dated as of December 24, 1986, between Universal Health Realty Income Trust and UHS of Delaware, Inc. 10.16 Sale and Servicing Agreement dated as of November 16, 1993, between Certain Hospitals and UHS Receivables Corp. 10.17 Servicing Agreement dated as of November 16, 1993, among UHS Receivables Corp., UHS of Delaware, Inc. and Continental Bank, National Association. 10.18 Pooling Agreement dated as of November 16, 1993, among UHS Receivables Corp., Sheffield Receivables Corporation and Continental Bank, National Association. 10.19 Guarantee dated as of November 16, 1993, by Universal Health Services, Inc. in favor of UHS Receivables Corp. 10.20 Amendment No. 1 to the 1989 Non-Employee Director Stock Option Plan. 10.21 Amendment No. 1 to the 1992 Stock Bonus Plan. 10.22 1994 Executive Incentive Plan. 11. Statement re: computation of per share earnings. 22. Subsidiaries of Registrant. 24. Consent of Independent Public Accountants. EXHIBIT 10.3 RESTATED EMPLOYMENT AGREEMENT THIS AGREEMENT, dated as of July 14, 1992, by and between UNIVERSAL HEALTH SERVICES, INC., a Delaware corporation having its principal office at 367 South Gulph Road, King of Prussia, Pennsylvania 19406 (the "Company") and ALAN B. MILLER, residing at 57 Crosby Brown Road, Gladwyne, Pennsylvania 19035 ("Employee"). W I T N E S S E T H: WHEREAS, employee has been and is employed by the Company as its President and Chief Executive Officer pursuant to an Employment Agreement dated as of January 1, 1981, as amended December 1984, July 15, 1987 and June 1, 1989 (the "Employment Agreement"), and Employee has served and is presently serving as a Director of the Company; WHEREAS, the Company and Employee desire that such employment continue pursuant to the terms and conditions hereof; WHEREAS, because of the position Employee now holds with the Company and will hold during the term of this Agreement, the Company's Board of Directors considers it in the best interests of the Company, for an extended period after the term of Employee's active employment, that the Company have the benefit of Employee's services as a consultant and that Employee refrain from competing with the Company; and WHEREAS, after the term of his active employment by the Company, Employee is willing to serve as a consultant to the Company and to refrain from competing with the Company pursuant to the terms and conditions hereof applicable thereto; WHEREAS, the Employment Agreement is hereby amended and restated in its entirety by this Agreement; NOW, THEREFORE, for and in consideration of the mutual premises, representations and covenants herein contained, it is agreed as follows: 1. Term of Active Employment and Consulting Period. The phrase "term of active employment", as used in this Agreement, shall mean the period beginning July 14, 1992 and ending on December 31, 1997, subject, however, to earlier termination as expressly provided herein, and subject further to the right of Employee or the Company to extend the term of active employment until December 31, 2002 by giving written notice thereof to the other within 180 days prior to December 31, 1997. The phrase "consulting period", as used in this Agreement, shall mean, except as otherwise provided herein, the period beginning immediately upon the expiration of the term of active employment, as it may be extended, and continuing for five years after such expiration. The phrase "term of this Agreement", as used in this Agreement, shall mean the term of active employment and the consulting period together. 2. Active Employment. The Company agrees to employ Employee, and Employee agrees to be employed by the Company, as Chief Executive Officer and President of the Company during the term of employment. 3. Duties. (a) Employee agrees in the performance of his duties as Chief Executive Officer and President of the Company during the term of active employment to comply with the policies and reasonable directives of the Board of Directors of the Company (and any subsidiary or subsidiaries of the Company which shall, with the consent of Employee, at the time employ Employee). (b) Employee agrees to devote his full time to the performance of his duties during the term of active employment; and Employee shall not, directly or indirectly, alone or as a member of a partnership, or as an officer, director or employee of any other corporation, partnership or other organization, be actively engaged in or concerned with any other duties or pursuits which interfere with the performance of his duties hereunder. (c) The Company agrees that during the term of active employment Employees' duties shall be such as to allow him to work and live in the Philadelphia Metropolitan Area, and in no event shall Employee be required to move his residence from, or operate (except in accordance with past practice) outside of, the Philadelphia Metropolitan Area. 4. Base Salary. (a) As compensation for the services to be rendered by Employee hereunder, the Company agrees to pay or cause to be paid to Employee for the fiscal year ending December 31, 1992 and each fiscal year thereafter during the term of this Agreement a base salary of six hundred seventy five thousand ($675,000) dollars per annum which salary shall be increased by an amount equal at least to the percentage increase in the Consumer Price Index over the previous year as reported by the United States Department of Labor, Bureau of Labor Statistics, for the Philadelphia Metropolitan Area, and may be increased by such larger amount as the Board of Directors in its discretion may determine, but in no event shall the salary be reduced from the salary paid during the previous fiscal year. (b) The Company also agrees to pay or reimburse Employee during the term of active employment for all reasonable travel and other expenses incurred or paid by Employee in connection with the performance of his services under this Agreement in accordance with past practice. 5. Annual Bonus. It is acknowledged that it has been the practice of the Company to award Employee an annual bonus (the "Annual Bonus"). It is agreed that the Annual Bonus award shall be continued during the term of employment as follows: the Company shall pay to Employee during the term of active employment, within ninety (90) days after the end of the fiscal year ending December 31, 1992 and of each fiscal year of the Company thereafter during the term of active employment, an amount determined by the Board of Directors, but not less than $100,000. 6. Other Bonuses and Benefits. (a) Employee may also be paid during the term of active employment, in addition to the arrangements described above, such bonuses and other compensation as may from time to time be determined by the Board of Directors of the Company. (b) (1) The Company agrees to pay Employee an annual amount of $13,674.00 during the term of this Agreement as payment for premiums under a life insurance policy, Policy No. 158034323 (the "Policy") issued by Manufacturers Life Insurance Company (the "Insurer"), on the life of Employee. (2) Should Employee's employment with the Company cease because of Employee's resignation from employment with the Company or "discharge for cause" under the terms of this Agreement, the Company's obligations under clause (b)(1) hereof shall also cease. At such time, the Company shall be entitled to receive from Employee a payment (based on the year of resignation or "discharge for cause") as follows: Year Amount ---- ------- 1992 $29,090 1993 $38,716 1994 $48,815 1995 $59,410 1996 $70,534 1997 $90,843 1998 $103,774 1999 $117,338 2000 $131,443 2001 $146,119 2002 $151,334 (3) Employee's obligations under clause (b)(2) hereof are non-recourse to Employee and are secured solely by the cash surrender value of the Policy. Should Employee not make the required payment to the Company of the amounts set forth in clause (b)(2) hereof, Employee agrees to surrender the Policy for termination by the Insurer in return for the payment by the Insurer to the Company of the cash surrender value of the Policy. (4) The Company's interest in the Policy shall be limited to the right to recover the cash surrender value of the Policy under the terms of this Agreement. (5) Except as specifically herein granted to the Company, Employee shall retain all incidents of ownership in the Policy, including, but not limited to, the right to change the beneficiary of the Policy, and the right to exercise all settlement options permitted by the terms of the Policy; provided, however, that all rights retained by Employee, transferee and beneficiary shall be subject to the terms and conditions of this Agreement. (6) The Insurer is authorized by this Agreement to recognize the Company's claims to rights hereunder without investigating the reason for any action taken by the Company, the termination of Employees' employment, the giving of any notice required herein, or the application to be made by the Company of any amounts to be paid to the Company. The signature of any officer of the Company shall be sufficient for the exercise of any rights under the Policy and the receipt of the Company for any sums received by it shall be a full discharge and release therefor to the Insurer. (7) If the Insurer is made or elects to become a party to any litigation concerning the proper apportionment under this agreement, Employee and the Company and their transferees agree to be jointly and severally liable for the Insurer's litigation expenses, including reasonable attorney fees. (c) Employee shall also be eligible to and shall participate in, and receive the benefits of, any and all profit sharing, pension, bonus, stock option or insurance plans, or other similar types of benefit plans which may be initiated or adopted by the Company. 7. Fringe Benefits. Employee shall be entitled to and shall receive the following benefits during the term of this Agreement: (a) All prior benefits previously enjoyed in accordance with past practice; and (b) Health, disability and accident insurance as presently in force or as may be improved by the Board of Directors. 8. Consulting Period Retention and Duties. (a) Except as otherwise provided in Sections 9, 10 and 11 hereof, Employee agrees to be retained by the Company, and Company agrees to retain Employee, as a consultant to the Company during the consulting period. (b) During the consulting period Employee will provide such reasonable consulting services concerning the business, affairs and management of the Company as may be requested by the Company's Board of Directors, but Employee shall not be required to devote more than five (5) business days each month to such services, which shall be performed at such place as is mutually convenient to both parties or, in the event there is no agreement as to a mutually convenient place, such services shall be performed at the principal executive offices of the Company. Employee may, subject to the restrictions of Section 13, engage in other employment during the consulting period as is not inconsistent with his consulting obligations hereunder. 9. Consulting Period Compensation. (a) As compensation for the services to be rendered by Employee during the consulting period the Company agrees to pay or cause to be paid to Employee a fee equal to one-half Employee's base salary paid under Section 4 hereof at the date of the expiration of the term of active employment, payable in equal monthly installments during the consulting period. (b) The Company also agrees to pay or reimburse Employee for all reasonable travel and other expenses incurred or paid by Employee in connection with the performance of his services under this Agreement during the consulting period in accordance with the payment or reimbursement practices in effect during the term of active employment. 10. Disability. If during the term of active employment Employee shall become physically or mentally disabled, whether totally or partially, so that he is prevented from performing his usual duties for a period of six consecutive months, or for shorter periods aggregating six months in any twelve-month period, the Company shall, nevertheless, continue to pay Employee his full compensation, when otherwise due, as provided in this Agreement through the last day of the sixth consecutive month of disability or the date on which the shorter periods of disability shall have equalled a total of six months in any twelve-month period. The Company may, by action of all but one of the members of the Company's Board of Directors, at any time on or after such day, by written notice to Employee (the "Disability Notice"), provided Employee has not resumed his usual duties prior to the date of the Disability Notice, terminate (as of the first day of the month following the date of the Disability Notice, provided that Employee shall also be paid a pro rata portion of the Annual Bonus which would otherwise have been payable for such fiscal year in which the Disability Notice is given) the compensation otherwise payable to Employee during the term of active employment and pay to Employee the Disability Payment. The Disability Payment shall mean the payment by the Company to Employee of a sum equal to one-half of Employee's base salary paid under Section 4 hereof at the date of the Disability Notice, payable in twelve equal monthly installments. 11. Death. (a) If Employee shall die during the term of this Agreement, this Agreement shall terminate as of the last day of the month of Employee's death except as set forth in subsection (b) of this Section 11. (b) Anything to the contrary notwithstanding, the Company shall pay to Employee's wife on the date of his death or, in the event Employee is unmarried on the date of his death, to his estate, a pro rata portion of the Annual Bonus which would otherwise have been payable to Employee for the fiscal year in which he died, which pro rata portion shall be determined as of the last day of the month of Employee's death, together with any items of reimbursement or salary owed to Employee as of the date of his death. In addition, the Company shall file claims and take other appropriate action with respect to any life insurance policies maintained on Employee's life by the Company for which Employee had the right to designate the beneficiary. 12. Termination. (a) Discharge for cause. The Company recognizes that during the many ears of Employee's employment by the Company, the Company has become familiar with Employee's ability, competence and judgment. The Company acknowledges, on the basis of such familiarity, that Employee's ability, competence and judgment are satisfactory to the Company. Employee is continuing his employment with the Company hereunder in reliance upon the foregoing expression of satisfaction by the Company. It is therefore agreed that "discharge for cause" shall include discharge by the Company on the following grounds only: (i) Employee's conviction (which, through lapse of time or otherwise, is not subject to appeal) of any crime or offense involving money or other property of the Company or its subsidiaries; or (ii) Employee's conviction (which, through lapse of time or otherwise, is not subject to appeal) of any other crime (whether or not involving the Company or its subsidiaries) which constitutes a felony in the jurisdiction involved; or (iii) Employee's continuing repeated wilful failure or refusal to perform his duties as required by this Agreement, provided that discharge pursuant to this subparagraph (iii) shall not constitute discharge for cause unless Employee shall have first received written notice from the Board of Directors of such failure and refusal and affording Employee an opportunity, as soon as practicable, to correct the acts or omissions complained of. In the event that Employee shall be discharged for cause, all salary and other benefits payable by the Company under this Agreement in respect of periods after such discharge shall terminate upon such discharge, but any benefits payable to or earned by Employee with respect to any period of his employment prior to such discharge shall not be terminated by reason of such discharge. Anything in the foregoing to the contrary notwithstanding, if Employee is convicted of any crime set forth in either Section 12(a)(i) or 12(a)(ii) above, the Company may forthwith suspend Employee without any compensation and choose a new person or persons to perform his duties hereunder during the period between conviction and the time when such conviction, through lapse of time or otherwise, is no longer subject to appeal; provided, however, that if Employee's conviction is subsequently reversed (i) he shall promptly be paid all compensation to which he would otherwise have been entitled during the period of suspension, together with interest thereon (which interest shall be calculated at a rate per annum equal to the rate of interest payable on the date of such reversal on money judgments after entry thereof under the laws of the Commonwealth of Pennsylvania), and (ii) the Company shall have the right (exercisable within sixty (60) days after such reversal) but not the obligation to restore Employee to active service hereunder at full compensation. If the Company elects not to restore Employee to active service after reversal of a conviction, Employee shall thereafter be paid the full compensation which would otherwise have been payable during the balance of the term of active employment and during the consulting period and Employee shall be entitled to obtain other employment, subject however to (i) an obligation to perform consulting services so long as he is receiving compensation pursuant to the terms of this Agreement, (ii) the continued application of the covenants provided in Section 13 and (iii) the condition that, if Employee does obtain other employment during the period ending on December 31, 1997, or December 31, 2002 if this Agreement is extended by Employee or the Company, his total compensation therefrom (whether paid to him or deferred for his benefit) shall reduce, pro tanto, any amount which the Company would otherwise have been required to pay him during the period ending on December 31, 1997, or December 31, 2002 if this Agreement is extended by Employee or the Company. (b) Breach by Company. If Employee shall terminate his employment with the Company because of a material change in the duties of his office or any other breach by the Company of its obligations hereunder, or in the event of the termination of Employee's employment by the Company in breach of this Agreement, Employee shall, except as otherwise provided herein, continue to receive all of the compensation provided hereunder and shall be entitled to all of the benefits otherwise provided herein, during the term of this Agreement notwithstanding such termination and Employee shall have no further obligations or duties under this Agreement. (c) Mitigation. In the event of the termination by Employee of his employment with the Company as a result of a material breach by the Company of any of its obligations hereunder, or in the event of the termination of Employee's employment by the Company in breach of this Agreement, Employee shall not be required to seek other employment in order to mitigate his damages hereunder; provided, however, that if Employee does obtain other employment, his total compensation therefrom, whether paid to him or deferred for his benefit, shall reduce, pro tanto, any amount which the Company would otherwise be required to pay to him as a result of such breach. 13. Non-Competition. Employee agrees that he will not during the term of this Agreement, directly or indirectly, own, manage, operate, join, control, be controlled by, or be connected in any manner with any business of the type conducted by the Company or render any service or assistance of any kind to any competitor of the Company or any of its subsidiaries; provided, however, that (i) in the event Employee terminates his employment with the Company as result of a material breach by the Company of any of its obligations hereunder or in the event the Company discharges Employee without cause, Employee shall continue to be bound by the restrictions of this Section 13 only if Employee is receiving the compensation payable to him in accordance with Section 12(b) hereof and (ii) in the event the Company discharges Employee for cause, Employee shall be bound by the restrictions of this Section for a period of one year following such discharge. 14. Binding Effect. Except as otherwise provided for herein, this Agreement shall inure to the benefit of and be binding upon the heirs, executors, administrators, successors in interest and assigns of the parties hereto. 15. Effective Date. This Agreement shall become effective on July 14, 1992. 16. Notices. All notices provided for herein to be given to any party shall be in writing and signed by the party giving the notice and shall be deemed to have been duly given if mailed, registered or certified mail, return receipt requested, as follows: (i) If to Employee: 57 Crosby Brown Road Gladwyne, Pennsylvania 19035 (ii) If to Company: 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: Secretary Either party may change the address to which notices, requests, demands and other communications hereunder shall be sent by sending written notice of such change of address to the other party. 17. Amendment, Modification and Waiver. The terms, covenants, representations, warranties or conditions of this Agreement may be amended, modified or waived only by a written instrument executed by the parties hereto, except that a waiver need only be executed by the party waiving compliance. No waiver by any party of any condition, or of the breach of any term, covenant, representation or warranty contained in this Agreement, whether by conduct or otherwise, in any one or more instances shall be deemed to be or construed as a waiver of any other condition or breach of any other term, covenant, representation or warranty of this Agreement. 18. Governing Law. This Agreement shall be construed in accordance with the laws of the Commonwealth of Pennsylvania applicable to agreements made and to be performed therein. 19. Entire Agreement. This Agreement contains the entire agreement of the parties relating to the subject matter herein contained and supersedes all prior contracts, agreements or understandings between and among the parties, except as set forth herein. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the day and year first above written. UNIVERSAL HEALTH SERVICES, INC. By:__________________________________ Executive Vice President ______________________________________ Alan B. Miller EXHIBIT 10.7 January 12, 1994 Mr. Alan B. Miller President UHS of Delaware, Inc. 367 South Gulph Road King of Prussia, PA 19406 Dear Alan: The Board of Trustees of Universal Health Realty Income Trust at their December 1, 1993, meeting authorized the renewal of the current Advisory Agreement between the Trust and UHS of Delaware, Inc. ("Agreement") upon the same terms and conditions. This letter constitutes the Trust's offer to renew the Agreement until December 31, 1994, upon the same terms and conditions. Please acknowledge UHS of Delaware, Inc.'s acceptance of this offer by signing in the space provided below and returning one copy of this letter to me. Sincerely yours, Sidney Miller Secretary SM/jds cc: Warren J. Nimetz, Esquire Charles Boyle AGREED TO AND ACCEPTED: UHS of Delaware, Inc. By: ------------------------- Alan B. Miller, President - ------------------------------------------------------------------------------ SALE AND SERVICING AGREEMENT between the HOSPITAL and UHS RECEIVABLES CORP. - ------------------------------------------------------------------------------ Page ARTICLE I DEFINITIONS . . . . . . . . . . . . 1 1.1. Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 ARTICLE II PURCHASES AND SALES . . . . . . . . . . 2 2.1. Agreement to Purchase and to Sell . . . . . . . . . . . . . . . . 2 2.2. Purchase of Receivables . . . . . . . . . . . . . . . . . . . . . 2 2.3. Payment of Purchase Price . . . . . . . . . . . . . . . . . . . . 3 ARTICLE III CONDITIONS TO PURCHASE . . . . . . . . 3 3.1. Conditions to Initial Purchase . . . . . . . . . . . . . . . . . 3 3.2. Conditions to All Purchases . . . . . . . . . . . . . . . . . . 4 ARTICLE IV REPRESENTATIONS, WARRANTIES AND COVENANTS OF THE HOSPITAL. . . . . . . . 5 4.1. Representations, Warranties and Covenants of the Hospital . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 4.2. Representations and Warranties Concerning Receivables . . . . . . 9 4.3. Additional Covenants of the Hospital. . . . . . . . . . . . . . . 11 4.4. Removal of Non-qualifying Receivables . . . . . . . . . . . . . . 16 4.5. Representations and Warranties of Finco . . . . . . . . . . . . . 17 ARTICLE V ADMINISTRATION AND COLLECTIONS . . . . . . 18 5.1. Servicing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 5.2. Collections . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 5.3. Hospital's Obligations as Agent for the Servicer. . . . . . . . . 19 5.4. Claims Against Third Parties. . . . . . . . . . . . . . . . . . . 19 5.5. Hospital Concentration Account. . . . . . . . . . . . . . . . . . 20 ARTICLE VI TERMINATION OF PURCHASE COMMITMENT. . . . . 20 6.1. Exclusion Events. . . . . . . . . . . . . . . . . . . . . . . . . 20 6.2. Remedies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 ARTICLE VII INDEMNIFICATION AND EXPENSES . . . . . . . 25 7.1. Indemnities by the Hospital . . . . . . . . . . . . . . . . . . . 25 7.2. Audits of Hospital, Etc . . . . . . . . . . . . . . . . . . . . . 26 ARTICLE VIII MISCELLANEOUS. . . . . . . . . . . 27 8.1. Notices, Etc. . . . . . . . . . . . . . . . . . . . . . . . . . . 27 8.2. Successors and Assigns. . . . . . . . . . . . . . . . . . . . . . 28 8.3. Severability. . . . . . . . . . . . . . . . . . . . . . . . . . . 28 8.4. Amendments. . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 8.5. The Hospital's Obligations. . . . . . . . . . . . . . . . . . . . 28 8.6. No Recourse . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 8.7. Further Assurances. . . . . . . . . . . . . . . . . . . . . . . . 29 8.8. Survival. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 8.9. Consent to Assignment; Third Party Beneficiaries. . . . . . . . . 29 8.10. Counterparts. . . . . . . . . . . . . . . . . . . . . . . . . . . 31 8.11. Headings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 8.12. No Bankruptcy Petition Against Finco or Sheffield . . . . . . . . 31 8.13. Finco May Act Through Agents. . . . . . . . . . . . . . . . . . . 31 8.14. GOVERNING LAW . . . . . . . . . . . . . . . . . . . . . . . . . . 31 8.15. No Waiver; Cumulative Remedies. . . . . . . . . . . . . . . . . . 31 8.16. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS . . . . . . . . . . . . . . . . . . . 32 8.17. UCC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 8.18. Execution; Effectiveness. . . . . . . . . . . . . . . . . . . . . 33 Exhibits Exhibit A Form of Subordinated Note Exhibit B Form of Confidentiality Agreement Schedules Schedule I Hospital and UHS place of business; List of Insurers; UCCs Filed Schedule II Notifications as to Accreditation and Licensing Schedule III Fiscal Years Open to Audit Schedule IV Governmental Programs for Which the Hospital is a Qualified Provider Schedule V Hospital Concentration Account SALE AND SERVICING AGREEMENT SALE AND SERVICING AGREEMENT, dated as of November 16, 1993 (this "Agreement"), between each hospital company referred to in Section 8.18 (together with its successors and assigns, the "Hospital") and UHS Receivables Corp., a Delaware corporation (together with its successors and assigns, "Finco"). W I T N E S S E T H : WHEREAS, subject to the terms and conditions of this Agreement, Finco wishes to purchase from the Hospital, and the Hospital wishes to sell to Finco, all of the Hospital's Receivables (all capitalized terms used in the recitals without definition, as defined in the Definitions List referred to below) and all related Transferred Property arising during the term of this Agreement; WHEREAS, pursuant to the Pooling Agreement, Finco has agreed to transfer to the Trust, for the benefit of the Participants, and the Trust will acquire from Finco, the Purchased Receivables and other Total Transferred Property on the terms and conditions of the Pooling Agreement; WHEREAS, in order to provide for the collection of all amounts payable under the Receivables, the Interested Parties have required as a condition precedent to the effectiveness of the Operative Documents that the Hospital undertake the primary responsibility for the management and administration of and collection on the Receivables, as such responsibilities are defined and set forth in the Servicing Agreement, and the Hospital, pursuant to the terms and conditions of this Agreement, has agreed to undertake all such responsibilities in consideration for payments to it under this Agreement and other valuable consideration; and WHEREAS, pursuant to the Guarantee, UHS has guaranteed the obligations of the Hospital hereunder and of UHS Delaware under the Servicing Agreement; NOW THEREFORE, the parties hereto agree as follows: ARTICLE I DEFINITIONS Section 1.1. Definitions. As used in this Agreement (unless the context requires a different meaning), capitalized terms used herein shall have the meanings assigned to them in the Definitions List, dated as of November 16, 1993 (the "Definitions List"), that refers to this Agreement, which Definitions List is incorporated herein by reference and shall be deemed to be a part of this Agreement. ARTICLE II PURCHASES AND SALES Section 2.1. Agreement to Purchase and to Sell. Subject to the terms of this Agreement, the Hospital shall sell, assign, transfer and convey all the Receivables and the related Transferred Property generated by it to Finco until an Exclusion Event shall have occurred and, upon the representations, warranties, covenants and agreements of the Hospital hereinafter set forth, and subject to the terms and conditions of this Agreement, Finco shall purchase such Receivables from the Hospital pursuant to Section 2.2 and pay the Hospital for such Receivables pursuant to Section 2.3 from time to time until an Exclusion Event shall have occurred. Section 2.2. Purchase of Receivables. (a) In consideration of the agreements set forth herein, the Hospital hereby sells, assigns, transfers and otherwise conveys to Finco all of its right, title and interest in and to the Receivables and the related Transferred Property now existing and hereafter arising. All of the Hospital's right, title and interest in and to such Receivables and the related Transferred Property, whether now existing or hereafter created, shall be sold, assigned, transferred and conveyed to Finco without any further action by the Hospital. The parties hereto intend that this transfer and conveyance shall be considered a sale; provided, however, in the event that for any reason such transfer is determined by a court of competent jurisdiction not to be a sale, the parties hereby agree that this transfer and conveyance creates a security interest in favor of Finco securing repayment by the Hospital of a loan, in the amount of the aggregate Purchase Price, made by Finco to the Hospital, and the Hospital hereby grants to Finco a first priority security interest in all of the Hospital's right, title and interest in the Receivables and the related Transferred Property, whether now existing or hereafter created, as collateral security for the repayment of such loan and all other amounts owed under and in connection with this Agreement by the Hospital to Finco. (b) All Receivables of the Hospital and the related Transferred Property shall be purchased by Finco immediately upon creation of such Receivables and the related Transferred Property. Payment of the Purchase Price for such Purchased Receivables shall be made on the related Payment Date in accordance with Section 2.3. On the Initial Closing Date, the aggregate Outstanding Balance of Receivables of the Hospital for which the Payment Date is on or prior to the Initial Closing Date will be reported in a Servicer Daily Statement prepared by the Servicer and delivered on the Initial Closing Date in accordance with Section 3.1, and the aggregate Purchase Price for all such Purchased Receivables will be paid on the Initial Closing Date in accordance with Section 2.3. At the close of business on each Business Day after the Initial Closing Date the Servicer will determine, in accordance with the Servicing Agreement, the aggregate Outstanding Balance of the Purchased Receivables created by the Hospital for which the Payment Date is such Business Day, and Finco shall make payment of the aggregate Purchase Price for all such Purchased Receivables on such Payment Date in accordance with Section 2.3. Section 2.3. Payment of Purchase Price. (a) On the Initial Closing Date, Finco shall pay to the Hospital, in cash, as payment in full for the Purchased Receivables and the related Transferred Property for which the Payment Date is on or prior to the Initial Closing Date, an amount equal to the aggregate Purchase Price with respect to all such Purchased Receivables and Transferred Property. (b) On each Business Day after the Initial Closing Date, Finco directs the Trustee, pursuant to Section 7.2(e) of the Pooling Agreement and subject to the terms and conditions of this Agreement and the Pooling Agreement, to pay to the Hospital, on behalf of Finco and as payment in full for the Purchased Receivables and the related Transferred Property for which the Payment Date is such Business Day, an amount equal to the aggregate Purchase Price with respect to such Purchased Receivables and related Transferred Property (after deducting any amounts payable by the Hospital pursuant to Section 4.4 on such Business Day), such payment to be in cash in immediately available funds to the extent of amounts available in accordance with the terms of the Pooling Agreement; provided, however, that to the extent that sufficient cash is not available under Section 7.2(e) of the Pooling Agreement to pay such aggregate Purchase Price in full on such date, then Finco shall deliver a Subordinated Note, substantially in the form of Exhibit A attached hereto, in favor of such Hospital or, if such Subordinated Note has previously been delivered pursuant to this Section, the principal amount thereof shall be increased, in each case in an amount equal to the difference between the aggregate Purchase Price (net of all deductions pursuant to Section 4.4) and the amount of cash so delivered pursuant to this Section 2.3(b). The Hospital hereby agrees to all of the terms and conditions of the Subordinated Note and such terms and conditions are incorporated herein by reference. ARTICLE III CONDITIONS TO PURCHASE Section 3.1. Conditions to Initial Purchase. The initial purchase of Receivables is subject to the satisfaction by the Hospital of all conditions precedent to be satisfied by it pursuant to the Conditions List, which Conditions List is incorporated herein by reference, and of all conditions set forth in Section 3.2. Section 3.2. Conditions to All Purchases. The obligation of Finco to cause the Trustee to make payment of the Purchase Price on any Payment Date with respect to any purchase of Purchased Receivables hereunder from the Hospital is subject to the following conditions precedent: (a) On the Purchase Date and on such Payment Date the Hospital shall have complied with all of its covenants hereunder and shall have fulfilled all of its obligations hereunder; (b) The representations and warranties of the Hospital set forth in Article IV shall be true and correct in all material respects on and as of the applicable Purchase Date after giving effect to any such payment; (c) The Hospital shall be in full compliance with all the terms and conditions of Article V, including, without limitation, those terms and conditions governing the Hospital Concentration Account; (d) All legal matters incident to the execution and delivery by the Hospital of this Agreement and to the purchases by Finco of the Purchased Receivables from the Hospital shall be satisfactory to counsel for Finco; and (e) No Exclusion Event, and no event which, after notice or lapse of time or both, would become an Exclusion Event, shall have occurred and then be continuing. The acceptance by the Hospital of any payment or Subordinated Note for any Purchased Receivables shall be deemed to be a representation and warranty by the Hospital as of such acceptance date as to the matters in paragraphs (a), (b), (c) and (e) of this Section 3.2; provided that if, prior to the Payment Date, Finco shall have been notified of the occurrence of an Exclusion Event and shall have elected to exercise the remedy provided in Section 6.2(a)(i) or (ii) with respect to such Exclusion Event, then the acceptance by the Hospital of any Subordinated Note for any Purchased Receivable shall not be deemed to be a representation and warranty as to the matters in paragraph (e) of this Section 3.2. If, on any Payment Date, any of the conditions precedent set forth in this Section 3.2 with respect to the related purchase of Receivables from the Hospital are not satisfied, Finco shall have the option to (A) make payment for such Purchased Receivables pursuant to the terms hereof and retain its interest therein or (B) reassign to the Hospital without recourse, representation or warranty its interest in such Receivables and the related Transferred Property and not make any payment therefor. ARTICLE IV REPRESENTATIONS, WARRANTIES AND COVENANTS OF THE HOSPITAL Section 4.1. Representations, Warranties and Covenants of the Hospital. The Hospital represents and warrants to and covenants with Finco as of the date hereof, and as of each future Purchase Date and each related Payment Date, that: (a) The Hospital has been duly organized and is validly existing and in good standing as a corporation or limited partnership under the laws of the state of its organization, with full power and authority to own or lease its properties and to conduct its business as presently conducted and to execute, deliver and perform this Agreement and the other Hospital Documents and any other documents related hereto and thereto to which it is a party and to consummate the transactions contemplated hereby and thereby. The Hospital is duly qualified as a foreign corporation or limited partnership and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, have a material adverse effect on its business, operations, properties, assets or financial condition. (b) The execution, delivery and performance by the Hospital of this Agreement and the other Hospital Documents to which it is a party and the consummation of the transactions contemplated hereby and thereby have been duly and validly authorized by all requisite action and will not (with due notice or lapse of time or both) conflict with or result in a breach of any of the terms or provisions of, or constitute a default under, or result in the creation or imposition of any Lien upon any of its property or assets pursuant to the terms of any indenture, mortgage, deed of trust, lease, loan agreement or other agreement, instrument or undertaking by which it is bound or to which any of its property or assets is subject, nor will such action result in any violation or violations of any applicable Requirement of Law, including, without limitation, any rule or regulation of JCAHO or AOA, as the case may be, or otherwise relating to the eligibility of the Hospital to receive payment and to participate as an accredited and certified provider of healthcare services under Medicare, Medicaid, Champus, Blue Cross/Blue Shield, Worker's Compensation or equivalent programs, which violation or violations would, alone or in the aggregate, have a material adverse effect on the Hospital's ability to perform under the terms of this Agreement or the other Hospital Documents to which it is a party or on the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables purchased on the date on which this representation is made or deemed made or the value of the related Transferred Property; and no consent, approval, authorization, order, registration, filing, qualification, license or permit of or with any Governmental Authority or body or any other Person is required to be obtained by or with respect to the Hospital in connection with the execution, delivery and performance by the Hospital of this Agreement, the other Hospital Documents (other than the actions required to file or record any Security Filings, all of which actions, subject to Section 5.3 of the Pooling Agreement, have been taken) or the consummation of the transactions contemplated hereby or thereby. (c) Each of the Hospital Documents to which the Hospital is a party has been duly and validly authorized, executed and delivered by the Hospital and constitutes a valid and legally binding obligation of the Hospital, enforceable against the Hospital in accordance with its terms, subject as to enforceability to applicable bankruptcy, reorganization, insolvency, moratorium or other similar laws affecting creditors' rights generally, and to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). (d) There is (i) no effective financing statement (or similar statement or instrument of registration under the law of any jurisdiction) on file or registered in any public office and (ii) no assignment filed or delivered by or on behalf of the Hospital covering any interest of any kind in the Transferred Property or intended so to be filed, delivered or registered, and the Hospital will not execute nor will there be on file in any public office any effective financing statement (or similar statement or instrument of registration under the laws of any jurisdiction) or any assignment or other notification relating to the Transferred Property, except (i) the Security Filings relating to the Permitted Interests and (ii) any such financing statements or notifications as to which the Hospital has submitted to Finco evidence satisfactory to Finco of the termination of the ownership or security interest intended to be perfected by the filing, delivery or registration thereof. The interest of Finco in the Transferred Property purchased on the date on which this representation is made or deemed made is an ownership interest, valid and enforceable against, and prior to, all claims of existing and future creditors of the Hospital and all subsequent purchasers from the Hospital of the Purchased Receivables. (e) All Security Filings which are required to perfect the interests of Finco in the Purchased Receivables purchased on the date on which this representation is made or deemed made and the related Transferred Property have been filed, delivered or received, as the case may be (other than as limited by Section 5.3 of the Pooling Agreement) and are in full force and effect, and the Hospital shall, at its expense, perform all acts and execute all documents reasonably requested by Finco at any time to evidence, perfect, maintain and enforce the first priority ownership, and, in the alternative, security interests of Finco in the Transferred Property. Schedule I attached hereto lists (i) all offices where UCC filings must be made to perfect the Permitted Interests of Finco in the Purchased Receivables purchased on the date on which this representation is made or deemed made and the related Transferred Property and (ii) the insurers or other third-party payors which are Obligors maintaining the ten highest average Outstanding Balances of Receivables, calculated, as of August 31, 1993, on an aggregate basis for all Hospitals that are parties to any Sale and Servicing Agreement. The Hospital will, on the reasonable request of an Authorized Officer of Finco, execute and deliver all such Security Filings (satisfactory in form and substance to Finco) requested by Finco and, where permitted by law, the Hospital authorizes Finco to file one or more such Security Filings signed only by Finco. The Hospital hereby irrevocably appoints Finco its attorney-in-fact to file and deliver, and to receive Confirmations in respect of, one or more such Security Filings signed on behalf of the Hospital by Finco as the attorney-in-fact of the Hospital. (f) There are no actions, proceedings or investigations pending or, to the knowledge of the Hospital, threatened, before any court, administrative agency or other tribunal (i) which, if determined adversely to the Hospital, could, alone or in the aggregate, have a material adverse effect on the business, operations, properties, assets, condition (financial or otherwise) or prospects of the Hospital, (ii) asserting the invalidity of this Agreement or any of the other Hospital Documents, (iii) questioning the consummation by the Hospital of any of the transactions contemplated by this Agreement or the other Hospital Documents or (iv) which, if determined adversely, could, alone or in the aggregate, materially and adversely affect the ability of the Hospital to perform its obligations under, or the validity or enforceability of, this Agreement, the other Hospital Documents or the Purchased Receivables purchased on the date on which this representation is made or deemed made. (g) The place of business of the Hospital is located at the address set forth on Schedule I hereto, which place of business is the place where the Hospital is "located" for the purposes of Section 9-103(3)(d) of the UCC of the state indicated in such Schedule, and the locations of the offices where the Hospital keeps all of the Transferred Property are at the addresses set forth on Schedule I hereto. (h) The Hospital has, and will have on each Purchase Date, all permits, licenses, agreements with third-party payors, accreditations and certifications (including, without limitation, any required accreditations by JCAHO and AOA and any required accreditations and certifications as a provider of healthcare services eligible to receive payment and compensation and to participate under Medicare, Medicaid, Champus, Blue Cross/Blue Shield, Worker's Compensation and similar applicable programs) necessary to own its assets and to carry on its business as now conducted, except where failure to have such permits, licenses, agreements with third-party payors, accreditation and certifications would not, alone or in the aggregate, have a material adverse effect on (i) the business, operations, property or condition (financial or otherwise) of the UHS Entities taken as a whole, (ii) the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables purchased on the date on which this representation is made or deemed made or the value of the related Transferred Property or (iii) the ability of the Hospital to perform its servicing obligations hereunder. Except as set forth on Schedule II hereto, during the last twenty-four months, the Hospital has not been notified by JCAHO, AOA or any relevant Governmental Authority (including, without limitation, any state licensing authority) with respect to a license to operate an acute care or psychiatric facility, as the case may be, of such Person's intention to rescind or not renew any of its respective accreditations or licenses. (i) No material Reportable Event has occurred during the five-year period prior to the date on which this representation is made or deemed made with respect to any Plan, and each Plan has complied in all material respects with the applicable provisions of ERISA and the Code. The present value of all accrued benefits under each Single Employer Plan maintained by the Hospital or any Commonly Controlled Entity (based on those assumptions used to fund such Plans) did not, as of the last annual valuation date prior to the date on which this representation is made or deemed made, materially exceed the value of the assets of such Plan allocable to such accrued benefits. Neither the Hospital nor any Commonly Controlled Entity has had a complete or partial withdrawal from any Multiemployer Plan which has resulted or could result in any material liability under ERISA, and neither the Hospital nor any Commonly Controlled Entity would become subject to any material liability under ERISA if the Hospital or any such Commonly Controlled Entity were to withdraw completely from all Multiemployer Plans as of the valuation date most closely preceding the date on which this representation is made or deemed made. No such Multiemployer Plan is in reorganization or insolvent. The present value (determined using actuarial and other assumptions which are reasonable in respect of the benefits provided and the employees participating) of the liability of the Hospital and each Commonly Controlled Entity for post-retirement benefits to be provided to their current and former employees under Plans which are welfare benefit plans (as defined in Section 3(1) of ERISA) does not, in the aggregate, materially exceed the assets under all such Plans allocable to such benefits. (j) The Hospital has no Subsidiaries. (k) The Hospital has filed or caused to be filed all material federal, state and local tax returns which are required to be filed, and has paid or caused to be paid all taxes as shown on said returns and any other taxes or assessments payable by it (other than any such taxes or assessments the amount or validity of which are currently being contested in good faith by appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of the Hospital and with respect to which collection has been stayed), and no tax Lien has been filed and, to the knowledge of the Hospital, no claims are being asserted with respect to any such taxes, fees or other charges which, alone or in the aggregate, could reasonably be expected to have a material adverse effect on the rights of Finco or its direct or indirect assignees under the Operative Documents or with respect to the Transferred Property. Except with respect to the fiscal years of the Hospital listed on Schedule III, as of the Initial Closing Date, the federal tax returns previously filed by or on behalf of the Hospital are not subject to future challenge or audit by the Internal Revenue Service. Section 4.2. Representations and Warranties Concerning Receivables. (i) On the date hereof and (ii) with respect to Sections 4.2(a), 4.2(j) and 4.2(l) on each following date and (iii) with respect to Sections 4.2(b) through (i) and 4.2(k), with respect to Purchased Receivables on each related Purchase Date, the Hospital represents and warrants to Finco as follows: (a) The Hospital has, immediately prior to its conveyance of the Purchased Receivables pursuant to Section 2.2, good title to the Purchased Receivables and the related Transferred Property, and the Outstanding Balances are free and clear of any Lien or other claim of any kind or any offset, counterclaim or defense of any kind, other than contractual adjustments in respect of, and in no event greater than, the Applicable Contractual Adjustment and any offsets included in the Offset Reserves. At all times during which this Agreement is in effect, the Transferred Property and the Outstanding Balances in relation thereto will not be subject to any Lien or claim of any kind or to any counterclaim or defense of any other kind other than the Permitted Interests and the offsets included in the Offset Reserves. (b) Each of the Purchased Receivables and the related Transferred Property complies with and will comply with all Requirements of Law (including, in the case of Governmental Receivables, all applicable requirements of the programs listed on Schedule IV) and is not the subject of any litigation, court proceeding or other dispute. (c) Each of the Purchased Receivables (i) is and will be in full force and effect and represents and will represent a valid and legally binding obligation of the related Obligor, enforceable against such Obligor in accordance with its terms and (ii) constitutes an "account" or "general intangible" under the UCC in effect in the state in which the Hospital's place of business is located, or a right to payment under a policy of insurance or proceeds thereof. (d) (i) The statements and information constituting Receivables Information provided by the Hospital are true and correct and do not contain any untrue statement of a material fact or omit any material fact which would make such statements and information, in light of the circumstances in which they were made or given, misleading and (ii) the other statements and information furnished by any Authorized Officer of the Hospital to Finco are true and correct and do not contain any untrue statement of a material fact or omit any material fact which would make such other statement or information, in light of the circumstances in which they were made or given, misleading. (e) This Agreement, together with the Security Filings, vests and at all times will vest in Finco the ownership interest in, or, in the event such interest is recharacterized by a court of competent jurisdiction as a security interest, the security interest in and Lien on, the Transferred Property purported to be conveyed hereby and thereby and in accordance with the terms hereof and thereof, and such conveyance of the Transferred Property constitutes and will constitute a valid sale of, or, if recharacterized as described above, a security interest in, and Lien on, such Transferred Property and the Collections in respect thereof, enforceable against the Hospital and all creditors of and purchasers from the Hospital prior to all sales or other assignments thereof. (f) No Obligor on the Purchased Receivables and other Transferred Property (including, without limitation, any insurance company or other third- party payor or guarantor of such Obligor obligated in respect of any such Purchased Receivables) is bankrupt, insolvent, undergoing composition or adjustment of debts or is unable to make payment of its obligations when due; provided that this representation shall not apply to any Governmental Authority which is an Obligor on Medicaid Receivables and which is currently insolvent but the Receivables of which would not be considered Uncollectible Receivables under clause (c) of the definition of Uncollectible Receivables (taking into account the proviso contained in such definition). (g) The Hospital is a qualified provider in respect of the Purchased Receivables of the Hospital constituting Governmental Receivables. (h) All amounts paid on each Governmental Receivable being purchased on any Purchase Date will be paid to the Hospital in accordance with all Requirements of Law either (i) in the Hospital's name to the Hospital Concentration Account in accordance with Section 4.3(m) or (ii) in the name of UHS, for the benefit of the Hospital, to the Master Receivables Account. (i) Each Non-governmental Receivable of the Hospital being purchased by Finco hereunder is not and will not be payable by an Obligor which is an agency or instrumentality of the federal government of the United States of America unless all applicable requirements of the Assignment of Claims Act of 1940, as amended, including the giving of all requisite notices of assignment to all Persons to whom such notices must be given and the acknowledgement of receipt thereof by all such Persons, have been complied with in all material respects and unless Finco shall have been provided with evidence thereof in form and substance satisfactory to it. (j) All accounting information relating to the Receivables of the Hospital which is provided to Finco hereunder shall be in accordance with the Hospital's accounting policies, including the Hospital's Credit and Collection Policy. (k) Each of the Purchased Receivables, other than any Excluded Receivable and any Self-pay Receivable, is and will be an Eligible Receivable on the Purchase Date for such Purchased Receivable. (l) Each of the Purchased Receivables originated by the Hospital shall at all times be separately identifiable from the Receivables, if any, repurchased by Finco in accordance with Section 4.4, and the Financible Receivables shall at all times be separately identifiable from those Purchased Receivables that are not Financible. Section 4.3. Additional Covenants of the Hospital. The Hospital covenants and agrees with Finco that so long as this Agreement shall remain in effect: (a) The Hospital will preserve and maintain its existence as a corporation or limited partnership, as the case may be, in good standing under the laws of the state of its incorporation or organization and its qualification as a foreign corporation or limited partnership where such qualification is required, except where any such failure or failures to so qualify would not, alone or in the aggregate, be material to the Hospital's performance of its obligations under the Hospital Documents. (b) The Hospital, as agent for the Servicer, will, at its own cost and expense, (i) retain a record of the Receivables generated by the Hospital and copies of all documents relating to each Receivable generated by the Hospital, (ii) mark such record to the effect that the Purchased Receivables generated by the Hospital listed thereon have been sold to Finco and (iii) take any actions necessary to remove reference thereto to Receivables that have been repurchased by it in accordance with the terms of this Agreement. (c) In any suit, proceeding or action brought by Finco for any sum owing with respect to any Receivable, the Hospital will save, indemnify and keep Finco harmless from and against all expense, loss or damage suffered by reason of any defense, set-off, counterclaim, recoupment or reduction of liability whatsoever under such Receivable and the related Transferred Property, in each case arising out of a breach by the Hospital of any obligation under such Receivable or the related Transferred Property or arising out of any other agreement, indebtedness or liability at any time owing to or in favor of any other Person from the Hospital, and all such obligations of the Hospital shall be and remain enforceable against and only against the Hospital and shall not be enforceable against Finco. (d) The Hospital will comply with all Requirements of Law which are applicable to the Purchased Receivables or any part thereof; provided, however, that the Hospital may contest any act, regulation, order, decree or direction in any manner which, in the reasonable opinion of Finco, shall not materially and adversely affect the rights of Finco in the Transferred Property. The Hospital will comply with the terms of its contracts with Obligors relating to Purchased Receivables except where any such non-compliance would not, alone or in the aggregate, reasonably be expected to have a material adverse effect on its ability to receive payments under any such contract. (e) The Hospital will not create, permit or suffer to exist, and will defend Finco's rights against, and take such other actions as are necessary to remove, any Lien on, claim in respect of or right to, the Transferred Property, and will defend the right, title and interest of Finco in and to the Transferred Property against the claims and demands of all Persons whomsoever, other than the Permitted Interests and will not otherwise enter into any agreement or execute any document or instrument or take any other action inconsistent with Finco's ownership of the Receivables and Transferred Property. (f) The Hospital will advise Finco promptly and in reasonable detail of (i) any Lien asserted or offset or claim made against any of the Transferred Property, (ii) the occurrence of any breach by the Hospital of any of its representations, warranties and covenants contained herein, (iii) the occurrence of any Exclusion Event or any other event which, with the giving of notice or lapse of time or both, would become an Exclusion Event and (iv) the occurrence of any event of which the Hospital has knowledge which would reasonably be expected to have a material adverse effect on (A) the business, operations, property or condition (financial or otherwise) of the UHS Entities taken as a whole, (B) the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables or the value of the Transferred Property or (C) the ability of the Hospital to perform its servicing obligations hereunder, (iv) the receipt from any Governmental Authority of a deficiency notice with respect to the Purchased Receivables, (v) the receipt by the Hospital from any Governmental Authority of a Deficiency Notice with respect to the Receivables originated by the Hospital, (vi) the receipt by the Hospital of any notice of preliminary or final determination resulting from any Audit relating to the Hospital or its Receivables. (g) Unless prohibited by any Requirement of Law including, without limitation, any applicable regulations of JCAHO and AOA, Finco and its employees, agents and representatives (A) shall at all times have full and free access during normal business hours to all the books, correspondence and records of the Hospital insofar as they relate to the Transferred Property and may examine the same, take extracts therefrom and make photocopies thereof, and the Hospital agrees to render to Finco (and its employees, agents and representatives), at the Hospital's cost and expense, such clerical and other assistance as may be reasonably requested with regard thereto and (B) may discuss the affairs, finances and accounts of the Hospital with, and be advised as to the same by, executive officers and independent accountants of the Hospital, all as Finco may reasonably deem appropriate for the purpose of verifying the accuracy of any reports or information delivered to Finco pursuant to this Agreement or for otherwise ascertaining compliance with this Agreement; provided, however, that Finco acknowledges that in exercising the rights and privileges conferred in this Section 4.3(g) Finco may, from time to time, obtain knowledge of information, practices, books, correspondence and records of a confidential nature and in which the Hospital has a proprietary interest; and provided, further, that the Hospital and Finco acknowledge that the Operative Documents and documents required to be filed by or on behalf of UHS and its Subsidiaries with the Securities and Exchange Commission and available to the public shall not be considered confidential for purposes of this Agreement (such confidential information, collectively, the "Information"). Finco agrees that the Information is to be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality and agrees that subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose without the prior written consent of the Hospital any or all of the Information and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by this Agreement, the Pooling Agreement, the other Operative Documents or for the enforcement of any of the rights granted hereunder or thereunder) of any of the Information without the prior written consent of the Hospital. Notwithstanding the foregoing, Finco may (x) disclose Information to any Person that has executed and delivered to the addressee thereof and UHS a confidentiality agreement, substantially in the form of Exhibit B with respect to the Information, or (y) disclose or use such Information (A) to the extent that such Information is required or appropriate in any reports, statement or testimony submitted to any municipal, state, or federal regulatory body having or claiming to have jurisdiction over Finco or the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed by Finco to be required in order to comply with any law, order, regulation or ruling applicable to Finco, (D) to the extent that such information was publicly available or otherwise known to Finco at the time of disclosure (E) to the extent that such information subsequently becomes publicly available other than through any act or omission of Finco or (F) to the extent that such information subsequently becomes known to Finco other than through a person known to be acting in violation of his or its obligations to the Hospital. (h) The Hospital shall execute and file, at the Hospital's expense, such continuation statements and other documents relating to the Security Filings requested by Finco which may be required by law to fully preserve and protect the interest of Finco hereunder in and to the Transferred Property. (i) The Hospital will not, without providing 30 days' notice to Finco, and without filing such amendments to the Security Filings as Finco may require, (i) change the location of its place of business or the location of the offices where the records relating to the Receivables or the other Transferred Property are kept or (ii) change its name, identity or corporate structure in any manner which would, could or might make any Security Filing or continuation statement filed by the Hospital in accordance with Section 4.1(e) or Section 4.3(h) seriously misleading within the meaning of Section 9-402(7) of any applicable enactment of the UCC. (j) The Hospital shall (i) promptly instruct the Servicer to (A) notify Finco of any insurance provider or other third-party payor which becomes an Obligor after the Initial Closing Date pursuant to a written contract or arrangement which purports to prohibit the assignment of any rights of the Hospital under such contract or arrangement without the consent of such Obligor and (B) deliver or cause to be delivered to such Obligor a Notice of Assignment and receive a Confirmation in respect thereof as may be required by Finco or its counsel and (ii) comply with all other reasonable requests of Finco with respect to the Security Filings. (k) The Hospital shall not change the terms of the payor contracts and agreements relating to the Purchased Receivables and related Transferred Property or its normal policies and procedures with respect to the servicing thereof (including, without limitation, the amount and timing of finance charges, fees and write-offs) except such changes as are permitted under Section 3.1(e) of the Servicing Agreement. (l) The Hospital hereby acknowledges that UHS Delaware will initially be appointed as Servicer for Finco pursuant to the Servicing Agreement and that, pursuant to the Guarantee, UHS will guarantee the performance by UHS Delaware of all of its obligations as Servicer. (m) The Hospital hereby represents and covenants that it has (i) designated personnel and (ii) directed such personnel to deposit all Collections and proceeds thereof in respect of Purchased Receivables on each Business Day upon which Collections are received (or, if such Collections are received by the Hospital on a day which is not a Business Day, on the next Business Day) into the Hospital Concentration Account in accordance with Section 5.2. (n) Subject to Section 4.3(k), the Hospital will duly fulfill all obligations on its part to be fulfilled under or in connection with each Purchased Receivable and will do nothing to impair the rights of Finco in the Transferred Property. (o) Except for the purpose of collection in the ordinary course of business, the Hospital will not sell, discount or otherwise dispose of any Receivable of such Hospital except to Finco as provided hereunder. (p) All financial statements prepared by Finco or any Hospital and made available to any Person other than any UHS Entity shall indicate the sale to Finco of the Purchased Receivables and other Transferred Property. (q) The Hospital shall not terminate the Hospital Concentration Account or modify the conditions upon which such account was established, or establish any other Hospital Concentration Account unless (i) the Hospital has given Finco 10 days' prior written notice of such change and (ii) the Hospital, after such change, remains in full compliance with the terms of Article V. (r) The Hospital shall promptly instruct the Servicer to notify Finco on any date on which the Hospital becomes, applies to become or no longer remains a qualified provider in respect of Governmental Receivables. (s) The Hospital shall have filed, and shall have caused each of its Subsidiaries to file, all federal, state and local tax returns which are required to be filed, and shall have paid or caused to be paid all taxes as shown on said returns or any other taxes or assessments payable by it (other than any taxes or assessments the amount or validity of which are currently being contested in good faith by appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of the Hospital or such Subsidiary and with respect to which collection has been stayed); and no tax Lien has been filed and, to the knowledge of the Hospital, no claims are being asserted with respect to any such taxes or assessments which could, alone or in the aggregate, reasonably be expected to have a material adverse effect on the rights of Finco hereunder or with respect to the Transferred Property. (t) The Hospital shall cause each contract entered into after the Initial Closing Date with any third-party payor in respect of Non-governmental Receivables to permit the assignment of payments thereunder pursuant to the terms of this Agreement and the other Operative Documents. The Hospital shall also cause each invoice delivered after the Initial Closing Date to each insurance carrier (including, without limitation, each invoice to be transmitted to the Obligor thereunder solely through electronic means) to include a notice that the amounts payable under such invoice have been assigned to Finco and its assignees, including the Trustee, and that future amounts payable by such insurance carrier will be so assigned. (u) The Hospital will take no action to cause any Purchased Receivable to be evidenced by any instrument (as defined in the UCC of the state in which the Hospital is located), except in connection with its enforcement or collection of such Receivable, in which event the Hospital shall deliver such instrument to Finco as soon as reasonably practicable but in no event more than five days after execution thereof. (v) The Hospital will not hold itself out, or permit itself to be held out by any other Person, as having agreed to pay, or as being liable for, any debt or liability of Finco. Section 4.4. Removal of Non-qualifying Receivables; Purchase Price Adjustments. (a) Subject to Section 4.4(b), the Hospital will notify each of the Servicer and Finco of the aggregate Outstanding Balances of those Receivables, if any, which were Non-qualifying Receivables as of the Purchase Date for such Receivables. All Non-qualifying Receivables generated by the Hospital and sold to Finco shall be repurchased by it on any Business Day (a "Repurchase Date") on which Finco shall so request. On the Repurchase Date, the Hospital shall make available to Finco by deposit in the Collateral Account in immediately available funds, or by deduction from the Purchase Price payable by Finco on such date, an amount equal to the acquisition price of each such Non-qualifying Receivable previously sold to Finco. Such acquisition price shall be equal to the Hospital Repurchase Price of such Non- qualifying Receivable as determined by the Servicer. Such payment or deduction of the Hospital Repurchase Price shall be considered a payment in full of each such Non-qualifying Receivable. On the date on which such amount is deposited in the Collateral Account or on which such deduction is made, Finco shall automatically and without further action be deemed to transfer, assign, set-over and otherwise convey to the Hospital, without recourse, representation or warranty, all the right, title and interest of Finco in and to such Non-qualifying Receivables, all monies due or to become due with respect thereto, and all proceeds thereof. Finco shall execute such documents and instruments of transfer or assignment and take such other actions as shall reasonably be requested by the Hospital to effect the conveyance of such Non- qualifying Receivables repurchased pursuant to this Section 4.4. (b) Notwithstanding anything to the contrary in this Section 4.4, the Hospital's obligation in respect of Receivables which are Non-qualifying Receivables solely because the Applicable Contractual Adjustment on the related Purchase Date was less than the Actual Contractual Adjustment shall be to make available to Finco, by deposit in the Collateral Account in immediately available funds, or by deduction from the Purchase Price payable on such date, an amount equal to the difference between the Applicable Contractual Adjustment as calculated on the Purchase Date and the Actual Contractual Adjustment, and such Receivable shall not be repurchased by or transferred to the Hospital from Finco. The deposit or deduction referred to in the immediately preceding sentence shall be made by the Hospital (i) in the case of any Receivable designated as a Financible Receivable on the Payment Date therefor, on any Business Day that Finco shall request and (ii) in the case of any Purchased Receivable that was not designated as a Financible Receivable on the Payment Date therefor, on the Settlement Date next succeeding the Purchase Date for such Receivable. Section 4.5. Representations and Warranties of Finco. Finco represents and warrants to the Hospital that, as of the Initial Closing Date and as of each Purchase Date and each related Payment Date: (a) Finco has been duly organized and is validly existing and in good standing as a corporation under the laws of the State of Delaware, with full corporate power and authority to own its properties and to transact the business in which it is now engaged or in which it proposes to engage. (b) The purchase by Finco of the Purchased Receivables pursuant to this Agreement and the consummation of the transactions herein contemplated will not conflict with, or result in a breach of any of the terms or provisions of, or constitute a default under, any indenture, mortgage, deed of trust, lease, loan agreement or other agreement, instrument or undertaking to which Finco is a party or by which it is bound or to which any of the property or assets of Finco is subject, nor will such action result in any violation of any applicable Requirement of Law; and no consent, approval, authorization, order, registration or qualification of or with any Governmental Authority is required for the purchase by Finco of the Purchased Receivables hereunder except such as have been obtained. (c) This Agreement has been duly authorized, executed and delivered by Finco and constitutes the valid and legally binding obligation of Finco, enforceable against Finco in accordance with its terms, subject as to enforceability to applicable bankruptcy, reorganization, insolvency, moratorium or other similar laws affecting creditors' rights generally, and to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). ARTICLE V ADMINISTRATION AND COLLECTIONS Section 5.1. Servicing. (a) In further consideration for Finco entering into this Agreement with the Hospital, the Hospital agrees that it shall undertake such obligations in connection with the servicing of the Receivables as shall be delegated to it by the Servicer. In this connection, the Hospital covenants and agrees that it will comply with all the agreements made by the Servicer, and shall perform all the obligations undertaken by the Servicer in Article III of the Servicing Agreement with respect to the Purchased Receivables of such Hospital as if such agreements were set forth herein as covenants of the Hospital and as if such obligations were directly undertaken by the Hospital. (b) In furtherance of Section 5.1(a), the Hospital agrees that it will, in a timely manner, provide the Servicer with all information regarding itself and its Receivables and other Transferred Property necessary for the Servicer or that the Servicer has requested. (c) The obligation of the Hospital to service the Receivables of the Hospital is personal to the Hospital and the parties recognize that it would be difficult for any other Person to perform such obligations. Accordingly, the Hospital's obligation to service the Receivables of the Hospital hereunder shall, to the extent permitted by applicable law, be specifically enforceable and shall be absolute and unconditional in all circumstances, including, without limitation, after the occurrence and during the continuation of any Exclusion Event. (d) The Hospital shall not resign from the obligations and duties hereby imposed on it as servicer of the Receivables of the Hospital. Section 5.2. Collections. (a) All Collections on account of Non- governmental Receivables sold to Finco shall be deposited directly into the Hospital Concentration Account or the Master Receivables Account on the date of receipt thereof by the Hospital or the Servicer. The Hospital agrees to require all Obligors in respect of Non-Governmental Receivables who make payment in the form of electronic or wire transfers to make such payments directly to the Master Receivables Account. All such Collections on account of Non-governmental Receivables will be held in trust by the Hospital for the benefit of Finco pending remittance to the Collateral Account. All Collections on Non-governmental Receivables received by Finco or any of its direct or indirect assignees shall be transferred by Finco or such assignee to the Trustee for deposit in the Collateral Account. (b) All Collections received by the Hospital or the Servicer on account of Governmental Receivables sold to Finco shall be deposited directly into the Hospital Concentration Account on the date of receipt thereof. The Hospital agrees to require all Obligors in respect of Governmental Receivables who make payment in the form of electronic or wire transfers to UHS, for the benefit of the Hospital, to make such payments directly to the Master Receivables Account. Except as provided in the preceding sentence, all Collections on Governmental Receivables received by Finco or any of its direct or indirect assignees shall be transferred to the Hospital payee for deposit into the Hospital Concentration Account or the Master Receivables Account. (c) In no event shall the Hospital deposit any Collections into any account established, held or maintained by the Hospital or any other Person other than the Hospital Concentration Account or the Master Receivables Account or transfer such Collections other than in accordance with the provisions of this Agreement. The Hospital and Finco hereby agree that all available funds received in the Hospital Concentration Account shall be transferred within one Business Day of receipt to the Master Receivables Account. Amounts so transferred from the Hospital Concentration Account or otherwise received in the Master Receivables Account prior to the close of business on any Business Day shall be transferred at the close of business on such Business Day to the Collateral Account. Amounts received in the Master Receivables Account after the close of business on any Business Day or on any day which is not a Business Day shall be transferred to the Collateral Account on the next succeeding day. Amounts transferred to the Collateral Account shall be applied in accordance with Article VII of the Pooling Agreement. Section 5.3. Hospital's Obligations as Agent for the Servicer. The Hospital and Finco expressly agree that the obligations of the Hospital under Sections 5.1 and 5.2 hereof have been undertaken by the Hospital, to the extent permitted by all Requirements of Law, solely as agent for Finco and the Servicer and the Hospital hereby disavows any other interest in such Collections or in any such funds collected on behalf of Finco or the Servicer or transferred by the Hospital for deposit pursuant to this Article V. Section 5.4. Claims Against Third Parties. The Hospital agrees that it will continue to make and pursue claims on the Purchased Receivables to the extent that any Requirement of Law or contractual provision requires the Hospital to directly make and pursue such claims; provided that the Hospital agrees that it is making and pursuing such claims for the benefit of Finco, and that any funds received by the Hospital based on such claims will be transferred in accordance with Section 5.2. Section 5.5. Hospital Concentration Account. (a) The Hospital has, prior to the execution and delivery of this Agreement, established a deposit account with the Hospital's banking institution in the sole name of the Hospital and for the benefit of the Hospital (such account, the "Hospital Concentration Account") into which all Collections are to be deposited by the Hospital by the close of business on each Business Day received, or on the next Business Day if not received on a Business Day. The name, location and account number of the Hospital Concentration Account is set forth on Schedule V to this Agreement. The Hospital Concentration Account shall be maintained with documentation and instructions in form and substance satisfactory to Finco. Available amounts received in the Hospital Concentration Account in respect of Collections shall be transferred within one Business Day to the Collateral Account. The Hospital shall not (i) without 10 days' prior written notice to Finco, change the Hospital Concentration Account or establish any additional Hospital Concentration Account or (ii) change such instructions or documentation at any time so long as Finco or any of its direct or indirect assignees has any interest in the Hospital's Receivables. (b) The Hospital agrees that it shall use its best efforts to ensure that only Collections on Purchased Receivables are deposited into the Hospital Concentration Account and the Master Receivables Account. Finco agrees that, promptly following the establishment to the satisfaction of the Hospital that any funds received in the Hospital Concentration Account or the Master Receivables Account do not constitute Collections on Purchased Receivables, including any payments on Receivables which have been reassigned to the Hospital and any payments to the Hospital not in respect of Receivables, Finco shall remit such funds to the Hospital in immediately available funds. In the event that the Hospital is unable to determine whether funds received by the Hospital or the Servicer constitute Collections on Purchased Receivables, such funds shall be deposited in the Hospital Concentration Account and applied in accordance with Section 5.2. ARTICLE VI TERMINATION OF PURCHASE COMMITMENT Section 6.1. Exclusion Events. If any of the following events occur (any such event, an "Exclusion Event"), Finco may give notice thereof pursuant to Section 6.2, and Finco may exercise the remedies available to it pursuant to Section 6.2: (a) the Hospital shall fail to make any payment to be made by it to any party to any of the Operative Documents when due; or the Hospital shall fail to perform or observe any term, covenant or agreement contained in Sections 4.3(e) through 4.3(i), Section 4.3(k), Sections 4.3(o) through 4.3(r) or Section 7.2 of this Agreement; (b) the Hospital shall default in the performance of any agreement or undertaking hereunder (other than as provided in clause (a) above) and such default shall continue for 30 days after written notice thereof has been given to the Hospital by Finco; or (c) any representation or warranty made by the Hospital in any Hospital Document to which it is a party or in any certificate or financial or other statement furnished pursuant to the terms of any Operative Document (other than as provided in clauses (a) or (b) above) shall prove to have been untrue or incomplete in any material respect when made or deemed made and the Hospital shall fail to cure such breach of representation, warranty or other statement within 15 days after written notice thereof has been given to the Hospital by Finco; provided, however, that no breach of any representation or warranty made by the Hospital under Section 4.2 as to any Receivable on the related Purchase Date shall constitute an "Exclusion Event" hereunder if the Hospital cures such breach in accordance with the terms of Section 4.4 of this Agreement; or (d) (i) the Hospital shall (A) apply for or consent to the appointment of a receiver, trustee, liquidator or custodian or the like of itself or of its property, (B) admit in writing its inability to pay its debts generally as they become due, (C) make a general assignment for the benefit of creditors, (D) be adjudicated a bankrupt or insolvent or (E) commence a voluntary case under the federal bankruptcy laws of the United States of America or file a voluntary petition or answer seeking reorganization, an arrangement with creditors or an order for relief or seek to take advantage of any insolvency law or file an answer admitting the material allegations of a petition filed against it in any bankruptcy, reorganization or insolvency proceeding or take any corporate action for the purpose of effecting any of the foregoing; or (ii) without the application, approval or consent of the Hospital, a proceeding shall be instituted in any court of competent jurisdiction under any law relating to bankruptcy, insolvency, reorganization or relief of debtors, seeking in respect of the Hospital, an order for relief or an adjudication in bankruptcy, reorganization, dissolution, winding up or liquidation, a composition or arrangement with creditors, a readjustment of debts, the appointment of a trustee, receiver, liquidator or custodian or the like of the Hospital or of all or any substantial part of the Hospital's assets, or other like relief in respect thereof under any bankruptcy or insolvency law, and, if such proceeding is being contested by the Hospital in good faith, the same shall (A) result in the entry of an order for relief or any such adjudication or appointment or (B) continue undismissed, or pending and unstayed, for any period of sixty (60) consecutive days; or (e) (i) obligations of the Hospital or any of its Subsidiaries in respect of Debt in excess of $1,000,000 in the aggregate shall be declared to be or shall become due and payable prior to the stated maturity thereof, (ii) principal payments in excess of $1,000,000 in the aggregate in respect of any Debt of the Hospital shall not be paid when due or (iii) any judgment or judgments for the payment of money in an aggregate amount in excess of $500,000 shall have been rendered against the Hospital and the same shall have remained unsatisfied and in effect for any period of 30 consecutive days during which no stay of execution shall have been obtained; or (f) there shall have occurred an Early Amortization Event; or (g) UHS shall cease to (i) have the power to control the board of directors or other managing body of the Hospital, (ii) operate the Hospital, (iii) own, directly or indirectly, through one or more wholly-owned Subsidiaries, at least sixty percent (60%) of the outstanding capital stock or other ownership interests of the Hospital, (iv) any such capital stock or ownership interests shall be subject to any Lien, charge, pledge or encumbrance (other than (A) Liens for taxes which are not then due and payable or which are being contested in good faith through appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of the Hospital or (B) any Lien of any Financial institution securing Debt of UHS and its subsidiaries) or (v) any pledgee of any such stock of the Hospital pledged as collateral pursuant to clause (ii) shall take any action to realize upon such collateral; or (h) (i) the Hospital or any Commonly Controlled Entity shall engage in any Prohibited Transaction (as defined in Section 406 of ERISA or Section 4975 of the Code) involving any Plan, (ii) any "accumulated funding deficiency" (as defined in Section 302 of ERISA), whether or not waived, shall exist with respect to any Plan, (iii) a Reportable Event shall occur with respect to, or proceedings shall commence to have a trustee appointed, or a trustee shall be appointed, to administer or to terminate, any Single Employer Plan, which Reportable Event or commencement of proceedings or appointment or a trustee is, in the reasonable opinion of Finco, likely to result in the termination of such Plan for purposes of Title IV of ERISA, (iv) any Single Employer Plan shall terminate for purposes of Title IV of ERISA, (v) the Hospital or any Commonly Controlled Entity shall, or in the reasonable opinion of Finco is likely to, incur any liability in connection with a withdrawal from, or the Insolvency or Reorganization of, a Multiemployer Plan or (vi) any other event or condition shall occur or exist, with respect to a Plan; and in each case in clauses (i) through (vi) above, such event or condition, together with all other such events or conditions, if any, could subject the Hospital or any of its Subsidiaries, to any tax, penalty or other liabilities in the aggregate material in relation to the business, operations, property or financial or other condition of the UHS Entities taken as a whole; or (i) there shall have occurred any other circumstance which could, in the sole judgement of Finco have a material adverse impact on the validity or enforceability of this Agreement or any Operative Document or on the enforceability or collectibility (other than as a result of the credit quality of any Obligor) of the Purchased Receivables or the value of the related Transferred Property; or (j) a Voluntary Exclusion Event with respect to the Hospital shall have occurred. Section 6.2. Remedies. (a) If any Exclusion Event shall have occurred and be continuing, Finco, by notice in writing given to the Hospital, may do any or all of the following: (i) continue to purchase Receivables in accordance with this Agreement except that Finco shall only pay for Purchased Receivables with Subordinated Notes, (ii) notify the Servicer that such Purchased Receivables are Excluded Receivables or (iii) cease purchasing Receivables from the Excluded Hospital, and the Excluded Hospital hereby agrees to any and all such remedies taken by Finco; provided, however that if an Exclusion Event described in Section 6.1(d) shall have occurred and be continuing, then the obligation of Finco to acquire Receivables shall immediately terminate without written notice and without presentment, demand, protest, notice of protest or dishonor or any other notice of any other kind, all of which are hereby expressly waived by the Hospital. (b) If an Exclusion Event described in Section 6.1(d) shall have occurred or if Finco ceases to acquire Receivables from the Hospital pursuant to Section 6.2(a)(iii), then the obligation of the Hospital to continue to sell Receivables to Finco shall also immediately terminate and all Collections thereafter received from each Obligor in respect of the Purchased Receivables for which such Obligor is obligated to make payments shall be applied to the Purchased Receivables to which such payments relate. (c) Notwithstanding the occurrence of any Exclusion Event and the remedies elected by Finco in respect thereof, if the Hospital thereafter (i) cures all Exclusion Events at such time continuing and (ii) complies, in the sole judgment of Finco, with all of the terms and conditions of this Agreement for a period of 60 consecutive days during which no Exclusion Event shall have occurred, then, upon the Hospital's provision of all documentation required, in the sole judgment of Finco, to demonstrate such compliance, the Hospital shall cease to be an Excluded Hospital and Finco shall resume purchasing Receivables from the Hospital in accordance with the terms of this Agreement; provided, however, that in no event shall any Receivables which were Excluded Receivables be deemed to be Eligible Receivables. (d) If for any reason (i) the transfer of the Transferred Property is not considered a sale and (ii) an Exclusion Event shall have occurred, in addition to all other rights and remedies granted to it under this Agreement and in any other instrument or agreement securing, evidencing or relating to the rights and remedies hereunder, and by operation of law, Finco shall have all rights and remedies of a secured party under the UCC (and under any other applicable law). Without limiting the generality of the foregoing, and subject to the provisions of Section 8.9 and to the terms and conditions of the Pooling Agreement, Finco, without demand of performance or other demand, presentment, protest, advertisement or notice of any kind (except any notice required by law referred to below) to or upon the Hospital or any other Person (all and each of which demands, defenses, advertisements and notices are hereby waived to the extent permitted by applicable law), may in such circumstances forthwith collect, receive, appropriate and realize upon the Transferred Property, or any part thereof, and/or may forthwith sell, lease, assign, give option or options to purchase, or otherwise dispose of and deliver the Transferred Property or any part thereof (or contract to do any of the foregoing), in one or more parcels at public or private sale or sales, at any exchange, broker's board or office of Finco or elsewhere upon such terms and conditions as it may deem advisable and at such prices as it may deem best, for cash or on credit or for future delivery without assumption of any credit risk. To the extent permitted by applicable law, the Hospital waives all claims, damages and demands it may acquire against each of Finco, its direct and indirect assignees and each of their respective directors, officers, employees and Affiliates arising out of the exercise by any of them of any rights under this Section 6.2(d). If any notice of a proposed sale or other disposition of the Transferred Property shall be required by law, such notice shall be deemed reasonable and proper if given at least 10 days before such sale or other disposition. (e) Notwithstanding any Exclusion Event, Finco shall continue to maintain its interest in all Purchased Receivables. Subject to Section 4.4, all amounts received as payments on Purchased Receivables will continue to be paid by the Hospital to Finco for application in accordance with Article V. In the event that the Hospital shall, after any Exclusion Event, receive payments from any Obligor which is an Obligor with respect to both Purchased Receivables and Receivables not purchased under this Agreement, to the extent that the Servicer is unable to determine the specific Receivables to which such payments relate, the Hospital shall apply all such amounts first to the Outstanding Balance of such Obligor's Purchased Receivables, in the order such Purchased Receivables were created, until such Purchased Receivables have been paid in full. ARTICLE VII INDEMNIFICATION AND EXPENSES Section 7.1. Indemnities by the Hospital. Without limiting any other rights which Finco may have hereunder or under applicable law, the Hospital hereby agrees to indemnify each of Finco, its direct and indirect assignees and each of their respective officers, directors, employees and Affiliates (collectively, the "Indemnified Parties") from and against any and all damages, losses (other than loss of profit), claims, actions, suits, judgments, demands, taxes, liabilities (including liabilities for penalties) and out-of-pocket costs and expenses, including without limitation, reasonable attorneys' fees and expenses but excluding costs and expenses attributable to administrative overhead (all of the foregoing being collectively referred to as "Indemnified Amounts"), awarded against or incurred by any of them arising out of or as a result of this Agreement, the other Hospital Documents or Finco's ownership of any Transferred Property or its assignment thereof pursuant to Section 8.9, excluding, however, Indemnified Amounts resulting from gross negligence or willful misconduct on the part of the Indemnified Party to which such Indemnified Amounts would otherwise be due. Without limiting the generality of the foregoing, the Hospital shall indemnify the Indemnified Parties for Indemnified Amounts relating to or resulting from: (i) the transfer of any Non-qualifying Receivable; (ii) any set-off or adjustment applied by any Obligor against any Non-governmental Receivable conveyed to Finco whether or not the amount of such set-off or adjustment was reflected in the Offset Reserves on the Purchase Date relating to such Purchased Receivable; (iii) reliance on any representation or warranty made by the Hospital (or any of its Authorized Officers) under or in connection with this Agreement, and any information or report delivered by the Hospital pursuant hereto, which shall have been false or incorrect in any material respect when made or deemed made; (iv) the failure by the Hospital to comply with any Requirement of Law with respect to any Purchased Receivable or the related Transferred Property, or the nonconformity of any Purchased Receivable or the related Transferred Property with any Requirement of Law; (v) the failure to take all actions which would be required to maintain in favor of Finco a valid, perfected, first priority security interest in and Lien on the Purchased Receivables and related Transferred Property, together with all Collections and Outstanding Balances related to such Receivables, free and clear of any Lien whether existing at the Initial Closing Date or at any time thereafter; (vi) the failure to file, record, deliver or receive in a timely manner all Security Filings, including without limitation, financing statements or other similar instruments or documents required under the UCC in effect in the state in which the Hospital's place of business is located or under other applicable laws with respect to any Purchased Receivables; (vii) any failure of the Hospital to perform its duties or obligations in accordance with the provisions of this Agreement or the other Hospital Documents; or (viii) the administration or enforcement of this Agreement by Finco or any of its direct or indirect assignees. Section 7.2. Audits of Hospital, Etc. (a) The Hospital shall immediately, but in no event later than five Business Days thereafter, notify Finco (i) of any Deficiency Notice received by it and (ii) of any preliminary or final determination resulting from any audit relating to it or the Receivables generated by it (including, without limitation, any "audit exception" to such determination), or any other investigation, by HHS or any other Governmental Authority or any intermediary thereof (any of the preceding, an "Audit"). (b) If, as a result of any Audit, any Governmental Authority or any intermediary thereof determines that the Hospital shall owe any amounts, (i) to the extent possible, the Hospital shall not permit any claims or adjustments resulting from the Audit to be applied as set-offs or adjustments to the Purchased Receivables and (ii) to the extent any claims or adjustments resulting from any Audit are applied against any Purchased Receivables, the Hospital shall immediately pay to the Hospital Concentration Account the amount so set-off or adjusted as Collections in respect of the Purchased Receivables. ARTICLE VIII MISCELLANEOUS Section 8.1. Notices, Etc. Except where telephonic instructions or notices are authorized herein to be given, all notices, demands, instructions and other communications required or permitted to be given to or made upon any party hereto shall be in writing and shall be personally delivered or sent by registered, certified or express mail, postage prepaid, return receipt requested, or by telecopy (with voice confirmation thereof) or telegram (with messenger delivery specified in the case of a telegram) and shall be deemed to be given when such personal delivery is made or such return receipt or confirmation is received by the party giving such notice, demand, instruction or communication. Unless otherwise specified in a notice sent or delivered in accordance with the foregoing provisions of this Section, notices, demands, instructions and other communications in writing shall be given to or made upon the respective parties hereto at their respective addresses (or to their respective telecopy numbers) indicated below, and, in the case of telephonic instructions or notices, by calling the telephone number or numbers indicated for such party below: If to the Hospital: At the location set forth in Schedule I hereto. If to Finco: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 Attention: President Tel. No.: 714-661-9323 Telecopier No.: 714-661-9445 With a copy to: UHS Receivables Corp. c/o Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: General Counsel Tel. No.: 215-768-3300 Telecopier No.: 215-768-3318 Section 8.2. Successors and Assigns. This Agreement shall be binding upon the Hospital and Finco and their respective successors and assigns and shall inure to the benefit of the Hospital and Finco and their respective successors and assigns; provided that the Hospital shall not assign any of its rights or obligations hereunder without the prior written consent of Finco. Except as expressly permitted hereunder or in the other Operative Documents, Finco shall not assign any of its rights or obligations hereunder without the prior written consent of the Trustee. Section 8.3. Severability. Any provisions of this Agreement which are prohibited or unenforceable in any jurisdiction shall, as to such jurisdiction, be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions hereof, and any such prohibition or unenforceability in any jurisdiction shall not invalidate or render unenforceable such provision in any other jurisdiction. Section 8.4. Amendments. This Agreement may not be modified, amended, waived, supplemented or surrendered except pursuant to a written instrument executed by the Hospital and Finco, and then such amendment, supplement, waiver or consent shall be effective only in the specific instance and for the specific purpose given. If any amendment, modification, supplement or waiver shall be so consented to by Finco, the Hospital agrees, promptly following a request by Finco, to execute and deliver in its own name and at its own expense, such instruments, consents and other documents as Finco may deem necessary or appropriate in the circumstances. Notwithstanding anything in this Section 8.4, no amendment shall be entered into if such amendment would, in the aggregate, adversely affect the interests of Finco. Section 8.5. The Hospital's Obligations. It is expressly agreed that, anything contained in this Agreement to the contrary notwithstanding, the Hospital shall be obligated to perform all of its obligations under the Receivables to the same extent as if Finco had no interest therein and Finco shall have no obligations or liability under the Receivables or the Transferred Property to any Obligor thereunder by reason of or arising out of this Agreement, nor shall Finco be required or obligated in any manner to perform or fulfill any of the obligations of the Hospital under or pursuant to any Receivables. Section 8.6. No Recourse. (a) No directors, officers, employees or agents of the Hospital shall be under any liability to Finco or any other Person for any action of the Hospital hereunder pursuant to this Agreement; provided, however, that this provision shall not protect the Hospital or any such Person against any liability which would otherwise be imposed by reason of willful misfeasance, bad faith or gross negligence in the performance of duties or by reason of reckless disregard of obligations and duties hereunder. (b) Except as expressly provided in this Agreement, the Hospital shall have no liability for the payment of the Purchased Receivables in excess of the Collections and amounts deemed Collections on all Purchased Receivables. The preceding sentence shall not relieve the Hospital or UHS from any obligations hereunder or under the Guarantee with respect to its respective representations, warranties, covenants and other payment and performance obligations herein or therein described. Section 8.7. Further Assurances. The Hospital agrees to do such further acts and things and to execute and deliver to Finco such additional assignments, agreements, powers and instruments as are required by Finco to carry into effect the purposes of this Agreement or to better assure and confirm unto Finco its rights, powers and remedies hereunder. Section 8.8. Survival. Notwithstanding any termination of this Agreement (whether on account of an Exclusion Event or otherwise) and subject to Section 6.2, and without limiting the survival of any other obligation of the Hospital or Finco hereunder, (i) all representations and warranties of the Hospital and Finco shall survive the execution and delivery of this Agreement, (ii) all of the rights and obligations of the parties (A) under Article VII, shall survive such termination and (B) under any other provision hereof, shall survive such termination as long as any Purchased Receivable is an Outstanding Receivable and (iii) the Hospital shall continue to be obligated to do all things necessary to collect on all Uncollectible Receivables and to apply Collections that it receives with respect thereto in the manner provided in this Agreement and to perform its obligations hereunder with respect thereto. Section 8.9. Consent to Assignment; Third Party Beneficiaries. (a) The Hospital acknowledges that all of Finco's right, title and interest in (i) the Purchased Receivables and related Transferred Property and (ii) the obligations of the Hospital to Finco and the rights of Finco against the Hospital under this Agreement with respect to the Transferred Property have been assigned, transferred and otherwise conveyed by Finco to the Trustee, for the benefit of the Participants, pursuant to the terms and conditions of the Pooling Agreement. It is understood, agreed and acknowledged that Sheffield shall assign to the Liquidity Agent, for the benefit of the Liquidity Banks, all of Sheffield's right, title and interest in, to and under this Agreement and in the Transferred Property. The Hospital consents to such assignment by Finco to the Trustee, and by Sheffield to the Liquidity Agent, and agrees that the Trustee and the Participants (or upon notice by Sheffield or the Liquidity Agent of a default under the Liquidity Agreement or the Security Agreement, and to the extent provided in the Pooling Agreement, the TRIPS Holders and the Liquidity Agent) shall be entitled to enforce the terms of this Agreement and the rights and responsibilities of Finco directly against the Hospital, whether or not any Early Amortization Event or Exclusion Event shall have occurred. The Hospital further agrees that (i) it will not take any action in connection with the Receivables or which could affect the rights of Finco hereunder (other than those actions which are consistent with its obligations hereunder and which occur in the normal course of its operations) without the prior consent of the Trustee or the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) and (ii) in respect of its obligations hereunder, the Hospital will act at the direction of and in accordance with all requests and instructions from the Trustee or the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be). The Hospital and Finco hereby agree that, in the event of any conflict of requests or instructions to the Hospital between Finco on the one hand, and the Trustee or the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) on the other hand, the Hospital will at all times act in accordance with the requests and instructions of the Trustee or the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be), and in the event of any conflict of requests or instructions among Participants, Finco shall act in accordance with the instructions of the Trustee. The Hospital and Finco further agree that, in the event of any conflict of requests or instructions to the Hospital between Sheffield on the one hand and the Liquidity Agent on the other hand, the Hospital will at all times act in accordance with the requests and instructions of the Liquidity Agent. (b) Notwithstanding anything in Section 8.9(a) to the contrary, and without limitation upon the rights and obligations of the parties set forth in such Section, each of the Interested Parties shall have the rights of third- party beneficiaries hereunder. (c) Each of Finco and the Hospital acknowledges that Sheffield has appointed Barclays to act as Managing Agent. Unless otherwise instructed by Sheffield, copies of all notices, requests, demands and other documents to be delivered to Sheffield pursuant to the terms hereof shall be delivered to the Managing Agent. Unless otherwise instructed by Sheffield, all notices, requests, demands and other documents to be executed or delivered, and any action to be taken, by Sheffield pursuant to the terms hereof may be executed, delivered and/or taken by the Managing Agent. The rights and responsibilities of the Managing Agent under this Agreement with respect to any action taken by the Managing Agent or the exercise or non-exercise by the Managing Agent of any option, right, request, judgment or other right or remedy provided to Sheffield herein or resulting or arising out of this Agreement shall, as between the Managing Agent and Sheffield be governed by such agreements with respect thereto as may exist from time to time between them, but, as between the Managing Agent and the Hospital, the Managing Agent shall be conclusively presumed to be acting as agent for Sheffield with full and valid authority so to act or refrain from acting, and neither Finco nor the Hospital shall be under any obligation or entitlement to make any inquiry respecting such authority. Section 8.10. Counterparts. This Agreement may be executed by the Hospital and Finco on the same or separate counterparts, each of which shall be deemed to be an original instrument. Section 8.11. Headings. Section headings used in this Agreement are for convenience of reference only and shall not affect the construction or interpretation of this Agreement. Section 8.12. No Bankruptcy Petition Against Finco or Sheffield. The Hospital covenants and agrees that prior to the date which is one year and one day after the Aggregate Capital is reduced to zero and all other amounts due under or in connection with the Operative Documents are paid in full it will not institute against, or join any other Person in instituting against, Finco or Sheffield any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. Section 8.13. Finco May Act Through Agents. Finco may exercise any of its rights or perform any of its duties hereunder through agents of its choosing, and any action so taken shall have the same force and effect as if taken by Finco directly. Section 8.14. GOVERNING LAW. THIS AGREEMENT SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE INTERNAL LAW OF THE STATE OF NEW YORK WITHOUT REFERENCE TO CONFLICTS OF LAW RULES OF THE STATE OF NEW YORK; PROVIDED THAT ALL MATTERS RELATING TO THE PERFECTION AND PRIORITY OF THE OWNERSHIP OR SECURITY INTEREST GRANTED HEREIN IN THE RECEIVABLES AND TRANSFERRED PROPERTY OF THE HOSPITAL SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE LAWS OF THE STATE WHERE THE HOSPITAL IS LOCATED. Section 8.15. No Waiver; Cumulative Remedies. No failure to exercise and no delay in exercising, on the part of Finco, 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. The rights, remedies, powers and privileges herein provided are cumulative and not exhaustive of any rights, remedies, powers and privileges provided by law. Section 8.16. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. (a) THE HOSPITAL (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY IRREVOCABLY SUBMITS, FOR ITSELF AND ITS PROPERTY, TO THE JURISDICTION OF THE STATE COURTS OF THE STATE OF NEW YORK AND TO THE JURISDICTION OF THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK, FOR THE PURPOSES OF ANY SUIT, ACTION OR OTHER PROCEEDING ARISING OUT OF OR BASED UPON THIS AGREEMENT, THE OTHER HOSPITAL DOCUMENTS OR THE SUBJECT MATTER HEREOF OR THEREOF BROUGHT BY FINCO OR ANY OF ITS DIRECT OR INDIRECT ASSIGNEES. THE HOSPITAL (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS), TO THE EXTENT PERMITTED BY ANY REQUIREMENTS OF LAW, HEREBY (A) WAIVES, AND AGREES NOT TO ASSERT, BY WAY OF MOTION, AS A DEFENSE, OR OTHERWISE, IN ANY SUCH SUIT, ACTION OR PROCEEDING BROUGHT IN ANY SUCH COURT, ANY CLAIM THAT IT IS NOT SUBJECT PERSONALLY TO THE JURISDICTION OF THE ABOVE- NAMED COURTS, THAT ITS PROPERTY IS EXEMPT OR IMMUNE FROM ATTACHMENT OR EXECUTION, THAT THE SUIT, ACTION OR PROCEEDING IS BROUGHT IN AN INCONVENIENT FORUM, THAT THE VENUE OF THE SUIT, ACTION OR PROCEEDING IS IMPROPER OR THAT THIS AGREEMENT OR THE OTHER HOSPITAL DOCUMENTS OR THE SUBJECT MATTER HEREOF OR THEREOF MAY NOT BE ENFORCED IN OR BY SUCH COURT AND (B) WAIVES THE RIGHT TO ASSERT IN ANY SUCH ACTION, SUIT OR PROCEEDING ANY SET-OFFS OR COUNTERCLAIMS EXCEPT COUNTERCLAIMS THAT ARE COMPULSORY OR OTHERWISE ARISE FROM THE SAME SUBJECT MATTER. THE HOSPITAL HEREBY AGREES THAT SERVICE OF PROCESS AND OTHER DOCUMENTS ON THE HOSPITAL MAY BE EFFECTED BY CERTIFIED OR REGISTERED MAIL (OR ANY SUBSTANTIALLY SIMILAR FORM OF MAIL) TO ITS ADDRESS AS SET FORTH ON SCHEDULE I AND SUCH SERVICE SHALL CONSTITUTE VALID AND EFFECTIVE SERVICE AGAINST THE HOSPITAL. THE HOSPITAL AGREES THAT ITS SUBMISSION TO JURISDICTION AND CONSENT TO SERVICE OF PROCESS BY MAIL IN ANY SUCH ACTION, SUIT OR PROCEEDING SHALL BE CONCLUSIVE, AND MAY BE ENFORCED IN ANY OTHER JURISDICTION (A) BY SUIT, ACTION OR PROCEEDING ON THE JUDGMENT, A CERTIFIED OR TRUE COPY OF WHICH SHALL BE CONCLUSIVE EVIDENCE OF THE FACT AND THE AMOUNT OF INDEBTEDNESS OR LIABILITY THEREIN DESCRIBED OR (B) IN ANY OTHER MANNER PROVIDED BY OR PURSUANT TO THE LAWS OF SUCH OTHER JURISDICTION, PROVIDED, HOWEVER, THAT FINCO OR ANY DIRECT ASSIGNEE MAY AT ITS OPTION BRING SUIT OR INSTITUTE OTHER JUDICIAL PROCEEDINGS AGAINST THE HOSPITAL OR ANY OF ITS RESPECTIVE ASSETS IN ANY STATE OR FEDERAL COURT OF THE UNITED STATES OR OF ANY COUNTRY OR PLACE WHERE THE HOSPITAL OR SUCH ASSETS MAY BE FOUND. (b) EACH OF FINCO AND THE HOSPITAL (AND THEIR RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY WAIVES ALL RIGHTS TO TRIAL BY JURY IN ANY ACTION OR PROCEEDING ARISING OUT OF OR RELATING TO ANY OF THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT OR THE OTHER HOSPITAL DOCUMENTS. (c) THIS SECTION 8.16 SHALL SURVIVE THE TERMINATION OF THIS AGREEMENT. Section 8.17. UCC. Finco and the Hospital hereby agree that each sale hereunder, to the extent permitted by all Requirements of Law, is intended to be, for all purposes of New York law, a "sale of accounts" (as that term is used in Section 9-102(1)(b) of the New York UCC). Section 8.18. Execution; Effectiveness. (a) This Agreement shall constitute a two-party agreement between Finco on the one hand and the hospital company designated on any signature page hereto (in respect of the hospital indicated as the d/b/a on such signature page) on the other hand. This Agreement shall become effective on the date on which counterparts of such signature page shall have been executed and delivered by each of Finco and such hospital company. To the extent any Schedule referred to in this Agreement designates information applicable to a particular Hospital, only such portion of such Schedule shall be deemed to be delivered by such Hospital and no other portion of such Schedule shall be deemed to be part of the Agreement between Finco and such Hospital. To the extent that the information in any Schedule does not specify which Hospital to which such information applies, such information shall be deemed to be delivered initially by each Hospital; provided that Finco and each such Hospital may amend the information on any such Schedule without affecting the information on such Schedule deemed to be delivered by any other Hospital. All references to the "Hospital", this "Agreement" or this "Sale and Servicing Agreement" or to any Schedule hereto shall be deemed to be a reference to the hospital company executing such signature page, to the agreement between Finco and such hospital company and to the Schedules or portions thereof deemed to be delivered by such hospital company only, without regard to any Sale and Servicing Agreement or schedules executed and delivered by any other hospital company. (b) Any amendment, supplement or other modification of the terms, covenants and conditions contained herein approved by Finco and any Hospital in accordance with the terms of Section 8.4 shall be effective only as between Finco and such Hospital and shall have no effect on such terms, covenants and conditions as they apply to any Sale and Servicing Agreement between Finco and any other Hospital. IN WITNESS WHEREOF, each of the Hospital and Finco have caused this Sale and Servicing Agreement to be duly executed and delivered by its duly authorized officer on the date indicated below. Date: November 16, 1993 CHALMETTE GENERAL HOSPITAL, INC. DALLAS FAMILY HOSPITAL, INC. DEL AMO HOSPITAL, INC. HRI HOSPITAL, INC. LA AMISTAD RESIDENTIAL TREATMENT CENTER, INC. MCALLEN MEDICAL CENTER, INC. MERIDELL ACHIEVEMENT CENTER, INC. RIVER OAKS, INC. TURNING POINT CARE CENTER, INC. UHS OF ARKANSAS, INC. UHS OF AUBURN, INC. UHS OF BELMONT, INC. UHS OF MASSACHUSETTS, INC. UHS OF RIVER PARISHES, INC. UHS OF SHREVEPORT, INC. UNIVERSAL HEALTH SERVICES OF INLAND VALLEY, INC. UNIVERSAL HEALTH SERVICES OF NEVADA, INC. VICTORIA REGIONAL MEDICAL CENTER, INC. WELLINGTON REGIONAL MEDICAL CENTER INCORPORATED By:__________________________ Kirk E. Gorman Treasurer SPARKS RENO PARTNERSHIP L.P. By: Sparks Family Hospital, Inc., General Partner By:__________________________ Kirk E. Gorman Treasurer UHS RECEIVABLES CORP. By:__________________________ Cheryl Ramagano Vice President and Treasurer EXHIBIT A TO SALE AND SERVICING AGREEMENT UHS RECEIVABLES CORP. NON-NEGOTIABLE SUBORDINATED NOTE ___________ __, 1993 For value received, UHS Receivables Corp., a Delaware corporation ("Finco"), promises to pay (but only on a subordinated basis and to the extent of Available Cash, as defined below), to the order of ______________________ (the "Hospital"), the principal amounts indicated on Schedule A attached hereto on the dates shown on such schedule (subject to the terms hereof). This Subordinated Note shall be due and payable on the Trust Termination Date, but may be prepaid at any time without premium. Capitalized terms used herein without definition shall have the meanings set forth in the Definitions List, dated as of November 16, 1993, 1993 that refers to the Sale and Servicing Agreement, dated as of November 16, 1993 (as amended, supplemented, or otherwise modified from time to time, the "Sale and Servicing Agreement"), between Finco and the Hospital. This Subordinated Note is subject to the terms and conditions of the Sale and Servicing Agreement. Finco further promises to pay interest on the unpaid principal hereof from the dates specified in the schedule attached hereto at the annual fixed rate or rates specified therein (but only on a subordinated basis and to the extent of Available Cash from time to time) and payable on each anniversary of the date of this Subordinated Note to the extent funds are available therefor (subject to the terms hereof) until such principal shall have been paid in full; provided, however, that the interest rate or rates shall not be in excess of the Base Rate applicable from time to time. All payments of principal hereof and interest hereon shall be made in Dollars and in immediately available funds. The Hospital agrees that it shall not sell, transfer, assign, negotiate or pledge its rights under this Subordinated Note to any third party; provided that if the Hospital shall cease to be a Subsidiary of UHS, the Hospital shall assign this Subordinated Note to another Hospital or to UHS. Notwithstanding any provision to the contrary in this Subordinated Note or elsewhere, no demand for the payment of principal or interest may be made hereunder, no principal or interest shall be due with respect hereto and the Hospital shall have no claim for the payment of any principal or interest, except to the extent that Finco, pursuant to the terms and conditions of the Pooling Agreement, holds and owns cash ("Available Cash") free and clear of any lien, claim, encumbrance or obligation to make payments under the Sale and Servicing Agreement, and free and clear of any lien, claim, encumbrance or obligation under any similar agreement hereafter entered into by Finco including, without limitation, to the extent provided under the terms of the Pooling Agreement and in any event only to the extent such payments are provided for in the Pooling Agreement. The Hospital understands and agrees that the obligations of Finco under this Subordinated Note are subordinated in right of payment to the prior payment in full of the Participations and all of the other obligations of Finco under the Finco Documents. The Hospital further understands that the Hospital shall have no recourse to any assets or property of Finco or any assignee thereof other than Available Cash and further agrees that in the event of any assignment for the benefit of creditors, marshalling of assets dissolution, winding up or liquidation of Finco, whether voluntary or involuntary, in bankruptcy or insolvency or other similar proceedings, the obligations of Finco to pay principal and interest on this Subordinated Note shall remain fully subordinated and may not be accelerated, claimed or proved. In the event that, notwithstanding the foregoing provision prohibiting such payment or distribution, the Hospital shall receive any payment or distribution on this Subordinated Note from any source other than Available Cash, such payment shall be received and held in trust by the Hospital for the benefit of Finco and its assignees and shall be paid over to the Trustee by the Hospital. The Hospital covenants and agrees that prior to the date which is one year and one day after the Aggregate Capital is reduced to zero it will not institute against, or join any other Person in instituting against, Finco or Sheffield any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. Finco may prepay all or any portion of this Subordinated Note on any Business Day out of Available Cash only to the extent and in the manner provided under the Pooling Agreement. NOTWITHSTANDING ANYTHING TO THE CONTRARY IN THIS SUBORDINATED NOTE OR ELSEWHERE, NO AMOUNTS OTHERWISE PAYABLE TO THE HOSPITAL BY FINCO UNDER THIS NOTE OR THE SALE AND SERVICING AGREEMENT SHALL BE DUE OR PAYABLE TO THE HOSPITAL IF IT IS AN EXCLUDED HOSPITAL PURSUANT TO THE SALE AND SERVICING AGREEMENT, AND NO INTEREST SHALL BE DUE OR PAYABLE ON ANY AMOUNTS OTHERWISE DUE OR PAYABLE UNDER THIS SUBORDINATED NOTE FOR ANY PERIOD THAT THE HOSPITAL IS AN EXCLUDED HOSPITAL. This Subordinated Note shall be deemed to have been made under and shall be governed by and construed in accordance with the laws of the state of New York. IN WITNESS WHEREOF, Finco has caused this Subordinated Note to be duly executed on the date first above written. UHS RECEIVABLES CORP. By:___________________________ Authorized Officer Schedule A to Subordinated Note Interest Rate: 4% Principal Principal Unpaid Amount Amount Principal Notation Date of Loan Repaid Balance Made By EXHIBIT B TO SALE AND SERVICING AGREEMENT FORM OF CONFIDENTIALITY AGREEMENT [Letterhead of RECIPIENT of Information] ___________ __, 199_ UHS Receivables Corp. 27292 Calle Arroyo Suite B San Juan Capistrano, CA 92675 Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, PA 19406 Dear Sirs: Reference is made to the Sale and Servicing Agreement, dated as of November 16, 1993 (as amended from time to time, the "Sale and Servicing Agreement"), UHS Receivables Corp., a Delaware corporation (the "Transferor"), and [Hospital] (the "Hospital"), and to the pending and proposed discussions between the Transferor and [recipient] (the "Recipient") regarding [describe transaction requiring disclosure]. Unless otherwise defined herein, capitalized terms defined in the Sale and Servicing Agreement are used herein as so defined. Pursuant to our discussions, the Transferor hereby agrees to provide to the Recipient certain information, practices, books, correspondence, and records of a confidential nature and in which the Hospital has a proprietary interest (the "Information") on the terms and conditions set forth below. By its execution of this Agreement, the Recipient hereby agrees to all such terms and conditions. The Recipient hereby acknowledges that all Information received by it from the Transferor shall be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality. The Recipient agrees that, subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose the Information without the prior written consent of the Transferor and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by the Sale and Servicing Agreement and the other Operative Documents or for the enforcement of any of the rights granted thereunder) of any of the Information without the prior written consent of the Transferor. Notwithstanding the foregoing, the Recipient may (x) disclose Information to any Person that has executed and delivered a confidentiality agreement in substantially the same form as this agreement naming the Transferor and the Hospital as third party beneficiaries thereof and (y) disclose or otherwise use Information (A) to the extent that such Information is required or appropriate in any report, statement or testimony submitted to any municipal, state or federal regulatory body having or claiming to have jurisdiction over the Recipient or submitted to the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such Information subsequently becomes publicly available, other than through any act or omission of the Recipient or (F) to the extent that such Information subsequently becomes known to the Recipient, other than through a Person whom the Recipient knows to be acting in violation of its obligations to the Transferor or the Hospital. The parties agree that any breach of this letter agreement would cause damages which cannot be determined in money and that injunction is an appropriate remedy for breach, though not necessarily the sole remedy. This Agreement shall inure to the benefit of the parties hereto, each of their respective successors and permitted assigns and the Hospital, and the Hospital will be deemed to be a third party beneficiary of this Agreement. This Agreement shall be governed by, and construed in accordance with the law of the State of New York, and may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one agreement. Please acknowledge your agreement to the foregoing by signing three copies of this letter agreement and returning them to the Transferor. Upon receipt of the executed letter agreement, the Transferor pursuant to the terms of the Sale and Servicing Agreement, will deliver an executed agreement to UHS and the Hospital. Very truly yours, [RECIPIENT] By:_________________________ Title: Acknowledged and Agreed: UHS Receivables Corp. 27292 Calle Arroyo Suite B San Juan Capistrano, CA 92675 By:____________________________ Title: cc: [Hospital Name] [Address] SCHEDULE I Hospital and UHS place of business List of Insurers UCCs Filed A. Locations of Hospital and UHS place of business s Name Place of business Universal Health Services, Inc. 367 South Gulph Road King of Prussia, PA 19406 Chalmette General Hospital, Inc. 9001 Patricia Street Chalmette, LA 70043 and 800 Virtue Street Chalmette, LA 70043 Dallas Family Hospital, Inc. 2929 South Hampton Road Dallas, TX 75224 Del Amo Hospital, Inc. 23700 Camino del Sol Torrance, CA 90505 HRI Hospital, Inc. 227 Babcock Street Brookline, NM 02146 La Amistad Residential Treatment 201 Alpine Drive Center, Inc. Maitland, FL 32751 McAllen Medical Center, Inc. 301 West Expressway 83 McAllen, TX 78503 Meridell Achievement Center, Inc. Highway 29 West Liberty Hill, TX 78642 and 2501 Cypress Creek Road Cedar Park, TX 78613 River Oaks, Inc. 1525 River Oaks Road West New Orleans, LA 70123 Sparks Reno Partnership, L.P. 2375 E. Prater Way Sparks, NV 89434 Turning Point Care Center, Inc. 319 East By-Pass Moultrie, GA 31768 UHS of Arkansas, Inc. 21 BridgeWay Road North Little Rock, AR 72118 UHS of Auburn, Inc. 20 Second Street, N.E. Auburn, WA 98002 UHS of Belmont, Inc. 4058 West Melrose Street Chicago, IL 60641 UHS of Massachusetts, Inc. 49 Robinwood Avenue Boston, MA 02130 UHS of River Parishes, Inc. 500 Rue de Sante LaPlace, LA 70068 UHS of Shreveport, Inc. 1130 Louisiana Avenue Shreveport, LA 71101 Universal Health Services 36485 Inland Valley Drive of Inland Valley, Inc. Wildomar, CA 92395 Universal Health Services of 620 Shadow Lane Nevada, Inc. Las Vegas, NV 89106 Victoria Regional Medical 101 Medical Drive Center, Inc. Victoria, TX 77904 Wellington Regional Medical 10101 Forest Hill Blvd. Center Incorporated West Palm Beach, FL 33414 B. List of Insurers Insurers or other third-party payors which are Obligors maintaining the ten highest average Outstanding Balances of Receivables, calculated as of August 31, 1993, on an aggregate basis for all Hospitals that are parties to any Sale and Servicing Agreement: 1. Aetna $ 1,824,491 2.43% 2. Family Health Plan HMO 1,086,921 1.45% 3. Metropolitan 1,013,152 1.35% 4. Culinary HMO 831,672 1.11% 5. Travelers 781,682 1.04% 6. CIGNA 712,905 .95% 7. Prudential 607,419 .81% 8. King County HMO 495,950 .66% 9. CAC HMO 374,835 .50% 10. Kaiser HMO 365,364 .49% ----------- ---- Total Top 10 8,094,391 10.79% Total Financial Receivables $74,995,728 100% =========== ==== C. UCCs Filed Name Filing Location(s) Universal Health Services, Inc. Secretary of the Commonwealth of Pennsylvania and Montgomery County Prothonotary's Office Chalmette General Hospital, Inc. Clerk of Court of Saint Bernard Parish Dallas Family Hospital, Inc. Secretary of State of State of Texas Del Amo Hospital, Inc. Secretary of State of State of California HRI Hospital, Inc. Secretary of State of State of Massachusetts and Town Clerk's Office of town of Brookline McAllen Medical Center, Inc. Secretary of State of State of Texas Meridell Achievement Center, Inc. Secretary of State of State of Texas River Oaks, Inc. Clerk of Court of Jefferson Parish Sparks Reno Partnership, L.P. Secretary of State of State of Nevada Turning Point Care Center, Inc. Clerk of Superior Court of Colquitt County UHS of Arkansas, Inc. Secretary of State of State of Arkansas and Clerk of Circuit Court and Ex-Officio Recorder of Pulaski County UHS of Auburn, Inc. Licensing Department of State of Washington UHS of Belmont, Inc. Secretary of State of State of Illinois UHS of Maitland, Inc. Florida Department of State UHS of Massachusetts, Inc. Secretary of State of State of Massachusetts and Town Clerk's Office of town of Boston Name Filing Location(s) UHS of River Parishes, Inc. Clerk of Court of St. John the Baptist Parish UHS of Shreveport, Inc. Clerk of Court of Caddo Parish Universal Health Recovery Secretary of the Commonwealth of Centers, Inc. Pennsylvania and Chester County Prothonotary's Office Universal Health Services of Secretary of State of State of Inland Valley, Inc. California Universal Health Services of Secretary of State of State Nevada, Inc. of Nevada Victoria Regional Medical Secretary of State of State Center, Inc. of Texas Wellington Regional Medical Florida Department of State Center Incorporated Westlake Medical Center, Inc. Secretary of State of State of California SCHEDULE II Notifications: Accreditation and Licensing None. SCHEDULE III Fiscal Years Open to Audit Name of Hospital Years Open Chalmette General Hospital, Inc. 1990, 1991, 1992 Dallas Family Hospital, Inc. 1990, 1991, 1992 Del Amo Hospital, Inc. 1991, 1992 HRI Hospital, Inc. 1990, 1991, 1992 McAllen Medical Center, Inc. 1990, 1991, 1992 Meridell Achievement Center, Inc. 1990, 1991, 1992 River Oaks, Inc. 1990, 1991, 1992 Sparks Reno Partnership, L.P. 1990, 1991, 1992 Turning Point Care Center, Inc. 1990, 1991, 1992 UHS of Arkansas, Inc. 1990, 1991, 1992 UHS of Auburn, Inc. 1990, 1991, 1992 UHS of Belmont, Inc. 1990, 1991, 1992 UHS of Maitland, Inc. 1990, 1991, 1992 UHS of Massachusetts, Inc. 1990, 1991, 1992 UHS of River Parishes, Inc. 1990, 1991, 1992 UHS of Shreveport, Inc. 1990, 1991, 1992 Universal Health Recovery Centers, Inc. 1990, 1991, 1992 Universal Health Services of Inland 1990, 1991, 1992 Valley, Inc. Universal Health Services of Nevada, 1990, 1991, 1992 Inc. Victoria Regional Medical Center, Inc. 1990, 1991, 1992 Wellington Regional Medical Center 1990, 1991, 1992 Incorporated Westlake Medical Center, Inc. 1990, 1991, 1992 SCHEDULE IV Governmental Programs for which the Hospital is a Qualified Provider ============================================================================== Governmental Program Hospitals Qualified - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- ============================================================================== SCHEDULE V Location and Identification of Hospital Concentration Accounts Name of Hospital Bank Account Number Chalmette General Hospital, Inc. Hibernia National 8122-2924-9 Bank UHS of De La Ronde, Inc. Hibernia National 8122-2925-7 Bank Dallas Family Hospital, Inc. Bank One -- Texas 9830-10-741-7 Del Amo Hospital, Inc. Bank of America 1233-4-57852 HRI Hospital, Inc. First National 503-11965 Bank of Boston McAllen Medical Center, Inc. Texas Commerce 0960-0370185 Bank Meridell Achievement Center, Inc.Bank One -- Texas 75-0025-5968 River Oaks, Inc. Hibernia National 8122-2923-0 Bank Sparks Reno Partnership, L.P. Bank of America 47-0012378 Turning Point Care Center, Inc. Moultrie National 01-41110-1-01 Bank UHS of Arkansas, Inc. First Commercial 0657433 Bank UHS of Auburn, Inc. Seafirst 62269519 UHS of Belmont, Inc. Park National 16-5301 Bank UHS of Maitland, Inc. Nationsbank of 0088376877 Florida UHS of Massachusetts, Inc. First National 503-52636 Bank of Boston UHS of River Parishes, Inc. Bank of La Place 01-0622-4 UHS of Shreveport, Inc. Hibernia National 762001756 Bank Universal Health Recovery First Fidelity 4004517290 Centers, Inc. Bank Universal Health Services of Bank of America 1233-2-56080 Inland Valley, Inc. Universal Health Services of Bank of America 01-212-2036 Nevada, Inc. Victoria Regional Medical Victoria Bank & 5101017337 Center, Inc. Trust Wellington Regional Medical Sun Bank South 0629-002-005381 Center Incorporated Florida N.A. Westlake Medical Center, Inc. Bank of America 1233-9-56195 - ------------------------------------------------------------------------------ DEFINITIONS LIST dated as of November 16, 1993 - ------------------------------------------------------------------------------ DEFINITIONS LIST The capitalized terms used herein and in the documents listed below shall have the meanings set forth in this Definitions List. 1. Each of the Sale and Servicing Agreements (each as amended, supplemented or otherwise modified from time to time, a "Sale and Servicing Agreement"), in each case between a Hospital and Finco. 2. The Servicing Agreement, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Servicing Agreement"), among Finco, UHS Delaware, as Servicer, and the Trustee. 3. The Pooling Agreement, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Pooling Agreement"), among Finco, ONC, Sheffield and the Trustee. 4. The Guarantee, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, "Guarantee"), executed by UHS in favor of Finco and the Trustee. 5. The Conditions List, dated as of November 16, 1993 (the "Conditions List"), incorporated by reference in certain of the above documents. Accounting Terms - As used in this Definitions List and in all documents incorporating this Definitions List, all accounting terms not otherwise defined shall have the meanings assigned to them under GAAP as in effect at the time of the relevant determination. Other Definitional Provisions - References to "Sections," "Subsections," "Paragraphs," "Subparagraphs," "Appendices," "Recitals" and "Exhibits" shall be to Sections Subsections, Paragraphs, Subparagraphs, Appendices, Recitals and Exhibits of the document in which such references appear unless otherwise specifically provided. Any of the terms defined in this Definitions List may be used in singular or plural form. As used herein, the singular includes the plural, and the masculine gender includes the feminine and neuter genders, and vice versa, unless the context otherwise requires. Except as otherwise provided herein or in any document incorporating this Definitions List, references to any document or instrument are as amended or supplemented or otherwise modified from time to time in accordance with the terms and conditions of such document. The words "hereof," "herein" and "hereunder" and words of similar import when used in any document incorporating this Definitions List shall refer to such document as a whole and not to any particular provision of such document. Acceleration Event: As defined in Section 10.1(h) of the Pooling Agreement. Actual Contractual Adjustment: With respect to each Purchased Receivable, at the time of reference thereto, the amount by which the payment due from the Obligor of such Purchased Receivable is less than the gross amount chargeable by the relevant Hospital for the goods or services reflected on the invoice relating to such Purchased Receivable. The amount due from the Obligor shall be determined for each payor class and for each Hospital and shall result in an amount due which is no greater than the amount of revenue (net of contractual adjustments) which would be reflected in respect of such Receivable for purposes of the consolidated financial statements of UHS and its Subsidiaries. To the extent that a Financible Receivable reflects a discount in excess of the discount which would be reflected in the determination of revenue, such excess shall be a Deleted Receivable. Additional Account: Any lockbox account established by the Trustee, as permitted by Section 7.8 of the Pooling Agreement or Section 3.7 of the Servicing Agreement. Adjusted Aggregate Capital: At any time, the sum of the Adjusted TRIPs Capital and the Adjusted Sheffield Capital. Adjusted Eurodollar Rate: With respect to any Sheffield Tranche for any Fixed Period, an interest rate per annum equal to (a) 1-1/4% plus (b) the Reference Rate for that Fixed Period. Adjusted Sheffield Capital: On any date, the Sheffield Capital on such date minus all funds on deposit in the Sheffield Payment Account on such date (other than funds to be used for payment of Sheffield Yield). Adjusted TRIPs Capital: On any date, the TRIPs Capital on such date minus the amount of all funds on deposit in the TRIPs Payment Account on such date (other than funds to be used for payment of TRIPs Yield or the Make-Whole Payment Amount). Affiliate: As to any specified Person, any other Person controlling or controlled by or under common control with such specified Person. For the purposes of this definition, "control" when used with respect to any specified Person means the power to direct the management and policies of such Person, directly or indirectly, whether through the ownership of voting securities, by contract or otherwise; and the terms "controlling" or "controlled" have meanings correlative to the foregoing. Aggregate Blue Cross/Blue Shield: Collectively, Preferred Blue Cross Blue Shield and Other Blue Cross/Blue Shield. Aggregate Capital: At any time, the sum of the TRIPs Capital and the Sheffield Capital at such time. Aggregate Insurers/HMOs/PPOs: Collectively, Preferred Insurers/HMOs/PPOs and Other Insurers/HMOs/PPOs. Allocable Sheffield Capital: With respect to any Business Day during the Sheffield Revolving Period, the Adjusted Sheffield Capital on the preceding Business Day, and with respect to any Business Day during the Sheffield Amortization Period, the Adjusted Sheffield Capital on the last day of the Sheffield Revolving Period. Allocable TRIPs Capital: With respect to any Business Day during the Adjusted TRIPs Revolving Period, the Sheffield TRIPs Capital on the preceding Business Day, and with respect to any Business Day during the TRIPs Amortization Period, the Adjusted TRIPs Capital on the last day of the TRIPs Revolving Period. Alternative Rate: For any Fixed Period with respect to any Sheffield Tranche, an interest rate per annum equal to the Adjusted Eurodollar Rate or the Base Rate, as Finco shall select in accordance with the terms of the Pooling Agreement; provided, however, that the "Alternative Rate" for any Sheffield Tranche shall be the Base Rate if (i) on or before the first day of such Fixed Period, the Liquidity Agent shall have notified Sheffield that a Eurodollar Disruption Event has occurred, (ii) such Fixed Period is a period of from one to 29 days or (iii) the Sheffield Capital allocated to such Sheffield Tranche is less than $100,000. AOA: The American Osteopathic Association, and any successor thereto. Applicable Contractual Adjustment: With respect to each Purchased Receivable, the amount which the Servicer estimates, to the best of its knowledge in accordance with the Credit and Collection Policy, on the basis of the payor class of the Obligor and the Hospital originating such Receivable, to be the Actual Contractual Adjustment which will be applicable to such Purchased Receivable. Assigned Agreements: Each Sale and Servicing Agreement, the Servicing Agreement, the Pooling Agreement and the Guarantee. Assignors: Each of the Hospitals, UHS, Finco and the Servicer. Audit: As defined in Section 7.2 of each Sale and Servicing Agreement. Authorized Officer: (i) With respect to the Trustee, any officer within its corporate trust office, including any Vice President, Assistant Vice President, Secretary, Assistant Secretary, Trust Officer and any other officer of the Trustee customarily performing functions similar to those customarily performed by any of the above designated officers, and also, with respect to a particular matter, any other officer of the Trustee to whom such matter is referred because of such officer's knowledge of, or familiarity with, the particular subject and (ii) with respect to any party to any Operative Document, each officer whose name appears in an officers' certificate delivered by such party on the Initial Closing Date, as such officers' certificate may be amended from time to time. Available Cash Collections: On any date, the portion of Collections actually received in the Collateral Account in the form of immediately available funds pursuant to the terms of the Operative Documents. Average Financible Turnover Period: As of any Settlement Date, a number, calculated as of the last day of the fiscal month immediately preceding such Settlement Date (such date, the "Reference Date"), equal to (a) the sum, for each Aging Category (as defined below) of the product of (i) the aggregate Outstanding Balance of all Financible Receivables in such Aging Category as of the Reference Date and (ii) the number designated below as the "Midpoint" applicable to such Aging Category, as specified below, divided by (b) the total Outstanding Balance of Financible Receivables as of the Reference Date. For purposes of this definition "Aging Category" shall mean, as of the Reference Date, any of the five categories of Financible Receivables for which the number of days which have elapsed since the date on which Financible Receivables in such category were first billed is as set forth below: Number of Days Elapsed Since Date of Billing Midpoint 1. More than zero days but not more than 60 days. 30 2. More than 60 days but not more than 90 days. 75 3. More than 90 days but not more than 120 days. 105 4. More than 120 days but not more than 150 days. 135 5. More than 150 days but not more than 180 days. 165 Average Pool Turnover Period: On any day during any Settlement Period, (i) the aggregate Outstanding Balance of all Purchased Receivables as of the last day of the preceding Settlement Period divided by (ii) the daily average amount of Purchased Receivables purchased by Finco during such preceding Settlement Period. Average Sheffield Yield Rate: On any day during any Settlement Period, the daily weighted average Sheffield Yield Rate for all Sheffield Tranches outstanding during the immediately preceding Settlement Period. Barclays: Barclays Bank PLC, New York Branch. Base Rate: As of any day, a fluctuating interest rate per annum equal to the higher of (a) the rate of interest announced publicly by Barclays in New York, New York from time to time as Barclays' prime rate in effect on such date and (b) 1% above the weighted average of the rates on overnight Federal funds transactions with members of the Federal Reserve System arranged by Federal funds brokers, as published on the next succeeding Business Day by the Federal Reserve Bank of New York, or, if such rate is not so published for any day which is a Business Day, the average of the quotations for the day of such transactions received by Barclays from three Federal funds brokers of recognized standing selected by it. Borrowing Base: On any date, (a) all cash and Permitted Investments held in the Collateral Account, any sub-account thereof, other than the TRIPs Interest Sub-account, the Sheffield Interest Sub-account or the Expense Sub- account (exclusive of Collections that have not been identified as to Receivables), and any Other Account plus (b) the Financible Pool Balance minus (c) the Loss Reserves minus (d) the Yield Reserves minus (e) the Fee/Expense Reserves minus (f) if the Call Option has been exercised, the excess of the Make-Whole Estimated Amount over the TRIPs Make-Whole Funds; provided, however, that during the TRIPs Amortization Period or the Sheffield Amortization Period, for purposes of calculating any of the reserves set forth in clauses (c), (d) and (f), the TRIPs Capital or the Sheffield Capital, as the case may be, on the last day of the applicable Revolving Period, rather than the Capital on the date of calculation, shall be used to make the related reserve calculation. Business Day: A day of the year on which (a) banks in New York, New York or Chicago, Illinois are not required or authorized to close and (b) if the term "Business Day" is used in connection with the Adjusted Eurodollar Rate, dealings in dollar deposits are carried on in the London interbank market. Call Date: As defined in Section 2.14 of the Pooling Agreement. Call Option: As defined in Section 2.14 of the Pooling Agreement. Champus: The Civilian Health and Medical Program of the Uniformed Services, 32 C.F.R. 199, jointly administered by the Secretary of Defense, the Secretary of Transportation and HHS, as the same may be amended from time to time. Champus Receivable: A Receivable of which the Obligor is the United States and which arises out of charges reimbursable to a Hospital under Champus. Change of Control: As to any specified Person, a Change of Control shall be deemed to have occurred if, at any time after the Initial Closing Date, (i) a majority of the board of directors or other managers of such specified Person shall have first become a director or other manager during the preceding twelve months or (ii) any other Person or group of Persons has during the preceding twelve months acquired or increased its ownership interest in such Person so that it owns, directly or indirectly, 50% or more of such specified Person's stock ordinarily having voting power for the election of directors. Code: The United States Internal Revenue Code of 1986, as the same may be amended from time to time. Collateral Account: An account established under Section 7.1(a) of the Pooling Agreement, including all sub-accounts thereof established from time to time pursuant to the Pooling Agreement. Collections: All amounts due and owing on Purchased Receivables that either (a) have been collected in available funds by any Hospital or by the Servicer, Finco or the Trustee for deposit into the related Hospital Concentration Account or the Master Receivables Account in accordance with the terms of the Sale and Servicing Agreements or (b) have been posted as received by the Servicer pursuant to the Credit and Collection Policy but have not yet become available funds; provided, however, that amounts collected on Purchased Receivables that are not Financible Receivables shall be deemed to be "Collections" only upon satisfaction of clause (b) above. Commercial Paper or Commercial Paper Note: The short-term promissory notes of Sheffield and issued to fund the maintenance of the Sheffield Participation under the Pooling Agreement, which promissory notes shall be denominated in Dollars and shall have a maturity of not more than 120 days. Commonly-Controlled Entity: As to any Person, a Person, whether or not incorporated, which is under common control with such Person within the meaning of Section 4001 of ERISA or is part of a group which includes such Person and which is treated as a single employer under Section 414 of the Code. Concentration Limit: On any date of determination and when used with reference to Eligible Receivables of a specified type held by Finco and in which the Participants have acquired the Participations, the following applicable percentage of the aggregate Outstanding Balance of all Eligible Receivables so held by Finco represented by such type of Eligible Receivables, after giving effect to any purchases by Finco of Eligible Receivables to be effected on such date: Obligor Medicare 40% Medicaid 10% Preferred Blue Cross/Blue Shield 10% Aggregate Blue Cross/Blue Shield 10% Aggregate Insurers/HMOs/PPOs 60% Champus 7% Worker's Compensation 10% Preferred Insurer/HMO/PPO 7% Other Blue Cross/Blue Shield 1% Other Insurer/HMO/PPO 1% Concentration Limit Excess: On any date of determination, the portion of the Outstanding Balance of Eligible Receivables (or portions thereof) as of the last day of the immediately preceding Settlement Period that exceeded the Concentration Limits. Conditions List: As defined on the first page hereof. Confirmation: Each acknowledgement or notice of receipt of or agreement in respect of a related Notice of Assignment which is required to be delivered by or received from the recipient of such Notice of Assignment to any Hospital pursuant to Section 5.3 of the Pooling Agreement. Continental: Continental Bank, National Association, a national banking association. Cost of Funds: In any Settlement Period, and for any Purchased Receivable of any Hospital purchased by Finco on any Purchase Date, the product of (i) the Average Pool Turnover Period then in effect times (ii) the Outstanding Balance of such Purchased Receivable times (iii) the Base Rate plus 1% divided by 365. CP Holders: The holders from time to time of Outstanding Commercial Paper Notes. CP Rate: For any Fixed Period, with respect to any Sheffield Tranche, the rate equivalent to the rate (or if more than one rate, the weighted average of the rates) at which Commercial Paper Notes issued by Sheffield having a term equal to such Fixed Period and to be issued to fund the acquisition or maintenance of, such Sheffield Tranche may be sold by the commercial paper dealer or placement agent selected by Sheffield, as agreed between each such agent or dealer and Sheffield and notified by Sheffield to the Trustee; provided, however, that if the rate (or rates) as agreed between any such agent or dealer and Sheffield is a discount rate (or rates), the "CP Rate" for such Fixed Period shall be the rate (or if more than one rate, the weighted average of the rates) resulting from converting such discount rate (or rates), including the portion of such discount representing dealers' fees, to an interest-bearing equivalent rate per annum. Credit and Collection Policy: Those credit and collection policies and practices of UHS and the Servicer relating to Receivables in existence on the date hereof and attached hereto as Exhibit B, as modified in compliance with Section 4.3(k) of each Sale and Servicing Agreement and 3.1(k) of the Servicing Agreement. Daily Program Expense Amount: On any Business Day, 105% of (a) the Monthly Program Expense Amount divided by (b) the number of days in the current Settlement Period. Daily Sheffield Expense Amount: On any Business Day, 105% of (a) the Monthly Sheffield Expense Amount divided by (b) the number of days in the current Settlement Period. Daily TRIPs Expense Amount: On any Business Day, 105% of (a) the Monthly TRIPs Expense Amount divided by (b) the number of days in the current Settlement Period. Debt: Of a Person at a particular date, the sum at such date of (i) indebtedness for borrowed money or for the deferred purchase price of property or services, (ii) obligations as lessee under leases which shall have been or should be, in accordance with GAAP, recorded as capital leases, (iii) obligations under direct or indirect guarantees in respect of, and obligations (contingent or otherwise) to purchase or otherwise acquire, or otherwise to assure a creditor against loss in respect of, indebtedness or obligations of others of the kinds referred to in clause (i) or (ii) above and (iv) liabilities in respect of unfunded vested benefits under any Plan. Decrease: As defined in Section 2.6(b) of the Pooling Agreement. Deficiency Notice: A notice from any Governmental Authority to UHS or any Subsidiary thereof indicating that UHS or such Subsidiary is required to pay any amounts to such Governmental Authority, to the extent that the failure to pay such amount would, in accordance with applicable law, result in the offset by any Obligor of any amount owed to UHS or any Subsidiary under any Receivable. Defaulted Receivable: Any Receivable as to which the Servicer believes, in its good faith judgment, all amounts due thereunder are not or would not be ultimately recoverable because of the bankruptcy, insolvency or poor credit quality of the Obligor. Deleted Receivable: Any Eligible Receivable or portion thereof designated by the Servicer pursuant to Section 3.6 of the Servicing Agreement to be excluded from the pool of Financible Receivables. Delinquency Ratio: With respect to any Settlement Period, a fraction, the numerator of which is the Outstanding Balance of Financible Receivables which were Delinquent Receivables on the last day or the immediately preceding Settlement Period and the denominator of which is the Outstanding Balance of Financible Receivables as of the last day of the immediately preceding Settlement Period. Delinquent Receivable: As to any date of determination, any Receivable as to which all amounts due and payable thereunder have not been paid and in respect of which the date on which such Receivable was first billed occurred more than 120 days but less than 181 days prior to such date of determination. Deposited Funds: All funds at any time, and from time to time, on deposit or otherwise to the credit of the Collateral Account or any Other Account, including, without limitation, all Permitted Investments. Dollars and $: Lawful money of the United States of America. Early Amortization Event: As defined in Section 10.1 of the Pooling Agreement. Eligible Institution: Any depositary institution or trust company organized under the laws of the United States of America or any state thereof or the District of Columbia; provided that each such institution shall be a member of the FDIC and shall maintain at all times a long-term unsecured debt rating of A or better by Moody's and S&P; provided that Continental shall be an Eligible Institution so long as it either has a rating for its long-term deposits of at least Baa3 from Moody's and at least BBB- from S&P or is otherwise acceptable to the Rating Agencies. Eligible Pool Balance: At any date of determination, (a) the Outstanding Balance of all Eligible Receivables in the Receivables Pool minus (b) the Offset Reserves. Eligible Receivable: On any date, each Receivable other than any Self-pay Receivable, (a) as to which the Obligor is not an Obligor on any Defaulted Receivable, (b) (i) as to which on the Purchase Date of such Receivable each representation and warranty of the Hospital made under Sections 4.1(d), 4.1(e) and 4.2 of the related Sale and Servicing Agreement and Section 4.2 of the Pooling Agreement is true and correct and (ii) which, on each date after the related Purchase Date, satisfies all of the criteria set forth in Sections 4.1(d), 4.1(e), 4.2(a) through 4.2(f), 4.2(h) and 4.2(i) of the related Sale and Servicing Agreement and Sections 4.2(a) through (h), 4.2(j) and 4.2(k) of the Pooling Agreement, (c) as to which every covenant of the Hospital under the Sale and Servicing Agreement shall have been complied with in all material respects, (d) which is not an Uncollectible Receivable, (e) the Obligor of which is located in the United States and is not an affiliate of UHS, (f) which is denominated and payable in United States Dollars in the United States, (g) which is in full force and effect and constitutes the legal, valid and binding obligation of the Obligor in accordance with its terms, (h) which is not subject to any dispute, counterclaim or defense, or any offset other or greater than the Applicable Contractual Adjustment, (i) which is not an Excluded Receivable, (j) which is not a Receivable as to which the Obligor thereof has a guarantee thereof, a letter of credit providing credit support therefor or collateral security therefor unless such guarantee, letter of credit or collateral security shall have been assigned to Finco and the Interested Parties and such guarantee, letter of credit or collateral security is not to Finco's knowledge subject to any Lien in favor of any other Person and (k) which, as of the Payment Date, arose under an invoice (i) delivered to the Obligor within [15] days after the date of discharge of the patient to whose account such Receivable related and (ii) with respect to which the goods or services billed under such invoice were not previously billed to any other third party payor. ERISA: The Employee Retirement Income Security Act of 1974, as amended. Eurocurrency Liabilities: As defined in Regulation D of the Board of governors of the Federal Reserve System, as in effect from time to time. Eurodollar Disruption Event: With respect to any Sheffield Tranche for any Fixed Period, any of the following: (i) a determination by Sheffield that it would be contrary to law or to the directive of any central bank or other Governmental Authority (whether or not having the force of law) to obtain United States Dollars in the London interbank market for the acquisition or maintenance of such Sheffield Tranche for such Fixed Period, (ii) the failure of the Barclays to furnish timely information for purposes of determining the Adjusted Eurodollar Rate, (iii) a determination by Sheffield that the rate at which deposits of United States Dollars are being offered to Sheffield in the London interbank market does not accurately reflect the cost to Sheffield of funding its acquisition or maintenance of such Sheffield Tranche for such Fixed Period or (iv) the inability of Sheffield to obtain United States Dollars in the London interbank market to fund its acquisition of such Sheffield Tranche for such Fixed Period. Eurodollar Reserve Percentage: For any Fixed Period for any Sheffield Tranche, the reserve percentage applicable during such Fixed Period (or, if more than one such percentage shall be so applicable, the daily average of such percentages for those days in such Fixed Period during which any such percentage shall be so applicable) under regulations issued from time to time by the Board of Governors of the Federal Reserve System (or any successor) for determining the maximum reserve requirement (including, without limitation, any emergency, supplemental or other marginal reserve requirement) for Barclays with respect to liabilities or assets consisting of or including Eurocurrency Liabilities having a term equal to such Fixed Period. Exchange Act: The Securities Exchange Act of 1934, as amended from time to time. Excluded Hospital: Any Hospital as to which an Exclusion Event has occurred and as to which Finco has exercised the remedies available to it under Section 6.3(a) of the related Sale and Servicing Agreement. Excluded Receivable: Any Receivable purchased from an Excluded Hospital as to which Finco has exercised on the related Purchase Date its non- exclusive remedy, under Section 6.3(a)(ii) of the related Sale and Servicing Agreement, that no such Purchased Receivable shall be an Eligible Receivable. Exclusion Event: As defined in Section 6.1 of each Sale and Servicing Agreement. Expense Sub-account: A sub-account of the Collateral Account established pursuant to Section 7.1(a) of the Pooling Agreement. Face Amount: With respect to the Commercial Paper Notes, the face amount of any Commercial Paper Note issued on a discount basis and the principal amount of, plus the amount of all interest stated to accrue thereon to the stated maturity date of, any Commercial Paper Note issued on an interest-bearing basis and, with respect to any TRIP, the principal amount of such TRIP. Fee/Expense Reserves: At any date of determination, (a) (i) 105% of the amount of all liabilities of Finco (other than any Capital of or Yield on the Participations) accrued as of such date pursuant to the Operative Documents, including, without limitation, liabilities in respect of the Servicing Fee and all other liabilities included in the calculation of the Monthly Program Expense Amount, the Monthly Sheffield Expense Amount and the Monthly TRIPs Expense Amount minus (ii) the amount on deposit in the Expense Sub-account on such date plus (without duplication) (b) 105% of the amount budgeted to accrue in respect of such liabilities during a period equal to the Average Financible Turnover Period. Final Sheffield Maturity Date: The Transfer Date occurring 12 months after the Sheffield Termination Date. Final TRIPs Maturity Date: The Transfer Date occurring 12 months after the TRIPs Termination Date. Financible Pool Balance: At any date of determination, (a) the Outstanding Balance of all Financible Receivables in the Receivables Pool minus (b) the Offset Reserves and minus (c) the Concentration Limit Excess. Financible Receivables: At any time, all Eligible Receivables, other than all Deleted Receivables. Finco Documents: The collective reference to the Sale and Servicing Agreements, the Servicing Agreement, the Pooling Agreement, the Security Filings in favor of the Trustee and any other agreement or instrument related to any of the foregoing. Finco Transferred Property: All of Finco's right, title and interest in and to the Assigned Agreements and any documents or instruments delivered in connection therewith. Finco: UHS Receivables Corp., a Delaware corporation. Fixed Period: For any Sheffield Tranche, (i) if Sheffield Yield in respect thereof is computed by reference to the CP Rate, a period of 1 to and including 120 days, (ii) if Sheffield Yield in respect thereof is computed by reference to the Adjusted Eurodollar Rate, a period of one, two or three months and (iii) if Sheffield Yield in respect thereof is computed at the Base Rate, a period of 1 to and including 30 days. GAAP: Generally accepted accounting principles in effect from time to time in the United States. Governmental Authority: Any nation or government, any state or other political subdivision thereof and any entity exercising executive, legislative, judicial, regulatory or administrative functions of or pertaining to government. Governmental Receivables: With respect to each Hospital, the Receivables of such Hospital which, consistent with UHS's past accounting practice, are initially classified as (i) Medicare Receivables, (ii) Medicaid Receivables or (iii) Champus Receivables. Guarantee: As defined on the first page hereof. Guaranteed Parties: The collective reference to the Hospitals and UHS Delaware. HCFA: The Health Care Finance Administration, a division of HHS, and any successor thereof. HHS: The United States Department of Health and Human Services, or the Secretary thereof, as the context may require, and successors thereof. Hospital: any hospital or other health care institution which enters into a Sale and Servicing Agreement with Finco, initially as listed on Exhibit A hereto. Hospital Concentration Account: The account or sub-account maintained by each Hospital in the name of such Hospital in accordance with the terms of Section 5.5 of the respective Sale and Servicing Agreements. Hospital Documents: The collective reference, as to each Hospital, to the related Sale and Servicing Agreement, the Security Filings executed on behalf of the Hospital in favor of Finco and the Trustee, and any other agreement or instrument related to any of the foregoing. Hospital Repurchase Price: With respect to any Receivable, the Purchase Price of such Receivable less any amounts collected or received by Finco with respect to such Receivable plus interest at the rate equal to the Base Rate plus 1% on the Purchase Price from the Purchase Date of such Receivable to the Repurchase Date. Increase: As defined in Section 2.6 of the Pooling Agreement. Increase Amount: The amount designated as the Increase Amount in the notice delivered by Finco pursuant to Section 2.6 of the Pooling Agreement and paid to Finco by Sheffield on any Business Day in payment for any Increase. Indemnified Amounts: As defined pursuant to each related Operative Document. Initial Closing Date: The date on which all conditions precedent contained in the Conditions List are first satisfied or waived. Initial Sheffield Capital: The amount specified as the Initial Sheffield Capital in the notice delivered to Sheffield by Finco, and paid to Finco by Sheffield on the Initial Closing Date in respect of the Initial Sheffield Purchase, pursuant to Section 2.5(a) of the Pooling Agreement. Initial Sheffield Purchase: As defined in Section 2.5(a) of the Pooling Agreement. Initial TRIPs Capital: The amount paid to Finco on the TRIPs Closing Date by all TRIPs Holders in respect of their purchases of the TRIPs Participations pursuant to Section 2.5(b) of the Pooling Agreement. Insolvency: With respect to any Multiemployer Plan, the condition that such Plan is insolvent within the meaning of Section 4245 of ERISA. Insolvent: Pertaining to a condition of Insolvency. Interested Parties: The collective reference to the Participants, the Trustee, the Liquidity Agent and the Program Bank. Investment Company Act: The Investment Company Act of 1940, as amended from time to time. JCAHO: The Joint Commission on the Accreditation of Healthcare Organizations, and any successor thereto. Lenders: The collective reference to the Liquidity Agent, the Liquidity Banks, the Program Bank, Barclays (in its capacity as lender under the Stub Loan) and their respective successors. Lien: Any lien, mortgage, security interest, pledge, charge, equity, encumbrance or right of any kind whatsoever. Liquidation Date: The earlier to occur of (a) the fifteenth day preceding the Scheduled Liquidity Commitment Termination Date (as defined in the Liquidity Agreement) and (b) the date of the termination in whole of the commitments of the Liquidity Banks under the Liquidity Agreement. Liquidity Agent: Barclays, in its capacity as Liquidity Agent under the Liquidity Agreement, and its successors in such capacity. Liquidity Agreement: The Liquidity Agreement, dated as of November 16, 1993, among Sheffield, the Liquidity Agent and the Liquidity Banks, as the same may be amended, supplemented or otherwise modified from time to time. Liquidity Bank: Each bank or other financial institution providing liquidity support for the Sheffield Participation pursuant to the Liquidity Agreement. Liquidity Loan: An advance made by the Liquidity Banks to Sheffield pursuant to the Liquidity Agreement in order to pay maturing Commercial Paper or maintain the level of the Sheffield Participation. Loans: The collective reference to Liquidity Loans, Program Loans and Stub Loans. Loss Factor: For any Settlement Period, the percentage equivalent of the greater of (a) .15 and (b) three times the average Loss-to-Liquidation Ratio for the three immediately preceding Settlement Periods. Loss Reserves: On any date, the product of (a) the Loss Factor and (b) the Aggregate Capital on such date. Loss-to-Liquidation Ratio: With respect to any Settlement Period, the percentage equivalent of a fraction, (a) the numerator of which is the sum of (i) the amount of Receivables which were included as Financible Receivables and which became Uncollectible Receivables during such Settlement Period (including any such Uncollectible Receivables which were repurchased pursuant to Section 4.4 of the applicable Sale and Servicing Agreement) and (ii) the aggregate of the Uncollectible Amounts which arose during such Settlement Period with respect to Receivables which were included as Financible Receivables during such Settlement Period (including any such Uncollectible Amounts reimbursed pursuant to Section 4.4 of the Applicable Sale and Servicing Agreement) and (b) the denominator of which is the aggregate amount of Collections during such Settlement Period. Make-Whole Estimated Amount: An amount equal to the present value, discounted, at an interest rate equal to 1/2 of 1% above the interest rate set forth in H.15(519) on the date the Call Option is exercised as the interest rate on United States Treasury securities having a maturity date of the Scheduled TRIPs Termination Date (such rate, the "Estimated Comparison Rate"), from the period from the Call Date to the Scheduled TRIPs Termination Date, of (a) the TRIPs Capital on such date times (b) the excess of (i) the TRIPs Yield Rate over (ii) the Estimated Comparison Rate. Make-Whole Payment Amount: With respect to any repayment of TRIPs Capital on any Transfer Date following the Call Date, an amount equal to the present value, discounted in accordance with standard financial practices, at an interest rate equal to 1/2 of 1% above the interest rate set forth in the Federal Reserve Board publication H.15(519) on the last day of the immediately preceding Settlement Period as the interest rate on United States Treasury securities having a maturity date of the Scheduled TRIPs Termination Date or determined by linear interpolation therefrom (such rate, the "Actual Comparison Rate"), from the period from such Transfer Date to the Scheduled TRIPs Termination Date, of (a) the TRIPs Capital being repaid on such date times (b) the excess of (i) the TRIPs Yield Rate over (ii) the Actual Comparison Rate. Managing Agent: Barclays, in its capacity as managing agent or administrative agent for Sheffield. Master Receivables Account: As defined in Section 3.7 of the Servicing Agreement. Maximum Aggregate Capital. $85,000,000. Maximum Sheffield Capital: $25,000,000, as such amount may be increased from time to time in accordance with Section 2.13 of the Pooling Agreement. Maximum TRIPs Capital: $50,000,000. Medicaid: In any state, the hospital insurance program created by that state's statutes in accordance with Title XIX of the Social Security Act. Medicaid Receivable: With respect to any state, a Receivable of which the Obligor is the state and, to the extent provided by law, the United States, acting through the state Medicaid agency, and which arises out of charges properly reimbursable to a Hospital under Medicaid. Medicare: The hospital insurance program created by Part A of Title XVIII of the Social Security Act. Medicare Receivable: A Receivable of which the Obligor is the United States and which arises out of charges reimbursable to a Hospital under Medicare. Monthly Program Expense Amount: With respect to each Settlement Period, the following fees and expenses payable by Finco during such Settlement Period and to be paid pursuant to Section 7.3(a) of the Pooling Agreement on the subsequent Transfer Date: (i) the Servicing Fee; (iv) all Indemnified Amounts; and (v) all other fees (all of which fees shall have been agreed to by Finco prior to the Initial Closing Date), costs, expenses and indemnities payable by Finco, the Participants or any other party to the Operative Documents other than those fees, costs and expenses to be payable out of the Servicing Fee or included in the Monthly Sheffield Expense Amount or the Monthly TRIPs Expense Amount. Monthly Sheffield Expense Amount: With respect to each Settlement Period, all fees (all of which fees shall have been agreed to by Finco prior to the Initial Closing Date) and expenses payable by Finco during such Settlement Period (other than Sheffield Yield) solely in connection with the issuance and administration of the Commercial Paper Notes, including all commitment fees and other fees payable by Sheffield to the Liquidity Agent, the Liquidity Banks, the Program Bank and Barclays under the Liquidity Agreement, the Program Loan Agreement and any Stub Loan and all fees and expenses set forth in the letter dated the date hereof among Finco, UHS, Sheffield and the Placement Agent. Monthly TRIPs Expense Amount: With respect to each Settlement Period, all fees (which fees shall be specified in writing prior to the TRIPs Closing Date) and expenses payable by Finco during such Settlement Period (other than TRIPs Yield) solely in connection with the issuance and administration of the TRIPs. Moody's: Moody's Investors Service, Inc., and any successor thereof. Multiemployer Plan: A Plan which is a multiemployer plan as defined in Section 4001(a)(3) of ERISA. Non-governmental Receivables: With respect to each Hospital, the Receivables of such Hospital, other than Governmental Receivables, together with any and all rights to receive payments due thereon, and all proceeds thereof in any way derived, whether directly or indirectly. Non-qualifying Receivable: Any Receivable as to which any representation or warranty set forth in Section 4.1(d) or (e) or 4.2 of the related Sale and Servicing Agreement is not true and correct on the related Purchase Date. Notice of Assignment: Each notice of assignment delivered by or on behalf of any Hospital to any insurer or third party intermediary that is an Obligor on such Hospital's Receivables pursuant to the Conditions List and Section 5.3 of the Pooling Agreement, which notice of assignment shall notify such Obligor of the assignment of the Permitted Interests and, to the extent required by Section 5.3 of the Pooling Agreement, request such Obligor to consent to such assignment. Notice Review Date: The date 90 days after the Initial Closing Date or such other date determined pursuant to Section 5.3(b) of the Pooling Agreement. Obligations: As defined in Paragraph 1 of the Guarantee. Obligor: Each Person who is indebted on a Receivable. Offset Reserves: On any date, the sum of (a) $1,000,000, (b) an amount determined as of the last day of the preceding Settlement Period to be equal to the unpaid portion, as reflected in all audited periodic cost reports filed by all Hospitals with the appropriate state and federal Governmental Authorities under the applicable Medicaid programs and with HCFA under Medicare, of the amount payable by all Hospitals for which cost reports indicate amounts payable to such governmental authorities and (c) an additional amount, if greater than zero, determined as of the date of completion of all audits of all periodic cost reports filed during the preceding fiscal year of UHS for all UHS Entities to be equal to (i) the greater of (A) 1.5 times the highest amount (rounded to the nearest $1,000,000) payable to such Governmental Authorities and reflected in the past three annual audited cost reports of all Hospitals for which audits determined amounts to be payable to such Governmental Authorities and (B) three times the amount payable to such Governmental Authorities and reflected in the most recent audited cost reports of all Hospitals for which audits determined amounts to be payable to such governmental authorities minus (ii) an amount equal to the aggregate Collections received in respect of Self-Pay Receivables during the period of two Consecutive Settlement Periods occurring in the fiscal year immediately preceding such date of determination for which such aggregate Collections were the lowest. Operative Documents: The collective reference to the Hospital Documents, the Sheffield Documents, the Finco Documents, the Servicing Agreement, the Guarantee and any other agreement or instrument related to any of the foregoing. Other Accounts: As defined in Section 7.1(d) of the Pooling Agreement. Other Blue Cross/Blue Shield: At any time of reference, individually, an Obligor that is a blue cross or blue shield entity and is not a Preferred Blue Cross/Blue Shield. Other Insurer/HMO/PPO: At any time of reference, individually, a commercial insurer, health maintenance organization, primary pay organization or similar entity (excluding Blue Cross/Blue Shield) which is not a Preferred Insurer/HMO/PPO. Outstanding: At any time, (a) with respect to any Commercial Paper Note, each Commercial Paper Note authenticated and issued by Sheffield, other than (i) each Commercial Paper Note paid upon or following its maturity as provided in such Commercial Paper Note, and (ii) each Commercial Paper Note as to which funds for payment have been deposited with any depositary or paying agent with respect thereto and are not subject to any Lien, (b) with respect to any of the TRIPs, each TRIP authenticated and issued pursuant to the Pooling Agreement, other than each TRIP paid upon, prior to or following its maturity as provided in accordance with its terms and (c) with respect to any Loan, each advance made by any Lender, other than any such advance paid upon, prior to or following its maturity as provided in accordance with its terms. Outstanding Balance: With respect to any Receivable as of any time of determination, (i) the net amount of such Receivable as calculated by the Hospital in accordance with its normal and reasonable billing procedures, after deduction for any contractual or similar allowance or write-off determined based on payor class of Obligor, including the Applicable Contractual Adjustment (or, if determined, the Actual Contractual Adjustment) applicable to such Receivable, minus (ii) all Uncollectible Amounts in respect of such Receivable and minus (iii) Collections received by the Hospital in respect of such Receivable. It is understood that the Outstanding Balance of an Uncollectible Receivable is $0. Outstanding Receivable: With respect to any Receivable as of any time of reference, a Receivable that has not been fully paid, has not become an Uncollectible Receivable or has not been repurchased pursuant to Section 4.4 of the related Sale and Servicing Agreement prior to such time of reference. Participants: The TRIPs Holders (if any) and Sheffield, collectively, as transferees of the Participations pursuant to the Pooling Agreement. Participation: As defined in Section 2.4 of the Pooling Agreement. Payment Date: With respect to any Purchased Receivable, one Business Day following the earlier to occur of (a) the date on which the invoice relating to such Purchased Receivable is sent to the Obligor and (b) the date of discharge of the patient to whose account such Receivable relates. PBGC: The Pension Benefit Guarantee Corporation established pursuant to Subtitle A of title IV of ERISA. Permitted Interests: All rights granted (a) by the Hospitals to Finco pursuant to the Sale and Servicing Agreements and (b) to the Interested Parties pursuant to the Pooling Agreement and the Security Agreement. Permitted Investments: (a) Direct obligations of, or obligations the principal of and interest on which are unconditionally guaranteed by, the full faith and credit of the United States of America (including obligations issued or held in book-entry form on the books of the Department of the Treasury of the United States of America); (b) commercial or finance paper or other similar obligations rated at the time of purchase A-1+ or better by S&P and P-1 or VMIG-1 by Moody's; (c) interest-bearing demand or time deposits (including certificates of deposit) in any issuing bank or trust company rated A-1+ by S&P and P-1 by Moody's and secured at all times, in the manner and to the extent provided by law, by collateral security (described in clause (a) of this definition) of a market value (valued at least quarterly) of no less than the amount of money so invested; (d) negotiable or non-negotiable certificates of deposit, time deposits or other similar banking arrangements issued by any bank or trust company, having the highest short-term rating by S&P and Moody's or fully insured by the Federal Deposit Insurance Corporation; (e) any money market fund having the highest fund rating by S&P and Moody's and the funds of which are invested only in any of the above (including, without limitation, such mutual funds as are offered by the Person who is acting as Trustee or any agent of such Person). Person: An individual, a partnership, a corporation, a business trust, a joint stock company, a trust, an unincorporated association, a joint venture, a Governmental Authority or other entity of whatever nature. Plan: With respect to a particular Person at a particular time, any employee benefit plan which is covered by ERISA and in respect of which such Person or a Commonly Controlled Entity is (or, if such plan were terminated at such time, would under Section 4069 of ERISA be deemed to be) an "employer" as defined in Section 3(5) of ERISA. Pooling Agreement: The Pooling Agreement, as defined on the first page hereof. Preferred Blue Cross/Blue Shield: At any time of reference, individually, any Obligor that is a blue cross or blue shield organization rated at least "A" by S&P and Moody's. Preferred Insurer/HMO/PPO: At any time of reference, individually, any Obligor which is a commercial insurer, health maintenance organization, primary pay organization or similar entity (excluding Blue Cross/Blue Shield) and which is rated at least "A" by S&P and Moody's. Principal Pay-Down: With respect to any Commercial Paper Notes or Loans maturing on any Business Day, the excess of (a) the sum of (i) the Face Amount of such Commercial Paper Notes or principal amount of such Loans, as the case may be, and (ii) all accrued and unpaid Sheffield Yield (except to the extent included in the Face Amount of the applicable Commercial Paper Note) with respect to such Commercial Paper Notes or Loans over (b) the sum of (x) the net proceeds from the sale of any Commercial Paper Notes (after deduction of all fees payable to any issuing and paying agent or commercial paper dealer in connection therewith) or the incurrence of Loans on such Business Day and (y) the amount on deposit in the Sheffield Payment Account on such Business Day. Program Bank: Barclays, in its capacity as Program Bank under the Program Loan Agreement, and its successors in such capacity. Program Loan: An advance made by the Program Bank to Sheffield pursuant to the Program Loan Agreement in order to pay maturing Commercial Paper. Program Loan Agreement: The Irrevocable Program Loan Agreement, dated as of December 12, 1991, between Sheffield and the Program Bank, as the same may be amended, supplemented or otherwise modified from time to time. Prohibited Transaction: The meaning assigned to that term in Section 4975 of the Code. Purchase Date: Each date (commencing with the Initial Closing Date) on which any Receivable is purchased by Finco pursuant to the terms of any Sale and Servicing Agreement. Purchase Price: With respect to any Receivable to be purchased on any Purchase Date, an amount equal to (a) the aggregate Outstanding Balance of such Receivable minus (b) the Cost of Funds. Purchased Receivables: The Receivables, including any Receivables that have become Uncollectible Receivables, purchased by Finco from all Hospitals pursuant to all Sale and Servicing Agreements and not repurchased by the applicable Hospital in accordance with the terms thereof. Rating Agency: Initially, S&P and Moody's, and thereafter, any other such agency or agencies then rating the Commercial Paper Notes at the request of Sheffield or the TRIPs at the request of the TRIPs Holders. Receivables: With respect to each Hospital, the patient accounts existing or hereafter created of that Hospital (including, without limitation, Self-pay Receivables), any and all rights to receive payments due on such accounts from any Obligor or other third-party payor under or in respect of such accounts (including without limitation all insurance companies, Blue Cross/Blue Shield, Medicare, Medicaid, Champus, Workers' Compensation and health maintenance organizations and primary pay organizations) and all proceeds of, or in any way derived, whether directly or indirectly, from any of the foregoing. Receivables Information: Any information provided in writing by an Authorized Officer of any Hospital, Finco, UHS or UHS Delaware to any Interested Party. Receivables Pool: At any date of determination, all Purchased Receivables with an Outstanding Balance, less all Receivables repurchased pursuant to Section 4.4 of any Sale and Servicing Agreement. Record Date: With respect to each Transfer Date, the date occurring five Business Days prior to such Transfer Date. Reference Rate: With respect to each Sheffield Tranche for the relevant Fixed Period, an interest rate per annum determined by Barclays equal to the quotient of (a) the rate at which it would offer deposits in United States dollars to prime banks in the London interbank market for a period equal to such Fixed Period and in a principal amount of not less than $1,000,000 at or about 11:00 A.M. (London time) on the second Business Day before (and for value on) the first day of such Fixed Period divided by (b) one minus the Eurodollar Reserve Percentage (expressed as a decimal) applicable to Barclays for such Fixed Period. Reorganization: With respect to any Multiemployer Plan, the condition that such plan is in reorganization within the meaning of Section 4241 of ERISA. Reportable Event: Any of the events set forth in Section 4043(b) of ERISA, other than those events as to which the thirty day notice period is waived under subsections .13, .14, .16, .18, .19 or .20 of PBGC Reg. Section 2615. Repurchase Date: Any date on which Non-qualifying Receivables are to be purchased by a Hospital in accordance with Section 4.4 of each Sale and Servicing Agreement. Required Coverage Amount: On any date of determination, an amount equal to (a) the sum of (i) the TRIPs Capital on such date, (ii) the Sheffield Capital on such date and (iii) the principal amount of all Loans Outstanding on such date plus (b) the Loss Reserves plus (c) the Yield Reserves plus (d) the Fee/Expense Reserves plus (e) the Make-Whole Estimated Amount minus (f) the Sheffield Retained Funds and minus (g) the TRIPs Make-Whole Funds; provided, however, that during the TRIPs Amortization Period or the Sheffield Amortization Period, (i) the Required Coverage Amount shall be reduced by the amount of all funds in any Other Account (other than funds to be used for the payment of Yield or the Make Whole Payment Amount) and (ii) for purposes of calculating any of the reserves set forth in clauses (b), (c) and (f) above, the TRIPs Capital or Sheffield Capital, as the case may be, on the last day of the applicable Revolving Period, rather than the Capital on the date of calculation, shall be used to make the related reserve calculation. Required Participants: At any time, Participants holding Participations aggregating more than 50% of the Aggregate Capital at such time. Required TRIPs Holders: At any time, TRIPs Holders holding TRIPs Participations aggregating more than 50% of the TRIPs Capital at such time. Requirement of Law: As to any Person, (i) the Certificate of Incorporation and By-laws, corporation agreement or other organizational or governing documents of such Person, and (ii) any law, treaty, rule or regulation, or determination of an arbitrator or a court, in each case applicable to or binding upon such Person or any of its property or to which such Person or any of its property is subject. Revolving Period: The TRIPs Revolving Period or the Sheffield Revolving Period, as the context requires. S&P: Standard & Poor's Corporation, and any successor thereof. Sale and Servicing Agreement: Each Sale and Servicing Agreement, as defined on the first page hereof. Scheduled Sheffield Termination Date: ________, 1998, as such date may be extended pursuant to Section 2.13 of the Pooling Agreement. Scheduled TRIPs Termination Date: The date designated in writing by Finco as the Scheduled TRIPs Termination Date in its notice to Sheffield and the Trustee pursuant to Section 2.5(b) of the Pooling Agreement. Securities Act: The Securities Act of 1933, as amended from time to time. Security Agreement: The Security Agreement, dated as of November 16, 1993, between Sheffield and the Liquidity Agent. Security Filings: All filings and recordations (including, without limitation, those filings pursuant to the UCC in effect in the State in which any Hospital's chief executive office is located), and, subject to Section 5.3 of the Pooling Agreement and the Conditions List, all Notices of Assignments and Confirmations, which are required to be made to perfect (i) the interest of Finco and its assignees in the Purchased Receivables and other Transferred Property, (ii) the interest of the Trustee and the Participants in the Trust Assets and (iii) the interest of the Liquidity Agent and the Liquidity Banks in Sheffield's right, title and interest in and to the Trust Assets. Self-pay Receivable: That portion of any patient account under which the primary obligation to pay for any services rendered under such account is solely and directly that of the patient or a guarantor of such patient's account who is a natural person. Servicer: UHS Delaware, in its capacity as servicer of the Receivables, and any successor under the Servicing Agreement. Servicer Daily Statement: As defined in Section 3.5 of the Servicing Agreement. Servicer Incumbency Certificate: A certificate as to the incumbency and specimen signatures of the Servicing Agents. Servicer Termination Notice: The notice delivered by Finco pursuant to Section 4.2 of the Servicing Agreement terminating all rights and obligations of the Servicer. Servicer's Certificate: The Certificate required to be delivered by the Servicer to Sheffield and the Trustee pursuant to Section 3.2 of the Servicing Agreement. Servicing Agent: Any Secretary or Assistant Secretary of the Servicer, or any other person authorized to act, and to give instructions and notices on behalf of the Servicer under the Servicing Agreement whose name and specimen signature appears on a Servicer Incumbency Certificate signed by any Secretary or Assistant Secretary thereof and delivered to Sheffield and the Trustee. Such Servicing Agents may be designated from time to time by the Servicer. Servicing Agreement: The Servicing Agreement, as defined on the first page hereof. Servicing Fee: The fee set forth in Section 3.1 of the Servicing Agreement. Settlement Date: The date during each month occurring two Business Days prior to the Transfer Date. Settlement Date Statement: The statement required to be delivered by the Servicer, on or before each Settlement Date, pursuant to Section 3.3 of the Servicing Agreement. Settlement Period: The period from the first day of a month (or, in the case of the month in which the Initial Closing Date occurs, the period from the Initial Closing Date) through and including the last day of that month. Sheffield: Sheffield Receivables Corporation, a Delaware corporation. Sheffield Amortization Period: The period commencing on the Sheffield Termination Date and ending on the earliest to occur of (a) the date on which the Sheffield Capital is reduced to zero, (b) the date on which the Outstanding Balance of Purchased Receivables is reduced to zero and (c) the Final Sheffield Maturity Date. Sheffield Bankruptcy Event: Any of the following events: (a) Sheffield shall have made a general assignment for the benefit of creditors; (b) any proceeding shall have been instituted by or against Sheffield seeking to adjudicate it a bankrupt or insolvent, or seeking liquidation, winding up, reorganization, arrangement, adjustment, protection, relief or composition of it or its debts under any law relating to bankruptcy, insolvency or reorganization or relief of debtors, or seeking the entry of an order for relief or the appointment of a receiver, trustee, custodian or other similar official for it or for any substantial part of its property and, in the case of any proceeding against it (but not instituted by it), either such proceeding shall remain unstayed or undismissed for a period of 60 days, or any of the actions sought in such proceeding (including, without limitation, the entry of an order for relief against, or the appointment of a receiver, trustee, custodian or similar official for, it or for any substantial part of its property) shall occur; or (c) Sheffield shall take any corporate action to authorize any of the foregoing actions. Sheffield Capital: With respect to the Sheffield Participation, (a) the Initial Sheffield Capital plus (b) each Increase Amount minus (c) funds received and distributed to Sheffield on account of such Sheffield Capital pursuant to Section 7.4 of the Pooling Agreement; provided, however, that such Sheffield Capital shall not be reduced by any distribution of any portion of Collections if at any time such distribution is rescinded or must be returned for any reason. Sheffield Documents: The Commercial Paper Notes, the Pooling Agreement, the Liquidity Agreement, the Program Loan Agreement, the Security Agreement, the Security Filings executed by Sheffield in favor of the Liquidity Agent and any other agreement or instrument related to any of the foregoing. Sheffield Interest Sub-account: A sub-account of the Sheffield Sub- account established pursuant to Section 7.1(a) of the Pooling Agreement. Sheffield Participation: A senior undivided participating interest in the Trust Assets acquired by Sheffield from Finco pursuant to the terms and conditions of the Pooling Agreement. Sheffield Payment Account: As defined in Section 7.1(c) of the Pooling Agreement. Sheffield Percentage: On any Business Day, the percentage equivalent of a fraction, the numerator of which is the Allocable Sheffield Capital and the denominator of which is the sum of the (i) the Allocable Sheffield Capital and (ii) the Allocable TRIPs Capital. Sheffield Retained Funds: On any date, the aggregate amount of funds in the Sheffield Sub-account on such date which have been retained in such sub-account pursuant to Section 7.2(b)(iv) of the Pooling Agreement. Sheffield Revolving Period: The period commencing on the Initial Closing Date and ending on the Sheffield Termination Date. Sheffield Sub-account: A sub-account of the Collateral Account established pursuant to Section 7.1(a) of the Pooling Agreement. Sheffield Termination Date: The earliest to occur of (a) the Scheduled Sheffield Termination date, (b) the occurrence of an Early Amortization Event (i) described in Section 10.1(f) of the Pooling Agreement or (ii) declared by Sheffield pursuant to Section 10.2 of the Pooling Agreement, (c) the date which occurs three days after the occurrence of any Early Amortization Event described in Section 10.1(o) through (r) of the Pooling Agreement and (d) the date on which Sheffield gives written notice to Finco and the Trustees of the occurrence of (i) the Liquidation Date or (ii) a Sheffield Bankruptcy Event. Sheffield Termination Sale Amount: With respect to any sale of Receivables or interests therein pursuant to Section 14.1(a) of the Pooling Agreement, the product of (a) the sum of (i) $7,500,000 and (ii) (A) one plus the Loss Factor times (B) the Outstanding Balance of Purchased Receivables on such date and (b) the Sheffield Percentage. Sheffield Tranche: Any portion of the Sheffield Capital, as designated by Finco and approved by Sheffield pursuant to Section 2.5, 2.6 or 2.10 of the Pooling Agreement, with respect to which Sheffield Yield is calculated by reference to a specified Sheffield Yield Rate and Fixed Period. Sheffield Yield: With respect to a Sheffield Tranche for any Fixed Period, the product of (a) the Sheffield Yield Rate divided by 365, (b) the portion of the Sheffield Capital allocable to such Sheffield Tranche and (c) the number of days elapsed in such Fixed Period. Sheffield Yield Factor Amount: For any Business Day, (a) (i) the Average Financible Turnover Period plus 10 divided by (ii) 360 times (b) the Base Rate times (c) the Sheffield Capital on such Business Day. Sheffield Yield Rate: For any Fixed Period with respect to a Sheffield Tranche, (a) to the extent Sheffield will fund such Sheffield Tranche through the issuance of Commercial Paper Notes, the CP Rate and (b) to the extent that Sheffield will fund such Sheffield Tranche through the incurrence of Loans, the Alternative Rate. Single Employer Plan: Any Plan which is covered by Title IV of ERISA, but which is not a Multiemployer Plan. Social Security Act: The Social Security Act of 1935, 42 U.S.C. Sections 401 et seq., as the same may be amended, supplemented or otherwise modified from time to time. Statement Delivery Day: As defined in Section 3.5(b) of the Servicing Agreement. Stub Loan: An advance, other than a Liquidity Loan or a Program Loan, made by Barclays to Sheffield, the proceeds of which are used to maintain the Sheffield Participation. Subordinated Interest: As defined in Section 2.9 of the Pooling Agreement. Subordinated Note: A subordinated promissory note, substantially in the form of Exhibit A to any Sale and Servicing Agreement, executed by Finco in favor of the Hospital party to such Sale and Servicing Agreement. Subsidiary: As to any Person, a corporation, partnership or other entity of which shares of stock or other ownership interests having ordinary voting power (other than stock or such other ownership interests having such voting power only by reason of the happening of a contingency) to elect a majority of the board of directors or other managers of such corporation, partnership or other entity are at the time owned, or the management of which is otherwise controlled directly or indirectly through one or more intermediaries, or both, by such Person. Successor Servicer: Any successor servicer as defined pursuant to Section 4.4 of the Servicing Agreement. Taxes: As defined in Section 2.12 of the Pooling Agreement. Total Transferred Property: The collective reference to the Transferred Property and the Finco Transferred Property. Transfer Agent and Registrar: As defined in Section 9.3 of the Pooling Agreement. Transfer Date: The 15th calendar day of each month, or if such day is not a Business Day, the subsequent Business Day, commencing December 15, 1993. Transferred Property: The Purchased Receivables and, subject to confidentiality rights under applicable laws and regulations and under the rules of JCAHO or AOA, as the case may be, all now existing or hereafter arising instruments, documents, agreements, books and records relating to the foregoing. TRIPs: The Trade Receivables Investment Participations, substantially in the form of Exhibit A to the Pooling Agreement, issued by the Trust to the TRIPs Holders pursuant to the Pooling Agreement. TRIPs Amortization Period: The period commencing on the Business Day following the TRIPs Termination Date and ending on the earliest to occur of (a) the date on which the TRIPs Capital is reduced to zero, (b) the date on which the Outstanding Balance of Purchased Receivables is reduced to zero and (c) the Final TRIPs Maturity Date. TRIPs Capital: With respect to the TRIPs Participations, the Initial TRIPs Capital, as reduced from time to time by Collections received and distributed on account of the TRIPs Capital pursuant to Section 7.5 of the Pooling Agreement; provided, however, that the TRIPs Capital shall not be reduced by any distribution of any portion of Collections if at any time such distribution is rescinded or must be returned for any reason. TRIPs Closing Date: Any date after the Initial Closing Date on which all applicable conditions precedent required by Section 3.1 of the Pooling Agreement with respect to such date are satisfied or waived. TRIPs Holders: The holders from time to time of the Outstanding TRIPs. TRIPs Interest Default: The occurrence on any Transfer Date of an excess of (a) the TRIPs Yield payable on such Transfer Date over (b) the amount of funds on deposit in the TRIPs Interest Sub-account on such Transfer Date. TRIPs Interest Sub-account: A sub-account of the TRIPs Sub-account established pursuant to Section 7.1(a) of the Pooling Agreement. TRIPs Make-Whole Funds: On any date, the aggregate amount of funds in the TRIPs Interest Sub-Account on such date which have been deposited in such sub-account pursuant to Section 7.2(c)(iv) of the Pooling Agreement. TRIPs Participation: The aggregate senior undivided participating interest in the Trust Assets acquired by any TRIPs Holder from Finco pursuant to the terms and conditions of the Pooling Agreement and evidenced by a TRIP; collectively, the "TRIPs Participations". TRIPs Payment Account: As defined in Section 7.1(d) of the Pooling Agreement. TRIPs Percentage: On any Business Day, the percentage equivalent of a fraction, the numerator of which is the Allocable TRIPs Capital and the denominator of which is the sum of (i) the Allocable TRIPs Capital and (ii) the Allocable Sheffield Capital. TRIPs Register: As defined in Section 9.3 of the Pooling Agreement. TRIPs Revolving Period: The period commencing on the TRIPs Closing Date and ending on the TRIPs Termination Date. TRIPs Sub-account: A sub-account of the Collateral Account established pursuant to Section 7.1(a) of the Pooling Agreement. TRIPs Termination Date: The earliest to occur of (a) the Scheduled TRIPs Termination Date, (b) the Call Date, (c) the occurrence of an Early Amortization Event (i) described in Section 10.1(f) of the Pooling Agreement or (ii) declared by the TRIPs Holders pursuant to Section 10.2 of the Pooling Agreement and (d) the date which is three days after the occurrence of any Early Amortization Event described in Section 10.1(o) through (r) of the Pooling Agreement. TRIPs Termination Sale Amount: With respect to any sale of Receivables or interests therein pursuant to Section 14.1(b) of the Pooling Agreement, the product of (a) the sum of (i) $7,500,000 and (ii) (A) one plus the Loss Factor times (B) the Outstanding Balance of Purchased Receivables on such date and (b) the TRIPs Percentage. TRIPs Yield: With respect to any date, (a) the TRIPs Yield Rate divided by 360 times (b) the TRIPs Capital on such date. TRIPs Yield Factor Amount: On any date of determination, (i) the TRIPs Yield Rate times (ii) (A) the Average Financible Turnover Period plus 10 divided by (B) 360 times (iii) the TRIPs Capital on such date. TRIPs Yield Rate: The rate specified as the TRIPs Yield Rate in the written notice delivered by Finco pursuant to Section 2.5(b) of the Pooling Agreement. Trust: The UHS Healthcare Receivables Trust created by the Pooling Agreement. Trust Assets: As defined in Section 2.1 of the Pooling Agreement. Trust Termination Date: The later to occur of the Final Sheffield Maturity Date and the Final TRIPs Maturity Date. Trustee: Continental, in its capacity as Trustee under the Pooling Agreement, and any successor in such capacity. Trustee Fee: The fees specified in the Trustee Fee Letter. Trustee Fee Letter: The letter agreement among Finco, UHS and the Trustee setting forth the trustee fee. UCC: The Uniform Commercial Code as in effect in the specified jurisdiction or, if no jurisdiction is specified, as in effect in the state whose law, by agreement of the parties, governs the document or agreement in which the term "UCC" or "security interest" appears. UHS: Universal Health Services, Inc., a Delaware corporation. UHS Delaware: UHS of Delaware, Inc., a Delaware corporation. UHS Entities: The collective reference to UHS, the Hospitals, Finco and UHS Delaware. Uncollectible Amount: With respect to each Receivable other than an Uncollectible Receivable, all reductions in the gross amount due under such Receivable other than the lesser of (a) the Applicable Contractual Adjustment and (b) the Actual Contractual Adjustment (including, without limitation, any write-offs and/or reserves taken in relation to such Receivable). Uncollectible Receivable: On any date of determination, any Receivable as to which all amounts due and payable thereunder have not been paid and (a) as to which the Servicer believes, in its good faith judgment, all amounts due thereunder are not or would not be ultimately recoverable or (b) in respect of which more than 180 days have elapsed since the date on which such Receivable was first billed or (c) as to which any Obligor on such Receivable is bankrupt, insolvent, undergoing composition or adjustment of debts or is otherwise unable to make payments on its obligations when due; provided that a Medicaid Receivable (other than a Medicaid Receivable described in clause (a) or (b) above) shall not be deemed to be an Uncollectible Receivable solely because the Obligor on such Medicaid Receivable is currently insolvent if (i) such Obligor would not reasonably be expected to remain insolvent or otherwise unable or unwilling to make payment under such Receivable and (ii) the Servicer has determined in good faith and in accordance with the Credit and Collection Policy that such Medicaid Receivable should not be deemed an Uncollectible Receivable. Voluntary Exclusion Event: With respect to any UHS Entity, such UHS Entity shall contest or deny that it is bound by, or has any or further liability or obligation under, the terms and conditions of any of the Operative Documents to which it is a party provided that a denial of liability by any Hospital and the Sale and Servicing Agreement to which it is a party as a result of (i) the disposition by UHS of such Hospital or (ii) the occurrence of an Exclusion Event of the type described in Section 6.1(d) of such Sale and Servicing Agreement shall not constitute a Voluntary Exclusion Event. Yield: Sheffield Yield or TRIPs Yield, as the context requires. Yield Reserves: On any date, the sum of (i) the portion of all accrued and unpaid Sheffield Yield which is not on deposit in the Sheffield Interest Sub-account on such date plus (ii) the portion of all accrued and unpaid TRIPs Yield which is not on deposit in the TRIPs Interest Sub-account on such date plus (iii) the Sheffield Yield Factor Amount plus (iv) the TRIPs Yield Factor Amount. EXHIBIT A LIST OF HOSPITALS Names and Principal Place of Business of Hospitals Name Principal Place of Business Chalmette General Hospital, Inc. 9001 Patricia Street Chalmette, LA 70043 and 800 Virtue Street Chalmette, LA 70043 Dallas Family Hospital, Inc. 2929 South Hampton Road Dallas, TX 75224 Del Amo Hospital, Inc. 23700 Camino del Sol Torrance, CA 90505 HRI Hospital, Inc. 227 Babcock Street Brookline, NM 02146 La Amistad Residential 201 Alpine Drive Treatment Center, Inc. Maitland, FL 32751 McAllen Medical Center, Inc. 301 West Expressway 83 McAllen, TX 78503 Meridell Achievement Center, Inc. Highway 29 West Liberty Hill, TX 78642 and 2501 Cypress Creek Road Cedar Park, TX 78613 River Oaks, Inc. 1525 River Oaks Road West New Orleans, LA 70123 Sparks Reno Partnership, L.P. 2375 E. Prater Way Sparks, NV 89434 Turning Point Care Center, Inc. 319 East By-Pass Moultrie, GA 31768 UHS of Arkansas, Inc. 21 BridgeWay Road North Little Rock, AR 72118 UHS of Auburn, Inc. 20 Second Street, N.E. Auburn, WA 98002 UHS of Belmont, Inc. 4058 West Melrose Street Chicago, IL 60641 UHS of Massachusetts, Inc. 49 Robinwood Avenue Boston, MA 02130 UHS of River Parishes, Inc. 500 Rue de Sante LaPlace, LA 70068 UHS of Shreveport, Inc. 1130 Louisiana Avenue Shreveport, LA 71101 Universal Health Services 36485 Inland Valley Drive of Inland Valley, Inc. Wildomar, CA 92395 Universal Health Services of 620 Shadow Lane Nevada, Inc. Las Vegas, NV 89106 Victoria Regional Medical 101 Medical Drive Center, Inc. Victoria, TX 77904 Wellington Regional Medical 10101 Forest Hill Blvd. Center Incorporated West Palm Beach, FL 33414 - ------------------------------------------------------------------------------ SERVICING AGREEMENT among UHS RECEIVABLES CORP., UHS OF DELAWARE, INC. as Servicer and CONTINENTAL BANK, NATIONAL ASSOCIATION, as Trustee dated as of November 16, 1993 - ------------------------------------------------------------------------------ Page ARTICLE I DEFINITIONS . . . . . . . . . . . . . . . 2 ARTICLE II REPRESENTATIONS, WARRANTIES AND COVENANTS. . . . . . . . 2 Section 2.1. Representations, Warranties and Covenants of the Servicer . . . . . . . . . . . . . . . . . . . . . . . 2 Section 2.2. Covenants of the Servicer. . . . . . . . . . . . . . . . . 4 ARTICLE III ADMINISTRATION, COLLECTIONS AND OTHER OBLIGATIONS. . . . . . . . . . . . . 8 Section 3.1. Servicing. . . . . . . . . . . . . . . . . . . . . . . . . 8 Section 3.2. Delivery of Settlement Date Statement. . . . . . . . . . . 13 Section 3.3. Settlement Date Statement. . . . . . . . . . . . . . . . . 13 Section 3.4. Record of Collections. . . . . . . . . . . . . . . . . . . 14 Section 3.5. Servicer Daily Statement . . . . . . . . . . . . . . . . . 14 Section 3.6. Deleted Receivables. . . . . . . . . . . . . . . . . . . . 15 Section 3.7. Master Receivables Account . . . . . . . . . . . . . . . . 16 ARTICLE IV EVENTS OF DEFAULT; SERVICING TERMINATION. . . . . . . 17 Section 4.1. Events of Default. . . . . . . . . . . . . . . . . . . . . 17 Section 4.2. Remedies . . . . . . . . . . . . . . . . . . . . . . . . . 18 Section 4.3. Successor Servicer . . . . . . . . . . . . . . . . . . . . 18 Section 4.4. Appointment of Successor . . . . . . . . . . . . . . . . . 19 Section 4.5. Monitoring . . . . . . . . . . . . . . . . . . . . . . . . 20 ARTICLE V MISCELLANEOUS . . . . . . . . . . . . . . 20 Section 5.1. Notices, Etc.. . . . . . . . . . . . . . . . . . . . . . . 20 Page Section 5.2. Successors and Assigns . . . . . . . . . . . . . . . . . . 21 Section 5.3. Severability Clause. . . . . . . . . . . . . . . . . . . . 21 Section 5.4. Amendments . . . . . . . . . . . . . . . . . . . . . . . . 22 Section 5.5. The Servicer's Obligations . . . . . . . . . . . . . . . . 22 Section 5.6. No Recourse. . . . . . . . . . . . . . . . . . . . . . . . 22 Section 5.7. Further Assurances . . . . . . . . . . . . . . . . . . . . 22 Section 5.8. Termination. . . . . . . . . . . . . . . . . . . . . . . . 23 Section 5.9. Consent to Assignment; Third Party Beneficiaries. . . . . . . . . . . . . . . . . . . . . . . 23 Section 5.10. Counterparts. . . . . . . . . . . . . . . . . . . . . . . . 24 Section 5.11. Headings. . . . . . . . . . . . . . . . . . . . . . . . . . 24 Section 5.12. No Bankruptcy Petition. . . . . . . . . . . . . . . . . . . 24 Section 5.13. Servicer May Act Through Agents . . . . . . . . . . . . . . 25 Section 5.14. GOVERNING LAW . . . . . . . . . . . . . . . . . . . . . . . 25 Section 5.15. No Waiver; Cumulative Remedies. . . . . . . . . . . . . . . 25 Section 5.16. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS . . . . . . . . . . . . . . 25 Section 5.17. Indemnification . . . . . . . . . . . . . . . . . . . . . . 26 Schedule I - Document Locations; Servicer's Principal Place of Business; UHS's Principal Place of Business Schedule II - Master Receivables Account Exhibit A - Settlement Date Statement Exhibit B - Servicer's Certificate Exhibit C - Servicer Daily Statement Exhibit D - Form Confidentiality Agreement SERVICING AGREEMENT SERVICING AGREEMENT (this "Agreement"), dated as of November 16, 1993, among UHS Receivables Corp., a Delaware corporation (together with its successors and assigns, "Finco"), UHS of Delaware, Inc., a Delaware corporation (in its individual capacity, together with its successors and assigns, "UHS Delaware"; as servicer, together with its successors and assigns, the "Servicer"), and Continental Bank, National Association, as trustee (in such capacity, together with its successors and assigns, the "Trustee") under the Pooling Agreement (all capitalized terms used in the preamble and the recitals unless otherwise defined, as defined in the Definitions List referred to below). W I T N E S S E T H : WHEREAS, Sheffield desires to issue and sell its promissory notes in the commercial paper market and Finco desires to issue the TRIPs to certain financial institutions; WHEREAS, subject to the terms and conditions of the several Sale and Servicing Agreements, each between a Hospital and Finco, Finco will purchase from each Hospital and each Hospital will sell to Finco its Receivables, other than Non-qualifying Receivables, and the related Transferred Property; WHEREAS, in order for Finco to pay for the Transferred Property purchased by it from the Hospitals, Finco has entered into a Pooling Agreement under which Finco has conveyed to the Trustee, for the benefit of the Participants, its right, title and interest in and to the Transferred Property and the Finco Transferred Property, and the Participants have offered to acquire from Finco, and Finco has agreed to transfer to the Participants, senior undivided participating interests in the Trust Assets; WHEREAS, Sheffield intends to issue and sell its promissory notes in the commercial paper market and Finco intends to issue the TRIPs to certain financial institutions; WHEREAS, in order to collect the amounts due to Finco under the Purchased Receivables sold to Finco by the Hospitals pursuant to the Sale and Servicing Agreements and in which the Participants have acquired the Participations pursuant to the Pooling Agreement, the Interested Parties have required Finco and the Trustee to enter into an agreement with UHS Delaware requiring UHS Delaware to administer and collect the amounts owing to Finco in respect of the Receivables; WHEREAS, it is contemplated that following the sale and assignment of the Purchased Receivables from the Hospitals to Finco and the transfer of the Participations from Finco to the Participants, the Hospitals will collect the Receivables from the Obligors thereon and will transfer such sums as provided herein and in the Sale and Servicing Agreements; WHEREAS, Finco, the Trustee and UHS Delaware, as Servicer under this Agreement, accordingly wish to enter into this Agreement providing, among other things, for the servicing and administration of, and collection on, such Receivables by the Servicer; and WHEREAS, pursuant to the Guarantee executed by UHS in favor of Finco, UHS has guaranteed all obligations of UHS Delaware as Servicer hereunder and the Hospitals under the Sale and Servicing Agreements. NOW THEREFORE, the parties hereto agree as follows: ARTICLE I DEFINITIONS As used in this Servicing Agreement and unless the context requires a different meaning, capitalized terms used herein shall have the meanings assigned to such terms in the Definitions List, dated as of the date hereof (the "Definitions List"), that refers to this Agreement, which Definitions List is incorporated herein by reference and shall be deemed to be a part of this Agreement. ARTICLE II REPRESENTATIONS, WARRANTIES AND COVENANTS Section 2.1. Representations, Warranties and Covenants of the Servicer. The Servicer, on the Initial Closing Date, the TRIPs Closing Date, each Purchase Date and each Payment Date, represents, warrants and covenants to Finco and the Trustee that: (a) The Servicer has been duly organized and (i) is validly existing and in good standing as a corporation under the laws of the state of its incorporation, with full corporate power and authority to own or lease its properties and to conduct its business as presently conducted and to execute, deliver and perform this Agreement, and to consummate the transactions contemplated hereby, (ii) is duly qualified as a foreign corporation and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, have a material adverse effect on its business, operations, properties, assets or condition (financial or otherwise), (iii) is in compliance with all Requirements of Law and (iv) is not in default under any mortgage, indenture, deed of trust, loan agreement lease, contract or other agreement, instrument or undertaking to which the Servicer is a party or by which the Servicer or any of its assets may be bound, except to the extent that such defaults would not, alone or in the aggregate, have a material adverse effect on the ability of the Servicer to perform its obligations hereunder. (b) The execution, delivery and performance by the Servicer of this Agreement and the consummation of the transactions contemplated hereby have been duly and validly authorized by all requisite corporate action and will not conflict with, violate or result in a breach of any of the terms or provisions of, or constitute a default under, or result in the creation or imposition of any lien, charge or encumbrance upon any of its property or assets pursuant to the terms of, any indenture, mortgage, deed of trust, loan agreement, lease, contract or other agreement, instrument or undertaking by which it is bound or to which any of its property or assets is subject, nor will such action, result in any violation of any applicable Requirement of Law; and no consent, approval, authorization, order, registration, filing, qualification, license or permit of or with any such court or any such regulatory authority or other such Governmental Authority, other body or any other Person, will be required to be obtained by, or with respect to, the Servicer in connection with the execution, delivery and performance by the Servicer of this Agreement and the consummation of the transactions contemplated hereby and thereby which the Servicer shall not have so obtained. (c) This Agreement has been duly and validly authorized, executed and delivered by the Servicer and constitutes a valid and legally binding obligation of the Servicer, enforceable against the Servicer in accordance with its terms, subject to applicable bankruptcy, reorganization, insolvency, moratorium or other similar laws affecting creditors' rights generally, and subject as to enforceability to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). (d) All filings, recordings and notices (including pursuant to the UCC) required to perfect the interest of Finco in the Transferred Property and of the Trustee in the Total Transferred Property have been accomplished and are in full force and effect and the Servicer shall at its expense perform all acts and execute all documents reasonably requested by Finco or the Trustee at any time to evidence, perfect, maintain and enforce the interests of Finco and the Trustee. (e) There is (i) no effective financing statement (or similar statement or instrument of registration under the law of any jurisdiction) on file or registered in any public office and (ii) no assignment filed or delivered by or on behalf of the Servicer, in each case covering any interest of any kind in the Transferred Property or intended so to be filed, delivered or registered, and, except to the extent required hereunder, the Servicer will not execute any effective financing statement (or similar statement or instrument of registration under the laws of any jurisdiction) or statements or any assignment or other notification relating to the Total Transferred Property. (f) There are no actions, proceedings or investigations pending or, to the knowledge of the Servicer, threatened, before any court, administrative agency or other tribunal, (i) asserting the invalidity of this Agreement or any of the Security Filings, (ii) questioning the consummation by the Servicer or any of its Subsidiaries of any of the transactions contemplated by the Operative Documents or (iii) which, if determined adversely, alone or in the aggregate, could materially and adversely affect the ability of the Servicer to perform its obligations under, or the validity or enforceability of, this Agreement. (g) The Receivables Information provided by the Servicer on the date hereof or on the Purchase Date on which these representations are made or deemed made does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements in the Receivables Information, in light of the circumstances in which they were made, not misleading. (h) The chief place of business and chief executive office of the Servicer is at the address set forth on Schedule I hereto, which place of business is the place where the Servicer is "located" for the purposes of Section 9-103(3)(d) of the UCC of the state indicated on such Schedule, and the locations of the offices where all of the instruments, documents, agreements, books and records relating to the Receivables are kept are at the addresses shown on the schedule attached hereto as Schedule I. Section 2.2. Covenants of the Servicer. (a) The Servicer will preserve and maintain its existence as a corporation in good standing under the laws of Delaware or any other state in which it is incorporated. The Servicer will preserve and maintain its existence as a foreign corporation in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, have a material adverse effect on its ability to perform its obligations hereunder. (b) The Servicer, will, at its own cost and expense, (i) retain the electronic ledger used by the Servicer as a master record of the Receivables and copies of all documents relating to each Receivable as custodian for Finco and the Interested Parties, (ii) mark such electronic ledger to the effect that the Receivables listed thereon that have been sold to Finco have been transferred and assigned from each of the Hospitals to Finco and (iii) take any actions necessary to remove references to Receivables that have been repurchased by any Hospital in accordance with the Sale and Servicing Agreements. (c) The Servicer will advise Finco and the Trustee promptly, and in reasonable detail, of (i) any Lien asserted or claim made against any of the Transferred Property of which it obtains knowledge, (ii) the occurrence of any breach by the Servicer or any other UHS Entity of any of its respective representations, warranties and covenants contained in any Operative Document of which the Servicer has knowledge, (iii) the occurrence of any event which would be reasonably be expected to have a material adverse effect on the ability of the Servicer to perform its obligations hereunder and (iv) the receipt from any Governmental Authority of a deficiency notice with respect to the Purchased Receivables. (d) Unless prohibited by any Requirement of Law, including, without limitation, by regulations of JCAHO or AOA, as the case may be, Finco, the Trustee and each of their respective employees, agents, representatives (A) shall at all times have full and free access during normal business hours to all the books, correspondence and records of the Servicer insofar as they relate to the Transferred Property, and Finco and the Trustee (and their respective employees, agents and representatives) may examine the same, take extracts therefrom and make photocopies thereof, and the Servicer agrees to render to Finco and the Trustee, at the Servicer's cost and expense, such clerical and other assistance as may be reasonably requested with regard thereto and (B) may discuss the affairs, finances and accounts of the Servicer with, and be advised as to the same by, executive officers and independent accountants of the Servicer, all as Finco or the Trustee may reasonably deem appropriate for the purpose of verifying the accuracy of any reports or information delivered to Finco or the Trustee pursuant to this Agreement or for otherwise ascertaining compliance with this Agreement; provided, however, that each of Finco and the Trustee acknowledges that in exercising the rights and privileges conferred in this Section 2.2(d) it may, from time to time, obtain knowledge of information, practices, books, correspondence and records of a confidential nature and in which the Servicer has a proprietary interest; and provided, further, that the Servicer, Finco and the Trustee acknowledge that the Operative Documents and documents required to be filed by or on behalf of UHS and its Subsidiaries with the Securities and Exchange Commission and available to the public shall not be considered confidential for purposes of this Agreement (such confidential information, collectively, the "Information"). Each of Finco and the Trustee agrees that the Information is to be regarded as confidential information and may be subject to laws, rules and regulations regarding patient confidentiality and agrees that subject to the following sentence, (i) it shall, and shall cause its employees agents and representatives to, retain in confidence not disclose without the prior written consent of the Servicer any or all of the Information and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by this Agreement, the other Operative Documents or for the enforcement of any of the rights granted hereunder or thereunder) of the Information without the prior written consent of the Servicer. Notwithstanding the foregoing, each of Finco and the Trustee may (x) disclose Information to any Person that executes and delivers to the addressee and UHS a confidentiality agreement, substantially in the form of Exhibit D hereto with respect to the Information or (y) disclose or use such Information (A) to the extent that such Information is required or appropriate in any reports, statement or testimony submitted to any municipal, state, or federal regulatory body having or claiming to have jurisdiction over Finco, the Trustee or the National Association of Insurance Commissioners or similar organization or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed by Finco or the Trustee to be required in order to comply with any law, order, regulation or ruling applicable to Finco or the Trustee, (D) to the extent that such information was publicly available or otherwise known to Finco or the Trustee at the time of disclosure, (E) to the extent that such information subsequently becomes publicly available other than through any act or omission of Finco, and (F) to the extent that such information subsequently becomes known to Finco or the Trustee other than through a person known to be acting in violation of his or its obligations to the Servicer. (e) The Servicer shall execute and file such UCC financing statements, continuation statements and any other documents, if any, requested by Finco (and in form and substance satisfactory to Finco), or which may be required by law to fully preserve and protect the ownership interests and/or security interests of Finco and the Interested Parties under the Operative Documents in and to the Total Transferred Property. (f) The Servicer will not, without providing 30 days' notice to Finco and without filing such amendments to the Security Filings as Finco may require, (i) change the location of its chief executive office or the location of the offices where the records relating to the Receivables are kept or (ii) change its name, identity or corporate structure in any manner which could make any Security Filing or related continuation statement seriously misleading within the meaning of Section 9-402(7) of any applicable enactment of the UCC applicable thereto or (iii) delete or otherwise modify the marking on the electronic ledger referred to in Section 2.2(b) other than as provided in clause (iii) thereof. (g) The Servicer will preserve all records that it is required to maintain pursuant to this Agreement until the later of (i) four years after the date upon which the Receivable to which such records relate is paid in full or (ii) seven years. (h) The Servicer shall deliver or cause to be delivered to Finco and the Trustee, all such documents, reports, certificates and other matters as are required by the Operative Documents including, without limitation, notice, to the extent required pursuant to the terms of any Sale and Servicing Agreement, of commercial insurers or other third-party payors which are Obligors of any Hospital and which first become Obligors after the Initial Closing Date (with any related Notice of Assignment and Confirmation required pursuant to such Sale and Servicing Agreement) and notice of each change in any Hospital's qualifications and status as a provider in respect of Governmental Receivables. (i) The Servicer will comply with all Requirements of Law which are applicable to the Transferred Property or any part thereof; provided, however, that the Servicer may contest any act, regulation, order, decree or direction in any manner which, in the reasonable opinion of Finco and the Trustee, would not reasonably be expected to materially and adversely affect the rights of Finco or any Interested Party in the Transferred Property or the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables. (j) The Servicer will not create, permit or suffer to exist, and will defend Finco's and the Interested Parties' rights to the Total Transferred Property against, and take such other actions as are necessary to remove, any Lien on, or claim or right in, to or under the Total Transferred Property, and will defend the right, title and interest of Finco and the Interested Parties in and to the Total Transferred Property against the claims and demands of all Persons whomsoever, other than the Liens in respect of the Permitted Interests. (k) Subject to Section 3.1(e), the Servicer will duly fulfill all obligations on its part to be fulfilled under or in connection with each Purchased Receivable and will do nothing to impair the rights of Finco or the Interested Parties in the Transferred Property. (l) Subject to Section 3.1(e), the Servicer will not sell, discount or otherwise dispose of any Purchased Receivable except to Finco or the Interested Parties as provided under the Sale and Servicing Agreements and the Pooling Agreement. (m) The Servicer shall not distribute or assist in the distribution of any financial statements which shall not account for the transactions contemplated by the Sale and Servicing Agreements in a manner which reflects the sale to Finco of the Purchased Receivables, and any publicly available financial statements prepared by the Servicer shall indicate the sale to Finco of the Purchased Receivables originated by the Hospitals. (n) The Servicer shall not merge or consolidate with, or transfer all or substantially all its assets to, any other entity unless the Servicer is the entity surviving such merger or consolidation or unless (i) the surviving or transferee entity expressly assumes all of the covenants, obligations and agreements of the Servicer under this Agreement in a written instrument satisfactory in form and substance to Finco and the Trustee and (ii) such merger, consolidation or other transfer shall not, in the judgment of Finco, result in an Exclusion Event or an Early Amortization Event. (o) The Servicer shall not, without the prior written consent of Finco and the Trustee, which consent shall not be unreasonably withheld, permit any Hospital to alter the hardware or software systems used by such Hospital in generating its reports to the Servicer in respect of the Purchased Receivables and Collections and, in any event, shall not permit any such alteration unless such alteration is designed to improve the Servicer's ability to monitor and collect on the Receivables. (p) The Servicer shall give to Finco and the Trustee prompt notice of any breach of any representation, warranty, covenant or agreement under this Agreement of which it has knowledge. (q) The Servicer will not hold itself out as liable for any Debt of Finco. ARTICLE III ADMINISTRATION, COLLECTIONS AND OTHER OBLIGATIONS Section 3.1. Servicing. (a) Finco and the Trustee hereby appoint the Servicer as their agent to administer and service, in accordance with the terms of this Article III, all Purchased Receivables, and the Servicer hereby accepts such appointment to administer and service the Purchased Receivables for the benefit of Finco and the Interested Parties. Except as otherwise provided herein, the Servicer shall have full power and authority to do any and all things in connection with such administration and servicing as it may deem necessary or desirable, including, without limitation, appointing subservicers to perform its servicing obligations hereunder. Without in any respect limiting the foregoing, the Servicer shall, in accordance with all Requirements of Law, but subject to the terms and conditions of the Operative Documents, manage and administer each of the Purchased Receivables, exercise all discretionary powers involved in such management, collection and administration and bear all costs and expenses incurred in connection therewith that may be necessary or advisable and permitted for carrying out the transactions contemplated by this Agreement and the other Operative Documents. In the management, collection and administration of the Purchased Receivables, the Servicer shall exercise the same care that it exercises in handling similar matters for its own account, and the Servicer will create and administer policies and practices (including those with respect to reserves and write-offs) consistent with the policies and practices applied in handling similar matters for its own account. The Servicer will comply at all times, in all material respects, with good business policies, practices, procedures and internal controls in effect at such time with respect to servicing and collecting the Receivables. Subject to the provisions of Article VII of the Pooling Agreement, the Servicing Fee payable by Finco with respect to the Purchased Receivables shall be 0.35 of 1% per annum of the average Outstanding Balance of the Purchased Receivables during each Settlement Period and shall be paid to the Servicer in accordance with Sections 7.2 and 7.3 of the Pooling Agreement. The Servicer shall be required to pay expenses for its own account, and shall not be entitled to any payment therefor other than the Servicing Fee. The Trustee Fee and the other fees and expenses of the Trustee payable pursuant to Section 11.5 of the Pooling Agreement during any Settlement Period shall be payable by the Servicer solely out of the Servicing Fee paid to the Servicer with respect to such Settlement Period. In no event shall the Servicer be liable for any federal, state or local income or franchise tax, or any interest or penalties with respect thereto, assessed on the Trust, the Trustee or the Participants except as expressly provided herein. To the extent provided in Article VII of the Pooling Agreement, or in the event that the Servicer fails to pay any amount due to the Trustee pursuant to Section 11.5 of the Pooling Agreement, the Trustee shall be entitled, in addition to any other rights it may have under law, to receive such amounts from the Servicing Fee prior to the payment thereof to the Servicer. (b) The Servicer hereby agrees and acknowledges that all Collections on account of Non-governmental Receivables sold to Finco shall be deposited directly into the Hospital Concentration Account or the Master Receivables Account on the date of receipt thereof. Payments in respect of Non-Governmental Receivables in the form of electronic or wire transfers shall be made to the Master Receivables Account. Except as provided in the following sentence, all Collections on account of Governmental Receivables sold to Finco shall be paid to the Hospital and deposited directly into the applicable Hospital Concentration Account on the date of receipt thereof. Collections from Obligors on Governmental Receivables in the form of electronic or wire transfers to UHS, for the benefit of a Hospital, shall be made directly to the Master Receivables Account. Available Collections received in the Hospital Concentration Accounts shall be transferred within one Business Day of receipt to the Master Receivables Account. Amounts so transferred or otherwise received in the Master Receivables Account prior to the close of business on any Business Day shall be transferred to the Collateral Account at the close of business on the Business Day received. Amounts received in the Master Receivables Account after the close of business on any Business Day or on any day which is not a Business Day shall be transferred to the Collateral Account at the close of business on the next succeeding Business Day. Except as provided in Section 3.1(i), the Servicer shall not transfer, or permit to be transferred, any amount from any Hospital Concentration Account or the Master Receivables Account other than to the Collateral Account. Subject to Section 3.1(h), all such Collections received will be endorsed by the Servicer in the name of the Hospital where required. (c) The obligation of UHS Delaware to service the Receivables is personal to UHS Delaware and the parties recognize that another Person may not be qualified to perform such obligations. Accordingly, UHS Delaware's obligation to service the Receivables hereunder, to the extent permitted by applicable law, shall be specifically enforceable and shall be absolute and unconditional in all circumstances, including, without limitation, after the occurrence and during the continuation of any Exclusion Event or Early Amortization Event; provided, however, that a Successor Servicer may be appointed pursuant to Article IV; and provided, further, that nothing contained in this Agreement shall be construed to prevent UHS from performing any obligation hereunder in accordance with the terms of the Guarantee. The provisions of this Section 3.1(c) shall not preclude UHS Delaware from subcontracting any or all of its responsibilities hereunder so long as UHS Delaware shall retain supervisory control of any such subcontractor and UHS Delaware shall obtain the consent of Finco and the Trustee prior to entering into such subcontracting arrangement. UHS Delaware shall insure, as a condition precedent to entering such subcontracting arrangement, that each such subcontractor shall agree to service the Receivables in accordance with all Requirements of Law and pursuant to the terms of this Agreement and the related Sale and Servicing Agreements, including, without limitation, such terms as are related to Collections in respect of Governmental Receivables and Non-governmental Receivables. Notwithstanding the immediately preceding sentence, UHS Delaware shall be fully responsible to Finco and the Interested Parties for any and all acts or failures to act of any such subcontractor to the same extent as if UHS Delaware were performing or directly responsible for such subcontractor's duties and responsibilities. (d) The Servicer shall not resign from the obligations and duties hereby imposed on it as Servicer except upon determination that (i) the performance of its duties hereunder is no longer permissible under applicable law and (ii) there is no reasonable action which the Servicer could take to make the performance of its duties hereunder permissible under applicable law. Any such determination permitting the resignation of the Servicer shall be evidenced as to clause (i) above by an opinion of counsel to the Servicer to such effect and as to clause (ii) above by a certificate of an Authorized Officer of the Servicer, in each case addressed to Finco, the Trustee and the Participants. No such resignation shall become effective until a Successor Servicer shall have assumed the responsibilities and obligations of the Servicer in accordance with Section 4.4. (e) The Servicer shall have the power and authority, with notice to Finco, to make such changes in contracts, agreements and terms in respect of any Purchased Receivable as the Servicer, on behalf of Finco, may reasonably deem advisable to the extent that (i) the Servicer shall reasonably believe that such changes in contracts, agreements or terms in respect of any Purchased Receivables will increase the collectibility of such Receivable without extending the payment date, so long as (A) such change is in accordance with the Credit and Collection Policy and consistent with past practice and (B) such change shall not have a disproportionate effect on the Purchased Receivables as compared with Receivables (or future Receivables) not sold to Finco; and (ii) the Servicer, in the event that such Purchased Receivable becomes an Uncollectible Receivable, shall reasonably believe that such change of contracts, agreements or terms will improve the collectibility of such Uncollectible Receivable; provided that no such change permitted by clause (i) or (ii) shall, in the reasonable belief of Finco, result in an Exclusion Event or an Early Amortization Event; and provided, further, that no such change shall cause the Borrowing Base to be less than the sum of (A) the TRIPs Capital, (B) the Face Amount of Commercial Paper Outstanding and (C) the principal amount of Loans Outstanding. In the enforcement or collection of any such Purchased Receivable, the Servicer shall be entitled to sue thereon in its own name, if possible, or, if, and only if, Finco or the Trustee consents in writing, as agent of Finco or the Trustee, as the case may be. (f) Subject to Section 3.1(e), the Servicer shall not change the terms of the payor contracts and agreements relating to the Purchased Receivables and related Transferred Property or its normal policies and procedures with respect to the servicing thereof (including without limitation the amount and timing of finance charges, fees and write-offs). (g) Finco hereby irrevocably grants to the Servicer an irrevocable power-of-attorney, which power is coupled with an interest, with full power of substitution, to take in the name of Finco or in its own name all steps necessary or advisable to endorse, negotiate or otherwise realize upon any writing or other report of any kind held or owned by Finco or transmitted to or received by the Servicer as payment on account or otherwise in respect of any Purchased Receivables. Finco shall execute and deliver to the Servicer such additional powers-of-attorney as the Servicer may deem necessary or appropriate to enable the Servicer to endorse for payment any check, draft or other instrument delivered in payment of any amount under or in respect of the Purchased Receivables. (h) If, at any time, the Servicer receives any Collections on account or otherwise in respect of Non-governmental Receivables, the Servicer shall hold such Collections in trust for the benefit of Finco and the Interested Parties and shall use its best efforts not to commingle any such amounts with any other funds or property held by the Servicer other than Collections and the Servicer shall cause such Collections (properly endorsed, where required, so that such items may be collected by Finco) to be paid over or delivered to the Trustee (as soon as practicable and in any event within one Business Day) pursuant to the terms of Section 7.1 of the Pooling Agreement, which transmission or delivery shall occur forthwith after any such Collections shall have been identified by the Servicer as being on account of such a Purchased Receivable. If, and at any time, the Servicer receives any such Collections in respect of Governmental Receivables, the Servicer shall transfer all such amounts to the related Hospital payee for immediate deposit by such Hospital into the appropriate Hospital Concentration Account or the Master Receivables Account. (i) The Servicer agrees that it shall use its best efforts to ensure that only Collections on Purchased Receivables are deposited into the Hospital Concentration Accounts and the Master Receivables Account. Finco agrees that, promptly following the establishment to the satisfaction of the Servicer and any Hospital that any funds received in any Hospital Concentration Account or the Master Receivables Account do not constitute Collections on Purchased Receivables, including any payments on Receivables which have been reassigned to such Hospital and any payments to such Hospital not in respect of Receivables, to the extent such funds are available in the Hospital Concentration Account, the Master Receivables Account or the Collateral Account, the Servicer shall remit, or cause the Trustee to remit, such funds to such Hospital in immediately available funds. In the event that the Servicer and any Hospital are unable to determine whether funds received by the Servicer or such Hospital constitute Collections on Purchased Receivables, such funds shall be deposited in the Hospital Concentration Account or the Master Receivables Account and transferred in accordance with Section 3.1(b) hereof and Article V of the applicable Sale and Servicing Agreement. (j) The Servicer shall cause each written contract entered into by any Hospital after the Initial Closing Date with a third-party payor in respect of Non-governmental Receivables to permit the assignment of payments thereunder pursuant to the terms of this Agreement and the Operative Documents. In the alternative the Servicer shall promptly (A) notify Finco of any insurance provider or other third-party payor which becomes an Obligor after the Initial Closing Date pursuant to a written contract or arrangement which purports to prohibit the assignment of any rights of any Hospital under such contract or arrangement without the consent of such Obligor and (B) deliver or cause to be delivered to such Obligor a Notice of Assignment from each Hospital party to any such contract or arrangement and receive a Confirmation in respect thereof as may be required by Finco or its counsel and (ii) comply with all other reasonable requests of Finco with respect to the Security Filings. The Servicer shall also cause each invoice sent after the Initial Closing Date to each insurance carrier or third party intermediary to include a notice that the amount payable under such invoice has been assigned to Finco and its assignees, including the Trustee, and that future amounts payable by such insurance carrier will be so assigned. Section 3.2. Delivery of Settlement Date Statement. On each Settlement Date the Servicer shall report to Finco, the Trustee and such other Persons as Finco or the Trustee may designate, by delivering to them, by 1:00 p.m. (New York City time) on such Settlement Date, the Settlement Date Statement, substantially in the form of Exhibit A hereto (the "Settlement Date Statement"), with a certificate, substantially in the form of Exhibit B hereto (the "Servicer's Certificate"), covering the Settlement Period next preceding such Settlement Date. Section 3.3. Settlement Date Statement. The Servicer shall set forth in the Settlement Date Statement: (a) all Collections respecting Purchased Receivables and Financible Receivables owned by Finco that have been collected during the Settlement Period immediately preceding the Settlement Date; (b) the aggregate Outstanding Balance of Purchased Receivables, the aggregate Outstanding Balance of Eligible Receivables and the aggregate Outstanding Balance of all Financible Receivables then owned by Finco (and in respect of which the Participants have acquired the Participations) as of the last day of the immediately preceding Settlement Period, in each case determined in accordance with GAAP and based on all Receivables created and outstanding on such last day, whether or not invoiced; (c) the aggregate amount of all adjustments to the Purchase Prices to be paid by Finco to the Hospitals on such date; (d) the aggregate balance of all Receivables which were included as Financible Receivables and which became Uncollectible Receivables during the immediately preceding Settlement Date and all Uncollectible Amounts arising during the immediately preceding Settlement Date in respect of Receivables included as Financible Receivables during such Settlement Period; (e) the Loss-to Liquidation Ratio, the Loss Factor, the Sheffield Yield Factor Amount, the TRIPs Yield Factor Amount, the Monthly Program Expense Amount and the aggregate fees and expenses scheduled to accrue during the Average Financible Turnover Period, each calculated as of the last day of the immediately preceding Settlement Period; (f) costs, expenses, fees, taxes, indemnities and other amounts payable from the Collateral Account and due to be paid on the related Transfer Date pursuant to Section 7.3(a) of the Pooling Agreement; (g) the Average Pool Turnover Period and the Average Financible Turnover Period as of the last day of the immediately preceding Settlement Period; (h) the Delinquency Ratio as of the last day of the immediately preceding Settlement Period; and (i) the aggregate amount of all liabilities reflected on the periodic cost reports of all UHS Entities for each of the three most recent reporting periods; the aggregate amount of Collections received during each Settlement Period in the preceding fiscal year in respect of Self-pay Receivables; and any other information required to determine the Offset Reserve. The Servicer shall set forth its determinations in each Settlement Date Statement, which shall contain the numbers, amounts or information called for in each of clauses (a) through (h) above and any additional calculations as the Rating Agencies may reasonably require. Section 3.4. Record of Collections. The Servicer shall keep a computer record of all Collections on Purchased Receivables owned by Finco and deposited in the Collateral Account. Section 3.5. Servicer Daily Statement. (a) As of the close of business on each Business Day, the Servicer shall determine, and set forth its determinations in a statement substantially in the form of Exhibit C (a "Servicer Daily Statement") as to: (i) the aggregate Purchased Receivables, Financible Receivables and the estimated amount of Eligible Receivables owned by Finco and in which the Participants have acquired the Participations, and all required adjustments thereto, as of the end of the preceding Business Day and all Collections received on Purchased Receivables, Eligible Receivables and Financible Receivables; (ii) amounts in the Collateral Account as of the end of the prior Business Day, all Available Cash Collections and other funds received in the Collateral Account since the preceding Business Day and all transfers to the Sub-accounts required to be made since the prior Business Day; (iii) the aggregate Outstanding Balances of all Purchased Receivables, Eligible Receivables and Financible Receivables purchased on such Business Day and to be paid for on the Statement Delivery Day and the aggregate Outstanding Balances of Purchased Receivables, Eligible Receivables and Financible Receivables in the Receivables Pool after giving effect to such purchases; (iv) the Purchase Price of all Receivables to be paid for on the Statement Delivery Day, the aggregate amount of cash available in the Collateral Account to be paid and the Subordinated Notes to be issued to the Hospitals in respect thereof on the Statement Delivery Day; (v) the Servicer's calculations in respect of the Offset Reserves, the Yield Reserves, the Loss Reserves, the Fee/Expense Reserves and the Required Coverage Amount as of such Business Day; (vi) the amount of all Deleted Receivables purchased on such Business Day to be paid for on the Statement Delivery Day; and (vii) such additional calculations as the Trustee or Sheffield shall reasonably require; it being understood that cash deposited from Collections in the Collateral Account shall not be deemed to be available for the purposes of calculating the Borrowing Base or for the determination of any payments to be made to any of UHS Delaware, Finco or any Hospital until the identification of the Receivables to which such Collections relate. (b) The Servicer shall deliver to Finco, the Trustee and such other Persons as Finco or the Trustee may designate, by 1:00 p.m. New York City time on each Business Day (the "Statement Delivery Day"), the Servicer Daily Statement prepared as of the close of business on the previous Business Day, certified by an Authorized Officer of the Servicer; the Trustee and each of the other Interested Parties shall rely on such Servicer Daily Statement in respect of all actions under this Agreement and the other Operative Documents. Each such Servicer Daily Statement shall also contain all information as the Trustee shall require, pursuant to the terms of the Pooling Agreement, to pay all Sheffield Capital and TRIPs Capital of, and all Yield on, all Commercial Paper Notes, Loans and TRIPs, to retain all required amounts in the Collateral Account, each sub-account of the Collateral Account and each Other Account, to purchase Receivables and to make all other payments and transfers, all in accordance with the terms and conditions of the Pooling Agreement. The Servicer shall furnish to the Trustee such further information as it may require in connection with the preparation of the Servicer Daily Statement. Section 3.6. Deleted Receivables. (a) On each Purchase Date, the Servicer shall, in its discretion, designate certain Receivables purchased by Finco on such Purchase Date and to be paid for by Finco on the Statement Delivery Day as Deleted Receivables, which Deleted Receivables shall be excluded from the pool of Financible Receivables; provided, however, that the Servicer shall not so exclude Deleted Receivables from the Financible Pool Balance if, as a result of such designation and exclusion, the quality and collectibility (including as a result of the credit quality of the Obligors on the Financible Receivables) of the pool of Financible Receivables would reasonably be expected to be any worse than the quality and collectibility (including as a result of the credit quality of the Obligors on the Eligible Receivables) of the pool of Eligible Receivables. (b) The aggregate Outstanding Balance of Deleted Receivables identified on each Business Day shall be included in the Daily Servicer Statement delivered by the Servicer on the related Statement Delivery Day. Such disclosure shall constitute a representation and warranty by the Servicer that, after giving effect to the exclusion of such Deleted Receivables from the pool of Financible Receivables, the quality and collectibility (including as a result of the credit quality of the Obligors on the Financible Receivables) of the pool of Financible Receivables is no worse than the quality and collectibility (including as a result of the credit quality of the Obligors on the Eligible Receivables) of the pool of Eligible Receivables. (c) The designation by the Servicer of any Purchased Receivable as a Deleted Receivable is irrevocable, and no such Deleted Receivable shall be considered a Financible Receivable or included in the Financible Pool Balance for any purpose. Section 3.7. Master Receivables Account. UHS has previously established an account with Continental (the "Master Receivables Account") into which Collections received from Obligors by means of electronic transfers shall be deposited by such Obligors. The Master Receivables Account has been designated as an account in the name of UHS, for the benefit of UHS, the Hospitals, Finco and the Interested Parties. The Servicer hereby represents and warrants that set forth on Schedule II hereto is the name, location and account number of the Master Receivables Account. The Servicer shall not, and shall not permit any other Person to, establish, terminate or change the Master Receivables Account designated on Schedule II, unless such action is in conformity with all Requirements of Law and the prior written consent of Finco and the Trustee has been obtained. At any time that the Servicer receives notice that an Early Amortization Event shall have occurred and is continuing, the Servicer agrees, to the extent permitted by applicable Requirements of Law, to immediately take all actions necessary, upon receipt of indemnification satisfactory to it and written directions from Finco or the Trustee as to the nature of such actions to direct those Obligors making payments into the Master Receivables Account to make all payments on the Receivables to an Additional Account or directly to the Trustee for deposit in the Collateral Account. ARTICLE IV EVENTS OF DEFAULT; SERVICING TERMINATION Section 4.1. Events of Default. The occurrence and continuation of any one of the following events shall be an "Event of Default" under this Agreement: (a) The entry of a decree or order for relief by a court having jurisdiction in respect of the Servicer in an involuntary case under the federal bankruptcy laws, as now or hereafter in effect, or any other present or future federal or state bankruptcy, insolvency or similar law, or appointing a receiver, liquidator, assignee, trustee, custodian, sequestrator or other similar official of the Servicer or of any substantial part of its property, or ordering the winding up or liquidation of the affairs of the Servicer and the continuance of any such decree or order unstayed and in effect for a period of 60 consecutive days; or (b) The Servicer shall (i) become insolvent or admit in writing its inability to pay its debts as they come due, (ii) commence a voluntary case under the federal bankruptcy laws, as now or hereafter in effect, or any other present or future federal or state bankruptcy, insolvency or similar law, (iii) consent to the appointment of, or taking possession by a receiver, liquidator, assignee, trustee, custodian, sequestrator or other similar official of the Servicer or of any substantial part of its property, (iv) make an assignment for the benefit of creditors, (v) fail generally to pay its debts as such debts become due or (vi) take any corporate action in furtherance of any of the foregoing; or (c) The Servicer shall fail to pay any amount required to be paid by it under this Agreement or transfer to the Trustee any amount collected by the Servicer in accordance with the terms of this Agreement; or (d) There shall occur a material default by the Servicer in the observance or performance of any other covenant or agreement in this Agreement, and such default shall continue unremedied for a period of 30 days following notice given by Finco or any Interested Party to the Servicer; or (e) Any of the representations or warranties by the Servicer contained in this Agreement shall prove to have been incorrect when made or deemed made in any material respect; or (f) A material adverse change in the business, operations, property or financial or other condition of the Servicer and its Subsidiaries taken as a whole shall have occurred and such change shall materially adversely affect its ability to perform its obligations, hereunder; or (g) The Guarantee shall at any time fail to be in full force and effect. Section 4.2. Remedies. Following the occurrence of an Event of Default hereunder Finco or the Trustee may, by notice given in writing to the Servicer (a "Servicer Termination Notice"), terminate all of the rights and obligations of the Servicer, as Servicer, under this Agreement. Notwithstanding any termination of the rights and obligations of the Servicer pursuant to this Section 4.2, the Servicer shall remain responsible for any acts or omissions to act by it as Servicer prior to such termination. Section 4.3. Successor Servicer. (a) On the date that a Successor Servicer shall have been appointed by Finco and the Trustee pursuant to Section 4.4, all authority and power of the then Servicer under this Agreement shall pass to and be vested in a Successor Servicer; and, without limitation, each of Finco and the Trustee are hereby authorized and empowered (upon the failure of the Servicer to cooperate) to execute and deliver, on behalf of the Servicer, as attorney-in-fact or otherwise, all documents and other instruments upon the failure of the Servicer to execute or deliver such documents or instruments, and to do and accomplish all other acts or things necessary or appropriate to effect the purposes of such transfer of servicing rights. (b) The Servicer agrees to cooperate with Finco and the Successor Servicer in effecting the termination of the responsibilities and rights of the Servicer to conduct servicing hereunder, including, without limitation, the transfer to such Successor Servicer of all authority of the Servicer to service the Receivables provided for under this Agreement, including, without limitation, all authority to receive Collections which shall on the date of transfer be held by the Servicer for deposit, or which shall thereafter be received with respect to the Receivables. (c) Subject to any Requirement of Law, the Servicer shall promptly transfer its electronic records (including, without limitation, the related computer programs necessary to use such electronic records) and all other records relating to the Receivables and the Transferred Property to the Successor Servicer in such electronic form or other forms as the Successor Servicer may reasonably request and shall promptly transfer to the Successor Servicer all other records, correspondence and documents necessary for the continued servicing of the Receivables in the manner and at such times as the Successor Servicer shall reasonably request. To the extent that compliance with this Section 4.3 shall require the Servicer to disclose to the Successor Servicer information of any kind which the Servicer reasonably deems to be confidential or subject to license, the Successor Servicer shall be required to enter into such customary licensing and confidentiality agreements as the Servicer shall deem necessary to protect its interest. (d) At any time following the designation of the Successor Servicer, any Successor Servicer shall be authorized to take any and all steps in UHS Delaware's name as Servicer and on behalf of UHS Delaware necessary or desirable (subject to laws, rules and regulations regarding patient confidentiality), in the determination of the Successor Servicer, to collect all amounts due under any and all Receivables, including, without limitation, endorsing UHS Delaware's name on checks and other instruments representing Collections and enforcing the Receivables. Section 4.4. Appointment of Successor. (a) Notwithstanding the receipt by a Servicer of a Servicer Termination Notice or the resignation of a Servicer pursuant to Section 3.1(d), the Servicer shall continue to perform all of its obligations under this Agreement until the later of (i) the appointment of a Successor Servicer or (ii) the date specified in the Servicer Termination Notice or otherwise specified by Finco or the Trustee in writing or, if no such date is specified in the Servicer Termination Notice, or otherwise specified by Finco or the Trustee, until a date mutually agreed upon by the Servicer, Finco and the Trustee. Finco and the Trustee shall (as promptly as possible after the giving of a Servicer Termination Notice or the resignation of a Servicer pursuant to Section 3.1(d)) appoint a successor servicer (the "Successor Servicer") and such Successor Servicer shall accept its appointment by a written assumption in a form acceptable to Finco and the Trustee. Such Successor Servicer, as a condition precedent to its appointment, shall represent, warrant and covenant on its behalf to each of Finco and the Trustee, for the benefit of the Participants, the representations, warranties and covenants in Section 2.1 in a writing satisfactory to Finco and the Trustee in their sole discretion. Finco and the Trustee may obtain bids from any potential Successor Servicer. (b) Upon its appointment, the Successor Servicer shall be the successor in all respects to the Servicer with respect to servicing functions under this Agreement and shall be subject to all the responsibilities, duties and liabilities relating thereto placed on UHS Delaware or the Servicer by the terms and provisions hereof, and all references in this Agreement to UHS Delaware or the Servicer shall be deemed to refer to the Successor Servicer. Any Successor Servicer, by its acceptance of its appointment, will automatically agree to be bound by the terms and provisions of the Operative Documents, if any are applicable. (c) In connection with the appointment of a Successor Servicer, Finco may make such arrangements to compensate the Successor Servicer out of Collections as it and such Successor Servicer shall agree; provided, however, that the priority of payment of such compensation shall be determined pursuant to Sections 7.2 and 7.3 of the Pooling Agreement and that no such compensation shall be in excess of the Servicing Fee paid to UHS Delaware. (d) All authority and power granted to any Successor Servicer under this Agreement shall automatically cease and terminate upon the termination of this Agreement and upon payment of all amounts due the parties under the Sale and Servicing Agreements, the Pooling Agreement and the other Operative Documents and shall pass to and be vested in UHS Delaware and, without limitation, UHS Delaware is hereby authorized and empowered to execute and deliver, on behalf of the Successor Servicer, as attorney-in-fact or otherwise, all documents and other instruments, and to do and accomplish all other acts or things necessary or appropriate to effect the purposes of such transfer of servicing rights. The Successor Servicer shall transfer its electronic records relating to the Receivables to UHS Delaware in such electronic form as UHS Delaware may reasonably request and shall transfer all other records, correspondence and documents to UHS Delaware in the manner and at such times as UHS Delaware shall reasonably request. Section 4.5. Monitoring. If Finco and the Trustee shall be unable to replace the Servicer with a Successor Servicer, Finco and the Trustee shall have the right to appoint a firm of public accountants to monitor the servicing of the Receivables by the Servicer and to furnish to Finco and the Trustee, at the expense of the Servicer, such letters, certificates or reports thereon as Finco and the Trustee shall reasonably request. The Servicer shall cooperate with such firm in the subsequent monitoring of its servicing of the Receivables pursuant to this Agreement notwithstanding that any fees in connection therewith shall be the expense of Finco. ARTICLE V MISCELLANEOUS Section 5.1. Notices, Etc. Except where telephonic instructions or notices are authorized herein to be given, all notices, demands, instructions and other communications required or permitted to be given to or made upon any party hereto shall be in writing and shall be personally delivered or sent by registered, certified or express mail, postage prepaid, return receipt requested, or by telecopy (with voice confirmation thereof) or telegram (with messenger delivery specified in the case of a telegram) and shall be deemed to be given for purposes of this Agreement when such personal delivery is made or such return receipt or confirmation is received by the party giving such notice, demand, instruction or other communication. Unless otherwise specified in a notice sent or delivered in accordance with the foregoing provisions of this Section, notices, demands, instructions and other communications in writing shall be given to or made upon the respective parties hereto at their respective addresses (or to their respective telecopy numbers) indicated below, and, in the case of telephonic instructions or notices, by calling the telephone number or numbers indicated for such party below: If to Finco: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 Attention: President Tel. No.: 714-661-9323 Telecopier No.: 714-661-9445 with a copy to: UHS Receivables Corp. c/o Universal Health Services, Inc. 367 South Gulph Road King of Prussia, PA 19406 If to UHS Delaware: UHS of Delaware, Inc. 367 South Gulph Road King of Prussia, PA 19406 Attention: Tel. No.: 215-768-3300 Telecopier No.: 215-768-3336 If to the Trustee: Continental Bank, National Association 231 South LaSalle Street, 7th Floor Chicago, Illinois 60697 Attention: Steve Charles Tel. No.: (312) 828-7321 Telecopier No.: (312) 828-6528 Section 5.2. Successors and Assigns. This Agreement shall be binding upon the Servicer, Finco and the Trustee and their respective successors and assigns and shall inure to the benefit of the Servicer, Finco and the Trustee and their respective successors and assigns; provided that except as provided hereunder the Servicer shall not assign any of its rights or obligations hereunder without the prior written consent of Finco. Except as expressly permitted hereunder or in any of the Operative Documents, Finco shall not assign any of its rights or obligations hereunder without the prior written consent of the Trustee. Section 5.3. Severability Clause. Any provisions of this Agreement which are prohibited or unenforceable in any jurisdiction shall, as to such jurisdiction, be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions hereof, and any such prohibition or unenforceability in any jurisdiction shall not invalidate or render unenforceable such provision in any other jurisdiction. Section 5.4. Amendments. This Agreement may not be modified, amended, waived, supplemented or surrendered except pursuant to a written instrument executed by the Servicer, Finco and the Trustee, and then such amendment, modification, supplement or waiver shall be effective only in the specific instance and for the specific purpose given. If any such amendment, modification, supplement or waiver shall be so consented to by Finco and the Trustee, the Servicer agrees, promptly following a request by Finco or the Trustee, to execute and deliver in its own name, and at its own expense, such instruments, consents and other documents as Finco and the Trustee may deem necessary or appropriate in the circumstances. Section 5.5. The Servicer's Obligations. It is expressly agreed that, anything contained in this Agreement to the contrary notwithstanding, the Servicer shall be obligated to perform all of its obligations hereunder to the same extent as if the Interested Parties had no interest therein and neither Finco, the Trustee nor any Interested Party shall have obligations or liability under the Purchased Receivables to any Obligor thereunder by reason of or arising out of this Agreement, nor shall Finco, the Trustee or any Interested Party be required or obligated in any manner to perform or fulfill any of the obligations of the Servicer in connection with any Receivables. Section 5.6. No Recourse. (a) No directors or officers or employees or agents of the Servicer shall be under any liability to Finco, the Hospitals, the Interested Parties, the CP Holders or any other Person for any action of the Servicer hereunder pursuant to this Agreement; provided, however, that this provision shall not protect the Servicer or any such Person against any liability which would otherwise be imposed by reason of willful misfeasance, bad faith or gross negligence in the performance of duties or by reason of reckless disregard of obligations and duties hereunder. (b) The obligations of the Interested Parties, if any, under this Agreement are solely the corporate obligations of such entities. No recourse shall be had for the payment of any amount owing in respect of this Agreement or for the payment of any fee hereunder or for any other obligation or claim arising out of or based upon this Agreement against any such entity or against any stockholder, employee, officer, director or incorporator thereof. Section 5.7. Further Assurances. The Servicer agrees to do such further acts and things and to execute and deliver to Finco and the Trustee such additional assignments, agreements, powers and instruments as are required by Finco to carry into effect the purposes of this Agreement or to better assure and confirm unto Finco its rights, powers and remedies hereunder. Section 5.8. Termination. (a) The Servicer's obligations under this Agreement shall terminate with respect to any Hospital upon the termination of the related Sale and Servicing Agreement and all Purchased Receivables owned by Finco and purchased from such Hospital having been paid in full or having become Uncollectible Receivables; provided, however, that the Servicer shall continue to be obligated to do all things necessary to collect such Uncollectible Receivables and to apply Collections with respect thereto that it receives in the manner provided in this Agreement and to perform its obligations hereunder with respect thereto. (b) This Agreement shall terminate (whether on account of a Early Amortization Event or otherwise) when the Outstanding Balance of all Purchased Receivables which are Outstanding Receivables shall be reduced to zero, provided that the Servicer shall continue to be obligated to do all things necessary to collect on all Uncollectible Receivables and to apply all Collections that it receives with respect thereto in the manner provided in this Agreement and to perform its obligations hereunder with respect thereto. (c) The representations and warranties of the Servicer hereunder shall survive the execution and delivery of this Agreement and the purchase of the Participations. Section 5.9. Consent to Assignment; Third Party Beneficiaries. (a) The Servicer acknowledges that all of Finco's right, title and interest in the obligations of the Servicer to Finco and the rights of Finco against the Servicer under this Agreement have been assigned, transferred and otherwise conveyed by Finco to the Trustee, for the benefit of the Participants, pursuant to the terms and conditions of the Pooling Agreement. The Servicer hereby agrees and acknowledges that Sheffield shall assign to the Liquidity Agent, for the benefit of the Liquidity Banks, all of Sheffield's right, title and interest in, to and under this Agreement. The Servicer consents to such assignment and transfer to the Trustee and by Sheffield to the Liquidity Agent and agrees that the Participants (or upon notice by Sheffield or the Liquidity Agent of a default under the Liquidity Agreement or the Security Agreement, and to the extent provided in the Pooling Agreement, the TRIPS Holders and the Liquidity Agent) and the Trustee shall be entitled to enforce the terms of this Agreement directly against the Servicer, whether or not any Early Amortization Event or Exclusion Event shall have occurred. The Servicer and Finco further agree that (i) the Servicer will not take any action (other than those actions which are consistent with its obligations hereunder and which occur in the normal course of its operations) without the prior consent of the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee and (ii) in respect of its obligations hereunder the Servicer will act at the direction of and in accordance with all requests and instructions of the Trustee and the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be). Finco and the Servicer hereby agree that, in the event of any conflict of requests or instructions to the Servicer between Finco on the one hand and the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee, on the other hand, the Servicer will at all times act in accordance with the requests and instructions of the Participants(or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee, and in the event of any conflict of requests or instructions among Participants, Finco shall act in accordance with the instructions of the Trustee. The Servicer, Finco and the Trustee agree that in the event of any conflict of requests or instructions to the Servicer between Sheffield and the Liquidity Agent, the Servicer will at all times act in accordance with the requests and instructions of the Liquidity Agent. (b) Notwithstanding anything hereunder to the contrary, each Interested Party shall have the rights of a third-party beneficiary hereunder. (c) Each of Finco, the Trustee and the Servicer acknowledges that Sheffield has appointed Barclays to act as Managing Agent. Unless otherwise instructed by Sheffield, copies of all notices, requests, demands and other documents to be delivered to Sheffield pursuant to the terms hereof shall be delivered to the Managing Agent. Unless otherwise instructed by Sheffield, all notices, requests, demands and other documents to be executed or delivered, and any action to be taken, by Sheffield pursuant to the terms hereof may be executed, delivered and/or taken by the Managing Agent. The rights and responsibilities of the Managing Agent under this Agreement with respect to any action taken by the Managing Agent or the exercise or non- exercise by the Managing Agent of any option, right, request, judgment or other right or remedy provided to Sheffield herein or resulting or arising out of this Agreement shall, as between the Managing Agent and Sheffield, be governed by such agreements with respect thereto as may exist from time to time between them, but, as between the Managing Agent and the parties to this Agreement, the Managing Agent shall be conclusively presumed to be acting as agent for Sheffield, with full and valid authority so to act or refrain from acting, and neither Finco, the Trustee nor the Servicer shall be under any obligation or entitlement to make any inquiry respecting such authority. Section 5.10. Counterparts. This Agreement may be executed in any number of copies, and by the different parties hereto on the same or separate counterparts, each of which shall be deemed to be an original instrument. Section 5.11. Headings. Section headings used in this Agreement are for convenience of reference only and shall not affect the construction or interpretation of this Agreement. Section 5.12. No Bankruptcy Petition. Each of the parties hereto covenants and agrees that prior to the date which is one year and one day after the Aggregate Capital has been reduced to zero and all other amounts due under or in connection with the Operative Documents have been paid, it will not institute against, or join any other Person in instituting against, Finco or Sheffield any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. Section 5.13. Servicer May Act Through Agents. Subject to the terms and conditions of this Agreement, the Servicer may exercise any of its rights or perform any of its duties hereunder through agents of its choosing, and any action so taken shall have the same force and effect as if taken by the Servicer directly. Section 5.14. GOVERNING LAW. THIS AGREEMENT SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE INTERNAL LAW OF THE STATE OF NEW YORK WITHOUT REFERENCE TO CONFLICTS OF LAW RULES OF THE STATE OF NEW YORK. Section 5.15. No Waiver; Cumulative Remedies. No failure to exercise, and no delay in exercising, on the part of Finco or any Interested Party, 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. The rights, remedies, powers and privileges herein provided are cumulative and not exhaustive of any rights, remedies, powers and privileges provided by law. Section 5.16. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. (a) EACH OF THE SERVICER AND UHS DELAWARE (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY IRREVOCABLY SUBMITS, FOR ITSELF AND ITS PROPERTY, TO THE JURISDICTION OF THE STATE COURTS OF THE STATE OF NEW YORK AND TO THE JURISDICTION OF THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK, FOR THE PURPOSES OF ANY SUIT, ACTION OR OTHER PROCEEDING ARISING OUT OF OR BASED UPON THIS AGREEMENT OR THE SUBJECT MATTER HEREOF BROUGHT BY FINCO OR ANY INTERESTED PARTY. EACH OF THE SERVICER AND UHS DELAWARE (FOR ITSELF AND ITS SUCCESSORS AND ASSIGNS) TO THE EXTENT PERMITTED BY ANY REQUIREMENTS OF LAW (A) HEREBY WAIVES, AND AGREES NOT TO ASSERT, BY WAY OF MOTION, AS A DEFENSE, OR OTHERWISE, IN ANY SUCH SUIT, ACTION OR PROCEEDING BROUGHT IN ANY SUCH COURT, ANY CLAIM THAT IT IS NOT SUBJECT PERSONALLY TO THE JURISDICTION OF THE ABOVE-NAMED COURTS, THAT ITS PROPERTY IS EXEMPT OR IMMUNE FROM ATTACHMENT OR EXECUTION, THAT THE SUIT, ACTION OR PROCEEDING IS BROUGHT IN AN INCONVENIENT FORUM, THAT THE VENUE OF THE SUIT, ACTION OR PROCEEDING IS IMPROPER OR THAT THIS AGREEMENT OR THE SUBJECT MATTER HEREOF MAY NOT BE ENFORCED IN OR BY SUCH COURT, AND (B) HEREBY WAIVES THE RIGHT TO ASSERT IN ANY SUCH ACTION, SUIT OR PROCEEDING ANY OFFSETS OR COUNTERCLAIMS EXCEPT COUNTERCLAIMS THAT ARE COMPULSORY OR OTHERWISE ARISE FROM THE SAME SUBJECT MATTER. THE SERVICER AND UHS DELAWARE HEREBY AGREE THAT SERVICE OF ANY AND ALL PROCESS AND OTHER DOCUMENTS ON THE SERVICER OR UHS DELAWARE, AS THE CASE MAY BE, MAY BE EFFECTED BY CERTIFIED OR REGISTERED MAIL (OR ANY SUBSTANTIALLY SIMILAR FORM OF MAIL) TO ITS RESPECTIVE ADDRESS AS SET FORTH ON SCHEDULE I AND SUCH SERVICE SHALL CONSTITUTE VALID AND EFFECTIVE SERVICE AGAINST UHS DELAWARE OR THE SERVICER, AS THE CASE MAY BE. EACH OF THE SERVICER AND UHS DELAWARE AGREES THAT ITS SUBMISSION TO JURISDICTION AND CONSENT TO SERVICE OF PROCESS BY MAIL IN ANY SUCH ACTION, SUIT OR PROCEEDING SHALL BE CONCLUSIVE, AND MAY BE ENFORCED IN ANY OTHER JURISDICTION (A) BY SUIT, ACTION OR PROCEEDING ON THE JUDGMENT, A CERTIFIED OR TRUE COPY OF WHICH SHALL BE CONCLUSIVE EVIDENCE OF THE FACT AND THE AMOUNT OF INDEBTEDNESS OR LIABILITY THEREIN DESCRIBED OR (B) IN ANY OTHER MANNER PROVIDED BY OR PURSUANT TO THE LAWS OF SUCH OTHER JURISDICTION, PROVIDED, HOWEVER, THAT ANY OF FINCO OR ANY INTERESTED PARTY MAY AT ITS OPTION BRING SUIT, OR INSTITUTE OTHER JUDICIAL PROCEEDINGS AGAINST THE SERVICER OR UHS DELAWARE OR ANY OF ITS RESPECTIVE ASSETS IN ANY STATE OR FEDERAL COURT OF THE UNITED STATES OR OF ANY COUNTRY OR PLACE WHERE THE SERVICER OR UHS DELAWARE OR SUCH ASSETS MAY BE FOUND. (b) EACH OF THE SERVICER, UHS DELAWARE, FINCO, THE TRUSTEE (AND THEIR RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY WAIVES ALL RIGHTS TO TRIAL BY JURY IN ANY ACTION OR PROCEEDING ARISING OUT OF OR RELATING TO ANY OF THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT. (c) THIS SECTION 5.16 SHALL SURVIVE THE TERMINATION OF THIS AGREEMENT. Section 5.17. Indemnification. If at any time any demand, claim, cause of action, damage or liability or any action or other legal proceeding (collectively a "claim") should be asserted against, or incurred by Finco, any Interested Party or any of their respective directors, officers, employees and agents by reason of, or in connection with, any act or failure to act on the part of the Servicer, the Servicer shall indemnify and hold Finco any such Interested Party, and any such directors, officers, employees and agents, as the case may be, harmless of and from any and all loss (other than loss of profit as a result of the credit quality of the Obligor), damage, claim, penalty, liability and/or expense which it may sustain or incur by reason thereof, including the amount of any judgment, plus costs and interest thereon, which may be entered against or incurred by Finco or any Interested Party with respect to any such claim, as well as any and all reasonable attorneys' fees and other disbursements paid or incurred in connection therewith (any of the foregoing, an "Indemnified Amount"), provided the Servicer has been notified thereof in writing and has been given a reasonable opportunity to respond to and to defend same. This indemnity shall survive the termination of this Agreement. IN WITNESS WHEREOF, UHS Delaware, as Servicer, and Finco have caused this Agreement to be duly executed by their duly authorized officers, all on the day and year first above written. UHS OF DELAWARE, INC., as Servicer By:__________________________ Title: UHS RECEIVABLES CORP. By:__________________________ Title: CONTINENTAL BANK, NATIONAL ASSOCIATION, as Trustee By:__________________________ Title: Acknowledged and Agreed: BARCLAYS BANK PLC, as Managing Agent for Sheffield By:____________________________ Title: SCHEDULE I Document Locations Servicer's Principal Place of Business UHS's Principal Place of Business A. Document Locations Hospital Document Locations(s) Chalmette General Hospital, Inc. 9001 Patricia Street Chalmette, LA 70043 and 800 Virtue Street Chalmette, LA 70043 Dallas Family Hospital, Inc. 2929 South Hampton Road Dallas, TX 75224 Del Amo Hospital, Inc. 23700 Camino del Sol Torrance, CA 90505 Doctors' General Hospital, Ltd. 6701 West Sunrise Blvd. Plantation, FL 33313 HRI Hospital, Inc. 227 Babcock Street Brookline, MA 02146 McAllen Medical Center, Inc. 301 West Expressway 83 McAllen, TX 78503 Meridell Achievement Center, Inc. Highway 29 West Liberty Hill, TX 78642 and 2501 Cypress Creek Road Cedar Park, TX 78613 River Oaks, Inc. 1525 River Oaks Road West New Orleans, LA 70123 Sparks Reno Partnership, L.P. 2375 E. Prater Way Sparks, NV 89434 Turning Point Care Center, Inc. 319 East By-Pass Moultrie, GA 31768 UHS of Arkansas, Inc. 21 BridgeWay Road North Little Rock, AR 72118 UHS of Auburn, Inc. 20 Second Street, N.E. Auburn, WA 98002 UHS of Belmont, Inc. 4058 West Melrose Street Chicago, IL 60641 UHS of Maitland, Inc. 201 Alpine Drive Maitland, FL 32751 UHS of Massachusetts, Inc. 49 Robinwood Avenue Boston, MA 02130 UHS of River Parishes, Inc. 500 Rue de Sante LaPlace, LA 70068 UHS of Shreveport, Inc. 1130 Louisiana Avenue Shreveport, LA 71101 Universal Health Recovery Centers, Inc. 2001 Providence Road Chester, PA 19013 Universal Health Services of Inland 36485 Inland Valley Drive Valley, Inc. Wildomar, CA 92395 Universal Health Services of Nevada, Inc. 620 Shadow Lane Las Vegas, NV 89106 Victoria Regional Medical Center, Inc. 101 Medical Drive Victoria, TX 77904 Wellington Regional Medical Center 10101 Forest Hill Blvd. Incorporated West Palm Beach, FL 33414 Westlake Medical Center, Inc. 4415 South Lakeview Canyon Road Westlake Village, CA 91361 B. Servicer's Principal Place of Business 367 South Gulph Road King of Prussia, PA 19406 C. UHS Principal Place of Business 367 South Gulph Road King of Prussia, PA 19406 SCHEDULE II Master Receivables Account Bank: Continental Bank, N.A., Chicago, Illinois Account Name: Universal Health Services, Inc. Master Receivables Account Account Number: 78-27784 EXHIBIT A TO SERVICING AGREEMENT Settlement Date Statement EXHIBIT B TO SERVICING AGREEMENT Servicer's Certificate [Settlement Date Statement] [Servicer Daily Statement] _________________________ hereby certifies that he/she is an Authorized Officer of UHS of Delaware, Inc. (the "Servicer") holding the office set forth beneath his/her signature and that he/she is duly authorized to execute this Servicer's Certificate on behalf of the Servicer and further certifies [with respect to the immediately preceding Settlement Period (________) to (________) that (i) the information set forth in the Settlement Date Statement attached hereto as Exhibit A is true and correct in all material respects as of the date thereof, (ii) the Servicer has, to the best of my knowledge, fully performed its obligations under the Servicing Agreement and (iii) except as set forth on Exhibit A attached, no default in the performance of such obligations has occurred and is continuing] [that the information set forth in the Servicer Daily Statement attached hereto as Exhibit A is true and correct in all material respects as of the Statement Delivery Day]. UHS of Delaware, Inc., as Servicer By: _________________________ Name: Title: Dated: __________________ EXHIBIT C TO SERVICING AGREEMENT Servicer Daily Statement EXHIBIT D TO SERVICING AGREEMENT FORM OF CONFIDENTIALITY AGREEMENT FOR USE BY FINCO [Letterhead of Recipient of Information] ___________ __, 199_ UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, CA 92675 Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, PA 19406 Dear Sirs: Reference is made to the Servicing Agreement, dated as of _______ __, 1993 (as amended from time to time, the "Servicing Agreement"), among UHS Receivables Corp., a Delaware corporation (the "Transferor"), Universal Health Services, Inc., a Delaware corporation (the "Servicer"), and Continental Bank, a national banking association, not in its individual capacity but solely as Trustee, and to the pending and proposed discussions between the Transferor and [recipient] (the "Recipient") regarding [describe transaction requiring disclosure]. Unless otherwise defined herein, capitalized terms defined in the Servicing Agreement are used herein as so defined. Pursuant to our discussions, the Transferor hereby agrees to provide to the Recipient certain information, practices, books, correspondence, and records of a confidential nature and in which the Servicer has a proprietary interest (the "Information") on the terms and conditions set forth below. By its execution of this Agreement, the Recipient hereby agrees to all such terms and conditions. The Recipient hereby acknowledges that all Information received by it from the Transferor shall be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality. The Recipient agrees that, subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose the Information without the prior written consent of the Transferor and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by the Servicing Agreement and the other Operative Documents or for the enforcement of any of the rights granted thereunder) of any of the Information without the prior written consent of the Transferor. Notwithstanding the foregoing, the Recipient may (x) disclose Information to any Person that has executed and delivered a confidentiality agreement in substantially the same form as this agreement naming the Transferor and the Servicer as third party beneficiaries thereof and (y) disclose or otherwise use Information (A) to the extent that such Information is required or appropriate in any report, statement or testimony submitted to any municipal, state or federal regulatory body having or claiming to have jurisdiction over the Recipient or submitted to the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such Information subsequently becomes publicly available, other than through any act or omission of the Recipient or (F) to the extent that such Information subsequently becomes known to the Recipient, other than through a Person whom the Recipient knows to be acting in violation of its obligations to the Transferor or the Servicer. The parties agree that any breach of this letter agreement would cause damages which cannot be determined in money and that injunction is an appropriate remedy for breach, though not necessarily the sole remedy. This Agreement shall inure to the benefit of the parties hereto, each of their respective successors and permitted assigns and the Servicer, and the Servicer will be deemed to be a third party beneficiary of this Agreement. This Agreement shall be governed by, and construed in accordance with the law of the State of New York, and may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one agreement. Please acknowledge your agreement to the foregoing by signing three copies of this letter agreement and returning them to the Transferor. Upon receipt of the executed letter agreement, the Transferor pursuant to the terms of the Servicing Agreement, will deliver an executed agreement to the Servicer. Very truly yours, [RECIPIENT] By:_________________________ Title: Acknowledged and Agreed: UHS RECEIVABLES CORP. By:____________________________ Title: - ----------------------------------------------------------------------------- POOLING AGREEMENT among UHS RECEIVABLES CORP., SHEFFIELD RECEIVABLES CORPORATION, and CONTINENTAL BANK, NATIONAL ASSOCIATION, Trustee, dated as of November 16, 1993 UHS HEALTHCARE RECEIVABLES TRUST - ------------------------------------------------------------------------------ ********** Page ARTICLE I DEFINITIONS 1.1. Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 ARTICLE II CONVEYANCE OF THE RECEIVABLES; PARTICIPATIONS; TRIPs 2.1. Conveyance of Receivables and Total Transferred Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2.2. Acceptance by Trustee . . . . . . . . . . . . . . . . . . . . . 3 2.3. Construction of Agreement. . . . . . . . . . . . . . . . . . . . 4 2.4. Participations . . . . . . . . . . . . . . . . . . . . . . . . . 4 2.5. Initial Purchase of the Sheffield Participation and Issuance of the TRIPs. . . . . . . . . . . . . . . . . . . . 4 2.6. Increases and Decreases in the Sheffield Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2.7. Maintenance of Aggregate Capital . . . . . . . . . . . . . . . . 7 2.8. Borrowing Base Compliance. . . . . . . . . . . . . . . . . . . . 7 2.9. Subordination of Finco Interest. . . . . . . . . . . . . . . . . 8 2.10. Selection of Fixed Periods . . . . . . . . . . . . . . . . . . 8 2.11. Increased Costs; Capital Adequacy; Illegality . . . . . . . . . 10 2.12. Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2.13. Extension of Sheffield Revolving Period; Increase of Maximum Sheffield Capital . . . . . . . . . . . . 12 2.14. Optional Acceleration of TRIPs Amortization Period. . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 ARTICLE III CONDITIONS TO PAYMENTS 3.1. Conditions to Initial Purchase . . . . . . . . . . . . . . . 14 3.2. Conditions to all Payments . . . . . . . . . . . . . . . . . 14 ARTICLE IV REPRESENTATIONS AND WARRANTIES 4.1. General Representations and Warranties of Finco. . . . . . . 15 4.2. Representations and Warranties of Finco Concerning the Receivables . . . . . . . . . . . . . . . . . 19 ARTICLE V COVENANTS OF FINCO 5.1. General Covenants. . . . . . . . . . . . . . . . . . . . . . 22 Page 5.2. Covenants of Finco Relating to the Receivables . . . . . . . 26 5.3. Notice and Consent Procedures . . . . . . . . . . . . . . . 31 5.4. Removal of Non-qualifying Receivables. . . . . . . . . . . .. 32 5.5. Hospital Concentration Accounts. . . . . . . . . . . . . . . 33 5.6. Performance of Agreements. . . . . . . . . . . . . . . . . . 33 5.7. Amendment of Assigned Agreements; Waivers. . . . . . . . . . 34 ARTICLE VI ADMINISTRATION AND COLLECTIONS 6.1. Servicing. . . . . . . . . . . . . . . . . . . . . . . . . . 35 6.2. Collections. . . . . . . . . . . . . . . . . . . . . . . . . 35 6.3. Claims Against Third Parties . . . . . . . . . . . . . . . . 36 6.4. Deleted Receivables. . . . . . . . . . . . . . . . . . . . . 37 ARTICLE VII COLLATERAL ACCOUNT AND OTHER ACCOUNTS; ALLOCATIONS AND DISTRIBUTIONS 7.1. Establishment of Collateral Account and Other Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . 37 7.2. Daily Allocations. . . . . . . . . . . . . . . . . . . . . . 39 7.3. Monthly Applications . . . . . . . . . . . . . . . . . . . . 42 7.4. Payments to Sheffield. . . . . . . . . . . . . . . . . . . . 44 7.5. Amortization . . . . . . . . . . . . . . . . . . . . . . . . 44 7.6. Allocation and Payment Procedures. . . . . . . . . . . . . . 46 7.7. Permitted Investments. . . . . . . . . . . . . . . . . . . . 47 7.8. Additional Accounts. . . . . . . . . . . . . . . . . . . . . 47 ARTICLE VIII DISTRIBUTIONS AND REPORTS TO PARTICIPANTS 8.1. Distributions. . . . . . . . . . . . . . . . . . . . . . . . 48 8.2. Statements to Participants . . . . . . . . . . . . . . . . . 48 ARTICLE IX TRIPs; RIGHTS OF PARTICIPANTS 9.1. The TRIPs. . . . . . . . . . . . . . . . . . . . . . . . . . 48 9.2. Authentication of TRIPs. . . . . . . . . . . . . . . . . . . 49 9.3. Registration of Transfer and Exchange of TRIPs . . . . . . . 49 9.4. Restrictions on Transfer . . . . . . . . . . . . . . . . . . 50 9.5. Mutilated, Destroyed, Lost or Stolen TRIPs . . . . . . . . . 50 9.6. Persons Deemed Owners. . . . . . . . . . . . . . . . . . . . 51 9.7. Access to List of Participants' Names and Addresses. . . . . . . . . . . . . . . . . . . . . . . . . . 51 9.8. Authenticating Agent . . . . . . . . . . . . . . . . . . . . 52 9.9. Limitation on Rights of Participants . . . . . . . . . . . . 53 9.10. Participations Nonassessable and Fully Paid . . . . . . . . . . 53 9.11. Actions by TRIPs Holders. . . . . . . . . . . . . . . . . . . . 53 Page ARTICLE X EARLY AMORTIZATION EVENTS 10.1. Early Amortization Events . . . . . . . . . . . . . . . . . . . 54 10.2. Remedies. . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 ARTICLE XI THE TRUSTEE 11.1. Duties of Trustee. . . . . . . . . . . . . . . . . . . . . . . 60 11.2. Rights of the Trustee. . . . . . . . . . . . . . . . . . . . . 61 11.3. Trustee Not Liable for Recitals. . . . . . . . . . . . . . . . 62 11.4. Trustee May Own TRIPs. . . . . . . . . . . . . . . . . . . . . 63 11.5. Compensation of Trustee. . . . . . . . . . . . . . . . . . . . 63 11.6. Eligibility Requirements for Trustee . . . . . . . . . . . . . 63 11.7. Resignation or Removal of Trustee. . . . . . . . . . . . . . . 64 11.8. Successor Trustee. . . . . . . . . . . . . . . . . . . . . . . 64 11.9. Merger or Consolidation of Trustee . . . . . . . . . . . . . . 65 11.10. Appointment of Co-Trustee or Separate Trustee. . . . . . . . . 65 11.11. Tax Returns. . . . . . . . . . . . . . . . . . . . . . . . . . 66 11.12. Trustee May Enforce Claims Without Possession of TRIPs. . . . . . . . . . . . . . . . . . . . . . . . . . 67 11.13. Suits for Enforcement. . . . . . . . . . . . . . . . . . . . . 67 11.14. Rights of Participants to Direct Trustee . . . . . . . . . . . 67 11.15. Representations and Warranties of Trustee. . . . . . . . . . . 68 11.16. Maintenance of Office or Agency. . . . . . . . . . . . . . . . 68 ARTICLE XII INDEMNIFICATION AND EXPENSES 12.1. Indemnities by Finco. . . . . . . . . . . . . . . . . . . . . . 69 12.2. Additional Costs. . . . . . . . . . . . . . . . . . . . . . . . 70 12.3. Survival of Indemnities . . . . . . . . . . . . . . . . . . . . 71 12.4. Method of Payment . . . . . . . . . . . . . . . . . . . . . . . 71 ARTICLE XIII TERMINATION OF TRUST 13.1. Final Termination of Participations; Optional Repurchase of TRIPs. . . . . . . . . . . . . . . . . . . . . 72 13.2. Final Payment of the TRIPs. . . . . . . . . . . . . . . . . . . 73 13.3. Termination of Trust. . . . . . . . . . . . . . . . . . . . . . 73 13.4. Finco's Termination Rights. . . . . . . . . . . . . . . . . . . 74 ARTICLE XIV MISCELLANEOUS 14.1. Notices, Etc . . . . . . . . . . . . . . . . . . . . . . . . . 74 14.2. Successors and Assigns; Survival . . . . . . . . . . . . . . . 76 14.3. Severability Clause. . . . . . . . . . . . . . . . . . . . . . 76 14.4. Amendments . . . . . . . . . . . . . . . . . . . . . . . . . . 76 Page 14.5. Finco's Obligations. . . . . . . . . . . . . . . . . . . . . . 77 14.6. Consent to Assignment. . . . . . . . . . . . . . . . . . . . . 77 14.7. Authority of Managing Agent. . . . . . . . . . . . . . . . . . 78 14.8. Further Assurances . . . . . . . . . . . . . . . . . . . . . . 78 14.9. Counterparts . . . . . . . . . . . . . . . . . . . . . . . . . 78 14.10. Headings . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 14.11. No Bankruptcy Petition Against Sheffield or Finco . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 14.12. GOVERNING LAW. . . . . . . . . . . . . . . . . . . . . . . . . 79 14.13. No Waiver; Cumulative Remedies . . . . . . . . . . . . . . . . 79 14.14. SUMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. . . . . . . . . . . . . . . 79 14.15. Acquisition of Participations. . . . . . . . . . . . . . . . . 80 14.16. Waivers. . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 EXHIBIT A Form of TRIP EXHIBIT B Auditors' Report EXHIBIT C Form of Confidentiality Agreement EXHIBIT D Transfer Certificate SCHEDULE I Finco Principal Place of Business SCHEDULE II Accounts POOLING AGREEMENT POOLING AGREEMENT, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, this "Agreement"), among UHS Receivables Corp., a Delaware corporation (together with its successors and assigns, "Finco"), Sheffield Receivables Corporation, a Delaware corporation (together with its successors and assigns, "Sheffield"), and Continental Bank, National Association, a national banking association, as trustee (in such capacity, together with its successors and assigns, the "Trustee"). WHEREAS, pursuant to the Sale and Servicing Agreements (capitalized terms used without definition in the recitals have the meanings assigned to them in the Definitions List referred to below) the Hospitals have agreed to sell, and Finco has agreed to purchase, the Receivables and other Transferred Property; WHEREAS, Finco wishes to assign and transfer to the Trustee on behalf of the Trust and pursuant to the terms and conditions set forth herein all of its right, title and interest in, to and under the Receivables and other Finco Transferred Property; WHEREAS, the Trust will issue the Sheffield Participation on the Initial Closing Date, which Participation will be subject to increase or decrease as set forth herein; and WHEREAS, it is contemplated that one or more TRIPs Participations will be issued on a TRIPs Closing Date to occur after the Initial Closing Date. In consideration for the premises and the mutual agreements herein contained, each party agrees, for the benefit of the other parties and the Participants, as follows: ARTICLE I DEFINITIONS Section 1.1. Definitions. As used in this Agreement (unless the context requires a different meaning), capitalized terms shall have the meanings assigned to them in the Definitions List, dated as of the date hereof (the "Definitions List"), that refers to this Agreement, which Definitions List is incorporated herein by reference and shall be deemed to be a part of this Agreement, and all terms herein shall be interpreted in accordance with the terms of the Definitions List. ARTICLE II CONVEYANCE OF THE RECEIVABLES; PARTICIPATIONS; TRIPs Section 2.1. Conveyance of Receivables and Total Transferred Property. (a) By execution of this Agreement, Finco does hereby transfer, assign, set over and otherwise convey to the Trustee on behalf of the Trust, in trust for the benefit of the Participants and, to the extent set forth in Section 2.9, Finco, without recourse (except as specifically provided herein), all its right, title and interest in, to and under: (i) the Purchased Receivables and the other Transferred Property with respect to which the Payment Date is the Initial Closing Date and created from time to time thereafter until the Trust Termination Date, all monies due or to become due and all amounts received or to be received with respect thereto and all proceeds thereof (including, without limitation, "proceeds" as defined in Section 9-306 of the UCC in effect in the state in which Finco's chief executive office is located), subject, however, to the repurchase provisions of Section 5.4 and (ii) the Assigned Agreements and the other Finco Transferred Property, including, without limitation, all amounts due and to become due to Finco from the Servicer, the Hospitals, UHS or any other Person under or in connection with the Assigned Agreements, whether payable as interest, fees, expenses, costs, taxes, indemnities, insurance recoveries, damages for breach of any of the Assigned Agreements or otherwise and all proceeds thereof (including, without limitation, "proceeds" as defined in Section 9-306 of the UCC in effect in the state in which Finco's chief executive office is located), and all rights, remedies, powers, privileges and claims of Finco against any or all of the Assignors under or with respect to the respective Assigned Agreements (whether arising pursuant to the terms of the Assigned Agreements or otherwise available to Finco at law or in equity), including, without limitation, the rights of Finco (A) to enforce (x) the Sale and Servicing Agreements against the respective Hospitals thereunder, (y) the Servicing Agreement against the Servicer and (z) the Guarantee against UHS and (B) to give or withhold any and all consents, requests, notices, directions, approvals, extensions or waivers under or with respect to the Assigned Agreements to the same extent as Finco might do but for the assignment of all such rights by Finco to the Trustee in this Section 2.1. Such property, together with all monies from time to time on deposit in the Collateral Account, the Other Accounts and any Additional Account, shall constitute the assets of the Trust (the "Trust Assets"). In exchange for the conveyance of the Trust Assets on the Initial Closing Date, Finco shall receive the Sheffield Participation to be acquired on the Initial Closing Date by Sheffield and the Subordinated Interest. (b) Notwithstanding the foregoing transfer, assignment, set-over and conveyance, subject to Sections 5.6 and 5.7, Finco shall nevertheless be permitted to take all actions, if any, required by the specific terms of any of the Assigned Agreements, and such transfer, assignment, set-over and conveyance (i) does not constitute and is not intended to result in the creation or an assumption by the Trust, the Trustee or any Interested Party of any obligation of Finco, any UHS Entity or any other Person in the Transferred Property, the Assigned Agreements or the other Finco Transferred Property and (ii) shall not relieve Finco from the performance of any term, covenant, condition or agreement on Finco's part to be performed or observed under or in connection with any of the Assigned Agreements, or from any liability to any Assignor under any of the Assigned Agreements, or impose any obligation on any of the Interested Parties to perform or observe any such term, covenant, condition or agreement on Finco's part to be so performed or observed or impose any liability on any of the Interested Parties for any act or omission on the part of Finco or any Assignor or from any breach of any representation or warranty on the part of Finco or any Assignor contained herein or in the other Assigned Agreements, or made in connection herewith or therewith. (c) In connection with such transfer, assignment, set-over and conveyance, and subject to Section 5.3, Finco agrees to file or deliver, as the case may be, at its own expense, all Security Filings with respect to the Purchased Receivables, the other Transferred Property, and the Finco Transferred Property, now existing and hereafter created, meeting the requirements of applicable state laws in such manner and in such jurisdictions as are necessary to perfect the assignment of the Transferred Property and the Finco Transferred Property to the Trustee, and to deliver a file-stamped copy or other evidence of filing of any UCC financing statements and any continuation statements to the Trustee. The Trustee shall be entitled to rely on the Security Filings filed or delivered by Finco without any independent investigation. (d) In connection with such transfer, assignment, set-over and conveyance, Finco further agrees, at its own expense, on or prior to the Initial Closing Date, to indicate in its computer files and to cause the Servicer and the Hospitals to indicate in their computer files that the Purchased Receivables have been conveyed to the Trustee on behalf of the Trust pursuant to this Agreement for the benefit of the Participants. Section 2.2. Acceptance by Trustee. (a) The Trustee hereby acknowledges its acceptance on behalf of the Trust of all right, title and interest to the property, now existing and hereafter created, conveyed to the Trustee on behalf of the Trust pursuant to Section 2.1 and declares that it shall maintain such right, title and interest, upon the trust herein set forth, for the benefit of all Participants. (b) The Trustee shall have no power to create, assume or incur indebtedness or other liabilities in the name of the Trust other than as contemplated in Sections 9.3(b) and 9.8(d) of this Agreement. Section 2.3. Construction of Agreement. (a) Finco hereby grants to the Trustee on behalf of the Trust a security interest in all of Finco's right, title and interest in, to and under the Total Transferred Property to secure all of Finco's obligations hereunder and under the other Finco documents, including, without limitation, Finco's obligation to transfer Receivables hereafter created to the Trustee on behalf of the Trust, and this Agreement shall constitute a security agreement under applicable law. (b) It is the intent of Finco, the Trustee and the Participants that, for federal, state and local income and franchise tax purposes and consolidated financial accounting, the Participations will be considered indebtedness of Finco secured by the Total Transferred Property. Finco and Sheffield, by entering into this Agreement, and each TRIPs Holder, by its acceptance of its TRIP, agree to treat the Participations for federal, state and local income and franchise tax purposes as indebtedness of Finco. Section 2.4. Participations. Subject to the terms of this Agreement, each Participation shall represent senior undivided participating ownership or security interests in the Trust Assets, including the right to receive all Collections and other amounts received in respect of the Purchased Receivables, all funds on deposit in the Collateral Account credited to the sub-accounts maintained for the Participants and all funds in the Other Accounts and any Additional Accounts (each such interest being hereinafter referred to as a "Participation"), all as provided in this Agreement. The TRIPs Participations shall be evidenced by the TRIPs, each substantially in the form of Exhibit A. The TRIPs shall, upon issue, be executed and delivered by Finco to the Trustee for authentication and redelivery as provided in Sections 2.5 and 9.2. Sheffield is hereby authorized to record the date of the Initial Sheffield Purchase and each Increase, the Initial Sheffield Capital and each Increase Amount and the date and amount of each Decrease on its books and records, and any such recordation shall, absent manifest error, constitute prima facie evidence of the Sheffield Capital and the Sheffield Participation. Section 2.5. Initial Purchase of the Sheffield Participation and Issuance of the TRIPs. (a) Subject to the terms and conditions of this Agreement, the Sheffield Participation shall be initially acquired (the "Initial Sheffield Purchase") by Sheffield on the Initial Closing Date and upon request of Finco and acceptance by Sheffield; provided that Finco gives irrevocable written notice to Sheffield prior to 3:00 pm (New York City time) on the Business Day prior to the Initial Closing Date, unless the Sheffield Yield Rate with respect to the Initial Sheffield Capital shall be calculated by reference to the Adjusted Eurodollar Rate, in which case such notice shall be delivered no later than 3:00 pm (New York City time) three Business Days prior to the Initial Closing Date. Such notice shall state (i) the Initial Closing Date, (ii) the Initial Sheffield Capital, which shall not be less than $1,000,000, (iii) the Fixed Period applicable to each Sheffield Tranche comprising such Initial Sheffield Capital and (iv) the Sheffield Yield Rate approved by Sheffield for each such Sheffield Tranche provided that the Fixed Period applicable to any Sheffield Tranche comprising the Initial Sheffield Capital shall be selected in accordance with the requirements of Section 2.10. On the Initial Closing Date, Sheffield shall make available to Finco at Finco's office specified in Section 14.1, in immediately available funds, the Initial Sheffield Capital. Sheffield shall not agree to make the Initial Sheffield Purchase if, after giving effect thereto, the Sheffield Capital would exceed the Maximum Sheffield Capital. (b) On the TRIPs Closing Date, Sheffield may reduce the Sheffield Participation. In exchange therefor, subject to the terms and conditions of this Agreement and payment of any amounts required to be paid in respect of the Sheffield Participation, upon written order of Finco to the Trustee, on the TRIPs Closing Date the Trust shall (i) issue the TRIPs evidencing the TRIPs Participations and (ii) reduce the Sheffield Capital to the extent of the TRIPs Capital of the TRIPs so issued. The TRIPs Participations so issued on the TRIPs Closing Date shall be acquired by the TRIPs Holders and the TRIPs shall be issued in favor of the TRIPs Holders on the TRIPs Closing Date in an aggregate amount equal to the Initial TRIPs Capital; provided that Finco shall give five Business Days' prior written notice to Sheffield, the Rating Agencies and the Trustee of such acquisition, and if such acquisition will result in a Decrease of the Sheffield Capital, Finco shall satisfy the conditions of Section 2.6(b). Such notice shall specify (i) the TRIPs Closing Date, (ii) the Initial TRIPs Capital, (iii) the Scheduled TRIPs Termination Date and (iv) the TRIPs Yield Rate. On the TRIPs Closing Date, each TRIPs Holder shall make available to the Trustee, for deposit in the Collateral Account, in immediately available funds, its portion of the Initial TRIPs Capital; provided, however, that, after giving effect to such deposit and to any Increases and Decreases proposed to be made on the TRIPs Closing Date, the Initial TRIPs Capital shall not exceed the Maximum TRIPs Capital and the sum of the Sheffield Capital and the TRIPs Capital shall not exceed the Maximum Aggregate Capital. On the TRIPs Closing Date, Finco shall execute, and the Trustee, upon written order of Finco, shall duly authenticate and deliver to the TRIPs Holders, TRIPs executed in favor of each TRIPs Holder, in denominations equal to the TRIPs Holders' respective portions of the Initial TRIPs Capital. Section 2.6. Increases and Decreases in the Sheffield Capital. (a) The Sheffield Capital may be increased (an "Increase") on any Business Day upon request of Finco and (subject to the limitations set forth herein) at Sheffield's option; provided that Finco gives irrevocable written notice to Sheffield prior to 3:00 pm (New York City time) on the Business Day prior to the date of such Increase, unless the Sheffield Yield Rate with respect to the Increase Amount shall be calculated by reference to the Adjusted Eurodollar Rate, in which case such notice shall be delivered no later than 3:00 pm three Business Days prior to the date of such Increase. Such notice shall state (i) the Business Day on which such Increase is proposed to occur, (ii) the Increase Amount, which shall not be less than $1,000,000, (iii) the Fixed Period applicable to such Increase Amount and (iv) the Sheffield Yield Rate applicable to such Increase Amount. Promptly upon receipt of such notice, Sheffield shall determine, in its sole discretion, its willingness to acquire the Increase, and shall promptly notify Finco of such determination. If Sheffield agrees to acquire any Increase, on the applicable Business Day on which such Increase is scheduled to occur, Sheffield shall make available to Finco at its office specified in Section 14.1, in immediately available funds, the applicable Increase Amount. Sheffield shall not agree to acquire any Increase if, after giving effect thereto, the Sheffield Capital would exceed the Maximum Sheffield Capital. (b) Prior to 3:00 pm (New York City time) on the last day of any Fixed Period with respect to any Sheffield Tranche, upon election of Finco, the Sheffield Capital may be decreased (a "Decrease") through the distribution to Sheffield of an amount equal to all or any portion of such Sheffield Tranche; provided that (i) Finco shall give written notice of such Decrease prior to 3:00 pm (New York City time) on the Business Day preceding such decrease to Sheffield and the Trustee, (ii) such distribution shall be made from funds (A) retained in the Sheffield Sub-account pursuant to Section 7.2(b)(iv)(B) or (B) allocated to the Collateral Account pursuant to Sections 7.2(b)(v) and 7.2(c)(v) and (iii) after giving effect to such distribution, and to Section 2.10, no Sheffield Tranche shall be less than $100,000. (c) The Sheffield Capital shall not be increased unless each of the following conditions have been satisfied, and delivery by Finco of any request for any Increase pursuant to subsection 2.6(a) shall be deemed to be a representation and warranty by Finco as to the satisfaction of such conditions: (i) On each such date Finco shall have complied, in all material respects, with all its covenants hereunder and shall have fulfilled all its obligations hereunder; (ii) The representations and warranties of Finco set forth in Article IV shall be true and correct in all material respects on and as of such date after giving effect to any such payment; and (iii) Since the previous Business Day, there shall have been no material adverse change or changes in (i) the business, property, assets or condition (financial or otherwise) of the UHS Entities taken as a whole that would reasonably be expected to have, alone or in the aggregate, a material adverse effect on the ability of the UHS Entities to perform their obligations under the Operative Documents or (B) the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables taken as a whole or the value of the related Transferred Property. (d) To the extent that Sheffield elects to maintain the Sheffield Participation and the Sheffield Capital in accordance with Section 2.7, Fixed Periods shall be selected from time to time to apply to each Sheffield Tranche in accordance with Section 2.10. Section 2.7. Maintenance of Aggregate Capital. (a) During the TRIPs Revolving Period, and subject to the terms and conditions of this Agreement, the Trustee, on behalf of the TRIPs Holders, shall maintain the TRIPs Capital by paying to Finco on each Business Day the amounts (if any) required to be paid pursuant to Section 7.2(d). (b) During the Sheffield Revolving Period, and subject to the terms and conditions of this Agreement, the Trustee, on behalf of Sheffield, shall, unless otherwise instructed in writing by Sheffield, maintain the Sheffield Capital, subject to increase or decrease as provided herein, by paying to Finco on each Business Day the amounts (if any) required to be paid pursuant to Section 7.2(d). Nothing in this Agreement shall be deemed to be or construed as a commitment by Sheffield to make the Initial Sheffield Purchase or any Increase or to make any payment to Finco to maintain the Sheffield Capital. Sheffield may elect upon 90 days' prior written notice, in its sole discretion, not to maintain the Sheffield Capital. Sheffield shall send notice of such election to Finco and the Trustee and the Trustee shall thereupon provide notice thereof to each TRIPs Holder. Commencing 90 days after receipt of such notice, the Trustee, on behalf of Sheffield, shall make the allocation provided in Section 7.2(b)(iv)(A). Section 2.8. Borrowing Base Compliance. (a) If, on any Business Day during the Sheffield Revolving Period, after giving effect to all allocations and distributions required pursuant to Sections 7.2(a) through (c), the Aggregate Capital would exceed the Borrowing Base (as reflected in the Servicer Daily Statement), the Sheffield Capital shall be reduced through the repayment of Commercial Paper and Loans by the lesser of (i) the amount of such excess, (ii) the sum of (A) the portion of the Sheffield Capital allocable to all Commercial Paper maturing on such Business Day and (B) the principal amount of all Loans maturing or which may be prepaid on such Business Day and (iii) the amount of funds deposited in the Collateral Account pursuant to Sections 7.2(b)(v)(A) and 7.2(c)(vi)(A) on such Business Day. The amount of new Commercial Paper which could otherwise be issued on such date shall be reduced to the extent of such excess. If no Commercial Paper Notes are scheduled to mature on such date and no Loans are then Outstanding, then the Sheffield Capital shall not be so reduced as a result of such excess. (b) Notwithstanding any provision of this Agreement to the contrary, the amount of any payment to Finco in respect of the Participations, whether in respect of the initial acquisition of any Participation, any Increase or the maintenance of the Aggregate Capital, shall be reduced to the extent that, after giving effect to such payment (absent the reduction required pursuant to this Section) and to all allocations and distributions required pursuant to Article VII on such day, and any reduction in the Sheffield Capital required by Section 2.8(a), the Aggregate Capital would exceed the Borrowing Base. Section 2.9. Subordination of Finco Interest. (a) Finco shall receive an interest in the Trust Assets not represented by the Participations (the "Subordinated Interest"), which interest shall be subordinated to the interests of the Participants in the Trust Assets; provided that, except as specifically provided in Article VII, the Subordinated Interest shall not represent any interest in the Collateral Account, the Other Accounts, any Additional Account or any other account maintained for the benefit of the Participants. Subject to the terms and conditions of this Agreement, Finco shall be entitled to receive the amounts (if any) payable to it pursuant to Section 7.2(d) in respect of the Subordinated Interest. Finco hereby agrees that all its right, title and interest in the Collections on the Purchased Receivables shall be subordinated to the extent of the priorities and in the manner set forth in Article VII. (b) If an Early Amortization Event shall have occurred and be continuing, no amount shall be paid to Finco in respect of the Subordinated Interest or otherwise until (i) the Adjusted Aggregate Capital shall have been reduced to zero, (ii) all Yield and any Make-Whole Payment Amount scheduled to accrue or be paid in respect of the Participations shall have been deposited in the Sheffield Interest Sub-account or the TRIPs Interest Sub-account, as the case may be, and (iii) all fees, costs, expenses and Indemnified Amounts scheduled to accrue or be paid pursuant to the Operative Documents shall have been deposited in the Expense Sub-account. Section 2.10. Selection of Fixed Periods. (a) From time to time hereafter until the Sheffield Termination Date, Finco shall, subject to the limitations described below, select (i) Fixed Periods for each Sheffield Tranche so that all Sheffield Capital is at all times allocated to a Fixed Period and (ii) Sheffield Yield Rates approved by Sheffield to apply to each such Sheffield Tranche for each such Fixed Period. The initial Fixed Periods and Sheffield Yield Rates applicable to the Initial Sheffield Capital and each Increase Amount, respectively, shall be specified in the notice relating to the Initial Sheffield Purchase and each Increase, as described in Sections 2.5 and 2.6. Each subsequent Fixed Period for each Sheffield Tranche shall commence on the last day of the immediately preceding Fixed Period for such Sheffield Tranche, and the duration of, and Sheffield Yield Rate applicable to, such subsequent Fixed Period shall be such as Finco shall select and Sheffield shall approve on notice from Finco received by Sheffield (including notice by telephone, confirmed in writing) not later than 3:00 pm (New York City time) on such last day, except that (i) (A) if Sheffield shall notify Finco on or prior to receipt of such notice that the Sheffield Yield Rate applicable to any Sheffield Tranche shall be the Alternative Rate, then the Sheffield Yield Rate applicable to such Sheffield Tranche shall be the Alternative Rate, (B) no Sheffield Tranche outstanding after the Sheffield Termination Date and calculated by reference to the CP Rate shall have a fixed period ending after the 120th day after the Sheffield Termination Date (or if an Early Amortization Event of a type specified in subsection 10.1(f) or (s) shall have occurred, after the Sheffield Termination Date) and (C) each Fixed Period commencing after the occurrence of an Early Amortization Event of a type specified in subsection 10.1(f) or (s) hereof shall be calculated by reference to the Alternative Rate, (ii) if Sheffield shall not have received such notice before 3:00 pm (New York City time) or Sheffield and Finco shall not have so mutually agreed before 3:00 pm (New York City time) on such last day, such Fixed Period shall be one day and the applicable Sheffield Yield Rate shall be the Base Rate, (iii) if Finco is requesting that Sheffield Yield accrue at the Adjusted Eurodollar Rate for such Fixed Period, such notice must be received by Sheffield no later than 3:00 pm on the third Business Day prior to such last day and (iv) if Sheffield shall have notified Finco of the existence of a Eurodollar Disruption Event, the Applicable Sheffield Yield Rate shall not be calculated by reference to the Adjusted Eurodollar Rate. Any Fixed Period which would otherwise end on a day which is not a Business Day shall be extended to the next succeeding Business Day. In addition, whenever any Fixed Period as to which Sheffield Yield accrues at the Adjusted Eurodollar Rate commences on the last Business Day in a month or on a day for which there is no numerically corresponding day in the month in which such Fixed Period ends, the last day of such Fixed Period shall occur on the last Business Day of the month in which such Fixed Period ends. Any Fixed Period which commences before the Scheduled Sheffield Termination Date and would otherwise end on a date occurring after the Scheduled Sheffield Termination Date shall end on the Scheduled Sheffield Termination Date. Any Fixed Period which commences on or after the Scheduled Sheffield Termination Date shall be of such duration as shall be selected by Sheffield. Sheffield shall, on the first day of each Fixed Period for each Sheffield Tranche, notify the Trustee of the Sheffield Yield Rate for such Sheffield Tranche. (b) Sheffield shall notify Finco in the event that a Eurodollar Disruption Event as described in clause (i) of the definition of "Eurodollar Disruption Event" has occurred, whereupon any Sheffield Tranche in respect of which Sheffield Yield accrues at the Adjusted Eurodollar Rate for the then current Fixed Period shall immediately be converted to accrue at the Base Rate for the remainder of such Fixed Period. (c) If any acquisition of the Initial Sheffield Purchase or any Increase requested by Finco, or any selection of a subsequent Fixed Period and Sheffield Yield Rate approved by Sheffield pursuant to this Section 2.10 for any Sheffield Tranche is not, for any reason (other than as a result of the gross negligence or willful misconduct of Sheffield or any Lender), made or effectuated, as the case may be, on the date specified therefor, or if any Decrease in any Sheffield Tranche is made on any day other than the last day of the Fixed Period with respect to such Sheffield Tranche, Finco shall indemnify Sheffield for any loss, cost or expense incurred by Sheffield, including, without limitation, any loss, cost or expense incurred by reason of the liquidation or reemployment of deposits or other funds acquired by Sheffield to fund such Initial Sheffield Purchase or Increase or to maintain such Sheffield Tranche during the applicable Fixed Period. The agreements and obligations of Finco contained in this Section 2.10(c) shall survive the termination of this Agreement. Section 2.11. Increased Costs; Capital Adequacy; Illegality. (a) If as a result of the introduction of or any change (including, without limitation, any change by way of imposition or increase of reserve requirements) in or in the interpretation of any Requirement of Law or the compliance by any Lender or any Affiliate thereof with any law, guideline, rule, regulation, directive or request from any central bank or other Governmental Authority or agency (whether or not having the force of law), Sheffield is required to compensate any Lender in connection with this Agreement or the funding or maintenance of the Sheffield Participation hereunder, then within ten days after demand by Sheffield, Finco shall pay to Sheffield such additional amount or amounts as may be necessary to reimburse Sheffield for any amounts paid by it. (b) When making a claim under this Section 2.11, Sheffield shall submit to Finco a certificate as to such additional or increased cost or reduction, which certificate shall be conclusive absent manifest error. (c) The agreements and obligations of Finco contained in this Section 2.11 shall survive the termination of this Agreement. Section 2.12. Taxes. (a) Any and all payments in respect of the Participations or any other fees, costs, expenses or Indemnified Amounts hereunder shall be made free and clear of and without deduction for any and all present or future taxes, levies, imposts, deductions, charges or withholdings, and all liabilities with respect thereto, excluding, in the case of each Interested Party, net income taxes that are imposed by the United States and franchise taxes, gross receipts taxes and net income taxes that are imposed on such Interested Party by any state or foreign jurisdiction (as the case may be) under the laws of which such Interested Party is organized or with which such Interested Party is associated other than as a result of this Agreement, or any political subdivision thereof (all such non-excluded taxes, levies, imposts, deductions, charges, withholdings and liabilities being hereinafter referred to as "Taxes"). If Finco or the Servicer shall be required by law to deduct any Taxes from or in respect of any sum payable hereunder to any Interested Party, (i) Finco shall make an additional payment to such Interested Party in an amount sufficient so that, after making all required deductions (including deductions applicable to additional sums payable under this Section 2.12), such Interested Party receives an amount equal to the sum it would have received had no such deductions been made, (ii) Finco or the Servicer, as the case may be, shall make such deductions and (iii) Finco or the Servicer, as the case may be, shall pay the full amount deducted to the relevant taxation authority or other authority in accordance with applicable law. (b) Finco will indemnify each Interested Party for the full amount of Taxes, including, without limitation, any Taxes imposed by any jurisdiction on amounts payable under this Section 2.12 paid by such Interested Party, and any liability (including penalties, interest and expenses) arising therefrom or with respect thereto; provided that, in making a demand for indemnity payment an Interested Party shall provide Finco, at its address referred to in Section 14.1, with a certificate from the relevant taxing authority or from a responsible officer of such Interested Party stating or otherwise evidencing that such Interested Party has made payment of such Taxes and will provide a copy of or extract from documentation, if available, furnished by such taxing authority evidencing assertion or payment of such Taxes. This indemnification shall be made within ten days after the date such Interested Party makes written demand therefor. (c) Within 30 days after the date of any payment of Taxes by Finco, Finco will furnish to the party requesting such payment, at its address referred to in Section 14.1, appropriate evidence of payment thereof. (d) Each Interested Party that is not incorporated under the laws of the United States of America or a state thereof shall, to the extent that it may then do so under applicable laws and regulations, deliver to Finco (i) within 15 days after the date hereof (or after the TRIPs Closing Date in the case of the TRIPs Holders), two (or such other number as may from time to time be prescribed by applicable laws or regulations) duly completed copies of IRS Form 4224 or Form 1001 (or any successor forms or other certificates or statements which may be required from time to time by the relevant United States taxing authorities or applicable laws or regulations), as appropriate, to permit payments to be made hereunder for the account of such Interested Party without deduction or withholding of United States federal income or similar taxes and (ii) upon the obsolescence of or after the occurrence of any event requiring a change in, any form or certificate previously delivered pursuant to this Section 2.12(d), copies (in such numbers as may from time to time be prescribed by applicable laws or regulations) of such additional, amended or successor forms, certificates or statements as may be required under applicable laws or regulations to permit payments to be made hereunder for the account of such Interested Party without deduction or withholding of United States federal income or similar taxes. (e) For any period with respect to which an Interested Party has failed to provide Finco with the appropriate form, certificate or statement required pursuant to Section 2.12(d) (other than if such failure is due to a change in law occurring after the date of this Agreement), such Interested Party shall not be entitled to indemnification under Section 2.12(a) or 2.12(b) with respect to Taxes imposed by the United States. (f) Within 30 days of the written request of Finco therefor, each Interested Party shall execute and deliver to Finco such certificates, forms or other documents which can be furnished consistent with the facts, which are reasonably necessary to assist Finco in applying for refunds of Taxes remitted hereunder and which are not detrimental to such Interested Party. (g) If Sheffield is required to compensate a Lender in respect of taxes under circumstances equivalent to those described in this Section 2.12, then within ten days after demand by Sheffield, Finco shall pay to Sheffield such additional amount or amounts as may be necessary to reimburse Sheffield for any amounts paid by it. (h) The agreements and obligations of Finco contained in this Section 2.12 shall survive the termination of this Agreement. Section 2.13. Extension of Sheffield Revolving Period; Increase of Maximum Sheffield Capital. (a) Finco may request that the Sheffield Revolving Period be extended for one or more additional years by submitting in writing to Sheffield and the Trustee, no later than 90 days prior to the Scheduled Sheffield Termination Date, a request for such extension; provided that at the time of such request (i) no Early Amortization Event shall have occurred and be continuing and (ii) neither Finco nor the Servicer shall be in default in the performance of any covenant or agreement contained herein or in any Operative Document. Sheffield shall, in its sole discretion, accept or reject such request in writing within 45 days of receipt thereof and Finco shall thereupon notify the Trustee in writing of such acceptance or rejection. If Sheffield shall accept such request in writing, the Sheffield Revolving Period shall automatically and without any further action be extended for the period specified in such request. A failure by Sheffield to provide the required response to such request shall be deemed to be a rejection of such request. (b) On any Business Day following the Initial Closing Date, Finco may request, by submission of an irrevocable written request to Sheffield and the Trustee, that the Maximum Sheffield Capital be increased by an amount specified by Finco in such request, provided that, after giving effect to such increase, the Aggregate Capital shall be no greater than $85,000,000; and provided, further, that no such increase shall become effective unless all conditions precedent set forth in subsection (c) shall have been satisfied. Within 30 days of receipt of such request, Sheffield shall, in its sole discretion, accept or reject such request in writing and Finco shall thereupon notify the Trustee in writing of such acceptance or rejection. (c) Any increase requested by Finco and agreed to by Sheffield shall become effective on the first day of the Settlement Period following the satisfaction of the following conditions precedent: (i) Each Rating Agency shall have delivered written confirmation to Finco and the Trustee that the proposed increase will not adversely affect its rating of the TRIPs and/or the Commercial Paper, as the case may be; and (ii) Finco shall have delivered a certificate of an Authorized Officer dated the date of such increase to the effect that, after giving effect to such increase, (A) no Early Amortization Event shall have occurred and (B) neither Finco nor the Servicer shall be in default in the performance of any covenant or agreement contained herein or in any Operative Document. Section 2.14. Optional Acceleration of TRIPs Amortization Period. Upon at least 30 days prior written notice to Sheffield and the Trustee, which notice shall be irrevocable, Finco may elect (such election being referred to herein as the exercise of the "Call Option") to have the TRIPs Amortization Period begin after the close of business on the Transfer Date specified in such written notice (such Transfer Date, the "Call Date"); provided that Finco may not exercise the Call Option if, after giving effect to such exercise, and all allocations and distributions to be made pursuant to Article VII on such date, the Aggregate Capital would exceed the Borrowing Base. The Trustee shall give prompt notice to the TRIPs Holders of the exercise of the Call Option by Finco. If the Call Option is exercised, the TRIPs Holders shall be entitled to receive in repayment of the Participations, in addition to repayments of the TRIPs Capital and all TRIPs Yield accrued thereon, the Make- Whole Payment Amounts as provided in Article VII. ARTICLE III CONDITIONS TO PAYMENTS Section 3.1. Conditions to Initial Purchase. The initial purchase of any Participation on the Initial Closing Date or the TRIPs Closing Date, as the case may be, is subject to the satisfaction, on terms satisfactory to such Participants, the Trustee and the Placement Agent, if any, of all applicable conditions specified in the Conditions List and to all conditions specified in Section 3.2. Section 3.2. Conditions to all Payments. The Trustee shall make payments to Finco on behalf of the Participants as provided in this Agreement on each Business Day unless it shall have received notice from Sheffield or the Required TRIPs Holders or unless an Authorized Officer of the Trustee shall otherwise have actual knowledge (in which case the Trustee shall immediately notify the Participants), that one or more of the following conditions precedent have not been satisfied: (a) Finco and the Servicer shall be in full compliance with all the terms and conditions of Article VI hereof and Article III of the Servicing Agreement, including the terms and conditions regarding the Master Receivables Account; (b) No Early Amortization Event and no event which, after notice or lapse of time or both, would become an Early Amortization Event, shall have occurred and then be continuing; and (c) After giving effect to such payment, and all other allocations and distributions to be made on such date, the Aggregate Capital shall not exceed the Borrowing Base. The acceptance by Finco of any payment by or on behalf of any Participant shall be deemed to be a representation and warranty by Finco to the Trustee and each Participant as of such acceptance date as to the matters in paragraphs (a) through (c) of this Section 3.2. If, on any Business Day, the condition precedent set forth in subsection 3.2(a) is not satisfied, Sheffield or the TRIPs Holders shall have the option to (A) take no action, in which case the Trustee shall make payment to Finco pursuant to the terms hereof, (B) by written notice delivered by Sheffield to the Trustee, instruct the Trustee not to make the portion of such payment hereunder payable from the Sheffield Sub-account and to retain the amount of such payment in the Sheffield Sub- account pursuant to Section 7.2(b)(iv)(A), thereby requiring Finco to increase its Subordinated Interest on such date or (C) by written notice by the Required TRIPs Holders to the Trustee, instruct the Trustee not to make the portion of such payment hereunder payable from the TRIPs Sub-account and to retain the amount of such payment in the TRIPs Sub-account pursuant to Section 7.2(c)(v), thereby requiring Finco to increase its Subordinated Interest on such date. In the event that the condition precedent set forth in Section 3.2(c) is not satisfied, the Trustee shall, without further notice or instruction by any Participant, retain in the Collateral Account pursuant to Section 7.2(d)(ii), such portion of the amount otherwise payable to Finco as shall be necessary to satisfy such condition. In the event that the condition precedent set forth in Section 3.2(b) is not satisfied, the Trustee may, and to the extent required hereunder shall, exercise such rights and remedies as set forth in Article X and make the appropriate allocations set forth in Article VII. ARTICLE IV REPRESENTATIONS AND WARRANTIES Section 4.1. General Representations and Warranties of Finco. Finco represents and warrants to and covenants with the Trustee and the Participants, as of the date hereof, as of the TRIPs Closing Date and as of the date of any Increase as follows: (a) Finco has been duly organized and is validly existing and in good standing as a corporation under the laws of the state of Delaware, with full corporate power and authority to own or lease its properties and to conduct its business as presently conducted and to execute, deliver and perform this Agreement and the other Finco Documents and each other document related hereto and thereto to which it is a party and to consummate the transactions contemplated hereby and thereby. Finco is duly qualified as a foreign corporation and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not have, alone or in the aggregate, a material adverse effect on its business, operations, properties, assets or condition (financial or otherwise). (b) The execution, delivery and performance by Finco of this Agreement and the other Finco Documents and the consummation of the transactions contemplated hereby and thereby have been duly and validly authorized by all requisite corporate action and will not (with due notice or lapse of time or both) conflict with or result in a breach of any of the terms or provisions of, or constitute a default under, or result in the creation or imposition of any Lien upon any of its property or assets pursuant to the terms of, any indenture, mortgage, deed of trust, lease, loan agreement or other agreement, instrument or undertaking by which it is bound or to which any of its property or assets is subject, nor will such action result in any violation of any applicable Requirement of Law; and no consent, approval, authorization, order, registration, filing, qualification, license or permit of or with any court or any regulatory authority or other Governmental Authority or body or any other Person is required to be obtained by or with respect to Finco in connection with the execution, delivery and performance by Finco of this Agreement, the other Finco Documents, any other documents related hereto or thereto or the consummation of the transactions contemplated hereby or thereby (other than the actions required to file, deliver or record any Security Filings, all of which actions have been taken). (c) Each of the Finco Documents has been duly authorized, executed and delivered by Finco and constitutes a valid and legally binding obligation of Finco, enforceable against Finco in accordance with its terms, subject as to enforceability to applicable bankruptcy, reorganization, insolvency, moratorium and other similar laws affecting creditors' rights generally, and to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). (d) There are no actions, proceedings or investigations pending or, to the knowledge of Finco (after due investigation), threatened, before any court, administrative agency or other tribunal (i) which, if determined adversely to Finco, alone or in the aggregate, could have a material adverse effect on the business, operations, properties, assets or condition (financial or otherwise) of Finco, (ii) asserting the invalidity of this Agreement or any of the other Finco Documents, (iii) questioning the consummation by Finco of any of the transactions contemplated by this Agreement or the other Finco Documents, or (iv) which, if determined adversely, alone or in the aggregate, could materially and adversely affect the ability of Finco to perform its obligations under, or the validity or enforceability of, this Agreement, the other Finco Documents or the Participations; and Finco is not in default with respect to any order of any court, arbitrator or Governmental Authority. (e) Each purchase of any Participation hereunder, each Increase and each reinvestment of Collections will constitute a purchase or other acquisition of notes, drafts, acceptances, open accounts receivable or other obligations representing part or all of the sale price of merchandise, insurance or services within the meaning of Section 3(c)(5) of the Investment Company Act. Neither Finco nor the Trust is an "investment company" or a company "controlled" by an "investment company" within the meaning of the Investment Company Act. (f) The chief executive office of Finco is located at the address set forth on Schedule I hereto, which place of business is the place where Finco is "located" for the purposes of Section 9-103(3)(d) of the UCC of the state indicated on such Schedule, and the location of the office where Finco keeps all of the instruments, documents, agreements, books and records relating to the Total Transferred Property is at the address set forth on Schedule I hereto. (g) Finco has no Subsidiaries. (h) Each Hospital (including, without limitation, each Excluded Hospital with respect to Receivables and Transferred Property purchased by Finco prior to exercise by Finco of the remedy set forth in subsection 6.2(a)(iii) of the applicable Sale and Servicing Agreement) is in compliance with the terms and conditions of Article V of the related Sale and Servicing Agreement. (i) Finco has no trade names, fictitious names, assumed names or "doing business as" names. (j) No material Reportable Event has occurred during the five-year period prior to the date on which this representation is made or deemed made with respect to any Plan, and each Plan has complied in all material respects with the applicable provisions of ERISA and the Code. The present value of all accrued benefits under each Single Employer Plan maintained by Finco or any Commonly Controlled Entity (based on those assumptions used to fund the Plans) did not, as of the last annual valuation date prior to the date on which this representation is made or deemed made, materially exceed the value of the assets of such Plan allocable to such accrued benefits. Neither Finco nor any Commonly Controlled Entity has had a complete or partial withdrawal or withdrawals from any Multiemployer Plan which, alone or in the aggregate, has resulted or could result in any material liability under ERISA, and neither Finco nor any Commonly Controlled Entity would become subject to any material liability under ERISA if Finco or any such Commonly Controlled Entity were to withdraw completely from all Multiemployer Plans as of the valuation date most closely preceding the date on which this representation is made or deemed made. No such Multiemployer Plan is in reorganization or Insolvent. The present value (determined using actuarial and other assumptions which are reasonable in respect of the benefits provided and the employees participating) of the liability of Finco and each Commonly Controlled Entity for post-retirement benefits to be provided to their current and former employees under Plans which are welfare benefit plans (as defined in Section 3(1) of ERISA) does not, in the aggregate, materially exceed the assets under all such Plans allocable to such benefits. (k) As of the date of delivery thereof, each Servicer Daily Statement and each Settlement Date Statement were true, correct and complete in all material respects. (l) The Master Receivables Account has been established in accordance with, and is in compliance with, the terms and conditions of Section 3.7 of the Servicing Agreement. (m) Finco has and shall have filed or caused to be filed all material federal, state and local tax returns which are required to be filed, and has and shall have paid or caused to be paid all taxes as shown on said returns or any other taxes or assessments payable by it (other than any such taxes or assessments the amount or validity of which are currently being contested in good faith by appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of Finco and with respect to which collection has been stayed), and no tax Lien has been filed and, to the knowledge of Finco, no claims are being asserted with respect to any such taxes, fees or other charges which, alone or in the aggregate, could reasonably be expected to have a material adverse effect on the rights of the Interested Parties under the Operative Documents or with respect to the Transferred Property. (n) None of the transactions contemplated in this Agreement (including the use of proceeds from the sale of the TRIPs) will result in a violation of Section 7 of the Securities Exchange Act of 1934, as amended, or any regulations issued pursuant thereto, including Regulations G, T, U, and X of the Board of Governors of the Federal Reserve System, 12 C.F.R., Chapter II. (o) Neither Finco nor anyone acting on its behalf has offered, or will offer, directly or indirectly, any TRIPs, any interest in any TRIPs, or any other similar instrument, or has solicited, or will solicit any offer to buy any of the same, from such type or aggregate number of Persons, or in such manner, as to require the offering, issuance or sale of the TRIPs to be registered pursuant to the provisions of the Securities Act. The offer and sale of the TRIPs to the TRIPs Holders are exempt from the registration requirements of the Securities Act and neither Finco nor any Person acting on behalf of Finco will take any action that will subject the offer and sale of the TRIPs to such registration requirements. Section 4.2. Representations and Warranties of Finco Concerning the Receivables. On the date hereof and (i) with respect to Sections 4.2(a), (e), (f), (l) and (n), on each following date (including each Purchase Date) and (ii) with respect to Sections 4.2(b) through (k) and (m), with respect to the Receivables purchased by Finco on each related Purchase Date, Finco represents and warrants to the Trustee and the Participants as follows: (a) Finco has, immediately prior to each conveyance pursuant to Section 2.1, good title to the Purchased Receivables and other Total Transferred Property conveyed to the Trust, and such Purchased Receivables and other Total Transferred Property are not subject to any Lien or other claim of any kind or to any offset, counterclaim or defense of any kind, other than contractual adjustments in respect of, and in no event greater than, the Applicable Contractual Adjustment and any offsets included in the Offset Reserves. At all times during which this Agreement is in effect, the Purchased Receivables, the Total Transferred Property and the Outstanding Balances in relation thereto conveyed to the Trustee on behalf of the Trust and in which the Participants have purchased the Participations will not be subject to any Lien or claim of any kind or to any counterclaim or defense of any kind other than the Permitted Interests and the offsets included in the Offset Reserves. (b) All of the Purchased Receivables and the other Total Transferred Property comply with and will comply with all Requirements of Law (including, in the case of Governmental Receivables originated by any Hospital, all applicable requirements of the programs listed on Schedule II of the Sale and Servicing Agreement to which such Hospital is a party) and are not the subject of any litigation, court proceeding or other dispute. (c) Each of the Purchased Receivables (i) is and will be in full force and effect and represents and will represent a valid and legally binding obligation of the related Obligor enforceable against such Obligor in accordance with its terms and (ii) constitutes an "account" or a "general intangible" under the UCC in effect in the state in which Finco's chief executive office is located, or a right to payment under a policy of insurance or proceeds thereof; the Assigned Agreements and the other Finco Transferred Property (x) are and will be in full force and effect and represent and will represent valid and legally binding obligations of the Assignors enforceable against the Assignors in accordance with their terms and (y) constitute accounts or general intangibles under the UCC in effect in the state in which Finco's chief executive office is located. (d) (i) The statements and information constituting Receivables Information, as they relate to Finco, are true and correct and do not contain any untrue statement of a material fact or any omission of any material fact which would make such statements and information, in light of the circumstances in which they were made or given, misleading and (ii) the other statements and information furnished by any Authorized Officer of Finco to any Interested Party are true and correct and shall not contain any untrue statement of a material fact or any omission of any material fact which would make such other statements or information, in light of the circumstances in which they were made or given, misleading. (e) There is (i) no effective financing statement (or similar statement or instrument of registration under the law of any jurisdiction) on file or registered in any public office and (ii) no assignment filed or delivered by or on behalf of Finco covering any interest of any kind in the Purchased Receivables or the other Total Transferred Property or intended so to be filed, delivered or registered, and Finco will not execute nor will there be on file in any public office any effective financing statement (or any similar statement or instrument of registration under the laws of any jurisdiction) or any assignment or other notification relating to the Total Transferred Property, except the Security Filings in respect of the Permitted Interests. The interest of the Trustee, on behalf of the Trust, is an ownership or security interest, valid and enforceable against, and prior to, all claims of existing and future creditors of Finco and all subsequent purchasers from Finco of the Total Transferred Property. (f) All Security Filings which are required to perfect the interests of the Participants in the Purchased Receivables and the other Total Transferred Property have been filed, delivered or received, as the case may be (other than as limited by Section 5.3), and are in full force and effect. Schedule I attached hereto lists all offices where UCC filings must be made to perfect the security interests of the Participants in the Purchased Receivables and other Total Transferred Property. (g) This Agreement, together with the Security Filings, vests and at all times will vest in the Trustee on behalf of the Trust, for the benefit of the Participants, the ownership interests or first priority security interests in, and Liens on, the Purchased Receivables and other Total Transferred Property and the Collections purported to be conveyed hereby and in accordance with the terms hereof, and such conveyance of the Purchased Receivables, other Total Transferred Property and Collections constitutes and will constitute a valid transfer of, or security interest in and Lien on, the Purchased Receivables, Total Transferred Property and Collections, enforceable against Finco and all creditors of and purchasers from Finco prior to all sales or other assignments thereof. (h) No Obligor on the Purchased Receivables and other Transferred Property (including, without limitation, any insurance company or other third-party payor or guarantor of such Obligor obligated in respect of any such Purchased Receivables or Transferred Property) is bankrupt, insolvent, undergoing composition or adjustment of debts or is unable to make payment of its obligations when due; provided that this representation shall not apply to any Governmental Authority which is an Obligor on Medicaid Receivables if the Receivables of such Obligor would not be considered Uncollectible Receivables under clause (c) of the definition of Uncollectible Receivables (taking into account the proviso contained in such definition). (i) Each Hospital is a qualified provider in respect of all Purchased Receivables of such Hospital constituting Governmental Receivables. (j) All amounts paid on each Governmental Receivable will be paid to each Hospital in accordance with all Requirements of Law, either (i) in such Hospital's name to the related Hospital Concentration Account in accordance with Section 4.3(m) of the applicable Sale and Servicing Agreement or (ii) in the name of UHS, for the benefit of such Hospital, to the Master Receivables Account. (k) Each Non-governmental Receivable being purchased by Finco from each Hospital pursuant to the Sale and Servicing Agreement to which such Hospital is a party is not and will not be payable by an Obligor which is an agency or instrumentality of the federal government of the United States of America unless all applicable requirements of the Assignment of Claims Act of 1940, as amended, and all regulations promulgated thereunder, including the giving of all requisite notices of assignment to all Persons to whom such notice must be given and the acknowledgement of receipt thereof by all such Persons, have been complied with in all material respects and unless the Participants shall have been provided with evidence thereof in form and substance satisfactory to the Required Participants. (l) All accounting information relating to the Receivables which has been provided to any Participant hereunder is in accordance with each Hospital's accounting policies, including such Hospital's Credit and Collection Policy. (m) Each of the Purchased Receivables, other than any Excluded Receivable, any Self-pay Receivable and any Uncollectible Receivable for which the Payment Date is the Initial Closing Date, is and will be an Eligible Receivable on the Purchase Date for such Purchased Receivable. (n) Each of the Purchased Receivables shall at all times be separately identifiable from those Receivables not transferred by Finco to the Trust, and all Financible Receivables shall at all times be separately identifiable from those Receivables that are not Financible Receivables. ARTICLE V COVENANTS OF FINCO Section 5.1. General Covenants. Finco covenants and agrees with the Trustee and the Participants that, so long as this Agreement shall remain in effect: (a) Finco will preserve and maintain its existence as a corporation in good standing under the laws of the state of its incorporation and its qualification as a foreign corporation where such qualification is required, except where any such failure or failures to so qualify, alone or in the aggregate, could not have a material adverse effect on Finco's performance of its obligations under the Finco Documents. (b) Finco will advise Sheffield and the Trustee promptly and in reasonable detail, and the Trustee shall thereupon provide notice thereof to the TRIPs Holders, of (i) any Lien asserted or offset or claim made against any of the Purchased Receivables or Total Transferred Property, (ii) the occurrence of any breach by any of Finco or any Assignor of any of its respective representations, warranties and covenants contained herein or in any of the other Finco Documents or the Assigned Agreements, as the case may be, (iii) the occurrence of any Early Amortization Event and of any event which, with the giving of notice or passage of time or both would become an Early Amortization Event, (iv) the occurrence of any Exclusion Event and of any event which, with the giving of notice or passage of time or both would become an Exclusion Event, (v) the occurrence of any event or events of which Finco has knowledge which would, alone or in the aggregate, reasonably be expected to have a material adverse effect on (A) the business, operations, property or condition (financial or otherwise) of the UHS Entities taken as a whole, (B) the value of the Total Transferred Property or the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables or (C) the ability of Finco to perform its obligations hereunder, (vi) the receipt from any Governmental Authority of a Deficiency Notice with respect to the Purchased Receivables or otherwise, (vii) the receipt of any notice of preliminary or final determination resulting from any Audit relating to any Hospital or the Receivables (including, without limitation, any "audit exception" to such determination), (viii) any other investigation of any Hospital by HHS or any intermediary thereof or (ix) any investigation by any other Governmental Authority or any intermediary thereof concerning the Receivables or the result of which could alone or in the aggregate materially adversely affect the ability of any UHS Entity to perform its obligations under the Operative Documents. (c) Subject to Section 5.2(i), Finco will duly fulfill all obligations on its part to be fulfilled under or in connection with the conveyance by Finco of the Total Transferred Property to the Trustee on behalf of the Trust and the conveyance of the Participations to the Participants and will do nothing, and shall cause each Assignor to do nothing, to impair the rights of the Interested Parties in the Total Transferred Property. (d) All financial statements prepared by Finco or any Hospital and made available to any Person other than any UHS Entity shall indicate the sale to Finco of the Purchased Receivables and other Transferred Property. (e) Finco shall file or shall cause to be filed all federal, state and local tax returns which are required to be filed, and shall pay or cause to be paid all taxes as shown on said returns and any other taxes or assessments payable by it (other than any such taxes or assessments the amount or validity of which are contested in good faith by appropriate proceedings and with respect to which reserves in conformity with GAAP are provided on the books of Finco and with respect to which collection has been stayed). (f) Finco shall not (i) invest in (by capital contribution or otherwise), suffer to exist any investment in, or acquire or purchase or make any commitment to purchase the obligations or capital stock of, or other indicia of equity rights in, or make any loan, advance or extension of credit to, or purchase any bonds, notes, debentures or other securities of, any Person or (ii) make any expenditure (by long-term or operating lease or otherwise) for capital assets (either realty or personalty). (g) Finco shall not wind up, liquidate or dissolve its affairs or enter into any transaction of merger or consolidation, convey, sell, lease or otherwise dispose of all or any part of its property or assets other than in accordance with the terms of the Operative Documents; enter into any joint venture, syndicate or other combination with any other Person, or issue any shares of capital stock or other securities (other than to UHS or any Hospital) or agree to do any of the foregoing at any future time. (h) Finco shall not declare or pay or permit to be paid any dividends or make or agree to make any other payments to any Affiliate; provided, however, that Finco shall not be prohibited from paying to UHS any amounts received pursuant to Section 7.2(d) and not payable to the Hospitals pursuant to Section 7.2(e). (i) Finco shall not engage in any business, or enter into any contract, agreement or transaction, except as contemplated by its Certificate of Incorporation, its By-Laws and the Operative Documents. (j) Finco shall not, except as approved by the Required Participants, amend any provision of its Certificate of Incorporation, By-Laws or any Operative Document to which it is a party, or waive any rights or claims of substantial value thereunder or enter into any additional Operative Documents. (k) Finco shall not contract, create, incur, assume or suffer to exist any indebtedness for borrowed money or any obligation in respect of a lease of property which is required to be capitalized in accordance with GAAP or any other liability (contingent or otherwise), except as permitted under the Operative Documents. (l) Finco shall: (i) (A) subject to Article V of the Sale and Servicing Agreement, Section 3.1 of the Servicing Agreement and Article VI hereof, maintain its own deposit account or accounts with commercial banking institutions, separate from those of any Affiliate; (B) not divert the funds of Finco to any other Person or for other than corporate uses of Finco nor, subject to Article V of the Sale and Servicing Agreement, Section 3.1 of the Servicing Agreement and Article VI hereof, commingle the funds of Finco with funds of any other person held in any account of any other Person; and (C) use its best efforts to ensure that no funds of any other Person are commingled with funds of Finco held in any account of Finco; (ii) to the extent that it shares the same officers or other employees as any of its stockholders or Affiliates, ensure that the salaries of and the expenses related to providing benefits to such officers and other employees are fairly allocated among such entities, and that each such entity bears its fair share of the salary and benefit costs associated with all such common officers and employees; (iii) to the extent that it jointly contracts with any of its stockholders or Affiliates to do business with vendors or service providers or to share overhead expenses, ensure that the costs incurred in so doing are allocated fairly among such entities, and that each such entity bears its fair share of such costs; to the extent that Finco contracts or does business with vendors or service providers where the goods and services provided are partially for the benefit of any other Person, ensure that the costs incurred in so doing are fairly allocated to or among such entities for whose benefit the goods and services are provided, and that each such entity bears its fair share of such costs; (iv) ensure that all material transactions between Finco and any of its Affiliates are on an arm's length basis; (v) conduct its business separate from that of each other UHS Entity and each other Subsidiary of UHS; and not hold itself out or permit itself to be held out as being liable for the debts of any Affiliate; and (vi) conduct its affairs strictly in accordance with its Certificate of Incorporation and By-laws and observe all necessary, appropriate and customary corporate formalities, including, but not limited to, holding regular and special stockholders' and directors' meetings appropriate to authorize all corporate action, keeping separate and accurate minutes of its meetings, passing all resolutions or consents necessary to authorize actions taken or to be taken, and maintaining accurate and separate books, records and accounts, including, but not limited to, payroll and intercompany transaction accounts. (m) Finco shall furnish to the Trustee and Sheffield, and the Trustee shall promptly deliver to each TRIPs Holder, (i) as soon as practicable and in any event within 90 days after the end of each fiscal year of Finco, (A) a report prepared by Arthur Andersen & Co. or such other firm of independent certified public accountants, substantially in the form of Exhibit B and (B) an unaudited balance sheet of Finco as of the end of such fiscal year and unaudited statements of income and retained earnings and of cash flow of Finco for such fiscal year; (ii) as soon as practicable and in any event within 45 days after the end of each of the first three fiscal quarters of Finco, an unaudited balance sheet of Finco as of the close of such fiscal quarter and unaudited statements of income and retained earnings and of cash flow of Finco for such fiscal quarter and the portion of the fiscal year through such date, setting forth in comparative form the figures for the corresponding periods of the preceding fiscal year; (iii) at the time of the delivery of the financial statements required by clauses (i) and (ii) of this Section 5.2(m), a certificate of an Authorized Officer of Finco to the effect that (i) such financial statements are complete and correct and were prepared in accordance with GAAP applied consistently throughout the periods reflected therein and with prior periods, except as approved by such Authorized Officer and disclosed therein and (ii) there exists no Early Amortization Event or Exclusion Event under any Sale and Servicing Agreement and no condition, event or act which, with the giving of notice or lapse of time, or both, would constitute an Early Amortization Event or an Exclusion Event, or if any such Early Amortization Event, Exclusion Event, condition, event or act exists, specifying the nature thereof, the period of existence thereof and the action Finco proposes to take with respect thereto; and (iv) with reasonable promptness, such further information regarding the business, affairs and financial condition of Finco as the Trustee or any Participant may reasonably request. Section 5.2. Covenants of Finco Relating to the Receivables. Finco covenants and agrees with the Trustee and the Participants that so long as this Agreement shall remain in effect: (a) Finco will cause each Hospital, at such Hospital's own cost and expense, to (i) retain a record of the Receivables generated by such Hospital and copies of all documents relating to each Receivable generated by such Hospital, (ii) mark such record to the effect that the Purchased Receivables generated by such Hospital listed thereon have been sold to Finco, (iii) maintain a record of Receivables that have been repurchased by such Hospital in accordance with the terms of the applicable Sale and Servicing Agreement and (iv) maintain a record of Receivables that have been repurchased by Finco pursuant to Section 5.4 hereof. (b) Finco will take no action and will not permit any Hospital to take any action to cause any Purchased Receivable to be evidenced by any instrument (as defined in the UCC in the state in which the chief executive office of Finco or such Hospital, as the case may be, is located), except in connection with its enforcement or collection of such Receivable, in which event Finco shall deliver such instrument to the Trustee as soon as reasonably practicable but in no event more than 10 days after execution thereof. (c) Finco will comply and cause each Hospital to comply with all Requirements of Law which are applicable to the Purchased Receivables and the other Total Transferred Property or any part thereof; provided, however, that Finco may contest and permit any Hospital to contest any act, regulation, order, decree or direction in any manner which could not reasonably, alone or in the aggregate, materially and adversely affect the Participations or the Interested Parties. Subject to Section 5.2(i) hereof and Section 4.3(k) of each Sale and Servicing Agreement, Finco will, and will cause each Hospital to, comply with the terms of its respective contracts with Obligors relating to such Receivables except where non-compliance would not in the aggregate reasonably be expected to have a material adverse effect on any Hospital's ability to receive payments under such contracts. (d) Finco will not create, permit or suffer to exist, and will defend the Interested Parties' rights to the Total Transferred Property against, and take such other actions as are necessary to remove, any Lien on, claim in respect of, or right to, such Total Transferred Property, and will defend the right, title and interest of the Interested Parties in and to such Total Transferred Property against the claims and demands of all Persons whomsoever, other than the Permitted Interests. (e) Unless prohibited by any Requirement of Law, the Participants and the Trustee and their respective employees, agents and representatives (collectively, the "Recipients") (A) shall at all times have full and free access during normal business hours to all the books, correspondence and records of Finco, the Servicer, UHS and the Hospitals insofar as they relate to the Total Transferred Property, and the Recipients may examine the same, take extracts therefrom and make photocopies thereof, and Finco agrees to render to the Recipients and cause the Servicer, UHS and the Hospitals to render to such Recipients, at Finco's cost and expense, such clerical and other assistance as may be reasonably requested with regard thereto and (B) may discuss the affairs, finances and accounts of Finco, the Servicer, UHS and the Hospitals with, and be advised as to the same by, executive officers and independent accountants of Finco, the Servicer, UHS and the Hospitals (and Finco shall cause the executive officers and independent accountants of Finco, the Servicer, UHS and the Hospitals to so discuss and advise), all as any such Recipient may reasonably deem appropriate for the purpose of verifying the accuracy of any reports or information delivered to the Trustee or the Participants pursuant to this Agreement or for otherwise ascertaining compliance with this Agreement; provided, however, that each of the Recipients acknowledges that in exercising the rights and privileges conferred in this Section 5.2(e) the Recipients may, from time to time, obtain knowledge of information, practices, books, correspondence and records of a confidential nature and in which Finco, the Servicer, UHS or any Hospital has a proprietary interest; and provided, further, that Finco and each Recipient acknowledges that the Operative Documents and documents required to be filed on behalf of UHS and its Subsidiaries with the Securities and Exchange Commission and available to the public shall not be considered confidential for the purposes of this Agreement (all such confidential information, collectively, the "Information"). Each of the Recipients agrees that the Information is to be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality and agrees that, subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose without the prior written consent of Finco, the Servicer, UHS or such Hospital, as the case may be, any or all of the Information, and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by this Agreement and the other Operative Documents or for the enforcement of any of the rights granted hereunder or thereunder) of any of the Information without the prior written consent of Finco, the Servicer, UHS or such Hospital, as the case may be. Notwithstanding the foregoing, a Recipient may (x) disclose Information to any Person that has executed and delivered to the addressee and UHS a confidentiality agreement, substantially in the form of Exhibit C hereto, with respect to such Information and (y) disclose Information (A) to the extent that such Information is required or appropriate in any report, statement or testimony submitted to any municipal, state, or federal regulatory body having or claiming to have jurisdiction over the Recipient or to the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed by the Recipient to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such information subsequently becomes publicly available, other than through any act or omission of the Recipient or (F) to the extent that such Information subsequently becomes known to the Recipient other than through a Person whom the Recipient knows to be acting in violation of his or its obligations to Finco, the Servicer, UHS or such Hospital. (f) Finco shall execute and file, and shall cause each Hospital to file, at Finco's expense, such continuation statements and other documents relating to the Security Filings which may be required by law to fully preserve and protect the interest of the Interested Parties in and to the Total Transferred Property. Finco shall, at its own expense, perform or cause to be performed all acts and execute all documents necessary to evidence, perfect, maintain and enforce the security interests and Liens of the Interested Parties in the Purchased Receivables and the other Total Transferred Property and the first priority thereof. Finco will, on the reasonable request of the Required Participants or an Authorized Officer of the Trustee, execute and deliver all such Security Filings (satisfactory in form and substance to the Trustee and the Required Participants) and, where permitted by law, Finco authorizes the Trustee to file one or more such Security Filings signed only by the Trustee. Finco hereby irrevocably appoints the Trustee as its attorney-in-fact to file and deliver Security Filings (and receive Confirmations in respect of one or more such Security Filings) signed on behalf of Finco by the Trustee as the attorney-in-fact of Finco. (g) Finco will not, without providing 30 days' notice to the Trustee and Sheffield, and without filing such amendments to the Security Filings as may be required to preserve the priority of the ownership or security interest perfected thereby change or permit any Hospital to change (i) the location of its chief executive office or the location of the offices where the records relating to the Receivables and the other Total Transferred Property are kept or (ii) its name, identity or corporate structure in any manner which would, could or might make any Security Filing or continuation statement filed by Finco or such Hospital in accordance with Section 4.2(f) or Section 5.2(f) of this Agreement or the provisions of the applicable Sale and Servicing Agreement seriously misleading within the meaning of Section 9-402(7) of any enactment of the UCC applicable thereto. (h) Finco shall (i) promptly cause the Servicer to (A) notify the Trustee and Sheffield of any insurance provider or other third-party payor which becomes an Obligor after the Initial Closing Date pursuant to a written contract or arrangement which purports to prohibit the assignment of any rights of the Hospital under such contract or arrangement without the consent of such Obligor and (B) deliver or cause to be delivered to such Obligor a Notice of Assignment and receive a Confirmation with respect thereto; and (ii) comply with and cause each Hospital to comply with all other reasonable requests of the Trustee, the Required Participants or Sheffield with respect to the Security Filings. (i) Finco shall not change, and shall not cause or otherwise allow any Hospital or the Servicer to change, the terms of the payor contracts and agreements relating to the Purchased Receivables and related Transferred Property or the normal policies and procedures with respect to the origination and servicing thereof (including without limitation the amount and timing of finance charges, fees and write-offs) except (i) that Finco or any Hospital may make such changes in connection with Purchased Receivables which increase the collectibility of such Purchased Receivables without extending the payment date thereof, so long as each such change (A) is in accordance with the Credit and Collection Policy and consistent with past practice and (B) shall not have a disproportionate effect on the Purchased Receivables as compared with Receivables (or future Receivables) not sold to Finco; and (ii) in respect of such Purchased Receivables which have become Uncollectible Receivables and only to the extent that Finco or any Hospital shall reasonably believe that such change of terms will improve the collectibility of such Uncollectible Receivables; provided that no such change permitted by clause (i) or (ii) shall, or shall reasonably be expected to, result in an Exclusion Event or an Early Amortization Event; and provided, further, that no such change shall cause the Borrowing Base to be less than the Aggregate Capital. (j) Finco hereby acknowledges and agrees that UHS Delaware will be initially appointed as the Servicer of the Receivables pursuant to the Servicing Agreement, that each Hospital will perform certain servicing functions with respect to the Receivables pursuant to the terms of the Servicing Agreement and the Sale and Servicing Agreements, that UHS Delaware may subcontract certain other servicing functions as permitted under the Servicing Agreement while still retaining liability for performance of such functions and that UHS will guarantee the performance by UHS Delaware and the Hospitals of their respective obligations. Finco shall cooperate with any requests made by the Servicer for information required by the Servicer in connection with the Servicer's determination of amounts due hereunder and under the Servicing Agreement and in connection with the delivery by the Servicer of statements and reports required thereunder. (k) Finco hereby covenants that it will cause each Hospital to designate personnel and to direct such designated personnel to deposit all Collections and proceeds thereof on each Business Day upon which such Collections are received (or, if such Collections are received by any Hospital on a day which is not a Business Day, on the next Business Day) into such Hospital's Hospital Concentration Account in accordance with Section 6.2. (l) Except for the purpose of collection in the ordinary course of business and in accordance with the restrictions set forth in Section 5.2(i), Finco will not, and will not allow any Hospital to, sell, discount or otherwise dispose of any Purchased Receivable except to the Interested Parties as provided hereunder and to Finco as provided under the Sale and Servicing Agreement to which such Hospital is a party. (m) Finco shall not terminate and shall not allow any other Person to terminate any Hospital Concentration Account or establish any other Hospital Concentration Account, unless (i) Finco has provided 10 days' prior written notice of such change to the Trustee and Sheffield and (ii) immediately after any such event, the representations and warranties in Section 4.1(h) shall be true and correct; and Finco shall not terminate and shall not allow any other Person to terminate, or change the instructions governing the operation of, the Master Receivables Account or establish any other Master Receivables Account, unless (i) the Required TRIPs Holders and Sheffield shall have consented to such change or termination and (ii) immediately after such event, the representations and warranties in Section 4.1(h) shall be true and correct. The Trustee shall promptly forward any notice received by it from Finco under this Section 5.2(m) to the TRIPs Holders. (n) Finco shall promptly cause the Servicer to notify the Trustee and Sheffield, and the Trustee shall thereupon promptly notify the TRIPs Holders, on any date on which any Hospital becomes, applies to become, or no longer remains, a qualified provider in respect of Governmental Receivables listed on Schedule II of the Sale and Servicing Agreement to which such Hospital is a party. (o) Finco shall not, without the prior written consent of the Required Participants, which consent shall not be unreasonably withheld, permit any Hospital to materially alter the hardware or software systems used by such Hospital in generating its reports to the Servicer in respect of the Purchased Receivables and the Collections and, in any event, shall not permit any such alteration unless such alteration is designed to improve the Servicer's ability to monitor and collect on the Receivables. Section 5.3. Notice and Consent Procedures. Finco represents and warrants as of the date hereof and as of the TRIPs Closing Date that (i) each Hospital has sent or caused to be sent a Notice of Assignment to each insurer or third-party intermediary that is an Obligor on such Hospital's Non- governmental Receivables and that has a written contract or other written arrangement with one or more of the Hospitals which prohibits assignment of any rights of such Hospital under such contract or arrangement without the consent of such insurer or third party intermediary and (ii) each Hospital has sent or caused to be sent a Notice of Assignment to each of the ten insurers or third-party intermediaries that are Obligors on any Receivables and that maintained the ten highest average Outstanding Balances of Receivables originated by all UHS Entities taken as a whole during the August, 1993 fiscal month. Finco agrees to use its best efforts to ensure that the Trustee and Sheffield promptly receive all Confirmations in respect of the Notices of Assignment described in clauses (i) and (ii). Section 5.4. Removal of Non-qualifying Receivables. (a) In the event that any representation or warranty set forth in Section 4.2 with respect to any Purchased Receivable is not true and correct on the Purchase Date with respect thereto, then Finco shall repurchase such Purchased Receivable by depositing in the Collateral Account or deducting from the amount otherwise payable to Finco pursuant to Article VII, the Outstanding Balance of such Purchased Receivable as of the date of conveyance to the Trust less any Collections received in respect thereof. The deposit or deduction required pursuant to subsection 5.4 hereof shall be made by Finco on any date on which the Trustee shall request. Notwithstanding the foregoing, if any such representation or warranty with respect to such Purchased Receivable was untrue solely because the Applicable Contractual Adjustment on the Purchase Date was less than the Actual Contractual Adjustment, such Purchased Receivable shall not be repurchased, but instead the difference between the Actual Contractual Adjustment and the Applicable Contractual Adjustment shall be deposited in the Collateral Account by Finco or deducted from the amount otherwise payable to Finco under Article VII. Notwithstanding the foregoing provisions of this Section 5.4, no such deduction or repurchase shall be required in respect of any Receivable conveyed to the Trust on the Initial Closing Date that was an Uncollectible Receivable on such date unless and until an Early Amortization Event occurs hereunder. In such event, the amount that would otherwise be payable by Finco or deducted from amounts payable to Finco in respect of such Receivable shall be reduced by the amount of any Collections (if any) on such Receivable received by Finco prior to the date of such Early Amortization Event. (b) In addition, upon notice by any Hospital that Non-qualifying Receivables of such Hospital have been sold to Finco, Finco shall immediately demand that all such Non-qualifying Receivables be repurchased or a portion of the purchase price thereof be reimbursed pursuant to Section 4.4 of the applicable Sale and Servicing Agreement. (c) On the date on which any amount required to be paid to the Collateral Account or deducted from the amount payable to Finco pursuant to Section 5.4(a) or 5.4(b) is so paid or deducted, the Trustee shall automatically and without further action be deemed to sell, transfer, assign, set over and otherwise convey to Finco (or in the case of Non-qualifying Receivables repurchased by a Hospital, to the applicable Hospital), without recourse, representation or warranty, all the right title and interest of the Trustee in and to such repurchased Receivable, all monies due or to become due with respect thereto, and all proceeds thereof. The Trustee shall execute such documents and instruments of transfer or assignment and take such other actions as shall be reasonably requested by Finco to effect the conveyance pursuant to this Section 5.4. Amounts paid to the Trustee pursuant to paragraph (a) above shall be treated as Collections on Non-governmental Receivables. Section 5.5. Hospital Concentration Accounts. Finco represents and warrants to the Trustee and the Participants as of the date hereof and as of the TRIPs Closing Date that each Hospital has previously established in its name a Hospital Concentration Account into which Collections on the Hospital's Purchased Receivables are transferred in accordance with the terms and conditions of Section 5.2 of the Sale and Servicing Agreement to which such Hospital is a party. Finco hereby represents and warrants to the Trustee and the Participants that set forth as Schedule II hereto is the name, location and account number of each such Hospital Concentration Account. Pursuant to Section 5.2(m), Finco will give to the Trustee and Sheffield, and upon receipt thereof the Trustee will give to the TRIPs Holders, prior written notification of the establishment of any Hospital Concentration Account or the termination of any Hospital Concentration Account. Subject to all Requirements of Law, Finco shall not, and shall not instruct or permit any Person to, deposit any Collections into any account other than such designated Hospital Concentration Account or the Master Receivables Account without the prior written consent of the Required TRIPs Holders and Sheffield. Finco hereby agrees that it will promptly notify the Trustee and Sheffield, which notice shall be promptly forwarded by the Trustee to each of the TRIPs Holders, if Finco has received notice or otherwise obtained information that any Hospital is not in full compliance with the provisions of this Section 5.5 or of the related provisions of the Sale and Servicing Agreements. Section 5.6. Performance of Agreements. Finco, for the benefit of the Trust and the Participants, hereby agrees, at its own expense, duly and punctually to perform and observe each of its obligations to the Servicer under the Servicing Agreement and to the Hospitals under the related Sale and Servicing Agreements. In addition, promptly following a request from Sheffield or the Trustee, on behalf of the Participants, to do so, and at Finco's own expense, Finco agrees to take all such lawful action as the Trustee or the Required Participants may request to compel or secure the performance and observance by any or all of the Assignors under or in connection with the respective Assigned Agreements in accordance with the terms thereof, and to exercise any and all rights, remedies, powers and privileges lawfully available to Finco under or in connection with the Assigned Agreements to the extent and in the manner directed by the Trustee or the Required Participants, including, without limitation, the transmission of notices of default on the part of any of the Assignors thereunder and the institution of legal or administrative actions or proceedings to compel or secure performance by such Assignor or Assignors of their obligations under the Assigned Agreements. Finco further agrees that it will not, without the prior written consent of the Trustee and the Required Participants, exercise any right, remedy, power or privilege available to it with respect to any of the Assignors under the respective Assigned Agreements or take any action to compel or secure performance or observance by any of such Assignors of their respective obligations thereunder, or give any consent, request, notice, direction, approval, extension or waiver to any of such Assignors under the Assigned Agreements not required to be exercised, taken, observed or given by Finco pursuant to the terms of the respective Assigned Agreements. Finco agrees promptly to provide, or cause to be provided, to Sheffield and the Trustee copies of all notices, requests, demands and other documents received from any Assignor under any of the Assigned Agreements and to cause all legal opinions and other documents delivered for the benefit of Finco under the Assigned Agreements to be delivered and addressed to each Interested Party. Section 5.7. Amendment of Assigned Agreements; Waivers. Finco agrees that it will not amend, modify, supplement, waive, terminate or surrender, or agree to any amendment, modification, supplement, waiver, termination or surrender of, any of the Total Transferred Property or any portion thereof or any Assigned Agreement or part thereof, or waive timely performance or observance by any of the Assignors of their respective obligations thereunder, or any default on the part of any Assignor under any Assigned Agreement without the prior written consent of the Required Participants; provided, however, that Finco may take whatever action any applicable Hospital reasonably deems necessary (if any) to release Non- qualifying Receivables repurchased pursuant to Section 4.4 of any Sale and Servicing Agreement by such Hospital, so long as such action does not affect the ownership or security interest granted in the Trust Assets other than the Non-qualifying Receivables so repurchased, without obtaining such consent. If any such amendment, modification, supplement or waiver shall be so consented to by the Required Participants, Finco agrees, promptly following a request by the Trustee or the Required Participants, to execute and deliver, in its own name and at its own expense, such agreements, instruments, consents and other documents (in form and substance reasonably satisfactory to the Required Participants) as the Trustee or the Required Participants may reasonably deem necessary or appropriate in the circumstances. ARTICLE VI ADMINISTRATION AND COLLECTIONS Section 6.1. Servicing. (a) In further consideration for the obligations of the Trustee and the Participants hereunder, Finco agrees that it shall service the Purchased Receivables by (i) causing UHS Delaware, pursuant to the Servicing Agreement, to undertake all obligations of the Servicer thereunder in connection with the servicing of the Purchased Receivables and the other Transferred Property, (ii) causing each Hospital, pursuant to the Sale and Servicing Agreement to which such Hospital is a party, to undertake such obligations in connection with the servicing of the Purchased Receivables and the other Transferred Property as the Servicer shall delegate to such Hospital and (iii) causing UHS to comply with the terms of the Guarantee, pursuant to which UHS will guarantee the performance by the Hospitals and UHS Delaware of all of their respective obligations under the Sale and Servicing Agreements and the Servicing Agreement. By their acceptance of the Participations, the Participants consent to UHS Delaware acting as Servicer in accordance with the Servicing Agreement and to the Servicing arrangements described therein and in the previous sentence. (b) In furtherance of Section 6.1(a), Finco agrees, subject to applicable confidentiality requirements under law, that it will provide promptly and shall cause the Servicer, UHS and each Hospital to provide promptly to the Trustee and the Participants and any other Person retained by any of them all information, including, without limitation, all information in relation to the Purchased Receivables and other Total Transferred Property, that any such Person requests, including, without limitation, information with respect to the periodic reports by Arthur Andersen & Co. or other certified public accountant delivered pursuant to Section 5.1(m) or reports by any other agent of Finco, the Servicer, UHS or the Hospitals on the Purchased Receivables and other Total Transferred Property conveyed to the Trust. The Trustee and the Participants agree that all such information is to be regarded as Information subject to the confidentiality provisions of Section 5.2(e). Section 6.2. Collections. (a) Finco shall apply, and shall cause each of the Servicer and each Hospital to apply, all Collections on all Purchased Receivables strictly in accordance with the terms of the Sale and Servicing Agreements, the Servicing Agreement and this Agreement in order to permit the Trustee, for the benefit of the Interested Parties, to make all allocations and payments required hereunder. (b) To the extent held or received by Finco or any Interested Party (other than the Hospital payee), all Collections on account of Non- governmental Receivables will be held in trust for the benefit of the Participants and deposited in the Master Receivables Account pending remittance to the Trustee. (c) Any Collections on Governmental Receivables received by any Interested Party or Finco shall be immediately paid to the Hospital payee for deposit in such Hospital's Hospital Concentration Account or the Master Receivables Account. (d) In no event shall Finco permit any Hospital to deposit any Collections into any account established, held or maintained by such Hospital or any other Person other than the related Hospital Concentration Account or the Master Receivables Account or transfer such Collections other than in accordance with the provisions of this Agreement, the related Sale and Servicing Agreement and the Servicing Agreement. Available amounts in the Hospital Concentration Accounts shall be transferred within one Business Day of receipt to the Master Receivables Account. Amounts so transferred from the Hospital Concentration Accounts and amounts otherwise received in the Master Receivables Account prior to the close of business on any Business Day shall be transferred to the Collateral Account on such Business Day. Amounts received in the Master Receivables Account after the close of business on any Business Day or on any day which is not a Business Day shall be transferred to the Collateral Account on the next succeeding Business Day. Amounts received in the Collateral Account shall be applied in accordance with Article VII. (e) Finco agrees that it shall use its best efforts to ensure that only Collections on Purchased Receivables are deposited into the Hospital Concentration Accounts and the Master Receivables Account. The Participants and the Trustee agree that, promptly following the establishment to the satisfaction of Finco and any Hospital that any funds received in such Hospital's Hospital Concentration Account or the Master Receivables Account do not constitute Collections on Purchased Receivables (including any funds constituting payments on Receivables which have been reassigned to such Hospital and payments to such Hospital not in respect of Receivables) to the extent such funds are available in the Hospital Concentration Accounts, the Master Receivables Account or the Collateral Account, the Servicer shall remit, or cause the Trustee to remit, such funds to such Hospital in immediately available funds. Section 6.3. Claims Against Third Parties. Finco agrees that it will make and pursue, and continue to cause each Hospital to make and pursue, for the benefit of the Interested Parties, claims on the Purchased Receivables sold to Finco and not repurchased pursuant to Section 4.4 of each Sale and Servicing Agreement to the extent that any Requirement of Law or contractual provision requires Finco or such Hospital to directly make and pursue such claims; provided that Finco agrees that it is making and pursuing such claims for the benefit of the Interested Parties and that any funds received by Finco based on such claims will be transferred in accordance with Section 6.2. Section 6.4. Deleted Receivables. Finco agrees that it shall permit the Servicer, in accordance with the terms of Section 3.6 of the Servicing Agreement, to exclude Deleted Receivables from the pool of Financible Receivables only on the Business Day on which Finco is obligated to make payment of the Purchase Price with respect thereto under the Sale and Servicing Agreement and only to the extent that, after giving effect to such exclusion, the quality and collectibility (including as a result of the credit quality of the Obligors on the Financible Receivables) of the pool of Financible Receivables would not be any worse than the quality and collectibility (including as a result of the credit quality of the Obligors on the Eligible Receivables) of the pool of Eligible Receivables. Finco agrees to cause the Servicer, for the benefit of the Interested Parties, to comply with all representations, warranties and covenants of the Servicer with respect to the Deleted Receivables, including, without limitation, the agreement that no Deleted Receivable shall be added to the calculation of the Financible Pool Balance or considered to be a Financible Receivable for any reason. ARTICLE VII COLLATERAL ACCOUNT AND OTHER ACCOUNTS; ALLOCATIONS AND DISTRIBUTIONS Section 7.1. Establishment of Collateral Account and Other Accounts. (a) The Trustee, for the benefit of the Participants, shall maintain a segregated trust account, in the name of the Trust, on behalf of the Trust and in the corporate trust department of an Eligible Institution satisfactory to the Trustee and Finco, bearing a designation clearly indicating that the funds deposited therein are held for the benefit of the Participants (the "Collateral Account" and identified as Account No. 0004359), the operation of which Collateral Account shall be governed by this Article VII. For administrative purposes only, the Trustee shall establish or cause to be established, simultaneously with the Collateral Account (i) the following three sub-accounts of the Collateral Account: (A) for the benefit of Sheffield, the "Sheffield Sub-account", (B) for the benefit of the TRIPs Holders, the "TRIPs Sub-account" and (C) for the benefit of the Participants and certain Persons specified in Section 7.3(a) to whom amounts are payable in connection with the administration of the Trust and the Participations, the "Expense Sub-account" and (ii) a sub-account of each of the Sheffield Sub- account and the TRIPs Sub-account (the "Sheffield Interest Sub-account" and the "TRIPs Interest Sub-account", respectively). The Trustee shall make all transfers, deposits and withdrawals to and from the Collateral Account, all sub-accounts thereof and the Other Accounts pursuant to this Article VII. (b) There shall be deposited in the Collateral Account the following monies, cash and proceeds: (i) all Available Cash Collections received by the Trustee pursuant to Section 3.1 of the Servicing Agreement, Section 5.2 of the Sale and Servicing Agreements and Section 6.2 hereof, (ii) all amounts earned pursuant to Section 7.7, (iii) all proceeds, if any, of Commercial Paper and Loans in excess of the amount required to repay maturing Commercial Paper and Loans and (iv) any and all other monies at any time and from time to time received by or on behalf of the Participants or Finco, and required by the terms of this Agreement, each of the Sale and Servicing Agreements, the Servicing Agreement or any other Operative Document to be deposited in the Collateral Account. (c) The Trustee shall at all times during the term of this Agreement maintain a segregated trust account in the name of the Trust in the corporate trust department of an Eligible Institution satisfactory to the Trustee, Finco and Sheffield, for the exclusive benefit of Sheffield and the Liquidity Agent, for the benefit of the Lenders (the "Sheffield Payment Account" and identified as Account No. 0004365), into which account shall be deposited all amounts required pursuant to this Article VII. (d) The Trustee shall at all times during the term of this Agreement maintain a segregated trust account in the name of the Trust in the corporate trust department of an Eligible Institution satisfactory to the Trustee, Finco and the Required TRIPs Holders, for the benefit of the TRIPs Holders (the "TRIPs Payment Account" and identified as Account No. 0004366; the TRIPs Payment Account and the Sheffield Payment Account, collectively, the "Other Accounts") into which account shall be deposited all amounts required pursuant to this Article VII. (e) Schedule II hereto sets forth the Eligible Institution at which the Collateral Account and each Other Account is held, along with the name and account number of each such account. Subject to all Requirements of Law, the Trustee shall have exclusive dominion and control over the Collateral Account, the Other Accounts and any Additional Accounts, for the exclusive benefit of the Participants and those Persons specified in Section 7.3(a) as their respective interests may appear. Except as expressly provided herein, no Person other than the Trustee shall have any right of withdrawal therefrom. The Servicer shall have no right of set-off or banker's lien against, and no right to otherwise deduct from, any funds held or to be deposited in the Collateral Account, any Other Account or any Additional Account for any amount owed to it by the Trust or any Interested Party. If, at any time the institution holding the Collateral Account, any Other Account or any Additional Account ceases to be an Eligible Institution and the Trustee is notified of such fact, the Trustee shall establish a new account with an Eligible Institution meeting the applicable conditions specified above, transfer any cash and/or any investments to such new account and from the date such new account is established, it shall be the "Collateral Account" or the applicable "Other Account" or "Additional Account", as the case may be. Section 7.2. Daily Allocations. (a) On each Business Day, the Trustee shall allocate Available Cash Collections, all other amounts received on deposit in the Collateral Account and all amounts remaining on deposit in the Collateral Account from the previous Business Day that have not been allocated to any sub-account thereof as follows: (i) an amount equal to the Sheffield Percentage of such amount shall be allocated to the Sheffield Sub-account; and (ii) an amount equal to the TRIPs Percentage of such amount shall be allocated to the TRIPs Sub-account. (b) On each Business Day, amounts allocated to the Sheffield Sub- account (or retained therein on a prior Business Day) shall be applied by the Trustee in the following priority: (i) an amount equal to the imputed or stated Sheffield Yield, as the case may be, accrued since the previous Business Day shall be allocated (to the extent not previously so allocated) to the Sheffield Interest Sub-account; provided that on any date on which a Stub Loan is incurred, five hundred dollars ($500) shall be allocated to the Sheffield Interest Sub-account and no further daily allocation shall be made in respect of the Sheffield Yield to accrue on such Stub Loan; (ii) the following amounts shall be allocated to the Expense Sub- account: (A) an amount equal to the Sheffield Percentage of the Daily Program Expense Amount for such Business Day; provided, however, that for so long as the Servicer is an Affiliate of Finco and no Early Amortization Event shall have occurred, the Sheffield Percentage of the accrued and unpaid Servicing Fee shall not be transferred to the Expense Subaccount but rather shall be paid to the Servicer on such Business Day; and provided, further, that the amount so paid on any Business Day shall be reduced by an amount equal to the excess of (A) the Required Coverage Amount over (B) the Financible Pool Balance on such Business Day (and such excess shall be transferred to the Expense Sub-account); plus (B) any amounts not allocated from the Sheffield Sub-account to the Expense Sub-account as required on any previous Business Day; plus (C) if such Business Day is a Transfer Date, an amount equal to the excess of (1) (x) the Sheffield Percentage of the amount to be withdrawn from the Expense Sub-account on such Business Day in respect of the Monthly Program Expense Amount plus (y) the amount to be withdrawn from the Expense Sub-account in respect of the Monthly Sheffield Expense Amount accrued and unpaid on such date, in each case pursuant to Section 7.3(a) over (2) the total amount on deposit in the Expense Sub-account, after giving effect to all allocations to be made to the Expense Sub-account on such Business Day; (iii) the Daily Sheffield Expense Amount, and any amount in respect of the Daily Sheffield Expense Amount not allocated as required on any prior Business Day, shall be allocated to the Expense Sub-account; (iv) In the event that the Trustee has been directed in writing by either Finco or Sheffield to reserve funds in order to decrease the Sheffield Capital, the following funds shall be retained in the Sheffield Sub-account: (A) upon written notice by Sheffield of (1) the occurrence of the Liquidation Date, (2) an election by Sheffield pursuant to Section 2.7 (and the passage of the appropriate notice period) or (3) the failure by Finco to satisfy a condition precedent set forth in Section 3.2, any funds remaining in the Sheffield Sub-account after application pursuant to Section 7.2(b)(iii); and (B) in the case of an election by Finco pursuant to Section 2.6, an amount specified by the Servicer in the Servicer Daily Statement for such Business Day; and (v) after giving effect to any Principal Pay-Down pursuant to Section 7.4, any remaining funds shall be applied as follows: (A) during the Sheffield Revolving Period, such funds shall be allocated to the Collateral Account and applied pursuant to Section 7.2(d); and (B) during the Sheffield Amortization Period, such funds shall be applied pursuant to Section 7.5. (c) On each Business Day, amounts allocated to the TRIPs Sub- account shall be applied by the Trustee in the following priority: (i) an amount equal to the TRIPs Yield accrued since the previous Business Day shall be allocated (to the extent not previously so allocated) to the TRIPs Interest Sub-account; provided that in the event that a TRIPs Interest Default has occurred on any prior Transfer Date, then the amount to be so allocated shall be an amount equal to the excess of (A) the aggregate TRIPs Yield scheduled to be paid on the subsequent Transfer Date over (B) the amount on deposit in the TRIPs Interest Sub- account on such Business Day; (ii) the following amounts shall be allocated to the Expense Sub- account: (A) an amount equal to the TRIPs Percentage of the Daily Program Expense Amount; provided, however, that for so long as the Servicer is an Affiliate of Finco and no Early Amortization Event shall have occurred, the TRIPs Percentage of the accrued and unpaid Servicing Fee shall not be transferred to the Expense Subaccount but rather shall be paid to the Servicer on such Business Days; and provided, further, that the amount so paid on any Business Day shall be reduced by an amount equal to the excess of (A) the Required Coverage Amount over (B) the Financible Pool Balance on such Business Day (and such excess shall be transferred to the Expense Sub-account); plus (B) any amounts not allocated from the TRIPs Sub-account to the Expense Sub-account as required on any previous Business Day; plus (C) if such Business Day is a Transfer Date, an amount equal to the excess of (1) (x) the TRIPs Percentage of the amount to be withdrawn from the Expense Sub-account on such Business Day in respect of the Monthly Program Expense Amount plus (y) the amount to be withdrawn on such Business Day in respect of the Monthly TRIPs Expense Amount accrued and unpaid on such date, in each case pursuant to section 7.3(a) over (2) the total amount on deposit in the Expense Sub-account, after giving effect to all allocations to be made to the Expense Sub-account on such Business Day; (iii) the Daily TRIPs Expense Amount for such Business Day, and any amount in respect of the Daily TRIPs Expense Amount not allocated as required on any prior Business Day, shall be allocated to the Expense Sub-account; (iv) during the period commencing on the date on which the Call Option is exercised and ending on the Call Date, an amount equal to the excess, if any, of (A) the Make-Whole Estimated Amount over (B) the amount on deposit in the TRIPs Interest Sub-account minus the portion of such amount deposited therein pursuant to Section 7.2(c)(i) shall be deposited in the TRIPs Interest Sub-account; (v) in the event that the Trustee has been directed in writing by the Required TRIPs Holders to retain funds in the TRIPs Sub-account as a result of a failure by Finco to satisfy a condition precedent set forth in Section 3.2, any remaining funds shall be retained in the TRIPs Sub- account; and (vi) any remaining funds shall be applied as follows: (A) during the TRIPs Revolving Period such funds shall be allocated to the Collateral Account and applied pursuant to Section 7.2(d); and (B) during the TRIPs Amortization Period such funds shall be applied pursuant to Section 7.5. (d) On each Business Day, after giving effect to any Principal Pay- Down pursuant to Section 7.4, funds allocated to the Collateral Account (other than any sub-account thereof) pursuant to Sections 7.2(b)(v)(A) and (c)(vi)(A) shall be applied by the Trustee in the following priority: (i) an amount equal to the excess, if any, of (A) the Required Coverage Amount over (B) the Financible Pool Balance shall be retained in the Collateral Account until the following Business Day; and (ii) any remaining funds shall be paid to Finco to maintain the Aggregate Capital as provided in Section 2.7 and in respect of the Subordinated Interest. (e) Amounts paid to Finco pursuant to Section 7.2(d) shall be applied by the Trustee, on behalf of Finco, as follows: (i) first, the aggregate Purchase Price payable on such Business Day pursuant to the Sale and Servicing Agreements (after giving effect to all adjustments thereto) shall, pursuant to Section 2.3 of the Sale and Servicing Agreements, be paid to the Hospitals pro rata in accordance with the respective Purchase Prices payable to such Hospitals; provided that no amount otherwise payable pursuant to this provision shall be paid to any Excluded Hospital; (ii) second, the aggregate principal amount plus all outstanding interest payable on all Subordinated Notes shall be paid to the Hospitals pro rata in accordance with the amounts payable to such Hospitals; provided that no amount otherwise payable pursuant to this provision shall be paid to any Excluded Hospital; and (iii) third, all remaining amounts may be retained by Finco for its own account and applied by Finco in any manner not otherwise prohibited by the Operative Documents. Section 7.3. Monthly Applications. The Trustee shall make the following applications and distributions from the Collateral Account, the applicable sub-accounts thereof and the applicable Other Accounts on each Transfer Date: (a) an amount equal to the sum of (x) the Monthly Program Expense Amount, (y) the Monthly Sheffield Expense Amount and (z) the Monthly TRIPs Expense Amount with respect to the related Settlement Period, and any unpaid amounts in respect of such amounts payable on any prior Transfer Date shall be paid from the Expense Sub-account in the following manner and priority: (i) first, all amounts payable and not paid on any prior Transfer Date shall be paid in the order of priority stated in clauses (ii) through (iv) below; (ii) second, to the extent not otherwise paid by the Servicer prior to such date out of the Servicing Fee pursuant to Section 3.1 of the Servicing Agreement, and subject to the aggregate dollar limitation set forth in such Section of the Servicing Agreement, all reasonable out-of-pocket costs and expenses of the Trustee, including all expenses incurred by the Trustee in compensating the Transfer Agent and Registrar and any authenticating agent or co- trustee, and all Indemnified Amounts owing to the Trustee shall be paid to the Trustee; (iii) third, to the extent not otherwise paid by the Servicer prior to such date pursuant to the Servicing Agreement, and subject to the aggregate dollar limitation set forth in such Section of the Servicing Agreement, the Trustee Fee accrued during the related Settlement Period shall be paid to the Trustee; and (iv) fourth, all other fees in respect of the Monthly Program Expense Amount, the Monthly Sheffield Expense Amount and the Monthly TRIPs Expense Amount and all other fees, costs and expenses shall be paid to the appropriate payees; provided that except in the case of regularly scheduled fees payable to any Interested Party such payees shall have submitted a statement of such expenses to the Trustee at least 10 days prior to such Transfer Date; provided, further, that if sufficient funds are not available to pay all such fees, costs and expenses in full, such fees, costs and expenses shall be paid pro rata according to the respective amounts owed to each such payee; and provided, further, that if the Servicer is an Affiliate of UHS, after giving effect to the payment to the Trustee of any portion of the Servicing Fee payable to it pursuant to Section 3.1 of the Servicing Agreement and subsections 7.3(a)(i), (ii) and (iii) hereof, the Servicing Fee (to the extent not otherwise paid pursuant to Section 7.2(b)(ii)(A) and 7.2(c)(ii)(A)) shall be paid to the Servicer only after all other amounts payable pursuant to this clause (iv) have been paid in full; any amounts remaining in the Expense Sub-account after payment of the above amounts shall be deposited in the Collateral Account and allocated pursuant to Section 7.2(a) on the following Business Day; and (b) an amount equal to the sum of (i) the TRIPs Yield with respect to the related Settlement Period and (ii) any TRIPs Yield previously due but not distributed on any prior Transfer Date shall be transferred from the TRIPs Interest Sub-account to the TRIPs Payment Account and distributed to the TRIPs Holders pursuant to Section 8.1(b). Section 7.4. Payments to Sheffield. (a) On the last day of the Fixed Period with respect to any Sheffield Tranche, in payment of any amounts owing in respect of any Commercial Paper Notes or Loans issued to fund such Sheffield Tranche, the Trustee shall make the following applications: (i) an amount equal to the Sheffield Yield on such Sheffield Tranche shall be transferred from the Sheffield Interest Sub-account to the Sheffield Payment Account; and (ii) an amount equal to the Principal Pay-Down, if any, with respect to such Sheffield Tranche shall be transferred to the Sheffield Payment Account from the Sheffield Sub-account or the Collateral Account (excluding any sub-account thereof). (b) The Principal Pay-Down, if any, plus all accrued and unpaid Sheffield Yield with respect to such Sheffield Tranche shall be distributed by the Trustee to Sheffield on such date. Section 7.5. Amortization. (a) During the Sheffield Amortization Period, the Trustee shall make the following applications: (i) on each Business Day on which the Adjusted Sheffield Capital is greater than zero, an amount equal to the lesser of (A) the amount remaining in the Sheffield Sub-account after application pursuant to Section 7.2(b) and (B) the Adjusted Sheffield Capital shall be deposited in the Sheffield Payment Account to pay maturing Commercial Paper Notes and Loans; and (ii) on each Business Day after the Adjusted Sheffield Capital has been reduced to zero, first, an amount equal to the excess of all Sheffield Yield scheduled to accrue in respect of all Commercial Paper Notes and Loans Outstanding over the amount on deposit in the Sheffield Interest Sub-account shall be deposited in the Sheffield Interest Sub- account and, thereafter, so long as no Early Amortization Event shall have occurred and be continuing, all amounts remaining in the Sheffield Sub-account after application pursuant to Section 7.2(b) shall be paid to Finco. During the Sheffield Amortization Period, no payments shall be made to Finco from the Sheffield Sub-account or any sub-account thereof until the Adjusted Sheffield Capital has been reduced to zero, all unpaid Sheffield Yield scheduled to accrue thereon has been deposited in the Sheffield Interest Sub- account and all unpaid fees, costs and expenses accrued or scheduled to accrue which are allocable to the Sheffield Participation have been deposited in the Expense Sub-account. (b) During the TRIPs Amortization Period, the Trustee shall make the following applications: (i) on each Business Day on which the Adjusted TRIPs Capital is greater than zero, an amount equal to the lesser of (A) the amount remaining in the TRIPs Sub-account after application pursuant to Section 7.2(c) and (B) the Adjusted TRIPs Capital shall be deposited in the TRIPs Payment Account; (ii) on each Business Day after the Adjusted TRIPs Capital has been reduced to zero, first, an amount equal to the excess of the TRIPs Yield payable on the subsequent Transfer Date over the amount on deposit in the TRIPs Interest Sub-account shall be deposited in the TRIPs Interest Sub- account and, thereafter, so long as no Early Amortization Event shall have occurred and be continuing, all amounts remaining in the TRIPs Sub- account after application pursuant to Section 7.2(c) shall be paid to Finco; (iii) on each Transfer Date after the Call Date, the Make-Whole Payment Amount for such Transfer Date shall be transferred from the TRIPs Interest Sub-account to the TRIPs Payment Account; and (iv) on each Transfer Date, the amount on deposit in the TRIPs Payment Account shall be distributed to the TRIPs Holders pursuant to Section 8.1(b) in payment of accrued TRIPs Yield, the Make-Whole Payment Amount, if any, with respect to such Transfer Date and the TRIPs Capital. During the TRIPs Amortization Period, no payments shall be made to Finco from the TRIPs Sub-account or any sub-account thereof until the Adjusted TRIPs Capital has been reduced to zero, all unpaid TRIPs Yield and each unpaid Make- Whole Payment Amount accrued or scheduled to accrue thereon has been deposited in the TRIPs Interest Sub-account and all unpaid fees, costs and expenses accrued or scheduled to accrue which are allocable to the TRIPs Participations have been deposited in the Expense Sub-account. (c) Upon the occurrence and during the continuation of an Early Amortization Event, no amounts shall be payable to Finco or any Affiliate thereof pursuant to the Operative Documents until the date on which (i) the Adjusted Aggregate Capital has been reduced to zero, (ii) all amounts have been allocated to the Sheffield Interest Sub-account and the TRIPs Interest Sub-account pursuant to Sections 7.5(a) and (b) and (iii) all fees, costs and expenses scheduled to accrue shall have been deposited in the Expense Sub- account. Prior to such date, any amounts otherwise payable to Finco or any Affiliate thereof from the Sheffield Sub-account pursuant to Section 7.5(a) shall be deposited in the TRIPs Sub-account for application pursuant to this Article VII, and any amounts otherwise payable to Finco or any Affiliate thereof from the TRIPs Sub-account pursuant to Section 7.5(b) shall be deposited in the Sheffield Sub-account for application pursuant to this Article VII. On any date after the occurrence and continuation of an Early Amortization Event, the priority of allocations to be made pursuant to this Article VII shall be adjusted so that no amount shall be allocated pursuant to this Article unless the full amount of the Servicing Fee with respect to such Settlement Period shall have first been deposited in the Expense Sub-account (or, if the Servicer is an Affiliate of Finco, the portion of the Servicing Fee distributable to the Trustee pursuant to subsections 7.3(a)(i), (ii) and (iii)). (d) On the date on which the Aggregate Capital has been reduced to zero, all Yield and each Make-Whole Payment Amount, if any, has been paid and all fees, expenses and other amounts payable under the Operative Documents have been paid, all amounts remaining in the Master Receivables Account, the Collateral Account, any sub-account thereof, the Other Accounts and any Additional Account shall be paid to Finco. Section 7.6. Allocation and Payment Procedures. (a) All calculations made by the Servicer and any other Person designated by the Participants and delivered to the Trustee in order to effectuate the operation of this Article VII shall be effective upon receipt of written instructions from such Person. The Trustee shall promptly comply with any calculations delivered to it pursuant to this Section 7.6. (b) The Trustee shall from time to time, and at least monthly, provide the Participants, Finco, the Servicer and UHS with statements of account relative to the Collateral Account and the Other Accounts in accordance with the Trustee's customary practices. (c) For purposes of determining the payments to be made to any Person pursuant to Sections 7.2 through 7.5 and in transferring such amounts, the Trustee may rely on certificates or statements furnished to or by it in accordance with the provisions of this Section 7.6. Any application to be made of Deposited Funds by the Trustee pursuant to Section 7.3(a) may be made pursuant to a statement by the payee delivered to the Trustee, Sheffield, Finco, the Servicer and UHS setting forth in reasonable detail the nature of the payee's claim and the amount owing on account thereof. For purposes of determining the application to be made of Deposited Funds payable pursuant to this Article VII (other than pursuant to the immediately preceding sentence), the Trustee may rely exclusively, absent manifest error, upon the Servicer Daily Statement and the Settlement Date Statement. (d) Finco shall cause a copy of each Servicer Daily Statement and each Settlement Date Statement to be provided by Servicer to the Trustee. The Trustee shall not be liable for any application of the Deposited Funds in accordance with any certificate or direction delivered pursuant to this Section 7.6; provided, however, that no application of the Deposited Funds in accordance with any certificate delivered pursuant to this Section 7.6 shall be deemed to restrict or limit the right of the Trustee or Sheffield to contest with purported obligees their respective claims in respect of the amount set forth in such certificate. Section 7.7. Permitted Investments. (a) Monies held in the Collateral Account and the Other Accounts shall be invested by the Trustee exclusively in Permitted Investments (which investments, prior to the occurrence of an Early Amortization Event, shall be specified pursuant to the written direction of the Servicer). Each such direction shall certify that the requested investment constitutes a Permitted Investment. The Trustee shall not be responsible or liable for any loss resulting from the investment performance of any investment or reinvestment of monies held in the Collateral Account or any other account maintained by the Trustee for the purposes of this Agreement in Permitted Investments (other than any Permitted Investment in respect of which the Trustee is the obligor), or from the sale or liquidation of any Permitted Investments in accordance with this Agreement. All Permitted Investments shall be made exclusively in the name of the Trust, shall be payable to the Trustee and shall be held exclusively in the Collateral Account and the Other Accounts. All proceeds from Permitted Investments shall be retained in the Collateral Account or the Other Account in which they are earned. Proceeds from Permitted Investments held in the Collateral Account shall be allocated pursuant to Section 7.2(a). (b) The Trustee may liquidate any Permitted Investment when required to make an application pursuant to this Article VII. Finco agrees to cause the Servicer to use its best efforts to schedule the maturities of such Permitted Investments so as to avoid the necessity of liquidating the same. Section 7.8. Additional Accounts. At any time that the Trustee receives written notice that a bankruptcy, insolvency, reorganization or similar proceeding has been commenced with respect to any Hospital, the Trustee agrees to immediately take all actions necessary, upon receipt of indemnification satisfactory to it and written directions from Required Participants as to the nature of such actions, to obtain a court order directing Obligors to make all payments on the Receivables from such Hospital directly to an Additional Account or to the Trustee for deposit in the Collateral Account. In any such event, the Trustee is hereby authorized to establish an Additional Account for the receipt of such payments, and all such payments shall be promptly transferred from such Additional Account to the Collateral Account by the Trustee after such payments become immediately available funds. The Trustee shall notify each of the Participants, Finco, UHS and the Servicer of the establishment of any Additional Account. The Trustee shall receive such assurances of indemnification for any actions taken by it in good faith pursuant to this Section 7.8 as it shall reasonably request. ARTICLE VIII DISTRIBUTIONS AND REPORTS TO PARTICIPANTS Section 8.1. Distributions. (a) The Trustee shall distribute to Sheffield such amounts from the Sheffield Payment Account on such dates as are specified in Section 7.4. (b) On each Transfer Date, the Trustee shall pay to each TRIPs Holder of record on the Record Date for such Transfer Date, by wire transfer of immediately available funds to an account designated by such TRIPs Holder, such TRIPs Holder's pro rata share (based on the aggregate portion of the TRIPs Capital represented by TRIPs held by such TRIPs Holder) of the amounts on deposit in the TRIPs Payment Account. Section 8.2. Statements to Participants. (a) On each Business Day, Finco shall cause the Servicer, on behalf of the Trustee, to deliver the Servicer Daily Statement to Sheffield. (b) On each Settlement Date, Finco shall cause the Servicer, on behalf of the Trustee, to deliver the Settlement Date Statement to each Participant and the Rating Agency and the Liquidity Agent. (c) On or before January 31 of each calendar year, commencing in 1994, the Trustee shall furnish or cause to be furnished to each Person who was a Participant at any time during the preceding calendar year, a statement on the appropriate Internal Revenue Service form prepared by the Servicer containing the information required to be provided by an issuer of indebtedness under the Code and such other customary information as is necessary to enable the Participants to prepare their tax returns. ARTICLE IX TRIPs; RIGHTS OF PARTICIPANTS Section 9.1. The TRIPs. The TRIPs shall be issued in fully registered form and shall be substantially in the form of Exhibit A. The TRIPs shall, upon issue, be executed and delivered by Finco to the Trustee for authentication and redelivery as provided in Sections 2.5 and 9.2. The TRIPs shall be issued in minimum denominations of $1,000,000 and in integral multiples of $100,000 in excess thereof. Each TRIP shall be executed by manual or facsimile signature on behalf of Finco by an Authorized Officer of Finco. TRIPs bearing the manual or facsimile signature of an individual who was, at the time when such signature was affixed, authorized to sign on behalf of Finco or the Trustee shall not be rendered invalid, notwithstanding that such individual has ceased to be so authorized prior to or on the date of the authentication and delivery of such TRIPs or does not hold such office at the date of such TRIPs. No TRIP shall be entitled to any benefit under this Agreement, or be valid for any purpose, unless there appears on such TRIP a certificate of authentication substantially in the form provided for herein executed by or on behalf of the Trustee by the manual or facsimile signature of an Authorized Officer, and such certificate upon any TRIP shall be conclusive evidence, and the only evidence, that such TRIP has been duly authenticated and delivered hereunder. All TRIPs shall be dated the date of their authentication. Section 9.2. Authentication of TRIPs. On the TRIPs Closing Date, the Trustee shall authenticate and deliver the TRIPs to the TRIPs Holders, executed in favor of the TRIPs Holders upon the order of Finco, against payment to Finco in accordance with Section 2.5(a). The TRIPs shall be duly authenticated by or on behalf of the Trustee in authorized denominations equal to (in the aggregate) the Initial TRIPs Capital. Section 9.3. Registration of Transfer and Exchange of TRIPs. (a) The Trustee shall cause to be kept at the office or agency to be maintained by a transfer agent and registrar (which may be the Trustee) (the "Transfer Agent and Registrar") in accordance with the provisions of Section 11.16 a register (the "TRIPs Register") in which, subject to such reasonable regulations as the Trustee may prescribe, the Transfer Agent and Registrar shall provide for the registration of the TRIPs and of transfers and exchanges of the TRIPs as herein provided. The Trust hereby appoints Continental as the initial Transfer Agent and Registrar for the purpose of registering the TRIPs and transfers and exchanges of the TRIPs as herein provided. Continental shall be permitted to resign as Transfer Agent and Registrar upon 30 days' written notice to Finco, the Trustee and the Participants; provided, however, that such resignation shall not be effective and Continental shall continue to perform its duties as Transfer Agent and Registrar until the Trust has appointed a successor Transfer Agent and Registrar acceptable to Finco and the Required TRIPs Holders. If the Transfer Agent and Registrar does not have an office in New York City, Finco may appoint any co-transfer agent and co- registrar chosen by Finco and acceptable to the Required TRIPs Holders. Any reference in this Agreement to the Transfer Agent and Registrar shall include any co-transfer agent and co-registrar unless the context requires otherwise. (b) The Trustee agrees to pay to the Transfer Agent and Registrar from time to time reasonable compensation for its services under this Section 9.3, and the Trustee shall be entitled to be reimbursed, and the Trustee shall be reimbursed, for such payments in accordance with and subject to Article VII. (c) Upon surrender for registration of transfer of any TRIP at any office or agency of the Transfer Agent and Registrar maintained for such purpose, Finco shall execute, and the Trustee shall authenticate and deliver, in the name of the designated transferee or transferees, one or more new TRIPs in authorized denominations representing a like aggregate portion of the TRIPs Capital. (d) At the option of any TRIPs Holder, TRIPs may be exchanged for other TRIPs in authorized denominations of a like aggregate portion of the TRIPs Capital, upon surrender of the TRIPs to be exchanged at any such office or agency of the Transfer Agent and Registrar maintained for such purpose. Whenever any TRIPs are so surrendered for exchange, Finco shall execute, and the Trustee shall authenticate and (unless the Transfer Agent and Registrar is different than the Trustee, in which case the Transfer Agent and Registrar shall) deliver the TRIPs which the TRIPs Holder making the exchange is entitled to receive. Every TRIP presented or surrendered for registration of transfer or exchange shall be accompanied by a written instrument of transfer in a form satisfactory to the Trustee and the Transfer Agent and Registrar duly executed by the TRIPs Holder thereof or his attorney duly authorized in writing. (e) No service charge shall be made for any registration of transfer or exchange of TRIPs, but the Transfer Agent and Registrar may require payment of a sum sufficient to cover any tax or governmental charge that may be imposed in connection with any transfer or exchange of TRIPs. (f) All TRIPs surrendered for registration of transfer and exchange shall be cancelled and disposed of in a manner satisfactory to the Trustee and Finco. (g) Finco shall execute and deliver to the Trustee or the Transfer Agent and Registrar, as applicable, TRIPs in such amounts and at such times as are necessary to enable the Trustee and the Transfer Agent and Registrar to fulfill their respective responsibilities under this Agreement and the TRIPs. Section 9.4. Restrictions on Transfer. The Trustee shall not register the transfer of any TRIP unless the Trustee shall have received a certificate, substantially in the form of Exhibit D hereto, and an opinion of counsel (which opinion of counsel may be rendered by salaried counsel employed by the holder or prospective holder of such TRIP) reasonably acceptable to the Trustee that such transfer is exempt from, or not subject to, the registration requirements of the Securities Act. Section 9.5. Mutilated, Destroyed, Lost or Stolen TRIPs. If (a) any mutilated TRIP is surrendered to the Transfer Agent and Registrar or the Transfer Agent and Registrar receives evidence to its satisfaction of the destruction, loss or theft of any TRIP and (b) there is delivered to the Transfer Agent and Registrar and the Trustee such security or indemnity as may be required by them to save each of them harmless (any institutional TRIPs Holder's unsecured agreement of indemnity being satisfactory for these purposes), then, in the absence of notice to an Authorized Officer of the Trustee that such TRIP has been acquired by a bona fide purchaser, Finco shall execute, and the Trustee shall authenticate and deliver (in compliance with applicable law), in exchange for or in lieu of any such mutilated, destroyed, lost or stolen TRIP, a new TRIP of like tenor and aggregate portion of the TRIPs Capital. In connection with the issuance of any new TRIP under this Section 9.5, the Trustee or the Transfer Agent and Registrar may require the payment by the TRIPs holder of a sum sufficient to cover any tax or other governmental expenses (including the fees and expenses of the Trustee and the Transfer Agent and Registrar) connected therewith. Any duplicate TRIP issued pursuant to this Section 9.5 shall constitute complete and indefeasible evidence of ownership in the Trust Assets, as if originally issued, whether or not the lost, stolen or destroyed TRIP shall be found at any time. Section 9.6. Persons Deemed Owners. Prior to due presentation of a TRIP for registration of transfer, the Trustee, the Transfer Agent and Registrar and any agent of any of them may treat the Person in whose name any TRIP is registered as the owner of such TRIP for the purpose of receiving distributions pursuant to Article VII and for all other purposes whatsoever, and neither the Trustee, the Transfer Agent and Registrar nor any agent of any of them shall be affected by any notice to the contrary. Notwithstanding the foregoing provisions of this Section 9.6, in determining whether the holders of the requisite portion of the TRIPs Capital have given any request, demand, authorization, direction, notice, consent or waiver hereunder, TRIPs owned by any UHS Entity or any affiliate thereof (as defined in Rule 405 under the Securities Act), shall be disregarded and deemed not to be outstanding, except that, in determining whether the Trustee shall be protected in relying upon any such request, demand, authorization, direction, notice, consent or waiver, only TRIPs which an Authorized Officer of the Trustee knows to be so owned shall be so disregarded. TRIPs so owned which have been pledged in good faith shall not be disregarded and may be regarded as outstanding if the pledgee establishes to the satisfaction of the Trustee the pledgee's right so to act with respect to such TRIPs and that the pledgee is not Finco, any UHS Entity or an affiliate thereof (as defined above). Section 9.7. Access to List of Participants' Names and Addresses. The Trustee will furnish or cause to be furnished by the Transfer Agent and Registrar to Finco, any Participant or the Servicer, within five Business Days after receipt by the Trustee of a request therefor in writing, a list in such form as Finco, such Participant or the Servicer may reasonably require, of the names and addresses of the Participants. Every Participant, by acquiring the Participations, agrees with the Trustee that neither the Trustee, the Transfer Agent and Registrar, nor any of their respective agents shall be held accountable by reason of the disclosure of any such information as to the names and addresses of the Participants hereunder, regardless of the sources from which such information was derived. Section 9.8. Authenticating Agent. (a) The Trustee may appoint one or more authenticating agents with respect to the TRIPs which shall be authorized to act on behalf of the Trustee in authenticating the TRIPs in connection with the issuance, delivery, registration of transfer, exchange or repayment of the TRIPs. Whenever reference is made in this Agreement to the authentication of TRIPs by the Trustee or the Trustee's certificate of authentication, such reference shall be deemed to include authentication on behalf of the Trustee by an authenticating agent and a certificate of authentication executed on behalf of the Trustee by an authenticating agent. Each authenticating agent must be acceptable to the Trustee and Finco. (b) Any institution succeeding to the corporate agency business of an authenticating agent shall continue to be an authenticating agent without the execution or filing of any paper or any further act on the part of the Trustee or such authenticating agent. (c) An authenticating agent may at any time resign by giving written notice of resignation to the Trustee and to Finco, which notice shall be forwarded by the Trustee to the Participants. The Trustee may at any time terminate the agency of an authenticating agent by giving notice of termination to such authenticating agent, the Participants and Finco. Upon receiving such a notice of resignation or upon such a termination, or in case at any time an authenticating agent shall cease to be acceptable to the Trustee or Finco, the Trustee promptly may appoint a successor authenticating agent. Any successor authenticating agent upon acceptance of its appointment hereunder shall become vested with all the rights, powers and duties of its predecessor hereunder, with like effect as if originally named as an authenticating agent. No successor authenticating agent shall be appointed unless acceptable to the Trustee and Finco. (d) The Trustee agrees to pay to each authenticating agent from time to time reasonable compensation for its services under this Section 9.8, and the Trustee shall be entitled to be reimbursed for such payments in accordance with and subject to the provisions of Article VII. (e) The provisions of Sections 11.1, 11.2 and 11.3 shall be applicable to any authenticating agent. (f) Pursuant to an appointment made under this Section 9.8, the TRIPs may have endorsed thereon, in lieu of the Trustee's certificate of authentication, an alternate certificate of authentication in substantially the following form: This is one of the TRIPs described in the Pooling Agreement. _________________________ _________________________ as authenticating agent for the Trustee By _______________________ Authorized Officer Section 9.9. Limitation on Rights of Participants. (a) The death or incapacity of any Participant shall not operate to terminate this Agreement or the Trust, nor shall such death or incapacity entitle such Participant's legal representatives or heirs to claim an accounting or to take any action or commence any proceeding in any court for a partition or winding up of the Trust, nor otherwise affect the rights, obligations and liabilities of the parties hereto or any of them. (b) Except as expressly provided herein, no Participant shall have any right to vote or in any manner otherwise control the operation and management of the Trust, or the obligations of the parties hereto, nor shall anything herein set forth, or contained in the terms of the TRIPs, be construed so as to constitute the Participants from time to time as partners or members of an association; nor shall any Participant be under any liability to any third person by reason of any action taken by the parties to this Agreement pursuant to any provision hereof. Section 9.10. Participations Nonassessable and Fully Paid. It is the intention of the parties to this Agreement that the Participants shall not be personally liable for obligations of the Trust, that the interests in the Trust represented by the Participations shall be nonassessable for any losses or expenses of the Trust or for any reason whatsoever and that the TRIPs upon authentication thereof by the Trustee pursuant to Sections 2.5 and 9.2 are and shall be deemed fully paid. Section 9.11. Actions by TRIPs Holders. Any request, demand, authorization, direction, notice, consent, waiver or other act by a TRIPs Holder shall bind such TRIPs Holder and every subsequent holder of such TRIP issued upon the registration of transfer thereof or in exchange therefor or in lieu thereof in respect of anything done or omitted to be done by the Trustee in reliance thereon, whether or not notation of such action is made upon such TRIP. ARTICLE X EARLY AMORTIZATION EVENTS Section 10.1. Early Amortization Events. If any of the following events occur (each, an "Early Amortization Event"), Sheffield or the Required TRIPs Holders may give notice thereof pursuant to Section 10.2, and the Trustee, on behalf of the Participants, may exercise the remedies available to it pursuant to Section 10.2: (a) Finco shall fail to make any payment to be made by it hereunder to any party to any of the Operative Documents when due; or Finco shall fail to perform or observe any term, covenant or agreement contained in Section 5.1(b), 5.1(d), 5.1(g), 5.1(j), 5.1(k), 5.2(d) through (f), 5.2(i) or 5.2(k) through (n); or (b) Finco shall default in the performance of any covenant or agreement set forth in subsection 5.1(l) and such default shall continue unremedied for a period of three days or Finco shall default in the performance of any other agreement or undertaking hereunder (other than as provided in clause (a) above) and such default shall continue for 30 days after written notice thereof has been given to Finco by the Servicer, any Participant or the Trustee; or (c) any representation or warranty made by Finco, UHS or the Servicer in any Operative Document or in any certificate or financial or other statement furnished pursuant to the terms of such Operative Document (other than as provided in clauses (a) or (b) above) shall prove to have been untrue or incomplete in any material respect when made or deemed made and Finco, UHS or the Servicer, as the case may be, shall fail to cure such breach of representation, warranty or other statement within 15 days after written notice thereof has been given to Finco, UHS or the Servicer by the Servicer, any Participant or the Trustee; provided, however, that no breach of any representation or warranty made by Finco as to any Receivable being an Eligible Receivable on the related Purchase Date shall constitute an "Early Amortization Event" hereunder if Finco cures or causes to be cured such breach in accordance with the terms of Section 5.4 of this Agreement; or (d) any of Finco, the Servicer or UHS shall fail to perform or observe any other term, covenant or agreement contained in any of the Operative Documents to which it is a party (other than as provided in paragraphs (a) through (c) above), and any such failure shall remain unremedied for 30 days after written notice thereof shall have been given to Finco, the Servicer or UHS, as the case may be, by the Servicer, any Participant or the Trustee; or (e) any material provision of any of the Operative Documents shall at any time for any reason cease to be valid and binding on the parties thereto or shall be declared to be null and void, or the validity or enforceability thereof shall be contested by any Governmental Authority, in each case in a manner and to an extent which, either individually or in the aggregate, could have or result in a material adverse effect on any of the Interested Parties or the CP Holders; or (f) (i) any of Finco, UHS or the Servicer shall (A) apply for or consent to the appointment of a receiver, trustee, liquidator or custodian or the like of itself or of its property, (B) admit in writing its inability to pay its debts generally as they become due, (C) make a general assignment for the benefit of creditors, (D) be adjudicated a bankrupt or insolvent, or (E) commence a voluntary case under the Federal bankruptcy laws of the United States of America or file a voluntary petition or answer seeking reorganization, an arrangement with creditors or an order for relief or seeking to take advantage of any insolvency law or file an answer admitting the material allegations of a petition filed against it in any bankruptcy, reorganization or insolvency proceeding; or corporate action shall be taken by it for the purpose of effecting any of the foregoing; or (ii) without the application, approval or consent of Finco, UHS or the Servicer, a proceeding shall be instituted in any court of competent jurisdiction, under any law relating to bankruptcy, insolvency, reorganization or relief of debtors, seeking in respect of Finco, UHS or the Servicer an order for relief or an adjudication in bankruptcy, reorganization, dissolution, winding up, liquidation, a composition or arrangement with creditors, a readjustment of debts, the appointment of a trustee, receiver, liquidator or custodian or the like of Finco, UHS or the Servicer or of all or any substantial part of the assets of Finco, UHS or the Servicer, or other like relief in respect thereof under any bankruptcy or insolvency law, and, if such proceeding is being contested by Finco, UHS or the Servicer in good faith, the same shall (A) result in the entry of an order for relief or any such adjudication or appointment or (B) continue undismissed, or pending and unstayed, for any period of 60 consecutive days; or (g) (i) Finco, UHS, the Servicer or any Hospital or any Commonly Controlled Entity shall engage in any Prohibited Transaction (as defined in Section 406 of ERISA or Section 4975 of the Code) involving any Plan, (ii) any "accumulated funding deficiency" (as defined in Section 302 of ERISA), whether or not waived, shall exist with respect to any Plan, (iii) a Reportable Event shall occur with respect to, or proceedings shall commence to have a trustee appointed, or a trustee shall be appointed, to administer or to terminate, any Single Employer Plan, which Reportable Event or commencement of proceedings or appointment of a trustee is, in the reasonable opinion of the Required TRIPs Holders or Sheffield, likely to result in the termination of such Plan for purposes of Title IV of ERISA, (iv) any Single Employer Plan shall terminate for purposes of Title IV of ERISA, (v) UHS or any Commonly Controlled Entity shall, or in the reasonable opinion of the Required TRIPs Holders or Sheffield is likely to, incur any liability in connection with a withdrawal from, or the Insolvency or Reorganization of, a Multiemployer Plan or (vi) any other event or condition shall occur or exist, with respect to a Plan; and in each case in clauses (i) through (vi) above, such event or condition, together with all other such events or conditions, if any, could subject UHS or any of its Subsidiaries to any tax, penalty or other liabilities in the aggregate material in relation to the business, operations, property or financial or other condition of the UHS Entities taken as a whole; or (h) (i) Except as permitted hereunder, Finco shall incur any Debt or obligations of UHS or any of its Subsidiaries in respect of Debt in excess of $5,000,000 in the aggregate, including Debt assumed or guaranteed by UHS or any of its Subsidiaries, shall be declared to be or shall become due and payable prior to the stated maturity thereof (an "Acceleration Event"); (ii) obligations of UHS or any of its Subsidiaries in respect of Debt in excess of $5,000,000 in the aggregate shall not be paid when the same becomes due and payable (after taking into account any period of grace permitted with respect thereto); (iii) (A) there shall occur and be continuing any other default or defaults by UHS or any of its Subsidiaries under any instruments, agreements or evidences of indebtedness relating to Debt in excess of $5,000,000 in the aggregate and such defaults shall continue unremedied for 30 days beyond any period of grace permitted with respect thereto and (B) the effect of such default or defaults is to permit the holder or holders of such instruments, agreements or evidences of indebtedness, or a trustee, agent or other representative on behalf of such holder or holders, to cause Debt in excess of $5,000,000 in the aggregate to become due prior to its stated maturity; or (i) any judgment or judgments for the payment of money (A) in an aggregate amount in excess of $10,000 shall have been rendered against Finco or (B) in an aggregate amount in excess of $5,000,000 shall have been rendered against UHS or any Subsidiary or Subsidiaries of UHS (other than Finco), and in any such case the same shall have remained unsatisfied and in effect for any period of 30 consecutive days during which no stay of execution shall have been obtained; and any such event, in the reasonable judgment of Sheffield or the Required TRIPs Holders, shall materially impair the ability of any UHS Entity to perform its obligations under the Operative Documents; or (j) (i) UHS shall cease to own, directly or indirectly through one or more wholly owned Subsidiaries, all of the outstanding capital stock of Finco or of UHS Delaware; or (ii) any such capital stock of Finco or UHS Delaware shall be subject to any Lien, charge, pledge or encumbrance (other than (a) any Lien for taxes which may not then be due and payable or which can be discharged thereafter without penalty or (b) any Lien of any financial institution securing Debt of UHS and its Subsidiaries); or (iii) any pledgee of any such stock of Finco or UHS Delaware pledged as collateral as permitted by clause (ii) shall take any action to realize upon such collateral; or (k) this Agreement shall at any time not give the Trustee the ownership or security interests and rights, powers and privileges purported to be created hereby (including, without limitation, a perfected ownership or security interest in, or Lien on, all of the Trust Assets), prior to the rights of all other Persons and subject to no other mortgage, pledge, Lien, security interest or other charge or encumbrance of any kind; or (l) (i) the Servicer or any Hospital shall fail to make any payment or deposit within one Business Day after the date it is required to do so under the terms of the Sale and Servicing Agreements or the Servicing Agreement; or (ii) the Servicer shall fail to deliver a Settlement Date Statement and the related Servicer's Certificate within three Business Days after the date it is required to do so or shall fail to deliver a Servicer Daily Statement within one Business Day after it is required to do so under the terms of the Servicing Agreement; or (iii) any Hospital shall fail to comply with the terms of Section 7.2 of the related Sale and Servicing Agreement; or (m) UHS shall undergo a Change of Control or change in management, unless such event, in the reasonable judgment of Sheffield and the Required TRIPs Holders, would not be expected to materially impair the ability of UHS to perform its obligations under the Guarantee; or (n) a Voluntary Exclusion Event shall have occurred; or (o) the Loss-to-Liquidation Ratio for any Settlement Period shall exceed 12%; or (p) the average Loss-to-Liquidation Ratio for the three most recent Settlement Periods shall exceed 10%; or (q) the Delinquency Ratio shall exceed 12% on any Settlement Date; or (r) at any time (i) the Eligible Pool Balance plus (ii) all cash held in the Collateral Account (other than the TRIPs Interest Sub- account, the Sheffield Interest Sub-account or the Expense Sub-account) shall cease to be at least $7,500,000 greater than the Required Coverage Amount; or (s) there shall have occurred any other circumstance or circumstances which would, alone or in the aggregate, in the sole judgment of Sheffield or the Required TRIPs Holders, have a material adverse impact on the validity or enforceability of this Agreement or any other Operative Document, or on the enforceability or collectibility (other than as a result of the credit quality of any Obligor) of the Participations. Section 10.2. Remedies. (a) If any Early Amortization Event, other than an event described in Section 10.1(f) or (o) through (r), shall have occurred and be continuing, (i) upon written notice given by the Required TRIPs Holders to Finco, Sheffield and the Trustee, the TRIPs Amortization Period shall commence and (ii) upon written notice given by Sheffield to Finco and the Trustee (a copy of which notice the Trustee shall promptly deliver to the TRIPs Holders), the Sheffield Amortization Period shall commence. (b) If any Early Amortization Event described in Section 10.1(f) or (o) through (r) shall have occurred and be continuing, then, without notice or other action on the part of the Trustee or any Participant, (i) in the case of an Early Amortization Event described in Section 10.1(f) or (r), immediately upon the occurrence of such event, (ii) in the case of an Early Amortization Event described in Section 10.1(o) or (q), three days after the Settlement Date on which the occurrence of such event is, or is required to be, reported in the Settlement Date Statement, and (iii) in the case of an Early Amortization Event described in Section 10.1(p), three days after the occurrence of such event, the TRIPs Amortization Period and the Sheffield Amortization Period shall commence. (c) If both the TRIPs Amortization Period and the Sheffield Amortization Period have commenced pursuant to Section 10.2(a) or (b) or if the Sheffield Amortization Period shall have commenced when there are no TRIPs outstanding, Finco shall immediately cease to transfer Purchased Receivables to the Trust. In any such event, all Collections thereafter received from each Obligor in respect of the Purchased Receivables previously conveyed to the Trust shall continue to be a part of the Trust as provided in this Agreement and shall be applied to such Purchased Receivables in the order such Purchased Receivables were created. If both the TRIPs Amortization Period and the Sheffield Amortization Period have commenced pursuant to Section 10.2(a) or (b), the Trustee, for the benefit of the Participants, without demand of performance or other demand, presentment, protest, advertisement or notice of any kind (except any notice required by law referred to below) to or upon Finco or any other Person (all and each of which demands, defenses, advertisements and notices are hereby waived), may forthwith collect, receive, appropriate and realize upon the Total Transferred Property, or any part thereof, and/or may forthwith sell, lease, assign, give option or options to purchase, or otherwise dispose of and deliver the Trust Assets or any part thereof (or contract to do any of the foregoing), in one or more parcels at public or private sale or sales, at any exchange, broker's board or office of the Trustee or elsewhere upon such terms and conditions as it may deem advisable and at such prices as it may deem best, for cash or on credit or for future delivery without assumption of any credit risk. To the extent permitted by applicable law, Finco waives all claims, damages and demands it may acquire against the Trustee and any Participant arising out of the exercise by the Trustee of any rights under this Section 10.2. If any notice of a proposed sale or other disposition of such Total Transferred Property shall be required by law, such notice shall be deemed reasonable and proper if given at least 10 days before such sale or other disposition. Without limiting the generality of the foregoing, the Trustee, for the benefit of the Participants, shall have, in addition to all other rights and remedies granted to it under this Agreement and in any other instrument or agreement securing, evidencing or relating to the rights and remedies hereunder, all rights and remedies of a secured party under the UCC. Nothing in this Section 10.2 shall be construed to prejudice any rights the Trustee or the Participants have as purchasers or owners of the Transferred Property. (d) In case any Early Amortization Event occurs, and as a result thereof the TRIPs Amortization Period commences, by reason of any willful action (or inaction) taken (or not taken) by or on behalf of any UHS Entity with the intention of avoiding payment of any Make-Whole Payment Amount which Finco would have had to pay if Finco had exercised the Call Option pursuant to Section 2.14, then Finco shall pay to the TRIPs Holders, after payment of all Capital and Yield, an amount equal to the sum of each Make-Whole Payment Amount that would have been payable during the TRIPs Amortization Period if such TRIPs Amortization Period had commenced as a result of the exercise of the Call Option. (e) In the event that Finco shall, after any Early Amortization Event, receive payments from any Obligor which is an Obligor with respect to both Purchased Receivables and Receivables which have not been conveyed to the Trustee, on behalf of the Trust, then, to the extent that Finco shall be unable to determine the Receivables to which such payments relate, Finco shall apply all such amounts first to the Outstanding Balance of such Obligor's Purchased Receivables, and in the order such Purchased Receivables were created, until all such Purchased Receivables have been paid in full. (f) Unless the Trustee shall fail to take action required to be taken by it in this Section 10.2 and Article XIV, no Participant shall have any right directly to enforce the ownership or security interests and Liens granted by this Agreement. No CP Holder shall have any right to require the Trustee to take or fail to take any action under this Agreement. ARTICLE XI THE TRUSTEE Section 11.1. Duties of Trustee. (a) The Trustee, prior to the occurrence of an Early Amortization Event of which an Authorized Officer of the Trustee has actual knowledge, undertakes to perform such duties and only such duties as are specifically set forth in this Agreement. If, to the actual knowledge of an Authorized Officer of the Trustee, an Early Amortization Event has occurred (and has not been cured or waived), the Trustee shall exercise such of the rights and powers vested in it by this Agreement and use the same degree of care and skill in their exercise, as a prudent man would exercise or use under the circumstances in the conduct of his own affairs. (b) The Trustee, upon receipt of all resolutions, certificates, statements, opinions, reports, documents, orders or other instruments furnished to the Trustee which are specifically required to be furnished pursuant to any provision of this Agreement, shall, subject to Section 11.2, examine them to determine whether they substantially conform to the requirements of this Agreement. The Trustee shall give prompt written notice to the Participants of any material lack of conformity of any such instrument to the applicable requirements of this Agreement discovered by the Trustee which would entitle a specified percentage of the Participants to take any action pursuant to this Agreement. (c) Subject to Section 11.1(a), no provision of this Agreement shall be construed to relieve the Trustee from liability for its own negligent action, its own negligent failure to act or its own willful misconduct; provided, however, that: (i) The Trustee shall not be liable for an error of judgment made in good faith by an Authorized Officer or Authorized Officers of the Trustee, unless it shall be proved that the Trustee was negligent in ascertaining the pertinent facts; (ii) The Trustee shall not be liable with respect to any action taken, suffered or omitted to be taken by it in good faith in accordance with the direction of the Required TRIPs Holders or Sheffield, or if such directions given by the Required TRIPs Holders, Sheffield conflict or if the Operative Documents so require, the direction of the Required Participants or the Required TRIPs Holders and Sheffield jointly, relating to the time, method and place of conducting any proceeding for any remedy available to the Trustee, or exercising any trust or power conferred upon the Trustee, under this Agreement; and (iii) The Trustee shall not be charged with knowledge of an Early Amortization Event or any default by the Servicer unless an Authorized Officer of the Trustee obtains actual knowledge of such event or the Trustee receives written notice of such event from Finco, the Servicer or any Participant. (d) The Trustee shall not be required to expend or risk its own funds or otherwise incur financial liability in the performance of any of its duties hereunder or in the exercise of any of its rights or powers if there is reasonable ground for believing that the repayment of such funds or adequate indemnity against such risk or liability is not reasonably assured to it, and none of the provisions contained in this Agreement shall in any event require the Trustee to perform, or be responsible for the manner of performance of, any obligations of the Servicer under or pursuant to this Agreement or the Servicing Agreement except during such time, if any, as the Trustee shall be the successor to, and be vested with the rights, duties, powers and privileges of the Servicer. (e) Except for actions expressly authorized by this Agreement, the Trustee shall take no action reasonably likely to impair the interests of the Trust in any Purchased Receivable now existing or hereafter created or to impair the value of any Purchased Receivable now existing or hereafter created. (f) Except as expressly provided in this Agreement, the Trustee shall have no power to vary the corpus of the Trust. (g) In the event that the Transfer Agent and Registrar shall fail to perform any obligation, duty or agreement in the manner or on the day required to be performed by the Transfer Agent and Registrar under this Agreement, the Trustee shall be obligated, promptly upon actual knowledge of an Authorized Officer thereof, to perform such obligation, duty or agreement in the manner so required. Section 11.2. Rights of the Trustee. Except as otherwise provided in Section 11.1: (a) The Trustee may rely on and shall be protected in acting on, or in refraining from acting in accordance with, any resolution, officer's certificate, certificate of auditors or any other certificate, statement, instrument, opinion, report, notice, request, consent, order, appraisal, bond or other paper or document believed by it to be genuine and to have been signed or presented to it pursuant to this Agreement by the proper party or parties; (b) The Trustee may consult with counsel, and any opinion of counsel (other than any such opinion rendered subsequent to the Initial Closing Date by any counsel for any UHS Entity) shall be full and complete authorization and protection in respect of any action taken or suffered or omitted by it hereunder in good faith and in accordance with such opinion of counsel; (c) The Trustee shall not be personally liable for any action taken, suffered or omitted by it in good faith and believed by it to be authorized or within the discretion or rights or powers conferred upon it by this Agreement; (d) The Trustee shall not be bound to make any investigation into the facts of matters stated in any resolution, certificate, statement, instrument, opinion, report, notice, request, consent, order, approval, bond or other paper or document, unless requested in writing to do so by the Required TRIPs Holders or Sheffield; (e) The Trustee may execute any of the trusts or powers hereunder or perform any duties hereunder either directly or by or through agents or attorneys or a custodian or nominee, and the Trustee shall not be responsible for any misconduct or negligence on the part of, or for the supervision of, any such agent, attorney, custodian or nominee appointed with due care by it hereunder; (f) Except as may be required by Section 11.1 hereof, the Trustee shall not be required to make any initial or periodic examination of any documents or records related to the Purchased Receivables or the Transferred Property for the purpose of establishing the presence or absence of defects, the compliance by Finco with its representations and warranties or for any other purpose; and (g) In the event that the Trustee is also acting as Transfer Agent and Registrar hereunder, the rights and protections afforded to the Trustee pursuant to this Article XI shall also be afforded to such Transfer Agent and Registrar. Section 11.3. Trustee Not Liable for Recitals. The Trustee assumes no responsibility for the correctness of the recitals contained herein and in the TRIPs (other than the certificate of authentication on the TRIPs). Except as set forth in Section 11.15, the Trustee makes no representations as to the validity or sufficiency of this Agreement or of the TRIPs (other than the certificate of authentication on the TRIPs) or of any Transferred Property or Finco Transferred Property. The Trustee shall not be accountable for the use or application by Finco of any of the TRIPs or the proceeds of the Participations or for the use or application of any funds paid to Finco in respect of the Transferred Property or deposited in or withdrawn from the Collateral Account, any Other Account or any account hereafter established to effectuate the transactions contemplated herein and in accordance with the terms hereof. Section 11.4. Trustee May Own TRIPs. The Trustee, in its individual or any other capacity, may become the owner or pledgee of TRIPs with the same rights as it would have if it were not the Trustee. Section 11.5. Compensation of Trustee. Subject to the provisions of Section 3.1 of the Servicing Agreement, Article VII hereof and the Trustee Fee Letter, the Trustee shall be entitled to receive reasonable compensation (which shall not be limited by any provision of law in regard to the compensation of a trustee of an express trust), but which shall be limited to the extent of the Servicing Fee, for all services rendered by it in the execution of the trust hereby created and in the exercise and performance of any of the powers and duties hereunder of the Trustee, and, subject to such subsection, shall be entitled to reimbursement for its request for all reasonable expenses (including, without limitation, expenses incurred in connection with notices or other communications to Participants), disbursements and advances incurred or made by the Trustee in accordance with any of the provisions of this Agreement (including the reasonable fees and expenses of its agents, any co-trustee and counsel) except any such expense, disbursement or advance as may arise from its gross negligence or bad faith. All amounts payable pursuant to this Section 11.5 shall be paid from the Collateral Account in accordance with Article VII. Section 11.6. Eligibility Requirements for Trustee. The Trustee hereunder shall at all times be a corporation organized and doing business under the laws of the United States of America or any state thereof authorized under such laws to exercise corporate trust powers, having a combined capital and surplus of at least $50,000,000 and subject to supervision or examination by Federal or State authority and, except in the case of Continental, a long- term unsecured debt rating of A or higher from Moody's and S&P. If such corporation publishes reports of condition at least annually, pursuant to law or to the requirements of the aforesaid supervising or examining authority, then, for the purpose of this Section 11.6, the combined capital and surplus of such corporation shall be deemed to be its combined capital and surplus as set forth in its most recent report of condition so published. In case at any time the Trustee shall cease to be eligible in accordance with the provisions of this Section 11.6, the Trustee shall resign immediately in the manner and with the effect specified in Section 11.7. Section 11.7. Resignation or Removal of Trustee. (a) The Trustee may at any time resign and be discharged from the trust hereby created by giving written notice thereof to Finco and the Participants. Upon receiving such notice of resignation, Finco shall, with the consent of the Required Participants (which consent may not be unreasonably withheld) promptly appoint a successor trustee by written instrument, in duplicate, one copy of which instrument shall be delivered to the resigning Trustee and one copy to the successor trustee. If no successor trustee shall have been so appointed and have accepted appointment within 30 days after the giving of such notice of resignation, the resigning Trustee may petition any court of competent jurisdiction for the appointment of a successor trustee. (b) If at any time the Trustee shall cease to be eligible in accordance with the provisions of Section 11.6 hereof and shall fail to resign after written request therefor by Finco or the Required Participants, or if at any time the Trustee shall be legally unable to act, or shall be adjudged a bankrupt or insolvent, or if a receiver of the Trustee or of its property shall be appointed, or any public officer shall take charge or control of the Trustee or of its property or affairs for the purpose of rehabilitation, conservation or liquidation, then Finco or the Required Participants may remove the Trustee and promptly appoint a successor trustee acceptable to Finco and the Required Participants by written instrument, in duplicate, one copy of which instrument shall be delivered to the Trustee so removed and one copy to the successor trustee. (c) Any resignation or removal of the Trustee and appointment of successor trustee pursuant to any of the provisions of this Section 11.7 shall not become effective until acceptance of appointment by the successor trustee as provided in Section 11.8 hereof. (d) The obligations of Finco described in Sections 12.1 and 11.5 shall survive the removal or resignation of the Trustee as provided in this Agreement. Section 11.8. Successor Trustee. (a) Any successor trustee appointed as provided in Section 11.7 hereof shall execute, acknowledge and deliver to Finco and to its predecessor Trustee an instrument accepting such appointment hereunder, and thereupon the resignation or removal of the predecessor Trustee shall become effective and such successor trustee, without any further act, deed or conveyance, shall become fully vested with all the rights, powers, duties and obligations of its predecessor hereunder, with like effect as if originally named as Trustee herein. The predecessor Trustee shall, at the expense of Finco, deliver to the successor trustee all documents or copies thereof and statements held by it hereunder; and Finco and the predecessor Trustee shall execute and deliver such instruments and do such other things as may reasonably be required for fully and certainly vesting and confirming in the successor trustee all such rights, power, duties and obligations. Finco shall immediately give notice to the Rating Agency upon the appointment of a successor trustee. (b) No successor trustee shall accept appointment as provided in this Section 11.8 unless at the time of such acceptance such successor trustee shall be eligible under the provisions of Section 11.6 hereof. (c) Upon acceptance of appointment by a successor trustee as provided in this Section 11.8, such successor trustee shall mail notice of such succession hereunder to all Participants at their addresses as specified in Section 14.1. Section 11.9. Merger or Consolidation of Trustee. Any Person into which the Trustee may be merged or converted or with which it may be consolidated, or any Person resulting from any merger, conversion or consolidation to which the Trustee shall be a party, or any Person succeeding to the corporate trust business of the Trustee, shall be the successor of the Trustee hereunder, provided such corporation shall be eligible under the provisions of Section 11.6 hereof, without the execution or filing of any paper or any further act on the part of any of the parties hereto, anything herein to the contrary notwithstanding. Section 11.10. Appointment of Co-Trustee or Separate Trustee. (a) Notwithstanding any other provisions of this Agreement, at any time, for the purpose of meeting any legal requirements of any jurisdiction in which any part of the Trust may at the time be located, the Trustee shall have the power and may execute and deliver all instruments to appoint one or more Persons to act as a co-trustee or co-trustees, or separate trustee or separate trustees, of all or any part of the Trust, and to vest in such Person or Persons, in such capacity and for the benefit of the Participants, such title to the Trust, or any part thereof, and, subject to the other provisions of this Section 11.10, such powers, duties, obligations, rights and trusts as the Trustee may consider necessary or desirable. No co-trustee or separate trustee hereunder shall be required to meet the terms of eligibility as a successor trustee under Section 11.6 and no notice to the Participants of the appointment of any co-trustee or separate trustee shall be required under Section 11.8 hereof. (b) Every separate trustee and co-trustee shall, to the extent permitted by law, be appointed and act subject to the following provisions and conditions: (i) all rights, powers, duties and obligations conferred or imposed upon the Trustee shall be conferred or imposed upon and exercised or performed by the Trustee and such separate trustee or co-trustee jointly (it being understood that such separate trustee or co-trustee is not authorized to act separately without the Trustee joining in such act), except to the extent that under any statute of any jurisdiction in which any particular act or acts are to be performed, the Trustee shall be incompetent or unqualified to perform such act or acts, in which event such rights, powers, duties and obligations (including the holding of title to the Trust or any portion thereof in any such jurisdiction) shall be exercised and performed singly by such separate trustee or co-trustee, but solely at the direction of the Trustee; (ii) no trustee hereunder shall be personally liable by reason of any act or omission of any other trustee hereunder; and (iii) the Trustee may at any time accept the resignation of or remove any separate trustee or co-trustee. (c) Any notice, request or other writing given to the Trustee shall be deemed to have been given to each of the then separate trustees and co- trustees, as effectively as if given to each of them. Every instrument appointing any separate trustee or co-trustee shall refer to this Agreement and the conditions of this Article XI. Each separate trustee and co-trustee, upon its acceptance of the trusts conferred, shall be vested with the estates or property specified in its instrument of appointment, either jointly with the Trustee or separately, as may be provided therein, subject to all the provisions of this Agreement, specifically including every provision of this Agreement relating to the conduct of, affecting the liability of, or affording protection to, the Trustee. Every such instrument shall be filed with the Trustee and a copy thereof given to Finco and the Servicer. (d) Any separate trustee or co-trustee may at any time constitute the Trustee its agent or attorney-in-fact with full power and authority, to the extent not prohibited by law, to do any lawful act under or in respect of this Agreement on its behalf and in its name. If any separate trustee or co- trustee shall die, become incapable of acting, resign or be removed, all of its estates, properties, rights, remedies and trusts shall vest in and be exercised by the Trustee, to the extent permitted by law, without the appointment of a new or successor trustee. Section 11.11. Tax Returns. In the event the Trust shall be required to file tax returns, Finco shall cause the Servicer to prepare or cause to be prepared any tax returns required to be filed by the Trust and shall cause the Servicer to remit such returns to the Trustee for signature at least five days before such returns are due to be filed. Finco shall also cause the Servicer to prepare or cause to be prepared all tax information required by law and pursuant to Section 8.2 to be distributed to the Participants and shall cause the Servicer to deliver such information to the Trustee at least five Business Days prior to the date it is required by law to be distributed to the Participants. The Trustee, upon request, will furnish the Servicer with all such information known to the Trustee as may be reasonably required in connection with the preparation of all tax returns of the Trust, and shall, upon request, execute such returns. In no event shall the Trustee in its individual capacity be liable for any liabilities, costs or expenses of the Trust, the Participants or any UHS Entity arising under any tax law or regulation, including, without limitation, federal, state or local income or excise taxes or any other tax imposed on or measured by income (or any interest or penalty with respect thereto or arising from any failure to comply therewith). Section 11.12. Trustee May Enforce Claims Without Possession of TRIPs. All rights of action and claims under this Agreement or the Participations may be prosecuted and enforced by the Trustee and, in the case of the TRIPs Participations, without the possession of any of the TRIPs or the production thereof in any proceeding relating thereto, and any such proceeding instituted by the Trustee shall be brought in its own name as trustee. Any recovery of judgment shall, after provision for the payment of the reasonable compensation, expenses, disbursements and advances of the Trustee, its agents and counsel, be for the ratable benefit of the Participants in respect of which such judgment has been obtained. Section 11.13. Suits for Enforcement. If an Early Amortization Event or a default under the Servicing Agreement shall occur and be continuing, the Trustee, in its discretion may, subject to the provisions of Section 11.1, proceed to protect and enforce its rights and the rights of the Participants under this Agreement and the Servicing Agreement by suit, action or proceeding in equity or at law or otherwise, whether for the specific performance of any covenant or agreement contained in this Agreement or the Servicing Agreement or in aid of the execution of any power granted in this Agreement or the Servicing Agreement for the enforcement of any other legal, equitable or other remedy as the Trustee, being advised by counsel, shall deem most effective to protect and enforce any of the rights of the Trustee or the Participants. Nothing herein contained shall be deemed to authorize the Trustee to authorize or consent to or accept or adopt on behalf of any Participant any plan of reorganization, arrangement, adjustment or composition affecting the Participations or the rights of any Participant, or authorize the Trustee to vote in respect of the claim of any Participant in any such proceeding. Section 11.14. Rights of Participants to Direct Trustee. Either the Required TRIPs Holders or Sheffield shall have the right at any time to direct the Trustee in (i) the granting of any consents, waivers, amendments, terminations or similar actions pertaining to the Participations, (ii) the time, method and place of conducting any proceeding and (iii) the exercise of any right or power conferred on the Trustee pursuant to the Operative Documents; provided that if this Agreement or any other Operative Document specifies that the consent of the Required Participants or the joint consent of Sheffield and the Required TRIPs Holders shall be required with respect to the matters specified in clauses (i), (ii) and (iii) above, then such consent of the Required Participants or such joint consent shall be so required; and provided, further, that if the taking of any action directed by the Required TRIPs Holders or Sheffield, as the case may be, would cause the Trustee to violate any instruction previously given by any Participants in accordance with the Operative Documents, the Trustee shall follow the direction of the Required Participants with respect to such matter; and provided, further, that, subject to Section 11.1, the Trustee shall have the right to decline to follow any such direction if the Trustee being advised by counsel determines that the action so directed may not lawfully be taken, or if the Trustee in good faith shall, by an Authorized Officer or Authorized Officers of the Trustee, determine that the proceedings so directed would be illegal or involve it in personal liability or be unduly prejudicial to the rights of Participants not parties to such direction; and provided, further, that nothing in this Agreement shall impair the right of the Trustee to take any action deemed proper by the Trustee and which is not inconsistent with such direction of the requisite Participants given in accordance with the immediately preceding sentence. Section 11.15. Representations and Warranties of Trustee. The Trustee represents and warrants that: (i) the Trustee is a national banking association organized, existing and in good standing under the laws of the United States of America; (ii) the Trustee has full power, authority and right to execute, deliver and perform this Agreement, and has taken all necessary action to authorize the execution, delivery and performance by it of this Agreement and the Servicing Agreement; and (iii) this Agreement and the Servicing Agreement have been duly executed and delivered by the Trustee. Section 11.16. Maintenance of Office or Agency. The Trustee will maintain at its expense in the Borough of Manhattan, The City of New York, an office or offices or agency or agencies where notices and demands to or upon the Trustee in respect of the Participations and this Agreement may be served. The Trustee will give prompt written notice to Finco, the Servicer and the Participants of any change in the location of the TRIPs Register or any such office or agency. ARTICLE XII INDEMNIFICATION AND EXPENSES Section 12.1. Indemnities by Finco. (a) Without limiting any other rights which the Participants and the Trustee may have hereunder or under applicable law, Finco hereby agrees to indemnify each of the Participants, the Trustee, their respective assignees and each of their respective officers, directors, employees, representatives, agents and Affiliates (collectively, the "Indemnified Parties") from and against any and all damages, losses (other than loss of profit), claims, Taxes, liabilities (including liabilities for penalties), actions, suits, judgments, demands and related costs and expenses, including, without limitation, reasonable attorneys' fees and expenses (all of the foregoing being collectively referred to as "Indemnified Amounts"), awarded against or incurred by any of them arising out of or as a result of this Agreement, the other Finco Documents or the Participations, the Purchased Receivables and the other Total Transferred Property or its assignment thereof to the Trustee pursuant to Section 2.1, excluding however, Indemnified Amounts resulting from gross negligence or willful misconduct on the part of the Indemnified Party to which such Indemnified Amount would otherwise be due. Without limiting the generality of the foregoing, Finco shall indemnify the Indemnified Parties for Indemnified Amounts relating to or resulting from: (i) the transfer of an interest in any Non-qualifying Receivable; (ii) any set-off or adjustment applied by any Obligor against any Purchased Receivable conveyed to the Trustee, whether or not the amount of such set-off or adjustment was reflected in the Offset Reserves on the Purchase Date relating to such Purchased Receivable; (iii) reliance on any representation or warranty made by Finco (or any of its respective Authorized Officers) under or in connection with this Agreement and any information or report delivered by Finco pursuant hereto or thereto, which shall have been false or incorrect in any material respect when made or deemed made; (iv) the failure by Finco to comply with any Requirement of Law with respect to any Purchased Receivable or other Transferred Property, or the nonconformity of any such Purchased Receivable or other Transferred Property with any such Requirement of Law; (v) the failure to take all actions which would be required to maintain in favor of the Trustee, for the bene-fit of the Participants, a valid, perfected, first priority ownership or security interest in, or Lien on, the Purchased Receivables and other Total Transferred Property, together with all Collections and Outstanding Balances related to such Receivables, free and clear of any Lien whether exist-ing at the Initial Closing Date or at any time thereafter; (vi) the failure to file, record, deliver or receive in a timely manner all Security Filings, including, without limitation, financing statements or other similar instru-ments or documents required under the UCC in effect in the state in which Finco's or any Hospital's chief executive office is located or under other applicable laws with respect to any Purchased Receivables or other Total Transferred Property; (vii) any failure of Finco to perform its duties or obligations in accordance with the provisions of this Agreement or the other Finco Documents; or (viii) the administration or enforcement of this Agree-ment or the other Finco Documents by any Interested Party. (b) By entering into this Agreement, Finco agrees to be liable, directly to the injured party, for the entire amount of any losses, claims, damages or liabilities (other than those incurred by a Participant in the capacity of an investor in its Participation) arising out of or based on the arrangement created by this Agreement and the actions of Finco taken pursuant hereto as though the Agreement created a partnership under the New York Uniform Partnership Act with Finco a general partner thereof. Finco agrees to pay, indemnify and hold harmless each Interested Party against and from any and all such losses, claims, damages and liabilities except to the extent that they arise from any action by such Interested Parties other than in accordance with the Operative Documents. Section 12.2. Additional Costs. (a) Whether or not the TRIPs Participations are acquired by the TRIPs Holders or the Sheffield Participation is acquired by Sheffield, Finco agrees to pay all reasonable out-of-pocket costs and expenses of the Participants and the Trustee (including fees and disbursements of counsel) in connection with (i) the preparation, reproduction, execution, delivery and administration of this Agreement, the other Operative Documents and any related documents, (ii) the sale of the Purchased Receivables and other Total Transferred Property to the Trust and the transfer of the Participations in the Trust Assets hereunder, (iii) the perfection as against all third parties whatsoever of the Trust's right, title and interest in, to and under the Purchased Receivables and the other Total Transferred Property, (iv) the enforcement by any Interested Party of the Participations and of the obligations and liabilities of Finco under this Agreement, the other Operative Documents or any related document or of any Obligor under any Purchased Receivable and (v) the maintenance of, and the obligations of the Participants in connection with, the Hospital Concentration Accounts, the Master Receivables Account, the Collateral Account, the Other Accounts and any Additional Accounts established pursuant hereto; provided that in connection with clauses (i) and (ii), Finco shall not be obligated to pay the fees and expenses of more than one counsel representing the TRIPs Holders and shall not be obligated to pay legal fees, taxes or governmental charges in connection with the transfer by any TRIPs Holder of its Participation hereunder. In addition, Finco will pay all reasonable out-of-pocket costs and expenses of the Participants and the Trustee (including fees and disbursements of counsel) in connection with any modifications of, or consents under, this Agreement, the other Finco Documents or any related document or of any Obligor under any Purchased Receivable or any consents under this Agreement, the other Finco Documents or any related document to the extent such modifications or consents are requested by Finco or otherwise required under the aforementioned documents (whether or not any such modification or consent becomes effective), including but not limited to the out-of-pocket expenses and the fees and disbursements of counsel representing the TRIPs Holders and any local counsel engaged by them and the allocated costs and expenses of the in-house counsel of the TRIPs Holders (but exclusive of salaries or compensation payable to the officers or employees of such TRIPs Holders other than such in-house counsel). (b) Determinations and allocations by the TRIPs Holders, Sheffield or the Trustee, as the case may be, for purposes of this Section 12.2 shall be conclusive, absent manifest error, provided that such determinations and allocations are made in good faith and on a reasonable basis and that the TRIPs Holders, Sheffield or the Trustee, as the case may be, delivers a certificate to such effect to Finco and the Servicer. Section 12.3. Survival of Indemnities. All of the rights and obligations set forth in this Article XII shall survive the termination of the Trust, the payment of the Participations and the termination of this Agreement. Section 12.4. Method of Payment. Any Indemnified Amounts due under this Article, and any other fees, costs and expenses payable by Finco to any person pursuant to the terms of any Operative Document shall be payable in immediately available funds to any Person from the Expense Sub-account in accordance with the terms and conditions of Article VII (or from any other source available to Finco consistent with the terms of the Operative Documents); provided that any such amounts to be paid from the Expense Sub- account shall be deposited in the Expense Sub-account only to the extent that, after giving effect to such deposit, no Early Amortization Event shall have occurred; and provided, further, after the occurrence of an Early Amortization Event, amounts payable to the Trustee and, if the Servicer is not an affiliate of Finco, the Servicer, pursuant to subsection 7.3(a), shall be deposited and paid in accordance with the provisions of Article VII without regard to the foregoing proviso. ARTICLE XIII TERMINATION OF TRUST Section 13.1. Final Termination of Participations; Optional Repurchase of TRIPs. (a) All Sheffield Capital and Sheffield Yield with respect to the Sheffield Participation shall be due and payable no later than the Final Sheffield Maturity Date. In the event that the Adjusted Sheffield Capital is greater than zero on the last day of the Settlement Period immediately preceding such date (after giving effect to all allocations and distributions to be made pursuant to Article VII on such date), Finco, on behalf of the Trustee, upon written direction by Sheffield, will promptly sell or cause to be sold an amount of Purchased Receivables or interests in Purchased Receivables (along with all related Transferred Property) having an aggregate Outstanding Balance equal to up to the Sheffield Termination Sale Amount. Proceeds of such sale shall be paid to the Sheffield Payment Account for application pursuant to Section 7.5 and distribution to Sheffield in final payment for all Sheffield Capital of and Sheffield Yield in respect of the Sheffield Participation. Proceeds of such sale in excess of the Adjusted Sheffield Capital shall be paid to the Collateral Account and applied in accordance with Section 7.5. (b) All TRIPs Capital and TRIPs Yield on the TRIPs shall be due and payable no later than the Final TRIPs Maturity Date. In the event that the Adjusted TRIPs Capital is greater than zero on the last day of the Settlement Period immediately preceding such date (after giving effect to all allocations and distributions to be made pursuant to Article VII on such date), the Trustee, upon written direction of the Required TRIPs Holders, will promptly sell or cause to be sold an amount of Purchased Receivables or interests in Purchased Receivables (along with all related Transferred Property) having an aggregate Outstanding Balance equal to the TRIPs Termination Sale Amount. Proceeds of such sale shall be deposited in the TRIPs Payment Account and applied to make final payment of the TRIPs in the manner specified in Section 13.2. Proceeds of such sale in excess of the Adjusted TRIPs Capital shall be paid to the Collateral Account and applied in accordance with Section 7.5. (c) On the Transfer Date during the TRIPs Amortization Period on which the Adjusted TRIPs Capital is reduced to an amount equal to or less than 10% of the TRIPs Capital as of the Business Day preceding the beginning of the TRIPs Amortization Period, Finco shall have the option to repurchase the TRIPs, at a purchase price equal to the outstanding TRIPs Capital plus accrued and unpaid TRIPs Yield and any Make-Whole Payment Amount payable through the date of such purchase (after giving effect to any payment of TRIPs Capital and TRIPs Yield on such date of purchase). The amount of the purchase price will be deposited into the TRIPs Payment Account on the Transfer Date in immediately available funds and distributed to the TRIPs Holders. Following any such repurchase, the TRIPs Holders' interest in the Purchased Receivables shall terminate and the TRIPs Holders will have no further rights with respect thereto. In the event that Finco fails for any reason to deposit the purchase price for such Purchased Receivables, the Trust will continue to hold such interest in the Purchased Receivables and monthly payments will continue to be made to the TRIPs Holders. Section 13.2. Final Payment of the TRIPs. Written notice of the Transfer Date on which TRIPs Holders shall receive payment of the final distribution with respect to their TRIPs shall be given by the Trustee (upon 10 Business Days' prior written notice from the Servicer containing all information required for such Trustee's notice) to the TRIPs Holders of record not less than five Business Days prior to such final Transfer Date. Such notice shall specify (i) the Transfer Date on which final payment will be made, (ii) the amount of the final payment and (iii) the office at which the TRIPs Holders may surrender their TRIPs on or after such date. The Trustee shall deliver such Trustee's notice to the Transfer Agent and Registrar at the time such notice is delivered to the TRIPs Holders. The TRIPs Holders, by their acceptance of the TRIPs, agree to surrender their TRIPs to the Trustee on or promptly after such Transfer Date. Section 13.3. Termination of Trust. (a) The respective obligations and responsibilities of Finco, the Participants and the Trustee created hereby shall (except as expressly provided otherwise herein) terminate on the earlier to occur of (i) the Trust Termination Date and (ii) the date on which Aggregate Capital is reduced to zero and all Yield, any Make-Whole Payment Amount and all other amounts payable under the Operative Documents have been paid, and the Trust shall terminate one year and one day thereafter. If on the last day of the Settlement Period immediately preceding the Trust Termination Date the Adjusted Aggregate Capital is greater than zero (after giving effect to all allocations and distributions to be made on such date pursuant to Article VII), Finco, on behalf of the Trustee, will promptly sell all Purchased Receivables conveyed to the Trust. The proceeds of such sale shall be treated as Collections and allocated in accordance with Article VII. (b) Notwithstanding the termination of the Trust pursuant to subsection 13.3(a) or the occurrence of the Final Sheffield Maturity Date or the Final TRIPs Maturity Date, all funds then on deposit in the Collateral Account, the Other Accounts and any Additional Accounts shall continue to be held in trust for the benefit of the Participants, and the Trustee shall pay such funds to the Participants in accordance with Sections 13.1 and 13.2. (c) All TRIPs surrendered on or after the date of the final distribution with respect to such TRIPs shall be cancelled by the Transfer Agent and Registrar and be disposed of in a manner satisfactory to the Trustee and Finco. Section 13.4. Finco's Termination Rights. Upon payment of all amounts required pursuant to Section 7.5 and the termination of the obligations of the parties hereunder pursuant to Section 13.3, the Trustee shall sell, assign and convey to Finco (without recourse, representation or warranty for no additional consideration other than Finco's interest in the Trust) all right, title and interest of the Trust in the Purchased Receivables, whether then existing or thereafter created, and the Total Transferred Property, and all proceeds thereof, except for amounts held by the Trustee pursuant to Section 13.3(b). The Trustee shall execute and deliver such instruments of transfer and assignment, in each case without recourse, representation or warranty, as shall be reasonably requested by Finco to vest in Finco all right, title and interest which the Trust had in the Purchased Receivables and the Total Transferred Property. ARTICLE XIV MISCELLANEOUS Section 14.1. Notices, Etc. Except where telephonic instructions or notices are authorized herein to be given, all notices, demands, instructions and other communications required or permitted to be given to or made upon any party hereto shall be in writing and shall be personally delivered or sent by registered, certified or express mail, postage prepaid, return receipt requested, or by telecopy (with voice confirmation thereof) or telegram (with messenger delivery specified in the case of a telegram) and shall be deemed to be given for purposes of this Agreement on the day that such personal delivery is made or such return receipt or confirmation is received by the party giving such notice, demand, instruction or communication. Unless otherwise specified in a notice sent or delivered in accordance with the foregoing provisions of this Section, notices, demands, instructions and other communications in writing shall be given to or made upon the respective parties hereto at their respective addresses (or to their respective telecopy numbers) indicated below, and, in the case of telephonic instructions or notices, by calling the telephone number or numbers indicated for such party below: If to Finco: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 Attention: President Tel No.: (714) 661-9323 Telecopier No.: (714) 661-9445 with a copy to: UHS Receivables Corp. c/o Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: Chief Financial Officer Tel. No.: (215) 768-3300 Telecopier No.: (215) 768-3318 If to Sheffield: Sheffield Receivables Corporation c/o Barclays Bank PLC, New York Branch, as Managing Agent 222 Broadway New York, New York 10038 Attention: Barry Wood Tel. No.: (212) 412-6797 Telecopier No.: (212) 412-6846 If to any TRIPs Holder: to its address set forth in the TRIPs Register If to the Trustee: Continental Bank, National Association 231 South La Salle Street, 7th Floor Chicago, Illinois 60697 Attention: Steve Charles Tel. No.: (312) 828-7321 Telecopier No.: (312) 828-6528 If to the Managing Agent: Barclays Bank PLC, New York Branch 222 Broadway New York, New York 10038 Attention: Barry Wood Tel. No.: (212) 412-6797 Telecopier No.: (212) 412-6846 If to any Lender: c/o Barclays Bank PLC, New York Branch 222 Broadway New York, New York 10038 Attention: Steven McKenna Tel. No.: (212) 412-4084 Telecopier No.: (212) 412-6846 Section 14.2. Successors and Assigns; Survival. (a) This Agreement shall be binding upon Finco, the Participants, the Trustee and their respective successors and assigns and shall inure to the benefit of Finco and the Interested Parties; provided that Finco shall not assign any of its rights or obligations hereunder (including, without limitation, its rights in respect of, or any interest in, the Subordinated Interest) (other than as expressly assigned hereunder) without the prior written consent of each Participant. (b) The representations and warranties of Finco contained in this Agreement shall survive the execution, delivery and termination of this Agreement and the purchase of the Participations. Section 14.3. Severability Clause. Any provisions of this Agreement which are prohibited or unenforceable in any jurisdiction shall, as to such jurisdiction, be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions hereof, and any such prohibition or unenforceability in any jurisdiction shall not invalidate or render unenforceable such provision in any other jurisdiction. Section 14.4. Amendments. This Agreement may not be modified, amended, waived, supplemented or surrendered except in accordance with the provisions of this Section. This Agreement may be amended, supplemented or modified pursuant to a written instrument executed by Finco, Sheffield and the Trustee, and consented to in writing by the Required TRIPs Holders; provided that after an Early Amortization Event occurs, the consent of Finco shall not be necessary to make any such amendment, modification or supplement which does not directly affect the rights of Finco under this Agreement; provided, further, that no such amendment, modification or supplement shall decrease the amount or extend the time for any notification of Rating Agency of Amendment or waivers payment to any Participant hereunder without the consent of such Participant. Any provision of this Agreement may be waived by a written instrument executed by Sheffield, the Required TRIPs Holders and the Trustee; provided that, notwithstanding anything herein to the contrary, Sheffield shall be permitted to waive performance of any provision of this Agreement so long as such waiver shall not affect the rights and duties of the TRIPs Holders or the Trustee; and provided, further, that, notwithstanding anything herein to the contrary, the Required TRIPs Holders shall be permitted to waive performance of any provision of this Agreement so long as such waiver shall not affect the rights and duties of Sheffield or the Trustee. Any amendment, supplement, waiver or consent approved in accordance with this Section shall be effective only in the specific instance and for the specific purpose given. Section 14.5. Finco's Obligations. It is expressly agreed that, anything contained in this Agreement to the contrary notwithstanding, Finco shall be obligated to perform all of its obligations under the Sale and Servicing Agreements and the other Finco Documents to the same extent as if the Interested Parties had no interest therein and no Interested Party shall have any obligation or liability under the Purchased Receivables or the other Total Transferred Property to any Obligor thereunder by reason of or arising out of this Agreement, nor shall any Interested Party be required or obligated in any manner to perform or fulfill any of the obligations of Finco under or pursuant to any Sale and Servicing Agreements and the other Finco Documents, any Receivables or the other Total Transferred Property. Section 14.6. Consent to Assignment. Each of Finco, each TRIPs Holder, by its acceptance of its TRIPs Participation, and the Trustee acknowledges that all of Sheffield's right, title and interest in the obligations of Finco to Sheffield and the rights of Sheffield against Finco under this Agreement have been assigned, transferred and otherwise conveyed by Sheffield to the Liquidity Agent, for the benefit of the Liquidity Banks, pursuant to the terms and conditions of the Security Agreement. Each of Finco, each TRIPs Holder, by its acceptance of its TRIPs Participation, and the Trustee consents to such assignment and transfer to the Liquidity Agent and agrees that the Liquidity Agent shall be entitled to enforce the terms of this Agreement directly against Finco, the TRIPs Holders and the Trustee if any event of default under the Liquidity Agreement shall have occurred and be continuing. Upon notice of any such event by Sheffield or the Liquidity Agent, each of Finco and the Trustee further agrees that in respect of its obligations hereunder it will act at the direction of and in accordance with all requests and instructions of the Liquidity Agent. Finco, each TRIPs Holder and the Trustee further agree that, in the event of any conflict of requests or instructions to Finco or the Trustee, as the case may be, between Sheffield and the Liquidity Agent, Finco or the Trustee, as the case may be, will at all times act in accordance with the requests and instructions of the Liquidity Agent. Section 14.7. Authority of Managing Agent. Each of Finco, the Trustee and each TRIPs Holder, by its acceptance of its TRIPs, acknowledges that Sheffield has appointed Barclays to act as its Managing Agent. Unless otherwise instructed by Sheffield, copies of all notices, requests, demands and other documents to be delivered to Sheffield pursuant to the terms hereof shall be delivered to the Managing Agent. Unless otherwise instructed by Sheffield, all notices, requests, demands and other documents to be executed or delivered, and any action to be taken, by Sheffield pursuant to the terms hereof may be executed, delivered and/or taken by the Managing Agent. The rights and responsibilities of the Managing Agent under this Agreement with respect to any action taken by the Managing Agent or the exercise or non- exercise by the Managing Agent of any option, right, request, judgment or other right or remedy provided to Sheffield herein or resulting or arising out of this Agreement shall, as between the Managing Agent and Sheffield, be governed by such agreements with respect thereto as may exist from time to time between them, but, as between the Managing Agent and Finco or any Interested Party, the Managing Agent shall be conclusively presumed to be acting as agent for Sheffield, with full and valid authority so to act or refrain from acting, and neither Finco nor any Interested Party shall be under any obligation, or entitlement, to make any inquiry respecting such authority. Section 14.8. Further Assurances. Finco agrees to do such further acts and things and to execute and deliver to the Participants and the Trustee such additional assignments, agreements, powers and instruments as are required by Sheffield, the Required TRIPs Holders or the Trustee to carry into effect the purposes of this Agreement or to better assure and confirm unto the Interested Parties their respective rights, powers and remedies hereunder. Section 14.9. Counterparts. This Agreement may be executed in any number of copies, and by the different parties hereto on the same or separate counterparts, each of which shall be deemed to be an original instrument. Section 14.10. Headings. Section headings used in this Agreement are for convenience of reference only and shall not affect the construction or interpretation of this Agreement. Section 14.11. No Bankruptcy Petition Against Sheffield or Finco. Each of Finco, each Participant, by its acceptance of any Participation, and the Trustee covenants and agrees that prior to the date which is one year and one day after the date on which the Aggregate Capital is reduced to zero and all other amounts due under or in connection with the Operative Documents are paid in full, it will not institute against, or join any other Person in instituting against Finco or Sheffield, as the case may be, any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. Section 14.12. GOVERNING LAW. THIS AGREEMENT SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE INTERNAL LAW OF THE STATE OF NEW YORK WITHOUT REFERENCE TO CONFLICTS OF LAW RULES OF THE STATE OF NEW YORK. Section 14.13. No Waiver; Cumulative Remedies. No failure to exercise and no delay in exercising, on the part of any Interested Party, 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. The rights, remedies, powers and privileges herein provided are cumulative and not exhaustive of any rights, remedies, powers and privileges provided by law. Section 14.14. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. (a) FINCO (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY IRREVOCABLY SUBMITS, FOR ITSELF AND ITS PROPERTY, TO THE JURISDICTION OF THE STATE COURTS OF THE STATE OF NEW YORK AND TO THE JURISDICTION OF THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK, FOR THE PURPOSES OF ANY SUIT, ACTION OR OTHER PROCEEDING ARISING OUT OF OR BASED UPON THIS AGREEMENT, THE OTHER FINCO DOCUMENTS OR THE SUBJECT MATTER HEREOF OR THEREOF BROUGHT BY ANY INTERESTED PARTY. FINCO (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS) TO THE EXTENT PERMITTED BY ANY REQUIREMENTS OF LAW (A) HEREBY WAIVES, AND AGREES NOT TO ASSERT, BY WAY OF MOTION, AS A DEFENSE, OR OTHERWISE, IN ANY SUCH SUIT, ACTION OR PROCEEDING BROUGHT IN SUCH COURTS, ANY CLAIM THAT IT IS NOT SUBJECT PERSONALLY TO THE JURISDICTION OF THE ABOVE-NAMED COURTS, THAT ITS PROPERTY IS EXEMPT OR IMMUNE FROM ATTACHMENT OR EXECUTION, THAT THE SUIT, ACTION OR PROCEEDING IS BROUGHT IN AN INCONVENIENT FORUM, THAT THE VENUE OF THE SUIT, ACTION OR PROCEEDING IS IMPROPER OR THAT THIS AGREEMENT OR THE OTHER FINCO DOCUMENTS OR THE SUBJECT MATTER HEREOF OR THEREOF MAY NOT BE ENFORCED IN OR BY SUCH COURT, AND (B) HEREBY WAIVES THE RIGHT TO ASSERT IN ANY SUCH ACTION, SUIT OR PROCEEDING ANY OFFSETS OR COUNTERCLAIMS EXCEPT COUNTERCLAIMS THAT ARE COMPULSORY OR OTHERWISE ARISE FROM THE SAME SUBJECT MATTER. FOR THE PURPOSE OF PROCEEDINGS IN THE COURTS OF THE STATE OF NEW YORK AND THE UNITED STATES COURTS FOR THE SOUTHERN DISTRICT OF NEW YORK, FINCO AGREES THAT SERVICE OF PROCESS EFFECTED BY CERTIFIED OR REGISTERED MAIL (OR ANY SUBSTANTIALLY SIMILAR FORM OF MAIL), POSTAGE PREPAID, TO FINCO AT ITS ADDRESS SET FORTH IN SECTION 14.1 SHALL CONSTITUTE VALID AND EFFECTIVE SERVICE UPON FINCO. FINCO AGREES THAT ITS SUBMISSION TO JURISDICTION AND CONSENT TO SERVICE OF PROCESS BY MAIL IN ANY SUCH ACTION, SUIT OR PROCEEDING SHALL BE CONCLUSIVE, AND MAY BE ENFORCED IN ANY OTHER JURISDICTION (A) BY SUIT, ACTION OR PROCEEDING ON THE JUDGMENT, A CERTIFIED OR TRUE COPY OF WHICH SHALL BE CONCLUSIVE EVIDENCE OF THE FACT AND THE AMOUNT OF INDEBTEDNESS OR LIABILITY THEREIN DESCRIBED OR (B) IN ANY OTHER MANNER PROVIDED BY OR PURSUANT TO THE LAWS OF SUCH OTHER JURISDICTION, PROVIDED, HOWEVER, THAT ANY INTERESTED PARTY, MAY AT ITS OPTION BRING SUIT, OR INSTITUTE OTHER JUDICIAL PROCEEDINGS AGAINST FINCO OR ANY OF ITS ASSETS IN ANY STATE OR FEDERAL COURT OF THE UNITED STATES OR OF ANY COUNTRY OR PLACE WHERE SUCH HOSPITAL OR SUCH ASSETS MAY BE FOUND. (b) EACH OF THE INTERESTED PARTIES AND FINCO HEREBY WAIVES ALL RIGHTS TO TRIAL BY JURY IN ANY ACTION OR PROCEEDING ARISING OUT OF OR RELATING TO ANY OF THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT OR THE OTHER FINCO DOCUMENTS. Section 14.15. Acquisition of Participations. Neither UHS, Finco nor any other UHS Entity will directly or indirectly acquire or make any offer to acquire any TRIPs Participation, or part thereof, unless UHS, Finco or such UHS Entity, as the case may be, shall contemporaneously offer to acquire TRIPs Participations (or parts thereof), pro rata, from all TRIPs Holders and upon the same terms. Section 14.16. Waivers. (a) Finco hereby irrevocably and unconditionally waives, to the maximum extent not prohibited by law, any right it may have to claim or recover in any legal action or proceeding referred to in this paragraph any special, exemplary, punitive or consequential damages. (b) Each Participant and the Trustee, solely in its capacity as representative of the Participants, each hereby irrevocably and unconditionally waives, to the maximum extent not prohibited by law, any right such party may have to claim or recover in any legal action or proceeding relating to this Agreement any special, exemplary, punitive or consequential damages; provided that the waiver contained in this Section 14.16 shall not extend to any right to claim or recover from Finco any special, exemplary, punitive or consequential damages for which the Trustee, Sheffield or such TRIPs Holder is liable to any Person. IN WITNESS WHEREOF, Finco, Sheffield and the Trustee have caused this Agreement to be duly executed by their duly authorized officers, all on the day and year first above written. UHS RECEIVABLES CORP. By: _______________________________ Title: SHEFFIELD RECEIVABLES CORPORATION By: _______________________________ Title: CONTINENTAL BANK, NATIONAL ASSOCIATION, Trustee By: ________________________________ Title: SCHEDULE I The Principal Place of Business of Finco is: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 The Locations where documents relating to the Receivables are located are: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 The locations where UCC financing statements must be filed are: Name Filing Location(s) Universal Health Services, Inc. Secretary of the Commonwealth of Pennsylvania and Montgomery County Prothonotary's Office Chalmette General Hospital, Inc. Clerk of Court of Saint Bernard Parish Dallas Family Hospital, Inc. Secretary of State of State of Texas Del Amo Hospital, Inc. Secretary of State of State of California Doctors' General Hospital, Ltd. Florida Department of State Doctors' Hospital of Florida Department of State Hollywood, Inc. HRI Hospital, Inc. Secretary of State of State of Massachusetts and Town Clerk's Office of town of Brookline McAllen Medical Center, Inc. Secretary of State of State of Texas Meridell Achievement Center, Inc. Secretary of State of State of Texas River Oaks, Inc. Clerk of Court of Jefferson Parish Sparks Reno Partnership, L.P. Secretary of State of State of Nevada Turning Point Care Center, Inc. Clerk of Superior Court of Colquitt County UHS of Arkansas, Inc. Secretary of State of State of Arkansas and Clerk of Circuit Court and Ex-Officio Recorder of Pulaski County UHS of Auburn, Inc. Licensing Department of State of Washington UHS of Belmont, Inc. Secretary of State of State of Illinois UHS of Maitland, Inc. Florida Department of State UHS of Massachusetts, Inc. Secretary of State of State of Massachusetts and Town Clerk's Office of town of Boston UHS of River Parishes, Inc. Clerk of Court of St. John the Baptist Parish UHS of Shreveport, Inc. Clerk of Court of Caddo Parish Universal Health Recovery Secretary of the Commonwealth of Centers, Inc. Pennsylvania and Chester County Prothonotary's Office Universal Health Services of Secretary of State of State of Inland Valley, Inc. California Universal Health Services of Secretary of State of State Nevada, Inc. of Nevada Victoria Regional Medical Secretary of State of State Center, Inc. of Texas Wellington Regional Medical Florida Department of State Center Incorporated Westlake Medical Center, Inc. Secretary of State of State of California Schedule II Accounts Hospital Concentration Accounts Name of Hospital Bank Account Number Chalmette General Hospital, Inc. Hibernia National Bank 8122-2924-9 UHS of De La Ronde, Inc. Hibernia National Bank 8122-2925-7 Dallas Family Hospital, Inc. Bank One -- Texas 9830-10-741-7 Del Amo Hospital, Inc. Bank of America 1233-4-57852 Doctors' General Hospital, Ltd. Barnett Bank of South Florida, N.A. 1595100654 Doctors' Hospital of Hollywood, Inc. Sun Bank 385 315 1229 HRI Hospital, Inc. First National Bank of Boston 503-11965 McAllen Medical Center, Inc. Texas Commerce Bank 0960-0370185 Meridell Achievement Center, Inc. Bank One -- Texas 75-0025-5968 River Oaks, Inc. Hibernia National Bank 8122-2923-0 Sparks Reno Partnership, L.P. Bank of America 47-0012378 Turning Point Care Center, Inc. Moultrie National Bank 01-41110-1-01 UHS of Arkansas, Inc. First Commercial Bank 0657433 UHS of Auburn, Inc. Seafirst 62269519 UHS of Belmont, Inc. Park National Bank 16-5301 UHS of Maitland, Inc. Nationsbank of Florida 0088376877 USH of Massachusetts, Inc. First National Bank of Boston 503-52636 UHS of River Parishes, Inc. Bank of La Place 01-0622-4 UHS of Shreveport, Inc. Hibernia National Bank 762001756 Universal Health Recovery Centers, Inc. First Fidelity Bank 4004517290 Universal Health Services of Inland Valley, Inc. Bank of America 1233-2-56080 Universal Health Services of Nevada, Inc. Bank of America 01-212-2036 Victoria Regional Medical Center, Inc. Victoria Bank & Trust 5101017337 Wellington Regional Medical Center Sun Bank South Incorporated Florida N.A. 0629-002-005381 Westlake Medical Center, Inc. Bank of America 1233-9-56195 Master Receivables Account Bank: Continental Bank, N.A., Chicago, Illinois Account Name: Universal Health Services, Inc. Master Receivables Account Account Number: 78-27784 EXHIBIT A TO POOLING AGREEMENT FORM OF TRIP Form of Face of TRIP REGISTERED $______________(1) UHS RECEIVABLES CORP. HEALTHCARE RECEIVABLES TRUST TRADE RECEIVABLES INVESTMENT PARTICIPATION THIS TRADE RECEIVABLES INVESTMENT PARTICIPATION ("TRIP") HAS NOT BEEN REGISTERED UNDER THE UNITED STATES SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"). THE HOLDER HEREOF, BY ACQUIRING THIS TRIP, AGREES THAT THIS TRIP MAY NOT BE RESOLD, PLEDGED OR OTHERWISE TRANSFERRED TO A U.S. PERSON EXCEPT PURSUANT TO AN EXEMPTION FROM, OR IN A TRANSACTION NOT SUBJECT TO, THE REGISTRATION REQUIREMENTS OF THE SECURITIES ACT, BUT ONLY UPON DELIVERY TO CONTINENTAL BANK, NATIONAL ASSOCIATION OF A CERTIFICATE OF THE TRANSFEROR AND AN OPINION OF COUNSEL (SATISFACTORY TO THE TRUSTEE) TO THE EFFECT THAT SUCH TRANSFER IS IN COMPLIANCE WITH THE SECURITIES ACT. This TRIP evidences an undivided interest in a trust, the corpus of which consists of healthcare receivables generated from time to time by certain hospital subsidiaries of Universal Health Services, Inc. ("UHS") and purchased by UHS RECEIVABLES CORP. (Not an interest in or obligation of UHS or any affiliate thereof, other than UHS Receivables Corp.) This certifies that ________________________ (the "TRIPs Holder") is the registered owner of a senior, undivided interest (a "Participation") in the assets of the UHS Receivables Corp. Healthcare Receivables Trust (the "Trust"), created pursuant to the Pooling Agreement, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Pooling Agreement"), by and among UHS Receivables Corp., a Delaware corporation ("Finco"), Sheffield Receivables Corporation, a Delaware corporation ("Sheffield"), and Continental Bank, a national banking association (in such capacity, the "Trustee"). To the extent not defined herein, capitalized terms used herein have the meanings ascribed to them in the Definitions List, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Definitions List"), incorporated (1) Denominations of $1,000,000 and $100,000 in excess thereof. by reference into the Pooling Agreement. Unless the certificate of authentication hereon has been executed by the Trustee, this TRIP shall not be entitled to any benefit under the Pooling Agreement or be valid for any reason. Reference is hereby made to the further provisions of this TRIP set forth on the reverse hereof, which further provisions shall for all purposes have the same effect as if set forth at this place. IN WITNESS WHEREOF, Finco has caused this TRIP to be duly executed. Dated: __________ __, 199_ UHS RECEIVABLES CORP. By:__________________________ Name: Title: TRUSTEE'S CERTIFICATE OF AUTHENTICATION This is one of the TRIPs described in the within-mentioned Pooling Agreement. CONTINENTAL BANK, NATIONAL ASSOCIATION By:________________________ OR By:_____________________ Authorized Signatory Authenticating Agent By:______________________ Authorized Signatory Form of Reverse of TRIP The corpus of the Trust consists of (i) all receivables meeting certain eligibility requirements generated by certain hospital subsidiaries of UHS and sold to Finco (the "Purchased Receivables"), (ii) all funds collected or to be collected from Obligors in respect of the Purchased Receivables, (iii) all funds which are from time to time on deposit in the Collateral Account and any other account held for the benefit of the TRIPs Holders, (iv) the Finco Transferred Property and (v) all other assets and interests constituting the Trust. Although a summary of certain provisions of the Pooling Agreement is set forth below, this TRIP does not purport to summarize the Pooling Agreement, is qualified in its entirety by the terms and provisions of the Pooling Agreement and reference is hereby made to the Pooling Agreement for information with respect to the interests, rights, benefits, obligations, proceeds and duties evidenced hereby and the rights, duties and obligations of the Trustee. A copy of the Pooling Agreement may be requested by writing to Continental Bank, National Association, 231 South La Salle Street, 7th Floor, Chicago, Illinois 60697. This TRIP is issued under and is subject to the terms of, and entitled to the benefits of, the Pooling Agreement, to which Pooling Agreement the TRIPs Holder, by virtue of the acceptance hereof, assents and agree to be bound. It is the intent of Finco and the Participants that, for federal and state income and franchise tax purposes only, the TRIPs will be evidence of indebtedness of Finco secured by the Purchased Receivables. The TRIPs Holder, by the acceptance hereof, assents and is bound by such intent. The Participations, which include the TRIPs and the interest acquired by Sheffield, constitute senior interests in the Trust Assets and entitle the Participants to, among other things, all Collections received from Obligors in respect of the Purchased Receivables. The Participations are allocated in part to the TRIPs Holders, with the remainder allocated to Sheffield. In addition to the Participations, Finco will receive and maintain a subordinated interest in the Trust Assets subordinated in right of payment to the Participations. The aggregate interest represented by this TRIP at any time in the Purchased Receivables in the Trust shall not exceed an amount equal to the TRIPs Holder's pro rata portion of the TRIPs Capital at such time. The TRIPs Capital on the TRIPs Closing Date is $ . The TRIPs Capital at any time will be equal to the Initial TRIPs Capital, as reduced by Collections received and distributed to the TRIPS Holders on account of the TRIPs Capital pursuant to the Pooling Agreement. Payments of TRIPs Yield with respect to the TRIPs shall be distributed to the TRIPs Holders on each Transfer Date. Payments of TRIPs Yield will be paid in immediately available funds to the person in whose name such TRIP is registered at the close of business on the applicable Record Date to an account specified by such person. During the TRIPs Revolving Period, Collections otherwise allocable to the TRIPs Holders shall be reinvested in new Purchased Receivables as provided in the Pooling Agreement. The TRIPs Revolving Period under the Pooling Agreement shall terminate, and the TRIPs Amortization Period shall commence, on the earliest to occur of (a) the Scheduled TRIPs Maturity Date, (b) the Call Date and (c) certain Early Amortization Events specified in the Agreement or declared by the TRIPs Holders or the Trustee pursuant to the terms of the Pooling Agreement. The TRIPs are subject to optional redemption by Finco (i) upon the exercise of the Call Option, subject to certain conditions described in the Pooling Agreement and (ii) during the TRIPs Amortization Period as described below. During the TRIPs Amortization Period, certain Collections allocable to the TRIPs (other than Collections allocated to the TRIPs Interest Sub- account and the Expense Sub-account in respect of accrued Yield and certain fees, costs and expenses) will be accumulated in the TRIPs Payment Account and distributed to the TRIPs Holders, up to the amount of the TRIPs Capital, on each Transfer Date, but not beyond the date which is twelve months after the commencement of the TRIPs Amortization Period. If the TRIPs Capital has not been reduced to zero prior to such date, the Trustee, upon written direction of the Required TRIPs Holders, will cause to be sold an amount of Purchased Receivables or interests therein having an Outstanding Balance equal to the TRIPs Termination Sale Amount. On the Transfer Date on which the Adjusted TRIPs Capital is reduced to 10% or less of the TRIPs Capital as of the close of business on the last day of the TRIPs Revolving Period, Finco may (but shall not be obligated to) repurchase all of the TRIPs Participations evidenced by the TRIPs. The aggregate purchase price payable with respect to the TRIPs Participations will be equal to the outstanding balance of the TRIPs Capital, all accrued and unpaid TRIPs Yield through the date of such repurchase and all other amounts payable by Finco pursuant to the Pooling Agreement. The Pooling Agreement may be amended by Finco, Sheffield and the Trustee with the prior written consent of the Required TRIPs Holders; provided that after the occurrence of an Early Amortization Event, the consent of Finco shall not be necessary for any amendment to the Pooling Agreement which does not directly affect the rights of Finco thereunder; provided, further, that no such amendment shall extend the time for any payment to any Participant without the consent of such Participant; and provided, further, that Sheffield shall be permitted to waive performance of any provision of the Pooling Agreement so long as such waiver shall not adversely affect the TRIPs Holders. The TRIPs may be transferred upon surrender of the TRIPs to an office of the Trustee where newly executed and authenticated TRIPs in the name of the designated transferee will be delivered. Prior to the date which is three years after the Effective Date, the Trustee shall not register the transfer of any TRIP unless certain conditions stated in the Pooling Agreement are satisfied. As provided in the Pooling Agreement, and subject to certain limitations set forth therein, this TRIP is exchangeable for new TRIPs evidencing a like aggregate portion of the TRIPs Capital, as requested by the TRIPs Holder surrendering this TRIP. No service charge may be imposed for any such transfer or exchange, but the Transfer Agent and Registrar may require payment of a sum sufficient to cover any tax or other governmental charge that may be imposed in connection therewith. By its acceptance of this TRIP, the TRIPs Holder agrees that (a) the Pooling Agreement was executed and delivered, and this TRIP is authenticated, by Continental Bank, National Association, not individually or personally but solely as Trustee of the Trust, in the exercise of the powers and authority conferred and vested in it, (b) except with respect to Section 11.15 of the Pooling Agreement, the representations, undertakings and agreements made on the part of the Trust are made and intended not as personal representations, undertakings and agreements by Continental Bank, National Association, but are made and intended for the purpose of binding only the Trust and (c) under no circumstances shall Continental Bank, National Association be personally liable for the payment of any indebtedness or expenses of the Trust or be liable for the breach or failure of any obligation, representation, warranty or covenant made or undertaken by the Trust under this TRIP or the Pooling Agreement. This TRIP shall be governed by, and construed and interpreted in accordance with, the law of the State of New York. __________________________________ ASSIGNMENT FOR VALUE RECEIVED, the undersigned hereby sells, assigns and transfers unto PLEASE INSERT SOCIAL SECURITY OR OTHER IDENTIFYING NUMBER OF ASSIGNEE(S) - ------------------------------- - ------------------------------- ............. (PLEASE PRINT OR TYPEWRITE NAME AND ADDRESS OF ASSIGNEE) ............................................... ............................................... the within TRIP and all rights thereunder, and hereby irrevocably constitutes and appoints ............................................... attorney, with full power of substitution in the premises, to transfer said TRIP on the books kept for registration thereof. Dated: ....................................... ............................... Note: The signature(s) to this Assignment must correspond with the name(s) as written on the face of the within TRIP in every particular, without alteration or enlargement or any change whatever. EXHIBIT B TO POOLING AGREEMENT Form of Auditors' Report EXHIBIT C TO POOLING AGREEMENT FORM OF CONFIDENTIALITY AGREEMENT [Letterhead of RECIPIENT of Information] ___________ __, 199_ [TRANSFEROR] [Address] Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Dear Sirs: Reference is made to the Pooling Agreement, dated as of November 16, 1993 (as amended from time to time, the "Pooling Agreement"), among UHS Receivables Corp. ("Finco"), a Delaware corporation, Sheffield Receivables Corporation, a Delaware corporation, and Continental Bank, National Association, a national banking association, and to the pending and proposed discussions between [transferor] (the "Transferor") and [recipient] (the "Recipient") regarding [describe transaction requiring disclosure]. Unless otherwise defined herein, capitalized terms defined in the Pooling Agreement are used herein as so defined. Pursuant to our discussions, the Transferor hereby agrees to provide to the Recipient certain information, practices, books, correspondence, and records of a confidential nature and in which a UHS Entity has a proprietary interest (the "Information") on the terms and conditions set forth below. By its execution of this Agreement, the Recipient hereby agrees to all such terms and conditions. The Recipient hereby acknowledges that all Information received by it from the Transferor shall be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality. The Recipient agrees that, subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose the Information without the prior written consent of the Transferor and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by the Pooling Agreement and the other Operative Documents or for the enforcement of any of the rights granted thereunder) of any of the Information without the prior written consent of the Transferor. Notwithstanding the foregoing, the Recipient may (x) disclose Information to any Person that has executed and delivered a confidentiality agreement in substantially the same form as this agreement naming the Transferor and the UHS Entities as third party beneficiaries thereof and (y) disclose or otherwise use Information (A) to the extent that such Information is required or appropriate in any report, statement or testimony submitted to any municipal, state or federal regulatory body having or claiming to have jurisdiction over the Recipient or submitted to the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such Information subsequently becomes publicly available, other than through any act or omission of the Recipient or (F) to the extent that such Information subsequently becomes known to the Recipient, other than through a Person whom the Recipient knows to be acting in violation of its obligations to the Transferor or the UHS Entities. The parties agree that any breach of this letter agreement would cause damages which cannot be determined in money and that injunction is an appropriate remedy for breach, though not necessarily the sole remedy. This Agreement shall inure to the benefit of the parties hereto, each of their respective successors and permitted assigns and each of the UHS Entities, which UHS Entities will be deemed to be third party beneficiaries of this Agreement. This Agreement shall be governed by, and construed in accordance with the law of the State of New York, and may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one agreement. Please acknowledge your agreement to the foregoing by signing three copies of this letter agreement and returning them to the Transferor. Upon receipt of the executed letter agreement, the Transferor, pursuant to the terms of the Pooling Agreement, will deliver an executed agreement to each of UHS and Finco. Very truly yours, [RECIPIENT] By:_________________________ Title: Acknowledged and Agreed: [TRANSFEROR] By:____________________________ Title: EXHIBIT D TO POOLING AGREEMENT Transfer Certificate EXHIBIT 10.19 GUARANTEE GUARANTEE, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, this "Guarantee"), made by UNIVERSAL HEALTH SERVICES, INC., a Delaware corporation ("UHS") in favor of UHS RECEIVABLES CORP., a Delaware corporation ("Finco"). W I T N E S S E T H : WHEREAS, pursuant to each of the Sale and Servicing Agreements (capitalized terms used in the recitals without definition are used as defined in the Definitions List referred to below), Finco has agreed to purchase all of the Receivables and other Transferred Property from the Hospitals; WHEREAS, pursuant to the Pooling Agreement, Finco has assigned and conveyed to the Trustee, in trust for the benefit of the Participants, the Transferred Property and the Finco Transferred Property, and the Participants have offered to acquire from Finco, and Finco has agreed to transfer to the Participants, senior undivided participating interests in the Trust Assets; WHEREAS, in order to collect the amounts due to Finco under the Sale and Servicing Agreements and in which the Participants have acquired their Participations, Finco and UHS Delaware have entered into the Servicing Agreement, pursuant to which UHS Delaware, as Servicer, will provide for the administration of, and servicing on, the Receivables; WHEREAS, each of UHS Delaware and each Hospital is a subsidiary of UHS; WHEREAS, it is a condition precedent to the obligations of Finco and the Interested Parties under the Operative Documents that UHS shall have executed and delivered this Guarantee; NOW, THEREFORE, in consideration of the premises and to induce Finco to enter into the Servicing Agreement and to induce Finco to make its purchases from the Hospitals under the Sale and Servicing Agreements, UHS hereby agrees as follows: 1. Defined Terms. Unless otherwise defined, capitalized terms used herein are used as defined in the Definitions List, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Definitions List"), that refers to this Guarantee, which Definitions List is incorporated herein by reference and the following term shall have the following meaning: "Obligations": all obligations and liabilities of (i) each Hospital to Finco and the Interested Parties, whether direct or indirect, absolute or contingent, due or to become due, or now existing or hereafter incurred pursuant to the Sale and Servicing Agreements, including, without limitation, the obligations arising under Sections 4.4 and 7.1 and 7.2(b) of each of the Sale and Servicing Agreements and all fees, indemnities, costs and expenses to be paid by the Hospitals pursuant to the terms thereof (including, without limitation, interest accruing after the filing of any petition in bankruptcy, or the commencement of any insolvency, reorganization or like proceeding, relating to any Hospital, whether or not a claim for post-filing or post-petition interest is allowed in such proceeding) and (ii) UHS Delaware to Finco and the Interested Parties, whether direct or indirect, absolute or contingent, due or to become due, or now existing or hereafter incurred pursuant to the Servicing Agreement, including, without limitation, the obligations arising out of Section 5.17 of the Servicing Agreement and all fees, indemnities, costs and expenses to be paid by UHS Delaware pursuant to the terms of the Servicing Agreement (including, without limitation, interest accruing after the filing of any petition in bankruptcy, or the commencement of any insolvency, reorganization or like proceeding, relating to UHS Delaware, whether or not a claim for post-filing or post- petition interest is allowed in such proceeding). 2. Guarantee. (a) UHS hereby unconditionally and irrevocably guarantees to Finco the prompt and complete payment by the Hospital when due (whether at the stated maturity, by acceleration or otherwise) of the Obligations. Such guarantee shall be a guarantee of payment. (b) UHS further unconditionally and irrevocably covenants and agrees with Finco that UHS will cause each Hospital duly and punctually to perform and observe all the terms, conditions, covenants, agreements and indemnities to be performed or observed by it under the Sale and Servicing Agreement to which it is a party and any other document executed and delivered by such Hospital in connection therewith, strictly in accordance with the terms thereof, and that if for any reason whatsoever such Hospital shall fail so to perform and observe such terms, conditions, covenants, agreements and indemnities, UHS will duly and punctually perform and observe the same. (c) UHS further unconditionally and irrevocably covenants and agrees with Finco that UHS will cause UHS Delaware duly and punctually to perform and observe all the terms, conditions, covenants, agreements and indemnities to be performed or observed by it under the Servicing Agreement and any other document executed and delivered by UHS Delaware in connection therewith, strictly in accordance with the terms thereof, and that if for any reason whatsoever UHS Delaware shall fail so to perform and observe such terms, conditions, covenants, agreements and indemnities, UHS will duly and punctually perform and observe the same. (d) UHS further agrees to pay any and all expenses (including, without limitation, all reasonable fees and disbursements of counsel) which may be paid or incurred by Finco or the Interested Parties in enforcing or preserving any of their rights under this Guarantee. (e) UHS agrees that whenever, at any time, or from time to time, it shall make any payment to Finco or any Interested Party on account of its liability hereunder, it will notify Finco in writing that such payment is made under this Guarantee for such purpose. No payment or payments made by any Guaranteed Party or any other Person or received or collected by Finco or any Interested Party from any Guaranteed Party or any other Person by virtue of any action or proceeding or any set-off or appropriation or application, at any time or from time to time, in reduction of or in payment of the Obligations shall be deemed to modify, reduce, release or otherwise affect the liability of UHS hereunder, which shall, notwithstanding any such payment or payments, continue until the Guarantee Termination Date (as hereinafter defined). This Guarantee shall remain in full force and effect until the later to occur of (i) the date on which the Servicing Agreement and all Sale and Servicing Agreement are terminated in accordance their terms and (ii) the date on which all Obligations are paid in full (such later date, the "Guarantee Termination Date"). 3. No Subrogation, Contribution, Reimbursement or Indemnity. Notwithstanding anything to the contrary in this Guarantee, UHS hereby irrevocably waives all rights which may have arisen in connection with this Guarantee to be subrogated to any of the rights (whether contractual, under Title 11 of the United States Code, including Section 509 thereof, under common law or otherwise) of Finco or any Interested Party against any Guaranteed Party or against any right of offset of Finco or any Interested Party with respect to the Obligations. UHS hereby further irrevocably waives all contractual, common law, statutory or other rights of reimbursement, contribution, exoneration or indemnity (or any similar right) from or against any Guaranteed Party or any other Person which may have arisen in connection with this Guarantee. So long as any Obligations remain outstanding or so long as the Servicing Agreement or any Sale and Servicing Agreement remains in effect, if any amount shall be paid by or on behalf of any Guaranteed Party to UHS on account of any of the rights waived in this paragraph, such amount shall be held by UHS in trust, segregated from other funds of UHS, and shall, forthwith upon receipt by UHS, be applied against the Obligations, whether matured or unmatured, in such order as Finco may determine. The provisions of this paragraph shall survive the Guarantee Termination Date. 4. Amendments, etc. with respect to the Obligations. UHS shall remain obligated hereunder notwithstanding that, without any reservation of rights against UHS, and without notice to or further assent by UHS, any demand for payment of any of the Obligations may be rescinded, and any of the Obligations continued, and the Obligations, or the liability of any other Person upon or for any part thereof, or any collateral security or guarantee therefor or right of offset with respect thereto, may, from time to time, in whole or in part, be renewed, extended, amended, modified, accelerated, compromised, waived, surrendered or released, and the Servicing Agreement, any Sale and Servicing Agreement, any other Operative Document or any other documents executed and delivered in connection therewith may be amended, modified, supplemented or terminated, in whole or in part, from time to time, and any collateral security, guarantee or right of offset at any time held by Finco or any Interested Party for the payment of the Obligations may be sold, exchanged, waived, surrendered or released. Finco shall not have any obligation to protect, secure, perfect or insure any Lien at any time held by it as security for the Obligations or for this Guarantee or any property subject thereto. 5. Guarantee Absolute and Unconditional. UHS waives any and all notice of the creation, renewal, extension or accrual of any of the Obligations and notice of or proof of reliance by Finco or any Interested Party upon this Guarantee or acceptance of this Guarantee; the Obligations, and any of them, shall be conclusively deemed to have been created, contracted or incurred in reliance upon this Guarantee; and all dealings between any Guaranteed Party or UHS, on the one hand, and Finco or any Interested Party, on the other, shall likewise be conclusively presumed to have been had or consummated in reliance upon this Guarantee. UHS waives diligence, presentment, protest, demand for payment and notice of default or nonpayment to or upon any Guaranteed Party or UHS with respect to the Obligations. This Guarantee shall be construed as a continuing, absolute and unconditional guarantee without regard to (a) the validity or enforceability of the Servicing Agreement or any Sale and Servicing Agreement, any of the Obligations or any collateral security therefor or guarantee or right of offset with respect thereto at any time or from time to time held by Finco or any Interested Party, (b) any defense which relates, directly or indirectly, to the matters covered by the representations and warranties of the Hospitals set forth in the Sale and Servicing Agreements or of UHS Delaware set forth in the Servicing Agreement, or any set-off, which in any case may at any time be available to or asserted by any Guaranteed Party against Finco or any Interested Party or (c) any other circumstance whatsoever (with or without notice to or knowledge of any Guaranteed Party or UHS) which constitutes, or might be construed to constitute, an equitable or legal discharge of a Guaranteed Party for the Obligations, or of UHS under this Guarantee, in bankruptcy or in any other instance. 6. Reinstatement. Notwithstanding anything contained herein to the contrary, this Guarantee shall continue to be effective, or shall be reinstated, as the case may be, if at any time payment, or any part thereof, of any of the Obligations is rescinded or must otherwise be restored or returned by Finco or any Interested Party upon the insolvency, bankruptcy, dissolution, liquidation or reorganization of any Guaranteed Party or upon or as a result of the appointment of a receiver, intervenor or conservator of, or trustee or similar officer for, any Guaranteed Party or any substantial part of its property, or otherwise, all as though such payments had not been made. 7. Payments. UHS hereby agrees that the Obligations will be paid to the Trustee in immediately available funds without set-off at the office of the Trustee at the address specified in Section 15.1 of the Pooling Agreement. 8. Representations and Warranties. UHS represents and warrants as of each Purchase Date that: (a) UHS has been duly organized and (i) is validly existing and in good standing as a corporation under the laws of the State of Delaware, with full corporate power and authority to own or lease its properties and to conduct its business as presently conducted and to execute, deliver and perform this Guarantee and to consummate the transactions contemplated hereby, (ii) is duly qualified as a foreign corporation and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, reasonably be expected to have a material adverse effect on its business, operations, properties, assets or condition (financial or otherwise), (iii) is in compliance with all Requirements of Law and (iv) is not in default under any mortgage, indenture, deed of trust, loan agreement, lease, contract or other agreement, instrument or undertaking to which UHS is a party or by which UHS or any of its assets may be bound, except to the extent that such defaults would not, alone or in the aggregate, have a material adverse effect on its business, operations, property or condition (financial or otherwise). (b) The execution, delivery and performance by UHS of this Guarantee and the consummation of the transactions contemplated hereby have been duly and validly authorized by all requisite corporate action and will not conflict with, violate, or result in a breach of any of the terms or provisions of, or constitute a default under, or result in the creation or imposition of any Lien upon any of its property or assets pursuant to the terms of any, indenture, mortgage, deed of trust, loan agreement, lease, contract or other agreement, instrument or undertaking by which it is bound or to which any of its property or assets is subject, nor will such action, result in any violation of any applicable Requirement of Law; and no consent, approval, authorization, order, registration, filing, qualification, license or permit of or with any such court or any such regulatory authority or other such Governmental Authority, other body, or any other Person, will be required to be obtained by, or with respect to, UHS in connection with the execution, delivery and performance by UHS of this Guarantee and the consummation of the transactions contemplated hereby, except those which UHS shall have so obtained. (c) This Guarantee has been duly and validly authorized, executed and delivered by UHS and constitutes a valid and legally binding obligation of UHS, enforceable against UHS in accordance with its terms, subject to applicable bankruptcy, reorganization, insolvency, moratorium or other similar laws affecting creditors' rights generally, and subject as to enforceability to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). (d) Except for the Security Filings, and those financing statements listed on Schedule I for which executed UCC-3 termination statements have been delivered to Finco for filing in the appropriate filing offices, there is (i) no effective financing statement (or similar statement or instrument of registration under the law of any jurisdiction) on file or registered in any public office and (ii) no assignment filed or delivered by or on behalf of any Subsidiary of UHS, in each case covering any interest of any kind in the Transferred Property or intended so to be filed, delivered or registered, and UHS will not execute or cause any Subsidiary to execute any effective financing statement (or similar statement or instrument of registration under the laws of any jurisdiction) or any assignment or other notification relating to the Transferred Property. (e) There are no actions, proceedings or investigations pending or, to the knowledge of UHS, threatened, before any court, administrative agency or other tribunal, (i) which, if determined adversely, would, alone or in the aggregate, reasonably be expected to have a material adverse effect on the ability of any of the UHS Entities to perform their respective obligations under the Operative Documents, (ii) asserting the invalidity of this Guarantee or any of the Security Filings or (iii) questioning the consummation by UHS or any of its Subsidiaries of any of the transactions contemplated by any of the Operative Documents. (f) The Receivables Information provided by UHS on such Purchase Date does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements in the Receivables Information, in light of the circumstances in which they were made, not misleading. (g) UHS and each of its Subsidiaries has and shall have filed or caused to be filed all material federal, state and local tax returns which are required to be filed, and has and shall have paid or have caused to be paid all taxes or assessments payable by it (other than any the amount or validity of which are currently being contested in good faith through appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of UHS or such Subsidiary and with respect to which collection has been stayed); and no tax Lien has been filed, and to the knowledge of UHS no claims are being assessed with respect to any such taxes or assessments which, alone or in the aggregate, could reasonably be expected to have a material adverse effect on UHS and its Subsidiaries, taken as a whole, or on the rights of Finco hereunder or with respect to the Transferred Property. (h) (i) No material Reportable Event has occurred during the five-year period prior to the date on which this representation is made or deemed made with respect to any Plan, and each Plan has complied in all material respects with the applicable provisions of ERISA and the Code. The present value of all accrued benefits under each Single Employer Plan maintained by UHS or any Commonly Controlled Entity (based on those assumptions used to fund the Plans) did not, as of the last annual valuation date prior to the date on which this representation is made or deemed made, materially exceed the value of the assets of such Plan allocable to such accrued benefits. Neither UHS nor any Commonly Controlled Entity has had a complete or partial withdrawal from any Multiemployer Plan which has resulted or could result in any material liability under ERISA, and neither UHS nor any Commonly Controlled Entity would become subject to any material liability under ERISA if UHS or any such Commonly Controlled Entity were to withdraw completely from all Multiemployer Plans as of the valuation date most closely preceding the date on which this representation is made or deemed made. No such Multiemployer Plan is in Reorganization or Insolvent. The present value (determined using actuarial and other assumptions which are reasonable in respect of the benefits provided and the employees participating) of the liability of UHS and each Commonly Controlled Entity for post retirement benefits to be provided to their current and former employees under Plans which are welfare benefit plans (as defined in Section 3(1) of ERISA) does not, in the aggregate, materially exceed the assets under all such Plans allocable to such benefits. (ii) From the Initial Closing Date and until the Guarantee Termination Date, UHS and its Subsidiaries shall comply in all material respects with the applicable provisions of ERISA and the regulations and published interpretations thereunder. (i) The audited consolidated balance sheet of UHS at December 31, 1992, and the unaudited consolidated balance sheet of UHS at September 30, 1993 together, in each case, with the related statements of income and cash flow and the related notes have been prepared in accordance with GAAP consistently applied, except as otherwise indicated in the notes to such financial statements and subject in the case of unaudited statements to changes resulting from year-end and audit adjustments. All of such financial statements fairly present the financial position or the results of operations, as the case may be, of UHS and its Subsidiaries at the dates or for the periods indicated, subject to year-end and audit adjustments in the case of unaudited statements, and (in the case of balance sheets, including the notes thereto) reflect all known liabilities, contingent or otherwise, that GAAP requires, as of such dates, to be shown, reserved against or disclosed in notes to such financial statements. 9. Covenants of UHS. (a) UHS will preserve and maintain its existence as a corporation in good standing under the laws of Delaware or any other state in which it is so incorporated. UHS will preserve and maintain its existence as a foreign corporation in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, reasonably be expected to have a material adverse effect on its business, operations, properties, assets or condition (financial or otherwise). (b) UHS shall furnish to Finco and such other parties as Finco may designate (i) as soon as practicable and in any event within 90 days after the end of each fiscal year of UHS, a balance sheet of UHS as of the close of such fiscal year and statements of income and retained earnings and of cash flow of UHS for such fiscal year, setting forth in comparative form corresponding consolidated figures from the preceding annual audit, all in reasonable detail, certified by Arthur Andersen & Co. or such other independent certified public accountants of recognized standing as are selected by UHS and satisfactory to Finco (the scope and substance of the certificate to be reasonably satisfactory to Finco); (ii) within 45 days after the end of each of the first three fiscal quarters of each fiscal year of UHS, a consolidated balance sheet of UHS as of the close of such quarter and consolidated statements of income and retained earnings and of cash flow of UHS for the period from the beginning of such fiscal year to the end of such quarter, setting forth in each case in comparative form the corresponding consolidated figures for the corresponding period in the preceding fiscal year, all in reasonable detail and certified by the chief financial officer of UHS, subject to usual and customary year-end audit adjustments (the scope and substance of such certificate to be reasonably satisfactory to Finco); (iii) at the time of delivery of the financial statements required to be delivered by clauses (i) and (ii) of this paragraph 9(b), a certificate of the chief financial officer of UHS, to the effect that there exists no Early Amortization Event under the Pooling Agreement or any Exclusion Event under any Sale and Servicing Agreement and no condition, event or act which, with the giving of notice or lapse of time, or both, would constitute an Early Amortization Event or an Exclusion Event, or if any such Early Amortization Event, Exclusion Event, condition, event or act exists, specifying the nature thereof, the period of existence thereof and the action UHS proposes to take with respect thereto; (iv) with reasonable promptness, copies of all regular and periodic financial and other reports, if any, which UHS shall provide to its shareholders or to any lending institution pursuant to any revolving credit facility to which UHS is a party, or shall file with the SEC or any other Governmental Authority or any other governmental commission, board, bureau or agency, or any federal or state health care regulatory authority having jurisdiction over UHS, or any national securities exchange; and (v) with reasonable promptness, such further information regarding the business, affairs and financial condition of UHS as Finco may reasonably request. (c) UHS will advise Finco promptly, and in reasonable detail, (i) of any Lien asserted or claim made against any of the Transferred Property of which it obtains knowledge, (ii) of the occurrence of any breach by UHS or any UHS Entity of any of its respective representations, warranties and covenants contained herein or in any Operative Document, (iii) to the extent it has knowledge thereof, of any Exclusion Event or Early Amortization Event or of any event which, with the passage of time or giving of notice will become an Exclusion Event or Early Amortization Event, (iv) of the occurrence of any event of which it obtains knowledge, concerning (A) the business, assets, operations, property or condition (financial or otherwise) of UHS, any Guaranteed Party or any Obligor or (B) any change in any Requirement of Law governing the Purchased Receivables, in either case, alone or in the aggregate, which would reasonably be expected to have a material adverse effect on the value of the Transferred Property or the collectibility or enforceability of the Purchased Receivables (other than as a result of the credit quality) and (v) the receipt from any Governmental Authority of a Deficiency Notice with respect to the Receivables. (d) Unless prohibited by any Requirement of Law, including, without limitation, by regulations of JCAHO or AOA, Finco and its direct and indirect assignees, and its and their respective employees, agents and representatives (collectively, the "Recipients") (A) shall at all times have full and free access during normal business hours to all the books, correspondence and records of UHS insofar as they relate to the Transferred Property, and the Recipients may examine the same, take extracts therefrom and make photocopies thereof, and UHS agrees to render to the Recipients, at UHS's cost and expense, such clerical and other assistance as may be reasonably requested with regard thereto and (B) may discuss the affairs, finances and accounts of UHS with and be advised as to the same by, executive officers and independent accountants of UHS, all as any of the Recipients may reasonably deem appropriate for the purpose of verifying the accuracy of any reports or information delivered to any of the Recipients pursuant hereto or for otherwise ascertaining compliance herewith; provided, however, that Finco acknowledges that in exercising the rights and privileges conferred in this paragraph 9(b) such Recipients may, from time to time, obtain knowledge of information, practices, books, correspondence and records of a confidential nature and in which UHS has a proprietary interest; and provided, further, that UHS acknowledges that the Operative Documents and documents required to be filed on behalf of UHS and its Subsidiaries with the Securities and Exchange Commission and available to the public shall not be considered confidential for the purposes of this Agreement (all such confidential information, collectively, the "Information"). Finco agrees that the Information is to be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality and agrees that (i) subject to the following sentence, it shall, and shall cause the Recipients to, retain in confidence and not disclose without the prior written consent of UHS any or all of the Information, and (ii) it will not, and will ensure that the Recipients will not, make any use whatsoever (other than for the purposes contemplated by this Agreement and the other Operative Documents or for the enforcement of any of the rights granted hereunder or thereunder) of any of the Information without the prior written consent of UHS. Notwithstanding the foregoing, a Recipient may (x) disclose Information to any Person that executes and delivers to the addressee and UHS a confidentiality agreement with respect to such Information and (y) disclose or otherwise use Information (A) to the extent that such Information is required or appropriate in any reports, statement or testimony submitted to any municipal, state, or federal regulatory body having or claiming to have jurisdiction over the Recipient or submitted to the National Association of Insurance Commissioners or similar organization or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such information subsequently becomes publicly available other than through any act or omission of the Recipient, (F) to the extent that such Information subsequently becomes known to the Recipient, other than through a person whom the Recipient knows to be acting in violation of his or its obligations to UHS. (e) UHS shall not, and shall not permit any Subsidiary to, change the instructions governing, or make any withdrawal from, or transfer to or from, any of the Hospital Concentration Accounts or the Master Receivables Account, except as permitted pursuant to the Operative Documents. (f) UHS will preserve all records that it is required to maintain in order to fulfill its obligations under this Guarantee until the later of (i) four years after the date upon which the Receivable to which such records relate is paid in full or (ii) seven years. (g) UHS will comply with all Requirements of Law which are applicable to the Transferred Property or any part thereof; provided, however, that UHS may contest any act, regulation, order, decree or direction in any manner which, in the reasonable opinion of Finco, shall not, alone or in the aggregate, materially and adversely affect the rights of Finco or any Interested Party in the Transferred Property or the collectibility or enforceability of the Purchased Receivables. (h) UHS will not create, permit or suffer to exist, and will defend Finco's and the Interested Parties' rights to the Total Transferred Property against, and take such other actions as are necessary to remove, any Lien, claim or right in, to or on the Total Transferred Property, and will defend the right, title and interest of Finco and the Interested Parties in and to the Total Transferred Property against the claims and demands of all Persons whomsoever, other than the Liens in respect of the Permitted Interests. (i) UHS will duly fulfill all obligations on its part to be fulfilled under or in connection with each Purchased Receivable and will do nothing to impair the rights of Finco or the Interested Parties in the Total Transferred Property. (j) UHS will not, and will not permit any of its Subsidiaries to, sell, discount or otherwise dispose of any Purchased Receivable except to Finco or the Interested Parties or as provided under the Sale and Servicing Agreements and the Pooling Agreement. (k) All financial statements prepared by Finco or any Hospital and made available to any Person other than any UHS Entity shall indicate the sale to Finco of the Purchased Receivables and other Transferred Property. (l) UHS shall not merge or consolidate with, or transfer all or substantially all its assets to, any other entity unless UHS is the entity surviving such merger or consolidation or unless (i) the surviving or transferee entity expressly assumes all of the covenants, obligations and agreements of UHS under this Guarantee in a written instrument satisfactory in form and substance to Finco, (ii) the surviving or transferee is organized under the laws of the United States and substantially all of such entity's assets are located in the United States and (iii) such merger, consolidation or other transfer shall not, in the judgment of Finco, result in an Exclusion Event or an Early Amortization Event. (m) UHS shall not, without the prior written consent of Finco, which consent shall not be unreasonably withheld, permit any Hospital to materially alter the hardware or software systems used by such Hospital in generating its reports to UHS Delaware in respect of the Purchased Receivables and Collections. (n) UHS shall cause each Guaranteed Party to duly and punctually perform in all material respects each of the terms, conditions, covenants, obligations, indemnities and warranties under all Operative Documents to which it is a party and under each agreement, contract or other arrangement relating to any Purchased Receivable in accordance with the terms thereof. (o) UHS will not hold itself out as liable for Debt of Finco. 10. Severability. Any provision of this Guarantee which is prohibited or unenforceable in any jurisdiction shall, as to such jurisdiction, be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions hereof, and any such prohibition or unenforceability in any jurisdiction shall not invalidate or render unenforceable such provision in any other jurisdiction. 11. Paragraph Headings. The paragraph headings used in this Guarantee are for convenience of reference only and are not to affect the construction hereof or be taken into consideration in the interpretation hereof. 12. No Waiver; Cumulative Remedies. Neither Finco nor any Interested Party shall by any act (except by a written instrument pursuant to paragraph 13 hereof), delay, indulgence, omission or otherwise be deemed to have waived any right or remedy hereunder or to have acquiesced in any Exclusion Event or Early Amortization Event or in any breach of any of the terms and conditions hereof. No failure to exercise, nor any delay in exercising, on the part of Finco or any Interested Party, any right, power or privilege hereunder shall operate as a waiver thereof. No single or partial exercise of any right, power or privilege hereunder shall preclude any other or further exercise thereof or the exercise of any other right, power or privilege. A waiver by Finco or any Interested Party of any right or remedy hereunder on any one occasion shall not be construed as a bar to any right or remedy which Finco or such Interested Party would otherwise have on any future occasion. The rights and remedies herein provided are cumulative, may be exercised singly or concurrently and are not exclusive of any rights or remedies provided by law. 13. Waivers and Amendments. None of the terms or provisions of this Guarantee may be waived, amended, supplemented or otherwise modified except by a written instrument executed by UHS, and consented to in writing by Finco. 14. Successors and Assigns; Consent to Assignment; Third Party Beneficiaries. (a) This Guarantee shall be binding upon the successors and assigns of UHS and shall inure to the benefit of Finco, the Interested Parties and their successors and assigns. (b) UHS acknowledges that all of Finco's right, title and interest in the obligations of UHS to Finco and the rights of Finco against UHS under this Guarantee have been assigned, transferred and otherwise conveyed by Finco to the Trustee, for the benefit of the Participants. UHS acknowledges that Sheffield shall assign to the Liquidity Agent, for the benefit of the Liquidity Banks all of Sheffield's right, title and interest in, to and under this Guarantee. UHS consents to such assignment and transfer by Finco to the Trustee and by Sheffield to the Liquidity Agent, and agrees that the Trustee and the Participants (or upon notice by Sheffield or the Liquidity Agent of a default under the Liquidity Agreement or the Security Agreement, and to the extent provided in the Pooling Agreement, the TRIPs Holders and the Liquidity Agent), shall be entitled to enforce the terms of this Guarantee directly against UHS, whether or not any Early Amortization Event or Exclusion Event shall have occurred. UHS further agrees that it will not take any action with respect to the Purchased Receivables (other than those actions which are consistent with its obligations hereunder and which occur in the normal course of its operations) without the prior consent of the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee, and in respect of its obligations hereunder UHS will act at the direction of and in accordance with all requests and instructions of the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee. Finco and UHS hereby agree that, in the event of any conflict of requests or instructions to UHS between Finco and the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee, UHS will at all times act in accordance with the requests and instructions of the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee and in the event of any conflict of requests or instructions among Participants, UHS shall act in accordance with the instructions of the Trustee. Finco and UHS agree that, in the event of any conflict of requests or instructions to UHS between Sheffield and the Liquidity Agent, UHS will at all times act in accordance with the requests and instructions of the Liquidity Agent. (c) Notwithstanding anything in this Paragraph 14 to the contrary, and without limitation on the rights and obligations of UHS hereunder, each of the Interested Parties shall have the rights of a third-party beneficiary hereunder. 15. Right of Set-off. Upon the occurrence and continuance of an Early Amortization Event or an Exclusion Event, each of Finco and each Interested Party is hereby irrevocably authorized at any time and from time to time, without notice to UHS, any such notice being hereby waived by UHS, to set off and appropriate and apply any and all deposits (general or special, time or demand, provisional or final), in any currency, and any other credits, indebtedness or claims, in any currency, in each case whether direct or indirect, absolute or contingent, matured or unmatured, at any time held or owing by Finco or such Interested Party to or for the credit or the account of UHS, or any part thereof in such amounts as Finco or such Interested Party may elect, on account of the liabilities of UHS hereunder, and claims of every nature and description of Finco or such Interested Party against UHS, in any currency, whether arising hereunder or under the Servicing Agreement or any Sale and Servicing Agreement, as Finco or such Interested Party may elect, whether or not Finco or such Interested Party has made any demand for payment and although such liabilities and claims may be contingent or unmatured. Finco or such Interested Party, as the case may be, shall notify UHS promptly of any such set-off made by it and the application made by it of the proceeds thereof, provided that the failure to give such notice shall not affect the validity of such set-off and application. The rights of Finco and each Interested Party under this paragraph are in addition to other rights and remedies (including, without limitation, other rights of set-off) which Finco or such Interested Party may have. 16. GOVERNING LAW. THIS GUARANTEE AND THE OBLIGATIONS OF UHS HEREUNDER SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE LAW OF THE STATE OF NEW YORK. 17. Notices. Except where telephonic instructions or notices are authorized herein to be given, all notices, demands, instructions and other communications required or permitted to be given to or made upon any party hereto shall be in writing and shall be personally delivered or sent by registered, certified or express mail, postage prepaid, return receipt requested, or by telecopy (with voice confirmation thereof) or telegram (with messenger delivery specified in the case of a telegram) and shall be deemed to be given for purposes of this Guarantee when such personal delivery is made or such return receipt or confirmation is received by the party giving such notice, demand, instruction or other communication. Unless otherwise specified in a notice sent or delivered in accordance with the foregoing provisions of this paragraph, notices, demands, instructions and other communications in writing shall be given to or made upon the respective parties hereto at their respective addresses (or to their respective telecopy numbers) indicated below, and, in the case of telephonic instructions or notices, by calling the telephone number or numbers indicated for such party below: If to UHS: Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: General Counsel Tel. No.: 215-768-3300 Telecopier No: 215-768-3318 If to Finco: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 Attention: President Tel. No.: 714-661-9323 Telecopier No.: 714-661-9445 With a copy to: UHS Receivables Corp. c/o Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: General Counsel Tel. No.: 215-768-3300 Telecopier No: 215-768-3318 The above-referenced Persons may change their addresses and transmission numbers by written notice to the other Persons listed above. 18. Authority of Managing Agent. UHS hereby acknowledges that Sheffield has appointed Barclays to act as its Managing Agent. Unless otherwise instructed by Sheffield, copies of all notices, requests, demands and other documents to be delivered to Sheffield pursuant to the terms hereof shall be delivered to the Managing Agent. Unless otherwise instructed by Sheffield, all notices, requests, demands and other documents to be executed or delivered, and any action to be taken, by Sheffield pursuant to the terms hereof may be executed, delivered and/or taken by the Managing Agent. The rights and responsibilities of the Managing Agent under this Guarantee with respect to any action taken by the Managing Agent or the exercise or non- exercise by the Managing Agent of any option, right, request, judgment or other right or remedy provided to Sheffield herein or resulting or arising out of this Guarantee shall, as between the Managing Agent and Sheffield be governed by such agreements with respect thereto as may exist from time to time between them, but, as between the Managing Agent and UHS, the Managing Agent shall be conclusively presumed to be acting as agent for Sheffield with full and valid authority so to act or refrain from acting, and UHS shall not be under any obligation, or entitlement, to make any inquiry respecting such authority. 19. Waivers. (a) UHS hereby irrevocably and unconditionally waives, to the maximum extent not prohibited by law, any right it may have to claim or recover in any legal action or proceeding referred to in this paragraph any special, exemplary, punitive or consequential damages. (b) Finco hereby irrevocably and unconditionally waives, to the maximum extent not prohibited by law, any right Finco may have to claim or recover in any legal action or proceeding relating to this Guarantee any special, exemplary, punitive or consequential damages; provided that the waiver contained in this paragraph 19(b) shall not extend to any right to claim or recover from UHS any special, exemplary, punitive or consequential damages for which Finco is liable to any Person. 20. Acknowledgements. UHS hereby acknowledges with respect to the transactions contemplated by the Operative Documents that: (a) it has been advised by counsel in the negotiation, execution and delivery of this Guarantee; (b) no Interested Party has any fiduciary relationship to UHS or the Hospital and the relationship between any Interested Party, on the one hand, and UHS or any Hospital, on the other hand, is solely that of debtor and creditor; and (c) no joint venture exists between UHS or any Hospital on the one hand, and any Interested Party on the other. 21. WAIVERS OF JURY TRIAL. UHS AND, BY FINCO'S ACCEPTANCE HEREOF, FINCO AND THE INTERESTED PARTIES HEREBY IRREVOCABLY AND UNCONDITIONALLY WAIVE TRIAL BY JURY IN ANY LEGAL ACTION OR PROCEEDING RELATING TO THIS GUARANTEE AND FOR ANY COUNTERCLAIM THEREIN. 22. No Bankruptcy Petition. UHS covenants and agrees that prior to the date which is one year and one day after the payment in full of the Sheffield Certificate and all TRIPs issued by Finco and all other amounts due under or in connection with the Operative Documents it will not institute against, or join any other Person in instituting against, Finco, Sheffield or any Hospital any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. 23. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. UHS (FOR ITSELF AND ITS SUCCESSORS AND ASSIGNS) HEREBY IRREVOCABLY SUBMITS, FOR ITSELF AND ITS PROPERTY, TO THE JURISDICTION OF THE STATE COURTS OF THE STATE OF NEW YORK AND TO THE JURISDICTION OF THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK, FOR THE PURPOSES OF ANY SUIT, ACTION OR OTHER PROCEEDING ARISING OUT OF OR BASED UPON THIS GUARANTEE OR THE SUBJECT MATTER HEREOF BROUGHT BY FINCO OR ANY INTERESTED PARTY. UHS (FOR ITSELF AND ITS SUCCESSORS AND ASSIGNS) TO THE EXTENT PERMITTED BY ANY REQUIREMENTS OF LAW (A) HEREBY WAIVES, AND AGREES NOT TO ASSERT, BY WAY OF MOTION, AS A DEFENSE, OR OTHERWISE, IN ANY SUCH SUIT, ACTION OR PROCEEDING BROUGHT IN ANY SUCH COURT, ANY CLAIM THAT IT IS NOT SUBJECT PERSONALLY TO THE JURISDICTION OF THE ABOVE-NAMED COURTS, THAT ITS PROPERTY IS EXEMPT OR IMMUNE FROM ATTACHMENT OR EXECUTION, THAT THE SUIT, ACTION OR PROCEEDING IS BROUGHT IN AN INCONVENIENT FORUM, THAT THE VENUE OF THE SUIT, ACTION OR PROCEEDING IS IMPROPER OR THAT THIS GUARANTEE OR THE SUBJECT MATTER HEREOF MAY NOT BE ENFORCED IN OR BY SUCH COURT, AND (B) HEREBY WAIVES THE RIGHT TO ASSERT IN ANY SUCH ACTION, SUIT OR PROCEEDING ANY OFFSETS OR COUNTERCLAIMS EXCEPT COUNTERCLAIMS THAT ARE COMPULSORY OR OTHERWISE ARISE FROM THE SAME SUBJECT MATTER. UHS HEREBY AGREES THAT SERVICE OF ANY AND ALL PROCESS AND OTHER DOCUMENTS ON UHS MAY BE EFFECTED BY CERTIFIED OR REGISTERED MAIL (OR ANY SUBSTANTIALLY SIMILAR FORM OF MAIL) TO ITS ADDRESS AS SET FORTH IN PARAGRAPH 17 AND SUCH SERVICE SHALL CONSTITUTE VALID AND EFFECTIVE SERVICE AGAINST UHS. UHS AGREES THAT ITS SUBMISSION TO JURISDICTION AND CONSENT TO SERVICE OF PROCESS BY MAIL IN ANY SUCH ACTION, SUIT OR PROCEEDING SHALL BE CONCLUSIVE, AND MAY BE ENFORCED IN ANY OTHER JURISDICTION (A) BY SUIT, ACTION OR PROCEEDING ON THE JUDGMENT, A CERTIFIED OR TRUE COPY OF WHICH SHALL BE CONCLUSIVE EVIDENCE OF THE FACT AND THE AMOUNT OF INDEBTEDNESS OR LIABILITY THEREIN DESCRIBED OR (B) IN ANY OTHER MANNER PROVIDED BY OR PURSUANT TO THE LAWS OF SUCH OTHER JURISDICTION, PROVIDED, HOWEVER, THAT ANY OF FINCO OR ANY INTERESTED PARTY MAY AT ITS OPTION BRING SUIT, OR INSTITUTE OTHER JUDICIAL PROCEEDINGS AGAINST UHS OR ANY OF ITS ASSETS IN ANY STATE OR FEDERAL COURT OF THE UNITED STATES OR OF ANY COUNTRY OR PLACE WHERE THE SERVICER OR UHS OR SUCH ASSETS MAY BE FOUND. 24. Survival. The representations and warranties of UHS contained herein, and the provisions of Paragraph 23, shall survive the execution and delivery of this Guarantee and the Guarantee Termination Date. IN WITNESS WHEREOF, UHS has caused this Guarantee to be duly executed and delivered in New York, New York by its proper and duly authorized officer as of the day and year first above written. UNIVERSAL HEALTH SERVICES, INC. By: _______________________________ Title: Acknowledged By: UHS RECEIVABLES CORP. By: _______________________________ Title: EXHIBIT 10.20 AMENDMENT NO. 1 TO 1989 NON-EMPLOYEE DIRECTOR STOCK OPTION PLAN The 1989 Non-Employee Director Stock Option Plan is amended by deleting Section 8 thereof and replacing it with the following: "8. Automatic Grant of Options. Each member of the Company's Board of Directors who is neither an employee nor an officer of the Company serving on the date of the approval of Amendment No. 1 to the Plan by the Board of Directors is automatically granted on such approval date without further action by the Board, an option to purchase two thousand five hundred (2,500) shares of the Company's Class B Common Stock. Each person who is first elected to the Board of Directors after the date of approval of Amendment No. 1 to the Plan by the Board of Directors and who is at that time neither an employee nor an officer of the Company shall be automatically granted, on the date of such election and without further action by the Board of Directors, an option to purchase two thousand five hundred (2,500) shares of the Company's Class B Common Stock." EXHIBIT 10.21 AMENDMENT NO. 1 TO 1992 STOCK BONUS PLAN The 1992 Stock Bonus Plan is amended by deleting Section 3.5 thereof and replacing it with the following: "3.5. Composition of Bonuses. Eligible Key Employees other than officers shall elect to take from the mandatory minimum of 20% up to 100% of their annual Bonus in Stock Bonuses, and the Committee shall set forth in the related Stock Bonus Agreement the percentage composition of the Stock Bonus that the Key Employee chooses, the corresponding amount of Stock Bonus Premium that the Key Employee is entitled to and any other terms, conditions and limitations that are applicable to each particular Stock Bonus and Stock Bonus Premium and that are in accordance with provisions of this Plan. Key Employees other than officers may make an election to take more than the mandatory minimum of 20% of their Bonus in the form of a Stock Bonus any time on or before the Grant Date. Officers shall automatically be awarded 20% of their annual Bonus in Stock Bonuses." EXHIBIT 10.22 UNIVERSAL HEALTH SERVICES 1994 EXECUTIVE INCENTIVE PLAN 1. Purpose. The purpose of the Plan is to foster the ability of the Company and its Affiliates to attract, retain and motivate highly qualified senior management and other executive officers of the Company and its Affiliates through the payment of performance-based incentive bonuses. 2. Definitions. Wherever used herein, the masculine includes the feminine, the singular includes the plural, and the following terms have the following meanings unless a different meaning is clearly required by the context. (a) "Affiliate" means any entity (whether or not incorporated) which is required to be aggregated with the Company under Section 414(b) or 414(c) of the Internal Revenue Code of 1986 (the "Code"). (b) "Board" means the Board of Directors of the Company. (c) "Company" means Universal Health Services, Inc. (d) "Committee" means the administrative committee appointed by the Board in accordance with the provisions hereof. (e) "Compensation" means the base salary of a Participant for a calendar year, determined as of the beginning of the calendar year and without regard to increases, if any, made during the calendar year. (f) "Net Income" means the net income of the Company or of an Affiliate, division, hospital or other units, as determined by the Committee. (g) "Participant" means, with respect to any calendar year, an individual who is designated by the Committee as eligible to receive an incentive bonus for the year upon achievement of the applicable performance conditions. (h) "Plan" means the incentive compensation plan as set forth herein and any amendments thereto. (i) "Return on Capital" means Net Income divided by the quarterly average net capital of the Company or of an Affiliate, division, hospital or other unit, as determined by the Committee. 3. Administration. The Plan will be administered by a committee consisting of at least two directors appointed by and serving at the pleasure of the Board. Each member of the Committee will be a "disinterested director" within the meaning and for the purposes of Rule 16b-3 issued by the Securities and Exchange Commission under the Securities Exchange Act of 1934, and an "outside director" within the meaning of Section 162(m) of the Code. Subject to the provisions of the Plan, the Committee, acting in its sole and absolute discretion, will have full power and authority to interpret, construe and apply the provisions of the Plan and to take such action as may be necessary or desirable in order to carry out the provisions of the Plan. A majority of the members of the Committee will constitute a quorum. The Committee may act by the vote of a majority of its members present at a meeting at which there is a quorum or by unanimous written consent. The Committee will keep a record of its proceedings and acts and will keep or cause to be kept such books and records as may be necessary in connection with the proper administration of the Plan. The Company shall indemnify and hold harmless each member of the Committee and any employee or director of the Company or an Affiliate to whom any duty or power relating to the administration or interpretation of the Plan is delegated from and against any loss, cost, liability (including any sum paid in settlement of a claim with the approval of the Board), damage and expense (including legal and other expenses incident thereto) arising out of or incurred in connection with the Plan, unless and except to the extent attributable to such person's fraud or wilful misconduct. 4. Eligibility. Annual incentive bonuses may be awarded under the Plan to any person who is a member of the senior management of the Company and to other executive officers of the Company or an Affiliate. Subject to the provisions hereof, the Committee will select the persons to whom incentive bonuses may be awarded for any calendar year and will fix the terms and conditions of each such award. 5. Annual Performance Bonus. The amount of a Participant's incentive bonus for a year will be equal to the Participant's base bonus amount (described in (a) below) multiplied by the applicable performance factor (described in (b) below). (a) Base Bonus Amount. For each calendar year, the Committee will establish the amount of bonus ("base bonus amount") which will be payable to a Participant if the performance goals for the year are met. A Participants' base bonus amount will be expressed as a percentage of the Participant's Compensation, which percentage may vary from year to year and may be different for each Participant or class of Participants, all as determined by the Committee. (b) Applicable Performance Factor. For each calendar year, the Committee will establish performance targets based upon the following business criteria: increase in Net Income from the preceding calendar year, and Return on Capital. As to any Participant or class of Participants, the performance targets may be based upon either or both of such criteria and on Company-wide figures, local or divisional figures, or a combination thereof. If a Participant's performance targets for a calendar year are achieved, then the Participant will be entitled to receive an incentive bonus equal to 100% of the Participant's base bonus amount for the year. No incentive bonus will be payable for a year if neither performance target is achieved, and a performance bonus (which may be greater than 100% of a Participant's base bonus amount) may be payable if either or both performance targets are exceeded for a calendar year, all in accordance with a Company performance matrix established by the Committee. (c) Performance Conditions to be Pre-Established. Performance targets, as well as percentage factors used to determine base bonus amounts and performance percentages with respect to any calendar year will be established in writing by the Committee before the beginning of that calendar year; provided, however, that the Committee may establish any one or more of said factors during the calendar year if and to the extent permitted by the Treasury Department pursuant to Section 162(m) of the Code. (d) Payment of Stock. Notwithstanding anything to the contrary contained in the Company's 1992 Stock Bonus Plan, an amount equal to 20% of a Participant's incentive bonus for a calendar year will be payable in the form of Common Stock of the Company and no election may be made by the Participant to receive a greater portion of his or her incentive bonus in such form. Subject to the provisions of the 1992 Stock Bonus Plan, a Participant will be entitled to receive an additional bonus, payable in the form of shares of Common Stock of the Company, equal to 4% of the Participant's incentive bonus (determined without regard to this section). (e) Limitation on Amount of Incentive Bonuses. Notwithstanding anything to the contrary contained herein, the maximum incentive bonus which any Participant may earn hereunder for any calendar year is an amount equal to 125% of the Participant's Compensation for that calendar year (130% after taking into account the stock bonus premium described in the preceding subsection). For purposes of the preceding sentence, a Participant's Compensation for any calendar year will be disregarded to the extent it is greater than 25% of the Participant's Compensation (determined with regard to this sentence) for the preceding calendar year. 6. Calculation and Payment of Performance Bonus. As soon as practicable after the end of each calendar year, the Committee, based upon the Company's financial statements for the year, will determine the amount, if any, of the incentive bonus payable to each Participant for that calendar year. A Participant's incentive bonus for a calendar year will be paid to the Participant at such time as the Committee determines; provided, however, that the Committee may authorize an advance payment based upon its preliminary calculations, and provided further that the Committee may establish a procedure pursuant to which payment of all or a portion of a Participant's incentive bonus for a calendar year will be deferred. Unless the Committee determines otherwise, no incentive bonus will be payable to a Participant with respect to a calendar year if the Participant's employment with the Company and its Affiliates terminates at any time prior to the payment thereof. 7. Amendment or Termination. The Board may amend or terminate the Plan at any time. 8. Governing Law. The Plan and each award made under the Plan shall be governed by the laws of the State of Delaware, it being understood, however, that incentive bonuses awarded and paid under the Plan are intended to constitute "performance-based compensation" within the meaning of Section 162(m) of the Code, and the provisions of the Plan and any award made hereunder will be interpreted and construed accordingly. 9. No Rights Conferred. Nothing contained herein will be deemed to give any person any right to receive an incentive bonus award under the Plan or to be retained in the employ or service of the Company or any Affiliate. 10. Decisions of Board or Committee to be Final. Any decision or determination made by the Board pursuant to the provisions hereof and, except to the extent rights or powers under the Plan are reserved specifically to the discretion of the Board, all decisions and determinations of the Committee hereunder, shall be final and binding. EXHIBIT 11 UNIVERSAL HEALTH SERVICES, INC. and Subsidiaries Computation of Earnings Per Share Year Ended December 31, ---------------------------------------- 1993 1992 1991 ---- ---- ---- Weighted Average Shares: Class A common 1,211,850 1,386,267 2,567,652 Class B common 12,276,146 12,148,177 10,814,566 Class C common 121,755 149,165 262,001 Class D common 28,648 49,853 70,383 ---------- ---------- ---------- Total 13,638,399 13,733,462 13,714,602 Less: Effect of shares repurchased (105,795) (58,274) - Less: Incremental number of shares of restricted stock excluded from EPS computation (46,893) (59,096) (87,829) Effect of shares issued 10,250 26,788 18,499 ---------- ---------- ---------- 13,495,961 13,642,880 13,645,272 Common Stock Equivalents: Assumed conversion of 7 1/2 % convertible debentures issued in April 1983 1,271,471 1,274,653 1,275,256 Assumed conversion of options to purchase common stock 51,101 52,784 71,506 ---------- ---------- ---------- Weighted average shares - fully diluted 14,818,533 14,970,317 14,992,034 ========== ========== ========== Income: $24,010,645 $20,019,839 $20,319,444 Interest expense, net of tax effect, on assumed conversion of 7 1/2% convertible debentures $ 1,392,404 $ 1,420,699 $ 1,417,894 ----------- ----------- ----------- Income Applicable to Common Stock - Fully Diluted $25,403,049 $21,440,538 $21,737,338 =========== =========== =========== Earnings per Common and Common Equivalent Share: Fully diluted - $1.71 $1.43 $1.45 =========== =========== =========== EXHIBIT 22 SUBSIDIARIES OF THE COMPANY JURISDICTION NAME OF SUBSIDIARY OF INCORPORATION ..------------------ ---------------- ASC of Canton, Inc........................................ Georgia ASC of Littleton, Inc..................................... Colorado ASC of Midwest City, Inc.................................. Oklahoma ASC of Las Vegas, Inc..................................... Nevada ASC of New Albany, Inc.................................... Indiana ASC of Palm Springs, Inc.................................. California ASC of Ponca City, Inc.................................... Oklahoma ASC of Springfield, Inc................................... Missouri ASC of St. George, Inc.................................... Utah The BridgeWay, Inc........................................ Arkansas Children's Hospital of McAllen, Inc....................... Texas Comprehensive Occupational and Clinical Health, Inc....... Delaware Dallas Family Hospital, Inc............................... Texas Del Amo Hospital, Inc..................................... California Doctors' General Hospital, Ltd. (d/b/a/ Universal Medical Center)....................... Florida Doctors' Hospital of Hollywood, Inc....................... Florida Forest View Psychiatric Hospital, Inc..................... Michigan Glen Oaks Hospital, Inc................................... Texas Health Care Finance & Construction Corp................... Delaware HRI Clinics, Inc.......................................... Massachusetts HRI Hospital, Inc......................................... Massachusetts Hope Square Surgical Center, L.P. (d/b/a Hope Square Surgical Center)..................... Delaware La Amistad Residential Treatment Center, Inc.............. Florida McAllen Medical Center, Inc............................... Texas Meridell Achievement Center, Inc.......................... Texas Merion Building Management, Inc........................... Delaware New Albany Outpatient Surgery, L.P. (d/b/a Surgical Center of New Albany)................... Delaware Panorama Community Hospital, Inc.......................... Delaware Relational Therapy Clinic, Inc............................ Louisiana River Crest Hospital, Inc................................. Texas River Oaks, Inc........................................... Louisiana .Southwest Dallas Hospital, Inc............................ Texas Sparks Family Hospital, Inc............................... Nevada Sparks Reno Partnership, L.P. (d/b/a Sparks Family Hospital).......................... Delaware St. George Surgical Center, L.P. (d/b/a St. George Surgery Center)....................... Delaware Surgery Center of Canton, L.P............................. Delaware Surgery Center of Littleton, L.P. (d/b/a Littleton Day Surgery Center).................... Delaware Surgery Center of Midwest City, L.P. (d/b/a MD Physicians Surgicenter of Midwest City)....... Delaware Surgery Center of Odessa, L.P. (d/b/a Surgery Center of Texas)......................... Delaware Surgery Center of Ponca City, L.P. (d/b/a Outpatient Surgical Center of Ponca City)........ Delaware JURISDICTION NAME OF SUBSIDIARY OF INCORPORATION - ------------------ ---------------- Surgery Center of Springfield, L.P. (d/b/a Surgery Center of Springfield)................... Delaware Tonopah Health Services, Inc.............................. Nevada Turning Point Care Center, Inc. (d/b/a Turning Point Hospital).......................... Georgia Two Rivers Psychiatric Hospital, Inc...................... Delaware UHS of Auburn, Inc. (d/b/a Auburn General Hospital)......................... Washington UHS of Belmont, Inc....................................... Delaware UHS of Bethesda, Inc...................................... Delaware District of UHS of Columbia, Inc...................................... Columbia UHS Croyden Limited....................................... United Kingdom UHS of DeLaRonde, Inc. (d/b/a Chalmette Medical Center)........................ Louisiana UHS of Delaware, Inc...................................... Delaware UHS of Florida, Inc....................................... Florida UHS Holding Company, Inc.................................. Nevada UHS International, Inc.................................... Delaware UHS International Limited................................. United Kingdom UHS Las Vegas Properties, Inc............................. Nevada UHS Leasing Company, Inc.................................. Delaware UHS Leasing Company, Limited.............................. United Kingdom UHS of London, Inc........................................ Delaware UHS London Limited........................................ United Kingdom UHS of Massachusetts, Inc. (d/b/a The Arbour)...................................... Massachusetts UHS of New Orleans, Inc. (d/b/a Chalmette Hospital).............................. Louisiana UHS of Odessa, Inc........................................ Texas UHS of Plantation, Inc.................................... Florida UHSR Corporation.......................................... Delaware UHS Receivables Corp...................................... Delaware UHS of River Parishes, Inc. (d/b/a River Parishes Hospital)......................... Louisiana UHS of Riverton, Inc...................................... Washington UHS of Shreveport, Inc. (d/b/a Doctors' Hospital of Shreveport)................. Louisiana UHS of Springfield, Inc................................... Missouri UHS of Vermont, Inc....................................... Vermont Universal HMO, Inc........................................ Nevada Universal Health Network, Inc............................. Nevada Universal Health Pennsylvania Properties, Inc............. Pennsylvania Universal Health Recovery Centers, Inc. (d/b/a UHS KeyStone Center)............................. Pennsylvania Universal Health Services of Cedar Hill, Inc.............. Texas Universal Health Services of Concord, Inc................. California Universal Health Services of Inland Valley, Inc. (d/b/a Inland Valley Regional Medical Center)........... California Universal Health Services of Nevada, Inc. (d/b/a Valley Hospital Medical Center).................. Nevada Victoria Regional Medical Center, Inc..................... Texas Wellington Regional Medical Center Incorporated........... Florida Westlake Medical Center, Inc.............................. California EXHIBIT 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports, included in this Form 10-K, into the Company's previously filed Registration Statements on Forms S-8 (No. 2-80903), (No. 2-98913), (No. 33-43276), (No. 33-49426), (No. 33-49428), and (No. 33-51671). ARTHUR ANDERSEN & CO. Philadelphia, PA March 30, 1994

104669_1993.txt

104669_1993

1993

104669

ITEM 1. BUSINESS. The term 'Warner-Lambert' or 'the Company' refers to Warner-Lambert Company, a Delaware corporation organized in that state in 1920, and its consolidated subsidiaries unless otherwise indicated or unless the context otherwise requires. Industry Segments and Geographic Areas. Financial information by industry segment and geographic area for the years 1993, 1992 and 1991 is presented in the Warner-Lambert 1993 Annual Report as set forth below. The summary of Warner-Lambert's industry segments, geographic areas and related financial information, set forth in Note 20 to the consolidated financial statements on page 47 of the Warner-Lambert 1993 Annual Report, is incorporated herein by reference. All product names appearing in capitalized letters in this report on Form 10-K, with the exception of ZOVIRAX and ZANTAC, are trademarks of Warner-Lambert, its affiliates, related companies or licensors. ZOVIRAX is a registered trademark of Wellcome plc. ZANTAC is a registered trademark of Glaxo Holdings plc. BUSINESS SEGMENTS A detailed description of Warner-Lambert's industry segments is as follows: Pharmaceutical Products The principal products of Warner-Lambert in its Pharmaceutical Products segment are ethical pharmaceuticals, biologicals, specialty chemicals and capsules. Ethical Pharmaceuticals and Biologicals: Warner-Lambert manufactures and/or sells, in the United States and/or internationally, an extensive line of ethical pharmaceuticals, biologicals and specialty chemicals under trademarks and trade names such as PARKE-DAVIS and GOEDECKE. Among these products are analgesics (PONSTAN, PONSTEL, EASPRIN, VALORON, VALORON-N and VEGANIN), anesthetics (KETALAR), anthelmintics (VANQUIN), anticonvulsants (DILANTIN, ZARONTIN and NEURONTIN), anti-infectives (CHLOROMYCETIN, COLYMYCIN, DORYX, ERYC and MANDELAMINE), antihistamines (BENADRYL), antivaricosities (HEPATHROMBIN), anti-viral agents (VIRA-A), bronchodilators (CHOLEDYL and CHOLEDYL SA), cardiovascular products (NOVADRAL, DILZEM, PROCAN SR, ACCUPRIL, ACCUZIDE, ACCURETIC and NITROSTAT), cognition drugs for treatment of mild-to-moderate Alzheimer's disease (COGNEX), dermatologics (BEBEN and UTICORT), prescription hemorrhoidal preparations (ANUSOL HC), hemostatic agents (THROMBOSTAT), hormonal agents (PITRESSIN), influenza vaccines (FLUOGEN), lipid regulators (LOPID), nonsteroidal anti-inflammatories (MECLOMEN), oral contraceptives (LOESTRIN), oxytocics (PITOCIN), psychotherapeutic products (CETAL RETARD, DEMETRIN and NARDIL) and urinary analgesics (PYRIDIUM). These products are promoted for the most part directly to health care professionals through personal solicitation of doctors and other professionals by sales representatives with scientific training, direct mail contact and advertising in professional journals. They are sold either directly or through wholesalers to government agencies, chain and independent retail pharmacies, physician supply houses, hospitals, clinics, convalescent and nursing homes, mail order houses, health care professionals and health maintenance organizations. For further discussion of Warner-Lambert's ethical products, see 'Regulation' below. On September 9, 1993, Warner-Lambert received marketing approval for COGNEX (Warner-Lambert's trademark for tacrine or THA), the first effective treatment for mild-to-moderate Alzheimer's disease, in the United States and began to ship the product in late September. Warner-Lambert is attempting to obtain marketing approval for COGNEX in other major markets such as Europe and Canada. Warner-Lambert received clearance on December 30, 1993 to market NEURONTIN (gabapentin capsules) in the United States as add-on therapy in the treatment of certain types of adult epilepsy (i.e., partial seizures, with and without secondary generalization). Warner-Lambert began marketing NEURONTIN in the United Kingdom in 1993. On January 4, 1993, the U.S. patent covering LOPID, a lipid regulator, expired, subjecting LOPID to generic competition. In December 1992, Warner-Lambert began marketing gemfibrozil, the generic equivalent of LOPID, through its division, Warner Chilcott Laboratories, as described below. In the third quarter of 1993, two competitive generic versions of gemfibrozil tablets received marketing approval in the United States. Combined worldwide sales of LOPID and gemfibrozil declined in 1993 and are expected to decline further in 1994. Warner-Lambert has a separate division, Warner Chilcott Laboratories, which is dedicated solely to the generic drug business. Warner Chilcott Laboratories is a manufacturer and/or marketer of 80 generic drugs including gemfibrozil, carbamazapine chewable, hydrocodone with acetaminophen, nitroglycerin patch, potassium chloride ER, sulindac, and a line of generic antibiotics, including ampicillin, amoxicillin, penicillin, cephalexin and minocycline. These products are promoted directly to the pharmacy community and are sold principally to drug wholesalers, chain and retail pharmacies and health maintenance organizations. In January 1993, Warner-Lambert acquired a 34 percent equity interest in Jouveinal S.A., a French pharmaceutical company, and entered into a license option agreement that grants Warner-Lambert the right of first refusal as to the licensing of future Jouveinal products outside of France, Canada and French-speaking Africa. Capsules: Warner-Lambert is the leading worldwide producer of empty hard-gelatin capsules used by pharmaceutical companies for their production of encapsulated products. These capsules are used by Warner-Lambert or manufactured by Warner-Lambert according to the specifications of each of its customers and are sold under such trademarks as CAPSUGEL, CONI-SNAP and SNAP-FIT. Consumer Health Care Products The principal products of Warner-Lambert in its Consumer Health Care Products segment are over-the-counter products, shaving products and pet care products. Over-the-counter Products: Warner-Lambert manufactures and/or sells, in the United States and/or internationally, a line of over-the-counter pharmaceuticals and health care products, including antacids (ROLAIDS, SODIUM FREE ROLAIDS, EXTRA STRENGTH ROLAIDS and GELUSIL), dermatological products (LUBRIDERM, LUBRIDERM BODY BAR, LUBRIDERM LOOFA BAR, ROSKEN SKIN REPAIR, CORN HUSKERS and LISTEREX), sinus preparations (SINUTAB), antihistamines and allergy products (BENADRYL, BENADRYL-D, BENADRYL COLD, BENADRYL DAY & NIGHT and BENADRYL ALLERGY/SINUS/HEADACHE), hemorrhoidal preparations (ANUSOL, ANUSOL HC-1 and TUCKS), vaginal moisturizers (REPLENS), laxatives (AGORAL), cough syrups/suppressants (BENYLIN, BENYLIN-DM, BENYLIN DECONGESTANT, BENYLIN EXPECTORANT and BENYLIN PEDIATRIC), cough tablets (HALLS and HALLS-PLUS), throat drops (HALLS SOOTHERS), vitamin C drops (HALLS), vitamins (MYADEC), antipruritics (CALADRYL, BENADRYL spray and cream and STINGOSE), rubbing alcohol (LAVACOL), hydrogen peroxide (PROXACOL), self-diagnostic early pregnancy test kits (e.p.t'r' stick test), oral antiseptics (LISTERINE and COOL MINT LISTERINE), mouthwash/anticavity dental rinses (LISTERMINT with fluoride), effervescent denture cleaning tablets and denture cleanser pastes (EFFERDENT and FRESH 'N BRITE) and denture adhesives (EFFERGRIP). These products are promoted principally through consumer advertising and promotional programs and some are promoted directly to health care professionals. They are sold principally to drug wholesalers, chain and retail pharmacies, chain and independent food stores, mass merchandisers, physician supply houses and hospitals. In December 1993, Warner-Lambert signed separate agreements with Glaxo Holdings plc ('Glaxo') and Wellcome plc ('Wellcome') to establish joint ventures in various countries to develop and market non-prescription consumer health care products. Pursuant to the agreements with Glaxo, Warner-Lambert and Glaxo formed a joint venture in the United States named Glaxo Warner-Lambert OTC G.P. The joint venture will develop, seek approval of and market over-the-counter versions of Glaxo prescription drugs in the United States, including ZANTAC, the leading prescription ulcer treatment product. The joint venture will concentrate initially on developing ZANTAC for sale as an over-the-counter product in the United States. Additional joint ventures are expected to be formed with Glaxo in other major markets outside the United States, excluding Japan. Direction of the joint ventures will be provided by a management committee of representatives from each company. Day-to-day operations will be the responsibility of Warner-Lambert, and the joint ventures' over-the-counter products will be sold by Warner-Lambert's consumer health care products sales and marketing organization, which in most countries will be a Warner Wellcome joint venture, as described below. Warner-Lambert and Glaxo will share development costs and profits equally, with Glaxo receiving a royalty on all over-the-counter sales by the joint ventures. Pursuant to the agreements with Wellcome, Warner-Lambert and Wellcome formed a joint venture in the United States and a joint venture in Canada, each named Warner Wellcome Consumer Health Products. Joint ventures are expected to be established by Warner-Lambert and Wellcome in Europe, Australia and other countries throughout the world. The alliance calls for both companies to contribute to the joint ventures current and future over-the-counter products (excluding HALLS and ROLAIDS products). Under the agreements, after a two-year phase-in period, Warner-Lambert and Wellcome respectively will receive approximately 70 percent and 30 percent of the profits generated in the United States. A New Drug Application ('NDA') for the conversion to over-the-counter use of Wellcome's anti-viral drug ZOVIRAX as an anti-herpes medication was filed with the U.S. Food and Drug Administration ('FDA') in August 1993. Subject to such conversion, over-the-counter profits on ZOVIRAX in the United States will be shared in favor of the innovator, Wellcome. Profits on current products will be shared equally in Canada and, when joint ventures are established in such countries, in Australia and the European countries. Profits on ZOVIRAX cream outside the United States will also be shared equally, subject to a royalty to Wellcome if sales exceed a threshold amount. Other future over-the-counter switch products will be subject to a profit split favoring the innovator. Warner-Lambert will be the managing partner of the joint ventures with Wellcome (referred to herein as the 'Warner Wellcome' joint ventures or organizations), with day-to-day operating responsibility. Each partner will continue to manufacture products it contributes to the joint ventures. Glaxo Warner-Lambert OTC G.P. commenced operations in December 1993. The Warner Wellcome joint ventures in the United States and Canada commenced operations in January 1994. Warner Wellcome organizations are expected to be formed in Europe and Australia in 1994. Shaving Products: Warner-Lambert manufactures and/or sells razors and blades, both domestically and internationally. In March 1993, Warner-Lambert acquired the European, U.S. and Canadian operations of Wilkinson Sword, an international manufacturer and marketer of razors and blades. Shaving products are manufactured and/or marketed under the SCHICK, WILKINSON, WILKINSON SWORD and related trademarks. Permanent (nondisposable) products marketed under the SCHICK trademark include TRACER/FX, SUPER II, SUPER II PLUS, ULTREX PLUS, SLIM TWIN, ADVANTAGE, PERSONAL TOUCH and INJECTOR PLUS CHROMIUM. Disposable twin blade products marketed under the SCHICK trademark include SCHICK DISPOSABLE, SLIM TWIN, PERSONAL TOUCH, PERSONAL TOUCH SLIM and ULTREX DISPOSABLE. Products marketed under the WILKINSON or WILKINSON SWORD trademarks include nondisposable systems such as PROTECTOR, PROFILE, SYSTEM II and DUPLO, and disposable products that include COLOURS, PRONTO, RETRACTOR, RETRACTOR TWIN, SHAVA II and ULTRA CARESSE LADYSHAVER. These products are distributed directly to large retail outlets, as well as to wholesalers for sale to smaller retailers, drugstores and pharmacies. Retail outlets include pharmacies, food stores, department stores, variety stores, mass merchandisers and other miscellaneous outlets. Pet Care Products: Warner-Lambert manufactures and sells various products on a worldwide basis for ornamental fish and for other small pets, as well as books relating to various pets, under the trademark TETRA. In addition, in September 1993 Warner-Lambert acquired Willinger Bros., Inc., a manufacturer and distributor of aquarium products (including power filters and replacement cartridges, air pumps, plastic plants and other accessories) that are marketed largely under the WHISPER and SECONDNATURE trademarks. These pet care products are promoted to consumers through cooperative advertising and to retailers through direct promotion and advertising in trade publications. They are sold to wholesalers for sale to smaller retailers and directly to larger chain stores and retailers, in each case for ultimate sale to consumers. Confectionery Products The principal products of Warner-Lambert in its Confectionery Products segment are chewing gums and breath mints. Warner-Lambert manufactures and/or sells, in the United States and/or internationally, a broad line of chewing gums and breath mints, as well as specialty candies. Among these products are slab chewing gums (TRIDENT, DENTYNE and DENTYNE SUGARFREE), chunk bubble gums (BUBBLICIOUS, BUBBLICIOUS MONDO and TRIDENT SOFT), center-filled gums (FRESHEN-UP), candy-coated gums (CHICLETS, CHICLETS TINY SIZE and CLORETS) and stick gums (CLORETS, CINN*A*BURST and MINT*A*BURST). The breath mint line includes CERTS, SUGARFREE CERTS, SUGARFREE CERTS MINI-MINTS, CERTS EXTRA FLAVOR and CLORETS. These products are promoted directly to the consumer primarily through consumer advertising and in-store promotion programs. They are sold directly to chain and independent food stores, chain pharmacies and mass merchandisers or through candy and tobacco wholesalers and to other miscellaneous outlets which in turn sell to consumers. In the fourth quarter of 1993, Warner-Lambert sold the assets of its chocolate/caramel business, including the Junior Mints'r', Sugar Daddy'r', Sugar Babies'r', Charleston Chew!'r' and Pom Poms'r' product lines, in order to refocus its resources on its core pharmaceutical and consumer products businesses. Novon Products Group NOVON is the trademark for a family of specialty polymers based upon starch and other fully biodegradable materials. Warner-Lambert discontinued the operations of its Novon Products Group as of November 30, 1993, primarily in order to focus its resources on its core business areas. Warner-Lambert has entered into agreements with licensees and is currently in discussions with respect to the sale of substantially all of the intellectual property and certain other assets of the business. In the first quarter of 1993, Warner-Lambert recorded a one-time charge of $70 million before tax or $45 million after-tax, in connection with the disposition of the Novon Products Group. The charge included a write-down of Novon's physical assets to net realizable value, as well as a provision for additional anticipated costs to be incurred during the phase-out period. INTERNATIONAL OPERATIONS Although Warner-Lambert has globalized its organization on a segment basis, Warner-Lambert's international businesses are carried on principally through subsidiaries and branches, which are generally staffed and managed by citizens of the countries in which they operate. Approximately 23,000 of Warner-Lambert's employees are located outside the United States and only a small number of such employees are United States citizens. Certain of the products discussed above are manufactured and marketed solely in the United States and certain of such products are manufactured and marketed solely in one or more foreign countries. International sales to unaffiliated customers in 1993 amounted to approximately 53% of worldwide sales. International sales do not include United States export sales, which represent less than 1% of domestic sales. The seven largest markets with respect to the distribution of Warner-Lambert products sold outside the United States during 1993 were Japan, Germany, Canada, Mexico, France, the United Kingdom and Italy. Sales in these markets accounted for approximately 64% of Warner-Lambert's international sales, with no one country accounting for more than 17% of international sales. The international operations are subject to certain risks inherent in carrying on business abroad, including possible nationalization, expropriation and other governmental action, as well as fluctuations in currency exchange rates. RESTRUCTURING In November 1993, Warner-Lambert announced a program covering the rationalization of manufacturing facilities, principally in North America, including the eventual closing of seven plants, an organizational restructuring and related workforce reductions of approximately 2,800 positions over the next several years. The program was prompted by the combined impact of rapid and profound changes in the Company's competitive environment, including the growing impact of managed health care and other cost-containment efforts in the United States, cost regulations in Europe and changes in U.S. tax law (discussed below under the caption 'Regulation'). For further discussion of Warner-Lambert's restructuring, see 'Management's Discussion and Analysis of Financial Condition and Results of Operations -- Restructuring Actions' and Note 3 to the Company's consolidated financial statements, contained in the Warner-Lambert 1993 Annual Report and incorporated herein by reference. COMPETITION Most markets in which Warner-Lambert is engaged are highly competitive and characterized by substantial expenditures in the advertising and promotion of new and existing products. In addition, there is intense competition in research and development in all of Warner-Lambert's industry segments. No material part of the business of any of Warner-Lambert's industry segments is dependent upon one or a few customers. However, the Company cannot predict what effect, if any, the health care proposals described below under the caption 'Regulation' may have on its operations. MATERIALS AND SUPPLIES Warner-Lambert's products, in general, are produced and packaged at its own facilities. Other than certain generic drug products, relatively few items are manufactured in whole or in part by outside suppliers. Raw materials and packaging supplies are purchased from a variety of outside suppliers. The loss of any one source of supply would not have a material effect on the business of any of Warner-Lambert's industry segments. Warner-Lambert seeks to protect against fluctuating costs and to assure availability of raw materials and packaging supplies by, among other things, locating alternative sources of supply and, in some instances, making selective advance purchases. TRADEMARKS AND PATENTS Warner-Lambert's major trademarks are protected by registration in the United States and other countries where its products are marketed. Warner-Lambert believes these trademarks are important to the marketing of the related products and acts to protect them from infringement. Warner-Lambert owns many patents and has many patent applications pending in the patent offices of the United States and other countries. Although a number of products and product lines have patent protection that is significant in the marketing of such products, the management of Warner-Lambert does not consider that any single patent or related group of patents is material to Warner-Lambert's business as a whole or any of its industry segments. On January 4, 1993, the United States patent for LOPID expired, subjecting LOPID to generic competition, as discussed above under the caption 'Business Segments -- Pharmaceutical Products'. RESEARCH AND DEVELOPMENT Warner-Lambert employs over 2,000 scientific and technical personnel in research and development activities at various research facilities located in the United States and in foreign countries. Warner-Lambert invested approximately $465 million in research and development in 1993, compared with $473 million in 1992 and $423 million in 1991. Approximately eighty-two percent (82%) of Warner-Lambert's 1993 research and development spending was for research and development related to pharmaceutical products. Warner-Lambert believes research and development activities are essential to its business and intends to continue such activities. EMPLOYEES At December 31, 1993 approximately 35,000 people were employed by Warner-Lambert throughout the world. REGULATION Warner-Lambert's business is subject to varying degrees of governmental regulation in the countries in which it manufactures and distributes products, and the general trend in these countries is toward more stringent regulation. In the United States, the food, drug and cosmetic industries have been subject to regulation by various federal, state and local agencies with respect to product safety and effectiveness, manufacturing and advertising and labeling. Accordingly, from time to time, with respect to particular products under review, such agencies may require Warner-Lambert to participate in meetings, whether public or private, to address safety, efficacy, manufacturing and/or regulatory issues, to conduct additional testing or to modify its advertising and/or labeling. During the third quarter of 1993, a consent decree with the FDA was entered into by Warner-Lambert and Melvin R. Goodes, Chairman and Chief Executive Officer, and Lodewijk J. R. de Vink, President and Chief Operating Officer, covering issues related to compliance with manufacturing and quality procedures. The decree is a court-approved agreement that primarily requires Warner-Lambert to certify that laboratory and/or manufacturing procedures at its pharmaceutical manufacturing facilities in the United States and Puerto Rico meet current Good Manufacturing Practices established by the FDA. Under the terms of the decree, Warner-Lambert was permitted to ship inventory existing at the time of entry of the decree of most of its products, and has been permitted to continue to manufacture and ship prescription medications deemed medically necessary while the certification process is ongoing. The manufacture and distribution of its remaining products was suspended pending completion of certain certification procedures. Warner-Lambert's manufacturing facilities in the mainland United States quickly resumed substantially full operations. The bulk of the prescription products manufactured at the two Puerto Rico facilities were deemed medically necessary and had no significant interruption in supply, and the production of certain other products has been transferred from such facilities to mainland U.S. facilities or sourced from third parties. There are several prescription products that have not yet returned to the market or have been withdrawn. It is not possible to predict when the manufacturing facilities in Puerto Rico will be fully operational, although Warner-Lambert is actively working with outside experts and the FDA to accomplish this as soon as possible. Compliance with FDA restrictions, including the consent decree, resulted in an estimated aggregate loss of sales revenue of approximately $135 million in 1993. Pursuant to the FDA's Application Integrity Policy, Warner-Lambert, through independent experts in pharmaceutical manufacturing, is also conducting validity assessments of FDA filings made with respect to products manufactured or to be manufactured at its facilities in Vega Baja and Fajardo, Puerto Rico, due to discrepancies found in data generated at those facilities. The FDA has deferred substantive scientific reviews of pending NDA's and Abbreviated New Drug Applications ('ANDA's') for products to be manufactured at these facilities (including the oral contraceptive ESTROSTEP), and for supplements to NDA's or ANDA's for products currently manufactured at these facilities, until further assessments of Warner-Lambert filings are completed. The FDA did not suspend review of two potentially medically important drugs, COGNEX (tacrine) and NEURONTIN (gabapentin), discussed under the caption 'Business Segments -- Pharmaceutical Products' above, both of which obtained U.S. marketing approval in 1993. Warner-Lambert has pledged its full cooperation and has actively worked with the FDA in order to resolve all issues relating to this matter. Warner-Lambert expects to file shortly the expert validity assessments that have not yet been filed. The FDA will review all of these filings, as well as a Corrective Action Plan the Company is currently preparing, which outlines mechanisms in place to prevent a recurrence of the data integrity issue. The FDA will then inspect the two facilities prior to lifting the Application Integrity Policy. It is not possible to predict when the Application Integrity Policy will be lifted or whether the FDA will take additional action. Regulatory requirements concerning the research and development of drug products have increased in complexity and scope in recent years. This has resulted in a substantial increase in the time and expense required to bring new products to market. At the same time, the FDA requirements for approval of generic drugs (drugs containing the same active chemical as an innovator's product) have been decreased by the adoption of abbreviated new drug approval procedures for most generic drugs. Generic versions of many of Warner-Lambert's products in the Pharmaceutical Products segment are being marketed, and generic substitution legislation, which permits a pharmacist to substitute a generic version of a drug for the one prescribed, has been enacted in some form in all states. These factors have resulted in increased competition from generic manufacturers in the market for ethical products. For example, LOPID has been subject to this increased competition since its patent expired on January 4, 1993, as discussed above under the caption 'Business Segments -- Pharmaceutical Products'. Federal legislation enacted in late 1990 prohibits the expenditure of federal Medicaid funds for outpatient drugs of manufacturers that do not agree to pay specified rebates. Similar legislation has been enacted in several states extending rebates to state administered non-Medicaid programs. Warner-Lambert has been adhering to such rebate programs and other related rebate programs and has incurred rebate expenses of $57 million, $37 million and $15 million in 1993, 1992 and 1991, respectively. However, Warner-Lambert does not believe such rebate expenses have had, or will have, a material adverse effect upon its financial position. The Clinton Administration has identified the containment of health care costs as a major priority. The Administration's proposed health care plan, along with a number of alternative proposals, has negative implications for the pharmaceutical industry. Although Warner-Lambert cannot predict at this time which legislation, if any, will be enacted, it is likely that such legislation would result in increased pressures on the operating results of Warner-Lambert. In addition, primarily as a result of the passage by Congress of the Omnibus Budget Reconciliation Act of 1993, including changes to Section 936 of the Internal Revenue Code, Warner-Lambert estimates that its effective tax rate will increase in 1994 by approximately 1.5 to 2.5 percentage points. The regulatory agencies under whose purview Warner-Lambert operates have administrative and legal powers that may subject Warner-Lambert and its products to seizure actions, product recalls and other civil and criminal actions. They may also subject the industry to emergency regulatory requirements. Warner-Lambert's policy is to comply fully with all regulatory requirements. It is impossible to predict, however, what effect, if any, these matters or any pending or future legislation, regulations or governmental actions may have on the conduct of Warner-Lambert's business in the future. In most of the foreign countries where Warner-Lambert does business, it is subject to a regulatory and legislative climate similar to or more restrictive than that described above. Certain health care reform measures enacted in 1993 in Germany, including the imposition of price reductions on pharmaceutical products and prescribing restrictions on doctors, had a negative impact on Warner-Lambert's pharmaceutical operations in Germany in 1993 and are expected to have a negative impact on such operations in 1994. The long-term impact of such measures on Warner-Lambert's operations cannot be assessed at this time. ENVIRONMENT Warner-Lambert is responsible for compliance with a number of environmental laws and regulations. While Warner-Lambert has maintained control systems designed to assure compliance in all material respects with environmental laws and regulations, during 1993 it initiated a worldwide audit program to assure environmental compliance with a growing number of increasingly complex environmental regulations. Warner-Lambert is involved in various environmental matters, including actions initiated by the Environmental Protection Agency (the 'EPA') under the Comprehensive Environmental Response, Compensation and Liability Act, also known as Superfund, by state agencies under similar state legislation, or by other parties. The Company is presently remediating environmental problems at certain sites, including sites it previously owned. While it is not possible to predict the outcome of the proceedings described above or the ultimate costs of remediation, the management of Warner-Lambert believes it is unlikely that their ultimate disposition will have a material adverse effect on Warner-Lambert's financial position, liquidity, cash flow or results of operations for any year. Actions with respect to environmental programs and compliance result in operating expenses and capital expenditures. Warner-Lambert's capital expenditures with respect to environmental programs and compliance in 1993 were not, and in 1994 are not expected to be, material to the business of Warner-Lambert. For additional information relating to environmental matters, see Note 14 to the consolidated financial statements, 'Environmental Liabilities', on page 43 of the Warner-Lambert 1993 Annual Report, incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES. The executive offices of Warner-Lambert are located in Morris Plains, New Jersey. In the United States, including Puerto Rico, Warner-Lambert owns facilities aggregating approximately 6,464,000 square feet and leases facilities having an aggregate of approximately 874,000 square feet. Warner-Lambert's principal U.S. manufacturing plants are located in Lititz, Pennsylvania (pharmaceuticals and consumer health care); Rockford, Illinois (confectionery and consumer health care); Rochester, Michigan (pharmaceuticals); Holland, Michigan (pharmaceuticals); Greenwood, South Carolina (capsules); and Milford, Connecticut (razors and blades). Warner-Lambert Inc., a wholly owned subsidiary of Warner-Lambert operating in Puerto Rico, has plants located in Carolina (confectionery); Fajardo (pharmaceuticals); and Vega Baja (pharmaceuticals, consumer health care and confectionery). In November 1993, in connection with the restructuring discussed above under the caption 'Business -- Restructuring', Warner-Lambert announced plans to phase out and close its Carolina, Puerto Rico confectionery manufacturing plant by the end of 1994. In the United States, Warner-Lambert currently distributes its various products through its manufacturing plants and two primary distribution centers located in Lititz, Pennsylvania and Elk Grove, Illinois. Principal U.S. research facilities are located in Ann Arbor, Michigan (pharmaceuticals) and Morris Plains, New Jersey (pharmaceuticals, consumer health care and confectionery). Internationally, Warner-Lambert owns, leases, or operates, through its subsidiaries or branches, 72 production facilities in 35 countries. Principal international manufacturing plants are located in Germany, the United Kingdom, Belgium, Italy, Canada, Mexico, Hong Kong, Japan, Ireland, Spain, France, Brazil, Venezuela and Australia. Principal international research facilities are located in Germany, Japan, the United Kingdom and Canada. In order to increase efficiency and to lower its cost of goods sold, Warner-Lambert, over a number of years and at significant cost, has consolidated many of its plants and facilities around the world. This has often resulted in the production of pharmaceutical products, consumer health care products and/or confectionery products at a single facility. Warner-Lambert's facilities are generally in good operating condition and repair and at present are adequately utilized within reasonable limits. Leases are not material to the business of Warner-Lambert taken as a whole. For information regarding the organizational restructuring and plant rationalization announced by Warner-Lambert in November 1993, see 'Business -- Restructuring' above. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Warner-Lambert and certain present and former employees have been served with subpoenas by the U.S. Attorney's office in Maryland, which is conducting an inquiry relating to compliance with FDA regulations, to produce records and/or appear before a federal grand jury in Baltimore. Warner-Lambert is cooperating with the inquiry and cannot predict what the outcome of the investigation will be. In September 1993, Warner-Lambert received a Complaint and Compliance Order from the EPA seeking penalties of $268,000 for alleged violations of the Resource Conservation and Recovery Act, Boilers and Industrial Furnace regulations. Warner-Lambert responded to the complaint in October 1993. The Company is contesting the allegations and has entered into negotiations with the EPA. Warner-Lambert, along with numerous other pharmaceutical manufacturers and wholesalers, has been sued in a number of state and federal antitrust lawsuits by retail pharmacies seeking treble damages and injunctive relief. These actions arise from alleged price discrimination by which the defendant drug companies, acting alone or in concert, are alleged to have favored institutions, managed care entities, mail order pharmacies and other buyers with lower prices for brand name prescription drugs than those afforded to plaintiff retailers. The federal cases have been consolidated by the Judicial Panel on Multidistrict Litigation and transferred to the United States District Court for the Northern District of Illinois for pre-trial proceedings. The state cases, which are pending in California, are expected to be coordinated in the Superior Court of California, County of San Francisco. Warner-Lambert believes that these actions are without merit and will defend itself vigorously. Although it is too early to predict the outcome of these actions, Warner-Lambert does not expect this litigation to have a material adverse effect on its financial position, liquidity, cash flow or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to the executive officers of Warner-Lambert as of March 1, 1994 is set forth below: (table continued on next page) (table continued from previous page) (table continued on next page) (table continued from previous page) (table continued on next page) (table continued from previous page) All of the above-mentioned officers, with the exception of Dr. Cuatrecasas, Mr. Fotiades, Mr. Gross and Dr. Kumar, have been employed by Warner-Lambert for the past five years. Dr. Cuatrecasas has been employed by Warner-Lambert since October 1989. Prior to that time, Dr. Cuatrecasas had been employed as Senior Vice President, Research and Development, at Glaxo, Inc. from February 1986 to August 1989. Glaxo, Inc., a multinational pharmaceutical company, had sales of approximately $3.5 billion for the year ending June 1988. Prior to his employment with Glaxo, Dr. Cuatrecasas had been employed since 1975 as Vice President, Research, Development and Medical, at Burroughs Wellcome Company. Burroughs Wellcome Company is a wholly owned subsidiary of The Wellcome Foundation Ltd., a multinational pharmaceutical company which had sales of approximately $1.5 billion in 1986. Mr. Fotiades has been employed by Warner-Lambert since November 1992. Prior to that time, Mr. Fotiades had been employed by Bristol-Myers Squibb Company. From January 1992 to November 1992, Mr. Fotiades held the position of President, Consumer Products, Japan and from January 1991 to January 1992 he served as Senior Vice President, General Manager, Clairol U.S., Bristol-Myers Squibb Company, a multinational health care and consumer products company with sales of approximately $11.0 billion in 1992. Prior to his employment with Bristol-Myers Squibb, he held the position of Senior Vice President, Marketing, Boyle-Midway, American Home Products Corporation, from August 1988 to December 1990. American Home Products Corporation, a multinational health care and food products company, had sales of approximately $6.8 billion in 1990. From September 1987 to July 1988, Mr. Fotiades held the position of General Manager, Antiperspirant/Deodorant, the Proctor & Gamble Company, a multinational consumer products company with sales of approximately $21.3 billion for the year ended June 30, 1989. Mr. Gross has been employed by Warner-Lambert since January 1990. Prior to that time, Mr. Gross had been employed since 1963 by General Electric Company in various executive positions. From January 1987 to March 1989, Mr. Gross held the position of Vice President and General Manager, GE Silicones. General Electric Company, a multinational diversified company, had sales in excess of $38.0 billion in 1988. Dr. Kumar has been employed by Warner-Lambert since October 1992. Prior to that time, Dr. Kumar had been employed since January 1986 by Pepsico, Inc. From February 1990 to October 1992 Dr. Kumar held the position of Senior Vice President, Research & Development, Pepsi Worldwide Beverage. From February 1988 to February 1990 he held the position of Vice President, Research & Development, Pepsi Worldwide Beverage, and from January 1986 to February 1988, the position of Vice President, Research & Development, Pepsi U.S.A. Pepsico, Inc. is in the beverage, snack food and restaurant business, both domestically and internationally, with sales of approximately $22 billion in 1992. None of the above officers has any family relationship with any Director or with any other officer. Officers are elected by the Board of Directors for a term of office lasting until the next annual organizational meeting of the Board of Directors or until their successors are elected and have qualified. No officer listed above was appointed pursuant to any arrangement or understanding between such officer and the Board of Directors or any member or members thereof. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information set forth under the caption 'Management's Discussion and Analysis of Financial Condition and Results of Operations -- Shareholder Information' on page 33 of the Warner-Lambert 1993 Annual Report is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information set forth under the caption 'Five-Year Summary of Selected Financial Data' on page 34 of the Warner-Lambert 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 of Financial Condition and Results of Operations' on pages 28 through 33 of the Warner-Lambert 1993 Annual Report is incorporated herein by reference and should be read in conjunction with the consolidated financial statements and the notes thereto contained on pages 34 through 47 of the Warner-Lambert 1993 Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of Warner-Lambert and its subsidiaries, together with the report thereon of Price Waterhouse dated January 24, 1994, listed in Item 14(a)1 and included in the Warner-Lambert 1993 Annual Report at pages 35 through 48, are 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. The required information relating to the Warner-Lambert Directors and nominees is incorporated herein by reference to pages 2 through 7 of the Warner-Lambert Proxy Statement for the Annual Meeting of Stockholders to be held on April 26, 1994. Information relating to executive officers of Warner-Lambert is set forth in Part I of this Form 10-K on pages 9 through 13. Information relating to compliance with Section 16(a) of the Securities Exchange Act of 1934 is contained in the Proxy Statement, referred to above, at page 8 and such information is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information relating to executive compensation is contained in the Proxy Statement, referred to above in Item 10, at pages 11 through 22 and such information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) Information relating to the beneficial ownership of more than five percent of Warner-Lambert's Common Stock is contained in the Proxy Statement, referred to above in Item 10, at page 9 and such information is incorporated herein by reference. (b) Information relating to security ownership of management is contained in the Proxy Statement, referred to above in Item 10, at page 8 and such information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Not Applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) 1. ALL FINANCIAL STATEMENTS The following items are included in Part II of this report through incorporation by reference to pages 35 through 48 of the Warner-Lambert 1993 Annual Report: Consolidated Statements of Income for each of the three years in the period ended December 31, 1993. Consolidated Statements of Retained Earnings for each of the three years in the period ended December 31, 1993. Consolidated Balance Sheets at December 31, 1993 and 1992. Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993. Notes to Consolidated Financial Statements. Report of Independent Accountants. 2. FINANCIAL STATEMENT SCHEDULES Included in Part IV of this report: Report of Independent Accountants on Financial Statement Schedules. Schedule I -- Marketable Securities -- Other Investments 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 of Property, Plant and Equipment Schedule VIII -- Valuation and Qualifying Accounts and Reserves Schedule IX -- Short-term Borrowings Schedule X -- Supplementary Income Statement Information Schedules other than those listed above are omitted because they are either not applicable or the required information is included through incorporation by reference to pages 35 through 48 of the Warner-Lambert 1993 Annual Report. 3. EXHIBITS (3) Articles of Incorporation and by-laws (a) Restated Certificate of Incorporation of Warner-Lambert Company filed November 10, 1972, as amended to April 24, 1990 (Incorporated by reference to Warner-Lambert's Current Report on Form 8-K, dated April 24, 1990). (b) By-Laws of Warner-Lambert Company, as amended to October 25, 1988 (Incorporated by reference to Warner-Lambert's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988 (File No. 1-3608)). (4) Instruments defining the rights of security holders, including indentures (a) Rights Agreement, dated as of June 28, 1988, and amended as of June 27, 1989, between Warner-Lambert Company and First Chicago Trust Company of New York, as Rights Agent (Incorporated by reference to Warner-Lambert's Registration Statement on Form 8-A, dated June 28, 1988, as amended by Form 8, dated July 5, 1989 (File No. 1-3608)). (b) Warner-Lambert agrees to furnish to the Commission, upon request, a copy of each instrument with respect to issues of long-term debt of Warner-Lambert. The principal amount of debt securities authorized under each such instrument does not exceed 10% of the total assets of Warner-Lambert. (10) Material contracts (12) Computation of Ratio of Earnings to Fixed Charges. (13) Copy of the Warner-Lambert Company Annual Report for the fiscal year ended December 31, 1993. Such report, except for those portions thereof which are expressly incorporated by reference herein, is furnished solely for the information of the Commission and is not to be deemed 'filed' as part of this filing. (21) Subsidiaries of the registrant. (23) Consent of Independent Accountants. - ------------ * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 14(c). (B) REPORTS ON FORM 8-K A Current Report on Form 8-K, dated December 13, 1993, was filed with the Securities and Exchange Commission in connection with the announcement of Warner Lambert's signing of separate agreements establishing joint ventures with Glaxo Holdings plc and Wellcome plc. Warner-Lambert will furnish to any holder of its securities, upon request and at a reasonable cost, copies of the Exhibits listed in Item 14. WARNER-LAMBERT COMPANY AND CONSOLIDATED SUBSIDIARIES REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Shareholders of WARNER-LAMBERT COMPANY Our audits of the consolidated financial statements referred to in our report dated January 24, 1994 appearing on page 48 of the 1993 Annual Report to Shareholders of Warner-Lambert Company (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed 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 Morristown, New Jersey January 24, 1994 SCHEDULE I WARNER-LAMBERT COMPANY AND SUBSIDIARIES MARKETABLE SECURITIES -- OTHER INVESTMENTS DECEMBER 31, 1993 SCHEDULE II WARNER-LAMBERT COMPANY AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (1) In connection with the relocations of Mr. Joseph E. Smith and Dr. Pedro M. Cuatrecasas, interest-free loans, secured by real estate, were granted. The terms of the loans, including provisions relating to acceleration and repayment, depend on various factors. SCHEDULE V WARNER-LAMBERT COMPANY AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (a) Other Changes included reclassifications, activity related to restructuring actions and assets of companies acquired. (b) Additions in 1993 included capitalized leases of $13.6 million. SCHEDULE VI WARNER-LAMBERT COMPANY AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (a) As a result of the restructuring actions discussed in Note 3 to the consolidated financial statements, accumulated depreciation was increased by $108.5 million and $84.9 million in 1993 and 1991, respectively, reflecting the write-down of assets to their net realizable values. Note: Depreciation is calculated using estimated useful lives of 20 to 50 years for buildings, and 3 to 15 years for machinery, furniture and fixtures. SCHEDULE VIII WARNER-LAMBERT COMPANY AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (a) Primarily the write-off of accounts receivable considered uncollectible. (b) The addition to allowance for deferred tax assets of $108.9 million reflects $92.0 million for the adoption of Statement of Financial Accounting Standards (SFAS) No. 109, 'Accounting for Income Taxes,' as of January 1, 1993, and $16.9 million for 1993 additions (see Note 19 to the consolidated financial statements). SCHEDULE IX WARNER-LAMBERT COMPANY AND SUBSIDIARIES SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (a) At the end of any quarter. (b) Average of month-end balances. (c) The weighted average interest rate was calculated by relating appropriate interest expense to monthly aggregate borrowings. (d) Notes payable -- banks consist primarily of foreign currency short-term loans, terms of which vary with each agreement. (e) Commercial paper is issued in the United States with average maturities of approximately one month and is supported by lines of credit. (f) Other notes payable primarily include master notes which mature every six months and are renewable at the option of Warner-Lambert. (g) High interest rates on certain loans in South America increased the weighted average interest rates. These rates exclude the effect of foreign exchange gains attributable to the debt, which tend to offset the higher interest costs in highly inflationary economies. SCHEDULE X WARNER-LAMBERT COMPANY AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The amounts charged to costs and expenses in the consolidated statements of income are: Taxes other than payroll and income taxes, and royalties were not significant. 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. WARNER-LAMBERT COMPANY Registrant 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. STATEMENT OF DIFFERENCES The registered trademark shall be expressed as 'r'. Subscript numerics in chemistry notation shall be expressed as baseline numerics, e.g., sulfur hexaflouride would be expressed as SF6. EXHIBIT INDEX

81020_1993.txt

81020_1993

1993

81020

ITEM 1. BUSINESS Organization PSI Energy, Inc. (Energy) is a wholly-owned subsidiary of PSI Resources, Inc. (Resources). . Merger Agreement with The Cincinnati Gas & Electric Company (CG&E) - Refer to the information appearing in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on page 17 and Notes 19, 20, and 21 of the "Notes to Consolidated Financial Statements" beginning on page 61. . IPALCO Enterprises, Inc.'s Withdrawn Acquisition Offer - Refer to the information appearing in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on page 19. The Company Energy is an Indiana corporation engaged in the production, transmission, dis- tribution, and sale of electric energy in north central, central, and southern Indiana. It serves an estimated population of 1.9 million people located in 69 of the state's 92 counties including the cities of Terre Haute, Kokomo, Columbus, Lafayette, Bloomington, and New Albany. PSI Energy Argentina, Inc. (PSI Energy Argentina), a wholly-owned subsidiary of Energy, is an Indiana corporation which was incorporated in 1992. The corporation was formed for the purpose of acquiring, purchasing, owning, and holding the stock of other energy, environmental, or functionally-related corporations and as a holding company for Energy's other energy ventures. PSI Energy Argentina is a member of a multinational consortium which has controlling ownership of Edesur, S.A. (Edesur). Edesur is an electricity- distribution network serving the southern half of Buenos Aires, Argentina. Edesur provides distribution services to 1.8 million customers. PSI Energy Argentina owns a small equity interest in this project and provides operating and consulting services. Regulation Energy, being a public utility under the laws of Indiana, is regulated by the Indiana Utility Regulatory Commission (IURC) as to its retail rates, services, accounts, depreciation, issuance of securities, acquisitions and sales of utility properties, and in other respects as provided by Indiana law. Energy is also subject to regulation by the Federal Energy Regulatory Commission (FERC) with respect to borrowings and the issuance of securities not regulated by the IURC, the classification of accounts, rates to wholesale customers, interconnection agreements, and acquisitions and sales of certain utility properties as provided by Federal law. Fuel Supplies Energy has both long- and short-term coal supply agreements for a major portion of the coal requirements for its generating stations from mines located principally in Indiana and Illinois. Several of these agreements include extension options, and some are subject to price revision. Energy monitors alternative sources to assure a continuing availability of economical fuel supplies. At the present time, Energy is evaluating the use of western and midwestern coal blends in connection with its plans to comply with the acid rain provisions of the Clean Air Act Amendments of 1990. Refer to the information appearing in Note 15(c) of the "Notes to Consolidated Financial Statements" on page 59. Customer, Kilowatt-hour Sales, and Revenue Data The area served by Energy is a residential, agricultural, and widely diver- sified industrial territory. Approximately 98% of Energy's operating revenues are derived from sales of electricity. As of December 31, 1993, Energy supplied electric service to over 624,000 customers in approximately 700 cities, towns, unincorporated communities, and adjacent rural areas, including municipal utilities and rural electric cooperatives. No one customer accounts for more than 5% of electric operating revenues. Sales of electricity by Energy are affected by the various seasonal patterns throughout the year and, therefore, its operating revenues and associated operating expenses are not generated evenly during the year. Power Supply Energy and 28 other electric utilities in an eight-state area are participating in the East Central Area Reliability Coordination Agreement for the purpose of coordinating the planning and operation of generating and transmission facilities to provide for maximum reliability of regional bulk power supply. Energy's electric system is interconnected with the electric systems of CG&E, Kentucky Utilities Company, Louisville Gas and Electric Company, Indianapolis Power & Light Company, Indiana Michigan Power Company, Northern Indiana Public Service Company, Central Illinois Public Service Company, Southern Indiana Gas and Electric Company, and Hoosier Energy R.E.C., Inc. In addition, Energy has a power supply relationship with Wabash Valley Power Association, Inc. (WVPA) and Indiana Municipal Power Agency (IMPA) through power coordination agreements. These two entities are also parties with Energy to a Joint Transmission and Local Facilities Agreement. Competition Refer to the information appearing under the caption "Competitive Pressures" in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on page 12. Environmental Matters Refer to the information appearing in "Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on page 12. Employees The number of employees of Energy at December 31, 1993, was 4,235. ITEM 2. ITEM 2. PROPERTIES Refer to the information appearing in Note 17 of the "Notes to Consolidated Financial Statements" on page 60. Substantially all electric utility plant is subject to the lien of Energy's first mortgage bond indenture. Energy operates six steam electric generating stations, one hydroelectric generating station, and 16 rapid-start internal combustion generating units, all within the State of Indiana. Energy owns all of the above, except for 49.95% of Gibson Unit 5 which is jointly owned with WVPA (25%) and IMPA (24.95%). Company-owned system generating capability as of December 31, 1993, was 5,807 megawatts (mw). Additionally, in May 1993, the IURC issued "certificates of need" for Energy and Destec Energy, Inc.'s 262-mw clean coal power generating facility to be located at Energy's Wabash River Generating Station. The clean coal facility consists of a coal gasification plant and a gas turbine generator. Exhaust heat from the gas turbine (192 mw) will produce steam to repower an existing steam turbine (70 mw). Refer to the information appearing under the caption "New Generation" in "Management's Discussion and Analysis of Financial Condition and Results of Operations" on page 26. Energy's 1993 summer peak load, which occurred on August 26, was 4,812 mw, and its 1993 winter peak load, which occurred on February 18, was 4,155 mw, exclu- sive of off-system transactions. For the period 1994 to 2003, summer and winter peak load and kilowatt-hour (kwh) sales are each forecasted to have annual growth rates of 2%. These forecasts reflect Energy's assessment of load growth, alternative fuel choices, population growth, and housing starts. These forecasts exclude non-firm power transactions and any potential long- term firm power sales at market-based prices. As of December 31, 1993, Energy's transmission system consisted of 719 circuit miles of 345,000 volt line, 656 circuit miles of 230,000 volt line, 1,601 circuit miles of 138,000 volt line, and 2,418 circuit miles of 69,000 volt line, all within the State of Indiana. As of the same date, Energy's transmission substations had a combined capacity of 20,520,154 kilovolt- amperes and the distribution substations had a combined capacity of 5,952,175 kilovolt-amperes. For the year ended December 31, 1993, 99% and 1% of Energy's kwh production was obtained from coal-fired generation and hydroelectric generation, respectively. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Merger Agreement Litigation Resources' original merger agreement with CG&E was amended in response to a June 25, 1993, ruling by the IURC which dismissed a petition by Energy for approval of the transfer of its license or property to CINergy Corp., an Ohio corporation, pursuant to the original merger agreement. The IURC held that such transfer could not be made to a corporation incorporated outside of Indiana. Under the terms of the amended merger agreement, CINergy Corp. (CINergy), a Delaware corporation, will be the parent holding company of Energy and CG&E and will be required to register under the Public Utility Holding Company Act of 1935 (PUHCA). Pursuant to the amended merger agreement, Energy agreed to appeal the IURC's decision or take other action to obtain the permission of the IURC for a non-Indiana corporation to own Energy's assets. Energy has appealed the IURC's decision. In the event the appeal or other action is successful, the parties to the amended merger agreement could take actions to achieve the original merger structure. The original structure provided that Resources, Energy, and CG&E would be merged into CINergy Corp., an Ohio corporation. Under this structure, Energy and CG&E would become operating divisions of CINergy Corp., ceasing to exist as separate corporations, and CINergy Corp. would not be a registered holding company under the PUHCA. Any action taken with respect to this litigation is not expected to delay the merger of Resources and CG&E under a registered holding company structure. The Katz Action On March 16, 1993, after the announcement of IPALCO Enterprises, Inc.'s acquisition offer, a purported class action was filed by Moise Katz (Katz Action) in the Superior Court for Hendricks County in the State of Indiana (Superior Court) in which Resources and the directors of Resources and Energy were named as defendants. The Katz Action alleges, among other things, that the directors breached their fiduciary duties in connection with the original merger agreement, Resources Stock Option Agreement (see Note 19 of the "Notes to Consolidated Financial Statements" beginning on page 61), and Resources Shareholder Rights Plan and seeks, among other things, to enjoin the CINergy merger transaction and to require that an auction for Resources be held. On April 7, 1993, Resources and the other defendants filed a motion to dismiss the Katz Action, and on July 1, 1993, the Superior Court granted that motion. On July 19, 1993, the Superior Court issued an order which vacated its July 1, 1993, order but granted Resources' motion to dismiss Count I of the Katz Action for failure to bring the breach of fiduciary duty claims in a derivative proceeding. On August 18, 1993, a purported third amended class action and derivative complaint was filed in the Katz Action, seeking injunctive relief and damages for alleged breach of fiduciary duty by the directors of Resources. Among other things, this complaint alleges that the defendants failed to disclose (i) the factors that Resources' Board of Directors considered in reaffirming its recommendation that Resources' shareholders approve the merger with CG&E and whether those factors included a consideration of the divestiture of the CG&E gas operations; (ii) whether and to what extent Lehman Brothers took into consideration the divestiture of the CG&E gas operations, and the ramifications thereof, in rendering its July 2, 1993, fairness opinion regarding the merger with CG&E; (iii) the pro forma effect on the merged company taking into consideration the divestiture of the CG&E gas operations; (iv) whether the "comparable" company analysis performed by Lehman Brothers consisted of companies operating electrical systems or gas and electrical systems and whether such analysis included or excluded the CG&E gas operations; and (v) whether Resources' Board of Directors was informed of the ramifications of the divestiture of the CG&E gas operations and to what extent, if any, Resources' Board of Directors took into consideration such ramifications before it endorsed the amended merger agreement to Resources' shareholders. Resources denies these allegations. Resources anticipates that the dismissal of the PSI Merger Shareholder Action and the resolution of related attorney fees, as discussed below, will result in the dismissal of the Katz Action. The foregoing descriptions of the July 1993 orders and the August 18, 1993, third amended complaint in the Katz Action are qualified in their entirety by reference to copies of such orders incorporated by reference as exhibits hereto. The PSI Merger Shareholder Action On March 17, 1993, a purported class action was filed by Lydia Grady (Grady Action) in the Superior Court in which Resources and 13 directors of Resources and Energy were named as defendants. On April 13, 1993, the Indiana District Court issued an order which, among other things, consolidated the Grady Action with the following cases: J.E. and Z.B. Butler Foundation v. PSI Resources, Inc., et al.; Lamont Carpenter, et al. v. PSI Resources, Inc., et al.; Ronald Gaudiano, et al. v. PSI Resources, Inc., et al.; and Sonny Merrit v. PSI Resources, Inc., et al. (together, the "PSI Merger Shareholder Action"). On July 19, 1993, a hearing was held in the Indiana District Court in the PSI Merger Shareholder Action on the plaintiffs' motion for a preliminary injunction. On August 5, 1993, the Indiana District Court issued an order granting the preliminary injunction sought by the plaintiffs and ordered Resources, within 20 days, to provide shareholders with certain additional information relating to the pro forma effect on CINergy Corp.'s financial condition of the possible divestiture of CG&E's gas operations. The Indiana District Court also ordered additional disclosure concerning, among other things, Lehman Brothers' consideration of that possibility in connection with its July 2, 1993, fairness opinion to Resources' Board of Directors. Resources complied with this order in its Proxy Statement Supplement dated August 12, 1993. In January 1994, the parties in the PSI Merger Shareholder Action as well as the parties to the Katz Action signed a Stipulation and Agreement of Dismissal (the "Stipulation"). The Stipulation contemplates, among other things, that the parties will jointly move the Indiana District Court for entry of a final order dismissing the PSI Merger Shareholder Action with prejudice and ruling on the plaintiffs' application for fees and expenses. The parties to the Stipulation have agreed to provide notice to Resources' shareholders of a hearing during which the proposed final order will be considered by the Indiana District Court. If the plaintiffs are entitled to recover these fees, Resources does not anticipate this cost to have a material adverse effect on its financial condition. The foregoing descriptions of the April 13, 1993, class actions consolidation order, and the August 5, 1993, Indiana District Court order are qualified in their entirety by reference to copies of such documents incorporated by reference as exhibits hereto. In addition to the above litigation, see Notes 2, 3(a), and 15(b) and (c) beginning on pages 43, 45, and 58, respectively, of the "Notes to Consolidated Financial Statements". ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Age at Dec. 31, Name 1993 Office & Date Elected or in Job James E. Rogers 46 Chairman, President and Chief Executive Officer - 1990 Chairman and Chief Executive Officer - 1988 Jon D. Noland 55 Executive Vice President and Chief Administration Officer - 1992 Executive Vice President - 1990 Executive Vice President - Law and Regulation - 1989 Executive Vice President - Law and Financial Services - 1986 Joseph W. Messick, Jr. 54 Senior Vice President and Chief Engineering and Construction Officer - 1992 Senior Vice President and Chief Operating Officer - Power System Operations - 1990 Senior Vice President - Power System Operations - 1989 Senior Vice President - Power - 1988 Larry E. Thomas 48 Senior Vice President and Chief Operations Officer - 1992 Senior Vice President and Chief Operating Officer - Customer Operations - 1990 Senior Vice President - Customer Operations - 1986 J. Wayne Leonard 43 Senior Vice President and Chief Financial Officer - 1992 Vice President and Chief Financial Officer - 1989 Vice President - Corporate Planning - 1987 Cheryl M. Foley 1/ 46 Vice President, General Counsel and Secretary - 1991 Vice President and General Counsel - 1989 Vice President and General Counsel - Interstate Pipelines - Enron Corporation 2/ - 1987 M. Stephen Harkness 45 Treasurer - 1991 Treasurer and Assistant Secretary - 1986 Charles J. Winger 48 Comptroller - 1984 EXECUTIVE OFFICERS OF THE REGISTRANT (continued) None of the officers are related in any manner. Executive officers of Energy are elected to the offices set opposite their respective names until the next annual meeting of the Board of Directors and until their successors shall have been duly elected and shall have been qualified. 1/ Prior to joining Energy, Mrs. Foley was vice president and general counsel for various divisions/subsidiaries of Enron Corporation, a diversified energy company headquartered in Houston, Texas. 2/ Non-affiliate of Energy. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All Energy common stock is held by Resources; therefore, there is no public trading market for Energy common stock. All Energy cumulative preferred stock sold publicly (except 3 1/2% Series) is listed on the New York Stock Exchange. Refer to the information in Notes 6 and 7 of the "Notes to Consolidated Financial Statements" beginning on page 48. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION The financial condition of PSI Energy, Inc. (Energy), the principal subsidiary of PSI Resources, Inc. (Resources), is currently, and will continue to be, significantly affected by: . The changing competitive environment for electric utilities, including more intense competition in wholesale power markets and emerging competition for the provision of energy services to retail customers, particularly industrial; . The regulatory response to the changing competitive environment, including the application of incentive ratemaking, the need for more flexible pricing, and the treatment of business alliances entered into in response to such changes (e.g., the merger with The Cincinnati Gas & Electric Company [CG&E] discussed further herein); and . The substantial costs associated with Energy's construction program, including environmental compliance and the regulatory response to the potentially significant earnings attrition resulting from such program. Energy's goal is to achieve the financial measures necessary to assure access, at a reasonable cost, to the capital required to finance its construction program, which is necessary to provide adequate and reliable service to its customers. Specific financial objectives include achieving and maintaining common equity at a minimum of 45% of capitalization, achieving at least an "A" credit rating on senior securities, and increasing the common dividend in an orderly manner. Energy's achievement of its goal is increasingly dependent upon maintaining its favorable competitive position. Competitive Pressures The increasing competitive pressures in the electric utility industry are primarily driven by the need of U.S. industries for low cost power in order to remain competitive in the global marketplace. The restrictions on access to low cost power are exacerbated by cost-of-service regulation which has produced average industrial rates to customers that vary substantially across the U.S. (from 3 cents per kilowatt-hour [kwh] to over 10 cents per kwh). Although the electric utility industry has already experienced substantial competition in the wholesale power market, the effect of competition has arguably had only a marginal effect on the overall profitability of the industry. The effect of the Energy Policy Act of 1992 (Energy Act), the most comprehensive energy legislation enacted since the late 1970s, is to essentially provide open competition, at the wholesale level, for new generation resources. The Energy Act increases the level of competition by creating a new class of wholesale power providers that are not subject to the restrictive requirements of the Public Utility Holding Company Act of 1935 (PUHCA) nor the ownership restrictions of the Public Utility Regulatory Policies Act of 1978. This, combined with the provision of the Energy Act granting the Federal Energy Regulatory Commission (FERC) the authority to order wholesale transmission access, makes the competition real in the wholesale power market. However, by prohibiting the FERC from ordering utilities to provide transmission access to retail customers (retail wheeling), Congress clearly intended to allow states to decide whether a competitive generation market will extend to retail customers. In the face of ongoing international competition, Energy believes major industrial customers of electric utilities will continue to pressure state legislatures and utility regulatory commissions to permit retail wheeling. Although specific proposals for retail wheeling have not been advanced in Indiana, at least eight states are at various stages in considering proposals for retail wheeling. In the fourth quarter of 1993, major credit rating agencies issued reports sounding a warning as to the long-term effect of competition on the electric utility industry. Standard & Poor's (S&P), in particular, announced fundamental changes in the way it evaluates credit quality of electric utilities, essentially declaring its view that business risk is increasing, in part, because electric utility prices will be capped at some level established by competition, regardless of the particular company's costs. Not only will it be difficult for high cost producers to secure further rate increases, they also will likely experience substantial price decreases as competition intensifies. Consequently, it appears inevitable that high cost producers will require better financial fundamentals than low cost producers to secure the same credit rating. Specifically, S&P has categorized each electric utility's business position, ranking it as being above average, average, or below average. As a result, S&P revised the rating outlooks of approximately one-third of the electric utility industry from stable to negative and placed several electric utilities on CreditWatch with negative implications. Energy believes the concerns raised by S&P and other major credit rating agencies, in part, explain recent activity in the electric utility segment of the stock market. The electric utility group dropped substantially more in the fourth quarter of 1993 than the bond market (usually a barometer for electric utility stocks). As a result, the yield spread between long-term U.S. Treasuries and electric utility stocks dropped from the 3 to 5 year average of 110 to 120 basis points to 20 to 30 basis points. During this same period, several "sell-side" equity analysts have expressed their concerns in written reports that investors, particularly small retail investors, do not currently understand the increased business risk facing electric utilities due to competitive pressures, the threat of lower prices to customers, and the threat of "regulated competition". As a result, some equity analysts believe that electric utility stock prices were driven upwards to near record market to book levels by investors seeking higher yields during a period of lower interest rates without full recognition of the changed risks in the industry. Similar to S&P's analysis of fixed income securities, Energy believes that many equity analysts are now basing their buy-sell equity recommendations for electric utility stocks, in large part, on (i) the price position of the utility relative to neighboring competition, (ii) the elasticity of the current customer make-up, particularly industrial, (iii) the response of state regulators to competitive issues, and (iv) the aggressiveness of management in "inventing its own future". Energy believes it is well positioned to succeed in the increasingly competitive environment. Energy's favorable competitive position is a result of and/or will be enhanced by: . The consummation of the merger with CG&E which will combine two low cost providers of electric energy and provide substantial competitive benefits and opportunities; . Energy's demonstrated ability to be a low cost producer of electric energy. Energy has consistently held operating cost increases below inflation and has current average retail rates below 1983 levels. This low cost position is further illustrated in a December 1993 report (using 1992 data) by Bear, Stearns & Co., Inc. which listed Energy as the third lowest cost (fixed plus variable production costs) provider of generation among 28 utilities in the North Central Region of the U.S. Additionally, in a May 1993 study (using 1992 data) by Regulatory Research Associates, Inc. (RRA) of 135 major investor-owned operating utilities and holding companies, Energy's average industrial rate of 3.5 cents per kwh was approximately 30% lower than the national average industrial rate of 5.1 cents per kwh. This same study also indicated that the average rate for Energy's retail customers of 4.6 cents per kwh was at least 35% below the national average of 7.1 cents per kwh, and lower than at least 85% of the companies included in the study. Further, Energy's average industrial and retail rates were both at least 15% below the North Central Region of the U.S. average rates derived from the data relating to these utilities included in the May 1993 RRA report; . Management's focus on flexible strategies which are directed toward reducing its cost structure and reducing operating leverage, in part, by shifting the cost mix from fixed to variable. For example, Energy is actively enforcing its rights under its existing coal contracts, litigating where necessary, in order to significantly lower fuel costs. Energy has also recently received approval of its emission allowance banking strategy, which is expected not only to substantially reduce Energy's future cost structure and capital outlays, but also to greatly enhance its flexibility to meet future energy needs and environmental requirements. Additionally, Energy intends to purchase power to defer the construction of new generation which will likely be further deferred if the merger with CG&E is consummated; and . Energy's success at creating customer value, as demonstrated by customer satisfaction levels at the top of a peer group of 16 electric and combination electric and gas utilities. This success was further demonstrated during 1993 as several mayors and leaders of communities within Energy's service territory, including over 30 economic development organizations across Energy's service territory and eight Indiana environmental groups, actively supported Energy in its response to IPALCO Enterprises, Inc.'s (IPALCO) hostile takeover attempt, as the electric utility of choice to serve their communities. Energy further believes its low cost position and strategic initiatives will allow it to maintain, and perhaps expand, its wholesale market share and its current base of industrial customers. Sales to industrial customers represented approximately 28% of Energy's 1993 total operating revenues. During the fourth quarter of 1993, S&P, using its revised benchmarks for rating electric utility senior securities, placed Energy in an above average business position. At the same time, certain sell-side equity analysts placed Energy near the top of their lists of those best equipped to handle increasing competitive pressures. Energy believes that the reaction of these equity analysts and the stock market in 1993 supports its position that its competitive strategy will be successful. According to a January 1994 edition of Electric Utility Week, the 32.5% increase in Resources' stock price was the third highest of the 105 utilities studied, while the group as a whole averaged only a 5.5% gain over 1992. Increasing competitive pressures, and the regulatory response thereto, may ultimately result in some electric utilities being unable to continue their current basis of accounting. The basis of accounting currently followed by most regulated electric utilities is based on the premise that customer rates authorized by regulators are cost based and that a utility will be able to charge and collect rates based on its costs. To the extent regulators no longer provide assurances for recovery of a utility's costs or the marketplace does not allow the pricing necessary to fully recover costs, a regulated utility could be required to prepare its financial statements on the same basis as enterprises in general for all or some portion of its business. Energy believes its low cost position and competitive strategy, combined with its current regulatory environment, would mitigate the potentially adverse effects of such changes. Securities Ratings The current ratings of Energy's senior securities reflect the risk associated with the costs of achieving compliance with environmental laws and regulations. However, Duff & Phelps, Fitch Investors Service, and S&P continue to place Energy's debt ratings on review for possible upgrade primarily as a result of the announced merger with CG&E. The ratings are currently as follows: First Mortgage Bonds and Secured Preferred Medium-term Notes Stock Duff & Phelps BBB+ BBB Fitch Investors Service BBB+ BBB Moody's Baa1 baa2 Standard & Poor's BBB+ BBB These securities ratings may be revised or withdrawn at any time, and each rating should be evaluated independently of any other rating. Significant Achievements The following events during 1993 indicate Energy's progress towards achieving its financial objectives: . The announced merger with CG&E, which was initiated in response to the changing competitive environment in the electric utility industry, was approved by shareholders of Resources and CG&E in November 1993 (see Merger Agreement with CG&E discussion beginning on page 17); . In October 1993, Resources' Board of Directors increased its quarterly common dividend 3 cents (10.7%), to 31 cents per share. This marks the fourth consecutive year in which the dividend has increased at a double-digit rate and is an integral part of the ongoing effort to strengthen and broaden the market for Resources' common stock. Future increases in Resources' common dividend will continue to be influenced by Energy's financial condition (see Dividend Restrictions discussion on page 32). Resources currently has an effective shelf registration statement for the sale of up to eight million shares of common stock; . The Indiana Utility Regulatory Commission (IURC) issued an order approving Energy's plan for complying with Phase I of the acid rain provisions of the Clean Air Act Amendments of 1990 (CAAA) and Energy's emission allowance banking strategy (see Regulatory Matters and Capital Needs discussions beginning on pages 20 and 23, respectively); . Energy filed testimony with the IURC in support of a $103 million, 11.6% retail rate increase. This testimony also includes proposals for certain innovative ratemaking mechanisms designed to reduce business and regulatory risks over the next three years (see Regulatory Matters discussion beginning on page 20); . In accordance with a January 1993 IURC order, Energy implemented accounting changes on certain major capital projects to offset the effects of regulatory lag, i.e., earnings attrition. These accounting changes favorably affected 1993 earnings by approximately $7 million. Energy's current retail rate proceeding includes a proposal to continue this accounting treatment for certain major capital projects (see Regulatory Matters discussion beginning on page 20); . Energy refinanced $223 million of long-term debt and preferred stock to take advantage of lower interest and dividend rates. Energy expects to save approximately $4 million in annualized interest and preferred stock dividends as a result of these refinancings; and . The IURC approved a settlement agreement which resolved outstanding issues related to the IURC's April 1990 rate order (April 1990 Order) and June 1987 tax order (June 1987 Order) (see Regulatory Matters discussion beginning on page 20). Although this settlement resulted in a significant customer refund, it resolved major uncertainties with respect to Energy's financial condition. Recent Developments Merger Agreement with CG&E General Resources, Energy, and CG&E entered into an Agreement and Plan of Reorganization dated as of December 11, 1992, which was subsequently amended and restated on July 2, 1993, and as of September 10, 1993 (as amended and restated, the "Merger Agreement"). Under the Merger Agreement, Resources will be merged with and into a newly formed corporation named CINergy Corp. (CINergy) and a subsidiary of CINergy will be merged with and into CG&E ("CG&E Merger", collectively referred to as the "Mergers"). Following the Mergers, CINergy will be the parent holding company of Energy and CG&E and will be required to register under the PUHCA. The combined entity will be the 13th largest investor-owned electric utility in the nation, based on generating capacity, and will serve approximately 1.3 million electric customers and 420,000 gas customers in a 25,000-square-mile area of Indiana, Ohio, and Kentucky. See the discussion under "Shareholder and Regulatory Approvals" for information concerning the possible divestiture of CG&E's gas operations as a consequence of the Mergers. Customer revenue requirement savings as a result of the Mergers are estimated to be approximately $1.5 billion over the first 10 years. These savings are expected to include the elimination or deferral of certain capital expenditures and a reduction in production, administrative, and financing costs. The Merger Agreement can be terminated by any party, without financial penalty, if the Mergers are not consummated by June 30, 1994. Under certain circumstances, the termination of the Merger Agreement would result in the payment of termination fees, which may not exceed $70 million, if Resources is required to pay, or $130 million, if CG&E is required to pay. Exchange Ratio The Merger Agreement provides that, upon consummation of the Mergers, each outstanding share of common stock of Resources will be converted into the right to receive not less than .909 nor more than 1.023 shares of common stock of CINergy depending on certain closing sales prices of the common stock of CG&E during a period prior to the consummation of the Mergers. The Merger Agreement also provides that, upon consummation of the Mergers, each outstanding share of common stock of CG&E will be converted into the right to receive one share of common stock of CINergy. The outstanding preferred stock and debt securities of Energy and CG&E will not be affected. Shareholder and Regulatory Approvals In November 1993, the Mergers were approved by the shareholders of Resources and CG&E. In August 1993, the FERC conditionally approved the Mergers. This conditional approval was made by the FERC without a formal hearing and, according to public statements by the FERC Commissioners, was done in reliance, in part, on the FERC's belief that the regulatory commissions of the affected states would have authority to approve or disapprove the Mergers. The companies accepted the FERC's conditions and indicated their belief that none of the conditions would have a material adverse effect on the operations, financial condition, or business prospects of CINergy. Certain parties petitioned for rehearing of the FERC's conditional approval. On September 15, 1993, Energy and CG&E filed a statement with the FERC clarifying their conclusions at that time that the Mergers would not require any prior approval of a state commission under state law. Given the issues raised on the requests for rehearing and the lack of certainty in the record regarding state regulatory powers, on January 12, 1994, the FERC issued an order withdrawing its prior conditional approval of the Mergers and initiating a 60-day, FERC-sponsored settlement procedure. The settlement procedure is expected to be concluded prior to the end of March 1994. The FERC has indicated that, if the settlement procedure is not successful, it intends to issue a further order setting appropriate issues for hearing. The companies are currently participating in a collaborative process with representatives from the IURC, the Public Utilities Commission of Ohio, various consumer groups, and other parties to settle all merger-related issues. Discussions have also taken place with representatives of the Kentucky Public Service Commission (KPSC) regarding merger-related issues at the FERC. In conjunction with the FERC-sponsored settlement procedure, on February 11, 1994, Energy filed a petition with the IURC requesting approval of various proposals regarding state regulation after consummation of the Mergers. These proposals do not address the allocation between shareholders and customers of projected revenue requirement savings as a result of the Mergers. This allocation will be the subject of a subsequent IURC proceeding. In connection with the 60-day, FERC-sponsored settlement procedure and the collaborative process, Resources, Energy, CINergy, the Indiana Utility Consumer Counselor, the Citizens Action Coalition of Indiana, Inc., and industrial customer representatives reached a global settlement agreement on merger-related issues. This agreement was filed with the IURC on March 2, 1994, and is expressly conditioned upon approval by the IURC in its entirety and without any change or condition that is unacceptable to any party. On March 4, 1994, CG&E, the Public Utilities Commission of Ohio, and the Ohio Office of Consumers Counsel reached an agreement substantially similar to the Indiana agreement. Both settlement agreements were filed with the FERC on March 4, 1994. Energy expects the FERC settlement judge to forward the settlements to FERC Commissioners on or about March 21, 1994, beginning what is normally a 30-day comment period. The Indiana settlement addresses, among other things, the coordination of state and Federal regulation, the operation of the combined Energy and CG&E electric utility system, the allocation of costs and their effect on customer rates, and a retail "hold harmless" provision that provides that Energy's retail rates will not reflect merger- related costs to the extent that they are not offset entirely by merger- related benefits. IURC hearings on the Indiana settlement were held on March 17, 1994. Energy has asked the IURC for an order approving the settlement agreement by early April 1994, which should fall within the expected comment period at the FERC. CG&E also filed with the FERC a unilateral offer of settlement addressing all issues raised in the KPSC's application for rehearing with the FERC. On March 15, 1994, CG&E filed an application with the KPSC seeking approval of the indirect acquisition of control of CG&E's Kentucky subsidiary, The Union Light, Heat and Power Company. Also included in the filings with the FERC were settlement agreements with WVPA and the city of Hamilton, Ohio. These agreements resolve issues related to the transmission of power and operation of Energy's jointly owned transmission system. Negotiations with other parties at the FERC are continuing. Energy and CG&E also filed with the FERC the operating agreement among Energy, CG&E, and CINergy Services, Inc., a subsidiary of CINergy. The parties to the Indiana and Ohio FERC settlements have agreed to support or not oppose the operating agreement, and the settlements are conditioned upon the FERC approving the filed operating agreement without material change. The Mergers are also subject to the approval of the Securities and Exchange Commission (SEC) under the PUHCA. An application requesting such SEC approval is expected to be filed during the first quarter or early second quarter of 1994. The PUHCA imposes restrictions on the operations of registered holding company systems. Among these are requirements that securities issuances, sales and acquisitions of utility assets or of securities of utility companies, and acquisitions of interests in any other business be approved by the SEC. The PUHCA also limits the ability of registered holding companies to engage in non-utility ventures and regulates holding company system service companies and the rendering of services by holding company affiliates to the system's utilities. Also, under the PUHCA, the divestiture of CG&E's gas operations may be required. The companies believe they have a justifiable basis for retention of CG&E's gas operations and will request SEC approval to retain this portion of the business. Divestiture, if ordered, would occur after the consummation of the Mergers. Historically, the SEC has allowed companies sufficient time to accomplish divestitures in a manner that protects shareholder value, which, in some cases, has been 10 to 20 years. The companies' goal is to consummate the Mergers during the third quarter of 1994. However, if the settlement procedure is not successful and a hearing is convened by the FERC, the consummation of the Mergers would likely be further extended. There can be no assurance that the Mergers will be consummated. See Notes 19, 20, and 21 beginning on page 61. IPALCO's Withdrawn Acquisition Offer On March 15, 1993, IPALCO announced its intention to make an offer to exchange IPALCO common stock and cash for all of the outstanding shares of Resources' common stock (Exchange Offer). IPALCO also announced its intention to solicit proxies to vote (i) in favor of its slate of five nominees for the Board of Directors of Resources at Resources' 1993 Annual Meeting of Shareholders and (ii) against the merger with CG&E. On April 21, 1993, IPALCO commenced its Exchange Offer and also commenced solicitation of proxies. On August 23, 1993, at Resources' 1993 Annual Meeting of Shareholders, IPALCO announced that it had received insufficient proxies to elect its nominees to Resources' Board of Directors, and on that same date, terminated its Exchange Offer. On October 27, 1993, Resources, Energy, CG&E, IPALCO, and other parties entered into a settlement agreement pursuant to which the parties agreed to settle all pending issues related to IPALCO's Exchange Offer. Among other things, the parties agreed, for a period of five years, to grant one another transmission access rights to other utilities, in certain circumstances, if those rights are required for one of the parties to obtain approval for a business combination with another utility. The parties would be fully compensated for any facilities made available. Energy currently has an open access tariff that allows other utilities to use its transmission facilities to deliver power, which it believes should be sufficient to satisfy this provision of the settlement agreement. The settlement agreement also provides that Indianapolis Power & Light (IP&L), IPALCO's principal subsidiary, will have the right to purchase power from Energy at current market prices. Energy has offered to sell IP&L up to 100 megawatts of power for each month in 1996 and up to 250 megawatts for each month in the years 1997 through 2000. The offer will remain open for one year, and if IP&L does not accept the offer, it will have a right of first refusal on the power for an additional six months. Regulatory Matters Environmental Order In 1992, Energy filed its plan for complying with Phase I of the acid rain provisions of the CAAA with the IURC. This filing was made pursuant to a state law enacted in 1991 which allows utilities to seek pre- approval of their compliance plans. In October 1993, the IURC issued an order approving Energy's Phase I compliance plan. The IURC's order also approved Energy's emission allowance banking strategy, which will afford Energy greater flexibility in developing its plan for complying with Phase II of the acid rain provisions of the CAAA. The IURC accepted Energy's proposal to annually review the implementation of its Phase I compliance plan and ordered a semi- annual review of Energy's emission allowance banking plan. Energy had proposed innovative performance incentive mechanisms as part of its Phase I compliance plan and emission allowance banking strategy. In its post- hearing filing, Energy requested that the IURC defer consideration of such incentives to Energy's pending retail rate proceeding in which Energy has proposed modified environmental compliance incentives with respect to its emission allowance banking strategy. Rate Case Energy filed testimony with the IURC in support of a $103 million, 11.6% retail rate increase. This rate proceeding addresses the financial and operating requirements of Energy on a "stand-alone" basis without consideration of the anticipated effects of the Mergers. Approximately 3.7% of the rate increase is needed to meet new environmental requirements, 6.6% is primarily needed to meet Energy's growing electric needs, including construction and operation of one combustion turbine generating unit and implementation of demand-side management (DSM) programs, and 1.3% of the increase is necessary for the recognition of postretirement benefits other than pensions on an accrual basis. Energy's petition for an increase in retail rates includes a "performance efficiency plan" which would allow Energy to retain all earnings up to a 12.5% common equity return and provide for sharing of common equity returns from 12.5% to 14.5% between shareholders and ratepayers depending upon Energy's performance on measures of customer prices, customer satisfaction, customer service reliability, equivalent availability of its generating units, and employee safety. All earnings above a 14.5% return on common equity would be returned to ratepayers. In addition, Energy is requesting approval of various ratemaking mechanisms to address regulatory lag on specific environmental and new generation projects to ensure that the interests of ratepayers and shareholders are properly aligned. One such mechanism includes capital costs associated with major environmental compliance projects and the applicable portion of its Wabash River clean coal project (Clean Coal Project) in rate base while the projects are under construction, as permitted by state law, thus allowing Energy to earn a cash return on these costs prior to the projects' in-service dates. Hearings are expected to begin in April 1994, and a final rate order is anticipated in late 1994 or early 1995. Energy cannot predict what action the IURC may take with respect to this proposed rate increase. Settlement Agreement In December 1993, the IURC issued an order (December 1993 Order) approving a settlement agreement entered into by Energy, the appellants, and certain other intervenors which resolved the outstanding issues related to the appeals of the IURC's April 1990 Order and June 1987 Order. At issue with respect to the April 1990 Order was whether the level of return on common equity allowed Energy was adequately supported by factual findings. The April 1990 Order had been remanded to the IURC by the Indiana Court of Appeals for further proceedings, including redetermination of the cost of equity and its components. The June 1987 Order, which related to the effect on Energy of the 1987 reduction in the Federal income tax rate, had been remanded to the IURC by the Indiana Supreme Court and was awaiting a final order from the IURC. The December 1993 Order provides for Energy to refund $150 million to its retail customers ($119 million applicable to the June 1987 Order and $31 million applicable to the April 1990 Order). The December 1993 Order further provides for Energy to reduce its retail rates by 1.5% (approximately $13.5 million on an annual basis) to reflect a return on common equity of 14.25%. The refunds and rate reduction commenced in December 1993 (see Note 3 beginning on page 45). Energy had previously recognized a loss of $139 million for the June 1987 Order. The difference between the $139 million and the $119 million portion of the refund applicable to the June 1987 Order is reflected in the Consolidated Statement of Income for the year ended December 31, 1993, as a reduction of the loss. The $31 million portion of the refund applicable to the April 1990 Order is reflected in the Consolidated Statement of Income for the same period as a reduction in operating revenues. Energy has an agreement through January 1996 to sell, with limited recourse, an undivided percentage interest in certain of its accounts receivable from customers up to a maximum of $90 million. The refund provided for by the December 1993 Order reduced Energy's accounts receivable available for sale and caused a termination event under the agreement governing the sale of accounts receivable. Due to the temporary nature of the event, Energy obtained a waiver of the termination event provision of the agreement as it relates to the refund (see Note 9 beginning on page 49). Manufactured Gas Plants Coal tar residues and other substances associated with manufactured gas plant (MGP) sites have been found at former MGP sites in Indiana, including, but not limited to, two sites previously owned by Energy. Energy has identified at least 21 MGP sites which it previously owned, including 19 it sold in 1945 to Indiana Gas and Water Company, Inc. (now Indiana Gas Company [IGC]). In April 1993, IGC filed testimony with the IURC seeking recovery of costs incurred in complying with Federal, state, and local environmental regulations related to MGP sites in which it has an interest, including sites acquired from Energy. In its testimony, IGC stated that it would also seek to recover a portion of these costs from other potentially responsible parties, including previous owners. The IURC has not ruled on IGC's petition. With the exception of one site (Shelbyville), it is premature for Energy to predict the nature, extent, and costs of, or Energy's responsibility for, any environmental investigations and remediations which may be required at MGP sites owned, or previously owned, by Energy. With respect to the Shelbyville site, for which Energy and IGC are sharing the costs, based upon environmental investigations completed to date, Energy believes that any required investigation and remediation will not have a material adverse effect on its financial condition (see Note 15 beginning on page 58). Other Industry Issues Global Climate Change Concern has been expressed by environmentalists, scientists, and policymakers as to the potential climate change from increasing amounts of "greenhouse" gases released as by-products of burning fossil fuel and other industrial processes. In response to this concern, in October 1993, the Clinton Administration announced its plan to reduce greenhouse gases to 1990 levels by the year 2000. The plan calls for the reduction of 109 million metric tons of carbon equivalents of all greenhouse gases. Initially, the plan would rely largely on voluntary participation of many industries, with a substantial contribution expected from the utility industry. Numerous utilities, including Energy, have agreed to study voluntary, cost-effective emission reduction programs. Energy's voluntary participation would likely include its residential, commercial, and industrial DSM programs, increased use of natural gas in generation, and other energy efficiency improvements, and possibly other pollution prevention measures. The Clinton Administration has stated it will monitor the progress of industry to determine whether targeted reductions are being achieved. If the Clinton Administration or Congress should conclude that further reductions are needed, legislation requiring utilities to achieve additional reductions is possible. Air Toxics The air toxics provisions of the CAAA exempt fossil-fueled steam utility plants from mandatory reduction of 189 listed air toxics until the Environmental Protection Agency (EPA) completes a study on the risk of these emissions on public health. The EPA is not expected to complete its study until November 1995. If additional air toxics regulations are established, the cost of compliance could be significant. Energy cannot predict the outcome of this EPA study. Future Outlook Notwithstanding the anticipated benefits from the timely consummation of the Mergers, further improvement in Energy's financial condition is largely dependent on: . Effectively responding to the increasing competitive pressures in the electric utility industry; . Effectively managing its substantial construction program and achieving favorable results from related regulatory proceedings, including the current retail rate proceeding; . Maintaining a regulatory climate that is responsive to and supportive of changes in the utility industry, including increased competition, business alliances, and the need to more closely align the economic interests of customers and shareholders through the application of incentive ratemaking, and more flexible pricing strategies; and . Successfully accessing financial markets for capital needs, including issuance by Resources of significant amounts of common stock (see Capital Resources discussion beginning on page 27). CAPITAL NEEDS Construction Energy's total construction expenditures over the 1994 to 1998 period are forecasted to be $1.1 billion, of which approximately $.8 billion is for capital improvements to, and expansion of, Energy's operating facilities, $.2 billion is for new generation, and $.1 billion is for environmental compliance. Total construction expenditures for 1993 and forecasted construction expenditures for the 1994 to 1997 period are approximately $.2 billion less than forecasted amounts for the same period reflected in Energy's 1992 Annual Report on Form 10-K, as amended. This reduction reflects continued aggressive management by Energy of its substantial construction program consistent with maintaining its competitive position and providing adequate and reliable service to its customers. (All forecasted amounts are in nominal dollars and reflect assumptions as to the economy, capital markets, construction program, legislative and regulatory actions, frequency and timing of rate increase requests, and other related factors which may be subject to significant change. In addition, forecasted construction expenditures do not reflect any consideration for the effects of the Mergers.) Forecasted construction expenditures by year for new business, system reliability, new generation, environmental, and other projects are presented in the following table: Environmental The acid rain provisions of the CAAA require reductions in both sulfur dioxide (SO2) and nitrogen oxide (NOx) emissions from utility sources. Reductions of both SO2 and NOx emissions will be accomplished in two phases. Compliance under Phase I affects Energy's four largest coal-fired generating stations and is required by January 1, 1995. Phase II includes all of Energy's existing power plants, and compliance is required by January 1, 2000. To achieve the SO2 reduction objectives of the CAAA, SO2 emission allowances will be allocated by the EPA to affected sources. Each allowance permits one ton of SO2 emissions. Energy will receive approximately 277,000 of these emission allowances per year during Phase I. As one of the most affected utilities, Energy will also be entitled to approximately 35,000 "midwestern" bonus allowances per year from 1995 through 1999. In addition, as a member of the Utility Extension Allowance Pooling Group, a group composed of a majority of the affected utilities currently planning to use qualifying Phase I technologies, e.g., flue-gas desulfurization (scrubbers), Energy expects to receive approximately 150,000 allowances during the Phase I period. The CAAA allows compliance to be achieved on a national level, which provides companies the option to achieve compliance by reducing emissions or purchasing emission allowances. The Chicago Board of Trade (CBOT) was authorized to establish a futures- options market, and the CBOT also plans to administer a cash market in emission allowances. In addition, the CBOT will administer the EPA's annual auction and direct sales of emission allowances. In March 1993, the first annual auction of emission allowances was held. The EPA provided 150,000 allowances for this auction with the intent of stimulating the allowance trading market. The allowances provided by the EPA for auction become useable in either the year 1995 or 2000. The average price paid at the auction for an allowance first useable in 1995 was $156, with prices ranging from $131 to $450. Energy purchased 10,000 of these allowances for $150 each. The prices paid at the auction for an allowance first useable in the year 2000 ranged from $122 to $310 with an average of $136. The availability and economic value of allowances in the long-term is still uncertain. As previously discussed, in October 1993, the IURC issued an order approving Energy's Phase I compliance plan and emission allowance banking strategy. To comply with Phase I of the CAAA SO2 requirements, Energy will have to reduce SO2 emissions by approximately 34% (based on an approximate 334,000 ton annual target) from 1991 levels or acquire offsetting emission allowances. Energy's compliance plan for the Phase I SO2 reduction requirements includes the addition of one scrubber at Gibson Unit 4 by late 1994, installation of flue- gas conditioning equipment on certain units, upgrading certain precipitators, implementation of its DSM programs, burning lower-sulfur coal at its four major coal-fired generating stations, and inclusion of the value of emission allowances in the economic dispatch process. To meet NOx reductions required by Phase I, Energy is installing low-NOx burners on affected units at these same stations. Energy's capital expenditures for Phase I compliance projects totaled approximately $290 million through December 31, 1993. In addition, the successful operation of Energy's Clean Coal Project will further reduce SO2 and NOx emissions (see New Generation discussion on page 26). To comply with Phase II SO2 requirements, Energy must reduce SO2 emissions an additional 38% from 1991 levels (based on an approximate 143,000 ton annual cap) or acquire offsetting emission allowances. Own-system compliance alternatives could include additional scrubbers, use of western and midwestern coal blends, installation of precipitators, and installation of flue-gas conditioning equipment. Energy is evaluating these alternatives in order to provide the most cost-effective strategy for meeting Phase II SO2 requirements while maintaining optimal flexibility to meet potentially significant new environmental demands. To meet NOx reductions required by Phase II, Energy plans to install low-NOx burners on affected units. Energy anticipates filing its Phase II plan with the IURC as early as the fourth quarter of 1994. Energy's implementation of its emission allowance banking strategy is a critical component of maintaining optimal flexibility in its Phase II compliance plan. In order to delay or eliminate own-system compliance alternatives, which could be significantly more costly, Energy intends to utilize its emission allowance banking strategy to the extent a viable emission allowance market is available. Energy is forecasting environmental compliance expenditures to meet the acid rain provisions of the CAAA ranging from $.6 billion to $1.2 billion during the 1994 to 2005 period. Energy's Phase I plan is expected to result in banked emission allowances by the year 2000 sufficient to meet its Phase II SO2 requirements for approximately three years. The low-end of the capital costs range assumes that Energy achieves Phase II compliance primarily by purchasing additional emission allowances and continuing to delay, or eliminate, capital intensive alternatives. However, as previously stated, the availability and economic value of emission allowances in the long-term is still uncertain. As such, the high-end of the range assumes that Energy is forced to achieve compliance through the own- system compliance alternatives previously discussed. New Generation In 1992, the United States Department of Energy (DOE) approved for partial funding a joint proposal by Energy and Destec Energy, Inc. (Destec) for a 262- megawatt clean coal power generating facility to be located at Energy's Wabash River Generating Station. In May 1993, the IURC issued "certificates of need" for the project. The total project cost, including construction, Destec's operating costs for a three-year demonstration period, and Energy's operating costs for a one-year demonstration period, is estimated to be $550 million. The DOE awarded the project up to $198 million. Of this amount, Energy will receive approximately $53 million to be used to offset project costs. The remainder of the project costs will be funded by Energy and Destec, with Energy's portion being approximately $108 million. The project is currently under construction and the three-year demonstration period of the project is expected to commence in the third quarter of 1995. In 1992, the IURC issued certificates of need to Energy for the construction of two 100-megawatt combustion turbine generating units adjacent to its Cayuga Generating Station. The first unit went into service in June 1993. Energy intends to defer the second unit until 1996 and will purchase power during the interim period. Other Mandatory redemptions of long-term debt total $97 million during the 1994 to 1998 period (see Note 8 on page 49). Additionally, funds are required to make a payment of $80 million in accordance with the settlement of the Wabash Valley Power Association, Inc. (WVPA) litigation. This payment is not currently expected to occur before 1995 (see Note 2 beginning on page 43). Since 1990, Energy has focused its marketing efforts on the aggressive implementation of various DSM programs. DSM generally refers to actions taken by a utility to affect customers' energy usage patterns. DSM programs are evaluated on an "equal footing" with supply-side options, with the goal of deferring the need for new generating capacity. The expenditures for these programs over the next five years are forecasted to be approximately $185 million. It is anticipated that these expenditures will result in a summer peak demand reduction of 236 megawatts by 1998, of which approximately 77 megawatts have already been achieved. The IURC has authorized Energy to defer DSM expenditures, with carrying costs, for subsequent recovery through rates. In its current retail rate proceeding, Energy has proposed to amortize and recover amounts deferred through July 1993 ($35 million), together with carrying costs, over a four-year period commencing with the effective date of the IURC's order in the current retail rate proceeding. Deferred DSM costs as of the effective date of an order in Energy's current retail rate proceeding, which are not included for recovery in the current proceeding, will continue to be deferred, with carrying costs, for recovery in subsequent rate proceedings. In addition, Energy has proposed the recovery of approximately $23 million of DSM expenditures in base rates on an annual basis. Energy has also requested that the IURC approve the deferral of reasonably incurred DSM expenditures which exceed the base level of $23 million. CAPITAL RESOURCES Cash flows from operations are forecasted to provide approximately 70% of the capital needs during the 1994 to 1998 period. External funds required during this period are estimated to be $.6 billion. (All forecasted amounts are in nominal dollars and reflect assumptions as to the economy, capital markets, construction program, legislative and regulatory actions, frequency and timing of rate increase requests, and other related factors which may be subject to significant change. In addition, forecasted cash flows from operations do not reflect any consideration for the effects of the Mergers.) Internal Cash Flows Over the next several years, Energy's internal cash flows are heavily dependent upon timely retail rate relief and obtaining the related requested modifications to traditional regulation. Integral to this effort is Energy's success in controlling its costs, obtaining performance based regulatory incentives, and securing alternative measures where necessary that allow for ultimate, although deferred, recovery of its costs, including a return to investors. This is especially important during the next three years when Energy's substantial construction program creates potentially significant regulatory lag (i.e., scheduling of capital investment projects cannot be fully synchronized with rate case timing). As previously discussed, Energy has filed testimony with the IURC in support of a $103 million, 11.6% retail rate increase. Approximately 10.3% of the pending rate increase request is needed to meet new environmental requirements and Energy's growing electric needs. Energy is also requesting approval of ratemaking mechanisms to provide more timely recovery of the costs associated with environmental and new generation projects. One such mechanism includes capital costs associated with major environmental compliance projects and the applicable portion of its Clean Coal Project in rate base, while the projects are under construction, as permitted by state law, thus allowing Energy to earn a cash return on these costs prior to the projects' in-service dates. The IURC's ruling in this proceeding is anticipated in late 1994 or early 1995. Where the adverse effects on earnings and cash flows cannot be mitigated by rate relief, Energy is further addressing the issue of regulatory lag through accounting and ratemaking mechanisms that align the interests of customers and shareholders. In January 1993, Energy received authority from the IURC to continue accrual of the debt component of the allowance for funds used during construction (AFUDC) and to defer depreciation expense on its planned combustion turbine generating units and major environmental compliance projects from the respective in-service dates until the effective date of an order in its current retail rate proceeding. Energy has requested similar accounting treatment to mitigate regulatory lag in its current retail rate proceeding. Energy's construction program will require rate relief during the next three years in addition to the current petition. Specifically, Energy expects to file for additional rate relief, primarily to reflect the costs of the Gibson Unit 4 scrubber, the Clean Coal Project, and potentially two additional combustion turbine generating units in rates. All of the major projects (Phase I environmental compliance, the Clean Coal Project, and one of the two combustion turbines) creating the need for retail rate relief have received pre-approval from the IURC for construction. Pre-approval of the second combustion turbine generating unit would be required before commencement of the project. Given its current low cost position, Energy believes that these rate increases, while significant, will not prevent it from maintaining competitive rates over the long-term. Cash flows will be adversely affected by the $150 million refund resulting from the December 1993 Order, which will be partially offset by tax refunds in 1994 of approximately $29 million to realize the remaining tax consequences of the refund. External Financing Energy currently has IURC authority to issue up to an additional $428 million of long-term debt and $40 million of preferred stock. Energy will request regulatory approval to issue additional amounts of debt securities and preferred stock on an as needed basis. As of December 31, 1993, Energy has effective shelf registration statements for the sale of up to $315 million of debt securities and $40 million of preferred stock. In addition, as of December 31, 1993, Resources has an effective shelf registration statement for the sale of up to eight million shares of Resources' common stock. A public offering of Resources' common stock is expected to occur by mid-1994. The net proceeds from the issuance and sale of this common stock will be used by Resources to reduce its short-term indebtedness, with the balance contributed to the equity capital of Energy. Energy will use this contributed capital for general purposes, including construction expenditures. Energy has regulatory authority to borrow up to $200 million under short-term credit arrangements. In connection with this authority, Energy has unsecured, but committed, lines of credit (Committed Lines) which currently permit borrowings of up to $155 million. In addition, Energy has temporary Committed Lines of $15 million. As of December 31, 1993, Energy had $111 million outstanding under these short-term borrowing arrangements. Energy also has Board of Directors approval to arrange for additional short-term borrowings of up to $100 million with various banks (Uncommitted Lines). The Uncommitted Lines are on an "as offered" basis with such banks. Under these arrangements, $16 million was outstanding as of December 31, 1993 (see Note 12 beginning on page 53). Energy believes its current borrowing capacity and Resources' planned common stock issuance will be sufficient to meet short-term cash needs. RESULTS OF OPERATIONS Kilowatt-hour Sales New customers and a return to more normal weather contributed to the 4% increase in total kwh sales in 1993, as compared to 1992. In addition, growth in the primary metals, transportation equipment, and precision instruments, photographic and optical goods sectors resulted in increased industrial sales. Partially offsetting these increases was a reduction in non-firm power sales for resale, which reflected a significant decrease in sales associated with third party short-term power to other utilities through Energy's system. The reduction of sales for resale in 1992 was largely responsible for a 5% decrease in total kwh sales, as compared to 1991. Reflected in this decrease was the reduction of firm power sales to WVPA and the Indiana Municipal Power Agency (IMPA) as they served more of their customers' requirements from their portion of the jointly owned Gibson Unit 5. This resulted from the final (January 1, 1992) scheduled reduction and elimination of Energy's purchase obligations from WVPA and IMPA under the Gibson Unit 5 joint ownership arrangement. In addition, beginning August 1, 1992, WVPA substantially reduced its purchases associated with an interim scheduled power agreement between Energy and WVPA. Non-firm power sales also decreased, partially reflecting a reduction in sales associated with third party short-term power sales to other utilities through Energy's system. The decrease in domestic and commercial sales due to the milder weather experienced in 1992 was offset, in part, by continued growth in industrial sales. Sales increases in 1991 were primarily related to higher sales to retail customers. Specifically, unusually hot temperatures experienced during the second and third quarters of 1991 contributed to increased sales to domestic and commercial customers, whereas industrial sales increased, in part, due to continued growth in production at Nucor Steel. Partially offsetting these increases were decreased sales for resale due to reduced sales to WVPA and IMPA. They served more of their customers' requirements from their portion of the jointly owned Gibson Unit 5 as a consequence of a scheduled (January 1, 1991) reduction (from 156 megawatts to 78 megawatts) in Energy's purchase obligations from WVPA and IMPA under the Gibson Unit 5 joint ownership arrangement. Year-to-year changes in kwh sales for each class of customer are shown below: Energy currently forecasts a 2% annual compound growth rate in kwh sales over the 1994 to 2003 period. This forecast excludes non-firm power transactions and any potential long-term firm power sales at market-based prices. Revenues Revenues in 1993 remained relatively unchanged, reflecting increased kwh sales which were substantially offset by the $31 million refund resulting from the settlement of the April 1990 Order (see Note 3 beginning on page 45) and the effects of lower fuel costs. Total operating revenues decreased $48 million (4%) in 1992, as compared to 1991, primarily as a result of the lower kwh sales previously discussed. In 1991, revenues increased $14 million (1%). The increases realized from kwh sales were partially offset by the effects of the April 1990 (4.25%) retail rate reduction. An analysis of operating revenues for the past three years is shown below: Operating Expenses Fuel Fuel costs, Energy's largest operating expense, decreased $6 million (2%) in 1993. This decrease reflects Energy's continuing efforts to reduce the unit cost of fuel, which include increased purchases in the spot market and realized benefits from price reopener provisions of existing contracts. The following is an analysis of fuel costs for the past three years: Purchased and Exchanged Power In 1993, Energy increased its purchases of non-firm power primarily to serve its own load, which resulted in an increase in purchased and exchanged power of $11 million (77%), as compared to 1992. Purchased and exchanged power decreased $40 million (74%) in 1992, as compared to 1991, reflecting the reduction in third party short-term power sales to other utilities through Energy's system and the scheduled reduction in Energy's purchase obligations from WVPA and IMPA under the Gibson Unit 5 joint ownership arrangement, as previously discussed. Other Operation and Maintenance Charges in 1991 for the incremental non-capital portion ($5 million) of the costs associated with a severe ice and wind storm primarily attributed to the $8 million (3%) decrease in 1992, as compared to 1991. The incremental non-capital portion ($5 million) of storm damage repair costs described above and general inflationary effects on operating costs contributed to other operation and maintenance expenses increasing $15 million (6%) in 1991. Depreciation Additions to electric utility plant led to increases in depreciation expense of $10 million (8%) in 1993 and $6 million (5%) in 1992, when compared to each of the prior years. In 1991, depreciation expense increased $9 million (8%) primarily reflecting additional plant ($7 million) and a full year's effect of the May 1990 revision in depreciation rates ($2 million), following approval by the IURC in its April 1990 Order. Other Income and Expense - Net Other income and expense, excluding the effects of the loss related to the IURC's June 1987 Order, increased $6 million in 1993, as compared to 1992. This increase was due, in part, to the implementation of the January 1993 IURC order authorizing the accrual of post-in-service carrying costs (see Note 1 beginning on page 42). In addition, the equity component of AFUDC increased primarily as a result of increased construction. Interest and Preferred Dividends Increased borrowings and accrued interest of $4 million in connection with the loss related to the IURC's June 1987 Order resulted in increased interest and preferred dividends of $7 million (10%) in 1992, as compared to 1991. ACCOUNTING CHANGES In 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, Employers' Accounting for Postemployment Benefits (Statement 112). Statement 112 establishes accounting standards for the costs of benefits provided to former or inactive employees, including their beneficiaries and dependents, after employment but before retirement. Under the provisions of Statement 112, the costs of these benefits will be recognized for accounting purposes when the employees or their beneficiaries become eligible for such benefits (accrual basis) rather than when such benefits are paid, which is Energy's current practice. Energy's unrecognized and unfunded obligation for these benefits (the transition obligation) as of September 30, 1993, measured in accordance with the new accounting standard, is $8.5 million. The new standard requires immediate recognition of the transition obligation at the date the new standard is adopted. Energy is required to adopt Statement 112 effective January 1, 1994. In connection with its current retail rate proceeding, Energy has requested deferral of the transition obligation for recovery over a reasonable period of time beginning with an order in its next retail rate proceeding. INFLATION In a capital-intensive business such as the utility industry, inflation causes the internal generation of funds to be inadequate to replace and add to productive facilities. Depreciation, based on the original cost of property, does not adequately reflect the current cost of plant and equipment consumed during the year. Accounting based on historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-rate obligations such as long-term debt and preferred stock. Under the ratemaking prescribed by regulatory bodies, depreciation expense recoverable through Energy's rates is based on historical cost. Consequently, cash flows are inadequate to replace property in future years or preserve the purchasing power of common equity capital previously invested. As a result, the common shareholder may experience a significant net purchasing power loss under inflationary conditions. DIVIDEND RESTRICTIONS See Note 6 on page 48 for a discussion of the restrictions on common dividends. Index to Financial Statements and Financial Statement Schedules Page Number Financial Statements Report of Independent Public Accountants. . . . . . . . . 34-35 Consolidated Statements of Income for the three years ended December 31, 1993 . . . . . . . . . . 36 Consolidated Balance Sheets at December 31, 1993 and 1992. . . . . . . . . . . . . . . 37-38 Consolidated Statements of Changes in Common Stock Equity for the three years ended December 31, 1993 . . . . . . . . . . . . . . . . 39 Consolidated Statements of Cash Flows for the three years ended December 31, 1993 . . . . . . 40 Cumulative Preferred Stock. . . . . . . . . . . . . . . . 41 Long-term Debt. . . . . . . . . . . . . . . . . . . . . . 41 Notes to Consolidated Financial Statements. . . . . . . . 42-66 Page Number Financial Statement Schedules Schedule V - Electric Utility Plant . . . . . . . . . . . 79-81 Schedule VI - Accumulated Depreciation. . . . . . . . . . 82-84 Schedule VIII - Valuation and Qualifying Accounts . . . . 85-87 The information required to be submitted in schedules other than those indicated above has been included in the consolidated balance sheets, the consolidated statements of income, related schedules, the notes thereto or omitted as not required by the Rules of Regulation S-X. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of PSI Energy, Inc.: We have audited the consolidated balance sheets of PSI Energy, Inc. (Energy) (a wholly owned subsidiary of PSI Resources, Inc.) and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in common stock 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 management of Energy. 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 Energy and subsidiary 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 more fully discussed in Note 2, Wabash Valley Power Association, Inc. (WVPA) filed suit against Energy for $478 million plus interest and other damages to recover its share of Marble Hill Nuclear Project (Marble Hill) costs. The suit was amended to include as defendants several officers of Energy and certain other parties, and to allege claims under the Racketeer Influenced and Corrupt Organizations Act, which would permit trebling of damages and assessment of attorneys' fees. The suit was further amended to add claims of common law fraud, constructive fraud and deceit and negligent misrepresentation against Energy and the other defendants. Energy and its officers have reached a settlement with WVPA that is subject to the approval of judicial and regulatory authorities and has recorded an estimated loss related to the litigation. The eventual outcome of this litigation cannot presently be determined. As more fully discussed in Notes 11 and 14, effective January 1, 1993, Energy implemented the provisions of Statements of Financial Accounting Standards Nos. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and 109, "Accounting for Income Taxes." 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 on page 33 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our 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. Indianapolis, Indiana, February 22, 1994. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies (a) Consolidation Policy PSI Energy, Inc. (Energy) is a wholly-owned subsidiary of PSI Resources, Inc. (Resources). The accompanying Consolidated Financial Statements include the accounts of Energy and its subsidiary, PSI Energy Argentina, Inc., after elimination of intercompany transactions and balances. (b) Regulation Energy is subject to regulation by the Indiana Utility Regulatory Commission (IURC) and the Federal Energy Regulatory Commission (FERC). Energy's accounting policies conform to generally accepted accounting principles, as applied to regulated public utilities, and to the accounting requirements and ratemaking practices of these regulatory authorities. (c) Electric Utility Plant, Depreciation, and Maintenance Substantially all electric utility plant is subject to the lien of Energy's first mortgage bond indenture (Indenture). Construction work in progress is charged with a proportionate share of overhead costs. Construction overhead costs include salaries, payroll taxes, fringe benefits, and other expenses. Energy capitalizes an allowance for funds used during construction (AFUDC), an item not representing cash income, which is defined in the regulatory system of accounts prescribed by the FERC as the cost of capital used for construction purposes. The AFUDC rate was 9.5% in 1993, 8.5% in 1992, and 12.0% in 1991, and is compounded semi- annually. Energy's provision for depreciation is determined by using the straight-line method applied to the cost of depreciable plant in service. The composite depreciation rate was 3.8% per year during 1991 to 1993. In January 1993, Energy received authority from the IURC to continue accrual of the debt component of AFUDC (post-in-service carrying costs) and to defer depreciation expense (post-in-service deferred depreciation) on its planned combustion turbine generating units and major environmental compliance projects from the date the projects are placed in service until the effective date of an order in Energy's current retail rate proceeding. This proceeding includes a request for authorization to recover a portion of these deferrals and to continue similar accounting treatment on these projects until an order in Energy's next retail rate proceeding. Maintenance and repairs of property units and replacements of minor items of property are charged to maintenance expense. The costs of replacements of property units are capitalized. The original cost of the property retired and the related cost of removal, less salvage recovered, are charged to accumulated depreciation. (d) Federal and State Income Taxes Deferred tax assets and liabilities are recognized for the expected future tax consequences of existing differences between the financial reporting and tax reporting bases of assets and liabilities. Investment tax credits utilized to reduce Federal income taxes payable have been deferred for financial reporting purposes and are being amortized over the useful lives of the property which gave rise to such credits. (e) Operating Revenues and Fuel Costs Energy records revenues each period for energy delivered during the period. Revenues reflect fuel cost charges based on the actual costs of fuel. Fuel cost charges applicable to all of Energy's metered kilowatt-hour sales are included in customer billings based on the estimated costs of fuel. Customer bills are adjusted in subsequent months to reflect the difference between actual and estimated costs of fuel. Indiana law subjects the recovery of fuel costs to a determination that such recovery will not result in earning a return in excess of that allowed by the IURC in its last general rate order. (f) Debt Discount, Premium, and Issuance Expense and Costs of Reacquiring Debt Debt discount, premium, and issuance expense on Energy's outstanding long-term debt are amortized over the lives of the respective issues. Energy defers costs (principally call premiums) arising from the reacquisition of long-term debt and amortizes such amounts over the remaining life of the debt reacquired. (g) Consolidated Statements of Cash Flows All temporary cash investments with maturities of three months or less, when acquired, are reported as cash equivalents. Energy and its subsidiary had no material non-cash investing or financing transactions during the years 1991 to 1993. (h) Reclassification Certain amounts in the 1991 and 1992 Consolidated Financial Statements have been reclassified to conform to the 1993 presentation. 2. WVPA Litigation In February 1984, Wabash Valley Power Association, Inc. (WVPA) discontinued payments to Energy for its 17% share of Marble Hill, a nuclear project jointly owned by Energy and WVPA which was cancelled by Energy in 1984, and filed suit against Energy in the United States District Court for the Southern District of Indiana (Indiana District Court), seeking $478 million plus interest and other damages to recover its Marble Hill costs. The suit was amended to include as defendants several officers of Energy along with certain contractors and their officers involved in the Marble Hill project, and to allege claims against all defendants under the Racketeer Influenced and Corrupt Organizations Act (RICO). Claims proven and damages allowed under RICO may be trebled and attorneys' fees assessed against the defendants. The suit was further amended to add claims of common law fraud, constructive fraud and deceit, and negligent misrepresentation against Energy and the other defendants. In May 1985, WVPA filed for protection under Chapter 11 of the Federal Bank- ruptcy Code. Due to the Chapter 11 filing, Energy and WVPA entered into an agreement under which Energy agreed to place in escrow 17% of all salvage proceeds received from the sales of Marble Hill equipment, materials, and nuclear fuel after May 23, 1985. In February 1989, Energy and its officers reached a settlement with WVPA which, if approved by judicial and regulatory authorities, will settle the suit filed by WVPA. The settlement is also contingent on the resolution of the WVPA bankruptcy proceeding. The principal terms of the settlement are: . Energy, on behalf of itself and its officers, will pay $80 million on behalf of WVPA to the Rural Electrification Administration (REA) and the National Rural Utilities Cooperative Finance Corporation (CFC). The $80 million obligation, net of insurance proceeds, other credits, and applicable income tax effects, was charged to income in 1988 and 1989. . Energy will consent to the disbursement to REA and CFC of the balance in the Marble Hill salvage escrow account. . Energy will pay to REA and CFC 17% of future Marble Hill salvage pro- ceeds, net of related salvage program expenses. . WVPA will transfer its 17% interest in the Marble Hill site to Energy (exclusive of WVPA's interest in future salvage). Energy will assume responsibility for all future costs associated with the site, other than WVPA's 17% share of future salvage program expenses. . Energy will enter into a 35-year take-or-pay power supply agreement for the sale of 70 megawatts of firm power to WVPA. Such power will be supplied from Gibson Unit 1 and will be priced at Energy's firm power rates for service to WVPA. The difference between the revenues received from WVPA and the costs of operating Gibson Unit 1 (the Margin) will be remitted annually by Energy, on behalf of itself and its officers, to REA and CFC to discharge a $90 million obligation, plus accrued interest. If, at the end of the term of the power supply agreement, the $90 million obligation plus accrued interest has not been fully discharged, Energy must do so within 60 days. The settlement provides that in the event Energy is party to a merger or acquisition, Energy and WVPA will use their best efforts to obtain regulatory approval to price the power sale exclusive of the effects of the merger or acquisition. Certain aspects of the settlement are subject to approval by the FERC and potentially by the IURC and the Michigan Public Service Commission. At such time as the necessary approvals from these regulatory authorities are received, Energy will record a $90 million regulatory asset. Concurrently, a $90 million obligation to REA and CFC will be recorded as a long-term commitment. Recognition of the asset is based, in part, on projections which indicate that the Margin will be sufficient to discharge the $90 million obligation to REA and CFC, plus accrued interest, within the 35-year term of the power supply agreement. If, in some future period, projections indicate the Margin would not be sufficient to discharge the obligation plus accrued interest within the 35-year term, the deficiency would be recognized as a loss. The alternative plans of reorganization sponsored by WVPA and REA incorporate the settlement agreement. However, REA's proposed plan provides for full recovery of principal and interest on WVPA's debt to REA, which is substantially in excess of the amount to be recovered under WVPA's proposed plan. In August 1991, the U.S. Bankruptcy Court for the Southern District of Indiana (Bankruptcy Court) confirmed WVPA's plan of reorganization and denied confirmation of REA's opposing plan. The Bankruptcy Court's approval of WVPA's reorganization plan is contingent upon WVPA's receipt of regulatory approval to increase its rates. REA appealed the Bankruptcy Court's decision to the Indiana District Court. Energy cannot predict the outcome of this appeal, nor is it known whether WVPA can obtain regulatory approval to increase its rates. If reasonable progress is not made in satisfying conditions to the settlement by February 1, 1995, either party may terminate the settlement agreement. 3. Rates (a) Settlement Agreement In April 1993, the Indiana Court of Appeals (Court of Appeals) issued a decision in the appeal of the IURC's April 1990 retail rate order (April 1990 Order). In its decision, the Court of Appeals ruled that the level of return on common equity allowed Energy in the April 1990 Order, including the range of common equity return, was not adequately supported by factual findings. The April 1990 Order was remanded to the IURC by the Court of Appeals for further proceedings including a redetermination of the cost of equity and its components. In December 1993, the IURC issued an order (December 1993 Order) approving a settlement agreement entered into by Energy, the appellants, and certain other intervenors which resolved the outstanding issues related to the appeals of the April 1990 Order and the IURC's June 1987 tax order (June 1987 Order), which related to the effect on Energy of the 1987 reduction in the Federal income tax rate. The June 1987 Order had been remanded to the IURC by the Indiana Supreme Court and was awaiting a final order from the IURC. The December 1993 Order provides for Energy to refund $150 million to its retail customers ($119 million applicable to the June 1987 Order and $31 million applicable to the April 1990 Order). The December 1993 Order further provides for Energy to reduce its retail rates by 1.5% (approximately $13.5 million on an annual basis) to reflect a return on common equity of 14.25%. The refunds and rate reduction commenced in December 1993. As of December 31, 1993, approximately $68 million of the $150 million refund has been reflected as a reduction in accounts receivable, with the remaining amount reflected in the accompanying Consolidated Balance Sheet at December 31, 1993, as "Refund due to customers". Energy had previously recognized a loss of $139 million for the June 1987 Order. The difference between the $139 million and the $119 million portion of the refund applicable to the June 1987 Order is reflected in the Consolidated Statement of Income for the year ended December 31, 1993, as a reduction of the loss. The $31 million portion of the refund applicable to the April 1990 Order is reflected in the Consolidated Statement of Income for the same period as a reduction in operating revenues. (b) Current Retail Rate Proceeding Energy filed testimony with the IURC in support of a $103 million, 11.6% retail rate increase. The rate increase is needed to meet new environmental requirements, Energy's growing electric needs, including construction and operation of one combustion turbine generating unit and implementation of demand-side management (DSM) programs, and to recognize postretirement benefits other than pensions on an accrual basis. In addition, Energy is requesting approval of various ratemaking mechanisms to address regulatory lag on specific environmental and new generation projects. Hearings are expected to begin in April 1994, and a final rate order is anticipated in late 1994 or early 1995. 4. Resources' Common Stock Resources' common stock shares reserved for issuance at December 31, 1993, and the shares issued in 1993, 1992, and 1991 were as follows: Resources is a party to two Master Trust Agreements whereby all accrued benefit payments or awards under certain benefit plans are to be funded in the event of a "potential change in control" (as defined in the Master Trust Agreements). The Master Trust Agreements provide for the payment of amounts which may become due under such plans, subject only to claims of general creditors of Resources in the event Resources were to become bankrupt or insolvent. In addition to the above issuances of common stock, as of December 31, 1993, Resources had issued to the trustee of its Master Trust Agreements 1,093,520 shares of common stock for all employees and directors participating in the 1989 Stock Option Plan, and the Employee Stock Purchase and Savings Plan. These issuances were required as a result of the announcement of the merger with The Cincinnati Gas & Electric Company (CG&E) (see Note 19 beginning on page 61). In April 1990, the shareholders of Resources approved an Employee Stock Purchase and Savings Plan designed to conform with Section 423 of the Internal Revenue Code. The initial offering under the plan allowed eligible employees, through payroll deductions, the option to purchase Resources' common stock at $16.51 per share on August 31, 1992, and the second offering under this plan allows for the purchase of Resources' common stock at $18.05 per share on October 31, 1994. With respect to the second offering, eligible employees purchased 71,188 shares of Resources' common stock at $18.05 per share on February 2, 1994. This accelerated opportunity was a result of the approval of the merger with CG&E by Resources' shareholders in November 1993. In January 1994, Resources' Board of Directors approved the issuance of up to 94,364 shares, distributable over two years, under the Performance Shares Plan, a long-term incentive compensation plan for certain officers. Resources currently has an effective shelf registration statement for the sale of up to eight million shares of common stock. 5. Resources' Stock Option Plan In April 1989, the shareholders of Resources approved a stock option plan (1989 Stock Option Plan) under which incentive and non-qualified stock options and stock appreciation rights may be granted to key employees, officers, and outside directors. Common stock granted under the 1989 Stock Option Plan may not exceed 2.5 million shares. Options are granted at the fair market value of the shares on the date of grant, except that non-qualified stock options were granted to two executive officers when the plan was adopted at an option price equal to 91% of the fair market value of the shares at the date of grant. Options have a purchase term of up to 10 years, and all options, not previously vested, became vested upon approval of the merger with CG&E by Resources' shareholders. No incentive stock options may be granted under the plan after January 31, 1999. The 1989 Stock Option Plan activity for 1991, 1992, and 1993 is summarized as follows: No stock appreciation rights have been granted under this plan. The total options exercisable at December 31, 1993, 1992, and 1991, were 1,024,000, 714,900, and 542,400, respectively. 6. Common Stock All of Energy's common stock is held by Resources. No common dividends can be paid by Energy if there are dividends in arrears on its preferred stock. Energy's Indenture provides that, so long as any bonds are outstanding under the Indenture, Energy shall not declare or pay cash dividends on shares of its capital stock (other than on preferred stock) except out of its earned surplus or net profits. In addition, Energy's Amended Articles of Consolidation limit dividends on common stock to 75% of net income available for common stock if the ratio of common stock equity to total capitalization is less than 25%, or to 50% of such net income available if such ratio is less than 20%. Compliance with this provision is determined based on income available for common stock during the preceding 12-month period and the common stock equity balance after payment of the applicable dividend. At December 31, 1993, Energy's common stock equity was 42% of total capitalization, excluding debt due within one year. The above restrictions would limit Energy's common dividends to $347 million as of December 31, 1993. 7. Preferred Stock In 1993, Energy issued $100 million of 7.44% Series Cumulative Preferred Stock, $25 par value. This preferred stock is not redeemable prior to March 1, 1998, and is redeemable thereafter at the option of Energy. In addition, Energy issued $60 million of 6 7/8% Series Cumulative Preferred Stock, $100 par value. This preferred stock is not redeemable prior to October 1, 2003, and is redeemable thereafter at the option of Energy. Energy applied the net proceeds of the $60 million issuance to the refinancing of 162,520 shares of 8.38% Series and 211,190 shares of 8.52% Series, $100 par value, Cumulative Preferred Stock at $101 per share and 216,900 shares of 8.96% Series, $100 par value, Cumulative Preferred Stock at $103 per share in December 1993. As of December 31, 1993, Energy can sell up to an additional $40 million of preferred stock under an effective shelf registration statement and IURC authority. Energy retired 237 shares, 10 shares, and 50 shares in 1993, 1992, and 1991, respectively, of its $100 par value, 3 1/2% Series Cumulative Preferred Stock. In addition, Energy redeemed all 255,000 outstanding shares of its $100 par value, 13.25% Series Cumulative Preferred Stock in 1992 and redeemed 30,000 shares of this series in 1991. 8. Long-term Debt The sinking fund requirements with respect to Energy's long-term debt outstanding at December 31, 1993, are $.2 million in 1994, $.4 million per year during 1995 to 1997, and $.5 million in 1998. Long-term debt maturities for the next five years are $50 million in 1996, $10 million in 1997, and $35 million in 1998. Energy currently has IURC authority to issue up to $428 million of first mortgage bonds or other long-term debt. As of December 31, 1993, Energy can sell up to $315 million of these debt securities under an effective shelf registration statement. 9. Sale of Accounts Receivable Energy has an agreement through January 1996 to sell, with limited recourse, an undivided percentage interest in certain of its accounts receivable from customers up to a maximum of $90 million. As of December 31, 1993, Energy's obligation under the limited recourse provision is $22 million. The refund provided for by the December 1993 Order, as previously discussed (see Note 3 beginning on page 45), reduced accounts receivable available for sale at December 31, 1993, to $40 million. Accounts receivable on the Consolidated Balance Sheets are net of the $40 million and $90 million interest sold at December 31, 1993, and December 31, 1992, respectively. The excess of $90 million over the accounts receivable available for sale at December 31, 1993, is reflected in the Consolidated Balance Sheet as "Advance under accounts receivable purchase agreement". The refund provided for by the December 1993 Order caused a termination event under the agreement governing the sale of accounts receivable. Due to the temporary nature of this event, Energy obtained a waiver of the termination event provision of the agreement as it relates to the refund. Effective February 1, 1991, Energy entered into an interest rate swap agreement which effectively changed Energy's variable interest rate exposure on its sale of accounts receivable to a fixed rate of 8.19%. The interest rate swap agreement matures January 31, 1996. In the event of nonperformance by the other parties to the interest rate swap agreement, Energy would be exposed to floating rate conditions. 10. Pension Plan Energy's defined benefit pension plan (Plan) covers all employees meeting certain minimum age and service requirements. Plan benefits are determined under a final average pay formula with consideration of years of participation, age at retirement, and the applicable average Social Security wage base. Energy's funding policy is to maintain the Plan on an actuarially sound basis. Energy's contribution for the 1993 plan year is $8.2 million. Contributions applicable to the 1992 and 1991 plan years were $7.4 million and $7.9 million, respectively. The Plan's assets consist of investments in equity and fixed income securities. Pension costs for 1993, 1992, and 1991 include the following components: The following table reconciles the Plan's funded status at September 30, 1993, 1992, and 1991 with amounts recorded in the Consolidated Financial Statements. Under the provisions of Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions (Statement 87), certain assets and obligations of the Plan are deferred and recognized in the Consolidated Financial Statements in subsequent periods. 11. Other Postretirement and Postemployment Benefits (a) Postretirement Benefits Energy provides certain health care and life insurance benefits to retired employees and their eligible dependents. Energy's employees are eligible for postretirement health care benefits if they retire at age 55 or older with at least 10 years of service and are eligible for life insurance if they retire with unreduced pension benefits. The health care benefits provided include medical, prescription drugs, and dental. Prior to 1993, the cost of retiree health care was charged to expense as claims were paid and the cost of life insurance benefits was charged to expense at retirement. Energy does not currently pre-fund its obligation for these postretirement benefits. Effective with the first quarter of 1993, Energy implemented the provisions of Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (Statement 106). Under the provisions of Statement 106, the costs of health care and life insurance benefits provided to retirees are recognized for accounting purposes during periods of employee service (accrual basis). The unrecognized and unfunded Accumulated Postretirement Benefit Obligation (APBO) existing at the date of initial application of Statement 106 (i.e., the transition obligation) of $107.6 million is being amortized over a 20-year period. Postretirement benefit costs for 1993 include the following components: Amount (in millions) Benefits earned during the period. . . . . . . . $ 3.4 Interest accrued on APBO . . . . . . . . . . . . 9.3 Amortization of transition obligation. . . . . . 5.4 Total postretirement benefit costs . . . . . . . $18.1 In December 1993, the IURC issued a generic order regarding regulatory treatment of postretirement benefit costs other than pensions determined in accordance with the provisions of Statement 106. In accordance with the provisions of this order, Energy has included a request for recovery of these costs on an accrual basis in its current retail rate proceeding. Prior to the recovery of these costs in customers' rates on an accrual basis, the difference between postretirement benefit costs determined in accordance with the provisions of Statement 106 and the costs determined in accordance with Energy's previous accounting practice is being deferred for future recovery in accordance with the provisions of the generic order. Postretirement benefit costs for 1993, 1992, and 1991, determined in accordance with Energy's previous accounting practice, were $5.3 million, $5.0 million, and $4.6 million, respectively. The following table reconciles the APBO of the health care and life insurance plans at September 30, 1993, with amounts recorded in the Consolidated Financial Statements: Amount (in millions) Actuarial present value of benefits Fully eligible active plan participants . . . . . $ (20.8) Other active plan participants. . . . . . . . . . (54.7) Retirees and beneficiaries. . . . . . . . . . . . (61.5) Projected APBO. . . . . . . . . . . . . . . . . . . (137.0) Unamortized transition obligation . . . . . . . . . 102.2 Benefit payments subsequent to September 30, 1993. . . . . . . . . . . . . . . . 1.1 Unrecognized net loss resulting from experience different from that assumed and effect of changes in assumptions. . . . . . . 16.0 Accrued postretirement benefit obligation at December 31, 1993 . . . . . . . . . . . . . . . . $ (17.7) The weighted-average discount rate used in determining the APBO at September 30, 1993, was 7.5%. The assumed initial health care cost trend rate used in measuring the APBO was 8% for dental and post-65 medical and 12% for pre-65 medical and prescription drugs. These rates are assumed to decrease gradually to an ultimate level of 5% by the year 2007. Increasing the health care cost trend rate by one percentage point in each year would increase the APBO as of September 30, 1993, by approximately $19 million (14%) and the aggregate of the service and interest cost components of the postretirement benefit costs for 1993 by approximately $2 million (17%). (b) Postemployment Benefits In 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, Employers' Accounting for Postemployment Benefits (Statement 112). Statement 112 establishes accounting standards for the costs of benefits provided to former or inactive employees, including their beneficiaries and dependents, after employment but before retirement. Under the provisions of Statement 112, the costs of these benefits will be recognized for accounting purposes when the employees or their beneficiaries become eligible for such benefits (accrual basis) rather than when such benefits are paid, which is Energy's current practice. Energy's unrecognized and unfunded obligation for these benefits (the transition obligation) as of September 30, 1993, measured in accordance with the new accounting standard, is $8.5 million. The new standard requires immediate recognition of the transition obligation at the date the new standard is adopted. Energy is required to adopt Statement 112 effective January 1, 1994. In connection with its current retail rate proceeding, Energy has requested deferral of the transition obligation for recovery over a reasonable period of time beginning with an order in its next retail rate proceeding. 12. Notes Payable Energy currently has IURC authority to borrow up to $200 million under short- term credit arrangements. In connection with this authority, Energy has established agreements with 11 banks for unsecured, but committed, lines of credit (Committed Lines) which currently permit borrowings of up to $155 million. These Committed Lines provide for maturities of one year and one day with interest rate options at or below prime rate. In addition, Energy has a temporary Committed Line with one bank of $15 million which provides for maturities of less than one year. Energy also issues commercial paper from time to time. All outstanding commercial paper is supported by Energy's Committed Lines. Amounts outstanding under the above lines of credit would become immediately due upon an event of default which includes non-payment, default under other agreements governing company indebtedness, bankruptcy, or insolvency. Commitment fees, which are assessed on the daily unused portion of the Committed Lines, were immaterial during 1991 to 1993. Energy also has Board of Directors' approval to arrange for additional short- term borrowings of up to $100 million with various banks on an "as offered" basis (Uncommitted Lines). All Uncommitted Lines provide for maturities of 364 days with various interest rate options. For the years 1993, 1992, and 1991, short-term borrowings outstanding at various times were as follows: 13. Fair Value of Financial Instruments The estimated fair values of Energy's financial instruments were as follows: December 31 December 31 1993 1992 Carrying Fair Carrying Fair Financial Instrument Amount Value Amount Value (in millions) Cash and temporary cash investments. . . . . . . $ 5 $ 5 $ 9 $ 9 Restricted deposits . . . . . . 49 49 18 18 Long-term debt (includes amounts due within one year). 816 896 777 807 Notes payable . . . . . . . . . 127 127 121 121 The following methods and assumptions were used to estimate the fair values of these financial instruments: Cash and temporary cash investments, restricted deposits, and notes payable The carrying amounts approximate fair values. Long-term debt The fair value of Energy's long-term debt issues, excluding tax-exempt bonds, was estimated based on the latest quoted market prices or, if not publicly traded, on the current rates offered to Energy for debt of the same remaining maturities. The fair value of tax-exempt bonds was estimated by obtaining broker quotes. Under current regulatory treatment, gains and losses on reacquisition of long- term debt are amortized in customers' rates over the remaining life of the debt reacquired. Accordingly, any reacquisition would not have a material effect on Energy's financial position or results of operations. 14. Income Taxes Effective with the first quarter of 1993, Energy implemented the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (Statement 109). Statement 109 requires recognition of deferred tax assets and liabilities for the expected future tax consequences of existing differences between the financial reporting and tax reporting bases of assets and liabilities. Energy adopted this new accounting standard as the cumulative effect of a change in accounting principle with no restatement of prior periods. The adoption of Statement 109 had no material effect on Energy's consolidated earnings or the Consolidated Balance Sheet. In August 1993, Congress enacted the Omnibus Budget Reconciliation Act of 1993 (Act), which included a provision to increase the Federal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. Statement 109 requires adjustment of deferred income taxes upon enacted changes in income tax rates. The change in the income tax rate resulted in an increase in the net deferred income tax liability of approximately $12 million and recognition of a regulatory asset of approximately $12 million to reflect expected future recovery of the increased liability in customers' rates. The significant components of Energy's net deferred income tax liability at December 31, 1993, and January 1, 1993, after adoption of the provisions of Statement 109, are as follows: A summary of Federal and state income taxes charged (credited) to income and the allocation of such amounts is as follows: Energy participates in the filing of a consolidated Federal income tax return with its parent, Resources, and other affiliated companies. The current tax liability is determined on a stand-alone basis for each member of the group pursuant to a tax sharing agreement. As a result of the $150 million refund resulting from the December 1993 Order, Energy incurred an alternative minimum tax (AMT) liability of approximately $6.9 million ($2.3 million for the consolidated group) for 1993. AMT paid can be used as a tax credit to offset income taxes (other than AMT) payable in future years. Resources expects to be able to utilize the AMT credit in 1994. Pursuant to the tax sharing agreement, Energy reported the tax benefits of Resources' consolidated net operating loss of approximately $22 million and income taxes paid during 1993 in excess of the AMT liability as "Income tax refunds" on the December 31, 1993, Consolidated Balance Sheet. Federal income taxes computed by applying the statutory Federal income tax rate to book income before Federal income tax are reconciled to Federal income tax expense reported in the Consolidated Statements of Income as follows: 18. 1993 and 1992 Quarterly Financial Data (unaudited) 19. Pending Merger General Resources, Energy, and CG&E entered into an Agreement and Plan of Reorganization dated as of December 11, 1992, which was subsequently amended and restated on July 2, 1993, and as of September 10, 1993 (as amended and restated, the "Merger Agreement"). Under the Merger Agreement, Resources will be merged with and into a newly formed corporation named CINergy Corp. (CINergy) and a subsidiary of CINergy will be merged with and into CG&E ("CG&E Merger", collectively referred to as the "Mergers"). Following the Mergers, CINergy will be the parent holding company of Energy and CG&E and will be required to register under the Public Utility Holding Company Act of 1935 (PUHCA). The Merger Agreement can be terminated by any party, without financial penalty, if the Mergers are not consummated by June 30, 1994. Under certain circumstances, the termination of the Merger Agreement would result in the payment of termination fees which may not exceed $70 million, if Resources is required to pay, or $130 million, if CG&E is required to pay. In August 1993, Resources established a $70 million irrevocable standby letter of credit in favor of CG&E to fund the aggregate amounts (not to exceed $70 million) payable in certain circumstances pursuant to the provisions of the Merger Agreement and the related Resources Stock Option Agreement as termination fees, option repurchase payments, and related expenses. Exchange Ratio The Merger Agreement provides that, upon consummation of the Mergers, each outstanding share of common stock of Resources will be converted into the right to receive that number of shares of the common stock, par value of $.01 each, of CINergy obtained by dividing $30.69 by the average closing sales price of common stock, par value of $8.50 each, of CG&E as reported on the Transaction Reporting System operated by the Consolidated Tape Association for the 15 consecutive trading days preceding the fifth trading day prior to the Mergers; provided that, if the actual quotient obtained thereby is less than .909, the quotient shall be .909, and if the actual quotient obtained thereby is more than 1.023, the quotient shall be 1.023. The Merger Agreement also provides that, upon consummation of the Mergers, each outstanding share of common stock of CG&E will be converted into the right to receive one share of common stock of CINergy. The outstanding preferred stock and debt securities of Energy and CG&E will not be affected. Shareholder and Regulatory Approvals In November 1993, the Mergers were approved by the shareholders of Resources and CG&E. In August 1993, the FERC conditionally approved the Mergers. This conditional approval was made by the FERC without a formal hearing and, according to public statements by the FERC Commissioners, was done in reliance, in part, on the FERC's belief that the regulatory commissions of the affected states would have authority to approve or disapprove the Mergers. The companies accepted the FERC's conditions and indicated their belief that none of the conditions would have a material adverse effect on the operations, financial condition, or business prospects of CINergy. Certain parties petitioned for rehearing of the FERC's conditional approval. On September 15, 1993, Energy and CG&E filed a statement with the FERC clarifying their conclusions at that time that the Mergers would not require any prior approval of a state commission under state law. Given the issues raised on the requests for rehearing and the lack of certainty in the record regarding state regulatory powers, on January 12, 1994, the FERC issued an order withdrawing its prior conditional approval of the Mergers and initiating a 60-day, FERC-sponsored settlement procedure. The settlement procedure is expected to be concluded prior to the end of March 1994. The FERC has indicated that, if the settlement procedure is not successful, it intends to issue a further order setting appropriate issues for hearing. The companies are currently participating in a collaborative process with representatives from the IURC, the Public Utilities Commission of Ohio, the Kentucky Public Service Commission (KPSC), various consumer groups, and other parties to settle all merger-related issues. In conjunction with the FERC- sponsored settlement procedure, on February 11, 1994, Energy filed a petition with the IURC requesting approval of various proposals regarding state regulation after consummation of the Mergers. These proposals do not address the allocation between shareholders and customers of projected revenue requirement savings as a result of the Mergers. This allocation will be the subject of a subsequent IURC proceeding. Hearings on the current petition are expected to conclude prior to the end of the 60-day settlement period established by the FERC. In addition, CG&E had originally intended to file, in January 1994, an application with the KPSC for approval of the CG&E Merger. However, given the initiation of the FERC settlement procedure, CG&E notified the KPSC, and the KPSC agreed, that CG&E would temporarily defer such filing (see Note 21 on page 66 for a discussion of subsequent events). The Mergers are also subject to the approval of the Securities and Exchange Commission (SEC) under the PUHCA. An application requesting such SEC approval is expected to be filed during the first quarter or early second quarter of 1994. Under the PUHCA, the divestiture of CG&E's gas operations may be required. The companies believe they have a justifiable basis for retention of CG&E's gas operations and will request SEC approval to retain this portion of the business. Divestiture, if ordered, would occur after the consummation of the Mergers. Historically, the SEC has allowed companies sufficient time to accomplish divestitures in a manner that protects shareholder value, which, in some cases, has been 10 to 20 years. The companies' goal is to consummate the Mergers during the third quarter of 1994. However, if the settlement procedure is not successful and a hearing is convened by the FERC, the consummation of the Mergers would likely be further extended. There can be no assurance that the Mergers will be consummated. Stock Option Agreements Concurrently with the Merger Agreement, Resources and CG&E have entered into reciprocal stock option agreements granting each other the right to purchase certain shares of their common stock under certain circumstances if the Merger Agreement becomes terminable, or is terminated, because of a breach or a third party proposal for a business combination. Specifically, under these certain circumstances, CG&E has the option to purchase 10 million shares of common stock of Resources at a price of $18.65 per share, and Resources has the option to purchase approximately 7.7 million shares of common stock of CG&E at a price of $24.325 per share. These options will terminate upon the earlier of the consummation of the Mergers, termination of the Merger Agreement pursuant to its terms (other than a breach or a third party proposal for a business combination), 180 days, or longer under certain circumstances, following the termination of the Merger Agreement due to a breach or a third party proposal for a business combination, or June 30, 1994. 20. Pro Forma Condensed Consolidated Financial Information (unaudited) The following pro forma condensed consolidated financial information combines the historical Consolidated Statements of Income and Consolidated Balance Sheets of Resources and CG&E after giving effect to the Mergers. The unaudited Pro Forma Condensed Consolidated Statements of Income for each of the three years ended December 31, 1993, give effect to the Mergers as if the Mergers had occurred at January 1, 1991. The unaudited Pro Forma Condensed Consolidated Balance Sheet at December 31, 1993, gives effect to the Mergers as if the Mergers had occurred at December 31, 1993. These statements are prepared on the basis of accounting for the Mergers as a pooling of interests and are based on the assumptions set forth in the notes thereto. In addition, the following pro forma condensed consolidated financial information should be read in conjunction with the historical consolidated financial statements and related notes thereto of Resources, Energy, and CG&E. The following information is not necessarily indicative of the operating results or financial position that would have occurred had the Mergers been consummated at the beginning of the periods, or on the date, for which the Mergers are being given effect, nor is it necessarily indicative of future operating results or financial position. 21. Events Subsequent to Date of Report of Independent Public Accountants - Pending Merger (unaudited) In connection with the 60-day, FERC-sponsored settlement procedure and the collaborative process, Resources, Energy, CINergy, the Indiana Utility Consumer Counselor, the Citizens Action Coalition of Indiana, Inc., and industrial customer representatives reached a global settlement agreement on merger-related issues. This agreement was filed with the IURC on March 2, 1994, and is expressly conditioned upon approval by the IURC in its entirety and without any change or condition that is unacceptable to any party. On March 4, 1994, CG&E, the Public Utilities Commission of Ohio, and the Ohio Office of Consumers Counsel reached an agreement substantially similar to the Indiana agreement. Both settlement agreements were filed with the FERC on March 4, 1994. Energy expects the FERC settlement judge to forward the settlements to FERC Commissioners on or about March 21, 1994, beginning what is normally a 30-day comment period. The Indiana settlement addresses, among other things, the coordination of state and Federal regulation, the operation of the combined Energy and CG&E electric utility system, the allocation of costs and their effect on customer rates, and a retail "hold harmless" provision that provides that Energy's retail rates will not reflect merger- related costs to the extent that they are not offset entirely by merger- related benefits. IURC hearings on the Indiana settlement were held on March 17, 1994. Energy has asked the IURC for an order approving the settlement agreement by early April 1994, which should fall within the expected comment period at the FERC. CG&E also filed with the FERC a unilateral offer of settlement addressing all issues raised in the KPSC's application for rehearing with the FERC. On March 15, 1994, CG&E filed an application with the KPSC seeking approval of the indirect acquisition of control of CG&E's Kentucky subsidiary, The Union Light, Heat and Power Company. Also included in the filings with the FERC were settlement agreements with WVPA and the city of Hamilton, Ohio. These agreements resolve issues related to the transmission of power and operation of Energy's jointly owned transmission system. Negotiations with other parties at the FERC are continuing. Energy and CG&E also filed with the FERC the operating agreement among Energy, CG&E, and CINergy Services, Inc., a subsidiary of CINergy. The parties to the Indiana and Ohio FERC settlements have agreed to support or not oppose the operating agreement, and the settlements are conditioned upon the FERC approving the filed operating agreement without material change. 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 Board of Directors Reference is made to pages 6 through 9 of the 1994 Information Statement, "Election of Directors", with respect to identification of directors and their current principal occupations. In addition, reference is made to pages 21 and 22 of the 1994 Information Statement, "Directors' Compensation", regarding compliance with Section 16 of the Securities Exchange Act of 1934. Executive Officers The information included in Part I of this report on pages 9 and 10 under the caption "Executive Officers of the Registrant" is referenced in reliance upon General Instruction G to Form 10-K and Instruction 3 to Item 401(b) of Regulation S-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Reference is made to the discussion "Executive Compensation and Other Transactions" on pages 17 through 26 of the 1994 Information Statement with respect to executive compensation. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is made to the discussions "Introduction", "Voting Securities and Principal Shareholders", and "Security Ownership of Management" on pages 2 through 5 of the 1994 Information Statement with respect to security ownership of certain beneficial owners, security ownership of management, and changes in control. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is made to the discussion "Election of Directors" on pages 6 through 9 of the 1994 Information Statement concerning certain relationships and related transactions. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements and Schedules. Refer to the page captioned "Index to Financial Statements and Financial Statement Schedules", page 33 of this report, for an index of the financial statements and financial statement schedules included in this report. (b) Reports on Form 8-K. The following reports on Form 8-K or Form 8-K/A were filed during the last quarter of 1993 and through March 18, 1994: Date of Report Items Filed Form 8-K: October 27, 1993 Item 5 - Other Events. (On October 27, 1993, PSI Resources, Inc., PSI Energy, Inc., IPALCO Enterprises, Inc., Indianapolis Power & Light Company, The Cincinnati Gas & Electric Company, CINergy Corp., James E. Rogers, John R. Hodowal, and Ramon L. Humke entered into an agreement pursuant to which, among other things, the parties agreed to settle certain pending lawsuits and other issues in connection with IPALCO Enterprises, Inc.'s attempted acquisition of PSI Resources, Inc. and IPALCO Enterprises, Inc.'s opposition to the merger of PSI Resources, Inc. and The Cincinnati Gas & Electric Company to create CINergy Corp.) Item 7 - Financial Statements and Exhibits. (Text of Agreement dated October 27, 1993, by and among PSI Resources, Inc., PSI Energy, Inc., The Cincinnati Gas & Electric Company, CINergy Corp., IPALCO Enterprises, Inc., Indianapolis Power & Light Company, James E. Rogers, John R. Hodowal, and Ramon L. Humke (together with the exhibits and schedules thereto) and text of joint press release issued by PSI Resources, Inc. and The Cincinnati Gas & Electric Company on October 27, 1993.) November 19, 1993 Item 7 - Financial Statements and Exhibits. (The Cincinnati Gas & Electric Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993.) Date of Report Items Filed Form 8-K (continued): January 12, 1994 Item 5 - Other Events. (On January 12, 1994, the Federal Energy Regulatory Commission issued an order withdrawing its prior conditional approval of PSI Resources, Inc.'s merger with The Cincinnati Gas & Electric Company and initiating a 60-day, FERC-sponsored settlement procedure.) Form 8-K/A: November 26, 1993 Item 7 - Financial Statements and Exhibits. (Amendment No. 1 filed by The Cincinnati Gas & Electric Company on Form 10-K/A dated November 26, 1993, to The Cincinnati Gas & Electric Company's Annual Report on Form 10-K for the year ended December 31, 1992, and Consent of Independent Public Accountants.) (c) Exhibits. Refer to the page captioned "Exhibits", page 70 of this report, for a listing of all exhibits included in this report. Exhibits Copies of the documents listed below which are identified with an asterisk (*) have heretofore been filed with the Securities and Exchange Commission and are incorporated herein by reference and made a part hereof; and the exhibit number and file number of the document so filed, and incorporated herein by reference, are stated in parentheses in the description of such exhibit. Exhibits not so identified are filed herewith. Exhibit Designation Nature of Exhibit 2-a *Amended and Restated Agreement and Plan of Reorganization by and among The Cincinnati Gas & Electric Company, PSI Resources, Inc., PSI Energy, Inc., CINergy Corp., an Ohio corporation, CINergy Corp., a Delaware corporation, and CINergy Sub, Inc. dated as of December 11, 1992, as amended and restated on July 2, 1993 (Exhibit to Amendment No. 21 to the Schedule 14D-9 filed by PSI Resources, Inc. (Commission File No. 1-9941) on July 2, 1993), as further amended and restated on September 10, 1993. (Exhibit to PSI Energy, Inc.'s Form 8-K dated September 27, 1993.) 2-b *Press release issued by The Cincinnati Gas & Electric Company and PSI Resources, Inc. dated July 2, 1993, announcing the restructured merger transaction. (Exhibit to Amendment No. 21 to Schedule 14D-9 filed by PSI Resources, Inc. (Commission File No. 1-9941) on July 2, 1993.) 2-c *Letter Agreement dated as of August 13, 1993, between PSI Resources, Inc. and The Cincinnati Gas & Electric Company (with attachments thereto). (Exhibit to Amendment No. 32 to the Schedule 14D-9 filed by PSI Resources, Inc. (Commission File No. 1-9941) on August 16, 1993 (PSI Resources, Inc.'s Schedule 14D-9, Amendment No. 32).) Exhibit Designation Nature of Exhibit 2-d *Press release issued by PSI Resources, Inc. and The Cincinnati Gas & Electric Company dated August 16, 1993, announcing that The Cincinnati Gas & Electric Company, under a letter agreement, will increase the exchange ratio of CINergy Corp. common stock for PSI Resources, Inc. common stock in the proposed merger to form CINergy Corp., contingent on PSI Resources, Inc.'s nominees for directors being elected at PSI Resources, Inc.'s Annual Shareholders Meeting. (Exhibit to PSI Resources, Inc.'s Schedule 14D-9, Amendment No. 32.) 3-a *Amended Articles of Consolidation dated May 13, 1992. (Exhibit to PSI Energy, Inc.'s June 30, 1992, Form 10-Q.) 3-b *By-laws, as amended January 28, 1993, of PSI Energy, Inc. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 4-a *Original Indenture (First Mortgage Bonds) dated September 1, 1939, between PSI Energy, Inc. and The First National Bank of Chicago, as Trustee (Exhibit A-Part 3 in File No. 70- 258), and LaSalle National Bank as Successor Trustee (supplemental indenture dated March 30, 1984) and the indentures supplemental thereto dated, respectively, January 1, 1969, January 1, 1971, January 1, 1972, February 1, 1974, January 1, 1977, October 1, 1977, September 1, 1978, September 1, 1978, and March 1, 1979, between PSI Energy, Inc. and said Trustee. (Exhibit 2-5 in Second Amendment File No. 2- 30779; Exhibit 2-3 in File No. 2-38994; Exhibit 2-4 in File No. 2-42545; Exhibit 2-5 in File No. 2-50007; Exhibit 2-5 in File No. 2-57828; Exhibit 2-5 in File No. 2-59833; Exhibit 2-4 in File No. 2-62543; Exhibit 2-6 in File No. 2-62543; Exhibit 2-5 in File No. 2-63753.) 4-b *Thirty-fifth Supplemental Indenture dated March 30, 1984. (Exhibit to PSI Energy, Inc.'s, formerly Public Service Company of Indiana, Inc., 1984 Form 10-K.) Exhibit Designation Nature of Exhibit 4-c *Thirty-ninth Supplemental Indenture dated March 15, 1987. (Exhibit to PSI Energy, Inc.'s 1987 Form 10-K.) 4-d *Forty-first Supplemental Indenture dated June 15, 1988. (Exhibit to PSI Energy, Inc.'s 1988 Form 10-K.) 4-e *Forty-second Supplemental Indenture dated August 1, 1988. (Exhibit to PSI Energy, Inc.'s 1988 Form 10-K.) 4-f *Forty-third Supplemental Indenture dated September 15, 1988. (Exhibit to PSI Energy, Inc.'s 1988 Form 10-K.) 4-g *Forty-fourth Supplemental Indenture dated March 15, 1990. (Exhibit to PSI Energy, Inc.'s 1990 Form 10-K.) 4-h *Forty-fifth Supplemental Indenture dated March 15, 1990. (Exhibit to PSI Energy, Inc.'s 1990 Form 10-K.) 4-i *Forty-sixth Supplemental Indenture dated June 1, 1990. (Exhibit to PSI Energy, Inc.'s 1991 Form 10-K.) 4-j *Forty-seventh Supplemental Indenture dated July 15, 1991. (Exhibit to PSI Energy, Inc.'s 1991 Form 10-K.) 4-k *Forty-eighth Supplemental Indenture dated July 15, 1992. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 4-l *Forty-ninth Supplemental Indenture dated February 15, 1993. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 4-m *Fiftieth Supplemental Indenture dated February 15, 1993. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 4-n Fifty-first Supplemental Indenture dated February 1, 1994. Exhibit Designation Nature of Exhibit 4-o *Indenture (Secured Medium-term Notes, Series A), dated July 15, 1991, between PSI Energy, Inc. and The First National Bank of Chicago, as Trustee. (Exhibit to PSI Energy, Inc.'s Form 10-K/A, Amendment No. 2, dated July 15, 1993.) 4-p *Indenture (Secured Medium-term Notes, Series B), dated July 15, 1992, between PSI Energy, Inc. and The First National Bank of Chicago, as Trustee. (Exhibit to PSI Energy, Inc.'s Form 10-K/A, Amendment No. 2, dated July 15, 1993.) 10-a +PSI Energy, Inc. Annual Incentive Plan, amended and restated July 30, 1991, retroactively effective July 1, 1991. 10-b *+Supplemental Retirement Plan amended and restated December 16, 1992, retroactively effective January 1, 1989. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 10-c *+Excess Benefit Plan, formerly named the Supplemental Pension Plan, amended and restated December 16, 1992, retroactively effective January 1, 1989. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 10-d *+Performance Shares Plan, amended and restated January 30, 1992, retroactively effective January 1, 1992. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 10-e *+Amendment to Annual Incentive Plan dated December 1, 1992. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 10-f *+Employment Agreement dated May 17, 1990, among PSI Resources, Inc., PSI Energy, Inc. and James E. Rogers, Jr. (Exhibit to the Schedule 14D-9 filed by PSI Resources, Inc. (Commission File No. 1-9941) on April 7, 1993 (the "Resources Schedule 14D-9").) Exhibit Designation Nature of Exhibit 10-g *+Deferred Compensation Agreement, effective as of January 1, 1992, between PSI Energy, Inc. and James E. Rogers, Jr. (Exhibit to PSI Energy, Inc.'s Form 10-K/A, Amendment No. 1, dated April 29, 1993.) 10-h *+Split Dollar Life Insurance Agreement, effective as of January 1, 1992, between PSI Energy, Inc. and James E. Rogers, Jr. (Exhibit to PSI Energy, Inc.'s Form 10-K/A, Amendment No. 1, dated April 29, 1993.) 10-i *+First Amendment to Split Dollar Life Insurance Agreement between PSI Energy, Inc. and James E. Rogers, Jr. dated December 11, 1992. (Exhibit to PSI Energy, Inc.'s Form 10-K/A, Amendment No. 1, dated April 29, 1993.) 10-j *+Employment Agreement dated December 11, 1992, among PSI Resources, Inc., PSI Energy, Inc., The Cincinnati Gas & Electric Company, CINergy Corp. and James E. Rogers, Jr. (Exhibit to the Form S-4 filed by CINergy Corp. (Commission File No. 33-59964) filed March 23, 1993). 10-k *+Severance Agreement dated December 11, 1992, among PSI Resources, Inc., PSI Energy, Inc. and James E. Rogers, Jr. (Exhibit to PSI Energy, Inc.'s Form 10-K/A, Amendment No. 1, dated April 29, 1993.) 10-l *+Form of Severance Agreement dated December 11, 1992, among PSI Resources, Inc., PSI Energy, Inc. and each of Cheryl M. Foley, Joseph W. Messick, Jr., Jon D. Noland, J. Wayne Leonard, and Larry E. Thomas. (Exhibit to PSI Energy, Inc.'s Form 10-K/A, Amendment No. 1, dated April 29, 1993.) 10-m *PSI Energy, Inc. Pension Plan, amended and restated December 16, 1992, retroactively effective January 1, 1989. (Exhibit to the Resources Schedule 14D-9.) Exhibit Designation Nature of Exhibit 10-n *+Master Trust Agreement for Employees' Plans (the "Employees' Trust Agreement") between PSI Resources, Inc. and National City Bank, Indiana. (Exhibit to the Resources Schedule 14D-9.) 10-o *+Master Trust Agreement for Directors' Plans (the "Directors' Trust Agreement") between PSI Resources, Inc. and National City Bank, Indiana. (Exhibit to the Resources Schedule 14D-9.) 10-p *+PSI Energy, Inc. Executive Supplemental Life Insurance Program. (Exhibit to the Resources Schedule 14D-9.) 10-q *PSI Energy, Inc. Severance Pay Plan. (Exhibit to the Resources Schedule 14D-9.) 10-r *+Amendment No. 1 to each of the Employees' Trust Agreement and the Directors' Trust Agreement. (Exhibit to the Resources Schedule 14D-9.) 10-s *+Form of Amendment No. 2 to the Employees' Trust Agreement. (Exhibit to Amendment No. 1 to the Resources Schedule 14D-9 filed April 23, 1993.) 10-t *Employment Agreement dated October 4, 1993, among PSI Resources, Inc., PSI Energy, Inc., and John M. Mutz. (Exhibit to PSI Energy, Inc.'s September 30, 1993, Form 10-Q.) 10-u *Text of Settlement Agreement dated October 27, 1993, by and among PSI Resources, Inc., PSI Energy, Inc., The Cincinnati Gas & Electric Company, CINergy Corp., IPALCO Enterprises, Inc., Indianapolis Power & Light Company, James E. Rogers, John R. Hodowal, and Ramon L. Humke (together with the exhibits and schedules thereto). (Exhibit to PSI Energy, Inc.'s Form 8-K dated October 27, 1993.) 10-v +Amendment to PSI Energy, Inc.'s Annual Incentive Plan dated July 2, 1993. Exhibit Designation Nature of Exhibit 10-w +Amendment No. 2 to the Directors' Trust Agreement. 10-x +Amendment No. 3 to the Employees' Trust Agreement. 10-y +Amendment No. 3 to the Directors' Trust Agreement. 10-z +Amendment No. 4 to the Employees' Trust Agreement. 21 Subsidiaries of PSI Energy, Inc. 23 Consent of Independent Public Accountants. 24 Power of Attorney. 99-a *Complaint of Lydia Grady, as Plaintiff, and PSI Resources, Inc. et al., as Defendants dated March 17, 1993. Superior Court No. 1 of Hendricks County in the State of Indiana. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 99-b *Complaint of Moise Katz, as Plaintiff, and PSI Resources, Inc. et al., as Defendants dated March 16, 1993. Superior Court No. 2 of Hendricks County in the State of Indiana. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 99-c *Complaint of J. E. and Z. B. Butler Foundation, as Plaintiff, and PSI Resources, Inc., et al., as Defendants dated March 17, 1993. U.S. District Court for the Southern District of Indiana, Indianapolis Division. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) 99-d *Amended Complaint of J. E. and Z. B. Butler Foundation, as Plaintiff, and PSI Resources, Inc., et al., as Defendants dated March 23, 1993. U.S. District Court for the Southern District of Indiana, Indianapolis Division. (Exhibit to PSI Energy, Inc.'s 1992 Form 10-K.) Exhibit Designation Nature of Exhibit 99-e *Class Action Complaint of Lamont Carpenter, individually, and on behalf of all others situated, as Plaintiffs, and PSI Resources, Inc., et al., as Defendants dated March 26, 1993. U.S. District Court for the Southern District of Indiana, Indianapolis Division. (Exhibit to the Resources Schedule 14D-9.) 99-f *Complaint of Ronald Gaudiano and Gladys Post, as Plaintiffs, and PSI Resources, Inc., et al., as Defendants dated March 26, 1993. U.S. District Court for the Southern District of Indiana, Indianapolis Division. (Exhibit to the Resources Schedule 14D-9.) 99-g *Stipulated Order of Consolidation and Appointment of Co-Lead Counsel and Liaison Counsel, dated April 13, 1993, in the case entitled Lydia Grady v. PSI Resources, Inc. et al., (Case No. IP-93-345-C), U.S. District Court for the Southern District of Indiana. (Exhibit to Amendment No. 1 to Schedule 14D-9 filed by PSI Resources, Inc. (Commission File No. 1-9941) on April 23, 1993.) 99-h *Order of Dismissal dated July 1, 1993, issued in Katz v. PSI Resources, Inc., et al., (Case No. 32D02-9303-CP-27) Superior Court for Hendricks County in the State of Indiana. (Exhibit to Amendment No. 22 to the Schedule 14D-9 filed by PSI Resources, Inc. (Commission File No. 1-9941) on July 6, 1993.) 99-i *Order entered on July 19, 1993, in Katz v. PSI Resources, Inc., et al., (Case No. 32D02-9303-CP-27), Superior Court for Hendricks County in the State of Indiana. (Exhibit to Amendment No. 26 to the Schedule 14D-9 filed by PSI Resources, Inc. (Commission File No. 1-9941) on July 23, 1993.) Exhibit Designation Nature of Exhibit 99-j *Text of an Order Granting Preliminary Injunction dated August 5, 1993, in In re: PSI Merger Shareholder Litigation, (Consolidated Master File No. IP 93-345-C), U.S. District Court for the Southern District of Indiana, Indianapolis Division; Entry Regarding Motion for Preliminary Injunction in the foregoing case. (Exhibit to Amendment No. 29 to the Schedule 14D-9 filed by PSI Resources, Inc. (Commission File No. 1-9941) on August 6, 1993.) 99-k *Third amended complaint of Moise Katz, as Plaintiff, and PSI Resources, Inc., et al., as Defendants dated August 18, 1993. Superior Court No. 2 of Hendricks County in the State of Indiana. (Exhibit to PSI Energy, Inc.'s September 30, 1993, Form 10- Q.) 99-l *Press release issued by PSI Resources, Inc. and The Cincinnati Gas & Electric Company announcing that PSI Resources, Inc., The Cincinnati Gas & Electric Company, and IPALCO Enterprises, Inc. had reached a settlement agreement. (Exhibit to PSI Energy, Inc.'s Form 8-K dated October 27, 1993.) ________________________ + Management contract, compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PSI ENERGY, INC. Registrant Dated: March 18, 1994 By /s/ James E. Rogers (James E. Rogers) Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date James K. Baker Director Hugh A. Barker Director Michael G. Browning Director Kenneth M. Duberstein Director John A. Hillenbrand, II Director John M. Mutz Director Melvin Perelman, Ph.D. Director Van P. Smith Director Robert L. Thompson, Ph.D. Director /s/ J. Wayne Leonard Senior Vice President and March 18, 1994 (J. Wayne Leonard) Director Attorney-in-fact for all (Principal Financial Officer) the foregoing persons /s/ James E. Rogers Chairman, President and Director March 18, 1994 (James E. Rogers) (Principal Executive Officer) /s/ Charles J. Winger Comptroller March 18, 1994 (Charles J. Winger) (Principal Accounting Officer)

846902_1993.txt

846902_1993

1993

846902

ITEM 1. BUSINESS GENERAL Carlisle Plastics, Inc. (the "Company") is a global leader in the production of consumer products made from plastics. The Company's products include trash bags, garment hangers and sheeting used for home improvement, construction and agriculture. The Company's trash bag products include private label and institutional lines, as well as the Company's own national consumer brands. Other Company products include plastic bottles, containers and packaging. The Company's film products (including trash bag, sheeting and industrial film products) in 1993, 1992 and 1991 accounted for 65.4%, 67.7% and 69.6%, respectively, of the Company's consolidated net sales. The Company's molded products (including hangers, bottles and containers) in 1993, 1992 and 1991 accounted for 34.6%, 32.3% and 30.4%, respectively, of the Company's consolidated net sales. Poly-Tech, which is an additional registrant hereunder, is a wholly-owned subsidiary of the Company. HISTORY The Company was incorporated in Delaware in 1985 and adopted its present name in February, 1989. In 1989, the Company acquired 79% ownership in Poly-Tech. In 1990, the Company, through Poly-Tech, purchased 100% of the outstanding capital stock of American Western Corporation ("American Western"). In 1991, the Company completed an initial public offering (the "Class A Stock Offering"). In conjunction with the Class A Stock Offering, the Company converted all shares of the Company's outstanding common stock into shares of Class B Common Stock; acquired the 21% minority interests in its directly owned subsidiaries in exchange for shares of Class A Common Stock; and changed its tax status from a "S" corporation to a "C" corporation. In July 1991, the Company purchased a two-thirds interest in Rhino-X Industries, Inc. ("Rhino-X"). Under a put and call arrangement signed in conjunction with the acquisition of Rhino-X, the Company purchased the remaining shares on January 1, 1994. PRODUCTS The Company supplies plastic trash bags to three major markets. For mass merchandise and other retail stores, the Company provides Ruffies(R), a national brand consumer trash bag. For grocery chains nationwide, the Company provides private label consumer trash bags and food contact products, such as sandwich bags and wrap, recloseable bags and freezer bags. For institutional customers, such as food service distributors, janitorial supply houses, restaurants, hotels and hospitals, the Company provides heavy-duty trash liners. The Company's leading plastic sheeting product, Film-Gard(R), is sold to consumers and professional contractors through do-it-yourself outlets, home improvement centers and hardware stores. A wide range of Film-Gard(R) products are sold for various uses, including painting, renovation/construction, landscaping and agriculture. The Company's industrial packaging film is sold directly to manufacturers for use as shrink wrap and for other packaging requirements. The Company sells molded plastic garment hangers to four markets. The first is garment manufacturers who place their clothes on the Company's hangers before shipping to retail outlets. Another is the stores themselves, who buy standard Company hanger lines for retail display. For national retailers, the Company creates and sells customized hanger designs. The Company also supplies consumer plastic hangers directly to mass merchandise stores. The Company manufactures a line of plastic bottles marketed to the dairy, water, juice, food and industrial markets on the eastern coast of the United States. The Company operates in a competitive marketplace where success is dependent upon price, service and quality. The Company has positioned itself as a major supplier of innovative plastic products to large, rapidly growing national customers at the highest levels of value, service and quality. In the consumer trash bag market, the Company competes primarily with two highly advertised national brands, as well as other private and controlled label products. The Company has historically concentrated on mass merchandisers as the primary market for its branded trash bags, while the other major national brands are marketed primarily through food retailers. RAW MATERIALS The primary raw materials used by the Company in the manufacture of its products are various plastic resins, primarily polyethylene. Because plastic resins are commodity products, the Company selects its suppliers primarily on the basis of price. Consequently, the Company's sources for plastic resins tend to vary from year to year. Shortages of plastic resins have been infrequent. The Company uses in excess of 400 million pounds of plastic resins annually. At this level, the Company is one of the largest purchasers of plastic resin in the United States. Management believes that large volume purchases of plastic resin result in lower unit raw material costs. Natural gas and crude oil markets experience substantial cyclical price fluctuations as well as other market disturbances, including shortages of supply, the effect of OPEC policy and crises in the oil producing regions of the world. The capacity, supply and demand for plastic resins and the petrochemical intermediates from which they are produced are also subject to cyclical and other market factors. Plastic resin prices may fluctuate as a result of these factors. The Company may not always be able to pass through increases in the cost of its raw materials to its customers in the form of price increases. To the extent that increases in the cost of plastic resin cannot be passed on to its customers, such increases may have a detrimental impact on the profitability of the Company due to decreases in its profit margins. MAJOR CUSTOMERS The Company has no customer that accounts for over 10% of its consolidated net sales. EMPLOYEES As of December 31, 1993, the Company employed approximately 2,800 full-time employees, of whom approximately 2,400 are engaged in manufacturing and approximately 400 are engaged in administration and sales. CYCLICALITY AND SEASONALITY OF PORTIONS OF BUSINESS The trash bag and plastic bottle businesses, which account for approximately 50% of 1993 consolidated net sales, have been stable during the recent economic cycles. The hanger, construction film and industrial film businesses, which are sensitive to economic conditions, gained market share in the difficult market conditions of 1992 and 1993. Historically, the Company's results have been affected, in part, by the nature of its customers' purchasing trends for various seasonal and promotional programs. The first quarter is typically the least profitable quarter, and the third quarter is the strongest due to demands for hangers during the holiday season, lawn and leaf bags in the fall and strong promotional activity by major mass merchandisers. ENVIRONMENTAL AND SAFETY MATTERS The Company is currently not subject to any environmental proceedings. During 1993, the Company did not make any material capital expenditures for environmental control facilities, nor does it anticipate any in the near future. Actions by federal, state and local governments concerning environmental matters could result in laws or regulations that could increase the cost of producing the products manufactured by the Company or otherwise adversely affect the demand for its products. At present, environmental laws and regulations do not have a material adverse effect upon the demand for the Company's products. The Company is aware, however, that certain local governments have adopted ordinances prohibiting or restricting the use or disposal of certain plastic products that are among the types of products produced by the Company. If such prohibitions or restrictions were widely adopted, such regulatory and environmental measures could have a material adverse effect upon the Company. In addition, a decline in consumer preferences for plastic products due to environmental considerations could have a material adverse effect upon the Company. In addition, certain of the Company's operations are subject to federal, state and local environmental laws and regulations that impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. While historically the Company has not had to make significant capital expenditures for environmental compliance, the Company cannot predict with any certainty its future capital expenditures for environmental compliance because of continually changing compliance standards and technology. The Company does not currently have any insurance coverage for environmental liabilities and does not anticipate obtaining such coverage in the future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the financial statements of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II The Company estimates that it had 7,000 beneficial owners of the Class A Common Stock at December 31, 1993. The Company's Class B Common Stock was held by 8 record holders at December 31, 1993. Each share of Class A Common Stock is entitled to one vote and each share of Class B Common Stock is entitled to twenty votes. As of December 31, 1993, officers and directors of the Company controlled 74.4% of the combined voting power of the two classes of stock. The indentures for the Company's senior notes generally prohibit the Company from paying dividends on its common stock (other than dividends on non-convertible capital stock or certain other securities). See Notes to Consolidated Financial Statements included herein. - --------------- (a) In April 1989, the Company acquired 79% of the stock of Poly-Tech. In March 1990, Poly-Tech acquired 100% of the stock of American Western. In May 1991, the Company acquired the remaining 21% of Poly-Tech. In July 1991, the Company acquired 66.6% of the stock of Rhino-X. Results are included from the date of each respective purchase. (b) In 1992, pretax income was reduced by $7.7 million for a new product introduction and $4.3 million for a restructuring charge. In 1991, pretax income was reduced by $3.4 million for a restructuring charge. In 1990, pretax income was net of certain non-recurring costs aggregating approximately $4.1 million, including $1.3 million settlement of a loan guarantee, $0.7 million estimated loss on property, and $2.1 million of costs associated with termination of the phantom stock plan, expenses incurred in connection with the American Western acquisition and transition of a manufacturing plant to Mexico. Net income was reduced $234, $89 and $3,576 in 1993, 1992 and 1991, respectively, for extraordinary items related to the early extinguishment of debt. Net income in 1993 was also increased by $1,586 for the cumulative effect of an accounting principle change relating to income taxes. (c) In 1991, the provision for income taxes includes a $3.0 million non-recurring deferred tax charge to recognize tax effects of timing differences on conversion of the Company from a "S" corporation to a "C" corporation. (d) Pro forma net income includes a provision for income taxes as if the entire Company had been a "C" corporation for the entire year. (e) Share amounts in 1991, 1990 and 1989 have been retroactively adjusted to reflect a 125.9-for-1 stock split in May 1991. (f) Includes junior subordinated notes due to stockholders and affiliates in the aggregate amount of $7.0 million in 1991, 1990 and 1989. 1993 as Compared with 1992 Net sales were $360.9 million in 1993 compared to $359.9 million in 1992. Unit volume for 1993 increased 4 percent from 1992. Gross profit increased 2.6 percent to $98.9 million in 1993 from $96.4 million in 1992. Gross margin as a percent of sales increased to 27.4 percent in 1993 from 26.8 percent in 1992. The increase was largely due to improved margins for the film products group due to lower costs. Operating expenses decreased 18.1 percent in 1993 to $67.4 million from $82.3 million in 1992. Operating expenses as a percent of sales decreased to 18.7 percent from 22.9 percent in 1992. Operating expenses in 1992 included $7.7 million associated with a new product introduction and $4.3 million of restructuring charges. These restructuring charges were utilized for realignment of production facilities, management reorganization, product re-engineering and reduction of product offerings. Interest expense, including amortization of deferred financing costs, increased to $22.5 million in 1993 from $22.0 million in 1992 due to the issuance of $90.0 million 10.25% Notes in June of 1992. Interest expense for 1993 was reduced $0.8 million as the result of interest rate swap agreements. The Company recorded a tax provision of $3.5 million in 1993, reflecting an effective tax rate of 37.2 percent, compared to a benefit of ($0.7) million in 1992 as a result of losses incurred. Net income increased to $7.2 million in 1993 from a net loss of ($6.3) million in 1992. Net income in 1993 and 1992 included an after-tax extraordinary charge of $0.2 and $0.1 million, respectively, relating to the early extinguishment of debt. Net income in 1993 also included a $1.6 million net benefit from the adoption of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." 1992 Compared with 1991 Net sales increased 4.7 percent in 1992 to $359.9 million from $343.6 million in 1991. Unit volume increased 18 percent from 1991, partially offset by reductions in selling prices in the film products group. Gross profit decreased 7.3 percent in 1992 to $96.4 million from $104.0 million in 1991. Gross margin as a percent of sales decreased to 26.8 percent in 1992 from 30.3 percent in 1991. The decrease in 1992 resulted from heavy promotional activity by competitors in certain segments of the plastic trash bag market. Operating expenses increased 19.2 percent in 1992 to $82.3 million from $69.1 million in 1991. Operating expenses as a percent of net sales increased to 22.9 percent in 1992 from 20.1 percent in 1991. Operating expenses for 1992 included $7.7 million associated with a new product introduction and $4.3 million charges as a result of a restructuring plan. Interest expense, including amortization of deferred financing costs, was $22.0 million in 1992 compared to $22.6 million in 1991. The decrease resulted from repayment of long-term debt from the proceeds of the Class A Stock Offering in May 1991 and lower interest rates in 1992. The decrease was partially offset by the issuance of the 10.25% Notes in June of 1992. Interest and other income was $0.5 million in 1992 compared to $1.5 million in 1991. The 1991 amount included interest income from investment of the proceeds from the Class A Stock Offering until they were used to repay Company indebtedness. The Company recorded a benefit of ($0.7) million in 1992 for income taxes, compared to a provision of $8.3 million in 1991. The 1991 provision included $3.0 million recorded for a non-recurring deferred tax charge to recognize the tax effects of timing differences on conversion of the Company from a "S" corporation to a "C" corporation. LIQUIDITY AND CAPITAL RESOURCES Cash provided from operations increased 47.7 percent to $19.5 million in 1993 from $13.2 million in 1992 primarily due to the increase in net income. The Company's working capital of $54.3 million at December 31, 1993 decreased $7.6 million from December 31, 1992. This was primarily due to the reclassification of the $10.0 million 1994 Notes and a $2.7 million stock purchase obligation from long-term to current. The Company's $10.0 million of 1994 Notes become due in March 1994. In addition, the Company is actively pursuing refinancing alternatives for $68.5 million of the 13.75% Notes, which become callable at the option of the Company at 103.93% of the outstanding principal amount in April 1994. In September 1993, the Company received $2.0 million from the termination of an interest rate swap agreement, which it had entered into in June 1993. This gain has been deferred and is being amortized over the original term of the swap agreement. In September 1993, the Company entered into a new interest rate swap agreement on a notional principal amount of $90.0 million, terminating in June 1997, matching the principal and due date of the Company's 10.25% Notes. Under the agreement, the Company receives interest at a fixed rate and pays interest at a floating rate, which is established in arrears at six month intervals. In December 1993, the Company received $0.3 million from the first settlement period of the swap agreement. The net interest differential and amortization of the deferred gain of $0.8 million was recorded as a reduction of interest expense in 1993. The agreement is collateralized by the Company's accounts receivable. The Company is subject to interest rate risk during the term of the swap agreement. A sufficient increase in market interest rates during the term of the agreement could result in the Company having a net payment obligation under the agreement. Further, the Company is subject to credit risk exposure from nonperformance by the counterparty during periods when such party has a net payment obligation to the Company. The Company expects its cash on hand and funds from operations will be sufficient to cover future operating cash requirements. Approximately $179.7 million of the Company's outstanding indebtedness matures in 1997. Management believes that the Company will have the funds necessary to meet all of its financing requirements and obligations, based upon the Company's ability to generate funds from operations and obtain additional credit facilities. The Company plans to use cash generated from operations and other sources to retire long-term indebtedness. The Company expects to fund its 1994 capital expenditures from cash from operations approximately equal to its 1994 depreciation expense. TAX LAW CHANGE The Omnibus Budget Reconciliation Act of 1993 (the "Act") was signed into law on August 10, 1993. Under SFAS No. 109, the effect of changes in tax law or rates is reported as a component of income tax expense from continuing operations in the period of enactment. The Act has not significantly changed the income tax consequences for the Company. ACCOUNTING PRONOUNCEMENTS In May 1993, the Financial Accounting Standards Board issued SFAS No. 114, "Accounting for Impairment of a Loan," and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company has evaluated the effects of these standards and believes that they will not affect the Company's financial condition or operating results. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 14 beginning on page 11. 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 set forth in the Company's 1994 Proxy Statement under the caption "Election of Directors" is incorporated herein by reference. Each of the executive officers of the Company is also a director of the Company; thus, the required information regarding executive officers of the Company is included in the 1994 Proxy Statement. Information in response to this Item with respect to Poly-Tech is set forth in Appendix A under the caption "Directors and Executive Officers," which is included in this Form 10-K starting on page 43, following the Consolidated Financial Statements and Consolidated Financial Statement Schedules. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information set forth in the 1994 Proxy Statement under the caption "Executive Compensation" (except for the information under the subheadings "Compensation Committee Report on Executive Compensation" and "Stock Performance") is incorporated herein by reference and also as it relates to the directors and officers with respect to Poly-Tech (as described in Appendix A under the caption "Executive Compensation"). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth in the 1994 Proxy Statement under the caption "Security Ownership of Principal Shareholders and Management" is incorporated herein by reference. Information in response to this Item with respect to Poly-Tech is set forth in Appendix A under the caption "Security Ownership of Certain Beneficial Owners and Management." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth in the 1994 Proxy Statement under the caption "Certain Transactions" 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. Consolidated Financial Statements CARLISLE PLASTICS, INC. AND SUBSIDIARIES Independent Auditors' Report Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Consolidated Financial Statement Schedules of Carlisle Plastics, Inc. required to be filed by Item 8 and Paragraph (d) of this Item Schedule III -- Condensed Financial Information of Registrant Schedule V -- Property, Plant and Equipment Schedule VI -- Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII -- Valuation and Qualifying Accounts Schedule X -- Supplementary Income Statement Information Such schedules and reports are at pages 36 through 42 of this report. All other schedules for Carlisle Plastics, Inc. and Subsidiaries and all schedules for Poly-Tech, Inc. have been omitted because they are inapplicable, not required, or the information is included elsewhere in the consolidated financial statements or notes thereto. 3. The Exhibits are listed in the Index of Exhibits required by Item 601 of Regulation S-K at Item (c) below. (b) No reports on Form 8-K were filed during the last quarter of the period covered by this report. (c) The Index to Exhibits and required Exhibits are included following the Consolidated Financial Statement Schedules beginning at page 44 of this report. (d) The Index to Consolidated Financial Statements and Consolidated Financial Statement Schedules are included following the signatures beginning at page 14 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. CARLISLE PLASTICS, INC. Dated: February 18, 1994 By /s/ WILLIAM H. BINNIE ----------------------------------- William H. Binnie Chairman of The Board and Chief Executive Officer 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. POLY-TECH, INC. Dated: February 18, 1994 By /s/WILLIAM H. BINNIE ------------------------------------ William H. Binnie Chairman of The Board INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Carlisle Plastics, Inc. Boston, Massachusetts We have audited the accompanying consolidated balance sheets of Carlisle Plastics, 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 consolidated financial statement schedules listed at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on 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 Carlisle Plastics, 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. 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, the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," during the year ended December 31, 1993. DELOITTE & TOUCHE Boston, Massachusetts February 9, 1994 See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) 1. BUSINESS ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES BUSINESS The principal business of Carlisle Plastics, Inc. (the "Company") is the manufacture, sale and distribution of plastic products. In May 1991, the Company completed an initial public offering (the "Class A Stock Offering") of 6,750,000 shares of Class A Common Stock (a newly authorized series). In conjunction with the Class A Stock Offering, the Company converted all shares of the Company's outstanding common stock into 10,810,846 shares of Class B Common Stock; the Company acquired the minority interests in its directly owned subsidiaries in exchange for shares of Class A Common Stock; and the Company changed its tax status from a "S" corporation to a "C" corporation. The Company used proceeds from the Class A Stock Offering to retire indebtedness. BASIS OF CONSOLIDATION The consolidated financial statements of the Company include the accounts of Poly-Tech, Inc. ("Poly-Tech"), American Western Corporation ("American Western"), Rhino-X Industries, Inc. ("Rhino-X"), A&E Products (Far East) Ltd. ("Far East") and Plasticos Bajacal, S. A. De C. V. ("Plasticos"). Significant intercompany transactions have been eliminated in consolidation. Certain amounts in the prior years' financial statements have been reclassified to conform to the current year's presentation. CASH EQUIVALENTS Cash equivalents include highly liquid investments with a maturity of three months or less when purchased. The recorded amount of cash equivalents approximates fair market value. INVENTORIES Inventories are stated at the lower of cost or market. Cost is principally determined using the first-in, first-out (FIFO) method. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Depreciation is computed on a straight-line basis over the estimated lives of the assets ranging from two to fifty years. Amortization of property acquired under capitalized leases and leasehold improvements is computed on a straight-line basis over the shorter of the estimated useful lives of the assets or the remaining term of the lease. GOODWILL Goodwill arising from excess purchase cost over net assets acquired is amortized on the straight-line method principally over forty years. Accumulated amortization aggregated $10,352 and $8,221 for the years ended December 31, 1993 and 1992, respectively. DEFERRED FINANCING COSTS Included in other assets at December 31, 1993 and 1992 are $9,570 and $9,415, respectively, of deferred financing costs which are being amortized using the interest method over the term of the related debt. Accumulated amortization aggregated $5,355 and $3,990 at December 31, 1993 and 1992, respectively. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) REVENUE RECOGNITION Revenues are generally recognized in the ordinary course when products are shipped and customers are invoiced. In 1992, the Company entered into a bartering agreement, whereby it exchanged inventory for advertising credits. The credits were valued at the $1,600 cost basis of the inventory exchanged. The difference between fair value of the advertising credits and the cost basis of the inventory is recognized as income when the credits are used. During 1993, credits of $981 were used; as a result, income of $760 and advertising expense of $1,741 were recognized. During 1992, no credits were used and no income was recognized. INCOME TAXES The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective January 1, 1993, and recorded the cumulative effect of this change, which increased net income by $1,586. This statement requires recognition of deferred assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statements and the tax basis of assets and liabilities using enacted tax rates. Previously, the Company accounted for income taxes under the provisions of SFAS No. 96, "Accounting for Income Taxes." Prior to the Class A Stock Offering, the Company was treated as a "S" corporation, although certain of its subsidiaries were "C" corporations. As a "S" corporation, the Company was generally not liable for federal and certain state income taxes where the "S" corporation status was recognized. Accordingly, such income taxes relating to earnings were the obligation of the Company's stockholders and, therefore, were not recorded in the accompanying consolidated financial statements. In conjunction with the Class A Stock Offering, the Company unified its tax status to a "C" corporation. Pro forma income taxes and net income for 1991 reflect the effect on such amounts as if the Company had been a "C" corporation for the entire period. INCOME PER COMMON SHARE Income per common share is computed on the basis of the weighted average number of common shares (retroactively adjusted to reflect a 125.9-for-1 stock split in May 1991) and common equivalent shares, consisting of the dilutive effect of stock options outstanding during each year. Pro forma income reflects the effect on income taxes in 1991 as if the Company had been a "C" corporation for the entire period. ACCOUNTING PRONOUNCEMENTS In May 1993, the Financial Accounting Standards Board issued SFAS No. 114, "Accounting for Impairment of a Loan," and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company has evaluated the effects of these standards and believes that they will not affect the Company's financial condition or operating results. Accumulated depreciation and amortization includes $1,745 and $1,689 at December 31, 1993 and 1992, respectively, relating to assets acquired under capital leases. In April 1989, the Company, in connection with the acquisition of Poly-Tech, issued $100,000 Senior Notes (the "13.75% Notes"). The 13.75% Notes may be redeemed at the option of the Company after April 1, 1994, in whole at any time or in part from time to time, on not less than 30 nor more than 60 days notice to the noteholders, at the following redemption prices (expressed as percentages of principal amount), plus accrued interest (if any) to the date of redemption. Redemption prices are 103.93%, 101.96% and 100.00% if redeemed during the 12-month period commencing April 1, 1994, 1995 and 1996, respectively. The fair value of the $68,525 principal of the 13.75% Notes at December 31, 1993 is estimated to be $72,506, based on the quoted market price for this issuance. In March 1990, the Company, in connection with the long-term financing of Poly-Tech's acquisition of American Western, issued $60,000 Senior Variable Rate Notes due 1997 (the "1997 Notes") and $10,000 Senior Variable Rate Notes due 1994 (the "1994 Notes"), (together, the "Variable Rate Notes"). The Variable Rate Notes may be redeemed at the option of the Company, in whole at any time or in part from time to time, on not less than 30 nor more than 60 days notice to the noteholders, at par plus accrued interest. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Market price is not readily available; however, management believes that the carrying value of the Variable Rate Notes approximates fair value for these obligations. In June 1992, the Company issued $90,000 Senior Notes (the "10.25% Notes"). The 10.25% Notes may be redeemed at the option of the Company after June 14, 1995, in whole at any time or in part from time to time, on not less than 30 nor more than 60 days notice to the noteholders, at the following redemption prices (expressed as percentages of principal amount), plus accrued interest (if any) to the date of redemption. Redemption prices are 102.56% if redeemed during the 12-month period commencing June 15, 1995 and 100% thereafter. The fair value of the 10.25% Notes is estimated to be $96,039, based on the quoted market price for this issuance. The Company retired $5,000, $1,800, and $24,675 of its 13.75% Notes in 1993, 1992 and 1991, respectively, and $40,900 of its 1997 Notes in 1991. The Company incurred extraordinary charges of $234, $89 and $3,576 (net of taxes of $138, $52 and $2,056, respectively) related to the early retirement of debt in 1993, 1992 and 1991, respectively. The indentures relating to the 13.75% Notes, the Variable Rate Notes, and the 10.25% Notes (collectively, the "Notes") have been guaranteed by Poly-Tech and contain certain restrictive covenants affecting the Company and its subsidiaries. Such restrictive covenants limit the incurrence of additional debt by the Company, additional secured debt by the Company and its subsidiaries, sale and leaseback transactions, debt and preferred stock of the Company's subsidiaries, redemptions of capital stock of the Company and its subsidiaries, redemptions of certain subordinated obligations of the Company, sales of assets and subsidiary stock, transactions with affiliates, mergers and amendments to certain intercompany securities. In addition, the covenants generally prohibit dividends or distributions on capital stock of the Company and its subsidiaries, except for dividends or distributions payable in certain equity securities and except for dividends or distributions payable to the Company or a subsidiary and, if a subsidiary has minority stockholders, pro rata to such stockholders. Under certain circumstances the Company's subsidiaries (other than Poly-Tech) may be required to guarantee the Notes. Upon a "change of control" or "fundamental change of control" (as such terms are defined in the indentures) of the Company, each holder of the notes has the right to require the Company to repurchase its notes at 101% of the principal amount plus accrued interest. Certain property, plant and equipment are utilized as collateral to secure certain indebtedness. Cash paid for interest during the years ended December 31, 1993, 1992 and 1991 was $21,946, $20,813 and $23,537, respectively. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The discount rate used in determining the projected benefit obligation was 7% in 1993 and 8% in 1992 and 1991. The assumed long-term rate of return on plan assets was 8% in 1993, 1992 and 1991. The rate of increase in future compensation levels used in determining the projected benefit obligation was 4.5 to 5.5% in 1993, 1992 and 1991. Plan assets consist of guaranteed insurance contracts, pooled fixed income, pooled equity and pooled real estate investments. Cash contributions to the pension plan were $122, $294 and $208 for the years ended December 31, 1993, 1992 and 1991, respectively. The Company also maintains a defined contribution plan (the "Plan"). Full time employees of the Company who are not members of collective bargaining units or who are not covered by another qualified retirement plan sponsored by the Company are eligible to participate in the Plan after six months of employment. Under the Plan, a participant may elect to reduce annual compensation by 1% to 16% and to have that amount contributed to the Plan by the Company on a pre-tax basis. The Company matches employee contributions at a rate of 50% of the employee's contribution up to 6% of the employee's salary up to the maximum allowable deferral per the Internal Revenue Code. Employee contributions vest immediately, whereas employer contributions vest over a period of three years. During 1993, 1992 and 1991, the Company's aggregate matching contributions were $372, $405 and $421, respectively. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. INCOME TAXES As discussed in Note 1, the Company adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993. This Statement supersedes SFAS No. 96, "Accounting for Income Taxes." The cumulative effect of adopting SFAS No. 109 on the Company's financial statements was to increase net income by $1,586 ($.09 per share). Deferred income taxes reflect the net tax effects of (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and (b) operating loss and tax credit carryforwards. The Company provided a valuation allowance of $1,165 against deferred tax assets recorded as of January 1, 1993. The valuation reserve decreased $1,165 for the year ended December 31, 1993. The valuation allowance was reversed because the Company acquired the minority interest of its 67%-owned subsidiary on January 1, 1994 and the realization of tax loss carryforwards became more likely than not. Of the valuation allowance reversed, $675 was allocated to reduce goodwill, which primarily relates to the tax loss carryforwards acquired in a prior year business combination. The effect of applying SFAS No. 109 was to decrease pretax accounting income by $495 for the year ended December 31, 1993. The impact resulted from a requirement to adjust the assets and liabilities for prior business combinations from net-of-tax to pretax amounts. As of December 31, 1993, the Company had net operating loss carryforwards from a subsidiary which is not consolidated for the purpose of filing income tax returns. These carryforwards, totalling $9,385, expire in the years 2006 to 2008. The Company also had alternative minimum tax credits totalling $2,553, which have no expiration date. Cash paid for income taxes during the years ended December 31, 1993, 1992 and 1991 was $2,382, $1,864 and $3,497, respectively. The Omnibus Budget Reconciliation Act of 1993 (the "Act") was signed into law on August 10, 1993. The Act did not significantly change the income tax consequences for the Company. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. RELATED PARTY TRANSACTIONS NOTES RECEIVABLE FROM AFFILIATES At December 31, 1993 and 1992, the Company had a $125 non-interest bearing note receivable from an affiliate. The Company provides purchasing, accounting, and other administrative services for the affiliate. In 1993, 1992 and 1991, the Company received $86, $130 and $203, respectively, from the affiliate as payment for the services rendered. SUBORDINATED PROMISSORY NOTES Interest expense paid to stockholders and affiliates (the notes were retired in 1992) was $263 and $564 in 1992 and 1991, respectively. MANAGEMENT FEES In May 1991, the Company entered into a three-year Management Agreement with Carlisle Plastics Management Corporation ("CPMC"), an affiliate of the Company, which receives an annual management fee of $1,500. Management fees in 1993, 1992 and 1991 include $1,500, $1,500 and $875, respectively, paid by the Company to CPMC under this agreement. In addition, prior to May, in 1991 the Company paid management fees of $1,763 to other affiliates of the Company. The indentures for the 10.25% Notes require that management fees do not exceed 2.0% of sales per year and that each affiliate execute a management fee subordination agreement. LEASES Rental expense of approximately $246, $217, and $206 was incurred during the years ended December 31, 1993, 1992 and 1991, respectively, with respect to the lease of office, manufacturing and warehouse space owned by affiliates of the Company. The Company leases an aircraft from Carlisle Air Corporation ("CAC"), an affiliate of the Company. Lease payments were paid to CAC in the amount of $303, $325 and $90 for 1993, 1992 and 1991, respectively, in connection therewith. INSURANCE PREMIUMS During a portion of 1991, the Company obtained insurance coverage from Greenhill Financial Group, Inc. ("Greenhill"), an affiliate of the Company. Greenhill consolidated the insurance coverage for various entities, including the Company. In 1991, the Company paid $2,100 in premiums to Greenhill. AFFILIATED PURCHASES Purchases from affiliates of the Company were $257, $355 and $28 for the years ended December 31, 1993, 1992 and 1991, respectively. OTHER TRANSACTIONS Distributions to stockholders of $1,744 were made during the year ended December 31, 1991. These distributions were approximately equal to income taxes owed by stockholders with respect to the Company's taxable income for a period of time during which the Company operated as a "S" corporation. In conjunction with the Class A Stock Offering, the Company made a special distribution to those stockholders who owned common stock of the Company prior to the Class A Stock Offering. The special distribution was valued at $4,493 and consisted of the Company's interest in a metals foundry in Costa Rica, CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) two unsecured notes payable to the Company by Carlisle Realty Holdings I Limited Partnership plus accrued interest, and certain notes receivable from stockholders plus accrued interest. Prior to the Class A Stock Offering, the Chairman of the Board and Chief Executive Officer and a former director of the Company owned an aggregate 21% interest in each of the Company's direct subsidiaries (the "Minority Interests"). Concurrent with the completion of the Class A Stock Offering, the Company acquired their Minority Interests in exchange for issuance of 48,364 shares of Class A Stock having an aggregate fair market value equal to the book value of the Minority Interests. 8. STOCKHOLDERS' EQUITY As of December 31, 1993 and 1992, the Company had authorized 10,000,000 shares of preferred stock at $.01 par value, 50,000,000 shares of Class A Common Stock at $.01 par value, and 20,000,000 shares of Class B Common Stock at $.01 par value. The Class B Common Stock is one-for-one convertible to Class A Common Stock and has restrictions on transfers other than those to entities outside the current holders of Class B Common Stock. Each share of Class A Common Stock is entitled to one vote, and each share of Class B Common Stock is entitled to twenty votes. In 1992, 355,900 options granted in 1991 were repriced to $5.00, the market price at the time of repricing. All options granted were at an option price per share greater than or equal to the market value at the date of grant. In 1992, a director and officer was granted options (which are not included in the above table) to purchase 400,000 shares of the Company's Class A Common Stock at $4.00 per share (which was the fair market value of the shares at the date of the agreement). The options vest on September 1, 1993, 1994 and 1995 in the amount of 50,000, 50,000 and 300,000, respectively. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. COMMITMENTS AND CONTINGENCIES Amounts above include $2,573 which is payable to affiliates of the Company. Total rent expense under all operating leases was $4,476, $4,969 and $4,828 for 1993, 1992 and 1991, respectively. LETTERS OF CREDIT The Company had outstanding letters of credit amounting to approximately $1,357 and $1,455 at December 31, 1993 and 1992, respectively, relating to purchase commitments issued to suppliers and an insurance carrier. LITIGATION The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the financial statements of the Company. 10. CONCENTRATION OF CREDIT RISK In September 1993, the Company received $2,000 from the termination of an interest rate swap agreement, which it had entered into in June 1993. This gain has been deferred and is being amortized over the original term of the swap agreement. On September 15, 1993, the Company entered into a new interest rate swap agreement on a notional principal amount of $90,000 terminating on June 15, 1997 (matching the principal and due date of the Company's 10.25% Notes). Under the agreement, the Company receives interest at a fixed rate and pays interest at a floating rate, which is established in arrears at six month intervals. The net interest differential and amortization of the deferred gain of $752 was recorded as a reduction of interest expense in the year ended December 31, 1993. The agreement is collateralized by the Company's accounts receivable. The Company is subject to interest rate risk during the term of the swap agreement. A sufficient increase in market interest rates during the term of the agreement could result in the Company having a net payment obligation under the agreement. Further, the Company is subject to credit risk exposure from nonperformance by the counterparty during periods when such party has a net payment obligation to the Company. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company had accounts receivable from a single customer, Wal*Mart, of $3,200 and $4,500 at December 31, 1993 and 1992, respectively. This customer has a history of timely payments to the Company. The Company believes it had no significant exposure to credit risk at December 31, 1993. 11. RESTRUCTURING CHARGE AND NEW PRODUCT INTRODUCTION During 1992 and 1991, the Company recorded restructuring charges aggregating $4,320 and $3,431, respectively. These restructuring charges included realignment of production facilities, management reorganization, product re-engineering and reduction of product offerings. In addition, in 1992 the Company incurred costs of $7,743 associated with a new product introduction. 12. BUSINESS ACQUISITION In July 1991, the Company purchased a two-thirds interest in Rhino-X for $5,000. This acquisition was accounted for using the purchase method of accounting, and accordingly, the purchase price has been allocated to assets acquired and liabilities assumed based on their fair market value. Included in goodwill at December 31, 1993 is $6,230 relating to this acquisition. Under a put and call arrangement signed in conjunction with the acquisition of Rhino-X in July 1991, the Company purchased the minority interest shares at the minimum price of $12 per share on January 1, 1994. The Company had discounted this purchase at 10% and, accordingly, recorded an obligation of $3,500 and $3,152 at December 31, 1993 and 1992, respectively. At December 31, 1993 and 1992, this obligation was reduced by $779 and $714, respectively, for sales tax payments made by the Company and recoverable from the minority shareholders. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. CONDENSED FINANCIAL INFORMATION OF CARLISLE PLASTICS, INC. AND SUBSIDIARIES Condensed consolidating financial information of the Company and subsidiaries is included in this Note. Mr. Binnie has been Chairman of the Board of Directors of Poly-Tech since 1989. Mr. Wilbur has been President of Poly-Tech since September 1992. From 1990 to 1992, Mr. Wilbur was President of Wilbur and Associates, a consulting and merger and acquisition company, and Vice Chairman of Edina Group, Inc., a merger and acquisition company. Mr. Wilbur was President and Chief Operating Officer of Poly-Tech, Inc. from 1984 to 1990. Mr. Bhatt has been Vice President, Secretary and Chief Financial Officer of Poly-Tech since 1989. EXECUTIVE COMPENSATION The compensation paid or accrued in 1993 on behalf of Messrs. Binnie, Wilbur and Bhatt was paid or accrued for services rendered to Carlisle Plastics, Inc., Poly-Tech and their respective subsidiaries. Information regarding such compensation is included in Item 11 of the Annual Report on Form 10-K, which incorporates by reference the information set forth in the 1994 Proxy Statement under the caption "Executive Compensation."

351696_1993.txt

351696_1993

1993

351696

ITEM 1. BUSINESS GENERAL Panhandle Eastern Corporation ("PEC"), a Delaware corporation, is a holding company whose subsidiaries are engaged primarily in the transportation of natural gas in interstate commerce and related services. The principal operating subsidiaries of PEC are Texas Eastern Transmission Corporation ("TETCO"), Algonquin Gas Transmission Company ("Algonquin"), Panhandle Eastern Pipe Line Company ("PEPL") and Trunkline Gas Company ("Trunkline"). Subsidiaries 1 Source Corporation ("1 Source") and Centana Energy Corporation ("Centana") pursue emerging opportunities in the natural gas market and producing areas, respectively. 1 Source provides customized transportation management services. In addition to gathering and processing natural gas, Centana owns and operates an intrastate pipeline system, markets hydrocarbon liquids and is a leading producer of helium. PEC also owns subsidiaries engaged in the importation of liquefied natural gas ("LNG") from Algeria, as well as in the transportation, storage and regasification of LNG. In addition, PEC owns subsidiaries engaged in the non-regulated marketing of natural gas in the national market and in investment in a cogeneration venture. Through subsidiaries, PEC also owns interests in a joint venture that owns and operates a chemical-grade methanol plant in Saudi Arabia and in a master limited partnership engaged in the transportation and storage of petroleum products. PEC and its subsidiaries are treated for reporting purposes as being predominately involved in the interstate transportation and storage of natural gas. Information concerning components of consolidated operating revenues, including revenues attributable to transportation and sales of natural gas, for the years 1993, 1992 and 1991 is contained in the Consolidated Statement of Income on page 41 of the PEC 1993 Annual Report to Stockholders (the "Annual Report"), filed as Exhibit 13, which is incorporated herein by reference. PEC was organized in 1981 pursuant to the corporate restructuring of PEPL, which was incorporated in 1929. Executive offices of PEC are located at 5400 Westheimer Court, Houston, Texas 77056-5310, and the telephone number is (713) 627-5400. As used herein, and unless otherwise stated, "PEC" refers to Panhandle Eastern Corporation and "Company" refers to Panhandle Eastern Corporation and its subsidiaries. NATURAL GAS PIPELINES Together, TETCO, Algonquin, PEPL and Trunkline own and operate one of the nation's largest gas transmission networks. This fully interconnected 26,000-mile system can receive natural gas from most major North American producing regions for delivery to markets throughout the Mid-Atlantic, New England and Midwest states. Within these states, the Company's pipelines hold an approximate one-third market share. During 1993, the Company's pipelines delivered 2.39 trillion cubic feet of natural gas, equal to approximately 12% of U.S. consumption. Since the early 1980s, the business operations of interstate pipelines have undergone substantial transformation, reflecting both significant changes in the marketplace for natural gas and sweeping changes in regulatory policies. As a consequence of these changes, TETCO, Algonquin, PEPL, Trunkline and many other pipelines have significantly adjusted operations to respond more effectively to an evolving business environment. During 1993, all four of the Company's pipelines implemented restructured services under Order 636. See "Regulation." CERTAIN TERMS Certain terms used in the description of the Company's business are explained below. Demand or Reservation Charge: The amount paid by firm sales, transportation and storage customers to reserve pipeline and storage capacity. Federal Energy Regulatory Commission ("FERC"): The agency that regulates the transportation and sale of natural gas in interstate commerce under the Natural Gas Act of 1938 (the "NGA") and the Natural Gas Policy Act of 1978 (the "NGPA"). FERC's jurisdiction includes rate-making, construction of facilities and authorization to provide service. Firm Service: Transportation, storage or sales of third-party gas, where customers pay a charge to reserve pipeline or storage capacity. Gathering Systems: Pipeline, processing and related facilities having the purpose of accessing production and other sources of natural gas supplies for delivery to a mainline transportation system. Interruptible Service: Transportation or storage of third-party gas provided on a capacity-available basis. Local Distribution Company ("LDC"): A municipal or investor-owned utility that sells or transports gas to local commercial, industrial and residential consumers. Merchant Sales Service: Volumes aggregated by pipelines, under purchase contracts with producers, that are transported and resold to LDCs and other customers at FERC-approved rates. Open-Access: Service provided on a non-discriminatory basis to any shipper pursuant to applicable FERC rules and regulations. Open Season: A specified period during which potential customers are asked to indicate interest in contracting for capacity in a new project. Expression of such interest is non-binding and generally followed by negotiations to establish firm commitments. Order 636: The FERC pipeline service restructuring rule that guided the industry's transition to unbundled, open-access pipeline services, creating a more market-responsive environment. Straight Fixed-Variable ("SFV") Method: A rate design method, provided for in Order 636, which assigns return on equity, related taxes and other fixed costs to the demand component of rates. Transition Costs: Those costs incurred as a result of the pipelines' transition to unbundled services under Order 636. The disposition of natural gas contracts tied to the former merchant sales function comprise the majority of such costs. Units of Measure: MARKET AND SUPPLY AREA DELIVERIES Market-area natural gas deliveries by the Company's four interstate pipelines were 2.08 Tcf in 1993, up from the 2.03 Tcf delivered in 1992. Consolidated pipeline deliveries totaled 2.39 Tcf, compared to 2.38 Tcf in 1992. Transportation volumes increased to 94% of market-area throughput in 1993, compared with 87% in 1992, as the Company's pipelines replaced merchant sales of gas with transportation service. As used herein, "market area" with respect to each pipeline refers to those portions of the pipeline that include primarily delivery points for natural gas leaving the pipeline, and "supply area" with respect to each pipeline refers to those portions of the pipeline that include primarily receipt points for gas entering the pipeline. Market-area transportation represents volumes of gas delivered to the market area under transportation service agreements, while supply-area transportation represents volumes of gas delivered to the supply area under transportation service agreements. Generally, rates for supply-area transportation have lower margins than rates for market-area transportation. Market-area throughput (deliveries) refers to combined market-area transportation volumes and merchant sales volumes. Set forth below is information concerning volumes for PEC's pipeline subsidiaries for 1993, 1992 and 1991 (volumes in Bcf). - - - --------------- (1) Represents intercompany transactions. (2) Excludes 41 Bcf which was both sold and transported, and was reported as transportation throughput in 1993. During 1993, total billings for sales and transportation services provided by the Company to Consumers Power Company ("Consumers") accounted for approximately 14% of the Company's consolidated revenues. Consumers was the only customer of the Company accounting for 10% or more of consolidated revenues in 1993. Demand for gas transmission on the Company's pipeline systems is seasonal, with the highest throughput occurring during the colder periods in the first and fourth quarters -- the winter heating season. See also "Management's Discussion and Analysis of Financial Condition and Results of Operations" on page 31 of the Annual Report, which is incorporated herein by reference. NORTHEAST AREA TETCO. TETCO's principal customers are located in Pennsylvania, New Jersey and New York, and include LDCs serving the Pittsburgh, Philadelphia, Newark and New York City metropolitan areas. On June 1, 1993, TETCO implemented restructured services pursuant to Order 636, terminating its firm merchant service in connection therewith. Customers converted existing sales contracts to firm transportation contracts, and began purchasing all gas supplies directly from producers and marketers. As a result, market-area transportation increased to 86% of 1993 total throughput, as compared with 75% in 1992. Total market-area throughput increased 11% in 1993 as a result of expanded marketing efforts, TETCO's early implementation of Order 636 and completion of several expansion projects in late 1992. TETCO continues to pursue a strategy of growing through fully subscribed customer-driven expansions of pipeline capacity. Market-expansion projects added 63 MMcf/d of transportation service to customers under long-term firm contracts during 1993, including the first 33 MMcf/d of service for the Integrated Transportation Program initiated on November 1, 1993. TETCO and Algonquin have agreed to add a total of approximately 200 MMcf/d of firm service to Northeast customers through 1995, utilizing capacity on all four of the Company's pipelines. Liberty Pipeline Company, 30% owned by the Company, proposes to construct a 38-mile, 500 MMcf/d pipeline from interconnections with TETCO and another system in New Jersey to a delivery point on Long Island, with service to be phased in during 1995 and 1996. TETCO's Liberty Upstream expansion project, pending FERC approvals, will provide 243 MMcf/d of firm service to Liberty Pipeline. PEPL will provide 60 MMcf/d of firm service to TETCO in connection with the project. On the supply area portion of its system, TETCO in 1993 continued to deliver gas to PEMEX Gas and Basic Petrochemicals, Mexico's national gas and petrochemical company, under a contract providing for interruptible transportation service. TETCO also transported Mexican gas from the U.S.-Mexico border into the United States during December under various shipping contracts. Algonquin. Algonquin's major customers include LDCs and electric power generators that utilize gas transportation services to the Boston, Providence, Hartford and New Haven areas. Algonquin's overall throughput for 1993 decreased by 7% compared to 1992. The 1993 market-area transportation volumes were virtually unchanged from the 1992 volumes. Sales volumes for 1993 decreased by 90% from 1992 due primarily to the implementation of Order 636 on June 1, 1993, which eliminated Algonquin's merchant sales function. Continued expansion efforts added 90 MMcf/d of incremental firm transportation service to Algonquin customers during 1993, including 80 MMcf/d of new capacity to LDCs and electric power generating customer pursuant to Algonquin's Open Season project. MIDWEST AREA PEPL. PEPL's market volumes are concentrated among approximately 20 utilities located in the Midwest market area that encompasses large portions of Michigan, Ohio, Indiana, Illinois and Missouri. PEPL's major customers serving this market include the utilities, producers and independent marketers. Market-area volumes in 1993 fell 13% to 560 Bcf and supply-area volumes fell 28% to 43 Bcf. The decline in market-area deliveries reflects one-time storage inventory sales in 1992, while the supply-area decline is related to the sale of a non-contiguous system during the first quarter of 1993. See Item 2. ITEM 2. PROPERTIES TRANSMISSION AND STORAGE FACILITIES The combined transmission systems of TETCO, Algonquin, PEPL and Trunkline consist of approximately 26,000 miles of pipeline and 108 mainline compressor stations having an aggregate of 2,227,000 installed horsepower. TETCO's gas transmission system extends approximately 1,700 miles from producing fields in the Gulf Coast region of Texas and Louisiana to Ohio, Pennsylvania, New Jersey and New York. It consists of two parallel systems, one comprised of three large-diameter parallel pipelines and the other comprised of from one to three large-diameter pipelines over its length. TETCO's system, including the gathering systems, has 73 compressor stations having a total of 1,345,000 installed horsepower. The Lebanon Lateral is located between Grant County, Indiana, and Lebanon, Ohio. TETCO owns the Indiana portion and a small segment of the Ohio portion of this pipeline, while the rest of this pipeline in Ohio is jointly owned by TETCO and another interstate gas pipeline company. The Indiana portion of the Lebanon Lateral extends approximately 53 miles, while the Ohio portion of this pipeline is 61 miles long. Algonquin's transmission system connects with TETCO's facilities in Lambertville and Hanover, New Jersey, and extends through New Jersey, New York, Connecticut, Rhode Island and Massachusetts to the Boston area. The system consists of approximately 1,000 miles of pipeline with five compressor stations having a total of approximately 99,000 installed horsepower. PEPL's transmission system, which consists of four large-diameter parallel pipelines, gathering systems and 13 mainline compressor stations having an aggregate of 403,000 installed horsepower, extends a distance of approximately 1,300 miles from producing areas in the Anadarko Basin of Texas, Oklahoma and Kansas through the states of Missouri, Illinois, Indiana and Ohio into Michigan. On March 31, 1993, PEPL completed the sale of the Wattenberg system, a natural gas supply system in Colorado. Trunkline's transmission system extends approximately 1,400 miles from the Gulf Coast areas of Texas and Louisiana through the states of Arkansas, Mississippi, Tennessee, Kentucky, Illinois and Indiana to a point on the Indiana-Michigan border near Elkhart, Indiana. The system consists principally of three large-diameter parallel pipelines and 18 mainline compressor stations having an aggregate of 335,000 installed horsepower. Trunkline also owns and operates two offshore Louisiana gas supply systems consisting of 337 miles of pipeline extending approximately 81 miles into the Gulf of Mexico. TETCO owns and operates two offshore Louisiana gas supply systems, which extend as far as 103 miles into the Gulf of Mexico and consist of 477 miles of pipeline. Northern Border Pipeline Company ("Northern Border"), in which a PEPL subsidiary has an approximate 6% effective ownership interest, owns a transmission system consisting of 969 miles of pipeline extending from the Canadian border through Montana to Iowa. Northern Border transports gas both under traditional long-term contracts and on an open-access basis. It has a certificated transport capacity of 975 MMcf/d. In 1992, PEPL terminated its gas supply arrangements with respect to Canadian gas. The agreement calls for an affiliate of Pan Alberta Gas Limited ("Pan Alberta") to assume PEPL's 150 MMcf/d of transportation capacity on Northern Border. PEPL has guaranteed payments to Northern Border by Pan Alberta's affiliate. For information regarding this guarantee and the sale of a portion of the Company's interest in Northern Border, see Note 6 of the Notes to Consolidated Financial Statements on page 51 of the Annual Report, which is incorporated herein by reference. For information concerning natural gas storage properties, see "Natural Gas Pipelines -- Natural Gas Storage" under Item 1, which is incorporated herein by reference. LNG FACILITIES Algonquin LNG, Inc., a subsidiary of Algonquin, owns and operates an LNG storage facility in Providence, Rhode Island. This facility has a storage capacity of 600,000 barrels, which approximates 2 Bcf, and a design output capacity of 100 MMcf/d. Trunkline LNG owns a marine terminal, storage and regasification facility for LNG located near Lake Charles, Louisiana. The Trunkline LNG facilities have a design output capacity of approximately 700 MMcf/d and a storage capacity of approximately 1.8 million barrels, which approximates 6 Bcf. Lachmar, a partnership in which subsidiaries of PEC own all of the partnership interests, owns two LNG ships, each with a transportation capacity of 125,000 cubic meters of LNG. Both ships are currently under charter to Indonesia's national oil and gas company. The Company continues to examine opportunities to better utilize its LNG assets, including the ships. TEPPCO PARTNERS FACILITIES TEPPCO Partners owns and operates an approximate 4,200-mile refined petroleum products and LPG pipeline system extending from southeast Texas through the midwestern and central United States to the northeastern United States. The pipeline system includes delivery terminals along the pipeline for outloading product to tank trucks, rail cars or barges, as well as storage capacity at Mont Belvieu, Texas, the largest LPG storage complex in the United States, and at other locations. TEPPCO Partners also owns two marine receiving terminals at Beaumont, Texas, and Providence, Rhode Island. The TEPPCO Partners pipeline system is the only pipeline that transports LPGs to the Northeast. OTHER None of the other properties used in connection with the Company's other business activities, which are described under "Other Business Activities" under Item 1, is considered material to the Company's operations as a whole. [MAP] ITEM 3. ITEM 3. LEGAL PROCEEDINGS For information concerning material legal proceedings, see Notes 2, 3, 9 and 11, on pages 47 through 50, 53, 54 and 55 of the Annual Report, which are incorporated herein by reference. In connection with the incident on March 24, 1994 in Edison, New Jersey (see "Recent Development" under Item 1), a lawsuit was filed by Nancy Kemps, et al. in the Superior Court of New Jersey for Middlesex county naming TETCO as one of the defendants. The plaintiffs seek unspecified damages for personal injury and property damage and request the court to grant class certification. Other lawsuits have been reported but the Company has not been served. 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 fiscal year. EXECUTIVE OFFICERS OF REGISTRANT - - - --------------- (1) Mr. Hendrix was elected Chairman of the Board, President and Chief Executive Officer in 1990 and relinquished the title of President to Mr. Anderson in December 1993. Mr. Hendrix was President, TEC, 1985-1989; and Chief Executive Officer, TEC, 1987-1989. (2) Mr. Anderson was Executive Vice President from March 1991 until December 1993, when he was elected President. Prior to joining PEC, Mr. Anderson was Vice President, Finance and Chief Financial Officer, Inland Steel Industries, Inc., 1990-1991. He was Senior Vice President, TEC, 1987-1989. (3) Mr. Mazanec was Executive Vice President from April 1991 until December 1993, when he was elected Vice Chairman of the Board. Prior thereto, he was Group Vice President from November 1989 until April 1991, and Senior Vice President, TEC and TETCO, 1987-1989. (4) Mr. Hipple was elected Senior Vice President and Chief Financial Officer in July 1990. Prior to his election as Senior Vice President and Chief Financial Officer, Mr. Hipple served as Senior Vice President-Finance from July 1989. (5) Mr. King was elected Senior Vice President and General Counsel in 1990. Prior to joining PEC, Mr. King was President, Oil Tool Division, Cooper Industries, 1989-1990; and Senior Vice President, Cameron Iron Works (oil field equipment manufacturer), 1984-1989. (6) Mr. Ferguson was elected Vice President, Finance and Accounting, in 1992. Prior thereto, Mr. Ferguson was Vice President and Treasurer from 1990, after having served as Treasurer. Mr. Ferguson was Treasurer, TEC, 1988-1989. (7) Mr. Hart has been an officer or employee of PEC, or a subsidiary of PEC, for at least five years. (8) Mr. Ludwig was elected Vice President, Corporate Development, in January 1993. He was President of Algonquin Energy Corporation and Algonquin from April 1991 and January 1991, respectively, until January 1993. Prior thereto, Mr. Ludwig was Executive Vice President of those companies from July 1986. (9) Ms. Meyer has been an officer or employee of PEC, or a subsidiary of PEC, for at least five years. She was elected Controller of PEC in 1993. (10) Mr. Thomas was elected Treasurer of the Company, PEPL, TEC and TETCO in April 1992. He was Assistant Treasurer of those companies from January 1991 to April 1992, and held various financial management positions at PEC and TEC for more than five years prior thereto. (11) Mr. Church was elected Senior Vice President of TETCO in January 1994. Prior thereto, he was Vice President of TETCO since January 1991. He was an Executive Vice President of Texas Eastern Gas Pipeline Company ("TEGP"), a division of TETCO, 1987-1989, and Senior Vice President, TEGP, 1985-1987. In January 1994, Mr. Church was appointed to the Company's Executive Management Committee. (12) Mr. Fowler was elected President of TETCO in January 1994. Prior thereto, he was the Company's Vice President of Marketing from December 1992 until January 1994; President and Director of 1 Source from March 1993 until January 1994; President of Trunkline from January 1991 to December 1992; Vice President of PEPL and Trunkline from January 1988 to January 1991, and of TETCO from July 1989 to January 1991. In December 1992, Mr. Fowler was appointed to the Company's Executive Management Committee. (13) Mr. Perkins was elected President of 1 Source in January 1994. Prior thereto, he was Senior Vice President, TETCO, from May 1992 until January 1994; Vice President of TETCO from January 1991 to May 1992; and an officer or employee of PEC, or a subsidiary of PEC, for more than five years. In January 1994, Mr. Perkins was appointed to the Company's Executive Management Committee. All officers of PEC are elected in April of each year at the organizational meeting of the Board of Directors. There are no family relationships among any directors or executive officers of PEC. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS See "Stockholders' Information -- Common Stock" on page 59 and Note 10 of the Notes to Consolidated Financial Statements on page 54 of the Annual Report, which are incorporated herein by reference. The Common Stock is listed on the New York and Pacific Stock Exchanges. At February 28, 1994, there were 30,195 holders of record of the Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA See page 58 of the Annual Report, which is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See pages 31 through 39 of the Annual Report, which are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to "Index -- Financial Statements" under Item 14(a)(1). See the consolidated quarterly financial data on page 57 of the Annual Report, which is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See pages 2 through 4 and page 6 of the Panhandle Eastern Corporation Definitive Proxy Statement, dated March 11, 1994 ("Proxy Statement"), which are incorporated herein by reference. See list of "Executive Officers of Registrant" on pages 15 and 16, which is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION See pages 8 through 16 of the Proxy Statement, which are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See pages 7 and 8 of the Proxy Statement, which are incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See pages 2 through 4, 7 and 8 of the Proxy Statement, which are 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 a part of this report or incorporated herein by reference: (1) The Consolidated Financial Statements and Financial Statement Schedules of Panhandle Eastern Corporation and Subsidiaries are listed on the Index, page 19. (2) Exhibits not incorporated by reference to a prior filing are designated by an asterisk (*) and are filed herewith; all exhibits not so designated are incorporated herein by reference to a prior filing as indicated. Items constituting management contracts or compensatory plans or arrangements are designated by a double asterisk (**). The total amount of securities of the Registrant or its subsidiaries authorized under any instrument with respect to long-term debt not filed as an Exhibit does not exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. The Registrant agrees, upon request of the Securities and Exchange Commission, to furnish copies of any or all of such instruments. (b) Reports on Form 8-K. No reports on Form 8-K were filed during the three months ended December 31, 1993. PANHANDLE EASTERN CORPORATION AND SUBSIDIARIES INDEX FINANCIAL STATEMENTS AND SCHEDULES --------------------- FINANCIAL STATEMENTS - - - --------------- * Refers to the pages in the Panhandle Eastern Corporation 1993 Annual Report to Stockholders, which are incorporated herein by reference. --------------------- SCHEDULES All other Schedules are omitted because they are not applicable, not required or the information is included in the Consolidated Financial Statements or the Notes thereto. SCHEDULE V PANHANDLE EASTERN CORPORATION AND SUBSIDIARIES PLANT, PROPERTY AND EQUIPMENT THREE YEARS ENDED DECEMBER 31, 1993 - - - --------------- (1) Includes gathering, underground storage and certain general plant and construction work in progress amounts. (2) Includes allowance for equity funds and interest on borrowed funds charged to construction of $4.2 million for 1991, $4.4 million for 1992 and $6.4 million for 1993. (3) Includes reclassification of costs related to TETCO's PCB (polychlorinated biphenyl) cleanup program. (4) Includes the sale of the Wattenberg system, a natural gas supply system in Colorado. See Note 7 of the Notes to Consolidated Financial Statements for depreciation rates. S-1 SCHEDULE VI PANHANDLE EASTERN CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT THREE YEARS ENDED DECEMBER 31, 1993 - - - --------------- (1) Excludes amortization of goodwill and includes amounts charged to other operating expenses. (2) Includes a reclassification from rate refund provisions related to settlement of a PEPL rate case. (3) Includes the sale of the Wattenberg system, a natural gas supply system in Colorado. S-2 SCHEDULE IX PANHANDLE EASTERN CORPORATION AND SUBSIDIARIES SHORT-TERM BORROWINGS THREE YEARS ENDED DECEMBER 31, 1993 - - - --------------- (1) Average of daily balances for period outstanding. (2) Total interest (discounted basis) divided by average net balance for the period outstanding. (3) Secured by future demand charges. (4) Uncommitted bid facilities. S-3 SCHEDULE X PANHANDLE EASTERN CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION S-4 INDEPENDENT AUDITORS' REPORT The Board of Directors Panhandle Eastern Corporation: Under date of January 26, 1994, we reported on the consolidated balance sheet of Panhandle Eastern 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 years in the three-year period ended December 31, 1993 as contained in the 1993 annual report to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Houston, Texas January 26, 1994 S-5 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. PANHANDLE EASTERN CORPORATION* By ROBERT W. REED ------------------------------------ (Robert W. Reed, Secretary) 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. - - - --------------- * Signed on behalf of the registrant and each of these persons: By ROBERT W. REED ---------------------------------- (Robert W. Reed, Attorney-in-Fact)

67646_1993.txt

67646_1993

1993

67646

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.

68813_1993.txt

68813_1993

1993

68813

Item 1. Business. Multimedia, Inc. (the "Company") is a diversified media company with corporate headquarters in Greenville, South Carolina. The Company is a South Carolina corporation which began using its current name in 1968; however, its predecessor newspaper and broadcasting companies date back as early as 1888. The Company publishes 11 daily and approximately 50 non-daily newspaper publications; owns and operates five television and five radio stations; serves approximately 417,000 cable television subscribers in five states; monitors approximately 52,000 security alarm customers; and produces and syndicates television programming. The Company's industry segments are newspaper publishing, broadcasting, cable television, entertainment and security alarms. Financial information for these segments is presented in Note 14 of the Notes to Consolidated Financial Statements in the 1993 Annual Report, which material is incorporated herein by reference. Further information relating to the development of the business since the beginning of the fiscal year covered by this report is included in Management's Discussion and Analysis of Financial Condition and Results of Operations set forth on pages 16 through 23 in the 1993 Annual Report and in the Notes to Consolidated Financial Statements in the 1993 Annual Report, which material is incorporated herein by reference. RECAPITALIZATION MERGER On September 20, 1985, the Company's shareholders approved a Recapitalization Agreement and Plan of Merger providing for the merger of MM Acquiring Corp., a new corporation which had been organized for purposes of the merger, with and into the Company (the "Recapitalization Merger"). The purpose of the Recapitalization Merger was to recapitalize the Company and thereby provide the Company's shareholders with an opportunity to receive a premium over historical prices for a significant portion of their shares while retaining an ongoing equity interest in the Company and to provide performance incentives to members of senior management of the Company by providing them with increased equity participation in the Company. The Recapitalization Merger was consummated on October 1, 1985. Further information relating to the Recapitalization Merger is included in Note 2 of the Notes to Consolidated Financial Statements in the 1993 Annual Report, which material is incorporated herein by reference. NEWSPAPER OPERATIONS The Company publishes the only daily newspapers in Greenville, South Carolina; Asheville, North Carolina; Montgomery, Alabama; Clarksville, Tennessee; Gallipolis and Pomeroy, Ohio; Point Pleasant, West Virginia; Staunton, Virginia; Moultrie, Georgia; and Mountain Home, Arkansas. It also publishes Sunday newspapers in each market except Moultrie, Point Pleasant and Mountain Home. The Company also publishes approximately 50 non-daily publications in Alabama, Arkansas, Georgia, North Carolina, Ohio, South Carolina, Virginia and Tennessee, including the monthly MUSIC CITY NEWS and THE GOSPEL VOICE. In April 1993, the Company's Montgomery newspaper merged its morning and afternoon newspapers. Prior year linage comparisons have not been restated. However, if restated, billed advertising linage would have increased 2.2% from 1992 to 1993. The increase is primarily due to a strong rebound in classified advertising. Substantially all of the Company's newspaper revenues are obtained from advertising and circulation. Advertising rates and rate structures vary depending upon circulation and type of advertising (local, classified, national, etc.). The following table indicates billed newspaper advertising linage and advertising revenues for 1993, 1992 and 1991. 1993 1992 1991 Advertising linage 144,928,000 146,172,000 155,199,000 Advertising revenues $99,173,000 $98,254,000 $98,127,000 The Company's newspapers are primarily home-delivered and are generally sold by independent carriers and circulation dealers. Certain non-daily publications are distributed free of charge, using both mail and carrier delivery. The following table indicates total paid newspaper circulation at year-end and circulation revenues for 1993, 1992 and 1991. 1993 1992 1991 Circulation: Daily 323,000 325,000 318,000 Sunday 352,000 351,000 344,000 Non-daily 202,000 159,000 159,000 Circulation revenues $30,233,000 $28,491,000 $26,024,000 The percentages of the Company's newspaper revenues contributed by advertising, circulation and other operating revenues for the five years ended December 31, 1993, were: 1993 1992 1991 1990 1989 Advertising revenues 73% 74% 76% 78% 79% Circulation revenues 22 22 20 19 19 Other operating revenues 5 4 4 3 2 100% 100% 100% 100% 100% Newsprint represents approximately 20% of the newspaper division's operating expenses. The basis weight of newsprint used by the Company is 30 pound paper. The price of newsprint remains volatile, and it is difficult to predict any significant price increase or decrease. The average cost per ton may vary depending upon the competitive discount allowance throughout the year. Two newsprint suppliers provide the majority of the Company's newsprint. The Company believes that its newsprint supply sources under existing arrangements are adequate. The Company's newspapers compete for advertising principally on the basis of readership and compete for circulation principally on the basis of content. The Company's daily newspapers do not compete directly with any other general circulation daily newspaper published in that community. Most of the Company's newspapers compete with other newspapers published in nearby cities and towns, or with free distribution advertising weeklies. Further, all of the Company's newspapers compete with newspapers having national or regional circulation, as well as with magazines, radio, television, outdoor and other advertising media. BROADCASTING OPERATIONS The Company wholly owns and operates four VHF television stations located in St. Louis, Missouri (KSDK, an NBC affiliate); Cincinnati, Ohio (WLWT, an NBC affiliate); Knoxville, Tennessee (WBIR-TV, an NBC affiliate); and Macon, Georgia (WMAZ-TV, a CBS affiliate). In addition, the Company owns a 51% majority interest in WKYC-TV (an NBC affiliate) Cleveland, Ohio, and has operating control of the station. Television stations operate under network affiliation contracts running from two to five years. The network provides programs to its affiliated stations and sells commercial time in the programs to national advertisers. The stations also sell commercial time in the programs to national and local advertisers. Generally, a network affiliation agreement can be cancelled prior to the expiration of the contract by either party with 180 days notice. The Company has experienced no difficulties in the past with such affiliation renewals. The Company's television stations' affiliation renewal dates follow: Television Station Network Affiliation Renewal KSDK May 1, 1994 WLWT September 1, 1994 WBIR September 10, 1994 WKYC December 26, 1994 WMAZ February 1, 1995 Each television station transmits live, filmed or taped programs purchased from others or produced by the station. For both television and radio, the Company endeavors to present a balanced schedule of programs, including entertainment, news, public affairs, sports and other programs of public service and public interest. The Company owns and operates AM and FM radio broadcasting stations in Greenville, South Carolina, and Macon, Georgia, and an AM station in Spartanburg, South Carolina. Each of these stations is authorized to operate 24 hours per day, and each maintains a daily operating schedule of at least 18 hours. The principal sources of the Company's television and radio revenues consist of payments from national, regional and local advertisers or agencies for program time or advertising announcements, payments from the networks for broadcasting network programming and payments by advertisers and other broadcasters for services such as the production of films or the taping of advertising material. The percentages of the Company's broadcasting revenues contributed by television and radio and other for the five years ended December 31, 1993, were: 1993 1992 1991 1990 1989 Television revenues 94% 91% 91% 89% 89% Radio and other revenues 6 9 9 11 11 100% 100% 100% 100% 100% In January 1993, the Company sold its mobile video production business for $4.5 million, which resulted in a gain of approximately $2.3 million before taxes. Revenues from the mobile video production business are included in the above table under other revenues. During the first quarter of 1994, the Company sold its radio stations in Milwaukee, Wisconsin, and Shreveport, Louisiana, for a total of $7.2 million, which resulted in a gain of approximately $3.6 million before taxes. Excluding the results of the properties sold during 1993 and the first quarter of 1994, broadcasting revenues would have decreased approximately 1% and operating profit would have increased approximately 5% from 1992 to 1993. The market size, rank and share for the Company's television stations are presented below: Rank Share WKYC (Market #12) 1993 2 17 1992 3 17 1991 3 17 KSDK (Market #18) 1993 1 26 1992 1 24 1991 1 24 WLWT (Market #31) 1993 2 19 1992 3 17 1991 2 21 WBIR (Market #62) 1993 1 28 1992 1 27 1991 1 27 WMAZ (Market #120) 1993 1 42 1992 1 43 1991 1 44 Note: Information represents station ADI TV Household share sign-on/sign-off for the November Arbitron or Nielsen of the respective period. Source for market size: "Arbitron Television - 1993" The Company's television and radio stations compete for revenues principally on the basis of ratings. The Company's television and radio stations compete for revenues with other advertising media such as newspapers, magazines and other television and radio stations. Other sources of present and potential competition include cable television ("CATV"), pay cable and subscription TV operations. CATV systems currently operate in most of the market areas served by the Company's communications media. In addition, franchises for CATV systems have been granted by various communities in these market areas, and additional CATV franchises may be considered and granted from time to time. The future of broadcasting depends on a number of factors, including the general strength of the economy, population growth, overall advertising revenues, relative efficiency compared to other competing advertising media and existing and future governmental regulations and policies. The business strategy of the Company's broadcasting division focuses on providing quality local programming and service to each of its respective communities. The most important local programming segment to the Company's broadcasting division is local news programming. Local news programming typically has the highest rating of any local programming segment, and television stations usually receive a significant portion of their advertising revenues from the local news segments. Quality local news coverage is also important in establishing a local station's public service reputation. Further information regarding the Company's broadcasting operations is presented under "Federal Regulation of Broadcasting". CABLE OPERATIONS The Company operates cable television systems serving subscribers in Kansas, Oklahoma, Illinois, Indiana and North Carolina. The following table shows homes passed, basic and pay subscribers, basic penetration, pay-to-basic ratio and average monthly revenue per cable subscriber at the end of 1993, 1992 and 1991. 1993 1992 1991 Homes passed 694,000 688,000 623,000 Basic subscribers 417,000 410,000 365,000 Pay subscribers 323,000 333,000 312,000 Basic penetration 60.1% 59.6% 58.6% Pay-to-basic ratio 77.5% 81.2% 85.5% Average monthly revenue per cable subscriber $33.29 $32.13 $30.36 The majority of the increase in basic subscribers from 1991 to 1992 was due to the purchase of 33,000 cable television subscribers in Indiana and Illinois. Cable television is the distribution of television signals and special information programs to subscribers within the community by means of a coaxial cable system. A cable system may also offer pay television services which provide, for an extra charge, special programs such as recently released movies, entertainment programs or selected sports events. Subscribers receive these programs on a designated channel of the cable system which is restricted with electronic security devices to isolate the pay television signal so that only subscribers to the service can receive it. The Company holds approximately 140 franchises from local governing authorities which permit the Company to operate a CATV system in the granting community (see Federal Regulation of Cable Television). These franchises, which expire at varying dates ranging from one to 20 years, are generally non-exclusive and may be terminated for failure to comply with specified conditions. In most cases, the Company is required to pay fees generally ranging from three to five percent of the system's revenues to the particular local governing authority granting the franchise. At the end of 1993, approximately 52 systems, which account for more than 68% of the Company's subscribers, have franchise agreements expiring in the year 2000 and beyond. During 1993, the Company began a five-year $150 million investment in the technological upgrade of its cable television operations. The investment includes approximately $45 million in each of the next two years to replace the coaxial wire in our cable systems with fiber. The majority of the remaining portion of the $150 million program will include the integration of digital compression and the installation of interactive converter boxes in the homes of approximately 50% of our customers, being the percent of the existing customers that we expect will want the new interactive services. The Company believes the technological upgrade will prepare it for new competitors and potential revenue opportunities. The Company may compete with other companies and individuals in the submission of applications for additional franchises, the renewal of existing franchises and in seeking to acquire operating CATV systems and under-developed franchises. Since most franchises are granted on a non-exclusive basis, other applicants may obtain franchises in areas where the Company presently operates systems or holds franchises. The Company's cable television division competes for revenues principally on the basis of quality of service, a variety of programming options and pricing. The Company's strategy is to develop clusters of cable television systems in suburban communities of major metropolitan markets and other areas with favorable demographics. Management believes that the clustering of cable systems produces operating, marketing and servicing efficiencies. On February 22, 1994, the Federal Communications Commission ("FCC" or "Commission") announced several decisions relating to cable rates (see Federal Regulation of Cable Television). Wireless Cable Service The Company operates wireless cable systems in the Oklahoma City, Oklahoma, and Wichita, Kansas, metropolitan areas. Wireless cable is over-the-air distribution to consumers' residences of video programming by means of microwave radio channels. It combines standard broadcast television reception equipment with microwave reception equipment and uses a combination downconverter and channel selector to provide a composite of broadcast and non- broadcast signals to subscribers. In this regard, wireless cable may provide an alternative programming delivery service to that offered by a traditional cable television system. The frequencies allocated by the FCC for this use are those in the multichannel multipoint distribution service ("MMDS"), Private Operational Fixed Microwave Service ("OFS") and, on a part-time basis, the Instructional Television Fixed Service ("ITFS"). The Company holds several licenses issued by the FCC for use of frequencies in its Oklahoma City systems. For both the Oklahoma City and Wichita systems, the Company has entered into lease agreements with the FCC license-holders for various MMDS and ITFS frequencies. Terms of these agreements vary from one year to five years with provision for renewal. In 1990 and 1991, the Commission simplified its regulations and procedures applicable to the wireless cable business in order to allow wireless cable systems to compete more effectively with traditional cable systems. Among other things, the Commission eliminated its rules restricting the number of wireless cable channels a single entity can control in a market and modified interference requirements and processing practices to accelerate the application process. The Commission also limited the future ownership or lease of wireless cable channels by cable television operators within their local franchise areas, while grandfathering existing wireless cable operations owned by cable television operators. Further, the Commission modified restrictions on lease terms for MMDS use of ITFS frequencies and increased power limitations and channel assignment standards. The Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Act") prohibits common ownership of cable television and wireless cable operations in a franchise area. However, existing operations, such as those of the Company, are grandfathered, and the FCC is authorized to grant waivers of the cross-ownership restriction in other situations. Wireless cable operators that include local or distant television stations in their service offerings traditionally have relied upon the compulsory broadcast retransmission license established by the Copyright Act to cover their use of copyrighted material contained in such signals. The Copyright Office has ruled that the compulsory license does not cover wireless cable operations. The wireless cable industry is expected to seek legislation to clarify that wireless cable operators are eligible for the license. The provisions of the 1992 Act governing mandatory carriage of television broadcast signals (see Federal Regulation of Broadcasting) do not apply to wireless cable operations. However, those provisions dealing with retransmission consent are applicable. Consequently, wireless cable operators are required to obtain the consent of local broadcast stations prior to utilizing microwave frequencies to distribute such stations. The Company does not use microwave frequencies to distribute local over-the-air television stations in its Oklahoma City operations, but it does in Wichita, and it has obtained the requisite consents for distribution of those local stations. SECURITY ALARM OPERATIONS The Company sells or leases and installs residential and commercial alarm equipment and provides monitoring services for the alarm owner or lessee. These accounts are monitored through a central computer located in Wichita, Kansas. At year-end, the Company provided security monitoring services for approximately 52,000 customers (both residential and commercial) primarily located in the midwest and western United States. These accounts were obtained through acquisitions and through in-house sales efforts. The following table shows the number of subscribers and the average recurring monthly revenue per security subscriber at the end of 1993, 1992 and 1991. 1993 1992 1991 Number of subscribers 52,000 35,000 26,000 Average recurring monthly revenue per subscriber $25.13 $23.09 $21.94 The Company's security alarm division generates revenues from the installation, monitoring and servicing of security alarm systems. Monitoring fees, which represent approximately 80% of the division's revenues, consist of payments from customers for the surveillance of the security devices in their home or business. These devices transmit a signal through telephone lines or radio waves to the monitoring station whenever the customer's alarm is triggered. Generally, monitoring contracts between the Company and alarm customers are for at least three years. There are many security companies competing in the same markets with the Company. The Company may also compete with other companies in the acquisition of existing security accounts. The Company's security division competes for revenues with many other security companies on the basis of quality of service, ability to monitor and service security systems and price. ENTERTAINMENT OPERATIONS The Company's entertainment division produces television programming for broadcast both in the U.S. and internationally. The division derives virtually all of its operating profits and approximately 50% and 25%, respectively, of its revenues from the production and syndication of two daytime television talk shows, the "DONAHUE" and "SALLY JESSY RAPHAEL" shows. Both of these shows are primarily distributed via satellite to the stations for showing. A significant portion of operating profit for the division is contributed by the "DONAHUE" show. The Company's syndication activities continue to be an important source of revenues, particularly the "DONAHUE" show. The Company contracts with television stations for exclusive rights to air these programs in their respective markets. The length of these contracts generally range from one to three years. Fees from these sales to stations and the sale of advertising in these shows are the principal sources of revenue for the Company's entertainment division. In addition, the Company produces other talk shows, and special dramas, movies and docudramas for first-run syndication, the networks, cable, PBS and the international marketplace. The "DONAHUE" show, hosted by Phil Donahue, is in its twenty-sixth year of production and syndication. The show is currently seen in 189 U.S. markets and in 50 foreign countries. Phil Donahue is currently under contract with the Company through August 31, 1995. The "SALLY JESSY RAPHAEL" show is currently in its eleventh season of production and syndication and is broadcast in 186 U.S. markets and in 30 foreign countries. The show's revenues have grown significantly over the last five years, due to increased ratings and clearances. Sally Jessy Raphael is currently under contract with the Company through September 1998. In September 1991, the Company purchased certain television and first-run syndicated television assets from Carolco Pictures, Inc.'s wholly owned subsidiary, Orbis Communications, now named Multimedia Motion Pictures, Inc. ("MMP"). MMP's primary objective is to produce made-for-television movies or miniseries for the networks, syndication and cable marketplace. The number of hours of programming produced and sold to various networks increased from six hours in 1992 to 16 hours in 1993. The Company expects to curtail this activity in the future to concentrate its resources on more profitable programming opportunities. The Company introduced a talk show, "JERRY SPRINGER", in September 1991 on four stations and began nationwide syndication in September 1992. The "Jerry Springer" show is currently seen in 145 U.S. markets. Jerry Springer is currently under contract with the Company through September 1997. "RUSH LIMBAUGH, THE TELEVISION SHOW", a late-night talk show, premiered in September 1992 and is currently seen in 223 U.S. markets. "RUSH LIMBAUGH, THE TELEVISION SHOW" is a joint venture between Ailes Communications, Rush Limbaugh and the Company. Rush Limbaugh is currently under contract with the Company through August 1995. The Company plans to launch a news-oriented all talk channel for cable in the fall of 1994. The Company's entertainment division competes for revenues with numerous other syndicated programming principally on the basis of ratings. EMPLOYEE RELATIONS The Company employs approximately 3,500 full-time employees and has contracts with local collective bargaining agents representing approximately 5% of its employees. Employees of the Company receive various supplemental benefits including group life and health insurance, pension and salary deferral thrift plans. The Company considers its relationship with employees excellent. REGULATION OF BROADCASTING AND CABLE OPERATIONS Federal Regulation of Broadcasting The Company's television and radio broadcasting operations are subject to the jurisdiction of the FCC under the Communications Act of 1934 as amended (the "Act"). The Act empowers the FCC, among other things, to issue, revoke or modify broadcasting licenses, to assign frequency bands, to determine the location of stations, to regulate the apparatus used by stations, to establish areas to be served, to adopt such regulations as may be necessary to carry out the provisions of the Act and to impose certain penalties for violation of its regulations. Under the Act, radio and television broadcast licenses may be granted for maximum periods of seven and five years, respectively. Upon application, and in the absence of conflicting applications or adverse findings as to the licensee's qualifications, existing radio and television licenses will be renewed without hearing by the FCC for additional seven and five year terms, respectively. If a competing application is filed against a licensee's renewal application, the Act requires a full comparative hearing. The U.S. Court of Appeals for the District of Columbia Circuit affirmed a significant FCC decision in a comparative television renewal proceeding which recognized an incumbent licensee's "renewal expectancy" based on substantial service to its community. The Court's decision indicated that a renewal expectancy, if proven by sound past performance, should be considered by the FCC along with other standard comparative factors applicable to both the incumbent and the competing applicants such as (i) the applicants' other media holdings (in this context, FCC policy disfavors owners of multiple properties); (ii) the applicants' plans for management of the facility by their respective owners (which is normally not required in the case of a publicly owned broadcasting company); and (iii) other factors, including local residency, civic involvement and provision of signals to under-served populations. The FCC has established procedures placing strict limitation on settlement payments made to competing applicants in return for dismissal of their applications. These rules were intended to reduce the potential for abuse of the FCC's renewal procedures. The FCC currently has pending a rulemaking and inquiry proceeding to develop specific standards for determining whether an incumbent is entitled to a renewal expectancy and for comparing incumbent licensees with competing applicants as well as to establish procedures regarding the order of proof for determining entitlement to renewal expectancy. Petitions to deny broadcast station license renewal applications (as well as other types of broadcast applications) have been filed in recent years by various parties asserting programming, employment and other complaints. Most such petitions have been denied by the FCC on the basis of pleadings and without formal hearings. The Company's applications for the renewal of its broadcast licenses for the regular term have heretofore been granted without hearing; however, there is no assurance that this experience will be repeated in the future. The Company's television stations' FCC license renewal dates follow: Television Station FCC License Renewal WMAZ April 1, 1997 WBIR August 1, 1997 WKYC October 1, 1997 WLWT October 1, 1997 KSDK February 1, 1998 The Act also prohibits the assignment of a license or the transfer of control of a license or significant modification of broadcast transmission facilities without prior approval of the FCC. Moreover, FCC multiple ownership regulations prohibit the common ownership or control of most communications media (i.e., television and radio, television and daily newspapers, radio and daily newspapers or television and cable television operations ("Cable")) serving common or overlapping market areas. The Company owns daily newspapers and AM and FM radio stations in Greenville, South Carolina; and AM and FM radio stations and a television station in Macon, Georgia. These ownership interests pre-dated the FCC's multiple ownership rules and thus are "grandfathered", and divestiture by the Company is not required. In the case of a sale or transfer of control (other than a "pro forma" or non-substantial transfer of control), however, the buyer or transferee would not be able to continue the common ownership of the relevant properties absent a waiver of the FCC's rules. In addition, FCC multiple ownership regulations generally limit the number of cognizable broadcast interests which may be owned by an entity or individual. Cognizable interests under FCC multiple ownership rules include 5% or greater voting stockholder interests (10% or more for investment companies, bank trust departments and insurance companies), general (and some types of limited) partnership interests and official positions as officers or directors. FCC multiple ownership regulations generally permit the common ownership of up to 12 television stations (without regard to whether they are in the UHF or VHF band), provided the total audience reach of commonly owned television stations is less than 25% of the nation's television households. (For purposes of calculating the total percentage of national television households, only 50% of each UHF station's audience reach is counted.) A rulemaking proceeding currently pending before the FCC proposes to liberalize both the local and national limits on television ownership. It is unlikely that this rulemaking will be concluded before the end of 1994, and there can be no assurance that any of these rules will be changed. In any event, the Company's broadcast operations will continue to be subject to the FCC's ownership rules and any changes the agency may adopt. The Company does not believe that the FCC multiple ownership regulations for television stations will restrict its growth except in areas with overlapping coverage to its existing properties. In 1992 the FCC relaxed its "duopoly" rule governing ownership by a single entity of multiple radio stations in the same market. In local markets with 15 or more stations, one entity is permitted to own two AM and two FM stations, so long as the combined audience share of these stations does not exceed 25% of the market at the time of acquisition. In markets with fewer than 15 stations, ownership of up to three radio stations is permitted, no more than two of which may be in the same service (AM or FM), provided that the total number of stations owned comprises less than 50% of the total number of stations in the market. The FCC also increased the number of stations which may be owned by a single entity on a national basis to 18 AM and 18 FM stations; in 1994 this will increase to 20 AM and 20 FM stations. The 1992 Act contains two provisions that fundamentally alter the relationship that has existed in recent years between cable television systems and television broadcast stations whose signals are distributed to cable subscribers. The first deals with the rights of "local" commercial and non-commercial television broadcasters to mandatory carriage of their signals on cable systems ("must-carry"). The second, in certain defined circumstances, prohibits cable operators from carrying the signals of television stations without first obtaining their consent ("retransmission consent"). The two provisions are related in that, with respect to local cable carriage, broadcasters must make a choice once every three years on a system by system basis whether to proceed under the must-carry rules or whether to insist upon retransmission consent in order for their signal to be carried. The FCC's implementing regulations required broadcasters to elect between must-carry and retransmission consent by June 17, 1993, with the choice binding for three years. A broadcast station has the right to choose must-carry, assuming it can deliver a signal of specified strength, with regard to cable systems in its Area of Dominant Influence as defined by the audience measurement service Arbitron. Stations electing to grant retransmission authority were expected to conclude their consent agreements with cable systems by October 6, 1993, the date on which system's authority to carry broadcast signals without consent expired. In June 1993, the Company elected retransmission consent on the majority of cable systems that carry the signals of the stations in the stations' markets. Must-carry was elected on a small percentage of systems. Pending negotiation of long-term retransmission agreements, the stations have entered into interim agreements (currently scheduled to expire June 30, 1994) with all of the affected cable system operators. The must-carry provisions of the 1992 Act have been challenged as unconstitutional. A special three-judge district court rejected the challenge. That decision has been appealed, and the Supreme Court of the United States heard oral arguments in the case on January 12, 1994. Its decision is expected later this year. The Company cannot predict the outcome of the case. A separate challenge to the retransmission consent provision of the 1992 Act was rejected by a Federal district court. An appeal of that decision is pending. The FCC's syndicated exclusivity and network non-duplication rules enable television broadcast stations, that have obtained exclusive distribution rights for programming in their market, to require cable systems (with more than 1,000 subscribers) to delete or "black-out" such programming from other television stations which are carried by the cable system. The FCC is studying whether to relax or abolish the geographic limitations on program exclusivity contained in its rules so as to allow parties to set by contract the geographic scope of exclusive distribution rights. In addition to full service television broadcast stations, the FCC, under its rules, provides for authorization of low power television stations ("LPTV"), subscription television stations ("STV"), multipoint distribution services ("MDS"), multichannel multipoint distribution services ("MMDS") and direct satellite-to-home broadcast services ("DBS"). These services have the technical capability to distribute television programming to viewers' homes and, thus, to compete with conventional full service television stations. Technological developments in broadcasting and related fields, such as High Definition Television ("HDTV"), Digital Audio Broadcasting ("DAB") as well as changes in FCC regulations, may affect the competitiveness of new and existing alternatives to conventional radio and television services or otherwise affect the market for radio and television broadcast services. For example, the FCC favors relaxation of the cross-ownership ban on telephone companies providing cable television services in their telephone service area and has authorized telephone companies to provide cable service on a "video dial tone" basis. (See Federal Regulation of Cable Television.) In this regard, the United States District Court for the Eastern District of Virginia recently held that the provision of the Communications Act that prohibits telephone companies from providing video programming to subscribers within their service area is unconstitutional. Although the court's ruling only applied to the operations of Bell Atlantic (the regional Bell Operating Company ["RBOC"] that brought the suit) and its subscribers, other RBOCs have brought suit in other courts seeking to have the provision declared unconstitutional. Congressional legislation to eliminate or modify this cross- ownership ban has also been proposed. The FCC also has proposed the establishment of a local multipoint distribution service ("LMDS") that could offer multiple channels of video programming using very high-frequency microwave signals in the 28 GHz band. Under the proposal, two service providers in each of 489 markets across the country would be licensed to distribute video, data and other telecommunications services. In January 1994, the FCC announced that it would issue a Second Notice of Proposed Rulemaking in this proceeding designed to determine whether it should implement a Negotiated Rulemaking Proceeding to allow participants to determine whether the 28 GHz band could be shared by terrestrial LMDS and satellite users. The Company cannot predict the outcome of the FCC's proceeding, nor can the Company assess the effect which future technological developments or changes in FCC regulations or policies may have on the Company's operations. There are additional FCC regulations and policies, and regulations and policies of other federal agencies, regulating network- affiliate relations, political broadcasts, advertising practices, program content, equal employment opportunities, application procedures and other areas affecting the business or operation of broadcast stations. Proposals for additional or revised regulations or legislation are pending and considered by federal regulatory agencies and Congress from time to time. The Company cannot predict the effect of existing and proposed federal regulations, legislation and policies on its broadcasting business. The foregoing does not purport to be a complete summary of all the provisions of the Act or the regulations and policies of the FCC thereunder. Federal Regulation of Cable Television The cable television industry is subject to extensive government regulation at the federal and local levels and, in some cases, at the state level. The relationship of various levels of government in regulating cable television and the extent of such regulation is established by the Cable Communications Policy Act of 1984 (the "1984 Act") and the recent amendment thereto, the 1992 Act. The FCC has had and will continue to have principal federal responsibility for regulating cable television. The 1992 Act has greatly expanded the regulatory framework of the FCC within which cable operators must operate. Under this new framework, the FCC was required to adopt new regulations implementing Congressional policies for such aspects of cable operations as rates, customer service obligations, carriage of television broadcast signals and other types of programming, technical matters, leased access, franchise issues, consumer electronics equipment standards, ownership and employment practices. During the past year, the FCC completed initial rulemaking proceedings in accordance with timetables imposed by the 1992 Act; however, many of the new rules remain under reconsideration by the FCC. In addition, provisions of the 1992 Act and some of the FCC's implementing regulations have been challenged in court. Thus, there remains an element of uncertainty as to the ultimate nature and scope of the new requirements. A. Television Signal Carriage and Programming. The 1992 Act contains two elements that fundamentally alter the relationship between cable systems and television broadcast stations. The first reinstates the mandatory carriage of certain local over-the-air television stations ("must-carry" rules). Such rules have previously been held unconstitutional as violative of cable operators' First Amendment Rights. The second element provides that in certain circumstances television stations may prohibit the carriage by cable systems absent consent ("retransmission consent"). The two provisions are related in that broadcast stations must elect either must-carry or retransmission consent on local cable systems. Election must be made every three years. For the current three-year election period, the Company's cable systems have succeeded in maintaining desirable channel line-ups by accommodating those stations electing mandatory carriage and entering into retransmission consent agreements with others. The U.S. Supreme Court recently heard arguments on an appeal of the 1992 Act's must-carry provisions and is expected to rule on their constitutionality later this year. In addition, the FCC is reconsidering certain aspects of its recently-adopted regulations governing must-carry and retransmission consent. (See also, Federal Regulation of Broadcasting, above.) The FCC's syndicated exclusivity and network non-duplication rules enable television broadcast stations, that have obtained exclusive distribution rights for programming in their market, to require cable systems (with more than 1,000 subscribers) to delete or "black-out" such programming from other television stations which are carried by the cable system. The extent of such deletions varies from market to market but generally makes distant broadcast signals less attractive sources of programming. The FCC also is studying whether to relax or abolish the geographic limitations on program exclusivity contained in its rules so as to allow parties to set by contract the geographic scope of exclusive distribution rights. This could result in even more extensive program black- outs. The FCC has recommended to Congress that it repeal at least part of the cable industry's compulsory copyright license which Congress established in 1976 to serve as a means of compensating program suppliers for cable retransmission of broadcast signals. (See Copyright discussion, below.) The FCC determined that the statutory compulsory copyright license for distant broadcast signals no longer served the public interest and that private negotiations between the applicable parties would better serve the public. The FCC has deferred a decision on whether to recommend the repeal of the statutory compulsory copyright license for retransmission of local broadcast signals. Legislation has been proposed to repeal the compulsory copyright license law. Without the compulsory license, cable operators might need to negotiate rights from the copyright owners for each program carried on each broadcast station in the channel lineup. Such negotiated agreements could increase the cost to cable operators of carrying broadcast signals. The exact relationship between the compulsory license and the 1992 Act's retransmission consent provision is unclear, and it is expected that additional legislation will be introduced to address this issue. The FCC requires that non-broadcast cable origination programming comply with FCC standards similar to those imposed on broadcasters. These standards include regulations governing political advertising and programming, advertising during children's programming, prohibition of lottery information and sponsorship identification requirements. The 1992 Act imposes certain restrictions on cable operators which have an attributable ownership interest in satellite programming services. Vertically-integrated companies are prohibited from unreasonably refusing to deal with a multichannel distributor and from discriminating in price, terms and conditions in the sale of programming to multichannel distributors if the effect is to hinder or prevent competition. As required by the 1992 Act, the FCC issued rules governing distribution practices and contractual relationships between vertically-integrated programmers and cable systems in an effort to promote competition and diversity in the programming market and to increase its availability to consumers. However, the rules allow programmers to: establish credit, financial or technical qualifications; establish different prices, terms and conditions based on actual and reasonable differences; and enter into exclusive arrangements if in the public interest. This provision has withstood judicial challenge, but an appeal of the court's decision is pending. In addition, the FCC is reconsidering the rules it adopted to implement statutory policy. B. Cable Television Ownership. As a result of the 1984 Act, the FCC is, with a few exceptions, the only governmental agency authorized to prescribe rules relating to cable system ownership or control by persons with interest in other mass media communications. The 1984 Act prohibits common ownership or control of a television station and a cable system in the station's Grade B signal coverage area (typically an area approximately 15-75 miles from the station's transmitting antenna). The 1992 Act imposes restrictions on common ownership or control of MMDS and Satellite Master Antenna Television ("SMATV") operations in a cable service area. (SMATV is a video delivery system that receives programming through a satellite earth station for distribution to viewers (without using public rights of way) in multiple dwelling complexes such as apartment buildings and hotels.) Existing ownership interests of MMDS or SMATV services are unaffected. The 1992 Act directed the FCC to implement horizontal and vertical ownership limitations on cable operators. With regard to horizontal ownership, the FCC adopted rules limiting the number of subscribers a cable operator is authorized to reach to no more than 30 percent of all homes passed by cable nationwide. The horizontal ownership limits were invalidated by a federal court, and the FCC has stayed its rule pending further judicial appeal. The FCC's new vertical integration rules limit to 40 percent of a system's capacity the number of channels that can be occupied by a commonly-owned programmer. These rules are undergoing FCC reconsideration. The 1992 Act grants local franchising authorities certain rights to deny franchise awards or transfer approvals upon a finding of common ownership by the applicant of another system in the same service area or that competition would be reduced or eliminated by such award or transfer. Except for rural telephone companies as defined by the FCC, federal law restricts the ability of telephone companies to engage in cable television operations within their local service areas. Specifically, local telephone companies may not provide video programming, channels of communication, pole or conduit space or other rental arrangements to an affiliate. The FCC favors relaxation of this ban and authorizes telephone companies to provide cable service on a "video dial tone" basis by furnishing transmission facilities to customers who would distribute programming. In the FCC's view, neither the phone company nor its programmer/customer would be subject to local franchise requirements that would apply to a conventional cable operator. Legislation which would eliminate or modify this ownership ban has also been proposed. If the restrictions are relaxed or removed, cable television companies could face increased competition. Recently, Bell Atlantic was successful in overturning the 1984 Cable Act cable-telco cross-ownership restrictions on constitutional grounds. The decision, which is limited in applications to Bell Atlantic and its subsidiaries, has been appealed, but other regional Bell Operating Companies have brought similar challenges in other jurisdictions. (See also Federal Regulation of Broadcasting, above.) Other measures that would eliminate barriers to telephone companies' entry into the cable television business are being considered by Congress. In 1992 the FCC modified its regulations governing common ownership or control of cable systems with national television networks. The new rules allow national television networks to own cable systems if such a system (when aggregated with all other cable systems in which the network holds such an interest) does not pass (i) more than 10 percent of homes passed on a nationwide basis, and (ii) 50 percent of the homes passed within any one Arbitron area of dominant influence (ADI). The 1992 Act prohibits, with some exceptions, cable operators from selling a system within 36 months of acquisition or construction. Franchise authorities must act within a certain time period to act on a request for transfer by a cable operator. The FCC has adopted rules dealing with both of these matters and has them under consideration. C. Leased Access. Cable systems with more than 36 activated channels are required by the 1984 Act to make a certain number of those channels available for commercial leased access by third parties unaffiliated with the system operator. (This provision does not, however, require a system in operation on or before December 29, 1984, to delete existing programming that was on the system before July 1, 1984, to accommodate potential lessees.) Under the 1992 Act, the FCC must determine maximum reasonable rates for commercial use of designated channel capacity and establish reasonable terms and conditions for such use. Parties who believe they have been denied access wrongfully may petition the FCC for relief or seek relief in Federal Court. Under the 1992 Act, Cable operators may prohibit the carriage of any material deemed to be obscene or otherwise patently offensive on commercial access channels. Alternatively, cable operators may place all "indecent" leased access programming on a single channel and must block the channel unless otherwise requested by a subscriber. FCC implementing rules allowing cable operators to ban such programming from access channels were struck down by the court, which remanded to the FCC regulations dealing with operators' rights and obligations to sequester certain programming on a separate channel. The FCC has asked the court for a rehearing and has stayed enforcement of its rules in the meanwhile. D. Other Non-Programming Requirements. The 1992 Act mandates that the FCC modify and adopt new rules regarding frequency utilization standards for cable systems. The FCC has preempted, except upon a FCC-granted waiver, state and local authorities from enforcing technical standards which are more stringent than the FCC's guidelines. The 1992 Act requires the FCC to issue regulations to ensure compatibility between cable systems and television receivers and video cassette recorders ("VCR"). Regulations shall include, among other things, requirements that cable operators notify subscribers if certain functions of television receivers and VCRs are not compatible with converter boxes. Regulations must also be adopted to promote the commercial availability of converter boxes and remote control devices. The FCC will also determine whether, and under what circumstances, to permit cable operators to scramble signals. The FCC issues licenses for microwave relay stations, mobile radios and receive-only earth stations, all of which are commonly used in the operation of cable systems. A cable system's failure to comply with any FCC requirements may result in a variety of sanctions including monetary fines or revocation or suspension of licenses for stations used in connection with the system. A cable system's inability to use a microwave relay station or a mobile radio due to license revocation could adversely affect system operations, particularly if the relay microwave is used to provide service to distant communities or to relay distant television signals to the system. The FCC rules contain signal leakage monitoring standards which must be complied with by all cable systems annually. These requirements pertain to cable operators' use of certain frequencies at specified power levels and involve specific testing which must be completed each year to test for signal leakage. The FCC currently regulates the rates and conditions imposed by public utilities for use of their poles, unless under the Federal Pole Attachments Act state public service commissions are able to demonstrate that they regulate the cable television pole attachment rates. Nineteen states (including Illinois among those served by the Company) have certified to the FCC that they regulate the rates, terms and conditions for pole attachments. In the absence of state regulation, the FCC administers such pole attachment rates through use of a formula which it has devised. The validity of this FCC function was upheld by the U.S. Supreme Court. The 1992 Act and FCC implementing rules expand the cable industry's Equal Employment Opportunity obligations by requiring cable companies to provide additional information on race, sex, hiring, promotion and recruitment practices for six employment positions that the FCC has identified as performing key management functions. E. Rate Regulation. The 1992 Act establishes a mechanism for regulation of the rates charged by a cable operator for its service. Local regulation of basic (that level of service which includes broadcast signals) cable rates will be permitted for those cable systems not subject to "effective competition". The definition of "effective competition" (fewer than 30 percent of the households in the service area subscribe; or at least 50 percent of the households in the service area are served by two multichannel video programming distributors and at least 15 percent subscribe to the smaller operator; or a franchising authority serves as a multichannel video programming distributor and offers service to at least 50 percent of the households) ensures that virtually all cable systems are now subject to rate regulation. In order to regulate rates for the basic tier of service and related equipment, local officials must request FCC certification and must follow detailed FCC guidelines and procedures to determine whether the rates in question conform to a highly complex, FCC-approved "benchmark" or, if rates exceed the benchmark, whether the operator can justify them with a cost-of-service showing. FCC rules also limit related rates, including those for set-top converters, additional outlets and home wiring, to cost, plus a modest element of profit. Rates for expanded tiers of service (other than pay channels or pay-per-view) are subject to the same benchmark or cost-of-service standards as basic rates, but compliance is enforced by the FCC in response to complaints by subscribers or the local franchising authority. Although the new rules eventually will permit cable companies periodic rate increases for inflation and certain external costs, a rate freeze imposed by the FCC in May 1993 has been extended several times and continues in effect. On February 22, 1994, the FCC announced several decisions relating to cable rates including revisions to its "benchmark" approach. New benchmark formulas will be issued to reflect a new competitive differential -- that is, the average amount by which rates charged by cable operators not subject to effective competition exceeds "reasonable" rates - of 17 percent, rather than the 10 percent previously found by the FCC. In addition, the FCC altered its treatment of packages of a la carte channels. New rules will be issued setting forth factors that will be used, on a case-by-case basis, to determine whether an a la carte package "enhances subscriber choice" or "evades" rate regulation. Procedures for adding channels were adopted to permit operators to recover their programming costs, a markup of 7.5 percent on the programming, and some portion of the benchmark per channel rate. The FCC also adopted "interim" rules to govern cable operator cost-of-service showings, based on principles similar to those used in the telephone regulatory context. It set an interim industry-wide rate of return of 11.25 percent. The new rules also will include "streamlined" cost-of-service showings for upgrades and an experimental incentive upgrade plan. Taken as a whole, the new regulations have compelled significant changes in the Company's operations including restructuring of the Company's service offerings and reduced rates for the reconstituted basic service. Additional changes are likely as a result of the February 1994 decisions. The ultimate impact of these regulations cannot be predicted at this time because many aspects of the regulatory scheme are under reconsideration by the FCC, are under judicial challenge, or have yet to be adopted by the FCC. F. Franchise Fees and Access. Although franchising authorities may impose franchise fees under the 1984 Act, such payments cannot exceed five percent of system revenues per year. Franchising authorities are also empowered to require that the operator provide certain cable-related facilities, equipment and services to the public and to enforce operator compliance with franchise requirements and voluntary commitments. The 1992 Act permits cable operators to itemize on its subscriber bills amounts assessed as a franchise fee or dedicated to certain franchisor- imposed requirements. When changed circumstances render compliance with such requirements commercially impracticable, the 1984 Act requires franchising authorities to renegotiate performance standards and, under certain conditions, permits the operator to make changes in program commitments without local approval. Although franchising authorities are permitted to require and enforce the dedication of system channels for non-commercial public, educational and governmental access use, they must permit the operator to make other use of such channels until the demand for use of designated access purposes is sufficient to occupy the dedicated capacity. In addition, if the franchising authority requires or the operator volunteers to provide free services or financial support for non-commercial access users, the value of such commitments must be credited toward the franchise fee payment. G. Local Franchising. Because a cable distribution system uses local streets and rights-of-way, cable television systems have been subject to state and local regulation, typically imposed through the franchising process. State and local officials have been involved in franchisee selection, system design and construction, safety, service rates, consumer relations and billing practices and community-related programming and services. Except for cable systems lawfully operating without a franchise on or before July 1, 1984, the 1984 Act requires that a cable operator obtain a franchise prior to instituting service. Under the 1992 Act, franchising authorities may not award an exclusive franchise or unreasonably deny a competitive franchise. Local authorities may, without obtaining a franchise, operate their own cable system, notwithstanding the granting of one or more franchises by a local authority. The FCC has adopted rules which establish minimum customer service requirements. However, the 1992 Act permits local franchising authorities to establish, in excess of or in addition to those of the FCC, certain customer service requirements regarding such matters as office hours, telephone availability and service calls. H. Renewal. The 1992 Act did not significantly alter the procedures for the renewal of cable television franchises which provide an incumbent franchisee certain protections against having its franchise renewal application denied. These procedures are designed to provide the incumbent franchisee with a fair hearing on past performance, an opportunity to present a renewal proposal and to have it fairly and carefully considered, and a right of appeal if the franchising authority either fails to follow the procedures or denies renewal unfairly. Nevertheless, renewal is not assured, as the franchisee must meet certain statutory and franchise standards. Moreover, even if a franchise is renewed, the franchising authority may attempt to impose new and more onerous requirements such as significant upgrading of facilities and services or higher franchise fees as a condition of renewal. I. Theft of Cable Service and Unauthorized Reception of Satellite Programming. The 1984 Act addresses the problem of unauthorized connections to cable systems and the use of private earth stations capable of receiving many of the attractive satellite-delivered program services offered by cable systems without payment to or authorization of the program owner. Both of these practices are potential sources of significant revenue loss for cable systems. The 1992 Act has raised the penalties for engaging in theft of service and the manufacturing or sale of devices used to assist theft of service. However, it is not a violation to receive satellite-delivered programming by private earth stations without permission, if the program signal in question is not scrambled (transmitted in an encoded form which cannot be received without special decoding equipment), and the program owner has no specific marketing arrangement in place for granting such user permission. J. Copyright. Cable television systems are subject to a federal copyright licensing scheme covering carriage of television broadcast signals. In exchange for contributing a percentage of their revenues to a federal copyright royalty pool, cable operators receive blanket permission (a "compulsory license") to retransmit copyrighted material in broadcast signals. The amount of this royalty payment varies depending on the amount of system revenues from certain sources, the number of distant signals carried and the location of the cable system with respect to over-the-air television markets. Royalty rates paid by operators are subject to periodic adjustment by a copyright arbitration royalty panel, which can be convened by the Librarian of Congress when necessary in order to compensate for the effects of national monetary inflation and for FCC rule changes that increase the amount of television broadcast signals that cable systems carry. Legislative proposals have been and continue to be made to simplify or eliminate the compulsory license. The FCC has recommended to Congress that the compulsory license for the carriage of distant broadcast signals be eliminated. In addition, the full impact of the 1992 Act's retransmission consent provision is unclear. Therefore, the nature or amount of future payments for broadcast signal carriage cannot be predicted at this time. For the copyrighted materials they use in carriage or origination of non-broadcast programming, cable systems, like broadcasters, must have the permission of each copyright holder. System compliance with both the statutory copyright license and provisions of the Copyright Act of 1976 requiring private clearance is enforced through copyright infringement litigation brought by either the copyright holder or its representative or, in the case of violations of the statutory copyright license, by a local broadcaster or the copyright holder. K. Regulatory Change. Since its adoption in 1984, the Cable Act has been shaped by FCC regulations and by judicial interpretation. The 1992 Act has resulted in significant changes in the operation of cable television systems. As discussed above, the FCC has been charged with adopting rules and regulations and implementing the new provisions, although at present it is difficult to predict the ultimate course of such rules and regulations. Additionally, major provisions of the 1992 Act have been challenged in the courts, most significantly, the must-carry, retransmission consent and rate regulation provisions. It is likely that FCC regulations will also be challenged in court. Until the FCC has concluded its rule-making proceedings and the courts have adjudicated the issues presented to them, it would be premature to assess the full impact of the 1992 Act on the Company. The foregoing does not purport to be a complete summary of all present and proposed federal, state and local regulations relating to the cable industry. Item 2. Item 2. Properties. The Company owns all of its newspaper publishing plants and properties; 222,000 square feet in Greenville, South Carolina; 124,000 square feet in Montgomery, Alabama; 91,000 square feet in Asheville, North Carolina; 65,000 square feet in Clarksville, Tennessee; 27,000 square feet in Staunton, Virginia; 19,000 square feet in Gallipolis, Ohio; 11,000 square feet in Moultrie, Georgia; and 14,000 square feet in Mountain Home, Arkansas. In addition, the Company leases approximately 30,000 square feet of newspaper production and office space in Alabama, North Carolina, South Carolina and Tennessee. The Company's Montgomery, Alabama, newspaper has begun a $15 million capital project to purchase a new press and upgrade its production plant with $4 million to be invested in 1994. In its broadcasting operations, the Company owns buildings with approximately 68,000 square feet in St. Louis, Missouri; 12,000 square feet in Cincinnati, Ohio; 39,000 square feet in Knoxville, Tennessee; 10,000 square feet in Greenville, South Carolina; and 28,000 square feet in Macon, Georgia. The Company leases its studio buildings in Cincinnati and Cleveland. The Company owns all of its cable television systems and equipment. The Company leases certain offices and tower sites. The Company owns the offices in Wichita, Great Bend and McPherson, Kansas; Edmond and Bixby, Oklahoma; Oak Lawn and Harvey, Illinois; Rocky Mount, New Bern, Greenville, Washington and Kinston, North Carolina; and Laporte, Indiana. In its entertainment operations, the Company leases approximately 16,000 square feet in New York, New York, and 13,000 square feet in Los Angeles, California. In its security operations, the Company leases office space in Oklahoma City, Oklahoma; Dallas and Houston, Texas; Miami, Florida; Chicago, Illinois; and St. Louis, Missouri. The central monitoring station is located in the Company's cable television headquarters in Wichita, Kansas. Except as noted above, the Company generally owns the equipment used in its newspaper, broadcasting, cable, entertainment and security operations. The Company believes that all of its properties are in good condition, well maintained and adequate for its current operations. Item 3. Item 3. Legal Proceedings. The Company from time to time becomes involved in litigation incidental to its business, including libel actions. In the opinion of management, the Company carries adequate insurance against any judgments of material amounts which are likely to be recovered in such actions. At the present time, the Company is not a party to any litigation in which it is anticipated that the amount of any likely recovery would have a material adverse effect on its financial position. 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 Company's Common Stock is traded in the National Market System over-the-counter market and appears on The National Association of Securities Dealers Automated Quotation ("NASDAQ") under the symbol MMEDC. The following table sets forth the range of closing high and low bid prices for the Company's Common Stock in the over-the-counter market by quarter since January 1, 1992. The prices were reported by The NASDAQ Information Exchange System. These prices represent prices between dealers in securities and, as such, do not include retail mark-ups, mark-downs, or commissions and do not necessarily represent actual transactions. Low Bid High Bid 1993: First Quarter $32.00 $36.25 Second Quarter $32.00 $38.00 Third Quarter $30.75 $36.75 Fourth Quarter $33.50 $39.00 1992: First Quarter $23.00 $28.00 Second Quarter $26.00 $29.00 Third Quarter $23.50 $28.75 Fourth Quarter $24.00 $32.00 The Company's Credit and Note Agreements limit the payment of dividends on any capital stock of the Company. Currently the most restrictive of these limits the annual payment of dividends to 25% of annualized net income. No dividends were declared or paid during 1993 or 1992. The Company has no intention of paying any cash dividends in the foreseeable future. (See Note 6 to the Consolidated Financial Statements included in the 1993 Annual Report, which material is incorporated herein by reference.) As of March 3, 1994, there were approximately 1,200 record holders of the Company's Common Stock. Item 6. Item 6. Selected Financial Data. The required information is set forth on pages 18 and 19 of the accompanying 1993 Annual Report, which material is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The required information is set forth on pages 16 through 23 of the accompanying 1993 Annual Report, which material is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The following information is set forth in the accompanying 1993 Annual Report, which material is incorporated herein by reference: All Consolidated Financial Statements of Multimedia, Inc. and Subsidiaries (pages 24 through 27); all Notes to Consolidated Financial Statements (pages 28 through 41); and the "Independent Auditors' Report" (page 42). With the exception of the information herein expressly incorporated by reference, the 1993 Annual Report of the Registrant is not deemed filed as part of this Annual Report on Form 10-K. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III. Item 10. Item 10. Directors and Executive Officers of the Registrant. The required information is incorporated herein by reference from the information in the Company's definitive proxy statement dated March 15, 1994, for the Annual Meeting of Shareholders to be held April 20, 1994, under the headings "Election of Directors" and "Executive Officers". Item 11. Item 11. Executive Compensation. The required information is incorporated herein by reference from the information in the Company's definitive proxy statement dated March 15, 1994, for the Annual Meeting of Shareholders to be held April 20, 1994, under the headings "Management Compensation" and "Compensation Committee Interlocks and Insider Participation". Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The required information is incorporated herein by reference from the information in the Company's definitive proxy statement dated March 15, 1994, for the Annual Meeting of Shareholders to be held April 20, 1994, under the headings "Election of Directors", "Principal Shareholders of the Company" and "Executive Officers". Item 13. Item 13. Certain Relationships and Related Transactions. The required information is incorporated herein by reference from the information in the Company's definitive proxy statement dated March 15, 1994, for the Annual Meeting of Shareholders to be held April 20, 1994, under the headings "Election of Directors", "Management Compensation" and "Compensation Committee Interlocks and Insider Participation". PART IV. Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) (1) The following consolidated financial statements are incorporated by reference from the 1993 Annual Report attached hereto: Consolidated Statements of Earnings, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' Equity (Deficit), years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets, December 31, 1993 and 1992 Notes to Consolidated Financial Statements Independent Auditors' Report (a) (2) The following auditors' report and financial schedules for years ended December 31, 1993, 1992 and 1991 are submitted herewith: Independent Auditors' Report on 10-K Schedules Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation - Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule X - Supplementary Income Statement Information All other schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. (a) (3) Exhibits: (2) See Exhibit 10.8. (3.1) Restated Articles of Incorporation of the Company filed on December 22, 1967, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.4 to the Company's Registration Statement on Form S-3, No. 33-9622. (3.2) Amendments to the Company's Restated Articles of Incorporation filed on June 27, 1969; April 20, 1972; April 25, 1978; May 1, 1980; and May 13, 1983, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.5 to the Company's Registration Statement on Form S-3, No. 33-9622. (3.3) Amendment to the Company's Restated Articles of Incorporation attached as Annex B to Articles of Merger filed on October 1, 1985, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.6 to the Company's Registration Statement on Form S-3, No. 33-9622. (3.4) Articles of Amendment filed February 8, 1990, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 3.4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989 ("1989 Form 10-K") (File No. 0-6265). (3.5) Articles of Amendment to the Company's Restated Articles of Incorporation filed April 18, 1991, in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.4 to the Company's Registration Statement on Form S-8, File No. 33-40050 ("S-8 No. 33-40050"). (3.6) By-laws of the Company: Incorporated by reference to Exhibit 3.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1985 ("1985 Form 10-K") (File No. 0-6265). (3.6.1) Amendment to By-laws of the Company, effective April 23, 1992: Incorporated by reference to Exhibit 4.2.1 to the Company's Registration Statement on Form S-3, File No. 33-46557. (3.6.2) Amendment to By-laws of the Company, effective December 10, 1993. (4.1) See Exhibits 3.1, 3.2, 3.3, 3.4, 3.5, 3.6, 3.6.1, 3.6.2, 10.5 and 10.7. (4.2) Form of Certificates for Common Stock: Incorporated by reference to Exhibit 4.2 to the Company's Form 10-K for the year ended December 31, 1992 ("1992 Form 10-K") (File No. 0-6265). (4.3) Rights agreement, dated as of September 6, 1989, by and between the Company and South Carolina National Bank, Rights agent: Incorporated by reference to Exhibit 1 to Form 8-K of the Company dated September 6, 1989. (4.4) The Company hereby agrees to furnish to the Securities and Exchange Commission, upon request of the Commission, a copy of any instrument with respect to long-term debt not being registered in a principal amount less than 10% of the total assets of the Company and its subsidiaries on a consolidated basis. (10.1)* Restricted Option Plan of the Company: Incorporated by reference to Exhibit 10.1 to the Company's 1985 Form 10-K. (10.2)* Performance Stock Option Plan of the Company: Incorporated by reference to Exhibit 10.2 to the Company's Form 10-K for the year ended December 31, 1987 (File No. 0-6265). (10.2.1)* Amendment of Performance Stock Option Plan: Incorporated by reference to Exhibit 10.2.1 to the Company's Form 10-K for the year ended December 31, 1988 ("1988 Form 10-K") (File No. 0-6265). (10.3)* Key Executive Stock Option Plan of the Company: Incorporated by reference to Exhibit 28.1 to the Company's Registration Statement on Form S-8, No. 33-17234. (10.4)* Director Stock Option Plan: Incorporated by reference to Exhibit 10.20 to 1992 Form 10-K. (10.5) Credit Agreement between the Company and the Chase Manhattan Bank (National Association) and Citibank, N.A. as Lead Agents, the First National Bank of Chicago, First Union National Bank of North Carolina and the Toronto- Dominion Bank, Cayman Islands Branch, as Co-Agents and the Chase Manhattan Bank (National Association), as Administrative Agent, and various banks (excluding schedules and certain exhibits); the Registrant agrees to furnish supplementally to the Securities and Exchange Commission a copy of any omitted Schedule or Exhibit upon request of the Commission: Incorporated by reference to Exhibit 4.1 of the Company's 1990 second quarter Form 10-Q (File No. 0-6265). (10.5.1) List of Lenders under Credit Agreement as of March 3, 1994. (10.6) Contract for Services between Multimedia Entertainment, Inc. and Phillip J. Donahue, dated as of April 15, 1982, as amended by letter agreements dated April 15, 1982, February 10, 1984, and August 6, 1985: Incorporated by reference to Exhibit 10.6 to the Company's 1985 Form 10-K. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.6.1) Amendment to Contract for Services: Incorporated by reference to Exhibit 10.6.1 to the Company's 1988 Form 10-K. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.6.2) Amendment to Contract for Services: Incorporated by reference to Exhibit 10.6.2 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1991. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.6.3) 1993 Amendment to Contract for services: Incorporated by reference to Exhibit 10.6.3 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1993. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.7) Form of Note Agreement between the Company and various institutional holders (excluding schedules and certain exhibits); the Registrant agrees to furnish supplementally to the Securities and Exchange Commission a copy of any omitted schedule or exhibit upon request of the Commission: Incorporated by reference to Exhibit 4.2 of the Company's 1990 second quarter Form 10-Q. (10.8) Recapitalization Agreement and Plan of Merger, dated May 1, 1985, as amended and restated between MM Acquiring Corp. and the Company: Incorporated by reference to Exhibit 2 to the Company's Registration Statement on Form S-14 dated August 20, 1985 (Registration No. 2-99786). (10.9)* Executive Salary Protection Plan: Incorporated by reference to Exhibit 10.15 to the Company's Form 10-K for the year ended December 31, 1986. (10.10)* Executive Salary Protection Agreement - First Amendment: Incorporated by reference to Exhibit 10.10 to the Company's Form 10-K for the year ended December 31, 1991 ("1991 Form 10-K"). (10.11) Purchase Agreement by and between Multimedia, Inc. and National Broadcasting Company, Inc.: Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 1990. (10.12) Exchange Agreement between National Broadcasting Company, Inc. and Multimedia, Inc.: Incorporated by reference to Exhibit 10.2 to the Company's Form 10-Q for the quarter ended September 30, 1990 (File No. 0-6265). (10.13)* 1991 Stock Option Plan: Incorporated by reference to Exhibit 10.15 to the Company's Form 10-K for the year ended December 31, 1990 (File No. 0-6265). (10.13.1)* Amendment to 1991 Stock Option Plan: Incorporated by reference to Exhibit 28.2 to S-8 No. 33-40050. (10.13.2)* Amendments to 1991 Stock Option Plan, dated as of February 24, 1993: Incorporated by reference to Exhibit 10.13.2 to the 1992 Form 10-K. (10.14)* Management Committee Incentive Plan: Incorporated by reference to Exhibit 10.14 to 1991 Form 10-K. (10.15)* Executive Incentive Plan: Incorporated by reference to Exhibit 10.15 to 1991 Form 10-K. (10.16)* Summary of Supplemental Retirement Program for Messrs. Bartlett and Sbarra: Incorporated by reference to Exhibit 10.16 to 1991 Form 10-K. (10.17)* Agreements between Multimedia, Inc. and J. William Grimes dated August 6 and September 20, 1991: Incorporated by reference to Exhibit 10.16 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1991 (File No. 0-6265). (10.17.1)* Resolution of Board of Directors relating to J. William Grimes, adopted April 23, 1992: Incorporated by reference to Exhibit 10.7.1 to the Company's Form 10-Q for the quarter ended March 31, 1992. (10.17.2)* Resolution of Board of Directors relating to J. William Grimes, adopted December 18, 1992: Incorporated by reference to Exhibit 10.17.2 to 1992 Form 10-K. (10.17.3)* Resignation and release agreement between Multimedia, Inc. and J. William Grimes dated December 9, 1993. (10.18)* Agreement with Robert L. Turner, dated January 29, 1991: Incorporated by reference to Exhibit 10.18 to 1991 Form 10-K. (10.19) Contract for Services between Multimedia Entertainment, Inc. and Rabbit Ears Enterprises, f/s/o Sally Jessy Raphael, dated as of April 26, 1989, as amended by letter dated December 4, 1990: Incorporated by reference to Exhibit 10.19 to 1991 Form 10-K. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.19.1) Agreement between Multimedia Entertainment, Inc. and Wonderland Entertainment, f/s/o Sally Jessy Raphael, dated as of August 17, 1993: Incorporated by reference to Exhibit 10.19.1 to the Company's Form 10-Q for the quarter ended September 30, 1993. Portions of this exhibit have been omitted and are the subject of an order of the United States Securities and Exchange Commission granting the Company's request for confidential treatment. (10.20) Asset Purchase and Sale Agreement by and between Prime Cable Income Partners, L.P., as seller and Tar River Communications, Inc., as buyer, relating to Valparaiso and Laporte, Indiana systems dated as of July 30, 1992, as amended by letter supplement dated as of December 3, 1992: Incorporated by reference to Exhibits to Form 8-K dated December 16, 1992. (11) Computation of Primary and Fully Diluted Earnings per Share. (13) 1993 Annual Report. (21) Subsidiaries of the Registrant. (23) Accountants' Consent to incorporate by reference in Registration Statements No. 2-68069, 33-17234, 33-40050, 33-40253, 33-61574 and 33-61462, on Form S-8, and in Registration Statements No. 33-42179 and 33-46557 on Form S-3. (99) Proxy Statement dated March 15, 1994. ________________________ * This is a management contract or compensatory plan or arrangement. (b) Reports on Form 8-K. Items reported on Form 8-K dated December 10, 1993: (5) Other Events (7) Exhibits 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. MULTIMEDIA, INC. By: Signature Title Date /s/ Walter E. Bartlett Chairman, Chief March 28, 1994 Walter E. Bartlett Executive Officer and President /s/ Robert E. Hamby, Jr. Senior Vice President March 28, 1994 Robert E. Hamby, Jr. Finance and Administration and Chief Financial Officer /s/ Thomas L. Magaha Vice President March 28, 1994 Thomas L. Magaha Finance and Development/ 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 as of the dates indicated. By: /s/ Walter E. Bartlett Director March 28, 1994 Walter E. Bartlett /s/ Rhea T. Eskew Director March 28, 1994 Rhea T. Eskew /s/ David L. Freeman Director March 28, 1994 David L. Freeman /s/ Robert E. Hamby, Jr. Director March 28, 1994 Robert E. Hamby, Jr. /s/ Donald D. Sbarra Director March 28, 1994 Donald D. Sbarra /s/ Elizabeth P. Stall Director March 28, 1994 Elizabeth P. Stall INDEPENDENT AUDITORS' REPORT ON 10-K SCHEDULES The Board of Directors and Stockholders Multimedia, Inc.: Under the date of February 11, 1994, we reported on the consolidated balance sheets of Multimedia, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of earnings, stockholders' equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual reports 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 financial statement schedules as listed in Item 4(a)(2). These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statement taken as a whole, present fairly, in all material respects, the information set forth therein. (signature of KPMG Peat Marwick appears here) Greenville, South Carolina February 11, 1994 Schedule V MULTIMEDIA, INC. AND SUBSIDIARIES Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 Schedule VI MULTIMEDIA, INC. AND SUBSIDIARIES Accumulated Depreciation - Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 Schedule VIII MULTIMEDIA, INC. AND SUBSIDIARIES Valuation and Qualifying Accounts Years ended December 31, 1993, 1992 and 1991 Schedule X MULTIMEDIA, INC. AND SUBSIDIARIES Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 Charged directly to Costs and Expenses 1993 1992 1991 Amortization of intangible assets $14,778,000 11,272,000 9,308,000 ========== ========== ========= Advertising costs $11,099,000 9,669,000 8,785,000 ========== ========== ========= All other information is inapplicable or less than one percent of total revenue.

13390_1993.txt

13390_1993

1993

13390

ITEM 1. BUSINESS. GENERAL DEVELOPMENT OF BUSINESS Boston Gas Company (the "Company") is engaged in the transportation, distribution and sale of natural gas to residential, commercial, and industrial customers which includes the City of Boston, Massachusetts, and 73 other Massachusetts communities. The Company has one subsidiary, Massachusetts LNG Incorporated ("Mass LNG"), which holds a long-term lease on two liquefied natural gas facilities. The Company has been in business for 171 years and is the second oldest gas company in the United States. Since 1929, all of the common stock of the Company has been owned by Eastern Enterprises ("Eastern"), which is headquartered in Weston, Massachusetts. GAS SALES Firm gas sales are made under rate schedules or contracts with customers who do not contemplate service interruption. Firm sales of natural gas sold for purposes of space heating are directly related to weather conditions. Consequently, variations in weather patterns can have a significant impact upon the Company's revenues and earnings. The Company also provides seasonal firm sales and transportation services to customers for terms of less than 365 days. Non-firm sales include interruptible sales made pursuant to contracts with customers who typically can use oil and gas interchangeably and special sales for resale to other gas companies for distribution to their customers. Non-firm sales are dependent upon gas supply availability, weather conditions and the price of gas in relation to the price of alternate fuels. The price the Company charges is generally tied to the price of the customer's alternate fuel. Availability of gas supply and price competition from residual oil are important factors in retaining non-firm sales. Beginning November 1, 1993, gross margins from non-firm sales and transportation services ($8,434,000 in 1993 and $10,248,000 in 1992) are passed back to firm customers through the cost of gas adjustment clause up to a threshold based upon the prior season's experience. Non-firm margins realized in excess of the threshold are shared between shareholders and core customers 25% and 75%, respectively. One customer accounted for 4.0% of the Company's operating revenues in 1993, 2.3% in 1992 and 3.5% in 1991. GAS SUPPLY The Company purchases approximately 70% of its pipeline gas supplies directly from producers and marketers pursuant to long-term contracts which are subject to review and approval by the Massachusetts Department of Public Utilities ("Department"). Seven of the Company's direct purchase agreements have been approved by the Department including two long-term Canadian agreements. Five other long-term agreements are pending before the Department, with orders expected by April, 1994. The Company purchases its remaining pipeline supplies pursuant to short-term, firm winter service agreements and on a spot basis. Pipeline supplies are transported on interstate pipeline systems to the Company's service territory pursuant to transportation agreements approved by the Federal Energy Regulatory Commission ("FERC"). The Company has also contracted with pipeline companies and others for the storage of natural gas and related transportation from underground storage fields located in New York and Pennsylvania. Supplemental supplies of liquefied natural gas ("LNG") and propane are purchased and produced from foreign and domestic sources. All interstate pipelines serving the Company have implemented service restructuring plans on terms and conditions approved by FERC pursuant to Order No. 636. Order No. 636, issued April 8, 1992, required interstate pipeline companies to unbundle existing gas service contracts into separate gas sales, transportation and storage services. Accordingly, the Company's firm bundled service with Algonquin Gas Transmission Company ("Algonquin"), a wholly-owned subsidiary of Algonquin Energy, Inc., a wholly-owned subsidiary of Texas Eastern Transmission Corporation ("Texas Eastern"), itself a wholly-owned subsidiary of Panhandle Eastern Corporation, was converted to an annual firm transportation entitlement of 65,600 MMCF. Similarly, the Company's firm bundled sales service with Texas Eastern has been converted to an annual firm transportation entitlement of 100,100 MMCF; and its firm bundled sales service with Tennessee Gas Pipeline Company, a division of Tenneco, Inc. ("Tennessee"), has been converted to an annual firm transportation entitlement of 77,800 MMCF. In addition, as a result of industry restructuring, the Company has firm entitlements on interstate pipelines upstream of Tennessee, Texas Eastern, and Algonquin, with direct access to supply areas. Together, these transportation entitlements are used to transport natural gas purchased by the Company from producing regions and underground storage facilities to our service territory. After restructuring, the Company now holds direct entitlements to 16,500 MMCF of storage capacity with Tennessee, Texas Eastern and others. These new transportation and storage agreements with Algonquin, Texas Eastern, and Tennessee have terms generally expiring no earlier than November 1996, April 2012, and April 2000, respectively. The Company is provided rights of first refusal under Order No. 636 to extend the terms of such service. The Company considers the service reliability of its natural gas portfolio after industry restructuring to be comparable to that existing prior to Order No. 636. In addition to its domestic supply arrangements, the Company has three contracts for the purchase of Canadian gas supplies. The Company's contract with Boundary, Inc. provides for the purchase of 3,845 MMCF of gas annually and expires on January, 2003. The Company also has contracts with Alberta Northeast Gas, Ltd. ("ANE") to purchase up to 6,242 MMCF of gas annually, and with Imperial Oil of Canada, Ltd. ("Imperial"), formerly Esso Resources Canada, Ltd., for the purchase of 12,775 MMCF of gas annually. These contracts expire on November, 2003 and April, 2007, respectively. The Company has contracted with Iroquois Gas Transmission System ("IGTS"), Tennessee and Algonquin to transport these gas supplies from the Canadian border to delivery points in the Company's service territory. All necessary Canadian government approvals for the purchase, import, and transportation of these volumes have been issued. The Company has contracts, expiring in 1998, with Distrigas of Massachusetts Corporation ("DOMAC") for the purchase of an annual quantity of up to 2,000 MMCF of LNG and for 1,000 MMCF of LNG storage capacity and related vaporization services. The Company also purchases LNG from DOMAC on a spot basis when prices are competitive with alternative supplies. DOMAC's affiliate, Distrigas Corporation, imports the LNG from Algeria pursuant to agreements with Sonatrach, the Algerian National Energy Company, through its wholly-owned subsidiary Sonatrading Amsterdam B.V. The United States Department of Energy ("DOE") and FERC have granted the necessary approvals for the import, sale and storage of LNG. The Company relies on supplemental supplies to meet firm sendout requirements which are greater than its firm pipeline capacity entitlements. The number of days that peak sendout can be maintained is limited by the capacity of the Company's storage facilities for supplemental gas supplies and the rate at which these supplies can be sent out, and subsequently replenished. Increased deliveries of pipeline supplies have reduced the Company's dependence on more costly supplemental supplies. The Company considers its peak day sendout capability, based on its total supply resources, adequate to meet the requirements of its customers. The Company owns or leases facilities which enable it to store the equivalent of 4,000 MMCF of natural gas in liquid form as LNG and vaporize it for use during periods of high demand. The inventory for these facilities is provided by liquefaction of pipeline gas and from LNG purchased. The maximum storage capacity of these facilities may be limited by various factors, including maintenance and other operating considerations. In addition to LNG, the Company has the ability to use propane to meet its demand requirements during periods of extreme cold weather. Propane can be mixed with air and introduced, along with natural gas, into the gas distribution system at a number of propane-air facilities owned by the Company. REGULATION AND RATES The Company's operations are subject to Massachusetts statutes applicable to gas utilities. Rates, the territorial limit of the Company's service area, issuance of securities, affiliated party transactions, purchase of gas and pipeline safety regulations are regulated by the Department. The rates for gas service rendered by the Company are subject to approval by, and are on file with, the Department. Gas operating revenues are recognized when billed. No revenue is recorded for the amount of gas distributed to customers which is unbilled at the end of a period. The Company has a cost of gas adjustment clause which allows for the adjustment of billing rates for firm gas sales to recover the cost of gas delivered to firm customers. For financial reporting purposes, the Company defers the cost of any firm gas that has been distributed, but is unbilled at the end of a period, to a period in which the gas is billed to customers. On October 30, 1993, the Department allowed the Company an annual revenue increase of $37,700,000, effective November 1, 1993, and also approved several rate design changes that reduce the volatility of the Company's margins attributable to weather. This was accomplished by increasing customer charges and moving the recovery of certain local production and storage costs from base rates to the cost of gas adjustment clause. Facility expansion is regulated by the Department. Municipal, state and federal authorities have jurisdiction over the use of public ways, land and waters for gas mains and other distribution facilities. LICENSES AND FRANCHISES The Company and Eastern were granted an intrastate exemption from the provisions of the Public Utility Holding Company Act of 1935 ("the Act") under Section 3(a)(1) thereof, pursuant to an order of the Securities and Exchange Commission (the "SEC") dated February 28, 1955, as amended by orders dated November 3, 1967 and August 28, 1975. On February 7, 1989, the SEC issued a proposed rule under the Act which would provide limits for non-utility related diversification by intrastate public utility holding companies, such as Eastern, that are exempt under the Act. Since its proposal in 1989, the SEC has taken no action with respect to this proposed rule. Eastern and the Company cannot predict whether this proposed rule will be adopted or whether it will affect their exemption under the Act. Except as set forth above, there are no patents, trademarks, licenses or concessions that are important to the business of the Company. COMPETITION AND MARKETING The Company competes with fuel oil and electricity and other supplies of gas for residential, commercial and industrial uses. The Company's marketing efforts continue to benefit from growing customer awareness of natural gas as a safe, reliable, economical and environmentally sound fuel. Customer recognition that the use of gas improves overall air quality, reduces pollutants and eliminates on-site fuel storage problems has become increasingly significant. The Company added annual firm sales of approximately 2,443 MMCF in 1993. In the commercial and industrial markets, where the Company has a 22% market share in its service territory, a degree of penetration which is approximately half that of the United States commercial and industrial market share, considerable growth opportunities exist. In 1993, the Company added new firm annual load of 1,812 MMCF in these markets. Increasing environmental regulation of emissions should provide additional opportunities in the commercial and industrial markets. The Company has identified several industrial facilities that must file compliance plans under these regulations by April 1, 1994. Approximately 4,391 residential customers converted to gas for central heating last year. Despite lower oil prices, the Company expects continued strong activity in the residential conversion market. Approximately 46% of the Company's existing customers do not use gas for central heating. The Company plans on targeting this group as well as electrically-heated residential complexes with special programs to encourage the conversion to natural gas. FERC Order No. 636 and other regulatory changes have increased the potential for competition among existing and new suppliers of natural gas in the Company's service area, particularly in large commercial and industrial markets (see "Gas Supply"). The Company believes it is well positioned to respond to such sales competition. The Company received approval from the Department to file contracts designed to compete with non-captive commercial and industrial customers with alternative energy options. This provides for an expedited approval process and enhances the Company's ability to negotiate sales agreements that reflect competitive market conditions. In June 1992, FERC granted the Company authority to make sales for resale in interstate commerce under the terms of a blanket marketing certificate. This additional sales authority allows the Company to maximize the use of its supply entitlements, thereby minimizing the cost of gas to firm customers and making its sales rates more competitive. The Company is also well positioned to provide transportation service to customers who may engage in direct purchases of natural gas from other suppliers under firm and interruptible transportation tariffs approved by the Department. The rate design changes approved by the Department in the October 30, 1993 rate order provide for margin neutrality regardless of the customer's decision to purchase gas directly from the Company or purchase third-party gas for transportation on the Company's distribution system. The Company continues to pursue market opportunities in natural gas-powered vehicles. The recent passage of The National Energy Policy Act, as well as the Clean Air Act Amendments of 1990, both of which mandate the use of alternative fuel vehicles by the mid-1990's by certain commercial fleets, have enhanced opportunities in this market. The Company has initiated a number of programs demonstrating the environmental and operating advantages of natural gas vehicles. The Company's marketing activities include the installation of two Company-owned fueling stations, conversion of 92 Company vehicles, and establishment of pilot programs with a number of large fleet operators to demonstrate the advantages of choosing natural gas to meet alternative fuel vehicle requirements. Other new markets, such as air conditioning, cogeneration and desiccant dehumidification continue to develop as new technologies emerge. ENVIRONMENTAL REGULATION The Company is subject to local, state and federal environmental regulation of its operations and properties. The Company is working with the Massachusetts Department of Environmental Protection ("DEP") to determine the environmental impact, if any, of by-products associated with 13 former manufactured gas plant ("MGP") properties which the Company currently owns and for which the Company may be potentially responsible. The Company is currently assessing seven of these properties pursuant to applicable DEP procedures. The Company expects to spend approximately $1 million in assessing these properties in 1994 and expects similar expenditures for site assessment for the next several years as other properties are investigated. Since the DEP has not yet approved a remediation plan for any Company site, the Company cannot reliably predict the potential liability associated with final remediation of any of these properties. Company experience to date indicates that assessment and remediation costs of at least $18 million could be incurred over the next several years at these thirteen properties, subject to possible contribution or the assumption of responsibility by New England Electric System ("NEES") or one of its subsidiaries as discussed below. Massachusetts Electric Company, a wholly-owned subsidiary of NEES, has assumed responsibility for remediating a fourteenth property currently owned by the Company (part of the site of gas manufacturing operations in Lynn, Massachusetts) pursuant to the decision of the Court of Appeals for the First Circuit in The John S. Boyd, Inc., et al. v. Boston Gas Company, et al, Civil Action No. 89-575-T (May 26, 1993). The First Circuit found that NEES and its subsidiaries, as the prior owners and operators of the Lynn MGP site, were responsible for remediating the site and that the Company did not assume any liability for environmental remediation when it acquired the property from NEES in 1973. Of the thirteen other sites currently owned by the Company, ten were acquired from NEES. Given substantial similarities between these acquisitions and that involved in Boyd, it is not probable that the Company will have any material exposure for environmental remediation at these ten sites. There are 23 other former MGP sites within the Company's service territory which the Company does not currently own. The DEP has not issued a Notice of Responsibility to the Company for any of these 23 sites. At this time, there is substantial uncertainty as to whether the Company is responsible for remediating any of these sites either because the Company never owned the site, the Company does not have successor liability for contamination of the site by earlier operators, or site conditions do not require remediation by the Company. By an order issued on May 25, 1990, the Department approved a settlement agreement which provides for the recovery through the cost of gas adjustment clause of all environmental response costs associated with former MGP sites over separate, seven-year amortization periods without a return on the unamortized balance. The settlement agreement also provides for no further investigation of the prudency of any Massachusetts gas utility's past MGP operations. EMPLOYEE RELATIONS As of December 31, 1993, the Company had 1,720 employees, 71% of whom were organized in six local unions with which the Company has collective bargaining agreements. In 1993, after a seventeen-week work stoppage, the Company entered into a new six-year labor contract with the bargaining units which, among other things, provides for annual general wage increases of approximately 4%, updates work rules and changes health care coverage to a managed care program with cost sharing. ITEM 2. ITEM 2. PROPERTIES. The Company and Mass LNG own or lease facilities which enable them to liquefy natural gas in periods of low demand, store the resulting LNG and vaporize it for use in periods of high demand. The Company owns and operates such a facility in Dorchester, Massachusetts, and Mass LNG leases and operates one such facility in Lynn, Massachusetts, and a storage facility in Salem, Massachusetts. In addition, the Company owns propane-air facilities at several locations throughout its service territory. In addition to the properties described above, the Company owns or leases several small buildings and miscellaneous parcels of land located throughout its service area which are used for such purposes as storage, subsidiary operations centers, district business offices and natural gas receiving stations. The Company's gas distribution system on December 31, 1993 included approximately 5,700 miles of gas mains, 396,000 services and 519,000 active customer meters. The Company's gas mains and services, as well as related equipment, are, in general not on land owned in fee, being in part, in, under or over public ways, land or water and, in part, upon or under private ways or other property not owned by the Company, such occupation of public and private property being, in general, pursuant to easements, licenses, permits or grants of location. Except as stated above, the principal items of property of the Company are owned in fee. A portion of the utility properties and franchises of the Company are pledged as security for the Company's First Mortgage Bonds. In 1993, the Company's expenditures on capital expansion and improvement were $47.1 million. Capital expenditures were principally made for improvements to the distribution system, for system expansion to meet customer demand and for productivity enhancement. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. With the resolution of the John Boyd case discussed in Item 1 above, and other than normal routine litigation incidental to the Company's business, there are no material pending legal proceedings involving the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted to a vote of Security Holders in the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Eastern was the holder of record of all of the outstanding common equity securities of the Company throughout the year ended December 31, 1993. Dividends on such common equity amounted to $8,998,219 and $7,712,760 for 1993 and 1992, respectively. At December 31, 1993, under the most restrictive provision limiting dividend payments in the Company's financing indentures, there were no restrictions on retained earnings. 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. 1993 COMPARED TO 1992 Earnings available to common shareholders in 1993 of $18.0 million were $9.3 million lower than the prior year. Earnings in 1992 reflect a one-time increase of $7.2 million, as a result of a modification to the Company's gas cost recovery mechanism approved by the Department in May 1992. The modification shifted the recovery of a portion of pipeline gas costs from the non-heating season to the heating season to more closely match revenues with costs incurred. Excluding such modification, earnings year to year decreased $2.1 million. This decline in earnings was primarily due to the seventeen week labor dispute and increased depreciation and amortization expense. In addition, weather was 1.3% warmer than normal and 4.5% warmer than 1992. Partially offsetting the above was a $5.0 million increase in net earnings related to the rate increase granted the Company by the Department effective November 1, 1993. The Department awarded the Company an annual revenue increase of $37.7 million, or 6.3%. During 1993, the Company added annual firm sales of approximately 2.4 BCF from the conversion of approximately 4,391 existing non-heating residences to natural gas and the addition of new customers. Operating earnings of $49.0 million , excluding the 1992 operating earnings impact of the change in the gas cost recovery mechanism of $11.6 million, were $2.4 million lower than 1992. The increase in operating expenses was mainly due to the work stoppage and its resultant impact on expenditure capitalization. Depreciation and amortization expense increases in 1993 are principally the result of continued investments in system replacement and expansion and productivity programs. Year to year increases in property taxes also contributed to the decline in operating earnings. 1992 COMPARED TO 1991 Earnings available to common shareholders in 1992 of $27.3 million were 76% higher than 1991 earnings of $15.5 million primarily due to more seasonable weather and the modification to the Company's gas cost recovery mechanism approved by the Department effective May 1, 1992. Since the change took effect May 1, 1992, the Company recognized a one-time increase in earnings of $7.2 million; however, the modification has no impact on earnings over a 12 month period. Excluding the modification to the gas cost recovery mechanism, earnings year to year increased $4.6 million. More seasonal weather, following unusually warm weather conditions in 1990 and 1991, produced the most favorable impact on 1992 earnings, representing a $9.1 million increase over 1991 results. 1992, which was 19% colder as compared to 1991, resulted in an increase in firm gas sales of 7.3 BCF. Growth in the firm customer base also contributed to the increase in earnings. During 1992, the Company added annual firm sales of approximately 3.1 BCF from the conversion of 4,690 existing non-heating residences to natural gas and the additional new customers. Operating earnings, excluding the pre-tax impact of the change in the gas cost recovery mechanism of $11.6 million, were $12.2 million higher than 1991 operating earnings of $39.3 million. Operating expense increases were primarily the result of higher labor and system maintenance costs. Depreciation and amortization expense increased in 1992 due to continued investments related primarily to customer growth, system replacement and productivity improvements. Interest expense increased in 1992 as compared to 1991 due to higher levels of average debt outstanding and reduced capitalized interest. LIQUIDITY AND CAPITAL RESOURCES The Company maintains four committed lines of credit totaling $40.0 million. The Company also maintains various uncommitted lines of credit and markets its own commercial paper. In addition, the Company may borrow up to $45.0 million under Eastern's credit facilities. In accordance with the rate order issued by the Department effective October 1, 1988, the Company funds all of its gas inventory through external financing. The costs of such financing are recovered from customers through the Company's cost of gas adjustment clause. Effective December 31, 1993, the Company increased its credit capacity for fuel financing through the negotiation of a credit agreement with a group of banks which provides for borrowing of up to $90.0 million for the purpose of financing its inventory of gas supplies. The Company's' capacity under the prior agreement was $60.0 million. (See Note 4 of the Notes to Consolidated Financial Statements.) On May 12, 1993, the Company received from its shareholder, Eastern Enterprises, a $20.0 million equity contribution, which was used to redeem $20.0 million of the Company's outstanding 9% Debentures, due 2001. On July 13, 1993, the Registrant selected a Final Term which is a Mandatory Redemption Term with respect to its Variable Term Cumulative Preferred Stock, Series A. The dividend rate during the Final Term is 6.421% per annum and dividends are paid quarterly. The Final Term calls for 5% annual sinking fund payments beginning on September 1, 1999, is non-callable for 10 years, and shall end on September 1, 2018. The Company expects capital expenditures for 1994 to be approximately $53.0 million. Capital expenditures will be largely for improvements to the distribution system, for system expansion to meet customer demand and for productivity enhancement. The Company also expects to incur assessment and remediation costs of approximately $1.0 million in 1994 associated with MGP sites. Such costs are recoverable in rates as discussed more fully in Note 12 of Notes to Consolidated Financial Statements. On October 30, 1993, the Department granted the Company an annual revenue increase of $37.7 million effective November 1, 1993. In January 1994, the Company issued $36.0 million of Medium-term Notes Series B, with a weighted average maturity of 24 years and coupon of 6.94% pursuant to a $50.0 million shelf registration statement dated October 28, 1992 on file with the SEC. The Company believes that projected cash flow from operations, in combination with currently available resources, is sufficient to meet 1994 capital expenditures and working capital requirements, normal debt repayments and dividends to shareholders. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Information with respect to this item appears commencing on Page of this Report. Such information is incorporated herein by reference. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY. Not required. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Not required. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Not required. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Not required. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES. Information with respect to these items appears on Page of this Report. Such information is incorporated herein by reference. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. BOSTON GAS COMPANY Registrant By: J. F. BODANZA _________________________________ J. F.BODANZA SENIOR VICE PRESIDENT AND TREASURER (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) Dated: Schedules other than those listed above have been omitted as the information has been included in the consolidated financial statements and related notes or is not applicable nor required. Separate financial statements of the Company are omitted because the Company is primarily an operating company and its subsidiary is wholly-owned and is not indebted to any person in an amount that is in excess of 5% of total consolidated assets. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. BOSTON GAS COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ACCOUNTING POLICIES The significant accounting policies followed by the Company and its subsidiary are described below and in the following footnotes: Note 2--Cost of Gas Adjustment Clause and Deferred Gas Costs Note 3--Income Taxes Note 6--Pension Benefits Note 7--Post-Retirement Benefits Other Than Pensions Note 8--Leases Principles of Consolidation The Company is a wholly-owned subsidiary of Eastern Enterprises ("Eastern"). The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Massachusetts LNG Incorporated ("Mass LNG"). All material intercompany balances and transactions between the Company and its subsidiary have been eliminated in consolidation. Depreciation Depreciation is provided at rates designed to amortize the cost of depreciable property, plant and equipment over their estimated remaining useful lives. The composite depreciation rate, expressed as a percentage of the average depreciable property in service, was 3.98% in 1993, 3.80% in 1992 and 3.79% in 1991. Accumulated depreciation is charged with the original cost and cost of removal, less salvage value, of units retired. Expenditures for repairs, upkeep of units of property and renewal of minor items of property replaced independently of the unit of which they are a part are charged to maintenance expense as incurred. Gas Operating Revenues Gas operating revenues are recorded when billed. Revenue is not recorded for the amount of gas distributed to customers which is unbilled at the end of the period; however, the cost of this gas is deferred as discussed in Note 2. (2) COST OF GAS ADJUSTMENT CLAUSE AND DEFERRED GAS COSTS The cost of gas adjustment clause requires the Company to adjust its rates semiannually for firm gas sales in order to track changes in the cost of gas distributed with an annual adjustment of subsequent rates for any collection over or under actual costs incurred. As a result, the Company defers the cost of any firm gas that has been distributed, but is unbilled at the end of a period, to a period in which the gas is billed to customers. The cost of gas adjustment clause also recovers the amortization of all environmental response costs associated with former manufactured gas plant ("MGP") sites and costs related to the Company's various conservation and load management programs. In May of 1992, the Company modified the cost of gas adjustment clause shifting a portion of pipeline gas costs from the non-heating to the heating season in order to more closely match revenues with the related costs. (3) INCOME TAXES The Company is a member of an affiliated group of companies which files a consolidated federal income tax return. The Company follows the policy, established for the group, of providing for income taxes which would be payable on a separate company basis. The Company's effective income tax rate was 38.4% in 1993, BOSTON GAS COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (3) INCOME TAXES (CONTINUED) 39.4% in 1992 and 36.2% in 1991. State taxes represent the majority, or 4.3%, 4.6% and 4.8% of the difference between the effective rate and the Federal income tax rate for 1993, 1992 and 1991, respectively. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes." SFAS 109 requires adjustment of deferred tax assets and liabilities to reflect the future tax consequences, at currently enacted rates, of items already reflected in the financial statements. A regulatory asset of $1,880,000 was established for the recovery of prepaid taxes established at the higher federal tax rates in effect prior to 1988. In its most recent rate request proceeding, the Company received permission to recover this amount over three years. A regulatory liability of $6,144,000 was established for the tax benefit of unamortized investment tax credits, which SFAS 109 requires to be treated as a temporary difference. This benefit will be passed on to customers over the lives of property giving rise to the investment credits, consistent with the 1986 Tax Reform Act. About 38% of each of these items reflect a "gross-up" for taxes as SFAS 109 eliminated net-of tax accounting for regulatory assets and liabilities. The regulatory liability for excess deferred taxes being returned to customers over a 30 year period pursuant to a 1988 rate order was similarly increased by $4,445,000 upon the adoption of SFAS 109. The Revenue Reconciliation Act of 1993, enacted on August 10, 1993, increased the statutory Federal income tax rate from 34% to 35%, retroactive to January 1, 1993. The provision for income taxes in 1993 includes approximately $300,000 for the impact of the rate change on current earnings. The effect of the rate change on deferred tax requirements at January 1, 1993 is reflected in the regulatory asset and liability established at the adoption of SFAS 109. During 1991, deferred income taxes were provided for significant timing differences in the recognition of revenue and expenses for tax and financial statement purposes. The principal component of the 1991 deferred provision was $2,308,000 for accelerated depreciation, partially offset by a credit of $1,021,000 for deferred gas costs. Investment tax credits are deferred and credited to income over the lives of the property giving rise to such credits. The credit to income was approximately $689,000 in 1993, $673,000 in 1992 and $692,000 in 1991. (4) COMMITMENTS Long-term Obligations The First Mortgage Bonds are secured by a first mortgage lien on a portion of the Company's utility properties and franchises. The annual sinking fund requirement for the 8.375% First Mortgage Bonds is $480,000. BOSTON GAS COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) COMMITMENTS (CONTINUED) The 7.95% Sinking Fund Debentures have an annual sinking fund requirement of $425,000. The 9.0% and 8.75% Sinking Fund Debentures require annual sinking fund payments of $5,000,000 and $3,000,000, respectively, beginning in 1997. On October 28, 1992, the Company filed a Shelf registration covering the issuance of up to $50,000,000 of additional Medium-Term Notes through December 31, 1994 for the financing of capital expenditures and the payment of related obligations. In January 1994 the Company issued $36,000,000 of Medium-Term Notes with maturities of 20 - 30 years and an average weighted interest rate of 6.94%. The terms of the various indentures referred to above, as supplemented, provide that dividends may not be paid on common stock of the Company under certain conditions. At December 31, 1993 there were no restrictions on retained earnings available for payment of dividends. Gas Inventory Financing Under the terms of the general rate order issued by the Department of Public Utilities (the Department) effective October 1, 1988, the Company funds all of its inventory of gas supplies through external sources. All costs related to this funding are recoverable from its customers. The Company maintains a credit agreement with a group of banks which provides for the borrowing of up to $90,000,000 for the exclusive purpose of funding its inventory of gas supplies or for backing commercial paper issued for the same purpose. The Company had $59,297,000 and $48,631,000 of commercial paper outstanding at December 31, 1993 and 1992, respectively, for this purpose. Since the commercial paper is supported by the credit agreement, these borrowings have been classified as non-current in the accompanying consolidated balance sheets. The credit agreement includes a 364 day revolving credit which may be converted to a two-year term loan at the Company's option if the 364 day revolving credit is not renewed by the banks. The Company may select interest rate alternatives based on prime or Eurodollar rates. No borrowings were outstanding under this agreement at December 31, 1993 and no borrowings were outstanding under the prior $60,000,000 credit agreement at December 31, 1992. Notes Payable The Company maintains four committed lines of credit totaling $40,000,000 which provide for interest at either prime rate or money market rates. The Company pays facility fees related to these lines of credit. In addition, the Company has various uncommitted lines of credit which provide for interest at the federal funds, money market or prime rates. These lines of credit are used for short-term borrowings. The Company had outstanding borrowings of $106,300,000 and $53,332,000 in commercial paper and bank loans not related to gas inventory financing at December 31, 1993 and 1992, respectively. BOSTON GAS COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) COMMITMENTS (CONTINUED) Eastern Borrowing Arrangement Eastern has a credit agreement with a group of banks which provides for the borrowing by Eastern and its subsidiaries of up to $60,000,000 (of which the Company may borrow up to $35,000,000) at any time through December 31, 1994, with borrowings thereunder maturing not later than December 31, 1995. The interest rate for such borrowings is the agent bank's prime rate, or at Eastern's option, 1/4 of 1% over the agent bank's Eurodollar rate or 3/8 of 1% over the agent bank's certificate of deposit rate. Eastern has the option until December 31, 1994 to convert up to $25,000,000 of the total commitment to a five-year term loan arrangement with the same interest rate provisions through 1994 and thereafter with interest of 1/8 of 1% over the agent bank's prime rate or 5/8 of 1% over the agent bank's Eurodollar rate or 7/8 of 1% over the agent bank's certificate of deposit rate. The credit agreement provides, among other things, for a commitment fee of 1/4 of 1% on the first $50,000,000 unused portion of the commitment and 3/16 of 1% on the unborrowed portion of the commitment greater than $50,000,000. Eastern also has a $10,000,000 line of credit under which the Company is entitled to borrow which provides for interest at the prime rate, or at Eastern's option, rates tied to Eurodollar, certificate of deposit or money market quotes. (5) VARIABLE TERM CUMULATIVE PREFERRED STOCK On July 13, 1993, the Company selected a Final Term which is a Mandatory Redemption Term with respect to its Variable Term Cumulative Preferred Stock, Series A. The dividend rate during the Final Term is 6.421% per annum and dividends are paid quarterly. The Final Term calls for 5% annual sinking fund payments beginning on September 1, 1999, is non-callable for 10 years, and shall end on September 1, 2018. (6) PENSION BENEFITS The Company, through retirement plans under collective bargaining agreements and participation in Eastern's pension plans, provides retirement benefits for substantially all of its employees. The benefits under these plans are based on stated amounts for years of service or employee's average compensation during the five years prior to retirement. The Company follows a policy of funding retirement and employee benefit plans in accordance with the requirements of the plans and agreements in sufficient amounts to satisfy the "Minimum Funding Standards" of the Employee Retirement Income Security Act of 1974 ("ERISA"). The expected long-term rate of return on assets was 8.5% in 1993 and 1992 and 7.5% in 1991. The discount rate used in determining the actuarial present value of the projected benefit obligation was 7.5% for 1993 as well as for prior years. The rate of increase in future compensation levels was 5.0%. BOSTON GAS COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (6) PENSION BENEFITS (CONTINUED) (7) POST-RETIREMENT BENEFITS OTHER THAN PENSIONS In addition to providing pension benefits, the Company, through participation in Eastern administered plans and welfare plans under collective bargaining agreements, provides certain health care and life insurance benefits for retired employees. Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106 ("SFAS 106"), "Employers' Accounting for Post-Retirement Benefits Other Than Pensions," by immediately recognizing the cumulative effect of the accounting change. SFAS 106 requires that the expected cost of post-retirement benefits other than pensions be charged to expense during the period that the employee renders service. As of the date of adoption, the cumulative effect of the accounting change ("transition obligation") was, $89,120,000. With approval by the Department, the Company has deferred the cost of the transition obligation and the amount by which expense under SFAS 106 exceeds amounts currently included in rates. The 1993 rate order allows the Company to phase in incremental costs associated with SFAS 106 over a four-year period. Each year during the phase-in, the Company will file for an increase in rates to reflect an additional increment of SFAS 106 costs. The difference between the incremental annual amount allowed in rates during the phase-in period and the SFAS 106 costs will be deferred as a regulatory asset with carrying costs. BOSTON GAS COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (7) POST-RETIREMENT BENEFITS OTHER THAN PENSIONS (CONTINUED) Prior to the 1993 rate order, the Company recognized as expense and recovered through rates billed to customers the cost of post-retirement benefits on a claims paid basis. Such costs totalled $4,437,000 in 1993, $4,110,000 in 1992 and $3,431,000 in 1991. The Company established a 501(c)(9) Voluntary Employee Beneficiary Association ("VEBA") Trust in 1991 to begin funding its post-retirement benefit obligation for collectively bargained employees. The Company contributed $5,000,000 in 1992 to the VEBA. The weighted average discount rate used in determining the accumulated post-retirement benefit obligation was 7.5% in 1993 and 1992. A 12% and 15% annual increase in the cost of covered health care benefits was assumed for 1993 and 1992, respectively. This rate of increase is assumed to drop gradually to 5% after 7 years. A 1% increase in the assumed health care cost trend would have increased the post-retirement benefit cost by $489,000 and $1,056,000 and the accumulated post-retirement benefit obligation by $5,691,000 in 1993 and $9,164,000 in 1992. In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112 ("SFAS 112"), "Employer's Accounting for Postemployment Benefits", which establishes standards of financial accounting and reporting for certain postemployment benefit obligations. The adoption of SFAS 112 is not expected to have a material effect on the Company's financial condition or results of operations. SFAS 112 is effective for fiscal years beginning after December 15, 1993. (8) LEASES The Company and its subsidiary lease certain facilities and equipment under long-term leases which expire on various dates through the year 2000. Total rentals charged to income under all lease agreements were approximately $7,663,000 in 1993, $6,939,000 in 1992 and $6,417,000 in 1991. BOSTON GAS COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (8) LEASES (CONTINUED) Under the terms of SFAS 71, the timing of expense recognition on capitalized leases should conform with regulatory rate treatment. The Company has included the rental payments on its financing leases in its cost of service for rate purposes. Therefore, the total depreciation and interest expense that was recorded on the leases was equal to the rental payments included in other operating and maintenance expense in the accompanying consolidated statements of income. (9) FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value disclosures for financial instruments: Cash and Short-term Investments The carrying amounts approximate fair value because of the short maturity of those instruments. Short-term Debt The carrying amounts of the Company's short-term debt, including notes payable and gas inventory financing, approximate their fair value. Long-term Debt The fair value of long-term debt is estimated based on currently quoted market prices for similar types of borrowing arrangements. BOSTON GAS COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (9) FAIR VALUES OF FINANCIAL INSTRUMENTS (CONTINUED) Preferred Stock The fair value of the preferred stock for 1993 is based on currently quoted market prices. For 1992 the carrying amount approximates fair value because of the frequency with which dividend rates were reset. (10) SUPPLEMENTARY INFORMATION The Company paid Eastern $3,096,000 in 1993, $2,707,000 in 1992 and $2,520,000 in 1991 for various legal, tax and corporate services rendered. (11) SIGNIFICANT CUSTOMER Firm and non-firm sales to a single customer produced revenues totaling $24,800,000 in 1993, $13,900,000 in 1992 and $18,500,000 in 1991, or 4.0%, 2.3% and 3.5% of total revenues in 1993, 1992 and 1991, respectively. (12) ENVIRONMENTAL ISSUES The Company is subject to local, state and federal environmental regulation of its operations and properties. The Company is working with the Massachusetts Department of Environmental Protection ("DEP") to determine the environmental impact, if any, of by-products associated with 13 former manufactured gas plant ("MGP") properties which the Company currently owns and for which the Company may be potentially responsible. The Company is currently assessing seven of these properties pursuant to applicable DEP procedures. The Company expects to spend approximately $1 million in assessing these properties in 1994 and expects similar expenditures for site assessment for the next several years as other properties are investigated. Since the DEP has not yet approved a remediation plan for any Company site, the Company cannot reliably predict the potential liability associated with final remediation of any of these properties. Company experience to date indicates that assessment and remediation costs of at least $18 million could be incurred over the next several years at these thirteen properties, subject to possible contribution or the assumption of responsibility by New England Electric System ("NEES") or one of its subsidiaries as discussed below. Massachusetts Electric Company, a wholly-owned subsidiary of NEES, has assumed responsibility for remediating a fourteenth property currently owned by the Company (part of the site of gas manufacturing operations in Lynn, Massachusetts) pursuant to the decision of the Court of Appeals for the First Circuit in The John S. Boyd, Inc., et al. v. Boston Gas Company, et al, Civil Action No. 89-575-T (May 26, 1993). The First Circuit found that NEES and its subsidiaries, as the prior owners and operators of the Lynn MGP site, were responsible for remediating the site and that the Company did not assume any liability for environmental remediation when it acquired the property from NEES in 1973. Of the 13 other sites currently owned by the Company, 10 were acquired from NEES. Given substantial similarities between these acquisitions and that involved in Boyd, it is not probable that the Company will have any material exposure for environmental remediation at these 10 sites. BOSTON GAS COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (12) ENVIRONMENTAL ISSUES (CONTINUED) There are 23 other former MGP sites within the Company's service territory which the Company does not currently own. The DEP has not issued a Notice of Responsibility to the Company for any of these 23 sites. At this time, there is substantial uncertainty as to whether the Company is responsible for remediating any of these sites either because the Company never owned the site, the Company does not have successor liability for contamination of the site by earlier operators, or site conditions do not require remediation by the Company. By an order issued on May 25, 1990, the Department approved a settlement agreement which provides for the recovery through the cost of gas adjustment clause of all environmental response costs associated with former MGP sites over separate, seven-year amortization periods without a return on the unamoritized balance. The settlement agreement also provides for no further investigation of the prudency of any Massachusetts gas utility's past MGP operations. (13) PIPELINE TRANSITION COSTS Pursuant to Federal Energy Regulatory Commission ("FERC") Order No. 636, pipelines will be allowed to recover prudently incurred transition costs, including (1) gas supply realignment costs or the costs of renegotiating existing gas supply contracts with producers; (2) unrecovered purchased gas adjustment costs or unrecovered gas costs at the time the pipelines ceased the merchant function; (3) stranded costs or the unrecovered costs of assets that cannot be assigned to customers of unbundled services; and (4) new facilities costs or the costs of new facilities required to physically implement the order. The Company's obligation for transition costs is $30.6 million and it has recorded this amount less actual billings at December 31, 1993 of $6.3 million as a liability in the accompanying consolidated balance sheet. As pipelines continue to incur and file for recovery of transition costs, the Company's obligation may increase. The Company's obligation to Tennessee for transition costs is $12.0 million, based on filings by Tennessee at FERC. Payments to Tennessee for such costs commenced in October 1993. The Company's obligations to Texas Eastern and Algonquin for transition costs is $18.6 million, based on filings by Texas Eastern and Algonquin at FERC. Payments to Texas Eastern and Algonquin began in July 1993. The Department has allowed recovery of the Company's transition costs liability over a five-year period commencing in May 1994. Accordingly, the Company has recorded a regulatory asset equivalent to the liability established at December 31, 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Boston Gas Company: We have audited the accompanying consolidated balance sheets of Boston Gas Company (a Massachusetts Corporation and wholly-owned subsidiary of Eastern Enterprises) and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of earnings, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements 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 Boston Gas Company and subsidiary 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 consolidated financial statements and schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a 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. Boston, Massachusetts February 4, 1994 BOSTON GAS COMPANY AND SUBSIDIARY INTERIM FINANCIAL INFORMATION FOR THE TWO YEARS ENDED DECEMBER 31, 1993 (UNAUDITED) The following table summarizes the Company's reported quarterly information for the years ended December 31, 1993 and 1992: The above amounts vary significantly due to the seasonality of the Company's business. SCHEDULE V BOSTON GAS COMPANY AND SUBSIDIARY PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (IN THOUSANDS) SCHEDULE VI ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (IN THOUSANDS) SCHEDULE V BOSTON GAS COMPANY AND SUBSIDIARY PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (IN THOUSANDS) SCHEDULE VI ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (IN THOUSANDS) SCHEDULE V BOSTON GAS COMPANY AND SUBSIDIARY PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (IN THOUSANDS) SCHEDULE VI ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (IN THOUSANDS) SCHEDULE VIII BOSTON GAS COMPANY AND SUBSIDIARY VALUATION AND QUALIFYING ACCOUNTS FOR THE YEAR ENDED DECEMBER 31, 1993 (IN THOUSANDS) SCHEDULE VIII BOSTON GAS COMPANY AND SUBSIDIARY VALUATION AND QUALIFYING ACCOUNTS FOR THE YEAR ENDED DECEMBER 31, 1992 (IN THOUSANDS) SCHEDULE VIII BOSTON GAS COMPANY AND SUBSIDIARY VALUATION AND QUALIFYING ACCOUNTS FOR THE YEAR ENDED DECEMBER 31, 1991 (IN THOUSANDS) - --------------- (1) Reclassified from other accounts SCHEDULE IX BOSTON GAS COMPANY AND SUBSIDIARY SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS) - --------------- (A) Average daily balances. (B) Actual interest incurred divided by average amount outstanding during the year. SCHEDULE X BOSTON GAS COMPANY AND SUBSIDIARY SUPPLEMENTARY EARNINGS STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS)

17206_1993.txt

17206_1993

1993

17206

Item 1. BUSINESS ORGANIZATION AND SEGMENTS Capital Holding Corporation (the "Company"), an insurance and diversified financial services holding company based in Louisville, Kentucky, was incorporated in Delaware in 1969 by Commonwealth Life Insurance Company ("Commonwealth Life"). The objective was to achieve earnings growth through acquisitions of other insurance companies and, thus, effect economies of scale and the sharing of commonly needed resources, while preserving the strengths of acquired companies' marketing operations. Through affiliates of its Agency Group, Direct Response Group and Accumulation and Investment Group, the Company offers accumulation, life and annuity, accident and health and property and casualty insurance products. The Company's Banking Group affiliates provide consumer loans, deposits and other banking services. Agency Group By 1976, the Company had acquired Peoples Life Insurance Company ("Peoples Life") in Washington, D.C.; National Standard Life Insurance Company ("National Standard") in Orlando, Florida; Georgia International Life Insurance Company ("Georgia International") in Atlanta, Georgia; Home Security Life Insurance Company ("Home Security") in Durham, North Carolina; and several other companies that were subsequently merged into these affiliates. On October 1, 1985, Peoples Life and Home Security were merged to form Peoples Security Life Insurance Company ("Peoples Security") with headquarters in Durham. On March 31, 1987, the Company sold Georgia International to Southmark Corporation. On April 1, 1988, National Standard was merged into Commonwealth Life. On September 8, 1989, the Company acquired Southlife Holding Company and its primary operating companies, Public Savings Life Insurance Company ("Public Savings Insurance") and Security Trust Life Insurance Company ("Security Trust"). In December 1991 the Company created Capital Security Life Insurance Company ("Capital Security") with headquarters in Durham, as the successor to Public Savings Insurance. On November 14, 1991, the Company acquired Durham Corporation ("Durham") and its primary operating company, Durham Life Insurance Company ("Durham Life"), with headquarters in Raleigh, North Carolina. Agency Group's business is conducted primarily through four affiliates: Commonwealth Life, Peoples Security, Capital Security and Durham Life. Direct Response Group National Liberty Corporation ("National Liberty") in Valley Forge, Pennsylvania, was acquired on January 14, 1981, and added a nationwide direct marketing operation to what previously had been a regional, agent based marketing system. In addition, National Home Life Assurance Company ("National Home"), domiciled in Missouri, was also acquired as National Liberty's primary operating company, together with its principal subsidiaries, Veterans Life Insurance Company ("Veterans Life") and National Home Life Insurance Company of New York ("National Home NY"). - 2 - Item 1. (continued) In 1979, Commonwealth Life's property and casualty operation was recapitalized, made a direct subsidiary of the Company and later renamed Capital Enterprise Insurance Company ("Capital Enterprise"). On December 31, 1986, the Company acquired Worldwide Underwriters Insurance Company ("Worldwide Insurance"), located in St. Louis, Missouri, and the personal lines property and casualty insurance business of the Wausau Insurance Companies. Concurrently, it made Capital Enterprise a direct subsidiary of Worldwide Insurance. These two affiliates, together with Capital Landmark Insurance Company, a subsidiary of Capital Enterprise, and Worldwide Underwriters Insurance Company of North Carolina, a subsidiary of Worldwide Underwriters Insurance, form the property and casualty line of business of the Company's Direct Response Group. On January 15, 1993, Worldwide Insurance acquired Academy Insurance Group ("Academy") and its subsidiaries, Academy Life Insurance Company and Pension Life Insurance Company. Academy principally markets life insurance to active duty military service personnel. Accumulation And Investment Group In 1987, the institutional accumulation product business, previously managed in Agency Group, and the retail accumulation product business, previously managed by National Liberty, were moved to the Accumulation and Investment Group. Affiliates of Agency Group and Direct Response Group offer these institutional and retail accumulation products. In addition to the marketing and management of accumulation (investment-type) products, Accumulation and Investment Group manages the Company's insurance-related investment portfolios. Banking Group In April 1984, the Company acquired a controlling interest in First Deposit Corporation ("First Deposit"), located in San Francisco, California, which owns a consumer bank (First Deposit National Bank) and a credit card bank (First Deposit National Credit Card Bank). Ownership in First Deposit was increased each year until 1989 when the remaining shares were purchased. These affiliates form the Banking Group. Financial information about business segments is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. PRODUCTS Insurance Commonwealth Life, Peoples Security, Capital Security, Durham Life, National Home, Veterans Life, National Home NY and Academy write a variety of individual, nonparticipating life insurance products. These include universal life contracts, traditional and interest-sensitive whole life insurance, term life insurance, endowments, accidental death and dismemberment coverage and premium waiver disability insurance. - 3 - Item 1. (continued) The following table progresses total life insurance in force for the year ended December 31, 1993: Total Life Insurance (dollars in thousands) In force at December 31, 1992 $58,262,410 Sales and additions 18,483,161 76,745,571 Terminations: Surrender and Conversion 2,380,274 Lapse 6,664,218 Reinsurance - Other 1,714,575 Subtotal 10,759,067 In force at December 31, 1993 $65,986,504 (1) Number of policies in force before reinsurance ceded at December 31, 1993 1,850,455 (1) (1) Reinsurance assumed has been included. Reinsurance ceded has not been deducted. Commonwealth Life, Peoples Security, Capital Security, Durham Life, National Home, Veterans Life, National Home NY and Academy also issue an assortment of individual accident and health insurance products. These include coverages for regular income during periods of hospitalization, scheduled reimbursement for specific hospital/surgical expenses and cancer treatments, hospice care, deductible and co-payment amounts not covered by other health insurance, lump sum payments for accidental death or dismemberment and benefits for death and injury resulting from an accident. Additionally, National Home and Academy offer a Medicare supplement product. Worldwide Insurance, Capital Enterprise and their subsidiaries underwrite personal lines automobile, homeowners and umbrella liability coverages, mainly for standard and preferred risks. Accumulation The institutional line of accumulation products, offered through Commonwealth Life, Peoples Security and National Home, consists of fixed rate guaranteed investment contracts ("GICs") and floating rate GICs which can receive interest based on rates indexed to either short-, intermediate- or long-term rates. In addition, the institutional line includes Trust GICs where the plan sponsor owns and retains assets related to these contracts and Commonwealth Life and Peoples Security provide benefit responsiveness in the event that benefit requests and other contractual commitments exceed current cash flows. Further, Commonwealth Life and Peoples Security offer to institutional customers Total Return Account Contracts ("TRACs"), which guarantee the total return of selected indices without the additional transaction costs, including - 4 - Item 1. (continued) the S & P 500 Index, the Shearson Lehman Aggregate Index and the Government Corporate Index. Through National Home, Commonwealth Life and Peoples Security, the Company offers retail products including immediate life annuities (primarily structured settlements), variable annuities, single premium and flexible premium deferred annuities and individual retirement annuities. Single premium deferred annuities and flexible premium deferred annuities are offered at a fixed interest rate on either a fixed or indexed basis. In addition, flexible premium deferred annuities are offered on a variable contract basis. Banking Banking Group affiliates offer both secured and unsecured loan accounts, as well as a broad range of deposit products. The receivables portfolio consists primarily of unsecured consumer loans which use a VISAR or MasterCardR credit card as the credit extension vehicle, a revolving cash loan product without a credit card, a secured line of credit using a VISAR or MasterCardR credit card, a home equity secured loan product called Select EquityR and insurance premium finance installment loans. Banking Group affiliates also offer fee-based products designed to suspend certain customer payment obligations in situations such as loss of income due to unemployment or disability. Deposit products include retail and institutional certificates of deposit and money market deposit accounts. MARKETING Agency Group markets individual insurance products primarily through home service agents, who call on customers in their homes to sell policies and provide related services. Home office and field associates, including individuals who provide direct customer sales and those who deliver service and support, are organized as Customer Service Units ("CSUs"), each of which operates under a single management structure, as opposed to the prior organization where marketing and administration were managed separately. There are 11 CSUs providing full service to customers in particular geographic and/or market segments. Substantially all of the home service representatives are employees of Agency Group affiliates and do not represent other insurers. Such representatives receive compensation from sales commissions and from renewal and service commissions. The compensation arrangement is designed to reward representatives who not only sell new policies, but who also effectively maintain and service in-force business to meet Company sales and persistency objectives. In addition to its home service sales organization, marketing partnerships have also been formed whereby products are distributed through the insurance and marketing organizations of third parties. Direct Response Group primarily uses television and print media solicitation, direct mail, telephone and third-party programs to market its insurance products. Additional mail correspondence and telephone communications are used to follow up and close sales. Sponsored marketing programs are conducted through major banks, oil companies, department stores, associations and other businesses with large customer bases. Products are also marketed to active duty military personnel on military bases through Agents/Counselors. Property and casualty products are also marketed through some of the home service agents of Agency Group. - 5 - Item 1. (continued) Institutional accumulation products of the Accumulation and Investment Group are marketed through a small sales staff, bank trustees, municipal GIC brokers, GIC fund managers, brokers and direct marketing. Retail products are marketed through financial planners, stock brokerage firms, pension consultants, savings and loan associations, banks and other financial institutions. Banking Group's consumer loan and deposit products are primarily marketed using direct mail and telemarketing channels and other direct response methods. Installment loans are primarily marketed through agents. In 1993, the Banking Group also entered into joint marketing arrangements with unaffiliated third parties whereby the Banking Group's consumer credit products would be endorsed by, or offered in connection with the products or services of, such third parties. The Company's Agency Group affiliates concentrate their marketing efforts in the Southeast and Mid-Atlantic states, while the Direct Response, Accumulation and Investment and Banking Groups market their products nationwide. RISK Risk is integral to insurance but, as is customary in the insurance business, risk exposure is kept within acceptable limits. The Company's subsidiaries retain no more than $1,000,000 of life insurance and $250,000 of accidental death benefits for any single life. Excess coverages are reinsured externally. At December 31, 1993, approximately $4.6 billion, or approximately 6.9 percent of total life insurance in force, was reinsured with nonaffiliated insurance companies. The Company would become liable for the reinsured risks if the reinsurers could not meet their obligations. The Company's life insurance affiliates in many cases require evidence of insurability before issuing individual life policies including, in some cases, a medical examination or a statement by an attending physician. Home office underwriters review that evidence and approve the issuance of the policy in accordance with the application if the risk is acceptable. Some applicants who are substandard risks are rejected, but many are offered policies with higher premiums or restricted coverages. As of December 31, 1993, approximately 1.9 percent of life insurance in force was represented by risks which were substandard at the time the policy was issued. The majority of individual health insurance is Direct Response Group business and written without evidence of insurability, relying on safeguards such as product design, limits on the amount of coverage, and premiums which recognize the resultant higher level of claims. Banking Group's unsecured consumer loans are principally generated through direct mail solicitations sent to a prescreened list of prospective account holders, followed by credit verification. Four principles guide development of specific underwriting criteria for each mailing: (i) sufficient credit history; (ii) no unacceptable derogatory credit remarks; (iii) necessary income qualification; and (iv) no rapid increase in outstanding debt or credit availability. - 6 - Item 1. (continued) As a diversified financial services company, many of the Company's assets and liabilities are monetary in nature and thus are sensitive to changes in the interest rate environment. Detailed discussions about the Company's investments are included in Note C to the Consolidated Financial Statements on pages 44 through 46 of the Company's 1993 Annual Report and Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. REGULATION Insurance The business of the Company's insurance subsidiaries is subject to regulation and supervision by the insurance regulatory authority of each state in which the subsidiaries are licensed to do business. Such regulators grant licenses to transact business; regulate trade practices; approve policy forms; license agents; approve certain premium rates; establish minimum reserve and loss ratio requirements; review form and content of required financial statements; prescribe type and amount of investments permitted; and assure that capital, surplus and solvency requirements are met. Insurance companies can also be required under the solvency or guaranty laws of most states in which they do business to pay assessments up to prescribed limits to fund policyholder losses or liabilities of insolvent insurance companies. They are also required to file detailed annual reports with supervisory agencies, and records of their business are subject to examination at any time. Under the rules of the National Association of Insurance Commissioners (the "NAIC"), a self-regulatory organization of state insurance commissioners, insurance companies are examined periodically by one or more of the regulatory authorities. The NAIC adopted, in December of 1992, a "Risk Based Capital for Life and/or Health Insurers Model Act" (the "Model Act") which was designed to identify inadequately capitalized life and health insurers. The Model Act defines two key measures: (i) Adjusted Capital, which equals an insurer's statutory capital and surplus plus its Asset Valuation Reserve, plus half its liability for policyholder dividends, and (ii) Risk Based Capital. Risk Based Capital is determined by a complex formula which is intended to take into account the various risks assumed by an insurer. Should an insurer's Adjusted Capital fall below certain prescribed levels (defined in terms of its Risk Based Capital), the Model Act provides for four different levels of regulatory attention: "Plan Level": Triggered if an insurer's Adjusted Capital is less than 100% but greater than or equal to 75% of its Risk Based Capital; requires the insurer to submit a plan to the appropriate regulatory authority that discusses proposed corrective action. "Action Level": Triggered if an insurer's Adjusted Capital is less than 75% but greater than or equal to 50% of its Risk Based Capital; authorizes the regulatory authority to perform a special examination of the insurer and to issue an order specifying corrective actions. - 7 - Item 1. (continued) "Authorized Control Level": Triggered if an insurer's Adjusted Capital is less than 50% but greater than or equal to 35% of its Risk Based Capital; authorizes the regulatory authority to take whatever action it deems necessary. "Mandatory Control Level": Triggered if an insurer's Adjusted Capital falls below 35% of its Risk Based Capital; requires the regulatory authority to place the insurer under its control. Since the Adjusted Capital levels of the Company's insurance subsidiaries currently exceed all of the regulatory action levels as defined by the NAIC's Model Act, the Model Act currently has no impact on the Company's operations or financial condition. The federal government does not directly regulate insurance business, except with respect to Medicare supplement plans; however, legislation and administration policies concerning premiums, age and gender discrimination, financial services and taxation, among other areas, can significantly affect the insurance business. Banking First Deposit's consumer banking subsidiaries are subject to federal and state regulation with respect to lending and investment practices, capital requirements, and financial reporting. The primary regulator for these consumer banking subsidiaries is the Office of the Comptroller of the Currency. Holding Company States have enacted legislation requiring registration and periodic reporting by insurance companies domiciled within their respective jurisdictions that control or are controlled by other corporations so as to constitute a holding company system. The Company and its subsidiaries have registered as a holding company system pursuant to such legislation in Kentucky, Missouri, North Carolina, New York, Illinois, Pennsylvania and New Jersey. Insurance holding company system statutes and rules impose various limitations on investments in subsidiaries and may require prior regulatory approval for the payment of dividends and other distributions in excess of statutory net gain from operations on an annual noncumulative basis by the registered insurance company to the holding company or its affiliates. Separate Accounts Separate accounts of the Company's subsidiaries which offer retail variable annuities are registered with the Securities and Exchange Commission under the Investment Company Act of 1940 and are governed by the provisions of the Internal Revenue Code of 1986, as amended, pertaining to the tax treatment of annuities. - 8 - Item 1. (continued) COMPETITION The insurance industry is highly competitive with over 2,000 life insurance companies competing in the United States, some of which have substantially greater financial resources, broader product lines and larger staffs than the Company's insurance subsidiaries. Additionally, life insurance companies face increasing competition from banks, mutual funds and other financial entities for attracting investment funds. The Company's insurance subsidiaries differentiate themselves through progressive marketing techniques, product features, price, customer service, stability and reputation, as well as competitive credit ratings. The insurance subsidiaries maintain their competitive position by their focus on low risk/high return markets and an efficient cost structure. Other competitive strengths include integrated asset/liability management, risk management and innovative product engineering. The credit card and consumer revolving loan industry business in which First Deposit's subsidiaries are engaged is also highly competitive. The industry has recently experienced consolidation, lower growth and rising charge-offs. Competitors are increasing their use of advertising, target marketing, pricing competition and incentive programs and have also announced changes in the terms of certain credit cards, including lowering the fixed annual percentage rate charged on balances or converting the annual percentage rate charged on balances from a fixed per annum rate to a variable rate. In addition, other credit card issuers have announced "tiered" or "risk-adjusted" rates under which the annual percentage rate for the issuer's most creditworthy customers is lowered. In response to the competitive environment, First Deposit's subsidiaries have implemented a variety of new programs to attract and retain customers, including reducing interest rates on selected accounts. First Deposit's subsidiaries have generally retained the right to alter various charges, fees and other terms with respect to consumer credit accounts. In addition, the Banking Group has experienced steady growth in its secured loan products and is increasing its efforts to offer its products to underserved markets. EMPLOYEES The total number of persons employed by the Company and its subsidiaries was approximately 9,360 as of December 31, 1993, including an agency sales force of 3,609. The Company has approximately 350 employees. FOREIGN OPERATIONS Substantially all of the Company's operations are conducted in the United States. - 9 - Item 2. Item 2. PROPERTIES Principal properties of the Company and its affiliates include home offices located in Louisville, Kentucky (Commonwealth Life) and Valley Forge, Pennsylvania (National Liberty and Worldwide Insurance), which are owned; and Louisville, Kentucky (Capital Holding Corporation), Durham, North Carolina (Peoples Security, Capital Security and Durham Life) and San Francisco and Pleasanton, California (First Deposit), which are leased. Item 3. Item 3. LEGAL PROCEEDINGS The last subsection, titled "Legal Proceedings", of Note J - Commitments and Contingencies on page 53 of the Annual Report for the year ended December 31, 1993, is incorporated by reference. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None EXECUTIVE OFFICERS OF THE REGISTRANT Name and Age Principal Occupation and Business Experience Irving W. Bailey II Chairman of the Board of Directors, Capital Holding Age: 52 Corporation, since November 1988, and President and Chief Executive Officer, Capital Holding Corporation, since April 1988. President and Chief Operating Officer, Capital Holding Corporation, September 1987 to April 1988. Executive Vice President and Chief Investment Officer, Capital Holding Corporation, from February 1981 to September 1987. He was with Phoenix Mutual Life Insurance Company for 9 1/2 years, serving as Senior Vice President, Investments from 1979 to 1981 and Vice President, Investments from 1976 to 1979. Robert L. Walker Senior Vice President - Finance and Chief Financial Age 43 Officer, Capital Holding Corporation, since August 1993. He served as Vice President and General Counsel, Capital Holding Corporation, from December 1991 to August 1993, and Vice President, Corporate Tax, Capital Holding Corporation, from March 1988 to December 1991. Prior to joining Capital Holding Corporation, he was with The Mead Corporation from 1975 to 1988, serving most recently as Tax Counsel. Steven T. Downey Vice President and Controller, Capital Holding Age: 36 Corporation, since November 1993. He served as Director, Finance and Accounting - Accumulation and Investment Group, Capital Holding Corporation, from January 1993 to November 1993, and Second Vice President and Assistant Controller from August 1991 to January 1993. Prior to joining Capital Holding Corporation, he was with Ernst & Young, Certified Public Accountants, from 1978 to 1991. - 10 - EXECUTIVE OFFICERS OF THE REGISTRANT (continued) Name and Age Principal Occupation and Business Experience Shailesh J. Mehta Executive Vice President, Capital Holding Age: 44 Corporation and President and CEO - Direct Response Group, Capital Holding Corporation, since August 1993. Also, President and CEO - Banking Group, Capital Holding Corporation, and Chairman of the Board, President and Chief Executive Officer of First Deposit Corporation (FDC) and subsidiaries since April 1988. He served as Executive Vice President and Chief Operating Officer of FDC from March 1986 until his selection as CEO. Prior to joining FDC, he served as Vice President, 1977 to 1982; Senior Vice President of Bank Operations, 1982 to 1985; and finally Executive Vice President, 1985 to 1986, of AmeriTrust Bank, Cleveland, Ohio. During his thirteen year tenure at AmeriTrust, he also served on the boards of AmeriTrust Venture Capital Corporation, AmeriTrust Development Bank, NationNet National ATM Network, and InstaNet National ATM Network. He is one of the founders of the Cirrus debit card network. Lee Adrean President and CEO - Agency Group, Capital Holding Age: 42 Corporation, since August 1993. He served as Senior Vice President, Planning and Finance and Chief Financial Officer, Capital Holding Corporation, from December 1991 to August 1993, and Senior Vice President, Strategic Planning and Corporate Development, Capital Holding Corporation, from September 1990 to August 1993. Prior to joining Capital Holding Corporation, he was with Bain & Company, Inc. from 1979 to 1990, serving as Vice President, 1985 to 1990; Manager, 1982 to 1985; and Consultant, 1979 to 1982. Joseph M. Tumbler President and CEO - Accumulation and Investment Age: 45 Group, Capital Holding Corporation, since November 1989. He served as Senior Vice President - Strategic Planning and Corporate Development, Capital Holding Corporation, from January 1988 to November 1989. Previously with National Liberty Corporation as Executive Vice President - Financial Marketing from September 1986 to January 1988. He was with CIGNA Corporation from 1978 to 1986, serving as Senior Vice President, International Life and Group, 1983 to 1986; Vice President, Planning, CIGNA Worldwide, Inc., 1981 to 1983; Director - Corporate Strategy, INA Corporation, 1978 to 1981. - 11 - EXECUTIVE OFFICERS OF THE REGISTRANT (continued) Name and Age Principal Occupation and Business Experience Lawrence Pitterman Senior Vice President of Administration, Capital Age: 46 Holding Corporation, since January 1991. Previously with First Deposit Corporation as Vice President, Human Resources, from July 1990 to December 1990; Vice President, Corporate Communications, from 1989 to 1990; and Vice President, First Deposit Savings Bank, from 1987 to 1989. Prior to joining FDC, he served as Director, Human Resources, for Data General Corporation from 1983 to 1987. Elaine J. Robinson Vice President and Treasurer, Capital Holding Age 45 Corporation, since December 1991, Second Vice President and Assistant Treasurer, Capital Holding Corporation, from November 1987 to December 1991, and Second Vice President, Corporate Finance, Capital Holding Corporation, from August 1987 to November 1987. Prior to joining Capital Holding Corporation, she was with Brown-Forman Corporation from 1971 to 1987, serving most recently as Assistant Vice President, Corporate Finance and Treasury. Bruce E. Ogle Vice President and Corporate Auditor, Capital Holding Age 38 Corporation, since 1989. He served as Director, Marketing Support-Agency Group, Capital Holding Corporation, from 1987 to 1988, and as Manager, Computer Audit Function-Agency Group, Capital Holding Corporation, from 1984 to 1987. Frederick C. Kessell Vice President and Chief Investment Officer - Age 45 Accumulation and Investment Group, Capital Holding Corporation, since 1988, and Vice President, Fixed Income Securities - Accumulation and Investment Group, Capital Holding Corporation from May, 1985 to 1988. Prior to joining Capital Holding Corporation, he was with Schroder Capital Management from 1979 to 1985, serving as Vice President. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Common Stock Dividend and Market Data, and Quarterly Price Ranges of Common Stock and Dividends Per Common Share on pages 32 and 34 of the Annual Report for the year ended December 31, 1993 are incorporated by reference. Item 6. Item 6. SELECTED FINANCIAL DATA Selected Financial Data on pages 18 and 19 of the Annual Report for the year ended December 31, 1993, is incorporated by reference. - 12 - PART II (continued) Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Results and Analysis on pages 18 and 19, Results by Business Segment on pages 20 through 31, Business Segment Data on pages 22 and 23, Supplemental Earnings Data on page 35 and Liquidity and Capital Resources and Inflation on pages 31 and 32 of the Annual Report for the year ended December 31, 1993, are incorporated by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries included on pages 37 through 53 and Quarterly Financial Data on page 34 of the Annual Report for the year ended December 31, 1993, 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. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Election of Directors on pages 3 through 5 of the Proxy Statement for the Annual Meeting of Stockholders to be held May 11, 1994, is incorporated by reference. Item 11. Item 11. EXECUTIVE COMPENSATION Compensation of Directors and Executive Officers on pages 5 through 14 of the Proxy Statement for the Annual Meeting of Stockholders to be held May 11, 1994, is incorporated by reference. Item l2. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Security Ownership of Certain Beneficial Owners and Management on pages 1 and 2 and Compliance with Section 16(a) of the Securities Exchange Act of 1934 on page 18 of the Proxy Statement for the Annual Meeting of Stockholders to be held May 11, 1994, are incorporated by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. - 13 - PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) and (2)--The response to these portions of Item 14 is submitted as a separate section of this report. (a) (3)--The response to this portion of Item 14 is submitted as a separate section of this report. (b) No reports on Form 8-K were filed for the three month period ended December 31, 1993. (c) Exhibits are submitted as a separate section of this report. (d) Financial statement schedules are submitted as a separate section of this report. - 14 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Louisville, and the Commonwealth of Kentucky, on the 16th day of February 1994: CAPITAL HOLDING CORPORATION Irving W. Bailey II Irving W. Bailey II 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 in the capacities indicated on the 16th day of February 1994: SIGNATURE TITLE Irving W. Bailey II Chairman, President, Chief Executive Irving W. Bailey II Officer and Director Robert L. Walker Senior Vice President and Robert L. Walker Chief Financial Officer Steven T. Downey Vice President and Controller Steven T. Downey (Principal Accounting Officer) John L. Clendenin Director John L. Clendenin Director John M. Cranor III Joseph F. Decosimo Director Joseph F. Decosimo - 15 - SIGNATURE TITLE Lyle Everingham Director Lyle Everingham Raymond V. Gilmartin Director Raymond V. Gilmartin J. David Grissom Director J. David Grissom Watts Hill, Jr. Director Watts Hill, Jr. F. Warren McFarlan Director F. Warren McFarlan Martha R. Seger Director Martha R. Seger Director Florence R. Skelly Larry D. Thompson Director Larry D. Thompson Director John L. Weinberg - 16 - ANNUAL REPORT ON FORM 10-K ITEM l4(a)(1), (2) and (3), (c) and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENT SCHEDULES LIST AND INDEX OF EXHIBITS YEAR ENDED DECEMBER 31, 1993 CAPITAL HOLDING CORPORATION LOUISVILLE, KENTUCKY - 17 - FORM 10-K--ITEM 14(a)(1) and (2) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES INDEX OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries, included on pages 37 through 53 of the Annual Report for the year ended December 31, 1993, are incorporated by reference in Item 8: Page Consolidated Statements of Income - Years Ended December 31, 1993, 1992 and 1991 37 Consolidated Statements of Financial Condition - December 31, 1993 and 1992 38-39 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991 40 Consolidated Statements of Shareholders' Equity - Years Ended December 31, 1993, 1992 and 1991 41 Notes to Consolidated Financial Statements 42-53 The following financial statement schedules and the related Report of Independent Auditors are included in Item 14(d): Schedule I - Summary of Investments - Other Than Investments in Related Parties Schedule III - Condensed Financial Information of Registrant Schedule V - Supplementary Insurance Information Schedule VI - Reinsurance Schedule IX - Short-term Borrowings Information required in Schedule VIII, "Valuation and Qualifying Accounts," is included in Note C to the consolidated financial statements of Capital Holding Corporation and subsidiaries, 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. - 18 - REPORT OF INDEPENDENT AUDITORS Board of Directors and Shareholders Capital Holding Corporation We have audited the consolidated financial statements of Capital Holding Corporation and subsidiaries listed in the accompanying Index to financial statements (Item 14(a)). 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 Capital Holding Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the 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 Louisville, Kentucky February 9, 1994 - 19 - - 23 - SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - CONTINUED CAPITAL HOLDING CORPORATION (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS In the parent company only condensed financial statements, the Company's investment in subsidiaries is stated at cost plus equity in undistributed income of subsidiaries since date of acquisition. The condensed financial statements of the parent company should be read in conjunction with the Consolidated Financial Statements and Notes of Capital Holding Corporation and Subsidiaries. Note A Federal Income Tax The Company files a consolidated federal income tax return with certain of its subsidiaries. The federal income tax benefit in the accompanying condensed financial statements reflects the Company's allocable share of the consolidated provision. See Note G to the Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries for a description of the components of the consolidated federal income tax provision. Note B Long-Term Debt Long-term debt of the Company at December 31, 1993 and 1992 consisted of Debentures and Notes in the amount of $587,750,000. See Note H to the Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries for a description of the terms and aggregate maturities of the Company's long-term debt. Note C Common Stock On February 17, 1993, the Board of Directors declared a two-for-one stock split of the Company's common stock effected in the form of a stock dividend. The stock dividend was payable on April 30, 1993, to holders of record on April 15, 1993. Note D Preferred Stock The Company has 6,000,000 shares of preferred stock, par value $5, authorized for issuance in series. Redeemable Cumulative Preferred Stock Held By Subsidiary The Company has designated 827,400 shares of preferred stock as redeemable cumulative preferred stock to be issued in different series with varying annual dividend rates. The shares outstanding at December 31, 1993 and 1992 were 707,400 and 768,600, respectively. The subsidiary has the right, on an annual basis, to waive receipt of dividends and has waived any dividends payable through 1993. The characteristics of the redeemable preferred stock are as follows: SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - CONTINUED CAPITAL HOLDING CORPORATION (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS - NOTE D - CONTINUED Shares outstanding Dividend Shares Year at December 31 Period of Series rate authorized issued 1993 1992 redemption B 12.25% 57,400 1980 57,400 65,600 1991-2000 C 14.00% 120,000 1981 120,000 135,000 1992-2001 D 15.00% 90,000 1982 90,000 100,000 1993-2002 E 14.25% 135,000 1982 135,000 150,000 1993-2002 G 12.00% 237,000 1983 117,000 130,000 1993-2002 H 11.50% 100,000 1984 100,000 100,000 1994-2003 I 12.00% 88,000 1984 88,000 88,000 1994-2003 827,400 707,400 768,600 Mandatory pro-rata sinking fund payments are required to redeem 10% of each series of redeemable preferred stock annually, beginning approximately ten years after issuance at $100 per share. As the shares are redeemed, they are retired thereby reducing the total authorized shares. The Company redeemed the following shares of cumulative preferred stock in 1993: 8,200 of the Series B; 15,000 of the Series C; 10,000 of the Series D; 15,000 of the Series E; and 13,000 of the Series G. The aggregate amount of mandatory pro-rata sinking fund payments required for redemption of the redeemable preferred stock in each of the following years are: 1994-$8,000,000; 1995-$8,000,000; 1996-$8,000,000, 1997-$8,000,000 and 1998-$8,000,000. The Company shall have the annual non-cumulative option to double any sinking fund payment subject to an aggregate limitation of 25% of the total issue. The redeemable preferred stock is non-callable for approximately ten years and callable thereafter at $105 per share plus accrued dividends. However, in the event the Company is required to obtain approval of a specified percentage of the holders of the issue to effect a merger, consolidation, or sale of assets and such approval is denied, then the Company may redeem the preferred stock in its entirety at $100 per share plus accrued dividends. Noncumulative Convertible Junior Preferred Stock On November 14, 1991, the Company issued 1,918,200 shares of Noncumulative Convertible Junior Preferred Stock, Series J, par value $5, in connection with the acquisition of Durham Corporation. Effective June 16, 1993, each outstanding share of Series J preferred stock was exchanged for 5.55 shares of the Company's common stock and all rights of the holders of Series J preferred stock, including the rights to receive dividends, were terminated. Adjustable Rate Cumulative Preferred Stock In 1982, the Company issued 1,000,000 shares of Adjustable Rate Cumulative Preferred Stock, Series F, par value $5, at face value of $100 per share. See Note I to the Consolidated Financial Statements of Capital Holding Corporation and Subsidiaries for a description of the terms and dividend rate of the Series F Preferred Stock. On March 2, 1994, the Company redeemed the preferred stock for cash at face value. Note E Management and Service Fees The Company provides its subsidiaries with general management support, including services in the data processing, human resources, legal and financial areas. The related charges are billed to the subsidiaries being serviced as management fees, and are computed using various allocation methods which are, in the opinion of management, reasonable in relation to services rendered. - 25 - - 30 - FORM 10-K--ITEM 14(a)(3) AND (c) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES LIST AND INDEX OF EXHIBITS Reference Number Per Exhibit Exhibit Table Description of Exhibit Number Page (3) Certificate of Incorporation as amended 3.1 - on October 17, 1991. (Incorporated by reference as Exhibit 3.1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (3) By-Laws of Capital Holding Corporation as 3.2 - amended on February 17, 1988. (Incorporated by reference as Exhibit 3.3 of the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) (4) Indenture dated April 1, 1983 between 4.1 - the Company and Connecticut National Bank (as successor to National Westminster Bank USA) for Debt Securities (which now are 8 3/4% Sinking Fund Debentures due January 15, 2017 and Medium Term Notes due 1995 to 2022). (Incorporated by reference as Exhibit 4.2 to Registration Statement on Form S-3, Registration No. 2-82957 filed with the Commission on April 8, 1983.) (4) Supplemental Indenture, dated 4.2 - September 1, 1989, between the Company and Connecticut National Bank (as successor to National Westminster Bank USA), Supplements the Indenture dated April 1, 1983, between the Company and Connecticut National Bank (as successor to National Westminster Bank USA). (Incorporated by reference as Exhibit 4.1 of Form 8-K dated September 18, 1989.) (4) Capital Holding Corporation 1987 4.3 - Shareholder Rights Agreement as amended on November 4, 1992. (Incorporated by reference as Exhibit 4.5 of the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (4) Indenture between the Company and 4.4 - Morgan Guaranty Trust Company of New York, as Trustee, dated as of January 1, 1994. (Provided as part of electronic submission). - 31 - FORM 10-K--ITEM 14(a)(3) AND (c) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES LIST AND INDEX OF EXHIBITS (CONTINUED) Reference Number Per Exhibit Exhibit Table Description of Exhibit Number Page (10) Capital Holding Corporation 1981 10.1 - Stock Option Incentive Plan, through August 7,1991 (Incorporated by reference as Exhibit 10.1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (10) 1991 amendments to 1981 Stock Option 10.2 - Incentive Plan and 1989 Stock Option Plan. (Incorporated by reference as Exhibit 10.2 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) Capital Holding Corporation 1981 Tax- 10.3 - Qualified Stock Option Plan, as amended. (Incorporated by reference as Exhibit 10.2 of the Company's annual Report on Form 10-K for the year ended December 31, 1990.) (10) Employment Agreement between Capital 10.4 - Holding Corporation and Irving W. Bailey II. (Incorporated by reference as Exhibit 10.6 of the Company's Annual Report on Form 10-K for the year ended December 31, 1987.) (10) Descriptions of Company's Management 10.5 - Incentive Plan, First Deposit Corporation's Annual Incentive Plan and Company's Long-Term Incentive Plan. (Incorporated by reference to the descriptions of the Incentive Compensation Plans as described on Pages 6 and 7 of the Proxy Statement for the Annual Meeting of Stockholders held May 1, 1992.) (10) Capital Holding Corporation 1989 Stock 10.6 - Option Plan, through August 7, 1991. (Incorporated by reference as Exhibit 10.6 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) - 32 - FORM 10-K--ITEM 14(a)(3) AND (c) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES LIST AND INDEX OF EXHIBITS (CONTINUED) Reference Number Per Exhibit Exhibit Table Description of Exhibit Number Page (10) Amendment to Employment Agreement 10.7 - between Capital Holding Corporation and Irving W. Bailey II. (Incorporated by reference as Exhibit 10.7 of the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) (10) Employment Agreements between 10.8 - Capital Holding Corporation and Joseph M. Tumbler. (Incorporated by reference as Exhibit 10.8 of the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) (10) Employment Agreements between Capital 10.9 - Holding Corporation and Lee Adrean, Shailesh J. Mehta and Lawrence Pitterman. (Incorporated by reference as Exhibit 10.9 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (10) Employment Agreements between Capital 10.10 - Holding Corporation and Frederick C. Kessell and Robert L. Walker. (Incorporated by reference as Exhibit 10.11 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) First Deposit Corporation Equity Unit 10.11 - Plan. (Incorporated by reference as Exhibit 10.12 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) Capital Holding Corporation Deferred 10.12 - Compensation Plan for Deferral of Payments under the Capital Holding Corporation Management Incentive Plan. (Incorporated by reference as Exhibit 10.13 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) - 33 - FORM 10-K--ITEM 14(a)(3) AND (c) CAPITAL HOLDING CORPORATION AND SUBSIDIARIES LIST AND INDEX OF EXHIBITS (CONTINUED) Reference Number Per Exhibit Exhibit Table Description of Exhibit Number Page (10) Capital Holding Corporation Deferred 10.13 - Compensation Plan under the Capital Holding Corporation Long-Term Incentive Plan. (Incorporated by reference as Exhibit 10.14 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) First Deposit Corporation Deferred 10.14 - Compensation Plan under the First Deposit Corporation Annual Incentive Plan. (Incorporated by reference as Exhibit 10.15 of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) (10) Descriptions of Capital Holding 10.15 - Corporation Supplemental Non-qualified Thrift Savings Plan and Non-qualified Pension Agreements. (Incorporated by reference to the descriptions of the Retirement Plans and Thrift Savings Plan as described on pages 7 through 9 of the Proxy Statement for the Annual meeting of Stockholders held May 1, 1992.) (10) Capital Holding Corporation Stock 10.16 - Ownership Plan (Incorporated by reference as Exhibit 10.17 of the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (12) Computation of ratio of earnings to fixed 12.1 35 charges (Provided as part of electronic transmission.) (13) Portions of the Annual Report for the year 13.1 - ended December 31, 1993. (Provided as part of electronic transmission.) (21) List of subsidiaries. (Provided as part 21.1 37 of electronic transmission.) (23) Consent of independent auditors. (Provided 23.1 39 as part of electronic transmission.) - 34 -

75608_1993.txt

75608_1993

1993

75608

ITEM 1. BUSINESS (a) GENERAL DESCRIPTION OF BUSINESS Pacific Scientific Company ("Registrant" or the "Company") was incorporated in California in 1937 as successor to a company in business since 1919; it has used the name Pacific Scientific Company since 1923. Registrant's business is making and selling electrical equipment and safety equipment. In addition to six main United States operating divisions, the Registrant has wholly-owned sales subsidiaries in Germany, France, England and the U. S. Virgin Islands. In July and August of 1993, the Company purchased all the outstanding shares of common stock of Powertec Industrial Corporation and Automation Intelligence, Inc., respectively. In April 1993, the Company purchased certain operating assets of Unidynamics/Phoenix, Inc., a subsidiary of Crane Co. Additional information regarding these acquisitions is presented in Note 6 on Page 25 of Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993, a copy of which has been delivered to the Securities and Exchange Commission (the "Commission") pursuant to Rule 14a-3 of the Commission, and such Note 6 is incorporated herein by reference in accordance with the provisions of Rule 12b-23 of the Commission ("Rule 12b-23"). The Unidynamics/Phoenix, Inc. acquisition necessitated the expansion of the manufacturing facilities of the Energy Dynamics Division in Chandler, AZ. Currently, the Registrant has 25,000 square feet of manufacturing space under construction. The estimated cost of construction is $3 million. (b) and (c)(1)(i) DESCRIPTION OF BUSINESS SEGMENTS Information regarding business segments is presented in Note 11 beginning on Page 27 of Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 and is incorporated herein by reference in accordance with the provisions of Rule 12b-23. Each of Registrant's divisions is responsible for marketing its own products, generally selling through a combination of its own sales personnel, sales representatives and distributors, both in the United States and foreign countries. Additional information regarding the Company's products and markets is presented on Pages 4 through 9 in the Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 and is incorporated herein by reference in accordance with the provisions of Rule 12b-23. The percentages of the Company's consolidated net sales represented by its major markets for the fiscal years 1993, 1992 and 1991, respectively, were as follows: (c)(1)(ii) MATERIAL NEW PRODUCTS OR SEGMENTS There has been no public announcement of, nor has the Registrant made public, information about a new product or industry segment that would require the investment of a material amount of assets of the Registrant or that otherwise is material. (c)(1)(iii) SOURCES OF RAW MATERIAL Registrant's manufacturing operations consist primarily of fabricating and assembling parts, components and units into finished products and then testing the products. Raw materials, parts, components and assemblies are obtained from independent suppliers. Except as described in the following paragraph, the Registrant generally has not experienced any serious difficulty in obtaining adequate supplies of required materials and services, and continues to seek secondary sources of supply in the few cases where it relies upon a single supplier. Within the Safety Equipment segment, Halon 1301, the fire suppression agent used in all aircraft fire suppression systems, contains chlorofluorocarbon an ozone depleting chemical. By international agreement, the production of Halon 1301 was discontinued in 1993. During 1992, the Company developed a system capable of recovering and reprocessing Halon 1301 and also increased its storage capacity for this material. During 1993, the Company was able to increase its supply of this agent to a level that management believes is adequate to meet future demands. The Company was able to accomplish this by recycling Halon 1301 from suppression systems used in applications less critical than aircraft (i.e. systems that protect equipment rather than human life). The Company is also investigating the viability of various non- chlorofluorocarbon suppression agents. (c)(1)(iv) EFFECT OF PATENTS, TRADEMARKS, LICENSES, ETC. Registrant owns numerous United States and foreign patents expiring at various dates to 2008. Registrant also owns a number of trademarks. Although these patents and trademarks have been and are expected to be of value in the opinion of the Registrant, the loss of any single such item or group of related items would not have a material effect on the conduct of the business. (c)(1)(v)&(vi) SEASONAL AND WORKING CAPITAL REQUIREMENTS Not applicable. (c)(1)(vii) MAJOR CUSTOMERS For the year ended December 31, 1993, approximately 19% of Registrant's sales were attributable to United States defense contracts, of which 5% were awarded directly by the United States government and 14% through subcontracting procedures. Virtually all defense programs are subject to curtailment or cancellation due to the annual nature of the government appropriations and allocations process. A material reduction in United States government appropriations for defense programs may have an adverse effect on the Registrant's business, depending on the specific defense programs affected by any such reduction. Currently, the Registrant is not aware of the curtailment or cancellation of any United States defense program under which Registrant is performing as a prime contractor or subcontractor, that would have a material adverse effect on the Registrant's business. Government contracts are subject to termination by the government without cause, but in the event of such termination, Registrant would ordinarily be entitled to reasonable compensation for work completed prior to termination. Additional information regarding sales to military customers is included on Page 10 in the Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 and is incorporated herein by reference in accordance with the provisions of Rule 12b-23. (c)(1)(viii) BACKLOG Registrant's backlog of unfilled purchase orders believed by Registrant to be firm, amounted to $91,774,000 on December 31, 1993, compared with a backlog of $77,740,000 and $78,749,000 at year end 1992 and 1991, respectively. Registrant considers an unfilled purchase order to be firm when a specific delivery date has been established by the parties. Of the backlog, approximately 80% is expected to be shipped in the current fiscal year. Additional information concerning backlog is included on Page 10 in the Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 and is incorporated herein by reference in accordance with the provisions of Rule 12b- 23. (c)(1)(ix) GOVERNMENT CONTRACTS See (c)(1)(vii) above. (c)(1)(x) COMPETITION A number of companies, some of which are significantly larger than Registrant, manufacture products which compete directly with those Registrant produces. No single company competes with Registrant across its entire product line. The Registrant's competitive strategy is to achieve cost and quality advantages, offer excellent customer service, and broaden the markets in which its core competence can be applied. Competition by major product line is as follows: ELECTRICAL EQUIPMENT Motors and Control The Company's five motor and control product lines are primarily sold for industrial applications with some motors being used in consumer products. The market for permanent magnet brush type DC motors is extremely fragmented and none of the three main domestic competitors has a dominant market share. The emerging market for brushless DC motors, drives and controls has many competitors vying for market share in industrial markets, although Registrant believes it has the highest market share of any domestic supplier. The alternator and regulator product line used in aircraft and missiles has several significant domestic competitors with numerous foreign companies that would be classified as indirect competition. Products for Electrical Utilities The Registrant and at least four major competitors account for virtually all of the United States market for outdoor lighting controls. However, Registrant has a major share of the United States market for controls used in street lighting. The local and remote control market segment within the electric utilities market is highly fragmented and niche application oriented. Each product has competition from different companies with no single competitor having a product line offering similar to Registrant's. Particle Monitoring Instrument In particle monitoring, Registrant has a leading market position for sensing particulate contamination in liquid, air and vacuum environments. There are at least six direct global competitors for particle monitoring. SAFETY EQUIPMENT Fire Detection and Suppression Registrant has a leading position in the aircraft market for its aircraft fire suppression product line. There is one significant domestic competitor in the fire suppression product line with three other competitors sharing a smaller portion of the market. There are at least five other competitors for fire detection equipment sold to the aerospace and military vehicle markets. Restraints There are at least two major competitors in the United States and two in Europe for Registrant's ballistic and inertia reels which are used, mainly in aircraft, for the safety restraint of the crews. However, Registrant has maintained a significant share of this market. There are two principal competitors for the cable tension regulator, the Registrant's principal flight control component. Pyrotechnic The pyrotechnic product line addresses multiple niches within the domestic aerospace and commercial oil well marketplace and the Registrant has at least two competitors in each segment. (c)(1)(xi) RESEARCH AND DEVELOPMENT Research and development is conducted by the Registrant at its various United States divisions for its own account and at some locations for customers on a contract basis. For its own account, Registrant spent $8,584,000, $8,235,000 and $8,446,000 in 1993, 1992 and 1991, respectively. (c)(1)(xii) ENVIRONMENTAL COMPLIANCE In the opinion of Registrant, compliance with existing Federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, will not have a material effect on the capital expenditures, earnings or competitive position of Registrant and its subsidiaries. The Company is continuing environmental remediation at one of its former plant sites and has been designated as a potentially responsible party, along with other companies, for certain waste disposal sites. The Company establishes reserves for such costs which are probable and reasonably estimable and believes that any possible liability incurred will not have a material adverse effect on the financial position of the Company. (c)(1)(xiii) EMPLOYEES Registrant and its subsidiaries employ 1,597 persons, as of December 31, 1993. (d)(1) EXPORT SALES During the years of 1993, 1992 and 1991, Registrant did not engage in material manufacturing operations in foreign countries. Export sales by United States operations to customers in foreign countries represented approximately 18% in 1993, 17% in 1992 and 14% in 1991 of Registrant's sales. (d)(1)(i)&(ii) RESTATEMENTS Not applicable. (d)(2) RISK TO FOREIGN OPERATIONS In the opinion of Registrant, there is no significant risk attendant to its foreign operations or any dependence of its industry segments on its foreign operations. (d)(3) INTERIM FINANCIAL STATEMENTS Not applicable. ITEM 2. ITEM 2. PROPERTIES Registrant's properties are summarized in the following table: As noted in Part I, Item 1 of this Annual Report on Form 10-K, the acquisition of Unidynamics/Phoenix, Inc. has necessitated the addition of approximately 25,000 square feet of manufacturing facilities in Chandler, Arizona. Upon completion of these facilities (estimated to occur in the second quarter of 1994) the lease on the facilities in Goodyear, Arizona will expire and it will not be renewed. All other manufacturing facilities and manufacturing equipment are adequate, with minor changes and additions, for conducting operations as presently contemplated. To the extent the above referenced leases expire and are not renewed, Registrant believes it has the ability to acquire adequate space for conducting its operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material legal, administrative or judicial 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 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 The text and tabular presentations appearing under the captions "Dividends" and "Price Range of Common Stock" on Page 28 of the Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 are incorporated herein by reference in accordance with the provisions of Rule 12b-23. At the end of 1993, there were 1,630 stockholders of record. The total number of beneficial holders of Registrant's common stock is estimated at approximately 4,200. Registrant's common stock is traded on the New York, Midwest and Pacific Stock Exchanges. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The material appearing under the caption "Five Year Financial Summary" on Page 15 of the Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 is incorporated herein by reference in accordance with the provisions of Rule 12b-23. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The text appearing under the caption "Management's Discussion and Analysis" appearing on Pages 10, 11, 12 and 13 of the Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 is incorporated herein by reference in accordance with the provisions of Rule 12b-23. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated Financial Statements for the fiscal years ended December 31, 1993, December 25, 1992 and December 27, 1991 appearing on Pages 17 through 27; the Independent Auditors' Report appearing on Page 16; and Management's Report appearing on Page 14 of the Annual Report to Stockholders for the fiscal year ended December 31, 1993 are incorporated herein by reference in accordance with the provisions of Rule 12b- 23. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Registrant has not had disagreements with, nor has the Registrant changed independent accountants during the past two years. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding the Company's directors and all persons nominated or chosen to become directors, as well as information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 (the "Exchange Act") by the directors, officers and beneficial owners of more than 10% of any class of equity securities of the Registrant, is incorporated by reference from Registrant's definitive proxy statement to be filed by Registrant with the Commission pursuant to Regulation 14A of the Exchange Act no later than 120 days after the end of Registrant's fiscal year ended December 31, 1993. Information regarding the Company's executive officers appears below: No executive officer of the Registrant is related to any other executive officer of the Registrant. All executive officers of the Registrant serve at the discretion of the Board of Directors. No understanding or arrangement exists between any executive officer and any other person pursuant to which he was chosen as an officer. Mr. Brower was elected Chairman of the Board of Directors of the Registrant in 1990. He was hired as President and Chief Operating Officer in 1985 and was named Chief Executive Officer later in that year. Mr. Plat was hired as Vice President of Finance and Administration and Secretary in 1977 and was promoted to Senior Vice President in 1983. Mr. Breitzka was promoted to Corporate Vice President and President of the HTL/Kin-Tech Division in 1992. He had been a Product Line Vice President of that division since 1988. Mr. Day was promoted in 1993 to Corporate Vice President and President of the newly formed Energy Dynamics Division. Previously, Mr. Day was General Manager of the Company's Energy Systems Division which was a part of and manufactured a product line for the HTL/Kin-Tech Division. With the acquisition of Unidynamics/Phoenix, Inc. and its subsequent merger into the Energy Systems product lines, the Energy Dynamics Division was formed. Mr. Day has held various management positions within Pacific Scientific Company since 1981. Mr. Knoblock was hired as President of the Electro-Kinetics Division in 1988 and was promoted to Corporate Vice President in 1989. Mr. Nelson was hired as President of the Motor & Control Division and appointed Corporate Vice President in early 1990. He was General Manager of the Motor Division of Barber Colman Co. from 1982 to 1990. Mr. Olsen was hired as President of the Instrument Division, now known as HIAC/ROYCO, in 1988. He was promoted to Corporate Vice President in 1989. Mr. Ossenmacher joined Pacific Scientific in 1992 as Product Line Director for the HTL/Kin-Tech Division. He was promoted to Corporate Vice President and President of the Fisher Pierce Division in 1993. Previously, Mr. Ossenmacher was with the Parker-Hannefin Corporation where he held various management positions since 1981, the most recent being Director of Worldwide Commercial Transport Business. Mr. Nothwang was hired as Corporate Controller in 1978 and later appointed Assistant Secretary. Mr. Swan was hired in 1977 as Assistant Treasurer and promoted to Treasurer in 1982. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information with respect to executive compensation is incorporated by reference from Registrant's definitive proxy statement to be filed by Registrant with the Commission pursuant to Regulation 14A no later than 120 days after the end of Registrant's fiscal year ended December 31, 1993. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information with respect to security ownership of certain beneficial owners and management is incorporated by reference from Registrant's definitive proxy statement to be filed by Registrant with the Commission pursuant to Regulation 14A no later than 120 days after the end of Registrant's fiscal year ended December 31, 1993. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Registrant and its subsidiaries have not had any transaction or series of similar transactions nor is there any currently proposed transaction or series of transactions that would exceed $60,000 and in which any director, executive officer, security holder of more than 5% of the Company's voting securities or the immediate family of any of the foregoing persons, would have a direct or indirect material interest as defined by Item 404(a) of Regulation S-K. There have been no business relationships, as defined by Item 404(b) of Regulation S-K, with regard to any of the Registrant's directors or nominees for director. No director, executive officer or nominee for election as director nor any member of their immediate family has been indebted to the Registrant or its subsidiaries at any time since December 26, 1993 in an amount in excess of $60,000, as defined by Item 404(c) of Regulation S-K. Item 404(d) of Regulation S-K does not apply to the Registrant. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1 List of Documents filed as a part of the Report: Financial Statements: Consolidated Financial Statements for the fiscal years ended December 31, 1993, December 25, 1992 and December 27, 1991 appearing on Pages 17 through 27; the Independent Auditors' Report appearing on Page 16; and Management's Report appearing on Page 14 of the Annual Report to Stockholders for the fiscal year ended December 31, 1993 are incorporated herein by reference in accordance with the provisions of Rule 12b-23. With the exception of the pages referred to in the preceding sentence and other information specifically incorporated by reference in this Form 10-K, the Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 is not to be deemed filed as part of this report. (a) 2 Included herein: (a) 3 Exhibits (b) Reports on Form 8-K A Form 8-K Current Report was filed by the Registrant on August 13, 1993 and the related Form 8-K/A Amendment No. 1 was filed October 13, 1993 pursuant to the requirements of the Securities Exchange Act of 1934. Information was provided with regards to Items 2 and 7, "Acquisition of Assets" and "Financial Statements of Businesses Acquired", respectively, for the Registrant's acquisition of Powertec Industrial Corporation on July 30, 1993. The following financial statements were included in the filings: Form 8-K: Item 7(a) Financial Statements and Financial Information (a) Independent Auditors' Report (b) Consolidated Balance Sheets as of December 31, 1991 and 1992 (c) Consolidated Statements of Income for the years ended December 31, 1991 and 1992 (d) Consolidated Statements of Stockholders' Equity for the years ended December 31, 1991 and 1992. (e) Consolidated Statements of Cash Flows for the years ended December 31, 1991 and 1992 (f) Notes to Consolidated Financial Statements (g) Independent Auditors' Report on Supplementary Information (h) Selling Expenses (i) General and Administrative Expenses for the years ended December 31, 1991 and 1992 Form 8-K/A: Item 7(b) Proforma Financial Information (a) Historical and Proforma Condensed Consolidated Statements of Income for the six months ended June 25, 1993 (unaudited) (b) Historical and Proforma Condensed Consolidated Statements of Income for the year ended December 25, 1992 (unaudited) (c) Historical and Proforma Condensed Consolidated Balance Sheets as of June 25, 1993 (unaudited) (d) Notes to Historical and Proforma Condensed Consolidated Financial Statements Additional information regarding this acquisition is contained in Items 1(a) appearing on Page 2 of this Form 10-K. (c) Included in 14(a) 3 above. (d) Included in 14(a) 2 above. ___________________________________________ (1) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 28, 1984. (2) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 26, 1986. (3) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 24, 1987. (4) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 24, 1988. (5) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 30, 1989. (6) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 28, 1990. (7) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 28, 1991. (8) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 19, 1993. (9) Incorporated by reference to Registrant's Form 8-K filed November 22, 1988. (10) Incorporated by reference to Registrant's Form 8-K filed August 13, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PACIFIC SCIENTIFIC COMPANY March 28, 1994 By /s/ Richard V. Plat ------------------------- Richard V. Plat Senior Vice President, Finance & Administration 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. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Pacific Scientific Company: We have audited the consolidated financial statements of Pacific Scientific Company and subsidiaries as of December 31, 1993, December 25, 1992 and December 27, 1991 and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 3, 1994; such financial statements and report are included in your 1993 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the financial statement schedules of Pacific Scientific Company, listed in Item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Costa Mesa, California February 3, 1994 PACIFIC SCIENTIFIC COMPANY AND SUBSIDIARIES Schedule IX - Short-Term Borrowings Years Ended December 31, 1993, December 25, 1992 and December 27, 1991 Notes payable represent obligations payable under several credit agreements to various banks and financial institutions. The average amount outstanding was computed by averaging the weekly balances during the year. The weighted average interest rate was computed by dividing the interest expense by the average amount outstanding. PACIFIC SCIENTIFIC COMPANY AND SUBSIDIARIES Schedule X - Supplementary Income Statement Information Years Ended December 31, 1993, December 25, 1992 and December 27, 1991 INDEX TO EXHIBITS __________________________________________________________________ (1) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 28, 1984. (2) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 26, 1986. (3) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 24, 1987. (4) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 24, 1988. (5) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 30, 1989. (6) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 28, 1990. (7) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 28, 1991. (8) Incorporated by reference to Registrant's Annual Report on Form 10-K filed March 19, 1993. (9) Incorporated by reference to Registrant's Form 8-K filed November 22, 1988. (10) Incorporated by reference to Registrant's Form 8-K filed August 13, 1993.

884219_1993.txt

884219_1993

1993

884219

ITEM 1. BUSINESS The Dial Corp ("Dial" or "Company"), conducts a consumer products and services business focused on North American markets producing annual revenues in excess of $3 billion. Dial's CONSUMER PRODUCTS segment operates through four divisions, as follows: PERSONAL CARE, which manufactures and markets DIAL, TONE, SPIRIT, PURE & NATURAL and LIQUID DIAL soaps, and other soap and personal care products; LAUNDRY, which manufactures and markets PUREX and PUREX ULTRA dry detergent, PUREX heavy duty liquid detergent, TREND, PUREX TOSS 'N SOFT and other laundry products; HOUSEHOLD, which manufactures and markets RENUZIT air fresheners, BRILLO scouring pads, SNO BOL and SNO DROPS toilet bowl cleaners, PARSONS ammonia, BRUCE floor care products and other household items; and FOOD, which processes and markets ARMOUR STAR chili, beef stew, corned beef hash and Vienna sausage, TREET luncheon meat and other shelf- stable canned foods, LUNCH BUCKET microwaveable meals and other food products. Dial's SERVICES business operates in three principal business segments through subsidiary corporations of Dial, as follows: AIRLINE CATERING AND OTHER FOOD SERVICES, which engages in airline catering operations, providing in-flight meals to more than 60 domestic and international airlines, and operates foodservice facilities ranging from cafeterias in manufacturing plants to corporate executive dining rooms to the food and beverage facilities of the America West Arena in Phoenix, Arizona; CONVENTION SERVICES, which provides exhibit design and construction and exhibition preparation, installation, electrical, transportation and management services to major trade shows, manufacturers, museums and exhibit halls and other customers; and TRAVEL AND LEISURE AND PAYMENT SERVICES, which engages in airplane fueling and ground handling, cruise line and hotel/resort operations, recreation and travel services, Canadian intercity bus transportation, and operation of duty-free shops on cruise ships and at international airports, and offers money orders, official checks and negotiable instrument clearing services through a national network of approximately 43,000 retail agents, mid-size bank customers and over 4,500 credit unions in the United States and Puerto Rico. Dial subsidiaries operate service or production facilities and maintain sales and service offices in the United States, Canada and Mexico. The Company also conducts business in other foreign countries. Dial had approximately 215 employees at its corporate center at December 31, 1993, providing management, financial and accounting, tax, administrative, legal and other services to its operating units and handling residual matters pertaining to businesses previously discontinued or sold by the Company. Dial is managed by a Board of Directors comprised of 10 nonemployee directors and one employee director and has an executive management team consisting of six Dial officers and seven principal executives of significant operating divisions or companies. Dial's corporate headquarters and certain Consumer Products division and subsidiary activities are located in Phoenix, Arizona, in a modern high-rise building. A portion of the headquarters building is rented to unaffiliated tenants. A description of each of the Dial business segments and recent developments in each follows. CONSUMER PRODUCTS SEGMENT CONSUMER PRODUCTS is a leading producer and marketer of personal care, laundry, household and shelf-stable food products. This segment is the outgrowth of the Dial personal care and shelf-stable canned meats unit of Armour and Company, expanded in recent years to include PUREX household and laundry products, BORAXO household and industrial specialty products, BRECK hair care products and RENUZIT air fresheners. The segment manufactures and markets a variety of products, including bar and liquid soaps, liquid and powdered detergents, antiperspirants, hairsprays, shampoos, hair conditioners, bleaches, fabric softeners, soap pads, air fresheners, floor care products, household cleaners, fabric sizing, laundry starch products, borax and industrial specialties products, microwaveable food products and canned meats. PERSONAL CARE Personal Care products are marketed under a number of brand names, including DIAL, MOUNTAIN FRESH DIAL, TONE, PURE & NATURAL, SPIRIT and FELS NAPTHA soaps, LIQUID DIAL antibacterial soap, BORAXO powdered hand soap and DIAL antiperspirant. Personal Care also markets the BRECK line of hair care products, including hair sprays, shampoos and hair conditioners. DIAL bar soap is the nation's leading deodorant soap and LIQUID DIAL soap is the nation's leading antibacterial liquid soap. SPIRIT bar soap, a three-in-one combination bar soap that cleans, moisturizes and provides deodorant protection, is now available nationally. In late 1993, DIAL PLUS soap, an antibacterial skin care bar soap with moisturizing ingredients was introduced nationally. Personal Care also markets hotel amenity products, including personal-size bar soaps under the DIAL, TONE and PURE & NATURAL labels, and industrial specialties products, including hand soaps and soap dispensers, sold under the BORAXO and LURON trademarks, hand and body surface cleaners for the medical market and hand cleaners for the automotive market. LAUNDRY Laundry products include brands such as PUREX liquid, powdered and ultra laundry detergents, TREND and ULTRA TREND dry detergents, DUTCH detergents, PUREX TOSS 'N SOFT and STA PUF fabric softeners, MAGIC sizing and starch, BORATEEM dry bleach, STA-FLO starch, and 20 MULE TEAM borax. In 1993, Laundry introduced several new products and line extensions, including PUREX liquid detergent with bleach, RINSE 'N SOFT fabric softener, ULTRA TREND detergent and CLASSIC PUREX detergent and TREND detergent with bleach. HOUSEHOLD Household products include brands such as RENUZIT air fresheners, BRILLO soap pads, SNO BOL and SNO DROPS toilet bowl cleaners, CAMEO powdered cleanser, PARSONS and BO-PEEP ammonia and BRUCE floor care products. The RENUZIT air freshener brand was acquired in the second quarter of 1993. RENUZIT, a leading brand in the air freshener category, currently offers products for the continuous-action and aerosol segments of the air freshener market, including RENUZIT Adjustable, RENUZIT Aerosol and ROOMMATE products and has completed its rollout of RENUZIT LONGLAST ELECTRIC product, the brand's entry into the electric subsegment of the air freshener category. In 1993, Household introduced SNO BOL thick toilet bowl cleaner and a larger DOBIE scouring pad. FOOD In the shelf-stable food category, CONSUMER PRODUCTS processes and markets ARMOUR STAR and TREET canned meats, LUNCH BUCKET microwaveable meals, APPIAN WAY pizza mix, SUNRISE syrup and CREAM corn starch. ARMOUR STAR products maintain a leading market position in the canned meats category. ARMOUR STAR Vienna sausage, potted meat and dried beef lead their respective segments on a national basis. ARMOUR STAR canned meats now account for nearly one-fifth of all canned meat sales in the United States. During 1993, CONSUMER PRODUCTS introduced ARMOUR hot dog chili sauce, ARMOUR meatless sloppy joe sauce and ARMOUR western-style chili, and began test marketing VILLA LORENZO PASTA FOR ONE microwaveable meals, a seven item line of single-serving dry pastas with sauce pouches. CUSTOMERS CONSUMER PRODUCTS sells to over 15,000 customers, primarily in the United States, including supermarkets, drug stores, wholesalers, mass merchandisers, membership club stores and other outlets. These customers are served by a national sales organization of approximately 370 employees organized into 6 individual sales regions plus specialized sales operations which sell to large mass merchandisers, membership club stores, chain drug stores, vending and military customers. RAW MATERIALS Ample sources of raw materials are available with respect to all major products of the CONSUMER PRODUCTS segment. COMPETITION CONSUMER PRODUCTS competes primarily on the basis of price, brand advertising, customer service, product performance, and product identity and quality. Its operations must compete with numerous well-established local, regional and national companies, some of which are very large and act aggressively in obtaining and defending their products' market shares and brands. Principal competitors, in one or more categories, are Procter & Gamble, Colgate-Palmolive, Lever Brothers Co., American Home Food Products, G. A. Hormel & Co., The Clorox Company, Church & Dwight and S.C. Johnson & Son, Inc. SERVICES SEGMENTS SERVICES is built around several company groups which are leading competitors in their businesses, including companies engaged in airline catering (Dobbs International), contract foodservices (Restaura), convention services (GES Exposition Services and Exhibitgroup), payment services (Travelers Express), airplane fueling and ground handling (Aircraft Service International), Canadian intercity bus service (Greyhound Lines of Canada), family cruises (Premier Cruise Lines), airport and cruise ship duty-free businesses (Greyhound Leisure Services), and travel services (Jetsave and Crystal Holidays). SERVICES provides specialized services to both the business and consumer markets, increasingly in the airline travel and leisure services areas. Its money order business, travel and tour operations, restaurants, fast food outlets, gift shops, national park hotel facilities, cruise ships, and duty-free shops located at airports and on cruise ships are directed primarily to the consumer market. Primarily for the business market, in major cities throughout the United States, SERVICES provides airline in-flight catering operations as well as contract foodservices in the form of cafeteria-style operations, private dining rooms, group catering and machine-vended services; performs services as decorating contractor at various convention and trade show sites; designs, fabricates, ships and warehouses displays and exhibits for trade shows, conventions and other exhibitions; and engages in aircraft ground-handling services such as aircraft fueling, cleaning and baggage handling. AIRLINE CATERING AND OTHER FOOD SERVICES SERVICES conducts airline catering operations under the "Dobbs" name through the Dobbs International group of companies. Dobbs International, which has been conducting airline catering operations since 1941, will become the nation's largest domestic in-flight caterer as a result of its agreement made in November 1993 to acquire from United Airlines 15 in-flight catering kitchens at 12 domestic airports. The acquisition will be phased-in over a period ending in May 1994. Dobbs International will be United's exclusive in-flight caterer at the 12 locations where the kitchens are located. The company also recently expanded its presence in the United Kingdom by the acquisition in February 1994 of 4 catering kitchens in England and Scotland. In 1993, Dobbs International's in-flight catering operations provided in-flight meals to more than 60 domestic and international airlines at 44 airports in the United States plus Heathrow Airport, London, England, and Glasgow Airport, Scotland, and in 1994, as a result of the recent acquisitions, will provide in-flight meals to more than 60 domestic and international airlines at 51 airports. Dobbs International has been involved in a "Quality Improvement Process" for many years and has been recognized for its innovations by its customers and suppliers. Other food services are provided through the Restaura group of companies. The contract foodservice division of Restaura serves meals to employees at approximately 200 locations, including employees of major companies such as General Motors, IBM and Ford, through cafeteria, executive dining rooms and vending operations. Restaura also acts as the prime concessionaire for all food and beverage services at the America West Arena in Phoenix, Arizona, and operates 7 historic lodges in and around Glacier National Park in Montana and Canada. CONVENTION SERVICES Convention services are provided by the Company's GES Exposition and Exhibitgroup companies. GES Exposition, the nation's leading supplier of convention services, provides decorating, exhibit preparation, installation, electrical, transportation and management services for conventions and tradeshows. During 1993 Convention services acquired United Exposition Services Co., Inc., a general-service convention contractor serving locations primarily in the eastern United States; Andrews, Bartlett & Associates, Inc., which has major operations in Chicago, Cleveland, Orlando, New Orleans, Washington, D.C. and Atlanta; and Gelco Convention Services, Inc., which operates principally in the southeastern United States. Exhibitgroup is a leading designer and builder of custom and rental convention exhibits and displays. TRAVEL AND LEISURE AND PAYMENT SERVICES Travel and leisure services directed to the consumer market are provided by the Premier Cruise Lines, Greyhound Leisure Services, Jetsave, Crystal Holidays and Greyhound Lines of Canada business units. Premier Cruise Lines provides three and four-day BIG RED BOAT cruises from Port Canaveral, Florida, to the Bahamas and, commencing in April 1994, from Port Tampa, Florida, to Mexico and Key West, and offers a seven-day package which combines a cruise with a three or four-day vacation at Walt Disney World or Universal Studios and Sea World. Premier operates three cruise ships, the Star/Ship Oceanic, the Star/Ship Atlantic and the Star/Ship Majestic. Cruise destinations offer various underwater diving and snorkeling attractions, historical tours, sandy beaches and shopping opportunities. Premier has contracted with Warner Bros. for the right to use Warner Bros.' famous LOONEY TUNES characters (Bugs Bunny and others) commencing in April 1994 for entertainment on board Premier Cruise Lines' ships. Premier's status as Official Cruise Line of Walt Disney World will expire March 31, 1994. Greyhound Leisure Services operates duty-free shipboard concessions on 56 cruise ships and also operates duty-free shops at the Chicago, Miami and Fort Lauderdale/Hollywood Florida international airports, and in Washington, D.C. Other recreation and travel services are provided under the Jetsave and Crystal Holidays names. Jetsave and Crystal Holidays are leading United Kingdom operators of tour packages and specialty tours throughout Europe, and from Europe to the United States, Canada and the Bahamas. Greyhound Lines of Canada Ltd. ("GLOC"), a Canadian publicly traded company, is a 69%-owned subsidiary which operates the largest intercity bus transportation system for passengers, charter service and courier express in Canada. Routes connect with those of other intercity bus carriers, providing interconnecting service to areas of the United States and Canada not served directly by GLOC. GLOC owns and operates 465 intercity coaches. Brewster Transport Company, Ltd., a subsidiary of GLOC, operates tour and charter buses in the Canadian Rockies, engages in travel agency, hotel and snocoach tour operations and holds a joint venture interest in the Mt. Norquay ski attraction in Banff, Canada. Brewster owns and operates 87 intercity coaches, and 13 snocoaches which transport sightseers on tours of the Columbia Icefield. The Aircraft Service International group of companies provides aircraft ground-handling services such as aircraft fueling, aircraft cleaning and baggage handling for major domestic and foreign airlines at 28 airports throughout the United States and in Freeport, Bahamas and London, England. The Travelers Express group of companies engages in the sale of money orders to the public through approximately 43,000 agent locations in the United States and Puerto Rico. Travelers Express is the nation's leading issuer of money orders, issuing approximately 236 million money orders in 1993. The United States Postal Service, which is the second largest issuer, issued approximately 180 million money orders in 1993. Travelers Express also provides processing services for more than 4,500 credit unions and other financial institutions which offer share drafts (the credit union industry's version of a personal check) or official checks (used by financial institutions in place of their own bank check or teller check). Republic Money Order Company, a Travelers Express unit, is a leader in the issuance of money orders through chain convenience and supermarket stores and in money order-issuance technology. Virtually all airport concessions operated by the Company, other than certain concessions at Hartsfield Atlanta International Airport, which are scheduled to expire September 30, 1994, were sold to Host International, Inc., during the second half of 1992. COMPETITION SERVICES companies generally compete on the basis of price, quality, convenience and service, and encounter substantial competition from a large number of providers of similar services, including numerous well-known local, regional and national companies, cruise lines, private money order companies and the U.S. Postal Service (money orders), many of which have greater resources than the Company. Dobbs International also competes on the basis of reliability, appearance of kitchen facilities, quality of truck fleet and on-time record. Caterair International Corporation, Sky Chefs, Inc., and Ogden Corporation are the principal competitors of Dobbs International. Freeman Decorating Company is the principal competitor of GES Exposition. GLOC competes primarily on the basis of price and service. Principal competitors include airlines, private automobiles and other intercity bus lines. PATENTS AND TRADEMARKS United States trademark registrations are for a term of 10 years, renewable every 10 years so long as the trademarks are used in the regular course of trade; patents are granted for a term of 17 years. The Dial companies maintain a portfolio of trademarks representing substantial goodwill in the businesses using the marks, and own many patents which give them competitive advantages in the marketplace. Many trademarks used by CONSUMER PRODUCTS, including DIAL, PURE & NATURAL, ARMOUR STAR, TONE, TREET, PARSONS, BRUCE, PUREX, DUTCH, RENUZIT, BRILLO, SNO BOL, BRECK, TREND, PUREX TOSS N' SOFT, STA PUF, FLEECY WHITE, 20 MULE TEAM, BORAXO, LUNCH BUCKET, and MAGIC trademarks, and by SERVICES, including the DOBBS, PREMIER CRUISE LINES, BIG RED BOAT and TRAVELERS EXPRESS service marks, have substantial importance and value. Use of the ARMOUR and ARMOUR STAR trademarks by CONSUMER PRODUCTS is permitted by a license expiring in 2043 granted by ConAgra, Inc. and use of the 20 MULE TEAM trademark is permitted by a perpetual license granted by U.S. Borax, Inc. In addition, certain subsidiaries within SERVICES use the Greyhound and the Image of the Running Dog marks in connection with their businesses. CONSUMER PRODUCTS also has the right, pursuant to license agreements, to operate under certain third-party patents covering specific technologies. GOVERNMENT REGULATION Substantially all of the operations of CONSUMER PRODUCTS and many of the operations of SERVICES are subject to various federal laws and agency regulation, in particular, the Food, Drug and Cosmetic Act, the Food and Drug Administration, the Department of Agriculture, the Federal Maritime Commission, and various state laws and regulatory agencies. In addition, other subsidiaries of Dial are subject to similar laws and regulations imposed by foreign jurisdictions. Both rates and routes of GLOC are regulated by federal and provincial authorities of Canada. ENVIRONMENTAL Dial and its subsidiaries are subject to various environmental laws and regulations in the United States, Canada and other foreign countries where they have operations or own real estate. Dial cannot accurately predict future expenses or liability which might be incurred as a result of such laws and regulations. However, Dial believes that any liabilities resulting therefrom, after taking into consideration Dial's insurance coverage and amounts previously provided, should not have any material adverse effect on Dial's financial position or results of operations. EMPLOYEES EMPLOYMENT AT DECEMBER 31, 1993 EMPLOYEES COVERED BY APPROXIMATE NUMBER COLLECTIVE BARGAINING SEGMENT OF EMPLOYEES AGREEMENTS - ------- ------------------ --------------------- Consumer Products 4,000 2,100 Airline Catering and Other Food Services 11,900 5,800 Convention Services 2,500 1,100 Travel and Leisure and Payment Services 7,600 3,200 Dial believes that relations with its employees are satisfactory and that collective bargaining agreements expiring in 1994 will be renegotiated in the ordinary course without adverse effect on Dial's operations. SEASONALITY The first quarter is normally the slowest quarter of the year for Dial. Consumption patterns, current marketing practices and competition cause CONSUMER PRODUCTS' revenues and operating income to be highest in the second and fourth quarters. Due to increased leisure travel during the summer and year-end holidays, Dial's airline catering, cruise ship and intercity bus travel operations experience peak activity at these times. Convention service companies generally experience increased activity during the first half of the year. RESTRUCTURING MATTERS On August 5, 1993, Dial completed the initial public offering of 20 million shares of common stock of Motor Coach Industries International, Inc. (NYSE:MCO), its transportation manufacturing and service parts subsidiary. The transaction followed the March 1992 spin-off of GFC Financial Corporation (NYSE:GFC), a corporation which comprised substantially all of the financial services and insurance businesses of Dial, and was the final step in Dial's restructuring plan to focus its financial and management resources on its consumer products and services business. See Note D of Notes to Consolidated Financial Statements for further information concerning the sale of the Company's transportation manufacturing and service parts segment and the spin-off of GFC Financial Corporation. REINCORPORATION MERGER At a special meeting of shareholders of The Dial Corp, an Arizona Corporation ("Arizona Dial"), held on March 3, 1992, shareholders of Arizona Dial approved a reincorporation merger proposal to change Arizona Dial's state of incorporation from Arizona to Delaware by means of a merger in which Arizona Dial would be merged with and into Dial. The merger was effected on March 3, 1992. BUSINESS SEGMENTS Principal business segment information is set forth in Annex A attached hereto and made a part hereof. ITEM 2. ITEM 2. PROPERTIES During December 1993, a subsidiary of Dial acquired the corporation which owned the remaining 49% interest in a joint venture which owns Dial's headquarters building. Dial owns a 200,000-square-foot facility in Scottsdale, Arizona, which is used by the CONSUMER PRODUCTS segment to conduct much of its research and certain other activities. CONSUMER PRODUCTS operates 13 plants in the United States, 1 plant in Mexico, and 7 offices in 7 foreign countries. All of the plants are owned; 6 of the offices are leased. Principal manufacturing plants are as follows: LOCATION SQ. FEET PRODUCTS MANUFACTURED - -------- -------- --------------------- Aurora, IL 425,000 Bar Soaps Fort Madison, IA 453,000 Canned Meats, Microwaveable Meals St. Louis, MO 475,000 Bleach, Ammonia, Fabric Softener, Laundry Detergents Bristol, PA 253,700 Dry Detergents and Cleansers Hazelton, PA 232,000 Liquid Detergents, Ammonia, Scouring Pads, Fabric Softener Auburndale, FL 208,000 Bleach, Ammonia, Fabric Softener, Dishwashing Detergents Memphis, TN 130,000 Dial Liquid Soap, Antiperspirants, Shampoos and Conditioners, Hotel Amenities (shampoos, conditioners and hand lotions) AIRLINE CATERING AND OTHER FOOD SERVICES operates 14 offices, 53 catering kitchens, 37 foodservice facilities and 7 lodges with ancillary foodservice and recreational facilities. All of the properties are in the United States, except for 2 catering kitchens, 1 foodservice facility and 1 lodge which are located in foreign countries. Ten of the catering kitchens, 2 hotels and 3 of the foodservice facilities are owned; all other properties are leased. Five of the hotels are operated pursuant to a concessionaire agreement. CONVENTION SERVICES operates 29 offices and 26 exhibit construction and warehouse facilities. All of the properties are in the United States. One of the offices and one of the warehouses are owned; all other properties are leased. TRAVEL AND LEISURE AND PAYMENT SERVICES operates 54 offices, 191 duty-free shops, 3 cruise ships and 6 hotels with ancillary foodservice and recreational facilities. All of the properties are in the United States, except for 9 offices and 3 hotels, which are located in foreign countries. Travel and Leisure and Payment Services owns 2 of the hotels, leases 1 of the hotels, has a partial interest in the other hotel for which it is also the lessee and operator, and operates 2 of the hotels under management contract. One of the cruise ships is owned; all other properties are leased. Approximate passenger capacity of the cruise ships is 1600, 1500 and 1000 persons, respectively. This segment also operates certain airport concessions which, as discussed earlier, are scheduled to expire September 30, 1994. GLOC operates 10 terminals and 7 garages in Canada. Five terminals and 6 garages are owned; the other properties are leased. In addition, bus stop facilities at approximately 600 locations in Canada are provided by commission agents. Principal properties of GLOC are as follows: LOCATION SQ. FEET FUNCTION - -------- -------- -------- Calgary, Alberta 179,000 Terminal and Headquarters Office Edmonton, Alberta 63,000 Terminal London, Ontario 12,000 Terminal Vancouver, British Columbia 23,000 Terminal Winnipeg, Manitoba 21,000 Terminal Edmonton, Alberta 23,000 Garage Winnipeg, Manitoba 39,000 Garage Toronto, Ontario 46,000 Garage Vancouver, British Columbia 16,000 Garage Calgary, Alberta 135,000 Maintenance and Overhaul Center Of the property owned by Dial, only the facility in Auburndale, Florida, is subject to a mortgage with $3,989,000 outstanding at December 31, 1993. Management believes that Dial's facilities in the aggregate are adequate and suitable for their purposes and that capacity is sufficient for current needs. ITEM 3. ITEM 3. LEGAL PROCEEDINGS During the fourth quarter of 1993, the Company settled the matter of John E. Washburn, Director of Insurance for the State of Illinois, as Liquidator of Pine Top Insurance Company vs. Ralph C. Batastini, et al. The net cost of the settlement is not material to the Company and is being charged against a previously provided reserve. The lawsuit was instituted June 20, 1988, in Circuit Court of Cook County, Illinois. Plaintiff alleged negligent management on the part of certain directors and officers of Pine Top Insurance Company ("PTIC"), a discontinued insurance operation. On February 14, 1992, Transportation Manufacturing Corporation, a former subsidiary of Dial ("TMC"), filed a lawsuit against Chicago Transit Authority ("CTA") in the United States District Court for the District of New Mexico. The lawsuit arises from a contract between TMC and CTA for the manufacture and delivery of 491 wheelchair-lift transit buses. In addition to relief from any liquidated damages for late deliveries, TMC is seeking reimbursement for increased costs due to changes, delays and interferences TMC alleges were caused by CTA. TMC is also seeking treble damages under the New Mexico Unfair Trade Practices Act, alleging that CTA breached its covenant of good faith and fair dealing in the handling of this contract with TMC. TMC was divested by the Company in connection with its sale of MCII in August 1993, but the Company retained rights to certain recoveries, indemnified MCII against certain costs and damages and continued to direct the litigation pursuant to a Litigation Cooperation Agreement. On January 12, 1994, TMC and CTA agreed on a tentative settlement under which the Company would realize certain recoveries. Settlement documents are being finalized. The Company and certain subsidiaries are parties either as plaintiffs or defendants to various other actions, proceedings and pending claims, certain of which are or purport to be class actions. The pending cases range from claims for additional employment benefits to cases involving accidents, injuries, product liability or business contract disputes, certain of which involve claims for compensatory, punitive or other damages in material amounts. Litigation is subject to many uncertainties and it is possible that some of the legal actions, proceedings or claims referred to above could be decided against Dial. Although the amount of liability at December 31, 1993, with respect to matters where Dial is defendant is not ascertainable, Dial believes that any resulting liability should not materially affect Dial's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS. No matters were submitted to a vote of securityholders during the fourth quarter of 1993. OPTIONAL ITEM. EXECUTIVE OFFICERS OF REGISTRANT. The names, ages and positions of the executive officers of the Company as of March 15, 1994, are listed below: EXECUTIVE POSITION NAME AGE OFFICE HELD SINCE - ---- --- ------ ---------- John W. Teets 60 Chairman, President and 1982 Chief Executive Officer and Director and Chairman of Executive Committee of Registrant Frederick G. 60 Vice President and 1977 Emerson Secretary of Registrant Joan F. Ingalls 45 Vice President-Human 1991 Resources of Registrant F. Edward Lake 59 Vice President-Finance 1987 of Registrant L. Gene Lemon 53 Vice President and 1979 General Counsel of Registrant Richard C. Stephan 54 Vice President- 1980 Controller of Registrant William L. Anthony 51 Executive Vice 1987 President-Administration and Controller, Consumer Products Group of Registrant Robert H. Bohannon 49 President and Chief 1993 Executive Officer of Travelers Express Company, Inc., a subsidiary of Registrant Mark R. Shook 39 Executive Vice 1994 President-General Manager, Laundry and International Divisions, Consumer Products Group of Registrant Karen L. Hendricks 46 Executive Vice 1992 President-General Manager, Personal Care Division, Consumer Products Group of Registrant Frederick J. Martin 59 President of Dobbs 1985 International Services, Inc., a subsidiary of Registrant Andrew S. Patti 53 President and Chief 1986 Operating Officer of the Consumer Products Group of Registrant Norton D. 59 Chairman and Chief 1983 Rittmaster Executive Officer of GES Exposition Services, Inc., a subsidiary of Registrant Position currently Executive Vice President- vacant General Manager, Food Division, Consumer Products Group of Registrant Each of the foregoing officers, with the exceptions set forth below, has served in the same, similar or other executive positions with Dial or its subsidiaries for more than the past five (5) years. Ms. Ingalls has served in her current, or a similar, position since 1990, and prior thereto as Executive Director of Compensation and Benefits of the Registrant. Mr. Bohannon was elected as President and Chief Executive Officer of Travelers Express Company, Inc. effective March 15, 1993. Prior thereto, he was a senior officer at Marine Midland Bank of Buffalo, New York. Prior to 1992, Ms. Hendricks was employed at Procter & Gamble as Manager, Worldwide Strategic Planning, Health and Beauty Aids, and prior thereto, as General Manager, US Vidal Sassoon Hair Care Company. Prior to March 1994, Mr. Shook was Executive Vice President- General Manager, Food and International Divisions, and prior thereto was Vice President and General Manager of the commercial markets business unit of Registrant's Consumer Products Group. The term of office of the executive officers is until the next annual organization meetings of the Boards of Directors of Dial or appropriate subsidiaries, all of which are scheduled for April or May of this year. The Directors of Dial are divided into three classes, with the terms of one class of Directors to expire at each Annual Meeting of Stockholders. The current term of office of John W. Teets is scheduled to expire at the 1994 Annual Meeting of Stockholders. Mr. Teets has been nominated for reelection at that meeting for a term expiring in May 1997. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal market on which the common stock of Dial is traded is the New York Stock Exchange. The common stock is also listed for trading on the Pacific Exchange, and admitted for trading on the Midwest, Philadelphia and Cincinnati Exchanges. The following tables summarize the high and low market prices as reported on the New York Stock Exchange Composite Tape and the cash dividends declared for the two years ended December 31, 1993: SALES PRICE RANGE OF COMMON STOCK --------------------------------- CALENDAR 1993 1992 QUARTERS HIGH LOW HIGH LOW - -------- ------------------- ------------------- First $44 1/2 $39 $50 5/8(1) $37 3/8(1) Second 43 7/8 36 7/8 39 3/8 33 3/8 Third 41 1/8 35 7/8 39 1/2 35 1/2 Fourth 42 1/4 36 3/4 42 37 DIVIDENDS DECLARED ON COMMON STOCK ---------------------------------- CALENDAR QUARTERS 1993 1992(2) - ----------------- ----- ----- February $ .28 $ .35 May .28 .28 August .28 .28 November .28 .28 ----- ----- TOTAL $1.12 $1.19 (1) On March 18, 1992, the spin-off of GFC Financial Corporation to the Company's stockholders became effective. The closing price of Dial's shares immediately prior to the spin-off was $49 and immediately after the spin-off was $40, as a result of the special distribution. The high and low prices for the period January 1 through March 17, 1992, were $50 5/8 and $45 3/8, respectively. The high and low prices for the period March 18 through March 31, 1992, were $40 1/4 and $37 3/8, respectively. (2) The decline in dividends declared per common share in 1992 and 1993 reflects the spin-off of GFC Financial Corporation. Regular quarterly dividends have been paid on the first business day of January, April, July and October. As of March 11, 1994, there were 49,576 holders of record of Dial's common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Applicable information is included in Annex A. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION. Applicable information is included in Annex A. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. 1. Financial Statements--See Item 14 hereof. 2. Supplementary Data--See Condensed Consolidated Quarterly Results in Annex A. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information regarding Directors of the Registrant is included in Dial's Proxy Statement for Annual Meeting of Shareholders to be held on May 10, 1994 ("Proxy Statement"), and is incorporated herein and made a part hereof. The information regarding executive officers of the Registrant is found as an Optional Item in Part I hereof. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information is contained in the Proxy Statement and is incorporated herein and made a part hereof. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information is contained in the Proxy Statement and is incorporated herein and made a part hereof. 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) List the following documents filed as a part of the report: 1. FINANCIAL STATEMENTS. The following are included in Annex A: Independent Auditors' Report and consolidated financial statements (Balance Sheet, Income, Cash Flows, Common Stock and Other Equity, and Notes to Financial Statements). 2. FINANCIAL STATEMENT SCHEDULES. Independent Auditors' Report on Schedules to Consolidated Financial Statements of The Dial Corp is found on page of Annex A. Schedule I--Marketable Securities --Other Security Investments is found on page of Annex A. Schedule IX--Short-term Borrowings. This information is included in Management's Discussion and Analysis of Results of Operations and Financial Condition and Note G-- Short-Term Debt in Annex A and is incorporated herein by reference. Schedule X--Supplementary Income Statement Information is found on page of Annex A. 3. EXHIBITS. 3.A Copy of Restated Certificate of Incorporation of Dial, as amended through March 3, 1992, filed as Exhibit (3)(A) to Dial's 1991 Form 10-K, is hereby incorporated by reference. 3.B Copy of Bylaws of Dial, as amended through February 21, 1992, filed as Exhibit (3)(B) to Dial's 1991 Form 10-K, is hereby incorporated by reference. 4.A Instruments with respect to issues of long-term debt have not been filed as exhibits to this Annual Report on Form 10-K if the authorized principal amount of any one of such issues does not exceed 10% of total assets of the Company and its subsidiaries on a consolidated basis. The Company agrees to furnish a copy of each such instrument to the Securities and Exchange Commission upon request. 4.B Copy of Amended and Restated Credit Agreement dated as of December 15, 1993, among Dial, the Banks parties thereto, Bank of America National Trust and Savings Association as Agent and Reporting Agent and Citibank, N.A. as Agent and Funding Agent.* 10.A Copy of Employment Agreement between Dial and John W. Teets dated April 14, 1987, filed as Exhibit (10)(A) to Dial's 1989 Form 10-K, is hereby incorporated by reference.+ 10.B Sample forms of Contingent Agreements relating to funding of Supplemental Executive Pensions, filed as Exhibit (10)(T) to Dial's 1989 Form 10-K, is hereby incorporated by reference.+ 10.C Copy of The Dial Corp Supplemental Pension Plan, amended and restated as of January 1, 1987, filed as Exhibit (10)(F) to Dial's 1986 Form 10-K, is hereby incorporated by reference.+ 10.C1 Copy of amendment dated February 21, 1991, to The Dial Corp Supplemental Pension Plan, filed as Exhibit (10)(G)(i) to Dial's 1990 Form 10-K, is hereby incorporated by reference.+ 10.D Copy of The Dial Corp 1992 Deferred Compensation Plan for Directors, adopted November 20, 1980, as amended through February 21, 1991, filed as Exhibit (10)(H) to Dial's 1990 Form 10-K, is hereby incorporated by reference.+ 10.E Copy of The Dial Corp Management Incentive Plan.*+ 10.F1 Copy of form of Executive Severance Agreement between Dial and three executive officers, filed as Exhibit (10)(G)(i) to Dial's 1991 Form 10-K, is hereby incorporated by reference.+ 10.F2 Copy of forms of The Dial Corp Executive Severance Plans covering certain executive officers, filed as Exhibit (10)(G)(ii) to Dial's 1992 Form 10-K, is hereby incorporated by reference.+ 10.G Copy of Travelers Express Company, Inc. Supplemental Pension Plan, filed as Exhibit (10)(L) to Dial's 1984 Form 10-K, is hereby incorporated by reference.+ 10.H Copy of Greyhound Dial Corporation 1983 Stock Option and Incentive Plan, filed as Exhibit (28) to Dial's Registration Statement on Form S-8 (Registration No. 33-23713), is hereby incorporated by reference.+ 10.I Copy of The Dial Corp 1992 Stock Incentive Plan, filed as Exhibit (10)(J) to Dial's 1991 Form 10-K, is hereby incorporated by reference.+ 10.J Description of Spousal Income Continuation Plan, filed as Exhibit 10(Q) to Dial's 1985 Form 10-K, is hereby incorporated by reference.+ 10.K Copy of The Dial Corp Director's Retirement Benefit Plan, filed as Exhibit (10)(R) to Dial's 1988 Form 10- K, is hereby incorporated by reference.+ 10.L Copy of The Dial Corp Performance Unit Incentive Plan.*+ 10.M Copy of The Dial Corp Supplemental Trim Plan, filed as Exhibit (10)(S) to Dial's 1989 Form 10-K, is hereby incorporated by reference.+ 10.N Copy of Employment Agreement between Greyhound Exposition Services and Norton Rittmaster dated May 20, 1982, filed as Exhibit (10)(O) to Dial's 1992 Form 10- K, is hereby incorporated by reference.+ 10.O Copy of Greyhound Exposition Services, Inc. Incentive Compensation Plan, filed as Exhibit (10)(P) to Dial's 1992 Form 10-K, is hereby incorporated by reference.+ 10.P Copy of The Dial Corp Performance-Based Stock Plan.*+ 10.Q Copy of The Dial Corp Deferred Compensation Plan.*+ 11 Statement Re Computation of Per Share Earnings.* 22 List of Subsidiaries of Dial.* 23 Consent of Independent Auditors to the incorporation by reference into specified registration statements on Form S-3 or on Form S-8 of their reports contained in or incorporated by reference into this report.* 24 Power of Attorney signed by directors of Dial.* *Filed herewith. +Management contract or compensation plan or arrangement. Note: The 1993 Annual Report to Securityholders will be furnished to the Commission when, or before, it is sent to securityholders. (b) REPORTS ON FORM 8-K. A report on Form 8-K dated October 1, 1993, was filed by the Registrant. The Form 8-K reported under Item 5 the reclassifications of previously filed financial statements and other financial information related to the disposition of Dial's Transportation Manufacturing and Service Parts segment. Included with the 8-K report as Exhibit No. 28 were financial statements and other financial information reflecting the restatements required by such disposition. The financial statements and financial information contained in Dial's 1992 Annual Report on Form 10-K and Quarterly Reports on Form 10-Q for the quarters ended March 31, 1993, and June 30, 1993, were modified or superseded to the extent that the information contained in the Form 8-K modified or superseded such statements and other information. 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, in Phoenix, Arizona, on the 25th day of March, 1994. THE DIAL CORP By: /s/ John W. Teets John W. Teets 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: Principal Executive Officer Date: March 25, 1994 By: /s/ John W. Teets John W. Teets Director; Chairman, President and Chief Executive Officer Principal Financial Officer Date: March 25, 1994 By: /s/ F. Edward Lake F. Edward Lake Vice President-Finance Principal Accounting Officer Date: March 25, 1994 By: /s/ Richard C. Stephan Richard C. Stephan Vice President-Controller Directors James E. Cunningham Joe T. Ford Thomas L. Gossage Donald E. Guinn Jess Hay Judith K. Hofer Jack F. Reichert Linda Johnson Rice Dennis C. Stanfill A. Thomas Young Date: March 25, 1994 By: /s/ Richard C. Stephan Richard C. Stephan Attorney-in-Fact ANNEX "A" THE DIAL CORP 1993 FINANCIAL INFORMATION   MANAGEMENT'S REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of The Dial Corp and its subsidiaries has the responsibility for preparing and assuring the integrity and objectivity of the accompanying financial statements and other financial information in this report. The financial statements were developed using generally accepted accounting principles and appropriate policies, consistently applied, except for the change in 1992 to comply with new accounting requirements for postretirement benefits other than pensions as discussed in Note L of Notes to Consolidated Financial Statements. They reflect, where applicable, management's best estimates and judgments and include disclosures and explanations which are relevant to an understanding of the financial affairs of the Company. The Company's financial statements have been audited by Deloitte & Touche, independent auditors elected by the stockholders. Management has made available to Deloitte & Touche all of the Company's financial records and related data, and has made appropriate and complete written and oral representations and disclosures in connection with the audit. Management has established and maintains a system of internal control that it believes provides reasonable assurance as to the integrity and reliability of the financial statements, the protection of assets and the prevention and detection of fraudulent financial reporting. The system of internal control is believed to provide for appropriate division of responsibilities and is documented by written policies and procedures that are utilized by employees involved in the financial reporting process. Management also recognizes its responsibility for fostering a strong ethical climate. This responsibility is characterized and reflected in the Company's Code of Corporate Conduct, which is communicated to all of the Company's executives and managers. The Company also maintains a comprehensive internal auditing function which independently monitors compliance and assesses the effectiveness of the internal controls and recommends possible improvements thereto. In addition, as part of their audit of the Company's financial statements, the independent auditors review and evaluate selected internal accounting and other controls to establish a basis for reliance thereon in determining the audit tests to be applied. There is close coordination of audit planning and coverage between the Company's internal auditing function and the independent auditors. Management has considered the recommendations of both internal auditing and the independent auditors concerning the Company's system of internal control and has taken actions believed to be cost-effective in the circumstances to implement appropriate recommendations and otherwise enhance controls. Management believes that the Company's system of internal control accomplishes the objectives discussed herein. The Board of Directors oversees the Company's financial reporting through its Audit Committee, which regularly meets with management representatives and, jointly and separately, with the independent auditors and internal auditing management to review accounting, auditing and financial reporting matters. /s/ Ermo S. Bartoletti Ermo S. Bartoletti Vice President - Internal Auditing /s/ Richard C. Stephan Richard C. Stephan Vice President - Controller  INDEPENDENT AUDITORS' REPORT To the Stockholders and Board of Directors of The Dial Corp: We have audited the accompanying consolidated balance sheets of The Dial Corp as of December 31, 1993 and 1992, and the related consolidated statements of income, common stock and other equity and of cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of The Dial Corp 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 Note L of Notes to Consolidated Financial Statements, the Company changed its method of accounting for postretirement benefits other than pensions in 1992. /s/ Deloitte & Touche Deloitte & Touche Phoenix, Arizona February 25, 1994  MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION OF THE DIAL CORP RESULTS OF OPERATIONS: Dial is a diversified company which sells products and provides services in many markets. Because of this diversity, components of net income are affected, some favorably, others unfavorably, by general economic conditions and other fluctuations which occur in the various markets each year. Inflation has not materially affected operations in recent years. Dial sold its Transportation Manufacturing and Service Parts Group in 1993 and spun-off GFC Financial Corporation ("GFC Financial") in 1992. The Transportation Manufacturing and Service Parts Group and GFC Financial are presented as discontinued operations for all periods. Such dispositions are discussed further in Note D of Notes to Consolidated Financial Statements. 1993 VS. 1992: Revenues for 1993 were $3 billion compared with $2.9 billion in 1992. Income from continuing operations was $110.3 million in 1993, or $2.56 per share. Before restructuring and other charges, income from continuing operations in 1992 was $94.2 million, or $2.21 per share. After restructuring and other charges of $19.8 million, or $0.47 per share, Dial had income from continuing operations of $74.4 million, or $1.74 per share, in 1992. CONSUMER PRODUCTS. The Consumer Products Group's revenues were up $144.7 million, or 11 percent from those in 1992. Operating income was up $20.6 million, or 17 percent over 1992 amounts. Personal Care Division revenues declined $700,000 due primarily to a decline in the sales of Breck hair care products. Offsetting this decline were strong showings by all other personal care products, especially the Dial label products. Personal Care Division operating income increased by $6.4 million due primarily to the increase in Dial product revenues and reduced manufacturing costs. The Breck decline was substantially offset by reduced marketing costs. Food Division revenues increased $11.6 million from those of 1992 due to increases in the canned meat line offset in part by a decline in microwaveable product revenue. Operating income increased by $2.3 million primarily due to the favorable sales mix, the pricing of canned meats and reductions in manufacturing costs of microwaveable products. Household and Laundry Division revenues increased $130 million from 1992, led by strong performances in liquid detergents and liquid fabric softeners. The addition of Rinse 'n Soft as a new product in the liquid fabric softener category and the acquisition of Renuzit during the 1993 second quarter contributed to the favorable comparisons between periods. Operating income increased $10.8 million over 1992 amounts, reflecting higher revenue and improved margins. Margins increased as a result of reduced marketing expenses associated with a modified everyday low pricing strategy. International revenues and operating results increased $3.8 million and $1.1 million, respectively, from those of 1992 due primarily to an expansion program. SERVICES. During 1993, Dial redefined its Services business into three principal segments for financial reporting purposes. Excluding certain airport concession operations, which were sold in September, 1992, and excluding the effects of $30 million of restructuring charges in 1992, combined Services revenues and operating income increased $109.6 million, or 8 percent, and $11.3 million, or 9 percent, respectively. AIRLINE CATERING AND OTHER FOOD SERVICES. Revenues of the Airline Catering and Other Food Services Group declined $26.2 million from those of 1992, while operating income increased $6.1 million. Airline catering revenues decreased $21.4 million from those of 1992 due primarily to service cutbacks by major airlines and the effects of the air fare discounts which had boosted 1992 volume; however, operating income was up $600,000 due to new customers and stringent cost controls. The contract food service companies' revenues were down $4.8 million, due primarily to closing marginal locations in 1992. Operating income increased $5.5 million from last year's results, due primarily to a gain from curtailment of a postretirement benefit plan in 1993. CONVENTION SERVICES. Convention Services Group revenues and operating income increased $117.6 million and $7.6 million, respectively, from those in 1992. Growth in existing business, the inclusion of operations of United Exposition Service Co., Inc. and Andrews, Bartlett and Associates, Incorporated, which were acquired during the second and fourth quarters, respectively, contributed to the increases. TRAVEL AND LEISURE AND PAYMENT SERVICES. Revenues for the Travel and Leisure and Payment Services Group declined $109.9 million, and, excluding the effects of $30 million of restructuring charges in 1992, operating income declined $11.7 million from 1992 results. The declines were primarily attributable to the sale, in late September 1992, of most of Dial's food and merchandise airport terminal concession operations; as a result, revenues and operating income of sold and miscellaneous operations declined $113.9 million and $6.8 million, respectively, from those in 1992. Revenues and operating income for aircraft fueling and other ground-handling services declined $3.7 million and $100,000, respectively, due primarily to lower foreign exchange rates. Revenues and operating income of the transportation services companies increased $5.5 million and $2.9 million, respectively, from those of 1992. Continued emphasis on cost control programs, the acquisition of a small transportation services company in late 1992 and a gradually recovering Canadian economy contributed to the improved operating results. Cruise revenues were down $20.4 million and operating results decreased $8.3 million from those of 1992 due to lower passenger counts, increased competition, the major dry-dock of the Oceanic in the 1993 first quarter and the introduction of a new itinerary for the Majestic out of Port Everglades during the second quarter of 1993. Reductions in operating expenses from ongoing cost reduction programs helped limit the decline in operating results. Travel tour service revenues and operating income decreased $5 million and $3.9 million, respectively, due to lower results from the U.K. tour operation which is suffering from a slowly recovering economy. In addition, passenger volume to Florida for 1993 was down 30% from the volume in 1992. Duty Free and shipboard concession revenues were up $34.5 million due primarily to new business. Operating income increased $900,000 from that of 1992 despite start-up costs associated with a major new contract. Payment service revenues decreased $6.9 million due primarily to reduced money order revenues and lower investment income due to lower market interest rates and increased investment in tax-exempt securities. Operating income was $2.7 million ahead of last year's results due primarily to terminating unprofitable business even though investment income was lower for the reasons stated above. UNALLOCATED CORPORATE EXPENSE AND OTHER ITEMS, NET. Unallocated corporate expense and other items, net, increased $6.5 million from that in 1992, due primarily to the expiration in early 1993 of subleases of buses and related amortization of deferred intercompany and sale-leaseback profit. INTEREST EXPENSE. Interest expense was down $6.1 million from that in 1992, due primarily to lower short-term interest rates and the prepayment of certain high-coupon, fixed-rate debt at the end of the third quarter of 1993. 1992 VS. 1991: Revenues for 1992 were $2.9 billion, compared to $2.8 billion in 1991. Income from continuing operations before restructuring and other charges described below, was $94.2 million, or $2.21 per share, compared with $80.6 million, or $1.99 per share, in 1991. After restructuring and other charges of $19.8 million, or $0.47 per share, Dial had income from continuing operations of $74.4 million, or $1.74 per share, for the year, compared with $25.8 million, or $0.62 per share, in 1991 after restructuring and other charges and spin-off transaction costs of $54.9 million, or $1.37 per share. The adoption of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106") was mandatory for all U.S. public companies beginning in 1993. The statement requires recognition of liabilities for postretirement benefits other than pensions over the period that services are provided by employees, but does not change the pattern of cash payments for such benefits. Dial adopted the new standard in 1992, and recorded the cumulative effect of such initial application rather than amortizing such amount over 20 years, as permitted by the statement. Accordingly, results for 1992 include a one-time charge as of January 1, 1992, for the cumulative effect of the initial application of SFAS No. 106 of $110.7 million (after-tax), or $2.64 per share, and an ongoing annual expense increase of $9.1 million (after-tax), or $0.22 per share. RESTRUCTURING AND OTHER CHARGES. Dial recorded restructuring and other charges of $19.8 million (after-tax), or $0.47 per share, in the fourth quarter of 1992, attributable to the Travel and Leisure and Payment Services Group, primarily to provide for termination of an unfavorable airport concession contract and related matters, and to provide for costs to reposition the cruise line to compete more effectively in the Caribbean market. In the fourth quarter of 1991, Dial provided for restructuring and other charges and spin-off transaction costs of $54.9 million (after-tax), or $1.37 per share. Of this amount, $26 million (after-tax) was charged to the Travel and Leisure and Payment Services Group primarily to provide for estimated losses on an unfavorable airport concession contract and for losses as a result of the bankruptcy of a large money order agent in its payment services subsidiary. The remaining provision of $28.9 million (after-tax) was made primarily to provide for transaction costs arising from the spin-off of GFC Financial and for certain income tax matters related to prior years. CONSUMER PRODUCTS. The Consumer Products Group reported a $78.9 million increase in revenues over 1991 amounts, and before the $6.8 million ongoing expense increase for 1992 resulting from the adoption of SFAS No. 106, operating income increased $14.8 million over 1991 amounts. The following comments exclude the effects of the ongoing expense increase for 1992 resulting from the adoption of SFAS No. 106. Revenues and operating income of the Personal Care Division were up $58.9 million and $7 million, respectively, from those of 1991. The increases were due primarily to strong sales volume performance for Dial Soap and Liquid Dial. The Food Division revenues declined $25.9 million from those of 1991, due primarily to new pricing strategies for microwaveables to adopt everyday low prices, increased competition in the microwaveable meals category and lower meat prices. Operating income of the Food Division increased $3.2 million as the decline in revenues was offset by lower ingredient costs and other efficiencies. Household and Laundry Division revenues and operating income increased $33.3 million and $7.7 million, respectively, due to increased sales of higher margin detergent products. International revenues increased $12.6 million while operating income decreased $3.1 million from 1991 amounts. The decline in operating results was due primarily to expansion and product introduction costs. SERVICES. Combined Services companies reported a $32.7 million decrease in revenues from those of 1991 due primarily to the sale of most airport concession operations in late September 1992. Excluding the effects of $30 million and $40 million of restructuring and other charges in 1992 and 1991, respectively, and before the $1 million, $700,000 and $1.5 million expense increases for Airline Catering and Other Food Services, Convention Services, and Travel and Leisure and Payment Services, respectively, for 1992 resulting from the adoption of SFAS No. 106, combined Services operating income increased $11.6 million over 1991 amounts. The following comments exclude the effects of restructuring and other charges and the ongoing expense increase for 1992 resulting from the adoption of SFAS No. 106. AIRLINE CATERING AND OTHER FOOD SERVICES. Revenues of the Airline Catering and Other Food Services Group were down $19.8 million, while operating income increased $6.3 million from 1991. Airline catering revenues and operating income were up $27.5 million and $5.5 million, respectively, primarily as a result of new customers and growth from existing customers, aided in part by the traffic increase from the air fare discounts in the summer of 1992. Contract food service revenues declined $47.3 million, while operating income increased $800,000. The sale or closure of unprofitable locations in 1992 contributed to the reduction in contract food revenues. CONVENTION SERVICES. Revenues and operating income of the Convention Services Group increased $25.9 million and $4.2 million, respectively, due primarily to growth in existing convention show services, new customers and somewhat improved margins. TRAVEL AND LEISURE AND PAYMENT SERVICES. Revenues for the Travel and Leisure and Payment Services Group declined $38.8 million and operating income increased $1.1 million from 1991 amounts. The decline in revenues was attributable primarily to the sale, in late September, of most of Dial's food and merchandise airport terminal concession operations. Food and merchandise airport terminal concession and related operations revenues declined $41.8 million due to the September sale, while operating income was up $10.8 million from the prior year, aided by increased traffic from summer air fare discounts up to the sale date. Aircraft fueling and other ground-handling services revenues and operating income increased $8.2 million and $1 million, respectively, due to new customers and growth from existing customers. Revenues and operating income of the transportation services companies were down $16.2 million and $2.2 million, respectively, from those of 1991, reflecting a decrease in ridership as the stagnant Canadian economy continued to lag behind the U.S. recovery. Cost reduction programs helped limit the decline in operating income. Cruise revenues increased $1.4 million from those of 1991 due primarily to increased onboard revenues, offset partially by lower passenger counts and per diems. Deep discounting in selling prices, resulting from continued sluggish demand, contributed to lower per diems. The heavy discounts in selling prices and higher promotional costs accounted for the $1 million decrease in operating income from that of 1991. Travel tour service revenues and operating income increased $6.7 million and $2.3 million, respectively, from 1991 results due primarily to the full-year inclusion of Crystal Holidays Limited which was acquired in mid-1991. In addition, 1991 results were depressed due to the Persian Gulf War and its aftereffects. Duty Free and shipboard concession revenues and operating income were up $8.9 million and $600,000, respectively, from those in 1991 as airport terminal traffic increased and the revenue per passenger on vessels where duty free shops are operated increased. Payment service revenues were down $6 million due primarily to lower revenue on investments, money order fees and gains on sale of investments. Operating income was about even with that of 1991 as lower revenues were offset by lower expenses, due primarily to lower provisions for credit losses. UNALLOCATED CORPORATE EXPENSE AND OTHER ITEMS, NET. Before the $4.4 million ongoing expense increase for 1992 resulting from the adoption of SFAS No. 106, unallocated corporate expense and other items, net, decreased $500,000 from that of 1991. INTEREST EXPENSE. Interest expense was down $700,000 from that in 1991, due primarily to lower short-term interest rates and the repayment of certain higher cost debt, partially offset by higher average short-term borrowings of commercial paper and promissory notes. Also, the 1991 period had benefited from a reduction of interest previously accrued for a federal tax audit. LIQUIDITY AND CAPITAL RESOURCES: Dial's total debt at December 31, 1993 was $636 million compared to $707 million at December 31, 1992. The debt to capital ratio was 0.55 to 1 and 0.62 to 1 at December 31, 1993 and December 31, 1992, respectively. Capital is defined as total debt plus minority interests, preferred stock and common stock and other equity. During the third quarter of 1993, Dial utilized the proceeds from the sale of MCII to repurchase approximately 1,000,000 shares of common stock on the open market and to reduce outstanding short-term debt. Dial also prepaid $187 million principal amount of long-term, fixed-rate debt having a weighted average interest rate of 10%. These prepayments resulted in an extraordinary charge for early extinguishment of debt of $21.9 million (net of tax benefit of $11.8 million). During 1993, Dial filed a $300 million Senior Debt Securities Shelf Registration with the Securities and Exchange Commission under which Dial could issue senior notes for various amounts and at various rates and maturities. During 1993, Dial issued $230 million of debt under the program with maturities of five to eleven years. Subsequent to December 31, 1993, Dial issued the remaining $70 million of debt under the senior note program with maturities of six to fifteen years. With respect to working capital, in order to minimize the effects of borrowing costs on earnings, Dial strives to maintain current assets (principally cash, inventories and receivables) at the lowest practicable levels while at the same time taking advantage of the payment terms offered by trade creditors. These efforts notwithstanding, working capital requirements will fluctuate significantly from seasonal factors as well as changes in levels of receivables and inventories caused by numerous business factors. Dial satisfies a portion of its working capital and other financing requirements with short-term borrowings (through commercial paper, bank note programs and bank lines of credit) and the sale of receivables. Short-term borrowings are supported by long-term revolving bank credit agreements or short-term lines of credit. At December 31, 1993, Dial had a $500 million long-term revolving credit line in place, of which $257 million was being used to support $225 million of commercial paper and promissory notes and the guarantee of a $32 million ESOP loan. Dial's subsidiaries have agreements to sell $115 million of accounts receivable under which the purchaser has agreed to invest collected amounts in new purchases, providing a stable level of purchased accounts. The commitments to purchase accounts receivable, which are fully utilized, mature in January of each year, but are expected to be extended annually by mutual agreement. The agreements are currently extended to January 1995. As discussed in Note I of Notes to Consolidated Financial Statements, in September 1992, Dial sold 5,245,900 shares of treasury stock to The Dial Corp Employee Equity Trust (the "Trust") at $38.125 per share. This Trust is being used to fund certain existing employee compensation and benefit plans over the scheduled 15-year term of the Trust. The Trust acquired the shares of common stock from Dial for a promissory note valued at $200 million at the date of sale. Proceeds from sales of shares released by the Trust are used to repay Dial's note and thereby satisfy benefit obligations. At December 31, 1993, a total of 3,923,933 shares remained in the Trust and are available to fund future benefit obligations. Capital spending has been reduced by obtaining, where appropriate, equipment and other property under operating leases. Dial's capital asset needs and working capital requirements are expected to be financed primarily with internally generated funds. Generally, cash flows from operations and the proceeds from the sale of businesses during the past three years along with increased proceeds from the exercise of stock options have been sufficient to finance capital expenditures, the purchase of businesses and cash dividends to shareholders. Dial expects these trends to continue with operating cash flows and proceeds from stock issuances generally being sufficient to finance its business. Should financing requirements exceed such sources of funds, Dial believes it has adequate external financing sources available to cover any such shortfall. As indicated in Note L of Notes to Consolidated Financial Statements, although Dial has paid the minimum funding required by applicable regulations, certain pension plans remain underfunded while others are overfunded. The deficiency in funding of the underfunded plans is expected to be reduced through the payment of the minimum funding requirement over a period of several years. Unfunded pension and other postretirement benefit plans require payments over extended periods of time. Such payments are not likely to materially affect Dial's liquidity. As of December 31, 1993, Dial has recorded U.S. deferred income tax benefits under SFAS No. 109 totaling $170 million, which Dial believes to be fully realizable in future years. The realization of such benefits will require average annual taxable income over the next 15 years (the current Federal loss carryforward period) of approximately $30 million. Dial's average U.S. pretax reported income, exclusive of nondeductible goodwill amortization but after deducting restructuring and other charges, over the past three years has been approximately $113 million. Furthermore, approximately $112 million of the deferred income tax benefits relate to pensions and other postretirement benefits which will become deductible for income tax purposes as they are paid, which will occur over many years. Dial is subject to various environmental laws and regulations of the United States as well as of the states in whose jurisdictions Dial operates. As is the case with many companies, Dial faces exposure to actual or potential claims and lawsuits involving environmental matters. Dial believes that any liabilities resulting therefrom should not have a material adverse effect on Dial's financial position or results of operations. BUSINESS OUTLOOK AND RECENT DEVELOPMENTS: In November 1993, Dial announced the finalization of an agreement to purchase 15 in-flight catering kitchens from United Airlines. Dial purchased the first four kitchens on December 30, with the remaining kitchens expected to be phased-in during the first and second quarters of 1994. In February 1994, Dial announced that it had reached an agreement to acquire the assets of Steels Aviation Services Limited, a British airline caterer that operates four airline catering kitchens in England and Scotland. Management anticipates financing the acquisitions through cash flow from operations and long-term debt. The business outlook holds many uncertainties. Proposed legislation, health care costs, interest rates, tax law changes, environmental issues, competitive pressures from within the marketplace and the unpredictable economic environment, will all affect the growth and future of Dial. Dial remains aggressive in its commitment to monitor and reduce costs and expenses, positioning Dial to continue to produce positive results in the years ahead.      THE DIAL CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended December 31, 1993, 1992 and 1991 A. SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION-The consolidated financial statements of The Dial Corp and subsidiaries ("Dial") include the accounts of Dial and all of its subsidiaries. Dial sold its Transportation Manufacturing and Service Parts Group in 1993 and spun-off GFC Financial Corporation ("GFC Financial") in 1992. The Transportation Manufacturing and Service Parts Group and GFC Financial are presented as discontinued operations for all periods. Such dispositions are discussed further in Note D of Notes to Consolidated Financial Statements. The consolidated financial statements are prepared in accordance with generally accepted accounting principles. Intercompany accounts and transactions between Dial and its subsidiaries have been eliminated in consolidation. Certain reclassifications have been made to the prior years' financial statements to conform to 1993 classifications. Described below are those accounting policies particularly significant to Dial, including those selected from acceptable alternatives. CASH EQUIVALENTS-Dial considers all highly liquid investments with original maturities of three months or less from date of purchase as cash equivalents. INVENTORIES-Generally, inventories are stated at the lower of cost (first-in, first-out and average cost methods) or market. PROPERTY AND EQUIPMENT-Property and equipment are stated at cost. Depreciation is provided principally by use of the straight-line method at annual rates as follows: Buildings 2% to 5% Machinery and other equipment 5% to 33% Leasehold improvements Lesser of lease term or useful life INVESTMENTS RESTRICTED FOR PAYMENT SERVICE OBLIGATIONS-Investments restricted for payment service obligations include U.S. Treasury and Government agency securities, obligations of states and political subdivisions, debt securities issued by foreign governments, corporate securities, a corporate note and other debt securities due beyond one year. These investments are stated at amortized cost, or at estimated realizable value when there is other than temporary impairment of value. Marketable equity securities (common and preferred stocks) are stated at the lower of aggregate cost or market. A valuation allowance, representing the excess of cost over market of equity securities, is included as a reduction of common stock and other equity. The cost of investment securities sold is determined using the specific identification method. Realized gains and losses on the disposition of investment securities and adjustments to reflect other than temporary impairment of the value of investment securities are reflected in income. INTANGIBLES-Intangibles (primarily goodwill) are carried at cost less accumulated amortization of $113,453,000 at December 31,1993 and $99,602,000 at December 31, 1992. Intangibles of $166,688,000, which arose prior to October 31, 1970, are not being amortized. Intangibles arising after October 31, 1970 are amortized on the straight-line method over the periods of expected benefit, but not in excess of 40 years. Dial evaluates the possible impairment of goodwill and other intangible assets at each reporting period based on the undiscounted projected operating income of the related business unit. INCOME TAXES-Income taxes are provided based upon the provisions of SFAS No. 109, "Accounting for Income Taxes," which, among other things, requires that recognition of deferred income taxes be measured by the provisions of enacted tax laws in effect at the date of the financial statements. PENSION AND OTHER BENEFITS-Trusteed, noncontributory pension plans cover substantially all employees. Benefits are based primarily on final average salary and years of service. Funding policies provide that payments to pension trusts shall be at least equal to the minimum funding required by applicable regulations. Dial has defined benefit postretirement plans that provide medical and life insurance for eligible retirees and dependents. Until 1992, the cost of these benefits was generally expensed as claims were incurred. Effective January 1, 1992, Dial adopted the method of accounting for postretirement benefits other than pensions prescribed by SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires recognition of liabilities for such benefits over the period that services are provided by employees. Dial elected to record the cumulative effect of initial application of SFAS No. 106 rather than amortizing such amount over 20 years as permitted by the standard. See Note L of Notes to Consolidated Financial Statements for further information. NET INCOME (LOSS) PER COMMON SHARE-Net income (loss) per common share is based on net income (loss) after preferred stock dividend requirements and the weighted average number of common shares outstanding during each year after giving effect to stock options considered to be dilutive common stock equivalents. Fully diluted net income (loss) per common share is not materially different from primary net income (loss) per common share. The average outstanding common and equivalent shares does not include 3,923,933 and 5,033,565 shares held by the Employee Equity Trust (the "Trust") at December 31, 1993 and 1992, respectively. Shares held by the Trust are not considered outstanding for net income (loss) per share calculations until the shares are released from the Trust.  B. ACQUISITIONS OF BUSINESSES AND OTHER ASSETS Net cash paid, assets acquired and debt and other liabilities assumed in all acquisitions were as follows: During 1993, Dial purchased the Renuzit line of air fresheners and three convention services companies. In November 1993, Dial announced the finalization of an agreement to purchase 15 in-flight catering kitchens from United Airlines. Dial purchased the first four kitchens on December 30, 1993. The remaining kitchens are expected to be phased-in during 1994, at a purchase price of approximately $111,000,000. In December 1993, Dial acquired the remaining 49% interest in a joint venture which constructed an office building in Phoenix, Arizona, that serves as its corporate headquarters complex. Acquisitions of businesses were accounted for as purchases and the results of their operations have been included in the Statement of Consolidated Income from the dates of acquisition. The results of operations of the acquired companies from the beginning of the year to the dates of acquisition are not material.  C. RESTRUCTURING AND OTHER CHARGES-CONTINUING OPERATIONS Dial recorded restructuring and other charges of $30,000,000 ($19,800,000 after-tax, or $0.47 per share) in the fourth quarter of 1992, attributable to the Travel and Leisure and Payment Services Group primarily to provide for termination of an unfavorable airport concession contract and related matters, and to provide for costs to reposition the cruise line to compete more effectively in the Caribbean market. In the fourth quarter of 1991, Dial provided for restructuring and other charges and spin-off transaction costs of $64,000,000 ($54,871,000 after-tax, or $1.37 per share). Of this amount, $40,000,000 ($25,971,000 after-tax) was charged to the Travel and Leisure and Payment Services Group primarily to provide for estimated losses on an unfavorable airport concession contract and for losses as a result of the bankruptcy of a large money order agent in its payment services subsidiary. The remaining provision of $24,000,000 ($28,900,000 after-tax) was made primarily to provide for transaction costs arising from the spin-off of GFC Financial and for certain income tax matters related to prior years. Such restructuring and other charges and spin-off transaction costs are summarized below:  D. DISCONTINUED OPERATIONS AND DISPOSITIONS On August 12, 1993, Dial sold, through an initial public offering, 20 million shares of common stock of MCII, pursuant to an underwriting agreement dated August 4, 1993. Transportation Manufacturing Operations, Inc., Dial's Transportation Manufacturing and Service Parts subsidiary, was transferred to MCII in connection with the public offering of MCII shares. The disposition of MCII, the sale of the Canadian transit bus manufacturing business in June 1993, and the liquidation, completed in early 1993, of a trailer manufacturing and transport services company, concluded the disposal of the Transportation Manufacturing and Service Parts Group. At a special meeting on March 3, 1992, shareholders of Dial approved the spin-off of GFC Financial, which comprised Dial's commercial lending and mortgage insurance subsidiaries. As a result of the spin-off, the holders of common stock of Dial received a Distribution (the "Distribution") of one share of common stock of GFC Financial for every two shares of Dial common stock. In connection with the dispositions, special charges to earnings were made in 1992 and 1991 to cover restructuring of certain operations, provisions against Latin American and other loans, certain tax, spin-off transaction and other costs and, in 1993 and 1991, provisions related primarily to previously discontinued businesses. In addition, Greyhound Lines, Inc., which was sold in 1987 and filed for bankruptcy on June 4, 1990 as the result of a work stoppage and strike-related violence, emerged from bankruptcy in late 1991, resulting in a partial reversal of a loss provision made in 1990.  The caption "Income (loss) from discontinued operations" in the Statement of Consolidated Income for the years ended December 31 includes the following: Businesses, other than those described above, with aggregate net assets of $48,584,000 and $3,713,000 were sold in 1992 and 1991, respectively.  E. INVENTORIES Inventories at December 31 consisted of the following: F. PROPERTY AND EQUIPMENT Property and equipment at December 31 consisted of the following:  G. SHORT-TERM DEBT Dial satisfies its short-term borrowing requirements with bank lines of credit and by the issuance of commercial paper and promissory notes. At December 31, 1993, outstanding commercial paper and promissory notes were supported by $500,000,000 of credit commitments available under a long-term revolving bank credit agreement. At December 31, 1993, $256,666,000 of the long-term revolving bank credit supported $224,666,000 of commercial paper and promissory notes, and the guarantee of a $32,000,000 ESOP loan. Dial's foreign subsidiaries also maintain short-term bank lines in various currencies, which amount to approximately $12,269,000, of which $2,335,000 was outstanding at December 31, 1993. The short-term bank lines are subject to annual renewal and, in most instances, can be withdrawn at any time at the option of the banks. The following information pertains to Dial's commercial paper and promissory notes (classified as long-term debt) and other short-term debt:  H. LONG-TERM DEBT Long-term debt at December 31 was as follows: Interest paid in 1993, 1992 and 1991 was approximately $55,807,000, $59,962,000 and $69,218,000, respectively. As a result of Dial's management of its interest rate exposure through interest rate swap agreements as discussed further in Note N to the Consolidated Financial Statements, the effective interest rate on certain debt may differ from that disclosed above. During the third quarter of 1993, Dial utilized the proceeds from the sale of MCII to repurchase approximately 1,000,000 shares of Dial's common stock on the open market and to reduce outstanding short-term debt. Dial also prepaid $187,250,000 principal amount of long-term, fixed-rate debt, having a weighted average interest rate of 10%. These prepayments resulted in an extraordinary charge (after-tax) of $21,908,000. During 1993, Dial filed a $300,000,000 Senior Debt Securities Shelf Registration with the Securities and Exchange Commission under which Dial could issue senior notes for various amounts and at various rates and maturities. During 1993, Dial issued $230,000,000 of debt under the program with maturities of five to eleven years with a weighted average interest rate of 6.2%. Subsequent to December 31, 1993, Dial issued the remaining $70,000,000 of debt under the senior note program with maturities of six to fifteen years with a weighted average interest rate of 6.1%. A long-term revolving bank credit is available from participating banks under an agreement which provides for a total credit of $500,000,000. Borrowings were available at December 31, 1993 on a revolving basis until June 30, 1997. Annually, at Dial's request and with the participating banks' consent, the terms of the agreement may be extended for a one-year period. The interest rate applicable to borrowings under the agreement is, at Dial's option, indexed to the bank prime rate or the London Interbank Offering Rate ("LIBOR"), plus appropriate spreads over such indices during the period of the borrowing agreement. The agreement also provides for commitment fees. Such spreads and fees can change moderately should Dial's debt ratings change. Dial, in the event that it becomes advisable, intends to exercise its right under the agreement to borrow for the purpose of refinancing short-term borrowings; accordingly, short-term borrowings totaling $224,666,000 and $336,447,000 at December 31, 1993 and 1992, respectively, have been classified as long-term debt. Annual maturities of long-term debt due in the next five years will approximate $2,295,000 (1994), $22,185,000 (1995), $32,167,000 (1996), $226,714,000 (1997) and $32,043,000 (1998). Included in 1997 is $224,666,000 which represents the maturity of short-term borrowings assuming they had been refinanced utilizing the revolving credit facility and the term of the facility was not extended. However, Dial expects the term of the facility to be extended. Canadian revolving credit loans are available to a Canadian Services subsidiary from banks under agreements which provide for credit of $7,554,000. Dial's long-term debt agreements include various restrictive covenants and require the maintenance of certain defined financial ratios with which Dial is in compliance.  I. PREFERRED STOCK AND COMMON STOCK AND OTHER EQUITY At December 31, 1993, there were 48,554,362 shares of common stock issued and 46,018,008 shares outstanding. At December 31, 1993, 3,923,933 of the outstanding shares were held by The Dial Corp Employee Equity Trust. Dial has 442,352 shares of $4.75 Preferred Stock authorized, of which 388,352 shares are issued. The holders of the $4.75 Preferred Stock are entitled to a liquidation preference of $100 per share and to annual cumulative sinking fund redemptions of 6,000 shares. Dial presently holds 153,251 shares which will be applied to this sinking fund requirement; therefore, the 235,101 shares held by others are scheduled to be redeemed in the years 2019 to 2058. In addition, Dial has authorized 5,000,000 and 2,000,000 shares of Preferred Stock and Junior Participating Preferred Stock, respectively. Dial has one Preferred Stock Purchase Right ("Right") outstanding on each outstanding share of its common stock. The Rights contain provisions to protect shareholders in the event of an unsolicited attempt to acquire Dial which is not believed by the Board of Directors to be in the best interest of shareholders. The Rights are represented by the common share certificates and are not exercisable or transferable apart from the common stock until such a situation arises. The Rights may be redeemed by Dial at $0.05 per Right prior to the time any person or group has acquired 20% or more of Dial's shares. Dial has reserved 1,000,000 shares of Junior Participating Preferred Stock for issuance in connection with the Rights. During 1989, Dial arranged to fund its matching contributions to employees' 401k plans through a leveraged Employee Stock Ownership Plan ("ESOP"). All eligible employees of Dial and its participating affiliates, other than certain employees covered by collective bargaining agreements that do not expressly provide for participation of such employees in an ESOP, may participate in the ESOP. In June 1989, Dial sold 1,138,791 shares of treasury stock to the ESOP for $35.125 per share. In connection with the spin-off of GFC Financial in March 1992, the ESOP received one share of common stock of GFC Financial for every two shares of Dial common stock held by the ESOP. The ESOP subsequently sold the shares of GFC Financial on the open market and used the proceeds to purchase 273,129 shares of Dial's common stock. ESOP shares are treated as outstanding for net income (loss) per share calculations. The ESOP borrowed $40,000,000 to purchase the 1,138,791 shares of treasury stock in 1989. The ESOP's obligation to repay this borrowing is guaranteed by Dial; therefore, the unpaid balance of the borrowing ($32,000,000 at December 31, 1993) has been reflected in the accompanying balance sheet as long-term debt and the amount representing unearned employee benefits has been recorded as a deduction from common stock and other equity. The liability is being reduced as the ESOP repays the borrowing, and the amount in common stock and other equity is being reduced as the employee benefits are charged to expense. The ESOP intends to repay the loan (plus interest) using Dial contributions and dividends received on the shares of common stock held by the ESOP. Information regarding ESOP transactions for the years ended December 31 is as follows: Shares are released for allocation to participants based upon the ratio of the year's principal and interest payments to the sum of the total principal and interest payments over the life of the plan. Expense of the ESOP is recognized based upon the greater of cumulative cash payments to the plan or 80% of the cumulative expense that would have been recognized under the shares allocated method, in accordance with Statement of Position 76-3, "Accounting for Certain Employee Stock Ownership Plans" and Emerging Issues Task Force Abstract No. 89-8, "Expense Recognition for Employee Stock Ownership Plans". Under this method, Dial has recorded expense of $1,782,000, $2,210,000 and $2,630,000 in 1993, 1992 and 1991, respectively. ESOP shares at December 31 were as follows: In September 1992, Dial sold 5,245,900 shares of treasury stock to The Dial Corp Employee Equity Trust (the "Trust") for a promissory note valued at $200,000,000 ($38.125 per share). The Trust is being used to fund certain existing employee compensation and benefit plans over the scheduled 15-year term. Through December 31, 1993, the Trust had sold 1,321,967 shares to fund such benefits. The $200,000,000, representing unearned employee benefits, was recorded as a deduction from common stock and other equity, and is being reduced as employee benefits are funded. At December 31, 1993, retained income of $75,687,000 was unrestricted as to payment of dividends by Dial.  J. STOCK OPTIONS The Board of Directors approved and on March 3, 1992, the shareholders adopted the 1992 Stock Incentive Plan ("1992 Plan") for the grant of options and restricted stock to officers, directors and certain key employees. The Plan replaces the 1983 Stock Option and Incentive Plan ("1983 Plan"). No new awards will be made under the 1983 Plan except to provide for the adjustments hereafter described. In connection with the Distribution, each option, related Limited Stock Appreciation Right ("LSAR") and related Stock Appreciation Right ("SAR") held by an employee of Dial who remained an employee of Dial after the Distribution was adjusted so that the aggregate exercise price and the aggregate spread before the Distribution were preserved at the time of the Distribution. For each share of restricted stock held by a Dial employee who remained an employee of Dial after the Distribution, such employee received additional shares of restricted stock with a market value which compensated for the Distribution. Options and restricted stock held by an employee of Dial that became an employee of GFC Financial were surrendered in accordance with the related agreements. The 1992 Plan provides for the following types of awards: (a) stock options (both incentive stock options and nonqualified stock options), (b) SARs, and (c) performance-based and restricted stock. The Plan authorized the issuance of options for up to 2 1/2% of the total number of shares of common stock outstanding as of the first day of each year; provided that any shares available for grant in a particular calendar year which are not, in fact, granted in such year shall not be added to shares available for grant in any subsequent calendar year. In addition to the limitation set forth above with respect to number of shares available for grant in any single calendar year, no more than 5,000,000 shares of common stock shall be cumulatively available for grant of incentive options over the life of the Plan. In addition, 500,000 shares of Preferred Stock are reserved for distribution under the 1992 Plan. The stock options and SARs outstanding at December 31, 1993 are granted for terms of ten years; 50% become exercisable after one year and the balance become exercisable after two years from the date of grant. Stock options and appreciation rights are exercisable based on the market value at the date of grant. LSARs vest fully at date of grant and are exercisable only for a limited period (in the event of certain tenders or exchange offers for Dial's common stock). SARs and/or LSARs are issued in tandem with certain stock options and the exercise of one reduces, to the extent exercised, the number of shares represented by the other.  Information with respect to options granted and exercised for the three years ended December 31, 1993 is as follows: At December 31, 1993, stock options with respect to 3,883,370 common shares are outstanding at exercise prices ranging from $18.35 to $42.56 per share, of which 2,653,695 shares are exercisable at an average price of $28.36 per share. Performance-based stock awards (75,900 shares awarded in 1993) vest over a three-year period from the date of grant. The stock awarded vests only if performance targets relative to the S & P 500 stock index and Dial's proxy comparator group are achieved. Restricted stock awards (89,625 shares awarded in 1991) vest generally over periods not exceeding five years from the date of grant. There were no restricted stock awards in 1993 and 1992. However, 85,161 shares of restricted stock were allocated to employees of Dial in 1992 to compensate for the effect of the Distribution. A holder of the performance-based and restricted stock has the right to receive dividends and vote the shares but may not sell, assign, transfer, pledge or otherwise encumber the stock.  K. INCOME TAXES Deferred income tax assets (liabilities) included in the Consolidated Balance Sheet at December 31 related to the following: Deferred income tax assets (liabilities) at December 31, 1993, relating to interest rate swaps, amortization of intangibles and advertising and promotion costs capitalized for tax, reflect adjustments in 1993 resulting from the settlement of Internal Revenue Service examinations for 1985 and 1986. The consolidated provision (benefit) for income taxes on income from continuing operations for the years ended December 31 consisted of the following: Income taxes paid in 1993, 1992 and 1991, amounted to $12,206,000, $35,160,000 and $35,391,000, respectively. Certain tax benefits related primarily to stock options and dividends paid to the ESOP are credited to common stock and other equity and amounted to $1,913,000, $5,382,000 and $1,240,000 in 1993, 1992 and 1991, respectively. Eligible subsidiaries (including MCII and GFC Financial and certain of their subsidiaries up to the sale and Distribution date, respectively) are included in the consolidated federal and other applicable income tax returns of Dial. Certain benefits of tax losses and credits, which would not have been currently available to certain subsidiaries, or MCII and GFC Financial, on a separate return basis, have been credited to those subsidiaries, or MCII and GFC Financial, by Dial. These benefits are included in the determination of the income taxes of those subsidiaries and MCII and GFC Financial and this policy has been documented by written agreements. A reconciliation of the provision for income taxes on income from continuing operations and the amount that would be computed using statutory federal income tax rates on income before income taxes for the years ended December 31 is as follows: United States and foreign income before income taxes from continuing operations for the years ended December 31 is as follows: In the first quarter of 1992, Dial adopted SFAS No. 109, "Accounting for Income Taxes," which had no material effect on the consolidated financial statements.  L. PENSIONS AND OTHER BENEFITS PENSION BENEFITS Net periodic pension cost for the three years ended December 31, 1993 included the following components: Weighted average assumptions used were:  The following table indicates the plans' funded status and amounts recognized in Dial's consolidated balance sheet at December 31, 1993 and 1992: Dial recorded an additional minimum liability of $14,451,000, an intangible asset of $8,587,000, a deferred tax asset of $2,053,000 and a reduction of retained income of $3,811,000 at December 31, 1993; and, an additional minimum liability of $6,868,000, an intangible asset of $5,587,000, a deferred tax asset of $436,000 and a reduction of retained income of $845,000 at December 31, 1992. There are restrictions on the use of excess pension plan assets in the event of a defined change in control of Dial.  POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Dial and its subsidiaries have defined benefit postretirement plans that provide medical and life insurance for eligible employees, retirees and dependents. In addition, Dial retained the obligations for such benefits for eligible retirees of Greyhound Lines, Inc. (sold in 1987) and Armour and Company (sold in 1983). Benefits applicable to retirees of the businesses sold were recorded as accrued liabilities on an estimated present value basis at the respective dates of sale. Effective January 1, 1992, Dial and its U.S. subsidiaries adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("OPEB") which requires that estimated OPEB benefits be accrued during the years the employees provide services. Dial elected to recognize the accumulated postretirement benefit obligation as a one-time charge to income. The accumulated postretirement benefit obligation is the aggregate amount that would have been accrued for OPEB benefits in the years prior to adoption of SFAS No. 106 had the new standard been in effect for those years. The adoption of SFAS No. 106 has no cash impact because the plans are not funded and the pattern of benefit payments did not change. Dial expects to adopt SFAS No. 106 for its foreign subsidiaries in 1995, and anticipates that the effect of such adoption will not be material to the consolidated financial statements. The status of the plans as of December 31, was as follows: The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 14.5% in 1993 gradually declining to 5.5% by the year 2002 and remaining at that level thereafter for retirees below age 65, and 11% in 1993 gradually declining to 5.5% by the year 2002 and remaining at that level thereafter for retirees above age 65. This is a 1/2% decrease from the trend rates used for 1993 and later years in 1992's valuations. 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 by approximately 11% and the ongoing annual expense by approximately 13%. The net periodic postretirement benefit cost at December 31 includes the following components:  M. LEASES Certain airport and other retail facilities, cruise ships, plants, offices and equipment are leased. The leases expire in periods ranging generally from one to 30 years and some provide for renewal options ranging from one to 29 years. Also, certain leases contain purchase options. Leases which expire are generally renewed or replaced by similar leases. At December 31, 1993, future minimum rental payments and related sublease rentals receivable with respect to noncancellable operating leases with terms in excess of one year were as follows: At the end of the lease terms, Dial has options to purchase the cruise ships and certain other leased assets for an aggregate purchase price of $136,250,000. If the purchase options are not exercised, Dial will make residual guarantee payments aggregating $93,207,000 which are refundable to the extent that the lessors' subsequent sales prices exceed certain levels. As discussed in Note B of Notes to Consolidated Financial Statements, in November 1993, Dial entered into an agreement to purchase 15 in-flight catering kitchens from United Airlines. Future minimum rental payments for leases related to the kitchens expected to be phased in during 1994 are as follows: $3,875,000 (1994), $4,267,000 (1995), $4,265,000 (1996), $4,275,000 (1997), $4,265,000 (1998), and $90,135,000 thereafter. These amounts are not included in the table of future minimum rental payments at December 31, 1993.  Information regarding net operating lease rentals for the three years ended December 31 is as follows: Contingent rentals on operating leases are based primarily on sales and revenues for buildings and leasehold improvements and usage for other equipment. Dial is a 50% partner in a joint venture which owns a resort and conference hotel in Oakbrook, Illinois. Dial has leased the hotel through September 1, 2002, and the future rental payments are included in the table of future minimum rental payments. In addition, Dial and a third party have agreed to lend the joint venture $10,000,000 and $5,000,000, respectively, at 8 3/4% on July 1, 1997 to be secured by a second mortgage on the property to prepay $15,000,000 of the joint venture's nonrecourse first mortgage obligation. If the joint venture is unable to repay or refinance the first mortgage note, Dial has an option to purchase the note from the lender on September 30, 2002, its due date, at its then unpaid principal amount which is expected to be approximately $24,650,000. If the purchase option is not exercised, Dial will make residual guarantee payments equal to the greater of $5,000,000 or 150% of any shortfall in fair market value of the hotel compared to the unpaid principal amount of the note on such date.  N. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND FAIR VALUE OF FINANCIAL INSTRUMENTS FINANCIAL ISNTRUMENTS WITH OFF-BALANCE-SHEET RISK Dial is a party to financial instruments with off-balance-sheet risk which are entered into in the normal course of business to meet its financing needs and to manage its exposure to fluctuations in interest and foreign exchange rates. These financial instruments include revolving sale of receivable agreements, interest rate swap agreements and foreign exchange forward contracts. The instruments involve, to a varying degree, elements of credit, interest rate and exchange rate risk in addition to amounts recognized in the financial statements. At December 31, 1993, Dial's subsidiaries have agreements to sell up to $115,000,000 of accounts receivable with a major financial institution under which the financial institution has agreed to invest collected amounts in new purchases, providing a stable level of purchased accounts. The agreements to purchase accounts receivable, which were fully utilized at December 31, 1993 and December 31, 1992, mature in January of each year, but are expected to be extended annually by mutual agreement. They are currently extended to January 1995. Average monthly proceeds from the sale of accounts receivable were $103,700,000, $91,200,000 and $90,900,000 during 1993, 1992 and 1991, respectively. Dial's exposure to credit loss for receivables sold is represented by the recourse provision under which Dial is obligated to repurchase uncollectible receivables sold subject to certain limitations. Dial enters into interest rate swap agreements as a means of managing its interest rate exposure. The agreements are with major financial institutions which are expected to fully perform under the terms of the agreements thereby mitigating the credit risk from the transactions. The agreements are contracts to exchange fixed and floating interest rate payments periodically over the life of the agreements without the exchange of the underlying notional amounts. The notional amounts of such agreements are used to measure interest to be paid or received and do not represent the amount of exposure to credit loss. The amounts to be paid or received under the interest rate swap agreements are accrued consistent with the terms of the agreements and market interest rates. At December 31, 1993, Dial had $140,000,000 notional amount of interest rate swap agreements in effect which exchange floating rate interest payments for fixed rate interest payments with a weighted average interest rate of 9.3%. These swap agreements expire as follows: $100,000,000 (1995), and $40,000,000 (1998). Dial also had $250,000,000 notional amount of interest rate swap agreements in effect at December 31, 1993, which exchange fixed rate interest payments with a weighted average interest rate of 5.6% for floating rate interest payments. These swap agreements, which were entered into during 1993, expire as follows: $50,000,000 (1994), and $200,000,000 (2003). In addition, Dial had $332,600,000 notional amount of interest rate swap agreements in effect at December 31, 1993 which were counterswapped, fixing the future net payments owed by Dial against the cash proceeds received by Dial when the swap agreements were entered, at discount rates ranging from 7.1% to 10.4%. The swap and related counterswap agreements expire as follows: $65,000,000 (1994), $67,600,000 (1995), and $200,000,000 (1996), except for $67,600,000 expiring in 1995 and $100,000,000 expiring in 1996, for which the related counterswap agreement expires in 2000. Following the period that the swap agreements expire through 2000, Dial will pay a fixed rate of interest in exchange for a floating rate. Cash consideration received on the swaps is amortized as an offset to expense from future net swap payments over the life of the related swap. Net expense of $13,999,000, $18,856,000 and $14,048,000 for 1993, 1992 and 1991, respectively, is included in the Statement of Consolidated Income under the caption, "Unallocated corporate expense and other items, net." The unamortized balance ($37,780,000 and $57,709,000 at December 31, 1993 and 1992, respectively) of such consideration is included in the Consolidated Balance Sheet under the caption, "Other deferred items and insurance reserves." Dial also enters into foreign exchange forward contracts to hedge foreign currency transactions. These contracts are purchased to reduce the impact of foreign currency fluctuations on operating results. Dial does not engage in foreign currency speculation. The contracts do not subject Dial to risk due to exchange rate movements as gains and losses on the contracts offset gains and losses on the transactions being hedged. At December 31, 1993, Dial had approximately $125,000,000 of foreign exchange forward contracts outstanding. Dial's theoretical risk in these transactions is the cost of replacing, at current market rates, these contracts in the event of default by the other party. Management believes the risk of incurring such losses is remote as the contracts are entered into with major financial institutions. FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments." The estimated fair value amounts have been determined by Dial using available market information and valuation methodologies described below. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein may not be indicative of the amounts that Dial could realize in a current market exchange. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts.  The carrying values of cash and cash equivalents, receivables, accounts payable and payment service obligations approximate fair values due to the short-term maturities of these instruments. The carrying amounts and estimated fair values of Dial's other financial instruments at December 31, 1993 are as follows: The methods and assumptions used to estimate the fair values of the financial instruments are summarized as follows: Investments restricted for payment service obligations and equity and debt investments and notes receivable-The fair values of investments were estimated using either quoted market prices or, to the extent there are no quoted market prices, market prices of investments of a similar nature. For notes receivable, the carrying amounts approximate fair values because the rates on such notes are floating rates. Debt-The fair value of debt was estimated by discounting the future cash flows using rates currently available for debt of similar terms and maturity. The carrying values of short-term bank loans, commercial paper and promissory notes were assumed to approximate fair values due to their short-term maturities. Interest rate swaps-The fair values were estimated by discounting the expected cash flows using rates currently available for interest rate swaps of similar terms and maturities. The fair value represents the estimated amount that Dial would pay to the dealer to terminate the swap agreement at December 31, 1993. Foreign exchange forward contracts (used for hedging purposes)- The fair value is estimated using quoted exchange rates.  O. LITIGATION AND CLAIMS Dial and certain subsidiaries are plaintiffs or defendants to various actions, proceedings and pending claims. Certain of these pending legal actions are or purport to be class actions. Some of the foregoing involve, or may involve, compensatory, punitive or other damages in material amounts. Litigation is subject to many uncertainties and it is possible that some of the legal actions, proceedings or claims referred to above could be decided against Dial. Although the amount of liability at December 31, 1993 with respect to these matters is not ascertainable, Dial believes that any resulting liability should not materially affect Dial's financial condition or results of operations. Dial is subject to various environmental laws and regulations of the United States as well as of the states in whose jurisdictions Dial operates. As is the case with many companies, Dial faces exposure to actual or potential claims and lawsuits involving environmental matters. It is Dial's policy to accrue environmental and clean-up costs when it is probable that a liability has been incurred and the amount of the liability is reasonably estimable. Although Dial is a party to certain environmental disputes, Dial believes that any liabilities resulting therefrom, after taking into consideration Dial's insurance coverage and amounts already provided for, should not have a material adverse effect on Dial's financial position or results of operations.  P. PRINCIPAL BUSINESS SEGMENTS For 1993, Dial's Services companies, previously reported as a single principal business segment, were separated into three principal business segments for financial reporting purposes. Prior year data have been restated to reflect this change. The business activities included in each segment are set forth elsewhere in this Annual Report. Operating income by segment represents revenues less costs of sales and services before unallocated corporate and other items, net, interest expense, minority interests and income taxes.   Q. CONDENSED CONSOLIDATED QUARTERLY RESULTS (UNAUDITED) INDEPENDENT AUDITORS' REPORT To the Stockholders and Board of Directors of The Dial Corp: We have audited the consolidated financial statements of The Dial Corp as of December 31, 1993 and 1992, and for the three years in the period ended December 31, 1993, and have issued our report thereon dated February 25, 1993; such report is included elsewhere in this Form 10-K. Our audits also included the financial statement schedules of The Dial Corp listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Deloitte & Touche Deloitte & Touche Phoenix, Arizona February 25, 1994  All other required items are presented elsewhere in this document or are less than 1% of revenues.

700850_1993.txt

700850_1993

1993

700850

ITEM 2. PROPERTIES FNB owns the following properties: Main Office 5 Church Circle, Annapolis, Maryland Parole Office 2015 West Street, Annapolis, Maryland Arnold Office Arnold Road and Ritchie Highway, Anne Arundel County, Maryland Pasadena Office 3030 Mountain Road, Anne Arundel County, Maryland Millington Office Millington, Kent County, Maryland Centreville Office Centreville, Queen Anne's County, Maryland The following properties are leased by FNB or owned subject to land lease: Eastport Office Eastport Shopping Center, Annapolis, Maryland City Dock Office 91 Main Street, Annapolis, Maryland Hillsmere Office 101 Hillsmere Drive, Annapolis, Maryland Heritage Harbour Compass Way, Annapolis, Maryland Severna Park Office Severna Park Shopping Village, Anne Arundel County, Maryland Edgewater Office Route 2 and Maryland Avenue, Anne Arundel County, Maryland Wayson's Corner Office 5401 Southern Maryland Boulevard, Anne Arundel County, Maryland Benfield Road Office Benfield and Jumpers Hole Roads, Anne Arundel County, Maryland Central Avenue Office 52 West Central Avenue, Anne Arundel County, Maryland Operations-Data Center McGuckian Street and Chinquapin Round Road, Annapolis, Maryland CCB owns the following property: Main Office Sunset and Main Streets, Greensboro, Maryland Operations Center Main Street, Greensboro, Maryland ANB owns the following property: Ocean Pines Office 11111 Racetrack Road, Ocean Pines, Maryland Salisbury Office 528 Riverside Drive, Salisbury, Maryland The following properties are leased by ANB or owned subject to land lease: Main Office 4604 Coastal Highway, Ocean City, Maryland N. Salisbury Office 2400 N. Salisbury Blvd, Salisbury, Maryland FNLC owns the following property: Commercial Building McGukian Street and Chinquapin Round Road, Annapolis, Maryland Commercial Building and 23 West Street, Annapolis, Maryland Parking Lot Banking Office 4604 Coastal Highway, Ocean City, Maryland Commercial Building and 33-41 West Street, Annapolis, Parking Lot Maryland Commercial Parking Lot George Avenue and Chinquapin Round Road, Annapolis, Maryland Commercial Building 203 N. Commerce Street, Centreville, Maryland Commercial Building and 104 Cathedral Street, Annapolis, Parking Lot Maryland Land (other real Bywater Road, Annapolis, Maryland estate owned) Commercial Building 15 West Street, Annapolis, Maryland The following properties are leased by FNLC or owned subject to land lease: Pad Site Ritchie Highway, Severna Park, Maryland ITEM 3. ITEM 3. LEGAL PROCEEDINGS Bancorp and its subsidiaries are at times, in the ordinary course of business, subject to legal actions. Management is of the opinion that losses, if any, resulting from such matters will not have a material adverse effect on Bancorp'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 REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information set forth under the caption "Common Stock Price and Dividend History" on page 13 of the Annual Report to Stockholders, which contains information concerning the market price of Bancorp and its affiliates for the past two years and the dividend record with respect thereto for the past two years, is incorporated herein by reference. As of March 1, 1994, it was determined by a count of registered shareholders that there were approximately 1,400 holders of common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information set forth under the caption "Selected Financial Data" on page 3 of the Annual Report to Stockholders, which contains a summary of operations, per share data, return on equity and assets, dividend payout ratio and other data for the past five years, 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 on pages 4 through 13 of the Annual Report to Stockholders, which contains information with respect to Bancorp's financial condition and results of operations (including liquidity, interest rate sensitivity and inflation, and capital resources), is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of Bancorp and its subsidiaries, included in the Annual Report to Stockholders on pages 14 through 24 are incorporated herein by reference: Independent Auditors' Report Consolidated Balance Sheets - December 31, 1993 and 1992. Consolidated Statements of Income - Years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Changes in Stockholders' Equity - Years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992, and 1991. Notes to Consolidated Financial Statements - Years ended December 31, 1993, 1992, and 1991. 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 Pages 1 through 4 of Bancorp's definitive Proxy Statement prepared for the 1994 annual meeting of stockholders, which contains information concerning the Directors of Bancorp, are incorporated herein by reference. Information concerning the Executive Officers of Bancorp is included on page 38 in Part I of the report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Except for information under the caption "Report of Personnel Committee of Farmers National on Executive Compensation" and the performance graph on page 11 of Bancorp's definitve proxy statement that is required by paragraphs (k)(l) of item 402, the information contained on pages 7 through 11 of Bancorp's definitive proxy statement prepared for the 1994 annual meeting of stockholders, which contains information concerning current remuneration of Bancorp's officers and directors and transactions with management, are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pages 5 through 6 of Bancorp's definitive proxy statement prepared for the 1994 annual meeting of stockholders, which contains information concerning ownership of Bancorp equity securities, are incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Certain Relationships and Related Transactions" appearing on page 11 of Bancorp's definitive proxy statement prepared for the 1994 annual meeting of stockholders, which contains information concerning transactions with directors and officers, is incorporated herein by reference. The information set forth under the caption "Related Party Transactions" on page 23 of the Annual Report to stockholders which contains information concerning indebtness of management is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS,FINANCIAL STATEMENT SCHEDULES,AND REPORTS ON FORM 8-K (a) Documents filed as a part of the report: 1. The following financial statements included in the Annual Report, for the year ended December 31, 1993, at pages 14 through 24 thereof, are incorporated by reference in Item 8. Independent Auditors' Report. Consolidated Balance Sheets - December 31, 1993 and 1992. Consolidated Statements of Income - Years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Change in Stockholders' Equity - Years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992, and 1991. Notes to Consolidated Financial Statements - Years ended December 31, 1993, 1992, and 1991. 2. All schedules for which provision is made in the accounting regulation of the Commission are not applicable or are not required under the related instruction and have therefore been omitted. 3. Exhibits required by Item 601 of Regulation S-K: Exhibit 3A - Charter of the Registrant, as amended, is incorporated by reference to Exhibit 3A of Form 10-K for the fiscal year ended December 31, 1993, of the Registrant. Exhibit 3B - By-Laws of the Registrant, as amended, is incorporated by reference to Exhibit 3B of Form 10-K for the fiscal year ended December 31, 1993, of the Registrant. Exhibit 10A - Farmers National bank of Maryland Executive Benefits Plan, as amended, is incorporated by reference to Exhibit 10A of Form 10-K for the fiscal year ended December 31, 1993, of the Registrant. Exhibit 10B - Executive Benefits Plan Participation Agreement (Charles L. Schelberg), as amended, is incorporated by reference to Exhibit 10B of Form 10-K for the fiscal year ended December 31, 1993, of the Registrant. Exhibit 10C - Executive Benefit Plan Participation Agreement (Louis A. Supanek), as amended, is incorporated by reference to Exhibit 10C of Form 10-K for the fiscal year ended December 31, 1993, of the Registrant. Exhibit 10D - Executive Benefit Plan Participation Agreement (John M. Suit, II), is incorporated by reference to Exhibit 10D of Form 10-K for the fiscal year ended December 31, 1993, of the Registrant. Exhibit 10E - Executive Benefit Plan Participation Agreement (Frank T. Lowman, III), as amended, is incorporated by reference to Exhibit 10E of Form 10-K for the fiscal year ended December 31, 1993, of the Registrant. Exhibit 13 - 1993 Annual Report of the Registrant, filed herewith. Exhibit 22 - Subsidiaries of the Registrant, filed herewith. Exhibit 23 - Registrant's Proxy Statement for the 1994 Annual Meeting of Stockholders is incorporated by reference. Exhibit 24 - Consent of Independent Certified Public Accountants, filed herewith. Exhibit 25 - Power of Attorney, filed herewith. All other required Exhibits are not applicable to the Registrant. (b) Farmers National Bancorp filed no reports on Form 8-K during the last quarter ended December 31, 1993. (c) Exhibits - The Exhibits required by Item 601 of Regulation S- K are filed herewith or are incorporated by reference. (d) Financial Statement Schedules - All required Schedules are not applicable to the Registrant. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereonto duly authorized. FARMERS NATIONAL BANCORP \s\Charles L. Schelberg ___________________________________ Charles L. Schelberg Chairman of the Board March 8, 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. Principal Executive Officer \s\John M. Suit, II ___________________________________ John M. Suit, II President and Chief Executive Officer March 8, 1994 Principal Financial Officer \s\Louis A. Supanek ___________________________________ Louis A. Supanek Vice President & Treasurer March 8, 1994 Principal Accounting Officer \s\Louis A. Supanek ___________________________________ Louis A. Supanek Vice President & Treasurer March 8, 1994 SIGNATURES Majority of the Board of Directors * Charles L. Schelberg * John M. Suit, II * L. Tayloe Lewis, Jr. * Louis Hyatt * Alexander V. Sandusky * Raymond C. Shockley * Joseph S. Quimby * John B. Melvin * W. Robert Newnam * M. Virginai Meredith * Donald S. Taylor * Cary L. Meredith * William W. Simmons * James D. Edwards * W. Calvin Gray, Jr. *Signed by the undersigned as attorney in fact for the persons indicated. \s\Charles L. Schelberg ___________________________________ * Charles L. Schelberg SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 FARMERS NATIONAL BANCORP EXHIBIT INDEX Exhibit 13 1993 Annual Report of the Registrant Exhibit 22 Subsidiaries of the Registrant Exhibit 24 Consent of Independent Certified Public Accountants Exhibit 25 Power of Attorney

77227_1993.txt

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1993

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ITEM 1. BUSINESS. Pennsylvania Electric Company (Company), a Pennsylvania corporation incorporated in 1919, is a subsidiary of General Public Utilities Corporation (GPU), a holding company registered under the Public Utility Holding Company Act of 1935 (the 1935 Act). The Company's business is the generation, transmission, distribution and sale of electricity. The Company has two minor wholly-owned subsidiaries. The Company is affiliated with Jersey Central Power & Light Company (JCP&L) and Metropolitan Edison Company (Met-Ed). The Company, JCP&L and Met-Ed are referred to herein as the "Company and its affiliates." The Company is also affiliated with GPU Service Corporation (GPUSC), a service company; GPU Nuclear Corporation (GPUN), which operates and maintains the nuclear units of the Company and its affiliates; and General Portfolios Corporation (GPC), parent of Energy Initiatives, Inc., which develops, owns and operates nonutility generating facilities. All of the Company's affiliates are wholly-owned subsidiaries of GPU. The Company and its affiliates own all of the common stock of the Saxton Nuclear Experimental Corporation which owns a small demonstration nuclear reactor that has been partially decommissioned. The Company and its affiliates, GPUSC, GPUN and GPC considered together are referred to as the "GPU System." As a subsidiary of a registered holding company, the Company is subject to regulation by the Securities and Exchange Commission (SEC) under the 1935 Act. The Company's retail rates, conditions of service, issuance of securities and other matters of the Company are subject to regulation by the Pennsylvania Public Utility Commission (PaPUC). The Nuclear Regulatory Commission (NRC) regulates the construction, ownership and operation of nuclear generating stations. The Company is also subject to wholesale rate and other regulation by the Federal Energy Regulatory Commission (FERC) under the Federal Power Act. INDUSTRY DEVELOPMENTS The Energy Policy Act of 1992 (Energy Act) has made significant changes to the 1935 Act and the Federal Power Act. As a result of this legislation, the FERC is now authorized to order utilities to provide transmission or wheeling service to third parties for wholesale power transactions provided specified reliability and pricing criteria are met. In addition, the legislation amends the 1935 Act to permit the development and ownership of a broad category of independent power production facilities by utilities and nonutilities alike without subjecting them to regulation under the 1935 Act. These and other aspects of the Energy Act are expected to accelerate the changing character of the electric utility industry. (See "Regulation.") The electric utility industry appears to be undergoing a major transition as it proceeds from a traditional rate regulated environment based on cost recovery to some combination of a competitive marketplace and modified regulation of certain market segments. The industry challenges resulting from various instances of competition, deregulation and restructuring thus far have been minor compared with the impact that is expected in the future. The Public Utility Regulatory Policies Act of 1978 (PURPA) facilitated the entry of competitors into the electric generation business. Since then, more competition has been introduced through various state actions to encourage cogeneration and, most recently, the Energy Act. The Energy Act is intended to promote competition among utility and nonutility generators in the wholesale electric generation market, accelerating the industry restructuring that has been underway since the enactment of PURPA. This legislation, coupled with increasing customer demands for lower-priced electricity, is generally expected to stimulate even greater competition in both the wholesale and retail electricity markets. These competitive pressures may create opportunities to compete for new customers and revenues, as well as increase risk which could lead to the loss of customers. Operating in a competitive environment will place added pressures on utility profit margins and credit quality. Utilities with significantly higher cost structures than supportable in the marketplace may experience reduced earnings as they attempt to meet their customers' demands for lower- priced electricity. This prospect of increasing competition in the electric utility industry has already led the major credit rating agencies to address and apply more stringent guidelines in making credit rating determinations. Among its provisions, the Energy Act allows the FERC, subject to certain criteria, to order owners of electric transmission systems, such as the Company and its affiliates, to provide third parties with transmission access for wholesale power transactions. The Energy Act did not give the FERC the authority, however, to order retail transmission access. Movement toward opening the transmission network to retail customers is currently under consideration in several states. The competitive forces have also begun to influence some retail pricing in the industry. In a few instances, industrial customers, threatening to pursue cogeneration, self-generation or relocation to other service territories, have leveraged price concessions from utilities. Recent state regulatory actions, such as in New Jersey, suggest that utilities may have limited success with attempting to shift costs associated with such discounts to other customers. Utilities may have to absorb, in whole or part, the effects of price reductions designed to retain large retail customers. State regulators may put a limit or cap on prices, especially for those customers unable to pursue alternative supply options. Insofar as the Company is concerned, unrecovered costs will most likely be related to generation investment, purchased power contracts, and "regulatory assets", which are deferred accounting transactions whose value rests on the strength of a state regulatory decision to allow future recovery from ratepayers. In markets where there is excess capacity (as there currently is in the region including Pennsylvania) and many available sources of power supply, the market price of electricity may be too low to support full recovery of capital costs of certain existing power plants, primarily the capital intensive plants such as nuclear units. Another significant exposure in the transition to a competitive market results if the prices of a utility's existing purchase power contracts, consisting primarily of contractual obligations with nonutility generators, are higher than future market prices. Utilities locked into expensive purchase power arrangements may be forced to value the contracts at market prices and recognize certain losses. A third source of exposure is regulatory assets which, if not supported by regulators, would have no value in a competitive market. Financial Accounting Standard No. 71 (FAS 71), "Accounting for the Effects of Certain Types of Regulation", applies to regulated utilities that have the ability to recover their costs through rates established by regulators and charged to customers. If a portion of the Company's operations continues to be regulated, FAS 71 accounting may only be applied to that portion. Write- offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the Company no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. At this time, it is difficult for management to project the future level of stranded assets or other unrecoverable costs, if any, without knowing what the market price of electricity will be, or if regulators will allow recovery of industry transition costs from customers. Corporate Realignment In February 1994, GPU announced a corporate realignment and related actions as a result of its ongoing strategic planning studies. GPU Generation Corporation (GPU Generation) will be formed to operate and maintain the fossil-fueled and hydroelectric generating units of the Company and its affiliates; ownership of the generating assets will remain with the Company and its affiliates. GPU Generation will also build new generation facilities as needed by the Company and its affiliates in the future. Involvement in the independent power generation market will continue through Energy Initiatives, Inc. Additionally, the management and staff of the Company and Met-Ed will be combined but the two companies will not be merged and will retain their separate corporate existence. This action is intended to increase effectiveness and lower cost. Included in this effort will be a search for parallel opportunities at GPUN and JCP&L. Completion of these realignment initiatives will be subject to various regulatory reviews and approvals from the SEC, FERC, PaPUC and the New Jersey Board of Regulatory Commissioners (NJBRC). The GPU System is also developing a performance improvement and cost reduction program to help assure ongoing competitiveness, and, among other matters, will also address workforce issues in terms of compensation, size and skill mix. The GPU System is seeking annual cost savings of approximately $80 million by the end of 1996 as a result of these organizational changes. Duquesne Transaction In September 1990, the Company and its affiliates entered into a series of interdependent agreements with Duquesne Light Company (Duquesne) for the joint construction and ownership of associated high voltage bulk transmission facilities and the purchase by JCP&L and Met-Ed of a 50% ownership interest in Duquesne's 300 MW Phillips Generating Station. The Company and its affiliates' share of the total cost of these agreements was estimated to be $500 million (of which the Company's share of its participation in the transmission line was $117 million), the major part of which was expected to be incurred after 1994. In addition, JCP&L and Met-Ed simultaneously entered into a related agreement with Duquesne to purchase 350 MW of capacity and energy from Duquesne for 20 years beginning in 1997. The Company and its affiliates and Duquesne filed several petitions with the PaPUC and the NJBRC seeking certain of the regulatory authorizations required for the transactions. In December 1993, the NJBRC denied JCP&L's request to participate in the proposed transactions. As a result of this action and other developments, the Company and its affiliates notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. Consequently, the Company wrote off the approximately $8 million it had invested in the project. GENERAL The Company provides electric service within a territory located in western, northern and south central Pennsylvania extending from the Maryland state line northerly to the New York state line, with a population of about 1.5 million, approximately 24% of which is concentrated in ten cities and twelve boroughs, all with populations over 5,000. The Company owns all of the common stock of the Waverly Electric Light & Power Company, the owner of electric distribution facilities in the village of Waverly, New York. The Company, as lessee of the property of the Waverly Electric Light and Power Company, also serves a population of about 13,700 in Waverly, New York and vicinity. The Company's other wholly-owned subsidiary is Nineveh Water Company. The electric generating and transmission facilities of the Company, Met-Ed and JCP&L are physically interconnected and are operated as a single integrated and coordinated system. The transmission facilities are physically interconnected with neighboring nonaffiliated utilities in Pennsylvania, New Jersey, Maryland, New York and Ohio. The Company and its affiliates are members of the Pennsylvania-New Jersey-Maryland Interconnection (PJM) and the Mid-Atlantic Area Council, an organization providing coordinated review of the planning by utilities in the PJM area. The interconnection facilities are used for substantial capacity and energy interchange and purchased power transactions as well as emergency assistance. During 1993, residential sales accounted for about 37% of the Company's operating revenues from customers and 30% of kilowatt-hour (KWH) sales to customers; commercial sales accounted for about 32% of operating revenues from customers and 30% of KWH sales to customers; industrial sales accounted for about 27% of operating revenues from customers and 35% of KWH sales to customers; and sales to rural electric cooperatives, municipalities (primarily for street and highway lighting) and others accounted for about 4% of operating revenues from customers and 5% of KWH sales to customers. The Company also makes interchange and spot market sales of electricity to other utilities. The revenues derived from the 25 largest customers in the aggregate accounted for approximately 12% of operating revenues from customers for the year 1993. Reference is made to "Company Statistics" on page for additional information concerning the Company's sales and revenues. The Company and its affiliates along with the other members of the PJM power pool, experienced an electric emergency due to extremely cold temperature from January 18 through January 20, 1994. In order to maintain the electric system and to avoid a total black-out, intermittent black-outs for periods of one to two hours were instituted on January 19, 1994 to control peak loads. In February 1994, the NJBRC, the PaPUC and the FERC initiated investigations of the energy emergency, and forwarded data requests to all affected utilities. In addition, the United States House of Representatives' Energy and Power Subcommittee, among others, held hearings on this matter. At this time, management is unable to estimate the impact, if any, from any conclusions that may be reached by the regulators. In May 1993, the Pennsylvania Office of Consumer Advocate (Consumer Advocate) filed a petition for review of Met-Ed's rate order with the Pennsylvania Commonwealth Court seeking to set aside a March 1993 decision which allowed Met-Ed to (a) recover in the future certain Three Mile Island Unit 2 (TMI-2) retirement costs (radiological decommissioning and nonradiological cost of removal) and (b) defer the incremental costs associated with the adoption of the Statement of Financial Accounting Standards No. 106 (FAS 106) "Employers' Accounting for Postretirement Benefits Other Than Pensions." If the 1993 Met-Ed rate order is reversed, the Company would be required to write off a total of approximately $50 million for TMI-2 retirement costs. In addition, the Consumer Advocate is contesting utility deferral of FAS 106 costs in a proceeding involving another utility. The outcome of this proceeding may affect the Company's recovery of FAS 106 costs. This matter is pending before the court. (See "Rate Proceedings.") Competition in the electric utility industry has already played a significant role in wholesale transactions, affecting the pricing of energy sales to electric cooperatives and municipal customers. During 1993, the Company successfully negotiated power supply agreements with several existing GPU System wholesale customers in response to offers made by other utilities seeking to provide electric service at rates lower than those of Met-Ed or JCP&L. The Company has made similar offers to certain wholesale customers now being served by other utilities. Although wholesale customers represent a relatively small portion of Company sales, the Company will continue its efforts to retain and add customers. NUCLEAR FACILITIES The Company has made investments in two major nuclear projects -- Three Mile Island Unit 1 (TMI-1), which is an operational generating facility, and TMI-2, which was damaged during the 1979 accident. At December 31, 1993, the Company's net investment in TMI-1, including nuclear fuel, was $165 million. TMI-1 and TMI-2 are jointly owned by the Company, JCP&L and Met-Ed in the percentages of 25%, 25% and 50%, respectively. Costs associated with the operation, maintenance and retirement of nuclear plants have continued to increase and become less predictable, in large part due to changing regulatory requirements and safety standards and experience gained in the construction and operation of nuclear facilities. The Company and its affiliates may also incur costs and experience reduced output at their nuclear plants because of the design criteria prevailing at the time of construction and the age of the plants' systems and equipment. In addition, for economic or other reasons, operation of these plants for the full term of their now assumed lives cannot be assured. Also, not all risks associated with ownership or operation of nuclear facilities may be adequately insured or insurable. Consequently, the ability of electric utilities to obtain adequate and timely recovery of costs associated with nuclear projects, including replacement power, any unamortized investment at the end of the plants' useful life (whether scheduled or premature), the carrying costs of that investment and retirement costs, is not assured. Management intends, in general, to seek recovery of any such costs described above through the ratemaking process, but recognizes that recovery is not assured. TMI-1 TMI-1, a 786-MW pressurized water reactor, was licensed by the NRC in 1974 for operation through 2008. The NRC has extended the TMI-1 operating license through April 2014, in recognition of the plant's approximate six- year construction period. During 1993, TMI-1 operated at a capacity factor of approximately 87%. A scheduled refueling outage that year lasted 36 days; the next refueling outage is scheduled for late 1995. TMI-2 The 1979 TMI-2 accident resulted in significant damage to, and contamination of, the plant and a release of radioactivity to the environment. The cleanup program was completed in 1990, and, after receiving NRC approval, TMI-2 entered into long-term monitored storage in December 1993. As a result of the accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against GPU and the Company and its affiliates. Approximately 2,100 of such claims are pending in the U.S. District Court for the Middle District of Pennsylvania. Some of the claims also seek recovery for injuries from alleged emissions of radioactivity before and after the accident. Questions have not yet been resolved as to whether the punitive damage claims are (a) subject to the overall limitation of liability set by the Price-Anderson Act ($560 million at the time of the accident) and (b) outside the primary insurance coverage provided pursuant to that Act (remaining primary coverage of approximately $80 million as of December 1993). If punitive damages are not covered by insurance or are not subject to the Price-Anderson liability limitation, punitive damage awards could have a material adverse effect on the financial position of the GPU System. In June 1993, the District Court agreed to permit pre-trial discovery on the punitive damage claims to proceed. A trial of twelve allegedly representative cases is scheduled to begin in October 1994. In February 1994, the Court held that the plaintiffs' claims for punitive damages are not barred by the Price-Anderson Act to the extent that the funds to pay punitive damages do not come out of the U.S. Treasury. The Court also denied the defendants' motion seeking a dismissal of all cases on the grounds that the defendants complied with applicable federal safety standards regarding permissible radiation releases from TMI-2 and that, as a matter of law, the defendants therefore did not breach any duty that they may have owed to the individual plaintiffs. The Court stated that a dispute about what radiation and emissions were released cannot be resolved on a motion for summary judgment. NUCLEAR PLANT RETIREMENT COSTS Retirement costs for nuclear plants include decommissioning the radiological portions of the plants and the cost of removal of nonradiological structures and materials. The disposal of spent nuclear fuel is covered separately by contracts with the U.S. Department of Energy. See Note 2 to consolidated financial statements for further information regarding nuclear fuel disposal costs. In 1990, the Company and its affiliates submitted a report, in compliance with NRC regulations, setting forth a funding plan (employing the external sinking fund method) for the decommissioning of their nuclear reactors. Under this plan, the Company and its affiliates intend to complete the funding for TMI-1 by the end of the plant's license term, 2014. The TMI-2 funding completion date is 2014, consistent with TMI-2 remaining in long- term storage and being decommissioned at the same time as TMI-1. Under the NRC regulations, the funding target (in 1993 dollars) for TMI-1 is $143 million, of which the Company's share is $36 million. Based on NRC studies, a comparable funding target for TMI-2 (in 1993 dollars), which takes into account the accident, is $228 million, of which the Company's share would be $57 million. The NRC is currently studying the levels of these funding targets. Management cannot predict the effect that the results of this review will have on the funding targets. NRC regulations and a regulatory guide provide mechanisms, including exemptions, to adjust the funding targets over their collection periods to reflect increases or decreases due to inflation and changes in technology and regulatory requirements. The funding targets, while not actual cost estimates, are reference levels designed to assure that licensees demonstrate adequate financial responsibility for decommissioning. While the regulations address activities related to the removal of the radiological portions of the plants, they do not establish residual radioactivity limits nor do they address costs related to the removal of nonradiological structures and materials. In 1988, a consultant to GPUN performed a site-specific study of TMI-1 that considered various decommissioning plans and estimated the cost of decommissioning the radiological portions of TMI-1 to range from approximately $205 to $285 million (adjusted to 1993 dollars), of which the Company's share would range between approximately $51 to $71 million. In addition, the study estimated the cost of removal of nonradiological structures and materials for TMI-1 at $72 million, of which the Company's share would be $18 million. The ultimate cost of retiring the Company and its affiliates' nuclear facilities may be materially different from the funding targets and the cost estimates contained in the site-specific studies and cannot now be more reasonably estimated than the level of the NRC funding target because such costs are subject to (a) the type of decommissioning plan selected, (b) the escalation of various cost elements (including, but not limited to, general inflation), (c) the further development of regulatory requirements governing decommissioning, (d) the absence to date of significant experience in decommissioning such facilities and (e) the technology available at the time of decommissioning. The Company is charging to expense and contributing to external trusts amounts collected from customers for nuclear plant decommissioning and nonradiological costs. In addition, the Company has contributed to external trusts amounts written off for nuclear plant decommissioning in 1991. TMI-1 Effective October 1993, the PaPUC approved a rate change for the Company which increased the collection of revenues for decommissioning costs for TMI-1 based on its share of the NRC funding target and nonradiological cost of removal as estimated in the site-specific study. Collections from customers for decommissioning expenditures are deposited in external trusts. These external trust funds, including the interest earned, are classified as Decommissioning Funds on the balance sheet. Provision for the future expenditure of these funds has been made in accumulated depreciation, amounting to $4 million at December 31, 1993. Management believes that TMI-1 retirement costs, in excess of those currently recognized for ratemaking purposes, should be recoverable through the ratemaking process. TMI-2 The Company has recorded a liability amounting to $57 million, as of December 31, 1993, for its share of the radiological decommissioning of TMI- 2, reflecting the NRC funding target (unadjusted for an immaterial decrease in 1993). The Company records escalations, when applicable, in the liability based upon changes in the NRC funding target. The Company has also recorded a liability in the amount of $5 million, for its share of incremental costs specifically attributable to monitored storage. Such costs are expected to be incurred between 1994 and 2014, when decommissioning is forecast to begin. In addition, the Company has recorded a liability in the amount of $18 million, for its share of nonradiological cost of removal. The above amounts for retirement costs and monitored storage are reflected as Three Mile Island Unit 2 Future Costs on the balance sheet. The Company has made a nonrecoverable contribution of $20 million to an external decommissioning trust relating to its share of the accident-related portion of the decommissioning liability. The PaPUC has granted Met-Ed decommissioning revenues for its share of the remainder of the NRC funding target and allowances for the cost of removal of nonradiological structures and materials, although the PaPUC's order has been appealed by the Consumer Advocate (see "Rate Proceedings"). The Company intends to request decommissioning revenues and an allowance for the cost of removal of nonradiological structures and materials, equivalent to its share of the amounts granted to Met-Ed, in its next retail base rate filing. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. As a result of TMI-2's entering long-term monitored storage, the Company is incurring incremental storage costs currently estimated at $.25 million annually. The Company has deferred the $5 million, for its share of the total estimated incremental costs attributable to monitored storage through 2014, the expected retirement date of TMI-1. The Company believes these costs should be recoverable through the ratemaking process. INSURANCE The GPU System has insurance (subject to retentions and deductibles) for its operations and facilities including coverage for property damage, liability to employees and third parties, and loss of use and occupancy (primarily incremental replacement power costs). There is no assurance that the GPU System will maintain all existing insurance coverages. Losses or liabilities that are not completely insured, unless allowed to be recovered through ratemaking, could have a material adverse effect on the financial position of the Company. The decontamination liability, premature decommissioning and property damage insurance coverage for the TMI station (TMI-1 and TMI-2 are considered one site for insurance purposes) totals $2.7 billion. In accordance with NRC regulations, these insurance policies generally require that proceeds first be used for stabilization of the reactors and then to pay for decontamination and debris removal expenses. Any remaining amounts available under the policies may then be used for repair and restoration costs and decommissioning costs. Consequently, there can be no assurance that in the event of a nuclear incident, property damage insurance proceeds would be available for the repair and restoration of the stations. The Price-Anderson Act limits the of GPU System's liability to third parties for a nuclear incident at one of its sites to approximately $9.4 billion. Coverage for the first $200 million of such liability is provided by private insurance. The remaining coverage, or secondary protection, is provided by retrospective premiums payable by all nuclear reactor owners. Under secondary protection, a nuclear incident at any licensed nuclear power reactor in the country, including those owned by the GPU System, could result in assessments of up to $79 million per incident for each of the GPU System's reactors, subject to an annual maximum payment of $10 million per incident per reactor. In 1993, GPUN requested an exemption from the NRC to eliminate the secondary protection requirements for TMI-2. This matter is pending before the NRC. The Company and its affiliates have insurance coverage for incremental replacement power costs resulting from an accident-related outage at their nuclear plants. Coverage for TMI-1 commences after the first 21 weeks of the outage and continues for three years at decreasing levels beginning at a weekly amount of $2.6 million. Under its insurance policies applicable to nuclear operations and facilities, the Company is subject to retrospective premium assessments of up to $7 million in any one year, in addition to those payable under the Price-Anderson Act. NONUTILITY AND OTHER POWER PURCHASES The Company has entered into power purchase agreements with independently owned power production facilities (nonutility generators) for the purchase of energy and capacity for periods up to 25 years. The majority of these agreements are subject to penalties for nonperformance and other contract limitations. All of these facilities are must-run and generally obligate the Company to purchase all of the power produced up to the contract limits. The agreements have been approved by the PaPUC and permit the Company to recover energy and demand costs from customers through its energy clause. These agreements provide for the sale of approximately 412 MW of capacity and energy to the Company by the mid 1990s. As of December 31, 1993, facilities covered by these agreements having 293 MW of capacity were in service. Payments made pursuant to these agreements were $104 million for 1993 and are estimated to aggregate $121 million for 1994. The price of the energy and capacity to be purchased under these agreements is determined by the terms of the contracts. The rates payable under a number of these agreements are in excess of current market prices. While the Company has been granted full recovery of these costs from customers by the PaPUC, there can be no assurance that the Company will continue to be able to recover these costs throughout the term of the related contracts. The emerging competitive market has created additional uncertainty regarding the forecasting of the Company's energy supply needs which, in turn, has caused the Company to change its supply strategy to seek shorter term agreements offering more flexibility. At the same time, the Company is attempting to renegotiate higher cost long-term nonutility generation contracts where opportunities arise. The extent to which the Company may be able to do so, however, or recover associated costs through rates, is uncertain. Moreover, these efforts have led to disputes before the PaPUC, as well as to litigation, and may result in claims against the Company for substantial damages. There can be no assurance as to the outcome of these matters. In July 1993, the PaPUC acted to initiate a rulemaking proceeding which, in general, would establish a mandatory all source competitive bidding program by which utilities would meet their future capacity and energy needs. In November 1993, the Company filed an appeal with the Commonwealth Court seeking to overturn a PaPUC order which directs the Company to enter into two power purchase agreements with nonutility generators for a total of 160 MW under long-term contracts commencing in 1997 or later. The Company believes it does not need this additional capacity and believes the costs associated with these contracts are not in the economic interests of its customers. The matter is pending before the Commonwealth Court. The Company and its affiliates have entered into agreements with other utilities for the purchase of capacity and energy for various periods through 1999. These agreements provide for up to 2,130 MW in 1994, declining to 1,307 MW in 1995 and 183 MW by 1999. Payments pursuant to these agreements are estimated to aggregate $244 million in 1994. The price of the energy purchased under these agreements is determined by contracts providing generally for the recovery by the sellers of their costs. RATE PROCEEDINGS Pennsylvania In March 1993, in response to a petition filed by the Company's affiliate Met-Ed, the PaPUC modified portions of its January 1993 Met-Ed rate order to allow for the future recovery of certain TMI-2 retirement costs (radiological decommissioning and nonradiological cost of removal). (See "Nuclear Plant Retirement Costs.") In addition, the PaPUC action on the Met-Ed petition allowed the Company to defer the incremental costs associated with the adoption of FAS 106. In May 1993, the Consumer Advocate filed a petition for review with the Pennsylvania Commonwealth Court seeking to set aside the PaPUC 1993 Met-Ed rate order. The matter is pending before the court. If the 1993 rate order is reversed, the Company would be required to write off a total of approximately $50 million for TMI-2 retirement costs. The Company intends to request decommissioning revenues and an allowance for the cost of removal of nonradiological structures and materials for TMI-2, equivalent to its share of the amounts granted to Met-Ed, in its next retail base rate filing. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. In March 1993, the PaPUC issued a generic policy statement that permitted the deferral of FAS 106 costs for review and recovery in subsequent base rate making. Consistent with the PaPUC's policy statement, the Company filed a petition with the PaPUC in July 1993 for deferral of FAS 106 costs. That petition was approved by the PaPUC in October 1993. The Consumer Advocate is contesting utility deferral of FAS 106 costs in a proceeding involving another utility. The outcome of this proceeding may affect the Company's future recovery of these costs. The PaPUC has recently completed its generic investigation into demand- side management (DSM) cost recovery mechanisms and issued a cost recovery and ratemaking order in December 1993. The Company is currently developing plans which will reflect changes since its original plan was filed in 1991. In December 1993, the Pennsylvania Industrial Energy Coalition (PIEC) appealed to the Commonwealth Court to reverse the PaPUC Order. On February 4, 1994, the Company and Met-Ed filed a petition seeking a stay of the PaPUC's Order until the PIEC's appeal is resolved (See "Construction Program - Demand-Side Management"). In March 1994, the Company made its annual filing with the PaPUC for an increase in its Energy Cost Rate of $38.3 million. The new rate is expected to become effective April 1, 1994. The PaPUC is considering generic nuclear performance standards for Pennsylvania utilities. In January 1994, the Company submitted a proposal which, along with proposals submitted by the other Pennsylvania utilities, may result in the PaPUC adopting a generic nuclear performance standard. CONSTRUCTION PROGRAM General During 1993, the Company had gross plant additions of approximately $168 million attributable principally to improvements and modifications to existing generating stations, additions to the transmission and distribution system and clean air requirements. During 1994, the Company contemplates gross plant additions of approximately $218 million. The Company's gross plant additions are expected to total approximately $242 million in 1995. The anticipated increase in construction expenditures during 1995 is principally attributable to expenditures associated with clean air requirements. The principal categories of the 1994 anticipated expenditures, which include an allowance for other funds used during construction, are as follows: (In Millions) Generation - Nuclear $ 6 Nonnuclear 111 Total Generation 117 Transmission & Distribution 86 Other 15 Total $218 In addition, expenditures for maturing debt are expected to be $70 million for 1994. The Company will have no expenditures for maturing debt in 1995. Subject to market conditions, the Company intends to redeem during these periods outstanding senior securities pursuant to optional redemption provisions thereof should it prove economical to do so. Management estimates that approximately one-half of the Company's total capital needs for 1994 and 1995 will be satisfied through internally generated funds. The Company expects to obtain the remainder of these funds principally through the sale of first mortgage bonds and preferred stock, subject to market conditions. The Company's bond indenture and articles of incorporation include provisions that limit the amount of long-term debt, preferred stock and short-term debt the Company may issue. The Company's interest and preferred stock dividend coverage ratios are currently in excess of indenture or charter restrictions. (see "Limitations on Issuing Additional Securities"). Present plans call for the Company to issue long- term debt and preferred stock during the next three years to finance construction activities and, depending on the level of interest rates, refinance outstanding senior securities. The Company's 1994 construction program includes $66 million in connection with the federal Clean Air Act Amendments of 1990 (Clean Air Act) requirements (see "Environmental Matters-Air"). The 1995 construction program currently includes approximately $62 million for Clean Air Act compliance. The Company's gross plant additions exclude nuclear fuel requirements provided under capital leases that amounted to $11 million in 1993. When consumed, the presently leased material, which amounted to $21 million at December 31, 1993, is expected to be replaced by additional leased material at an average rate of approximately $9 million annually. In the event the replacement nuclear fuel needs cannot be leased, the associated capital requirements would have to be met by other means. The Company has projected increases in peak loads of approximately 275 MW (summer rating) and 440 MW (winter rating) by the year 1998. The Company expects to experience an average growth in sales to customers during this period of about 2.3% annually. The Company expects to meet this growth through existing and contracted supply sources and the utilization of capacity of its affiliates. In response to the increasingly competitive business climate and excess capacity of nearby utilities, the Company's supply plan places an emphasis on maintaining flexibility. Supply planning focuses increasingly on short to intermediate term commitments, reliance on "spot" markets, and avoidance of long-term firm commitments. Through 1998, the Company's plan consists of the continued utilization of most existing generating facilities, power purchases and the continued promotion of economic energy conservation and load management programs. Given the future direction of the industry, the Company's present strategy includes minimizing the financial exposure associated with new long-term purchase commitments and the construction of new facilities by including projected market prices in the evaluation of these options. The Company will resist efforts to compel it to add or contract for new capacity at costs that may exceed future market prices. In addition, the Company is attempting to renegotiate higher cost long-term nonutility generation contracts where opportunities arise. Demand-Side Management The regulatory environment in Pennsylvania encourages the development of new conservation and load management programs as evidenced by recent approval of a cost recovery mechanism for DSM. DSM includes utility sponsored activities designed to improve energy efficiency in customer end-use, and includes load management programs (i.e., peak reduction) and conservation programs (i.e., energy and peak reduction). In 1990, the Company and Met-Ed jointly filed a proposal with the PaPUC on DSM issues. The proposal recommends that the PaPUC preapprove DSM programs of utilities to enable the collection of their costs and that the PaPUC issue an order on a generic basis. In December 1993, the PaPUC issued an order adopting generic guidelines for recovery of DSM expenses. Also in December 1993, the Consumer Advocate and the Pennsylvania Energy Office filed separate petitions for clarification and reconsideration of the PaPUC's order and the PIEC appealed to the Commonwealth Court to reverse the PaPUC order. On February 4, 1994, the Company and Met-Ed filed a petition seeking a stay of the PaPUC's order until the PIEC's appeal is resolved. FINANCING ARRANGEMENTS The Company expects to have short-term debt outstanding from time to time throughout the year. The peak in short-term debt outstanding is expected to occur in the spring coinciding with normal cash requirements for revenue tax payments. GPU and the Company and its affiliates have $398 million of credit facilities, which includes a Revolving Credit Agreement (Credit Agreement) with a consortium of banks that permits total borrowing of $150 million outstanding at any one time. The credit facilities generally provide for the payment of a commitment fee on the unborrowed amount of 1/8 of 1% annually. Borrowings under these credit facilities generally bear interest based on the prime rate or money market rates. Notes issued under the Credit Agreement, which expires April 1, 1995, are subject to various covenants and acceleration under certain conditions. In 1993, the Company refinanced higher cost long-term debt in the principal amount of $108 million resulting in an estimated annualized after- tax savings of $1 million. Total long-term debt issued during 1993 amounted to $120 million. In addition, the Company redeemed $25 million of high- dividend rate preferred stock. The funds for this redemption were derived from GPU through sales of its common stock. In January 1994, the Company issued an aggregate of $90 million of first mortgage bonds, of which a portion of the net proceeds were used to redeem early $38 million principal amount of 6 5/8% series bonds in late February 1994. The Company has regulatory authority to issue and sell first mortgage bonds, which may be issued as secured medium-term notes, and preferred stock for various periods through 1995. Under existing authorization, the Company may issue senior securities in the amount of $330 million, of which $100 million may consist of preferred stock. The Company also has regulatory authority to incur short-term debt, a portion of which may be through the issuance of commercial paper. Under the Company and its affiliates' nuclear fuel lease agreements with nonaffiliated fuel trusts, up to $125 million of TMI-1 nuclear fuel costs may be outstanding at any one time. It is contemplated that when consumed, portions of the presently leased material will be replaced by additional leased material. The Company and its affiliates are responsible for the disposal costs of nuclear fuel leased under these agreements. LIMITATIONS ON ISSUING ADDITIONAL SECURITIES The Company's first mortgage bond indenture and/or articles of incorporation include provisions which limit the total amount of securities evidencing secured indebtedness, and/or unsecured indebtedness which the Company may issue, the more restrictive of which are described below. The Company's first mortgage bond indenture restricts the ratio of first mortgage bonds issued to not more than 60 percent of qualified property additions. At December 31, 1993, the Company had qualified property additions sufficient to permit the Company to issue approximately $270 million of additional first mortgage bonds. In addition, the indenture generally permits the Company to issue first mortgage bonds against like principal amount of previously retired bonds, which at December 31, 1993 totalled approximately $50 million. The Company's mortgage indenture requires that for a period of any twelve consecutive months out of the fifteen calendar months preceding the issuance of additional first mortgage bonds, the Company's net earnings (before income taxes, with other income limited to 10% of operating income before income taxes) available for interest on first mortgage bonds shall have been at least twice the annual interest requirements on all first mortgage bonds to be outstanding immediately after such issuance. At December 31, 1993, these provisions would have permitted the Company to issue approximately $798 million principal amount of first mortgage bonds at an assumed rate of 8.0 percent. However, as described above, under the Company's first mortgage bond indenture the Company had qualified property additions along with previously retired bonds which would have permitted it to issue only approximately $320 million of additional first mortgage bonds at such date. Among other restrictions, the Company's articles of incorporation provide that without the consent of the holders of two-thirds of the outstanding preferred stock, no additional shares of preferred stock may be issued, unless, for a period of any twelve consecutive months out of the fifteen calendar months preceding such issuance (a) the Company's net earnings available for the payment of dividends on preferred stock shall have been at least three times the annual dividend requirements on all shares of preferred stock to be outstanding immediately after such issuance, and (b) the Company's after tax net earnings available for the payment of interest on indebtedness shall have been at least one and one-half times the aggregate of (1) the annual interest charges on indebtedness and (2) the annual dividend requirements on all shares of preferred stock to be outstanding immediately after such issuance. At December 31, 1993, these provisions would have permitted the Company to issue approximately $353 million stated value of cumulative preferred stock at an assumed dividend rate of 8.0 percent. Under the Company's articles of incorporation, without the consent of the holders of a majority of the total voting power of the Company's outstanding preferred stock, the Company may not issue or assume any securities representing unsecured indebtedness (except to refund certain outstanding unsecured securities issued or assumed by the Company or to redeem all outstanding preferred stock) if immediately thereafter the total principal amount of all outstanding unsecured debt securities having an initial maturity of less than ten years issued or assumed by the Company would exceed 10 percent of the aggregate of (a) the total principal amount of all outstanding secured indebtedness issued or assumed by the Company and (b) the capital and surplus of the Company. At December 31, 1993, these restrictions would have permitted the Company to have approximately $135 million of unsecured indebtedness outstanding. The Company has obtained authorization from the SEC to incur short-term debt (including indebtedness under the Credit Agreement and commercial paper) up to the Company's charter limitation. REGULATION As a registered holding company, GPU is subject to regulation by the SEC under the 1935 Act. The Company, as a subsidiary of GPU, is also subject to regulation under the 1935 Act with respect to accounting, the issuance of securities, the acquisition and sale of utility assets, securities or any other interest in any business, the entering into, and performance of, service, sales and construction contracts, and certain other matters. The SEC has determined that the electric facilities of the Company and its affiliates constitute a single integrated public utility system under the standards of the 1935 Act. The 1935 Act also limits the extent to which the Company may engage in nonutility businesses. The Company's retail rates for Pennsylvania customers, conditions of service, issuance of securities and other matters are subject to regulation by the PaPUC. The Company's retail rates for New York customers are subject to regulation by the New York Public Service Commission (NYPSC). Moreover, with respect to wholesale rates, the transmission of electric energy, accounting, the construction and maintenance of hydroelectric projects and certain other matters, the Company is subject to regulation by the FERC under the Federal Power Act. The NRC regulates the construction, ownership and operation of nuclear generating stations and other related matters. Although the Company does not render electric service in Maryland, the Public Service Commission of Maryland has jurisdiction over the portion of the Company's property located in that state. The Company has a levelized energy cost rate for Pennsylvania retail rates and current fuel adjustment clauses for wholesale rates and New York retail rates. The Company, as lessee, operates the facilities serving the Village of Waverly, New York, and the NYPSC has jurisdiction over such operations and property. (See "Electric Generation and the Environment - Environmental Matters" for additional regulation to which the Company is or may be subject.) The rates charged by the Company for electric service are set by regulators under statutory requirements that they be "just and reasonable." As such, they are subject to adjustment, up or down, in the event they vary from that statutory standard. In 1992, as a result of a rulemaking proceeding, the PaPUC established quarterly financial reporting requirements to monitor public utility earnings. ELECTRIC GENERATION AND THE ENVIRONMENT Fuel Of the portion of its energy requirements supplied by its own generation, the Company utilized fuels in the generation of electric energy during 1993 in approximately the following percentages: Coal--87%; Nuclear--12%; and Gas, Hydro and Oil--1%. For 1994, the Company estimates that its generation of electric energy will be supplied in approximately the same proportions. Approximately 8% of the Company's energy requirements in 1993 was supplied by purchases (including net interchange) from other utilities and nonutility generators. Approximately 13% of the Company's 1994 energy requirements are expected to be supplied by purchases (including net interchange) from other utilities and nonutility generators. Fossil: The Company has entered into long-term contracts with nonaffiliated mining companies for the purchase of coal for its Homer City generating station in which it has a fifty percent ownership interest. The contracts, which expire between 1995 and 2003, require the purchase of fixed amounts of coal. Under the contracts the price of coal is based on adjustments of indexed cost components. One contract also includes a provision for the payment of environmental and post-employment benefits. The Company's share of the cost of coal purchased under these agreements is expected to aggregate $55 million for 1994. The Company's coal-fired generating stations now in service are estimated to require an aggregate of 95 million tons of coal over the next twenty years. Of this total requirement, approximately 8 million tons are expected to be supplied by a nonaffiliated mine-mouth coal company with the balance supplied through long-term contracts and spot market purchases. At the present time, adequate supplies of fossil fuels are readily available to the Company, but this situation could change rapidly as a result of actions over which it has no control. Nuclear: Preparation of nuclear fuel for generating station use involves various manufacturing stages for which the Company and its affiliates contract separately. Stage I involves the mining and milling of uranium ores to produce natural uranium concentrates. Stage II provides for the chemical conversion of the natural uranium concentrates into uranium hexafluoride. Stage III involves the process of enrichment to produce enriched uranium hexafluoride from the natural uranium hexafluoride. Stage IV provides for the fabrication of the enriched uranium hexafluoride into nuclear fuel assemblies for use in the reactor core at the nuclear generating station. For TMI-1, under normal operating conditions, there is, with minor planned modifications, sufficient on-site storage capacity to accommodate spent nuclear fuel through the end of its licensed life while maintaining the ability to remove the entire reactor core. Environmental Matters The Company is subject to federal and state water quality, air quality, solid waste disposal and employee health and safety legislation and to environmental regulations issued by the U.S. Environmental Protection Agency (EPA), state environmental agencies and other federal agencies. In addition, the Company is subject to licensing of hydroelectric projects by the FERC and of nuclear power projects by the NRC. Such licensing and other actions by federal agencies with respect to projects of the Company are also subject to the National Environmental Policy Act. As a result of existing and proposed legislation and regulations, and ongoing legal proceedings dealing with environmental matters, including but not limited to acid rain, water quality, air quality, global warming, electromagnetic fields, and storage and disposal of hazardous and/or toxic wastes, the Company may be required to incur substantial additional costs to construct new equipment, modify or replace existing and proposed equipment, remediate or clean up waste disposal and other sites currently or formerly used by it, including formerly owned manufactured gas plants and mine refuse piles, and with regard to electromagnetic fields, postpone or cancel the installation of, or replace or modify, utility plant, the costs of which could be material. The consequences of environmental issues, which could cause the postponement or cancellation of either the installation or replacement of utility plant are unknown. Management believes the costs described above should be recoverable through the ratemaking process but recognizes that recovery cannot be assured. Water: The federal Water Pollution Control Act (Clean Water Act) generally requires, with respect to existing steam electric power plants, the application of the best conventional or practicable pollutant control technology available and compliance with state-established water quality standards. With respect to future plants, the Clean Water Act requires the application of the "best available demonstrated control technology, processes, operating methods or other alternatives" to achieve, where practicable, no discharge of pollutants. Congress may amend the Clean Water Act during 1994. The EPA has adopted regulations that establish thermal and other limitations for effluents discharged from both existing and new steam electric generating stations. Standards of performance are developed and enforcement of effluent limitations is accomplished through the issuance by the EPA, or states authorized by the EPA, of discharge permits that specify limitations to be applied. Discharge permits, which have been issued for all of the Company's generating stations, where required, have expiration dates ranging through 1996. Timely reapplications for such permits have been filed as required by regulations. The Company is also subject to environmental and water diversion requirements adopted by the Delaware River Basin Commission and the Susquehanna River Basin Commission as administered by those commissions or the Pennsylvania Department of Environmental Resources (PaDER). Nuclear: Reference is made to "Nuclear Facilities" for information regarding the TMI-2 accident, its aftermath and TMI-1. Pennsylvania has established, in conjunction with several other states, a low level radioactive waste (radwaste) compact for the construction, licensing and operation of low level radwaste disposal facilities to service their respective areas by the year 2000. Pennsylvania, Delaware, Maryland and West Virginia have established the Appalachian Compact, which will build a single facility to dispose of low level radwaste in their areas, including low level radwaste from TMI-1. The estimated cost to license and build this facility is approximately $60 million, of which the Company and its affiliates' share is $12 million. These payments are considered advance waste disposal fees and will be recovered during the facility's operation. The Company has provided for future contributions to the Decontamination and Decommissioning Fund (part of the Energy Act) for the cleanup of enrichment plants operated by the Federal government. The Company's share of the total liability at December 31, 1993 amounted to $6 million. The Company made its initial payment in 1993. The remaining amounts recoverable from ratepayers is $7 million at December 31, 1993. Air: The Company is subject to certain state environmental regulations of the PaDER. The Company is also subject to certain federal environmental regulations of the EPA. The PaDER and the EPA have adopted air quality regulations designed to implement Pennsylvania and federal statutes relating to air quality. Current Pennsylvania environmental regulations prescribe criteria that generally limit the sulfur dioxide content of stack gas emissions from generating stations constructed before 1972 and stations constructed after 1971 but before 1978, to 3.7 pounds and 1.2 pounds per million BTU of heat input, respectively. On a weighted average basis, the Company has been able to obtain coal having a sulfur content meeting these criteria. If, and to the extent that, the Company cannot continue to meet such limitations with processed coal, it may be necessary to retrofit operating stations with sulfur removal equipment that may require substantial capital expenditures as well as substantial additional operating costs. Such retrofitting, if it could be accomplished to permit continued reliable operation of the facilities concerned, would take approximately five years. As a result of the Clean Air Act, which requires substantial reductions in sulfur dioxide and nitrogen oxide (NOx) emissions by the year 2000, it may be necessary for the Company to install and operate emission control equipment as well as switch to slightly lower sulfur coal at some of the Company's coal-fired plants in order to achieve compliance. To comply with Title IV of the Clean Air Act, the Company expects to expend up to $295 million by the year 2000, of which approximately $35 million has been spent as of December 31, 1993, for the installation of scrubbers, low NOx burner technology and various precipitator upgrades. The capital costs of this equipment and the increased operating costs of the affected stations are expected to be recoverable through the ratemaking process. The Company's current strategy for Phase II compliance under the Clean Air Act is to evaluate the installation of scrubbers or fuel switching at the Homer City Unit 3 Station. Switching to lower sulfur coal is currently planned for the Seward and Warren Stations. Homer City Units 1 and 2 will use existing coal cleaning technology. The Company continues to review available options to comply with the Clean Air Act, including those which may result from the development of an emission allowance trading market. The Company's compliance strategy, especially with respect to Phase II, could change as a result of further review, discussions with co-owners of jointly-owned stations and changes in federal and state regulatory requirements. The ultimate impact of Title I of the Clean Air Act, which deals with the attainment of ambient air quality standards, is highly uncertain. In particular, this Title has established an ozone transport or emission control region that includes 11 northeast states. Pennsylvania is part of this transport region, and will be required to control NOx emissions to a level that will provide for the attainment of the ozone standard in the northeast. As an initial step, major sources of NOx will be required to implement Reasonably Available Control Technology (RACT) by May 31, 1995. This will affect the Company's steam generating stations. PaDER's RACT regulations have been approved by the Environmental Quality Board and became effective in January 1994. Large coal-fired combustion units are required to comply with a presumptive RACT emission limitation (technology) or may elect to use a case-by-case analysis to establish RACT requirements. The ultimate impact of Title III of the Clean Air Act, which deals with emissions of hazardous air pollutants, is also highly uncertain. Specifically, the EPA has not completed a Clean Air Act study to determine whether it is appropriate to regulate emissions of hazardous air pollutants from electric utility steam generating units. However, the Homer City Coal Processing Plant is being studied to determine if it is a major stationary source for air toxins. Both the EPA and PaDER are questioning the attainment of National Ambient Air Quality Standards (NAAQS) for sulfur dioxide in the vicinity of the Chestnut Ridge Energy Complex (Homer City and Seward generating stations). The Homer City generating station is jointly owned with New York State Electric and Gas Corporation (NYSEG). The EPA and the PaDER have approved the use of a nonguideline air quality model. This model is more representative and less conservative than the EPA guideline model and will be used in the development of a compliance strategy for all generating stations in the Chestnut Ridge Energy Complex. The area around the Warren generating station has been designated as nonattainment for sulfur dioxide. An air quality model evaluation study began in early 1993. The results of the study will be used to determine if a nonguideline model can be used. The study results will be available in 1994. A Consent Order and Agreement has been negotiated to allow PaDER to revise the implementation plan for Warren Station. A model evaluation study is also being conducted at Shawville Station. The results of this study will be available in 1995. Based on the results of the studies pursuant to NAAQS, significant sulfur dioxide reductions may be required at one or more of these stations which could result in material capital and additional operating expenditures. Certain other environmental regulations limit the amount of particulate matter emitted into the environment. The Company has installed equipment at its coal-fired generating stations and may find it necessary to either upgrade or install additional equipment at certain of its stations to consistently meet particulate emission requirements. In the fall of 1993, the Clinton Administration unveiled its climate change action plan which intends to reduce greenhouse gas emissions to 1990 levels by the year 2000. The climate action plan relies heavily on voluntary action by industry. The Company and its affiliates notified the Department of Energy (DOE) that they support the voluntary approach proposed by the President and expressed their intent to work with the DOE. Title IV of the Clean Air Act requires Phase I and Phase II affected units to install a continuous emission monitoring system (CEMS) and quality assure the data for sulfur dioxide, nitrogen oxides, opacity and volumetric flow. In addition, Title VIII requires all affected sources to monitor carbon dioxide emissions. Monitoring systems have been installed and certified on all of the Company's affected units as required by EPA and PaDER regulations. The PaDER has a CEMS enforcement policy to ensure consistent compliance with air quality regulations under federal and state statutes. The CEMS enforcement policy includes matters such as visible emissions, sulfur dioxide emission standards, nitrogen oxide emissions and a requirement to maintain certified continuous emission monitoring equipment. In addition, this policy provides a mechanism for the payment of certain prescribed amounts to the Pennsylvania Clean Air Fund (Clean Air Fund) for air pollutant emission excesses or monitoring failures. With respect to the operation of the Company's generating stations for 1994, it is not anticipated that payments to be made to the Clean Air Fund will be material in amount. The Clean Air Act has also expanded the enforcement options available to the EPA and the states and contains more stringent enforcement provisions and penalties. Moreover, citizen suits can seek civil penalties for violations of this act. The EPA has established Best Available Retrofit Technology (BART) sulfur dioxide emission standards to be used for the Company's Shawville and Seward generating stations under the Good Engineering Practice stack height regulation. Dependent upon the Chestnut Ridge Compliance Strategy and the results of the Shawville model evaluation study mentioned above, lower sulfur coal purchases may be necessary for compliance. Discussions with the EPA regarding this matter are continuing. In 1988, the Environmental Defense Fund (EDF), the New Jersey Conservation Foundation, the Sierra Club and Pennsylvanians for Acid Rain Control requested that the New Jersey Department of Environmental Protection and Energy (NJDEPE) and the NJBRC seek to reduce sulfur deposition in New Jersey, either by reducing emissions from both in-state and out-of-state sources, or by requiring that certain electricity imported into New Jersey be generated from facilities meeting minimum emission standards. The Company owns coal-fired generating facilities that supply electric energy to JCP&L and other New Jersey members of PJM. Hearings on the EDF petition were held during 1989 and 1990, and the matter is pending before the NJDEPE and the NJBRC. In 1993, the Company made capital expenditures of approximately $32 million in response to environmental considerations and has included approximately $73 million for this purpose in its 1994 construction program. The operating and maintenance costs, including the incremental costs of low-sulfur fuel, for such equipment were approximately $40 million in 1993 and are expected to be approximately $39 million in 1994. Electromagnetic Fields: There have been a number of scientific studies regarding the possibility of adverse health effects from electric and magnetic fields (EMF) that are found everywhere there is electricity. While some of the studies have indicated some association between exposure to EMF and cancer, other studies have indicated no such association. The studies have not shown any causal relationship between exposure to EMF and cancer, or any other adverse health effects. In 1990, the EPA issued a draft report that identifies EMF as a possible carcinogen, although it acknowledges that there is still scientific uncertainty surrounding these fields and their possible link to adverse health effects. On the other hand, a 1992 White House Office of Science and Technology policy report states that "there is no convincing evidence in the published literature to support the contention that exposures to extremely low frequency electric and magnetic fields generated by sources such as household appliances, video display terminals, and local power lines are demonstrable health hazards." Additional studies, which may foster a better understanding of the subject, are presently underway. Bills introduced in the Pennsylvania legislature could, if enacted, establish a framework under which the intensity of EMF produced by electric transmission and distribution lines would be limited or otherwise regulated. The Company cannot determine at this time what effect, if any, this matter will have on it. Residual Waste: PaDER has finalized the residual waste regulations which became effective in July 1992. These regulations impose additional restrictions on operating existing ash disposal sites and for siting future disposal sites and will increase the costs of establishing and operating these facilities. The main objective of these regulations is to prevent degradation of groundwater and to abate any existing degradation. One of the first significant compliance requirements of the regulations is conducting groundwater assessments of landfills if existing groundwater monitoring indicates the possibility of degradation. The assessments require the installation of additional monitoring wells and the evaluation of one year's worth of data. All of the Company's active landfills require assessments. If the assessments show degradation of the groundwater, then the next step is to develop abatement plans. However, there is no specific timetable on the implementation of abatement activities, if required. The Company's landfills are to have preliminary permit modification applications submitted to the PaDER by July 1994, and complete permit applications under evaluation by July 1997. In addition, the regulations can also be enforced at sites closed since 1980 at the PaDER's option. Other compliance requirements that will be implemented in the future include the lining of currently unlined disposal sites and storage impoundments. Impoundments also will eventually require groundwater monitoring systems and assessments of impact on groundwater. Groundwater abatement may be necessary at locations where pollution problems are identified. The removal of all the residual waste or "clean closed" will be done at some impoundments to eliminate the need for future monitoring and abatement requirements. Storage impoundments must have implemented groundwater monitoring plans by 2002, but PaDER can require this at any time prior to this date or defer full compliance beyond 2002 for some storage impoundments at their discretion. Also being evaluated are the exercising of beneficial use options authorized by the regulations, and source reductions. There are also a number of issues still to be resolved regarding certain waivers related to the Company's existing landfill and storage impoundment compliance requirements. These waivers could significantly reduce the cost of many of the Company's facility compliance upgrades. Another aspect of the regulations deals with the storage and disposal of polychlorinated biphenyl (PCB) wastes between 2 and 50 parts per million (ppm). Federal regulations only deal with wastes over 50 ppm. The compliance requirements for this regulation are currently being evaluated. Hazardous/Toxic Wastes: Under the Toxic Substances Control Act (TSCA), the EPA has adopted certain regulations governing the use, storage, testing, inspection and disposal of electrical equipment that contains PCBs. Such regulations permit the continued use and servicing of certain electrical equipment (including transformers and capacitors) that contain PCBs. The Company has met all requirements of the TSCA necessary to allow the continued use of equipment containing PCBs and has taken substantive voluntary actions to reduce the amount of PCB containing electrical equipment in its system. Prior to 1947, the Company owned and operated manufactured gas plants in Pennsylvania. Wastes associated with the operation and dismantlement of these gas manufacturing plants may have been disposed of both on-site and off-site. Claims may be asserted against the Company for the cost of investigation and remediation of these waste disposal sites. The amount of such remediation costs and penalties may be significant and may not be covered by insurance. The federal Resource Conservation and Recovery Act of 1976, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and the Superfund Amendment and Reauthorization Act of 1986 authorize the EPA to issue an order compelling responsible parties to take cleanup action at any location that is determined to present an imminent and substantial danger to the public or to the environment because of an actual or threatened release of one or more hazardous substances. Pennsylvania has enacted legislation giving similar authority to the PaDER. Because of the nature of the Company's business, various by-products and substances are produced and/or handled that are classified as hazardous under one or more of these statutes. The Company generally provides for the treatment, disposal or recycling of such substances through licensed independent contractors, but these statutory provisions also impose potential responsibility for certain cleanup costs on the generators of the wastes. The Company has been notified by the EPA and state environmental authorities that it is among the potentially responsible parties (PRPs) who may be jointly and severally liable to pay for the costs associated with the investigation and remediation at two hazardous and/or toxic waste sites. In addition, the Company has been requested to supply information to the EPA and state environmental authorities on several other sites for which the Company has not as yet been named as a PRP. The Company has also been named in lawsuits requesting damages for hazardous and/or toxic substances allegedly released into the environment. The Company received notification in 1986 from the EPA that it is among the more than 800 PRPs under CERCLA who may be liable to pay for the cost associated with the investigation and remediation of the Maxey Flats disposal site, located in Fleming County, Kentucky. The Company is alleged to have contributed approximately .0003% of the total volume of waste shipped to the Maxey Flats site. On September 30, 1991, the EPA issued a Record of Decision (ROD) advising that a remedial alternative had been selected. The PRPs estimate the cost of the remedial alternative selected and associated activities identified in the ROD at more than $60 million, for which all responsible parties would be jointly and severally liable. The EPA has initiated a suit under CERCLA and other laws for the initial cleanup of hazardous materials deposited at a waste disposal site at Harper Drive, Millcreek Township, Pennsylvania (Millcreek site). The Company is one of over 50 PRPs at this site. The Company does not know whether its insurance carriers will assume the responsibility to defend and indemnify it in connection with this matter. Two lawsuits involving property owners at or near the Millcreek site have been filed against the Company and other PRPs. The Company's insurance carriers are defending these actions but may not provide coverage in the event compensatory damages are awarded. In addition, claims have also been made for punitive damages which may not be covered by insurance. The Company, together with 24 others, has been named as a third party defendant in an action commenced under the CERCLA by the EPA in the U.S. District Court in Ohio. The EPA is seeking to recover costs for the cleanup of hazardous and toxic materials disposed at the New Lyme landfill site in Ashtabula, Ohio. The Company, together with 22 others, has also been named as a third party defendant in an action under the CERCLA by the state of Ohio seeking to recover costs it has incurred and will incur in the future at the New Lyme landfill site. The ultimate cost of remediation of these sites will depend upon changing circumstances as site investigations continue, including (a) the technology required for site cleanup, (b) the remedial action plan chosen and (c) the extent of site contamination and the portion attributed to the Company. The Company is unable to estimate the extent of possible remediation and associated costs of additional environmental matters. Management believes the costs described above should be recoverable through the ratemaking process. FRANCHISES AND CONCESSIONS The electric franchise rights of the Company which are generally nonexclusive, consist generally of (a) charter rights to furnish electric service, and (b) certificates of public convenience and/or "grandfather rights," which allow the Company to furnish electric service in a specified city, borough, town or township or part thereof. Such electric franchises are unlimited as to time, except in a few relatively minor cases concerning the rights mentioned in clause (a) of the preceding sentence. The Company was granted a licensing exemption by the FERC for the operation of its Deep Creek hydroelectric project after its current license expired in December, 1993. Instead of reapplying for a FERC license, the Company is now able to negotiate with the Maryland Department of Natural Resources (DNR) for a permit to operate the plant. The DNR has agreed to permit the Company to continue operations at Deep Creek until an agreement is finalized. The Company also holds a license, which expires in 2002, for the continued operation and maintenance of the Piney hydroelectric project. In addition, the Company and the Cleveland Electric Illuminating Company hold a license expiring in 2015 for the Seneca pumped storage hydroelectric station, in which the Company has a 20% undivided interest. For the same station, the Company and the Cleveland Electric Illuminating Company hold a Limited Power Permit issued by the Pennsylvania Water and Power Resources Board which is unlimited as to time. For purposes of the Homer City station, the Company and NYSEG hold a Limited Power Permit issued by the Pennsylvania Water and Power Resources Board which expires in 2017, but is renewable by the permittees until they have recovered all capital invested by them in the project. The Company also holds a Limited Power Permit issued by the Pennsylvania Water and Power Resources Board for its Shawville station which expires in 2003, but is renewable by the Company until it has recovered all capital invested in the project. EMPLOYEE RELATIONS At February 28, 1994, the Company had 3,532 full-time employees. The nonsupervisory production and maintenance employees of the Company and certain of its nonsupervisory clerical employees are represented for collective bargaining purposes by local unions of the International Brotherhood of Electrical Workers (IBEW) and the Utility Workers Union of America (UWUA). The Company's five-year contracts with the IBEW and UWUA expire on May 14, 1998 and June 30, 1998, respectively. ITEM 2. ITEM 2. PROPERTIES Generating Stations At December 31, 1993, the Company's generating stations had an aggregate effective winter capability of 2,369,000 net kilowatts (KW), as follows: Year of Name and Location of Station Installation Net KW COAL-FIRED: Homer City, Homer City, Pa. (a) 1969-1977 942,000 Shawville, Shawville, Pa. 1954-1960 618,000 Seward, Seward, Pa. 1950-1957 199,000 Warren, Warren, Pa. 1948-1949 82,000 NUCLEAR: Three Mile Island Unit No. 1, Dauphin County, Pa. (b) 1974 203,000 GAS or OIL-FIRED: Other (c) 1960-1972 191,000 HYDROELECTRIC: Piney, Clarion, Pa. 1923-1926 28,000 Deep Creek, Oakland, Md. 1925 19,000 PUMPED STORAGE: Seneca, Warren, Pa. (d) 1969 87,000 Total 2,369,000 (a) Represents the Company's 50% interest in this station. (b) Represents the Company's 25% interest in this unit. (c) Consists of combustion turbine and internal combustion units, all of which are located in Pennsylvania. (d) Represents the Company's 20% interest in this station which is a net user rather than a net producer of electric energy. Substantially all of the Company's properties are subject to the lien of its first mortgage bond indenture. The peak load of the Company, which occurred on January 18, 1994, was 2,514,000 KW. Transmission and Distribution System At December 31, 1993, the Company owned 649 transmission and distribution substations that had an aggregate installed transformer capacity of 16,008,712 kilovoltamperes (KVA), and 2,734 circuit miles of transmission lines, of which 235 miles were operated at 500 kilovolts (KV), 149 miles at 345 KV, 650 miles at 230 KV, 11 miles at 138 KV, 1,325 miles at 115 KV, and the balance of 364 miles at 46 KV. The Company's distribution system included 6,036,111 KVA of line transformer capacity, 22,145 pole miles of overhead lines and 1,704 trench miles of underground cables. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Reference is made to "Nuclear Facilities - TMI-2", "Rate Proceedings" and "Environmental Matters" under Item 1 and to Note 1 of consolidated financial statements for a description of certain pending legal proceedings involving the Company. See page for reference to the Notes to Consolidated Financial Statements. 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. All of the Company's outstanding common stock is owned by GPU. During 1993, the Company paid $40 million in dividends on its common stock. On February 23, 1994, the Company paid $5 million in dividends on its common stock. In accordance with the Company's mortgage indenture as supplemented, $10 million of the balance of retained earnings at December 31, 1993 is restricted as to the payment of dividends on its common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. See page for reference to the Selected Financial Data required by this item. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See page for reference to Management's Discussion and Analysis of Financial Condition and Results of Operations required by this item. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See page for reference to Financial Statements and Supplementary Data required by this item. 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. Identification of Directors The present directors of the Company, their ages, positions held and business experience during the past five years are as follows: Year First Name Age Position Elected J. R. Leva (a) 61 Chairman and Chief 1992 Executive Officer R. L. Wise (b) 50 President 1986 J. G. Graham (c) 55 Vice President and Chief 1986 Financial Officer W. R. Stinson (d) 58 Vice President and 1985 Comptroller R. C. Arnold (e) 56 Director 1989 J. G. Herbein (f) 55 Vice President 1990 G. R. Repko (g) 48 Vice President 1993 (a) Mr. Leva became Chairman of the Board and Chief Executive Officer of the Company in 1992. He became Chairman, President and Chief Executive Officer of GPU in 1992. He is also Chairman, President, Chief Executive Officer and a director of GPUSC, Chairman of the Board, Chief Executive Officer and a director of JCP&L, Met-Ed and GPC, and Chairman of the Board and a director of GPUN. Prior to assuming his present positions, Mr. Leva served as President of JCP&L since 1986. He is also a director of Utilities Mutual Insurance Company, the New Jersey Utilities Association, Chemical Bank, NJ and Princeton Bank and Trust Company. (b) Mr. Wise became President and a director in 1986. He is also a director of GPUSC and GPUN. Mr. Wise is also a director of USBANCORP, Inc. and U.S. National Bank. (c) Mr. Graham became Senior Vice President in 1989 and Chief Financial Officer of GPU in 1987. He is also Executive Vice President, Chief Financial Officer and a director of GPUSC; Vice President, Chief Financial Officer and a director of JCP&L and Met-Ed; Vice President and Chief Financial Officer of GPUN; President and a director of GPC and a director of Energy Initiatives, Inc. (d) Mr. Stinson has been Vice President and Comptroller since 1982. (e) Mr. Arnold became Executive Vice President-Power Supply of GPUSC in 1990. He was Senior Vice President-Power Supply from 1987 to 1989. He is also a director of GPUSC, JCP&L and Met-Ed. (f) Mr. Herbein became Vice President, Generation in December 1992. He was Vice President, Station Operations from 1982 to December 1992. (g) Mr. Repko became Vice President, Customer Operations in April 1993. Prior to that time he served as Vice President, Division Operations since 1986. The Company's directors are elected each year at the annual meeting of shareholders to serve until the next annual meeting of shareholders and until their respective successors are duly elected and qualified. There are no family relations among the directors and/or executive officers of the Company. Identification of Executive Officers The executive officers of the Company, their ages, positions held and business experience during the past five years are as follows: Year First Name Age Position Elected J. R. Leva (a) 61 Chairman and Chief 1992 Executive Officer R. L. Wise (b) 50 President 1980 T. N. Elston (c) 61 Vice President 1990 J. F. Furst (d) 47 Vice President 1984 J. G. Graham (e) 55 Vice President and Chief 1987 Financial Officer J. G. Herbein (f) 55 Vice President 1982 W. C. Matthews (g) 41 Secretary and Corporate 1990 Counsel D. W. Myers (h) 49 Vice President and 1993 Treasurer G. R. Repko (i) 48 Vice President 1982 W. R. Stinson (j) 58 Vice President and 1982 Comptroller (a) See footnote (a) on page 29. (b) See footnote (b) on page 29. (c) Mr. Elston has been Vice President, Human Resources since March 1990. Prior to that time he served as Personnel Services Director since 1983. (d) Mr. Furst became Vice President, Customer Services and Communication in April 1993. Prior to that time he served as Vice President, Customer Services since 1984. (e) See footnote (c) on page 29. (f) See footnote (f) above. (g) Mr. Matthews has been Secretary and Corporate Counsel since November 1990. He served as Chief Counsel to the Independent Regulatory Review Commission of the State of Pennsylvania from October 1987 to November 1990. (h) Mr. Myers became a Vice President and Treasurer of GPU in 1993. He is also Vice President and Treasurer of GPUSC, JCP&L, Met-Ed, GPUN and GPC. Prior to assuming his present positions, Mr. Myers served as Vice President and Comptroller of GPUN since 1986. (i) See footnote (g) on page 30. (j) See footnote (d) on page 29. The Company's executive officers are elected each year at the first meeting of the Board of Directors held following the annual meeting of shareholders. Executive officers hold office until the next meeting of directors following the annual meeting of shareholders and until their respective successors are duly elected and qualified. There are no family relationships among the Company's executive officers. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. (1) "Other Annual Compensation" is composed entirely of the above-market interest accrued on the pre-retirement portion of deferred compensation. (2) Number and value of aggregate restricted shares/units at the end of 1993 (dividends are paid or accrued on these restricted shares/units and reinvested): Aggregate Shares/Units Aggregate Value Robert L. Wise 6,260 $159,160 John G. Herbein 1,990 $ 51,206 Willard R. Stinson 1,770 $ 45,655 George R. Repko 1,710 $ 44,094 Thomas N. Elston 1,570 $ 40,201 (3) As noted above, Mr. Leva is Chairman and Chief Executive Officer of the Company and its affiliates, as well as Chairman and Chief Executive Officer of GPU and GPUSC. Mr. Leva is compensated by GPUSC for his overall service on behalf of the GPU System and accordingly is not compensated directly by the Company for his services. Information with respect to Mr. Leva's compensation is included on pages 13 through 15 in GPU's 1994 definitive proxy statement, which are incorporated herein by reference. (4) Consists of the Company's matching contributions under the Savings Plan ($9,434), matching contributions under the non-qualified deferred compensation plan ($1,696), the imputed interest on employer paid premiums for split-dollar life insurance ($5,286), and above-market interest accrued on the retirement portion of deferred compensation ($12,337). (5) Consists of the Company's matching contributions under the Savings Plan ($4,368) and above-market interest accrued on the retirement portion of deferred compensation ($10,970). (6) Consists of the Company's matching contributions under the Savings Plan ($5,330) and above-market interest accrued on the retirement portion of deferred compensation ($2,264). (7) Consists of the Company's matching contributions under the Savings Plan. (8) Consists of the Company's matching contributions under the Savings Plan ($4,657) and above-market interest accrued on the retirement portion of deferred compensation ($1,450). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. All of the Company's 5,290,596 outstanding shares of common stock are owned beneficially and of record by the Company's parent, General Public Utilities Corporation, 100 Interpace Parkway, Parsippany, New Jersey 07054. The following table sets forth, as of February 1, 1994, the beneficial ownership of equity securities of the Company and other GPU System companies of each of the Company's directors, each of the named executive officers in the Summary Compensation Table and all directors and officers of the Company as a group. The shares owned by all directors and officers as a group constitute less than one percent of the total shares outstanding. Amount and Nature of Name Title of Security Beneficial Ownership R. C. Arnold GPU Common Stock 6,751 shares-Direct J. G. Graham GPU Common Stock 6,411 shares-Direct 1,780 shares-Indirect J. G. Herbein GPU Common Stock 1,071 shares-Direct J. R. Leva GPU Common Stock 3,912 shares-Direct 100 shares-Indirect G. R. Repko GPU Common Stock 897 shares-Direct W. R. Stinson GPU Common Stock 1,132 shares-Direct R. L. Wise GPU Common Stock 5,092 shares-Direct All Directors and Officers as a Group GPU Common Stock 29,174 shares-Direct 1,880 shares-Indirect 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) See page for reference to the financial statement schedules required by this item. 1. Exhibits: 10-A 1990 Stock Plan for Employees of General Public Utilities Corporation and Subsidiaries, incorporated by reference to Exhibit 10-B of the GPU Annual Report on Form 10-K for 1993 - SEC File No. 1-6047. 10-B Form of Restricted Units Agreement under the 1990 Stock Plan, incorporated by reference to Exhibit 10-C of the GPU Annual Report on Form 10-K for 1993 - SEC File No. 1-6047. 10-C Incentive Compensation Plan for Officers of GPU System Companies, incorporated by reference to Exhibit 10-E of the GPU Annual Report on Form 10-K for 1993 - SEC File No. 1-6047. 12 Statements Showing Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends 23 Consent of Independent Accountants (b) Reports on Form 8-K: For the month of December 1993, dated December 10, 1993, under Item 5 (Other Events). For the month of February 1994, dated February 16 and February 28, 1994, under Item 5 (Other Events). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PENNSYLVANIA ELECTRIC COMPANY Dated: March 10, 1994 BY: /s/ R. L. Wise R. L. Wise, President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature and Title Date /s/ J. R. Leva March 10, 1994 J. R. Leva, Chairman (Principal Executive Officer) and Director /s/ R. L. Wise March 10, 1994 R. L. Wise, President and Director /s/ J. G. Graham March 10, 1994 J. G. Graham, Vice President (Principal Financial Officer) and Director /s/ W. R. Stinson March 10, 1994 W. R. Stinson, Vice President and Comptroller (Principal Accounting Officer) and Director /s/ R. C. Arnold March 10, 1994 R. C. Arnold, Director /s/ J. G. Herbein March 10, 1994 J. G. Herbein, Vice President, Generation and Director /s/ G. R. Repko March 10, 1994 G. R. Repko, Vice President, Customer Operations and Director PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARY COMPANIES INDEX TO SUPPLEMENTARY DATA, CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES PAGE Supplementary Data Company Statistics Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Quarterly Financial Data Consolidated Financial Statements Report of Independent Accountants Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Long-Term Debt as of December 31, 1993 Consolidated Statement of Capital Stock as of December 31, 1993 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Financial Statement Schedules V - Property, Plant and Equipment for the Years 1991 to 1993 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Years 1991 to 1993 VIII - Valuation and Qualifying Accounts for the Years 1991 to 1993 IX - Short-Term Borrowings for the Years 1991 to 1993 Schedules other than those listed above have been omitted since they are not required, are inapplicable or the required information is presented in the financial statements or notes thereto. Pennsylvania Electric Company and Subsidiary Companies MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS In 1993, earnings available for common stock decreased $3.4 million to $90.7 million. The decrease in earnings was principally the result of higher other operation and maintenance expense, the write-off of approximately $8 million of costs related to the cancellation of proposed energy-related agreements, and increased depreciation expense. These items which decreased earnings were partially offset by higher KWH revenues, the recovery of prior period transmission service revenues and lower reserve capacity expense. In 1992, earnings available for common stock decreased $6.3 million to $94.1 million. The decrease in earnings was principally because of lower kilowatt-hour revenues and decreased other income. These items which decreased earnings were offset somewhat by the effects of tax surcharge revenues for the 1991 state tax increases, lower interest charges on long- term debt and lower depreciation and amortization expenses. The earnings comparison also reflects the absence in 1992 of a nonrecurring credit with respect to a change in accounting policy resulting in the recognition of unbilled revenues in 1991 and a charge for certain TMI-2 costs in 1991. The Company's return on average common equity was 13.5% for 1993 as compared to 14.5% for 1992. REVENUES: Total revenues increased 1.3% to $908 million in 1993 after increasing 3.6% in 1992 to $896 million. The components of these changes are as follows: (In Millions) 1993 1992 Kilowatt-hour (KWH) revenues $ 6.3 $(3.4) (excluding energy portion) Energy revenues (5.2) 22.5 Other revenues 10.8 11.7 Increase in revenues $11.9 $30.8 Pennsylvania Electric Company and Subsidiary Companies Kilowatt-hour revenues KWH revenues increased in 1993 primarily from higher KWH usage by residential and commercial customers and higher capacity sales to associated companies. Revenues also increased because of new sales to the Company's principal wholesale customer. Wholesale purchases by this customer are now resold to consumers both inside and outside the Company's service territory. The 1992 federal Energy Policy Act (Energy Act) which allows transmission access and competition for wholesale customers made this possible. These out of service territory sales began during the third quarter of 1993 (See "Recent Events"). These increases were partially offset by decreased usage of industrial customers. One of the most significant reductions occurred because of the phase out of operations by the Company's largest industrial customer. KWH revenues decreased in 1992 primarily from decreased KWH sales to one principal wholesale customer and the phase out of operations of the Company's largest industrial customer. The Company's largest industrial customer accounted for approximately 5% of total KWH sales to customers in 1991, its last full year of operation. These decreases were partially offset by increased KWH sales to residential and commercial customers. Energy revenues 1993 and 1992 Changes in energy revenues do not affect earnings as they reflect corresponding changes in the energy cost rates (ECR's) billed to customers and expensed. Energy revenues decreased in 1993 as a result of decreased sales to non-associated utilities and the reclassification of certain transmission service revenues to Other revenues. The reclassification resulted from a favorable PaPUC Order allowing the Company to exclude these transmission service revenues from the Company's ECR. Partially offsetting these decreases were increased energy revenues resulting from higher energy cost rates in effect during the current periods. Energy revenues also increased in 1992 as a result of increased KWH sales to other utilities. Other revenues 1993 and 1992 Earnings were favorably affected in 1993 primarily from the reclassification of the transmission service revenues mentioned above. Earnings were also favorably affected in 1992 as a result of a timing difference in the receipt of Pennsylvania tax surcharge revenues received during 1992 for state tax increases enacted in the third quarter of 1991. For both periods other revenues reflect increased wheeling revenues. Pennsylvania Electric Company and Subsidiary Companies OPERATING EXPENSES: Power purchased and interchanged Power purchased and interchanged with affiliated companies decreased in 1993 primarily as a result of lower capacity costs. The decrease in expense favorably affected earnings because capacity costs are not recovered through energy revenues. Power purchased and interchanged with nonaffiliated companies increased in 1993 primarily from increased nonutility generation purchases. This increase was partially offset by lower purchases from other utilities. The increase in expense related to nonaffiliated purchases had little effect on earnings in 1993 because this increase was primarily comprised of energy costs which are generally recovered through energy revenues. Power purchased and interchanged increased in 1992 as a result of an increase in nonutility generation purchases and purchases from other utilities. This increase in expense had little effect on earnings in 1992 because it was comprised primarily of energy costs. Other operation and maintenance The increase in other operation and maintenance expense is due largely to higher outage activity at several of the Company's coal fired generating stations, higher payroll and higher tree trimming expenses. These increases were partially offset by the recognition of proceeds from the settlement of a property insurance claim. The decrease in other operation and maintenance expense is due largely to the absence of $9.0 million of estimated costs recognized in 1991 for preparing the TMI-2 plant for long-term monitored storage. Excluding that amount, other operation and maintenance expense remained relatively stable in 1992. Depreciation and amortization Depreciation and amortization expense increased in 1993 primarily from higher cost of removal charges and a $3.6 million charge for TMI-2 non- radiological costs not considered likely to be recovered through ratemaking. Pennsylvania Electric Company and Subsidiary Companies Depreciation and amortization expense decreased $3.9 million in 1992 primarily because of a change in depreciation rates for the year, exclusive of a $20 million charge in 1991 for the Company's share of radiological TMI-2 decommissioning costs which are not considered likely to be recovered through ratemaking. Taxes, other than income taxes 1993 and 1992 Generally, changes in taxes other than income taxes do not significantly affect earnings as they are substantially recovered in revenues. OTHER INCOME AND DEDUCTIONS: Other income, net The reduction in Other income, net is principally because of the write- off of approximately $8 million which represents the Company's share of costs related to the cancellation of proposed power supply and transmission facilities agreements between the Company and its affiliates and Duquesne Light Company (Duquesne). The decrease is mainly attributable to a reduction in interest income resulting from the 1991 collection of federal income tax refunds. INTEREST CHARGES AND PREFERRED DIVIDENDS: Interest on long-term debt increased in 1993 primarily from the issuance of additional long-term debt, offset partially by decreases associated with the refinancing of higher cost debt at lower interest rates. Other interest decreased primarily as a result of lower interest rates and lower interest on ECR overcollections resulting from the reclassification in 1993 of certain transmission service revenues (See "Energy revenues"). Interest on long-term debt decreased primarily because of the refinancing of higher cost debt at lower available interest rates in 1992. Preferred dividends decreased for both periods as a result of redemptions of preferred stock in 1993 and 1991 of $25 million and $35 million, respectively. Pennsylvania Electric Company and Subsidiary Companies LIQUIDITY AND CAPITAL RESOURCES CAPITAL NEEDS: The Company's capital needs were $150 million in 1993, consisting of cash construction expenditures. During 1993, construction funds were primarily used to continue to maintain and improve existing generating facilities, add to the transmission and distribution system and clean air act requirements. Construction expenditures are estimated to be $218 million in 1994, consisting mainly of $136 million for ongoing system development and $66 million for clean air requirements. Expenditures for maturing debt are expected to be $70 million for 1994. The Company will not have expenditures for maturing debt in 1995. In the mid 1990s, construction expenditures may include substantial amounts for clean air requirements and other system needs. Management estimates that approximately one-half of the Company's 1994 capital needs will be satisfied through internally generated funds. The Company and its affiliates' capital leases consist primarily of leases for nuclear fuel. These nuclear fuel leases are renewable annually, subject to certain conditions. An aggregate of up to $125 million of nuclear fuel costs may be outstanding at any one time for TMI-1. The Company's share of the nuclear fuel capital leases at December 31, 1993 totaled $21 million. When consumed, portions of the presently leased material will be replaced by additional leased material at a rate of approximately $9 million annually. In the event these nuclear fuel needs cannot be leased, the associated capital requirements would have to be met by other means. FINANCING: In 1993, the Company refinanced higher cost long-term debt in the principal amount of $108 million resulting in an estimated annualized after- tax savings of $1 million. Total long-term debt issued during 1993 amounted to $120 million. In addition, the Company redeemed $25 million of high- dividend rate preferred stock. In January 1994, the Company issued an aggregate of $90 million of first mortgage bonds, of which a portion of the net proceeds were used to redeem early $38 million principal amount of 6 5/8% series bonds in late February 1994. The Company has regulatory authority to issue and sell first mortgage bonds, which may be issued as secured medium-term notes, and preferred stock for various periods through 1995. Under existing authorization, the Company may issue senior securities in the amount of $330 million, of which $100 million may consist of preferred stock. The Company also has regulatory authority to incur short-term debt, a portion of which may be through the issuance of commercial paper. Pennsylvania Electric Company and Subsidiary Companies The Company's cost of capital and ability to obtain external financing is affected by its security ratings, which continue to remain well above minimum investment grade. The Company's first mortgage bonds are currently rated at an equivalent of an A rating by the three major credit rating agencies, while an equivalent of an A- rating is assigned to the preferred stock issues. In addition, the Company's commercial paper is rated as having a high credit quality. During 1993, Standard & Poor's revised its financial benchmarking standards for rating the debt of electric utilities to reflect the changing risk profiles resulting primarily from the intensifying competitive pressures in the industry. These guidelines now include an assessment of each company's business risk. Standard & Poor's new rating structure changed the business outlook for the debt ratings of approximately one-third of the industry, which moved from "A-stable" to "A-negative", meaning their credit ratings may be lowered. The Company was classified as having an "average" business risk position. Moody's announced that it expects to reduce its average credit ratings for the electric utility industry within the next three years to take into account the effects of the new competitive environment. Duff & Phelps also indicated that it intends to introduce a forecast element to its quantitative analysis to, among other things, "alert investors to the possibility of equity value reduction and credit quality deterioration." The Company's bond indenture and articles of incorporation include provisions that limit the amount of long-term debt, preferred stock and short- term debt it may issue. The Company's interest and preferred stock coverage ratios are currently in excess of indenture or charter restrictions. The ability to issue securities in the future will depend on coverages at that time. Present plans call for the Company to issue long-term debt and preferred stock during the next three years to finance construction activities and, depending on the level of interest rates, refinance outstanding senior securities. CAPITALIZATION: The Company supports its credit quality rating by maintaining capitalization ratios that permit access to capital markets at a competitive cost. Recent evaluations of the industry by credit rating agencies indicate that the Company may have to increase its equity ratio to maintain its current credit rating. The targets and actual capitalization ratios are as follows: Capitalization Target Range 1993 1992 1991 Common equity 44-47% 48% 46% 49% Preferred stock 8-10 4 7 7 Notes payable and long-term debt 48-43 48 47 44 100% 100% 100% 100% Pennsylvania Electric Company and Subsidiary Companies COMPETITIVE ENVIRONMENT: The Push Toward Competition The electric utility industry appears to be undergoing a major transition as it proceeds from a traditional rate regulated environment based on cost recovery to some combination of competitive marketplace and modified regulation of certain market segments. The industry challenges resulting from various instances of competition, deregulation and restructuring thus far have been minor compared with the impact that is expected in the future. The Public Utility Regulatory Policies Act of 1978 (PURPA) facilitated the entry of competitors into the electric generation business. Since then, more competition has been introduced through various state actions to encourage cogeneration and, most recently, the Energy Act. The Energy Act is intended to promote competition among utility and nonutility generators in the wholesale electric generation market, accelerating the industry restructuring that has been underway since the enactment of PURPA. This legislation, coupled with increasing customer demands for lower-priced electricity, is generally expected to stimulate even greater competition in both the wholesale and retail electricity markets. These competitive pressures may create opportunities to compete for new customers and revenues, as well as increase risk which could lead to the loss of customers. Operating in a competitive environment will place added pressures on utility profit margins and credit quality. Utilities with significantly higher cost structures than supportable in the marketplace may experience reduced earnings as they attempt to meet their customers' demands for lower- priced electricity. This prospect of increasing competition in the electric utility industry has already led the credit rating agencies to address and apply more stringent guidelines in making credit rating determinations. Among its provisions, the Energy Act allows the Federal Energy Regulatory Commission (FERC), subject to certain criteria, to order owners of electric transmission systems, such as the Company, to provide third parties transmission access for wholesale power transactions. The Energy Act did not give the FERC the authority, however, to order retail transmission access. That authority lies with the individual states and movement toward opening the transmission network to retail customers is currently under consideration in several states. Recent Events Competition in the electric utility industry has already played a significant role in wholesale transactions, affecting the pricing of energy sales to electric cooperatives and municipal customers. During 1993, the Company successfully negotiated power supply agreements with several existing GPU System wholesale customers in response to offers made by other utilities seeking to provide electric service at rates lower than those of Met-Ed or JCP&L. The Company has made similar offers to certain wholesale customers now being served by other utilities. Although wholesale customers represent a relatively small portion of Company's sales, the Company will continue its efforts to retain and add customers by offering competitive rates. Pennsylvania Electric Company and Subsidiary Companies The competitive forces have also begun to influence some retail pricing in the industry. In a few instances, industrial customers, threatening to pursue cogeneration, self-generation or relocation to other service territories, have leveraged price concessions from utilities. Recent state regulatory actions, such as in New Jersey, suggest that utilities may have limited success with attempting to shift costs associated with such discounts to other customers. Utilities may have to absorb, in whole or part, the effects of price reductions designed to retain large retail customers. State regulators may put a limit or cap on prices, especially for those customers unable to pursue alternative supply options. Financial Exposure In the transition from a regulated to competitive environment, there can be a significant change in the economic value of a utility's assets. Traditional utility regulation provides an opportunity for recovery of the cost of plant assets, along with a return on investment, through ratemaking. In a competitive market, the value of an asset may be determined by the market price of the services derived from that asset. If the cost of operating existing assets results in above market prices, a utility may be unable to recover all of its costs, resulting in "stranded assets" and other unrecoverable costs. This may result in write-downs to remove stranded assets from a utility's balance sheet in recognition of their reduced economic value and the recognition of other losses. Unrecovered costs will most likely be related to generation investment, purchase power contracts, and "regulatory assets", which are deferred accounting transactions whose value rests on the strength of a state regulatory decision to allow future recovery from ratepayers. In markets where there is excess capacity (as there currently is in the region including Pennsylvania) and many available sources of power supply, the market price of electricity may be too low to support full recovery of capital costs of certain existing power plants, primarily the capital intensive plants such as nuclear units. Another significant exposure in the transition to a competitive market results if the prices of a utility's existing purchase power contracts, consisting primarily of contractual obligations with nonutility generators, are higher than future market prices. Utilities locked into expensive purchase power arrangements may be forced to value the contracts at market prices and recognize certain losses. A third source of exposure is regulatory assets which if not supported by regulators would have no value in a competitive market. Financial Accounting Standard No. 71 (FAS 71), "Accounting for the Effects of Certain Types of Regulation", applies to regulated utilities that have the ability to recover their costs through rates established by regulators and charged to customers. If a portion of the Company's operations continues to be regulated, FAS 71 accounting may only be applied to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the Company no longer qualifies for FAS 71 accounting treatment, a material adverse effect on Pennsylvania Electric Company and Subsidiary Companies its results of operations and financial position may result. At this time, it is difficult for management to project the future level of stranded assets or other unrecoverable costs, if any, without knowing what the market price of electricity will be, or if regulators will allow recovery of industry transition costs from customers. Positioning the GPU System The typical electric utility today is vertically integrated, operating its plant assets to serve all customers within a franchised service territory. In the future, franchised service territories may be replaced by markets whose boundaries are defined by price, available capacity and transmission access. This may result in changes to the organizational structure of utilities and an emphasis on certain segments of the business among generation, transmission and distribution. In order to achieve a strong competitive position in a less regulated future, the GPU System has in place a strategic planning process. In the initial phases of the program, task forces are defining the principal challenges facing GPU, exploring opportunities and risks, and defining and evaluating strategic alternatives. Management is now analyzing issues associated with various competition and regulatory scenarios to determine how best to position the GPU System for a competitive environment. An initial outcome of the GPU System ongoing strategic planning process was a realignment proposed in February 1994, of certain system operations. Subject to necessary regulatory approval, a new subsidiary, GPU Generation Corporation, will be formed to operate and maintain the GPU System's fossil-fueled and hydroelectric generating stations, which are now owned and operated by the Company and its affiliates. It is also intended to combine the remaining operations of the Company and Met-Ed without merging the two companies. GPU is also developing a performance improvement and cost reduction program to help assure ongoing competitiveness, and, among other matters, will also address workforce issues in terms of compensation, size and skill mix. MEETING ENERGY DEMANDS: In response to the increasingly competitive business climate and excess capacity of nearby utilities, the Company's supply plan places an emphasis on maintaining flexibility. Supply planning focuses increasingly on short to intermediate term commitments, reliance on "spot" markets, and avoidance of long-term firm commitments. The Company is expected to experience an average growth rate in sales to customers through 1998 of about 1.7% annually. The Company will also have higher sales as a result of adding former JCP&L municipal customers and other load formerly serviced by JCP&L and Met-Ed, resulting in a total average growth of 2.3%. The Company also expects to experience peak load growth although at a somewhat lesser rate. Through 1998, the Company's plan consists of the continued utilization of existing Pennsylvania Electric Company and Subsidiary Companies generating facilities combined with present commitments for power purchases and the utilization of capacity of its affiliates. The plan also includes the continued promotion of economic energy conservation and load management programs. Given the future direction of the industry, the Company's present strategy includes minimizing the financial exposure associated with new long- term purchase commitments and the construction of new facilities by evaulating these options in terms of an unregulated power market. The Company will resist efforts to compel it to add new capacity at costs that may exceed future market prices. The Company is attempting to renegotiate higher cost long- term nonutility generation contracts where opportunities arise. New Energy Supplies The Company's supply plan includes the addition of 119 MW of presently contracted capacity by 1998 from nonutility generation suppliers. In July 1993, the Pennsylvania Public Utility Commission (PaPUC) acted to initiate a rulemaking proceeding which, in general, would establish a mandatory all source competitive bidding program by which utilities would meet their future capacity and energy needs. In November 1993, the Company filed an appeal with the Commonwealth Court seeking to overturn a PaPUC order which directs the Company to enter into two power purchase agreements with nonutility generators for a total of 160 MW under long-term contracts commencing in 1997 or later. The Company does not need this additional capacity and believes the costs associated with these contracts are not in the economic interests of its customers. In December 1993, the New Jersey Board of Regulatory Commissioners (NJBRC) denied JCP&L's petition to participate in the proposed power supply and transmission facilities agreements between the Company and its affiliates and Duquesne. As a result of this action and other developments, the Company and its affiliates notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. The capital costs of these transactions would have totaled approximately $500 million, of which the Company's share would have been approximately $117 million. Conservation and Load Management The regulatory environment in Pennsylvania encourages the development of new conservation and load management programs as evidenced by recent approval of a cost recovery mechanism for demand-side management (DSM) incentive regulations. DSM includes utility sponsored activities designed to improve energy efficiency in customer end-use, and includes load management programs (i.e., peak reduction) and conservation programs (i.e., energy and peak reduction). Pennsylvania Electric Company and Subsidiary Companies The PaPUC has recently completed its generic investigation into DSM cost recovery mechanisms and issued a cost recovery and ratemaking order in December 1993. The Company is currently developing plans which will reflect changes since its original plan was filed in 1991. New targets for DSM initiatives are currently being determined and will be identified when the new DSM plan is filed in the first quarter of 1994. ENVIRONMENTAL ISSUES: The Company is committed to complying with all applicable environmental regulations in a responsible manner. Compliance with the federal Clean Air Act Amendments of 1990 (Clean Air Act) and other environmental needs will present a major challenge to the Company through the late 1990s. The Clean Air Act will require substantial reductions in sulfur dioxide and nitrogen oxide emissions by the year 2000. The Company's current plan includes installing and operating emission control equipment at some of its coal-fired plants as well as switching to lower sulfur coal at other coal- fired plants. To comply with the Clean Air Act, the Company expects to expend up to $295 million by the year 2000 for air pollution control equipment. The Company reviews its plans and alternatives to comply with the Clean Air Act on a least-cost basis taking into account advances in technology and the emission allowance market and assesses the risk of recovering capital investments in a competitive environment. The Company may be able to defer substantial capital investments while attaining the required level of compliance if an alternative such as increased participation in the emission allowance market is determined to result in the least-cost plan. This and other compliance alternatives may result in the substitution of increased operating expenses for capital costs. At this time, costs associated with the capital invested in this pollution control equipment and the increased operating costs of the affected stations are expected to be recoverable through the ratemaking process, but management recognizes that recovery is not assured. For more information, see the Environmental Matters section of Note 1 to the consolidated financial statements. LEGAL MATTERS - TMI-2 ACCIDENT CLAIMS: As a result of the TMI-2 accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against the Company and its affiliates and GPU and are still pending. For more information, see Note 1 to the consolidated financial statements. Pennsylvania Electric Company and Subsidiary Companies EFFECTS OF INFLATION: The Company is affected by inflation since the regulatory process results in a time lag during which increased operating expenses are not fully recovered in rates. Inflation may have an even greater effect in a period of increasing competition and deregulation as the Company and the utility industry attempt to keep rates competitive. Inflation also affects the Company in the form of higher replacement costs of utility plant. In the past, the Company anticipated the recovery of these cost increases through the ratemaking process. However, as competition and deregulation accelerate throughout the industry, there can be no assurance of the recovery of these increased costs. The Company is committed to long-term cost control and is continuing to seek measures to reduce or limit the growth in operating expenses. The prudent expenditure of capital and debt refinancing programs have kept down increases in debt levels and capital costs. ACCOUNTING ISSUES: In May 1993, the Financial Accounting Standards Board issued FAS 115, "Accounting for Certain Investments in Debt and Equity Securities", which is effective for fiscal years beginning after December 15, 1993. FAS 115 requires the recording of unrealized gains and losses with a corresponding offsetting entry to earnings or shareholder's equity. The impact on the Company's financial position is expected to be immaterial and there will be no impact on the results of operations. FAS 115 will be implemented in 1994. Pennsylvania Electric Company and Subsidiary Companies QUARTERLY FINANCIAL DATA (UNAUDITED) First Quarter Second Quarter In Thousands 1993 1992 1993 1992 Operating revenues $231,148 $237,784 $219,232 $214,108 Operating income 45,279 40,832 32,357 29,356 Net income 33,212 29,832 20,246 17,870 Earnings available for common stock 31,796 28,416 18,830 16,454 Third Quarter Fourth Quarter In Thousands 1993 1992 1993 * 1992 Operating revenues $229,447 $215,750 $228,453 $228,695 Operating income 42,835 38,013 26,566 39,107 Net income 31,714 25,281 10,556 26,761 Earnings available for common stock 30,467 23,865 9,648 25,345 * Results for the fourth quarter of 1993 reflect a decrease in earnings of $4.6 million (net of income taxes of $2.7 million) for the write-off of the Duquesne transactions. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Pennsylvania Electric Company We have audited the accompanying consolidated financial statements and the financial statement schedules of Pennsylvania Electric Company and Subsidiary Companies listed in the Index on page and set forth on pages to, inclusive, of this Form 10-K. 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. These 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 the 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 Pennsylvania Electric Company and Subsidiary Companies 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 consolidated financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As more fully discussed in Note 1 to consolidated financial statements, the Company and its affiliates are unable to determine the ultimate consequences of certain contingencies which have resulted from the accident at Unit 2 of the Three Mile Island Nuclear Generating Station (TMI-2). The matters which remain uncertain are (a) the extent to which the retirement costs of TMI-2 could exceed amounts currently recognized for ratemaking purposes or otherwise accrued, and (b) the excess, if any, of amounts which might be paid in connection with claims for damages resulting from the accident over available insurance proceeds. As discussed in Notes 5 and 7 to the consolidated financial statements, the Company was required to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," and the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1993. Also, as discussed in Note 2 to the financial statements, the Company changed its method of accounting for unbilled revenues in 1991. Coopers & Lybrand 2400 Eleven Penn Center Philadelphia, Pennsylvania February 2, 1994 PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARY COMPANIES Consolidated Statements of Retained Earnings (In Thousands) For The Years Ended December 31, 1993 1992 1991 Balance, beginning of year $278 482 $289 402 $265 358 Add, net income 95 728 99 744 106 595 Total 374 210 389 146 371 953 Deduct, cash dividends on capital stock: Cumulative preferred stock (at the annual rates indicated below): 4.40% Series B ($ 4.40 a share) 250 250 250 3.70% Series C ($ 3.70 a share) 359 359 359 4.05% Series D ($ 4.05 a share) 258 258 258 4.70% Series E ($ 4.70 a share) 135 135 135 4.50% Series F ($ 4.50 a share) 193 194 194 4.60% Series G ($ 4.60 a share) 349 348 348 8.36% Series H ($ 8.36 a share) 2 090 2 090 2 090 8.12% Series I ($ 8.12 a share) 1 353 2 030 2 030 9.00% Series L ($ 2.25 a share) - - 525 Common stock (not declared on a per share basis) 40 000 105 000 75 000 Total 44 987 110 664 81 189 Deduct, other adjustments 933 - 1 362 Balance, end of year $328 290 $278 482 $289 402 The accompanying notes are an integral part of the consolidated financial statements. PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARY COMPANIES Consolidated Statement of Long-Term Debt December 31, 1993 (In Thousands) First Mortgage Bonds-Series as noted (a)(b): 9.35 %, due 1994 $40 000 7.92 %, due 2002 $10 000 8.50 %, due 1994 30 000 7.40 %, due 2003 10 000 7.45 %, due 1996 30 000 6.60 %, due 2003 30 000 6 1/4%, due 1996 25 000 7.48 %, due 2004 40 000 6.80 %, due 1996 20 000 6.10 %, due 2004 30 000 6 1/4%, due 1997 26 000 7 3/4%, due 2006 12 000 6 5/8%, due 1998 38 000 8.05 %, due 2006 10 000 8.72 %, due 1999 30 000 6 1/8%, due 2007 16 420 6.15 %, due 2000 30 000 8 3/8%, due 2015 20 000 (c) 8.70 %, due 2001 30 000 6 1/2%, due 2016 25 000 (c) 7.40 %, due 2002 10 000 8.33 %, due 2022 20 000 7.43 %, due 2002 30 000 7.49 %, due 2023 30 000 Subtotal $592 420 Maturities and sinking fund requirements due within one year (70 000) 522 420 Other long-term debt 3 084 Other current obligations (8) Subtotal 3 076 Unamortized net discount on long-term debt (1 005) Total long-term debt $524 491 (a) Substantially all of the properties owned by the Company are subject to the lien of the mortgage. (b) For the years 1994, 1996, 1997 and 1998, the Company has total long-term debt maturities of $70.0 million, $75.0 million, $26.0 million and $38.0 million, respectively. The Company has no long-term debt maturities in 1995. (c) Effective as of any June 1 or December 1, the interest rate may be converted, at the option of the registered holder thereof, to a variable rate. The accompanying notes are an integral part of the consolidated financial statements. PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARY COMPANIES Consolidated Statement of Capital Stock December 31, 1993 (In Thousands) Cumulative preferred stock, without par value, 11,435,000 shares authorized, 615,000 shares issued and outstanding, without mandatory redemption (a)&(b): 56 810 shares, 4.40% Series B (callable at $108.25 per share) $ 5 681 97 054 shares, 3.70% Series C (callable at $105.00 per share) 9 705 63 696 shares, 4.05% Series D (callable at $104.53 per share) 6 370 28 739 shares, 4.70% Series E (callable at $105.25 per share) 2 874 42 969 shares, 4.50% Series F (callable at $104.27 per share) 4 297 75 732 shares, 4.60% Series G (callable at $104.25 per share) 7 573 250 000 shares, 8.36% Series H (callable at $104.09 per share) 25 000 Subtotal - Cumulative preferred stock issued 61 500 Premium on cumulative preferred stock 342 Total cumulative preferred stock $ 61 842 Common stock, par value $20 per share, 5,400,000 shares authorized, 5,290,596 shares issued and outstanding $105 812 (a) If dividends upon any shares of preferred stock are in arrears in an amount equal to the annual dividend, the holders of preferred stock, voting as a class, are entitled to elect a majority of the board of directors until all dividends in arrears have been paid. No redemptions of preferred stock may be made unless dividends on all preferred stock for all past quarterly dividend periods have been paid or declared and set aside for payment. Stated value of the Company's cumulative preferred stock is $100 per share. (b) No shares of capital stock have been sold during the three years ended December 31, 1993. All of the issued and outstanding shares of the 9% Series L (1,400,000 shares, stated value $35,000,000) and the 8.12% Series I (250,000 shares, stated value $25,000,000) cumulative preferred stock were redeemed on May 1, 1991 and September 17, 1993, respectively. The 1991 redemption of the 9% Series L and the 1993 redemption of the 8.12% Series I cumulative preferred stock resulted in charges to Retained Earnings of $1.4 million and $.9 million, respectively. No shares of capital stock were redeemed or repurchased during 1992. The accompanying notes are an integral part of the consolidated financial statements. Pennsylvania Electric Company and Subsidiary Companies NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Pennsylvania Electric Company (Company), a Pennsylvania corporation incorporated in 1919, is a wholly-owned subsidiary of General Public Utilities Corporation (GPU), a holding company registered under the Public Utility Holding Company Act of 1935. The Company has two minor wholly-owned subsidiaries. The Company is affiliated with Jersey Central Power & Light Company (JCP&L) and Metropolitan Edison Company (Met-Ed). The Company, JCP&L and Met-Ed are referred to herein as the "Company and its affiliates". The Company is also affiliated with GPU Service Corporation (GPUSC), a service company; GPU Nuclear Corporation (GPUN), which operates and maintains the nuclear units of the Company and its affiliates; and General Portfolios Corporation (GPC), parent of Energy Initiatives, Inc., which develops, owns, and operates nonutility generating facilities. The Company and its affiliates, GPUSC, GPUN and GPC considered together are referred to as the "GPU System." 1. COMMITMENTS AND CONTINGENCIES NUCLEAR FACILITIES The Company has made investments in two major nuclear projects -- Three Mile Island Unit 1 (TMI-1), which is an operational generating facility, and Three Mile Island Unit 2 (TMI-2), which was damaged during a 1979 accident. At December 31, 1993, the Company's net investment in TMI-1, including nuclear fuel, was $165 million. TMI-1 and TMI-2 are jointly owned by the Company, JCP&L and Met-Ed in the percentages of 25%, 25% and 50%, respectively. Costs associated with the operation, maintenance and retirement of nuclear plants have continued to increase and become less predictable, in large part due to changing regulatory requirements and safety standards and experience gained in the construction and operation of nuclear facilities. The Company and its affiliates may also incur costs and experience reduced output at their nuclear plants because of the design criteria prevailing at the time of construction and the age of the plants' systems and equipment. In addition, for economic or other reasons, operation of these plants for the full term of their now assumed lives cannot be assured. Also, not all risks associated with ownership or operation of nuclear facilities may be adequately insured or insurable. Consequently, the ability of electric utilities to obtain adequate and timely recovery of costs associated with nuclear projects, including replacement power, any unamortized investment at the end of the plants' useful life (whether scheduled or premature), the carrying costs of that investment and retirement costs, is not assured. Management intends, in general, to seek recovery of any such costs described above through the ratemaking process, but recognizes that recovery is not assured. Pennsylvania Electric Company and Subsidiary Companies TMI-2: The 1979 TMI-2 accident resulted in significant damage to, and contamination of, the plant and a release of radioactivity to the environment. The cleanup program was completed in 1990. After receiving Nuclear Regulatory Commission (NRC) approval, TMI-2 entered into long-term monitored storage in December 1993. As a result of the accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against GPU and the Company and its affiliates. Approximately 2,100 of such claims are pending in the U.S. District Court for the Middle District of Pennsylvania. Some of the claims also seek recovery for injuries from alleged emissions of radioactivity before and after the accident. Questions have not yet been resolved as to whether the punitive damage claims are (a) subject to the overall limitation of liability set by the Price-Anderson Act ($560 million at the time of the accident) and (b) outside the primary insurance coverage provided pursuant to that Act (remaining primary coverage of approximately $80 million as of December 31, 1993). If punitive damages are not covered by insurance or are not subject to the Price-Anderson liability limitation, punitive damage awards could have a material adverse effect on the financial position of the GPU System. In June 1993, the District Court agreed to permit pre-trial discovery on the punitive damage claims to proceed. A trial of twelve allegedly representative cases is scheduled to begin in October 1994. In February 1994, the Court held that the plaintiffs' claims for punitive damages are not barred by the Price-Anderson Act to the extent that the funds to pay punitive damages do not come out of the U.S. Treasury. The Court also denied the defendants' motion seeking a dismissal of all cases on the grounds that the defendants complied with applicable federal safety standards regarding permissible radiation releases from TMI-2 and that, as a matter of law, the defendants therefore did not breach any duty that they may have owed to the individual plaintiffs. The Court stated that a dispute about what radiation and emissions were released cannot be resolved on a motion for summary judgment. NUCLEAR PLANT RETIREMENT COSTS Retirement costs for nuclear plants include decommissioning the radiological portions of the plants and the cost of removal of nonradiological structures and materials. As described in the Nuclear Fuel Disposal Fee section of Note 2, the disposal of spent nuclear fuel is covered separately by contracts with the U.S. Department of Energy (DOE). In 1990, the Company and its affiliates submitted a report, in compliance with NRC regulations, setting forth a funding plan (employing the external sinking fund method) for the decommissioning of their nuclear reactors. Under this plan, the Company and its affiliates intend to complete the funding for TMI-1 by the end of the plant's license term, 2014. The TMI- 2 funding completion date is 2014, consistent with TMI-2 remaining in long- term storage and being decommissioned at the same time as TMI-1. Under Pennsylvania Electric Company and Subsidiary Companies the NRC regulations, the funding target (in 1993 dollars) for TMI-1 is $143 million, of which the Company's share is $36 million. Based on NRC studies, a comparable funding target for TMI-2 (in 1993 dollars), which takes into account the accident, is $228 million, of which the Company's share would be $57 million. The NRC is currently studying the levels of these funding targets. Management cannot predict the effect that the results of this review will have on the funding targets. NRC regulations and a regulatory guide provide mechanisms, including exemptions, to adjust the funding targets over their collection periods to reflect increases or decreases due to inflation and changes in technology and regulatory requirements. The funding targets, while not actual cost estimates, are reference levels designed to assure that licensees demonstrate adequate financial responsibility for decommissioning. While the regulations address activities related to the removal of the radiological portions of the plants, they do not establish residual radioactivity limits nor do they address costs related to the removal of nonradiological structures and materials. In 1988, a consultant to GPUN performed a site-specific study of TMI-1 that considered various decommissioning plans and estimated the cost of decommissioning the radiological portions of TMI-1 to range from approximately $205 to $285 million (adjusted to 1993 dollars), of which the Company's share would range between approximately $51 to $71 million. In addition, the study estimated the cost of removal of nonradiological structures and materials for TMI-1 at $72 million, of which the Company's share would be $18 million. The ultimate cost of retiring the Company and its affiliates' nuclear facilities may be materially different from the funding targets and the cost estimates contained in the site-specific studies and cannot now be more reasonably estimated than the level of the NRC funding target because such costs are subject to (a) the type of decommissioning plan selected, (b) the escalation of various cost elements (including, but not limited to, general inflation), (c) the further development of regulatory requirements governing decommissioning, (d) the absence to date of significant experience in decommissioning such facilities and (e) the technology available at the time of decommissioning. The Company is charging to expense and contributing to external trusts amounts collected from customers for nuclear plant decommissioning and nonradiological costs. In addition, the Company has contributed to external trusts amounts written off for nuclear plant decommissioning in 1991. TMI-1: Effective October 1993, the Pennsylvania Public Utility Commission (PaPUC) approved a rate change for the Company which increased the collection of revenues for decommissioning costs for TMI-1 based on its share of the NRC funding target and nonradiological cost of removal as estimated in the site- specific study. Collections from customers for decommissioning expenditures are deposited in external trusts and are classified as Decommissioning Funds on the balance sheet, which includes the interest earned on these funds. Provision for the future expenditure of these funds has been made in accumulated depreciation, amounting to $4 million at December 31, 1993. Pennsylvania Electric Company and Subsidiary Companies Management believes that any TMI-1 retirement costs, in excess of those currently recognized for ratemaking purposes, should be recoverable through the ratemaking process. TMI-2: The Company and its affiliates have recorded a liability amounting to $229 million (of which the Company's share was $57 million) as of December 31, 1993, for the radiological decommissioning of TMI-2, reflecting the NRC funding target (unadjusted for an immaterial decrease in 1993). The Company and its affiliates record escalations, when applicable, in the liability based upon changes in the NRC funding target. The Company and its affiliates have also recorded a liability in the amount of $20 million (of which the Company's share was $5 million) for incremental costs specifically attributable to monitored storage. Such costs are expected to be incurred between 1994 and 2014, when decommissioning is forecast to begin. In addition, the Company and its affiliates have recorded a liability in the amount of $71 million (of which the Company's share was $18 million) for nonradiological cost of removal. The above amounts for retirement costs and monitored storage are reflected as Three Mile Island Unit 2 Future Costs on the balance sheet. The Company has made a nonrecoverable contribution of $20 million to an external decommissioning trust relating to its share of the accident-related portion of the decommissioning liability. The PaPUC has granted Met-Ed decommissioning revenues for its share of the remainder of the NRC funding target and allowances for its share of the cost of removal of nonradiological structures and materials. In March 1993, a PaPUC rate order for Met-Ed allowed for the future recovery of certain TMI-2 retirement costs. In May 1993, the Pennsylvania Office of Consumer Advocate filed a petition for review with the Pennsylvania Commonwealth Court seeking to set aside the PaPUC's 1993 Met-Ed rate order. The matter is pending before the court. If the 1993 rate order is reversed, the Company would be required to write off a total of approximately $50 million for retirement costs. The Company intends to request decommissioning revenues and an allowance for the cost of removal of nonradiological structures and materials, equivalent to its share of the amounts granted to Met-Ed, in its next retail base rate filing. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. Upon TMI-2's entering long-term monitored storage, the Company and its affiliates will incur currently estimated incremental annual storage costs of $1 million (of which the Company's share will be $.25 million). The Company and its affiliates have deferred the $20 million (of which the Company's share was $5 million) for the total estimated incremental costs attributable to monitored storage. The Company believes these costs should be recoverable through the ratemaking process. Pennsylvania Electric Company and Subsidiary Companies INSURANCE The GPU System has insurance (subject to retentions and deductibles) for its operations and facilities including coverage for property damage, liability to employees and third parties, and loss of use and occupancy (primarily incremental replacement power costs). There is no assurance that the GPU System will maintain all existing insurance coverages. Losses or liabilities that are not completely insured, unless allowed to be recovered through ratemaking, could have a material adverse effect on the financial position of the Company. The decontamination liability, premature decommissioning and property damage insurance coverage for the TMI station (TMI-1 and TMI-2 are considered one site for insurance purposes) totals $2.7 billion. In accordance with NRC regulations, these insurance policies generally require that proceeds first be used for stabilization of the reactors and then to pay for decontamination and debris removal expenses. Any remaining amounts available under the policies may then be used for repair and restoration costs and decommissioning costs. Consequently, there can be no assurance that in the event of a nuclear incident, property damage insurance proceeds would be available for the repair and restoration of the stations. The Price-Anderson Act limits the GPU System's liability to third parties for a nuclear incident at one of its sites to approximately $9.4 billion. Coverage for the first $200 million of such liability is provided by private insurance. The remaining coverage, or secondary protection, is provided by retrospective premiums payable by all nuclear reactor owners. Under secondary protection, a nuclear incident at any licensed nuclear power reactor in the country, including those owned by the GPU System, could result in assessments of up to $79 million per incident for each of the GPU System's reactors, subject to an annual maximum payment of $10 million per incident per reactor. In 1993, GPUN requested an exemption from the NRC to eliminate the secondary protection requirements for TMI-2. This matter is pending before the NRC. The Company and its affiliates have insurance coverage for incremental replacement power costs resulting from an accident-related outage at their nuclear plants. Coverage for TMI-1 commences after the first 21 weeks of the outage and continues for three years at decreasing levels beginning at a weekly amount of $2.6 million. Under its insurance policies applicable to nuclear operations and facilities, the Company and its affiliates are subject to retrospective premium assessments of up to $52 million in any one year (of which the Company's share is $7 million), in addition to those payable under the Price-Anderson Act. Pennsylvania Electric Company and Subsidiary Companies ENVIRONMENTAL MATTERS As a result of existing and proposed legislation and regulations, and ongoing legal proceedings dealing with environmental matters, including but not limited to acid rain, water quality, air quality, global warming, electromagnetic fields, and storage and disposal of hazardous and/or toxic wastes, the Company may be required to incur substantial additional costs to construct new equipment, modify or replace existing and proposed equipment, remediate or clean up waste disposal and other sites currently or formerly used by it, including formerly owned manufactured gas plants and mine refuse piles, and with regard to electromagnetic fields, postpone or cancel the installation of, or replace or modify, utility plant, the costs of which could be material. Management intends to seek recovery through the ratemaking process for any additional costs, but recognizes that recovery cannot be assured. To comply with the federal Clean Air Act Amendments of 1990, the Company expects to expend up to $295 million for air pollution control equipment by the year 2000. Costs associated with the capital invested in this equipment and the increased operating costs of the affected stations should be recoverable through the ratemaking process. The Company has been notified by the Environmental Protection Agency (EPA) and state environmental authorities that it is among the potentially responsible parties (PRPs) who may be jointly and severally liable to pay for the costs associated with the investigation and remediation at two hazardous and/or toxic waste sites. In addition, the Company has been requested to supply information to the EPA and state environmental authorities on several other sites for which it has not as yet been named a PRP. The Company has also been named in lawsuits requesting damages for hazardous and/or toxic substances allegedly released into the environment. The ultimate cost of remediation will depend upon changing circumstances as site investigations continue, including (a) the existing technology required for site cleanup, (b) the remedial action plan chosen and (c) the extent of site contamination and the portion attributed to the Company. The Company is unable to estimate the extent of possible remediation and associated costs of additional environmental matters. Also unknown are the consequences of environmental issues, which could cause the postponement or cancellation of either the installation or replacement of utility plant. Management believes the costs described above should be recoverable through the ratemaking process. OTHER COMMITMENTS AND CONTINGENCIES The PaPUC is considering generic nuclear performance standards for Pennsylvania utilities. At the request of the PaPUC, the Company, Pennsylvania Electric Company and Subsidiary Companies as well as the other Pennsylvania utilities, have supplied the PaPUC with proposals which may result in the PaPUC adopting a generic nuclear performance standard in the future. In December 1993, the NJBRC denied JCP&L's request to participate in the proposed power supply and transmission facilities agreements between the Company and its affiliates and Duquesne Light Company (Duquesne). As a result of this action and other developments, the Company and its affiliates notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. Consequently, the Company wrote off the approximately $8 million it had invested in the project. The Company's construction program, for which substantial commitments have been incurred and which extends over several years, contemplate expenditures of approximately $218 million during 1994. As a consequence of reliability, licensing, environmental and other requirements, substantial additions to utility plant may be required relatively late in their expected service lives. If such additions are made, current depreciation allowance methodology may not make adequate provision for the recovery of such investments during their remaining lives. Management intends to seek recovery of any such costs through the ratemaking process, but recognizes that recovery is not assured. As a result of the Energy Policy Act of 1992 (Energy Act) and actions of regulatory commissions, the electric utility industry appears to be moving toward a combination of competition and a modified regulatory environment. In accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (FAS 71), the Company's financial statements reflect assets and costs based on current cost- based ratemaking regulations. Continued accounting under FAS 71 requires that the following criteria be met: a) A utility's rates for regulated services provided to its customers are established by, or are subject to approval by, an independent third-party regulator; b) The regulated rates are designed to recover specific costs of providing the regulated services or products; and c) In view of the demand for the regulated services and the level of competition, direct and indirect, it is reasonable to assume that rates set at levels that will recover a utility's costs can be charged to and collected from customers. This criteria requires consideration of anticipated changes in levels of demand or competition during the recovery period for any capitalized costs. Pennsylvania Electric Company and Subsidiary Companies A utility's operations can cease to meet those criteria for various reasons, including deregulation, a change in the method of regulation, or a change in the competitive environment for the utility's regulated services. Regardless of the reason, a utility whose operations cease to meet those criteria should discontinue application of FAS 71 and report that discontinuation by eliminating from its balance sheet the effects of any actions of regulators that had been recognized as assets and liabilities pursuant to FAS 71 but which would not have been recognized as assets and liabilities by enterprises in general. If a portion of the Company's operations continues to be regulated and meets the above criteria, FAS 71 accounting may only be applied to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the Company no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. The Company has entered into long-term contracts with nonaffiliated mining companies for the purchase of coal for its Homer City generating station in which it has a fifty percent ownership interest. The contracts, which expire between 1995 and 2003, require the purchase of fixed amounts of coal. Under the contracts the price of coal is based on adjustments of indexed cost components. One contract also includes a provision for the payment of environmental and post-employment benefits. The Company's share of the cost of coal purchased under these agreements is expected to aggregate $55 million for 1994. The Company and its affiliates have entered into agreements with other utilities for the purchase of capacity and energy for various periods through 1999. These agreements provide for up to 2,130 MW in 1994, declining to 1,307 MW in 1995 and 183 MW by 1999. Payments pursuant to these agreements are estimated to aggregate $244 million in 1994. The price of the energy purchased under these agreements is determined by contracts providing generally for the recovery by the sellers of their costs. The Company has also entered into power purchase agreements with independently owned power production facilities (nonutility generators) for the purchase of energy and capacity for periods up to 25 years. The majority of these agreements are subject to penalties for nonperformance and other contract limitations. All of these facilities are must-run and generally obligate the Company to purchase all of the power produced up to the contract limits. The agreements have been approved by the PaPUC and permit the Company to recover energy and demand costs from customers through its energy clause. These agreements provide for the sale of approximately 412 MW of capacity and energy to the Company by the mid 1990s. As of December 31, 1993, facilities covered by these agreements having 293 MW of capacity were in service. Pennsylvania Electric Company and Subsidiary Companies Payments made pursuant to these agreements were $104 million, $77 million and $61 million for 1993, 1992 and 1991, respectively, and are estimated to aggregate $121 million for 1994. The price of the energy and capacity to be purchased under these agreements is determined by the terms of the contracts. The rates payable under a number of these agreements are in excess of current market prices. While the Company has been granted full recovery of these costs from customers by the PaPUC, there can be no assurance that the Company will continue to be able to recover these costs throughout the term of the related contracts. The emerging competitive market has created additional uncertainty regarding the forecasting of the Company's energy supply needs which, in turn, has caused the Company to change its supply strategy to seek shorter term agreements offering more flexibility. At the same time, the Company is attempting to renegotiate presently higher cost long-term nonutility generation contracts where opportunities arise. The extent to which the Company may be able to do so, however, or recover associated costs through rates, is uncertain. Moreover, these efforts have led to disputes before the PaPUC, as well as to litigation, and may result in claims against the Company for substantial damages. There can be no assurance as to the outcome of these matters. During the normal course of the operation of its business, in addition to the matters described above, the Company is from time to time involved in disputes, claims and, in some cases, as defendants in litigation in which compensatory damages are sought by customers, contractors, vendors and other suppliers of equipment and services and by employees alleging unlawful employment practices. It is not expected that the outcome of these matters will have a material effect on the Company's financial position or results of operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES SYSTEM OF ACCOUNTS The consolidated financial statements include the accounts of the Company and its subsidiaries. Certain reclassifications of prior years' data have been made to conform with current presentation. The Company's accounting records are maintained in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by the PaPUC. REVENUES The Company recognizes electric operating revenues for services rendered and, beginning in 1991, an estimate of unbilled revenues to record services provided to the end of the respective accounting period. DEFERRED ENERGY COSTS Energy costs are recognized in the period in which the related energy clause revenues are billed. Pennsylvania Electric Company and Subsidiary Companies UTILITY PLANT It is the policy of the Company to record additions to utility plant (material, labor, overhead and an allowance for funds used during construction) at cost. The cost of current repairs and minor replacements is charged to appropriate operating and maintenance expense and clearing accounts and the cost of renewals is capitalized. The original cost of utility plant retired or otherwise disposed of is charged to accumulated depreciation. DEPRECIATION The Company provides for depreciation at annual rates determined and revised periodically, on the basis of studies, to be sufficient to depreciate the original cost of depreciable property over estimated remaining service lives, which are generally longer than those employed for tax purposes. The Company used depreciation rates which, on an aggregate composite basis, resulted in annual rates of 2.74%, 2.86% and 3.08% for the years 1993, 1992 and 1991, respectively. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) The Uniform System of Accounts defines AFUDC as "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 recorded as a charge to construction work in progress, and the equivalent credits are to interest charges for the pretax cost of borrowed funds and to other income for the allowance for other funds. While AFUDC results in an increase in utility plant and represents current earnings, it is realized in cash through depreciation or amortization allowances only when the related plant is recognized in rates. On an aggregate composite basis, the annual rates utilized were 4.91%, 4.15% and 8.50% for the years 1993, 1992 and 1991, respectively. AMORTIZATION POLICIES Accounting for TMI-2 Investment: The Company has collected all of its TMI-2 investment attributable to its retail customers. Because the Company had not been provided revenues for a return on the unamortized balance of its share of the damaged TMI-2 facility, this investment was carried at its discounted present value. The related annual accretion, which represents the carrying charges that are accrued as the asset is written up from its discounted value, is recorded in Other Income, Net. Nuclear Fuel: Nuclear fuel is amortized on a unit of production basis. Rates are determined and periodically revised to amortize the cost over the useful life. Pennsylvania Electric Company and Subsidiary Companies The Company has provided for future contributions to the Decontamination and Decommissioning Fund (part of the Energy Act) for the cleanup of enrichment plants operated by the federal government. The total liability at December 31, 1993 amounted to $6 million and is primarily reflected in Deferred Credits and Other Liabilities - Other. Utilities with nuclear plants will contribute a total of $150 million annually, based on an assessment computed on prior enrichment purchases, over a 15 year period up to a total of $2.3 billion (in 1993 dollars). The Company made its initial payment to this fund in 1993. The Company has recorded an asset for remaining amounts recoverable from ratepayers of $7 million at December 31, 1993 in Deferred Debits and Other Assets - Other. NUCLEAR OUTAGE MAINTENANCE COSTS The Company accrues its share of incremental nuclear outage maintenance costs anticipated to be incurred during scheduled nuclear plant refueling outages. NUCLEAR FUEL DISPOSAL FEE The Company is providing for its share of the estimated future disposal costs for spent nuclear fuel at TMI-1 in accordance with the Nuclear Waste Policy Act of 1982. The Company entered into a contract in 1983 with the DOE for the disposal of spent nuclear fuel. The total liability under this contract, including interest, at December 31, 1993, all of which relates to spent nuclear fuel from nuclear generation through April 1983, amounts to $12 million, and is reflected in Deferred Credits and Other Liabilities- Other. As the actual liability is in excess of the amount recovered to date from ratepayers, the Company has reflected such excess of $.5 million at December 31, 1993 in Deferred Debits and Other Assets-Other. The rates presently charged to customers provide for the collection of these costs, plus interest, over a remaining period of four years. The Company is collecting 1 mill per kilowatt-hour from its customers for spent nuclear fuel disposal costs resulting from nuclear generation subsequent to April 1983. These amounts are remitted quarterly to the DOE. INCOME TAXES The GPU System files a consolidated federal income tax return and all participants are jointly and severally liable for the full amount of any tax, including penalties and interest, which may be assessed against the group. Each subsidiary is allocated the tax reduction attributable to GPU expenses in proportion to the average common stock equity investment of GPU in such subsidiary, during the year. In addition, each subsidiary will receive in current cash payments the benefit of its own net operating loss carrybacks to the extent that the other subsidiaries can utilize such net operating loss carrybacks to offset the tax liability they would otherwise have on a separate return basis (after taking into account any investment tax credits they could utilize on a separate return basis). This method of allocation does not allow any subsidiary to pay more than its separate return liability. Pennsylvania Electric Company and Subsidiary Companies Deferred income taxes, which result primarily from liberalized depreciation methods and deferred energy costs, are provided for differences between book and taxable income. Investment tax credits (ITC) are amortized over the estimated service lives of the related facilities. Effective January 1, 1993, the Company implemented Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes" which requires the use of the liability method of financial accounting and reporting for income taxes. Under FAS 109, deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. STATEMENTS OF CASH FLOWS For the purpose of the consolidated statements of cash flows, temporary investments include all unrestricted liquid assets, such as cash deposits and debt securities, with maturities generally of three months or less. 3. SHORT-TERM BORROWING ARRANGEMENTS At December 31, 1993, the Company had $102 million of short-term notes outstanding, of which $37 million was commercial paper and the remainder was issued under bank lines of credit (credit facilities). GPU and the Company and its affiliates have $398 million of credit facilities, which includes a Revolving Credit Agreement (Credit Agreement) with a consortium of banks that permits total borrowing of $150 million outstanding at any one time. The credit facilities generally provide for the payment of a commitment fee on the unborrowed amount of 1/8 of 1% annually. Borrowings under these credit facilities generally bear interest based on the prime rate or money market rates. Notes issued under the Credit Agreement which expires April 1, 1995, are subject to various covenants and acceleration under certain conditions. 4. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value of the Company's long-term debt, as of December 31, 1993 and 1992 is as follows: (In Thousands) Carrying Fair Amount Value 1993 $524,491 $550,751 1992 582,647 601,810 The fair value of the 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 Company for debt of the same remaining maturities. Pennsylvania Electric Company and Subsidiary Companies 5. INCOME TAXES Effective January 1, 1993, the Company implemented FAS 109 "Accounting for Income Taxes". In 1993, the cumulative effect on net income of this accounting change was immaterial. Also in 1993, the federal income tax rate changed from 34% to 35%, retroactive to January 1, 1993, resulting in an increase in the deferred tax assets of $2 million and an increase in the deferred tax liabilities of $16 million. The tax rate change did not have a material effect on net income as the changes in deferred taxes were substantially offset by the recording of regulatory assets and liabilities. The balance sheet effect as of December 31, 1993 of implementing FAS 109 resulted in a regulatory asset for income taxes recoverable through future rates of $234 million (related to liberalized depreciation), and a regulatory liability for income taxes refundable through future rates of $39 million (related to unamortized ITC), substantially due to the recognition of amounts not previously recorded. A summary of the components of deferred taxes as of December 31, 1993 follows: (In Millions) Deferred Tax Assets Deferred Tax Liabilities Current: Current: Unbilled revenue $ 1 Deferred energy $ 7 Noncurrent: Noncurrent: Unamortized ITC $39 Liberalized Decommissioning 11 depreciation: Contribution in aid previously flowed of construction 3 through $134 Other 12 future revenue Total $65 requirements 100 $234 Liberalized depreciation 205 Other 16 Total $455 Pennsylvania Electric Company and Subsidiary Companies The reconciliations from net income to book income subject to tax and from the federal statutory rate to combined federal and state effective tax rates are as follows: (In Millions) 1993 1992 1991 Net income $ 96 $ 99 $106 Income tax expense 69 71 59 Book income subject to tax $165 $170 $165 Federal statutory rate 35% 34% 34% Effect of difference between tax and book depreciation for which deferred taxes were not provided 2 3 4 Amortization of ITC (2) (2) (3) State tax, net of federal benefit 7 7 6 Other - (1) (5) Effective income tax rate 42% 41% 36% Federal and state income tax expense is comprised of the following: (In Millions) 1993 1992 1991 Provisions for taxes currently payable $ 51 $ 60 $ 59 Deferred income taxes: Liberalized depreciation 8 7 9 Decommissioning - - (8) Deferral of energy costs 11 (1) 1 Accretion income - 1 1 Unbilled revenues (1) 2 8 Nuclear outage maintenance costs 1 (1) - TMI-2 pre-monitored storage costs - 2 (4) Interest on prior years' taxes - - (4) Other 3 4 2 Deferred income taxes, net 22 14 5 Amortization of ITC, net (4) (3) (5) Income tax expense $ 69 $ 71 $ 59 The Internal Revenue Service has completed its examinations of the GPU System's federal income tax returns through 1986. The GPU System and the Internal Revenue Service have reached an agreement to settle GPU's claim that TMI-2 has been retired for tax purposes. When approved by the Joint Congressional Committee on Taxation, this settlement will provide refunds for previously paid taxes. GPU estimates that the Company would receive net refunds totaling $4 million, which would be credited to its customers. The Company would also be entitled to receive net interest estimated to total $11 million (before income taxes) through December 31, 1993, which would be credited to income. The years 1987, 1988 and 1989 are currently under audit. Pennsylvania Electric Company and Subsidiary Companies 6. SUPPLEMENTARY INCOME STATEMENT INFORMATION Maintenance expense and other taxes charged to operating expenses consisted of the following: (In Millions) 1993 1992 1991 Maintenance $81 $70 $66 Other taxes: State gross receipts $36 $35 $35 Capital stock 9 10 10 Real estate and personal property 8 8 8 Other 9 8 8 Total $62 $61 $61 For the years 1993, 1992, and 1991, the cost to the Company of services rendered to it by GPUSC amounted to approximately $37 million, $35 million and $33 million, respectively, of which approximately $25 million, $24 million and $23 million, respectively, were charged to income. For the years 1993, 1992, and 1991, the cost to the Company of services rendered to it by GPUN amounted to approximately $46 million, $40 million and $42 million, respectively, of which approximately $38 million, $31 million and $34 million, respectively, were charged to income. 7. EMPLOYEE BENEFITS Pension Plans: The Company maintains defined benefit pension plans covering substantially all employees. The Company's policy is to currently fund net pension costs within the deduction limits permitted by the Internal Revenue Code. A summary of the components of net periodic pension cost follows: (In Millions) 1993 1992 1991 Service cost-benefits earned during the period $ 8.0 $ 6.9 $ 8.7 Interest cost on projected benefit obligation 29.9 29.5 26.8 Less: Expected return on plan assets (30.4) (28.9) (27.2) Add: Amortization .1 - - Net periodic pension cost $ 7.6 $ 7.5 $ 8.3 The actual return on the plans' assets for the years 1993, 1992 and 1991 were gains of $46.1 million, $16.9 million and $61.3 million, respectively. Pennsylvania Electric Company and Subsidiary Companies The funded status of the plans and related assumptions at December 31, 1993 and 1992 were as follows: (In Millions) 1993 1992 Accumulated benefit obligation (ABO): Vested benefits $ 315.8 $ 272.0 Nonvested benefits 40.5 33.6 Total ABO 356.3 305.6 Effect of future compensation levels 63.6 57.8 Projected benefit obligation (PBO) $ 419.9 $ 363.4 PBO $ (419.9) $ (363.4) Plan assets at fair value 402.9 369.4 PBO (in excess of) less than plan assets (17.0) 6.0 Unrecognized net loss (gain) 10.7 (7.9) Unrecognized prior service credits (costs) 1.7 (4.2) Unrecognized net transition obligation 4.0 4.4 Accrued pension liability $ (.6) $ (1.7) Principal actuarial assumptions(%): Annual long-term rate of return on plan assets 8.5 8.5 Discount rate 7.5 8.5 Annual increase in compensation levels 5.0 6.0 Changes in assumptions in 1993 primarily due to reducing the discount rate assumption from 8.5% to 7.5%, resulted in a $38 million change in the PBO as of December 31, 1993. The assets of the plans are held in a Master Trust and generally invested in common stocks, fixed income securities and real estate equity investments. The unrecognized net loss represents actual experience different from that assumed, which is deferred and not included in the determination of pension cost until it exceeds certain levels. The unrecognized prior service credit or cost resulting from retroactive changes in benefits is being amortized as a charge or credit, respectively, to pension cost over the average remaining service periods for covered employees. The unrecognized net transition obligation arising out of the adoption of Statement of Financial Accounting Standards No. 87 is being amortized as a charge to pension cost over the average remaining service periods for covered employees. Savings Plans: The Company also maintains savings plans for substantially all employees. These plans provide for employee contributions up to specified limits. The Company's savings plans provide for various levels of matching contributions. The matching contributions for the Company for 1993, 1992 and 1991 were $3.0 million, $2.8 million and $2.6 million, respectively. Pennsylvania Electric Company and Subsidiary Companies Postretirement Benefits Other than Pensions: The Company provides certain retiree health care and life insurance benefits for substantially all employees who reach retirement age while working for the Company. Health care benefits are administered by various organizations. A portion of the costs are borne by the participants. For 1992 and 1991, the annual premium costs associated with providing these benefits totaled approximately $6.2 million and $5.8 million, respectively. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (FAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." FAS 106 requires that the estimated cost of these benefits, which are primarily for health care, be accrued during the employee's active working career. The Company has elected to amortize the unfunded transition obligation existing at January 1, 1993, over a period of 20 years. A summary of the components of the net periodic postretirement benefit cost for 1993 follows: (In Millions) Service cost-benefits attributed to service during the period $ 3.6 Interest cost on the accumulated postretirement benefit obligation 12.2 Expected return on plan assets (1.2) Amortization of transition obligation 6.5 Net periodic postretirement benefit cost 21.1 Less, deferred for future recovery (10.1) Postretirement benefit cost, net of deferrals $ 11.0 The actual return on the plans' assets for the year 1993 was a gain of $1.3 million. The funded status of the plans at December 31, 1993, was as follows: (In Millions) Accumulated Postretirement Benefit Obligation: Retirees $ 83.8 Fully eligible active plan participants 23.0 Other active plan participants 75.7 Total accumulated postretirement benefit obligation (APBO) $ 182.5 APBO $(182.5) Plan assets at fair value 18.6 APBO (in excess of) plan assets (163.9) Less: Unrecognized net loss 25.3 Unrecognized prior service cost 2.9 Unrecognized transition obligation 123.7 Accrued postretirement benefit liability $ (12.0) Principal actuarial assumptions (%): Annual long-term rate of return on plan assets 8.5 Discount rate 7.5 Pennsylvania Electric Company and Subsidiary Companies The Company intends to fund amounts for postretirement benefits with an independent trustee, as deemed appropriate from time to time. The plan assets include equities and fixed income securities. The Company has begun to defer the incremental postretirement benefit costs, charged to expense, associated with the adoption of FAS 106 and in accordance with Emerging Issues Task Force (EITF) Issue Number 92-12, "Accounting for OPEB Costs by Rate-Regulated Enterprises", as authorized by the PaPUC in 1993. A portion of the increase in annual costs recognized under FAS 106 of $10.1 million is being deferred and should be recoverable through the ratemaking process. The Consumer Advocate in Pennsylvania is contesting utility deferral of FAS 106 costs in a proceeding involving another utility. The outcome of this proceeding may affect the Company's recovery of deferred FAS 106 costs. The accumulated postretirement benefits obligation was determined by application of the terms of the medical and life insurance plans, including the effects of established maximums on covered costs, together with relevant actuarial assumptions and health-care cost trend rates of 14% for those not eligible for Medicare and 11% for those eligible for Medicare for 1994, decreasing gradually to 7% in 2000 and thereafter. These costs also reflect the implementation of a cost cap of 6% for individuals who retire after December 1, 1995. The effect of a 1% annual increase in these assumed cost trend rates would increase the accumulated postretirement benefit obligation by approximately $18 million and the aggregate of the service and interest cost components of net postretirement health-care cost for 1994 by approximately $2 million. Postemployment Benefits: In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (FAS 112) which addresses accounting by employers who provide benefits to former or inactive employees after employment but before retirement, which is effective for fiscal years beginning after December 15, 1993. The Company adopted the accrual method required under FAS 112 during 1993, which did not have a material impact on the financial position or results of operations of the Company. Pennsylvania Electric Company and Subsidiary Companies 8. JOINTLY OWNED STATIONS Each participant in a jointly owned station finances its portion of the investment and charges its share of operating expenses to the appropriate expense accounts. The Company participated with affiliated and nonaffiliated utilities in the following jointly owned stations at December 31, 1993: Balance (In Millions) % Accumulated Station Ownership Investment Depreciation Homer City 50 $428.9 $151.3 Three Mile Island Unit 1 25 206.2 64.4 Seneca 20 16.5 4.4 9. LEASES The Company's capital leases consist primarily of leases for nuclear fuel. Nuclear fuel capital leases at December 31, 1993 and 1992 totaled $21 million and $17 million, respectively (net of amortization of $20 million and $15 million, respectively). The recording of capital leases has no effect on net income because all leases, for ratemaking purposes, are considered operating leases. The Company and its affiliates have nuclear fuel lease agreements with nonaffiliated fuel trusts. An aggregate of up to $125 million of nuclear fuel costs may be outstanding at any one time for TMI-1. It is contemplated that when consumed, portions of the presently leased material will be replaced by additional leased material. The Company and its affiliates are responsible for the disposal costs of nuclear fuel leased under these agreements. These nuclear fuel leases are renewable annually. Lease expense consists of an amount designed to amortize the cost of the nuclear fuel as consumed plus interest costs. For the years ended December 31, 1993, 1992 and 1991 the Company's share of these amounts were $7 million, $8 million and $8 million, respectively. The leases may be terminated at any time with at least five months notice by either party prior to the end of the current period. Subject to certain conditions of termination, the Company and its affiliates are required to purchase all nuclear fuel then under lease at a price that will allow the lessor to recover its net investment.

310433_1993.txt

310433_1993

1993

310433

Item 1. Business. The Company C-TEC Corporation was organized in 1979. It is incorporated under the laws of the Commonwealth of Pennsylvania and has its principal office in Wilkes-Barre, Pennsylvania. C-TEC is a holding company with wholly-owned subsidiaries, which are engaged in various aspects of the communications industry and which are organized into five principal groups - Telephone, Cable Television, Communications Services, Mobile Services, and Long Distance. Through its wholly-owned subsidiaries, C-TEC also has ownership interests of 80% in a cable television subsidiary; 79.98% and 93.05% in two cellular telephone subsidiaries; and 53.55% in an alternative access telephone service provider. Operations Telephone The Telephone Group consists of a Pennsylvania public utility providing local telephone service to a 19 county, 5,067 square mile service territory in Pennsylvania. As of December 31, 1993, the Telephone Group provided service to approximately 211,000 main access lines. Of these 167,000 are residential and 44,000 primarily relate to business. This Group's operating territory is rural, containing only 38.8 access lines per square mile as compared to a Pennsylvania average of 151.0 lines per square mile. The Group's 79 central offices serve an average of 2,500 lines and 65 square miles. In addition to providing local telephone service, this Group provides network access and long distance services to interexchange carriers. This Group also has other revenues which are considered non-regulated and primarily relate to telecommunications equipment sales and services and billing/ collection services for interexchange long distance carriers. Today, this Group's greatest competition is for the sale of telecommunications equipment. This revenue source is not a significant portion of the Group's business. Intralata toll bypass and alternative local access telephone service providers are potential competitive threats, although no significant competition has occurred to date. Intralata toll and access revenue comprise a significant portion of the Group's business. Cable The Cable Group is a cable television operator with cable television systems located in the States of New York, New Jersey, Michigan, Delaware and Pennsylvania. The Group owns and operates cable television systems serving 224,000 customers and manages cable television systems with an additional 34,000 customers, ranking it in the top 35 of U.S. multiple system operators. - - -1- PART I Item 1. Business, continued Cable, continue During 1993, the Cable Group restructured rates and channel offerings to comply with the basic rate regulations and to minimize the impact on revenue of the Cable Television Consumer Protection and Competition Act of 1992 (the "Act"). The future impact of the Act on the Cable Group and the cable television industry is still unclear. The Cable Group's 1993 operating results were not significantly impacted by the Act. The Group's performance is dependent to a large extent on its ability to obtain and renew its franchise agreements from local government authorities on acceptable terms. To date, all of the Group's franchises have been renewed or extended, generally at or prior to their stated expirations and on acceptable terms. During 1993, the Cable Group completed negotiations with 64 communities resulting in franchise renewals on terms which are acceptable to the Group. The Cable Group has 369 franchises, 63 of which are in the 3 year Federal Communications Commission franchise renewal window at December 31, 1993. No one franchise accounts for more than 10% of the Group's total revenue. Competition for the Group's services traditionally has come from a variety of providers including broadcast television, video cassette recorders and home satellite dishes. Direct broadcast satellite (DBS) which will allow a consumer to receive cable programming for a fee once they purchase an 18 inch receiving dish and a set-top terminal for approximately $700 may increase competition in the future. Two DBS companies are scheduled to launch their services in April 1994. In addition, recent changes in federal regulation allow telephone companies to lease their networks to video programmers under the video dial-tone platform. Also, in 1993, the announced mergers of various telephone and cable companies heightened the questions about competition in the future. The current regulatory environment appears to be fostering competition in cable television by telephone companies, and in telephone by cable companies, however these regulations are still evolving. The Cable and Telephone Groups continue to monitor the progress of regulations affecting the telecommunications industry and are developing a business plan to meet future competition. It is impossible to predict at this time the impact of these technological and regulatory developments on the cable television industry in general or on the Group in particular. Mobile Services The Mobile Services Group currently operates cellular telephone systems in metropolitan service areas (MSAs) and rural areas (RSAs) throughout eight counties in Northeastern and Central Pennsylvania and 24 counties in Southeast Iowa ("IA"), serving a total population of 1.5 million. The Group also operates paging and message management services in Northeastern Pennsylvania. - - -2- PART I Item 1. Business, continued Mobile Services, continued The Pennsylvania cellular territory consists of 2 MSA and 3 RSA service areas. Vanguard Cellular is the primary competitor in the 2 MSA markets and in 1 RSA market. There is no competition in the other two RSA markets. The Iowa cellular territory consists of 1 MSA and 4 RSA markets. The Iowa market is fragmented in regards to competition. Centel Cellular is the primary competitor in the MSA market, U.S. Cellular in IA RSA 3, Contel in IA RSA 4, and CommNet 2000 in IA RSA 6. The IA RSA 11 territory is covered by two cellular competitors - U.S. West and Centel. The Group's service territory was increased with the activation of three new cell sites in Pennsylvania in 1993. The Iowa cellular properties benefited from four new cell sites in 1993. The Group increased subscribers by approximately 53% in 1993. In 1993, the Group introduced a call delivery Supersystem. Through a key strategic relationship with a neighboring service provider in Pennsylvania, the Group is now able to offer over 12,000 square miles of seamless cellular service in major surrounding travel corridors. The Supersystem allows customers to have calls automatically delivered to their roaming location in the Supersystem. Callers need only dial the customary seven-digit cellular phone number to contact the customer; roaming access numbers and codes are no longer necessary. To be competitive, the Group eliminated daily roaming charges and reduced roaming rates throughout the Supersystem area. Also instrumental in the subscriber growth has been the success of the Group's venture in the retail arena. The first company-operated retail location was opened in the fourth quarter of 1992. During 1993, the group added four additional kiosks in key population areas in the Pennsylvania market. The kiosks allow the Group to reach the ever-growing consumer market by being strategically positioned in major shopping malls, providing added shopping convenience and a continued marketing presence. Communication Services The Communications Services Group presently carries out business in the Northeastern United States providing telecommunications-related engineering and technical services. These services are provided out of the headquarters in Wilkes-Barre, Pennsylvania, and regional offices in Pennsylvania, New York City and Virginia. The services provided by the Group include telephony engineering; system integration; operation and management of telecommunications facilities for large corporate clients, hospitals and universities; and installation of premises distribution systems in large campus environments. In addition, the Communications Services Group sells, installs and maintains private branch exchanges (PBXs) in Pennsylvania and New Jersey. The Group has also expanded its engineering services to include video and data engineering, and successfully implemented several major projects during 1993. - - -3- PART I Item 1. Business, continued Communication Services, continued The Group encounters major competition from interexchange carriers (AT&T), regional bell operating companies, independent telephone companies, system integrators, interconnect companies and small independent consultants. The competition from various sources results in significant downward pressure on the prices and margins for the services the Group provides. The Group's cost effective operations and competitive pricing, flexibility to meet customer requirements, and reputation in the telecommunications industry for quality service have been its primary strengths against the competition. Long Distance The Long Distance Group presently operates in two territories. The Group began operations in 1990 by servicing the local service area of the Telephone Group. In late 1992, the Long Distance Group entered the Wilkes-Barre/Scranton territory served by Bell of PA. The primary focus in this market is the business segment. In late 1993, the Long Distance Group established sales offices in additional markets served by Bell of PA - Philadelphia, Pittsburgh, Harrisburg and Allentown. The Group provides several types of services. The primary service offered is a switched service in which a customer chooses the Long Distance Group as their long distance provider and dials the common "1+" to use the service. In addition to providing customers with direct dial long distance service, equal access also requires the Long Distance Group to offer operator services - referred to as "0+". This service provides the additional capabilities of third party billing, and calling card service, among others. The Group also provides private line service, 800 service and calling card service. The Long Distance Group is basically a "reseller" of the above services and employs the networks of several long distance providers on a wholesale basis. The Group also provides telemarketing services, primarily to cable companies. Additionally, the Long Distance Group recognized the need for an AT&T product to sell nationwide to large business customers with multiple locations. In 1992, the Group procured an AT&T Tariff 12 agreement and has also included this service as an additional line of business. The Group's recent expansion of services includes wholesale activities in which a complete line of services is offered, including marketing, billing and collection. PART I Item 1. Business, continued Long Distance, continued As a result of expansion, in 1993, the Group procured its own long distance switch. The Northern Telecom DMS-250 switch will enable the Long Distance Group to provide full service long distance, including, but not limited to, switched services, private line services, 800 services, operator services, calling card services and enhanced platform services such as message delivery and debit card at reduced rates to customers while providing quality customer service. In conjunction with the switch implementation, the Group has invested in an improved billing system possessing the capabilities to provide real time customer service inquiry, toll investigation, trouble ticketing, immediate customer interface with the local exchange carriers and direct billing on a "one bill" concept with the local exchange telephone companies. The interexchange carrier market is crowded and competitive. Recent industry surveys indicate an estimated 350-400 interexchange carriers in operation. A key development was the rapid revenue growth by regional and niche oriented companies. Although the top three carriers (AT&T, MCI and Sprint) account for almost 90% of all interexchange carrier revenue, that share declines as other interexchange carrier revenue grows almost 13% annually. Intense competition in the mid-sized business market reflects the rapid growth of business customer revenue. Estimates indicate the business market has doubled the growth rate of the residential market. It is the regional interexchange carriers who have been the major beneficiaries of the battle for the mid-sized business market. This group has shown triple revenue growth for this market segment compared to the top three carriers. The residential market is still dominated by the top three carriers. However, this domination should decline given increased price pressure combined with more aggressive marketing by the regional carriers. Locally, the Long Distance Group has mirrored the overall growth statistics of the regional carriers. Competition for the mid-sized business market has come from other similarly situated carriers rather than the top three. The primary deviation from industry growth trends is seen in the residential market segment in the Telephone Group's operating territories. Here the Long Distance Group has continued to hold the predominant market share. This dominance has not gone unnoticed however, as marketing activities by the top three carriers have been increasing in the territory. A combination of value priced products, exceptional customer service and aggressive marketing activities has been the Group's primary strength against competition. Financial information regarding the Registrant's industry segments is set forth on page XX of this Form 10-K. As of December 31, 1993, the Company had 1,282 full-time employees including general office and administrative personnel. - - -5- PART I Item 2. Item 2. Properties. C-TEC, the holding company, does not own any physical properties. The Telephone Group owns and maintains in good operating condition switching centers, cables and wires connecting the telephone company and its customers with the switching centers and other telephone instruments and equipment. These properties enable the Telephone Group to provide customers with prompt and reliable telephone service. Substantially all of the properties of the Telephone Group are subject to mortgage liens held by the United States of America acting through the Rural Electrification Administration, Federal Financing Bank, and the Rural Telephone Bank. C-TEC Cable Systems of New York, Inc., ComVideo Systems, Inc., C-TEC Cable Systems of Michigan, Inc. (the "Cable Television Group") own and maintain in good operating condition head-end, distribution and subscriber equipment. These properties enable the Cable Television Group to provide customers with state-of-the-art, reliable cable television service. Paging Plus, Inc. owns paging and answering service assets. Cellular Plus of Iowa, Inc., Iowa City Cellular Telephone Company, Inc., a 93.95% owned subsidiary, Northeast Pennsylvania SMSA Limited Partnership, a 78.98% owned subsidiary, and C-TEC Cellular Centre County, Inc. own and maintain cellular electronic equipment which provides cellular telephone services to designated metropolitan and rural service areas. Also, SRHC Inc. owns buildings in Wilkes-Barre and Dallas, PA. Item 3. Item 3. Legal Proceedings. In the normal course of business, there are various legal proceedings outstanding. In the opinion of management, these proceedings will not have a material adverse effect on 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 of the Registrant during the fourth quarter of the Registrant's 1993 fiscal year. EXECUTIVE OFFICER OF THE REGISTRANT Pursuant to General Instruction G(3) of Form 10-K, the following list is included as an un-numbered Item in Part I of this Report in lieu of being included in the definitive proxy statement relating to the Registrant's Annual Meeting of Shareholders to be filed by Registrant with the Commission pursuant to section 14 (A) of the Securities Exchange Act of 1934 (the "1934 Act"). Information with respect to Executive Officers who are also Directors is set forth in the definitive proxy statement relating to Registrant's Annual Meeting of Shareholders, and is hereby specifically incorporated herein by reference thereto. - - -6- Executive Officers of the Registrant, continued Age as of Office and Date Office Held Since: Name March 1, 1994 Other Positions Held Michael Adams 36 Vice President of Technology (since November 1993); Vice President of Technology - Mercom, Inc. (since November 1993); Vice President of Engineering - RCN Corporation (since September 1992); Vice President - McCourt Communications Co., Inc. (since June 1992); Vice President of Business Development - McCourt/Kiewit International (May 1991 - June 1992); Managing Director - McCourt Cable & Communications, Ltd. (October 1990 - June 1992); Director of Operations - MFS/McCourt (January 1990 - October 1990); Vice President of Engineering - McCourt Cable Systems, Inc. (June 1982 - January 1990). John C. Balan 59 Executive Vice President - Commonwealth Communications, Inc. (since July 1990); Vice President Marketing and Sales - Commonwealth Communications, Inc. (September 1989 - July 1990); Vice President - Marketing and Sales - Fairchild Industries (January 1984 - September 1989). Richard J. Burnheimer 35 Treasurer (since February 1994); Treasurer - Mercom, Inc. (since February 1994); Director of Finance (since February 1992); Assistant Treasurer (December 1987 - February 1994). Marc C. Elgaway 39 Executive Vice President - Mobile Services Group (since April 1989); Vice President - Mobile Services Group (since July 1988); General Manager - Commonwealth Communications, Inc., (January 1988 - July 1988); Senior Manager - Commonwealth Communications, Inc. (April 1987 - January 1988); Senior Manager Planning & Marketing Strategies - Commonwealth Communications, Inc. (August 1985 - April 1987). - - -7- Executive Officers of the Registrant, continued Age as of Office and Date Office Held Since: Name March 1, 1994 Other Positions Held Mark Haverkate 39 Vice President of Development (since December 1993); Vice President - Cable Television Group (October 1989 - December 1993); Director of Acquisitions and Development (July 1988 - October 1989); Corporate Marketing Manager - Cable Television Group (May 1987 - July 1988). Kenneth M. Jantz 51 Executive Vice President and Chief Financial Officer (since February 1994); Executive Vice President and Chief Financial Officer - Mercom, Inc. (since February 1994); Executive Vice President - Kiewit Industrial Co. (March 1992 - October 1993); Vice President and Controller - Morrison Knudsen Corporation (July 1966 - - - March 1992). B. Stephen May 45 Executive Vice President - Long Distance Group (since July 1993); Corporate Director of Marketing - Consolidated Communications, Inc. (1991 - 1993); Vice President and General Manager - American Express ISC (1989 - 1991). Michael J. Mahoeny 43 President - C-TEC Corporation (since February 1994); President - Mercom, Inc. (since February 1994); Executive Vice President - Cable Television Group (June 1991 - February 1994); Executive Vice President of Mercom, Inc., an affiliate of C-TEC (December 17, 1991 - February 1994); Chief Operating Officer - Harron Communications Corp. (April 1983 - December 1990). Paul W. Mazza 49 Executive Vice-President - Telephone Group (since December 1990); Executive Vice President - - - Cable Television Group (September 1981 - November 1990); Executive Vice President - Mobile Services Group (February 1986 - - - July 1988). - - -8- Executive Officers of the Registrant, continued Age as of Office and Date Office Held Since: Name March 1, 1994 Other Positions Held John J. Menapace 49 Vice President - Chief Administrative Officer (since December 1990); Vice President - Chief Administrative Officer - Mercom, Inc. (since March 1992); Vice President Human Resources and Administration September 1986 - December 1990); Director Network Services - Commonwealth Telephone Co. (May 1985 - September 1986); Director - Operations - Commonwealth Telephone Co. (January 1984 - May 1985); Staff & Services Manager - Commonwealth Telephone Co. (April 1983 - January 1984). Raymond B. Ostroski 39 Vice President and General Counsel (since December 1990); Secretary and General Counsel - Mercom, Inc. (since December 17, 1991); Corporate Secretary - C-TEC (since October 1989); Corporate Counsel C-TEC (August 1988 - - - December 1990); Assistant Corporate Secretary - C-TEC (April 1986 - October 1989); Associate Counsel - C-TEC (August 1985 - August 1988). PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholders There were approximately 2,258 holders of Registrant's Common Stock and 979 holders of Registrant's Class B Common Stock on March 1, 1994. The Company has maintained a no cash dividend policy since 1989. The Company does not intend to alter this policy in the foreseeable future. Other information required under Item 5 of Part II is set forth in Note 17 to the consolidated financial statements included in Part IV Item 14(a)(1) of this Form 10-K. Item 6. Item 6. Selected Financial Data. Information required under Item 6 of Part II is set forth in Part IV Item 14(a)(1) of this Form 10-K. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Information required under Item 7 of Part II is set forth in Part IV Item 14(a)(1) of this Form 10-K. - - -9- Item 8. Item 8. Financial Statements and Supplementary Data. The consolidated financial statements and supplementary data required under Item 8 of Part II are set forth in Part IV Item 14(a)(1) of this Form 10-K. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure. During the two years preceding December 31, 1993, there has been neither a change of accountants of the Registrant nor any disagreement on any matter of accounting principles, practices or financial statement disclosure. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The information required under Item 10 of Part III with respect to the Directors of Registrant is set forth in the definitive proxy statement relating to Registrant's Annual Meeting of Shareholders to be filed by the Registrant with the Commission pursuant to Section 14(A) of the 1934 Act and is hereby specifically incorporated herein by reference thereto. The information required under Item 10 of Part III with respect to the executive officers of the Registrant is set forth at the end of Part I hereof. Item 11. Item 11. Executive Compensation The information required under Item 11 of Part III is set forth in the definitive proxy statement relating to Registrant's Annual Meeting of Shareholders to be filed by the Registrant with the Commission pursuant to Section 14(A) of the 1934 Act, and is hereby specifically incorporated herein by reference thereto. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required under Item 12 of Part III is included in the definitive Proxy Statement relating to Registrant's Annual Meeting of Shareholders to be filed by Registrant with the Commission pursuant to Section 14(A) of the 1934 Act, and is hereby specifically incorporated herein by reference thereto. Item 13. Item 13. Certain Relationships and Related Transactions The information required under Item 13 of Part III is included in the definitive proxy statement to Registrant's Annual Meeting of Shareholders to be filed by Registrant with the Commission pursuant to Section 14(A) of the 1934 Act, and is hereby specifically incorporated herein by reference thereto. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K. (a)(1) Financial Statements: Description Page Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Consolidated Statements of Operations for Years Ended December 31, 1993, 1992 and 1991 - - -10- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K. (a)(1) Financial Statements: Description Page Consolidated Statements of Cash Flows for Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Common Shareholders' Equity for Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Accountants (a)(2) Financial Statement Schedules: Description Condensed Financial Information of Registrant for the Years Ended December 31, 1993, 1992 and 1991 (Schedule III) Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 (Schedule V) Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 (Schedule VI) (a)(2) Financial Statement Schedules continued Valuation and Qualifying Accounts and Reserves for the Years Ended December 31, 1993, 1992 and 1991 (Schedule VIII) Short Term Borrowings for the Years Ended December 31, 1993, 1992 and 1991 (Schedule IX) Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991 (Schedule X) All other financial statement schedules not listed have been omitted since the required information is included in the consolidated financial statements or the notes thereto, or are not applicable or required. (a)(3) Exhibits Exhibits marked with an asterisk are filed herewith and are listed in the index to exhibits on page E-1 of this Form 10-K. The remainder of the exhibits have been filed with the Commission and are incorporated herein by reference. (3) Articles of Incorporation and By-Laws - - -11- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K - continued. (a) Articles of Incorporation of Registrant as amended and restated April 24, 1986 are incorporated herein by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986, (Commission File No. 0-11053). (b) By-laws of Registrant, as amended through October 28, 1993. (4) Instruments Defining the Rights of Security Holders, Including Indentures (a) Telephone Loan Contract dated as of March 1, 1977 between Commonwealth Telephone Company ("CTCo") and the United States of America, ("USA") acting through the Administrator of the Rural Electrification Administration ("REA") is incorporated herein by reference to Exhibit 4(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, (Commission File No. 0-1094). (b) Mortgage Note dated as of June 14, 1977 made by CTCo. to the Federal Financing Bank ("FFB") is incorporated herein by reference to Exhibit B to the Form 10-Q Report of CTCo. for the quarter ended June 30, 1977. (c) Mortgage and Security Agreement dated as of June 16, 1977 made by and between CTCo. and USA acting through REA is incorporated herein by reference to Exhibit C to the Form 10-Q Report of CTCo. for the quarter ended June 30, 1977. (d) Telephone Loan Contract Amendment dated as of January 30, 1978 between CTCo., Rural Telephone Bank ("RTB"), corporation existing under the laws of the USA, and USA is incorporated herein by reference to Exhibit 4(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, (Commission File No. 0-1094). (e) Evidence of indebtedness dated as of May 26, 1978 issued under Telephone Loan Contract Amendment identified in 4(d) made by CTCo. to RTB is incorporated herein by reference to Exhibit 4(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, (Commission File No. 0-1094). (f) Supplemental Mortgage and Security Agreement dated as of May 26, 1978 made by and among CTCo., RTB and USA acting through the Administrator of REA is incorporated herein by reference to Exhibit B to the Form 10-Q Report of CTCo. for the quarter ended June 30, 1978. - - -12- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K - continued. (g) Telephone Loan Contract Amendment dated as of September 11, 1978 among CTCo., RTB and USA acting through the Administrator of REA is incorporated herein by reference to Exhibit 4(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, (Commission File No. 0-1094). (h) Mortgage Note dated as of March 19, 1980 made by CTCo. to RTB is incorporated herein by reference to Exhibit 4(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, (Commission File No. 0-1094). (i) Supplement to Supplemental Mortgage and Security Agreement dated as of March 19, 1980 by and among CTCo., RTB and USA acting through the Administrator of REA is incorporated herein by reference to Exhibit 4(i) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, (Commission File No. 0-1094). (j) Senior Secured Note Purchase Agreement dated as of July 31, 1989 among C-TEC Cable Systems, Inc., C-TEC, and various purchasers of the Senior Secured Notes is incorporated herein by reference to Exhibit 4(j) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, (Commission File No. 0-110-53). (k) Revolving Secured Credit Agreement dated as of July 31, 1989 among C-TEC Cable Systems, Inc., C-TEC and a group of commercial banks is incorporated herein by reference to Exhibit 4(k) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, (Commission File No. 0-110-53). (l) Telephone Loan Contract Amendment, dated as of September 12, 1989, among CTCo, USA acting through the Administrator of the REA, and the RTB is incorporated herein by reference to Exhibit 4(m) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, (Commission File No. 0-110-53). (m) Mortgage Note, dated July 5, 1990 payable to the order of the RTB is incorporated herein by reference to Exhibit 4(n) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, (Commission File No. 0-110-53). (n) Supplement to Supplemental Mortgage and Security Agreement, dated as of July 5, 1990, among CTCo, USA and the RTB is incorporated herein by reference to Exhibit 4(o) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, (Commission File No. 0-110-53). - - -13- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K - continued. (o) Note Purchase Agreement dated as of December 1, 1991 among C-TEC and various purchasers of senior secured notes is incorporated herein by reference to Exhibit 4(q) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, (Commission File No. 0-110- 53). (p) Amended and Restated Credit Agreement dated as of March 27, 1992 among C-TEC and a syndicate of banks is incorporated herein by reference to Exhibit 4(p) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, (Commission File No. 0-11053). (q) Amendment to 9.65% Senior Secured Note Purchase Agreement is incorporated herein by reference to Exhibit 4(q) to the Company's report on Form 10-Q for the quarter ended September 30, 1993, (Commission File No. 0-11053). (r) Amendment to Credit Agreement dated as of July 31, 1989 is incorporated herein by reference to Exhibit 4(r) to the Company's report on Form 10-Q for the quarter ended September 30, 1993, (Commission File No. 0-11053). (s) Amendment to 9.52% Senior Secured Note Purchase Agreement is incorporated herein by reference to Exhibit 4(s) to the Company's report on form 10-Q for the quarter ended September 30, 1993, (Commission File No. 0-11053). (t) Amendment to Amended and Restated Credit Agreement dated as of March 27, 1992 is incorporated herein by reference to Exhibit 4(t) to the Company's report on Form 10-Q for the quarter ended September 30, 1993, (Commission File No. 0-11053). (10) Material Contracts (a) C-TEC Corporation, 1984 Stock Option and Stock Appreciation Rights Plan (as amended) is incorporated herein by reference to Exhibit 10(a) to Form S-8 Registration Statement (as amended) of Registrant filed with the Commission, Registration Nos. 2-98305 and 33-5723. (b) Form of Stock Option Agreement is incorporated herein by reference to Exhibit 10(b) to Form S-8 Registration Statements (as amended) of Registrant filed with the Commission, Registration Nos. 2-98305 and 33-5723. - - -14- Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K - continued. (c) Form of Stock Option Agreements is incorporated herein by reference to Exhibit 10(c) to Form S-8 Registration Statements (as amended) of Registrant filed with the Commission, Registration Nos. 2-98305 and 33-5723. (d) C-TEC Corporation, Common-Wealth Builder Employee Savings Plan is incorporated herein by reference to Exhibit 28(b) to Form S-8 Registration Statements (as amended) of Registrant filed with the Commission, Registration No. 2-98306 and 33-13066. (e) Performance Incentive Compensation Plan is incorporated herein by reference to Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986, (Commission File No. 0-11053). (f) C-TEC Corporation 1994 Stock Option Plan. * (11) Computation of Per Share Earnings * (13) Annual Report to Security Holders * Registrant's Annual Report to Shareholders for 1993. (22) Subsidiaries of the Registrant * Subsidiaries of Registrant as of December 31, 1993. (24) Consent of Independent Accountants * (28) Additional Exhibits (a) Undertakings to be incorporated by reference into Form S-8 Registration Statement Nos. 2-98305, 33-5723, 2-98306 and 33-13066 are incorporated herein by reference to Exhibit 28(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1987, (Commission File No. 01-110-53). (b) Report on Form 11-K with respect to the Common-Wealth Builder Plan will be filed as an amendment to this report on Form 10-K. (b) Report on Form 8-K No report on Form 8-K has been filed by Registrant during the last quarter of the period covered by this report on Form 10-K. - - -15- 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. C-TEC CORPORATION Date: March 30, 1994 By David C. McCourt, 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 PRINCIPAL EXECUTIVE OFFICERS: David C. McCourt Chief Executive Officer March 30, 1994 Michael J. Mahoney President March 30, 1994 PRINCIPAL FINANCIAL OFFICER: Kenneth M. Jantz Executive Vice President March 30, 1994 and Chief Financial Officer - - -16- DIRECTORS: March 30, David C. McCourt March 30, 1994 James Q. Crowe March 30, 1994 Walter E. Scott, Jr. March 30, Richard R. Jaros March 30, Robert E. Julian March 30, Thomas C. Stortz March 30, David C. Mitchell March 30, Frank M. Henry March 30, Donald G. Reinhard March 30, Eugene Roth, Esquire March 30, Stuart E. Graham - - -17- Form 10-K Index to Exhibits Certain exhibits to this report on Form 10-K have been incorporated by reference. For a list of these and all exhibits, see Item 14 (a)(3) hereof. The following exhibits are being filed herewith. Exhibit No. Page (3) Articles of Incorporation and By-laws (b) By-laws of Registrant, as amended through October 28, 1993 (4) Instruments Defining the Rights of Security Holders, Including Indentures (11) Computation of Per Share Earnings (13) Annual Report to Security Holders (22) Subsidiaries of the Registrant (24) Consent of Independent Accountants - - -18-

70858_1993.txt

70858_1993

1993

70858

ITEM 1. BUSINESS GENERAL The registrant is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "Act"), with its principal assets being the stock of its subsidiaries. Through its banking subsidiaries (the "Banks") and its various non-banking subsidiaries, the registrant provides banking and banking-related services, primarily throughout the Southeast and Mid-Atlantic states and Texas. The principal executive offices of the registrant are located at NationsBank Corporate Center in Charlotte, North Carolina 28255. ACQUISITIONS On February 18, 1994, the registrant, through NationsBank of Florida, N.A. and NationsBank of Georgia, N.A., entered into an agreement with California Savings Bank, a Federal Savings Bank, to acquire for cash forty-three branches, including deposits, in Florida and one branch, including deposits, in Georgia at a purchase price of approximately $160 million. The registrant expects to complete the acquisition during the third quarter of 1994. On February 28, 1994, the registrant acquired by merger Corpus Christi National Bank ("CCNB") of Corpus Christi, Texas, which had assets at the closing date of $687 million. The registrant acquired all the outstanding capital stock of CCNB by exchanging 2.5 shares of its Common Stock for each share of CCNB common stock outstanding, resulting in a total consideration of approximately $62 million. As a result, the registrant issued 2.6 million shares of Common Stock. Effective October 1, 1993, MNC Financial Inc. ("MNC"), a bank holding company headquartered in Baltimore, Maryland, with total assets of $16.5 billion, was merged into the registrant pursuant to an Agreement and Plan of Consolidation, dated July 16, 1992, as amended, between the registrant and MNC. Based on 90.8 million shares of MNC common stock outstanding on the closing date, the purchase price for the common stock was approximately $1.39 billion. The registrant paid 50.1% of the purchase price with shares of its common stock (approximately 13.6 million shares), with cash paid in lieu of fractional shares, and 49.9% in cash (approximately $687 million). On July 28, 1993, the registrant entered into an agreement with US WEST, Inc. and US WEST Financial Services, Inc., a corporate finance subsidiary of US WEST, Inc. ("USWFS"), to acquire from USWFS for cash, approximately $2.0 billion in net receivables as well as its ongoing business. Effective December 1, 1993, the registrant completed the asset acquisition and established Nations Financial Capital Corporation. On July 2, 1993, the registrant, through NationsBank of North Carolina, N.A. completed its acquisition of substantially all the assets and certain of the liabilities of Chicago Research & Trading Group Ltd. ("CRT") and certain of its subsidiaries. Total assets at the date of purchase were approximately $12 billion and consisted primarily of trading account assets and securities purchased under agreements to resell. The options market-making and trading portion of CRT became known as NationsBanc-CRT, and the primary government securities dealer portion became a part of NationsBanc Capital Markets, Inc. On June 7, 1993, the registrant's joint venture with Dean Witter, Discover & Co. to market and sell various investment products and services in selected banking centers commenced operations as NationsSecurities, a Dean Witter/NationsBank Company. In the past, the registrant has successfully completed numerous bank and bank holding company acquisitions. As part of its operations, the registrant regularly evaluates the potential acquisition of, and holds discussions with, various financial institutions and other businesses of a type eligible for bank holding company investment. In addition, the registrant regularly analyzes the values of, and submits bids for, the acquisition of customer-based funds and other liabilities and assets of failed financial institutions. As a general rule, the registrant publicly announces such material acquisitions when a definitive agreement has been reached. BANKING OPERATIONS The registrant, through its various subsidiaries, provides a diversified range of financial services to its customers. These services include activities related to the banking business as provided through the following customer groups. The General Bank Group's services include comprehensive service in the commercial and retail banking fields; the origination and servicing of home mortgage loans; the issuance and servicing of credit cards; certain insurance services and private banking services. The Trust Group's services include trust and investment management services and mutual fund products. The Institutional Bank Group's services include comprehensive service in the corporate and investment banking fields; trading in financial futures through contractual arrangements with members of the various commodities exchanges, options market making and trading; and arranging and structuring mergers, acquisitions, leveraged buyouts, private debt placements, international financings and venture capital. The Institutional Bank Group also provides international operations through branches, merchant banks or representative offices located in London, Frankfurt, Singapore, Mexico City, Grand Cayman and Nassau, including the traditional services of paying and receiving, international collections, bankers' acceptances, letters of credit and foreign exchange services, as well as specialized international services, such as tax-based leasing, export financing of certain capital goods and raw materials and capital market services, to its corporate customers. The Secured Lending Group's services include real estate lending; commercial finance and factoring; and leasing and financing a wide variety of commercial equipment. The registrant routinely analyzes its lines of business and from time to time may increase, decrease or terminate one or more of its activities as a result of such evaluation. The following table indicates for each jurisdiction in which the registrant has banking operations its total banking assets, deposits and shareholder's equity and approximate number of banking offices, all as of December 31, 1993: (1) This subsidiary is engaged primarily in the business of issuing and servicing credit cards. In addition to the banking offices located in the above states, the various Banks have loan production offices located in New York City, Chicago, Los Angeles, Denver and Birmingham. The Banks also provide fully automated, 24-hour cash dispensing and depositing services throughout the states in which they are located. The Banks have automated teller machines (ATMs) which are linked to the PLUS, CIRRUS, VISA, MASTERCARD, and Armed Forces Financial Network (AFFN) ATM networks. ATMs in the Southeastern and Mid-Atlantic states are linked to HONOR (a regional network). ATMs in Texas are linked to the PULSE network (a regional network throughout the Southwest). ATMs in the Mid-Atlantic states also are linked to MOST (a regional network operating only in the Mid-Atlantic states). NON-BANKING OPERATIONS The registrant conducts its non-banking operations through several subsidiaries. NationsCredit Corporation and several other subsidiaries engage in consumer credit activities. Nations Financial Capital Corporation engages in corporate finance activities. NationsBanc Mortgage Corporation originates and services loans for the Banks as well as for other investors. NationsBanc Commercial Corporation and an additional subsidiary provide services related to the factoring of accounts receivable. NationsBanc Leasing Corporation and several additional subsidiaries engage in equipment and leveraged leasing activities. NationsSecurities, a Dean Witter/NationsBank Company, provides full service retail brokerage services. NationsBanc Discount Brokerage, Inc. conducts discount brokerage activities. In addition, NationsBanc Capital Markets, Inc. ("NCMI"), NationsBank's institutional securities subsidiary, underwrites and deals in bank-eligible securities (generally U.S. government and government agency securities, certain municipal securities, primarily municipal general obligation securities, and certain certificates of deposit, bankers acceptances and money market instruments) and, to a limited extent, certain bank-ineligible securities, including corporate debt, as authorized by the Federal Reserve Board under Section 20 of the Glass-Steagall Act. Through NCMI's securities underwriting authority, NationsBank provides corporate and institutional customers a broad range of debt-related financial services. GOVERNMENT SUPERVISION AND REGULATION GENERAL As a registered bank holding company, the registrant is subject to the supervision of, and to regular inspection by, the Federal Reserve Board. The registrant's banking subsidiaries are organized as national banking associations, which are subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (the "Comptroller"). The various banking subsidiaries also are subject to regulation by the FDIC and other federal bank regulatory bodies. In addition to banking laws, regulations and regulatory agencies, the registrant and its subsidiaries and affiliates are subject to various other laws and regulations and supervison and examination by other regulatory agencies, all of which directly or indirectly affect the registrant's operations, manangement and ability to make distributions. The following discussion summarizes certain aspects of those laws and regulations that affect the registrant. Proposals to change the laws and regulations governing the banking industry are frequently introduced in Congress, in the state legislatures and before the various bank regulatory agencies. For example, Federal interstate bank acquisitions and branching legislation currently is being considered by Congress which, if enacted, would permit nationwide interstate branching by the registrant. In addition, other states including Georgia, North Carolina and Virginia recently revised their banking statutes to facilitate interstate banking in other states that have similar statutes regarding interstate banking. Other states in which the registrant has banking operations are considering similar legislation. However, the likelihood and timing of any changes and the impact such changes might have on the registrant and its subsidiaries are difficult to determine. Under the Act, the registrant's activities, and those of companies which it controls or in which it holds more than 5% of the voting stock, are limited to banking or managing or controlling banks or furnishing services to or performing services for its subsidiaries, or any other activity which the Federal Reserve Board determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making such determinations, the Federal Reserve Board is required to consider whether the performance of such activities by a bank holding company or its subsidiaries can reasonably be expected to produce benefits to the public such as greater convenience, increased competition or gains in efficiency that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. Bank holding companies, such as the registrant, are required to obtain prior approval of the Federal Reserve Board to engage in any new activity or to acquire more than 5% of any class of voting stock of any company. The Act also requires bank holding companies to obtain the prior approval of the Federal Reserve Board before acquiring more than 5% of any class of voting shares of any bank which is not already majority-owned. No application to acquire shares of a bank located outside of North Carolina, the state in which the operations of the applicant's banking subsidiaries were principally conducted on the date it became subject to the Act, may be approved by the Federal Reserve Board unless such acquisition is specifically authorized by the laws of the state in which the bank whose shares are to be acquired is located. DISTRIBUTIONS The registrant's funds for cash distributions to its shareholders are derived from a variety of sources, including cash and temporary investments. The primary source of such funds, however, is dividends received from its banking subsidiaries. Without prior regulatory approval the Banks can initiate dividend payments in 1993 of up to $1.4 billion plus an additional amount equal to their net profits for 1994, as defined by statute, up to the date of any such dividend declaration. The amount of dividends that each subsidiary national bank may declare in a calendar year without approval of the Comptroller is the bank's net profits for that year combined with its net retained profits, as defined, for the preceding two years. In addition to the foregoing, the ability of the registrant and the Banks to pay dividends may be affected by the various minimum capital requirements and the capital and non-capital standards to be established under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") as described below. Furthermore, the Comptroller may prohibit the payment of a dividend by a national bank if it determines that such payment would constitute an unsafe or unsound practice. The right of the registrant, its shareholders and its creditors to participate in any distribution of the assets or earnings of its subsidiaries is further subject to the prior claims of creditors of the respective subsidiaries. DEPOSIT INSURANCE The deposits of each of the Banks are insured up to applicable limits by the FDIC. Accordingly, the Banks are subject to deposit insurance assessments to maintain the Bank Insurance Fund (the "BIF") of the FDIC. As mandated by FDICIA, the FDIC has adopted regulations effective January 1, 1993, for the transition from a flat-rate insurance assessment system to a risk-based system by January 1, 1994. Pursuant to these regulations, a financial institution's deposit insurance assessment will be within a range of 0.23 percent to 0.31 percent of its qualifying deposits, depending on the institution's risk classification. The assessment for the registrant's banks is estimated to average 25.2 cents per $100 of eligible deposits in 1994. SOURCE OF STRENGTH According to Federal Reserve Board policy, bank holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. This support may be required at times when a bank holding company may not be able to provide such support. In the event of a loss suffered or anticipated by the FDIC -- either as a result of default of a banking subsidiary of the registrant or related to FDIC assistance provided to a subsidiary in danger of default -- the other banking subsidiaries of the registrant may be assessed for the FDIC's loss, subject to certain exceptions. CAPITAL AND OPERATIONAL GUIDELINES The narrative comments under the caption "Capital" (page 48) set forth in the accompanying 1993 Annual Report to Shareholders of the registrant are hereby incorporated by reference. The Federal Reserve Board risk-based guidelines define a two-tier capital framework. Tier 1 capital consists of common and qualifying preferred shareholders' equity, less certain intangibles and other adjustments. Tier 2 capital consists of subordinated and other qualifying debt, and the allowance for credit losses up to 1.25 percent of risk-weighted assets. The sum of Tier 1 and Tier 2 capital less investments in unconsolidated subsidiaries represents qualifying total capital, at least 50 percent of which must consist of Tier 1 capital. Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. The minimum Tier 1 capital ratio is 4 percent and the minimum total capital ratio is 8 percent. The registrant's Tier 1 and total risk-based capital ratios under these guidelines at December 31, 1993 were 7.41 percent and 11.73 percent, respectively. The leverage ratio is determined by dividing Tier 1 capital by adjusted total assets. Although the stated minimum ratio is 3 percent, most banking organizations are required to maintain ratios of at least 100 to 200 basis points above 3 percent. The registrant's leverage ratio at December 31, 1993 was 6.00 percent. FDICIA identifies the five capital categories for insured depository institutions (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) and requires the respective Federal regulatory agencies to implement systems for "prompt corrective action" for insured depository institutions that do not meet minimum capital requirements within such categories. FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Failure to meet the capital guidelines could also subject a banking institution to capital raising requirements. An "undercapitalized" bank must develop a capital restoration plan and its parent holding company must guarantee that bank's compliance with the plan. The liability of the parent holding company under any such guarantee is limited to the lesser of 5 percent of the bank's assets at the time it became "undercapitalized" or the amount needed to comply with the plan. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parent's general unsecured creditors. In addition, FDICIA required the various regulatory agencies to prescribe certain non-capital standards for safety and soundness relating generally to operations and management, asset quality and executive compensation and permits regulatory action against a financial institution that does not meet such standards. The various regulatory agencies have adopted substantially similar regulations that define the five capital categories identified by FDICIA, using the total risk-based capital, Tier 1 risk-based capital and leverage capital ratios as the relevant capital measures. Such regulations establish various degrees of corrective action to be taken when an institution is considered undercapitalized. Under the regulations, a "well capitalized" institution must have a Tier 1 capital ratio of at least 6 percent, a total capital ratio of at least 10 percent and a leverage ratio of at least 5 percent and not be subject to a capital directive order. An "adequately capitalized" institution must have a Tier 1 capital ratio of at least 4 percent, a total capital ratio of at least 8 percent and a leverage ratio of at least 4 percent, or 3 percent in some cases. Under these guidelines, each of the Banks is adequately or well capitalized. ADDITIONAL INFORMATION The following information set forth in the accompanying 1993 Annual Report to Shareholders of the registrant is hereby incorporated by reference: Table 3 (pages 28 and 29) for average balance sheet amounts, related taxable equivalent interest earned or paid, and related average yields earned and rates paid. Tables 3 (pages 28 and 29) and 5 (page 31) and the narrative comments under the caption "Net Interest Income" (pages 30 and 32) for changes in taxable equivalent interest income and expense for each major category of interest-earning asset and interest-bearing liability. Tables 9 and 10 (pages 36 and 37, respectively) and the narrative comments under the caption "Securities" (pages 36 through 38) for information on the book values, maturities and weighted average yields of the securities (by category) of the registrant; and Note 5 (pages 66 and 67) of the Notes to Consolidated Financial Statements. Tables 19 (page 45), 21 (page 47) and 22 (page 48) for distribution of loans and leases, interest-rate risk and selected loan maturity data. Table 16 (page 43), the narrative comments under the caption "Nonperforming Assets" (pages 41 and 43), and Note 1 (pages 62 to 63) of the Notes to Consolidated Financial Statements for information on the nonperforming assets of the registrant. The narrative comments under the captions "Concentrations of Credit Risk" (pages 43 to 45) and "Loans and Leases" (page 38) for a discussion of the characteristics of the loan portfolio. Tables 14 (page 41) and 15 (page 42), the narrative comments under the caption "Provision for Credit Losses" (pages 32 and 33), "Allowance for Credit Losses" (pages 40 and 41) and Note 1 (page 62) of the Notes to Consolidated Financial Statements for information on the credit loss experience of the registrant. Tables 11 and 12 (pages 38 and 39, respectively) and the narrative comments under the caption "Sources of Funds" (pages 38 to 39) and Note 8 (page 68) of the Notes to Consolidated Financial Statements for deposit information. "Six-Year Consolidated Statistical Summary" (page 79) for return on assets, return on equity and dividend payout ratio for 1988 through 1993, inclusive. Table 13 (page 40) and Note 9 (pages 69 and 70) of the Notes to Consolidated Financial Statements for information on the short-term borrowings of the registrant. All tables, graphs, charts, summaries and narrative on pages 1, 25 through 55, and 78 through 79 for additional data on the consolidated operations of NationsBank Corporation and its majority-owned subsidiaries. COMPETITION The activities in which the registrant, its non-banking subsidiaries and the Banks engage are highly competitive. Generally, the lines of activity and markets served involve competition with other banks and non-bank financial institutions, as well as other entities which offer financial services, located both within and without the United States. The methods of competition center around various factors, such as customer services, interest rates on loans and deposits, lending limits and location of offices. The commercial banking business in the various local markets served by the various non-banking subsidiaries and the various Banks is highly competitive, and the non-banking subsidiaries and the Banks compete with other commercial banks, savings and loan associations and other businesses which provide similar services. The non-banking subsidiaries and the Banks actively compete in commercial lending activities with local, regional and international banks and non-bank financial organizations, some of which are larger than certain of the non-banking subsidiaries and the Banks. In its consumer lending operations, the non-banking subsidiaries and the Banks' competitors include other banks, savings and loan associations, credit unions, regulated small loan companies and other non-bank organizations offering financial services. In the trust business, the Banks compete with other banks, investment counselors and insurance companies in national markets for institutional funds and corporate pension and profit sharing accounts. The Banks also compete with other banks, insurance agents, financial counselors and other fiduciaries for personal trust business. The non-banking subsidiaries and the Banks also actively compete for funds. A primary source of funds for the Banks is deposits, and competition for deposits includes other deposit taking organizations, such as commercial banks, savings and loan associations and credit unions, and so-called "money market" mutual funds. The non-banking subsidiaries and the Banks also actively compete for funds in the open market. The registrant's ability to expand into additional states remains subject to various federal and state laws. See "Government Supervision and Regulation -- General" for a more detailed discussion of interstate branching legislation and certain state legislation. EMPLOYEES At December 31, 1993, the registrant and its subsidiaries had 57,463 full time equivalent employees. Of the foregoing employees, 1,341 were employed by the registrant holding company, 5,832 were employed by the North Carolina subsidiary bank, 7,094 were employed by the Texas subsidiary bank, 5,080 were employed by the Florida subsidiary bank, 2,417 were employed by the South Carolina subsidiary bank, 5,897 were employed by the Virginia subsidiary bank, 3,712 were employed by the Georgia subsidiary bank, 1,595 were employed by the Tennessee subsidiary bank, 5,989 were employed by the Maryland subsidiary banks, 10,268 were employed by NationsBanc Services, Inc. (a subsidiary providing operational support services to the registrant and its subsidiaries) and the remainder were employed by the registrant's other banking and operating subsidiaries. ITEM 2. ITEM 2. PROPERTIES Construction was completed in 1992 on the 60-story NationsBank Corporate Center in Charlotte, North Carolina owned by the registrant through subsidiaries who are partners in NationsBanc Corporate Center Associates. NationsBank occupies approximately 475,000 square feet at market rates under a lease which expires in 2002, and approximately 630,000 square feet of office space is available for lease to third parties at market rates. At year end, approximately 95 percent was occupied by the registrant or subject to existing third party leases or letters of intention to lease. The principal offices of NationsBank of North Carolina, N.A. ("NationsBank North Carolina") are located in leased space in the 40-story NationsBank Tower located at NationsBank Plaza, Charlotte, North Carolina. NationsBank North Carolina is the major tenant of the building with approximately 588,000 square feet of the net rentable space, of which approximately 456,000 square feet of space is under a lease which expires in 2009 and the remaining space is under leases of shorter duration. The principal offices of NationsBank of Texas, N.A. ("NationsBank Texas") are located in approximately 667,000 square feet of leased space in the 72-story NationsBank Plaza in Dallas. NationsBank Texas is the major tenant of the building under a lease which expires in 2001 with renewal options through 2011. The principal offices of NationsBank of Florida, N.A. ("NationsBank Florida") are located in approximately 304,000 square feet of leased space in the NationsBank Plaza in downtown Tampa, Florida. The lease is on a staggered schedule such that the upper floors expire in 1996 while the lower floors and branch bank expire in 2000. NationsBank Florida has four five-year renewal options on this space. The principal offices of NationsBank of Virginia, N.A. ("NationsBank Virginia") are located in approximately 470,000 square feet of space in NationsBank Center in Richmond, Virginia, a facility that is owned by NationsBank Virginia. The principal offices of NationsBank of Georgia, N.A. ("NationsBank Georgia") are located in leased space in the new 55-story NationsBank Plaza in Atlanta, Georgia which was completed in 1992. The registrant, through a subsidiary, is a partner in CSC Associates, L.P., a partnership that was formed with Cousins Properties Incorporated for the development and ownership of the office tower. NationsBank Georgia is the major tenant of the building with approximately 566,000 square feet of the net rentable space, under a lease that expires in 2012. NationsBank Georgia has three ten-year renewal options on this space. Of the approximately 668,000 remaining square feet, 417,000 square feet has been leased to third parties with 251,000 remaining square feet available for lease to third parties at market rates. The principal offices of NationsBank of South Carolina, N.A. ("NationsBank South Carolina") are located in approximately 90,921 square feet of leased space in the NationsBank Tower in Columbia, South Carolina, under a lease which expires in 1995. NationsBank South Carolina, through subsidiaries, owns partnership interests in the tower and the underlying land. In addition, NationsBank South Carolina maintains offices in approximately 81,666 square feet of leased space in NationsBank Plaza in Columbia under a lease that expires in 1999. NationsBank South Carolina has four five-year renewal options. The principal offices of NationsBank of Maryland, N.A. ("NationsBank Maryland") are located in approximately 142,000 square feet of leased space in the Rockledge Executive Center in Bethesda, Maryland under a lease that expires in 2002. NationsBank Maryland has two five-year renewal options on this space. The principal offices of Maryland National Bank are located in approximately 232,000 square feet of space in Baltimore, Maryland in a facility that is owned by Maryland National Bank. The principal offices of NationsBank of Tennessee, N.A. ("NationsBank Tennessee") are located in approximately 191,000 square feet of leased space in One Sovran Plaza in Nashville, Tennessee under a lease that expires in 2012. NationsBank Tennessee has two ten-year and one five-year renewal options on this space. The principal offices of NationsCredit are located in approximately 136,000 square feet of space in Allentown, Pennsylvania in a facility that is owned by NationsCredit. In addition, NationsCredit has approximately 287 leased premises around the country. The principal offices of Nations Financial Capital Corporation are located in approximately 42,880 square feet of leased space in Canterbury Green in Stamford, Connecticut, under a lease which expires in 1997. Nations Financial Capital Corporation, through subsidiaries or branch offices, leases space in the following states: Alabama, Arizona, Florida, Georgia, Illinois, Louisiana, Maryland, Mississippi, Nevada, Ohio, Oregon, Pennsylvania, Tennessee, Texas and Washington. As of December 31, 1993, the registrant and its subsidiaries conducted their banking and bank-related activities in both leased and owned facilities throughout the jurisdictions in which the Banks are located, as follows: ITEM 3. ITEM 3. LEGAL PROCEEDINGS The registrant and its subsidiaries are defendants in or parties to a number of pending and threatened legal actions and proceedings. Management believes, based upon the opinion of counsel, that the actions and liability and loss, if any, resulting from the final outcome of these proceedings, will not be material in the aggregate. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to security holders in the fourth quarter of the registrant's fiscal year. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The principal market on which the registrant's Common Stock (the "Common Stock") is traded is the New York Stock Exchange. The registrant also listed certain of its shares of Common Stock for trading on the Pacific Stock Exchange and on the Tokyo Stock Exchange. The high and low sales prices of Common Stock on the Composite Tape, as reported in published financial sources, for each quarterly period indicated below are as follows: As of December 31, 1993, there were 108,435 record holders of Common Stock. During 1992 and 1993, the registrant paid dividends on a quarterly basis, which aggregated $1.51 per share in 1992 and $1.64 per share in 1993. The tenth paragraph of Note 9 (page 70) and Note 12 (page 71) of the Notes to Consolidated Financial Statements in the registrant's accompanying 1993 Annual Report to Shareholders are hereby incorporated by reference. See also "Government Supervision and Regulation -- Distributions." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information set forth in Table 1 (page 25) in the registrant's accompanying 1993 Annual Report to Shareholders is hereby incorporated by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS All of the information set forth under the captions "Management's Discussion and Analysis -- 1993 Compared to 1992" (pages 25 through 50), "Management's Discussion and Analysis -- 1992 Compared to 1991" (pages 50, 51, 54 and 55), "Report of Management" (page 56) and all tables, graphs and charts presented under the foregoing captions, in the 1993 Annual Report to Shareholders of the registrant is hereby incorporated by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following information set forth in the accompanying 1993 Annual Report to Shareholders of the registrant is hereby incorporated by reference: The Consolidated Financial Statements of NationsBank Corporation and Subsidiaries together with the report thereon of Price Waterhouse dated January 14, 1994 (pages 57 through 61); all Notes to Consolidated Financial Statements (pages 62 through 77); the unaudited information presented in Table 24 (page 51); and the narrative comments under the caption "Fourth Quarter Review" (page 50). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes in or disagreements with accountants on accounting and financial disclosure as defined by Item 304 of Regulation S-K. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information set forth under the caption "Election of Directors" on pages 3 through 12 of the definitive 1994 Proxy Statement of the registrant furnished to shareholders in connection with its Annual Meeting to be held on April 27, 1994 (the "1994 Proxy Statement") with respect to the name of each nominee or director, that person's age, that person's positions and offices with the registrant, that person's business experience, that person's directorships in other public companies, that person's service on the registrant's Board and certain of that person's family relationships and information set forth in the first paragraph on page 15 of the 1994 Proxy Statement with respect to Section 16 matters is hereby incorporated by reference. CERTAIN ADDITIONAL INFORMATION CONCERNING EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to Instructions to Form 10-K and Item 401(b) of Regulation S-K, the name, age and position of each person who presently may be deemed to be an executive officer of the registrant are listed below along with such person's business experience during the past five years. Officers are appointed annually by the Board of Directors at the meeting of directors immediately following the annual meeting of shareholders. There are no arrangements or understandings between any officer and any other person pursuant to which the officer was selected. Fredric J. Figge, II, age 57, Chairman, Corporate Risk Policy of the registrant. Mr. Figge was named Chairman, Corporate Risk Policy in October, 1993 and prior to that time served as Chairman, Credit Policy of the registrant and of the Banks. He first became an officer of the registrant in September, 1987. He also serves as Chairman, Corporate Risk Policy of the Banks and as director of various subsidiaries of the registrant. James H. Hance, Jr., age 49, Vice Chairman and Chief Financial Officer of the registrant. Mr. Hance was named Chief Financial Officer in August, 1988, also served as Executive Vice President from March, 1987 to December 31, 1991 and was named Vice Chairman in October, 1993. He first became an officer of the registrant in 1987. He also serves as a director of Maryland National Bank, NationsBank of D.C., N.A., NationsBank Maryland, NationsBank Tennessee and various other subsidiaries of the registrant. Kenneth D. Lewis, age 46, President of the registrant. Mr. Lewis was named to his present position in October, 1993. Prior to that time, from June, 1990 to October, 1993 he served as President of the registrant's General Bank and from August, 1988 to June, 1990, he served as President of NationsBank Texas. He first became an officer in 1971. Mr. Lewis also serves as a director of NationsBank Florida, NationsBank Georgia, NationsBank South Carolina and NationsBank Texas. Hugh L. McColl, Jr., age 58, Chairman of the Board and Chief Executive Officer of the registrant. He first became an officer in 1962. Mr. McColl was Chairman of the registrant from September, 1983 until effectiveness of the merger of C&S/Sovran on December 31, 1991, and was re-appointed Chairman on December 31, 1992. He also serves as a director of the registrant and as Chief Executive Officer of the Banks. Marc D. Oken, age 47, Executive Vice President and Principal Accounting Officer of the registrant. Mr. Oken was named to his present position in July, 1989, and from 1983 to 1989 served as an Audit Partner with Price Waterhouse. He first became an officer in 1989. James W. Thompson, age 54, Vice Chairman of the registrant and Chairman of NationsBank East. Mr. Thompson was named Vice Chairman in October, 1993, and as Chairman of NationsBank East upon effectiveness of the merger of C&S/Sovran on December 31, 1991. He first became an officer of NationsBank North Carolina in May, 1963. He also serves as chairman of the board of directors of Maryland National Bank, NationsBank North Carolina, NationsBank of D.C., N.A., NationsBank Maryland, NationsBank South Carolina and NationsBank Virginia. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information with respect to current remuneration of executive officers, certain proposed remuneration to them, their options and certain indebtedness and other transactions set forth in the 1994 Proxy Statement (i) under the caption "Board of Directors' Compensation" on page 17 thereof, (ii) under the caption "Executive Compensation" on pages 18 and 19 thereof, (iii) under the caption "Retirement Plans" on pages 19 and 20 thereof, (iv) under the caption "Deferred Compensation Plan" on pages 20 and 21 thereof, (v) under the caption "Benefit Security Trust" on page 21 thereof, (vi) under the caption "Stock Options" on page 22 thereof, and (vii) under the caption "Certain Transactions" on pages 31 through the first paragraph on page 34 thereof, is, to the extent such information is required by Item 402 of Regulation S-K, hereby incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The security ownership information required by Item 403 of Regulation S-K and relating to persons who beneficially own more than 5% of the outstanding shares of Common Stock or ESOP Preferred Stock is hereby incorporated by reference to the second full paragraph on page 3 of the 1994 Proxy Statement. Such required ownership information relating to directors, nominees and named executive officers individually and directors and executive officers as a group is hereby incorporated by reference to the Equity Securities ownership information set forth on pages 13 through 15 of the 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information with respect to relationships and related transactions between the registrant and any director, nominee for director, executive officer, security holder owning 5% or more of the registrant's voting securities or any member of the immediate family of any of the above, as set forth in the 1994 Proxy Statement under the caption "Compensation Committee Interlocks and Insider Participation" beginning with the second full paragraph on page 29 through page 30 and under the caption "Certain Transactions" on pages 31 through the first paragraph on 34 thereof, is, to the extent such information is required by Item 404 of Regulation S-K, 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: b. The following reports on Form 8-K have been filed by the registrant during the quarter ended December 31, 1993: Current Report on Form 8-K dated and filed October 8, 1993, Items 2 and 7. Current Report on Form 8-K dated and filed October 18, 1993, Items 5 and 7. Current Report on Form 8-K dated and filed October 29, 1993, Items 5 and 7. Form 8-K/A Amendment No. 1 to Form 8-K dated and filed November 10, 1993, Item 7. c. The exhibits filed as part of this report and exhibits incorporated herein by reference to other documents are listed in the Index to Exhibits to this Annual Report on Form 10-K (pages E-1 through E-7, including executive compensation plans and arrangements which are identified separately by asterisk). With the exception of the information herein expressly incorporated by reference, the 1993 Annual Report to Shareholders and the 1994 Proxy Statement of the registrant are not to be deemed filed as part of this Annual Report on Form 10-K. SIGNATURE 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. NATIONSBANK CORPORATION Date: March 30, 1994 By: /s/ JAMES H. HANCE, JR. JAMES H. HANCE, JR. VICE CHAIRMAN AND CHIEF FINANCIAL OFFICER (PRINCIPAL FINANCIAL OFFICER) 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. II-1 II-2 INDEX TO EXHIBITS E-1 E-2 E-3 E-4 * Denotes executive compensation plan or arrangements. E-5

4672_1993.txt

4672_1993

1993

4672

ITEM 1 - BUSINESS General American Business Products was incorporated under the laws of Delaware in December 1967 to acquire the stock of Curtis 1000 Inc., a producer of envelopes and forms which has operated since 1882. Hereinafter, American Business Products, Inc. and its subsidiaries are collectively referred to as the "Company." In April 1986, the Company was reincorporated under the laws of Georgia. The Company is one of the nation's leading producers of printed business supplies, principally envelope products and custom business forms. Additionally, the Company manufactures and distributes books for the publishing industry and also is engaged in specialty extrusion coating and laminating of papers, films, and nonwoven fabrics for packaging. On September 1, 1993, the Company acquired all of the stock of Home Safety Equipment, Inc., d/b/a Discount Labels for $26,745,000. Discount Labels is located in New Albany, Indiana and is engaged in the manufacture and sale of custom-printed labels. In addition, on October 28, 1993, the Company acquired certain assets of International Envelope Company for $15,125,000. Located principally in Exton, Pennsylvania, International Envelope Company is engaged in the manufacture of envelopes. (See "Item 1 - Business - Business Segments.") Business Segments The Company's product line is among the broadest in the industry and is composed of three business segments: business supplies printing, book manufacturing, and specialty extrusion coating and laminating. Business supplies printing consists principally of the manufacture of specialty mailers and envelopes of all kinds, and the printing and production of business forms. The manufacture and distribution of specialty labels is a growing part of this segment. The Company produces a complete line of standard and special types and sizes of commercial mailing products including specialty mailers, which utilize multi-part forms and envelopes. Business forms include customized continuous forms for computer printers and word processors, snap-apart forms and checks, statements and invoices as well as other forms, with several thousand types of forms produced. Business supplies printing accounted for 74% of the Company's sales in 1993, 74% in 1992, and 77% in 1991. Book manufacturing consists of the printing and binding of both hard cover and soft cover books for the publishing industry. In addition, the Company provides storage and order fulfillment services by shipping orders to publishers' customers from a large, centrally located distribution center. This business segment accounted for 9% of the Company's sales in 1993, 9% in 1992, and 9% in 1991. Specialty extrusion coating and laminating, the Company's newest business segment, consists of applying plastic coatings in varying degrees of thickness to rolls of paper, film or fabric. The Company also prints and metalizes certain of these products for customers. The materials produced by this segment are used primarily for packaging consumer products such as individual servings of sugar, salt and pepper, sugar substitutes, and candy and ice cream bars, as well as medical and pharmaceutical products. These materials also are used for composite can liners and release liner papers for pressure sensitive products such as labels. This business segment accounted for 17% of the Company's sales in 1993, 17% in 1992, and 14% of sales in 1991. Financial information regarding the Company's three business segments is presented in the Notes to Consolidated Financial Statements under the heading "Business Segment Information" on page 24 of the Company's 1993 Annual Report, which information is incorporated herein by reference. Portions of the 1993 Annual Report are filed as Exhibit 13 to this Annual Report on Form 10-K. Production Substantially all of the Company's products are manufactured by wholly owned subsidiaries of the Company in 41 manufacturing facilities located throughout the United States. (See "Item 2 ITEM 2 - PROPERTIES The Company's executive offices are located in approximately 21,400 square feet of space at 2100 RiverEdge Parkway, Suite 1200, Atlanta, Georgia 30328. The offices are leased from an unaffiliated party under a lease expiring on January 26, 2003. The principal properties of the Company include production facilities, administrative/sales offices and warehouses. The Company operates 41 production facilities throughout the United States encompassing approximately 1,975,844 square feet. The Company owns 30 of these facilities while 11 are leased facilities. In addition, the Company and a European joint venture/partner operate production facilities which are owned or leased by the joint venture in Germany, Poland, England, and Luxembourg. The facilities in Germany and Poland are owned by the joint venture, and the facilities in England and Luxembourg are leased. The Company leases 60 administrative/sales offices and 6 warehouses, all of which are located in the United States. All of the Company's production facilities, administrative/sales offices and warehouses are used in the Company's business supplies printing business except for three of such facilities which are used in the Company's book manufacturing business and one which is used in the extrusion coating and laminating business. Certain properties owned by the Company are held subject to mortgages. See the information set forth under the heading "Long Term Debt" in the Notes to Consolidated Financial Statements on page 20 in the Company's 1993 Annual Report, which information is incorporated herein by reference. The Company believes that all of its properties and equipment are in good condition, fully utilized and suitable for the purposes for which they are being used. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS As of March 25, 1994, there were no material pending legal proceedings, other than routine litigation incidental to the business, to which the Company or its subsidiaries was a party or of which any of their properties were the subject and none are expected by management to materially effect the Company's financial position and results of operations. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of the shareholders of the Company during the fourth quarter of 1993. ITEM 4 (A) - EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below is information as of March 25, 1994 regarding the executive officers of the Company: THOMAS R. CARMODY, 60, has served as President and Chief Executive Officer of the Company since July 1988. From July 1985 until July 1988, he served as President and Chief Operating Officer and he served as Executive Vice President and Chief Operating Officer from July 1982 until July 1985. He has been a director since 1983 and has served with the Company or Curtis 1000 Inc. for over 38 years. WILLIAM C. DOWNER, 57, has served as Vice President-Finance and Chief Financial and Accounting Officer of the Company since August 1982. He has served with the Company or Curtis 1000 Inc. for over 26 years. DAWN M. GRAY, 49, has served as Secretary of the Company since July 1989. She served as Assistant Secretary from October 1976 to June 1989. She has served with the Company or Curtis 1000 Inc. for over 27 years. ROBERT W. GUNDECK, 51, has served as Executive Vice President and Chief Operating Officer of the Company since January 1993. He served as Vice President-Corporate Development of the Company from July 1990 to December 1992. He served as Director of Corporate Development from March 1988 to June 1990. He has served with the Company for over 6 years. RICHARD A. LEFEBER, 58, has served as Vice President-Administration of the Company since January 1980. He served as Secretary of the Company from August 1982 to June 1989. He has served with the Company or Curtis 1000 Inc. for over 36 years. BOBBY ROGERS, 60, has served as Vice President-Information Systems of the Company since January 1981. He has served with the Company or Curtis 1000 Inc. for over 32 years. The Board of Directors elects officers annually in April for one year terms or until their successors are elected and qualified. Officers are subject to removal by the Board of Directors at any time. PART II ITEM 5 ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information relating to the market for, holders of and dividends paid on the Company's Common Stock is set forth under the captions "Stock Exchange Listing," "Shareholders of Record," "Quarterly Data 1993" and "Quarterly Data 1992" on the inside front cover and pages 14 and 15 of the Company's 1993 Annual Report, which information is incorporated herein by reference. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA Selected consolidated financial data for the Company for each year of the eleven year period ended December 31, 1993 is set forth under the caption "Eleven Year Financial Review" on pages 14 and 15 in the Company's 1993 Annual Report, which information is incorporated herein by reference. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS A discussion of the Company's financial condition and results of operations at and for the dates and periods covered by the consolidated financial statements set forth in the Company's 1993 Annual Report is set forth under the caption "Management's Discussion and Analysis" on pages 25 through 27 of the Company's 1993 Annual Report. Such discussion is incorporated herein by reference. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following Consolidated Financial Statements of the Company and its subsidiaries, together with the Independent Auditors' Report, which are set forth on pages 16 through 24 in the Company's 1993 Annual Report, are incorporated herein by reference: Consolidated Statements of Income for each of the three years in the period ended December 31, 1993 Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 Notes to Consolidated Financial Statements The supplementary consolidated financial information regarding the Company which is required by Item 302 of Regulation S-K is set forth under the caption "Quarterly Data 1993" on page 14 and "Quarterly Data 1992" on page 15 of the Company's 1993 Annual Report. Such information is incorporated herein by reference. ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has been no change of independent accountants by the Company in the past two fiscal years or subsequently. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information relating to the directors of the Company is set forth in "Proposal 1 - Election of Directors" under the captions "Nominees," "Information Regarding Nominees and Directors" and "Meetings and Committees of the Board of Directors" in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Shareholders to be held on April 27, 1994 (the "Proxy Statement"). Such information is incorporated herein by reference. Pursuant to Instruction 3 of Item 401(b) of Regulation S-K and General Instruction G(3) of Form 10-K, information relating to the executive officers of the Company is set forth in Part I, Item 4(A) of this Report under the caption "Executive Officers of the Registrant." Information regarding compliance by directors and executive officers of the Company and owners of more than ten percent of the Company's Common Stock with the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934, as amended, is set forth in the Proxy Statement under the caption "Compliance with Section 16(a) of the Securities Exchange Act of 1934." Such information is incorporated herein by reference. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION Information relating to compensation of the executive officers and directors of the Company is set forth in "Proposal 1 - Election of Directors" under the caption "Director Compensation" and in "Executive Compensation" in the Proxy Statement. Such information is incorporated herein by reference. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding ownership of the Company's $2.00 par value Common Stock by certain persons is set forth in "Voting" under the caption "Principal Shareholders" and in "Proposal 1 - Election of Directors" under the caption "Information Regarding Nominees and Directors" and under the caption "Executive Compensation" in the Proxy Statement. Such information is incorporated herein by reference. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Company is aware of no relationships or transactions between the Company and affiliates of the Company which are required to be reported under this Item 13. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this Report: 1. Financial Statements The Consolidated Financial Statements and the Independent Auditors' Report thereon which are required to be filed as part of this Report are included in the Company's 1993 Annual Report and are set forth in and incorporated by reference in Part II, Item 8 hereof. These Consolidated Financial Statements are as follows: Consolidated Statements of Income for each of the three years in the period ended December 31, 1993 Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 Notes to Consolidated Financial Statements 2. Financial Statement Schedules The financial statement schedules filed as part of this Report pursuant to Article 12 of Regulation S-X and the Independent Auditors' Report in connection therewith are contained in the Index of Financial Statement Schedules on page S-1 of this Report. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because such schedules are not required under the related instructions or are inapplicable or because the information required is included in the Consolidated Financial Statements or notes thereto. 3. Exhibits The exhibits required to be filed as part of this Report are set forth in the Index of Exhibits on page E-1 of this Report. (b) Reports on Form 8-K: On October 29, 1993, the Company filed a Current Report on Form 8-K to report the acquisition of International Envelope Company of Exton, PA. On November 5, 1993, the Company filed a Current Report on Form 8-K/A which amended a Current Report on Form 8-K filed September 13, 1993, and contained required Item 7 Financial Statements and Exhibits. (c) The exhibits required to be filed as part of this Report are set forth in the Index of Exhibits on page E-1 of this Report. (d) The financial statement schedules required to be filed as part of this Report are set forth in the Index of Financial Statement Schedules on page S-1 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. AMERICAN BUSINESS PRODUCTS, INC. BY: /s/ Thomas R. Carmody ------------------------------------ Thomas R. Carmody President and Chief 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 the registrant and in the capacities and on the date indicated. AMERICAN BUSINESS PRODUCTS, INC. INDEX OF FINANCIAL STATEMENT SCHEDULES S-1 INDEPENDENT AUDITORS' REPORT American Business Products, Inc.: We have audited the consolidated financial statements of American Business Products, 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 25, 1994; such 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 American Business Products, 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. DELOITTE & TOUCHE Atlanta, Georgia February 25, 1994 S-2 SCHEDULE V AMERICAN BUSINESS PRODUCTS, INC. AND SUBSIDIARIES PLANT AND EQUIPMENT (IN THOUSANDS) (1) Cost of assets acquired from Discount Labels, Inc. on September 1, 1993, $7,600. Cost of assets acquired from International Envelope Co. on October 28, 1993, $6,760. S-3 SCHEDULE VI AMERICAN BUSINESS PRODUCTS, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PLANT AND EQUIPMENT (IN THOUSANDS) S-4 SCHEDULE VIII AMERICAN BUSINESS PRODUCTS, INC. AND SUBSIDIARIES VALUATION RESERVES (IN THOUSANDS) (1) Reserve assumed from Discount Labels, Inc. on September 1, 1993. (2) Deductions represent uncollectible accounts charged off, less recoveries. S-5 AMERICAN BUSINESS PRODUCTS, INC. INDEX OF EXHIBITS Where an exhibit is filed by incorporation by reference to a previously filed registration statement or report, such registration statement or report is identified in parentheses.

106926_1993.txt

106926_1993

1993

106926

ITEM 1: BUSINESS Whitney Holding Corporation (the "Company") is a Louisiana bank holding company registered pursuant to the Bank Holding Company Act of 1956. The Company became an operating entity in 1962 with Whitney National Bank (the "Bank") as its only significant subsidiary. The Bank, which has its headquarters in Orleans parish, has been engaged in general banking business in the City of New Orleans since 1883. The Bank engages in commercial and retail banking and in trust business, including the taking of deposits, the making of secured and unsecured loans, the financing of commercial transactions, the issuance of credit cards, the performance of corporate, pension and personal trust services, and safe deposit rentals. The Bank is also active as a correspondent for other banks. The Bank renders specialized services of different kinds in connection with all of the foregoing, and has thirty-eight domestic offices and one foreign office. There is significant competition within the financial services industry in general as well as with respect to the particular financial services provided by the Bank. Within its market area, the Bank competes directly with several major banking institutions of comparable or larger size and resources as well as with various other smaller banking organizations and local and national "non-bank" competitors, including savings and loans, credit unions, mortgage companies, personal and commercial finance companies, investment brokerage firms, and registered investment companies (mutual funds). All material funds of the Company are invested in the Bank. The Bank has a large number of customer relationships which have been acquired over a period of many years and is not dependent upon any single customer or upon a few customers, so the loss of any single customer or a few customers would not have a material adverse effect on the Bank or the Company. The Bank has customers in a number of foreign countries but the portion of revenue derived from these foreign customers is not a material portion of its overall revenues. The Company and the Bank and their related operations are subject to federal, state and local laws applicable to banks and bank holding companies and to the regulations of the Board of Governors of the Federal Reserve System, the Comptroller of Currency and the Federal Deposit Insurance Corporation. The Company does not believe that compliance with existing federal, state or local environmental laws and regulations will impose any material financial obligation on the Company or materially affect the realizable value of its assets. ITEM 2: ITEM 2: PROPERTIES The Company owns no real estate in its own name. The Bank owns the fourteen-story Whitney National Bank Building at 228 St. Charles Avenue in New Orleans. The Bank occupies approximately one half of the 306,000 square feet in this building, and the balance is either leased to third parties or available to be leased. The Bank also owns the premises for twelve branches in Orleans parish, six branches in Jefferson parish, four branches in Lafayette parish, one branch in East Baton Rouge parish and three branches in St. Tammany parish, one of which is located on leased ground. None of these properties is subject to any significant encumbrances. The Bank holds a variety of property interests acquired throughout the years in settlement of loans. Reference is made to Note 7 to the financial statements included in Item 8 for further information. ITEM 3: ITEM 3: LEGAL PROCEEDINGS There are no material pending legal proceedings, other than routine litigation incidental to the business, to which the Company or its subsidiaries is a party or to which any of their property is a subject. Page 3 of 50 PART II ITEM 5: ITEM 5: MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS a) The Company's stock price is reported on the National Association of Securities Dealers Automated Quotation (NASDAQ) system under the symbol WTNY. The following table shows the range of closing prices of the Company's stock for each calendar quarter of 1993 and 1992 as reported on the NASDAQ National Market System. b) The approximate number of shareholders of record of the Company, as of March 1, 1994, is as follows: c) During 1993 and 1992, the Company declared dividends as follows: Per-share stock price and dividend information shown above has been adjusted where appropriate to give retroactive effect to the three-for-two stock splits that were effective February 22, 1993 and November 29, 1993. Page 4 of 50 ITEM 6: ITEM 6: SELECTED FINANCIAL DATA Note: All share and per-share figures give effect to the three-for-two stock splits effective February 22, 1993 and November 29, 1993. Page 5 of 50 ITEM 7: ITEM 7: MANAGEMENTS'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SUMMARY For 1993, the Company earned $76.4 million or $5.30 per share. These results include the effect of a $60.0 million reduction in the level of the reserve for possible loan losses, which on an after-tax basis contributed $39.5 million or $2.74 per share to net income for the year. Excluding the impact of the reserve reduction, the Company had after-tax earnings in 1993 of $36.9 million or $2.56 per share. This represents an increase of $16.7 million from the $20.2 million, or $1.41 per share, earned in 1992. The increase in earnings in 1993 before the effect of the reduction in the reserve for possible loan losses was attributable both to higher net interest income and other non-interest income as well as to an overall reduction in non- interest expense. The impact of these factors was partly offset, however, by the absence in 1993 of any gains on sales of investment securities. Non-performing assets decreased throughout 1993 to $49.9 million at December 31, 1993, down 55% from $111.2 million at December 31, 1992. The reserve for possible loan losses, after the $60 million reduction, was $44.5 million on December 31, 1993, an amount which represented 132% of non-performing loans and 4.6% of total loans. At year end 1992, the loan loss reserve was $98.6 million, or 140% of non-performing loans and 9.4% of total loans on that date. In 1993, the Company continued to experience soft loan demand in the market area serviced by the Bank. Average gross loans outstanding totalled $952 million during 1993 compared with $1.125 billion in the previous year, a decrease of $173 million or 15%. Average total deposits, however, showed modest growth between 1993 and 1992, increasing $16 million to $2.415 billion. Deposit funds not needed for loans were redirected to the investment portfolio, which rose on average by $265 million or 21% from $1.282 billion in 1992 to $1.547 billion in 1993. Adding the significant reduction in non-performing assets, these year-to-year changes translated into a $103 million or 4.2% increase in average earning assets, excluding nonaccruing loans, to $2.556 billion in 1993 from $2.453 billion in 1992. After reinstating its dividend in the fourth quarter of 1992, the Company declared dividends in each quarter of 1993, totalling $0.43 per share for the year. During 1993, the Company's Board of Directors twice approved three-for- two stock splits which were effective in February and November. All share and per-share data in this report on Form 10-K reflect the effect of these stock splits. Page 6 of 50 AVERAGE BALANCE SHEETS - ---------------------- (in thousands) FINANCIAL CONDITION LOANS Economic conditions in the Company's market area, which is primarily southern Louisiana and Mississippi, have in recent years slowed the overall demand for loans and have prompted efforts by many commercial loan customers to reduce their existing debt levels. Over this period, the Bank also consciously reduced its exposure to credits whose performance had been adversely affected by these economic conditions. The $173 million decrease in average loans outstanding during 1993 as compared to 1992 is largely a reflection of the prevailing economic conditions. The smaller $71 million decrease in gross loans outstanding at December 31, 1993 as compared to the prior year end is influenced by seasonal fluctuations in the short-term credit needs of certain industries serviced by the Bank. During 1993, the Bank has been expanding its lending resources and products and plans to continue to intensify its efforts to compete for and place high quality credits in the communities served by the Bank. Unfunded loan commitments outstanding at December 31, 1993, have increased to nearly $400 million, some $43 million above the level at December 31, 1992. Page 7 of 50 LOAN PORTFOLIO BALANCES AT DECEMBER 31 - -------------------------------------- (in thousands) DEPOSITS AND SHORT-TERM BORROWINGS The Company's average deposit base was essentially stable during 1993, increasing $16 million or 0.7% to $2.415 billion in 1993 from $2.399 billion in 1992. Underlying this modest overall increase is a shift in the deposit mix away from time deposits, both core and those in amounts of $100,000 and over, in favor of demand and savings deposits. As is shown in the table of average balance sheets, non-interest-bearing demand deposits increased on average by $37 million in 1993 as compared to 1992. The increase in average deposits in interest-bearing demand and other transaction accounts and non-time savings products was approximately $56 million over this same period. Average total time deposits in 1993 declined $77 million from the 1992 level, including a decrease of $46 million of deposits of $100,000 and over. The Company has emphasized and will continue to emphasize offering core deposit products that respond to current market conditions while still yielding customers a meaningful rate of return. The Company's short-term borrowings arise from the purchase of federal funds and the sale of securities under repurchase agreements, mainly as part the Bank's services to correspondent banks and certain other customers. The Company's average short-term borrowing position, net of federal funds sold, was approximately $122 million in 1993 and $113 million in 1992. INVESTMENT IN SECURITIES At December 31, 1993, the Company's total investment in securities was $1.634 billion or 54% of total assets and 60% of earning assets on that date. The balance at year-end 1993 represents an increase of approximately $159 million or 10.8% over the December 31, 1992 investment total of $1.475 billion. The average total investment portfolio outstanding increased $265 million or 21% between 1992 and 1993 as funds not needed for loans were invested in securities. The major portion of the increased investment activity was directed to U.S. Treasury securities and securities of U. S. government agencies, excluding mortgage-backed issues. The mix of period-end and average investments, however, remained relatively stable, with U. S. Treasury and government agency securities representing approximately 77% to 80% of the total investment in securities. The weighted average maturity of the overall portfolio of securities was 34 months at year end 1993, virtually unchanged from year end 1992. The weighted average taxable-equivalent portfolio yield decreased 57 basis points to 5.71% at December 31, 1993 from 6.28% at December 31, 1992. Page 8 of 50 INVESTMENT IN SECURITIES - ------------------------ (dollars in thousands) (1) Tax exempt yields are expressed on a fully taxable equivalent basis. (2) Distributed by contractual maturity without regard to repayment schedules or projected prepayments. (3) These securities have no stated maturities or guaranteed dividends. (4) These securities are classified as available for sale before maturity. The actual timing of any such sales, however, is not determinable at year end. Effective December 31, 1993, the Company adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The statement specifies criteria for classifying investments as either trading securities, securities held to maturity, or securities available for sale, and establishes reporting standards for each classification. Management considered the Company's existing investment portfolio and underlying asset/liability management policies and strategies in light of the new standard and determined that its investments in mortgage-backed securities met the criteria for classification as securities available for sale. These securities were reported at their estimated fair values at December 31, 1993, and a tax-effected net unrealized gain of approximately $3.1 million was recognized as a component of shareholders' equity. The remaining portfolio of securities was classified as held to maturity and continues to be reported at amortized cost. The Company currently maintains no trading portfolio. In accordance with SFAS No. 115, prior period investment information has not been restated to reflect the new standard. On an ongoing basis, investment securities will be classified as they are acquired and the continued propriety of classifications will be periodically evaluated by management. Page 9 of 50 ASSET QUALITY Overall asset quality has exhibited a trend of steady improvement over the past three years. During 1993, the Company continued to be successful in its efforts to reduce all categories of its non-performing assets through the full rehabilitation of nonaccruing loans, the workout of troubled credits, or the sale of repossessed loan collateral. Non-performing assets totalled $49.9 million at December 31, 1993, a decrease of $61.3 million or 55% from $111.2 million at year end 1992. Of the $33.6 million in nonaccruing loans at December 31, 1993, $15.6 million or 46% represented loans that are performing as contractually agreed but are being carried in nonaccrual status because there is some doubt as to the ultimate collectibility of all principal and interest. Nonaccruing loans totalling approximately $18.6 million at year end 1993 were secured by real property collateral. Another $14.2 million consisted of various commercial credits. NON-PERFORMING ASSETS AT DECEMBER 31 - --------------------------------------- (in thousands) In 1993, the Company identified $6.4 million of loans to be charged off as uncollectible against the reserve for possible loan losses, a decrease of 70% from the $21.4 million of charge-offs in 1992. At the same time, the Company was successful in increasing its loan recoveries to $12.4 million in 1993 from $9.4 million in 1992. The reserve for possible loan losses is maintained at a level believed by management to be adequate to absorb potential losses in the portfolio. The $60 million reduction in the reserve during 1993 reflects management's determination that the steps taken in recent years to deal with the Bank's asset quality issues have yielded lasting positive results, evidenced in part by the positive trends noted above. In management's judgment, some of the reserve levels that had been established in the past in recognition of these asset quality issues were no longer needed. After the reduction, the reserve for possible loan losses was $44.5 million at December 31, 1993, or a 132% coverage of total non- performing loans and 4.6% of total loans. Page 10 of 50 SUMMARY OF LOAN LOSS EXPERIENCE - -------------------------------------------------------------------------------- ALLOCATION OF THE RESERVE FOR POSSIBLE LOAN LOSSES - ---------------------------------------------------- (dollars in thousands) Page 11 of 50 During 1993, the Company disposed of other real estate owned ("OREO") properties with a carrying value at the time of sale totalling approximately $24 million. The value of OREO properties acquired in settlement of loans during the year was $3.7 million. The balance of other real estate owned at December 31, 1993, which includes $8.2 million of loans deemed to have been foreclosed in substance, consisted mainly of commercial land and buildings. The Company has several property interests which were acquired through routine banking transactions generally prior to 1933 and which are recorded in its financial records at a nominal value. Management continually investigates ways to maximize the return on these assets. There were no significant dispositions of these property interests in 1993. Future dispositions may result in the recognition of substantial gains. The Company has not extended any credit in connection with what would be defined under regulatory guidelines as highly leveraged transactions, nor has it acquired any investment securities arising from such transactions. The Company's foreign lending and investing activities are currently insignificant. Note 3 to the consolidated financial statements discusses credit concentrations in the loan portfolio. CAPITAL ADEQUACY The strong earnings reported for 1993, including the effect of the reduction in the reserve for loan losses, are reflected in the increase in the Company's and the Bank's regulatory capital ratios between December 31, 1993 and 1992. Also contributing to this increase was the shift in the asset mix toward investments in securities which are assigned a risk-weighting lower than for loans in the capital ratio calculations. For the purposes of these calculations, capital does not currently include the net unrealized gain or loss on securities held for sale which is reported as a separate component of shareholders' equity under SFAS No. 115. The Company's regulatory capital ratios, which are essentially the same as those calculated for the Bank, are shown here compared to the minimums currently required for regulatory classification as a "well capitalized" institution: The Company is committed to maintaining a strong capital base to support its philosophy of soundness, profitability and growth. The Bank's regulators have proposed rules which will incorporate a measure of the Bank's interest rate risk into the level of regulatory capital it is required to maintain. These rules are expected to be finalized and become effective in 1994. Considering the Bank's current level of regulatory capital and its interest rate risk position, management believes that adoption of the proposed rule will not have a significant impact on the Bank's ability to satisfy its regulatory capital requirements. Page 12 of 50 RESULTS OF OPERATIONS The following table of comparative analytical income statements offers an overview of the Company's results of operations. NET INTEREST INCOME Taxable-equivalent net interest income increased $8.5 million or 7.4% in 1993 as compared to 1992, as the net interest margin rose to 4.75% from 4.52%. A combination of factors contributed to this increase, the components of which are detailed in the following tables analyzing changes in interest income and expense. Interest expense decreased $16.3 million in 1993, despite a modest rise in average deposits, because of both the lower rate environment that prevailed in 1993 as compared to 1992 as well as the shift in the mix of deposits to non- interest-bearing and lower-cost deposits between these periods. Average total time deposits in 1993 were down $77 million from 1992's level, including a decrease in deposits of $100,000 or more of $46 million. Interest income also decreased in 1993 as compared to 1992, by $7.8 million, but not to the same degree as interest expense. Overall asset yields declined in 1993 as a result of the lower rate environment and as the mix of earning assets shifted from loans to lower-yielding investment securities. Asset yields were favorably impacted, however, by an overall increase in average earning assets, excluding nonaccruing loans, of $103 million from 1992 to 1993, reflecting in part the continued positive trend in asset quality. Page 13 of 50 ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE YIELDS ON AVERAGE EARNINGS ASSETS AND RATES ON AVERAGE INTEREST-BEARING LIABILITIES - ----------------------------------------------------------- (dollars in thousands) Note: Tax equivalent amounts are calculated using a marginal federal income tax rate of 35% for 1993 and 34% for 1992 and 1991. Page 14 of 50 VOLUME AND YIELD/RATE VARIANCE ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE - ----------------------------------------------------------- (in thousands) Note: Tax equivalent amounts are calculated using a marginal federal income tax rate of 35% for 1993 and 34% for 1992 and 1991. Page 15 of 50 OTHER INCOME AND EXPENSE Non-interest operating income, excluding securities gains and net gains from OREO sales, increased $1.5 million, or 5.8%, to $27.4 million in 1993 from $25.9 million in 1992. The overall increase was primarily attributable to an $800 thousand, or 5.4% increase in income from service charges on deposit accounts and an additional $700 thousand in income related to international banking services. There were no securities sales during 1993. In 1992, the Company recognized a $5.4 million gain on the sale of a block of mortgage-backed securities that was experiencing excessive prepayments as market interest rates declined. This block of securities was replaced with another offering a more stable return. Gains of $18.4 million were recognized on securities sales in 1991 in connection with an overall repositioning of the portfolio begun in 1990 to implement a revised asset/liability management strategy. Non-interest operating expenses, excluding provisions for possible losses on loans, OREO and other problem assets, were $98.2 million in 1993, an increase of $1.4 million, or 1.4%, over 1992's total of $96.8 million. Personnel expense increased $2.0 million in 1993 as compared to 1992. Both compensation expense and the expense of providing insurance benefits contributed to this 4.3% increase. Other non-interest operating expenses showed a net decrease of approximately $500 thousand from 1992 to 1993. The positive effects of improving asset quality were evident in the 1993 reductions of $1.2 million in legal expense and $287 thousand in the expense of maintaining and operating OREO net of revenues generated by the properties prior to sale. In addition to the $60 million reduction in the reserve for possible loan losses discussed earlier, there was a decrease of $14 million from 1992 to 1993 in provisions for losses on OREO and other problem assets. This decrease is directly related to the Company's success in reducing its exposure to non- performing assets. INCOME TAXES The Company provided for income taxes at an overall effective rate of 32.0% in 1993, up from the 30.6% rate in 1992. The effective rates in each period differ from the statutory rates of 35% in 1993 and 34% in 1992 primarily because of the tax exempt income earned on investments in state and municipal obligations. The higher effective rate in 1993 is largely the result of a lower proportion of tax-exempt to pre-tax income for 1993 compared to 1992. ASSET/LIABILITY MANAGEMENT The asset/liability management process has as its focus the development and implementation of strategies in the funding and deployment of the Company's financial resources which is expected to maximize soundness and profitability over time. Such strategies reflect the goals set by the Company for capital adequacy, liquidity, and growth and the tolerance for risk established in Company policies. INTEREST RATE RISK/INTEREST RATE SENSITIVITY The Company's financial assets and liabilities are subject to scheduled and unscheduled repricing opportunities over time. The Company's potential for generating net interest income, as well as the current market values of financial assets and liabilities, are sensitive to the levels of market interest rates available as these repricing opportunities arise. Interest rate risk is a measure of this potential volatility in net interest income and market values. As part of the asset/liability management process, the Company uses a variety of tools, including an earnings simulation model, to measure interest rate risk and to evaluate the impact of proposed changes in its internal strategies and potential changes in its economic environment. The interest rate sensitivity gap analysis, which compares the volume of repricing assets against repricing liabilities over time, is a relatively simple tool which is useful in highlighting significant short-term repricing volume mismatches but is limited in measuring the potential impact on earnings and net asset values. The following table presents the rate sensitivity gap analysis at December 31, 1993. The interest rates on most of the Bank's commercial loans vary with changes in its prime rate or the prime rates of certain money-center banks. These loans are assigned to the earliest repricing period in the rate sensitivity analysis. A substantial portion of loans shown in the analysis as repricing after one year is made up of fixed-rate real estate loans, both retail and commercial. These loans generally mature within five years. In preparing this analysis, deposit funding sources with no scheduled maturity or contractual repricing date are assigned to a particular repricing period after consideration of past and expected customer behavior in response to general market rate changes. Surveying Page 16 of 50 the twelve-month period from December 31, 1993, the analysis indicates that the Company is in a balanced rate sensitivity position on a cumulative basis. INTEREST RATE SENSITIVITY - ------------------------- December 31, 1993 (dollars in millions) LIQUIDITY The Company and the Bank manage liquidity to ensure their ability to satisfy customer demand for credit, to fund deposit withdrawals, to meet operating and other corporate obligations, and to take advantage of investment opportunities, all in a timely and cost-effective manner. Traditionally, these liquidity needs have been met by maintaining a strong base of core deposits within the Bank and by carefully managing the maturity structure of the Bank's investment portfolio. The funds provided by current operations and forecasts of loan repayments are also considered in the liquidity management process. The Bank enters into short-term borrowing arrangements by purchasing federal funds and selling securities under repurchase agreements, mainly as part of its services to correspondent banks and certain other customers. Neither the Company nor the Bank has had to access short or long term debt markets as part of liquidity management. Page 17 of 50 The following tables present information concerning deposits and short-term borrowings for the years 1993, 1992 and 1991. DEPOSITS - -------- (in thousands) FEDERAL FUNDS PURCHASED AND BORROWINGS UNDER REPURCHASE AGREEMENTS - ------------------------------------------------------------------ (in thousands) Average core deposits, defined as all deposits other than time deposits of $100,000 or more, increased approximately $63 million in 1993 over the prior year. During 1993, core deposits comprised 90.2% of total average deposits, compared to 88.2% during 1992. As of December 31, 1993, $329 million or 22.7% of the portfolio of securities held to maturity was scheduled to mature within one year. An additional $182 million of investment securities are classified as available for sale at year end 1993, although management's determination of this classification does not derive primarily from liquidity considerations. The Bank had $399 million in unfunded loan commitments outstanding at December 31, 1993, an increase of $43 million from the level at December 31, 1992. Contingent obligations under letters of credit and financial guarantees of $58 million and available credit card lines of $26 million at year end 1993 were both down slightly from year end 1992. Draws under these financial commitments should not place any unusual strain on the Bank's or the Company's liquidity positions. Page 18 of 50 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WHITNEY HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS Note: All share and per-share figures in the consolidated financial statements give effect to the three-for-two stock splits effective February 22, 1993 and November 29, 1993. The accompanying notes are an intergral part of these financial statements. Page 19 of 50 WHITNEY HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these financial statements. Page 20 of 50 WHITNEY HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these financial statements. Page 21 of 50 WHITNEY HOLDING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these financial statements. Page 22 of 50 NOTES TO FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of Whitney Holding Corporation and its subsidiaries (the "Company") follow generally accepted accounting principles and policies within the banking industry. The following is a summary of the more significant policies. CONSOLIDATION The consolidated financial statements of the Company include the accounts of Whitney Holding Corporation and its wholly-owned subsidiary, Whitney National Bank (the "Bank"). Intercompany accounts and transactions have been eliminated in consolidation. Certain balances in prior years have been reclassified to conform with this year's presentation. CASH AND DUE FROM FINANCIAL INSTITUTIONS The Company considers cash and cash due from financial institutions as cash and cash equivalents for purposes of the consolidated statement of cash flows. INVESTMENT IN SECURITIES 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." Under SFAS No. 115, debt securities which the Company both positively intends and has the ability to hold to maturity are carried at amortized cost. These criteria are not considered satisfied when a security is available to be sold in response to changes in interest rates, prepayment rates, liquidity needs or other reasons as part of an overall asset/liability management strategy. Debt securities and equity securities with readily determinable fair values that are acquired with the intention of being resold in the near term are classified under SFAS No. 115 as trading securities and are carried at fair value, with unrealized holding gains and losses recognized in current earnings. The Company does not currently hold any securities for trading purposes. Securities not meeting the criteria of either trading securities or securities held to maturity are classified as available for sale and are carried at fair value. Unrealized holding gains and losses for these securities are recognized, net of related tax effects, as a separate component of shareholders' equity. The Company adopted this new standard effective December 31, 1993. As a result, investments in mortgage-backed securities were reclassified as of that date as securities available for sale and are being reported at fair value. Shareholders' equity was increased at year-end 1993 to reflect the tax-effected net unrealized holding gain on these securities which previously had been carried at the lower of either aggregate amortized cost or market. In accordance with SFAS No. 115, prior period financial statements have not been restated to reflect this change in accounting principle. Interest and dividend income earned on securities either held to maturity or available for sale is included in current earnings, including the amortization of premiums and the accretion of discounts using the interest method. The gain or loss realized on the sale of a security held to maturity or available for sale is computed with reference to its amortized cost and is also included in current earnings. LOANS Loans are generally carried at the principal amounts outstanding, less unearned income and the reserve for possible loan losses. Interest on loans is accrued and credited to income based on the outstanding loan principal amounts. The accrual of interest on loans is discontinued when, in management's judgement, there is an indication that a borrower will be unable to meet contractual payments as they become due. For commercial and real estate loans, this generally occurs when a loan falls 90- days past due as to principal or interest, and the loan is not otherwise both well secured and in the process of collection. Upon discontinuance, accrued but uncollected interest is reversed against current income. Interest payments received on nonaccrual loans are used to reduce the Page 23 of 50 reported loan principal until the collectibility of the remaining principal is reasonably assured. A nonaccrual loan may be reinstated to accrual status when full payment of contractual principal and interest is expected and this expectation is supported by current performance. RESERVE FOR POSSIBLE LOAN LOSSES The reserve for possible loan losses is maintained at a level which, in management's judgment, is considered adequate to absorb potential losses inherent in the loan portfolio. The adequacy of the reserve is evaluated by management on an ongoing basis. As adjustments to the level of reserves become necessary, they are reported in current earnings. The factors considered in this evaluation include estimated potential losses from specific lending relationships, including unused loan commitments and credit guarantees; general economic conditions; economic conditions affecting specific classes of borrowers or types of loan collateral; historical loss experience; and various trends in loan portfolio characteristics, such as volume, maturity, customer mix, delinquencies and nonaccruals. As actual loan losses are incurred, they are charged against the reserve. Recoveries on loans previously charged off are added back to the reserve. FORECLOSED ASSETS Collateral acquired through foreclosure or in settlement of loans is classified as either other real estate owned ("OREO") or other assets and is carried at its fair value, net of estimated costs to sell, or the remaining investment in the loan, whichever is lower. At acquisition, any excess of the recorded loan value over the estimated fair value of the collateral is charged against the allowance for possible loan losses. After acquisition, valuation allowances are established with a charge to current earnings to adjust the reported value of foreclosed assets to reflect changes in the estimate of a property's fair value or selling costs. Revenues and expenses associated with the management of foreclosed assets prior to sale are included in current earnings. BANK PREMISES AND EQUIPMENT Bank premises and equipment are carried at cost, net of accumulated depreciation, as follows (in thousands): Accumulated depreciation was $57,408,000 in 1993 and $51,437,000 in 1992. Provisions for depreciation included in non-interest expenses were computed primarily on the straight-line method over the estimated useful lives of the assets. Estimated useful lives range mainly from 15 to 45 years for buildings and improvements and from 5 to 7 years for furnishings and equipment. INCOME TAXES Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes." In general, under this new accounting standard, the tax consequences of all temporary differences that arise between the tax bases of assets or liabilities and their reported amounts in the financial statements represent either tax liabilities to be settled in the future or tax assets that will be realized as a reduction of future taxes. The change in net deferred assets or liabilities between periods is recognized as a deferred tax expense or benefit in the consolidated statement of operations. In prior years, a deferred tax expense or benefit was provided on those items of income and expense which were recognized in different time periods for financial statement and income tax purposes. See Note 4 for a more detailed discussion of the accounting for income taxes and of the impact of the adoption of SFAS No. 109 in 1993. EARNINGS (LOSS) PER SHARE Earnings (loss) per share is calculated using the weighted average number of shares outstanding during each period presented. Potentially dilutive common stock equivalents consist of stock options which have been granted to certain officers. Incorporating these common stock equivalents into the calculation of earnings (loss) per share using the treasury method does not materially affect the Page 24 of 50 reported results whether on a primary or fully-diluted basis. All share and per-share data in this report on Form 10-K reflect the three- for-two stock splits that were effective February 22, 1993 and November 29, 1993. (2) INVESTMENT IN SECURITIES Summary information regarding securities available for sale and securities held to maturity follows. As discussed in Note 1, the Company adopted SFAS No. 115 effective December 31, 1993. As a result, investments in mortgage-backed securities were reclassified as of that date as securities available for sale and are being reported at fair value. The tax-effected net unrealized holding gain on these securities at date of adoption of $3,083,000 is reported as a separate component of shareholders' equity. At December 31, 1993 and 1992, U.S. Treasury and agency securities with a carrying value of $477,904,000 and $432,751,000, respectively, were pledged to secure public and trust deposits or sold under repurchase agreements. There were no sales from the securities portfolios during 1993. Proceeds from sales of investment securities during 1992 were $150,120,000. In 1992, the Company sold a block of mortgage-backed securities that was experiencing excessive early payoffs because of declining mortgage rates and replaced it with a block of mortgage-backed securities that offered a more stable return. The Company realized a $5.4 million gain as a result of this transaction. In 1990, the Company developed and began to implement a strategy to balance maturities and liquidity needs and to diversify and increase yields in the investment securities portfolio. Page 25 of 50 Repositioning the portfolio in line with this strategy resulted in the realization of $18,376,000 in gains in 1991 on sales of $582,377,000. The amortized cost and estimated fair value of investment securities held to maturity at December 31, 1993, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because certain issuers have the right to call or prepay obligations with or without call or prepayment penalties. (3) LOANS AND RESERVE FOR POSSIBLE LOAN LOSSES The composition of the Company's loan portfolio at December 31, was as follows (in thousands): The Company's lending activity, both commercial and retail, is conducted primarily among customers in Louisiana and Mississippi. In its market area, the Company serves a broad base of commercial customers in diverse industries. Within the portfolio, the Company maintains a relatively significant concentration of outstanding credits and loan commitments to customers involved in the oil and gas industry. At December 31, 1993, outstanding loans to this industry totalled $78,488,000, and unused loan commitments and letters of credit and guarantees were $99,727,000 and $15,959,000, respectively. The operations of this industry have been stabilizing in recent years, following a period of severe decline and major restructuring which had adversely impacted the overall economy of the Company's market area. Management continues to closely monitor its lending relationships in this industry. The total of commercial and other real estate loans shown above includes both those for which the primary source of repayment is the operation or sale of the underlying project, as well as those secured by real estate employed in other operations of the customer. Unfunded commitments for loans secured by commercial or other real estate were $9,140,000 at December 31, 1993. Real estate values had declined steeply during the period of economic contraction in the Company's market area, but have in recent periods been stabilizing. The Company's portfolio of commercial and other real estate loans is diversified as to both the types of collateral property and the industries in which the properties are employed. Loans on which the accrual of interest had been discontinued totalled $33,631,000 and $70,640,000 at December 31, 1993 and 1992, respectively. If interest on nonaccrual loans had been recognized in accordance with contractual terms, reported interest income would have been increased by approximately $1,458,000 in 1993, $6,256,000 in 1992, and $13,328,000 in 1991. The Bank has made loans, in the normal course of business, to certain directors and executive officers of the Company and to their associates (related parties). The aggregate amount of these loans was $31,341,000 and $27,907,000 at December 31, 1993 and 1992, respectively. During 1993, $78,061,000 of new loan advances were made, and repayments totalled $74,627,000. Outstanding commitments and letters of credit to related parties totalled $39,517,000 and $9,092,000 at December 31, 1993 and 1992, respectively. Related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons, and do not involve more than the normal risk of collectibility. The FASB has issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," which is effective January 1, Page 26 of 50 1995. This statement establishes standards, including the use of discounted cash flow techniques, for measuring the impairment of a loan when it is probable that the contractual terms will not be met. Adoption of this new accounting standard is not expected to have a significant impact on the Company's financial condition and results of operations based on the current loan portfolio. Changes in the reserve for possible loan losses for the three years ended December 31, 1993 were as follows (in thousands): (4) INCOME TAXES Income tax expense (benefit) consists of the following components for the three years ended December 31, 1993 (in thousands): Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Under this new accounting standard, the tax consequences of all temporary differences between the tax bases of assets or liabilities and their reported amounts in the financial statements represent either tax liabilities to be settled in the future or tax assets that will be realized as a reduction of future taxes. Among other provisions, SFAS No. 109 requires the use of currently enacted tax rates to measure these deferred tax assets and liabilities. The impact of any change in the enacted tax rates is included in the deferred tax expense or benefit recognized in the period in which the change occurs. The change in the net deferred tax asset or liability between periods represents the deferred tax expense or benefit recognized in the financial statements. With the adoption of SFAS No. 109, the Company recognized an additional net deferred tax asset of $4,574,000, which is reported in the consolidated statements of operations as a cumulative effect of an accounting change (Note 6). Page 27 of 50 Net deferred income tax assets, which are included in other assets on the consolidated balance sheets, were approximately $19,046,000 and $34,113,000 at December 31, 1993 and 1992, respectively. The components of the net deferred tax asset as of December 31, 1993 were as follows (in thousands): For years ending before January 1, 1993, deferred tax expense (benefit) resulted from timing differences in the recognition of revenue and expense for income tax and financial statement purposes. For the year ended December 31, 1992, the most significant timing difference was the excess of interest income recognized for tax purposes over the amount recognized for financial statement purposes. The most significant timing difference in the year ended December 31, 1991 was in the excess of the provision for possible loan losses over losses recognized for income tax purposes. The sources of timing differences and the tax effects for the years ended December 31, 1992 and 1991 are summarized as follows (in thousands): Page 28 of 50 The effective tax rate is less than the statutory federal income tax rate in each of the three years in the period ended December 31, 1993 because of the following: Under SFAS No. 109, the Company is required to establish a valuation allowance against the deferred tax assets if, based on all available evidence, it is more likely than not that some or all of the asset will not be realized. Management has weighed the evidence, including current earnings performance, taxable income generated during available carryback periods, and the nature of significant deductible temporary differences, and believes that no valuation reserve is required as of December 31, 1993. Rules issued by regulatory agencies impose additional limitations on the amount of deferred tax assets that may be recognized when calculating regulatory capital ratios. The Company's ratio calculations were not affected by these rules at December 31, 1993. (5) EMPLOYEE BENEFIT PLANS The Company has a noncontributory qualified defined benefit pension plan covering substantially all of its employees. The benefits are based on an employee's total years of service and his or her highest five-year level of compensation during the final ten years of employment. Contributions are made in amounts sufficient to meet funding requirements set forth in federal employee benefit and tax laws plus such additional amounts as the Company may determine to be appropriate from time to time. In October, 1992, the Company authorized certain amendments to the defined benefit plan which were effective on January 1, 1993. The amendments included provisions to accelerate early retirement availability and to discontinue life insurance and disability benefits now provided by other Company-sponsored benefit programs. The amounts disclosed below as of December 31, 1993 and 1992, include consideration of these amendments. As of December 31, 1993, the actuarial present values of vested and total accumulated benefit obligations (excluding projected future increases in compensation levels) were $34,012,000 and $37,375,000, respectively, and as of December 31, 1992, $31,799,000 and $34,458,000, respectively. The following table sets forth the plan's funded status and amounts recognized in the Company's consolidated financial statements (in thousands): Page 29 of 50 The net pension expense (benefit) recognized for 1993, 1992, and 1991 is comprised of the following components (in thousands): The weighted-average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.5% in 1993 and 8.0% in prior periods. For all periods presented, the Company assumed an 8.0% expected long-term rate of return on plan assets and an annual rate of increase in future compensation levels of 5.0%. For participants in the qualified defined benefit plan whose calculated benefits are reduced as a result of limitations under federal tax laws, the Company sponsors an unfunded non-qualified plan that provides benefits equal to those reductions. At December 31, 1993, the accrued pension cost and accumulated benefit obligation, substantially all of which is vested, related to this plan were $1,358,000 and $962,000, respectively. The net pension expense under the plan was $11,000, $55,000 and $163,000 in 1993, 1992, and 1991, respectively. Effective October 1, 1993, the Company converted its noncontributory employee thrift plan into an employee savings plan under Section 401(k) of the Internal Revenue Code. Under the new plan, which covers substantially all full- time employees, the Company will match the savings of each participant up to 3% of his or her compensation. Annual participant savings are limited by tax law. Participants are fully vested in their savings and in the matching Company contributions at all times. For 1993, the expense of the Company's matching contributions was approximately $245,000. There had been no Company contributions to the noncontributory thrift plan in 1993, 1992 or 1991. At current participation levels, the Company's annual matching contributions under the savings plan are expected to total approximately $1 million. The Company also maintains certain health care and life insurance benefit plans for retirees and their eligible dependents. Participant contributions are required under the health plan, and the Company has established annual and lifetime maximum health care benefit limits. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." This statement requires that the expected cost of providing these postretirement benefits be recognized during the period employees are actively working. Prior to 1993, the Company recognized the cost only as benefit payments were made to or on behalf of retirees. The Company continues to fund its obligations under the postretirement benefit plans as the benefit payments are made. Upon adoption of SFAS No. 106, the Company elected to immediately recognize the accumulated postretirement benefit obligation of $5,963,000. The expense related to the recognition of this transition obligation is reported, net of income tax effects of $2,023,000, as a cumulative effect of a accounting change in the consolidated statements of operations (Note 6). At December 31, 1993, the net postretirement benefit liability reported with other liabilities in the consolidated balance sheets was approximately $6,306,000. The net periodic postretirement benefit expense recognized under SFAS No. 106 for 1993 was $450,000, including components for both the portion of the expected benefit obligation attributed to current service as well as interest on the accumulated benefit obligation. The expense recognized is not materially different from that which would have been reported under the previous accounting method. For the actuarial calculation of its postretirement benefit obligations at December 31, 1993, the Company assumed annual health care cost increases beginning at 12% and decreasing 0.6% per year to a 5.5% rate, and used a discount rate of 7.5% in determining the present value of projected benefits. A 1% rise in the assumed health care cost trend rates would not materially impact the accumulated benefit obligation or the periodic net benefit expense. The FASB has issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which is effective January 1, 1994. Postemployment benefits are those provided to former or inactive employees after active employment but before retirement. Given the current structure of such benefit programs offered by the Company, this accounting standard will not have a significant impact on the Company's financial position or results of operations when adopted. The Company has a long-term incentive program for which all employees are eligible. As of December 31, 1993, 494,625 Page 30 of 50 shares of treasury stock are reserved for the purposes of this program, which include the granting of stock options and restricted, performance and phantom stock. The Company granted 36,000 shares of restricted stock to certain employees during 1993 for no cash consideration. During 1992, restricted stock grants totalled 37,125 shares. Employees receiving the grants are restricted from transferring or otherwise disposing of the stock until June, 1998, for the grants in 1993, and until May, 1997, for the 1992 grants. The market values of the restricted shares, determined as of the grant dates, were $699,000 and $491,000, respectively, for 1993 and 1992. These amounts are being amortized as compensation expense over the five year restriction periods. Compensation expense recognized during 1993 and 1992 related to these stock grants was $168,000 and $49,000, respectively. The following table summarizes stock option activity under the long-term incentive program for 1993 and 1992: The incentive and non-qualified options are exercisable at the market price on the grant dates. All outstanding options were exercisable at December 31, 1993. On February 28, 1990, an executive officer was granted options to purchase 33,750 shares of common stock of the Company at the then market price of $18.11 per share through February 28, 2000. At December 31, 1993, none of those options had been exercised. If this officer terminates his employment with the Company, the options will be exercisable for six months after his date of termination. The options will also be exercisable up to one year past the date of his death, but in no event beyond February 28, 2000. (6) NET CUMULATIVE EFFECT OF ACCOUNTING CHANGES The net cumulative effect of accounting changes reported in the consolidated statement of operation for 1993 consists of the following (in thousands): (7) OTHER REAL ESTATE OWNED Other real estate owned ("OREO") is comprised of real property collateral acquired through foreclosure or in settlement of loans and surplus banking property. With the exception of the pre-1933 properties discussed below, these properties are reported at their fair value, less expected disposition costs, or the recorded investment in the related loan, whichever is lower. Activity in the OREO valuation reserve for the three years ended December 31, 1993 was as follows (in thousands): Page 31 of 50 OREO includes a variety of property interests which were acquired though routine banking transactions generally prior to 1933 and for which there existed no ready market. These were subsequently written down to a nominal holding value in accordance with general banking practice at that time. These property interests include a few commercial and residential site locations principally in the New Orleans area, ownership interests in scattered undeveloped acreage, and various mineral interests. Not included in OREO are real estate interests evidenced by stock ownership. Such stock is carried as an investment in securities and dividends are recognized as investment income. In 1991, the Company recorded a gain of approximately $4 million on the sale of one of the pre-1933 property interests. Other revenues derived from these direct and indirect property interests and related expenses have not been significant over the three-year period ended December 31, 1993. (8) NON-INTEREST INCOME The components of non-interest income were as follows for the three years ended December 31, 1993 (in thousands): (9) NON-INTEREST EXPENSE The components of non-interest expense were as follows for the three years ended December 31, 1993 (in thousands): Page 32 of 50 (10) OTHER ASSETS AND LIABILITIES The significant components of other assets and other liabilities at December 31, 1993 and 1992, were as follows (in thousands): Costs in excess of the net tangible assets acquired in prior years' business combinations are being amortized over remaining lives ranging from one to twelve years as of December 31, 1993. (11) ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosure is made in accordance with the requirements of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments." In cases where quoted market prices are not available, fair values have been estimated using present value or other valuation techniques. The results of these techniques are highly sensitive to the assumptions used, such as those concerning appropriate discount rates and estimates of future cash flows, which require considerable judgment. Accordingly, estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current settlement of the underlying financial instruments. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. These disclosures should not be interpreted as representing an aggregate measure of the underlying value of the Company. Page 33 of 50 The following significant methods and assumptions were used by the Company in estimating the fair value of financial instruments. CASH AND SHORT-TERM INVESTMENTS The carrying value of highly liquid instruments, such as cash on hand, interest-and non-interest bearing deposits in financial institutions, and federal funds sold, provides a reasonable estimate of their fair value. INVESTMENT SECURITIES Substantially all of the Company's investment securities are traded in active markets. Fair value estimates for these securities are based on quoted market prices obtained from independent pricing services. The carrying amount of accrued interest on securities approximates its fair value. LOANS, NET For loans with rates that are repriced in coordination with movements in market rates and with no significant change in credit risk, fair value estimates are based on carrying values. The fair values for other loans are estimated through discounted cash flow analysis, using current rates at which loans with similar terms would be made to borrowers of similar credit quality. Appropriate adjustments are made to reflect probable credit losses. The carrying amount of accrued interest on loans approximates its fair value. DEPOSITS SFAS No. 107 specifies that the fair value of deposit liabilities with no defined maturity is to be disclosed as the amount payable on demand at the reporting date, i.e., at their carrying or book value. These deposits, which include interest and non-interest checking, passbook savings, and money market accounts, represented approximately 80% of total deposits at December 31, 1993 and 1992. The fair value of fixed maturity deposits is estimated using a discounted cash flow calculation that applies rates currently offered for time deposits of similar remaining maturities. The carrying amount of accrued interest payable on deposits approximates its fair value. The economic value attributable to the relationship with depositors who provide low-cost funds to the Company is viewed as a separate intangible asset and is excluded in SFAS No. 107 from the definition of a financial instrument. SHORT-TERM BORROWINGS The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, approximate their fair values. OFF-BALANCE-SHEET INSTRUMENTS Off-balance-sheet financial instruments include commitments to extend credit, letters of credit, and other financial guarantees. The fair value of such instruments is estimated using fees currently charged for similar arrangements in the marketplace, adjusted for changes in terms and credit risk as appropriate. The estimated fair value for these instruments was insignificant at December 31, 1993 and 1992. (12) FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK In order to meet the financing needs of its customers, the Company deals in financial instruments that expose it to off-balance-sheet risk. These financial instruments include commitments to extend credit, letters of credit, and other financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statements of financial position. The Company's exposure to credit loss in the event of nonperformance by other parties for commitments to extend credit and letters of credit and other financial guarantees written is represented by the contractual amount of those instruments. The Company follows the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Page 34 of 50 Commitments to extend credit and credit card lines are agreements to make a loan to a customer as long as there is no violation of any condition established in the commitment or credit card contract. Commitments generally have fixed expiration dates or other termination clauses and may require payments of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount outstanding does not necessarily represent total future cash outlay requirements. The amount of collateral, if any, required by the Company upon issuance of a commitment is based on management's credit evaluation of the borrower. Collateral varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Letters of credit and financial guarantees written are conditional agreements issued by the Company to guarantee the performance of a customer to a third party. These agreements are primarily issued to support commercial trade. Agreements totalling $10.5 million at December 31, 1993 have original maturities greater than one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds marketable securities as collateral to support those letters of credit and guarantees for which collateral is deemed necessary. Letters of credit and financial guarantees outstanding at December 31, 1993, ranged from unsecured to fully secured. (13) REGULATORY MATTERS The Bank is required to maintain non-interest-bearing reserve balances with the Federal Reserve Bank to fulfill its reserve requirements. The average balance maintained was approximately $63,243,000 in 1993 and $61,182,000 in 1992. In 1990, the Company and the Bank entered into an agreement with federal bank regulators designed to ensure the continued strength of the institution and to improve its internal policies in certain respects. The terms of the agreement have been satisfied and the agreement was dissolved during 1993. (14) COMMITMENTS AND CONTINGENCIES On December 21, 1993, the Company and the Bank entered into an agreement for the Bank to purchase substantially all of the assets and assume the deposit and certain other liabilities of Baton Rouge Bank and Trust. This transaction, which is expected to be completed in the first half of 1994, is subject to regulatory approvals and certain other conditions. The assets to be acquired total approximately $120,000,000. The final purchase price has not yet been determined. The Company and its subsidiaries are parties to various legal proceedings arising in the ordinary course of business. After reviewing with outside legal counsel pending and threatened actions, management is of the opinion that the ultimate resolution of these actions will not have a material effect on the Company's financial condition and results of operations. Management also does not believe that compliance with existing federal, state or local environmental laws and regulations will impose any material financial obligation on the Company or materially affect the realizable value of its assets. The Company owns its own main office building as well as most of its branch banking facilities and has not entered into material commitments under non- cancellable leases for facilities or equipment. The defined benefit retirement plan is sufficiently funded on an actuarial basis so as not to have required an additional contribution by the Company during 1993. Current projections do not indicate that a contribution will be required for 1994. Page 35 of 50 (15) PARENT COMPANY FINANCIAL STATEMENTS Summarized parent-company-only financial statements of Whitney Holding Corporation follow (in thousands): Page 36 of 50 MANAGEMENT REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of Whitney Holding Corporation is responsible for the preparation of the financial statements, related financial data and other information in this report on Form 10-K. The financial statements are prepared in accordance with generally accepted accounting principles and include amounts based on management's estimates and judgement where appropriate. Financial information appearing throughout this report on Form 10-K is consistent with the financial statements. The Company's financial statements have been audited by Arthur Andersen & Co., independent public accountants. Management has made available to Arthur Andersen & Co. all of the Company's financial records and related data, as well as the minutes of shareholders' 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 continually monitors the system of internal control for compliance. The Company maintains a strong internal control auditing program that independently assesses the effectiveness of the internal controls and recommends possible improvements thereto. As part of their audit of the Company's 1993 financial statements, Arthur Andersen & Co. considered the Company's system of internal control to the extent they deemed necessary to determine the nature, timing and extent of their audit tests. Management has considered the internal auditor's 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 herein. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF WHITNEY HOLDING CORPORATION: We have audited the accompanying consolidated balance sheets of Whitney Holding Corporation (a Louisiana corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the 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 Whitney Holding Corporation and subsidiaries as of December 31, 1993 and 1992, and 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. As discussed in Notes 4 and 5 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. As discussed in Notes 1 and 2 to the consolidated financial statements, effective December 31, 1993, the Company changed its method of accounting for certain investments in debt and equity securities. (SIGNATURE OF ARTHUR ANDERSEN & CO. APPEARS HERE) Arthur Andersen & Co. New Orleans, Louisiana January 13, 1994 Page 37 of 50 SUMMARY OF QUARTERLY FINANCIAL INFORMATION - ------------------------------------------ The following quarterly financial information is unaudited. In the opinion of management all normal recurring adjustments necessary to present fairly the results of operations for such periods are reflected. Page 38 of 50 ITEM 9: ITEM 9: DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable PART III ITEM 10: ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT In response to this item, registrant incorporates by reference the section entitled "Election of Directors" of the Proxy Statement dated March 24, 1994. EXECUTIVE OFFICERS OF THE REGISTRANT WILLIAM L. MARKS, 50, Chairman of the Board and Chief Executive Officer of WNB and the Company since February 28, 1990. Former Senior Executive Vice President and Regional Executive of AmSouth Bank NA, headquartered in Birmingham, Alabama, responsible for a division with $1 billion in assets and 702 employees. R. KING MILLING, 53, since 1978, Director, since December, 1984, Director and President, of the Bank and the Company. G. BLAIR FERGUSON, 50, since July, 1993, Executive Vice President, of the Bank. Former Executive Vice President and Regional Director of First City, Texas - Dallas. EDWARD B. GRIMBALL, 49, from September, 1990 to October, 1991, Vice President and Chief Financial Officer, since October, 1991, Executive Vice President and Chief Financial Officer, of the Bank and the Company. Former Senior Vice President, Comptroller and Secretary of Bank South Corp., a $5- billion multi-bank holding company headquartered in Atlanta, Georgia. KENNETH A. LAWDER, JR., 52, since December, 1991, Executive Vice President, of the Bank and the Company. Former Senior Vice President, Wachovia Bank NA., a $17-billion bank headquartered in Winston-Salem, North Carolina. JOSEPH W. MAY, 48, since December, 1993, Executive Vice President, of the Bank and the Company. Former Executive Vice President and Chief Credit Policy Officer, Comerica, Inc., a $27-billion bank headquartered in Detroit, Michigan. ITEM 11: ITEM 11: EXECUTIVE COMPENSATION In response to this item, registrant incorporates by reference the section entitled "Executive Compensation" of the Proxy Statement dated March 24, 1994. ITEM 12: ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT In response to this item, registrant incorporates by reference the sections entitled "Voting Securities and Principal Holders Thereof" and "Election of Directors" of the Proxy Statement dated March 24, 1994. ITEM 13: ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In response to this item, registrant incorporates by reference the section entitled "Certain Transactions" of the Proxy Statement dated March 24, 1994. Page 39 of 50 PART IV ITEM 14: ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) and (2) Financial Statements and Schedules The following consolidated financial statements of the Company and its subsidiaries are included in Part II Item 8: All schedules have been omitted because they are either not applicable or the required information has been included in the financial statements or notes to the financial statements. (a) (3) Exhibits: Exhibit 3.1 - Copy of Composite Charter, incorporated by reference to the Company's March 31, 1993 Form 10-Q Exhibit 3.2 - Copy of Bylaws, as amended, incorporated by reference to the Company's March 31, 1993 Form 10-Q Exhibit 10.1 - Stock Option Agreement between Whitney Holding Corporation and William L. Marks, incorporated by reference to the Company's 1990 Form 10-K Exhibit 10.2 - Executive agreement between Whitney Holding Corporation, Whitney National Bank and William L. Marks, incorporated by reference to the Company's June 30, 1993 Form 10-Q Exhibit 10.3 - Executive agreement between Whitney Holding Corporation, Whitney National Bank and R. King Milling, incorporated by reference to the Company's June 30, 1993 Form 10-Q Exhibit 10.4 - Executive agreement between Whitney Holding Corporation, Whitney National Bank and Edward B. Grimball, incorporated by reference to the Company's June 30, 1993 Form 10-Q Exhibit 10.5 - Executive agreement between Whitney Holding Corporation, Whitney National Bank and Kenneth A. Lawder, Jr., incorporated by reference to the Company's June 30, 1993 Form 10-Q Exhibit 10.6 - Executive agreement between Whitney Holding Corporation, Whitney National Bank and G. Blair Ferguson, incorporated by reference to the Company's September 30, 1993 From 10-Q Page 40 of 50 Exhibit 10.7 - Executive agreement between Whitney Holding Corporation, Whitney National Bank and Joseph W. May, effective December 13, 1993 Exhibit 10.8 - Long-term incentive program, incorporated by reference to the Company's 1991 Form 10-K Exhibit 10.9 - Executive compensation plan, incorporated by reference to the Company's 1991 Form 10-K Exhibit 10.10 - Form of restricted stock agreement between Whitney Holding Corporation and certain of its officers, incorporated by reference to the Company's June 30, 1992 Form 10-Q Exhibit 10.11 - Form of stock option agreement between Whitney Holding Corporation and certain of its officers, incorporated by reference to the Company's June 30, 1992 Form 10-Q Exhibit 10.12 - Directors' Compensation Plan, incorporated by reference to the Company's Proxy Statement dated March 24, 1994 Exhibit 21 - Subsidiaries Whitney Holding Corporation owns 100% of the capital stock of Whitney National Bank. All other subsidiaries considered in the aggregate would not constitute a significant subsidiary. (b) No report on Form 8-K was required to be filed by the Registrant during the last quarter of 1993. Pursuant to the requirements of the 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. WHITNEY HOLDING CORPORATION (Registrant) By: /s/ William L. Marks ----------------------------- William L. Marks Chairman of the Board and Chief Executive Officer March 23, 1994 Page 41 of 50 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. Page 42 of 50

774350_1993.txt

774350_1993

1993

774350

Item 1. BUSINESS General Information regarding Meditrust's business is given as of February 28, 1994. Meditrust (the "Company"), a real estate investment trust organized on August 6, 1985, invests in the subacute sector of the health care industry in locations throughout the United States. The objective of the Company is to enable shareholders to participate in the investment in health care related facilities held primarily for the production of income to be distributed to shareholders. In meeting this objective, the Company attempts to invest in high quality facilities that are managed by experienced operators and to achieve diversity in its property portfolio by sector of the health care industry, geographic location, operator and form of investment. The Company was organized to qualify, and intends to continue to operate, as a real estate investment trust in accordance with federal tax laws and regulations. So long as the Company so complies, with limited exceptions, the Company will not be taxed under federal income tax laws on that portion of its taxable income that it distributes to its shareholders. The Company has distributed, and intends to continue to distribute, substantially all of its real estate investment trust taxable income to shareholders. The Company currently has investments in 213 facilities, consisting of 179 long-term care facilities, 20 rehabilitation hospitals, two alcohol and substance abuse treatment facilities, six psychiatric hospitals, four retirement living centers and two medical office buildings. Included in the 213 facilities are four properties under construction that are expected to begin operations during the next three to twelve months. The Company's investments take the form of sale/leaseback transactions, permanent mortgage loans and development mortgage loans. The Company only enters into development mortgage loans if, upon completion of the facility, the Company's development mortgage loan is to be replaced by either a permanent mortgage loan from the Company or a sale/leaseback transaction with the Company. The Company's gross real estate investments increased by $206,822,000 during 1993 to $1,287,602,000 at December 31, 1993 as a result of the Company making permanent and development mortgage loans and entering into sale/leaseback transactions. Permanent Mortgage Loans. During 1993, the Company provided permanent mortgage financing of $181,908,000 for 26 long-term care facilities, one rehabilitation facility and one retirement living facility totaling approximately 4,300 beds and located in 13 states and for additions to four facilities having permanent mortgage loans. As of February 28, 1994, the Company was committed to provide additional financing of approximately $2,207,000 for four existing permanent mortgage loans. Sale/Leaseback Transactions. During 1993, the Company funded $8,000,000 for the purchase of a rehabilitation facility located in Arkansas and capitalized additional costs of $10,272,000 relating to thirteen facilities located in eight states. Other Transactions. During the year ended December 31, 1993, the Company entered into a series of transactions with a prior operator of certain rehabilitation and long-term care facilities financed by the Company. As a result of these transactions, the Company acquired for $99,763,000 five rehabilitation and four long-term care facilities (located in New York, Massachusetts, Michigan, New Hampshire, Wisconsin and Washington), reduced existing mortgage loans by $81,690,000, reduced a related bank participation in one of the mortgage loans by $18,073,000, acquired from the operators of certain facilities operating receivables and provided advances under a working capital line. Also in connection with these transactions, the Company leased eight of these facilities to four different operators and entered into a management agreement for the remaining facility. During 1993, the Company acquired a psychiatric facility in Texas for an amount equal to its existing mortgage loan of $6,803,000 and entered into a lease transaction with one of its existing operators. Also during 1993, the Company reduced its real estate investments by $34,978,000 from the sale of a long-term care facility located in Washington and from the prepayment of permanent mortgage loans on five long-term care facilities located in Massachusetts and two long-term care facilities located in Connecticut. In addition, the Company collected principal payments of $4,662,000 and reduced its investment in a partnership by $178,000. Conversion of Development Mortgage Loans to Permanent Loans. During 1993, the Company provided ongoing development financing of $16,097,000 resulting in an aggregate funding of $33,963,000 for four long-term care facilities located in four states totaling 496 beds. Construction of these facilities was completed and development mortgage loans totaling $16,969,000 were converted to permanent mortgage loans and development mortgage loans totaling $16,994,000 were converted into sale/leaseback transactions. Development Mortgage Loans. During 1993, the Company provided ongoing construction financing of $12,290,000 for three long- term care facilities and for additions to two existing long-term care facilities. As of February 28, 1994, the Company is committed to provide additional financing of approximately $17,831,000 for the completion of seven facilities. Financings. In February 1993, the Company completed the sale of 3,277,500 Shares at $30.625 per Share and issued $92,120,000 of 7% convertible debentures due 1998. The Company used the proceeds to repay short-term borrowings and for investments in additional health care facilities. In November 1993, the Company issued $86,250,000 of 6 7/8% convertible debentures due 1998. The Company used the proceeds to repay short-term borrowings and for investments in additional health care facilities. The Company may raise additional capital from public or private sources and invest in additional health care related facilities. INVESTMENT AND OTHER POLICIES General The Company invests in income-producing health care related facilities which may include long-term care facilities, rehabilitation hospitals, alcohol and substance abuse treatment facilities, psychiatric hospitals, retirement living facilities, medical office buildings and other health care related facilities. These investments are made primarily for the production of income. Because the Company invests in health care related facilities, the Company is not in a position to diversify its investment portfolio to include assets selected to reduce the risks associated with investment in improved real estate in a single industry. However, the Company intends to continue to diversify its portfolio by broadening its geographic base, providing financing to more operators, diversifying the type of health care facilities in its portfolio and diversifying the types of financing methods provided. In evaluating potential investments, the Company considers such factors as: (1) the current and anticipated cash flow and its adequacy to meet operational needs and other obligations and to provide a competitive market return on equity to the Company's shareholders; (2) the geographic area, type of property and demographic profile; (3) the location, construction quality, condition and design of the property; (4) the potential for capital appreciation, if any; (5) the growth, tax and regulatory environment of the communities in which the properties are located; (6) occupancy and demand for similar health care facilities in the same or nearby communities; (7) an adequate mix of private and governmental-sponsored patients; (8) potential alternative uses of the facilities; and (9) prospects of liquidity through financing or refinancing. Management conducts market research and analysis for all potential investments on behalf of the Company. Management also reviews the value of the property, the interest rates and debt service coverage requirements of any debt to be assumed and the anticipated sources of repayment for such debt. The Company's Declaration of Trust places no limitations on the percentage of the Company's total assets that may be invested in any one property or joint venture or on the nature or identity of the operators of such properties. The independent Trustees of the Company, however, may establish such limitations as they deem appropriate from time to time. From time to time, the Company enters into senior debt transactions. The Company has no current plans to underwrite securities of other issuers. The Company has authority to offer shares of beneficial interest ("Shares") in exchange for investments which conform to its standards and to repurchase or otherwise acquire its Shares or other securities. The Company has no present plans to invest in the securities of others for the purpose of exercising control, although the Company owns interests in partnerships which own health care facilities. The Company makes loans on such terms as the Trustees may approve. The Company will not, without the prior approval of a majority of Trustees, including a majority of the independent Trustees of the Company, acquire from or sell to any Trustee, director, officer or employee of the Company, or any affiliate thereof, any of the assets or other property of the Company. The Company provides its shareholders with annual reports containing audited financial statements and quarterly reports containing unaudited financial information. Reinvestment of Sales Proceeds In the event the Company sells or otherwise disposes of any of its properties, the independent Trustees will determine whether and to what extent the Company will acquire additional properties or distribute the proceeds to the shareholders. Short-Term Investments The Company invests its cash in certain short-term investments during interim periods between the receipt of revenues and distributions to shareholders. Cash not invested in facilities may be invested in interest-bearing bank accounts, certificates of deposit, short-term money-market securities, short-term United States government securities, mortgage-backed securities guaranteed by the Government National Mortgage Association, mortgages insured by the Federal Housing Administration or guaranteed by the Veterans Administration, mortgage loans, mortgage loan participations, and certain other similar investments. The Company's ability to make certain of these investments may be limited by tax considerations. The Company's return on these short-term investments may be more or less than its return on real estate investments. Borrowing Policies The Company may incur additional indebtedness when, in the opinion of the Trustees, it is advisable. For short-term purposes, the Company may, from time to time, negotiate lines of credit, arrange for other short-term borrowings from banks or others or issue commercial paper. The Company may arrange for long-term borrowing from banks, insurance companies, public offerings or private placements to institutional investors. Under the Company's Declaration of Trust and under documents pertaining to certain existing indebtedness, the Company is subject to various restrictions with respect to borrowings. See "Prohibited Investments and Activities." In addition, the Company may incur mortgage indebtedness on real estate which it has acquired through purchase, foreclosure or otherwise. When terms are deemed favorable, the Company may invest in properties subject to existing loans or mortgages. The Company also may obtain financing for unleveraged properties in which it has invested or may refinance properties acquired on a leveraged basis. There is no limitation on the number or amount of mortgages which may be placed on any one property, but overall restrictions on mortgage indebtedness are provided under documents pertaining to certain existing indebtedness. Prohibited Investments and Activities The Declaration of Trust imposes certain prohibitions and restrictions on various investment practices or activities of the Company, including prohibitions against: (i) investing in junior mortgage loans, unless, by appraisal or other method, the Independent Trustees determine: (a) the capital investment in any such mortgage loan is adequately secured on the basis of the equity of the borrower in the property underlying such investment and of the ability of the borrower to repay the mortgage loan; or (b) such mortgage loan is a financing device entered into by the Company to establish the priority of its capital investment over the capital of others investing with the Company in a real estate project; (ii) allowing the aggregate borrowings of the Company to exceed 300% of the net assets of the Company, unless the Independent Trustees determine that a higher level of borrowing is appropriate; (iii) investing more than 10% of the Company's total assets in unimproved real property or mortgage loans with respect thereto; (iv) investing in commodity or commodity futures contracts other than interest rate futures used solely for hedging purposes; (v) issuing equity securities which are redeemable at the option of the holders thereof; (vi) issuing debt securities, unless the historical debt service coverage for the most recently completed fiscal year, as adjusted for known changes, is sufficient to service the higher level of debt; (vii) granting options or issuing warrants to purchase Shares at an exercise price or for consideration less than the fair market value of such Shares on the date of such grant or issuance; (viii) investing more than 1% of the assets of the Company in real estate contracts for sale, unless such real estate contracts are recordable in the chain of title; and (ix) acting in any way that would disqualify the Company as a real estate investment trust under the provisions of the Internal Revenue Code. At the Annual Meeting in May 1992, the shareholders voted to amend the Declaration of Trust by deleting all of the foregoing restrictions. The amendment remains subject to the consent of certain third party lenders. In addition to prohibitions and restrictions imposed by the Declaration of Trust, there are and may be, from time to time, additional restrictions imposed by debt instruments or other agreements entered into by the Company. Policy Changes The prohibitions and restrictions contained in the Declaration of Trust may not be changed by the Trustees without shareholder approval. All other policies set forth herein may be changed by the Trustees without shareholder approval. Competition The Company competes, primarily on the basis of price, knowledge of the industry, and flexibility of financing structure, with real estate partnerships, other real estate investment trusts, banks and other investors generally in the acquisition, leasing and financing of health care related facilities. The operators of the facilities compete on a local and regional basis with other operators of comparable facilities. They compete with independent operators as well as companies managing multiple facilities, some of which are substantially larger and have greater resources than the operators of the Company's facilities. Some of these facilities are operated for profit while others are owned by governmental agencies or tax-exempt not-for-profit organizations. Employees The Company currently employs 44 persons. Declaration of Trust The Declaration of Trust of the Company provides that shareholders of the Company shall not be subject to any liability for the acts or obligations of the Company and that, as far as is practicable, each written agreement of the Company is to contain a provision to that effect. No personal liability will attach to the shareholders for claims under any contract containing such a provision in writing where adequate notice is given of such provision, except possibly in a few jurisdictions. With respect to all types of claims in such jurisdictions and with respect to tort claims, contract claims where the shareholder liability is not disavowed as described above, claims for taxes and certain statutory liabilities in other jurisdictions, a shareholder may be held personally liable to the extent that claims are not satisfied by the Company. However, the Declaration of Trust provides that, upon payment of any such liability, the shareholder will be entitled to reimbursement from the general assets of the Company. The Trustees intend to conduct the operations of the Company, with the advice of counsel, in such a way as to avoid, as far as is practicable, the ultimate liability of the shareholders of the Company. The Trustees do not intend to provide insurance covering such risks to the shareholders. GOVERNMENT REGULATION Each of the Company's investments is in a health care related facility and the amount of percentage rent or additional interest, if any, which is based on the operator's gross revenues from certain of the facilities, is in most cases subject to changes in the reimbursement and license policies of federal, state and local governments. In addition, the acquisition of health care facilities is generally subject to state and local regulatory approval. Medicare, Medicaid, Blue Cross and Other Payors Certain of the operators receive payments for patient care from federal Medicare programs for elderly and disabled patients, state Medicaid programs for medically indigent and cash grant patients, private insurance carriers, employers and Blue Cross plans, health maintenance organizations, preferred provider organizations and directly from patients. In general, Medicare payments for psychiatric care, long-term care services and rehabilitative care are based on allowable costs plus a return on equity for proprietary facilities. Payments from state Medicaid programs for psychiatric care are based on reasonable costs or are at fixed rates. Long-term care facilities are generally paid by the Medicaid programs at fixed rates. Most Medicare and Medicaid payments are below retail rates. Blue Cross payments in different states and areas are based on costs, negotiated rates or retail rates. Long-Term Care Facilities Regulation of long-term care facilities is exercised primarily through the licensing of such facilities. The particular agency having regulatory authority and the license qualification standards vary from state to state and, in some instances, from locality to locality. Licensure standards are constantly under review and undergo periodic revision. Governmental authorities generally have the power to review the character, competence and community standing of the operator and the financial resources and adequacy of the facility, including its plant, equipment, personnel and standards of medical care. Long-term care facilities are certified under the Medicare program and all are eligible to qualify under state Medicaid programs, although not all participate in the Medicaid programs. Rehabilitation Hospitals Rehabilitation hospitals are also subject to extensive federal, state and local legislation and regulation. Rehabilitation hospitals are subject to periodic inspections and licensure requirements. Inpatient rehabilitation facilities are cost-reimbursed, receiving the lower of reasonable costs or reasonable charges. Typically, the fiscal intermediary pays a set rate per day based on the prior year's costs for each facility. Annual cost reports are filed with the operator's fiscal intermediary and adjustments are made, if necessary. Alcohol and Substance Abuse Treatment Facilities Alcohol and substance abuse treatment facilities must comply with the licensing requirements of federal, state and local health agencies and with the requirements of municipal building codes, health codes and local fire departments. In granting and renewing a facility's license, a state health agency considers, among other things, the physical buildings and equipment, the qualifications of the administrative personnel and health care staff, the quality of nursing and other services and the continuing compliance of such facility with the laws and regulations applicable to its operations. Psychiatric Hospitals Psychiatric hospitals generally are subject to extensive federal, state and local legislation and regulation. Licensing for psychiatric hospitals is subject to periodic inspections regarding standards of medical care, equipment and hygiene. In addition, there are specific laws regulating civil commitment of patients and disclosure of information regarding patients being treated for chemical dependency. Many states have adopted a "patient's bill of rights" which sets forth standards, such as using the least restrictive treatment, allowing patient access to the telephone and mail, allowing the patient to see a lawyer and requiring the patient to be treated with dignity. Insurance reimbursement for psychiatric treatment generally is more limited than for general health care. Medical Office Buildings The individual physicians, groups of physicians and health care providers which occupy medical office buildings are subject to a variety of federal, state and local regulations applicable to their specific areas of practice. Since medical office buildings may contain numerous types of medical services, a wide variety of regulations may apply. In addition, medical office buildings must comply with the requirements of municipal building codes, health codes and local fire departments. Item 2. Item 2. PROPERTIES The table sets forth certain information as of February 28, 1994 regarding the Company's facilities: (1) Based upon information provided by the operators of the facilities, the average occupancy of the Company's facilities for the year ended December 31, 1993, was as follows: long-term care facilities, 90%; rehabilitation hospitals, 54%; alcohol and substance abuse treatment facilities, 61%; psychiatric hospitals, 52%; retirement living facilities, 82%. Generally, average occupancy rates are determined by dividing the number of patient days in each period by the average number of licensed bed days during such period. (2) Represents purchase price or mortgage amount at February 28, 1994 for operating facilities and the estimated construction loan amount for facilities under construction. The annual base rentals/interest payments under the leases or mortgages are generally projected to be 10.0% - 12.5% of the purchase price or mortgage amount, in accordance with the terms of the respective agreements. (3) Base rent excludes additional and percentage rent and interest but includes an aggregate of $6,868,000 in debt service. Additional and percentage rent and interest for the year ended December 31, 1993 was an aggregate of $8,657,000 for all of the facilities. Additional and percentage rent and interest are calculated based upon a percentage of a facility's revenues over an agreed upon base amount. (4) Permanent mortgage loans. (5) Includes a permanent mortgage loan of $7,301,000. (6) Includes permanent mortgage loans aggregating $69,158,000. (7) Includes permanent mortgage loan of $8,432,000 (8) Includes a permanent mortgage loan of $50,500,000. (9) Includes permanent mortgage loans of $74,292,000. (10) Includes permanent mortgage loans of $21,494,000. (11) Includes a permanent mortgage loan of $3,426,000. (12) Includes a permanent mortgage loan of $9,911,000. (13) Includes permanent mortgage loans of $36,246,000. (14) Includes a permanent mortgage loan of $29,911,000. (15) Fifty percent owned by the Company. The amount shown as annual base rent represents the Company's partnership distribution received during the year ended December 31, 1993. (16) Represents mortgages collateralized by multi-state facilities. (17) Represents a permanent mortgage on fifteen properties located in nine states. (18) Represents a permanent mortgage on seventeen properties located in ten states. (19) Construction mortgage loan. (20) Investments by the Company in facilities operated by The Mediplex Group, Inc., Life Care Centers of America, Inc., and Continental Medical Systems, Inc. represented 27.2%, 14.6% and 9.7%, respectively, of the Company's total assets as of February 28, 1994. (21) The 28 facilities for which The Mediplex Group, Inc. has guaranteed the lessee's or borrower's obligations or provided working capital assurances are located in Massachusetts, Connecticut, New York, New Jersey, Florida, Michigan and Arkansas and include 22 long-term care facilities, 3 rehabilitation hospitals, 2 alcohol and substance abuse treatment facilities and 1 psychiatric hospital. Long-Term Care Facilities. The long-term care facilities offer restorative, rehabilitative and custodial nursing care for patients not requiring more extensive and sophisticated treatment available at acute care hospitals. The facilities are designed to provide custodial care and to supplement hospital care and many have transfer agreements with one or more acute care hospitals. Rehabilitation Hospitals. The rehabilitation hospitals provide treatment to restore physical, psycho-social, educational, vocational and economic usefulness and independence to disabled persons. Rehabilitation concentrates on physical disabilities and impairments and utilizes a coordinated multidisciplinary team approach to help patients attain measurable goals. Alcohol and Substance Abuse Treatment Facilities. These facilities provide inpatient treatment for alcohol and substance abuse, including medical evaluation, detoxification and rehabilitation. Specialized programs offer treatment for adults, adolescents, families and chronic abusers. Psychiatric Hospitals. The psychiatric hospitals offer comprehensive, multidisciplinary adult, adolescent and substance abuse psychiatric programs. Patients are evaluated upon admission and an individualized treatment plan is developed. Elements of the treatment plan include individual, group and family therapy, activity therapy, educational programs and career and vocational planning. Retirement Living Facilities. The retirement living facilities offer specially designed residential units for active and ambulatory elderly residents and provide various ancillary services. They contain nursing facilities to provide a continuum of care. The retirement living facilities offer their residents an opportunity for an independent lifestyle with a range of social and health services. Medical Office Buildings. Medical office building facilities contain individual physician, physician group and other health care provider offices for the administration and treatment of patients, usually in close proximity to the general service acute care hospital to which the physicians are affiliated. The types of services provided in a medical office building may include outpatient therapy, clinics, examination facilities and the provision of other medical services in a non-hospital setting. LEASES Each facility (which includes the land, buildings and improvements, related easements and rights and fixtures (the "Leased Properties")), that is owned by the Company is leased to a health care provider pursuant to a long-term net lease (collectively, the "Leases") which generally contains terms as outlined below. Generally, the Leased Properties do not include major movable equipment. The fixed terms of the Leases generally range from 10 to 20 years and contain from two to nine five-year renewal options. Some Leases are subject to earlier termination upon the occurrence of certain contingencies described in the Lease. The Company's Leased Properties aggregated approximately $686,000,000 of gross real estate investments at December 31, 1993. The base rents range from approximately 10% to 15% per annum of the Company's equity investment in the Leased Properties and many may be adjusted upward during the terms of the leases to an amount equal to 300 to 500 basis points over the five-year United States Treasury securities' yield at the time of adjustment. The base rents for the renewal periods are generally fixed rents for the initial renewal periods and market rates for later renewal periods. All Leases, except for two facilities located in New York, provide for additional rents in addition to the base rent, based on revenues exceeding specified base revenues. The rents for these two facilities are subject to periodic fixed increases. In addition, the Company typically charges a lease commitment fee at the initiation of the sale/leaseback transaction. Each Lease is a net lease requiring the lessee to pay rent and all additional charges incurred in the operation of the Leased Property. The lessees are required to repair, rebuild and maintain the Leased Properties. The obligations under the Leases are guaranteed by the parent corporation of the lessee, if any, or affiliates or individual principals of the lessee. Some obligations are further backed by letters of credit, security deposits or certificates of deposit from various financial institutions which cover up to one full year's lease payments and which remain in effect until the expiration of a fixed time period or the fulfillment of certain performance criteria. The Company also may obtain other credit enhancement devices similar to those it may obtain with respect to permanent mortgage loans. See "Permanent Mortgage Loans." With respect to two of the facilities, the Company leases the land pursuant to ground leases and in turn subleases the land to the operator of the facility. Such subleases contain substantially similar terms as the Leases. PERMANENT MORTGAGE LOANS The Company's permanent mortgage loan program is comprised of secured loans which are structured to provide the Company with interest income, additional interest based upon the revenue growth of the operating facility, principal amortization and commitment fees. Virtually all of the approximately $589,000,000 of permanent mortgage loans as of December 31, 1993 are first mortgage loans. The interest rates on the Company's investments in permanent mortgage loans for operating facilities ranged from 10.0% to 13.5% per annum on the outstanding balances. The yield to the Company on permanent mortgage loans depends upon a number of factors, including the stated interest rate, average principal amount outstanding during the term of the loan, the amount of the commitment fee charged at the inception of the loan, the interest rate adjustments and the additional interest earned in the revenue growth of the operating facility. The permanent mortgage loans for operating facilities made through December 31, 1993 are generally subject to 10-year terms that provide for a balloon payment on the outstanding principal balance at the end of the tenth year. The interest adjustment generally provides for interest to be charged at the greater of the current interest rate or 300 to 450 basis points over the five- year United States Treasury securities' yield at the time of adjustment. The Company generally requires a variety of additional forms of security and collateral beyond that which is provided by the lien of the mortgage. For example, the Company requires one or more of the following items: (a) a guaranty of the complete payment and performance of all obligations associated with each mortgage loan from the borrower's parent corporation, if any, other affiliates of the borrower and/or one or more of the individual principals controlling such borrower; (b) a collateral assignment from the borrower of the leases and the rents relating to the mortgaged property; (c) a collateral assignment from the borrower of all permits, licenses, approvals and contracts relating to the operation of the mortgaged property; (d) a pledge of all, or substantially all, of the equity interest held in the borrower; (e) cash collateral or a pledge of a certificate of deposit, for a negotiated dollar amount typically equal to at least one year's principal and interest on the loan (which cash collateral or pledge of certificate of deposit typically remains in effect until the later to occur of (i) three years after the closing of the mortgage loan or (ii) the achievement by the facility of an agreed-upon cash flow debt coverage ratio for three consecutive fiscal quarters and, in the event that after the expiration of the letter of credit or pledge of certificate of deposit, the agreed-upon financial covenants are not maintained throughout the loan term, the borrower is often required to provide the Company with cash collateral or pledge of certificate of deposit); (f) an agreement by any affiliate of the borrower or the facility to subordinate all payments due to it from the borrower to all payments due to the Company under the mortgage loan; and (g) a security interest in all of the borrower's personal property, including, in some instances, the borrower's accounts receivable. In addition, the mortgage loans are generally cross-defaulted and cross-collateralized with any other mortgage loans, leases or other agreements between the borrower or an affiliate of the borrower and the Company. DEVELOPMENT MORTGAGE LOANS The Company makes development mortgage loans that by their terms convert either into sale/leaseback transactions or permanent mortgage loans upon the completion of development of the facilities. Generally, the interest rates on the outstanding balances of the Company's development mortgage loans are the greater of a base rate or 75 to 550 basis points over the prime rate of a specified financial institution. The Company also typically charges a commitment fee at the commencement of the loan. The development loan period generally commences upon the funding of such loans and terminates upon the earlier of (a) the completion of development of the applicable facility or (b) a specific date. This period is generally 12 to 18 months. During the term of the development loan, funds are advanced pursuant to draw requests made by the borrower in accordance with the terms and conditions of the applicable loan agreement which require a site visit prior to the advancement of funds. Monthly payments of interest only are made on the total amount of the loan proceeds advanced during the development period. Since it began its development mortgage loan program in August 1987, the Company has funded the development of ten rehabilitation hospitals, six long-term care facilities and one retirement living facility. These facilities, subsequently converted into sale/leaseback transactions, represent an investment of approximately $140,606,000 as of December 31, 1993. The Company had advanced approximately $11,477,000 towards a commitment of $13,896,000 of development mortgage loans in conjunction with the development of additions to three additional long-term care facilities as of December 31, 1993. These development loans convert automatically into sale/leaseback transactions upon completion of the facility. Simultaneously with the commencement of the term of each of these development loans, the Company has generally entered into a purchase and sale and lease agreement with the borrower pursuant to which (a) the Company will purchase the facility upon completion of the development for purchase prices ranging from (i) a stated maximum price that is generally equal to the face amount of the development mortgage loan to (ii) the actual cost of developing the facility plus an amount equal to the sum of specified "soft costs" items associated with such development and (b) upon such sale the borrower will immediately lease back the facility from the Company. The base rent under the lease is established upon the conclusion of the development loan period at the greater of (i) a rate specifically agreed to at the time of the issuance of the commitment for the loan or (ii) 300 to 450 basis points over the five-year United States Treasury securities' yield at the time of adjustment. See "Leases." The Company has also funded since inception the development of two rehabilitation hospitals, eight long-term care facilities and one retirement living facility that were converted to permanent mortgage loans, representing an investment of approximately $104,788,000 as of December 31, 1993. The Company had advanced approximately $4,663,000 towards a total commitment of $10,335,000 of development mortgage loans in conjunction with the development of two additional long-term care facilities as of December 31, 1993. These development mortgage loans convert automatically into permanent mortgage loans upon completion of the facility and the balance, if any, of the principal amount of the loan is advanced to the borrower. The interest rate of the loans is adjusted upon their conversion to permanent status to be the greater of (i) a rate specifically agreed to at the time of the issuance of the commitment for the loan or (ii) 300 to 350 basis points over the five-year United States Treasury securities' yield at the time of adjustment. The other terms and conditions of such loans generally are substantially similar to the Company's permanent mortgage loans. See "Permanent Mortgage Loans." As with the Company's permanent mortgage financing program, the development mortgage loans generally include a variety of additional forms of security and collateral beyond that which is provided by the lien of the mortgage. See "Permanent Mortgage Loans." During the development loan period, the Company generally requires additional security and collateral in the form of either (a) payment and performance completion bonds or (b) completion guarantees by either one, or a combination of, the borrower's parent entity, other affiliates of the borrower or one or more of the individual principals who control the borrower. In addition, prior to any advance of funds by the Company under the development mortgage loan, the borrower must provide (a) satisfactory evidence in the form of an endorsement to the Company's title insurance policy for the loan that no intervening liens have been placed on the property since the date of the Company's previous advance; (b) a certificate executed by the architect for the project that indicates that all construction work completed on the project conforms with the requirements of the applicable plans and specifications; (c) a certificate executed by the general contractor that all work requested for reimbursement by the borrower has been completed; and (d) satisfactory evidence that the funds remaining unadvanced under the loan are sufficient for the payment of all costs necessary for the completion of the project in accordance with the terms and provisions of the applicable loan agreement. As a further safeguard during the development loan period, the Company generally will retain a portion of the loan proceeds equal to 10% of the principal loan amount until it has received satisfactory evidence that the project has been fully completed in accordance with the applicable plans and specifications and the period during which liens may be perfected with respect to any work performed, or labor or materials supplied, in connection with the construction of the project has expired. The Company also monitors the progress of the development of each project and the accuracy of the borrower's draw requests by having its own inspector perform on- site inspections of the project prior to the release of any requested funds. Item 3. Item 3. LEGAL PROCEEDINGS NONE. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS NONE. EXECUTIVE OFFICERS OF THE REGISTRANT The following information relative to the Company's executive officers is given as of February 28, 1994: Abraham D. Gosman has been Chairman of the Company since its organization in 1985 and became Chief Executive Officer in February 1991. He had been Chief Executive Officer of A.M.A. Advisory Corp., the Company's former advisor (the "Advisor"), from June 1988 until February 1991 and President of the Advisor from its incorporation until July 1988. From August 1989 until April 12, 1991, Mr. Gosman had been Chief Executive Officer of Diamond Treatment Centers, Inc. ("Diamond") and, until he resigned in March 1991, each of its subsidiaries, which own and operate alcohol treatment facilities. On April 12, 1991, involuntary proceedings under Chapter 11 of the Federal Bankruptcy Code were filed against Diamond and each of its subsidiaries, to which filing such companies consented on April 24, 1991. Mr. Gosman was the Chief Executive Officer of The Mediplex Group, Inc. ("Mediplex"), an operator and developer of health care facilities, from its incorporation in 1983 until September 1988. After the acquisition of Mediplex in August 1990 by a company, the majority of whose stock was owned by Mr. Gosman, Mr. Gosman again assumed the position of Chief Executive Officer and Chairman of the Board of Mediplex. Mr. Gosman has been in the health care and development business for more than thirty years. David F. Benson has been President of the Company since September 1991 and was Treasurer of the Company from January 1986 to May 1992. He was Treasurer of Mediplex from January 1986 through June 1987. He was previously associated with Coopers & Lybrand, independent accountants, from 1979 to 1985. Michael F. Bushee has been Senior Vice President of Operations of the Company since October 1993. He was Vice President from December 1989 to October 1993, Director of Development from January 1988 to December 1989 and has been associated with the Company since July 1987. He was previously associated with The Stop & Shop Companies, Inc., a retailer of food products and general merchandise, for three years and Wolf & Company, P.C., independent accountants, for four years. Michael S. Benjamin has been Senior Vice President, Secretary and General Counsel of the Company since October 1993. He was Vice President, Secretary and General Counsel from May 1992 to October 1993, Secretary and General Counsel from December 1990 to May 1992 and Assistant Counsel to the Company from November 1989 to December 1990. His previous association was with the law firm of Brown, Rudnick, Freed & Gesmer, from 1983 to 1989. Lisa M. Pavelka has been Vice President of the Company since October 1993 and Treasurer since May 1992. She was Controller from December 1990 to May 1992 and Assistant Controller of the Company from November 1988 to December 1990. She was previously associated with Arthur Andersen & Co., independent accountants, from 1985 to 1988. Stephen H. Press has been Vice President of Acquisitions of the Company since October 1993 and previously held this position with the Company from June 1987 to December 1990. He was Vice President of Development and Regulatory Affairs for Integrated Health Services, Inc., a medical services company, from April 1991 to October 1993. C. Michael Ford has been Vice President of Marketing of the Company since October 1993. He previously was Chairman of the Board and Chief Executive Officer of Montpelier Corporation, a health care consulting company, from December 1990 to October 1993. He was previously associated with Charter Medical Corporation, an acute care and psychiatric hospital management company, from 1976 to 1990. Keith E. Grant has been Controller of the Company since May 1992. He was Director of Operations Management of the Company from January 1990 to May 1992. He was previously associated with New MediCo Holding Co., Inc., an operator of health care facilities, from September 1989 to December 1989 and Damon Corporation, a health care company, from August 1971 to August 1989. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The Shares are traded on the New York Stock Exchange under the symbol MT. The following table sets forth for periods shown the high and low sale prices for the Shares as reported on the New York Stock Exchange composite tape. (b) As of February 28, 1994, there were 3,942 holders of record of the Shares. (c) The Company has declared the following dividends during its two most recent fiscal years: The Company intends to distribute to its shareholders on a quarterly basis a majority of cash flow from operating activities available for distribution. Cash flow from operating activities available for distribution to shareholders of the Company will be derived primarily from the rental payments and interest payments derived from its real estate investments. All distributions will be made by the Company at the discretion of the Trustees and will depend on the earnings of the Company, its financial condition and such other factors as the Trustees deem relevant. In order to qualify for the beneficial tax treatment accorded to real estate investment trusts by Sections 856 to 860 of the Internal Revenue Code, the Company is required to make distributions to holders of its Shares which actually will be of at least 95% of the Company's "real estate investment trust taxable income". Item 6. Item 6. SELECTED FINANCIAL INFORMATION The following table presents selected financial information with respect to the Company for each of the five years in the period ended December 31, 1993. This financial information has been derived from financial statements included elsewhere in this Form 10-K and should be read in conjunction with those financial statements and accompanying footnotes. (1) Dividends, used in this context, include distributions in excess of current or accumulated net income. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations Year Ended December 31, 1993 vs. Year Ended December 31, 1992 Revenues for the year ended December 31, 1993 were $150,826,000 compared to $132,394,000 for the year ended December 31, 1992, an increase of $18,432,000 or 14%. Revenue growth resulted from increased rental income of $10,776,000 and increased interest income of $7,656,000 as a result of additional real estate investments made during the past year. For the year ended December 31, 1993, total expenses increased by $6,154,000. Interest expense increased by $4,034,000 and resulted primarily from the issuance of convertible debentures in February and November 1993 which was partially offset by the prepayment of senior debt in December 1992. Depreciation and amortization increased by $2,245,000 primarily due to depreciation of the additional real estate investments made during the past year. Other expenses decreased by $125,000 principally attributable to lower administrative expenses. Year Ended December 31, 1992 vs. Year Ended December 31, 1991 Revenues for the year ended December 31, 1992 were $132,394,000 compared to $112,910,000 for the year ended December 31, 1991, an increase of $19,484,000 or 17%. This increase is primarily the result of increased interest income of $19,259,000 from additional mortgage investments made during the year. Additional rent and interest increased approximately $2,222,000 or 41% from $5,399,000 in 1991 to $7,621,000 in 1992. Interest earned on investments decreased in 1992 by $3,005,000 resulting from a higher level of investment cash available from an equity offering in the second quarter of 1991. Other revenues increased by approximately $1,008,000. For the year ended December 31, 1992, total expenses increased $6,035,000. Interest expense increased by $1,273,000, resulting from the issuance of $100,000,000 of convertible debentures in April 1992 and was partially offset by the secured debt prepayment of $57,000,000 in December 1991. Depreciation and amortization increased by $847,000, principally due to increased amortization expense of other assets. Other expenses increased by $3,915,000, principally due to a higher level of operating costs associated with the portfolio growth and the issuance of Shares for executive compensation, a non-cash expense of $1,220,000. Liquidity and Capital Resources The Company provides funding for its investments through a combination of long-term and short-term financing including both debt and equity. The Company obtains long-term financing through the issuance of Shares, the issuance of long-term secured and unsecured notes, the issuance of convertible debentures and the assumption of mortgage notes. The Company obtains short-term financing through the use of bank lines of credit which are replaced with long-term financing as appropriate. It is the Company's objective to match the mortgage and lease terms with the terms of its borrowings. The Company seeks to maintain an appropriate spread between its borrowing costs and the rate of return on its investments. When development mortgage loans convert to sale/leaseback transactions or permanent mortgage loans, the base rent or interest rate, as appropriate, is fixed at the time of such conversion. In February 1993, the Company completed the sale of 3,277,500 Shares at $30.63 per Share and issued $92,120,000 of 7% convertible debentures due 1998. The Company used the proceeds to repay short-term borrowings and for investments in additional health care facilities. In November 1993, the Company issued $86,250,000 of 6 7/8% convertible debentures due 1998. The Company used the proceeds to repay short-term borrowings and for investments in additional health care facilities. As of February 28, 1994, the Company's gross real estate investments totaled approximately $1,338,599,000 including 179 long- term care facilities, 20 rehabilitation hospitals, two alcohol and substance abuse treatment facilities, six psychiatric hospitals, three retirement living facilities and two medical office buildings. The Company has shareholders' equity of approximately $590,313,000 and a total debt to equity ratio of approximately 1.2 to 1.0 as of February 28, 1994. The Company has an unsecured line of credit of $130,000,000 bearing interest at the lender's prime rate or LIBOR plus 1.5%, of which $16,000,000 is available at February 28, 1994. As of February 28, 1994, the Company had outstanding funding commitments of approximately $20,038,000 for the completion of four facilities under construction and for additions to seven existing facilities. The Company believes that its various sources of capital resources are adequate to finance its operations as well as pending property acquisitions, mortgage financings and future dividends. For the balance of 1994, however, in the event that the Company identifies appropriate investment opportunities, the Company may raise additional capital through the sale of shares of beneficial interest or by the issuance of additional long-term debt. Item 8. Item 8. FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Trustees of Meditrust: We have audited the accompanying consolidated balance sheets of Meditrust 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 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 Meditrust 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. COOPERS & LYBRAND Boston, Massachusetts March 10, 1994 MEDITRUST CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these financial statements. MEDITRUST CONSOLIDATED STATEMENTS OF INCOME The accompanying notes are an integral part of these financial statements. MEDITRUST CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these financial statements. MEDITRUST CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these financial statements. MEDITRUST CONSOLIDATED STATEMENTS OF CASH FLOWS, continued The accompanying notes are an integral part of these financial statements. MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ACCOUNTING POLICIES Meditrust (the "Company"), a real estate investment trust, invests in the sub-acute sector of the health care industry, including long-term care facilities, rehabilitation hospitals, and other sub-acute health care related facilities. These facilities are located throughout the United States and are operated by regional and national health care providers. The Company's more significant accounting policies follow: Principles of Consolidation The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries and its majority- owned partnerships after the elimination of all significant intercompany accounts and transactions. The Company uses the equity method of accounting for its 50% ownership in a limited partnership. Real Estate Investments Land, buildings and improvements are stated at cost. Depreciation is provided for on a straight-line basis over 40 years, the expected useful lives of the buildings and improvements. The Company provides reserves for potential losses based upon management's periodic review of its portfolio and such reserves are included in accrued expenses and other liabilities. Capitalization of Construction Period Interest The Company capitalizes interest costs associated with funds used to finance the construction of facilities. The amount capitalized is based upon the borrowings outstanding during the construction period using the rate of interest which approximates the Company's cost of financing. Short-term Cash Investments Short-term cash investments consist of certificates of deposit and other investments with less than 90-day maturities at time of purchase and are stated at cost which approximates fair value. Other Assets Other assets includes cash restricted for specified disbursement in accordance with certain facility acquisitions and mortgage financings. The corresponding liabilities are reflected in accrued expenses and other liabilities. Other assets also includes goodwill associated with the acquisition of the Company's previous investment advisor which is being amortized on a straight-line basis over a ten year period and facilities' operating receivables and working capital advances. MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--continued Debt Issuance Costs Debt issuance costs have been deferred and are being amortized using primarily the effective interest method over the term of the related borrowings. Revenue Recognition Rental income from operating leases is recognized as earned over the life of the lease agreements. Interest income on real estate mortgages is recognized on the accrual basis. Deferred income consists principally of fees which are being amortized over the fixed term of the lease, construction period or mortgage related to such facilities. Net Income Per Share Net income per Share of Beneficial Interest ("Shares") is computed using the weighted average number of Shares outstanding during the year of computation. Income Taxes The Company has elected to be taxed as a real estate investment trust under the Internal Revenue Code of 1986, as amended, and believes it has met all the requirements for qualification as such. Accordingly, the Company will not be subject to federal income taxes on amounts distributed to shareholders, provided it distributes annually at least 95% of its real estate investment trust taxable income and meets certain other requirements for qualifying as a real estate investment trust. Therefore, no provision for federal income taxes is believed necessary in the financial statements. Reclassifications Certain reclassifications have been made in the prior years' consolidated financial statements to conform with the current year's presentation. MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--continued 2. SUPPLEMENTAL CASH FLOW INFORMATION Details of net change in other assets and liabilities (excluding non-cash items, deferred income recognized in excess of cash received and changes in restricted cash and related liabilities) follow: 3. REAL ESTATE INVESTMENTS During 1993, the Company funded $8,000,000 for the purchase of a rehabilitation facility located in Arkansas and capitalized additional costs of $10,272,000 relating to thirteen facilities located in eight states. Also during 1993, the Company received proceeds of $5,194,000 from the sale of a long-term care facility located in Washington. Depreciation of real estate amounted to $14,548,000, $12,250,000 and $11,992,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Minority interest in the equity of the majority-owned (94%) partnerships relating to the Company's investment in seven rehabilitation facilities is $2,661,000 and $2,686,000 as of December 31, 1993 and 1992 and is included in accrued expenses and other liabilities in the consolidated financial statements. 4. REAL ESTATE MORTGAGES During 1993, the Company provided permanent mortgage financing of approximately $181,908,000 for 26 long-term care facilities, one rehabilitation facility and one retirement living facility, which are located in 13 states and for additions to four facilities having permanent mortgage loans. During 1993, the Company also provided ongoing construction financing of $12,290,000 for three long-term care facilities and for additions to two existing long-term care facilities. Also during 1993, the Company provided ongoing development funding of $16,097,000, resulting in aggregate funding of $33,963,000 for four long-term care facilities located in three states. Construction of these facilities was completed and development mortgage loans totaling $16,969,000 were converted to permanent mortgage loans and development mortgage loans totaling $16,994,000 were converted into sale/leaseback transactions. MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--continued During 1993, the Company received proceeds amounting to $37,383,000 from the prepayment of permanent mortgage loans on five long-term care facilities located in Massachusetts and two long-term care facilities located in Connecticut and collected principal payments of $4,662,000 on mortgage loans. During the year ended December 31, 1993, the Company entered into a series of transactions with a prior operator of certain rehabilitation and long-term care facilities financed by the Company. As a result of these transactions, the Company acquired for $99,763,000 five rehabilitation and four long-term care facilities (located in New York, Massachusetts, Michigan, New Hampshire, Wisconsin and Washington), reduced existing mortgage loans by $81,690,000, reduced a related bank participation in one of the mortgage loans by $18,073,000, acquired from operators of certain facilities operating receivables and provided advances under a working capital line. Amounts associated with the receivables and advances under the working capital line are included in other assets at December 31, 1993. Also in connection with these transactions, the Company leased eight of these facilities to four different operators and entered into a management agreement for the remaining facility. During 1993, the Company acquired a psychiatric facility in Texas for an amount equal to its existing mortgage loan of $6,803,000 and entered into a lease transaction with one of its existing operators. At December 31, 1993, the Company was committed to provide additional financing of approximately $8,994,000 relating to three long-term care facilities currently under construction and for additions to four existing long-term care facilities. 5. SHARES OF BENEFICIAL INTEREST Distributions paid to shareholders are determined by the Company's Board of Trustees based on an analysis of cash flows from operating activities. Cash flows from operating activities differ from net income primarily due to depreciation and amortization expense, a noncash item. Distributions in excess of net income as reflected on the Company's consolidated balance sheets is primarily a result of an accumulation of this difference. All Shares participate equally in dividends and in net assets available for distribution to shareholders on liquidation or termination of the Company. The Trustees of the Company have the authority to effect certain Share redemptions or prohibit the transfer of Shares under certain circumstances. Total distributions to shareholders during the years ended December 31, 1993, 1992 and 1991 included a return of capital per Share of $.3797, $.7462 and $.7273, respectively. Also, the 1993 distribution includes a long-term capital gain distribution of $.1351 per Share. MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--continued 6. INDEBTEDNESS. Indebtedness of the Company at December 31, 1993 and 1992 is as follows: MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--continued Convertible Debentures. The 9% convertible debentures issued in April 1992 are subject to redemption by the Company on or after April 23, 1995 at 100% of the principal amount plus accrued interest. During the year ended December 31, 1993, $53,042,000 of debentures were converted into 1,964,495 Shares. During the year ended December 31, 1992, $3,075,000 of debentures were converted into 113,886 Shares. The 7% debentures issued in February 1993 are subject to redemption by the Company on or after March 1, 1996 at 100% of the principal amount plus accrued interest. During the year ended December 31, 1993, $16,635,000 of debentures were converted into 543,182 Shares. The 6 7/8% debentures issued in November 1993 are subject to redemption, to the extent necessary to preserve the Company's status as a real estate investment trust, at any time by the Company at 100% of the principal amount plus accrued interest. Senior Mortgage Notes. The 10.75% notes due December 1997 are collateralized by six facilities. In December 1992, $10,800,000 of principal amount due December 1997 was prepaid. These notes were issued with detachable warrants to purchase 790,000 Shares at a price of $20 per Share with an expiration date of December 1994. The Company has valued these warrants at $1,202,500 and is amortizing this discount over ten years. Warrants were exercised for 182,308 Shares and 486,154 Shares during 1993 and 1992, respectively. Principal payments on the mortgage notes in the amounts of $33,000,000 (9.95%) due in March 1994, $11,000,000 (9.81%) due in March 1993 and $11,000,000 (9.81%) due in March 1992 were prepaid in December 1993, December 1992 and December 1991, respectively. In connection with the prepayment in 1991, the Company incurred charges and wrote off unamortized debt issuance costs of $121,000, which is included in loss on prepayment of debt. In December 1991, the Company prepaid a $46,200,000, 10.25% five-year note agreement with a bank and incurred prepayment charges of $3,251,000 and wrote off unamortized issuance costs of $312,000, which amounts are included in loss on prepayment of debt. Bank Notes Payable. The Company has an unsecured revolving credit agreement for a maximum of $130,000,000 bearing interest at the lender's prime rate or LIBOR plus 1.5%. Fees associated with this agreement are .5% per annum of the total unused commitment plus an $80,000 agent fee. MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--continued Bonds Payable. In December 1987, the Company defeased the Camden County, New Jersey Economic Development Revenue Bonds, Series A and extinguished the related debt. The Company placed U.S. Treasury bills aggregating $5,019,986 in an irrevocable trust to fund applicable trustee fees and satisfy the interest and sinking fund payments on the remaining balance of $4,270,000. The senior unsecured notes payable, senior mortgage notes payable, convertible debentures, bank notes payable and mortgages payable are presented net of unamortized debt issuance costs of $9,785,000 and $9,347,000 at December 31, 1993 and 1992, respectively. Amortization expense associated with the debt issuance costs amounted to $2,961,000, $2,123,000 and $1,797,000 for the years ended December 31, 1993, 1992 and 1991, respectively, and is reflected in interest expense. All debt instruments contain certain covenants, the most restrictive of which limits the ratio of total debt to consolidated shareholders' equity. The Company's debt-to-equity ratio may exceed 180% no longer than 180 days out of any 450-day period and may not exceed 225% at any time. The aggregate maturities of senior unsecured notes payable, senior mortgage notes payable, bonds and mortgages payable and convertible debentures, excluding the bank notes payable, the 9% convertible debentures and amounts defeased for the five years subsequent to December 31, 1993, are as follows: 7. RELATED PARTY TRANSACTIONS The Company has material transactions with related parties as described in these notes, including, but not limited to, the acquisition of health care facilities, lending of mortgage and construction funds, lease transactions and advisory services (through February 26, 1991), all of which transactions have been reviewed by the Independent Trustees. On February 26, 1991, the Company's Advisor merged (the "Merger") with and into a wholly-owned subsidiary of the Company, Meditrust Management Corp. ("MMC"), pursuant to an Agreement and Plan of Merger among the Company, MMC, the Advisor and all of the shareholders of the Advisor. Initial consideration for this transaction totaled approximately $5,000,000, comprised of 185,000 Shares and $1,300,000 in cash. In addition, the Company agreed to pay to the shareholders of the Advisor a contingent acquisition price up to a maximum of $2,000,000 for each $1.00 increase in the price per Share in excess of $20.00 per Share during the five year period ending December 31, 1995, up to an aggregate maximum amount of $10,000,000. During 1991, contingent payments totaling $10,000,000 were paid in the form of Shares. MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--continued Until the Merger, the Company had an Advisory Agreement with the Advisor, a corporation principally owned by Abraham D. Gosman, the Company's Chairman of the Board. For the year ended December 31, 1991, the fees pursuant to its advisory agreements amounted to $738,000. As of December 31, 1993, The Mediplex Group, Inc. ("Mediplex") guarantees the lessees' and borrowers' obligations or provides working capital assurances for 28 of the Company's facilities and a Mediplex affiliate is a subordinated participant in six of the Company's permanent mortgage loans. Approximately 25% of the stock of Mediplex is owned by the Chairman of the Company. The expiration of the fixed term of the Company's leases and mortgages with Mediplex or its subsidiaries range from 1995 to 2007. The lease terms require Mediplex to pay aggregate base rent of $32,669,000 per annum and the mortgages require annual principal and interest payments of $3,598,000. As a result of these lease and mortgage transactions with Mediplex or its subsidiaries, the Company recorded revenues of approximately $34,516,000, $29,256,000 and $28,609,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Mediplex owed the Company $450,000 and $250,000 for additional rent at December 31, 1993 and 1992, respectively. During 1992, the Company acquired from a prior operator for $22,500,000 two previously mortgaged long-term care facilities located in Massachusetts and leased these facilities to The Mediplex Group, Inc. During 1993, the Company acquired from a prior operator for $26,353,000 two previously mortgaged rehabilitation facilities located in Michigan and in New York and a long-term care facility located in Massachusetts and leased these properties to The Mediplex Group, Inc. Also, during 1993, the Company provided permanent mortgage financing of $32,740,000 for four long-term care facilities located in Massachusetts and Connecticut and entered into a sale/leaseback transaction for $8,000,000 for a rehabilitation facility located in Arkansas. The land and facility owned by one of the Company's subsidiaries is leased to a corporation wholly-owned by Abraham D. Gosman and is managed by a Mediplex subsidiary. The lease is a fixed-term operating lease expiring in 2006. The lessee is required to pay aggregate base rent of $3,364,000 per annum over the lease term and supplemental rent (as defined in the lease agreements). Total revenues earned by the Company from this lease arrangement were $3,421,000, $3,486,000 and $3,440,000 for the years ended December 31, 1993, 1992 and 1990, respectively. For further information regarding the Company and Mediplex, see Note 12. 8. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," requires that the Company disclose estimated fair values for certain of its financial instruments as defined by the Standard. MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--continued Fair value estimates are subjective in nature and are dependent on a number of significant assumptions associated with each financial instrument or group of financial instruments. Because of a variety of permitted calculations and assumptions regarding estimates of future cash flows, risks, discount rates and relevant comparable market information, reasonable comparisons of the Company's fair value information with other companies cannot necessarily be made. The following methods and assumptions were used to estimate the fair value of financial instruments for which it is practicable to estimate that value: Real Estate Mortgages The fair value of real estate mortgages have been estimated by discounting future cash flows using current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. As of December 31, 1993, the fair value of real estate mortgages amounted to approximately $652,000,000. Indebtedness The quoted market price for the Company's publicly traded convertible debentures and rates currently available to the Company for debt with similar terms and remaining maturities were used to estimate fair value of existing debt. As of December 31, 1993, the fair value of the Company's indebtedness amounted to approximately $711,000,000. 9. LEASE COMMITMENTS The Company's land and facilities are generally leased pursuant to noncancelable, fixed-term operating leases expiring from 1995 to 2007. The leases also generally provide multiple, five-year renewal options and the option to purchase the facilities at fair market value at the end of the initial term of the lease or at various times during the lease. The lessees are required to pay aggregate base rent during the lease term and applicable debt service payments as well as percentage, supplemental and additional rent (as defined in the lease agreements). For the years ended December 31, 1993, 1992 and 1991, additional rent and interest amounted to $8,657,000, $7,621,000 and $5,399,000, respectively. In addition, the lessees pay all taxes, insurance, maintenance and other operating costs of the land and facilities. MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--continued Future minimum lease payments, including debt service payments (as defined in the lease agreements) which are based on interest rates in effect at December 31, 1993, expected to be received by the Company during the initial term of the leases for the years subsequent to December 31, 1993, are as follows: 10. STOCK OPTION PLANS Incentive awards under the Company's stock option plans (the "Plans") which may be granted by the Board of Trustees include nonqualified or nonstatutory options to purchase Company shares and incentive stock options (collectively, "options"). The number of Shares available for issuance under the Plans is 5% of the number of outstanding Shares. Up to 500,000 Shares available under each Plan may be issued pursuant to incentive stock options. Trustees, officers and key employees of the Company or any other entity providing similar services to the Company and its officers, directors and key employees, and all persons retained by the Company solely as consultants are eligible to participate in the Plans. Such options expire 10 years after the date granted. One third of all options granted become exercisable at the end of each year following the date of issuance. Options to purchase 290,000 Shares were exercisable as of December 31, 1993. Information concerning option activity for the years 1993, 1992, and 1991 is as follows: MEDITRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued 11. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The following quarterly financial data summarizes the unaudited quarterly results for the years ended December 31, 1993 and 1992: 12. SUBSEQUENT EVENTS On January 11, 1994, the Board of Trustees of the Company declared a dividend of $.6475 per Share payable February 15, 1994, to shareholders of record on January 31, 1994. The dividend related to the period October 1, 1993 through December 31, 1993. On January 27, 1994, the Company entered into a Consent Agreement with Sun Healthcare Group, Inc. ("Sun"), pursuant to which the Company agreed to consent to a proposed merger of Mediplex with a subsidiary of Sun, subject to the fulfillment by Sun and Mediplex of certain closing conditions. The Company's consent to the merger is required pursuant to the terms of the various leases and loans between the Company and Mediplex (the "Mediplex Financing Documents"). As a condition to the Company's consent to the merger, Sun and Mediplex have agreed to certain modifications to the existing Mediplex Financing Documents and to certain terms which will govern the ongoing relationship and future transactions among the Company, Mediplex and Sun. (See Note 7 for further information regarding related party transactions between the Company and Mediplex). On March 2, 1994, the Company announced the sale of $90,000,000 of 7 1/2% convertible debentures due 1998 and convertible at $36.18 per Share. The Company used the proceeds to repay short-term borrowings. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Shareholders and Trustees of Meditrust: Our report on the consolidated financial statements of Meditrust is included on page of this Form 10-K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. Coopers & Lybrand Boston, Massachusetts March 10, 1994 S-1 MEDITRUST SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS (A) Costs primarily associated with the disposition of certain real estate investments. S-2 MEDITRUST SCHEDULE XI REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 S-3 MEDITRUST SCHEDULE XI REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 S-4 MEDITRUST SCHEDULE XI REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 S-5 MEDITRUST SCHEDULE XI REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 (1) Facility classifications are Long-Term Care (LTC), Retirement Living (RL), Psychiatric Hospital (Psych), Alcohol and Substance Abuse Treatment (A&D) and Rehabilitation Hospital (Rehab). (2) Gross amount at which land is carried at close of period also represents initial cost to Company. (3) Cost for federal income tax purposes. (4) Depreciation is calculated using a 40-year life for all completed facilities. (5) Real estate and accumulated depreciation reconciliations for the three years ended December 31, 1993 are as follows: S-6 MEDITRUST SCHEDULE XII MORTGAGE LOANS ON REAL ESTATE December 31, 1993 S-7 MEDITRUST SCHEDULE XII MORTGAGE LOANS ON REAL ESTATE (A) All mortgage loans on real estate are first mortgage loans except a second mortgage loan amounting to $4,250,000 for a Connecticut facility. (B) Ten-year terms (except for loan on fifteen facilities located in nine states which is two years, Waterford, CT, Bourne and New Bedford, MA and Lauderhill, FL, which are five years and Waterbury and Bristol, CT, which are seven years) with principal and interest payable at varying amounts over life to maturity with interest adjustment generally at the end of the fifth year. (C) Balloon payment is due upon maturity based on current interest rate with various prepayment penalties. (D) No mortgage loan is subject to delinquent principal or interest. (E) Mortgage loan term has been extended for a one year period. (F) Mortgage loan term has been extended for a ten year period. (G) The aggregate cost for federal income tax purposes. (H) Reconciliation of carrying amount of mortgage loans for the three years ended December 31, 1993 is as follows: S-8 Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NOT APPLICABLE. PART III Item 10. Item 10. TRUSTEES AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference to Item 4a above and the table and the information following it appearing in the first subsection of the section entitled "Election of Trustees" contained in the Company's Proxy Statement for its Annual Meeting of Shareholders ("Annual Meeting Proxy Statement"), to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended ("Regulation 14A"). There are no family relationships among any of the Trustees or executive officers of the Company. Item 11. Item 11. EXECUTIVE COMPENSATION Incorporated by reference to the section entitled "Executive Compensation" contained in the Company's Annual Meeting Proxy Statement, to be filed pursuant to Regulation 14A. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference to the table appearing in the first subsection of the section entitled "Election of Trustees" and the section entitled "Voting Securities, Principal Holders Thereof and Holdings by Certain Executive Officers" contained in the Company's Annual Meeting Proxy Statement, to be filed pursuant to Regulation 14A. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference to the section entitled "Certain Transactions" contained in the Company's Annual Meeting Proxy Statement, to be filed pursuant to Regulation 14A. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements Financial Statements filed as a part of this report are listed in the index appearing on Page. (a) 2. Financial Statement Schedules Financial Statement Schedules required as part of this report are listed on the index appearing on Page. (a) 3. Exhibits Exhibits required as part of this report are listed in the index appearing on Page 29. EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS (b) No reports on Form 8-K were filed during the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MEDITRUST By:/s/ Lisa M. Pavelka Vice President and Treasurer (and Principal Financial and Accounting Officer) Dated: 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 dates indicated. The Declaration of Trust establishing Meditrust dated August 6, 1985 (the "Declaration"), a copy of which is duly filed in the office of the Secretary of State of the Commonwealth of Massachusetts, provides that the name "Meditrust" refers to the Trustees under the Declaration collectively as Trustees, but not individually or personally; and that no Trustee, officer, shareholder, employee or agent of the Company shall be held to any personal liability, jointly or severally, for any obligation of, or claim against, the Company. All persons dealing with the Company, in any way, shall look only to the assets of the Company for the payment of any sum or the performance of any obligation. EXHIBITS

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ITEM 1. BUSINESS General The Columbia Gas System, Inc. (the Corporation) organized under the laws of the State of Delaware on September 30, 1926, is a registered holding company under the Public Utility Holding Company Act of 1935, as amended, (1935 Act) and derives substantially all its revenues and earnings from the operating results of its 19 direct subsidiaries. On July 31, 1991, the Corporation and its wholly-owned subsidiary, Columbia Gas Transmission Corporation (Columbia Transmission), filed separate petitions for protection under Chapter 11 of the Federal Bankruptcy Code. Both the Corporation and Columbia Transmission are debtors-in-possession under the Bankruptcy Code and continue to operate their businesses in the normal course subject to the jurisdiction of the United States Bankruptcy Court for the District of Delaware. The Corporation owns all of the securities of its subsidiaries except for approximately 10 percent of the stock in Columbia LNG Corporation. The Corporation's subsidiaries are engaged in exploration for and production of oil and natural gas, natural gas transmission, natural gas distribution and other energy operations. In addition, Columbia Gas System Service Corporation provides data processing, financial, accounting, legal and other services for the Corporation and other affiliates. The Corporation and its subsidiaries are sometimes referred to herein as the System. Oil and Gas Operations The Corporation's oil and gas subsidiaries, Columbia Gas Development Corporation and Columbia Natural Resources, Inc., explore for, develop, produce, and market oil and natural gas in the United States. These companies hold interests in more than two million net acres of gas and oil leases and have proved oil and gas reserves in excess of 750 billion cubic feet of gas equivalent. Operations are focused in the Appalachian, Arkoma, Michigan, Permian, Powder River and Williston basins; both onshore and offshore in the Gulf Coast areas of Texas and Louisiana, and in Utah and California. Offshore holdings include interests in federal blocks, most of which are located in the West Cameron, Vermilion, Eugene Island, and Ship Shoal areas of the Gulf of Mexico. Transmission Operations The Corporation's two interstate pipeline transmission companies, Columbia Transmission and Columbia Gulf Transmission Company (Columbia Gulf), operate a 23,700-mile pipeline network that extends from offshore in the Gulf of Mexico to New York State and the eastern seaboard. In addition, Columbia Transmission operates one of the nation's largest underground storage systems. Historically, Columbia Transmission offered both a wholesale sales service and a transportation service to local distribution companies. However, when a new federally mandated business restructuring of the industry took effect in late 1993, Columbia Transmission expanded its transportation and storage services for local distribution companies and industrial and commercial customers and now provides only a minimal sales service. Columbia Gulf's pipeline system, which extends from offshore Louisiana to West Virginia, carries a major portion of the gas delivered by Columbia Transmission. It also transports gas for third parties within the production areas of the Gulf Coast. Columbia Gulf owns interests in the Overthrust, Ozark and Trailblazer pipelines, which extend into major midcontinent and western gas-producing areas. Combined, Columbia Transmission and Columbia Gulf serve customers in 15 northeastern, middle Atlantic, midwestern, and southern states and the District of Columbia. Columbia LNG Corporation has announced plans to initiate peaking services from its Cove Point LNG facility by the end of 1995. Distribution Operations The Corporation's five distribution subsidiaries provide natural gas service to more than 1.9 million residential, commercial and industrial customers in Ohio, Pennsylvania, Virginia, Kentucky, and Maryland. These subsidiaries purchase gas supplies to serve their high-priority customers and transport gas for industrial and commercial customers who purchase gas from other sources. More than 28,000 miles of distribution pipelines serve such major ITEM 1. BUSINESS (Continued) markets as Columbus, Lorain, Parma, Springfield, and Toledo in Ohio; Gettysburg, York and a part of Pittsburgh in Pennsylvania; Lynchburg, Staunton, Portsmouth and Richmond suburbs in Virginia; Ashland, Frankfort and Lexington in Kentucky; and Cumberland and Hagerstown in Maryland. Other Energy Operations The Corporation's TriStar Ventures Corporation participates in natural gas-fueled cogeneration projects that produce both electricity and useful thermal energy. Two subsidiaries, Columbia Propane Corporation and Commonwealth Propane, Inc., sell propane at wholesale and retail to approximately 68,000 customers in six states. In the Appalachian area, Columbia Coal Gasification Corporation another subsidiary owns over 500 million tons of coal reserves, much of which contains less than one percent sulfur. Approximately 50 percent of the total reserves are leased to other companies for development. Columbia Energy Services oversees the System's nonregulated natural gas marketing efforts and provides an array of supply and fuel management services to distribution companies, independent power producers and other large end users both on and off the transmission and distribution subsidiaries' pipeline systems. Columbia Gas System Service Corporation provides centralized, cost-efficient data processing, financial, accounting, legal, and other services for the Corporation and other operating subsidiaries. For additional discussion of the System's business segments, including financial information for the last three fiscal years, see Item 7, page 19 through 52 and Note 16 on page 93 of Item 8. Other Relevant Business Information The System's customer base is broadly diversified, with no single customer accounting for a significant portion of sales or transportation revenues. The Corporation's operating subsidiaries are subject to competitive pressures from other pipeline systems and producers that sell and/or transport natural gas as well as from competition from alternative fuels, primarily oil and electricity. The oil and gas subsidiaries compete in the marketplace for sales of their oil and gas production through a combination of long-term contracts and spot sales. The transportation subsidiaries compete in the highly competitive northeast and midwest energy markets. The distribution subsidiaries compete with alternative fuels and to a limited extent with other gas companies. Certain subsidiaries file reports with various federal agencies containing estimates of company-owned oil and gas reserves. These estimates are generally consistent but not always comparable to those reported in the 1993 Annual Report to Shareholders. At January 31, 1994, the System had 10,114 full-time employees of which 2,089 are subject to collective bargaining agreements. Information relating to environmental matters is detailed in Item 7 pages 33 through 34, page 41 and page 46 and in Item 8, Note 12H on pages 87 through 91. For a listing of the subsidiaries of the Corporation and their lines of business refer to Exhibit 22. Public Utility Holding Company Act of 1935 The Corporation and its subsidiaries are subject, in certain matters, to the jurisdiction of the Securities and Exchange Commission (SEC) under the 1935 Act. In 1944, the SEC held that the major portions of the System complied with the requirements of Section 11 of the 1935 Act relating to a "single integrated public-utility system" and businesses reasonably incidental thereto, but the SEC reserved jurisdiction over the retainability of certain subsidiaries. ITEM 1. BUSINESS (Continued) Included were two companies owning pipelines in West Virginia and Northern Virginia extending into Maryland and New York (the reserved pipelines are now part of Columbia Transmission) and Virginia Gas Distribution Corporation (now a part of Commonwealth Gas Services, Inc.). Since that time, the reservation of jurisdiction has been expanded to include the subsequently acquired properties of Blue Ridge Gas Company (a Virginia retail company which is now part of Commonwealth Gas Services, Inc.), Commonwealth Gas Pipeline Corporation (now a part of Columbia Transmission) and a retail subsidiary (Commonwealth Gas Services, Inc.) acquired as a result of the merger of the Corporation with Commonwealth Natural Resources, Inc. and Lynchburg Gas Company, (now a part of Commonwealth Gas Services, Inc.). The Corporation filed a motion with the SEC in June 1955 requesting the termination of such reserved jurisdiction. After hearings, no further action has been taken and the Corporation is unable to predict whether or when the SEC will finally dispose of the Corporation's 1955 motion and resolve the retainability issue. The Gas Related Activities Act (GRAA), enacted in 1990, provides that gas transmission is deemed to be reasonably incidental or economically necessary or appropriate to the operation of the gas utility system under Section 11 of the 1935 Act. Since the basis for questioning the retainability of the gas transmission pipelines was compliance with this Section 11 criteria, the passage of the GRAA supports, and should resolve, the retainability of the gas transmission pipelines. If however, any of these properties were ultimately to be held not retainable, management believes that the SEC would permit the Corporation to adopt a plan for orderly disposition which would permit full realization of their intrinsic values. ITEM 2. ITEM 2. PROPERTIES Information relating to properties of subsidiary companies is detailed on pages 6 through 7 herein and pages 96 through 99 of Item 8 under Note 18. The System also owns coal interests in the Appalachian area. Assets under lien and other guarantees are described on page 86 in Note 12E of Item 8. Neither the Corporation nor any subsidiary knows of material defects in the title to any real properties of the subsidiaries of the Corporation or of any material adverse claim of any right, title, or interest therein, pending or contemplated except the Official Committee of Unsecured Creditors of Columbia Transmission has filed a complaint which challenges the 1990 property transfer from Columbia Transmission to Columbia Natural Resources, Inc. as an alleged fraudulent transfer. Substantially all of Columbia Transmission's property has been pledged to the Corporation as security for First Mortgage Bonds issued by Columbia Transmission to the Corporation which has also been challenged by the Official Committee of Unsecured Creditors of Columbia Transmission. ITEM 2. PROPERTIES (Continued) OIL AND GAS DATA Acreage - At December 31, 1993 Net Wells Completed - 12 Months Ended December 31 Productive and Drilling Wells - At December 31, 1993 (a) Includes 17 net horizontal wells in 1993, 13 net horizontal wells in 1992 and 14 net horizontal wells in 1991. (b) Includes 808 multiple completion gas wells and 8 multiple completion oil wells, all of which are included as single wells in the table. Also includes 46 gross productive horizontal wells. ITEM 2. PROPERTIES (Continued) GAS PROPERTIES OF SUBSIDIARIES - AS OF DECEMBER 31, 1993 NOTE: This table excludes minor gas properties and all construction work in progress. The titles to the real properties of the subsidiaries of the Corporation have not been examined for the purpose of this document. Neither the Corporation nor any subsidiary knows of material defects in the title to any of the real properties of the subsidiaries of the Corporation or of any material adverse claim of any right, title, or interest therein, pending or contemplated except the Official Committee of Unsecured Creditors of Columbia Transmission has filed a complaint which challenges the 1990 property transfer from Columbia Transmission to Columbia Natural Resources, Inc. as an alleged fraudulent transfer. Substantially all of Columbia Transmission's property has been pledged to the Corporation as security for First Mortgage Bonds issued by Columbia Transmission to the Corporation which has also been challenged by the Official Committee of Unsecured Creditors of Columbia Transmission ITEM 3. ITEM 3. LEGAL PROCEEDINGS I. Shareholder Class Actions and Derivative Suits (Unless otherwise noted, all matters are stayed pursuant to Section 362 of the Bankruptcy Code) Since the June 19, 1991 announcement by the Board of Directors regarding the Corporation's proposed charge to second quarter earnings and suspension of its dividend, seventeen complaints including suits purporting to be class actions, or alleging claims common to the purported class actions, have been filed in the U.S. District Court for the District of Delaware. These actions have been consolidated under the style In re Columbia Gas Securities Litigation, Consol. C.A. No. 91-357. Although an amended and consolidated complaint has yet to be filed, the preconsolidated complaints variously named the Corporation, then current members of its Board of Directors, certain officers, the Corporation's independent public accountants, and the Corporation's underwriters for its 1990 common stock offering as defendants (the Defendants). These complaints generally allege the Defendants publicly made material misleading statements during the relevant class periods (from February 28, 1990 to June 19, 1991) concerning the Corporation's financial condition, and failed to disclose material facts which rendered other statements misleading, thereby artificially inflating the market price of the Corporation's common stock and publicly traded debt securities, causing the various plaintiffs and other class members to purchase such publicly traded securities at artificially inflated prices. The complaints allege violations of Sections 11, 12(2) and 15 of the Securities Act of 1933, Sections 10(b), 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934, negligent misrepresentations, and common law fraud and deceit. In addition to the above-referenced class actions, three derivative stockholder actions have been filed in the Court of Chancery of the State of Delaware. These cases have been consolidated under the style In Re Columbia Gas Derivative Litigation. The complaints in these actions name as defendants the Board of Directors and the Corporation (nominal). The complaints generally allege that the members of the Board of Directors breached their fiduciary duties to the Corporation by failing to make required disclosures thereby causing the Corporation to be subjected to federal securities law liabilities. II. Bankruptcy Matters A. Matters in the United States Bankruptcy Court for the District of Delaware 1. Columbia Gas Transmission Corporation v. The Columbia Gas System, Inc. and Columbia Natural Resources, Inc., C.A. No. 92-35. (U.S. Bankruptcy Ct. Dist. of Delaware, filed March 18, 1992). The Official Committee of Unsecured Creditors of Columbia Transmission filed a complaint (the Intercompany Complaint) challenging the status of approximately $1.7 billion of debt owed by Columbia Transmission to the Corporation and the transfer of natural resource properties representing 450 billion cubic feet of natural gas reserves and one million barrels of oil reserves to Columbia Natural Resources, Inc. (Columbia Natural Resources) as well as other intercompany transactions. On May 14, 1992, the Official Committee of Unsecured Creditors of Columbia Transmission filed a motion to withdraw the jurisdictional reference to the U.S. District Court for the District of Delaware and filed a demand for a jury trial. On February 9, 1993, the motion was denied by the U. S. District Court and on August 20, 1993, the Third Circuit denied the appeal by the Official Committee of Unsecured Creditors of Columbia Transmission of the District Court's order allowing resolution of the Intercompany Complaint before the Bankruptcy Court. On June 11, 1992 the Corporation filed a motion and supporting brief for partial dismissal or, in the alternative partial summary judgment with respect to certain counts of the complaint which was supported by Columbia's Equity Security Holders Committee and Unsecured Creditors Committee. The motion has been fully briefed and a pretrial schedule has been established which, if followed, would result in a trial of the Intercompany ITEM 3. LEGAL PROCEEDINGS (Continued) Complaint in the spring of 1994. There has been no indication as to when the Bankruptcy Court might act on Columbia's motion for summary judgment. 2. Motion to Fix Procedures to Establish Columbia Transmission's Liability to Third Party Beneficiary Investor Complaints. On February 17, 1993, movants, who are investors in production companies and claim to be third party beneficiaries of the contracts between Columbia Transmission and the production companies, filed a motion seeking to have their status as third party beneficiaries recognized and seeking to have their claims against Columbia Transmission liquidated separate from the Estimation Procedure established to deal with producer claims. By order dated April 5, 1993, the Bankruptcy Court lifted the stay in order to allow the New Jersey State Court to determine whether plaintiffs enjoyed third party beneficiary status in the pending State Court action. However, the Bankruptcy Court with movants' acquiescence, held that movants' claim (to the extent that they are established) would be governed by the estimation procedure. 3. Bank of Boston, Trustee v. The Columbia Gas System, Inc. On March 2, 1993, the Trustee for the Indenture under which debentures were issued by the Employees Thrift Plan of Columbia Gas System (Plan) filed a complaint against the Corporation alleging tortious interference with contract and breach of duty. The Indenture Trustee alleges that the Corporation is not acting in accordance with the Plan when it directs the Plan Trustee to use sums paid by participating employers to match employee contributions and not to pay debt service on the outstanding debentures. The Corporation's Answer to the complaint alleging tortious interference with contract for failure to pay installments due LESOP debenture holders was filed April 2, 1993. On May 14, 1993, the Corporation filed a motion for summary judgment challenging the Bank's standing to bring the action. Bank of Boston filed its brief in opposition to the Corporation's motion on June 14, 1993 and the Corporation's reply brief was filed on June 29, 1993. Bank of Boston filed an amended adversary complaint on June 30, 1993. B. Appeals to the United States Court of Appeals for the Third Circuit 1. Enterprise Energy Corporation, et al., v. United States of America, on behalf of its Internal Revenue Service On June 18, 1991, the U.S. District Court for the Southern District of Ohio approved a settlement of this class action suit by Appalachian oil and gas producers. The settlement required Columbia Transmission to make two $15 million payments into escrow, for distribution to class members as formal contract amendments were finalized. The first $15 million was paid into escrow in March 1991. Columbia Transmission filed an application with the Bankruptcy Court which would permit it to honor the settlement (including authority to make the second $15 million payment into escrow in March 1992) but to reject the amended contracts. On December 12, 1991, the Bankruptcy Court ruled that distribution from escrow of the first $15 million payment could be effected pursuant to the settlement; however, the Bankruptcy Court denied Columbia Transmission's request for approval to make the second $15 million payment scheduled to be made in March 1992. Further, the Bankruptcy Court granted the motion to reject the contracts, as amended, pursuant to the Enterprise settlement. On October 6, 1992, the District Court affirmed the Bankruptcy Court's order denying Columbia Transmission's motion to assume the executory settlement contract. Enterprise Energy Corp.'s request for rehearing, reargument and reconsideration of the order denying Columbia Transmission's motion to assume the executory settlement contract was denied on April 27, 1993. On May 25, 1993, Enterprise Energy filed a notice of appeal to the United States Court of Appeals for the Third Circuit from the Bankruptcy Court order denying Columbia Transmission's motion to require assumption or rejection of the executory settlement contract. Briefing is complete. Oral argument was held January 18, 1993. 2. In re The Columbia Gas System, Inc. et al.; West Virginia State Department of Taxation v. U.S., Nos. 93-7531 and 93-7532. This is the appeal of the District Court's Memorandum Opinion and Order affirming ITEM 3. LEGAL PROCEEDINGS (Continued) the Bankruptcy Court's ruling that the property taxes centrally assessed by West Virginia as public service business taxes for the "1992 tax year" were incurred by Columbia Transmission prepetition and denying Columbia Transmission's motion for authorization to pay the taxes. Briefing has been completed and oral argument was heard on March 2, 1994. 3. The Columbia Gas System, Inc. and Columbia Gas Transmission v. U.S. Trustee, No. 93-7609. On August 30, 1993, the Corporation and Columbia Transmission filed an Appeal of the District Court's order adopting the Magistrate's Report and Recommendation and granting the U.S. Trustee's appeal of the Bankruptcy Court's July 31, 1993 order approving certain investment guidelines and the Bankruptcy Court's order denying the U.S. Trustee's Motion for Reconsideration of the Bankruptcy Court's July 31, 1993 order. On February 10, 1994, the District Court granted a stay pending appeal of the August 19, 1993 order which approved the Magistrate's Report and Recommendation. III. Purchase and Production Matters (Unless otherwise noted, all matters are stayed pursuant to Section 362 of the Bankruptcy Code) A. Appalachian Producer Litigation 1. Enterprise Energy Corp. et al. v. Columbia Gas Transmission Corp., C. A. No. C2-85-1209, (U. S. Dist. Ct., S. D. Ohio, filed July 26, 1985). See II B. 1. 2. Phillips Production Co. v. Columbia Gas Transmission Corp., C.A. No. 89-0269, (U.S. Dist. Ct., W.D. Pa. filed February 7, 1989). The complaint as filed contained six separate counts involving ten gas purchase contracts with Columbia Transmission. Plaintiff's principal claims were for additional take-or-pay payments, for retroactive tight sands gas pricing, and a challenge to Columbia Transmission's invocation of cost recovery clauses in the gas purchase contracts. All claims except those relating to Columbia Transmission's invocation of the cost recovery clause were settled and dismissed December 18, 1989, pursuant to agreement of the parties. The cost recovery claim was stayed pending resolution of Enterprise Energy suit (discussed above). Thereafter, Phillips cost recovery claim was stayed by Columbia Transmission's filing. 3. Columbia Gas Transmission Corp. v. Alamco, Inc. et al., C.A. No. 88-C-38-2 (Harrison (W.Va) Cir. Ct. filed January 15, 1988). Under a 1983 release agreement, Columbia Transmission filed suit against Alamco, Inc. (Alamco) contending that Alamco was obligated to sell gas to Columbia Transmission at prices and under terms and conditions being generally offered by Columbia Transmission at the time purchases were resumed as opposed to the conditions of the original contract. Trial of the state court action was interrupted and stayed by Columbia Transmission's petition in Bankruptcy filed July 31, 1991. A parallel suit was filed by Alamco, naming the Corporation, Columbia Transmission, Columbia Gas System Service Corporation and Commonwealth Gas Pipeline Corporation, alleging antitrust violations. In the opinion of counsel, the antitrust claim was barred by the statute of limitations; however on March 13, 1991, Columbia Transmission's and Commonwealth Gas Pipeline's motions to dismiss were denied without prejudice to Columbia Transmission's right to assert, by summary judgment or otherwise, that Alamco's claims are time barred, or that Alamco cannot prove the allegations in its complaint. In late May 1992, a settlement agreement in principle was reached which was approved by the Bankruptcy Court on July 28, 1992. As a result, after the order becomes final, these actions will be dismissed upon the earlier of confirmation of a Columbia Transmission plan of reorganization or closing of the Columbia Transmission bankruptcy proceeding. B. Southwest Producer Litigation (Suits naming Columbia Transmission are stayed as to Columbia Transmission; indemnification agreements will be effective if the contract providing indemnification is not rejected) ITEM 3. LEGAL PROCEEDINGS (Continued) 1. Royalty Owners Litigation: The agreements between Columbia Transmission and certain southwest producers effective in 1985 which reformed gas purchase contracts have resulted in a number of lawsuits against the producers. Under the agreements, Columbia Transmission has a qualified obligation to indemnify the producers in certain instances against claims by their royalty owners. Certain suits were pending against Amoco Production Company for which it was seeking indemnification from Columbia Transmission as of the commencement of Columbia Transmission's proceeding in bankruptcy. In November 1993, Columbia Transmission and Amoco entered an agreement, subject to Bankruptcy Court approval, terminating the contracts and providing that Amoco shall have an allowed unsecured claim for $4.1 million for all royalty indemnification and excess royalty claims. New Ulm and Fox v. Mobil Oil Corporation, Columbia Gas Transmission Corp. and Columbia Gulf Transmission Co., C.A. No. 88-V-655 (155th Judicial Dist. Ct. of Austin County, TX). New Ulm alleged Columbia Transmission incorrectly paid for gas on the basis of Columbia Transmission's market-out price rather than the higher price New Ulm claimed was available to it under the contracts. After the Bankruptcy Court entered an order modifying the automatic stay provisions of the Bankruptcy Code, jury trial began on June 22, 1992, and concluded with a verdict against Columbia Transmission on July 2, 1992, in the amount of approximately $5.6 million, including interest. On July 30, 1992, the Court denied Columbia Transmission's motion for judgment notwithstanding the jury's verdict and entered judgment against Columbia Transmission in such amount for actual damages, prejudgment interest and attorneys' fees. Columbia Transmission's motion for new trial was denied on October 12, 1992. Columbia Transmission has perfected an appeal to the First Court of Appeals at Houston, Texas. Briefing is complete and oral argument was held on December 7, 1993. 2. Wagner & Brown v. Columbia Gas Transmission Corp., C.A. No. 83-15091 (Orleans Parish (La.) Civ. Dist. Ct.). This suit involves Columbia Transmission's alleged breach of a gas purchase and sales agreement. The claims of Wagner & Brown have been settled, and the case was dismissed as to Wagner & Brown on March 6, 1986. The claims of El Paso Exploration Co. (now Meridian Oil Production, Inc. (Meridian)), which intervened as a plaintiff and asserted all the claims and allegations made by Wagner & Brown, including take-or-pay, price differential and specific performance, have not been settled. In September 1990, Meridian served a Second Amended Petition in which it alleges damages in excess of $60 million (and an additional $40 million of interest) as a result of Columbia Transmission's failure to meet its take-or-pay and minimum take obligations. The issue of price differential has been settled. A status conference was held May 28, 1991, and a hearing on the plaintiff's motion for partial summary judgment on Columbia Transmission's legal defenses was held June 14, 1991. A motion by Meridian for a Bankruptcy Court order lifting the automatic stay so as to permit it to prosecute its claims against Columbia Transmission was denied. 3. Koch Industries Inc. v. Columbia Gas Transmission Corp. C.A. No. 89-2156 (U.S. Dist. Ct., E.D. La., filed May 12, 1989). On January 11, 1991, Columbia Transmission filed an action, Columbia Gas Transmission Corp. v. Koch Industries. Inc., C.A. No. 91-0174, (U.S. Dist. Ct., E.D. La). This lawsuit was related to the settlement of an earlier lawsuit between the parties. Columbia Transmission sought an order declaring that it is under no obligation to increase its purchase nominations under the contracts because of Koch's unasserted right to correct imbalances between it and other working interests owners in the acreage dedicated under the contract. Koch filed a complaint seeking a contrary determination. Koch Industries, Inc. v. Columbia Gas Transmission Corp., C.A. No. 91-0177 (U.S. Dist. Ct. E.D. La). The two cases were consolidated. Judgment in favor of Koch Industries, Inc. and against Columbia Transmission was issued on April 29, 1991. Columbia Transmission's motion to alter or amend the judgment was denied on June 5, 1991. On June 19, 1991, Columbia Transmission filed a Notice of Appeal to the Fifth Circuit. On August 20, 1991, the Clerk of the Court advised ITEM 3. LEGAL PROCEEDINGS (Continued) Columbia Transmission that the case was stayed during the Chapter 11 Bankruptcy proceedings. 4. Energy Development Corp. v. Columbia Gas Transmission Corp., C.A. No. CV91-0960, (U.S. Dist. Ct., W. D., La., division Lafayette/Opelousas, filed May 13, 1991). Energy Development Corporation alleges that Columbia Transmission breached the take-or-pay, minimum daily quantity and inequitable withdrawal provisions of the gas purchase contract between Energy Development Corporation and Columbia Transmission. IV. Corporate Matters 1. The East Lynn Condemnation - United States v. 16.286.08 Acres et al., C.A. No. 77-3324H (U. S. Dist. Ct., S.D. W.Va. filed December 26, 1976). The United States Corps of Engineers condemned certain fee lands in Wayne County, West Virginia. On December 7, 1990, a United States District Judge issued an order which adjudicates the amount of just compensation Columbia Natural Resources was entitled to receive for the minerals taken, including interest on the award through October 31, 1990, at $44,830,148. In October 1991, checks totalling $52,254,883 were issued to Columbia Transmission (holder of letter to the property when the condemnation proceeding commenced), Columbia Natural Resources (current owner) and the attorneys in the condemnation proceeding. To allow immediate deposit, the checks were endorsed to Columbia Transmission. Columbia Natural Resources and Columbia Transmission believe that a constructive trust in favor of Columbia Natural Resources, the real party in interest, was created; however, this view may be subject to challenge in Columbia Transmission's bankruptcy proceeding. V. Regulatory Matters A. Take-or-Pay and Contract Reformation Costs Billed by Pipeline Suppliers 1. Columbia Gas Transmission Corp., FERC Dkt. No. RP91-41, appeals pending sub nom., Baltimore Gas & Electric Co. v. FERC, C.A. No. 88-1779 U.S. Ct. of App., D.C. Cir.) On February 3, 1992, FERC denied requests for rehearing of orders accepting Columbia Transmission's Order No. 528 flowthrough filings, except to the extent that customers may challenge Columbia Transmission's prudence for actions after April 1, 1987, to the extent that it contributed to these upstream pipeline charges. On March 19, 1993 the FERC issued an order denying requests for rehearing and permitting Columbia Transmission to flow through upstream pipeline Order No. 528 costs. On December 30, 1993, the FERC issued an order denying Cincinnati Gas & Electric Company's request for rehearing of the March 19, 1993 order, reaffirmed the February 3, 1992 and March 19, 1993 orders in all respects, and indicated that no further rehearing requests would be entertained. The Court issued a procedural order in the joint appeals, leading to oral argument on May 10, 1994. 2. AGD v. FERC, No. 88-1385 (U.S. Ct. of App., D.C. Cir.). On December 28, 1989, the U.S. Court of Appeals for the District of Columbia Circuit ruled that the deficiency-based direct billing of Order No. 500 costs approved by the FERC in Tennessee Gas Pipeline Co., No. RP86-119, is unlawful retroactive ratemaking and violates the filed rate doctrine. On October 9, 1990, the U.S. Supreme Court denied certiorari in AGD. Accordingly, the FERC issued its order on remand on November 1, 1990 (Order No. 528). The FERC has approved Order No. 528 settlements for some of Columbia Transmission's pipeline suppliers. However, there are remaining unresolved direct upstream pipeline supplier Order No. 528 proceedings. The Order No. 528 filings and settlements to date have reduced Columbia Transmission's Order No. 528 liability to upstream pipelines significantly. Columbia Transmission's customers continue to challenge its right to recover any of these amounts. B. Direct Billing of Past Period Production and Production-Related Costs ITEM 3. LEGAL PROCEEDINGS (Continued) 1. Columbia Gas Transmission Corp. v. FERC., C.A. No. 88-1701 (U.S. Ct. of App., D.C. Circuit). On February 9, 1990, the Court issued its opinion finding that the FERC's orders authorizing five of Columbia Transmission's upstream pipeline suppliers to directly bill past period production related costs (Order Nos. 94 and 473) to customers allocated based upon past period purchases violates the filed rate doctrine and the rule against retroactive ratemaking. Therefore, the Court struck the orders authorizing direct billing and remanded the issue to the FERC for further proceedings. On October 9, 1990, the U.S. Supreme Court denied certiorari. Columbia Transmission reached settlements with Panhandle, Trunkline, Texas Eastern and Texas Gas, which provided for full refunds of Order No. 94 direct billings with rebillings to Columbia Transmission of lesser amounts. These settlements would reduce Columbia Transmission's Order No. 94 direct billing liability to these pipelines from $29 million to $17 million exclusive of interest. Columbia Transmission's customers have objected to those settlements because they contemplate Columbia Transmission's recovery of these rebilled amounts from its customers. On February 10, 1993, the FERC approved Columbia Transmission's Order 94 settlement with four pipeline suppliers, which settlements authorized Columbia Transmission to recover the rebilled payments to its' customers. On October 28, 1993, Transco and Columbia Transmission filed a letter with the FERC indicating that the remaining issues have been resolved, and that they agreed on a refund to Columbia Transmission of $1.4 million. The FERC is treating this as a settlement offer. On January 12, 1994, the FERC issued an order on rehearing in which it reversed its earlier conclusions and rejected the Order No. 94 settlements with Panhandle, Trunkline, Texas Eastern and Texas Gas. FERC now holds that Columbia Transmission's 1985 PGA settlement essentially bars recovery of any of the rejected costs. The January 12, 1994, order required Panhandle, Texas Eastern and Texas Gas to refund all Order No. 94 costs, but absolved them of responsibility for paying interest. On February 14, 1994, Columbia Transmission and the upstream pipelines requested rehearing of the January 12 orders. The pipelines have received an extension of time to make refunds until after the FERC rules on rehearing. Columbia Transmission has asked the FERC to hold the Transco settlement in abeyance until after the FERC rules on rehearing. Transco has opposed this request. C. WACOG Recovery. 1. Columbia Gas Transmission Corp., FERC Dkt. No. RP91-206. On August 1, 1991, Columbia Transmission filed for a 12- month, 20 cent surcharge to its commodity rate to recover certain pre-April 1, 1985, supplier costs which it is entitled to recover, in accordance with the terms of its 1985 Purchased Gas Adjustment settlement, to the extent that its annual weighted average cost of gas (WACOG) compares favorably with the WACOGs of competing pipelines. On August 30, 1991, FERC rejected such filing, without prejudice, finding that Columbia Transmission's calculation of its WACOG was inconsistent with the 1985 settlement. On May 22, 1992, the FERC denied Columbia Transmission's request for rehearing. Columbia Transmission has filed a petition for review of these orders. The matter has been briefed by the parties and oral argument was held on October 22, 1993. On January 3, 1994, Columbia Transmission filed an offer of settlement in Docket Nos. RP93-161 and RP94-1 (see C.3. below) which provides that, upon final approval of the settlement, Columbia Transmission will dismiss its appeal. 2. Columbia Gas Transmission Corp., FERC Dkt. No. RP92-215. On July 31, 1992, Columbia Transmission proposed an 8 cents per Dekatherm surcharge for the 12 months commencing September 1, 1992. On August 31, 1992, the FERC accepted Columbia Transmission's filing subject to suspension, refund and a technical conference. After such technical conference and statements of position by the parties, the FERC rejected the WACOG filing on January 21, 1993 and ordered Columbia Transmission to refund all WACOG charges which it previously collected. On November 26, 1993, the FERC denied Columbia Transmission's request for rehearing of the January 21, 1993, order. Columbia Transmission has filed a petition for review of these orders with the ITEM 3. LEGAL PROCEEDINGS (Continued) United States Court of Appeals for the D.C. Circuit. On January 3, 1994, Columbia filed an offer of settlement in Docket Nos. RP93-161 and RP94-1 (see C.3. below) which provides that, upon final approval of the settlement, Columbia Transmission will dismiss its appeal of the orders. 3. Columbia Gas Transmission Corp., Dkt. Nos. RP93-161 and RP94-1. These filings proposed a WACOG surcharge for the 1993-94 period, the last year Columbia Transmission is eligible to file such surcharge. The filing in RP93-161 proposed to collect a 28 cents per Dth surcharge for sales customers for the months of September and October 1993. The filing in RP94-1 proposed to collect a surcharge of 7.22 cents per Dth for most firm transportation customers from November 1, 1993 when Columbia Transmission implemented Order 636, through October 31, 1994. On January 3, 1994, Columbia Transmission filed a settlement which is unopposed to obtain all WACOG surcharges collected during September-December, 1993 and collect a WACOG surcharge of 3.8c. per Dth during January-October, 1994. If Columbia Transmission's WACOG surcharge revenues exceed $42.8 million, it will refund 90% of the excess to customers and retain the remaining 10%. FERC approved the settlement on February 28, 1994. VI. Other A. Canada Southern Petroleum Ltd. v. Columbia Gas Development of Canada Ltd. et al., (C.A. No. 9001-03466, Court of Queen's Bench, Alberta, Canada, filed March 7, 1990). The plaintiff asserts, among other things, that the defendant working interest owners, including Columbia Gas Development of Canada Ltd. (Columbia Canada) and various Amoco affiliates, breached an alleged fiduciary duty to ensure the earliest feasible marketing of gas from the Kotaneelee field (Yukon Territory, Canada). The plaintiff seeks, among other remedies, the return of the defendants' interests in the Kotaneelee field to the plaintiff, a declaration that such interests are held in trust for the plaintiff, and an order requiring the defendants to promptly market Kotaneelee gas or assessing damages. The judge granted the application of Allied Signal, Inc., Home Oil Company and Kern County Land Company to relieve them of the requirement to participate in the proceedings. An appeal of the order by Amoco is pending. Examination for discovery is still proceeding in the referenced actions. Columbia Canada has had a second round of discovery of its witnesses and has made undertakings to provide additional information which it is in the process of preparing. Amoco has not yet fulfilled the undertakings from its first round of discoveries. Upon it doing so, it is reasonable to suppose that further discoveries of Amoco will be required by Canada Southern. None of the defendants has yet conducted any discovery of Canada Southern nor of one another. On the present schedule, it is likely that this discovery process will continue well into 1994. In early 1993, Canada Southern filed a motion to amend their statement of claim to seek an accounting of the amount of operation costs properly recoverable by the working interest holders including Columbia Canada. Columbia has not consented to the amendment and contends that any amounts accrued since the initial statement of claim in 1988 should be barred and more basically, that litigation is inappropriate prior to an audit. Note: Columbia Canada was sold to Anderson Exploration Ltd. effective December 31, 1991, and the company name subsequently changed to Anderson Oil & Gas, Inc. Pursuant to an Indemnification Agreement re Kotaneelee Litigation, Columbia agreed to indemnify and hold Anderson harmless from losses due to this litigation. An escrow account in the amount of approximately $30,000,000 (Cdn) was established as partial security for the indemnification obligation. Upon emerging from bankruptcy, an additional deposit to the Escrow Account of $25,000,000 (Cdn) will be required in cash or by letter of credit. ITEM 3. LEGAL PROCEEDINGS (Continued) B. Minerals Management Service (MMS) has demanded that Columbia Gas Development Corporation (Columbia Development) pay additional royalties for the period October 1, 1983 to December 31, 1985, claiming the prices received by Columbia Development from its affiliate under non-arm's-length contracts were less than the prices received for like-quality gas under comparable arms-length contracts in the field. A complaint was filed by Columbia Development in U.S. District Court in Dallas on October 23, 1992, (Case No. 3:92-CV2199-T), claiming that the six-year statute of limitation applicable to the claim has expired and a protective administrative appeal was filed with the MMS on October 27, 1992. A decision was rendered August 27, 1993, by the Northern District of Texas District Court in favor of the government on the statute of limitations issue, reasoning that the MMS order to pay is not "an action for money damages" under the language of the statute and further granted the government's motion to dismiss in part on the basis of the doctrine of exhaustion of administrative remedies. Columbia Development has appealed the District Court decision to the Fifth Circuit Court of Appeals. Columbia Development's initial brief was filed on January 10, 1994. In another case, the 10th Circuit Court of Appeals ruled in favor of the government on the statue of limitations issue on the grounds that the six-year statute of limitations is tolled until such time as the government could reasonably have known about all facts material to its right of action. In addition, the MMS audited Columbia Development for the period January 1, 1986, through December 31, 1990, and has made a similar but unquantified claim. Columbia Development has appealed this claim to the Interior Board of Land Appeals and has obtained the MMS's pricing data and analyzed it using comparable pricing from surrounding OCS blocks to determine probable liability. Meetings with the MMS to eliminate less controversial claims (third party sales and sales at MLP) and to present the comparable pricing analysis have been held. MMS is reviewing the information presented. VII. Environmental A. Commonwealth of Kentucky Natural Resources and Environmental Protection Cabinet, Department for Environmental Protection. On January 22, 1992, Columbia Transmission received Notices of Violation (NOV) from the Commonwealth of Kentucky, Natural Resources and Environmental Cabinet, Department of Environmental Protection (KyDEP) with respect to ten compressor station sites in the Commonwealth of Kentucky. These notices generally cite the release or disposal of waste materials or hazardous substances, including but not limited to polychlorinated-biphenyls (PCBs). It appears from a letter dated January 13, 1992, from the Natural Resources Environmental Protection Cabinet, Department of Law, that the violations have been asserted for the purposes of establishing the Cabinet's prepetition claims against Columbia Transmission. The alleged violations provide for fines and penalties that apply separately for each violation and each day of noncompliance which, in the aggregate, are significant. Columbia Transmission's prior experiences, however, as well as those of other companies in the industry, have demonstrated that such fines and penalties have not been assessed at the maximum rate when the company is cooperating with governmental agencies and authorities in remediation activities. Columbia Transmission intends to continue to work with the KyDEP in negotiating a consent decree approving prior remediation activity and a prospective remediation plan. B. In the Matter of Columbia Gas Transmission Corp., (Region III). Columbia Transmission was subpoenaed to supply information under the authority of the Toxic Substance Control Act (TSCA), the Resource Conservation Recovery Act and the Comprehensive Environmental Response Compensation and Liability Act of 1980. Documents were accumulated and delivered in June and July and conferences with personnel of the Environmental Protection Agency Region III have been held. Columbia Transmission is continuing to provide documents and information to Environmental Protection Agency Region III and has begun negotiation of a possible consent decree under the TSCA approving prior remediation activity and prospective remediation plans developed by Columbia Transmission. Fines or penalties may also be included. ITEM 3. LEGAL PROCEEDINGS (Continued) C. Portsmouth Redevelopment and Housing Authority and Commonwealth Gas Services, Inc. (Commonwealth) v. BMI Apartment Associates, C.A. No. 2:93CV242, (U.S. Dist. Ct. E.D. Va., filed March 25, 1993.) A gas manufacturing plant had been operated in Portsmouth, Virginia by Portsmouth Gas Co on a site that was subsequently sold by Portsmouth Gas Co. to the Portsmouth Redevelopment and Housing Authority, which removed equipment and sold the property to developers of apartment complexes and single-family homes. Portsmouth Gas Co. was later acquired by Commonwealth. On February 10, 1993, without admitting or conceding responsibility for the site, Commonwealth provided notice of site contamination to the United States Environmental Protection Agency. On March 25, 1993, Commonwealth and the Portsmouth Housing and Redevelopment Authority filed a cost recovery action in federal court under the Comprehensive Environmental Response Compensation and Liability Act of 1980 against the current and past owners of a former manufactured gas plant site and sought a court order to obtain access to the site for health risk testing. BMI Apartment Associates (BMI), the owners of apartments on the site objected to the request for access and filed a "citizens' suit" under the Resource Conservation and Recovery Act as a counterclaim and cross-claim. On June 14, 1993, the United States District Court granted Commonwealth and the Portsmouth Redevelopment and Housing Authority access to the site to perform the health risk testing and testing on-site was completed June 24, 1993. On July 28, 1993, the Court dismissed the counterclaims of BMI that were drawn on RCRA and loss of contribution protection under CERCLA. The remaining liabilities, damages and allocations are similar for both defendants and plaintiffs. The Health Risk Assessment Report was provided to all parties on August 27, 1993. It finds "no imminent risk to public health." Further investigation will be conducted without relocating residents. In mid-September, 1993, the judge granted an eight month stay of all legal proceedings to permit Commonwealth to conduct full site investigation and provide the opportunity for the parties to discuss settlement. The workplan was completed and work began on November 1, 1993. Emergency permits for waste handling from the City of Portsmouth were obtained to facilitate the investigation. Residents and nearby homeowners were notified of the work. Commonwealth met with the voluntary Remediation Group of VaDEQ. A draft consent agreement delineating the VaDEQ's supervisory responsibility for site work is being developed. On February 14, 1994, a Magistrate was appointed to facilitate settlement discussions. D. Commonwealth Gas Services/Virginia Department of Environmental Quality. On February 9, 1993, Commonwealth reported to the Virginia Department of Environmental Quality's (VaDEQ) State Water Control Board that an oily substance was seeping through a retaining wall at a former manufactured gas plant site at Petersburg, Virginia. On April 5, 1993 Commonwealth received a request from the State Water Control Board to investigate the seep and submit a report to the Board. Commonwealth has retained a consultant to investigate the seep and prepare the report. Site assessment was submitted to the VaDEQ on July 20, 1993. That report recommends removal of contents of a tank behind the retaining wall. The report also disclosed an additional seep of materials from the creek upstream of the retaining wall area. On July 27, 1993, VaDEQ accepted Commonwealth's recommendations on the two seeps. Commonwealth is proceeding to implement those recommendations over the next six months. On November 1, 1993, a report on the creek bank seep was sent to VaDEQ. It notes fairly widespread groundwater and soil contamination, as well as identifying the source of the creek bank seep. On December 10, 1993, Commonwealth met with the VaDEQ regarding the recently filed report. Commonwealth consultants are developing a workplan to address the contamination noted in the report. Commonwealth is now dealing with VaDEQ remediation group and is in the process of developing a draft memorandum of understanding delineating the course of action to be taken. E. In Re Columbia Gas Transmission (Region V). On January 28, 1994, Columbia Transmission received from USEPA Region V an Information Request pursuant to the Resource Conservation and Recovery Act (RCRA). The Agency requests Columbia Transmission to submit information and knowledge relating to its generation and management of natural gas pipeline condensate, used engine oil and similar liquids in the state of Ohio. Transmission is in the process of analyzing the information requested and will be discussing this Information Request with Region V. 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 common stock of the Corporation is traded on the New York Stock Exchange under the ticker symbol CG and abbreviated as either ColumGas or ColGs in trading reports. The number of shareholders of record on February 28, 1994, was approximately 64,271 and the stock closed at $28.375. On June 19, 1991, the Corporation suspended the dividend on its common stock. Management cannot determine at this time when dividends will again be paid. See Item 7 on page 51 for additional information regarding the Corporation's common stock prices and dividends. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SELECTED FINANCIAL DATA The Columbia Gas System, Inc. and Subsidiaries N/M - Not meaningful * Reference is made to Notes 1A and 2 of Notes to Consolidated Financial Statements. **Prior to its Chapter 11 filing, the Corporation made extensive use of variable rate debt since the associated cost was normally less than senior long-term debt. Inclusion of the short-term debt in years prior to 1991 makes those historical ratios more meaningful. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BANKRUPTCY MATTERS On July 31, 1991, The Columbia Gas System, Inc. (Corporation) and its wholly-owned subsidiary, Columbia Gas Transmission Corporation (Columbia Transmission), filed separate petitions seeking protection under Chapter 11 of the Federal Bankruptcy Code. Both the Corporation and Columbia Transmission were granted debtor-in-possession status under the Bankruptcy Code, allowing them to continue normal business operations subject to the jurisdiction of the United States Bankruptcy Court for the District of Delaware (Bankruptcy Court). Columbia Transmission's Plan of Reorganization The Corporation's and Columbia Transmission's discussions with the Official Committee of Unsecured Creditors of Columbia Transmission (Columbia Transmission Creditors' Committee) to negotiate a reorganization plan for Columbia Transmission and expedite emergence from Chapter 11 proceedings had been largely unsuccessful. Therefore, on January 18, 1994, Columbia Transmission filed, with the Corporation as cosponsor, a reorganization plan (plan) and a disclosure statement, for consideration by its creditors and other interested parties. The plan, which management believes is fair and equitable, proposes to pay 100 percent for all priority, administrative and secured claims and offers various classes of general unsecured creditors, including producers whose gas contracts were rejected by Columbia Transmission, between 80 and 100 percent of Columbia Transmission's estimates of their allowable claims. The $3.3 billion total distribution proposed in Columbia Transmission's plan is based on an estimated value for Columbia Transmission of $3.1 billion and includes significant financial contributions by the Corporation. The plan is premised on a proposed omnibus settlement whereby the Corporation would settle the Intercompany Complaint and facilitate Columbia Transmission's reorganization by (i) accepting the value of the Corporation's secured claims against Columbia Transmission in the form of secured debt and equity securities of Columbia Transmission, and (ii) ensuring the cash (or at the option of the Corporation cash and $100 million market value of the Corporation's common stock) necessary to bring the aggregate distribution to $3.3 billion. Creditors, other than the Corporation, would share in distributions of over $1.2 billion in cash. In addition, the Corporation would consent to the reorganized Columbia Transmission's assumption of responsibility for public environmental enforcement agency claims so that the recoveries of the other creditors would not, with minor exceptions, be diminished by the environmental liabilities of Columbia Transmission's estate. The plan provides that Columbia Transmission will remain a wholly-owned subsidiary of the Corporation, will continue to offer an array of competitive transportation and storage services, and will retain ownership of its 18,800-mile pipeline network and related facilities. Columbia Transmission's proposed business solution will offer to producers, whose gas supply contracts were rejected or who have prepetition claims under those contracts, individual, specific settlements of the producers' claims that are based upon uniform assumptions and principles and which, in the view of Columbia Transmission's management, are fair and reasonable settlement values. These specific settlement proposals are being developed ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) and will be filed as an adjunct to the plan. Columbia Transmission estimates that aggregate distributions to producers under the plan would come to approximately $900 million. In general, the plan provides for immediate cash payment in full to all priority claims, all secured claims held other than by the Corporation, trust fund claims, administrative expenses and unsecured claims of $50,000 or less. The Corporation's secured claims will be satisfied in full with new secured debt and equity securities to be issued by the reorganized Columbia Transmission. Unsecured claims between $50,000 and $250,000 would receive 95 percent of their allowed claims in cash. All other unsecured claims, including the Corporation's unsecured debt and producer contract rejection claims, would receive between 80 and 100 percent of their allowed claims based on current projections. With respect to some of the classes of creditors, the treatment described above depends on the acceptance of the plan by the relevant class. At this time, no creditors have agreed to any of the proposed plan's provisions, and the ultimate confirmed plan of reorganization could be materially different from this initial filing. Although Columbia Transmission's plan utilizes June 30, 1994, as an assumed date of emergence from bankruptcy, the actual date of emergence will depend on the time required to complete the bankruptcy process and obtain necessary creditor, judicial and regulatory approvals. As part of its filing with the Bankruptcy Court, Columbia Transmission requested that the court defer scheduling required proceedings on the plan and related disclosure statement in order to permit discussions of the plan, including the settlements proposed therein, with Columbia Transmission's creditors, official committees and other interested parties. Under bankruptcy procedures, after Columbia Transmission's disclosure statement has been approved by the Bankruptcy Court, the disclosure statement and the reorganization plan will be sent to the company's creditors for voting. The Corporation intends to file a plan for its reorganization which will be consistent with the financial aspects and structure of Columbia Transmission's proposed plan of reorganization. Both plans will be subject to a lengthy review and approval process, including SEC approval, and obtaining adequate financing. Implementation of Columbia Transmission's plan, and the levels and timing of distributions to its creditors, are subject to a number of risk factors which could materially impact their outcome. The plan sets forth numerous conditions to its confirmation and consummation. The failure to satisfy these conditions in accordance with the terms of the plan would have a material adverse effect on the outcome of Columbia Transmission's bankruptcy and on the Corporation. These conditions include, among others, the confirmation of a reorganization plan for the Corporation, the receipt of necessary approvals for the implementation of Columbia Transmission's plan and the recovery of regulatory and tax benefits which are fundamental to the plan's viability. Both companies anticipate emerging from bankruptcy at the same time. The provisions of the reorganization plans of either Columbia Transmission or the Corporation that are ultimately implemented could be materially different from this initial filing for Columbia Transmission and have a material adverse effect on the Corporation and its subsidiaries and on the rights of shareholders and holders of debt and other obligations. Events Leading to Bankruptcy Filings Columbia Transmission's Chapter 11 filing was precipitated by a combination of events that adversely affected its physical operations and financial viability. Most notable were federal legislative and regulatory actions, instituted years after Columbia Transmission's gas purchase contracts were signed, that significantly impacted Columbia Transmission's ability to sell the gas it had contracted to buy and to recover its costs from its customers. These problems were exacerbated by record-setting warm weather in 1990 and 1991, which caused spot market prices for gas to plunge and created excess transportation capacity, thus making an unexpected and persistent oversupply of bargain-priced gas available to Columbia Transmission's customers. As a result, Columbia Transmission's ability to market its gas was severely undercut, substantially reducing both sales volumes and revenues. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) After completing studies, in early June 1991, that revealed the magnitude of Columbia Transmission's gas supply problems, the Corporation announced on June 19, 1991, that: (i) it anticipated that a substantial portion of Columbia Transmission's exposure on above-market priced gas purchase contracts would be charged to income in the second quarter; (ii) Columbia Transmission was launching a comprehensive effort to renegotiate or terminate all of its above-market gas purchase contracts under a program which contemplated offering producers up to $600 million of Columbia Transmission's obligations as compensation for restructuring their contracts; (iii) the Corporation was suspending the dividend on its common stock; and (iv) corporate officers were meeting with bank lenders that day seeking to reestablish the Corporation's credit facilities on revised terms in view of Columbia Transmission's financial difficulties. In addition, Columbia Transmission's financial problems were exacerbated when the West Virginia Supreme Court ordered the posting of a $10 million bond by July 29, 1991, in order to stay the execution of a $29.5 million judgment in a lease dispute which was subsequently reversed. As of July 31, 1991, the Corporation was in default on $83.5 million of short-term obligations and the negotiations with banks and producers had met with only limited success. As a result, on July 31, 1991, the Corporation and Columbia Transmission filed for protection under Chapter 11 of the Federal Bankruptcy Code in the Bankruptcy Court. A discussion of the proceedings under Chapter 11 protection is included in Note 2 of Notes to Consolidated Financial Statements. In contrast to the situation of many other Chapter 11 debtors, reorganization of Columbia Transmission has not been hampered by unprofitable or marginal business operations. Rather, in Columbia Transmission's case the achievement of the Chapter 11 objective of reorganization has been impacted by the enormity and complexity of the disputed and contingent claims filed against it by unaffiliated creditors and by attempts on behalf of those creditors to obtain recoveries on such claims from the assets of the Corporation's estate. In addition, Columbia Transmission's status as a regulated gas transmission company under the Natural Gas Act (NGA) and its resulting obligations has brought into the bankruptcy forum creditors' rights issues which are complicated by public law issues arising under the NGA. Bankruptcy Issues On March 19, 1992, the Columbia Transmission Creditors' Committee filed a complaint (Intercompany Complaint) with the Bankruptcy Court alleging that the $1.7 billion of Columbia Transmission's secured and unsecured debt securities held by the Corporation should be recharacterized as capital contributions (rather than loans) and equitably subordinated to the claims of Columbia Transmission's other creditors. The Intercompany Complaint also challenges interest and dividend payments made by Columbia Transmission to the Corporation of approximately $500 million for the period from 1988 to the petition date and the 1990 property transfer from Columbia Transmission to Columbia Natural Resources, Inc. (CNR) as an alleged fraudulent transfer. Based on the SEC's standardized measurement procedures, CNR's properties had a reserve value of approximately $387 million as of December 31, 1993, a significant portion of which is attributable to the transfer from Columbia Transmission. In May 1992, Columbia Transmission Creditors' Committee filed with the U.S. District Court a motion for a jury trial and to move the Intercompany Complaint from the Bankruptcy Court to the U.S. District Court. This motion was denied and subsequently appealed to the Third Circuit Court of Appeals (Third Circuit). In June 1992, the Corporation filed a motion with the Bankruptcy Court seeking dismissal of, or summary judgment on, principal portions of the Intercompany Complaint. On August 20, 1993, the Third Circuit denied Columbia Transmission Creditors' Committee's appeal, allowing the Bankruptcy Court to consider the merits of the Intercompany Complaint and act upon the Corporation's June 1992 motion for summary judgment. The Bankruptcy Court has not acted on the Corporation's motion for summary judgment, but tentatively scheduled a trial on the Intercompany Complaint to begin June 13, 1994. Management believes that the Intercompany Complaint is without merit; however, the ultimate outcome of these issues is uncertain at this stage of the proceedings. Discussions with Columbia Transmission's creditors in an attempt to establish the value of the estate and to resolve ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) the matters raised in the Intercompany Complaint are ongoing. Since the standing and value of the Corporation's debt investment in Columbia Transmission is crucial to the determination of the value of the Corporation's estate, the Corporation's reorganization could be affected by the ultimate outcome of the Intercompany Complaint. At December 31, 1993, the Corporation's investment in Columbia Transmission is as follows: The Corporation has claims against Columbia Transmission's estate for money it borrowed which are secured by substantially all of Columbia Transmission's assets, including cash. This indebtedness bears interest at rates significantly higher than those earned by Columbia Transmission on its excess cash because of bankruptcy imposed limitations on Columbia Transmission's temporary investments and the current level of interest rates. As a result, the growth in Columbia Transmission's secured interest obligations has exceeded its interest earnings on its cash available for debt service by an amount projected to exceed $300 million by the end of June 1994. The Internal Revenue Service (IRS) filed identical claims of $553.7 million against both debtor companies and the consolidated Columbia Gas System for tax deficiencies, interest and penalties for the years 1983-1990. Negotiations with IRS representatives have resulted in a settlement on all of the issues included in the IRS claims. This settlement has been documented in a written closing agreement and filed with the Joint Committee on Taxation of the U.S. Congress for formal approval. The IRS settlement also requires Bankruptcy Court approval. Recording the IRS settlement reduced 1993 net income by $44.3 million. Columbia Transmission has recorded liabilities of approximately $1.2 billion to reflect the estimated effects of its above- market producer contracts and estimated supplier obligations associated with pricing disputes and take-or-pay obligations for historical periods. With Bankruptcy Court approval, Columbia Transmission rejected more than 4,800 above-market gas purchase contracts with producers. The producers whose gas purchase contracts were rejected filed claims for damages that, after being adjusted for duplicative and other erroneous claims, are in excess of $13 billion. The Bankruptcy Court approved the appointment of a claims mediator in 1992 to implement a claims estimation procedure related to the rejected above-market producer contracts and other producer claims. The mediator held hearings on generic issues and various estimation methodologies and discovery matters during 1993. Columbia Transmission anticipates that the mediator may issue recommended determinations during the second quarter of 1994 which, under the Bankruptcy Court-approved estimation procedure, are expected to provide the basis for a recalculation of producer contract rejection claims. In Columbia Transmission's judgment, the positions taken by all producers before the claims mediator and the evidence presented demonstrate that the total level of allowable contract rejection claims, generically determined, will not exceed 1/10th of the $13 billion asserted in the claims as filed and is likely to be between $600 million and $950 million. The acceptance of certain positions advanced by Columbia Transmission on the evidence of record, as well as Columbia Transmission's as yet unheard defenses, could decrease substantially this range of possible aggregate outcomes. Resolution of the contract-specific issues ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) not yet presented could increase or decrease individual claims materially but should not significantly alter the range of possible aggregate outcomes. The resolution of these issues can significantly influence future reported financial results. Accounting standards require that as claim amounts are allowed by the Bankruptcy Court, the full amount of the allowed claim must be recorded. This could result in liabilities being recorded which bear little relationship to the amounts ultimately required to be paid in settlement of those claims and could conceivably exceed the Corporation's total investment in Columbia Transmission. Any such distortion would not be corrected until final plans of reorganization are approved for the Corporation and Columbia Transmission. At a hearing on February 23, 1994, the Bankruptcy Court granted the Columbia Transmission Creditors' Committee's motion for the establishment of a data room that will make business information on Columbia Transmission available to third parties who may be interested in the company. In granting the motion, the Bankruptcy Court instructed the parties to jointly develop proposed data room procedures which should provide for a substantial entrance fee, exclude Columbia Transmission's future business plans and projections and establish strong confidentiality protections. The Bankruptcy Court also instructed that such procedures should be filed with the Bankruptcy Court by March 11, 1994, for a hearing on March 15, 1994. Columbia Transmission is working toward the expeditious development and conclusion of the data room process in order to minimize any potential delays to its reorganization efforts. The Corporation has stated that its Columbia Transmission subsidiary is not for sale but that if a credible, bona fide third party offer is made for that company, it would be given appropriate consideration. Other Related Issues Corporation's Objection to Claims In 1993, the Bankruptcy Court granted the Corporation's request to expunge over 7,100 proofs of claim filed against the Corporation. As a result, less than 500 filed claims against the Corporation currently remain to be resolved. Leveraged Employee Stock Ownership Plan On May 31, 1992, the debt service payment on debentures issued under the Leveraged Employee Stock Ownership Plan (LESOP) portion of the Columbia's Employees' Thrift Plan (Thrift Plan) was not made and no further debt service payments are likely to be made until the Corporation emerges from bankruptcy. Under the terms of the Corporation's guarantee of the debentures, the LESOP debenture holders will become creditors of the Corporation, subordinated to holders of the debentures and medium-term notes issued by the Corporation. Management has concluded that it is more equitable and may be economically preferable to pay all creditors at the same time in accordance with consummation of the Corporation's plan of reorganization. The Trustee for the Indenture under which the debentures were issued by the Thrift Plan filed a complaint against the Corporation on March 2, 1993, alleging tortious interference with contract for failure to pay installments due LESOP debenture holders. On April 2, 1993, the Corporation filed an answer to the complaint and, on May 14, 1993, filed a motion in the Bankruptcy Court for summary judgment to dismiss this action which is still pending. Security Holder Litigation After the announcement on June 19, 1991, regarding the Corporation's probable charge to second quarter earnings and the suspension of its dividend, 17 complaints including purported class actions were filed against the Corporation and its directors and certain officers of the debtor companies in the U.S. District Court of Delaware. The actions, which generally allege violations of certain antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934, have been consolidated. In addition, three derivative actions were filed in the Court of Chancery in and for New Castle County (Delaware) alleging that directors breached their fiduciary duties. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) These suits have been stayed by either the Bankruptcy Court filing or by stipulation of the parties. While the Corporation believes that it has meritorious defenses to these actions, the outcome is uncertain at this time. Customer Refunds In July 1993, the U.S. Court of Appeals for the Third Circuit overturned most of a U.S. District Court ruling and affirmed an earlier Bankruptcy Court decision that refunds Columbia Transmission received from upstream pipelines, as well as the Gas Research Institute (GRI) surcharge payments it collected from customers, are held in trust, by Columbia Transmission, for those customers and the GRI and are not part of Columbia Transmission's estate. In August 1993, the Third Circuit denied the Columbia Transmission Creditors' Committee's request for a rehearing. In February 1994, the Supreme Court denied petitions for review of the Third Circuit decision. Under the Third Circuit ruling, approximately $173 million in refunds that Columbia Transmission has received, or expects to receive postpetition from upstream pipelines and GRI surcharges collected should be passed through to the customers and to the GRI. In addition, the Third Circuit determined that $35 million in upstream pipeline refunds and GRI surcharges, which Columbia Transmission collected prior to filing Chapter 11 while received in trust, were subject to the "lowest intermediate cash balance test" (the amount remaining in trust at the time of bankruptcy) and should be distributed on a pro rata basis to the customers and to the GRI to the extent of Columbia Transmission's $3.3 million cash balance on July 31, 1991. The Third Circuit affirmed another part of the U. S. District Court's decision and held that approximately $16 million that Columbia Transmission owes upstream suppliers, for gas purchased and transportation services received prior to its bankruptcy filing, is ordinary unsecured debt which must be discharged in the bankruptcy process. On February 10, 1994, the District Court issued an order for the Bankruptcy Court to pursue further proceedings in accordance with the Third Circuit's refund decision directing the pass-through of these refunds. At a hearing on December 29, 1993, the Bankruptcy Court observed that the Federal Energy Regulatory Commission (FERC) should determine whether customers are entitled to the actual interest earned on refunds being held by Columbia Transmission or the higher FERC-prescribed interest rate. On February 18, 1994, Columbia Transmission filed a motion with the FERC for determination of this interest issue. Columbia Transmission will ask the Bankruptcy Court for implementation of the mandate. Columbia Transmission will also have to file with the FERC to reimplement its flow-through of Order Nos. 500/528 refunds from its pipeline suppliers, which represent the majority of the refunds at issue. It is anticipated that Columbia Transmission will recommence the flow-through of the upstream pipeline refunds in 1994. Total customer claims in Columbia Transmission's bankruptcy proceedings relating to, or arising from, Columbia Transmission's contracts with its customers for sales, transportation, gas storage and similar services and other miscellaneous claims represent about 450 claims for a total of approximately $550 million as filed, plus a potentially substantial sum filed in undetermined amounts. Columbia Transmission successfully resolved a significant portion of these customer claims. Not resolved are customer claims that total approximately $113 million at December 31, 1993, that seek to protect rights associated with any prepetition revenues collected subject to refund in general rate filings and purchased gas adjustment filings, including matters subject to court appeals. In addition, the claims filed in undetermined amounts, which potentially could be significant, still remain to be resolved. In October 1993, approximately $160 million was refunded to customers by Columbia Transmission reflecting the terms of a settlement of a 1991 rate case approved by the Bankruptcy Court in July 1993. Bankruptcy Court approval for a 1990 rate case settlement for rates in effect from November 1, 1990 through November 30, 1991 was deferred pending the decision by the Third Circuit regarding the flow-through of certain refunds. Appropriate reserves for rate refund liabilities have been recorded for these matters to reflect management's judgment of the ultimate outcome of the proceedings. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Customer Recoupment Rights During the fourth quarter of 1993, various customers of Columbia Transmission filed motions with the Bankruptcy Court seeking authority to exercise alleged recoupment and setoff rights, whereby they would be permitted to reduce amounts owed to Columbia Transmission against refunds owed to the customers by Columbia Transmission, including amounts which were not otherwise payable in full under the above-mentioned July 1993 Third Circuit decision, all customer refunds under the 1990 rate case settlement and miscellaneous refunds not otherwise payable in full to them. Customers are alleging that they have recoupment and setoff rights of approximately $83 million at December 31, 1993. On October 20, 1993, the Bankruptcy Court approved an interim settlement under which customers continued to pay Columbia Transmission for FERC-authorized services at authorized rates, and Columbia Transmission has agreed to grant these customers a priority claim to the extent the Bankruptcy Court finds them entitled to recoupment rights. In January 1994, the Bankruptcy Court issued a procedural order whereby other customers would be permitted to file recoupment and setoff motions by February 18, 1994, with a trial on all such motions scheduled for June 1994. Interest Expense Interest expense of the Corporation is not being accrued during bankruptcy but a calculation of interest is included in a footnote on the Statements of Consolidated Income and Consolidated Balance Sheets. Such interest has been calculated based on management's interpretation of the contractual arrangements which govern the various debt instruments the Corporation has outstanding exclusive of any redemption premiums. The Official Committee of Unsecured Creditors of the Corporation (Committee) has asserted claims for interest which exceed disclosed amounts by approximately $40 million at December 31, 1993. There are several factors to be considered in making these calculations that are subject to uncertainty as to their ultimate outcome in the bankruptcy proceeding, including the interest rates and method of calculation to be applied to overdue payments of principal and interest. In addition, the Committee has asserted that approximately $110 million of redemption premiums should be paid on high cost debt instruments. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) OIL AND GAS OPERATIONS Market Conditions Natural gas markets showed renewed strength in 1993, responding to seasonal weather conditions and uncertainty regarding the availability of supplies in the new operating environment brought about by FERC Order No. 636 (Order 636). Overall for 1993, natural gas prices averaged $2.28 per Mcf compared to $2.02 in 1992. Oil prices continued their decline from a 1992 level of $18.20 per barrel to $16.17 per barrel for 1993. Capital Expenditures The 1993 capital expenditure program increased to $95 million from the $71 million level in 1992. The 1993 program provided for increased development drilling and a modest exploration program in the southwest. In the southwest, Columbia Gas Development Corporation (Columbia Development) experienced an increase in both gas and oil production in 1993, reflecting the continuing success of its drilling program, especially its horizontal drilling program in the Austin Chalk Trend in Texas. During the fourth quarter of 1993, Columbia Development drilled and completed its 100th horizontal well in that area. Major reconditioning work in early 1993 also contributed to the increase in production. During 1993, 87 gross (46 net) wells were drilled with a 69 percent success rate. Of these, 47 were drilled in the Austin Chalk, 94 percent of which were successful. Productivity was enhanced by an increased emphasis on dual lateral wells (multiple lateral wells drilled from a single vertical well). The 44 successful wells drilled included 70 laterals. This substantially increased production while reducing overall cost per well, since the costs of the vertical portion of each well were shared by more than one lateral and the combined laterals accessed a larger area. In 1992, 30 wells with 38 laterals were drilled. Horizontal wells drilled in the Austin Chalk formation during 1993 tested at average daily rates ranging from 250 to 1,040 barrels of oil and 550,000 to 3.1 million cubic feet of gas. Columbia Development holds varying interests in these wells. Development drilling continues in the South Harmony Church area in southern Louisiana. In 1993, three successful wells in this area, 100 percent owned by Columbia Development, tested at combined rates of seven million cubic feet of gas and 925 barrels of oil per day. In the Appalachian area, CNR's 1993 development well program totaled 120 gross (75 net) wells, with a success rate of 89 percent. One of the most promising areas under development is a formation underlying existing production in Ohio, known as Rose Run. CNR has been producing in this formation in recent years with excellent results. Favorable reservoir characteristics allow Rose Run prospects to quickly generate a return on invested capital. CNR's 1994 development program will continue to target several prospects in this area. The oil and gas segment's total 1994 exploration and development program of $91 million will continue to focus primarily on development drilling while maintaining the modest level of the 1993 exploration program. Because of weak oil prices the Corporation has adopted more conservative guidelines for economic evaluations to reduce risk. Reserves Net proved natural gas reserves at the end of 1993 totalled 697 Bcf, compared to 779.5 Bcf at the end of 1992. Proved oil, condensate and natural gas liquids decreased from 14.7 million barrels at the end of 1992 to 12.8 million barrels at the end of 1993. The year end drop in oil prices accounted for approximately 0.6 million barrels of the decline by rendering some properties uneconomical. Increased oil prices would result in recovery of those reserves. As a result of a year end decline from 1992 to 1993 in gas prices together with an increase in lifting costs, the ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) recoverable gas reserves for CNR were revised downward 65.9 Bcf (11 percent). Without this reduction, newly discovered reserves and extensions approximately equaled production. In addition, Columbia Development's Huntington Beach oil recovery waterflood project has shown disappointing production during 1993, resulting in revised reserve estimates of 1.1 million barrels, down 1.6 million barrels from 1992. Geological and engineering analysis of the project is continuing. Current pricing has enhanced the profitability of gas prospects, and these prospects are the focus of the 1994 capital program. Royalty Dispute Columbia Development is involved in a $14 million royalty dispute with the U.S. Minerals Management Service (MMS) regarding royalty valuation issues in connection with prior sales to an affiliate. As a result of an unfavorable lower-court decision regarding the statute of limitations, a pre-tax reserve of $5.4 million has been established by Columbia Development. Based on information currently available, management believes this reserve to be adequate; however, the contested matters are under review, and management is currently negotiating a settlement with the MMS. Proposed Rulemaking for Offshore Drilling Financial Responsibility The MMS has issued an advance notice of proposed rulemaking for oil spill financial responsibility that would establish financial responsibility at $150 million for all operators of offshore facilities and facilities in, on, or under the navigable waters of the United States. Regulations currently require operators to demonstrate financial responsibility of up to $35 million in liability coverage. Both Columbia Development and CNR operate in navigable waterways covered under the proposed regulations. The insurance industry has indicated an unwillingness to meet the proposed financial responsibility due to certain proposed provisions contained in the rulemaking. Many comments have been received by the MMS critical of this rulemaking and its new financial responsibility requirement as well as other provisions. Since final rules may be at least two years away, it is impossible to determine the implications for the Corporation's oil and gas operations. Volumes Gas production totalled 71.5 Bcf in 1993, an increase of 3 percent over 1992. The increase includes new Southwest offshore production and new onshore production in Texas, south Louisiana and New Mexico. This improvement was tempered by a small decrease in production due to construction and maintenance activities on pipelines and compressors serving Columbia's Appalachian production area. After adjusting for the 1991 sale of the Canadian operations, gas production for 1992 was essentially unchanged from the previous year. Oil and liquids production in 1993 of 3,603,000 barrels reflected an increase of nearly 18 percent compared to 1992 due largely to the success of the Southwest program. Production for 1992, after adjusting for the sale of the Canadian operations, increased 228,000 barrels over 1991. Operating Revenues Higher gas prices together with increases in oil and gas production led to operating revenues of $222.2 million in 1993, an increase of 12 percent over 1992. Dampening these improvements was the lower average price for oil and liquids and the $5.4 million reserve for the royalty dispute discussed above. The sale of the Canadian subsidiary was the primary reason for 1992 operating revenues to decrease $16.1 million from 1991, or 7 percent. The decline was somewhat offset as the average gas price in 1992 was $2.02 per Mcf, 7 percent higher than 1991, after adjusting for the 1991 sale of the Canadian operations. The average price for oil ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) and liquids in 1992 of $18.20 per barrel represented a decline of 18 percent from the price for domestic production the previous year. Operating Income (Loss) Operating income of $53.6 million in 1993 compares to an operating loss of $101.2 million in the prior year which was due largely to recording a writedown in the carrying value of oil and gas properties of $126.4 million due to depressed energy prices. The current period improvement in operating income also reflected higher operating revenues and lower depletion expense. These improvements were partially offset by higher operation and maintenance expense for costs related to new wells and additional reconditioning work on older wells. The $96.7 million additional operating loss in 1992 compared to 1991 resulted from the effect of the writedown mentioned above together with higher operating expenses. These declines were mitigated by writedowns incurred in 1991 for the Canadian properties. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) STATEMENTS OF OPERATING INCOME FROM OIL AND GAS OPERATIONS (UNAUDITED) * Includes results from Canadian operations that were sold effective December 31, 1991. OIL AND GAS OPERATING HIGHLIGHTS* * Years 1991 through 1989 include results from Canadian operations that were sold effective December 31, 1991. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) TRANSMISSION OPERATIONS Operations The transportation and storage rates of Columbia Transmission and the transportation rates of Columbia Gulf Transmission Company (Columbia Gulf) are currently among the most competitive serving the companies' general market areas. The companies are committed to maintaining their competitive position on an ongoing basis through a combination of efficient and effective maintenance of existing facilities, economical new market development and a commitment to the highest level of overall customer satisfaction. Columbia Transmission recently received an order from the FERC for the construction of the Rutledge Compressor Station in Harford County, Maryland. This station will allow Columbia Transmission to transport 53,400 Mcf per day to the Eagle Point Cogeneration Plant in New Jersey and over 58,000 Mcf per day to New England Power. It is anticipated that the Rutledge Compressor Station will be in service by December 1994. Columbia Transmission will provide approximately 52,000 Mcf per day of interruptible transportation service to Gordonsville Energy Limited Partnership, an independent power producer in Louisa County, Virginia, in late summer of 1994. Rate Cases Columbia Transmission's and Columbia Gulf's rates are subject to the jurisdiction of the FERC. These transmission companies (Transmission) make periodic filings for rate changes to recover costs associated with new facilities, operating and capital costs, and to reflect changes in throughput, cost allocation or rate design. Settlements of issues related to these filings are subject to approval by the FERC, and with respect to Columbia Transmission during its bankruptcy, the Bankruptcy Court. During 1993, Columbia Transmission and Columbia Gulf sought approval of two rate settlements. As previously reported, a 1990 rate filing by both companies covering the period November 1, 1990 through November 30, 1991, received FERC approval in 1992; however, Bankruptcy Court approval for Columbia Transmission to make refunds has been delayed pending resolution of certain motions filed by various creditors. Columbia Transmission and Columbia Gulf received FERC and Bankruptcy Court approvals for a settlement of a general rate case that went into effect on December 1, 1991. Two parties continue to contest certain aspects of the settlement. Columbia Transmission and Columbia Gulf have made refunds and implemented rates prescribed to all parties consenting to this settlement. The nonconsenting parties, for whom separate proceedings are expected to be scheduled soon, have challenged the FERC's order and have filed a court appeal. In management's opinion, the outcome of the legal proceedings with the nonconsenting parties, including the above mentioned court appeal, will not have a material adverse impact on the Corporation. WACOG Surcharge Under the terms of a 1985 settlement with its customers, Columbia Transmission is entitled to impose a sales commodity surcharge when its weighted average cost of gas (WACOG) met certain conditions. These conditions were met in 1992, and Columbia Transmission was authorized to include the surcharge in its rates for the period September 1, 1993 through August 31, 1994. Under Order 636, which became effective November 1, 1993, Columbia Transmission essentially eliminated its merchant function and proposed an alternative method of recovering these costs which the FERC conditionally accepted. In January 1994, Columbia Transmission filed a settlement with the FERC resolving all issues relating to this unrecovered surcharge. The settlement permits Columbia Transmission to continue collecting a surcharge on transportation volumes through October 1994, that would result in the opportunity to collect approximately $42.8 million in additional revenues. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Order No. 636 During 1993, Columbia Transmission and Columbia Gulf implemented the restructured services mandated by the FERC's Order 636. Columbia Transmission has virtually eliminated its merchant function and now offers a variety of unbundled storage and transportation services. In order to implement this restructuring, the companies made a series of filings with the FERC reflecting changes in rates and the terms and conditions under which services would be offered. On October 22, 1993, Columbia Transmission and Columbia Gulf made their final compliance filing before implementing restructured services, under Order 636, on November 1, 1993. In this filing, the companies complied with previous FERC orders and made various revisions to the terms and conditions applicable to their restructured transportation and storage services. In December 1993, the FERC issued an order on rehearing that permitted Columbia Transmission to retain in its rates, costs which the FERC had previously determined were associated with its merchant function, and approved the level of costs that Columbia Transmission proposed to be allocated to interruptible transportation service. In the series of orders issued in Columbia Transmission's Order 636 proceeding, the FERC addressed issues related to Columbia Transmission's ability to recover transition costs. The FERC determined that costs incurred by Columbia Transmission as a result of rejecting producer gas supply contracts, in its bankruptcy proceeding in 1991, were not eligible for recovery as Gas Supply Realignment (GSR) costs under Order 636. In addition, recovery of these costs pursuant to Orders 500 and 528 was prohibited by the terms of a 1989 customer settlement. The FERC determined that Columbia Transmission could recover certain contract rejection costs through its existing Gas Inventory Charge (GIC), but only to the extent such costs were not incurred during the 1991 contract year, a period in which Columbia Transmission did not meet the qualifying competitive test under the GIC. If upheld, the FERC rulings, which are subject to pending court review, effectively preclude Columbia Transmission from recovering a significant portion of the producer contract rejection costs from its customers. The FERC has generally acknowledged Columbia Transmission's right to seek recovery of other types of transition costs. The FERC approved Columbia Transmission's proposal to recover certain purchased gas costs that were incurred prior to Order 636 restructuring. It also agreed to waive a nine-month time limit on Columbia Transmission's ability to seek recovery of unrecovered purchased gas costs to the extent the costs resulted from contracts that are currently in litigation, including bankruptcy litigation. Approximately $60 million in unrecovered purchased gas costs were outstanding at December 31, 1993, in addition to approximately $140 million of prepetition unrecovered purchased gas costs that have not been paid due to the bankruptcy filing. The FERC also addressed Columbia Transmission's ability to recover costs associated with upstream pipeline contracts. Columbia Transmission currently holds firm transportation agreements with certain pipeline companies that historically have been used to deliver gas to Columbia Transmission. These contracts have remaining terms of various lengths and require the payment of monthly reservation fees whether or not the capacity is utilized. Under Order 636, downstream pipelines such as Columbia Transmission are required to offer to assign most of their firm upstream capacity to their customers. Columbia Transmission's annual demand charge commitments on these upstream non-affiliated pipelines was approximately $108 million; however, assignments of certain of these contracts by Columbia Transmission to its customers in conjunction with service restructuring under Order 636 have reduced this amount to less than $74 million. The total commitment for demand charges after November 1, 1993, is approximately $421 million on an undiscounted basis, excluding any mitigating effect of the pipelines marketing the capacity to others. Subject to review in connection with periodic rate filings, the FERC approved Columbia Transmission's proposal to continue to recover costs associated with retained upstream pipeline contracts through its demand rates. Recovery of such costs would be subject to review and approval in semiannual limited rate filings. Columbia Transmission ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) has reached settlements that will eliminate approximately half of the annual cost of these contracts and is continuing its efforts to negotiate a mutually agreeable termination of the remainder of the contracts. Columbia Transmission's strategy has been to assume all upstream pipeline contracts that can be directly assigned to its customers or need to be retained by Columbia Transmission for operational reasons and negotiate exit fees for other upstream contracts. The FERC ruling in the Order 636 proceedings permits recovery of these exit fees through rates, provided that Columbia Transmission can show that they are prudently incurred. Columbia Transmission retains the option of rejecting such contracts in its bankruptcy proceedings, if appropriate exit fees cannot be negotiated. The financial statements reflect a $130 million liability and offsetting receivable for the exit fee issue; however, the ultimate cost could vary depending on the outcome of ongoing discussions with the affected pipelines. Several settlements with upstream pipelines have been concluded. In 1993, the Bankruptcy Court approved settlements between Columbia Transmission and Texas Eastern Transmission Corporation, Panhandle Eastern Pipe Line Company and Texas Gas Transmission Corporation which provide for assumption of certain contracts and termination of others. None of these settlements required Columbia Transmission to pay an exit fee to the upstream pipeline. In November 1993, the Bankruptcy Court approved a settlement between Columbia Transmission and Tennessee Gas Pipe Line Company (Tennessee). This settlement provides for Columbia Transmission's assumption of certain contracts, the termination of certain other contracts that are no longer necessary for Columbia Transmission's operations and payment to Tennessee of approximately $42 million in consideration for Tennessee's substantial reduction of its major transportation contracts with Columbia Transmission. On January 11, 1994, Columbia Transmission and Tennessee made a filing at the FERC to approve the settlement. Columbia Transmission expects to ultimately recover the costs and fees associated with the assumption and termination of these contracts under Order 636. The Tennessee settlement agreement is conditioned upon this recoverability. The FERC affirmed that Columbia Transmission could continue its existing rate structure to recover costs associated with its gathering facilities through its gathering and other transportation rates until it files a general rate case. Management continues to evaluate the long-term plans for Columbia Transmission's gathering facilities which have a net book value of approximately $63 million at December 31, 1993. The regulatory treatment of gathering facilities is currently the subject of a generic FERC proceeding. While the ultimate outcome of issues related to realization of its investment in gathering facilities is uncertain at this time and future charges to income may be required, management believes that substantially all of these costs will be recovered through rates or sale of the facilities. As part of its September 29, 1993 order on Columbia Transmission's and Columbia Gulf's Order 636 compliance filings, the FERC initiated a proceeding concerning Columbia Gulf's transportation service to Columbia Transmission. Columbia Gulf was directed to show cause as to why it has not filed for FERC abandonment authorization to reduce capacity and service to Columbia Transmission as required under the Natural Gas Act. Columbia Gulf responded to the show cause order on December 22, 1993. Management does not believe an abandonment filing was necessary and does not expect the resolution of this issue to have a material adverse effect on the Corporation's financial position. One type of transition cost which the FERC acknowledged would be eligible for recovery consideration is "stranded costs", which are the costs of a pipeline's assets previously used to provide bundled sales service in the pre-Order 636 era and are unsubscribed in the Order 636 environment. Columbia Gulf has several pipelines and related facilities that are not fully subscribed to under Order 636. Certain facilities south of Rayne, Louisiana (primarily in the offshore Gulf of Mexico area), are being evaluated; however, management has not identified any stranded facilities at this time and the outcome of these evaluations is uncertain. Dependent upon the results of such evaluation, charges to income could be required. The net book value of the facilities under study was approximately $40 million at December 31, 1993. It is management's view that any costs associated with these facilities will be fully recoverable through rates. Order 94 Settlements On January 12, 1994, the FERC granted requests for rehearing of prior orders approving settlements between ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Columbia Transmission and four of its upstream pipeline suppliers relating to those suppliers' direct billings to Columbia Transmission of the FERC's Order 94 (Order 94) costs in the mid-1980s. The rehearing orders found that the settlements must be rejected because they are expressly contingent upon Columbia Transmission's recovery of the Order 94 settlement payments from its customers and Columbia Transmission's 1985 PGA Settlement essentially bars such recovery. The orders also hold that these pipelines are not entitled to bill any Order 94 charges to Columbia Transmission. The FERC ordered these upstream pipelines to refund the principal amounts of all Order 94 collections from Columbia Transmission, but waived any requirement that these pipelines pay interest on the refunds. Since Columbia Transmission has been reflecting the interest income on these refunds since 1990, these orders led to a $19.5 million reduction to interest income in 1993. Columbia Transmission has sought rehearing and, if necessary, will seek court review of these orders. It is expected that pipeline suppliers will also request rehearing arguing their rights to re-bill such charges to Columbia Transmission. The ultimate outcome of this issue is uncertain at this time and could impact future operating results depending upon the results of these additional regulatory and court reviews. Environmental Matters Columbia Transmission and Columbia Gulf are subject to extensive federal, state and local laws and regulations relating to environmental matters. These laws and regulations, which are constantly changing, require expenditures for corrective action at various operating facilities and waste disposal sites for conditions resulting from past practices that subsequently were determined to be environmentally unsound. The transmission subsidiaries have received notice from the United States Environmental Protection Agency (EPA) that they are among several parties responsible under federal law for placing wastes at Superfund sites and may be required to share in the cost of remediation of these sites. However, considering known facts, existing laws and possible insurance and rate recoveries, management does not believe the identified Superfund matters will have a material adverse effect on future income or on the Corporation's financial position. The transmission subsidiaries are continuing their comprehensive review of compliance with existing environmental standards, including review of past operational activities and identification of potential site problems, through site reviews and formulation of remediation programs where necessary. The transmission subsidiaries have made progress in these ongoing self- assessment programs. However, because of the thousands of miles of pipeline which they operate, the exceptionally large number of sites at which they conduct or have conducted operations, and the long period over which operations have been conducted, completion of site screenings, characterizations and site-specific remediations will require approximately 10 to 12 years. All environmental agencies have been declared exempt from the Bar Date established by the Bankruptcy Court for claims by creditors. A study for Columbia Transmission to quantify the scope of remediation activities which will be undertaken in future years to address the issues identified was recently concluded. This study, site investigations and characterization efforts performed throughout 1993, resulted in total accruals for the year of approximately $60 million for Columbia Transmission. These and other minor adjustments bring Columbia Transmission's recorded net liability to $143.6 million at December 31, 1993. This represents the lower end of the range of reasonable outcomes with the upper end estimated to total approximately $280 million based on information currently available. As characterization and site-specific activities by Columbia Transmission determine the nature and extent of contamination at its facilities and as remediation plans are developed, additional charges to earnings could occur. To the extent such plans require approval of federal and/or state authorities, estimates are subject to revision. Based on the limited data now available and various assumptions as to characterization and remediation, management believes that annual future expenditures for Columbia Transmission's site investigations, characterization and remediation activities could be up to $20 million per year over a 10- to 12- year time frame. Since the transmission companies do not account for their operations under SFAS No. 71, earnings will continue to be charged as costs become probable and reasonably estimable, regardless of when expenditures are made. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) As a result of site characterization studies at various locations during 1993, Columbia Gulf recorded an additional accrual of $6.7 million for environmental remediation. This accrual is for polychlorinated biphenyl (PCB) cleanup and hydrocarbon spills at certain compressor station sites and screenings for possible exposure at other locations. Columbia Gulf anticipates completion of cleanup during 1994. At that time, costs of remediation, if any, will be quantified, and an additional accrual may become necessary. In 1992, Columbia Transmission received a subpoena and information request (Request) from the EPA Region III regarding three major environmental statutes: The Toxic Substance Control Act (TSCA), the Resource Conservation and Recovery Act (RCRA), and the Comprehensive Environmental Response Compensation and Liability Act (CERCLA). The Request relates to Columbia Transmission's past and current environmental practices. Since receipt of the Request, Columbia Transmission has provided the EPA with substantial materials regarding the Request. Columbia Transmission continues to meet with the EPA to attempt to resolve the subpoena issues, including related fines and penalties, which it believes will be resolved in the near future. Columbia Transmission on January 28, 1994 received from EPA Region V an Information Request pursuant to RCRA. The agency requested Columbia Transmission to submit information and knowledge relating to its generation and management of natural gas pipeline condensate, used engine oil and similar liquids in the state of Ohio. Columbia Transmission is in the process of analyzing the information requested and will be discussing this Information Request with EPA Region V. It is management's continued intent to address environmental issues in cooperation with regulatory authorities in such a manner as to achieve mutually acceptable compliance plans. However, there can be no assurance that fines and penalties will not be incurred by Columbia Transmission and Columbia Gulf. The eventual total cost of full future environmental compliance for Columbia Transmission and Columbia Gulf is difficult to estimate due to, among other things: (1) the possibility of as yet unknown contamination; (2) the possible effect of future legislation and new environmental agency rules; (3) the possibility of future litigation; (4) the possibility of future designations as a potentially responsible party by the EPA and the difficulty of determining liability, if any, in proportion to other responsible parties; (5) possible insurance and rate recoveries; and (6) the effect of possible technological changes relating to future remediation. Management expects most environmental assessment and remediation costs to be recoverable through rates or insurance. Although significant charges to earnings could be required prior to rate recovery, management does not believe that environmental expenditures will have a material adverse effect on the Corporation's financial position based on known facts, existing laws and regulations and the period over which expenditures are required. Clean Air Act Amendments of 1990 Columbia Transmission and Columbia Gulf have completed preliminary studies to determine the impact of the Clean Air Act Amendments of 1990 (CAA-90). The studies focused on various compressor facilities for both companies. The facilities are among those affected by the new nitrogen oxide emission standards under CAA-90. It is estimated that capital expenditures necessary to comply with these new standards could be in excess of $30 million over the next few years. However, due to the preliminary nature of the studies, the uncertainty of individual state regulations and other variables, the actual amount of future expenditures related to CAA-90 is difficult to estimate. Management anticipates that all capital expenditures made in compliance with CAA-90 will be recoverable through the rate-making process. Operation and maintenance expenses, including monitoring of emissions and permit fees, could approximate $5 million to $10 million per year for the transmission companies. Partnership Issues Columbia Gulf is a general partner in the Trailblazer, Overthrust and Ozark pipeline partnerships. Since these partnerships are nonrecourse project-financed pipelines, the partnerships' firm shipper contracts were assigned to various banks (or in the case of Ozark, to the Indenture Trustee) as collateral for loans. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Columbia Transmission and other shippers are attempting to negotiate exit fees under Order 636 with the partnerships. As a result of these negotiations and the current depressed demand for capacity in certain of the partnerships, the realizability of these investments is uncertain, and a valuation reserve of $5.4 million was established in 1993. It is not expected that these issues will be resolved until late 1994. At December 31, 1993, Columbia Gulf's investment in the partnerships amounted to $35.4 million, net of the valuation reserve and before related deferred taxes. Cove Point LNG Terminal As previously reported, Columbia LNG Corporation (Columbia LNG) has developed a new business plan to reactivate the Cove Point facility. Originally this plan anticipated a new peaking and storage service by the end of 1994, as well as a terminalling service for liquefied natural gas (LNG) received by tanker. However, that plan has been modified to where now only a peaking service will be offered initially. As a consequence, Columbia LNG recorded a writedown in the carrying value of its investment in the Cove Point facility in the second quarter 1993 that reduced the Corporation's income by $37.9 million after-tax. This amount included estimated dismantling costs for the offshore facilities of approximately $12 million after-tax. Until transferred to the new partnership, as discussed below, Columbia LNG plans to maintain the offshore facilities for possible future imports and at the present time has no plans to abandon or dismantle them. A partnership between Columbia LNG and a wholly-owned subsidiary of Potomac Electric Power Company was formed in October 1993. The partnership, which is pursuing Columbia LNG's business plan filed an application with the FERC on November 3, 1993, seeking authorization to acquire all of the existing plant and pipeline facilities owned by Columbia LNG and for authorization to recommission the plant and construct new facilities in order to provide peaking services beginning in 1995. In addition to the FERC, this transaction will require other governmental approvals. Bankruptcy Court approval was received in January 1994. The realization of the Corporation's remaining investment in Columbia LNG of $10.1 million will be dependent upon successful implementation of the partnership and the related business plan. Volumes Throughput for Transmission includes tariff sales and transportation service to local distribution companies (LDCs) and other customers in Columbia Transmission's market area, Columbia Gulf's main line transportation service from Louisiana to West Virginia and Columbia Gulf's short-haul transportation service primarily from the Gulf of Mexico to Rayne, Louisiana. Transmission's throughput in 1993 was 1,355.9 Bcf, a decrease of 18.4 Bcf from 1992. In 1992, throughput increased 144.8 Bcf over 1991 to 1,374.3 Bcf. A decrease of 13.1 Bcf in market area transportation between 1993 and 1992 was due primarily to the one-time arrangement in 1992 in which customers used market area transportation to repay certain gas delivered to them during the 1990 - 1991 winter season by Columbia Transmission. Throughput losses not associated with prior period activity also occurred primarily due to competition from other pipelines that began operating under Order 636 (or a modified version thereof) earlier this year. As expected, this load loss began to reverse following Columbia Transmission's implementation of Order 636 in November 1993, when its transportation rates became more competitive. This effect was partially offset by a throughput improvement resulting from customers using firm transportation services for delivering gas withdrawn from storage during 1993. In 1992, customers' increased use of Columbia Transmission's firm storage service (FSS) led to an increase of 59.1 Bcf in market area transportation from the year before. Columbia Gulf's 1993 mainline transportation service increased 5.6 Bcf from 1992 and between 1992 and 1991 increased by 38.9 Bcf. These increases primarily reflect additional transportation services for customers to move gas to Columbia Transmission's storage under its FSS agreement and to meet their supply requirements. Prior to the implementation of Order 636, a portion of Columbia Gulf's mainline capacity was reserved for Columbia Transmission's use for deliveries to LDCs and other markets. Beginning on November 1, 1993, however, Columbia Gulf's capacity was assigned to LDCs and end users. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Short-haul transportation has been increasing in recent years, reflecting additional arrangements made by marketers and customers for delivery of lower-priced spot market gas. In 1993, short-haul transportation was essentially unchanged from last year and reflected an increase of 60.3 Bcf between 1992 and 1991. Sales volumes for 1993 decreased 12.3 Bcf from 1992 due primarily to the implementation of Order 636. This decrease was partially offset by colder weather in the current period and the timing of prepaid gas sales. Comparing 1992 to 1991, sales increased 83.4 Bcf reflecting 10 percent colder weather, timing changes for prepaid gas sales and Columbia Transmission's competitive market-sensitive commodity rate, that resulted from the rejection in Bankruptcy Court of noncompetitive above-market gas purchase contracts. Net Revenues Transmission's 1993 net revenues of $841.5 million increased $80.1 million over 1992. Included in 1993's net revenues are $20.3 million associated with the recovery through Columbia Transmission's WACOG surcharge, as discussed previously, and GIC revenues of $20.8 million. 1992 GIC revenues were $20.9 million. The GIC mechanism allowed Columbia Transmission to charge a fee to customers whose purchases fell below a pre-determined level provided Columbia Transmission's cost of gas meets a comparability test with competing pipelines. Also improving 1993 net revenue was an adjustment to rate refund reserves and the favorable effect of normal weather. These effects combined with the benefit of the full year effect of Columbia Transmission's new rate design where a greater portion of its fixed costs are recovered through a monthly demand charge more than offset the recording of a loss on the sale of storage inventory. Net revenues for 1992 increased to $761.4 million, up $126.9 million over 1991 principally reflecting improved rate design together with higher throughput and GIC revenues. Operating Income (Loss) Operating income for 1993 of $178.7 million, increased $48.8 million over 1992. Higher net revenues together with a 1992 provision for gas supply costs combined to more than offset the effect of recording a second quarter 1993 writedown of $57.5 million for the investment in the Cove Point LNG facility (See Note 12F in Notes to Consolidated Financial Statements for more information). Additional reserves for environmental costs of $66.8 million and $65.3 million were recorded in 1993 and 1992, respectively. After adjusting for these and other unusual items, operating income would have increased $37.8 million. These improvements more than offset higher operating expenses, including increased labor and benefits costs due in part to employee severance costs. These costs resulted from reengineering Transmission's operations to improve the segment's efficiency and effectiveness in the increasingly competitive natural gas industry. Transmission's 1992 operating income of $129.9 million compares to a loss of $1,192.2 million for 1991. The principal reason for the increase was the 1991 provision for gas supply charges of $1,319.2 million. After adjusting for bankruptcy and other unusual items, Transmission's operating income would have improved $62.1 million in 1992 over 1991, due to increased throughput and rate design changes. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) STATEMENTS OF OPERATING INCOME FROM TRANSMISSION OPERATIONS (UNAUDITED) ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) TRANSMISSION OPERATING HIGHLIGHTS * Includes 116 billion cubic feet applicable to the sale of storage inventory gas. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) DISTRIBUTION OPERATIONS Market Conditions For the first time in four years, weather in the market area served by the distribution companies (Distribution) was colder than normal. Weather was only 1 percent colder than normal but 3 percent colder than last year, and resulted in a 7.7 Bcf improvement in Distribution's weather sensitive deliveries. In addition, relatively strong economic conditions throughout Distribution's service territory, low interest rates, strong new housing starts in several key market areas, and moderate unemployment, enabled Distribution to add about 28,000 net residential and commercial customers during the year, a 1.5 percent growth rate that tracks last year's growth and compares favorably with the national average. Transportation deliveries in 1993 increased 13.8 Bcf, 6.8 percent over 1992, reflecting strong electric power generation demand and increasing industrial activity. Distribution's electric competitors continue to pursue well-organized, heavily funded strategic initiatives targeting markets such as space and water heating. Electric companies in Distribution's markets are using a variety of aggressive measures such as equipment leasing programs, rebates and promotional incentives to make marketing inroads. These marketing efforts have resulted in a reduction of approximately 0.6 percent in Distribution's space heating load as a result of electric add-on heat pump penetration and a 1.4 percent reduction in gas water heating saturation since 1987. As a result, Distribution has been countering with its own strategic programs such as equipment leasing, targeted advertising and promotional activity that is designed to bolster Distribution's core marketing and counter these negative competitive impacts. Distribution's marketing strategy is to augment ongoing development of its core residential, commercial, and industrial markets by pursuing opportunities to develop new markets for natural gas in the areas of natural gas vehicles (NGV), electric power generation and gas cooling. Distribution is a leading participant in the gas industry's efforts to promote NGVs as alternatives to conventionally fueled fleet and mass transit vehicles. In March 1993, Columbia Gas of Ohio, Inc. (COH) opened the nation's largest publicly accessible NGV fueling station in Columbus, Ohio. Distribution operates five other publicly accessible stations and is initiating a five-year program to establish approximately 100 additional publicly accessible fueling sites throughout its service territory. Distribution is also committed to maximizing the number of NGVs in its own fleet over the next several years to approximately 2,500, and continues to work with commercial and industrial prospects to assist them in evaluating NGVs for fleet applications. Distribution's concentration on public sector initiatives is also yielding results. Recently, Virginia enacted laws to provide tax credits and reduced fuel taxes for alternative fuel vehicles (AFV) as well as require federal Clean Fuel Fleet programs in two areas beyond requirements of federal law. Pennsylvania established a $3.5 million fund to provide up to a 60 percent grant for purchases of AFVs and AFV filling equipment. Pending are initiatives in Kentucky to exempt NGVs from motor fuel testing and a proposal in Ohio to provide partial sales and use tax exemptions for the purchase of AFVs and filling equipment. Distribution continues to actively pursue the developing power generating market. Distribution currently serves 15 power generation and cogeneration facilities which consume about 30 Bcf of natural gas each year. CAA-90 offers significant new opportunities to promote the use of natural gas for electric power generation. Commonwealth Gas Services, Inc. (COS) reached agreement with Gordonsville Energy Limited Partnership to transport gas for a new combined cycle generating plant which will produce electric power for a Virginia utility beginning in mid-1994 which is expected to use approximately 3.0 Bcf of gas annually. Distribution is currently working with five additional prospects, both existing and new electric power generating plants, that may want to use natural gas in order to comply with the CAA-90 by the year 2000. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Distribution's customers operate commercial and industrial cooling and refrigeration systems with a capacity of approximately four million refrigerant tons. Less than one percent of this cooling and refrigeration load, roughly 0.2 Bcf, is currently served by gas cooling equipment. Distribution is aggressively pursuing this market. With improved gas cooling equipment, rising peak electric costs and concerns about the environmental effects of chlorofluorocarbon refrigerants, Distribution has an opportunity to add significant load in the summer months when demand for gas is relatively low. The GRI estimates that 30-50 percent of this market could be served economically with gas cooling systems. Sales of gas cooling equipment in Distribution's service territory increased tenfold in 1993 to 3,096 refrigerant tons, or about 1.5 percent of total new and replacement equipment sales and 6 percent of large tonnage chiller sales. Rate Cases During 1993, Distribution filed two rate cases. COS filed an expedited rate case for a $3.5 million annual revenue increase, seeking recovery of increased operating expenses and a return on additional plant investments since COS' 1992 general rate case. A final order in this expedited proceeding is expected by June 1994. The Virginia State Corporation Commission (VSCC) in October 1993, issued an order resolving COS' 1992 general rate case. While the VSCC provided a favorable increase in annual revenues of $5.6 million, a 4.5 percent increase, it did not adopt an array of regulatory reform proposals advanced by COS that included establishing rates based on a fully projected test year and a weather normalization clause. In October 1993, the Maryland Public Service Commission approved a rate settlement for Columbia Gas of Maryland, Inc. (CMD) that provided for a two-step increase in annual revenues of $2.2 million beginning October 1993, implementation of a weather normalization adjustment effective with the winter season which began November 1993, as well as full recovery of postretirement medical benefit costs. In contrast to 1993, Distribution's rate activity for 1994 is expected to accelerate and may involve up to four general rate cases to recover increasing costs. Columbia Gas of Pennsylvania, Inc. (CPA) filed a rate case in early 1994 and filings are tentatively scheduled in Ohio for the first quarter and in Virginia and Kentucky on or about May 1. Distribution's total revenue request could range between $90 and $100 million or roughly 5 percent of its total revenue. Even though these filings are scheduled early in the year, new rates will not be effective until the fourth quarter of 1994 or later. All filings will incorporate the regulatory initiatives currently being pursued by Distribution and addressed below. Strategic Regulatory Issues Distribution continues to actively pursue an array of regulatory reform initiatives designed to overcome regulatory barriers in the increasingly competitive Order 636 era. It is advocating a comprehensive package of new services, increased revenue levels and incentive rate mechanisms. Specific elements include the use of enhanced projected ratemaking and cost deferral mechanisms to mitigate adverse timing lags, cost containment and enhanced customer service and supply initiatives, and revenue stabilization mechanisms to mitigate the effects of unusual weather conditions and take into account typical increases in operation and maintenance expenses and capital expenditures without resorting to time consuming and costly general rate case proceedings. While no state commission has yet adopted Distribution's comprehensive reform package, Distribution has made notable strides in some of its jurisdictions, including the innovative settlement in Maryland mentioned above reflecting many elements of its comprehensive initiative. In Ohio, COH has been involved in proposed legislation that provides utilities the option of filing rate cases on a fully projected test year basis. In Pennsylvania, CPA is supporting a number of the Public Utility Commission's (PUC) recently announced initiatives aimed at providing more regulatory responsiveness and flexibility, specifically, recognizing in rates construction work in progress for certain investments placed in service after the ratemaking test year. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FERC Order 636 Distribution successfully began the transition into the new environment created by Order 636. All of the requirements mandated by the Order have been implemented by Distribution's interstate pipeline suppliers and thus far operations have been running smoothly despite the much colder than normal weather experienced in early 1994. Over the next several years, additional pipeline filings and related FERC orders, addressing the recovery of pipeline transition costs stemming from Order 636, are expected. However, based on current estimates of these transition costs and indications from state commissions, management does not expect the transition costs to have a significant adverse impact on Distribution's earnings or customer rates. Gas Supply Distribution has developed supply arrangements and operating plans and has aggregated gas supplies to meet market needs in a flexible, cost- effective manner. Distribution entered the 1993-94 winter heating season with storage inventory near maximum levels and with a short-term purchasing/operating plan designed to fully satisfy firm retail and standby service obligations during periods that are up to ten percent colder than normal. Early operating experience during the extreme cold weather conditions of mid-January 1994, when peak design conditions were met or exceeded over the course of two consecutive days, thoroughly tested Distribution's capabilities. Throughout this extraordinary period of record-setting peak demands, Distribution's facilities maintained deliveries and adequate gas supplies were available. Beyond a few isolated operating problems and certain brief limitations on customers who elected to contract for interruptible service, reliable customer service was maintained. Environmental Matters Distribution has initiated a comprehensive environmental program designed to ensure complete and prompt compliance with all state and federal environmental requirements. As part of this program, Distribution is continuing the process of conducting an environmental assessment of its sites and evaluating procedures. The assessment and evaluation process will continue over the next three to five years. Distribution's primary environmental issues relate to former manufactured gas plant sites. Currently, Distribution has identified twelve former gas plant sites that it either owned or acquired through facility purchases. Environmental investigations are being conducted at five of these sites and remedial action may be required. Investigations will be conducted at a number of the other sites in the near future. Manufactured gas plant sites currently being investigated include areas in York and Bellefonte, Pennsylvania, and Portsmouth, Petersburg and Lynchburg, Virginia. (See Note 12H of Notes to Consolidated Financial Statements for additional information regarding these sites.) To the extent site investigations have been completed, remediation plans developed and any Distribution responsibility for remedial action established, the appropriate liability has been recorded. As additional investigations are completed and remediation costs become probable, the appropriate liability will be recorded. As of December 31, 1993, the distribution subsidiaries recorded net liabilities of $5.9 million for environmental matters. Management anticipates recovery of remediation costs through normal rate proceedings. SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (OPEB) Management anticipates that full rate recovery of its accrued OPEB costs in all states is likely, based on the state commissions' awareness of this issue and favorable generic policy decisions in a number of jurisdictions coupled with Distribution's cost management efforts and plans to fully fund all postretirement benefits allowed in rates in irrevocable trust arrangements. The present value of the postretirement benefit obligation to be paid to current and retired employees for all the distribution subsidiaries amounts to approximately $143.2 million as of December 31, 1993. Of this amount, $138.1 million has been deferred as a regulatory asset pending anticipated recovery through rates in various jurisdictions. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) The Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board issued guidelines establishing criteria for recording such a regulatory asset, including a requirement for collection of accrual basis expense in rates and recovery of the transition obligation within approximately 20 years. These criteria are not necessarily being adopted by the public utility commissions regulating the distribution subsidiaries. Differences in requirements between the accounting rules and the ratemaking decisions ultimately adopted can result in a writedown of some or all of this regulatory asset. The distribution subsidiaries have implemented cost containment measures designed to reduce their OPEB obligations. In addition to other measures, employees will be required to share a portion of their postretirement health benefit costs and guidelines have been established redefining years of service requirements before an employee is eligible for retiree health benefits. Other cost-saving plans are being reviewed for consideration in an ongoing effort to effectively manage OPEB costs. Integrated Resource Planning Integrated Resource Planning (IRP) combines the concepts of supply side and demand side management (DSM). The DSM component of IRP generally deals with programs to reduce customer demand, particularly during peak demand periods, and thereby reduce the need to construct or acquire additional supply capacity. The supply side component of IRP generally involves the evaluation of supply options, including the acquisition of supply from alternative sources or supply arrangements. IRP was first implemented for electric utilities by state utility commissions because of the major investments required to add new electric generating capacity and the resultant impact of these investments on customer rates. However, state commissions in Distribution's market area are now actively considering the adoption of natural gas IRP programs. Distribution generally regards this as a positive development since it provides a more balanced competitive situation between gas and electric utilities. Distribution has significant concerns that electric DSM programs, if not properly controlled by state regulators, could result in ratepayer-financed marketing programs and incentives that would inappropriately influence long-term purchases committing customers to electric use. The proper development of gas IRP programs should enable Distribution to continue to compete for new load and replacement appliances and equipment to improve system load factors and operating economics. However, certain significant competitive concerns remain because electric utilities can generally support higher incentives for customers to purchase certain electric appliances because it is far more expensive to expand electric generating capacity than to expand gas distribution capacity to deliver the same quantity of useful energy. Also, most commissions have been reluctant to deal with the relative environmental impacts of using natural gas versus coal, oil or nuclear generated electric power for residential and commercial end uses, which would result in reduced overall emissions and provide higher incentives for gas usage. Distribution's IRP efforts are designed to encourage state regulators to deal with utility IRP programs on a comprehensive basis. Distribution believes that under such an approach, commissions are more likely to recognize the many significant advantages of using natural gas rather than electricity for most residential and commercial and many industrial end uses or at a minimum, work to maintain more competitive parity between gas and electric rates. Distribution is working aggressively to communicate the many advantages of a comprehensive approach to IRP. Volumes Throughput for 1993 totaled 509.8 Bcf, a 23.1 Bcf increase over 1992. Higher transportation deliveries of 13.8 Bcf were due mainly to increased usage by power generating facilities in Virginia and Pennsylvania. The 9.3 Bcf increase in tariff sales volumes reflects higher customer usage due primarily to 3 percent colder weather and the net addition of approximately 28,000 customers. Distribution's throughput for 1992 increased 30.3 Bcf over 1991 after adjusting for the 1991 sale of a New York subsidiary. Despite 1992 being 2 percent warmer than normal, it was still 10 percent colder than the prior year. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) This colder weather and the net addition of 28,000 new customers led to higher sales volumes. Transportation volumes also increased in 1992 due largely to increased deliveries to power-generating facilities as well as other customers using this service to meet their supply requirements. Net Revenues For the year ended December 31, 1993, net revenues of $726 million reflected an increase of $29.5 million over the same period last year. Increased throughput generated $18.7 million of this improvement. Additionally, new rates in effect during 1993 in Virginia and Maryland and the full year impact of rates placed in effect in 1992 combined to generate $7.6 million with revenues for fixed charges from new customers accounting for most of the remaining $3.2 million increase. Colder weather was the principal reason for 1992's net revenues increasing to $696.5 million. After adjusting for the sale of the New York subsidiary in 1991, the net revenues in 1992 represented an increase of $62 million over 1991. The full year effect of favorable rate settlements in all of Distribution's operating areas also contributed to the higher net revenues. Operating Income Operating income improved $8.7 million over the previous year. Higher net revenues of $29.5 million were partially offset by increased operating expenses of $20.8 million. An $8.8 million increase in operation and maintenance expense reflecting wage increases, additional personnel requirements associated with the implementation of Order 636, as well as the filling of certain vacancies that had been deferred and higher lease costs for the Columbus, Ohio headquarters building were the primary reasons for the increase. Additionally, costs for the streamlining of corporate service functions and studies underway to enhance customer service also contributed to the increase. These increases were partially offset by a $4.2 million charge recorded in 1992 for COS OPEB costs. Depreciation expense increased $4.7 million primarily reflecting plant additions, while increased gross receipts taxes and property taxes of $7.3 million were attributable to higher taxable revenues and plant additions. After adjusting for the sale of the New York subsidiary, operating income in 1992 of $137.7 million increased $27 million over 1991 as higher net revenues were partially offset by increased operating expenses. Increased operating expenses of $558.8 million resulted primarily from higher labor and benefit costs and the effect of regulatory lag that resulted in only a portion of increased costs being recovered through rates. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) STATEMENTS OF OPERATING INCOME FROM DISTRIBUTION OPERATIONS (UNAUDITED) * Includes Columbia Gas of New York, Inc. through March 31, 1991. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) DISTRIBUTION OPERATING HIGHLIGHTS* * Includes Columbia Gas of New York, Inc. through March 31, 1991. ** Reflects volumes under purchase contracts of less than one year. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) OTHER ENERGY OPERATIONS Cogeneration Independent power production continues to be a growth area for natural gas. The Corporation is involved in several cogeneration projects through TriStar Ventures Corporation (TriStar), a wholly-owned subsidiary. Projects in operation or under construction total nearly 300 megawatts in which TriStar holds various interests. Three cogeneration facilities are now operating; a 117-megawatt facility in Pedricktown, New Jersey, a 50-megawatt plant in Binghamton, New York and an 85-megawatt plant in Rumford, Maine. Natural gas is delivered to the Binghamton and Pedricktown facilities by Columbia Transmission. These three projects generated $5.8 million and $4.5 million of income before interest and income taxes in 1993 and 1992, respectively. A 47-megawatt plant near Vineland, New Jersey is scheduled to begin operations in mid-1994. TriStar and its partners also have other projects in various stages of development. Value is also generated from the projects for the transmission subsidiaries of the Corporation who benefit from increased throughput while the oil and gas segment has increased sales opportunities. TriStar was participating in the development of a 56-megawatt plant in Washington, D.C. on which construction had been delayed pending regulatory review and approval. On October 13, 1993, processing of the building permit was suspended indefinitely by the District of Columbia. This action combined with numerous regulatory delays, caused the project to become financially nonviable. Accordingly, TriStar and its partner halted efforts to build the project and TriStar wrote off its net investment in the project of $3.1 million after-tax. On November 1, 1993, the partnership filed an $80 million lawsuit in federal court against the District of Columbia and certain District officials. Propane During 1993, propane sales by Columbia Propane Corporation and Commonwealth Propane, Inc., totaled 58.1 million gallons, a decrease of 8 percent from the previous year. The propane companies serve approximately 68,000 customers in parts of Maryland, North Carolina, Ohio, Pennsylvania, Virginia and West Virginia. The companies are focusing their sales efforts on the higher-margin residential segment. Coal Operations The Corporation has in excess of 500 million tons of coal reserves. Approximately 50 percent of the reserves, much of which contain less than one percent sulfur, are leased to other parties for development. Environmental Matters The Columbia Gas System Service Corporation (Service Corporation) received a "General Notice of Potential Liability and CERCLA Section 104(2) Request for Information" concerning a process site to which the Service Corporation sent certain solvents. This notice was sent to in excess of 100 parties requesting information about any involvement with the owner of the site or the site itself. Management has furnished the information requested and does not believe this Superfund matter will have a material adverse effect on future income or on the Corporation's financial position. Net Revenues Propane sales to wholesale and industrial customers have been decreasing over the past few years due to unacceptable margins while, to a lesser extent, sales to higher-margin residential customers have been increasing. As a result of this strategy, total sales volumes have decreased, but net sales revenues have been rising. This change led to net sales revenues of $29.8 million in 1993, an increase of $2.5 million, and in 1992 an increase of $700,000 compared to the year earlier. Increases in revenues resulting from gas marketing activities were largely offset by increased products purchased expense. Revenues in 1993 from services provided to affiliates and coal royalties resulted in an increase in other revenues of $3.1 million, to $73.4 million, from the prior year. Other revenues in 1992 of $70.3 million, were $5.2 million ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) lower than the year earlier primarily because a decrease in revenues from affiliate companies more than offset higher coal royalty revenues. Operating Income The net revenue increase of $5.6 million was more than offset by $10.7 million higher operating expenses primarily reflecting increased labor and benefits costs that included employee severance costs recorded in 1993. The 1992 net revenue decline of $4.5 million compared to 1991 was more than offset by reduced operating expenses of $6.4 million, resulting from lower labor and benefits costs in 1992 due to a reduction in the number of employees and a charge in 1991 for employee severance costs. STATEMENTS OF OPERATING INCOME FROM OTHER ENERGY OPERATIONS (UNAUDITED) OTHER ENERGY OPERATING HIGHLIGHTS ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) CONSOLIDATED REVIEW Net Income The Corporation reported net income for 1993 of $152.2 million, or $3.01 per share, compared to $51.2 million, or $1.01 per share in 1992. After adjusting for the unusual and bankruptcy related items detailed below, 1993 net income of $155.1 million was up $56.4 million over the prior year. The oil and gas, transmission and distribution segments all experienced improved results in 1993. These improvements resulted from increased throughput, the full year effect of a new rate design implemented by the transmission companies as well as lower depletion expense, higher prices for gas production and increased oil and gas production for the oil and gas segment. The distribution segment's results improved because the weather was 3 percent colder than 1992 and because of higher transportation volumes. Unusual and Bankruptcy Related Items After-tax Effect on Net Income * Reflects charges that are allowed to be collected by Columbia Transmission to recover costs when it meets certain competitive tests for its commodity sales rate or cost of gas. Operating Income by Segment The oil and gas segment had operating income of $53.6 million in 1993, compared to an operating loss of $101.2 million in 1992. The prior period loss was mainly due to a writedown of $126.4 million in the carrying value of oil and gas assets due to low energy prices. Lower depletion expense, higher gas prices and increased oil and gas production also contributed to the current period increase and were only partially offset by lower oil and liquids prices and the recording of a reserve for a royalty dispute with the MMS. The average gas price in 1993 was $2.28 per Mcf, up $0.26 per Mcf over last year, whereas the average price for oil and liquids decreased to $16.17 per barrel, down $2.03 per barrel from 1992. Oil and gas production for 1993 of 3,603,000 barrels and 71.5 Bcf, increased 542,000 barrels and 2.3 Bcf, respectively, over last year. The transmission segment's 1993 operating income of $178.7 million, up $48.8 million, reflected a significant improvement over the 1992 level. After adjusting for the pre-tax effect of the unusual items, operating income increased $37.8 million over 1992. Included in these unusual items are increased revenues from GIC and WACOG ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) revenues Columbia Transmission is permitted to recover from its customers when it met certain competitive tests with other pipelines. These sources of revenue were unique to Columbia Transmission's merchant function which was essentially eliminated under Order 636. After adjusting 1992 throughput for a customer exchange arrangement, throughput improved resulting in higher revenues. This effect together with the full year effect in 1993 of Columbia Transmission's new rate design were the principal reasons for the $37.8 million improvement. Under this new rate design, a greater portion of fixed costs are collected through a monthly demand charge rather than the commodity charge where they are susceptible to weather fluctuations. Gas costs continue to be recovered through commodity charges. Also contributing to the 1993 improvement over 1992 was approximately $15 million of additional expense recorded in the prior period for settlements with a supplier. Weather in the distribution segment's service areas was 3 percent colder than 1992. The colder weather helped raise 1993 operating income to $146.4 million, an increase of $8.7 million over 1992. Improved recovery of costs through higher rates in effect in Virginia and Maryland contributed to the increase. Mitigating these improvements were higher operating expenses that included increases in labor and benefits expense and costs associated with streamlining corporate service functions and studies underway to enhance customer service. Other energy operations had operating income of $1.7 million, a decrease of $5.1 million compared to 1992. The reduction primarily reflects recording $6.3 million for costs associated with the Service Corporation's reengineering program. Revenues Operating revenues for 1993 of $3,391.2 million, increased more than 16 percent from the year earlier largely due to the full year effect of Columbia Transmission's new rate design, pipeline exit fees of $130 million for Columbia Transmission, higher retail sales resulting from colder weather during 1993 and higher distribution rates. In addition, Columbia Transmission's WACOG revenues, sale of storage to customers, higher gas prices and increased oil and gas production also contributed to the improvement. Revenues associated with pipeline exit fees were offset in products purchased expense and had no effect on income. Operating revenues for 1992 increased $345.2 million over 1991 to $2,922 million due to a combination of higher sales volumes as a result of colder weather, the full year effect of higher distribution rates and Columbia Transmission's new rate design and more competitive sales rate. Expenses Over the last three years, higher sales necessitated an increase in volumes of gas purchased resulting in an increase in products purchased expense of $337.6 million in 1993, compared to 1992, and $180.4 million for 1992 over 1991. In addition, higher average rates for gas purchased, particularly spot market purchases, also contributed to the increase in 1993. Higher expense for pipeline exit fees were offset in revenues as mentioned above. In 1992, Columbia Transmission anticipated only a minimal merchant function would be offered when Order 636 was implemented in November 1993; therefore, a provision for gas supply charges of $38.6 million was recorded to reflect a writedown of certain capitalized gas costs in excess of amounts to be amortized in 1993. Higher labor and benefits expense in 1993, which included $14.8 million for severance costs associated with reengineering many of the System functions to gain efficiencies and improve competitiveness, together with rising operating costs led to higher operation and maintenance expense of $26.5 million. Partially offsetting these increases was higher expense in 1992 for certain supplier settlements by Columbia Transmission. Raising expense in both 1993 and 1992 were environmental costs of $66.8 million and $65.3 million, respectively. The higher environmental costs recorded in 1992 and increased labor and benefits expense of Columbia Transmission ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) were the primary reasons for the $111.3 million increase in operation and maintenance expense over 1991. Additional expenses in 1992 associated with certain producer settlements also contributed to the increase. Due to depressed energy prices in early 1992, a writedown was recorded of $126.4 million in the carrying value of oil and gas properties. This was the principal reason for the $128.3 million decrease in 1993 in depreciation and depletion expense. The significant increase in depreciation and depletion expense of $83.1 million in 1992 over 1991 was also the result of this writedown, which was partially offset by writedowns for the Canadian oil and gas properties in 1991. Income Taxes As detailed in Note 5 of Notes to Consolidated Financial Statements, income taxes in 1993 increased $65.4 million over last year reflecting increased income, adjustments due to the IRS settlement and the increased tax rate. In 1992, income taxes increased $481.5 million as the Corporation had pre-tax book income in 1992 compared to a loss in 1991. Other Income (Deductions) Other Income (Deductions) reduced income in 1993 and 1992 by $85.3 million and $1.5 million, respectively. In 1993, interest expense increased $87.8 million due largely to recording interest on prior years' taxes of $74.5 million primarily as a result of the IRS settlement. Interest income and other, net decreased $13.2 million primarily reflecting $19.5 million for a FERC order eliminating interest payments from certain upstream pipeline suppliers and a reserve for pipeline partnership investments partially offset by increased interest income on prior years' taxes and other issues. Income was improved in 1993 and 1992 by approximately $212.4 million and $224.9 million, respectively, from not accruing interest expense for prepetition obligations. (Since the July 31, 1991 bankruptcy filing, the estimated effect of not accruing interest expense on these prepetition obligations totals approximately $523 million. However, the actual interest that will ultimately be paid pursuant to the final plans of reorganization could differ significantly and cannot be determined at this time.) Reorganization items, net reflects bankruptcy issues that improved income $8.9 million in 1993 compared to an income decrease of $8.3 million last year. Included in these amounts is $39.9 million of interest earned on accumulated cash, up $13 million over 1992, and $31 million for 1993 professional fees and related expenses together with other miscellaneous reorganization items, a decrease of $4.2 million from last year. In 1992 Other Income (Deductions), net reduced income $1.5 million versus $119.4 million in 1991. Income was improved in both 1992 and 1991 by not accruing interest expense on prepetition obligations by approximately $224.9 million and $85.6 million, respectively. The decrease of $11.9 million in Interest Income and Other, net was due to several items including a $17.9 million gain in 1991 on the sale of the New York distribution subsidiary and a $2.9 million gain on the 1991 sale of the Canadian oil and gas properties. These items were partially offset by a $14.5 million writedown for certain cogeneration projects. The change between 1992 and 1991 for bankruptcy issues increased income $6.1 million. Professional fees and related expenses, combined with other miscellaneous reorganization items, were $35.2 million and $18.9 million in 1992 and 1991, respectively, while interest earned on accumulated cash was $26.9 million in 1992 and $4.5 million in the prior year. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) STATEMENTS OF COMMON STOCK PRICES AND DIVIDENDS LIQUIDITY AND CAPITAL RESOURCES Cash from Operations The full year effect of Transmission's new rate design, higher rates for Distribution and colder weather during 1993 compared to last year, together with certain refunds received from suppliers, resulted in net cash from operations of $850.4 million, an increase of $85 million for 1993. Higher oil and gas production and increased gas prices also contributed to this improvement. Cash received from customers increased $412 million in 1993, primarily reflecting increased volumes due to colder weather earlier in the year together with higher rates. The receipt of rate refunds by certain subsidiaries led to the $79.4 million rise in other operating cash receipts. An increase in the spot market price for gas and additional gas volumes purchased to meet customer requirements resulted in $302.2 million more cash being paid to suppliers partially offsetting the above cash improvements. In addition, a refund payment by Columbia Transmission led to a $102 million rise in other operating cash payments in 1993. Colder weather in 1992 compared to the prior year and the suspension of interest payments on August 1, 1991, due to the bankruptcy filing raised net cash from operations $233.8 million to $765.4 million in 1992 over 1991. Higher 1992 throughput from colder weather, increased receipts due to implementing a new rate design for Columbia Transmission and higher distribution rates were the primary reasons for the $300.5 million increase in cash received from customers. The suspension of interest payments on prepetition debt obligations led to the $100.4 million decrease in interest paid. Partially offsetting these improvements was the 1991 receipt of a settlement payment on a property dispute which caused other operating cash receipts to decline $48 million. Also, higher income taxes due to timing differences between periods and increased property tax assessments caused income taxes paid and other tax payments to increase $40.6 million and $31.5 million, respectively. The Corporation maintains a debtor-in-possession facility (DIP Facility) for up to $100 million, including the availability of letters of credit of up to $50 million. The DIP Facility is available for use in conjunction with internally generated funds for general corporate purposes and to provide financing for subsidiaries not involved in the bankruptcy proceedings. As of January 31, 1994, $12.7 million of letters of credit were outstanding under the ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ESULTS OF OPERATIONS (Continued) DIP Facility. The DIP Facility expires December 31, 1994, although a request to extend it will be made, if necessary. During 1993, there were no borrowings under the DIP Facility. Absent unusual circumstances, the Corporation expects to remain in a cash surplus position during all of 1994. As of January 31, 1994, the Corporation and its subsidiaries, excluding Columbia Transmission, had excess cash of $148 million, which was invested in money market instruments. The liquidity needs of Columbia Transmission are being satisfied by internally generated funds. As of January 31, 1994, Columbia Transmission had $1,250.9 million invested in money market instruments through a wholly-owned subsidiary, Columbia Transmission Investment Corporation. Columbia Transmission also maintains a DIP Facility solely for the issuance of letters of credit for up to $25 million. As of January 31, 1994, the balance of outstanding letters of credit under Columbia Transmission's DIP Facility was $1.8 million. In December 1993, Columbia Transmission extended its DIP Facility through December 31, 1995. The Corporation's subsidiaries (other than Columbia Transmission during bankruptcy) must receive SEC approval under the Public Utility Holding Company Act of 1935 for all financing. As part of the approval process, the Corporation files the financing requirements of each of its subsidiaries with the SEC along with other material supporting management's opinion that the amounts requested are in the best interest of the Corporation's investors. In connection with recent filings, the Corporation has been requested to provide greater detail in support of the financing of subsidiaries which have, from time to time, experienced losses. These companies include: Columbia LNG, TriStar, TriStar Capital Corporation, Columbia Coal Gasification Corporation and Columbia Development. The need to provide information requested by the SEC to satisfy these concerns has made the receipt of timely approval more difficult and future delays could be experienced. However, management continues to believe it will receive approval of its financing requests. CAPITAL EXPENDITURES Capital expenditures for 1993 were $361 million, an increase of $61 million over 1992. The increase reflects expenditures on some projects that had been deferred in previous years. In 1992 and 1991, the Corporation's subsidiaries reduced capital expenditures to the extent possible consistent with the need to maintain safe and efficient operating facilities, the need to meet new service and tariff obligations, drilling commitments and the need to preserve going concern values. Some of the Corporation's subsidiaries will be initiating projects that can no longer be deferred which will increase the 1994 program $107 million, to $468 million. In 1994, Distribution will make investments of approximately $18 million to improve the efficiency of support services where expenditures had previously been deferred. Also included in Distribution's 1994 capital expenditure program are expenditures to provide deliveries to gas powered electric generating plants in its market areas and third-party natural gas vehicle public refueling stations. The majority of the transmission companies' expenditures will be for maintaining their extensive pipeline and storage system. In addition, $26 million is included for a project to provide gas to a New England electric generating facility which has been deferred since 1990 pending regulatory approval. Expenditures in 1994 for the oil and gas segment will remain essentially at 1993 levels. The current weakness in oil prices has resulted in a reduction in planned 1994 expenditures for exploratory drilling. The majority of the segment's expenditures will be for less risky development drilling. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) COMPARATIVE GAS OPERATIONS DATA The Columbia Gas System, Inc. and Subsidiaries * Certain amounts in prior periods have been reclassified to conform with the current presentation. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of The Columbia Gas System, Inc.: We have audited the accompanying consolidated balance sheets of The Columbia Gas System, Inc. (a Delaware corporation, the "Corporation") and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated income, cash flows and common stock equity for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform 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 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. On July 31, 1991, the Corporation and Columbia Gas Transmission Corporation ("Columbia Transmission"), a wholly-owned subsidiary, filed separate petitions seeking protection under Chapter 11 of the Federal Bankruptcy Code. Note 2 discusses, among other matters, uncertainties associated with the Chapter 11 proceedings, including the status of the Corporation's loans to Columbia Transmission, certain prepetition intercompany asset transfers and the measurement of certain liabilities. This note also discusses purported class action and other complaints which have been filed against the Corporation generally alleging violations of certain securities laws. The accompanying financial statements do not reflect any liability associated with these complaints as the Corporation believes it has meritorious defenses to these actions; however, the ultimate outcome is uncertain. As a result of these matters, the Corporation may take, or be required to take, actions which may cause assets to be realized or liabilities to be liquidated for amounts other than those reflected in the financial statements. These factors create substantial doubt about the Corporation's ability to continue as a going concern. The accompanying financial statements have been prepared assuming that the Corporation and Columbia Transmission will continue as going concerns which contemplates the realization of assets and payment of liabilities in the ordinary course of business. The appropriateness of the Corporation continuing to present financial statements on a going concern basis is dependent upon, among other items, the terms of the ultimate plan of reorganization and the ability to generate sufficient cash from operations and financing sources to meet obligations. As discussed in Note 4, effective January 1, 1991, the Corporation changed its method of accounting for income taxes and postretirement benefits other than pensions pursuant to standards promulgated by the Financial Accounting Standards Board. The schedules listed in the Index to Item 8, Financial Statements and Supplementary Data, 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 consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, New York February 10, 1994 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) STATEMENTS OF CONSOLIDATED INCOME The Columbia Gas System, Inc. and Subsidiaries *Reference is made to Notes 1A and 2 of Notes to Consolidated Financial Statements. **Due to the bankruptcy filings, interest expense of approximately $212 million, $225 million and $86 million has not been recorded for 1993, 1992 and 1991, respectively. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) CONSOLIDATED BALANCE SHEETS The Columbia Gas System, Inc. and Subsidiaries *Reference is made to Notes 1A and 2 of Notes to Consolidated Financial Statements. **The Corporation has 10,000,000 shares of preferred stock, $50 par value, authorized but unissued. ***Due to the bankruptcy filings, accrued interest of approximately $523 million and $311 million has not been recorded as of December 31, 1993 and December 31, 1992, respectively. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) STATEMENTS OF CONSOLIDATED CASH FLOWS The Columbia Gas System, Inc. and Subsidiaries *Reference is made to Notes 1A and 2 of Notes to Consolidated Financial Statements. **Includes amounts transferred from interest paid, cash paid to employees and for other employee benefits and other operating cash payments. ***The Corporation considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) STATEMENTS OF CONSOLIDATED COMMON STOCK EQUITY The Columbia Gas System, Inc. and Subsidiaries *100 million shares authorized at December 31, 1993, 1992 and 1991 - $10 par value. **The Corporation's only foreign subsidiary, Columbia Gas Development of Canada Ltd., was sold during 1991. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. PRINCIPLES OF CONSOLIDATION. The Consolidated Financial Statements include the accounts of the Corporation and all subsidiaries. All intercompany accounts and transactions have been eliminated, except for the Corporation's investment in Columbia LNG Corporation (see Note 12F). On July 31, 1991, the Corporation and its wholly-owned subsidiary, Columbia Gas Transmission Corporation (Columbia Transmission), filed separate petitions seeking protection under Chapter 11 of the Federal Bankruptcy Code. The debtor companies are operating their businesses as debtors-in-possession (DIP) under the jurisdiction of the United States Bankruptcy Court for the District of Delaware (Bankruptcy Court). As such, the debtor companies cannot engage in transactions considered to be outside the ordinary course of business without obtaining Bankruptcy Court approval (see Note 2). The accompanying financial statements reflect all adjustments necessary in the opinion of management to present fairly the results of operations in accordance with generally accepted accounting principles applicable to a going concern. Such presentation contemplates the realization of assets and payment of liabilities in the ordinary course of business. As a result of the reorganization proceedings under Chapter 11, the debtor companies may take, or be required to take, actions which may cause assets to be realized, or liabilities to be liquidated, for amounts other than those reflected in the financial statements. The appropriateness of continuing to present consolidated financial statements on a going concern basis is dependent upon, among other things, the terms of the ultimate plan of reorganization, future profitable operations, the ability to comply with DIP and other financing agreements and the ability to generate sufficient cash from operations and financing sources to meet obligations. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or the amounts and classification of liabilities that might be necessary as a result of the outcome of the uncertainties discussed herein. Certain reclassifications have been made to the 1992 and 1991 financial statements to conform to the 1993 presentation. B. BASIS OF ACCOUNTING FOR RATE-REGULATED SUBSIDIARIES. Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation," provides that rate-regulated public utilities account for and report assets and liabilities consistent with the economic effect of the way in which regulators establish rates, if the rates established are designed to recover the costs of providing the regulated service and if the competitive environment makes it reasonable to assume that such rates can be charged and collected. The Corporation's interstate transmission companies did not meet these criteria, and consequently are not applying the provisions of SFAS No. 71. In 1992, management concluded that it was no longer appropriate for Columbia LNG Corporation (Columbia LNG) to continue application of SFAS No. 71 (see Note 12F). The Corporation's gas distribution subsidiaries follow the accounting and reporting requirements of SFAS No. 71. C. GAS UTILITY AND OTHER PLANT AND RELATED DEPRECIATION. Property, plant and equipment (principally utility plant) are stated at original cost. The cost of gas utility and other plant of the distribution companies includes an allowance for funds used during construction (AFUDC). In addition, Columbia Gas of Ohio, Inc. is permitted to include in its plant investment post-in-service carrying charges on those eligible plant investments which are placed in service between December 31, 1990, and December 31, 1994. Subject to commission approval, the carrying charges are also authorized ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) to be included in base rates in subsequent rate filings. These carrying charges are subject to a net income limitation, as determined by the commission. Property, plant and equipment of other subsidiaries includes interest during construction (IDC). The 1993, 1992 and 1991 before-tax rates for AFUDC and IDC were 8.0 percent and 9.6 percent, respectively. They represent the rates in effect prior to Chapter 11 filings. The portion of interest capitalized by subsidiaries during the period the Corporation is in bankruptcy is eliminated in the Consolidated Financial Statements. Improvements and replacements of retirement units are capitalized at cost. When units of property are retired, the accumulated provision for depreciation is charged with the cost of the units and the cost of removal, net of salvage. Maintenance, repairs and minor replacements of property are charged to expense. The Corporation's subsidiaries provide for annual depreciation on a composite straight-line basis. The average annual depreciation rate for Transmission property was 2.6 percent in 1993, 1992 and 1991. The average annual depreciation rate for Distribution property was 3.3 percent in 1993 and 1992, and 3.6 percent in 1991. D. OIL AND GAS PRODUCING PROPERTIES. The Corporation's subsidiaries engaged in exploring for and developing oil and gas reserves follow the full cost method of accounting. Under this method of accounting, all productive and nonproductive costs directly identified with acquisition, exploration and development activities are capitalized in a countrywide cost center. If costs exceed the sum of the estimated present value of the cost center's net future oil and gas revenues and the lower of cost or estimated value of unproved properties, an amount equivalent to the excess is charged to current depletion expense. Gains or losses on the sale or other disposition of oil and gas properties are normally recorded as adjustments to capitalized costs. Depletion for domestic subsidiaries is based upon the ratio of current-year revenues to expected total revenues, utilizing current prices, over the life of production. Depletion for the Canadian subsidiary, which was sold as of December 31, 1991, was based upon the ratio of volumes produced to total reserves. E. COMMODITY HEDGING. Commodity futures, options on futures, and commodity price swaps are used from time to time to hedge prices of crude oil, natural gas production, propane inventories and commitments for natural gas purchases and sales, in order to minimize the risk of market fluctuations. Under internal guidelines, hedging positions for oil and gas production can be taken for up to 80 percent of the expected uncommitted monthly production. Gains and losses on the hedging transactions are recognized when the hedged commodity is sold or purchased. F. GAS INVENTORY. Gas inventory is carried at cost on a last-in, first-out (LIFO) basis. The estimated replacement cost of gas inventory in excess of carrying amounts at December 31, 1993, was approximately $85 million for the distribution companies. Liquidation of LIFO layers related to gas delivered by the distribu- tion companies does not affect income since the effect is passed through to customers as part of purchased gas adjustment tariffs. As a result of implementing Federal Energy Regulatory Commission (FERC) Order No. 636 (Order 636), Columbia Transmission substantially eliminated its merchant function and, therefore, no longer carries a gas inventory. Amounts previously recorded as "Gas Inventory - Noncurrent" have been reclassified to Property, Plant and Equipment which represents the volume of gas required to maintain pressure levels for storage service. G. INCOME TAXES AND INVESTMENT TAX CREDITS. The Corporation and its subsidiaries record income taxes to recognize full interperiod tax allocations. Under the liability method, deferred income taxes are ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) 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 basis of existing assets and liabilities. Previously recorded investment tax credits of the gas distribution subsidiaries were deferred and are being amortized over the life of the related properties to conform with regulatory policy. H. ESTIMATED RATE REFUNDS. Certain rate-regulated subsidiaries collect revenues subject to refund pending final determination in rate proceedings. In connection with such revenues, estimated rate refund liabilities are recorded which reflect management's current judgment of the ultimate outcome of the proceedings. No provisions are made when, in the opinion of management, the facts and circumstances preclude a reasonable estimate of the outcome. I. DEFERRED GAS PURCHASE COSTS. The Corporation's gas distribution subsidiaries defer differences between gas purchase costs and the recovery of such costs in revenues, and adjust future billings for such deferrals on a basis consistent with applicable tariff provisions. J. REVENUE RECOGNITION. The Corporation's rate-regulated subsidiaries bill customers on a monthly cycle billing basis. Revenues are recorded on the accrual basis including an estimate for gas delivered but unbilled at the end of each accounting period. Columbia Transmission also records the impact on revenues of the future recovery or refund of differences between current gas and transportation costs and amounts currently included in the billed rates. In addition, Columbia Transmission and Columbia Gulf record the effect on revenues to reflect the recovery or refund of differences between current fuel usage and amounts retained. 2. REORGANIZATION PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE A. GENERAL. Under the Bankruptcy Code, actions by creditors to collect prepetition indebtedness are stayed and other contractual obligations may not be enforced against either the Corporation or Columbia Transmission. As debtors-in-possession, both the Corporation and Columbia Transmission have the right, subject to Bankruptcy Court approval and certain other limitations, to assume or reject executory contracts and unexpired leases. In this context, "rejection" means that the debtor companies are relieved from their obligations to perform further under the contract or lease but are subject to a claim for damages for the breach thereof. Any claims for damages resulting from rejection are treated as general unsecured claims in the reorganization. The parties affected by these rejections may file claims with the Bankruptcy Court in accordance with bankruptcy procedures. Prepetition claims which were contingent or unliquidated at the commencement of the Chapter 11 proceeding are generally allowable against the debtor-in-possession in amounts fixed by the Bankruptcy Court. Substantially all liabilities as of the petition date are subject to resolution under plans of reorganization to be approved by the Bankruptcy Court after submission to any required vote by affected parties. The Corporation's reorganization plan also requires approval by the Securities and Exchange Commission (SEC) under the Public Utility Holding Company Act of 1935. B. COLUMBIA TRANSMISSION'S PLAN OF REORGANIZATION. The Corporation's and Columbia Transmission's discussions with the Official Committee of Unsecured Creditors of Columbia Transmission (Columbia Transmission Creditors' Committee) to negotiate a reorganization plan for Columbia Transmission and expedite emergence from Chapter 11 proceedings had been largely unsuccessful. Therefore, on January 18, 1994, Columbia Transmission filed, with the Corporation as cosponsor, a reorganization plan (plan) and a disclosure statement, for consideration by its creditors and other interested parties. The plan, which management believes is fair and equitable, proposes to pay 100 percent for all priority, administrative and secured claims and offers various classes of general unsecured creditors, including producers whose gas ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) contracts were rejected by Columbia Transmission, between 80 and 100 percent of Columbia Transmission's estimates of their allowable claims. The $3.3 billion total distribution proposed in Columbia Transmission's plan is based on an estimated value for Columbia Transmission of $3.1 billion and includes significant financial contributions by the Corporation. The plan is premised on a proposed omnibus settlement whereby the Corporation would settle the Intercompany Complaint (see page 65, C. Prepetition Obligations) and facilitate Columbia Transmission's reorganization by (i) accepting the value of the Corporation's secured claims against Columbia Transmission in the form of secured debt and equity securities of Columbia Transmission, and (ii) ensuring the cash (or at the option of the Corporation cash and $100 million market value of the Corporation's common stock) necessary to bring the aggregate distribution to $3.3 billion. Creditors, other than the Corporation, would share in distributions of over $1.2 billion in cash. In addition, the Corporation would consent to the reorganized Columbia Transmission's assumption of responsibility for public environmental enforcement agency claims so that the recoveries of the other creditors would not, with minor exceptions, be diminished by the environmental liabilities of Columbia Transmission's estate. The plan provides that Columbia Transmission will remain a wholly-owned subsidiary of the Corporation, will continue to offer an array of competitive transportation and storage services, and will retain ownership of its 18,800-mile pipeline network and related facilities. Columbia Transmission's proposed business solution will offer to producers, whose gas supply contracts were rejected or who have prepetition claims under those contracts, individual, specific settlements of the producers' claims that are based upon uniform assumptions and principles and which, in the view of Columbia Transmission's management, are fair and reasonable settlement values. These specific settlement proposals are being developed and will be filed as an adjunct to the plan. Columbia Transmission estimates that aggregate distributions to producers under the plan would come to approximately $900 million. In general, the plan provides for immediate cash payment in full to all priority claims, all secured claims held other than by the Corporation, trust fund claims, administrative expenses and unsecured claims of $50,000 or less. The Corporation's secured claims will be satisfied in full with new secured debt and equity securities to be issued by the reorganized Columbia Transmission. Unsecured claims between $50,000 and $250,000 would receive 95 percent of their allowed claims in cash. All other unsecured claims, including the Corporation's unsecured debt and producer contract rejection claims, would receive between 80 and 100 percent of their allowed claims based on current projections. With respect to some of the classes of creditors, the treatment described above depends on the acceptance of the plan by the relevant class. At this time, no creditors have agreed to any of the proposed plan's provisions, and the ultimate confirmed plan of reorganization could be materially different from this initial filing. Although Columbia Transmission's plan utilizes June 30, 1994, as an assumed date of emergence from bankruptcy, the actual date of emergence will depend on the time required to complete the bankruptcy process and obtain necessary creditor, judicial and regulatory approvals. As part of its filing with the Bankruptcy Court, Columbia Transmission requested that the court defer scheduling required proceedings on the plan and related disclosure statement in order to permit discussions of the plan, including the settlements proposed therein, with Columbia Transmission's creditors, official committees and other interested parties. Under bankruptcy procedures, after Columbia Transmission's disclosure statement has been approved by the Bankruptcy Court, the disclosure statement and the reorganization plan will be sent to the company's creditors for voting. The Corporation intends to file a plan for its reorganization which will be consistent with the financial aspects and structure of Columbia Transmission's proposed plan of reorganization. Both plans will be ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) subject to a lengthy review and approval process, including SEC approval, and obtaining adequate financing. Implementation of Columbia Transmission's plan, and the levels and timing of distributions to its creditors, are subject to a number of risk factors which could materially impact their outcome. The plan sets forth numerous conditions to its confirmation and consummation. The failure to satisfy these conditions in accordance with the terms of the plan would have a material adverse effect on the outcome of Columbia Transmission's bankruptcy and on the Corporation. These conditions include, among others, the confirmation of a reorganization plan for the Corporation, the receipt of necessary approvals for the implementation of Columbia Transmission's plan and the recovery of regulatory and tax benefits which are fundamental to the plan's viability. Both companies anticipate emerging from bankruptcy at the same time. The provisions of the reorganization plans of either Columbia Transmission or the Corporation that are ultimately implemented could be materially different from this initial filing for Columbia Transmission and have a material adverse effect on the Corporation and its subsidiaries and on the rights of shareholders and holders of debt and other obligations. C. PREPETITION OBLIGATIONS. Columbia Transmission's prepetition obligations include secured and unsecured debt payable to the Corporation, estimated supplier obligations, estimated rate refunds, accrued taxes and other trade payables and liabilities. Prepetition obligations of the Corporation primarily represent debentures, bank loans and commercial paper outstanding on the filing date together with accrued interest to that date. A substantial amount of Columbia Transmission's liabilities subject to Chapter 11 proceedings relate to amounts owed to the Corporation. Columbia Transmission's borrowings have been funded by the Corporation on a secured basis since June 1985 and are secured by mortgages and a cash collateral order approved by the Bankruptcy Court. On the petition date, the principal amount of the First Mortgage Bonds outstanding was $930.4 million. Prepetition and postpetition interest on secured debt owed by Columbia Transmission to the Corporation is $346.4 million at December 31, 1993. In addition to these secured claims, the Corporation has an unsecured claim against Columbia Transmission of $351 million in installment notes issued prior to 1985 and accrued interest to the petition date. On March 19, 1992, the Columbia Transmission Creditors' Committee filed a complaint (Intercompany Complaint) with the Bankruptcy Court alleging that the $1.7 billion of Columbia Transmission's secured and unsecured debt securities held by the Corporation should be recharacterized as capital contributions (rather than loans) and equitably subordinated to the claims of Columbia Transmission's other creditors. The Intercompany Complaint also challenges interest and dividend payments made by Columbia Transmission to the Corporation of approximately $500 million for the period from 1988 to the petition date and the 1990 property transfer from Columbia Transmission to Columbia Natural Resources, Inc. (CNR) as an alleged fraudulent transfer. Based on the SEC standardized measurement procedures, CNR's properties had a reserve value of approximately $387 million as of December 31, 1993, a significant portion of which is attributable to the transfer from Columbia Transmission. In May 1992, Columbia Transmission Creditors' Committee filed with the U.S. District Court a motion for a jury trial and to move the Intercompany Complaint from the Bankruptcy Court to the U. S. District Court. This motion was denied and subsequently appealed to the Third Circuit Court of Appeals (Third Circuit). In June 1992, the Corporation filed a motion with the Bankruptcy Court seeking dismissal of, or summary judgment on, principal portions of the Intercompany Complaint. On August 20, 1993, the Third Circuit denied Columbia Transmission Creditors' Committee's appeal, allowing the Bankruptcy Court to consider the merits of the Intercompany Complaint and act upon the Corporation's June 1992 motion for summary judgment. The Bankruptcy Court has not acted on the Corporation's motion for summary judgment, but tentatively scheduled a trial on the Intercompany Complaint to begin June 13, 1994. Management believes that the Intercompany Complaint is without merit; however, the ultimate outcome of these issues is uncertain at this stage of the proceedings. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Discussions with Columbia Transmission's creditors in an attempt to establish the value of the estate and to resolve the matters raised in the Intercompany Complaint are ongoing. Since the standing and value of the Corporation's debt investment in Columbia Transmission is crucial to the determination of the value of the Corporation's estate, the Corporation's reorganization could be affected by the ultimate outcome of the Intercompany Complaint. The Internal Revenue Service (IRS) filed identical claims of $553.7 million against both debtor companies and the consolidated Columbia Gas System for tax deficiencies, interest and penalties for the years 1983-1990. Negotiations with IRS representatives have resulted in a settlement on all of the issues included in the IRS claims. This settlement has been documented in a written closing agreement and filed with the Joint Committee on Taxation of the U.S. Congress for formal approval. The IRS settlement also requires Bankruptcy Court approval. Recording the IRS settlement reduced 1993 net income by $44.3 million. Columbia Transmission has recorded liabilities of approximately $1.2 billion to reflect the estimated effects of its above-market producer contracts and estimated supplier obligations associated with pricing disputes and take-or-pay obligations for historical periods. With Bankruptcy Court approval, Columbia Transmission rejected more than 4,800 above-market gas purchase contracts with producers. The producers whose gas purchase contracts were rejected filed claims for damages that, after being adjusted for duplicative and other erroneous claims, are in excess of $13 billion. The Bankruptcy Court approved the appointment of a claims mediator in 1992 to implement a claims estimation procedure related to the rejected above-market producer contracts and other producer claims. The mediator held hearings on generic issues and various estimation methodologies and discovery matters during 1993. Columbia Transmission anticipates that the mediator may issue recommended determinations during the second quarter of 1994 which, under the Bankruptcy Court-approved estimation procedure, are expected to provide the basis for a recalculation of producer contract rejection claims. In Columbia Transmission's judgment, the positions taken by all producers before the claims mediator and the evidence presented demonstrate that the total level of allowable contract rejection claims, generically determined, will not exceed 1/10th of the $13 billion asserted in the claims as filed and is likely to be between $600 million and $950 million. The acceptance of certain positions advanced by Columbia Transmission on the evidence of record, as well as Columbia Transmission's as yet unheard defenses, could decrease substantially this range of possible aggregate outcomes. Resolution of the contract-specific issues not yet presented could increase or decrease individual claims materially but should not significantly alter the range of possible aggregate outcomes. The resolution of these issues can significantly influence future reported financial results. Accounting standards require that as claim amounts are allowed by the Bankruptcy Court, the full amount of the allowed claim must be recorded. This could result in liabilities being recorded which bear little relationship to the amounts ultimately required to be paid in settlement of those claims and could conceivably exceed the Corporation's total investment in Columbia Transmission. Any such distortion would not be corrected until final plans of reorganization are approved for the Corporation and Columbia Transmission. Regarding claims made by pipeline suppliers, on September 13, 1993, the Bankruptcy Court approved an agreement between Columbia Transmission and Texas Eastern Corporation (Texas Eastern) and the settlement of related claims. Under the terms of this agreement, Columbia Transmission will collect $30 million in refunds from Texas Eastern and all claims filed by Texas Eastern against Columbia Transmission, totalling $672 million, will be withdrawn. In November 1993, the Bankruptcy Court approved a settlement between Columbia Transmission and Tennessee Gas Pipe Line Company (Tennessee). This agreement provides for Columbia Transmission's assumption of certain contracts, the termination of certain other contracts that are no longer necessary for Columbia Transmission's operations, and payment to Tennessee of approximately $42 million in consideration for Tennessee's substantial reduction of its major transportation contracts with Columbia Transmission. On January 11, 1994, Columbia Transmission and Tennessee made a filing with the FERC to approve the settlement. Columbia Transmission expects to ultimately recover the costs and fees associated with the assumption and termination of these contracts under ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Order 636. The Tennessee settlement agreement is conditioned upon this recoverability. These settlements resolve a significant portion of the pipeline supplier claims against Columbia Transmission. The Pension Benefit Guaranty Corporation (PBGC) filed claims of $150 million against both the Corporation and Columbia Transmission alleging that if the retirement plan had been terminated by March 31, 1992, it would have been underfunded. Management believes that the claims made by the PBGC are inappropriate and in error since the Bankruptcy Court has approved continued operation of the retirement plan, required annual contributions are being made, there is no intention to terminate the plan and the plan is not underfunded. Management further believes that the PBGC's claim can be resolved without any financial consequences to the Corporation or Columbia Transmission. On January 29, 1993, the PBGC confirmed that while it remains confident that issues regarding its claims can be resolved by mutual agreement, the PBGC has decided not to proceed further with settlement negotiations regarding withdrawal of its claims at the present time due to the uncertainties associated with the bankruptcy proceedings. At December 31, 1993, the date of the latest actuarial valuation, plan assets exceeded the accumulated benefit obligations by $166.5 million. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) The accompanying Consolidated Balance Sheets include approximately $4 billion of liabilities subject to the Chapter 11 proceedings of the Corporation and Columbia Transmission as follows: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) D. PAYMENT OF DIVIDENDS AND DEBT SERVICE. The Corporation's Board of Directors suspended the payment of dividends on the Corporation's common stock on June 19, 1991. The Corporation also discontinued payments related to debt service. Columbia Transmission suspended dividend, interest and debt payments to the Corporation. The Corporation and Columbia Transmission have also suspended the payment of most other prepetition obligations. Management cannot predict at this time when or whether any financial restructuring plans will be approved or what provisions, if any, such plans would contain as related to the resumption of dividends, debt service and other payments. E. INTEREST EXPENSE. Interest expense of the Corporation is not being accrued during bankruptcy, but a calculation of interest is included in a footnote on the Statements of Consolidated Income and Consolidated Balance Sheets. Such interest has been calculated based on management's interpretation of the contractual arrangements which govern the various debt instruments the Corporation has outstanding exclusive of any redemption premiums. The Official Committee of Unsecured Creditors of the Corporation has asserted claims for interest which exceed disclosed amounts by approximately $40 million at December 31, 1993. There are several factors to be considered in making these calculations that are subject to uncertainty as to their ultimate outcome in the bankruptcy proceeding, including the interest rates and method of calculation to be applied to overdue payments of principal and interest. In addition, the committee has asserted that approximately $110 million of redemption premiums should be paid on high cost debt instruments. F. SECURITY HOLDER LITIGATION. After the announcement on June 19, 1991, regarding the Corporation's probable charge to second quarter earnings and the suspension of its dividend, 17 complaints including purported class actions were filed against the Corporation and its directors and certain officers of the debtor companies in the U.S. District Court of Delaware. The actions, which generally allege violations of certain anti-fraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934, have been consolidated. In addition, three derivative actions were filed in the Court of Chancery in and for New Castle County (Delaware) alleging that directors breached their fiduciary duties. These suits have been stayed by either the Bankruptcy Court filing or by stipulation of the parties. While the Corporation believes that it has meritorious defenses to these actions, the outcome is uncertain at this time. G. CUSTOMER RECOUPMENT RIGHTS. During the fourth quarter of 1993, various customers of Columbia Transmission filed motions with the Bankruptcy Court seeking authority to exercise alleged recoupment and setoff rights, whereby they would be permitted to reduce amounts owed to Columbia Transmission against refunds owed to the customers by Columbia Transmission, including amounts which were not otherwise payable in full under the July 1993 Third Circuit decision discussed below, all customer refunds under the 1990 rate case settlement and miscellaneous refunds not otherwise payable in full to them. Customers are alleging that they have recoupment and setoff rights of approximately $83 million at December 31, 1993. On October 20, 1993, the Bankruptcy Court approved an interim settlement under which customers continued to pay Columbia Transmission for FERC-authorized services at authorized rates, and Columbia Transmission has agreed to grant these customers a priority claim to the extent the Bankruptcy Court finds them entitled to recoupment rights. In January 1994, the Bankruptcy Court issued a procedural order whereby other customers would be permitted to file recoupment and setoff motions by February 18, 1994, with a trial on all such motions scheduled for June 1994. H. CUSTOMER REFUNDS. In July 1993, the Third Circuit overturned most of a U.S. District Court ruling and affirmed an earlier Bankruptcy Court decision that refunds Columbia Transmission received from upstream pipelines, as well as the Gas Research Institute (GRI) surcharge payments it collected from customers, are held in trust, by Columbia Transmission, for those customers and the GRI and are not part of Columbia Transmission's estate. In August 1993, the Third Circuit denied the Columbia Transmission Creditors' Committee's request for a rehearing. In February 1994, the Supreme Court denied petitions for review of the Third Circuit decision. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Under the Third Circuit ruling, approximately $173 million in refunds that Columbia Transmission has received, or expects to receive postpetition from upstream pipelines and GRI surcharges collected, should be passed through to the customers and to the GRI. In addition, the Third Circuit determined that $35 million in upstream pipeline refunds and GRI surcharges, which Columbia Transmission collected prior to filing Chapter 11 while received in trust, were subject to the "lowest intermediate cash balance test" (the amount remaining in trust at the time of bankruptcy) and should be distributed on a pro rata basis to the customers and to the GRI to the extent of Columbia Transmission's $3.3 million cash balance on July 31, 1991. The Third Circuit affirmed another part of the U.S. District Court's decision and held that approximately $16 million that Columbia Transmission owes upstream suppliers, for gas purchased and transportation services received prior to its bankruptcy filing, is ordinary unsecured debt which must be discharged in the bankruptcy process. On February 10, 1994, the U.S. District Court issued an order for the Bankruptcy Court to pursue further proceedings in accordance with the Third Circuit's refund decision directing the pass-through of these refunds. At a hearing on December 29, 1993, the Bankruptcy Court observed that the FERC should determine whether customers are entitled to the actual interest earned on refunds being held by Columbia Transmission or the higher FERC-prescribed interest rate. On February 18, 1994, Columbia Transmission filed a motion with the FERC for determination of the interest issue. Columbia Transmission will ask the Bankruptcy Court for implementation of the mandate. Columbia Transmission will also have to file with the FERC to reimplement its flow-through of Order Nos. 500/528 refunds from its pipeline suppliers, which represent the majority of the refunds at issue. It is anticipated that Columbia Transmission will recommence the flow-through of the upstream pipeline refunds in 1994. Total customer claims in Columbia Transmission's bankruptcy proceedings relating to, or arising from, Columbia Transmission's contracts with its customers for sales, transportation, gas storage and similar services and other miscellaneous claims represent about 450 claims for a total of approximately $550 million as filed, plus a potentially substantial sum filed in undetermined amounts. Columbia Transmission successfully resolved a significant portion of these customers claims. Not resolved are customer claims that total approximately $113 million at December 31, 1993, that seek to protect rights associated with any prepetition revenues collected subject to refund in general rate filings and purchased gas adjustment filings, including matters subject to court appeals. In addition, the claims filed in undetermined amounts, which potentially could be significant, still remain to be resolved. In October 1993, approximately $160 million was refunded to customers by Columbia Transmission reflecting the terms of a settlement of a 1991 rate case approved by the Bankruptcy Court in July 1993. Bankruptcy Court approval for a 1990 rate case settlement for rates in effect from November 1, 1990 through November 30, 1991 was deferred pending the decision by the Third Circuit regarding the flow- through of certain refunds. Appropriate reserves for rate refund liabilities have been recorded for these matters to reflect management's judgment of the ultimate outcome of the proceedings. I. REORGANIZATION ITEMS. During 1993, 1992 and 1991 the Corporation and Columbia Transmission have earned interest income on cash accumulated from the suspension of payments related to prepetition liabilities and incurred expenses associated with professional fees and other related services, as detailed below: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) J. FINANCIAL INFORMATION FOR THE DEBTOR COMPANIES. Condensed financial information for the Corporation and Columbia Transmission as of, and for, periods ended December 31, are as follows: 3. REGULATORY MATTERS A. Columbia Transmission has collected revenues from its customers associated with the pass-through of upstream pipeline supplier take- or-pay and contract reformation costs under FERC Order Nos. 500 and 528. Certain customers have challenged recovery of such costs which totals $160 million, (excluding interest) net of amounts to be refunded, on the basis that a 1985 rate settlement precludes collection. The FERC has consistently denied the customers' assertions and appeals have been filed with the U.S. Court of Appeals, D.C. Circuit. Management continues to believe these challenges are without merit and the FERC orders, which support collection of these costs, will ultimately be upheld. B. In April 1992, the FERC issued Order 636, its final rule on Pipeline Service Obligations and Equality of Transportation Services by Pipelines. This order fundamentally changes the role of pipelines from providing a merchant function to one in which they perform principally as transporters of gas that distribution companies and end users purchase directly from producers and other suppliers. While Order 636 provided that pipelines may recover all prudently incurred costs resulting from the transition to Order 636, the FERC stated that filings to recover such costs should not be made until a pipeline's service restructuring proposal, that identifies various transition costs, has been approved. With respect to gas supply realignment costs, costs associated with reforming or terminating above-market price supply contracts, Columbia Transmission noted in its filing that the majority of such costs on its system will be determined in the context of the bankruptcy proceedings regarding the treatment of producer ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) contract rejection costs. The company stated that the ultimate level of such costs is uncertain and that recovery would be pursued in future filings with the FERC. In 1993, the FERC issued a series of orders on the restructuring proposals and on September 29, 1993, the FERC issued an order which allowed Columbia Transmission and Columbia Gulf to implement restructured services on November 1, 1993. While confirming its initial ruling regarding the ineligibility for recovery of producer contract rejection costs as gas supply realignment or Order Nos. 500/528 costs, the FERC did rule that Columbia Transmission could seek to recover a small portion of the contract rejection costs that had earlier been ruled to be unrecoverable. The FERC also agreed to waive a nine-month time limit on Columbia Transmission's ability to seek recovery of unrecovered purchased gas costs to the extent the costs resulted from contracts that are currently in litigation, including bankruptcy litigation. Approximately $60 million in unrecovered purchased gas costs were outstanding at December 31, 1993, in addition to approximately $140 million of prepetition unrecovered purchased gas costs that have not been paid due to the bankruptcy filing. The FERC affirmed that Columbia Transmission could maintain recovery of gathering costs through its gathering and other transportation rates at least until the filing of a general rate case and approved a separate charge applicable to product extraction activities. Management continues to evaluate long-term plans for these gathering facilities ($63.3 million at December 31, 1993). Subject to review in connection with periodic rate filings, the FERC approved Columbia Transmission's proposal to continue to recover costs associated with retained upstream pipeline contracts through its demand rates. Recovery of such costs would be subject to review and approval in semiannual limited rate filings. Columbia Transmission has reached settlements that will eliminate approximately half of the annual cost of these contracts and is continuing its efforts to negotiate a mutually agreeable termination of the remainder of the contracts. The FERC also addressed Columbia Transmission's ability to recover costs associated with upstream pipeline contracts. Columbia Transmission currently holds firm transportation agreements with certain pipeline companies that historically have been used to deliver gas to Columbia Transmission. These contracts have remaining terms of various lengths and require the payment of monthly reservation fees whether or not the capacity is utilized. Under Order 636, downstream pipelines such as Columbia Transmission are required to offer to assign most of their firm upstream capacity to their customers. Columbia Transmission's annual demand charge commitments on these upstream nonaffiliated pipelines was approximately $108 million; however, assignments of certain of these contracts by Columbia Transmission to its customers in conjunction with service restructuring under Order 636 have reduced this amount to less than $74 million. The total commitment for demand charges after November 1, 1993, is approximately $421 million on an undiscounted basis, excluding any mitigating effect of the pipelines marketing the capacity to others. Columbia Transmission's strategy has been to assume all upstream pipeline contracts that can be directly assigned to its customers or need to be retained by Columbia Transmission for operational reasons and negotiate exit fees for other upstream contracts. The FERC ruling in the Order 636 proceedings permits recovery of these exit fees through rates, provided that Columbia Transmission can show that they are prudently incurred. Columbia Transmission retains the option of rejecting such contracts in its bankruptcy proceedings, if appropriate exit fees cannot be negotiated. The financial statements reflect a $130 million liability and offsetting receivable for the exit fee issue; however, the ultimate cost could vary depending on the outcome of ongoing discussions with the affected pipelines. Several settlements with upstream pipelines have been concluded. In 1993, the Bankruptcy Court approved ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) settlements between Columbia Transmission and Texas Eastern Transmission Corporation, Panhandle Eastern Pipe Line Company and Texas Gas Transmission Corporation which provide for assumption of certain contracts and termination of others. None of these settlements required Columbia Transmission to pay an exit fee to the upstream pipeline. One type of transition cost which the FERC acknowledged would be eligible for recovery consideration is "stranded costs", which are the costs of a pipeline's assets previously used to provide bundled sales service in the pre-Order 636 era, that are unsubscribed in the Order 636 environment. Columbia Gulf has several pipelines and related facilities that are not fully subscribed to under Order 636. Certain facilities south of Rayne, Louisiana, (primarily in the offshore Gulf of Mexico area) are being evaluated; however, management has not identified any stranded facilities at this time and the outcome of these evaluations is uncertain. Dependent upon the results of such evaluation, charges to income could be required. The net book value of the facilities under study was approximately $40 million at December 31, 1993. It is management's view that any costs associated with these facilities will be fully recoverable through rates. As part of its September 29, 1993 order on Columbia Transmission's and Columbia Gulf's Order 636 compliance filings, the FERC initiated a proceeding concerning Columbia Gulf's transportation service to Columbia Transmission. Columbia Gulf was directed to show cause as to why it has not filed for abandonment to reduce capacity and service to Columbia Transmission under the required FERC authorization under Section 7(b) of the Natural Gas Act. Columbia Gulf responded to the show cause order on December 22, 1993. Management does not believe an abandonment filing was necessary and does not expect the resolution of this issue to have a material adverse effect on the Corporation's financial position. C. On January 12, 1994, the FERC granted requests for rehearing of prior orders approving settlements between Columbia Transmission and four of its upstream pipeline suppliers relating to those suppliers' direct billings to Columbia Transmission in the mid-1980s of production-related FERC Order No. 94 (Order 94) costs. The rehearing orders find that the settlements must be rejected because they are expressly contingent upon Columbia Transmission's recovery of the Order 94 settlement payments from its customers, and that Columbia Transmission's 1985 PGA Settlement essentially bars such recovery. However, the orders also hold that these pipelines are not entitled to bill any Order 94 charges to Columbia Transmission, and ordered these upstream pipelines to refund the principal portion of all Order 94 collections from Columbia Transmission, but waived any requirements that these pipelines pay interest on the refunds. Since Columbia Transmission has been reflecting the interest income on these refunds since 1990, the effect of these orders led to a $19.5 million reduction in interest income in 1993. Columbia Transmission has sought rehearing and, if necessary, will seek court review of these orders. It is expected that pipeline suppliers will also request a rehearing arguing their rights to re-bill such charges to Columbia Transmission. The ultimate outcome of this issue is uncertain at this time and could impact future operating results depending upon the results of these regulatory and court reviews. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) 4. ACCOUNTING CHANGES A. In the fourth quarter of 1991, the Corporation adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (OPEB), retroactive to January 1, 1991. This method of accounting for postretirement benefits accrues the actuarially determined costs for life insurance and medical benefits ratably from the date an employee becomes eligible for such benefits. The Corporation's subsidiaries previously expensed these costs as cash payments were made. As permitted under SFAS No. 106, the subsidiaries elected to record the full amount of their estimated accumulated postretirement benefits obligation other than pensions of $223.8 million. These obligations represent the actuarial present value of the postretirement benefits to be paid to current employees and retirees based on services rendered. The present value of the postretirement benefit obligation to be paid to current and retired employees for all the distribution subsidiaries amounts to approximately $143 million as of December 31, 1993. Of this amount, $138.1 million has been deferred as a regulatory asset pending anticipated recovery through rates in various jurisdictions. The Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board issued guidelines establishing criteria for recording such a regulatory asset, including a requirement for collection of accrual basis expense in rates and recovery of the transition obligation within approximately 20 years. These criteria are not necessarily being adopted by the public utility commissions regulating the distribution subsidiaries. Differences in requirements between the accounting rules and the rate making decisions ultimately adopted can result in a writedown of some of this regulatory asset. The distribution subsidiaries, as well as the Corporation's other operating companies, have implemented cost-management measures designed to reduce their OPEB obligations. In addition to other measures, employees will be required to share a portion of their postretirement health benefit costs and guidelines have been established redefining years of service requirements before an employee is eligible for retiree health benefits. Other cost-saving plans are being reviewed for consideration in an ongoing effort to effectively manage OPEB costs. The regulatory commission in Ohio issued a final order in February, 1993 in a generic rate investigation regarding recovery of postretirement benefit costs. The commission's order provides utilities the opportunity to fully recover prudently incurred postretirement costs on an accrual basis. Amounts in excess of pay-as-you-go costs may continue to be deferred until rate recovery begins. The amount of the Columbia Gas of Ohio regulatory asset in the accompanying balance sheet was $85.6 million as of December 31, 1993. In March 1993, the Pennsylvania PUC stated in a proposed policy statement that any utility in its jurisdiction meeting certain conditions may seek formal PUC approval to record a regulatory asset equal to the difference between its current rate recognition of postretirement benefit costs and its accrued liability for such expenses. The amounts recorded will be subject to recovery in future rate proceedings to the extent that such costs are prudently incurred and certain conditions are met, such as dedicated funding of postretirement costs in excess of the pay-as-you-go level. Columbia Gas of Pennsylvania's (CPA) petition to maintain the postretirement benefit deferred regulatory asset until rate recovery begins was granted in December, 1993. This order gave CPA the permission to recover transition costs over 20 years. At December 31, 1993, the carrying value of CPA's regulatory asset was approximately $33.1 million. The Kentucky state commission has indicated that the rate treatment of accrued postretirement benefits will be addressed on a company- by-company basis. Management believes Columbia Gas of Kentucky (CKY) will ultimately obtain recovery authorization based on a recent commission rate order for another utility, holding that recovery of these costs on an accrual basis better reflects the true cost of providing service to current customers. CKY will continue to defer its postretirement benefit costs in excess of the pay-as-you-go amount, pending the filing of its next general rate case which is currently scheduled for mid-1994. At December 31, 1993, the carrying value of CKY's regulatory asset was approximately $9.8 million. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Commonwealth Gas Services (COS) placed interim rates into effect June 1, 1993, subject to refund, which included recovery of accrued OPEB costs. Indications from the Virginia State Corporation Commission (VSCC) are that the costs will be deemed prudent and recoverable according to the commission's 1992 generic order addressing postretirement costs. As a result of the recovery of transition costs over a period of 40 years, the EITF guidelines required COS to expense $4.2 million in 1992. Columbia Gas of Maryland's (CMD) general rate case settlement, effective October 1993, allows CMD to include in rates the full amount of accrued postretirement benefit costs as well as the recovery of the transition obligation over 20 years. Although proceedings in certain state jurisdictions have yet to be finalized, based on currently available information, management believes rate recovery mechanisms will be adopted that permit continued regulatory asset treatment in accordance with recent EITF guidelines. B. In February 1992, the Financial Accounting Standards Board issued SFAS No. 109, "Accounting for Income Taxes." The Corporation adopted SFAS No. 109 in the fourth quarter of 1992, retroactive to January 1, 1992. This Statement supersedes SFAS No. 96, "Accounting for Income Taxes," which was adopted by the Corporation in 1991 and improved earnings by $170 million. SFAS No. 109 changes the criteria for recognition and measurement of deferred tax assets and reduces complexity. The adoption of SFAS No. 109 had no impact on the Corporation's financial statements. C. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This Statement requires employers to recognize any obligation which exists to provide benefits to former or inactive employees after employment, but before retirement. Such benefits include, but are not limited to, salary continuation, supplemental unemployment, severance, disability (including workers' compensation), job training, counseling, and continuation of benefits such as health care and life insurance coverage. This Statement will be effective for fiscal years beginning after December 15, 1993, and the Corporation plans to adopt the Statement on January 1, 1994. Based on the facts and circumstances known today, the total obligation to the Corporation and its subsidiaries will be approximately $8.8 million. Of this amount, approximately $5.4 million will be expensed upon adoption. The remaining $3.4 million will be deferred by certain of the distribution subsidiaries as a regulatory asset pending rate recovery from the various state commissions. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) 5. INCOME TAXES The components of income tax expense are as follows: Total income taxes are different than the amount which would be computed by applying the statutory Federal income tax rate to book income before income tax. The major reasons for this difference are as follows: *Includes losses from foreign operations of $41.5 million for 1991. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Deferred tax balances are as follows: Deferred income taxes result from temporary differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. The source of these differences and tax effect of each is as follows: 6. SALE OF SUBSIDIARIES A. The sale of Columbia Gas of New York, Inc. to New York State Electric & Gas Corporation was completed on April 5, 1991, and provided an increase to net income of $9.2 million. The total price was $57.5 million including $39.2 million for the 328,000 outstanding shares of common stock and $18.3 million for the outstanding debt. B. The sale of Columbia Gas Development of Canada Ltd. (Columbia Canada), a wholly-owned Canadian oil and gas exploration and production subsidiary, to Anderson Exploration, Ltd. was effective as of December 31, 1991. The sales price for Columbia Canada was $94.8 million. Of this amount, $27.7 million was placed in escrow as security for certain post-closing obligations of the Corporation including indemnification for potential losses arising from litigation involving Columbia Canada. The Corporation expects to receive all or substantially all of the escrow account when the litigation is concluded. Upon emergence from bankruptcy, the Corporation is obligated to deposit into an escrow account an additional $25 million (Canadian). If after emergence from bankruptcy, the Corporation maintains an investment grade bond rating for a six-month period, the additional deposit would be ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) returned. Also, the Corporation has the right to provide a letter of credit in place of the cash deposit. As of December 31, 1993, $25.4 million, including accrued interest, remains in escrow for potential losses arising from litigation. 7. PENSION AND OTHER POSTRETIREMENT BENEFITS The Corporation has a trusteed, noncontributory pension plan which covers all regular employees, 21 years of age and older. The plan provides defined benefits based on the highest three-year average annual compensation in the final five years of service and years of credited service. It is the Corporation's funding policy to contribute to the plan based on a percentage of payroll, subject to the statutory minimum and maximum limits. The following table provides 1993-1991 pension cost components for the plan, along with additional relevant data: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Pension plan assets consist principally of common stock equities and fixed income securities. The following table reconciles plan assets and liabilities to the funded status of the plan: As of December 31, 1993 the assumptions for the discount rate and the average compensation growth rate have been revised downward to 7.0% and 5.5%, respectively. The net effect of these changes was to increase the accumulated benefit obligation and the projected benefit obligation by $42.2 and $38.2 million, respectively. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) In addition to providing pension benefits, the Corporation's subsidiaries provide other postretirement benefits, including medical care and life insurance, which cover substantially all active employees upon their retirement. The following table provides the total postretirement benefit cost components recognized during 1993 and 1992 along with additional relevant data: *One of the several established medical trusts is subject to taxation which results in an after-tax asset earnings rate that is less than 9.0%. * Includes $138.1 million and $127.2 million capitalized by the distribution subsidiaries as a regulatory asset in 1993 and 1992, respectively. As of December 31, 1993, the assumptions for the discount rate and the average compensation growth rate have been revised downward to 7.0 percent and 5.5 percent, respectively. The net effect of these changes was an $11.0 million increase in the accumulated postretirement benefit obligation. The healthcare cost trend rate assumption significantly affects the amounts reported. For example, a 1 percent increase in this rate would increase the accumulated postretirement benefit obligation by $19.0 million at December 31, 1993, and increase other postretirement costs by $3.7 million for the year. The accumulated ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) postretirement benefit obligations for 1993 and 1992 were calculated assuming healthcare cost trend rates starting at 12 percent and 16 percent and decreasing to 5.5 percent and 6.5 percent, respectively, after approximately 25 years. The postretirement medical plans of the majority of the Corporation's subsidiaries are currently funded on a pay-as-you-go basis. However, several subsidiaries have begun advanced funding as this benefit obligation is granted rate recovery. A total of $16.9 million and $13.0 million were contributed to the various medical trusts in 1993 and 1992, respectively. All of the Corporation's subsidiaries participate in funding for postretirement life insurance benefits utilizing a voluntary employee beneficiary association trust. The Corporation's funding policy is to make annual contributions to this trust, subject to the statutory maximum tax-deductible limit. Employee contributions are not required. 8. LONG-TERM INCENTIVE PLAN The Corporation has a Long-Term Incentive Plan (Plan) which provides for the granting of nonqualified stock options, stock appreciation rights and contingent stock awards as determined by the Compensation Committee of the Board of Directors. That committee also has the right to modify any outstanding award. A total of 1,500,000 shares of the Corporation's authorized common stock was initially reserved for issuance under the Plan's provisions. There were 363,415 shares remaining available for awards at December 31, 1993. Stock appreciation rights, which are granted in connection with certain nonqualified stock options, entitle the holders to receive stock, cash or a combination thereof equal to the excess market value over the grant price. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Transactions for the three years ended December 31, 1993, are as follows: In addition to the options, a contingent stock award of 4,110 shares was granted to a key executive in 1991 which remains outstanding at December 31, 1993. 9. DEFINED CONTRIBUTION (THRIFT) PLAN Eligible employees may participate in the Thrift Plan by contributing up to 16 percent of their monthly basic earnings to any one or more of several funds. The Corporation's participating subsidiaries make matching contributions of 50 percent to 100 percent of deposits made by each of its participating employees up to 6 percent of basic earnings based upon the months of participation in the plan by each employee. All employer matching contributions for participants under age 55 are invested in the fund holding common stock of the Corporation. Participants age 55 and older may invest employer contributions in any one or more of the several funds. Employees are eligible for participation in the Thrift Plan after completing one year of service. In 1990, the Corporation established a Leveraged Employee Stock Ownership Plan (LESOP). The LESOP was designed to pre-fund a portion of the matching obligation under the terms of the Thrift Plan and to utilize tax ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) advantages afforded by the Internal Revenue Code. In October 1991, the Board of Directors of the Corporation authorized the termination of the LESOP subject to the approval of the Bankruptcy Court. It is anticipated that the termination will be part of the Corporation's plan of reorganization. Upon termination, any shares of common stock of the Corporation remaining in the LESOP Trust account would be sold and the proceeds paid to the holders of debentures issued under the LESOP. Any unpaid balance due would become subject to the subordinate guarantee of the Corporation and become a claim to be resolved as part of the reorganization plan. Based on recently issued guidance from the American Institute of Certified Public Accountants, it is anticipated the ultimate termination will not result in any charges to earnings, but will result in a reduction to capital of approximately $34.1 million based on a closing stock price of $25 3/8 on January 31, 1994. As of December 31, 1993, the LESOP suspense account held 1,416,155 shares. The participating subsidiaries ceased making contributions to the LESOP for debt service payments but continue to contribute to the Thrift Plan those amounts necessary to fulfill the matching obligations to participants. Matching contributions to the Thrift Plan were $11.0 million, $13.2 million and $8.6 million in 1993, 1992, and 1991, respectively. Thrift Plan expenses were $11.0 million, $13.2 million and $17.9 million for 1993, 1992 and 1991, respectively. The difference between matching contributions and expense for 1991 was attributable to the additional expenses required under the now suspended LESOP. 10. DEBT OBLIGATIONS The Corporation's filing for protection under the Bankruptcy Code constituted an event of default under substantially all of its debt agreements. Because payment of debt which existed at the filing date is suspended by the Bankruptcy Code, substantially all of the Corporation's debt, including short-term debt, has been classified as Liabilities Subject to Chapter 11 Proceedings. In addition, payment of interest on prepetition debt is suspended, and no interest expense on such debt has been recorded since commencement of the bankruptcy proceedings. Following the Chapter 11 filing, the Corporation received approval from the Bankruptcy Court and the SEC, under the Public Utility Holding Company Act of 1935, for debtor-in-possession financing (the DIP Facility). The DIP Facility is for up to $100 million and includes the availability of letters of credit of up to $50 million. The DIP Facility was reduced by the Corporation from $275 million to $200 million on July 10, 1992 and was reduced to the current level effective June 17, 1993. The Corporation has extended the DIP Facility to December 31, 1994. Two borrowing options are available to the Corporation under the DIP Facility. The Corporation may borrow at the agent's alternative reference rate plus 1 percent or the Eurodollar rate plus 2 1/4 percent (for either 1, 2 or 3 months). In addition to a commitment fee of 1/2 of 1 percent per annum on the average daily unused amount of the facility, other fees have been paid to the lenders under the DIP Facility. Columbia Transmission also maintains a DIP Facility solely for the issuance of letters of credit for up to $25 million. Columbia Transmission has extended its DIP Facility to December 31, 1995, to allow for letters of credit with terms for the full calendar year of 1995. 11. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The Corporation, effective December 31, 1992, adopted SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." The Statement extends existing fair value disclosure practices by requiring all entities to disclose the fair value of financial instruments, both assets and liabilities, recognized and not recognized in ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) the Consolidated Balance Sheets, for which it is practicable to estimate fair value. For purposes of this disclosure, the fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Fair value may be based on quoted market prices for the same or similar financial instruments, or on valuation techniques such as the present value of estimated future cash flows using a discount rate commensurate with the risks involved. The uncertainties related to the outcome of the Corporation's Chapter 11 proceedings and the resulting effect upon the ultimate value of the Corporation's financial assets and liabilities add significantly to the uncertain nature of any estimate of fair value. The estimates of fair value required under SFAS No. 107 require the application of broad assumptions and estimates. Accordingly, any actual exchange of such financial instruments could occur at values significantly different from the amounts disclosed. 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: As cash and temporary cash investments, current receivables, current payables, and certain other short-term financial instruments are all short-term in nature, their carrying amount approximates fair value. The estimated fair values of the Corporation's other financial instruments are reflected in the accompanying table. Long-term investments Long-term investments include escrowed proceeds from the sale of the Canadian subsidiary (see Note 6B), which consist of hedged Canadian Treasury bills ($25.4 million and $25.1 million for 1993 and 1992, respectively). The Canadian Treasury bills are hedged with short-term foreign currency contracts, so that the combined carrying amount of the asset and related hedging instrument approximates fair value. Long-term investments also include an income tax refund receivable with associated interest at IRS rates ($31.2 million for 1993) whose carrying amount approximates fair value. Also included are loans receivable ($12.8 million and $15.6 million for 1993 and 1992, respectively) whose estimated fair values are based on the present value of estimated future cash flows using an estimated rate for similar loans extended currently. It is not practicable to estimate the fair value of long-term receivables ($144.4 million and $154.2 million for 1993 and 1992, respectively) for the expected recovery by Columbia Transmission of certain gas purchase liabilities for which the timing and amount of payments to be received will be dependent on the outcome of the Chapter 11 proceedings. As discussed in Note 2, the uncertainties related to these proceedings could significantly influence the fair value of this financial instrument. The financial instruments included in long-term investments are primarily reflected in Investments and Other Assets in the Consolidated Balance Sheets. Liabilities subject to Chapter 11 proceedings The estimated fair value of the Corporation's debentures and medium-term notes is based on quoted market prices for those issues that are traded on an exchange, and estimates provided by brokers for other issues. However, quoted market prices and broker estimates inherently include judgments concerning the outcome of the Corporation's and Columbia Transmission's Chapter 11 proceedings. Note 2 discusses the uncertainties related to these proceedings which could significantly influence the fair value of these financial instruments. It was not practicable to estimate the fair value of the remaining long-term debt, which includes the Subordinated Guarantee of the LESOP debt ($87.0 million) and miscellaneous debt of Columbia Transmission ($1.4 million for 1993 and 1992), because no reliable measurement methodology exists. Prior to filing its petition for protection under Chapter 11 of the Bankruptcy Code, the Corporation regularly issued commercial paper, bank notes and other short-term debt instruments. The carrying amount of such securities ($892.6 million) is included in Liabilities Subject to Chapter 11 Proceedings. Payment of these obligations and any related interest is subject to approval by the Bankruptcy Court. Although investors from time to time may buy and sell these debt obligations, the terms of any such transactions are private and not ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) disclosed to the Corporation. Because there can be no assurance as to the ultimate timing and amount of principal and interest repayments of these obligations, it is not practicable to determine their fair values. The carrying amount of other Liabilities Subject to Chapter 11 Proceedings ($1,556.0 million and $1,595.4 million for 1993 and 1992, respectively) primarily represents accounts payable, accrued liabilities and other liabilities. As discussed in Note 2, these liabilities are subject to adjustment at the direction of the Bankruptcy Court. In addition, the timing of the ultimate payment of these liabilities, as well as interest, if any, is also subject to determination by the Bankruptcy Court. Accordingly, it is not practicable to determine the fair value of these liabilities. 12. OTHER COMMITMENTS AND CONTINGENCIES A. CAPITAL EXPENDITURES. Capital expenditures for 1994 are currently estimated at $468 million. Of this amount, $91 million is for oil and gas operations, $201 million for transmission operations, $152 million for distribution operations and $24 million for other energy operations. B. PRODUCER CONTRACT MATTERS. Columbia Transmission has rejected more than 4,800 natural gas purchase contracts which collectively made the company's gas sales rate noncompetitive. Under Order 636, Columbia Transmission will have a minimal merchant function, i.e., less than one percent of total throughput. Customers' requirements will be met with gas purchased under remaining and new contracts including 30- day spot contracts as may be required. Rejection of additional contracts could result in liabilities that could require future charges against earnings. C. PARTNERSHIP PROJECTS. Columbia Gulf is a general partner in the Trailblazer, Overthrust and Ozark partnerships. Since these partnerships are nonrecourse, project-financed pipelines, firm shipper contracts were assigned to banks (or in the case of Ozark to the Indenture Trustee) as collateral for loans. Columbia Transmission and other shippers are attempting to negotiate exit fees under Order 636 with the partnerships. As a result of these negotiations and the current depressed demand for the capacity on several of these pipelines, the realizability of these investments is uncertain. Accordingly, a reserve of $5.4 million was established in 1993. At December 31, 1993, Columbia Gulf's investment in the partnerships amounted to $35.4 million, net of the valuation reserve and before related deferred taxes. D. OTHER LEGAL PROCEEDINGS. The Corporation and its subsidiaries have been named as defendants in various legal ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) proceedings. In the opinion of management, the ultimate disposition of these currently asserted claims will not have a material adverse impact on the Corporation's consolidated financial position or results of operations. E. ASSETS UNDER LIEN. The loans under the debtor-in-possession financing arrangement for the Corporation are given superpriority claim status pursuant to Section 364(c) (1) of the Bankruptcy Code. Loans to the Corporation are secured by either a first or second priority perfected lien on, and security interest in, all property of the Corporation including intercompany loans, other than the voting securities of the Corporation's distribution subsidiaries and Columbia LNG. Columbia Transmission's letter of credit facility is secured by either a first or second priority perfected lien on, and security interest in, all property of Columbia Transmission. Substantially all of Columbia Transmission's properties have been pledged to the Corporation as security for debt owed by Columbia Transmission to the Corporation. F. COVE POINT LNG TERMINAL. In 1991, the Corporation entered into a conditional agreement for the sale of its remaining interest in Columbia LNG to Shell LNG Company (Shell LNG), a subsidiary of Shell Oil Company. On July 16, 1992, the Corporation was notified by Shell LNG that it would not proceed with the interim purchase of 40.8 percent of the stock of Columbia LNG. Shell LNG's notification terminated the agreements between the Corporation and Shell LNG for the purchase of the remaining Columbia LNG stock. Shell LNG currently owns 9.2 percent of Columbia LNG's outstanding stock. As previously reported, Columbia LNG has developed a new business plan to reactivate the Cove Point facility. This plan anticipated a new peaking and storage service by the end of 1994, as well as a terminalling service for liquefied natural gas (LNG) received by tanker. An application with the FERC to charge customers based upon individually negotiated market rates was filed in February 1993. In accordance with the business plan and in anticipation of the FERC filing, management concluded, in 1992, that it was no longer appropriate for Columbia LNG to continue application of SFAS No. 71 and regulatory assets were removed from Columbia LNG's balance sheet resulting in an extraordinary charge of $60.1 million pre-tax ($39.7 million after-tax) recorded in the third quarter of 1992. An open season, allowing potential customers to bid on the capacity of all of the offered services, was held March 31, 1993 through April 14, 1993. Based on the results of the bids, which were not sufficient to proceed with the project as it was originally proposed, Columbia LNG restructured the offered services to more adequately address the service needs of the potential customers. A second open season, offering additional services, was held May 24, 1993 through June 2, 1993. This open season resulted in sufficient bids to proceed with the peaking and transportation services. The one bid received during the second open season for baseload terminalling service was subsequently withdrawn. As a result, Columbia LNG does not currently anticipate a baseload terminalling service in the near future. As a consequence, Columbia LNG recorded a writedown in the carrying value of its investment in the Cove Point facility in the second quarter 1993 that reduced the Corporation's income $37.9 million after-tax. This amount included estimated dismantling costs for the offshore facilities of approximately $12 million after-tax. However, until such time as the offshore facilities are transferred to the new partnership, as discussed below, Columbia LNG plans to maintain the facilities for possible future imports and, at the present time, has no plans to abandon or dismantle them. Besides the writedown discussed above and the extraordinary charge discussed in the preceding paragraph, Columbia LNG has incurred operating losses during the prior three years which are not significant to the consolidated financial results of the Corporation. On October 28, 1993, as amended on January 27, 1994, PEPCO Enterprises, Inc. (PEPCO), which is a wholly-owned subsidiary of Potomac Electric Power Company, entered into an agreement to form a limited partnership. The February 1993 filing with the FERC was withdrawn by Columbia LNG and the Partnership, Cove Point LNG Limited Partnership (Cove Point LNG) that will pursue the business plan discussed above, filed an ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) application with the FERC on November 3, 1993, seeking authorization to acquire all of the existing plant and pipeline facilities owned by Columbia LNG and for authorization to recommission the plant and construct new facilities in order to provide peaking services beginning in 1995. On the same day, Columbia LNG filed with the FERC for authorization to abandon its facilities by transfer to Cove Point LNG and to withdraw its February 26, 1993 filing. In addition to the FERC, this transaction will require other governmental approvals. Bankruptcy Court approval was received in January 1994. After the receipt of necessary regulatory approvals, the PEPCO affiliates will contribute up to $25 million in equity and loans for their half interest in the partnership. At the same time, Columbia LNG will transfer title to its existing plant and pipeline facilities to the partnership and assign to the partnership the precedent agreements for the services to be offered. Any cash requirements of the partnership prior to the in-service date of the project which are in excess of $25 million will be provided by Columbia LNG up to a maximum of $7 million. The cost of recommissioning the Cove Point facility and installing the necessary liquefaction equipment is estimated to be approximately $27 million. Columbia LNG or an affiliate will operate the plant and pipeline facilities for the partnership. A number of intervenors filed with the FERC in regard to Columbia LNG's plan for the Cove Point facility. While generally supportive of the plan to reopen the facility, some of the intervenors questioned the use of the individually negotiated market rates and requested the pass-through of certain benefits from prior collections from Columbia Transmission. The realization of the Corporation's remaining investment in Columbia LNG of $10.1 million will be dependent upon successful implementation of the partnership and related business plan. G. OPERATING LEASES. Payments made in connection with operating leases are charged to operation and maintenance expense as incurred. Such amounts were $55.5 million in 1993, $57.9 million in 1992 and $57.9 million in 1991. Future minimum rental payments required under operating leases that have initial or remaining noncancelable lease terms in excess of one year are: H. ENVIRONMENTAL MATTERS. The Corporation's subsidiaries are subject to extensive federal, state and local laws and regulations relating to environmental matters. These laws and regulations, which are constantly changing, require expenditures for corrective action at various operating facilities, waste disposal sites and former gas manufacturing sites for conditions resulting from past practices that subsequently were determined to be environmentally unsound. Certain subsidiaries have received notice from the United States Environmental Protection Agency (EPA) that ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) they are among several parties responsible under federal law for placing wastes at Superfund sites and may be required to share in the cost of remediation for these sites. However, considering known facts, existing laws and possible insurance and rate recoveries, management does not believe the identified Superfund matters will have a material adverse effect on future annual income or on the Corporation's financial position. The transmission subsidiaries are continuing their comprehensive review of compliance with existing environmental standards, including review of past operational activities and identification of potential site problems, through site reviews and formulation of remediation programs where necessary. While the Corporation's transmission subsidiaries have made progress in these ongoing self-assessment programs, because of the thousands of miles of pipeline which they operate, the exceptionally large number of sites at which they conduct or have conducted operations, and the long period over which operations have been conducted, completion of site screenings, characterizations and site-specific remediations will cover a time frame of approximately 10 to 12 years. A study for Columbia Transmission to quantify the scope of remediation activities which will be undertaken in future years to address the issues identified was recently concluded. The study, site investigations and characterization efforts performed throughout 1993 resulted in total accruals for the year of approximately $60 million for Columbia Transmission. These and other minor adjustments bring Columbia Transmission's recorded net liability to approximately $143.6 million at December 31, 1993. This represents the lower end of the range of reasonable outcomes with the upper end estimated to total approximately $280 million based on information currently available. As characterization and site-specific activities by Columbia Transmission determine the nature and extent of contamination, if any, at its operating facilities and as remediation plans are developed, additional charges to earnings could occur. To the extent such plans require approval of federal and/or state authorities, estimates are subject to revision. Based on the limited data now available and various assumptions as to characterization, management believes that annual future expenditures for Columbia Transmission's site investigations, characterization and remediation activities could be up to $20 million per year over an approximate 10 to 12 year time frame. Earnings will continue to be charged appropriately in advance of required expenditures. As a result of site characterization studies at various locations, during 1993, Columbia Gulf recorded an additional accrual of $6.7 million for environmental remediation. This accrual is for polychlorinated biphenyl (PCB) and petroleum hydrocarbon cleanup at certain compressor station sites and screenings for possible exposure at other locations. Columbia Gulf anticipates completion of cleanup during 1994. At that time, costs of remediation, if any, will be quantified and an additional accrual may become necessary. In 1992, Columbia Transmission received a subpoena and information request (Request) from the EPA Region III regarding three major environmental statutes: The Toxic Substances Control Act (TSCA), the Resource Conservation and Recovery Act (RCRA) and the Comprehensive Environmental Response Compensation and Liability Act (CERCLA). The Request relates to Columbia Transmission's past and current environmental practices. Since receipt of the Request, Columbia Transmission has provided the EPA with various materials pursuant to the Request. Columbia Transmission has continued to meet with the EPA to attempt to resolve the subpoena issues and continues to work cooperatively with environmental officials in the various states in which it operates. All environmental agencies have been declared exempt from the Bar Date established by the Bankruptcy Court for claims by creditors. Columbia Transmission on January 28, 1994, received from EPA Region V an Information Request pursuant to the RCRA. The agency requested Columbia Transmission to submit information and knowledge relating to its generation and management of natural gas pipeline condensate, used engine oil and similar liquids in the state of Ohio. Columbia Transmission is in the process of analyzing the information requested and will be discussing this Information Request with EPA Region V. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) At least one distribution subsidiary and some of the predecessor companies of the distribution subsidiaries were, or may have been, involved with the ownership and/or the operation of manufactured gas plants. At the present time management is aware of twelve such sites. The distribution subsidiaries are conducting investigations at five sites that date back to the mid-1800s. These plants heated coal tar in a low-oxygen atmosphere to manufacture low-cost gas for areas where natural gas was not generally available. The process created residues such as coal tar which were typically stored on site prior to being sold for commercial use. However, when the plants stopped operation the remaining residue material was in some cases simply buried on the plant sites. As time passed, other uses were made of the plant sites and in some cases their identity as a manufactured gas plant was lost. To the extent site investigations have been completed, remediation plans developed, and any responsibility for remedial action established, the appropriate liability has been recorded. The environmental assessment and evaluation process will continue over the next three to five years. Environmental investigations indicate that remedial action may be required. Investigations will be conducted at a number of the other sites in the near future. The following discusses the status of certain sites: In 1985, CPA was cited by the Pennsylvania Department of Environmental Resources for coal tar residues on the bottom of a creek bed in York, Pennsylvania. The area was adjacent to the site of a manufactured gas plant operated from 1885 to the early 1950s by a predecessor company, the York County Gas Company, which was purchased in 1968. The site has been under investigation by CPA's consultants to determine the extent of any underground contamination and to propose various remedial measures that can be used to eliminate the release to the creek or remediate the premises. The current costs of the investigation are being recovered in rates. Site remediation costs have been estimated at $4.2 million, which has been recorded as a liability and a corresponding regulatory asset. CPA expects to continue to recover these costs in rates based upon orders received in previous rate cases. However, the ability to recover these costs is subject to (1) the results of each future rate case during the expenditure period or (2) the outcome of a settlement proposal to treat these expenditures as a cost of removal by charging them to the reserve for depreciation and recover them over a five-year period. Remediation work is expected to start in 1994. Penn Fuel Gas, Inc. (Penn Fuel) advised CPA that a site in Bellefonte, Pennsylvania, sold to Penn Fuel by Central Pennsylvania Gas Company in 1960 was the location of a manufactured gas plant until the mid-1950s. The plant's equipment was disassembled at the time Penn Fuel acquired the property. The old processing building is still used as a warehouse by Penn Fuel. In 1966, CPA acquired substantially all of Central Pennsylvania Gas Company's assets and liabilities. CPA has agreed to share with Penn Fuel, the costs of investigating the site for environmental contamination and up to $300,000 of the investigation costs. A regulatory asset and offsetting liability was recorded by CPA in March 1993. There is no agreement, nor is there any admission by either CPA or Penn Fuel, regarding liability, if any, for abatement and/or remediation of the site. It is expected that the positions and potential responsibility of each party will become clearer as the investigation proceeds. In January 1993, the owners of the Patio Plaza Apartments, BMI Apartment Associates (a partnership), contacted COS about possible soil contamination of a site in Portsmouth, Virginia, on which the Portsmouth Gas Company operated a manufactured gas plant from 1854 to 1951. The Portsmouth Gas Company sold this site to the Portsmouth Redevelopment and Housing Authority in 1960. The Portsmouth Gas Company was acquired by Commonwealth Natural Resources, Inc. and subsequently merged into COS in 1981. The Redevelopment Authority subsequently razed the plant and sold the vacant land. Apartments and houses were built on the property and the current owners of some of the apartments reported possible soil contamination to the Virginia Water Quality Control Board. COS notified the EPA regarding the engineering reports provided to it by the owners. On March 25, 1993, COS and the Portsmouth Redevelopment and Housing Authority jointly filed suit in U.S. District Court, Eastern District of Virginia at Norfolk, Virginia, against the current and former owners of the apartments. The suit sought a declaration that those other parties are liable for the site and requested access to the property for testing which had been denied by the current owners. On June 14, 1993, the Court ordered ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) that COS be permitted access to perform necessary testing of soil and air that resulted in a determination that there was no imminent danger to the residents. Subsequently, the Court granted a stay of all legal proceedings until May 16, 1994 to permit COS to conduct further site testing to determine the extent of any contamination and to recommend corrective measures. Most of that testing was completed in November and December 1993, and the results are anticipated in early 1994. On February 14, 1994, the judge appointed a magistrate to oversee settlement of the suit. COS incurred legal and engineering consultant expenses that reached approximately $400,000 in 1993. Additional costs are currently anticipated to reach $400,000 in 1994 and accordingly a regulatory asset has been established for $800,000 and the appropriate liability recorded. Other work at this site is anticipated but it is not possible at this time to estimate the costs. Permission was granted by the VSCC to defer the costs of this project as a regulatory asset, subject to recovery in the next rate case. In February 1993, COS reported to the Virginia Department of Environmental Quality (VaDEQ) a potential soil contamination below a retaining wall at the Petersburg, Virginia Service Center . The VaDEQ has ordered COS to prepare a preliminary site assessment related to the report. In early June 1993, COS contractors performed testing and prepared the preliminary site assessment which was submitted to VaDEQ in July 1993. Additional testing on another area of leakage was conducted in September 1993 with results reported to the VaDEQ in late October 1993. COS is currently completing the removal of contaminated material from an old underground tank on the property which was contributing to the leakage problem. Additional corrective work may be performed in 1994 as a result of further testing that will be conducted. COS has incurred legal and engineering consultant expenses that reached approximately $170,000 by the end of 1993. At this time, it is not possible to estimate the costs of corrective action or of further work the VaDEQ might require. However, additional consultant costs are estimated to be $280,000 in 1994. Accordingly, a regulatory asset of $450,000 has been established and the liability recorded. Permission was granted by the VSCC to defer the costs of this project as a regulatory asset subject to recovery in the next rate case. A former manufactured gas plant site in Lynchburg, Virginia was included with the assets of the Lynchburg Gas Company when it was merged into COS in 1989. A liability of $600,000 has been recorded for the removal of certain remaining structures from the manufactured gas plant and clean up of debris at the site. The VSCC has granted COS permission to defer the costs associated with this work and any other remediation related to the site for review and potential recovery in rates at a later time. A former manufactured gas plant site in Hagerstown, Maryland was included with other assets of the Hagerstown Gas Company acquired by CMD in 1969. This plant operated between 1891 and 1949. The site, at the location of the CMD service center in Hagerstown was reported to the EPA by the state and has been assigned medium priority status by the EPA for future investigation. No investigations have been conducted by the state of Maryland or the EPA at this site and, therefore, it is not possible at this time to estimate the cost of remediation activities, if any. To the extent the above-mentioned site investigations have been completed, remediation plans developed, and any Distribution responsibility for remedial action established, the appropriate liability has been recorded. As additional investigations are completed and remediation costs become probable, the appropriate liability will be recorded. As of December 31, 1993, the distribution subsidiaries recorded net liabilities of $5.9 million. Management anticipates recovery of remediation costs through normal rate proceedings. The eventual total cost of full future environmental compliance for the Columbia Gas System is difficult to estimate due to, among other things: (1) the possibility of as yet unknown contamination, (2) the possible effect of future legislation and new environmental agency rules, (3) the possibility of future litigation, (4) the possibility of future designations as a potential responsible party by the EPA and the difficulty of determining liability, if any, in proportion to other responsible parties, (5) possible insurance and rate recoveries, and (6) the effect of possible technological changes relating to future remediation. However, reserves have been ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) established based on information currently available which resulted in a total recorded net liability of $156.1 million for the Columbia Gas System at December 31, 1993, which includes the low end of a range for certain expenditures for the transmission segment previously discussed. As new issues are identified, appropriate additional liabilities may have to be recorded. It is management's continued intent to address environmental issues in cooperation with regulatory authorities in such a manner as to achieve mutually acceptable compliance plans. However, there can be no assurance that fines and penalties will not be incurred. Management expects most environmental assessment and remediation costs to be recoverable through rates. Although significant charges to earnings could be required prior to rate recovery, management does not believe that environmental expenditures will have a material adverse effect on the Corporation's financial position, based on known facts, existing laws and regulations and the period over which expenditures are required. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) 13. INTEREST INCOME AND OTHER, NET 14. INTEREST EXPENSE AND RELATED CHARGES 15. CHANGES IN COMPONENTS OF WORKING CAPITAL (excludes cash and temporary cash investments, short-term debt and current maturities of long-term debt) ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) 16. BUSINESS SEGMENT INFORMATION The following tables provide information concerning the Corporation's major business segments. Revenues include intersegment sales to affiliated subsidiaries, which are eliminated when consolidated. Affiliated sales are recognized on the basis of prevailing market or regulated prices. Operating income is derived from revenues and expenses directly associated with each segment. Identifiable assets include only those attributable to the operations of each segment. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) 17. QUARTERLY FINANCIAL DATA (UNAUDITED) Quarterly financial data does not always reveal the trend of the System's business operations due to bankruptcy matters, nonrecurring items and seasonal weather patterns which affect earnings and related components of operating revenues and expenses. (a) Includes an increase in net income of $13.2 million for the reversal of rate reserves to reflect the outcome of rate cases related to the transmission segment. The effect of not recording interest expense on prepetition debt improved net income $38.2 million. (b) Includes a decrease in net income of $37.9 million to record a writedown in the investment in the Cove Point LNG facility and a decrease in net income of $7.4 million to record the estimated loss on the sale of storage inventory. The effect of not recording interest expense on prepetition debt improved net income $36.0 million. (c) Includes a decrease in net income of $40.4 million to record the effect of a preliminary settlement with the IRS, a decrease in net income of $13.0 million to record a liability for future environmental remediation costs, a decrease in net income of $9.8 million to reflect the effect of the higher federal corporate tax rate and a decrease in net income of $9.8 million for several smaller unusual items. The effect of not recording interest expense on prepetition debt improved net income $33.8 million. (d) Includes an increase in net income of $13.5 million for gas inventory charges collected from customers and an increase in net income of $12.8 million for the WACOG surcharge collected from customers, partially offset by a decrease in net income of $12.6 million for an adjustment to interest income for pipeline direct billings. The effect of not recording interest expense on prepetition debt improved net income $30.1 million. (e) Includes a decrease in net income of $83.4 million to record a writedown in the carrying value of U.S. oil and gas properties. The effect of not recording interest expense on prepetition debt improved net income $36.8 million. (f) The effect of not recording interest expense on prepetition debt improved net income $36.0 million. (g) Includes a decrease in net income of $39.2 million to record a liability for future environmental remediation costs and a decrease in net income of $24.2 million to record a provision for gas supply charges. The effect of not recording interest expense on prepetition debt improved net income $36.6 million. (h) Includes an increase in net income of $13.1 million for gas inventory charges collected from customers. The effect of not recording interest expense on prepetition debt improved net income $39.1 million. 18. OIL AND GAS PRODUCING ACTIVITIES (UNAUDITED) INTRODUCTION. Reserve information contained in the following tables for the U.S. properties is management's estimate, which was reviewed by the independent consulting firm of Ryder Scott Company Petroleum Engineers. Reserves are reported as net working interest. Gross revenues are reported after deduction of royalty interest payments. The Corporation sold its Canadian subsidiary to Anderson Exploration Ltd. of Calgary effective December 31, 1991. In 1991 the oil and gas operations of the Canadian subsidiary resulted in a $24.4 million loss. Accordingly, the reserve and other information for the Canadian properties are not included in the tables for 1991, 1992 and 1993. (a) Represents expenditures associated with properties on which evaluations have not been completed. Results of operations for producing activities exclude administrative and general costs, corporate overhead and interest expense. Income tax expense is expressed at statutory rates less Section 29 credits. (a) Includes writedown of the carrying value of $126.4 million for 1992. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS Future cash inflows are computed by applying year-end prices to estimated future production of proved oil and gas reserves. Future expenditures (based on year-end costs) represent those costs to be incurred in developing and producing the reserves. Discounted future net cash flows are derived by applying a 10% discount rate, as required by the Financial Accounting Standards Board, to the future net cash flows. This data is not intended to reflect the actual economic value of the Corporation's oil and gas producing properties or the true present value of estimated future cash flows since many arbitrary assumptions are used. The data does provide a means of comparison among companies through the use of standardized measurement techniques. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) A reconciliation of the components resulting in changes in the standardized measure of discounted cash flows attributable to proved oil and gas reserves for the three years ending December 31, 1993, follows: The estimated discounted future net cash flows decreased during 1993 primarily due to net changes in prices and production costs and revisions to the economic feasibility of producing certain wells. The standardized measure of the Corporation's oil and gas properties can be influenced by affiliated and unaffiliated pipeline transportation rate design (which continues to be evaluated by the FERC). ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Schedule I ---------- Page 1 of 2 MARKETABLE SECURITIES - OTHER INVESTMENTS The Columbia Gas System, Inc. and Subsidiaries December 31, 1993 ($ in Millions) * The short-term investment portfolio consists of numerous securities with similar market characteristics such as credit quality, maturity and marketability. These include bills, notes and bonds issued by the U.S. Government or its agencies (either purchased directly for the System or through repurchase agreements) and money market instruments issued by foreign and domestic corporations. Such instruments include commercial paper and bank certificates of deposit. ** As these securities are short-term in nature, their carrying amount approximates market value. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Schedule I ---------- Page 2 of 2 MARKETABLE SECURITIES - OTHER INVESTMENTS The Columbia Gas System, Inc. and Subsidiaries December 31, 1992 ($ in Millions) * The short-term investment portfolio consists of numerous securities with similar market characteristics such as credit quality, maturity and marketability. These include bills, notes and bonds issued by the U.S. Government or its agencies (either purchased directly for the System or through repurchase agreements) and money market instruments issued by foreign and domestic corporations. Such instruments include commercial paper and bank certificates of deposit. ** As these securities are short-term in nature, their carrying amount approximates market value. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) PROPERTY, PLANT AND EQUIPMENT Schedule V The Columbia Gas System, Inc. and Subsidiaries ---------- Year Ended December 31, 1993 Page 1 of 3 ($ in Millions) (a) Primarily reflects well sales by Columbia Natural Resources, Inc. ($5.5 million). (b) Primarily reflects Columbia Transmission's transfer of 1.3 Bcf from current gas inventory. (c) Excludes capital expenditures related to "Investments and Other Assets" ($6.8 million). NOTE:Construction work in progress for Gas Utility Plant was $56.7 million as of December 31, 1993. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) PROPERTY, PLANT AND EQUIPMENT Schedule V The Columbia Gas System, Inc. and Subsidiaries ---------- Year Ended December 31, 1992 Page 2 of 3 ($ in Millions) (a) Primarily reflects the net transfer of assets from Inland Gas Company (Oil and Gas - $5.5 million) to Columbia Gas of Kentucky, Inc. (Distribution $5.5 million), and sales of assets by Columbia Natural Resources, Inc. (Oil and Gas - $4.9 million). (b) Excludes capital expenditures related to "Investments and Other Assets" ($6.1 million). (c) Primarily reflects Columbia Transmission's transfer of 9.7 Bcf of gas to current gas inventory. NOTE:Construction work in progress for Gas Utility Plant was $55.9 million as of December 31, 1992. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) PROPERTY, PLANT AND EQUIPMENT Schedule V The Columbia Gas System, Inc. and Subsidiaries ---------- Year Ended December 31, 1991 Page 3 of 3 ($ in Millions) (a) Reflects sales of assets by Columbia Natural Resources, Inc. (b) Includes foreign currency translation adjustment applicable to Canadian property ($1.1 million). (c) Includes the sale of Columbia Gas Development of Canada Ltd. in a transaction completed in January 1992, effective December 31, 1991. (Canadian Cost Center - $276.5 million and Other General Plant - $1.8 million). (d) Includes reclassification of certain Inland Gas Company assets from Distribution properties (Distribution - $7.7 million and Other - $7.0 million) to Oil and Gas properties (Other General Plant $14.7 million). (e) Reflects the deconsolidation of Columbia LNG Corporation, now recorded as "Investment in Columbia LNG Corporation". (f) Includes the sale of Columbia Gas of New York, Inc. in a transaction completed in April 1991 (Distribution - $55.4 million and Other - $5.6 million). (g) Excludes capital expenditures related to "Investments and Other Assets" ($5.1 million). NOTE:Construction work in progress for Gas Utility Plant was $52.1 million as of December 31, 1991. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY, PLANT AND EQUIPMENT Schedule VI The Columbia Gas System, Inc. and Subsidiaries ----------- Year Ended December 31, 1993 Page 1 of 3 ($ in Millions) NOTE:"Other Changes" generally includes reductions for property sold and the cost of retiring property, offset by salvage on property retired and miscellaneous items. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY, PLANT AND EQUIPMENT Schedule VI The Columbia Gas System, Inc. and Subsidiaries ----------- Year Ended December 31, 1992 Page 2 of 3 ($ in Millions) NOTE:"Other Changes" generally includes reductions for property sold and the cost of retiring property, offset by salvage on property retired, and miscellaneous items. Significant items are noted below. (a) Includes a writedown in the carrying value of the United States Cost Center ($126.4 million). (b) Primarily reflects the net transfer of assets from Inland Gas Company (Oil and Gas - $3.4 million) to Columbia Gas of Kentucky, Inc. and sales of assets by Columbia Natural Resources, Inc. (Oil and Gas - $5.5 million). ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY, PLANT AND EQUIPMENT Schedule VI The Columbia Gas System, Inc. and Subsidiaries ----------- Year Ended December 31, 1991 Page 3 of 3 ($ in Millions) Note:"Other Changes" generally includes reductions for property sold and the cost of retiring property, offset by salvage on property retired, and miscellaneous items. Significant items are noted below. (a) Includes writedowns to reduce the carrying value of the Canadian Cost Center ($61.6 million). A portion of the writedown was recorded in "Cumulative Effect of Change in Accounting for Income Taxes" ($25.2 million) in connection with the adoption of SFAS No. 96. (b) Includes the sale of Columbia Gas Development of Canada Ltd. in a transaction completed in January 1992, effective December 31, 1991. (Canadian Cost Center - $191.1 million and Other General Plant - $1.1 million). (c) Includes reclassification of certain Inland Gas Company assets from Distribution properties (Distribution - $5.1 million and Other - $5.4 million) to Oil and Gas properties (Other General Plant $11.3 million). (d) Reflects the deconsolidation of Columbia LNG Corporation, now recorded as "Investment in Columbia LNG Corporation". (e) Includes the sale of Columbia Gas of New York, Inc. in a transaction completed in April 1991 (Distribution - $14.6 million and Other - $3.0 million). ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Schedule VIII ------------- VALUATION AND QUALIFYING ACCOUNTS The Columbia Gas System, Inc. and Subsidiaries Year Ended December 31, ($ in Millions) (a) Reflects reclassification to a regulatory asset of the uncollectible accounts related to the Percent of Income Plan (PIP) of Columbia Gas of Ohio, Inc. (b) Principally reflects amounts charged off as uncollectible less amounts recovered. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) SHORT-TERM BORROWINGS (A) Schedule IX The Columbia Gas System, Inc. and Subsidiaries ----------- ($ in Millions) Page 1 of 2 (a) Prior to June 19, 1991, certain working capital requirements of the Corporation and its subsidiaries were met through the sale of commercial paper, through notes sold directly to commercial banks and/or through borrowings under bank lines of credit. The commercial paper was sold through dealers with maturities ranging from one day to nine months. The Corporation maintained a $500 million revolving short-term committed line of credit, for which participating banks were paid fees of 1/8% per annum on the total facility and 1/16% per annum on the unused portion of the facility. In addition, a $750 million revolving ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) SHORT-TERM BORROWINGS (A) Schedule IX The Columbia Gas System, Inc. and Subsidiaries ----------- ($ in Millions) Page 2 of 2 subordinated committed line of credit was maintained, for which participating banks were paid 3/8% per annum on the unused portion of the facility. Loans under the lines of credit bore interest according to rate options based on prime, bank certificates of deposit or the London InterBank Offered Rate. Since its Chapter 11 filing, the Corporation has had $266.5 million of commercial paper and $621 million of bank loans in default under these facilities. For periods subsequent to the Chapter 11 filings, Debtor-In-Possession (DIP) Financing facilities were established by the Corporation and Columbia Transmission. The Corporation has available up to $100 million, reduced from $200 million on June 18, 1993, under its DIP Financing facility. Borrowings are at the agent's per annum alternate reference rate plus 1% or the Eurodollar Rate plus 2-1/4% (for either 1, 2 or 3 months). Also, the Corporation is subject to a commitment fee of one-half of 1% per annum on the average daily unused amount of the facility. Additionally, Columbia Transmission's separate DIP facility initially of up to $80 million was reduced to $25 million, on November 29, 1991, which is only available for the issuances of Letters of Credit. Borrowings were at the agent's per annum alternate reference rate plus 1-1/2% or the Eurodollar Rate plus 2-3/4% (for either 1, 2 or 3 months). Columbia Transmission is also subject to a commitment fee of one-half of 1% per annum on the average daily unused amount of the facility. For additional information regarding these DIP facilities, reference is made to pages 51 and 52 of Management's Discussion and Analysis in Item 7 and Note 10 in Item 8 on page 83. Reference is also made to the DIP Financing Exhibits 10-BR, 10-CB, 10-CC, 10-CD, 10-CF, 10- CG, 10-CH, 10-CK and 10-CL included or incorporated by reference, in this filing. (b) Based on actual interest expense divided by the average daily borrowings outstanding during the period. (c) The Corporation did not have any amounts outstanding under its DIP facility during 1993. However, the Corporation's facility was used during the periods January 1, 1992 through December 31, 1992 and August 20, 1991 through December 31, 1991. Columbia Transmission did not have any amounts outstanding under its DIP facility during 1993 and 1992. However, the facility was used during the period of August 6, 1991 through August 21, 1991. Both the Corporation's and Columbia Transmission's DIP facilities include the availability of letters of credit of up to $50 million and $25 million, respectively. As of December 31, 1993, $12.8 million and $1.8 million of letters of credit were outstanding under the Corporation's and Columbia Transmission's DIP facilities, respectively. (d) The period used in calculating the amounts for short-term financing was from January 1, 1991 through June 18, 1991. This period represents the time during which the Corporation was not in default of its loan agreements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (Continued) Schedule X ---------- SUPPLEMENTARY INCOME STATEMENT INFORMATION The Columbia Gas System, Inc. and Subsidiaries ($ Millions) Depreciation and amortization of intangible assets, pre-operating costs and similar deferrals, royalties and advertising costs have been omitted inasmuch as the amounts are not in excess of one percent of total revenues as reported in the Statements of Consolidated Income. ITEM 9. ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has not been a change of accountants nor any disagreements concerning accounting and financial disclosure within the past two years. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by this item is contained in the Corporation's Proxy Statement related to the 1993 Annual Meeting of Stockholders, filed pursuant to Section 14 of the Securities Exchange Act of 1934 and is incorporated herein by reference. Information regarding the System's executive officers, who are elected annually by the directors, is as follows: The Columbia Gas System, Inc. JOHN H. CROOM, 61, Chairman of the Board, President and Chief Executive Officer of the Corporation since August 1984. DANIEL L. BELL, JR., 64, Senior Vice President and Chief Legal Officer of the Corporation since January 1989, Corporate Secretary since January 1988. Senior Vice President of Columbia's Service Corporation since September 1979. LOGAN W. WALLINGFORD, 61, Senior Vice President of Columbia Gas System Service Corporation since March 1989. Senior Vice President of Planning and Storage for Columbia Transmission from July 1988 to February 1989, Senior Vice President, Gas Acquisition from July 1987 to June 1988, Vice President of Planning from March 1985 to June 1987. RICHARD E. LOWE, 53, Vice President of the Corporation and Columbia Gas System Service Corporation since September 1988. Vice President and General Auditor of Columbia Gas System Service Corporation from April 1987 to August 1988. Treasurer of Columbia Gas Development Corporation from April 1979 to March 1987. JAMES P. HOLLAND, 45, Chairman and Chief Executive Officer of Columbia Transmission and Columbia Gulf Transmission Company since September 1990. President of Columbia Transmission from May 1988 to August 1990. President of Columbia Gulf Transmission Company from October 1989 to August 1990. Senior Vice President of Marketing of Columbia Transmission from July 1987 to April 1988, Senior Vice President of Gas Procurement from January 1986 to June 1987. C. RONALD TILLEY, 56, Chairman and Chief Executive Officer of Columbia Distribution Companies since January 1987. MICHAEL W. O'DONNELL, 49, Senior Vice President and Chief Financial Officer of the Corporation since October 1993. Senior Vice President and Assistant Chief Financial Officer of the Columbia Gas System Service Corporation since 1989. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information required by this item is contained in the Corporation's Proxy Statement related to the 1993 Annual Meeting of Stockholders, filed pursuant to Section 14 of the Securities Exchange Act of 1934 and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this item is contained in the Corporation's Proxy Statement related to the 1993 Annual Meeting of Stockholders, filed pursuant to Section 14 of the Securities Exchange Act of 1934 and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item is contained in the Corporation's Proxy Statement related to the 1993 Annual Meeting of Stockholders, filed pursuant to Section 14 of the Securities Exchange Act of 1934 and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Exhibits Reference is made to pages 116 through 120 for the list of exhibits filed as a part of this Annual Report on Form 10-K. Pursuant to Item 601(b), paragraph (4)(iii)(A) of Regulation S-K, certain instruments representing long-term debt of the Corporation or its subsidiaries have not been included as Exhibits because such debt does not exceed 10% of the total assets of the Corporation and its subsidiaries on a consolidated basis. The Corporation agrees to furnish a copy of any such instrument to the SEC upon request. Financial Statement Schedules All of the financial statements and financial statement schedules filed as a part of the Annual Report on Form 10-K are included in Item 8. Reports on Form 8-K A report on Form 8-K was filed on November 18, 1993, discussing the retirement of Mr. John D. Daly, executive vice president of The Columbia Gas System, Inc. and Columbia Gas System Service Corporation effective December 1, 1993. A report on Form 8-K was filed on January 3, 1994, discussing the Bankruptcy Court's approval of the extension to March 22, 1994, that Columbia Transmission and the Corporation have the exclusive right to file Chapter 11 plans of reorganization. A report on Form 8-K was filed on January 19, 1994, discussing Columbia Transmission's filing of its Chapter 11 Reorganization Plan with the Bankruptcy Court. A report on Form 8-K was filed on February 14, 1994, containing a Press Release published on February 10, 1994, regarding the financial and operating results for the year ended December 31, 1993. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (Continued) Undertaking made in Connection with 1933 Act Compliance on Form S-8 For purposes of complying with the amendments to the rules governing Form S-8 under the Securities Act of 1933, the Corporation undertakes the following, which is incorporated by reference into the registration statements on Form S-8, Nos. 33-10004 (filed November 26, 1986) and 33- 42776 (filed September 13, 1991): Insofar as indemnification for liabilities arising under the Securities Act of 1933 (Act) 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 Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the questions whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE COLUMBIA GAS SYSTEM, INC. ----------------------------- (Registrant) Dated: March 11, 1994 By: /s/ M. W. O'Donnell ---------------------------------------- (M. W. O'Donnell) 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 and on the dates indicated. EXHIBIT INDEX ------------- Reference is made in the two right-hand columns below to those exhibits which have heretofore been filed with the Commission. Exhibits so referred to are incorporated herein by reference. EXHIBIT INDEX (Continued) - --------------- (a) Executive Compensation arrangements filed pursuant to Item 14 of Form 10-K. *Filed herewith EXHIBIT INDEX (Continued) - --------------------------- (a) Executive Compensation arrangements filed pursuant to Item 14 of Form 10-K. EXHIBIT INDEX (Continued) - --------------------------- (a) Executive Compensation arrangements filed pursuant to Item 14 of Form 10-K. *Filed herewith. EXHIBIT INDEX (Continued) - -------------------------- (a) Executive Compensation arrangements filed pursuant to Item 14 of Form 10-K. *Filed herewith.

99193_1993.txt

99193_1993

1993

99193

ITEM 1. BUSINESS THE COMPANY Transamerica Finance Corporation, a wholly owned subsidiary of Transamerica Finance Group, Inc. ("TFG") which is a wholly owned subsidiary of Transamerica Corporation, is principally engaged in consumer lending, commercial lending and leasing operations. Unless the context indicates otherwise, the terms "Company" and "Registrant" as used herein refer to Transamerica Finance Corporation and its subsidiaries. Transamerica Corporation (Transamerica) is a financial services organization which engages through its subsidiaries in consumer lending, commercial lending, leasing, real estate services, life insurance and asset management. Transamerica was incorporated in Delaware in 1928. The Company was incorporated in Delaware in 1931 under the name Pacific Finance Corporation, as successor to a California corporation of the same name organized in 1920. In 1961, the Company became a wholly owned subsidiary of Transamerica Corporation, which in 1990 formed TFG to own all the Company's outstanding capital stock. On July 17, 1990, the Company acquired FIFSI, Inc. (dba NOVA Financial Services), a consumer lending subsidiary of First Interstate Bancorp, for $117,455,000 in cash and the assumption of $445,400,000 of liabilities. The transaction was accounted for as a purchase and the operations of NOVA Financial Services have been included in the Consolidated Statement of Operations from the date of acquisition. The Company provides funding for its subsidiaries' consumer lending, commercial lending and leasing operations and for the operations of certain wholly owned subsidiaries of TFG. Capital is allocated among the operations based on their capital needs. The operations are required to maintain prudent financial ratios consistent with other companies in their respective industries. The Company's total notes and loans payable were $7,031,503,000 at December 31, 1993 and $6,589,576,000 at December 31, 1992. Variable rate debt was $3,970,484,000 at December 31, 1993 and $3,492,842,000 at December 31, 1992. The ratio of debt to debt plus equity was 83% at December 31, 1993 and 82% at December 31, 1992. Transamerica Finance Corporation offers publicly, from time to time, senior or subordinated debt securities. Public debt issued totaled approximately $407,000,000 in 1993, $538,700,000 in 1992 and $1,107,800,000 in 1991. Under a shelf registration filed with the Securities and Exchange Commission in 1991 to offer publicly up to $1,500,000,000 of senior or subordinated debt securities with varying terms, debt securities totaling $1,400,000,000 had been sold through December 31, 1993. In addition, under a registration statement filed in July 1993, the Company may offer up to $2,000,000,000 of senior or subordinated debt securities (which may include medium-term notes,) with varying terms, of which $1,853,000,000 remained unsold as of December 31, 1993. Liquidity is a characteristic of the Company's operations since the majority of the assets consist of finance receivables. Principal cash collections of finance receivables totaled $11,535,766,000 during 1993, $9,415,231,000 during 1992 and $8,375,018,000 during 1991.CONSUMER LENDING GENERAL The Company's consumer lending services are provided by Transamerica Financial Services, headquartered in Los Angeles, California, which has 561 branch lending offices. Branch offices are located in the United States (548 in 41 states), Canada (11) and United Kingdom (2). Transamerica Financial Services makes both real estate secured and unsecured loans to individuals. The company's customers typically borrow to consolidate debt, finance home remodeling, pay for their children's college educations, make major purchases, take vacations, and for other personal uses. Transamerica Financial Services offers three principal loan products: fixed rate real estate secured loans, revolving real estate secured lines of credit and personal loans. The company's primary business is making fixed rate, home equity loans that generally range up to $200,000. Approximately 83% of the net finance receivables outstanding at December 31, 1993 are secured by residential properties. Of the Company's real estate portfolio, 50% is secured by first mortgages. Since 1991, the company has continued to broaden its receivable portfolio by expanding its revolving real estate secured lines of credit, its unsecured personal loan business and its purchase of retail finance contracts from dealers (i.e., appliances, furniture and services). When permitted by law, the consumer lending services offer to arrange credit life and disability insurance in connection with consumer instalment loans and generally require that property securing consumer loans be insured. The consumer lending operation receives a fee if it arranges such insurance. Credit life insurance satisfies the obligation of the borrower in the event of death, while credit disability insurance satisfies the borrower's obligation to pay instalments during a period of disability. Property insurance insures the collateral against damage or loss. Beginning in April 1991, substantially all such insurance arranged for by the consumer lending operation was underwritten by subsidiaries of the Company's commercial lending operation. Nonearning Receivables Nonearning consumer finance receivables, which are defined as those past due more than 29 days, amounted to $156,542,000 and $140,763,000 at December 31, 1993 and 1992. Payments received on nonearning receivables are applied to principal and interest according to the terms of the loan; however, accrued interest receivable and amortization of other finance charges are recognized in income only on accounts past due less than 30 days. During 1993, the gross amount of interest income that would have been recorded on receivables classified as nonearning at year end was $25,496,000 and the amount of interest on those loans that was recognized in income was $15,234,000. Accounts in Foreclosure and Assets Held for Sale Generally, by the time an account secured by residential real estate becomes past due 90 days, foreclosure proceedings have begun, at which time the account is moved from finance receivables to other assets and is written down to the estimated realizable value of the collateral if less than the account balance. After foreclosure, repossessed assets are carried at the lower of cost or fair value less estimated selling costs and are reclassified to assets held for sale. Accounts in foreclosure and repossessed assets held for sale totaled $214,665,000 at December 31, 1993 compared to $176,054,000 at December 31, 1992. The increase primarily reflects increased repossessions in California and longer disposal times due to its weak real estate market. Offices and Employees The number of offices and employees of the Company in connection with its consumer lending operation as of the dates indicated were as follows: As of December 31, ------------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Offices 561 509 464 448 428 Employees 2,381 2,256 2,148 2,093 1,861 The following table sets forth the geographical distribution of the Company's consumer lending offices at December 31, 1993: No. of No. of Offices Offices ------- ------- United States: United States: Alabama 15 New Jersey 5 Arizona 20 New Mexico 6 California 174 New York 26 Colorado 9 North Carolina 12 Connecticut 2 Ohio 21 Delaware 2 Oklahoma 6 Florida 21 Oregon 10 Georgia 14 Pennsylvania 23 Hawaii 4 Rhode Island 1 Idaho 4 South Carolina 7 Illinois 29 Tennessee 7 Indiana 12 Texas 5 Iowa 6 Utah 4 Kansas 2 Virginia 10 Kentucky 8 Washington 22 Louisiana 8 Wisconsin 10 Maryland 9 Wyoming 1 Massachusetts 3 --- Michigan 8 Minnesota 5 Canada 548 Mississippi 1 United Kingdom 11 Missouri 11 2 Nebraska 2 --- Nevada 3 Total 561 === Competition The Company's consumer lending subsidiaries operate in a highly competitive industry, in many cases competing with companies and financial institutions with long established operating histories and substantial financial resources. Regulation The Company's consumer lending operation is subject to various state and federal laws. Depending upon the type of lending, these laws may require licensing and certain disclosures and may limit the amounts, terms and interest rates that may be offered.COMMERCIAL LENDING General The Company's commercial lending services are provided by Transamerica Commercial Finance Corporation ("Transamerica Commercial Finance"). Transamerica Commercial Finance operates from its executive office in Chicago, Illinois, as well as from 72 branch lending offices. Branch offices are located in the United States (47), Puerto Rico (15), Canada (6) and Europe (4). Transamerica Commercial Finance made a decision late in the fourth quarter of 1991 to exit the rent-to-own finance business, reduce lending to certain asset based lending lines, accelerate disposal of repossessed assets and liquidate receivables remaining from previously sold businesses. As a result of this action the commercial lending operation recognized a special after tax charge of $130,000,000. In conjunction with the decisions discussed above, Transamerica Commercial Finance's operations were reorganized into two core business units: inventory finance and business credit. The lending activities of these core businesses are discussed below. Inventory Finance Inventory finance (also known as wholesale financing or floor plan financing) consists principally of financing dealers' purchases from distributors or manufacturers of goods for inventory. The products financed primarily include boats and other recreational equipment, television and stereo equipment, major appliances such as refrigerators, washers, dryers and air conditioners, and manufactured housing. Loan terms typically provide for repayment within 30 days following sale of the inventory by the borrower. After initial review of a borrower's credit worthiness, the ongoing management of credit risk in this area may include various monitoring techniques, such as periodic physical inventory checks and review of the borrower's sales, as well as maintenance of repurchase agreements with manufacturers which provides a degree of security in the event of slow moving or obsolete inventory. Business Credit Business credit consists of secured loans, primarily revolving, to manufacturers, distributors and selected service businesses, including financial service companies. The loans are fully collateralized, with credit lines typically from $5,000,000 to $25,000,000 and terms ranging from three to five years. Actual borrowings are limited to specified percentages of the borrower's inventory, receivables and other eligible collateral which are regularly monitored to ascertain that outstandings are within approved limits and that the borrower is otherwise in compliance with the terms of the arrangement. The loans to financial service companies are secured by their respective finance receivable portfolios. The company manages its credit risk in this area by monitoring the quality of the borrower's loan portfolio and compliance with financial covenants. Other The "Other" category of receivables includes furniture and appliance retail and finance operations in Puerto Rico and the liquidating portfolios of businesses the company has exited. Transamerica Commercial Finance also offers credit life and credit disability insurance in connection with the financing activities of both the consumer and commercial lending operations and to unrelated third party lenders. The unrelated insurance accounted for substantially all of the insurance subsidiaries' total premium volume in 1990, 64% in 1991, 45% in 1992 and 7% in 1993.Interest Rate Sensitivity As a result of the relatively short-term nature of its financings, Transamerica Commercial Finance is able to adjust its finance charges rather quickly in response to competitive factors and changes in its costs. However, the interest rates at which Transamerica Commercial Finance borrows funds for its businesses generally move more quickly than the rates at which it lends to customers. As a result, in rising interest rate environments, margins are normally compressed until interest rates restabilize. Conversely, in declining interest rate environments, margins are generally enhanced. Acquisitions and Divestitures In March 1992, the commercial lending operation purchased for cash a business credit portfolio consisting of twelve manufacturer/distributor accounts with a net outstanding balance of $134,000,000. In September 1991, an inventory finance portfolio was purchased for cash, which comprised lending arrangements with over 700 manufactured housing and recreational product dealers with a net balance outstanding of $290,604,000. These transactions were funded with short-term debt. The commercial lending operation sold its automobile fleet leasing operation in 1990 and its commercial leasing and wholesale automobile financing operations in 1989. Finance receivables included in the assets sold totaled $45,478,000 in 1990 and $534,734,000 in 1989. Also in 1990, the insurance finance operations were dividended to TFG. Commercial Finance Receivables The following tables set forth the volume of commercial finance receivables acquired during the years indicated and the amount of commercial finance receivables outstanding at the end of each such year: Earned finance charges as a percentage of the average amount of net finance receivables outstanding during each of the years 1989 through 1993 were 14.9%, 14.7%, 13.3%, 12.1% and 11.3%. Delinquent Receivables Effective in 1993, the policy used for determining delinquent receivables was revised to provide greater consistency among the company's receivable portfolios. It is management's view that the new methodology provides a better and more meaningful assessment of the condition of the portfolio. Delinquent receivables are now defined as the instalment balance for inventory finance and business credit receivables and the receivable balance for all other receivables over 60 days past due. Previously, delinquent receivables were generally defined as financed inventory sold but unpaid 30 days or more, the portion of business credit loans in excess of the approved lending limit and all other receivable balances contractually past due 60 days or more. The following table shows the ratio of deliquent commercial finance receivables to finance receivables outstanding for each category and in total as of the end of each of the years indicated. Delinquency ratios for 1992 and prior years have not been restated for the change in policy outlined above. As of December 31, ---------------------------------------------- 1993 1992 1991 1990 1989 ------ ------ ------ ------ ----- Inventory finance(1) 0.13% 0.82% 1.31% 3.42% 2.95% Insurance finance(2) 1.78 Business credit(1)(3) 0.21 0.88 10.34 2.35 ------ ------ ------ ------ ----- Core businesses 0.10 0.68 1.25 5.78 2.63 Other(4) 19.14 22.42 25.84 12.79 9.54 ------ ------ ------ ------ ----- Total(5) 1.02% 2.38% 5.64% 6.65% 3.61% ====== ====== ====== ====== ====== - --------------- (1)The decreases in 1992 and 1991 reflect write offs of delinquent accounts (and accounting reclassifications - see note 3 on preceding table), implementation of stronger portfolio management procedures and general improvement in the economy. Increased delinquency in 1990 reflected the overall weak economy. This trend began in 1989 when consumer spending, which supports these businesses, began to decline. Particularly affected were the marine industry (inventory finance), and the appliance and furniture rental and Canadian computer markets (business credit). (2)See note 2 on preceding table. (3)The decline in 1991 was due principally to rent-to-own finance receivables being reclassified to assets held for sale, and certain finance receivables being reclassified to the "other" category. These reclassifications resulted from the company's decision to exit the rent-to-own finance business and reduce its lending to certain asset based lending lines. Prior year data has not been restated. (4)Represents finance receivables retained from businesses sold or exited which are being liquidated and receivables reclassified in 1991 due to the company's decision to reduce lending to certain asset based lending lines (see note 3 on preceding table). (5)Delinquency statistics exclude assets held for sale (see discussion on page 13). -------------------- Nonearning Receivables Effective in 1993, the policy used for determining nonearning receivables was revised to provide greater consistency among the company's receivable portfolios. It is management's view that the new methodology provides a better and more meaningful assessment of the condition of the portfolio. Nonearning receivables are now defined as balances from borrowers that are over 90 days delinquent or at such earlier time as full collectibility becomes doubtful. Previously, nonearning receivables were defined as balances from borrowers in bankruptcy or litigation and other accounts for which full collectibility was doubtful. Accrual of finance charges is suspended on nonearning receivables until such time as past due amounts are collected. Nonearning receivables were $31,763,000 (1.20% of receivables outstanding) and $90,919,000 (3.42% of receivables outstanding) at December 31, 1993 and 1992; the 1992 data has not been restated. Those amounts exclude nonearning rent-to-own finance receivables which have been reclassified to assets held for sale (see page 13). During 1993, the gross amount of interest income that would have been recorded on receivables classified as nonearning at year end was $4,649,000 and the amount of interest on those loans that was recognized in income was $2,423,000.Assets Held for Sale Assets held for sale at December 31, 1993 totaled $90,114,000, net of a $156,985,000 valuation allowance and consisted of rent-to-own finance receivables of $120,469,000, repossessed rent-to-own stores of $107,227,000 and other repossessed assets of $19,403,000. Assets held for sale at December 31, 1992 totaled $191,515,000, net of a $121,549,000 valuation allowance, and comprised rent-to-own finance receivables of $179,013,000, repossessed rent-to-own stores of $103,418,000 and other repossessed assets of $30,633,000. At December 31, 1993, $27,489,000 of the rent-to-own finance receivables were classified as both delinquent and nonearning. At December 31, 1992, delinquent rent-to-own finance receivables were $15,397,000 and nonearning rent-to-own finance receivables were $32,615,000. Delinquent and nonearning receivables as of December 31, 1992 have not be restated for the change in policies effective in 1993 as outlined above. Credit Loss Experience Certain information regarding credit losses on finance receivables for the commercial lending operation during the years indicated is set forth in the following table: [CAPTION] Offices and Employees The number of offices and employees of the Company in connection with its commercial lending operation as of the dates indicated were as follows: As of December 31, --------------------------------------------- 1993 1992 1991 1990 1989 ------ ------ ------ ------ ------ Offices 72 108 130 152 231 Employees 1,899 1,993 2,114 2,292 3,011 The following table sets forth the geographical distribution of the Company's commercial lending offices at December 31, 1993: No. of No. of Offices Offices ------- ------- United States: United States: Alabama 1 South Dakota 1 California 3 Tennessee 2 Colorado 1 Texas 4 Florida 1 Virginia 1 Georgia 2 Wisconsin 2 Hawaii 1 --- Illinois 10 47 Indiana 1 --- Iowa 1 Puerto Rico 15 Kansas 1 --- Minnesota 2 Canada: Mississippi 1 Alberta 1 Missouri 1 British Columbia 1 New Hampshire 1 Ontario 3 New Jersey 2 Quebec 1 New York 3 --- North Carolina 2 6 Ohio 1 --- Oregon 1 Europe: Pennsylvania 1 France 1 Netherlands 1 United Kingdom 2 --- --- Total 7 === Competition The Company's commercial lending subsidiaries operate in a highly competitive industry, in many cases competing with companies with long established operating histories and substantial financial resources. Regulation The Company's commercial lending operation is subject to various state and federal laws. Depending upon the type of lending, these laws may require licensing and certain disclosures and may limit the amounts, terms and interest rates that may be offered.LEASING OPERATION General Transamerica Leasing Inc. ("Transamerica Leasing") leases, services and manages containers, chassis and trailers around the world. The company is based in Purchase, New York and maintains 386 offices, depots and other facilities in 44 countries. The company specializes in intermodal transportation equipment, which allows goods to travel by road, rail or ship. The company's customers include railroads, steamship lines and motor carriers. At December 31, 1993, Transamerica Leasing's fleet consisted of standard containers, refrigerated containers, domestic containers, tank containers and chassis totaling 316,000 units which are owned or managed, and leased from 347 depots worldwide, 36,500 rail trailers leased to all major United States railroads and to roll on/roll off steamship operators, shippers, shippers' agents and regional truckers, and 3,800 over-the-road trailers in Europe. Transamerica Leasing began leasing tank containers for carrying bulk liquids in 1990 and had 1,900 tank containers in its fleet at December 31, 1993. In November 1992, the company sold its domestic over-the-road trailer business. Proceeds from the sale totaled $191,000,000 and resulted in no gain or loss. Approximately 49% of the standard container, refrigerated container, domestic container, tank container and chassis fleet is on term lease or service contract minimum lease for periods of one to five years. Also, 34% of the rail trailer fleet is on term lease or service contract minimum lease for periods of one to five years. The following table sets forth Transamerica Leasing's fleet size in units as of the end of each of the years indicated: As of December 31, --------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Containers and 316,000 280,000 255,100 244,400 235,900 chassis Rail trailers 36,500 34,400 36,800 40,500 43,300 European trailers 3,800 2,900 1,700 800 The following table sets forth Transamerica Leasing's fleet utilization for the years indicated: Years Ended December 31, -------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Containers and chassis 83% 85% 89% 90% 93% Rail trailers 91% 84% 75% 79% 83% European trailers 89% 84% 83% 81% The 1993 container and chassis utilization decline was due to slow economic growth in key European economies and Japan; the 1992 decline was due to higher than expected industry-wide supply of equipment. The 1991 and 1990 reductions resulted from a small decline in the rate of growth of world trade and a less favorable geographic balance of business. The rail trailer utilization increased in 1993 and 1992 due to a smaller industry fleet, higher domestic economic activity and because many shippers are moving from trucks to rail transport for long- haul shipments; the 1991 and 1990 declines were due to reduced domestic economic activity. Revenues of the domestic leasing operation derived from foreign customers were $210,301,000 in 1993, $176,172,000 in 1992 and $137,127,000 in 1991, of which European customers accounted for 41%, 42% and 40%. Revenues of foreign-domiciled leasing operations were less than 10% of the consolidated total in each of the three years in the period ended December 31, 1993.Offices and Employees The number of offices, depots and other facilities, and employees of the Company in connection with its leasing operation as of the dates indicated were as follows: As of December 31, ------------------------------------ 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Offices, depots and other facilities 386 386 301 306 322 Employees 765 796 946 1,026 1,055 Competition Transamerica Leasing operates in a highly competitive industry, in many cases competing with companies with long established operating histories and substantial financial resources. Subsequent Event On March 15, 1994, the Company completed the purchase of substantially all of the assets of the container rental division of Tiphook plc for approximately $1,100,000,000 in cash. BORROWING OPERATIONS Funds employed in the Company's operations are obtained from invested capital, retained earnings and the sale of short and long-term debt. Capitalization of the Company as of the dates indicated was as follows: Short-term borrowings before reclassification to long-term debt (see Note G of Notes to Financial Statements, Item 8) are primarily in the form of commercial paper notes issued by the Company. Such commercial paper is continuously offered, with maturities not exceeding 270 days in the U.S. and 365 days in Canada, at prevailing rates for major finance companies. Bank loans are an additional source of short-term borrowings. At December 31, 1993, $721,814,000 of bank credit lines were available to the Company, $75,000,000 of which were also available to Transamerica Corporation. At December 31, 1993, all borrowings under these lines were made by the Company and amounted to $240,927,000. The cost of short-term borrowings is directly related to prevailing rates of interest in the money market; such rates are subject to fluctuation. Interest rates on borrowings during the years indicated were as follows: Years Ended December 31, ----------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Weighted average annual interest rate during year:(1) Short-term borrowings 3.41% 3.93% 6.47% 8.23% 9.26% Long-term borrowings 8.24% 8.71% 9.77% 9.23% 9.69% Total borrowings 6.00% 6.87% 8.28% 9.22% 9.68% (1) Excludes the cost of maintaining credit lines and the effect of interest rates on borrowings denominated in foreign currencies. Return on Assets and Equity Certain information regarding the Company's consolidated return on assets and equity, and certain other ratios, are set forth below: Years Ended December 31, ---------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Return on assets(1) 1.1% 1.9% (1.2)% 1.4% 2.1% Return on equity(2) 6.9% 11.7% (7.6)% 8.2% 12.3% Dividend payout ratio(3) 75.2% 55.7% N.A. 136.3% 64.8% Equity to assets ratio(4) 16.2% 16.2% 16.2 % 16.7% 16.8% (1) Net income divided by simple average total assets. (2) Net income divided by simple average equity. (3) Cash dividends declared (excluding cash dividends in connection with corporate restructuring in 1990) divided by net income. (4) Simple average equity divided by simple average total assets. Ratio of Earnings to Fixed Charges The following table sets forth the consolidated ratios of earnings to fixed charges for the years indicated. The ratios are computed by dividing income from continuing operations before income taxes, extraordinary loss on early extinguishment of debt and cumulative effect of change in accounting, and before fixed charges, by the fixed charges. Fixed charges consist of interest and debt expense, and one-third of rent expense (which approximates the interest factor). Years Ended December 31, -------------------------------------------- 1993 1992 1991 1990 1989 Ratio of earnings 1.50 1.59 0.77 1.28 1.42 to fixed charges Excluding the effect of the previously discussed special charge ($130,000,000 after tax) reported by the commercial lending operation, the ratio of earnings to fixed charges would have been 1.14 for 1991. ITEM 2. ITEM 2. PROPERTIES Transamerica Finance Corporation leases its principal executive offices at 1150 South Olive Street, Los Angeles, California, from an affiliated company under a lease expiring in November 1994 at an annual rental of approximately $2,000,000. The Company and its subsidiaries have noncancelable lease agreements expiring mainly through 1998. These agreements are principally operating leases for facilities used in the Company's operations.ITEM 3. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Omitted in accordance with General Instruction J. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Not applicable. All of the outstanding shares of the Registrant's capital stock are owned by Transamerica Finance Group, Inc., which is wholly owned by Transamerica Corporation. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Omitted in accordance with General Instruction J. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Omitted in accordance with General Instruction J. See "Management's Discussion and Analysis of the Results of Operations" following the Notes to Financial Statements (Item 8). ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to this Item is submitted as 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 Omitted in accordance with General Instruction J. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Omitted in accordance with General Instruction J. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Omitted in accordance with General Instruction J. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Omitted in accordance with General Instruction J. 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) List of Exhibits: EX-2 Assets Purchase Agreement dated as of February 13, 1994 between Transamerica Container Acquisition Corporation and Tiphook plc and certain of its affiliated companies. EX-2.1 Amendment and Supplement to Asset Purchase Agreement dated as of March 15, 1994 between Transamerica Container Acquisition Corporation and the Container Rental Division of Tiphook plc. EX-3(i).1 Transamerica Finance Corporation Restated Certificate of Incorporation as filed with the Secretary of State of Delaware on December 12, 1988 (incorporated by reference to Exhibit 3.1 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1988). EX-3(i).2 Transamerica Finance Corporation Certificate of Amendment of Certificate of Incorporation as filed with the Secretary of State of Delaware on February 19, 1991 (incorporated by reference to Exhibit 3.1a to Registrant's Form 10-K Annual Report (File No. 1- 6798) for the year ended December 31, 1990). EX-3(ii) Transamerica Finance Corporation By-Laws, as amended, last amendment - December 12, 1988 (incorporated by reference to Exhibit 3.2 to Registrant's Form 10-K Annual Report (File No. 1- 6798) for the year ended December 31, 1988). EX 4 Indenture dated as of November 1, 1987 between Registrant and Harris Trust and Savings Bank, as Trustee (incorporated by reference to Exhibit 4.2 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1988). EX-10.1 Lease dated October 31, 1984 between Transamerica Occidental Life Insurance Company, as lessor, and Registrant, as lessee, and Addendums thereto dated November 14, 1984 and November 7, 1989 (incorporated by reference to Exhibit 10.1 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1989). EX-10.2 Loan Sales Agreement dated as of November 1, 1990 between Transamerica Financial Services and Transamerica Financial Services Finance Co. (incorporated by reference to Exhibit 10.2 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990). EX-10.3.a Corporate Separateness Agreement dated as of December 17, 1990 between Transamerica Financial Services and Transamerica Financial Services Finance Co. (incorporated by reference to Exhibit 10.3.a to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990). EX-10.3.b Corporate Separateness Agreement dated as of December 17, 1990 between Transamerica Finance Group, Inc. [subsequently renamed Transamerica Finance Corporation] and Transamerica Financial Services Finance Co. (incorporated by reference to Exhibit 10.3.b. to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990).EX-10.4 Pooling and Servicing Agreement dated as of November 1, 1990 among Transamerica Financial Services, as servicer, Transamerica Financial Services Finance Co., as seller, and The First National Bank of Chicago, as Trustee (incorporated by reference to Exhibit 2 to Form 8-A Registration Statement re: TFG Home Loan Trust 1990- 1 dated March 26, 1991 - Registration No. 33-36431-01). EX-10.5 Investment Agreement dated December 17, 1990 among Transamerica Finance Group, Inc. [subsequently renamed Transamerica Finance Corporation], Transamerica Financial Services Finance Co., as seller, and The First National Bank of Chicago, as Trustee (incorporated by reference to Exhibit 2 to Form 8-A Registration Statement re: TFG Home Loan Trust 1990-1 dated March 26, 1991 - Registration No. 33-36431-01). EX-10.6 Guaranty dated July 31, 1990 by Transamerica Finance Group, Inc. [subsequently renamed Transamerica Finance Corporation], in favor of Corporate Asset Funding Company, Inc. et. al. re: certain obligations of Transamerica Insurance Finance Corporation, California (incorporated by reference to Exhibit 10.6 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990). EX-10.7 Guaranty dated July 31, 1990 by Transamerica Finance Group, Inc. [subsequently renamed Transamerica Finance Corporation], in favor of Corporate Asset Funding Company, Inc. et. al. re: certain obligations of Transamerica Insurance Finance Corporation (incorporated by reference to Exhibit 10.7 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990). EX-12 Computation of Ratio of Earnings to Fixed Charges. EX-23 Consent of Ernst & Young to the incorporation by reference of their report dated February 16, 1994 in the Registrant's Registration Statements on Form S-3, File Nos. 33-40236 and 33- 49763. Pursuant to the instructions as to exhibits, the registrant is not filing certain instruments with respect to long-term debt since the total amount of securities currently authorized under each of such instruments does not exceed 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. The registrant hereby agrees to furnish a copy of any such instrument to the Commission upon request. (b) Reports on Form 8-K filed in the fourth quarter of 1993: A report on Form 8-K was filed on November 19, 1993 relating to the proposed acquisition by the Registrant or one of its subsidiaries of Tiphook plc, a London-based container, trailer, and rail equipment lessor. (c) Exhibits: The response to this portion of Item 14 is submitted as a separate section of this report. (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. TRANSAMERICA FINANCE CORPORATION (Registrant) By RAYMOND A. GOLAN (Raymond A. Golan, Vice President and Controller) Date: March 15, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 15, 1994. Signature Title Principal Executive Officer and Director: RICHARD H. FINN Chief Executive Officer and Director - ---------------------------- (Richard H. Finn) Principal Financial Officer and Director: Senior Vice President, Treasurer and DAVID H. HAWKINS Director - ---------------------------- (David H. Hawkins) Principal Accounting Officer: RAYMOND A. GOLAN - ---------------------------- (Raymond A. Golan) Vice President and Controller Directors: - ---------------------------- (David R. Carpenter) Director KENT L. COLWELL - ---------------------------- (Kent L. Colwell) Director EDGAR H. GRUBB - ---------------------------- (Edgar H. Grubb) Director FRANK C. HERRINGER - ---------------------------- (Frank C. Herringer) Director ROBERT R. LINDBERG - ---------------------------- (Robert R. Lindberg) Director ALLEN C. MIECH - ---------------------------- (Allen C. Miech) Director CHARLES E. TINGLEY - ---------------------------- (Charles E. Tingley) Director (THIS PAGE INTENTIONALLY LEFT BLANK) ANNUAL REPORT ON FORM 10-K ITEM 8, ITEM 14(a)(1) and (2), (c) and (d) FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES Year Ended December 31, 1993 TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES LOS ANGELES, CALIFORNIA (THIS PAGE INTENTIONALLY LEFT BLANK) FORM 10-K - ITEM 8, ITEM 14(a)(1) and (2) TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following financial statements of Transamerica Finance Corporation and subsidiaries, together with the report of the independent auditors, are included in Item 8: Report 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 Cash Flows -- Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Shareholder's Equity -- Years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Management's Discussion and Analysis of the Results of Operations -- Year ended December 31, 1993 Supplementary Financial Information -- Years ended December 31, 1993 and 1992 The following consolidated financial statement schedules of Transamerica Finance Corporation and subsidiaries are included in Item 14(d): VIII - Valuation and Qualifying Accounts -- Years ended December 31, 1993, 1992 and 1991 IX - Short-Term Borrowings -- Years ended December 31, 1993, 1992 and 1991 X - Supplementary Income Statement Information -- Years ended December 31, 1993, 1992 and 1991 All other schedules for which provision is made in the applicable accounting 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 Shareholder and Board of Directors Transamerica Finance Corporation We have audited the accompanying consolidated balance sheet of Transamerica Finance Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and shareholder's equity 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 Transamerica Finance Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note J to the consolidated financial statements, effective January 1, 1991 the Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. ERNST & YOUNG Los Angeles, California February 16, 1994, except for Note N, as to which the date is March 15, 1994 See notes to financial statements. TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (dollar amounts in thousands) Note A - Significant Accounting Policies Transamerica Finance Corporation (together with its consolidated subsidiaries, the "Company") is principally engaged in consumer lending, commercial lending and leasing operations. The Company is a wholly owned subsidiary of Transamerica Finance Group, Inc., which is a wholly owned subsidiary of Transamerica Corporation. Certain amounts for prior years have been reclassified to conform with the 1993 presentation. The significant accounting policies followed by the Company and its subsidiaries are: Consolidation - The consolidated financial statements include the accounts of Transamerica Finance Corporation and all its majority owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. The Company's nonvoting preferred stock ownership interest in the distributable earnings of Transamerica Financial Services Finance Co. ("TFSFC"), which is the Company's only significant non-majority owned investee, is accounted for by the equity method after elimination of intercompany transactions (see Note M.) Cash and Cash Equivalents - Cash and cash equivalents include all highly liquid investments with original maturities of three months or less except for such securities held by the Company's credit insurance subsidiaries which are included in investments. Depreciation and Amortization - Property and equipment, which are stated on the basis of cost, are depreciated by use of the straight- line method over their estimated useful lives, which range from eight to 15 years (with residual values of 10% to 20%) for equipment held for lease, three to 10 years for administrative and service equipment, and 20 years for buildings. Other intangible assets, principally renewal, referral and other rights incident to businesses acquired, are amortized over estimated future benefit periods ranging from five to 25 years in proportion to estimated revenues. Goodwill is amortized over 40 years. Foreign Currency Translation - The net assets and operations of foreign subsidiaries included in the consolidated financial statements are attributable to Canadian and European operations. The accounts of these subsidiaries have been converted at rates of exchange in effect at year end as to balance sheet accounts and at average rates for the year as to operations. The effect of changes in exchange rates in translating foreign subsidiaries' financial statements is accumulated in a separate component of shareholder's equity. The effect of transaction gains and losses on the Consolidated Statement of Operations is insignificant for all years presented. Transactions with Affiliates - In the normal course of operations, the Company has various transactions with Transamerica Corporation and certain of its other subsidiaries. In addition to the filing of consolidated income tax returns and the transactions discussed in Notes J and M, these transactions include computer and other specialized services, various types of insurance coverage and pension administration, the effects of which are insignificant for all years presented.Finance Charges - Finance charges, including loan origination fees, offset by direct loan origination costs, are generally recognized as earned on an accrual basis under an effective yield method, except that accrual of finance charges is suspended on accounts that become past due in excess of 29 days in the case of consumer loans or 60 days for commercial loans. At December 31, 1993 and 1992, finance receivables for which the accrual of finance charges was suspended approximated $188,300 and $231,700. Charges collected in advance, including renewal charges, on inventory finance receivables are taken into income on a straight-line basis over the periods to which the charges relate. Allowance for Losses - The allowance for losses is maintained in an amount sufficient to cover estimated uncollectible receivables. Such estimates are based on percentages of net finance receivables outstanding developed from historical credit loss experience and, if appropriate, provision for deviation from historical averages, supplemented in the case of commercial loans by specific reserves for accounts known to be impaired. The allowance is provided through charges against current income. Accounts are charged against the allowance when they are deemed to be uncollectible. When foreclosure proceedings are begun in the case of a real estate secured consumer loan, the account is written down to the estimated realizable value of the collateral if less than the account balance. After foreclosure, repossessed assets are carried at the lower cost or fair value less estimated selling costs and are reclassified to assets held for sale. Additionally, accounts are generally charged against the allowance when no payment has been received for six months for consumer lending and when all avenues for repayment have been exhausted for commercial lending. Leasing Revenues - Leasing revenues include income from operating, finance and sales-type leases. Operating lease income is recognized on the straight-line method over the lease term. Finance lease income, represented by the excess of the total lease receivable (reduced by the amount attributable to contract maintenance) over the net cost of the related equipment, is deferred and amortized over the noncancelable term of the lease using an accelerated method which provides a level rate of return on the outstanding lease contract receivable. Dealer profit on sales-type leases, represented by the excess of the total fair market value of the equipment over its cost or carrying value, is recognized at the inception of the lease. Unearned income is amortized over the term of the lease in the same manner described above. Contract maintenance revenues are credited to income on a straight-line basis over the term of the related leases. Income Taxes - Taxable results of the Company's operations are included in the consolidated federal and certain state income tax returns filed by Transamerica Corporation, which by the terms of a tax sharing agreement generally requires the Company to accrue and settle income tax obligations as if it filed separate returns with the applicable taxing authorities. The Company provides deferred income taxes based on enacted rates in effect on the dates temporary differences between the book and tax bases of assets and liabilities reverse. In 1988, the Company adopted the liability method of accounting for income taxes and the adoption of Financial Accounting Standard No. 109, Accounting for Income Taxes, in 1992 had no effect on the financial statements. New Accounting Standards - In May 1993, the Financial Accounting Standards Board issued a new standard on accounting for impairment of loans which the Company must adopt by the first quarter of 1995. The new standard requires that impaired loans be measured based on either the fair value of the loan, if discernible, the present value of expected cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent. When adopted, the new standard is not expected to have a material effect on the consolidated financial statements of the Company. Also in May 1993, the Financial Accounting Standards Board issued a new standard on accounting for certain investments in debt and equity securities which the Company will adopt in the first quarter of 1994. Under the new standard the Company will report at fair value its investments in debt securities for which the Company does not have the positive intent and ability to hold to maturity. Unrealized gains and losses will be reported on an after tax basis in a separate component of shareholder's equity.When adopted, the new standard is not expected to have a material effect on the consolidated financial statements of the Company. Note B - Investments Investments are summarized as: 1993 1992 ---- ---- Fixed maturities, at amortized cost (market value: $103,035 $ 92,004 $111,621 in 1993 and $97,903 in1992) Equity securities, at market value 765 (cost: $683 in 1992) Short-term investments 7,043 4,933 -------- -------- Total $110,078 $ 97,702 Investments totaling $4,175 at December 31, 1993 and 1992 were on deposit with various states to meet requirements of state insurance and financial codes. In addition, various state insurance codes require that the Company's credit insurance subsidiaries hold an amount equal to their statutory unearned premium reserve ($36,069 and $42,442 at December 31, 1993 and 1992) as cash or in suitable investments for the protection of policyholders. Such assets are not available for distribution until all liabilities on insurance policies have been discharged. There were no unrealized gains or losses on marketable equity securities at December 31, 1993. Note C - Concentration of Risk During the normal conduct of its operations, the Company engages in the extension of credit to homeowners, electronics and appliance dealers, retail recreational product and computer stores, appliance and furniture rental operations and others. The risk associated with that credit is subject to economic, competitive and other influences. While a substantial portion of the risk is diversified, certain operations are concentrated in one industry or geographic area. The Company's finance receivables at December 31, 1993 included $3,046,579, net of unearned finance charges and insurance premiums, of real estate secured loans, principally first and second mortgages secured by residential properties, of which approximately 49% are located in California. The commercial finance receivables portfolio represents lending arrangements with over 120,000 customers. At December 31, 1993, the portfolio included 11 customers with individual balances in excess of $15,000. These accounts represented 9% of commercial gross finance receivables outstanding at December 31, 1993.Note D - Finance Receivables The carrying amounts and estimated fair values of the finance receivable portfolio at December 31, 1993 and 1992 are as follows: 1993 1992 ------------------------ ------------------------ Estimated Estimated Carrying Fair Carrying Fair Value Value Value Value --------- ----------- --------- -------- Fixed rate receivables: Consumer $3,547,210 $4,307,048 $3,478,148 $4,216,770 Commercial 134,040 132,662 144,881 143,927 Variable rate receivables: Commercial 2,390,328 2,390,328 2,371,483 2,371,483 ---------- ---------- ---------- ---------- $6,071,578 $6,830,038 $5,994,512 $6,732,180 ========== ========== ========== ========== The estimated fair values of consumer finance receivables, substantially all of which are fixed rate instalment loans collateralized by residential real estate, and the fixed rate commercial finance loans are based on the discounted value of the future cash flows expected to be received using available secondary market prices for securities backed by similar loans after adjustment for differences in loan characteristics. In the absence of readily available market prices, the expected future cash flows are discounted at effective rates currently offered by the Company for similar loans. For variable rate commercial loans, which comprise the majority of the commercial loan portfolio, the carrying amount represents a reasonable estimate of fair value. Additional information pertaining to finance receivables outstanding follows: Contractual maturities of finance receivables outstanding, before deduction of unearned finance charges and insurance premiums, at December 31, 1993 are: Experience of the Company has shown that a substantial majority of the consumer finance receivables will be renewed or prepaid many months prior to contractual maturity dates. Accordingly, the above schedule is not to be regarded as a forecast of future cash collections. For 1993 and 1992, the ratio for consumer finance receivables of principal cash collections (excluding balances refinanced) to average net finance receivables was 29% and 26%. The commercial lending operation's business credit unit provides revolving lines of credit, letters of credit and standby letters of credit. At December 31, 1993 and 1992, borrowers' unused credit availability under such arrangements totaled $533,781 and $416,200, and the estimated amount the Company would have to pay another financial institution to assume the possible future obligation to fund them was $1,591 and $,2080. Note E - Allowance for Losses Changes in the allowance for losses on finance receivables are: Consumer Commercial Total --------- ----------- -------- Balance at January 1, 1991 $ 88,535 $ 99,402 $ 187,937 Provision charged to income 42,214 245,190 287,404 Receivables charged off (34,920) (177,083) (212,003) Recoveries 1,934 4,469 6,403 Other 422 (2,449) (2,027) --------- ---------- ---------- Balance at December 31, 1991 98,185 169,529 267,714 Provision charged to income 47,985 36,830 84,815 Receivables charged off (44,448) (122,974) (167,422) Recoveries 1,487 5,922 7,409 Other (2,014) (2,138) (4,152) --------- ---------- ---------- Balance at December 31, 1992 101,195 87,169 188,364 Provision charged to income 62,349 31,793 94,142 Receivables charged off (62,524) (51,832) (114,356) Recoveries 1,871 9,122 10,993 Other 422 (173) 249 --------- ---------- ---------- Balance at December 31, 1993 $ 103,313 $ 76,079 $ 179,392 ========= ========== ========== Note F - Commercial Lending Special Charges and Assets Held for Sale The commercial lending operation made a decision late in the fourth quarter of 1991 to exit the rent-to-own finance business, reduce lending to certain asset based lending lines, accelerate disposal of repossessed assets and liquidate receivables remaining from previously sold businesses. As a result of this action, the commercial lending operation recognized a special pretax charge of $200,220 ($130,000 after tax). The $200,220 special charge comprised $137,404 included in the provision for losses on assets held for sale and $62,816 included in the provision for losses on receivables. The $137,404 provision consisted of $117,304 for anticipated losses on disposition of the assets, generally comprising rent-to-own finance receivables and repossessed collateral, including rent-to-own stores, and $20,100 for implementation costs. The 1991 provision for losses on assets held for sale of $141,225 comprises the $137,404 portion of the special charge referred to above plus an additional provision of $3,821. In 1993, an additional provision of $50,000,000 ($35,960 after tax) was made to reduce the net carrying value of repossessed rent-to-own stores to their estimated realizable value. Assets held for sale are: 1993 1992 ---- ---- Consumer: Repossessed residential properties $137,455 $ 89,405 Other repossessed assets 1,746 2,787 -------- -------- 139,201 92,192 Less valuation allowance 2,547 2,206 -------- -------- 136,654 89,986 -------- -------- Commercial: Rent-to-own finance receivables 120,469 179,013 Repossessed rent-to-own stores 107,227 103,418 Other repossessed assets 19,403 30,633 -------- -------- 247,099 313,064 Less valuation allowance 156,985 121,549 -------- -------- 90,114 191,515 -------- -------- Total $226,768 $281,501 ======== ======== Note G - Debt Debt consists of: 1993 1992 ----- ----- Unsubordinated Short-term debt: Commercial paper $3,585,249 $2,748,766 Other 84,644 64,342 ---------- ---------- 3,669,893 2,813,108 Less classified as long-term debt 2,505,000 2,813,108 ---------- ---------- Total unsubordinated short-term debt 1,164,893 -- ---------- ---------- Long-term debt: Short-term debt supported by noncancelable credit agreements 2,505,000 2,813,108 4.48% to 9.10% notes and debentures due 1994 to 2002 2,323,110 2,673,847 Loans due to Transamerica Corporation and its subsidiaries, at various interest rates, maturing through 1994 67,491 101,376 Zero to 6.50% notes and debentures due 1994 to 2012 issued at a discount to yield 13.80% to 13.88%; with benefit from deferred taxes, effective cost of 8.79% to 12.35%; maturity value of $722,760 274,884 444,200 ---------- ---------- Total unsubordinated long-term debt 5,170,485 6,032,531 ---------- ---------- Total unsubordinated debt 6,335,378 6,032,531 ---------- ---------- Subordinated 6.75% to 12.75% notes due 1994 to 2003 696,125 557,045 ---------- ---------- Total debt $7,031,503 $6,589,576 ========== ========== The estimated fair value of debt, using rates currently available for debt with similar terms and maturities, at December 31, 1993 and 1992 was $7,407,000 and $6,805,000. In 1993, the Company redeemed $125,000 of deep discount long-term debt with a book value of $90,710, which resulted in a $23,084 extraordinary loss, after related taxes of $11,447. Commercial paper notes are issued for maturities up to 270 days in the U.S. and 365 days in Canada. At December 31, 1993, $200,000 of the outstanding commercial paper, which matured January 24, 1994, was held by Transamerica Corporation. In support of its commercial paper operations, bank credit lines aggregating $721,814 at December 31, 1993 were available to the Company, $75,000 of which were also available to Transamerica Corporation. At December 31, 1993, all borrowings under these lines were made by the Company and amounted to $240,927, of which $156,283 is long-term. In support of the short-term debt classified as long-term debt at December 31, 1993, the Company has unsubordinated noncancelable credit agreements totaling $3,433,000 with 55 banks, of which $2,505,000 matures after one year. Fees are paid on the average unused commitment. The Company uses interest rate exchange agreements to hedge the interest rate sensitivity of its outstanding indebtedness. Certain of these agreements call for the payment of fixed rate interest by the Company in return for the assumption by other contracting parties of the variable rate cost. At December 31, 1993, such agreements covering the notional amount of $214,400 at a weighted average fixed interest rate of 8.25% expiring through 1999 and $840,000 of one year agreements expiring in 1994 with an average interest rate of 3.78% were outstanding. Additionally at December 31, 1993, exchange agreements covering the notional amount of $216,000 expiring through 1997 were outstanding, in which the Company receives interest from other contracting parties at a weighted average fixed interest rate of 6.98% and pays interest at variable rates to those parties. While the Company is exposed to credit risk in the event of nonperformance by the other party, nonperformance is not anticipated due to the credit rating of the counter parties. At December 31, 1993, the interest rate exchange agreements are with banks rated A or better by one or more of the major credit rating agencies.The estimated fair value of the interest rate exchange agreements, determined on a net present value basis, at December 31, 1993 and 1992 was a negative $5,320 and $9,067. The fair value represents the estimated amount that the Company would be required to pay to terminate the exchange agreements, taking into account current interest rates. Long-term debt outstanding at December 31, 1993, other than the $2,505,000 supported by noncancelable credit agreements, matures as follows: Unsubordinated Subordinated Total -------------- ------------- ------------ 1994 $ 900,056 $113,350 $1,013,406 1995 703,414 40,000 743,414 1996 469,813 79,195 549,008 1997 198,900 87,100 286,000 1998 196,005 235,480 431,485 Thereafter 197,297 141,000 338,297 ---------- -------- ----------- $2,665,485 $696,125 $3,361,610* ========== ======== =========== *Includes the accreted values at December 31, 1993 on original issue discount debt and not the amount due at maturity. Interest payments, net of amounts received from interest rate exchange agreements, totaled $513,541 in 1993, $558,997 in 1992 and $481,200 in 1991. Note H - Dividend and Other Restrictions Consolidated equity is restricted by the provisions of debt agreements. At December 31, 1993, $180,127 was available for dividends and other stock payments. Under certain circumstances, the provisions of loan agreements and statutory requirements place limitations on the amount of funds which can be remitted to the Company by its consolidated subsidiaries. Of the net assets of the Company's consolidated subsidiaries, as adjusted for intercompany account balances, at December 31, 1993, $51,985 is so restricted. Note I - Income Taxes The provision for income taxes comprises: 1993 1992 1991 Current taxes: Federal $41,544 $ 95,239 $ 13,606 State 15,427 18,391 20,368 Foreign 88 (14,637) 12,722 ------- -------- -------- 57,059 98,993 46,696 ------- -------- -------- Deferred taxes Federal 32,461 588 (53,963) State 5,034 6,533 (8,443) Foreign 803 14,938 (14,378) ------- -------- -------- 38,298 22,059 (76,784) ------- -------- -------- Total income taxes (benefit) $95,357 $121,052 $(30,088) ======= ======== =========The difference between federal income taxes computed at the statutory rate and the total provision for income taxes is: 1993 1992 1991 --------- -------- ------- Federal income taxes (benefit) at statutory rate $76,967 $96,467 $(42,024) State income taxes, net of federal income tax benefit 13,986 16,449 7,953 Book and tax basis difference of assets acquired 2,999 5,026 6,341 Settlement of disputed items (4,224) Dividends from affiliates (663) (2,109) Other 5,629 3,773 (249) -------- -------- --------- Total income taxes (benefit) $95,357 $121,052 $ (30,088) ======= ======== ========= Deferred tax liabilities (assets) are comprised of the following at December 31: 1993 1992 ---- ---- Depreciation $197,196 $190,462 Amortization of bond discount and interest 66,071 65,380 Direct finance and sales type leases 7,865 34,134 Insurance reserves and acquisition costs 9,698 7,785 Other 35,475 10,410 -------- -------- Gross deferred tax liabilities 316,305 308,171 -------- -------- Allowances for losses on finance receivables and other assets (113,331) (104,221) Post employment benefits other than pensions (8,166) (8,343) Net operating loss and foreign tax credit carryforwards (10,683) (33,263) Other (15,993) (21,855) -------- -------- Gross deferred tax assets (148,173) (167,682) -------- -------- Net deferred tax liability $168,132 $140,489 ======== ======== Pretax income (loss) from foreign operations totaled $4,236 in 1993, $4,332 in 1992 and $(25,960) in 1991. Income tax payments totaled $77,089 in 1993, $92,190 in 1992 and $27,802 in 1991. Note J- Pension and Stock Savings Plans and Other Post Employment Benefits The Company participates in the Retirement Plan for Salaried Employees of Transamerica Corporation and Affiliates (the pension plan). The pension plan is a noncontributory defined benefit plan covering substantially all employees. Pension benefits are based on the employee's compensation during the highest paid 60 consecutive months during the 120 months before retirement. Pension costs are allocated to the Company based on the number of participants. The Company also participates in the Transamerica Corporation Employee Stock Savings Plan (the 401(k) plan). The 401(k) plan is a contributory defined contribution plan covering eligible employees who elect to participate. Currently, the Company matches 75 cents for every dollar contributed up to six percent of eligible compensation. The Company matching portion is always invested in Transamerica Corporation common stock. Employees are 25% vested in the matching contributions after three years, 50% vested after four years and 100% vested after five years of service. The Company's total costs for both the pension plan and the 401(k) plan were $9,163 in 1993, $7,913 in 1992 and $9,045 in 1991. The Company also participates in various programs sponsored by Transamerica Corporation that provide medical and certain other benefits to eligible retirees. Effective January 1, 1991, Transamerica Corporation and its subsidiaries elected early adoption of FASB Statement No. 106 on accounting for post employment benefits other than pensions. Adoption of the statement increased the Company's loss before the cumulative effect of the accounting change and net loss for the year ended December 31, 1991 by $377 and $11,252.Note K - Commitments and Contingencies The Company and its subsidiaries have noncancelable lease agreements expiring mainly through 1998. These agreements are principally operating leases for facilities used in the Company's operations. Total rental expense amounted to $54,799 in 1993, $60,286 in 1992 and $62,899 in 1991. Contingent liabilities arising from litigation, income taxes and other matters are not considered material in relation to the consolidated financial position of the Company and its subsidiaries. Note L - Business Segment Information Business segment information is: Note M - Transactions With Affiliates On November 1, 1990, the Company sold without recourse a pool of real estate secured receivables to TFSFC for cash of $547,655 plus interest of $9,661 to the closing date of December 17, 1990. The purchase price, which represented the fair value of the receivables sold, was based on an independent appraisal. For financial reporting purposes, the intercompany gain on this sale has been deferred and is being amortized to income as a component of the Company's equity in the distributable earnings of TFSFC. TFSFC subsequently securitized and sold to outside investors a $430,000 participation interest in the receivable pool. The Company continues to service these receivables for a fee. The Company has entered into an agreement whereby it directs the investment of excess funds in the pool pending their distribution and guarantees that such funds will be invested at a certain minimum rate, currently 9.25%. Investments in and advances to affiliates consist of the following at December 31: 1993 1992 ---- ---- Preferred stock of TFSFC $ 72,946 $ 82,665 Unamortized deferred gain on sale of (18,729) (31,571) receivables to TFSFC Unsecured receivable from BWAC Twelve, 308,858 238,595 Inc. Unsecured receivable from Transamerica HomeFirst, Inc. 7,937 551 -------- -------- $371,012 $290,240 ======== ======== The receivables from BWAC Twelve, Inc. and Transamerica HomeFirst, Inc. are payable on demand and bear interest at a rate that varies based on the Company's average cost of borrowings. The weighted average interest rate was 4.21% in 1993, 4.04% in 1992 and 7.18% in 1991. Under the terms of certain debt agreements, the Company may maintain investments in and advances to affiliates up to $649,621 at December 31, 1993. Income from affiliates comprises the following for the years ended December 31: 1993 1992 1991 ---- ---- ---- Interest income $11,572 $13,486 $14,299 Servicing fees 833 861 866 Amortization of deferred gain and equity in earnings of TFSFC 5,616 6,901 14,359 ------- ------- ------- $18,021 $21,248 $29,524 ======= ======= ======= Note N - Subsequent Event On March 15, 1994, the Company completed the purchase of substantially all of the assets of the container rental division of Tiphook plc for approximately $1,100,000 in cash. TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF THE RESULTS OF OPERATIONS The following table sets forth revenues and income by line of business for the periods indicated (in thousands): Income (Loss) Before Revenues Extraordinary Item ------------------ --------------------- 1993 1992 1993 1992 ------- -------- ------- ------- Consumer lending $651,218 $654,078 $91,742 $99,210 Commercial lending 333,297 356,275 (12,775) 17,938 Leasing 407,774 420,512 53,641 58,068 Other operations (163) 18 1,931 (888) Amortization of goodwill (11,658) (11,656) ---------- ---------- --------- --------- Total $1,392,126 $1,430,883 $122,881 $162,672 ========== ========== ======== ======== The following discussion should be read in conjunction with the information presented under Item 1, Business. Consumer Lending Consumer lending income, before the amortization of goodwill, in 1993 decreased $7,468,000 (8%) from 1992. The decrease was principally due to increased operating expenses, an increased provision for losses on receivables and lower revenues that more than offset lower interest expense and a $5,269,000 benefit included in operating expenses from a reversal of reserves related to a 1990 sales of receivables to Transamerica Financial Services Finance Co. which subsequently were securitized. Revenues in 1993 decreased $2,860,000 (%) from 1992 principally because of lower income from affiliates and servicing fees related to the run off of the receivables that Transamerica Financial Services Finance Co. securitized in 1990 and lower fees due to reduced volume of real estate secured loans. Operating expenses increased in 1993 mainly due to investments in new branches and losses on the disposal of repossessed assets. With the adoption in the fourth quarter of 1992 of a required new accounting rule, losses on the disposal of repossessed assets, which were $5,952,000 for 1993 and $3,021,000 in the fourth quarter of 1992, were classified as operating expenses rather than as credit losses. Data for periods prior to the fourth quarter of 1992 have not been reclassified. The provision for losses on receivables increased $14,364,000 (30%) in 1993 over 1992 due to increased credit losses. Credit losses, net of recoveries, as a percentage of average consumer finance receivables outstanding, net of unearned finance charges and insurance premiums, were 1.67% in 1993 compared to 1.22% in 1992. Credit losses increased partly due to continued sluggishness in the domestic economy and a weak California real estate market. Interest expense declined $24,449,000 (9%) in 1993 from 1992 due to a lower average interest rate which more than offset the effect of higher borrowings due to increased average receivables outstanding. Net consumer finance receivables outstanding increased $71,180,000 (2%) in 1993. Net consumer finance receivables at December 31, 1993 included $3,046,579 of real estate secured loans, principally first and second mortgages secured by residential properties, of which approximately 49% are located in California. Company policy generally limits the amount of cash advanced on any one loan, plus any existing mortgage, to between 70% and 80% (depending on location) of the appraised value of the mortgaged property, as determined by qualified independent appraisers at the time ofloan origination. Delinquent real estate secured loans, which are defined as loans contractually past due 60 days or more, totaled $59,767 (1.86% of total real estate secured loans outstanding) at December 31, 1993 compared to $60,211,000 (1.84% of total real estate secured loans outstanding) at December 31, 1992. Management has established an allowance for losses equal to 2.83% of net consumer finance receivables outstanding at December 31, 1993 and 1992. Generally, by the time an account secured by residential real estate becomes past due 90 days, foreclosure proceedings have begun, at which time the account is moved from finance receivables to other assets and is written down to the estimated realizable value of the collateral if less than the account balance. After foreclosure, repossessed assets are carried at the lower of cost or fair value less estimated selling costs and are reclassified to assets held for sale. Accounts in foreclosure and repossessed assets held for sale totaled $214,665,000 at December 31, 1993 compared to $176,054,000 at December 31, 1992. The increase primarily reflects increased repossessions in California and longer disposal times due to its weak real estate market. Commercial Lending Commercial lending results, before the amortization of goodwill and a $23,084,000 after tax extraordinary loss on the early extinguishment of $125,000,000 deep discount long-term debt in 1993, were a a loss of $12,775,000 for 1993 compared to income in 1992 of $17,938,000. The 1993 loss was due primarily to the inclusion of a $50,000,000 ($35,960,000 after tax) provision to reduce the net carrying value of repossessed rent-to-own stores to their estimated realizable value. Information received during the year from prospective buyers of the repossessed rent-to-own stores held for sale indicated that the realizable value of the business had declined below its carrying value. The 1993 results also included an $8,799,000 after tax charge for the restructuring of the commercial lending unit's infrastructure, a $4,224,000 after tax provision for anticipated legal and other costs associated with the runoff of the liquidating portfolios and a $4,224,000 tax benefit from the resolution of prior years' tax matters. Excluding the aforementioned items, commercial lending income, before the amortization of goodwill and the extraordinary loss on the early extinguishment of debt, increased $14,046,000 (78%) in 1993 over 1992. This improvement was primarily due to lower operating expenses, a lower provision for losses on receivables and stronger margins brought about by the declining interest rate environment. The interest rates at which commercial lending borrows funds for its businesses have moved more quickly than the rates at which it lends to its customers. As a result, margins have been enhanced by the declining interest rate environment. Revenues in 1993 decreased $22,978,000 (6%) from 1992 primarily as a result of reduced yields attributable to the current low interest rate environment. Interest expense declined $25,459,000 (19%) in 1993 from 1992 as a result of lower average interest rates. Operating expenses increased $14,127,000 (9%) during 1993 over 1992 due to the restructuring charge and provision for anticipated legal and other costs associated with the runoff of the liquidating portfolios described above, aggregating $21,500,000, partially offset by cost reduction efforts in the inventory finance and business credit core businesses. The provision for losses on receivables in 1993 was $5,037,000 (14%) less than in 1992 primarily due to lower credit losses. Credit losses, net of recoveries, as a percentage of average commerical finance receivables outstanding, net of unearned finance charges, were 1.64% in 1993 compared to 4.53% in 1992. Credit losses declined in 1993 primarily due to lower losses in the liquidating portfolios. In March 1992, the commercial lending operation purchased for cash a business credit portfolio consisting of twelve manufacturer/distributor accounts with a net outstanding balance of $134,000,000. Net commercial finance receivables outstanding decreased $3,086,000 (%) from December 31, 1992. Growth in the inventory finance portfolio was more than offset by a decline in the liquidating and business credit portfolios. Management has established an allowance for credit losses equal to 2.93% of net commercial finance receivables outstanding as of December 31, 1993 compared to 3.35% at December 31, 1992. Effective in 1993, the policies used for the determination of delinquent and nonearning receivables have been revised to provide greater consistency among the company's receivable portfolios. It is management's view that the new methodology provides a better and more meaningful assessment of the condition of the portfolio. Delinquent receivables, which were generally defined as financed inventory sold but unpaid 30 days or more, the portion of business credit loans in excess of the approved lending limit and all other receivable balances contractually past due 60 days or more, are now defined as the instalment balance for inventory finance and business credit receivables and the receivable balance for all other receivables over 60 days past due. Nonearning receivables, which were defined as receivables from borrowers in bankruptcy or litigation and other accounts for which full collectibility was doubtful, are now defined as receivables from borrowers that are over 90 days delinquent or at such earlier time as full collectibility becomes doubtful. At December 31, 1993, delinquent receivables were $26,940,000 (1.02% of receivables outstanding) and nonearning receivables were $31,763,000 (1.20% of receivables outstanding). At December 31, 1992, delinquent receivables were $63,384,000 (2.38% of receivables outstanding) and nonearning receivables were $90,919,000 (3.42% of receivables outstanding). Delinquency and nonearning data as of December 31, 1992 has not been restated. Assets held for sale as of December 31, 1993 totaled $90,114,000, net of a $156,985,000 valuation allowance, and consisted of rent-to-own finance receivables of $120,469,000, repossessed rent-to-own stores of $107,227,000 and other repossessed assets of $19,403,000. Assets held for sale at December 31, 1992 totaled $191,515,000, net of a $121,549,000 valuation allowance, and comprised rent-to-own finance receivables of $179,013,000, repossessed rent-to-own stores of $103,418,000 and other repossessed assets of $30,633,000. At December 31, 1993, $27,489,000 of the rent-to-own finance receivables were classified as both delinquent and nonearning. At December 31, 1992, delinquent rent-to-own finance receivables were $15,397,000 and nonearning rent-to-own finance receivables were $32,615,000. Delinquency and nonearning data as of December 31, 1992 has not been restated. Leasing Leasing income, before the amortization of goodwill, decreased $4,427,000 (8%) in 1993 due primarily to an additional tax provision of $4,300,000 caused by the revaluation of deferred income tax liability for the 1993 federal tax rate increase. Excluding the additional tax provision, results for 1993 were comparable to 1992 as higher fleet utilization and per diem rates in the rail trailer business, a larger finance lease portfolio and a larger fleet of refrigerated containers were offset by a decline in standard container utilization. In November 1992, the company sold its domestic over-the-road trailer business. Proceeds from the sale totaled $191,000,000 and resulted in no gain or loss. Revenues for 1993 decreased $12,738,000 (3%) from 1992. The decline was mainly due to the sale of the domestic over-the-road trailer business in November 1992 and a decline in standard container utilization. The decrease was partially offset by higher fleet utilization and per diem rates in the rail trailer business, an increased finance lease portfolio, and a larger fleet of standard containers, refrigerated containers and European trailers. Expenses decreased $12,135,000 (4%) in 1993 from 1992 due to the sale of the domestic over-the-road trailer business. The decrease was partially offset by higher ownership cost due to a larger fleet. The combined utilization of standard containers, refrigerated containers, domestic containers, tank containers and chassis averaged 83% in 1993 compared to 85% in 1992. Rail trailer utilization was 91% in 1993 compared to 84% in 1992. European trailer utilization was 89% in 1993 compared to 84% in 1992. The company's standard container, refrigerated container, domestic container, tank container and chassis fleet of 316,000 units increased by 36,000 units (13%) in 1993. The rail trailer fleet of 36,500 units increased by 2,100 units (6%) in 1993. At December 31, 1993, the company also operated a fleet of 3,800 over-the-road trailers in Europe. Other Operations The other operations represent principally unallocated interest expense and certain financing activities of Transamerica Equipment Leasing Company, Inc. which are not related to the leasing operations of Transamerica Leasing Inc. and are therefore not combined with such operations. TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES Financial Statement Schedules

107830_1993.txt

107830_1993

1993

107830

ITEM 1. BUSINESS Wisconsin Natural Gas Company ("Wisconsin Natural" or "company"), incorporated in the State of Wisconsin in 1866, is a wholly-owned subsidiary of Wisconsin Energy Corporation ("Wisconsin Energy") and is an affiliated company to Wisconsin Electric Power Company ("Wisconsin Electric"), the electric utility subsidiary of Wisconsin Energy. Wisconsin Natural's operations are presently limited to a single business: the purchase, distribution and sale of natural gas to retail customers and transportation of customer-owned gas in its three distinct service areas in Wisconsin: west and south of the City of Milwaukee; the Appleton area and the Prairie du Chien area. The gas service territory has an estimated population of over 1,000,000. There were 287,732 customers at December 31, 1993, an increase of 2.9 percent since December 31, 1992. Effective January 1, 1994, Wisconsin Southern Gas Company, Inc. ("Wisconsin Southern") was acquired by Wisconsin Energy through a merger of Wisconsin Southern into Wisconsin Natural. In the transaction, all outstanding shares of Wisconsin Southern common stock were converted into 1,637,935 shares of Wisconsin Energy common stock. An order approving the merger was issued by the PSCW on December 7, 1993. Wisconsin Natural will continue to use the acquired facilities of Wisconsin Southern for the distribution and transportation of natural gas. For additional information, see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. On January 24, 1994, Wisconsin Energy announced plans to merge Wisconsin Natural into Wisconsin Electric. The merger, which will be subject to a number of conditions, including requisite regulatory and other approvals, is anticipated to be effective by year-end 1994. The merger of Wisconsin Natural into Wisconsin Electric is expected to improve customer service and reduce future operating costs. GAS UTILITY OPERATIONS Total gas therms delivered by Wisconsin Natural, including customer-owned gas transported by Wisconsin Natural, increased 4.9 percent in 1993 compared to 1992, largely reflecting colder winter weather during the first quarter of 1993. Approximately 31 percent of total 1993 deliveries were on interruptible rates. Wisconsin Natural's maximum daily send-out in 1993 was 478,425 Dths. A dekatherm ("Dth") is equivalent to ten therms or one million British Thermal Units ("BTU"). Sales of the gas utility fluctuate with the heating cycle of the year and are also impacted by varying weather conditions from year-to- year. During 1993, ANR Pipeline Company ("ANR"), Wisconsin Natural's largest pipeline transporter, received approval from the FERC to implement new rates in compliance with FERC Order 636. Wisconsin Natural's other pipeline transporters also implemented new rates based on FERC Order 636 during 1993. The number of service choices now available to Wisconsin Natural has expanded, but the responsibility for selecting the proper mix and level of services has commensurately increased. - 3 - ITEM 1. BUSINESS - Gas Utility Operations (Cont'd) As a result of the restructuring of pipeline rates and services under FERC Order 636, Wisconsin Natural has entered into more than 20 firm gas supply contracts, which vary in term from less than one year to ten years, that price natural gas at the market rate. Wisconsin Natural also has other pricing options, such as fixing future prices for varying terms, built into these contracts which it can exercise to manage the risk of substantial market price increases. The gas from these contracts is used to meet customer requirements and to fill storage during the warm months and is combined with withdrawals from storage during the heating season to meet system gas demand. Wisconsin Natural has four firm gas storage and associated firm transportation agreements with ANR and Natural Gas Pipeline Company of America ("NGPL") which allow daily withdrawals of 256,900 Dths and an annual capacity of 20 million Dths. The initial terms of these contracts vary, with the first one expiring in March 1996 and the last one expiring in October 2002. This storage effectively replaces storage used by the pipeline companies to provide gas sales service to Wisconsin Natural in the pre-FERC Order 636 environment. Gas stored at these facilities is purchased by Wisconsin Natural from a number of suppliers. Wisconsin Natural has four transportation contracts each with ANR and NGPL and one transportation contract with Northern Natural Pipeline Company ("Northern Natural"). All but three of these contracts expire in 2002 with the remaining contracts expiring in 1997, 2001 and 2003. In each case, subject to certain provisions, Wisconsin Natural can extend the terms of these contracts at the time that the agreements would otherwise expire. Wisconsin Natural transports gas for its customers who purchase gas directly from other suppliers. Transported gas accounted for approximately 32 percent of the company's total therms delivered during 1993, 34 percent during 1992 and 35 percent during 1991. Wisconsin Natural anticipates that because of the above mentioned restructuring of ANR's rates and services, some of its existing gas transportation customers will begin purchasing gas directly from Wisconsin Natural, thereby reducing the amount of customer-owned gas to be transported. Since rates charged for transportation services are designed to recover the same margin as gas sold directly by Wisconsin Natural, no significant impact on operating income is expected due to this change. Wisconsin Natural is the supplier of natural gas for Wisconsin Electric's new Concord combustion turbine power plant which began operation in July 1993. Delivery of this facility's fuel requirements is made possible by an eleven mile pipeline extension which was completed in 1992. Wisconsin Natural provides utility service to a diversified base of industrial customers. Major industries served include the paper industry, the food products industry and the machinery production industry. No single customer accounted for more than 2.8 percent of total gas therms sold and transported in 1993. REGULATION Wisconsin Natural is subject to the jurisdiction of the Public Service Commission of Wisconsin ("PSCW") as to gas rates, standards of service, issuance of securities, construction of new facilities, transactions with affiliates, billing practices and various other matters. - 4 - ITEM 1. BUSINESS - (Cont'd) RATE MATTERS See Item 3. LEGAL PROCEEDINGS - "RATE MATTERS" for a discussion of rate matters, including a discussion of the tariffs with respect to the adjustment for the cost of gas purchased for resale. ENERGY EFFICIENCY The management of Wisconsin Natural believes that a strong and continuing emphasis must be placed on energy management and efficient energy use. Wisconsin Natural is continuing to develop programs to meet the identified needs of its customers and to assist customers and inform them about energy efficiency options. This policy is regarded by Wisconsin Natural as in the best interests of its customers and the owners of its securities. ENVIRONMENTAL COMPLIANCE Environmental regulations have had no material impact on the financial position of Wisconsin Natural. Solid Waste Landfills Wisconsin Natural provides for the disposal of hazardous wastes through licensed independent contractors, but federal statutory provisions impose joint and several liability on the generators of waste for certain clean-up costs. Remediation-related activity pertaining to specific sites is discussed below. Hunt's Landfill: In 1991, Wisconsin Natural was notified by the EPA that it is a PRP with regard to the former Hunt's Landfill (located in Racine County, Wisconsin). Wisconsin Electric is also a participant in the clean-up of this site to avoid litigation with the PRPs. Even though Wisconsin Electric and Wisconsin Natural have taken the position that they were not responsible for the disposal of any hazardous substances or materials at the site, both companies have agreed to participate in the funding as "de minimis" parties in the execution of a consent decree with the EPA for clean-up. Materials disposed of at the site by Wisconsin Electric and Wisconsin Natural consisted primarily of waste paper and soil from construction sites. The portion of clean-up costs assigned to Wisconsin Electric and Wisconsin Natural is expected to be about $20,000 in total. OTHER Wisconsin Natural is authorized to provide gas service in designated territories in the state of Wisconsin, as established by indeterminate permits, certificates of public convenience and necessity, or boundary agreements with other utilities. Research and development expenditures of Wisconsin Natural amounted to $144,000 in 1993, $50,000 in 1992 and $3,000 in 1991. In addition to the foregoing amounts, Wisconsin Natural paid $619,000 in 1991 and $652,000 in 1992 for support of the Gas Research Institute under a surcharge of 1.42 cents per Dth sold in 1991 and 1.47 cents per Dth sold in 1992. As a result of the decoupling of rates and services under FERC Order 636 these surcharges are no longer determinable. - 5 - ITEM 1. BUSINESS - Other (Cont'd) At December 31, 1993, Wisconsin Natural employed 761 persons, of which 8 were part-time. ITEM 2. ITEM 2. PROPERTIES As of December 31, 1993, the gas distribution system of Wisconsin Natural includes approximately 5,315 miles of mains connected to the ANR, NGPL and Northern Natural pipeline transmission systems at 12 gate stations. Wisconsin Natural has a liquefied natural gas storage plant which converts and stores in liquefied form natural gas received during periods of low consumption. The liquefied natural gas storage plant has a send-out capability of 68,000 Dths per day. For information regarding the former Wisconsin Southern Gas Company Inc., which was merged into Wisconsin Natural effective January 1, 1994, see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The liquefied natural gas plant is located on land owned in fee by Wisconsin Natural. The gas distribution mains and services are located, for the most part, in public streets and highways and on land owned by others. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ENVIRONMENTAL MATTERS Wisconsin Natural is subject to federal, state and certain local laws and regulations governing the environmental aspects of its operations. Wisconsin Natural believes that, with immaterial exceptions, its existing facilities are in compliance with applicable environmental requirements. As have other public utilities, Wisconsin Natural and/or its predecessors and affiliates, have operated manufactured gas plants and disposed of ash and other waste products from electric utility activities. Operations at these manufactured gas sites ceased over 40 years ago with remediation activities having been conducted at certain of these sites, while other sites are currently being or are planned to be investigated. Costs associated with remediation activities, to the extent not covered by insurance, have been allowed in rates for utility service. Wisconsin Natural believes any such future costs will continue to be considered appropriate for inclusion in rates and therefore will not have a material adverse impact on its financial condition. Burlington Manufactured Gas Site: As a result of the acquisition and merger of Wisconsin Southern into Wisconsin Natural effective January 1, 1994, Wisconsin Natural has assumed ownership of a manufactured gas site formerly operated by Wisconsin Southern in Burlington, Wisconsin. Prior to the acquisition and merger, Wisconsin Southern hired an environmental engineering firm to perform testing at this site. Wisconsin Southern had recorded a liability of $3 million for future estimated site remediation costs, based upon estimates that such costs may total $3-7 million in the future. Wisconsin Natural believes that all associated costs incurred for remediation are probable for recovery in future rates based on Wisconsin Southern's correspondence with the PSCW and prior regulatory treatment by the PSCW. Under current plans, remediation expenditures could begin during 1994. See Item 1. BUSINESS - ENVIRONMENTAL COMPLIANCE - "Solid Waste Landfills" for a discussion of matters related to specific solid waste landfill sites. - 6 - ITEM 3. LEGAL PROCEEDINGS - (Cont'd) RATE MATTERS Wisconsin Retail Gas Jurisdiction 1993/1994 Rate Case: The PSCW granted an annualized rate increase of $9.2 million, or 3.3 percent, effective September 2, 1993. The new rates, for the test year ending August 31, 1994, are based on an 11.9 percent regulatory return on common equity, as determined for ratemaking purposes, down from the previously authorized return of 12.75 percent. 1994/1995 Test Year: During 1993, the PSCW announced that it will discontinue the practice of conducting annual rate case proceedings, replacing it with a new schedule which calls for future rate cases to be conducted once every two years. As a result, no filing was made with respect to the 1994/1995 test year. Purchased Gas Adjustment Tariffs: Sales of natural gas are subject to adjustment tariffs designed to pass on to gas customers increases or decreases in the cost of natural gas purchased for resale. Take-or-Pay and FERC Order 636 Transition Costs Take-or-pay costs being billed by the pipeline companies are no longer material. However, as a result of FERC Order 636, pipeline companies are no longer in the merchant business and have begun billing transition costs, such as Gas Supply Realignment and stranded capacity costs, to their customers. The transition costs to be billed to Wisconsin Natural are currently estimated to be about $10.0 million annually during 1994-1995, $7.5 million annually during 1996-1997 and $2.5 million each year thereafter until 2008. These estimates include the components attributable to the former Wisconsin Southern Gas Company Inc., which was acquired by Wisconsin Energy through a merger of Wisconsin Southern into Wisconsin Natural effective January 1, 1994. The PSCW is allowing the local gas distribution companies to pass these costs on to their customers through the purchased gas adjustment mechanism. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. - 7 - PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The amount of cash dividends declared on Wisconsin Natural's Common Stock during the two most recent fiscal years are set forth below. Dividends were paid to Wisconsin Natural's sole common stockholder, Wisconsin Energy. Total Quarter Dividend - ---------------------------------------------------------------------------- 1992 1 $2,121,750 2 2,121,750 3 2,121,750 4 2,121,750 - ---------------------------------------------------------------------------- 1993 1 $2,121,750 2 2,121,750 3 2,121,750 4 2,121,750 - ---------------------------------------------------------------------------- ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Information required by Item 6 is omitted pursuant to General Instruction J(2)(a) of Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information required by Item 7 is omitted pursuant to General Instruction J(2)(a) of Form 10-K and in lieu thereof Wisconsin Natural provides the following: Wisconsin Natural's revenues increased $41.7 million, or 17.4 percent, in 1993 compared to 1992. This reflects the recovery of increased purchased gas costs, the increase in natural gas therm deliveries made during 1993 and annualized retail rate increases of $4.0 million, or 1.4 percent, effective October 15, 1992 and $9.2 million, or 3.3 percent, effective September 2, 1993. Total gas therms delivered by Wisconsin Natural increased 4.9 percent in 1993 compared to 1992, largely reflecting colder winter weather during the first quarter of 1993. The $32 million increase in the cost of gas sold during 1993 compared to 1992 reflects the impact of a higher average delivered cost of gas and the 8.7 percent increase in natural gas therm sales during 1993. Changes in the cost of purchased gas are reflected in rates through Wisconsin Natural's purchased gas adjustment clause. For further discussion of purchased gas contracts and gas market purchases see Item 1. BUSINESS - "Gas Utility Operations". - 8 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) Other operation expenses were $7 million higher during 1993 compared to 1992 reflecting an increase in postretirement benefit costs associated with the adoption of Statement of Accounting Standards No. 106 ("FAS No. 106") - Employers' Accounting for Postretirement Benefits Other Than Pensions" (see Note C to the Financial Statements - Benefits Other Than Pensions) and growth in conservation related expenses associated with improving the efficiency of customers' use of natural gas. Effective January 1, 1994, Wisconsin Southern Gas Company, Inc. ("Wisconsin Southern") was acquired by Wisconsin Energy through a merger of Wisconsin Southern into Wisconsin Natural. In the transaction, structured as a tax-free reorganization, all outstanding shares of Wisconsin Southern common stock were converted into 1,637,935 shares of Wisconsin Energy common stock, with fractional interests paid in cash, based on an exchange ratio of 1.6330 shares of Wisconsin Energy common stock for each outstanding share of Wisconsin Southern common stock. The merger has been structured to qualify as a pooling of interests for accounting and financial reporting purposes beginning in 1994. Wisconsin Southern was a gas utility engaged in the purchase, distribution, transportation and sale of natural gas for residential, commercial and industrial consumption in a service territory contiguous to Wisconsin Natural's service territory located in southeastern Wisconsin. Following the merger, Wisconsin Natural now serves approximately 336,000 customers and is Wisconsin's second largest gas distribution company. For additional information, see Note M - Subsequent Events in the Notes to Financial Statements. In January 1992, Wisconsin Natural issued $10 million of 5-5/8% Series and $10 million of 6-5/8% Series First Mortgage Bonds, using the proceeds to refund its 8-3/4% and 8-3/8% Series First Mortgage Bonds. In August 1992, Wisconsin Natural issued $25 million of 6-1/8% Debentures due September 1, 1997, using the proceeds to redeem $24 million of its 9-1/4% Series First Mortgage Bonds. Depending on market conditions and other factors, additional debt refundings may occur. In December 1992, Wisconsin Natural issued $25 million of 8-1/4% Debentures due December 15, 2022, using the proceeds to repay short-term borrowings which had been incurred to finance part of the company's on-going capital requirements. Wisconsin Natural's parent, Wisconsin Energy, made capital contributions of $10 million and $7 million to Wisconsin Natural in 1993 and 1991, respectively, which were used to reduce short-term debt. Wisconsin Electric and Wisconsin Natural Revitalization In response to increasing competitive pressures in the markets for electricity and natural gas, Wisconsin Electric and Wisconsin Natural have developed a revitalization process to increase efficiencies and improve customer service. - 9 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) Wisconsin Electric and Wisconsin Natural are "reengineering" and restructuring their organizations. The new structures consolidate many business functions. This "reengineering" and restructuring of the business systems will lead to a reduction in the total Wisconsin Electric/Wisconsin Natural workforce. Effective in early 1994, employees have the option of choosing a voluntary separation package. An early retirement option also has been offered to qualified employees. As a result, it is currently estimated that Wisconsin Energy's utility subsidiaries will incur non-recurring reorganization charges aggregating between $30 to $75 million during 1994. The portion attributable to Wisconsin Natural is currently estimated to be between $3 to $10 million. See Note C to the Financial Statements - Benefits Other Than Pensions, for additional information. It is expected that these costs will be offset, before the end of 1995, by the reductions in future operating costs that these programs will achieve. In addition to the corporate restructuring at Wisconsin Electric and Wisconsin Natural, as part of this revitalization effort, Wisconsin Energy announced its intent to merge the two companies to form a single combined utility subsidiary. The proposed merger will accomplish the goal of improved customer service and will also enable the reduction of operating costs. The merger, which is anticipated to be effective by year-end 1994, will be subject to a number of conditions, including regulatory and other approvals. The following details the principal changes in revenues and expenses contributing to the decrease in net income in 1993. Thousands of Dollars -------------------- Aggregate increase in gas therm sales net of increase in gas therms purchased $ 7,812 Aggregate decrease in revenue per therm sold net of decrease in cost of gas per therm purchased 1,704 --------- $ 9,516 Increase in other operation expenses $(7,226) Decrease in maintenance 84 Increase in depreciation (765) Increase in taxes other than income taxes (303) Increase in operating income taxes (412) Decrease in other income (165) Increase in interest charges (842) --------- (9,629) ------- Decrease in net income $ (113) ======= - 10 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WISCONSIN NATURAL GAS COMPANY STATEMENT OF INCOME AND RETAINED EARNINGS Year Ended December 31 1993 1992 1991 ---- ---- ---- (Thousands of Dollars) Operating Revenues $281,718 $239,991 $233,120 Operating Expenses Cost of gas sold 183,759 151,548 148,386 Other operation expenses 45,611 38,385 37,402 Maintenance 5,934 6,018 6,055 Depreciation (Note D) 14,511 13,746 12,699 Taxes other than income taxes 4,783 4,480 3,924 Federal income tax (Note E) 5,324 5,929 4,640 State income tax (Note E) 1,393 1,548 1,217 Deferred income taxes - net (Note E) 1,062 (104) 985 Investment tax credit - net (Note E) (456) (462) (467) -------- -------- -------- Total Operating Expenses 261,921 221,088 214,841 Operating Income 19,797 18,903 18,279 Other Income and Deductions Interest income 336 525 491 Allowance for other funds used during construction (Note F) 4 32 196 Miscellaneous - net (85) (52) (45) Federal income tax (Note E) (88) (155) (147) State income tax (Note E) (21) (39) (37) -------- -------- -------- Total Other Income and Deductions 146 311 458 Income Before Interest Charges 19,943 19,214 18,737 Interest Charges Long-term debt 6,090 4,958 5,009 Other interest 1,348 1,654 1,742 Allowance for borrowed funds used during construction (Note F) (2) (18) (109) -------- -------- -------- Total Interest Charges 7,436 6,594 6,642 -------- -------- -------- Net Income 12,507 12,620 12,095 Retained Earnings - Balance, January 1 41,214 37,081 33,473 -------- -------- -------- 53,721 49,701 45,568 Cash Dividends Common Stock (8,487) (8,487) (8,487) -------- -------- -------- Balance, December 31 $ 45,234 $ 41,214 $ 37,081 ======== ======== ======== NOTE: Earnings and Dividends per share of common stock are not applicable because all of the company's common stock is owned by Wisconsin Energy Corporation. See Notes to Financial Statements. - 11 - WISCONSIN NATURAL GAS COMPANY STATEMENT OF CASH FLOWS Year Ended December 31 1993 1992 1991 ---- ---- ---- (Thousands of Dollars) Operating Activities Net income $ 12,507 $ 12,620 $ 12,095 Reconciliation to cash Depreciation 14,511 13,746 12,699 Deferred income taxes - net 1,062 (104) 985 Investment tax credit - net (456) (462) (467) Allowance for other funds used during construction (4) (32) (196) Change in Accounts receivable (2,607) 1,636 (6,213) Inventories (25,034) (3,061) (6,862) Accounts payable (3,875) 5,059 (6,652) Other current assets (2,695) (2,934) 3,829 Other current liabilities 3,347 (3,147) (584) Other 576 781 (267) ------- ------- ------- Cash Provided by (Used in) Operating Activities (2,668) 24,102 8,367 Investing Activities Construction expenditures (21,361) (22,578) (20,587) Allowance for borrowed funds used during construction (2) (18) (109) Other 432 (428) (407) ------- ------- ------- Cash Used in Investing Activities (20,931) (23,024) (21,103) Financing Activities Sale of long-term debt - 69,032 - Retirement of long-term debt (2,991) (53,674) - Change in short-term debt 24,925 (4,840) 13,275 Stockholder contribution 10,000 - 7,000 Dividends on common stock (8,487) (8,487) (8,487) ------- ------- ------- Cash Provided by Financing Activities 23,447 2,031 11,788 Change in Cash and Cash Equivalents $ (152) $ 3,109 $ (948) ======= ======= ======= Supplemental information disclosures Cash Paid for Interest (net of amount capitalized) $ 6,684 $ 6,400 $ 6,722 Income taxes 5,800 9,519 6,800 See Notes to Financial Statements. - 12 - WISCONSIN NATURAL GAS COMPANY BALANCE SHEET December 31 ASSETS 1993 1992 ---- ---- (Thousands of Dollars) Utility Plant $393,032 $372,956 Accumulated provision for depreciation (180,202) (165,920) -------- -------- Net Utility Plant 212,830 207,036 Other Property and Investments 70 71 Current Assets Cash and cash equivalents 6,318 6,470 Accounts receivable, net of allowance for doubtful accounts - $999 and $919 23,251 20,644 Accrued utility revenues 34,961 32,407 Materials and supplies (at average cost) 2,641 2,546 Natural gas stored (at first-in, first-out cost) 36,571 11,632 Prepayments and other assets 3,091 2,950 -------- -------- Total Current Assets 106,833 76,649 Deferred Charges and Other Assets Accumulated deferred income taxes (Note E) 11,918 3,993 Deferred take-or-pay buyout 606 3,316 Deferred regulatory assets (Note A) 3,879 - Other 1,843 2,587 -------- -------- Total Deferred Charges and Other Assets 18,246 9,896 -------- -------- Total Assets $337,979 $293,652 ======== ======== See Notes to Financial Statements. - 13 - WISCONSIN NATURAL GAS COMPANY BALANCE SHEET December 31 CAPITALIZATION AND LIABILITIES 1993 1992 ---- ---- (Thousands of Dollars) Capitalization (See Capitalization Statement) Common stock equity $114,734 $100,714 Long-term debt (Note I) 71,192 74,059 -------- -------- Total Capitalization 185,926 174,773 Current Liabilities Long-term debt due currently (Note I) 1,200 1,200 Notes payable (Note J) 68,508 43,583 Accounts payable 24,434 28,309 Payroll and vacation accrued 2,587 2,427 Taxes accrued - income and other 4,047 2,069 Interest accrued 1,458 1,516 Other 1,776 509 -------- ------- Total Current Liabilities 104,010 79,613 Deferred Credits and Other Liabilities Accumulated deferred income taxes (Note E) 28,657 28,264 Accumulated deferred investment tax credits 6,667 7,123 Deferred take-or-pay buyout 606 3,316 Deferred regulatory liabilities (Note A) 11,530 - Other 583 563 -------- ------- Total Deferred Credits and Other Liabilities 48,043 39,266 Commitments and Contingencies (Note L) -------- -------- Total Capitalization and Liabilities $337,979 $293,652 ======== ======== See Notes to Financial Statements. - 14 - WISCONSIN NATURAL GAS COMPANY CAPITALIZATION STATEMENT December 31 1993 1992 ---- ---- (Thousands of Dollars) Common Stock Equity Common stock ($1 par value; authorized 38,000,000 shares; issued 1,725,000 shares) $ 1,725 $ 1,725 Other paid in capital 67,775 57,775 Retained earnings 45,234 41,214 -------- -------- Total Common Stock Equity 114,734 100,714 Long-Term Debt First mortgage bonds Series Due ------ --- 5-5/8% 1995 10,000 10,000 6-5/8% 1997 10,000 10,000 9-1/4% 2016 3,000 6,000 -------- -------- 23,000 26,000 Debentures (unsecured) 6-1/8% Series due 1997 25,000 25,000 8-1/4% Series due 2022 25,000 25,000 Unamortized discount - net (608) (741) Long-term debt due currently (1,200) (1,200) -------- -------- Total Long-Term Debt 71,192 74,059 -------- -------- Total Capitalization $185,926 $174,773 ======== ======== See Notes to Financial Statements. - 15 - WISCONSIN NATURAL GAS COMPANY NOTES TO FINANCIAL STATEMENTS A - Summary of Significant Accounting Policies - ---------------------------------------------- General - ------- The accounting records of the company are kept as prescribed by the Public Service Commission of Wisconsin (PSCW). Revenues - -------- Utility revenues are recognized on the accrual basis and include estimated amounts for service rendered but not billed. Property - -------- Property is recorded at cost. Additions to and significant replacements of utility property are charged to utility plant at cost; minor items are charged to maintenance expense. Cost includes material, labor and allowance for funds used during construction (see Note F). The cost of depreciable utility property, together with removal cost less salvage, is charged to accumulated provision for depreciation when property is retired. Deferred Regulatory Assets and Liabilities - ------------------------------------------ Pursuant to Statement of Financial Accounting Standards No. 71, Accounting for the Effects of Certain Types of Regulation, the company capitalizes as deferred regulatory assets incurred costs which are expected to be recovered in future utility rates. The company also records as deferred regulatory liabilities the current recovery in utility rates of costs which are expected to be paid in the future. The significant portion of the company's deferred regulatory assets and liabilities relate to the amounts recorded due to the adoption of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (FAS 109). See Note E. Statement of Cash Flows - ----------------------- Cash and cash equivalents includes marketable debt securities acquired three months or less from maturity. B - Pension Plans - ----------------- Effective in 1993, the PSCW adopted Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions (FAS 87), for ratemaking. For 1992 and 1991, the PSCW recognized funded amounts for ratemaking and the company charged the following amounts to expense as paid, $165,000 and $555,000, respectively. - 16 - B - Pension Plans - (Cont'd) - ---------------------------- The company has several noncontributory pension plans covering all eligible employees. Pension benefits are based on years of service and the employee's compensation. The majority of the plans' assets are equity securities; other assets include corporate and government bonds, guaranteed investment contracts and real estate. The plans are funded to meet the requirements of the Employee Retirement Income Security Act of 1974. In the opinion of the company, current pension trust assets and amounts which are expected to be paid to the trust in the future will be adequate to meet future pension payment obligations to current and future retirees. Pension Cost calculated per FAS 87 1993 1992 1991 - ---------------------------------- ------ ------ ------ (Thousands of Dollars) Components of Net Periodic Pension Cost, Year Ended December 31 - Cost of pension benefits earned by employees $ 1,207 $ 1,077 $ 967 Interest cost on projected benefit obligation 3,633 3,264 3,085 Actual return on plan assets (4,292) (1,599) (9,878) Net amortization and deferral 305 (3,318) 5,875 ------- ------- ------ Total pension cost (credit) calculated under FAS 87 $ 853 $ (576) $ 49 ======= ======= ====== Actuarial Present Value of Accumulated Benefit Obligation, at December 31 - Vested benefits-employees' right to receive benefit no longer contingent upon continued employment $39,142 $34,112 Nonvested benefits-employees' right to receive benefit contingent upon continued employment 428 424 ------- ------- Total obligation $39,570 $34,536 ======= ======= Funded Status of Plans: Pension Assets and Obligations at December 31 - Pension assets at fair market value $55,224 $52,172 Projected benefit obligation at present value (50,455) (43,112) Unrecognized transition asset (1,511) (1,635) Unrecognized prior service cost 1,908 1,854 Unrecognized net gain (2,802) (6,806) ------- ------ Projected status of plans $ 2,364 $ 2,473 ======= ====== Rates used for calculations (%) - Discount Rate-interest rate used to adjust for the time value of money 7.5 8.0 8.0 Assumed rate of increase in compensation levels 5.0 5.0 5.0 Expected long-term rate of return on pension assets 9.0 9.0 9.0 - 17 - C - Benefits Other Than Pensions - -------------------------------- In January 1993, the company adopted prospectively Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (FAS 106), and elected the 20 year option for amortization of the previously unrecognized accumulated postretirement benefit obligation. The PSCW has issued an order recognizing FAS 106 for ratemaking; therefore adoption has no material impact on net income. For years prior to 1993 the cost of these postretirement benefits was expensed when paid and was $614,000 in 1992, and $527,000 in 1991. The company sponsors defined benefit postretirement plans that cover both salaried and nonsalaried employees who retire at age 55 or older with at least 10 years of credited service. The postretirement medical plan provides coverage to retirees and their dependents. Retirees contribute to the medical plan. The group life insurance benefit is based on employee compensation and is reduced upon retirement. Employees' Benefit Trusts (Trusts) are used to fund a major portion of postretirement benefits. The funding policy for the Trusts is to maximize tax deductibility. The majority of the Trusts' assets are mutual funds. Postretirement Benefit Cost calculated per FAS 106 (Thousands of Dollars) - -------------------------------------------------- Components of Net Periodic Postretirement Benefit Cost, Year Ended December 31, 1993 - Cost of postretirement benefits earned by employees $ 297 Interest cost on projected benefit obligation 1,024 Actual return on plan assets (221) Net amortization and deferral 520 -------- Total postretirement benefit cost calculated $ 1,620 under FAS 106 ======== Funded Status of Plans: Postretirement Obligations and Assets at December 31, 1993 - Accumulated Postretirement Benefit Obligation at December 31, 1993 - Retirees $ (5,710) Fully eligible active plan participants (2,221) Other active plan participants (6,039) -------- Total obligation (13,970) Postretirement assets at fair market value 2,771 -------- Accumulated postretirement benefit obligation in excess of plan assets (11,199) Unrecognized transition obligation 9,787 Unrecognized net loss 336 -------- Accrued Postretirement Benefit Obligation $ (1,076) ======== - 18 - C - Benefits Other Than Pensions - (Cont'd) - ------------------------------------------- Rates used for calculations (%) - Discount Rate-interest rate used to adjust for the time value of money 7.5 Assumed rate of increase in compensation levels 5.0 Expected long-term rate of return on postretirement assets 9.0 Health care cost trend rate 14.0 declining to 5.0 in 2002 Changes in health care cost trend rates will affect the amounts reported. For example, a 1% increase in rates would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $1,000,000 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by $100,000. Statement of Financial Accounting Standards No. 112, Employers' Accounting for Postemployment Benefits (FAS 112), was issued in 1992. This statement establishes standards of financial accounting and reporting for the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement. The company adopted FAS 112 prospectively for 1994. It is anticipate that adoption will not have a material effect on net income. The company has announced a Voluntary Severance Package (VSP) and Early Retirement Incentive Program (ERIP) effective January 1994 and March 1994, respectively to eligible employees. The availability of these plans to various bargaining units is based upon agreements made between the company and the unions. These plans are available to all management employees but not elected officers. The VSP includes a severance payment, medical/dental insurance, outplacement services, personal financial planning and tuition support. ERIP provides for a monthly income supplement, medical benefits, and personal financial planning. It is estimated that 8%-20% of total employees will elect one of these plans. The estimated cost associated with these plans is $3,000,000 - $10,000,000. D - Depreciation - ---------------- Depreciation expense is accrued at straight line rates, certified by the PSCW, which include estimates of salvage and removal costs. Depreciation as a percent of average depreciable utility plant was 4.0% in 1993 and 1992 and 3.9% in 1991. E - Income Taxes - ---------------- Comprehensive interperiod income tax allocation is used for federal and state temporary differences. The federal investment tax credit is accounted for on the deferred basis and is reflected in income ratably over the life of the related property. - 19 - E - Income Taxes - (Cont'd) - --------------------------- Following is a summary of income tax expense and a reconciliation of total income tax expense with the tax expected at the federal statutory rate. 1993 1992 1991 ------- ------- ------- (Thousands of Dollars) Current tax expense $ 6,826 $ 7,671 $ 6,041 Investment tax credit-net (456) (462) (467) Deferred tax expense 1,062 (104) 985 ------- ------- ------- Total tax expense $ 7,432 $ 7,105 $ 6,559 ======= ======= ======= Income before income taxes $19,939 $19,725 $18,654 ======= ======= ======= Expected tax at federal statutory rate $ 6,979 $ 6,706 $ 6,342 State income tax net of federal tax reduction 1,106 1,107 1,036 Investment tax credit restored (456) (462) (467) Deferred tax restored - rate differential (234) (255) (255) Other (no item over 5% of expected tax) 37 9 (97) ------- ------- ------- Total tax expense $ 7,432 $ 7,105 $ 6,559 ======= ======= ======= FAS 109 requires the recording of deferred assets and liabilities to recognize the expected future tax consequences of events that have been reflected in the company's financial statements or tax returns, the adjustment of deferred tax balances to reflect tax rate changes and the recognition of previously unrecorded deferred taxes. The company adopted FAS 109 prospectively in 1993. Following is a summary of deferred income taxes as of December 31, 1993, after FAS 109 adoption, and December 31, 1992, prior to adoption. 1993 1992 ------- ------- (Thousands of Dollars) Deferred Income Tax Assets Construction advances $ 8,720 $ 3,993 Other 3,198 - ------- ------- Total Deferred Income Tax Assets $11,918 $ 3,993 ======= ======= Deferred Income Tax Liabilities Plant related $26,397 $28,264 Other 2,260 - ------- ------- Total Deferred Income Tax Liabilities $28,657 $28,264 ======= ======= The company also has recorded deferred regulatory assets and liabilities of $3,879,000 and $11,530,000, respectively, as of December 31, 1993, which represent the future expected impact of deferred taxes on utility revenues. Adoption of FAS 109 had no material effect on net income. - 20 - F - Allowance for Funds Used During Construction (AFUDC) - -------------------------------------------------------- Through August 1993, AFUDC is capitalized in utility plant accounts and represents the cost of borrowed funds used during construction and a rate of return on stockholder's capital used for construction purposes. On the income statement the cost of borrowed funds (before income taxes) is a reduction of interest expense and the return on stockholder's capital is an item of noncash other income. Beginning September 1993, all construction work in progress (CWIP) is allowed to earn a current return. AFUDC was capitalized at the following rates, as approved by the PSCW: October 1992 - August 1993 Current return on investment for selected projects included in CWIP; 10.97% for remaining CWIP September 1991 - September 1992 Current return on investment for selected projects included in CWIP; 11.19% for remaining CWIP January 1991 - August 1991 11.37% for all projects G - Transactions With Associated Companies - ------------------------------------------ Managerial, financial, accounting, legal, data processing and other services may be rendered between associated companies and are billed in accordance with service agreements approved by the PSCW. The company also sells gas to Wisconsin Electric Power Company (WE), another subsidiary of Wisconsin Energy Corporation (WEC), for electric generation at rates approved by the PSCW. The company received from WEC a stockholder contribution of $10,000,000 and $7,000,000 in 1993 and 1991, respectively. H - Preferred Stock - ------------------- Serial Preferred Stock authorized but unissued is cumulative, $100 par value, 120,000 shares. I - Long-Term Debt - ------------------ The maturities and sinking fund requirements through 1998 for the aggregate amount of long-term debt outstanding at December 31, 1993 are shown below. 1994 $ 1,200,000 1995 11,200,000 1996 600,000 1997 35,000,000 1998 - Sinking fund requirements for the years 1994 through 1998, included in the table above, are $3,000,000. Substantially all utility plant is subject to the applicable mortgage. Long-term debt premium or discount and expense of issuance are amortized by the straight line method over the lives of the debt issues and included as interest expense. Unamortized amounts pertaining to reacquired debt are written off currently, when acquired for sinking fund purposes, or amortized in accordance with PSCW orders, when acquired for early retirement. - 21 - J - Notes Payable - ----------------- Short-term notes payable consist of: December 31 1993 1992 ------ ------ (Thousands of Dollars) Banks $39,999 $ 4,999 Commercial paper 28,509 38,584 ------- ------- $68,508 $43,583 ======= ======= Unused lines of credit for short-term borrowings amounted to $35,509,000 at December 31, 1993. In support of various informal lines of credit from banks, the company has agreed to pay commitment fees; these commitment fees are not significant. K - Fair Value of Financial Instruments - --------------------------------------- Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments (FAS 107), requires, if practicable, disclosure of the fair value of financial instruments, both assets and liabilities recognized and not recognized in the balance sheet. The fair values provided below represent the amounts at which the financial instruments could have been exchanged between willing parties on December 31. Fair value is estimated based upon the market value of the financial instrument or upon instruments with similar characteristics. For most financial instruments held by the company, book value approximates fair value. The value of financial instruments recognized on the balance sheet, for which book value does not approximate fair value, is as follows: December 31 1993 1992 Book Fair Book Fair Value Value Value Value -------- -------- -------- -------- (Thousands of dollars) Debentures $ 50,000 $ 54,469 $ 50,000 $ 50,219 In 1993, the FASB issued Statement of Financial Accounting Standards No. 115 (FAS 115), Accounting for Certain Investments in Debt and Equity Securities. This standard addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. The company adopted FAS 115 prospectively in 1994. It is anticipated that adoption will not have a material effect on net income. - 22 - L - Commitments and Contingencies - --------------------------------- Discussion of take-or-pay costs and FERC Order 636 transition costs billed by natural gas pipeline companies can be found elsewhere in this report in "Legal Proceedings - Rate Matters" in Item 3. M - Subsequent Events - --------------------- Effective January 1, 1994 Wisconsin Energy Corporation (WEC) acquired all of the outstanding common stock of Wisconsin Southern Gas Company, Inc. (WSG) through a statutory merger of WSG into WN in which all of WSG's common stock was converted into common stock of WEC. WSG was a gas utility engaged in the purchase, distribution, transportation and sale of natural gas primarily in a section of southeastern Wisconsin which is contiguous to WN's service territory. WSG was merged into WN using the pooling of interests method of accounting. Accordingly, historical financial data in future reports will be restated to include WSG. The following unaudited proforma data summarizes the combined results of operations of the company and WSG as though the merger had occurred at the beginning of 1991: (Thousands of Dollars) 1993 1992 1991 ---- ---- ---- Total operating revenues $331,301 $283,699 $273,804 Net income 14,155 14,209 12,913 In January 1994, WEC announced plans to merge WN into Wisconsin Electric Power Company, a wholly-owned utility subsidiary of WEC. The merger, subject to requisite regulatory and other approvals, is anticipated to be effective by year-end 1994. - 23 - REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and the Stockholder of Wisconsin Natural Gas Company In our opinion, the financial statements listed under Item 14(a)(1) and (2) on pages 25 and 26 present fairly, in all material respects, the financial position of Wisconsin Natural Gas 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. 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, 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 Financial Statements, the Company changed its method of accounting for income taxes and postretirement benefits effective January 1, 1993. We concur with these changes in accounting. /s/Price Waterhouse - ------------------- PRICE WATERHOUSE Milwaukee, Wisconsin January 26, 1994 - 24 - 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 called for by Item 10 is omitted pursuant to General Instruction J(2)(c) to Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information called for by Item 11 is omitted pursuant to General Instruction J(2)(c) to Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information called for by Item 12 is omitted pursuant to General Instruction J(2)(c) to Form 10-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information called for by Item 13 is omitted pursuant to General Instruction J(2)(c) to Form 10-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements Included in Part II of this report: Statement of Income and Retained Earnings for the three years ended December 31, 1993 Statement of Cash Flows for the three years ended December 31, 1993 Balance Sheet at December 31, 1993 and 1992 Capitalization Statement at December 31, 1993 and 1992 Notes to Financial Statements Report of Independent Accountants - 25 - ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (Cont'd) (a) 2. Financial Statement Schedules Included in Part IV of this report: For the three years ended December 31, 1993 Schedule V Property, Plant and Equipment Schedule VI Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment Schedule IX Short-Term Borrowings Schedule X Supplementary Income Statement Information Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. 3. Exhibits The following Exhibits are filed with this report: Exhibit No. (23) Consent of Independent Accountants, dated March 30, 1994 appearing on page 33 of this Annual Report on Form 10-K for the year ended December 31, 1993. In addition to the Exhibit shown above, which is filed herewith, Wisconsin Natural hereby incorporates the following Exhibits pursuant to Exchange Act Rule 12b-32 and Regulation Section 201.24 by reference to the filings set forth below: (2) Agreement and Plan of Reorganization, dated as of July 30, 1993, by and among Wisconsin Energy Corporation, Wisconsin Natural Gas Company and Wisconsin Southern Gas Company, Inc., including the related Plan and Agreement of Merger between Wisconsin Natural and Wisconsin Southern. (Exhibit A to the Proxy Statement/Prospectus dated October 20, 1993 contained in the Registration Statement of Wisconsin Energy Corporation on Form S-4, No. 33-50653) (3)-1 Restated Articles of Incorporation of Wisconsin Natural Gas Company, as adopted on December 1, 1982. (Exhibit (3)-1 to Wisconsin Natural's 1982 Form 10-K in File No. 2-2066) 2 Bylaws of Wisconsin Natural Gas Company, as amended to November 23, 1992. (Exhibit (3)-1 to Wisconsin Natural's 1992 Form 10-K in File No. 2-2066) - 26 - Mortgage, Indenture or Under Supplemental Indenture Date Exhibit # File No. ------------------------------------------------------------ (4)-1 Mortgage and Deed of 6/1/50 7-C 2-8457 Trust 2 Third 9/1/57 2-D 2-13563 3 Fourth 10/15/61 2-E 2-18922 4 Fifth 11/1/62 2-F 2-20799 5 Sixth 10/1/65 2-G 2-24012 6 Seventh 9/15/67 2-H 2-27101 7 Eighth 9/15/69 4-J 2-34303 8 Ninth 7/1/71 (4)-1 2-2066 (1980 Form 10-K) 9 Tenth 9/15/86 (4)-9 2-2066 (1986 Form 10-K) 10 Eleventh 1/15/92 (4)-1 2-2066 (1991 Form 10-K) 11 Twelfth 11/1/92 (4)-1 2-2066 (9/30/92 Form 10-Q) 12 Thirteenth 1/1/94 (4)-1 2-2066 (1/01/94 Form 8-K) 13 Indenture for Debt 9/1/92 (4)-2 2-2066 Securities (9/30/92 (the "Indenture") Form 10-Q) 14 Securities 9/1/92 (4)-3 2-2066 Resolution No. 1 (9/30/92 under the Indenture Form 10-Q) 15 Securities 12/1/92 (4)-1 2-2066 Resolution No. 2 (1992 under the Indenture Form 10-K) 16 Thirteenth Supplemental Indenture, dated January 1, 1994, to Indenture dated September 1, 1950 of Wisconsin Southern Gas Company, Inc. (to reflect the assumption of bonds (4)-2 2-2066 by Wisconsin Natural in (1/01/94 connection with merger). Form 8-K) All agreements and instruments with respect to long-term debt not exceeding 10% of the total assets of the Registrant have been omitted as permitted by related instructions. The Registrant agrees pursuant to Item 601(b)(4) of Regulation S-K to furnish to the Securities and Exchange Commission, upon request, a copy of all such agreements and instruments. (10)-1 Supplemental Benefits Agreement between Wisconsin Natural and employee Ronald K. Espe dated December 14, 1990. (Exhibit (10)-1 to Wisconsin Natural's 1990 Form 10-K in File No. 2-2066) * - 27 - 2 Service Agreement dated January 1, 1987 between Wisconsin Natural Gas Company, Wisconsin Energy Corporation and other non-utility affiliated companies. (Exhibit (10)-(a) to Wisconsin Natural's Form 8-K dated January 2, 1987 in File No. 2-2066) * Management contracts and executive compensation plans or arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K. Certain compensatory plans in which directors or executive officers of the Registrant are eligible to participate are not filed in reliance on the exclusion in Item 601(b)(10)(iii)(B)(6) of Regulation S-K. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. However, a report on Form 8-K dated January 1, 1994 was filed by Wisconsin Natural reporting the effectiveness of the acquisition of Wisconsin Southern Gas Company, Inc. by Wisconsin Energy through a merger of Wisconsin Southern Gas Company, Inc. into Wisconsin Natural, a wholly-owned subsidiary of Wisconsin Energy, and filing the related historical financial statements and pro forma financial information. Additionally, a report on Form 8-K dated January 24, 1994 was filed by Wisconsin Natural reporting the announced plan of Wisconsin Energy to merge Wisconsin Natural into Wisconsin Energy's wholly-owned principal utility subsidiary, Wisconsin Electric, anticipated to be effective by year-end 1994. - 28 - WISCONSIN NATURAL GAS COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT DECEMBER 31 Col. A Col. F ------ ------------------------------- Classification 1993 1992 1991 -------------- ---- ---- ---- (Thousands of Dollars) Gas Utility Plant Storage Plant $ 9,101 $ 9,101 $ 9,030 Distribution Plant 345,732 328,110 309,846 General Plant 37,712 34,490 33,239 Work in Progress 487 1,255 972 -------- -------- -------- Total Gas Utility Plant 393,032 372,956 353,087 Nonutility Property 70 79 79 -------- -------- -------- Total Property and Plant $393,102 $373,035 $353,166 ======== ======== ======== Note: Neither total additions nor total retirements in 1993, 1992, and 1991 amounted to more than 10% of the total property balances at December 31 of these years. All additions were for ordinary extensions and improvements of the system. Additions include Allowance for Funds Used During Construction of $6,000 in 1993, $50,000 in 1992, and $305,000 in 1991. Total additions and retirements for the years 1991-1993 are shown below. 1993 1992 1991 ---- ---- ---- (Thousands of Dollars) Total Additions $ 21,367 $ 22,628 $ 20,892 Total Retirements 1,300 2,759 1,364 Depreciation Depreciation expense is accrued at straight line rates certified by the PSCW. The average depreciation rate was 4.0% in 1993, 4.0% in 1992 and 3.9% in 1991. - 29 - WISCONSIN NATURAL GAS COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (Note A) Col. A Col. B Charged to Costs and Expenses ----------------------------- Item 1993 1992 1991 ---- ---- ---- ---- (Thousands of Dollars) Taxes other than payroll and income taxes Wisconsin license fee tax $2,328 $2,221 $2,128 Other(B) 421 308 (75) ------ ------ ------ Total $2,749 $2,529 $2,053 ====== ====== ====== Note A - Maintenance expense and depreciation are shown on the Income Statement. No royalties were paid and advertising costs did not exceed 1% of revenues. Note B - 1991 includes Wisconsin ad valorem tax refunds for years 1984-1985 and 1986-1989. 1992 includes Wisconsin ad valorem tax refunds for years 1986-1989. - 32 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements and Prospectuses constituting part of the Registration Statements on Form S-3 (Nos. 33-41368 and 33-48927) of Wisconsin Natural Gas Company of our report dated January 26, 1994 appearing on page 24 of this Form 10-K. /s/Price Waterhouse - ------------------- PRICE WATERHOUSE Milwaukee, Wisconsin March 30, 1994 - 33 - 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. WISCONSIN NATURAL GAS COMPANY /s/R. A. Abdoo By ------------------------------------- Date March 30, 1994 (R. A. Abdoo, 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 and Title Date /s/R. A. Abdoo - ----------------------------------------------- March 30, 1994 (R. A. Abdoo, Chairman of the Board and Chief Executive Officer and Director - Principal Executive Officer) /s/R. K. Espe - ----------------------------------------------- March 30, 1994 (R. K. Espe, President and Chief Operating Officer and Director) /s/J. G. Remmel - ----------------------------------------------- March 30, 1994 (J. G. Remmel, Chief Financial Officer and Director - Principal Financial Officer) /s/A. K. Klisurich - ----------------------------------------------- March 30, 1994 (A. K. Klisurich, Controller - Principal Accounting Officer) /s/R. H. Gorske - ----------------------------------------------- March 30, 1994 (R. H. Gorske, Vice President and General Counsel and Director) /s/D. K. Porter - ----------------------------------------------- March 30, 1994 (D. K. Porter, Vice President and Director) - 34 - Wisconsin Natural Gas Company EXHIBIT INDEX ------------- 1993 Annual Report on Form 10-K Exhibit Number ------- (23) Consent of Independent Accountants, dated March 30, 1994 appearing on page 33 of this Annual Report on Form 10-K for the year ended December 31, 1993. The foregoing Exhibit is filed with this report. The additional Exhibits which are incorporated by reference are listed in Item 14(a)(3) of this report. - 35 -

882239_1993.txt

882239_1993

1993

882239

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

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ITEM 1. BUSINESS General Sotheby's Holdings, Inc. (together with its subsidiaries, unless the context otherwise requires, the "Company") is the world's leading fine art auctioneer, specializing in paintings, jewelry, decorative art and a wide range of other property. The worldwide auction business is conducted through a division known as "Sotheby's" and consists of three principal operating units: Sotheby's North and South America ("Sotheby's, Inc."), Sotheby's Europe and Sotheby's Asia. In addition to auctioneering, the Company is engaged in two other lines of business: art-related financing and marketing and brokering luxury real estate. The Company believes it is one of the world's leaders in art-related financing. The Company lends money secured by consigned art to clients in order to facilitate their bringing property to auction. In addition, a portion of the Company's loan portfolio consists of loans to collectors, dealers and museums secured by collections not presently intended for sale. The Company, through its subsidiary, Sotheby's International Realty, Inc., is engaged in marketing and brokering luxury residential real estate. The Company was incorporated in Michigan in August 1983. In October 1983, the Company purchased Sotheby Parke Bernet Group Limited, which was then a publicly held company listed on the International Stock Exchange of the United Kingdom and the Republic of Ireland Limited (the "London Stock Exchange") and which, through its predecessors, had been engaged in the auction business since 1744. In 1988, the Company sold shares of Class A Limited Voting Common Stock to the public. The Class A Limited Voting Common Stock is listed on the New York Stock Exchange and the London Stock Exchange. Additional information relating to the Company's business segments and the geographic areas in which the Company operates appears in Note C to the Company's Consolidated Financial Statements in the Annual Shareholders Report for the year ended December 31, 1993 (the "Annual Report"), which is incorporated herein by reference. THE AUCTION BUSINESS Transactions in the world art market are effected through numerous dealers, the two major auction houses and smaller auction houses and also directly between collectors. Although dealers and smaller auction firms do not report sales, the Company believes that dealers account for the majority of the volume of transactions in the world art market. The Company and Christies International Plc, a publicly held company in the United Kingdom ("Christie's"), are the two largest art auction houses in the world. The Company conducted aggregate auction sales in 1993 of $1.33 billion (approximately B.P.888 million). Christie's aggregate auction sales in 1993 were approximately $1.09 billion (B.P.728 million). The auction sales of the next largest art auction house, Phillips Son & Neale, were approximately $123 million (B.P.82 million) for the year ended December 31, 1993. The Company auctions a wide variety of property, including fine art, jewelry, decorative art and rare books. In an approximate breakdown of 1993 auction sales by type of property, fine art accounted for approximately $589 million, or 44%, of auction sales, decorative art accounted for approximately $423 million, or 32%, of auction sales and jewelry, rare books and other property accounted for approximately $313 million, or 24%, of auction sales. Most of the objects auctioned by the Company are unique items, and their value, therefore, can only be estimated prior to sale. The Company's principal role as an auctioneer is to identify, evaluate and authenticate works of art through its international staff of experts, to stimulate purchaser interest through professional marketing techniques and to match sellers and buyers through the auction process. In its role as auctioneer, the Company normally functions as an agent accepting property on consignment from its selling clients. The Company conducts its auctions as agent of the consignor, billing the buyer for property purchased, receiving payment from the buyer and remitting to the consignor the consignor's portion of the buyer's payments. The Company frequently releases property sold at auction to buyers, primarily dealers, before the Company receives payment. In such event, the Company is liable to the seller for the net sale proceeds even if the Company never receives payment from the buyer. In addition, on certain occasions, the Company will assure the consignor a minimum price in connection with the sale of property. The Company must perform under its assurances only in the event that (a) the property fails to sell at auction and (b) the consignor prefers to be paid the minimum price rather than retain ownership of the unsold property. In such event, the Company purchases the property at the minimum price. Occasionally, the Company acts as a principal in connection with the sale of property. For example, the Company acts as a principal through its participation in Acquavella Modern Art (the "Partnership" or "AMA"), a partnership consisting of a wholly-owned subsidiary of the Company and Acquavella Contemporary Art, Inc. ("ACA"). The Company's investment in the Partnership is the contribution of the inventory acquired through the purchase of the common stock of the Pierre Matisse Gallery ("Matisse") for $153.1 million in 1990. The primary purpose of the Partnership is to dispose of the inventory. According to the terms of the Partnership agreement, each partner has a 50% interest in the earnings of the Partnership and all cash available for distribution is initially distributed to the Company until the Company receives $270,339,390, together with a return equal to the prime rate (as defined). Thereafter, cash distributions are made on a 50-50 basis. To the extent that the Partnership requires working capital, the Company has agreed to lend the same to the Partnership. Any amounts loaned to the Partnership by the Company would bear interest, compounded monthly, at prime plus 1%. As of December 31, 1993, the Company had received the $270,339,390 noted above and no amounts had been loaned to the Partnership or advanced to ACA. Inventory in the amount of $89.1 million had been sold through December 31, 1993, primarily through private sales. See Note E to the Consolidated Financial Statements in the Annual Report. All buyers pay a premium (known as the buyer's premium) to the Company on auction purchases. Effective January 1, 1993, the buyer's premium in North America was increased to 15% of the hammer price on all items sold for $50,000 or less, and 15% of the first $50,000 for items sold in excess of that amount (10% on the remainder). Generally, similar structures were simultaneously implemented throughout most of the rest of Sotheby's auction operations. Previously the buyer's premium had been 10% in most locations. A selling commission, which can vary depending on the sale location, type of seller (for example, dealers) and the selling price of the property, is charged to the seller. In situations involving major individual works of art, collections or collectors, the selling commission tends to be negotiated to a level below that which otherwise would apply. The Company's operating revenues are significantly influenced by a number of factors not within the Company's control, including the overall strength of the international economy, in particular, the economies of the United States, the United Kingdom, the major countries of continental Europe and Asia, principally Japan and Hong Kong; political conditions in various nations; the presence of export and exchange controls; taxation of sales of auctioned property; competition and the amount of property being consigned to art auction houses. The Company's business is seasonal, with peak revenues and operating income generally occurring in the second and fourth quarters of each year as a result of the traditional spring and fall art auction seasons. See "Management's Discussion and Analysis of Results of Operations and Financial Condition--Seasonality" in the Annual Report, which is incorporated herein by reference. The Auction Market Competition in the world art market is intense. A fundamental challenge facing any auctioneer or dealer is to obtain high quality and valuable property for sale. The Company's primary auction competitor is Christie's. The owner of a work of art wishing to sell it has three options: sale or consignment to, or private brokerage by, an art dealer; consignment to an auction house; or private sale to a collector or museum without use of an intermediary. The more valuable the property, the more likely it is that the owner will consider more than one option and will solicit proposals from more than one potential purchaser or agent, particularly if the seller is a fiduciary representing an estate or trust. A complex array of factors influences the seller's decision. These factors include: the level of expertise of the dealer or auction house with respect to the property; a prior relationship between the seller and the firm; the reputation and historic level of achievement by a firm in attaining high sale prices in the property's specialized category; the amount of cash offered by a dealer or other purchaser to purchase the property outright compared with the estimates given by auction houses; the time that will elapse before the seller will receive sale proceeds; the desirability of a public auction in order to achieve the maximum possible price (a particular concern for fiduciary sellers); the amount of commission proposed by dealers or auction houses to sell a work on consignment; the cost, style and extent of presale promotion to be undertaken by a firm; recommendations by third parties consulted by the seller; personal interaction between the seller and the firm's staff; and the availability and extent of related services, such as a tax or insurance appraisal and short-term financing. The Company's ability to obtain high quality and valuable property for sale depends, in part, on the relationships that certain employees of the Company, particularly its senior art experts, have established with potential sellers. It is not possible to measure the entire world art market or to reach any conclusions regarding overall competition because dealers and smaller auction firms do not report sales. Based on the reported sales of the Company and Christie's during each of the last 10 years, the Company has been and remains the world leader in auction sales. Regulation Regulation of the auction business varies from jurisdiction to jurisdiction. Such regulations do not impose a material impediment to the worldwide business of the Company. In February 1990, certain members of the Assembly of the State of New York, the jurisdiction where the Company's principal U.S. auctions are held, initiated an inquiry with respect to the business practices of auction houses, museums and art dealers, including the Company. In January 1991, and again in 1992 and 1993, the Assemblymen reintroduced proposed legislation which, if enacted, would substantially alter the manner in which the Company's auction business in New York is conducted. To date, no legislation has been enacted by the State of New York. THE FINANCE BUSINESS The Company arranges financing secured by works of art and other personal property owned by its customers. The Company's finance operations are conducted through its wholly-owned subsidiary, Sotheby's Financial Services, Inc. The Company generally makes two types of art-related loans: (1) advances to consignors who are contractually committed, in the near term, to sell property at auction; and (2) term loans to collectors, museums or dealers secured by property not intended for sale. The loans are generally made with full recourse to the borrower. In certain instances, consignor advances are made with recourse limited to the works of art consigned for sale and pledged as security for the loan, or with recourse limited to the consigned works and to other works of art owned by the consignor but not pledged as security. The consignor advance allows a consignor to receive funds shortly after consignment for an auction that will occur several weeks or months in the future, while preserving for the benefit of the consignor the potential of the auction process. The term loan allows the Company to establish or enhance a mutually beneficial relationship with major dealers and collectors. Term loans generally have a maturity of one year. The Company's loans generally are variable rate loans. The Company reviews its loan portfolio on a quarterly basis. Each loan is categorized based on the financial status of the borrower and the current estimated realizable value of collateral securing the loan. When management believes that the estimated realizable collateral value has fallen below the principal amount of a loan or when the borrower is in default, the loan becomes subject to more frequent monitoring. For financial statement purposes, the Company establishes reserves for certain loans that the Company believes are under-collateralized and with respect to which the shortfall may not be collectible from the borrower. With respect to any such loan, the amount of the applicable reserve is adjusted quarterly to reflect the portion of the loan that the Company believes may become uncollectible. See Note D to the Consolidated Financial Statements in the Annual Report. The Company funds its finance operations through internally generated funds, through the issuance of U.S. commercial paper and through its bank credit lines, including its revolving credit facilities. See "Management's Discussion and Analysis of Results of Operations and Financial Condition--Liquidity and Capital Resources" and Note G to the Consolidated Financial Statements in the Annual Report. Competition A considerable number of conventional lending sources offer loans at a lower cost to borrowers than those offered by the Company. However, the Company believes that, with the exception of Christie's, few other lenders are as willing to accept works of art as collateral. The Company believes that its financing alternatives are attractive to clients who wish to obtain liquidity from their art assets for various reasons, despite the comparatively higher interest rates charged by the Company. THE LUXURY REAL ESTATE BUSINESS Sotheby's International Realty, Inc. ("SIR") was founded in 1976 as an outgrowth of Sotheby's auction activities and in response to the requests of major clients to market estates and other real property that required exposure beyond a local market. SIR responds to the needs of its clients by (a) acting as an exclusive marketing agent providing services to licensed real estate brokerage offices and (b) operating its own real estate brokerage offices in certain locations. Competition SIR's primary competitors are small, local real estate brokerage firms that deal exclusively with luxury real estate and the "distinctive property" divisions of large regional and national real estate firms. Competition in the luxury real estate business takes many forms, including competition in price, marketing expertise and the provision of personalized service to sellers and buyers. Regulation The real estate brokerage business is subject to regulation in most jurisdictions in which SIR operates. Typically, individual real estate brokers and brokerage firms are subject to licensing requirements. SIR is registered to conduct business in 34 states and maintains real estate brokerage licenses in 12 states. In other jurisdictions, SIR acts as an exclusive marketing agent providing services to licensed real estate brokers. PERSONNEL At December 31, 1993, the Company had 1,531 employees: 620 located in North America; 644 in the United Kingdom and 267 in the rest of the world. The following table provides a breakdown of employees by operational areas as of December 31, 1993: OPERATIONAL AREA NUMBER OF EMPLOYEES - ---------------- -------------------- Auction..................................................... 1,388 Realty...................................................... 56 Other....................................................... 87 ------- Total.................................................. 1,531 ------- ------- The Company regards its relations with its employees as good. ITEM 2. ITEM 2. PROPERTIES U.S. PROPERTIES Sotheby's, Inc. and Sotheby's Financial Services, Inc. are headquartered at 1334 York Avenue, New York, New York (the "York Property"). The Company also leases office and warehouse space in four other locations in the New York City area, and leases office and exhibition space in several other major cities throughout the United States, including Los Angeles, San Francisco, Chicago and Palm Beach. The Company currently leases the York Property, comprising approximately 160,500 square feet, from an unaffiliated party under a 30-year lease expiring in 2009, which contains an option to extend the term for an additional 30 years until July 31, 2039. The lease also grants the Company a right of first refusal with respect to the sale of the York Property. York Avenue Development, Inc. ("York"), a wholly-owned subsidiary of Sotheby's, Inc., has the right to purchase the fee interest in the York Property by exercising certain options available through January 31, 1999 and during the months of August 1999, August 2004 and July 2009. Since 1983, management of the Company has evaluated various alternatives for the realization of the value of the right to purchase the fee interest in the York Property. Additionally, the Company has studied how best to satisfy its demand for additional office and auction space. Under an agreement with Taubman York Avenue Associates, Inc. ("Associates"), Associates has agreed that it will assist York in developing and financing a new, mixed-use tower (the "New Tower") over the existing four-story building on the York Property, should a decision be made to proceed with such development. Sotheby's, Inc. has structured the transaction to isolate the financial exposure of the Company with respect to development of the New Tower in one subsidiary, namely, York. A. Alfred Taubman, the Company's Chairman and largest shareholder, is presently the sole shareholder of Associates. See Note I to the Consolidated Financial Statements in the Annual Report. Sotheby's, Inc. also assigned to York its rights and obligations under a project services agreement dated November 8, 1985 (the "Project Services Agreement") between Sotheby's, Inc. and The Taubman Company ("TTC"), which is an affiliate of A. Alfred Taubman. Under the Project Services Agreement, TTC agreed to develop the New Tower on behalf of Sotheby's, Inc. and to provide consultation and advice to Sotheby's, Inc. in connection with the development of the New Tower, should a decision be made to proceed with the development. SIR leases approximately 10,900 square feet of office space at 980 Madison Avenue, New York, New York, from unaffiliated parties under leases expiring in 1994 and 2001. SIR also leases satellite office space at a number of locations, totalling another 11,200 square feet. OVERSEAS PROPERTIES The Company's U.K. operations are centered at New Bond Street, London, where the main salesrooms and administrative offices of Sotheby's (U.K.) are located. Additional salesrooms are located in proximity to New Bond Street. The total net usable floor area amounts to approximately 124,000 square feet. The Company owns or holds long-term leasehold interests in approximately 75% of these properties by area, the balance being held on leases with remaining terms of less than 20 years. In addition, 50,000 square feet of warehouse space is leased at King's House in West London. The Company also owns a country estate in Sussex where it conducts satellite auctions. The Company also leases office space in various locations throughout continental Europe, including Paris, Geneva, Zurich, Amsterdam, Frankfurt, Munich, Milan and Madrid; in Asia, including Japan and Hong Kong; and in South America. In management's opinion, the Company's premises are generally adequate for the current conduct of its business. However, the Company evaluates, on an ongoing basis, the adequacy of its premises for the requirements of the present and future conduct of its business, with particular focus on its major auction locations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company becomes involved from time to time in various claims and lawsuits incidental to the ordinary course of its business. The Company does not believe that the outcome of any such pending claims or proceedings will have a material effect upon its business or financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Company's shareholders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS Market Information The principal U.S. market for the Company's Class A Limited Voting Common Stock, par value $0.10 per share (the "Class A Common Stock"), is the New York Stock Exchange (symbol: BID). The Class A Common Stock is also traded on the London Stock Exchange. The Company also has a Class B Common Stock, par value $0.10 per share, convertible on a share for share basis into Class A Common Stock. There is no public market for the Class B Common Stock. Per share cash dividends are equal for the Class A and Class B Common Stock. The quarterly price ranges on the New York Stock Exchange of the Class A Common Stock and dividends per share for 1993 and 1992 are shown in the following schedules: The number of holders of record of the Class A Common Stock as of March 11, 1994 was 1,483. The number of holders of record of the Class B Common Stock as of March 11, 1994 was 44. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected Financial Data on page 17 of the Annual Report are incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Management's Discussion and Analysis of Results of Operations and Financial Condition on pages 18 through 23 of the Annual Report is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements on pages 24 through 37 of the Annual Report are incorporated herein by reference. The Independent Auditors' Report on page 38 of the Annual Report 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 REGISTRANT All directors of the Company are elected to hold office until the next annual meeting of shareholders and until their successors are elected and qualified. Officers of the Company are appointed by the Board of Directors and serve at the discretion of the Board. As of March 25, 1994, the directors and executive officers of the Company (including certain officers of certain principal subsidiaries and divisions) are as follows: Mr. Taubman is a private investor. Since 1983, Mr. Taubman has been the largest shareholder, Chairman and a director of the Company. He is Chairman of Taubman Centers, Inc., a company engaged in the regional retail shopping center business. He is also a director of R. H. Macy & Co., Inc., which owns and operates department stores throughout the United States. In January 1992, R.H. Macy & Co. filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. He is also Chairman of the Board of Woodward & Lothrop Holdings, Inc. and a director of Woodward & Lothrop Incorporated, both of which filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code in January 1994. Mr. Fisher is a private investor and has been Vice Chairman of the Company since 1986 and a director of the Company since 1983. He is a director of Comerica Bank. Lord Blakenham became a director of the Company in 1987. Since 1961, he has served in various executive positions with Pearson plc, a British media company that serves worldwide information, education and entertainment markets and which has a substantial interest in the three Lazard investment banking firms. He has been Executive Chairman of Pearson plc since 1983. He is a Managing Director of Lazard Brothers & Co., Limited, an investment banking firm, and the non- executive Chairman of MEPC, plc, a commercial real estate investment and development company. Lord Camoys became a director of the Company in October 1993. In addition, he will assume the role of Deputy Chairman of the Company effective April 1, 1994. Since 1989 he has been Deputy Chairman of Barclays de Zoete Wedd Holdings Limited, the international investment banking arm of Barclays Group. He is a director of Barclays Bank PLC and 3i Group plc, an investment group, and is Deputy Chairman of National Provident Institution. Mr. Curley became a director of the Company in April 1993. From 1989 to March 1993, Mr. Curley served as U.S. Ambassador to France. Prior to 1989, Mr. Curley was U.S. Ambassador to Ireland, was a partner of J.H. Whitney & Co., and was a principal in his own private venture capital investment firm, W.J.P. Curley. Mr. Curley is a director of American Exploration Company, an oil and gas exploration and development company, Coflexip S.A., a manufacturer of flexible pipe for the petroleum industry, Fiduciary Trust International, a funds management firm, and The France Growth Fund, a closed end investment company. He is also a member of the International Advisory Committee of Compagnie Financiere de Paribas, an international bank. Lord Gowrie has been a director of the Company since 1985. He served as Chairman of Sotheby's Europe from 1992 through 1993. From 1988 to 1991, Lord Gowrie served as Chairman of Sotheby's (U.K.), which then encompassed the United Kingdom, Europe, Asia and Australia. Lord Gowrie is a director of the Ladbroke Group PLC, an entertainment and leisure company. Mr. Wexner has been a director of the Company since 1983. Since 1963, he has been President and Chairman of The Limited, Inc., which is one of the leading women's apparel specialty stores and mail order retailers in the United States. Mr. Wexner is a director and a member of the Executive Committee of Banc One Corporation. Mr. Ainslie has been the President, Chief Executive Officer and a director of the Company since 1984. Mr. Ainslie has resigned as President and Chief Executive Officer of the Company effective April 1, 1994. Mr. Ainslie is also Chairman of SIR. Mr. Bailey was appointed Managing Director of Sotheby's Europe in January 1994. From 1992 through 1993, he served as director of Business Development, Sotheby's Europe. From 1987 to 1992, Mr. Bailey was the director of operations, Sotheby's (U.K.). Mr. Bailey joined Sotheby's in 1979. Mr. Bousquette has been Senior Vice President and Chief Financial Officer since April 1993. From 1985 to 1992, Mr. Bousquette was an executive at Kohlberg Kravis Roberts & Co., L.P., a merchant banking firm, and a limited partner of KKR Associates, L.P. Ms. Brooks became President and Chief Executive Officer of Sotheby's, the Company's worldwide auction business, in March 1993. She became a director of the Company in 1992. She was named Chief Executive Officer of Sotheby's, Inc. in 1990. In addition, she has been President of Sotheby's, Inc., responsible for North and South American operations, since 1987. Effective April 1, 1994, Ms. Brooks has been appointed President and Chief Executive Officer of the Company, succeeding Mr. Ainslie. Mr. Gannalo was appointed Vice President and Controller in April 1991, and was also named Chief Accounting Officer in August 1992. He joined the Company in 1987 as Controller of Sotheby's, Inc. Mr. de Pury was appointed Chairman of Sotheby's Europe in January 1994. He served as Deputy Chairman of Sotheby's Europe from 1992 through 1993. From 1988 to 1991, he served as Deputy Chairman of Sotheby's (U.K.), directly responsible for European development. He joined the Company in 1986 as Managing Director, Sotheby's International, Inc., responsible for all continental European offices. Mr. Ruprecht was appointed Executive Vice President and Managing Director of Sotheby's, Inc. in February 1994. In 1992, he became Director of Marketing for the Company worldwide, a position he continues to hold. From 1986 to 1992, he served as director of marketing for Sotheby's, Inc. Mr. Ruprecht joined the Company in 1980. Mr. Thompson has been a director of the Company since 1983 and became Chairman of Sotheby's Asia in January 1992, directly responsible for development in Asia, India and Australia. From 1988 to 1991 he was Deputy Chairman of Sotheby's (U.K.), directly responsible for development in Asia. Mr. Wyndham became Chairman of Sotheby's (U.K.) in February 1994. Since prior to 1989, he was partner of the St. James Art Group, an art dealing business. Mr. Zuckerman has been President of Sotheby's Financial Services, Inc., since 1988. From June 1986 until 1989, he served as Senior Vice President, Corporate Development of the Company. From 1984 to 1988, he was Senior Vice President, Business Development of Sotheby's, Inc. Based on the Company's review of the filings made by the Company's directors and executive officers under Section 16 of the Securities and Exchange Act of 1934, all transactions in and beneficial ownership of the Company's equity securities were reported in a timely manner, except that Mr. Fisher was inadvertently three days late in reporting a sale of shares of Class A Common Stock by a charitable foundation of which he is a director. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth all compensation paid to the Chief Executive Officer and each of the four most highly compensated executive officers of the Company during 1993 for each of the last three years. SUMMARY COMPENSATION TABLE - --------------- (1) Mr. Faxon resigned from the Company effective December 31, 1993. (2) Mr. de Pury served as Deputy Chairman of Sotheby's Europe in 1993. He assumed the position of Chairman of Sotheby's Europe on January 1, 1994. (3) Mr. Bousquette joined the Company in March 1993. (4) The 1993 bonus amounts include cash paid in 1994 in respect of 1993 performance. (Footnotes continued on following page) (Footnotes continued from preceding page) (5) The 1993 bonus amount includes a payment of $60,000, representing part of a special payment awarded to senior officers to reflect the fact that salaries had been frozen since January 1990, and the 1992 bonus amount includes a payment of $30,000, representing part of the special payment. The balance of the special payment will be paid to Ms. Brooks in 1994, contingent on her continued employment. The 1993 bonus amount also includes payment of a deferred bonus of $23,000 paid for services rendered in connection with the acquisition of Matisse and the management of AMA. The 1992 bonus amount also includes payment of a deferred bonus of $75,000 paid in connection with the acquisition of Matisse and the management of AMA. (6) The 1993 bonus amount includes a special bonus of $25,000 paid to Mr. Faxon in 1993 in respect of 1993 performance. The 1992 bonus amount reflects not only performance-related payments but also inducements to relocate to London to manage European operations. (7) The 1993 bonus amount includes a payment of $60,000, representing part of a special payment awarded to senior officers to reflect the fact that salaries had been frozen since January 1990. The balance of the special payment will be paid to Mr. de Pury in 1994, contingent on his continued employment. (8) Company car payment. (9) Includes a company car payment and, in accordance with the terms of Mr. Ainslie's employment agreement, a payment of $207,525 in respect of stock options exercised in 1992 ($0.15 per share). (10) Company car payment. (11) Company car payment. (12) This amount includes a housing allowance ($78,156), a utilities allowance, a company car payment and moving expenses. This amount also includes a $150,000 severance payment paid to Mr. Faxon in connection with his resignation from the Company effective December 31, 1993. This amount does not include amounts which will be paid to Mr. Faxon in respect of 1993 to compensate him for the increased income tax for which he was liable as a result of his relocation to London in 1992, which amounts have not yet been finally calculated. (13) Mr. Faxon relocated to London at the Company's request. This amount reflects reimbursement for losses associated with a sale, controlled by the Company, of his U.S. residence ($455,898) and the related tax reimbursement ($204,824), moving expenses, a housing allowance and an annual company car payment. This amount does not include amounts which will be paid to Mr. Faxon in respect of 1992 to compensate him for the increased income tax for which he was liable as a result of his relocation to London, which amounts have not yet been finally calculated. (14) Moving expense associated with Mr. Faxon's relocation from Los Angeles to New York. (15) The amounts disclosed in this column for 1993 include: (a) Company contributions of the following amounts under the Retirement Savings Plan: $11,792 on behalf of Mr. Ainslie, $11,792 on behalf of Ms. Brooks, $11,467 on behalf of Mr. Faxon and $5,171 on behalf of Mr. Bousquette; (b) Company contributions of the following amounts under benefit equalization agreements: $7,916 on behalf of Mr. Ainslie, $22,458 on behalf of Ms. Brooks, $13,533 on behalf of Mr. Faxon and $2,329 on behalf of Mr. Bousquette; and (c) a Company contribution under the Switzerland plan of $30,469 on behalf of Mr. de Pury. Stock Option Plan In 1987, the Company instituted the 1987 Stock Option Plan, including its U.K. Sub-Plan (the "Stock Option Plan" or "Plan"), for employees of the Company. The purposes of the Plan are to provide employees with added incentives to continue in the employ of the Company, to encourage proprietary interest in the Company through the acquisition of its stock and to attract new employees with outstanding qualifications. Options may be granted under the Plan until July 27, 1997, and the Plan expires for all purposes on July 27, 2007. The Board of Directors may suspend, discontinue, revise or amend the Plan at any time with respect to shares not subject to options at the time of the amendment, except that, without the approval of the Company's shareholders, no such revision or amendment may increase the number of shares subject to the Plan, change the eligibility requirements or remove the restrictions regarding amendment of the Plan. The Audit and Compensation Committee of the Company's Board of Directors (the "Committee"), in its discretion (based on each employee's performance and expected future contribution to the Company), selects the employees eligible to participate in the Plan. Under the U.K. Sub-Plan, options may only be granted to a director or employee of the Company, or any of its subsidiaries, who is a U.K. resident, and only if the resident devotes not less than 25 hours per week, in the case of a director, or 20 hours per week, in the case of an employee who is not a director, to his or her duties, subject to certain other limitations. The Committee, in its discretion, determines the number of options to be granted to an employee. Under the U.K. Sub-Plan, a U.K. resident may not receive options for shares under the U.K. Sub-Plan with aggregate exercise prices (converted to their pound sterling equivalent at the date of grant) exceeding the greater of B.P.100,000 or four times relevant compensation during the current or preceding year. Only options on shares of Class B Common Stock can be granted under the Plan, although, under certain circumstances, optionees may receive shares of Class A Common Stock upon exercise. In July 1988, Rule 19c-4 (the "Rule") adopted under the Securities Exchange Act of 1934 became effective. Although the Rule has been vacated by a federal appellate court, the Rule has been adopted by the New York Stock Exchange ("NYSE") as a NYSE rule. The NYSE's version of the Rule, as currently interpreted and applied, prevents the continued listing of the Class A Common Stock on the NYSE if the Company issues any additional shares of Class B Common Stock other than in satisfaction of options granted under the Plan prior to the Rule's effective date. The Company has received permission from the NYSE to continue to grant options under the Plan subject to the condition that each prospective optionee must agree that if the Company cannot issue shares of Class B Common Stock to such optionee upon exercise and maintain the listing of the Class A Common Stock on the NYSE, the optionee will receive shares of Class A Common Stock instead of shares of Class B Common Stock. The NYSE has proposed a change to its rules which would allow the Company to issue additional shares of Class B Common Stock. An optionee may exercise an option to the extent of one-third of the number of shares subject to the option in each of the fourth, fifth and sixth years of employment after the date of the grant of the option on a cumulative basis, although the Committee has the discretion to accelerate the exercise dates of options to a date, in the case of an option granted under the U.K. Sub-Plan subsequent to July 3, 1991, not earlier than the third anniversary of the date of grant and, in the case of any other option, not earlier than six months and one day after the relevant date of grant. Effective October 1992, the Committee approved a change in vesting for all subsequent grants, such that an optionee, except those subject to the U.K. Sub-Plan, may exercise an option to the extent of one-fifth of the number of shares subject to the option in each of the second, third, fourth, fifth and sixth years of employment after the date of the grant on a cumulative basis. Under the U.K. Sub-Plan, optionees may exercise an option to the extent of three-fifths of the number of shares subject to the option in the fourth year and one-fifth in each of the fifth and sixth years of employment after the grant date. If an optionee terminates employment more than three years after the date of grant for reasons other than death, disability, retirement or cause, the option may be exercised to the extent it is vested and has not previously been exercised at the time of termination of employment. If the termination is for cause, which is defined as gross misconduct or unacceptable behavior as determined by the Committee, the right to exercise the option is forfeited. If the termination of employment is because of death, disability or retirement, the option may be exercised in full. There are certain limitations on the timing of exercise of the option after termination of employment. No option may be exercised after ten years from the date of the initial grant. Under the current provisions of the Internal Revenue Code of 1986, an optionee who is a U.S. citizen or resident will not realize any income for federal income tax purposes upon the grant of an option. The optionee will, however, receive compensation income at the time of the exercise of the option in the amount of the excess of the fair market value of the shares at the time of exercise over the exercise price. In the United States, the Company will receive a deduction at that time in the amount that the U.S. optionee includes in income. The aggregate number of shares of stock that may be issued upon exercise of options is limited to 16,507,076 shares of authorized but unissued or reacquired Class B Common Stock. As of December 31, 1993, options for 5,229,997 shares of Class B Common Stock held by 410 employees of the Company were outstanding. Of this total, options for 1,099,166 shares were held by executive officers of the Company. At December 31, 1993, options for 4,809,433 shares of Class B Common Stock were available for grant under the Plan. The limitation on the number of shares, the number of shares covered by each option and the exercise price for such shares will be adjusted proportionately in the event of any increase or decrease in the number of issued shares of Class A Common Stock or Class B Common Stock or both resulting from a subdivision or consolidation of such shares, any payment of a stock dividend, any reorganization, consolidation, dissolution, liquidation, merger, exchange of shares, recapitalization, stock split, reverse stock split or any other increase or decrease, without consideration, in the number of issued shares of either Class A Common Stock or Class B Common Stock. Participants in the Plan receive an annual statement regarding their option activity. This statement includes date of grant, number of options granted, exercise price and vesting dates. Participants also receive all information sent to shareholders generally, including annual and quarterly reports and proxy statements. The exercise price of an option is determined by the Committee at the date of grant, and may not be less than the fair market value of the underlying shares as of the date of grant. The following table sets forth information regarding option grants to the named executive officers in 1993: OPTION GRANTS IN 1993 - --------------- (1) Each named executive officer's options will vest and become exercisable to the extent of one-fifth of the number of shares subject to the option on each of the first, second, third, fourth and fifth anniversary of the date of grant. None of the options granted to Mr. Faxon will vest before March 31, 1994, when such options expire. (Footnotes continued on following page) (Footnotes continued from preceding page) (2) The actual value, if any, that may be realized by each individual will depend on the closing price of the Class A Common Stock on the NYSE on the day preceding the exercise date. The option term for these option grants is ten years. The appreciation rates used in the table are provided to comply with Item 402(c) of Regulation S-K and do not necessarily reflect the views of management as to the potential realizable value of options. The following table provides information on option exercises in 1993 by the named executive officers and year-end option values for unexercised options held by the named executive officers: AGGREGATED OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES See Note J to the Consolidated Financial Statements in the Annual Report for additional information about the Plan. Retirement Savings Plan The Company has a Retirement Savings Plan (the "Retirement Savings Plan") for employees of the Company and its subsidiaries in the United States. Effective May 1, 1993, there was a change in the eligibility requirements for participation, such that employees are eligible to participate in the Retirement Savings Plan as of the first day of the month following completion of a 90-day waiting period commencing on the date of employment. Prior to May 1, 1993, employees who had completed 1,000 hours of service during the 12-month period commencing on the date of employment or during any calendar year thereafter were eligible to participate in the Retirement Savings Plan as of the first day of the month following completion of the service requirement. The Company contributes 2% of each participant's compensation to the Retirement Savings Plan on behalf of the participant. In addition, participants may elect to save between 2% and 12% of their compensation, up to the maximum amount allowable under the Internal Revenue Code of 1986, as amended (the "Code") and the regulations thereunder, on a pre-tax basis. Participants also may elect to make after-tax contributions, subject to certain limits. Employee pre-tax savings are matched by a Company contribution of up to an additional 3% of the participant's compensation. The total amount of contributions for each participant is subject to certain limitations under the Code, and the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). For the purpose of determining contributions, compensation is defined as aggregate earnings, including basic compensation, commissions, overtime, premiums, sickness (other than long-term disability) and vacation pay and cash bonuses, but specifically excludes other incentive compensation, severance pay, contributions to other welfare and pension plans (except other plans qualifying under Section 401(k) of the Code) and reimbursement of expenses. Employees may direct the apportionment of their account balances between four funds: a fixed income fund, an equity fund, a balanced fund and, subject to certain limitations, a Company stock fund. Income taxes on savings, contributions (other than after-tax contributions) and investment earnings are deferred until benefits are paid out to the employee upon retirement, death or earlier termination of employment or withdrawal. The receipt of benefits attributable to the Company's contributions (including the 2% Company contribution and matching contributions) is subject to vesting and forfeiture provisions of the plan; other amounts are fully vested at all times. Participants may borrow from their Retirement Savings Plan accounts for any purpose. The maximum amount which may be borrowed by any participant is the lesser of $50,000 or one-half of the participant's vested account balance in the plan. Company contributions to the Retirement Savings Plan made on behalf of the named executive officers have been included in the Summary Compensation Table. Switzerland Plan In accordance with the requirements of Swiss law, Sotheby's AG, the Company's Swiss operating subsidiary, established in 1985 a fully insured pension plan for its full-time employees whose salaries exceed 22,560 Swiss francs ("SF"). There are two elements of the plan: a savings element (the "Savings Plan") and a risk element (the "Risk Plan"). Employees are eligible to join the Savings Plan as of the January 1 following attainment of age 24 and the Risk Plan as of the January 1 following attainment of age 17. Under the Savings Plan, an individual retirement account is established for each participating employee. Each year, the account is credited with a percentage of the employee's adjusted salary, which is the employee's annual salary including bonuses and other allowances reduced by SF 22,560, with a minimum adjusted salary of SF 2,820. Longer serving employees were made eligible for additional Company contributions in respect of service with the Company prior to 1985 and in respect of salary in excess of SF 112,800 for which no contributions had been made prior to 1993. The percentage of adjusted salary credited to the account ranges from 7% to 30%, depending on the employees' age, sex and past service. The Company pays between 66% and 80% of this total contribution, with the remainder paid by employees. The account is also credited with interest at a rate fixed by the Federal Council. At retirement age, which is age 65 for men and age 62 for women, the employee's account is converted to a life annuity, with provisions for contingent widow's pension of 60% of the retiree's benefit and immediate pensions of 20% of the retiree's benefit for certain children of the retiree. Participants may elect to receive their retirement benefits in a lump sum in lieu of the annuity. The Risk Plan provides disability and death benefits to employees, their widows and certain of their children. Benefits are generally a percentage of the amount credited to the employee's account, excluding interest. Benefits under the Risk Plan are funded by insurance premiums, all of which are paid by the Company. Mr. de Pury is the only named executive officer who participates in the plan. A total of SF 47,227 ($30,469) contributed in 1993 by the Company on behalf of Mr. de Pury is included in the Summary Compensation Table. Bonuses The Company's officers are eligible to receive incentive bonuses. Bonuses are recommended by management and approved by the Committee. Actual awards are a function of the Company's after-tax worldwide profit and the individual's performance. In view of a 36-month salary freeze for senior officers of the Company, supplemental compensation was approved in 1992 for selected officers as an alternative to market-based salary adjustments. Once granted, these awards are paid in four semiannual payments and are contingent upon continued employment. Bonuses awarded to the named executives have been included in the Summary Compensation Table. Benefit Equalization Agreements The total annual contributions to the Company's Retirement Savings Plan are subject to certain limitations under the Code and ERISA for each participant. Officers (generally senior vice presidents and above) of the Company and its U.S. subsidiaries who are affected by such limitations may enter into agreements pursuant to which their salaries will be reduced, and the Company will maintain accounts on their behalf, in the amount of the difference between (i) the aggregate amount of contributions that would have been made to the Retirement Savings Plan in the absence of the limitations, and (ii) the aggregate amount of contributions actually made to the plan. Amounts deferred in 1993 and subsequent years will be credited with the same earnings yield credited to contributions made to the fixed income fund maintained under the Retirement Savings Plan. Benefits under these unfunded agreements will be paid at the same time and in the same manner as benefits under the Company's Retirement Savings Plan. Amounts deferred by named executives of the Company pursuant to benefit equalization agreements in 1993 have been included in the Summary Compensation Table. COMPENSATION OF DIRECTORS Each director of the Company who is not an executive officer of the Company receives an annual fee of $15,000, plus a fee of $1,000 for each Board meeting attended by such director, and a fee of $500 ($1,000 for the chairman of the committee) for each committee meeting attended by such director, in addition to reimbursement of expenses. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth certain information regarding the beneficial ownership of the Company's Class A and Class B Common Stock as of March 11, 1994 by its directors, named executive officers and 5% shareholders. The Company has relied upon information supplied by its officers, directors and certain shareholders and upon information contained in filings with the Securities and Exchange Commission. Each share of Class B Common Stock is freely convertible into one share of Class A Common Stock. Accordingly, under the applicable rules of the Securities and Exchange Act of 1934, holders of Class B Common Stock are deemed to own an equal number of shares of Class A Common Stock. For purposes of the calculation of the percentage of each class that each named officer, director and 5% shareholder beneficially owns, the number of shares of such class deemed to be outstanding is the sum of all outstanding shares of such class plus the number of shares that such beneficial owner has, or is deemed to have, the right to acquire by the exercise of options and/or conversion. CLASS A AND CLASS B COMMON STOCK OWNERSHIP OF DIRECTORS, EXECUTIVE OFFICERS AND 5% SHAREHOLDERS - --------------- * Represents less than 1%. (1) Mr. Taubman owns 100 shares of Class A Common Stock. This figure includes 9,730,886 shares of Class A Common Stock that he has, or is deemed to have, the right to acquire by converting shares of Class B Common Stock that Mr. Taubman owns as trustee of his grantor trust and also includes 3,468,630 shares of Class A Common Stock that he has the right to acquire by converting shares of Class B Common Stock owned by Taubman Investments Limited Partnership, as to which he has sole voting and dispositive control. (2) This figure includes 3,468,630 shares of Class B Common Stock owned by Taubman Investments Limited Partnership, as to which Mr. Taubman has sole voting and dispositive control, and excludes shares owned by Judith Taubman. Mr. Taubman disclaims beneficial ownership of the 792,830 shares of Class B Common Stock owned by Judith Taubman, his wife. Mr. Taubman and Taubman Investments Limited Partnership have pledged all of their shares of Class B Common Stock to certain banks. If the banks were to foreclose on the pledges, a change in control of the Company could take place under certain circumstances. In the opinion of Mr. Taubman, the chances of a foreclosure on the pledges are remote. (3) This figure includes 1,840,921 shares of Class A Common Stock that Mr. Fisher has, or is deemed to have, the right to acquire by converting shares of Class B Common Stock. See footnote 4 below. This figure also includes 91,900 shares of Class A Common Stock owned by a charitable foundation of which Mr. Fisher is a director. Mr. Fisher disclaims beneficial ownership of all shares of Class A Common Stock other than 1,830,161 shares relating to the shares of Class B Common Stock held by him as trustee of his grantor trust. See footnote 4. (4) This figure includes 10,760 shares of Class B Common Stock owned by various family trusts of which Mr. Fisher is a co-trustee and 1,830,161 shares of Class B Common Stock that Mr. Fisher holds as trustee of his grantor trust. This figure excludes 668,624 shares owned by Martinique Hotel, Inc., a corporation owned by Mr. Fisher's family. This figure also excludes 56,519 shares of Class B Common Stock owned by various family trusts of which Mr. Fisher's wife is a co-trustee. Mr. Fisher disclaims beneficial ownership of all shares other than those held by him as trustee of his grantor trust. (5) Mr. Wexner owns 146,900 shares of Class A Common Stock. This figure includes 993,316 shares of Class A Common Stock that he has the right to acquire by converting shares of Class B Common Stock. (6) This figure includes 200 shares of Class A Common Stock owned by a trust for Mr. Ainslie's son, of which Mr. Ainslie is a trustee, Mr. Ainslie disclaims beneficial ownership of such shares. This figure also includes 700,000 shares of Class A Common Stock that he has the right to acquire by converting shares of Class B Common Stock. (7) This figure includes 100,000 shares of Class A Common Stock that Ms. Brooks has the right to acquire by converting shares of Class B Common Stock and 93,000 shares of Class A Common Stock (Footnotes continued on following page) (Footnotes continued from preceding page) that she has the right to acquire by exercising options for shares of Class B Common Stock and converting those shares. (8) This figure includes 93,000 shares of Class B Common Stock that Ms. Brooks has the right to acquire by exercising options. (9) This figure represents shares of Class A Common Stock that Lord Gowrie has the right to acquire by exercising options for shares of Class B Common Stock and converting those shares. (10) This figure represents shares of Class B Common Stock that Lord Gowrie has the right to acquire by exercising options. (11) This figure includes 75,000 shares of Class A Common Stock that Mr. Thompson has the right to acquire by converting shares of Class B Common Stock and 49,500 shares of Class A Common Stock that he has the right to acquire by exercising options for Class B Common Stock and converting those shares. (12) This figure includes 49,500 shares of Class B Common Stock that Mr. Thompson has the right to acquire by exercising options. (13) Mr. de Pury owns 15,000 shares of Class A Common Stock. This figure includes 40,000 shares of Class A Common Stock that Mr. de Pury has the right to acquire by exercising options for shares of Class B Common Stock and converting those shares. (14) This figure represents shares of Class B Common Stock that Mr. de Pury has the right to acquire by exercising options. (15) This figure includes shares held in third parties' accounts over which GeoCapital Corporation has investment discretion. (16) See above notes. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Loan Programs The Company has two loan programs that are available to certain U.S. employees at the President's discretion. The first is a mortgage guarantee program, whereby the employee borrows from a bank on a demand basis and pays an annual interest rate equal to the prime rate. All of the repayment obligations of the employee are guaranteed by the Company. Under the second program, the Company lends money to certain employees to purchase a residence under term notes bearing interest at an annual interest rate equal to the prime rate minus 1 - 2%. This program is available to employees at the Company's discretion. At March 9, 1994, Mitchell Zuckerman, an executive officer, had borrowings outstanding under the first program of $14,167 and borrowings outstanding under the second program of $186,666. At March 9, 1994, William Ruprecht, another executive officer, had borrowings outstanding under the first program of $68,333 and borrowings outstanding under the second program of $168,333. In October 1993, Sotheby's (U.K.), a subsidiary of the Company, entered into an agreement with Henry Wyndham Fine Art Ltd. ("Fine Art"), an art dealing business in which Henry Wyndham, who has since become Chairman of Sotheby's (U.K.), has a substantial equity interest. Under the agreement, Sotheby's (U.K.) agreed to purchase from Fine Art various paintings outright, as well as Fine Art's interest in another painting. Under the terms of the agreement, Sotheby's (U.K.) paid Fine Art B.P.218,000 ($327,654) for a group of paintings in December 1993 and B.P.150,000 ($225,450) for a portion of its interest in another painting in February 1994. Fine Art has the right to sell its remaining interest in such painting to Sotheby's (U.K.) in February 1995 for B.P.180,000 ($270,540). The original cost to Fine Art of its interest in such painting was approximately B.P.300,000 ($450,900). However, the fair market value of such interest is deemed by the Company to be in excess of the purchase price. The various purchase prices were determined by the Company with reference to recent sale prices of comparable property. In addition to the above-described transactions, the Company has entered into agreements with its largest shareholder and certain of his affiliates regarding the proposed development of the York Property. See "Properties" and Note I to the Consolidated Financial Statements in the Annual Report. 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--The information required by this item is included in the response to Item 14(c). (b) Reports on Form 8-K filed in the fourth quarter of 1993--None (c) Exhibits--The response to this portion of Item 14 is submitted as a separate section of this report. (d) Financial Statement Schedules--The response to this portion of Item 14 is submitted as a separate section of this report. ANNUAL REPORT ON FORM 10-K ITEM 14(A) (1) AND (2) AND (D) YEAR ENDED DECEMBER 31, 1993 SOTHEBY'S HOLDINGS, INC. BLOOMFIELD HILLS, MICHIGAN FORM 10-K--ITEM 14(A) (1) AND (2) SOTHEBY'S HOLDINGS, INC., AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Sotheby's Holdings, Inc. and subsidiaries, included in the annual report of the registrant to its shareholders for the year ended December 31, 1993, are incorporated by reference in Item 8: Consolidated Balance Sheets--December 31, 1993 and 1992 Consolidated Statements of Income--Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Changes in Shareholders' Equity--Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows--Years ended December 31, 1993, 1992 and Notes to Consolidated Financial Statements--December 31, 1993 The following consolidated financial statement schedules of Sotheby's Holdings, Inc. and subsidiaries and the Independent Auditors' Report are included in Item 14(d): Independent Auditors' Report on Financial Statement Schedules Schedule VIII--Valuation and Qualifying Accounts Schedule IX--Short-Term Borrowings All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable, and therefore have been omitted. INDEPENDENT AUDITORS' REPORT Shareholders and Board of Directors Sotheby's Holdings, Inc.: We have audited the consolidated financial statements of Sotheby's Holdings, 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 28, 1994; such consolidated financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of Sotheby's Holdings, 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. DELOITTE & TOUCHE New York, New York February 28, 1994 SCHEDULE VIII SOTHEBY'S HOLDINGS, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS SCHEDULE IX SOTHEBY'S HOLDINGS, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. SOTHEBY'S HOLDINGS, INC. BY: /S/ MICHAEL L. AINSLIE -------------------------- MICHAEL L. AINSLIE 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. ITEM 14(C) EXHIBITS - --------------- * A compensatory agreement or plan required to be filed pursuant to Item 14(c) of Form 10-K.

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ITEM 1. BUSINESS THE NORTHEAST UTILITIES SYSTEM Northeast Utilities (NU) is the parent company of the Northeast Utilities system (the System). It is not itself an operating company. Through four of NU's wholly-owned subsidiaries (The Connecticut Light and Power Company [CL&P], Public Service Company of New Hampshire [PSNH], Western Massachusetts Electric Company [WMECO] and Holyoke Water Power Company [HWP]), the System furnishes electric service in Connecticut, New Hampshire and western Massachusetts. In addition to their retail electric service, CL&P, PSNH, WMECO and HWP (including its wholly-owned subsidiary Holyoke Power and Electric Company) together furnish firm wholesale electric service to eight municipalities and utilities. The System companies also supply other wholesale electric services to various municipalities and other utilities. NU serves about 30 percent of New England's electric needs and is one of the 20 largest electric utility systems in the country. NU acquired PSNH, the largest electric utility in New Hampshire, in June 1992. PSNH was in bankruptcy reorganization proceedings from January 1988 to May 1991, when it emerged from bankruptcy in the first step of an NU- sponsored two-step plan of reorganization. NU's acquisition of PSNH was the second step of the reorganization plan. On October 1, 1993, the Bankruptcy Court in New Hampshire formally terminated the bankruptcy proceeding. See Item 3, Legal Proceedings. PSNH continues to operate its core electric utility business, but pursuant to the reorganization plan, PSNH transferred its 35.6 percent interest in the Seabrook nuclear generating facility (Seabrook) in Seabrook, New Hampshire to North Atlantic Energy Corporation (NAEC), a special purpose subsidiary of NU which sells the capacity and output of that unit to PSNH under two life-of-unit, full cost recovery contracts. In June 1992, NU's subsidiary North Atlantic Energy Service Corporation (North Atlantic) assumed operational responsibility for Seabrook. Before that, Seabrook had been operated by a division of PSNH. Other wholly-owned subsidiaries of NU provide support services for the System companies and, in some cases, for other New England utilities. Northeast Utilities Service Company (NUSCO or the Service Company) provides centralized accounting, administrative, data processing, engineering, financial, legal, operational, planning, purchasing and other services to the System companies. Northeast Nuclear Energy Company (NNECO) acts as agent for the System companies and other New England utilities in operating nuclear generating facilities in Connecticut. North Atlantic acts as agent for the System companies and other New England utilities in operating Seabrook. Two other subsidiaries construct, acquire or lease some of the property and facilities used by the System companies. NU has two other principal subsidiaries, Charter Oak Energy, Inc. (Charter Oak) and HEC Inc. (HEC), which have non-utility businesses. Directly and through subsidiaries, Charter Oak develops and invests in cogeneration, small power production and independent power production facilities. HEC provides energy management services for commercial, industrial and institutional electric customers. See "Non-Utility Businesses." COMPETITION AND MARKETING Competition within the electric utility industry is increasing. In response, NU has developed, and is continuing to develop, a number of initiatives to retain and continue to serve its existing customers and to expand its retail and wholesale customer base. These initiatives are aimed at keeping customers from either leaving NU's retail service territory or replacing NU's electric service with alternative energy sources and at attracting new customers. Management believes that CL&P, PSNH and WMECO must continue to be responsive to their business customers, in particular, in dealing with the price of electricity and to recognize that many business customers have alternatives such as fuel switching, relocation and self- generation if the price of electricity is not competitive. A System-wide emphasis on improved customer service is a central focus of the reorganization of NU that became effective on January 1, 1994. The reorganization entails realignment of the System into two new core business groups. The first core business group, the energy resources group, is devoted to energy resource acquisition and wholesale marketing and focuses on nuclear, fossil and hydroelectric generation, wholesale power marketing and new business development. The second core business group, the retail business group, oversees all customer service, transmission and distribution operations and retail marketing in Connecticut, New Hampshire and Massachusetts. These two core business groups are served by various support functions known collectively as the corporate center. In connection with NU's reorganization, the System has begun a corporate reengineering process which should help it to identify opportunities to become more competitive while improving customer service and maintaining a high level of operational performance. ECONOMIC DEVELOPMENT The cost of doing business, including the price of electricity, is higher in the System's service area, and the Northeast generally, than in most other parts of the country. Relatively high state and local taxes, labor costs and other costs of doing business in New England also contribute to competitive disadvantages for many industrial and commercial customers of CL&P, PSNH and WMECO. These disadvantages have aggravated the pressures on business customers in the current weakened regional economy. As a result, state and local governments in the region frequently offer incentives to attract new business development to, and to expand existing businesses within, their states. Since 1991, CL&P and WMECO have worked actively with state and local economic development authorities to package incentives for a variety of prospective or expanding customers. These economic development packages typically include both electric rate discounts and incentive payments for energy efficient construction, as well as technical support and energy conservation services. In general, electric rate discounts are phased out over varying periods generally not in excess of ten years. From September 1991 through March 1, 1994, economic development rate agreements had been reached with approximately 45 industrial and commercial customers in the three states served by the System, including 38 customers in CL&P's service territory, one customer in PSNH's service territory and six customers in WMECO's service territory. As an adjunct to their economic development efforts, CL&P and WMECO have also developed programs which provide incentives to customers planning to construct or significantly renovate commercial or industrial buildings within the System's service territory. Approximately 40 percent of all such construction qualifies for incentive payments for the installation or retrofitting of energy-efficient equipment designed to result in permanent savings for the customer in addition to any savings that result from the rate discounts. The business expansion-related rate agreements cover small-to- medium-sized industrial companies and a few medium-sized commercial business relocations. In all cases where economic development rates are in effect, the additional load and associated revenues, even though received under discounted rates, result in a net benefit to the System by making a contribution towards the System's fixed costs. During 1993, 28 customers were on economic development rate riders, including 24 CL&P customers and four WMECO customers. The net benefit to the System during 1993 as a result of these agreements was approximately $300,000. BUSINESS RETENTION/BUSINESS RECOVERY From 1983 through 1989, the System's retail kilowatt-hour sales grew by an annual average rate of 3.8 percent. Since the end of 1989, retail sales have been level, except for the addition of PSNH's electric load as a result of NU's acquisition of PSNH, effective in June 1992. The leveling effect has resulted in part from the System's conservation and load management (C&LM) efforts, but is largely due to the region's persistent weak economy. Management expects a modest improvement in the economy in 1994 and moderate electric sales growth is anticipated. To spur economic activity, NU's subsidiaries have worked in concert with state and local authorities to retain businesses that are considering relocating outside of the NU service territory. C&LM incentives are used with temporary rate reductions to produce both short-term and long-term cost savings for customers. These reductions are generally limited to five years but may be for as long as ten years. As of the end of 1993, 25 System customers received such reductions, including 19 CL&P customers, two PSNH customers and five WMECO customers. These customers in the aggregate represented less than 0.5 percent of System revenues. The NU operating subsidiaries also offer rate reductions to business entities that can demonstrate that they are encountering financial problems threatening their viability but have reasonable prospects for improvement. These "business recovery" reductions can be brief in duration, sometimes lasting only a few months, or may extend for up to five years. From the time these rates became available in late 1991 through the end of 1993, 23 CL&P customers, two PSNH customers and eight WMECO customers have been granted such rate reductions. The CL&P customers provided approximately $10 million in annual revenues; the PSNH customers provided approximately $10 million in annual revenues and the WMECO customers provided approximately $1.5 million in annual revenues. The bulk of the cost of the presently estimated discounts has been anticipated in base rates. The cost of the C&LM program is also collected from ratepayers. COMPETITIVE GENERATION A growing source of competition in the electric utility industry comes from companies that are marketing co-generation systems, primarily to those customers who can use both the electricity and the steam created by such systems. See "Regulatory and Environmental Matters - Public Utility Regulation." For instance, the Pratt & Whitney Aircraft Division of United Technologies Corporation, the System's largest industrial customer, put into service a 25-megawatt generating system in January 1993, reducing CL&P's industrial sales by approximately 1.5 percent, or $8 million, during 1993. While only a few other such systems have been installed in the System's service territory to date, the extent of growth of further self-generation cannot be predicted. To help convince retail customers not to generate their own power, CL&P, PSNH and WMECO have offered a competitive generation rate or special rate contracts that typically provide for up to ten years of rate reductions in return for a commitment not to self-generate. Two of CL&P's largest customers, together accounting for approximately $12 million of annual revenues in 1993, are operating under these arrangements. The New Hampshire Public Utilities Commission (NHPUC) also approved a special PSNH rate available for operators of sawmills to help prevent those customers from installing diesel generation. Altogether, approximately 28 System customers were on some type of competitive generation rate or special contract at the end of 1993, consisting of two CL&P customers, 20 PSNH customers and six WMECO customers. The PSNH customers provided approximately $3 million in annual revenues and the WMECO customers provided approximately $1.5 million in annual revenues. Overall, all types of flexible rate riders and special contracts offered by the System have preserved System revenues of approximately $50 million. As each subsidiary intensifies its efforts to retain existing customers and gain new customers, the number of customers covered under such flexible rates, and the number and amount of overall discounts, are expected to rise moderately over the next few years. RETAIL WHEELING In principle, retail wheeling would enable a retail customer to select an electricity supplier and force the local electric utility to transmit the power to the customer's site. While wholesale wheeling was mandated by the Energy Policy Act of 1992 (Energy Policy Act) under certain circumstances, retail wheeling is generally not required in any of the System's jurisdictions. See "Regulatory and Environmental Matters - Public Utility Regulation." In Connecticut, the Department of Public Utility Control (DPUC) has begun an investigation into the desirability of retail wheeling; a similar DPUC study undertaken in 1987 concluded that full-scale ail wheeling was not in the public interest at that time. See "Rates-Connecticut Retail Rates." In New Hampshire, there have been no legislative proposals on full- scale retail wheeling to date. In Massachusetts, bills being reviewed by legislative committees could permit limited retail wheeling in economically distressed areas and to municipal and state-owned facilities. FUEL SWITCHING/ELECTROTECHNOLOGIES A customer's ability to switch to or from electricity as an energy source for heating, cooling or industrial processes (fuel switching) will continue to provide the System with both opportunities and risks over the coming years. While it is an important load, residential electric space heating makes up only five percent of the System's retail sales. In Connecticut and Massachusetts, the risk of fuel switching among residential customers is concentrated in the area of electric to natural gas conversions with lesser risks of oil and propane conversions, while in New Hampshire, conversions to oil and propane are more common. During 1993, approximately three percent of WMECO and PSNH space heating customers converted their heating systems from electric resistance or baseboard heating. Conversion activity in CL&P's service territory was minimal during 1993 and the net number of electric space heating customers in CL&P's territory increased during 1993. Since 1992, space heating conversions on the System have not represented more than a 0.1 percent loss of annual retail sales. Nonetheless, the System operating companies have implemented a number of programs to mitigate these losses. In New Hampshire, a new thermal energy storage program is being reviewed for approval by the NHPUC. In Connecticut and Massachusetts, programs are in place to encourage the use of ground source and advanced air-to-air heat pumps in both new and existing construction. In addition, in 1993 WMECO lowered rates for its electric space heating cusomters by approximately five percent with permission from the Massachusetts Department of Public Utilities (DPU) to address the competitive threat. Because of these programs and other initiatives, NU forecasts a continued increase in the net number of electric space heating customers. With respect to residential sales, central air conditioning continues to become more common in the System's service territory. The System has also begun to test the use of electric vehicles in all three of its service territories and is working to promote the manufacture of electric vehicles and their components in the System's service area. The System's energy conservation programs which target electric heat and hot water customers can be effective in lowering electric bills substantially. In 1993, the System embarked upon two aggressive field testing programs involving heat pumps to provide residential heating, cooling and hot water heating in cost effective ways. These programs, in Massachusetts and at Heritage Village in Southbury, Connecticut, are intended to demonstrate that the combination of cost effective conservation and the use of heat pumps will provide lower cost heating, cooling and water heating than other available fuels. The System also faces commercial load loss because of fuel switching, such as in the area of electrically heated commercial buildings. Additionally, natural gas distribution companies have been actively marketing gas-fired chillers to commercial and industrial customers. Electric space and hot water heating and air conditioning have come under increasing pressure in recent years from aggressive campaigns by natural gas distribution companies seeking to add new customers. In Connecticut and Massachusetts, NU's subsidiaries have initiated market driven heating, ventilating and air-conditioning (HVAC) incentive programs, which include some design assistance, to promote efficient, nonchlorofluorocarbon refrigerant electric chillers. In response to the threat of load loss due to alternative fuel sources, the System's marketing and customer service staff works proactively to compare relative costs of alternative fuels. In most instances, accurate cost comparisons and energy conservation programs allow the System to preserve most of each customer's load by assisting the customer to achieve a more efficient use of its electric energy. WHOLESALE MARKETING In general and subject to existing contractual restrictions, the System's wholesale customers, both within and outside the System's retail service area, are free to select any supplier they choose. NU's subsidiaries do not have an exclusive franchise right to serve such customers. Thus, the wholesale segment of the System's business is highly competitive. As a result of very limited load growth throughout the Northeast in the past five years and the operation of several new generating plants, competition has grown, and a seller's market for electricity has turned into a buyer's market. Of the approximately 2,000 - 3,000 megawatts of surplus capacity in New England, the System's total is approximately 1,000 megawatts. The prices the System has been able to receive for new wholesale contracts have generally been far lower than the prices prevalent in recent years. Nevertheless, in 1993, the System sold a monthly average of 350 megawatts on a daily and short-term basis and 1,150 megawatts under preexisting long-term commitments of capacity to over 20 utilities throughout the Northeast. These sales resulted in approximately $150 million of capacity revenues. The majority of these revenues have been recognized in System company base rates. In addition, System companies entered into approximately 11 long- term sales contracts in 1993 with both new and existing customers. These contracts are expected to increase sales by a yearly average of 60 megawatts from late 1993 through 2005. The new wholesale customers include the municipal electric systems in Georgetown, Middletown, South Hadley, Princeton, Danvers, Littleton and Mansfield, all in Massachusetts. Including these new sales, the System currently has capacity sales commitments with other New England utilities to sell an aggregate 4,000 megawatt-years of capacity from 1994 through 2008. The net benefits after costs from these sales are estimated at approximately $550 million over the remaining life of the contracts. Most of these benefits will be realized over the next few years. In addition, a contract for the sale of approximately 450 megawatt- years to the municipal electric system in Madison, Maine has been signed and is awaiting certain approvals. For information on competitive pressures affecting wholesale transmission, see "Electric Operations - Generation and Transmission." Over the next five years, intense competition in the Northeast market is expected to continue as new generating facilities, located for the most part outside the System's retail service areas and contracted to sell to others, become operational. See "Regulatory and Environmental Matters - Public Utility Regulation." This increase in power supply sources could put further downward pressure on prices, but the potential price decreases may be somewhat offset by an improvement in the region's economy and the retirement of a number of the region's existing generating plants. See "Electric Operations - Generation and Transmission." SUMMARY To date, the System has not been materially affected by competition, and it does not foresee substantial adverse effect in the near future unless the current regulatory structure or practice is substantially altered. The rate, service, business development and conservation initiatives described above, portions of which are funded in base rates, plus other cost containment efforts described below, have been adequate to date in retaining customers, preventing fuel switching and attracting new customers at a level sufficient to maintain the System's revenue and profit base and should have significant positive effects in the next few years. As noted above, however, the DPUC has begun a retail wheeling investigation in Connecticut, and its outcome is uncertain at this time. In Massachusetts, retail wheeling legislation is under consideration. To date, no such initiatives are underway in New Hampshire. NU's subsidiaries benefit from a diverse retail base, and the System has no significant dependance on any one customer or industry. The System's extensive transmission facilities and diversified generating capacity position it to be a strong factor in the regional wholesale power market for the foreseeable future. The System's wholesale power business should further cushion the financial effects of competitive inroads within its service area. The System believes that the corporate reengineering process initiated in early 1994 and structural reorganization effective January 1, 1994 should better position it to compete in the retail and wholesale electric businesses in the future. RATES CONNECTICUT RETAIL RATES GENERAL CL&P's retail electric rate schedules are subject to the jurisdiction of the DPUC. Connecticut law provides that increased rates may not be put into effect without the prior approval of the DPUC, which has 150 days to act upon a proposed rate increase, with one 30-day extension possible. If the DPUC does not act within that period, the proposed rates may be put into effect subject to refund. Connecticut law authorizes the DPUC to order a rate reduction before holding a full-scale rate proceeding if it finds that (i) a utility's earnings exceed authorized levels by one percentage point or more for six consecutive months, (ii) tax law changes significantly increase the utility's profits, or (iii) the utility may be collecting rates that are more than just and reasonable. The law requires the DPUC to give notice to the utility and any customers affected by the interim decrease. The utility would be afforded a hearing. If final rates set after a full rate proceeding or court appeal are higher, customers would be surcharged to make up the difference. 1992-1993 CL&P RETAIL RATE CASE In December 1992, CL&P filed an application for rate relief with the DPUC. The updated request sought to increase CL&P's revenues by $344 million or 15.4 percent in total over three years. That increase incorporated requested annual increases of $130 million, $104 million and $110 million starting in May 1993. As an alternative to the multi-year plan, CL&P also proposed a one-time increase totaling about $280 million, or 13.9 percent. On June 16, 1993, the DPUC issued a decision (Decision) approving the multi-year plan and providing for annual rate increases of $46.0 million, or 2.01 percent, in July 1993, $47.1 million, or 2.04 percent, in July 1994 and $48.2 million, or 2.06 percent, in July 1995. The total increase granted of $141.3 million, or 6.11 percent, is approximately 42 percent of CL&P's updated request. In light of the State of Connecticut's concern over economic development and industrial and commercial rates, one important aspect of the Decision was that industrial and manufacturing rates will rise only about 1.1 percent anually over the three-year period. Other significant aspects of the Decision include the reduction of CL&P's return on equity (ROE) from 12.9 percent (CL&P had sought to continue its ROE at that level) to 11.5 percent for the first year of the multi-year plan, 11.6 percent for the second year and 11.7 percent for the third year; recognition in CL&P's rates, by 1998, of non-pension, post-retirement benefit cost accruals required under Statement of Financial Accounting Standards (SFAS) No. 106; the identification of $49 million of prior fuel overrecoveries and the use of that amount to offset a similar amount of the unrecovered balance in CL&P's generation utilization adjustment clause (GUAC); the reduction of CL&P's projected operating and maintenance expense for contingency funding by approximately $53.6 million spread over three years; and the deferral of cogeneration expenses projected for 1994 and 1995 and the future recovery of those deferred amounts (approximately $63 million in total) plus carrying costs over five years beginning July 1, 1996. The Decision also required CL&P to allocate to customers $10 million of after tax earnings from a $47.7 million property tax accounting change made in the first quarter of 1993. CL&P recorded this $10 million adjustment as a reduction to second quarter net income. On August 2, 1993, two appeals were filed from the Decision. CL&P filed an appeal on four issues. The second appeal was filed by the Connecticut Office of Consumer Counsel (OCC) and the City of Hartford, challenging the legality of the multi-year plan approved by the DPUC. The two appeals were consolidated. CL&P moved to dismiss the appeal by the City of Hartford and the OCC on jurisdictional grounds. Oral arguments were held on October 15, 1993 and February 14, 1994 on CL&P's motion to dismiss the appeals challenging the multi-year rate plan. It is not known when a decision on CL&P's motion will be issued. In addition, the Court rejected (without prejudice to renewal) the City of Hartford's and the OCC's motion to stay implementation of the second and third year of the rate plan pending the outcome of their appeal. The City of Hartford and the OCC could renew a request for a stay following the outcome of their appeal. CL&P ADJUSTMENT CLAUSES CL&P has a fossil fuel adjustment clause and a GUAC applicable to its retail electric rates. In Connecticut, the DPUC is required to approve each month the charges or credits proposed for the following month under the fossil fuel adjustment clause. These charges and credits are designed to recover or refund changes in purchased power (energy) and fossil fuel prices from those set in base rates. Monthly fossil fuel charges or credits are also subject to review and appropriate adjustment by the DPUC each quarter after full public hearings. The Connecticut clause allows CL&P to recover substantially all prudently incurred fossil fuel expenses. CL&P's current retail electric base rate schedules assume that the nuclear units in which CL&P has entitlements will operate at a 72 percent composite capacity factor. The GUAC levels the effect on rates of fuel costs incurred or avoided due to variations in nuclear generation above and below that performance level. When actual nuclear performance is above the specified level, net fuel costs are lower than the costs reflected in base rates, and when nuclear performance is below the specified level, net fuel costs are higher than the costs reflected in base rates. At the end of a twelve-month period ending July 31 of each year, with DPUC approval, these net variations from the costs reflected in base rates are generally refunded to or collected from customers over the subsequent eleven-month period beginning September 1. This clause, however, does not permit automatic collection from customers to the extent the capacity factor is less than 55 percent for the twelve-month period. When and to the extent the annual nuclear capacity factor is less than 55 percent, it is necessary for CL&P to apply to the DPUC for permission to recover the additional fuel expense. In the Decision, the DPUC disallowed recovery of $41.5 million, the GUAC deferral balance associated with operation at a nuclear capacity factor below 55 percent during the 12-month GUAC period ending July 31, 1992. In the same Decision, the DPUC also disallowed $7.5 million of the $96 million deferral balance, representing operation at a nuclear capacity factor above 55 percent for that period, which had already been approved for collection from customers through December 31, 1993. The reason given for the disallowances was CL&P's $49 million overrecovery of fuel costs through base rates and the fuel adjustment clauses for the period August 1991 to July 1992. The Decision also cut short the previously allowed recovery of $96 million in GUAC deferrals by four months. The DPUC ordered the remaining unrecovered GUAC balance of $24.6 million to be "trued-up" against the deferral for the 1992-93 GUAC year. As result of two previous prudence decisions imposing disallowances for outages at the nuclear unit (CY) operated by the Connecticut Yankee Atomic Power Company (CYAPC) and Millstone I, the DPUC also ordered CL&P to refund to customers a total of $5.1 million in the GUAC billing period beginning September 1, 1993. In the most recent GUAC period, which ended July 31, 1993, the actual level of nuclear generating performance was 72.6 percent, resulting in a GUAC deferral of $4.0 million to be credited to customers beginning in September 1993. The GUAC rate filed by CL&P for the September 1993 - August 1994 GUAC billing period had five components: the $7.5 million disallowance from the rate case, the $5.1 million of prudence disallowances, the $4.0 million credit deferral for the most recent GUAC period, and the $24.6 million debit of previously unrecovered GUAC deferrals, for a total of $7.9 million. On September 1, 1993, the DPUC issued an interim order setting a GUAC rate of zero beginning September 1, 1993, subject to a proceeding to consider further CL&P's GUAC rate for the period September 1, 1993 to July 31, 1994. On January 5, 1994, the DPUC issued a decision fixing the GUAC rate at zero through August 31, 1994 and disallowing recovery of $7.9 million through the GUAC. The disallowance was based on a comparison of fuel revenues with fuel expenses, in the August 1992 - July 1993 period. On January 24, 1994, CL&P requested the DPUC to clarify its January 5, 1994 decision with respect to future application of the GUAC. Based on management's interpretation of the January 5, 1994 decision, CL&P does not expect that any future DPUC review using this methodology will have a material adverse impact on its future earnings. On March 4, 1994, CL&P appealed the January 5 GUAC decision to Connecticut Superior Court. For the 1984-1991 GUAC periods, CL&P refunded more than $112 million to its customers through the GUAC mechanism. For the five months ended December 31, 1993, the composite nuclear generation capacity factor was 66.7 percent. For the full twelve-month period ending July 31, 1994, the factor is projected to be approximately 74.7 percent. The DPUC has opened a docket to review the prudence of the 1992 outage related to the Millstone 2 steam generator replacement project. Discovery and filing of testimony is expected to continue through May 1994 and hearings, if required, will be held in the summer of 1994. CL&P incurred approximately $88 million in replacement power costs associated with Millstone outages that occurred during the period October 1990 - February 1992. These outages were the subject of several separate prudence reviews conducted by the DPUC, three of which are either on appeal or still pending at the DPUC. On May 19, 1993, the DPUC issued a final decision allowing recovery of costs related to the July 1991 shutdown of Millstone 3 caused by mussel- fouling of the heat exchangers. Approximately $0.9 million of replacement power costs are at issue. The OCC has appealed that decision to the Connecticut Superior Court. On September 1, 1993, the DPUC issued a final decision in the prudence investigation of outages at all four Connecticut nuclear plants resulting from an erosion/corrosion-induced pipe rupture at Millstone 2 on November 6, 1991. The decision concluded that CL&P's management of its erosion/corrosion program was reasonable and prudent and that expenses incurred as a result of the outages, which total approximately $65 million ($51 million of which represents replacement power costs) for CL&P, should be allowed. The OCC has also appealed this decision to the Connecticut Superior Court. The third ongoing prudence investigation involves a Millstone 3 outage caused by repairs to the service water piping in the fall of 1991. The OCC's witness filed testimony that, as a result of the DPUC's decision finding that the concurrent mussel-fouling outage was prudent, and the fact that the mussel-fouling outage continued at least as long as the service water outage, there was no economic impact on ratepayers from the service water outage. On September 23, 1993, the DPUC suspended the service water docket pending the outcome of OCC's appeal of the decision on the mussel- fouling outage. Approximately $26 million of replacement power costs are at issue. For further information on the shutdowns of Millstone units currently under review by the DPUC, see "Electric Operations -- Nuclear Generation -- Millstone Units." Some portion of the replacement power costs reflected in the three Millstone outages, as to which the DPUC has not completed its review or as to which the DPUC's decision has been appealed, may be disallowed. However, management believes that its actions with respect to these outages have been prudent, and it does not expect the outcome of the prudence reviews to result in material disallowances. CL&P has recognized that it will not recover in rates approximately $9.4 million in replacement power costs resulting from two other shutdowns at Millstone 1: one related to the unit's licensed operators failing requalification exams and the other related to seaweed blockage at the intake structure. CL&P owns 34.5 percent of the common stock of CYAPC, a regional nuclear generating company. During the 1987-1988 refueling outage, repairs were made to CY's thermal shield. During an extended 1989-1990 refueling outage, the thermal shield was removed due to continued degradation. The DPUC reviewed these outages. In a report issued in 1990, the DPUC's auditors concluded that the actions of CYAPC's personnel and its contractors were reasonable with respect to the thermal shield's repair and removal. However, the auditors also concluded that the failure to clean the entire refueling cavity during the 1987-1988 outage was the most likely cause of debris left in the cavity that subsequently resulted in the additional damage that was repaired during the 1989-1990 outage. In October 1992, the DPUC disallowed CL&P's recovery of $3 million in replacement power costs and $230,000 of related operating and maintenance costs resulting from CY's 1989-1990 extended outage. CL&P appealed the DPUC's decision. On December 2, 1993, the Connecticut Superior Court issued a decision reversing the DPUC, in part, and upholding it in part. The court ruled in favor of CL&P by reversing the $230,000 disallowance and in favor of the DPUC by upholding the $3 million disallowance of replacement power costs. The partial reversal in favor of CL&P was based on the principle of federal preemption and is an important legal precedent for future CYAPC matters. CONSERVATION AND LOAD MANAGEMENT CL&P participates in a collaborative process for the development and implementation of C&LM programs for its residential, commercial and industrial customers. In September 1992, the DPUC approved a Conservation Adjustment Mechanism (CAM) that allows CL&P to recover C&LM costs to the extent not recovered through current base rates. The CAM authorized continued recovery of C&LM costs over a ten-year period with a return on the unrecovered costs. In December 1992, CL&P filed an application with the DPUC for approval of budgeted C&LM expenditures for 1993 of $47.5 million and a proposed CAM for 1993. On April 14, 1993, the DPUC issued an order approving a new CAM rate, which allows CL&P to recover $24 million of its budgeted $47 million C&LM expenditures during 1993 and associated true-ups of past C&LM expenditures. The order also provided that any unrecovered expenditures would be recovered over eight years. CL&P's actual 1993 C&LM expenditures were approximately $42.8 million. The unrecovered C&LM costs at December 31, 1993 excluding carrying costs were $116.2 million. On December 30, 1993, CL&P and the other participants in the collaborative process filed an offer of settlement with the DPUC regarding CL&P's 1994 C&LM expenditures, program designs, performance incentive and lost fixed cost revenue recovery. The settlement proposed a budget level of $39 million for 1994 C&LM and a reduction in the amortization period for new expenditures from eight to 3.85 years. CL&P expects additional 1994 C&LM expenditures of approximately $1 million for state facilities. The DPUC began hearings on the proposed settlement during March 1994. NEW HAMPSHIRE RETAIL RATES RATE AGREEMENT AND FPPAC NU acquired PSNH, the largest electric utility in New Hampshire, in June 1992. See "The Northeast Utilities System." PSNH's 1989 Rate Agreement (Rate Agreement) provides the financial basis for the plan under which PSNH was reorganized and became an NU subsidiary. The Rate Agreement sets out a comprehensive plan of retail rates for PSNH, providing for seven base rate increases of 5.5 percent per year and a comprehensive fuel and purchased power adjustment clause (FPPAC). The first of these base retail rate increases was put into effect in January 1990. The second rate increase took place on May 16, 1991, when PSNH reorganized as an interim, stand-alone company; the third rate increase occurred on June 1, 1992, just before NU's acquisition of PSNH; and the fourth rate increase went into effect on June 1, 1993. The remaining three increases are to be placed in effect by the NHPUC annually beginning June 1, 1994, concurrently with a semi-annual adjustment in the FPPAC. The Rate Agreement also provides for the recovery by PSNH through rates of a regulatory asset, which is the aggregate value placed by PSNH's reorganization plan on PSNH's assets in excess of the net book value of PSNH's non-Seabrook assets and the value assigned to Seabrook. In accordance with the Rate Agreement, approximately $265 million of the remaining regulatory asset is scheduled to be amortized and recovered through rates by 1998, and the remaining amount, approximately $504 million, is scheduled to be amortized and recovered through rates by 2011. PSNH is entitled to a return each year on the unamortized portion of the asset. The unrecovered balance of the regulatory asset at December 31, 1993 was approximately $769.5 million. In order to provide protection from significant variations from the costs assumed in the base rates over the period of the seven base rate increases (Fixed Rate Period), the Rate Agreement established a return on equity (ROE) collar to prevent PSNH from earning an ROE in excess of an upper limit or below a lower limit. To date, PSNH's ROE has been within the limits of the ROE collar. The FPPAC provides for the recovery or refund by PSNH, for the ten- year period beginning on May 16, 1991, of the difference between the actual prudent energy and purchased power costs and the costs included in base rates. The rate is calculated for a six-month period based on forecasted data and is reconciled to actual data in subsequent FPPAC billing periods. PSNH costs included in the FPPAC calculation are the cost of fuel used at its generating plants and purchased power, energy savings and support payments associated with PSNH's participation in the Hydro-Quebec arrangements, the Seabrook Power Contract costs billed to PSNH from NAEC, NEPOOL Interchange expense and savings, fifty percent of the joint dispatch energy expense savings resulting from the combination of PSNH and the System companies as a single pool participant, purchased capacity costs associated with other System power and unit contract capacity purchases excluding the Yankee nuclear companies and the cost to amortize capital expenditures for, and to operate, environmental or safety backfits or fuel switching. The FPPAC also provides for the recovery of a portion of the payments made currently to qualifying facilities and a portion of the costs associated with the PSNH buyback of the New Hampshire Electric Cooperative, Inc. (NHEC) entitlement in Seabrook. For information on NHEC's 1991 filing for bankruptcy and its subsequent reorganization, see "Rates - Wholesale Rates." The balance of the current payments to qualifying facilities, representing a part of the payments made currently to eight specific small power producers (SPPs), are deferred each year and amortized and recovered over the succeeding ten years. A portion of the current payments to NHEC is also deferred and will be recovered either through the FPPAC during the fixed rate period or through base rates after the fixed rate period. Recovery of the NHEC deferral through the FPPAC occurs only if the FPPAC rate is negative; in such instance, deferred NHEC costs would be recovered to the extent required to bring the FPPAC rate to zero. From June to November 1992, the FPPAC rate, which would otherwise have been negative, was set at zero, and some NHEC deferrals were amortized. The operation of the FPPAC during this period resulted in an overrecovery, which was also netted against NHEC deferrals in December 1992 and March 1993. As of December 31, 1993, SPP and NHEC deferrals totaled approximately $107.6 and $14.8 million, respectively. Under the Rate Agreement, PSNH has an obligation to use its best efforts to renegotiate the purchase power arrangements with 13 specified SPPs that were selling their output to PSNH under long term rate orders. Agreements have been reached with all five of the hydroelectric facilities under which the rates PSNH pays for their output would be reduced but the term of years for sales from the hydro producers would be extended by five years. The NHPUC held a hearing concerning these agreements on February 25, 1994. PSNH has also reached agreements with three of the eight wood-fired qualifying facilities with long term rate orders. Under each agreement, PSNH would pay each operator a lump sum in exchange for canceling the operator's right to sell its output to PSNH under rate orders. The total payment to the three operators would be approximately $91.8 million (covering approximately 35 MW of capacity). The three wood operators' agreements will be considered in hearings before the NHPUC in late spring 1994. PSNH is unable to predict if any or all of these agreements will be consummated. Although the Rate Agreement provides an unusually high degree of certainty about PSNH's future retail rates, it also entails a risk if sales are lower than anticipated, as they were in 1991 and 1992, or if PSNH should experience unexpected increases in its costs other than those for fuel and purchased power, since PSNH has agreed that it will not seek additional rate relief before 1997, except in limited circumstances. Even if allowed under the Rate Agreement, any additional increases above 5.5 percent per year are subject to political and economic pressures that tend to limit overall retail rate increases, including FPPAC increases. In accordance with the Rate Agreement, PSNH increased its average retail electric rates by about 4.5 percent in June 1993 and by 1.8 percent on December 1, 1993. The 4.5 percent increase in June resulted from the combined effect of decreasing to $.00110 per kilowatthour the FPPAC charge at the same time that (1) the fourth of the seven increases in base electric rates of 5.5 percent and (2) a temporary increase associated with recently enacted legislation associated with the settlement of the Seabrook tax suit described below took effect. The decrease in the FPPAC charge also reflected lower costs paid by PSNH through the Seabrook Power Contract for Seabrook property tax imposed on NAEC. The December 1993 increase resulted from an increase in the FPPAC rate. In its decision on the June 1, 1993 increase, the NHPUC disallowed replacement power costs for three Seabrook outages totalling about $0.4 million. On August 16, 1993, the NHPUC affirmed its decision to disallow that amount. In the August 16 decision, the NHPUC also rejected a request by the New Hampshire Office of Consumer Advocate (OCA) to allow access to certain confidential, self-critical documents generated at Seabrook station by plant personnel following outages and power reductions. PSNH has been providing summary analyses of the circumstances surrounding outages; however, it declined to provide the original self-critical documents in an effort to maintain an atmosphere in which employees would be encouraged to report and comment on all possible problems. The OCA filed an appeal of the NHPUC's decision on its request for access to these documents with the New Hampshire Supreme Court on November 16, 1993. On February 8, 1994, the court accepted the appeal. On September 14, 1993, PSNH filed a request for an increase in its FPPAC rate for the period December 1, 1993 through May 31, 1994. The increase of one percent of the average retail rate was expected to produce less than the revenues necessary to cover PSNH's FPPAC costs over these six months, a period during which Seabrook will undergo a two-month refueling outage. PSNH waived its right to immediate collection and proposed to defer about $13 million of FPPAC costs for later collection in order to limit its total rate increases for 1993 to 5.5 percent. Hearings on the FPPAC rate request were held on November 9 and 10, 1993. On November 29, 1993, the NHPUC approved a higher FPPAC rate than the rate requested by PSNH. The increase was 1.8 percent higher than rates previously in effect and allowed PSNH to recover a deferral of $10.5 million over a twelve month period beginning June 1, 1994, which ends prior to the next scheduled Seabrook refueling outage. In its June 1992 decision concerning PSNH's FPPAC rate, the NHPUC had determined that PSNH should not be entitled to recover approximately $1.3 million with respect to wholesale power agreements with two New England utilities. Also, the NHPUC had questioned the prudence of a series of short term contractual agreements (SWAP Agreements) for energy and capacity exchanges entered into between the System and PSNH prior to the merger and the allocation of savings resulting from the SWAP Agreements. In November 1992, PSNH entered into proposed settlements with the NHPUC staff and the OCA to settle these issues. The settlements proposed disallowances of approximately $500,000 for the two wholesale power agreements and $250,000 for the SWAP Agreements. On March 23, 1993, the NHPUC approved the settlements. SETTLEMENT OF THE SEABROOK TAX SUIT On April 16, 1993, the Governor of New Hampshire signed into law legislation that implemented the settlement of a suit concerning property tax on Seabrook station (the Seabrook Tax) that was filed with the United States Supreme Court by Attorneys General of Connecticut, Massachusetts and Rhode Island. The legislation made various changes to New Hampshire tax laws, resulting in taxes of approximately $5.8 million to be paid by NU on a consolidated basis in each of 1993 and 1994 and $3.0 million in 1995, a reduction from the $9.5 million paid by NU on a consolidated basis in 1992. Of such amounts to be paid, CL&P's portion will be approximately $0.6 million in each of 1993 and 1994 and approximately $0.3 million in 1995 and NAEC's portion will be approximately $5.2 million in each of 1993 and 1994 and approximately $2.7 million in 1995. MEMORANDUM OF UNDERSTANDING On May 6, 1993, PSNH, NAEC, NUSCO and the Attorney General of the State of New Hampshire entered into a Memorandum of Understanding (Memorandum) relating to certain issues which had arisen under the Rate Agreement. In part, the issues addressed relate to the enactment of the legislation implementing the settlement of the Seabrook Tax lawsuit. Pursuant to the Memorandum, tax changes imposed by the legislation will not increase PSNH's overall ratepayer charges, but will be reflected in PSNH rates pursuant to the Rate Agreement through offsetting adjustments to PSNH's base rates and FPPAC charges. On June 1, 1993, PSNH put into effect a temporary increase of $0.00074 per kilowatthour in base rates designed to recover the increased costs associated with the enactment of the legislation. A corresponding decrease in the FPPAC costs collected after June 1, 1993 offset the base rate increase. The FPPAC decrease reflected the reduction of the Seabrook property tax resulting from the legislation. The Memorandum also addresses the implementation of new accounting standards imposed by SFAS 106 and SFAS 109. The Memorandum establishes the method of accounting under SFAS 106 for employees' post-retirement benefits other than pensions for PSNH ratemaking purposes. Under SFAS 109, companies may recognize as a deferred tax asset the value of certain tax attributes. The Memorandum provides for the establishment of a regulatory liability attributable to significant net operating loss carryforwards and establishes that such liability should be amortized over a six-year period beginning on May 1, 1993. Other provisions of the Memorandum cover: NAEC's acquisition of the Vermont Electric Generation and Transmission Cooperative's (VEG&T) 0.41259% interest in Seabrook for approximately $6.4 million and NAEC's sale of the output to PSNH. All necessary regulatory approvals for NAEC's acquisition have been received and NAEC acquired VEG&T's interest on February 15, 1994. The Rate Agreement will be amended to ensure that this acquisition will not impact PSNH rates during the fixed rate period. The Rate Agreement's ROE collar floor provisions were amended to provide for the adjustment by PSNH of its revenue received from James River Corporation and Wausau Papers of New Hampshire by the amount of the demand charge discount previously approved by the NHPUC. The Rate Agreement was also amended to provide that any adjustments to the amount of PSNH's liability under the Seabrook Power Contract to reimburse NAEC for payments to the Seabrook Nuclear Decommissioning Financing Fund (a fund administered by the State of New Hampshire to finance decommissioning of Seabrook) will be recovered through adjustments to PSNH's base rates; however, such adjustments will not be subject to the annual 5.5 percent increases established under the Rate Agreement. See "Electric Operations - Nuclear Generation - Decommissioning" for further information on decommissioning costs for Seabrook station and other nuclear units that the System owns or participates in. On May 11, 1993, PSNH and the State of New Hampshire filed a petition with the NHPUC seeking approval of the Memorandum. As required for implementation, PSNH's lenders approved the Memorandum. The NHPUC hearing on the petition seeking approval of the Memorandum and a request to make the June 1, 1993, temporary base rate increase permanent was held on December 2, 1993. PSNH entered into a stipulation with the NHPUC staff and the OCA which modified the Memorandum slightly, clarifying terms of the NAEC power contract applicable to the VEG&T interest in Seabrook. The NHPUC approved the Memorandum as modified by the stipulation, the permanent base rate increase and the Third Amendment to the Rate Agreement on January 3, 1994. As a result of the approval of the Memorandum, PSNH's earnings in 1993 increased by $10 million. The cumulative impact of the issues resolved by the Memorandum is not expected to have a significant impact on PSNH's future earnings. SEABROOK POWER CONTRACT PSNH and NAEC entered into the Seabrook Power Contract (Contract) on June 5, 1992. Under the terms of the Contract, PSNH is obligated to purchase NAEC's initial 35.56942% ownership share of the capacity and output of Seabrook 1 for the term of Seabrook's NRC operating license and to pay NAEC's "cost of service" during this period, whether or not Seabrook 1 continues to operate. NAEC's cost of service includes all of its prudently incurred Seabrook-related costs, including maintenance and operation expenses, cost of fuel, depreciation of NAEC's recoverable investment in Seabrook 1 and a phased-in return on that investment. The payments by PSNH to NAEC under the Contract constitute purchased power costs for purposes of the FPPAC and are recovered from customers under the Rate Agreement. Decommissioning costs are separately collected by PSNH in its base rates. See "Rates - New Hampshire Retail Rates - Rate Agreement and FPPAC" for information relating to the Rate Agreement. If Seabrook 1 is retired prior to the expiration of the Nuclear Regulatory Commission (NRC) operating license term, NAEC will continue to be entitled under the Contract to recover its remaining Seabrook investment and a return of that investment and its other Seabrook-related costs for 39 years, less the period during which Seabrook 1 has operated. At December 31, 1993, NAEC's net utility plant investment in Seabrook 1 was $732 million. The Contract provides that NAEC's return on its "allowed investment" in Seabrook 1 (its investment in working capital, fuel, capital additions after the date of commercial operation of Seabrook 1 and a portion of the initial investment) is calculated based on NAEC's actual capitalization from time to time over the term of the Contract, its actual debt and preferred equity costs, and a common equity cost of 12.53 percent for the first ten years of the Contract, and thereafter at an equity rate of return to be fixed in a filing with the FERC. The portion of the initial investment which is included in the "allowed investment" was 20 percent for the twelve months commencing May 16, 1991, increasing by 20 percent in the second year and by 15 percent in each of the next four years, resulting in 100 percent in the sixth and each succeeding year. As of December 31, 1993, 55 percent of the investment was included in rates. NAEC is entitled to earn a deferred return on the portion of the initial investment not yet phased into rates. The deferred return on the excluded portion of the initial investment will be recovered, together with a return on it, beginning in the first year after PSNH's Fixed Rate Period, and will be fully recovered prior to the tenth anniversary of PSNH's reorganization date. Effective February 15, 1994, NAEC also owns the 0.41259% share of capacity and output of Seabrook it purchased from VEG&T. NAEC sells that share to PSNH under an agreement that has been approved by FERC and is substantially similar to the Contract; however, the agreement does not provide for a phase-in of allowed investment and associated deferrals of capital recovery. MASSACHUSETTS RETAIL RATES GENERAL WMECO's retail electric rate schedules are subject to the jurisdiction of the DPU. The rates charged under HWP's contracts with industrial customers are not subject to the ratemaking jurisdiction of any state or federal regulatory agency. Massachusetts law allows the DPU to suspend a proposed rate increase for up to six months. If the DPU does not act within the suspension period, the proposed rates may be put into effect. Under present rate-making standards, the DPU allows few adjustments to historic test year expenses to reflect the conditions anticipated by a company during the first year amended rate schedules are to be in effect. The principal adjustments that are permitted are inflation adjustments to historic test year non-fuel operation and maintenance expenses. Rate base is based on test year-end levels, and capital structure is based on test year-end levels adjusted for known and measurable changes. Current DPU practices permit WMECO to normalize most income tax timing differences. In Holyoke, Massachusetts, where HWP and Holyoke Gas and Electric Department, a municipal utility, operate side-by-side, approximately 30 HWP industrial customers sought bids as a group in 1993 for future electric service. HWP retained the load and has a 10-year contract, at substantially lower rates than in the past, to supply the group. WMECO REGULATORY ACTIVITY In December 1991, WMECO filed an application with the DPU for a retail rate increase of approximately $36 million or 9.1 percent. In April 1992, WMECO and the Massachusetts Attorney General filed a partial settlement agreement for approval by the DPU. Also in April 1992, a settlement agreement on WMECO's C&LM program budget was filed with the DPU jointly by WMECO, the Massachusetts Attorney General, Massachusetts Division of Energy Resources (DOER), the Conservation Law Foundation, Inc. (CLF) and the DPU's Settlement Intervention Staff. The settlement agreement covered WMECO's C&LM program through 1993 and included an annual budget of $17 million for both years. The parties also agreed that all expenditures and other charges relating to C&LM would be collected through a conservation charge (CC). In May 1992, the DPU accepted the WMECO retail rate case and the C&LM settlement agreements. As a result, WMECO's annual retail rates increased by $12 million, or three percent, on July 1, 1992, and by a further $11 million, or 2.7 percent, on July 1, 1993. In June 1992, the DPU resolved the remaining issues in the rate case filed in December 1991, when it issued an order on WMECO's rate design. The DPU order required the first and second year base revenue increases to be allocated so that all classes contribute the same percentage increase. In July 1992, the DPU approved an amended settlement agreement for 1992 and 1993 C&LM programs that established a CC that promoted rate stability by spreading the costs and subsequent recovery of 1992 and 1993 C&LM programs over the 18-month period from July 1, 1992 through December 31, 1993. The CC includes incremental C&LM program costs above or below base rate recovery levels, C&LM fixed cost recovery adjustments, and the provision for a C&LM incentive mechanism. In January 1993, WMECO filed with the DPU a request to reduce the CC rate by an aggregate of $3 million in 1993. On February 5, 1993, the DPU directed WMECO to file a revised CC to be effective on March 1, 1993 based on actual 1992 expenditures and the preapproved 1993 budget. The DPU approved the new CC on February 26, 1993. A motion for reconsideration was filed by certain of the parties to the original settlement. The DPU rejected that motion on July 9, 1993. WMECO filed for approval of a new CC on February 2, 1994. The DPU held a hearing on the proposed new CC on February 18, 1994. In October 1992, the DPU approved an Integrated Resource Management (IRM) settlement agreement that had been proposed by WMECO, the Attorney General, CLF, DOER and the Massachusetts Public Interest Research Group (MASSPIRG) concerning WMECO's IRM. The settlement required WMECO to submit its C&LM programs for 1994, 1995 and a portion of 1996 for approval by the DPU prior to October 1993, and to file its next IRM draft initial filing on January 3, 1994. The settlement also requires WMECO to prepare a competitive resource solicitation at least six months before its C&LM filing for any new C&LM programs it proposes. On March 16, 1993 WMECO filed a motion with the DPU to request authority to eliminate the separate (and higher) rates for residential electric heating customers by placing those customers on the same rates as the residential non-electric heating customers. WMECO proposed this change in order to be more competitive and to stem its losses of electric heating customers. On April 30, 1993, the DPU denied WMECO's request to eliminate the separate rates for residential electric heating customers but reduced the customer and energy charges for the electric heating customers to equal the comparable charges for non-electric heating customers. In November 1993, WMECO submitted its C&LM filing required in the settlement of the IRM proceeding, along with a settlement offer from WMECO, the Attorney General, DOER, CLF and MASSPIRG. The settlement offer incorporated preapproved C&LM funding levels for 1994 and 1995 of $14.2 million and $15.8 million, respectively. The settlement also provides for the recovery of lost fixed revenue and a bonus incentive if certain implementation objectives are met. On January 21, 1994, the DPU approved the settlement. On January 3, 1994, WMECO submitted its next draft initial IRM filing required by the October 1992 settlement to the DPU. The filing indicates the System does not need additional resources until at least the year 2007 and, therefore, WMECO does not intend to issue any solicitation for additional resources anytime in the foreseeable future. WMECO is presently participating in settlement discussions concerning this IRM filing. Should no settlement be reached, WMECO is scheduled to submit its initial IRM filing to the DPU in April 1994. WMECO ADJUSTMENT CLAUSE In Massachusetts, all fuel costs are collected on a current basis by means of a forecasted quarterly fuel clause. The DPU must hold public hearings before permitting quarterly adjustments in WMECO's retail fuel adjustment clause. In addition to energy costs, the fuel adjustment clause includes capacity and transmission charges and credits that result from short-term transactions with other utilities and from the operation of the Northeast Utilities Generation and Transmission Agreement (NUG&T). The NUG&T is the FERC-approved contract among the System operating companies, other than PSNH, that provides for the sharing among the companies of system-wide costs of generation and transmission and serves as the basis for planning and operating the System's bulk power supply system on a unified basis. Massachusetts law establishes an annual performance program related to fuel procurement and use, and requires the DPU to review generating unit performance and related fuel costs if a utility fails to meet the fuel procurement and use performance goals set for that utility. Goals are established for equivalent availability factor, availability factor, capacity factor, forced outage rate and heat rate. Fuel clause revenues collected in Massachusetts are subject to potential refund, pending the DPU's examination of the actual performance of WMECO's generating units. Currently pending before the DPU are investigations into the performance of WMECO's generating units for the 12-month periods ending May 31, 1992 and May 31, 1993. The DPU held a hearing on February 1, 1994 on WMECO's non-nuclear performance for the 12-month period ending May 31, 1992. Except for the order concerning CYAPC discussed below, the DPU has completed investigations of, but not yet issued decisions reviewing WMECO's actual generating unit performance for the program years between June 1987 and May 1991. The DPU has consistently set performance goals for generating units that are not wholly-owned and operated by the company whose goals are being set. The DPU has found that possession of a minority ownership interest in a generating plant does not relieve a company of its responsibilities for the prudent operation of that plant. Accordingly, the DPU has established goals, as discussed above, for the three Millstone units and for the three regional nuclear generating units (the Yankee plants) in which WMECO has minority ownership interests. The total amount of WMECO retail replacement power costs attributable to the major outages in the 1991 performance year -- the Millstone 3 July 1991 outage (mussel-fouling and service water), the Millstone 1 October 1991 outage (operator requalification examinations) and the November 1991 outages to perform pipe inspections, analysis and repair -- is approximately $17 million. In December 1992, WMECO notified the DPU that it will forego recovery of $1.2 million in replacement power costs associated with the October 1991 Millstone 1 operator requalification examination outage. The total amount of WMECO retail replacement power costs attributable to outages in the 1992-1993 performance year is approximately $17 million. Management believes that some portion of these replacement power costs may be subject to refund upon completion of the DPU's performance program reviews. However, management believes that its actions with respect to these outages have been prudent and does not expect the outcome of the DPU review to have a material adverse impact on WMECO's future earnings. In September 1992, the DPU issued a partial order pertaining to CY's extended 1989-1990 refueling outage (discussed above), disallowing the recovery of $0.6 million of incremental replacement power costs that could be attributable to the outage. WMECO filed a motion for reconsideration with the DPU in the same month, which motion is pending before the DPU. WHOLESALE RATES CL&P currently furnishes firm wholesale electric service to one Connecticut municipal electric system. PSNH serves NHEC, three New Hampshire municipal electric systems and one investor-owned utility in Vermont. HWP and its wholly-owned subsidiary, Holyoke Power and Electric Company, serve one Massachusetts municipal electric system. WMECO serves one New York investor-owned electric utility. The System's 1993 firm wholesale load was approximately 275 megawatts (MW). In 1993, firm wholesale electric service accounted for approximately 2.5 percent of the System's consolidated electric operating revenues (approximately 1.2 percent of CL&P's operating revenue, 6.0 percent of PSNH's operating revenue, 0.1 percent of WMECO's operating revenue and 21.5 percent of HWP's operating revenue). NHEC, PSNH's largest customer, representing 5.9 percent of its revenues for 1993, filed a petition for reorganization in 1991 under Chapter 11 of the United States Bankruptcy Code. A plan of reorganization for NHEC, which was confirmed by the Bankruptcy Court in March 1992 and became effective on December 1, 1993, resolves a series of disputes between PSNH and NHEC and provides for PSNH to continue to serve NHEC. The contract covering this continued service has been filed with and accepted by FERC. In addition to firm service, the System engages in numerous other bulk supply transactions that reduce retail customer costs, at rates that are subject to FERC jurisdiction, and it transmits power for other utilities at FERC-regulated rates. See "Electric Operations - Generation and Transmission" for further information on those bulk supply transactions and for information on pending FERC proceedings relating to transmission service. All of the wholesale electric transactions of CL&P, PSNH, WMECO, NAEC and HWP are subject to the jurisdiction of the FERC. For a discussion of certain FERC-regulated sales of power by CL&P, PSNH, WMECO and HWP to other utilities, see "Electric Operations -- Distribution and Load." For a discussion of sales of power by NAEC to PSNH, see "Rates - Seabrook Power Contract." For a discussion of the effects of competition on the System, see "Competition and Marketing." RESOURCE PLANS CONSTRUCTION The System's construction program expenditures, including allowance for funds used during construction (AFUDC), in the period 1994 through 1998 are estimated to be as follows: 1994 1995 1996 1997 1998 (Millions of Dollars) PRODUCTION CL&P . . . . . $ 60.9 $54.5 $44.3 $41.5 $39.6 PSNH . . . . . 10.5 7.0 13.3 8.7 15.8 WMECO . . . . 17.3 13.5 10.1 9.3 17.4 NAEC . . . . . 8.2 8.5 8.3 7.0 5.8 Other . . . . 16.2 3.0 2.0 0.7 0.5 System Total . 113.1 86.5 78.0 67.2 79.1 SUBSTATIONS AND TRANSMISSION LINES CL&P . . . . . 12.2 9.4 11.6 12.3 14.6 PSNH . . . . . 3.0 6.9 9.9 6.1 6.7 WMECO. . . . . 0.8 0.4 0.5 0.8 1.3 NAEC . . . . . 0.0 0.0 0.0 0.0 0.0 Other . . . . 0.0 0.0 0.0 0.0 0.0 System Total 16.0 16.7 22.0 19.2 22.6 DISTRIBUTION OPERATIONS CL&P . . . . . 76.1 78.8 80.9 84.1 85.5 PSNH . . . . . 22.0 11.7 10.6 14.5 14.2 WMECO. . . . . 17.4 19.3 17.3 17.2 18.7 NAEC . . . . . 0.0 0.0 0.0 0.0 0.0 Other . . . . 0.4 0.2 0.2 0.2 0.2 System Total 115.9 110.0 109.0 116.0 118.6 GENERAL CL&P . . . . . 8.6 8.8 7.2 5.8 5.1 PSNH . . . . . 2.0 3.3 1.9 2.4 2.0 WMECO . . . . 2.0 2.1 1.9 1.5 1.3 NAEC . . . . . 0.0 0.0 0.0 0.0 0.0 Other . . . . 9.9 7.4 7.8 9.8 9.8 System Total 22.5 21.6 18.8 19.5 18.2 TOTAL CONSTRUCTION CL&P . . . . . 157.8 151.5 144.0 143.7 144.8 PSNH . . . . . 37.5 28.9 35.7 31.7 38.7 WMECO . . . . 37.5 35.3 29.8 28.8 38.7 NAEC . . . . . 8.2 8.5 8.3 7.0 5.8 Other . . . . 26.5 10.6 10.0 10.7 10.5 System Total $267.5 $234.8 $227.8 $221.9 $238.5 The construction program data shown above include all anticipated capital costs necessary for committed projects and for those reasonably expected to become committed, regardless of whether the need for the project arises from environmental compliance, nuclear safety, improved reliability or other causes. The construction program data shown above generally include the anticipated capital costs necessary for fossil generating units to operate at least until their scheduled retirement dates. Whether a unit will be operated beyond its scheduled retirement date, be deactivated or be retired on or before its scheduled retirement date is regularly evaluated in light of the System's needs for resources at the time, the cost and availability of alternatives, and the costs and benefits of operating the unit compared with the costs and benefits of retiring the unit. Retirement of certain of the units could, in turn, require substantial compensating expenditures for other parts of the System's bulk power supply system. Those compensating capital expenditures have not been fully identified or evaluated and are not included in the table. FUTURE NEEDS The System's integrated demand and supply planning process is the means by which the System periodically updates its long-range resource needs. The current resource plan identifies a need for new resources beginning in 2007. Because New England and the System have surplus generating capacity and are forecasting low load growth over the next several years, the System has no current plans to construct or to contract for any new generating units. Additional capacity beyond 2007, the projected System year of need, can come from a variety of sources. The design and implementation of new C&LM programs, the timely development of economic, reliable and efficient qualifying cogeneration and small power production facilities (QFs) or independent power producer (IPP) capacity through state-sanctioned resource acquisition processes, economic utility-sponsored generating resources (including the possibility of repowering retired power plants) and purchases from other utilities will all receive consideration in the System's integrated resource planning process. With respect to demand-side management measures, the System's long- term plans rely, in part, on encouraging additional C&LM by customers. These measures, including installations to date, are projected to lower the System summer peak load in 2007 by over 1000 MW. In addition, System companies have long-term arrangements to purchase the output from QFs and IPPs under federal and state laws, regulations and orders mandating such purchases. CL&P's, PSNH's and WMECO's plans anticipate the development of QFs and IPPs supplying 710 MW of firm capacity by 1995, of which approximately 695 MW was operational in 1993. See "New Hampshire Retail Rates -- Rate Agreement and FPPAC" for information concerning PSNH's efforts to renegotiate its agreements with thirteen QFs. CL&P and WMECO filed applications with the U.S. Environmental Protection Agency to receive 203 SO2 allowances for C&LM activity as authorized by the Clean Air Act Amendments. See "Regulatory and Environmental Matters - Environmental Regulation - Air Quality Requirements." The DPUC has issued regulations establishing competitive bidding systems for future purchases by Connecticut electric utilities from QFs and IPPs and from C&LM vendors. The regulations also implement a state law which provides that a utility may seek a premium of between one and five percentage points above its most recently authorized rate of return for each multi-year C&LM program requiring capital investment by the utility. In April 1993, CL&P submitted its eighth annual filing to the DPUC on private power production, C&LM, projected avoided costs and related matters. CL&P stated that the System's existing and committed resources are expected to be sufficient to meet System capacity requirements until 2007, and therefore, CL&P did not solicit new capacity from QFs or C&LM vendors in 1993. In December 1993, the DPUC issued its final decision approving CL&P's avoided cost estimates as filed. In 1993, regulatory preapproval was obtained for all 1993 C&LM expenditures in each of the three retail jurisdictions. In addition, the DPUC authorized a maximum of 3 percent premium rate of return (after tax) on CL&P C&LM investment in 1993. WMECO is currently projected to earn $1.2 million of incentive (after tax) based on 1993 program savings. See "Rates - Connecticut Retail Rates - Conservation and Load Management" and "Rates - Massachusetts Retail Rates -WMECO Regulatory Activity" for information about rate treatment of C&LM costs. In 1988, the DPU adopted regulations requiring preapproval of Massachusetts utilities' major investments in electric generating facilities, including life extensions. In 1990, the DPU adopted new IRM regulations, which established procedures by which additional resources are planned, solicited and processed to provide for reliable electric service in a least- cost manner. The regulations provide a mechanism for preapproval (rather than after-the-fact review) of utility plant construction, procurement of non-utility generation (QFs and IPPs), and C&LM programs. The regulations specifically require that environmental externalities be considered in the evaluation of resource alternatives. In January 1994, WMECO filed its initial draft IRM filing, stating that WMECO's year of need is estimated to be 2007, and that no new capacity need be solicited at this time. WMECO is presently in settlement discussions. See "Rates-Massachusetts Retail Rates - WMECO Regulatory Activity" for further information relating to WMECO C&LM issues. In 1993, the NHPUC approved a settlement agreement related to PSNH's 1992 least cost planning filing, which defers various planning issues to PSNH's April 1, 1994 filing. In addition to the contributions from C&LM, QFs and IPPs, the System's long-term resource plan includes consideration of continued operation of certain of the System's fossil generating units beyond their current book retirement dates to the extent that it is economic, and possibly repowering certain of the System's older fossil plants. Continued operation of existing fossil units past their book retirement dates (and replacing certain critically located peaking units if they fail) is expected by 2007 to provide approximately 1,400 MW of resources that would otherwise have been retired. Repowering of some of the System's retired generating plants could make available an additional 900 MW of capacity. The capacity could be brought on line in various increments timed with the year of need. The System's need for new resources may be affected by any additional retirements of the System's existing generating units. The System companies periodically study the economics of their generating units as part of their overall resource planning process. In 1992, the DPUC ordered CL&P to submit economic analyses of the continued operation of 11 fossil steam units by April 1, 1993, and of Millstone Units 1 and 2 and CY, of which the System companies own 49 percent) by April 1, 1994. In 1993, the DPUC reviewed the continued unit operation (CUO) studies submitted by CL&P for the eleven fossil units in Connecticut and Massachusetts in its annual review of Integrated Resource Planning. The DPUC concluded that a decision was inappropriate at that time and that it would review the issue again in its management audit of CL&P and in CL&P's 1994 integrated resource planning docket. For Millstone 1 and 2 and CY, the CUO studies are in progress. Preliminary indications are that the operation of the units continues to be economic for customers. Final analyses for CY and the Millstone units will be filed with the DPUC in 1994. For planning and budgetary purposes, the System assumes that CL&P's Montville Station (497.5 MW) will be deactivated from November 1994 through October 1998. A final decision is expected to be made in 1994. Since reactivation is expected to occur in 1998, the System year of need of 2007 is unaffected. The System year of need of 2007 assumes PSNH's Merrimack 2 continues to operate. However, Merrimack 2's continued operation is in question because Merrimack 2 produces significant NOx emissions. The concern has been raised as to whether the emissions can be lowered to acceptable levels in the short and long term. In 1993, PSNH worked successfully with local, state and federal interests to arrive at a solution for Merrimack 2 NOx compliance by 1995, while deferring a decision on continued unit operation beyond 1999 to the future. For information regarding the agreement concerning NOX emissions at the Merrimack units, see "Regulatory and Environmental Matters - Environmental Regulation - Air Quality Requirements." See "Regulatory and Environmental Matters -- NRC Nuclear Plant Licensing" for further information on the NRC rule on nuclear plant operating license renewal and information on the expiration dates of the operating licenses of the nuclear plants in which System companies have interests. Before the System can make any decisions about whether license extensions for any of its nuclear units are feasible, detailed technical and economic studies will be needed. FINANCING PROGRAM 1993 FINANCINGS In January 1993, WMECO issued $60 million in principal amount of 6 7/8 percent first mortgage bonds due in 2000. In July 1993, CL&P issued $200 million and $100 million, respectively, of 5 3/4 percent and 7 1/2 percent first mortgage bonds due in 2000 and 2023, respectively. In December 1993, CL&P issued $125 million of 7 3/8 percent first mortgage bonds due in 2025. The proceeds from the foregoing issues were used to redeem outstanding bonds with interest rates ranging from 8 3/4 percent to 9 3/4 percent. In October 1993, CL&P issued $80 million of 5.30 percent preferred stock, $50 par value. The proceeds of this issuance, together with $30 million of short-term debt, were used to redeem $110 million of preferred stock with dividend rates ranging from 7.6 percent to 9.1 percent. In September 1993, the Connecticut Development Authority (CDA) issued, on behalf of CL&P, two tax-exempt variable rate pollution control revenue bonds (PCRBs) in the amounts of $245.5 million and $70 million, respectively. At the same time, the CDA issued, on behalf of WMECO, $53.8 million of tax-exempt variable rate PCRBs. The proceeds of these issues were used to redeem like amounts of tax-exempt PCRBs having less favorable structures. These refinancings will result in savings from the extension of maturities, the redemption of two issues of fixed-rate bonds with proceeds of the issuance of variable-rate bonds, the improved credit ratings of new supporting letter of credit banks and associated administrative savings. In December 1993, the New Hampshire Business Finance Authority (BFA) issued, on behalf of PSNH, $44.8 million of tax-exempt variable rate PCRBs. The proceeds of this issue were used to redeem a like amount of taxable PCRBs. Taxable BFA bonds issued on behalf of PSNH in the amount of $109.2 million are outstanding and may be refinanced with tax-exempt bonds upon the receipt of an allocation of the state's private activity volume allocation. In January 1993, CL&P, PSNH and WMECO purchased $340 million, $75 million and $52 million, respectively, of three-year variable rate debt caps. The caps were purchased to hedge the interest rate risk of the companies' respective variable rate PCRBs and were sized to approximate each respective company's then-current tax-exempt variable rate PCRB issuances. If the interest rate, based on the J. J. Kenny index, exceeds 4.5 percent (the strike rate), each company will receive payments under the terms of its respective interest rate cap agreement. In June 1993, PSNH purchased a $50 million six-month interest rate cap, a $50 million 12 month cap and a $100 million 18 month cap to hedge its interest rate exposure on its variable rate term note. The six-month and 12 month caps have a strike rate of 4.5 percent and the 18 month cap has a strike rate of 5.0 percent, all based on 90 day LIBOR. These caps were sized to approximate portions of a PSNH term note which has a quarterly sinking fund of $23.5 million. In February 1993, NU, CL&P, WMECO and the Niantic Bay Fuel Trust (NBFT) began a co-managed commercial paper program with two commercial paper dealers. Prior to this time, each company's commercial paper program was managed by one commercial paper dealer. The co-managed program was implemented to promote competition between commercial paper dealers, to increase the investor universe and to increase the range of maturities available to the issuers. On December 31, 1993, $113.0 million commercial paper was outstanding under these programs. In December 1993, NNECO issued $25 million of 7.17 percent unsecured amortizing notes maturing in 2019. The proceeds of this issuance are being used to finance the construction of a new building at Millstone station to house various administrative and technical support functions. FINANCING NUCLEAR FUEL The System requires nuclear fuel for the three Millstone units and for Seabrook 1. The requirements for the Millstone 1, Millstone 2 and CL&P's and WMECO's share of the Millstone 3 units are financed through a third party trust financing arrangement described below. All nuclear fuel for NAEC's and CL&P's shares of Seabrook 1 and PSNH's share of Millstone 3 is owned and financed directly by the respective companies. For the period 1994 through 1998, NAEC's and CL&P's shares of the cost of nuclear fuel for Seabrook 1 are estimated at $56.8 million and $6.4 million, respectively, excluding AFUDC. For the same period, PSNH's share of the cost of nuclear fuel for Millstone 3 is estimated at $6 million, excluding AFUDC. In 1982, CL&P and WMECO entered into arrangements under which NBFT owns and finances the nuclear fuel for Millstone 1 and 2 and CL&P's and WMECO's share of the nuclear fuel for Millstone 3. NBFT finances the fuel from the time uranium is acquired, during the off-site processing stages and through its use in the units' reactors. NBFT obtains funds from bank loans, the sale of commercial paper and the sale of intermediate term notes. The fuel is leased to CL&P and WMECO by the trust while it is used in the reactors, and ownership of the fuel is transferred to CL&P and WMECO when it is permanently discharged from the reactors. CL&P and WMECO are severally obligated to make quarterly lease payments, to pay all expenses incurred by NBFT in connection with the fuel and the financing arrangements, to purchase the fuel under certain circumstances and to indemnify all the parties to the transactions. The trust arrangements presently allow up to $530 million to be financed by NBFT with bank loans and commercial paper (up to $230 million) and with intermediate term notes (up to $300 million). The arrangements with the banks are in effect until February 19, 1996, and can be extended for an additional three years if the parties so agree. On December 31, 1993, NBFT had $80 million of intermediate term notes and $113 million of commercial paper outstanding. As of December 31, 1993, NBFT's investment in nuclear fuel, net of the fourth quarter 1993 lease payment made on January 31, 1994, for all three Millstone units was $172.1 million, as follows: Total CL&P WMECO System (Millions of Dollars) In process.......... $20.3 $4.7 $25.0 In stock............ 8.0 1.9 9.9 In reactor.......... 111.2 26.0 137.2 Total.......... $139.5 $32.6 $172.1 For the period 1994 through 1998, CL&P and WMECO's share of the cost of nuclear fuel for the three Millstone units that will be acquired through NBFT will be $313.5 million and $73.2 million, respectively, excluding AFUDC. Nuclear fuel costs and a provision for spent fuel disposal costs are being recovered through rates as the fuel is consumed in reactors. 1994 FINANCING REQUIREMENTS In addition to financing the construction requirements described under "Resource Plans - Construction," the System companies are obligated to meet $1,373.8 million of long-term debt maturities and cash sinking fund requirements and $76.4 million of preferred stock cash sinking fund requirements in 1994 through 1998. In 1994, long-term debt maturity and cash sinking fund requirements will be $295.3 million, consisting of $182 million of long-term debt maturities and $7 million of debt cash sinking fund requirements to be met by CL&P, $94 million of cash sinking fund requirements to be met by PSNH, $1.5 million of cash sinking funds to be met by WMECO and $10.7 million of cash sinking fund requirements to be met by other subsidiaries. These figures do not include $125 million of long-term debt redeemed by CL&P on January 7, 1994 with the proceeds of its issuance of $125 million mortgage bonds in December 1993. See "Financing Program - 1993 Financings." See "Electric Operations -- Nuclear Generation -- Operations -- Seabrook" for information on CL&P's commitment to advance funds to cover payments that a 12 percent Seabrook owner might be unable to pay with respect to Seabrook project costs. The System's aggregate capital requirements for 1994, exclusive of requirements under NBFT, are as follows: Total CL&P PSNH WMECO NAEC Other System (Millions of Dollars) Construction (including AFUDC)..... $157.8 $37.5 $37.5 $ 8.2 $26.5 $267.5 Nuclear Fuel (excluding AFUDC). (.3) 1.8 (.2) 5.8 - 7.1 Maturities......... 182.0 - - - - 182.0 Cash Sinking Funds. 7.0 94.0 1.5 - 10.7 113.2 Total.......... $346.5 $133.3 $38.8 $14.0 $37.2 $569.8 1994 FINANCING PLANS The System companies, other than CL&P, currently expect to finance their 1994 requirements through internally generated funds. CL&P may issue up to $200 million of long-term debt, primarily to finance maturing securities. This estimate excludes the nuclear fuel requirements financed through the NBFT. See "Financing Nuclear Fuel" above for information on the NBFT. In addition to financing their 1994 requirements, the System companies intend, if market conditions permit, to continue to refinance a portion of their outstanding long-term debt and preferred stock, if that can be done at a lower effective cost. On February 17, 1994, CL&P issued $140 million in principal amount of 5 1/2 percent first mortgage bonds due in 1999 and $140 million in principal amount of 6 1/2 percent first mortgage bonds due in 2004. The net proceeds were used to redeem higher cost first mortgage bonds. On March 8, 1994, WMECO contracted to issue $40 million principal amount of 6 1/4 percent first mortgage bonds due in 1999 and $50 million in principal amount of 7 3/4 percent first mortgage bonds due in 2024. The net proceeds will be used to redeem higher cost first mortgage bonds. FINANCING LIMITATIONS The amounts of short-term borrowings that may be incurred by NU, CL&P, PSNH, WMECO, HWP, NAEC, NNECO, The Rocky River Realty Company (RRR), The Quinnehtuk Company (Quinnehtuk) (RRR and Quinnehtuk are real estate subsidiaries), and HEC are subject to periodic approval by the SEC under the Public Utility Holding Company Act of 1935 (1935 Act). The following table shows the amount of short-term borrowings authorized by the SEC for each company and the amounts of outstanding short term debt of those companies at the end of 1993. Maximum Authorized Short-Term Debt Short-Term Debt Outstanding at 12/31/93* (Millions of Dollars) NU.................. $ 175.0 $ 72.5 CL&P ............... 375.0 96.2 PSNH ............... 125.0 2.5 WMECO............... 75.0 6.0 HWP................. 8.0 - NAEC................ 50.0 - NNECO............... 65.0 - RRR................. 25.0 16.5 Quinnehtuk.......... 8.0 4.3 HEC................. 11.0 2.9 ______ $200.9 _________________ * This column includes borrowings of various System companies from NU and other System companies through the Northeast Utilities System Money Pool (Money Pool). Total System short term indebtedness to unaffiliated lenders was $173.5 million at December 31, 1993. The supplemental indentures under which NU issued $175 million in principal amount of 8.58 percent amortizing notes in December 1991 and $75 million in principal amount of 8.38 percent amortizing notes in March 1992 contain restrictions on dispositions of certain System companies' stock, limitations of liens on NU assets and restrictions on distributions on and acquisitions of NU stock. Under these provisions, neither NU, CL&P, PSNH nor WMECO may dispose of voting stock of CL&P, PSNH or WMECO other than to NU or another System company, except that CL&P may sell voting stock for cash to third persons if so ordered by a regulatory agency so long as the amount sold is not more than 19 percent of CL&P's voting stock after the sale. The restrictions also generally prohibit NU from pledging voting stock of CL&P, PSNH or WMECO or granting liens on its other assets in amounts greater than five percent of the total common equity of NU. As of March 1, 1994, no NU debt was secured by liens on NU assets. Finally, NU may not declare or make distributions on its capital stock, acquire its capital stock (or rights thereto), or permit a System company to do the same, at times when there is an Event of Default under the supplemental indentures under which the amortizing notes were issued. The charters of CL&P and WMECO contain preferred stock provisions restricting the amount of short term or other unsecured borrowings those companies may incur. As of December 31, 1993, CL&P's charter would permit CL&P to incur an additional $570 million of unsecured debt and WMECO's charter would permit it to incur an additional $141.1 million of unsecured debt. In connection with NU's acquisition of PSNH, certain financial conditions intended to prevent NU from relying on CL&P resources if the PSNH acquisition strains NU's financial condition were imposed by the DPUC. The principal conditions provide for a DPUC review if CL&P's common equity falls to 36 percent or below, require NU to obtain DPUC approval to secure NU financings with CL&P stock or assets, and obligate NU to use its best efforts to sell CL&P preferred or common stock to the public if NU cannot meet CL&P's need for equity capital. At December 31, 1993, CL&P's common equity ratio was 39.1 percent. While not directly restricting the amount of short-term debt that CL&P, WMECO, RRR, NNECO and NU may incur, credit agreements to which CL&P, WMECO, HWP, RRR, NNECO and NU are parties provide that the lenders are not required to make additional loans, or that the maturity of indebtedness can be accelerated, if NU (on a consolidated basis) does not meet a common equity ratio that requires, in effect, that the NU consolidated common equity (as defined) be at least 27 percent for three consecutive quarters. At December 31, 1993, NU's common equity ratio was 30.9 percent. Credit agreements to which PSNH is a party forbid its incurrence of additional debt unless it is able to demonstrate, on a pro forma basis for the prior quarter and going forward, that its equity ratio (as defined) will be at least 21 percent of total capitalization (as defined) through June 30, 1994, 23 percent through June 30, 1995 and 25 percent thereafter. In addition, PSNH must demonstrate that its ratio of operating income to interest expense will be at least 1.5 to 1 for each period of four fiscal quarters ending after June 30, 1993 through June 30, 1994 and 1.75 to 1 thereafter. At December 31, 1993, PSNH's common equity ratio was 28.2 percent and its operating income to interest expense ratio was 2.27 to 1. See "Short-Term Debt" in the notes to NU's, CL&P's, PSNH's and WMECO's financial statements for information about credit lines available to System companies. The indentures securing the outstanding first mortgage bonds of CL&P, PSNH, WMECO and NAEC provide that additional bonds may not be issued, except for certain refunding purposes, unless earnings (as defined in each indenture, and before income taxes, and, in the case of PSNH, without deducting the amortization of PSNH's regulatory asset) are at least twice the pro forma annual interest charges on outstanding bonds and certain prior lien obligations and the bonds to be issued. The preferred stock provisions of CL&P's, WMECO's and PSNH's charters also prohibit the issuance of additional preferred stock (except for refinancing purposes) unless income before interest charges (as defined and after income taxes and depreciation) is at least 1.5 times the pro forma annual interest charges on indebtedness and the annual dividend requirements on preferred stock that will be outstanding after the additional stock is issued. Beginning with the dividends paid on NU common shares by NU in June 1990, NU's Dividend Reinvestment Plan (DRP) was amended to authorize the dividends and optional cash purchases of participating shareholders to be reinvested in NU common shares purchased either in the open market or directly from NU. NU received approximately $42.4 million in 1991 and approximately $35.6 million in 1992 of new common shareholders' equity from the reinvestment of dividends and voluntary cash investments. No funds have been raised by NU through DRP since August 1992, when management ended direct purchases and caused shares to be purchased for DRP participants in the open market. As part of the PSNH acquisition in June 1992, NU issued warrants for the purchase of NU common stock at a price of $24 per share. In 1993, NU received $8.3 million from the exercise of these warrants. As of December 31, 1993, warrants for 7,975,516 shares of NU common stock remained unexercised. NU is dependent on the earnings of, and dividends received from, its subsidiaries to meet its own financial requirements, including the payment of dividends on NU common shares. At the current indicated annual dividend of $1.76 per share, NU's aggregate annual dividends on common shares outstanding at December 31, 1993, including unallocated shares held by the ESOP trust, would be approximately $236.2 million. Dividends are payable on common shares only if, and in the amounts, declared by the NU Board of Trustees. SEC rules under the 1935 Act require that dividends on NU's shares be based on the amounts of dividends received from subsidiaries, not on the undistributed retained earnings of subsidiaries. The SEC's order approving NU's acquisition of PSNH under the 1935 Act approved NU's request for a waiver of this requirement through June 1997. PSNH and NAEC were effectively prohibited from paying dividends to NU through May 1993. Through the remainder of 1993, PSNH and NAEC did not pay dividends to permit them to build up the common equity portion of their capitalizations. Until PSNH and NAEC can begin to fund a part of NU's dividend requirements, NU expects to fund that portion of its dividend requirements with the proceeds of borrowings. The supplemental indentures under which CL&P's and WMECO's first mortgage bonds and the indenture under which PSNH's first mortgage bonds have been issued limit the amount of cash dividends and other distributions these subsidiaries can make to NU out of their retained earnings. As of December 31, 1993, CL&P had $210.6 million, WMECO had $26.5 million and PSNH had $60.8 million of unrestricted retained earnings. PSNH's preferred stock provisions also limit the amount of cash dividends and other distributions PSNH can make to NU if after taking the dividend or other distribution into account, PSNH's common stock equity is less than 25 percent of total capitalization. The indenture under which NAEC's Series A Bonds have been issued also limits the amount of cash dividends or distributions NAEC can make to NU to retained earnings plus $10 million. At December 31, 1993, $48.7 million was available to be paid under this provision. PSNH's credit agreements prohibit PSNH from declaring or paying any cash dividends or distributions on any of its capital stock, except for dividends on the preferred stock, unless minimum interest coverage and common equity ratio tests are satisfied. Certain subsidiaries of NU established the Money Pool to provide a more effective use of the cash resources of the System, and to reduce outside short term borrowings. The Service Company administers the Money Pool as agent for the participating companies. Short term borrowing needs of the participating companies (except NU) are first met with available funds of other member companies, including funds borrowed by NU from third parties. NU may lend to, but not borrow from, the Money Pool. Investing and borrowing subsidiaries receive or pay interest based on the average daily Federal Funds rate, except that borrowings based on loans from NU bear interest at NU cost. Funds may be withdrawn or repaid to the Money Pool at any time without prior notice. ELECTRIC OPERATIONS DISTRIBUTION AND LOAD The System operating companies own and operate a fully-integrated electric utility business. The System operating companies' retail electric service territories cover approximately 11,335 square miles (4,400 in CL&P's service area, 5,445 in PSNH's service area and 1,490 in WMECO's service area) and have an estimated total population of approximately 3.7 million (2.5 million in Connecticut, 780,000 in New Hampshire and 450,000 in Massachusetts). The companies furnish retail electric service in 149, 198 and 59 cities and towns in Connecticut, New Hampshire and Massachusetts, respectively. In December 1993, CL&P furnished retail electric service to approximately 1.085 million customers in Connecticut, PSNH provided retail electric service to approximately 397,000 customers in New Hampshire and WMECO served approximately 193,000 retail electric customers in Massachusetts. HWP serves approximately 25 customers in a portion of the town of Holyoke, Massachusetts. The following table shows the sources of 1993 electric revenues based on categories of customers: CL&P PSNH WMECO NAEC Total System Residential........... 39% 35% 38% - 39% Commercial............ 33 17 30 - 29 Industrial ........... 14 28 20 - 18 Wholesale* ........... 11 17 8 100% 11 Other ................ 3 3 4 - 3 ____ ____ ____ ____ ____ Total ................ 100% 100% 100% 100% 100% ______________________ * Includes capacity sales. NAEC's 1993 electric revenues were derived entirely from sales to PSNH under the Seabrook Power Contract. See "Rates - Seabrook Power Contract" for a discussion of the contract. Through December 31, 1993, the all-time maximum demand on the System was 6,191 MW, which occurred on July 8, 1993. At the time of the peak, the System's generating capacity, including capacity purchases, was 8,965 MW. The System was also selling approximately 1,431 MW of capacity to other utilities at that time. In 1993, System energy requirements were met 62 percent by nuclear units, nine percent by oil burning units, 10 percent by coal burning units, three percent by hydroelectric units, two percent by natural gas burning units and 14 percent by cogenerators and small power producers. By comparison, in 1992 the System's energy requirements were met 48 percent by nuclear units, 24 percent by oil burning units, 10 percent by coal burning units, four percent by hydroelectric units, one percent by natural gas burning units and 13 percent by cogenerators and small power producers. See "Electric Operations-Generation and Transmission" for further information. The actual changes in kWh sales for the last two years and the forecasted sales growth estimates for the 10-year period 1993 through 2003, in each case exclusive of bulk power sales, for the System, CL&P, PSNH and WMECO are set forth below: 1993 over 1992 over Forecast 1993-2003 (under) 1992 (under) 1991 Compound Rate of Growth System......... 10.9%(1) 15.3%(1) 1.4% CL&P........... (0.3)% 0.2% 1.3% PSNH........... 1.0% 1.1% 1.7% WMECO....... 0.1% (1.6)% 1.1% ___________________ (1) The percent increase in System 1992 sales over 1991 sales and 1993 sales over 1992 sales is due to the inclusion of PSNH sales beginning in June 1992. In 1990, FERC required the reclassification of bulk power sales from "purchased power" to "sales for resale" for the 1990 and later reporting years. Bulk power sales are not included in the development of any long-term forecasted growth rates. The actual changes in kWh sales for the last two years, adjusted for bulk power sales (by adding back the bulk power sales), for the System, CL&P, PSNH and WMECO are set forth below: 1993 over (under) 1992 1992 over (under) 1991 System ................... 11.8%(1) 19.7%(1) CL&P ..................... 1.2% 3.3% PSNH ..................... (9.3)% 6.7% WMECO .................... 13.5% 9.9% __________________ (1) System sales percentages reflect the inclusion of PSNH sales beginning in June 1992. Despite a warmer than normal summer that added to cooling requirements, sales showed negligible growth in 1993. Widespread economic recovery throughout the System's service territory did not occur in 1993, but there were mixed pockets of regional economic growth aided by very favorable interest rates. Curtailments in defense spending continue to affect the Connecticut, New Hampshire and western Massachusetts economies, which are heavily dependent on defense-related industries. Competition in various forms may also adversely affect the projected growth rate of sales over the next ten years. Where energy costs are a significant part of operating expenses, business customers may turn to self-generation, switch fuel sources, or relocate to other states and countries which have aggressive programs to attract new businesses. For further information on the effect of competition on sales growth rates, see "Marketing and Competition." The forecasted load growth for the System as a whole is significantly below historic rates in part because of forecasted savings from NU-sponsored C&LM programs, which are designed to minimize operating expenses for System customers and postpone the need for new capacity on the System. The forecasted ten-year growth rate of System sales would be approximately 1.8 percent instead of 1.4 percent if the System did not pursue C&LM savings. See "Resource Plans - Future Needs" for an estimate of the impact of C&LM programs on the System's need for new generating resources and for information about C&LM cost impacts and cost recovery. See "Rates - Connecticut Retail Rates" and "Rates - Massachusetts Retail Rates" for information about rate treatment of C&LM costs. With the System's generating capacity of 8,268 MW as of January 1, 1994 (including the net of capacity sales to and purchases from other utilities, and approximately 690 MW of capacity to be purchased from QFs and IPPs under existing contracts and contracts under negotiation), the System expects to meet its projected annual peak load growth of 1.3 percent reliably until at least the year 2007. The availability of new resources and reduced demand for electricity have combined to place the System and most other New England electric utilities in a surplus capacity situation. The principal resource changes were Seabrook 1's commercial operation, the full operation of the second phase of the Hydro-Quebec project, and increased availability of power from QF and IPP projects. As a consequence, the competition from capacity-long utilities as sellers and the loss of utilities that are no longer capacity- short as buyers have adversely affected the System companies' efforts to sell additional surplus capacity at the price levels that prevailed in the late 1980s. Taking into account projected load growth for the System and committed capacity sales, but not taking into account future potential capacity sales to other utilities that are not subject to firm commitments, the System's surplus capacity is expected to be approximately 1,000 MW in 1994. For further information on the effect of competition on sales of surplus capacity, see "Competition and Marketing." The System operating companies operate and dispatch their generation as provided in the New England Power Pool (NEPOOL) Agreement. In 1993, the peak demand on the NEPOOL system was 19,570 MW, which occurred in July, above the 1992 peak load of 18,853 MW in January of that year. NEPOOL has projected that there will be an increase in demand in 1994 and estimates that the summer 1994 peak load could reach 19,800 MW. NEPOOL projects that sufficient capacity will be available to meet this anticipated demand. GENERATION AND TRANSMISSION The System operating companies and most other New England utilities with electric generating facilities are parties to the NEPOOL Agreement. Under the NEPOOL Agreement, the region's generation and transmission facilities are planned and operated as part of the regional New England bulk power system. System transmission lines form part of the New England transmission system linking System generating plants with one another and with the facilities of other utilities in the northeastern United States and Canada. The generating facilities of all NEPOOL participants are dispatched as a single system through the New England Power Exchange, a central dispatch facility. The NEPOOL Agreement provides for a determination of the generating capacity responsibilities of participants and certain transmission rights and responsibilities. Pool dispatch results in substantial purchases and sales of electric energy by pool participants, including the System companies, at prices determined in accordance with the NEPOOL Agreement. The System operating companies, except PSNH, pool their electric production costs and the costs of their principal transmission facilities under the NUG&T agreement. In addition, a ten-year agreement between PSNH and CL&P, WMECO and HWP provides for a sharing of the capability responsibility savings and energy expense savings resulting from a single system dispatch. In connection with NU's acquisition of PSNH, the System proposed a comprehensive plan for opening up a transmission corridor between northern and southern New England for use in "wheeling" power of other utilities. The plan was designed to accomplish a level of access to transmission resources of the PSNH and New England Electric System (NEES) systems that could formerly be accomplished only after a series of multilateral negotiations. The plan includes provisions to (i) make 452 MW of long term transmission service available across the PSNH system from Maine to Massachusetts, Rhode Island, Connecticut and Vermont at embedded cost rates, (ii) make 200 MW of long term transmission service available by NEES for those utilities requiring deliveries across NEES's system in order to make use of access to the PSNH system, and (iii) construct new facilities as needed to expand the corridor from Maine to Massachusetts, if the cost of expansion is supported and if regulatory approvals for the expansion are received. Further, NU committed to make access to the combined NU-PSNH transmission system available for third-party wheeling transactions whenever capacity is available, and to expand the system when expansion is feasible. The principal constraints are that NU and PSNH have reserved a priority on the use of their transmission systems to serve the reliability needs of their own native load customers, and the commitment to expand would be subject to obtaining all necessary approvals. This plan became effective in October 1992, subject to the outcome of a hearing ordered by FERC in this proceeding, and the Commission's final decision in the compliance phase of the merger proceeding discussed below. NU and NEES filed offers of settlement in this proceeding in May and June 1993, respectively, and the Presiding Administrative Law Judge certified both settlement offers to the Commission in July 1993. The only contested issue was the refund and surcharge provision that was included in both offers of settlement. The Commission has not yet acted on these settlement offers. These commitments, and the entire issue of access to the NU and PSNH transmission systems by other utilities and non-utility generators, were the subject of extensive controversy in New England. On January 29, 1992, FERC issued a decision approving the acquisition and allowing NU and PSNH customers to be held harmless if other utilities and non-utility generators need to use the NU-PSNH transmission to buy or sell electricity. In accordance with the January 29 decision, on April 23, 1992 and August 4, 1992, NU made compliance filings, including transmission tariffs implementing the FERC's conditions. All tariffs have been accepted by FERC and were effective as of the merger date. FERC has issued summary determinations (without hearing) and NU has filed for rehearing of FERC's compliance tariff order in an effort to reinstate the originally proposed rates. FERC has not yet acted on NU's rehearing petition. FERC's approval of NU's acquisition of PSNH was appealed to the United States Court of Appeals for the First Circuit. On May 19, 1993, the First Circuit Court affirmed FERC's decision approving the merger but remanded to FERC one issue brought by NU related to FERC's ability to change the terms of the Seabrook Power Contract. FERC filed for en banc (full court) review by the First Circuit Court on the Seabrook Power Contract issue, which was denied. No petitions for review were filed in the U.S. Supreme Court, therefore, the First Circuit Court's decision is final. FERC has yet to initiate any proceeding on the court's remand, which would address whether FERC could modify the Seabrook Power Contract under a more stringent "public interest standard." On December 21, 1993, NU filed an appeal in the United States Court of Appeals for the District of Columbia Circuit of a FERC order directing NU to put itself on its own transmission tariffs in connection with all NU sales of wholesale power. NU had committed, as part of the PSNH merger, to place itself on its tariff when it was competing with other wholesale power suppliers to make a sale in order to "level the playing field." In its order, FERC expanded NU's merger commitment to include all transactions, regardless of whether or not NU's competitors need to use the NU transmission system. The controversy about the terms on which wheeling transactions are to be effected in New England has stimulated a series of negotiations among utilities, regulators and non-utility generators, directed at the possible development of new regional transmission arrangements. While an original draft regional transmission arrangement was not supported by all parties, there have been negotiations on a less comprehensive arrangement. Any arrangement would be subject to approval by NEPOOL members and FERC. HYDRO-QUEBEC Along with other New England utility companies, CL&P, PSNH, WMECO and HWP is each a participant in agreements to finance, construct, and operate the United States portion of direct current transmission circuits between New England and Quebec, Canada. The project was built in two phases, and now provides 2,000 MW of rated transfer capacity with Canadian facilities constructed and owned by Hydro-Quebec, a Canadian utility system. Phase 1, which entered into commercial operation in 1986, initially provided 690 MW of North-South transfer capacity. In Phase 2, the transmission line was extended to a new converter station in eastern Massachusetts. Phase 2 entered into full operation in 1991. The actual transfers over the interconnection to date have averaged in the 1,400 to 1,800 MW range. The interconnection permits a reduction in oil consumption in New England and has the potential to produce cost savings to customers through the purchase of power from Hydro-Quebec's hydroelectric generating facilities. The interconnection also reduces the level of reserves New England utilities must carry to assure that pool reliability criteria are met. The System companies are obligated to pay 34.22 percent of the annual costs of the Phase 1 facilities and 32.78 percent of the annual cost of the Phase 2 facilities. They are entitled, on the basis of a composite of these percentages, to use the capacity of the facilities for their own transactions and to share in the savings from pool energy transactions with Hydro-Quebec. The Phase 1 total project cost was $141 million and the Phase 2 total project cost was approximately $495 million. Phase 2 was constructed and is owned and operated by two companies in which NU has a 22.66 percent equity ownership interest. As an equity participant, NU guarantees certain obligations in connection with the debt financing of certain other participants that have lower credit ratings, and it receives compensation for such undertakings. When the Phase 2 facilities became fully operational in 1991, a contract covering the purchase by the New England utilities of 70 terawatthours of energy from Hydro-Quebec over a period of approximately ten years came into effect. While transactions under this contract are expected to constitute the principal use of the interconnection during the 1990s, the interconnection is also available for other energy transactions and for the "banking" of energy in Canada during off-peak hours in New England, with equivalent amounts of energy available to New England during peak hours. FOSSIL FUELS OIL The System's residual oil-fired generation stations used approximately 5.89 million barrels of oil in 1993. The System obtained the majority of its oil requirements in 1993 through contracts with three large, independent oil companies. Those contracts allow for some spot purchases when market conditions warrant, but spot purchases represented less than 15 percent of the System's fuel oil purchases in 1993. The contracts expire annually or biennially. The average 1993 price paid for fuel oil used for electric generation was approximately $14 per barrel, which was the same as the average 1992 price. No. 6 fuel oil prices were high during the first quarter of 1993 due to increased demand and firm crude oil prices. Fuel oil prices declined slightly during the second and third quarters, weakened in the fourth quarter due to weak crude prices associated with OPEC over-production and then firmed in the first quarter of 1994 due to severe weather in the Northeast. On February 1, 1994, the weighted average price being paid for the System's fuel oil had increased to $17 per barrel. The System-wide fuel oil storage capacity is approximately 2.5 million barrels. In 1993, inventories were maintained at levels between 40 - 60 percent of capacity. This inventory constitutes approximately 13 days of full load operation. GAS Currently, three system generating units, PSNH's Newington unit, WMECO's West Springfield Unit 3 and CL&P's Montville 5, can burn either residual oil or natural gas as economics dictate. The System is currently in the process of converting CL&P's Devon Units 7 & 8 into oil and gas dual-fuel generating units. Devon Unit 8's boiler conversion, which gave it gas burning capability, was completed in December 1993. Devon Unit 7's boiler conversion is scheduled for completion during its upcoming April 1994 outage. The System plans to have both units operational by the end of July 1994. Annual gas consumption depends on factors such as oil prices, gas prices and unit availability. In 1993, gas was used sparingly at the System's dual-fuel units because of the attractiveness of oil prices relative to those for natural gas. CL&P, PSNH and WMECO all have contracts with the local gas distribution companies where the Montville, Newington and West Springfield units are located, under which natural gas is made available by those companies on an interruptible basis. While WMECO and PSNH meet all of their gas supply needs for the West Springfield and Newington units through purchases from the local gas distribution company, CL&P can supply its Montville unit either by purchasing gas from the local gas distribution company at a DPUC-approved rate or by purchasing gas directly from producers or brokers and transporting that gas through the interstate pipeline system and the local gas distribution system. In 1993, all of the gas burned at Montville Unit 5 was purchased from a local gas distribution company. It is expected that gas for the Devon units will be purchased directly from producers or brokers on an interruptible basis and transported through the interstate pipeline system and the local gas distribution company. The System expects that interruptible natural gas will continue to be available for its dual-fuel electric generating units and will continue to supplement fuel oil requirements. The Iroquois Gas Transportation System, which became fully operational in November 1992, is expected to increase New England's gas supplies by at least 35 percent by November 1994. The increased availability of gas may make the option of converting other oil- burning electric generating units to gas on an interruptible dual-fuel basis more attractive to the System. COAL Currently, coal is purchased for HWP's Mt. Tom Station and for PSNH's Merrimack Units 1 and 2 and its coal-oil Schiller Units 4, 5 and 6. Mt. Tom Station received approximately 314,000 tons of coal in 1993 at an average delivered coal price of $ 43.40 per ton, which is down from the average 1992 coal price of $44.25 per ton. In 1993, HWP extended an existing contract for the majority of the coal to be supplied to Mt. Tom Station. This contract provides the System with assurance of coal supply and the flexibility to purchase some coal on the spot market. In the future, the System will evaluate whether to continue to purchase coal by contract or return to the spot market. The coal inventory for Mt. Tom Station varies between a minimum level of 30 days fuel and a maximum of approximately 100 days fuel. Typically, the higher level is achieved in December, when deliveries are suspended for the winter. The stockpile provides the plant's operating fuel until deliveries are resumed in March. Because of changes in federal and state air quality requirements, by 1995 HWP will need to change the kinds of coal that it purchases for use at Mt. Tom Station. The potential impact of changing air quality requirements on coal supplies is being evaluated, and HWP is testing various types of coal to meet these requirements. See "Regulatory and Environmental Matters - Environmental Regulation-Air Quality Requirements." In December 1991, PSNH executed a contract for the purchase of up to 100 percent of the coal requirements for PSNH's Merrimack Units 1 and 2 through December 31, 1993. This contract has been extended through December 31, 1994. Under this agreement, PSNH may also purchase coal on the spot market. In 1993, Merrimack Station received approximately 1.1 million tons of coal. The average delivered coal price in 1993 was $43.00 per ton. The coal inventory at Merrimack Station varies between a minimum of 60 days and a maximum of 90 days of fuel. Schiller Units 4, 5 and 6, PSNH's dual-fuel coal and oil fired units, are dispatched on the most economical fuel in accordance with the provisions of the NEPOOL Agreement. Schiller Station consumed approximately 236,000 tons of coal in 1993 at an average delivered price of $39.40 per ton. Schiller's 1993 coal requirements were fulfilled through three primary contracts, pursuant to which 77 percent was provided by foreign suppliers and the remaining 23 percent by a domestic supplier. FOSSIL PLANT RETIREMENTS In 1991, the System retired seven of the System's oldest, least used, and most costly oil-fired steam generating units. In 1992, five oil-burning combustion turbines were retired. The decision to retire these units reflected both the surplus of generating capacity in New England and the System's continuing efforts to reduce operation and maintenance costs. There were no significant fossil plant retirements in 1993, but the System's plan calls for deactivating, by the end of 1994 Montville Units 5 and 6, which have a capacity of 82 MW and 410 MW, respectively. A final decision on the future of these units will be made following the completion of further economic evaluations and consideration of possible alternatives. NUCLEAR GENERATION GENERAL The System companies have interests in seven operating nuclear units: Millstone 1, 2 and 3, Seabrook 1 and three other units owned by regional nuclear generating companies (the Yankee companies). System companies operate the three Millstone units, Seabrook 1 and CY. The System companies also have interests in the owned by the Yankee Atomic Electric Company (Yankee Rowe), which was permanently removed from service in 1992. CL&P and WMECO own 100 percent of Millstone 1 and 2 as tenants in common. Their respective ownership interests are 81 percent and 19 percent. CL&P, PSNH and WMECO have agreements with other New England utilities covering their joint ownership as tenants in common of Millstone 3. CL&P's ownership interest in the unit is 52.9330 percent (608 MW), PSNH's ownership interest in the unit is 2.8475 percent (32.7 MW) and WMECO's interest is 12.2385 percent (140.6 MW). NAEC and CL&P are parties to an agreement, similar to the Millstone 3 agreements, with respect to their 35.98201 percent (413.8 MW) and 4.05985 percent (46.7 MW) interests, respectively, in Seabrook. The agreements all provide for pro rata sharing of the construction and operating costs and the electrical output of each unit by the owners, as well as associated transmission costs. CL&P, PSNH, WMECO and other New England electric utilities are the stockholders of the Yankee companies. Each Yankee company owns a single nuclear generating unit. The stockholder-sponsors of a Yankee company are responsible for proportional shares of the operating costs of the Yankee company and are entitled to proportional shares of the electrical output. The relative rights and obligations with respect to the Yankee companies are approximately proportional to the stockholders' percentage stock holdings, but vary slightly to reflect arrangements under which non-stockholder electric utilities have contractual rights to some of the output of particular units. The Yankee companies and CL&P's, PSNH's and WMECO's stock ownership percentages and approximate MW entitlements in each are set forth below: CL&P PSNH WMECO System % MW % MW % MW % MW Connecticut Yankee Atomic Power Company (CYAPC) ...... 34.5 204 5.0 29 9.5 56 49.0 289 Maine Yankee Atomic Power Company (MYAPC) ............ 12.0 95 5.0 39 3.0 24 20.0 158 Vermont Yankee Nuclear Power Corporation (VYNPC)... 9.5 44 4.0 19 2.5 12 16.0 75 Yankee Atomic Electric Company (YAEC)* ............ 24.5 - 7.0 - 7.0 - 38.5 - _____________________________ * See "Yankee Units" for information about the permanent shutdown of the unit owned and operated by YAEC. CL&P, PSNH and WMECO are obligated to provide their percentages of any additional equity capital necessary for the Yankee companies. CL&P, PSNH and WMECO believe that the Yankee companies, excluding YAEC, will require additional external financing in the next several years to finance construction expenditures and nuclear fuel and for other purposes. Although the ways in which each Yankee company will attempt to finance these expenditures have not been determined, CL&P, PSNH and WMECO could be asked to provide direct or indirect financial support for one or more Yankee companies. OPERATIONS Capacity factor is a ratio that compares a unit's actual generating output for a period with the unit's maximum potential output. In 1993, the nuclear units in which the System companies have entitlements achieved an actual composite (weighted by entitlement) capacity factor of 79.9 percent. The five nuclear units operated by the System had a composite capacity factor of 80.3 percent based on normal winter claimed capability. The average capacity factor for operating nuclear units in the United States was 73.2 percent for January through September 1993 and 80.4 percent for the five System nuclear units operated in 1993, in each case using the design electrical rating method rather than normal winter claimed capability. When the nuclear units in which they have interests are out of service, CL&P, PSNH and WMECO need to generate and/or purchase replacement power. Recovery of prudently incurred replacement power costs is permitted, with limitations, through the GUAC for CL&P, through a retail fuel adjustment clause for WMECO and through a comprehensive fuel and purchased power adjustment clause (FPPAC) for PSNH. For the status of regulatory and legal proceedings related to recovery of replacement power costs for the 1990-1993 period, see "Rates - Connecticut Retail Rates," "Rates-Massachusetts Retail Rates" and "Rates - New Hampshire Retail Rates." MILLSTONE UNITS The 1993 overall performance of the three nuclear electric generating units located at Millstone station and operated by the System was substantially better than in 1992. For the twelve months ended December 31, 1993, the three units' composite capacity factor was 79.3 percent, compared with a composite capacity factor of 53.1 percent for the twelve months ended December 31, 1992 and 38.4 percent for the same period in 1991. In 1993 Millstone 1 operated at a 92.4 percent capacity factor with no extended outages. The unit began a planned refueling and maintenance outage on January 15, 1994 that is expected to last seventy-one days. Major work includes replacement of the main condenser tubes and installation of a new low pressure turbine. These modifications are intended to reduce the number of unplanned outages and improve the overall plant efficiency. In 1993 Millstone 2 operated at a 82.5 percent capacity factor. On January 13, 1993, the plant returned to service following a refueling outage that commenced on May 29, 1992. During that outage, both steam generators were replaced. The DPUC has opened a docket to review CL&P's performance in replacing Millstone 2's steam generators. See "Rates-Connecticut Retail Rates" for further information on the steam generator replacement docket. In addition to several short outages during 1993, Millstone 2 was shut down for two unplanned outages of significant duration. The first such outage began on August 5, 1993, to replace a leaking primary system valve. That outage lasted ten days. For more information on this outage, see "Electric Operations - Nuclear Generation - Operations - NRC Regulation." The second significant unplanned outage lasted twenty-six days, commencing on September 15, 1993, and was necessary to upgrade the motor-operated feedwater isolation valves. Millstone 2 is scheduled to begin a refueling and maintenance outage on July 30, 1994. The outage is currently planned for a 63-day duration. Major work activities will include a reactor vessel in-service inspection, erosion/corrosion piping inspections, motor-operated valve testing and service water piping replacement. In 1993 Millstone 3 operated at a 64.8 percent capacity factor. The unit began a refueling and maintenance outage on July 31, 1993 and completed it in 99 days. During the outage two significant issues were identified and resolved. Each of these issues resulted in an outage extension beyond original plans. The first issue required replacement of all four reactor coolant pumps due to concerns over turning vane cap screw and locking cup integrity. The second issue related to problems identified during inspection and testing of the supplementary leak collection and release system (SLCRS) and the auxiliary building ventilation system (ABVS), which provide secondary protection against radiological releases to the atmosphere. For more information on this issue, see "Electric Operations - Nuclear Generation - Operations - NRC Regulation." Resolution of these problems necessitated various modifications to these systems. No refueling or maintenance outages are planned for Millstone 3 during 1994. NUCLEAR PERFORMANCE IMPROVEMENT INITIATIVES The System's nuclear organization is taking major steps to correct identified performance weaknesses. For instance, on a 1992 to 1995 cumulative basis, NU anticipates total expenditures of approximately $2.3 billion for operation and maintenance and $440 million in capital improvements for the five plants that it operates. In addition, the comprehensive Performance Enhancement Program (PEP), authorized in 1992, continues to be one of the major initiatives that the nuclear organization is implementing to improve its overall performance. The program, in conjunction with other actions to address the long-term performance of the nuclear group, is designed to correct the root causes of the declining performance trend noted in the early 1990's. The PEP is organized into four major areas of activities, each focusing on a particular aspect of nuclear operations. The areas are management practices, programs and processes, performance assessments and functional programs. These areas were established based on an internal self-assessment completed in 1992. Detailed action plans have been prepared to address the specific activities. At the end of 1992, six of the forty-two action plans were completed and validated. An additional fourteen action plans were completed in 1993 and are awaiting validation. Seven action plans are to be completed in 1994, leaving fifteen action plans to complete during the remainder of the program. The 1993 PEP budget was $32.9 million. The System also announced a major reorganization of its Connecticut-based nuclear organization on November 8, 1993. The primary focus was realignment of engineering services along unit lines. The changes also included the appointment of a new senior vice president for Millstone station, some management consolidation, and a reorganization of the nuclear plant maintenance staff. See "Employees." In addition, most of the nuclear support staff currently located in Berlin, Connecticut will be centralized at the generating stations by the summer of 1994. To support these efforts, the System is constructing a five-story office building at Millstone station. This building will replace several temporary modular buildings and will house most of the nuclear technical support staff that is now located at various System locations. The prudence of this construction project is the subject of an ongoing inquiry by the DPUC. SEABROOK In 1993 Seabrook 1 operated at a capacity factor of 89.8 percent. The unit is currently in an 18-month operating cycle that began in November 1992. The unit is scheduled to begin a 57-day refueling and maintenance outage on April 16, 1994. During this outage, the main plant computer will be replaced. CL&P, PSNH and NAEC could be affected by the ability of other Seabrook joint owners to fund their share of Seabrook costs. Great Bay Power Corporation (GBPC), a former subsidiary of Eastern Utilities Associates and owner of 12.13 percent of Seabrook, has been in bankruptcy since February 1991. The Bankruptcy Court confirmed GBPC's reorganization plan on March 5, 1993 and approvals are required from NRC, FERC and NHPUC to consummate the plan. CL&P has committed to advance GBPC up to $12 million, secured by a high priority lien on GBPC's share of Seabrook, to cover GBPC's shortfalls in funding its share of the operation of Seabrook through June 30, 1994. As of March 1, 1994, CL&P was lending approximately $2 million to GBPC under this arrangement. GBPC has advised CL&P that it expects to consummate its reorganization plan, emerge from bankruptcy and repay CL&P for all advances by June 30, 1994. CL&P is unable to predict what impact, if any, failure of the reorganization plan to become effective will have on the operating license for Seabrook or what actions CL&P and the other joint owners of the unit may be required to take. On May 6, 1991, NHEC, PSNH's largest customer and one of the joint owners of Seabrook, filed a petition for reorganization under Chapter 11 of the Federal Bankruptcy Code. The plan of reorganization for NHEC was confirmed by the United States Bankruptcy Court on March 20, 1992 and wholesale power arrangements were accepted by FERC on July 22, 1992. On October 5, 1992, the NHPUC released an order approving NHEC's plan of reorganization. Under the plan of reorganization, NHEC will remain a customer of PSNH. The plan also provides that PSNH will purchase the capacity and energy of NHEC's 2.2 percent ownership interest in Seabrook 1 and pay all of NHEC's Seabrook costs for a ten-year period, which began July 1, 1990. On December 1, 1993, the United States Bankruptcy Court for the District of New Hampshire declared the NHEC reorganization plan effective as of that date. See "Rates--Wholesale Rates" for further information on the bankruptcy and subsequent reorganization of NHEC. At certain times, VEG&T failed to pay its share of Seabrook costs. Certain joint owners, including PSNH and CL&P, provided funds against future payments due from VEG&T to assure that funds were available to meet its ownership share of Seabrook costs. PSNH initially participated in such payments, but ceased providing such funds in January 1988, when it commenced bankruptcy proceedings under Chapter 11 of the Bankruptcy Code. The total amount contributed by PSNH until then was $976,000. The total amount contributed by CL&P was $265,000. As part of an agreement to resolve issues raised during the bankruptcy of PSNH, PSNH agreed that it or its designee would purchase the VEG&T 0.41259 percent interest in Seabrook for approximately $6.4 million. NAEC, the current owner of PSNH's ownership share in Seabrook, agreed to purchase the interest and to enter into a separate power contract with PSNH, under which PSNH would be obligated to buy from NAEC all of the capacity and output of Seabrook attributable to such interest for a period equal to the length of the NRC full power operating license for Seabrook. On January 7, 1994, the NRC approved the transfer of VEG&T's ownership share of Seabrook to NAEC. All other regulatory approvals for NAEC's purchase were received and the acquisition became effective on February 15, 1994. In settlement of their claims against VEG&T for advances, PSNH and CL&P received payment of the amounts advanced, $1.78 million and $390,000, respectively, out of proceeds of the sale, with interest thereon, for the period each advance was outstanding at the prime rate. See "Rates-New Hampshire Retail Rates-Memorandum of Understanding" and "Rates-New Hampshire Retail Rates-Seabrook Power Contract" for further information on NAEC's acquisition of VEG&T's share of Seabrook. In 1989, as part of a comprehensive settlement of Seabrook issues, PSNH agreed to make certain payments totaling $16 million to Massachusetts Municipal Wholesale Electric Company during the first eight years of Seabrook operation. As of December 31, 1993, PSNH had made approximately $7.2 million of these payments. YANKEE UNITS CY, the nuclear unit owned by MYAPC (MY) and the nuclear unit owned by VYAPC (VY) operated in 1993 at capacity factors of 73.1 percent, 74.3 percent and 74.1 percent, respectively, based on normal winter claimed capability. Yankee Rowe has not operated since October 1991. CY. As of December 31, 1993, CY, since it began commercial operation in 1968, had generated over 99 billion kWh (gross) of electricity, making it one of the most productive nuclear generating units in the United States. The unit completed, on schedule, a 66-day refueling and maintenance outage that began on May 15, 1993. The second reload of fuel clad with zircalloy was installed during this outage to replace the stainless steel clad fuel. There is one more phase to this upgrade project that, when completed, will make the operation of the reactor core more economical by allowing longer operating cycles. CY's next refueling and maintenance outage is scheduled to begin on November 12, 1994 and is expected to last 54 days. Major work activities will include auxiliary feedwater system modifications and motor-operated valve testing. The start date and length of this refueling outage may be impacted by an unplanned shutdown which occurred on February 12, 1994, when the plant was required to come off line to address integrity concerns in the safety-related service water system. CYAPC is reviewing the scope of work required and schedule for returning the unit to service from the unplanned outage. In October 1992, CYAPC filed an application with the FERC for wholesale rate relief. CYAPC requested the increase to become effective on January 1, 1993. The filing requested an increase in estimated decommissioning cost collections from $130 million to $309.1 million (in July 1992 dollars) and also proposed to adjust decommissioning accruals automatically on an annual basis beginning January 1, 1993. In December 1992, FERC accepted CYAPC's increased rates for filing, to become effective on June 1, 1993, subject to refund, and rejected the proposal to automatically adjust decommissioning accruals. A settlement between all the parties was reached in 1992 and was accepted by FERC in 1993. This included an accrual level for decommissioning of $294.2 million in 1992 dollars and an automatic increase of 5.5% annually in the decommissioning accrual for each of the next five years. MY. MY began a refueling and maintenance outage on July 31, 1993 and completed it in 75 days. During the outage, repairs were made to the reactor vessel thermal shield. VY. VY began a refueling and maintenance outage on August 27, 1993, and completed it in 59 days, including recovery from a dropped fuel bundle that suspended fuel movement for approximately 20 days. Yankee Rowe. In February 1992, YAEC's owners voted to shut down Yankee Rowe permanently and to begin preparations for an orderly decommissioning of the facility. The decision to close the generating plant eight years before the end of its operating license was based on an economic evaluation of the cost of a proposed safety review, the reduced demand for electricity in New England, the price of alternative energy sources and uncertainty about the regulatory requirements that the unit would need to meet in order to restart. See "Electric Operations-Nuclear Generation-Operations-Decommissioning" for information on YAEC's filing with FERC to collect for shutdown and decommissioning costs and the recovery of the remaining investment in the Yankee Rowe plant. The power contracts between CL&P, PSNH and WMECO and YAEC permit YAEC to recover from each its proportional share of these costs from CL&P, PSNH and WMECO. Management believes that, although Yankee Rowe was shut down eight years before the end of the unit's current license, CL&P, PSNH and WMECO will recover their investments in YAEC, along with any other costs associated with the shutdown and decommissioning of Yankee Rowe. Accordingly, the System has recognized these costs as a regulatory asset on its consolidated balance sheet and as a corresponding obligation to YAEC. NRC REGULATION As holders of licenses to operate nuclear reactors, CL&P, PSNH, WMECO, NAEC, North Atlantic, NNECO and the Yankee companies are subject to the jurisdiction of the NRC. The NRC has broad jurisdiction over the design, construction and operation of nuclear generating stations, including matters of public health and safety, financial qualifications, antitrust considerations and environmental impact. In its latest Systematic Assessment of Licensee Performance Report (SALP report) issued on October 19, 1993, the NRC gave the three Millstone nuclear plants a Category 1 rating in the area of radiological controls and a Category 2 rating in five of the seven areas rated: plant operations, maintenance/surveillance, emergency preparedness, security and engineering/technical support. The Millstone units received a Category 3 rating in the area of safety assessment/quality verification. Category 1 indicates "a superior level of performance," Category 2 indicates "a good level of performance" and Category 3 denotes "an acceptable level of performance." The evaluation covered plant activities for the period February 16, 1992 through April 3, 1993. Management expects to continue to improve performance, thereby raising these scores. The NRC issued its latest SALP report for Seabrook 1 on November 18, 1993. The report covered the interval from March 1, 1992 through August 28, 1993. This report reflects the recent revisions to the SALP program in which the number of functional evaluation areas has been reduced from seven to four: plant operations, maintenance, engineering and plant support. The evaluation rated Seabrook 1 a Category 1 in the engineering and plant support areas. In the areas of plant operations and maintenance, the unit was rated a Category 2. The NRC issued its latest SALP report for CY on May 21, 1993. The report covered the interval from July 14, 1991 through January 9, 1993. This evaluation recognized the superior performance of CY by awarding the unit a Category 1 in six of the seven areas rated: plant operations, emergency preparedness, security, engineering/technical support, safety assessment/quality verification and radiological controls. In the final area, maintenance/surveillance, CY was rated as a Category 2. Despite the overall improved performance of the Millstone units, there were a number of regulatory enforcement actions taken by the NRC in 1993. On May 4, 1993, the NRC issued to NNECO a Notice of Violation (NOV) identifying two potential violations. The first violation concerned NRC findings that a former employee was subjected to harassment and intimidation in 1989 for raising a nuclear safety concern and that senior management was not effective in dealing with the situation. The second violation involved NRC concerns that an employee may have deliberately delayed the processing of a contemplated substantial safety hazard evaluation conducted to fulfill the requirements of federal law. Following NNECO's response to the NOV, the NRC withdrew the second violation. To resolve this matter, NNECO paid a fine of $100,000 in connection with the first violation. On August 5, 1993, Millstone Unit 2 was shut down by plant personnel after extensive efforts to repair a leaking primary system valve proved unsuccessful, and a sudden increase in the leak rate was experienced. Following replacement of the damaged valve, the unit was returned to service on August 16, 1993. Recognizing the seriousness of this event and the potentially severe consequences of the failed repair efforts, NNECO performed a detailed evaluation of this event to consider potential deficiencies and identify the actions needed to prevent recurrence. The NRC also conducted a special investigation of this event and on September 22, 1993, identified to NNECO three apparent violations, related to work control planning and implementation, which were being considered for escalated enforcement. On December 3, 1993, the NRC informed NNECO that it was imposing a civil penalty of $237,500 for the three violations. NNECO has since paid the fine. On September 10, 1993, NNECO was informed by the NRC that, as a result of an investigation by the NRC Office of Investigation and a routine safety inspection of the Millstone Unit 1 nuclear power plant, two apparent violations arising from 1989 events were being considered for possible civil monetary penalties. The first issue concerned the alleged failure to initiate and perform a required engineering analysis to determine the operability of safety-related system in a timely manner. The second issue relates to allegations that the engineer who identified the system as being potentially inoperable was harassed and discriminated against in retaliation for the findings of his technical evaluations. These matters were investigated between early 1992 and June 1993 by a grand jury acting under the direction of the U.S. Attorney's Office in Bridgeport, Connecticut. The U.S. Attorney's office issued a letter on June 30, 1993, stating that no prosecutorial action would be initiated. On March 17, 1994, the NRC informed NNECO that further enforcement action with respect to this matter was not planned, because their review had determined that there was insufficient evidence to support the apparent violations. On September 20, 1993, the NRC issued to NNECO an NOV concerning two violations at the Millstone Station identified during its evaluation of the licensed operator requalification training (LORT) program. The first violation concerned an inspection finding that various licensed operators at Millstone 1 and 2 did not fully complete the LORT program for the 1991 and 1992 training periods. The second violation cited the failure of NNECO's internal nuclear review board to perform comprehensive audits of the training, retaining, requalification, and performance of the operations staff at Millstone 2 and 3. NNECO chose not to contest the violations nor the imposition of a $50,000 civil penalty. On December 15, 1993, the NRC issued an inspection report concerning the SLCRS and ABVS systems deficiencies that were identified during the 1993 Millstone 3 refueling outage. The report identified two apparent violations that are being considered for escalated enforcement. The apparent violations involve the inability of the systems to provide the necessary drawdown of secondary containment following a postulated accident and NNECO's failure to fully resolve these problems earlier, as a result of previous similar violations identified in September 1992. On March 11, 1994, the NRC notified NNECO that it proposed to impose a civil penalty of $50,000 in respect of these violations. NNECO has 30 days to respond to the NRC. In January 1994, the NRC issued a report finding that the overall Millstone 1 operator requalification training program was satisfactory. The NRC had previously found the program to be unsatisfactory. The recent conclusion was based on the results of a number of NRC inspections and the operator examinations conducted in September 1993. The NRC reviewed NNECO's corrective actions and determined that all actions necessary to obtain and maintain a satisfactory requalification training program had been completed and verified. INDUSTRY-WIDE NUCLEAR ISSUES The NRC regularly conducts generic reviews of technical and other issues, a number of which may affect the nuclear plants in which System companies have interests. Issues currently under review include individual plant examination programs to evaluate the likelihood and effects of severe accidents at operating nuclear plants, pipe crack phenomena, post-accident measures for controlling hydrogen, reactor vessel embrittlement, upgrading of emergency response facilities and communications, the ability of plants to cope with a total loss of power, emergency response planning, fitness for duty policies, operator requalification training, reactor containment suitability, maintenance adequacy, motor-operated valve testing, design basis reconstitution, diesel generator reliability, life extension, equipment procurement, electrical distribution system adequacy, reactor coolant pump seal integrity, plant risk during shutdown and low power operation, technical specification improvements, accident management, component aging, steam generator degradation phenomena, service water system adequacy, seismic qualification of equipment and other issues. At present, the outcome of the NRC's reviews of these and other technical issues, and the ways in which the different nuclear plants in which System companies have interests may be affected, cannot be determined. The cost of complying with any new requirements that may result from these reviews cannot be estimated at this time, but such costs could be substantial. Further, the NRC is currently evaluating a staff report on the reporting of nuclear safety concerns, which may result in changes in the way such concerns are addressed. The NRC has authorized the conduct of various regulatory activities designed to lower costs to its licensees while maintaining or improving public safety. Public controversy concerning nuclear power could affect the nuclear units in which System companies have ownership interests. Over the past decade, proposals to force the premature shutdown of nuclear units have become issues of serious and recurring attention in Maine, Massachusetts, Vermont and New Hampshire. States' efforts to deal with the siting of low level radioactive waste repositories have also stimulated negative reactions in communities being considered for those facilities. The continuing controversy about nuclear power may affect the cost of operating the nuclear units in which System companies have interests. While much of the public policy debate about nuclear power has been critical in the past, some trends in the energy environment have stimulated renewed support for nuclear power in the northeastern United States. Among these trends are the growing national environmental concerns and legislation about acid rain, air quality and global warming associated with fossil fuels. These concerns particularly affect the densely populated areas in the Northeast, downwind of coal-burning regions like the Midwest and mid-Atlantic states. In addition, at times when the price and availability of fuel oil have been volatile, the System's commitment to nuclear power has allowed it to minimize the oil-related rise in customers' bills. While the public controversy about nuclear power is not expected to disappear, recent trends suggest a more balanced public policy debate about the impacts of fossil fuel generation as well. NUCLEAR INSURANCE The NRC's nuclear property insurance rule requires nuclear plant licensees to obtain a minimum of $1.06 billion in insurance coverage. The rule requires that, although such policies may provide traditional property coverage, proceeds from the policy following an accident in which estimated stabilization and decontamination expenses exceed $100 million will first be applied to pay such expenses. The insurance carried by the licensees of the Millstone units, Seabrook 1, CY, MY and VY meets the requirements of this rule. YAEC has obtained an exemption for the Yankee Rowe plant from the $1.06 billion requirement and currently carries $25 million of insurance that otherwise meets the requirements of the rule. The Price-Anderson Act currently limits public liability from a single incident at a nuclear power plant to $9.4 billion. The first $200 million of liability would be provided by purchasing the maximum amount of commercially available insurance. Additional coverage of up to $8.8 billion would be provided by an assessment of $75.5 million per incident, levied on each of the 116 United States nuclear units that are currently subject to the secondary financial protection program, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. In addition, if the sum of all public liability claims and legal costs arising from any nuclear incident exceeds the maximum amount of financial protection, each reactor operator can be assessed an additional five percent, up to $3.8 million or $437.9 million in total for all 116 reactors. The maximum assessment is to be adjusted for inflation at least every five years. Based on CL&P's, PSNH's and WMECO's ownership interests in the three Millstone units and CL&P's and NAEC's interests in Seabrook 1, the System's current maximum direct liability would be $244.2 million per incident. In addition, through CL&P's, PSNH's and WMECO's power purchase contracts with the four Yankee regional nuclear electric generating companies, the System would be responsible for up to an additional $97.9 million per incident. These payments would be limited to a maximum in any year of $43.2 million per incident. Insurance has been purchased from Nuclear Electric Insurance Limited (NEIL) to cover: (1) certain extra costs incurred in obtaining replacement power during prolonged accidental outages with respect to CL&P's and WMECO's ownership interests in Millstone 1, 2, 3, and CY, CL&P's ownership interest in Seabrook, and PSNH's Seabrook Power Contract with NAEC; and (2) the cost of repair, replacement, or decontamination or premature decommissioning of utility property resulting from insured occurrences with respect to CL&P's ownership interests in Millstone 1, 2, 3, CY, MY, VY, and Seabrook 1; WMECO's ownership interests in Millstone 1, 2, 3, CY, MY, and VY; PSNH's ownership interest in Millstone 3, CY, MY and VY; and NAEC's ownership interest in Seabrook 1. All companies insured with NEIL are subject to retroactive assessments if losses exceed the accumulated funds available to NEIL. The maximum potential assessments against CL&P, PSNH, WMECO, and NAEC with respect to losses arising during current policy years are approximately $13.9 million under the replacement power policies and $29.9 million under the property damage, decontamination, and decommissioning policies. Although CL&P, PSNH, WMECO, and NAEC have purchased the limits of coverage currently available from the conventional nuclear insurance pools, the cost of a nuclear incident could exceed available insurance proceeds. Insurance has been purchased from American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters, aggregating $200 million on an industry basis, for coverage of worker claims. All companies insured under this coverage are subject to retrospective assessments of $3.2 million per reactor. The maximum potential assessments against CL&P, PSNH, WMECO, and NAEC with respect to losses arising during the current policy period are approximately $13.9 million. CYAPC expects that it will receive an insurance recovery for costs related to the CY thermal shield repair which occurred during the 1987 outage, and the removal which occurred during the 1989 outage, but the amount and time of payment are not certain. See "Rates-Connecticut Retail Rates-Adjustment Clauses." NUCLEAR FUEL The supply of nuclear fuel for the System's existing units requires the procurement of uranium concentrates, followed by the conversion, enrichment and fabrication of the uranium into fuel assemblies suitable for use in the System's units. These materials and services are available from a number of domestic and foreign sources. The System companies have predominantly relied on long term contracts with both domestic and foreign suppliers, supplemented with short term contracts and market purchases, to satisfy the units' requirements. Although the System has increased the use of foreign suppliers, domestic suppliers still provide the majority of the materials and services. The System companies have maintained diversified sources of supply, relying on no single source of supply for any one component of the fuel cycle, with the exception of enrichment services of which the majority of the System companies' requirements are provided under a long term contract with the U.S. Enrichment Corporation, a wholly-owned government corporation, established on July 1, 1993, in accordance with the Energy Policy Act and the successor to the U.S. DOE Uranium Enrichment Enterprise. The System expects that uranium concentrates and related services for the units operated by the System and for the other units in which the System companies are participating, that are not covered by existing contracts, will be available for the foreseeable future on reasonable terms and prices. As a result of the Energy Policy Act, the U.S. utility industry is required to pay to the DOE, via a special assessment for the costs of the decontamination and decommissioning of uranium enrichment plants operated by the DOE, $150 million each U.S. Government fiscal year for 15 years beginning in 1993. Each domestic utility will make a payment proportioned on its past purchases from the DOE's Uranium Enrichment Enterprise. Each year, the DOE will adjust the annual assessment using the Consumer Price Index. The Energy Policy Act provides that the assessments are to be treated as reasonable and necessary current costs of fuel, which costs shall be fully recoverable in rates in all jurisdictions. The System's total share of the estimated assessment was approximately $56.7 million. Management believes that the DOE assessments against CL&P, WMECO, PSNH and NAEC will be recoverable in future rates. Accordingly, each of these companies has recognized these costs as regulatory asset, with corresponding obligation on its balance sheet. Costs associated with nuclear plant operations include amounts for disposal of nuclear wastes, including spent fuel, and for the ultimate decommissioning of the plants. The System companies include in their nuclear fuel expense spent fuel disposal costs accepted by the DPUC, the NHPUC and the DPU in rate case or fuel adjustment decisions. Spent fuel disposal costs are also reflected in wholesale charges. Such provisions include amortization and recovery in rates of previously unrecovered disposal costs of accumulated spent nuclear fuel. HIGH-LEVEL RADIOACTIVE WASTES Under the Nuclear Waste Policy Act of 1982, the DOE is required to design, license, construct and operate a permanent repository for high level radioactive wastes and spent nuclear fuel. The act requires the DOE to provide, beginning in 1998, for the disposal of spent nuclear fuel and high level radioactive waste from commercial nuclear plants through contracts with the owners and generators of such waste. The System companies have entered into such contracts with the DOE with respect to Millstone 1, 2 and 3 and Seabrook 1, and have been advised that the Yankee companies have entered into similar contracts. The DOE has established disposal fees to be paid to the federal government by electric utilities owning or operating nuclear generating units. The System companies have been paying for such services for fuel burned starting in April 1983 on a quarterly basis since July 1983 in accordance with the contracts; the DPUC, the NHPUC and the DPU permit the fee to be recovered through rates. The disposal fee for fuel burned before April 1983 (previously burned fuel) is determined in accordance with a fee structure based on fuel burnup. Under the contract payment option selected, the System companies anticipate making payment to the DOE for disposal of previously burned fuel just before the first delivery of spent fuel to the DOE. That payment obligation is not a funded obligation. The liability under the selected payment option for previously burned fuel, including interest, through December 31, 1993, and the amounts recovered through rates for previously burned fuel through the end of 1993 for Millstone 1 and 2, are as follows: Previously Burned Fuel Liability, Amounts Recovered for Previously Including Interest, Thru 12/31/93 Burned Fuel Thru 12/31/93 (Millions) CL&P $136.1 $134.5 WMECO 31.9 32.3 Total $168.0 $166.8 Because Millstone 3 and Seabrook 1 went into service after 1983, there is no previously burned fuel liability for those units. In return for payment of the fees prescribed by the Nuclear Waste Policy Act, the federal government is to take title to and dispose of the utilities' high level wastes and spent nuclear fuel beginning no later than 1998. Until the federal government begins receiving such materials, operating nuclear generating plants will need to retain high-level wastes and spent fuel on-site or make some other provisions for their storage. With the addition of new storage racks or through fuel consolidation, storage facilities for Millstone 3 and CY are expected to be adequate for the projected life of the units. With the storage facilities for Millstone 1 and 2 are expected to be adequate (maintaining the capacity to accommodate a full-core discharge from the reactor) until 2000. Fuel consolidation, which has been licensed for Millstone 2, could provide adequate storage capability for the projected lives of Millstone 1 and 2. In addition, other licensed technologies, such as dry storage casks or on-site transfers, are being considered to accommodate spent fuel storage requirements. With the addition of new racks, Seabrook 1 is expected to have spent fuel storage capacity until at least 2010. Under the terms of a license amendment approved by the NRC in 1984, MY's present storage capacity of the spent fuel pool at the unit will be reached in 1999, and after 1996 the available capacity of the pool will not accommodate a full-core removal. After consideration of available technologies, MYAPC elected to provide additional capacity by replacing the fuel racks in the spent fuel pool at the unit and, on January 25, 1993, filed with the NRC seeking authorization to implement the plan. MYAPC believes that the replacement of the fuel racks, if approved, will provide adequate storage capacity through the unit's licensed operating life. While no intervention has occurred, MYAPC cannot predict with certainty whether the NRC authorization will be granted or whether or to what extent the storage capacity limitation at the unit will affect the operation of the unit or the future cost of disposal. Under the terms of a license amendment approved by the NRC in 1991, the storage capacity of the spent fuel pool at VY is expected to be reached in 2003, and the available capacity of the pool is not expected to be able to accommodate a full-core removal after 1998. Because the Yankee Rowe plant was permanently shut down effective February 26, 1992, YAEC is planning to construct a temporary facility to store the spent nuclear fuel produced by the Yankee Rowe plant over its operating lifetime until that fuel is removed by the DOE. See "Electric Operations - Nuclear Generation - Decommissioning" for further information on the closing and decommissioning of Yankee Rowe. LOW-LEVEL RADIOACTIVE WASTES Disposal costs for low-level radioactive wastes (LLRW) have continued to rise in recent years despite significant reductions in volume. Approximately $7.65 million was spent on LLRW disposal for the Millstone units and CY in 1993. In accordance with the provisions of the federal Low-Level Radioactive Waste Policy Act of 1980, as amended (the Waste Policy Act), on December 31, 1992 the disposal site at Beatty, Nevada closed, and the Richland, Washington facility closed to disposal of LLRW from outside its compact region. During 1992, the Barnwell, South Carolina site announced its intention to remain open for disposal of out-of-region LLRW until June 30, 1994. In November 1992, the Northeast Compact commission entered into an agreement with the Southeast Interstate Low-Level Radioactive Waste Management Compact (the Southeast Compact) commission providing for continued access to the Barnwell facility until June 30, 1994 by Connecticut LLRW generators, and the System agreed to pay, in addition to disposal fees, an access fee of $220 per cubic foot, with a minimum of $4.73 million, for the right to dispose of LLRW at Barnwell during this period. The Connecticut Hazardous Waste Management Service (the Service), a state quasi-public corporation, is charged with coordinating the establishment of a facility for disposal of LLRW originating in Connecticut. In June 1991, the Service announced that it had selected three potential sites in north-central Connecticut for further study. The Service's announcement provoked intense controversy in the affected municipalities and resulted in legislative action to stop the selection process. On February 1, 1993, the Service presented the legislature with a new site selection plan under which communities are urged to volunteer a site for a facility in return for financial and other incentives. The volunteer process is being continued in 1994. The Service's activities in this regard are funded by assessments on Connecticut's LLRW generators. The System was assessed approximately $1.8 million for the state's 1992-1993 fiscal year. Due to the change to a volunteer process, there was no assessment for the 1993-1994 fiscal year and the state projects no assessment for the 1994-1995 and 1995-1996 fiscal years. The System has plans to acquire or construct additional LLRW storage capacity at the Millstone and CY sites to provide for temporary storage of LLRW should that become necessary. The System can manage its Connecticut LLRW by volume reduction, storage or shipment at least through 1999. Management cannot predict whether and when a disposal site will be designated in Connecticut. Since January 1, 1989, the State of New Hampshire has been barred from shipping Seabrook LLRW to the operating disposal facilities in South Carolina, Nevada and Washington for failure to meet the milestones required by the Waste Policy Act. Seabrook 1 has never shipped LLRW but has capacity to store at least five years' worth of the LLRW generated on-site, with the capability to expand this on-site capacity if necessary. The Seabrook station accrued approximately $1.3 million in off-site disposal costs in 1993. New Hampshire is pursuing options for out-of-state disposal of LLRW generated at Seabrook. Massachusetts and Vermont have arranged for continued access to the Barnwell facility until mid-1994 for the nuclear waste generators in their states. YAEC is currently disposing of its LLRW at the Barnwell facility. MY has been storing its LLRW on-site since January 1993. VY and MY each has on-site storage capacity for at least five years' production of LLRW from its respective plants. Maine and Vermont are in the process of finalizing an agreement with the state of Texas to provide access to a facility that will be developed in that state. DECOMMISSIONING The System's most recent comprehensive site-specific updates of the decommissioning costs for each of the three Millstone units were completed in 1992 and for Seabrook was completed in 1991. The recommended decommissioning method reflected in the cost estimates continues to be immediate and complete dismantlement of those units at their retirement. The table below sets forth the estimated Millstone and Seabrook decommissioning costs for the System companies. The estimates are based on the latest site studies, escalated to December 31, 1993 dollars, and include costs allocable to NAEC's share of Seabrook recently acquired from VEG&T. CL&P PSNH WMECO NAEC NU System (Millions) Millstone 1 $312.5 $ - $ 73.3 $ - $385.8 Millstone 2 251.0 - 58.9 - $309.9 Millstone 3 223.0 12.0 51.6 - 286.6 Seabrook 1 14.9 - - 131.7 146.6 Total $801.4 $12.0 $183.8 $131.7 $1,128.9 Pursuant to Connecticut law, CL&P has periodically filed plans with the DPUC for financing the decommissioning of the three Millstone units. In 1986, the DPUC approved the establishment of separate external trusts for the currently tax-deductible portions of decommissioning expense accruals for Millstone 1 and 2 and for all expense accruals for Millstone 3. In its 1993 CL&P multi-year rate case decision, the DPUC allowed CL&P's full decommissioning estimate for the three Millstone units to be collected from customers. This estimate includes an approximately 16 percent contingency factor for each unit. The estimated aggregate cost of decommissioning the Millstone units is $1.1 billion in December 1993 dollars. WMECO has established independent trusts to hold all decommissioning expense collections from customers. In its 1990 WMECO multi-year rate case decision, the DPU allowed WMECO's decommissioning estimate for the three Millstone units ($840 million in December 1990 dollars) to be collected from customers. Due to the settlement in the 1992 WMECO rate case, the aggregate decommissioning estimate for the three Millstone units remains unchanged. The decommissioning cost estimates for the Millstone units are reviewed and updated regularly to reflect inflation and changes in decommissioning requirements and technology. Changes in requirements or technology, or adoption of a decommissioning method other than immediate dismantlement, could change these estimates. CL&P, PSNH and WMECO attempt to recover sufficient amounts through their allowed rates to cover their expected decommissioning costs. Only the portion of currently estimated total decommissioning costs that has been accepted by regulatory agencies is reflected in rates of the System companies. Although allowances for decommissioning have increased significantly in recent years, ratepayers in future years will need to increase their payments to offset the effects of any insufficient rate recoveries in previous years. New Hampshire enacted a law in 1981 requiring the creation of a state-managed fund to finance decommissioning of any units in that state. In 1992, the New Hampshire Nuclear Decommissioning Financing Committee (NDFC) established approximately $323 million (in 1991 dollars) as the decommissioning cost estimate for immediate and complete dismantlement of Seabrook 1 upon its retirement. On March 10, 1993, FERC approved this estimate. The estimated total decommissioning cost for Seabrook 1 is $366 million in December 1993 dollars. The NHPUC is authorized to permit the utilities subject to its jurisdiction that own an interest in Seabrook 1 to recover from their customers on a per-kilowatt-hour basis amounts paid into the decommissioning fund over a period of years. NAEC's costs for decommissioning are billed by it to PSNH and recovered by PSNH under the Rate Agreement. Under the Rate Agreement, PSNH is entitled to a base rate increase to recover increased decommissioning costs. See "Rates - New Hampshire Retail Rates" for further information on the Rate Agreement. North Atlantic submitted its annual update of the 1991 Decommissioning Study and Funding Schedule to the NDFC on March 31, 1993. It included an updated estimate for the prompt removal and dismantling of Seabrook station in 2026 at the end of licensed life and a review of the assumptions on inflation and rate-of-return on fund investments used to develop the joint owner contribution schedule. North Atlantic concluded that the 1991 estimate, escalated in accordance with these assumptions to 1993 dollars, is still valid. Although a schedule has not been set by the NDFC, public hearings on the decommissioning estimate and funding schedule will probably be held in the third quarter of 1994. The new Investment Guidelines for the Seabrook Nuclear Decommissioning Financing Fund, which were approved by the New Hampshire State Treasurer and would have gone into effect on November 1, 1993, have been put on hold by a recent decision of FERC. The October 20, 1993 FERC order effectively reinstated the so-called "black lung" investment restrictions on decommissioning funds subject to its jurisdiction, although Congress, in the Energy Policy Act, had repealed the IRS regulation which mandated them. Under these restrictions, investments are limited to public debt securities that are fully backed by the U.S. government, tax exempt obligations of state or local governments and time deposits with a bank or insured credit union. The new guidelines would allow equity holdings by the joint owners of Seabrook, beginning with a limit of 10 percent in 1994 and gradually increasing to a limit of 40 percent in 1997. The strategies also call for a gradual reduction in the equity position as the plant approaches the end of its licensed life. Implementation of new investment guidelines for the Millstone units and CY have also been delayed because of the FERC decision. The System is party to petitions filed with FERC in November 1993, seeking reconsideration of the FERC decision. As of December 31, 1993, the balances (at cost) in the external decommissioning trust funds were as follows: Millstone 1 Millstone 2 Millstone 3 Seabrook 1 (Millions of Dollars) CL&P........... $70.4 $45.5 $30.9 $ .9 PSNH........... * * 1.5 * WMECO.......... 24.0 16.5 8.6 * NAEC........... * * * 7.9 _____ _____ _____ ____ Total........ $94.4 $62.0 $41.0 $8.8 *PSNH has no ownership interest in the Millstone 1 and 2 units. WMECO has no ownership interest in Seabrook 1. NAEC's only ownership interest is in Seabrook 1. YAEC, MYAPC, VYNPC and CYAPC are all collecting revenues for decommissioning from their power purchasers. The table below sets forth the estimated decommissioning costs of the Yankee units for the System companies. The estimates are based on the latest site studies, escalated to December 31, 1993 dollars. For information on the equity ownership of the System companies in each of the Yankee units, see "Electric Operations - Nuclear Generation - General." CL&P PSNH WMECO NU System (Millions) CY $117.3 $17.0 $32.3 $166.6 MY 38.8 16.2 9.7 64.7 VY * * * * Yankee Rowe 68.7 19.6 19.6 107.9 ______ _____ _____ ______ Total $255.3 $65.6 $69.6 $390.5 *VYNPC is currently reestimating the cost of decommissioning VY. Based on recent estimates for comparable units, the projected cost is expected to fall into the $300 - $350 million range. The System's share of these costs is expected to be between $48 million and $56 million. The results of the VYNPC study are expected to be available in the spring of 1994. In June 1992, YAEC filed a rate filing to obtain FERC authorization for an increase in rates to cover the costs of closing and decommissioning the Yankee Rowe plant and for the recovery of the remaining investment in the unit over the remaining period of its NRC operating license. At December 31, 1993, the System's share of these estimated costs was approximately $132.8 million. A settlement agreement among YAEC, the FERC staff and intervenors to the FERC proceeding addressing all issues has been filed with and accepted by FERC. YAEC has submitted its decommissioning plan to the NRC for approval. Due to the unexpected continued availability of the low level waste disposal facility in Barnwell, South Carolina, YAEC requested NRC permission to use decommissioning funds prior to final NRC approval of the complete plan. On April 16, 1993, the NRC approved YAEC's request to use funds for removal of the steam generators, pressurizer and reactor internals. By December 31, 1993, all major components were successfully disposed of at Barnwell and only a small number of internals shipments remain to be made. YAEC will continue its dismantling of the plant in 1994. The NRC's review of the decommissioning plan is expected to be completed by December 31, 1994 at which time YAEC will, depending upon the availability of a low level waste site, move to completely dismantle the facility. CYAPC accrues decommissioning costs on the basis of immediate dismantlement at retirement. The most current estimated decommissioning cost, based on a 1992 study, is approximately $339.9 million in year-end 1993 dollars. As a result of a 1987 study approved by FERC, CYAPC has been accruing expenses based on an estimated decommissioning level of $130 million. On October 30, 1992, CYAPC filed with FERC a proposed change in rates to recover the increase in estimated decommissioning costs. On May 11, 1993, FERC approved a settlement agreement allowing a decommissioning estimate of $294.2 million (in July 1992 dollars) to be recovered in rates effective June 1, 1993. See "Electric Operations - Nuclear Generation - Operations - Yankee Units." In 1984, CYAPC established an independent irrevocable decommissioning trust fund, which was modified for tax purposes in 1987 to create two trusts. Each month, CYAPC's sponsors are billed for their proportionate share of decommissioning expense as allowed by FERC and payments are made directly to the trust. The combined balance of the trusts at December 31, 1993 was $137.8 million. The trust balances must be used exclusively to discharge decommissioning costs as incurred. MYAPC estimates the cost of decommissioning MY at $323.7 million in December 31, 1993 dollars based on a study completed in July 1993. NON-UTILITY BUSINESSES GENERAL In addition to its core electric utility businesses in Connecticut, New Hampshire and Massachusetts, in recent years the System has begun a diversification of its business activities into two energy-related fields: private power development and energy management services. PRIVATE POWER DEVELOPMENT In 1988, NU organized a new subsidiary corporation, Charter Oak, through which the System participates as a developer and investor in domestic and international private power projects. With the passage of the Energy Policy Act, Charter Oak can invest in cogeneration and small power production (SPP) facilities anywhere in the world. This legislation also expands Charter Oak's permissible involvement in exempt wholesale generators (EWGs) to include development, construction and ownership. Management currently does not permit Charter Oak to invest in facilities which are located within the System service territory or to sell its electric output to any of the System electric utility companies. For a discussion of certain highlights of the Energy Policy Act relating to EWGs, see "Regulatory and Environmental Matters - - Public Utility Regulation." Under the Public Utility Regulatory Policies Act of 1978 (PURPA), as a subsidiary of an electric utility holding company, Charter Oak is effectively limited to no more than 50 percent ownership in a QF within the United States. To work within this constraint, Charter Oak has made strategic alliances with several experienced developers to pursue development opportunities. Through these relationships, Charter Oak is pursuing development opportunities nationwide and internationally. Although Charter Oak has no full-time employees, eight NUSCO employees are dedicated to Charter Oak activities on a full-time basis. Other NUSCO employees provide services as required. Charter Oak owns, through a wholly-owned special purpose subsidiary, a ten percent equity interest in a 220 MW natural gas-fired combined cycle cogeneration QF in Texas which provides steam to Campbell Soup Company's Paris, Texas manufacturing facility and electricity to Texas Utilities Electric Company. Charter Oak also owns 56 MW of the 1,875 MW Teesside natural gas-fired cogeneration facility in the United Kingdom. Charter Oak is pursuing other project development opportunities in both the domestic and international markets with a combined capacity over 1,000 MW. Charter Oak is currently participating in the development stage of projects in Texas, the West Coast, the Midwest, Latin America and the Pacific Rim. NU's total investment in Charter Oak was approximately $23.0 million as of December 31, 1993. NU, Charter Oak and its subsidiary, Charter Oak Energy Development, have received approval from the SEC to increase NU's authorized investment in Charter Oak to up to $100 million and to increase Charter Oak's authorized investment in COE Development to up to $100 million for preliminary development activities in QFs, IPPs, EWGs and foreign utility companies. ENERGY MANAGEMENT SERVICES In 1990, NU organized a new subsidiary corporation, HEC, which acquired substantially all of the assets and personnel of an existing, non-affiliated energy management services company. In general, the energy management services that HEC provides are performed for customers pursuant to contracts to reduce the customers' overall energy consumption and reduce energy costs and/or conserve energy resources. HEC also provides demand side management consulting services to utilities. HEC's energy management and consulting services are directed primarily to the commercial, industrial and institutional markets and utilities in New England and New York, although the SEC's order under the 1935 Act that authorized NU to operate HEC also permits HEC to serve customers outside that area, so long as over half of its revenues are attributable to customers in New England and New York. NU's initial equity investment in HEC was approximately $4 million and NU has made additional capital contributions of approximately $300,000 through March 1, 1994. Under the SEC order authorizing HEC's participation in the Money Pool, HEC may borrow up to $11 million from the Money Pool. At December 31, 1993, HEC had $2.9 million outstanding from its borrowings from the Money Pool. REGULATORY AND ENVIRONMENTAL MATTERS PUBLIC UTILITY REGULATION NU is registered with the SEC as an electric utility holding company under the 1935 Act. Under the 1935 Act, the SEC has jurisdiction over NU and its subsidiaries with respect to, among other things, securities issues, sales and acquisitions of securities and utility assets, intercompany loans, services performed by and for associated companies, accounts and records, involvement in non-utility operations and dividends. The Energy Policy Act amended the 1935 Act to give registered holding companies, like NU, broadened authority to invest in small power production facilities qualifying under PURPA and to own a new class of IPPs known as EWGs. An EWG is an entity exclusively in the business of owning and/or operating generating facilities that sell electricity at wholesale. EWGs are exempt from most regulation under the 1935 Act. A registered holding company may also invest in foreign utility companies with SEC approval. EWGs, however, are subject to state regulation with respect to siting and financial regulation to prevent cross-subsidies and self-dealing among utilities and affiliated EWGs. The Energy Policy Act also amended the Federal Power Act to authorize FERC to order wholesale transmission wheeling services, including the enlargement of transmission capacity necessary to provide such services, unless such transmission would unreasonably impair the reliability of the electric systems affected or the utility ordered to provide transmission is unable to obtain necessary governmental approvals or property rights. Rates for transmission ordered under the Energy Policy Act are to be designed to protect the wheeling utilities' existing customers. FERC's authority to order wheeling does not extend to retail wheeling, and FERC may not issue a wheeling order that is inconsistent with state franchise laws. CL&P is subject to regulation by the DPUC, which has jurisdiction over, among other things, retail rates, accounting procedures, certain dispositions of property and plant, mergers and consolidations, securities issues, standards of service, management efficiency and construction and operation of generation, transmission and distribution facilities. Because of their ownership interests in the Millstone units, PSNH and WMECO are also subject to the jurisdiction of the DPUC with respect to their activities in Connecticut and their securities issues. PSNH and NAEC are subject to regulation by the NHPUC, which has jurisdiction over retail rates, accounting procedures, certain dispositions of property and plant, quality of service, securities issues, acquisitions of securities of other utilities, mortgages of property, declaration of dividends, contracts with affiliates, management efficiency, construction and operation of generation, transmission and distribution facilities, integrated resource planning and other matters. Although the Seabrook Power Contract between PSNH and NAEC is a wholesale contract subject to the jurisdiction of FERC, pursuant to the terms of the Rate Agreement, the NHPUC has the right to review the prudence of costs incurred by NAEC to determine whether they should be passed on to ratepayers through FPPAC, and the NHPUC and the State of New Hampshire have additional rights and limited jurisdiction over certain other Seabrook Power Contract issues. NU and its subsidiaries are subject to the general supervision of the NHPUC with respect to all dealings with PSNH and NAEC. Based upon PSNH's ownership of generating and transmission facilities in Maine and transmission and hydroelectric facilities in Vermont, PSNH is also subject to limited regulatory jurisdiction in those states. WMECO is subject to regulation by the DPU, which has jurisdiction over retail rates, accounting procedures, quality of service, contracts for the purchase of electricity, mergers, securities issues and other matters. The DPU has adopted regulations that provide for DPU preapproval of utility plant construction, procurement of non-utility generation (QFs and IPPs), and C&LM programs. HWP is subject to regulation by the DPU with respect to certain contracts and quality of service. NU and its subsidiaries are subject to the general supervision of the DPU with respect to all dealings with WMECO and HWP. CL&P is subject to the jurisdiction of the NHPUC for limited purposes in connection with its ownership interest in Seabrook. CL&P, PSNH, WMECO, NAEC and HWP are public utilities under Part II of the Federal Power Act and are subject to regulation by the FERC with respect to, among other things, interconnection and coordination of facilities, wholesale rates and accounting procedures. The System incurs substantial capital expenditures and operating expenses to identify and comply with environmental, energy, licensing and other regulatory requirements, including those described in the following subsections, and it expects to incur additional costs to satisfy further requirements in these and other areas of regulation. Because of the continually changing nature of regulations affecting the System, the total amount of these costs is not determinable. The System has active auditing programs addressing a variety of legal and regulatory areas, including an environmental auditing program. To the extent it is determined that a System operation or facility is not in full compliance with applicable environmental or other laws or regulations, the System attempts to resolve non-compliance through the auditing response process or other management processes. Compliance with existing and proposed regulations also affects the time needed to complete new facilities or to modify present facilities, and it affects System companies' rates, sales, revenues and net income, all in ways that may be substantial but are not readily calculable. NRC NUCLEAR PLANT LICENSING The operators of the Millstone 1, 2 and 3 units, the CY, MY and VY and Seabrook 1 all have full term full power operating licenses from the NRC. The following table sets forth the current license expiration dates for each unit: Operating License Unit Expiration Date (*) Millstone 1 October 6, 2010 Millstone 2 July 31, 2015 Millstone 3 November 25, 2025 Seabrook 1 October 17, 2026 CY June 29, 2007 MY October 21, 2008 VY March 21, 2012 _________________________ (*) For all units except Seabrook 1 and MY, the current operating license expires 40 years from the date the operating licensee was issued. The Seabrook license expires 40 years from the date on which the NRC issued a license for the unit to load nuclear fuel, which was about 3 1/2 years before the full power operating license was issued. MY's operating license expires 40 years from the date the construction license was issued, which was about four years before the operating license was issued. The System will determine at the appropriate time whether to seek to recapture these periods and add them to the operating license terms for those units. YAEC had been working with the NRC on a preliminary analysis to extend the license expiration date for Yankee Rowe from 2000 to 2020, but that effort was suspended when the unit was shut down for evaluation. YAEC received a "possession only" license from the NRC in August 1992. See "Electric Operations - Nuclear Generation - Operations - Yankee Units" for further information on the decision to shut down the Yankee Rowe unit permanently. Currently the NRC issues 40-year operating licenses to nuclear units. In December 1991, the NRC issued a final rule that establishes the requirements that must be met by an applicant for renewal of a nuclear power plant operating license, the information that must be submitted to the NRC for review, so that the agency can determine whether those requirements have in fact been met, and the application procedures that must be used to obtain an extension of a nuclear plant operating license beyond 40 years. A renewal license may be granted for not more than 20 years beyond the current licensed life. The licensing requirements for a nuclear plant during the renewal term will consist of the plant's current licensing requirements and new commitments to monitor, manage, and correct age-related degradation of plant systems, structures, and components that is unique to the license renewal term but will not encompass the higher licensing standards imposed on new plants. An opportunity for a formal public hearing is provided to permit interested persons to raise contentions on the adequacy of the renewal applicant's proposals to address age-related degradation and compliance with applicable requirements relating to an environmental impact statement. The NRC rule was challenged on antitrust grounds and upheld in the District of Columbia Court of Appeals. ENVIRONMENTAL REGULATION GENERAL The National Environmental Policy Act (NEPA) requires that detailed statements of the environmental effects of major federal actions be prepared by federal agencies. Major federal actions can include licenses or permits issued to the System by FERC, NRC and other federal agencies for construction or operation of generation and transmission facilities. NEPA requires that federal licensing agencies make an independent evaluation of the alternatives and environmental impacts of the proposed actions. Under Connecticut law, major generation or transmission facilities may not be constructed or significantly modified without a certificate of environmental compatibility and public need from the Connecticut Siting Council (CSC). After public hearings, CSC may issue the certificate, which addresses the public need for the facility and probable environmental impact of the facility and may impose specific conditions for protection of the environment. In New Hampshire, construction of major new generation or transmission facilities, or sizeable additions to existing facilities, requires a certificate of site and facility from the New Hampshire Site Evaluation Committee (NHSEC) and NHPUC under the state's energy facility siting law. In addition to review by all state agencies having jurisdiction over any aspect of the construction or operation of the proposed facility, the law requires full review by NHSEC of the environmental impact of the proposed site or route after allowing for public comment and conducting public hearings. Issuance of a certificate requires, among other findings, a finding that the proposed site and facility will not have an unreasonable adverse effect on environmental values. Massachusetts law requires all state agencies to determine the environmental impact of any projects proposed by private companies requiring state permits, or involving state funding or participation. Massachusetts state agencies are required to make a finding that all feasible measures have been taken to avoid or minimize the environmental impact of the project. In certain instances, Massachusetts law also requires the preparation and dissemination, among various state agencies, of an environmental impact report for the proposed project. Major generation or transmission facilities may not be constructed or significantly modified without approval by the Massachusetts Energy Facilities Siting Board; new transmission facilities also require approval by the DPU. The System anticipates that additional environmental legislation will be seriously considered by Congress and state legislatures in the coming years. The issues of global warming, air pollution, hazardous waste handling and disposal and water pollution control are receiving a significant amount of public and political attention and are likely areas for federal or state legislative activity in the near future. Until and unless any such legislation is enacted and implementing regulations are issued, the effects on the System cannot be determined. Compliance with environmental laws and regulations, particularly air and water pollution control requirements, may limit operations or require substantial investments in new equipment at existing facilities. Such laws and regulations may also require substantial investments that are not included in the estimated construction budget set forth herein. See "Resource Plans" for a discussion of the System's construction plans. SURFACE WATER QUALITY REQUIREMENTS The federal Clean Water Act (CWA) provides that every "point source" discharger of pollutants into navigable waters must obtain a National Pollutant Discharge Elimination System (NPDES) permit from EPA specifying the allowable quantity and characteristics of its effluent. To obtain an NPDES permit, a discharger must meet technology-based and biologically-based effluent standards and must also demonstrate that its effluent will not cause a violation of established standards for the quality of the receiving waters. Connecticut, Massachusetts and New Hampshire regulations contain similar permit requirements and these states can impose more stringent requirements. All of the System's steam-electric generating plants have NPDES permits in effect. Any of the permits may be reopened to incorporate more stringent regulations adopted by EPA or state environmental agencies. Compliance with NPDES and state water discharge permit requirements has necessitated substantial expenditures and may require further expenditures because of additional requirements that could be imposed in the future. The CWA requires EPA and state permitting authorities to approve the cooling water intake structure design and thermal discharge of steam-electric generating plants. All System steam-electric plants have received these approvals. In the renewed discharge permit for the three Millstone nuclear units, issued in 1992, CDEP included a condition requiring a feasibility study of various structural or operational modifications of the cooling water intake system to reduce the entrainment of winter flounder larvae. This study was submitted to CDEP in January 1993 and includes analyses of the costs and benefits of each alternative considered. The costs ranged from $1.8 million to $519 million. The study concluded that the substantial incremental costs of each of the alternatives studied are not justified by the small benefits to the winter flounder population. In a letter dated January 14, 1994, CDEP approved the report requiring only that Millstone station continue efforts to schedule refueling outages to coincide with the period of high winter flounder larvae abundance and that the station continue to monitor the Niantic River winter flounder population in accordance with existing NPDES permit conditions. Merrimack station's NHDES discharge permit requires site work to isolate adjacent wetlands from the station's waste water system. Plans have been approved by the New Hampshire Department of Environmental Services (NHDES), and PSNH is now preparing a permit application to begin construction. The new permit may require PSNH to perform further biological studies because significant numbers of migratory fish are being restored to lower reaches of the Merrimack River. Should the studies indicate that Merrimack Station's once-through cooling system interferes with the establishment of a balanced aquatic community, PSNH could be required to construct a partially enclosed cooling water system for Merrimack station. The amount of capital expenditures relating to the foregoing cannot be determined at this time. However, if such expenditures were to be required, they would likely be substantial and a reduction of Merrimack station's net generation capability could result. The ultimate cost impact of the CWA and state water quality regulations on the System cannot be estimated because of uncertainties such as the impact of changes to the effluent guidelines or water quality standards. Additional modifications, in some cases extensive and involving substantial cost, may ultimately be required for some or all of the System's generating facilities. In response to several major oil spills in recent years, Congress passed the Oil Pollution Act of 1990 (OPA 90). OPA 90 sets out the requirements for facility response plans and periodic inspections of spill response equipment at certain facilities. The requirements apply to facilities that can cause substantial harm or significant and substantial harm to the environment by discharging oil or hazardous substances into the navigable waters of the United States and adjoining shorelines. Pursuant to OPA 90, EPA has authority to regulate non-transportation-related fixed onshore facilities and the Coast Guard has the authority to regulate transportation-related onshore facilities. Response plans were filed for all System facilities believed to be subject to this requirement. EPA and the Coast Guard have reviewed these plans and accepted the information provided in them as certification of contracted resources for response to a worst case discharge. The Coast Guard expects to complete its review process by February 17, 1995, and EPA by August 18, 1995. Both agencies have authorized continued operation pending final plan approval. OPA 90 includes limits on the liability that may be imposed on persons deemed responsible for release of oil. The limits do not apply to oil spills caused by negligence or violation of laws or regulations. OPA 90 also does not preempt state laws regarding liability for oil spills. In general, the laws of the states in which the System owns facilities and through which the System transports oil could be interpreted to impose strict liability for the cost of remediating releases of oil and for damages caused by releases. The System and its principal oil transporter currently carry a total of $890 million in insurance coverage for oil spills. AIR QUALITY REQUIREMENTS Under the federal Clean Air Act, EPA has promulgated national ambient air quality standards for certain air pollutants, including sulfur dioxide, particulate matter, nitrogen oxides and ozone. EPA has approved a Connecticut implementation plan prepared by CDEP, a New Hampshire plan prepared by NHDES and a Massachusetts plan prepared by MDEP for the achievement and maintenance of these standards. The Connecticut, New Hampshire and Massachusetts plans impose limits on the amounts of various airborne pollutants that can be emitted from utility boilers. Under the Clean Air Act, emissions from new or substantially modified sources are limited by new source performance standards and very strict technology-based emission limits. The Clean Air Act Amendments of 1990 (CAAA) made extensive revisions and additions to the Clean Air Act and imposed many stringent new requirements on air emissions sources. The CAAA contains provisions further regulating emissions of sulfur dioxide (SO2) and nitrogen oxides (NOX) for the purpose of controlling acid rain, toxic air pollutants and other pollutants, requiring installation of continuous emissions monitors (CEMs) and expanding permitting provisions. Existing and additional federal and state air quality regulations could hinder or possibly preclude the construction of new, or modification of existing, fossil units in the System's service area, could raise the capital and operating cost of existing units, and may affect the operations of the System's work centers and other facilities. The ultimate cost impact of these requirements on the System cannot be estimated because of uncertainties about how EPA and the states will implement various requirements of the CAAA. NOX. The CAAA identifies NOX emissions as a precursor of ambient ozone for the northeastern region of the United States, much of which is in violation of the ambient air quality standard for ozone. Pursuant to the CAAA, Connecticut, New Hampshire and Massachusetts must implement plans to address ozone nonattainment. Probable actions include additional NOX controls that could impose costs on the System's generating units. The capital cost to comply with 1995's anticipated Phase I requirements is expected to approximate $10 million for CL&P, $11 million for PSNH, $1 million for WMECO and $3 million for HWP, while compliance costs for Phase II, effective in 1999, could be substantially higher depending on the level of NOX reductions required. Costs for meeting the 1999 NOX emission reduction requirements cannot be estimated at this time. Connecticut and New Hampshire have not as yet issued final regulations to implement NOX reduction requirements, although both have previously indicated that they will attempt to achieve NOX reduction requirements at the lowest possible costs. The System companies are in the process of reviewing compliance strategies and costs and of providing input to state environmental regulators. Massachusetts issued final NOX Reasonably Available Control Technology (RACT) rules in September, 1993. In December 1993, PSNH reached a revised agreement regarding NOX emissions with various environmental groups and the New Hampshire Business and Industrial Association. The agreement has been submitted to the New Hampshire Air Resources Division (NHARD) in the form of proposed regulations. The agreement provides for aggressive unit specific NOX emission rate limits for PSNH's generating facilities, effective May 31, 1995. The agreement no longer requires a PSNH commitment to retire or repower Merrimack Unit 2 by May 15, 1999, however more stringent emission rate limits equivalent to the range of 0.1 to 0.4 pounds of NOX per million Btu are required for the unit by that date. PSNH recently received an amendment to its Permit to Operate for Merrimack Unit 1 from NHARD to allow the testing of wood chips as a fuel. Testing has begun and if it is successful it may assist PSNH in compliance with the CAAA. SO2. The CAAA mandates reductions in sulfur dioxide (SO2) emissions to control acid rain. These reductions are to occur in two phases. First, high SO2 emitting plants are required to reduce their emissions beginning January 1, 1995. The only System units subject to the Phase I reduction requirements are PSNH's Merrimack Units 1 and 2. Management plans to meet the requirements of both Phase I and Phase II by burning low sulfur fuels and substituting (i.e. adding) Newington and Mt. Tom stations as Phase I units, if allowed by EPA regulations. On January 1, 2000, the start of Phase II, a nationwide cap of 8.9 million tons per year of utility SO2 emissions will be imposed and existing units will be granted allowances to emit SO2. These allowances are freely tradable. One allowance entitles a source to emit one ton of SO2 in a year. No unit may emit more SO2 in a particular year than the amount for which it has allowances. The System expects to be allocated allowances by EPA that substantially exceed its expected SO2 emissions for 2000 and subsequent years. In 1993, the System agreed to donate, subject to regulatory approval, 10,000 of its surplus SO2 allowances to the American Lung Association thereby effectively preventing 10,000 tons of SO2 from being emitted into the atmosphere. The System expects to be able to sell some of its surplus allowances. The price of allowances depends on the market. The amount of surplus allowances and the allocation of the revenues received from such sales between ratepayers and shareholders have not been determined. On February 15, 1993, as required by the CAAA, PSNH filed Phase I Acid Rain Permit Applications for Merrimack Station. In addition, as allowed by the CAAA, PSNH designated its Newington station unit, and HWP designated its Mt. Tom unit, as conditional Phase I substitution units. EPA is currently reviewing whether it will accept Newington and Mt. Tom as substitution units and the number of allowances each will be awarded. All Phase I units, including substitution units accepted by EPA, will be allocated SO2 allowances for the period 1995-1999. On December 31, 1992, pursuant to Connecticut Public Act 92-106, CL&P filed a report with the Energy and Public Utilities Committee of the Connecticut General Assembly and the DPUC describing its plan for allocation of revenues from sale of SO2 allowances. CL&P proposed that its shareholders receive 20 percent of the proceeds from sales of allowances to compensate for the risks they have taken to reduce CL&P's SO2 emissions and to provide appropriate incentive to CL&P to sell allowances at the maximum price. In 1993 the DPUC approved a proposal by The United Illuminating Company (UI) to grant an option to another utility for the purchase of SO2 allowances, and ruled that shareholders would receive 15 percent of the proceeds from the eventual sale. The DPUC opened a docket and held hearings to review the reports filed by CL&P and UI. This review is addressing development of a policy on allocation between shareholders and ratepayers of SO2 allowance proceeds as well as CL&P's allowance donation. CDEP's air quality regulations permit CL&P to burn 1.0 percent sulfur oil at oil-fired generating stations in Connecticut, except that 0.5 percent sulfur oil must be burned at Middletown station. Current CDEP policy requires CL&P to use 0.5 percent or lower sulfur oil when replacing older (1.0 percent sulfur oil fueled) plant auxiliary boilers needed for unit start-up and plant space heating. The regulations also permit the burning of coal with a sulfur content of up to 0.7 percent at CL&P's plants, or up to 1.0 percent if a special permit is obtained. New Hampshire air quality regulations permit PSNH to emit 55,150 tons of SO2 annually. The New Hampshire acid rain control law required a 25 percent reduction in SO2 emissions from the 1979-1982 baseline emissions at PSNH's units, which has been achieved. Compliance with New Hampshire's acid rain control law has brought PSNH very close to compliance with the SO2 emission limits of Phase I of the CAAA. PSNH may need to install additional pollution control equipment or use fuel with lower sulfur content in order to meet the requirements of the CAAA. The EPA has issued an order requiring modeling of the impact on ambient air quality of SO2 emissions from Merrimack Station. Work on this study has begun and the final results of the modeling are expected to be available in mid-1995. If the modeling study indicates that compliance with the primary ambient air quality standards for SO2 is not being achieved, additional control strategies, possibly including the addition of emission control devices or a higher stack, will be required. Management cannot at this time predict the results of the modeling or estimate the cost of any additional control strategies that may be required. The Massachusetts air quality regulations permit HWP to burn 1.5 percent sulfur coal with an ash content up to 9 percent at Mt. Tom Station. Coal with a higher ash content can be burned with MDEP approval. Mt. Tom Station is required to reduce sulfur emissions to the equivalent of 1.0 percent sulfur oil if certain air quality monitors show levels of SO2 approaching ambient air quality limits. WMECO's West Springfield station currently burns 1.0 percent sulfur oil or natural gas. The Massachusetts acid rain control law requires MDEP to adopt regulations to limit future sulfur dioxide emissions. These regulations limit the allowable SO2 emissions from utility power plants and other major fuel burning sources to 1.2 pounds per million BTUs averaged over all of the System's Massachusetts plants, effective January 1, 1995. The System's generating plants in Massachusetts on average emit approximately 1.9 pounds of SO2 per million BTUs. The System expects to meet the new sulfur dioxide limitation by using natural gas and lower sulfur oil and coal in its plants. The System could incur additional costs for the lower sulfur fuels it may burn to meet the requirements of this legislation. Under the existing fuel adjustment clauses in Connecticut, New Hampshire and Massachusetts, the System would be able to recover the additional fuel costs of compliance with the CAAA and state laws from its customers. Management does not believe that the acid rain provisions of the CAAA will have a significant impact on the System's overall costs or rates due to the very strict limits on SO2 emissions already imposed by Connecticut, New Hampshire and Massachusetts and on NOX limitations imposed by Connecticut and New Hampshire. EPA, Connecticut, New Hampshire and Massachusetts regulations also include other air quality standards, emission standards and monitoring, and testing and reporting requirements that apply to the System's generating stations. They require that new or modified fossil fuel-fired electric generating units operate within stringent emission limits. Air Toxics. Title III of the CAAA imposes new stringent discharge limitations on hazardous air pollutants. EPA is required to study toxic emissions and mercury emissions from power plants. Pending completion of these studies, power plants are exempt from the hazardous air pollutant requirements. Should EPA or Congress determine that power plant emissions must be controlled to the same extent as emissions from other sources under Title III, the System could be required to make substantial capital expenditures to upgrade or replace pollution control equipment, but the amount of these expenditures cannot be readily estimated. Connecticut and New Hampshire have enacted, and Massachusetts is considering, toxic air pollution regulations limiting emissions of numerous substances that may extend beyond those regulated under federal law. TOXIC SUBSTANCES AND HAZARDOUS WASTE REGULATIONS PCBs. Under the federal Toxic Substances Control Act of 1976 (TSCA), EPA has issued regulations that control the use and disposal of polychlorinated biphenyls (PCBs). PCBs had been widely used as insulating fluids in many electric utility transformers and capacitors before TSCA prohibited any further manufacture of such PCB equipment. System companies have taken numerous steps to comply with these regulations and have incurred increased costs for disposal of used fluids and equipment that are subject to the regulations. One disposal measure involves the System's burning of some waste oil with a low level of PCB contamination (up to 500 parts per million (ppm)) as supplemental fuel at CL&P's Middletown station Unit 3. EPA and CDEP have approved this disposal method. In general, the System sends fluids with concentrations of PCBs equal to or higher than 500 ppm but lower than 8,500 ppm to an unaffiliated company to dispose of using a chemical treatment process. Electrical capacitors that contain PCB fluid are sent offsite to dispose of through burning in high temperature incinerators approved by EPA. Currently, there are only four such approved incinerators operating in the United States, which has resulted in a sharp rise in the price of disposal through these facilities. The System disposes of solid wastes containing PCBs in secure chemical waste landfills. In 1993, the System incurred costs of approximately $450,000 for disposal of materials at these facilities. Asbestos. Federal, Connecticut, New Hampshire and Massachusetts asbestos regulations have required the System to expend significant sums on removal of asbestos including measures to protect the health of workers and the general public and to properly dispose of asbestos wastes. Areas of the System currently undergoing removal of asbestos include nuclear, fossil/hydro production, transmission and distribution and facilities operations. The System expects to expend approximately $3.4 million in 1994 on the removal of asbestos in nuclear units, fossil and hydro generating stations and buildings. Even greater costs are likely to be incurred annually in the future if federal and state asbestos regulations become more stringent and the System's need to remove asbestos grows. RCRA. Under the federal Resource Conservation and Recovery Act of 1976, as amended (RCRA), the generation, transportation, treatment, storage and disposal of hazardous wastes are subject to EPA regulations. Connecticut, New Hampshire and Massachusetts have adopted state regulations that parallel RCRA regulations but in some cases are more stringent. A change in interpretation of RCRA by EPA now requires that nuclear facilities obtain EPA permits to handle radioactive wastes that are also hazardous under RCRA (so-called mixed wastes). The notifications and applications required by these regulations have been made by all units to which these regulations apply. The procedures by which System companies handle, store, treat and dispose of hazardous wastes are regularly revised, where necessary, to comply with these regulations. CL&P has discontinued operation of surface impoundments in its four Connecticut wastewater treatment facilities used to treat hazardous waste. This is because CL&P was unable to obtain variances from EPA to exempt the facilities from the double lining requirement under the 1984 RCRA amendments. CL&P has constructed replacement above-ground concrete tanks at an estimated cost of approximately $22 million. It is expected that in early 1994, EPA and DEP will approve clean closure for CL&P's Montville Station's impoundment. Accordingly, CL&P will no longer be required to maintain liability insurance or financial assurance for closure and post-closure for this former impoundment site. EPA's final approval of the closure of the remaining three surface impoundments is pending. The System estimates that it will incur approximately $2 million in costs of monitoring and closure of the container storage areas for these sites in the future, but the ultimate amount will depend on EPA's final disposition. Underground Storage Tanks. Federal and state regulations regulate underground tanks storing petroleum products or hazardous substances. The System has about 130 underground storage tanks that are used primarily for gasoline, diesel, house-heating and fuel oil. To reduce its environmental and financial liabilities, the System has begun implementing a policy calling for the permanent removal of all non-essential underground vehicle fueling tanks. Costs for this program are not substantial. Hazardous Waste Liability. As many other industrial companies have done in the past, System companies have disposed of residues from operations by depositing or burying such materials on-site or disposing of them at off-site landfills or facilities. Typical materials disposed of include coal gasification waste and oils that might contain PCBs. In recent years it has been determined that deposited or buried wastes, under certain circumstances, could cause groundwater contamination or other environmental harm. The System continues to evaluate the environmental impact of its former disposal practices. Under federal and state law, government agencies and private parties can attempt to impose liability on System companies for such past disposal. Under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, commonly known as Superfund, EPA has the authority to clean up hazardous waste sites and to impose the cleanup costs on parties deemed responsible for the hazardous waste activities on the sites. Responsible parties include the current owner of a site, past owners of a site at the time of waste disposal, waste transporters and waste generators. It is EPA's position that all responsible parties are jointly and severally liable, so that any single responsible party can be required to pay the entire costs of cleaning up the site. As a practical matter, however, the costs of cleanup are usually allocated by agreement of the parties, or by the courts on an equitable basis among the parties deemed responsible, and several recent federal appellate court decisions have rejected EPA's position on strict joint and several liability. Superfund also contains provisions that require System companies to report releases of specified quantities of hazardous materials and require notification of known hazardous waste disposal sites. Management believes that the System companies are in compliance with these reporting and notification requirements. The System is or has recently been involved in eight Superfund sites. Three of these sites are in Connecticut, one is in Kentucky, one is in West Virginia and three are in New Hampshire. The level of study of each site and the information about the waste contributed to the site by the System and other parties differs from site to site. Where reliable information is available that permits the System to make a reasonable estimate of the expected total costs of remedial action and/or the System's likely share of remediation costs for a particular site, those cost estimates are provided below. All cost estimates were made, in accordance with Financial Accounting Standards Board Statement No. 5, where remediation costs were probable and reasonably estimable. Any estimated costs disclosed for cleaning up the sites discussed below were determined without consideration of possible recoveries from third parties, including insurance recoveries. Where the System has not accrued a liability, the costs either were not material or there was insufficient information to accurately assess the System's exposure. At two Connecticut sites, the Beacon Heights and Laurel Park landfills, the major parties formed coalitions to clean the sites and settled their suits with EPA and CDEP. The coalitions then attempted to join as defendants a large number of potential contributors, including "Northeast Utilities (Connecticut Light and Power)." Litigation on both sites was consolidated in a single case in the federal district court. In January 1993, Judge Dorsey denied the motion of the Laurel Park Coalition to join NU (CL&P). In December 1993, Judge Dorsey dismissed the claims of Beacon Heights Coalition against many of the defendants and directed the coalition to indicate which remaining defendants it intended to pursue claims against. In January 1994, the Beacon Heights Coalition filed a response listing NU (CL&P) as a defendant they would not continue to pursue. As a result of Judge Dorsey's rulings and the coalition's actions, it is not likely that CL&P will incur any cleanup costs for these sites. In June, 1993, EPA notified the System that it was a Potentially Responsible Party (PRP) at the Solvents Recovery Service of New England site in Southington, Connecticut. PSNH is a de minimis PRP at this site and does not expect its cost to be substantial. At the Maxey Flats nuclear waste disposal site in Fleming County, Kentucky, EPA has issued a notice of potential liability to NNECO and CYAPC. The System had sent a substantial volume of LLRW from Millstone 1, Millstone 2 and CY to this site. CL&P and WMECO had previously recorded a liability for future remediation costs for this site based on System estimates. To date, the costs have not been material with respect to their earnings or financial positions. In September 1991, EPA issued its record of decision for the Maxey Flats nuclear waste disposal site. The EPA-approved remedy requires pumping and treatment of leachate, installing of an initial cap, allowing materials in the trenches to settle and ultimately constructing a permanent cap. EPA estimated that the cost of the remedy is approximately $33.5 million. Based on that estimate and the volume contributed, the System's share would be approximately $0.5 million. However, the System believes that the cost of the remedy could be substantially higher. The System estimates that its total cost for cleanup could be approximately $1-$2 million. EPA provided an opportunity for PRPs, including certain System companies, to enter into a consent decree with EPA under which each PRP would reimburse EPA for its past costs and would undertake remedial action at the site or pay the costs of EPA undertaking remedial action. On October 20, 1992, PRPs that are members of the Maxey Flats PRP Steering Committee, including System companies, and several federal government agencies, including DOE and the Department of Defense, made a settlement offer to EPA involving a commitment to perform a substantial portion of the remedial work required by EPA in its record of decision. On that same date, the Commonwealth of Kentucky made a settlement offer. EPA rejected the settlement offers in December 1992, but gave the parties an additional 60 days to make a "good faith" offer. On March 16, 1993, the PRP Steering Committee and the federal government agencies made a revised offer to EPA. Since then all parties have been actively involved in settlement negotiations. PSNH has settled with EPA and other PRPs at sites in West Virginia and Kingston, New Hampshire. PSNH paid approximately $33,700 to cash out of these sites. PSNH has committed approximately $280,000 as its share of the costs to clean up municipal landfills in Dover and North Hampton, New Hampshire. Some additional costs may be incurred at these sites but they are not expected to be significant. Other New Hampshire sites include municipal landfills in Somersworth and Peterborough, and the Dover Point site owned by PSNH in Dover, New Hampshire. PSNH's liability at the landfills is not expected to be significant and its liability at the Dover Point site cannot be estimated at this time. PSNH contacted NHDES in December 1993 concerning possible coal tar contamination in the headwater of Lake Winnipesaukee near an area where PSNH formerly owned and operated a coal gasification plant which was sold in 1945. PSNH agreed to conduct an historical review and provide a report to NHDES in February 1994. PSNH, along with two other identified PRPs, most likely will be conducting a site investigation in the spring of 1994. In 1987, CDEP published a list of 567 hazardous waste disposal sites in Connecticut. The System owns two sites on this list. The System has spent approximately $0.5 million to date completing investigations at these sites. Both sites were formerly used by CL&P predecessor companies for the manufacture of coal gas (also known as town gas sites) from the late 1800s to the 1950s. This process resulted in the production of coal tar residues, which, when not sold for roofing or road construction, were frequently deposited on or near the production facilities. Site investigations are being carried out to gain an understanding of the environmental and health risks of these sites. Should future site remediation become necessary, the level of cleanup will be established in cooperation with CDEP. Connecticut is currently developing cleanup standards and guidelines for soil and groundwater. One of the sites is a 25.8 acre site located in the south end of Stamford, Connecticut. Site investigations have located coal tar deposits covering approximately 5.5 acres and having a volume of approximately 45,000 cubic yards. A final risk assessment report for the site was completed in January 1994. Several remedial options are currently being evaluated to clean up the site; however, CL&P is focusing on institutional and engineering controls, such as capping and paving, which would reduce the potential health risks and secure the site. The estimated costs of institutional controls range from $2 million to $3 million. As part of the 1989 divestiture of CL&P's gas business, site investigations were performed for properties that were transferred to Yankee Gas Services Company (Yankee Gas). As a result of those investigations, ten properties were identified for which negative declarations under the Property Transfer Act could not be filed. A negative declaration is a statement that there has been no discharge of hazardous wastes at the site, or that if there was such a discharge, it has been cleaned up or determined to pose no threat to health, safety or the environment and is being managed lawfully. Of the ten sites, CL&P agreed to accept liability for required cleanup for the three sites it retained. At one location, CL&P and Yankee Gas share the site and any liability for any required cleanup. Yankee Gas accepted liability for any required cleanup of the other sites. CL&P and Yankee Gas will share the costs of cleanup of sites formerly used in CL&P's gas business but not currently owned by either of them. In Massachusetts, System companies have been designated by MDEP as PRPs for ten sites under MDEP's hazardous waste and spill remediation program. The System does not expect that its share of the remaining remediation costs for any of these sites will be material. At some of these sites, the System is responsible for only a small portion or none of the hazardous wastes. For some of these and for other sites, the total remediation costs are not expected to be material. At one of the sites, the System has spent approximately $2 million for cleanup and it expects to incur approximately $250,000 for the remaining remediation costs. HWP has been identified by MDEP as a PRP in a coal tar site in Holyoke, Massachusetts. HWP owned and operated the Holyoke Gas Works from 1859 to 1902. It was sold to the city of Holyoke and operated by its Gas and Electric Department (HG&E) from 1902 to 1951. Currently, one third of the two acre property is owned by HG&E, with the remaining portion owned by a construction company. The site is located on the west side of Holyoke, adjacent to the Connecticut River and immediately downstream of HWP's Hadley Falls Station. MDEP has classified both the land and river deposit areas as Tier I priority waste disposal sites. Due to the presence of tar patches in the vicinity of the spawning habitat of the shortnose sturgeon (SNS) - an endangered species - the National Oceanographic and Atmospheric Administration (NOAA) and National Marine Fisheries Service have taken an active role in overseeing site activities. Although HWP denies that it is a PRP, it has cooperated with the agencies in investigating this problem. Both MDEP and NOAA have indicated they may require the removal of tar deposits from the vicinity of the SNS spawning habitat. To date, HWP has spent approximately $200,000 for river studies and construction costs for an oil containment boom to prevent leaching hydrocarbons from entering the Hadley Falls tailrace and the Connecticut River. The System has received other claims from government agencies and third parties for the cost of remediating sites not currently owned by the System but affected by past System disposal activities and expects to receive more such claims in the future. The System expects that the costs of resolving claims for remediating sites about which it has been notified will not be material, but cannot estimate the costs with respect to sites about which it has not been notified. If the System, regulatory agencies or courts determine that remedial actions must be taken in relation to past disposal practices on property owned or used for disposal by the System in the past, the System could incur substantial costs. ELECTRIC AND MAGNETIC FIELDS In recent years, published reports have discussed the possibility of adverse health effects from electric and magnetic fields (EMF) associated with electric transmission and distribution facilities and appliances and wiring in buildings and homes. On the basis of scientific reviews of these reports conducted by various state, federal and international panels, management does not believe that a causal relationship has been established or that significant capital expenditures are appropriate to minimize unsubstantiated risks. The System supports further research into the subject and is participating in the funding of the National EMF Research and Public Information Dissemination Program and other industry-sponsored studies. If further investigation were to demonstrate that the present electricity delivery system is contributing to increased risk of cancer or other health problems, the industry could be faced with the difficult problem of delivering reliable electric service in a cost-effective manner while managing EMF exposures. In addition, if the courts were to conclude that individuals have been harmed and that utilities are liable for damages, the potential monetary exposure for all utilities, including the System companies, could be enormous. Without definitive scientific evidence of a causal relationship between EMF and health effects, and without reliable information about the kinds of changes in utilities' transmission and distribution systems that might be needed to address the problem, if one is found, no estimates of the cost impacts of remedial actions and liability awards are available. Epidemiological studies, rather than laboratory studies, have been primarily responsible for increased scientific interest in and public concern over EMF exposures in the past decade. New epidemiological study results from international researchers were released and publicized in late-1992 and in 1993, but these only added to a picture of inconsistency from previous studies. Researchers from Sweden and Denmark concluded that their statistical results support the hypothesis that EMF may be a causative factor in certain types of cancer (although they disagreed on which types), while researchers from Finland and Greece found no evidence to support such a hypothesis. These researchers, as well as scientific review panels considering all significant EMF epidemiological and laboratory research to date, all agree that current information remains inconclusive, inconsistent and insufficient for risk assessment of EMF exposures. NU is closely monitoring research and government policy developments. In 1993, there were several notable events on the federal government level regarding EMF. The EPA has indefinitely postponed completion of a report on EMF, citing as its reasons high costs and the unlikelihood of shedding new light on the issue. Instead, it now plans to issue a 30-page "summary of science" in early 1994. In a related development, the Department of Energy has initiated a scientific review of EMF research by the National Academy of Sciences. Also on the federal level, the National EMF Research and Public Information Dissemination Program (created by the Energy Policy Act) moved forward in 1993 by establishing a federal interagency committee and an advisory committee, and by soliciting the required non-federal matching funds (through The Edison Electric Institute, NU will be making a voluntary contribution of approximately $62,000 for each year of the five-year program). The Connecticut Interagency EMF Task Force (Task Force) provided reports to the state legislature in March 1993 and in January 1994. The Task Force recognizes and supports the need for more research, and has suggested a policy of "voluntary exposure control," which involves providing people with information to enable them to make individual decisions about EMF exposure. Neither the Task Force, nor any Connecticut state agency, has recommended changes to the existing electrical supply system. Finally, the Connecticut Siting Council adopted a set of EMF "best management practices" in February 1993, which must now be considered in the justification, siting and design of new transmission lines and substations. EMF has become increasingly important as a factor in facility siting decisions in many states. Several bills were introduced in Massachusetts in January 1993, and were last reported to be pending before various legislative committees. It is not known whether there will be further action on the bills, which would require certain disclosures to real estate purchasers and utility employees, a scientific literature review, establishment of a fund to reduce certain field exposures, identification of schools and day care centers within 500 feet of transmission lines and development of EMF regulations. No action was taken on EMF bills previously pending in 1992. CL&P has been the focus of media reports charging that EMF associated with a CL&P substation and related distribution lines in Guilford, Connecticut, is linked with various cancers and other illnesses in several nearby residents. See Item 3, Legal Proceedings, for information about two suits brought by plaintiffs who now live or formerly lived near that substation. FERC HYDRO PROJECT LICENSING Federal Power Act licenses may be issued for hydroelectric projects for terms of up to 50 years as determined by FERC. Any hydroelectric project so licensed is subject to recapture by the United States for licensing to others after expiration of the license upon payment to the licensee of the lesser of fair value or the net investment in the project plus severance damages less certain amounts earned by the licensee in excess of a reasonable rate of return. Licenses are customarily conditioned on the licensee's development of recreational and other non-power uses at each licensed project. Conditions may be imposed with respect to low flow augmentation of streams and fish passage facilities. On September 28, 1993, the United States Fish and Wildlife Service (FWS) was petitioned to list the anadromous Atlantic salmon (Salmo salar) as an endangered species in the United States. After a 90-day review, the petition was found to be complete and was accepted. The National Marine Fisheries Service and FWS were given joint jurisdiction over this petition. Within the next 12 months, these agencies will decide if the petition is warranted. If salmon are listed as an endangered species, the System may be required to take a number of actions including increasing spillage over some dams during the salmon migration period resulting in loss of generation capacity at the affected hydroelectric facilities; modifying spillways to accommodate safe fish passage; curtailing pumping at Northfield Mountain during the salmon migration period; improving upstream and downstream passage facilities at all hydroelectric dams on the Connecticut and Merrimack Rivers; and modifying intake structures and curtailing operations during salmon migration periods at certain of the System's thermal structures. Although these are all possible implications of a listing, the System cannot estimate the impact on System facilities at this time. The System is continuing to conduct studies on the Connecticut River in fulfillment of the Memorandum of Agreement (MOA) concerning downstream passage of anadromous fishes (Atlantic salmon, American shad and blueback herring). The MOA was signed by the System and the Connecticut River Atlantic Salmon Commission and its member agencies in 1990. The System conducted studies in 1991 and 1992 of the entrainment of salmon smolts and juvenile shad and herring in water pumped to the upper reservoir of the Northfield Mountain Pumped Storage Project. Studies of entrainment of shad and herring indicated that Northfield's impact on these species is low, and further studies have not been conducted. Studies of salmon smolts, however, indicated the potential for unacceptable losses of smolts due to entrainment, but the results also indicated that firm conclusions could not be drawn. Accordingly, the System conducted a more definitive study indicating that about 10 percent of the 1993 smolt run was entrained at Northfield. The System will continue to pursue practical techniques to reduce salmon smolt entrainment at Northfield and has agreed to alter its 1994 maintenance schedule to reduce the amount of time when all four pump/turbine units will be pumping simultaneously during the smolt migration period. Should the system be unable to reduce smolt entrainment through operational changes or practical exclusion techniques, substantial additional costs are possible. The total cost cannot be determined at this time. The System operating companies hold licenses granted under Part I of the Federal Power Act for the operation and maintenance of thirteen existing hydroelectric projects, four of which are in Massachusetts (Northfield, Turners Falls, Gardners Falls and Holyoke [river and canal units]), three of which are in Connecticut (Scotland, Housatonic [encompassing Bulls Bridge, Rocky River, Shepaug and Stevenson] and Falls Village) and six of which are in New Hampshire (Merrimack [encompassing Garvins Falls, Hooksett and Amoskeag], Smith, Ayers Island, Eastman Falls, Canaan and Gorham). In 1992, FERC issued orders exempting from licensing WMECO's four Chicopee River projects: Dwight, Indian Orchard, Putts Bridge and Red Bridge. To date, FERC has not claimed jurisdiction over CL&P's Bantam, Robertsville, Taftville and Tunnel Projects or PSNH's Jackman project. Four of the System's FERC licenses expired at the end of 1993 (Gardners Falls, Ayers Island, Gorham and Smith). Relicensing efforts have been under way for these projects for several years. As no third parties have filed competing license applications with FERC for these projects, it is highly likely that FERC will grant renewal licenses for these projects to the System. However, certain operating, environmental and/or recreational conditions may be placed on these licenses. Because FERC was unable to complete its relicensing process prior to the December 31, 1993 expiration of these licenses, under the provision of section 15 of the Federal Power Act, FERC has issued one-year extensions to each of these licensees. FERC will continue to issue annual licenses until it completes the relicensing process. EMPLOYEES As of December 31, 1993, the System companies had approximately 9,697 full and part time employees on their payrolls, of which approximately 2,697 were employed by CL&P, approximately 1,452 by PSNH, approximately 656 by WMECO, approximately 119 by HWP, approximately 1,252 by NNECO, approximately 2,584 by NUSCO and approximately 937 by North Atlantic. NU and NAEC have no employees. Approximately 2,242 employees of CL&P, PSNH, WMECO and HWP are covered by union agreements, which expire between October 1994 and May 1996. Certain employees of North Atlantic negotiated a union contract in 1993. On August 3, 1993, the System announced that it intended to reduce its total workforce by 600 to 700 positions and offered a voluntary early retirement program to about 800 eligible employees. The program was available generally to all nonbargaining unit employees of NU's subsidiaries, NUSCO, CL&P, WMECO, HWP, PSNH and NAESCO, who would be at least age 55 with ten years of service as of November 1, 1993. Most nuclear-related job classifications at NUSCO and NAESCO were not eligible. The program enhanced pension benefits by adding an additional three years to age and service for the purpose of calculating pension benefits and early retirement reduction factors, as well as providing a supplemental payment to employees who retired prior to becoming eligible for social security benefits. Each program participant has retired or will retire on a date to be established by the employer between November 1, 1993 and November 1, 1994. A similar program was offered to approximately 300 bargaining unit employees working for System companies and 12 employees of NEPOOL/NEPEX. The workforce reduction affected approximately 811 employees, of which 498 individuals accepted the early retirement program and another 313 individuals who were involuntarily terminated. Involuntarily terminated employees were eligible to receive a lump sum severance payment of up to a maximum of 52 weeks salary, depending on years of credited service. In addition, as part of the System's reorganization of its Connecticut-based nuclear organization, 32 employees were involuntarily terminated through January 12, 1994. For more information on the reorganization see "Nuclear Generation - Operations - Nuclear Performance Improvement Initiatives." The total cost of the workforce reduction program and the nuclear reorganization was approximately $38 million, including pension, severance and other benefits. Item 2. Item 2. Properties The physical properties of the System are owned or leased by subsidiaries of NU. CL&P's principal plants and other properties are located either on land which is owned in fee or on land, as to which CL&P owns perpetual occupancy rights adequate to exclude all parties except possibly state and federal governments, which has been reclaimed and filled pursuant to permits issued by the United States Army Corps of Engineers. The principal properties of PSNH are held by it in fee. In addition, PSNH leases space in an office building under a 30-year lease expiring in 2002. WMECO's principal plants and a major portion of its other properties are owned in fee, although one hydroelectric plant is leased. NAEC owns a 35.98201 percent interest in Seabrook 1, and approximately 719 acres of exclusion area land located around the unit. In addition, CL&P, PSNH, and WMECO have certain substation equipment, data processing equipment, nuclear fuel, nuclear control room simulators, vehicles, and office space that are leased. With few exceptions, the System's companies' lines are located on or under streets or highways, or on properties either owned, leased, or in which the company has appropriate rights, easements, or permits from the owners. CL&P's properties are subject to the liens of CL&P's first mortgage indenture and, with respect to properties formerly owned by The Hartford Electric Light Company (HELCO), to the lien of HELCO's first mortgage indenture. PSNH's properties are subject to the lien of its first mortgage indenture. In addition, PSNH's outstanding term loan and revolving credit agreement borrowings are secured by a second lien, junior to the lien of the first mortgage indenture, on PSNH property located in New Hampshire. WMECO's properties are subject to the lien of its first mortgage indenture. NAEC's First Mortgage Bond are secured by a lien on the Seabrook 1 interest described above, and all rights of NAEC under the Seabrook Power Contract. In addition, CL&P's and WMECO's interests in Millstone 1 are subject to second liens for the benefit of lenders under agreements related to pollution control revenue bonds. Various ones of these properties are also subject to minor encumbrances which do not substantially impair the usefulness of the properties to the owning company. The System companies' properties are well maintained and are in good operating condition. Notes: 1. Until 1991, awards under the short-term programs of the Northeast tilities Executive Incentive Compensation Program (EICP) were made in restricted stock. In 1991, the Northeast Utilities Executive Incentive Plan (EIP) was adopted, which did not require restricted stock awards. Awards under the 1991 and 1992 short-term programs under the EIP were paid in 1992 and 1993, respectively, in the form of unrestricted stock and, in accordance with the requirements of the SEC, are included as "bonus" in the years earned. 2. The five executive officers listed in the table above each received an award of restricted stock in May, 1991 (which vested in January, 1993), under the EICP. The number of shares in each such award is shown below. All restricted stock awards under the EICP vested prior to December 31, 1993. Name Shares B. M. Fox 1,807 W. B. Ellis 2,585 J. F. Opeka 1,349 R. E. Busch 1,090 J. P. Cagnetta 847 3. "All Other Compensation" consists of employer matching contributions under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k) Plan), generally available to all eligible employees. In 1993, the employer match for non-union employees was 100 percent of the first three percent of compensation contributed on a before-tax basis. 4. Awards under the short-term program of the EIP have typically been made by NU's Committee on Organization, Compensation and Board Affairs in April each year. Based on preliminary estimates of corporate performance, and assuming that the individual performance levels of Messrs. Opeka, Busch and Cagnetta approximate those of other system officers, it is estimated that the five executive officers listed in the table above would receive the following awards: Mr. Fox - $180,780; Mr. Ellis - $160,693; Mr. Busch - $64,946; Mr. Opeka - $64,946; and Dr. Cagnetta - $43,828. 5. Mr. Fox served as President and Chief Operating Officer of CL&P, NAEC and WMECO and Vice Chairman and Chief Operating Officers of PSNH until July 1, 1993, when he became President and Chief Executive Officer of CL&P, NAEC and WMECO and Vice Chairman and Chief Executive Officer of PSNH. Mr. Ellis served as Chairman and Chief Executive Officer of these companies until July 1, 1993, when he became Chairman. Amounts listed in the "Long Term Incentive Program" column of the Summary Compensation Table for 1993 were received by these individuals prior to their change in responsibilities. $267,500 of Mr. Ellis's 1993 salary was paid prior to July 1, 1993, while he was Chief Executive Officer, and $253,750 was paid after July 1, 1993. $217,500 of Mr. Fox's 1993 salary was paid prior to July 1, 1993, and $261,275 was paid after Mr. Fox became Chief Executive Officer on July 1, 1993. PENSION BENEFITS The following table shows the estimated annual retirement benefits payable to an executive officer of NU, CL&P, WMECO, PSNH and NAEC upon retirement, assuming that retirement occurs at age 65 and that the officer is at that time not only eligible for a pension benefit under the Northeast Utilities Service Company Retirement Plan (the Retirement Plan) but also eligible for the "make-whole benefit" and the "target benefit" under the Supplemental Executive Retirement Plan for Officers of Northeast Utilities System Companies (the Supplemental Plan). The Supplemental Plan is a non-qualified pension plan providing supplemental retirement income to System officers. The "make-whole benefit" under the Supplemental Plan makes up for benefits lost through application of certain tax code limitations on the benefits that may be provided under the Retirement Plan, and is available to all officers. The "target benefit" further supplements these benefits and is available to officers at the Senior Vice President level and higher who are selected by the NU Board of Trustees to participate in the target benefit and who remain in the employ of NU companies until at least age 60 (unless the NU Board of Trustees sets an earlier age). Each of the executive officers of NU, CL&P, WMECO, PSNH and NAEC named in the summary compensation table above is currently eligible for a target benefit. If an executive officer were not eligible for a target benefit at the time of retirement, a lower level of retirement benefits would be paid. The benefits presented are based on a straight life annuity beginning at age 65 and do not take into account any reduction for joint and survivorship annuity payments. Years of Credited Service Final Average ------------------------------------------------------ Compensation 15 20 25 30 35 - ------------------ ------------------------------------------------------ $ 125,000 $ 45,000 $ 60,000 $ 75,000 $ 75,000 $ 75,000 $ 150,000 $ 54,000 $ 72,000 $ 90,000 $ 90,000 $ 90,000 $ 175,000 $ 63,000 $ 84,000 $105,000 $105,000 $105,000 $ 200,000 $ 72,000 $ 96,000 $120,000 $120,000 $120,000 $ 225,000 $ 81,000 $108,000 $135,000 $135,000 $135,000 $ 250,000 $ 90,000 $120,000 $150,000 $150,000 $150,000 $ 300,000 $108,000 $144,000 $180,000 $180,000 $180,000 $ 350,000 $126,000 $168,000 $210,000 $210,000 $210,000 $ 400,000 $144,000 $192,000 $240,000 $240,000 $240,000 $ 450,000 $162,000 $216,000 $270,000 $270,000 $270,000 $ 500,000 $180,000 $240,000 $300,000 $300,000 $300,000 $ 600,000 $216,000 $288,000 $360,000 $360,000 $360,000 $ 700,000 $252,000 $336,000 $420,000 $420,000 $420,000 $ 800,000 $288,000 $384,000 $480,000 $480,000 $480,000 Final average compensation for purposes of calculating the "target benefit" is the highest average annual compensation of the participant during any 36 consecutive months compensation was earned. Compensation taken into account under the "target benefit" described above includes salary, bonus, restricted stock awards, and long-term incentive payouts shown in the Summary Compensation Table above, but does not include employer matching contributions under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k)) Plan. In the event that an officer's employment terminates because of disability, the retirement benefits shown above would be offset by the amount of any disability benefits payable to the recipient that are attributable to contributions made by NU and its subsidiaries under long term disability plans and policies. As of December 31, 1993, the five executive officers named in the Summary Compensation Table above had the following years of credited service for retirement compensation purposes: Mr. Fox - 29, Mr. Ellis - 17, Mr. Opeka - 23, Mr. Busch - 20 and Dr. Cagnetta - 21. Assuming that retirement were to occur at age 65 for these officers, retirement would occur with 43, 29, 35, 38 and 25 years of credited service, respectively. NU has entered into agreements with Messrs. Ellis and Fox to provide for an orderly management succession. The agreement with Mr. Ellis calls for him to work with the NU Board of Trustees and Mr. Fox to effect the orderly transition of his responsibilities to Mr. Fox. In accordance with the agreement, Mr. Ellis stepped down as Chief Executive Officer of NU, CL&P, WMECO, PSNH and NAEC as of July 1, 1993. The agreement anticipates his retirement as of August 1, 1995. The agreement provides that, upon his retirement, Mr. Ellis will be entitled to receive from NU and its subsidiaries a target benefit under the Supplemental Plan. His target benefit will be based on the greater of his actual final average compensation or an amount determined as if his salary had increased each year since 1991 at a rate equal to the average rate of the increases of all other target benefit participants and as if he had received incentive awards each year based on this modified salary, but with the same performance as the Chief Executive Officer at the time. The agreement also provides specified death and disability benefits for the period before Mr. Ellis's 1995 retirement. The agreement with Mr. Fox states that if he is terminated as Chief Executive Officer without cause, he will be entitled to specified severance pay and benefits. Those benefits consist primarily of (i) two years' base pay, medical, dental and life insurance benefits, (ii) a supplemental retirement benefit equal to the difference between the target benefit he would be entitled to receive if he had reached the age of 55 on the termination date and the actual target benefit to which he is entitled as of the termination date, and (iii) a target benefit under the Supplemental Plan, notwithstanding that he might not have reached age 60 on the termination date and notwithstanding other forfeiture provisions of that plan. The agreement also provides specified death and disability benefits. The agreement terminates two years after NU gives Mr. Fox a notice of termination, but no earlier than the date he becomes 55. The agreements do not address the officers' normal compensation and benefits, which are to be determined by NU's Committee on Organization, Compensation and Board Affairs and the NU Board of Trustees in accordance with their customary practices. Item 12. Security Ownership of Certain Beneficial Owners and Management NU. Incorporated herein by reference are pages 5 through 12 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. As of February 28, 1994, the Directors of CL&P, PSNH, WMECO and NAEC, beneficially owned the following number of shares of each class of equity securities of NU. No equity securities of CL&P, PSNH or WMECO are owned by the Directors and Executive Officers. CL&P, PSNH, WMECO, and NAEC DIRECTORS AND NAMED EXECUTIVE OFFICERS Amount and Nature of Title Of Name of Beneficial Percent of Class Beneficial Owner Ownership (1) Class (2) NU Common Robert G. Abair (3) (621) 4,271 shares NU Common Robert E. Busch (772) 6,054 shares NU Common John P. Cagnetta (4) (581) 3,979 shares NU Common John C. Collins (5) 0 shares NU Common William B. Ellis (6) (1,259) 14,837 shares NU Common Ted C. Feigenbaum(7) 151 shares NU Common Bernard M. Fox (8) (1,072) 17,428 shares NU Common William T. Frain, Jr. 885 shares NU Common Cheryl W. Grise (221) 1,349 shares NU Common John B. Keane (9) (368) 1,146 shares NU Common Francis L. Kinney (10) (303) 3,781 shares NU Common Gerald Letendre (5) 0 shares NU Common Hugh C. MacKenzie (4)(11) (779) 4,277 shares NU Common Jane E. Newman (5) 0 shares NU Common Dale F. Nitzschke (5) 0 shares NU Common John W. Noyes (658) 2,789 shares NU Common John F. Opeka (4)(12) (1,075) 16,463 shares NU Common Robert P. Wax (5) (651) 1,436 shares Amount beneficially owned by Directors and Executive Officers as a group - CL&P (7,709) 77,259 shares - PSNH (6,790) 69,299 shares - WMECO (7,709) 77,259 shares - NAEC (7,088) 73,139 shares (1) Unless otherwise noted, each Director and Executive Officer of CL&P, PSNH, WMECO and NAEC has sole voting and investment power with respect to the listed shares. The numbers in parentheses reflect the number of shares owned by each Director and Executive Officer under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k) Plan), as to which the Officer has no investment power. (2) As of February 28, 1994 there were 134,208,461 common shares of NU outstanding. The percentage of such shares beneficially owned by any Director or Executive Officer, or by all Directors and Executive Officers of CL&P, PSNH, WMECO and NAEC as a group, does not exceed one percent. (3) Mr. Abair is a Director of CL&P and WMECO only. (4) Mr. Opeka and Dr. Cagnetta are not officers of PSNH, but each in his capacity as an officer (with the stated title) of NUSCO, an affiliate of PSNH, performs policy-making functions for PSNH. (5) Messrs. Collins, Letendre, Nitzschke and Wax and Ms. Newman areDirectors of PSNH only. (6) Mr. Ellis shares voting and investment power with his wife for 1,117 shares. (7) Mr. Feigenbaum is a Director and an Executive Officer of NAEC only. (8) Mr. Fox shares voting and investment power with his wife for 3,031 of these shares. In addition, Mr. Fox's wife has sole voting and investment power for 140 shares, as to which Mr. Fox disclaims beneficial ownership. (9) Mr. Keane is a Director of CL&P, WMECO and NAEC only. (10) Mr. Kinney shares voting and investment power with his wife for 2,155 shares. (11) Mr. MacKenzie shares voting and investment power with his wife for 1,259 shares. (12) Mr. Opeka shares voting and investment power with his wife for 1,718 shares. Item 13. Certain Relationships and Related Transactions NU. Incorporated herein by reference is page 14 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. No relationships or transactions that would be described in response to this item exist now or existed during 1993 with respect to CL&P, PSNH, WMECO and NAEC. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements: The Report of Independent Public Accountants and financial statements of NU, CL&P, PSNH, WMECO, and NAEC are hereby incorporated by reference and made a part of this report (see "Item 8. Financial Statements and Supplementary Data"). Reports of Independent Public Accountants on Schedules S-1 Consents of Independent Public Accountants S-3 2. Schedules: Financial Statement Schedules for NU (Parent), NU and Subsidiaries, CL&P, PSNH, WMECO, and NAEC are listed in the Index to Financial Statement Schedules S-5 3. Exhibits Index E-1 (b) Reports on Form 8-K: During the fourth quarter of 1993, the companies filed Form 8-Ks dated December 2, 1993 disclosing the following: o On December 2, 1993, the Northeast Utilities system announced a reorganization of its corporate structure. o On December 3, 1993, NNECO was informed by the NRC that it was being assessed a civil penalty in response to repair activities at Millstone 2. In addition, the Form 8-K dated December 2, 1993 which was filed by PSNH also discussed the following: o On June 8, 1992, PSNH changed its independent public accountant. NORTHEAST UTILITIES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NORTHEAST UTILITIES ------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------------- William B. Ellis Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Trustee and Chairman /s/ William B. Ellis - -------------- of the Board ------------------------- William B. Ellis March 18, 1994 Trustee, President /s/ Bernard M. Fox - -------------- and Chief Executive ------------------------- Officer Bernard M. Fox March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President and Chief ------------------------- Financial Officer Robert E. Busch March 18, 1994 Vice President and /s/ John B. Keane - -------------- Treasurer ------------------------- John B. Keane March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller ------------------------- John W. Noyes NORTHEAST UTILITIES SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Trustee /s/ Cotton Mather Cleveland - -------------- --------------------------- Cotton Mather Cleveland March 18, 1994 Trustee /s/ George David - -------------- --------------------------- George David March 18, 1994 Trustee /s/ Donald J. Donahue - -------------- --------------------------- Donald J. Donahue March 18, 1994 Trustee /s/ Eugene D. Jones - -------------- --------------------------- Eugene D. Jones March 18, 1994 Trustee /s/ Elizabeth T. Kennan - -------------- --------------------------- Elizabeth T. Kennan Trustee - -------------- --------------------------- Denham C. Lunt, Jr. March 18, 1994 Trustee /s/ William J. Pape II - -------------- --------------------------- William J. Pape II March 18, 1994 Trustee /s/ Robert E. Patricelli - -------------- --------------------------- Robert E. Patricelli Trustee - -------------- --------------------------- Norman C. Rasmussen Trustee - -------------- --------------------------- John F. Swope THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE CONNECTICUT LIGHT AND POWER COMPANY --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE 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. PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- ------------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ William T. Frain, Jr. - -------------- Operating Officer -------------------------- and Director William T. Frain, Jr. March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John C. Collins - ------------------- -------------------------- John C. Collins March 18, 1994 Director /s/ Gerald Letendre - ------------------- -------------------------- Gerald Letendre March 18, 1994 Director /s/ Hugh C. MacKenzie - ------------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ Jane E. Newman - ------------------- -------------------------- Jane E. Newman March 18, 1994 Director /s/ Dale S. Nitzschke - ------------------- -------------------------- Dale S. Nitzschke March 18, 1994 Director /s/ Robert P. Wax - ------------------- -------------------------- Robert P. Wax WESTERN MASSACHUSETTS ELECTRIC 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. WESTERN MASSACHUSETTS ELECTRIC COMPANY -------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- -------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes WESTERN MASSACHUSETTS ELECTRIC COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka NORTH ATLANTIC ENERGY 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. NORTH ATLANTIC ENERGY CORPORATION --------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ Robert E. Busch - -------------- Operating Officer -------------------------- and Director Robert E. Busch March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes NORTH ATLANTIC ENERGY CORPORATION SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John P. Cagnetta - -------------- -------------------------- John P. Cagnetta - -------------- Director -------------------------- Ted C. Feigenbaum March 18, 1994 Director /s/ William T. Frain. Jr. - -------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - -------------- -------------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - -------------- -------------------------- John B. Keane March 18, 1994 Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ John F. Opeka - -------------- -------------------------- John F. Opeka REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES We have audited in accordance with generally accepted auditing standards, the financial statements included in Northeast Utilities' annual report to shareholders and The Connecticut Light and Power Company's, Western Massachusetts Electric Company's, North Atlantic Energy Corporation's, and Public Service Company of New Hampshire's annual reports, incorporated by reference in this Form 10-K, and have issued our reports thereon dated February 18, 1994. Our reports on the financial statements include an explanatory paragraph with respect to the change in methods of accounting for property taxes, postretirement benefits other than pensions, income taxes, and employee stock ownership plans, as applicable to each company, as explained in Note 1 to the related company's financial statements. Our audits were made for the purpose of forming an opinion on each company's statements taken as a whole. The schedules listed in the index to financial statement schedules are the responsibility of each company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of each company's basic financial statements. The schedules have been subjected to the auditing procedures applied in the audits of each company's 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 each company's basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut February 18, 1994 S-1 INDEPENDENT AUDITORS' REPORT ON SCHEDULES The Board of Directors Public Service Company of New Hampshire: Under date of February 7, 1992, we reported on the balance sheet and statement of capitalization of Public Service Company of New Hampshire as of December 31, 1991 (not presented in the 1993 annual report to stockholders) and the related statements of income, cash flows and common stock equity for the periods January 1, 1991 to May 15, 1991 and May 16, 1991 to December 31, 1991, as contained in the annual report to stockholders of Public Service Company for the year 1993. These financial statements and our report thereon are incorporated by reference herein. In connection with our audits of the aforementioned financial statements, we have also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsiblity is to express an opinion on these financial statement schedules based on our audit. 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/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massachusetts February 7, 1992 S-2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference of our reports in this Form 10-K, into previously filed Registration Statement No. 33-13444, No. 33-46291 , No. 33-59430, and No. 33-50853 of The Connecticut Light and Power Company, No. 33-34886, No. 33-51185 and No. 33-25619 of Western Massachusetts Electric Company, and No. 33-34622 and No. 33-40156 of Northeast Utilities. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut March 18, 1994 S-3 INDEPENDENT AUDITORS' CONSENT The Board of Directors Public Service Company of New Hampshire: We consent to the use of our reports included or incorporated by reference herein. /s/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massaschusetts March 18, 1994 S-4 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedule Page - -------- ---- III. Financial Information of Registrant: Northeast Utilities (Parent) Balance Sheets 1993 and 1992 S-7 Northeast Utilities (Parent) Statements of Income 1993, 1992, and 1991 S-8 Northeast Utilities (Parent) Statements of Cash Flows 1993, 1992, and 1991 S-9 V. Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-10 -- S-12 The Connecticut Light and Power Company S-13 -- S-15 Public Service Company of New Hampshire S-16 -- S-20 Western Massachusetts Electric Company S-21 -- S-23 North Atlantic Energy Corporation S-24 -- S-25 V. Nuclear Fuel 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-26 -- S-28 The Connecticut Light and Power Company S-29 -- S-31 Public Service Company of New Hampshire S-32 -- S-36 Western Massachusetts Electric Company S-37 -- S-39 North Atlantic Energy Corporation S-40 -- S-41 VI. Accumulated Provision for Depreciation of Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-42 -- S-44 The Connecticut Light and Power Company S-45 Public Service Company of New Hampshire S-46 -- S-48 Western Massachusetts Electric Company S-49 North Atlantic Energy Corporation S-50 VIII. Valuation and Qualifying Accounts and Reserves 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-51 -- S-53 The Connecticut Light and Power Company S-54 -- S-56 Public Service Company of New Hampshire S-57 -- S-61 Western Massachusetts Electric Company S-62 -- S-64 S-5 Schedule Page - -------- ---- IX. Short-Term Borrowings 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-65 The Connecticut Light and Power Company S-66 Public Service Company of New Hampshire S-67 Western Massachusetts Electric Company S-68 North Atlantic Energy Corporation S-69 X. Supplementary Income Statement Information 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-70 The Connecticut Light and Power Company S-71 Public Service Company of New Hampshire S-72 Western Massachusetts Electric Company S-73 North Atlantic Energy Corporation S-74 All other schedules of the companies' for which provision is made in the applicable regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable, and therefore have been omitted. S-6 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- BALANCE SHEETS -------------- AT DECEMBER 31, 1993 AND 1992 ------------------------------ (Thousands of Dollars) S-7 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- STATEMENTS OF INCOME -------------------- YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 --------------------------------------------- (Thousands of Dollars Except Share Information) S-8 SCHEDULE III NORTHEAST UTILITIES (PARENT) FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Thousands of Dollars) S-9 S-10 S-11 S-12 S-13 S-14 S-15 S-16 S-17 S-18 S-19 S-20 S-21 S-22 S-23 S-24 S-25 S-26 S-27 S-28 S-29 S-30 S-31 S-32 S-33 S-34 S-35 S-36 S-37 S-38 S-39 S-40 S-41 S-42 S-43 S-44 S-45 S-46 S-47 S-48 S-49 S-50 S-51 S-52 S-53 S-54 S-55 S-56 S-57 S-58 S-59 S-60 S-61 S-62 S-63 S-64 S-65 S-66 S-67 S-68 S-69 S-70 S-71 S-72 S-73 S-74 EXHIBIT INDEX Each document described below is incorporated by reference to the files of the Securities and Exchange Commission, unless the reference to the document is marked as follows: * - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Reports on Form 10-K for CL&P, PSNH, WMECO and NAEC. # - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for CL&P. @ - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for PSNH. ** - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for WMECO. ## - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for NAEC. Exhibit Number Description 3 Articles of Incorporation and By-Laws 3.1 Northeast Utilities 3.1.1 Declaration of Trust of NU, as amended through May 24, 1988. (Exhibit 3.1.1, 1988 NU Form 10-K, File No. 1-5324) 3.2 The Connecticut Light and Power Company # 3.2.1 Certificate of Incorporation of CL&P, restated to March 22, 1994. # 3.2.2 By-laws of CL&P, as amended to March 1, 1982. 3.3 Public Service Company of New Hampshire @ 3.3.1 Articles of Incorporation, as amended to May 16, 1991. @ 3.3.2 By-laws of PSNH, as amended to November 1, 1993. 3.4 Western Massachusetts Electric Company 3.4.1 Certificate of Organization of WMECO, as amended, to August 31, 1954. (Exhibit 3.1, File No. 2-11114) 3.4.2 Amendments to Certificate of Organization of WMECO of May 19, 1966 and of December 5, 1967. (Exhibit 3.2, File No. 2-30534) E-1 3.4.3 Articles of Amendment dated December 9, 1981. (Exhibit 3.1.2, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.4 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated December 16, 1981. (Exhibit 3.1.3, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.5 Articles of Amendment dated April 7, 1983. (Exhibit 3.3.5, 1983 NU Form 10-K, File No. 1-5324) 3.4.6 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated April 12, 1983. (Exhibit 3.3.6, 1983 NU Form 10-K, File No. 1-5324) 3.4.7 Articles of Amendment dated January 29, 1987. (Exhibit 3.3.7, 1986 NU Form 10-K, File No. 1-5324) 3.4.8 Articles of Amendment dated February 11, 1987. (Exhibit 3.3.8, 1986 NU Form 10-K, File No. 1-5324) 3.4.9 Articles of Amendment dated February 19, 1988. (Exhibit 3.3.9, 1987 NU Form 10-K, File No. 1-5324) 3.4.10 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated February 23, 1988. (Exhibit 3.3.10, 1987 NU Form 10-K, File No. 1-5324) ** 3.4.11 By-laws of WMECO, as amended to February 24, 1988. 3.5 North Atlantic Energy Corporation ## 3.5.1 Articles of Incorporation of NAEC dated September 20, 1991. ## 3.5.2 Articles of Amendment dated October 16, 1991 and June 2, 1992 to Articles of Incorporation of NAEC. ## 3.5.3 By-laws of NAEC, as amended to November 8, 1993. 4 Instruments defining the rights of security holders, including indentures 4.1 Northeast Utilities 4.1.1 Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Debt Securities. (Exhibit 4.1.1, 1991 NU Form 10-K, File No. 1-5324) 4.1.2 First Supplemental Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Series A Notes. (Exhibit 4.1.2, 1991 NU Form 10-K, File No. 1-5324) 4.1.3 Second Supplemental Indenture dated as of March 1, 1992 between Northeast Utilities and IBJ Schroder Bank & Trust Company with respect to the issuance of 8.38% Amortizing Notes. (Exhibit 4.1.3, 1992 NU Form 10-K, File No. 1-5324) E-2 4.1.4 Warrant Agreement dated as of June 5, 1992 between Northeast Utilities and the Service Company. (Exhibit 4.1.4, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.1 Additional Warrant Agent Agreement dated as of June 5, 1992 between Northeast Utilities and State Street Bank and Trust Company. (Exhibit 4.1.4.1, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.2 Exchange and Disbursing Agent Agreement dated as of June 5, 1992 among Northeast Utilities, Public Service Company of New Hampshire and State Street Bank and Trust Company. (Exhibit 4.1.4.2, 1992 NU Form 10-K, File No. 1-5324) 4.1.5 Credit Agreements among CL&P, NU, WMECO, NUSCO (as Agent) and 19 Commercial Banks dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.38, 1992 NU Form U5S, File No. 30-246) 4.1.6 Credit Agreements among CL&P, WMECO, NU, Holyoke Water Power Company, RRR, NNECO and NUSCO (as Agent) dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.39, 1992 NU Form U5S, File No. 30-246) 4.2 The Connecticut Light and Power Company 4.2.1 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, Trustee, dated as of May 1, 1921. (Composite including all twenty-four amendments to May 1, 1967.) (Exhibit 4.1.1, 1989 NU Form 10-K, File No. 1-5324) Supplemental Indentures to the Composite May 1, 1921 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, dated as of: 4.2.2 April 1, 1967. (Exhibit 4.16, File No. 2-60806) 4.2.3 January 1, 1968. (Exhibit 4.18, File No. 2-60806) 4.2.4 December 1, 1969. (Exhibit 4.20, File No. 2-60806) 4.2.5 June 30, 1982. (Exhibit 4.33, File No. 2-79235) 4.2.6 June 1, 1989. (Exhibit 4.1.24, 1989 NU Form 10-K, File No. 1-5324) 4.2.7 September 1, 1989. (Exhibit 4.1.25, 1989 NU Form 10-K, File No. 1-5324) 4.2.8 December 1, 1989. (Exhibit 4.1.26, 1989 NU Form 10-K, File No. 1-5324) 4.2.9 April 1, 1992. (Exhibit 4.30, File No. 33-59430) 4.2.10 July 1, 1992. (Exhibit 4.31, File No. 33-59430) E-3 4.2.11 October 1, 1992. (Exhibit 4.32, File No. 33-59430) 4.2.12 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) 4.2.13 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) # 4.2.14 December 1, 1993. # 4.2.15 February 1, 1994. # 4.2.16 February 1, 1994. 4.2.17 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1986. (Exhibit C.1.47, 1986 NU Form U5S, File No. 30-246) 4.2.18 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of October 1, 1988. (Exhibit C.1.55, 1988 NU Form U5S, File No. 30-246) 4.2.19 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1989. (Exhibit C.1.39, 1989 NU Form U5S, File No. 30-246) 4.2.20 Loan and Trust Agreement among Business Finance Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1992. (Exhibit C.2.33, 1992 NU Form U5S, File No. 30-246) # 4.2.21 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.22 Series B (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.23 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.24 Series B (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.3 Public Service Company of New Hampshire 4.3.1 First Mortgage Indenture dated as of August 15, 1978 between PSNH and First Fidelity Bank, National Association, New Jersey, Trustee, (Composite including all amendments to May 16, 1991). (Exhibit 4.4.1, 1992 NU Form 10-K, File No. 1- 5324) E-4 4.3.1.1 Tenth Supplemental Indenture dated as of May 1, 1991 between PSNH and First Fidelity Bank, National Association. (Exhibit 4.1, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392). 4.3.2 Revolving Credit Agreement dated as May 1, 1991. (Exhibit 4.12, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.3 Term Credit Agreement dated as of May 1, 1991. (Exhibit 4.11, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.4 Series A (Tax Exempt New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.2, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.5 Series B (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.3, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.6 Series C (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.4, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7 Series D (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.5, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7.1 First Supplement to Series D (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1992. (Exhibit 4.4.5.1, 1992 NU Form 10-K, File No. 1-5324) 4.3.8 Series E (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.6, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) @ 4.3.8.1 First Supplement to Series E (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1993. @ 4.3.9 Series D (May 1, 1991 Taxable New Issue and December 1, 1992 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of October 1, 1992. @ 4.3.9.1 Amended and Restated Letter of Credit dated December 17, 1992. 4.3.10 Series E (May 1, 1991 Taxable New Issue and December 1, 1993 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of May 1, 1991. (Exhibit 4.8, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-5 @ 4.3.10.1 Amended and Restated Letter of Credit dated December 15, 1993. 4.4 Western Massachusetts Electric Company ** 4.4.1 First Mortgage Indenture and Deed of Trust between WMECO and Old Colony Trust Company, Trustee, dated as of August 1, 1954. Supplemental Indentures thereto dated as of: 4.4.2 March 1, 1967. (Exhibit 2.5, File No. 2-68808) 4.4.3 March 1, 1968. (Exhibit 2.6, File No. 2-68808) 4.4.4 December 1, 1968. (Exhibit 2.7, File No. 2-68808) 4.4.5 July 1, 1972. (Exhibit 2.9, File No. 2-68808) 4.4.6 May 1, 1986. (Exhibit 4.3.18, 1986 NU Form 10-K, File No. 1-5324) 4.4.7 December 1, 1988. (Exhibit 4.3.20, 1988 NU Form 10-K, File No. 1-5324.) 4.4.8 September 1, 1990. (Exhibit 4.3.15, 1990 NU Form 10-K, File No. 1-5324.) 4.4.9 December 1, 1992. (Exhibit 4.15, File No. 33-55772) 4.4.10 January 1, 1993. (Exhibit 4.5.13, 1992 NU Form 10-K, File No. 1-5324) ** 4.4.11 March 1, 1994. ** 4.4.12 March 1, 1994. ** 4.4.13 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and WMECO (Pollution Control Bonds) dated as of September 1, 1993. ** 4.4.14 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.5 North Atlantic Energy Corporation 4.5.1 First Mortgage Indenture and Deed of Trust between NAEC and United States Trust Company of New York, Trustee, dated as of June 1, 1992. (Exhibit 4.6.1, 1992 NU Form 10-K, File No. 1-5324) 4.5.2 Note Indenture dated as of May 15, 1991. (Exhibit 4.10, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-6 4.5.3 First Supplemental Indenture dated as of June 5, 1992 between NAEC, PSNH and United States Trust Company of New York, Trustee. (Exhibit 4.6.3, 1992 NU Form 10-K, File No. 1-5324) 10 Material Contracts 10.1 Stockholder Agreement dated as of July 1, 1964 among the stockholders of Connecticut Yankee Atomic Power Company (CYAPC). (Exhibit 13.1, File No. 2-22958) 10.2 Form of Power Contract dated as of July 1, 1964 between CYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 13.2, File No. 2-22958) 10.2.1 Form of Additional Power Contract dated as of April 30, 1984, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.4, 1984 NU Form 10-K, File No. 1-5324) 10.2.2 Form of 1987 Supplementary Power Contract dated as of April 1, 1987, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.6, 1987 NU Form 10-K, File No. 1-5324) 10.3 Capital Funds Agreement dated as of September 1, 1964 between CYAPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 13.3, File No. 2-22958) #@** 10.4 Stockholder Agreement dated December 10, 1958 between Yankee Atomic Electric Company (YAEC) and CL&P, HELCO, PSNH and WMECO. 10.5 Form of Amendment No. 3, dated as of April 1, 1985, to Power Contract between YAEC and each of CL&P, PSNH and WMECO, including a composite restatement of original Power Contract dated June 30, 1959 and Amendment No. 1 dated April 1, 1975 and Amendment No. 2 dated October 1, 1980. (Exhibit 10.5, 1988 NU Form 10-K, File No. 1-5324.) 10.5.1 Form of Amendment No. 4 to Power Contract, dated May 6, 1988, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.1, 1989 NU Form 10-K, File No. 1-5324) 10.5.2 Form of Amendment No. 5 to Power Contract, dated June 26, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.2, 1989 NU Form 10-K, File No. 1-5324) 10.5.3 Form of Amendment No. 6 to Power Contract, dated July 1, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.3, 1989 NU Form 10-K, File No. 1-5324) #@** 10.5.4 Form of Amendment No. 7 to Power Contract, dated February 1, 1992, between YAEC and each of CL&P, PSNH and WMECO. 10.6 Stockholder Agreement dated as of May 20, 1968 among stockholders of MYAPC. (Exhibit 4.15, File No. 2-30018) 10.7 Form of Power Contract dated as of May 20, 1968 between MYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.14, File No. 2-30018) E-7 #@** 10.7.1 Form of Amendment No. 1 to Power Contract dated as of March 1, 1983 between MYAPC and each of CL&P, PSNH and WMECO. #@** 10.7.2 Form of Amendment No. 2 to Power Contract dated as of January 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.7.3 Form of Amendment No. 3 to Power Contract dated as of October 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.7.3, 1985 NU Form 10-K, File No. 1-5324) #@** 10.7.4 Form of Additional Power Contract dated as of February 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.8 Capital Funds Agreement dated as of May 20, 1968 between Maine Yankee Atomic Power Company (MYAPC) and CL&P, PSNH, HELCO and WMECO. (Exhibit 4.13, File No. 2-30018) 10.8.1 Amendment No. 1 to Capital Funds Agreement, dated as of August 1, 1985, between MYAPC, CL&P, PSNH and WMECO. (Exhibit 10.6.1, 1985 NU Form 10-K, File No. 1-5324) 10.9 Sponsor Agreement dated as of August 1, 1968 among the sponsors of VYNPC. (Exhibit 4.16, File No. 2-30285) 10.10 Form of Power Contract dated as of February 1, 1968 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.18, File No. 2-30018) 10.10.1 Form of Amendment to Power Contract dated as of June 1, 1972 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 5.22, File No. 2-47038) #@** 10.10.2 Form of Second Amendment to Power Contract dated as of April 15, 1983 between VYNPC and each of CL&P, PSNH and WMECO. 10.10.3 Form of Third Amendment to Power Contract dated as of April 24, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.3, 1986 NU Form 10-K, File No. 1-5324) 10.10.4 Form of Fourth Amendment to Power Contract dated as of June 1, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.4, 1986 NU Form 10-K, File No. 1-5324) 10.10.5 Form of Fifth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.5, 1990 NU Form 10-K, File No. 1-5324) 10.10.6 Form of Sixth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.6, 1990 NU Form 10-K, File No. 1-5324) E-8 10.10.7 Form of Seventh Amendment to Power Contract dated as of June 15, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.7, 1990 NU Form 10-K, File No. 1-5324) 10.10.8 Form of Eighth Amendment to Power Contract dated as of December 1, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.8, 1990 NU Form 10-K, File No. 1-5324) #@** 10.10.9 Form of Additional Power Contract dated as of February 1, 1984 between VYNPC and each of CL&P, PSNH and WMECO. 10.11 Capital Funds Agreement dated as of February 1, 1968 between Vermont Yankee Nuclear Power Corporation (VYNPC) and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.16, File No. 2-30018) 10.11.1 Form of First Amendment to Capital Funds Agreement dated as of March 12, 1968 between VYNPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.17, File No. 2-30018) #@** 10.11.2 Form of Second Amendment to Capital Funds Agreement dated as of September 1, 1993 between VYNPC and CL&P, HELCO, PSNH and WMECO. 10.12 Amended and Restated Millstone Plant Agreement dated as of December 1, 1984 by and among CL&P, WMECO and Northeast Nuclear Energy Company (NNECO). (Exhibit 10.17, 1985 NU Form 10-K, File No. 1-5324) 10.13 Sharing Agreement dated as of September 1, 1973 with respect to 1979 Connecticut nuclear generating unit (Millstone 3). (Exhibit 6.43, File No. 2-50142) 10.13.1 Amendment dated August 1, 1974 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 5.45, File No. 2-52392) 10.13.2 Amendment dated December 15, 1975 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 7.47, File No. 2-60806) 10.13.3 Amendment dated April 1, 1986 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 10.17.3, 1990 NU Form 10-K, File No. 1-5324) 10.14 Agreement dated July 19, 1990, among NAESCO and Seabrook Joint owners with respect to operation of Seabrook. (Exhibit 10.53, 1990 NU Form 10-K, File No. 1-5324) 10.15 Sharing Agreement between CL&P, WMECO, HP&E, HWP and PSNH dated as of June 1, 1992. (Exhibit 10.17, 1992 NU Form 10- K, File No. 1-5324) 10.16 Form of Seabrook Power Contract between PSNH and NAEC, as amended and restated. (Exhibit 10.45, NU 1992 Form 10-K, File No. 1-5324) E-9 10.17 Agreement for joint ownership, construction and operation of New Hampshire nuclear generating units dated as of May 1, 1973. (Exhibit 13-57, File No. 2-48966) 10.17.1 Amendments to Exhibit 10.17 dated May 24, 1974, June 21, 1974 and September 25, 1974. (Exhibit 5.15, File No. 2-51999) 10.17.2 Amendments to Exhibit 10.17 dated October 25, 1974 and January 31, 1975. (Exhibit 5.23, File No. 2-54646) 10.17.3 Sixth Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.3, File No. 2-64294) 10.17.4 Seventh Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.4, File No. 2-64294) 10.17.5 Eighth Amendment to Exhibit 10.17 dated as of April 25, 1979. (Exhibit 5.4.5, File No. 2-64815) 10.17.6 Ninth Amendment to Exhibit 10.17 dated as of June 8, 1979. (Exhibit 5.4.6, File No. 2-64815) 10.17.7 Tenth Amendment to Exhibit 10.17 dated as of October 10, 1979. (Exhibit 5.4.2, File No. 2-66334) 10.17.8 Eleventh Amendment to Exhibit 10.17 dated as of December 15, 1979. (Exhibit 5.4.8, File No. 2-66492) 10.17.9 Twelfth Amendment to Exhibit 10.17 dated as of June 16, 1980. (Exhibit 5.4.9, File No. 2-68168) 10.17.10 Thirteenth Amendment to Exhibit 10.17 dated as of December 31, 1980. (Exhibit 10.6, File No. 2-70579) * 10.17.11 Fourteenth Amendment to Exhibit 10.17 dated as of June 1, 1982. 10.17.12 Fifteenth Amendment to Exhibit 10.17 dated as of April 27, 1984. (Exhibit 10.14.12, 1984 NU Form 10-K, File No. 1-5324) 10.17.13 Sixteenth Amendment to Exhibit 10.17 dated as of June 15, 1984. (Exhibit 10.14.13, 1984 NU Form 10-K, File No. 1-5324) 10.17.14 Seventeenth Amendment to Exhibit 10.17 dated as of March 8, 1985. (Exhibit 10.13.14, 1985 NU Form 10-K, File No. 1-5324) 10.17.15 Eighteenth Amendment to Exhibit 10.17 dated as of March 14, 1986. (Exhibit 10.13.15, 1986 NU Form 10-K, File No. 1-5324) 10.17.16 Nineteenth Amendment to Exhibit 10.17 dated as of May 1, 1986. (Exhibit 10.13.16, 1986 NU Form 10-K, File No. 1-5324) E-10 10.17.17 Twentieth Amendment to Exhibit 10.17 dated as of July 15, 1986. (Exhibit 10.13.17, 1986 NU Form 10-K, File No. 1-5324) 10.17.18 Twenty-first Amendment to Exhibit 10.17 dated as of November 12, 1987. (Exhibit 10.13.18, 1987 NU Form 10-K, File No. 1-5324) 10.17.19 Twenty-second Amendment to Exhibit 10.17 dated as of January 13, 1989. (Exhibit 10.13.19, 1989 NU Form 10-K, File No. 1-5324) 10.17.20 Twenty-third Amendment to Exhibit 10.17 dated as of November 1, 1990. (Exhibit 10.13.20, 1990 NU Form 10- K, File No. 1-5324) 10.17.21 Memorandum of Understanding dated November 7, 1988 between PSNH and Massachusetts Municipal Wholesale Electric Company (Exhibit 10.17, PSNH 1989 Form 10-K, File No. 1-6392) 10.17.22 Agreement of Settlement among Joint Owners dated as of January 13, 1989. (Exhibit 10.13.21, 1988 NU Form 10- K, File No. 1-5324) 10.17.22.1 Supplement to Settlement Agreement, dated as of February 7, 1989, between PSNH and Central Maine Power Company. (Exhibit 10.18.1, PSNH 1989 Form 10-K, File No. 1-6392) 10.18 Amended and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990. (Exhibit 10.4.7, File No. 33-35312) 10.18.1 Form of First Amendment to Exhibit 10.18. (Exhibit 10.4.8, File No. 33-35312) * 10.18.2 Form (Composite) of Second Amendment to Exhibit 10.18. 10.19 Agreement dated November 1, 1974 for Joint Ownership, Construction and Operation of William F. Wyman Unit No. 4 among PSNH, Central Maine Power Company and other utilities. (Exhibit 5.16 , File No. 2-52900) 10.19.1 Amendment to Exhibit 10.19 dated June 30, 1975. (Exhibit 5.48, File No. 2-55458) 10.19.2 Amendment to Exhibit 10.19 dated as of August 16, 1976. (Exhibit 5.19, File No. 2-58251) 10.19.3 Amendment to Exhibit 10.19 dated as of December 31, 1978. (Exhibit 5.10.3, File No. 2-64294) #** 10.20 Form of Service Contract dated as of July 1, 1966 between each of NU, CL&P and WMECO and the Service Company. 10.20.1 Service Contract dated as of June 5, 1992 between PSNH and the Service Company. (Exhibit 10.12.4, 1992 NU Form 10-K, File No. 1-5324) E-11 10.20.2 Service Contract dated as of June 5, 1992 between NAEC and the Service Company. (Exhibit 10.12.5, 1992 NU Form 10-K, File No. 1-5324) * 10.20.3 Form of Annual Renewal of Service Contract. 10.21 Memorandum of Understanding between CL&P, HELCO, Holyoke Power and Electric Company (HP&E), Holyoke Water Power Company (HWP) and WMECO dated as of June 1, 1970 with respect to pooling of generation and transmission. (Exhibit 13.32, File No. 2-38177) #** 10.21.1 Amendment to Memorandum of Understanding between CL&P, HELCO, HP&E, HWP and WMECO dated as of February 2, 1982 with respect to pooling of generation and transmission. 10.22 New England Power Pool Agreement effective as of November 1, 1971, as amended to November 1, 1988. (Exhibit 10.15, 1988 NU Form 10-K, File No. 1-5324.) 10.22.1 Twenty-sixth Amendment to Exhibit 10.22 dated as of March 15, 1989. (Exhibit 10.15.1, 1990 NU Form 10-K, File No. 1-5324) 10.22.2 Twenty-seventh Amendment to Exhibit 10.22 dated as of October 1, 1990. (Exhibit 10.15.2, 1991 NU Form 10-K, File No. 1-5324) 10.22.3 Twenty-eighth Amendment to Exhibit 10.22 dated as of September 15, 1992. (Exhibit 10.18.3, 1992 NU Form 10-K, File No. 1-5324) * 10.22.4 Twenty-ninth Amendment to Exhibit 10.22 dated as of May 1, 1993. 10.23 Agreements among New England Utilities with respect to the Hydro-Quebec interconnection projects. (See Exhibits 10(u) and 10(v); 10(w), 10(x), and 10(y), 1990 and 1988, respectively, Form 10-K of New England Electric System, File No. 1-3446.) 10.24 Trust Agreement dated February 11, 1992, between State Street Bank and Trust Company of Connecticut, as Trustor, and Bankers Trust Company, as Trustee, and CL&P and WMECO, with respect to NBFT. (Exhibit 10.23, 1991 NU Form 10-K, File No. 1-5324) 10.24.1 Nuclear Fuel Lease Agreement dated as of February 11, 1992, between Bankers Trust Company, Trustee, as Lessor, and CL&P and WMECO, as Lessees. (Exhibit 10.23.1, 1991 NU Form 10-K, File No. 1-5324) 10.25 Simulator Financing Lease Agreement, dated as of February 1, 1985, by and between ComPlan and NNECO. (Exhibit 10.52, 1985 NU Form 10-K, File No. 1-5324) E-12 10.26 Simulator Financing Lease Agreement, dated as of May 2, 1985, by and between The Prudential Insurance Company of America and NNECO. (Exhibit 10.53, 1985 NU Form 10-K, File No. 1-5324) 10.27 Lease dated as of April 14, 1992 between The Rocky River Realty Company (RRR) and Northeast Utilities Service Company (NUSCO) with respect to the Berlin, Connecticut headquarters (office lease). (Exhibit 10.29, 1992 NU Form 10-K, File No. 1-5324) 10.27.1 Lease date as of April 14, 1992 between RRR and NUSCO with respect to the Berlin, Connecticut headquarters (project lease). (Exhibit 10.29.1, 1992 NU Form 10-K, File No. 1-5324) * 10.28 Millstone Technical Building Note Agreement dated as of December 21, 1993 between, by and between The Prudential Insurance Company of America and NNECO. 10.29 Lease and Agreement, dated as of December 15, 1988, by and between WMECO and Bank of New England, N.A., with BNE Realty Leasing Corporation of North Carolina. (Exhibit 10.63, 1988 NU Form 10-K, File No. 1-5324.) 10.30 Note Agreement dated April 14, 1992, by and between The Rocky River Realty Company (RRR) and Purchasers named therein (Connecticut General Life Insurance Company, Life Insurance Company of North America, INA Life Insurance Company of New York, Life Insurance Company of Georgia), with respect to RRR's sale of $15 million of guaranteed senior secured notes due 2007 and $28 million of guaranteed senior secured notes due 2017. (Exhibit 10.52, 1992 NU Form 10-K, File No. 1-5324) 10.30.1 Note Guaranty dated April 14, 1992 by Northeast Utilities pursuant to Note Agreement dated April 14, 1992 between RRR and Note Purchasers, for the benefit of The Connecticut National Bank as Trustee, the Purchasers and the owners of the notes. (Exhibit 10.52.1, 1992 NU Form 10-K, File No. 1-5324) 10.30.2 Assignment of Leases, Rents and Profits, Security Agreement and Negative Pledge, dated as of April 14, 1992 among RRR, NUSCO and The Connecticut National Bank as Trustee, securing notes sold by RRR pursuant to April 14, 1992 Note Agreement. (Exhibit 10.52.2, 1992 NU Form 10-K, File No. 1-5324) 10.31 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 1 decommissioning costs. (Exhibit 10.80, 1986 NU Form 10-K, File No. 1-5324) 10.31.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.41.1, 1992 NU Form 10-K, File No. 1-5324) E-13 10.32 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 2 decommissioning costs. (Exhibit 10.81, 1986 NU Form 10-K, File No. 1-5324) 10.32.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.42.1, 1992 NU Form 10-K, File No. 1-5324) 10.33 Master Trust Agreement dated as of April 23, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 3 decommissioning costs. (Exhibit 10.82, 1986 NU Form 10-K, File No. 1-5324) 10.33.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.43.1, 1992 NU Form 10-K, File No. 1-5324) 10.34 NU Executive Incentive Plan, effective as of January 1, 1991. (Exhibit 10.44, NU 1991 Form 10-K, File No. 1-5324) 10.35 Supplemental Executive Retirement Plan for Officers of NU System Companies, Amended and Restated effective as of January 1, 1992. (Exhibit 10.45.1, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) * 10.35.1 Amendment 1 to Exhibit 10.35, effective as of August 1, 1993. * 10.35.2 Amendment 2 to Exhibit 10.35, effective as of January 1, 1994. 10.36 Loan Agreement dated as of December 2, 1991, by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $175 million to an ESOP Trust. (Exhibit 10.46, NU 1991 Form 10-K, File No. 1-5324) * 10.36.1 First Amendment to Exhibit 10.36 dated February 7, 1992. 10.36.2 Loan Agreement dated as of March 19, 1992 by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $75 million to the ESOP Trust. (Exhibit 10.49.1, 1992 NU Form 10-K, File No. 1-5324) * 10.36.3 Second Amendment to Exhibit 10.36 dated April 9, 1992. 10.37 Management Succession Agreement. (Exhibit 10.47, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 10.38 Employment Agreement. (Exhibit 10.48, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 13 Annual Report to Security Holders (Each of the Annual Reports is filed only with the Form 10-K of that respective registrant.) E-14 * 13.1 Portions of the Annual Report to Security Holders of NU (pages 17 - 54) that have been incorporated by reference into this Form 10-K. 13.2 Annual Report of CL&P. 13.3 Annual Report of WMECO. 13.4 Annual Report of PSNH. 13.5 Annual Report of NAEC. 21 Subsidiaries of the Registrant (Exhibit 22, 1992 NU Form 10-K, File 1-5324) E-15 Item 12. Security Ownership of Certain Beneficial Owners and Management NU. Incorporated herein by reference are pages 5 through 12 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. As of February 28, 1994, the Directors of CL&P, PSNH, WMECO and NAEC, beneficially owned the following number of shares of each class of equity securities of NU. No equity securities of CL&P, PSNH or WMECO are owned by the Directors and Executive Officers. CL&P, PSNH, WMECO, and NAEC DIRECTORS AND NAMED EXECUTIVE OFFICERS Amount and Nature of Title Of Name of Beneficial Percent of Class Beneficial Owner Ownership (1) Class (2) NU Common Robert G. Abair (3) (621) 4,271 shares NU Common Robert E. Busch (772) 6,054 shares NU Common John P. Cagnetta (4) (581) 3,979 shares NU Common John C. Collins (5) 0 shares NU Common William B. Ellis (6) (1,259) 14,837 shares NU Common Ted C. Feigenbaum(7) 151 shares NU Common Bernard M. Fox (8) (1,072) 17,428 shares NU Common William T. Frain, Jr. 885 shares NU Common Cheryl W. Grise (221) 1,349 shares NU Common John B. Keane (9) (368) 1,146 shares NU Common Francis L. Kinney (10) (303) 3,781 shares NU Common Gerald Letendre (5) 0 shares NU Common Hugh C. MacKenzie (4)(11) (779) 4,277 shares NU Common Jane E. Newman (5) 0 shares NU Common Dale F. Nitzschke (5) 0 shares NU Common John W. Noyes (658) 2,789 shares NU Common John F. Opeka (4)(12) (1,075) 16,463 shares NU Common Robert P. Wax (5) (651) 1,436 shares Amount beneficially owned by Directors and Executive Officers as a group - CL&P (7,709) 77,259 shares - PSNH (6,790) 69,299 shares - WMECO (7,709) 77,259 shares - NAEC (7,088) 73,139 shares (1) Unless otherwise noted, each Director and Executive Officer of CL&P, PSNH, WMECO and NAEC has sole voting and investment power with respect to the listed shares. The numbers in parentheses reflect the number of shares owned by each Director and Executive Officer under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k) Plan), as to which the Officer has no investment power. (2) As of February 28, 1994 there were 134,208,461 common shares of NU outstanding. The percentage of such shares beneficially owned by any Director or Executive Officer, or by all Directors and Executive Officers of CL&P, PSNH, WMECO and NAEC as a group, does not exceed one percent. (3) Mr. Abair is a Director of CL&P and WMECO only. (4) Mr. Opeka and Dr. Cagnetta are not officers of PSNH, but each in his capacity as an officer (with the stated title) of NUSCO, an affiliate of PSNH, performs policy-making functions for PSNH. (5) Messrs. Collins, Letendre, Nitzschke and Wax and Ms. Newman areDirectors of PSNH only. (6) Mr. Ellis shares voting and investment power with his wife for 1,117 shares. (7) Mr. Feigenbaum is a Director and an Executive Officer of NAEC only. (8) Mr. Fox shares voting and investment power with his wife for 3,031 of these shares. In addition, Mr. Fox's wife has sole voting and investment power for 140 shares, as to which Mr. Fox disclaims beneficial ownership. (9) Mr. Keane is a Director of CL&P, WMECO and NAEC only. (10) Mr. Kinney shares voting and investment power with his wife for 2,155 shares. (11) Mr. MacKenzie shares voting and investment power with his wife for 1,259 shares. (12) Mr. Opeka shares voting and investment power with his wife for 1,718 shares. Item 13. Item 13. Certain Relationships and Related Transactions NU. Incorporated herein by reference is page 14 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. No relationships or transactions that would be described in response to this item exist now or existed during 1993 with respect to CL&P, PSNH, WMECO and NAEC. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements: The Report of Independent Public Accountants and financial statements of NU, CL&P, PSNH, WMECO, and NAEC are hereby incorporated by reference and made a part of this report (see "Item 8. Financial Statements and Supplementary Data"). Reports of Independent Public Accountants on Schedules S-1 Consents of Independent Public Accountants S-3 2. Schedules: Financial Statement Schedules for NU (Parent), NU and Subsidiaries, CL&P, PSNH, WMECO, and NAEC are listed in the Index to Financial Statement Schedules S-5 3. Exhibits Index E-1 (b) Reports on Form 8-K: During the fourth quarter of 1993, the companies filed Form 8-Ks dated December 2, 1993 disclosing the following: o On December 2, 1993, the Northeast Utilities system announced a reorganization of its corporate structure. o On December 3, 1993, NNECO was informed by the NRC that it was being assessed a civil penalty in response to repair activities at Millstone 2. In addition, the Form 8-K dated December 2, 1993 which was filed by PSNH also discussed the following: o On June 8, 1992, PSNH changed its independent public accountant. NORTHEAST UTILITIES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NORTHEAST UTILITIES ------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------------- William B. Ellis Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Trustee and Chairman /s/ William B. Ellis - -------------- of the Board ------------------------- William B. Ellis March 18, 1994 Trustee, President /s/ Bernard M. Fox - -------------- and Chief Executive ------------------------- Officer Bernard M. Fox March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President and Chief ------------------------- Financial Officer Robert E. Busch March 18, 1994 Vice President and /s/ John B. Keane - -------------- Treasurer ------------------------- John B. Keane March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller ------------------------- John W. Noyes NORTHEAST UTILITIES SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Trustee /s/ Cotton Mather Cleveland - -------------- --------------------------- Cotton Mather Cleveland March 18, 1994 Trustee /s/ George David - -------------- --------------------------- George David March 18, 1994 Trustee /s/ Donald J. Donahue - -------------- --------------------------- Donald J. Donahue March 18, 1994 Trustee /s/ Eugene D. Jones - -------------- --------------------------- Eugene D. Jones March 18, 1994 Trustee /s/ Elizabeth T. Kennan - -------------- --------------------------- Elizabeth T. Kennan Trustee - -------------- --------------------------- Denham C. Lunt, Jr. March 18, 1994 Trustee /s/ William J. Pape II - -------------- --------------------------- William J. Pape II March 18, 1994 Trustee /s/ Robert E. Patricelli - -------------- --------------------------- Robert E. Patricelli Trustee - -------------- --------------------------- Norman C. Rasmussen Trustee - -------------- --------------------------- John F. Swope THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE CONNECTICUT LIGHT AND POWER COMPANY --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE 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. PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- ------------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ William T. Frain, Jr. - -------------- Operating Officer -------------------------- and Director William T. Frain, Jr. March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John C. Collins - ------------------- -------------------------- John C. Collins March 18, 1994 Director /s/ Gerald Letendre - ------------------- -------------------------- Gerald Letendre March 18, 1994 Director /s/ Hugh C. MacKenzie - ------------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ Jane E. Newman - ------------------- -------------------------- Jane E. Newman March 18, 1994 Director /s/ Dale S. Nitzschke - ------------------- -------------------------- Dale S. Nitzschke March 18, 1994 Director /s/ Robert P. Wax - ------------------- -------------------------- Robert P. Wax WESTERN MASSACHUSETTS ELECTRIC 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. WESTERN MASSACHUSETTS ELECTRIC COMPANY -------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- -------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes WESTERN MASSACHUSETTS ELECTRIC COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka NORTH ATLANTIC ENERGY 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. NORTH ATLANTIC ENERGY CORPORATION --------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ Robert E. Busch - -------------- Operating Officer -------------------------- and Director Robert E. Busch March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes NORTH ATLANTIC ENERGY CORPORATION SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John P. Cagnetta - -------------- -------------------------- John P. Cagnetta - -------------- Director -------------------------- Ted C. Feigenbaum March 18, 1994 Director /s/ William T. Frain. Jr. - -------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - -------------- -------------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - -------------- -------------------------- John B. Keane March 18, 1994 Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ John F. Opeka - -------------- -------------------------- John F. Opeka REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES We have audited in accordance with generally accepted auditing standards, the financial statements included in Northeast Utilities' annual report to shareholders and The Connecticut Light and Power Company's, Western Massachusetts Electric Company's, North Atlantic Energy Corporation's, and Public Service Company of New Hampshire's annual reports, incorporated by reference in this Form 10-K, and have issued our reports thereon dated February 18, 1994. Our reports on the financial statements include an explanatory paragraph with respect to the change in methods of accounting for property taxes, postretirement benefits other than pensions, income taxes, and employee stock ownership plans, as applicable to each company, as explained in Note 1 to the related company's financial statements. Our audits were made for the purpose of forming an opinion on each company's statements taken as a whole. The schedules listed in the index to financial statement schedules are the responsibility of each company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of each company's basic financial statements. The schedules have been subjected to the auditing procedures applied in the audits of each company's 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 each company's basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut February 18, 1994 S-1 INDEPENDENT AUDITORS' REPORT ON SCHEDULES The Board of Directors Public Service Company of New Hampshire: Under date of February 7, 1992, we reported on the balance sheet and statement of capitalization of Public Service Company of New Hampshire as of December 31, 1991 (not presented in the 1993 annual report to stockholders) and the related statements of income, cash flows and common stock equity for the periods January 1, 1991 to May 15, 1991 and May 16, 1991 to December 31, 1991, as contained in the annual report to stockholders of Public Service Company for the year 1993. These financial statements and our report thereon are incorporated by reference herein. In connection with our audits of the aforementioned financial statements, we have also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsiblity is to express an opinion on these financial statement schedules based on our audit. 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/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massachusetts February 7, 1992 S-2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference of our reports in this Form 10-K, into previously filed Registration Statement No. 33-13444, No. 33-46291 , No. 33-59430, and No. 33-50853 of The Connecticut Light and Power Company, No. 33-34886, No. 33-51185 and No. 33-25619 of Western Massachusetts Electric Company, and No. 33-34622 and No. 33-40156 of Northeast Utilities. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut March 18, 1994 S-3 INDEPENDENT AUDITORS' CONSENT The Board of Directors Public Service Company of New Hampshire: We consent to the use of our reports included or incorporated by reference herein. /s/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massaschusetts March 18, 1994 S-4 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedule Page - -------- ---- III. Financial Information of Registrant: Northeast Utilities (Parent) Balance Sheets 1993 and 1992 S-7 Northeast Utilities (Parent) Statements of Income 1993, 1992, and 1991 S-8 Northeast Utilities (Parent) Statements of Cash Flows 1993, 1992, and 1991 S-9 V. Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-10 -- S-12 The Connecticut Light and Power Company S-13 -- S-15 Public Service Company of New Hampshire S-16 -- S-20 Western Massachusetts Electric Company S-21 -- S-23 North Atlantic Energy Corporation S-24 -- S-25 V. Nuclear Fuel 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-26 -- S-28 The Connecticut Light and Power Company S-29 -- S-31 Public Service Company of New Hampshire S-32 -- S-36 Western Massachusetts Electric Company S-37 -- S-39 North Atlantic Energy Corporation S-40 -- S-41 VI. Accumulated Provision for Depreciation of Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-42 -- S-44 The Connecticut Light and Power Company S-45 Public Service Company of New Hampshire S-46 -- S-48 Western Massachusetts Electric Company S-49 North Atlantic Energy Corporation S-50 VIII. Valuation and Qualifying Accounts and Reserves 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-51 -- S-53 The Connecticut Light and Power Company S-54 -- S-56 Public Service Company of New Hampshire S-57 -- S-61 Western Massachusetts Electric Company S-62 -- S-64 S-5 Schedule Page - -------- ---- IX. Short-Term Borrowings 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-65 The Connecticut Light and Power Company S-66 Public Service Company of New Hampshire S-67 Western Massachusetts Electric Company S-68 North Atlantic Energy Corporation S-69 X. Supplementary Income Statement Information 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-70 The Connecticut Light and Power Company S-71 Public Service Company of New Hampshire S-72 Western Massachusetts Electric Company S-73 North Atlantic Energy Corporation S-74 All other schedules of the companies' for which provision is made in the applicable regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable, and therefore have been omitted. S-6 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- BALANCE SHEETS -------------- AT DECEMBER 31, 1993 AND 1992 ------------------------------ (Thousands of Dollars) S-7 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- STATEMENTS OF INCOME -------------------- YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 --------------------------------------------- (Thousands of Dollars Except Share Information) S-8 SCHEDULE III NORTHEAST UTILITIES (PARENT) FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Thousands of Dollars) S-9 S-10 S-11 S-12 S-13 S-14 S-15 S-16 S-17 S-18 S-19 S-20 S-21 S-22 S-23 S-24 S-25 S-26 S-27 S-28 S-29 S-30 S-31 S-32 S-33 S-34 S-35 S-36 S-37 S-38 S-39 S-40 S-41 S-42 S-43 S-44 S-45 S-46 S-47 S-48 S-49 S-50 S-51 S-52 S-53 S-54 S-55 S-56 S-57 S-58 S-59 S-60 S-61 S-62 S-63 S-64 S-65 S-66 S-67 S-68 S-69 S-70 S-71 S-72 S-73 S-74 EXHIBIT INDEX Each document described below is incorporated by reference to the files of the Securities and Exchange Commission, unless the reference to the document is marked as follows: * - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Reports on Form 10-K for CL&P, PSNH, WMECO and NAEC. # - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for CL&P. @ - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for PSNH. ** - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for WMECO. ## - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for NAEC. Exhibit Number Description 3 Articles of Incorporation and By-Laws 3.1 Northeast Utilities 3.1.1 Declaration of Trust of NU, as amended through May 24, 1988. (Exhibit 3.1.1, 1988 NU Form 10-K, File No. 1-5324) 3.2 The Connecticut Light and Power Company # 3.2.1 Certificate of Incorporation of CL&P, restated to March 22, 1994. # 3.2.2 By-laws of CL&P, as amended to March 1, 1982. 3.3 Public Service Company of New Hampshire @ 3.3.1 Articles of Incorporation, as amended to May 16, 1991. @ 3.3.2 By-laws of PSNH, as amended to November 1, 1993. 3.4 Western Massachusetts Electric Company 3.4.1 Certificate of Organization of WMECO, as amended, to August 31, 1954. (Exhibit 3.1, File No. 2-11114) 3.4.2 Amendments to Certificate of Organization of WMECO of May 19, 1966 and of December 5, 1967. (Exhibit 3.2, File No. 2-30534) E-1 3.4.3 Articles of Amendment dated December 9, 1981. (Exhibit 3.1.2, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.4 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated December 16, 1981. (Exhibit 3.1.3, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.5 Articles of Amendment dated April 7, 1983. (Exhibit 3.3.5, 1983 NU Form 10-K, File No. 1-5324) 3.4.6 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated April 12, 1983. (Exhibit 3.3.6, 1983 NU Form 10-K, File No. 1-5324) 3.4.7 Articles of Amendment dated January 29, 1987. (Exhibit 3.3.7, 1986 NU Form 10-K, File No. 1-5324) 3.4.8 Articles of Amendment dated February 11, 1987. (Exhibit 3.3.8, 1986 NU Form 10-K, File No. 1-5324) 3.4.9 Articles of Amendment dated February 19, 1988. (Exhibit 3.3.9, 1987 NU Form 10-K, File No. 1-5324) 3.4.10 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated February 23, 1988. (Exhibit 3.3.10, 1987 NU Form 10-K, File No. 1-5324) ** 3.4.11 By-laws of WMECO, as amended to February 24, 1988. 3.5 North Atlantic Energy Corporation ## 3.5.1 Articles of Incorporation of NAEC dated September 20, 1991. ## 3.5.2 Articles of Amendment dated October 16, 1991 and June 2, 1992 to Articles of Incorporation of NAEC. ## 3.5.3 By-laws of NAEC, as amended to November 8, 1993. 4 Instruments defining the rights of security holders, including indentures 4.1 Northeast Utilities 4.1.1 Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Debt Securities. (Exhibit 4.1.1, 1991 NU Form 10-K, File No. 1-5324) 4.1.2 First Supplemental Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Series A Notes. (Exhibit 4.1.2, 1991 NU Form 10-K, File No. 1-5324) 4.1.3 Second Supplemental Indenture dated as of March 1, 1992 between Northeast Utilities and IBJ Schroder Bank & Trust Company with respect to the issuance of 8.38% Amortizing Notes. (Exhibit 4.1.3, 1992 NU Form 10-K, File No. 1-5324) E-2 4.1.4 Warrant Agreement dated as of June 5, 1992 between Northeast Utilities and the Service Company. (Exhibit 4.1.4, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.1 Additional Warrant Agent Agreement dated as of June 5, 1992 between Northeast Utilities and State Street Bank and Trust Company. (Exhibit 4.1.4.1, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.2 Exchange and Disbursing Agent Agreement dated as of June 5, 1992 among Northeast Utilities, Public Service Company of New Hampshire and State Street Bank and Trust Company. (Exhibit 4.1.4.2, 1992 NU Form 10-K, File No. 1-5324) 4.1.5 Credit Agreements among CL&P, NU, WMECO, NUSCO (as Agent) and 19 Commercial Banks dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.38, 1992 NU Form U5S, File No. 30-246) 4.1.6 Credit Agreements among CL&P, WMECO, NU, Holyoke Water Power Company, RRR, NNECO and NUSCO (as Agent) dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.39, 1992 NU Form U5S, File No. 30-246) 4.2 The Connecticut Light and Power Company 4.2.1 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, Trustee, dated as of May 1, 1921. (Composite including all twenty-four amendments to May 1, 1967.) (Exhibit 4.1.1, 1989 NU Form 10-K, File No. 1-5324) Supplemental Indentures to the Composite May 1, 1921 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, dated as of: 4.2.2 April 1, 1967. (Exhibit 4.16, File No. 2-60806) 4.2.3 January 1, 1968. (Exhibit 4.18, File No. 2-60806) 4.2.4 December 1, 1969. (Exhibit 4.20, File No. 2-60806) 4.2.5 June 30, 1982. (Exhibit 4.33, File No. 2-79235) 4.2.6 June 1, 1989. (Exhibit 4.1.24, 1989 NU Form 10-K, File No. 1-5324) 4.2.7 September 1, 1989. (Exhibit 4.1.25, 1989 NU Form 10-K, File No. 1-5324) 4.2.8 December 1, 1989. (Exhibit 4.1.26, 1989 NU Form 10-K, File No. 1-5324) 4.2.9 April 1, 1992. (Exhibit 4.30, File No. 33-59430) 4.2.10 July 1, 1992. (Exhibit 4.31, File No. 33-59430) E-3 4.2.11 October 1, 1992. (Exhibit 4.32, File No. 33-59430) 4.2.12 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) 4.2.13 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) # 4.2.14 December 1, 1993. # 4.2.15 February 1, 1994. # 4.2.16 February 1, 1994. 4.2.17 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1986. (Exhibit C.1.47, 1986 NU Form U5S, File No. 30-246) 4.2.18 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of October 1, 1988. (Exhibit C.1.55, 1988 NU Form U5S, File No. 30-246) 4.2.19 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1989. (Exhibit C.1.39, 1989 NU Form U5S, File No. 30-246) 4.2.20 Loan and Trust Agreement among Business Finance Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1992. (Exhibit C.2.33, 1992 NU Form U5S, File No. 30-246) # 4.2.21 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.22 Series B (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.23 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.24 Series B (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.3 Public Service Company of New Hampshire 4.3.1 First Mortgage Indenture dated as of August 15, 1978 between PSNH and First Fidelity Bank, National Association, New Jersey, Trustee, (Composite including all amendments to May 16, 1991). (Exhibit 4.4.1, 1992 NU Form 10-K, File No. 1- 5324) E-4 4.3.1.1 Tenth Supplemental Indenture dated as of May 1, 1991 between PSNH and First Fidelity Bank, National Association. (Exhibit 4.1, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392). 4.3.2 Revolving Credit Agreement dated as May 1, 1991. (Exhibit 4.12, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.3 Term Credit Agreement dated as of May 1, 1991. (Exhibit 4.11, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.4 Series A (Tax Exempt New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.2, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.5 Series B (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.3, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.6 Series C (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.4, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7 Series D (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.5, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7.1 First Supplement to Series D (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1992. (Exhibit 4.4.5.1, 1992 NU Form 10-K, File No. 1-5324) 4.3.8 Series E (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.6, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) @ 4.3.8.1 First Supplement to Series E (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1993. @ 4.3.9 Series D (May 1, 1991 Taxable New Issue and December 1, 1992 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of October 1, 1992. @ 4.3.9.1 Amended and Restated Letter of Credit dated December 17, 1992. 4.3.10 Series E (May 1, 1991 Taxable New Issue and December 1, 1993 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of May 1, 1991. (Exhibit 4.8, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-5 @ 4.3.10.1 Amended and Restated Letter of Credit dated December 15, 1993. 4.4 Western Massachusetts Electric Company ** 4.4.1 First Mortgage Indenture and Deed of Trust between WMECO and Old Colony Trust Company, Trustee, dated as of August 1, 1954. Supplemental Indentures thereto dated as of: 4.4.2 March 1, 1967. (Exhibit 2.5, File No. 2-68808) 4.4.3 March 1, 1968. (Exhibit 2.6, File No. 2-68808) 4.4.4 December 1, 1968. (Exhibit 2.7, File No. 2-68808) 4.4.5 July 1, 1972. (Exhibit 2.9, File No. 2-68808) 4.4.6 May 1, 1986. (Exhibit 4.3.18, 1986 NU Form 10-K, File No. 1-5324) 4.4.7 December 1, 1988. (Exhibit 4.3.20, 1988 NU Form 10-K, File No. 1-5324.) 4.4.8 September 1, 1990. (Exhibit 4.3.15, 1990 NU Form 10-K, File No. 1-5324.) 4.4.9 December 1, 1992. (Exhibit 4.15, File No. 33-55772) 4.4.10 January 1, 1993. (Exhibit 4.5.13, 1992 NU Form 10-K, File No. 1-5324) ** 4.4.11 March 1, 1994. ** 4.4.12 March 1, 1994. ** 4.4.13 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and WMECO (Pollution Control Bonds) dated as of September 1, 1993. ** 4.4.14 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.5 North Atlantic Energy Corporation 4.5.1 First Mortgage Indenture and Deed of Trust between NAEC and United States Trust Company of New York, Trustee, dated as of June 1, 1992. (Exhibit 4.6.1, 1992 NU Form 10-K, File No. 1-5324) 4.5.2 Note Indenture dated as of May 15, 1991. (Exhibit 4.10, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-6 4.5.3 First Supplemental Indenture dated as of June 5, 1992 between NAEC, PSNH and United States Trust Company of New York, Trustee. (Exhibit 4.6.3, 1992 NU Form 10-K, File No. 1-5324) 10 Material Contracts 10.1 Stockholder Agreement dated as of July 1, 1964 among the stockholders of Connecticut Yankee Atomic Power Company (CYAPC). (Exhibit 13.1, File No. 2-22958) 10.2 Form of Power Contract dated as of July 1, 1964 between CYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 13.2, File No. 2-22958) 10.2.1 Form of Additional Power Contract dated as of April 30, 1984, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.4, 1984 NU Form 10-K, File No. 1-5324) 10.2.2 Form of 1987 Supplementary Power Contract dated as of April 1, 1987, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.6, 1987 NU Form 10-K, File No. 1-5324) 10.3 Capital Funds Agreement dated as of September 1, 1964 between CYAPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 13.3, File No. 2-22958) #@** 10.4 Stockholder Agreement dated December 10, 1958 between Yankee Atomic Electric Company (YAEC) and CL&P, HELCO, PSNH and WMECO. 10.5 Form of Amendment No. 3, dated as of April 1, 1985, to Power Contract between YAEC and each of CL&P, PSNH and WMECO, including a composite restatement of original Power Contract dated June 30, 1959 and Amendment No. 1 dated April 1, 1975 and Amendment No. 2 dated October 1, 1980. (Exhibit 10.5, 1988 NU Form 10-K, File No. 1-5324.) 10.5.1 Form of Amendment No. 4 to Power Contract, dated May 6, 1988, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.1, 1989 NU Form 10-K, File No. 1-5324) 10.5.2 Form of Amendment No. 5 to Power Contract, dated June 26, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.2, 1989 NU Form 10-K, File No. 1-5324) 10.5.3 Form of Amendment No. 6 to Power Contract, dated July 1, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.3, 1989 NU Form 10-K, File No. 1-5324) #@** 10.5.4 Form of Amendment No. 7 to Power Contract, dated February 1, 1992, between YAEC and each of CL&P, PSNH and WMECO. 10.6 Stockholder Agreement dated as of May 20, 1968 among stockholders of MYAPC. (Exhibit 4.15, File No. 2-30018) 10.7 Form of Power Contract dated as of May 20, 1968 between MYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.14, File No. 2-30018) E-7 #@** 10.7.1 Form of Amendment No. 1 to Power Contract dated as of March 1, 1983 between MYAPC and each of CL&P, PSNH and WMECO. #@** 10.7.2 Form of Amendment No. 2 to Power Contract dated as of January 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.7.3 Form of Amendment No. 3 to Power Contract dated as of October 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.7.3, 1985 NU Form 10-K, File No. 1-5324) #@** 10.7.4 Form of Additional Power Contract dated as of February 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.8 Capital Funds Agreement dated as of May 20, 1968 between Maine Yankee Atomic Power Company (MYAPC) and CL&P, PSNH, HELCO and WMECO. (Exhibit 4.13, File No. 2-30018) 10.8.1 Amendment No. 1 to Capital Funds Agreement, dated as of August 1, 1985, between MYAPC, CL&P, PSNH and WMECO. (Exhibit 10.6.1, 1985 NU Form 10-K, File No. 1-5324) 10.9 Sponsor Agreement dated as of August 1, 1968 among the sponsors of VYNPC. (Exhibit 4.16, File No. 2-30285) 10.10 Form of Power Contract dated as of February 1, 1968 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.18, File No. 2-30018) 10.10.1 Form of Amendment to Power Contract dated as of June 1, 1972 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 5.22, File No. 2-47038) #@** 10.10.2 Form of Second Amendment to Power Contract dated as of April 15, 1983 between VYNPC and each of CL&P, PSNH and WMECO. 10.10.3 Form of Third Amendment to Power Contract dated as of April 24, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.3, 1986 NU Form 10-K, File No. 1-5324) 10.10.4 Form of Fourth Amendment to Power Contract dated as of June 1, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.4, 1986 NU Form 10-K, File No. 1-5324) 10.10.5 Form of Fifth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.5, 1990 NU Form 10-K, File No. 1-5324) 10.10.6 Form of Sixth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.6, 1990 NU Form 10-K, File No. 1-5324) E-8 10.10.7 Form of Seventh Amendment to Power Contract dated as of June 15, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.7, 1990 NU Form 10-K, File No. 1-5324) 10.10.8 Form of Eighth Amendment to Power Contract dated as of December 1, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.8, 1990 NU Form 10-K, File No. 1-5324) #@** 10.10.9 Form of Additional Power Contract dated as of February 1, 1984 between VYNPC and each of CL&P, PSNH and WMECO. 10.11 Capital Funds Agreement dated as of February 1, 1968 between Vermont Yankee Nuclear Power Corporation (VYNPC) and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.16, File No. 2-30018) 10.11.1 Form of First Amendment to Capital Funds Agreement dated as of March 12, 1968 between VYNPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.17, File No. 2-30018) #@** 10.11.2 Form of Second Amendment to Capital Funds Agreement dated as of September 1, 1993 between VYNPC and CL&P, HELCO, PSNH and WMECO. 10.12 Amended and Restated Millstone Plant Agreement dated as of December 1, 1984 by and among CL&P, WMECO and Northeast Nuclear Energy Company (NNECO). (Exhibit 10.17, 1985 NU Form 10-K, File No. 1-5324) 10.13 Sharing Agreement dated as of September 1, 1973 with respect to 1979 Connecticut nuclear generating unit (Millstone 3). (Exhibit 6.43, File No. 2-50142) 10.13.1 Amendment dated August 1, 1974 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 5.45, File No. 2-52392) 10.13.2 Amendment dated December 15, 1975 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 7.47, File No. 2-60806) 10.13.3 Amendment dated April 1, 1986 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 10.17.3, 1990 NU Form 10-K, File No. 1-5324) 10.14 Agreement dated July 19, 1990, among NAESCO and Seabrook Joint owners with respect to operation of Seabrook. (Exhibit 10.53, 1990 NU Form 10-K, File No. 1-5324) 10.15 Sharing Agreement between CL&P, WMECO, HP&E, HWP and PSNH dated as of June 1, 1992. (Exhibit 10.17, 1992 NU Form 10- K, File No. 1-5324) 10.16 Form of Seabrook Power Contract between PSNH and NAEC, as amended and restated. (Exhibit 10.45, NU 1992 Form 10-K, File No. 1-5324) E-9 10.17 Agreement for joint ownership, construction and operation of New Hampshire nuclear generating units dated as of May 1, 1973. (Exhibit 13-57, File No. 2-48966) 10.17.1 Amendments to Exhibit 10.17 dated May 24, 1974, June 21, 1974 and September 25, 1974. (Exhibit 5.15, File No. 2-51999) 10.17.2 Amendments to Exhibit 10.17 dated October 25, 1974 and January 31, 1975. (Exhibit 5.23, File No. 2-54646) 10.17.3 Sixth Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.3, File No. 2-64294) 10.17.4 Seventh Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.4, File No. 2-64294) 10.17.5 Eighth Amendment to Exhibit 10.17 dated as of April 25, 1979. (Exhibit 5.4.5, File No. 2-64815) 10.17.6 Ninth Amendment to Exhibit 10.17 dated as of June 8, 1979. (Exhibit 5.4.6, File No. 2-64815) 10.17.7 Tenth Amendment to Exhibit 10.17 dated as of October 10, 1979. (Exhibit 5.4.2, File No. 2-66334) 10.17.8 Eleventh Amendment to Exhibit 10.17 dated as of December 15, 1979. (Exhibit 5.4.8, File No. 2-66492) 10.17.9 Twelfth Amendment to Exhibit 10.17 dated as of June 16, 1980. (Exhibit 5.4.9, File No. 2-68168) 10.17.10 Thirteenth Amendment to Exhibit 10.17 dated as of December 31, 1980. (Exhibit 10.6, File No. 2-70579) * 10.17.11 Fourteenth Amendment to Exhibit 10.17 dated as of June 1, 1982. 10.17.12 Fifteenth Amendment to Exhibit 10.17 dated as of April 27, 1984. (Exhibit 10.14.12, 1984 NU Form 10-K, File No. 1-5324) 10.17.13 Sixteenth Amendment to Exhibit 10.17 dated as of June 15, 1984. (Exhibit 10.14.13, 1984 NU Form 10-K, File No. 1-5324) 10.17.14 Seventeenth Amendment to Exhibit 10.17 dated as of March 8, 1985. (Exhibit 10.13.14, 1985 NU Form 10-K, File No. 1-5324) 10.17.15 Eighteenth Amendment to Exhibit 10.17 dated as of March 14, 1986. (Exhibit 10.13.15, 1986 NU Form 10-K, File No. 1-5324) 10.17.16 Nineteenth Amendment to Exhibit 10.17 dated as of May 1, 1986. (Exhibit 10.13.16, 1986 NU Form 10-K, File No. 1-5324) E-10 10.17.17 Twentieth Amendment to Exhibit 10.17 dated as of July 15, 1986. (Exhibit 10.13.17, 1986 NU Form 10-K, File No. 1-5324) 10.17.18 Twenty-first Amendment to Exhibit 10.17 dated as of November 12, 1987. (Exhibit 10.13.18, 1987 NU Form 10-K, File No. 1-5324) 10.17.19 Twenty-second Amendment to Exhibit 10.17 dated as of January 13, 1989. (Exhibit 10.13.19, 1989 NU Form 10-K, File No. 1-5324) 10.17.20 Twenty-third Amendment to Exhibit 10.17 dated as of November 1, 1990. (Exhibit 10.13.20, 1990 NU Form 10- K, File No. 1-5324) 10.17.21 Memorandum of Understanding dated November 7, 1988 between PSNH and Massachusetts Municipal Wholesale Electric Company (Exhibit 10.17, PSNH 1989 Form 10-K, File No. 1-6392) 10.17.22 Agreement of Settlement among Joint Owners dated as of January 13, 1989. (Exhibit 10.13.21, 1988 NU Form 10- K, File No. 1-5324) 10.17.22.1 Supplement to Settlement Agreement, dated as of February 7, 1989, between PSNH and Central Maine Power Company. (Exhibit 10.18.1, PSNH 1989 Form 10-K, File No. 1-6392) 10.18 Amended and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990. (Exhibit 10.4.7, File No. 33-35312) 10.18.1 Form of First Amendment to Exhibit 10.18. (Exhibit 10.4.8, File No. 33-35312) * 10.18.2 Form (Composite) of Second Amendment to Exhibit 10.18. 10.19 Agreement dated November 1, 1974 for Joint Ownership, Construction and Operation of William F. Wyman Unit No. 4 among PSNH, Central Maine Power Company and other utilities. (Exhibit 5.16 , File No. 2-52900) 10.19.1 Amendment to Exhibit 10.19 dated June 30, 1975. (Exhibit 5.48, File No. 2-55458) 10.19.2 Amendment to Exhibit 10.19 dated as of August 16, 1976. (Exhibit 5.19, File No. 2-58251) 10.19.3 Amendment to Exhibit 10.19 dated as of December 31, 1978. (Exhibit 5.10.3, File No. 2-64294) #** 10.20 Form of Service Contract dated as of July 1, 1966 between each of NU, CL&P and WMECO and the Service Company. 10.20.1 Service Contract dated as of June 5, 1992 between PSNH and the Service Company. (Exhibit 10.12.4, 1992 NU Form 10-K, File No. 1-5324) E-11 10.20.2 Service Contract dated as of June 5, 1992 between NAEC and the Service Company. (Exhibit 10.12.5, 1992 NU Form 10-K, File No. 1-5324) * 10.20.3 Form of Annual Renewal of Service Contract. 10.21 Memorandum of Understanding between CL&P, HELCO, Holyoke Power and Electric Company (HP&E), Holyoke Water Power Company (HWP) and WMECO dated as of June 1, 1970 with respect to pooling of generation and transmission. (Exhibit 13.32, File No. 2-38177) #** 10.21.1 Amendment to Memorandum of Understanding between CL&P, HELCO, HP&E, HWP and WMECO dated as of February 2, 1982 with respect to pooling of generation and transmission. 10.22 New England Power Pool Agreement effective as of November 1, 1971, as amended to November 1, 1988. (Exhibit 10.15, 1988 NU Form 10-K, File No. 1-5324.) 10.22.1 Twenty-sixth Amendment to Exhibit 10.22 dated as of March 15, 1989. (Exhibit 10.15.1, 1990 NU Form 10-K, File No. 1-5324) 10.22.2 Twenty-seventh Amendment to Exhibit 10.22 dated as of October 1, 1990. (Exhibit 10.15.2, 1991 NU Form 10-K, File No. 1-5324) 10.22.3 Twenty-eighth Amendment to Exhibit 10.22 dated as of September 15, 1992. (Exhibit 10.18.3, 1992 NU Form 10-K, File No. 1-5324) * 10.22.4 Twenty-ninth Amendment to Exhibit 10.22 dated as of May 1, 1993. 10.23 Agreements among New England Utilities with respect to the Hydro-Quebec interconnection projects. (See Exhibits 10(u) and 10(v); 10(w), 10(x), and 10(y), 1990 and 1988, respectively, Form 10-K of New England Electric System, File No. 1-3446.) 10.24 Trust Agreement dated February 11, 1992, between State Street Bank and Trust Company of Connecticut, as Trustor, and Bankers Trust Company, as Trustee, and CL&P and WMECO, with respect to NBFT. (Exhibit 10.23, 1991 NU Form 10-K, File No. 1-5324) 10.24.1 Nuclear Fuel Lease Agreement dated as of February 11, 1992, between Bankers Trust Company, Trustee, as Lessor, and CL&P and WMECO, as Lessees. (Exhibit 10.23.1, 1991 NU Form 10-K, File No. 1-5324) 10.25 Simulator Financing Lease Agreement, dated as of February 1, 1985, by and between ComPlan and NNECO. (Exhibit 10.52, 1985 NU Form 10-K, File No. 1-5324) E-12 10.26 Simulator Financing Lease Agreement, dated as of May 2, 1985, by and between The Prudential Insurance Company of America and NNECO. (Exhibit 10.53, 1985 NU Form 10-K, File No. 1-5324) 10.27 Lease dated as of April 14, 1992 between The Rocky River Realty Company (RRR) and Northeast Utilities Service Company (NUSCO) with respect to the Berlin, Connecticut headquarters (office lease). (Exhibit 10.29, 1992 NU Form 10-K, File No. 1-5324) 10.27.1 Lease date as of April 14, 1992 between RRR and NUSCO with respect to the Berlin, Connecticut headquarters (project lease). (Exhibit 10.29.1, 1992 NU Form 10-K, File No. 1-5324) * 10.28 Millstone Technical Building Note Agreement dated as of December 21, 1993 between, by and between The Prudential Insurance Company of America and NNECO. 10.29 Lease and Agreement, dated as of December 15, 1988, by and between WMECO and Bank of New England, N.A., with BNE Realty Leasing Corporation of North Carolina. (Exhibit 10.63, 1988 NU Form 10-K, File No. 1-5324.) 10.30 Note Agreement dated April 14, 1992, by and between The Rocky River Realty Company (RRR) and Purchasers named therein (Connecticut General Life Insurance Company, Life Insurance Company of North America, INA Life Insurance Company of New York, Life Insurance Company of Georgia), with respect to RRR's sale of $15 million of guaranteed senior secured notes due 2007 and $28 million of guaranteed senior secured notes due 2017. (Exhibit 10.52, 1992 NU Form 10-K, File No. 1-5324) 10.30.1 Note Guaranty dated April 14, 1992 by Northeast Utilities pursuant to Note Agreement dated April 14, 1992 between RRR and Note Purchasers, for the benefit of The Connecticut National Bank as Trustee, the Purchasers and the owners of the notes. (Exhibit 10.52.1, 1992 NU Form 10-K, File No. 1-5324) 10.30.2 Assignment of Leases, Rents and Profits, Security Agreement and Negative Pledge, dated as of April 14, 1992 among RRR, NUSCO and The Connecticut National Bank as Trustee, securing notes sold by RRR pursuant to April 14, 1992 Note Agreement. (Exhibit 10.52.2, 1992 NU Form 10-K, File No. 1-5324) 10.31 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 1 decommissioning costs. (Exhibit 10.80, 1986 NU Form 10-K, File No. 1-5324) 10.31.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.41.1, 1992 NU Form 10-K, File No. 1-5324) E-13 10.32 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 2 decommissioning costs. (Exhibit 10.81, 1986 NU Form 10-K, File No. 1-5324) 10.32.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.42.1, 1992 NU Form 10-K, File No. 1-5324) 10.33 Master Trust Agreement dated as of April 23, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 3 decommissioning costs. (Exhibit 10.82, 1986 NU Form 10-K, File No. 1-5324) 10.33.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.43.1, 1992 NU Form 10-K, File No. 1-5324) 10.34 NU Executive Incentive Plan, effective as of January 1, 1991. (Exhibit 10.44, NU 1991 Form 10-K, File No. 1-5324) 10.35 Supplemental Executive Retirement Plan for Officers of NU System Companies, Amended and Restated effective as of January 1, 1992. (Exhibit 10.45.1, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) * 10.35.1 Amendment 1 to Exhibit 10.35, effective as of August 1, 1993. * 10.35.2 Amendment 2 to Exhibit 10.35, effective as of January 1, 1994. 10.36 Loan Agreement dated as of December 2, 1991, by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $175 million to an ESOP Trust. (Exhibit 10.46, NU 1991 Form 10-K, File No. 1-5324) * 10.36.1 First Amendment to Exhibit 10.36 dated February 7, 1992. 10.36.2 Loan Agreement dated as of March 19, 1992 by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $75 million to the ESOP Trust. (Exhibit 10.49.1, 1992 NU Form 10-K, File No. 1-5324) * 10.36.3 Second Amendment to Exhibit 10.36 dated April 9, 1992. 10.37 Management Succession Agreement. (Exhibit 10.47, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 10.38 Employment Agreement. (Exhibit 10.48, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 13 Annual Report to Security Holders (Each of the Annual Reports is filed only with the Form 10-K of that respective registrant.) E-14 * 13.1 Portions of the Annual Report to Security Holders of NU (pages 17 - 54) that have been incorporated by reference into this Form 10-K. 13.2 Annual Report of CL&P. 13.3 Annual Report of WMECO. 13.4 Annual Report of PSNH. 13.5 Annual Report of NAEC. 21 Subsidiaries of the Registrant (Exhibit 22, 1992 NU Form 10-K, File 1-5324) E-15

835664_1993.txt

835664_1993

1993

835664

Item 1. BUSINESS General Koger Equity, Inc. is engaged in acquiring and holding commercial office buildings for the production of income (Koger Equity, Inc. and its two wholly owned subsidiaries is hereafter referred to as the "Company"). As of December 31, 1993, the Company owned 219 commercial properties in 16 metropolitan areas in the Southeast and Southwest. A total of 126 buildings were acquired from Koger Properties, Inc. ("KPI") or its subsidiaries through 1990. As the result of the merger of KPI with and into the Company (the "Merger") on December 21, 1993, the Company acquired an additional 93 buildings. In addition, the Company provides property management services for third parties, including the 20 buildings owned by Centoff Realty Company, Inc., a subsidiary of Morgan Guaranty Trust Company of New York, and 92 office buildings owned by The Koger Partnership, Ltd. ("TKPL"). The Company provides these services through its wholly owned subsidiaries, Southeast Properties Holding Corporation, Inc. ("Southeast") and Koger Real Estate Services, Inc. ("KRES"). The Company is currently self-administered and self-managed. The Company operates in a manner so as to qualify as a real estate investment trust under the provisions of the Internal Revenue Code of 1986, as amended (a "REIT"). As a REIT, the Company will not, with certain limited exceptions, be taxed at the corporate level on taxable income distributed to its shareholders on a current basis. Accordingly, the Company distributes at least 95 percent of its annual real estate investment trust taxable income to its shareholders. Since the Company intends to pay dividends equal to or in excess of 95 percent of its annual real estate investment trust taxable income and meets other qualifying criteria for a real estate investment trust, no federal income tax provision has been recorded. To be eligible to be a REIT, a corporation must meet five substantive tests: (a) at least 95 percent of its gross income must be derived from certain passive sources; (b) at least 75 percent of its gross income must be derived from certain real estate sources; (c) less than 30 percent of its gross income must be derived from the sale or other disposition of certain items, including certain real property held for less than four years; (d) at the close of each calendar quarter, it must meet certain tests designed to ensure that its assets are adequately diversified; and (e) each year, it must distribute at least 95 percent of its REIT taxable income. Management fee revenue does not qualify as passive income for purposes of determining whether the Company has met the REIT requirement that at least 95 percent of the Company's gross income is derived from passive sources. Accordingly, in the event the Company derives income in excess of five percent from management and other "non-passive" activities, the Company would no longer qualify as a REIT for federal income tax purposes and would be required to pay federal income taxes. No single tenant occupies 10 percent or more of the net rentable area of the Company's buildings or contributes 10 percent or more of the Company's rental revenues. Some of the Company's principal tenants are the State of Florida, U. S. Government, Blue Cross/Blue Shield, Lumbermans Mutual Casualty Company, Travelers Insurance Company, State of Texas, Aetna, FDIC, USAA Federal Savings Bank and Bell South. Governmental tenants (including the State of Florida and the United States Government), which account for 22 percent of the Company's leased space, may be subject to budget reductions in times of recession and governmental austerity. There can be no assurance that governmental appropriations for rents may not be reduced. Additionally, with the current economic conditions related to the rental of office space, certain of the private sector tenants which have contributed to the Company's rent stream may reduce their current demands or curtail their need for additional office space. Merger of KPI and the Company; Resolution of KPI Chapter 11 Case On September 25, 1991, KPI filed a petition under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Middle District of Florida (the "Bankruptcy Court"). The Company was the single largest creditor of KPI in the KPI Chapter 11 Case (indebtedness to the Company of approximately $116 million). On April 30, 1993, the Company and KPI jointly proposed a plan of reorganization of KPI (the "Plan") which provided for the merger of KPI with and into the Company in exchange for the issuance of shares of the Company's common stock (the "Shares") to certain creditors of KPI and the issuance of warrants to purchase Shares (the "Warrants") to shareholders of KPI and holders of certain securities laws claims against KPI and the settlement of the Company's claim against KPI. On August 11, 1993, the shareholders of the Company approved the Merger and the issuance of the Shares and Warrants pursuant thereto. On December 8, 1993, the Plan was confirmed by the Bankruptcy Court and the Merger became effective on December 21, 1993. Pursuant to the Merger, 6,158,977 Shares, or approximately 35 percent of the Shares outstanding after the Merger, and Warrants to purchase an aggregate of 644,000 Shares (3.5 percent of currently outstanding shares on a fully diluted basis) were issued under the Plan and Merger. The Warrants are to be exercisable until June 30, 1999 at $8.00 per share and are subject to redemption at the option of the Company at prices ranging from $1.92 to $5.24 per Warrant. With the Merger, the Company succeeded to substantially all of the assets of KPI, free and clear of all liens, claims and encumbrances, except (i) encumbrances relating to certain secured indebtedness of KPI (aggregating $182.6 million) which was restructured under the Plan and (ii) an option and right of first refusal held by TKPL on certain developed buildings and parcels of undeveloped land, which are located in TKPL office centers. KPI assets acquired by the Company in the Merger included 93 buildings containing 3,848,130 net rentable square feet together with approximately 295 acres of unimproved land suitable for development, and 1,781,419 Shares held by KPI. As a result of the Merger, the Company assumed all of the leasing and other management responsibilities for its properties including those acquired in the Merger. In addition, KPI transferred all of its debt and equity interests in TKPL to Southeast, which became the managing general partner of TKPL. Competition The Company competes in the leasing of office space with a considerable number of other realty concerns, both local and national, some of which have greater resources than the Company. Through its ownership of suburban office parks, the Company seeks to attract tenants by offering office space convenient to residential areas and away from the congestion and attendant traffic problems of the downtown business districts. In recent years both local and national concerns have built competing office parks and single buildings in suburban areas in which the Company's centers are located. In addition, the Company competes for tenants with large high-rise office buildings generally located in the downtown business districts of these cities. Although competition from other lessors of office space varies from city to city, the Company has been able to attain and maintain what it considers satisfactory occupancy levels at satisfactory rental rates. However, higher vacancy levels in metropolitan areas in which the Company's properties are located have had an adverse affect on the Company's ability to increase its rental rates while maintaining satisfactory occupancy levels. Investment Policies The Company is not currently engaged in the acquisition of additional properties and does not contemplate acquiring any material additional properties for the foreseeable future. The investment policies of the Company may be changed by the Company's directors at any time without notice to or a vote of security holders. The Company has no current policy which limits the percentage of its assets which may be invested in any one type of investment or the geographic areas in which the Company may acquire properties. The Company, however, intends to continue to operate so as to qualify for tax treatment as a REIT. Although it has no current plans to do so, the Company may in the future invest in other types of office buildings, apartment buildings, shopping centers, and other properties. It also may invest in the securities (including mortgages) of companies primarily engaged in real estate activities, although the Company does not intend to become an investment company regulated under the Investment Company Act of 1940. For the year ended December 31, 1993, all of the Company's rental revenues were derived from the buildings purchased from KPI or buildings acquired pursuant to the Merger. All of the Company's 1993 interest revenues were derived from temporary cash investments. Employees Prior to the Merger, the Company had seven full-time employees. Through that date the Company paid Koger Management, Inc. ("KMI"), a wholly owned subsidiary of KPI, five percent of gross rental income for property management and leasing services. Salaries for property management and leasing services were paid by KMI. With the consummation of the Merger, the Company became fully self-managed. In connection with its current real estate operations and property management agreements, the Company has a combined financial, administrative, leasing, and center maintenance staff of 242 employees. A resident general manager is responsible for the leasing and operations of all buildings in a center or city. The Company has approximately 100 employees who perform maintenance activities. Item 2. Item 2. PROPERTIES General At December 31, 1993, the Company owned 219 office buildings located in 21 Koger Centers in the 16 metropolitan areas of Jacksonville, Miami, Orlando, St. Petersburg, and Tallahassee, Florida; Atlanta, Georgia; Greenville, South Carolina; Charlotte, Greensboro and Raleigh, North Carolina; Memphis, Tennessee; Austin, El Paso, and San Antonio, Texas; Tulsa, Oklahoma; and Norfolk, Virginia. These centers have been developed in campus-like settings with extensive Landscaping and ample tenant parking. The buildings are generally one to five-story structures of contemporary design and constructed of masonry, concrete and steel, with facings of brick, concrete and glass. Each building contains lobby and lounge areas and is centrally air-conditioned. All multi-story buildings contain elevators. The centers are generally located with easy access, via expressways, to the central business district and to shopping and residential areas in the respective communities. The properties are well maintained and adequately covered by insurance. Leases on these properties vary between net leases (where the tenant pays some operating expenses, such as utilities, insurance and repairs) and gross leases (where the Company pays all such items). Most leases are on a gross basis and are for terms varying from three to five years. In some instances, such as when a tenant rents the entire building, leases are for terms of up to 20 years. At December 31, 1993, the Company's buildings were on average 88 percent leased and the average effective annual rent per net rentable square foot was $13.26. The buildings are occupied by numerous tenants, many of whom lease relatively small amounts of space, conducting a broad range of commercial activities. New leases and renewals of existing leases are negotiated at the current market rate at date of execution. The Company endeavors to require escalation provisions in all of its gross leases. As of December 31, 1993, approximately 38 percent of the annualized gross rental revenues was derived from existing leases containing rental escalation provisions based upon changes in the Consumer Price Index (some of which contain maximum rates of increase); approximately 56 percent was derived from leases containing escalation provisions based upon real estate tax and operating expense increases; and approximately 6 percent was derived from leases without escalation provisions. Some of the Company's leases contain options which allow the lessee to renew for varying periods, generally at the same rental rate and subject, in most instances, to Consumer Price Index escalation provisions. The Company owns approximately 295 acres of unimproved land suitable for development located in the metropolitan areas of Birmingham, Alabama; Jacksonville, Miami, Orlando and St. Petersburg, Florida; Atlanta, Georgia; Columbia and Greenville, South Carolina; Charlotte, Greensboro, and Raleigh, North Carolina; Memphis, Tennessee; Austin and San Antonio, Texas; Tulsa, Oklahoma; and Norfolk and Richmond, Virginia. A portion of this land has been partially or wholly developed with streets and/or utilities. Title to Property No examinations of title to real properties have been made for the purpose of this report. However, the Company obtained title insurance on all of its properties acquired prior to the Merger at the time of their purchases. Although no additional title insurance was obtained related to the properties acquired from KPI pursuant to the Merger, the Company succeeded to KPI's existing title policies on the properties acquired in the Merger. The Company believes that all of the real estate described herein as owned by the Company is owned in fee simple without encumbrances except for the leases and mortgages described in this report and other encumbrances which do not substantially interfere with the use of the properties or have a material adverse effect upon their values. Property Location and Other Information The following table sets forth information relating to the properties owned by the Company as of December 31, 1993. Land Number Net Improved Unimproved of Rentable with Bldgs Land Center Buildings Sq.Ft. (In Acres) (In Acres) Atlanta Chamblee 22 947,920 76.2 2.5 Atlanta Gwinnett 31.0 Austin 12 370,860 29.6 1.8 Birmingham 30.0 Charlotte Carmel 1 109,600 7.6 27.0 Charlotte East 11 468,820 39.9 3.9 Columbia Spring Valley 1.0 El Paso 14 251,930 19.6 Greensboro South 13 610,470 46.0 Greensboro Wendover 18.5 Greenville 8 290,560 24.7 4.5 Jacksonville Baymeadows 4 467,860 34.6 13.3 Jacksonville Central 32 677,680 48.4 0.4 Memphis Germantown 3 258,400 18.4 16.2 Memphis Kirby Gate 23.0 Miami 1 96,800 5.6 8.1 Norfolk West 1 59,680 4.0 16.0 Orlando Central 22 565,220 46.0 Orlando University 2 159,600 11.6 15.5 Raleigh Crossroads 1 77,500 9.1 28.0 Richmond South 23.0 San Antonio 26 788,670 63.5 11.0 St. Petersburg 15 519,320 64.4 7.2 Tallahassee Apalachee Pkwy 14 408,500 33.7 Tallahassee Capital Circle 4 300,700 23.3 Tulsa North 2 103,520 9.1 13.4 Tulsa South 11 372,760 26.9 219 7,906,370 642.2 295.3 Occupancy The following table sets forth, with respect to the Company's centers at December 31, 1993, the number of buildings, number of leases, net rentable square feet, weighted average leased rate, and the average effective annual rent per net rentable square foot. Lease Expirations on the Company's Properties The following schedule sets forth for each of the Company's centers (i) the number of tenants whose leases will expire in calendar years 1994 through 2002, (ii) the total area in square feet covered by such leases, (iii) the current annual rental represented by such leases, and (iv) the percentage of gross annual rental for such center contributed by such leases. This information is based on the buildings owned by the Company on December 31, 1993 and on the terms of leases in effect as of December 31, 1993, on the basis of then existing base rentals, and without regard to the exercise of options to renew. This table does not include tenants in possession where leases were in process of execution but were not delivered to the Company at December 31, 1993. Leases representing 23.0 percent, 28.5 percent and 16.2 percent of the Company's annual rentals at December 31, 1993 are due to expire in 1994, 1995, and 1996, respectively. Fixed Rate Indebtedness on the Company's Properties The following table shows indebtedness (dollars in thousands) encumbering each of the Company's properties which have fixed interest rates as of December 31, 1993. Weighted Mortgage Average Loan Interest Center Balance Rate Atlanta Chamblee $ 34,101 8.12% Atlanta Gwinnett 79 8.50% Austin 3,453 9.55% Birmingham 32 8.50% Charlotte Carmel 9,443 6.69% Charlotte East 14,702 8.22% El Paso 1,674 9.15% Greensboro South 23,953 8.74% Greenville 7,296 6.40% Jacksonville Baymeadows 35,773 6.67% Jacksonville Central 13,521 6.75% Memphis Germantown 13,554 8.57% Memphis Kirby Gate 68 8.50% Miami 8,061 6.68% Norfolk West 4,028 9.97% Orlando Central 18,625 8.20% Orlando University 9,845 6.56% Raleigh Crossroads 4,857 9.96% San Antonio 7,407 8.14% St. Petersburg 20,701 7.82% Tallahassee Apalachee Pkwy 15,837 6.69% Tallahassee Capital Circle 21,068 8.02% Tulsa North 9 8.50% Tulsa South 4,455 9.95% Total $272,542 8.12% For additional information concerning certain interest rate reset provisions and reset dates for these loans see Note 5, "Loan and Mortgages Payable" of the Notes to Consolidated Financial Statements. Indebtedness with Variable Interest Rates In addition to the above mortgage indebtedness, at December 31, 1993, the Company had $58,861,000 of loans outstanding with variable interest rates which are collateralized by mortgages on certain operating properties. These loans bear interest at rates based upon such institutions' prime rates. Information with respect to these loans is as follows (dollars in thousands): As of December 31, 1993, $27,625,000 of this indebtedness represents a bank loan which bears interest at prime plus 1/2 percent and matures on December 21, 1998, with an optional two year extension. Monthly payments include interest and fixed payments of principal which increase annually. This loan is collateralized by properties with a carrying value of approximately $49,888,000 at December 31, 1993. As of December 31, 1993, $10,278,000 of this indebtedness represents junior bank mortgage debt which was assumed from KPI pursuant to the Merger. This junior bank mortgage debt matures in December, 2000 and accrues interest at the prime rate of the respective lender. Accrued interest on this debt must be paid no later than December, 1998 and monthly interest payments are required beginning in January, 1999. The accrued interest on this debt is forgiven if the debt is paid in full prior to December, 1996. The junior bank mortgage debt is secured by properties that also serve as collateral for certain fixed rate senior bank mortgage debt assumed from KPI pursuant to the Merger. As of December 31, 1993, $20,958,000 of this indebtedness represents the outstanding balance of other mortgage debt assumed from KPI pursuant to the Merger. This debt bears interest at the respective institution's prime rate plus one percent with a minimum rate of 6.62 percent and a maximum rate of 10 percent. Interest only payments are due on a monthly basis and these loans mature in June, 2001. These loans are collateralized by properties with a carrying value of approximately $24,850,000 at December 31, 1993. Management Agreement Prior to the Merger, KMI was responsible for the leasing, operation, maintenance and management of each of the Company's properties. The management fee was five percent of the gross rental receipts collected on the property managed for the Company by KMI. For the years ended December 31, 1993, 1992, and 1991, the Company incurred management fee expense to KMI of $2,184,000, $2,314,000, and $2,281,000, respectively. With the Merger, the Company assumed all of the leasing and other management responsibilities for its properties including those acquired in the Merger. Item 3. Item 3. LEGAL PROCEEDINGS An action in the U. S. District Court, Middle District of Florida (the "District Court") was filed on October 11, 1990, by Gerald and Althea Best and Jerome Wilem, shareholders of the Company, against KPI, the Company, two subsidiaries of KPI (Koger Advisors, Inc. and KMI), Messrs. Allen R. Ransom (a former director of the Company), Ira M. Koger (a former director of the Company), S. D. Stoneburner, and W.F.E. Kienast (a former director of the Company), alleging that various press releases, shareholder reports, and/or securities filings failed to disclose and/or misrepresented the Company's business policies and seeking damages therefore (the "Securities Action"). William L. Coalson, a shareholder of the Company, was subsequently added as an additional plaintiff. The Company believes that the claims asserted in the Securities Action are without merit and intends to vigorously contest the Securities Action. A derivative action in the District Court was commenced on October 29, 1990, by Howard Greenwald and Albert and Phyllis Schlesinger, shareholders of the Company, against the Company, KPI, all of the then current directors of the Company, including: Ira M. Koger, James B. Holderman, Allen R. Ransom, Wallace F. E. Kienast, S. D. Stoneburner, Yank D. Coble, Jr., G. Christian Lantzsch, A. Paul Funkhouser and Stephen D. Lobrano, alleging breach of fiduciary duty by favoring KPI over the interest of the Company and failing to disclose or intentionally misleading the public as to the Company's cash flow, dividend and financing policies and status, and seeking damages therefor (the "Derivative Action"). During the course of the Derivative Action, the plaintiffs therein further alleged Mr. Lobrano was liable to the Company for certain alleged acts of legal malpractice. The Company's Board of Directors' Independent Litigation Committee, which was composed of outside independent members of the Company's Board of Directors, completed an extensive investigation of the facts and circumstances surrounding the Derivative Action, including the allegations against Mr. Lobrano. It was the conclusion of this committee that the ultimate best interest of the Company and its shareholders would not be served in prosecuting this litigation. Subsequently, the Company moved that the Derivative Action be dismissed under the provisions of Florida law. Thereafter, the plaintiffs filed a Second Amended and Supplemental Complaint which realleged the original cause of action ("Count I"); and realleged the cause of action against Stephen D. Lobrano ("Count II"); and a new cause of action against the members of the Special Litigation Committee for alleged violation of fiduciary duties in conducting its investigation ("Count III"). During 1993, the Company filed further motions seeking dismissal of the Second Amended and Supplemental Complaint. On January 27, 1994, the United States Magistrate issued his Report and Recommendation concerning the Derivative Action, which recommended that (1) Count I should be dismissed pursuant to the Special Litigation Committee Report, (2) Count III against the Special Litigation Committee members should be dismissed, and (3) Count II should not be dismissed. Both plaintiffs and the Company have filed objections to portions of this Report and Recommendation, which is now pending before the District Court. Pursuant to Florida Statutes Section 607.0850, the Indemnification Committee of the Company's Board of Directors has made an initial determination that certain officers and directors and former officers and directors of the Company who are defendants in each of the Securities Action and the Derivative Action are entitled to the advancement of expenses in defending these actions. This Committee will not make a final determination on indemnification of these defendants until a final resolution of these actions. The Committee has agreed to indemnify these defendants to the extent permitted by law. Should it be determined that any defendant was not entitled to indemnification, such defendant will be obligated to reimburse the Company for any expenses it has incurred or reimbursed in the defense of that defendant. In accordance with Florida law, each of the present and former directors and officers, who are defendants in the suits described above, have so agreed to reimburse the Company. Through December 31, 1993, the Company had paid in attorneys' fees and expenses incurred on behalf of itself, certain directors and officers and former directors and officers in connection with the Securities Action and the Derivative Action $351,865. On March 23, 1993, the Securities and Exchange Commission ("the Commission") entered an Order directing a private investigation with respect to KPI's accounting practices, including the accuracy of financial information included in certain reports filed with the Commission, possible insider trading in KPI's stock, and possible misleading statements concerning the financial condition of KPI and its ability to pay dividends to its shareholders. Prior to March 23, 1993, the Commission had been engaged in a confidential investigation without a formal order. As a result of the Merger of KPI with and into the Company, the Company has assumed responsibility for responding to the requests and subpoenas of the Commission staff in connection with this private investigation. Although the staff of the Commission had subpoenaed KPI documents and former employees of KPI, who are presently employees of the Company, for testimony, on February 8, 1994, the Commission staff advised the Company, through its counsel, that the scheduled depositions of former KPI employees and the review of documents of KPI had been suspended. The Company has received no communication from the Commission staff since the above notice of suspension. Based on the information currently available to the Company, it is unable to determine whether or not the private investigation will lead to formal legal proceedings or administrative actions or whether or not such legal proceedings or administrative actions will involve the Company. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is listed on the American Stock Exchange. The high and low closing sales prices for the periods indicated were: Years 1993 1992 1991 Quarter High Low High Low High Low March 31 $9 3/8 $4 3/8 $6 1/4 $4 1/8 $11 3/8 $7 1/2 June 30 8 1/2 7 1/8 5 5/8 4 5/8 11 8 1/2 September 30 9 7 1/8 5 5/8 4 3/4 9 3/4 4 December 31 9 1/4 7 3/4 5 1/4 3 1/2 6 3 1/4 The Company intends that the dividend payout in the last quarter of each year will generally be adjusted to reflect the distribution of at least 95 percent of the Company's real estate investment trust taxable income as required by the Federal income tax laws for qualification as a real estate investment trust. Set forth below are the dividends per share for the three years ended December 31, 1993. Years Quarter 1993 1992 1991 March 31 -- -- $.325 June 30 -- -- .325 September 30 -- -- .120 December 31 -- -- -- The terms of the Company's secured debt subjects the Company to certain dividend limitations which, however, will not restrict the Company from paying the dividends required to maintain its qualification as a REIT. In the event that the Company no longer qualifies as a REIT, additional dividend limitations would be imposed by the terms of such debt. In addition, two of the Company's bank lenders have required that until the Company has raised an aggregate of $50 million of equity the following limitations on dividends will be applied: (a) in 1996 and 1997, $11 million unless imposition of the limit would cause loss of REIT status and (b) in 1998 and 1999, $11 million regardless of impact on REIT status. On March 1, 1994, there were approximately 1,344 shareholders of record and the closing price of the Company's stock on the American Stock Exchange was $7.375. Item 6. Item 6. SELECTED FINANCIAL DATA The following selected financial data sets forth certain financial information of the Company as of or for the five periods ended December 31, 1993. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The following discussion should be read in conjunction with the selected financial data and the consolidated financial statements appearing elsewhere in this report. Historical results and percentage relationships in the Consolidated Financial Statements, including trends which might appear, should not be taken as indicative of future operations or financial position. The Company has prepared and is responsible for the accompanying consolidated financial statements and related consolidated financial information included in this report. These consolidated financial statements were prepared in accordance with generally accepted accounting principles and include amounts determined using management's best judgments and estimates of the expected effects of events and transactions that are being accounted for currently. The Company's independent auditors, Deloitte & Touche, have audited the accompanying consolidated financial statements. The objective of their audit, conducted in accordance with generally accepted auditing standards, was to express an opinion on the fairness of presentation, in all material respects, of the Company's consolidated financial position, results of operations and cash flows in conformity with generally accepted accounting principles. They evaluated the Company's internal control structure to the extent considered necessary by them to determine the audit procedures required to support their report on the consolidated financial statements and not to provide assurance on such structure. The Company maintains accounting and other control systems which management believes provide reasonable assurance that assets are safeguarded and that the books and records reflect the authorized transactions of the Company, although there are inherent limitations in any internal control structure, as well as cost versus benefit considerations. The Audit Committee of the Company's Board of Directors, which is composed exclusively of directors who are not officers of the Company, directs matters relating to audit functions, annually appoints the auditors, reviews the auditors' independence, reviews the scope and results of the annual audit, and periodically reviews the adequacy of the Company's internal control structure. RECENT DEVELOPMENTS Merger of KPI and the Company; Resolution of KPI Chapter 11 Case. On September 25, 1991, KPI filed a petition under the Bankruptcy Code in the Bankruptcy Court. The Company was the single largest creditor of KPI in the KPI Chapter 11 Case (indebtedness to the Company of approximately $116 million). On April 30, 1993, the Company and KPI jointly proposed the Plan which provided, among other things, for the merger of KPI with and into the Company in exchange for the issuance of the Shares and Warrants and the assumption of the restructured KPI indebtedness. On December 8, 1993, the Plan was confirmed by the Bankruptcy Court and the Merger became effective on December 21, 1993. Pursuant to the Merger, 6,158,977 Shares, or approximately 35 percent of the Shares outstanding after the Merger, and Warrants to purchase an aggregate of 644,000 Shares (3.5 percent of currently outstanding shares on a fully diluted basis) were issued under the Plan and Merger. The Warrants are to be exercisable until June 30, 1999 at $8.00 per share and are subject to redemption at the option of the Company at prices ranging from $1.92 to $5.24 per Warrant. With the Merger, the Company succeeded to substantially all of the assets of KPI, free and clear of all liens, claims and encumbrances, except (i) encumbrances relating to certain secured indebtedness of KPI (aggregating $182.6 million) which was restructured under the Plan and (ii) an option and a right of first refusal held by TKPL on certain developed buildings and parcels of undeveloped land, which are located in TKPL office centers. KPI assets acquired by the Company in the Merger included 93 buildings containing 3,848,130 net rentable square feet together with approximately 295 acres of unimproved land suitable for development, and 1,781,419 Shares held by KPI. As a result of the Merger, the Company assumed all of the leasing and other management responsibilities for its properties including those acquired in the Merger. The Company also acquired in connection with the Merger all of the debt and equity interest in TKPL previously owned by KPI. Under the provisions of the TKPL plan of reorganization, recovery of any value to the Company in respect of the foregoing debt and equity interests in TKPL is dependent upon the refinancing of the indebtedness restructured under the TKPL plan (approximately $149.7 million as of December 31, 1993) or sales of TKPL assets at prices sufficient to retire this indebtedness. The TKPL plan sets forth benchmarks for the accomplishment of retirement of certain of this indebtedness within four, five and six years, and requires that all such indebtedness be retired by June 1, 2000. In the event that refinancing or sale can be accomplished in the period prior to June 1, 1999, certain indebtedness may be retired at a discount. In the event that benchmarks for retirement of indebtedness are not met, the TKPL plan provides that an alternate general partner will assume responsibilities for operation and management of TKPL, and will initiate procedures to liquidate the assets of TKPL on an expedited basis. There is no assurance that necessary refinancing(s) and/or sale(s) can be achieved or that the alternate general partner will not assume control of TKPL. In view of the foregoing and the likelihood of satisfying such conditions, the Company has determined that its debt and equity interests in TKPL have no recoverable value. Debt Assumed Pursuant To The Merger. On December 21, 1993, the Company assumed approximately $182.6 million of restructured debt from KPI in connection with the Merger. Information with respect to such debt is as follows (in thousands): Balance Assumed KPI Restructured Debt 12/21/93 Senior Bank Mortgage Debt $ 83,992 Junior Bank Mortgage Debt 11,354 Insurance Company Mortgage Debt 60,707 Negative Amortization (Insurance Company Debt) 80 Other Mortgage Debt 21,168 Tax Notes 5,040 Mechanics' Liens 287 Total $182,628 For additional information concerning terms, interest rates, and maturity dates see "Loans and Mortgages Payable" footnote contained in the Notes to Consolidated Financial Statements. RESULTS OF OPERATIONS Rental Revenues. Rental revenues increased $151,000 from the year ended December 31, 1992, to the year ended December 31, 1993. This increase resulted primarily from (i) the rental revenues (from December 21, 1993 through December 31, 1993) from the 93 buildings acquired pursuant to the Merger (approximately $1,345,000) and (ii) increases in miscellaneous rental revenues during 1993. These increases to rental revenues were substantially offset by the decrease in rental revenues (approximately $1,311,000) on the 126 buildings which the Company owned the entire year. For 1992, rental revenues increased $564,000 from the year ended December 31, 1991. This increase resulted primarily from (i) increased billings to tenants for contingent rental revenues and (ii) the effect of reductions in the occupancy rate of the Company's buildings being partially offset by increased rental rates. At December 31, 1993, the Company's buildings were on average 88 percent leased. At December 31, 1992 and 1991, the Company's buildings were on average 88 and 91 percent leased, respectively. Interest Revenues. Interest revenues declined $25,000 from the year ended December 31, 1992 to the year ended December 31, 1993. This decline in interest revenues was due to (i) lower interest rates earned on the Company's temporary cash investments and (ii) the lower average balance of cash to invest. For 1992, interest revenues decreased $6,868,000 from the year ended December 31, 1991. This decrease resulted from the failure of KPI to pay contractual interest due on or after September 30, 1991, under the Restated Credit Agreement and the Land Credit Agreement. During the KPI Chapter 11 Case, the Company ceased to record interest on loans under the Restated Credit Agreement and the Land Credit Agreement. As a result of declines in the estimated fair value of the collateral underlying such loans to KPI prior to the Merger, which had been deemed foreclosed in-substance, the Company recorded a provision for loss in the amount of $18.7 million through December 21, 1993. This included a $2.0 million provision recorded during 1992 based upon management's periodic evaluation of collateral values. During 1993, 1992, and 1991, interest revenues on loans to KPI under the Credit Agreement and Restated Credit Agreement totalled $0, $0, and $4,786,000, respectively. The Credit Agreement and Restated Credit Agreement loans had floating interest rates based on the average yield of U. S. Treasury Notes maturing in three years plus 2.5 percent, with an 11 percent floor and a 13 percent ceiling. On the effective date of the Merger, the Company received the collateral for the Restated Credit Agreement loans in full satisfaction of these loans. During 1993, 1992, and 1991, interest revenues on loans to KPI under the Land Credit Agreement (the "Land Loans") totalled $0, $0, and $1,934,000. The Land Loans contractually earned interest at a fixed rate of 10.25 percent and were to mature in November, 2000. The Company did not receive any debt service payments in respect of the Land Loans during the pendency of KPI's Chapter 11 Case. On the effective date of the Merger, the Company received the collateral for the Land Credit Agreement loans in full satisfaction of these loans. Management Fee Revenues. During 1993, the Company earned $92,000 of management fees from TKPL and third party management contracts which it assumed from KPI on the date of the Merger. Management fee revenue does not qualify as passive income for purposes of determining whether the Company has met the REIT requirement that at least 95 percent of the Company's gross income is derived from passive sources. Accordingly, in the event the Company derives income in excess of five percent from management and other "non-passive" activities, the Company would no longer qualify as a REIT for federal income tax purposes. Expenses. Property operating expenses include such charges as utilities, taxes, janitorial, maintenance, and property insurance. During 1993, property operating expenses and management fees increased $1,311,000 or 6.8 percent, compared to 1992, primarily due to (i) the operating expenses (from December 21, 1993 through December 31, 1993) on the 93 buildings acquired pursuant to the Merger (approximately $546,000) and (ii) increases in real estate taxes, utilities and maintenance costs on the 126 buildings owned by the Company for the entire year. During 1992, property operating expenses and management fees increased $839,000 or 4.5 percent primarily due to increases in maintenance costs on the Company's buildings, which was partially offset by reductions in real estate taxes and utility costs during 1992. For 1993, property operating expenses and management fees as a percent of rental revenues were 44.9 percent. For 1992 and 1991, property operating expenses and management fees as a percent of rental revenues were 42.2 percent and 40.8 percent, respectively. In 1993, the increase in the percent of operating expenses and management fees to rental revenues was primarily due to decreases in rental revenues and increases in real estate taxes, utilities and maintenance costs on the 126 buildings owned by the Company for the entire year. In 1992, the increase in the percent of operating expenses and management fees to rental revenues was due to the increase in maintenance costs of the Company's buildings. Depreciation expense has been calculated on the straight-line method based upon the useful lives of the Company's depreciable assets, generally 5 to 40 years. For 1993, depreciation expense increased $731,000 or 9.5 percent compared to the prior year due to improvements made to the Company's existing properties during 1993 and 1992. For 1992, depreciation expense increased $544,000 or 7.6 percent compared to the prior year due to improvements made to the Company's existing properties during 1991 and 1992. For 1993, amortization expense increased $138,000 compared to the prior year due to amounts incurred for loan financing costs, deferred tenant costs, and goodwill related to the Merger during the year. For 1992, amortization expense increased $61,000 compared to the prior year due to amounts incurred for loan financing costs and deferred tenant costs during the year. Under an advisory agreement with Koger Advisors, Inc. ("KA"), which was terminated by the Company on December 31, 1991, the Company reimbursed KA for actual costs incurred in performing advisory services. Advisory expenses were 0.1 percent of average annualized invested assets for 1991. General and administrative expenses were 0.6 percent, 1.0 percent, and 0.5 percent of average annualized invested assets for 1993, 1992, and 1991, respectively. For 1993, general and administrative expenses decreased $1,664,000 compared to the prior year primarily due to the reduction of required legal and professional services for dealing with the KPI Chapter 11 Case. For 1992, general and administrative expenses increased $1,963,000 primarily due to (i) the transfer of general and administrative functions from KA to the Company and (ii) increases in legal fees and professional fees, principally related to the KPI Chapter 11 Case. Total interest expense decreased by $59,000 during 1993 primarily because the average outstanding balance of the Company's loans and mortgages payable declined. This more than offset the interest expense on the KPI restructured debt assumed pursuant to the Merger from December 21, 1993 to the end of the year. Total interest expense decreased by $1,535,000 during 1992 primarily as a result of the decline in the prime rate, which was the contractual interest rate for the Company's bank loans. During 1993, 1992, and 1991, the weighted average interest rate on the Company's variable rate loans was 6.2 percent, 6.2 percent, and 7.9 percent, respectively. The average amount of these loans outstanding for the Company during 1993, 1992, and 1991 was $95,110,000, $98,918,000, and $96,481,000, respectively. Operating Results. Net income totalled $2,452,000 and $933,000 for 1993 and 1992, respectively, and net loss totalled $5,949,000 for 1991. For 1993, net income increased over the prior year primarily because reductions in the provision for loan losses and general and administrative expenses were partially offset by increases in property operations expense and depreciation and amortization expense. For 1992, the increase is primarily due to the reduction in provision for loan losses (from $16.7 million to $2.0 million) and the reduction in total interest expense (from $13.1 million to $11.5 million), which was largely offset by the reduction in interest revenues and the increases in property operating expenses, depreciation and amortization expense, and general and administrative expenses. Management periodically reviews its investment in properties for evidence of other than temporary impairments in value. Factors considered consist of, but are not limited to, the following: current and projected occupancy rates, market conditions in different geographic regions, and management's plans with respect to its properties. Where management concludes that expected cash flows will not enable the Company to recover the carrying amount of its investments, losses are recorded and asset values are reduced. No such impairments in value existed during 1993, 1992 or 1991. LIQUIDITY AND CAPITAL RESOURCES Operating Activities. The Company's primary internal sources of cash are the collection of rents in respect of buildings owned and, prior to KPI's bankruptcy filing in 1991, receipt of interest on its loans outstanding to KPI under the Restated Credit Agreement and the Land Credit Agreement. On the effective date of the Merger, the Company acquired all of the collateral for the loans to KPI under the Restated Credit Agreement and the Land Credit Agreement in full satisfaction of these loans. As a real estate investment trust for Federal income tax purposes (a "REIT"), the Company is required to pay out annually, as dividends, 95 percent of its REIT taxable income (which, due to non-cash charges, including provision for losses and depreciation, may be substantially less than cash flow). In the past, the Company has paid out dividends in amounts at least equal to its taxable income. The Company believes that its cash provided by operating activities will be sufficient to cover debt service payments, and to pay the dividends required, if any, to maintain REIT status through 1994. As set forth in the Notes to Consolidated Financial Statements and in Results of Operations above, because of a decline in the estimated fair value of collateral which secured the loans to KPI foreclosed in-substance prior to the Merger, the Company had recorded a total provision for loss on such loans of $18.7 million through December 21, 1993. The level of cash flow generated by rents depends primarily on the occupancy rates of the Company's buildings and increases in effective rental rates on new and renewed leases and under escalation provisions. As of December 31, 1993, approximately 94 percent of the Company's annualized gross rental revenues were derived from existing leases containing provisions for rent escalations. However, market conditions may prevent the Company from escalating rents under said provisions. At December 31, 1993, leases representing approximately 23.0 percent of the gross annual rent from the Company's properties, without regard to the exercise of options to renew, were due to expire during 1994. Leases were renewed on approximately 74 percent and 60 percent of the Company's net rentable square feet which expired during 1993 and 1992, respectively. With the current economic conditions, certain of these tenants may not renew their leases or may reduce their demand for space. Based upon the significant amount of leases which will expire during 1994 and the intense competition for tenants in the markets in which the Company operates, the Company has and expects to continue to offer incentives to certain new and renewal tenants, such as reduced rent during initial lease periods and payment of tenant improvements costs, which the Company expects will require greater capital expenditures in 1994 than in 1993. Although most of the Company's leases permit it to increase rents annually to reflect increases in the Consumer Price Index or increases in real estate taxes and certain operating expenses, the Company has chosen, for competitive reasons, in certain cases not to demand the full increase permitted. In addition, current market conditions may require that rental rates at which leases are renewed or at which vacated space is leased be lower than rental rates under existing leases. These factors may result in reduced occupancy rates for the Company's buildings which could result in reduced levels of cash flow generated by operations. The Company cannot predict with any certainty the degree to which the current economic conditions will affect its operations, however, slower economic growth in the markets in which the Company owns buildings may result in lower occupancy rates for, and reduced cash flow from, the Company's properties. Governmental tenants (including the State of Florida and the United States Government) which account for 22 percent of the Company's leased space at December 31, 1993, may be subject to budget reductions in times of recession and governmental austerity. There can be no assurance that governmental appropriations for rents may not be reduced. Additionally, with the current economic conditions related to the rental of office space, certain of the private sector tenants which have contributed to the Company's rent stream may reduce their current demands or curtail their need for additional office space. Investing Activities. At December 31, 1993, all of the Company's invested assets were in properties. Improvements to the Company's existing properties have been financed through internal operations. During 1993, the Company's expenditures for improvements to existing properties increased by $3,449,000 over the prior year due to (i) increased building improvement activity, (ii) increased leasing activity and longer term renewal activity related to lease expirations in 1993, and (iii) the acquisition of 93 buildings on December 21, 1993 pursuant to the Merger. Prior to the Merger, purchases of properties were made from KPI under the Purchase Agreement. During 1992 and 1991, the Company did not purchase any buildings. With the consummation of the Merger, the Company acquired 93 additional buildings generally located in Koger Centers in which the Company previously owned buildings. Management of the Company believes that the Merger will result in advantages to the Company in three significant areas. First, management believes that the Merger represented the most expeditious and advantageous method of resolving the uncertainty about the financial condition of the Company which existed because of the KPI Chapter 11 Case. Second, by achieving common ownership and management of buildings within the Koger Centers where the Company and KPI had both owned buildings, the combined entity will be in a position to maximize the values of all assets. Third, as one of the largest publicly-held REIT's, management believes that the combined entity will have access to sources of new debt or equity capital which neither of the Company nor KPI would have had alone, although there can be no assurance additional debt or equity can be raised by the Company on terms acceptable to it. While the Company believes that the resolution of the KPI Chapter 11 Case, and consummation of the Merger has provided such advantages, the terms of the restructured indebtedness of KPI assumed by the Company and the modified terms of the Company's existing indebtedness will require that a substantial portion of any debt or equity financing achieved by the Company during the foreseeable future be applied to the reduction of the current secured indebtedness of the Company. The Company's restructured debt contains provisions requiring the Company to use the first $50 million of proceeds from any equity offering to pay down certain debt. To the extent that the equity offering proceeds exceed $50 million, one half of the excess must be used to pay down certain debt with the remainder being available for use at the Company's discretion. In addition, the Company's bank loans contain certain principal prepayment obligations in addition to normal principal repayment. Two of these bank loans require that the Company make additional principal payments totalling $10 million by December, 1998. Another bank loan provides that the Company must reduce the principal balance of this loan, which existed at the date of the Merger, by $5 million (less the amount of scheduled principal payments which are $2,150,000 in the aggregate) by December, 1996. Under such circumstances, it is unlikely that the Company will have financial resources available to complete any significant additional purchases of income-producing properties, even if the Company determined that such purchases were otherwise available. During the quarter ended June 30, 1991, the Company loaned $10 million to KPI under a promissory note which was collateralized by a pledge of the Company's stock owned by KPI. On June 29, 1991, the Company repurchased 1,081,081 shares of its common stock from KPI, payment for which was made by giving KPI full credit against the $10 million loan. Financing Activities. Historically, the Company's primary external sources of cash have been bank borrowings, mortgage financings, and public offerings of equity securities. The proceeds of these financings have been used by the Company to acquire additional buildings under the Purchase Agreement and, in anticipation of such acquisitions, had been loaned to KPI under the Restated Credit Agreement and the Land Credit Agreement. At December 31, 1993, the Company had no uncollateralized loans outstanding to banks under short-term open lines of credit. During 1991, the Company adopted a program to refinance its uncollateralized indebtedness with financing which was more closely matched in term with the long-term nature of its assets. Through March 31, 1991, the Company had converted $30 million of an open line into a term loan which originally matured in January, 1992. The maturity date on this loan was extended on several occasions through the date of the Merger. The Company had a revolving line of credit with another bank which bore interest at the bank's prime rate and matured on December 31, 1992, at which time the outstanding balance of the loan, which also represented the maximum amount available under this line of credit, was $43,648,000. On January 1, 1993, this loan was converted to a term loan which would have been amortized over 25 years by equal quarterly payments for principal reduction plus interest at the bank's prime rate. The lender had the option to require payment of the outstanding principal at the end of 24 months from the commencement of the term period and at the expiration of each successive 24 month period thereafter. This loan renewed and modified an existing unsecured line of credit in the original principal amount of $25 million. From the proceeds of this loan, the Company also repaid an additional $20 million of its uncollateralized lines of credit owed to another bank. During the quarter ended June 30, 1991, the Company restructured an existing demand line of credit with another bank and borrowed an additional $9,365,000 which increased the total loan outstanding to $25,365,000. On September 30, 1991, the Company borrowed an additional $458,000 which increased the total loan outstanding to $25,823,000. The loan converted on that date to a two-year term loan collateralized by certain properties. In December, 1993, in connection with the Merger and the resolution of the KPI Chapter 11 Case, the Company entered into agreements with its three major bank lenders which provided for revised terms and conditions, including extended maturity dates, interest rates and amortization schedules. With respect to approximately $72.7 million of secured bank indebtedness, the maturity of that indebtedness has been extended to December 21, 2000. During the first three years of this term, the interest rate is fixed at 6.42 percent per annum for approximately $47.7 million and at 6.386 percent per annum for approximately $25 million. During the remaining four years of the term, the interest rate will be set at a rate equal to the sum of (x) the effective interest rate prevailing on December 21, 1996 for U.S. Treasury Obligations having a term to maturity of four years plus (y) 210 basis points, subject to a maximum of 11 percent per annum. Amortization with respect to this indebtedness will be based on equal monthly installments over a twenty-five year amortization period. The Company will be required to make additional principal payments totalling approximately $10 million on December 21, 1998, although the Company's obligation to do so would be reduced to the extent that it had made prepayments in respect of secured indebtedness to such lenders out of equity proceeds during the first three years after the Merger. These lenders have required that until the Company has raised an aggregate of $50 million of equity the following limitations on dividends will be applied: (a) in 1996 and 1997, $11,000,000 unless imposition of the limit would cause loss of REIT status and (b) in 1998 and 1999, $11,000,000 regardless of impact of REIT status. With respect to approximately $27.6 million of bank indebtedness of the Company, the maturity has been extended to December 21, 1998 with interest at the prime rate of the specific bank plus one-half percent per annum. On or before December 21, 1996, the Company will be required to repay not less than $5 million of principal of this indebtedness. If the Company pays an additional $5 million prior to December 21, 1998, the maturity will be extended to seven years. Distributions of equity proceeds to this lender made consistent with the terms of the Plan will be a credit against approximately $8 million of these required principal payments. In addition, each of these lenders have required affirmative and negative covenants and other agreements which may become burdensome to the Company. In particular, all three bank lenders have required that, commencing on the fifth anniversary of the Effective Date, the Company maintain a debt to net worth ratio of 1.0 to 1, that the Company maintain loan-to-value ratios determined on the basis of periodic appraisals of bank collateral and that, under certain circumstances, additional collateral be provided for indebtedness to such bank. At December 31, 1993, the debt to net worth ratio of the Company was 1.2 to 1.0. In addition, each of these bank lenders have required other covenants generally similar to the provisions set forth in the Plan with respect to the KPI restructured debt. These other covenants include reporting requirements, provisions limiting the amount of annual dividends, limitations regarding additional debt, and general and administrative expense limitations. In addition, the Company is also required to maintain certain financial ratios. With the consummation of the Merger, the Company assumed approximately $182.6 million of KPI restructured debt. At December 31, 1993, the outstanding balance of this debt was approximately $181 million. For additional information concerning terms, interest rates, and maturity dates see "Loans and Mortgages Payable" footnote in the Notes to Consolidated Financial Statements. Based upon current interest rates and assuming only scheduled principal payments for 1994, management expects total interest expense for 1994 to increase to approximately $25.5 million. In addition, the high degree of leverage of the Company may result in the impairment of its ability to obtain additional financing, to make acquisitions, and to take advantage of significant business opportunities that may arise, including activities which require significant funding. This high degree of leverage may also increase the vulnerability of the Company to adverse general economic and industry conditions and to increased competitive pressures, especially rental pressures from less highly leveraged competitors. In order to generate funds sufficient to make principal payments in respect of indebtedness of the Company over the longer term, as well as necessary capital and tenant acquisition expenditures, the Company will be required to successfully complete refinancings of its indebtedness or procure additional equity capital. However, there can be no assurance that any such refinancings or equity investments will be achieved or will generate adequate funds on a timely basis for these purposes. If additional funds are raised by issuing equity securities, further dilution to existing shareholders may result. Moreover, under the terms of the Plan, the Company will be required to utilize the first $50 million of any proceeds from the sale of equity securities, as well as 50 percent of such proceeds in excess of $50 million, to reduce secured indebtedness. The prepayments generally will be made pro rata among the holders of secured indebtedness and will not generally relieve the Company of the obligation to meet maturities on the remaining secured indebtedness. Unfavorable conditions in the financial markets, the high degree of leverage of the Company, restrictive covenants contained in its debt instruments and various other factors may limit the ability of the Company to successfully undertake any such financings and no assurance can be given as to the availability of alternative sources of funds. In addition, in the event the Company is unable to generate sufficient funds to meet principal payments in respect of its indebtedness and distribution requirements of 95 percent of annual REIT taxable income to its shareholders, the Company may be unable to qualify for REIT status under the Internal Revenue Code of 1986. In such an event, the Company will incur federal income taxes and perhaps penalties, and may be required to decrease the payment of dividends to its shareholders, and the market price of the Company's Shares may decrease. The Company would also be prohibited from requalifying for status as a REIT for tax purposes for five years. IMPACT OF INFLATION The Company may experience increases in its expenses as a result of inflation; however, the amount of such increases cannot be accurately determined. The Company attempts to pass on inflationary cost increases through escalation clauses which are included in most leases. However, market conditions may prevent the Company from escalating rents. Inflationary pressure may increase operating expenses, including labor and energy costs (and, indirectly, property taxes) above expected levels, at a time when it may not be possible to increase lease rates to offset such higher operating expenses. In addition, inflation can have secondary effects upon occupancy rates by decreasing the demand for office space in many of the markets in which the Company will operate. At December 31, 1993, 94 percent of the Company's annualized rentals were subject to leases having annual escalation clauses as described under Item 2 "Properties," above. At December 31, 1992 and 1991, 94 percent of the Company's annualized rentals were subject to leases having annual escalation clauses. The interest rate on approximately $58,861,000 of the Company's debt is floating. Interest rates on the Company's remaining debt is subject to reset at various dates through December 21, 2003, based upon then current interest rates for U.S. Treasury obligations. Therefore, the interest rates payable from time to time on this debt will reflect changes in underlying market rates of interest, and thus be subject to the effects of inflation. Historically, inflation has often caused increases in the value of income- producing real estate through higher rentals. The Company, however, can provide no assurance that inflation will increase the value of its properties in the future. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page Independent Auditors' Report 27 Consolidated Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992 28 Consolidated Statements of Operations for Each of the Three Years in the Period Ended December 31, 1993 29 Consolidated Statements of Changes in Shareholders' Equity for Each of the Three Years in the Period Ended December 31, 1993 30 Consolidated Statements of Cash Flows for Each of the Three Years in the Period Ended December 31, 1993 31 Notes to Consolidated Financial Statements for Each of the Three Years in the Period Ended December 31, 1993 32 Financial Statement Schedules: Schedule IV - Indebtedness of Related Parties for Each of the Three Years in the Period Ended December 31, 1993 50 Schedule X - Supplementary Income Statement Information for Each of the Three Years in the Period Ended December 31, 1993 51 Schedule XI - Real Estate and Accumulated Depreciation as of December 31, 1993 52 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Koger Equity, Inc. Jacksonville, Florida We have audited the accompanying consolidated balance sheets of Koger Equity, Inc. and subsidiaries (the "Company") as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in 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 8. These financial statements and financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Koger Equity, 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. 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 9 to the consolidated financial statements the Company is a defendant in a class action proceeding and a derivative action and has an indemnity agreement with certain former directors of KPI. The ultimate outcome of these uncertainties cannot presently be determined. Accordingly, no provision for any loss that may result upon resolution of these matters has been made in the accompanying consolidated financial statements. DELOITTE & TOUCHE Jacksonville, Florida March 4, 1994 KOGER EQUITY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1993 AND 1992 (In Thousands Except Share Data) 1993 1992 ASSETS Real Estate Investments: Operating properties $565,957 $311,261 Furniture and equipment 813 25 Accumulated depreciation (30,706) (22,300) Operating properties - net 536,064 288,986 Undeveloped land held for investment 33,054 Undeveloped land held for sale, at lower of cost or market value 6,982 Loans to Koger Properties, Inc. foreclosed in-substance, net 94,889 Cash and temporary investments 18,566 9,283 Accounts receivable, net 3,030 1,910 Receivable from The Koger Partnership, Ltd. 634 Cost in excess of fair value of net assets acquired from KPI, net of accumulated amortization of $23 11,623 Other assets 5,136 1,773 TOTAL ASSETS $615,089 $396,841 LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities Mortgages and loans payable $330,625 $155,362 Accounts payable 3,945 1,009 Payable to Koger Properties, Inc. 1,644 Accrued interest 294 823 Accrued real estate taxes payable 1,201 719 Dividends payable to Koger Properties, Inc. 214 Other liabilities 3,574 1,556 Total Liabilities 339,639 161,327 Commitments and Contingencies (Notes 2, 3, 4 and 9) - - Shareholders' Equity Common stock, $.01 par value; 100,000,000 shares authorized; issued: 20,471,577 and 14,312,500 shares; outstanding 17,597,177 and 13,219,519 shares 205 143 Capital in excess of par value 318,574 267,824 Warrants 1,368 Accumulated dividends in excess of net income (19,872) (22,324) Treasury stock, at cost; 2,874,400 and 1,092,981 shares (24,825) (10,129) Total Shareholders' Equity 275,450 235,514 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $615,089 $396,841 See Notes to Consolidated Financial Statements. KOGER EQUITY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 (In Thousands Except Per Share Data) 1993 1992 1991 Revenues Rental $46,108 $45,957 $45,393 Interest 206 231 7,099 Management fees ($89 from TKPL) 92 Total revenues 46,406 46,188 52,492 Expenses Property operations 18,507 17,066 16,260 Management fee to Koger Management, Inc. 2,184 2,314 2,281 Depreciation and amortization 8,958 8,089 7,484 Mortgage and loan interest 11,471 11,530 13,065 General and administrative 2,411 4,075 2,112 Provisions for losses on loans to Koger Properties, Inc. foreclosed in-substance 1,982 16,700 Provision for uncollectible rents 343 199 Direct cost of management fees 56 Undeveloped land costs 24 Advisory fee 539 Total expenses 43,954 45,255 58,441 Net Income(Loss) $ 2,452 $ 933 $(5,949) Earnings(Loss) Per Common Share $ 0.18 $ 0.07 $ (0.43) See Notes to Consolidated Financial Statements. KOGER EQUITY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 (In Thousands) 1993 1992 1991 Operating Activities Net income (loss) $ 2,452 $ 933 $(5,949) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 8,958 8,089 7,484 Provision for losses on loans to KPI foreclosed in-substance - 1,982 16,700 Provision for uncollectible rents 343 199 - Amortization of mortgage discounts 267 216 - Accrued interest added to principal 38 - - Total 12,058 11,419 18,235 Changes in assets and liabilities, net of effects from purchase of assets from KPI: Increase (decrease) in accounts payable, accrued liabilities and other liabilities (104) 270 924 Increase (decrease) in payable to KPI 1,287 (160) (709) Increase in receivables and other assets (1,316) (1,076) (53) Net cash provided by operating activities 11,925 10,453 18,397 Investing Activities Improvements to properties (6,423) (2,974) (3,603) Deferred tenant costs (598) (297) (189) Additions to furniture and equipment - (19) - Merger costs (4,221) - - Cash acquired in purchase of assets from KPI 15,596 - - Investments in loans to KPI - - (10,000) Payments received on loans to KPI - Cash Collateral Order 1,392 1,181 95 Net cash provided by (used in) investing activities 5,746 (2,109) (13,697) Financing Activities Proceeds from exercise of stock options 1 - - Dividends paid - - (10,668) Proceeds from loans - net - - 9,642 Principal payments on mortgages and loans (7,670) (2,227) (2,855) Financing costs (719) - - Net cash used in financing activities (8,388) (2,227) (3,881) Net increase in cash and cash equivalents 9,283 6,117 819 Cash and cash equivalents - beginning of year 9,283 3,166 2,347 Cash and cash equivalents - end of year $ 18,566 $ 9,283 $ 3,166 See Notes to Consolidated Financial Statements. KOGER EQUITY, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES. Organization. Koger Equity, Inc. was incorporated in Florida on June 21, 1988. Koger Properties, Inc. ("KPI") had maintained a 20 percent interest in Koger Equity, Inc. through June 28, 1991. On June 29, 1991, Koger Equity repurchased 1,081,081 shares of its common stock from KPI, which reduced KPI's percentage ownership to 13.5 percent of Koger Equity's issued and outstanding shares. On December 21, 1993, KPI was merged with and into Koger Equity, Inc. (the "Merger"). Principles of Consolidation. The consolidated financial statements include the accounts of Koger Equity, Inc. and its wholly owned subsidiaries (the "Company"). All material intercompany accounts have been eliminated in consolidation. Real Estate Investments. Operating properties, furniture and equipment, and undeveloped land held for investment are stated at cost less accumulated depreciation. Undeveloped land held for sale is carried at the lower of cost or market value. The Company's debt and equity interest in The Koger Partnership, Ltd. acquired from KPI were determined by management to have no assignable value. Periodically, management reviews its portfolio of operating properties and undeveloped land held for investment and in those instances where properties have suffered an impairment in value that is deemed to be other than temporary, the properties will be reduced to their net realizable value. This review includes a quarterly analysis of occupancy levels and rental rates for the Company's properties in order to identify properties which may have suffered an impairment in value. Management prepares estimates of future cash flows for these properties to determine whether the Company will be able to recover its investment. In making such estimates, management considers the conditions in the commercial real estate markets in which the properties are located, current and expected occupancy rates, current and expected rental rates, and expected changes in operating costs. As of December 31, 1993, there were no such impairments in value. Maintenance and repairs are charged to operations. Acquisitions, additions, and improvements are capitalized. Prior to the Merger, loans foreclosed in-substance consisted of loans to KPI accounted for as foreclosed property even though actual foreclosure had not occurred. The carrying value of these loans was reduced to the estimated fair value of the underlying collateral, less estimated selling costs, in 1991 when in-substance foreclosure occurred. At that time, the Company determined the estimated fair value of the underlying collateral by obtaining appraisals on certain property and performing forecasted discounted cash flow analyses on other property. The forecasted discounted cash flow analyses were reviewed by an independent appraiser. The Company periodically reviewed the estimated fair value of the underlying collateral and as a result had established an additional allowance for loss in 1992. During 1992, this review consisted of obtaining new appraisals, updating previous appraisals and performing updated forecasted discounted cash flow analyses based on market assumptions provided by an independent appraiser. During 1993, this review consisted of performing updated discounted cash flow analyses. The underlying collateral for these loans was obtained by the Company with the consummation of the Merger. Cash collateral order payments received on these loans were recorded as reductions to principal. Depreciation and Amortization. The Company uses the straight-line method for depreciation and amortization. Acquisition costs and building and tenant improvements are depreciated over the periods benefitted by the expenditures which range from 5 to 40 years. Deferred tenant costs are amortized over the term of the related leases. Deferred financing charges are amortized over the terms of the related agreements. Cost in excess of fair value of net assets acquired related to the Merger is being amortized over 15 years. Revenue Recognition. Rentals are generally recognized as revenue over the lives of leases according to provisions of the lease agreements. However, the straight-line basis, which averages annual minimum rents over the terms of leases, is used to recognize minimum rent revenues under leases which provide for material varying rents over their terms. Interest income is recognized on the accrual basis on interest-earning investments. Interest for which payment was due, based upon the contractual provisions of the loans to KPI under the Restated Credit Agreement and the Land Credit Agreement, after KPI filed a petition under Chapter 11 of the United States Bankruptcy Code in September 1991 and through the date of the Merger, was not accrued. Federal Income Taxes. The Company is qualified and has elected tax treatment as a real estate investment trust under the Internal Revenue Code (a "REIT"). Accordingly, the Company distributes at least 95 percent of its REIT taxable income to its shareholders. Since the Company had no REIT taxable income in 1993 or 1992, no distributions to shareholders were made. To the extent that the Company pays dividends equal to 100 percent of real estate investment trust taxable income, the earnings of the Company are taxed at the shareholder level. Earnings (Loss) Per Common Share. Earnings (loss) per common share have been computed based on the weighted average number of shares of common stock outstanding (13,351,525 shares for the year ended December 31, 1993, 13,219,519 shares for the year ended December 31, 1992, and 13,749,693 shares for the year ended December 31, 1991). There were no dilutive common equivalent shares outstanding during the years ended December 31, 1993, 1992, and 1991. Fair Value of Financial Instruments. The Company believes that the carrying amount of its financial instruments (cash and short-term investments, accounts receivable, loans to KPI foreclosed in-substance, accounts payable, and mortgages and loans payable) is a reasonable estimate of fair value of these instruments. Statements of Cash Flows. Cash in excess of daily requirements is invested in short-term monetary securities. Such temporary cash investments have an original maturity of less than three months and are deemed to be cash equivalents for purposes of the statements of cash flows. During 1993, KPI was merged with and into the Company. Pursuant to the Merger, the Company received the collateral for the loans to KPI, which were accounted for as foreclosed in-substance, in full satisfaction of those loans. As of December 21, 1993, the loans to KPI foreclosed in-substance had a carrying value of approximately $93,498,000 which was management's best estimate of the fair value of the collateral received ($121,743,000) less the mortgage debt related to such collateral ($28,245,000) which was assumed by the Company. In addition, the Company acquired the remaining assets and liabilities of KPI by issuing 6,158,977 shares of the Company's common stock and warrants to purchase 644,000 shares of the Company's common stock. The following represents the fair value of the KPI assets acquired and liabilities assumed by the Company pursuant to the Merger in exchange for the Company's common stock and warrants (in thousands). Fair value of assets and treasury stock acquired, including cash of $15,596 $215,855 Fair value of common stock and warrants issued and direct merger costs (56,461) Fair value of liabilities assumed $159,394 During 1991, the Company converted $30,000,000, of a $50,000,000 uncollateralized line of credit, into a term loan collateralized by certain buildings. The remaining $20,000,000 portion of this credit facility plus $418,000 in related financing costs were repaid from the proceeds of a revolving line of credit from another bank. In addition, in 1991 the Company loaned $10,000,000 to KPI under a promissory note which was collateralized by a pledge of the Company's stock owned by KPI. On June 29, 1991, the Company repurchased 1,081,081 shares of its common stock from KPI, payment for which was made by giving full credit against the $10,000,000 loan. The purchase was based upon the composite closing price per share of the Company's common stock on June 28, 1991, of $9.25. For 1993, 1992, and 1991, total interest payments were $12,421,000, $10,693,000, and $13,129,000, respectively, for the Company. Reclassification. Certain 1992 amounts have been reclassified to conform with 1993 presentation. 2. TRANSACTIONS WITH RELATED PARTIES. General. The Company was incorporated for the purpose of investing in the ownership of income producing properties, primarily commercial office buildings developed by KPI. On September 25, 1991, KPI and The Koger Partnership, Ltd. ("TKPL"), a Florida limited partnership of which KPI was the managing general partner, filed petitions under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code"). On August 10, 1993, TKPL completed the establishment of a $4.5 million reorganization financing facility which represented the fulfillment and the final condition to TKPL's emergence from bankruptcy and, as a result, the plan of reorganization for the TKPL Chapter 11 Case became effective as of June 1, 1993. On December 21, 1993, KPI was merged with and into the Company. Purchase Agreement. Under a purchase agreement (the "Purchase Agreement") with KPI and its subsidiaries, through December 31, 1990, the Company purchased an aggregate of 126 buildings for $299.9 million. In connection with such purchases, the Company purchased $80.6 million of buildings in 1988 for cash. Subsequent buildings were purchased by either assuming previously existing indebtedness of the selling entity secured by the purchased properties or by reducing the amount of indebtedness outstanding under a Credit Agreement between the Company as lender and KPI and its affiliates, as borrowers, dated August 25, 1988, as amended (the "Credit Agreement"). The total of previously existing indebtedness assumed was $32,377,000 related to the purchase of 30 buildings. The Purchase Agreement established, and the purchase transactions were accomplished with procedures, including independent appraisals, which required that each purchase transaction be conducted in good faith, and at purchase prices, which in the Company's opinion, provided not less than a reasonably equivalent value to the seller in each instance. Loans to KPI Foreclosed In-Substance. As of December 31, 1990, the Company and KPI entered into an Amended and Restated Credit Agreement (the "Restated Credit Agreement") which replaced the Credit Agreement. These loans were collateralized by first and second mortgages and assignments of rents on 62 completed office buildings and two parcels of land held for future development which were owned by KPI and located in existing Koger Centers in which the Company owned buildings or claimed rights under the Purchase Agreement. These loans bore interest at a floating rate, adjusted quarterly and determined by adding 2.5 percent to the average yield for the prior quarter on U. S. Treasury Notes maturing three years after any date during such quarter but not less than 11 percent or more than 13 percent. KPI failed to make the interest payments due on this loan as of September 30, 1991, did not make contractual interest payments after that date, and was in default by reason of such failure. Unpaid interest (amounting to $23,676,000 from the date of KPI's bankruptcy to December 20, 1993) has not been recognized in the accompanying consolidated financial statements of the Company. On October 17, 1991, the Bankruptcy Court entered an Order granting KPI's Motion to Use Cash Collateral (the "Cash Collateral Order"). Under the terms of the Cash Collateral Order, during the period of the KPI Chapter 11 Case, the Company was entitled to be paid debt service in respect of the loans which were outstanding under the Restated Credit Agreement to the extent of the net cash flow of the collateral for such loans, after provision for payment of property-specific operating costs and expenses, a management fee equal to five percent of rents received, an allocation of KPI's excess overhead, certain escrows for property-specific capital and tenant improvements costs, leasing commissions and taxes, and payment of debt service on senior mortgages, if any. The Company recognized no interest on these loans during 1993 and 1992. For the year ended December 31, 1991, KPI paid the Company $4,786,000, for interest on these loans. All payments received under the Cash Collateral Order ($94,910 in 1991, $1,180,447 in 1992 and $1,392,113 in 1993) were applied to the principal balance outstanding. Immediately prior to the Merger, the loans outstanding under the Restated Credit Agreement totalled approximately $85.4 million, with a carrying value of approximately $67.0 million. On the date of the Merger, the Company received the collateral for the loans to KPI under the Restated Credit Agreement in full satisfaction of these loans. As of December 31, 1990, the Company and KPI entered into an agreement (the "Land Credit Agreement") under which the Company loaned $28.3 million to KPI. The loans under the Land Credit Agreement were collateralized by mortgages on land held for future development in existing Koger Centers in which the Company owned buildings or claimed rights under the Purchase Agreement. The interest rate on these loans was fixed at 10.25 percent. KPI failed to make interest payments due on this loan as of September 30, 1991, did not make contractual interest payments after that date, and was in default by reason of such failure. Unpaid interest (amounting to $6,673,000 from the date of KPI's bankruptcy to December 20, 1993) has not been recognized in the accompanying consolidated financial statements of the Company. The Company recognized no interest on this loan during 1993 and 1992. During 1991, KPI paid the Company $1,934,000 for interest on this loan. Since none of the properties which collateralized this loan generated cash flow, the Company did not receive any debt service payments for this loan under the provisions of the Cash Collateral Order. Immediately prior to the Merger, the loan outstanding under the Land Credit Agreement totalled approximately $28.3 million, with a carrying value of $26.5 million, which was net of a $1.4 million discount. This discount was not being amortized as interest income because management had discontinued recognition of interest income on this loan. On the date of the Merger, the Company received the collateral for the loan to KPI under the Land Credit Agreement in full satisfaction of this loan. Through the date of the Merger, the Company continued to account for the collateral for the loans under the Restated Credit Agreement and the Land Credit Agreement as loans foreclosed in-substance and had recorded a provision for loss in the amount of $18.7 million through December 21, 1993. This included a $2 million provision recorded during 1992 based upon management's continuing evaluation of collateral values. Resolution of KPI Chapter 11 Case. On April 30, 1993, the Company and KPI jointly proposed a plan of reorganization of KPI (the "Plan") which provided for the merger of KPI with and into the Company in exchange for the issuance of shares of the Company's common stock (the "Shares") to certain creditors of KPI and the issuance of warrants to purchase Shares (the "Warrants") to shareholders of KPI and holders of certain securities laws claims against KPI and the settlement of the Company's claim against KPI. On August 11, 1993, the shareholders of the Company approved the Merger and the issuance of the Shares and Warrants pursuant thereto. On December 8, 1993, the Plan was confirmed by the Bankruptcy Court and the Merger became effective on December 21, 1993. See Note 3 "KPI Merger" for further discussion. Advisory Agreement. Under the terms of an advisory agreement, Koger Advisors, Inc. ("KA"), a former wholly owned subsidiary of KPI, managed the Company's investment portfolio and provided advice and recommendations with respect to all aspects of the Company's business through December 31, 1991. For the year ended December 31, 1991, the Company reimbursed KA $539,000, for out-of-pocket expenses incurred by KA in providing advisory services to the Company. The term of the Advisory Agreement ended December 31, 1991. Functions formerly performed by KA have been performed by the Company through its officers and employees since January 1, 1992. Management Agreement. Prior to the Merger, Koger Management, Inc. ("KMI") was responsible for the leasing, operation, maintenance, and management of each of the Company's properties. The management fee was five percent of the gross rental receipts collected on the property managed for the Company by KMI. For the years ended December 31, 1993, 1992, and 1991, the Company incurred management fee expenses to KMI of $2,184,000, $2,314,000, and $2,281,000, respectively, for property management services. The Management Agreement expired on December 31, 1991, but had been extended on a month-to- month basis. With the Merger, the Company assumed all of the leasing and other management responsibilities for its properties including those acquired in the Merger. Other. A director of the Company is a Vice President of an affiliate of a shareholder who along with certain of its affiliates owns 18 percent of the Shares of the Company. The Company has entered into an agreement with this shareholder to register shares owned by the shareholder and its affiliates pursuant to the registration requirements of the Securities Act of 1933 in up to four public offerings and include these Shares in an unlimited number of public offerings which may be made on behalf of the Company or others for a period of eight years following the effective date of the Merger, December 21, 1993. All expenses, except for brokerage discount, of any of these offerings will be borne by the Company. In addition, one of the agreements contains provisions which permit the shareholder and certain of its affiliates to own the greater of (i) 23 percent of the outstanding Shares or (ii) 4,047,350 of the outstanding Shares, as adjusted for recapitalization without triggering the Company's common stock rights agreement. The Company has also covenanted that following the effective date of the Merger, December 21, 1993, for a period of eight years the Company would not amend, alter or otherwise modify the common stock rights agreement or take any action, which would limit or eliminate certain rights of the shareholder and its affiliates without prior consent of the shareholder. 3. KPI MERGER. On December 8, 1993, the Plan was confirmed by the Bankruptcy Court and the Merger of KPI into the Company became effective on December 21, 1993. Pursuant to the Merger, the Company received the collateral of 62 office buildings and thirteen parcels of land and related restructured mortgages, for the loans to KPI under the Restated Credit Agreement and the Land Credit Agreement in full satisfaction of these loans. In addition, in exchange for the remaining office buildings, land parcels, related restructured debt and other net assets of KPI, the Company issued 6,158,977 Shares, or approximately 35 percent of the Shares outstanding after the Merger, to certain unsecured creditors of KPI. The KPI common stock outstanding immediately prior to the Merger was converted into the right to receive one Warrant for every 50 shares of KPI common stock. Holders of certain securities law claims against KPI also received Warrants. A total of 644,000 Warrants were issued. Each Warrant gives the holder the right to purchase one Share at a price of $8.00 per share, such rights to be exercisable until June 30, 1999. The Warrants are subject to redemption at the option of the Company at prices ranging from $1.92 to $5.24 per Warrant. With the Merger, the Company acquired substantially all of the assets of KPI, free and clear of all liens, claims and encumbrances, except (i) encumbrances relating to certain secured indebtedness of KPI (aggregating $182.6 million) which was restructured under the Plan and (ii) an option and right of first refusal held by TKPL on certain developed buildings and parcels of undeveloped land, which are located in TKPL office centers. KPI assets acquired by the Company in the Merger included a total of 93 buildings containing 3,848,130 net rentable square feet together with approximately 295 acres of unimproved land suitable for development, and 1,781,419 Shares held by KPI. As a result of the Merger, the Company assumed all of the leasing and other management responsibilities for its properties including those acquired in the Merger. In addition, immediately prior to the Merger KPI transferred all of its debt and equity interest in TKPL to a newly formed wholly owned subsidiary of the Company, Southeast Properties Holding Corporation, Inc., which became the managing general partner of TKPL. The accounting treatment for the Merger has been separated into two components: (i) the receipt by the Company of the collateral for the loans to KPI made pursuant to the Restated Credit Agreement and the Land Credit Agreement (loans to KPI foreclosed in-substance), in full satisfaction of these loans; and (ii) the acquisition by the Company of the remaining assets and restructured liabilities of KPI. At the date of the Merger, the KPI real estate assets securing the loans due from KPI and related restructured mortgage balances were recorded at their relative fair values. The remaining assets and treasury stock acquired and liabilities assumed in exchange for the Shares and Warrants issued were recorded at their relative fair values under the purchase method of accounting. The acquisition price for these net assets was established based upon the value of Shares ($8.25 per Share) and Warrants ($2.125 per Warrant) as of the consummation date of the Merger plus the direct acquisition costs totaling $4,281,000 incurred by the Company. Cost in excess of fair value of net assets acquired from KPI totalled $11,646,000 and is being amortized over 15 years. Revenues and expenses of the assets and liabilities acquired from KPI are reflected in the Consolidated Statements of Operations for the 11 days from the date of the Merger, December 21, 1993, through December 31, 1993. The following unaudited pro forma results of operations for the years ended December 31, 1993 and 1992 assume the acquisition occurred as of the beginning of the respective periods after giving effect to certain adjustments including amortization of cost in excess of fair value of net assets acquired from KPI, increased interest expenses on assumed debt and increased depreciation expense on the new adjusted accounting bases of the real estate assets acquired. 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. (in thousands) UNAUDITED 1993 1992 Total Revenues $94,459 $91,933 Total Expenses 91,183 90,530 Net Income $ 3,276 $ 1,403 Earnings Per Common Share $ 0.19 $ 0.08 4. INVESTMENTS IN THE KOGER PARTNERSHIP, LTD. General. Pursuant to the Merger, Southeast Properties Holding Corporation, Inc. ("Southeast"), a wholly owned subsidiary of the Company, became the managing general partner of TKPL. Immediately prior to the Merger, KPI transferred all of its debt and equity interest in TKPL to Southeast. These interests included (1) 90,360 TKPL General and Limited Partnership Units (the "Units") and (2) a restructured unsecured note from TKPL with a principal amount of approximately $31 million. In light of the terms of the TKPL plan of reorganization and its restructured debt, the Company has determined that these investments have no value. Basis of Accounting for the Investment in TKPL. Southeast has significant influence over TKPL's activities because it owns 32 percent of TKPL's outstanding Units. However, Southeast does not control TKPL for accounting purposes and, accordingly, accounts for its investment using the equity method. No losses of TKPL are allocated to Southeast because Southeast is not obligated to fund losses of TKPL as stated in the Third Amended and Restated Agreement of Limited Partnership dated August 3, 1993. Duties to and Compensation from TKPL. Southeast, in its capacity as Managing General Partner, generally has responsibility for all aspects of TKPL's operations and receives as compensation for its services a management fee equal to nine percent of the gross rental revenues derived from the properties it manages for TKPL. All third-party leasing commissions incurred on TKPL buildings are the responsibility of the Company. From the date of the Merger, December 21, 1993, through December 31, 1993, the management fees earned were approximately $89,000. In the event that certain benchmarks for retirement of indebtedness are not met, the TKPL plan provides that an alternate general partner will assume responsibilities for operation and management of TKPL, and will initiate procedures to liquidate the assets of TKPL on an expedited basis. There is no assurance that necessary refinancing(s) and/or sale(s) can be achieved or that the alternate general partner will not assume control of TKPL. Option Agreement with TKPL. Pursuant to the Merger, the Company assumed an Option Agreement, between KPI and TKPL, which granted TKPL the exclusive right to acquire (the "Option") from KPI all of its interest in any or all of the developed buildings and parcels of undeveloped land, which are located in TKPL office centers (the "Option Property"). Under the Option Agreement, TKPL was also granted a right of first refusal as to the Option Property. The Option's exercise price will be based on the fair value of the subject property determined as of a date within 180 days of exercise. The Option Agreement will be effective until June, 2000. Incentive Agreement with TKPL. Pursuant to the Merger, Southeast assumed an incentive agreement, originally between KPI and TKPL. Under the terms of this agreement, TKPL shall pay to Southeast, as long as Southeast is the property manager for TKPL, an incentive fee (the "Incentive Fee") in respect of any sale or refinancing of individual buildings (or buildings as unified office parks). The Incentive Fee will be computed based on the net proceeds received by TKPL in respect of such dispositions or refinancings (defined generally as gross proceeds of such dispositions or refinancings, less any repayment of certain obligations in respect of such disposed or refinanced property, and payment of any related costs of sales or refinancing costs (commissions to related parties not to exceed 3 percent of net proceeds)) and will decline according to the following schedule: Twelve Month Periods following Percentage of June, 1993 Net Proceeds 1 through 4 15% 5 through 6 5% Thereafter 0% Pursuant to an agreement, the first $5 million of Incentive Fees which otherwise would be payable to Southeast under the terms of the Incentive Agreement will be required to be deposited into a special collateral account to provide additional collateral to secure the payment of certain debt of TKPL. Summarized Financial Information. The condensed balance sheets of TKPL as of December 31, 1993 and 1992 and the condensed statements of operations for TKPL for the three years ended December 31, 1993, are summarized below (in thousands). BALANCE SHEET DATA: As Restated (in thousands) 1993 1992 Total Assets $157,239 $175,072 Liabilities $188,740 $194,780 Deficiency in assets (31,501) (19,708) Total Liabilities and Deficiency in Assets $157,239 $175,072 OPERATIONS DATA: As Restated As Restated (in thousands) 1993 1992 1991 Revenues $ 35,753 $ 36,765 $ 36,342 Operating, Interest and Other Expenses (34,089) (31,957) (35,674) Depreciation and Amortization (13,457) (15,201) (15,426) Net loss $(11,793) $(10,393) $(14,758) 5. LOANS AND MORTGAGES PAYABLE. During 1993, the Company's bank loans were modified and extended in connection with the Merger. These bank loans had an outstanding balance of $100,308,000 at December 31, 1993. Prior to the modification of the loans, the loans bore interest at rates equal to such banks' prime rates. These loans are collateralized by mortgages on certain operating properties. At December 31, 1993, $47,656,000 of these loans bear interest at 6.42 percent and have a final maturity date of December 21, 2000. This loan is collateralized by properties with a carrying value of $69,137,000. At December 31, 1993, $25,027,000 of these loans bear interest at 6.386 percent and have a final maturity date of December 21, 2000. This loan is collateralized by properties with a carrying value of $43,210,000. The interest rate on both of these bank loans will be adjusted in December, 1996 to a rate equal to the sum of (i) the effective interest rate prevailing on four year U.S. Treasury Obligations, plus (ii) 210 basis points, subject to a maximum of 11 percent per annum. Monthly payments on these loans include principal amortization based on a 25 year amortization period. In addition, the Company will be required to make additional principal payments totalling $10 million by December, 1998. At December 31, 1993, $27,625,000 of these loans bear interest at the bank's prime rate plus one-half percent and has a maturity date of December 21, 1998, with an optional two year extension. Monthly payments on this loan include interest and fixed payments of principal which increase annually. This loan is collateralized by properties with a carrying value of $49,888,000. On or before December 21, 1996, the Company will be required to repay not less than $5 million of principal of this indebtedness. If the Company pays an additional $5 million prior to December 21, 1998, the maturity will be extended to seven years. At December 31, 1993, the Company had mortgages payable which total $49,334,000. The mortgages payable represent the outstanding balance of $22,917,000, which is net of a $170,000 discount, for debt assumed in connection with property purchased from KPI through 1990 and the outstanding balance of $26,417,000, which is net of a $1,121,000 discount, for mortgage debt obtained from an insurance company. Such mortgages are generally amortizing, bear interest at rates ranging from 7.75 percent to 10.125 percent, and are collateralized by office buildings with a carrying value of $97,567,000 at December 31, 1993. In connection with the Merger, the Company assumed approximately $182.6 million of restructured debt from KPI on December 21, 1993. Information with respect to such debt is as follows (in thousands): Outstanding Balance KPI Restructured Debt 12/21/93 12/31/93 Senior Bank Mortgage Debt $ 83,992 $ 83,992 Junior Bank Mortgage Debt 11,354 10,278 Insurance Company Mortgage Debt 60,707 60,298 Negative Amortization (Insurance Company Debt) 80 118 Other Mortgage Debt 21,168 20,958 Tax Notes 5,040 5,040 Mechanics' Liens 287 287 $182,628 $180,971 Senior Bank Mortgage Debt, acquired in connection with the Merger, with outstanding balances of approximately $84 million will mature in December, 2003. Interest payments are due monthly based on a 6.62 percent interest rate with monthly amortization beginning in December, 1994. The interest rate will adjust in April, 1998 to a rate equal to the sum of (i) the then prevailing interest rate on five year U.S. Treasury Obligations plus (ii) 210 basis points with a maximum rate of 10 percent. Junior Bank Mortgage Debt totaling approximately $10.3 million is secured by properties that also serve as collateral for Senior Bank Mortgage Debt. The Junior Bank Mortgage Debt matures in December, 2000 and accrues interest at the prime rate of the lender (6 percent at December 31, 1993). Accrued interest on Junior Bank Mortgage Debt must be paid no later than December, 1998. Monthly interest payments are required beginning in January, 1999. Accrued interest on this debt will be forgiven if the outstanding balance is paid in full prior to December, 1996. Interest accrued and forgiven will be reflected as an adjustment to interest expense in the year forgiven. Insurance Company Mortgage Debt with outstanding balances at December 31, 1993, of approximately $59.9 million were acquired in connection with the Merger. This indebtedness is non-recourse to the Company, but is secured by all former KPI properties on which each lender held mortgages. These mortgages include provisions during the period ending December 21, 1996, for a portion of the interest earned, equal to 25 percent, 20 percent and 15 percent in, respectively, the first, second and third years, may be deferred at the option of the Company and added to principal, subject to a minimum interest payment rate of seven and one-half percent per annum. The interest rates will be reset on various dates, as defined. No reset interest rate may be less than eight percent per annum. However, if any interest reset rate would exceed ten percent per annum, the Company may elect to establish the interest reset rate at ten percent per annum, in which case the maturity of the indebtedness in question shall be the date on which a U.S. Treasury Obligation purchased on the interest reset date in question with an effective interest rate of 210 basis points below ten percent per annum would mature. In the absence of an election to fix any interest reset rate at ten percent per annum, all of such indebtedness matures on December 21, 2003. The loans begin principal amortization in 1997. Additional Insurance Company Mortgage Debt totalling $0.4 million which retained their existing balances and terms were also acquired from KPI in connection with the Merger. The interest rates on these loans range from 7.5 percent to 9.5 percent. Other Mortgage Debt acquired in the Merger totals approximately $21 million and matures in June, 2001. Interest payments are due monthly based on the prime rate plus one percent with a minimum rate of 6.62 percent and a maximum rate of 10 percent. At December 31, 1993, approximately $4.5 million of Tax Notes were outstanding to taxing authorities and banks for 1991 taxes on certain properties acquired from KPI. The Tax Notes mature in December, 1999 and bear interest at 8.5 percent. The notes are interest only for two years and beginning in December, 1995 must be repaid in five equal annual installments of principal. Other notes issued for outstanding taxes are unsecured with an outstanding balance of $501,000. These notes mature September, 1997 and accrue interest at 7.0 percent. Principal and interest are paid on a quarterly basis commencing March, 1994. Mechanics Liens of $287,000 mature in December, 2000. Payments are made annually and bear interest at 8.5 percent. The Company's restructured debt contains provisions requiring the Company to use the first $50 million of proceeds from any equity offering to pay down certain debt. To the extent that equity offering proceeds exceed $50 million, one half of the excess must be used to pay down debt with the remainder being available for use at the Company's discretion. In addition to reporting and other requirements, the restructured debt agreements contain provisions limiting the amount of annual dividends, limiting additional borrowings, and limiting general and administrative expense. The Company is also required to maintain certain financial ratios. The annual maturities of loans and mortgages payable, which are gross of $1,291,000 of unamortized discounts, as of December 31, 1993, are summarized as follows (dollars in thousands): Year Ending December 31, Total 1994 $ 3,252 1995 5,736 1996 8,901 1997 14,564 1998 18,920 Subsequent Years 280,543 Total $331,916 6. LEASES. The Company's operations consist principally of owning and leasing of office space. Most of the leases are for terms of three to five years. Generally, the Company pays all operating expenses, including real estate taxes and insurance. At December 31, 1993, 94 percent of the Company's annualized rentals were subject to rent escalations based on changes in the Consumer Price Index or increases in real estate taxes and certain operating expenses. A substantial number of leases contain options that allow leases to renew for varying periods. The Company's leases are operating leases and expire at various dates through 2003. Minimum future rental revenues from leases in effect at December 31, 1993, determined without regard to renewal options, are summarized as follows: Year Ending Amount December 31, (In thousands) 1994 $ 79,048 1995 58,728 1996 37,983 1997 24,618 1998 14,026 Subsequent Years 30,218 Total $244,621 The above minimum future rental income does not include contingent rentals that may be received under provisions of the lease agreements. Contingent rentals amounted to $1,407,000, $1,638,000, and $762,000 for the years 1993, 1992, and 1991, respectively. 7. STOCK OPTIONS AND RIGHTS. 1988 Stock Option Plan. The Company's Amended and Restated 1988 Stock Option Plan (the "1988 Plan") provides for the granting of options to purchase up to 500,000 shares of its common stock to key employees of the Company and its subsidiaries. The 1988 Plan provides that the options granted contain stock appreciation rights which may be exercised in lieu of the option. To exercise the option, payment of the option price is required before the option shares are delivered. Alternatively, the optionee may elect to receive shares equal in value to the difference between the aggregate fair market value of the shares exercised on the exercise date and the aggregate exercise price of those shares. With the consent of the Company's Compensation Committee, the optionee may also elect to exercise the option in part by receiving cash equal to the minimum amount required to be withheld for payroll tax purposes and the balance by receiving shares equal to the difference between the aggregate fair market value and the aggregate exercise price, less any cash received. All options originally granted under the 1988 Plan on August 25, 1988, at an exercise price of $20.00 per share were exercisable on December 31, 1993, and terminate August 24, 1995, seven years after the date of grant. Pursuant to the 1988 Plan, the Compensation Committee of the Company's Board of Directors granted options to purchase 286,250 shares on February 5, 1992 to the Company's officers at an exercise price of $5.125 per share, which was the closing market price on the American Stock Exchange on the date of the grant. These options expire seven years from the date of grant and are exercisable beginning one year from the date of grant at a cumulative annual rate of 20 percent of the shares covered by each option being fully exercisable five years after the date of grant. The grant of certain of these options was conditioned upon the surrender of previously granted and outstanding options to purchase 23,825 shares at an exercise price of $20.00 per share. 1988 Stock Purchase Option Plan. As incentive compensation, on August 25, 1988, the Company granted a Stock Purchase Option to purchase up to 500,000 shares of its common stock to its former advisor, KA, which were assigned to key employees of KA, KMI, KPI, and other affiliates of KA. The Stock Purchase Option provides that upon exercise of an option, the optionee may purchase shares for cash or may elect to receive shares equal in value to the excess of the fair market value of shares exercised over the exercise price. The shares became exercisable in March, 1990 and will expire June 29, 1995. Options to purchase shares under the Stock Purchase Option were assigned by KA to its respective key employees and those of its affiliates who are now employees of the Company. Information concerning the options granted is summarized below. Date of Shares Under Exercise Price Plan Grant Option Per Share Total 1988 Stock Option Plan 8/25/88 173,246 $20.000 $3,464,920 2/05/92 286,150 5.125 1,466,519 Stock Purchase Option 8/25/88 299,180 20.000 5,983,600 At December 31, 1993, there were 40,504 shares available for the granting of options under the 1988 Plan. At December 31, 1993, options to purchase 100 shares had been exercised. 1993 Stock Option Plan. The Company's 1993 Stock Option Plan (the "1993 Plan") was approved by the Shareholders of the Company at its Annual Meeting held on August 11, 1993. The 1993 Plan provides for the granting of options to purchase up to 1,000,000 shares of its common stock to key employees of the Company and its affiliates. The 1993 Plan provides that the options granted contain stock appreciation rights which may be exercised in lieu of the option. To exercise the option, payment of the option price is required before the option shares are delivered. Alternatively, the optionee may elect to receive shares equal in value to the difference between the aggregate fair market value of the shares exercised on the exercise date and the aggregate exercise price of those shares. With the consent of the Company's Compensation Committee, the optionee may also elect to exercise the option in part by receiving cash equal to the minimum amount required to be withheld for payroll tax purposes and the balance by receiving shares equal to the difference between the aggregate fair market value and the aggregate exercise price, less any cash received. At December 31, 1993, no options had been granted under the 1993 Plan. At December 31, 1993, there were 1,000,000 shares available for the granting of options under the 1993 Plan. Shareholder Rights Plan. Pursuant to a Shareholder Rights Plan (the "Rights Plan"), on September 30, 1990, the Board of Directors of the Company declared a dividend of one Common Stock Purchase Right for each outstanding share of common stock of the Company. Under the terms of the Rights Plan, the rights which were distributed to the shareholders of record on October 11, 1990, trade together with the Company's common stock and are not exercisable until the occurrence of certain events (none of which have occurred through December 31, 1993), including acquisition of, or commencement of a tender offer for, 15 percent or more of the Company's common stock. In such event, each right entitles its holder (other than the acquiring person or bidder) to acquire additional shares of the Company's common stock at a fifty percent discount from the market price. The rights are redeemable under circumstances as specified in the Rights Plan. The Rights Plan was amended effective December 21, 1993 for a certan shareholder and its affiliates, see Note 2 for further discussion of this amendment. 8. DIVIDENDS. The Company paid no dividends during 1993 or 1992. Dividends of $.77 per share were paid during the year ended December 31, 1991, all of which was ordinary income for income tax purposes. The Company intends that the quarterly dividend payout in the last quarter of each year will be adjusted to reflect the distribution of at least 95 percent of the Company's taxable income as required by the Federal income tax laws. The Company's taxable income/(loss) prior to the dividends paid deduction for the years ended December 31, 1993, 1992, and 1991 was approximately $(7,887,000), $(13,329,000), and $10,646,000, respectively. The difference between net income for financial reporting purposes and taxable income results primarily from different methods of accounting for bad debts, depreciable lives related to the properties owned, and advance rents received. At December 31, 1993, the net tax basis of the Company's assets and liabilities exceeded the net book basis of assets and liabilities in the amount of approximately $136,000. Pursuant to the Plan and the Merger of KPI into the Company, the Company will be subject to certain dividend limitations which, however, will not be applied if they would cause loss of the Company's REIT status. 9. LITIGATION. The Company, certain of its present and former officers and directors, and KPI and certain of its subsidiaries are parties to a class action filed in October, 1990 (the "Securities Action"). It is alleged in the Securities Action that various press releases, shareholder reports, and/or securities filings failed to disclose and/or misrepresented the Company's business policies in violation of certain provisions of the federal securities law and seeks unspecified damages therefore. The Company believes that claims made in the Securities Action are without merit and intends to vigorously contest the proceeding. A derivative action in the District Court was commenced on October 29, 1990, by Howard Greenwald and Albert and Phyllis Schlesinger, shareholders of the Company, against the Company, KPI, all of the then current directors of the Company, including: Ira M. Koger, James B. Holderman, Allen R. Ransom, Wallace F. E. Kienast, S. D. Stoneburner, Yank D. Coble, Jr., G. Christian Lantzsch, A. Paul Funkhouser and Stephen D. Lobrano, alleging breach of fiduciary duty by favoring KPI over the interest of the Company and failing to disclose or intentionally misleading the public as to the Company's cash flow, dividend and financing policies and status, and seeking damages therefor (the "Derivative Action"). During the course of the Derivative Action, the plaintiffs therein further alleged that Mr. Lobrano was liable to the Company for certain alleged acts of legal malpractice. The Company's Board of Directors' Independent Litigation Committee, which was composed of outside independent members of the Company's Board of Directors, completed an extensive investigation of the facts and circumstances surrounding the Derivative Action, including the allegations against Mr. Lobrano. It was the conclusion of this committee that the ultimate best interest of the Company and its shareholders would not be served in prosecuting this litigation. Subsequently, the Company moved that the Derivative Action be dismissed under the provisions of Florida law. Thereafter, the plaintiffs filed a Second Amended and Supplemental Complaint which realleged the original cause of action ("Count I"); and realleged the cause of action against Stephen D. Lobrano ("Count II"); and a new cause of action against the members of the Special Litigation Committee for alleged violation of fiduciary duties in conducting its investigation ("Count III"). During 1993, the Company filed further motions seeking dismissal of the Second Amended and Supplemental Complaint. On January 27, 1994, the United States Magistrate issued his Report and Recommendation concerning the Derivative Action, which recommended that (1) Count I should be dismissed pursuant to the Special Litigation Committee Report, (2) Count III against the Special Litigation Committee members should be dismissed, and (3) Count II should not be dismissed. Both plaintiffs and the Company have filed objections to portions of this Report and Recommendation, which is now pending before the District Court. At this time the Company's legal counsel is unable to determine whether the outcome of the above litigation will have a material impact on the Company. Accordingly, no provision has been made in the consolidated financial statements for any liability that may result from this litigation. Under the terms of the merger agreement between the Company and KPI, the Company has agreed to indemnify each current and former non-officer director of KPI other than Ira M. Koger (the "Indemnified Persons") in respect of amounts to which such Indemnified Person would be otherwise entitled to indemnification under Florida law, the articles of incorporation or the by-laws of KPI arising out of acts or omissions prior to September 25, 1991 (the "Indemnity"). Certain of the former non-officer directors of KPI are defendants in a Pension Plan class action suit. The Company is not named in this suit. However, certain former non-officer directors of KPI may be Indemnified Persons. The obligations, if any, of the Company under such indemnification do not exceed (i) $1,000,000 in the aggregate and (ii) $200,000 per Indemnified Person and are subject to certain other conditions precedent. Based upon its investigation to date, the Company does not believe that this suit will give rise to any material liability to Indemnified Persons or to the Company. Accordingly, no provision has been made in the Consolidated Financial Statements for any liability that may result from the Indemnity. 10.INTERIM FINANCIAL INFORMATION (UNAUDITED). Selected quarterly information for the two years in the period ended December 31, 1993, is presented below (in thousands except per share amounts): Net Earnings Rental Total Income (Loss) Per Quarters Ended Revenues Revenues (Loss) Common Share March 31, 1992 $11,488 $11,529 $820 $.06 June 30, 1992 11,643 11,701 292 .02 September 30, 1992 11,356 11,423 (142) (.01) December 31, 1992 11,470 11,535 (37) - March 31, 1993 10,970 11,030 951 .07 June 30, 1993 10,982 11,037 610 .05 September 30, 1993 11,212 11,265 (26) - December 31, 1993 12,944 13,074 917 .06 Schedule XI KOGER EQUITY, INC. AND SUBSIDIARIES REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 (in thousands) (a) At December 31, 1993, the outstanding balance of mortgages payable was $272,542. In addition, the Company has loans outstanding with variable interest rates which are collateralized by mortgages on pools of buildings. At December 31, 1993, the outstanding balance of these loans was $58,861. (b) Aggregate cost basis for Federal income tax purposes was $633,181 at December 31, 1993. (c) Reconciliation of total real estate carrying value for the years ended December 31, 1993, 1992 and 1991 is as follows: 1993 1992 1991 Balance at beginning of year $311,286 $308,293 $304,690 Additions during year: Acquisitions 289,097 19 4 Improvements 6,423 2,974 3,599 Balance at close of year $606,806 $311,286 $308,293 Acquisitions of land and buildings during 1993 were made pursuant to the merger of KPI with and into the Company. (d) Reconciliation of accumulated depreciation for the years ended December 31, 1993, 1992 and 1991 is as follows: 1993 1992 1991 Balance at beginning of year $22,300 $14,625 $7,493 Additions during year: Depreciation expense 8,406 7,675 7,132 Balance at close of year $30,706 $22,300 $14,625 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 about directors of the Company who are not executive officers is contained in the Company's Proxy Statement (the "1994 Proxy Statement") and is incorporated herein by reference. The following tabulation lists the executive officers of the Company, their ages and their occupations for the past five years: S. D. Stoneburner . . . . .Chairman of the Board Irvin H. Davis. . . . . . .President, Chief Executive Officer and Director Victor A. Hughes, Jr. . . .Senior Vice President, Chief Financial Officer and Director James L. Stephens . . . . .Treasurer and Chief Accounting Officer Mr. Stoneburner, age 75, was elected as Chairman of the Board of Directors of the Company on December 20, 1991, and has been a Director of the Company since June, 1988. He had also previously served the Company as President and Chief Financial Officer from June 22, 1988 through March 6, 1990. Mr. Stoneburner is the former Vice Chairman of the Board and former Chief Financial Officer of KPI, having served in that capacity from 1973 through June 21, 1988. Mr. Davis, age 64, was elected President and Chief Executive Officer of the Company on December 11, 1991. He has served as a Director of the Company since August 15, 1991. He previously held the positions of President and Chief Executive Officer pro tempore of the Company from August 15, 1991 to December 10, 1991. Prior to that Mr. Davis served the Company as Senior Vice President and Asset Manager from August 1, 1991 to August 14, 1991 and as Senior Vice President/Asset Management from June, 1988 to February 1, 1991. Mr. Davis was a Senior Vice President of KPI from 1982 to 1988 and also served in that capacity from February, 1991 to August 1, 1991. Mr. Hughes, age 58, has been the Chief Financial Officer of the Company since March 31, 1991, Senior Vice President of the Company since May 20, 1991, and Assistant Secretary of the Company from March 11, 1991 through December 21, 1993. Mr. Hughes was elected to the Board of Directors of the Company on July 29, 1992. Mr. Hughes had previously held the position of Vice President of the Company from April 1, 1990 to March 11, 1991. Mr. Hughes was President of Koger Securities, Inc., a former wholly owned subsidiary of KPI, from 1982 to March, 1990. Mr. Stephens, age 36, has been the Treasurer and Chief Accounting Officer of the Company since March 31, 1991. He also has held the position of Assistant Secretary of the Company from May 20, 1991 through December 21, 1993. Mr. Stephens was the Accounting Manager of KA from December, 1990 to March, 1991. He was a Division Controller of KPI from March, 1989 to December, 1990 and Cost Accounting Manager of KPI from September, 1987 to March, 1989. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's directors and executive officers to file with the SEC and the American Stock Exchange initial reports of ownership and reports of changes in ownership of the common stock of the Company. Executive officers and directors are required by the SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. To the Company's knowledge, based solely on review of the copies of such reports furnished to the Company and written representations that no other reports were required, during the fiscal year ended December 31, 1993 all Section 16(a) filing requirements applicable to its executive officers and directors were complied with. Item 11. Item 11. EXECUTIVE COMPENSATION Information regarding executive compensation is incorporated by reference to the section headed "Executive Compensation" in the 1994 Proxy Statement. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The stock ownership of each person known to the Company to be the beneficial owner of more than five percent (5%) of its outstanding common stock is incorporated by reference to the section headed "Principal Holders of Voting Securities" of the 1994 Proxy Statement. The beneficial ownership of Common Stock of all directors of the Company is incorporated by reference to the section headed "Election of Directors" contained in the 1994 Proxy Statement. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is made to Item 1. "Business," 2. "Properties," 3. "Lega Proceedings," 7. "Management's Discussion and Analysis of Financial Conditions and Results of Operations" and Note 2 "Transactions With Related Parties" to the Notes to Consolidated Financial Statements contained in this Report and to the heading "Certain Relationships and Transactions" contained in the 1994 Proxy Statement for information regarding certain relationships and related transactions which information is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) See "Item 8 - Financial Statements and Supplementary Data - Index to Consolidated Financial Statements and Financial Statement Schedules" for a list of the financial statements included in this report. The financial statements for The Koger Partnership, Ltd. are herein incorporated by reference as filed in its Form 10-K for the year ended December 31, 1993 (Commission File No. 0-8891). (2) The consolidated supplemental financial statement schedules required by Regulation S-X are included on pages 50 through 54 in this Form. (b) Reports on Form 8-K: There were no reports on Form 8-K filed during the quarter ended December 31, 1993. (c) The following exhibits are filed as part of this report: Exhibit Number Description 2 Agreement and Plan of Merger, dated as of December 21, 1993 between the Company and Koger Properties, Inc.* 3 (a) Amended and Restated Articles of Incorporation. Incorporated by reference to Exhibit IV of the 1993 Proxy Statement filed by the Registrant on June 30, 1993 (File No. 1-9997). (b) Koger Equity, Inc. By Laws, as Amended and Restated on May 5, 1992. Incorporated by reference to Exhibit 3 of the Form 10-Q filed by the Registrant for the quarter ended March 31, 1993 (Filed No. 1-9997). 4 (a) Common Stock Certificate of Koger Equity, Inc. See Exhibit 4(a) to Registration Statement on Form S-11 (Registration No. 33-22890) which Exhibit is herein incorporated by reference. (b)(1)(A) Koger Equity, Inc. Rights Agreement (the "Rights Agreement") dated as of September 30, 1990 between the Company and Wachovia Bank and Trust Company, N.A. as Rights Agent ("Wachovia"). See Exhibit 1 to a Registration Statement on Form 8-A, dated October 3, 1990, (File No. 1-9997) which Exhibit is herein incorporated by reference. (b)(1)(B) First Amendment to the Rights Agreement, dated as of March 22, 1993, between the Company and First Union National Bank of North Carolina, as Rights Agent ("First Union"), entered into for the purpose of replacing Wachovia. Incorporated by reference to Exhibit 4(b)(4) of the Form 10-Q filed by the Registrant for the quarter ended March 31, 1993 (File No. 1-9997). Exhibit Number Description (b)(1)(C) Second Amendment to the Rights Agreement, dated as of December 21, 1993, between the Company and First Union. See Exhibit 5 to an Amendment on Form 8-A/A to a Registration Statement on Form 8-A, dated December 21, 1993, (File No. 1-9997) which Exhibit is herein incorporated by reference. (b)(2) Form of Common Stock Purchase Rights Certificate (attached as Exhibit A to the Rights Agreement). Pursuant to the Rights Agreement, printed Common Stock Purchase Rights Certificates will not be mailed until the Distribution Date (as defined in the Rights Agreement). (b)(3) Summary of Common Stock Purchase Rights (attached as Exhibit B to the Rights Agreement). (c)(1) Warrant Agreement, dated as of December 21, 1993, between the Company and First Union (the "Warrant Agreement"). See Exhibit 2 to an Amendment on Form 8-A/A to a Registration Statement on Form 8-A, dated December 21, 1993, (File No. 1- 9997) which Exhibit is herein incorporated by reference. (c)(2) Form of a Common Share Purchase Warrant issued pursuant to the Warrant Agreement. See Exhibit 1 to an Amendment on Form 8-A/A to a Registration Statement on Form 8-A (File No. 1-9997) dated December 21, 1993, which Exhibit is herein incorporated by reference. 10 Material Contracts (a)(1) Purchase Agreement among Koger Equity, Inc., Koger Properties, Inc., and The Koger Company. Incorporated by reference to Exhibit 10(a) of Form 10-K filed by the Registrant for the period ended December 31, 1988 (File No. 1-9997). (a)(2) First Amendment to Purchase Agreement. Incorporated by reference to Exhibit 10(a)(2) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1989 (File No. 1-9997). (b)(1) Credit Agreement among Koger Equity, Inc., Koger Properties, Inc. and The Koger Company. Incorporated by reference to Exhibit 10(b) of Form 10-K filed by the Registrant for the period ended December 31, 1988 (File No. 1-9997). (b)(2) First Amendment to Credit Agreement. Incorporated by reference to Exhibit 10(b)(2) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1989 (File No. 1-9997). (c) Advisory Agreement between Koger Equity, Inc. and Koger Advisors, Inc. Incorporated by reference to Exhibit 10(c) of Form 10-K filed by the Registrant for the period ended December 31, 1988 (File No. 1-9997). (d)(1) Management Agreement between Koger Equity, Inc. and Koger Management, Inc. Incorporated by reference to Exhibit 10(d) of Form 10-K filed by the Registrant for the period ended December 31, 1988 (File No. 1-9997). Exhibit Number Description (d)(2) Amended Schedule "A" to Management Agreement between Koger Management, Inc. and Koger Equity, Inc. Incorporated by reference to Exhibit 10(d)(2) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1989 (File No. 1-9997). (e)(1)(A) Koger Equity, Inc. 1988 Stock Option Plan. Incorporated by reference to Exhibit 10(e)(2) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1989 (File No. 1-9997). (e)(1)(B) Koger Equity, Inc. Amended and Restated 1988 Stock Option Plan. Incorporated by reference to Exhibit 10(e)(1)(A) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1992 (File No. 1-9997). (e)(2)(A) Koger Equity, Inc. 1988 Stock Option Agreement. Incorporated by reference to Exhibit 10(e)(2) of Form 10-Q filed by the Registrant for the quarter ended March 31, 1989 (File No. 1-9997). (e)(2)(B) Form of Stock Option Agreement pursuant to Koger Equity, Inc. 1988 Stock Option Plan, as amended and restated. Incorporated by reference to Exhibit 10(e)(2)(A) of Form 10-Q filed by the registrant for the quarter ended June 30, 1992 (File No. 1-9997). (f)(1) Stock Purchase Option between Koger Equity, Inc. and Koger Advisors, Inc. Incorporated by reference to Exhibit 10(f)(1) of Form 10-Q filed by the Registrant for the quarter ended March 31, 1989 (File No. 1-9997). (f)(2) Koger Equity, Inc. Assignment of Stock Purchase Agreement. Incorporated by reference to Exhibit 10(f)(2) of Form 10-Q filed by the Registrant for the quarter ended March 31, 1989 (File No. 1-9997). (g) Addendum Agreement between Koger Equity, Inc. and Koger Properties, Inc. Incorporated by reference to Exhibit 10(g) of Form 10-K filed by the Registrant for the period ended December 31, 1988 (File No. 1-9997). (h) Agreement between KPI and the Company, dated September 30, 1990. Incorporated by reference to Exhibit 10(h) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1990 (File No. 1-9997). (i) Land Credit Agreement dated December 31, 1990 between Koger Properties, Inc. and the Company. Incorporated by reference to Exhibit 10(i) of Form 10-K filed by the Registrant for the year ended December 31, 1990 (File No. 1-9997). (j) Second Amendment To Credit Agreement dated as of March 30, 1990. Incorporated by reference to Exhibit 10(j) of Form 10-K filed by the Registrant for the year ended December 31, 1990 (File No. 1-9997). (k) Amended and Restated Credit Agreement dated December 31, 1990. Incorporated by reference to Exhibit 10(k) of Form 10-K filed by the Registrant for the year ended December 31, 1990 (File No. 1-9997). Exhibit Number Description (l) Term Loan commitment with NCNB National Bank of Florida dated January 25, 1991. Incorporated by reference to Exhibit 10(l) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1991 (File No. 1-9997). (l)(2) Agreement to extend NCNB Loan Maturity Date, dated February 4, 1992. Incorporated by reference to Exhibit 10(1)(2) of the Form 10-Q filed by the Registrant for the quarter ended September 30, 1992 (File No. 1-9997). (l)(3) Agreement to Extend NCNB Loan Maturity Date, dated June 8, 1992. Incorporated by reference to Exhibit 10(1)(3) of the Form 10-Q filed by the Registrant for the quarter ended September 30, 1992 (File No. 1-9997). (l)(4) Agreement to Extend NCNB Loan Maturity Date, dated September 30, 1992. Incorporated by reference to Exhibit 10(l) (4) of the Form 10-Q filed by the Registrant for the quarter ended September 30, 1992 (File No. 1-9997). (l)(5) Amendment to NCNB Loan Agreement, dated January 28, 1993. Incorporated by reference to Exhibit 10(l)(5) of the Form 10-K filed by the Registrant for the year ended December 31, 1992 (File No. 1-9997). (l)(6) Agreement to Extend NationsBank (NCNB) Loan Maturity Date, dated April 30, 1993. Incorporated by reference to Exhibit 10(l)(6) of the Form 10-Q filed by the Registrant for the quarter ended March 31, 1993 (File No. 1-9997). (l)(7) Commitment letter to Koger Equity, Inc. from NationsBank of Florida, N.A., to modify and extend mortgage loan, dated October 13, 1993. Incorporated by reference to Exhibit 10(l)(7) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1993 (File No. 1-9997). (l)(8) Agreement to Extend NationsBank (NCNB) Loan Maturity Date, dated as of October 15, 1993. Incorporated by reference to Exhibit 10(l)(7) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1993 (File No. 1-9997). (l)(9) Restated Loan Agreement between NationsBank of Florida, N.A., and Koger Equity, Inc., dated December 21, 1993.* (m) Loan Agreement with Barnett Bank of Jacksonville, N.A. dated April 5, 1991. Incorporated by reference to Exhibit 10(m) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1991 (File No. 1-9997). (m)(1) Commitment letter to Koger Equity, Inc., from Barnett Bank of Jacksonville, N.A., to modify and extend term loans, dated September 22, 1993. Incorporated by reference to Exhibit 10(m)(l) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1993 (File No. 1-9997). (m)(2) Consolidated Renewal Promissory Note between Barnett Bank of Jacksonville, N.A., and Koger Equity, Inc., dated December 21, 1993.* (n)(1) Commitment Letter to Koger Equity, Inc. with First Union National Bank of Florida dated April 19, 1991. Incorporated by reference to Exhibit 10(n)(1) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1991 (File No. 1-9997). Exhibit Number Description (n)(2) Amendment to commitment Letter to Koger Equity, Inc. with First Union National Bank of Florida dated June 5, 1991. Incorporated by reference to Exhibit 10(n)(2) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1991 (File No. 1-9997). (n)(3) Commitment Letter to Koger Equity of South Carolina, Inc. with First Union National Bank of Florida dated May 31, 1991. Incorporated by reference to Exhibit 10(n)(3) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1991 (File No. 1-9997). (n)(4) Commitment Letter to Koger Equity of South Carolina, Inc. with First Union National Bank of Florida dated May 31, 1991. Incorporated by reference to Exhibit 10(n)(4) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1991 (File No. 1-9997). (n)(5) Commitment Letter to Koger Equity of North Carolina, Inc. with First Union National Bank of Florida dated May 31, 1991. Incorporated by reference to Exhibit 10(n)(5) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1991 (File No. 1-9997). (n)(6) Amendment to Commitment Letter to Koger Equity of North Carolina, Inc. with First Union National Bank of Florida dated June 5, 1991. Incorporated by reference to Exhibit 10(n)(6) of Form 10-Q filed by the Registrant for the quarter ended June 30, 1991 (File No. 1-9997). (n)(7) Loan Extension Agreement and Modification of Mortgage between Koger Equity, Inc., and First Union National Bank of Florida. Incorporated by reference to Exhibit 10(n)(7) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1993 (File No. 1-9997). (n)(8) Loan Extension Agreement and Modification of Mortgage and Assignment of Leases (and Consent of Guarantor) between Koger Equity of South Carolina, Inc., Koger Equity, Inc., and First Union National Bank of Florida. Incorporated by reference to Exhibit 10(n)(8) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1993 (File No. 1-9997). (n)(9) Loan Extension Agreement and Modification of Deed of Trust (and Consent of Guarantor) between Koger Equity of North Carolina, Inc., Koger Equity, Inc., and First Union National Bank of Florida. Incorporated by reference to Exhibit 10(n)(9) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1993 (File No. 1-9997). (n)(10) Commitment letter to Koger Equity, Inc., with First Union National Bank of Florida to restructure loan, dated October 19, 1993. Incorporated by reference to Exhibit 10(n)(10) of Form 10-Q filed by the Registrant for the quarter ended September 30, 1993 (File No. 1-9997). (n)(11) Consolidated Note between First Union National Bank of Florida and Koger Equity, Inc., dated December 21, 1993.* Exhibit Number Description (o) Shareholders Agreement, dated August 9, 1993, between the Company and TCW Special Credits, a California general partnership.* (p) Registration Rights Agreement, dated as of August 9, 1993, between the company and TCW Special Credits, a California general partnership.* (q)(1) Amended and Restated Management Agreement, dated August 3, 1993, between The Koger Partnership, Ltd. and Koger Properties, Inc.* (q)(2) First Amendment to Amended and Restated Management Agreement, dated December 21, 1993, between The Koger Partnership, Ltd. and Koger Properties, Inc.* (q)(3) TKP Co-Management Agreement, dated as of December 21, 1993, between The Koger Partnership, Ltd. and the Company and Southeast Properties Holding Corporation, Inc.* (q)(4) Delegation of Duties Under TKP Co- Management Agreement, dated as of December 21, 1993, between the Company and its wholly owned subsidiary, Koger Real Estate Services, Inc.* (r)(1) Incentive Fee Agreement, dated August 3, 1993, between The Koger Partnership, Ltd. and Koger Properties, Inc.* (r)(2) First Amendment to Incentive Fee Agreement, dated December 21, 1993, between The Koger Partnership, Ltd, and Koger Properties, Inc.* (s) Limited Recourse Guaranty and Security Agreement, dated August 3, 1993, by The Koger Partnership, Ltd. and Koger Properties, Inc. in favor of the holders of the Basic Restructured Mortgages Notes of The Koger Partnership, Ltd.* (t) Option and Purchase and Sale Agreement, dated August 3, 1993, between The Koger Partnership, Ltd. and Koger Properties, Inc.* (u) Subordination Agreement, dated as of August 3, 1993, executed and delivered by Koger Properties, Inc.* 22 Subsidiaries of the Registrant.* 28 (a) Order Granting Debtor's Motion to Use Cash Collateral entered in RE Chapter 11 of Koger Properties, Inc. (Case No. 91-12294- 8P1) by United States Bankruptcy Court, Middle District of Florida, Tampa Division. Incorporated by reference to Exhibit 28 of Form 10-K filed by the Registrant for the year ended December 31, 1991 (File No. 1-9997). (b) First Amended and Restated Disclosure Statement, dated as of March 1, 1993, pursuant to Section 1125 of the Bankruptcy Code to accompany First Amended and Restated Plan of Reorganization dated as of March 1, 1993, for Koger Properties, Inc., proposed jointly by Koger Properties, Inc. and Koger Equity, Inc., including all exhibits thereto. Incorporated by reference to Exhibit 29 of Form 10-K filed by the Registrant for the year ended December 31, 1992. *Filed with this Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Koger Equity, Inc., has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. KOGER EQUITY, INC. By: IRVIN H. DAVIS Irvin H. Davis, President and Chief Executive Officer Date: March 11, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated. Signature Title Date IRVIN H. DAVIS President, Chief Executive Officer March 11, 1994 (Irvin H. Davis) and Director VICTOR A. HUGHES Senior Vice President, Chief March 11, 1994 (Victor A. Hughes) Financial Officer and Director JAMES L. STEPHENS Treasurer and Chief Accounting March 11, 1994 (James L. Stephens) Officer S. D. STONEBURNER Chairman of the Board of March 11, 1994 (S. D. Stoneburner) Directors and Director D. PIKE ALOIAN Director March 11, 1994 (D. Pike Aloian) BENJAMIN C. BISHOP Director March 11, 1994 (Benjamin C. Bishop) Director (Charles E. Commander, III) Director (David B. Hiley) G. CHRISTIAN LANTZSCH Director March 11, 1994 (G. Christian Lantzsch) Director (Thomas K. Smith, Jr.) Director (George F. Staudter)

745276_1993.txt

745276_1993

1993

745276

ITEM 1. BUSINESS - ---------------- Description of Business ----------------------- CoBancorp Inc. (the "Corporation"), headquartered in Elyria, Ohio, is a one-bank holding company registered with the Federal Reserve System whose principal asset is the common stock of its wholly owned commercial bank subsidiary, PremierBank & Trust (the "Bank"). The Corporation was organized under Ohio law in November 1983 and remained inactive until September 8, 1984. On that date, the Bank's shareholders became Corporation shareholders in a tax-free and regulatory reorganization. This transaction was accounted for as a pooling of interests. As a bank holding company, the Corporation is exclusively engaged and intends to continue to engage in the management of the Bank. The Bank was chartered by the State of Ohio in 1926 and is a member bank of the Federal Reserve System. The Bank operates twenty-three (23) banking offices throughout its market area of Lorain County and portions of Cuyahoga, Erie, Richland, Huron, Delaware and Crawford Counties. The Bank also operates a consumer loan office in Elyria and a loan production office in Franklin County. The Bank has 27 automated teller machines ("ATMs") and is a member of the MAC, Money Station and Plus ATM networks. As a member bank of the Federal Reserve System, the Bank's deposits are insured by the Federal Deposit Insurance Corporation (the "FDIC") to the extent permitted by law. The Bank is subject to primary regulation by the Federal Reserve and the Ohio Department of Commerce, Division of Banking. The Bank is also subject to regulation by the FDIC. The Corporation's activities as a bank holding company are regulated by the Federal Reserve, and the Corporation's corporate governance is determined by Ohio law. The Bank provides commercial and retail banking services to individual, business, institutional and governmental customers. These services include personal and commercial checking accounts, savings and time deposit accounts, personal and business loans, a credit card system and safe deposit facilities. The Trust Department of the Bank performs complete trust administrative functions and offers agency and trust services to individuals, partnerships, corporations, institutions and municipalities. As of December 31, 1993, in the opinion of management, the Corporation did not have any concentration of loans to similarly situated borrowers exceeding 10% of total loans. There were no foreseeable losses relating to other interest-earning nonloan assets. The Bank is not significantly affected by seasonal activity or large deposits of individual customers. The Bank is not engaged in operations in any foreign country. On December 31, 1993, the Corporation and its subsidiary employed approximately 277 full-time and 92 part-time employees. None of the employees is represented by a union or collective bargaining group. Management considers its relations with employees to be satisfactory. Employee benefit programs are considered by management to be competitive with benefits provided by other financial institutions and major employers within the normal operating area. Competition ----------- The Bank actively competes with other financial institutions in its market area. Competition for savings comes principally from other commercial banks, savings and loan associations, credit unions and brokerage house "money market funds" located in its primary market area. The primary factors in competing for savings are interest rates paid on deposits and convenience of office hours and locations. During periods when money market rates are relatively high, obligations offered by governments, government agencies and other entities seeking funds add significantly to competition for savings. The Bank's principal competition for loans is provided by other commercial banks, savings and loan associations, mortgage companies and credit unions. The primary factors in loan competition are interest rates, extent and time interval of interest rate adjustments, origination charges and convenience of office location for applications, closing and servicing. Regulation ---------- The Corporation is subject to regulation under the Bank Holding Company Act of 1956, as amended (the "Act"). The Act requires the prior approval of the Federal Reserve Board for a bank holding company to acquire or hold more than a 5 percent voting interest in any bank, and restricts interstate banking activities. The Act restricts the Corporation's non-banking activities to those which are closely related to banking. The Federal Reserve Board has determined by regulation that the following activities are permissible for bank holding companies and their subsidiaries. Some of these activities include the following: making, acquiring or servicing loans or other extensions of credit; trust company functions; leasing personal or real property; courier services; management and consulting for other depository institutions; and real estate appraising. The Corporation presently has no non-banking activities, but may in the future engage in one or more of the non-banking activities identified above. The Corporation's cash revenues are derived from dividends paid by the Bank, its subsidiary. These dividends are subject to various legal and regulatory restrictions as summarized in Note I on page 18 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. Under the Act and regulations of the Federal Reserve Board pursuant thereto, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit. The Bank is a stock-form commercial bank organized under the laws of the State of Ohio, and its deposits are insured by the FDIC. The Bank derives its lending, investment and other powers from the applicable provisions of Ohio law and the regulations of the Ohio Department of Banking (the "Banking Department"), subject to limitation or other modification under applicable federal laws and regulations of such agencies as the FDIC and the Federal Reserve Board. The Bank is subject to periodic examination and supervision by the Federal Reserve Board and the Banking Department. The Banking Department regulates the Bank's internal organization as well as its deposit, lending and investment activities. The Superintendent of the Banking Department must approve changes to the Bank's Certificate of Incorporation, establishing or relocating branch offices, mergers and the issuance of additional stock. Many of the areas regulated by the Banking Department are subject to similar regulation by the Federal Reserve Board. The Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDIC Improvement Act") covers a wide expanse of banking regulatory issues. The FDIC Improvement Act deals with the recapitalization of the Bank Insurance Fund, with deposit insurance reform, including requiring the FDIC to establish a risk-based premium assessment system, and with a number of other regulatory and supervisory matters. The effective dates for the provisions of the FDIC Improvement Act are staggered, some having already taken effect and others taking effect at various times in the future. Regulations have been proposed to implement this Act, but the full effects of the FDIC Improvement Act generally on the financial services industry, and specifically on the Corporation, cannot now be measured. Examination and Supervision --------------------------- Both the Banking Department and the Federal Reserve Board issue regulations and require the filing of reports describing the activities and financial condition of banks under their jurisdiction. Each regulatory body conducts periodic examinations to test compliance with various regulatory requirements and generally supervises the operations of such banks. This supervision and regulation is intended primarily for the protection of depositors. The Federal Reserve Board may sanction any insured bank that does not operate in accordance with Federal Reserve Board regulations, policies and directives. Proceedings may be instituted against any insured bank, or any trustee, director, officer or employee of the bank, that engages in unsafe and unsound practices, including the violation of applicable laws and regulations. The Federal Reserve Board may revalue assets of an institution, based upon appraisals, and may require the establishment of specific reserves in amounts equal to the difference between such revaluation and the book value of the assets. In addition, the FDIC has the authority to terminate insurance of accounts, after notice and hearing, upon a finding by the FDIC that the insured institution is or has engaged in any unsafe or unsound practice that has not been corrected, or is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule or order of or condition imposed by the FDIC. Under Ohio law, the Superintendent of the Banking Department may also issue an order to an Ohio-chartered banking institution to appear and explain an apparent violation of law, to discontinue unsound or unsafe practices, and to keep books and accounts as prescribed. Upon a finding by the Banking Department that any director, trustee or officer of any banking organization has violated any law or duly enacted regulation, or has continued unauthorized or unsafe practices in conducting the business of the banking organization after having been notified by the Superintendent to discontinue such practices, such director, trustee or officer may be removed from office after notice and an opportunity to be heard. Effective January 1, 1991, the Federal Reserve Board adopted core capital requirements to be applicable to state member banks and bank holding companies, which require a 3 percent core capital requirement for any institution in the highest regulatory rating ("CAMEL rating") category. All other banking organizations would be required to maintain levels 100 to 200 basis points higher, based on their particular circumstances. As of December 31, 1993, the Corporation and the Bank, respectively, had tier one leverage ratios of 7.90% and 8.10%, which placed each in compliance with applicable core capital requirements. Failure to meet the capital requirements would mean that the insured member bank would be treated as having inadequate capital, and such an insured member bank would have to develop and file a plan with the Federal Reserve Board describing the means and a schedule for achieving the minimum capital requirements. In addition, such an insured member bank would not receive the Federal Reserve Board's approval of any application that required the consideration of capital adequacy, for instance, a branch application, unless the Federal Reserve Board found that the bank had a reasonable plan to meet the capital requirement within a reasonable period of time. In March 1989, the Federal Reserve Board adopted a risk-based capital rule which will apply to all BIF-insured state-chartered banks that are members of the Federal Reserve System ("state member banks"), such as the Bank. The rule requires state member banks to maintain minimum capital levels based upon a weighting of the assets according to risk. Under the new rule, qualifying total risk-based capital equals the sum of Tier I and Tier II capital. Among other items, Tier I capital is generally comprised of common stockholders' equity, non-cumulative perpetual preferred stock and minority interests in the equity account of consolidated subsidiaries, while Tier II capital generally consists of allowances for loan and lease losses (limited to a percentage of risk-weighted assets) and maturing capital instruments such as cumulative perpetual preferred stock, convertible debt securities and subordinated debt. At least 50 percent of the qualifying total risk-based capital must consist of Tier I capital. Tier I capital is defined as the sum of Tier I capital elements minus all intangible assets other than mortgage servicing rights. Once risk-based capital is calculated, the rule then assigns each balance sheet asset held by state member banks to one of four risk categories (0%, 20%, 50% and 100%) based on the amount of credit risk associated with that particular class of assets. For example, cash and U.S. Government securities backed by the full faith and credit of the U.S. Government are assigned a 0% risk weight while qualifying first mortgages on one- to four-family residential loans are assigned a 50% risk weight. Assets not within a specific risk-based category are assigned to the 100% risk-weight category. Indirect holding of pools of assets, for example mutual funds, are assigned the highest risk category appropriate to the highest risk-weighted asset that the fund is permitted to hold. Off-balance sheet items are included in risk-weighted assets pursuant to a conversion formula. Assets not included for purposes of calculating capital are not included in calculating risk-weighted assets. The book value of assets in each category is multiplied by the weighing factor (from 0% to 100%) assigned to that category. The resulting weighted value from each of the four risk categories are added together and this sum is the risk-weighted assets total that, as adjusted, comprises the denominator of the risk-based capital ratio. The state member bank's risk-based capital ratio is then calculated by dividing its qualifying total risk-based capital base by its risk-weighted assets. The rule for calculating risk-based capital ratios took effect in 1989. At the end of 1992, state member banks are required to maintain qualifying total capital equal to 8 percent of their risk-weighted assets and off-balance sheet items. Banks that fail to meet the risk-based capital requirements are required to file a capital plan with the Federal Reserve Board describing the means and a schedule for achieving the minimum capital requirements. In addition, any application that requires the consideration of capital adequacy, such as a branch application, may not be approved by the Federal Reserve Board unless the Federal Reserve Board finds that the bank has a plan to meet the capital requirements within a reasonable period of time. At December 31, 1993, the Bank's total capital-to-risk weighted assets ratio calculated under the risk-based capital requirement was 14.93 percent, while the Bank's actual risk-based capital was in excess of that required by $20,132,000. Federal Reserve System ---------------------- Under Federal Reserve Board regulations, the Bank is required to maintain reserves against its transaction accounts (primarily checking and NOW accounts), non-personal money market deposit accounts, and non-personal time deposits. Effective April 2, 1992, the Federal Reserve Board cut the reserve requirement on transaction accounts from 12 percent to 10 percent. Effective December 31, 1990, in addition, no reserves (subject to adjustment by the Federal Reserve Board up to 9 percent) must be maintained on time deposits, which include borrowings with original maturities of less than one and one-half years. These amounts and percentages are subject to adjustment by the Federal Reserve Board. Money market deposit accounts are subject to the reserve requirement applicable to time deposits when held by an entity other than a natural person. Insurance of Deposits --------------------- Deposits in the Bank are insured by the Federal Deposit Insurance Corporation (the "FDIC"), to the legal maximum. Under FIRREA, the deposits of commercial banks continue to be insured to a maximum of $100,000 for each insured depositor. Community Reinvestment Act -------------------------- Ratings of depository institutions under the Community Reinvestment Act of 1977 ("CRA") must be disclosed. The disclosure will include both a four-unit descriptive rating for all CRA examinations at banks and thrifts after July 1, 1990, using terms such as satisfactory and unsatisfactory, and a written evaluation of each institution's performance. At its most recent CRA performance evaluation, the Bank received a satisfactory evaluation of its CRA performance. Each of the above executive officers of the Corporation has been an officer of the Registrant or its subsidiary, PremierBank & Trust, during the past five years, except as follows. Mr. Kreighbaum joined the Corporation and the Bank as President in January 1991. Mr. Kreighbaum most recently was the President and Chief Executive Officer of The Delaware County Bank, Delaware, Ohio, from 1986 through 1990. Mrs. Barnes joined the Corporation and the Bank as Vice President in August 1991, and became Senior Vice President/Branch Administration in June 1993. Prior to that, Mrs. Barnes was Vice President at Delaware County Bank from 1987 to July 1991. Mr. Miller joined the Corporation and the Bank in October 1992 as Vice President. In June 1993 he was made Senior Vice President/Operations. Prior to joining CoBancorp Inc. and PremierBank & Trust, Mr. Miller was Senior Vice President/Chief Auditor at First Security Corporation of Kentucky from 1988 to October 1992. Mr. Scott joined the Corporation and the Bank in March 1993. Prior to that, he was at Mid-State Bank and Trust Company, Altoona, Pennsylvania since 1983. Mr. Stevens joined the Corporation and the Bank in June 1992 as Vice President/Commercial Loan Officer, and became Vice President/Director, Commercial Lending in May 1993. Prior to joining CoBancorp Inc. and PremierBank & Trust, Mr. Stevens was Senior Vice President, Loan Administration at a local commercial bank from 1974 to 1992. There are no family relationships between any of the above executive officers of the Corporation. Supplemental Financial Data --------------------------- Numeric disclosure regarding the Corporation's business and supplemental financial data concerning the Corporation and the Bank as described below is incorporated herein by reference to the pages of this report set forth opposite each specific caption: ITEM 2. ITEM 2. PROPERTIES - ------------------ The principal office of CoBancorp Inc. and PremierBank & Trust is located at 124 Middle Avenue, Elyria, Ohio. At December 31, 1993, the Bank owned 19 of its banking facilities and leased the other 12 facilities. All but seven of the offices are located in Lorain County, Ohio. Through the Bank, the Corporation owns and operates 27 ATMs at various branch offices and at six remote locations and is a member of the MAC and Money Station ATM Networks, which provide their members with regional ATM access, and the Plus System ATM network, which provides its members with international access. The following table sets forth certain information regarding the properties of the Corporation and the Bank. Continued ITEM 3. ITEM 3. LEGAL PROCEEDINGS - ------------------------- There is no pending litigation of a material nature in which the Corporation or the Bank is involved and no such legal proceeding was terminated during the fourth quarter of 1993. Furthermore, there is no material proceeding in which any director, officer, or affiliate of the Registrant, or any associate of any such director or officer, is a party, or has a material interest, adverse to the Corporation or the Bank. As a part of its ordinary course of business, the Corporation and the Bank are each a party to lawsuits (such as garnishment proceedings) involving claims to the ownership of funds in particular accounts and involving the collection of delinquent accounts. All such litigation is incidental to the business of the Bank and the Corporation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ----------------------------------------------------------- None. PART II ------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER - ------------------------------------------------------------------------ MATTERS ------- Reference is made to the "Market and Dividend Information" on page 25 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference, for information concerning the principal market for Registrant's Common Stock, market prices, number of shareholders and dividends, which is incorporated herein by reference. The high and low bid prices quoted from the newspaper (prior to the Corporation's listing on the Nasdaq National Market System in August 1993) reflect inter-dealer prices without adjustments for retail markups, markdowns or commissions and may not represent actual transactions. Reference is made to Note I to the Consolidated Financial Statements on page 18 of the Registrant's 1993 Annual Report to Shareholders for information concerning dividend restrictions, which is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - ------------------------------- Reference is made to the table entitled "Five Year Financial Summary" on page 25 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------- RESULTS OF OPERATIONS --------------------- CoBancorp Inc. is a one-bank holding company with total consolidated assets at year-end 1993 of $492 million. Its subsidiary, PremierBank & Trust, maintains offices in Lorain County, as well as Cuyahoga, Erie, Huron, Richland, Delaware, Crawford and Franklin Counties. This section of the report provides a narrative discussion and analysis of the consolidated financial condition and results of operations of CoBancorp Inc. and PremierBank & Trust for the past three years. The supplemental financial data included in this section should be read in conjunction with the consolidated financial statements and related disclosures presented on pages 8 through 24 of the Registrant's 1993 Annual Report to Shareholders, which are incorporated herein by reference. All shares outstanding and per share data have been adjusted for a four-for-three stock split in February 1994, a four-for-three stock split in July 1993, a four percent stock dividend in 1992, a three percent stock dividend in 1991 and a five percent stock dividend in 1989. Consolidated Selected Financial Data ------------------------------------ Reference is made to the table entitled "Five Year Financial Summary" on page 25 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. Performance Overview -------------------- Net income for 1993 was $5,281,000, or $1.61 per share, compared to $4,378,000, or $1.35 per share in 1992, and $3,254,000, or $1.01 per share in 1991. Two key measures of performance in the banking industry are return on average equity (ROE) and return on average assets (ROA). ROE is the ratio of income earned to average shareholders' equity. ROE for 1993 was 14.6 percent, compared to 13.8 percent in 1992 and 11.3 percent in 1991. ROA measures how effectively a corporation uses its assets to produce earnings. For 1993, return on average assets was 1.10 percent. ROA was 1.01 percent in 1992 and .81 percent in 1991. ROE and ROA have been positively impacted by an upward trend in the net interest margin. The following table sets forth operating and capital ratios of the Corporation. Results of Operations --------------------- Net Interest Income - ------------------- The Corporation's primary source of earnings is net interest income, which is the difference between revenue generated from earning assets and the interest cost of funding those assets. For discussion, net interest income is adjusted to reflect the effect of the tax benefits of certain tax-exempt investments and loans to compare with other sources of interest income. Net interest income on a fully taxable-equivalent basis grew to $23,713,000 in 1993, from $21,828,000 in 1992 and $18,968,000 in 1991. Reference is made to the "Summary of Changes in Net Interest Income" on page 16 of this report for a detailed analysis of factors affecting this trend in net interest income. Net interest margin, which is net interest income divided by average earning assets, was 5.39 percent in 1993 compared with 5.43 percent in 1992 and 5.13 percent for 1991. Average earning assets, as a percentage of total assets, decreased slightly to 91.7 percent this year compared to 92.0 percent in 1992 and 92.1 percent in 1991. The trends in various components of the balance sheet and their respective yields and rates which affect interest income and expense are shown in the following table. The following table sets forth for the periods indicated a summary of the changes in interest income and interest expense on a fully taxable-equivalent basis resulting from changes in volume and changes in rates for the major components of interest-earning assets and interest-bearing liabilities: PROVISION FOR LOAN LOSSES The total provision for loan and real estate losses was $920,000 in 1993, $2,800,000 in 1992 and $2,500,000 in 1991. Additional discussion regarding the provision for loan losses and the allowance for loan losses is contained in this report in the section entitled "Credit Quality and Experience" on page 23. NONINTEREST INCOME Total noninterest income of $4.5 million for 1993 increased $500,000, or 10.5 percent, when compared to 1992. This follows increases of 30.1 percent during 1992 and 6.6 percent during 1991. Service charges on deposit accounts represented $178,000 of the growth in 1992 due principally to growth in transaction and savings deposit accounts coupled with price increases. Income from trust activities increased in 1993, 1992 and 1991 primarily due to the growth in assets under management. Total assets managed by the Trust Department aggregated $220.0 million, $173.0 million and $151.5 million at December 31, 1993, 1992 and 1991, respectively. Gains and losses on the sale of investment securities also impact comparisons. Security transactions resulted in gains of $665,000, $566,000 and $142,000 in 1993, 1992 and 1991, respectively. NONINTEREST EXPENSES Noninterest expenses increased 18.2 percent in 1993, 12.9 percent in 1992 and 2.5 percent in 1991. The increase in 1993 can be attributed to higher levels of expense relative to salaries, advertising, supplies and insurance. Salaries, wages and benefits account for 43.6 percent of total noninterest expense in 1993, compared to 43.2 percent in 1992 and 47.7 percent in 1991. These increases are primarily attributable to increases in the number of employees, the increased cost of benefits and merit raises. Also affecting the increase in 1991 was a one-time cost of the finalization of the outsourcing process of the electronic data processing activities of the Bank. In December 1993 there were 317 full-time equivalent employees, an increase of 12.8 percent from the 281 full-time equivalent employees at December 1992, which was an increase of 12.9 percent from the level of 249 full-time equivalent at December 1991. INCOME TAXES One element of the Corporation's tax planning is the implementation of various investment and loan strategies to maximize after-tax profits. This planning is an ongoing process which considers the levels of tax-exempt securities and loans, investment securities gains or losses and allowable loan loss deductions. The Corporation's effective income tax rate (income tax expense divided by income before income taxes) is less than the statutory rate primarily due to income on tax-exempt securities and loans. It should be recognized that the yield on these types of assets is considerably less than on other investments of the same maturity and risk. The income tax provision was $1,100,000 in 1993, compared with $1,130,000 in 1992 and $761,000 in 1991. The Corporation's effective tax rate was 20.8 percent in 1993, 20.5 percent in 1992 and 19.0 percent in 1991. It has been determined that for the year ended December 31, 1993, a valuation allowance is not required on any of the deferred tax assets recorded due primarily to the earnings history of the Corporation and the significant amount of federal income taxes paid in prior years. FINANCIAL CONDITION The consolidated financial condition of the Corporation and the Bank as of December 31, 1993 and 1992 is presented in the comparative balance sheets on page 8 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. The following discussions address key elements of financial condition, including earning assets, the sources of funds supporting earnings assets, credit quality and experience, asset and liability management and capital adequacy. EARNING ASSETS LOANS Loans comprise the majority of the Corporation's earning assets, representing 59.1 percent of average earning assets in 1993, and 58.5 percent in 1992. Average loans outstanding increased 11.3 percent in 1993 and 1.6 percent in 1992. The largest asset category in the loan portfolio was real estate mortgage loans, which comprised 45.8 percent of total loans at the end of 1993. Commercial and collateral loans totaled 42.4 percent of the portfolio and installment loans comprised 10.8 percent of the portfolio. All other loans were 1.0 percent of the portfolio. In 1992, commercial and collateral loans were 44.3 percent of the loan portfolio, real estate mortgages were 40.5 percent, installment loans were 13.9 percent and other loans were 1.3 percent. The mix within the commercial loan portfolio is diverse and represents loans to a broad range of business interests, located primarily within the Bank's defined market area, with no significant industry concentration. The installment loan portfolio is composed principally of financing to individuals for vehicles and consumer assets. The real estate portfolio is primarily residential mortgages that can qualify for sale into the secondary market. Loans by major category at the end of the last five years were as follows: The maturity distribution and sensitivity to interest rates of the loan portfolio are two factors in management's evaluation of the risk characteristics of the portfolio and the future profitability of the portfolio. Loans at December 31, 1993, reported at the earliest of maturity or repayment for fixed rate loans, and earliest repricing opportunity for variable rate loans, with nonaccrual loans included in the "after 5 years" category, are as follows (in thousands of dollars): Fixed rate loans maturing within one year and loans with adjustable rates that reprice annually or more frequently (exclusive of scheduled repayments) totaled $118,336,000 or 40.9 percent of the loan portfolio at December 31, 1993. INVESTMENT SECURITIES The investment portfolio is comprised of U. S. Treasury and other U. S. Government agency-backed securities, collateralized mortgage-backed securities, tax-exempt obligations of states and political subdivisions, and certain other investments. The quality of obligations of states and political subdivisions will be A, AA, or AAA, the majority of which will be AA or AAA, as rated by a nationally recognized service. As a matter of policy, in support of our service area, we may purchase certain unrated bonds of local schools, townships and municipalities, provided they are of reasonable credit risk. On December 31, 1993, the Corporation adoped FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Accordingly, securities available-for-sale are recorded at market value and the unrecognized gain of $982,000 (net of tax) is included in shareholders' equity. The adoption did not have a material effect on results of operations and prior years' financial statements were not restated. In anticipation of the adoption of FASB Statement No. 115, securities netting to $87,275,000 (adjusted cost basis) were reclassified between the held-to-maturity and available-for- sale portfolios. The portfolio accounting designations were made in order to attain the objectives of the Corporation's investment portfolio, which are to generate interest income, serve as a liquidity source and play an important role in the management of the interest rate sensitivity of the Corporation. Accordingly, securities purchased for the available-for-sale category are those which may be sold prior to their maturity for purposes of bank asset allocations, rate sensitivity or liquidity and, hence, tend to be more liquid. Securities in the held-to-maturity category are purchased with the intent and ability to hold them to maturity and are, therefore, carried at amortized cost. The investment portfolio represented 39.7 percent of average earning assets in 1993 and 39.4 percent in 1992. Average investment securities held increased 11.1 percent in 1993 compared to 1992. The tax-equivalent yield on the entire portfolio was 7.17, 8.19 and 9.07 percent in 1993, 1992 and 1991, respectively. These investments provide a stable yet diversified income stream and serve useful roles in liquidity and interest rate sensitivity management. In addition, they serve as a source of collateral for low-cost funding. The market value of investment securities was higher than book value at December 31, 1993 and 1992. The decision to purchase securities is based upon the assessment of current economic and financial trends. At December 31, 1993, the investment portfolio had a total book value of $152.9 million compared with $172.8 million at the previous year-end. Summary information with respect to the securities portfolio at December 31 follows (in thousands of dollars): The yield at December 31, 1993, was the combined rate for the held-to-maturity and available-for-sale securities portfolios. Mortgage-backed securities and other securities which may have prepayment provisions are assigned to a maturity category based on estimated average life. Securities with a call provision are assigned to a maturity category based on call date. Yield represents the weighted average yield to maturity. The yield on obligations of states and political subdivisions has been calculated on a fully taxable equivalent basis, assuming a 34% tax rate. FEDERAL FUNDS SOLD Short-term federal funds sold are used to manage interest rate sensitivity and to meet liquidity needs. During 1993, 1992 and 1991, these funds represented approximately 1.2 percent, 2.1 percent and 4.4 percent, respectively, of average earning assets. SOURCES OF FUNDS DEPOSITS The Corporation's major source of investable funds is core deposits from retail and business customers. These core deposits consist of interest-bearing and noninterest-bearing deposits, excluding certificates of deposit over $100,000. Average interest-bearing core deposits, comprised of interest-bearing checking accounts, savings, money market and other time accounts, grew 13.4 percent in 1993, compared to 14.3 percent in 1992 and 5.2 percent in 1991. Average demand deposits (noninterest-bearing core deposits) increased 5.7 percent in 1993 and 12.2 percent in 1992, following a decrease of 1.3 percent in 1991. These deposits represent approximately 13.1 and 13.9 percent of average core deposits in the last two years, respectively. The Corporation's core deposit fund position has allowed management to place less emphasis on purchased funds to support loans and investments. Purchased funds include certificates of deposit over $100,000. These funds are used to balance rate sensitivity and as a supplement to core deposits. Average certificates of deposit over $100,000 decreased 30.1 percent in 1993 from 1992 levels, to 3.5 percent of average assets. This followed a decrease of 15.5 percent in 1992 from 1991 levels, to 5.7 percent of average assets in 1992. The following table presents the average amount of and the average rate paid on each of the following deposit categories (dollar amounts in thousands). Average Deposits The maturity distribution of certificates of deposit of $100,000 or more at December 31, 1993, was (in thousands of dollars): Certificates of Deposit Over $100,000 There were three other time deposits of $100,000 or more at December 31, 1993, which will mature in 1994 through 1995. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND OTHER BORROWINGS Other interest-bearing liabilities include securities sold under agreements to repurchase, sweep accounts, federal funds purchased and notes payable TT&L. In 1993, these short-term funds increased slightly to 5.2 percent of average assets compared to 4.2 percent in 1992. The Corporation enters into sales of securities under agreements to repurchase for periods up to 29 days, which are treated as financings and reflected in the consolidated balance sheet as a liability. The following table presents information related to securities sold under agreements to repurchase (repurchase agreements). Securities Sold Under Agreements to Repurchase CREDIT QUALITY AND EXPERIENCE NONPERFORMING LOANS Inherent in the business of providing financial services is the risk involved in extending credit. Management believes the objective of a sound credit policy is to extend quality loans to customers while reducing risk affecting shareholders' and depositors' investments. Risk reduction is achieved through diversity of the loan portfolio as to type, borrower and industry concentration as well as sound credit policy guidelines and procedures. Except for installment and credit cards, loans on which interest and/or principal is 90 days or more past due are placed on nonaccrual status and any previously accrued but uncollected interest is reversed. Such loans remain on a cash basis for recognition of income until both interest and principal are current. Installment and credit cards loans past due greater than 120 days are charged off and previously accrued but uncollected interest is reversed. Nonperforming loans include loans accounted for on a nonaccrual basis, accruing loans which are contractually past due 90 days or more as to principal or interest payments and loans which have been renegotiated. Total nonperforming loans at December 31, 1993, were $1,459,000, compared to $2,540,000 at December 31, 1992 and $4,712,000 at December 31, 1991. The ratio of the allowance for loan losses to nonperforming loans at December 31, 1993, was 358.2 percent compared to 205.3 percent and 87.0 percent at December 31, 1992 and 1991, respectively. Total nonperforming loans as a percentage of total loans decreased to 0.5 percent at December 31, 1993, compared to 1.0 percent at December 31, 1992 and 2.1 percent at December 31, 1991. The following table summarizes nonaccrual, past due and restructured loans. The effect of the nonaccrual loans, on a fully taxable-equivalent basis, for the year ended December 31 was as follows: ALLOWANCE FOR LOAN LOSSES AND LOAN CHARGE-OFFS The allowance for loan losses is the reserve maintained to cover losses that may be incurred in the normal course of lending. The allowance for loan losses is increased by provisions charged against income and recoveries of loans previously charged off. The allowance is decreased by loans that are determined uncollectible by management and charged against the allowance. In determining the adequacy of the allowance for loan losses, management on a regular basis evaluates and gives consideration to the following factors: estimated future losses of significant loans including identified problem credits; historical loss experience based on volume and types of loans; trends in portfolio volume, maturity and composition; off-balance sheet credit risk; volume and trends in delinquencies and nonaccruals; economic conditions in the market area; and any other relevant factors that may be pertinent. Potential problem loans are those loans which are on the Corporation's "watch list." These loans exhibit characteristics that could cause the loans to become nonperforming or require restructuring in the future. Periodically, and at a minimum monthly, this "watch list" is reviewed and adjusted for changing conditions. ASSET AND LIABILITY MANAGEMENT AND CAPITAL ADEQUACY INTEREST RATE SENSITIVITY Balance sheet structure and interest rate changes play important roles in the growth of net interest income. PremierBank & Trust's Asset/Liability Committee manages the overall rate sensitivity and mix of the balance sheet to anticipate and minimize the effects of interest rate fluctuations and maintain a consistent net interest margin. Refer to the following tables for additional information regarding interest rate sensitivity: LIQUIDITY Liquidity is the ability to raise cash quickly and economically when funds are needed. The need for funds primarily arises from deposit withdrawals and demand for new loans. Stable core deposits and other interest-bearing funds are all important components of liquidity. PremierBank & Trust's long-term liquidity sources are a large core deposit base and a strong capital position. Core deposits are the most stable source of liquidity a bank can have due to the long-term relationship with deposit customers. Core deposits averaged 82.7 percent of total average assets during 1993, and 81.6 percent during 1992. Readily marketable assets, particularly short-term investments, provide another source of liquidity. These funds can be quickly converted into cash to meet short-term liquidity demands at minimal cost. CAPITAL ADEQUACY Shareholders' equity is a stable, noninterest-bearing source of funds which provides support for asset growth and is the primary component of capital. Capital adequacy refers to the level of capital required to sustain capital growth over time and to absorb losses on risk assets. It is management's intent to maintain a level of capitalization that allows the flexibility to take advantage of opportunities that may arise. Shareholders' equity at December 31, 1993, was $39.7 million, or $12.16 per share, compared with $34.2 million or $10.53 per share at December 31, 1992 and $30.4 million or $9.42 per share at December 31, 1991. At December 31, 1993, the Corporation's leverage ratio was 7.90 percent. The Corporation's risk-based capital ratios based on Federal Reserve Board guidelines were 13.34 percent for Tier 1, or "core" capital, and 14.60 percent for total qualifying capital. These ratios substantially exceed the minimums that are currently in effect for bank holding companies during 1993. These minimums are 4.00 percent and 8.00 percent for Tier I and total qualifying capital, respectively. It is management's intent to maintain a level of capitalization that allows the flexibility to take advantage of opportunities that may arise in the future. For additional discussion, see "Examination and Supervision," on pages 6 through 8 of this report. COMMON STOCK AND RELATED MARKET DATA COMMON STOCK Reference is made to the "Market and Dividend Information" on page 25 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. DIVIDENDS CoBancorp Inc.'s dividend policy balances shareholders' return with the need to retain an adequate capital level to support future growth opportunities. Dividend payout has ranged from 25.4 to 49.5 percent of earnings over the last five years. Dividends declared in 1993 were $0.41 per share, compared to the $0.34 of dividends declared in 1992. Dividends for 1991 were $0.25 per share. FINANCIAL REPORTING AND CHANGING PRICES Although inflation can have a significant effect on the financial condition and operating results of banks, it is difficult to measure the impact as neither the timing nor the magnitude of interest rate changes necessarily coincide with changes in the consumer price index or any other index of inflation. Inflation can impact the growth of total assets and result in a need to increase capital at a faster than normal rate in order to maintain an appropriate equity to assets ratio. This can result in a smaller proportion of earnings paid out in the form of dividends. The results of operations can also be affected by the impact of inflation on current interest rates. Intermediate to long-term interest rates tend to increase in an inflationary environment, thereby affecting the market value of long-term fixed rate assets. Higher short-term rates tend to increase funding costs. In addition, noninterest expenses are more directly impacted by current inflation rates. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - --------------------------------------------------- Reference is made to pages 8 through 24 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ----------------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- None. PART III -------- ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ----------------------------------------------------------- ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - ------------------------------- ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------ ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------- Reference is made to the Corporation's Proxy Statement dated March 21, 1994, and to information on page 9 of Part I of this report, for the information required by Items 10 through 13, and which information is incorporated herein by reference. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - ------------------------------------------------------------------------ (a) (1) and (2) Financial Statements and Schedules The following consolidated financial statements appear on pages 8 through 24 of the Registrant's 1993 Annual Report to Shareholders, which are incorporated herein by reference: Consolidated Balance Sheets at 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 Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Auditors Schedules I and II are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) Listing of Exhibits (b) Reports on Form 8-K No reports on Form 8-K were filed in the last quarter of the Registrant's latest fiscal year. [ERNST & YOUNG LETTERHEAD] REPORT OF INDEPENDENT AUDITORS Board of Directors CoBancorp Inc. We have audited the consolidated financial statements of CoBancorp Inc. and subsidiary listed in the accompanying index to financial statements (Item 14(a)). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these 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. As audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assesssing 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 CoBancorp Inc. and subsidiary 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 A and R to the consolidated financial statements, in 1993 the corporation changed its methods of accounting for income taxes and accounting for certain investments in debt and equity securities, respectively. /s/ ERNST & YOUNG ERNST & YOUNG January 21, 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. CoBancorp Inc. Date: March 29, 1994 By: /s/ ------------------------------------ Timothy W. Esson Executive Vice President (Principal Financial Officer and Principal Accounting Officer) SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.

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1993

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Item 1. Business The Registrant is Lockheed Corporation which, together with its consolidated subsidiaries (unless the context otherwise indicates), will be referred to hereinafter as the "company." Lockheed was incorporated in California in 1932. In 1986, under a plan of reorganization approved by its stockholders, the company's domicile was changed from California to Delaware. Its executive offices are located at 4500 Park Granada Boulevard, Calabasas, California 91399, and its telephone number is (818) 876-2000. Lockheed's primary businesses involve research, development, and production of aerospace products and systems. During 1993, approximately 77 percent of sales were to the United States government--64 percent in defense programs and 13 percent in nondefense. Sales to foreign governments accounted for 13 percent of revenues and sales to commercial customers 10 percent. Sales made to foreign governments through the United States government are included in sales to foreign governments. Industry Segments Lockheed's operating companies are aligned into four segments: Aeronautical Systems, Missiles and Space Systems, Electronic Systems, and Technology Services. The company is engaged in a number of classified programs, and the results of operations related to those programs are included in the company's consolidated financial statements and other financial data included herein. While no specific references to individual classified programs are--or could be--made, Management's Discussion and Analysis provides comments regarding trends and results of the classes of products that include these programs. The characteristics and business risks associated with classified business do not differ materially from those of the other programs and products in which the company participates. Financial information about industry segments, foreign and domestic operations, and export sales is included in the Selected Financial Data, Management's Discussion and Analysis, and in Note 13 to the Consolidated Financial Statements included in Part II. Aeronautical Systems The Aeronautical Systems segment comprises design and production of fighter/bomber aircraft, special mission and high performance aircraft, and systems for military operations, for airlift, for antisubmarine warfare, and for reconnaissance and surveillance; and aircraft modification and maintenance for military and civilian customers. In the first quarter of 1993, the company completed the acquisition of the former tactical military aircraft business of General Dynamics Corporation. This division, now called the Lockheed Fort Worth Company, is the prime contractor for the "Fighting Falcon" fighter aircraft. The company ended 1993 with a backlog of nearly 600 firm orders for aircraft from the United States Air Force and international customers. The company is also involved with upgrade and modification programs for the existing fleet ofs, and is the principal subcontractor to develop and manufacture the FS-X fighter aircraft for Japan, which will resemble the . As a result of the Lockheed Fort Worth Company acquisition, the company's share of the air superiority fighter program increased to two-thirds. A team, composed of the company as prime contractor with teammates Boeing and Pratt & Whitney, is currently engaged in the Engineering and Manufacturing Development phase of the program for the United States Air Force. During 1993, the program completed preliminary design review that finalized the interior and exterior lines of the production aircraft. The C-130 airlifter aircraft passed its 40th anniversary in 1993. As production of existing models continues, the company is developing an improved version, the C-130J. It will feature a two-person flight station, fully integrated digital avionics, more powerful engines, and a new, more efficient propeller system. The company is engaged in upgrade programs for its high performance aircraft. This includes re-engining the Air Force fleet of U-2 reconnais- sance aircraft and modifying theA aircraft with an advanced cockpit update for full-color displays and automated flight management system, including navigation, targeting, and mission planning systems. The company's aircraft modification and maintenance programs include major modification to C-130's for special military missions. In addition, the company performs modifications, service life extensions, modernizations, and maintenance services on both military and commercial aircraft. Missiles and Space Systems The Missiles and Space Systems segment comprises military and civil space systems, research laboratories, strategic fleet ballistic missiles, tactical defense missiles, and communications systems. The Trident II D-5 is the sixth generation of submarine-launched, strategic deterrent, fleet ballistic missiles developed and produced by the company for the U.S. Navy. The company is working on its eighth Trident production and support contract. Lockheed also provides fleet ballistic missiles and operations support to the United Kingdom. The company delivered the first Milstar communications satellite to the United States Air Force in 1993. It was launched in early 1994, and is the first of several Milstar satellites designed to provide assured, highly mobile, antijam, worldwide communication links to tactical troops as well as strategic users. As prime contractor for the Theater High Altitude Area Defense (THAAD) program, the company is working under a four-year, $745 million contract awarded in 1992 by the U.S. Army to develop a system capable of intercepting, at high altitudes and long ranges, theater ballistic missiles headed toward deployed military forces and population centers. The company is a part of NASA's Hubble Space Telescope team, having designed and built the spacecraft, provided systems integration, and participated in the 1993 telescope repair mission. Lockheed continues to support the Hubble, working each day with NASA at Goddard Space Center in Greenbelt, Maryland. The company remains as a principal subcontractor on the space station, and supported NASA on the modification of the space station as it went through a major redesign in 1993. The Lockheed components include the laboratory equipment, hardware and rotating joints for the station's exterior, and the solar arrays to power the station. In 1993, the company signed a contract to build spacecraft for Motorola's Iridium TM/SM global communication system. This system will consist of 66 low-Earth orbiting satellites sending signals that can link any telephone to Motorola's small hand-held unit. Lockheed will design and build the Iridium TM/SM bus, consisting of the structure, electrical power system and attitude control system. The company completed the preliminary design phase in 1993 and is scheduled to deliver the first Iridium TM/SM bus in 1995. Lockheed has created a partnership with two of the Russian Federation's major aerospace firms, Khrunichev Enterprises and NPO Energia, and incorporated Lockheed-Khrunichev-Energia International (LKEI), a consortium with worldwide rights to Russia's Proton rocket. In the latter part of 1993, LKEI and Space Systems Loral announced an agreement to provide up to five launches for Loral beginning in 1995. Lockheed's commercial space initiatives also include a new family of Lockheed Launch Vehicles (LLV). The first demonstration flight is scheduled for late 1994. LLV provides the capability to launch small satellites and science missions into low-Earth orbit. Electronic Systems The Electronic Systems segment participates in both defense and commercial markets. For defense markets, the company develops and manufactures radar frequency, infrared, and electro-optic countermeasures systems; mission planning systems; surveillance systems; automated test equipment; antisubmarine warfare systems; microwave systems; and avionics. The company was chosen to produce the new Air Force Mission Support System, a computer-based mission planner that automates many functions including flight and route planning, weapons delivery, and threat analysis. This segment also performs work on advanced cockpit display subsystems for the fighter and C-130J airlifter. This technology can be used to provide state-of-the-art cockpits for other new aircraft as well as upgrades for older systems. The Sanders unit is also supporting a number of Lockheed programs with state-of-the-art microwave monolithic integrated circuits technology. Revolutionary advances in this technology permit smaller, affordable electronic systems to operate more reliably and many times faster than the highest-speed silicon processors. The company also manufactures computer graphics equipment through its CalComp subsidiary, other electronic products, and distributes computer equipment and workstations through its Access Graphics subsidiary, for commercial markets worldwide. Technology Services The Technology Services segment comprises space shuttle processing, engineering sciences and support, military equipment maintenance and support services, airport facilities development and management, data processing and transaction services. The company marked its tenth year as NASA's space shuttle processing contractor in 1993. During the year, the program successfully launched seven shuttle missions. In 1993, NASA again selected Lockheed for the engineering services contract at the Johnson Space Center. Under the contract, the company will help develop NASA manned spaceflight programs and provide them with engineering and scientific support, and will operate and maintain NASA's engineering and science facilities and laboratories. The company provides information services directed to the state and municipal services markets, including processing of parking and moving violations and emergency medical services billing for cities. The company also provides child support locating and collecting services and payment processing for five states and the county of Los Angeles. The company is expanding its presence in government and commercial environmental markets, with contracts to decontaminate and decommission sites and remediate soil contaminated with heavy metals for commercial customers, as well as mixed-waste-technology demonstration projects for two Department of Energy (DOE) locations. The company continues to provide environmental monitoring and technical support services for the Environmental Protection Agency. General No portion of the business of the company is considered to be seasonal. Consolidated funded backlog at December 26, 1993, and December 27, 1992, was $13.2 billion and $8.9 billion, respectively. Of the year-end 1993 backlog, $4.9 billion is not anticipated to be filled by December 25, 1994. The company, along with others, is involved, or has been notified of potential involvement, in several United States Environmental Protection Agency "Superfund" sites. Federal, state, and local requirements relating to the discharge of materials into the environment, the disposal of hazard- ous wastes, and other factors affecting the environment have had and will continue to have an impact on the manufacturing operations of the company. Thus far, compliance with such provisions has been accomplished without material effect on the company's capital expenditures, earnings, and com- petitive position. For a further discussion, see Notes 1 and 11 to the Consolidated Financial Statements included in Part II. The company does not believe that expiration of any patent, trademark, license, franchise, concession, or termination of any agreement relating thereto would have a material effect on its business. Research and Development During 1993, 1992, and 1991, the company performed $3.1 billion, $3.1 billion, and $3.3 billion, respectively, of research and development work under customer contracts. In addition, it expended $449 million in 1993, $420 million in 1992, and $384 million in 1991 on company-sponsored research and development and bid and proposal efforts, a substantial portion of which was included in overhead allocable to U. S. government contracts. During fiscal year 1993, the company did not undertake the development of a new product or line of business requiring the investment of a material amount of its total assets. Raw Materials The company has not experienced difficulty in recent years in obtain- ing an adequate supply of any raw materials or other supplies needed in its manufacturing processes. The company believes that its experience in ob- taining such items will enable it to maintain its competitive position. Procurement and Subcontracting Many materials, items of equipment, and components used in the produc- tion of the company's products are purchased from other manufacturers. The company also purchases from outside sources such items as propulsion sys- tems, guidance systems, telemetry and gyroscopic devices, and electronic functional subsystems in support of its missiles and space programs. In addition, the company often subcontracts major sections of aircraft, such as wings, empennages, and landing gears, to other companies. The company utilizes competitive bidding in its procurement practices wherever feasible. A significant portion of the equipment and components, especially engines, propellers, selected avionics systems, and flight and engine instruments, used by the company in the manufacture of its products under United States government contracts is furnished without charge to the company by the government. The company does not include in its sales that value which is represented by such government-furnished equipment. The company is dependent upon the ability of certain of its suppliers and subcontractors to meet performance specifications, quality standards, and delivery schedules in order to fulfill its commitments to its custo- mers. While the company endeavors to assure the availability of multiple sources of supply, in certain cases involving complex equipment, it relies on a sole source. The failure of certain suppliers or subcontractors to meet the company's needs would adversely affect the company's operations. Although certain priorities under United States government contracts may be available, it has been and may continue to be necessary for the company to enter early orders for its materials with long lead time re- quirements to assure continued availability of materials needed for its programs under which such priorities are unavailable. United States Government Contracts and Regulations The company's United States government business is performed under cost-reimbursement-type contracts (cost-plus-fixed-fee, cost-plus- incentive-fee, and cost-plus-award-fee) and under fixed-price-type contracts (firm fixed-price and fixed-price incentive). During 1993, 39 percent of the company's total sales to the government were under fixed-price-type contracts, and 61 percent were under cost-reimbursement-type contracts. Cost-plus-fixed-fee contracts provide for reimbursement of costs, to the extent that such costs are allowable, and the payment of a fixed fee. This type of contract differs from the cost-plus-incentive fee contract in that the latter provides for increases or decreases in the contract fee, within specified limits, based upon actual results as compared to contrac- tual targets for such factors as cost, quality, schedule, and performance. In addition, these contract types differ from the cost-plus-award-fee con- tract in that the latter provides for an award fee to be paid upon a sub- jective evaluation by the customer of the company's performance, judged in such areas as quality, timeliness, ingenuity, and cost-effectiveness of work. Under firm fixed-price contracts, the company agrees to perform certain work for a fixed price and, accordingly, realizes all the benefit or detriment occasioned by decreased or increased costs of performing the contract. Fixed-price incentive contracts are fixed-price-type contracts providing for adjustment of profit and establishment of final contract prices by a formula based on the relationship which final total costs bear to total target costs, with the contractor absorbing costs which exceed a stipulated ceiling price. Other factors affecting incentive compensation under a fixed-price incentive contract, in addition to cost, may include reliability, schedule, and performance. Under United States government regulations, certain costs--including certain financing costs and marketing expenses--are not allowable. The government also regulates the methods under which costs are allocated to government contracts. For information concerning the company's accounting policies regarding sales and earnings, accounts receivable, and inventories under government contracts, see Notes 1, 5, and 6, respectively, to the Consolidated Financial Statements included in Part II. United States government contracts are, by their terms, subject to termination by the United States government either for its convenience or for default of the contractor. Cost-reimbursement-type contracts provide that, upon termination, the contractor is entitled to reimbursement of its allowable costs; and, if the termination is for convenience, a total fee proportionate to the percentage of the work completed under the contract. Fixed-price-type contracts provide for payment upon termination for items delivered to and accepted by the government; and, if the termination is for convenience, for payment of the contractor's costs incurred plus the costs of settling and paying claims by terminated subcontractors, other settle- ment expenses, and a reasonable profit on its costs incurred. However, if a 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 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 items from another source. In addition to the right of the government to terminate, government contracts are conditioned upon the continuing availability of Congressional appropriations. Congress usually appropriates funds on a fiscal-year basis even though contract performance may take many years. Consequently, at the outset of a major program, the contract is usually partially funded, and additional monies are normally committed to the contract by the procuring agency only as appropriations are made by Congress for future fiscal years. Licenses are required from United States government agencies for export from the United States of many of the company's products. The Export Administration Act of 1979 forbids participation by Americans in international boycotts of countries with which the United States maintains friendly trading relations. Competition and Risk The company encounters extensive competition in all of its lines of business from numerous other companies. Substantial efforts must be undertaken continually on a long-term basis in order to maintain existing levels of business. In some cases, investment in fixed assets is involved. Emphasis is placed by all United States government agencies on the technical and managerial capabilities of the corporations seeking business. Consequently, the degree to which the company may participate in future government business will depend to a large extent on the effectiveness and innovativeness of its research and development programs, its ability to offer better program performance than its competitors at a lower cost to the government, and its readiness in facilities, equipment, and manpower to undertake the programs for which it may be competing. A significant portion of the company's sales is associated with long- term contracts and programs for the United States government in which there are significant inherent risks. These risks include the uncertainty of economic conditions, dependence on Congressional appropriations and admin- istrative allotment of funds, changes in governmental policies which may reflect military and political developments, time required for design and development, significant changes in contract scheduling, complexity of designs and the rapidity with which product lines become obsolete due to technological advances, constant necessity for design improvements, intense competition for available government business, difficulty of forecasting costs and schedules when bidding on developmental and highly sophisticated technical work, and other factors characteristic of the industry. Foreign sales involve additional risks due to possible changes in economic and political conditions. For a further discussion of the risks inherent in the current defense industry environment, see the Management's Discussion and Analysis in Item 7, Part II. At December 26, 1993, the company had approximately 83,500 employees, the majority of whom are located in the United States. The company has a continuing need for many skilled and professional personnel in order to meet contract schedules and obtain new and ongoing orders for its products. Item 2. Item 2. Properties At December 26, 1993, the company operated approximately 40 manufac- turing plants and research and development facilities throughout the U. S. and the remainder consisted of sales offices, warehouses, and service centers. These facilities had an aggregate floor space of approximately 43 million square feet, a summary of which is listed in the table which follows. Of this floor space, approximately 36% was owned by the company, approximately 23% was leased, with the balance being made available under facilities contracts for use in the performance of contracts with the United States government. Floor Area (thousands of square feet) Company Government Industry Segments: Owned Leased Owned Total ----------------- ------- ------ ---------- ----- Aeronautical Systems Segment: Abilene, Texas ....................... 360 409 769 Fort Worth, Texas .................... 200 1,095 7,077 8,372 Burbank, California .................. 373 99 472 Palmdale, California ................. 1,918 165 754 2,837 Marietta, Georgia .................... 1,876 414 6,336 8,626 Charleston, South Carolina ........... 160 160 Ontario, California .................. 1,276 1,276 Greenville, South Carolina ........... 469 469 Tucson, Arizona ...................... 270 270 San Bernardino, California ........... 198 198 Various (8) .......................... 185 130 315 Missiles and Space Systems Segment: Sunnyvale and Palo Alto, California .. 6,508 2,439 770 9,717 Austin, Texas ........................ 605 156 761 Santa Cruz, California ............... 194 50 244 Huntsville, Alabama .................. 62 57 119 Houston, Texas ....................... 174 174 Various locations (12) ............... 304 304 Electronic Systems Segment: Nashua, New Hampshire ................ 2,501 163 2,664 Anaheim, California .................. 433 433 Scottsdale, Arizona .................. 68 49 117 Ottawa, Ontario, Canada .............. 108 108 Reno, Nevada ......................... 94 94 Various locations (64) ............... 12 319 331 Technology Services Segment: Arlington, Texas ..................... 36 36 Kennedy Space Center, Florida ........ 126 48 2,296 2,470 White Sands, New Mexico .............. 243 243 Teaneck, New Jersey .................. 41 41 Las Vegas, Nevada .................... 135 4 139 Houston, Texas ....................... 313 34 347 Various locations (60) ............... 4 622 132 758 Corporate Office Facilities: Calabasas, California ................ 350 350 Washington, D. C. .................... 52 52 Denver, Colorado ..................... 98 98 ------ ------ ------ ------ Total 15,775 9,893 17,696 43,364 ====== ====== ====== ====== In addition to the amounts included in the above table, the company owned or leased facilities with approximately 211,000 square feet in Seattle, Washington, related to discontinued operations and approximately 652,000 square feet of non-operating facilities in Plainfield, New Jersey, related to the merger of Lockheed Electronics Company into Lockheed Sanders, Inc. As discussed in Note 3 to the Consolidated Financial Statements, included in Part II, the company is consolidating its Aeronautical Systems manufacturing facilities and intends to dispose of surplus properties resulting from that consolidation. The company believes its facilities are generally well maintained, that it has sufficient productive capacity to meet its projected needs, and such productive capacity is adequately utilized but under continual review. A large part of the company's activity is related to engineering and research and development which is not susceptible to productive capacity analysis. In the area of manufacturing, most of the operations are of a job-order nature rather than an assembly line process, and productive equipment has multiple uses for multiple products. Item 3. Item 3. Legal Proceedings The EPA issued a notice of violation to the company on October 25, 1990, alleging violation of the Clean Water Act by discharging chromium- containing wastewater without pretreatment. The company believes the matter is settled and will not result in liability or other financial impact in excess of $500,000. See also Note 11 to the Consolidated Financial Statements, which is included in Part II. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant As of February 1, 1994, the following individuals were executive officers of the company. Information relating to the ages and five-year position history of these individuals is listed below. No family rela- tionship between officers exists. There were no arrangements or under- standings between any officer and any other person pursuant to which he was selected as an officer. Of the top six members of senior management, five are 62 years of age or older. In view of this situation, management and the Board of Directors of the company are continuing to develop an orderly succession plan primarily focusing on the many internal candidates for senior positions who are regarded as qualified for those positions. D. M. Tellep, 62, Chairman of the Board and Chief Executive Officer since 1-1-89; Director since 1987. V. N. Marafino, 63, Vice Chairman of the Board and Chief Financial and Administrative Officer since 8-1-88; Director since 1980. V. D. Coffman, 49, Executive Vice President since 3-2-92. He was Vice President from 10-3-88 to 3-2-92; President -- Space Systems Division, Lockheed Missiles & Space Company, Inc., from 10-3-88 to 3-2-92. He was a Vice President of Lockheed Missiles & Space Company, Inc., from 8-3-85 to 3-2-92 and an employee of that company since 1967. K. W. Cannestra, 63, President -- Aeronautical Systems Group since 11-7-88. J. N. McMahon, 64, President -- Missiles and Space Systems Group and President-- Lockheed Missiles & Space Company, Inc., since 8-1-88. V. P. Peline, 63, President -- Electronic Systems Group since 3-2-87. R. B. Young Jr., 59, Vice President since 4-4-83; President -- Technology Services Group since 7-1-92; he was President -- Lockheed Engineering & Sciences Company from 12-10-79 until 7-1-92. D. O. Allen, 57, Vice President -- Information and Administrative Services since 5-12-87. M. S. Araki, 62, Executive Vice President, Missiles and Space Systems Group and Executive Vice President -- Lockheed Missiles & Space Company, Inc., since 10-3-88. J. A. Blackwell, 53, Vice President since 4-28-93; and President -- Lockheed Aeronautical Systems Company since 4-28-93. He has been an executive employee of Lockheed Aeronautical Systems Company since 9-27-86. H. T. Bowling, 59, President -- Lockheed Aircraft Service Company since 2-6-89. He was Executive Vice President and General Manager -- Lockheed Aeronautical Systems Company - Ontario from 9-3-87 until 2-6-89. V. M. Butler, 51, Vice President since 8-6-90; President -- Lockheed Air Terminal, Inc., since 6-1-84. R. P. Caren, 61, Vice President -- Science and Engineering since 1-1-88. R. K. Cook, 62, Vice President -- Washington Area since 5-1-73. R. B. Corlett, 54, Vice President -- Human Resources since 3-1-91. He was an employee of Lockheed Advanced Development Company from 5-21-90 until 3-1-91, and an employee of Lockheed Aeronautical Systems Company from 5-28-87 until 5-21-90. J. F. Egan, 58, Vice President -- Corporate Development since 4-5-93; Vice President, Planning and Technology -- Electronic Systems Group from 12-27-86 until 4-5-92. G. R. England, 56, Vice President since 3-1-93; and President -- Lockheed Fort Worth Company since 3-1-93. From 1975 until 3-1-93 he was an executive employee of General Dynamics Corporation. B. E. Ewing, 49, Vice President since 3-1-93; and Vice President Aircraft Programs Operations -- Lockheed Fort Worth Company since 3-1-93. From 1-19-81 until 3-1-93 he was an employee of General Dynamics Corporation. R. R. Finkbiner, 54, Vice President -- Contracts and Pricing since 8-3-92. He has been an employee of Lockheed Corporation since 3-19-90. From 1987 until 3-19-90 he was an employee of Ernst & Young. D. M. Hancock, 52, Vice President since 3-1-93; and Vice President and Program Director -- Lockheed Fort Worth Company since 3-1-93. From 1966 until 3-1-93 he was an employee of General Dynamics Corporation. K. N. Hollander, 52, Vice President -- International Business Development since 7-1-90. From 1988 until 7-1-90 he was an employee of Ford Aerospace, Inc. J. R. Kreick, 49, Vice President since 1-1-88; President -- Lockheed Sanders, Inc., since 1-1-90; President -- Sanders Associates, Inc., from 1-1-88 until 1-1-90. G. M. Laden, 57, Vice President since 5-1-87; and Vice President and Assistant General Manager -- Missile Systems Division, Lockheed Missiles & Space Company, Inc., since 10-2-89. He was Vice President and General Manager -- Austin Division, Lockheed Missiles & Space Company, Inc., from 5-1-87 until 10-2-89. J. F. Manuel, 54, Vice President -- Domestic Business Development since 4-5-93. He was Staff Vice President -- Domestic Business Development from 5-4-91 until 4-5-93; and has been an employee of the Corporation since 9-12-79. C. R. Marshall, 40, Vice President -- Secretary and Assistant General Counsel since 1-1-92. From 7-25-86 until 1-1-92 she was a Corporate Counsel for the Corporation. L. D. Montague, 60, Vice President; and President -- Missile Systems Division, Lockheed Missiles & Space Company, Inc., since 5-9-89. He has been an executive employee of Lockheed Missiles & Space Company, Inc., since 2-19-77. S. N. Mullin, 58, Vice President since 10-3-88; President -- Lockheed Advanced Development Company since 12-3-90. He was Vice President and General Manager, Team Program Office, Advanced Tactical Fighter -- Lockheed Aeronautical Systems Company from 10-2-89 until 12-3-90. From 8-15-88 until 10-2-89 he was Vice President and General Manager, Advanced Tactical Fighter -- Lockheed Aeronautical Systems Company. G. T. Oppliger, 57, Vice President since 6-3-91; and President -- Lockheed Space Operations Company, Inc., since 8-1-91. He has been an employee of Lockheed Space Operations Company, Inc., since 6-22-85. A. G. Otsea, 64, Assistant Treasurer since 7-7-75. R. P. Parten, 58, Vice President; and President -- Lockheed Engineering and Sciences Company since 7-1-92. He has been an executive of that company since 7-1-85. S. M. Pearce, 56, Vice President - Corporate Communications since 7-17-90. From 1979 until 7-17-90 she was an employee of Ford Aerospace, Inc. J. B. Reagan, 59, Vice President; and Vice President and Assistant General Manager -- Research and Development Division, Lockheed Missiles & Space Company, Inc., since 1-1-91. He has been an employee of Lockheed Missiles & Space Company, Inc., since 1959. P. C. Reynolds, 60, Assistant Treasurer since 10-5-92. He has been an employee of Lockheed Corporation since 1960. R. E. Rulon, 51, Vice President and Controller since 2-3-92. He was Vice President -- Internal Audit from 8-6-90 until 2-3-92, and has been an executive employee of Lockheed Corporation since 1981. C. R. Scanlan, 59, Vice President since 1-2-90; Executive Vice President, Missiles and Space Systems Group and Executive Vice President, Lockheed Missiles & Space Company, Inc., since 1-2-90. He has been an employee of Lockheed Missiles & Space Company, Inc., since 1961. W. E. Skowronski, 45, Vice President and Treasurer since 9-18-92. He was Staff Vice President -- Investor Relations from 1-2-90 until 9-18-92. He was Assistant Treasurer of Boston Edison Company from 8-8-83 until 1-2-90. W. R. Sorenson, 52, Vice President -- Operations since 1-1-92. He was Staff Vice President -- Manufacturing from 1-2-91 until 1-1-92. From 3-31-81 until 1-2-91 he was an employee of Lockheed Aeronautical Systems Company. D. F. Tang, 60, Vice President since 10-7-91; President -- Space Systems Division, Lockheed Missiles & Space Company, Inc., since 3-2-92. He was Vice President and Assistant General Manager -- Space Systems Division of Lockheed Missiles & Space Company, Inc. from 11-19-88 until 3-2-92. R. W. Taylor, 55, Vice President since 7-12-75; and Vice President -- Business Strategy -- Aeronautical Systems Group since 8-1-93. He was Vice President -- Corporate Development from 10-2-89 until 8-1-93; and President -- Information Systems Group from 4-4-83 until 10-2-89. R. E. Tokerud, 57, Vice President since 2-1-93; and President -- Lockheed Support Systems, Inc., since 9-2-89. He has been an employee of the Corporation since 4-12-65. A. G. Van Schaick, 48, Vice President since 6-1-84; and Vice President Business Operations -- Aeronautical Systems Group since 8-17-92. From 7-1-85 until 8-17-92 he was Vice President and Treasurer of the Corporation. W. T. Vinson, 50, Vice President and General Counsel since 1-1-92. From 1-2-90 until 1-1-92 he was Vice President, Secretary and Assistant General Counsel. From 7-1-75 until 1-2-90 he was an employee of Lockheed Missiles & Space Company, Inc. PART II Item Page - ---- ---- 5. Market for the Registrant's Common Equity and 13 Related Stockholder Matters. 6. Selected Financial Data. 14 - 15 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. 16 - 27 8. Consolidated Financial Statements and Supplemen- 28 - 56 tary Data. 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not Applicable Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. Common Stock Prices (New York Stock Exchange -- composite transactions) High Low Fiscal Close ------------------------------------------ 1993 FISCAL QUARTERS 4th 72 3/8 62 1/2 69 3/8 3rd 68 1/2 59 3/4 2nd 66 58 1st 63 54 1/4 1992 FISCAL QUARTERS 4th 58 3/8 43 5/8 56 7/8 3rd 49 1/8 42 7/8 2nd 47 1/8 42 1/8 1st 46 39 5/8 Dividends Paid on Common Stock March 1 $.53 June 7 .53 September 7 .53 December 6 .53 March 2 .50 June 3 .53 September 8 .53 December 7 .53 As of December 26, 1993, there were approximately 11,400 holders of record of Lockheed common stock. Independent Auditors: Ernst & Young, 515 South Flower Street Los Angeles, California 90071 Common Stock: Stock symbol: LK Listed: New York; Pacific; London; Zurich and Geneva; and Amsterdam stock exchanges Transfer Agent: First Interstate Bank, 26610 West Agoura Road Calabasas, California 91302 1-800-522-6645 Item 6. Item 6. Selected Financial Data Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS Consolidated Sales and Program Profits Consolidated sales were $13.1 billion in 1993, a 29 percent increase over 1992 due to the 1993 acquisition of Lockheed Fort Worth Company (LFWC), the former tactical military aircraft business of General Dynamics Corporation. Total sales increased three percent in 1992 compared with the previous year. Revenues from U.S. government defense customers continued to decline as a percentage of total sales, to 64 percent in 1993 from 67 percent in 1992 and 70 percent in 1991, while sales to foreign governments increased to 13 percent of total sales in 1993, largely due to the LFWC acquisition, compared with eight percent in 1992 and six percent in 1991. Sales made to foreign governments through the U.S. government are included in sales to foreign governments. Sales to commercial customers increased as an absolute amount, but held steady as a percentage of total sales. The table below illustrates the changing customer mix. Sales by customer 1993 1992 1991 - ---------------------------------------------------------------- U.S. government Defense 64% 67% 70% Nondefense 13 15 15 - ---------------------------------------------------------------- 77 82 85 Foreign governments 13 8 6 Commercial 10 10 9 - ---------------------------------------------------------------- 100% 100% 100% - ---------------------------------------------------------------- Total program profits increased by 31 percent in 1993 following growth of about 12 percent in 1992. Program profit margins for 1993, 1992, and 1991 were 6.5 percent, 6.4 percent, and 5.9 percent, respectively. The 1993 results reflected, among other factors, the LFWC acquisition, the favorable settlement of a major dispute with a customer, a reduction in accrued future retiree medical costs due to reduced employment levels (reflected in varying degrees in the program profits of each business segment), as well as charges related to Aeronautical Systems Burbank property and the closure of the Norton maintenance operation. The 1992 improvement compared with 1991 reflected better performance in most business areas partly offset by higher investment in certain emerging lines of business. Operations by business segment are discussed beginning on page 18. Interest Expense Interest expense in 1993 increased by about 41 percent over 1992's amount due to substantially higher debt outstanding during most of the year. The higher debt was incurred to finance the purchase of LFWC. The average interest rate on outstanding borrowings was lower in 1993 than in the previous year. Interest expense was about the same in 1992 as in 1991, as both average outstanding borrowing levels and the company's effective borrowing rate showed little fluctuation from year to year. Other Income, Net Net other income was negligible in 1993, lower than in 1992 primarily due to lower interest income from the temporary investment of excess cash. Net other income was higher in 1992 compared with 1991 primarily due to higher interest income and the absence of costs associated with the 1991 stockholder proxy contest, partly offset by higher other costs. Provision for Income Taxes Income tax expense was higher in 1993 than in 1992 primarily due to the effect of higher pretax earnings, with a higher effective tax rate (nearly 38 percent in 1993 versus close to 37 percent in 1992) also having an impact. The increase in the effective tax rate was due to the settlement of certain tax issues outstanding from prior periods for a higher amount than had been accrued, and a higher nondeductible amount of intangible asset amortization related to the purchase of LFWC. Congress enacted an increase in the federal statutory tax rate from 34 percent to 35 percent in 1993, but the effect of this rate increase was offset by a related favorable one-time adjustment of the company's net deferred tax assets. Income tax expense was higher in 1992 compared with 1991, also due to higher pretax earnings and a higher effective tax rate. The effective rate (about 37 percent in 1992, compared with 35 percent in 1991) was higher primarily because certain tax credits used in 1991 were not available to the company in 1992. Earnings Before Cumulative Effect of Change in Accounting Principle Earnings increased 21 percent in 1993 compared with 1992 due to higher program profits, partly offset by higher interest expense, lower other income, and higher income tax expense. The per-share increase in earnings was slightly lower (19 percent) due to the higher average number of shares and equivalents outstanding in 1993. Earnings growth in 1992 came primarily from higher program profits. Higher other income also contributed, while higher income tax expense partly offset the effect of these improvements. Earnings per share before the effect of the change in accounting was higher in 1992 compared with 1991 as a result of these same factors, plus a lower average number of common and common equivalent shares outstanding during 1992, the result of the company's common stock repurchase program under way at that time. If inflation were taken into account, earnings would differ from the reported results due to the recognition of additional depreciation expense. Contracts in the aerospace industry generally reflect the impact of anticipated inflation in the selling price, and often contain price escalation clauses that protect against abnormal inflation. In the case of depreciation, however, regulations that determine U.S. government contract revenues do not allow inflation-adjusted depreciation to be taken into account. Therefore, earnings would have been lower than reported if inflation had been considered. Income taxes would not have been adjusted because tax laws do not permit deduction of such additional inflationary cost. Inflation rates in the United States have been relatively low in recent years. Net Earnings (Loss) The net loss in 1992, caused by the effect of a change in accounting principle, was related to the company's adoption of the accrual method of accounting for retiree medical costs specified by Statement of Financial Accounting Standards No. 106 (SFAS 106). The company's 1992 adoption of a new standard related to accounting for income taxes, SFAS 109, did not have a significant impact. Results of Operations by Business Segment Aeronautical Systems Aeronautical Systems sales more than doubled in 1993, reflecting the acquisition of LFWC during the first quarter. Revenues grew about 12 percent in 1992 compared with 1991. In millions 1993 1992 1991 - ---------------------------------------------------------------- Sales Fighter aircraft programs $3,661 $ 363 $ 49 Airlift aircraft programs 915 1,169 1,150 Aircraft modification and maintenance programs 517 538 431 Other aircraft programs and support activities 917 887 1,005 - ---------------------------------------------------------------- Total $6,010 $2,957 $2,635 - ---------------------------------------------------------------- Program profits $ 465 $ 193 $ 153 - ---------------------------------------------------------------- The approximately ten-fold increase in fighter aircraft sales in 1993 was primarily due to the acquisition of LFWC, whose business included the fighter program and one third of the advanced tactical fighter engineering and manufacturing development (EMD) program. Also contributing to the increase compared with 1992 were higher program revenues from the original one-third portion of the program held by Lockheed. The substantial growth in fighter aircraft revenues in 1992 compared with 1991 reflected the first full year of activity of the EMD program. Prior to mid-1991, effort was limited to the design development and prototype phase of the program. Airlift aircraft sales were 22 percent lower in 1993 than in 1992, principally due to five fewer deliveries of C-130 aircraft (30 versus 35 in 1992). Airlift aircraft sales were about the same in 1992 as in 1991. Although fewer C-130 aircraft were delivered in 1992 (35 versus 43 in 1991), the effects of increased spares sales and changes in contract pricing made up the difference. Revenues from aircraft modification and maintenance activities were down four percent in 1993 due to lower military and commercial aircraft modification sales. Aircraft modification and maintenance sales were up about 25 percent in 1992 over the prior year, primarily due to higher military aircraft modification activities, with higher commercial revenues also contributing. Other aircraft programs and support activities sales were up three percent in 1993 over 1992, mostly due to the delivery of two P-3/CP-140 maritime patrol aircraft (compared with one aircraft in 1992). Higher S-3 patrol aircraft upgrade sales were more than offset by other programs and spares sales which, on balance, were lower in 1993. Sales from other aircraft programs and support activities dropped by about 12 percent in 1992 from 1991's level, mostly due to the end of significant commercial aircraft subcontract activity in 1991. The sales increase associated with the delivery of one P-3/CP-140 aircraft in 1992 (there were none in 1991) was offset by lower S-3 aircraft upgrade revenues and lower spares sales. Program profits in Aeronautical Systems in 1993 were more than twice the 1992 amount, reflecting the LFWC acquisition. Other factors essentially offset one another. The sales variances described above had corresponding effects on program profits. In addition, negative cost adjustments on certain programs recorded in 1992 were absent in 1993. Program profit margins generally improved in most program areas. However, C-130 airlifter margins were lower in 1993, reflecting a change in customer mix. Also, 1993 saw higher spending on the development of an improved version of the C-130 aircraft (the C-130J) than in 1992. Intangible asset amortization related to the purchase of LFWC, reflected in program profits, amounted to $84 million in 1993. In addition, the following 1993 developments were significant. The U.S. Navy and the company settled their dispute related to the termination of the company's fixed-price contract for the P-7A aircraft development program. The contract was terminated for default by the U.S. Navy in July 1990. The settlement provided that the termination for default be converted to a termination of the contract by mutual agreement of the parties. After adjustment for final resolution of subcontractor claims and closure costs, the settlement amount of $111 million resulted in a reversal of approximately $90 million of the pretax losses recognized on this program in the fourth quarter of 1989. This reversal was reflected in program profits for the third quarter of 1993. The company recorded a charge to program profits in the third quarter of 1993 of $35 million, representing an expected excess of costs over anticipated sales proceeds related to its Burbank, California, property. (See Note 3 to the consolidated financial statements.) Also during the third quarter of 1993, the company concluded that its wide- body commercial aircraft modification and maintenance operations at Norton Air Force Base would be discontinued, and recorded a charge to program profits of $30 million related to the discontinuance. Program profits in Aeronautical Systems grew about 26 percent in 1992 over the 1991 level, primarily due to the first full year of the EMD program, more favorable contract pricing resulting in higher margins on the C-130 program, and improvements and favorable adjustments on certain other aircraft programs. Partly offsetting these increases were higher costs associated with the development of the C-130J airlifter, negative cost adjustments to several programs and, to a lesser extent, higher costs related to commercial aircraft maintenance operations. Missiles and Space Systems Missiles and Space Systems sales declined by about eight percent in 1993 following a six percent reduction in 1992. In millions 1993 1992 1991 - ---------------------------------------------------------------- Sales Fleet ballistic missiles $1,281 $1,503 $1,563 Other missile systems 579 429 442 Space and other programs 2,378 2,655 2,854 - ---------------------------------------------------------------- Total $4,238 $4,587 $4,859 - ---------------------------------------------------------------- Program profits $ 348 $ 401 $ 360 - ---------------------------------------------------------------- Fleet ballistic missiles sales declined 15 percent in 1993, primarily reflecting the completion of the development portion of the Trident II program. Fleet ballistic missiles revenues were down four percent in 1992 compared with 1991 as Trident II development activities wound down and production was relatively stable. Other missile systems sales were 35 percent higher in 1993 than in 1992, mostly due to the Theater High Altitude Area Defense (THAAD) defensive missile program, which was just getting under way in 1992. This increase was partly offset by lower revenues from most other missile programs, including the Advanced Solid Rocket Motor (ASRM) program which was cancelled in 1993. Other missile systems sales were three percent lower in 1992 compared with 1991, as slight increases in defensive missiles and the ASRM program were more than offset by decreases in other programs. Space and other programs sales were down 11 percent in 1993 compared with 1992 due to lower revenues from certain classified space programs and, to a lesser extent, lower NASA sales. Higher sales from the Milstar military communications satellite program partly offset the declines. Sales in space and other programs declined by about seven percent in 1992 compared with one year earlier, primarily due to reductions in certain classified space programs partly offset by slight increases in Milstar, tactical command and control, and NASA programs. Missiles and Space Systems program profits were down about 13 percent in 1993 compared with 1992. The reduction reflected the impact of the lower sales volume, the absence in 1993 of significant amounts of reliability incentive fees from the Trident II program recognized in 1992 as testing under the development portion of the program neared completion, and negative cost adjustments on several programs. Higher operating margins in most other programs, and the initial recognition of profits related to the IRIDIUM TM/SM commercial satellite program, partly offset the declines. Program profits in Missiles and Space Systems were up about 11 percent in 1992 over 1991, primarily due to the recognition of significantly higher Trident II reliability incentive fees in 1992, and to the resumption of the recording of profits on the Milstar program. The recognition of Milstar profits had been deferred in 1991 while the program was being restructured. In addition, operating margins were better in most business areas in 1992 than in 1991 and a prior year contract issue was favorably resolved, but these developments were mostly offset by initial development costs related to the IRIDIUM TM/SM program. Electronic Systems Sales in Electronic Systems were about eight percent higher in 1993, com- pared with a 15 percent increase registered in 1992. In millions 1993 1992 1991 - ---------------------------------------------------------------- Sales Defense electronics programs $ 619 $ 622 $ 603 Commercial product manufacturing 388 413 408 Commercial distribution activities 389 254 111 - ---------------------------------------------------------------- Total $1,396 $1,289 $1,122 - ---------------------------------------------------------------- Program profits (loss) $ (1) $ 32 $ 21 - ---------------------------------------------------------------- Revenues from defense electronics programs in 1993 were approximately equal to 1992's level. Increases in countermeasures, information systems, and avionics product lines were offset by decreases in defense system and surveillance system programs. Defense electronics sales grew about three percent in 1992 compared with 1991, mostly due to increases in antisubmarine warfare, countermeasures, and other electronic support programs, partly offset by reductions in surveillance systems revenues. Sales from commercial product manufacturing dipped six percent in 1993, principally due to further weakness and competitive pricing pressures in the computer peripherals market. Commercial product manufacturing sales were about the same in 1992 compared with 1991. Commercial distribution sales grew 53 percent in 1993, reflecting expansion of the Access Graphics subsidiary's business. Revenues from commercial distribution activities more than doubled in 1992 compared with 1991, mostly due to Access Graphics being included for the full year of 1992 versus only a portion of 1991. A small program loss was incurred by Electronic Systems in 1993, compared with program profits in 1992, due primarily to losses at CalComp. This commercial manufacturing unit suffered significant operating losses due to market weakness and pricing pressures, and also recorded charges related to downsizing and restructuring. Program profits from defense programs increased in 1993 due to improved operating performance at Sanders, and profits from commercial distribution activities were higher in 1993 than in 1992 due to improved performance and higher sales. In addition, Electronic Systems program profits were negatively affected in 1993 when the company recognized expense for future environmental remediation costs that are expected to be allocated to the company's commercial business. (See Notes 1 and 11 to the consolidated financial statements for additional information on the company's accounting policies related to environmental matters and the status of environmental matters now before the company.) Electronic Systems program profits grew 52 percent in 1992 compared with 1991, with the defense and commercial business sectors contributing about equally to the increase. In defense, the greater profits resulted from improved performance as well as higher volume at Sanders. Commercial distribution activities, included for the full year, were the primary cause of the commercial profit improvement. Purchase cost amortization related to the acquisition of Sanders and CalComp, reflected in program profits each year, was $25 million in 1993 and in 1992, and $26 million in 1991. Technology Services Technology Services sales increased by 13 percent in 1993, after growing about six percent in 1992. In millions 1993 1992 1991 - ---------------------------------------------------------------- Sales Space shuttle processing services $ 609 $ 600 $ 638 Engineering and scientific services 335 349 342 State and municipal government services 180 88 58 Other services 303 230 155 - ---------------------------------------------------------------- Total $1,427 $1,267 $1,193 - ---------------------------------------------------------------- Program profits $ 32 $ 18 $ 42 - ---------------------------------------------------------------- Space shuttle processing revenues increased about two percent in 1993, following a decrease of about six percent in 1992. Fluctuations in levels of activity in support of space shuttle operations were responsible for the variances. Sales from engineering and scientific services were down about four percent in 1993 compared with 1992 mostly due to lower levels of NASA support work, partly offset by higher environmental services revenue. Sales in 1992 were relatively stable compared with 1991, up about two percent. Revenues from state and municipal government services doubled in 1993, mostly due to the expansion of children and family services and transportation systems and services provided to state and local government agencies. Sales in this business area were up by about one-half in 1992 compared with 1991, mostly from growth in the children and family services and other municipal services business lines. Other services revenues were 32 percent higher in 1993 compared with 1992, and nearly 50 percent higher in 1992 compared with 1991, in both cases due to significantly increased levels of contract field support services provided to the military. Program profits increased substantially in 1993, primarily due to higher revenues and improved performance on contract field support programs, improved performance in airport management and consulting operations, and a reduction in accrued future retiree medical costs due to reduced employment levels. Elsewhere in this segment, program profits were approximately the same in 1993 as in 1992, reflecting both similar performance and a similar level of new business investment in each year. Program profits dropped by about 57 percent in 1992 compared with 1991, mostly because of higher investment in new business initiatives, particularly in state, county, and municipal services and environmental lines of business. FINANCIAL CONDITION Liquidity and Cash Flows Liquidity is primarily provided by cash generated from operating activities. Net cash provided by operating activities during 1993 was $795 million, over 35 percent higher than in 1992, due to higher earnings plus noncash-expending depreciation and amortization, partly offset by higher operating capital requirements. Operating cash flow was negatively impacted in 1993 by the withholding of a portion (currently approximately $170 million) of certain progress billings at LFWC by agreement with a U.S. government customer. These billings are being withheld pending resolution of issues pertaining to LFWC's manufacturing cost allocation system. The system issues are currently being addressed and withheld amounts are expected to be substantially reduced during 1994. With the exception of the temporary delay in cash flows from operating activities and higher net inventories, management expects the issues to be ultimately resolved with little, if any, effect on the company's financial statements. The company borrowed approximately $1.5 billion for the purchase of LFWC during the first quarter of 1993. Initially in the form of short-term obligations, these borrowings were subsequently refinanced with intermediate and long-term debt. By the end of the year, operating and other cash flows were sufficient to allow the company to reduce debt by over $400 million from the high point reached at the end of the first quarter. Additions to property, plant, and equipment were $321 million in 1993, approximately the same as in 1992. The amount expended on additions compared favorably with the company's 1993 depreciation expense of $328 million. The company continually monitors its capital spending in relation to current and anticipated business needs. As circumstances dictate, facilities are added, consolidated, disposed of, or modernized. Note 3 to the consolidated financial statements provides additional information regarding the disposal of excess Aeronautical Systems property. Significant numbers of employee stock options were exercised in 1993. The cash inflow from these exercises amounted to about $71 million and resulted in the issuance of approximately 1.6 million shares of company stock. Cash dividends amounted to $2.12, $2.09, and $1.95 per share in 1993, 1992, and 1991, respectively. Capital Resources Total debt, including the guarantee of salaried ESOP obligations, increased to $2,596 million at December 26, 1993, up from $1,681 million outstanding one year earlier, due to the financing of the purchase of LFWC. As discussed above, debt was reduced subsequent to the acquisition date. Cash flows are expected to allow a steady reduction of the higher debt levels over the next few years. Most of Lockheed's debt at the end of 1993 and 1992 was in the form of publicly issued fixed-rate notes. Total debt represented approximately 52 percent and 45 percent of the company's total capitalization at the respective year-end dates, about 43 percent and 34 percent if the effect of the guarantee of certain obligations of the salaried ESOP (accounted for as a component of debt and an offset to stockholders' equity) is excluded. The calculation of the debt ratio ex-ESOP reflects the fact that the assets of the salaried ESOP trust, not reflected on the company's balance sheet, are available for the service and repayment of the ESOP obligations guaranteed by the company. At its peak at the end of the first quarter of 1993, total debt was about 59 percent of total capitalization, 51 percent ex-ESOP. The "net debt" ratio consists of total debt, net of cash, as a percentage of total capitalization. Using this approach, the measures were 50 percent, 57 percent, and 40 percent at December 1993, March 1993, and December, 1992. Ex-ESOP, the amounts were 42 percent, 48 percent, and 28 percent, respectively. At December 26, 1993, the company had available committed credit lines aggregating $1.3 billion from groups of domestic and foreign banks. Generally, these lines are maintained to back up the company's commercial paper borrowings. There were no commercial paper borrowings, nor any borrowings outstanding under the committed lines, at year-end. The company receives advances on certain contracts and uses them to finance the inventories required to complete the contracted work. The amount of such advances in excess of costs incurred on these contracts was $606 million at December 26, 1993, and was mostly related to contracts with foreign government and commercial customers. These funds may be used for working capital requirements and other general corporate purposes until needed to complete the contracts. Cash on hand and temporarily invested, internally generated funds, and available financing resources are sufficient to meet anticipated operating and debt service requirements and discretionary investment needs. Stockholders' equity at December 26, 1993 was up by about $400 million or 20 percent compared with a year earlier due to the retention of earnings in excess of cash dividends paid, the issuance of new shares upon the exercise of employee stock options, and accounting benefits related to the salaried ESOP (the reduction of guaranteed debt and certain tax benefits). OTHER MATTERS Company-Sponsored Research and Development Spending on company-sponsored research and development is included in results from operations and amounted to $449 million in 1993, a seven percent increase over 1992. The company regularly monitors its research and development effort to assure an appropriate level of spending in relation to expected future benefits. Company-sponsored research and development is necessary to support the company's technologies and maintain its competitive position in the aerospace and electronics industries. Backlog Funded backlog consists of unfilled firm orders for the company's products for which funding has been both authorized and appropriated by the customer (Congress, in the case of U.S. government customers). Negotiated (total) backlog includes firm orders for which funding has not been appropriated. The following table shows funded backlog by major category for the company's two largest segments, and totals for the other two segments, at the end of each of the last three years: In millions 1993 1992 1991 - ----------------------------------------------------------------- Aeronautical Systems Fighter aircraft programs $ 6,229 $ 286 $ 300 Airlift aircraft programs 1,283 891 1,204 Aircraft modification and maintenance programs 460 504 514 Other aircraft programs and support activities 1,361 1,599 1,740 - ----------------------------------------------------------------- 9,333 3,280 3,758 Missiles and Space Systems Fleet ballistic missiles 1,423 2,389 2,254 Other missile systems 90 317 194 Space and other programs 1,273 1,605 1,262 - ----------------------------------------------------------------- 2,786 4,311 3,710 Electronic Systems 732 870 873 Technology Services 305 395 410 - ----------------------------------------------------------------- $13,156 $8,856 $8,751 - ----------------------------------------------------------------- Funded backlog was nearly 50 percent higher in 1993 compared with 1992 due to increases in Aeronautical Systems, the most significant of which was the acquisition of LFWC and its existing backlog. Funded backlog was lower in the other segments. In 1992, funded backlog increased slightly, about one percent, compared with 1991. An increase in Missiles and Space Systems was mostly offset by decreases in the other segments. In Aeronautical Systems, funded backlog almost tripled in 1993. The addition of LFWC with its fighter program and one-third share of the fighter program was most responsible for the increase. However, C-130 airlifter backlog was also significantly higher, primarily reflecting more U.S. government aircraft on order. These increases were partly offset by lower backlogs related to military aircraft modification work and maritime patrol aircraft. Funded backlog in Aeronautical Systems declined by about 13 percent in 1992 compared with 1991, mostly due to the absence of foreign and commercial C-130 airlifter sign-ups, partly offset by a higher U.S. government C-130 backlog. Elsewhere in the segment, lower funded backlog related to maritime patrol aircraft upgrade programs also had an effect. Funded backlog in Missiles and Space Systems declined by about 35 percent in 1993 compared with 1992, mostly due to a difference in the timing of the funding for the Trident II fleet ballistic missile program. Annual funding for this program, generally provided in the company's fourth quarter, was not obtained until the first quarter of 1994. The workdown of the initial THAAD defensive missile development program backlog, reductions in certain space programs, and lower Milstar and NASA backlogs, also contributed to the decrease. These reductions were partly offset by increases related to the start of the IRIDIUM TM/SM commercial satellite program. Missiles and Space Systems backlog grew about 16 percent in 1992 compared with 1991 due to higher funding of certain military space systems and defensive missile programs, partly offset by lower funded backlog in certain other space programs. In Electronic Systems, funded backlog is primarily related to defense electronics programs. In 1993, backlog was down about 16 percent compared with a year ago, with increases in surveillance systems and avionics programs more than offset by decreases in other defense electronics areas. Commercial backlogs grew slightly. In 1992, funded backlog remained about the same as in 1991, as increases in surveillance and avionics systems backlogs offset the decreases in other defense programs and in the commercial product sector. In Technology Services, 1993 funded backlog was down about 23 percent from 1992, primarily due to lower backlog of contract field support services, and timing differences in NASA funding of space shuttle processing and engineering and scientific support activities. In 1992, funded backlog was about four percent lower than in 1991, with changes in the timing of NASA funding partly offset by increased funding on contract field support programs. Service contracts represent the majority of this business segment's revenues, and are generally funded with less lead time than other contracts. As a result, funded backlog figures tend to be less of an indicator of future activity for this segment than for the others. The figures above do not include negotiated but unfunded amounts. Total negotiated backlog, both funded and unfunded, amounted to $28.9 billion in 1993, $19.4 billion in 1992, and $17.1 billion in 1991. The increase in 1993 was caused by many of the same factors responsible for the funded backlog variances described above, with the addition of LFWC in the Aeronautical Systems segment and the reductions in certain space programs in the Missiles and Space Systems segment the most prominent. The increase in 1992 compared with 1991 came from the win of the THAAD development program in the Missiles and Space Systems segment and the follow-on space shuttle processing contract in Technology Services, in addition to the funded backlog variances already discussed. As in previous years, a substantial portion of unfunded backlog is related to programs for the U.S. government and is dependent on future governmental appropriations for funding. Defense Industry Environment In recent years, significant changes in the global political climate have redefined the needs of the Department of Defense (DoD). New requirements emphasize a smaller, more technologically superior military, and the industrial base to support it. In addition, initiatives to reduce the federal budget deficit have placed increased downward pressure on defense budget levels. Defense budgets have been declining in real terms (after accounting for inflation) since 1985. Industry analysts generally expect defense spending to continue to decline through the latter part of the decade and then hold constant in real terms at a reduced level, but the ultimate outcome is uncertain. Reduced budget levels, rapidly changing customer requirements, and increased competition are expected for the defense industry in the years to come. The U.S. defense budget has a major impact on Lockheed's business base. In 1993, 64 percent of the company's sales were to DoD customers. The company provides a wide variety of products and services, and Lockheed's major programs have generally been well supported thus far during the budget decline. The company is a leader in advanced technologies, research and development, and limited production-rate manufacturing, all of which have been emphasized during the ongoing debate over the focus of future defense spending. However, uncertainty remains over the size and shape of future defense budgets and their impact on specific programs. The company has responded to these conditions and is focusing attention and resources on its most promising businesses and opportunities in both the defense and nondefense markets. The 1993 acquisition of Lockheed Fort Worth Company further broadened Lockheed's portfolio of programs and increased the company's presence in the international market. Other measures, such as cost reduction efforts, are continuing. Employment levels have been reduced to reflect changing business requirements, and will continue to be monitored and adjusted where appropriate. Management believes that the company is well-positioned for the future, with the resources and capabilities to respond appropriately to further industry developments. Environmental Matters The company is involved in a number of proceedings and potential proceedings relating to environmental matters. These matters and their impact on the company are discussed in Note 11 to the consolidated financial statements. As described in Note 11, a substantial portion of currently anticipated environmental expenditures will be reflected in the company's sales and costs of sales pursuant to U.S. government agreement or regulation. However, a timing difference in cash flows is expected between incurrence of certain of the costs related to the Burbank cleanup and allocation of these costs as part of the company's general and administrative expense. At the end of 1993, expenditures that had been made but not yet allocated amounted to $52 million. This timing difference is expected to increase through the end of 1995 before declining in subsequent years. Item 8. Item 8. Consolidated Financial Statements and Supplementary Data CONSOLIDATED STATEMENT OF EARNINGS In millions, except per-share data 1993 1992 1991 - ------------------------------------------------------------------------- Sales Aeronautical Systems $ 6,010 $ 2,957 $ 2,635 Missiles and Space Systems 4,238 4,587 4,859 Electronic Systems 1,396 1,289 1,122 Technology Services 1,427 1,267 1,193 ----------------------------------------------------------------------- Total sales 13,071 10,100 9,809 Costs and expenses 12,227 9,456 9,233 - ------------------------------------------------------------------------- Program profits Aeronautical Systems 465 193 153 Missiles and Space Systems 348 401 360 Electronic Systems (1) 32 21 Technology Services 32 18 42 ----------------------------------------------------------------------- Total program profits 844 644 576 Interest expense (168) (119) (118) Other income, net 24 16 - ------------------------------------------------------------------------- Earnings before income taxes and cumulative effect of change in accounting principle 676 549 474 Provision for income taxes 254 201 166 - ------------------------------------------------------------------------- Earnings before cumulative effect of change in accounting principle 422 348 308 Cumulative effect of change in accounting principle for retiree medical benefits, net of tax (631) - ------------------------------------------------------------------------- Net earnings (loss) $ 422 $ (283) $ 308 ========================================================================= Earnings per share Before cumulative effect of change in accounting principle $ 6.70 $ 5.65 $ 4.86 Cumulative effect of change in accounting principle (10.23) ----------------------------------------------------------------------- Net earnings (loss) per share $ 6.70 $ (4.58) $ 4.86 ========================================================================= Average number of common and common equivalent shares outstanding 62.9 61.7 63.4 - ------------------------------------------------------------------------- Number of common shares outstanding at year-end 62.7 61.1 62.8 - ------------------------------------------------------------------------- See accompanying notes. CONSOLIDATED STATEMENT OF CASH FLOWS In millions 1993 1992 1991 - -------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net earnings (loss) $ 422 $(283) $ 308 Adjustments to reconcile net earnings (loss) to net cash provided by operating activities Cumulative effect of change in accounting principle, net of tax 631 Depreciation and amortization 498 355 339 Changes in operating assets and liabilities Accounts receivable 232 (23) 545 Gross inventories 498 292 (12) Accounts payable 5 89 (118) Salaries and related items (41) (31) 9 Income taxes 18 (15) 12 Customer advances and progress payments (824) (238) (204) Other, net (13) (192) (171) ---------------------------------------------------------------------- Net cash provided by operating activities 795 585 708 - -------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Additions to property, plant, and equipment (321) (327) (312) Purchase of Lockheed Fort Worth Company (1,521) Purchases of marketable securities (200) Proceeds from sales of marketable securities 210 Capitalized restructuring and related costs (26) (22) (19) Decrease (increase) in finance and other long-term receivables 8 (11) (40) Other, net 41 (47) 21 - -------------------------------------------------------------------------- Net cash used for investing activities (1,819) (397) (350) - -------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Decrease in short-term borrowings (9) (2) (11) Borrowings of long-term debt 1,581 341 246 Repayments of long-term debt (634) (294) (555) Purchases of treasury shares (101) (25) Cash dividends (132) (128) (124) Proceeds from stock options exercised 71 24 5 - -------------------------------------------------------------------------- Net cash provided by (used for) financing activities 877 (160) (464) - -------------------------------------------------------------------------- Increase (decrease) in cash and cash equivalents (147) 28 (106) Cash and cash equivalents, beginning of year 294 266 372 - -------------------------------------------------------------------------- Cash and cash equivalents, end of year $ 147 $ 294 $ 266 ========================================================================== Supplemental Disclosure Information Cash paid during the year for Interest $ 165 $ 101 $ 104 Income taxes 230 219 155 ========================================================================== See accompanying notes. CONSOLIDATED BALANCE SHEET Dollar figures in millions, except per-share data 1993 1992 - -------------------------------------------------------------------------- Assets Current assets Cash and cash equivalents $ 147 $ 294 Accounts receivable 1,644 1,590 Inventories 1,699 1,178 Other current assets 350 171 ---------------------------------------------------------------------- Total current assets 3,840 3,233 Property, plant, and equipment, at cost Land 93 91 Buildings, structures, and leasehold improvements 1,686 1,678 Machinery and equipment 2,812 2,679 ---------------------------------------------------------------------- 4,591 4,448 Less accumulated depreciation and amortization 2,641 2,566 ---------------------------------------------------------------------- Net property, plant, and equipment 1,950 1,882 Noncurrent assets Intangible assets related to tactical aircraft programs acquired (net of accumulated amortization of $84) 1,425 Excess of purchase price over fair value of assets acquired (net of accumulated amortization of $204 in 1993 and $171 in 1992) 782 815 Deferred tax assets, net 33 227 Other noncurrent assets 931 867 - -------------------------------------------------------------------------- $8,961 $7,024 ========================================================================== Liabilities and Stockholders' Equity Current liabilities Short-term borrowings $ 21 $ 30 Accounts payable 841 758 Salaries and related items 355 296 Income taxes, including deferred amounts of $44 in 1993 and $72 in 1992 44 112 Customers' advances in excess of related costs 606 442 Current portion of long-term debt 28 323 Current portion of accumulated retiree medical benefit obligation 155 106 Other current liabilities 483 375 ---------------------------------------------------------------------- Total current liabilities 2,533 2,442 Long-term debt 2,547 1,328 Accumulated retiree medical benefit obligation 942 803 Other long-term liabilities 496 409 Commitments and contingencies Stockholders' equity Preferred stock Common stock, $1 par value, 100,000,000 shares authorized; 72,471,642 shares issued (70,876,030 in 1992) 73 71 Additional capital 804 735 Retained earnings 2,427 2,121 Treasury shares, at cost (9,775,996 shares) (454) (454) Guarantee of ESOP obligations (407) (431) ---------------------------------------------------------------------- Total stockholders' equity 2,443 2,042 - -------------------------------------------------------------------------- $8,961 $7,024 ========================================================================== See accompanying notes. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY Guarantee of ESOP In millions, except Common Additional Retained Treasury Obliga- per-share data Stock Capital Earnings Shares tions Total - ------------------------------------------------------------------------------ At December 30, 1990 $70 $707 $2,332 $(328) $(472) $2,309 Net earnings 308 308 Reduction of ESOP obligations guaranteed 20 20 Tax benefits from dividends paid to ESOP 10 10 Stock options exercised 5 5 Dividends declared on common stock ($1.95 per share) (124) (124) Treasury shares purchased (25) (25) - ------------------------------------------------------------------------------ At December 29, 1991 70 712 2,526 (353) (452) 2,503 Earnings before cumulative effect of change in accounting principle 348 348 Cumulative effect of change in accounting principle, net of tax (631) (631) Reduction of ESOP obligations guaranteed 21 21 Tax benefits from dividends paid to ESOP on unallocated shares 6 6 Stock options exercised 1 23 24 Dividends declared on common stock ($2.09 per share) (128) (128) Treasury shares purchased (101) (101) - ------------------------------------------------------------------------------ At December 27, 1992 71 735 2,121 (454) (431) 2,042 Net earnings 422 422 Reduction of ESOP obligations guaranteed 24 24 Tax benefits from dividends paid to ESOP on unallocated shares and stock options exercised 16 16 Stock options exercised 2 69 71 Dividends declared on common stock ($2.12 per share) (132) (132) ----------------------------------------------------------------------------- At December 26, 1993 $73 $804 $2,427 $(454) $(407) $2,443 ============================================================================== See accompanying notes. Lockheed Corporation Notes to Consolidated Financial Statements Note 1 -- Summary of Significant Accounting Policies - ---------------------------------------------------- Basis of consolidation--The consolidated financial statements for the years ended December 26, 1993, December 27, 1992, and December 29, 1991, include the accounts of wholly owned and majority-owned subsidiaries. The accounts of Lockheed Finance Corporation (LFC), a wholly owned finance company subsidiary, are included in the consolidated financial statements. LFC's assets, revenues, and earnings are immaterial and therefore not separately disclosed. Because LFC's business differs significantly from the rest of Lockheed's operations, LFC's results of operations are presented as a component of other income, net. Certain reclassifications have been made to the 1992 and 1991 data to conform to the 1993 presentation. Cash and cash equivalents -- The company considers securities purchased within three months of their date of maturity to be cash equivalents. Due to the short maturity of these instruments, carrying value on the company's consolidated balance sheet approximates fair value. Under Lockheed's cash management system, certain divisions' and subsidiaries' cash accounts reflect credit balances to the extent checks written have not been presented for payment. The amounts of these credit balances included in accounts payable were $154 million at December 26, 1993, and $178 million at December 27, 1992. Inventories -- Inventories are stated at the lower of cost or estimated net realizable value. In the case of materials and spare parts, cost represents average cost. Work-in-process inventory includes direct production costs, allocable operating overhead, and, except for commercial contracts and programs, general and administrative expenses. Inventories are primarily attributable to long-term contracts or programs on which the related operating cycles are longer than one year. In accordance with industry practice, these inventories are included in current assets. Property, plant, and equipment -- Depreciation is provided on most plant and equipment using declining balance methods of depreciation during the first half of the estimated useful lives of the assets; thereafter, straight-line depreciation is used. Estimated useful lives generally range from eight years to 33 years for buildings and structures and two years to 20 years for machinery and equipment. Leasehold improvements are amortized over the useful lives of the related assets or the terms of the leases, whichever is shorter. Intangible assets related to tactical aircraft programs acquired -- Intangible assets related to the acquisition of Lockheed Fort Worth Company (the former tactical military aircraft business of General Dynamics Corporation) are amortized on a straight-line basis over an estimated period of benefit of fifteen years. Excess of purchase price over fair value of net assets acquired -- The excess of purchase price over fair value of net assets of acquired businesses is amortized on a straight-line basis over the estimated periods of benefit. Such periods do not exceed 40 years. Sales and earnings -- Sales under cost-reimbursement-type contracts are recorded as costs are incurred. Applicable estimated profits are included in sales in the proportion that incurred costs bear to total estimated costs. Sales and anticipated profits under certain fixed-price contracts that require substantial performance over a long period of time before deliveries begin are accounted for under the percentage-of-completion (cost-to-cost) method. Under all other contracts, sales are recorded at delivery or on completion of specified tasks, as applicable, and estimated contract profits are taken into earnings in proportion to recorded sales. Some contracts include provisions for adjusting prices to reflect specification changes and other matters. For accounting purposes, estimates of such adjustments are used in recording sales and costs and expenses. Incentives or penalties applicable to performance on contracts are considered in estimating sales and profit rates and are recorded when there is sufficient information to assess anticipated contract performance. When the adjustments are ultimately determined, any changes from the estimates are reflected in earnings. Any anticipated losses on contracts or programs are charged to earnings when identified. Research and development costs -- Company-sponsored research and development costs (shown in Selected Financial Data on page 15) primarily include research and development and bid and proposal effort related to government products and services. Except for certain arrangements described below, these costs are generally included as part of the general and administrative costs that are allocated among all contracts and programs under U.S. government contractual arrangements. Company-sponsored product development costs not otherwise allocable are charged to expense when incurred. Under certain arrangements in which a customer shares in product development costs, the company's portion of such costs is expensed as incurred. Customer-sponsored research and development costs incurred pursuant to contracts are accounted for as program costs. Environmental matters -- The company records a liability for environmental matters when it is probable that a liability has been incurred and the amount can be reasonably estimated. A substantial portion of the costs are expected to be reflected in sales and costs of sales pursuant to U.S. government agreement or regulation. At the time a liability is recorded for future environmental costs, an asset is recorded for the probable future recovery of those costs in pricing U.S. government business. With the exception of applicable amounts representing current assets and liabilities, these amounts are included in other noncurrent assets and other long-term liabilities. The portion of those costs expected to be allocated to commercial business is reflected in cost of sales at the time the liability is established. Prior to 1993, environmental liabilities were recorded by the company net of the estimated expenditures that would be allocated and allowable in establishing prices of U.S. government business. The 1992 amounts have been reclassified on the consolidated balance sheet to conform to the 1993 presentation. Earnings per share -- Earnings per share are computed from the weighted average number of common shares, including common share equivalents, outstanding during each year. In general, this computation assumes that dilutive stock options were exercised and the resulting proceeds were used to purchase outstanding common stock. When there is no material difference between the computations of primary and fully diluted earnings per share, only the primary number is presented. Note 2 - Acquisition - -------------------- Effective February 28, 1993, the company acquired Lockheed Fort Worth Company (LFWC), formerly the tactical military aircraft business (Fort Worth Division) of General Dynamics Corporation, for approximately $1.5 billion in cash, plus the assumption of certain liabilities related to the business. The acquisition was accounted for as a purchase, and financed by intermediate and long-term borrowings. LFWC is active in research, design, and systems integration for manufacturing and upgrading manned tactical aircraft and related products, including electronic warfare, training, and mission support systems. The operating results of LFWC since February 28, 1993, are reported in the company's Aeronautical Systems segment. The excess of the purchase price over the fair value of the net assets acquired represented intangible assets related to the aircraft programs acquired and amounted to approximately $1.5 billion. These intangible assets are being amortized over 15 years. The following pro forma financial information combines Lockheed's and LFWC's results of operations assuming that the acquisition took place at the beginning of 1992. These pro forma results are not necessarily indicative of future operations of the combined company. In millions, except per-share data 1993 1992 - ------------------------------------------------------------- Sales $13,520 $12,941 Earnings before cumulative effect of change in accounting principle 426 388 Net earnings (loss) 426 (243) Earnings per share Before change in accounting principle 6.77 6.29 Net earnings (loss) 6.77 (3.94) - ------------------------------------------------------------- Note 3 - Restructuring Activities - --------------------------------- The company is holding and preparing for sale the excess property, primarily in Burbank, California, resulting from the restructuring of its Aeronautical Systems business in 1989. As a result of declining real estate values, the company recorded a charge of $35 million in the third quarter of 1993 representing the excess of capitalized and future costs applicable to the restructuring properties over the anticipated proceeds at time of sale. Until the properties are prepared for sale and sold, the ultimate cost and sales value of the properties will continue to be subject to change. Note 4 - Other Income, Net - -------------------------- Other income, net consisted of the following components: In millions 1993 1992 1991 - --------------------------------------------------------- Interest income $ 14 $ 38 $ 31 Earnings before income taxes of Lockheed Finance Corporation 6 6 6 Other (20) (20) (21) - --------------------------------------------------------- $ $ 24 $ 16 ========================================================= Note 5 - Accounts Receivable - ---------------------------- Accounts receivable consisted of the following components: In millions 1993 1992 - ------------------------------------------------------------ U.S. government, primarily on long-term contracts $ 521 $ 538 Commercial and foreign government Long-term contracts 48 111 Other 336 235 Unbilled costs and accrued profits, primarily related to U.S. government and foreign government contracts 739 706 - ------------------------------------------------------------ $1,644 $1,590 ============================================================ Unbilled costs and accrued profits consisted primarily of revenues on long-term contracts that had been recognized for accounting purposes but not yet billed to customers. Of this total at December 26, 1993, it is expected that approximately $670 million will be billed within 90 days. The remaining amount of unbilled costs and accrued profits represent amounts related to Lockheed's estimate of contract price adjustments that are expected to be billed and collected on completion of negotiations. Note 6 - Inventories - -------------------- Inventories consisted of the following components: In millions 1993 1992 - ----------------------------------------------------------------- Work in process, primarily on long-term contracts or programs $3,166 $1,524 Materials and spare parts 310 259 Advances to subcontractors 394 205 Finished goods 105 115 - ----------------------------------------------------------------- 3,975 2,103 Less customer advances and progress payments 2,276 925 - ----------------------------------------------------------------- $1,699 $1,178 ================================================================= A substantial portion of inventories was applicable to U.S. government contracts. Under contractual arrangements whereby Lockheed receives progress payments from the U.S. government, title to inventories identified with the related contracts is vested in the government. Inventories do not include any significant amounts of unamortized tooling, learning curve and other deferred costs, claims, or other similar items whose recovery is uncertain. An analysis of general and administrative costs included in work in process follows: In millions 1993 1992 1991 - -------------------------------------------------------------------- Beginning of period $ 215 $ 186 $ 207 Incurred during the year 1,113 913 812 Charged to costs and expenses during the year (956) (884) (833) - -------------------------------------------------------------------- $ 372 $ 215 $ 186 ==================================================================== Included in costs and expenses in 1993, 1992, and 1991, were general and administrative costs of approximately $110 million, $102 million, and $66 million, respectively, incurred by business units whose sales were principally not under government contracts. Note 7 - Income Taxes - --------------------- The provision for income taxes consisted of the following components: In millions 1993 1992 1991 - ------------------------------------------------------------ Current U.S. federal $ 83 $ 210 $ 199 Foreign 5 7 11 Deferred U.S. federal 166 (16) (44) - ------------------------------------------------------------ $ 254 $ 201 $ 166 ============================================================ All of the pretax earnings shown in the company's consolidated statement of earnings were included in the computation of the provision for U.S. federal income tax. For the approximate amounts of foreign pretax income, see Note 13. Net provisions for state taxes on income are included in general and administrative expenses which, as explained in Note 6, are primarily allocable to government contracts. Such state taxes were $30 million in 1993, $43 million in 1992, and $35 million in 1991. The following is a reconciliation of the difference between the actual provision for income taxes and the provision computed by applying the federal statutory tax rate on earnings before income taxes and cumulative effect of change in accounting principle: In millions 1993 1992 1991 - ------------------------------------------------------------ Computed income taxes using statutory tax rate (35% in 1993, 34% in 1992 and 1991) $ 237 $ 187 $ 161 Increases (reductions) from Amortization of purchase costs 16 13 12 Revisions to prior years' estimated income tax liabilities Tax credits (15) Other revisions 16 5 12 Other, net (15) (4) (4) - ------------------------------------------------------------ $ 254 $ 201 $ 166 ============================================================ The company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes," in 1992. Deferred income tax assets and liabilities on the consolidated balance sheet 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. SFAS 109 requires a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. The company has no recorded deferred tax assets which require a valuation allowance. Deferred tax assets and liabilities consisted of the following components: December 26, December 27, In millions 1993 1992 - ------------------------------------------------------------- Deferred tax assets related to: Accumulated retiree medical benefit obligation $384 $304 Accrued compensation and benefits 140 114 Other 27 25 - ------------------------------------------------------------- 551 443 - ------------------------------------------------------------- Deferred tax liabilities related to: Acquired intangible assets 257 Contract costing methods 170 158 Depreciation methods 85 83 Debt settlement costs 37 35 Restructuring costs 13 12 - ------------------------------------------------------------- 562 288 - ------------------------------------------------------------- Net deferred tax assets (liabilities) $(11) $155 ============================================================= The computation of the deferred tax provision for 1991, the last year in which the deferred method was used, included tax effects related to the following: In millions 1991 - ----------------------------------------------------------- Contract costing methods $ (9) Foreign tax credits (3) Undistributed earnings of foreign subsidiaries 11 Costing adjustment (10) Transition adjustments for changes in tax accounting methods (25) Other, net (8) - ----------------------------------------------------------- $ (44) =========================================================== Note 8 - Employee Benefit Plans - ------------------------------- DEFINED CONTRIBUTION PLANS The company maintains contributory 401(k) savings plans for salaried employees (the Salaried Plan) and hourly employees (the Hourly Plans) which cover substantially all employees. The Salaried Plan In 1989, a leveraged Employee Stock Ownership Plan (ESOP) was created and incorporated into the Salaried Plan. The ESOP purchased approximately 10.7 million shares of Lockheed stock with the proceeds from a $500 million note issue which is guaranteed by Lockheed (see Note 10). These shares are held in a suspense account in a salaried ESOP trust until allocated to participants as described below. Under provisions of the Salaried Plan, employees' eligible contributions are matched by the company at a 60 percent rate. The company's matching obligation is accounted for as compensation and was $104 million in 1993, $91 million in 1992, and $85 million in 1991. Since January 1992, one half of the company match has consisted of cash contributions to employee-selected investment options (including Lockheed stock) and one half of the company match has consisted of Lockheed stock. In 1991, the company match consisted entirely of Lockheed stock. The Lockheed stock portion of the matching obligation is fulfilled, in part, with stock allocated from the suspense account (approximately 710,000 shares per year) through the year 2004. The balance of the stock portion of the matching obligation is fulfilled through purchases of Lockheed stock from retiring participants or on the open market. Approximately 77,000, 184,000, and 1.2 million shares of Lockheed stock were purchased on the open market by the salaried ESOP trust in 1993, 1992, and 1991, respectively. The salaried ESOP trust also sold on the open market approximately 110,000 and 285,000 shares purchased from retirees in 1993 and 1992, respectively. Company payments to the salaried ESOP trust for the stock portion of the matching obligation consist of dividends on the unallocated shares, and an amount sufficient to fully service the ESOP debt and meet the company's matching obligation to employees that is not otherwise covered through the allocation of suspense account shares. In 1993, compensation expense accrued and dividends on unallocated shares exceeded the amount required to fully service the ESOP debt and fulfill the company's matching obligation by approximately $2 million. The amount was recognized as an addition to the company's other income, net. In 1992 and 1991, the company paid an amount in excess of compensation expense accrued and dividends on unallocated shares. These additional payments were recognized as additions to Lockheed's interest expense. The amount varied in each year due to changes in the market value of company stock allocated from the suspense account. The impact of the ESOP on the company also includes special tax benefits on dividends paid on allocated and unallocated ESOP shares. These various items are reflected in components of the company's consolidated statement of earnings or as direct increases to the company's retained earnings. The aggregate of these items resulted in a net favorable effect to the company of about $12 million, $6 million, and $5 million in 1993, 1992, and 1991, respectively. The salaried ESOP trust requirements and the company's payments are shown in the following table: In millions 1993 1992 1991 - ------------------------------------------------------------------- ESOP trust requirements: Debt service (including interest of $35 million in 1993, $38 million in 1992, and $39 million in 1991) $ 59 $ 59 $ 59 Purchase of additional shares (required to meet company matching obligation) 8 12 55 - ------------------------------------------------------------------- $ 67 $ 71 $ 114 =================================================================== Met by: Dividends on unallocated shares $ 17 $ 18 $ 22 Company matching funds (Lockheed stock portion) 52 45 85 Amounts recognized as additions to Lockheed's interest expense (other income) (2) 8 7 - ------------------------------------------------------------------- $ 67 $ 71 $ 114 =================================================================== The Hourly Plans In 1990, ESOPs were created and incorporated into the Hourly Plans. The company matches 60 percent of a participating employee's eligible contribution to the Hourly Plans through payments to an ESOP trust. The company's match consists of Lockheed stock purchased by the ESOPs on the open market and from retiring participants. The company's required match, which is reported as compensation, was $15 million in 1993, $16 million in 1992, and $17 million in 1991. Approximately 123,000, 311,000, and 370,000 shares were purchased on the open market to provide the company match in 1993, 1992, and 1991, respectively. ESOP Ownership of the Company's Stock The salaried and hourly ESOP trusts held approximately 16 million shares of the company's stock at December 26, 1993, December 27, 1992, and December 29, 1991, representing about 26 percent, 26 percent, and 25 percent of the total shares outstanding, respectively. DEFINED BENEFIT PLANS Most employees are covered by Lockheed-sponsored contributory or noncontributory defined benefit pension plans. Normal retirement age is 65, but provision is made for earlier retirement. Benefits for salaried plans are generally based on salary and years of service, while those for hourly plans are based on negotiated benefits and years of service. Substantially all benefits are paid from funds previously provided to trustees. Lockheed's funding policy is to make contributions that are consistent with U.S. government cost allowability and Internal Revenue Service deductibility requirements, subject to the full-funding limits of the Employee Retirement Income Security Act of 1974 (ERISA). When any Lockheed funded plan exceeds the full-funding limits of ERISA, no contribution is made to that plan. In addition, Lockheed has certain supplemental retirement and other benefit plans which are not material. Under these plans, benefits are paid directly by Lockheed and charged against liabilities previously accrued. Net pension cost for 1993, 1992 and 1991, as determined by Statement of Financial Accounting Standards No. 87 (SFAS 87), was $110 million, $76 million, and $90 million, respectively, as shown in the following table: In millions 1993 1992 1991 - ------------------------------------------------------------------- Service cost - benefits earned during the period $ 221 $ 176 $ 165 Interest cost on projected benefit obligation 534 439 419 Actual return on plan assets (856) (358) (1,266) Net amortization and deferral 214 (178) 775 Employee contributions (3) (3) (3) - ------------------------------------------------------------------- $ 110 $ 76 $ 90 =================================================================== An analysis of the status of the plans follows: December 26, December 27, In millions 1993 1992 - -------------------------------------------------------------- Plan assets, at fair value $8,322 $6,608 ============================================================== Actuarial present value of benefit obligations Vested benefits $6,696 $5,021 Nonvested benefits 77 81 - -------------------------------------------------------------- Accumulated benefit obligation 6,773 5,102 Effect of projected future salary increases 844 634 - -------------------------------------------------------------- Projected benefit obligation 7,617 5,736 - -------------------------------------------------------------- Plan assets in excess of projected benefit obligation $ 705 $ 872 ============================================================== Consisting of Unrecognized net asset existing at the date of initial application of SFAS 87 $ 422 $ 507 Unrecognized prior service cost (242) (148) Unrecognized net gain 308 528 Prepaid pension expense 217 (15) - -------------------------------------------------------------- $ 705 $ 872 ============================================================== At December 26, 1993 and December 27, 1992, approximately 48 percent and 49 percent, respectively, of the plan assets were equity securities and the rest were primarily fixed income securities. The actuarial determinations were based on various assumptions as illustrated in the following table. Net pension costs in 1993, 1992, and 1991 were based on assumptions in effect at the end of the respective preceding year-end. Benefit obligations as of each year-end were based on assumptions in effect as of those dates. 1993 1992 1991 - -------------------------------------------------------------------------- Discount rate on benefit obligations 7.0% 8.0% 8.25% Average of full-career compensation increases for those employees whose benefits are affected by compensation levels 6.0% 7.0% 7.0% Expected long-term rate of return on plan assets 8.0% 8.0% 8.0% - -------------------------------------------------------------------------- As required by SFAS 87, the projected benefit obligation includes the effect of projected future salary increases, but not the effect of projected future credited service. The excess of plan assets over the projected benefit obligation will be required to fund the plans' continuing benefit obligations that will result from, among other things, future credited service. The change in this excess in 1993 from 1992 resulted from an increase in the accumulated benefit obligation primarily due to the lower discount rate, as well as the assumption of benefit obligations for certain employees and retirees of the former Fort Worth Division of General Dynamics Corporation, offset in part by plan assets acquired related to the assumed benefit obligations, as well as earnings of the plan assets exceeding benefit payments and expenses. The net pension cost for 1993 includes costs associated with the assumed obligations related to the Fort Worth Division of General Dynamics. The company has no present intention of terminating any of its pension plans. However, if a qualified defined benefit pension plan is terminated, the company would be required to vest all participants and purchase annuities with plan assets to meet the accumulated benefit obligation for such participants. At December 26, 1993, the cost to purchase annuities to satisfy the accumulated benefit obligation of Lockheed's qualified defined benefit plans would be in excess of $8.8 billion, compared to the $6.8 billion of accumulated benefit obligation reflected on the second table on page 41. The main salaried retirement plan provides that, after satisfaction of the accumulated benefit obligation and payment of federal excise taxes and federal and state income taxes, remaining plan assets would, in the event of plan termination within five years following a change in control of the company, be transferred to a trust and applied to the payment of certain other employee benefits otherwise payable to employees and retirees (e.g. retiree medical benefits). To the extent that contributions to a defined benefit plan were reimbursed under U.S. government contracts, any remaining surplus amounts at the time of plan termination are subject to equitable sharing under an agreement with the government. RETIREE MEDICAL PLANS Lockheed currently provides medical benefits under a contributory group medical plan for certain early (pre-65) retirees and under a noncontributory group Medicare supplement plan for certain retirees aged 65 and over (post-65). Under the accrual accounting methods of Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," the present value of the actuarially determined expected future cost of providing medical benefits is attributed to each year of employee service. The service and interest cost recognized each year is added to the accumulated retiree medical benefit obligation. Net retiree medical benefit costs as determined under SFAS 106 were $102 million in 1993 and $91 million in 1992, and are shown in the following table: In millions 1993 1992 - ------------------------------------------------------- Service cost - benefits accrued during the year $ 24 $18 Interest cost on accumulated retiree medical benefit obligation 84 76 Actual return on plan assets (5) (2) Net amortization and deferral (1) (1) - ------------------------------------------------------- $102 $91 ======================================================= Lockheed has implemented funding approaches to help manage future retiree medical costs. A Voluntary Employees' Beneficiary Association (VEBA) trust was established and began receiving funding in 1991, and other trusts established under Internal Revenue Service (IRS) regulations began receiving funding in 1992. At December 26, 1993, these trusts held $113 million in assets, of which 52 percent were equity securities and the rest were primarily fixed income securities. In 1992, assets were held in short-term investment fund accounts. The funded amounts are allowable under government contracts in the pricing of the company's products and services and are deductible in the year of contribution under IRS regulations. Earnings on trust assets operate as a reduction to annual SFAS 106 costs. Upon adopting SFAS 106 effective the beginning of fiscal 1992, Lockheed elected to record the transition obligation (present value of future retiree medical benefits attributed to years prior to 1992) on the immediate recognition basis. This resulted in a charge to 1992 earnings for the cumulative effect of the accounting change of $631 million, or $10.23 per share, after recognition of the deferred tax benefit of $325 million associated with this transition obligation. Under SFAS 106, actual medical benefit payments to retirees reduce Lockheed's accumulated retiree medical benefit obligation, and any trust funding reduces the unfunded portion of this obligation on the company's consolidated balance sheet. An analysis of the status of the retiree medical benefit plans follows: December 26, December 27, In millions 1993 1992 - -------------------------------------------------------------- Plan assets at fair value $ 113 $ 63 ============================================================== Actuarial present value of benefit obligation: Retirees $ 726 $585 Employees eligible to retire 233 160 Employees not eligible to retire 309 195 - -------------------------------------------------------------- Accumulated retiree medical benefit obligation 1,268 940 Unrecognized net gain (loss) (58) 32 - -------------------------------------------------------------- Net unfunded retiree medical benefit obligation $1,097 $909 ============================================================== In 1993, in response to economic conditions affecting a number of U.S. government and commercial programs, the company undertook significant workforce reductions at several of its companies. This action resulted in a net curtailment gain of $28 million, representing a reversal of a portion of the previously accrued obligation for future retiree medical costs. In addition, the retiree medical benefit obligations at December 26, 1993, and the 1993 net retiree medical benefit costs reflect the assumption of benefit obligations for certain employees and retirees of the former Fort Worth Division of General Dynamics Corporation. Actuarial determinations were based on various assumptions as illustrated in the following table. Net retiree medical costs for 1993 and 1992 were based on assumptions in effect at the end of the respective preceding years. Benefit obligations as of the end of each year reflect assumptions in effect as of those dates. 1993 1992 - -------------------------------------------------------------- Discount rate 7.0% 8.25% Expected long-term rate of return on plan assets 8.0% 8.0% Range of medical trend rates: Initial: pre-65 retirees 11.0% 13.0% post-65 retirees 7.5% 10.0% Ultimate (20 years and after): pre-65 retirees 5.0% 6.0% post-65 retirees 2.0% 2.0% - -------------------------------------------------------------- An increase of one percentage point in the assumed medical trend rates would result in an accumulated retiree medical benefit obligation of $1.3 billion at December 26, 1993, and a 1993 net retiree medical benefit cost of approximately $119 million. The company believes that the cost containment features it has previously adopted and the funding approaches under way will allow it to effectively manage its retiree medical expenses, but it will continue to monitor the costs of retiree medical benefits and may further modify the plans if circumstances warrant. POSTEMPLOYMENT BENEFITS In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits." This statement establishes standards for accounting for benefits to former or inactive employees after employment, other than retirement benefits. Lockheed will adopt SFAS 112 in 1994, the required implementation date. Adoption of SFAS 112 is not expected to have a significant effect on the company's financial statements. Note 9 - Leases - --------------- Total rental expenses under operating leases, net of immaterial amounts of sublease rentals and contingent rentals, were $112 million, $114 million, and $123 million for 1993, 1992, and 1991, respectively. Future minimum lease commitments at December 26, 1993, for all operating leases that have a remaining term of more than one year were $507 million ($104 million in 1994, $80 million in 1995, $69 million in 1996, $51 million in 1997, $47 million in 1998, and $156 million in later years). Substantially all real estate leases contain renewal options ranging from one year to 10 years. Certain major plant facilities and equipment are furnished by the U.S. government under short-term or cancelable arrangements. Note 10 - Debt - -------------- At December 26, 1993, the company had two loan agreements (the 1993 Agreements) with a group of domestic and foreign banks. One agreement makes available $1 billion through August 30, 1996, while the other agreement makes available $300 million through August 29, 1994. The primary purpose of these agreements is to back up the company's commercial paper borrowings. There were no borrowings outstanding under either agreement, and no commercial paper borrowings outstanding, at December 26, 1993 (considerable commercial paper borrowing activity took place during the year, however, primarily to provide the initial financing of the LFWC acquisition and for temporary working capital needs). Borrowings under the 1993 Agreements would be unsecured and bear interest, at the company's option, at rates based on the Eurodollar rate or a bank base rate (as defined). The 1993 Agreements contain financial covenants relating to equity and debt, and provisions which relate to certain changes in control. Long-term debt consisted of the following components: In millions 1993 1992 - ------------------------------------------------------------ 7 7/8% notes due 1993 $ 300 8 1/2% notes due 1996, redeemed 1993 200 Variable-rate notes due 1995 $ 200 80 Fixed-rate notes due 1995 to 2004 140 77 4 7/8% notes due 1996 275 5.65% notes due 1997 100 5 7/8% notes due 1998 300 9 3/8% notes due 1999 300 300 6 3/4% notes due 2003 300 9% notes due 2022 200 200 7 7/8% notes due 2023 300 Obligations under long-term capital leases 17 10 Other obligations 36 53 - ------------------------------------------------------------ 2,168 1,220 Guarantee of ESOP obligations 407 431 - ------------------------------------------------------------ 2,575 1,651 Less portion due within one year 28 323 - ------------------------------------------------------------ $ 2,547 $ 1,328 ============================================================ All of the notes contain covenants relating to debt, and provisions which relate to certain changes in control. The variable-rate notes due in 1995 are unsecured and bear interest at rates based on the Eurodollar rate. The fixed-rate notes due in 1995 to 2004 are unsecured, were issued in various denominations with various maturity dates, and bear interest at fixed rates ranging from 4.55 percent to 8.34 percent. The 9 3/8% notes due in 1999 stipulate that, in the event of both a "designated event" and a related "rating decline" occurring within a specified period of time, holders of the notes may require Lockheed to redeem the notes and pay accrued interest. In general, a "designated event" occurs when any one of certain ownership, control, or capitalization changes takes place. A "rating decline" occurs when the ratings assigned to Lockheed debt are reduced below investment-grade levels. Lockheed's leveraged ESOP (see Note 8) borrowed $500 million through a private placement of notes in 1989. These notes bear interest at fixed rates ranging from 8.27 percent to 8.41 percent, and are being repaid in quarterly installments over terms ending in 2004. The ESOP note agreement stipulates that, in the event that the ratings assigned to Lockheed's long-term senior unsecured debt are below investment grade, holders of the notes may require Lockheed to purchase the notes and pay accrued interest. These notes are obligations of the ESOP but guaranteed by Lockheed and, in accordance with financial accounting standards, are reported as debt on Lockheed's balance sheet, with a corresponding offset to stockholders' equity. As the ESOP notes are repaid, the amount guaranteed decreases, as do the amounts reported as Lockheed debt and offsetting stockholders' equity. While the amount guaranteed affects Lockheed's consolidated balance sheet, the issuance of the guarantee and the subsequent reductions in its amount were not cash transactions and, accordingly, are not reflected on the consolidated statement of cash flows. Lockheed Finance Corporation (LFC) has a $155 million line of credit with a group of banks. The agreement limits borrowings to an amount reduced by the balance outstanding ($58 million at December 26, 1993) of LFC notes and leases receivable sold to the banks with certain recourse provisions. The company's long-term debt maturities, including those of LFC and the guaranteed ESOP obligations, for the five years following December 26, 1993, are: $28 million in 1994; $272 million in 1995; $306 million in 1996; $162 million in 1997; and $373 million in 1998. Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," requires the disclosure of the fair value of financial instruments, both assets and liabilities recognized and not recognized on the consolidated balance sheet, for which it is practicable to estimate fair value. Unless otherwise indicated elsewhere in the notes to the consolidated financial statements, the carrying value of the company's financial instruments approximates fair value. The estimated fair values of the company's long-term debt instruments at December 26, 1993, aggregated $2,776 million, compared with a carrying amount of $2,575 million on the consolidated balance sheet. The fair values were estimated based on quoted market prices for those instruments publicly traded. For privately placed debt, the fair values were estimated based on the quoted market prices for the same or similar issues, or on current rates offered to the company for debt of the same remaining maturities. Note 11 - Commitments and Contingencies - --------------------------------------- ENVIRONMENTAL MATTERS In March 1991, the company entered into a consent decree with the U.S. Environmental Protection Agency (EPA) relating to certain property in Burbank, California, which obligates the company to design and construct facilities to monitor, extract, and treat groundwater and operate and maintain such facilities for approximately eight years. The company currently estimates that expenditures required to comply with the terms of the consent decree over the remaining term of the project will approximate $120 million. The company has also been operating under a cleanup and abatement order from the California Regional Water Quality Control Board affecting its facilities in Burbank, California. This order requires site assessment and action to abate groundwater contamination by a combination of groundwater and soil cleanup and treatment. Based on experience being derived from initial remediation activities, the company currently estimates the anticipated costs of these actions in excess of the requirements under the EPA consent decree to approximate $175 million over the remaining term of the project; however, this estimate will be subject to changes as work progresses and as additional experience is gained. The company is also involved in several other proceedings and potential proceedings relating to environmental matters, including disposal of hazardous wastes and soil and water contamination. The company has not incurred any material costs relating to these environmental matters. The extent of the company's financial exposure cannot in all cases be reasonably estimated at this time. A liability of approximately $55 million for those cases in which an estimate of financial exposure can be determined has been recorded. Under an agreement with the U.S. government, the Burbank groundwater treatment and soil remediation expenditures are being allocated to all of the company's operations as general and administrative costs (see Note 1), and under existing government regulations these and other environmental expenditures related to U.S. government business are allowable in establishing the prices of the company's products and services. As a result, a substantial portion of the expenditures will be reflected in the company's sales and costs of sales pursuant to U.S. government agreement or regulation. The company has recorded a liability for probable future environmental costs as discussed above, and has recorded an asset for probable future recovery of these costs in pricing of the company's products and services for U.S. government business. The portion that is expected to be allocated to commercial business has been reflected in cost of sales. OTHER MATTERS Lockheed is a defendant in a number of shareholder lawsuits relating to the fourth quarter 1989 write-off of $300 million on the P-7A aircraft development program. The plaintiffs allege, among other things, that disclosure with respect to potential losses under the contract was not made on a timely basis. The company believes that if these actions, in the aggregate, were decided adversely to it, the result would not have a material impact on the company. Lockheed Missiles and Space Company, Inc., a subsidiary of Lockheed, is a defendant in a civil suit in the United States District Court for the Northern District of California brought under the so-called qui tam provisions of the False Claims Act, which permit an individual to bring suit in the name of the government and share in any recovery received. The suit, captioned United States ex rel. Margaret A. Newsham and Martin Overbeek Bloem v. Lockheed Missiles and Space Company, Inc., was filed by two ex-employees in 1988. The complaint sets forth numerous allegations of improper conduct by Lockheed and seeks unspecified damages. The Department of Justice conducted a thorough investigation of the matter after the complaint was filed and has declined to take over prosecution of the case. The company believes the litigation to be without merit and intends to aggressively defend its position. A number of other lawsuits and administrative proceedings are pending against the company and its subsidiaries. Management believes the lawsuits and administrative proceedings are either without merit or, if decided adversely, would be covered by insurance or by contract or would not be of material significance. The company has entered into standby letter of credit agreements and other arrangements with financial institutions primarily relating to the guarantee of future performance on certain contracts. At December 26, 1993, the company was contingently liable on outstanding letters of credit, guarantees, and other arrangements aggregating approximately $406 million. Lockheed Finance Corporation sold certain finance notes and leases receivable with certain recourse provisions during 1993 and in previous years. At December 26, 1993, the unpaid principal balance of these notes and leases was about $58 million. At December 26, 1993, LFC had entered into approximately $400 million in interest rate swap agreements to reduce the impact of changes in interest rates on its operations. The effect of these agreements is that the aggregate of the carrying value of LFC's financial instruments approximates their fair market value. LFC is exposed to credit loss, to the extent of future interest rate differentials, in the event of nonperformance by the intermediaries to the interest rate swap agreements. The company does not anticipate nonperformance by the intermediaries. Note 12 - Stockholders' Equity and Related Items - ------------------------------------------------ EMPLOYEE STOCK OPTIONS Lockheed's 1992 Employee Stock Purchase Program (1992 Program) authorizes grants of options to purchase up to 3,000,000 shares of the company's authorized but unissued common stock. Options granted under the 1992 Program and its predecessors, the 1986 Program and the 1982 Program, can be exercised at a price not less than the fair market value of the stock on the date that the option is granted. At December 26, 1993, 2,856,770 shares of the company's common stock were reserved for stock options granted. The 1992 Program is composed of two separate stock option plans. The first plan provides for the grant of incentive stock options. The second plan provides for the grant of nonstatutory stock options that may, at the discretion of the board of directors, be accompanied by stock appreciation rights. The following table summarizes the options exercisable and available for grant at December 26, 1993: Exercisable --------------------- Available Number Price range for grant - ---------------------------------------------------- 1992 Program 226,973 $42.75-58.81 1,821,500 1986 Program 1,447,538 31.94-55.31 1982 Program 287,009 46.00-47.50 ==================================================== The following table summarizes the activity under the company's plans during 1993: Option Shares price under range option - ------------------------------------------------ Outstanding at December 27, 1992 $31.94-55.31 3,870,883 Granted 58.31-58.81 633,450 Terminated 40.19-58.81 (26,200) Exercised 34.81-55.31 (1,621,363) - ------------------------------------------------ Outstanding at December 26, 1993 $31.94-58.81 2,856,770 ================================================ PREFERRED STOCK There are 2,500,000 shares of preferred stock, $1 par value, authorized for issuance. At December 26, 1993, there was no preferred stock outstanding and 1,000,000 shares of preferred stock were reserved for issuance in connection with the rights described below. In December 1986, Lockheed adopted a Shareholder Rights Plan and distributed a dividend of one right for each outstanding share of common stock. Upon becoming exercisable, each right entitles the holder to purchase one one-hundredth of a share of Series A Junior Participating Preferred stock (Series A Preferred), par value $1, at a price of $150, which is subject to adjustment. Shares of common stock issued by the company subsequent to the adoption of the plan have had rights attached. The rights are not exercisable into common stock or transferable apart from the common stock, and no separate rights certificates will be distributed until ten business days after the public announcement that a person or group either (i) has acquired, or has obtained the right to acquire, beneficial ownership of 20 percent or more of the outstanding common shares, or (ii) has commenced, or announced an intention to make, a tender offer or exchange offer if, upon consummation, such person or group would be the beneficial owner of 20 percent or more of the outstanding common shares. When such rights become exercisable, as described above, each right will entitle its holder, other than such person or group referred to above, upon payment of the exercise price, to receive Lockheed common shares with a deemed market value of twice such exercise price. Such rights will not be triggered in the event of a "qualifying offer" (basically defined as an all cash offer, fully financed, to acquire a majority of outstanding shares not owned by the offeror, which meets specified irrevocable criteria), or if the 20 percent acquisition is made pursuant to a tender or exchange offer for all outstanding common shares which a majority of the directors of the company deem to be in the best interests of the company and its stockholders. If there is a merger with an acquirer of 20 percent or more of Lockheed's common stock and Lockheed is not the surviving corporation, or more than 50 percent of Lockheed's assets, earning power, or cash flow is transferred or sold, each right will entitle its holder, other than the acquirer, to receive the acquiring company's common shares with a deemed market value of twice such exercise price. All of the rights may be redeemed by the board of directors of the company at a price of $.05 per right until the earlier of (i) ten business days after the public announcement that a person or group has acquired beneficial ownership of 20 percent or more of the outstanding common shares or (ii) December 1996. After a person or group acquires 20 percent or more of Lockheed's common shares, the board of directors may redeem the rights only with the concurrence of a majority of the continuing directors (as defined in the plan). The rights, which do not have voting rights and are not entitled to dividends, expire in December 1996. Note 13 - Information on Industry Segments, Foreign and - ------------------------------------------------------- Domestic Operations, and Major Customers - ---------------------------------------- Unaudited information on Lockheed's business segments is included in Part I of this Form 10-K and Management's Discussion and Analysis beginning on page 16. Selected additional information is summarized below: SELECTED FINANCIAL DATA BY BUSINESS SEGMENT In millions 1993 1992 1991 - --------------------------------------------------------------------- Depreciation and amortization Aeronautical Systems $ 216 $ 106 $ 95 Missiles and Space Systems 164 156 157 Electronic Systems 72 74 70 Technology Services 14 11 10 Corporate* 32 8 7 - --------------------------------------------------------------------- Total $ 498 $ 355 $ 339 ===================================================================== Expenditures for property, plant, and equipment Aeronautical Systems $ 148 $ 140 $ 108 Missiles and Space Systems 98 133 159 Electronic Systems 35 40 34 Technology Services 10 12 10 - --------------------------------------------------------------------- Total segments 291 325 311 Corporate 30 2 1 - --------------------------------------------------------------------- Total $ 321 $ 327 $ 312 ===================================================================== Identifiable assets Aeronautical Systems $4,336 $2,109 $2,248 Missiles and Space Systems 1,810 2,028 2,011 Electronic Systems 1,468 1,506 1,496 Technology Services 317 300 229 - --------------------------------------------------------------------- Total segments 7,931 5,943 5,984 Lockheed Finance Corporation 112 121 111 Corporate 918 960 522 - --------------------------------------------------------------------- Total $8,961 $7,024 $6,617 ===================================================================== *Depreciation and amortization is allocated to the operating segments. SELECTED FINANCIAL DATA BY GEOGRAPHIC AREA* In millions 1993 1992 1991 - ------------------------------------------------------------ Sales United States $12,390 $ 9,656 $ 9,481 Other 681 444 328 - ------------------------------------------------------------ Total $13,071 $10,100 $ 9,809 ============================================================ Program profits United States $ 827 $ 613 $ 545 Other 17 31 31 - ------------------------------------------------------------ Total $ 844 $ 644 $ 576 ============================================================ Identifiable assets United States $ 8,730 $ 6,777 $ 6,413 Other 231 247 204 - ------------------------------------------------------------ Total $ 8,961 $ 7,024 $ 6,617 ============================================================ * Defined by the location of Lockheed operations and not necessarily the locations of customers. Transfers between geographic areas were not material in any year. Identifiable assets in each segment or geographic area include the assets used in Lockheed's operations, and any applicable excess of the purchase price over the fair value of net assets acquired or intangible assets acquired, as appropriate. Consistent with Securities and Exchange Commission rules, identifiable assets are not reduced by identifiable liabilities. Corporate assets consisted primarily of cash and cash equivalents, property, plant, equipment, assets related to the probable future recovery of certain environmental remediation costs, current and deferred tax assets, and investments. SALES BY CUSTOMER CATEGORY In millions 1993 1992 1991 - --------------------------------------------------------------------- U.S. government* Aeronautical Systems $ 4,477 $2,245 $1,984 Missiles and Space Systems 3,846 4,386 4,777 Electronic Systems 547 507 476 Technology Services 1,179 1,103 1,058 - --------------------------------------------------------------------- Total $10,049 $8,241 $8,295 ===================================================================== Foreign governments Aeronautical Systems $ 1,408 $ 551 $ 424 Missiles and Space Systems 282 172 54 Electronic Systems 81 126 133 - --------------------------------------------------------------------- Total $ 1,771 $ 849 $ 611 ===================================================================== Commercial Aeronautical Systems $ 125 $ 161 $ 227 Missiles and Space Systems 110 29 28 Electronic Systems 768 656 513 Technology Services 248 164 135 - --------------------------------------------------------------------- Total $ 1,251 $1,010 $ 903 ===================================================================== * Sales made to foreign governments through the U.S. government are included in sales to foreign governments. Export sales were $1,743 million, $831 million, and $666 million in 1993, 1992, and 1991, respectively. Note 14 - Summary of Quarterly Information (Unaudited) - ------------------------------------------------------ 1993 Quarters In millions, except ----------------------------- per-share data First Second Third Fourth - -------------------------------------------------------------- Sales $2,508 $3,349 $3,475 $3,739 Program profits 158 200 226 260 Earnings before income taxes 126 149 187 214 Net earnings 76 94 117 135 Earnings per share 1.22 1.50 1.85 2.13 - -------------------------------------------------------------- 1992 Quarters ----------------------------- First Second Third Fourth - -------------------------------------------------------------- Sales $2,226 $2,480 $2,474 $2,920 Program profits 125 147 161 211 Earnings before income taxes 105 122 136 186 Earnings before change in accounting 66 77 86 119 Net earnings (loss) (565) 77 86 119 Earnings per share Before change in accounting 1.06 1.24 1.40 1.95 Net earnings (loss) (9.04) 1.24 1.40 1.95 - -------------------------------------------------------------- THE COMPANY'S RESPONSIBILITY FOR FINANCIAL REPORTING Management prepared, and is responsible for, the consolidated financial statements and all related financial information contained in this report. The consolidated financial statements, which include amounts based on estimates and judgments, were prepared in accordance with generally accepted accounting principles appropriate in the circumstances. Other financial information in this report is consistent with that in the consolidated financial statements. Management recognizes its responsibilities for conducting the company's affairs in an ethical and socially responsible manner. The company has written policy statements covering its business code of ethics which emphasize the importance of total allegiance to codes of personal and corporate conduct that leave no latitude for legal infractions or moral improprieties. The importance of ethical behavior is regularly communicated to all employees through ongoing education and review programs that are designed to create a strong compliance environment. Management maintains an accounting system and related internal controls which it believes provide reasonable assurance, at appropriate cost, that transactions are properly executed and recorded, that assets are safeguarded, and that accountability for assets is maintained. An environment that establishes an appropriate level of control consciousness is maintained and monitored and includes examinations by an internal audit staff. The audit committee of the board of directors is composed of five outside directors. This committee is convened at least four times a year and frequently meets separately with representatives of the independent auditors, company officers, and the internal auditors to review their activities. The consolidated financial statements have been audited by Ernst & Young, independent auditors, whose report follows. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS Board of Directors and Stockholders Lockheed Corporation We have audited the accompanying consolidated balance sheet of Lockheed Corporation at December 26, 1993 and December 27, 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the three years in the period ended December 26, 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 Lockheed Corporation at December 26, 1993 and December 27, 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 26, 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 herein. As discussed in Notes 8 and 7 to the financial statements, effective December 30, 1991 (the beginning of Lockheed's 1992 fiscal year), the company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." ERNST & YOUNG Los Angeles, California February 7, 1994 PART III The information required to be set forth herein, 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," except for a list of the Executive Officers which is provided in Part I of this report, is included in a definitive Proxy Statement pursuant to Regulation 14A, which is incorporated herein by reference, filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year ended December 26, 1993. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Index to Consolidated Financial Statements, Consolidated Financial Statement Schedules and Exhibits: Page No. -------- 1. Consolidated Financial Statements included in Part II Consolidated Statement of Earnings for Years Ended December 26, 1993, December 27, 1992, and December 29, 1991.................................... 28 Consolidated Statement of Cash Flows for Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 ................................................. 29 Consolidated Balance Sheet at December 26, 1993, Decem- ber 27, 1992, and December 29, 1991 .................. 30 Consolidated Statement of Stockholders' Equity for Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 .................................... 31 Notes to Consolidated Financial Statements ............ 32 The Company's Responsibility for Financial Reporting .. 55 Report of Ernst & Young, Independent Auditors ......... 56 2. Consolidated Financial Statement Schedules V -- Property, Plant, and Equipment .............. VI -- Accumulated Depreciation and Amortization of Property, Plant, and Equipment .............. VIII -- Valuation and Qualifying Accounts ........... IX -- Short-term Borrowings ....................... X -- Supplementary Income Statement Information .. 3. Index to Exhibits ...................................... E-1 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 Con- solidated Financial Statements and related notes. (b) Reports on Form 8-K: Form 8-K dated September 29, 1993, Item 5, Other Events. SCHEDULE V LOCKHEED CORPORATION PROPERTY, PLANT, AND EQUIPMENT Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of Dollars) Balance Add- Retire- Balance Beginning itions ments Other End of Description of Year at Cost or Sales Changes(1)Year(2) 1993: Land...................... $ 91 $ 2 $ (5) $ 5 $ 93 Buildings and structures.. 1,358 96 (139) 32 1,347 Machinery and equipment... 2,571 245 (217) 138 2,737 Leasehold improvements.... 206 16 (5) 13 230 Construction in progress(3) 222 (38) (2) 2 184 -------- -------- -------- -------- ------- $ 4,448 $ 321 $ (368) $ 190 $ 4,591 ======== ======== ======== ======== ======= 1992: Land...................... $ 90 $ 1 $ 91 Buildings and structures.. 1,318 $ 43 $ (3) 1,358 Machinery and equipment... 2,402 226 (57) 2,571 Leasehold improvements.... 208 10 (12) 206 Construction in progress(3) 174 48 222 -------- -------- -------- -------- ------- $ 4,192 $ 327 $ (72) $ 1 $ 4,448 ======== ======== ======== ======== ======== 1991: Land...................... $ 90 $ 90 Buildings and structures.. 1,289 $ 56 $ (23) $ (4) 1,318 Machinery and equipment... 2,342 212 (158) 6 2,402 Leasehold improvements.... 173 41 (6) 208 Construction in progress(3) 170 3 1 174 -------- -------- -------- -------- -------- $ 4,064 $ 312 $ (187) $ 3 $ 4,192 ======== ======== ======== ======== ======== Methods of depreciation for plant and equipment and leasehold improvements are discussed in Note 1 to the Consolidated Financial Statements. (1) Other changes in 1993 primarily consist of Lockheed Fort Worth Company asset balances at acquisition. (2) Includes $22 million at December 26, 1993, $14 million at December 27,1992, and $16 million at December 29, 1991, of leases capitalized in accordance with Statement of Financial Accounting Standards No. 13. (3) Construction in progress at December 26, 1993, December 27, 1992, and December 29, 1991 includes approximately $170 million, $154 million, and $128 million, respectively, of purchases that will be reclassified to the other property, plant, and equipment catagories in the following year. The remainder of the amount relates to projects that were in process at year-end, including construction of facilities primarily for the Aeronautical Systems and Missiles and Space Systems business segments. The cost of completed fixed assets transferred from construction in progress to another fixed asset category is recorded as a negative addition to construction in progress and a positive addition to the appropriate category. SCHEDULE VI LOCKHEED CORPORATION ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of Dollars) Balance Retire- Balance Beginning Pro- ments Other End of Description of Year vision or Sales Changes Year(1) 1993: Buildings and structures.. $ 634 $ 62 $ (79) $ 617 Machinery and equipment... 1,805 249 (165) $ 1 1,890 Leasehold improvements.... 127 17 (10) 134 -------- -------- -------- -------- -------- $ 2,566 $ 328 $ (254) $ 1 $ 2,641 ======== ======== ======== ======== ======== 1992: Buildings and structures.. $ 583 $ 53 $ (2) $ $ 634 Machinery and equipment... 1,649 227 (71) 1,805 Leasehold improvements.... 121 14 (8) 127 -------- -------- -------- -------- -------- $ 2,353 $ 294 $ (81) $ $ 2,566 ======== ======== ======== ======== ======== 1991: Buildings and structures.. $ 538 $ 56 $ (12) $ 1 $ 583 Machinery and equipment... 1,558 213 (109) (13) 1,649 Leasehold improvements.... 109 15 (3) 121 -------- -------- -------- -------- -------- $ 2,205 $ 284 $ (124) $ (12) $ 2,353 ======== ======== ======== ======== ======== (1) Includes $8 million at December 26, 1993, $7 million at December 27, 1992, and $9 million at December 29, 1991, of accumulated amortization of capital leases. SCHEDULE VIII LOCKHEED CORPORATION VALUATION AND QUALIFYING ACCOUNTS Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of Dollars) Balance Additions Deduct- Balance Beginning Charged to ions and End of Description of Year Earnings Other Year Deducted from assets to which applicable: 1993: Allowance for doubtful receivables: Accounts receivable............. $ 12 $ 20 $ 7 $ 25 ======= ======= ======= ======= 1992: Allowance for doubtful receivables: Accounts receivable............. $ 9 $ 8 $ 5 $ 12 ======= ======= ======= ======= 1991: Allowance for doubtful receivables: Accounts receivable............. $ 9 $ 3 $ 3 $ 9 ======= ======= ======= ======= SCHEDULE IX LOCKHEED CORPORATION SHORT-TERM BORROWINGS(1) Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of dollars) Maximum Average Weighted Category of Amount Amount Average Aggregate Balance Weighted Outstanding Outstanding Interest Short-Term at End Average During the During the Rate During Year Borrowings of Period Interest Rate Year Year(2) the Year(3) - ---- ---------- --------- ------------- ---- ------- ---------- 1993 Commercial Paper -0- -0- $1,551 $ 288 3.4% 1992 Commercial Paper -0- -0- 140 30 4.5 1991 Not Applicable (1) See Note 10 to the Consolidated Financial Statements. (2) Averages are based on the amount outstanding each day multiplied by the number of days outstanding divided by 364 days. (3) Averages are based on the actual interest expense on commercial paper borrowings divided by the average commercial paper borrowings outstanding during the year. SCHEDULE X LOCKHEED CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of Dollars) 1993 1992 1991 ----- ----- ----- Maintenance and repairs..................... $ 176 $ 182 $ 168 Most of the above amounts are accumulated in overhead and general and administrative expense pools, and are subsequently allocated to the U.S. government and foreign government contracts or commercial programs. The remainder of the above amounts is charged directly to contracts, and is ultimately included in the cost of sales in the same manner as overhead expenses. See Notes 1 and 6 to the consolidated financial statements included in Part II for a description of the company's accounting for inventories. INDEX TO EXHIBITS Exhibit Number - ------- 3.1 Certificate of Incorporation (A) 3.2 Amendment to Certificate of Incorporation (B) 3.3 Bylaws of Lockheed Corporation (C) 3.4 Amendment to Bylaws of Lockheed Corporation 4.1 Certificate of Incorporation (A) 4.2 Amendment to Certificate of Incorporation (B) 4.3 Bylaws of Lockheed Corporation (C) 4.4 Amendment to Bylaws of Lockheed Corporation (D) 4.5 The registrant undertakes to file with the Commission upon its request any agreements otherwise excluded from Item 601(b)(4) as not exceeding ten percent of the total assets of the registrant and its subsidiaries on a consolidated basis. 10.1 Asset Purchase Agreement, dated as of December 8, 1992, between the Registrant and General Dynamics Corporation (E) 10.2 $2,500,000,000 Loan Agreement dated February 8, 1993 (E) 10.3 Terms Agreement, dated April 13, 1993, among the Registrant and Goldman, Sachs & Co., The First Boston Corporation, Merrill Lynch, Pierce, Fenner & Smith Incorporated and J.P. Morgan Securities, Incorporated. (F) 10.4 Terms Agreement, Dated May 4, 1993, among the Registrant and Merrill Lynch, Pierce, Fenner & Smith Incorporated, the First Boston Corporation, Goldman, Sachs & Company and J.P. Morgan Securities Incorporated. (G) 10.5 $1,000,000,000 Loan Agreement dated August 30, 1993 (H) 10.6 $300,000,000 Loan Agreement dated August 30, 1993 (H) 11 Computation of Earnings per Share of Common Stock 12 Ratio of Earnings to Fixed Charges 21 Subsidiaries of the Registrant 23 Consent of Ernst & Young, Independent Auditors 99.1 Annual Report on Form 11-K for the Lockheed Salaried Employee Savings Plan Plus (to be filed at a later date under Form 10-K/A). 99.2 Annual Report on Form 11-K for the Lockheed Hourly Employee Savings Plan Plus (to be filed at a later date under Form 10-K/A). 99.3 Annual Report on Form 11-K for the Lockheed Space Operations Company Hourly Employee Investment Plan Plus (to be filed at a later date under Form 10-K/A). 99.4 Annual Report on Form 11-K for the Lockheed Corporation Hourly Employee Savings and Stock Investment Plan - Fort Worth and Abilene Divisions (to be filed at a later date under Form 10-K/A). ------------ (A) Incorporated by reference to registrant's registration on Form 8-B filed July 1, 1986, as Exhibit 3(a). (B) Incorporated by reference to registrant's report on Form 10-Q for the quarter ended June 28, 1987, as Exhibit 3. (C) Incorporated by reference to registrant's report on Form 10-Q for the quarter ended June 27, 1993, as Exhibit 3. (D) Incorporated herein as Exhibit 3.4. (E) Incorporated by reference to registrant's report on Form 10-K for the year ended December 27, 1992. (F) Incorporated by reference to registrant's report on Form 8-K dated April 13, 1993. (G) Incorporated by reference to registrant's report on Form 8-K dated May 4, 1993. (H) Incorporated by reference to registrant's report on Form 8-K dated August 30, 1993. E-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. LOCKHEED CORPORATION (Registrant) /s/ C. R. MARSHALL ----------------------------- C. R. Marshall (Vice President and Secretary) Date: March 7, 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/ D. M. TELLEP Chairman of the Board March 7, 1994 - ------------------------- and Chief Executive D. M. Tellep Officer (Principal Executive Officer) and Director /s/ V. N. MARAFINO Vice Chairman of the March 7, 1994 - ------------------------- Board, Chief Financial V. N. Marafino and Administrative Officer (Principal Financial Officer) and Director /s/ R. E. RULON Vice President and March 7, 1994 - ------------------------- Controller (Principal R. E. Rulon Accounting Officer) /s/ L. V. CHENEY Director March 7, 1994 - ------------------------- L. V. Cheney /s/ L. M. COOK Director March 7, 1994 - ------------------------- L. M. Cook /s/ H. I. FLOURNOY Director March 7, 1994 - ------------------------- H. I. Flournoy /s/ J. F. GIBBONS Director March 7, 1994 - ------------------------- J. F. Gibbons Signature Title Date --------- ----- ---- /s/ R. G. KIRBY Director March 7, 1994 - ------------------------- R. G. Kirby /s/ L. O. KITCHEN Director March 7, 1994 - ------------------------- L. O. Kitchen /s/ J. J. PINOLA Director March 7, 1994 - ------------------------- J. J. Pinola /s/ D. S. POTTER Director March 7, 1994 - ------------------------- D. S. Potter /s/ F. SAVAGE Director March 7, 1994 - ------------------------- F. Savage /s/ C. A. H. TROST Director March 7, 1994 - ------------------------- C. A. H. Trost /s/ J. R. UKROPINA Director March 7, 1994 - ------------------------- J. R. Ukropina /s/ D. C. YEARLEY Director March 7, 1994 - ------------------------- D. C. Yearley

34501_1993.txt

34501_1993

1993

34501

Item 1. BUSINESS Scope of Business - Farah Incorporated (formerly Farah Manufacturing Company, Inc.) was incorporated as a Texas corporation in 1947. Farah Incorporated and its subsidiaries (collectively, the "Company") are engaged in the production and sale of multiple apparel lines for men, young men and boys. Farah U.S.A., Inc. ("Farah U.S.A.") is the Company's largest operating subsidiary. Its products are sold throughout the United States. The largest area of sales volume for Farah U.S.A. is Men's apparel ("Men's"), with Boys' apparel ("Boys'") and Young Men's apparel ("Young Men's") being the next most significant, in that order. The major apparel items included in Farah U.S.A.'s lines are dress and casual slacks, sport coats and suit separates. The products are manufactured in a variety of fabrics, styles, colors and sizes. The Company believes that Farah U.S.A. is among the largest United States sources of Men's and Boys' slacks. Farah U.S.A. sales are made primarily through an employee sales force. Farah U.S.A. sells most of its products under the Farah, Farah Clothing Company and Savane labels. PROCESS 2000 is a trademark used to signify easy care fabrics, and is widely used on a number of Savane products. Farah U.S.A. also has an exclusive license agreement to manufacture and sell men's slacks, trousers, blazers, sport coats and shorts in the United States, its territories and possessions and Canada under the John Henry label. The Company believes all of the above trademarks to be important and material. Farah U.S.A. owns the Farah, Farah Clothing Company, Savane and Process 2000 trademarks. The John Henry trademark is under license from Zodiac International Trading Corporation and is renewable through May 31, 2038. Farah U.S.A. sells its products primarily to major department stores and specialty retailers. Farah International, Inc. ("Farah International") products are sold primarily through individual subsidiaries in the United Kingdom, Ireland, Australia and New Zealand. Farah International's largest subsidiary, Farah Manufacturing (U.K.) Limited ("Farah U.K."), is a wholesale apparel supplier in the United Kingdom. It also operates retail outlets in customer stores. Sales in the U.K. are primarily men's slacks, and to a lesser extent shirts, knitwear and sweaters. Farah Australia is the Company's other significant international subsidiary which sells its products in Australia. Sales in Australia are primarily men's slacks. The Company also sells products in New Zealand and certain European countries. Farah International sales are made primarily through employee sales forces, supplemented to a lesser degree by foreign distributors. Farah International sales are made primarily under the Farah label which the Company considers to be important and material. Additional information on foreign operations is presented in Note 9 to the consolidated financial statements, which is incorporated by reference. Value Slacks, Inc. ("Value Slacks") is the Company's factory outlet division which is used primarily to sell excess or slow moving Farah U.S.A. product. Value Slacks also sells shirts and other apparel accessory items sourced from third party vendors. As of November 5, 1993, Value Slacks operated 20 U.S. stores and 11 Puerto Rican stores. The Company's apparel is primarily marketed for the Spring and Fall retail selling seasons each year, with interim lines introduced periodically to complement the two primary lines. In past years, sales volume for the first quarter was generally the lowest of the year with each quarter getting progressively larger. However, with the introduction of more year-round basic products, the seasonality has been diminished somewhat. The Company anticipates that its first quarter will remain its lowest sales volume quarter. Farah U.S.A. closes some of its factories in the first quarter for approximately two weeks at Christmas time. This, combined with lower first quarter sales volumes, normally results in the first quarter being the lowest quarter in terms of profitability. The remaining three quarters are expected to be comparable in terms of sales and profitability, with the fourth quarter being somewhat higher than the second and third. Production - Farah U.S.A. and Farah International sourced approximately 67% and 94%, respectively, of their 1993 production from their own manufacturing facilities and the remainder from outside contractors. In response to increased sales, Farah U.S.A. has increased the use of outside production contractors. Additional needs in 1994 are anticipated to be satisfied through increased efficiencies in owned facilities and use of outside contractors. Farah U.S.A. considers its contractors to be an important component of its product sourcing strategy. In an effort to minimize the risk that would result from the failure of any one contractor, Farah U.S.A. uses a number of different contractors in different countries for production. Raw materials used in manufacturing operations consist mainly of fabrics made from cottons, wools, synthetics and blends of synthetics with cotton and wool. These fabrics are purchased principally from major textile producers located in the United States. In addition, the Company purchases such items as thread, zippers and trim from a large number of other suppliers. Five vendors supplied approximately 73% and 52% of Farah U.S.A.'s and Farah International's fabric and trim requirements, respectively, during the fiscal year ended November 5, 1993. The Company has no long-term contracts with any of its suppliers, nor does it anticipate shortages of raw materials in 1994. In order to be responsive to customer's "Quick Response" needs (see "Backlog" for more discussion), the Company maintains base stocks of certain raw materials and finished goods. However, most inventory is produced in response to indications of demand provided by customers. Competition - The apparel industry is highly competitive and includes a number of concerns (domestic and foreign) which have financial resources greater than those of the Company. Farah U.S.A.'s primary branded competitors are Haggar Corp. and Levi Strauss & Co. The Company believes that these competitors may have greater financial resources than those of the Company. In addition, there are a number of other competitors, including customer's private label products. The primary competitive factors in the apparel industry are styling, quality, price, customer service and brand recognition. The Company believes it is a significant supplier because of its volume, recent product innovations, and quality. Competitors of Farah U.K. are primarily its customer's private label products. The primary competitors of Farah Australia are other branded resources. The same competitive factors affecting Farah U.S.A. also affect Farah International. The Company's primary market is department stores. During fiscal year 1993, The May Department Stores Company, an unrelated company, accounted for approximately 12.4% of the Company's consolidated revenues. Backlog - Many of Farah U.S.A.'s major customers participate in an inventory replenishment concept referred to as "Quick Response". Essentially, Quick Response means that the Company will maintain enough shelf stock of certain key items to meet the customer's needs on short notice. As a result, customers tend to place orders closer to delivery dates than has been the historic case in the apparel industry. In addition, because of the trend toward Quick Response, orders which are received are not necessarily firm commitments. Therefore, the Company does not consider customer orders to be "backlog" or necessarily an indication of future sales. Inventory Management - As discussed above, the retail industry is requiring its manufacturing sources to maintain inventory for Quick Response purposes. As a result, Farah U.S.A. has maintained higher inventory levels during 1993 than was necessary historically. This, in turn, has resulted in higher borrowings by Farah U.S.A. to finance such inventories. Other Matters - In the fiscal years ended November 5, 1993, November 6, 1992 and October 31, 1991 the Company spent approximately $744,000, $530,000 and $530,000, respectively, on activities relating to the development of new products and the improvement of existing products. As of November 5, 1993, the Company employed approximately 5,300 people. Item 2. Item 2. PROPERTIES The following table reflects the Company's significant real properties: APPROXIMATE TYPE OF LOCATION SQUARE FEET PROPERTY Owned: El Paso, Texas (1) 116,000 Garment manufacturing plant Chihuahua, Mexico 54,000 Garment manufacturing plant San Jose, Costa Rica 168,000 Two garment manufacturing plants Galway & Kiltimagh, Ireland 59,000 Two garment manufacturing plants Leased (2)(3): El Paso, Texas (4) 1,033,000 Garment manufacturing plant, warehouse and office facility Piedras Negras, Mexico 98,000 Four garment manufacturing plants Ballyhaunis, Ireland 24,000 Garment manufacturing plant Sydney, Australia 15,000 Office/Warehouse Suva, Fiji 24,000 50% owned joint venture for garment manufacturing Witham, United Kingdom 57,000 Office/Warehouse Auckland, New Zealand 6,000 Office/Warehouse Various retail locations in the United States and Puerto Rico 118,000 Retail stores (1) Building is under lien (see Note 3 to the consolidated financial statements, included in the Company's 1993 Annual Report to Shareholders). Underlying land is leased through February 2002. (2) Leased properties are occupied under non-cancellable leases which expire at various dates through 2016. (3) See Note 8 to the consolidated financial statements included in the Company's 1993 Annual Report to Shareholders, for discussion of leases. (4) Originally owned by the Company and sold and leased back in 1988. Initial lease term is ten years ending in 1998. The Company's garment manufacturing plants and offices are of steel and masonry construction. All facilities are kept in good condition. The Company considers both its domestic and international facilities to be suitable and adequate for current operations. During 1993, all properties were fully utilized. Farah U.S.A. has sub-leased approximately 45% of the El Paso, Texas building through May 31, 1998. Including such sub-lease, all of the El Paso, Texas building is fully utilized. In increased sales, Farah U.S.A. has increased the use of outside production contractors. Additional needs in 1994 are anticipated to be satisfied through increased efficiencies in owned facilities and use of outside contractors. Item 3. Item 3. LEGAL PROCEEDINGS The Company is a defendant in several legal actions. In the opinion of management, based upon the advice of the respective attorneys handling such actions, the aggregate of expected fees, expenses, possible settlements and liability is not material. 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 information required under this item is set forth under the caption "Common Stock" on page 29 of the Company's Annual Report to Shareholders for the fiscal year ended November 5, 1993 and is incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA The information required under this item is set forth under the caption "Selected Financial Data" on page 39 of the Company's Annual Report to Shareholders for the fiscal year ended November 5, 1993 and is incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required under this Item is set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 30 to 38 of the Company's Annual Report to Shareholders for the fiscal year ended November 5, 1993 and is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of Farah Incorporated and Subsidiaries included in the Company's Annual Report to Shareholders for fiscal year ended November 5, 1993 on page 28 and 12 through 27 are incorporated herein by reference: Quarterly Data (Unaudited) - Supplementary Data for fiscal years 1993 and 1992 Consolidated Statements of Operations - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Consolidated Balance Sheets - November 5, 1993 and November 6, 1992 Consolidated Statements of Shareholders' Equity - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Consolidated Statements of Cash Flows - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Notes to Consolidated Financial Statements - November 5, 1993, November 6, 1992 and October 31, 1991 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 The information required under this item is set forth under the caption "Directors and Executive Officers" on pages 4 and 5 of the Company's Proxy Statement prepared in connection with its 1994 Annual Meeting of Shareholders and is incorporated herein by reference. Item 11. Item 11. EXECUTIVE COMPENSATION The information required under this item is set forth under the caption "Compensation of Executive Officers" on pages 7 through 10 of the Company's Proxy Statement prepared in connection with its 1994 Annual Meeting of Shareholders and is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required under this item is set forth under the caption "Ownership of Common Stock" on pages 2 and 3 of the Company's Proxy Statement prepared in connection with its 1994 Annual Meeting of Shareholders and is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required under this item is set forth under the captions "Certain Matters Involving Directors and Shareholders" and "Compensation of Directors" on pages 6 and 7 and 10 and 11, respectively, of the Company's Proxy Statement prepared in connection with its 1994 Annual Meeting of Shareholders and is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The consolidated financial statements and notes together with the Report of Independent Public Accountants and Selected Financial Highlights as included in the Company's Annual Report to Shareholders for fiscal year ended November 5, 1993 filed with this Annual Report on Form 10-K are incorporated herein by reference (only the financial statements listed below, which are included in the Annual Report to Shareholders for the fiscal year ended November 5, 1993, are filed herewith and the remainder of the Annual Report to Shareholders for the fiscal year ended November 5, 1993 is furnished to the Commission for its information): Consolidated Statements of Operations - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Consolidated Balance Sheets - November 5, 1993 and November 6, 1992 Consolidated Statements of Shareholders' Equity - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Consolidated Statements of Cash Flows - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 Notes to Consolidated Financial Statements Report of Independent Public Accountants Quarterly Data (unaudited) - Supplementary Data for fiscal years 1993 and 1992 Selected Financial Data for fiscal years ended 1989 to 1993 (b) Reports on Form 8-K. No reports on Form 8-K were filed during the last quarter of the period for which this report is filed. (c) Exhibits. 3 Articles of Incorporation and Bylaws. * 3.1Restated Articles of Incorporation dated March 29, 1988 (filed as Exhibit 3.1 to Form 10-K as of October 31, 1988). 3.2 Bylaws of Farah Incorporated Amended and Restated as of September 1, 1993. 4 Instruments defining the Rights of Security Holders, including Indentures. *4.1 Indenture, dated as of February 1, 1969 (filed as Exhibit 2.4 to Form 10- K as of October 31, 1980). Pursuant to subsection (b)(4)(iii) of Item 601 of Regulation S-K, Registrant hereby agrees to furnish to the Commission upon request copies of other instruments defining rights of holders of long-term debt, none of which instruments authorizes indebtedness in an amount in excess of 10% on consolidated assets. 10 Material Contracts. * 10.1 Employment Agreement dated March 1, 1993, (filed as Exhibit 10.4- 22 to Form 10-Q as of May 7, 1993). * 10.2 Employment Agreement dated March 1, 1993 (filed as Exhibit 10.4- 23 to Form 10-Q as of May 7, 1993). 10.3 Amended and Restated Employment Agreement dated September 30, 1993. 10.4 Amended and Restated Employment Agreement dated September 30, 1993. 10.5 Amended and Restated Employment Agreement dated September 30, 1993. * 10.6 Net Lease, dated as of May 16, 1988, between Farah U.S.A., Inc. and Far Pass Realty Associates, Ltd. (filed as Exhibit 5 to Form 8-K dated May 25, 1988). * 10.7 Guarantee of Lease by Farah Incorporated (filed as Exhibit 6 to Form 8-K dated May 25, 1988). * 10.8 Pledge Agreement by Farah U.S.A., Inc. to Far Pass Realty Associates, Ltd. (filed as Exhibit 7 to Form 8-K dated May 25, 1988). * 10.9 Amended and Restated Farah Manufacturing Company, Inc. 1986 Stock Option Plan, and Form of Stock Option Agreement (filed as Exhibit 4 (a) to the Company's Registration Statement on Form S- 8, Registration No. 2-75949). * 10.10 Farah Manufacturing Company, Inc. Executive Stock Option Plan, as amended, and form of Stock Option Agreement (filed as Exhibit 10.29 to Form 10-K as of October 31, 1988). * 10.11 Amended and Restated Farah Manufacturing Company, Inc. 1981 Stock Option Plan, and form of Stock Option Agreement (filed as Exhibit 28.2 to the Company's Registration Statement on Form S- 8, Registration No. 33-11930). * 10.12 Farah Incorporated 1988 Non- Employee Directors Stock Option Plan and form of Stock Option Agreement (filed as Exhibit 10.31 to Form 10-K as of October 31, 1988). * 10.13 Accounts Financing Agreement (Security Agreement), dated August 2, 1990 between Farah U.S.A., Inc. ("Farah U.S.A.") and Congress Financial Corporation (Southwest) ("Congress") (filed as Exhibit 10.53 to Form 10-Q as of July 31, 1990). * 10.14 Covenant Supplement to Accounts Financing Agreement (Security Agreement) dated August 2, 1990, between Farah U.S.A. and Congress (filed as Exhibit 10.54 to Form 10-Q as of July 31, 1990). * 10.15 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement (Security Agreement) dated August 2, 1990, between Farah U.S.A. and Congress (filed as Exhibit 10.56 to Form 10-Q as of July 31, 1990). *10.16 Trade Financing Agreement Supplement to Accounts Financing Agreement (Security Agreement) dated August 2, 1990, between Farah U.S.A. and Congress (filed as Exhibit 10.57 to Form 10-Q as of July 31, 1990). * 10.17 Form of Pledge and Security Agreement, dated August 2, 1990 (filed as Exhibit 10.58 to Form 10-K as of October 31, 1990). * 10.18 Collateral Assignment of License, dated August 2, 1990, by Farah U.S.A. in favor of Congress (filed as Exhibit 10.60 to Form 10-Q as of July 31, 1990). * 10.19 Estoppel and Consent Agreement, dated August 2, 1990 by Farah Incorporated ("Farah") (filed as Exhibit 10.61 to Form 10-Q as of July 31, 1990). * 10.20 Deed of Trust and Security Agreement, dated July 30, 1990, by Farah U.S.A. and Farah in favor of Congress (filed as Exhibit 10.63 to Form 10-Q as of July 31, 1990). * 10.21 Form of Guarantee and Waiver, dated August 2, 1990 (filed as Exhibit 10.64 to Form 10-K as of October 31, 1990). * 10.22 Collateral Assignment of Agreements, dated August 2, 1990, by Farah in favor of Congress (filed as Exhibit 10.68 to Form 10-Q as of July 31, 1990). * 10.23 Collateral Assignment of Agreements, dated August 2, 1990, by Farah Manufacturing Company of New Mexico, Inc. in favor of Congress (filed as Exhibit 10.69 to Form 10-Q as of July 31, 1990). * 10.24 Subordination Agreement, dated August 2, 1990, by Farah U.S.A. and Farah (filed as Exhibit 10.70 to Form 10-Q as of July 31, 1990). * 10.25 Form of Pledge and Security Agreement, dated August 2, 1990 (filed as Exhibit 10.71 to Form 10-K as of October 31, 1990). * 10.26 Trademark Collateral Assignment and Security Agreement, dated August 2, 1990, by Farah in favor of Congress (filed as Exhibit 10.75 to Form 10-Q as of July 31, 1990). * 10.27 Patent Collateral Assignment and Security Agreement, dated August 2, 1990, by Farah in favor of Congress (filed as Exhibit 10.76 to Form 10-Q as of July 31, 1990). * 10.28 General Security Agreement, dated August 2, 1990, by Farah in favor of Congress (filed as Exhibit 10.77 to Form 10-Q as of July 31, 1990). * 10.29 Form of General Security Agreement, dated August 2, 1990 (filed as Exhibit 10.78 to Form 10-K as of October 31, 1990). * 10.30 Amendment No. 1, dated November 5, 1990, to Financing Agreements dated August 2, 1990 (filed as Exhibit 10.98 to Form 10-K as of October 31, 1990). * 10.31 Amendment No. 2 dated February 11, 1991, to Financing Agreements dated August 2, 1990 (filed as Exhibit 10.103 to Form 10-Q as of January 31, 1991). * 10.32 Sublease between Farah U.S.A., Inc. and The Tonka Corporation, dated January 6, 1992 (filed as Exhibit 10.107 to Form 10-K as of October 31, 1991). * 10.33 Farah Incorporated 1991 Stock Option and Restricted Stock Plan dated October 15, 1991 (filed as Exhibit 10.108 to Form 10-K as of October 31, 1991). * 10.34 Amendment No. 3 dated January 29, 1992, to Financing Agreements dated August 2, 1990 (filed as Exhibit 10.112 to Form 10-Q as of February 7, 1992). * 10.35 Amendment No. 4 dated June 25, 1992, to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. (filed as Exhibit 10.118 to Form 10-Q as of August 7, 1992). * 10.36 Amendment No. 5 dated August 31, 1992, to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. (filed as Exhibit 10.119 to Form 10-Q as of August 7, 1992). * 10.37 Amendment No. 6 dated September 4, 1992, to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. (filed as Exhibit 10.120 to Form 10-Q as of August 7, 1992). * 10.38 Amendment No. 7 dated September 16, 1992, to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. (filed as Exhibit 10.121 to Form 10-Q as of August 7, 1992). * 10.39 Stock Purchase Agreement dated August 4, 1992, between Farah Incorporated and Marciano Investments, Inc. (filed as Exhibit 10.122 to Form 10-Q as of August 7, 1992). * 10.40 Letter Agreement dated October 28, 1992, amending the Accounts Financing Agreement dated August 2, 1990 between Farah U.S.A., Inc. and Congress Financial Corporation (Southwest), (filed as Exhibit 10.125 to Form 10-K as of November 6, 1992). * 10.41 Amended and Restated Farah Savings and Retirement Plan, as of January 1, 1991, (filed as Exhibit 10.125 to Form 10-K as of November 6, 1992). * 10.42 Amended and Restated Stock Purchase Agreement dated March 12, 1993 (amending and restating the stock purchase agreement dated February 23, 1993) between Farah Incorporated, the Georges Marciano Trust and the Paul Marciano Trust, (filed as Exhibit 10.128 to Form 10-Q as of May 7, 1993). * 10.43 Amendment No. 8 to Financing Agreements as of May 7, 1993 between Farah U.S.A., Inc. and Congress Financial Corporation (Southwest), (filed as Exhibit 10.129 to Form 10-Q as of May 7, 1993). * 10.44 Amendment No. 9 dated July 16, 1993 to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc., (filed as Exhibit 10.130 to Form 10-Q as of August 6, 1993). * 10.45 Consulting Agreement dated June 15, 1993, (filed as Exhibit 10.131 to Form 10-Q as of August 6, 1993). * 10.46 Deferred Compensation Agreement dated July 30, 1993, (filed as Exhibit 10.132 to Form 10-Q as of August 6, 1993). * 10.47 Deferred Compensation Agreement dated July 30, 1993, (filed as Exhibit 10.133 to Form 10-Q as of August 6, 1993). 10.48 Deferred Compensation Agreement dated July 30, 1993. 10.49 Amendment No. 10 dated November 5, 1993 to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. *Incorporated herein by reference. 22 Subsidiaries of Farah Incorporated 24 Consent of Independent Public Accountants (d) The following consolidated financial statement schedules are included in the Annual Report on Form 10-K along with the Report of Independent Public Accountants on supporting schedules: Page Report of Independent Public Accountants on Supporting Schedules 14 II- Amounts receivable from related parties, underwriters, promoters and employees other than related parties - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 15 X- Supplementary Income Statement Information - Years ended November 5, 1993, November 6, 1992 and October 31, 1991 16 All other schedules are omitted because they are not applicable, not required under the instructions, or the information is reflected in the consolidated financial statements or notes thereto. 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. 33-46661 (filed March 24, 1992), 33-11930 (filed February 12, 1987) and 2-75949 (filed February 4, 1982): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable, in the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FARAH INCORPORATED (Registrant) /s/ James C. Swaim James C. Swaim Principal Financial Officer Principal Accounting Officer Dated: January 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 January 28, 1994. /s/ Richard C. Allender Richard C. Allender President and Chief Executive Officer, Director /s/ Christopher L. Carameros Christopher L. Carameros Director /s/ Sylvan Landau Sylvan Landau Director /s/ Edward J. Monahan Edward J. Monahan Director /s/ Timothy B. Page Timothy B. Page Director /s/ Byron H. Rubin Byron H. Rubin Director /s/ James C. Swaim James C. Swaim Executive Vice President, Chief Financial Officer and Director /s/ Thomas G. Wyman Thomas G. Wyman Director FARAH INCORPORATED AND SUBSIDIARIES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPORTING SCHEDULES To the Shareholders of Farah Incorporated: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Farah Incorporated's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated December 15, 1993. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. Schedules II and X 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. /s/ Arthur Andersen & Co. ARTHUR ANDERSEN & CO. Dallas, Texas December 15, 1993 Schedule II FARAH INCORPORATED AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED NOVEMBER 5, 1993, NOVEMBER 6, 1992 AND OCTOBER 31, 1991 PART ONE OF SCHEDULE II TABLE: Balance at Year beginning ended Name of debtor of period 10/31/91 William F. Farah $ 100,708 11/6/92 - - 11/5/93 - - PART TWO OF SCHEDULE II TABLE: Deducted Year Amounts Amounts ended Additions Collectedwritten off 10/31/91 - 100,708 - 11/6/92 - - - 11/5/93 - - - PART THREE OF SCHEDULE II TABLE: Balance at end of period Year Not ended Current Current 10/31/91 - - 11/6/92 - - 11/5/93 - - Schedule X FARAH INCORPORATED AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION For years ended November 5, 1993, November 6, 1992 and October 31, 1991 November 5, November 6, October 31, 1993 1992 1991 (thousands of dollars) Amortization of intangible assets $ 200 489 592 Taxes other than income taxes and payroll taxes $ 843 934 1,096 Advertising $ 11,230 6,825 4,719 Neither royalties nor repairs and maintenance exceeded 1% of revenues in fiscal 1993. FARAH INCORPORATED AND SUBSIDIARIES FORM 10-K INDEX TO ATTACHED EXHIBITS (All Exhibits listed are on pages 17 through 113) Page Numbers Exhibit 3.2 Bylaws of Farah Incorporated Amended 18 and Restated as of September 1, 1993. Exhibit 10.3 Amended and Restated Employment Agreement 38 dated September 30, 1993. Exhibit 10.4 Amended and Restated Employment Agreement 47 dated September 30, 1993. Exhibit 10.5 Amended and Restated Employment Agreement 54 dated September 30, 1993. Exhibit 10.48 Deferred Compensation Agreement dated 62 July 30, 1993. Exhibit 10.49 Amendment No. 10 dated November 5, 1993 64 to Accounts Financing Agreement dated August 2, 1990 between Congress Financial Corporation (Southwest) and Farah U.S.A., Inc. Exhibit 13 Annual Report to Shareholders for Fiscal 83 Year 1993. Exhibit 22 Subsidiaries of Farah Incorporated. 112 Exhibit 24 Consent of Independent Public Accountants. 113

107815_1993.txt

107815_1993

1993

107815

ITEM 1. BUSINESS - Electric Utility Operations (Cont'd) In January 1994, Wisconsin Electric filed with the Public Service Commission of Wisconsin ("PSCW") its long-term load and supply plan as part of the Advance Plan 7 docket. In the Advance Plan process, the regulated electric utilities located in Wisconsin are required to file, for planning purposes, long-term forecasts of future resource requirements along with plans to meet those requirements, including the implementation of energy management and conservation programs ("demand-side savings"). In addition to specifying the expectations of conservation and load management programs, the plan filed with the PSCW demonstrates Wisconsin Electric's need to add peaking and intermediate load capacity during the 20-year planning period. Wisconsin Electric's next base load power plant is not expected to be placed in-service until after 2010. For additional information regarding Advance Plans, see Item 1. BUSINESS - "REGULATION", Item 3. LEGAL PROCEEDINGS - "OTHER LITIGATION" and Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - "LIQUIDITY AND CAPITAL RESOURCES". Wisconsin Electric currently estimates peak demand in the year 2003 to be about 5,100 megawatts assuming moderate growth in the economy and normal weather. Investments in demand-side management programs have reduced and delayed the need to add new generating capacity but have not eliminated the need entirely. Purchases of power from other utilities and transmission system upgrades will also combine to help delay the need to install some new generating capacity in the future. However, to meet the anticipated growth in peaking capacity demand requirements, Wisconsin Electric plans to complete during 1994 the remaining two units, or approximately 150 megawatts of additional generating capacity, at its Concord Generating Station, the first two units of which were completed during 1993, and is expected to place in- service an additional four units, or approximately 300 megawatts, at its new Paris Generating Station by the summer of 1995 as described below. Wisconsin Electric plans to make additional investments in conservation-related programs during this period. Wisconsin Electric is nearing completion of the renovation of units 1-4 at its Port Washington Power Plant, which includes upgrading the turbine generators and boilers and the installation of additional emission control equipment. Work at units 1 and 2 was completed during 1993 with unit 3 work completed in 1992. Renovation work at unit 4 is planned to be completed during the summer of 1994. The total cost of this renovation project is expected to be approximately $109 million. During the summer of 1993, Wisconsin Electric completed the construction of the first two units (comprising approximately 150 megawatts of additional generating capacity) at its Concord Generating Station, a four unit, approximately 300 megawatt gas-fired combustion turbine facility located near Watertown, Wisconsin. The remaining two units (comprising approximately 150 megawatts) are planned to be completed and available for the summer of 1994. The total cost of the project is currently estimated at $108 million, with capital expenditures as of December 31, 1993 totaling approximately $95 million. In addition to the planned completion of the Concord facility, Wisconsin Electric has contracted for the purchase of up to 280 megawatts of firm capacity for the summer of 1994 to maintain adequate reserve margins. Arrangements for additional capacity purchases after 1996 are anticipated. During 1993, having obtained the necessary regulatory approvals from the applicable regulatory agencies, Wisconsin Electric proceeded with the construction of the Paris Generating Station, an approximately 300 megawatt - 5 - ITEM 1. BUSINESS - Electric Utility Operations (Cont'd) gas-fired combustion turbine power plant, to be placed in-service during the summer of 1995. The estimated cost of this facility, to be located near Union Grove, Wisconsin, is currently estimated at $105 million. The supply of natural gas to operate the Concord and Paris units is to be provided by Wisconsin Natural, an affiliated company, but may be purchased from other suppliers with Wisconsin Natural providing gas transportation services. Approvals from various regulatory agencies including the PSCW, the U. S. Environmental Protection Agency ("EPA") and the Wisconsin Department of Natural Resources ("DNR") are required for all additions to generation capacity. All proposed generating facilities will meet or exceed the applicable federal and state environmental requirements. For further information regarding future capacity additions, see Item 1. BUSINESS - "REGULATION". For information regarding estimated costs of Wisconsin Energy's utility subsidiaries' construction program and projected investments in conservation programs for the five years ending December 31, 1998, see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - "LIQUIDITY AND CAPITAL RESOURCES". All estimates of construction expenditures exclude Allowance For Funds Used During Construction. For additional information regarding matters related to Allowance for Funds Used During Construction, see Note G to the Financial Statements in Item 8. In accordance with a PSCW order issued in November 1993, after completing a capacity-related competitive bidding process, Wisconsin Electric signed a 25- year agreement to purchase the electricity that would be generated from a 215 megawatt cogeneration facility planned to be constructed by an unaffiliated independent power producer ("IPP"). The agreement is contingent upon the facility being completed and going into operation, which at this time is planned for mid-1996. For additional information and related matters, see Item 3. LEGAL PROCEEDINGS - "OTHER LITIGATION - PSCW TWO-STAGE CPCN ORDER" and Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - "Capital Requirements 1994-1998". In response to increasing competitive pressures in the markets for electricity and natural gas, Wisconsin Electric and Wisconsin Natural have developed a revitalization process to increase efficiencies and improve customer service. The planned "reengineering" and restructuring of Wisconsin Electric and Wisconsin Natural will consolidate many business functions, reduce operating costs and lead to a reduction in the total Wisconsin Electric/Wisconsin Natural workforce, including the implementation of a voluntary separation package and an early retirement option for qualified employees. For additional information, see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - "Wisconsin Electric and Wisconsin Natural Revitalization". - 6 - ITEM 1. BUSINESS - (Cont'd) SOURCES OF GENERATION The table below indicates sources of energy generation by Wisconsin Electric: Year Ended December 31 ---------------------- 1993 1994* ---- ----- Coal 67.0% 69.4% Nuclear 30.8 28.6 Hydro-electric 1.7 1.6 Gas 0.4 0.3 Oil 0.1 0.1 ------ ------ TOTAL 100.0% 100.0% ------------------ *Estimated assuming that there are no unforeseen contingencies such as unscheduled maintenance or repairs. COAL: Wisconsin Electric diversifies its coal sources by purchasing from Northern Appalachia, the Southern Powder River Basin (Wyoming) and the Raton Basin (New Mexico) mining districts for the power plants in Wisconsin, and from central Appalachia and Montana mines for the Presque Isle Power Plant in Michigan. Approximately 76 percent of Wisconsin Electric's 1994 coal requirements are expected to be delivered by Wisconsin Electric-owned unit trains. The unit trains will transport coal for the Oak Creek and Pleasant Prairie Power Plants from New Mexico and Wyoming mines. Coal from Pennsylvania mines is also transported via rail to Lake Erie transfer docks and delivered to the Valley and Port Washington Power Plants by lake vessels. Montana coal for Presque Isle is transported via rail to Superior, Wisconsin, placed in dock storage and reloaded into lake vessels for plant delivery. The Presque Isle central Appalachian origin coal is shipped via rail to Lake Erie coal transfer docks for lake vessel delivery to the plant. Wisconsin Electric's 1994 coal requirements, projected to be 9.5 million tons, are 98 percent under contract. Wisconsin Electric does not anticipate any problem in procuring its remaining 1994 requirements through short-term or spot purchases and inventory adjustments. Pleasant Prairie Power Plant: All of the estimated 1994 coal requirements at Wisconsin Electric's Pleasant Prairie Power Plant are presently covered by three long-term contracts. Oak Creek Power Plant: All of the estimated 1994 coal requirements for Wisconsin Electric's Oak Creek Power Plant are covered by long-term contract. Contract provisions permit Wisconsin Electric to increase/decrease the annual volume to match burn requirements. Presque Isle Power Plant: This plant has six generating units designed to burn bituminous coal and three other units designed to burn sub-bituminous coal. The units burning sub-bituminous coal are supplied by three long-term contracts the annual volumes of which are anticipated to be adequate to cover coal requirements through 1996. Bituminous coal is generally purchased through one-year contracts. - 7 - ITEM 1. BUSINESS - Sources of Generation (Cont'd) Edgewater: Coal for Edgewater Unit 5, in which Wisconsin Electric has a 25 percent interest, is purchased by Wisconsin Power and Light Company, a non- affiliated utility, which is the principal owner of the facility. Valley and Port Washington Power Plants: Port Washington and Valley are both supplied through a long-term contract that, in combination with coal supplied to Wisconsin Electric's other Wisconsin plants, allows the plants to meet the Wisconsin acid rain law. In the event of further air quality emission requirements affecting these plants, the contract can be terminated without liability. The periods and annual tonnage amounts for Wisconsin Electric's principal coal contracts are as follows: Contract Period Annual Tonnage --------------- -------------- Jan. 1977 to Dec. 1994 300,000(A) Jan. 1977 to Dec. 1996 240,000 Nov. 1987 to Dec. 1997 500,000(A) Jan. 1980 to Dec. 2006 2,000,000 Jul. 1983 to Dec. 2002 1,000,000 Apr. 1990 to Nov. 1996 375,000(B) Jan. 1992 to Dec. 2005 1,200,000(C)(1994) Oct. 1992 to Sept. 2007 2,000,000 (A) The contract can be extended if the total volume has not been purchased by the respective termination dates. (B) Annual volume can be increased to meet requirements for the Port Washington and Valley Power Plants above the 375,000 ton volume indicated herein. (C) Subsequent years may be of greater tonnage as allowed under certain provisions of the contract. For information regarding emission restrictions, see Item 3. LEGAL PROCEEDINGS - - ENVIRONMENTAL MATTERS - "Air Quality - Acid Rain Legislation". NUCLEAR: Wisconsin Electric purchases uranium concentrates ("yellowcake") and contracts for its conversion, enrichment and fabrication. Wisconsin Electric maintains title to the nuclear fuel until the fabricated fuel assemblies are delivered to the Point Beach Nuclear Plant, whereupon it is sold to and leased back from the Wisconsin Electric Fuel Trust ("Trust"). See Note B to the Financial Statements in Item 8. Uranium Requirements: Wisconsin Electric requires approximately 450,000 pounds of yellowcake annually for its two-unit Point Beach Nuclear Plant. Uranium requirements through 1997 will be provided from a combination of existing contracts with Malapai Resources Company (of Arizona); Energy Resources of Australia, Ltd.; Nukem Inc. (U.S.); and Nuexco (U.S.). Wisconsin Electric may exercise flexibilities in these contracts and purchase certain quantities of uranium on the spot-market, should market conditions prove favorable. Wisconsin Electric believes that adequate supplies of uranium concentrates will be available to satisfy current and future operating requirements. - 8 - ITEM 1. BUSINESS - Sources of Generation (Cont'd) Conversion: Wisconsin Electric has a contract with Sequoyah Fuels Corporation, a subsidiary of General Atomics, to provide conversion services for the Point Beach reactors through 1995. Due to operating difficulties encountered in 1992, Sequoyah Fuels has decided to place its Gore, Oklahoma conversion plant on indefinite stand-by. In November 1992, Sequoyah Fuels signed an agreement with Allied Signal Corporation which formed a partnership called Converdyn Corporation. Converdyn administers all existing Allied and Sequoyah contracts, with all conversion services being performed at the existing Allied Signal conversion facility in Metropolis, Illinois. The transfer of all uranium inventories from the Sequoyah facility to the Allied facility will be paid for, performed by, and be the responsibility of Converdyn, and will occur over the next few years. Wisconsin Electric also has a conversion contract with the Cameco Corporation, to provide for an alternate supply of up to approximately 30 percent of conversion requirements through 1995 and up to 100 percent of conversion requirements from 1996 through 1999. Cameco is a Canadian based corporation located in Saskatoon, Saskatchewan, and is a major producer of uranium concentrates. Enrichment: Wisconsin Electric currently has a Utility Services ("US") enrichment contract with the U.S. Department of Energy ("DOE") for 70 percent of the enrichment services required for the operation of both of the Point Beach units. The contract can provide enrichment services for the entire operating life of each unit. Wisconsin Electric entered into a supplemental agreement with the DOE to supply the remaining 30 percent of enrichment service requirements for the period through 1995 at prices below those offered under the US enrichment contract. In March 1992, Wisconsin Electric entered into an agreement with Global Nuclear Services and Supply, an international supplier of enrichment services, for the remaining 30 percent of enrichment service requirements after 1995. Fabrication: Fabrication of fuel assemblies from enriched uranium for Point Beach is covered under a contract with Westinghouse Electric Corporation for the balance of the plant's current operating license. Spent Fuel Storage and Disposal: Wisconsin Electric currently has the capability to store certain amounts of spent nuclear fuel at its Point Beach Nuclear Plant. Previous modifications to the storage facilities at Point Beach have made it possible to accommodate all spent fuel expected to be discharged from the reactors through 1995. In accordance with the provisions of the Nuclear Waste Policy Act of 1982 (the "Act"), which require the DOE to provide for the disposal of spent fuel from all U.S. nuclear plants, Wisconsin Electric entered into a disposal contract providing for deliveries of spent fuel to the DOE for ultimate disposal commencing in January 1998. Because of the DOE's anticipated inability to accept spent fuel by the 1998 timeframe as contracted, Wisconsin Electric has filed with the PSCW for a Certificate of Authority to construct and operate an Independent Spent Fuel Storage Installation ("ISFSI"). The ISFSI will provide additional interim storage until the DOE begins to remove spent fuel from Point Beach in accordance with the terms of the contract it has with Wisconsin Electric. As part of the regulatory approval process for the ISFSI, in February 1994, the PSCW issued a Draft Environmental Impact Statement setting forth information which Wisconsin Electric believes supports the proposed project. Various parties have submitted comments on the Draft Environmental Impact Statement which the PSCW - 9 - ITEM 1. BUSINESS - Sources of Generation (Cont'd) will use in preparing a Final Environmental Impact Statement. Public hearings on the proposed project are anticipated to be held during August 1994 with a PSCW decision expected later in the year. If the PSCW grants approval during late 1994, loading of the first storage unit of the ISFSI could take place in the summer of 1995. The matter is pending. Point Beach Nuclear Plant: The Point Beach Nuclear Plant provided 30.8 percent of Wisconsin Electric's net generation in 1993. The plant has two generating units which had a combined dependable capability during December 1993 of 989 megawatts and which together constituted 19.4 percent of Wisconsin Electric's dependable generating capability in 1993. The U.S. Nuclear Regulatory Commission ("NRC") licenses for Point Beach Units 1 and 2 expire October 5, 2010 and March 8, 2013, respectively. The NRC has, at various times, directed that certain inspections, modifications and changes in operating practices be made at all nuclear plants. At Point Beach, such inspections have been made and necessary changes to equipment and in operating practices have either been completed or are expected to be completed within the time schedules permitted by the NRC or within approved extensions thereof. Wisconsin Electric has initiated certain plant betterment projects at its Point Beach Nuclear Plant that are judged to be appropriate and beneficial. Construction is progressing on the addition of two safety-related emergency diesel powered electrical generators with installation to be completed in 1995. Construction related to the replacement of the Unit 2 steam generators, which would allow for the unit's operation until the expiration of its operating license in 2013, is planned to begin in the fourth quarter of 1996 with a scheduled completion during 1997. This project is estimated to cost $119 million and is currently awaiting PSCW approval. (In 1984 Wisconsin Electric replaced the Unit 1 steam generators.) The PSCW has combined this project with the ISFSI for purposes of the regulatory approval process described above under Spent Fuel Storage and Disposal. Decommissioning Fund: Pursuant to a 1985 PSCW order, Wisconsin Electric provides for costs associated with the eventual decommissioning of the Point Beach Nuclear Plant through the use of an external trust fund. Payments to this fund, together with investment earnings, brought the balance on December 31, 1993 to approximately $214 million. For additional information regarding decommissioning see Note B to the Financial Statements in Item 8. Nuclear Plant Insurance: For information regarding matters pertaining to nuclear plant insurance, see Note B to the Financial Statements in Item 8. NATURAL GAS (FOR ELECTRIC GENERATION): The combustion turbine at the Oak Creek Power Plant is equipped to burn either natural gas or oil. This facility has used natural gas when available. Gas for the Oak Creek combustion turbine is supplied on an interruptible basis by Wisconsin Natural. Natural gas for boiler ignition and flame stabilization purposes for the Pleasant Prairie, Oak Creek and Valley Power Plants is purchased under an agency agreement. The agent purchases natural gas and arranges for pipeline transportation to the local gas distribution utility. Gas for the Pleasant Prairie and Oak Creek Power Plants is delivered by Wisconsin Natural. Gas for the Valley Power Plant is delivered by Wisconsin Gas Company, a non-affiliated company. - 10 - ITEM 1. BUSINESS - Sources of Generation (Cont'd) In July 1993, Wisconsin Electric began operation of the first two of four natural gas-fired combustion turbine peaking units at the Concord Generating Station. Gas for this facility is supplied by Wisconsin Natural. OIL: Oil is used for combustion turbines at the Germantown and Port Washington Power Plants and at the Point Beach Nuclear Plant. Small amounts of oil are also used for boiler ignition and flame stabilization at some coal- fired plants. Number 2 fuel oil requirements for 1994 at the Presque Isle Power Plant are provided under a one-year contract with an equitable price adjustment formula. All other oil requirements are purchased as needed from local suppliers. The Concord Generating Station will use oil as a secondary fuel source. HYDRO: Wisconsin Electric has various licenses from the Federal Energy Regulatory Commission ("FERC") for its hydro-electric generating facilities which expire during the period of 1998 to 2004. Hydro facilities provided 1.7 percent of Wisconsin Electric's generation in 1993. Wisconsin Electric evaluated the economic feasibility of continuing the operation of certain of its hydro-electric facilities which had licenses that expired during 1993. Where determined to be cost-effective, Wisconsin Electric is pursuing the renewal of four such operating licenses. However, the operating licenses of three other hydro facilities, totaling about 3 megawatts of generating capacity, expired without being renewed by Wisconsin Electric. The future ownership, operation and license renewal of these three facilities are currently being examined by independent hydro developers. Until the final disposition is determined, Wisconsin Electric expects to continue to operate these three facilities under authorization provided by the FERC. As required, where license renewal is being pursued, Wisconsin Electric is consulting with the U.S. Fish and Wildlife Service, the Michigan and Wisconsin Departments of Natural Resources and various other agencies. INTERCONNECTIONS WITH OTHER UTILITIES: Wisconsin Electric's system is interconnected at various locations with the systems of Madison Gas and Electric Company, Wisconsin Power and Light Company, Wisconsin Public Service Corporation, Commonwealth Edison Company ("Commonwealth Edison"), Northern States Power Company ("NSP") and Upper Peninsula Power Company ("UPPCO"). These interconnections provide for interchange of power to assure system reliability as well as facilitating access to generating capacity and the transfer of energy for economic purposes. Wisconsin Electric is a member of Wisconsin-Upper Michigan Systems ("WUMS"), a coordinating group which includes four other electric companies in Wisconsin and Upper Michigan. WUMS, in turn, is a member of Mid-America Interconnected Network, which is one of nine regional members of the North American Electric Reliability Council. Membership in these groups permits better utilization of reserve generating capacity and coordination of long-range system planning and day-to-day operations. On March 15, 1994, Wisconsin Electric executed a transmission service agreement with Commonwealth Edison that will allow Wisconsin Electric to purchase energy from southern Illinois and Indiana suppliers, using the Commonwealth Edison transmission system to import such energy into Wisconsin. Additionally, Wisconsin Electric has a 40 megawatt purchase agreement with Commonwealth Edison for the period of May to October 1994. - 11 - ITEM 1. BUSINESS - Sources of Generation (Cont'd) A transmission service agreement has been executed with NSP to allow Wisconsin Electric to import capacity and energy from members of the Mid-Continent Area Power Pool ("MAPP"), a group consisting of electric utilities generally located west of Wisconsin. Additionally, a 100 megawatt purchase agreement exists with the Basin Electric Power Company located in Fargo, North Dakota, allowing for capacity purchases to be made during the period of May to October 1994. A 40 megawatt purchase has been arranged for May to October 1994 with Otter Tail Power Company, another member of MAPP. Considerable non-firm energy is expected to be purchased from Basin Electric Power Company, Otter Tail Power Company and other MAPP members over the next several years. SALES TO WHOLESALE CUSTOMERS: Wisconsin Electric currently provides wholesale electric energy to five municipally owned systems, three rural cooperatives, two municipal joint action agencies and one isolated system of an investor- owned utility in Wisconsin, Illinois, and the Upper Peninsula of Michigan under rates approved by the FERC. Sales to these wholesale customers accounted for 6.2 percent of total kilowatt-hour sales in 1993. Under two agreements, service is being provided subject to an eight-year notice of cancellation from the Wisconsin Public Power Inc. SYSTEM ("WPPI"). Wisconsin Electric also has a nine-year power supply agreement with the Badger Power Marketing Authority. Sales to the Badger Power Marketing Authority and WPPI combined are expected to account for approximately one half of the wholesale sales for 1994. Service to UPPCO, under a 65 megawatt agreement which expires on December 31, 1997, is expected to account for another 30 percent of 1994 wholesale sales. In October 1993, UPPCO announced that it had reached an agreement in principle with NSP to purchase 90 megawatts of base-load electric energy beginning in 1998. Should a definitive agreement be reached between UPPCO and NSP, Wisconsin Electric expects to apply the 65 megawatts of capacity toward the electric energy needs of new customers and toward the overall increase in system supply needs anticipated by 1998. Wisconsin Electric does not believe that this matter will have a material adverse impact on its financial condition. Service to the remaining wholesale customers is provided under agreements which require a three-year notice of cancellation from the customers. During 1993, sales to wholesale customers declined 9.7 percent from 1992, largely the result of reductions in sales to WPPI. WPPI has been reducing its purchases from Wisconsin Electric subsequent to acquiring generation capacity in 1990. Sales to WPPI during 1993, 1992 and 1991 were approximately 944,000 megawatt-hours ("MWh"), 1,166,000 MWh and 1,338,000 MWh, respectively. Further reductions are expected in 1994 and beyond as WPPI installs additional capacity. These sales reductions are not expected to have a significant effect on future earnings. Under the provisions of a long-term agreement, Wisconsin Electric will continue to provide transmission services to WPPI. Wisconsin Electric's existing FERC tariffs also provide for transmission service to its wholesale customers. During 1993, Wisconsin Electric had three customers taking transmission service. For further information see Item 1. BUSINESS - "REGULATION". On October 24, 1992, the U.S. Energy Policy Act was signed into law. Passage of this law is expected to remove perceived encumbrances and facilitate the entry of power producers into the already competitive bulk power market. Notable among its provisions are the creation of a new class of energy - 12 - ITEM 1. BUSINESS - Sources of Generation (Cont'd) producer called Exempt Wholesale Generators ("EWGs"), who are exempt from the requirements of the Public Utility Holding Company Act of 1935, and the rights that the Energy Policy Act provides them and utilities to request a FERC order directing the provision of transmission service if denied transmission access from utilities. The transmission aspects of this law are expected to have little impact on Wisconsin Electric since it has had open access transmission tariffs on file with the FERC since 1980. The electric utility industry continues to become increasingly competitive. Some municipal utilities are approaching competing utilities in a search for lower energy prices. Additionally, some large industrial customers are seeking regulatory changes that could permit retail wheeling to allow them to seek proposals for energy from alternate suppliers. Independent power producers are also exploring cogeneration projects which would provide process steam to customers in Wisconsin Electric's service territory and sell electricity to Wisconsin Electric. Consequently, electric wholesale and large retail customers of Wisconsin Electric or other non-affiliated utilities may determine, from time to time, to switch energy suppliers, purchase interests in existing power plants or build new generating capacity, either directly or through joint ventures with third parties. The advent of EWGs can be expected to accelerate this practice. For additional information, see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - "LIQUIDITY AND CAPITAL RESOURCES". SALES TO LARGE CUSTOMERS Wisconsin Electric provides utility service to a diversified base of industrial customers. Major industries served include the iron ore mining industry, the paper industry, the machinery production industry, the foundry industry and the food products industry. The Empire and Tilden iron ore mines, the two largest customers of Wisconsin Electric, accounted for 4.4 percent and 3.4 percent, respectively, of total electric kilowatt-hour sales in 1993 and 5.1 percent and 3.9 percent, respectively, in 1992. The reduction in 1993 energy sales to the mines is attributable to a five-week long mine employee strike during the third quarter. STEAM UTILITY OPERATIONS Wisconsin Electric operates a district steam system for space heating and processing in downtown and near southside Milwaukee. Sales of the steam utility fluctuate with the heating cycle of the year and are impacted by varying weather conditions from year-to-year. The system consists of approximately 28 miles of high and low pressure mains and related regulating equipment. Steam for the system is supplied by Wisconsin Electric's Valley Power Plant. At December 31, 1993, there were 459 customers on the system. Steam sales in 1993 were 2,376 million pounds, an increase of 4.0 percent from the 2,284 million pounds sold in 1992. During 1993 Wisconsin Electric extended its high pressure steam main by approximately 10,000 feet, to provide process steam to a new customer beginning in November 1993. A minimum of 93 million pounds of steam are expected to be sold to this new customer per year. With the completion of this extension, which cost approximately $6 million, process steam is also being provided to additional new customers along its route. - 13 - ITEM 1. BUSINESS - (Cont'd) REGULATION Wisconsin Electric is subject to the regulation of the Public Service Commission of Wisconsin as to retail electric, gas and steam rates in Wisconsin, standards of service, issuance of securities, construction of new facilities, transactions with affiliates, levels of short-term debt obligations, billing practices and various other matters. Wisconsin Electric is also subject to the regulation of the Michigan Public Service Commission ("MPSC") as to the various matters associated with retail electric service in Michigan as noted above except as to construction of certain new facilities, levels of short-term debt obligations and advance approval of transactions with affiliates. Wisconsin Electric, with respect to hydro-electric facilities, wholesale rates and accounting, is subject to FERC regulation. Operation and construction relating to Wisconsin Electric's Point Beach Nuclear Plant facilities are subject to regulation by the NRC. Wisconsin Electric's operations are also subject to regulations of the EPA, the DNR and the Michigan Department of Natural Resources ("MDNR"). The PSCW is authorized to direct expenditures for promoting conservation if it determines that the programs are in the public interest. Recent rate orders have included provisions for substantial conservation programs initiated by Wisconsin Electric. For additional information, see Note A to the Financial Statements in Item 8. Wisconsin Electric is subject to a power plant siting law in Wisconsin which requires that electric utilities file updated long-term forecasts (called "Advance Plans") for the location, size and type of future large generating plants and high voltage transmission lines about every two years for PSCW approval after public hearings. Generally, the law provides that the PSCW may not authorize the construction of any large generating plants or high voltage transmission lines unless they are in substantial compliance with the most recently approved plan. The law also prohibits Wisconsin Electric from acquiring any interest in land for such plants or transmission lines by condemnation until construction authorization has been received. Advance Plan orders are based on a review of the utilities' long-term planning options. However, separate project-specific PSCW approval is required for the construction of generating facilities and transmission lines. Wisconsin Electric employs a least-cost integrated planning process, which examines a full range of supply and demand side options to meet its customers' electric needs, such as the renovation of existing power plants, promotion of cost-effective conservation and load management options, development of renewable energy sources, purchased power and construction of new company- owned generation facilities. In 1992, the Brown County Circuit Court ruled in favor of the electric utilities who filed a petition requesting judicial review of certain aspects of the PSCW's Advance Plan 5 order, which was issued by the PSCW in 1989, relating to transmission line access. During 1993, the Wisconsin Supreme Court affirmed the Circuit Court ruling on appeal. For additional information regarding Advance Plans, see Item 3. LEGAL PROCEEDINGS - "OTHER LITIGATION" and Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - "LIQUIDITY AND CAPITAL RESOURCES". - 14 - ITEM 1. BUSINESS - (Cont'd) RATE MATTERS See Item 3. LEGAL PROCEEDINGS - "RATE MATTERS" - for a discussion of rate matters, including recent rate changes and a discussion of the tariffs and procedures with respect to recovery of changes in the costs of fuel and purchased power. ENERGY EFFICIENCY The management of Wisconsin Electric believes that a strong and continuing emphasis must be placed on energy management and efficient energy use. Wisconsin Electric is continuing to develop programs to inform and assist its customers with respect to conservation options. This policy is regarded by Wisconsin Electric as in the best interests of its customers and the owners of its securities. Efficient use of energy is not limited to reduced consumption. Time-of-use rates for certain electric customers promote the shifting of electricity usage to those times when electric generating facilities are not fully utilized. Direct load control of some residential electric water heaters and interruptible and curtailable rates to certain industrial customers are used to control peak demand. Direct load control of some residential central air conditioners continues as part of a pilot program which began in 1992. To promote its energy management and conservation policies, Wisconsin Electric offers various programs and services to its customers. For industrial and commercial customers, Wisconsin Electric offers energy evaluations identifying cost-effective customer conservation opportunities as well as financial assistance, including direct grants and interest-free financing to purchase and maintain energy-efficient equipment. Additional financial incentives are also offered to residential electric customers to encourage the purchase of energy-efficient appliances and the removal of older inefficient appliances from the system. ENVIRONMENTAL COMPLIANCE Compliance with federal, state and local environmental protection requirements resulted in capital expenditures by Wisconsin Electric of approximately $65 million in 1993 and $50 million in 1992. Expenditures incurred during 1993 and 1992 included costs associated with the replacement of the precipitators at the Oak Creek Power Plant units 7 and 8, the installation of pollution abatement facilities at Wisconsin Electric's power plants, the installation of underground distribution lines and environmental studies associated with power plants. Such expenditures are budgeted at approximately $60 million for 1994. Operation, maintenance and depreciation expenses of Wisconsin Electric's fly ash removal equipment and other environmental protection systems are estimated to have been $44 million in 1993. Other environmental costs, primarily for environmental studies, amounted to $1 million in 1993. See Item 3. LEGAL PROCEEDINGS - ENVIRONMENTAL MATTERS - "Air Quality - Acid Rain Legislation" for a discussion of compliance matters with respect to Wisconsin's acid rain law and the amendments to the Clean Air Act. - 15 - ITEM 1. BUSINESS - Environmental Compliance (Cont'd) Solid Waste Landfills Wisconsin Electric provides for the disposal of non-ash related solid wastes and hazardous wastes through licensed independent contractors, but federal statutory provisions impose joint and several liability on the generators of waste for certain clean-up costs. Remediation-related activity pertaining to specific sites is discussed below. Maxey Flats Nuclear Disposal Site: In 1986, Wisconsin Electric was advised by the EPA that it is one of a number of potentially responsible parties ("PRPs") for clean-up at this low-level radioactive waste site located in Morehead, Kentucky. The amount of waste contributed by Wisconsin Electric is significantly less than one percent of the total. Wisconsin Electric has been cooperating with the appropriate agencies in this matter and believes that its portion of clean-up costs is not expected to exceed approximately $350,000. Wisconsin Electric's involvement in this matter is expected to be resolved during 1994. Hunt's Landfill: In 1991, PRPs included in the clean-up of the former Hunt's Landfill (located in Racine County, Wisconsin) notified Wisconsin Electric that they considered it an additional PRP which should be liable for a portion of the clean-up costs. Even though it is not believed that Wisconsin Electric was responsible for the disposal of any hazardous substances or materials at the site, to avoid litigation with the PRPs, Wisconsin Electric has agreed to participate in the funding as a "de minimis" party in the execution of a consent decree with the EPA for clean-up. Materials disposed of at the site by Wisconsin Electric consisted primarily of soil from construction sites. Wisconsin Natural, declared a PRP by the EPA in 1991, is also a participant in the clean-up of this site as a "de minimis" party. The portion of clean-up costs assigned to Wisconsin Electric and Wisconsin Natural is expected to be about $20,000 in total. Muskego Sanitary Landfill: In 1992, Wisconsin Electric was informed by the EPA that it will be included in a group of approximately 50 PRPs against which the EPA will issue orders requiring that the PRPs clean-up the Muskego Sanitary Landfill (located in Southeastern Waukesha County, Wisconsin), or face the risk of substantial penalties. On January 14, 1993, Wisconsin Electric notified the EPA that it is proceeding, with other PRPs, to comply with the order. The estimated total cost of the clean-up is $10 to $15 million. Under tentative allocation of the total estimated clean up cost among the PRPs, Wisconsin Electric's share is approximately $84,000. The EPA is conducting a second remedial investigation/feasibility study of alleged groundwater pollution at the site. Although this matter is in its early stages, Wisconsin Electric does not believe the outcome will have a material adverse effect on its financial condition. Presque Isle Landfill: Wisconsin Electric has entered into a settlement agreement with the MDNR for conditions existing at the site of an ash landfill acquired by Wisconsin Electric when it purchased the Presque Isle Power Plant in 1988. Wisconsin Electric's groundwater monitoring program at the site (located in Marquette Township, Michigan), has detected elevated levels of certain substances at the oldest portion of the landfill. Wisconsin Electric has reconstructed and capped that portion of the landfill to prevent further leachate from entering the groundwater at an approximate cost of $2.5 million and has paid a fine of $45,000 plus $6,000 in administrative costs to the state of Michigan. The cost to implement a remediation plan for the clean-up - 16 - ITEM 1. BUSINESS - Environmental Compliance (Cont'd) of the current groundwater conditions, when approved by the MDNR, is estimated to not exceed $1 million. Highway 59 Landfill: In 1989, a sulfate plume was detected in the groundwater beneath a Wisconsin Electric-owned former ash landfill located in the town of Waukesha, Wisconsin. After notifying the DNR, Wisconsin Electric initiated a five-year expanded monitoring program to determine if the level of groundwater contamination was increasing and if there was movement of the plume offsite. The additional monitoring data indicates that there is some offsite movement of the plume in the groundwater. Wisconsin Electric is further expanding its investigation. Although no remediation plan has yet been developed, Wisconsin Electric believes that any remediation plan developed, approved and implemented for this site would not have a material adverse effect on its financial condition. OTHER Wisconsin Electric is authorized to provide electric service in designated territories in the state of Wisconsin, as established by indeterminate permits, certificates of public convenience and necessity, or boundary agreements with other utilities. Wisconsin Electric provides electric service in certain territories in the state of Michigan pursuant to franchises granted by municipalities. Research and development expenditures of Wisconsin Electric amounted to $8,485,000 in 1993, $7,835,000 in 1992, and $7,562,000 in 1991. Such expenditures were primarily for improvement of service and abatement of air and water pollution. The capitalized portion of research and development costs amounted to $15,000 in 1993, $55,000 in 1992 and $15,000 in 1991. Research and development activities include work done by employees, consultants and contractors, plus sponsorship of research by industry associations. At December 31, 1993, Wisconsin Electric employed 5,068 persons, of which 157 were part-time. - 17 - ITEM 2. ITEM 2. PROPERTIES Wisconsin Electric owns the following generating stations with 1993 capabilities as indicated: Dependable Capability In Megawatts (1) ----------------------- No. of Generating August December Name Fuel Units 1993 1993 - ---- ---- ---------- ------- -------- Steam Plants: Point Beach Nuclear 2 981 989 Oak Creek Coal 4 1,103 1,114 Presque Isle (2) Coal 9 594 594 Pleasant Prairie Coal 2 1,160 1,170 Port Washington (3) Coal 4 310 312 Valley Coal 2 280 226 Edgewater (4) Coal 1 99 98 -- ----- ----- TOTAL STEAM 24 4,527 4,503 Hydro Plants (16 in number) 38 75 75 Germantown Combustion Turbines Oil 4 212 252 Other Combustion Turbines & Diesel(5) Gas/Oil 6 227 262 -- ----- ----- TOTAL SYSTEM 72 5,041 5,092 == ===== ===== - ----------------------- (1) Dependable capability is the net power output under average operating conditions with equipment in an average state of repair as of a given month in a given year. Changing seasonal conditions are responsible for the different capabilities reported for the winter and summer periods in the above table. The values were established by test and may change slightly from year to year. (2) UPPCO, a non-affiliated utility, staffs and operates the Presque Isle Power Plant under an operating agreement with Wisconsin Electric which extends through December 31, 1997. (3) Port Washington Unit 5 was retired in December 1991 and is not included in the dependable capability ratings shown in the table. Unit 5 will not be renovated as part of the Port Washington Power Plant renovation project which received PSCW approval in December 1990. Renovation work at units 1 and 2 was completed during 1993 with unit 3 work completed in 1992. The renovation of unit 4 is planned to be completed during the summer of 1994. (4) Wisconsin Electric has a 25 percent interest in Edgewater Unit 5, which is operated by Wisconsin Power and Light Company, a non-affiliated utility. (5) During July 1993, two units, or approximately 150 megawatts of peaking combustion turbine generation capacity, was placed in-service at Wisconsin Electric's Concord Generating Station. Another two units, or approximately 150 megawatts, are planned to be placed in-service during the summer of 1994 at this facility. - 18 - ITEM 2. PROPERTIES - (Cont'd) At December 31, 1993, the Wisconsin Electric system had 2,759 miles of transmission circuits, of which 639 miles were operating at 345 kilovolts, 123 miles at 230 kilovolts, 1,603 miles at 138 kilovolts, and 394 miles at voltage levels less than 138 kilovolts. At December 31, 1993, Wisconsin Electric was operating 21,697 pole miles of overhead distribution lines and 12,778 miles of underground distribution cable, as well as 359 distribution substations and 216,827 line transformers. Wisconsin Electric owns various office buildings and service centers throughout its service area. The principal properties of Wisconsin Electric are owned in fee except that the major portion of electric transmission and distribution lines and steam distribution mains are located, for the most part, on or in streets and highways and on land owned by others. Substantially all utility property is subject to first mortgage liens. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ENVIRONMENTAL MATTERS Wisconsin Electric is subject to federal, state and certain local laws and regulations governing the environmental aspects of its operations. Wisconsin Electric believes that, with immaterial exceptions, its existing facilities are in compliance with applicable environmental requirements. As have other public utilities, Wisconsin Electric and/or its predecessors and affiliated companies, have operated manufactured gas plants and disposed of ash and other waste products from electric utility activities. Operations at these manufactured gas sites ceased over 40 years ago with remediation activities having been conducted at certain of these sites, while other sites are currently being or are planned to be investigated. Costs associated with remediation activities, to the extent not covered by insurance, have been allowed in rates for utility service. Wisconsin Electric believes any such future costs will continue to be considered appropriate for inclusion in rates and therefore will not have a material adverse impact on its financial condition. See Item 1. BUSINESS - ENVIRONMENTAL COMPLIANCE - "Solid Waste Landfills" for a discussion of matters related to specific solid waste landfill sites. Air Quality - Acid Rain Legislation In 1986, the Wisconsin Legislature passed legislation establishing new sulfur dioxide limitations applicable to Wisconsin's five major electric utilities, including Wisconsin Electric. The law requires each of the five major electric utilities to meet a 1.20 lb sulfur dioxide per million BTU corporate average annual emission rate limit beginning in 1993. Prior to 1993, Wisconsin law limited the total annual sulfur dioxide emissions from the five major electric utilities to 500,000 tons per year. During 1993, approximately 174,000 tons of sulfur dioxide were emitted by such utilities, equivalent to an annual average emission rate of 0.97 lbs sulfur dioxide per million BTU. Wisconsin Electric's compliance plan to meet the sulfur dioxide limitations under Wisconsin's acid rain law includes the increased use of low-sulfur coal at certain power plant units. Some changes to existing power plant equipment have been made to accommodate the use of low-sulfur coals. - 19 - ITEM 3. LEGAL PROCEEDINGS - Environmental Matters (Cont'd) The 1990 amendments to the Federal Clean Air Act mandate significant nation- wide reductions in air emissions. Most significant to the country's electric utility companies are the "acid rain" provisions of the amendments which are scheduled to limit sulfur dioxide ("SO2") and nitrogen oxide ("NOX") emissions in phases which take effect in 1995 and 2000. Wisconsin Electric has evaluated the potential impact resulting from this legislation and has concluded that minimal impact will result from Phase I requirements because of actions taken to meet the above mentioned Wisconsin acid rain law. Phase II requirements, together with separate ozone nonattainment provisions of the Clean Air Act which may call for additional NOX reductions, however, will necessitate the implementation of a compliance strategy which could increase rates by 1 to 2 percent. Since a portion of the regulations that have been issued by the EPA are not complete or are not yet final, these rate estimates are subject to change and will be reevaluated as needed. For additional information regarding the impact of the Clean Air Act Amendments, including estimates of the cost of compliance, see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - "CLEAN AIR ACT". RATE MATTERS Wisconsin Retail Electric Jurisdiction Fuel Cost Adjustment Procedure: Wisconsin Electric's retail rates in Wisconsin do not contain an automatic fuel adjustment clause, but can be adjusted by the PSCW if actual cumulative fuel and purchased power costs, when compared to the costs projected in the retail electric rate proceeding, deviate from a prescribed range and are expected to continue to be above or below the authorized annual range of 3 percent. 1993 Rate Order: In February 1993, the PSCW authorized an annualized retail electric rate increase of $26.7 million, or 2.3 percent, effective February 17, 1993, which includes the elimination of the $24.2 million fuel adjustment rate reduction which had been in effect since May 29, 1992. The increase is based on an authorized regulatory return on common equity of 12.3 percent, down from 12.8 percent authorized for 1992. 1993 Fuel Cost Adjustment: Effective November 5, 1993 through December 31, 1993, the PSCW authorized Wisconsin Electric to reduce Wisconsin retail electric rates to reflect lower fuel and purchased power expenses. The adjustment reduced Wisconsin retail electric revenue by approximately $1.3 million during this period. 1994 Test Year: In April 1993, Wisconsin Electric filed with the PSCW required data relating to the 1994 test year. In support of its goal to become the lowest-cost energy provider in the region, Wisconsin Electric announced that it did not intend to seek an increase in retail electric rates for 1994. Under the PSCW's newly adopted biennial rate case schedule, Wisconsin Electric would be scheduled to file in mid-1995 for rates to reflect a 1996 test year. - 20 - ITEM 3. LEGAL PROCEEDINGS - Rate Matters (Cont'd) Wholesale Electric Jurisdiction Fuel and Purchased Power Adjustment Tariffs: Wisconsin Electric's wholesale rates contain an automatic fuel adjustment provision to reflect varying fuel and purchased power costs. 1993 Rate Order: In October 1993, the FERC approved the settlement agreement which Wisconsin Electric had previously reached with its wholesale customers in May 1993. The order authorizes an annualized wholesale electric base rate increase of $6 million, or 10.6%, effective June 9, 1993. In August 1993, the FERC had authorized Wisconsin Electric to implement its proposed settlement rates, on an interim basis effective as of June 9, 1993, pending final FERC approval of the settlement agreement. This action represents the first increase in wholesale base rates since 1986. Wholesale electric sales account for approximately 7 percent of Wisconsin Electric's total kilowatt-hour sales. Michigan Retail Electric Jurisdiction 1993 Test Year: Effective July 9, 1993, the MPSC authorized an annualized rate increase of $1.4 million, or 4.3%, for Wisconsin Electric's non-mine retail electric customers. Excluding sales to the two mine customers, which are separately regulated by the MPSC, retail electric sales in Michigan account for approximately 2% of Wisconsin Electric's total kilowatt-hour sales. Power Supply Cost Recovery Clause: Rates are adjusted to reflect varying fuel and purchased power costs through a power supply cost recovery ("PSCR") clause in Wisconsin Electric's tariffs. Such PSCR clause provides for, among other things, an annual filing of a PSCR plan and, after notice and an opportunity for hearing, the development of PSCR factors to be applied to customers' bills during the period covered by the PSCR plan to allow Wisconsin Electric to recover its costs of fuel and purchased power transactions, as estimated in its annual filing. The amounts so collected are subject to a reconciliation proceeding conducted by the MPSC at the end of the period covered by the plan for recovery of any undercollections of actual costs or for refund or credit of any amounts in excess of its actual costs in such period. On December 20, 1993, the MPSC approved the proposed PSCR credit factor of $.00483 per kilowatt-hour for the year 1994. Wisconsin Retail Steam Jurisdiction Fuel Adjustment: Wisconsin Electric steam rates contain a provision to adjust rates to reflect varying fuel costs for all customers except for a large volume contract representing approximately 16 percent of steam sales in 1993. 1993 Rate Order: In February 1993, the PSCW issued an order authorizing Wisconsin Electric to place in effect an annualized rate increase of $505,000, or 3.5 percent, in its steam rates effective February 17, 1993. The order was based on a 1993 test year and authorized a 12.3 percent regulatory return on common equity as determined for ratemaking purposes. - 21 - ITEM 3. LEGAL PROCEEDINGS - Rate Matters (Cont'd) 1994 Test Year: Consistent with the actions taken with respect to Wisconsin Electric's Wisconsin Retail Electric Jurisdiction, Wisconsin Electric announced that it did not intend to seek an increase in retail steam rates for 1994. Under the PSCW's newly adopted biennial rate case schedule, Wisconsin Electric would be scheduled to file in mid-1995 for rates to reflect a 1996 test year. For additional information see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - "Rates and Regulatory Matters". OTHER LITIGATION Personal Injury Suit: In 1990, a five-year old boy suffered severe and disabling injuries (including amputations) as a result of contacting energized equipment inside an unlocked Wisconsin Electric distribution transformer in the city of Oak Creek, Wisconsin. In 1992, Wisconsin Electric entered into a court-approved settlement of an action in Milwaukee County Circuit Court which sought compensatory, punitive and statutory treble damages. Of the total settlement payment, a self-insured retention of $2 million was not covered by insurance and was charged to income during 1990. After an investigation into whether the above described accident was caused by Wisconsin Electric's failure to maintain its equipment in a reasonably safe manner as required by a Wisconsin statute and PSCW rules, the PSCW in 1991 referred the matter of "probable violations" of its administrative rules to the Wisconsin Attorney General for possible forfeiture and enforcement. In June 1993, Wisconsin Electric agreed to pay a $1 million civil forfeiture to the state of Wisconsin to settle the matter. The amount of the forfeiture was charged to income during June 1993. Advance Plan 5: In 1992, a Brown County Circuit Court judge ruled in favor of Wisconsin Electric and three other major electric utilities in Wisconsin who had requested that the court set aside the transmission access provisions of the PSCW's Advance Plan 5 order which required the utilities to negotiate and file transmission access agreements. In summary, the court decided that such provisions are preempted by the Federal Power Act which gives the FERC exclusive jurisdiction over transmission service on an interconnected system. This decision was appealed to the Wisconsin Court of Appeals by the PSCW and WPPI, which later petitioned the Wisconsin Supreme Court to by-pass the Court of Appeals. In 1992, the Supreme Court granted WPPI's petition and accepted the appeal for consideration. In April 1993, a ruling by the Wisconsin Supreme Court resulted in a 3-3 split, thereby affirming the Circuit Court decision. A petition for a declaratory order is still pending at the FERC (Docket No. EL89-40). The petition seeks to have FERC acknowledge its jurisdiction over wholesale transmission services terms and conditions, including pricing. Advance Plan 6: In 1992, Wisconsin Electric joined with other state utilities in a petition filed in Brown County Circuit Court requesting judicial review of one aspect of the PSCW's Advance Plan 6 order. The action involves the Commission's authority to require the utilities to consider, in their planning, monetized effects of so-called "greenhouse gasses". - 22 - ITEM 3. LEGAL PROCEEDINGS - Other Litigation (Cont'd) Also, in 1992, Wisconsin Environmental Decade ("WED") filed a petition in Dane County Circuit Court requesting judicial review of another aspect of the PSCW's Advance Plan 6 order. That proceeding involves the question of whether the PSCW should have required the utilities to reflect, in their planning, claimed beneficial employment impacts associated with demand-side management activities. A group of utilities, including Wisconsin Electric, have appeared in that proceeding in opposition to WED. The two petitions have been consolidated for judicial review in Dane County Circuit Court. The matters are pending. Oglebay Norton Suit: In 1989, an action was brought to the U.S. District Court for the Northern District of Ohio by Oglebay Norton Company ("Oglebay") against Wisconsin Electric and other defendants. This action sought indemnity and contribution in the amount of $7.8 million in connection with the defense and settlement of two death claims resulting from a 1986 flash fire and explosion aboard its steamer Middletown which was carrying a cargo of coal to Wisconsin Electric's Port Washington Power Plant. A settlement was reached under which Wisconsin Electric paid $150,000 to Oglebay on December 9, 1993, in full satisfaction of Oglebay's claim for indemnity and contribution. PSCW Two-Stage CPCN Order: In January 1994, Wisconsin Electric filed a lawsuit in Milwaukee County Circuit Court seeking judicial determination concerning the PSCW's authority to adopt a new "two-stage" Certificate of Public Convenience and Necessity ("CPCN") process and to order utilities to enter into contracts to buy power from other entities. This action is in response to the PSCW's December 1993 order which details the requirements of the new process to be implemented by the PSCW in making the final selection from among competing alternatives to construct proposed future capacity additions, including projects that would be owned and operated by unaffiliated IPPs. In summary, Wisconsin Electric does not believe the PSCW has authority to specifically order utilities to enter into contracts. The matter is pending. For additional information see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - "Capital Requirements 1994-1998". Pittsburg & Midway Case: In a matter brought before the FERC, in July 1993, Wisconsin Electric filed an initial brief supporting its right to retain coal reclamation costs collected through the wholesale fuel adjustment clause in 1986 that it believes were prudently incurred in a settlement with the Pittsburg & Midway Coal Mining Company. Of the total costs involved, the portion recovered through the wholesale fuel clause amounts to approximately $750,000. This filing was made in response to a FERC audit staff determination that Wisconsin Electric should have applied for a waiver of the FERC's fuel clause regulations in order to attempt to pass through the wholesale portion of the settlement costs. In order for a final decision to be made, the FERC must first await the initial decision expected from an Administrative Law Judge. The matter is pending. In November 1993, the FERC rejected Wisconsin Electric's request to be allowed to recover, in wholesale rates in the future, the amount which may have to be refunded to customers in the event of an unfavorable ruling in the pending fuel adjustment clause proceeding concerning the Pittsburg and Midway reclamation charges. In January 1994, Wisconsin Electric filed an appeal with the U.S. Court of Appeals in the District of Columbia Circuit regarding this rejection. The matter is pending. - 23 - ITEM 3. LEGAL PROCEEDINGS - Other Litigation (Cont'd) Electromagnetic Fields: Claims are being made or threatened with increasing frequency against electric utilities across the country for bodily injury, disease or other damages allegedly caused or aggravated by exposure to electromagnetic fields ("EMFs") associated with electric transmission and distribution lines. Results of scientific studies conducted to date do not establish the existence of a causal connection between EMFs and any adverse health effects. Wisconsin Electric believes that its facilities are constructed and operated in accordance with all applicable legal requirements and standards. In an action filed against Wisconsin Electric in Waukesha County Circuit Court in 1992, plaintiffs sought unspecified compensatory and statutory treble damages by reason of pain, suffering, complications and aggravations of a congenital neurological disorder in a minor allegedly caused by EMFs associated with Wisconsin Electric's transmission lines. In July 1993, plaintiffs filed a motion to dismiss without prejudice their action. The reason given for dismissal was that medical science had not progressed to a point where the case could be adequately tried. Wisconsin Electric does not believe that other claims thus far made or threatened against it in connection with EMFs will result in any substantial liability on the part of Wisconsin Electric. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of Wisconsin Electric's security holders during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE REGISTRANT The names, ages at December 31, 1993 and positions of all of the executive officers of Wisconsin Electric are listed below along with their business experience during the past five years. All officers are elected for one year terms or until their respective successors are duly chosen. There are no family relationships among these officers, nor is there any agreement or understanding between any officer and any other person pursuant to which the officer was selected. Current Position(s) and Business Experience Name and Age During Past Five Years - --------------------- ---------------------- Richard A. Abdoo, 49 Chairman of the Board, President and Chief Executive Officer of Wisconsin Energy Corporation since 1991; Executive Vice President, 1990 to 1991; Vice President, 1987 to 1990; Director of Wisconsin Energy since 1988. Chairman of the Board and Chief Executive Officer of Wisconsin Electric Power Company since 1990; President and Chief Executive Officer, during 1990; President and Chief Operating Officer, 1989 to 1990; Executive Vice President, during 1989; Senior Vice President, 1984 to 1989; Director of Wisconsin Electric since 1989. Chairman of the Board and Chief Executive Officer of Wisconsin Natural Gas Company since 1990; Director of Wisconsin Natural since 1989. - 24 - EXECUTIVE OFFICERS OF THE REGISTRANT (Cont'd) Current Position(s) and Business Experience Name and Age During Past Five Years - --------------------- ---------------------- John W. Boston, 60 Vice President of Wisconsin Energy since 1991; Director of Wisconsin Energy since 1991. President and Chief Operating Officer of Wisconsin Electric since 1990; Executive Vice President and Chief Operating Officer during 1990; Senior Vice President, 1982 to 1990; Director of Wisconsin Electric since 1988. Director of Wisconsin Natural since March 1994. (Assuming the positions of President and Chief Operating Officer effective April 1, 1994). Robert H. Gorske, 61 General Counsel of Wisconsin Energy since 1981. Vice President and General Counsel of Wisconsin Electric since 1976; Director of Wisconsin Electric since 1991. Director, Vice President and General Counsel of Wisconsin Natural since 1976. Jerry G. Remmel, 62 Vice President of Wisconsin Energy since January 1994; Chief Financial Officer since 1989; Treasurer since 1981. Chief Financial Officer of Wisconsin Electric since 1989; Senior Vice President, 1989 to January 1994; Vice President and Treasurer, 1983 to 1989; Director of Wisconsin Electric since 1989. Chief Financial Officer of Wisconsin Natural since 1989; Vice President-Finance, 1989 to January 1994; Treasurer, 1974 to 1989; Director of Wisconsin Natural since 1988. David K. Porter, 50 Senior Vice President of Wisconsin Electric since 1989; Vice President-Corporate Planning, 1986 to 1989; Director of Wisconsin Electric since 1989. Vice President of Wisconsin Natural since 1989; Director of Wisconsin Natural since 1988. Calvin H. Baker, 50 Vice President-Finance of Wisconsin Electric since January 1994; Vice President-Marketing, 1992 to January 1994; Vice President-Finance, 1991 to 1992. Senior Vice President, Financial Services Corporation of New York City (provider of direct loan programs and industrial development projects in New York City), 1989 to 1991. Ann Marie Brady, 41 Assistant Secretary of Wisconsin Energy since 1989. Secretary of Wisconsin Electric since January 1994; Assistant Secretary, 1989 to January 1994. Secretary of Wisconsin Natural since June 1993; Assistant Secretary, 1989 to June 1993. - 25 - EXECUTIVE OFFICERS OF THE REGISTRANT (Cont'd) Current Position(s) and Business Experience Name and Age During Past Five Years - --------------------- ---------------------- Anne K. Klisurich, 46 Accounting Manager of Wisconsin Energy, 1987 to January 1994. Controller of Wisconsin Electric since January 1994. Controller of Wisconsin Natural since February 1994. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The amount of cash dividends declared on Wisconsin Electric's Common Stock during the two most recent fiscal years are set forth below. Dividends were paid to Wisconsin Electric's sole common stockholder, Wisconsin Energy. Quarter Total Dividend - ----------------------------------------------------------------------------- 1992 1 $16,250,000 2 $16,250,000 3 $16,250,000 4 $16,250,000 - ----------------------------------------------------------------------------- 1993 1 $16,250,000 2 $16,250,000 3 $16,250,000 4 $16,250,000 - 26 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Earnings Earnings for Wisconsin Electric increased to $173,548,000 in 1993 compared to $155,826,000 in 1992 primarily because of higher kilowatt-hour sales. Electric energy sales were positively impacted by, among other things, significantly warmer weather during the summer of 1993. The increase in revenues attributable to the increased energy sales and the various rate increases effective during 1993 were partially offset by increases in non-fuel related operation and maintenance expenses and higher interest charges. Electric Sales and Revenues Total electric sales of Wisconsin Electric, detailed below by customer class, increased 3.8 percent in 1993 compared to 1992 reflecting, among other things, the weather-related increase in sales to other utilities discussed below. Electric energy sales were positively impacted by, among other things, the significantly warmer summer weather experienced during the third quarter of 1993 which resulted in an increased use of electricity for air conditioning and other cooling purposes. The warmer than normal summer of 1993 contrasted sharply with the summer of 1992, the coolest since Wisconsin Electric began keeping records in 1948. Sales were also positively impacted by colder winter weather during the first quarter of 1993. The 3.8 percent increase in electric revenues achieved during 1993 over 1992 reflects the increase in kilowatt-hour sales and the net increases in electric rates effective in 1993. Electric Sales - Megawatt Hours 1993 1992 % Change - ------------------------------- ---------- ---------- -------- Residential 6,551,061 6,230,136 5.2 Small Commercial and Industrial 6,357,510 6,154,530 3.3 Large Commercial and Industrial 9,771,383 9,702,303 0.7 Other 1,776,061 1,995,349 (11.0) ---------- ---------- Total Retail and Municipal 24,456,015 24,082,318 1.6 Resale-Utilities 1,229,421 665,263 84.8 ---------- ---------- Total Sales 25,685,436 24,747,581 3.8 - -------------------------------------------------------------------------- Electric energy sales to the Empire and Tilden iron-ore mines, Wisconsin Electric's two largest customers, were 9.5 percent lower in 1993 compared to 1992. This decrease is attributable to a five-week long mine employee strike during the third quarter of 1993. Wisconsin Electric's contracts with the mines require the payment of a demand charge regardless of power usage which partially offset the impact of lost sales on revenues. Excluding the mines, sales to large commercial and industrial customers increased 3.7 percent in 1993. Sales to the mines represented 7.8 percent, 9.0 percent and 8.3 percent of total electric sales during 1993, 1992 and 1991, respectively. - 29 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) The 84.8 percent increase in the resale of energy to other utilities is attributable to unseasonable weather in the east and south and to the severe flooding which hit the midwestern states during the summer of 1993. This percentage change is not indicative of future sales growth in this customer class. The 11.0 percent reduction in sales to the Other customer class is largely the result of reductions in sales to The Wisconsin Public Power, Inc. SYSTEM ("WPPI"), Wisconsin Electric's largest municipal customer consortium. WPPI has been reducing its purchases from Wisconsin Electric subsequent to acquiring generation capacity in 1990. Since that time, WPPI has expanded the use of its existing generation facilities and has installed additional capacity during 1993, further reducing its reliance on energy purchases from Wisconsin Electric. Additional reductions are expected in 1994 and beyond. These sales reductions are not expected to have a significant effect on future earnings. Sales to WPPI during 1993, 1992 and 1991 were approximately 944,000 megawatt-hours ("MWh"), 1,166,000 MWh and 1,338,000 MWh, respectively. In addition to the revenues provided by the higher kilowatt-hour sales, the 3.8 percent increase in electric revenues during 1993 includes the impacts of rate changes which were effective during 1993, as shown in "Rates and Regulatory Matters". Total electric kilowatt-hour sales increased at a compound annual rate of 1.3 percent between the years 1991 and 1993, while electric revenues increased at a compound annual rate of 2.1 percent during this period. Excluding the mines, total electric kilowatt-hour sales increased at a compound annual rate of 1.6 percent between the years 1991 and 1993 and revenues increased at a compound annual rate of 2.5 percent. Electric revenues were slightly higher, 0.5 percent, in 1992 compared to 1991 despite a 1.1 percent reduction in electric kilowatt-hour sales, primarily because of net increases in Wisconsin and non-mine Michigan retail electric rates. Excluding the mines, total electric sales in 1992 decreased 1.7 percent compared to 1991. Electric Operation and Maintenance Expenses Total electric operating expenses, excluding income taxes and depreciation, were $18 million higher in 1993 compared to 1992. This increase largely reflects an increase in postretirement benefit costs associated with the adoption of Statement of Financial Accounting Standards No. 106 ("FAS No. 106") - "Employers' Accounting for Postretirement Benefits Other Than Pensions" (see Note D to the Financial Statements - Benefits Other Than Pensions), growth in conservation related expenditures associated with improving the efficiency of customers' electric energy usage and maintenance expenditures related to the renovation of the Port Washington Power Plant. The increases in other operation expenses and maintenance were partially offset by lower fuel and purchased power expenses due to lower average per unit generation and purchased power costs. - 30 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) While depreciation during 1993 increased 1.3 percent compared to 1992, largely reflecting higher depreciable plant balances and lower decommissioning payments, the 11.2 percent increase in depreciation during 1992 compared to 1991 is primarily the result of higher depreciable plant balances and higher authorized depreciation rates effective January 1992. Additionally, Taxes Other Than Income Taxes were higher during 1992 compared to 1991 largely due to a $5 million one-time ad valorem tax credit recognized in 1991 and an increase in the 1992 Wisconsin License Fee on gross revenues. Since 1991, operating expenses, excluding income taxes and depreciation, have increased at a compound annual rate of 1.9 percent, reflecting increases in non-fuel related operation and maintenance expenses which were largely offset by reductions in fuel and purchased power expenses. Other Items Interest charges on long-term debt increased $11 million during 1993 compared to 1992 largely due to the additional debt issued to finance Wisconsin Electric's construction program and the amortization of premiums associated with the debt securities refinanced during 1992 and 1993. Wisconsin Electric and Wisconsin Natural Revitalization In response to increasing competitive pressures in the markets for electricity and natural gas, Wisconsin Electric and Wisconsin Natural have developed a revitalization process to increase efficiencies and improve customer service. Wisconsin Electric and Wisconsin Natural are "reengineering" and restructuring their organizations. The new structures consolidate many business functions. This "reengineering" and restructuring of the business systems will lead to a reduction in the total Wisconsin Electric/Wisconsin Natural workforce. Effective in early 1994, employees have the option of choosing a voluntary separation package. An early retirement option also has been offered to qualified employees. As a result, it is currently estimated that Wisconsin Energy's utility subsidiaries will incur non-recurring reorganization charges aggregating between $30 to $75 million during 1994. The portion attributable to Wisconsin Electric is currently estimated to be between $27 and $65 million. See Note D to the Financial Statements - Benefits Other Than Pensions, for additional information. It is expected that these costs will be offset, before the end of 1995, by the reductions in future operating costs that these programs will achieve. In addition to the corporate restructuring at Wisconsin Electric and Wisconsin Natural, as part of this revitalization effort, Wisconsin Energy announced its intent to merge the two companies to form a single combined utility subsidiary. The proposed merger will accomplish the goal of improved customer service and will also enable the reduction of operating costs. The merger, which is anticipated to be effective by year-end 1994, will be subject to a number of conditions, including regulatory and other approvals. - 31 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) Rates and Regulatory Matters The following table summarizes the projected annual revenue impact of recent rate changes authorized by regulatory commissions based on the sales projections utilized by those commissions in setting rates. The Public Service Commission of Wisconsin ("PSCW") regulates Wisconsin retail electric and steam rates, while the FERC regulates wholesale electric rates. The Michigan Public Service Commission ("MPSC") regulates retail electric rates in Michigan. The PSCW announced that it will discontinue the practice of conducting annual rate case proceedings, replacing it with a new schedule which calls for future rate cases to be conducted once every two years. In April 1993, Wisconsin Electric filed required data with the PSCW relating to the 1994 test year indicating a need to raise retail rates. However, in support of its goal to become the lowest-cost energy provider in the region and in light of the operating cost reductions expected from the reengineering process discussed above, Wisconsin Electric has indicated that it has no current plans to seek an increase in rates for 1994 and 1995. Because of the PSCW's newly adopted biennial rate case schedule, Wisconsin Electric's next rate case would be filed in mid-1995 for rates to be effective in 1996. Revenue Percent Increase Change in Effective Company/Service (Decrease) Rates Date - ------------------------- ------------ --------- --------- Wisconsin Electric Fuel electric, WI $(24,207,000) (2.1) 05/29/92 Retail electric, WI 26,655,000 2.3 02/17/93 Steam heating 505,000 3.5 02/17/93 Wholesale electric 6,000,000 10.6 06/09/93 Retail electric, MI 1,366,000 4.3 07/09/93 Fuel electric, WI (8,596,000) (0.9) 11/05/93 - ------------------------------------------------------------------------------ Under the Wisconsin retail electric fuel adjustment procedure, retail electric rates may be adjusted, on a prospective basis, if cumulative fuel and purchased power costs, when compared to the costs projected in the retail electric rate proceeding, deviate from a prescribed range and are expected to continue to be above or below that range. With expectations of low-to-moderate inflation and future operating cost reductions discussed above, Wisconsin Electric does not believe the impact of inflation will have a material effect on its future results of operations. Electric Sales Outlook Assuming moderate growth in the service territory economy and normal weather, Wisconsin Electric presently anticipates electric kilowatt-hour sales to grow at a compound annual rate of approximately 1.1 percent over the five-year period ending December 31, 1998. This forecast is subject to a number of variables, including the economy and weather, which may affect the actual growth in sales. - 32 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) LIQUIDITY AND CAPITAL RESOURCES Investing Activities Wisconsin Electric invested $986 million in its business during the three years ended December 31, 1993. The investments made during this three year period include construction expenditures for new or improved facilities totaling $820 million, net capitalized conservation expenditures of $86 million, purchases of nuclear fuel at $57 million and payments to an external trust for the eventual decommissioning of Wisconsin Electric's Point Beach Nuclear Plant totaling $51 million. In July 1993, Wisconsin Electric placed in-service two units, or approximately 150 megawatts of capacity, at its new Concord Generating Station, a four unit, approximately 300 megawatt natural gas-fired combustion turbine facility designed to meet peak demand requirements. Capital expenditures of $35 million, $47 million and $13 million were made during 1993, 1992 and 1991, respectively, for the construction of this facility. The two remaining units, or approximately another 150 megawatts of capacity, are expected to be placed in-service during the summer of 1994. The total cost of this project is currently estimated at $108 million. Wisconsin Electric has firm capacity purchased power contracts intended to maintain adequate reserve margins prior to completion of this facility. Additionally, during 1993 Wisconsin Electric started work related to the construction of the new Paris Generating Station, also a four unit, approximately 300 megawatt combustion turbine facility intended to meet growing peak demand requirements. This generating station, which is expected to have all four units in-service during the summer of 1995 is currently estimated to cost $105 million. Capital expenditures of $28 million were made for work performed on this project during 1993. The PSCW has allowed Wisconsin Electric to earn a current return on construction work in progress ("CWIP") related to the construction of the Concord and Paris power plants. Wisconsin Electric is nearing completion of the renovation work at its Port Washington Power Plant, which includes upgrading the turbine generators and boilers and the installation of additional emission control equipment. With units 1 and 2 completed during 1993 and unit 3 completed in 1992, the project will conclude with the completion of the unit 4 work during the summer of 1994. The total cost of this project is currently estimated at $109 million. Expenditures totaling $32 million, $43 million and $15 million were made during 1993, 1992 and 1991, respectively. Cash Provided by Operating and Financing Activities During the three years ended December 31, 1993, cash provided by operating activities totaled $1,099 million. During this period, internal sources of funds, after the payment of dividends to Wisconsin Energy, Wisconsin Electric's sole common stockholder, provided 81 percent of the company's capital requirements. Financing activities during the three-year period ended December 31, 1993 included the issuance of $1,053 million of long-term debt, principally to - 33 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) refinance higher coupon debt and the retirement of $68 million of preferred stock. No preferred stock was issued during this period. Additionally, during the three-year period ended December 31, 1993, the company retired a total of $852 million of long-term debt and increased short-term debt by $62 million. Dividends on the company's common stock were $65 million, $65 million, and $168 million, during 1993, 1992, and 1991, respectively. The company continued efforts to reduce its overall cost of capital. During 1993, Wisconsin Electric issued five new series of First Mortgage Bonds aggregating $350 million in principal amount, the proceeds of which were used to redeem $284.3 million principal amount of four outstanding series of First Mortgage Bonds and 626,500 shares of Wisconsin Electric's 6.75% Series Preferred Stock. During 1992, Wisconsin Electric issued five new series of First Mortgage Bonds the proceeds of which provided $431 million principal amount to redeem 12 outstanding series of higher coupon First Mortgage Bonds and $130 million of new capital for the company. The aggregate principal amount of securities refunded during 1993 and 1992 represents approximately three-quarters of the outstanding long-term debt of Wisconsin Electric at December 31, 1991. These transactions have reduced the company's embedded cost of long-term debt from 8.24 percent at December 31, 1991 to 6.90 percent at December 31, 1993, and are expected to result in approximately $191 million in savings over the lives of the new debt issues. Depending on market conditions and other factors, additional debt refundings may occur. Other financing efforts during the three years ended December 31, 1993 include Wisconsin Electric's 1991 issuance of $100 million of First Mortgage Bonds, 8-3/8% Series, the proceeds of which were used to reduce short-term borrowings. Capital Structure The company's capitalization at December 31 is shown below: 1993 1992 1991 ------ ------ ------ Common Equity 50.7% 49.5% 50.2% Preferred Stock 1.3 3.8 4.2 Long-Term Debt (including current maturities) 43.7 43.9 44.0 Short-Term Debt 4.3 2.8 1.6 ------ ------ ------ 100.0% 100.0% 100.0% - 34 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) Compared to the electric utility industry generally, the company has maintained a relatively high ratio of common equity to total capitalization and low debt and preferred stock ratios. This conservative capital structure, along with strong bond ratings (Wisconsin Electric currently has ratings of AA+ by Standard & Poor's Corporation, Aa2 by Moody's Investors Service and AA+ by Duff & Phelps Inc.) and internal cash generation has provided, and should continue to provide, the company with access to the capital markets when necessary to finance the anticipated growth in the company's business. At year-end 1993, the company had $102 million of unused lines of bank credit, $13 million of cash and cash equivalents, $137 million of short-term debt (including long-term debt due currently) and $21 million of construction funds held by trustees. Capital Requirements 1994-1998 The company's estimated capital requirements for the years 1994-1998 are outlined below: (Millions of Dollars) ------------------------------------------------ 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- Construction $286 $344 $215 $245 $191 Conservation 24 14 13 13 14 Bond/Preferred Stock Maturities and Sinking Funds 5 0 30 130 60 Changes in Fuel Inventories 3 5 11 7 7 Decommissioning Trust Payments 16 17 39 42 45 ---- ---- ---- ---- ---- Total $334 $380 $308 $437 $317 - ------------------------------------------------------------------------------ A number of independent power producers ("IPPs") are actively exploring cogeneration projects in Wisconsin, which would be qualifying facilities ("QFs"), including some which are proposed to be within Wisconsin Electric's service territory. Under the requirements of the Public Utility Regulatory Policies Act ("PURPA"), utilities are required to purchase electricity from QFs at no more than the utilities' avoided costs. Consequently, should IPP- owned QF generating capacity be constructed and placed in operation in Wisconsin Electric's service territory, some generation-related expenditures included in the above forecast may be reduced or delayed. In November 1993, the PSCW, after conducting a competitive bidding process, issued an order selecting a proposal submitted by an unaffiliated IPP to construct a generation facility to meet a portion of Wisconsin Electric's anticipated increase in system supply needs. In accordance with the PSCW order, Wisconsin Electric subsequently signed a 25-year agreement to purchase electricity from the proposed facility. The agreement is contingent upon the facility being completed and going into operation, which at this time is planned for mid-1996. A number of parties have filed petitions for judicial review of this PSCW order, taking the position that the order should be set aside on various legal grounds. The matter is pending. - 35 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) Included in the above capital requirements are expenditures associated with the proposed construction of Wisconsin Electric's Kimberly Cogeneration Facility. This proposed facility, which was submitted to but not selected by the PSCW in the competitive bidding process described above, would have provided approximately 220 megawatts of intermediate-load capacity. This project would be canceled upon completion and operation of the IPP-owned facility discussed above. In December 1993, the PSCW issued an order detailing the requirements of a new "Two-Stage" Certificate of Public Convenience and Necessity ("CPCN") process which would be implemented by the PSCW in making the final selection from among competing alternatives to construct proposed future capacity additions (the "first stage"). Under this process, the proposal determined to be in the best public interest would be allowed to proceed to the "second stage" and submit a CPCN application requesting authority to proceed with construction. Wisconsin Electric and one other party have filed petitions for judicial review of this PSCW order, taking the position that the order should be set aside on various legal grounds. The matter is pending. In January 1994, a coordinated statewide plan for meeting future electricity needs of Wisconsin customers was filed with the PSCW in the Advance Plan 7 docket. In the Advance Plan process, Wisconsin Electric, in conjunction with the other regulated electric utilities located in Wisconsin, is required to file long-term forecasts of resource requirements, such as the need for generation and transmission facilities, along with plans to meet those requirements, including the use of energy management and conservation. In order to reliably meet its forecasted growth in demand, Wisconsin Electric employs a least-cost integrated planning process which includes renovation of existing power plants, promotion of cost effective conservation and load management options, development of renewable energy sources, purchased power and construction of new company-owned generation facilities. Investments in demand-side management programs have reduced and delayed the need to add new generating capacity but have not eliminated the need entirely. Purchases of power from other utilities and transmission system upgrades will also combine to help delay the need to install some new generating capacity in the future. However, in order to serve the near-term growth in peak demand requirements, Wisconsin Electric has received PSCW approval and is currently in various stages of completing two of its planned capacity additions. Included in the forecast of capital requirements shown above are expenditures related to the construction of the Concord and Paris Generating Stations, as previously described under "Investing Activities". Finally, Wisconsin Electric's Advance Plan 7 filing indicates a need for additional peaking capacity after the turn of the century along with an anticipated need for additional intermediate-load capacity during the 2000 to 2010 time period. Wisconsin Electric's next base load power plant is not expected to be placed in-service until after 2010. The addition of new generating units requires approval from various regulatory agencies including the PSCW, the U.S. Environmental Protection Agency ("EPA") and the Wisconsin Department of Natural Resources ("DNR"). All generating facilities proposed by Wisconsin Electric will meet or exceed the applicable federal and state environmental requirements. - 36 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) Because of the U.S. Department of Energy's ("DOE") inability to begin accepting spent nuclear fuel for permanent disposal as required by federal law, Wisconsin Electric's current capability to temporarily store spent nuclear fuel from its Point Beach Nuclear Plant ("Point Beach") is expected to reach full capacity by the end of 1998. In order to continue the operation of Point Beach beyond 1998, Wisconsin Electric has filed with the PSCW for a Certificate of Authority to construct and operate a twelve unit, above-ground steel and concrete cask spent fuel storage system. Capital costs associated with this facility, the design of which has been approved by the DOE, are estimated at $6 million and are included in the above forecast. The storage units will provide additional interim storage until the DOE begins to remove spent fuel in accordance with the terms of the contract it has with Wisconsin Electric. In a related matter, Wisconsin Electric has filed with the PSCW for a Certificate of Authority to proceed with the planned 1996 replacement of the Unit 2 steam generators at Point Beach. In 1984 Wisconsin Electric replaced the Unit 1 steam generators. Estimated at a cost of $119 million, which is also included in the above forecast, the Unit 2 project would allow for its operation until the expiration of its operating license in 2013. Without the replacement of the steam generators, the unit would not be able to operate to the end of its current license. Wisconsin Electric is awaiting approval from the PSCW to proceed with these projects. Capital Resources During the five-year forecast period ending December 31, 1998, Wisconsin Electric expects internal sources of funds from operations, after dividends to the company, to provide about 78 percent of the utility capital requirements. The remaining utility cash requirements are expected to be met through the reduction of existing cash investments and construction funds on deposit with trustees, short-term borrowings, the issuance of long-term debt and capital contributions from Wisconsin Energy. Exclusive of debt refundings, utility debt issues of $100 million are anticipated in 1994 and 1997. Clean Air Act The 1990 Amendments to the Clean Air Act mandate significant nationwide reductions in nitrogen oxide (NOX) and sulfur dioxide (SO2) emissions to address acid rain and ozone control requirements. Wisconsin Electric's strategy for complying with the requirements which become effective in 1995 calls for the use of low sulfur coal and the installation of low NOX burners and continuous emission monitoring equipment at its Oak Creek Power Plant. Equipment costs, which are not expected to exceed $9 million based on today's costs, along with additional operating expenses are expected to increase electric rates by less than 1 percent. Wisconsin Electric projects a surplus of SO2 allowances and is also seeking additional SO2 allowances which may be available as a result of its energy conservation programs. As an integral component of its least-cost SO2 emission compliance plan, Wisconsin Electric has been active in SO2 allowance - 37 - ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Cont'd) trading. Revenues from the sale of surplus allowances are being used to offset future rate increases. Wisconsin Electric's strategy for complying with the requirements which become effective after 1995 includes installation of continuous emission monitoring equipment on the remaining company boilers, fuel switching and installation of NOX control equipment, if needed. With an estimated cost not to exceed $75 million based on today's costs, this compliance strategy could increase rates by 1 to 2 percent. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The "Quarterly Financial Data" in Item 6 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 In accordance with General Instruction G(3) of Form 10-K, the information under "Information Concerning Nominees for Directors" in Wisconsin Electric's definitive Information Statement to be dated April 15, 1994 is incorporated herein by reference. Also see "Executive Officers of the Registrant" in Part I of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION In accordance with General Instruction G(3) of Form 10-K, the information under "Compensation" in Wisconsin Electric's definitive Information Statement to be dated April 15, 1994 is incorporated herein by reference (except for the information under "Compensation Committee Report on Executive Compensation Matters"). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of Wisconsin Electric's Common Stock (100% of such class) is owned by the parent company, Wisconsin Energy Corporation, 231 West Michigan Street, P.O. Box 2949, Milwaukee, Wisconsin 53201. The directors, director nominees and executive officers of Wisconsin Electric do not own any of the voting securities of Wisconsin Electric. In accordance with General Instruction G(3) of Form 10-K, the information concerning their beneficial ownership of Wisconsin Energy stock set forth under "Stock Ownership of Directors, Nominees and Executive Officers" in Wisconsin Electric's definitive Information Statement to be dated April 15, 1994 is incorporated herein by reference. 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 and Report of Independent Accountants Included in Part II of this report: Income Statement for the three years ended December 31, Statement of Cash Flows for the three years ended December 31, 1993 - 58 - Balance Sheet at December 31, 1993 and 1992 Capitalization Statement at December 31, 1993 and 1992 Common Stock Equity Statement for the three years ended December 31, 1993 Notes to Financial Statements Report of Independent Accountants 2. Financial Statement Schedules Included in Part IV of this report: For the three years ended December 31, 1993 Schedule V Property, Plant and Equipment Schedule VI Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment Schedule IX Short-Term Borrowings Schedule X Supplementary Income Statement Information As of December 31, 1993 Schedule VII Guarantees of Securities of Other Issuers Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. 3. Exhibits The following Exhibits are filed with this report: Exhibit No. (23) Consent of Independent Accountants, dated March 30, 1994 appearing on page 68 of this Annual Report on Form 10-K for the year ended December 31, 1993. - 59 - In addition to the Exhibits shown above, which are filed herewith, Wisconsin Electric hereby incorporates the following Exhibits pursuant to Exchange Act Rule 12b-32 and Regulation Section 201.24 by reference to the filings set forth below: (3)-1 Amended and Restated Articles of Incorporation of Wisconsin Electric Power Company dated March 23, 1987. (Exhibit (3)-2 to Wisconsin Electric's 1987 Form 10-K in File No. 1-1245) 2 Bylaws of Wisconsin Electric Power Company, as amended to November 25, 1992. (Exhibit (3)-1 to Wisconsin Electric's 1992 Form 10-K in File No. 1-1245) (4)-1 Reference is made to Article III of the Amended and Restated Articles of Incorporation of Wisconsin Electric dated March 23, 1987 (Exhibit (3)-1 herein). Mortgage or Supplemental Indenture Company Date Exhibit # Under File No. - ------------------------------------------------------------------------------ (4)- 2 Mortgage and Wisconsin 10/28/38 B-1 2-4340 Deed of Trust Electric ("WE") 3 Second WE 6/1/46 7-C 2-6422 4 Third WE 3/1/49 7-C 2-8456 5 Fourth WE 6/1/50 7-D 2-8456 6 Fifth WE 5/1/52 4-G 2-9588 7 Sixth WE 5/1/54 4-H 2-10846 8 Seventh WE 4/15/56 4-I 2-12400 9 Eighth WE 4/1/58 2-I 2-13937 10 Ninth WE 11/15/60 2-J 2-17087 11 Tenth WE 11/1/66 2-K 2-25593 12 Eleventh WE 11/15/67 2-L 2-27504 13 Twelfth WE 5/15/68 2-M 2-28799 14 Thirteenth WE 5/15/69 2-N 2-32629 15 Fourteenth WE 11/1/69 2-0 2-34942 16 Fifteenth WE 7/15/76 2-P 2-54211 17 Sixteenth WE 1/1/78 2-Q 2-61220 18 Seventeenth WE 5/1/78 2-R 2-61220 19 Eighteenth WE 5/15/78 2-S 2-61220 20 Nineteenth WE 8/1/79 (a)2(a) 1-1245 (9/30/79 Form 10-Q) 21 Twentieth WE 11/15/79 (a)2(a) 1-1245 (12/31/79 Form 10-K) 22 Twenty-First WE 4/15/80 (4)-21 2-69488 23 Twenty-Second WE 12/1/80 (4)-1 1-1245 (12/31/80 Form 10-K) 24 Twenty-Third WE 9/15/85 (4)-1 1-1245 (9/30/85 Form 10-Q) 25 Twenty-Four WE 9/15/85 (4)-2 1-1245 (9/30/85 Form 10-Q) 26 Twenty-Fifth WE 12/15/86 (4)-25 1-1245 (12/31/86 Form 10-K) 27 Twenty-Sixth WE 1/15/88 4 1-1245 (1/26/88 Form 8-K) - 60 - Mortgage or Supplemental Indenture Company Date Exhibit # Under File No. - ------------------------------------------------------------------------------ 28 Twenty-Seventh WE 4/15/88 4 1-1245 (3/31/88 Form 10-Q) 29 Twenty-Eighth WE 9/1/89 4 1-1245 (9/30/89 Form 10-Q) 30 Twenty-Ninth WE 10/1/91 (4)-1 1-1245 (12/31/91 Form 10-K) 31 Thirtieth WE 12/1/91 (4)-2 1-1245 (12/31/91 Form 10-K) 32 Thirty-First WE 8/1/92 (4)-1 1-1245 (6/30/92 Form 10-Q) 33 Thirty-Second WE 8/1/92 (4)-2 1-1245 (6/30/92 Form 10-Q) 34 Thirty-Third WE 10/1/92 (4)-1 1-1245 (9/30/92 Form 10-Q) 35 Thirty-Fourth WE 11/1/92 (4)-2 1-1245 (9/30/92 Form 10-Q) 36 Thirty-Fifth WE 12/15/92 (4)-1 1-1245 (12/31/92 Form 10-K) 37 Thirty-Sixth WE 1/15/93 (4)-2 1-1245 (12/31/92 Form 10-K) 38 Thirty-Seventh WE 3/15/93 (4)-3 1-1245 (12/31/92 Form 10-K) 39 Thirty-Eighth WE 8/01/93 (4)-1 1-1245 (6/30/93 Form 10-Q) 40 Thirty-Ninth WE 9/15/93 (4)-1 1-1245 (9/30/93 Form 10-Q) All agreements and instruments with respect to long-term debt not exceeding 10 percent of the total assets of the Registrant have been omitted as permitted by related instructions. The Registrant agrees pursuant to Item 601(b)(4) of Regulation S-K to furnish to the Securities and Exchange Commission, upon request, a copy of all such agreements and instruments. (10)-1 Purchase and Sale Agreement by and among The Cleveland-Cliffs Iron Company, Cliffs Electric Service Company, Upper Peninsula Generating Company, Upper Peninsula Power Company and Wisconsin Electric Power Company, dated as of December 8, 1987. (Exhibit 10 to Wisconsin Electric's Form 8-K dated December 18, 1987 in File No. 1-1245) 2 Supplemental Benefits Agreement between Wisconsin Energy Corporation and employee Richard A. Abdoo dated December 14, 1990. (Exhibit (10)-2 to Wisconsin Energy's 1990 Form 10-K in File No. 1-9057) * 3 Supplemental Benefits Agreement between Wisconsin Electric and employee John W. Boston dated December 14, 1990. (Exhibit (10)-1 to Wisconsin Electric's 1990 Form 10-K in File No. 1-1245) * 4 Supplemental Benefits Agreement between Wisconsin Electric and employee Robert H. Gorske dated December 14, 1990. (Exhibit (10)-3 to Wisconsin Energy's 1990 Form 10-K in File No. 1-9057) * 5 Director's Deferred Compensation Plan of Wisconsin Electric Power Company, effective January 1, 1987. (Exhibit (10)-(b) to Wisconsin Electric's Form 8-K dated January 2, 1987 in File No. 1-1245) * - 61 - 6 Service Agreement dated January 1, 1987 between Wisconsin Electric Power Company, Wisconsin Energy Corporation and other non-utility affiliated companies (Exhibit (10)-(a) to Wisconsin Electric's Form 8-K dated January 2, 1987 in File No. 1-1245) * Management contracts and executive compensation plans or arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K. Certain compensatory plans in which directors or executive officers of the Registrant are eligible to participate are not filed in reliance on the exclusion in Item 601(b)(10)(iii)(B)(6) of Regulation S-K. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. However, a report on Form 8-K dated January 24, 1994 was filed by Wisconsin Electric reporting the announced plan to merge Wisconsin Energy's wholly-owned natural gas utility subsidiary, Wisconsin Natural into Wisconsin Electric, anticipated to be effective by year-end 1994. - 62 - - 63 - - 64 - WISCONSIN ELECTRIC POWER COMPANY SCHEDULE VII - GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 Column A Column B Column C Column D -------- -------- -------- -------- Amount Owned By Person or Name of Issuer of Title of Issue Total Amount Persons for Securities Guaranteed of Each Class of Guaranteed Which By Person for Which Securities and Statement is Statement is Filed Guaranteed Outstanding Filed - --------------------- ---------------- ------------- ------------- Wisconsin Electric Commercial $42,225,000(a)(b) --- Fuel Trust Paper Column E Column F Column G -------- -------- -------- Name of any Default Amount in By Issuer of Securities Treasury of Guaranteed in Principal, Issuer of Interest, Sinking Fund Securities Nature of or Redemption Provisions, Guaranteed Guarantee or Payments of Dividends - ---------- --------- ------------------------- --- Principal, --- interest and other financing costs (c) (a) The Wisconsin Electric Fuel Trust owns nuclear fuel financed by the sale of commercial paper. The nuclear fuel is leased to Wisconsin Electric. The commercial paper is backed by a revolving line of bank credit. (b) A maximum of $75,000,000 of obligations may be incurred. (c) Principal, interest and other financing costs of borrowings are guaranteed through rent payments by Wisconsin Electric under a nuclear fuel lease agreement and are further guaranteed by a group of banks which will loan money if needed if payments by Wisconsin Electric are not sufficient. The line of revolving bank credit would be generally available to finance the trust's ownership for a period of three years if the trust were unable to sell its commercial paper. Wisconsin Electric is in effect the ultimate guarantor of the commercial paper and the revolving line of bank credit. - 65 - - 66 - WISCONSIN ELECTRIC POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (Note A) Col. A Col. B Charged to Costs and Expenses ------------------------------ Item 1993 1992 1991 ---- ---- ---- ---- (Thousands of Dollars) Taxes other than payroll and income taxes Wisconsin license fee tax $38,412 $38,269 $35,702 Other 15,062 14,101 6,633 ------- ------- ------- Total $53,474 $52,370 $42,335 ======= ======= ======= Note A - Maintenance expense and depreciation are shown on the Income Statement. No royalties were paid and advertising costs did not exceed 1% of revenues. - 67 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements and Prospectuses constituting part of the Registration Statements on Form S-3 (Nos. 33-49199 and 33-51749) of Wisconsin Electric Power Company of our report dated January 26, 1994 appearing on page 57 of this Form 10-K. /s/ Price Waterhouse - -------------------- PRICE WATERHOUSE Milwaukee, Wisconsin March 30, 1994 - 68 - 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. WISCONSIN ELECTRIC POWER COMPANY /s/R. A. Abdoo By ------------------------------------- Date March 30, 1994 (R. A. Abdoo, 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 and Title Date /s/R. A. Abdoo - --------------------------------------------------- March 30, 1994 (R. A. Abdoo, Chairman of the Board and Chief Executive Officer and Director - Principal Executive Officer) /s/J. W. Boston - --------------------------------------------------- March 30, 1994 (J. W. Boston, President and Chief Operating Officer and Director) /s/J. G. Remmel - --------------------------------------------------- March 30, 1994 (J. G. Remmel, Chief Financial Officer and Director - Principal Financial Officer) /s/A. K. Klisurich - --------------------------------------------------- March 30, 1994 (A. K. Klisurich, Controller - Principal Accounting Officer) /s/D. K. Porter - --------------------------------------------------- March 30, 1994 (D. K. Porter, Senior Vice President and Director) - 69 - Signature and Title Date /s/R. H. Gorske - ---------------------------------------------------- March 30, 1994 (R. H. Gorske, Vice President and General Counsel and Director) - --------------------------------------------------- (J. F. Bergstrom, Director) /s/R. A. Cornog - ---------------------------------------------------- March 30, 1994 (R. A. Cornog, Director - designate) /s/G. B. Johnson - ---------------------------------------------------- March 30, 1994 (G. B. Johnson, Director) /s/J. L. Murray - ---------------------------------------------------- March 30, 1994 (J. L. Murray, Director) /s/M. W. Reid - ---------------------------------------------------- March 30, 1994 (M. W. Reid, Director) /s/F. P. Stratton, Jr. - ---------------------------------------------------- March 30, 1994 (F. P. Stratton, Jr., Director) /s/J. G. Udell - ---------------------------------------------------- March 30, 1994 (J. G. Udell, Director) - 70 - Wisconsin Electric Power Company EXHIBIT INDEX ------------- 1993 Annual Report on Form 10-K Exhibit Number - ------- (23) Consent of Independent Accountants, dated March 30, 1994 appearing on page 68 of this Annual Report on Form 10-K for the year ended December 31, 1993. The foregoing Exhibit is filed with this report. The additional Exhibits which are incorporated by reference are listed in Item 14(a)(3) of this report. - 71 -

894405_1993.txt

894405_1993

1993

894405

ITEM 1. BUSINESS (a) General Development of Business Corporate Profile Arkansas Best Corporation (the "Company") is primarily engaged, through its motor carrier subsidiaries, in less-than-truckload ("LTL") shipments of general commodities. The Company is also engaged through its 46%-owned subsidiary, Treadco, Inc. ("Treadco"), in truck tire retreading and new truck tire sales. ABF Freight System, Inc. ("ABF"), founded in 1935, is the largest motor carrier subsidiary of the Company, accounting for approximately 87% of the Company's consolidated revenues. ABF has grown to become the fifth largest LTL motor carrier in the United States from the forty-eighth largest in 1965, based on revenues for 1993 as reported to the Interstate Commerce Commission (the "ICC"). Treadco, which accounted for approximately 11% of the Company's consolidated revenues, is the nation's largest independent tire retreader for the trucking industry and the second largest commercial truck tire dealer. Historical BackgroundIn July 1988, the Company was acquired in a leveraged buyout by a corporation organized by Kelso & Company, L.P., the predecessor of Kelso & Company, Inc. In May 1992, the Company completed a recapitalization, which included (i) an initial public offering of Common Stock par value $.01 (the "Common Stock") by the Company, the net proceeds of which were used to repurchase approximately $114 million in principal amount of its 14% Senior Subordinated Notes due 1998 (the "Notes") pursuant to a tender offer and related consent solicitation and to pay related fees and expenses, and (ii) the refinancing of the Company's existing bank indebtedness. On November 13, 1992, the Company repurchased approximately 4,439,000 shares of Common Stock beneficially owned by Kelso Best Partners, L.P. for approximately $55.5 million in the aggregate, or $12.50 per share (a discount of $1.50 per share to the then quoted NASDAQ/NMS sale price). Prior to the Repurchase, Kelso Partners was the Company's largest stockholder, with beneficial ownership of approximately 21.7% of the total outstanding shares of the Company's Common Stock. Kelso Partners distributed its remaining 650,000 shares to certain of its individual partners, thus ending Kelso Partners' investment in the Company. To pay for the repurchase of such shares, the Company borrowed $50 million under a new five-year term loan credit facility (the "Term Loan") provided by its existing bank group through an amendment and restatement of its existing credit agreement and used $5.5 million in available cash. See "Management's Discussion and Analysis -- Liquidity and Capital Resources." On February 3, 1993, the Company completed a public offering of 1,495,000 shares of preferred stock ("Preferred Stock"). The Company used the net proceeds of $72.3 million to repay the $50 million Term Loan and for general corporate purposes. See "Management's Discussion and Analysis -- Liquidity and Capital Resources." (b) Financial Information about Industry Segments The response to this portion of Item 1 is included in "Note M - Business Segment Data" of the notes to the Company's consolidated financial statements for the year ended December 31, 1993, which is submitted as a separate section of this report. (c) Narrative Description of Business Motor Carrier Operations General The Company's motor carrier operations are conducted through ABF, ABF Freight System (B.C.), Ltd. ("ABF-BC"), ABF Freight System Canada, Ltd. ("ABF- Canada"), ABF Cartage, Inc. ("Cartage"), and Land-Marine Cargo, Inc. ("Land- Marine"). ABF, which concentrates on long-haul transportation of general commodities freight, involving primarily LTL shipments, is the Company's largest motor carrier subsidiary, accounting for approximately 98% of the Company's motor carrier revenues for 1993. ABF-BC and ABF Canada operate out of eleven terminals in Canada. Cartage focuses on shipments in and out of Hawaii and Land-Marine currently concentrates on shipments in and out of Puerto Rico. ABF Freight System, Inc. ABF is the largest subsidiary of the Company, accounting for approximately 87% of the Company's consolidated revenues. ABF has grown to become the fifth largest LTL motor carrier in the United States from the forty-eighth largest in 1965, based on revenues for 1993 as reported to the ICC. ABF, which concentrates on long-haul LTL shipments, provides direct service to 939 of the 952 cities in the United States having a population of 25,000 or more. ABF and the Company's other motor carrier subsidiaries have 339 terminals and operate in all 50 states, Canada and Puerto Rico. Through an alliance and relationships with trucking companies in Mexico, ABF provides motor carrier services to customers in that country as well. ABF has more than 50,000 customers, including approximately 335 national accounts. ABF was incorporated in Delaware in 1982 as a successor to Arkansas Motor Freight, a business originally organized in 1935. ABF concentrates on long-haul transportation of general commodities freight, involving primarily LTL shipments. General commodities include all freight except hazardous waste, dangerous explosives, commodities of exceptionally high value, commodities in bulk and those requiring special equipment. ABF's general commodities shipments differ from shipments of bulk raw materials which are commonly transported by railroad, pipeline and water carrier. General commodities transported by ABF include, among other things, food, textiles, apparel, furniture, appliances, chemicals, non-bulk petroleum products, rubber, plastics, metal and metal products, wood, glass, automotive parts, machinery and miscellaneous manufactured products. During the year ended December 31, 1993, no single customer accounted for more than 4% of ABF's revenues, and the ten largest customers accounted for less than 11% of ABF's revenues. LTL Operations LTL carriers differ substantially from full truckload carriers by offering service to shippers which is tailored to the need to transport a wide variety of large and small shipments to geographically dispersed destinations. Generally, full truckload companies operate from the shipper's dock to the receiver's facility and require very little fixed investment beyond the cost of the trucks. LTL carriers pick up small shipments throughout the vicinity of a local terminal with local trucks and consolidate them at each terminal according to destination for transportation by intercity units to their destination cities or to breakbulk (rehandling) terminals, where shipments from various locations can be reconsolidated for transportation to distant destinations, other breakbulk terminals or local terminals. In most cases, a single driver's trip will consist of a day's run to the terminal or relay point which is appropriately located on the route, where the trailer containing the shipments will be transferred to continue towards its destination. Once delivered to a local terminal, a shipment is delivered to the customer by local trucks operating from such terminal. In some cases, when a sufficient number of different shipments at one origin terminal are going to a common destination, they can be combined to make a full trailerload. A trailer then is dispatched to that destination without having to rehandle the freight. In order to improve efficiency, reduce labor costs and enhance customer service, ABF seeks to minimize the number of times it handles freight. ABF estimates that at its breakbulk terminals it handles its LTL shipments, on average, approximately one and a quarter times. ABF's low average handling per shipment tends to result in fewer damage claims and reduced transit time. ABF has concentrated on increasing the LTL segment of its business, which has grown from 52.6% of its revenues in 1978 to 88.3% of its revenues in 1993. The Company believes that the opportunity to achieve economies of scale in LTL operations and the service-sensitive nature of the LTL freight business make this an attractive market. In addition, this market has been less affected by increased competition from new entrants because transportation of LTL freight requires significant capital assets, including terminal facilities and complex computer and communications systems, a skilled work force and a large sales organization. Expansion Program In anticipation of deregulation of the trucking industry, in the mid-1970's ABF determined it would be necessary to embark on a program of expansion designed to extend its services geographically and transform itself from a regional into a national carrier. The acquisition of Navajo Freight Lines, Inc. in 1978 extended ABF's routes and services into the Western and Southwestern United States and the acquisition of East Texas Motor Freight in 1982 added to ABF's existing services in the Midwestern and Southern United States and extended coverage into the Northwestern United States. Upon completion of these two acquisitions, ABF had a framework of routes and terminals that substantially covered all regions of the continental United States. Over the period of these acquisitions ABF increased its number of terminals from 67 in 1978 to 160 in 1982, with ABF and the Company's other motor carrier subsidiaries now having 339 terminals. ABF-Canada and ABF-BC operate out of eleven terminals in Canada. Although the Company does not maintain terminals in Mexico, through an alliance and relationships with trucking companies in Mexico, ABF provides motor carrier services to customers in that country as well. Although the Company expects to continue adding terminals and relocating existing terminals when and where strategically important, it does not expect to continue the rapid rate of growth experienced during the eighties. In April 1992, ABF announced that it had entered into an intermodal strategic alliance with Votainer International B.V. ("Votainer"). The alliance provides ABF and Votainer customers with world-wide intermodal transportation services to and from points in the United States. Such services feature through-rates based on a single factor, a through-bill-of-lading, and electronic shipment tracing from origin to destination. Although the Company believes that the alliance is unique in the international trade industry, the Company does not expect the strategic alliance to have a material effect on the Company's revenues or operating results in the near term. In January 1993, ABF announced the formation of an alliance with Servicio Libre a Bordo ("LAB") giving ABF single-bill service to major points in Mexico. The alliance gives ABF's customers a unique opportunity to move their freight in and out of Mexico. LAB is an LTL specialist in the Mexico market while most other Mexican carriers have truckload as their core business. The alliance features proportional through rates, single-carrier responsibility of limited cargo liability, single freight bill including all freight charges, the option for freight charges to be prepaid origin to destination, collect origin to destination or a combination of prepaid and collect, electronic tracing from origin to destination, and consistent transit times. In August 1993, ABF announced an alliance with Burnham Service Corporation ("Burnham") which provides specialized delivery and setup services. The alliance serves all points served by the ABF system, to any point in the 48 contiguous states. Utilizing the hookup of electronic services of both companies, it gives customers seamless service between ABF and Burnham. Primary product features include through-rates, single freight bill containing freight and setup charges, single-carrier liability, instant electronic shipment tracing from origin to destination, and consistent transit times. Statistical Information Marketing Prior to the partial deregulation of the trucking industry beginning in 1980, rates were extensively regulated by the ICC and were not a significant competitive factor, but now marketing, cost and rate of return have become an integral part of carrier operations. By expanding ABF's transcontinental system through the addition of terminals, ABF has increased its ability to service a greater number of customers directly. Maintaining ABF's competitive position requires operational and sales support that is customer oriented. To achieve this objective, ABF has sales representation in all cities in which it has terminals and also has ten separate national account sales offices. To improve service, ABF makes information readily accessible to its customers through various electronic pricing, billing and tracing services, referred to by ABF as the "Q-Family" of services. The ABF Q-Family offers a complete package of computer-supported information services. Q-Stat is the newest member of the Q-Family. It provides a monthly statistical report of a customer's shipping activity with ABF. Q-Bill offers most of the functions of a traffic department in a PC software package. Q-Bill provides for bill- of-lading preparation, automatic rating with an ABF tariff or competitor tariff, case label production and summary manifesting. Q-EDI is ABF's computer-to-computer electronic data interchange (EDI) system. The following standard transaction sets are presently supported:(i) shipment status information for shipment tracking and performance monitoring; (ii) freight bills for payment and auditing, and (iii) bill-of-lading information for carrier billing and rating. Q-Info is a PC-based shipment status information system designed to aid ABF customers in the performance of their daily traffic-related functions. Q-Info provides customized shipment status reports, up-to-the-minute tracing information and freight bill copies. Q-Line is a nationwide hotline which can be reached 24-hours a day, seven days a week, from any touch-tone telephone. It is a voice response system which allows "conversation" with the ABF computer for tracing, rates, loss and damage claims, and transit time information. Q-Rate III is ABF's third generation rating program. ABF originated diskette rating and, in management's opinion, continues to set the industry standard. Q-Rate III provides nationwide rating on two diskettes. In addition to supporting the ABF tariffs, information regarding coverage, transit times, and mileage is provided. Quality Improvement Process In 1984, ABF began implementing a Quality Improvement Process to focus on the specific requirements of customers and to develop measurement systems that determine the degree of success or failure in conforming to those requirements. Non-conforming results trigger a structured approach to problem solving, error identification and classification. The Quality Improvement Process requires that all levels of employees be educated in the process itself and trained in their respective job responsibilities so that the focus on customer requirements drives job performance. In that vein, ABF maintains permanent educational facilities in strategic locations to teach the Quality Improvement Process to sales personnel, branch managers and operations personnel in classroom environments. ABF believes that the Quality Improvement Process has enhanced performance in a number of areas. As an example, ABF has been able to reduce the incidence of inaccurate freight bills by over 70% in the last five years. Revenue Equipment and Truck Terminals In anticipation of the partial deregulation of the trucking industry, ABF began in 1978 to expand carrier services and geographic coverage. ABF and the Company's other motor carrier subsidiaries have increased their market coverage by expanding the number of terminals from 67 in early 1978 to 339 currently. A rapid period of terminal expansion from 1978 gave ABF substantially complete national geographic coverage and has not continued at the same pace since 1988. ABF owns 26 of its terminal facilities, leases 82 terminals from its affiliate, ABC Treadco, Inc. ("ABC Treadco") and leases the remaining terminals from independent third parties. ABF's equipment replacement policy generally provides for replacing intercity tractors every three years, intracity tractors every five to seven years, and trailers (which have a depreciable life of seven years) on an as needed basis (generally seven years or more), resulting in a relatively new and efficient tractor fleet and minimizing maintenance expenses. ABF presently intends to continue its tractor and trailer replacement policy. ABF has a comprehensive preventive maintenance program for its tractors and trailers to minimize equipment downtime and prolong equipment life. Repairs and maintenance are performed regularly at ABF's facilities and at independent contract maintenance facilities. In late 1993, ABF initiated a new computerized maintenance program which tracks equipment activity and provides automatic notification of the maintenance needs of each tractor, trailer and converter gear. The program keeps records of preventive maintenance schedules and governmental inspection requirements for each piece of equipment and routes the unit to the nearest ABF maintenance facility where the service can be performed. In 1993, under its equipment replacement program, ABF acquired 500 intercity tractors, 350 intracity tractors and 820 trailers. Internally generated funds, borrowings under the credit agreement and leases have been sufficient to finance these additions. Data Processing The Company, through its wholly owned service bureau subsidiary, is able to provide timely information, such as the status of all shipments in the system at any given point in time, that aids the marketing efforts of ABF as well as assisting its operating personnel. During 1993, ABF implemented a new on- line city manifest computer program which further enhances shipment tracing. The program also provides additional information which will improve operations. The service bureau is staffed with 182 data processing specialists. The Company believes that its allocation of resources to data processing has assisted ABF in providing the type of quality services required by a sophisticated shipping public. Employees At December 31, 1993, ABF employed 10,719 persons. Employee compensation and related costs are the largest components of carrier operating expenses. In 1993, such costs amounted to 67.6% of ABF's general commodities revenues. ABF is a signatory with the Teamsters to the National Master Freight Agreement (the "National Agreement") which became effective April 1, 1991, and expires March 31, 1994. Terms of the new agreement, which is currently under negotiation, are unknown at this time. Under the National Agreement, employee wages increased an average of 3.2% annually during 1991 and an average of 2.7% annually from April 1, 1992 through March 31, 1994. Health, welfare and pension costs increased 10.6% annually during 1991 and an average of 6.7% annually from April 1, 1992 through March 31, 1994. Under the terms of the National Agreement, ABF is required to contribute to various multiemployer pension plans maintained for the benefit of its employees who are members of the Teamsters. Amendments to the Employee Retirement Income Security Act of 1974 ("ERISA") pursuant to the Multiemployer Pension Plan Amendments Act of 1980 (the "MPPA Act") substantially expanded the potential liabilities of employers who participate in such plans. Under ERISA, as amended by the MPPA Act, an employer who contributes to a multiemployer pension plan and the members of such employer's controlled group are jointly and severally liable for their proportionate share of the plan's unfunded liabilities in the event the employer ceases to have an obligation to contribute to the plan or substantially reduces its contributions to the plan (i.e., in the event of plan termination or withdrawal by the Company from the multiemployer plans). Although the Company has no current information regarding its potential liability under ERISA in the event it wholly or partially ceases to have an obligation to contribute or substantially reduces its contributions to the multiemployer plans to which it currently contributes, management believes that such liability would be material. The Company has no intention of ceasing to contribute or of substantially reducing its contributions to such multiemployer plans. ABF is also a party to several smaller union contracts. Approximately 80% of ABF's employees are unionized, of whom approximately 1% are members of unions other than the Teamsters. Five of the six largest LTL carriers are unionized and generally pay comparable wages. Non-union companies typically pay employees less than union companies. Over the past ten years, ABF's operations have not been significantly affected by any work stoppages and management believes that it enjoys good labor relations with both union and non-union employees. There can be no assurance, however, that labor problems will not arise in the future that would adversely affect the operations and profitability of the motor carrier industry in general and ABF in particular. Since December 1989, the Department of Transportation ("DOT") has required ABF and other domestic motor carriers to implement drug testing programs for their truck drivers to deter drug use. In December 1991, ABF implemented a random testing program to cover its entire driver work force. ABF has since April 1992 been testing as required by the federal government at an average rate of 50% of its driver work force. Statistics for 1993 indicate that ABF has administered 4,409 random, biennial re-certification and post-accident tests to its employees, with a pass rate of 99.2%. Due to its national reputation and its high pay scale, the Company has not historically experienced any significant difficulty in attracting or retaining qualified drivers. Insurance and Safety Generally, claims exposure in the motor carrier industry consists of cargo loss and damage, auto liability, property damage and bodily injury and workers' compensation. The Company is generally self-insured for the first $100,000 of each cargo loss, $300,000 of each workers' compensation loss and $200,000 of each general and auto liability loss, plus an aggregate of $750,000 of auto liability losses between $200,000 and $500,000. The Company maintains insurance contracts covering the excess of such losses in amounts it believes are adequate. While insurance for motor carriers has become increasingly more expensive and more difficult to obtain, it remains essential to the continuing operations of a motor carrier. Although such insurance has become more difficult to obtain, the Company has been able to obtain adequate coverage and is not aware of problems in the foreseeable future which would significantly impair its ability to obtain adequate coverage at comparable rates. The Company also believes that it has one of the best safety records in the trucking industry, based in part on having received first, second or third place safety awards from the American Trucking Associations ("ATA") every year for the past 21 years. In 1993, ABF was awarded the ATA's President's Trophy for the company with the most outstanding safety program. ABF had previously won the President's Trophy in 1989 and 1984. ABF's tractors are equipped with governors which prevent drivers from driving at speeds in excess of 57 mph, thereby maximizing safety and fuel economy. Of the ABF general commodities shipments handled during the year ended December 31, 1993, more than 99% were free of any cargo claim, and of those having cargo claims, 89% were settled within 30 days of the claim date. The following table shows accidents and claims results for the last five years: Fuel The motor carrier industry is dependent upon the availability of diesel fuel. Material adverse effects on the operations and profitability of the industry, as well as ABF, could occur as a result of significant increases in fuel costs, fuel taxes or shortages of fuel. Management, however, believes that the Company would be impacted to a lesser extent than truckload carriers if prices increased dramatically because fuel costs are a smaller percentage of costs for LTL carriers. Further, management believes that the Company's operations and financial condition are no more susceptible to fuel price increases or fuel shortages than its competitors. On October 1, 1993, the new Federal Diesel Fuel Regulations went into effect. The new regulations require the use of low sulfur highway diesel in all on- road diesel powered motor vehicles. The Company is in compliance with the new regulations. The low sulfur requirement initially increased the price per gallon, but the overall price per gallon decreased late in 1993. At present, the price per gallon of diesel fuel, excluding taxes, is at its lowest level since 1990. Competition, Pricing and Industry Factors The trucking industry is highly competitive. ABF actively competes for freight business with other national, regional and local motor carriers and, to a lesser extent, with private carriage, freight forwarders, railroads and airlines. Competition is based primarily on personal relationships, price and service. In general, ABF and most of the other principal motor carriers use similar tariffs to rate interstate shipments. Intense competition for freight revenue, however, has resulted in discounting which effectively reduce prices paid by shippers. In an effort to maintain and improve its market share, ABF offers and negotiates various discounts. See "Business -- Motor Carrier Operations -- Regulation." Deregulation of the trucking industry has resulted in easier entry into the industry and increased competition, although there has also been consolidation in the industry, as a number of companies have since gone out of business. See "Business -- Motor Carrier Operations -- Regulation." New entrants (some of which have grown rapidly in regional markets) include some non-union carriers which have lower labor costs. ABF conducts the ABF Profit Improvement Program, which is designed to improve the overall profitability of ABF by working with those accounts which do not have an acceptable profit margin. Action to improve profitability may include changing the packaging and price renegotiation. The trucking industry, including the Company, is affected directly by the state of the overall economy. In addition, seasonal fluctuations also affect tonnage to be transported. Freight shipments, operating costs and earnings also are affected adversely by inclement weather conditions. Regulation ABF's operations in interstate commerce are regulated by the ICC which has power to authorize motor carrier operations; approve rates, charges and accounting systems; require periodic financial reporting; and approve certain mergers, consolidations and acquisitions. Certain of the intrastate motor carrier operations of ABF are subject to the licensing requirements, rate regulations and financial reporting requirements of state public utility commissions and similar authorities. The Company, like other interstate motor carriers, is subject to certain safety requirements governing interstate operations prescribed by the DOT. ABF has earned a "satisfactory" rating (the highest of three grading categories) from the DOT. In addition, vehicle weight and dimensions remain subject to both federal and state regulations. More restrictive limitations on vehicle weight and size or on trailer length or configuration could adversely affect the profitability of the Company. The Motor Carrier Act of 1980 (the "MCA") was the start of an effort to increase competition among motor carriers and reduce the level of regulation in the industry. The MCA enables applicants to obtain ICC operating authority easily and allows interstate motor carriers, such as ABF, to change their rates by a certain percentage per year without ICC approval and to provide discounts to shippers. The MCA also resulted in the removal of route and commodity restrictions on the transportation of freight, making it easier for interstate motor carriers to obtain nationwide authority to carry general commodities throughout the continental United States. Management believes that the Company is in compliance in all material respects with applicable regulatory requirements relating to its operations. The failure of the Company to comply with the regulations of ICC, DOT or state agencies could result in substantial fines or revocation of the Company's operating authorities. Specialized Motor Carriers In addition to ABF, the Company has four other motor carrier subsidiaries: ABF-BC, ABF-Canada, Land-Marine and Cartage. ABF-BC and ABF-Canada concentrate on shipments of general commodities freight primarily in Canada. Land-Marine currently concentrates on shipments of general commodities freight in and out of Puerto Rico and has ICC common carrier authority to operate in the continental United States. Cartage focuses on shipments in and out of Hawaii. In 1993, ABF-BC, ABF-Canada, Land-Marine and Cartage collectively provided approximately 2% of the Company's motor carrier revenues. Best Logistics, Inc. Best Logistics, Inc., a wholly-owned subsidiary of Arkansas Best Corporation, ("Best") is engaged in third-party logistics management. Best offers logistics planning and management services to companies desiring to outsource these activities. Customers choosing to outsource logistics management do so to reduce logistics costs, to concentrate on their core business or to improve customer service. Logistics focuses on the management of inventory and information through the supply chain from vendor to consumer. Best's role is to design the logistics network, contract with the necessary suppliers, to implement and then manage the design. Although, third-party logistics is a relatively new industry, a large number of participants exist in the market. Many are related to transportation or warehousing companies. Tire Operations Treadco, Inc. Treadco is the nation's largest independent tire retreader for the trucking industry and the second largest commercial truck tire dealer. Treadco's revenues accounted for approximately 11% of the Company's consolidated revenues in 1993, and are divided approximately 56% and 44% between retread sales and new tire sales, respectively. In 1993, Treadco sold approximately 535,000 retreaded truck tires, which were manufactured at its production facilities in Arizona, Arkansas, Florida, Georgia, Louisiana, Missouri, Ohio, Oklahoma and Texas, and sold approximately 268,000 new tires. In August 1993, Treadco acquired substantially all the assets and liabilities of Trans-World Tire Corporation. As a result of the acquisition, Treadco added four production facilities which retread tires under Bandag Incorporated ("Bandag") franchise agreements and one satellite sales outlet. Retreaded truck tires are significantly less expensive than new truck tires (about one-third of the cost) and generally last as long as new tires used in similar applications. Moreover, most tire casings can be retreaded one or two times. The retail selling price of Treadco's retread tires ranges from about $75 to $110 with an average retail selling price of $82, compared to $260 to $325 for a new tire. Treadco also sells retreads including casings not supplied by the customer for $150 to $180, averaging about $161 per tire. Since tire expenses are a significant operating cost for the trucking industry, many truck fleet operators develop comprehensive periodic tire replacement and retread management programs. On its weekly sales routes, Treadco picks up a fleet's casings and returns them the following week, thus providing a continuous supply of both retreads and new tires as needed. In order to fully service its customers, Treadco also sells new truck tires manufactured by Bridgestone, Michelin, General, Dunlop, Sumitomo, Kumho, Toyo and other manufacturers. According to Bridgestone, Treadco is its largest domestic truck tire dealer, and according to Michelin, Treadco is one of its largest domestic truck tire dealers. Treadco was organized in June 1991 as the successor to the tire business conducted and developed by ABC Treadco, a wholly owned subsidiary of the Company. ABC Treadco transferred the tire business-related assets, including the Bandag Incorporated ("Bandag") franchise agreements, to Treadco in exchange for all the outstanding capital stock of Treadco. At the same time, Treadco assumed substantially all of the liabilities relating to the tire business, including bank debt which, prior to the asset transfer, has been outstanding under a credit agreement, and indebtedness owed to the Company. Treadco's assets were pledged to secure repayment of the bank debt under the credit agreement. In connection with the assumption of the bank debt, Treadco became the primary obligor with respect to such debt. In October 1991, Treadco completed an initial public offering of 2,679,300 shares (including 179,300 shares sold by ABC Treadco pursuant to an over-allotment option) of its common stock at $16.00 per share (the "Treadco Offering"). The net proceeds of the Treadco Offering were used to repay all of the outstanding bank debt and to repay the affiliate indebtedness owed to the Company. Upon prepayment of the bank debt, Treadco's obligations under the credit agreement were terminated and the pledge against the assets was released. In December 1993, ABC Treadco's investment in Treadco was transferred to the Company. As of December 31, 1993, the Company's percentage ownership of Treadco is 46%, while retaining control of Treadco by reason of its stock ownership, board representation and provision of management services. As a result, Treadco is consolidated with the Company for financial reporting purposes, with the ownership interest of the other stockholders reflected as a minority interest. The Bandag Relationship Treadco retreads truck tires pursuant to multi-year franchise agreements with Bandag. Bandag's proprietary, high quality retreading processes have enabled it to achieve the largest market presence in the retreading industry. Each of Treadco's production facilities is covered by a separate Bandag franchise agreement that grants Treadco the non-exclusive right to retread truck tires at the facility using Bandag's retreading process, materials and equipment and to sell such retread tires, using the "Bandag" trademark, without any territorial restrictions. In return, each of Treadco's production facilities covered by a Bandag franchise agreement must purchase its rubber requirements from Bandag at prices established by Bandag. The franchises also provide Treadco with a number of support programs, including training for technical and sales personnel, field-service engineering back-up, marketing programs and ongoing research and development. Bandag has informed Treadco that Treadco, with its 26 separate franchise locations, is Bandag's largest domestic franchisee in terms of the number of Bandag franchises and rubber purchases from Bandag. In 1991, Treadco renewed and amended its existing franchise agreements with Bandag, for terms ranging from five to seven years each. Each Bandag franchise agreement grants Treadco the non-exclusive right to make, use and sell tires retreaded by the Bandag method, including improvements developed by Bandag, during the term of the agreement. Treadco has the right to sell Bandag retreads whenever, to whomever and at any price Treadco may choose, but Treadco may manufacture retreaded tires using the Bandag method only at the authorized location referred to in each agreement. The new franchise agreements do not provide Treadco with an exclusive production or sales territory, nor do they prohibit Treadco (or any other Bandag franchisees) from opening sales offices in other desired locations. Sales and Marketing Treadco's sales and marketing strategy is based on its service strengths, network of production and sales facilities and strong regional reputation. In addition to excellent service, Treadco offers broad geographical coverage across the South and the lower Midwest. This coverage is important for customers because they are able to establish uniform pricing, utilize national account billing processes of the major new tire suppliers, and generally reduce the risk of price fluctuations when service is needed. None of Treadco's customers for retreads and new tires, including the Company and ABF, represented more than 4% of Treadco's revenues for 1993. ABF accounted for approximately $1.7 million of Treadco's revenues in 1993 (1.5%), and has not accounted for more than 10% of Treadco's revenues in the last ten years. Treadco's customers are primarily mid-sized companies that maintain their own in-house trucking operations and rely on Treadco's expertise in servicing their tire management programs. Treadco markets its products through sales personnel located at each of its 26 production facilities and, in addition, through 19 "satellite" sales locations maintained in Arizona, Arkansas, Florida, Georgia, Louisiana, Mississippi, Missouri, Ohio and Texas. These satellite sales locations are supplied with retreads by nearby Treadco production facilities. Treadco locates its production facilities and sales locations in close proximity to interstate highways and operates approximately 80 mobile service trucks to provide ready accessibility and convenience to its customers, particularly fleet owners. Employees At December 31, 1993, Treadco employed 652 full-time employees. Thirteen employees at one Treadco facility are represented by a union. Treadco's management believes it enjoys a good relationship with its employees. Environmental and Other Government Regulations The Company is subject to federal, state and local environmental laws and regulations relating to, among other things, contingency planning for spills of petroleum products, and its disposal of waste oil. Additionally, the Company is subject to significant regulations dealing with underground fuel storage tanks. ABF stores some of its fuel for its trucks and tractors in approximately 103 underground tanks located in 27 states. The Company believes that it is in substantial compliance with all such environmental laws and regulations and is not aware of any leaks from such tanks that could reasonably be expected to have a material adverse effect on the Company's competitive position, operations or financial condition. The Company has in place policies and methods designed to conform with these regulations. The Company estimates that capital expenditures for upgrading underground tank systems and costs associated with cleaning activities for 1994 will not be material. The Company has received notices from the EPA and others that it has been identified as a potentially responsible party ("PRP") under the Comprehensive Environmental Response Compensation and Liability Act or other federal or state environmental statutes at several hazardous waste sites. After investigating the Company's or its subsidiaries' involvement in waste disposal or waste generation at such sites, the Company has either agreed to de minimis settlements (aggregating approximately $210,000 over the last five years), or believes its obligations with respect to such sites would involve immaterial monetary liability, although there can be no assurances in this regard. The Company remains responsible for certain environmental claims that arose with respect to its ownership of Riverside Furniture Corporation ("Riverside") prior to its sale in 1989. Riverside was notified in 1988 that it has been identified as a PRP for hazardous wastes shipped to two separate sites in Arkansas. To date, the Company, as a part of a PRP group, has paid approximately $50,000 on Riverside's behalf related to one site, with additional assessments expected related to that site. Riverside was dismissed as a PRP from the second site in March 1993. Management currently believes that resolution of its remaining site is unlikely to have a material adverse effect on the Company, although there can be no assurance in this regard. Treadco is affected by a number of governmental regulations relating to the development, production and sale of retreaded and new tires, the raw materials used to manufacture such products (including petroleum, styrene and butaliene), and to environmental, tax and safety matters. In addition, the retreading process creates rubber particulate, or "dust," which requires gathering and disposal, and Treadco disposes of used and nonretreadable tire casings, both of which require compliance with environmental and disposal laws. In some situations, Treadco could be liable for disposal problems, even if the situation resulted from previous conduct of Treadco that was lawful at the time or from improper conduct of, or conditions caused by, persons engaged by Treadco to dispose of particulate and discarded casings. Such cleanup costs or costs associated with compliance with environmental laws applicable to the tire retreading process could be substantial and have a material adverse effect on Treadco's financial condition. Treadco believes that it is in substantial compliance with all laws applicable to such operations, however, and is not aware of any situation or condition that could reasonably be expected to have a material adverse effect on Treadco's financial condition. ITEM 2. ITEM 2. PROPERTIES Directly or indirectly through its subsidiaries, the Company owns its executive offices in Fort Smith, Arkansas, and owns or leases approximately 390 other operating facilities, approximately 339 and 45 of which relate to its motor carrier operations, and tire retreading and sales operations, respectively. In addition to its executive offices, the Company's principal motor carrier facilities are as follows: Location --------- North Little Rock, Arkansas Los Angeles, California Sacramento, California Denver, Colorado Ellenwood, Georgia Springfield, Illinois Albuquerque, New Mexico Asheville, North Carolina Dayton, Ohio Portland, Oregon Harrisburg/Camp Hill, Pennsylvania Dallas, Texas Salt Lake City, Utah The properties listed above are leased by ABF from ABC Treadco, with the exception of the facilities in Asheville, North Carolina and Sacramento, California, which are owned by ABF, and the facilities in Portland, Oregon and Salt Lake City, Utah, which are leased from outside third parties. There are three facilities at the Harrisburg/Camp Hill, Pennsylvania location. The Camp Hill and one of the Harrisburg facilities are leased from outside third parties. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In August 1990, a lawsuit was filed in the United States District Court for the Southern District of New York, by Riverside Holdings, Inc., Riverside Furniture Corporation and MR Realty Associates, L.P. ("Plaintiffs") against the Company and ABC Treadco ("Defendants"). Plaintiffs have asserted state law, ERISA and securities claims against Defendants in conjunction with Defendants' sale of Riverside Furniture Corporation in April 1989. Plaintiffs are seeking approximately $4 million in actual damages and $10 million in punitive damages. The Company is contesting the lawsuit vigorously. After consultation with legal counsel, the Company has concluded that resolution of the foregoing lawsuit is not expected to have a material adverse effect on the Company's financial condition. Various other legal actions, the majority of which arise in the normal course of business, are pending. None of these other legal actions is expected to have a material adverse effect on the Company's financial condition. The Company maintains liability insurance against risks arising out of the normal course of its business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of stockholders during the fourth quarter ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market and Dividend Information On December 31, 1993, there were 786 shareholders of record. The declaration and payment of, and the timing, amount and form of future dividends on the Common Stock will be determined by the Company's results of operations, financial condition, cash requirements, certain corporate law requirements and other factors deemed relevant by the board of directors. The Company's credit agreement limits the total amount of "restricted payments" that the Company may make, including dividends on its capital stock, to $10 million in any one calendar year. The annual dividend requirements on the Company's preferred stock issued February 3, 1993 (approximately $4.3 million) and dividends paid on the Common Stock at the quarterly rate of $.01 per share (approximately $0.8 million based on the current number of issued and outstanding shares) would aggregate dividends of approximately $5.1 million on an annual basis. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company is primarily engaged, through its motor carrier subsidiaries, in LTL shipments of general commodities. The Company is also engaged through its 46%-owned consolidated subsidiary, Treadco, in truck tire retreading and sales. The Company in 1991 reduced its ownership in Treadco, through an initial public offering of Treadco common stock, to approximately 46%, while retaining control of Treadco by reason of its stock ownership, board representation and provision of management services. As a result, Treadco is consolidated with the Company for financial reporting purposes, with the ownership interests of the other stockholders reflected as minority interest. Segment Data Results of Operations 1993 as Compared to 1992 Consolidated revenues of the Company for 1993 were $1.0 billion compared to $959.9 million for 1992. Operating profit for the Company was $50.6 million in 1993 compared to $55.8 million during 1992. Net income for 1993 was $20.3 million, or $.85 per common share, compared to a net loss of $(583,000), or $(.03) per common share in 1992. Income before extraordinary item was $21.0 million, or $.89 per common share for 1993, compared to income before extraordinary item and cumulative effect of accounting change of $18.8 million, or $.99 per common share for 1992. During 1993, the Company recorded an extraordinary loss of $(661,000) (net of income tax benefit of $413,000), or $(.04) per common share, for the net loss on extinguishments of debt. During 1992, the Company recorded an extraordinary loss of $(16.0) million (net of income tax benefit of $9.8 million), or $(.84) per common share, for the net loss on extinguishments of debt. Also, during 1992, the Company recorded a charge for the cumulative effect on prior years of an accounting change in the recognition of revenue of $(3.4) million (net of income tax benefit of $2.1 million), or $(.18) per common share. Earnings per common share for 1993 give consideration to preferred stock dividends of $3.9 million. Average common shares outstanding for 1993 were 19.2 million shares compared to 19.0 million shares for 1992. As reported in the third quarter, net income for 1993 was reduced by $828,000, or $.04 per common share, to reflect the effect on current and deferred taxes of the retroactive corporate tax rate increase which became law in the third quarter of 1993. Motor Carrier Operations Segment. Revenues for the motor carrier operations segment increased 4.0% to $893.5 million in 1993 from $858.8 million in 1992, reflecting primarily 4.0% increase in total tonnage. The increase in total tonnage consisted of a 3.1% increase LTL tonnage and a 7.3% increase in truckload tonnage. The 4.6% rate increase effective January 1, 1993 was aggressively discounted by rate competition during the first six months of 1993. The discounting stabilized in the last half of the year and for the fourth quarter of 1993, ABF's LTL revenue per hundredweight reflected a 1.0% increase over the fourth quarter of 1992. For 1993, ABF's LTL revenue per hundredweight was up .2% compared to the average for 1992. Discounting and a relatively slow economy during the first half of the year also affected tonnage growth for 1993. Effective January 1, 1994, ABF implemented a general freight rate increase of 4.5% which is expected to result in a 3 to 3.25% initial impact on revenues. The diminished effect is the result of pricing that is on a contract basis which can only be increased when the contract is renewed. Motor carrier segment operating expenses as a percent of revenues was 95.3% for 1993 compared to 94.6% for 1992. Salaries and wages for motor carrier operations as a percent of revenues increased to 66.5% in 1993 from 65.3% in 1992, resulting primarily from contractual wage increases (averaging 2.7% annually for 1993) which went into effect in April 1993 under the current collective bargaining agreement. The current agreement expires March 31, 1994. The new agreement is currently under negotiation and terms are unknown at this time. Supplies and expenses for motor carrier operations as a percent of revenues decreased to 11.1% in 1993 from 11.6% in 1992 resulting primarily from the covering of the fixed portion of supplies and expenses by increased revenues. Depreciation and amortization expense for motor carrier operations as a percent of revenues decreased to 2.9% in 1993 from 3.8% in 1992. During the last three years, ABF financed its road tractor replacement program with operating leases instead of capital leases, which decreased both interest and depreciation expense and increased rent expense. Rent expense for motor carrier operations as a percent of revenues increased to 5.9% in 1993 from 4.6% in 1992. The additional rent expense was incurred primarily as a result of the operating leases discussed above and the utilization of alternate modes of outside transportation. Tire Operations Segment. Treadco's revenues for 1993 increased 15.9% to $111.6 million from $96.3 million in 1992. The increase resulted primarily from internal growth and the addition of four production facilities and one sales facility through the August 30, 1993 acquisition of Trans-World Tire Corporation in Florida. Revenues from retreading in 1993 increased 17.6% to $61.9 million from $52.6 million in 1992. Revenues from new tire sales increased 13.9% to $49.7 million in 1993 from $43.7 million in 1992. Tire operations segment operating expenses as a percent of revenues were 90.9% for each of 1993 and 1992. Cost of sales for the tire operations segment as a percent of revenues decreased to 71.5% in 1993 from 71.8% in 1992. Selling, administrative and general expenses for the tire operations segment increased to 19.3% in 1993 from 19.1% in 1992. Interest. Interest expense decreased 58.1% to $7.2 million in 1993 from $17.3 million during 1992. A reduction in long-term debt outstanding using proceeds from the Company's stock offerings, lower interest rates and utilization of operating leases resulted in the decrease in interest expense. The reduction in long-term debt consisted primarily of retiring its 14% Senior Subordinated Notes due 1998, maintaining a lesser average balance outstanding under the revolving credit facilities, and financing a portion of its revenue equipment with operating leases. Income Taxes. The difference between the effective tax rate in 1993 and the federal statutory rate resulted primarily from state income taxes, amortization of goodwill, minority interest, undistributed earnings of Treadco and other nondeductible expenses (see Note G to the consolidated financial statements). In August 1993, the Revenue Reconciliation Act of 1993 was enacted, which required a retroactive increase in the corporate federal tax rate. This resulted in an increase in the tax expense and a corresponding decrease in net income of $828,000. The increase in the corporate federal tax rate was accounted for in accordance with Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). 1992 As Compared With 1991 Consolidated revenues of the Company for 1992 increased 8.5% to $959.9 million from $884.5 million in 1991. Operating profit of the Company increased 52.8% to $55.8 million from $36.5 million in 1991. For 1992, the Company had income before an extraordinary item and the cumulative effect of an accounting change of $18.8 million, or $.99 per share, compared to $7.8 million, or $.61 per share, for 1991. In 1992, the Company recorded an extraordinary loss of $(16.0) million (net of income taxes of $9.8 million), or $(.84) per share, for the net loss on extinguishments of debt, following its public offering in May 1992. Pursuant to a pronouncement by the Emerging Issues Task Force of the Financial Accounting Standards Board, effective January 1, 1992, the Company changed its accounting method whereby revenue is recognized based on relative transit time in each reporting period with expenses continuing to be recognized as incurred. This change in accounting method resulted in a charge to earnings for 1992 having a cumulative effect of $(3.4) million (net of income taxes of $2.1 million), or $(.18) per share. After giving effect to the extraordinary item and the cumulative effect of the accounting change, the Company had a net loss for 1992 of $(583,000), or $(.03) per share, compared to net income of $7.2 million, or $.57 per share, for 1991. Net income for 1991 included a gain on the sale of subsidiary stock of $8.8 million (net of income taxes of $5.3 million), or $.69 per share. Average shares outstanding for 1992 increased to 19.0 million shares from 12.7 million shares in 1991. Motor Carrier Operations Segment. Revenues for the motor carrier operations segment increased 7.7% to $858.8 million in 1992 from $797.4 million in 1991, reflecting primarily an 8.4% increase in total tonnage offset in part by a 0.7% decrease in revenue per hundredweight. The decrease in revenue per hundredweight is due to some shift in the mix of shipment sizes, continued price competition and competitive pressure from truckload carriers on the larger shipments. The increase in total tonnage consisted of a 6.6% increase in LTL tonnage and a 15.0% increase in truckload tonnage. Effective January 1, 1993, ABF implemented a general freight rate increase of 4.6% which is expected to result in a 2.5 - 3% initial impact on revenues. The diminished effect is the result of pricing that is on a contract basis which can only be increased when the contract is renewed. Motor carrier segment operating expenses as a percent of revenues improved to 94.6% in 1992 from 96.2% in 1991. Salaries and wages for motor carrier operations as a percent of revenues increased to 65.3% in 1992 from 64.9% in 1991, resulting primarily from contractual wage increases (averaging 2.8% annually for 1992) which went into effect in April 1992 under the current collective bargaining agreement. Under the agreement, contractual wage increases are expected to increase approximately 2.7%, for 1993. Supplies and expenses for motor carrier operations as a percent of revenues decreased to 11.6% in 1992 from 11.9% in 1991. The decrease resulted primarily from the covering of the fixed portion of supplies and expenses by increased revenues. Operating taxes and licenses for motor carrier operations as a percent of revenues decreased to 3.8% during 1992 from 4.0% in 1991. The decrease resulted primarily from the higher level of revenues. Depreciation and amortization expense for motor carrier operations as a percent of revenues decreased to 3.8% in 1992 from 4.7% in 1991. In 1992 and 1991, ABF financed its road tractor replacement program with operating leases instead of capital leases, which decreased both interest and depreciation expense and increased rents. Rent expense for motor carrier operations as a percent of revenues increased to 4.6% in 1992 from 4.5% in 1991. The additional rent expense incurred as a result of the operating leases discussed above was partially offset by the covering of other rents by increased revenues. Other motor carrier operating expense decreased to 0.5% during 1992 from 0.6% in 1991. Other non-operating expenses decreased to 0.2% in 1992 from 0.6% in 1991. The decrease resulted primarily from gains on asset sales of $1.4 million for 1992 compared to a $1.2 million loss during 1991. Also, amortization of deferred financing costs decreased to $60,000 in 1992 from $1.4 million in 1991. Deferred financing costs associated with the Notes retired were written off and therefore reduced amortization expense. Tire Operations Segment. Treadco's revenues for 1992 increased 15.7% to $96.3 million from $83.2 million during 1991, reflecting primarily the addition of two production facilities in August 1991 and April 1992, three sales locations in 1991 and two sales locations in 1992. Revenues from retreading for 1992 increased 18.0% to $52.6 million from $44.6 million in 1991. Revenues from new tire sales for 1992 increased 13.0% to $43.7 million from $38.6 million in 1991. Tire operations segment operating expenses as a percent of revenues improved to 90.9% in 1992 from 91.4% in 1991, reflecting primarily a decrease in other non-operating expenses. Other non-operating expenses as a percent of revenues were negligible for 1992 compared to 1.1% for 1991. Included in other non-operating expenses is the amortization of deferred financing costs which was $18,500 for 1992 compared to $881,000 in 1991. Deferred financing costs associated with the debt retired as a result of the Treadco Offering were written off and therefore reduced amortization expense. Cost of sales as a percent of revenues increased to 71.8% in 1992 from 71.4% in 1991. The increase is due primarily to costs relating to a Bandag price increase for tread rubber, which were not fully passed on to customers. Management does not know to what extent future price increases can be passed on to customers. Selling, administrative and general expenses increased to 19.1% in 1992 from 18.9% for 1991, reflecting costs associated with being public and an increase in insurance reserves to cover expected losses. Interest. Interest expense decreased 49.8% to $17.3 million during 1992 from $34.4 million in 1991. A reduction in long-term debt outstanding, lower interest rates and utilization of operating leases resulted in the decrease in interest expense. The reduction in long-term debt consisted primarily of the tender for $113.8 million of the Notes with the proceeds from the Company's Common Stock offering and the repayment of $36.6 million of outstanding bank debt in connection with the Treadco Offering. Income Taxes. The difference between the effective tax rate for 1992 and the federal statutory rate resulted primarily from state income taxes, amortization of goodwill, minority interest, undistributed earnings of Treadco and other nondeductible expenses (see Note G to the consolidated financial statements). Liquidity and Capital Resources The Company and certain banks are parties to a Credit Agreement with Societe Generale, as Agent and NationsBank of Texas as Co-Agent (the "Credit Agreement") which provides funds available under a three-year Revolving Credit Facility of $100 million, including $40 million for letters of credit. There are no borrowings outstanding under the Revolving Credit Facility and approximately $39 million of letters of credit outstanding at December 31, 1993. The Revolving Credit Facility is payable on June 30, 1996. Outstanding revolving credit advances may not exceed a borrowing base calculated using the Company's revenue equipment, real property and the Treadco common stock owned by the Company. At December 31, 1993, the borrowing base was $93.9 million. The Company has paid and will continue to pay certain customary fees for such commitments and loans. Amounts advanced under the revolving credit facility bear interest, at the Company's option, at a rate per annum of either:(i) the greater of (a) the agent bank's prime rate and (b) the Federal Funds Rate plus 1/2%; or (ii) LIBOR plus 1 1/2%. The Credit Agreement contains various covenants which limit, among other things, dividends, indebtedness, capital expenditures, loans and investments, as well as requiring the Company to meet certain financial tests. As of December 31, 1993, these covenants have been met. If there is an event of default which is not remedied or waived within 10 days, the Credit Agreement will become secured to the extent of amounts then outstanding of all of the Company's revenue equipment, real property and common stock included in the borrowing base (subject to certain exceptions). The Credit Agreement also, at December 1992, included a $50 million Term Loan Facility. In February 1993, the Company completed its public offering of 1,495,000 shares of Preferred Stock. The Company used the net proceeds of approximately $71.9 million to repay the Term Loan and for general corporate purposes. The Preferred Stock is convertible at the option of the holder into Common Stock at the rate of 2.54 shares of Common Stock for each share of Preferred Stock. Annual dividends are $2.875 and are cumulative. The Preferred Stock is redeemable at the Company's option on or after February 15, 1996 at $52.01 per share plus accumulated unpaid dividends, and is exchangeable at the option of the Company for the Company's 5 3/4% Convertible Subordinated Debentures due February 15, 2018 at a rate of $50 principal amount of debentures for each share of Preferred Stock. The holders of the Preferred Stock have no voting rights unless dividends are in arrears six quarters or more, at which time the holders have the right to elect two directors of the Company until all dividends have been paid. Treadco is a party to a revolving credit facility with Societe Generale (the "Treadco Credit Agreement") providing for borrowings of up to the lesser of $12 million or the applicable borrowing base. At December 31, 1993, the borrowing base was $22.7 million. Borrowings under the Treadco Credit Agreement are collateralized by accounts receivable and inventory. Borrowings under the agreement bear interest, at Treadco's option, at 1% above the bank's LIBOR rate, or at the higher of the bank's prime rate or the "federal funds rate" plus 1/2%. At December 31, 1993, the interest rate was 5%. At December 31, 1993, Treadco had $7 million outstanding under the Treadco Credit Agreement. Treadco pays a commitment fee of 3/8% on the unused amount under the Treadco Credit Agreement. The Treadco Credit Agreement contains various convenants which limit, among other things, dividends, disposition of receivables, indebtedness and investments, as well as requiring Treadco to meet certain financial tests which have been met. Under the Treadco Credit Agreement, Treadco's assets are subject to pledge and, therefore, are available for use only by that subsidiary. The amounts presented in the table under operating leases reflect the estimated purchase price of the equipment had the Company purchased the equipment versus financing through operating lease transactions. In 1994, the Company anticipates spending approximately $70.9 million in total capital expenditures net of proceeds from equipment sales. It is expected that approximately $20 million of the expenditures for facilities will be financed through a term loan facility, $16.4 million of equipment expenditures will be financed by capital leases and the remaining $34.5 million will be financed through internally generated funds and borrowings under the Credit Agreement and Treadco Credit Agreement. Management believes, based upon the Company's current levels of operations and anticipated growth, the Company's cash, capital resources, borrowings available under the Credit Agreement and cash flow from operations will be sufficient to finance current and future operations and meet all present and future debt service requirements. The Company is a signatory with the Teamsters to the National Master Freight Agreement which expires March 31, 1994. Terms of the new agreement, which is currently under negotiation, are unknown at this time. There has not been a strike under this agreement since 1979; however, in the event of a strike, the Company's liquidity could be adversely impacted. The motor carrier segment is affected by seasonal fluctuations, which affect tonnage to be transported. Freight shipments, operating costs and earnings are also affected adversely by inclement weather conditions. The third calendar quarter of each year usually has the highest tonnage levels while the first quarter has the lowest. Treadco's operations are somewhat seasonal with the last six months of the calendar year generally having the highest levels of sales. Subsequent Event On March 2, 1994, ABF, Renaissance Asset Funding Corp. ("Renaissance") and Societe Generale entered into a receivables purchase agreement. The agreement allows ABF to sell to Renaissance interests of up to $55 million in a pool of receivables. ABF does not have any receivables sold at this time, but expects to use this facility from time to time throughout the year for various corporate needs, including working capital. New Accounting Standards In November 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"), requiring accrual accounting for non- accumulating postemployment benefits, such as disability and death benefits instead of recognizing an expense for those benefits when paid. The Company will comply with the new rules beginning January 1, 1994, using the cumulative effect method. The Company is accumulating the necessary data to adopt the standard and does not anticipate that adoption of this statement will materially impact net income in 1994. Environmental Matters ABF stores some fuel for its tractors and trucks in approximately 103 underground tanks located in 27 states. Maintenance of such tanks is regulated at the federal and, in some cases, state levels. ABF believes that it is in substantial compliance with all such regulations. ABF is not aware of any leaks from such tanks that could reasonably be expected to have a material adverse effect on the Company. Environmental regulations have been adopted by the United States Environmental Protection Agency ("EPA") that will require ABF to upgrade its underground tank systems by December 1998. ABF currently estimates that such upgrades, which are currently in process, will not have a material adverse effect on the Company. The Company has received notices from the EPA and others that it has been identified as a potentially responsible party ("PRP") under the Comprehensive Environmental Response Compensation and Liability Act or other federal or state environmental statutes at several hazardous waste sites. After investigating the Company's or its subsidiaries' involvement in waste disposal or waste generation at such sites, the Company has either agreed to de minimis settlements (aggregating approximately $210,000 over the last five years), or believes its obligations with respect to such sites would involve immaterial monetary liability, although there can be no assurances in this regard. The Company remains responsible for certain environmental claims that arose with respect to its ownership of Riverside prior to its sale in 1989. Riverside was notified in 1988 that it had been identified as a PRP for hazardous wastes shipped to two separate sites in Arkansas. To date, the Company, as a part of a PRP group, has paid approximately $50,000 on Riverside's behalf related to one site, with additional assessments expected related to that site. Riverside was dismissed as a PRP from the second site in March 1993. Management currently believes that resolution of its remaining site is unlikely to have a material adverse effect on the Company, although there can be no assurance in this regard. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response of this item is submitted in a separate section 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 OFFICERS OF THE REGISTRANT The sections entitled "Election of Directors," "Directors of the Company," "Board of Directors and Committees," "Executive Officers of the Company" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the Company's proxy statement for the annual meeting of stockholders to be held on May 10, 1994, set forth certain information with respect to the directors, nominees for election as directors and executive officers of the Company and are incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The sections entitled "Executive Compensation," "Option/SAR Exercises and Holdings," "Executive Compensation and Development and Stock Option Committees Interlocks and Insider Participation," "Retirement and Savings Plan," "Termination of Employment Agreements" and the paragraph concerning directors compensation in the section entitled "Board of Directors and Committees" in the Company's proxy statement for the annual meeting of stockholders to be held on May 10, 1994, set forth certain information with respect to compensation of management of the Company and are incorporated herein by reference, provided however, the information contained in the sections entitled "Report on Executive Compensation by Committees" and "Stock Performance Graph" are not incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The section entitled "Principal Shareholders and Management Ownership" in the Company's proxy statement for the annual meeting of stockholders to be held on May 10, 1994, set forth certain information with respect to the ownership of the Company's voting securities and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The section entitled "Certain Transactions and Relationships" in the Company's proxy statement for the annual meeting of stockholders to be held on May 10, 1994, set forth certain information with respect to relations of and transactions by management of the Company and 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 response to this portion of Item 14 is submitted as a separate section of this report. (a)(2) Financial Statement Schedules The response to this portion of Item 14 is submitted as a separate section of this report. (a)(3) Exhibits Exhibit 10 - Receivables Purchase Agreement dated as of March 2, 1994, by and between ABF Freight System, Inc., Renaissance Asset Funding Corp. and Societe Generale. Exhibit 11 - Statement Re: Computation of Per Share Earnings (Loss) Exhibit 22 - List of Subsidiary Corporations Exhibit 23 - Consent of Independent Auditors (b) Reports of Form 8-K There were no reports filed on Form 8-K during the last quarter of 1993. (c) Exhibits See Item 14(a)(3) above. (d) Financial Statements 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 underesigned, thereunto duly authorized. ARKANSAS BEST CORPORATION By: s/Donald L. Neal -------------------------------- Donald L. Neal Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- s/William A. Marquard Chairman of the Board, Director 3/7/94 - ---------------------------- ------- William A. Marquard s/Robert A. Young, III Director, Chief Executive Officer 3/9/94 - ---------------------------- and President (Principal -------- Robert A. Young, III Executive Officer) s/Donald L. Neal Senior Vice President - Chief 3/9/94 - ---------------------------- Financial Officer (Principal -------- Donald L. Neal Financial and Accounting Officer) s/Frank Edelstein Director 3/7/94 - ---------------------------- -------- Frank Edelstein s/Arthur J. Fritz Director 3/4/94 - ---------------------------- -------- Arthur J. Fritz s/John H. Morris Director 3/7/94 - ---------------------------- -------- John H. Morris s/Alan J. Zakon Director 3/3/94 - ---------------------------- -------- Alan J. Zakon ANNUAL REPORT ON FORM 10-K ITEM 8, ITEM 14(a)(1) and (2), (c) and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 ARKANSAS BEST CORPORATION FORT SMITH, ARKANSAS FORM 10-K -- ITEM 14(a)(1) and (2) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES ARKANSAS BEST CORPORATION The following consolidated financial statements of Arkansas Best Corporation 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 Shareholders' Equity -- Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows -- Years ended December 31, 1993, 1992 and 1991 The following consolidated financial statement schedules of Arkansas Best Corporation 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 Accounts 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. REPORT OF INDEPENDENT AUDITORS Shareholders and Board of Directors Arkansas Best Corporation We have audited the accompanying consolidated balance sheets of Arkansas Best Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the 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 Arkansas Best Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note C to the consolidated financial statements, in 1992 the Company changed its revenue recognition method. ERNST & YOUNG Little Rock, Arkansas January 28, 1994 ARKANSAS BEST CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 NOTE A - ORGANIZATION, PUBLIC OFFERINGS AND DESCRIPTION OF BUSINESS Arkansas Best Corporation (the "Company") is a diversified holding company engaged through its subsidiaries primarily in motor carrier operations and truck tire retreading and sales. The Company acquired its subsidiaries pursuant to a cash tender offer on July 26, 1988. For financial statement purposes, the acquisition was accounted for under the purchase method effective July 26, 1988. Principal subsidiaries owned are ABF Freight System, Inc., ("ABF"), Treadco, Inc. ("TREADCO"), and ABC Treadco, Inc. ("ABC Treadco"). Due to the extent of management shareholders of the predecessor company continuing their ownership interest in the Company subsequent to the 1988 acquisition, the equity interest of these management shareholders was valued at the predecessor basis rather than at fair market value. Accordingly, the new basis of reporting for the Company's net assets using fair market values at the date of the acquisition was reduced by $15,371,000 to reflect the carryover basis of the management shareholders. In February 1993, the Company completed a public offering of 1,495,000 shares of $2.875 Series A Cumulative Convertible Exchangeable Preferred Stock at $50 per share. The total net proceeds to the Company were approximately $71.9 million and were used to repay the $50 million term loan with Societe Generale. This transaction resulted in a loss on extinguishment of debt of $167,000 (net of income tax benefit of $103,000), which is reported as an extraordinary item in the accompanying consolidated financial statements. The Company completed an initial public offering of 15.7 million shares of common stock at $14 per share (the "Offering") on May 13, 1992. The Company sold 10.7 million shares with the remaining shares being sold by a shareholder. The total net proceeds to the Company as a result of the Offering were approximately $140.9 million and were used to repurchase $113.9 million of the Company's outstanding 14% Senior Subordinated Notes due 1998 (the "Notes") and to make premium and consent payments and pay certain other related expenses. This transaction resulted in a loss on extinguishment of debt of $15.9 million (net of income tax benefit of $9.7 million) which is reported as an extraordinary item in the accompanying consolidated financial statements. Assuming the public offering had occurred on January 1, 1992, with the Notes repurchased at that time, pro forma income before extraordinary items and cumulative effect of accounting change would have been approximately $22,902,000, or $.97 per share, for the year ended December 31, 1992. The average shares outstanding used in this computation was 23,531,434, which does not give consideration to the repurchase of 4,439,000 shares of Common Stock in November 1992 (see Note H). NOTE B - SALE OF SUBSIDIARY STOCK In June 1991, TREADCO was organized as the successor to the tire business previously conducted by ABC Treadco, a wholly owned subsidiary of the Company. In 1991, TREADCO completed an initial public offering of 2,679,300 of its common shares for $16 per share. The Company recognized an $8.8 million gain (net of tax of $5.3 million) on the transaction. The net proceeds of the offering were $39.3 million and were used to prepay outstanding bank and intercompany debt. TREADCO incurred a loss on extinguishment of debt of $.5 million (net of tax benefit of $.3 million) due to the write-off of deferred financing costs, which is reported as an extraordinary item in the accompanying consolidated financial statements. In December 1993, ABC Treadco's investment in TREADCO was transferred to the Company. As of December 31, 1993, the Company's percentage ownership of TREADCO is 46%. The Company's consolidated financial statements continue to consolidate the accounts of TREADCO, with the ownership interests of the other stockholders reflected as minority interest, because the Company continues to control TREADCO through stock ownership, board representation and agreement to provide management services under a transition services agreement. On August 29, 1993, TREADCO purchased substantially all of the assets and liabilities of Trans-World Tire Corporation Inc., a new and retread truck tire operation. Assets of approximately $8.2 million and liabilities of approximately $6.4 million were acquired for a purchase price of $2.9 million. A total of $1.1 million of goodwill was recognized in connection with the purchase. NOTE C - ACCOUNTING POLICIES Consolidation: The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. Cash and Cash Equivalents: Short term investments which have a maturity of ninety days or less when purchased are considered cash equivalents. Concentration of Credit Risk: The Company's services are provided primarily to customers throughout the United States and Canada. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Historically, credit losses have not been significant. Inventories: Inventories are stated at the lower of cost (first-in, first- out basis) or market. Property, Plant and Equipment: As of July 26, 1988, property, plant and equipment was recorded at its estimated fair market value in connection with the purchase described in Note A. Purchases of property, plant and equipment subsequent to July 26, 1988 are recorded at cost. For financial reporting purposes, such property is depreciated principally by the straight-line method. For tax reporting purposes, accelerated depreciation or cost recovery methods are used, with the assets' predecessor tax basis being used. Gains and losses on asset sales are reflected in the year of disposal. Trade- in allowances in excess of the book value of revenue equipment traded are accounted for by adjusting the cost of assets acquired. Tires and tubes purchased with revenue equipment are capitalized as a part of the cost of such equipment, with replacement tires and tubes being expensed when placed in service. Goodwill: Excess cost over fair value of net assets acquired (goodwill) is amortized on a straight-line basis over 15 to 40 years. The carrying value of goodwill will be reviewed if the facts and circumstances suggest that it may be impaired. If this review indicates that goodwill will not be recoverable, as determined based on the undiscounted cash flows over the remaining amortization period, the Company's carrying value of the goodwill would be reduced by the estimated shortfall of cash flows. No reduction was required for 1991 through 1993. Income Taxes: Effective January 1, 1993, the Company adopted Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). As permitted under the new rules, prior years' financial statements have not been restated. The Company previously used the liability method required by FAS 96. The adoption of FAS 109 as of January 1, 1993, had no impact on income. Under FAS 109, the liability method is used in accounting for income taxes. Under this method, deferred income taxes relate principally to asset and liability basis differences arising from the 1988 purchase transaction, to the timing of the depreciation and cost recovery deductions previously described and to temporary differences in the recognition of certain revenues and expenses of carrier operations. Revenue Recognition: Prior to 1992, carrier operating revenues were recognized on the date the shipments were picked up from the customer, with expenses recognized as incurred. In January 1992, the Emerging Issues Task Force of the Financial Accounting Standards Board reached a consensus that recognition of revenue for freight when picked up from the customer is no longer an acceptable accounting method. As a result, the Company adopted a new revenue recognition method effective January 1, 1992 whereby revenue is recognized based on relative transit time in each reporting period with expenses continuing to be recognized as incurred. This change in accounting method resulted in a charge to earnings in the first quarter of 1992 having a cumulative effect of approximately $3,400,000 (net of income taxes of $2,000,000). Unaudited pro forma results of operations as though the Company had adopted the change in accounting method as of January 1, 1991 and actual information for comparison purposes are as follows: Earnings (Loss) Per Share: The calculation of earnings (loss) per share is based on the weighted average number of common and common equivalent shares outstanding during the applicable period and retroactively adjusted for the effect of a March 1992 2.797 for 1 stock split in the form of a stock dividend. (See Note H.) The calculation reduces income available to common shareholders by preferred stock dividends paid or accrued during the period. Accounting for Sales of Stock by Subsidiaries: It is the Company's policy to recognize gains and losses on sales of subsidiary stock when incurred. Claims Liabilities: The Company is self-insured up to certain limits for workers' compensation, cargo loss and damage and certain property damage and liability claims. Provision has been made for the estimated liabilities for such claims as incurred. Recently Issued Financial Accounting Standards: In November 1993, the Financial Accounting Standards Board issued FAS 112, requiring accrual accounting for non-accumulating postemployment benefits, such as disability and death benefits instead of recognizing an expense for those benefits when paid. The Company will be required to comply with the new rules beginning January 1, 1994, using the cumulative effect method. The Company is accumulating the necessary data to adopt the standard and does not anticipate that adoption of this standard will materially impact net income in 1994. NOTE D - INVENTORIES NOTE E - LONG-TERM DEBT AND CREDIT AGREEMENTS (1) Term Loan and Revolving Credit Facilities: The Company and certain banks are parties to a Credit Agreement with Societe Generale, as Agent and NationsBank of Texas as Co-Agent (the "Credit Agreement") which provides funds available under a three-year Revolving Credit Facility of $100 million, including $40 million for letters of credit. There are no borrowings outstanding under the Revolving Credit Facility and approximately $39 million of letters of credit outstanding at December 31, 1993. The Revolving Credit Facility is payable on June 30, 1996. The Credit Agreement also requires mandatory prepayments to be made under certain circumstances, including the sales of certain assets and net cash proceeds from the issuance of certain equity or debt securities. The Credit Agreement also, at December 1992, included a $50 million Term Loan Facility. This facility was repaid with proceeds from the issuance of preferred stock in February 1993 (see Note A). The Company pays a commitment fee of 3/8% on the unused amount under the Revolving Credit Facility. Loans under the Credit Agreement bear interest at the Company's option, at a rate per annum of either: (i) the greater of (a) the agent bank's prime rate and (b) the Federal Funds Rate plus 1/2%; or (ii) LIBOR plus 1 1/2%. The Credit Agreement contains various covenants which limit, among other things, dividends, indebtedness, capital expenditures, loans and investments, as well as requiring the Company to meet certain financial tests. As of December 31, 1993, these covenants have been met. If there is an event of default which is not remedied or waived within 10 days, the Credit Agreement will become secured to the extent of amounts then outstanding of all of the Company's receivables, revenue equipment, real property and TREADCO common stock included in the borrowing base (subject to certain exceptions). (2) TREADCO is a party to a revolving credit facility with Societe Generale (the "TREADCO Credit Agreement") providing for borrowings of up to the lesser of $12 million or the applicable borrowing base. Borrowings under the TREADCO Credit Agreement are collateralized by accounts receivable and inventory. Borrowings under the agreement bear interest, at TREADCO's option, at 1% above the bank's LIBOR rate, or at the higher of the bank's prime rate or the "federal funds rate" plus 1/2%. At December 31, 1993, the interest rate was 5%. At December 31, 1993, TREADCO had $7 million outstanding under the Revolving Credit Agreement. TREADCO pays a commitment fee of 3/8% on the unused amount under the TREADCO Credit Agreement. The TREADCO Credit Agreement contains various covenants which limit, among other things, dividends, disposition of receivables, indebtedness and investments, as well as requiring TREADCO to meet certain financial tests which have been met. Under the TREADCO Credit Agreement, TREADCO's assets are subject to pledge and, therefore, are available for use only by that subsidiary. (3) The Notes were redeemed during the year at a premium of 8.75% and 5.25%. The balance of deferred financing costs were expensed. The total extraordinary loss recognized with the repurchase was $494,000 (net of income tax benefit of $310,000). (4) Includes approximately $46,823,000 relative to leases of carrier revenue equipment with an aggregate net book value of approximately $47,388,000 at December 31, 1993. These leases have a weighted average interest rate of approximately 8.3%. Also includes approximately $2,596,000 relative to leases of various terminals and a data processing building expansion, financed by Industrial Revenue Bond Issues, with a weighted average interest rate of approximately 7.4%. The net book value of the related assets was approximately $4,857,000 at December 31, 1993. Annual maturities on long-term debt, excluding capitalized lease obligations (see Note I), in 1994 through 1998 aggregate approximately $1,537,000; $187,000; $7,125,000; $109,000 and $120,000, respectively. Interest paid was $7,226,000 in 1993, $22,174,000 in 1992, and $36,385,000 in 1991. NOTE F - ACCRUED EXPENSES NOTE G - FEDERAL AND STATE INCOME TAXES Deferred income taxes include deferred state income taxes, net of federal benefits of $126,000 for 1992 and $12,000 for 1991. Income taxes paid were $20,740,000 in 1993, $6,302,000 in 1992, and $5,285,000 in 1991. In August 1993, the Revenue Reconciliation Act of 1993 was enacted, which required a retroactive increase in the corporate federal tax rate. This resulted in an increase in the tax expense and a corresponding decrease in net income of $828,000. The increase in the corporate federal tax rate was accounted for in accordance with FAS 109. The Company has a foreign tax credit carryover of approximately $100,000. If unused, the foreign tax credit carryover expires in 1998. Tax benefits of $320,000 for the 1991 extraordinary item are not included in the amounts disclosed above. NOTE H - SHAREHOLDERS' EQUITY Preferred Stock. On February 19, 1993, the Company completed a public offering of 1,495,000 shares of Preferred Stock at $50 per share. The preferred stock is convertible at the option of the holder into Common Stock at the rate of 2.5397 shares of Common Stock for each share of Preferred Stock. Annual dividends are $2.875 and are cumulative. The Preferred Stock is exchangeable, in whole or in part, at the option of the Company on any dividend payment date beginning February 15, 1995, for the Company's 5 3/4% Convertible Subordinated Debentures due February 15, 2018, at a rate of $50 principal amount of debentures for each share of Preferred Stock. The Preferred Stock is redeemable at any time on or after February 15, 1996, in whole or in part, at the Company's option, initially at a redemption price of $52.0125 per share and thereafter at redemption prices declining to $50 per share on or after February 15, 2003, plus unpaid dividends to the redemption date. Holders of Preferred Stock have no voting rights unless dividends are in arrears six quarters or more, at which time they have the right to elect two directors of the Company until all dividends have been paid. Total dividends paid during 1993 were $3,904,000. Stock Split. On March 13, 1992, the Company's Board of Directors voted to amend its Certificate of Incorporation to increase the Company's authorized Common Stock, $.01 par value, from 9,000,000 to 70,000,000 shares. In addition, the Company declared a 2.797 for 1 stock split of the Common Stock, $.01 par value (effected in the form of a stock dividend of 1.797 shares on each outstanding share). All references to share and per share data in the accompanying consolidated financial statements have been retroactively restated to give effect to the stock split. Repurchase of Common Stock. On November 13, 1992, 4,439,000 shares of Common Stock were repurchased from Kelso Best Partners, L.P. ("Kelso"), the Company's largest shareholder. These were purchased at a cost of $12.50 per share (a discount of $1.50 per share to the then quoted NASDAQ NMS sale price). These shares were subsequently retired by the Company. Stock Options. On March 13, 1992, the Company adopted a stock option plan which provides 1,000,000 shares of Common Stock for the granting of options to directors and key employees of the Company. On May 1993, the Company adopted a disinterested directors stockholder plan, which provides 225,000 shares of common stock for the granting of options to directors who administer the Company's stock option plan and are not permitted to receive stock option grants under such plan. These options are exercisable at the date they are granted. Shareholders' Rights Plan. Each issued and outstanding share of Common Stock has associated with it one Common Stock purchase right to purchase a share of Common Stock from the Company at a price of $60.00. Such rights are not exerciseable until certain events occur as detailed in the rights agreement. NOTE I - LEASES AND COMMITMENTS Rental expense amounted to approximately $58,369,000 in 1993, $45,875,000 in 1992, and $42,130,000 in 1991. Certain of the leases are renewable for substantially the same rentals for varying periods. Future minimum rentals to be received under noncancellable subleases totaled approximately $2,870,000 at December 31, 1993. The revenue equipment leases extend from two to seven years and contain renewal or fixed price purchase options. The lease agreements require the lessee to pay property taxes, maintenance and operating expenses. Lease amortization is included in depreciation expense. Capital lease obligations of $17,885,000, $5,491,000 and $11,841,000 were incurred for the years ended December 31, 1993, 1992 and 1991, respectively. Commitments for purchase of revenue equipment aggregated approximately $31,327,000 at December 31, 1993. Commitments for capital expenditures aggregate approximately $13,685,000 at December 31, 1993, for construction of a new corporate office building. The Company incurred annual fees of $300,000 in 1992, and $400,000 in 1991 for services rendered by Kelso. In 1992, an additional $1,000,000 was paid to Kelso as an advisory fee in connection with the repurchase of the Notes. The service agreement with Kelso was terminated effective December 31, 1992. NOTE J - LEGAL PROCEEDINGS AND ENVIRONMENTAL MATTERS In August 1990, a lawsuit was filed in the United States District Court for the Southern District of New York, by Riverside Holdings, Inc., Riverside Furniture Corporation ("Riverside") and MR Realty Associates, L.P. ("Plaintiffs") against the Company and Treadco. Plaintiffs have asserted state law, Employee Retirement Income Security Act of 1974 and securities claims against the Company in conjunction with the Company's sale of Riverside in April 1989. Plaintiffs are seeking approximately $4 million in actual damages and $10 million in punitive damages. The Company is vigorously contesting the lawsuit. After consultation with legal counsel, the Company has concluded that resolution of the foregoing lawsuit is not expected to have a material adverse effect on the Company's financial condition. Various other legal actions, the majority of which arise in the normal course of business, are pending. None of these other legal actions is expected to have a material adverse effect on the Company's financial condition. The Company maintains liability insurance against risks arising out of the normal course of its business. ABF stores some fuel for its tractors and trucks in approximately 103 underground tanks located in 27 states. Maintenance of such tanks is regulated at the federal and, in some cases, state levels. ABF believes that it is in substantial compliance with all such regulations. ABF is not aware of any leaks from such tanks that could reasonably be expected to have a material adverse effect on the Company. Environmental regulations have been adopted by the United State Environmental Protection Agency ("EPA") that will require ABF to upgrade its underground tank systems by December 1998. ABF currently estimates that such upgrades, which are currently in process, will not have a material adverse effect on the Company. The Company has received notices from the EPA and others that it has been identified as a potentially responsible party ("PRP") under the Comprehensive Environmental Response Compensation and Liability Act or other federal or state environmental statutes at several hazardous waste sites. After investigating the Company's or its subsidiaries' involvement in waste disposal or waste generation at such sites, the Company has either agreed to de minimis settlements (aggregating approximately $210,000 over the last five years), or believes its obligations with respect to such sites would involve immaterial monetary liability, although there can be no assurances in this regard. The Company remains responsible for certain environmental claims that arose with respect to its ownership of Riverside prior to its sale in 1989. Riverside was notified in 1988 that it has been identified as a PRP for hazardous wastes shipped to two separate sites in Arkansas. To date, the Company, as a part of a PRP group, has paid approximately $50,000 on Riverside's behalf related to one site, with additional assessments expected related to that site. Riverside was dismissed as a PRP from the second site in March 1993. Management currently believes that resolution of its remaining site is unlikely to have a material adverse effect on the Company, although there can be no assurance in this regard. NOTE K - EMPLOYEE BENEFIT PLANS The Company and its subsidiaries have noncontributory defined benefit pension plans covering substantially all noncontractual employees. Benefits are based on years of service and employee compensation. Contributions are made based upon at least the minimum amounts required to be funded under provisions of the Employee Retirement Income Security Act of 1974, with the maximum amounts not to exceed the maximum amount deductible under the Internal Revenue Code. The plans' assets are held in a common bank- administered trust fund and are primarily invested in governmental and equity securities. Additionally, the Company participates in several multiemployer plans, which provide defined benefits to the Company's union employees. In the event of insolvency or reorganization, plan terminations or withdrawal by the Company from the multiemployer plans, the Company may be liable for a portion of the plan's unfunded vested benefits, the amount of which, if any, has not been determined. At December 31, 1993, the net pension asset is reflected in the accompanying financial statements as an accrued expense of $989,000 and a noncurrent asset of $5,549,000 included in other assets. At December 31, 1992, the net pension asset is reflected in the accompanying financial statements as an accrued expense of $763,000 and a noncurrent asset of $6,143,000 included in other assets. The Company has deferred compensation agreements with certain executives for which liabilities aggregating $975,000 and $1,118,000 as of December 31, 1993 and 1992, respectively, have been accrued. The Company has a supplemental benefit plan for the purpose of supplementing benefits under the Company's retirement plans. The plan will pay sums in addition to amounts payable under the retirement plans to eligible participants. Participation in the plan is limited to employees of the Company who are participants in the Company's retirement plans and who are also either participants in the Company's executive incentive plan or are designated as participants in the plan by the Company's Board of Directors. As of December 31, 1993, the Company has a liability of $1,677,000 for future costs under this plan with $934,000 reflected in the accompanying consolidated financial statements as an accrued expense and $743,000 included in other liabilities. In July 1993, the Employee Stock Ownership Plan (the "ESOP") was merged with the employees investment plan to create a new plan known as the Arkansas Best Corporation Employees' Investment Plan (the "Investment Plan"). Participant account balances were transferred from the ESOP to the Investment Plan. The Investment Plan covers substantially all full-time, noncontractual employees of the Company and its subsidiaries. The Investment Plan permits participants to defer up to 15% of their salary by salary reduction as provided in Section 401(k) of the Internal Revenue Code. The percentage of Company match is set annually. In 1993, 1992 and 1991, up to 4% of a participant's compensation contributed to the Investment Plan was matched by a Company deposit of 25% of such contribution. The Company's matching contribution can be made in cash or common stock of the Company. The matching contributions charged to operations under the investment plans totaled approximately $875,000 for 1993, $805,000 for 1992, and $784,000 for 1991. At December 31, 1993 and 1992, the contribution payable was reflected as a component of shareholders' equity. In 1993, 67,813 shares were issued in settlement of the 1992 contributions payable. The number of shares to be issued in settlement of the 1993 contribution payable will be determined based upon the market value of the shares at the date of settlement. Shares were issued on a quarterly basis during 1993 for settlement of the 1993 liability. Total shares issued were 59,040. In 1991, TREADCO established an employee stock ownership plan (the "TREADCO ESOP") and a related trust (the "TREADCO Trust") covering substantially all employees of TREADCO. The cost of the TREADCO ESOP is borne by TREADCO through annual contributions to the TREADCO Trust in amounts determined by TREADCO's Board of Directors. Contributions may be paid in cash or in shares of TREADCO Common Stock. Participants become 100% vested after five years of service from January 1, 1990. Distribution of balances normally would be made in TREADCO's Common Stock. Charges to operations for contributions to the TREADCO ESOP totaled $250,000 for 1993 and $250,000 for 1992. No contributions were made to the TREADCO ESOP for 1991. The stock contributions to the ESOP and investment plans do not have a material effect on earnings per share. The Company sponsors plans that provide postretirement medical benefits, life insurance and accident and vision care to full-time officers of the Company. The plan is noncontributory, with the Company paying up to 80% of covered charges incurred by participants of the plan. In 1993, the Company adopted FAS 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." The effect of adopting the new rules increased net periodic postretirement benefit cost by $275,000 and decreased 1993 net income by $179,000. These costs are based on a 20-year amortization of the transition obligation. Postretirement benefit costs for prior years, which was recorded on a cash basis, have not been restated. The weighted-average annual assumed rate of increase in the per capita cost of covered benefits (in health care cost trend) is 10.5% for 1994 (11.5% for 1993) and is assumed to decrease gradually to 4.5% in years 2006 and later. 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 1% in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by $444,000 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $41,000. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.24% at December 31, 1993. Additionally, the Company's union employees are provided postretirement health care benefits through multiemployer plans. The cost of such benefits cannot be readily separated between retirees and active employees. The aggregate contribution to the multiemployer health and welfare benefit plans totaled approximately $45,400,000 for the year ended December 31, 1993. NOTE L - OPERATING EXPENSES AND COSTS NOTE M - BUSINESS SEGMENT DATA The Company operates principally in two industries: carrier operations and tire operations. Carrier operations include freight transportation services as a common carrier of general commodities and import/export container cargo between ports and inland points. These services are provided to a wide range of customers in various industries. Tire operations include the cold- cap retreading of truck tires and the sale of new tires primarily for trucks. Intersegment sales are not significant. Operating profit is total revenue less operating expenses, excluding interest. Identifiable assets by business segment include both assets directly identified with those operations and an allocable share of jointly used assets. General corporate assets consist primarily of cash and other investments. NOTE N - FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company 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- and Short-term Debt. The carrying amounts of the Company's borrowings under its revolving credit agreements approximate their fair values, since the interest rate under these agreements is variable. Also, the carrying amount of long-term debt was estimated to approximate their fair values. NOTE O - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) FORM 10-K -- ITEM 14(c) LIST OF EXHIBITS ARKANSAS BEST CORPORATION The following exhibits are filed with this report. Exhibit No. Page 10 Receivables Purchase Agreement dated as of March 2, 1994, by and between ABF Freight System, Inc., Renaissance Asset Funding Corp. and Societe Generale. 73 11 Statement Re: Computation of Earnings per Share 175 22 List of Subsidiary Corporations 177 23 Consent of Independent Auditors 179

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Item 1. Business GENERAL. Central Illinois Public Service Company (CIPS or the Company), an Illinois corporation, was organized in 1902. CIPS is a public utility operating company engaged in the sale of electricity and natural gas in portions of central and southern Illinois. CIPS generates, transmits and distributes electricity and, through interchange agreements with other utility systems, purchases and sells power on a firm basis, in emergency situations or when economical to do so. CIPS sells and distributes natural gas which it purchases from natural gas producers and other suppliers and transports natural gas purchased by end-users directly from suppliers. The principal executive offices of CIPS are located in Springfield, Illinois. CIPS furnishes electric service to about 316,000 retail customers in 557 incorporated and unincorporated communities and adjacent suburban and rural areas. See Business - Electric Operations and - Electric Power Sales/Participation Agreements regarding certain electric power arrangements with other utility systems. CIPS also furnishes natural gas service to about 164,000 retail customers in 267 incorporated and unincorporated communities and adjacent suburban and rural areas and provides gas transportation service to about 340 end-users. CIPS furnishes both electric and natural gas service in 236 of the communities served by it. The territory served by CIPS, located in 66 counties in Illinois, has an estimated population of 820,000 and is devoted principally to agriculture and diversified industrial operations. Key industries include petroleum and petrochemical industries, food processing, metal fabrication and coal mining. HOLDING COMPANY STRUCTURE. Effective October 1, 1990, CIPSCO Incorporated (CIPSCO) became the parent holding company of CIPS. CIPSCO owns 100% of the outstanding common stock of CIPS, representing in excess of 97% of the voting securities of CIPS. The electric and gas utility business of CIPS is expected to provide the major portion of CIPSCO's assets and earnings for the foreseeable future. REVENUES. The total operating revenues of CIPS for the year 1993 were $834,556,000 of which about 83% was derived from the sale of electricity and about 17% from the sale of natural gas. The retail electric revenues were derived approximately as follows (percentage of total electric operating revenue): 32% from residential customers, 26% from commercial customers, 16% from industrial customers and 2% from public authorities and other. The wholesale electric revenues were derived approximately as follows (percentage of total electric operating revenue): 10% from interchange sales (firm), 11% from interchange sales (economy/emergency) and 3% from cooperatives and municipal customers. Sales of power to the petroleum and related petrochemical industries and to the coal mining industry contributed about 6% of total electric revenues. Sales to these three industries accounted for approximately 37% of the 1993 electric revenue derived from the industrial customer group. Revenues from the coal mining industry may decline in the future as a result of declining consumption of Illinois coal, as many industrial coal customers shift to lower sulfur coal or other fuels as a means of complying with the Clean Air Act Amendments of 1990. The natural gas revenues for the year 1993 were derived approximately as follows: 63% from residential customers, 22% from commercial customers, 8% from industrial customers and 7% from transportation service customers and miscellaneous. The sources of the operating revenues of CIPS for the years indicated were as follows: Electric 1993 1992 1991 -------- ________ ________ ________ (in thousands) Residential . . . . . . . . . . . . . . . . $219,510 $197,120 $205,734 Commercial. . . . . . . . . . . . . . . . . 176,154 169,460 159,110 Industrial. . . . . . . . . . . . . . . . . 112,382 109,648 113,414 Public authorities and other. . . . . . . . 15,144 12,970 13,332 ________ ________ ________ Total retail revenues . . . . . . . . . 523,190 489,198 491,590 ________ ________ ________ Interchange sales (firm). . . . . . . . . . 68,040 58,913 56,235 Interchange sales (economy/emergency) . . . 76,272 27,949 26,624 Cooperatives and municipals . . . . . . . . 21,347 19,582 18,220 ________ ________ ________ Total wholesale revenues . . . . . . . . 165,659 106,444 101,079 ________ ________ ________ Total electric revenues. . . . . . . . . $688,849 $595,642 $592,669 ======== ======== ======== Natural Gas 1993 1992 1991 ----------- ________ ________ ________ (in thousands) Residential . . . . . . . . . . . . . . . . $ 92,213 $ 86,968 $ 78,070 Commercial. . . . . . . . . . . . . . . . . 32,023 31,036 26,751 Industrial. . . . . . . . . . . . . . . . . 12,139 6,445 3,200 Transportation service. . . . . . . . . . . 8,915 9,269 9,203 Miscellaneous . . . . . . . . . . . . . . . 417 42 312 -------- -------- -------- Total gas revenues. . . . . . . . . . . . $145,707 $133,760 $117,536 ======== ======== ======== The portions of operating income of CIPS, before income taxes, attributable to electric operations were approximately $154,779,000 (95%) in 1993, $123,228,000 (92%) in 1992 and $137,303,000 (95%) in 1991. The portions of operating income, before income taxes, attributable to gas operations were approximately $7,621,000 (5%) in 1993, $10,916,000 (8%) in 1992 and $7,161,000 (5%) in 1991. Identifiable assets relating to electric and gas operations were as follows: 1993 1992 1991 __________ __________ __________ (in thousands) Electric operations . . . . . . . . . . $1,459,073 $1,443,578 $1,419,036 Gas operations. . . . . . . . . . . . . 177,857 188,321 157,757 Other . . . . . . . . . . . . . . . . . 31,532 13,160 115,050 ---------- ---------- ---------- Total assets. . . . . . . . . . . . . $1,668,462 $1,645,059 $1,691,843 ========== ========== ========== COMPETITION -- ELECTRIC BUSINESS. Competition among suppliers of electric energy is increasing. In particular, competition for interchange sales, which is based primarily on price and availability of energy, has become much more intense in recent years with the addition of electric generating capacity by other utilities in the Midwest. However, such additional capacity has made lower cost power available for purchase by CIPS which, in certain instances, is at a cost lower than the variable cost of generating power from the generating stations owned by CIPS. CIPS is responding to overall increased competition in a number of ways designed to lower its costs and increase sales. Since instituting an economic development incentive rate in 1985, the CIPS economic development program has been expanded to include new customer and community development initiatives. An ongoing program in which senior management plays a critical role in communicating CIPS' competitive advantages to our largest industrial customers is continuing. Additional services to our customers have included energy technology assistance and market development programs. CIPS works in partnership with communities throughout the service area to implement projects to respond to growth opportunities. This, in combination with the ongoing business development initiatives including industrial site location assistance, community profiles and technical development services, is designed to maximize economic development throughout the CIPS territory. In addition to a general program of controlling costs, in 1987 CIPS initiated a major program of renegotiating long-term coal supply contracts. Savings from these renegotiation efforts continued during 1993. Further renegotiation is expected in 1994. The effect of this program has been and will be to help CIPS control its fuel costs. Passage of the National Energy Policy Act of 1992 ("NEPA") will require electric utilities, such as CIPS, to compete with nonutility power producers who can generate power. Under NEPA these producers may gain access to utility transmission lines. (See Management's Discussion and Analysis of Financial Condition and Results of Operations.) This enhances competition over time and will give customers and CIPS opportunities to take advantage of competitive markets. Furthermore, large retail customers may decide to install cogeneration or other facilities and supply their own electricity. Over the next several years, excluding the 1994 summer season, CIPS expects to have uncommitted generating capacity available to market principally because certain existing capacity sales agreements with other utility systems are scheduled to expire on various dates during that period. Such capacity sales during 1993 represented 532 megawatts, or 20% of CIPS' capacity. To compete successfully in the capacity sales market, as well as the interchange sales market, it will be important for CIPS to be a low-cost supplier. (See Business - Electric Power Sales/Participation Agreements.) COMPETITION -- GAS BUSINESS. Competition in the natural gas industry is increasing. For a number of years, CIPS customers have had the ability to purchase natural gas from producers or other suppliers and transport that gas through the interstate pipelines and the CIPS system. CIPS collects a rate for such transportation. New policies of the Federal Energy Regulatory Commission ("FERC") such as Order 636 (see "Gas Operations" below) have increased the competitive nature of the gas business. Customers have the ability to receive supply from pipelines that do not serve the CIPS system. In this case, CIPS would no longer necessarily serve the customer with either gas supply or transportation service. CIPS has negotiated or is currently negotiating with a number of its larger industrial gas customers regarding flexible rates to address the more competitive environment in which CIPS is operating. UTILITY INDUSTRY. CIPS is experiencing some of the problems common to electric and gas utility companies, namely, increased competition for customers, increased construction costs, delays and uncertainties in the regulatory process and costs of compliance with environmental and other laws and regulations. CONSTRUCTION PROGRAM AND FINANCING. Total construction expenditures for CIPS for 1994 through 1998 are estimated at $431 million. For 1994, anticipated construction expenditures are $87 million for replacements and improvements and consist of about $28 million for electric production facilities, $14 million for electric transmission facilities, $35 million for electric distribution and general facilities, and $10 million for gas utility facilities. Total capital costs through the year 2000 (including costs incurred through 1993) related to compliance with the Clean Air Act Amendments of 1990 including Phase I (effective in 1995) and Phase II (effective in 2000) are estimated to be less than $50 million. (See Business - Fuel.) CIPS continuously reviews its construction program, which may be affected by numerous factors, including the rate of load growth, escalation of construction costs, fuel shortages, changes in governmental and environmental regulations, customers' patterns of consumption and conservation of energy, the adequacy of rate relief and the ability of CIPS to raise necessary capital. Load growth projections are subject to a number of uncertainties due to influences on customer consumption, economic conditions and the effect of rates on consumption and peak load demand. CIPS has no electric generating units under construction. On May 11, 1993, the Illinois Commerce Commission (the "Illinois commission") approved CIPS' "least cost" plan which includes the 20-year generating plan of the utility. As demonstrated by the Plan, CIPS will not require additional generating capacity or demand-side resources during the 1993-2013 planning period. Pursuant to the Plan, CIPS will engage in several demand-side management activities intended to enhance its capability to deliver demand- side management resources in the future. For a discussion of the funds requirements for the period 1994-1998 and the assumptions as to the sources of funds to meet those requirements, see Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Requirements and - Financing Requirements. See Management's Discussion and Analysis of Financial Condition and Results of Operations - Financing Requirements for information regarding securities issuances and redemptions during 1993. The issuance by CIPS of first mortgage bonds, common stock, preferred stock and certain unsecured debt securities is subject to the receipt of necessary regulatory approvals. (See Business - Regulation.) The Mortgage Indenture of CIPS, as presently operative, permits the issuance of additional first mortgage bonds up to 60% of available net expenditures for bondable property, provided the "net earnings" of CIPS (determined after deducting income taxes and otherwise as provided in the Mortgage Indenture) for a recent 12-month period equal at least twice the annual interest requirements on all first mortgage bonds outstanding (and on all equally secured and prior lien indebtedness) and on the bonds then to be issued. At December 31, 1993, the more restrictive of these requirements was the "net earnings" test. The "net earnings" of CIPS for the year ended December 31, 1993, so computed, were equal to 5.70 times the interest for one year on the aggregate amount of bonds outstanding under the Mortgage Indenture at December 31, 1993. Based on the "net earnings" of CIPS (so computed) for the year ended December 31, 1993, and the bonds outstanding under the Mortgage Indenture at December 31, 1993, CIPS could have issued about $532 million of additional first mortgage bonds under the foregoing interest coverage provision (assuming an annual interest rate of 7.25% on such bonds). The Articles of Incorporation of CIPS provide, in effect, that so long as any CIPS preferred stock is outstanding, CIPS shall not, without the requisite vote of the holders of preferred stock, unless the retirement of such stock is provided for, (a) issue any preferred or equal ranking stock (except to retire or in exchange for an equal amount thereof) unless the "gross income available for interest" of CIPS for a recent 12-month period is at least one and one- half (1-1/2) times the sum of (i) one year's interest on all funded debt and notes maturing more than 12 months after the date of issuance of such shares and (ii) one year's dividend requirement on all preferred stock to be outstanding after such issue, or (b) issue or assume any unsecured debt securities maturing less than two years from the date of issuance or assumption (except for certain refunding or retirement purposes) if immediately after such issuance or assumption the total amount of all such unsecured debt securities would exceed 20% of the sum of all secured debt securities and the capital and surplus of CIPS. For the year ended December 31, 1993, the "gross income available for interest" of CIPS equalled 3.24 times the sum of the annual interest charges and dividend requirements on all such funded debt, notes and preferred stock outstanding at December 31, 1993. Such "gross income available for interest" was sufficient under the test to support the issuance of additional preferred stock (assuming an annual dividend rate on such preferred stock of 6.75%) in an amount in excess of the maximum amount ($185 million) of authorized and unissued preferred stock under the Articles. RATE MATTERS. The most recent CIPS retail rate case before the Illinois commission resulted in electric and natural gas rate increases which became effective March 20, 1992. In its decision, the Illinois commission allowed a return on net original cost rate base of 9.77% (electric) and 9.88% (natural gas) and a return on common equity of 12.28% (electric) and 12.50% (natural gas). The Illinois commission order was designed to increase annual electric and natural gas revenues of CIPS by $11.6 million. On March 6, 1991, the Illinois commission commenced a generic proceeding (Docket No. 91-0081 for CIPS) to consider whether costs related to the cleanup and restoration of former manufactured gas plant sites (environmental remediation sites) should be recoverable from ratepayers by Illinois utilities (including CIPS) and, if recoverable, what recovery mechanism should be utilized. See Note 2 of Notes to Financial Statements included under Item 8 of this report for a discussion of the regulatory and legal proceedings related to the recovery of remediation and related costs. On March 26, 1993, the Illinois commission entered an order accepting the proposed riders filed by CIPS designed to recover environmental cleanup costs and associated legal expenses relating to its environmental remediation sites (including costs previously incurred and deferred). The riders were filed in response to the Illinois commission's generic order described in Note 2 to the Financial Statements. CIPS began recovering amounts under the riders in April, 1993. On May 13, 1992, the Illinois commission entered an Order which approved a settlement agreement resolving all issues in the "show cause" proceeding which had been initiated by the Illinois commission in December 1986 for purposes of determining the effects on CIPS of the passage of the Tax Reform Act of 1986. See Note 11 of Notes to Financial Statements included under Item 8 of this report for a discussion of the impact of the settlement. The Illinois commission conducts annual proceedings to determine whether the electric fuel and purchased gas charges collected by CIPS in each year pursuant to the applicable fuel adjustment and purchased gas adjustment clauses reflect the actual costs of electric fuel and natural gas prudently purchased in that year and to reconcile revenues collected under the clauses during the year with actual costs incurred. The Illinois commission can order refunds to customers if it determines that actual costs of fuel or purchased gas were less than the amounts charged to customers pursuant to the clauses or if it finds that CIPS was imprudent in its purchases of fuel or gas. The Illinois commission has completed its review of fuel adjustment and purchased gas adjustment charges for all years prior to 1992. No significant refunds or adjustments were required for those years. Fuel reconciliation proceedings for the year 1992 commenced in October 1993. (See Business - Fuel.) The most recent general rate increase of CIPS approved by the FERC became effective in 1984. There are currently no rate proceedings pending at the FERC, and CIPS has no plans for any such rate increase filings. All of CIPS' requirements sales to cooperatives and municipals for resale are through negotiated service agreements. As a result of the retail rate increase granted to CIPS in 1992 referred to above, a corresponding rate adjustment was granted by the FERC for certain customers who purchase power from CIPS for resale. This rate adjustment was provided for in the service agreements between CIPS and these customers. In January 1985, CIPS received approval from the Illinois commission for an economic development rate which is designed to encourage industrial expansion and stimulate job creation in the service territory of CIPS. Under the economic development rate, each qualifying electric customer receives discounted rates for a maximum period of five years. In June 1986, CIPS received further approval which grants flexibility to negotiate agreements to fit the specific needs of certain industrial prospects. In August 1989, the Illinois commission granted CIPS further approval to offer customers the economic development rate through December 31, 1994. Since the rate was instituted, 117 new or existing business expansions have led to the creation of over 8,000 new jobs in the CIPS service territory. ELECTRIC OPERATIONS. Since late 1977 CIPS has been a net off-system seller of electricity and during 1993 it generated 120% of its system requirements. The maximum gross system load to date on the CIPS electrical system, on a one-hour integrated basis, occurred on August 27, 1993, and was 2,157,000 kilowatts. Gross system load includes sales to electric cooperative and municipal customers (but excludes emergency and interchange sales). The 1993 maximum gross system load of 2,157,000 kilowatts was 2.3% greater than the historical maximum gross system load of 2,108,000 which occurred in 1988. CIPS, Illinois Power Company and Union Electric Company are parties to an Interconnection Agreement providing for the coordination and interconnected operation of their respective electric systems and the interchange of power and energy at rates and under conditions set forth therein, including the maintenance by the parties of minimum reserve capacity positions. The Agreement provides that CIPS will maintain a minimum 15% system reserve capacity. CIPS, Illinois Power and Union Electric are parties to an Interconnection Agreement with Tennessee Valley Authority (TVA) providing for the interconnection of the TVA system with the systems of the three companies to exchange economy and emergency power and for other working arrangements. In addition, CIPS has interconnection agreements with various other neighboring utilities, including Central Illinois Light Company, Commonwealth Edison Company, Indiana Michigan Power Company, Public Service Company of Indiana, Inc., Iowa Electric Light and Power Company and Northern Indiana Public Service Company. These agreements provide for various interchanges, emergency services and other working arrangements. CIPS owns 20% (and three other utilities own the remaining 80%) of the common stock of Electric Energy, Inc., and is entitled to receive from it varying amounts of power. Electric Energy, Inc. owns and operates a 1,015,000 kilowatt coal-fired power station located in Joppa, Illinois. CIPS is one of 15 members of the Mid-America Interconnected Network reliability council, which has as its purpose the promotion of maximum coordination of planning, construction and utilization of generation and transmission facilities on a regional basis in order to assure the reliability of electric bulk power supply in the area served. One municipal agency, two municipal electric systems, one cooperative agency and one cooperative are engaged in the generation of electricity within, or in close proximity to, portions of the territory served by CIPS. In 1993 CIPS began the process of analyzing the economic value of each of its generating units, which will consider the cost effectiveness of continued operation, retirement or repowering of each unit and other options as well. The Electric Power Research Institute ("EPRI") is participating in this analysis with CIPS. The study is expected to be completed in mid-1994. Electric and magnetic fields (sometimes referred to as EMF) surround electric wires or conductors of electricity such as electrical tools, household wiring and appliances and electric transmission and distribution lines such as those owned by CIPS. A number of statistical and laboratory studies have investigated whether EMF pose human health risks. The United States Environmental Protection Agency (USEPA) stated in its December 1992 brochure "Questions and Answers about Electric and Magnetic Fields" that "Some epidemiological evidence is suggestive of an association between surrogate measurements of magnetic field exposure and certain cancer outcomes. Though the body of evidence cannot be dismissed, it is not complete enough at this time to draw meaningful conclusions." The nation's electric utilities, including CIPS, have participated in the sponsorship of millions of dollars of EMF research. CIPS has also agreed to participate in the National EMF Research and Public Information Dissemination Program, a 5-year $65 million effort headed by the United States Department of Energy aimed at furthering EMF research. Through its participation with EPRI, CIPS will continue its investigation and research with regard to the possible health effects posed by exposure to EMF. ELECTRIC POWER SALES/PARTICIPATION AGREEMENTS. As shown in the table below, CIPS currently has contracts with Norris Electric Cooperative, City of Newton, Village of Greenup and Mt. Carmel Public Utility Company for the sale of electric power. These contracts provide for firm full requirements service which obligates CIPS to maintain adequate system reserves to support the contracts, or to supply the requirements with off-system purchases. Peak Contract Demand Expiration Contract (Megawatts) Date - -------- ___________ __________ Norris Electric Cooperative. . . . . . . . . 49 MW 2007 City of Newton . . . . . . . . . . . . . . . 5 MW 1999 Village of Greenup . . . . . . . . . . . . . 2 MW 1999 Mt. Carmel Public Utility Co. . . . . . . . 40 MW 2001 CIPS has entered into an agreement with Central Illinois Light Company ("CILCO") to sell CILCO limited term power through May, 1998. The agreement calls for a minimum contract delivery rate of 50 megawatts in 1993 rising to 90 megawatts by the end of the contract period. At CILCO's request, and provided the capacity is available, purchases can be increased to 100 megawatts at any time during the contract period with prior written notice. In November 1992, CIPS entered into an agreement with CILCO to sell CILCO limited term power for the period of June, 1998 through May, 2002. The agreement calls for a minimum contract delivery rate of 100 megawatts for the entire period. At CILCO`s request, and provided the capacity is available, purchases can be increased to 150 megawatts with prior written notice. In addition, CIPS sells electric power to three power pooling agencies through negotiated capacity participation agreements identified in the following table. These agencies include Soyland Power Cooperative (Soyland), Illinois Municipal Electric Agency (IMEA) and Wabash Valley Power Association (WVPA). Maximum Capability Entitlement Contract (Megawatts) Expiration Contract (for years indicated) Date - -------- _____________________ __________ Soyland . . . . . . . . . 217MW 1993-1994 1999 103MW 1995-1999 IMEA. . . . . . . . . . . 116MW 1994-2014 2014 WVPA. . . . . . . . . . . 60 MW 1994 2011 65 MW 1995-2011 GAS OPERATIONS. CIPS distributes and sells natural gas to 267 incorporated and unincorporated communities located in 41 counties of Central and Southern Illinois. The CIPS service territory is predominantly made up of small towns and rural areas. Of the communities served, only 5 have populations greater than 15,000. CIPS operates 4,520 miles of transmission and distribution mains, and its customer density is approximately 36 customers per mile of main. Six interstate pipelines pass through various portions of the CIPS service area: Panhandle Eastern Pipe Line Company, Texas Eastern Transmission Corporation, Natural Gas Pipeline Company, Texas Gas Transmission Company, Midwestern Gas Transmission Company and Trunkline Gas Company. CIPS has multiple interconnections with each of these pipelines, with the total of all such interconnections being 45. Most of the CIPS system is integrated by virtue of Company-owned pipelines, or by transportation agreements with interstate pipelines. CIPS owns and operates four underground storage fields which provide a total peak day capacity of 36,500 mcf/day (thousand cubic feet per day). CIPS also operates one propane-air peak shaving facility which has a peak day capacity rating of 10,000 mcf/day. The peak day firm demand recorded by CIPS in 1993 was 254,870 mcf which was reached on February 17, 1993. This demand level is 20% less than the all- time peak demand of 319,033 mcf which occurred on December 24, 1983. During calendar year 1993, the CIPS throughput (total of sales and transportation) was 36 billion cubic feet (bcf) compared to 36.5 bcf experienced in 1972, the year of highest historical throughput. In 1993, CIPS transported 10.8 bcf of customer-owned gas which represented 30% of the total system throughput. Volumes of customer-owned gas transported in 1992 and 1991 were 11.8 bcf and 12.0 bcf, respectively. The average cost per mcf of natural gas purchased from all suppliers was about $3.66 in 1993, $3.66 in 1992 and $3.39 in 1991. The rate schedules of CIPS applicable to all of its gas sales include a uniform purchased gas adjustment clause, which permits CIPS to adjust its rates to its customers to reflect substantially all changes in the cost of purchased gas. (See Note 1 of Notes to Financial Statements included under Item 8 of this report. See Business - Rate Matters.) In 1992, the FERC issued orders (together called Order 636) which address pipeline service restructuring. Order 636 required interstate pipelines to "unbundle" their sales service, and offer separately the components of that service (i.e., gas supply, transportation and storage). Order 636 essentially precludes interstate pipelines from selling natural gas. However, many pipelines have established separate unregulated marketing affiliates which function as gas merchants in competition with producers and other sellers of gas. Each of the six pipelines providing service to CIPS have made restructured services filings at FERC to comply with Order 636. The last such filing was effective December 1, 1993. See Note 2 of Notes to Financial Statements included under Item 8 of this report for a discussion of the transition costs to be paid by CIPS and the Illinois commission order initiated to investigate the appropriate ratemaking treatment of Order 636 transition costs. Full implementation of Order 636 has resulted in several changes in CIPS' gas supply portfolio. Pipeline sales service contracts have been replaced by additional direct purchase gas supply contracts coupled with gas transportation contracts with various pipelines and storage contracts with pipelines or other independent storage service providers. In some cases CIPS has also contracted for so-called "no-notice" services with interstate pipelines. Under such contracts, the pipeline essentially combines and manages a number of independent supply, transportation and storage contracts in order to provide flexibility in the amount of gas actually delivered to CIPS on any day. Such flexibility, which was formerly provided by the pipeline sales service, is needed for CIPS to economically meet the highly weather sensitive needs of its firm service customers. In addition to its diversified portfolio of gas supply, transportation, leased storage and no-notice service contracts, CIPS' company-owned storage and propane-air facilities provide additional reliability and flexibility to meet peak day and peak season requirements. In recent years CIPS has made investments to construct additional pipeline interconnections, increase company owned storage capacity, improve reliability of existing storage facilities, modernize propane-air facilities and improve data acquisition capabilities. At the same time CIPS has reorganized and enhanced its gas supply planning and procurement functions. FUEL. Over 99% of the net kilowatthour generation of CIPS in 1993 was provided by coal-fired generating units and the remainder by an oil-fired unit. The average costs of fuel consumed by CIPS, per ton and per million Btu, for the periods shown were as follows: 1993 1992 1991 ----- ----- ----- Per ton ($) . . . . . . . . . . . . 36.62 36.46 36.68 Per million Btu ($) . . . . . . . . 1.67 1.67 1.67 In 1993, approximately 21.9% of the coal purchased for electric generation was purchased on a spot basis at average delivered costs of $31.35 per ton and $1.37 per million Btu. The retail fuel adjustment clause (FAC) of CIPS is consistent with the uniform FAC mandated by the Illinois commission for all electric utilities as applicable to retail electric sales in Illinois. The FAC provides for the recovery of changes in electric fuel costs, including certain transportation costs of coal, in billings to retail customers. CIPS adjusts fuel expense to recognize over- or under-recoveries of allowable fuel costs. The cumulative effect is deferred on the Balance Sheet as a Current Asset or Current Liability, pending automatic reflection in future billings to customers. In 1992, CIPS received Illinois commission approval to include certain coal transportation costs in the FAC in accordance with the August 1991 modifications to the Illinois Public Utilities Act. CIPS also has contractual arrangements with certain other utility system customers which contain a fuel adjustment clause which permits CIPS to adjust its rates to such customers to reflect substantially all changes in the cost of fuel (including all transportation costs) used to supply those customers. The amount of coal supplies on hand at the generating stations of CIPS varies from time to time. CIPS generally attempts to maintain a 65-day supply. High usage resulting from increased generation to meet interchange sales opportunities and increased native load requirements in 1993 led to somewhat lower than normal coal supplies in early 1994. More than 85% of the annual coal requirements of the generating facilities of CIPS are being met by long-term coal contracts expiring at various dates from 1995 to 2010. As contracts approach their expiration, or when appropriate, CIPS evaluates alternative supply arrangements based on then current and expected market conditions for coal. CIPS believes there are adequate reserves reasonably available to supply its existing generating units with the quantity and quality of coal required for the foreseeable future. Compliance with the sulfur dioxide emission requirements of Phase I (effective in 1995) and Phase II (effective in 2000) of the Clean Air Act Amendments of 1990 is expected to be accomplished through switching to lower sulfur coal for several generating units in combination with increased scrubbing with the existing scrubber at Newton Unit 1. In January 1991, CIPS entered into a long-term contract for the purchase of lower sulfur Illinois coal at its Coffeen Power Station to meet the requirements under the Clean Air Act Amendments. This new contract replaced an existing contract and, in addition to providing the source of coal for clean air compliance, resulted in lower fuel costs. The new contract provides for certain termination charges as described in Note 2 of Notes to Financial Statements included under item 8 of this report. CIPS estimates that capital costs to be incurred through the year 2000 for various equipment and coal handling facility modifications at all five of its generating stations in order to comply with the Clean Air Act Amendments will be less than $50 million. Such costs could result in electric base rate increases of approximately one to two percent by the year 2000. CIPS does not anticipate that operating costs will change materially as a result of compliance with the Clean Air Act Amendments. Under the Clean Air Act Amendments each utility must have, beginning in 1995, sufficient emission allowances, which are granted by the USEPA, to cover the amount of sulfur dioxide to be emitted each year from its generating stations. Any emission allowances in excess of a utility's needs for a year can be retained by it for future use or sold. Based upon CIPS' current compliance program, CIPS expects to have available allowances (after consideration of allowances sold) in excess of its requirements. REGULATION. CIPS is subject to regulation by the Illinois commission as to rates, accounting practices, issuance of certain securities and in other respects as provided by Illinois law. The Electric Supplier Act of Illinois permits utilities and electric cooperatives to delineate their respective service areas, subject to the approval of the Illinois commission, and gives the Illinois commission power to determine, pursuant to guidelines provided in the Act, whether a prospective electric customer will be furnished service by a public utility or by a cooperative. (See Item 3. Legal Proceedings.) The FERC has jurisdiction under the Federal Power Act over certain of the electric utility facilities and operations, accounting practices, issuance or acquisition of certain securities and electric rates of CIPS for resale and interchange customers. CIPS has been classified as a "public utility" within the meaning of that Act. CIPS has been declared exempt from the federal Natural Gas Act. CIPS is presently exempt from all the provisions of the Public Utility Holding Company Act of 1935, except provisions thereof relating to the acquisition of securities of other public utility companies, until further action by the Securities and Exchange Commission, by virtue of an annual exemption statement filed by CIPS with the Commission pursuant to Rule 2 under the Act. ENVIRONMENTAL MATTERS. CIPS is subject to regulation with respect to air and water quality standards, standards relating to the discharge and disposal of solid and hazardous wastes and other environmental matters by various federal, state and local authorities. The Illinois Pollution Control Board (the "Board") has jurisdiction over all phases of environmental control by the State of Illinois and has authority to grant variances from environmental requirements. The Illinois Environmental Protection Agency (the "Agency") has authority to issue permits, investigate violations and recommend enforcement cases. The Illinois Attorney General has the authority to prosecute enforcement cases. The USEPA has jurisdiction to promulgate and enforce air and water quality standards in addition to those standards which relate to the discharge and disposal of solid and hazardous wastes. Air pollution control regulations promulgated by the Board impose restrictions on emissions of particulate, sulfur dioxide, nitrogen oxides and other air pollutants and require that CIPS obtain permits from the Agency for the construction and operation of its generating facilities in compliance with these regulations. CIPS has secured all necessary operating permits for all of its existing generating facilities and is in substantial compliance with the provisions contained therein. Future construction projects may require additional construction permits. Water pollution control regulations promulgated by the Board impose restrictions on effluent discharges, set water quality standards and require CIPS to obtain construction permits for certain facilities and National Pollutant Discharge Elimination system ("NPDES") permits for discharges into public waters. CIPS has secured all necessary NPDES permits for all of its generating units and is in substantial compliance with the currently effective provisions contained therein. However, it would be difficult to comply with certain conditions in the recently renewed permits for the Coffeen and Newton Power Stations, scheduled to take effect in 1997. CIPS has appealed these permit conditions to the Illinois Pollution Control Board. If these appeals are unsuccessful, CIPS will seek regulatory relief under applicable rules to alter the requirements for these two stations. Pollution control regulations promulgated by the Board impose restrictions on the discharge and disposal of solid and hazardous waste, and determine design standards to prevent contamination of groundwater. CIPS has secured all necessary permits and authorizations for disposal and is in substantial compliance with the provisions contained therein. Future construction projects may require additional authorizations or permits. Beginning in 1986 and ending in October 1993, CIPS operated Units 1 and 2 at the Coffeen Power Station at a reduced load to meet applicable emission limitations. A new coal supply has allowed the operation of Coffeen Units 1 and 2 at their maximum capability of 325,000 KW and 550,000 KW, respectively, since October 1993. Total capability of the generating units was previously restricted to 750,000 KW when both units were in full operation. Removal of the operating restrictions increased total electric system capability to 2,852,000 KW. On May 21, 1993, the USEPA issued a Finding of Violation (FOV) to CIPS regarding Units 1 and 2 at the Newton Power Station. The FOV alleges that both generating units at the Newton Power Station were operated at various times from January 1991 through August 1992 in violation of applicable emission regulations, including opacity and sulfur dioxide limitations, regarding New Source Performance Standards established under the Clean Air Act for fossil fuel fired steam generating units. On January 3, 1994, CIPS entered into a consent agreement with the Illinois Environmental Protection Agency and the Illinois Attorney General resolving the issues presented in the FOV. Under terms of the consent agreement, CIPS will pay a fine of $40,000. CIPS also agreed to install a continuous emissions stack monitor on Newton Unit 2. This monitor has already been installed as part of the Company's Clean Air Act Compliance Plan. CIPS also entered into a consent agreement with the USEPA concerning these same issues. This latter agreement did not require any further action on the part of CIPS. See the subcaption "Environmental Remediation Costs" under Note 2 of the Notes to Financial Statements, included under Item 8 of this report, for information relating to costs incurred and to be incurred in connection with the remediation of certain sites where gas had been manufactured from coal and which contain potentially harmful materials. EMPLOYEES. Composition of the work force of CIPS at the payroll period nearest year-end 1993 and 1992 was as follows: Number of Employees ------------------- Employee Group 1993 1992 - -------------- ----- ----- Salaried. . . . . . . . . . . . . . . . . 1,218 1,182 IBEW - 702. . . . . . . . . . . . . . . . 922 965 IUOE - 148. . . . . . . . . . . . . . . . 479 489 ----- ----- Total . . . . . . . . . . . . . . . . . . 2,619 2,636 ===== ===== See Management's Discussion and Analysis of Financial Condition and Results of Operations--Union Negotiations for a discussion of the status of labor contracts, unfair labor practice charges and related matters involving those employees represented by labor unions. As part of the agreement leading to new labor contracts, International Brotherhood of Electrical Workers Local 702 ("IBEW 702") has dropped the class action suit filed by it against CIPS and others seeking treble damages for lost wages and benefits and other damages. The settlement is subject to court approval. Item 2. Item 2. Properties. The electric generating facilities of CIPS consist of the following: Estimated 1994 Summer Year Capability Station and Unit Fuel Installed (KW) - ---------------- ---- --------- ----------- Newton Unit 1 . . . . . . . . . . . . . . Coal 1977 555,000 Unit 2 . . . . . . . . . . . . . . Coal 1982 560,000 Coffeen Unit 1 . . . . . . . . . . . . . . Coal 1965 325,000 Unit 2 . . . . . . . . . . . . . . Coal 1972 550,000 Grand Tower Unit 3 . . . . . . . . . . . . . . Coal 1951 82,000 Unit 4 . . . . . . . . . . . . . . Coal 1958 104,000 Hutsonville Unit 3 . . . . . . . . . . . . . . Coal 1953 76,000 Unit 4 . . . . . . . . . . . . . . Coal 1954 77,000 Diesel Unit. . . . . . . . . . . . Oil 1968 3,000 Meredosia Unit 1 . . . . . . . . . . . . . . Coal 1948 62,000 Unit 2 . . . . . . . . . . . . . . Coal 1949 62,000 Unit 3 . . . . . . . . . . . . . . Coal 1960 220,000 Unit 4 . . . . . . . . . . . . . . Oil 1975 176,000 _________ Total . . . . . . . . . . . . . 2,852,000 ========== All of the generating stations are located in Illinois on land owned in fee by CIPS. At December 31, 1993, CIPS owned 12,922 pole miles of overhead electric lines and 843 miles of underground electric lines. At that date, CIPS also owned 4,520 miles of natural gas transmission and distribution mains, four underground gas storage fields and one propane-air gas plant used to supplement the available pipeline supply of natural gas during periods of abnormally high demands. Substantially all of the permanent fixed utility property of CIPS is subject to the lien of the Mortgage Indenture securing the first mortgage bonds. Item 3. Item 3. Legal Proceedings. Actions have been brought against CIPS by Southwestern Electric Cooperative, Inc. ("Southwestern") on October 30, 1991 in the Macon County, Illinois Circuit Court and by Wayne-White Counties Electric Cooperative ("Wayne-White" and together with Southwestern, the "Distribution Cooperatives") on August 15, 1991 in the White County, Illinois Circuit Court. Soyland Power Cooperative ("Soyland"), a generating and transmission cooperative that supplies power to the Distribution Cooperatives, is also a plaintiff in the actions. In various prior cases brought before the Illinois commission and finally determined on appeal, the Distribution Cooperatives prevailed in disputes between each of them and the Company as to which of them was entitled to serve certain electric customers under the Illinois Electric Supplier Act ("ESA") and certain service area agreements entered into pursuant to the ESA. Based on the results of the prior proceedings, the pending suits, in general, seek actual damages for breach of the service area agreements and punitive damages based on various grounds, such as tortious interference with contractual relationships and business expectancies and violation of the Illinois Public Utilities Act. A CIPS motion to dismiss the Southwestern/Soyland case was successful only as to certain counts. In the remaining counts, Southwestern seeks $182,000 in alleged actual damages for breach of the service area agreement and an additional $5 million in punitive damages for both interference with a contractual relationship and a business expectancy (it is not clear whether these claims are intended as separate bases for the recovery of $5 million in punitive damages or are cumulative). In addition, Soyland seeks $323,000 in alleged actual damages and $5 million in punitive damages for interference with a business expectancy. In the Wayne-White/Soyland action, Wayne-White seeks unspecified alleged actual damages for breach of the service area agreement and additional unspecified punitive damages for violation of the Public Utilities Act and interference with a business expectancy. In addition, Soyland claims $819,000 in alleged actual damages based on breach of the service area agreement and an additional $5 million in punitive damages based on interference with both a contractual relationship and a business expectancy and based on violation of the Public Utilities Act (again, it is not clear whether these claims are intended as separate bases for the recovery of $5 million in punitive damages or are cumulative). On March 11, 1993, Soyland was dismissed from the Wayne-White action on statue of limitations grounds and the claims by Wayne-White under the Illinois Public Utilities Act were dismissed. Soyland has filed an appeal of its dismissal. This action is continuing with regard to Wayne-White's other claims. While CIPS cannot predict the outcome of any of these matters, it intends to vigorously defend against all such claims. See Item 1. Business - Rate Matters, Business - Gas Operations and Business - Environmental Matters with respect to certain matters involving CIPS. See also Note 2 of Notes to Financial Statements included under Item 8 of this report. 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 three months ended December 31, 1993. Executive Officers of the Registrant (ages at December 31, 1993). Name Age Positions Held _____ ___ ______________ C. L. Greenwalt 60 President* R. W. Jackson 63 Senior Vice President Finance and Secretary* L. A. Dodd 55 Senior Vice President Operations J. G. Bachman 45 Vice President Corporate Planning W. A. Koertner 44 Vice President Corporate Services G. W. Moorman 50 Vice President Power Supply W. R. Morgan 57 Vice President Division Operations W. R. Voisin 58 Vice President Public Relations J. C. Fiaush 63 Controller (Principal Accounting Officer)* C. D. Nelson 40 Treasurer and Assistant Secretary* ______________________ * Messrs. Greenwalt and Jackson are directors of CIPS and are also officers of CIPSCO. Mr. Fiaush and Mr. Nelson are also officers of CIPSCO. The present term of office of the above executive officers extends to the first meeting of the Board of Directors of CIPS after the next annual election of Directors, scheduled to be held on April 27, 1994. There is no family relationship between any executive officer and any other executive officer or any director. All of the officers named above have been employed by CIPS in their present positions for more than the past five years except as indicated below: Mr. Greenwalt served as Senior Vice President Operations from August 4, 1980 to August 1, 1989, when he was named President. Mr. Dodd served as Vice President Corporate Planning from July 1, 1985 to August 1, 1989 and as Vice President Division Operations from August 1, 1989 to July 1, 1990 when he was named Senior Vice President Operations. Mr. Bachman served as Manager of Rates and Research from February 1, 1980 to August 1, 1989, when he was named Vice President Corporate Planning. Mr. Koertner served as Treasurer and Assistant Secretary from February 1, 1982 to August 1, 1989 and as Vice President Financial Services from August 1, 1989 to April 1, 1993, when he was named Vice President Corporate Services. Mr. Moorman served as Manager of System Operation from April 1, 1976 to June 1, 1988, when he was named Vice President Power Supply. Mr. Morgan served as Vice President Corporate Services from August 5, 1980 to July 1, 1990, when he became Vice President Division Operations. Mr. Voisin served as Superintendent of the Quincy Area from January 1, 1985 to July 1, 1989, when he was named Vice President Public Relations. Mr. Nelson served as Assistant Treasurer from January 1, 1985 to August 1, 1989 when he was named Treasurer and Assistant Secretary. Directors of the Registrant. Name, Age, Principal Occupation, and other Directorships Director Since ________________________________________________________ ______________ WILLIAM J. ALLEY, age 64. Chairman of the Board and Chief 1974 Executive Officer of American Brands, Inc. (diversified manufacturing and other businesses), Old Greenwich, Connecticut; director of American Brands, Inc., Moorman Manufacturing Company and Rayonier, Inc. ROBERT S. ECKLEY, age 72. President Emeritus of Illinois 1973 Wesleyan University, Bloomington, Illinois; director of State Farm Mutual Automobile Insurance Co. CLIFFORD L. GREENWALT, age 60. President and Chief 1986 Executive Officer of CIPS, CIPSCO and Chairman of the Board of CIPSCO Investment Company, and served as Senior Vice President - Operations of CIPS from 1980 to August 1989 when he became President; director of First of America Bank Corporation, Kalamazoo, Michigan and a director of its wholly owned subsidiary, First of America Bank - Springfield, N.A. Name, Age, Principal Occupation, and other Directorships Director Since ________________________________________________________ ______________ JOHN L. HEATH, age 58. Retired Chairman and President 1977 of the Heath Candy Company, Robinson, Illinois; served as Chairman of L.S. Heath & Sons, Inc. from 1971 until 1988 and also as President and Chief Executive Officer from 1971 until 1982 and is a director of the Biltmore Bank Corp. and of its wholly owned subsidiary, The Biltmore investors Bank of Phoenix, Arizona; and is a director of Sun Street Food Corporation of Phoenix, Arizona. ROBERT W. JACKSON, age 63. Senior Vice President - 1986 Finance and Secretary of CIPS, Senior Vice President and Chief Financial Officer and Secretary of CISPCO and President and Chief Executive Officer of CIPSCO Investment Company, and served as Senior Vice President - - Finance and Secretary of CIPS since 1980; director of Firstbank of Illinois Co. and each of its wholly owned subsidiary banks, including the First National Bank of Springfield. GORDON R. LOHMAN, age 59. President and Chief Executive 1989 Officer of AMSTED Industries Incorporated (diversified manufacturer of industrial products), Chicago, Illinois in 1988 and 1990, respectively; Executive Vice President of that firm in 1988 and Vice President from 1978 through 1987; and is a director of American Brands, Inc. HANNE M. MERRIMAN, age 52. Principal in Hanne Merriman 1990 Associates (retail business consultants), Washington, D.C.; President of Nan Duskin, Inc., from 1991 to 1992; retail business consultant since January 1990; President and Chief Executive Officer of Honeybee, Inc. a division of Spiegel, Inc. from January 1988 through December 1989; President of Garfinckels, a division of Allied Stores Corporation, from 1981 through 1987 and is a director of USAir Group, Inc., State Farm Mutual Automobile Insurance Co., The Rouse Company and AnnTaylor Stores Corporation. DONALD G. RAYMER, age 69. Retired President and Chief 1972 Executive Officer of CIPS; director of Bank One Springfield and served as President and Chief Executive Officer of CIPS from 1980 to August 1989. Name, Age, Principal Occupation, and other Directorships Director Since ________________________________________________________ ______________ THOMAS L. SHADE, age 63. Retired Chairman of the Board and 1991 Chief Executive Officer of Moorman Manufacturing Company (livestock feed products), Quincy, Illinois, having served in those capacities during 1992 and 1993 and was President and Chief Executive Officer of that firm from 1984 to 1992 and is a director of that firm and Quincy Soybean Company of Quincy, Illinois. JAMES W. WOGSLAND, age 62. Vice Chairman of Caterpillar 1992 Inc. (heavy equipment and engine manufacturer), Peoria, Illinois, since 1990 and was Executive Vice President of that firm from 1987 until 1990 and is a director of that firm and First of America Bank Corporation, Kalamazoo, Michigan and its wholly owned subsidiary First of America Bank-Illinois, N.A., Peoria, Illinois and is also a director of Protection Mutual Insurance Company. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder matters. All the common stock of CIPS is owned by CIPSCO, its corporate parent, and is not publicly traded. The following table sets forth the cash distributions on common stock paid to CIPSCO by CIPS, which, in some cases, were used to repurchase common shares of CIPS for the periods indicated: 1993 1992 ____ ____ First Quarter . . . . . . . . . . $16,500,000* $16,400,000* Second Quarter . . . . . . . . . . $16,750,000* $16,700,000* Third Quarter . . . . . . . . . . $16,750,000 $16,500,000* Fourth Quarter . . . . . . . . . . $16,750,000 $16,500,000* * Reflects the repurchase of common shares of CIPS. CIPS is subject to restrictions on the use of retained earnings for cash dividends on common stock as described in Note 6 of Notes to Financial Statements included under Item 8 of this report. Item 6. Item 6. Selected Financial Data. For the Years Ended December 31, 1993 1992 1991 1990 1989 __________ __________ __________ __________ __________ (in thousands) Operating Revenues $ 834,556 $ 729,402 $ 710,205 $ 685,226 $ 683,859 Operating Income 113,651 97,372 104,039 97,135 109,433 Net Income 84,011 72,601 75,683 71,562 71,222 Preferred Dividends 3,718 4,549 5,396 5,617 5,856 Earnings for Common Stock 80,293 68,052 70,287 65,945 65,366 As of December 31, Total Assets $1,668,462 $1,645,059 $1,691,843 $1,665,614 $1,714,544 Long-Term Debt 494,323 503,700 496,420 496,319 496,301 Preferred Stock subject to mandatory redemption - - 18,245 21,245 24,000 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. MANAGEMENT'S DISCUSSION AND ANALYSIS ____________________________________ Central Illinois Public Service Company (CIPS or the Utility) is a subsidiary of CIPSCO Incorporated (the Parent company), a holding company incorporated under the laws of the State of Illinois. FINANCIAL CONDITION. Central Illinois Public Service Company's financial position remained fundamentally strong during 1993. A strong capital structure and strong cash flows have minimized the need to access capital markets, other than for refinancings, in recent years. Neither CIPSCO nor CIPS has raised additional capital through the sale of common stock to the general public since 1980. Common stock was issued and sold to existing shareholders by CIPS through a dividend reinvestment plan until 1984. The long-range financial objectives for the capital structure of CIPS are: a debt ratio of no more than 45 percent, a common equity ratio of no less than 45 percent, and a preferred equity ratio of no more than 10 percent. At December 31, 1993, capitalization consisted of 43 percent long-term debt, 50 percent common equity and 7 percent preferred stock. At year end, 25,452,373 shares of CIPS common stock were outstanding, all of which were held by CIPSCO Incorporated. During 1993, 884,345 shares of common stock were repurchased by CIPS from CIPSCO as a means of conveying funds to the parent company for dividend payments and other corporate purposes. CAPITAL REQUIREMENTS. Construction expenditures were $88 million in 1993. Of that amount, $77 million and $11 million related to improvements and replacements to the electric and natural gas systems, respectively. In 1994 construction expenditures are expected to be about $87 million. Of that amount, $77 million is scheduled for electric facilities while gas system expenditures are estimated at $10 million. Construction expenditures are estimated at $431 million for the five-year period 1994-1998. This is $31 million, or seven percent, less than was spent in the preceding five years. In addition to construction funds, projected capital requirements for the 1994-1998 period include $93 million for scheduled debt retirements. FINANCING REQUIREMENTS. Capital requirements for the 1994-1998 period are expected to be met primarily through internally generated funds. External financing to fund scheduled debt retirements will be required. If external financing were needed to fund the construction program such financing could consist of funds from the parent, the issuance of short-term debt, long-term debt or preferred stock, or any combination of the four. Refinancings to lower the costs of capital may also occur, depending on market conditions. On April 6, 1993, CIPS issued $65 million of first mortgage bonds to refinance higher-cost debt issues. On May 4, 1993, and October 13, 1993, CIPS issued $30 million and $12.5 million of preferred stock, respectively. The new issues were used to redeem the utility's outstanding 7.48% Series and 8.08% Series of preferred stock, and to raise $15 million of additional capital. During the year, CIPS refinanced $130 million of pollution control loan obligations to achieve lower rates of interest. Financing requirements may be affected by such factors as availability and cost of capital, load growth, changes in construction expenditures, regulatory developments, changes in environmental regulations and other governmental activities. FINANCING FLEXIBILITY AND LIQUIDITY. The utility's ability to finance the construction program at reasonable cost and to provide for other capital needs is dependent upon its ability to earn a fair return on capital. Financing flexibility is enhanced by providing a high percentage of total capital requirements from internal sources and having the ability, if necessary, to issue long-term securities and to obtain short-term credit. Flexibility also is provided by the parent corporation which is capable of providing additional capital if circumstances warrant. The CIPS mortgage indenture limits the amount of first mortgage bonds which may be issued. At December 31, 1993, CIPS could have issued about $532 million of additional first mortgage bonds under the indenture, assuming an annual interest rate of 7.25 percent. CIPS' articles of incorporation limit amounts of preferred stock which may be issued. Assuming a preferred dividend rate of 6.75 percent, CIPS could have issued all $185 million of authorized, but unissued preferred stock remaining as of year end. At year-end 1993, CIPS had $2.7 million of temporary investments. There were no short-term borrowings. RESULTS OF OPERATIONS --------------------- (1991-1993) EARNINGS. Earnings for common stock increased 18 percent in 1993 to $80.3 million. The increases in electric and gas revenues were the result of increased sales due to the occurrence of more-normal weather conditions. Weather-related factors and a coal miners' strike which hampered coal deliveries to some utilities, resulted in increased sales of power by CIPS to other utility systems. The interchange sales in 1993 resulted from exceptional opportunities which are unlikely to be matched in future years. Earnings for common stock decreased three percent in 1992 to $68.1 million. Increases in gas and electric revenues resulting from the retail rate increase effective in March, and a favorable earnings adjustment of $3.3 million due to settlement of the revenues subject to refund proceeding, were offset by weather-related decreases in electric revenues. ELECTRIC OPERATIONS. Electric revenues increased $93.2 million in 1993. Cooling degree days for 1993 were 37 percent higher than in 1992. Electric kilowatthour sales, including interchange sales, were 39 percent higher than a year ago. Revenues from electric interchange sales to other utility systems for economy and emergency purposes were $76.3 million, or $48.3 million higher than a year ago, reflecting much greater sales opportunities. The greater opportunities for sales resulted from hot weather, flooding conditions which limited availablity of generating capacity at some neighboring utilities, and coal miners' strikes which hampered deliveries of coal at other utilities. These factors contributed to a significantly increased level of interchange economy and emergency sales which is unlikely to be matched in 1994. Electric revenues increased $3 million in 1992 as compared to 1991. The effects of a favorable settlement in the revenues subject to refund proceeding, and a rate increase of approximately one percent in March 1992, were offset by a one percent decrease in kilowatthour sales. The sales decrease was primarily caused by cooler summer weather in 1992. Cooling degree days for 1992 were 33 percent lower than in 1991. Fuel for electric generation increased eight percent, or $14.4 million, in 1993 primarily due to higher electric generation caused by increased kilowatthour sales. Kilowatthours generated increased 16 percent in 1993. Average fuel cost remained the same at $1.67 per million Btu in 1993, 1992 and 1991. Purchased power expense increased 185 percent, or $39.1 million in 1993 reflecting additional purchases principally used for economy and emergency interchange sales. Purchased power and fuel cost for electric generatin increased three percent, or $5.7 million, in 1992 as compared to 1991. Kilowatthours generated decreased two percent in 1992. GAS OPERATIONS. Gas revenues increased nine percent to $145.7 million in 1993 as compared to 1992 due to increases in therm sales and a full heating season of the increased rates effective March 1992. Therm sales increased 21 percent primarily due to more industrial customers purchasing gas from the utility's system rather than from other gas suppliers. Residential therm sales inreased 14 percent reflecting colder temperatures in 1993. Heating degree days were 13 percent higher in 1993 as compared to 1992. Gas revenues increased 14 percent to $133.8 million in 1992 due to increased rates effective in March 1992, and adjustments for higher purchased gas costs. Therm sales increased five percent in 1992 compared to 1991 primarily due to industrial customers purchasing gas from the utility's system rather than from other gas suppliers. The utility transported approximately 108 million therms of customer owned gas in 1993 compared with 118 million and 120 million therms in 1992 and 1991, respectively. Purchased gas costs increased $7.5 million, or nine percent, in 1993 due to higher therm sales, while the average price paid for purchased gas from suppliers remained unchanged. In 1992, purchased gas costs increased $9.4 million, or 13 percent, due to an average three-cent-per-therm price increase charged by gas suppliers. OPERATING EXPENSES. Other operation expense increased $11.4 million, or nine percent in 1993, and $15.5 million, or 13 percent in 1992 due principally, in each case, to postretirement medical expense which CIPS began accruing in April 1992 consistent with the related treatment afforded such costs for ratemaking. (See Note 4 to Financial Statements.) Depreciation expense increased $3.9 million and $4.7 million in 1993 and 1992, respectively, due to property additions. Taxes other than income taxes increased in 1993 because utility taxes, which are based upon receipts from sales, increased as sales increased. Other taxes decreased in 1992 because the rate refund reduced amounts collected from customers which in turn reduced utility taxes. Interest on long-term debt and preferred dividend requirements decreased $2.8 million, or seven percent, in 1993, due to refinancing of long-term debt and preferred stock at lower interest and dividend rates. Interest on provision for revenue refunds was not applicable in 1993 and decreased in 1992 due to settlement of the revenue subject to refund proceeding in 1992. (See Note 11 to Financial Statements.) Miscellaneous, net, for 1993 decreased $4.5 million, or 59 percent because Miscellaneous, net, for 1992 includes $3 million resulting from a Federal Energy Regulatory Commission (FERC) order issued February 12, 1992. That order reversed a 1989 order which required CIPS to refund to cooperative customers a portion of amounts paid to CIPS in a litigation settlement with a former coal supplier. Miscellaneous, net, increased in 1992 due to inclusion of the $3 million resulting from the FERC order. Income tax expense reflects the changes in pre-tax income in both 1993 and 1992. In addition, the federal tax rate changed from 34 percent to 35 percent effective January 1, 1993. OTHER MATTERS. Customer usage of electricity and natural gas varies with weather conditions, general business conditions, the state of the economy and the cost of energy services. The level of sales also is impacted by conditions in the interchange market. Further, certain large gas customers can purchase gas from alternative suppliers or bypass the utility's system by switching to other fuels or by connecting directly to pipelines. Forecasts indicate that retail sales growth will remain at the historical levels of the past decade. Rates for retail electric and gas service are regulated by the Illinois Commerce Commission. Non-retail electric rates are regulated by FERC. The utility's rates are designed to recover operating costs including depreciation on utility plant investment. Inflation continues to be a factor affecting its operations, earnings, shareholders' equity and financial performance. Changes in the cost of fuel for electric generation and purchased gas generally are reflected in billings to customers on a timely basis through fuel and purchased gas adjustment clauses. The Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" was adopted as of January 1, 1993. SFAS No. 106 requires that the expected cost of posretirement benefits be accrued during the employees' years of service. (See Note 4 to Financial Statements.) On January 1, 1993 the Company adopted SFAS No. 109, "Accounting for Income Taxes" which requires the use of the liability method for recording deferred income taxes on temporary differences using the rate at which the differences are expected to reverse. (See Notes 1 and 9 to Financial Statements.) In 1993, The Company adopted, SFAS No. 112 "Employers' Accounting for Postemployment Benefits". The new statement requires the accrual of certain postemployment benefits to former and inactive employees. (See Note 4 to Financial Statements.) ENVIRONMENTAL REMEDIATION COSTS. The utility has identified 13 former manufactured gas plant sites (environmental remediation sites) which contain potentially harmful materials. In 1990, one site was added to the United States Environmental Protection Agency (USEPA) Superfund list. The utility has a long-term remedial plan for the site. Costs and associated legal expenses related to investigation have been incurred at other sites. Commencing in 1987, the estimated incurred costs related to studies and remediation at these 13 sites and associated legal expenses and certain carrying charges are being accrued and deferred rather than expensed currently, pending recovery either from rates, from insurance carriers or from other parties. Management believes that costs incurred in connection with the sites that are not recovered from insurance carriers or other parties will be recovered through utility rates. Accordingly, management believes that costs incurred in connection with these sites will not have a material adverse effect on financial position or results of operations. (See Note 2 to Financial Statements.) CLEAN AIR ACT. CIPS' compliance strategy for Phases I and II of the Clean Air Act Amendments of 1990 is to switch to lower sulfur coal at some generating units along with increased scrubbing at Newton Unit 1. The utility estimates capital costs, including costs incurred to date, for various equipment modifications at its generating stations related to compliance will aggregate less than $50 million. These costs may result in electric base rate increases totaling about one to two percent by the year 2000. The utility does not anticipate that operating costs will change materially as a result of compliance with these amendments. (See Note 2 to Financial Statements.) FERC ORDER 636. During 1992, the FERC issued Order No. 636. This and successor orders have resulted in substantial restructuring of the service obligations of interstate pipeline suppliers. (See Note 2 to Financial Statements.) ENERGY POLICY ACT. The National Energy Policy Act of 1992 (NEPA) contains, among other provisions, legislation designed to promote competition in the development of wholesale power generation in the electric utility industry. NEPA exempts a new class of independent power producers from traditional utility regulation. This new class of producers can build generating plants and sell electricity in wholesale markets without the same constraints of regulated utilities. NEPA also allows FERC to order wholesale "wheeling" by public utilities to provide utility and non-utility generators access to public utility transmission facilities. Public utilities, not voluntarily providing access to their transportation system at agreed upon rates, may be ordered to deliver power at rates to be established by FERC. Although the final impact of the provisions of NEPA cannot be predicted, management believes that the increased competition in the area of generation and transmission may affect the traditional marketing and pricing strategies of the utility business. LABOR DISPUTES. Labor agreements ending June 1995 have been reached with the two unions representing 1,400 hourly employees of CIPS. The contracts with both unions have been signed. Before the agreements were reached, the memberships of both unions authorized a strike and institued an overtime boycott and work slowdown beginning in April 1993. CIPS initiated a lockout of union employees over a period of approximately 14 weeks beginning in May 1993. Subsequent to this date, both unions filed unfair labor practice charges with the National Labor Relations Board (NLRB) claiming back pay and other benefits during the lockout period. The Peoria Regional Office of the NLRB has issued a complaint against CIPS concerning the lockout of employees represented by one union. However, the Peoria Regional Office did not find merit to a similar charge filed by the other union and it has been dismissed. CIPS estimates the amount of back pay and other benefits for both unions to be less than $12 million. The NLRB decisions on the complaint and the charges will be subject to various appeals by the parties. Management believes that the lockout was both lawful and reasonable and that these matters will be ultimately resolved in favor of CIPS. (See Note 2 to Financial Statements.) Item 8. Item 8. Financial Statements and Supplementary Data. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY STATEMENTS OF INCOME Years Ended December 31, __________________________________ 1993 1992 1991 __________ __________ __________ (in thousands) Operating Revenues: Electric $ 688,849 $ 593,996 $ 604,565 Provision for revenue refunds - 1,646 (11,896) _________ _________ _________ 688,849 595,642 592,669 Gas 145,707 133,760 117,536 _________ _________ _________ Total operating revenues 834,556 729,402 710,205 _________ _________ _________ Operating Expenses: Fuel for electric generation 186,938 172,544 165,806 Purchased power 60,181 21,094 22,109 Gas purchased 90,097 82,553 73,189 Other operation 141,310 129,715 114,434 Maintenance 61,216 64,092 66,784 Depreciation and amortization 77,647 74,154 69,483 Taxes other than income taxes 54,767 51,106 53,936 Income taxes 48,749 36,772 40,425 _________ _________ _________ Total operating expenses 720,905 632,030 606,166 _________ _________ _________ Operating Income 113,651 97,372 104,039 _________ _________ _________ Other Income and Deductions: Allowance for equity funds used during construction 1,459 2,162 2,054 Nonoperating income taxes (631) (2,989) (2,413) Miscellaneous, net 3,632 10,978 13,472 _________ _________ _________ Total other income and deductions 4,460 10,151 13,113 _________ _________ _________ Income Before Interest Charges 118,111 107,523 117,152 _________ _________ _________ Interest Charges: Interest on long-term debt 34,421 36,397 36,990 Interest on provision for revenue refunds - (803) 4,261 Other interest charges 479 392 1,231 Allowance for borrowed funds used during construction (800) (1,064) (1,013) _________ _________ _________ Total interest charges 34,100 34,922 41,469 _________ _________ _________ Net Income 84,011 72,601 75,683 Preferred stock dividends 3,718 4,549 5,396 _________ _________ _________ Earnings for Common Stock $ 80,293 $ 68,052 $ 70,287 ========== ========== ========== The accompanying notes to financial statements are an integral part of these statements. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY BALANCE SHEETS December 31, ___________________________ 1993 1992 _____________ ____________ (in thousands) ASSETS Utility Plant, at original cost: Electric $2,172,259 $2,116,322 Gas 208,208 195,709 __________ __________ 2,380,467 2,312,031 Less--Accumulated depreciation 1,020,097 961,419 __________ __________ 1,360,370 1,350,612 Construction work in progress 61,104 45,219 __________ __________ 1,421,474 1,395,831 __________ __________ Current Assets: Cash 4,038 480 Temporary investments, at cost which approximates market 2,734 2,578 Accounts receivable, net 61,591 48,415 Accrued unbilled revenues 38,774 36,680 Materials and supplies, at average cost 40,824 38,529 Fuel for electric generation, at average cost 26,046 34,382 Gas stored underground, at average cost 14,335 12,180 Prepayments 9,847 13,152 __________ __________ 198,189 186,396 __________ __________ Other Assets 48,799 62,832 __________ __________ $1,668,462 $1,645,059 ========== ========== CAPITALIZATION AND LIABILITIES Capitalization: Common shareholder's equity: Common stock, no par value, authorized 45,000,000 shares; outstanding 25,452,373 and 26,336,718 shares respectively $ 121,282 $ 154,532 Retained earnings 443,741 398,235 __________ __________ 565,023 552,767 Preferred stock 80,000 65,000 Long-term debt 474,323 493,700 __________ __________ 1,119,346 1,111,467 __________ __________ Current Liabilities: Long-term debt due within one year 20,000 10,000 Commercial paper - 17,393 Accounts payable 55,931 56,786 Accrued wages 12,720 11,417 Accrued taxes 13,391 11,117 Accrued interest 9,204 6,564 Other 34,895 27,934 __________ __________ 146,141 141,211 __________ __________ Deferred Credits: Accumulated deferred income taxes 274,425 330,053 Investment tax credits 58,962 62,328 Regulatory liabilities, net 69,588 - __________ __________ 402,975 392,381 __________ __________ $1,668,462 $1,645,059 ========== ========== The accompanying notes to financial statements are an integral part of these statements. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY STATEMENTS OF CASH FLOW Years Ended December 31, __________________________________ 1993 1992 1991 __________ __________ __________ (in thousands) OPERATING ACTIVITIES: Net income $ 84,011 $ 72,601 $ 75,683 Adjustments to reconcile net income to net cash provided: Depreciation and amortization 77,647 74,154 69,483 Allowance for equity funds used during construction (AFUDC) (1,459) (2,162) (2,054) Deferred income taxes, net 7 16,407 10,822 Investment tax credit amortization (3,366) (3,336) (3,464) Cash flows impacted by changes in assets and liabilities: Accounts receivable, net and accrued unbilled revenues (15,270) 4,542 (9) Fuel for electric generation 8,336 2,872 664 Other inventories (4,450) (667) (893) Prepayments 3,305 23,585 (4,050) Other assets 14,033 (20,210) (12,958) Accounts payable and other 6,106 17,641 2,871 Accrued wages, taxes and interest 6,217 (5,197) (152) Accumulated provision for revenue refunds - (75,449) 16,157 Other 4,815 (5,991) (2,992) __________ __________ _________ Net cash provided by operating activities 179,932 98,790 149,108 __________ __________ _________ INVESTING ACTIVITIES: Construction expenditures, excluding AFUDC (85,453) (117,198) (110,815) Allowance for borrowed funds used during construction (800) (1,064) (1,013) Changes in temporary investments (156) 92,175 36,728 __________ __________ _________ Net cash used in investing activities. (86,409) (26,087) (75,100) __________ __________ _________ FINANCING ACTIVITIES: Proceeds from issuance of long-term debt 195,000 199,000 - Repayment of long-term debt (205,000) (190,500) - Proceeds from issuance of preferred stock 42,500 - - Redemption of preferred stock (27,500) (18,245) (3,000) Retirement of common stock (33,250) (66,100) (66,950) Proceeds from (repayment of) commercial paper (17,393) 17,393 - Dividends paid: Preferred stock (3,718) (4,549) (5,396) Common stock (33,500) - - Issuance expense, discount and premium (7,104) (11,718) - _________ _________ _________ Net cash used in financing activities. (89,965) (74,719) (75,346) _________ _________ _________ Net increase (decrease) in cash 3,558 (2,016) (1,338) Cash at beginning of period 480 2,496 3,834 _________ _________ _________ Cash at end of period $ 4,038 $ 480 $ 2,496 ========= ========= ========= Supplemental disclosures of cash flow information: Cash paid during the period for: Interest, net of amount capitalized $ 30,909 $ 38,382 $ 36,867 Income taxes 48,367 12,150 $ 42,731 The accompanying notes to financial statements are an integral part of these statements. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY STATEMENTS OF RETAINED EARNINGS Years Ended December 31, __________________________________ 1993 1992 1991 __________ __________ __________ (in thousands) Balance, beginning of year $ 398,235 $ 330,518 $ 260,304 Add (deduct); Net income 84,011 72,601 75,683 Dividends: Preferred stock (3,718) (4,549) (5,396) Common stock (33,500) - - Other (1,287) (335) (73) _________ _________ _________ Balance, end of year $ 443,741 $ 398,235 $ 330,518 ========= ========= ========= The accompanying notes to financial statements are an integral part of these statements. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES General. Central Illinois Public Service Company (CIPS or the Utility), a subsidiary of CIPSCO Incorporated (CIPSCO), provides certain services to CIPSCO and other affiliates for which all costs incurred are reimbursed to CIPS. In 1993, 1992 and 1991 these amounts were immaterial. Certain items previously reported for years prior to 1993 have been reclassified to conform with the current-year presentation. Regulation. CIPS is a public utility subject to regulation by the Illinois Commerce Commission (Illinois commission) and the Federal Energy Regulatory Commission (FERC). With respect to accounting matters, the utility maintains its accounts in accordance with the Uniform System of Accounts as defined by these agencies. Its accounting policies conform to generally accepted accounting principles applicable to rate regulated enterprises and reflect the effects of the ratemaking process. Operating Revenues. CIPS accrues an estimate of electric and gas revenues for service rendered but unbilled at the end of each accounting period. Utility Plant. Utility plant in service is stated at original cost. Substantially all of the utility plant of CIPS is subject to the lien of its first mortgage bond indenture. Additions to utility plant include the cost of contracted services, material, labor, overheads and an allowance for funds used during construction. Maintenance and repair of property and replacement of minor items of property are charged to operating expenses. Property retired is removed from utility plant accounts and charged to accumulated depreciation. Allowance for Funds Used During Construction (AFUDC). AFUDC is included in Construction Work in Progress (CWIP) and represents the cost of financing that construction. AFUDC does not represent a current source of cash funds. The inclusion of AFUDC in CWIP affords the opportunity to earn a return on the cost of construction capital after the related asset is placed in service and included in the rate base. The AFUDC rate, based on a formula prescribed by the FERC, on a before- tax basis, was 9% in 1993 and 10% in 1992 and 1991. Depreciation. Depreciation expense is based on remaining life straight-line rates (composite, approximately 3.4% in 1993 and 3.3% in 1992 and 1991) applied to the various classes of depreciable property. Concentration of Credit Risk. CIPS provides electric service to about 316,000 customers in 557 communities and natural gas service to approximately 164,000 customers in 267 communities throughout a 20,000-square-mile area in central and southern Illinois. Credit risk is spread over a diversified base of residential, commercial and industrial customers. Fuel and Purchased Gas Costs. CIPS adjusts fuel expense to recognize over- or under-recoveries from customers of allowable fuel costs through the uniform fuel adjustment clause (FAC). The FAC provides for the current recovery of changes in the cost of fuel for electric generation in billings to customers. Monthly, the difference between revenues recorded through application of the FAC and recoverable fuel costs is recorded as a current asset or liability, pending reflection in future billings to customers, with a corresponding decrease or increase in cost of fuel for electric generation. The uniform purchased gas adjustment clause (PGA) provides a matching of gas costs with revenues. Monthly, the difference between revenues recorded through application of the PGA and recoverable gas costs is recorded as a current asset or liability with a corresponding decrease or increase in the cost of gas purchased. The cumulative difference for the calendar year is collected from, or refunded to, customers over a one-year period beginning in the following April. The Illinois commission conducts annual reconciliation proceedings with respect to each year's FAC and PGA revenues and has completed its review for all years prior to 1992. Reconciliation proceedings for 1992 commenced in October 1993. No reconciliation proceeding has yet commenced for the year 1993. Income Taxes and Investment Tax Credits. Deferred income taxes are recorded which result from the use of accelerated depreciation methods, rapid amortization, repair allowance and certain other timing differences in recognition of income and expense for tax and financial statement purposes. CIPS is included as part of CIPSCO's consolidated federal income tax return. Income taxes are allocated to the individual companies, based on their respective taxable income or loss. Investment tax credits are being amortized over the estimated average useful lives of the related properties. The Company adopted, effective January 1, 1993, the liability method of accounting for deferred income taxes required by Statement of Financial Accounting Standards (SFAS) No. 109. This statement requires the establishment of deferred tax liabilities and assets for all temporary differences between the tax basis of assets and liabilities and the amounts reported in the financial statements. (See Note 9 to Financial Statements.) Cash and Temporary Investments. Temporary investments consist of deposits and U.S. Treasury obligations. For purposes of Statements of Cash Flows, temporary investments are not considered cash equivalents. 2. COMMITMENTS AND CONTINGENCIES Environmental Remediation Costs. The utility and certain of its predecessors and other affiliates operated facilities in the past for manufacturing gas from coal. In connection with manufacturing gas, various by-products were produced, some of which remain on sites where the facilities were located. The utility has identified 13 of these former manufactured gas plant sites (environmental remediation sites) which contain potentially harmful materials. Under directives from the Illinois Environmental Protection Agency (IEPA), CIPS has incurred costs and associated legal expenses related to the investigation and remediation of the sites. One site was added to the United States Environmental Protection Agency (USEPA) Superfund list on August 30, 1990. On September 30, 1992 the IEPA, in consultation with the USEPA, decided that the long-term remedial plan for this site should consist of a ground water pump-and-treat program. The IEPA and CIPS entered into an agreement, subject to court approval, for CIPS to carry out the remedial action with the IEPA providing oversight. It is not known at this time what specific remedial action will be required at the other 12 sites. In 1987, CIPS filed a lawsuit against a number of insurance carriers seeking full indemnification for all costs in connection with certain environmental sites. As of December 31, 1993 all but five insurance carriers have settled. The estimated incurred costs relating to studies and remediation at these 13 sites and associated legal expenses are being accrued and deferred rather than expensed currently, pending recovery through rates, from insurance carriers or from other parties. The total amount deferred represents costs incurred and estimates for costs of completing studies at various sites and an estimate of remediation costs at the Superfund site. At December 31, 1993, the amounts recovered have exceeded the aggregate amount deferred. In 1992, the Illinois commission issued an Order (the Generic Order) in its consolidated generic proceeding regarding appropriate ratemaking treatment of cleanup costs incurred by Illinois utilities with respect to environmental remediation sites. The Generic Order indicates that allowed cleanup costs may include prudently incurred cost of investigation, assessment and cleanup of environmental remediation sites, as well as litigation costs, including those involved in insurance recovery claims. The Generic Order authorizes utilities, including CIPS, to propose a mechanism to recover cleanup costs which is consistent with the provisions of the order. Such a mechanism must, among other things, provide for (1) recovery of cleanup costs over a five-year period, excluding carrying costs associated with the unrecovered balance of cleanup costs from the time that the recovery mechanism becomes effective; (2) a return to ratepayers over a five-year amortization period of any reimbursement of cleanup costs received from insurance carriers or other parties; and (3) a prudence review of each utility's expenditures. The Generic Order was upheld on appeal by the Third District Illinois Appellate Court. That decision held that a rate rider mechanism is an appropriate means for utilities to recover cleanup costs. An intervenor has filed a petition for leave to appeal the decision to the Illinois Supreme Court. The intervenor has maintained that no recovery of cleanup costs should be allowed. The Illinois Supreme Court has discretion to accept or deny the appeal. On March 26, 1993, the Illinois commission approved CIPS' proposed environmental cost-recovery rate riders, effective with April 1993 billings to customers. Known as the electric environmental adjustment clause and the gas environmental adjustment clause, the riders are designed to enable CIPS to recover from its customers costs associated with cleanup of the environmental remediation sites, along with associated legal expenses, over a five-year period on terms consistent with the Generic Order. The environmental adjustment clause riders provide for an annual review of amounts recovered through the riders. Amounts found to have been incorrectly included would be subject to refund. Through December 31, 1993, CIPS has collected $2.6 million from its customers pursuant to the riders. The total costs to be incurred for the cleanup of these sites or the possible recovery from insurance carriers and other parties cannot be estimated. Management believes that costs incurred in connection with the sites that are not recovered from insurance carriers or other parties will be recovered through utility rates. Accordingly, management believes that costs incurred in connection with these sites will not have a material adverse effect on financial position or results of operations. FERC Order 636. During 1992, FERC issued a series of orders that require substantial restructuring of the service obligations of interstate pipeline suppliers. These orders (together called Order 636) required mandatory unbundling of existing pipeline gas sales services. Mandatory unbundling requires pipelines to sell separately the various components previously included with gas sales services. Order 636 provides a mechanism for pipelines to recover four categories of transition costs associated with restructuring their gas sales services. Based on currently available information contained in the various interstate pipeline Order 636 compliance filings, CIPS estimates that the total amount of transition costs to be incurred by CIPS is approximately $10 million. At December 31, 1993 CIPS had recorded a liability and a related deferred gas cost for that portion of the transition costs that will be billed to CIPS regardless of future pipeline services. On September 15, 1993, the Illinois commission initiated an investigation into the appropriate ratemaking treatment of Order 636 transition costs. In January 1994, the hearing examiner released a draft order which would allow full recovery through rates by CIPS of transition costs. A final order from the Illinois commission is expected in the first quarter 1994. Management believes that all transition costs will be recoverable from customers. Clean Air Act. CIPS' compliance strategy to meet the sulfur dioxide emission reduction requirements of the Clean Air Act Amendments of 1990 (Amendments) includes complying with Phase I of the Amendments by switching to a lower sulfur coal at some of its units. Phase II compliance will be accomplished by additional fuel switching at various units and by increased scrubbing with its existing scrubber at Newton Unit 1. Phase I and Phase II emission provisions of the Amendments become effective in 1995 and 2000, respectively. The utility estimates that total capital costs, primarily for modifications to boilers, precipitators, coal handling facilities, and continuous monitoring equipment for implementation of this compliance strategy, will be less than $50 million in total including amounts spent to date. Operating costs are not expected to change materially. Compliance costs could result in electric base rate increases of approximately one to two percent by the year 2000. In 1991, in accordance with the plan to switch some units to lower sulfur coal, the utility signed a long-term coal contract with a current supplier for lower sulfur Illinois coal. Due to the magnitude of the supplier's capital investment, the contract includes a graduated termination charge. In 1994 CIPS can terminate the contract under certain conditions, and CIPS would be required to pay up to $41 million (plus an inflation adjustment) in termination charges. Each year subsequent to 1994 the termination charge is reduced according to a formula using tons of coal purchased. The termination charge would not be effective if CIPS terminated the contract due to the failure of the coal to meet quality specifications provided for in the contract. Labor Disputes. The International Union of Operating Engineers Local 148 and the International Brotherhood of Electric Workers Local 702 have both filed unfair labor practice charges with the National Labor Relations Board (NLRB) relating to the legality of the lockout by CIPS of both unions during 1993. The Peoria Regional Office of the NLRB has issued a complaint against CIPS concerning its lockout of IBEW-702 represented employees. However, the Peoria Regional Office did not find merit to a similar charge filed by IUOE 148 and it has been dismissed, subject to appeal rights. Both unions seek, among other things, back pay and other benefits for the period of the lockout. CIPS estimates the amount of back pay and other benefits for both unions to be less than $12 million. Management believes the lockout was both lawful and reasonable and that the final resolution of the disputes will not have a material adverse effect on financial position or results of operations. Other Issues. The utility is involved in other legal and administrative proceedings before various courts and agencies with respect to rates, taxes, gas and electric fuel cost reconciliations, service area disputes, environmental and other matters. Although unable to predict the outcome of these matters, management believes that appropriate liabilities have been established and that final disposition of these actions will have no material adverse effect on the results of operations or the financial position of CIPS. 3. PREFERRED STOCK The preferred stock is generally redeemable at the option of CIPS on 30 days notice at the redemption prices shown below. At December 31, 1993, 1992 and 1991 the preferred stock outstanding was: 4. PENSIONS AND OTHER POSTRETIREMENT BENEFITS CIPS sponsors a defined benefit pension plan covering substantially all of its employees. The benefits are based on years of service and employees' final average pay. Pension costs are accrued and funded on a current basis based upon actuarial determinations and in compliance with income tax regulations and federal funding requirements. CIPS uses a September 30 measurement date for its valuation of pension plan assets and liabilities. The utility also provides certain employees with pension benefits which exceed the qualified plan limits imposed by federal tax law. Funded Status of Pension Plan (in thousands) 1993 1992 1991 _________ _________ ____________ Fair value of plan assets* $177,824 $150,729 $127,075 _______ _______ _______ Accumulated benefit obligations:** Vested benefits 125,641 98,770 78,515 Nonvested benefits 559 284 212 Effect of projected future compensation levels (based on 4.3% annual increases in 1993, 4.5% in 1992 and 5% in 1991) 41,214 37,025 36,791 _______ _______ _______ Total projected benefit obligation 167,414 136,079 115,518 _______ _______ _______ Plan assets in excess of projected benefit obligation $ 10,410 $ 14,650 $ 11,557 ======= ======= ======= ________________________ * Plan assets are invested in common and preferred stocks, bonds, money market instruments, guaranteed income contracts and real estate. ** The assumed weighted average discount rate was 6.50% for 1993, 7.25% for 1992 and 7.75% for 1991. Pension Plan Assets in Excess of Projected Benefit Obligation (in thousands) 1993 1992 1991 _________ _________ ____________ Plan assets in excess of projected benefit obligation $ 10,410 $ 14,650 $ 11,557 Unrecognized transition asset (being amortized over 18.2 years) (4,862) (5,325) (5,772) Unrecognized net (gain) loss (5,188) (13,617) (14,756) Unrecognized prior service cost 760 1,590 1,703 _______ _______ _______ Prepaid (Accrued) pension costs at September 30 1,120 (2,702) (7,268) Expense, net of funding October to December 1,944 91 (1,347) _______ _______ _______ Prepaid (Accrued) pension costs at December 31 $ 3,064 $ (2,611) $ (8,615) ======= ======= ======= Components of Net Pension Expense (in thousands) 1993 1992 1991 _________ _________ ____________ Service cost (present value of benefits earned during the year) $ 6,398 $ 5,721 $ 6,467 Interest cost on projected benefit obligation 10,193 9,302 8,583 Actual return on plan assets (expected long-term rate of return was 8%) (21,101) (13,755) (19,490) Deferred investment gains 10,071 4,834 11,167 Amortization of the unrecognized prior service cost 118 118 118 Amortization of the transition amount (463) (463) (463) _______ _______ _______ Net pension expense $ 5,216 $ 5,757 $ 6,382 ======= ======= ======= Effective January 1, 1993, CIPS adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The standard requires companies to recognize the cost of providing postretirement medical and life insurance benefits over the employees' service period. CIPS is funding the medical benefits under two Voluntary Employee Beneficiary Association trusts (VEBA), and a 401(h) account established within the Company's retirement income trust. The Company sponsors postretirement plans providing medical and life benefits for certain of its retirees and their eligible dependents. The medical plan pays percentages of eligible medical expenses incurred by covered retirees after a deductible has been met, and after taking into account payment by Medicare or other providers. Currently, participants become eligible for coverage if they retire from CIPS after meeting age and years of service eligiblity requirements. The life insurance plan continues for all retirees who have been in the plan as employees for ten years or more. CIPS uses a September 30 measurement date for its valuation of postretirement assets and liabilities. Funded Status of Postretirement Benefit Plans (in thousands) _________ Fair value of plan assets* $ 13,302 ________ Accumulated benefit obligations: Retirees 39,599 Fully eligible active employees 17,026 Other active employees 80,532 ________ Total accumulated benefit obligation 137,157 ________ Accumulated benefit obligations in excess of plan assets (123,855) Unrecognized transition obligation (being amortized over 20 years) 110,511 Unrecognized net loss (including changes in assumptions) 1,959 ________ Accrued postretirement benefit cost at September 30 (11,385) Expense, net of funding, October to December 9,643 ________ Accrued postretirement benefit cost at December 31 $ (1,742) ======== * Plan assets are invested in common and preferred stocks, bonds, money market instruments, guaranteed income contracts and real estate. Components of Postretirement Benefit Cost (in thousands) _________ Service costs on benefits earned $ 4,215 Interest costs on accumulated benefit obligations 9,948 Actual return on plan assets (1,038) Deferred investment gains 397 Amortization of the transition amount 5,816 _______ Postretirement benefit cost $ 19,338 ======= For purposes of calculating the postretirement benefit obligation it is assumed that health-care costs will increase by 12.75% in 1994, and that the rate of increase thereafter (the health-care cost trend rate) will decline to 4.25% in 2007 and subsequent years. The health-care cost trend rate has a significant effect on the amounts reported for costs each year as well as on the accumulated postretirement benefit obligation. To illustrate, 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 by $20.2 million and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost $2.7 million annually. The weighted-average discount rate used to determine the accumulated postretirement benefit obligation was 7 percent. The expected long-term rate of return on plan assets is 8 percent. In March 1992, CIPS was granted rates by the Illinois commission which included its estimated postretirement costs determined on an accrual basis of accounting. CIPS' financial reporting for postretirement costs is consistent with the related rate treatment. Therefore, adoption of SFAS No. 106 did not have a material effect on financial position or results of operations. The Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," in 1993. The new statement required the accrual of certain postemployment benefits to former or inactive employees. The adoption of SFAS No. 112 did not have a material effect on financial position or results of operations. 5. LONG-TERM DEBT Maturities and sinking fund requirements of CIPS' long-term debt through 1998 are as follows: Sinking Fund Maturities Requirements Total __________ ____________ _______ (in thousands) 1994 $20,000 $300 $20,300 1995 15,000 150 15,150 1996 - 150 150 1997 58,000 - 58,000 1998 - - - In 1993 and 1992 the sinking fund requirements were satisfied by the application of net expenditures for bondable property in an amount equal to 166-2/3 percent of the annual requirement. The utility expects to meet the 1994 requirement in the same manner. Long-term debt outstanding at December 31, excluding maturities due within one year, was: 1993 1992 Amount Amount ______ ______ (in thousands) First mortgage bonds (principal amount): Series J, 4 1/2% due 5/1/1994 $ - $20,000 Series K, 4 5/8% due 6/1/1995 15,000 15,000 Series L, 5 7/8% due 5/1/1997 15,000 15,000 Series N, 7 1/2% due 4/1/2001 - 35,000 Series P, 7 1/2% due 5/1/2002 - 30,000 Series 6 5/8% due 8/1/2009 (for Newton pollution control) 1,000 1,000 Series W, 7 1/8% due 5/15/1999 50,000 50,000 Series W, 8 1/2% due 5/15/2022 33,000 33,000 Series X, 6 1/8% due 7/1/1997 43,000 43,000 Series X, 7 1/2% due 7/1/2007 50,000 50,000 Series Y, 6 3/4% due 9/15/2002 23,000 23,000 Series Z, 6% due 4/1/2000 25,000 - Series Z, 6 3/8% due 4/1/2003 40,000 - _______ _______ 295,000 315,000 _______ _______ 1993 1992 Amount Amount ______ ______ (in thousands) Pollution control loan obligations: Series A, 5.85% due 10/1/2007 - 60,000 Series B, 6.80% due 4/1/2005 - 17,500 Series B, 6 7/8% due 4/1/2009 - 17,500 Series C, 6 5/8% due 8/1/2004 - 20,000 Series C, 6 3/4% due 8/1/2009 - 15,000 1990 Series A, 7.60% due 3/1/2014 20,000 20,000 1990 Series B, 7.60% due 9/1/2013 32,000 32,000 1993 Series A, 6 3/8% due 1/1/2028 35,000 - 1993 Series B-1, 4 3/8% due 6/1/2028 17,500 - 1993 Series B-2, 5.90% due 6/1/2028 17,500 - 1993 Series C-1, 4.20% due 8/15/2026 35,000 - 1993 Series C-2, 5.70% due 8/15/2026 25,000 - _______ _______ 182,000 182,000 _______ _______ Unamortized net debt premium and discount (2,677) (3,300) _______ _______ $474,323 $493,700 ======= ======= Interest rates on the 1993 Series B-1 and 1993 Series C-1 bonds will be adjusted to a then current market rate on June 1, 1998 and August 15, 1998, respectively. Interest rates on the 1993 Series B-2 and 1993 Series C-2 bonds are subject to redetermination at the option of the utility commencing June 1, 2003 and August 15, 2003, respectively. 6. COMMON SHAREHOLDER'S EQUITY Common Stock. The authorized common stock, no par value, for CIPS was 45,000,000 shares as of December 31, 1993, 1992 and 1991. All outstanding shares were exchanged with CIPS shareholders for CIPSCO Incorporated stock on October 1, 1990. Since then, CIPSCO Incorporated which holds all CIPS common shares, has been retiring CIPS shares as detailed in the table below: Retained Earnings. CIPS is subject to restrictions on the use of retained earnings for cash dividends on common stock applicable to all corporations under the Illinois Business Corporation Act, as well as those contained in its mortgage indenture and articles of incorporation. At December 31, 1993, 1992 and 1991, no amount of retained earnings was restricted. 7. LINES OF CREDIT AND SHORT-TERM BORROWINGS CIPS has arrangements for bank lines of credit which totaled $77.9 million. CIPS compensates banks for lines of credit totaling $60 million. The bank lines of credit are for corporate purposes including the support of any commercial paper borrowings. At December 31, 1993 there were no short- term borrowings at CIPS. 8. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value at December 31, 1993 and 1992 of each class of financial instruments for which it is practicable to make such estimates. Cash and Temporary Investments - The carrying amounts approximate fair value because of the short-term maturity of these instruments. Short-Term Borrowings - The carrying amounts approximate fair value due to their short-term maturities. Preferred Stock - The fair value was estimated using market values provided by independent pricing services. Long-Term Debt - The fair value was estimated using market values provided by independent pricing services. The estimated fair value of the Company's financial instruments as of December 31, are shown below: 1993 1992 _________________ _________________ Carrying Fair Carrying Fair Value Value Value Value ________ _____ ________ _____ (in thousands) Preferred Stock $ 80,000 $ 68,403 $ 65,000 $ 50,519 Long-Term Debt 474,323 504,478 493,700 514,912 9. INCOME TAXES The Company adopted the liability method of accounting for deferred income taxes in compliance with Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" effective January 1, 1993. Due to rate regulation, adoption of this statement had an immaterial effect on net income. However, the adoption resulted in a balance sheet reduction of $81.3 million of deferred income taxes along with corresponding balance sheet increases of $95.3 million of regulatory liabilities, net, and $14 million of plant assets. Income tax expense continues to include provisions for deferred taxes to reflect the effect of temporary differences between the time certain costs are recorded for financial reporting and when they are deducted for income tax return purposes. As temporary differences reverse, the related accumulated deferred income taxes and a portion of the regulatory assets and liabilities are also reversed. Investment tax credits have been deferred and will continue to be credited to income over the lives of the related property. The components of federal and state income tax provisions and investment tax credits at December 31, were: 1993 1992 1991 ________ ________ ________ (in thousands) Current - - Federal $ 42,422 $ 6,859 $ 29,950 - - State 8,019 (749) 6,366 _______ _______ _______ 50,441 6,110 36,316 _______ _______ _______ Deferred - - Federal 1,483 26,551 5,800 - - State 191 7,447 1,773 _______ _______ _______ 1,674 33,998* 7,573* _______ _______ _______ Amortization of deferred investment tax credits (3,366) (3,336) (3,464) _______ _______ _______ Total 48,749 36,772 40,425 _______ _______ _______ Nonoperating income taxes: Current 1,119 2,411 1,629 Deferred (488) 578 784 _______ _______ _______ 631 2,989 2,413 _______ _______ _______ Total income taxes $ 49,380 $ 39,761 $ 42,838 ======= ======= ======= 1992 1991 ______ ______ (in thousands) *Detail of Deferred Taxes: Excess of tax depreciation and amortization over book $ 5,566 $ 7,465 Unbilled revenues - - Revenue refunds 29,526 (6,259) Deferred fuel cost (2,921) 2,030 Deferred environmental site cleanup costs 62 2,243 Alternative minimum tax credit carryforward (4,449) - Cost of removal 3,108 731 Unamortized loss on reacquired debt 3,561 (72) Miscellaneous (455) 1,435 _______ _______ Total $ 33,998 $ 7,573 ======= ======= Reconciliations with statutory federal income tax rates at December 31 were: 1993 1992 1991 ---- ---- ---- Effective income tax rate 37.0% 35.4% 36.1% Amortization of investment tax credits 2.5 3.0 2.9 Tax exempt interest and dividends .7 1.3 1.9 Out-of-period items (0.1) (0.6) (1.8) State income tax rate, net of federal income tax benefit (4.0) (4.2) (4.8) Other, net (1.1) (0.9) (0.3) ____ ____ ____ Statutory federal income tax rate 35.0% 34.0% 34.0% ==== ==== ==== The components of deferred income taxes at December 31 and January 1, 1993 are: December 31, 1993 January 1, 1993 _________________ _______________ (in thousands) Accumulated deferred income tax liabilities related to: Depreciable propeprty $316,327 $298,089 Investment tax credits (23,500) (24,145) Regulatory liabilities, net (27,423) (37,148) Other 9,021 11,773 _______ _______ Accumulated deferred income taxes per balance sheet $274,425 $248,569 ======= ======= Deferred tax assets (included in prepayments $ 5,977 $ 7,155 ======= ======= 10. SEGMENTS OF BUSINESS CIPS is a public utility engaged in the sale of electricity which it generates, transmits and distributes. CIPS also sells natural gas, which it purchases from producers and suppliers and distributes through its system, and transports customer-owned natural gas. The following is a summary of operations: Years Ended December 31, _________________________________ 1993 1992 1991 ______ ______ ______ (in thousands) OPERATING INFORMATION Electric operations: Operating revenues $ 688,849 $ 595,642 $ 592,669 Operating expenses, excluding provision for income taxes 534,070 472,414 455,366 _________ _________ _________ Pretax operating income 154,779 123,228 137,303 _________ _________ _________ Gas operations: Operating revenues 145,707 133,760 117,536 Operating expenses, excluding provision for income taxes 138,086 122,844 110,375 _________ _________ _________ Pretax operating income 7,621 10,916 7,161 _________ _________ _________ Total 162,400 134,144 144,464 _________ _________ _________ Plus other income and deductions 4,460 10,151 13,113 Less interest charges 34,100 34,922 41,469 Less income taxes 48,749 36,772 40,425 Less preferred dividends 3,718 4,549 5,396 _________ ________ _________ Earnings for common stock $ 80,293 $ 68,052 $ 70,287 ========= ========= ========= Depreciation expense: Electric $ 71,876 $ 68,902 $ 64,880 Gas 5,771 5,252 4,603 _________ ________ _________ Total $ 77,647 $ 74,154 $ 69,483 ========= ========= ========= INVESTMENT INFORMATION Identifiable assets: Electric $1,459,073 $1,443,578 $1,419,036 Gas 177,857 188,321 157,757 Temporary investments 2,734 2,578 94,753 Corporate 28,798 10,582 20,297 _________ ________ _________ Total $1,668,462 $1,645,059 $1,691,843 ========= ========= ========= Construction expenditues: Electric $ 76,956 $ 103,023 $ 99,004 Gas 10,756 17,401 14,878 _________ ________ _________ Total $ 87,712 $ 120,424 $ 113,882 ========= ========= ========= 11. REVENUES COLLECTED SUBJECT TO REFUND In May 1992, the Illinois commission approved a March 18, 1992 settlement agreement that resolved a proceeding regarding the impact on the utility of the reduced federal corporate income tax rates established by the Tax Reform Act of 1986. Under terms of the agreement, $73 million, including accrued interest, was refunded to customers from July through December 1992 in complete settlement of all issues related to the proceeding. For the 61-month period, March 1987 through March 1992, a total of $78.4 million had been accrued for refunds. The total liability recorded by the utility exceeded the settlement agreement amount by $5.4 million resulting in a $3.3 million (net of taxes) favorable impact on earnings during 1992. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The fluctuations in the quarterly results are due to the seasonal nature of the electric and gas utility business. Total Total Earnings Operating Operating for Common Revenues Income Stock _________ _________ __________ (in thousands) Quarters First $209,548 $ 24,726 $ 15,774 Second 187,385 20,093 11,610 Third 232,104 46,204 38,172 Fourth 205,519 22,628 14,737 First 182,208 17,055 10,884 Second 165,104 21,859 15,634* Third 187,154 38,129 29,441 Fourth 194,936 20,329 12,093 * Quarterly earnings reflect adjustment for settling Revenues Subject to Refund proceeding. See Note 11 to Notes to Financial Statements. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Central Illinois Public Service Company: We have audited the accompanying balance sheets of CENTRAL ILLINOIS PUBLIC SERVICE COMPANY (an Illinois corporation and a wholly owned subsidiary of CIPSCO Incorporated) 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 and schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Central Illinois Public Service 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. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in 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. 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 basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois, January 28, 1994 Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The information required by Item 10 relating to each director who is a nominee for election as director at the Company's 1994 Annual Meeting of Shareholders is to be set forth in the Company's definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 (the "proxy statement") in connection with the Company's Annual Meeting of Shareholders. Such information is incorporated herein by reference to the material appearing under the caption "Election of Directors -- Director Information" in the proxy statement. Information required by Item 10 relating to directors and executive officers of the Company is set forth under a separate caption in Part I hereof. Item 11. Item 11. Executive Compensation. The information required by Item 11 is to be set forth in the proxy statement. Such information is incorporated herein by reference to the material appearing under the caption "Election of Directors -- Executive Compensation" and -- "Directors' Compensation" appearing in the proxy statement; provided, however, that no part of the information appearing under the portion of the proxy statement entitled "Election of Directors -- Compensation Committee Report on Executive Compensation" or -- "Performance Graph" is deemed to be filed as part of this Form 10-K Annual Report. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required by Item 12 is to be set forth in the proxy statement. Such information is incorporated herein by reference to the material appearing under the captions "Voting Securities Beneficially Owned by Principal Holders, Directors, Nominees and Executive Officers" and "Election of Directors -- Director Information" appearing in the proxy statement. Item 13. Item 13. Certain Relationships and Related Transactions. CIPS is a subsidiary of CIPSCO. At December 31, 1993, CIPSCO owned 100% of the common stock of CIPS (representing 97% of the voting shares of CIPS). There are situations where CIPS interacts with its affiliated companies through the use of shared facilities, common employees and other business relationships. In these situations, CIPS receives payment in accordance with regulatory requirements for the services provided to affiliated companies. Each individual who is a member of the Board of Directors of CIPSCO is also a member of the Board of Directors of CIPS. Each of the officers of CIPSCO is also an officer of CIPS. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. Page of this Report on Form 10-K ____________ (a) 1. Financial statements (included in Item 8, Financial Statements and Supplementary Data): Statements of Income for the years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . 33-34 Balance Sheets - December 31, 1993 and 1992 . . . . . 35-36 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . 37-38 Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991. . . . . . . . 39 Notes to Financial Statements . . . . . . . . . . . . 40-58 Report of Independent Public Accountants. . . . . . . 59 (a) 2. Schedules supporting financial statements (included herein): Schedule V - Property, Plant and Equipment at Original Cost for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . 66-68 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equip- ment for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . 69-71 Schedule IX - Short-Term Borrowings for the years ended December 31, 1993, 1992 and 1991. . . . . . 72 Schedule X - Supplementary Income Statement Information for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . 73 All other schedules have been omitted as not applicable or not required or because the information required to be shown therein is included in the financial statements or notes thereto. Page of this Report on Form 10-K ____________ (a) 3. Exhibits 3.01 Amended and Restated Articles of Incorporation, as amended, of CIPS. (Exhibit 3.02 to Form 8-K, dated October 8, 1993). Incorporated by Reference. - 3.02 Bylaws of CIPS (Form 10-Q of the Company (1-3672), June 1990, Exhibit 19) Incorporated by Reference. - 4 Indenture of Mortgage or Deed of Trust dated October 1, 1941, from CIPS to Continental Illinois National Bank and Trust Company of Chicago and Edmond B. Stofft, as Trustees. (Exhibit 2.01 in File No. 2-60232.) Supplemental Indentures dated, respectively September 1, 1947, January 1, 1949, February 1, 1952, September 1, 1952, June 1, 1954, February 1, 1958, January 1, 1959, May 1, 1963, May 1, 1964, June 1, 1965, May 1, 1967, April 1, 1970, April 1, 1971, September 1, 1971, May 1, 1972, December 1, 1973, March 1, 1974, April 1, 1975, October 1, 1976, November 1, 1976, October 1, 1978, August 1, 1979, February 1, 1980, February 1, 1986, May 15, 1992, July 1, 1992, September 15, 1992 and April 1, 1993, between CIPS and the Trustees under the Indenture of Mortgage or Deed of Trust referred to above (Amended Exhibit 7(b) in File No. 2-7341; Second Amended Exhibit 7.03 in File No. 2-7795; Second Amended Exhibit 4.07 in File No. 2-9353; Amended Exhibit 4.05 in file No. 2-9802; Amended Exhibit 4.02 in File No. 2-10944; Amended Exhibit 2.02 in File No. 2-13866; Amended Exhibit 2.02 in File No. 2-14656; Amended Exhibit 2.02 in File No. 2-21345; Amended Exhibit 2.002 in File No. 2-22326; Amended Exhibit 2.02 in File No. 2-23569; Amended Exhibit 2.02 File No. 2-26284; Amended Exhibit 2.02 in File No. 2-36388; Amened Exhibit 2.02 in File No. 2-39587; Amended Exhibit 2.02 in File No. 2-41468; Amended Exhibit 2.02 in File No. 2-43912; Exhibit 2.03 in File No. 2-60232; Amended Exhibit 2.02 in File No. 2-50146; Amended Exhibit 2.02 in File No. 2-52886; Second Amended Exhibit 2.04 in File No. 2-57141; Amended Exhibit 2.04 in File No. 2-57557; Amended Exhibit 2.06 in File No. 2-62564; Exhibit 2.02(a) in File No. 2-65914; Amended Exhibit 2.02(a) in File No. 2-66380; and Amended Exhibit 4.02 in File No. 33-3188; Exhibit 4.02 to Form 8-K dated May 15, 1992; Exhibit 4.02 to Form 8-K dated July 1, 1992; Exhibit 4.02 to Form 8-K dated September 15, 1992; Exhibit 4.02 to Form 8-K dated March 30, 1993.) Incorporated by reference. - Page of this Report on Form 10-K ____________ Exhibits (Continued) 10.01 Form of Deferred Compensation Agreement for Directors . . . - (Exhibit 10.01 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.02 Amended Form of Deferred Compensation Agreement for . . . . 75-81 Directors 10.03 Form of Special Executive Retirement Plan . . . . . . . . . - (Exhibit 10.03 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.04 Amendment to Form of Special Executive Retirement . . . . . 82 Plan 10.05 Form of Employment Agreement (change in control . . . . . . - severance agreement) (Exhibit 10.05 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.06 Form of Director's Retirement Income Plan . . . . . . . . . - (Exhibit 10.06 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.07 Form of Excess Benefit Retirement Plan. . . . . . . . . . . - (Exhibit 10.07 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.08 Amendment to Form of Excess Benefit Retirement. . . . . . . 83 Plan 10.09 Form of Management Incentive Plan . . . . . . . . . . . . . - (Exhibit 10.09 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 12 Computation of Ratio of Earnings to Fixed Charges . . . . . 84 21 Subsidiaries of Registrant. . . . . . . . . . . . . . . . . 85 Page of this Report on Form 10-K ____________ Exhibits (Continued) 23 Consent of Independent Public Accountants . . . . . . . . . 86 24 Powers of Attorney. . . . . . . . . . . . . . . . . . . . . 87-94 99 Description of Capital Stock. . . . . . . . . . . . . . . . 95-96 Exhibits 10.01 through 10.09 are management contracts or compensatory plans or arrangements required to be filed as exhibits pursuant to Item 14(c) hereof. The following instruments defining the rights of holders of certain unregistered long-term debt of CIPS have not been filed with the Securities and Exchange Commission but will be furnished upon request. 1. Loan Agreement dated as of March 1, 1990, between CIPS and the Illinois Development Finance Authority (IDFA) in connection with the IDFA's $20,000,000 Pollution Control Revenue Refunding Bonds, 1990 Series A due March 1, 2014 and $32,000,000 Pollution Control Revenue Refunding Bonds, 1990 Series B due September 1, 2013. 2. Loan Agreement dated January 1, 1993, between CIPS and IDFA in connection with IDFA's $35,000,000, 6-3/8% Pollution Control Revenue Refunding Bonds (Central Illinois Public Service Company Project) 1993 Series A, due January 1, 2028. 3. Loan Agreement dated June 1, 1993, between CIPS and IDFA in connection with IDFA's $17,500,000 Pollution Control Revenue Refunding Bonds, 1993 Series B-1 due June 1, 2028 and $17,500,000 Pollution Control Revenue Refunding Bonds, 1993 Series B-2 due June 1, 2028. 4. Loan Agreement dated August 15, 1993, between CIPS and IDFA in connection with IDFA's $35,000,000 Pollution Control Revenue Refunding Bonds, 1993 Series C-1 due August 15, 2026 and $25,000,000 Pollution Control Revenue Refunding Bonds, 1993 Series C-2 due August 15, 2026. 5. CIPS Credit Agreement dated October 1, 1992 with various banks providing unsecured lines of credit in an aggregate amount of $60,000,000. (b) Reports on Form 8-K (filed during the reporting period): Date of Report Item Reported ______________ _____________ October 8, 1993 Item 7. Financial Statements, Pro Forma Financial Information and Exhibits. Contains certain exhibits filed in connection with the Registration Statements of CIPS (Registration Nos. 33-59674 and 33-50349) which became effective March 29, 1993 and September 30, 1993, respectively. (c) Reports on Form 8-K (filed subsequent to the reporting period): None. SCHEDULE X CENTRAL ILLINOIS PUBLIC SERVICE COMPANY SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (in thousands) = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = Column A Column B Charged to Costs and Expenses _____________________________ 1993 1992 1991 ____ ____ ____ Taxes other than income taxes: Real estate . . . . . . . . . . . . . . $ 7,517 $ 7,055 $ 7,301 Invested capital. . . . . . . . . . . . 8,876 8,888 8,989 Gross receipts and public utility . . . 30,961 27,207 30,150 Payroll . . . . . . . . . . . . . . . . 6,980 7,617 6,960 Other . . . . . . . . . . . . . . . . . 433 339 536 _______ _______ _______ $ 54,767 $ 51,106 $ 53,936 ======= ======= ======= The amounts charged to the respective accounts for royalties, advertising, and depreciation and amortization of intangible assets, preoperating costs and similar deferrals each aggregated 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 registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY (Registrant) By C. L. GREENWALT _____________________________________ C. L. Greenwalt President and Chief Executive Officer Date: March 10, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the date indicated. Signature Title Principal Executive Officer: C. L. GREENWALT President and Chief Executive Officer and Director Principal Financial Officer: R. W. JACKSON Senior Vice President and Secretary, Director and as Attorney-in-Fact* Principal Accounting Officer: J. C. FIAUSH Controller WILLIAM J. ALLEY* Director ROBERT S. ECKLEY* Director JOHN L. HEATH* Director GORDON R. LOHMAN* Director HANNE M. MERRIMAN* Director DONALD G. RAYMER* Director THOMAS L. SHADE* Director JAMES W. WOGSLAND* Director Date: March 10, 1994 EXHIBIT 10.02 A G R E E M E N T This AGREEMENT made this_______ day of _____________, 19__, by and between CENTRAL ILLINOIS PUBLIC SERVICE COMPANY, an Illinois corporation (hereinafter called the "Company"), and ____________________________ (hereinafter called the "Director"). WITNESSETH: WHEREAS, the Director is a member of the Board of Directors of the Company; and WHEREAS, the Company and the Director desire to enter into this Agreement with respect to compensation to accrue to the Director as a member of the Board of Directors commencing __________, 19__ (the "Effective Date"); NOW, THEREFORE, in consideration of the covenants and agreements hereinafter set forth it is agreed: 1. The Director shall serve diligently and honestly in the administration of the affairs of the Company during his or her service as a director. 2. As compensation for the services to be rendered by the Director to the Company, the Company shall set up on its books an account in the name of the Director to which shall be accrued, commencing with the Effective Date and continuing for the period that compensation is to be accrued hereunder, the amounts provided in subparagraphs (a) and (b) hereof. (a) There shall be accrued to the account amounts equivalent to such amounts as the Director would have received as a director of the Company as compensation for the services rendered by the Director but for this Agreement, such accruals to commence as of the respective dates payment of such amounts would have been made by the Company. (b) There shall be accrued an additional amount equivalent to such amounts as would have been available if the amount accrued to the account were invested in CIPSCO Incorporated Common Stock at the closing price as reported in the listing of the New York Stock Exchange - Composite Transactions for the trading day coincident with or next following the date payment would have been made to the Director but for this Agreement, including subsequent cash dividends on the shares of Common Stock treated as credited to the Director's account. Such cash dividends shall be treated as automatically reinvested in CIPSCO Incorporated Common Stock at the closing price as reported in the listing of the New York Stock Exchange - Composite Transactions for the trading day concident with or next following the applicable dividend payment date. Adjustments of the value of the account for appreciation or depreciation in the market value of shares of Common Stock deemed to be so held will be made on any applicable valuation date using the closing price as reported in the listing of the New York Stock Exchange - Composite Transactions. 3. The amount accrued to the Director's account shall be paid over in accordance with the provisions of this paragraph 3. (a) Commencing with the last day of the calendar quarter in which the Director shall have retired as a director of the Company and its affiliates, the Company shall pay, or commence to pay, to the Director in cash the amount accrued to his or her account as of such date. The manner of payment shall be in accordance with Payment Method 1 below or Payment Method 2 below, whichever the Director designates at the end of this Agreement as the method of payment; provided, however, that the Director may elect from time to time to change as of any January 1 his or her payment designation by filing an appropriate written direction with the Company prior to the January 1st as which the change is to be effective. A change in payment designation, however, shall only be effective with respect to amounts to be accrued to the Director's account attributable to years of service commencing on or after the effective date of such change for which compensation is accrued under Paragraph 2(a) of this Agreement. A payment designation shall be irrevocable with respect to amounts accrued to the Director's account that are attributable to years of service commencing prior to such January 1st during which the payment designation was in effect. Payment Method 1 -- The portion of the Director's account covered by this Payment Method 1 shall be paid over in equal quarterly installments, the number of which shall be the lesser of (i) 20 or (ii) the number of calendar quarters during which compensation was accrued under this Agreement and under any similar agreement with the Company or an affiliate of the Company (but not counting any such calendar quarter more than once). In addition, the Company shall pay to the Director quarterly an amount equivalent to interest on the balance of such portion of his or her account from time to time unpaid, at a rate, in respect of each quarterly payment, equal to the rate of interest obtained at the auction of six month United States Treasury Bills taking place nearest to the first day of the calendar quarter for which the payment is made. Payment Method 2 -- The portion of the Director's account covered by this Payment Method 2 shall be paid over in one of the following methods as the Company, in its sole discretion, shall determine prior to the Director's retirement after consultation with the Director: (i) By payment in a lump sum, or (ii) By payment in equal quarterly installments, the number of which shall be the lesser of (i) 20 or (ii) the number of calendar quarters during which compensation was accrued under this Agreement and under any similar agreement with the Company or an affiliate of the Company (but not counting any such calendar quarter more than once). In addition, the Company shall pay to the Director quarterly an amount equivalent to interest on the balance of such portion of his or her account from time to time unpaid at a rate, in respect of each quarterly payment, equal to the rate of interest obtained at the auction of six month United States Treasury Bills taking place nearest to the first day of the calendar quarter for which the payment is made. (b) Upon the death of the Director prior to complete distribution of the amount accrued to his or her account, any undistributed amount shall be paid in cash in a lump sum to such beneficiaries and in such proportions among them as the Director shall have designated in the latest instrument in writing filed by the Director with the Company. If there shall be no beneficiary designated or in existence at the Director's death, any undistributed amount shall be paid to the executor or administrator of the Director's estate. If the death of the Director occurs prior to retirement, the amount to be distributed shall be based on the value of his or her account as of the last day of the calendar quarter in which death occurs. 4. The Director, by filing an appropriate written direction with the Company prior to January 1 of any calendar year, may have the amounts payable for service referred to in paragraph 2 subsequent to such January 1 paid in cash. Any such direction shall be effective with respect to all future calendar years until revoked by the Director filing an appropriate written direction with the Company prior to January 1 of any calendar year to the have the amounts payable for such services subsequent to January 1 accrued hereunder. 5. The Director shall have no power to commute, encumber, sell or otherwise dispose of the rights provided herein and such rights shall be non-assignable and non-transferable. 6. This Agreement shall be binding upon and inure to the benefit of the Director, his heirs, executors and administrators, and the Company, its successors and assigns. 7. All amounts payable under this Agreement shall be paid by the Company from its general assets. No trust fund or other fund shall be created or held for the financing of such amounts. 8. Attached hereto and incorporated herein are the Elections of Director, dated the date hereof, made under this Agreement. Such elections are hereby acknowledged by the Company. IN WITNESS WHEREOF, the parties have signed this Agreement on the day and year first above written. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY By______________________________ ATTEST: ________________________ Secretary _____________________________________ Director ELECTIONS INSTRUCTION: CHECK APPROPRIATE BOXES AND FILL IN BLANKS. 1. Payment Method Under Paragraph 3: Subject to my right to change my payment designation to the extent provided in Paragraph 3 of the Agreement, I designate the following method for payment of amounts accrued to my account under the Agreement: / / Payment Method 1 / / Payment Method 2 2. Beneficiary: My beneficiary(ies) are as indicated on the attached "Designation of Beneficiary." Name of Director ________________________ Date _________________________* * Date as of date Agreement is signed, same date as in caption on page 1. _______________________________ _____________________________ Name of Director Account No. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY DEFERRED COMPENSATION AGREEMENT _______________________ DESIGNATION OF BENEFICIARY 1. Pursuant to the provisions of the Deferred Compensation Agreement ("Agreement") between Central Illinois Public Service Company and me, dated _______________, 19___, I hereby designate the following as the beneficiary(ies) to whom the entire undistributed amount accrued to my account under the Agreement shall be paid in the event of my death: Address (Street, City, Birth Perct. of Full Name State & Zip Code) Relationship Date Distribution ______________ _________________ ____________ ____ ____________ ______________ _________________ ____________ ____ ____________ ______________ _________________ ____________ ____ ____________ ______________ _________________ ____________ ____ ____________ I have designated above more than one beneficiary, payment of such undistributed amount shall be made to the beneficiary(ies) surviving me in the percentage indicated; provided, however, if any beneficiary shall not survive me, such beneficiary's share shall be paid to the beneficiaries(ies) who do survive me pro-rata based on the percentages indicated. 2.If no beneficiary designated above survives me, I hereby designate the following contingent beneficiary(ies) to whom the entire undistributed amount accrued to my account under the Agreement shall be paid in the event of my death: Address (Street, City, Birth Perct. of Full Name State & Zip Code) Relationship Date Distribution ____________ _________________ _____________ ______ ____________ ____________ _________________ _____________ ______ ____________ ____________ _________________ _____________ ______ ____________ ____________ _________________ _____________ ______ ____________ If I have designated above more than one contingent beneficiary, payment of such undistributed amount shall be made to the contingent beneficiary(ies) surviving me in the percentage indicated; provided, however, if any beneficiary shall not survive me, such beneficiary's share shall be paid to the beneficiary(ies) who do survive me pro-rata based on the percentages indicated. 3. I hereby revoke any previous beneficiary designations made by me with respect to the Agreement. IN WITNESS WHEREOF, I have signed this designation in duplicate this ______________ day of ____________, 19____. ____________________________________ Signature of Director The foregoing is in accordance with our records. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY By _______________________________ EXHIBIT 10.04 AMENDMENT NO. 3 TO CENTRAL ILLINOIS PUBLIC SERVICE COMPANY SPECIAL EXECUTIVE RETIREMENT PLAN The Central Illinois Public Service Company Special Executive Retirement Plan, as heretofore amended (the "Plan"), is hereby further amended, effective as of December 1, 1993, in the following respect: 1. By adding to Article III of the Plan a new paragraph L. after paragraph K. as follows: "L. VESTED BENEFIT - Each employee of an Employer on December 31, 1993 who is eligible to take normal or early retirement under the Retirement Income Plan and who on such retirement would be an eligible participant as defined in Article I shall be fully vested in his Accrued Benefit under the Plan as of December 31, 1993 subject to the terms and conditions of the Plan. For this purpose, "Accrued Benefit" means the amount of monthly benefit to which such employee would be entitled under Article II of the Plan if he terminated his employment with the Company and its affiliates as of December 31, 1993. Such employee's Accrued Benefit shall also include the amount of monthly benefit to which the employee's Eligible Spouse would be entitled following his death." IN WITNESS WHEREOF, Central Illinois Public Service Company has executed this instrument this _7th_ day of December, 1993. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY By: _______/s/Clifford L. Greenwalt_____ President [CORPORATE SEAL] ATTEST: _/s/Craig D. Nelson___ Assistant Secretary EXHIBIT 10.08 AMENDMENT NO. 1 TO CENTRAL ILLINOIS PUBLIC SERVICE COMPANY EXCESS BENEFIT PLAN (As Amended And Restated Effective As Of October 1, 1990) The Central Illinois Public Service Company Excess Benefit Plan (As Amended And Restated Effective As Of October 1, 1993), (the "Plan"), is hereby further amended, effective as of December 1, 1993, in the following respect: 1. By adding to Article II of the Plan a new paragraph L. after paragraph K. as follows: "L. VESTED BENEFIT - Each participant in the Basic Plan who is an employee of the Company on December 31, 1993 shall be fully vested in his Accrued Benefit under the Excess Benefit Plan as of December 31, 1993 subject to the terms and conditions of the Excess Benefit Plan. For this purpose, "Accrued Benefit" means the amount of monthly benefit to which a participant in the Basic Plan would be entitled under Article I of the Excess Benefit Plan if he terminated his employment with the Company and its affiliates as of December 31, 1993. A participant's Accrued Benefit shall also include the amount of monthly benefit to which the participant's Eligible Spouse would be entitled following his death." IN WITNESS WHEREOF, Central Illinois Public Service Company has executed this instrument this _7TH_ day of December, 1993. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY By: _____/s/Clifford L. Greenwalt______ President [CORPORATE SEAL] ATTEST: ___/s/Craig D. Nelson____ Assistant Secretary Exhibit 21 Central Illinois Public Service Company Subsidiaries of Registrant State or Jurisdiction Subsidiary of Incorporation __________ _____________________ Illinois Steam Inc. Illinois CIPS Energy Inc. Illinois Electric Energy, Inc.* Illinois *Central Illinois Public Service Company owns 20% of the common stock of EEI. Exhibit 23 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS _________________________________________ As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K, into Central Illinois Public Service Company's previously filed Registration Statements File Nos. 33-29384, 33- 31475, 33-59674, and 33-50349 and CIPSCO Incorporated's previously filed Registration Statement File No. 33-32936. ARTHUR ANDERSEN & CO. Chicago, Illinois, March 10, 1994 Exhibit 24 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/William J. Alley _______________________________ (SEAL) William J. Alley Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Robert S. Eckley _______________________________ (SEAL) Robert S. Eckley Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/John L. Heath _______________________________ (SEAL) John L. Heath Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Gordon R. Lohman _______________________________ (SEAL) Gordon R. Lohman Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Hanne M. Merriman _______________________________ (SEAL) Hanne M. Merriman Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Donald G. Raymer _______________________________ (SEAL) Donald G. Raymer Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Thomas L. Shade _______________________________ (SEAL) Thomas L. Shade Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/James W. Wogsland _______________________________ (SEAL) James W. Wogsland Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 Exhibit 99 DESCRIPTION OF CAPITAL STOCK General. The authorized capital stock of Central Illinois Public Service Company (the "Company") consists of 2,000,000 shares of Cumulative Preferred Stock, par value $100 per share, issuable in series, of which 800,000 shares are outstanding; 2,600,000 shares of Cumulative Preferred Stock without par value, issuable in series, of which no shares are outstanding (both such classes of preferred stock being hereinafter collectively referred to as the "Preferred Stock"); and 45,000,000 shares of Common Stock without par value of which 25,452,373 shares were outstanding (all of which were held by CIPSCO) at December 31, 1993. The following statements, unless the context otherwise indicates, are brief summaries of the substance or general effect of certain provisions of the Company's Restated and Amended Articles of Incorporation, as amended, and the reslutions establishing series of Preferred Stock (collectively, the "Articles"), and of its Mortgage Indenture securing its outstanding First Mortgage bonds. Such statements make use of defined terms and are not complete; they are subject to all the provisions of the Articles or the Mortgage Indenture, as the case may be. Dividend Rights. Whenever dividends on all outstanding shares of the Preferred Stock of all series for all previous quarter-yearly dividend periods and the current quarter-yearly dividend period shall have been paid or declared and set apart for payment, and whenever all amounts required to be set aside for any sinking fund for the redemption or purchase of shares of the Preferred Stock for all previous periods or dates shall have been paid or set aside, and subject to the limitations summarized below, the Board of Directors may declare dividends on the Common Stock out of any surplus or net profits of the Company legally available for the purpose. Currently, none of the series of the Preferred Stock have a sinking fund for the redemption or purchase of shares of such series. The Mortgage Indenture provides, in effect, that the Company will not declare or pay any dividends (other than in stock) on Common Stock, or make any other distribution on or purchase any Common Stock, unless the total amount charged or provided for maintenance, repairs and depreciation of the mortgaged properties subsequent to December 31, 1940, plus the surplus earned during the period and remaining after any such dividend, distribution or purchase, shall equal at least 15% of the Company's total utility operating revenues for the period, after deducting from such revenues the cost of electricity and gas purchased for resale. The Articles provide in effect that, so long as any Preferred Stock is outstanding, the total amount of all dividends or other distributions on Common Stock (other than in stock) that may be paid, and purchases of Common Stock that may be made, during any 12- month period shall not exceed (a) 75% of the Company's net income (as defined) for the 12-month period next preceding each such dividend, distribution or purchase, if the ratio of "common stock equity" to "total capital" (as defined) is 20% to 25%, or (b) 50% of such net income if such ratio is less than 20%. If such ratio is in excess of 25%, no such dividends may be paid or distributions or purchases made that would reduce such ratio to less than 25% except to the extent permitted by clauses (a) and (b). At December 31, 1993, no amount of retained earnings was restricted as to the payment of dividends on Common Stock under the foregoing provisions of the Mortgage Indenture or the Articles. Voting Rights. Under Illinois law, each share of common stock of the Company, common and preferred, is entitled to one vote on each matter voted on at all meetings of shareholders, with the right of cumulative voting in the election of directors and the right to vote as a class on certain questions. The Articles give to holders of Preferred Stock certain special voting rights designed to protect their interests with respect to specified corporate action, including certain amendments to the Articles, the issuance of Preferred Stock or parity stock, the issuance or assumption of certain unsecured indebtedness, and mergers, consolidations or sales or leases of substantially all of the Company's assets. Preemptive Rights. Holders of Common Stock have no preemptive subscription rights. Liquidation Rights. In the event of any liquidation or dissolution of the Company, holders of Common Stock are entitled to share ratably in the net assets and profits of the Company remaining after the payment in full to the holders of the Preferred Stock of the aggregate preferential amount payable in respect of the Preferred Stock in any such event. Miscellaneous. The Transfer Agents for the Common Stock are Illinois Stock Transfer Company, Chicago, Illinois, and Harris Trust and Savings Bank, Chicago, Illinois; and the Registrar is Harris Trust and Savings Bank, Chicago, Illinois. The Company reserves the right to increase, decrease or reclassify its authorized capitial stock or any class or series thereof, and to amend or repeal any provisions in the Articles; and all rights conferred on shareholders in the Articles are subject to this reservation.

68412_1993.txt

68412_1993

1993

68412

ITEM 1. BUSINESS. NATURE OF THE BUSINESS Mosinee Paper Corporation was incorporated in Wisconsin in 1910. The company and its subsidiaries (collectively, the "company") operate in the pulp and paper industry. The company's Pulp and Paper Division ("Pulp and Paper") produces and sells specialty papers and its Mosinee Converted Products Division ("Converted Products") produces and sells wax laminated and converted papers. Bay West Paper Corporation ("Bay West") produces, converts and sells towel and tissue paper products and The Sorg Paper Company ("Sorg Paper"), produces and sells specialty papers. Additional wholly-owned subsidiaries are: Mosinee Paper International Inc., which administers export sales for the company and acts as a foreign sales corporation (FSC); and Mosinee Holdings, Inc., which operates a power plant in Middletown, Ohio to provide steam and electricity to Sorg Paper and Bay West's towel and tissue paper mill located there. SEGMENT INFORMATION The manufacture and sale of paper is the company's only line of business. PRINCIPAL PRODUCTS AND SERVICES The principal product groups of the company are specialty papers, laminated and converted papers and towel and tissue products. SPECIALTY PAPERS ---------------- Specialty paper products are produced and sold by Pulp and Paper and Sorg Paper. Principal products of Pulp and Paper include industrial crepe, masking, gumming, converting and wax laminating, foil laminating, flame resistant, interleaver, cable wrap, electrical insulation, pressure sensitive backing, toweling, water base and film coating and packaging papers. Sorg Paper produces decorative laminate, deep-color and facial tissue, filter, construction, parchtex, saturating, soapboard and soapwrap and latex label papers. All products of the company's specialty paper operations are sold to other manufactures or converters for further processing and ultimate sale to end users. These manufacturers and converters are in many industries including housing, steel, aluminum and other metal producers, automotive, consumer packaging, food processing, home appliance, consumer goods and printing. TOWEL AND TISSUE PRODUCTS ------------------------- The towel and tissue products produced and sold by Bay West are primarily for the commercial and institutional wash room products markets that include recreation, health care, food service, manufacturing, education, automotive and dairy. The products include roll and folded towels, tissue products, soaps, windshield towels, dairy towels, household roll towels and glass cleaner. Bay West products are sold through independent distributors to end users both domestically and internationally. CONVERTED PRODUCTS ------------------ Wax-laminated and converted papers produced by Converted Products include roll, ream and skid wrap paper, can body stock, impregnated paper and coated papers. These products are sold to manufacturers and converters in the paper, can and corrugated container industries. EXPORT SALES Mosinee Paper International, Inc. acts as a commissioned sales agent for the export sales of the company and has elected to be treated as a foreign sales corporation, or FSC, for federal income tax purposes. During 1993, export sales of the company's products amounted to nearly $19 million. RAW MATERIALS For paper making operations, fiber represents approximately half of the cost of paper. The company satisfies its fiber requirements using virgin fiber from pulpwood and chips, purchased bleached pulp and both pre- and post-consumer waste or recyclable papers. The types of paper being made and their intended uses determine the type or quality of the fiber used. During 1993, Pulp and Paper required 33,000 tons, or 27% of total fiber requirements, of bleached pulp which it purchased on the open market. The balance, representing unbleached pulp, was produced at its kraft pulp mill. Sorg Paper is a non-integrated paper manufacturer and must purchase all required fiber on the open market. During the year it purchased 29,000 tons of bleached pulp, or 97% of its fiber requirements. The balance of purchased fiber represented waste papers, generally pre-consumer, available from printers and other paper converters. Bay West produces all its fiber requirements from its deink and direct entry systems. The fiber source for these systems is low grade recyclable waste papers that were relatively inexpensive and abundant. Bay West consumed over 121,000 tons of pre- and post-consumer waste papers during the year. Wood for Pulp and Paper's pulp mill is produced at its Mosinee Industrial Forest in northwestern Wisconsin and purchased from private landowners, public forests, and from other forest product manufacturers. During 1993, Pulp and Paper consumed 36,000 cords of pulpwood, or 24% of its total wood requirements, from its own forests. The balance was available on the open market. Toward the end of the year, increased demand for pulpwood and chips relative to supply began to increase prices. The availability of adequate pulpwood and chips is satisfactory, but higher prices are expected during 1994. Converted Products utilizes linerboard and various waxes to produce its laminated papers. Linerboard is readily available from large paper mills, but experienced some price increase activity in late 1993 and early 1994. All other chemicals, dyes and sundry raw materials have remained readily available with no anticipated shortages seen during 1994. ENERGY The company's paper mills require large amounts of steam and electricity for production. Both Pulp and Paper and the Sorg Paper/Bay West Middletown, Ohio complex have their own steam and electricity generating facilities. Additionally, Pulp and Paper operates a hydro-electric generating facility that produces a portion of its electricity requirements. Both facilities have the capability to purchase electricity from area utilities. The primary fuel used at the Middletown complex is coal while Pulp and Paper utilizes a mixture of coal, bark and sludge and also operates a recovery boiler that recovers inorganic chemicals from its pulping process. PATENTS AND TRADEMARKS The company obtains and files trademarks and patents as appropriate for newly developed products. The company does not own or hold material licenses, franchises or concessions. SEASONAL NATURE OF BUSINESS None of the products manufactured and sold by the company are seasonal in nature. Bay West unit shipments, however, are moderately higher during the summer and early fall months. WORKING CAPITAL As is customary in the paper industry, the company carries adequate amounts of raw materials and finished goods inventory to facilitate the manufacture and rapid delivery of paper products to its customers. MAJOR CUSTOMERS No single customer accounted for 10% or more of consolidated net sales during 1993. BACKLOG The sales backlog in dollars climbed to over $14 million, nearly double the level at 1992 year end. The backlog was nearly $11 million at specialty paper operations, and amounted to approximately twenty-eight days. Backlogs at converting facilities, where customer orders are serviced from inventories, generally represent orders being prepared for shipment. Backlogs at all operations existing at year end are expected to be shipped during 1994. COMPETITIVE CONDITIONS Competition in the paper industry in general has been strong as capacity in excess of demand for many grades of paper has heightened pricing pressure. The tissue portion of the industry has experienced the most severe competitive conditions during the last three years due primarily to added capacity. Specialty paper operations at Sorg Paper and Pulp and Paper compete in many different niche markets. The highly technical nature of specialty paper limits competition since not all paper mills can produce the required papers. The competition is generally based more upon quality and service to the customer than price. However, as quality and service are improving at most paper manufacturers and becoming expected attributes of the product, price competition has begun to intensify among competitors in specialty grades. The less technical specialty grades of paper encounter more price competition since more paper mills have the capability to produce them. Additionally, as demand for commodity grade papers declines, producers of these commodity grades temporarily may venture into the less technical specialty grades to maintain production volumes, thereby increasing price competition. Competition in the commercial and institutional tissue markets, which includes toweling, is among several large paper companies. Bay West, although growing, is one of the smaller competitors in this market. During the past three years capacity additions outpaced demand and resulted in severe pricing pressures as participants attempted to maintain sales volume. An improved economy and less announced capacity increases should provide modest reductions to the severe price competition among tissue producers during 1994. Wax-laminated and converted products compete with several similar sized producers. Competition is primarily focused on price. Additionally, wax-laminated roll wrap, for paper products sold in roll form by paper mills, competes with polywrap as an alternative roll wrap material. RESEARCH AND DEVELOPMENT The company is involved in research and development activities at all locations. Generally, research at specialty paper operations occurs in both the laboratory and actual paper machines in the form of trial runs. Research at converting facilities is limited to development, often in conjunction with suppliers, on new laminating compounds. Tissue operations perform trial run research in both deinking and paper production to improve product capability and quality. Additionally, research is conducted to improve existing, and develop the next generation, of product dispensers. The amounts spent on research activities are not material in relation to total operating expenses. ENVIRONMENT The paper industry is subject to stringent environmental laws and regulations which govern the discharge of materials into the air and ground and surface waters. Environmental regulations have become more restrictive in the past and additional changes can be anticipated in the future. The company is committed to full compliance with all rules designed to protect the environment and compliance with current rules is not expected to have a material adverse effect on the company's earnings or competitive position. There are no proposed regulatory changes of which the company is now aware which are expected to have a material effect on the business or financial condition of the company, but it can be anticipated that future environmental regulations will likely increase the company's capital expenditures and operating costs. Additional information concerning the company's status as a potentially responsible party ("PRP") and other environmental matters can be found in the first two paragraphs of Note 12 of the Notes to Consolidated Financial Statements, page 41. As noted therein, the company is of the opinion that any costs associated with its status as a PRP will not have a material adverse effect on the business and financial condition of the company. EMPLOYEES The company had 1,298 employees at the end of 1993. Hourly employees at the company's paper making operations are covered under collective bargaining agreements. During 1993 negotiations were conducted which led to four year agreement at Sorg Paper. During 1994 the company will be negotiating with the Union Bargaining Committee at Bay West's Middletown, Ohio mill and it looks forward to similar results. The company considers its relationship with its employees to be excellent. Eligible employees participate in retirement plans and group life, disability and medical insurance programs. EXECUTIVE OFFICERS OF THE COMPANY The following information relates to Executive Officers of the Company as of March 23, 1994: SAN W. ORR, JR., 52 ------------------- Chairman of the Board since 1987 Director since 1972 Also Attorney, Estates of A.P. Woodson & Family and Chairman of the Board of Wausau Paper Mills Previously, Vice Chairman of the Board (1978-1987); RICHARD L. RADT, 62 ------------------- Vice Chairman of the Board since August, 1993 Director since 1988 Previously, President and Chief Executive Officer (1987-1993) and President and Chief Executive Officer of Wausau Paper Mills Company (1977-1987) DANIEL R. OLVEY, 45 ------------------- President and Chief Executive Officer since August, 1993, Director since August, 1993 Previously, Executive Vice President and Chief Operating Officer (1992-1993), Group Vice President-Specialty Paper (1991-1992), Vice President-Finance; Secretary and Treasurer (1989-1991); Vice President Finance, Secretary and Treasurer, Wausau Paper Mills Company (1985-1989) GARY P. PETERSON, 45 -------------------- Sr. Vice President-Finance, Secretary and Treasurer since August, 1993 Previously, Vice President-Finance (1991-1993); partner, Wipfli Ullrich Bertelson CPAs (1981-1991). STUART R. CARLSON, 47 --------------------- Sr. Vice President-Administration since August, 1993 Previously, Vice President-Human Resources (1991-1993); Director of Human Resources, Georgia Pacific, Inc. (1990-1991) and Corporate Director of Industrial Relations, Great Northern Nekoosa Corporation (1989-1990) ITEM 2. ITEM 2. PROPERTIES. The company's corporate headquarters are located in Mosinee, Wisconsin. The building, which is owned by the company, was constructed in 1985, and consists of approximately 38,000 square feet. Executive officers and a corporate staff of approximately 17 persons who perform corporate accounting and financial, human resource and MIS services are located in the corporate headquarters The following paragraphs provide information on the location and general character of the company's facilities, including their productive capacity and extent of utilization. MOSINEE INDUSTRIAL FOREST LOCATION AND CAPACITY --------------------- Solon Springs, WI 1993 production: 41,638 cords 1993 acreage: 88,700 acres *"Practical capacity" is the amount of product a mill can produce with existing equipment and workforce and usually approximates maximum, or theoretical, capacity. At the company's converting operations it reflects the approximate maximum amount of product that can be made on existing equipment, but would require additional days and/or shifts of operation to achieve. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Legal proceedings are described in the first two paragraphs of Note 12 of the Notes to Consolidated Financial Statements, page 41. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders in the fourth quarter. 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 under the symbol MOSI. The number of shareholders of record as of March 2, 1994 was 1,925. In addition, the company has received identification of 1,319 non-objecting beneficial owners who own stock in "street name" or who are institutional owners. The company also believes that it has approximately 1,273 beneficial owners who either did not reply or who object to being disclosed. The total estimated number of shareholders as of March 25, 1994 is 4,517. Information related to high and low closing prices and dividends is set forth in Note 16 of Notes to Consolidated Financial Statements, page 44. A description of certain dividend restrictions under the company's credit agreement is set forth in Note 7 of the Notes to Consolidated Financial Statements, page 34. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. Sales increased $19 million, or 9%, over the prior year. All business units experienced increased volume of products sold. In the aggregate, tons sold increased to 238,000 tons, over 10% or 22,000 tons, over the prior year. The increased volume was relatively evenly spread between specialty paper and converted products. The largest gain, in tons sold, was registered at Bay West, accounting for 41% of the total increase. Export sales also experienced an increase to nearly $19 million and now account for nearly 8% of total net sales. Increased exports of Bay West towel and tissue products more than offset declines in exported specialty papers. While sales volume improved, strong price competition in all areas of the paper industry led to reduced selling prices. Excess capacity in the paper industry offset much of the potential gain from the general economic recovery that has progressed throughout the year. Besides unfavorably affecting pricing, some product mix deterioration resulted as less than optimal grades of paper were produced to maintain operating volumes. During the year, some tissue selling price relief was realized. With less new capacity being announced than has been the case over the past several years, some additional price strengthening may occur in 1994. In summary, strong volume increases added nearly $33 million in sales which was partially offset by unfavorable pricing effects of over $9 million and less optimal product mix of over $4 million. Sales increased in 1992 primarily due to volume which rose 32,000 tons over the prior year. Bay West, which led the increase in total volume, accounted for 42% of the change followed by Converted Products with a 39% share of the increase. These operations were the focus of the 1990-1991 expansion program. Specialty paper operations added 19% of the increase over the prior year. The strong growth in volume at Bay West resulted from expanding distribution nationally and gaining penetration in international areas. Pricing for all operations was difficult during the year reflecting the general economic slowness that persisted throughout the year. Highly competitive pricing continued during the year in the tissue area of our business as it had during 1991. Capacity increases in excess of existing demand caused serious price discounting among all tissue producers. Strong volume increases added approximately $36 million in sales and was partially offset by unfavorable pricing effects of over $8 million. During 1991, sales declined $13 million, or 6%, from the prior year through lowered volume and reduced selling prices. Bay West increased sales 11% on higher volume as distribution efforts were increased in anticipation of the expansion underway. Pricing was exceptionally competitive during the year in the tissue markets. Gross profit of nearly $44 million rose 43% over the more than $30 million reported last year. Gross profit margin improved to 18% from the year earlier level of 14%. The improvement in gross profit principally resulted from productivity improvements and cost reductions at the Bay West towel and tissue mill during the year. Production at this facility in 1992 was adversely affected by equipment downtime and a prolonged learning curve. In 1993, production at the Bay West mill increased 29%, or 17 thousand tons, helping to absorb fixed production costs. Gross profit also increased at all other operating units during the year. Strong volume increases combined with aggressive cost reduction programs offset lower selling prices at all units. Raw material prices, which remained stable during most of the year, also contributed to the improvement. There was some raw material price increase activity, primarily in purchased pulps and pulpwood, toward the end of the year. Gross profit for 1992 and 1991 has been restated for reclassification of certain expenses from cost of sales to selling and administrative expenses in the amounts of $2.4 million and $2.2 million, respectively, to place those years on a basis comparable to 1993. Fiber represents approximately half of the cost of paper. The company satisfies its fiber requirements using virgin fiber from pulpwood and chips, purchased bleached pulp and both pre- and post-consumer waste or recyclable papers. The types of paper being made and their intended uses determine the type or quality of the fiber used. During the year the Pulp and Paper Division required 33,000 tons of bleached pulp, or 27% of fiber needs, which were purchased on the open market. The balance, representing unbleached pulp, was produced at its kraft pulp mill. The pulpwood used to produce pulp consumed 36,000 cords from Mosinee's Industrial Forest, or 24% of wood requirements. The balance was available from the open market. Sorg Paper is a non-integrated paper manufacturer and must purchase all required fiber on the open market. During the year it purchased 29,000 tons of virgin fiber, or 97% of its total fiber requirements. The balance of purchased fiber represented waste papers, generally pre-consumer wastes from printers or paper converters. Bay West's towel and tissue mill produces all its pulp requirements from its deink or direct entry systems. The fiber requirements for these systems is low grade recyclable waste papers that were relatively inexpensive and abundant. Bay West consumed over 121,000 tons of waste paper during the year. During 1992, gross profit of $30 million declined slightly from the $31 million reported in the prior year and gross profit margin declined to 14% from the 1991 level of 16%. Gross profit margins declined at all operating units. The unfavorable gross profit and gross profit margin comparisons primarily resulted from weak selling prices. The Bay West towel and tissue mill experienced excessive operating costs during its first year of operation resulting from insufficient production and high broke, or "scrap", generation levels. Higher deink pulp cost from low yields and high raw material cost also unfavorably affected gross profit. Gross profit at specialty paper operations remained nearly constant as additional sales volume, a better product mix, higher efficiencies and cost reduction programs offset temporary pulp price increases and lower selling prices. Strong volume gains at Converted Products Division similarly offset lower selling prices and higher start-up related manufacturing cost. Bay West's converting and distribution facility in Harrodsburg, Kentucky made significant improvements in operating efficiencies during 1992, meeting and at times exceeding planned levels for this period. However, the depressed tissue market prices offset the favorable effects of this improvement. During 1991, gross profit of $31 million declined from $43 million reported the year before. Gross profit margin dropped to 16% from the prior year level of 20%. All operating units had lower gross profit except Sorg Paper which benefited from lower purchased pulp prices, aggressive cost management and production improvements. 1991 was a year of expansion. The relocation of Bay West and employing a new workforce resulted in lower productivity that gradually improved during the year. Bay West's paper mill in Ohio experienced high operating cost and low productivity as the workforce started up the newly constructed paper machines and deink pulp facilities. Additionally, low yields and higher cost waste papers needed to insure adequate deink pulp during start up further reduced gross profit. A decline in purchased pulp prices during the year provided some benefit to specialty paper operations. General economic conditions adversely affected profitability through reduced volumes and lower selling prices. Operating expenses increased nearly $2 million, or 8%, from the prior year level of $23 million. As a percent of net sales, operating expenses remained at 10% reflecting the higher dollar amount of sales. Selling and advertising expenses declined nearly $1 million from the prior year. Lower promotion and advertising programs at Bay West and Sorg Paper accounted for the improvement. Major programs were launched in 1992 to increase sales volumes for the expansion of Bay West and help overcome the difficult economic conditions, both domestic and international, to gain additional market penetration and absorb added capacity. The benefits from these reductions were partially offset by nominal inflation cost increases, primarily in salaries and related benefits at all operating units. The nearly $3 million increase in administrative expenses during the year is generally attributable to Stock Appreciation Rights Plans (SAR) further described in Note 11 to the financial statements. The SAR programs resulted in a charge, determined by the market price of the company's stock, of nearly $2 million due to a 22% increase in the stock price over the year compared to a $1 million credit to expense last year when the company's stock price had fallen at year end. This change in stock prices accounts for most of 1993's increase over the prior year. Cost reduction programs helped to offset modest inflationary increases in salary and benefit expenses incurred at all operating units. During 1991, operating expenses before restructuring increased nearly $2 million, or 6% over the prior year, and as a percent of net sales increased to 13%. Selling expenses increased as marketing and sales staffs were expanded to facilitate growth plans. Administrative expense increased due to over $2 million in charges for SAR programs and a continuation for part of the year of duplicate staffs involved in the relocation of Bay West to Kentucky and establishment of administrative staff at their towel and tissue mill in Ohio. Lowered incentive compensation and Thrift Plan (401-k) contributions and other cost reductions partially offset some of these increases. Income from operations reached over $18 million, climbing 155% over the prior year and near the record $19 million reported in 1990. As a percent of sales, income from operations improved to over 7% during the year. Selling prices for paper, particularly in the tissue market, remained below the prior year which had also been adversely affected by depressed prices. Lowered operating costs and higher sales volumes at all facilities, especially the Bay West towel and tissue mill during the year, more than offset the lower selling prices and resulted in the strong improvement. During 1992, high operating costs at the Bay West towel and tissue mill along with the depressed tissue selling prices offset progress at other facilities and accounted for the modest improvement over 1991. In 1991, income from operations before restructuring of nearly $6 million resulted from lower sales volumes and selling prices due in large part to the adverse economic conditions which persisted all year. Higher operating costs associated with the expansion at most operating units and high SAR program costs contributed to the decline in profitability. Additionally, a charge of $1.4 million for restructuring expense further lowered income from operations. Interest income was received on a state income tax refund from prior periods and a minimal amount from over-night investments of excess cash. Interest expense on commercial paper and other long-term debt totaled nearly $6 million this year compared to $8 million incurred in 1992 before immaterial amounts of capitalized interest were deducted in both years. During 1991, interest expense of $4 million on short-term debt, commercial paper and long-term bank notes was reduced by $2 million as interest was capitalized as part of the cost of assets acquired. Average debt level for 1993 of $99 million compared favorably to $111 million during the prior year. This reduction, combined with lower interest rate protection fees, accounted for the $2 million decrease in interest expense. Near the end of 1993, the company's interest rate protection agreement expired, and under existing interest rates in effect at year-end 1993, will result in lower interest expense. In early 1993, the U.S. Court of Appeals for the Federal Circuit upheld the District Court judgement awarded the company. The District Court found that James River Corporation had infringed upon certain washroom towel cabinet roll transfer mechanisms patented by Bay West Paper Corporation, a subsidiary of the company. The company received $5.5 million, including interest, which is included in income before taxes. The income tax provision varies with reported income, tax credits and federal, state and local tax rates. The 1993 provision for income taxes increased due to the substantial improvement in earnings and increased federal tax rates. The tax provision of nearly $8 million in 1993 results in an effective tax rate of 44.6%. This rate reflects the enactment of Revenue Reconciliation Act of 1993, which increased the marginal corporate tax rate, requiring a charge to earnings of nearly $1 million to recognize the adjustment of current and deferred taxes. During 1992, the effective tax rate of 37.3% more closely reflected the statutory rates in effect for the year. Also, in 1992, the adoption of the Statement of Financial Accounting Standards No. 109 (SFAS No. 109), Accounting for Income Taxes, allowed the recognition of deferred tax assets, subject to a valuation allowance, for the tax benefit of state income tax loss carryforwards. The ability to recognize a portion of this asset minimizes the impact of the company not being able to offset consolidated income with subsidiary losses. In 1991, under previous accounting guidelines, the inability to recognize deferred tax assets for state losses of subsidiaries increased the effective tax rate to 55.3%, substantially higher than the statutory rates in effect. Reflecting the above, net income for 1993 climbed to nearly $10 million, or $1.34 per share, over the prior year's loss of $8.5 million, or $1.21 loss per share. Net income for 1992 was adversely affected by the adoption of Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions. This adoption required the company to charge income with the cost of such benefits earned through December 31, 1991 by current employees and retirees. The charge to record the entire liability at January 1, 1992 was $13.3 million which generated a deferred tax benefit of $4.8 million resulting in a net cumulative effect of $8.5 million, or $1.20 per share. The decline in net income reported in 1991 reflected general economic conditions and high one-time operating expenses as projects in the expansion plan were constructed, relocated and started up. Statement of Financial Accounting Standards (SFAS) No. 112, Employers' Accounting for Postemployment Benefits, requires that employers accrue a liability for compensation for future absences of former or inactive employees and their beneficiaries and covered dependents. SFAS No. 112 will be adopted as of January 1, 1994, the required adoption date, by recognizing a cumulative effect expense in the range of $700,000 - $900,000, net of income taxes. The company does not anticipate routine accrual expenses, but, will record expenses in accordance with SFAS No. 112 when events occur that require such accrual. Net cash provided by operating activities increased to nearly $27 million, the highest recorded by the company, or 66% over the $16 million provided in 1992. Improved sales of $19 million combined with improved productivity and cost reduction efforts led to an improved gross profit margin of $13 million providing additional cash from operations that was partially offset by less than $2 million increase in accounts receivable. The company also received over $5 million from a patent infringement suit award which nearly offset the $6 million paid to banks for interest on outstanding debt. Payments of $4 million for income taxes were offset by $2 million in tax refunds in contrast to $4 million in tax refunds received in 1992. Gross trade receivables of the company increased slightly over $2 million, or 12% over the prior year. Accounts receivable allowances increased by $0.5 million in 1993 as a result of increases in price related credits offset by a reduction in doubtful accounts. The company invested $12 million, near the planned level, in plant and equipment additions in 1993. This level of capital spending, limited to replacement of equipment required in normal operations, allowed for sufficient cash to reduce the outstanding debt incurred during the past two years for capital asset expansions. Through improved cash from operations, cost reduction programs and reduced capital spending, the company was able to repay $12 million of outstanding debt this year and return nearly $3 million in cash dividends to shareholders. The effect of all operating, investing and financing activities for 1993 was to increase cash and cash equivalents by $0.7 million to $1.5 million by the end of the year. Working capital increased 59% to $21 million from the $13 million reported last year, mainly due to the reduction of $8 million in short-term debt. Increases in current assets such as receivables and inventories resulting from increases in sales volumes and manufacturing volumes were partially offset by increases in accounts payable and other liabilities. The current ratio, current assets divided by current liabilities, increased to 1.6:1 from the 1.3:1 reported last year. While the company's financing arrangements do not require scheduled repayments of its long-term debt, the company repaid $4 million of long-term debt and all of the $8 million in short-term debt outstanding at the beginning of the year. The reduction in long-term debt to $96 million improved upon planned debt reduction by nearly $1 million. Improved efficiencies at Bay West's towel and tissue mill and the receipt of the patent infringement award were the main reasons for generating sufficient cash flows from operations to repay the debt. The ratio of long-term debt to total capitalization of 55% improved from the prior year reflecting an increase in stockholders' equity due to stronger earnings and a lower level of debt. Early in the year the company refinanced its existing debt by entering into a $130 million unsecured five-year credit facility. By year-end, management's confidence in future cash generation allowed this credit facility to be reduced by $20 million to $110 million. The company currently utilizes $50 million of this credit agreement to support its participation in the commercial paper markets. At year-end, approximately $44 million of commercial paper was outstanding and classified as long-term debt. Management believes that with prior years' major expansions running close to designed levels and proper staffing now in place, a continuing upward economic trend that allows for selling price improvements will result in cash flow from operations which will adequately service existing debt and allow for planned capital expenditures for property and equipment of $22 million next year. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Management's Responsibility For Financial Reporting. . . . . . .20 Auditor's Report . . . . . . . . . . . . . . . . . . . . . . . .21 Consolidated Balance Sheets. . . . . . . . . . . . . . . . . . .23 Consolidated Statements of Stockholders' Equity. . . . . . . . .24 Consolidated Statements of Income. . . . . . . . . . . . . . . .25 Consolidated Statements of Cash Flows. . . . . . . . . . . . . .26 Notes to Consolidated Financial Statements . . . . . . . . . . .27 Schedules. . . . . . . . . . . . . . . . . . . . . . . . . . . .45 MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING The management of Mosinee Paper Corporation is responsible for the integrity and objectivity of the consolidated financial statements. Such financial statements were prepared in conformity with generally accepted accounting principles applied on a consistent basis throughout the periods. Some of the amounts included in these financial statements are estimates based upon management's best judgement of current conditions and circumstances. Management is also responsible for preparing other financial information included in this annual report. The company's management depends on the company's system of internal accounting controls to assure itself of the reliability of the financial statements. The internal control system is designed to provide reasonable assurance, at appropriate cost, that assets are safeguarded and transactions are executed in accordance with management's authorizations and recorded properly to permit the preparation of financial statements in accordance with generally accepted accounting principles. Periodic reviews of internal controls are made by management and the internal audit function and corrective action is taken if needed. The Audit Committee of the Board of Directors, consisting of outside directors, provides oversight of financial reporting. The company's internal audit function and independent public accountants meet with the Audit Committee to discuss financial reporting and internal control issues and have full and free access to the Audit Committee. The consolidated financial statements have been audited by the company's independent auditors and their report is presented below. The independent auditors are approved each year at the annual shareholders' meeting based on a recommendation by the Audit Committee and the Board of Directors. DANIEL R. OLVEY GARY P. PETERSON President and Sr. Vice President - Finance Chief Executive Officer and Secretary and Treasurer REPORT OF INDEPENDENT ACCOUNTANTS Board of Directors Mosinee Paper Corporation Mosinee, Wisconsin We have audited the accompanying consolidated balance sheets of MOSINEE PAPER CORPORATION and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of stockholders' equity, income and cash flows for each of the three years in the period ended December 31, 1993 and the supporting schedules appearing on pages 45-49. These consolidated financial statements and supporting schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these consolidated financial statements and supporting 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 and supporting schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements and supporting 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 financial position of MOSINEE PAPER CORPORATION and subsidiaries at December 31, 1993 and 1992, and the results of their operations and cash flows for each of the three years in the period ended December 31, 1993, and the supporting schedules appearing on pages 45-49 present fairly the information required to be set forth therein, all in conformity with generally accepted accounting principles. As discussed in Note 3 to the consolidated financial statements, the company changed its methods of accounting for postretirement benefits other than pensions and income taxes in 1992. We hereby consent to the incorporation by reference of this report in the Registration Statement on Form S-8 filed with the Securities and Exchange Commission by Mosinee Paper Corporation on April 19, 1991. WIPFLI ULLRICH BERTELSON February 2, 1994 Wipfli Ullrich Bertelson Wausau, Wisconsin Certified Public Accountants MOSINEE PAPER CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation - The consolidated financial statements include the accounts of Mosinee Paper Corporation and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. Cash Equivalents - The company considers all highly liquid debt instruments with an original maturity of three months or less to be cash equivalents. Inventories - Substantially all inventories are stated at the lower of cost, determined on the last-in, first-out method (LIFO), or market. Inventories not on the LIFO method, primarily supply items, are stated at cost (principally average cost) or market, whichever is lower. Allocation of the LIFO reserve among the components of inventories is impractical. Property, Plant and Equipment - Depreciable property is stated at cost less accumulated depreciation. Land, water power rights, and construction in progress are stated at cost and timberlands are stated at net depleted value. Facilities financed by leases, which are essentially equivalent to installment purchases, are recorded as assets and the related obligation as a long-term liability. When property units are retired, or otherwise disposed of, the applicable cost and accumulated depreciation thereon are removed from the accounts. The resulting gain or loss, if any, is reflected in income. Depreciation is computed on the straight-line method for financial statement purposes over 20 to 45 years for buildings and 3 to 20 years for machinery and equipment. Depletion on timberlands is computed on the unit-of-production method. Depreciation expense includes amortization on capitalized leases. Maintenance and repair costs are charged to expense when incurred. Improvements which extend the useful lives of the assets are added to the plant and equipment accounts. Revenue Recognition - Revenue is recognized upon shipment of goods and transfer of title to the customer. Concentrations of credit risk with respect to trade accounts receivable are generally diversified due to the large number of entities comprising the company's customer base and their dispersion across many different industries and geographies. Taxes - Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities, as measured by the enacted tax rates which will be in effect when these differences are expected to reverse. Deferred tax expense is the result of changes in the deferred tax asset and liability. The principal sources giving rise to such differences are identified in Note 10. See Note 3 for change in accounting policy for 1992. Per Share Data - Income per share is computed by dividing net income less Sorg Paper preferred stock dividends by the weighted average number of shares of common stock outstanding. Statements of Cash Flows - The 1993 statement of cash flows is prepared using the indirect method of presentation. Prior years' statements of cash flows, which had been presented using the direct method, have been reclassified to conform with the indirect method. Reclassifications - The 1992 and 1991 income statements have been reclassified to conform to the 1993 presentation by decreasing cost of sales and increasing selling and administrative expenses, $2,356,000 for 1992 and $2,244,000 for 1991. 2 - SEGMENT INFORMATION The company operates predominantly in the paper and allied products industry. The company formed Mosinee Paper International, Inc., a wholly-owned subsidiary located and domiciled in the U.S. Virgin Islands, to administer the export sales made by the company. 3 - CHANGES IN ACCOUNTING POLICIES During 1992, the company adopted the provisions of Statements of Financial Accounting Standards (SFAS) No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions" and SFAS No. 109 "Accounting for Income Taxes." In December 1992, the company adopted SFAS No. 106 which requires the estimated cost of retiree benefit payments, primarily health and life insurance, to be accrued during the employees' active service period. Previously, the cost of these benefits was expensed as incurred. The company elected to immediately recognize the accumulated liability as of January 1, 1992, which resulted in a one-time non-cash charge against earnings of $13,287,000 before taxes and $8,537,000 after taxes, or $1.20 per share. The effect of this change on 1992 operating results was to recognize an additional pre-tax expense of $967,000 and after-tax expense of $585,000, or $.07 per share. Previously reported quarterly earnings for 1992, as presented in Note 15, have been restated for the effect of this change as if it had been adopted on January 1, 1992. Additional information on retirement benefits can be found in Note 6. The company also adopted SFAS No. 109 during the first quarter of 1992. The cumulative effect of the accounting change at the time of adoption and the current year effect on net income was immaterial as the company had previously been on the liability method of accounting for deferred taxes. 4 - SUPPLEMENTAL BALANCE SHEET INFORMATION 5 - LEASES The company has various operating leases for machinery and equipment, automobiles, office equipment and warehouse space. In 1992, the company entered into a sales leaseback transaction for converting equipment, accounted for as an operating lease. For 1992, the future minimum lease payments for capitalized leases are reflected in the aggregate annual maturities of long-term debt disclosed in Note 7. Rent expense for all operating leases of plant and equipment was $3,081,000 in 1993, $2,698,000 in 1992 and $1,154,000 in 1991. 6 - RETIREMENT PLANS PENSIONS -------- Substantially all employees of the company are covered under various pension plans. The defined benefit pension plan benefits are based on the participants' years of service and either compensation earned over certain final years of employment or fixed benefit amounts for each year of service. The plans are funded in accordance with federal laws and regulations. The projected benefit obligations at September 30, were determined using an assumed discount rate of 7.25% and 8% for 1993 and 1992, respectively, and assumed compensation increases of 5% in 1993 and 5% and 6% in 1992. The assumed long-term rate of return on plan assets was 9%. Plan assets consist principally of fixed income and equity securities and includes $1,905,000 of Mosinee Paper Corporation common stock. The company's defined contribution pension plans, covering various salaried employees, provide for company contributions based on various formulas. The cost of such plans totaled $1,823,000 in 1993, $1,324,000 in 1992, and $1,189,000 in 1991. The company has deferred compensation or supplemental retirement agreements with certain present and past key officers, directors and employees. The principal cost of such plans is being or has been accrued over the period of active employment to the full eligibility date. Certain payments, insignificant in amount, are charged to expense when paid. Costs charged to operations under such agreements approximated $89,000, $78,000, and $28,000 for 1993, 1992, and 1991, respectively. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS ------------------------------------------- In addition to providing pension benefits, the company provides certain health care and nominal term life insurance benefits for retired employees. Substantially all of the company's employees may become eligible for those benefits if they reach normal retirement age while working for the company. Cost-sharing provisions, benefits and eligibility for various employee groups vary by location and union agreements. Generally, eligibility is attained after reaching age 55 or 62 with minimum service requirements. Upon reaching age 65, the benefits become coordinated with Medicare. The plans are unfunded and the company funds the benefit costs on a current basis. The 1993 assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 12%, declining by 1% annually for 6 years to an ultimate rate of 6%. The weighted average discount rate used was 7.25%. For 1992, the obligation was calculated using a health care cost trend rate of 12%, declining by 0.625% annually for 8 years to an ultimate rate of 7%. The weighted average discount rate was 8%. The effect of a 1% increase in the health care cost trend rate would increase the APBO by $1,714,000 or 10.4% and $1,850,000 or 13.0%, at December 31, 1993 and 1992, respectively. The effect of this change would increase the aggregate of the service cost and interest cost by $243,000 or 15.7% in 1993, and $245,000 or 16.6% in 1992. FUTURE ACCOUNTING CHANGE ------------------------ Statement of Financial Accounting Standards (SFAS) No. 112 "Employers' Accounting for Postemployment Benefits" enacted by the Financial Accounting Standards Board in November 1992, requires that employers accrue a liability for former or inactive employees, their beneficiaries and covered dependents compensation for future absences. SFAS No. 112 will be adopted as of January 1, 1994, the required adoption date, by recognizing a cumulative effect expense in the range of $700,000 - $900,000, net of income taxes. 7 - LONG-TERM DEBT The company has a commercial paper placement agreement to issue up to $50 million of unsecured debt obligations. The weighted average interest rate on commercial paper outstanding at December 31, 1993 was 3.6%. The amounts have been classified as long-term as the company intends, and has the ability, to refinance the obligations under the revolving credit agreement. A credit agreement with one bank as agent and certain financial institutions as lenders was established April 16, 1993 to issue up to $130 million of unsecured borrowings less the amount of commercial paper outstanding. This agreement was amended December 16, 1993 to reduce the issue amount to $110 million. The term of this agreement is five years requiring no payments until March 31, 1998, at which time, all outstanding amounts become due. The company may, however, reduce the commitment amount prior to that date without penalty. The weighted average interest rate at December 31, 1993 was 3.7%. The agreement provides for various restrictive covenants, which includes maintaining minimum net worth, interest coverage and debt to equity ratios and limits dividend and other restricted payments to approximately $10 million. The credit agreement provides for commitment and facility fees during the revolving loan period. Commitment fees are 0.1875% per annum of the unused portions of the commitment, payable quarterly. Facility fees are 0.125% per annum of the total commitment, payable quarterly. The difference between the book value and the fair market value of long-term debt is not material. The company maintained an interest rate protection agreement through November 6, 1993 for the revolving credit agreement. This agreement provided for interest rate protection on $60 million the first year, $85 million the second year and $50 million in the third year. Under terms of the agreement, the company received compensation when the 90 day LIBOR (London Interbank Offered Rate) exceeds 9.5% in the first year, 10.5% in the second year and 11% in the third year. The company paid compensation when LIBOR was less than 7.5% in the first year, 7% the second year and 6.5% the third year. Amounts paid or received are recognized as interest rates deviate beyond the stated amounts and are included in interest expense. 9 - PREFERRED SHARE PURCHASE RIGHTS PLAN Under the Rights Agreement dated June 26, 1986, amended February 21, 1991, each share of the company's common stock entitles its holder to one nonvoting preferred share purchase right ("Right"). Rights become exercisable 10 days after a person or group acquires 20% or more of the company's outstanding common stock (an "Acquiring Person"). The Board may reduce this threshold amount to 10%. The Right will entitle the holder to purchase from the company .01 share of Series A Junior Participating Preferred Stock at a price of $60. If the company is acquired in a merger or other business combination, the holder may exercise the Right and receive common stock of the acquiring company having a market value equal to two times the exercise price of the Right. If a person becomes an "Acquiring Person" the holder may exercise the Right and receive common stock of the company having a market value equal to two times the exercise price of the Right. Rights are subject to redemption by the company for $.05 per Right until a person or group becomes an Acquiring Person. After a person or group becomes an Acquiring Person, but before the Acquiring Person acquires 50% of the company's common stock, the company may exchange one share of common stock for each Right. Rights expire on July 10, 1996. The company has reserved 100,000 shares of Series A Junior Participating Preferred Stock. 10 - INCOME TAXES The 1991 state tax percentage of 17.8 percent is a result of subsidiaries of the company having unused state operating loss carryovers. At the end of 1993, $37,500,000 of such carryovers existed which may be used to offset future state taxable income in various amounts through the year 2007. Because separate state tax returns are filed, the company is not able to offset consolidated income with the subsidiaries' losses. Under the provisions of SFAS No. 109, the benefits of state tax losses are recognized as a deferred tax asset, subject to appropriate valuation allowances, which reduces the effective percentage from that obtained under the previous accounting method. At December 31, 1993, the company has unused alternative minimum tax credit carryforward of approximately $7,271,000 which can be used to offset regular tax liabilities through the year 2018. DEFERRED INCOME TAXES --------------------- A valuation allowance has been recognized for a subsidiary's state tax loss carryforward as cumulative losses creates uncertainty about the realization of the tax benefits in future years. 11 - STOCK OPTIONS AND APPRECIATION RIGHTS The company has a non-qualified stock option plan under which options to purchase 135,000 common shares may be issued to key executive employees of the company or subsidiaries. The plan provides for the granting of options at a price which is not less than market value at the time of the grant. Options can be exercised no sooner than six months or no later than twenty years from the date of the grant. No accounting recognition is given until the stock options are exercised. Two stock appreciation rights plans are maintained by the company. The 1988 Stock Appreciation Rights Plan gives certain officers and key employees the right to receive cash equal to the sum of the appreciation in value of the stock and the value of reinvested hypothetical cash dividends which would have been paid on the stock covered by the grant. The 1988 Management Incentive Plan gives certain management employees the right to receive similar cash payments. The stock appreciation rights granted under the plans may be exercised in whole or in installments and will vest at such times as specified in the grant. In all instances, the rights lapse if not exercised within 20 years of the grant date. Compensation expense is recorded with respect to the rights, based upon quoted market value of the shares and the exercise provisions. The provision (credit) for incentive compensation plans based upon the company's stock price, principally stock appreciation rights, was $1,668,000 in 1993, ($1,155,000) in 1992, and $2,513,000 in 1991. 12 - CONTINGENCIES, LITIGATION, COMMITMENTS, AND RELATED TRANSACTIONS The company has been informed by the Wisconsin Department of Natural Resources ("DNR") that a landfill, for which the company may be a potentially responsible party, has been nominated by the DNR for inclusion by the Environmental Protection Agency ("EPA") on the National Priorities List ("NPL") established under the federal Comprehensive Environmental Response, Compensation and Liability Act (Superfund). The EPA has not placed the landfill on the NPL nor has any other action been taken by the DNR or the EPA, although the company and DNR continue to explore ways to initiate an investigation outside of the Superfund program. The DNR has also advised the company that it might be a potentially responsible party at a second landfill which has not been nominated on the NPL. The company, the DNR and other parties have agreed to share certain costs of a remedial investigation and feasibility study and in 1993, the company contributed $107,000 as its allocated portion of the cost of remediation pursuant to the cost sharing agreement. The company cannot predict what, if any, additional costs will be borne by the company. The company expects at least a portion of the costs paid to date, and any which may be incurred in the future, to be reimbursed to the company through insurance coverage. Based on the information available, the company does not believe that any additional cost associated with these landfills will have a material adverse effect on the business and financial condition of the company. In the ordinary course of conducting business, the company also becomes involved in other environmental issues, investigations, administrative proceedings and litigation relating to contracts and other matters. While any proceeding or litigation has an element of uncertainty, the company believes that the outcome of any pending or threatened claim or lawsuit will not have a material adverse effect on the business and financial condition of the company. Through the year 2006, the company is to pay a municipality a minimum annual usage fee of approximately $150,000 paid on a quarterly basis, to discharge industrial waste into the municipality's wastewater treatment facility. The aggregate amount of such required future minimum payments at December 31, 1993 was $2,107,000. In addition, the company is to pay monthly contingent usage fees to the municipality based on the amount of industrial waste discharged. Minimum and contingent usage fees incurred totaled $611,000, $531,000 and $651,000 in 1993, 1992, and 1991 respectively. During 1992, the company sold 79,100 shares of its treasury stock for $2,195,000 to various pension plans it maintains. The sale price per share was determined using the trading price at the time of the sale as reflected on Nasdaq. In 1992, the company exchanged two airplanes with a total book value of $5,028,000 for an airplane with an estimated value of $5,200,000. The new equipment is recorded at $5,028,000, which represents the book value of the items traded. 14 - PATENT INFRINGEMENT AWARD On February 8, 1993, the U.S. Court of Appeals for the Federal Circuit upheld the District Court judgement awarded Mosinee Paper against James River Corporation. The District Court found that James River had infringed upon certain washroom towel cabinet roll transfer mechanisms patented by the Bay West Paper Corporation, a subsidiary. Mosinee Paper's judgement of approximately $5.5 million, including interest, is included in the 1993 statement of income. Prices reflect high and low closing price quotations on the Nasdaq National Market System and do not reflect mark-ups, mark-downs or commissions and may not represent actual transactions. The following table summarizes capital expenditures on major projects: Additions to fiber recovery system . . . . $ 1,200,000 Deink flotation system . . . . . . . . . . 1,100,000 Additions to tissue machine . . . . . . . . $ 3,346,000 Aircraft (non-cash "like-kind" exchange) . 5,106,000 Towel machine . . . . . . . . . . . . . . . $19,000,000 Tissue machine . . . . . . . . . . . . . . 30,000,000 Water treatment facility . . . . . . . . . 7,200,000 Deink plant . . . . . . . . . . . . . . . . 25,600,000 Completion of paper machine rebuild . . . . 8,700,000 The annual provisions for depreciation have been computed utilizing the following ranges: Buildings . . . . . . . . . . . . . . . . . 20 to 45 years Equipment . . . . . . . . . . . . . . . . . 3 to 20 years Amounts for taxes other than payroll and income taxes, royalties, advertising costs and amortization of intangible assets are not presented as such amounts are less than 1% of total sales. 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 relating to directors of the company is incorporated into this Form 10-K by this reference to the material set forth under the caption "Election of Directors", pages 2 and 3, in the company's proxy statement dated March 23, 1994 (the "1994 Proxy Statement"). Information relating to executive officers of the company is set forth in Part I, page 6. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information relating to director compensation is incorporated into this Form 10-K by this reference to the material set forth under the subcaption "Director Compensation", pages 4 and 5, in the 1994 Proxy Statement. Information relating to the compensation of executive officers is incorporated into this Form 10-K by this reference to (1) the material set forth under the caption "Executive Officer Compensation", page 7, through the material immediately preceding the subcaption "Committees' Report on Executive Compensation Policies", page 11, in the 1994 Proxy Statement and (2) the material set forth under the subcaption "Compensation Committee Interlocks and Insider Participation", page 14, in the 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information relating to security ownership of certain beneficial owners is incorporated into this Form 10-K by this reference to the material set forth under the caption "Beneficial Ownership of Common Stock", page 5, through the material immediately preceding final two paragraphs, page 6, in the 1994 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. (a) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES. Filed as part of this report and required by Item 14(d), are set forth on pages 21 to 49 herein. (b) REPORTS ON FORM 8-K. No reports on Form 8-K were filed by the company during the fourth quarter of fiscal 1993. (c) EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K. The following exhibits are filed with the Securities and Exchange Commission as part of this report. EXHIBIT 3 - ARTICLES OF INCORPORATION AND BYLAWS (a) Restated Articles of Incorporation, as amended . . . . . . . . . . . 12-53(1) (b) Restated Bylaws, as last amended April 16, 1992. . . . . . . . . . . . . 54-89(1) EXHIBIT 4 - INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS (a) Preferred Share Rights Agreement dated June 26, 1986 as amended. . . . . . . . . . . 54 (b) Restated Articles of Incorporation and Restated Bylaws (see Exhibit 3(a) and (b)) EXHIBIT 10 - MATERIAL CONTRACTS *(a) Deferred Compensation Plan for Directors as amended and restated June 17, 1993 . . . . . . . 148 *(b) 1985 Executive Stock Option Plan dated June 27, 1985 . . . . . . . . . . . 83-95(5) *(c) Mosinee Paper Corporation 1988 Stock Appreciation Rights Plan, as amended 4/18/91. . 41-50(2) *(d) 1993 and 1994 Incentive Compensation Plan for Corporate Executive Officers . . . . . . . 165 *(e) Supplemental Retirement Benefit Plan dated October 17, 1991 . . . . . . . . . . 63-71(2) *(f) Supplemental Retirement Benefit Agreement dated November 15, 1991 . . . . . . . . . . . . 72-76(2) * Denotes Executive Compensation Plans and Arrangements. EXHIBIT 11 - COMPUTATION OF PER SHARE EARNINGS . . . . . 170 EXHIBIT 22 - SUBSIDIARIES OF REGISTRANT. . . . . . . . 167(1) EXHIBIT 28 - ADDITIONAL EXHIBITS Proxy Statement Dated March 21, 1994. . . . . . . . 172 Page numbers set forth herein correspond to the page numbers using the sequential numbering system, where such exhibit can be found in the following Annual Reports on Form 10-K: (1) Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992; Commission File Number 0-1732. (2) Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991; Commission File Number 0-1732. (3) Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990; Commission File Number 0-1732. (4) Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989; Commission File Number 0-1732. (5) Exhibit 4(e) Form S-8 filed on April 19, 1991. The above exhibits are available upon request in writing from the Secretary, Mosinee Paper Corporation, 1244 Kronenwetter Drive, Mosinee, Wisconsin 54455-9099. 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. MOSINEE PAPER CORPORATION Date March 29, 1994 GARY P. PETERSON ------------------------------------ Gary P. Peterson Senior Vice-President, Finance, Secretary and Treasurer (Principal Financial Officer) Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SAN W. ORR, JR. RICHARD L. RADT - - ------------------------------ ------------------------------- San W. Orr, Jr. Richard L. Radt Chairman of the Board Vice Chairman of the Board February 17, 1994 February 17, 1994 DANIEL R. OLVEY STANLEY F. STAPLES, JR. - - ----------------------------- ------------------------------- Daniel R. Olvey Stanley F. Staples, Jr. President and CEO Director (Principal Executive Officer) February 17, 1994 February 17, 1994 RICHARD G. JACOBUS WALTER ALEXANDER - - ------------------------------ ------------------------------- Richard G. Jacobus Walter Alexander Director Director February 17, 1994 February 17, 1994 DONALD E. JANIS - - ------------------------------ Donald E. Janis Corporate Controller February 17, 1994 (Principal Accounting Officer) EXHIBIT 4(a) MOSINEE PAPER CORPORATION MOSINEE, WISCONSIN PREFERRED SHARE RIGHTS AGREEMENT Dated as of June 26, 1986 As Amended February 21, 1991 Mosinee Paper Corporation and M&I Marshall & Ilsley Bank Rights Agent Rights Agreement Dated as of June 26, 1986 RIGHTS AGREEMENT ---------------- Agreement, dated as of June 26, 1986, between Mosinee Paper Corporation, a Wisconsin corporation (the "Company"), and M&I Marshall & Ilsley Bank, a national banking association (the "Rights Agent"). The Board of Directors of the Company has authorized and declared a dividend of one preferred share purchase right (a "Right") for each Common Share (as hereinafter defined) of the Company outstanding on July 10, 1986, each Right representing the right to purchase one one-hundredth of a share of Series A Junior Participating Preferred Stock, par value $1.00 per share, of the Company having the rights and preferences set forth in the form of Certificate of Amendment attached hereto as Exhibit A, upon the terms and subject to the conditions herein set forth, and has further authorized the issuance of one Right with respect to each Common Share that shall become outstanding between July 10, 1986 and the earliest of the Distribution Date, the Redemption Date and the Final Expiration Date (as such terms are defined in Sections 3 and 7 hereof). Accordingly, in consideration of the premises and the mutual agreements herein set forth, the parties hereby agree as follows: Section 1. Certain Definitions. For purposes of this Agreement, the following terms have the meanings indicated: (a) "Acquiring Person" shall mean any Person (as such term is hereinafter defined) who or which, together with all Affiliates and Associates (as such terms are hereinafter defined) of such Person, shall be the Beneficial Owner (as such term is hereinafter defined) of 20% or more of the Common Shares then outstanding, but shall not include the Company, any wholly-owned Subsidiary (as such term is hereinafter defined) of the Company or any employee benefit plan of the Company or any Subsidiary of the Company, or any entity holding Common Shares for or pursuant to the terms of any such plan. (b) "Affiliate" and "Associate" shall have the respective meanings ascribed to such terms in Rule 12b-2 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as in effect on the date of this Agreement. (c) A Person shall be deemed the "Beneficial Owner" of and shall be deemed to "beneficially own" any securities: (i) which such Person or any of such Person's Affiliates or Associates beneficially owns, directly or indirectly; (ii) which such Person or any of such Person's Affiliates or Associates has (A) the right to acquire (whether such right is exercisable immediately or only after the passage of time) pursuant to any agreement, arrangement or understanding, or upon the exercise of conversion rights, exchange rights, rights (other than these Rights), warrants or options, or otherwise; provided, however, that a Person shall not be deemed the Beneficial Owner of, or to beneficially own, securities tendered pursuant to a tender or exchange offer made by or on behalf of such Person or any of such Person's Affiliates or Associates until such tendered securities are accepted for purchase or exchange; or (B) the right to vote pursuant to any agreement, arrangement or understanding; provided, however, that a Person shall not be deemed the Beneficial Owner of, or to beneficially own, any security if the agreement, arrangement or understanding to vote such security (1) arises solely from a revocable proxy or consent given to such Person in response to a public proxy or consent solicitation made pursuant to, and in accordance with, the applicable rules and regulations of the Exchange Act and (2) is not also then reportable on Schedule 13D under the Exchange Act (or any comparable or successor report); or (iii) which are beneficially owned, directly or indirectly, by any other Person with which such Person or any of such Person's Affiliates or Associates has any agreement, arrangement or understanding for the purpose of acquiring, holding, voting (except to the extent contemplated by the proviso to Section l(c)(ii)(B)) or disposing of any securities of the Company. (d) "Business Day" shall mean any day other than a Saturday, Sunday, or a day on which banking institutions in the State of New York are authorized or obligated by law or executive order to close. (e) "Close of business" on any given date shall mean 5:00 P.M., New York City time, on such date; provided, however, that if such date is not a Business Day it shall mean 5:00 P.M., New York City time, on the next succeeding Business Day. (f) "Common Shares" when used with reference to the Company shall mean the shares of Common Stock, par value $2.50 per share, of the Company. "Common Shares" when used with reference to any Person other than the Company shall mean the capital stock (or equity interest) with the greatest voting power of such other Person or, if such other Person is a Subsidiary of another Person, the Person or Persons which ultimately controls such first-mentioned Person. (g) "Person" shall mean any individual, firm, corporation or other entity, and shall include any successor (by merger or otherwise) of such entity. (h) "Preferred Shares" shall mean the shares of Series A Junior Participating Preferred Stock, par value $1.00 per share, of the Company. (i) "Shares Acquisition Date" shall mean the first date of public announcement by the Company or an Acquiring Person that an Acquiring Person has become such. (j) "Subsidiary" of any Person shall mean any corporation or other entity of which a majority of the voting power of the voting equity securities or equity interest is owned, directly or indirectly, by such Person. Section 2. Appointment of Rights Agent. The Company hereby appoints the Rights Agent to act as agent for the Company and the holders of the Rights (who, in accordance with Section 3 hereof, shall prior to the Distribution Date also be the holders of the Common Shares) in accordance with the terms and conditions hereof, and the Rights Agent hereby accepts such appointment. The Company may from time to time appoint such co-Rights Agents as it may deem necessary or desirable. Section 3. Issue of Right Certificates. (a) Until the earlier of (i) the tenth day after the Shares Acquisition Date or (ii) the tenth day after the date of the commencement of, or first public announcement of the intent of any Person (other than the Company, any wholly-owned Subsidiary of the Company, any employee benefit plan of the Company or of any Subsidiary of the Company or any entity holding Common Shares for or pursuant to the terms of any such Plan) to commence, a tender or exchange offer the consummation of which would result in beneficial ownership by a Person of 30% or more of the outstanding Common Shares (including any such date which is after the date of this Agreement and prior to the issuance of the Rights; the earlier of such dates being herein referred to as the "Distribution Date"), (x) the Rights will be evidenced (subject to the provisions of paragraph (b) of this Section 3) by the certificates for Common Shares registered in the names of the holders thereof (which certificates shall also be deemed to be Right Certificates) and not by separate Right Certificates, and (y) the right to receive Right Certificates will be transferable only in connection with the transfer of Common Shares. As soon as practicable after the Distribution Date, the Rights Agent will send, by first-class, insured, postage-prepaid mail, to each record holder of Common Shares as of the close of business on the Distribution Date, at the address of such holder shown on the records of the Company, a Right Certificate, in substantially the form of Exhibit B hereto (a "Right Certificate"), evidencing one Right for each Common Share so held. As of the Distribution Date, the Rights will be evidenced solely by such Right Certificates. (b) On July 10, 1986 or as soon as practicable thereafter, the Company will send a copy of a Summary of Rights to Purchase Preferred Shares, in substantially the form attached hereto as Exhibit C (the "Summary of Rights"), by first-class, postage-prepaid mail, to each record holder of Common Shares as of the close of business on July 10, 1986, at the address of such holder shown on the records of the Company. With respect to certificates for Common Shares outstanding as of July 10, 1986, until the Distribution Date, the Rights will be evidenced by such certificates registered in the names of the holders thereof together with a copy of the Summary of Rights. Until the Distribution Date (or the earlier of the Redemption Date or Final Expiration Date (as such terms are defined in Section 7 hereof)), the surrender for transfer of any certificate for Common Shares outstanding on July 10, 1986, with or without a copy of the Summary of Rights attached thereto, shall also constitute the transfer of the Rights associated with the Common Shares represented thereby. (c) Certificates for Common Shares issued after July 10, 1986 but prior to the earliest of the Distribution Date, the Redemption Date and the Final Expiration Date (as such terms are defined in Section 7) shall have impressed on, printed on, written on or otherwise affixed to them the following legend: This certificate also evidences and entitles the holder hereof to certain Rights as set forth in a Rights Agreement between Mosinee Paper Corporation and M&I Marshall & Ilsley Bank, dated as of June 26, 1986 (the "Rights Agreement"), the terms of which are hereby incorporated herein by reference and a copy of which is on file at the principal executive offices of Mosinee Paper Corporation. Under certain circumstances, as set forth in the Rights Agreement, such Rights will be evidenced by separate certificates and will no longer be evidenced by this certificate. Mosinee Paper Corporation will mail to the holder of this certificate a copy of the Rights Agreement without charge after receipt of a written request therefor. Under certain circumstances, Rights beneficially owned by Acquiring Persons (as defined in the Rights Agreement) may become null and void. With respect to such certificates containing the foregoing legend, until the Distribution Date, the Rights associated with the Common Shares represented by such certificates shall be evidenced by such certificates alone, and the surrender for transfer of any such certificate shall also constitute the transfer of the Rights associated with the Common Shares represented thereby. Section 4. Form of Right Certificates. The Right Certificates (and the forms of election to purchase Preferred Shares and of assignment to be printed on the reverse thereof) shall be substantially the same as Exhibit B hereto and may have such marks of identification or designation and such legends, summaries or endorsements printed thereon as the Company may deem appropriate and as are not inconsistent with the provisions of this Agreement, or as may be required to comply with any applicable law or with any rule or regulation made pursuant thereto or with any rule or regulation of any stock exchange on which the Rights may from time to time be listed, or to conform to usage. Subject to the provisions of Section 22 hereof, the Right Certificates, whenever issued, which are issued in respect of Common Shares which were issued and outstanding as of July 10, 1986, shall be dated as of July 10, 1986, and all Right Certificates which are issued in respect of other Common Shares shall be dated as of the respective dates of issuance of such Common Shares, and in each such case on their face shall entitle the holders thereof to purchase such number of Preferred Shares as shall be set forth therein at the price per Preferred Share set forth therein (the "Purchase Price"), but the number of such Pre- ferred Shares and the Purchase Price shall be subject to adjustment as provided herein. Section 5. Countersignature and Registration. The Right Certificates shall be executed on behalf of the Company by its Chairman of the Board, its President or any Executive Vice President, Senior Vice President or Vice President, and by the Secretary, an Assistant Secretary, Treasurer or an Assistant Treasurer of the Company, either manually or by facsimile signature, and have affixed thereto the Company's seal or a facsimile thereof. The Right Certificates shall not be valid for any purpose unless countersigned. In case any officer of the Company who shall have signed any of the Right Certificates shall cease to be such officer of the Company before counter-signature by the Rights Agent and issuance and delivery by the Company, such Right Certificates, nevertheless, may be countersigned by the Rights Agent, and issued and delivered by the Company with the same force and effect as though the person who signed such Right Certificates had not ceased to be such officer of the Company; and any Right Certificate may be signed on behalf of the Company by any person who, at the actual date of the execution of such Right Certificate, shall be a proper officer of the Company to sign such Right Certificate, although at the date of the execution of this Rights Agreement any such person was not such an officer. Following the Distribution Date, the Rights Agent will keep or cause to be kept, at its principal offices, books for registration and transfer of the Right Certificates issued hereunder. Such books shall show the names and addresses of the respective holders of the Right Certificates, the number of Rights evidenced on its face by each of the Right Certificates and the date of each of the Right Certificates. Section 6. Transfer, Split Up, Combination and Exchange of Right Certificates; Mutilated, Destroyed, Lost or Stolen Right Certificates. Subject to the provisions of Section 14 hereof, at any time after the close of business on the Distribution Date, and at or prior to the close of business on the earlier of the Redemption Date or the Final Expiration Date (as such terms are defined in Section 7 hereof), any Right Certificate or Right Certificates may be transferred, split up, combined or exchanged for another Right Certificate or Right Certificates, entitling the registered holder to purchase a like number of Preferred Shares as the Right Certificate or Right Certificates surrendered then entitled such holder to purchase. Any registered holder desiring to transfer, split up, combine or exchange any Right Certificate shall make such request in writing delivered to the Rights Agent, and shall surrender the Right Certificate or Right Certificates to be transferred, split up, combined or exchanged at the principal office of the Rights Agent in Milwaukee, Wisconsin. Thereupon the Rights Agent shall countersign and deliver to the person entitled thereto a Right Certificate or Right Certificates, as the case may be, as so requested. The Company may require payment of a sum sufficient to cover any tax or governmental charge that may be imposed in connection with any transfer, split up, combination or exchange of Right Certificates. Upon receipt by the Company and the Rights Agent of evidence reasonably satisfactory to them of the loss, theft, destruction or mutilation of a Right Certificate, and, in case of loss, theft or destruction, of indemnity or security reasonably satisfactory to them, and, at the Company's request, reimbursement to the Company and the Rights Agent of all reasonable expenses incidental thereto, and upon surrender to the Rights Agent and cancellation of the Right Certificate if mutilated, the Company will make and deliver a new Right Certificate of like tenor to the Rights Agent for delivery to the registered owner in lieu of the Right Certificate so lost, stolen, destroyed or mutilated. Section 7. Exercise of Rights: Purchase Price; Expiration Date of Rights. (a) The registered holder of any Right Certificate may exercise the Rights evidenced thereby (except as otherwise provided herein) in whole or in part at any time after the Distribution Date upon surrender of the Right Certificate, with the form of election to purchase on the reverse side thereof duly executed, to the Rights Agent at the principal office of the Rights Agent in Milwaukee, Wisconsin, together with payment of the Purchase Price for each Preferred Share as to which the Rights are exercised, at or prior to the close of business on the earlier of (i) the close of business on July 10, 1996 (the "Final Expiration Date"), or (ii) the date on which the Rights are redeemed as provided in Section 23 hereof (the "Redemption Date"). (b) The Purchase Price for each one one-hundredth of a Preferred Share pursuant to the exercise of a Right shall initially be $60, shall be subject to adjustment from time to time as provided in Sections 11 and 13 hereof and shall be payable in lawful money of the United States of America in accordance with paragraph (c) below. (c) Upon receipt of a Right Certificate representing exercisable Rights, with the form of election to purchase duly executed, accompanied by payment of the Purchase Price for the shares to be purchased and an amount equal to any applicable transfer tax required to be paid by the holder of such Right Certificate in accordance with Section 9 in cash, or by certified check or cashier's check payable to the order of the Company, the Rights Agent shall thereupon promptly (i) requisition from any transfer agent of the Preferred Shares certificates for the number of Preferred Shares to be purchased and the Company hereby irrevocably authorizes its transfer agent to comply with all such requests, (ii) when appropriate, requisition from the Company the amount of cash to be paid in lieu of issuance of fractional shares in accordance with Section 14, (iii) promptly after receipt of such certificates, cause the same to be delivered to or upon the order of the registered holder of such Right Certificate, registered in such name or names as may be designated by such holder and (iv) when appropriate, after receipt, promptly deliver such cash to or upon the order of the registered holder of such Right Certificate. (d) In case the registered holder of any Right Certificate shall exercise less than all the Rights evidenced thereby, a new Right Certificate evidencing Rights equivalent to the Rights remaining unexercised shall be issued by the Rights Agent to the registered holder of such Right Certificate or to his duly authorized assigns, subject to the provisions of Section 14 hereof. Section 8. Cancellation and Destruction of Right Certificates. All Right Certificates surrendered for the purpose of exercise, transfer, split up, combination or exchange shall, if surrendered to the Company or to any of its agents, be delivered to the Rights Agent for cancellation or in cancelled form, or, if surrendered to the Rights Agent, shall be cancelled by it, and no Right Certificates shall be issued in lieu thereof except as expressly permitted by any of the provisions of this Rights Agreement. The Company shall deliver to the Rights Agent for cancellation and retirement, and the Rights Agent shall so cancel and retire, any other Right Certificate purchased or acquired by the Company otherwise than upon the exercise thereof. The Rights Agent shall deliver all cancelled Right Certificates to the Com- pany, or shall, at the written request of the Company, destroy such cancelled Right Certificates, and in such case shall deliver a certificate of destruction thereof to the Company. Section 9. Reservation and Availability of Preferred Shares. The Company covenants and agrees that it will cause to be reserved and kept available out of its authorized and unissued Preferred Shares or any Preferred Shares held in its treasury, the number of Preferred Shares that will be sufficient to permit the exercise in full of all outstanding Rights. So long as the Preferred Shares issuable upon the exercise of Rights may be listed on any national securities exchange, the Company shall use its best efforts to cause, from and after such time as the Rights become exercisable, all shares reserved for such issuance to be listed on such exchange upon official notice of issuance upon such exercise. The Company covenants and agrees that it will take all such action as may be necessary to ensure that all Preferred Shares delivered upon exercise of Rights shall, at the time of delivery of the certificates for such Preferred Shares (subject to payment of the Purchase Price), be duly and validly authorized and issued and fully paid and nonassessable (except to the extent provided by Section 180.40(6) of the Wisconsin Business Corporation Law) shares. The Company further covenants and agrees that it will pay when due and payable any and all federal and state transfer taxes and charges which may be payable in respect of the issuance or delivery of the Right Certificates or of any Preferred Shares upon the exercise of Rights. The Company shall not, however, be required to pay any transfer tax which may be payable in respect of any transfer or delivery of Right Certificates to a person other than, or the issuance or delivery of certificates for the Preferred Shares in a name other than that of, the registered holder of the Right Certificate evidencing Rights surrendered for exercise or to issue or deliver any certificates for Preferred Shares upon the exercise of any Rights until any such tax shall have been paid (any such tax being payable by the holder of such Right Certificate at the time of surrender) or until it has been established to the Company's satisfaction that no such tax is due. Section 10. Preferred Shares Record Date. Each person in whose name any certificate for Preferred Shares is issued upon the exercise of Rights shall for all purposes be deemed to have become the holder of record of the Preferred Shares represented thereby on, and such certificate shall be dated, the date upon which the Right Certificate evidencing such Rights was duly surrendered and payment of the Purchase Price (and any applicable transfer taxes) was made; provided, however, that if the date of such surrender and payment is a date upon which the Preferred Shares transfer books of the Company are closed, such person shall be deemed to have become the record holder of such shares on, and such certificate shall be dated, the next succeeding business day on which the Preferred Shares transfer books of the Company are open. Prior to the exercise of the Rights evidenced thereby, the holder of a Right Certificate shall not be entitled to any rights of a holder of Preferred Shares for which the Rights shall be exercisable, including, without limitation, the right to vote, to receive dividends or other distributions or to exercise any preemptive rights, and shall not be entitled to receive any notice of any proceedings of the Company, except as provided herein. Section 11. Adjustment of Purchase price, Number of Shares or Number of Rights. The Purchase Price, the number of Preferred Shares covered by each Right and the number of Rights outstanding are subject to adjustment from time to time as provided in this Section 11. (a) (i) In the event the Company shall at any time after the date of this Agreement (A) declare a dividend on the Preferred Shares payable in Preferred Shares, (B) subdivide the outstanding Preferred Shares, (C) combine the outstanding Preferred Shares into a smaller number of Preferred Shares or (D) issue any shares of its capital stock in a reclassification of the Preferred Shares (including any such reclassification in connection with a consolidation or merger in which the Company is the continuing or surviving corporation), except as otherwise provided in this Section 11(a), the Purchase Price in effect at the time of the record date for such dividend or of the effective date of such subdivision, combination or reclassification, and the number and kind of shares of capital stock issuable on such date, shall be proportionately adjusted so that the holder of any Right exercised after such time shall be entitled to receive the aggregate number and kind of shares of capital stock which, if such Right had been exercised immediately prior to such date and at a time when the Preferred Shares transfer books of the Company were open, he would have owned upon such exercise and been entitled to receive by virtue of such dividend, subdivision, combination or reclassification. If an event occurs which would require an adjustment under both Section 11(a)(i) and Section 11(a)(ii), the adjustment provided for in this Section 11(a)(i) shall be in addition to, and shall be made prior to, any adjustment required pursuant to Section 11(a)(ii). (ii) In the event (A) any Acquiring Person or any Associate or Affiliate of any Acquiring Person, at any time after the date of this Agreement, directly or indirectly, (1) shall merge into the Company or otherwise combine with the Company and the Company shall be the continuing or surviving corporation of such merger or combination and the Common Shares of the Company shall remain outstanding and not changed into or exchanged for stock or other securities of any other Person or the Company or cash or any other property, (2) shall, in one or more transactions, other than in connection with the exercise of Rights or in connection with the exercise or conversion of securities exchangeable or convertible into capital stock of the Company or any of its Subsidiaries, transfer any assets to the Company or any of its Subsidiaries in exchange (in whole or in part) for shares of any class of capital stock of the Company or any of its Subsidiaries or for securities exercisable for or convertible into shares of any class of capital stock of the Company or any of its Subsidiaries or otherwise obtain from the Company or any of its Subsidiaries, with or without consideration, any additional shares of any class of capital stock of the Company or any of its Subsidiaries or securities exercisable for or convertible into shares of any class of capital stock of the Company or any of its Subsidiaries (other than as part of a pro rata distribution to all holders of such shares of any class of capital stock of the Company or any of its Subsidiaries), (3) shall sell, purchase, lease, exchange, mortgage, pledge, transfer or otherwise dispose (in one or more transactions), to, from, with or of, as the case may be, the Company or any of its subsidiaries, assets (including securities) on terms and conditions less favorable to the Company than the Company would be able to obtain in arm's-length negotiation with an unaffiliated third party, (4) shall receive any compensation from the Company or any of the Company's Subsidiaries other than compensation for full-time employment as a regular employee at rates in accordance with the Company's (or its Subsidiaries') past practices, or (5) shall receive the benefit, directly or indirectly (except proportionately as a shareholder), of any loans, advances, guarantees, pledges or other financial assistance or any tax credits or other tax advantage provided by the Company or any of its Subsidiaries, or (B) during such time as there is an Acquiring Person, there shall be any reclassification of securities (including any reverse stock split), or recapitalization of the Company, or any merger or consolidation of the Company with any of its Subsidiaries or any other transaction or series of transactions involving the Company or any Subsidiaries of the Company (whether or not with or into or otherwise involving an Acquiring Person) which has the effect, directly or indirectly, of increasing by more than 1% the proportionate share of the outstanding shares of any class of equity securities or of securities exercisable for or convertible into securities of the Company or any of its Subsidiaries which is directly or indirectly owned by any Acquiring Person or any Associate or Affiliate of any Acquiring Person, then, and in each such case, proper provision shall be made so that each holder of a Right, except as provided below, shall thereafter have a right to receive, upon exercise thereof at the then current Purchase Price in accordance with the terms of this Agreement, in lieu of Preferred Shares, such number of Common Shares as shall equal the result obtained by (x) multiplying the then current Purchase Price by the then number of one one-hundredths of a Preferred Share for which a Right is then exercisable and dividing that product by (y) 50% of the current per share market price of the Common Shares (determined pursuant to Section 11(d)) on the fifth day after the earlier of the date of the occurrence or the date of the first public announcement of any one of the events listed above in this subparagraph (ii); provided, however, that if the transaction that would otherwise give rise to the foregoing adjustment is also subject to the provisions of Section 13 hereof then only the provisions of Section 13 hereof shall apply and no adjustment shall be made pursuant to this Section 11(a)(ii). Notwithstanding the foregoing, upon the occurrence of any of the events listed above in this subparagraph (ii), any Rights that are or were on or after the earlier of the Distribution Date or Shares Acquisition Date beneficially owned by an Acquiring Person (or any Associate or Affiliate of such Acquiring Person) shall become void and any holder of such Rights shall thereafter have no right to exercise such Rights under any provision of this Agreement. The Company shall not enter into any transaction of the kind listed in this subparagraph (ii) if at the time of such transaction there are any rights, warrants, instruments or securities outstanding or any agreements or arrangements which, as a result of the consummation of such transaction, would eliminate or otherwise substantially diminish the benefits intended to be afforded by the Rights. Any Right Certificate issued pursuant to Section 3 that represents Rights beneficially owned by an Acquiring Person or any Associate or Affiliate thereof and any Right Certificate issued at any time upon the transfer of any Rights to an Acquiring Person or any Associate or Affiliate thereof or to any nominee of such Acquiring Person, Associate or Affiliate, and any Right Certificate issued pursuant to Section 6 or Section 11 upon transfer, exchange, replacement or adjustment of any other Right Certificate referred to in this sentence, shall contain the following legend: The Rights represented by this Right Certificate were issued to a Person who was an Acquiring Person or an Affiliate or an Associate of an Acquiring Person (as such terms are defined in the Rights Agreement). This Right Certificate and the Rights represented hereby may become void in the circumstances specified in Section 11(a)(ii) of the Rights Agreement. (iii) In the event that there shall not be sufficient Common Shares issued but not outstanding or authorized but unissued to permit the exercise in full of the Rights in accordance with the foregoing subparagraph (ii), the Company shall take all such action as may be necessary to authorize additional Common Shares for issuance upon exercise of the Rights. (b) In case the Company shall fix a record date for the issuance of rights, options or warrants to all holders of Preferred Shares entitling them (for a period expiring within 45 calendar days after such record date) to subscribe for or purchase Preferred Shares (or shares having the same rights, privileges and preferences as the Preferred Shares ("equivalent preferred shares")) or securities convertible into Preferred Shares or equivalent preferred shares at a price per Preferred Share or equivalent preferred share (or having a conversion price per share, if a security convertible into Preferred Shares or equivalent preferred shares) less than the current per share market price of the Preferred Shares (as defined in Section 11(d)) on such record date, the Purchase Price to be in effect after such record date shall be determined by multiplying the Purchase Price in effect immediately prior to such record date by a fraction, the numerator of which shall be the number of Preferred Shares outstanding on such record date plus the number of Preferred Shares which the aggregate offering price of the total number of Preferred Shares and/or equivalent preferred shares so to be offered (and/or the aggregate initial conversion price of the convertible securities so to be offered) would purchase at such current market price and the denominator of which shall be the number of Preferred Shares outstanding on such record date plus the number of additional Preferred Shares and/or equivalent preferred shares to be offered for subscription or purchase (or into which the convertible securities so to be offered are initially convertible). In case such subscription price may be paid in a consideration part or all of which shall be in a form other than cash, the value of such consideration shall be as determined in good faith by the Board of Directors of the Company, whose determination shall be described in a statement filed with the Rights Agent. Preferred Shares owned by or held for the account of the Company shall not be deemed outstanding for the purpose of any such computation. Such adjustment shall be made successively whenever such a record date is fixed; and in the event that such rights or warrants are not so issued, the Purchase Price shall be adjusted to be the Purchase Price which would then be in effect if such record date had not been fixed. (c) In case the Company shall fix a record date for the making of a distribution to all holders of the Preferred Shares (including any such distribution made in connection with a consolidation or merger in which the Company is the continuing corporation) of evidences of indebtedness or assets (other than a regular quarterly cash dividend or a dividend payable in Preferred Shares) or subscription rights or warrants (excluding those referred to in Section 11(b)), the Purchase Price to be in effect after such record date shall be determined by multiplying the Purchase Price in effect immediately prior to such record date by a fraction, the numerator of which shall be the current per share market price of the Preferred Shares (as defined in Section 11(d)) on such record date, less the fair market value (as determined in good faith by the Board of Directors of the Company, whose determination shall be described in a statement filed with the Rights Agent) of the portion of the assets or evidences of indebtedness so to be distributed or of such subscription rights or warrants applicable to one Preferred Share and the denominator of which shall be such current per share market price of the Preferred Shares. Such adjustments shall be made successively whenever such a record date is fixed; and in the event that such distribution is not so made, the Purchase Price shall again be adjusted to be the Purchase Price which would then be in effect if such record date had not been fixed. (d) (i) For the purpose of any computation hereunder, the "current per share market price" of the Common Shares on any date shall be deemed to be the average of the daily closing prices per share of such Common Shares for the 30 consecutive Trading Days (as such term is hereinafter defined) immediately prior to such date; provided, however, that in the event that the current per share market price of the Common Shares is determined during a period following the announcement by the issuer of such Common Shares of a dividend or distribution on such Common Shares payable in such Common Shares or securities convertible into such Common Shares, and prior to the expiration of 30 Trading Days after the ex-dividend date for such dividend or distribution, then, and in each such case, the current market price shall be appropriately adjusted to reflect the current market price per Common Share equivalent. The closing price for each day shall be the last sale price, regular way, or, in case no such sale takes place on such day, the average of the closing bid and asked prices, regular way, in either case as reported in the principal consolidated transaction reporting system with respect to securities listed or admitted to trading on the New York Stock Exchange or, if the Common Shares are not listed or admitted to trading on the New York Stock Exchange, as reported in the principal consolidated transaction reporting system with respect to securities listed on the principal national securities exchange on which the Common Shares are listed or admitted to trading or, if the Common Shares are not listed or admitted to trading on any national securities exchange, the last quoted price or, if not so quoted, the average of the high bid and low asked prices in the over-the-counter market, as reported by the National Association of Securities Dealers, Inc. Automated Quotations System ("NASDAQ") or such other system then in use, or, if on any such date the Common Shares are not quoted by any such organization, the average of the closing bid and asked prices as furnished by a professional market maker making a market in the Common Shares selected by the Board of Directors of the Company. The term "Trading Day" shall mean a day on which the principal national securities exchange on which the Common Shares are listed or admitted to trading is open for the transaction of business or, if the Common Shares are not listed or admitted to trading on any national securities exchange, a Monday, Tuesday, Wednesday, Thursday or Friday on which banking institutions in the State of New York are not authorized or obligated by law or executive order to close. (ii) For the purpose of any computation hereunder, the "current per share market price" of the Preferred Shares shall be determined in the same manner as set forth above for Common Shares in clause (i) of this Section 11(d). If the current per share market price of the Preferred Shares cannot be determined in the manner provided above, the "current per share market price" of the Preferred Shares shall be conclusively deemed to be the current per share market price of the Common Shares (appropriately adjusted to reflect any stock split, stock dividend or similar transaction occurring after the date hereof), multiplied by one hundred. If neither the Common Shares nor the Preferred Shares are publicly held or so listed or traded, "current per share market price" shall mean the fair value per share as determined in good faith by the Board of Directors of the Company, whose determination shall be described in a statement filed with the Rights Agent. (e) No adjustment in the Purchase Price shall be required unless such adjustment would require an increase or decrease of at least 1% in the Purchase Price; provided, however, that any adjustments which by reason of this Section 11(e) are not required to be made shall be carried forward and taken into account in any subsequent adjustment. All calculations under this Section 11 shall be made to the nearest cent or to the nearest ten-thousandth of a Common Share or one-millionth of a Preferred Share as the case may be. Notwithstanding the first sentence of this Section 11(e), any adjustment required by this Section 11 shall be made no later than the earlier of (i) three years from the date of the transaction which requires such adjustment or (ii) the date of the expiration of the right to exercise any Rights. (f) If as a result of an adjustment made pursuant to Section 11(a), the holder of any Right thereafter exercised shall become entitled to receive any shares of capital stock of the Company other than Preferred Shares, thereafter the number of such other shares so receivable upon exercise of any Right shall be subject to adjustment from time to time in a manner and on terms as nearly equivalent as practicable to the provisions with respect to the shares contained in Section 11(a) through (c), inclusive, and the provisions of Sections 7, 9, 10 and 13 with respect to the Preferred Shares shall apply on like terms to any such other shares. (g) All Rights originally issued by the Company subsequent to any adjustment made to the Purchase Price hereunder shall evidence the right to purchase, at the adjusted Purchase Price, the number of Preferred Shares purchasable from time to time hereunder upon exercise of the Rights, all subject to further adjustment as provided herein. (h) Unless the Company shall have exercised its election as provided in Section 11(i), upon each adjustment of the Purchase Price as a result of the calculations made in Section 11(b) and (c), each Right outstanding immediately prior to the making of such adjustment shall thereafter evidence the right to purchase, at the adjusted Purchase Price per one one-hundredth of a Preferred Share, that number of one one-hundredths of a Preferred Share (calculated to the nearest one-millionth of a Preferred Share) obtained by (i) multiplying (x) the number of one one-hundredths of a Preferred Share covered by a Right immediately prior to this adjustment by (y) the Purchase Price in effect immediately prior to such adjustment of the Purchase Price and (ii) dividing the product so obtained by the Purchase Price in effect immediately after such adjustment of the Purchase Price. (i) The Company may elect on or after the date of any adjustment of the Purchase Price to adjust the number of Rights, in substitution for any adjustment in the number of Preferred Shares purchasable upon the exercise of a Right. Each of the Rights outstanding after such adjustment of the number of Rights shall be exercisable for the number of one one-hundredths of a Preferred Share for which a Right was exercisable immediately prior to such adjustment. Each Right held of record prior to such adjustment of the number of Rights shall become that number of Rights (calculated to the nearest ten-thousandth) obtained by dividing the Purchase Price in effect immediately prior to adjustment of the Purchase Price by the Purchase Price in effect immediately after adjustment of the Purchase Price. The Company shall make a public announcement of its election to adjust the number of Rights, indicating the record date for the adjustment, and, if known at the time, the amount of the adjustment to be made. This record date may be the date on which the Purchase Price is adjusted or any day thereafter, but, if the Right Certificates have been issued, shall be at least 10 days later than the date of the public announcement. If Right Certificates have been issued, upon each adjustment of the number of Rights pursuant to this Section 11(i), the Company shall, as promptly as practicable, cause to be distributed to holders of record of Right Certificates on such record date Right Certificates evidencing, subject to Section 14 hereof, the additional Rights to which such holders shall be entitled as a result of such adjustment, or, at the option of the Company, shall cause to be distributed to such holders of record in substitution and replacement for the Right Certificates held by such holders prior to the date of adjustment, and upon surrender thereof, if required by the Company, new Right Certificates evidencing all the Rights to which such holders shall be entitled after such adjustment. Right Certificates so to be distributed shall be issued, executed and countersigned in this manner provided for herein and shall be registered in the names of the holders of record of Right Certificates on the record date specified in the public announcement. (j) Irrespective of any adjustment or change in the Purchase Price or the number of one-hundredths of a Preferred Share issuable upon the exercise of the Rights, the Right Certificates theretofore and thereafter issued may continue to express the Purchase Price per one one-hundredth of a share and the number of shares which were expressed in the initial Right Certificates issued hereunder. (k) Before taking any action that would cause an adjustment reducing the Purchase Price below one one-hundredth of the then par value, if any, of the Preferred Shares issuable upon exercise of the Rights, the Company shall take any corporate action which may, in the opinion of its counsel, be necessary in order that the Company may validly and legally issue fully paid and nonassessable (except to the extent provided by Section 180.40(6) of the Wisconsin Business Corporation Law) Preferred Shares at such adjusted Purchase Price. (l) In any case in which this Section 11 shall require that an adjustment in the Purchase Price be made effective as of a record date for a specified event, the Company may elect to defer until the occurrence of such event the issuing to the holder of any Right exercised after such record date of the Preferred Shares and other capital stock or securities of the Company, if any, issuable upon such exercise over and above the Preferred Shares and other capital stock or securities of the Company, if any, issuable upon such exercise on the basis of the Purchase Price in effect prior to such adjustment; provided, however, that the Company shall deliver to such holder a due bill or other appropriate instrument evidencing such holder's right to receive such additional shares upon the occurrence of the event requiring such adjustment. (m) Anything in this Section 11 to the contrary notwithstanding, the Company shall be entitled to make such reductions in the Purchase Price, in addition to those adjustments expressly required by this Section 11, as and to the extent that it in its sole discretion shall determine to be advisable in order that any consolidation or subdivision of the Preferred Shares, issuance wholly for cash of any of Preferred Shares at less than the current market price, issuance wholly for cash of Preferred Shares or securities which by their terms are convertible into or exchangeable for Preferred Shares, dividends on Preferred Shares payable in Preferred Shares or issuance of rights, options or warrants referred to hereinabove in subsection (b) of this Section 11, hereafter made by the Company to holders of its Preferred Shares shall not be taxable to such shareholders. (n) In the event that at any time after the date of this Agreement and prior to the Distribution Date, the Company shall (i) declare or pay any dividend on the Common Shares payable in Common Shares or (ii) effect a subdivision, combination or consolidation of the Common Shares (by reclassification or otherwise than by payment of dividends in Common Shares) into a greater or lesser number of Common Shares, then in any such case (x) the number of one one-hundredths of a Preferred Share purchasable after such event upon proper exercise of each Right shall be determined by multiplying the number of one one-hundredths of a Preferred Share so purchasable immediately prior to such event by a fraction, the numerator of which is the number of Common Shares outstanding immediately before such event and the denominator of which is the number of Common Shares outstanding immediately after such event and (y) action shall be taken such that each Common Share outstanding immediately after such event shall have issued with respect to it that number of Rights which each Common Share outstanding immediately prior to such event had issued with respect to it. The adjustments provided for in this Section 11(n) shall be made successively whenever such a dividend is declared or paid or such a subdivision, combination or consolidation is effected. If an event occurs which would require an adjustment under Section 11(a)(ii) and this Section 11(n), the adjustments provided for in this Section 11(n) shall be in addition and prior to any adjustment required pursuant to Section 11(a)(ii). Section 12. Certificate of Adjusted Purchase Price or Number of Shares. Whenever an adjustment is made as provided in Sections 11 and 13 hereof, the Company shall (a) promptly prepare a certificate setting forth such adjustment, and a brief statement of the facts accounting for such adjustment, (b) promptly file with the Rights Agent and with each transfer agent for the Common Shares and the Preferred Shares a copy of such certificate and (c) mail a brief summary thereof to each holder of a Right Certificate in accordance with Section 25 hereof. Section 13. Consolidation, Merger or Sale or Transfer of Assets or Earning Power. In the event, directly or indirectly, (a) the Company shall consolidate with, or merge with and into, any other Person (other than any employee benefit plan of the Company, or any entity holding Common Shares for or pursuant to the terms of any such plan), (b) any Person (other than any employee benefit plan of the Company, or any entity holding Common Shares for or pursuant to the terms of any such plan) shall consolidate with the Company, or merge with and into the Company and the Company shall be the continuing or surviving corporation of such merger and, in connection with such merger, all or part of the Common Shares shall be changed into or exchanged for stock or other securities of any other Person (or the Company) or cash or any other property, or (c) the Company shall sell or otherwise transfer (or one or more of its Subsidiaries shall sell or otherwise transfer), in one or more transactions, assets or earning power aggregating more than 50% of the assets or earning power of the Company and its Subsidiaries (taken as a whole) to any other Person other than the Company or one or more of its wholly-owned Subsidiaries, then, and in each such case, proper provision shall be made so that (i) each holder of a Right (except as otherwise provided herein) shall thereafter have the right to receive, upon the exercise thereof at the then current Purchase Price in accordance with the terms of this Agreement, such number of Common Shares of such other Person (including the Company as successor thereto or as the surviving corporation) as shall be equal to the result obtained by (X) multiplying the then current Purchase Price by the number of one one-hundredths of a Preferred Share for which a Right is then exercisable (without taking into account any adjustment previously made pursuant to Section 11(a)(ii)) and dividing that product by (Y) 50% of the current per share market price of the Common Shares of such other Person (determined pursuant to Section 11(d)) on the date of consummation of such consolidation, merger, sale or transfer; (ii) the issuer of such Common Shares shall thereafter be liable for, and shall assume, by virtue of such consolidation, merger, sale or transfer, all the obligations and duties of the Company pursuant to this Agreement; (iii) the term "Company" shall thereafter be deemed to refer to such issuer; and (iv) such issuer shall take such steps (including, but not limited to, the reservation of a sufficient number of shares of its Common Shares in accordance with Section 9) in connection with such consummation as may be necessary to assure that the provisions hereof shall thereafter be applicable, as nearly as reasonably may be, in relation to the shares of its Common Shares thereafter deliverable upon the exercise of the Rights. The Company shall not enter into any transaction of the kind referred to in this Section 13 if at the time of such transaction there are any rights, warrants, instruments or securities outstanding or any agreements or arrangements which, as a result of the consummation of such transaction, would eliminate or otherwise substantially diminish the benefits intended to be afforded by the Rights. The Company shall not consummate any such consolidation, merger, sale or transfer unless prior thereto the Company and such issuer shall have executed and delivered to the Rights Agent a supplemental agreement so providing. The provisions of this Section 13 shall similarly apply to successive mergers or consolidations or sales or other transfers. Section 14. Fractional Rights and Fractional Shares. (a) The Company shall not be required to issue fractions of Rights or to distribute Right Certificates which evidence fractional Rights. In lieu of such fractional Rights, there shall be paid to the registered holders of the Right Certificates with regard to which such fractional Rights would otherwise be issuable, an amount in cash equal to the same fraction of the current market value of a whole Right. For the purposes of this Section 14(a), the current market value of a whole Right shall be the closing price of the Rights for the Trading Day immediately prior to the date on which such fractional Rights would have been otherwise issuable. The closing price for any day shall be the last sale price, regular way, or, in case no such sale takes place on such day, the average of the closing bid and asked prices, regular way, in either case as reported in the principal consolidated transaction reporting system with respect to securities listed or admitted to trading on the New York Stock Exchange or, if the Rights are not listed or admitted to trading on the New York Stock Exchange, as reported in the principal consolidated transaction reporting system with respect to securities listed on the principal national securities exchange on which the Rights are listed or admitted to trading or, if the Rights are not listed or admitted to trading on any national securities exchange, the last quoted price or, if not so quoted, the average of the high bid and low asked prices in the over-the-counter market, as reported by NASDAQ or such other system then in use or, if on any such date the Rights are not quoted by any such organization, the average of the closing bid and asked prices as furnished by a professional market maker making a market in the Rights selected by the Board of Directors of the Company. If on any such date no such market maker is making a market in the Rights the fair value of the Rights on such date as determined in good faith by the Board of Directors of the Company shall be used. (b) The Company shall not be required to issue fractions of Preferred Shares (other than fractions which are integral multiples of one one-hundredth of a Preferred Share) upon exercise of the Rights or to distribute certificates which evidence fractional Preferred Shares (other than fractions which are integral multiples of one one-hundredth of a Preferred Share). Fractions of Preferred Shares in integral multiples of one one-hundredth of a Preferred Share may, at the election of the Company, be evidenced by depositary receiPts, pursuant to an appropriate agreement between the Company and a depositary selected by it, provided that such agreement shall provide that the holders of such depositary receipts shall have all the rights, privileges and preferences to which they are entitled as beneficial owners of the Preferred Shares. In lieu of fractional Preferred Shares that are not integral multiples of one one-hundredth of a Preferred Share, the Company shall pay to the registered holders of Right Certificates at the time such Rights are exercised as herein provided an amount in cash equal to the same fraction of the current market value of one Preferred Share. For purposes of this Section 14(b), the current market value of a Preferred Share stall be the closing price of a Preferred Share (as determined pursuant to the second sentence of Section 11(d)) for the Trading Day immediately prior to the date of such exercise. (c) The holder of a Right by the acceptance of the Rights expressly waives his right to receive any fractional Rights or any fractional shares upon exercise of a Right. Section 15. Rights of Action. All rights of action in respect of this Agreement, excepting the rights of action given to the Right Agent under Section 18 hereof, are vested in the respective registered holders of the Right Certificates (and, prior to the Distribution Date, the registered holders of the Common Shares); and any registered holder of any Right Certificate (or, prior to the Distribution Date, of the Common Shares), without the consent of the Rights Agent or of the holder of any other Right Certificate (or, prior to the Distribution Date, of the Common Shares), may, in his own behalf and for his own benefit, enforce, and may institute and maintain any suit, action or proceeding against the Company to enforce, or otherwise act in respect of, his right to exercise the Rights evidenced by such Right Certificate in the manner provided in such Right Certificate and in this Agreement. Without limiting the foregoing or any remedies available to the holders of Rights, it is specifically acknowledged that the holders of Rights would not have an adequate remedy at law for any breach of this Agreement and will be entitled to specific performance of the obligations under, and injunctive relief against actual or threatened violations of, the obligations of any Person subject to this Agreement. Section 16. Agreement of Right Holders. Every holder of a Right, by accepting the same, consents and agrees with the Company and the Rights Agent and with every other holder of a Right that: (a) prior to the Distribution Date, the Rights will be transferable only in connection with the transfer of the Common Shares; (b) after the Distribution Date, the Right Certificates are transferable only on the registry books of the Rights Agent if surrendered at the principal office of the Rights Agent in Milwaukee, Wisconsin, duly endorsed or accompanied by a proper instrument of transfer; and (c) the Company and the Rights Agent may deem and treat the person in whose name the Right Certificate (or, Prior to the Distribution Date, the associated Common Shares certificate) is registered as the absolute owner thereof and of the Rights evidenced thereby (notwithstanding any notations of ownership or writing on the Right Certificates or the associated Common Shares certificate made by anyone other than the Company or the Rights Agent) for all purposes whatsoever, and neither the Company nor the Rights Agent shall be affected by any notice to the contrary. Section 17. Right Certificate Holder Not Deemed a Shareholder. No holder, as such, of any Right Certificate shall be entitled to vote, receive dividends or be deemed for any purpose the holder of the Preferred Shares or any other securities of the Company which may at any time be issuable on the exercise of the Rights represented thereby, nor shall anything contained heroin or in any Right Certificate be construed to confer upon the holder of any Right Certificate, as such, any of the rights of a shareholder of the Company or any right to vote for the election of directors or upon any matter submitted to shareholders at any meeting thereof, or to give or withhold consent to any corporate action, or to receive notice of meetings or other actions affecting shareholders (except as provided in Section 24), or to receive dividends or subscription rights, or otherwise, until the Right or Rights evidenced by such Right Certificate shall have been exercised in accordance with the provisions hereof. Section 18. Concerning the Rights Agent. The Company agrees to pay to the Rights Agent reasonable compensation for all services rendered by it hereunder and, from time to time, on demand of the Rights Agent, it's reasonable expenses and counsel fees and other disbursements incurred in the administration and execution of this Agreement and the exercise and performance of its duties hereunder. The Company also agrees to indemnify the Rights Agent for, and to hold it harmless against, any loss, liability, or expense, incurred without negligence, bad faith or willful misconduct on the part of the Rights Agent, for anything done or omitted by the Rights Agent in connection with the acceptance and administration of this Agreement, including the costs and expenses of defending against any claim of liability in the premises. The Rights Agent shall be protected and shall incur no liability for, or in respect of any action taken, suffered or omitted by it in connection with, its administration of this Agreement in reliance upon any Right Certificate or certificate for the Preferred Shares or Common Shares or for other securities of the Company, instrument of assignment or transfer, power of attorney, endorsement, affidavit, letter, notice, direction, consent, certificate, statement, or other paper or document believed by it to be genuine and to be signed, executed and, where necessary, verified or acknowledged, by the proper person or persons, or otherwise upon the advice of its counsel as set forth in Section 20 hereof. Section 19. Merger or Consolidation or Change of Name of Rights Agent. Any corporation into which the Rights Agent or any successor Rights Agent may be merged or with which it may be consolidated, or any corporation resulting from any merger or consolidation to which the Rights Agent or any successor Rights Agent shall be a party, or any corporation succeeding to the corporate trust business of the Rights Agent or any successor Rights Agent, shall be the successor to the Rights Agent under this Agreement without the execution or filing of any paper or any further act on the part of any of the parties hereto, provided that such corporation would be eligible for appointment as a successor Rights Agent under the provisions of Section 21. In case at the time such successor Rights Agent shall succeed to the agency created by this Agreement, any of the Right Certificates shall have been countersigned but not delivered, any such successor Rights Agent may adopt the countersignature of the predecessor Rights Agent and deliver such Right Certificates so countersigned; and in case at that time any of the Right Certificates shall not have been countersigned, any successor Rights Agent may countersign such Right Certificates either in the name of the predecessor Rights Agent or in the name of the successor Rights Agent; and in all such cases such Right Certificates shall have the full force provided in the Right Certificates and in this Agreement. In case at any time the name of the Rights Agent shall be changed and at such time any of the Right Certificates shall have been countersigned but not delivered, the Rights Agent may adopt the countersignature under its prior name and deliver Right Certificates so countersigned; and in case at that time any of the Right Certificates shall not have been countersigned, the Rights Agent may countersign such Right Certificates either in its prior name or in its changed name; and in all such cases such Right Certificates shall have the full force provided in the Right Certificates and in this Agreement. Section 20. Duties of Rights Agent. The Rights Agent undertakes the duties and obligations imposed by this Agreement upon the following terms and conditions, by all of which the Company and the holders of Right Certificates, by their acceptance thereof, shall be bound: (a) The Rights Agent may consult with legal counsel (who may be legal counsel for the Company), and the opinion of such counsel shall be full and complete authorization and protection to the Rights Agent as to any action taken or omitted by it in good faith and in accordance with such opinion. (b) Whenever in the performance of its duties under this Agreement the Rights Agent shall deem it necessary or desirable that any fact or matter be proved or established by the Company prior to taking or suffering any action hereunder, such fact or matter (unless other evidence in respect thereof be herein specifically prescribed) may be deemed to be conclusively proved and established by a certificate signed by any one of the Chairman of the Board, the President, any Vice President, the Treasurer or the Secretary of the Company and delivered to the Rights Agent; and such certificate shall be full authorization to the Rights Agent for any action taken or suffered in good faith by it Under the provisions of this Agreement in reliance upon such certificate. (c) The Rights Agent shall be liable hereunder to the Company and any other Person only for its own negligence, bad faith or willful misconduct. (d) The Rights Agent shall not be liable for or by reason of any of the statements of fact or recitals contained in this Agreement or in the Right Certificates (except its countersignature thereof) or be required to verify the same, but all such statements and recitals are and shall be deemed to have been made by the Company only. (e) The Rights Agent shall not be under any responsibility in respect of the validity of this Agreement or the execution and delivery hereof (except the due execution hereof by the Rights Agent) or in respect of the validity or execution of any Right Certificate (except its countersignature thereof); nor shall it be responsible for any breach by the Company of any covenant or condition contained in this Agreement or in any Right Certificate; nor shall it be responsible for any change in the exercisability of the Rights (including the Rights becoming void pursuant to Section 11(a)(ii) hereof) or any adjustment in the terms of the Rights (including the manner, method or amount thereof) provided for in Sections 3, 11, 13 or 23, or the ascertaining of the existence of facts that would require any such change or adjustment (except with respect to the exercise of Right evidenced by Right Certificates after actual notice that such change or adjustment is required); nor shall it by any act hereunder be deemed to make any representation or warranty as to the authorization or reservation of any Preferred Shares to be issued pursuant to this Agreement or any Right Certificate or as to whether any Preferred Shares will, when issued, be validly authorized and issued, fully paid and nonassessable. (f) The Company agrees that it will perform, execute, acknowledge and deliver or cause to be performed, executed, acknowledged and delivered all such further and other acts, instruments and assurances as may reasonably be required by the Rights Agent for the carrying out or performing by the Rights Agent of the provisions of this Agreement. (g) The Rights Agent is hereby authorized and directed to accept instructions with respect to the performance of its duties hereunder from any one of the Chairman of the Board, the President, any Vice President, the Secretary or the Treasurer of the Company, and to apply to such officers for advice or instructions in connection with its duties, and it shall not be liable for any action taken or suffered to be taken by it in good faith in accordance with instructions of any such officer. (h) The Rights Agent and any shareholder, director, officer or employee of the Rights Agent may buy, sell or deal in any of the Rights or other securities of the Company or become pecuniarily interested in any transaction in which the Company may be interested, or contract with or lend money to the Company or otherwise act as fully and freely as though it were not Rights Agent under this Agreement. Nothing herein shall preclude the Rights Agent from acting in any other capacity for the Company or for any other legal entity. (i) The Rights Agent may execute and exercise any of the rights or powers hereby vested in it or perform any duty hereunder either itself or by or through its attorneys or agents, and the Rights Agent shall not be answerable or accountable for any act, default, neglect or misconduct of any such attorneys or agents or for any loss to the Company resulting from any such act, default, neglect or misconduct, provided reasonable care was exercised in the selection and continued employment thereof. Section 21. Change of Rights Agent. The Rights Agent or any successor Rights Agent may resign and be discharged from its duties under this Agreement upon 30 days' notice in writing mailed to the Company and to each transfer agent of the Common Shares and Preferred Shares by registered or certified mail, and to the holders of the Right Certificates by first-class mail. The Company may remove the Rights Agent or any successor Rights Agent upon 30 days' notice in writing, mailed to the Rights Agent or successor Rights Agent, as the case may be, and to each transfer agent of the Common Shares and Preferred Shares by registered or certified mail, and to the holders of the Right Certificates by first-class mail. If the Rights Agent shall resign or be removed or shall otherwise become incapable of acting, the Company shall appoint a successor to the Rights Agent. If the Company shall fail to make such appointment within a period of 30 days after giving notice of such removal or after it has been notified in writing of such resignation or incapacity by the resigning or incapacitated Rights Agent or by the holder of a Right Certificate (who shall, with such notice, submit his Right Certificate for inspection by the Company), then the registered holder of any Right Certificate may apply to any court of competent jurisdiction for the appointment of a new Rights Agent. Any successor Rights Agent, whether appointed by the Company or by such a court, shall be a corporation organized and doing business under the laws of the United States or of a state of the United States, in good standing, having a principal office in the State of New York, Illinois or Wisconsin, which is authorized under such laws to exercise corporate trust powers and is subject to supervision or examination by federal or state authority and which has at the time of its appointment as Rights Agent a combined capital and surplus of at least $50 million. After appointment, the successor Rights Agent shall be vested with the same powers, rights, duties and responsibilities as if it had been originally named as Rights Agent without further act or deed; but the predecessor Rights Agent shall deliver and transfer to the successor Rights Agent any property at the time held by it hereunder, and execute and deliver any further assurance, conveyance, act or deed necessary for the purpose. Not later than the effective date of any such appointment the Company shall file notice thereof in writing with the predecessor Rights Agent and each transfer agent of the Common Shares and Preferred Shares, and mail a notice thereof in writing to the registerer holders of the Right Certificates. Failure to give any notice provided for in this Section 21, however, or any defect therein, shall not affect the legality or validity of the resignation or removal of the Rights Agent or the appointment of the successor Rights Agent, as the case may be. Section 22. Issuance of New Right Certificates. Notwithstanding any of the provisions of this Agreement or of the Rights to the contrary, the Company may, at its option, issue new Right Certificates evidencing Rights in such form as may be approved by its Board of Directors to reflect any adjustment or change in the Purchase Price per share and the number or kind or class of shares or other securities or property purchasable under the Right Certificates made in accordance with the provisions of this Agreement. Section 23. Redemption. (a) The Board of Directors of the Company may, at its option, at any time prior to such time as any Person becomes an Acquiring Person redeem all but not less than all the then outstanding Rights at a redemption price of $.05 per Right, appropriately adjusted to reflect any stock split, stock dividend or similar transaction occurring after the date hereof (such redemption price being hereinafter referred to as the "Redemption Price"). (b) Immediately upon the action of the Board of Directors of the Company ordering the redemption of the Rights, and without any further action and without any notice, the right to exercise the Rights will terminate and the only right thereafter of the holders of Rights shall be to receive the Redemption Price. Within 10 days after the action of the Board of Directors ordering the redemption of the Rights, the Company shall give notice of such redemption to the holders of the then outstanding Rights by mailing such notice to all such holders at their last addresses as they appear upon the registry books of the Rights Agent or, prior to the Distribution Date, on the registry books of the Transfer Agent for the Common Shares. Any notice which is mailed in the manner herein provided shall be deemed given, whether or not the holder receives the notice. Each such notice of redemption will state the method by which the payment of the Redemption Price will be made. Neither the Company nor any of its Affiliates or Associates may redeem, acquire or purchase for value any Rights at any time in any manner other than that specifically set forth in this Section 23, and other than in connection with the purchase of Common Shares prior to the Distribution Date. Section 24. Notice of Certain Events. In case the Company shall propose (a) to pay any dividend payable in stock of any class to the holders of its Preferred Shares or to make any other distribution to the holders of its Preferred Shares (other than a regular quarterly cash dividend) or (b) to offer to the holders of its Preferred Shares rights or warrants to subscribe for or to purchase any additional Preferred Shares or shares of stock of any class or any other securities, rights or options, or (c) to effect any reclassification of its Preferred Shares (other than a reclassification involving only the subdivision of outstanding Preferred Shares), or (d) to effect any consolidation or merger into or with, or to effect any sale or other transfer (or to permit one or more of its Subsidiaries to effect any sale or other transfer), in one or more transactions, of more than 50% of the assets or earning power of the Company and its Subsidiaries (taken as a whole) to, any other Person, or (e) to effect the liquidation, dissolution or winding up of the Company, then, in each such case, the Company shall give to each holder of a Right Certificate, in accordance with Section 25 hereof, a notice of such proposed action, which shall specify the record date for the purposes of such stock dividend, or distribution of rights or warrants, or the date on which such reclassification, con- solidation, merger, sale, transfer, liquidation, dissolution, or winding up is to take place and the date of participation therein by the holders of the Common Shares and/or Preferred Shares, if any such date is to be fixed, and such notice shall be so given in the case of any action covered by clause (a) or (b) above at least 20 days prior to the record date for determining holders of the Preferred Shares for purposes of such action, and in the case of any such other action, at least 20 days prior to the date of the taking of such proposed action or the date of participation therein by the holders of the Common Shares and/or Preferred Shares, whichever shall be the earlier. In case any of the events set forth in Section 11(a)(ii) of this Agreement shall occur, then, in any such case, the Company shall as soon as practicable thereafter give to each holder of a Right Certificate, in accordance with Section 25 hereof, A notice of the occurrence of such event, which shall specify the event and the consequences of the event to holders of Rights under Section 11(a)(ii) hereof. Section 25. Notices. Notices or demands authorized by this Agreement to be given or made by the Rights Agent or by the holder of any Right Certificate to or on the Company shall be sufficiently given or made if sent by first-class mail, postage prepaid, addressed (until another address is filed in writing with the Rights Agent) as follows: Mosinee Paper Corporation 1244 Kronenwetter Drive Mosinee, Wisconsin 54455 Attention: Secretary Subject to the provisions of Section 21 hereof, any notice or demand authorized by this Agreement to be given or made by the Company or by the holder of any Right Certificate to or on the Rights Agent shall be sufficiently given or made if sent by first-class mail, postage prepaid, addressed (until another address is filed in writing with the Company) as follows: M&I Marshall & Ilsley Bank __________________________ Milwaukee, Wisconsin Attention: ______________ Notices or demands authorized by this Agreement to be given or made by the Company or the Rights Agent to the holder of any Right Certificate shall be sufficiently given or made if sent by first-class mail, postage prepaid, addressed to such holder at the address of such holder as shown on the registry books of the Company. Section 26. Supplements and Amendments. The Company and the Rights Agent may from time to time supplement or amend this Agreement without the approval of any holders of Right Certificates in order to cure any ambiguity, to correct or supplement any provision contained herein which may be defective or inconsistent with any other provisions herein, or to make any other provisions in regard to matters or questions arising hereunder, which the Company and the Rights Agent may deem necessary or desirable, including but not limited to extending the Final Expiration Date and, provided that at the time of such amendment there is no Acquiring Person, the period of time during which the Rights may be redeemed, and which shall not adversely affect the interests of the holders of Right Certificates. Section 27. Successors. All the covenants and provisions of this Agreement by or for the benefit of the Company or the Rights Agent shall bind and inure to the benefit of their respective successors and assigns hereunder. Section 28. Benefits of this Agreement. Nothing in this Agreement shall be construed to give to any person or corporation other than the Company, the Rights Agent and the registered holders of the Right Certificates (and, prior to the Distribution Date, the Common Shares) any legal or equitable right, remedy or claim under this Agreement; but this Agreement shall be for the sole and exclusive benefit of the Company, the Rights Agent and the registered holders of the Right Certificates (and, prior to the Distribution Date, the Common Shares). Section 29. Severability. If any term, provision, covenant or restriction of this Agreement is held by a court of competent jurisdiction or other authority to be invalid, void or unenforceable, the remainder of the terms, provisions, covenants and restrictions of this Agreement shall remain in full force and effect and shall in no way be affected, impaired or invalidated. Section 30. Governing Law. This Agreement and each Right Certificate issued hereunder shall be deemed no be a contract made under the laws of the State of Wisconsin and for all purposes shall be governed by and construed in accordance with the laws of such State applicable to contracts to be made and performed entirely within such State. Section 31. Counterparts. This Agreement may be executed in any number of counterparts and each of such counterparts shall for all purposes be deemed to be an original, and all such counterparts shall together constitute but one and the same instrument. Section 32. Descriptive Headings. Descriptive headings of the several Sections of this Agreement are inserted for convenience only and shall not control or affect the meaning or construction of any of the provisions hereof. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed and their respective corporate seals to be hereunto affixed and attested, all as of the day and year first above written. MOSINEE PAPER CORPORATION Attest: By:___________________________ By:___________________________ Title: Title: M&I MARSHALL & ILSLEY BANK Attest: By:___________________________ By:___________________________ Title: Title: Exhibit A --------- FORM OF CERTIFICATE OF AMENDMENT of RESTATED ARTICLES OF INCORPORATION of MOSINEE PAPER CORPORATION It is hereby certified that: 1. The name of the corporation (hereinafter called the "Corporation") is Mosinee Paper Corporation. 2. The following resolution has been adopted by the Board of Directors pursuant to Section 180.12 of the Wisconsin Business Corporation Act: RESOLVED, that pursuant to the authority granted to and vested in the Board of Directors of this Corporation (hereinafter called the "Board of Directors" or the "Board") in accordance with the provisions of the Corporation's Restated Articles,of Incorporation; as amended, the Board of Directors hereby creates a series of Preferred Stock, par value $1.00 per share, of the Corporation and hereby states the designation and number of shares, and fixes the relative rights, preferences, and limitations thereof (in addition to the provisions set forth in the Restated Articles of Incorporation of the Corporation, which are applicable to the Preferred Stock of all classes and series) as follows, so that Article 4(a) of the Corporation's Restated Articles of Incorporation be, and it hereby is, amended by inserting therein the following Section 6 immediately preceding Article 4(b): 6. Preferred Stock-Series A: A. Designation and Amount. The shares of such series shall be designated as "Series A Junior Participating Preferred Stock" (the "Series A Preferred Stock") and the number of shares constituting such series shall be 150,000. Such number of shares may be increased or decreased by resolution of the Board of Directors; provided, that no decrease shall reduce the number of shares of Series A Preferred Stock to a number less than that of the shares then outstanding. B. Dividends and Distributions. --------------------------- (I) Subject to the prior and superior rights of the holders of any shares of any series of capital stock of the Corporation ranking prior and superior to the shares of Series A Preferred Stock with respect to dividends, the holders of shares of Series A Preferred Stock, in preference to the holders of Common Stock and of any other junior stock, shall be entitled to receive, when, as and if declared by the Board of Directors out of funds legally available for the purpose, quarterly dividends payable in cash on the first day of March, June, September and December in each year (each such date being referred to herein as a "Quarterly Dividend Payment Date"), commencing on the first Quarterly Dividend Payment Date after the first issuance of a share or fraction of a share of Series A Preferred Stock, in an amount per share (rounded to the nearest cent) equal to the greater of (a) $5 or (b) subject to the provision for adjustment hereinafter set forth, 100 times the aggregate per share amount of all cash dividends, and 100 times the aggregate per share amount (payable in kind) of all non-cash dividends or other distributions, other than a dividend payable in shares of Common Stock, par value $2.50 per share, of the Corporation (the "Common Stock") or a subdivision of the outstanding shares of Common Stock (by reclassification or otherwise), declared on the Common Stock since the immediately preceding Quarterly Dividend Payment Date or, with respect to the first Quarterly Dividend Payment Date, since the first issuance of any share or fraction of a share of Series A Preferred Stock. In the event the Corporation shall at any time declare or pay any dividend on Common Stock payable in shares of Common Stock, or effect a subdivision or combination or consolidation of the outstanding shares of Common Stock (by reclassification or otherwise than by payment of a dividend in shares of Common Stock) into a greater or lesser number of shares of Common Stock, then in each such case the amount to which holders of shares of Series A Preferred Stock were entitled immediately prior to such event under clause (b) of the preceding sentence shall be adjusted by multiplying such amount by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. (II) The Corporation shall declare a dividend or distribution on the Series A Preferred Stock as provided in paragraph (I) of this Section 6(B) immediately after it declares a dividend or distribution on the Common Stock (other than a dividend payable in shares of Common Stock); provided that, in the event no dividend or distribution shall have been declared on the Common Stock during the period between any Quarterly Dividend Payment Date and the next subsequent Quarterly Dividend Payment Date, a dividend of $5 per share on the Series A ?referred Stock shall nevertheless be payable on such subsequent Quarterly Dividend Payment Date. (III) Dividends shall begin to accrue and be cumulative on outstanding shares of Series A Preferred Stock from the Quarterly Dividend Payment Date next preceding the date of issue of such shares of Series A Preferred Stock, unless the date of issue of such shares is prior to the record date for the first Quarterly Dividend Payment Date, in which case dividends on such shares shall begin to accrue from the date of issue of such shares, or unless the date of issue is a Quarterly Dividend Payment Date or is a date after the record date for the determination of holders of shares of Series A Preferred Stock entitled to receive a quarterly dividend and before such Quarterly Dividend Payment Date, in either of which events such dividends shall begin to accrue and be cumulative from such Quarterly Dividend Payment Date. Accrued but unpaid dividends shall not bear interest. Dividends paid on the shares of Series A Preferred Stock in an amount less than the total amount of such dividends at the time accrued and payable on such shares shall he allocated pro rata on a share-by-share basis among all such shares at the time outstanding. The Board of Directors may fix a record date for the determination of holders of shares of Series A Preferred Stock entitled to receive payment of a dividend or distribution declared thereon, which record date shall be not more than 60 days prior to the date fixed for the payment thereof. C. Voting Rights. The holders of shares of Series A Preferred Stock shall have the following voting rights: (I) Each share of Series A Preferred Stock shall entitle the holder thereof to 100 votes on all matters submitted to a vote of the shareholders of the Corporation. In the event the Corporation shall at any time declare or pay any dividend on Common Stock payable in shares of Common Stock, or effect a subdivision or combination or consolidation of the outstanding shares of Common Stock (by reclassification or otherwise than by payment of a dividend in shares of Common Stock) into a greater or lesser number of shares of Common Stock, then in each such case the number of votes per share to which holders of shares of Series A Preferred Stock were entitled immediately prior to such event shall be adjusted by multiplying such number by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. (II) Except as otherwise provided herein or by law, the holders of shares of Series A Preferred Stock and the holders of shares of Common Stock shall vote together as one class on all matters submitted to a vote of shareholders of the Corporation. (III) Except as set forth herein, holders of Series A Preferred Stock shall have no special voting rights and their consent shall not be required (except to the extent they are entitled to vote with holders of Common Stock as set forth herein) for taking any corporate action. D. Certain Restrictions. -------------------- (I) Whenever quarterly dividends or other dividends or distributions payable on the Series A Preferred Stock as provided in Section B are in arrears, thereafter and until all accrued and unpaid dividends and distributions, whether or not declared, on shares of Series A Preferred Stock outstanding shall have been paid in full, the Corporation shall not: (i) declare or pay dividends on, make any other distributions on, or redeem or purchase or otherwise acquire for consideration any shares of stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) to the Series A Preferred Stock; (ii) declare or pay dividends on or make any other distributions on any shares of stock ranking on a parity (either as to dividends or upon liquidation, dissolution or winding up) with the Series A Preferred Stock, except dividends paid ratably on the Series A Preferred Stock and all such parity stock on which dividends are payable or in arrears in proportion to the total amounts to which the holders of all such shares are then entitled; (iii) redeem or purchase or otherwise acquire for consideration shares of any stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) with the Series A Preferred Stock, provided that the Corporation may at any time redeem, purchase or otherwise acquire shares of any such junior stock in exchange for shares of any stock of the Corporation ranking junior (either as to dividends or upon dissolution, liquidation or winding up) to the Series A Preferred Stock; or (iv) purchase or otherwise acquire for consideration any shares of Series A Preferred Stock, or any shares of stock ranking on a parity with the Series A Preferred Stock, except in accordance with a purchase offer made in writing or by publication (as determined by the Board of Directors) to all holders of such shares upon such terms as the Board of Directors, after consideration of the respective annual dividend rates and other relative rights and preferences of the respective series and classes, shall determine in good faith will result in fair and equitable treatment among the respective series or classes. (II) The Corporation shall not permit any subsidiary of the Corporation to purchase or otherwise acquire for consideration any shares of stock of the Corporation unless the Corporation could, under paragraph (I) of this Section D purchase or otherwise acquire such shares at such time and in such manner. E. Reacquired Shares. Any shares of Series A Preferred Stock purchased or otherwise acquired by the Corporation in any manner whatsoever shall be retired and cancelled promptly after the acquisition thereof. All such shares shall upon their cancellation become authorized but unissued shares of Preferred Stock and may be reissued as part of a new series of Preferred Stock to be created by resolution or resolutions of the Board of Directors, subject to the conditions and restrictions on issuance set forth herein. F. Liquidation, Dissolution or Winding Up. Upon any liquidation, dissolution or winding up of the Corporation, no distribution shall be made (1) to the holders of shares of stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) to the Series A Preferred Stock unless, prior thereto, the holders of shares of Series A Preferred Stock shall have received $100 per share, plus an amount equal to accrued and unpaid dividends and distributions thereon, whether or not declared, to the date of such payment, provided that the holders of shares of Series A Preferred Stock shall be entitled to receive an aggregate amount per share, subject to the provision for adjustment hereinafter set forth, equal to 100 times the aggregate amount to be distributed per share to holders of Common Stock, or (2) to the holders of stock ranking on a parity (either as to dividends or upon liquidation, dissolution or winding up) with the Series A Preferred Stock, except distributions made ratably on the Series A Preferred Stock and all other such parity stock in proportion to the total amounts to which the holders of all such shares are entitled upon such liquidation, dissolution or winding up. In the event the Corporation shall at any time declare or pay any dividend on Common Stock payable in shares of Common Stock, or effect a subdivision or combination or consolidation of the outstanding shares of Common Stock (by reclassification or otherwise than by payment of a dividend in shares of Common Stock) into a greater or lesser number of shares of Common Stock, then in each such case the aggregate amount to which holders of shares of Series A Preferred Stock were entitled immediately prior to such event under the proviso in clause (1) of the preceding sentence shall be adjusted by multiplying such amount by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. G. Consolidation, Merger, etc. In case the Corporation shall enter into any consolidation, merger, combination or other transaction in which the shares of Common Stock are exchanged for or changed into other stock or securities, cash and/or any other property, then in any such case the shares of Series A Preferred Stock shall at the same time be similarly exchanged or changed in an amount per share (subject to the provision for adjustment hereinafter set forth) equal to the aggregate amount of stock, securities, cash and/or any other property (payable in kind), as the case may be, into which or for which each share of Common Stock is changed or exchanged. In the event the Corporation shall at any time declare or pay any dividend on Common Stock payable in shares of Common Stock, or effect a subdivision or combination or consolidation of the outstanding shares of Common Stock (by reclassification or otherwise) into a greater or lesser number of shares of Common Stock, then in each such case the amount set forth in the preceding sentence with respect to the exchange or change of shares of Series A Preferred Stock shall be adjusted by multiplying such amount by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. H. No Redemption. The shares of Series A Preferred Stock shall not be redeemable. I. Amendment. The Restated Articles of Incorporation, as amended, of the Corporation shall not be amended in any manner which would materially alter or change the powers, preferences or special rights of the Series A Preferred Stock so as to affect them adversely without the affirmative vote of the holders of at least two-thirds of the outstanding shares of Series A Preferred Stock, voting together as a single series. 3. Said resolution is the resolution duly adopted by the Board of Directors of the Corporation on June 26, 1986, pursuant to authority granted under Section 180.12 of the Wisconsin Business Corporation Act. 4. The Restated Articles of Incorporation are amended so that the designation and number of shares of the class and series acted upon in the foregoing resolution, and the relative rights, preferences and limitations of such class and series, are as stated in the resolution. IN WITNESS WHEREOF, this Certificate of Amendment of the Restated Articles of Incorporation is executed on behalf of the Corporation by its President and its Secretary, and sealed with the seal of the Corporation, on this _____th day of June, 1986. MOSINEE PAPER CORPORATION By:_________________________________ James L. Kemerling [SEAL] President and Chief Executive Officer By:______________________________ Daniel G. Briner Vice President-Finance, Secretary and Treasurer Exhibit B --------- [Form of Right Certificate] Certificate No. R- _________ Rights NOT EXERCISABLE AFTER JULY 10, 1996 OR EARLIER IF NOTICE OF REDEMPTION IS GIVEN. THE RIGHTS ARE SUBJECT TO REDEMPTION AT $.05 PER RIGHT ON THE TERMS SET FORTH IN THE RIGHTS AGREEMENT. UNDER CERTAIN CIRCUMSTANCES, RIGHTS BENEFICIALLY OWNED BY ACQUIRING PERSONS (AS DEFINED IN SECTION 11(a)(ii) OF THE RIGHTS AGREEMENT) OR ANY SUBSEQUENT HOLDER OF SUCH RIGHTS MAY BECOME NULL AND VOID. [THE RIGHTS REPRESENTED BY THIS RIGHT CERTIFICATE WERE ISSUED TO A PERSON WHO WAS AN ACQUIRING PERSON OR AN AFFILIATE OR AN ASSOCIATE OF AN ACQUIRING PERSON (AS SUCH TERMS ARE DEFINED IN THE RIGHTS AGREEMENT). THIS RIGHT CERTIFICATE AND THE RIGHTS REPRESENTED HEREBY MAY BECOME VOID IN THE CIRCUMSTANCES SPECIFIED IN SECTION 11(a)(ii) OF THE RIGHTS AGREEMENT.]* * The portion of the legend in brackets shall be inserted only if applicable. Right Certificate Mosinee Paper Corporation This certifies that ________________, or registered assigns, is the registered owner of the number of Rights set forth above, each of which entitles the owner thereof, subject to the terms, provisions and conditions of the Rights Agreement dated as of June 26, 1986 (the "Rights Agreement") between Mosinee Paper Corporation, a Wisconsin corporation (the "Company"), and M&I Marshall & Ilsley Bank (the "Rights Agent"), to purchase from the Company at any time after the Distribution Date (as such term is defined in the Rights Agreement) and prior to 5:00 P.M. (New York City time) on July 10, 1996 at the principal office of the Rights Agent in Milwaukee, Wisconsin, or at the office of its successors as Rights Agent, one one-hundredth of a fully paid non-assessable (except to the extent provided by Section 180.40(6) of the Wisconsin Business Corporation Law) share of Series A Junior Participating Preferred Stock, par value $1.00 per share (the " Preferred Shares"), of the Company, at a purchase price of $60 per one one-hundredth of a Preferred Share (the "Purchase Price"), upon presentation and surrender of this Right Certificate with the Form of Election to Purchase duly executed. The number of Rights evidenced by this Right Certificate (and the number of one one-hundredths of a Preferred Share which may be purchased upon exercise thereof) set forth above, and the Purchase Price per one one-hundredth of a share set forth above, are the number and Purchase Price as of June 26, 1986, based on the Preferred Shares as constituted at such date. As provided in the Rights Agreement, the Purchase Price and the number of one one-hundredths of a Preferred Share which may be purchased upon the exercise of the Rights evidenced by this Right Certificate are subject to modification and adjustment upon the happening of certain events. The, Right Certificate is subject to all of the terms, provisions and conditions of the Rights Agreement, which terms, provisions and conditions are hereby incorporated herein by reference and made a part hereof and to which Rights Agreement reference is hereby made for a full description of the rights, limitations of rights, obligations, duties and immunities hereunder of the Rights Agent, the Company and the holders of the Right Certificates. Copies of the Rights Agreement are on file at the principal executive offices of the Company and the above-mentioned offices of the Rights Agent. This Right Certificate, with or without other Right Certificates, upon surrender at the principal office of the Rights Agent, may be exchanged for another Right Certificate& or Right Certificate&s of like tenor and date evidencing Rights entitling the holder to purchase a like aggregate number of Preferred Shares as the Rights evidenced by the Right Certificate or Right Certificates surrendered shall have entitled such holder to purchase. If this Right Certificate shall be exercised in part, the holder shall be entitled to receive upon surrender hereof another Right Certificate or Right Certificates for the number of whole Rights not exercised. Subject to the provisions of the Rights Agreement, the Rights evidenced by this Certificate may, but are not required to, be redeemed by the Company at a redemption price of $.05 per Right. No fractional Preferred Shares (other than fractions which are integral multiples of one one-hundredth of a Preferred Share, which may, at the election of the Company, be evidenced by depositary receipts) will be issued upon the exercise of any Right or Rights evidenced hereby, but in lieu thereof a cash payment will be made, as provided in the Rights Agreement. No holder of this Right Certificate shall be entitled to vote or receive dividends or be deemed for any purpose the holder of the Preferred Shares or of any other securities of the Company which may at any time be issuable on the exercise hereof, nor shall anything contained in the Rights Agreement or herein be construed to confer upon the holder hereof, as such, any of the rights of a shareholder of the Company or any right to vote for the election of directors or upon any matter submitted to shareholders at any meeting thereof, or to give or withhold consent to any corporate action, or, to receive notice of meetings or other actions affecting shareholders (except as provided in the Rights Agreement), or to receive dividends or subscription rights, or otherwise, until the Right on Rights evidenced by this Right Certificate shall have been exercised as provided in the Rights Agreement. This Right Certificate shall not be valid or obligatory for any purpose until it shall have been countersigned by the Rights Agent. WITNESS the facsimile signature of the proper officers of the Company and its corporate seal. Dated as of July 10, 1986. ATTEST: MOSINEE PAPER CORPORATION ______________________________ By:____________________________ Secretary President and Chief Executive Officer Countersigned: M&I MARSHALL & ILSLEY BANK By:___________________________ [Authorized Signature] [Form of Reverse Side of Right Certificate] FORM OF ASSIGNMENT (To be executed by the registered holder if such holder desires to transfer the Right Certificates.) FOR VALUE RECEIVED ____________________________________ hereby sells, assigns and transfers unto ________________________ _________________________________________________________________ (Please print name and address of transferee) _________________________________________________________________ this Right Certificate, together with all right, title and interest therein, and does hereby irrevocably constitute and appoint ____________________ Attorney, to transfer the within Right Certificate on the books of the within-named Company, with full power of substitution. Dated: ___________________, 19__ ____________________________________ Signature Signature Guaranteed: Signatures must be guaranteed by a member firm of a registered national securities exchange, a member of the National Association of Securities Dealers, Inc., or a commercial bank or trust company having an office or correspondent in the United States. - - ----------------------------------------------------------------- (To be completed if applicable) The undersigned hereby certifies that the Rights evidenced by this Right Certificate are not beneficially owned by an Acquiring Person or an Affiliate or Associate thereof (as defined in the Rights Agreement). ____________________________________ Signature - - ----------------------------------------------------------------- [Form of Reverse Side of Right Certificate -- continued] FORM OF ELECTION TO PURCHASE ---------------------------- (To be executed if holder desires to exercise the Right Certificate.) To: MOSINEE PAPER CORPORATION: The undersigned hereby irrevocably elects to exercise ___________________________ Rights represented by this Right Certificate to purchase the Preferred Shares issuable upon the exercise of such Rights and requests that certificates for such Preferred Shares be issued in the name of: Please insert social security or other identifying number _________________________________________________________________ (Please print name and address) _________________________________________________________________ If such number of Rights shall not be all the Rights evidenced by this Right Certificate, a new Right Certificate for the balance remaining of such Rights shall be registered in the name of and delivered to: Please insert social security or other identifying number _________________________________________________________________ (Please print name and address) _________________________________________________________________ Dated: _____________________, 19__ ___________________________________ Signature (Signature must conform in all respects to name of holder as specified on the face of this Right Certificate in every particular, without alteration or enlargement or any change whatsoever) Signature Guaranteed: Signatures must be guaranteed by a member firm of a registered national securities exchange, a member of the National Association of Securities Dealers, Inc., or a commercial bank or trust company having an office or correspondent in the United States. [Form of Reverse Side of Right Certificate -- Continued] - - ----------------------------------------------------------------- (To be completed if applicable) The undersigned hereby certifies that the Rights evidenced by this Right Certificate are not beneficially owned by an Acquiring Person or an Affiliate or Associate thereof (as defined in the Rights Agreement). ____________________________________ Signature - - ----------------------------------------------------------------- NOTICE ------ The signatures in the foregoing Forms of Assignment and Election must correspond to the name as written upon the face of this Right Certificate in every particular, without alteration or enlargement or any change whatsoever. In the event the certification set forth above in the Forms of Assignment and Election is not completed, the Company will deem the beneficial owner of the Rights evidenced by this Right Certificate to be an Acquiring Person or an Affiliate or Associate thereof (as defined in the Rights Agreement) and, in the case of an Assignment, will affix a legend to that effect on any Right Certificates issued in exchange for this Rights Certificate. Exhibit C --------- SUMMARY OF RIGHTS TO PURCHASE PREFERRED SHARES On June 26, 1986, the Board of Directors of Mosinee Paper Corporation (the "Company") declared a dividend distribution of one preferred share purchase right (a "Right") for each outstanding share of common stock, par value $2.50 per share (the "Common Shares"), of the Company. The distribution is payable on July 10, 1986 to the shareholders of record on that date. Each Right entitles the registered holder to purchase from the Company one one-hundredth of a share of a Series A Junior Participating Preferred Stock, par value $1.00 per share, of the Company (the "Preferred Shares") at a price of $60 per one one-hundredth of a Preferred Share (the "Purchase Price"), subject to adjustment. The description and terms of the Rights are set forth in a Rights Agreement (the "Rights Agreement") between the Company and M&I Marshall & Ilsley Bank, as Rights Agent (the "Rights Agent"). Until the earlier to occur of (i) 10 days following a public announcement that a person or group of affiliated or associated persons (an "Acquiring Person") acquired, or obtained the right to acquire, beneficial ownership of 20% or more of the outstanding Common Shares or (ii) 10 days following the commencement or announcement of an intention to make a tender offer or exchange offer the consummation of which would result in the beneficial ownership by a person or group of 30% or more of such outstanding Common Shares (the earlier of such dates being called the "Distribution Date"), the Rights will be evidenced, with respect to any of the Common Share certificates outstanding as of July 10, 1986, by such Common Share certificate with a copy of this Summary of Rights attached thereto. The Rights Agreement provides that, until the Distribution Date, the Rights will be transferred with and only with the Common Shares. Until the Distribution Date (or earlier redemption or expiration of the Rights), new Common Share certificates issued after July 10, 1986 upon transfer or new issuance of the Common Shares will contain a notation incorporating the Rights Agreement by reference. Until the Distribution Date (or earlier redemption or expiration of the Rights), the surrender for transfer of any certificates for Common Shares, outstanding as of July 10, 1986, even without such notation or a copy of this Summary of Rights being attached thereto, will also constitute the transfer of the Rights associated with the Common Shares represented by such certificate. As soon as practicable following the Distribution Date, separate certificates evidencing the Rights ("Right Certificates") will be mailed to holders of record of the Common Shares as of the close of business on the Distribution Date and such separate Right Certificates alone will evidence the Rights. The Rights are not exercisable until the Distribution Date. The Rights will expire on July 10, 1996, unless earlier redeemed by the Company as described below. The Purchase Price payable, and the number of Preferred Shares or other securities or property issuable, upon exercise of the Rights are subject to adjustment from time to time to prevent dilution (i) in the event of a stock dividend on, or a subdivision, combination or reclassification of the Preferred Shares, (ii) upon the grant to holders of the Preferred Shares of certain rights or warrants to subscribe for Preferred Shares or convertible securities at less than the current market price of the Preferred Shares or (iii) upon the distribution to holders of the Preferred Shares of evidences of indebtedness or assets (excluding regular periodic cash dividends out of earnings or retained earnings or dividends payable in Preferred Shares) or of subscription rights or warrants (other than those referred to above). The number of Rights and number of Preferred Shares issuable upon exercise of each Right are also subject to adjustment in the event of a stock split, combination or stock dividend on the Common Shares prior to the Distribution Date. In the event that the Company were acquired in a merger or other business combination transaction or more than 50% of its consolidated assets or earning power were sold, proper provision will be made so that each holder of a Right will thereafter have the right to receive, upon the exercise thereof at the then current exercise price of the Right, that number of shares of common stock of the acquiring company which at the time of such transaction would have a market value of two times the exercise price of the Right. In the event that the Company were the surviving corporation in a merger and the Common Shares were not changed or exchanged, or in the event that an Acquiring Person engages in one of a number of self-dealing transactions specified in the Rights Agreement, proper provision will be made so that each holder of a Right, other than Rights that were beneficially owned by the Acquiring Person on the earlier of the Distribution Date or the date an Acquiring Person acquires 2000 or more of the outstanding Common Shares (which will thereafter be void), will thereafter have the right to receive upon exercise that number of Common Shares having a market value of two times the exercise price of the Right. With certain exceptions, no adjustment in the Purchase Price will be required until cumulative adjustments require an adjustment of at least 1% in such Purchase Price. No fractional Preferred Shares (other than fractions which are integral multiples of one-hundredth of a Preferred Share, which may, at the election of the Company, he evidenced by depositary receipts) will be issued; in lieu thereof, an adjustment in cash will be made based on the Market price of the Preferred Shares on the last trading date prior to the date of exercise. At any time prior to the acquisition by a person or group of affiliated or associated persons of beneficial ownership of 20% or more of the outstanding Common Shares, the Board of Directors of the Company may redeem the Rights in whole, but not in part, at a price of $.05 per Right (the "Redemption Price"). Immediately upon the action of the Board of Directors ordering redemption of the Rights, the right to exercise the Rights will terminate and the only right of the holders of Rights will be to receive the Redemption Price. Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends. A copy of the Rights Agreement has been filed with the Securities and Exchange Commission as an Exhibit to a Registration Statement on Form 8-A dated ________________, 1986. A copy of the Rights Agreement is available free of charge from the Rights Agent. This summary description of the Rights does not purport to be complete and is qualified in its entirety by reference to the Rights Agreement, which is hereby incorporated herein by reference. Assignment and Assumption Agreement ----------------------------------- This Assignment and Assumption Agreement (herein called the "Agreement"), made and entered into as of the 30th day of June, 1987, by and among M&I Marshall & Ilsley Bank, a state banking association (herein called "Assignor"), Continental Illinois National Bank and Trust Company of Chicago, a national banking association (herein called "Assignee"), and Mosinee Paper Corporation, a Wisconsin corporation (herein called the "Company"). W I T N E S S E T H: -------------------- WHEREAS, the Assignor in June 26, 1986, entered into a certain Rights Agreement with the Company (herein called the "Rights Agreement") pursuant to which the Assignor agreed to act as rights agent, depositary, transfer agent and registrar for the Company in respect to its Rights (the "Rights Certificates"), upon the terms and conditions set forth in the Rights Agreement, which is incorporated herein by reference and made a part hereof for all purposes; and WHEREAS, the Rights Agreement provides that Assignor may resign by delivery of written notice to the Company; and WHEREAS, Assignor has given written notice to the Company of its desire to resign as rights agent, such resignation to be effective at the close of business on June 30, 1987 (herein called the "Effective Time"); and WHEREAS, the Company has appointed Assignee as the successor rights agent, such appointment to be effective as of the Effective Time; and WHEREAS, the parties hereto desire to execute an instrument whereby Assignor will transfer all its authority, powers and rights in and under the Rights Agreement to Assignee and Assignee will agree to assume and perform all the duties and obligations of Assignor under the Depositary Agreement; NOW, THEREFORE, in consideration of the mutual agreements herein contained, the parties hereto agree as follows: 1. Assignment. Assignor assigns and transfers as of the Effective Time all of its authority, power and rights in and under the Rights Agreement to Assignee and Assignee, as successor rights agent, shall, by virtue of this Agreement and the Rights Agreement, be vested with all the authority, powers, rights and immunities of Assignor to the same extent as if Assignee had been originally named as Rights agent in the Rights Agreement. 2. Assumption. Assignee assumes and covenants to perform from and after the Effective Time all the duties and obligations of the Assignor under the Rights Agreement and Assignee, as successor rights agent, shall, by virtue of this Agreement and the Rights Agreement, be subject to all the duties and obligations of Assignor to the same extent as if Assignee had been originally named as rights agent in the Rights Agreement. 3. Notice. Within a reasonable period after the Effective Time, the Company shall give notice of its appointment of a successor rights agent to the Assignee and the registered holders of the Rights Certificates, if any. 4. Transfer of Property. By agreement with the Assignee, Assignor shall deliver and transfer to Assignee, at the expense of the Company, any property held by Assignor, at the Effective Time or thereafter, under the Rights Agreement. 5. Qualification. By execution of this Agreement, Assignee represents and warrants to the Assignor and the Company that Assignee is a corporation organized, in good standing and doing business under the laws of the United States of America, and authorized under such laws to exercise corporate trust powers and subject to supervision or examination by Federal or State authority and has a combined capital and surplus of not less than $50,000,000 as required by Section 21 (pg. 51) of the Rights Agreement. 6. Additional Instruments. The Company agrees to make, execute, acknowledge and deliver any and all additional instruments in writing necessary or appropriate to fully and effectually vest in and conform to Assignee all authority, powers, rights, immunities, duties and obligations under the Rights Agreement. 7. Counterpart Originals. This Agreement may be executed in one or more counterparts, with each such counterpart constituting an original and all such counterparts collectively constituting one and the same instrument. 8. Amendment to Rights Agreement. The Rights Agreement is hereby amended as follows: a. The definition of "Principal Office" in Section 16(b) is amended to mean the Office of the Assignee, located at 30 North LaSalle Street, Chicago, Illinois. b. The references to "Notice" in Section 25 is amended to mean the Office of the Assignee, Continental Illinois National Bank and Trust Company of Chicago, with offices located at 30 North LaSalle Street, Chicago, Illinois. WITNESS WHEREOF, this Agreement has been duly executed by the parties hereto under their respective seals as of the day and year first above written. M&I MARSHALL & ILSLEY BANK [Corporate Seal] By:___________________________ Attest:_______________________ Its:__________________________ CONTINENTAL ILLINOIS NATIONAL BANK AND TRUST COMPANY OF CHICAGO [Corporate Seal] By:___________________________ Attest:_______________________ Its:__________________________ MOSINEE PAPER CORPORATION [Corporate Seal] By:___________________________ Attest:_______________________ Its:__________________________ AMENDMENT TO RIGHTS AGREEMENT ----------------------------- AMENDMENT, dated as of February 21, 1991, between Mosinee Paper Corporation, a Wisconsin corporation (the "Company"), and Continental Bank, N.A., a national banking association (the "Rights Agent"), to the Rights Agreement dated as of June 26, 1986 (the "Rights Agreement") between the Company and M&I Marshall & Ilsley Bank, a state banking association (the "Predecessor Rights Agent"). The Company and the Predecessor Rights Agent have heretofore executed and entered into the Rights Agreement and, pursuant to Section 21 thereof, the Rights Agent has succeeded to the powers, rights, duties and responsibilities of the Predecessor Rights Agent under the Rights Agreement. Pursuant to Section 26 of the Rights Agreement, the Company and the Rights Agent may from time to time supplement or amend the Rights Agreement in accordance with the provisions of Section 26 thereof. All acts and things necessary to make this Amendment a valid agreement, enforceable according to its terms have been done and performed, and the execution and delivery of this Amendment by the Company and the Rights Agent have been in all respects duly authorized by the Company and the Rights Agent. In consideration of the foregoing and the mutual agreements set forth herein, the parties hereto agree as follows: 1. Section 1(a) of the Rights Agreement is hereby modified and amended to read, in its entirety as follows: (a) "Acquiring Person" shall mean any Person (as such term is hereinafter defined) who or which, together with all Affiliates and Associates (as such terms are hereinafter defined) of such Person, shall be the Beneficial Owner (as such term is hereinafter defined) of 20% or more of the Common Shares of the Company then outstanding, but shall not include the Company, any Subsidiary (as such term is hereinafter defined) of the Company or any employee benefit plan of the Company or any Subsidiary of the Company, or any entity holding Common Shares of the Company for or pursuant to the terms of any such plan. Notwithstanding the foregoing, no Person shall become an "Acquiring Person" as the result of an acquisition of Common Shares by the Company which, by reducing the number of shares outstanding, increases the proportionate number of shares beneficially owned by such Person to 20% or more of the Common Shares of the Company then outstanding; provided, however, that if a Person shall become the Beneficial Owner of 20% or more of the Common Shares of the Company then outstanding by reason of share purchases by the Company and shall, after such share purchases by the Company, become the Beneficial Owner of any additional Common Shares of the Company, then such Person shall be deemed to be an "Acquiring Person." Notwithstanding the foregoing, if the Board of Directors of the Company determines in good faith that a Person who would otherwise be an "Acquiring Person," as defined pursuant to the foregoing provisions of this paragraph (a), has become such inadvertently, and such Person divests as promptly as practicable a sufficient number of Common Shares of the Company so that such Person would no longer be an Acquiring Person, as defined pursuant to the foregoing provisions of this paragraph (a), then such Person shall not be deemed to be an "Acquiring Person" for any purposes of this Agreement. 2. Section 1(c) of the Rights Agreement is hereby modified and amended to read in its entirety as follows: (c) A Person shall be deemed the "Beneficial Owner" of and shall be deemed to "beneficially own" any securities: (i) which such Person or any of such Person's Affiliates or Associates beneficially owns, directly or indirectly; (ii) which such Person or any of such Person's Affiliates or Associates has (A) the right to acquire (whether such right is exercisable immediately or only after the passage of time) pursuant to any agreement, arrangement or understanding (other than customary agreements with and between underwriters and selling group members with respect to a bona fide public offering of securities), or upon the exercise of conversion rights, exchange rights, rights (other than these Rights), warrants or options, or otherwise; provided, however, that a Person shall not be deemed the Beneficial Owner of, or to beneficially own, securities tendered pursuant to a tender or exchange offer made by or on behalf of such Person or any of such Person's Affiliates or Associates until such tendered securities are accepted for purchase or exchange; or (B) the right to vote pursuant to any agreement, arrangement or understanding; provided, however, that a Person shall not be deemed the Beneficial Owner of, or to beneficially own, any security if the agreement, arrangement or understanding to vote such security (1) arises solely from a revocable proxy or consent given to such Person in response to a public proxy or consent solicitation made pursuant to, and in accordance with, the applicable rules and regulations promulgated under the Exchange Act and (2) is not also then reportable on Schedule 13D under the Exchange Act (or any comparable or successor report); or (iii) which are beneficially owned, directly or indirectly, by any other Person with which such Person or any of such Person's Affiliates or Associates has any agreement, arrangement or understanding (other than customary agreements with and between underwriters and selling group members with respect to a bona fide public offering of securities) for the purpose of acquiring, holding, voting (except to the extent contemplated by the proviso to Section 1(c)(ii)(B)) or disposing of any securities of the Company. Notwithstanding anything in this definition of Beneficial Ownership to the contrary, the phrase "then outstanding," when used with reference to a Person's Beneficial Ownership of securities of the Company, shall mean the number of such securities then issued and outstanding together with the number of such securities not then actually issued and outstanding which such Person would be deemed to own beneficially hereunder. 3. Section 3(a) of the Rights Agreement is hereby modified and amended to read in its entirety as follows: (a) Until the earlier of (i) the tenth day after the Shares Acquisition Date or (ii) the tenth Business Day (or such later date as may be determined by action of the Board of Directors prior to such time as any Person becomes an Acquiring Person) after the date of the commencement by any Person (other than the Company, any Subsidiary of the Company, any employee benefit plan of the Company or of any Subsidiary of the Company or any entity holding Common Shares for or pursuant to the terms of any such plan) of, or of the first public announcement of the intention of any Person (other than the Company, any Subsidiary of the Company, any employee benefit plan of the Company or of any Subsidiary of the Company or any entity holding Common Shares for or pursuant to the terms of any such plan) to commence, a tender or exchange offer the consummation of which would result in any Person becoming the Beneficial Owner of Common Shares aggregating 20% or more of the then outstanding Common Shares (including any such date which is after the date of this Agreement and prior to the issuance of the Rights; the earlier of such dates being herein referred to as the "Distribution Date"), (x) the Rights will be evidenced (subject to the provisions of paragraph (b) hereof) by the certificates for Common Shares registered in the names of the holders thereof (which certificates shall also be deemed to be Right Certificates), and (y) the right to receive Right Certificates will be transferable only in connection with the transfer of Common Shares. As soon as practicable after the Distribution Date, the Company will prepare and execute, the Rights Agent will countersign, and the Company will send or cause to be sent (and the Rights Agent will, if requested, send) by first-class, insured, postage-prepaid mail, to each record holder of Common Shares as of the close of business on the Distribution Date, at the address of such holder shown on the records of the Company, a Right Certificate, in substantially the form of Exhibit B hereto (a "Right Certificate"), evidencing one Right for each Common Share so held. As of the Distribution Date, the Rights will be evidenced solely by such Right Certificates. 4. Section 3(c) of the Rights Agreement is hereby modified and amended to read in its entirety as follows: (c) Certificates for Common Shares issued after June 30, 1987 but prior to the earliest of the Distribution Date, the Redemption Date and the Final Expiration Date (as such terms are defined in Section 7) shall have impressed on, printed on, written on or otherwise affixed to them the following legend: This certificate also evidences and entitles the holder hereof to certain Rights as set forth in a Rights Agreement between Mosinee Paper Corporation and Continental Bank, N.A., dated as of June 26, 1986, as amended (the "Rights Agreement"), the terms of which are hereby incorporated herein by reference and a copy of which is on file at the principal executive offices of Mosinee Paper Corporation. Under certain circumstances, as set forth in the Rights Agreement, such Rights will be evidenced by separate certificates and will no longer be evidenced by this certificate. Mosinee Paper Corporation will mail to the holder of this certificate a copy of the Rights Agreement without charge after receipt of a written request therefor. Rights beneficially owned by Acquiring Persons (as defined in the Rights Agreement) become null and void. The legend for certificates issued after July 10, 1986 and on or prior to June 30, 1987 shall be identical except that it shall refer to M&I Marshall & Ilsley Bank rather than to Continental Bank, N.A. With respect to such certificates containing the legend set forth in this Section 3(c), until the Distribution Date, the Rights associated with the Common Shares represented by such certificates shall be evidenced by such certificates alone, and the surrender for transfer of any such certificate shall also constitute the transfer of the Rights associated with the Common Shares represented thereby. In the event that the Company purchases or acquires any Common Shares after July 10, 1986 but prior to the Distribution Date, any Rights associated with such Common Shares shall be deemed canceled and retired so that the Company shall not be entitled to exercise any Rights associated with the Common Shares that are no longer outstanding. 5. The first sentence of Section 6 of the Rights Agreement is hereby modified and amended to read in its entirety as follows: Subject to the provisions of Section 14 hereof, at any time after the close of business on the Distribution Date, and at or prior to the close of business on the earlier of the Redemption Date or the Final Expiration Date (as such terms are defined in Section 7 hereof), any Right Certificate or Right Certificates (other than Right Certificates representing Rights that have become void pursuant to Section 11(a)(ii) hereof or that have been exchanged pursuant to Section 24 hereof) may be transferred, split up, combined or exchanged for another Right Certificate or Right Certificates, entitling the registered holder to purchase a like number of Preferred Shares as the Right Certificate or Right Certificates surrendered then entitled such holder to purchase. 6. Section 7(a) of the Rights Agreement is hereby modified and amended by replacing the word "earlier" with the word "earliest", deleting the word "or" appearing immediately prior to the numeral "(ii)", deleting the period at the end thereof and adding the following at the end thereof: , or (iii) the time at which such Rights are exchanged as provided in Section 24 hereof. 7. Section 11(a)(ii) of the Rights Agreement is hereby modified and amended to read in its entirety as follows: (ii) Subject to Section 24 of this Agreement, in the event any Person becomes an Acquiring Person, each holder of a Right, except as provided below, shall thereafter have the right to receive, upon exercise thereof at a price equal to the then current Purchase Price multiplied by the number of one one-hundredths of a Preferred Share for which a Right is then exercisable, in accordance with the terms of this Agreement and in lieu of Preferred Shares, such number of Common Shares of the Company as shall equal the result obtained by (x) multiplying the then current Purchase Price by the number of one one-hundredths of a Preferred Share for which a Right is then exercisable and dividing that product by (y) 50% of the then current per share market price of the Company's Common Shares (determined pursuant to Section 11(d) hereof) on the date of the occurrence of such event. In the event that any Person shall become an Acquiring Person and the Rights shall then be outstanding, the Company shall not take any action which would eliminate or diminish the benefits intended to be afforded by the Rights. From and after the occurrence of such event, any Rights that are or were acquired or beneficially owned by any Acquiring Person (or any Associate or Affiliate of such Acquiring Person) shall be void and any holder of such Rights shall thereafter have no right to exercise such Rights under any provision of this Agreement. No Right Certificate shall be issued pursuant to Section 3 that represents Rights beneficially owned by an Acquiring Person whose Rights would be void pursuant to the preceding sentence or any Associate or Affiliate thereof; no Right Certificate shall be issued at any time upon the transfer of any Rights to an Acquiring Person whose Rights would be void pursuant to the preceding sentence or any Associate or Affiliate thereof or to any nominee of such Acquiring Person, Associate or Affiliate; and any Right Certificate delivered to the Rights Agent for transfer to an Acquiring Person whose Rights would be void pursuant to the preceding sentence shall be canceled. 8. Section 11(a)(iii) of the Rights Agreement is hereby modified and amended by adding the following at the end thereof: In the event the Company shall, after a good faith effort, be unable to take all such action as may be necessary to authorize such additional Common Shares, the Company shall substitute, for each Common Share that would otherwise be issuable upon exercise of a Right, a number of Preferred Shares or fraction thereof such that the current per share market price of one Preferred Share multiplied by such number or fraction is equal to the current per share market price of one Common Share as of the date of issuance of such Preferred Shares or fraction thereof. 9. Section 23(a) of the Rights Agreement is hereby modified and amended by adding the following at the end thereof: The redemption of the Rights by the Board of Directors may be made effective at such time, on such basis and with such conditions as the Board of Directors in its sole discretion may establish. 10. The Rights Agreement is hereby further amended by inserting the following new Section 24 to the Rights Agreement and renumbering Sections 24 through 32 of the Rights Agreement (and all cross-references thereto in the Rights Agreement) as Sections 25 through 33 respectively: Section 24. Exchange. (a) The Board of Directors of the Company may, at its option, at any time after any Person becomes an Acquiring Person, exchange all or part of the then outstanding and exercisable Rights (which shall not include Rights that have become void pursuant to the provisions of Section 11(a)(ii) hereof) for Common Shares at an exchange ratio of one Common Share per Right, appropriately adjusted to reflect any stock split, stock dividend or similar transaction occurring after the date hereof (such exchange ratio being hereinafter referred to as the "Exchange Ratio"). Notwithstanding the foregoing, the Board of Directors shall not be empowered to effect such exchange at any time after any Person (other than the Company, any Subsidiary of the Company, any employee benefit plan of the Company or any such Subsidiary, or any entity holding Common Shares for or pursuant to the terms of any such plan), together with all Affiliates and Associates of such Person, becomes the Beneficial Owner of 50% or more of the Common Shares then outstanding. (b) Immediately upon the action of the Board of Directors of the Company ordering the exchange of any Rights pursuant to paragraph (a) of this Section 24 and without any further action and without any notice, the right to exercise such Rights shall terminate and the only right thereafter of a holder of such Rights shall be to receive that number of Common Shares equal to the number of such Rights held by such holder multiplied by the Exchange Ratio. The Company shall promptly give public notice of any such exchange; provided, however, that the failure to give, or any defect in, such notice shall not affect the validity of such exchange. The Company promptly shall mail a notice of any such exchange to all of the holders of such Rights at their last addresses as they appear upon the registry books of the Rights Agent. Any notice which is mailed in the manner herein provided shall be deemed given, whether or not the holder receives the notice. Each such notice of exchange will state the method by which the exchange of the Common Shares for Rights will be effected and, in the event of any partial exchange, the number of Rights which will be exchanged. Any partial exchange shall be effected pro rata based on the number of Rights (other than Rights which have become void pursuant to the provisions of Section 11(a)(ii) hereof) held by each holder of Rights. (c) In the event that there shall not be sufficient Common Shares issued but not outstanding or authorized but unissued to permit any exchange of Rights as contemplated in accordance with this Section 24, the Company shall take all such action as may be necessary to authorize additional Common Shares for issuance upon exchange of the Rights. In the event the Company shall, after good faith effort, be unable to take all such action as may be necessary to authorize such additional Common Shares, the Company shall substitute, for each Common Share that would otherwise be issuable upon exchange of a Right, a number of Preferred Shares or fraction thereof such that the current per share market price of one Preferred Share multiplied by such number or fraction is equal to the current per share market price of one Common Share as of the date of issuance of such Preferred Shares or fraction thereof. (d) The Company shall not be required to issue fractions of Common Shares or to distribute certificates which evidence fractional Common Shares. In lieu of such fractional Common Shares, the Company shall pay to the registered holders of the Right Certificates with regard to which such fractional Common Shares would otherwise be issuable an amount in cash equal to the same fraction of the current market value of a whole Common Share. For the purposes of this paragraph (d), the current market value of a whole Common Share shall be the closing price of a Common Shares (as determined pursuant to the second sentence of Section 11(d)(i) hereof) for the Trading Day immediately prior to the date of exchange pursuant to this Section 24. 11. Section 26 of the Rights Agreement (which shall have been renumbered Section 27 as a result of paragraph 10 of this Amendment) is hereby modified and amended by adding the following at the end thereof: Without limiting the foregoing, the Company may at any time prior to such time as any Person becomes an Acquiring Person amend this Agreement to reduce the thresholds set forth in Section l(a) and Section 3(a) of this Agreement to not less than the greater of (i) the sum of 0.001% and the largest percentage of the outstanding Common Shares then known by the Company to be beneficially owned by any Person (other than the Company, any Subsidiary of the Company, any employee benefit plan of the Company or any Subsidiary of the Company, or any entity holding Common Shares for or pursuant to the terms of any such plan) and (ii) 10%. 12. The legend on the Form of Right Certificate set forth on the first page of Exhibit B to the Rights Agreement is hereby modified and amended to read in its entirety as follows: NOT EXERCISABLE AFTER JULY 10, 1996 OR EARLIER IF NOTICE OF REDEMPTION OCCURS. THE RIGHTS ARE SUBJECT TO REDEMPTION AT $.05 PER RIGHT AND TO EXCHANGE ON THE TERMS SET FORTH IN THE RIGHTS AGREEMENT. RIGHTS BENEFICIALLY OWNED BY ACQUIRING PERSONS (AS DEFINED IN THE RIGHTS AGREEMENT) BECOME NULL AND VOID. 13. This Amendment to the Rights Agreement shall be governed by and construed in accordance with the laws of the State of Wisconsin and for all purposes shall be governed by and construed in accordance with the laws of such State applicable to contracts to be made and performed entirely within such State. 14. This Amendment to the Rights Agreement may be executed in any number of counterparts, each of which shall be an original, but such counterparts shall together constitute one and the same instrument. Terms not defined herein shall, unless the context otherwise requires, have the meanings assigned to such terms in the Rights Agreement. 15. In all respects not inconsistent with the terms and provisions of this Amendment to the Rights Agreement, the Rights Agreement is hereby ratified, adopted, approved and confirmed. In executing and delivering this, the Rights Agent shall be entitled to all the privileges and immunities afforded to the Rights Agent under the terms and conditions of the Rights Agreement. 16. If any term, provision, covenant or restriction of this Amendment to the Rights Agreement is held by a court of competent jurisdiction or other authority to be invalid, void or unenforceable, the remainder of the terms, provisions, covenants and restrictions of this Amendment to the Rights Agreement, and of the Rights Agreement, shall remain in full force and effect and shall in no way be affected, impaired or invalidated. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be duly executed and attested, all as of the date and year first above written. Attest: MOSINEE PAPER CORPORATION By:___________________________ By:____________________________ Attest: CONTINENTAL BANK, N.A. By:__________________________ By:____________________________ EXHIBIT 10(a) MOSINEE PAPER CORPORATION MOSINEE, WISCONSIN DEFERRED COMPENSATION PLAN FOR DIRECTORS As Amended and Restated June 17, 1993 MOSINEE PAPER CORPORATION DEFERRED COMPENSATION PLAN FOR DIRECTORS As Amended and Restated June 17, 1993 1. RESTATEMENT OF PLAN. Mosinee Paper Corporation (the "Company") hereby amends and restates the Mosinee Paper Corporation Deferred Compensation Plan for Directors effective as of June 17, 1993 (the "Plan"). 2. PURPOSE. The purpose of the Plan is to establish an alternative method of compensating members of the Board of Directors of the Company (the "Directors"), whether or not they otherwise receive compensation as employees of the Company, in order to aid the Company in attracting and retaining as Directors persons whose abilities, experience and judgment can contribute to the continued progress of the Company and to provide a mechanism by which the interests of the Directors and the shareholders can be more closely aligned. 3. DEFINITIONS. As used in this Plan the following terms shall have the meaning set forth in this paragraph 3: (a) "BENEFICIARY" shall mean such person or persons, or organization or organizations, as the Participant from time to time may designate by a written designation filed with the Company during the Participant's life. Any amounts payable hereunder to a Participant's Beneficiary shall be paid in such proportions and subject to such trusts, powers and conditions as the Participant may provide in such designation. Each such designation, unless otherwise expressly provided therein, may be revoked by the Participant by a written revocation filed with the Company during the Participant's life. If more than one such designation shall be filed by a Participant with the Company, the last designation so filed shall control over any revocable designation filed prior to such filing. To the extent that any amounts payable under this Plan to a Participant's Beneficiary are not effectively disposed of pursuant to the above provisions of this paragraph 3(a), either because no designation was in effect at the Participant's death or because a designation in effect at the Participant's death failed to dispose of such amounts in their entirety, then for purposes of this Plan, the Participant's "Beneficiary" as to such undisposed of amounts shall be the Participant's estate. (b) "CHANGE OF CONTROL OF THE COMPANY" shall be deemed to have occurred when: (1) any one of the following events occurs: (A) any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")), other than (i) the Company or any of its subsidiaries, (ii) a trustee or other fiduciary holding securities under an employee benefit plan of the Company or any of its subsidiaries, (iii) an underwriter temporarily holding securities pursuant to an offering of such securities, or (iv) a company owned, directly or indirectly, by the shareholders of the Company in substantially the same proportions as their ownership of stock of the Company, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company (not including in the securities beneficially owned by such persons any securities acquired directly from the Company or its affiliates) representing more than 50% of the combined voting power of the Company's then outstanding securities; provided, however, that for the purpose of determining whether any shareholder of the Company on the date hereof becomes the beneficial owner of securities of the Company representing more than 50% of the combined voting power of the Company's then outstanding securities, the securities of the Company held by such shareholder on the date hereof shall not be taken into account; (B) the shareholders of the Company approve a merger or consolidation of the Company or a share exchange with any other company, other than a merger or consolidation or share exchange which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) in combination with the ownership of any trustee or other fiduciary holding securities under an employee benefit plan of the Company, at least 50% of the combined voting power of the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation or share exchange, or a merger or consolidation or share exchange effected to implement a recapitalization of the Company (or similar transaction) in which no person acquires more than 50% of the combined voting power of the Company's then outstanding securities; or (C) the shareholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of all or substantially all of the Company's assets and (2) a majority of the members of the Board of Directors who are unaffiliated with an Interested Shareholder (defined below) and who were members of the Board of Directors as of a date prior to the date on which the Interested Shareholder became an Interested Shareholder has not, by resolution prior to (A) the person described in subparagraph (1)(A) becoming the beneficial owner of 10% of the combined voting power of the Company's then outstanding securities or (B) the approval of shareholders described in (1)(B) or (C) the approval of shareholders described in (1)(C), approved or recommended such event. For purposes of this paragraph 3(b), the term "Interested Shareholder" shall mean any person (other than the Company or any of its subsidiaries or any member of the Board of Directors as of the effective date of this Plan or any affiliate of such person) who first became the beneficial owner of 10% or more of the combined voting power of the Company's then outstanding securities after the effective date of this Plan. (c) "COMMON STOCK" shall mean the common stock, $2.50 par value, of the Company. (d) "DIRECTORS' FEES" shall mean all of the compensation to which a Director would otherwise become entitled for services to be rendered as a Director. (e) "FAIR MARKET VALUE" of the Common Stock on any day shall be deemed to be the mean between the published high and low sale prices at which the Common Stock is traded on a bona fide over-the-counter market or, if such stock is not so traded on such day, on the next preceding day on which the Common Stock was so traded. (f) "PARTICIPANT" shall mean a Director who has made an election to defer Directors' Fees in accordance with paragraph 4. (g) "TERMINATION OF SERVICE" shall mean the bona fide termination of a Participant's services as a member of the Board of Directors of the Company. 4. RIGHT TO DEFER DIRECTORS' FEES. (a) Each Director may elect before January 1 of any fiscal year of the Company to become a Participant and to defer the payment of all of the Directors' Fees to which the Participant would otherwise become entitled for services to be rendered during each fiscal year subsequent to the date on which such election is effective. An election by a Director to defer Directors' Fees pursuant to this subparagraph (a) shall be effective with respect to Directors' Fees earned during the first fiscal year beginning after the date such election is made and during each subsequent fiscal year until revoked or amended, provided that any such revocation or amendment shall only be effective with respect to fiscal years beginning after the date written notice of such revocation or amendment is first received by the Company. (b) Despite any other provision of subparagraph (a), if a person becomes a Director during a fiscal year, such Director may elect to become a Participant with respect to Directors' Fees earned during the year in which he became a Director, provided such election is made before such person begins to serve as a Director. An election by a Director to defer Directors' Fees pursuant to this subparagraph (b) shall be effective after the date such election is made and received by the Company with respect to Directors' Fees earned during the fiscal year in which such election is made and during each subsequent fiscal year until revoked or amended, provided that any such revocation or amendment shall only be effective with respect to fiscal years beginning after the date written notice of such revocation or amendment is first received by the Company. (c) Directors' Fees deferred by a Participant shall be distributable in accordance with paragraph 10 hereof and only after such Participant's Termination of Service. Any Directors' Fees not subject to an election made in accordance with this paragraph 4 shall be paid to the Director in cash. 5. ACCOUNTING AND ELECTIONS. (a) The Company shall establish a Deferred Cash Account and a Deferred Stock Account in the name of each Participant. (b) Each Participant shall make an initial election at the time his deferral election is filed pursuant to paragraph 4 to have his deferred Directors' Fees allocated to his Deferred Cash Account or his Deferred Stock Account. At any time prior to the first day of any subsequent fiscal year, the Participant may file a new election with the Company specifying the Account to which all Directors' Fees earned in the subsequent fiscal year shall be allocated, but in no event shall such election affect the allocation of Directors' Fees deferred prior to the effective date of such election. Any election made by a Participant in accordance with this paragraph 5 shall remain in effect for the fiscal year in which it is first effective and during each subsequent fiscal year until a new election is filed by the Participant. A Participant's initial election shall be effective as of the date the Director becomes a Participant. Each other election made pursuant to this subparagraph (b) shall only be effective with respect to fiscal years beginning after the date such election is first received by the Company. (c) As of each date on which the Company shall make a payment of Director's Fees and a Participant has a deferral election then in effect, there shall be credited to such Participant's Deferred Cash Account or Deferred Stock Account, as the case may be in accordance with such Participant's most recent effective election, the Directors' Fees otherwise payable to such Participant in cash as of such date. (d) Despite any other provision of this Plan, the most recent election in effect on June 16, 1993, made by a Participant with respect to the crediting of his Director's Fees to such Participant's Deferred Cash Account or Deferred Stock Account shall remain in effect as of June 17, 1993 as if such election had been made pursuant to subparagraph (a). (e) Within 90 days of the end of each fiscal year in which this Plan is in effect, the Company shall furnish each Participant a statement of the year-end balance in such Participant's Deferred Cash Account and Deferred Stock Account. 6. FORM FOR ELECTIONS. The Secretary of the Company shall provide election forms for use by Directors in making an initial election to become a Participant and for making all other elections or designations permitted or required by the Plan. 7. DEFERRED CASH ACCOUNT. As of the last day of each fiscal quarter, there shall be computed, with respect to each Deferred Cash Account which is then in existence, an amount equal to interest on the average daily balance in such Account during such quarter, computed at a rate per annum equal to the prime rate of interest then in effect at The Chase Manhattan Bank of New York. The amount so determined shall be credited to and become part of the balance of such Account as of the first day of the next fiscal quarter. 8. DEFERRED STOCK ACCOUNT. (a) As of each date on which the Company shall make a payment of Director's Fees and a Participant has a deferral election then in effect which provides for the deferral of payment of such fees to the Participant's Deferred Stock Account, the Directors' Fees otherwise payable to such Participant in cash as of such date shall be converted into that number of "Stock Equivalent Units" (rounded to the nearest one-ten thousandth of a unit) determined by dividing the amount of such Directors' Fees by an amount equal to the per share Fair Market Value of the Common Stock on such date. (b) On each date on which a dividend payable in cash or property is paid on the Common Stock, there shall be credited to each Deferred Stock Account such number of additional Stock Equivalent Units as are determined by dividing (1) the amount of the cash or other dividend which would have then been payable on the number of shares of Common Stock equal to the number of Stock Equivalent Units (including fractional shares) then represented in such Account by (2) an amount equal to the per share Fair Market Value of the Common Stock on such date. If the date on which a dividend is paid on the Common Stock is the same date as of which Directors' Fees are to be converted into Stock Equivalent Units, the dividend equivalent to be credited to such Account under this paragraph 8 shall be determined after giving effect to the conversion of the credit balance in such Account into Stock Equivalent Units. (c) The number of Stock Equivalent Units credited to a Participant's Deferred Stock Account shall be adjusted (to the nearest one-ten thousandth of a unit) to reflect any change in the Common Stock resulting from a stock dividend, stock split-up, combination, recapitalization or exchange of shares, or the like. 9. NO TRANSFERS BETWEEN ACCOUNTS. A Participant may not transfer any portion of the balance of his Deferred Cash Account to his Deferred Stock Account or any portion of his Deferred Stock Account to his Deferred Cash Account. 10. DISTRIBUTION OF DEFERRED AMOUNTS. (a) Distribution of amounts represented in a Participant's Deferred Cash Account or a Deferred Stock Account shall be made in accordance with the following: (1) Payment of the balance of the Deferred Cash Account and Deferred Stock Account of a Participant whose Termination of Service occurs for a reason other than death and prior to a Change of Control of the Company shall be made in a lump sum as of the last day of the fiscal quarter coincident with or immediately subsequent to the Participant's Termination of Service unless the Participant elects otherwise in accordance with the provisions of paragraph 10(b). (2) In the event a Participant ceases to be a Director because of his death or in connection with a Change of Control of the Company, payment of the balance of his Deferred Cash Account and Deferred Stock Account shall be made in a lump sum as of the last day of the fiscal quarter coincident with or immediately subsequent to the Participant's Termination of Service. (b) A Participant may, subject to the automatic distribution provisions of paragraph 10(a)(2), which shall govern the distribution of benefits in the event of Termination of Service which occurs because of death or a Change of Control of the Company, file one election prior to his Termination of Service which specifies that payment of the balance of his Deferred Cash Account and Deferred Stock Account shall be made in installments and the: (1) fiscal quarter in which distribution of the Participant's Accounts shall begin (but in no event (A) earlier than the Director's Termination of Service or (B) later than the earlier of (i) the Director's 70th birthday or (ii) the date five years after the date of the Director's Termination of Service; and (2) number of fiscal quarters over which such Accounts shall be distributed to the Participant, which period shall not extend beyond the end of the 40th fiscal quarter following the fiscal quarter in which such distribution begins. Any election filed pursuant to this paragraph 10(b) shall be subject to the approval of the Board of Directors as then in effect. (c) If installment payments were elected by the Participant pursuant to paragraph 10(b), distributions shall be made in quarterly installments beginning on the first day of the first fiscal quarter following the date on which such Participant's Termination of Service occurs or each other later fiscal quarter as the Participant may have specified. (1) In the case of a Deferred Cash Account with respect to which installment payments were elected, the amount of each quarterly installment shall be determined by dividing the credit balance in such Account as of the distribution date by the number of installments then remaining unpaid. The credit balance in such Account shall then be reduced by the amount of each distribution out of such Account. (2) In the case of a Deferred Stock Account with respect to which installment payments were elected, the amount to be distributed as each quarterly installment shall be determined as follows: (A) multiply the number of Stock Equivalent Units (including any fraction thereof) then reflected in such Account by the Fair Market Value of the Common Stock on such date; (B) add to the product so determined the amount (if any) which has been credited to such Account but which has not been converted into Stock Equivalent Units; and (C) divide the total so obtained by the number of installments then remaining unpaid. The number of Stock Equivalent Units represented in a Deferred Stock Account shall be reduced forthwith by that number (rounded to the nearest one-ten thousandth of a unit) determined by dividing the amount of the distribution by the Fair Market Value of the Common Stock taken into account for purposes of clause (A) of the preceding sentence. In the event that a Participant dies after receiving payment of some, but less than all, of the entire amount to which such Participant is entitled under this Plan, the unpaid balance shall be paid in a lump sum to the Participant's Beneficiary. (d) In the case of a Deferred Cash Account or a Deferred Stock Account with respect to which payment is to be made in a lump sum, the amount of such payment shall be determined as if installment payments had been elected and the lump sum was the last (but only) such payment. (e) After a Participant's Termination of Service occurs, neither such Participant or his Beneficiary shall have any right to modify in any way the schedule for the distribution of amounts credited to such Participant under this Plan as specified in the last election filed by the Participant. However, upon a written request submitted to the Secretary of the Company by the person then entitled to receive payments under this Plan (who may be the Participant, or a Beneficiary, the Board of Directors may in its sole discretion, accelerate the time for payment of any one or more installments remaining unpaid. 11. INCOMPETENCY. If, in the opinion of the Board of Directors of the Company, a Participant shall at any time be mentally incompetent, any payment to which such Participant would be entitled under this Plan may, with the approval of the Board of Directors, be paid to the Participant's legal representative, or to any other person for his benefit and in such case, the Board of Directors may in its sole discretion, accelerate the time for payment of any one or more installments remaining unpaid. 12. MISCELLANEOUS. (a) This Plan shall be effective upon adoption by the Board of Directors of the Company. (b) Amounts payable hereunder may not be voluntarily or involuntarily sold or assigned, and shall not be subject to any attachment, levy or garnishment. (c) Participation in this Plan by any person shall not confer upon such person any right to be nominated for re-election to the Board of Directors, or to be re-elected to the Board of Directors. (d) The Company shall not be obligated to reserve or otherwise set aside funds for the payment of its obligations hereunder, and the rights of any Participant under the Plan shall be an unsecured claim against the general assets of the Company. All amounts due Participants or Beneficiaries under this Plan shall be paid out of the general assets of the Company. (e) The Board of Directors shall have all powers necessary to administer this Plan, including all powers of Plan interpretation, of determining eligibility and the effectiveness of elections and of deciding all other matters relating to the Plan; provided, however, that no Participant shall take part in any discussion of, or vote with respect to, a matter of Plan administration which is personal to him and not of general applicability to all Participants or shall act with respect to his own election made pursuant to paragraph 10(b). All decisions of the Board of Directors shall be final as to any Participant under this Plan. (f) The Board of Directors of the Company may amend this Plan in any and all respects at any time, or from time to time, or may terminate this Plan at any time, but any such amendment or termination shall be without prejudice to any Participant's right to receive amounts previously credited to such Participant under this Plan. In Witness Whereof, this Plan has been executed as of the _____ day of June, 1993 by the undersigned duly authorized officer of the Company. MOSINEE PAPER CORPORATION _____________________________ Richard L. Radt President and Chief Executive Officer EXHIBIT 10(d) MOSINEE PAPER CORPORATION MOSINEE, WISCONSIN 1993 AND 1994 INCENTIVE COMPENSATION PLAN FOR CORPORATE EXECUTIVE OFFICERS EXHIBIT 10(d) MOSINEE PAPER CORPORATION 1994 INCENTIVE COMPENSATION PLAN FOR CORPORATE EXECUTIVE OFFICERS I. The President and Chief Executive Officer shall be entitled to receive incentive compensation in accordance with the following: Range of Incentive Compensation Earnings Per Share Range (1) as a % of Base Salary (2) ---------------------------- ------------------------- $1.50 - 2.50 0 - 100% (1) Earnings per share are to be adjusted for accruals on SAR's, bonus expense and extraordinary items. (2) Incremental earning results between performance range will result in corresponding and proportional adjustment in percentage of salary earned as incentive compensation limited to the maximum percentage indicated. II. The Senior Vice President - Finance, Secretary and Treasurer shall be entitled to receive incentive compensation in accordance with the following: Range of Incentive Compensation A. Earnings Per Share Range (1) as a % of Base Salary (2) ---------------------------- ------------------------- $1.50 - 2.50 0 - 75% (1) See (1) above. (2) See (2) above. B. The Senior Vice President - Finance, Secretary and Treasurer shall be entitled to incentive compensation not in excess of an aggregate of 25% of base salary upon achievement of objectives determined by the President and Chief Executive Officer. III. The Senior Vice President - Administration shall be entitled to receive incentive compensation in accordance with the following: Range of Incentive Compensation A. Earnings Per Share Range (1) as a % of Base Salary (2) ---------------------------- ------------------------- $1.50 - 2.50 0 - 55% (1) See (1) above. (2) See (2) above. Range of B. Converted Products Division Incentive Compensation Operating Profit Range (3) as a % of Base Salary (2) --------------------------- ------------------------- $3,300,000 - $4,300,000 0 - 20% (2) See (2) above. (3) Operating profit to be determined prior to bonus expense and extraordinary items. C. The Senior Vice President - Administration shall be entitled to incentive compensation not in excess of an aggregate of 25% of base salary upon achievement of objectives determined by the President and Chief Executive Officer. MOSINEE PAPER CORPORATION 1993 INCENTIVE COMPENSATION PLAN FOR CORPORATE EXECUTIVE OFFICERS I. The President and Chief Executive Officer shall be entitled to receive incentive compensation in accordance with the following: Range of Incentive Compensation as a % of Operating Unit Performance (1) Base Salary (2) ------------------------------ ---------------------- Towel & Tissue - $100,000 to $1,000,000 -0- to 28% Pulp & Paper - $15,000,000 to $21,500,000 -0- to 24% Bay West Converting - $4,000,000 to $7,000,000 -0- to 16% Converted Products - $3,500,000 to $4,800,000 -0- to 8% Sorg - $100,000 to $1,000,000 -0- to 4% 1. Operating earnings are to be determined prior to bonus expense and extraordinary items. 2. Incremental operating results between performance levels will result in corresponding and proportional adjustment in percentage of salary earned as incentive compensation limited to the maximum percentage indicated. II. The Executive Vice President and Chief Operating Officer, the Vice President - Finance, and the Vice President - Human Resources shall be entitled to receive incentive compensation in accordance with the following: Range of Incentive Compensation as a % of A. Operating Unit Performance (1) Base Salary (2) ------------------------------ ---------------------- Towel & Tissue - $100,000 to $1,000,000 -0- to 26.25% Pulp & Paper - $15,000,000 to $21,500,000 -0- to 22.5% Bay West Converting - $4,000,000 to $7,000,000 -0- to 15.0% Converted Products - $3,500,000 to $4,800,000 -0- to 7.5% Sorg - $100,000 to $1,000,000 -0- to 3.75% 1. See (1) above. 2. See (2) above. B. Each participant shall be entitled to incentive compensation not in excess of an aggregate of 25% of base salary upon achievement of objectives determined by the President and Chief Executive Officer. EXHIBIT 11 NOTICE OF ANNUAL MEETING OF SHAREHOLDERS _______________ To Our Shareholders: The annual meeting of shareholders of Mosinee Paper Corporation will be held at the Westwood Conference Room, Westwood Center, Wausau Insurance Companies, 1800 West Bridge Street, Wausau, Wisconsin on Thursday, April 21, 1994, at 11:00 a.m., local time, for the following purposes: 1. To elect two Class II Directors for terms which will expire at the annual meeting of shareholders to be held in 1997. 2. To approve the appointment of Wipfli Ullrich Bertelson CPAs as independent auditors for the year ending December 31, 1994. 3. To transact such other business as may properly come before the meeting. PLEASE PROMPTLY VOTE, SIGN, DATE AND RETURN THE ENCLOSED PROXY IN THE ENCLOSED ENVELOPE. DATED: March 23, 1994. MOSINEE PAPER CORPORATION Gary P. Peterson Secretary ____________________________ A RETURN ENVELOPE REQUIRING NO POSTAGE IF MAILED IN THE UNITED STATES IS ENCLOSED FOR YOUR CONVENIENCE IN SUBMITTING YOUR PROXY. MOSINEE PAPER CORPORATION MARCH 23, 1994 1244 KRONENWETTER DRIVE MOSINEE, WISCONSIN 54455 PROXY STATEMENT FOR ANNUAL MEETING OF SHAREHOLDERS TO BE HELD APRIL 21, 1994 SOLICITATION OF PROXIES The enclosed proxy is solicited by the Board of Directors of Mosinee Paper Corporation (the "Company") for use at the annual meeting of shareholders to be held on April 21, 1994, and at any adjournment thereof (the "Annual Meeting") for the purposes set forth in the foregoing notice. Officers, directors and employees of the Company may solicit proxies by telephone, telegraph or in person in addition to solicitation by mail. None of these persons will receive additional compensation. Expenses incurred in connection with the solicitation of proxies, including the reasonable expenses of brokers, fiduciaries and other nominees in forwarding proxy material, will be borne by the Company. VOTING OF PROXIES Each holder of the Company's common stock is entitled to one vote in person or by proxy for each share held of record on all matters to be voted upon at the Annual Meeting. Only shareholders of record on March 2, 1994 are entitled to notice of and to vote at the Annual Meeting. With respect to the election of directors, shareholders may vote in favor of the nominees specified on the accompanying proxy card or may withhold their vote. Votes that are withheld will be excluded entirely from the voting for directors and will have no effect. The nominees receiving the largest number of votes will be elected as directors of the Company. On all matters other than the election of directors, shareholders may vote in favor of a proposal, against a proposal or abstain from voting. Abstentions on any matter presented to the Annual Meeting will be treated as shares that are present and entitled to vote for purposes of determining whether a quorum is present, but such abstentions shall be treated as unvoted for purposes of determining whether the matter has been approved by the shareholders. If the votes cast in favor of a proposal (other than the election of directors) exceed the votes cast against the proposal, the matter will be approved by the shareholders. Brokers who hold shares of the Company's common stock in street name for customers may have discretionary authority to vote on certain matters when they have not received instructions from beneficial owners, but may not have authority to vote the shares on other matters. As to matters for which the broker cannot vote shares held in street name, the shares will be recorded as a "broker non-vote." Shares reported as broker non-votes will not be considered present and entitled to vote with respect to the matter and will not be counted for purposes of determining whether a quorum is present. A shareholder who executes the enclosed proxy may revoke it at any time before it is voted by giving written notice to the Secretary of the Company or oral notice to the presiding officer at the Annual Meeting. The persons named in the accompanying proxy card, as members of the Proxy Committee of the Board of Directors, will vote the shares subject to each proxy. The proxy in the accompanying form will be voted as specified by each shareholder, but if no specification is made, each proxy will be voted: (1) TO ELECT Messrs. Richard G. Jacobus and Daniel R. Olvey to terms of office as Class II Directors which will expire at the annual meeting of shareholders to be held in 1997 (see "Election of Directors"), (2) TO APPROVE the appointment of Wipfli Ullrich Bertelson CPAs as the Company's independent auditors for the year ending December 31, 1994 (see "Approval of Independent Auditors"), and (3) IN THE BEST JUDGMENT of those named as proxies on the enclosed form of proxy on any other matters to properly come before the Annual Meeting (see summary of Company bylaw requirements under "Shareholder Proposals"), the approval of minutes and matters incident to the conduct of the Annual Meeting or adjournment thereof. ELECTION OF DIRECTORS The Company's Restated Articles of Incorporation, as amended, provide that the number of directors shall be determined by the Board of Directors pursuant to the bylaws, but that there shall be not less than three nor more than ten directors, divided into three classes to be as nearly equal in size as possible. Except in cases of the appointment of a director by the Board to fill a vacancy resulting from the creation of a new directorship, one class of directors is to be elected each year to serve a three-year term. The Board has fixed the number of directors at six, consisting of two Class I, Class II and Class III Directors, respectively. On August 19, 1993, Daniel R. Olvey was elected President and Chief Executive Officer and a Class II Director of the Company and Richard L. Radt was elected Vice Chairman. Mr. Olvey's election filled a vacancy on the Board which had resulted from Clarence Scholtens' resignation from the Board of Directors after having reached the Board's mandatory retirement age. At the Annual Meeting, Richard G. Jacobus and Daniel R. Olvey will be candidates for reelection to the Board of Directors. Each of the nominees has consented to serve if elected, but in case one or both of the nominees is not a candidate at the Annual Meeting it is the intention of the Proxy Committee to vote for such substitute or substitutes as may be designated by the Board. The following information is furnished with respect to the nominees and all other directors: COMMITTEES AND COMPENSATION OF THE BOARD OF DIRECTORS COMMITTEES AND MEETINGS The Board of Directors annually establishes Audit, Nominating and Executive Compensation & Bonus Committees. During 1993, Messrs. Staples, Jacobus and Alexander served as members of the Audit Committee. The Audit Committee held two meetings during 1993 to review the audit of the previous fiscal year and the scope of the audit engagement and the range of audit fees and nature of consulting fees. The Nominating Committee consists of Messrs. Orr, Staples and Alexander. The Nominating Committee met once in 1993 to consider and recommend to the Board of Directors nominees for election as directors. Inquiries concerning nominations with pertinent background information should be directed to the Chairman of the Nominating Committee in care of the Company. Pursuant to the Company's bylaws, shareholders entitled to vote at the annual meeting of shareholders to be held in 1995 may make nominations from the floor only if proper notice of the proposed nomination has been provided to the Secretary of the Company not earlier than January 21, 1995 and not later than February 20, 1995. The precise requirements, including the information required to be provided in the notice and the procedures for notice in the event the date of the annual meeting is changed, are set forth in the Company's bylaws which may be obtained from the Secretary of the Company. Messrs. Orr, Jacobus and Staples served as members of the Executive Compensation & Bonus Committee during 1993. The Committee met five times during 1993 to review and establish executive compensation. The Committee is responsible for the establishment and implementation of executive bonus programs, including the granting of stock options. See subheading "Committees' Report on Executive Compensation Policies," page ___. During 1993, the Board of Directors met seven times, including its annual organizational meeting. All of the directors of the Company attended at least 75% of the aggregate number of meetings of the Board and meetings of committees of the Board on which they served. DIRECTOR COMPENSATION Directors received a base annual fee of $6,000 and $1,000 for each meeting of the Board attended in 1993. No additional compensation is paid to directors for service on committees. Directors are reimbursed for normal and customary travel expenses relating to meetings of the Board of Directors and Company business. Under the Company's Deferred Compensation Plan for Directors, directors may elect each year to defer fees otherwise payable in cash during the year. Amounts deferred become payable after the director's termination of service as a director in a lump sum or, if the participants elect with the approval of the Company, in quarterly installments over a period not in excess of 10 years. Payments are made in a lump sum in the event a director's service terminates as the result of a change of control of the Company, as defined by the plan. During the period of deferral, a director may elect that the deferred fees be credited with interest at the prime rate in effect as of each calendar quarter at The Chase Manhattan Bank of New York or that the deferred fees be converted into stock equivalent units. If stock equivalent units are elected, the director's account under the plan is credited with common stock equivalent units which are determined by dividing the amount deferred by the fair market value of the Company's common stock on the date of deferral and common stock equivalent units representing the fair market value of additional common stock equal in amount to the cash dividends which would have been paid on the accumulated stock equivalent units had they been actual shares of common stock. Upon distribution, stock units are converted to cash based upon the fair market value of the Company's common stock at the time of distribution. During 1993, Messrs. Orr, Olvey, Staples, Jacobus and Alexander participated in the plan and deferred the director or meeting fees otherwise payable to them. The Company maintains a supplemental retirement benefit plan under which Mr. Orr is entitled to receive a monthly retirement benefit in an amount equal to 50% of his highest five-year average monthly compensation beginning on the last to occur of his termination of employment or attainment of age 60. Upon Mr. Orr's death, his surviving spouse will be entitled to receive 50% of the monthly benefit otherwise payable to Mr. Orr. The plan is unfunded and provides for the accelerated payment of the present value of benefits in a lump sum in the event of a change of control of the Company, as defined in the plan. BENEFICIAL OWNERSHIP OF COMMON STOCK As of the close of business on March 2, 1994, the record date, the Company had 7,215,943 shares of common stock outstanding (including 67,500 shares subject to options exercisable within 60 days). The following table sets forth, based on statements filed with the Securities and Exchange Commission, the amount of common stock of the Company which is deemed beneficially owned as of the record date by each person known to the Company to be the beneficial owner of more than 5% of the outstanding shares of the Company's common stock. The following table sets forth, based on statements filed with the Securities and Exchange Commission or otherwise made to the Company, the amount of common stock of the Company which is deemed beneficially owned by each of the directors and each of the executive officers of the Company named in the summary compensation table on page 7 and all directors and executive officers as a group. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's directors and officers and persons who own more than 10% of the Company's common stock ("reporting persons") to file reports of ownership and changes in ownership with the Securities and Exchange Commission (the "SEC") and the Nasdaq National Market System. Reporting persons are also required by SEC regulations to furnish the Company with copies of all section 16(a) forms filed by them with the SEC. Based solely on its review of the copies of the section 16(a) forms received by it or upon written representations from certain of these reporting persons in lieu of such forms as to compliance with the section 16(a) regulations, the Company is of the opinion that during the 1993 fiscal year, all filing requirements applicable under section 16 to the reporting persons were satisfied. EXECUTIVE OFFICER COMPENSATION SUMMARY COMPENSATION TABLE The table below sets forth compensation awarded, earned or paid by the Company and its subsidiaries for services in all capacities during each of the three years ended December 31, 1993, 1992 and 1991, to each person who served as the Company's Chief Executive Officer ("CEO") during the 1993 fiscal year and each executive officer of the Company, other than the CEO, as of December 31, 1993, whose total annual salary and bonus compensation for the most recent fiscal year exceeded $100,000. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS The Company maintains a stock option plan and a stock appreciation rights plan pursuant to which options to purchase the Company's common stock and stock appreciation rights may be granted to key employees. The following table presents certain information with respect to grants of stock options during fiscal 1993 to executive officers named in the summary compensation table. No stock appreciation rights were granted in 1993 to executive officers. The following table sets forth information regarding the exercise of stock options or stock appreciation rights ("SARs") in fiscal 1993 by each of the executive officers named in the summary compensation table and the December 31, 1993 value of unexercised stock options or SARs held by such officers. PENSION PLAN BENEFITS MOSINEE RETIREMENT PLAN ----------------------- The following table reflects illustrative estimated single life normal retirement benefits payable at age 65 by the Retirement Plan on an annual basis to participants in selected remuneration and years of service classifications. In estimating the annual benefit, it is assumed that covered compensation for years after 1993 will continue at the same rate as 1993. The benefit amounts listed in the table are based on five-year average cash compensation paid to a participant and are not subject to any deduction for Social Security benefits or other offset amounts. Benefits are limited by Internal Revenue Service rules which provide that the maximum compensation which could be used in 1993 to determine benefits was $235,840. At December 31, 1993, the credited years of service and the approximate average remuneration covered by the Retirement Plan for the persons named in the summary compensation table were: Messrs. Radt, 6 years, $235,840; Olvey, 4 years, $183,000; Peterson, 2 years, $182,000; and Carlson, 3 years, $134,000. SUPPLEMENTAL RETIREMENT PLAN ---------------------------- The Company entered into a Supplemental Retirement Benefit Agreement with Mr. Radt in November, 1991 under which Mr. Radt is entitled to receive a lump sum supplemental retirement benefit plus interest credited at a rate, adjusted quarterly, equal to the prime rate as published in The Wall Street Journal. As of December 31, 1993, the accrued value of this benefit, including interest, was $141,696. The supplemental benefit is payable on Mr. Radt's termination of employment and will continue to be credited with interest until the date of payment. In the event of Mr. Radt's death prior to payment of the supplemental benefit, the supplemental benefit will be paid to Mr. Radt's beneficiary. COMMITTEES' REPORT ON EXECUTIVE COMPENSATION POLICIES Compensation policies are established by the Executive Compensation & Bonus Committee of the Board of Directors (the "Compensation Committee") which establishes and reviews base salaries of executive officers other than the Chairman of the Board and is also responsible for the establishment and implementation of executive bonus and incentive programs. The salary of Mr. Orr, the Chairman of the Board of the Company, is approved by the Board of Directors as a whole. The Company's compensation program for executive officers may include various grants under the Company's stock option and stock appreciation rights ("SAR") plans. The Company's SAR plan is administered by a separate committee appointed by the Board of Directors. The stock option plan is administered by the Compensation Committee. The SAR plan committee generally considers recommendations of the Compensation Committee with respect to grants, but each committee has full discretion and control over whether a grant will be made and the amount and terms of any such grant. Insofar as this report includes a description of the compensation policies relating to the SAR plan, this report is a joint report of the Compensation Committee and of the SAR plan committee. This report describes the policies of the committees and the Company as in effect in 1993. As circumstances change and one or more of the committees deem it appropriate, policies in effect from time to time for years after 1993 may change. GENERAL ------- The Company's executive compensation policies are designed to attract and retain individuals who have experience in the paper industry or who otherwise have particular training or skills which will satisfy particular requirements of the Company and to reward job performance which the Compensation Committee believes to be at or above the level expected of the Company's executive officers. The total compensation paid to executive officers and the retirement and other fringe benefits provided by the Company are designed to offer a level of compensation which is competitive with other paper companies or, in some cases, the operating units of larger paper companies which are comparable to the Company. Some, but not all, of the comparable companies used for purposes of compensation comparisons are included in the thirty-five companies which comprise the Media General MG Industry Group 381 index of paper company stock performance under the heading "Stock Price Performance Graph." In making compensation comparisons, the Committee uses only those companies whose operations are similar to the Company or, in some cases, have operating units similar to the Company. Given the disparity in size between companies which operate in the paper industry and the difficulty in determining the precise duties of executive officers of other companies, it is difficult to draw exact comparisons with the compensation policies of other companies and the determination of appropriate compensation levels by the Compensation Committee is, therefore, subjective. The Company's overall compensation policy is designed so that a significant portion of each executive officer's compensation package is directly tied to the performance of the Company through a combination of annual incentive bonuses which are based on the Company's financial performance during each fiscal year and stock based incentive programs which reflect the performance of the Company's common stock. The value of the stock based incentive awards to executive officers increases or decreases in value as the price of the Company's common stock increases or decreases in the Nasdaq National Market System. Beginning in 1994, the Company may not deduct compensation paid to the CEO and each of the four most highly paid executive officers named in the summary compensation table who are officers on the last day of the year to the extent the compensation paid to the individual officer exceeds $1 million. This limitation is subject to certain exceptions for compensation paid pursuant to performance based plans and amounts received through the exercise of stock options and SARs provided certain requirements are met. Amounts receivable by Company officers under stock options or SARs granted before February 18, 1993 are not subject to this limit. The Company does not expect any compensation paid in 1994 will exceed the deductible limit. The Committee is reviewing this limit and is determining what changes, if any, will be made in the Company's compensation policies. BASE SALARIES AND BENEFITS -------------------------- The Compensation Committee considers a general survey of paper industry compensation prepared by an independent compensation and benefit consultant to assist it in determining an appropriate and comparable level of base salary and benefits for executive officers. Annual increases in base salary are determined by the overall objective of maintaining competitive salary levels, more general factors such as the rate of inflation, and individual job performance. Individual job performance, including satisfaction of individual performance objectives and goals and the accomplishment of specified programs in appropriate cases, is the most important factor considered by the Compensation Committee in determining appropriate increases in base compensation. In the case of executive officers other than the CEO, individual performance objectives and goals are established by the CEO and the assessment of an individual's job performance is based on annual performance evaluations conducted by the CEO. The CEO's base salary is determined by the Compensation Committee on the same basis as that of the Company's other executive officers, except that it is the Compensation Committee which annually establishes individual performance objectives for the CEO and reviews his accomplishment of the objectives established by the Compensation Committee. In addition to base salary increases which reflected the foregoing factors, Messrs. Olvey, Peterson and Carlson also received increases in base salary in 1993 which reflect promotions received during the year and their increased management responsibilities and Mr. Radt's base salary was adjusted to reflect his election as Vice Chairman and Mr. Olvey's assumption of the duties of CEO. INCENTIVE COMPENSATION BASED ON FINANCIAL PERFORMANCE OF THE ------------------------------------------------------------ COMPANY AND INDIVIDUAL PERFORMANCE - - ---------------------------------- The Company maintains incentive reward plans for executive officers which provide for the payment of annual cash bonuses to participants if annual Company financial and individual performance objectives are met. The Compensation Committee, in its sole discretion, annually establishes performance levels for the plans and may throughout the year review and adjust the standards for performance measurements, performance levels, and the maximum cash bonuses (as a percentage of base salary) to be paid. In 1993, executive officers received incentive compensation, based on each operating unit's attainment of operating income within a specified minimum and maximum range for such unit. The maximum bonus payable in 1993 to Mr. Radt with respect to performance of the Company's various operating units was based on achievement of the maximum specified operating income by each unit and ranged from 4% to 28% of his base salary as CEO, with a maximum aggregate bonus of 80% of base salary. The maximum bonuses payable in 1993 to Mr. Olvey, who became President and CEO on August 19, 1993, and to each other executive officer of the Company was based on the achievement of the maximum specified operating income by each Company's various operating units and ranged from 3.75% to 26.25% of the officer's base salary with a maximum aggregate bonus of 75% of base salary. Operating income of each unit is determined prior to bonus expense and extraordinary items. In addition, during 1993 each executive officer other than Mr. Radt was eligible to receive incentive compensation upon satisfaction of individual performance objectives established at the beginning of the year by Mr. Radt. The maximum aggregate incentive compensation payable to an executive officer based upon achievement of all individual performance objectives could not exceed 25% of the officer's base salary. STOCK BASED COMPENSATION ------------------------ Executive officers participate in the Company's stock option and SAR plans at various levels. The stock option plan is administered by the Compensation Committee and the SAR plan is administered by a committee appointed by the Board of Directors. Each of the committees may impose conditions or restrictions as to exercise or vesting of grants under its respective plan. For example, the aggregate number of options granted in 1993 to executive officers were divided into three distinct increments which were exercisable at successively higher exercise prices. Neither of the committees has established formal criteria by which the size of plan grants are determined, but each committee considers the amount and terms of each grant already held by an executive officer in determining the size and amount of any new grant. The value of stock option and SAR grants are principally related to the long-term performance of the Company's common stock and therefore provide an identity of interests between the Company's executive officers and its shareholders. However, grantees of SARs benefit from the increase in value of the underlying common stock and from the value of the hypothetical cash dividends which would be paid with respect to a share of stock. The value of such hypothetical dividends is determined as if underlying shares subject to the SAR paid dividends in the same amount as actual common stock and that such hypothetical cash dividends are reinvested in shares of hypothetical stock on each dividend payment date (and further assume that dividends are paid and reinvested on the hypothetical stock in the same manner). Therefore, executive officers who exercise SARs will benefit from such grants regardless of an increase in the price of the Company's common stock, but such value will be enhanced by increases in the price of the Company's common stock and will be of maximum value to the executive officer only if such increase in the price of the common stock occurs. It is the intention of the Company that the hypothetical dividend features of the SARs will place the executive officers in the same position as shareholders of the Company, thereby enhancing the officer's long-term incentive and increasing his identity with the shareholders. Options and SARs can be, but are not necessarily, granted on an annual basis. See tables on pages 9 and 10. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION ----------------------------------------------------------- Mr. Orr is Chairman of the Compensation Committee and, as Chairman of the Board of the Company, he is considered an employee of the Company. See "Committees and Compensation of the Board of Directors." Executive Bonus and Compensation Committee San W. Orr, Jr. Richard G. Jacobus Stanley F. Staples, Jr. 1990 SAR Plan Committee Richard G. Jacobus Stanley F. Staples, Jr. Walter Alexander STOCK PRICE PERFORMANCE GRAPH The following graph and table compare the yearly percentage change in the cumulative total shareholder return on the Company's common stock for the five year period beginning December 31, 1988 with two indices published by Media General Financial Services. The Media General Nasdaq Market Index indicates the performance of all stocks which have been traded on the Nasdaq market during the entire five year period. The Media General MG Industry Group 381- Paper Products Index indicates the performance of thirty-five companies in the paper products industry. The graph and table assume that the value of the investment in the Company's common stock and each index on December 31, 1988 was $100 and that all dividends were reinvested. APPROVAL OF INDEPENDENT AUDITORS The Board of Directors will present to the Annual Meeting a resolution that the shareholders ratify the appointment of the firm of Wipfli Ullrich Bertelson CPAs as independent auditors to audit the books, records and accounts of the Company for the year ending December 31, 1994. The firm has audited the Company's books annually since 1931. Representatives of Wipfli Ullrich Bertelson CPAs will be present at the Annual Meeting and will have an opportunity to make a statement or respond to appropriate questions. SHAREHOLDER PROPOSALS If any shareholder desires to submit a proposal for inclusion in the proxy statement to be used in connection with the Annual Meeting of Shareholders to be held in 1995, the proposal must be in proper form and be received by the Company no later than November 15, 1994. Pursuant to the Company's bylaws, shareholders entitled to vote at the annual meeting of shareholders to be held in 1995 may bring business before the 1995 annual meeting for consideration only if proper notice of the proposed business has been provided to the Secretary of the Company not earlier than January 21, 1995 and not later than February 20, 1995. The precise requirements, including the information required to be provided in the shareholder notice and the procedures for notice in the event the date of the annual meeting is changed, are set forth in the Company's bylaws which may be obtained from the Secretary of the Company. See "Committees and Compensation of Board of Directors" regarding bylaw requirements relating to nominations from the floor at the annual meeting of shareholders to be held in 1995. OTHER MATTERS At this date, there are no other matters the Board of Directors intends to present or has reason to believe others will present to the Annual Meeting. If other matters now unknown to the Board of Directors are properly presented at the Annual Meeting, those named as proxies will vote in accordance with their judgment. DATED: March 23, 1994. BY ORDER OF THE BOARD OF DIRECTORS GARY P. PETERSON, Secretary PLEASE SIGN, DATE AND RETURN YOUR PROXY PROMPTLY.

314661_1993.txt

314661_1993

1993

314661

ITEM 1. BUSINESS - ----------------- INTRODUCTION Santa Anita Realty Enterprises, Inc. ("Realty") and Santa Anita Operating Company ("Operating Company") are two separate companies, the stocks of which trade as a single unit under a stock-pairing arrangement on the New York Stock Exchange. Realty and Operating Company were each incorporated in 1979 and are the successors of a corporation originally organized in 1934 to conduct thoroughbred horse racing in Southern California. As used herein, the terms "Realty" and "Operating Company" include wholly owned subsidiaries of Realty and Operating Company, respectively, unless the context requires otherwise. This document constitutes the annual report on Form 10-K for both Realty and Operating Company. REALTY Realty is incorporated under the laws of the State of Delaware. Realty's principal executive offices are located at 363 San Miguel Drive, Suite 100, Newport Beach, California 92660-7805. Realty operates as a real estate investment trust ("REIT") under the provisions of the Internal Revenue Code of 1986 (the "Code"). As such, Realty is principally engaged in investing in and holding real property, including Santa Anita Racetrack, 622,000 square feet of industrial space, the real estate underlying the Santa Anita Fashion Park shopping center ("Fashion Park"), a 50 percent interest in the operation of Fashion Park and a 32.5 percent interest in Towson Town Center (major regional shopping centers), and a number of neighborhood shopping centers and office buildings. Until February 18, 1994, Realty also owned 2,654 apartment units and an additional 185,000 square feet of industrial space. Realty is a self-administered equity REIT. PACIFIC GULF PROPERTIES INC. In June 1993, Realty's Board of Directors approved management's recommendation to recapitalize certain assets of Realty. Pursuant to this recapitalization, in November 1993, Realty entered into a Purchase and Sale Agreement to sell its multifamily and industrial operations to Pacific Gulf Properties Inc. ("Pacific"), in conjunction with Pacific's proposed public offering of common stock. The transaction was structured into two parts: (1) Realty would sell all of its apartments and industrial properties to Pacific with the exception of Realty's interest in the Baldwin Industrial Park joint venture; and (2) Pacific would enter into a binding agreement to buy Realty's interest in Baldwin Industrial Park. On February 18, 1994, Realty completed the first part of this transaction by selling to Pacific ten multifamily properties, containing 2,654 apartment units, located in Southern California, the Pacific Northwest, and Texas and three industrial properties, containing an aggregate of 185,000 leasable square feet of industrial space, located in the State of Washington (the "Transferred Properties"). Realty's corporate headquarters building and related assets were also acquired by Pacific. The sale of the Transferred Properties followed the public offerings of common stock and convertible subordinated debentures by Pacific. Pursuant to the Purchase and Sale Agreement, Pacific agreed to buy Realty's interest in Baldwin Industrial Park subject to satisfaction of certain conditions, for a minimum price of $8.9 million payable in additional shares of Pacific common stock, with the final price dependent upon completion of negotiations with other owners of Baldwin Industrial Park and an appraisal process. Management believes the sale of Realty's interest in Baldwin Industrial Park will be completed in the second half of 1994. Pacific is required to issue to Realty non-refundable letters of credit totaling up to $2.5 million by March 31, 1994 to secure its obligation to ITEM 1. BUSINESS (CONTINUED) - ---------------- acquire Realty's interest in Baldwin Industrial Park and pay for the corporate headquarters building and other assets related to the Transferred Properties. In consideration of the sale of the Transferred Properties, Realty received approximately $44.4 million in cash and 149,900 shares of the common stock of Pacific. In addition, Realty was relieved of approximately $44.3 million of mortgage debt on the Transferred Properties. Realty will also receive, at the time the acquisition of Baldwin Industrial Park is completed, up to $1.2 million in additional common stock of Pacific as consideration for its corporate headquarters and other net assets related to the Transferred Properties. The two parts of the above transaction will result in a loss of $10,974,000. This loss has been reflected in the Realty and Realty and Operating Company combined statements of operations for the year ended December 31, 1993. If the Baldwin Industrial Park portion of the transaction described above does not occur, an additional loss of approximately $5,900,000 will be recognized by Realty in 1994. (See "Notes to Financial Statements - Note 2 - Disposition of Multifamily and Industrial Properties Subsequent to Year End.") In connection with the sale, the executive officers, various managers and most other employees of Realty resigned and became officers and employees of Pacific on February 18, 1994. Realty and Pacific have also entered into a one-year management agreement whereby Pacific has agreed to provide management services to Realty. Finally, with respect to the common stock of Pacific owned by Realty, Pacific has entered into a registration rights agreement with Realty which, under certain circumstances, allows Realty to require the registration of the Pacific stock it owns. As a result of the February 18, 1994 sale to Pacific, Realty owns approximately 3.6% of Pacific's outstanding common shares. Upon completion of Pacific's acquisition of Baldwin Industrial Park assuming a price per share equal to $18.25 (the public offering price of Pacific's common shares) and the minimum price for Realty's interest in Baldwin Industrial Park and the corporate headquarters building and certain other assets related to the Transferred Properties, Realty will own approximately 14.9% of Pacific's outstanding common shares. The February 18, 1994 sale also accomplished the following objectives: (1) the transaction de-leveraged Realty by paying down its lines of credit by $44.4 million and transferring certain debt in the amount of $44.3 million related to the apartment and industrial properties to Pacific; (2) Realty's existing shareholders' interest in Santa Anita Racetrack and Fashion Park was not diluted; and (3) Realty shareholders will participate in the potential growth of Pacific through Realty's ownership position. Item 1. Business (continued) - ---------------- SUMMARY FINANCIAL INFORMATION The following table sets forth certain unaudited financial information with respect to Realty: - ------------------------- (a) See Item 1. "Business - Realty - Pacific Gulf Properties." (b) Calculated in accordance with the definition of funds from operations as defined by the National Association of Real Estate Investment Trusts ("NAREIT"), except 1993 which excludes $5,734,000 received from the California Franchise Tax Board related to the settlement of certain state tax issues. Net income (computed in accordance with generally accepted accounting principles), excluding gains (losses) from debt restructuring and sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated joint ventures were calculated by adding distributions from unconsolidated joint ventures net of equity in the earnings (losses) of the venture and excluding distributions associated with the sale of property by the venture. (c) Pro forma funds from operations for the year ended December 31, 1993, after giving effect to the Pacific transaction, was $16,151,000. ITEM 1. BUSINESS (CONTINUED) - ---------------- REAL ESTATE INVESTMENTS AND POLICIES Realty's portfolio of real estate investments is outlined below. Information with respect to the real estate investments subject to the Pacific transaction are separately listed: SUMMARY OF REAL ESTATE INVESTMENTS AS OF DECEMBER 31, 1993 - ------------------------------------- (a) Square feet except as indicated. (b) Net book value (total cost of project less accumulated depreciation) at December 31, 1993. Amounts represent 100% of project net book value. (c) Amounts represent 100% of project encumbrances. (d) Subsequent to December 31, 1993, the loan was refinanced (see Item 1. "Business - Realty - Regional Malls - Santa Anita Fashion Park"). (e) A major shopping center which was expanded into a 980,000 square foot regional mall. Expanded mall area opened in October 1991. Additional anchor tenant opened in fall of 1992. (f) Realty is entitled to receive a preferred return on its equity investment. (g) A retail building adjacent to the Towson Town Center project that is expected to become part of the regional mall described in (e) above. (h) Pacific has an option to acquire this property (see Item 1. "Business - Realty - Land"). (i) Corporate offices of Realty and Pacific. (j) Pacific has agreed to acquire this property during 1994 (see Item 1. "Business - Realty - Pacific Gulf Properties"). ITEM 1. BUSINESS (CONTINUED) - ----------------- The following table presents information with respect to Realty's wholly owned and consolidated joint venture projects, other than Santa Anita Racetrack, by type as of December 31, 1993. Information with respect to the projects subject to the Pacific transaction is separately listed. Information on the consolidated joint venture projects represents 100% of the projects' leasable area and net operating income. - ---------------------- (a) Rental property revenues less rental property operating expenses for all wholly owned properties and consolidated joint venture properties. (b) Does not include square footage in Towson Town Center (980,000 square feet) or Joppa Associates (240,000 square feet), or land underlying Fashion Park of 73 acres. (c) Net operating income includes only actual number of months of activity for each project. (d) Includes - property Pacific has agreed to acquire during 1994 (see Item 1. "Business - Realty - Pacific Gulf Properties"). The disposition of the multifamily and industrial operations to Pacific is consistent with Realty's plan to focus its efforts on the Santa Anita Racetrack and related property in Arcadia. Realty's current investment policy is to focus its efforts on the Santa Anita Racetrack and related property in Arcadia. Realty's investment policies are subject to ongoing review by its Board of Directors and may be changed in the future depending on various factors, including the general climate for real estate investments. SANTA ANITA RACETRACK Santa Anita Racetrack, which is leased by Realty to the Los Angeles Turf Club, Incorporated ("LATC"), a subsidiary of Operating Company, is located on approximately 312 acres, 14 miles northeast of downtown Los Angeles, adjacent to major transportation routes. LATC conducts one of the largest thoroughbred horse racing meets in the United States in terms of both average daily attendance and average daily pari-mutuel wagering. The Santa Anita Racetrack was opened for thoroughbred horse racing in 1934 by a group of investors led by Dr. Charles H. Strub. The Santa Anita Meet has been held at Santa Anita Racetrack each year since its founding except for three years during World War II. Over the years, the racetrack facilities have been expanded. At present, the physical plant consists of a large grandstand structure, stalls for approximately 2,000 horses, and a parking area covering approximately 128 acres which can accommodate approximately 20,000 automobiles. The grandstand facilities include clubhouse and Turf Club accommodations, a general admission Item 1. Business (continued) - ---------------- area, and food and beverage facilities, which range from fast food stands to restaurants, both at outdoor terrace tables and indoor dining areas. The grandstand has seating capacity for 25,000 as well as standing room for additional patrons. The structure also contains Operating Company's executive and administrative offices. The grounds surrounding the grandstand are extensively landscaped and contain a European-style paddock and infield accommodations, including picnic facilities for special groups and the general public. The lease rental payable to Realty by LATC is 1.5% of total live on-track wagering at Santa Anita Racetrack, including live on-track wagering during the meet conducted by the Oak Tree Racing Association ("Oak Tree"). In addition, Realty receives 40% of LATC's revenues from satellite wagering (not to exceed 1.5% of such wagering) and the simulcasting of races originating from Santa Anita Racetrack after mandated payments to the State, to horse owners and to breeders. Accordingly, the rental income which Realty receives from Santa Anita Racetrack is directly affected by and dependent upon the racing activities and the wagering by patrons (see Item 1. "Business -- Operating Company -- Santa Anita Racetrack"). Based upon the rental formula for the year ended December 31, 1993, Realty received approximately $11.6 million in rental income from horse racing. The lease expires in December 1994 at which time it is expected to be renewed on terms to be renegotiated by Realty and LATC which, in light of Operating Company's declining profitability, may result in reduced revenue to Realty (see Item 1. "Business -- Operating Company" and Item 6. "Selected Financial Data - - - Operating Company"). The following table shows rental earned by Realty under the LATC lease for the last five years: - ------------------------- (a) Oak Tree races five weeks in even-numbered years and six weeks in odd- numbered years. For a further description of the Santa Anita Meet and the Oak Tree Meet, see Item 1. "Business -- Operating Company -- Santa Anita Racetrack." REGIONAL MALLS SANTA ANITA FASHION PARK Santa Anita Fashion Park is a completely enclosed, climate-controlled regional mall located adjacent to Santa Anita Racetrack with approximately 900,000 square feet of leasable area. Fashion Park is owned and operated by a partnership, Anita Associates, of which Realty is a 50% limited partner. The general partner of Anita Associates is Hahn-UPI, which in turn is a limited partnership of which The Hahn Company, a developer of shopping centers, is the general partner. Fashion Park is currently undergoing an expansion which is anticipated to be completed in the fall of 1994. In addition to the existing major tenants, Robinsons/May, J.C. Penney and Broadway, a new 146,000 square foot Nordstrom store is being added. During 1993, the Robinsons/May store was expanded by Item 1. Business (continued) - ---------------- approximately 40,000 square feet. In 1994, an additional 45,000 square feet of mall stores will be completed with the Nordstrom expansion. During 1993, a food court of approximately 13,000 square feet was completed and opened. In January 1994, the partnership refinanced its existing debt by entering into a loan agreement with an insurance company whereby a maximum of $62,355,000 may be borrowed, bearing interest at 9%, with repayment over ten years. On January 25, 1994, $46,577,193 of the total loan amount was drawn. There are currently 116 tenants operating mall stores with original lease terms varying up to 10 years. New leases are generally seven to ten years with clauses providing for escalation of the basic rent every three years. Typically, leases with mall tenants are structured to provide Anita Associates with overage rents upon attainment by the tenant of certain sales levels, which are specified under the individual leases of the various stores. Overage rents represent a fixed percentage of the gross sales of a tenant less its base rent. Realty has leased the land underlying Fashion Park to Anita Associates and to the major tenants of Fashion Park until 2037, with two additional ten-year option periods and one additional five-year option period. The ground rent is $527,000 annually until 1996 when the annual rent will increase to $794,000 through 2007. During the remaining 30-year term and the three additional option periods, the annual ground rent may be increased up to 25% based upon the appraised value of the land. Under the provisions of the ground leases, Anita Associates is responsible for real estate taxes and other operating expenses. Robinsons/May, J. C. Penney and The Broadway pay their own real estate taxes. The following table contains certain information pertaining to the mall stores in Fashion Park (excluding major tenants): - ------------------- (a) Decline due primarily to certain leases not being renewed in anticipation of the expansion discussed above. The land underlying Fashion Park is security for a loan maturing in 2009 with a balance at December 31, 1993 of $4,100,000. Payments on this indebtedness, which is without recourse to Realty, are approximately $473,000 annually. The security to the lender also includes an assignment of the ground rents received by Realty and a collateral assignment of the ground leases. TOWSON TOWN CENTER Towson Town Center located in Towson, Maryland, is a 563,000 square foot (excluding major tenants) regional mall which opened in 1991. Realty is a 50% partner with The Hahn Company in H-T Associates, a joint venture which owns a 65% interest in a partnership which owns the Towson Town Center. Realty has invested a total of $7.5 million in H-T Associates. The major tenants at Towson Town Center are Nordstrom and Hecht's department stores. There are 183 other tenants operating mall stores with original lease terms varying up to 15 years. The average annual rental rate per square foot including overage rents was $28.23 per square foot for the operating mall stores. The mall tenant leases generally provide for escalation of the basic rent every three years and are structured to provide Towson Town Center with overage rents upon attainment by the tenant of certain sales levels, which are specified under the individual leases of the various stores. Overage rents represent a fixed percentage of the gross sales of a tenant less its base rent. ITEM 1. BUSINESS (CONTINUED) - ----------------- Realty is a joint and several guarantor of loans used to expand the Towson Town Center and a department store and land adjacent to the Towson Town Center in the amount of $82,630,000. In 1993 the guarantee amount was reduced by $93,337,000. Annually, the guarantors may request a reduction in the amount of the guaranty based on the economic performance of the regional mall (see "Notes to Financial Statements -- Note 3 -- Investments in Joint Ventures"). SHOPPING CENTERS Realty owns a portfolio of six neighborhood shopping centers. The shopping centers typically consist of a major supermarket, retail store or drugstore as a major tenant and often include a variety or general merchandise store and smaller service store tenants. The major tenant in two centers owns its building and the underlying land, while in the four other centers, the land or improvements are leased to the major tenant. Leases on the properties range from two to ten years in duration, but typically are from three to five years. They are generally triple net leases (tenant pays all operating costs, insurance and property taxes) and provide for future rental increases. At December 31, 1993, the average occupancy of the three shopping centers located in California was 88% and the average occupancy of the three shopping centers located in Arizona was 90%. OFFICE BUILDINGS Realty owns interests in four office buildings located in Arcadia, Santa Ana, Upland and Newport Beach, California. The office buildings in Santa Ana and Upland are for general office use, the building in Arcadia is a medical office building and the building in Newport Beach was occupied by Realty in March 1993 and was sold to Pacific on February 18, 1994. Office leases are typically for a period of five to ten years and are offered on a full-service gross basis. In addition, tenants are given a tenant improvement allowance and rental concessions in the form of additional tenant improvement allowances or free rent. At December 31, 1993, the occupancy of the office buildings, was 82%. Effective as of December 31, 1993, Realty acquired the minority partnership interest in the office building located in Santa Ana. The partnership interest was acquired in consideration for the cancellation of certain receivables from the minority partner, payment of $250,000 and the assumption of the minority partner's capital account. LAND Realty is a 50% partner in French Valley Ventures, a partnership which acquired 24 acres of unimproved land located in Temecula, California. The partnership is actively seeking the necessary entitlements on the property and is reviewing the possibility of developing an industrial project on the site. Subsequent to year-end, Realty granted to Pacific an option to acquire this partnership interest in the undeveloped parcel of land for $1,957,000. The option is exercisable beginning March 1, 1994 and expires December 31, 1994. APARTMENTS On July 1, 1993, Realty acquired a 256-unit apartment complex located in Austin, Texas, which was subsequently sold to Pacific. Realty acquired the project for $6,750,000. At December 31, 1993 the complex was 96% leased. During 1993, prior to the sale of its apartments to Pacific, Realty acquired the minority partnership interests in Applewood Village Partners and SAREFIM, partnerships which owned 406 and 504 units, respectively, from the minority partners. The partnership interests were acquired in consideration for cash, the cancellation of certain receivables from the minority partners and the assumption of the minority partners' share of the excess of partnership liabilities over assets. ITEM 1. BUSINESS (CONTINUED) - ---------------- INDUSTRIAL BALDWIN INDUSTRIAL PARK Realty is a 50% limited partner in a partnership formed to develop an industrial park on a 45-acre parcel of land in Baldwin Park, California. The land is leased from one of the partners for a period of 55 years. The industrial park is comprised of a total of approximately 622,000 square feet of office and industrial space in a complex of buildings ranging in size from 25,000 to 65,000 square feet. The park is currently 90% leased to tenants which include Gerber's Foods, Federal Express and Home Savings of America ("Home"). Home, the current lessee of a ten-acre parcel in the industrial park and of a 55,656 square foot building in the industrial park, has options to purchase both the ten-acre parcel and the building and land underlying the building under the terms of its leases. Home has exercised its options under both agreements. Under the partnership agreement, Realty is entitled to receive 80% of the cash flow from the partnership in order to provide Realty with a cumulative return of 12% per annum on its invested capital. To the extent there is sufficient cash flow for Realty to receive its 12% cumulative return, the remaining partners are entitled to 80% of the excess cash flow to provide them with a cumulative annual return equal to that received by Realty. Additional cash flow is to be divided equally between Realty and the remaining partners. The partnership exercised an option to buy the land underlying the Home parcel in 1991 and has the option to acquire the remaining parcels in 1994. If the partnership does not exercise any portion of its option to acquire the land, Realty then has the right to exercise that portion of the option under the same terms as the partnership. In addition to the above-mentioned partnership option, Realty has an option to purchase the partnership interests of the other partners in 1994 at the fair market value of the interests in 1994. Subsequent to year-end, Realty agreed to sell its interest in the partnership and assigned its option to purchase the partnership interest of the other partners to Pacific. (See Item 1. "Business - Realty-Pacific Gulf Properties Inc." and "Notes to Financial Statements - Note 2 - Disposition of Multifamily and Industrial Operations Subsequent to Year End"). Pacific has exercised this option to purchase the partnership interest of the other partners. SEATTLE INDUSTRIAL BUILDINGS During 1993, prior to the sale of its industrial properties to Pacific, Realty acquired the minority partnership interest in SARESAM Ventures, a partnership which owned 185,000 square feet of industrial buildings located in the Seattle, Washington area. The partnership interest was acquired in consideration for the cancellation of certain receivables from the minority partners and the assumption of the minority partners' share of the excess of partnership liabilities over assets. MANAGEMENT OF PROPERTIES Realty manages its shopping centers (other than the regional malls) and office buildings directly. Based on a normal property management fee charged by outside managers, Realty believes it realizes an economic benefit as well as the benefits of direct control by managing the properties directly. ITEM 1. BUSINESS (CONTINUED) - ---------------- COMPETITIVE AND OTHER CONDITIONS The industrial buildings, regional shopping malls, shopping centers and office buildings owned by Realty encounter significant competition from similar or larger industrial buildings, regional shopping malls, shopping centers and office buildings developed and owned by other companies. Realty's income from its real estate assets is also affected by general economic conditions. The current recession has adversely affected vacancy rates in office buildings and industrial parks generally. The current recession and other competitive conditions have also affected the rent payable by LATC (see Item 1. "Business -- Operating Company -- Competitive and Other Conditions"). Continuation of the recession could adversely impact vacancy rates, the nature of Realty's tenants, the rents Realty is able to obtain from its tenants and its financial results. Some of Realty's properties are located in Southern California, which is an area prone to earthquakes. To date, none of Realty's projects have sustained any significant damage as a result of earthquakes. However, there can be no assurance that any potential earthquakes will not damage Realty's properties or negatively impact the financial position or results of Realty. EMPLOYEES At December 31, 1993, Realty employed 58 persons on a full-time basis. In connection with the sale to Pacific, the executive officers, various managers and most other employees of Realty resigned and became officers and employees of Pacific on February 18, 1994. Realty has entered into a one-year management agreement with Pacific to assure an orderly transaction, and, as of March 16, 1994, appointed a new Chief Executive Officer (see Item 4a. "Executive Officers of Realty and Operating Company"). Realty believes that relations with its employees are satisfactory. Item 1. Business (continued) SEASONAL VARIATIONS IN BUSINESS Realty is subject to significant seasonal variation in revenues due primarily to the seasonality of thoroughbred horse racing. The following table presents unaudited quarterly results of operations for Realty during 1993 and 1992: ITEM 1. BUSINESS (CONTINUED) - ---------------- Operating Company Santa Anita Operating Company ("Operating Company") is organized under the laws of the State of Delaware. Operating Company's principal executive offices are located at Santa Anita Racetrack, 285 West Huntington Drive, Post Office Box 60014, Arcadia, California 91066-6014. Operating Company is engaged in thoroughbred horse racing. The thoroughbred horse racing operation is conducted by a subsidiary of Operating Company, Los Angeles Turf Club, Incorporated ("LATC"), which leases Santa Anita Racetrack from Realty. The lease expires in December 1994 when its terms will be renegotiated (see Item 1. "Business -- Realty -- Santa Anita Racetrack"). SANTA ANITA RACETRACK LATC conducts an annual 17-week thoroughbred horse racing meet which commences immediately after Christmas and continues through mid-April. LATC conducts one of the largest thoroughbred racing meets in the United States in terms of both average daily attendance and average daily pari-mutuel wagering. LATC leases the racetrack from Realty for the full year under a master lease for a fee of 1.5% of the total live on-track wagering at Santa Anita Racetrack, which includes the Oak Tree meet. In addition, LATC pays to Realty 40% of its revenues from satellite wagering (not to exceed 1.5% of such wagering) and the simulcasting of races originating from Santa Anita Racetrack after mandated payments to the State, to horse owners and to breeders. When LATC operates as a satellite for Hollywood Park Racetrack ("Hollywood Park") and Del Mar Racetrack ("Del Mar"), LATC does not pay any additional rent to Realty. LATC has sublet the racetrack to Oak Tree to conduct its annual thoroughbred horse racing meet (31 days in 1993), which commences in late September or early October. Oak Tree races five weeks in even-numbered years and six weeks in odd- numbered years. Under a sublease which expires in 2000, Oak Tree makes annual rental payments to LATC equal to 1.5% of the total live on-track pari-mutuel wagering from its racing meet and 25% of its satellite and simulcast revenues after mandated payments to the State, to horse owners and to breeders. LATC pays to Realty 40% of all satellite and simulcast revenues received from Oak Tree. Because the rental received from Oak Tree's on-track pari-mutuel wagering is identical to the rental paid to Realty, LATC does not reflect these amounts in its financial statements. In addition, Oak Tree reimburses LATC an amount equal to 0.8% of its on-track pari-mutuel wagering for certain expenses of operating Santa Anita Racetrack on behalf of Oak Tree. LATC also receives supplemental rent representing Oak Tree's adjusted profits above an agreed-upon level and will rebate rent to Oak Tree if Oak Tree's adjusted profits fall below such level (see Item 1. "Business -- Operating Company -- Santa Anita Racetrack -- Pari-Mutuel Wagering"). The number of racing days at the Santa Anita meet declined from 90 in 1989 to 83 in 1993. Total pari-mutuel wagering on the Santa Anita meet decreased from $654.1 million in 1989 to $613.5 million in 1993. For all years prior to 1989, all of Santa Anita pari-mutuel wagering was conducted on-track. In 1989, $122.1 million of the total amount wagered was wagered at satellite locations with $532.0 million being wagered on-track. In 1993, $362.8 million of the total amount wagered was wagered at satellite locations with $250.7 million being wagered on-track. Total attendance was 2.9 million in 1989, of which 621,000 was at satellite locations. By 1993, on-track attendance had declined to 1.2 million, down from 1.5 million in 1992. Although 1,332,126 and 1,576,763 patrons attended satellite locations during the Santa Anita meets in 1993 and 1992, respectively, LATC does not share in the revenues from admissions, parking and food and beverage sales at the satellite locations. Item 1. Business (continued) - ---------------------------- The following tables summarize key operating statistics for the 1989-1993 Santa Anita meets and the 1989-1993 Oak Tree meets, together with the attendance and wagering statistics relating to the transmission of the Del Mar and Hollywood Park signals to Santa Anita Racetrack. - ------------------ (a) Total handle or total attendance divided by the number of race days will produce a different average daily result due to the fact that satellite locations may not have operated from the beginning of the Santa Anita meet, therefore, average daily attendance and wagering is calculated based upon the number of days each satellite location is open. (b) Includes simulcast wagering on races originating at other racetracks. (c) Satellite wagering expanded to include Hollywood Park and Los Alamitos effective with the 1991 Oak Tree meet. (d) Interstate wagering (common pooling) began in October 1990. (e) Oak Tree races five weeks in even-numbered years and six weeks in odd- numbered years. - ------------------- (a) Began in November 1991. Management anticipates that the general trend of increases in off-track wagering will continue and the decrease experienced in on-track attendance and on-track wagering will also continue albeit at a slower rate. During the last five years, 54% of the annual revenues of LATC resulted from pari-mutuel and other wagering commissions. The remaining revenues resulted from admissions, parking, food and beverage sales, sale of programs and interest and other income. The following table sets forth certain unaudited financial information with respect to LATC: The mix of revenues has changed significantly from 1989 to 1993 primarily as a result of the introduction of satellite wagering on races originating at Santa Anita Racetrack, operating as a satellite location for Del Mar and Hollywood Park, changes in average daily pari-mutuel wagering, selective price increases, the introduction of additional exotic wagering opportunities on which the retention amount is higher than on conventional wagering and a new lease with Oak Tree, all of which have largely offset declines in commissions from on- track wagering. In addition, LATC recognized $400,000 in 1990 and $1,000,000 in 1991 from the 1990 sale of the Canterbury Downs management consulting contract. Also, interest income has fluctuated as a function of cash balances available for investments and changing interest rates. LATC's total expenses decreased from $63.8 million in 1989 to $61.5 million in 1993. The majority of these expenses are pari-mutuel wagering or attendance- related, the result of operating as a satellite location for Del Mar and Hollywood Park and the aggregate effect of a new lease with Oak Tree. In 1991, costs and expenses included $1.1 million in earthquake damage. From 1991 to 1992, total costs and expenses increased by $2,064,000 primarily due to the fact that LATC operated as a satellite location for the first time for Hollywood Park's spring thoroughbred meet, the engagement of outside consultants in the amount of $660,000 to review the company's operations, and additional rent paid to Realty in the amount of $1,027,000. From 1992 to 1993, total costs and expenses decreased primarily due to fewer race days and lower on-track attendance and wagering. ITEM 1. BUSINESS (CONTINUED) - ---------------- For further information regarding operating results, see Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Santa Anita Operating Company." PARI-MUTUEL WAGERING Pari-mutuel means literally a mutual wager, or wagering by individuals against each other. The racetrack acts as the broker for the wagers made by the public and deducts a "take-out" or gross commission which is fixed by the State and shared with the State, the racetrack operator, the horse owners and breeders, and the municipality in which the racetrack is located. The racetrack operator has no interest in which horse wins a given race. As a condition of the issuance of a racing license, California law requires that a certain number of racing days be conducted as charity days. The net proceeds from these charity days are distributed to beneficiaries through a nonprofit organization approved by the California Horse Racing Board (the "Horse Racing Board"). LATC is required to conduct five charity days. ON-TRACK WAGERING The State has vested administrative authority for racing and wagering at horse racing meets with the Horse Racing Board. The Horse Racing Board, which consists of seven members appointed by the governor of the State, is charged with the responsibility of regulating the form of wagering, the length and conduct of meets and the distribution of the pari-mutuel wagering within the limits set by the California legislature. The Horse Racing Board is also charged with the responsibility of licensing horse racing associations on an annual basis to conduct horse racing meets and of licensing directors, officers and persons employed by the associations to operate such meets. California law specifies the percentage distribution of pari-mutuel wagering with the percentage varying based upon the total wagering for the meet, breed of horse and type of wager. The following table sets forth the allocation of the total pari-mutuel wagering, on- and off-track, by percentage and dollar amount during the 1992-93 Santa Anita meet: ITEM 1. BUSINESS (CONTINUED) - ---------------- SATELLITE WAGERING - CALIFORNIA LATC and Oak Tree send televised racing signals to other southern California racetracks, wagering facilities on Indian reservation land in California and non-racing fair sites in central and southern California. Pari- mutuel wagering at a satellite facility is included in the pari-mutuel pools at the host racing associations. LATC's and Oak Tree's share of the satellite wagering was approximately 4.3% of the satellite pari-mutuel wagering on races originating at Santa Anita Racetrack. In the fall of 1993, California law permitted LATC and Oak Tree to send and receive televised racing signals on races with purses exceeding $20,000 to and from northern California racetracks and nonracing fairs. In 1993, Bay Meadows, San Mateo, California became an additional satellite location during the Santa Anita meet. LATC's commission on the northern California satellite wagering was about 3.3%. LATC has been advised that other Indian tribes are planning satellite wagering facilities on reservation land in southern California. Any other facilities opened by an Indian tribe must obtain approval from the State and must enter into an agreement with the racing associations with respect to the pari-mutuel operations. During the Hollywood Park and Del Mar meets, LATC and other Southern California racing associations and fairs operate as satellite facilities. In addition to retaining 2% of the pari-mutuel wagering at Santa Anita Racetrack as its commission, LATC receives income from admissions, parking and food and beverage sales. In 1993, Santa Anita Racetrack operated 141 days as a satellite for Hollywood Park and Del Mar. SATELLITE WAGERING - INTERSTATE Legislation has been enacted in certain states permitting the transmission of pari-mutuel wagers across state lines. This format permits patrons wagering in those states on races held at Santa Anita Racetrack to participate in the same pari-mutuel pool payouts available to LATC's on-track patrons and Southern California satellite patrons. LATC currently participates in satellite wagering with numerous sites in Nevada, and additional locations in Alabama, Arizona, Colorado, Connecticut, Delaware, Florida, Idaho, Iowa, Kansas, Louisiana, Maryland, Massachusetts, Montana, Nebraska, New Hampshire, New Jersey, New York, North Dakota, Oregon, Pennsylvania, Rhode Island, Texas, Washington and West Virginia and receives a negotiated percentage of the pari-mutuel wagering at such sites. Interstate satellite wagering started in 1991 with total pari-mutuel wagering of $39,445,000 which increased to $95,411,000 for 1993. LATC's share of the commissions from interstate satellite wagering was $1,811,000 for 1993. SIMULCASTING In 1993, LATC and Oak Tree transmitted their live racing signals (simulcast) to numerous locations in the United States, Mexico and Canada. LATC's share of the commissions for transmitting its racing signal, was $1,280,000 in 1993 and $1,416,000 in 1992. During the Oak Tree meet, LATC receives 25% of Oak Tree's share of simulcasting revenues. LATC is pursuing the opportunity to transmit its signal to other locations. CANTERBURY DOWNS In 1984, LATC entered into a management consulting contract with Minnesota Racetrack, Inc. ("MRI"). MRI developed and owned a horse racing facility, Canterbury Downs, in the Minneapolis area of Minnesota, which opened in June 1985. In 1990, LATC sold its interest in the management consulting contract with Canterbury Downs and recognized $400,000 as income. In 1991, LATC recognized an additional $1,000,000 as income. ITEM 1. BUSINESS (CONTINUED) - ---------------- COMPETITIVE AND OTHER CONDITIONS The southern California area offers a wide range of leisure time spectator activities, including professional and college teams which participate in all major sports. LATC and Oak Tree compete with such sporting events for their share of the leisure time market and with other numerous leisure time activities available to the community, some of which are broadcast on television. As an outdoor activity, horse racing is more susceptible to inclement weather than some other leisure time activities. This is particularly true of the Santa Anita meet which is held during the winter. Prior to the 1992-1993 meet, LATC had never lost a race due to inclement weather. During the 1992-1993 meet, LATC lost two full days and two partial days of racing because of inclement weather. A local Arcadia ordinance presently limits live horse racing to daylight hours but allows the importation of a horse racing broadcast signal one evening per week. The Horse Racing Board has annually licensed LATC and Oak Tree to conduct racing meets at Santa Anita Racetrack. At present, the Horse Racing Board has not licensed other thoroughbred racetracks in Southern California to conduct racing during these meets. Since 1972, however, night harness racing and night quarterhorse meets have been conducted at other racetracks in Southern California during portions of these meets. LATC and Oak Tree could be adversely affected by legislative or Horse Racing Board action which would increase the number of competitive racing days, reduce the number of racing days available to LATC and Oak Tree, or authorize other forms of wagering. The California State Lottery Act of 1984, which provides for the establishment of a state-operated lottery, was implemented in 1985. In the opinion of management, the State lottery has had an adverse impact and will continue to have an adverse impact on total attendance and pari-mutuel wagering at Santa Anita Racetrack (see Item 1 "Business -- Operating Company -- Santa Anita Racetrack"). Although it is unaware of any empirical studies, management believes that the State lottery has had and will continue to have an adverse impact on many other businesses in the State of California. In the future, legislation could be enacted to allow casino gaming or other forms of gaming which are competitive with pari-mutuel wagering at Santa Anita Park. Under federal law, certain types of gaming are lawful on Indian lands if conducted in conformance with a Tribal-State compact, which the applicable state must negotiate with an Indian tribe in good faith. Certain Indian tribes seeking to establish gaming in California have instituted litigation against the State of California to compel the State to permit them to do so. In 1993, one court held that California has a public policy prohibiting casino gaming and need not negotiate a compact with respect to casino gaming. However, the court also held that certain other forms of gaming were the proper subject of a compact. Other courts are not bound by that decision and may hold differently. If the Indian tribes are successful in establishing casino gaming or other forms of gaming in California, such gaming could have an adverse impact on LATC. DEPENDENCE ON LIMITED NUMBER OF CUSTOMERS No material part of Operating Company's business is dependent upon a single customer or a few customers; therefore, the loss of any one customer would not have a materially adverse effect on the business of Operating Company. EMPLOYEE AND LABOR RELATIONS During the year ended December 31, 1993, LATC regularly employed approximately 1,600 employees. Substantially all are employed on a seasonal basis in connection with live thoroughbred horse racing or satellite meets at Santa Anita Racetrack. During the relatively short periods when live or satellite racing meets at Santa Anita Racetrack are not being conducted, LATC maintains a staff of approximately 260 employees, most of whom are engaged in maintaining or improving the physical facilities at Santa Anita Racetrack or are engaged in preparing for the next live or satellite meet. All of LATC's employees, except for approximately 70 full-time management and clerical employees, are covered by collective bargaining agreements with labor unions. A majority of the current labor agreements covering racetrack employees will expire in April 1995 after the Santa Anita meet. SEASONAL VARIATIONS IN BUSINESS Operating Company is also subject to significant seasonal variation. LATC conducts an annual meet commencing immediately after Christmas and continuing through mid-April. This seasonal variation is indicated by the following unaudited quarterly results of operations for Operating Company during 1993 and 1992: In 1993, revenues and cost of sales from food and beverage operations have been reflected as a separate component in Operating Company's and Combined Realty and Operating Company's statement of operations. In prior years these operations were in horse racing revenues. All prior year and interim financial statements and disclosures for Operating Company and Combined Realty and Operating Company have been restated to reflect this reclassification. Operating Company has adopted an accounting practice whereby the revenues associated with thoroughbred horse racing at Santa Anita Racetrack are reported as they are earned. Costs and expenses associated with thoroughbred horse racing revenues are charged against income in those interim periods in which the thoroughbred horse racing revenues are recognized. Other costs and expenses are recognized as they actually occur throughout the year. ITEM 1. BUSINESS (CONTINUED) - ---------------- INCOME TAX MATTERS In the opinion of management, Realty has operated in a manner which has qualified it as a REIT under Sections 856 through 860 of the Code. Realty intends to continue to operate in a manner which will allow it to qualify as a REIT under the Code. Under these sections, a corporation that is principally engaged in the business of investing in real estate and that, in any taxable year, meets certain requirements that qualify it as a REIT generally is not subject to federal income tax on its taxable income and gains that it distributes to its shareholders. Income and gains that are not so distributed will be taxed to a REIT at regular corporate rates. In addition, a REIT is subject to certain taxes on net income from "foreclosure property" as defined in the Code, income from the sale of property held primarily for sale to customers in the ordinary course of business and excessive unqualified income. REIT REQUIREMENTS To qualify for tax treatment as a REIT under the Code, Realty at a minimum must meet the following requirements: (1) At least 95% of Realty's gross income each taxable year (excluding gains from the sale of property other than foreclosure property held primarily for sale to customers in the ordinary course of its trade or business) must be derived from: (a) rents from real property; (b) gain from the sale or disposition of real property that is not held primarily for sale to customers in the ordinary course of business; (c) interest on obligations secured by mortgages on real property (with certain minor exceptions); (d) dividends or other distributions from, or gains from the sale of, shares of qualified REITs that are not held primarily for sale to customers in the ordinary course of business; (e) abatements and refunds of real property taxes; (f) income and gain derived from foreclosure property; (g) most types of commitment fees related to either real property or mortgage loans; (h) gains from sales or dispositions of real estate assets that are not "prohibited transactions" under the Code; (i) income attributable to stock or debt instruments acquired with the proceeds from the sale of stock or certain debt obligations ("new capital") of Realty received during a one-year period beginning on the day such proceeds were received ("qualified temporary investment income"); (j) dividends; (k) interest on obligations other than those secured by mortgages on properties; and (l) gains from sales or dispositions of securities not held primarily for sale to customers in the ordinary course of business. ITEM 1. BUSINESS (CONTINUED) - ---------------- In addition, at least 75% of Realty's gross income each taxable year (excluding gains from the sale of property other than foreclosure property held primarily for sale to customers in the ordinary course of its trade or business) must be derived from items (a) through (i) above. For purposes of these requirements, the term "rents from real property" is defined in the Code to include charges for services customarily furnished or rendered in connection with the rental of real property, whether or not such charges are separately stated, and rent attributable to incidental personal property that is leased under, or in connection with, a lease of real property, provided that the rent attributable to such personal property for the taxable year does not exceed 15% of the total rent for the taxable year attributable to both the real and personal property leased under such lease. The term "rents from real property" is also defined to exclude: (i) any amount received or accrued with respect to real property, if the determination of such amount depends in whole or in part on the income or profits derived by any person from the property (except that any amount so received or accrued shall not be excluded from "rents from real property" solely by reason of being determined on the basis of a fixed percentage of receipts or sales); (ii) any amount received or accrued, directly or indirectly, from any person or corporation if ownership of a 10% or greater interest in the stock, assets or net profits of such person or corporation is attributed to Realty; (iii) any amount received or accrued from property that Realty manages or operates or for which Realty furnishes services to the tenants, which would constitute unrelated trade or business income if received by certain tax-exempt entities, either itself or through another person who is not an "independent contractor" (as defined in the Code) from whom Realty does not derive or receive income; and (iv) any amount received or accrued from property with respect to which Realty furnishes (whether or not through an independent contractor) services not customarily rendered to tenants in properties of a similar class in the geographic market in which the property is located. If Realty should fail to satisfy the foregoing income tests but otherwise satisfies the requirements for taxation as a REIT and if such failure is held to be due to reasonable cause and not willful neglect and if certain other requirements are met, then Realty would continue to qualify as a REIT but would be subject to a 100% tax on the excessive unqualified income reduced by an approximation of the expenses incurred in earning that income. (2) Less than 30% of Realty's gross income during any taxable year can be derived from the sale or disposition of: (i) stock or securities held for less than one year; (ii) property held primarily for sale to customers in the ordinary course of business (other than foreclosure property); and (iii) real property (including interests in mortgages on each property) held for less than four years (other than foreclosure property and gains arising from involuntary conversions). (3) At the end of each calendar quarter, at least 75% of the value of Realty's total assets must consist of real estate assets (real property, interests in real property, interests in mortgages on real property, shares in qualified real estate investment trusts and stock or debt instruments attributable to the temporary investment of new capital), cash and cash items (including receivables) and government securities. With respect to securities that are not included in the 75% asset class, Realty may not at the end of any calendar quarter own either (i) securities representing more than 10% of the outstanding voting securities of any one issuer or (ii) securities of any one issuer having a value that is more than 5% of the value of Realty's total assets. Realty's share of income earned or assets held by a partnership in which Realty is a partner will be characterized by Realty in the same manner as they are characterized by the partnership for purposes of the assets and income requirements described in this paragraph (3) and in paragraphs (1) and (2) above. (4) The shares of Realty must be "transferable" and beneficial ownership of them must be held by 100 or more persons during at least 335 days of each taxable year (or a proportionate part of a short taxable year). More than 50% of the outstanding stock may not be owned, directly or indirectly, actually or constructively, by or for five or fewer "individuals" at any time during the last half of any taxable year. For the purpose of such determination, shares owned directly or indirectly by or for a ITEM 1. BUSINESS (CONTINUED) - ---------------- corporation, partnership, estate or trust are considered as being owned proportionately by its shareholders, partners or beneficiaries; an individual is considered as owning shares directly or indirectly owned by or for members of his family; and the holder of an option to acquire shares is considered as owning such shares. In addition, because of the lessor- lessee relationship between Realty and LATC, no person may own, actually or constructively, 10% or more of the outstanding voting power or total number of shares of stock of the two companies. The bylaws of Operating Company and Realty preclude any transfer of shares which would cause the ownership of shares not to be in conformity with the above requirements. Each year Realty must demand written statements from the record holders of designated percentages of its shares disclosing the actual owners of the shares and must maintain, within the Internal Revenue District in which it is required to file its federal income tax return, permanent records showing the information it has thus received as to the actual ownership of such shares and a list of those persons failing or refusing to comply with such demand. (5) Realty must distribute to its shareholders dividends in an amount at least equal to the sum of 95% of its "real estate investment trust taxable income" before deduction of dividends paid (i.e., taxable income less any net capital gain and less any net income from foreclosure property or from property held primarily for sale to customers, and subject to certain other adjustments provided in the Code); plus (i) 95% of the excess of the net income from foreclosure property over the tax imposed on such income by the Code; less (ii) a portion of certain noncash items of Realty that are required to be included in income, such as the amounts includable in gross income under Section 467 of the Code (relating to certain payments for use of property or services). The distribution requirement is reduced by the amount by which the sum of such noncash items exceeds 5% of real estate investment trust taxable income. Such undistributed amount remains subject to tax at the tax rate then otherwise applicable to corporate taxpayers. During 1993, Realty has, or will be deemed to have, distributed at least 95% of its real estate investment trust taxable income as adjusted. For this purpose, certain dividends paid by Realty after the close of the taxable year may be considered as having been paid during the taxable year. However, if Realty does not actually distribute each year at least the sum of (i) 85% of its real estate investment taxable income, (ii) 95% of its capital gain net income and (iii) any undistributed taxable income from prior periods, then the amount by which such sums exceed the actual distributions during the taxable year will be subject to a 4% excise tax. If a determination (by a court or by the Internal Revenue Service) requires an adjustment to Realty's taxable income that results in a failure to meet the percentage distribution requirements (e.g., a determination that increases the amount of Realty's real estate investment taxable income), Realty may, by following the "deficiency dividend" procedure of the Code, cure the failure to meet the annual percentage distribution requirement by distributing a dividend within 90 days after the determination, even though this deficiency dividend is not distributed to the shareholders in the same taxable year as that in which income was earned. Realty will, however, be liable for interest based on the amount of the deficiency dividend. (6) The directors of Realty must have authority over the management of Realty, the conduct of its affairs and, with certain limitations, the management and disposition of Realty's property. (7) Realty must have the calendar year as its annual accounting period. (8) Realty must satisfy certain procedural requirements. TAXATION OF REALTY AS A REIT In any year in which Realty qualifies under the requirements summarized above, it generally will not be taxed on that portion of its ordinary income or net capital gain that is distributed to shareholders, other than net income from foreclosure property, excess unqualified income and gains from property held primarily for sale. ITEM 1. BUSINESS (CONTINUED) - ---------------- Realty will be taxed at applicable corporate rates on any undistributed taxable income or net capital gain and will not be entitled to carry back any net operating losses. It also will be taxed at the highest rate of tax applicable to corporations on any net income from foreclosure property and, subject to the safe harbor described below, at the rate of 100% on any income derived from the sale or other disposition of property, other than foreclosure property, held primarily for sale. In computing its net operating losses and the income subject to these latter taxes, Realty will not be allowed a deduction for dividends paid or received. Although Realty will also be subject to a 100% tax on the gain derived from the sale of property (other than foreclosure property) held primarily for sale, a safe harbor is provided such that gains from the sale of real property are excluded from this 100% tax for a given year if each of the following conditions is satisfied: (a) the property has been held by Realty for at least four years; (b) total capital expenditures with respect to the property during the four-year period preceding the date of sale do not exceed 30% of the net selling price of the property; (c) either (i) Realty does not make more than seven sales of properties (other than foreclosure property) during the taxable year or (ii) the aggregate adjusted bases (as determined for purposes of computing earnings and profits) of property (other than foreclosure property) sold by Realty during the taxable year do not exceed 10% of the aggregate adjusted bases (as so determined) of all of the assets of Realty as of the beginning of the taxable year; (d) if the property has not been acquired through foreclosure or lease termination, the property has been held by Realty for the production of rental income for at least four years; and (e) if the requirement of paragraph (c)(i) is not satisfied, substantially all of the marketing and development expenditures with respect to the sold properties were made through independent contractors from whom Realty does not derive or receive any income. TERMINATION OR REVOCATION OF REIT STATUS If, in any taxable year after it has filed an election with the Internal Revenue Service to be treated as a REIT, Realty fails to so qualify, Realty's election will be terminated, and Realty will not be permitted to file a new election to obtain such tax treatment until the fifth taxable year following the termination. However, if Realty's failure to qualify was due to reasonable cause and not due to willful neglect and if certain other requirements are met, Realty would be permitted to file a new election to be treated as a REIT for the year following the termination. If Realty voluntarily revokes its election for any year, it will not be eligible to file a new election until the fifth taxable year following such revocation. If Realty fails to qualify for taxation as a REIT in any taxable year and the above relief provisions do not apply, then Realty would be subject to tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. Distributions to shareholders of Realty with respect to any year in which Realty failed to qualify would not be deductible by Realty nor would they be required to be made. In such event, distributions to shareholders, to the extent out of current or accumulated earnings and profits, would be taxed as ordinary income and subject to certain limitations of the Code, eligible for the dividends-received deduction for corporations (see "Taxation of Realty's Shareholders"). Failure to qualify could result in Realty incurring substantial indebtedness (to the extent borrowings are feasible) or disposing of substantial investments, in order to pay the resulting taxes or, in the discretion of Realty, to maintain the level of Realty's distributions to its shareholders. ITEM 1. BUSINESS (CONTINUED) - ---------------- TAXATION OF REALTY'S SHAREHOLDERS So long as Realty qualifies for taxation as a REIT, distributions made to its shareholders out of current or accumulated earnings and profits (or deemed to be from current or accumulated earnings or profits), other than capital gain dividends (discussed below), will be dividends taxable as ordinary income. Distributions to shareholders of a REIT are not eligible for the dividends- received deduction for a corporation. Dividends to shareholders that are properly designated by Realty as capital gain dividends generally will be treated as long-term capital gain (to the extent they do not exceed Realty's actual net capital gain for the taxable year) regardless of how long a shareholder has owned his or her shares. However, corporate shareholders may be required to treat up to 20% of certain capital gain dividends as ordinary income. In general, any gain or loss realized upon a taxable disposition of shares will be treated as long-term capital gain or loss if the shares have been held for more than twelve months and otherwise as short-term capital gain or loss. However, if a shareholder receives a long-term capital gain dividend and such shareholder has held his or her stock for six months or less, any loss realized on the subsequent sale of the shares will, to the extent of the gain, be treated as long-term capital loss. Certain constructive ownership rules apply to determine the holding period. In the event that Realty distributes cash generated by its activities which exceeds its net earnings, and provided there are no undistributed current or accumulated earnings and profits and the distribution does not qualify as a "deficiency dividend," such distributions will constitute a return of capital to the extent they do not exceed a shareholder's tax basis for the shareholder's shares and will be tax free to the shareholder. In such event, the tax basis of the shares held by each shareholder must be reduced correspondingly by the amount of such distributions. If such distributions exceed the tax basis of the shares of a shareholder, the shareholder will recognize capital gain in an amount equal to such excess, provided the shareholder holds the shares as a capital asset. Shareholders may not include on their own returns any of Realty's ordinary or capital losses. Realty will notify each shareholder after the close of its taxable year as to the portions of the distributions that constitute ordinary income, return of capital and capital gain. For this purpose, any dividends declared in October, November or December of a year, which are payable to shareholders of record on any day of such a month, shall be treated as if they had been paid and received on December 31 of such year, provided such dividends are actually paid in January of the following year. Shareholders are required to include on their own returns any ordinary dividends in the taxable year in which such dividends are received. If in any taxable year Realty does not qualify as a REIT, it will be taxed as a corporation, and distributions to its shareholders will neither be required to be made nor will they be deductible by Realty in computing its taxable income, with the result that the assets of Realty and the amounts available for distribution to shareholders would be reduced to the extent of any tax payable. Disqualification as a REIT could occur even though Realty had previously distributed to its shareholders all of its income for such year, or years, in which it did not qualify as a REIT. In such circumstances, distributions, to the extent made out of Realty's current or accumulated earnings and profits, would be taxable to the shareholders as dividends, but, subject to certain limitations of the Code, would be eligible for the dividends-received deduction for corporations. TAX-EXEMPT INVESTORS The Internal Revenue Service has ruled that amounts distributed by a REIT to a tax-exempt employee's pension trust do not constitute ''unrelated trade or business income" and should therefore be nontaxable to such trust. This ruling does not apply to the extent the tax-exempt investor has borrowed to acquire shares of the REIT's stock. Moreover, the application of this ruling is subject to additional limitations that are beyond the scope of this disclosure. ITEM 1. BUSINESS (CONTINUED) - ---------------- STATE AND TERRITORIAL TAXES The state or territorial income tax treatment of Realty and its shareholders may not conform to the federal income tax treatment above. As a result, prospective shareholders should consult their own tax advisors for an explanation of the effect of state and territorial tax laws on their investment in Realty. FOREIGN INVESTORS The preceding discussion does not address the federal income tax consequences to foreign investors of an investment in Realty. Foreign investors should consult their own tax advisors concerning the federal income tax considerations to them of the ownership of shares in Realty. BACKUP WITHHOLDING The Code imposes a modified form of "backup withholding" for payments of interest and dividends. This withholding applies only if a shareholder, among other things: (i) fails to furnish Realty with a properly certified taxpayer identification number; (ii) furnishes Realty with an incorrect taxpayer identification number; (iii) fails to report properly interest or dividends from any source or; (iv) under certain circumstances, fails to provide Realty or his or her securities broker with a certified statement, under penalty of perjury, that he or she is not subject to backup withholding. The backup withholding rate is 31% of "reportable payments" which include dividends. Shareholders should consult their tax advisors as to the procedure for ensuring that Realty distributions to them will not be subject to backup withholding. TAXATION OF OPERATING COMPANY Operating Company pays ordinary corporate income taxes on its taxable income. Any income, net of taxes, will be available for retention in Operating Company's business or for distribution to shareholders as dividends. Any dividends distributed by Operating Company will be subject to tax at ordinary rates and generally will be eligible for the dividends received deduction for corporate shareholders to the extent of Operating Company's current or accumulated earnings and profits. Distributions in excess of current or accumulated earnings and profits are treated first, as a return of investment and then, to the extent that such distribution excludes a shareholder's investment, as gain from the sale or exchange of such shares. However, there is no tax provision which requires Operating Company to distribute any of its after-tax earnings and Operating Company does not expect to pay cash dividends in the foreseeable future. FUTURE LEGISLATION It should be noted that future legislation could be enacted or regulations promulgated, the nature and likelihood of which cannot be predicted, that might change in whole or in part, the income tax consequences summarized herein and reduce or eliminate the advantages which may be derived from the ownership of paired common stock. The foregoing is a summary of some of the more significant provisions of the Code as it relates to REITs and is qualified in its entirety by reference to the Code and regulations promulgated thereunder. ITEM 2. ITEM 2. PROPERTIES - ------------------- Information concerning property owned by Realty and Operating Company may be found under Item 1. "Business." ITEM 3. ITEM 3. LEGAL PROCEEDINGS - ------------------------- Certain claims, suits and complaints arising in the ordinary course of business have been filed or were pending against Realty and/or Operating Company and its subsidiaries at December 31, 1993. In the opinion of the managements of Realty and Operating Company, all such matters are adequately covered by insurance or, if not so covered, are without merit or are of such kind, or involve such amounts, as would not have a significant effect on the financial position or results of operations of Realty and Operating Company if disposed of unfavorably. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ----------------------------------------------------------- Not applicable. ITEM 4A. EXECUTIVE OFFICERS OF REALTY AND OPERATING COMPANY - ----------------------------------------------------------- (a) The names, ages and business experience of Realty's executive officers during the past five years are set forth below: Each executive officer of Realty is appointed by the Board of Directors annually and holds office until his successor is duly appointed. (b) The names, ages and business experience of Operating Company's executive officers during the past five years are set forth below: Each executive officer of Operating Company is appointed by the Board of Directors annually and holds office until a successor is duly appointed. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED SHAREHOLDER - -------------------------------------------------------------------------- MATTERS - ------- The paired Common Stock of Realty and Operating Company is traded on the New York Stock Exchange as Santa Anita Realty Enterprises under the symbol SAR. The following table sets forth the high and low closing prices for the paired Common Stock on the New York Stock Exchange Composite Tape and the cash dividends declared by Realty for the periods indicated. Operating Company has not declared cash dividends. - ---------- (a) $.56 of the dividends paid per share during 1992 represented a return of capital. (b) $.56 of the dividends paid per share during 1993 represented a return of capital. A regular quarterly dividend of $.34 per share is payable on April 8, 1994 to shareholders of record on March 8, 1994. The closing price of the paired Common Stock on the New York Stock Exchange Composite Tape on March 8, 1994 was $17- 5/8 per share. As of March 8, 1994, there were approximately 22,000 holders of the paired Common Stock, including the beneficial owners of shares held in nominee accounts. Realty intends to pay regular quarterly dividends based upon a percentage of management's estimate of funds from operations for the entire year and, if necessary, to pay special dividends after the close of the year to effect distribution of at least 95% of its taxable income (other than net capital gains) (see item 1. "Business -- Income Tax Matters -- REIT Requirements"). In order to retain earnings to finance its capital improvement program and for the growth of its business, Operating Company has not paid cash dividends since its formation and does not expect to pay cash dividends in the foreseeable future. ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED SHAREHOLDER - -------------------------------------------------------------------------- MATTERS (CONTINUED) - ------- The statement on the face of this annual report on Form 10-K regarding the aggregate market value of paired voting stock of Realty and Operating Company held by nonaffiliates is based on the assumption that all directors and officers of Realty and Operating Company were, for purposes of this calculation only (and not for any other purpose), affiliates of Realty or Operating Company. ITEM 6. Item 6. "Selected Financial Data - Operating Company"). Rental revenues from other real estate investments for the year ended December 31, 1993 were $38,953,000, an increase of 10.4% from those reported in 1992 of $35,290,000. The 1993 increases are due primarily to additional revenues from a new multifamily property acquisition in 1993 and the full year inclusion of several multifamily properties acquired in 1992. Interest and other income increased 115.3% to $4,991,000 for the year ended December 31, 1993 from $2,318,000 reported for 1992. The increase is primarily attributable to $3,211,000 of interest income in 1993 on a tax settlement from the California Franchise Tax Board. The settlement was for tax years prior to 1980 related to Realty's predecessor. In addition to the interest earned on the settlement, Realty recorded a $2,523,000 income tax benefit. Costs and expenses of $55,482,000 for the year ended December 31, 1993 increased 38.4% from those reported for 1992 of $40,080,000. The increase is primarily due to the loss on the disposition of the multifamily and industrial operations to Pacific and increases in depreciation and rental property operating expenses associated with the acquisitions of real estate projects noted above. In June 1993, Realty's Board of Directors approved management's recommendation to recapitalize certain assets of Realty. Pursuant to this recapitalization, in November 1993, Realty entered into a Purchase and Sale Agreement to sell its multifamily and industrial operations to Pacific Gulf Properties Inc. ("Pacific"), in conjunction with its proposed public offering of common stock. The transaction was scheduled to be completed in two parts: (1) Realty would sell all of its apartments and industrial properties to Pacific with the exception of Realty's interest in the Baldwin Industrial Park joint venture; and (2) Pacific would enter into a binding agreement to buy Realty's interest in Baldwin Industrial Park. On February 18, 1994, Realty completed the first part of this transaction by selling to Pacific ten multifamily properties, containing 2,654 apartment units, located in Southern California, the Pacific Northwest, and Texas and three industrial properties, containing an aggregate of 185,000 leasable square feet of industrial ITEM 7. ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) --------------------- space, located in the State of Washington (the "Transferred Properties"). Realty's corporate headquarters building and related assets were also acquired by Pacific. The sale of the Transferred Properties followed the public offerings of common stock and convertible subordinated debentures by Pacific. Pursuant to the Purchase and Sale Agreement, Pacific agreed to buy Realty's interest in Baldwin Industrial Park subject to satisfaction of certain conditions, for a minimum price of $8.9 million payable in additional shares of Pacific common stock with the final price dependent upon completion of negotiations with other owners of Baldwin Industrial Park and an appraisal process. Management believes the sale of Realty's interest in Baldwin Industrial Park will be completed in the second half of 1994. Pacific is required to issue to Realty non-refundable letters of credit totaling up to $2.5 million by March 31, 1994 to secure its obligation to acquire Realty's interest in Baldwin Industrial Park and pay for the corporate headquarters building and other assets related to the Transferred Properties. In consideration of the sale of the Transferred Properties, Realty received approximately $44.4 million in cash and 149,900 shares of the common stock of Pacific. In addition, Realty was relieved of approximately $44.3 million of mortgage debt on the Transferred Properties. Realty will also receive, at the time the acquisition of Baldwin Industrial Park is completed, up to $1.2 million in additional common stock of Pacific as consideration for its corporate headquarters and other net assets related to the Transferred Properties. The two parts of the above transaction will result in a loss of $10,974,000. This loss has been reflected in the Realty and Realty and Operating Company combined statements of operations for the year ended December 31, 1993. If the Baldwin Industrial Park portion of the transaction described above does not occur, an additional loss of approximately $5,900,000 will be recognized by Realty in 1994. (See "Notes to Financial Statements - Note 2 - Disposition of Multifamily and Industrial Properties Subsequent to Year End.") In connection with the sale, the executive officers, various managers and most other employees of Realty resigned and became officers and employees of Pacific on February 18, 1994. Realty and Pacific have also entered into a one-year management agreement whereby Pacific has agreed to provide management services to Realty. Finally, with respect to the common stock of Pacific owned by Realty, Pacific has entered into a registration rights agreement with Realty which, under certain circumstances, allows Realty to require the registration of the Pacific stock it owns. Net income for the year ended December 31, 1993 was $2,619,000, a decrease of 74.4% compared with the $10,211,000 reported in 1992 due to the factors described above. RESULTS OF OPERATIONS -- 1992 COMPARED WITH 1991 Realty's revenues were derived principally from the rental of real property. Total revenues for the year ended December 31, 1992 were $50,291,000 compared with $45,408,000 reported for the year ended December 31, 1991, a 10.8% increase. Rental revenue from real estate properties amounted to $47,973,000 for the year ended December 31, 1992, up 12.4% from the year-earlier level of $42,699,000. In 1992, the most significant source of rental revenue was the lease with Santa Anita Racetrack. Revenues for 1992 rose to $12,683,000, up 7.3% from $11,817,000 reported in 1991. The increase resulted from an increase in total wagering at Santa Anita Racetrack due to six additional racing days during 1992 and increases in out-of-state simulcast revenues. Rental revenues from other real estate investments for 1992 increased to $35,290,000, up 14.3% from $30,882,000 in 1991. This increase was due primarily to additional revenues from new property ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) --------------------- acquisitions, the receipt of previously reserved past due rents and increased revenues from Santa Anita Fashion Park. Interest and other income declined 14.4% to $2,318,000 in 1992 from $2,709,000 in 1991. The decrease is due to reduced funds held for investment and lower interest rates on funds held for investment, offset in part by the sale of a neighborhood shopping center in Phoenix, Arizona, net of a loss on a lease agreement, which generated a net gain of $646,000 (net of cost of $4,475,000). Realty reported a gain of $177,000 (net of cost of $223,000) in 1991 from the sale of a small land parcel in Southern California. Costs and expenses increased 12.2 percent to $40,080,000 in 1992, up from $35,709,000 in 1991. The increase is due primarily to higher levels of depreciation, interest and rental property operating expenses associated with the acquisition of 1,109 new apartment units, and the expensing in 1992 of $580,000 of nonrecurring charges for the engagement of consultants to review the operations of the Realty and to assist in preparing a long range strategic plan. Realty reported a loss of $1,446,000 from the Towson Town Center unconsolidated joint venture primarily due to depreciation (the project was under construction in the prior periods). Net income for the year ended December 31, 1992 increased 5.3% to $10,211,000 compared with income of $9,699,000 reported in 1991 due to the factors described above. LIQUIDITY AND CAPITAL RESOURCES Realty had liquidity available from a combination of short- and long- term sources. Short-term sources included cash of $7,633,000 at December 31, 1993. In connection with the sale of properties to Pacific, Realty paid down its lines of credit by $44.4 million and transferred to Pacific $44.3 million of indebtedness associated with the multifamily and industrial properties. As of December 31, 1993, Realty was not in compliance with certain covenants contained in its credit agreements. The banks have waived such noncompliance through April 30, 1994 conditioned, among other things, on no additional borrowings under the credit agreements (at December 31, 1993, $78,361,000 loans and letters of credit were outstanding under these agreements). Realty is in the process of renegotiating these credit agreements. Management is of the opinion that Realty has sufficient liquidity from other sources to assure that its operations will not be adversely affected pending this renegotiation. Realty had approximately $13,591,000 of long-term receivables at December 31, 1993, with maturities ranging from 1994 to 2002. For the year ended December 31, 1993, long-term receivables earned interest income of $996,000. In the opinion of management, as of December 31, 1993 Realty's real estate investments had a market value substantially in excess of the historical costs and indebtedness related to such real estate investments. Management believes that this provides significant additional borrowing capacity. IMPACT OF INFLATION Realty's management believes that, for the foreseeable future, revenues and income from Santa Anita Racetrack, Fashion Park and its other real estate should not be adversely affected in a material way by inflationary pressures. Leases at Fashion Park include clauses enabling Realty to participate in tenants' future increases and gross revenues. Tenant leases on many other properties include provisions which tie the lease payments to the Consumer Price Index or include step-up provisions. ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) - --------------------- SANTA ANITA OPERATING COMPANY Operating Company is engaged in thoroughbred horse racing through its wholly owned subsidiary, Los Angeles Turf Club, Incorporated ("LATC") which leases the Santa Anita Racetrack ("Santa Anita") from Realty. The following narrative discusses Operating Company's results of operations for the years ended December 31, 1993, 1992 and 1991 together with liquidity and capital resources as of December 31, 1993. RESULTS OF OPERATIONS -- 1993 COMPARED WITH 1992 Operating Company derives its revenues from thoroughbred horse racing activities. Total revenues were $61,347,000 in 1993, down 9.3% from $67,654,000 in 1992. In 1993, live thoroughbred horse racing at Santa Anita Racetrack totaled 83 days compared with 94 days in 1992. Total and average daily on- track attendance at the live racing events in 1993 were down 20.4% and 9.8%, respectively, from 1992. Total wagering at the live racing events was down 10.6% while average daily wagering increased 1.2% in 1993 compared with 1992. On-track wagering and inter-track wagering declined 20.2% and 13.6%, respectively, while interstate wagering increased 43.8% in 1993 compared with 1992. In addition to a weak California economy and the continued negative effect of inter-track wagering on the on-track attendance and wagering, management believes the declines in average daily attendance and wagering were the result of inclement weather (in excess of 41 inches of rain, three times normal) during much of the 1992-1993 race meet, which caused the cancellation of two full race days and two partial race days in January. Also, Santa Anita Racetrack operated 42 days in 1993 and 43 days in 1992 as a satellite wagering facility for Del Mar and 99 days in 1993 and 101 days in 1992 as a satellite wagering facility for Hollywood Park. Total attendance and wagering as a satellite wagering facility were down 3.5% and 2.5%, respectively, in 1993 compared with 1992. Average daily attendance and wagering were down 1.4% and 0.4%, respectively, in 1993 compared with 1992. Horse racing revenues and direct operating costs declined in 1993 compared with 1992 due to fewer race days, lower attendance and lower wagering at both the live racing events and as a satellite wagering facility. Horse racing revenues in 1993 were $49,081,000 down 8.6% from $53,683,000 in 1992. Direct horse racing operating costs in 1993 were $40,981,000, down 9.1% from $45,089,000 in 1992. Food and beverage revenues and cost of sales were also lower in 1993 compared with 1992 due to the factors described above. As a percentage of sales, cost of sales increased to 29.2% in 1993 compared with 27.5% in 1992. General and administrative expenses were $6,693,000 in 1993, down 19.9% from $8,361,000 in 1992 due to administrative staff reductions in 1993 and to the costs related to the engagement of outside consultants in the prior year to review the Operating Company's operations. Partially offsetting the declines in general and administrative expenses, however, was the one-time charge of $759,000 in 1993 for the post-retirement benefits payable as a result of the death of the former Chairman of the Board of Operating Company. Interest expense increased to $493,000 in 1993 from $194,000 in 1992 due to a higher level of debt at LATC. Rental expense to Realty was $9,233,000 in 1993 compared with $10,955,000 in 1992. The decrease in rental expense of $1,722,000 reflects the decline in wagering. ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) - --------------------- Due to the revenue and expense items previously discussed, Operating Company reported a net loss of $2,232,000 or $.20 per share in 1993 compared with a net loss of $2,896,000 or $.26 per share in 1992. RESULTS OF OPERATIONS -- 1992 COMPARED WITH 1991 In 1992, the expansion of intertrack wagering within Los Angeles and Orange Counties caused intertrack revenues to increase $7,657,000 while on-track revenues decreased $7,246,000. On-track attendance-related revenues declined as a result of a 24.0% drop in on-track attendance at the 1991-1992 Santa Anita race meet and a decline in on-track wagering of $147,248,000, or 31.3 percent at the same meet. The on-track attendance and wagering decreases were, in part, caused by the continuing economic recession in Southern California. These changes, combined with a decline in interest income of $1,842,000 as a result of declining interest rates, primarily account for the total decline of $899,000 in total revenues to $67,654,000 for the year ended December 31, 1992. The decline in revenues from live racing events was partially offset by an increase in revenue by Santa Anita Racetrack operating as a satellite location, selected price increases and increased interstate simulcasting revenues. Santa Anita Racetrack operated as a satellite location for Hollywood Park for an additional 69 days in 1992. Direct operating costs related to horse racing operations were $45,089,000 in 1992, virtually equal with $45,093,000 reported in 1991, in spite of the fact Santa Anita Racetrack operated as a satellite location for Hollywood Park for an additional 69 days. General and administrative expenses were $8,361,000 for 1992, an increase of $1,493,000 or 21.7 percent, compared with the $6,868,000 in 1991. The increase resulted primarily from the expanded satellite racing season at Santa Anita Racetrack and the engagement of outside consultants ($660,000) to review the company's operations, including cost efficiencies, and to identify opportunities to enhance revenue. Depreciation and amortization expenses were $2,732,000 for 1992, an increase of $98,000 or 3.7 percent, compared with $2,634,000 reported for 1991. These non-cash charges resulted from the ongoing capital improvement program at Santa Anita Racetrack. Total rent paid to Realty was $10,955,000 for the year ended December 31, 1992, compared with $9,928,000 in 1991. The increase of $1,027,000 reflects increases in interstate simulcast revenues offset by decreases in the on-track and intertrack wagering. Due to the revenue and expense items previously discussed, Operating Company reported a net loss of $2,896,000 or $.26 per share in 1992 compared with net income of $259,000 or $.02 per share in 1991. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, Operating Company's sources of liquidity included cash and short-term investments of $14,388,000 and an unsecured line of credit with Realty of $10,000,000, of which approximately $3,500,000 was utilized in connection with a guarantee of a capital lease. Operating Company's ability to utilize Realty's line of credit is dependent upon Realty's liquidity and capital resources. As a result of Realty's noncompliance with certain covenants contained within its credit agreements, Realty is currently unable to borrow additional moneys under its lines of credit. Accordingly, borrowings by Realty under these agreements would not provide a source of liquidity for Operating Company. Realty is in the process of renegotiating its credit agreements. (See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Realty - Liquidity and Capital Resources"). For the year ended December 31, 1993, short-term investments earned interest income of $326,000. ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) - --------------------- The cash balances and related interest income from short-term investments reflect seasonal variations associated with the Santa Anita meet. During the meet, large cash balances and short-term investments are maintained by LATC, including amounts to be disbursed, for payment of license fees payable to the state, purses payable to horse owners and uncashed winning pari-mutuel tickets payable to the public. IMPACT OF INFLATION LATC's expenses are heavily labor-intensive with labor rates being covered by negotiated contracts with labor unions. Labor contracts with the pari- mutuel, service and operational employees were successfully renegotiated in April 1992. These new contracts expire in 1995. Management continues to address cost containment and labor productivity in all areas. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ---------------------------------------------------- See Index to Financial Statements for a listing of the financial statements and supplementary data filed with this report. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ------------------------------------------------------------- Not applicable. PART III Pursuant to General Instruction G(3) to Form 10-K, the information called for by this part of Form 10-K is incorporated herein by reference to the registrants' definitive joint proxy statement to be filed, pursuant to Regulation 14A, with the Securities and Exchange Commission not later than 120 days after the end of the year ended December 31, 1993. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - ------------------------------------------------------------------------- (a) The following documents are filed as part of this report: 1. Financial Statements See Index to Financial Statements 2. Financial Statement Schedules See Index to Financial Statement Schedules 3. Exhibits See Exhibit Index (b) Reports on Form 8-K. No reports on Form 8-K have been filed during the last quarter of the fiscal year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Realty and Operating Company have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized. SANTA ANITA REALTY ENTERPRISES, INC. SANTA ANITA OPERATING COMPANY By: /s/ SHERWOOD C. CHILLINGWORTH By: /s/ STEPHEN F. KELLER ----------------------------- ---------------------------- Sherwood C. Chillingworth Stephen F. Keller Vice Chairman of the Board and Chairman of the Board, President Chief Executive Officer and Chief Executive Officer (Principal Executive Officer) (Principal Executive Officer) March 29, 1994 March 29, 1994 ---------------------------- ---------------------------- Date Date By: /s/ GLENNON E. KING /s/ RICHARD D. BRUMBAUGH ---------------------------- ---------------------------- Glennon E. King Richard D. Brumbaugh Acting Chief Financial Officer Vice President-Finance (Principal Financial and (Principal Financial and Accounting Officer) Accounting Officer) March 29, 1994 March 29, 1994 ---------------------------- ----------------------------- Date Date Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrants and in the capacity and on the date indicated. Date: March 29, 1994 --------------- SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENT SCHEDULES The schedules listed below relate to Realty and Operating Company as indicated: Schedules not listed above have been omitted because either the conditions under which they are required are absent, not applicable, or the required information is included in the financial statements and related notes thereto. INDEPENDENT AUDITORS' REPORT To the Shareholders and Board of Directors Santa Anita Realty Enterprises, Inc. and Santa Anita Operating Company We have audited the financial statements and the related financial statement schedules, listed on pages 42 and 43 of: (a) Santa Anita Realty Enterprises, Inc.; (b) Santa Anita Operating Company and Subsidiaries; and (c) Santa Anita Realty Enterprises, Inc. and Santa Anita Operating Company and Subsidiaries Combined. 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 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 above-listed entities 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. Further, it is our opinion that the financial statement schedules referred to above present fairly, in all material respects, the information set forth therein. KENNETH LEVENTHAL & COMPANY Newport Beach, California March 1, 1994 SANTA ANITA REALTY ENTERPRISES, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SANTA ANITA REALTY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS See accompanying notes. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31 ,1993, 1992 AND 1991 See accompanying notes. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES COMBINED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES COMBINED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES COMBINED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES COMBINED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS DECEMBER 31 , 1993, 1992 AND 1991 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Santa Anita Realty Enterprises, Inc. ("Realty") and Santa Anita Operating Company and Subsidiaries ("Operating Company") are two separate companies, the stock of which trades as a single unit under a stock-pairing arrangement on the New York Stock Exchange. Realty and Operating Company were each incorporated in 1979 and are the successors of a corporation originally organized in 1934 to conduct thoroughbred horse racing in Southern California. Realty is principally engaged in holding and investing in retail, commercial, industrial and multifamily real property located primarily in the western United States. Subsequent to year-end Realty disposed of its multifamily and industrial properties (Note 2). Realty operates as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986 and, accordingly, pays no income taxes on earnings distributed to shareholders. Operating Company is engaged in thoroughbred horse racing. The thoroughbred horse racing operation is conducted by a subsidiary of Operating Company, Los Angeles Turf Club, Incorporated ("LATC"), which leases the Santa Anita Racetrack from Realty. Separate and combined financial statements have been presented for Realty and Operating Company. Realty and Combined Realty and Operating Company use an unclassified balance sheet presentation. The separate results of operations and the separate net income per share of Realty and Operating Company cannot usually be added together to total the combined results of operations and net income per share because of adjustments and eliminations arising from inter-entity transactions. All significant intercompany and inter-entity balances and transactions have been eliminated in consolidation and combination. REAL ESTATE ASSETS Investment properties are carried at cost and consist of land, buildings, and related improvements. Depreciation is provided on a straight-line basis over the estimated useful lives of the properties, ranging primarily from 15 to 40 years. INVESTMENTS IN JOINT VENTURES All joint ventures in which Realty exercises significant control and has a 50% or greater ownership interest are consolidated. The ownership interests of outside partners in Realty's consolidated joint ventures are reflected as minority interest (excess of liabilities over assets) on the balance sheets for Realty and Combined Realty and Operating Company. Investments in unconsolidated joint ventures are accounted for using the equity method of accounting. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CASH AND CASH EQUIVALENTS Highly liquid short-term investments, with maturities of three months or less, at the date of acquisition, are considered cash equivalents. PROPERTY, PLANT AND EQUIPMENT Depreciation of property, plant and equipment and the capital lease obligation is provided primarily on the straight-line method generally over the following estimated useful lives: Building and improvements 25 to 45 years Machinery and other equipment 5 to 15 years Leasehold improvements 5 to 32 years Expenditures which materially increase property lives are capitalized. The cost of maintenance and repairs is charged to expense as incurred. When depreciable property is retired or disposed of, the related cost and accumulated depreciation is removed from the accounts and any gain or loss is reflected in current operations. INCOME TAXES Realty and Operating Company adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993. The new standard of accounting replaces SFAS No. 96 which the company adopted in 1988. The cumulative effect of adopting Statement 109 was immaterial for the year ended December 31, 1993. DEFERRED REVENUES Operating Company's deferred revenues consist of prepaid admission tickets and parking, which are recognized as income ratably over the period of the related race meets. Also, deferred revenue includes prepaid rent from Oak Tree which is recognized over the remaining term of the lease. SHAREHOLDERS' EQUITY The outstanding shares of Realty common stock and Operating Company common stock are only transferable and tradable in combination as a paired unit consisting of one share of Realty common stock and one share of Operating Company common stock. OPERATING COMPANY'S REVENUES AND COSTS Operating Company has adopted an accounting policy whereby the revenues associated with thoroughbred horse racing at Santa Anita Racetrack are reported as they are earned. Costs and expenses associated with thoroughbred horse racing revenues are charged against income in those periods in which the thoroughbred horse racing revenues are recognized. Other costs and expenses are recognized as they actually occur throughout the year. The rental fee paid by Operating Company to Realty is recognized by both Realty and Operating Company as it is earned. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) RENTAL PROPERTY REVENUES Rental property revenues are recorded on a straight-line basis over the related lease term. As a result, deferred rent is created when rental income is recognized during free rent periods of a lease. The deferred rent is included in prepaid expenses and other assets, evaluated for collectibility and amortized over the remaining term of the lease. HORSE RACING REVENUES AND DIRECT OPERATING COSTS Operating Company's horse racing revenues and direct operating costs are shown net of state and local taxes, stakes, purses and awards. CONCENTRATION OF CREDIT RISK Financial instruments which potentially subject Realty and Operating Company to concentrations of credit risk are primarily cash investments and receivables. Realty and Operating Company place their cash investments in investment grade short-term instruments and limit the amount of credit exposure to any one commercial issuer. Concentrations of credit risk with respect to accounts receivable are limited due to the number of retail, commercial and residential tenants, and Santa Anita catering patrons. Real estate receivables are secured by first trust deeds on commercial real estate located in Southern California, and Phoenix, Arizona. Advances to unconsolidated joint ventures are unsecured and due from partnerships in which Realty is a 50% or less general partner. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Realty is an issuer of financial instruments with off-balance sheet risk in the normal course of business which exposes Realty to credit risks. These financial instruments include commitments to extend credit, financial guarantees and letters of credit. FAIR VALUE OF FINANCIAL INSTRUMENTS Management has estimated the fair value of its financial instruments using available market information and appropriate valuation methodologies. Considerable judgment is required in interpreting market data to develop estimates of fair value. Accordingly, the estimated values for Realty and Operating Company as of December 31, 1993 are not necessarily indicative of the amounts that could be realized in current market exchanges. For those financial instruments for which it is practicable to estimate value, management has determined that the carrying amounts of Realty's and Operating Company's financial instruments approximate their fair value as of December 31,1993. DIVIDEND REINVESTMENT PLAN In November 1992 Realty and Operating Company terminated their dividend reinvestment and stock purchase plan (the "Plan") which had enabled shareholders to reinvest dividends and purchase shares of Realty and Operating Company stock. Since October 1990, shares issued under the terms of the Plan had been purchased in the open market. Prior to that date, new shares had been issued. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) COMMON STOCK AND NET INCOME (LOSS) PER COMMON SHARE Net income (loss) per common share is computed based upon the weighted average number of common shares outstanding during each period for each company. Stock options have not been included in the computation since they have no material dilutive effect. Operating Company holds shares of Realty's common stock which are unpaired pursuant to a stock option plan approved by the shareholders. The shares held totaled 115,500 as of December 31, 1993, 1992 and 1991, respectively. These shares affect the calculation of Realty's net income per common share but are eliminated in the combined calculation of net income per common share. RECLASSIFICATIONS Certain prior year amounts have been restated to conform to current year presentation. NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL PROPERTIES SUBSEQUENT TO YEAR END In November 1993, Realty entered into a Purchase and Sale Agreement to sell its multifamily and industrial operations to Pacific Gulf Properties Inc. ("Pacific"), in conjunction with Pacific's proposed public offering of common stock and debentures. The transaction was structured into two parts: (1) Realty would sell all of its apartments and industrial properties to Pacific with the exception of Realty's interest in the Baldwin Industrial Park joint venture; and (2) Pacific would enter into a binding agreement to buy Realty's interest in Baldwin Industrial Park. On February 18, 1994, Realty completed the first part of this transaction by selling to Pacific ten multifamily properties, containing 2,654 apartment units, located in Southern California, the Pacific Northwest, and Texas and three industrial properties, containing an aggregate of 185,000 leasable square feet of industrial space, located in the State of Washington (the "Transferred Properties"). Realty's corporate headquarters building and related assets were also acquired by Pacific. The sale of the Transferred Properties followed the public offerings of common stock and convertible subordinated debentures by Pacific. Pursuant to the Purchase and Sale Agreement, Pacific agreed to buy Realty's interest in Baldwin Industrial Park subject to satisfaction of certain conditions, for a minimum price of $8.9 million payable in additional shares of Pacific common stock, with the final price dependent upon completion of negotiations with the other owners of Baldwin Industrial Park and an appraisal process. Management believes the sale of Realty's interest in Baldwin Industrial Park will be completed in the second half of 1994. Pacific is required to issue to Realty non-refundable letters of credit totaling $2.5 million by March 31, 1994 to secure its obligation to acquire Realty's interest in Baldwin Industrial Park and pay for the corporate headquarters building and other assets related to the Transferred Properties. In consideration of the sale of the Transferred Properties, Realty received approximately $44.4 million in cash and 149,900 shares of the common stock of Pacific. In addition, Realty was relieved of approximately $44.3 million of mortgage debt on the Transferred Properties. Realty will also receive, at the time the acquisition of Baldwin Industrial Park is completed, up to $1.2 million in additional common stock of Pacific as consideration for its corporate headquarters and other net assets related to the Transferred Properties. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL OPERATIONS SUBSEQUENT TO YEAR END (CONTINUED) The two parts of the above transaction will result in a loss of $10,974,000. This loss has been reflected in the Realty and Realty and Operating Company combined statements of operations for the year ended December 31, 1993. If the Baldwin Industrial Park portion of the transaction described above does not occur, an additional loss will be recognized by Realty in 1994. The loss could approximate $5,900,000, depending upon whether the $2.5 million in letters of credit are drawn. Realty and Pacific have also entered into a one-year management agreement whereby Pacific has agreed to provide management services to Realty. Finally, with respect to the common stock of Pacific owned by Realty, Pacific has entered into a registration rights agreement with Realty which, under certain circumstances, allows Realty to require the registration of the Pacific stock it owns. The following unaudited pro forma condensed balance sheets of Realty and Realty and Operating Company combined are presented as if both parts of the transaction had occurred on December 31, 1993. The unaudited pro forma condensed balance sheets are not necessarily indicative of what the actual financial position of Realty or Realty and Operating Company combined would have been at December 31, 1993 nor do they purport to represent the future financial position of Realty or Realty and Operating Company combined. The accompanying notes are an integral part of this pro forma balance sheet. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL OPERATIONS SUBSEQUENT TO YEAR END (CONTINUED) Notes: - ------ (a) Reflects the disposition of the assets and liabilities of the Multifamily and Industrial Operations as if both parts of the transaction had occurred on December 31, 1993. The amounts reflected represent the assets and liabilities directly identifiable with the Multifamily and Industrial Operations transferred by Realty to Pacific. (b) As a result of the February 18, 1994 sale to Pacific, Realty will have an investment in the common shares of Pacific totaling $2,738,000. Upon completion of Realty's disposition of Baldwin Industrial Park, assuming a price per share equal to $18.25 (the initial public offering price of Pacific's common shares) and the minimum price for Realty's interest in Baldwin Industrial Park and the corporate headquarters building and certain other assets related to the Transferred Properties, Realty will receive additional Pacific stock totaling approximately $10,064,000. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL OPERATIONS SUBSEQUENT TO YEAR END (CONTINUED) The following unaudited pro forma statements of operation of Realty and Realty and Operating Company combined are presented as if both parts of the transaction had occurred on January 1, 1993. The unaudited pro forma statements of operation are not necessarily indicative of what the actual results of operations would have been if the transaction had been consummated on January 1, 1993 nor do they purport to represent the results of operations of Realty or Realty and Operating Company combined for any future period. The accompanying notes are an integral part of this pro forma statement of operations. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL OPERATIONS SUBSEQUENT TO YEAR END (CONTINUED) Notes: - ------ (1) Reflects the operations for the year ended December 31, 1993 of the Multifamily and Industrial Operations directly identifiable with, and allocations of other costs and expenses related to, the Multifamily and Industrial Operations being transferred by Realty to Pacific. (2) Estimated annual distributions to be received on Realty's investment in Pacific ($1.56 per common share) less the amount of such distributions estimated to represent the return of capital ($.56 per common share). (3) Elimination of interest expense on real estate and other loans payable repaid or assumed by Pacific. (4) Elimination of the minority interest in earnings of joint ventures resulting from Realty's acquisition of the Partnership interests and subsequent transfer to Pacific. NOTES TO FINANCIAL STATEMENTS (continued) Note 3 - Investments in Joint Ventures Realty's real estate properties include investments in the following consolidated real estate joint ventures: The financial condition and operations of the above-listed joint ventures are consolidated with the financial statements of Realty and Combined Realty and Operating Company. Combined condensed financial information for consolidated joint ventures as of December 31, 1993, 1992 and 1991 and for the years then ended is as follows: NOTE 3 - INVESTMENTS IN JOINT VENTURES (CONTINUED) During 1993, Realty acquired the partnership interests of its minority partners in the following joint ventures: SARESAM, SAREFIM, Applewood Village Partners and Hubanita. The partnership interests were acquired in consideration for cash, the cancellation of certain receivables from the minority partners and the assumption of the minority partners' capital account and payment of $250,000 related to Hubanita. The financial statements of Realty and Combined Realty and Operating Company reflect the acquisition of the minority interests. Realty's investments in unconsolidated joint ventures include investments in the following commercial real estate ventures: Unaudited combined condensed financial statement information for unconsolidated joint ventures as of December 31, 1993, 1992 and 1991 and for the years then ended is as follows: NOTE 3 - INVESTMENTS IN JOINT VENTURES (CONTINUED) Realty is a joint and several guarantor of loans issued to expand the Towson Town Center located in Towson, Maryland (owned 65% by H-T Associates) and a department store and land (owned 100% by Joppa Associates) adjacent to Towson Town Center in the amount of $82,630,000. The maximum loan balance to which the guarantees relate is $188,500,000. Realty's two partners in the ventures have also each executed repayment guarantees, although one of the partners has a limited repayment guaranty. Annually, the guarantors may request a reduction in the amount of the guaranty based on the economic performance of the regional mall. NOTE 4 - REAL ESTATE LOANS AND ADVANCES RECEIVABLE Realty's real estate loans and advances receivable as of December 31, 1993 and 1992 consist of the following: Contractual principal repayments on real estate loans and advances receivable as of December 31, 1993 are due as follows: The prime rate was 6.0% during 1993 and at December 31, 1993. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 5 - LOANS PAYABLE Realty's real estate loans payable related to real estate as of December 31, 1993 and 1992 consist of the following: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 5 - LOANS PAYABLE (CONTINUED) Realty's other loans payable as of December 31, 1993 and 1992 consist of the following: As of December 31, 1993, Realty was not in compliance with certain covenants contained in its credit agreements. The banks have waived such noncompliance through April 30, 1994 conditioned, among other things, on no additional borrowings under the credit agreements. Realty is in the process of renegotiating these credit agreements. Management is of the opinion that Realty has sufficient liquidity from other sources to assure that its operations will not be adversely affected pending this renegotiation. Under the terms of these agreements, Realty may borrow funds, at Realty's option, based upon prime rates, LIBOR (London Interbank Offered Rate) based rates or Certificate of Deposit rates. At December 31, 1993, all funds are borrowed on prime or LIBOR-based rates. LIBOR-based rates ranged from 2.80% to 3.84% and the prime rate was 6.0% at December 31, 1993. The revolving lines of credit require certain compensating balances. Under the lines of credit agreements, the compensating balance requirements at December 31, 1993, which represent cash balances that are not available for withdrawal, amounted to $1,000,000. In addition, Realty is required to pay annual commitment fees ranging from 0.15% to 0.25% on the unused portion of these lines of credit. Operating Company entered into a sale-leaseback transaction related to the financing of certain television, video monitoring and production equipment under a five-year lease expiring in December 1997. This financing arrangement is accounted for as a capital lease. Accordingly, the equipment and related lease obligation are reflected as machinery and other equipment and other loans payable, respectively, on Operating Company's and Realty and Operating Company's combined balance sheets. Realty has guaranteed $3,500,000 of the lease obligation. NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 5 - LOANS PAYABLE (CONTINUED) The assets recorded under this capital lease are: Total future minimum lease payments under this capital lease and the present value of the minimum lease payments as of December 31, 1993 consist of the following: For the year ending December 31, Interest costs for the years ended December 31, 1993, 1992 and 1991 are as follows: NOTES TO FINANCIAL STATEMENTS (COINTINUED) NOTE 5 - LOANS PAYABLE (CONTINUED) NOTE 6 - OTHER LIABILITIES Other liabilities as of December 31, 1993 and 1992 consist of the following: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 6 - OTHER LIABILITIES (CONTINUED) Advances payable represent amounts due to Realty's other partner in Anita Associates. The amount is expected to be repaid from the proceeds of the refinancing of Anita Associates' existing debt. The advances bear interest at 10% and are unsecured. NOTE 7 - INCOME TAXES As a REIT, Realty is taxed only on undistributed REIT income. During each of the years ended December 31, 1993, 1992 and 1991, Realty distributed at least 95% of its REIT taxable earnings to its shareholders. For the years ended December 31, 1993, 1992 and 1991, 41.2%, 41.2% and 52.9%, respectively, of the dividends distributed to shareholders represented a return of capital. None of the dividends distributed to shareholders during 1993, 1992 and 1991 represented capital gains. The composition of Combined Realty and Operating Company's income tax provision (benefit) and income taxes paid for the years ended December 31, 1993, 1992 and 1991 is as follows: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 7 - INCOME TAXES (CONTINUED) Deferred income taxes arise from temporary differences in the recognition of certain items of revenues and expenses for financial statement and tax reporting purposes. The sources of temporary differences and their related tax effect for the years ended December 31, 1993, 1992 and 1991 are as follows: A reconciliation of Combined Realty and Operating Company's total income tax provision for the years ended December 31, 1993, 1992 and 1991 to the statutory federal corporate income tax rate of 34% follows: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 7 - INCOME TAXES (CONTINUED) The deferred tax assets (liabilities) as of December 31, 1993 and 1992 consist of the following: In prior years, Realty had filed claims with the California Franchise Tax Board for refunds with respect to the 1970 through 1979 tax years; LATC was assessed California franchise tax and interest for the years 1980 through 1982; and, Operating Company was assessed additional franchise tax for the years 1983 through 1985. In 1993, a refund of interest and taxes in the amount of $6,082,000 was received from the California Franchise Tax Board in the settlement of the above claims. Realty has recognized $3,211,000 of interest income, net of expenses of $120,000 and an income tax benefit in the amount of $2,523,000. Operating Company has recorded additional deferred taxes payable in the amount of $228,000. The Franchise Tax Board has audited the 1986 through 1988 tax years of Operating Company. Operating Company has protested these proposed assessments. The additional assessment has been accrued by Operating Company. In February 1994, the Franchise Tax Board initiated an audit of Operating Company's 1989 through 1991 tax years. At December 31, 1993, for federal income tax purposes, Operating Company's net operating loss carryforward is approximately $6,504,000 which substantially expires in 2004. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 8 - COMMITMENTS AND CONTINGENCIES Realty's wholly owned and consolidated real estate investments consist of Santa Anita Racetrack, Fashion Park (a regional mall), various neighborhood shopping centers, industrial parks, apartment complexes and office buildings. The racetrack is leased to LATC (Note 11); the land underlying Fashion Park has been ground leased for 65 years; each of the various neighborhood shopping centers has been leased to non-anchor tenants with terms ranging from three to five years; and, the office buildings have been leased with terms generally ranging from two to ten years. The minimum future lease payments to be received from Realty's wholly owned and consolidated real estate investments (excluding rentals relating to the Santa Anita Racetrack which are paid by LATC to Realty) for the five years ending December 31, are as follows: Substantially all of the retail leases provide for additional contingent rentals based upon the gross income of the tenants in excess of stipulated minimums. Realty's share of these contingent rentals totaled $258,000 in 1993, $337,000 in 1992 and $362,000 in 1991. Realty leases the Santa Anita Racetrack to Operating Company's subsidiary, LATC. The lease provides for a rental fee of 1.5% of the total gross on-track pari-mutuel wagering generated at the racetrack. The lease, which is subject to renewal, expires in 1994. Realty also receives 40% of LATC's revenues from satellite wagering and the simulcasting of races originating from the Santa Anita Racetrack after mandated payments to the State of California and to horse owners. The lease amounts are eliminated in combination. Realty has entered into several general and limited partnerships to own and operate real estate. As of December 31, 1993, Realty has committed to invest an additional $307,000 in these partnerships. Realty has obtained a standby letter of credit totaling $448,000 related to financing on a real estate investment. In 1992, Realty and Operating Company entered into severance agreements with certain officers. Under certain circumstances, the severance agreements provide for a lump sum payment if there is a "change in control" of the entities. No provision under these severance agreements has been accrued or funded. Certain other claims, suits and complaints arising in the ordinary course of business have been filed or are pending against Realty and Operating Company. In the opinion of management, all such matters are adequately covered by insurance or, if not so covered, are without merit or are of such kind or involve such amounts as would not have a significant effect on the financial position or results of operations if disposed of unfavorably. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS STOCK OPTION PROGRAM During 1984, Realty reserved 400,000 shares of common stock for sale under its Stock Incentive Plan. During 1984, Operating Company also reserved 400,000 shares for sale under its Stock Option Program. Each company also reserved 400,000 shares for issuance under the other company's plan. During 1993, Operating Company reserved an additional 222,820 shares for sale. The shares are to be issued either as Incentive Stock Options or Non-Qualified Stock Options. The options, which are contingent upon continuous employment, are exercisable at any time once vested, for up to three years after the date of retirement or death and for up to 90 days after resignation. For both Realty and Operating Company, Incentive Stock Options and Non-Qualified Stock Options expire in 1995 through 2003. Information with respect to shares under option as of December 31, 1993, 1992 and 1991 is as follows: (a) In connection with the disposition of the multifamily and industrial operations (Note 2), the executive officers of Realty resigned effective February 18, 1994. In accordance with the stock option program, the nonvested portion of their stock options terminated on February 18, 1994. The nonvested stock options totaled 41,200 as of December 31, 1993. The unexercised vested portion of their stock options still outstanding 90 days subsequent to the resignation date will be terminated on that date. As of December 31, 1993 the vested portion of their stock options totaled 33,800. Certain officers and/or directors of Realty and Operating Company have exercised stock options. At the time of the exercise, the individuals signed notes for the purchase price of the stock (Note 11). At the time of exercise of Realty options, employees also have to buy directly from Operating Company shares of Operating Company stock at its fair market value per share to pair with Realty shares. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS (CONTINUED) In addition, Operating Company is required to purchase Realty shares to pair with the Operating Company shares being purchased by its employees. In 1984, Operating Company purchased 200,000 shares of Realty stock for this purpose. RETIREMENT INCOME PLAN Realty and Operating Company have a defined benefit retirement plan for year-round employees who are at least 21 years of age with one or more years of service and who are not covered by collective bargaining agreements. Plan assets consist of investments in a life insurance group annuity contract. Plan benefits are based primarily on years of service and qualifying compensation during the final years of employment. Funding requirements comply with federal requirements that are imposed by law. The net periodic pension cost for 1993 for Realty and Operating Company was $104,000 and $367,000 respectively; for 1992 was $109,000 and $339,000, respectively; and for 1991 was $87,000 and $300,000, respectively. The provisions include amortization of past service cost over 30 years. Based upon an actuarial valuation date of January 1, 1993, the present value of accumulated plan benefits (calculated using a rate of return of 8.5%) at December 31, 1993 was $6,280,000, and the plan's net assets available for benefits were $5,607,000. The combined net periodic pension cost for the years ended December 31, 1993, 1992 and 1991 for the retirement income plan included the following components: NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS (CONTINUED) The following table sets forth the funded status of Realty's and Operating Company's retirement income plan and amounts recognized in the balance sheets at December 31, 1993 and 1992: Assumptions used in determining the funded status of the retirement income plan are as follows: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS (CONTINUED) DEFERRED COMPENSATION PLAN Realty and Operating Company have defined benefit deferred compensation agreements which provide selected management employees with a fixed benefit at retirement. Plan benefits are based primarily on years of service and qualifying compensation during the final years of employment. The net periodic pension cost for 1993 for Realty and Operating Company was $263,000 and $860,000, respectively; for 1992 was $93,000 and $243,000, respectively; and for 1991 was $98,000 and $233,000 respectively. During 1993, Realty and Operating Company recorded a combined $961,000 of pension expense, net of $793,000 of life insurance proceeds as a nonrecurring charge to the plan resulting from the death of an officer. It is the policy of Realty and Operating Company to fund only amounts sufficient to cover current deferred compensation benefits payable to retirees. The present value of unfunded benefits at December 31, 1993, based upon an actuarial valuation date of January 1, 1993, was $4,280,000 (calculated using a rate of return of 10%) and Realty's and Operating Company's combined accrued liability totaled $3,792,000. Net periodic pension cost for the years ended December 31, 1993, 1992 and 1991 for the deferred compensation plan included the following components: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS (CONTINUED) The following table sets forth the funded status of Realty's and Operating Company's deferred compensation plan and amounts recognized in the balance sheets at December 31, 1993 and 1992: Assumptions used in determining the funded status of the deferred compensation plan are as follows: NOTE 10 - SHAREHOLDER RIGHTS PLAN In June 1989, the Board of Directors of Realty adopted a shareholder rights plan and declared the distribution of one right for each outstanding share of common stock. The distribution was made in August 1989. Each right entitles the holder to purchase from Realty, initially, one one-hundredth of a share of junior participating preferred stock at a price of $100 per share, subject to adjustment. The rights are attached to all outstanding common shares, and no separate rights certificates will be distributed. The rights are not exercisable or transferable apart from the common stock until the earlier of ten business days following a public announcement that a person or group has acquired beneficial ownership of 10% or more of Realty's general voting power or ten business days following the commencement of, or announcement of the intention to commence, a tender or exchange offer that would result in a person or group beneficially owning 10% or more of Realty's general voting power. Upon the occurrence of certain other events related to changes in the ownership of Realty's outstanding common stock or business combinations involving a holder of more than 10% of Realty's general voting power, each holder of a right would be entitled to purchase shares of Realty's common stock, or an acquiring corporation's common stock, having a market value of two times the exercise price of the right. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 10 - SHAREHOLDER RIGHTS PLAN (CONTINUED) During such time as the stock-pairing arrangement between Realty and Operating Company shall remain in effect, Operating Company will issue, on a share-for-share basis, Operating Company common shares, or, as the case may be, Operating Company junior participating preferred shares to each person receiving Realty common shares or preferred shares upon exercise or in exchange for one or more rights. Realty is entitled to redeem the rights in whole, but not in part, at a price of $.001 per right prior to the earlier of the expiration of the rights in August 1999 or the close of business ten days after the announcement that a 10% position has been acquired. NOTE 11 - RELATED PARTY TRANSACTIONS LATC leases the Santa Anita Racetrack from Realty. Rent is based upon 1.5% of the aggregate live on-track wagering and 40% of LATC's revenues received from simulcast and satellite wagering on races originating at Santa Anita Racetrack. For the years ended December 31, 1993, 1992 and 1991, LATC paid Realty (including charity days) $11,634,000, $12,683,000 and $11,817,000, respectively, in rent, of which $9,233,000, $10,955,000 and $9,928,000, respectively, were attributable to the Santa Anita meets (exclusive of charity days), with the remainder being attributable to the Oak Tree meets and charity days. The lease arrangement between LATC and Realty requires LATC to assume costs attributable to taxes, maintenance and insurance. Both Realty and Operating Company have notes receivable from certain officers, former officers and/or former directors resulting from their exercise of stock options (Note 9). Notes receivable from officers, former officers and/or former directors as of December 31, 1993 and 1992, for Realty were $81,000 and $184,000, respectively, and for Operating Company were $393,000 and $ 890,000, respectively. NOTE 12 - COMBINED QUARTERLY FINANCIAL INFORMATION - UNAUDITED Condensed combined unaudited quarterly results of operations for Combined Realty and Operating Company are as follows: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 12 - COMBINED QUARTERLY FINANCIAL INFORMATION - UNAUDITED (CONTINUED) In 1993, revenues and cost of sales from food and beverage operations have been reflected as a separate component in Operating Company's and Combined Realty and Operating Company's statements of operations. In prior years these operations were reflected in horse racing revenues. All prior year and interim financial statements and disclosures for Operating Company and Combined Realty and Operating Company have been restated to reflect this reclassification. Operating Company adopted an accounting practice whereby the revenues associated with thoroughbred horse racing at Santa Anita Racetrack are reported as they are earned. Costs and expenses associated with thoroughbred horse racing revenues are charged against income in those interim periods in which the thoroughbred horse racing revenues are recognized. Other costs and expenses are recognized as they actually occur throughout the year. The total of the amounts shown above as quarterly net income per common share may differ from the amount shown on the Combined Statements of Operations because the annual computation is made separately and is based upon the average number of shares outstanding for the year. Realty and Operating Company are subject to significant seasonal variations in revenues and net income (loss) due primarily to the seasonality of thoroughbred horse racing. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS SANTA ANITA REALTY ENTERPRISES, 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 - -------------- (a) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1993, arising from the exercise of stock options of Realty. (b) Resigned effective December 27, 1993. (c) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1994, arising from the exercise of stock options of Realty. (d) Note receivable at 7% interest, payable in five annual installments through 1992, arising from the exercise of stock options of Realty. SANTA ANITA REALTY ENTERPRISES, 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 - -------------- (a) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1993, arising from the exercise of stock options of Realty. (b) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1994, arising from the exercise of stock options of Realty. (c) Note receivable at 7% interest, payable in five annual installments through 1992, arising from the exercise of stock options of Realty. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES 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 - -------------- (a) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1995, arising from the exercise of stock options of Operating Company. (b) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1993, arising from the exercise of stock options of Operating Company. (c) Decreased May 5, 1993. (d) The balance of Mr. Strub's note will be reduced at the rate of $5,000 per month by his widow, Mrs. Elizabeth Strub, who has personally guaranteed the note. Additionally, irrevocable escrow instructions have been executed by the trustee of Mr. Strub's estate wherein escrow proceeds arising from the sale of a single family residence will be applied to the outstanding balance. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES 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 - -------------- (a) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1992, arising from the exercise of stock options of Operating Company. (b) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1995, arising from the exercise of stock options of Operating Company. (c) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1993, arising from the exercise of stock options of Operating Company. (d) Note receivable at 7% interest, payable in five annual installments through 1992, arising from the exercise of stock options of Operating Company. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS DECEMBER 31, 1993 SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE XI - REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 The accompanying notes are an integral part of this schedule. SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE XI - REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 (CONTINUED) - ------------ Notes (a) Initial costs December 31, 1979 book value (b) Component depreciation used (c) All dollar figures represent 100% of amounts attributable to the property (d) Initial costs December 31, 1987 book value (e) Property subject to Pacific transaction (Note 2) INDEPENDENT AUDITORS' REPORT ----------------------------- To the Partners H-T Associates We have audited the accompanying consolidated balance sheet of H-T Associates (a Maryland general partnership) and subsidiary (a Maryland general partnership) as of December 31, 1993, and the related consolidated statements of operations, partners' capital and cash flows for the year then ended. These consolidated financial statements are the responsibility of H-T Associates' management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of H-T Associates and subsidiary as of December 31, 1993, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. KPMG PEAT MARWICK San Diego, California February 11, 1994 INDEPENDENT AUDITORS' REPORT ----------------------------- To the Partners H-T Associates San Diego, California We have audited the accompanying consolidated balance sheet of H-T Associates (a Maryland general partnership) and subsidiary (a Maryland general partnership) as of December 31, 1992, and the related consolidated statements of operations, partners' capital and cash flows for the year then ended. These financial statements are the responsibility of H-T Associates' 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 1992 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of H-T Associates and subsidiary as of December 31, 1992, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. KENNETH LEVENTHAL & COMPANY Newport Beach, California January 28, 1993 INDEPENDENT AUDITORS' REPORT ---------------------------- To the Partners H-T Associates San Diego, California We have audited the accompanying consolidated statements of operations, partners' capital and cash flows of H-T Associates (a Maryland general partnership) and subsidiary (a Maryland general partnership) for the year ended December 31, 1991. These financial statements are the responsibility of H-T Associates' 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, such 1991 consolidated financial statements present fairly, in all material respects, the results of operations and cash flows of H-T Associates and subsidiary for the year ended December 31, 1991, in conformity with generally accepted accounting principles. DELOITTE & TOUCHE San Diego, California February 3, 1992 H-T ASSOCIATES (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED BALANCE SHEETS --------------------------- See notes to consolidated financial statements. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED STATEMENTS OF OPERATIONS ------------------------------------- See notes to consolidated financial statements. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL -------------------------------------------- YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 -------------------------------------------- See notes to consolidated financial statements. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- See notes to consolidated financial statements. H-T ASSOCIATES (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- (Continued) See notes to consolidated financial statements. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ DECEMBER 31, 1993, 1992 AND 1991 -------------------------------- A. Organization and Accounting Policies: ------------------------------------ H-T Associates (the "Partnership") is a Maryland general partnership formed on July 28, 1987. Its primary asset is a 65% ownership in Towson Town Center Associates ("TTCA"), formed to develop and operate a regional shopping center near Baltimore, Maryland. The general partners of the Partnership are Ernest W. Hahn, Inc. and Santa Anita Realty Enterprises, Inc. The Partnership is to continue until December 31, 2087, unless terminated earlier. Profits and losses are shared as follows: Ernest W. Hahn, Inc. ("Hahn") 50% Santa Anita Realty Enterprises, Inc. ("Santa Anita") 50% The consolidated financial statements of the Partnership include the accounts of the Partnership and TTCA. TTCA is a Maryland general partnership comprised of the Partnership and DeChiaro Associates ("DeChiaro") as 65% and 35% general partners, respectively. All significant intercompany balances and transactions have been eliminated. Certain reclassifications of prior year amounts have been made in order to conform with the current year presentation. The Partnership's accounting policies are as follows: 1. Shopping center property is recorded at cost and includes direct construction costs, interest, construction loan fees, property taxes and related costs capitalized during the construction period, as these amounts are expected to be recovered from operations. 2. The costs of shopping center buildings and improvements, less a 5% salvage value, are depreciated using the straight-line method over the estimated useful life of 40 years. 3. Direct costs of obtaining leases and permanent financing are deferred and are being amortized over the lease and loan periods, respectively. 4. Maintenance and repairs are charged to operations as incurred. 5. Expenditures for betterments are capitalized and depreciated over the remaining depreciable life of the property. 6. Costs incurred in connection with early termination of a tenant lease are amortized over the life of the lease with the replacement tenant. To the extent payments received from an incoming tenant do not represent future rentals or cost recoveries for tenant improvements, they are recorded as income when received. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) ------------------------------------------------------ A. Organization and Accounting Policies: (continued) ------------------------------------ 7. Taxable income or loss of the Partnership is reported by, and is the responsibility of, the respective partners. Accordingly, the Partnership makes no provision for income taxes. 8. The Partnership recognizes scheduled rent increases on a straight-line basis. Accordingly, a deferred receivable for rents which are to be received in subsequent years is reflected in the accompanying consolidated balance sheets. 9. The differential to be paid or received under interest rate swap agreements is accrued as interest rates change, and is recognized over the life of the agreements (Note B). B. Notes payable: ------------- In 1990, TTCA entered into a building loan agreement with a commercial bank, secured by an indemnity deed of trust encumbering the property. In connection with the loan, Hahn and Santa Anita executed a repayment guaranty of $66,135,000 each and DeChiaro executed a limited repayment guaranty of $4,513,000. TTCA can borrow up to $170,000,000. The principal balance of the loan is due May 1999. The agreement provides that TTCA can: (1) obtain funds at the then current prime rate of the commercial bank; (2) obtain funds based on the then current London Interbank Offered Rate ("LIBOR") plus a spread (as defined); or, (3) obtain funds through the issuance of commercial paper at rates based upon the interest rates offered in the commercial paper market plus letter of credit fees. For the years ended December 31, 1993 and 1992, all funds were obtained under the commercial paper option for a total outstanding balance of $164,641,000 and $159,473,000, respectively. Interest is payable monthly. The variable interest rate in effect on the outstanding balance as of December 31, 1993 and 1992 was 3.2% and 3.7%, respectively. TTCA has also entered into interest rate swap agreements to reduce the impact of changes in interest rates on its loan. As of December 31, 1993 and 1992, TTCA had two interest rate swap agreements outstanding with a commercial bank which have a total notional principal amount of $82,000,000. The agreements provide for TTCA to pay fixed rates of interest of 9.3% and 8.8% on swaps of $45,000,000 and $37,000,000, respectively, and to receive floating interest based on 30 day commercial paper rates. The effective variable rate of interest on the swap agreements as of December 31, 1993 is 3.2%. The interest rate swap agreements mature at the time the building loan matures. TTCA is exposed to credit loss in the event of nonperformance by the commercial bank with the interest rate swap agreements. The net effective interest rates on amounts outstanding under the building loan agreement at December 31, 1993, 1992 and 1991, after giving effect to the interest rate swaps, was 6.9%, 6.4% and 8.3%, respectively. H-T ASSOCIATES (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) B. Notes payable: (continued) ------------- The differential between the amounts paid and received under the interest rate contract is included as either an addition to, or a reduction in, interest incurred. Total interest incurred was $11,383,329, $11,420,746, and $10,419,887 of which $0, $3,491,669 and $8,515,010 was capitalized, for the years ended December 31, 1993, 1992, and 1991, respectively. C. Commitments: ------------ Partnership as Lessor: --------------------- TTCA leases space to tenants in the shopping center for which it charges minimum rents and receives reimbursement for real estate taxes and certain other operating expenses. The terms of the leases range from 5 to 30 years and generally provide for additional overage rents during any year that tenants' gross sales exceed stated amounts. Future minimum rental revenues to be received under leases in force at December 31, 1993 are as follows: Property Under Development: --------------------------- During 1991, TTCA completed a major expansion and renovation of the previously existing shopping center. Pursuant to the Development Manager's Agreement between TTCA and Hahn, Hahn is to receive an estimated $5.1 million as compensation for managing the development of the project. Of this amount $5,080,619, $5,041,792 and $4,682,015 were incurred as of December 31, 1993, 1992 and 1991, respectively. H-T ASSOCIATES -------------- (a Maryland general partnersip) AND SUBSIDIARY (A Maryland general partnership) D. Advances from Partners: ---------------------- Hahn and Santa Anita have both made advances to the Partnership to finance certain construction funding requirements and other cash flow needs. These advances bear interest at 1% above the prime rate and they are required to be repaid prior to any distributions to the partners, other than distributions of Net Cash Flow from Operations (Note E). Interest incurred on the advances totaled $540,555, $558,918 and $702,773 for the years ended December 31, 1993, 1992 and 1991, respectively. The prime rate was 6.0%, 6.0% and 6.5% at December 31, 1993, 1992 and 1991, respectively. E. Partnership Distributions: ------------------------- Distributions of Net Cash flow from Operations of the Partnership (as defined by the Amended and Restated Partnership Agreement) are subject to certain priorities. The period from inception of the Partnership through October 16, 1991 (the Grand Opening Date of the shopping center) is referred to as the Initial Term. During the Initial Term, both partners were entitled to a cumulative, compounded return (at the Prime Rate, as defined) on their capital contributions. A $500,000 distribution was made during the Initial Term. The "Primary Term" follows the Initial Term, and ends when cash flow for a consecutive 12-month period exceeds the sum of $1,192,000 plus any unpaid cumulative returns. During the "Primary Term," Santa Anita receives a cumulative return of $447,000 for the first year, $521,500 for the second year, and $596,000 for each year thereafter. Hahn receives non-cumulative returns of the same amounts. Following the Primary Term, distributions of Net Cash Flow from Operations are made to the partners in accordance with their percentage interests. F. Related Party Transactions: -------------------------- Hahn and its wholly owned subsidiary, Hahn Property Management Corporation ("HMPC"), provide property management, leasing and various legal services to TTCA. A summary of costs and fees incurred by Hahn and HMPC by TTCA during 1993, 1992 and 1991 is presented below: H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) ------------------------------------------------------ F. Related Party Transactions: (continued) -------------------------- Related Property: ----------------- Certain property adjacent to TTCA's regional shopping center is owned by Joppa Associates ("Joppa"). The partners of TTCA are also the partners of Joppa. TTCA has benefitted from Joppa's ownership of the adjacent property. The partners consider the two properties one project. G. Disclosures About the Fair Value of Financial Instruments: --------------------------------------------------------- In the opinion of management, the carrying amounts of TTCA's financial instruments approximate fair value except: Interest Rate Swaps (Note B): ---------------------------- The fair value of interest rate swaps (used for hedging purposes) is the estimated amount that TTCA would pay to terminate the swap agreements at the reporting date, taking into account current interest rates and the current credit worthiness of the swap counterparties. The fair value of the interest rate swaps is a net payable of $13,593,031. EXHIBIT INDEX EXHIBIT INDEX (CONTINUED) EXHIBIT INDEX (CONTINUED) EXHIBIT INDEX (CONTINUED)

740694_1993.txt

740694_1993

1993

740694

Item 1. BUSINESS a. General Development of Business Kaydon Corporation (the "Company" or "Kaydon") was formed in October 1983, as a wholly owned subsidiary of Bairnco Corporation ("Bairnco" or "former parent"), when it acquired all of the assets and assumed certain liabilities, other than amounts due from affiliates, from a subsidiary of Keene Corporation, another wholly owned subsidiary of Bairnco, which was then known as Kaydon Corporation and is now inactive. The Company was spun off from Bairnco in April 1984 and is no longer a member of its consolidated group. This spinoff was effected in the form of a 100 percent stock dividend to stockholders of the former parent's common stock. On June 30, 1986, Kaydon Ring and Seal, Inc., a wholly owned subsidiary of Kaydon, acquired for $29,600,000 certain assets and liabilities of the Piston Ring and Seal Division of Koppers Company, Inc., a manufacturer of piston rings and shaft seals. This acquisition was consummated by Kaydon Ring and Seal, Inc. with loaned funds from Kaydon. On July 17, 1987, Kaydon acquired for $5,100,000 certain assets and liabilities of the Spirolox operation of TRW, Inc., a manufacturer of specialty retaining rings. This acquisition was consummated with funds acquired through bank credit obtained in the normal course of business. On June 23, 1989, Kaydon Corporation, through its newly formed, wholly owned subsidiaries, Kaydon Acquisition Corp. III and Kaydon Acquisition Corp. IV, acquired for $22,710,000 all of the stock of I.D.M. Electronics Ltd., a United Kingdom corporation, and KDI Electro-Tec Corp., a Delaware corporation, from KDI Corporation. I.D.M. Electronics Ltd. and Electro-Tec Corp. manufacture high-performance, precision slip-rings, slip-ring capsules and slip-ring assemblies. Slip-rings are complex, electromechanical devices used to transmit electric signals or electrical power between the rotating and stationary members of an assembly, such as a gyro and its housing. The purchase price was financed by credit obtained in the normal course of business. On December 16, 1991, Kaydon Corporation, through its wholly owned subsidiaries, Kaydon Acquisition Corp. III and Kaydon Acquisition Corp. U.K. Ltd., acquired for L.24,000,000 (approximately $43,440,000 when translated at the exchange rate in effect at the time of purchase) all of the capital stock of Prizerandom Limited, a United Kingdom corporation, from Clairmont PLC, a Scotland corporation. Prizerandom Limited is a wholly owned subsidiary of Clairmont PLC and is the holding company for Cooper Bearings Limited, a United Kingdom corporation, which was the primary subject of the acquisition. Cooper Bearings Ltd. is a holding company consisting of the following operating subsidiaries, all of which are manufacturers or distributors of complete bearings and related components parts: Cooper U.K. is a manufacturing operation located in King's Lynn, Norfolk - U.K. that produces a range of split roller bearings including both a standard line and custom-designed product. Split bearings are designed specifically to aid the customer in solving problems where the application of full round bearings would be impractical. Cooper U.S. and Cooper Germany are distribution operations located in Virginia Beach, VA - U.S. and Krefeld, Germany, respectively. The purchase price was financed through Kaydon Corporation cash plus bank loans from the National Bank of Detroit and Continental Bank, U.K. b. and c. Financial Information About Industry Segments and Narrative Description of Business The Company designs, manufactures and sells custom-engineered products for a broad and diverse customer base. The Company's principal products include antifriction bearings, bearing systems, filters, filter housings, high-performance rings, sealing rings, specialty retaining rings, shaft seals and slip-rings. These products are used by customers in a variety of medical, instrumentation, material handling, machine tool positioning, aerospace, defense, construction and other industrial applications. Products Kaydon works closely with its customers to engineer the required solutions to their design problems. Design solutions are frequently unique to a single customer or application. Depending upon the nature of the application, the design may be used over a protracted time period and in large numbers, or it may be for a single use. The antifriction bearing products of Kaydon incorporate various types of rolling elements. The ball, tapered roller, cylindrical roller and needle roller bearings manufactured by Kaydon are made in sizes ranging from needle bearings with a 1/2-inch outside diameter to heavy-duty ball bearings with an outside diameter of 180 inches. These antifriction products are fabricated from aluminum, bearing-quality steel, stainless steel or special tool steels. They often incorporate a broad range of features such as gearing, special sealing systems and mounting arrangements in combination with other mechanical components. As a custom manufacturer, many diverse applications are served. Typical applications include large-diameter ball bearings for hydraulic cranes and excavators; thin-section ball bearings for rotating joints of industrial robots; lightweight airborne radar bearings; large-diameter aluminum roller bearings for military vehicle turret systems; needle roller bearings for passenger car transmissions; loose needle rollers for universal joints utilized in light trucks, agricultural tractors and passenger cars; special coalescing elements and filter housings for diesel fuel filtration on both commercial and military vehicles; hydraulic filter elements for tractor-mounted farm implement units; and ultra high-precision roller bearings for gear box applications. Kaydon's subsidiary, Kaydon Ring and Seal, Inc., manufactures metallic medium and large bore-size rings for low and medium-speed internal combustion engines, steam engines, pumps and reciprocating compressors. Sealing rings are engineered with metallic and nonmetallic products used to limit the leakage of fluids and gases within engines and a wide variety of other mechanical products. Sealing rings are used in industrial applications, such as: compressors, transmissions, hydraulic and pneumatic cylinders, and commercial and military aircraft, jet engines and control apparatus applications. Shaft seals are used to seal gases or liquids usually under extreme conditions of speed, pressure or temperature. Shaft seals are fabricated from a variety of materials depending on the application. Electro-Tec Corp. and I.D.M. Electronics Ltd., wholly owned subsidiaries of Kaydon Corporation, design and manufacture precision, high-performance slip-rings, slip-ring assemblies, capsules and related electromechanical devices to meet customers' exact needs and specifications. Slip-rings are manufactured from injection and transfer-molded plastics, aluminum and stainless steel castings, bearings and electronic components and connectors, and are sometimes subjected to an electro-deposition process. They are used to transmit electrical signals or power between the rotating and stationary members of an assembly and can be found in combat vehicles, aircraft inertial guidance systems, telecommunications satellites, aircraft targeting systems and medical diagnostic equipment. Cooper Bearings Ltd., a wholly owned subsidiary of Kaydon Corporation, designs and manufactures a range of split roller bearings, which include both standard and custom-designed lines. Split bearings are designed specifically to aid the customer in solving problems where the application of full round bearings would be less desirable. The product is used in a wide range of applications but particularly those where space and ease of change are important selection criteria. Approximately 69 percent of Kaydon's sales are to original equipment manufacturers, which incorporate the Kaydon products in the products they sell. Many of the applications for the Company's products also provide the opportunity for participation in the replacement or spare parts markets. New Product and Industry Segment Information On December 4, 1993 the Company acquired, for approximately $716,000, the assets of Kenyon Power Transmission Ltd. of Manchester, England. Kenyon manufactures pulleys and drive components which are complementary to the product offering of the Company's subsidiary, Cooper U.K., into which it will be absorbed. Subsequent to year end, on January 28, 1994 the Company acquired, for approximately $7,500,000, the assets of Industrial Tectonics Inc located in Dexter, Michigan. This company has been in existence since 1946 and is noted for the production of balls made of alloyed steel, plastic, tungsten carbide, glass and an assortment of other materials which are used in gauges, floats, measuring instruments, ball point pens and antifriction bearings. The Company has not made any other public announcement of, or otherwise made public information about, a new product or a new industry segment which would require the investment of a material amount of the Company's assets or which would otherwise result in a material cost. Patents, Trademarks, Licenses, Etc. The Company does not believe that any material part of its business is dependent on the continued availability of any one or all of its patents or trademarks. Seasonal Nature of Business The Company does not consider its business to be seasonal in nature. Working Capital Practices The Company does not believe that it or the industry in general has any special practices or special conditions affecting working capital items that are significant for an understanding of the Company's business. Customers Kaydon sells its products to over 1,000 companies throughout the world. The principal customers are generally large manufacturing corporations. During 1993, 1992 and 1991, sales to no single customer exceeded 10% of total sales. Customers can generally be divided into four major market groups: Aerospace and Military, Replacement Parts and Exports, Special Industrial Machinery and Heavy Industrial Equipment. Sales to these customer groups for 1993, 1992 and 1991 are set forth in the following table: Replacement parts are sold mainly through specialized distributors. Kaydon had export sales of $10,979,000 in 1993, $9,102,000 in 1992, and $10,762,000 in 1991, with most of such sales concentrated in Canada, Europe and Japan. Marketing Kaydon's sales organization consists of salespersons and representatives located throughout the United States, Canada, Europe and Asia. Salespersons are trained to provide technical assistance to customers, as well as to provide liaison with factory engineering staffs. A nationwide network of specialized distributors and agents provides local availability of Kaydon products to serve the requirements of the replacement market and small original equipment manufacturers. Manufacturing Kaydon manufactures virtually all of the products it sells and utilizes subcontractors only for occasional specialized services. Kaydon's products require sophisticated processes and equipment, and many of its products incorporate unique Kaydon-developed production techniques. Certain satellite and aircraft-type bearing products must meet extraordinary mechanical tolerances (for example, within 20 millionths of an inch) and many bearings and slip-rings are assembled in quality-controlled "white room" conditions. Nearly all of Kaydon's products require high levels of incoming quality control and process quality control. The manufacturing equipment required for Kaydon's operations entails a very high level of capital investment for any given level of sales. Suppliers Kaydon and its subsidiaries purchase large quantities of raw materials, mainly bearing-quality steel, special alloy steel, high-grade carbon and filter media, aluminum alloy and stainless steel castings, plastics, wire and electrical connectors, from multiple sources. Kaydon purchases large amounts of certain types of bearing-quality steel from a number of foreign suppliers. No significant supply problems have been encountered in recent years as relationships with suppliers have generally been good. Environmental Matters Reference is made to "Management's Discussion and Analysis" on pages 15 and 16 of Kaydon's 1993 Annual Report to Stockholders which is incorporated herein by reference. Employees On December 31, 1993, Kaydon employed 1,671 employees. Hourly employees at the Muskegon facilities (including Norton Shores) are represented by the International Association of Machinists and Aerospace Workers. The current collective bargaining agreement is effective until December 3, 1994. The Baltimore hourly employees are also represented by the International Association of Machinists and Aerospace Workers. The current collective bargaining agreement is effective until November 5, 1995. Greeneville hourly employees are represented by the United Steelworkers of America, with the current collective bargaining agreement effective until February 2, 1996. The remaining domestic factory employees, as well as all office employees, are non-union. Kaydon provides its employees with a full range of insurance, pension and deferred compensation benefits. The Company believes its levels of total compensation are equal to or better than comparable companies in communities adjacent to each facility. Backlog Kaydon sells certain products on a build-to-order basis that requires substantial order lead time. This results in a backlog of unshipped, scheduled orders. Other products are manufactured on the basis of sales projections or annual blanket purchase orders. Orders for such products are not entered into backlog until explicit shipping releases are received. Kaydon's backlog was $84,385,000 at December 31, 1993 and $83,296,000 at December 31, 1992. Based on experience, management would expect to ship over the following twelve months about 90 percent of the year-end backlog. The backlog increase reversed a downward trend over the last several years. Backlog has become less indicative of future results as the Company has made efforts to shorten manufacturing lead times, creating a faster response to customer orders. Competition Kaydon competes with divisions of SKF Industries, Timken Corporation, Torrington/Fafnir, Rotek, FAG, EG&G Inc., Litton Poly-Scientific and numerous other smaller companies. The markets served by Kaydon are large and extremely competitive. The major domestic competitors generally produce a wide line of standard products and do not specialize in custom products. The major domestic bearing manufacturers nonetheless do offer special-engineered bearings. The markets for Kaydon's special-machined components, fabricated products, filters, rings and seals are very diverse. Consequently, management feels that the size of the total market for such products cannot be meaningfully estimated. In all of the markets served by Kaydon, the principal methods of competition involve price, product performance, engineering support and timely delivery. Many of Kaydon's domestic competitors are part of large, worldwide manufacturing concerns and have significantly greater financial resources. While foreign competition is intense and growing for all industrial components, the special nature of Kaydon's products and the close working relationship with its customers have somewhat limited the impact of foreign competition on domestic business. Government Contracts and Renegotiation Various provisions of federal law and regulations require, under certain circumstances, the renegotiation of military procurement contracts or the refund of profits determined to be excessive. Based on Kaydon's experience under such provisions, management believes that no material renegotiation or refunds (if any) will be required. d. Information About International Operations Information with respect to operations by geographic area appears in Note 15, "Business Segment Information" of the Notes to Consolidated Financial Statements set forth on page 28 of the Annual Report to Stockholders, which is incorporated herein by reference. Fluctuating exchange rates and factors beyond the control of the Company, such as tariffs and foreign economic policies, may affect future results of foreign operations. Item 2. Item 2. PROPERTIES The following chart lists the principal locations, activity (use) and square footage of Kaydon's most significant facilities as of December 31, 1993 and indicates whether the property is owned or leased: Kaydon owns the two manufacturing facilities located in Muskegon (Norton Shores), the assembly facility located in Newaygo, the manufacturing facilities located in Sumter, Greeneville, LaGrange (lease option to purchase exercised June 1, 1993), Baltimore, Blacksburg, Monterrey, Mexico, and King's Lynn, England and the warehouse facility in Virginia Beach. The other property in Muskegon was leased (under a capitalized lease) in connection with a $10,000,000 Industrial Revenue Bond (IRB) financing for a term expiring January 15, 2009, with an option to purchase the property during the pendency of the lease and an obligation to purchase the property for nominal consideration upon its expiration. The IRB's were paid off on January 4, 1993, the lease was terminated, and the Company took title to the land. Due to the continuing shrinkage of the military and aerospace markets, Kaydon consolidated its three Muskegon, Michigan plants into two buildings and closed this plant which is located within a modern industrial park during the year. Management does not anticipate a material impact, if any, on earnings relating to the sale of this facility and anticipates that the desirable location will allow the plant facility to be sold for at least book value. Kaydon operates at two sites in Sumter, one site is owned and the other is leased (under a capitalized lease) in connection with a $4,000,000 Industrial Revenue Bond financing for a term expiring April 1, 1997, with an option to purchase the property during the pendency of the lease and an obligation to purchase the property for nominal consideration upon its expiration. The St. Louis property is leased for a term expiring July 31, 1997. The property in Reading, England, is leased for a term expiring May 1, 2009. The Krefeld, Germany property is leased for a term expiring September 30, 1994. The Corporate office located in Clearwater, Florida is leased for a term expiring January 31, 1999. Kaydon Corporation is the sole shareholder of the following operating subsidiaries: Item 3. Item 3. LEGAL PROCEEDINGS The Company, together with other companies, certain former officers, and certain current and former directors, has been named as a co-defendant in lawsuits filed in the federal court in New York. The suits purport to be class actions on behalf of all persons who have unsatisfied personal injury and property damage claims against Keene Corporation. The premise of the suits is that assets of Keene were transferred to Bairnco subsidiaries, of which Kaydon was one in 1983, at less than fair value. The suits also allege that the Company, among other named defendants, was a successor to and alter ego of Keene. While the ultimate outcome of this litigation is unknown at the present time, management believes that it has meritorious defenses to the asserted claims. Accordingly, no provision has been reflected in the financial statements for any alleged damages. Management believes that the outcome of this litigation will not have a materially adverse effect on the Company's financial position. Various other claims, lawsuits and environmental matters arising in the normal course of business are pending against the Company. Management believes that the outcome of these matters will not have a materially adverse effect on the Company's financial position or results of operations. Item 4. Item 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1993. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY & RELATED STOCKHOLDER MATTERS a. and c. Market Information and Dividends Information regarding the market price of Kaydon's common stock appears in Note 14, "Quarterly Results of Operations" of the Notes to Consolidated Financial Statements on page 27 of Kaydon's 1993 Annual Report to Stockholders, which is incorporated herein by reference. During 1992, the Company effected a two-for-one stock split; accordingly, all applicable financial data has been restated to reflect the split. Kaydon's common stock is listed on NASDAQ (over the counter) under the symbol KDON. Kaydon declared cash dividends during 1991, 1992 and 1993 as follows (on a per-share basis): Effective with the cash dividend declared in December 1993 and paid in January 1994, Kaydon adopted a plan which calls for quarterly cash dividends of $0.10 per share. This recent increase in the dividend amount reflects Kaydon management's continuing confidence in the growing financial strength of the Company and their expectation of continued earnings growth. b. Holders The number of common equity security holders is as follows: Item 6. Item 6. SELECTED FINANCIAL DATA Reference is made to "Financial History" on page 14 and "Management's Discussion and Analysis" on pages 15 and 16 of Kaydon's 1993 Annual Report to Stockholders, which 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 "To Our Stockholders" on pages 2 through 4 and "Management's Discussion and Analysis" on pages 15 and 16 of Kaydon's 1993 Annual Report to Stockholders, which is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the financial statements and related notes included on pages 18 through 28 and "Quarterly Results of Operations" on page 27 of Kaydon's 1993 Annual Report to Stockholders, which is incorporated herein by reference. Financial statement schedules are included in Part IV of this filing. 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 with respect to directors of Kaydon is included in the Proxy Statement for the 1994 Annual Meeting of Stockholders of Kaydon, which has been filed with the Securities and Exchange Commission and is incorporated herein by reference. The information required with respect to executive officers of the company is as follows: Item 11. Item 11. EXECUTIVE COMPENSATION The information required by Item 11 is included in the Proxy Statement for the 1994 Annual Meeting of Stockholders of Kaydon, which has been filed with the Securities and Exchange Commission and is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is included in the Proxy Statement for the 1994 Annual Meeting of Stockholders of Kaydon, which has been filed with the Securities and Exchange Commission and is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is included in the Proxy Statement for the 1994 Annual Meeting of Stockholders of Kaydon, which has been filed with the Securities and Exchange Commission and 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 consolidated financial statements of the Company are included in the Annual Report of the registrant to its stockholders for the year ended December 31, 1993 which is incorporated herein by reference in Part II, Item 8 of this report. 2. Financial Statement Schedules The following financial statement schedules and related Report of Independent Public Accountants on Financial Statement Schedules are included in this Form 10-K on the pages noted: All other schedules required by Form 10-K Annual Report have been omitted because they were inapplicable, the required information is included in the notes to the consolidated financial statements or otherwise is not required under instructions contained in Regulation S-X. Financial statements of the Company have been omitted since the Company is primarily an operating company and all subsidiaries included in the consolidated financial statements filed are wholly owned subsidiaries. 3. Reference to Exhibits Reference is made to the Exhibit Index which is found on pages 27 through 34 of this Form 10-K. b. Reports on Form 8-K No reports on Form 8-K have been filed during the fourth quarter of 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders and Board of Directors of Kaydon Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Kaydon Corporation and Subsidiaries' annual report to stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 20, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed at Item 14.a.2. 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 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. - - ------------------------- ARTHUR ANDERSEN & CO. Grand Rapids, Michigan January 20, 1994 (a) Plant and equipment of businesses acquired at date of acquisition. (b) Reclassification of plant and equipment. (c) Adjustment for change in foreign currency exchange rate. (a) Adjustment for change in foreign currency exchange rate. (1) Calculated based on daily balances. (2) Calculated based on daily rates. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Kaydon has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of Kaydon and in the capacities and on the dates indicated. c. 1. Exhibits Index

33619_1993.txt

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ITEM 1. BUSINESS (a) General Development of Business. Esterline Technologies Corporation (the "Company") conducts business through 14 principal domestic and foreign subsidiaries in three business segments described in sub-item (c) below. The Company was organized in August 1967. On September 27, 1989 the Company acquired six commercial aerospace and defense companies (The "Acquired Companies") from The Dyson-Kissner-Moran Corporation and certain of its affiliates together with 1,946,748 shares of common stock of Esterline (the "Shares"). The purchase price for the combined transactions was $153 million, including expenses, plus assumption of $3.2 million in debt. $27 million of the purchase price was related to the purchase of the Shares. The Acquired Companies primarily are in the commercial aerospace and defense industry and include Armtec Defense Products Co., Hytek Finishes Co., Midcon Cables Co., Republic Electronics Co. and TA Mfg. Co., which are in the Company's Aerospace and Defense Group, and Korry Electronics Co., which is in the Instrumentation Group. For additional discussion of the September 27, 1989 acquisition, see the Company's Form 8-K dated September 27, 1989 and the amendment thereto on Form 8 dated November 22, 1989. On March 30, 1992 the Company sold substantially all of the assets of Hollis Automation Co., an Esterline subsidiary which was not significant to the Company as a whole in terms of operations or financial condition. Hollis was in the Company's Automation Group. In the fourth quarter of 1993, the Company recorded a $40.6 million restructuring charge ($27.2 million net of income tax effect). It provided for the sale or shutdown of certain small operations in each of the Company's three business segments. On a pretax basis, $21.1 million of the restructuring charge related to the Aerospace and Defense Group, $8.9 million to the Instrumentation Group and $8.4 million to the Automation Group. The affected operations represented approximately 10% of the Company's fiscal 1993 sales. The charge further provides for the consolidation of plants and product lines, including employee severance, write-off of intangible assets which no longer have value and the write-down and sale of two vacant facilities. (b) Financial Information About Industry Segments. A summary of net sales to unaffiliated customers, operating earnings and identifiable assets attributable to the Company's business segments for the fiscal years ended October 31, 1993, 1992 and 1991 is incorporated herein by reference to Note 12 to the Company's Consolidated Financial Statements on pages 28 and 29 of the Annual Report to Shareholders for the fiscal year ended October 31, 1993. (c) Narrative Description of Business. The Company consists of 14 individual businesses whose results can vary widely based on a number of factors, including domestic and foreign economic conditions and developments affecting the specific industries and customers they serve. The products sold by most of these businesses represent capital investment by either the initial customer or the ultimate end user. Also, a significant portion of the sales and profitability of some Company businesses is derived from defense and other government contracts or the commercial aircraft industry. Changes in general economic conditions or conditions in specific industries, capital acquisition cycles, and government policies, collectively or individually, can have a significant effect on the Company's performance. Specific comments covering all of the Company's fiscal 1993 business segments and operating units are set forth below. AUTOMATION GROUP This Group produces and markets automated manufacturing equipment for the printed circuit board manufacturing industry (principally computer, telecommunications and automotive equipment); and automated metal fabrication equipment for transportation, heavy equipment and other related markets. Excellon Automation produces automated equipment for fabrication of printed circuit boards for the electronics industry. Its products are primarily drilling machines, driller/routers, programmers and editors, and networking systems. Excellon's products emphasize productivity and are designed to provide a highly efficient automated production system for printed circuit board manufacturers. Excellon's latest development involves autoload systems for its equipment which integrates multiple spindle microdrilling of circuit boards with automatic board loading and unloading capabilities. Excellon products are sold worldwide to the printed circuit board manufacturing industry, including both large and small electronics equipment manufacturers as well as component manufacturers, independent circuit board fabricators and custom drilling operations. In fiscal 1993, 1992 and 1991, printed circuit board drilling equipment accounted for 16%, 12% and 12%, respectively, of the Company's consolidated net sales. Tulon produces tungsten carbide drill and router bits for use in printed circuit board drilling equipment. Tulon utilizes computerized equipment which automatically inspects drill bits and provides the product consistency customers need for higher-technology drilling. W.A. Whitney produces automated equipment for the fabrication of structural steel, sheet metal and plate components and related material-handling equipment. This equipment performs such functions as punching, cutting, shearing and tapping. W.A. Whitney historically has specialized in equipment for punching and cutting heavier plate metal, utilizing plasma-arc air torch systems and hydraulic punching. Its customers consist principally of large metal fabricators, such as truck, farm implement and construction equipment manufacturers, and a wide range of independent fabricators. W.A. Whitney has also developed machines for the lighter gauge market which includes industries such as food service equipment, medical equipment and computer manufacturers. W.A. Whitney also produces a line of specialized screw machine and turret lathe tooling attachments under the Boyar-Schultz name. These products are sold to a wide range of customers primarily for use in tool room and production operations. Equipment Sales Co. acts as a sales representative principally for a manufacturer of high-speed assembly equipment for the printed circuit board industry. At October 31, 1993, the backlog of the Automation Group (of which $600,000 is expected to be filled after fiscal 1994) was $9.2 million compared with $14.8 million one year earlier. The decrease is primarily due to low incoming order levels in recent months at Excellon Automation. AEROSPACE AND DEFENSE GROUP This Group provides a broad range of measuring and sensing devices, high-performance elastomers and clamping systems, and specialized metal finishing principally for commercial aircraft and jet engine manufacturers; also combustible ammunition components and electronic warfare and radar simulation equipment for both domestic and foreign defense agencies. Armtec Defense Products manufactures molded fiber cartridge cases, mortar increments and other combustible ammunition components for the United States armed forces and domestic and foreign defense contractors. Armtec currently is the sole U.S. producer of combustible ordnance, including the 120mm combustible case used on the main armament system on the Army's M-1A1 tank and of 120mm, 81mm and 60mm combustible mortar increments for the U.S. Army. The majority of Armtec's sales are to ordnance suppliers to the U.S. Armed Forces. In fiscal 1993, 1992 and 1991, combustible ordnance components accounted for 9%, 12% and 10%, respectively, of the Company's consolidated net sales. Auxitrol, headquartered in France, manufactures aviation and industrial thermocouple-based products, liquid level measurement devices for ships and storage tanks, pneumatic accessories (including pressure gauges and regulators) and industrial alarms, as well as electrical penetration devices and alarm systems for European and other foreign nuclear power plants. This subsidiary also distributes products manufactured by others, including valves, temperature and pressure switches and flow gauges. The markets served by Auxitrol principally consist of aircraft manufacturers, shipbuilders, petroleum companies, process industries and electric utilities. During the year, Auxitrol acquired the temperature and pressure sensing product lines of a competitor increasing its market share, and added pressure sensing technology to its product line. Auxitrol has a joint venture with a Russian company to facilitate use of Auxitrol technology in retrofitting the aging nuclear plants in Eastern Europe. Exhaust gas temperature sensing equipment for a jet engine manufacturer constitute a significant portion of Auxitrol's sales. Hytek Finishes provides complete metal finishing and inspection services, including plating, anodizing, polishing, non- destructive testing and organic coatings, primarily to the commercial aircraft, aerospace and electronics markets. Hytek recently has installed an automated tin-lead plating line, employing the latest automated plating technology, to serve the semi-conductor industry. Midcon Cables manufactures electronic and electrical cable assemblies and wiring harnesses for the military, government contractors and the commercial electronics market, offering both product design services and assembly of product to customer specifications. Republic Electronics manufactures radar environmental simulators, tactical air navigation (TACAN) test equipment, identification friend or foe (IFF) interrogator test equipment, precision distance measuring equipment (PDME) test set simulators, electronic warfare simulators, and related support equipment for both U.S. and foreign commercial and military customers. TA Mfg. designs and manufactures systems installation components such as clamps, line blocks and brackets for airframe and engine manufacturers as well as military and commercial airline aftermarkets. TA's products include elastomers which are specifically formulated for various applications, including high-temperature environments. At October 31, 1993, the backlog of the Aerospace and Defense Group (of which $9.2 million is expected to be filled after fiscal 1994) was $40.8 million, compared with $58.9 million one year earlier. The decrease occurred primarily at Armtec Defense Products and Auxitrol and was due to the timing of the receipt of orders at both companies coupled with reduced levels of U.S. Army ordnance purchases. INSTRUMENTATION GROUP This Group designs and manufactures a variety of sophisticated meters, switches and indicators, panels and keyboards, gauges, control components, and measurement and analysis equipment for public utilities, industrial manufacturers, and suppliers and operators of commercial and military aircraft components. Angus Electronics manufactures recording instruments together with other analytical and process monitoring instrumentation. These include analog strip chart and digital printout recorders as well as electronic and multi-channel microprocessor-based recording equipment. Customers of Angus Electronics include industrial equipment manufacturers, electric utilities, scientific laboratories, pharmaceutical manufacturers and process industries. Korry Electronics manufactures high-reliability, lighted electromechanical components such as switches and indicators, and panels and keyboards which act as man-machine interfaces in a broad variety of control and display applications. Korry's customers include original equipment manufacturers and the aftermarkets (equipment operators and spare parts distributors), primarily in the commercial aviation, general aviation, military airborne, ground-based military equipment and shipboard military equipment markets. A significant portion of Korry's sales are to suppliers of military equipment to the U.S. Government and to a commercial aircraft manufacturer. Korry established a sales office in France during the year. Scientific Columbus (formerly Jemtec Electronics) produces analog and digital meters, electrical transducers and instruments for the monitoring, controlling and billing of electrical power. Included among these products are solid-state devices for calibration of electric utility instrumentation and a line of solid state-meters, including programmable multi-function billing meters. The latest products of Scientific Columbus are multi-function, microprocessor-based meters which offer a broad range of features on a modular basis. Scientific Columbus' products are sold to electrical utilities and industrial power users. Federal Products manufactures a broad line of analog and digital dimensional and surface measurement and inspection instruments and systems for a wide range of industrial quality control and scientific applications. Federal also distributes certain products which complement its manufactured product lines. These products constitute three major business segments: gauging, which includes dial indicators, air gauges and other precision gauges; instrumentation, which includes electronic gauges for use where ultra-precision measurement is required; and engineered products, which include custom-built and dedicated semi- automatic and automatic gauging systems. Distributed products manufactured by others include laser interferometer systems used primarily to check machine tool calibrations. Federal Products' equipment is used extensively in precision metal working. Its customers include the automotive, farm implement, construction equipment, aerospace, ordnance and bearing industries. In fiscal 1993, 1992 and 1991, gauge products manufactured by Federal Products accounted for 13%, 13% and 12%, respectively, of the Company's consolidated net sales. At October 31, 1993, the backlog of the Instrumentation Group (of which $4.6 million is expected to be filled after fiscal 1994) was $24.4 million compared with $23.9 million one year earlier. MARKETING AND DISTRIBUTION Automation Group products manufactured by Excellon are marketed domestically principally through employees and in foreign markets through employees, independent distributors, and affiliated distributors. Tulon products are marketed in the United States through employees and independent distributors and elsewhere principally through independent distributors. W.A. Whitney products are sold principally through independent distributors and representatives. Aerospace and Defense Group products manufactured by Auxitrol are marketed through employees, independent representatives, and an affiliated U.S. distributor. The products of Armtec Defense Products are marketed domestically and abroad by employees and independent representatives. Midcon Cables' products are marketed domestically by employees and independent representatives. Republic Electronics' products are marketed domestically by employees and abroad by independent representatives. Hytek's services are marketed domestically through employees. TA Mfg. products are marketed domestically and abroad by employees and independent representatives. Instrumentation Group products manufactured by Angus Electronics are marketed domestically through employees, independent representatives and distributors, and abroad through independent representatives and employees of Esterline's Auxitrol subsidiary. Scientific Columbus' products are sold through independent representatives. The products of Federal Products are marketed domestically principally through employees, and in foreign markets through both employees and independent representatives. Korry Electronics' products are marketed domestically and abroad principally through employees and independent representatives. For most of the Company's products, the maintenance of a service capability is an integral part of the marketing function. RESEARCH AND DEVELOPMENT The Company's subsidiaries conduct product development and design programs with approximately 175 professional engineers, technicians and support personnel, supplemented by independent engineering and consulting firms when needed. In fiscal 1993, approximately $14 million was expended for research, development and engineering, compared with $13.4 million in 1992 and $16.6 million in 1991. FOREIGN OPERATIONS The Company's principal foreign operations consist of manufacturing facilities of Auxitrol located in France and Spain, a manufacturing facility of Tulon located in Mexico, and sales and service operations of Excellon located in England, Germany and Japan. In addition, W.A. Whitney has a small manufacturing and distribution facility in Italy. For information as to sales, operating results and assets by geographic area and export sales, reference is made to Note 1 to the Consolidated Financial Statements on page 20, and Note 12 to the Consolidated Financial Statements on pages 28 and 29, of the Company's Annual Report to Shareholders for the fiscal year ended October 31, 1993, which is incorporated herein by reference. EMPLOYEES The Company and its subsidiaries had approximately 2,800 employees at October 31, 1993, a decrease of approximately 300 employees from October 31, 1992. COMPETITION AND PATENTS The Company's subsidiaries experience varying degrees of competition with respect to all of their products and services. Most subsidiaries are in specialized market niches with relatively few competitors. In automated drilling equipment for printed circuit board manufacturing, Excellon Automation is a leader in its field and believes it has the largest installed base in the world of automated drilling machines for the production of printed circuit boards. In molded fiber cartridge cases, mortar increments and other combustible ammunition components, Armtec currently is the sole supplier to the U.S. Army. In addition, Hytek is one of the largest metal finishers on the West Coast, and Korry Electronics, Federal Products, W.A. Whitney, and TA Mfg. are among the leaders in their respective markets. The Company's subsidiaries generally compete with many larger companies with substantially greater volume and financial resources. The Company believes the main competitive factors for the Company's products is product performance and service. Overall, the Company believes its ongoing product development and design programs, coupled with a strong customer service orientation, keep its various product groups competitive in the marketplace. The subsidiaries hold a number of patents but in general rely on technical superiority, exclusive features in their equipment and marketing and service to customers to meet competition. Patents and licenses which help maintain a significant advantage over competition include the patents covering a switch mechanism which Korry uses in its integrated panel product line, and a long-term license agreement under which Auxitrol manufactures and sells electrical penetration assemblies. SOURCES AND AVAILABILITY OF RAW MATERIALS AND COMPONENTS The Company's subsidiaries are not materially dependent for their raw materials and components upon any one source of supply except for certain components and supplies such as plasma torches, CNC controls and hydraulic components purchased by W.A. Whitney and certain other raw materials and components purchased by other subsidiaries. In such instances, ongoing efforts are conducted to develop alternative sources or designs to help avoid the possibility of any business impairment. (d) Financial Information About Foreign and Domestic Operations and Export Sales. See "Foreign Operations" above. ITEM 2. ITEM 2. PROPERTIES The following table summarizes the principal properties owned or leased by the Company and its subsidiaries as of October 31, 1993: The Company group (business segment) operating each facility described above is indicated by the letter following the description of the facility, as follows: (A) - Automation (D) - Aerospace and Defense (I) - Instrumentation In addition to the properties listed above, a 44,000 square foot facility in Torrance, CA and a 64,000 square foot facility in Nashua, NH are owned by the Company and planned for sale. Liabilities have been accrued for environmental remediation costs expected to be incurred in the disposition of the Nashua facility. In the opinion of the management of the Company, the subsidiaries' plants and equipment are in good condition, adequate for current operations and provide sufficient capacity for up to 25% expansion at most locations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In late 1992, Korry Electronics received a subpoena for records from the Department of Defense, Office of the Inspector General, and became aware of a government investigation focusing on whether Korry properly certified that certain switches used in military equipment were in compliance with applicable specifications and testing standards. The Company has supplied records requested in the subpoena and is engaged in discussions with government officials. The investigation remains open, but the Company currently believes that this matter will not have a material adverse affect on its financial position or results of operations. The Company has various lawsuits, claims, investigations and contingent liabilities arising from the conduct of business, including those associated with government contracting activities, none of which, in the opinion of management, is expected to have a material effect on the Company's financial position or results of operations. 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 ended October 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The names and ages of all executive officers of the Company and the positions and offices held by such persons as of January 21, 1994 are as follows: Mr. Hurlbut has been Chairman of the Board, President and Chief Executive Officer since January 1993. From February 1989 to December 1992, he was President and Chief Executive Officer. From May 1988 to February 1989, he was President and Chief Operating Officer. Mr. Stevenson has been Executive Vice President and Chief Financial Officer, Secretary and Treasurer since October 1987. Mr. Cremin has been Senior Vice President and Group Executive since December 1990. From October 1987 to December 1990, he was Group Vice President. Mr. Kring has been Group Vice President since August 1993. For more than five years prior to that date, he was President of Heath Tecna Aerospace Co., a unit of Ciba Composites Division, Anaheim, California. Mr. Larson has been Group Vice President since April 1991. For more than five years prior to that date, he held various executive positions with Korry Electronics, including President and Executive Vice President, Marketing. Mr. Zuker has been Group Vice President since March 1988. Ms. Greenberg has been Vice President, Human Relations since March 1993. For more than five years prior to that date, she was a partner in the law firm of Bogle & Gates, Seattle, Washington. Mr. Meden has been Vice President, Corporate Development since October 1987. Mr. Thompson has been Vice President and Controller since October 1987. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The following information which appears in the Company's Annual Report to Shareholders for fiscal 1993 is hereby incorporated by reference: (a) The high and low market prices of the Company's common stock for each quarterly period during the fiscal years ended October 31, 1993 and 1992, respectively (page 15 of the Annual Report to Shareholders). (b) The approximate number of holders of common stock (page 15 of the Annual Report to Shareholders). (c) Restrictions on the ability to pay future cash dividends (Note 4 to Consolidated Financial Statements, pages 21 and 22 of the Annual Report to Shareholders). No cash dividends were paid during the fiscal years ended October 31, 1993 and 1992 as the Company continued its policy of retaining all internally generated funds to support the long-term growth of the Company and to retire debt obligations. The principal market for the Company's common stock is the New York Stock Exchange. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Company hereby incorporates by reference the Selected Financial Data of the Company which appears on page 15 of the Company's Annual Report to Shareholders for fiscal 1993. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company hereby incorporates by reference Management's Discussion and Analysis of Results of Operations and Financial Condition which is set forth on pages 12, 13 and 14 of the Company's Annual Report to Shareholders for fiscal 1993. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company hereby incorporates by reference the Consolidated Financial Statements and the report thereon of Deloitte & Touche, dated December 17, 1993, which appear on pages 16 - 31 of the Company's Annual Report to Shareholders for fiscal 1993, including Note 13, page 30, which contains unaudited quarterly financial data. 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. The Company hereby incorporates by reference the information set forth under "Election of Directors" in the definitive form of the Company's Proxy Statement, relating to its Annual Meeting of Shareholders to be held on March 30, 1994, to be filed with the Securities and Exchange Commission and the New York Stock Exchange on or before February 10, 1994. (b) Executive Officers. Information concerning the Company's executive officers may be found in Part I of this Report following Item 4. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Company hereby incorporates by reference the information set forth under "Executive Compensation" in the definitive form of the Company's Proxy Statement, relating to its Annual Meeting of Shareholders to be held on March 30, 1994, to be filed with the Securities and Exchange Commission and the New York Stock Exchange on or about February 10, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Company hereby incorporates by reference the information with respect to stock ownership set forth under "Security Ownership of Certain Beneficial Owners and Management" in the definitive form of the Company's Proxy Statement, relating to its Annual Meeting of Shareholders to be held on March 30, 1994, to be filed with the Securities and Exchange Commission and the New York Stock Exchange on or about February 10, 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 (a) (1) Financial Statements. The following consolidated financial statements, together with the report thereon of Deloitte & Touche, dated December 17, 1993, appearing on pages 16 - 31 of the Company's Annual Report to Shareholders for fiscal 1993, are hereby incorporated by reference: The following additional financial data should be read in conjunction with the consolidated financial statements in the Annual Report to Shareholders for the fiscal year ended October 31, 1993: Independent Auditors' Report Schedule V -- Property, Plant and Equipment Schedule VI -- Accumulated Depreciation of Property, Plant and Equipment Schedule VIII -- Valuation and Qualifying Accounts and Reserves Schedule IX -- Short-Term Borrowings Schedule X -- Supplementary Income Statement Information (a) (3) Exhibits. (b) Reports on Form 8-K. No reports on Form 8-K were filed during the fourth quarter of fiscal 1993. 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. ESTERLINE TECHNOLOGIES CORPORATION (Registrant) By /s/ Robert W. Stevenson ------------------------ Robert W. Stevenson Executive Vice President and Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer) Dated: January 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. INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders Esterline Technologies Corporation Bellevue, Washington We have audited the financial statements of Esterline Technologies Corporation as of October 31, 1993 and 1992, and for each of the three years in the period ended October 31, 1993, and have issued our report thereon dated December 17, 1993; such financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the financial statement schedules of Esterline Technologies Corporation, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Deloitte & Touche - ---------------------- Deloitte & Touche Seattle, Washington December 17, 1993 ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (in thousands) For Years Ended October 31, 1993 and 1992 (1) Includes the related effects of the FY 1993 restructuring. ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (in thousands) For Years Ended October 31, 1993 and 1992 ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (in thousands) For Years Ended October 31, 1993, 1992 and 1991 ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS (in thousands) (1) Borrowings are under a line of credit of $35 million. (2) Borrowings are made by foreign subsidiaries from a number of banks located in countries in which the subsidiaries have operations. (3) Determined by averaging the borrowings outstanding at each month-end during the fiscal year. (4) Determined by averaging interest rates at each month-end during the fiscal year. ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE X-- SUPPLEMENTARY INCOME STATEMENT INFORMATION (in thousands) The following items have been charged to costs and expenses as stated: The following items have been charged to costs and expenses but do not individually exceed one per cent of net sales: Taxes, other than payroll and income taxes Royalties Advertising costs ESTERLINE TECHNOLOGIES CORPORATION Form 10-K Report for Fiscal Year Ended October 31, 1993 INDEX TO EXHIBITS -----------------

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Item 1. Business. The Company Millipore Corporation was incorporated under the laws of Massachusetts on May 3, 1954. Millipore and its subsidiaries operate in a single business segment, the analysis, identification and purification of fluids using separations technology. Business segment information is discussed in Note M to the Millipore Corporation Consolidated Financial Statements (the "Financial Statements") included in the Millipore Corporation Annual Report to Shareholders for the year ended December 31, 1993 (the "Annual Report"), which note is hereby incorporated herein by reference. Unless the context otherwise requires, the terms "Millipore" or the "Company" mean Millipore Corporation and its subsidiaries. On November 11, 1993, Millipore announced that its Board of Directors had approved a plan to focus the Company on its membrane business and to divest operations of its Instrumentation Divisions (the Waters Chromatography business and the non-membrane bioscience instrument business). The description of Millipore's business contained herein treats both the Waters Chromatography Business and the non-membrane bioscience business (the "Instrumentation Divisions") as discontinued operations. These Divisions with separate product lines with separate customers are accounted for as discontinued operations. The Company expects to realize a net gain in 1994 upon the disposition of these businesses. Operations of the discontinued Instrumentation Divisions subsequent to November 11, 1993 are set forth in the Company's Balance Sheet and are not material to its financial position; operations prior to that date are included in the Company's 1993 Consolidated Statement of Income. For a description of Millipore's business which includes no discontinued operations reference is made to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. Millipore is a leader in the field of membrane separations technology. The Company develops, manufactures and sells products which are used primarily for the analysis and purification of fluids. The Company's products are based on a variety of membranes and certain other technologies and effect separations, principally through physical and chemical methods. Millipore is an integrated multinational manufacturer of these products. During 1993, approximately 62% of Millipore's net sales were made to customers outside the Americas. For financial information concerning foreign and domestic operations and export sales, see Note M to the Financial Statements. Products and Technologies For analytical applications, the Company's products are used to gain knowledge about a molecule, compound or micro-organism by detecting, identifying and quantifying the relevant components of a sample. For purification applications, the Company's products are used in manufacturing and research operations to isolate and purify specific components or to remove contaminants. The principal separation technologies utilized by the Company are based on membrane filters, and certain chemistries, resins and enzyme immunoassays. Membranes are used to filter either the wanted or the unwanted particulate, bacterial, molecular or viral entities from fluids, or concentrate and retain such entities (in the fluid) for further processing. Some of the Company's newer membrane materials also use affinity, ion-exchange or electrical charge mechanisms for separation. Both analytical and purification products incorporate membrane and other technologies. The Company's products include disc and cartridge filters and housings of various sizes and configurations, filter-based test kits and precision pumps and other ancillary equipment and supplies. The Company has more than 3,000 products. Most of the Company's products are listed in its catalogs and are sold as standard items, systems or devices. For special applications, the Company assembles custom products, usually based upon standard modules and components. In certain instances, the Company also designs and engineers process systems specifically for the customer. Customers and Markets The Company's continuing operations sells its products primarily to customers in the following markets: pharmaceutical/biotechnology, microelectronics, chemical and food and beverage companies; government, university and private research and testing laboratories; and health care and medical facilities. Within each of these markets, the Company focuses its sales efforts upon those segments where customers have specific requirements which can be satisfied by the Company's products. Pharmaceutical/Biotechnology Industry. The Company's products are used by the pharmaceutical/biotechnology industry in sterilization, including virus reduction, and sterility testing of products such as antibiotics, vaccines, vitamins and protein solutions; concentration and fractionation of biological molecules such as vaccines and blood products; cell harvesting; isolation and purification of compounds from complex mixtures and the purification of water for laboratory use. The Company's membrane products also play an important role in the development of new drugs, particularly with respect to the mechanism through which they act. In addition, Millipore has developed and is developing products for biopharmaceutical applications in order to meet the separations requirements of the biotechnology industry. Microelectronics Industry. The microelectronics industry uses the Company's products to purify the liquids and gases used in the manufacturing processes of semiconductors and other microelectronics components, by removing particles and unwanted contaminating molecules. Chemical Industry. This industry uses the Company's products for purification of reagent grade chemicals, for monitoring in the industrial workplace and of waste streams and in the purification of water for laboratory use. Food and Beverage Industry. The Company's products are widely used by the food and beverage industry in quality control and process applications principally to monitor for microbiological contamination; to remove bacteria and yeast from products such as wine and beer, in order to prevent spoilage, and in producing pure water for laboratory use. Universities and Government Agencies. Universities, government and private and corporate research and testing laboratories, environmental science laboratories and regulatory agencies purchase a wide range of the Company's products. Typical applications include: purification of proteins; cell culture, structure studies and interactions; concentration of biological molecules; fractionation of complex molecular mixtures; and collection of microorganisms. The Company's water purification products are used extensively by these organizations to prepare high purity water for sensitive assays and the preparation of tissue culture media. Health Care and Medical Research. Customers in this field include hospitals, clinical laboratories, medical schools and medical research institutions who use the Company's products to filter particulate and bacterial contaminants which may be present in intravenous solutions, and its water purification products to produce high purity water. Sales and Marketing The Company sells its products within the United States primarily to end users through its own direct sales force. The Company sells its products in foreign markets through the sales forces of its subsidiaries and branches located in more than 25 major industrialized and developing countries as well as through independent distributors in other parts of the world. During 1993, the Company's marketing, sales and service forces consisted of approximately 360 employees in the United States and 520 employees abroad. The Company's marketing efforts focus on application development for existing products and on new and differentiated products for other existing, newly-identified and proposed customer uses. The Company seeks to educate customers as to the variety of analytical and purification problems which may be addressed by its products and to adapt its products and technologies to separations problems identified by customers. The Company believes that its technical support services are important to its marketing efforts. These services include assistance in defining the customer's needs, evaluating alternative solutions, designing a specific system to perform the desired separation and training users. Research and Development In its role as a pioneer of membrane separations Millipore has traditionally placed heavy emphasis on research and development. Research and development activities include the extension and enhancement of existing separations technologies to respond to new applications, the development of new membranes, and the upgrading of membrane based systems to afford the user greater purification capabilities. Research and development efforts also identify new separations applications to which disposable separations devices would be responsive, and develop new configurations into which membrane and ion exchange separations media can be fabricated to efficiently respond to the applications identified. Instruments, hardware, and accessories are also developed to incorporate membranes, modules and devices into total separations systems. Introduction of new applications frequently requires considerable market development prior to the generation of revenues. Millipore performs substantially all of its own research and development and does not provide material amounts of research services for others. Millipore's research and development expenses in 1991, 1992 and 1993 with respect to continuing operations were, $32,633,000, $32,953,000 and $34,952,000 respectively. When it believes it to be in its long-term interests, the Company will license newly developed technology from unaffiliated third parties and/or will acquire exclusive distribution rights with respect thereto. Competition The Company's continuing operations face intense competition in all of its markets. The Company believes that its principal competitors include Pall Corporation, Barnstead Thermolyne Corporation, Sartorius GmbH, and Gelman, Inc. Certain of the Company's competitors are larger and have greater resources than the Company. However, the Company believes that it offers a broader line of products, making use of a wider range of separations technologies and addressing a broader range of applications than any single competitor. While price is an important factor, the Company competes primarily on the basis of technical expertise, product quality and responsiveness to customer needs, including service and technical support. Acquisitions, Restructuring, and Divestitures On November 11, 1993 Millipore announced that its Board of Directors had approved a plan to divest its Instrumentation Division (the Waters Chromatography and non-membrane bioscience businesses) in order to focus the Company on its membrane business. The Waters Chromatography business was acquired in 1980. Growth in the analytical instrument market has been limited in the past few years. In the years 1986-1988 the Company expanded its MilliGen division in order to extend its analytical and chemical capabilities into the bio-instrumentation and chemicals field. In 1990 this business was consolidated into Millipore's then existing businesses, in order to achieve better focus and meaningful economics. The Company believes that the divestiture of its chromatography business along with that of its non- membrane bioscience business, will enable Millipore to better serve its membrane customers, improve operating performance and increase shareholder value. It is anticipated that the divestiture of the Instrumentation Divisions will be completed in the first half of 1994 and is anticipated to result in a net gain. At the time of the 1990 consolidation of MilliGen, the Company took certain other actions to improve profitability, these measures in total resulted in a non-recurring charge in the fourth quarter of 1990 amounting to $34,750,000. The Company took a further charge, with respect to the restructuring of its Waters Chromatography Division, of $13,000,000 in the first quarter of 1993. In the five-year period prior to its November 11, 1993 announcement concerning the sale of its Waters Chromatography and non-membrane bioscience business, the Company undertook a number of initiatives to expand its business into new markets within the field of analysis and purification. The Company has made several small, strategic acquisitions to accelerate technology and market development in its several divisions. These included the acquisition of the Bio Image division of Kodak in 1989, Extrel Corporation in February of 1992, and Immunosystems Incorporated in July of 1992. In November of 1989, the Company sold its process water division for approximately $54,000,000 in cash. Included in the transaction were the worldwide facilities and equipment and other assets for developing, manufacturing and marketing that division's complete line of water purification products, other than its laboratory scale water business. Also included were the Company's 18 service deionization branches located throughout the continental United States. This transaction is the subject of litigation brought by Eastern Enterprises (see "Legal Proceedings"). Other Information In April, 1988, the Company adopted a shareholder rights plan (the "Rights Plan") and declared a dividend to its shareholders of the right to purchase (a "Right"), for each share of Millipore Common Stock owned, one additional share of Millipore Common Stock at a price of $160 for each share. The Rights Plan is designed to protect Millipore's shareholders from attempts by others to acquire Millipore on terms or by using tactics that could deny all shareholders the opportunity to realize the full value of their investment. The Rights will be exercisable only if a person or group of affiliated or associated persons acquires beneficial ownership of 20% or more of the outstanding shares of the Company Common Stock or commences a tender or exchange offer that would result in a person or group owning 20% or more of the outstanding Common Stock. In such event, or in the event that Millipore is subsequently acquired in a merger or other business combination, each Right will entitle its holder to purchase, at the then current exercise price, shares of the common stock of the surviving company having a value equal to twice the exercise price. Millipore has been granted a number of patents and licenses and has other patent applications pending both in the United States and abroad. While these patents and licenses are viewed as valuable assets, Millipore's patent position is not of material importance to its operations. Millipore also owns a number of trademarks, the most significant being "Millipore." Millipore's products are made from a wide variety of raw materials which are generally available in quantity from alternate sources of supply; as a result, Millipore is not substantially dependent upon any single supplier. Millipore's business is neither seasonal nor dependent upon a single or limited group of customers. Bringing the Company's facilities into compliance with federal, state and local laws regulating the discharge of materials into the environment or otherwise relating to the protection of the environment has not, to date, had a material effect upon Millipore's capital expenditures, earnings or competitive position. (See "Legal Proceedings.") As of December 31, 1993, Millipore's continuing operations employed 3,664 persons worldwide, of whom 1,938 were employed in the United States and 1,726 overseas. Executive Officers of Millipore There follows a listing as of March 1, 1994 of the Executive Officers of Millipore. All of the following individuals were elected to serve until the Directors Meeting next following the 1994 Annual Stockholders Meeting. First Elected: To An Present Name Age Office Officer Office John A. Gilmartin 51 Chairman of the Board 1980 1986 President and Chief (Chairman Executive Officer of in 1987) the Corporation Geoffrey Nunes 63 Senior Vice President 1976 1980 General Counsel Douglas A. Berthiaume 45* Senior Vice President 1985 1989 of the Corporation Jack T. Johansen 51* Senior Vice President 1987 1989 of the Corporation Glenda K. Burkhart 42 Vice President 1993 1993 of the Corporation Douglas B. Jacoby 47 Vice President 1989 1989 of the Corporation Michael P. Carroll 43 Vice President of the Corporation Chief Financial Officer and Treasurer 1992 1992 Dominique F. Baly 45 President Intertech - 1988 Division of Millipore John E. Lary 47 Senior Vice President - 1993 and General Manager - Americas Operation Geoffrey D. Woodard 54 President of - 1989 Millipore's Analytical Group * It is anticipated that Messrs. Berthiaume and Johansen will leave the employ of the Company to head up the businesses to be divested, Waters Chromatography and non-membrane bioscience respectively. Mr. Gilmartin joined Millipore's finance department in 1978, was elected Vice President and Chief Financial Officer in 1980, Senior Vice President in 1982, and to the additional position of President of the Membrane Division in 1985. In 1986, Mr. Gilmartin was elected President and Chief Executive Officer of the Company and to the additional position of Chairman in 1987. Mr. Nunes joined Millipore in 1976 as Vice President and General Counsel and was elected a Senior Vice President in 1980. Mr. Berthiaume joined Millipore in 1980, was elected Vice President and Chief Financial Officer in 1985, and as a Senior Vice President in 1989. Dr. Johansen joined Millipore in 1987 as Vice President and was elected a Senior Vice President in 1989. Ms. Burkhart joined Millipore in 1993 as Corporate Vice President/Human Resources. Prior to joining Millipore, she was a principal of Mass Burkhart, a strategy consulting firm (1991-1993), responsible for organization development and work force planning for Exxon Chemical (1989-1991), a principal for Synectics, an organizational development consulting firm (1987- 1989), and a consultant for Bain and Co., a strategy consulting firm (1985- 1987). Mr. Jacoby joined Millipore in 1975. After serving in various sales and marketing capacities, Mr. Jacoby became Director of Marketing for the Millipore Membrane Products Division in 1983 and in 1985, he assumed the position of General Manager of the Membrane Pharmaceutical Division. Since 1987, Mr. Jacoby has been responsible for the Company's process membrane business. Mr. Jacoby was elected a Corporate officer in December, 1989. Mr. Carroll joined Millipore in 1986 as Vice President/Finance for the Membrane Products Division following a ten-year career in the general practice audit division of Coopers and Lybrand. In 1988, Mr. Carroll assumed the position of Vice President of Information Systems (worldwide) and in December of 1990, he became the Vice President of Finance for the Company's Waters Chromatography Division. Mr. Carroll was elected to his current position in February, 1992. Mr. Baly joined Millipore, S.A. (France) in 1972. For at least five years prior to relocating to the U.S. to assume his current position as President of the Millipore Intertech Division in 1988, Mr. Baly held positions of increasing sales and marketing responsibility within Millipore's European operations including Vice President/General Manager of the Millipore Products Division (1986-1987) and the Waters Chromatography Division (1984- 1985). Mr. Lary is Senior Vice President and General Manager of the Americas Operation, a position he has held since May, 1993. For the ten years prior to that time, he served as Senior Vice President of the Membrane Operations Division of Millipore. Mr. Woodard joined Millipore (U.K.) Ltd. (England) in 1976 and for the next seven years served in product management and marketing positions in Europe. In 1983, he was named Director of Marketing for Millipore Europe, and, in 1985, he relocated to the U.S. to assume the position of Director of Product Management for the Membrane Products Division. He continued in this position until 1986 when he became Vice President and General Manager of the Laboratory Products Division. In 1989 Mr. Woodard became President of the Membrane Analytical Group. Messrs. Baly, Lary and Woodard were first listed as executive officers in the Company's Annual Report on Form 10-K for 1989, the year it was determined they met the Securities and Exchange Commission's definition of "executive officer". Item 2. Item 2. Properties. Millipore owns in excess of 1.6 million square feet of facilities located in the United States, Europe and Japan. The following table identifies the principal properties owned by Millipore and describes the purpose, floor space and land area of each. Sq.Ft. of Floor Land Location Facility Space Area Bedford, Executive Offices, research, 346,000 32 acres Mass. pilot production & warehouse Milford,* Manufacturing, research, 410,000 31 acres Mass. office & warehouse Cidra, Manufacturing, warehouse Puerto Rico and office 134,000 36 acres Jaffrey, Manufacturing, warehouse 169,000 32 acres N.H. and office Pittsburgh,* Manufacturing, research 55,000 7 acres PA and office Molsheim, Manufacturing, warehouse 165,200 20 acres France and office Yonezawa, Manufacturing and warehouse 156,300 7 acres Japan Taunton,* Manufacturing 32,000 12 acres Mass. Cork, Manufacturing 83,000 20 acres Ireland St. Quentin Office and research 50,000 5 acres France _____________________________________ * It is anticipated that these properties will be sold in connection with the divestiture of the Waters Chromatography and non-membrane bioscience businesses. In addition to the above properties, Millipore has entered into a long term lease for premises abutting its Bedford facility. This lease makes 75,000 square feet of building available to Millipore and contains rights of first refusal and options with respect to the purchase of the premises by Millipore. During 1988 Millipore entered into a 10-year lease for a building of 130,000 square feet located in Burlington, Massachusetts, approximately 5 miles from its Bedford headquarters. This lease contains a single 5-year extension option. In 1991, the Company entered into two long term lease arrangements. The first was a sublease of a 130,000 square foot office building located in Marlborough, Massachusetts. This lease expires at the end of 1995 and Millipore has obtained from the owner an option to lease these premises for an additional five years. This facility is being used as the consolidated headquarters for all the Company's U. S. sales and support operations. It is anticipated that the Company will vacate these premises in 1994 and will not exercise its renewal option. The second lease arrangement is a 15-year lease with renewal options for an aggregate of 20 years, as well as a purchase option covering a 134,000 square foot building which is adjacent to the Company's Bedford facility and will be used for expansion purposes, initially the consolidation of the Company's Process System Division (part of the Membrane Process Group). In addition to its foregoing properties, Millipore currently leases various manufacturing, sales, warehouse, and administrative facilities throughout the world. Such leases expire at different times through 2017. The rented space aggregate is approximately 1,050,000 square feet and cost was approximately $8,068,000 in 1993. No single lease, in the opinion of Millipore, is material to its operations. Millipore is of the opinion that all the facilities owned or leased by it are well maintained, appropriately insured, in good operating condition and suitable for their present uses. Item 3. Item 3. Legal Proceedings. Millipore has been sued in the Superior Court for Middlesex County, Massachusetts by Eastern Enterprises and its subsidiary, Ionpure Technologies, Inc. ("Ionpure"), alleging misrepresentations made in conjunction with the sale by Millipore of its Process Water Division to Ionpure in November of 1989. The Company believes it has adequate and complete defenses to this litigation and intends to vigorously defend the action. Although the Company is unable to predict with certainty the outcome of the lawsuit, its ultimate disposition is not expected to have a material adverse effect on Millipore's financial condition. Millipore has been notified in nine instances that the United States Environmental Protection Agency ("EPA") has determined that a release or a substantial threat of a release of hazardous substances (a "Release") as defined in Section 101 of the Comprehensive Environmental Response Compensation and Liability Act of 1980 ("CERCLA") as amended by the Superfund Amendments and Reauthorization Act of 1986 (SARA) (the so-called "Superfund" law) has occurred at certain sites to which chemical wastes generated by the manufacturing operations of Millipore or one of its divisions may have been sent. These notifications typically also allege that Millipore may be a responsible party under CERCLA with respect to any remedial action needed to control or prevent any such Release. Under CERCLA the EPA may undertake remedial action in response to a Release and responsible parties may by liable, without regard to fault or negligence, for costs incurred. As a result it is possible, although highly unlikely given the large number and size of financially solvent corporations participating at each site who have been similarly notified, that the Company might be liable for all of the costs incurred in such a cleanup. In each instance Millipore knows that it is only one of many companies and entities which received such notification and who may likewise be held liable for any such remedial costs. In 1992, the EPA unexpectedly proposed settlements for several of these sites. Based on those proposed settlements and all other information available to management, the Company recorded a provision of $5,800,000 against cost of sales which, in management's best estimate, when combined with previously established reserves, will be sufficient to satisfy all known claims by the EPA. In seven separate instances involving a total of ten such sites; the Company has entered into consent decrees; paid approximately $13.9 million; and received partial releases. The aggregate of any future potential liabilities is not expected to have a material adverse effect on Millipore's financial condition. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. This item is not applicable. PART II Item 5. Item 5. Market for Millipore's Common Stock, and Related Stockholder Matters. The information called for by this item is set forth under the caption "Millipore Stock Prices" on page 51 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, which information is hereby incorporated herein by reference. Item 6. Item 6. Selected Financial Data. The information called for by this item is set forth under the caption "Millipore Corporation Eleven Year Summary of Operations" on pages 48 and 49 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, which information is hereby incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information called for by this item is set forth under the caption "Management's Discussion and Analysis" on pages 33 and 34 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, which information is hereby incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The information called for by this item is set forth on pages 35 to 47 and under the caption "Quarterly Results (Unaudited)" on page 50 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, which information is hereby incorporated herein by reference. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure. This item is not applicable. PART III Item 10. Item 10. Directors and Executive Officers of Millipore. The information called for by this item with respect to registrant's directors and compliance with Section 16(a) of the Securities Exchange Act of 1934 as amended is set forth under the caption "Management and Election of Directors--Nominees for Election as Directors" on pages 2 - 8 of Millipore's definitive Proxy Statement, dated March 18, 1994, for Millipore's Annual Meeting of Stockholders to be held on April 21, 1994, which information is hereby incorporated herein by reference. Information called for by this item with respect to registrant's executive officers is set forth under "Executive Officers of Millipore" in Item 1 of this report. Item 11. Item 11. Executive Compensation. The information called for by this item is set forth under the caption "Management and Election of Directors-Executive Compensation" on pages 8 - 17 of Millipore's definitive Proxy Statement, dated March 18, 1994, for Millipore's Annual Meeting of Stockholders to be held on April 21, 1994, which information is hereby incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information called for by this item is set forth under the caption "Ownership of Millipore Common Stock" on page 18 of Millipore's definitive Proxy Statement, dated March 18, 1994, for Millipore's Annual Meeting of Stockholders to be held April 21, 1994, which information is hereby incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions. The information called for by this item is set forth under the caption "Management and Election of Directors - Executive Compensation" on pages 2 - 8 and 12 - 17 of Millipore's definitive Proxy Statement, dated March 18, 1994, for Millipore's Annual Meeting of Stockholders to be held on April 21, 1994, which information is hereby 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 The financial statements set forth on pages 35 through 47, the Report of Independent Accounts on Page 47 and the Quarterly Results (Unaudited) set forth on page 50 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, are hereby incorporated herein by reference. Filed as part of this report are: (1) Report of Independent Accountants on the Financial Statement Schedules included in Form 10-K Annual Report. (2) Consent of Independent Accountants relating to the incorporation of their report on the Consolidated Financial Statements and their report on the Financial Statement Schedules into Registrant's Securities Act Registration Nos. 2-72124, 2-85698, 2-91432, 2-97280, 33-37319, 33-37323 and 33-11-790 on Form S-8 and Securities Act Registration Nos. 2-84252, 33-9706, 33-20792, 33- 22196, 33-47213 on Form S-3. 2. Financial Statement Schedules Schedule V Property, Plant and Equipment - Consolidated Schedule VI Accumulated Depreciation of Property, Plant and Equipment - Consolidated Schedule VIII Valuation and Qualifying Accounts Schedule IX Short-term Borrowings Schedule X Supplementary Income Statement Information All Schedules other than those listed above have been omitted because they are not applicable or not required under Regulation S-X. Items 5 through 8 and Item 14 (a) (1) of this Annual Report on Form 10-K incorporate only the indicated portions of Pages 33 through 51 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993; no other portion of such Annual Report to Shareholders shall be deemed to be incorporated herein or filed with the Commission. For purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos.: 2-72124; 2-85698; 2-91432; 2-97280; 33-37319; 33-37323 and 33- 11-790: Insofar as indemnification for liabilities arising under the Securities Act of 1933 (The "Act") 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. 3. Exhibits: A. Incorporated by Reference Document Incorporated Referenced Document on file with the Commission (3) Amendment to Restated Articles Form 10-K Report for of Organization dated May 22, year ended 12/31/87 1987 and By Laws and Form 10-K Report for year ended 12/31/90 respectively (4) Indenture dated as of March 30, Registration Statement 1988, relating to the issuance on Form S-3 (No. of $100,000,000 principal amount 33-20792); and a of Registrant's 9.20% Notes Due Form T-1 (No. 1998 22-18144) (10) Millipore's various employee benefit and executive compensation plans and arrangements are incorporated herein by reference to the indicated documents filed with the Commission: Document Referenced Document on File Incorporated with the Commission: Shareholder Rights Agreement Form 8-K Report for April, 1988 dated as of April 15, 1988 between Millipore and The First National Bank of Boston Long Term Restricted Stock Form 10-K Report for the year (Incentive) Plan for Senior ended December 31, 1984. Management 1985 Combined Stock Option Form 10-K Report for the year Plan ended December 31, 1985 Supplemental Savings and Form 10-K Report for the year Retirement Plan for Key ended December 31, 1984. Salaried Employees of Millipore Corporation Long Term Performance Plan Form 10-K Report for the year for Senior Executives ended December 31, 1984. Executive Termination Form 10-K Report for the year Agreement ended December 31, 1984. B. The following Exhibits are filed herewith: (10) Executive "Sale of Business" Incentive Termination Agreements (2) (11) Computation of Per Share Earnings (13) Annual Report to Shareholders, December 31, 1993 (21) Subsidiaries of Millipore (23) Consents of Experts (see page 21 hereto) (24) Power of Attorney (b) On November 30, 1993 the Company filed a Current Report on Form 8-K reporting on our November 11, 1993 event, the issuance of its press release announcing plans to divest its Waters Chromatography business and exit its non-membrane bioscience business. Said Report contained the following Company financial statements: (i) Consolidated Statements of Income (Restated) for the nine months ended September 30, 1993 and September 30, 1992. (ii) Consolidated Statements of Income (Restated) for each of the first three quarters of 1993 and the nine months ended September 30, 1993. (iii) Consolidated Statements of Income (Restated) for each quarter of 1992 and for the full year ended December 31, 1992. (iv) Consolidated Statements of Income (Restated) for each quarter of 1991 and for the full year ended December 31, 1991. (v) Consolidated Balance Sheet (Restated) as of September 30, 1993 and December 31, 1992. 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. MILLIPORE CORPORATION Geoffrey Nunes By /s/ Geoffrey Nunes Senior Vice President Dated: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacity and on the dates indicated. SIGNATURE TITLE DATE JOHN A. GILMARTIN* Chairman, President, February 10, 1994 John A. Gilmartin Chief Executive Officer, and Director /s/ Michael P. Carroll Vice President February 10, 1994 Michael P. Carroll Chief Financial Officer Treasurer CHARLES D. BAKER* Director February 10, 1994 Charles D. Baker ______________________ Director February 10, 1994 Samuel C. Butler MARK HOFFMAN* Director February 10, 1994 Mark Hoffman GERALD D. LAUBACH* Director February 10, 1994 Gerald D. Laubach STEVEN MULLER* Director February 10, 1994 Steven Muller THOMAS O. PYLE* Director February 10, 1994 Thomas O. Pyle JOHN F. RENO* Director February 10, 1994 John F. Reno JAMES L. VINCENT* Director February 10, 1994 James L. Vincent WARREN E. C. WACKER* Director February 10, 1994 Warren E. C. Wacker *By /s/ Geoffrey Nunes Attorney-in-Fact Geoffrey Nunes REPORT OF INDEPENDENT ACCOUNTANTS Our report on the consolidated financial statements of Millipore Corporation has been incorporated by reference in this Form 10-K from Page 47 of the 1993 Annual Report to Shareholders of Millipore Corporation. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index (Item 14 (a)2 - Financial Statement Schedules) on Page 14 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Boston, Massachusetts January 24, 1994, except as to the information presented in Note F, for which the date is March 3, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Millipore Corporation on Form S-8 (File Nos. 2-91432, 2-72124, 2-85698, 2- 97280, 33-37319, 33-37323, 33-11-790), and on Form S-3 (File Nos. 2-84252, 33- 9706, 33-22196, 33-20792, 33-47213) of our report dated January 24, 1994, except as to the information presented in Note F, for which the date is March 3, 1994, on our audits of the consolidated financial statements and financial statement schedules of Millipore Corporation as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992, and 1991, which report is incorporated by reference in this Annual Report on Form 10-K. COOPERS & LYBRAND Boston, Massachusetts March 24, 1994 Millipore Corporation Schedule X - Supplementary Income Statement Information (In Thousands) Charged to Costs and Expenses Year ended December 31, Item 1993 1992 1991 Maintenance and Repairs * * * Depreciation and Amortization of intangible assets, preoperating costs and similar deferrals * * * Taxes, other than payroll and income taxes * * * Royalties * * * Advertising costs $ 7,447 $ 5,950 $ 5,368 * Less than 1% of total sales - ------------------------------------------------------------------------ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K ANNUAL REPORT OF MILLIPORE CORPORATION For the Fiscal Year Ended December 31, 1993 **************** EXHIBITS **************** - ---------------------------------------------------------------- INDEX TO EXHIBITS Exhibit No. Description Tab No. (10) Executive "Sales of Business" 1 Incentive Termination Agreements (2) (11) Computation of Per Share Earnings 2 (13) Annual Report to Shareholders, December 31, 1993 3 (21) Subsidiaries of Millipore 4 (23) Consents of Experts (see page 21 hereto) (24) Power of Attorney 5

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ITEM 1. BUSINESS THE NORTHEAST UTILITIES SYSTEM Northeast Utilities (NU) is the parent company of the Northeast Utilities system (the System). It is not itself an operating company. Through four of NU's wholly-owned subsidiaries (The Connecticut Light and Power Company [CL&P], Public Service Company of New Hampshire [PSNH], Western Massachusetts Electric Company [WMECO] and Holyoke Water Power Company [HWP]), the System furnishes electric service in Connecticut, New Hampshire and western Massachusetts. In addition to their retail electric service, CL&P, PSNH, WMECO and HWP (including its wholly-owned subsidiary Holyoke Power and Electric Company) together furnish firm wholesale electric service to eight municipalities and utilities. The System companies also supply other wholesale electric services to various municipalities and other utilities. NU serves about 30 percent of New England's electric needs and is one of the 20 largest electric utility systems in the country. NU acquired PSNH, the largest electric utility in New Hampshire, in June 1992. PSNH was in bankruptcy reorganization proceedings from January 1988 to May 1991, when it emerged from bankruptcy in the first step of an NU- sponsored two-step plan of reorganization. NU's acquisition of PSNH was the second step of the reorganization plan. On October 1, 1993, the Bankruptcy Court in New Hampshire formally terminated the bankruptcy proceeding. See Item 3, Legal Proceedings. PSNH continues to operate its core electric utility business, but pursuant to the reorganization plan, PSNH transferred its 35.6 percent interest in the Seabrook nuclear generating facility (Seabrook) in Seabrook, New Hampshire to North Atlantic Energy Corporation (NAEC), a special purpose subsidiary of NU which sells the capacity and output of that unit to PSNH under two life-of-unit, full cost recovery contracts. In June 1992, NU's subsidiary North Atlantic Energy Service Corporation (North Atlantic) assumed operational responsibility for Seabrook. Before that, Seabrook had been operated by a division of PSNH. Other wholly-owned subsidiaries of NU provide support services for the System companies and, in some cases, for other New England utilities. Northeast Utilities Service Company (NUSCO or the Service Company) provides centralized accounting, administrative, data processing, engineering, financial, legal, operational, planning, purchasing and other services to the System companies. Northeast Nuclear Energy Company (NNECO) acts as agent for the System companies and other New England utilities in operating nuclear generating facilities in Connecticut. North Atlantic acts as agent for the System companies and other New England utilities in operating Seabrook. Two other subsidiaries construct, acquire or lease some of the property and facilities used by the System companies. NU has two other principal subsidiaries, Charter Oak Energy, Inc. (Charter Oak) and HEC Inc. (HEC), which have non-utility businesses. Directly and through subsidiaries, Charter Oak develops and invests in cogeneration, small power production and independent power production facilities. HEC provides energy management services for commercial, industrial and institutional electric customers. See "Non-Utility Businesses." COMPETITION AND MARKETING Competition within the electric utility industry is increasing. In response, NU has developed, and is continuing to develop, a number of initiatives to retain and continue to serve its existing customers and to expand its retail and wholesale customer base. These initiatives are aimed at keeping customers from either leaving NU's retail service territory or replacing NU's electric service with alternative energy sources and at attracting new customers. Management believes that CL&P, PSNH and WMECO must continue to be responsive to their business customers, in particular, in dealing with the price of electricity and to recognize that many business customers have alternatives such as fuel switching, relocation and self- generation if the price of electricity is not competitive. A System-wide emphasis on improved customer service is a central focus of the reorganization of NU that became effective on January 1, 1994. The reorganization entails realignment of the System into two new core business groups. The first core business group, the energy resources group, is devoted to energy resource acquisition and wholesale marketing and focuses on nuclear, fossil and hydroelectric generation, wholesale power marketing and new business development. The second core business group, the retail business group, oversees all customer service, transmission and distribution operations and retail marketing in Connecticut, New Hampshire and Massachusetts. These two core business groups are served by various support functions known collectively as the corporate center. In connection with NU's reorganization, the System has begun a corporate reengineering process which should help it to identify opportunities to become more competitive while improving customer service and maintaining a high level of operational performance. ECONOMIC DEVELOPMENT The cost of doing business, including the price of electricity, is higher in the System's service area, and the Northeast generally, than in most other parts of the country. Relatively high state and local taxes, labor costs and other costs of doing business in New England also contribute to competitive disadvantages for many industrial and commercial customers of CL&P, PSNH and WMECO. These disadvantages have aggravated the pressures on business customers in the current weakened regional economy. As a result, state and local governments in the region frequently offer incentives to attract new business development to, and to expand existing businesses within, their states. Since 1991, CL&P and WMECO have worked actively with state and local economic development authorities to package incentives for a variety of prospective or expanding customers. These economic development packages typically include both electric rate discounts and incentive payments for energy efficient construction, as well as technical support and energy conservation services. In general, electric rate discounts are phased out over varying periods generally not in excess of ten years. From September 1991 through March 1, 1994, economic development rate agreements had been reached with approximately 45 industrial and commercial customers in the three states served by the System, including 38 customers in CL&P's service territory, one customer in PSNH's service territory and six customers in WMECO's service territory. As an adjunct to their economic development efforts, CL&P and WMECO have also developed programs which provide incentives to customers planning to construct or significantly renovate commercial or industrial buildings within the System's service territory. Approximately 40 percent of all such construction qualifies for incentive payments for the installation or retrofitting of energy-efficient equipment designed to result in permanent savings for the customer in addition to any savings that result from the rate discounts. The business expansion-related rate agreements cover small-to- medium-sized industrial companies and a few medium-sized commercial business relocations. In all cases where economic development rates are in effect, the additional load and associated revenues, even though received under discounted rates, result in a net benefit to the System by making a contribution towards the System's fixed costs. During 1993, 28 customers were on economic development rate riders, including 24 CL&P customers and four WMECO customers. The net benefit to the System during 1993 as a result of these agreements was approximately $300,000. BUSINESS RETENTION/BUSINESS RECOVERY From 1983 through 1989, the System's retail kilowatt-hour sales grew by an annual average rate of 3.8 percent. Since the end of 1989, retail sales have been level, except for the addition of PSNH's electric load as a result of NU's acquisition of PSNH, effective in June 1992. The leveling effect has resulted in part from the System's conservation and load management (C&LM) efforts, but is largely due to the region's persistent weak economy. Management expects a modest improvement in the economy in 1994 and moderate electric sales growth is anticipated. To spur economic activity, NU's subsidiaries have worked in concert with state and local authorities to retain businesses that are considering relocating outside of the NU service territory. C&LM incentives are used with temporary rate reductions to produce both short-term and long-term cost savings for customers. These reductions are generally limited to five years but may be for as long as ten years. As of the end of 1993, 25 System customers received such reductions, including 19 CL&P customers, two PSNH customers and five WMECO customers. These customers in the aggregate represented less than 0.5 percent of System revenues. The NU operating subsidiaries also offer rate reductions to business entities that can demonstrate that they are encountering financial problems threatening their viability but have reasonable prospects for improvement. These "business recovery" reductions can be brief in duration, sometimes lasting only a few months, or may extend for up to five years. From the time these rates became available in late 1991 through the end of 1993, 23 CL&P customers, two PSNH customers and eight WMECO customers have been granted such rate reductions. The CL&P customers provided approximately $10 million in annual revenues; the PSNH customers provided approximately $10 million in annual revenues and the WMECO customers provided approximately $1.5 million in annual revenues. The bulk of the cost of the presently estimated discounts has been anticipated in base rates. The cost of the C&LM program is also collected from ratepayers. COMPETITIVE GENERATION A growing source of competition in the electric utility industry comes from companies that are marketing co-generation systems, primarily to those customers who can use both the electricity and the steam created by such systems. See "Regulatory and Environmental Matters - Public Utility Regulation." For instance, the Pratt & Whitney Aircraft Division of United Technologies Corporation, the System's largest industrial customer, put into service a 25-megawatt generating system in January 1993, reducing CL&P's industrial sales by approximately 1.5 percent, or $8 million, during 1993. While only a few other such systems have been installed in the System's service territory to date, the extent of growth of further self-generation cannot be predicted. To help convince retail customers not to generate their own power, CL&P, PSNH and WMECO have offered a competitive generation rate or special rate contracts that typically provide for up to ten years of rate reductions in return for a commitment not to self-generate. Two of CL&P's largest customers, together accounting for approximately $12 million of annual revenues in 1993, are operating under these arrangements. The New Hampshire Public Utilities Commission (NHPUC) also approved a special PSNH rate available for operators of sawmills to help prevent those customers from installing diesel generation. Altogether, approximately 28 System customers were on some type of competitive generation rate or special contract at the end of 1993, consisting of two CL&P customers, 20 PSNH customers and six WMECO customers. The PSNH customers provided approximately $3 million in annual revenues and the WMECO customers provided approximately $1.5 million in annual revenues. Overall, all types of flexible rate riders and special contracts offered by the System have preserved System revenues of approximately $50 million. As each subsidiary intensifies its efforts to retain existing customers and gain new customers, the number of customers covered under such flexible rates, and the number and amount of overall discounts, are expected to rise moderately over the next few years. RETAIL WHEELING In principle, retail wheeling would enable a retail customer to select an electricity supplier and force the local electric utility to transmit the power to the customer's site. While wholesale wheeling was mandated by the Energy Policy Act of 1992 (Energy Policy Act) under certain circumstances, retail wheeling is generally not required in any of the System's jurisdictions. See "Regulatory and Environmental Matters - Public Utility Regulation." In Connecticut, the Department of Public Utility Control (DPUC) has begun an investigation into the desirability of retail wheeling; a similar DPUC study undertaken in 1987 concluded that full-scale ail wheeling was not in the public interest at that time. See "Rates-Connecticut Retail Rates." In New Hampshire, there have been no legislative proposals on full- scale retail wheeling to date. In Massachusetts, bills being reviewed by legislative committees could permit limited retail wheeling in economically distressed areas and to municipal and state-owned facilities. FUEL SWITCHING/ELECTROTECHNOLOGIES A customer's ability to switch to or from electricity as an energy source for heating, cooling or industrial processes (fuel switching) will continue to provide the System with both opportunities and risks over the coming years. While it is an important load, residential electric space heating makes up only five percent of the System's retail sales. In Connecticut and Massachusetts, the risk of fuel switching among residential customers is concentrated in the area of electric to natural gas conversions with lesser risks of oil and propane conversions, while in New Hampshire, conversions to oil and propane are more common. During 1993, approximately three percent of WMECO and PSNH space heating customers converted their heating systems from electric resistance or baseboard heating. Conversion activity in CL&P's service territory was minimal during 1993 and the net number of electric space heating customers in CL&P's territory increased during 1993. Since 1992, space heating conversions on the System have not represented more than a 0.1 percent loss of annual retail sales. Nonetheless, the System operating companies have implemented a number of programs to mitigate these losses. In New Hampshire, a new thermal energy storage program is being reviewed for approval by the NHPUC. In Connecticut and Massachusetts, programs are in place to encourage the use of ground source and advanced air-to-air heat pumps in both new and existing construction. In addition, in 1993 WMECO lowered rates for its electric space heating cusomters by approximately five percent with permission from the Massachusetts Department of Public Utilities (DPU) to address the competitive threat. Because of these programs and other initiatives, NU forecasts a continued increase in the net number of electric space heating customers. With respect to residential sales, central air conditioning continues to become more common in the System's service territory. The System has also begun to test the use of electric vehicles in all three of its service territories and is working to promote the manufacture of electric vehicles and their components in the System's service area. The System's energy conservation programs which target electric heat and hot water customers can be effective in lowering electric bills substantially. In 1993, the System embarked upon two aggressive field testing programs involving heat pumps to provide residential heating, cooling and hot water heating in cost effective ways. These programs, in Massachusetts and at Heritage Village in Southbury, Connecticut, are intended to demonstrate that the combination of cost effective conservation and the use of heat pumps will provide lower cost heating, cooling and water heating than other available fuels. The System also faces commercial load loss because of fuel switching, such as in the area of electrically heated commercial buildings. Additionally, natural gas distribution companies have been actively marketing gas-fired chillers to commercial and industrial customers. Electric space and hot water heating and air conditioning have come under increasing pressure in recent years from aggressive campaigns by natural gas distribution companies seeking to add new customers. In Connecticut and Massachusetts, NU's subsidiaries have initiated market driven heating, ventilating and air-conditioning (HVAC) incentive programs, which include some design assistance, to promote efficient, nonchlorofluorocarbon refrigerant electric chillers. In response to the threat of load loss due to alternative fuel sources, the System's marketing and customer service staff works proactively to compare relative costs of alternative fuels. In most instances, accurate cost comparisons and energy conservation programs allow the System to preserve most of each customer's load by assisting the customer to achieve a more efficient use of its electric energy. WHOLESALE MARKETING In general and subject to existing contractual restrictions, the System's wholesale customers, both within and outside the System's retail service area, are free to select any supplier they choose. NU's subsidiaries do not have an exclusive franchise right to serve such customers. Thus, the wholesale segment of the System's business is highly competitive. As a result of very limited load growth throughout the Northeast in the past five years and the operation of several new generating plants, competition has grown, and a seller's market for electricity has turned into a buyer's market. Of the approximately 2,000 - 3,000 megawatts of surplus capacity in New England, the System's total is approximately 1,000 megawatts. The prices the System has been able to receive for new wholesale contracts have generally been far lower than the prices prevalent in recent years. Nevertheless, in 1993, the System sold a monthly average of 350 megawatts on a daily and short-term basis and 1,150 megawatts under preexisting long-term commitments of capacity to over 20 utilities throughout the Northeast. These sales resulted in approximately $150 million of capacity revenues. The majority of these revenues have been recognized in System company base rates. In addition, System companies entered into approximately 11 long- term sales contracts in 1993 with both new and existing customers. These contracts are expected to increase sales by a yearly average of 60 megawatts from late 1993 through 2005. The new wholesale customers include the municipal electric systems in Georgetown, Middletown, South Hadley, Princeton, Danvers, Littleton and Mansfield, all in Massachusetts. Including these new sales, the System currently has capacity sales commitments with other New England utilities to sell an aggregate 4,000 megawatt-years of capacity from 1994 through 2008. The net benefits after costs from these sales are estimated at approximately $550 million over the remaining life of the contracts. Most of these benefits will be realized over the next few years. In addition, a contract for the sale of approximately 450 megawatt- years to the municipal electric system in Madison, Maine has been signed and is awaiting certain approvals. For information on competitive pressures affecting wholesale transmission, see "Electric Operations - Generation and Transmission." Over the next five years, intense competition in the Northeast market is expected to continue as new generating facilities, located for the most part outside the System's retail service areas and contracted to sell to others, become operational. See "Regulatory and Environmental Matters - Public Utility Regulation." This increase in power supply sources could put further downward pressure on prices, but the potential price decreases may be somewhat offset by an improvement in the region's economy and the retirement of a number of the region's existing generating plants. See "Electric Operations - Generation and Transmission." SUMMARY To date, the System has not been materially affected by competition, and it does not foresee substantial adverse effect in the near future unless the current regulatory structure or practice is substantially altered. The rate, service, business development and conservation initiatives described above, portions of which are funded in base rates, plus other cost containment efforts described below, have been adequate to date in retaining customers, preventing fuel switching and attracting new customers at a level sufficient to maintain the System's revenue and profit base and should have significant positive effects in the next few years. As noted above, however, the DPUC has begun a retail wheeling investigation in Connecticut, and its outcome is uncertain at this time. In Massachusetts, retail wheeling legislation is under consideration. To date, no such initiatives are underway in New Hampshire. NU's subsidiaries benefit from a diverse retail base, and the System has no significant dependance on any one customer or industry. The System's extensive transmission facilities and diversified generating capacity position it to be a strong factor in the regional wholesale power market for the foreseeable future. The System's wholesale power business should further cushion the financial effects of competitive inroads within its service area. The System believes that the corporate reengineering process initiated in early 1994 and structural reorganization effective January 1, 1994 should better position it to compete in the retail and wholesale electric businesses in the future. RATES CONNECTICUT RETAIL RATES GENERAL CL&P's retail electric rate schedules are subject to the jurisdiction of the DPUC. Connecticut law provides that increased rates may not be put into effect without the prior approval of the DPUC, which has 150 days to act upon a proposed rate increase, with one 30-day extension possible. If the DPUC does not act within that period, the proposed rates may be put into effect subject to refund. Connecticut law authorizes the DPUC to order a rate reduction before holding a full-scale rate proceeding if it finds that (i) a utility's earnings exceed authorized levels by one percentage point or more for six consecutive months, (ii) tax law changes significantly increase the utility's profits, or (iii) the utility may be collecting rates that are more than just and reasonable. The law requires the DPUC to give notice to the utility and any customers affected by the interim decrease. The utility would be afforded a hearing. If final rates set after a full rate proceeding or court appeal are higher, customers would be surcharged to make up the difference. 1992-1993 CL&P RETAIL RATE CASE In December 1992, CL&P filed an application for rate relief with the DPUC. The updated request sought to increase CL&P's revenues by $344 million or 15.4 percent in total over three years. That increase incorporated requested annual increases of $130 million, $104 million and $110 million starting in May 1993. As an alternative to the multi-year plan, CL&P also proposed a one-time increase totaling about $280 million, or 13.9 percent. On June 16, 1993, the DPUC issued a decision (Decision) approving the multi-year plan and providing for annual rate increases of $46.0 million, or 2.01 percent, in July 1993, $47.1 million, or 2.04 percent, in July 1994 and $48.2 million, or 2.06 percent, in July 1995. The total increase granted of $141.3 million, or 6.11 percent, is approximately 42 percent of CL&P's updated request. In light of the State of Connecticut's concern over economic development and industrial and commercial rates, one important aspect of the Decision was that industrial and manufacturing rates will rise only about 1.1 percent anually over the three-year period. Other significant aspects of the Decision include the reduction of CL&P's return on equity (ROE) from 12.9 percent (CL&P had sought to continue its ROE at that level) to 11.5 percent for the first year of the multi-year plan, 11.6 percent for the second year and 11.7 percent for the third year; recognition in CL&P's rates, by 1998, of non-pension, post-retirement benefit cost accruals required under Statement of Financial Accounting Standards (SFAS) No. 106; the identification of $49 million of prior fuel overrecoveries and the use of that amount to offset a similar amount of the unrecovered balance in CL&P's generation utilization adjustment clause (GUAC); the reduction of CL&P's projected operating and maintenance expense for contingency funding by approximately $53.6 million spread over three years; and the deferral of cogeneration expenses projected for 1994 and 1995 and the future recovery of those deferred amounts (approximately $63 million in total) plus carrying costs over five years beginning July 1, 1996. The Decision also required CL&P to allocate to customers $10 million of after tax earnings from a $47.7 million property tax accounting change made in the first quarter of 1993. CL&P recorded this $10 million adjustment as a reduction to second quarter net income. On August 2, 1993, two appeals were filed from the Decision. CL&P filed an appeal on four issues. The second appeal was filed by the Connecticut Office of Consumer Counsel (OCC) and the City of Hartford, challenging the legality of the multi-year plan approved by the DPUC. The two appeals were consolidated. CL&P moved to dismiss the appeal by the City of Hartford and the OCC on jurisdictional grounds. Oral arguments were held on October 15, 1993 and February 14, 1994 on CL&P's motion to dismiss the appeals challenging the multi-year rate plan. It is not known when a decision on CL&P's motion will be issued. In addition, the Court rejected (without prejudice to renewal) the City of Hartford's and the OCC's motion to stay implementation of the second and third year of the rate plan pending the outcome of their appeal. The City of Hartford and the OCC could renew a request for a stay following the outcome of their appeal. CL&P ADJUSTMENT CLAUSES CL&P has a fossil fuel adjustment clause and a GUAC applicable to its retail electric rates. In Connecticut, the DPUC is required to approve each month the charges or credits proposed for the following month under the fossil fuel adjustment clause. These charges and credits are designed to recover or refund changes in purchased power (energy) and fossil fuel prices from those set in base rates. Monthly fossil fuel charges or credits are also subject to review and appropriate adjustment by the DPUC each quarter after full public hearings. The Connecticut clause allows CL&P to recover substantially all prudently incurred fossil fuel expenses. CL&P's current retail electric base rate schedules assume that the nuclear units in which CL&P has entitlements will operate at a 72 percent composite capacity factor. The GUAC levels the effect on rates of fuel costs incurred or avoided due to variations in nuclear generation above and below that performance level. When actual nuclear performance is above the specified level, net fuel costs are lower than the costs reflected in base rates, and when nuclear performance is below the specified level, net fuel costs are higher than the costs reflected in base rates. At the end of a twelve-month period ending July 31 of each year, with DPUC approval, these net variations from the costs reflected in base rates are generally refunded to or collected from customers over the subsequent eleven-month period beginning September 1. This clause, however, does not permit automatic collection from customers to the extent the capacity factor is less than 55 percent for the twelve-month period. When and to the extent the annual nuclear capacity factor is less than 55 percent, it is necessary for CL&P to apply to the DPUC for permission to recover the additional fuel expense. In the Decision, the DPUC disallowed recovery of $41.5 million, the GUAC deferral balance associated with operation at a nuclear capacity factor below 55 percent during the 12-month GUAC period ending July 31, 1992. In the same Decision, the DPUC also disallowed $7.5 million of the $96 million deferral balance, representing operation at a nuclear capacity factor above 55 percent for that period, which had already been approved for collection from customers through December 31, 1993. The reason given for the disallowances was CL&P's $49 million overrecovery of fuel costs through base rates and the fuel adjustment clauses for the period August 1991 to July 1992. The Decision also cut short the previously allowed recovery of $96 million in GUAC deferrals by four months. The DPUC ordered the remaining unrecovered GUAC balance of $24.6 million to be "trued-up" against the deferral for the 1992-93 GUAC year. As result of two previous prudence decisions imposing disallowances for outages at the nuclear unit (CY) operated by the Connecticut Yankee Atomic Power Company (CYAPC) and Millstone I, the DPUC also ordered CL&P to refund to customers a total of $5.1 million in the GUAC billing period beginning September 1, 1993. In the most recent GUAC period, which ended July 31, 1993, the actual level of nuclear generating performance was 72.6 percent, resulting in a GUAC deferral of $4.0 million to be credited to customers beginning in September 1993. The GUAC rate filed by CL&P for the September 1993 - August 1994 GUAC billing period had five components: the $7.5 million disallowance from the rate case, the $5.1 million of prudence disallowances, the $4.0 million credit deferral for the most recent GUAC period, and the $24.6 million debit of previously unrecovered GUAC deferrals, for a total of $7.9 million. On September 1, 1993, the DPUC issued an interim order setting a GUAC rate of zero beginning September 1, 1993, subject to a proceeding to consider further CL&P's GUAC rate for the period September 1, 1993 to July 31, 1994. On January 5, 1994, the DPUC issued a decision fixing the GUAC rate at zero through August 31, 1994 and disallowing recovery of $7.9 million through the GUAC. The disallowance was based on a comparison of fuel revenues with fuel expenses, in the August 1992 - July 1993 period. On January 24, 1994, CL&P requested the DPUC to clarify its January 5, 1994 decision with respect to future application of the GUAC. Based on management's interpretation of the January 5, 1994 decision, CL&P does not expect that any future DPUC review using this methodology will have a material adverse impact on its future earnings. On March 4, 1994, CL&P appealed the January 5 GUAC decision to Connecticut Superior Court. For the 1984-1991 GUAC periods, CL&P refunded more than $112 million to its customers through the GUAC mechanism. For the five months ended December 31, 1993, the composite nuclear generation capacity factor was 66.7 percent. For the full twelve-month period ending July 31, 1994, the factor is projected to be approximately 74.7 percent. The DPUC has opened a docket to review the prudence of the 1992 outage related to the Millstone 2 steam generator replacement project. Discovery and filing of testimony is expected to continue through May 1994 and hearings, if required, will be held in the summer of 1994. CL&P incurred approximately $88 million in replacement power costs associated with Millstone outages that occurred during the period October 1990 - February 1992. These outages were the subject of several separate prudence reviews conducted by the DPUC, three of which are either on appeal or still pending at the DPUC. On May 19, 1993, the DPUC issued a final decision allowing recovery of costs related to the July 1991 shutdown of Millstone 3 caused by mussel- fouling of the heat exchangers. Approximately $0.9 million of replacement power costs are at issue. The OCC has appealed that decision to the Connecticut Superior Court. On September 1, 1993, the DPUC issued a final decision in the prudence investigation of outages at all four Connecticut nuclear plants resulting from an erosion/corrosion-induced pipe rupture at Millstone 2 on November 6, 1991. The decision concluded that CL&P's management of its erosion/corrosion program was reasonable and prudent and that expenses incurred as a result of the outages, which total approximately $65 million ($51 million of which represents replacement power costs) for CL&P, should be allowed. The OCC has also appealed this decision to the Connecticut Superior Court. The third ongoing prudence investigation involves a Millstone 3 outage caused by repairs to the service water piping in the fall of 1991. The OCC's witness filed testimony that, as a result of the DPUC's decision finding that the concurrent mussel-fouling outage was prudent, and the fact that the mussel-fouling outage continued at least as long as the service water outage, there was no economic impact on ratepayers from the service water outage. On September 23, 1993, the DPUC suspended the service water docket pending the outcome of OCC's appeal of the decision on the mussel- fouling outage. Approximately $26 million of replacement power costs are at issue. For further information on the shutdowns of Millstone units currently under review by the DPUC, see "Electric Operations -- Nuclear Generation -- Millstone Units." Some portion of the replacement power costs reflected in the three Millstone outages, as to which the DPUC has not completed its review or as to which the DPUC's decision has been appealed, may be disallowed. However, management believes that its actions with respect to these outages have been prudent, and it does not expect the outcome of the prudence reviews to result in material disallowances. CL&P has recognized that it will not recover in rates approximately $9.4 million in replacement power costs resulting from two other shutdowns at Millstone 1: one related to the unit's licensed operators failing requalification exams and the other related to seaweed blockage at the intake structure. CL&P owns 34.5 percent of the common stock of CYAPC, a regional nuclear generating company. During the 1987-1988 refueling outage, repairs were made to CY's thermal shield. During an extended 1989-1990 refueling outage, the thermal shield was removed due to continued degradation. The DPUC reviewed these outages. In a report issued in 1990, the DPUC's auditors concluded that the actions of CYAPC's personnel and its contractors were reasonable with respect to the thermal shield's repair and removal. However, the auditors also concluded that the failure to clean the entire refueling cavity during the 1987-1988 outage was the most likely cause of debris left in the cavity that subsequently resulted in the additional damage that was repaired during the 1989-1990 outage. In October 1992, the DPUC disallowed CL&P's recovery of $3 million in replacement power costs and $230,000 of related operating and maintenance costs resulting from CY's 1989-1990 extended outage. CL&P appealed the DPUC's decision. On December 2, 1993, the Connecticut Superior Court issued a decision reversing the DPUC, in part, and upholding it in part. The court ruled in favor of CL&P by reversing the $230,000 disallowance and in favor of the DPUC by upholding the $3 million disallowance of replacement power costs. The partial reversal in favor of CL&P was based on the principle of federal preemption and is an important legal precedent for future CYAPC matters. CONSERVATION AND LOAD MANAGEMENT CL&P participates in a collaborative process for the development and implementation of C&LM programs for its residential, commercial and industrial customers. In September 1992, the DPUC approved a Conservation Adjustment Mechanism (CAM) that allows CL&P to recover C&LM costs to the extent not recovered through current base rates. The CAM authorized continued recovery of C&LM costs over a ten-year period with a return on the unrecovered costs. In December 1992, CL&P filed an application with the DPUC for approval of budgeted C&LM expenditures for 1993 of $47.5 million and a proposed CAM for 1993. On April 14, 1993, the DPUC issued an order approving a new CAM rate, which allows CL&P to recover $24 million of its budgeted $47 million C&LM expenditures during 1993 and associated true-ups of past C&LM expenditures. The order also provided that any unrecovered expenditures would be recovered over eight years. CL&P's actual 1993 C&LM expenditures were approximately $42.8 million. The unrecovered C&LM costs at December 31, 1993 excluding carrying costs were $116.2 million. On December 30, 1993, CL&P and the other participants in the collaborative process filed an offer of settlement with the DPUC regarding CL&P's 1994 C&LM expenditures, program designs, performance incentive and lost fixed cost revenue recovery. The settlement proposed a budget level of $39 million for 1994 C&LM and a reduction in the amortization period for new expenditures from eight to 3.85 years. CL&P expects additional 1994 C&LM expenditures of approximately $1 million for state facilities. The DPUC began hearings on the proposed settlement during March 1994. NEW HAMPSHIRE RETAIL RATES RATE AGREEMENT AND FPPAC NU acquired PSNH, the largest electric utility in New Hampshire, in June 1992. See "The Northeast Utilities System." PSNH's 1989 Rate Agreement (Rate Agreement) provides the financial basis for the plan under which PSNH was reorganized and became an NU subsidiary. The Rate Agreement sets out a comprehensive plan of retail rates for PSNH, providing for seven base rate increases of 5.5 percent per year and a comprehensive fuel and purchased power adjustment clause (FPPAC). The first of these base retail rate increases was put into effect in January 1990. The second rate increase took place on May 16, 1991, when PSNH reorganized as an interim, stand-alone company; the third rate increase occurred on June 1, 1992, just before NU's acquisition of PSNH; and the fourth rate increase went into effect on June 1, 1993. The remaining three increases are to be placed in effect by the NHPUC annually beginning June 1, 1994, concurrently with a semi-annual adjustment in the FPPAC. The Rate Agreement also provides for the recovery by PSNH through rates of a regulatory asset, which is the aggregate value placed by PSNH's reorganization plan on PSNH's assets in excess of the net book value of PSNH's non-Seabrook assets and the value assigned to Seabrook. In accordance with the Rate Agreement, approximately $265 million of the remaining regulatory asset is scheduled to be amortized and recovered through rates by 1998, and the remaining amount, approximately $504 million, is scheduled to be amortized and recovered through rates by 2011. PSNH is entitled to a return each year on the unamortized portion of the asset. The unrecovered balance of the regulatory asset at December 31, 1993 was approximately $769.5 million. In order to provide protection from significant variations from the costs assumed in the base rates over the period of the seven base rate increases (Fixed Rate Period), the Rate Agreement established a return on equity (ROE) collar to prevent PSNH from earning an ROE in excess of an upper limit or below a lower limit. To date, PSNH's ROE has been within the limits of the ROE collar. The FPPAC provides for the recovery or refund by PSNH, for the ten- year period beginning on May 16, 1991, of the difference between the actual prudent energy and purchased power costs and the costs included in base rates. The rate is calculated for a six-month period based on forecasted data and is reconciled to actual data in subsequent FPPAC billing periods. PSNH costs included in the FPPAC calculation are the cost of fuel used at its generating plants and purchased power, energy savings and support payments associated with PSNH's participation in the Hydro-Quebec arrangements, the Seabrook Power Contract costs billed to PSNH from NAEC, NEPOOL Interchange expense and savings, fifty percent of the joint dispatch energy expense savings resulting from the combination of PSNH and the System companies as a single pool participant, purchased capacity costs associated with other System power and unit contract capacity purchases excluding the Yankee nuclear companies and the cost to amortize capital expenditures for, and to operate, environmental or safety backfits or fuel switching. The FPPAC also provides for the recovery of a portion of the payments made currently to qualifying facilities and a portion of the costs associated with the PSNH buyback of the New Hampshire Electric Cooperative, Inc. (NHEC) entitlement in Seabrook. For information on NHEC's 1991 filing for bankruptcy and its subsequent reorganization, see "Rates - Wholesale Rates." The balance of the current payments to qualifying facilities, representing a part of the payments made currently to eight specific small power producers (SPPs), are deferred each year and amortized and recovered over the succeeding ten years. A portion of the current payments to NHEC is also deferred and will be recovered either through the FPPAC during the fixed rate period or through base rates after the fixed rate period. Recovery of the NHEC deferral through the FPPAC occurs only if the FPPAC rate is negative; in such instance, deferred NHEC costs would be recovered to the extent required to bring the FPPAC rate to zero. From June to November 1992, the FPPAC rate, which would otherwise have been negative, was set at zero, and some NHEC deferrals were amortized. The operation of the FPPAC during this period resulted in an overrecovery, which was also netted against NHEC deferrals in December 1992 and March 1993. As of December 31, 1993, SPP and NHEC deferrals totaled approximately $107.6 and $14.8 million, respectively. Under the Rate Agreement, PSNH has an obligation to use its best efforts to renegotiate the purchase power arrangements with 13 specified SPPs that were selling their output to PSNH under long term rate orders. Agreements have been reached with all five of the hydroelectric facilities under which the rates PSNH pays for their output would be reduced but the term of years for sales from the hydro producers would be extended by five years. The NHPUC held a hearing concerning these agreements on February 25, 1994. PSNH has also reached agreements with three of the eight wood-fired qualifying facilities with long term rate orders. Under each agreement, PSNH would pay each operator a lump sum in exchange for canceling the operator's right to sell its output to PSNH under rate orders. The total payment to the three operators would be approximately $91.8 million (covering approximately 35 MW of capacity). The three wood operators' agreements will be considered in hearings before the NHPUC in late spring 1994. PSNH is unable to predict if any or all of these agreements will be consummated. Although the Rate Agreement provides an unusually high degree of certainty about PSNH's future retail rates, it also entails a risk if sales are lower than anticipated, as they were in 1991 and 1992, or if PSNH should experience unexpected increases in its costs other than those for fuel and purchased power, since PSNH has agreed that it will not seek additional rate relief before 1997, except in limited circumstances. Even if allowed under the Rate Agreement, any additional increases above 5.5 percent per year are subject to political and economic pressures that tend to limit overall retail rate increases, including FPPAC increases. In accordance with the Rate Agreement, PSNH increased its average retail electric rates by about 4.5 percent in June 1993 and by 1.8 percent on December 1, 1993. The 4.5 percent increase in June resulted from the combined effect of decreasing to $.00110 per kilowatthour the FPPAC charge at the same time that (1) the fourth of the seven increases in base electric rates of 5.5 percent and (2) a temporary increase associated with recently enacted legislation associated with the settlement of the Seabrook tax suit described below took effect. The decrease in the FPPAC charge also reflected lower costs paid by PSNH through the Seabrook Power Contract for Seabrook property tax imposed on NAEC. The December 1993 increase resulted from an increase in the FPPAC rate. In its decision on the June 1, 1993 increase, the NHPUC disallowed replacement power costs for three Seabrook outages totalling about $0.4 million. On August 16, 1993, the NHPUC affirmed its decision to disallow that amount. In the August 16 decision, the NHPUC also rejected a request by the New Hampshire Office of Consumer Advocate (OCA) to allow access to certain confidential, self-critical documents generated at Seabrook station by plant personnel following outages and power reductions. PSNH has been providing summary analyses of the circumstances surrounding outages; however, it declined to provide the original self-critical documents in an effort to maintain an atmosphere in which employees would be encouraged to report and comment on all possible problems. The OCA filed an appeal of the NHPUC's decision on its request for access to these documents with the New Hampshire Supreme Court on November 16, 1993. On February 8, 1994, the court accepted the appeal. On September 14, 1993, PSNH filed a request for an increase in its FPPAC rate for the period December 1, 1993 through May 31, 1994. The increase of one percent of the average retail rate was expected to produce less than the revenues necessary to cover PSNH's FPPAC costs over these six months, a period during which Seabrook will undergo a two-month refueling outage. PSNH waived its right to immediate collection and proposed to defer about $13 million of FPPAC costs for later collection in order to limit its total rate increases for 1993 to 5.5 percent. Hearings on the FPPAC rate request were held on November 9 and 10, 1993. On November 29, 1993, the NHPUC approved a higher FPPAC rate than the rate requested by PSNH. The increase was 1.8 percent higher than rates previously in effect and allowed PSNH to recover a deferral of $10.5 million over a twelve month period beginning June 1, 1994, which ends prior to the next scheduled Seabrook refueling outage. In its June 1992 decision concerning PSNH's FPPAC rate, the NHPUC had determined that PSNH should not be entitled to recover approximately $1.3 million with respect to wholesale power agreements with two New England utilities. Also, the NHPUC had questioned the prudence of a series of short term contractual agreements (SWAP Agreements) for energy and capacity exchanges entered into between the System and PSNH prior to the merger and the allocation of savings resulting from the SWAP Agreements. In November 1992, PSNH entered into proposed settlements with the NHPUC staff and the OCA to settle these issues. The settlements proposed disallowances of approximately $500,000 for the two wholesale power agreements and $250,000 for the SWAP Agreements. On March 23, 1993, the NHPUC approved the settlements. SETTLEMENT OF THE SEABROOK TAX SUIT On April 16, 1993, the Governor of New Hampshire signed into law legislation that implemented the settlement of a suit concerning property tax on Seabrook station (the Seabrook Tax) that was filed with the United States Supreme Court by Attorneys General of Connecticut, Massachusetts and Rhode Island. The legislation made various changes to New Hampshire tax laws, resulting in taxes of approximately $5.8 million to be paid by NU on a consolidated basis in each of 1993 and 1994 and $3.0 million in 1995, a reduction from the $9.5 million paid by NU on a consolidated basis in 1992. Of such amounts to be paid, CL&P's portion will be approximately $0.6 million in each of 1993 and 1994 and approximately $0.3 million in 1995 and NAEC's portion will be approximately $5.2 million in each of 1993 and 1994 and approximately $2.7 million in 1995. MEMORANDUM OF UNDERSTANDING On May 6, 1993, PSNH, NAEC, NUSCO and the Attorney General of the State of New Hampshire entered into a Memorandum of Understanding (Memorandum) relating to certain issues which had arisen under the Rate Agreement. In part, the issues addressed relate to the enactment of the legislation implementing the settlement of the Seabrook Tax lawsuit. Pursuant to the Memorandum, tax changes imposed by the legislation will not increase PSNH's overall ratepayer charges, but will be reflected in PSNH rates pursuant to the Rate Agreement through offsetting adjustments to PSNH's base rates and FPPAC charges. On June 1, 1993, PSNH put into effect a temporary increase of $0.00074 per kilowatthour in base rates designed to recover the increased costs associated with the enactment of the legislation. A corresponding decrease in the FPPAC costs collected after June 1, 1993 offset the base rate increase. The FPPAC decrease reflected the reduction of the Seabrook property tax resulting from the legislation. The Memorandum also addresses the implementation of new accounting standards imposed by SFAS 106 and SFAS 109. The Memorandum establishes the method of accounting under SFAS 106 for employees' post-retirement benefits other than pensions for PSNH ratemaking purposes. Under SFAS 109, companies may recognize as a deferred tax asset the value of certain tax attributes. The Memorandum provides for the establishment of a regulatory liability attributable to significant net operating loss carryforwards and establishes that such liability should be amortized over a six-year period beginning on May 1, 1993. Other provisions of the Memorandum cover: NAEC's acquisition of the Vermont Electric Generation and Transmission Cooperative's (VEG&T) 0.41259% interest in Seabrook for approximately $6.4 million and NAEC's sale of the output to PSNH. All necessary regulatory approvals for NAEC's acquisition have been received and NAEC acquired VEG&T's interest on February 15, 1994. The Rate Agreement will be amended to ensure that this acquisition will not impact PSNH rates during the fixed rate period. The Rate Agreement's ROE collar floor provisions were amended to provide for the adjustment by PSNH of its revenue received from James River Corporation and Wausau Papers of New Hampshire by the amount of the demand charge discount previously approved by the NHPUC. The Rate Agreement was also amended to provide that any adjustments to the amount of PSNH's liability under the Seabrook Power Contract to reimburse NAEC for payments to the Seabrook Nuclear Decommissioning Financing Fund (a fund administered by the State of New Hampshire to finance decommissioning of Seabrook) will be recovered through adjustments to PSNH's base rates; however, such adjustments will not be subject to the annual 5.5 percent increases established under the Rate Agreement. See "Electric Operations - Nuclear Generation - Decommissioning" for further information on decommissioning costs for Seabrook station and other nuclear units that the System owns or participates in. On May 11, 1993, PSNH and the State of New Hampshire filed a petition with the NHPUC seeking approval of the Memorandum. As required for implementation, PSNH's lenders approved the Memorandum. The NHPUC hearing on the petition seeking approval of the Memorandum and a request to make the June 1, 1993, temporary base rate increase permanent was held on December 2, 1993. PSNH entered into a stipulation with the NHPUC staff and the OCA which modified the Memorandum slightly, clarifying terms of the NAEC power contract applicable to the VEG&T interest in Seabrook. The NHPUC approved the Memorandum as modified by the stipulation, the permanent base rate increase and the Third Amendment to the Rate Agreement on January 3, 1994. As a result of the approval of the Memorandum, PSNH's earnings in 1993 increased by $10 million. The cumulative impact of the issues resolved by the Memorandum is not expected to have a significant impact on PSNH's future earnings. SEABROOK POWER CONTRACT PSNH and NAEC entered into the Seabrook Power Contract (Contract) on June 5, 1992. Under the terms of the Contract, PSNH is obligated to purchase NAEC's initial 35.56942% ownership share of the capacity and output of Seabrook 1 for the term of Seabrook's NRC operating license and to pay NAEC's "cost of service" during this period, whether or not Seabrook 1 continues to operate. NAEC's cost of service includes all of its prudently incurred Seabrook-related costs, including maintenance and operation expenses, cost of fuel, depreciation of NAEC's recoverable investment in Seabrook 1 and a phased-in return on that investment. The payments by PSNH to NAEC under the Contract constitute purchased power costs for purposes of the FPPAC and are recovered from customers under the Rate Agreement. Decommissioning costs are separately collected by PSNH in its base rates. See "Rates - New Hampshire Retail Rates - Rate Agreement and FPPAC" for information relating to the Rate Agreement. If Seabrook 1 is retired prior to the expiration of the Nuclear Regulatory Commission (NRC) operating license term, NAEC will continue to be entitled under the Contract to recover its remaining Seabrook investment and a return of that investment and its other Seabrook-related costs for 39 years, less the period during which Seabrook 1 has operated. At December 31, 1993, NAEC's net utility plant investment in Seabrook 1 was $732 million. The Contract provides that NAEC's return on its "allowed investment" in Seabrook 1 (its investment in working capital, fuel, capital additions after the date of commercial operation of Seabrook 1 and a portion of the initial investment) is calculated based on NAEC's actual capitalization from time to time over the term of the Contract, its actual debt and preferred equity costs, and a common equity cost of 12.53 percent for the first ten years of the Contract, and thereafter at an equity rate of return to be fixed in a filing with the FERC. The portion of the initial investment which is included in the "allowed investment" was 20 percent for the twelve months commencing May 16, 1991, increasing by 20 percent in the second year and by 15 percent in each of the next four years, resulting in 100 percent in the sixth and each succeeding year. As of December 31, 1993, 55 percent of the investment was included in rates. NAEC is entitled to earn a deferred return on the portion of the initial investment not yet phased into rates. The deferred return on the excluded portion of the initial investment will be recovered, together with a return on it, beginning in the first year after PSNH's Fixed Rate Period, and will be fully recovered prior to the tenth anniversary of PSNH's reorganization date. Effective February 15, 1994, NAEC also owns the 0.41259% share of capacity and output of Seabrook it purchased from VEG&T. NAEC sells that share to PSNH under an agreement that has been approved by FERC and is substantially similar to the Contract; however, the agreement does not provide for a phase-in of allowed investment and associated deferrals of capital recovery. MASSACHUSETTS RETAIL RATES GENERAL WMECO's retail electric rate schedules are subject to the jurisdiction of the DPU. The rates charged under HWP's contracts with industrial customers are not subject to the ratemaking jurisdiction of any state or federal regulatory agency. Massachusetts law allows the DPU to suspend a proposed rate increase for up to six months. If the DPU does not act within the suspension period, the proposed rates may be put into effect. Under present rate-making standards, the DPU allows few adjustments to historic test year expenses to reflect the conditions anticipated by a company during the first year amended rate schedules are to be in effect. The principal adjustments that are permitted are inflation adjustments to historic test year non-fuel operation and maintenance expenses. Rate base is based on test year-end levels, and capital structure is based on test year-end levels adjusted for known and measurable changes. Current DPU practices permit WMECO to normalize most income tax timing differences. In Holyoke, Massachusetts, where HWP and Holyoke Gas and Electric Department, a municipal utility, operate side-by-side, approximately 30 HWP industrial customers sought bids as a group in 1993 for future electric service. HWP retained the load and has a 10-year contract, at substantially lower rates than in the past, to supply the group. WMECO REGULATORY ACTIVITY In December 1991, WMECO filed an application with the DPU for a retail rate increase of approximately $36 million or 9.1 percent. In April 1992, WMECO and the Massachusetts Attorney General filed a partial settlement agreement for approval by the DPU. Also in April 1992, a settlement agreement on WMECO's C&LM program budget was filed with the DPU jointly by WMECO, the Massachusetts Attorney General, Massachusetts Division of Energy Resources (DOER), the Conservation Law Foundation, Inc. (CLF) and the DPU's Settlement Intervention Staff. The settlement agreement covered WMECO's C&LM program through 1993 and included an annual budget of $17 million for both years. The parties also agreed that all expenditures and other charges relating to C&LM would be collected through a conservation charge (CC). In May 1992, the DPU accepted the WMECO retail rate case and the C&LM settlement agreements. As a result, WMECO's annual retail rates increased by $12 million, or three percent, on July 1, 1992, and by a further $11 million, or 2.7 percent, on July 1, 1993. In June 1992, the DPU resolved the remaining issues in the rate case filed in December 1991, when it issued an order on WMECO's rate design. The DPU order required the first and second year base revenue increases to be allocated so that all classes contribute the same percentage increase. In July 1992, the DPU approved an amended settlement agreement for 1992 and 1993 C&LM programs that established a CC that promoted rate stability by spreading the costs and subsequent recovery of 1992 and 1993 C&LM programs over the 18-month period from July 1, 1992 through December 31, 1993. The CC includes incremental C&LM program costs above or below base rate recovery levels, C&LM fixed cost recovery adjustments, and the provision for a C&LM incentive mechanism. In January 1993, WMECO filed with the DPU a request to reduce the CC rate by an aggregate of $3 million in 1993. On February 5, 1993, the DPU directed WMECO to file a revised CC to be effective on March 1, 1993 based on actual 1992 expenditures and the preapproved 1993 budget. The DPU approved the new CC on February 26, 1993. A motion for reconsideration was filed by certain of the parties to the original settlement. The DPU rejected that motion on July 9, 1993. WMECO filed for approval of a new CC on February 2, 1994. The DPU held a hearing on the proposed new CC on February 18, 1994. In October 1992, the DPU approved an Integrated Resource Management (IRM) settlement agreement that had been proposed by WMECO, the Attorney General, CLF, DOER and the Massachusetts Public Interest Research Group (MASSPIRG) concerning WMECO's IRM. The settlement required WMECO to submit its C&LM programs for 1994, 1995 and a portion of 1996 for approval by the DPU prior to October 1993, and to file its next IRM draft initial filing on January 3, 1994. The settlement also requires WMECO to prepare a competitive resource solicitation at least six months before its C&LM filing for any new C&LM programs it proposes. On March 16, 1993 WMECO filed a motion with the DPU to request authority to eliminate the separate (and higher) rates for residential electric heating customers by placing those customers on the same rates as the residential non-electric heating customers. WMECO proposed this change in order to be more competitive and to stem its losses of electric heating customers. On April 30, 1993, the DPU denied WMECO's request to eliminate the separate rates for residential electric heating customers but reduced the customer and energy charges for the electric heating customers to equal the comparable charges for non-electric heating customers. In November 1993, WMECO submitted its C&LM filing required in the settlement of the IRM proceeding, along with a settlement offer from WMECO, the Attorney General, DOER, CLF and MASSPIRG. The settlement offer incorporated preapproved C&LM funding levels for 1994 and 1995 of $14.2 million and $15.8 million, respectively. The settlement also provides for the recovery of lost fixed revenue and a bonus incentive if certain implementation objectives are met. On January 21, 1994, the DPU approved the settlement. On January 3, 1994, WMECO submitted its next draft initial IRM filing required by the October 1992 settlement to the DPU. The filing indicates the System does not need additional resources until at least the year 2007 and, therefore, WMECO does not intend to issue any solicitation for additional resources anytime in the foreseeable future. WMECO is presently participating in settlement discussions concerning this IRM filing. Should no settlement be reached, WMECO is scheduled to submit its initial IRM filing to the DPU in April 1994. WMECO ADJUSTMENT CLAUSE In Massachusetts, all fuel costs are collected on a current basis by means of a forecasted quarterly fuel clause. The DPU must hold public hearings before permitting quarterly adjustments in WMECO's retail fuel adjustment clause. In addition to energy costs, the fuel adjustment clause includes capacity and transmission charges and credits that result from short-term transactions with other utilities and from the operation of the Northeast Utilities Generation and Transmission Agreement (NUG&T). The NUG&T is the FERC-approved contract among the System operating companies, other than PSNH, that provides for the sharing among the companies of system-wide costs of generation and transmission and serves as the basis for planning and operating the System's bulk power supply system on a unified basis. Massachusetts law establishes an annual performance program related to fuel procurement and use, and requires the DPU to review generating unit performance and related fuel costs if a utility fails to meet the fuel procurement and use performance goals set for that utility. Goals are established for equivalent availability factor, availability factor, capacity factor, forced outage rate and heat rate. Fuel clause revenues collected in Massachusetts are subject to potential refund, pending the DPU's examination of the actual performance of WMECO's generating units. Currently pending before the DPU are investigations into the performance of WMECO's generating units for the 12-month periods ending May 31, 1992 and May 31, 1993. The DPU held a hearing on February 1, 1994 on WMECO's non-nuclear performance for the 12-month period ending May 31, 1992. Except for the order concerning CYAPC discussed below, the DPU has completed investigations of, but not yet issued decisions reviewing WMECO's actual generating unit performance for the program years between June 1987 and May 1991. The DPU has consistently set performance goals for generating units that are not wholly-owned and operated by the company whose goals are being set. The DPU has found that possession of a minority ownership interest in a generating plant does not relieve a company of its responsibilities for the prudent operation of that plant. Accordingly, the DPU has established goals, as discussed above, for the three Millstone units and for the three regional nuclear generating units (the Yankee plants) in which WMECO has minority ownership interests. The total amount of WMECO retail replacement power costs attributable to the major outages in the 1991 performance year -- the Millstone 3 July 1991 outage (mussel-fouling and service water), the Millstone 1 October 1991 outage (operator requalification examinations) and the November 1991 outages to perform pipe inspections, analysis and repair -- is approximately $17 million. In December 1992, WMECO notified the DPU that it will forego recovery of $1.2 million in replacement power costs associated with the October 1991 Millstone 1 operator requalification examination outage. The total amount of WMECO retail replacement power costs attributable to outages in the 1992-1993 performance year is approximately $17 million. Management believes that some portion of these replacement power costs may be subject to refund upon completion of the DPU's performance program reviews. However, management believes that its actions with respect to these outages have been prudent and does not expect the outcome of the DPU review to have a material adverse impact on WMECO's future earnings. In September 1992, the DPU issued a partial order pertaining to CY's extended 1989-1990 refueling outage (discussed above), disallowing the recovery of $0.6 million of incremental replacement power costs that could be attributable to the outage. WMECO filed a motion for reconsideration with the DPU in the same month, which motion is pending before the DPU. WHOLESALE RATES CL&P currently furnishes firm wholesale electric service to one Connecticut municipal electric system. PSNH serves NHEC, three New Hampshire municipal electric systems and one investor-owned utility in Vermont. HWP and its wholly-owned subsidiary, Holyoke Power and Electric Company, serve one Massachusetts municipal electric system. WMECO serves one New York investor-owned electric utility. The System's 1993 firm wholesale load was approximately 275 megawatts (MW). In 1993, firm wholesale electric service accounted for approximately 2.5 percent of the System's consolidated electric operating revenues (approximately 1.2 percent of CL&P's operating revenue, 6.0 percent of PSNH's operating revenue, 0.1 percent of WMECO's operating revenue and 21.5 percent of HWP's operating revenue). NHEC, PSNH's largest customer, representing 5.9 percent of its revenues for 1993, filed a petition for reorganization in 1991 under Chapter 11 of the United States Bankruptcy Code. A plan of reorganization for NHEC, which was confirmed by the Bankruptcy Court in March 1992 and became effective on December 1, 1993, resolves a series of disputes between PSNH and NHEC and provides for PSNH to continue to serve NHEC. The contract covering this continued service has been filed with and accepted by FERC. In addition to firm service, the System engages in numerous other bulk supply transactions that reduce retail customer costs, at rates that are subject to FERC jurisdiction, and it transmits power for other utilities at FERC-regulated rates. See "Electric Operations - Generation and Transmission" for further information on those bulk supply transactions and for information on pending FERC proceedings relating to transmission service. All of the wholesale electric transactions of CL&P, PSNH, WMECO, NAEC and HWP are subject to the jurisdiction of the FERC. For a discussion of certain FERC-regulated sales of power by CL&P, PSNH, WMECO and HWP to other utilities, see "Electric Operations -- Distribution and Load." For a discussion of sales of power by NAEC to PSNH, see "Rates - Seabrook Power Contract." For a discussion of the effects of competition on the System, see "Competition and Marketing." RESOURCE PLANS CONSTRUCTION The System's construction program expenditures, including allowance for funds used during construction (AFUDC), in the period 1994 through 1998 are estimated to be as follows: 1994 1995 1996 1997 1998 (Millions of Dollars) PRODUCTION CL&P . . . . . $ 60.9 $54.5 $44.3 $41.5 $39.6 PSNH . . . . . 10.5 7.0 13.3 8.7 15.8 WMECO . . . . 17.3 13.5 10.1 9.3 17.4 NAEC . . . . . 8.2 8.5 8.3 7.0 5.8 Other . . . . 16.2 3.0 2.0 0.7 0.5 System Total . 113.1 86.5 78.0 67.2 79.1 SUBSTATIONS AND TRANSMISSION LINES CL&P . . . . . 12.2 9.4 11.6 12.3 14.6 PSNH . . . . . 3.0 6.9 9.9 6.1 6.7 WMECO. . . . . 0.8 0.4 0.5 0.8 1.3 NAEC . . . . . 0.0 0.0 0.0 0.0 0.0 Other . . . . 0.0 0.0 0.0 0.0 0.0 System Total 16.0 16.7 22.0 19.2 22.6 DISTRIBUTION OPERATIONS CL&P . . . . . 76.1 78.8 80.9 84.1 85.5 PSNH . . . . . 22.0 11.7 10.6 14.5 14.2 WMECO. . . . . 17.4 19.3 17.3 17.2 18.7 NAEC . . . . . 0.0 0.0 0.0 0.0 0.0 Other . . . . 0.4 0.2 0.2 0.2 0.2 System Total 115.9 110.0 109.0 116.0 118.6 GENERAL CL&P . . . . . 8.6 8.8 7.2 5.8 5.1 PSNH . . . . . 2.0 3.3 1.9 2.4 2.0 WMECO . . . . 2.0 2.1 1.9 1.5 1.3 NAEC . . . . . 0.0 0.0 0.0 0.0 0.0 Other . . . . 9.9 7.4 7.8 9.8 9.8 System Total 22.5 21.6 18.8 19.5 18.2 TOTAL CONSTRUCTION CL&P . . . . . 157.8 151.5 144.0 143.7 144.8 PSNH . . . . . 37.5 28.9 35.7 31.7 38.7 WMECO . . . . 37.5 35.3 29.8 28.8 38.7 NAEC . . . . . 8.2 8.5 8.3 7.0 5.8 Other . . . . 26.5 10.6 10.0 10.7 10.5 System Total $267.5 $234.8 $227.8 $221.9 $238.5 The construction program data shown above include all anticipated capital costs necessary for committed projects and for those reasonably expected to become committed, regardless of whether the need for the project arises from environmental compliance, nuclear safety, improved reliability or other causes. The construction program data shown above generally include the anticipated capital costs necessary for fossil generating units to operate at least until their scheduled retirement dates. Whether a unit will be operated beyond its scheduled retirement date, be deactivated or be retired on or before its scheduled retirement date is regularly evaluated in light of the System's needs for resources at the time, the cost and availability of alternatives, and the costs and benefits of operating the unit compared with the costs and benefits of retiring the unit. Retirement of certain of the units could, in turn, require substantial compensating expenditures for other parts of the System's bulk power supply system. Those compensating capital expenditures have not been fully identified or evaluated and are not included in the table. FUTURE NEEDS The System's integrated demand and supply planning process is the means by which the System periodically updates its long-range resource needs. The current resource plan identifies a need for new resources beginning in 2007. Because New England and the System have surplus generating capacity and are forecasting low load growth over the next several years, the System has no current plans to construct or to contract for any new generating units. Additional capacity beyond 2007, the projected System year of need, can come from a variety of sources. The design and implementation of new C&LM programs, the timely development of economic, reliable and efficient qualifying cogeneration and small power production facilities (QFs) or independent power producer (IPP) capacity through state-sanctioned resource acquisition processes, economic utility-sponsored generating resources (including the possibility of repowering retired power plants) and purchases from other utilities will all receive consideration in the System's integrated resource planning process. With respect to demand-side management measures, the System's long- term plans rely, in part, on encouraging additional C&LM by customers. These measures, including installations to date, are projected to lower the System summer peak load in 2007 by over 1000 MW. In addition, System companies have long-term arrangements to purchase the output from QFs and IPPs under federal and state laws, regulations and orders mandating such purchases. CL&P's, PSNH's and WMECO's plans anticipate the development of QFs and IPPs supplying 710 MW of firm capacity by 1995, of which approximately 695 MW was operational in 1993. See "New Hampshire Retail Rates -- Rate Agreement and FPPAC" for information concerning PSNH's efforts to renegotiate its agreements with thirteen QFs. CL&P and WMECO filed applications with the U.S. Environmental Protection Agency to receive 203 SO2 allowances for C&LM activity as authorized by the Clean Air Act Amendments. See "Regulatory and Environmental Matters - Environmental Regulation - Air Quality Requirements." The DPUC has issued regulations establishing competitive bidding systems for future purchases by Connecticut electric utilities from QFs and IPPs and from C&LM vendors. The regulations also implement a state law which provides that a utility may seek a premium of between one and five percentage points above its most recently authorized rate of return for each multi-year C&LM program requiring capital investment by the utility. In April 1993, CL&P submitted its eighth annual filing to the DPUC on private power production, C&LM, projected avoided costs and related matters. CL&P stated that the System's existing and committed resources are expected to be sufficient to meet System capacity requirements until 2007, and therefore, CL&P did not solicit new capacity from QFs or C&LM vendors in 1993. In December 1993, the DPUC issued its final decision approving CL&P's avoided cost estimates as filed. In 1993, regulatory preapproval was obtained for all 1993 C&LM expenditures in each of the three retail jurisdictions. In addition, the DPUC authorized a maximum of 3 percent premium rate of return (after tax) on CL&P C&LM investment in 1993. WMECO is currently projected to earn $1.2 million of incentive (after tax) based on 1993 program savings. See "Rates - Connecticut Retail Rates - Conservation and Load Management" and "Rates - Massachusetts Retail Rates -WMECO Regulatory Activity" for information about rate treatment of C&LM costs. In 1988, the DPU adopted regulations requiring preapproval of Massachusetts utilities' major investments in electric generating facilities, including life extensions. In 1990, the DPU adopted new IRM regulations, which established procedures by which additional resources are planned, solicited and processed to provide for reliable electric service in a least- cost manner. The regulations provide a mechanism for preapproval (rather than after-the-fact review) of utility plant construction, procurement of non-utility generation (QFs and IPPs), and C&LM programs. The regulations specifically require that environmental externalities be considered in the evaluation of resource alternatives. In January 1994, WMECO filed its initial draft IRM filing, stating that WMECO's year of need is estimated to be 2007, and that no new capacity need be solicited at this time. WMECO is presently in settlement discussions. See "Rates-Massachusetts Retail Rates - WMECO Regulatory Activity" for further information relating to WMECO C&LM issues. In 1993, the NHPUC approved a settlement agreement related to PSNH's 1992 least cost planning filing, which defers various planning issues to PSNH's April 1, 1994 filing. In addition to the contributions from C&LM, QFs and IPPs, the System's long-term resource plan includes consideration of continued operation of certain of the System's fossil generating units beyond their current book retirement dates to the extent that it is economic, and possibly repowering certain of the System's older fossil plants. Continued operation of existing fossil units past their book retirement dates (and replacing certain critically located peaking units if they fail) is expected by 2007 to provide approximately 1,400 MW of resources that would otherwise have been retired. Repowering of some of the System's retired generating plants could make available an additional 900 MW of capacity. The capacity could be brought on line in various increments timed with the year of need. The System's need for new resources may be affected by any additional retirements of the System's existing generating units. The System companies periodically study the economics of their generating units as part of their overall resource planning process. In 1992, the DPUC ordered CL&P to submit economic analyses of the continued operation of 11 fossil steam units by April 1, 1993, and of Millstone Units 1 and 2 and CY, of which the System companies own 49 percent) by April 1, 1994. In 1993, the DPUC reviewed the continued unit operation (CUO) studies submitted by CL&P for the eleven fossil units in Connecticut and Massachusetts in its annual review of Integrated Resource Planning. The DPUC concluded that a decision was inappropriate at that time and that it would review the issue again in its management audit of CL&P and in CL&P's 1994 integrated resource planning docket. For Millstone 1 and 2 and CY, the CUO studies are in progress. Preliminary indications are that the operation of the units continues to be economic for customers. Final analyses for CY and the Millstone units will be filed with the DPUC in 1994. For planning and budgetary purposes, the System assumes that CL&P's Montville Station (497.5 MW) will be deactivated from November 1994 through October 1998. A final decision is expected to be made in 1994. Since reactivation is expected to occur in 1998, the System year of need of 2007 is unaffected. The System year of need of 2007 assumes PSNH's Merrimack 2 continues to operate. However, Merrimack 2's continued operation is in question because Merrimack 2 produces significant NOx emissions. The concern has been raised as to whether the emissions can be lowered to acceptable levels in the short and long term. In 1993, PSNH worked successfully with local, state and federal interests to arrive at a solution for Merrimack 2 NOx compliance by 1995, while deferring a decision on continued unit operation beyond 1999 to the future. For information regarding the agreement concerning NOX emissions at the Merrimack units, see "Regulatory and Environmental Matters - Environmental Regulation - Air Quality Requirements." See "Regulatory and Environmental Matters -- NRC Nuclear Plant Licensing" for further information on the NRC rule on nuclear plant operating license renewal and information on the expiration dates of the operating licenses of the nuclear plants in which System companies have interests. Before the System can make any decisions about whether license extensions for any of its nuclear units are feasible, detailed technical and economic studies will be needed. FINANCING PROGRAM 1993 FINANCINGS In January 1993, WMECO issued $60 million in principal amount of 6 7/8 percent first mortgage bonds due in 2000. In July 1993, CL&P issued $200 million and $100 million, respectively, of 5 3/4 percent and 7 1/2 percent first mortgage bonds due in 2000 and 2023, respectively. In December 1993, CL&P issued $125 million of 7 3/8 percent first mortgage bonds due in 2025. The proceeds from the foregoing issues were used to redeem outstanding bonds with interest rates ranging from 8 3/4 percent to 9 3/4 percent. In October 1993, CL&P issued $80 million of 5.30 percent preferred stock, $50 par value. The proceeds of this issuance, together with $30 million of short-term debt, were used to redeem $110 million of preferred stock with dividend rates ranging from 7.6 percent to 9.1 percent. In September 1993, the Connecticut Development Authority (CDA) issued, on behalf of CL&P, two tax-exempt variable rate pollution control revenue bonds (PCRBs) in the amounts of $245.5 million and $70 million, respectively. At the same time, the CDA issued, on behalf of WMECO, $53.8 million of tax-exempt variable rate PCRBs. The proceeds of these issues were used to redeem like amounts of tax-exempt PCRBs having less favorable structures. These refinancings will result in savings from the extension of maturities, the redemption of two issues of fixed-rate bonds with proceeds of the issuance of variable-rate bonds, the improved credit ratings of new supporting letter of credit banks and associated administrative savings. In December 1993, the New Hampshire Business Finance Authority (BFA) issued, on behalf of PSNH, $44.8 million of tax-exempt variable rate PCRBs. The proceeds of this issue were used to redeem a like amount of taxable PCRBs. Taxable BFA bonds issued on behalf of PSNH in the amount of $109.2 million are outstanding and may be refinanced with tax-exempt bonds upon the receipt of an allocation of the state's private activity volume allocation. In January 1993, CL&P, PSNH and WMECO purchased $340 million, $75 million and $52 million, respectively, of three-year variable rate debt caps. The caps were purchased to hedge the interest rate risk of the companies' respective variable rate PCRBs and were sized to approximate each respective company's then-current tax-exempt variable rate PCRB issuances. If the interest rate, based on the J. J. Kenny index, exceeds 4.5 percent (the strike rate), each company will receive payments under the terms of its respective interest rate cap agreement. In June 1993, PSNH purchased a $50 million six-month interest rate cap, a $50 million 12 month cap and a $100 million 18 month cap to hedge its interest rate exposure on its variable rate term note. The six-month and 12 month caps have a strike rate of 4.5 percent and the 18 month cap has a strike rate of 5.0 percent, all based on 90 day LIBOR. These caps were sized to approximate portions of a PSNH term note which has a quarterly sinking fund of $23.5 million. In February 1993, NU, CL&P, WMECO and the Niantic Bay Fuel Trust (NBFT) began a co-managed commercial paper program with two commercial paper dealers. Prior to this time, each company's commercial paper program was managed by one commercial paper dealer. The co-managed program was implemented to promote competition between commercial paper dealers, to increase the investor universe and to increase the range of maturities available to the issuers. On December 31, 1993, $113.0 million commercial paper was outstanding under these programs. In December 1993, NNECO issued $25 million of 7.17 percent unsecured amortizing notes maturing in 2019. The proceeds of this issuance are being used to finance the construction of a new building at Millstone station to house various administrative and technical support functions. FINANCING NUCLEAR FUEL The System requires nuclear fuel for the three Millstone units and for Seabrook 1. The requirements for the Millstone 1, Millstone 2 and CL&P's and WMECO's share of the Millstone 3 units are financed through a third party trust financing arrangement described below. All nuclear fuel for NAEC's and CL&P's shares of Seabrook 1 and PSNH's share of Millstone 3 is owned and financed directly by the respective companies. For the period 1994 through 1998, NAEC's and CL&P's shares of the cost of nuclear fuel for Seabrook 1 are estimated at $56.8 million and $6.4 million, respectively, excluding AFUDC. For the same period, PSNH's share of the cost of nuclear fuel for Millstone 3 is estimated at $6 million, excluding AFUDC. In 1982, CL&P and WMECO entered into arrangements under which NBFT owns and finances the nuclear fuel for Millstone 1 and 2 and CL&P's and WMECO's share of the nuclear fuel for Millstone 3. NBFT finances the fuel from the time uranium is acquired, during the off-site processing stages and through its use in the units' reactors. NBFT obtains funds from bank loans, the sale of commercial paper and the sale of intermediate term notes. The fuel is leased to CL&P and WMECO by the trust while it is used in the reactors, and ownership of the fuel is transferred to CL&P and WMECO when it is permanently discharged from the reactors. CL&P and WMECO are severally obligated to make quarterly lease payments, to pay all expenses incurred by NBFT in connection with the fuel and the financing arrangements, to purchase the fuel under certain circumstances and to indemnify all the parties to the transactions. The trust arrangements presently allow up to $530 million to be financed by NBFT with bank loans and commercial paper (up to $230 million) and with intermediate term notes (up to $300 million). The arrangements with the banks are in effect until February 19, 1996, and can be extended for an additional three years if the parties so agree. On December 31, 1993, NBFT had $80 million of intermediate term notes and $113 million of commercial paper outstanding. As of December 31, 1993, NBFT's investment in nuclear fuel, net of the fourth quarter 1993 lease payment made on January 31, 1994, for all three Millstone units was $172.1 million, as follows: Total CL&P WMECO System (Millions of Dollars) In process.......... $20.3 $4.7 $25.0 In stock............ 8.0 1.9 9.9 In reactor.......... 111.2 26.0 137.2 Total.......... $139.5 $32.6 $172.1 For the period 1994 through 1998, CL&P and WMECO's share of the cost of nuclear fuel for the three Millstone units that will be acquired through NBFT will be $313.5 million and $73.2 million, respectively, excluding AFUDC. Nuclear fuel costs and a provision for spent fuel disposal costs are being recovered through rates as the fuel is consumed in reactors. 1994 FINANCING REQUIREMENTS In addition to financing the construction requirements described under "Resource Plans - Construction," the System companies are obligated to meet $1,373.8 million of long-term debt maturities and cash sinking fund requirements and $76.4 million of preferred stock cash sinking fund requirements in 1994 through 1998. In 1994, long-term debt maturity and cash sinking fund requirements will be $295.3 million, consisting of $182 million of long-term debt maturities and $7 million of debt cash sinking fund requirements to be met by CL&P, $94 million of cash sinking fund requirements to be met by PSNH, $1.5 million of cash sinking funds to be met by WMECO and $10.7 million of cash sinking fund requirements to be met by other subsidiaries. These figures do not include $125 million of long-term debt redeemed by CL&P on January 7, 1994 with the proceeds of its issuance of $125 million mortgage bonds in December 1993. See "Financing Program - 1993 Financings." See "Electric Operations -- Nuclear Generation -- Operations -- Seabrook" for information on CL&P's commitment to advance funds to cover payments that a 12 percent Seabrook owner might be unable to pay with respect to Seabrook project costs. The System's aggregate capital requirements for 1994, exclusive of requirements under NBFT, are as follows: Total CL&P PSNH WMECO NAEC Other System (Millions of Dollars) Construction (including AFUDC)..... $157.8 $37.5 $37.5 $ 8.2 $26.5 $267.5 Nuclear Fuel (excluding AFUDC). (.3) 1.8 (.2) 5.8 - 7.1 Maturities......... 182.0 - - - - 182.0 Cash Sinking Funds. 7.0 94.0 1.5 - 10.7 113.2 Total.......... $346.5 $133.3 $38.8 $14.0 $37.2 $569.8 1994 FINANCING PLANS The System companies, other than CL&P, currently expect to finance their 1994 requirements through internally generated funds. CL&P may issue up to $200 million of long-term debt, primarily to finance maturing securities. This estimate excludes the nuclear fuel requirements financed through the NBFT. See "Financing Nuclear Fuel" above for information on the NBFT. In addition to financing their 1994 requirements, the System companies intend, if market conditions permit, to continue to refinance a portion of their outstanding long-term debt and preferred stock, if that can be done at a lower effective cost. On February 17, 1994, CL&P issued $140 million in principal amount of 5 1/2 percent first mortgage bonds due in 1999 and $140 million in principal amount of 6 1/2 percent first mortgage bonds due in 2004. The net proceeds were used to redeem higher cost first mortgage bonds. On March 8, 1994, WMECO contracted to issue $40 million principal amount of 6 1/4 percent first mortgage bonds due in 1999 and $50 million in principal amount of 7 3/4 percent first mortgage bonds due in 2024. The net proceeds will be used to redeem higher cost first mortgage bonds. FINANCING LIMITATIONS The amounts of short-term borrowings that may be incurred by NU, CL&P, PSNH, WMECO, HWP, NAEC, NNECO, The Rocky River Realty Company (RRR), The Quinnehtuk Company (Quinnehtuk) (RRR and Quinnehtuk are real estate subsidiaries), and HEC are subject to periodic approval by the SEC under the Public Utility Holding Company Act of 1935 (1935 Act). The following table shows the amount of short-term borrowings authorized by the SEC for each company and the amounts of outstanding short term debt of those companies at the end of 1993. Maximum Authorized Short-Term Debt Short-Term Debt Outstanding at 12/31/93* (Millions of Dollars) NU.................. $ 175.0 $ 72.5 CL&P ............... 375.0 96.2 PSNH ............... 125.0 2.5 WMECO............... 75.0 6.0 HWP................. 8.0 - NAEC................ 50.0 - NNECO............... 65.0 - RRR................. 25.0 16.5 Quinnehtuk.......... 8.0 4.3 HEC................. 11.0 2.9 ______ $200.9 _________________ * This column includes borrowings of various System companies from NU and other System companies through the Northeast Utilities System Money Pool (Money Pool). Total System short term indebtedness to unaffiliated lenders was $173.5 million at December 31, 1993. The supplemental indentures under which NU issued $175 million in principal amount of 8.58 percent amortizing notes in December 1991 and $75 million in principal amount of 8.38 percent amortizing notes in March 1992 contain restrictions on dispositions of certain System companies' stock, limitations of liens on NU assets and restrictions on distributions on and acquisitions of NU stock. Under these provisions, neither NU, CL&P, PSNH nor WMECO may dispose of voting stock of CL&P, PSNH or WMECO other than to NU or another System company, except that CL&P may sell voting stock for cash to third persons if so ordered by a regulatory agency so long as the amount sold is not more than 19 percent of CL&P's voting stock after the sale. The restrictions also generally prohibit NU from pledging voting stock of CL&P, PSNH or WMECO or granting liens on its other assets in amounts greater than five percent of the total common equity of NU. As of March 1, 1994, no NU debt was secured by liens on NU assets. Finally, NU may not declare or make distributions on its capital stock, acquire its capital stock (or rights thereto), or permit a System company to do the same, at times when there is an Event of Default under the supplemental indentures under which the amortizing notes were issued. The charters of CL&P and WMECO contain preferred stock provisions restricting the amount of short term or other unsecured borrowings those companies may incur. As of December 31, 1993, CL&P's charter would permit CL&P to incur an additional $570 million of unsecured debt and WMECO's charter would permit it to incur an additional $141.1 million of unsecured debt. In connection with NU's acquisition of PSNH, certain financial conditions intended to prevent NU from relying on CL&P resources if the PSNH acquisition strains NU's financial condition were imposed by the DPUC. The principal conditions provide for a DPUC review if CL&P's common equity falls to 36 percent or below, require NU to obtain DPUC approval to secure NU financings with CL&P stock or assets, and obligate NU to use its best efforts to sell CL&P preferred or common stock to the public if NU cannot meet CL&P's need for equity capital. At December 31, 1993, CL&P's common equity ratio was 39.1 percent. While not directly restricting the amount of short-term debt that CL&P, WMECO, RRR, NNECO and NU may incur, credit agreements to which CL&P, WMECO, HWP, RRR, NNECO and NU are parties provide that the lenders are not required to make additional loans, or that the maturity of indebtedness can be accelerated, if NU (on a consolidated basis) does not meet a common equity ratio that requires, in effect, that the NU consolidated common equity (as defined) be at least 27 percent for three consecutive quarters. At December 31, 1993, NU's common equity ratio was 30.9 percent. Credit agreements to which PSNH is a party forbid its incurrence of additional debt unless it is able to demonstrate, on a pro forma basis for the prior quarter and going forward, that its equity ratio (as defined) will be at least 21 percent of total capitalization (as defined) through June 30, 1994, 23 percent through June 30, 1995 and 25 percent thereafter. In addition, PSNH must demonstrate that its ratio of operating income to interest expense will be at least 1.5 to 1 for each period of four fiscal quarters ending after June 30, 1993 through June 30, 1994 and 1.75 to 1 thereafter. At December 31, 1993, PSNH's common equity ratio was 28.2 percent and its operating income to interest expense ratio was 2.27 to 1. See "Short-Term Debt" in the notes to NU's, CL&P's, PSNH's and WMECO's financial statements for information about credit lines available to System companies. The indentures securing the outstanding first mortgage bonds of CL&P, PSNH, WMECO and NAEC provide that additional bonds may not be issued, except for certain refunding purposes, unless earnings (as defined in each indenture, and before income taxes, and, in the case of PSNH, without deducting the amortization of PSNH's regulatory asset) are at least twice the pro forma annual interest charges on outstanding bonds and certain prior lien obligations and the bonds to be issued. The preferred stock provisions of CL&P's, WMECO's and PSNH's charters also prohibit the issuance of additional preferred stock (except for refinancing purposes) unless income before interest charges (as defined and after income taxes and depreciation) is at least 1.5 times the pro forma annual interest charges on indebtedness and the annual dividend requirements on preferred stock that will be outstanding after the additional stock is issued. Beginning with the dividends paid on NU common shares by NU in June 1990, NU's Dividend Reinvestment Plan (DRP) was amended to authorize the dividends and optional cash purchases of participating shareholders to be reinvested in NU common shares purchased either in the open market or directly from NU. NU received approximately $42.4 million in 1991 and approximately $35.6 million in 1992 of new common shareholders' equity from the reinvestment of dividends and voluntary cash investments. No funds have been raised by NU through DRP since August 1992, when management ended direct purchases and caused shares to be purchased for DRP participants in the open market. As part of the PSNH acquisition in June 1992, NU issued warrants for the purchase of NU common stock at a price of $24 per share. In 1993, NU received $8.3 million from the exercise of these warrants. As of December 31, 1993, warrants for 7,975,516 shares of NU common stock remained unexercised. NU is dependent on the earnings of, and dividends received from, its subsidiaries to meet its own financial requirements, including the payment of dividends on NU common shares. At the current indicated annual dividend of $1.76 per share, NU's aggregate annual dividends on common shares outstanding at December 31, 1993, including unallocated shares held by the ESOP trust, would be approximately $236.2 million. Dividends are payable on common shares only if, and in the amounts, declared by the NU Board of Trustees. SEC rules under the 1935 Act require that dividends on NU's shares be based on the amounts of dividends received from subsidiaries, not on the undistributed retained earnings of subsidiaries. The SEC's order approving NU's acquisition of PSNH under the 1935 Act approved NU's request for a waiver of this requirement through June 1997. PSNH and NAEC were effectively prohibited from paying dividends to NU through May 1993. Through the remainder of 1993, PSNH and NAEC did not pay dividends to permit them to build up the common equity portion of their capitalizations. Until PSNH and NAEC can begin to fund a part of NU's dividend requirements, NU expects to fund that portion of its dividend requirements with the proceeds of borrowings. The supplemental indentures under which CL&P's and WMECO's first mortgage bonds and the indenture under which PSNH's first mortgage bonds have been issued limit the amount of cash dividends and other distributions these subsidiaries can make to NU out of their retained earnings. As of December 31, 1993, CL&P had $210.6 million, WMECO had $26.5 million and PSNH had $60.8 million of unrestricted retained earnings. PSNH's preferred stock provisions also limit the amount of cash dividends and other distributions PSNH can make to NU if after taking the dividend or other distribution into account, PSNH's common stock equity is less than 25 percent of total capitalization. The indenture under which NAEC's Series A Bonds have been issued also limits the amount of cash dividends or distributions NAEC can make to NU to retained earnings plus $10 million. At December 31, 1993, $48.7 million was available to be paid under this provision. PSNH's credit agreements prohibit PSNH from declaring or paying any cash dividends or distributions on any of its capital stock, except for dividends on the preferred stock, unless minimum interest coverage and common equity ratio tests are satisfied. Certain subsidiaries of NU established the Money Pool to provide a more effective use of the cash resources of the System, and to reduce outside short term borrowings. The Service Company administers the Money Pool as agent for the participating companies. Short term borrowing needs of the participating companies (except NU) are first met with available funds of other member companies, including funds borrowed by NU from third parties. NU may lend to, but not borrow from, the Money Pool. Investing and borrowing subsidiaries receive or pay interest based on the average daily Federal Funds rate, except that borrowings based on loans from NU bear interest at NU cost. Funds may be withdrawn or repaid to the Money Pool at any time without prior notice. ELECTRIC OPERATIONS DISTRIBUTION AND LOAD The System operating companies own and operate a fully-integrated electric utility business. The System operating companies' retail electric service territories cover approximately 11,335 square miles (4,400 in CL&P's service area, 5,445 in PSNH's service area and 1,490 in WMECO's service area) and have an estimated total population of approximately 3.7 million (2.5 million in Connecticut, 780,000 in New Hampshire and 450,000 in Massachusetts). The companies furnish retail electric service in 149, 198 and 59 cities and towns in Connecticut, New Hampshire and Massachusetts, respectively. In December 1993, CL&P furnished retail electric service to approximately 1.085 million customers in Connecticut, PSNH provided retail electric service to approximately 397,000 customers in New Hampshire and WMECO served approximately 193,000 retail electric customers in Massachusetts. HWP serves approximately 25 customers in a portion of the town of Holyoke, Massachusetts. The following table shows the sources of 1993 electric revenues based on categories of customers: CL&P PSNH WMECO NAEC Total System Residential........... 39% 35% 38% - 39% Commercial............ 33 17 30 - 29 Industrial ........... 14 28 20 - 18 Wholesale* ........... 11 17 8 100% 11 Other ................ 3 3 4 - 3 ____ ____ ____ ____ ____ Total ................ 100% 100% 100% 100% 100% ______________________ * Includes capacity sales. NAEC's 1993 electric revenues were derived entirely from sales to PSNH under the Seabrook Power Contract. See "Rates - Seabrook Power Contract" for a discussion of the contract. Through December 31, 1993, the all-time maximum demand on the System was 6,191 MW, which occurred on July 8, 1993. At the time of the peak, the System's generating capacity, including capacity purchases, was 8,965 MW. The System was also selling approximately 1,431 MW of capacity to other utilities at that time. In 1993, System energy requirements were met 62 percent by nuclear units, nine percent by oil burning units, 10 percent by coal burning units, three percent by hydroelectric units, two percent by natural gas burning units and 14 percent by cogenerators and small power producers. By comparison, in 1992 the System's energy requirements were met 48 percent by nuclear units, 24 percent by oil burning units, 10 percent by coal burning units, four percent by hydroelectric units, one percent by natural gas burning units and 13 percent by cogenerators and small power producers. See "Electric Operations-Generation and Transmission" for further information. The actual changes in kWh sales for the last two years and the forecasted sales growth estimates for the 10-year period 1993 through 2003, in each case exclusive of bulk power sales, for the System, CL&P, PSNH and WMECO are set forth below: 1993 over 1992 over Forecast 1993-2003 (under) 1992 (under) 1991 Compound Rate of Growth System......... 10.9%(1) 15.3%(1) 1.4% CL&P........... (0.3)% 0.2% 1.3% PSNH........... 1.0% 1.1% 1.7% WMECO....... 0.1% (1.6)% 1.1% ___________________ (1) The percent increase in System 1992 sales over 1991 sales and 1993 sales over 1992 sales is due to the inclusion of PSNH sales beginning in June 1992. In 1990, FERC required the reclassification of bulk power sales from "purchased power" to "sales for resale" for the 1990 and later reporting years. Bulk power sales are not included in the development of any long-term forecasted growth rates. The actual changes in kWh sales for the last two years, adjusted for bulk power sales (by adding back the bulk power sales), for the System, CL&P, PSNH and WMECO are set forth below: 1993 over (under) 1992 1992 over (under) 1991 System ................... 11.8%(1) 19.7%(1) CL&P ..................... 1.2% 3.3% PSNH ..................... (9.3)% 6.7% WMECO .................... 13.5% 9.9% __________________ (1) System sales percentages reflect the inclusion of PSNH sales beginning in June 1992. Despite a warmer than normal summer that added to cooling requirements, sales showed negligible growth in 1993. Widespread economic recovery throughout the System's service territory did not occur in 1993, but there were mixed pockets of regional economic growth aided by very favorable interest rates. Curtailments in defense spending continue to affect the Connecticut, New Hampshire and western Massachusetts economies, which are heavily dependent on defense-related industries. Competition in various forms may also adversely affect the projected growth rate of sales over the next ten years. Where energy costs are a significant part of operating expenses, business customers may turn to self-generation, switch fuel sources, or relocate to other states and countries which have aggressive programs to attract new businesses. For further information on the effect of competition on sales growth rates, see "Marketing and Competition." The forecasted load growth for the System as a whole is significantly below historic rates in part because of forecasted savings from NU-sponsored C&LM programs, which are designed to minimize operating expenses for System customers and postpone the need for new capacity on the System. The forecasted ten-year growth rate of System sales would be approximately 1.8 percent instead of 1.4 percent if the System did not pursue C&LM savings. See "Resource Plans - Future Needs" for an estimate of the impact of C&LM programs on the System's need for new generating resources and for information about C&LM cost impacts and cost recovery. See "Rates - Connecticut Retail Rates" and "Rates - Massachusetts Retail Rates" for information about rate treatment of C&LM costs. With the System's generating capacity of 8,268 MW as of January 1, 1994 (including the net of capacity sales to and purchases from other utilities, and approximately 690 MW of capacity to be purchased from QFs and IPPs under existing contracts and contracts under negotiation), the System expects to meet its projected annual peak load growth of 1.3 percent reliably until at least the year 2007. The availability of new resources and reduced demand for electricity have combined to place the System and most other New England electric utilities in a surplus capacity situation. The principal resource changes were Seabrook 1's commercial operation, the full operation of the second phase of the Hydro-Quebec project, and increased availability of power from QF and IPP projects. As a consequence, the competition from capacity-long utilities as sellers and the loss of utilities that are no longer capacity- short as buyers have adversely affected the System companies' efforts to sell additional surplus capacity at the price levels that prevailed in the late 1980s. Taking into account projected load growth for the System and committed capacity sales, but not taking into account future potential capacity sales to other utilities that are not subject to firm commitments, the System's surplus capacity is expected to be approximately 1,000 MW in 1994. For further information on the effect of competition on sales of surplus capacity, see "Competition and Marketing." The System operating companies operate and dispatch their generation as provided in the New England Power Pool (NEPOOL) Agreement. In 1993, the peak demand on the NEPOOL system was 19,570 MW, which occurred in July, above the 1992 peak load of 18,853 MW in January of that year. NEPOOL has projected that there will be an increase in demand in 1994 and estimates that the summer 1994 peak load could reach 19,800 MW. NEPOOL projects that sufficient capacity will be available to meet this anticipated demand. GENERATION AND TRANSMISSION The System operating companies and most other New England utilities with electric generating facilities are parties to the NEPOOL Agreement. Under the NEPOOL Agreement, the region's generation and transmission facilities are planned and operated as part of the regional New England bulk power system. System transmission lines form part of the New England transmission system linking System generating plants with one another and with the facilities of other utilities in the northeastern United States and Canada. The generating facilities of all NEPOOL participants are dispatched as a single system through the New England Power Exchange, a central dispatch facility. The NEPOOL Agreement provides for a determination of the generating capacity responsibilities of participants and certain transmission rights and responsibilities. Pool dispatch results in substantial purchases and sales of electric energy by pool participants, including the System companies, at prices determined in accordance with the NEPOOL Agreement. The System operating companies, except PSNH, pool their electric production costs and the costs of their principal transmission facilities under the NUG&T agreement. In addition, a ten-year agreement between PSNH and CL&P, WMECO and HWP provides for a sharing of the capability responsibility savings and energy expense savings resulting from a single system dispatch. In connection with NU's acquisition of PSNH, the System proposed a comprehensive plan for opening up a transmission corridor between northern and southern New England for use in "wheeling" power of other utilities. The plan was designed to accomplish a level of access to transmission resources of the PSNH and New England Electric System (NEES) systems that could formerly be accomplished only after a series of multilateral negotiations. The plan includes provisions to (i) make 452 MW of long term transmission service available across the PSNH system from Maine to Massachusetts, Rhode Island, Connecticut and Vermont at embedded cost rates, (ii) make 200 MW of long term transmission service available by NEES for those utilities requiring deliveries across NEES's system in order to make use of access to the PSNH system, and (iii) construct new facilities as needed to expand the corridor from Maine to Massachusetts, if the cost of expansion is supported and if regulatory approvals for the expansion are received. Further, NU committed to make access to the combined NU-PSNH transmission system available for third-party wheeling transactions whenever capacity is available, and to expand the system when expansion is feasible. The principal constraints are that NU and PSNH have reserved a priority on the use of their transmission systems to serve the reliability needs of their own native load customers, and the commitment to expand would be subject to obtaining all necessary approvals. This plan became effective in October 1992, subject to the outcome of a hearing ordered by FERC in this proceeding, and the Commission's final decision in the compliance phase of the merger proceeding discussed below. NU and NEES filed offers of settlement in this proceeding in May and June 1993, respectively, and the Presiding Administrative Law Judge certified both settlement offers to the Commission in July 1993. The only contested issue was the refund and surcharge provision that was included in both offers of settlement. The Commission has not yet acted on these settlement offers. These commitments, and the entire issue of access to the NU and PSNH transmission systems by other utilities and non-utility generators, were the subject of extensive controversy in New England. On January 29, 1992, FERC issued a decision approving the acquisition and allowing NU and PSNH customers to be held harmless if other utilities and non-utility generators need to use the NU-PSNH transmission to buy or sell electricity. In accordance with the January 29 decision, on April 23, 1992 and August 4, 1992, NU made compliance filings, including transmission tariffs implementing the FERC's conditions. All tariffs have been accepted by FERC and were effective as of the merger date. FERC has issued summary determinations (without hearing) and NU has filed for rehearing of FERC's compliance tariff order in an effort to reinstate the originally proposed rates. FERC has not yet acted on NU's rehearing petition. FERC's approval of NU's acquisition of PSNH was appealed to the United States Court of Appeals for the First Circuit. On May 19, 1993, the First Circuit Court affirmed FERC's decision approving the merger but remanded to FERC one issue brought by NU related to FERC's ability to change the terms of the Seabrook Power Contract. FERC filed for en banc (full court) review by the First Circuit Court on the Seabrook Power Contract issue, which was denied. No petitions for review were filed in the U.S. Supreme Court, therefore, the First Circuit Court's decision is final. FERC has yet to initiate any proceeding on the court's remand, which would address whether FERC could modify the Seabrook Power Contract under a more stringent "public interest standard." On December 21, 1993, NU filed an appeal in the United States Court of Appeals for the District of Columbia Circuit of a FERC order directing NU to put itself on its own transmission tariffs in connection with all NU sales of wholesale power. NU had committed, as part of the PSNH merger, to place itself on its tariff when it was competing with other wholesale power suppliers to make a sale in order to "level the playing field." In its order, FERC expanded NU's merger commitment to include all transactions, regardless of whether or not NU's competitors need to use the NU transmission system. The controversy about the terms on which wheeling transactions are to be effected in New England has stimulated a series of negotiations among utilities, regulators and non-utility generators, directed at the possible development of new regional transmission arrangements. While an original draft regional transmission arrangement was not supported by all parties, there have been negotiations on a less comprehensive arrangement. Any arrangement would be subject to approval by NEPOOL members and FERC. HYDRO-QUEBEC Along with other New England utility companies, CL&P, PSNH, WMECO and HWP is each a participant in agreements to finance, construct, and operate the United States portion of direct current transmission circuits between New England and Quebec, Canada. The project was built in two phases, and now provides 2,000 MW of rated transfer capacity with Canadian facilities constructed and owned by Hydro-Quebec, a Canadian utility system. Phase 1, which entered into commercial operation in 1986, initially provided 690 MW of North-South transfer capacity. In Phase 2, the transmission line was extended to a new converter station in eastern Massachusetts. Phase 2 entered into full operation in 1991. The actual transfers over the interconnection to date have averaged in the 1,400 to 1,800 MW range. The interconnection permits a reduction in oil consumption in New England and has the potential to produce cost savings to customers through the purchase of power from Hydro-Quebec's hydroelectric generating facilities. The interconnection also reduces the level of reserves New England utilities must carry to assure that pool reliability criteria are met. The System companies are obligated to pay 34.22 percent of the annual costs of the Phase 1 facilities and 32.78 percent of the annual cost of the Phase 2 facilities. They are entitled, on the basis of a composite of these percentages, to use the capacity of the facilities for their own transactions and to share in the savings from pool energy transactions with Hydro-Quebec. The Phase 1 total project cost was $141 million and the Phase 2 total project cost was approximately $495 million. Phase 2 was constructed and is owned and operated by two companies in which NU has a 22.66 percent equity ownership interest. As an equity participant, NU guarantees certain obligations in connection with the debt financing of certain other participants that have lower credit ratings, and it receives compensation for such undertakings. When the Phase 2 facilities became fully operational in 1991, a contract covering the purchase by the New England utilities of 70 terawatthours of energy from Hydro-Quebec over a period of approximately ten years came into effect. While transactions under this contract are expected to constitute the principal use of the interconnection during the 1990s, the interconnection is also available for other energy transactions and for the "banking" of energy in Canada during off-peak hours in New England, with equivalent amounts of energy available to New England during peak hours. FOSSIL FUELS OIL The System's residual oil-fired generation stations used approximately 5.89 million barrels of oil in 1993. The System obtained the majority of its oil requirements in 1993 through contracts with three large, independent oil companies. Those contracts allow for some spot purchases when market conditions warrant, but spot purchases represented less than 15 percent of the System's fuel oil purchases in 1993. The contracts expire annually or biennially. The average 1993 price paid for fuel oil used for electric generation was approximately $14 per barrel, which was the same as the average 1992 price. No. 6 fuel oil prices were high during the first quarter of 1993 due to increased demand and firm crude oil prices. Fuel oil prices declined slightly during the second and third quarters, weakened in the fourth quarter due to weak crude prices associated with OPEC over-production and then firmed in the first quarter of 1994 due to severe weather in the Northeast. On February 1, 1994, the weighted average price being paid for the System's fuel oil had increased to $17 per barrel. The System-wide fuel oil storage capacity is approximately 2.5 million barrels. In 1993, inventories were maintained at levels between 40 - 60 percent of capacity. This inventory constitutes approximately 13 days of full load operation. GAS Currently, three system generating units, PSNH's Newington unit, WMECO's West Springfield Unit 3 and CL&P's Montville 5, can burn either residual oil or natural gas as economics dictate. The System is currently in the process of converting CL&P's Devon Units 7 & 8 into oil and gas dual-fuel generating units. Devon Unit 8's boiler conversion, which gave it gas burning capability, was completed in December 1993. Devon Unit 7's boiler conversion is scheduled for completion during its upcoming April 1994 outage. The System plans to have both units operational by the end of July 1994. Annual gas consumption depends on factors such as oil prices, gas prices and unit availability. In 1993, gas was used sparingly at the System's dual-fuel units because of the attractiveness of oil prices relative to those for natural gas. CL&P, PSNH and WMECO all have contracts with the local gas distribution companies where the Montville, Newington and West Springfield units are located, under which natural gas is made available by those companies on an interruptible basis. While WMECO and PSNH meet all of their gas supply needs for the West Springfield and Newington units through purchases from the local gas distribution company, CL&P can supply its Montville unit either by purchasing gas from the local gas distribution company at a DPUC-approved rate or by purchasing gas directly from producers or brokers and transporting that gas through the interstate pipeline system and the local gas distribution system. In 1993, all of the gas burned at Montville Unit 5 was purchased from a local gas distribution company. It is expected that gas for the Devon units will be purchased directly from producers or brokers on an interruptible basis and transported through the interstate pipeline system and the local gas distribution company. The System expects that interruptible natural gas will continue to be available for its dual-fuel electric generating units and will continue to supplement fuel oil requirements. The Iroquois Gas Transportation System, which became fully operational in November 1992, is expected to increase New England's gas supplies by at least 35 percent by November 1994. The increased availability of gas may make the option of converting other oil- burning electric generating units to gas on an interruptible dual-fuel basis more attractive to the System. COAL Currently, coal is purchased for HWP's Mt. Tom Station and for PSNH's Merrimack Units 1 and 2 and its coal-oil Schiller Units 4, 5 and 6. Mt. Tom Station received approximately 314,000 tons of coal in 1993 at an average delivered coal price of $ 43.40 per ton, which is down from the average 1992 coal price of $44.25 per ton. In 1993, HWP extended an existing contract for the majority of the coal to be supplied to Mt. Tom Station. This contract provides the System with assurance of coal supply and the flexibility to purchase some coal on the spot market. In the future, the System will evaluate whether to continue to purchase coal by contract or return to the spot market. The coal inventory for Mt. Tom Station varies between a minimum level of 30 days fuel and a maximum of approximately 100 days fuel. Typically, the higher level is achieved in December, when deliveries are suspended for the winter. The stockpile provides the plant's operating fuel until deliveries are resumed in March. Because of changes in federal and state air quality requirements, by 1995 HWP will need to change the kinds of coal that it purchases for use at Mt. Tom Station. The potential impact of changing air quality requirements on coal supplies is being evaluated, and HWP is testing various types of coal to meet these requirements. See "Regulatory and Environmental Matters - Environmental Regulation-Air Quality Requirements." In December 1991, PSNH executed a contract for the purchase of up to 100 percent of the coal requirements for PSNH's Merrimack Units 1 and 2 through December 31, 1993. This contract has been extended through December 31, 1994. Under this agreement, PSNH may also purchase coal on the spot market. In 1993, Merrimack Station received approximately 1.1 million tons of coal. The average delivered coal price in 1993 was $43.00 per ton. The coal inventory at Merrimack Station varies between a minimum of 60 days and a maximum of 90 days of fuel. Schiller Units 4, 5 and 6, PSNH's dual-fuel coal and oil fired units, are dispatched on the most economical fuel in accordance with the provisions of the NEPOOL Agreement. Schiller Station consumed approximately 236,000 tons of coal in 1993 at an average delivered price of $39.40 per ton. Schiller's 1993 coal requirements were fulfilled through three primary contracts, pursuant to which 77 percent was provided by foreign suppliers and the remaining 23 percent by a domestic supplier. FOSSIL PLANT RETIREMENTS In 1991, the System retired seven of the System's oldest, least used, and most costly oil-fired steam generating units. In 1992, five oil-burning combustion turbines were retired. The decision to retire these units reflected both the surplus of generating capacity in New England and the System's continuing efforts to reduce operation and maintenance costs. There were no significant fossil plant retirements in 1993, but the System's plan calls for deactivating, by the end of 1994 Montville Units 5 and 6, which have a capacity of 82 MW and 410 MW, respectively. A final decision on the future of these units will be made following the completion of further economic evaluations and consideration of possible alternatives. NUCLEAR GENERATION GENERAL The System companies have interests in seven operating nuclear units: Millstone 1, 2 and 3, Seabrook 1 and three other units owned by regional nuclear generating companies (the Yankee companies). System companies operate the three Millstone units, Seabrook 1 and CY. The System companies also have interests in the owned by the Yankee Atomic Electric Company (Yankee Rowe), which was permanently removed from service in 1992. CL&P and WMECO own 100 percent of Millstone 1 and 2 as tenants in common. Their respective ownership interests are 81 percent and 19 percent. CL&P, PSNH and WMECO have agreements with other New England utilities covering their joint ownership as tenants in common of Millstone 3. CL&P's ownership interest in the unit is 52.9330 percent (608 MW), PSNH's ownership interest in the unit is 2.8475 percent (32.7 MW) and WMECO's interest is 12.2385 percent (140.6 MW). NAEC and CL&P are parties to an agreement, similar to the Millstone 3 agreements, with respect to their 35.98201 percent (413.8 MW) and 4.05985 percent (46.7 MW) interests, respectively, in Seabrook. The agreements all provide for pro rata sharing of the construction and operating costs and the electrical output of each unit by the owners, as well as associated transmission costs. CL&P, PSNH, WMECO and other New England electric utilities are the stockholders of the Yankee companies. Each Yankee company owns a single nuclear generating unit. The stockholder-sponsors of a Yankee company are responsible for proportional shares of the operating costs of the Yankee company and are entitled to proportional shares of the electrical output. The relative rights and obligations with respect to the Yankee companies are approximately proportional to the stockholders' percentage stock holdings, but vary slightly to reflect arrangements under which non-stockholder electric utilities have contractual rights to some of the output of particular units. The Yankee companies and CL&P's, PSNH's and WMECO's stock ownership percentages and approximate MW entitlements in each are set forth below: CL&P PSNH WMECO System % MW % MW % MW % MW Connecticut Yankee Atomic Power Company (CYAPC) ...... 34.5 204 5.0 29 9.5 56 49.0 289 Maine Yankee Atomic Power Company (MYAPC) ............ 12.0 95 5.0 39 3.0 24 20.0 158 Vermont Yankee Nuclear Power Corporation (VYNPC)... 9.5 44 4.0 19 2.5 12 16.0 75 Yankee Atomic Electric Company (YAEC)* ............ 24.5 - 7.0 - 7.0 - 38.5 - _____________________________ * See "Yankee Units" for information about the permanent shutdown of the unit owned and operated by YAEC. CL&P, PSNH and WMECO are obligated to provide their percentages of any additional equity capital necessary for the Yankee companies. CL&P, PSNH and WMECO believe that the Yankee companies, excluding YAEC, will require additional external financing in the next several years to finance construction expenditures and nuclear fuel and for other purposes. Although the ways in which each Yankee company will attempt to finance these expenditures have not been determined, CL&P, PSNH and WMECO could be asked to provide direct or indirect financial support for one or more Yankee companies. OPERATIONS Capacity factor is a ratio that compares a unit's actual generating output for a period with the unit's maximum potential output. In 1993, the nuclear units in which the System companies have entitlements achieved an actual composite (weighted by entitlement) capacity factor of 79.9 percent. The five nuclear units operated by the System had a composite capacity factor of 80.3 percent based on normal winter claimed capability. The average capacity factor for operating nuclear units in the United States was 73.2 percent for January through September 1993 and 80.4 percent for the five System nuclear units operated in 1993, in each case using the design electrical rating method rather than normal winter claimed capability. When the nuclear units in which they have interests are out of service, CL&P, PSNH and WMECO need to generate and/or purchase replacement power. Recovery of prudently incurred replacement power costs is permitted, with limitations, through the GUAC for CL&P, through a retail fuel adjustment clause for WMECO and through a comprehensive fuel and purchased power adjustment clause (FPPAC) for PSNH. For the status of regulatory and legal proceedings related to recovery of replacement power costs for the 1990-1993 period, see "Rates - Connecticut Retail Rates," "Rates-Massachusetts Retail Rates" and "Rates - New Hampshire Retail Rates." MILLSTONE UNITS The 1993 overall performance of the three nuclear electric generating units located at Millstone station and operated by the System was substantially better than in 1992. For the twelve months ended December 31, 1993, the three units' composite capacity factor was 79.3 percent, compared with a composite capacity factor of 53.1 percent for the twelve months ended December 31, 1992 and 38.4 percent for the same period in 1991. In 1993 Millstone 1 operated at a 92.4 percent capacity factor with no extended outages. The unit began a planned refueling and maintenance outage on January 15, 1994 that is expected to last seventy-one days. Major work includes replacement of the main condenser tubes and installation of a new low pressure turbine. These modifications are intended to reduce the number of unplanned outages and improve the overall plant efficiency. In 1993 Millstone 2 operated at a 82.5 percent capacity factor. On January 13, 1993, the plant returned to service following a refueling outage that commenced on May 29, 1992. During that outage, both steam generators were replaced. The DPUC has opened a docket to review CL&P's performance in replacing Millstone 2's steam generators. See "Rates-Connecticut Retail Rates" for further information on the steam generator replacement docket. In addition to several short outages during 1993, Millstone 2 was shut down for two unplanned outages of significant duration. The first such outage began on August 5, 1993, to replace a leaking primary system valve. That outage lasted ten days. For more information on this outage, see "Electric Operations - Nuclear Generation - Operations - NRC Regulation." The second significant unplanned outage lasted twenty-six days, commencing on September 15, 1993, and was necessary to upgrade the motor-operated feedwater isolation valves. Millstone 2 is scheduled to begin a refueling and maintenance outage on July 30, 1994. The outage is currently planned for a 63-day duration. Major work activities will include a reactor vessel in-service inspection, erosion/corrosion piping inspections, motor-operated valve testing and service water piping replacement. In 1993 Millstone 3 operated at a 64.8 percent capacity factor. The unit began a refueling and maintenance outage on July 31, 1993 and completed it in 99 days. During the outage two significant issues were identified and resolved. Each of these issues resulted in an outage extension beyond original plans. The first issue required replacement of all four reactor coolant pumps due to concerns over turning vane cap screw and locking cup integrity. The second issue related to problems identified during inspection and testing of the supplementary leak collection and release system (SLCRS) and the auxiliary building ventilation system (ABVS), which provide secondary protection against radiological releases to the atmosphere. For more information on this issue, see "Electric Operations - Nuclear Generation - Operations - NRC Regulation." Resolution of these problems necessitated various modifications to these systems. No refueling or maintenance outages are planned for Millstone 3 during 1994. NUCLEAR PERFORMANCE IMPROVEMENT INITIATIVES The System's nuclear organization is taking major steps to correct identified performance weaknesses. For instance, on a 1992 to 1995 cumulative basis, NU anticipates total expenditures of approximately $2.3 billion for operation and maintenance and $440 million in capital improvements for the five plants that it operates. In addition, the comprehensive Performance Enhancement Program (PEP), authorized in 1992, continues to be one of the major initiatives that the nuclear organization is implementing to improve its overall performance. The program, in conjunction with other actions to address the long-term performance of the nuclear group, is designed to correct the root causes of the declining performance trend noted in the early 1990's. The PEP is organized into four major areas of activities, each focusing on a particular aspect of nuclear operations. The areas are management practices, programs and processes, performance assessments and functional programs. These areas were established based on an internal self-assessment completed in 1992. Detailed action plans have been prepared to address the specific activities. At the end of 1992, six of the forty-two action plans were completed and validated. An additional fourteen action plans were completed in 1993 and are awaiting validation. Seven action plans are to be completed in 1994, leaving fifteen action plans to complete during the remainder of the program. The 1993 PEP budget was $32.9 million. The System also announced a major reorganization of its Connecticut-based nuclear organization on November 8, 1993. The primary focus was realignment of engineering services along unit lines. The changes also included the appointment of a new senior vice president for Millstone station, some management consolidation, and a reorganization of the nuclear plant maintenance staff. See "Employees." In addition, most of the nuclear support staff currently located in Berlin, Connecticut will be centralized at the generating stations by the summer of 1994. To support these efforts, the System is constructing a five-story office building at Millstone station. This building will replace several temporary modular buildings and will house most of the nuclear technical support staff that is now located at various System locations. The prudence of this construction project is the subject of an ongoing inquiry by the DPUC. SEABROOK In 1993 Seabrook 1 operated at a capacity factor of 89.8 percent. The unit is currently in an 18-month operating cycle that began in November 1992. The unit is scheduled to begin a 57-day refueling and maintenance outage on April 16, 1994. During this outage, the main plant computer will be replaced. CL&P, PSNH and NAEC could be affected by the ability of other Seabrook joint owners to fund their share of Seabrook costs. Great Bay Power Corporation (GBPC), a former subsidiary of Eastern Utilities Associates and owner of 12.13 percent of Seabrook, has been in bankruptcy since February 1991. The Bankruptcy Court confirmed GBPC's reorganization plan on March 5, 1993 and approvals are required from NRC, FERC and NHPUC to consummate the plan. CL&P has committed to advance GBPC up to $12 million, secured by a high priority lien on GBPC's share of Seabrook, to cover GBPC's shortfalls in funding its share of the operation of Seabrook through June 30, 1994. As of March 1, 1994, CL&P was lending approximately $2 million to GBPC under this arrangement. GBPC has advised CL&P that it expects to consummate its reorganization plan, emerge from bankruptcy and repay CL&P for all advances by June 30, 1994. CL&P is unable to predict what impact, if any, failure of the reorganization plan to become effective will have on the operating license for Seabrook or what actions CL&P and the other joint owners of the unit may be required to take. On May 6, 1991, NHEC, PSNH's largest customer and one of the joint owners of Seabrook, filed a petition for reorganization under Chapter 11 of the Federal Bankruptcy Code. The plan of reorganization for NHEC was confirmed by the United States Bankruptcy Court on March 20, 1992 and wholesale power arrangements were accepted by FERC on July 22, 1992. On October 5, 1992, the NHPUC released an order approving NHEC's plan of reorganization. Under the plan of reorganization, NHEC will remain a customer of PSNH. The plan also provides that PSNH will purchase the capacity and energy of NHEC's 2.2 percent ownership interest in Seabrook 1 and pay all of NHEC's Seabrook costs for a ten-year period, which began July 1, 1990. On December 1, 1993, the United States Bankruptcy Court for the District of New Hampshire declared the NHEC reorganization plan effective as of that date. See "Rates--Wholesale Rates" for further information on the bankruptcy and subsequent reorganization of NHEC. At certain times, VEG&T failed to pay its share of Seabrook costs. Certain joint owners, including PSNH and CL&P, provided funds against future payments due from VEG&T to assure that funds were available to meet its ownership share of Seabrook costs. PSNH initially participated in such payments, but ceased providing such funds in January 1988, when it commenced bankruptcy proceedings under Chapter 11 of the Bankruptcy Code. The total amount contributed by PSNH until then was $976,000. The total amount contributed by CL&P was $265,000. As part of an agreement to resolve issues raised during the bankruptcy of PSNH, PSNH agreed that it or its designee would purchase the VEG&T 0.41259 percent interest in Seabrook for approximately $6.4 million. NAEC, the current owner of PSNH's ownership share in Seabrook, agreed to purchase the interest and to enter into a separate power contract with PSNH, under which PSNH would be obligated to buy from NAEC all of the capacity and output of Seabrook attributable to such interest for a period equal to the length of the NRC full power operating license for Seabrook. On January 7, 1994, the NRC approved the transfer of VEG&T's ownership share of Seabrook to NAEC. All other regulatory approvals for NAEC's purchase were received and the acquisition became effective on February 15, 1994. In settlement of their claims against VEG&T for advances, PSNH and CL&P received payment of the amounts advanced, $1.78 million and $390,000, respectively, out of proceeds of the sale, with interest thereon, for the period each advance was outstanding at the prime rate. See "Rates-New Hampshire Retail Rates-Memorandum of Understanding" and "Rates-New Hampshire Retail Rates-Seabrook Power Contract" for further information on NAEC's acquisition of VEG&T's share of Seabrook. In 1989, as part of a comprehensive settlement of Seabrook issues, PSNH agreed to make certain payments totaling $16 million to Massachusetts Municipal Wholesale Electric Company during the first eight years of Seabrook operation. As of December 31, 1993, PSNH had made approximately $7.2 million of these payments. YANKEE UNITS CY, the nuclear unit owned by MYAPC (MY) and the nuclear unit owned by VYAPC (VY) operated in 1993 at capacity factors of 73.1 percent, 74.3 percent and 74.1 percent, respectively, based on normal winter claimed capability. Yankee Rowe has not operated since October 1991. CY. As of December 31, 1993, CY, since it began commercial operation in 1968, had generated over 99 billion kWh (gross) of electricity, making it one of the most productive nuclear generating units in the United States. The unit completed, on schedule, a 66-day refueling and maintenance outage that began on May 15, 1993. The second reload of fuel clad with zircalloy was installed during this outage to replace the stainless steel clad fuel. There is one more phase to this upgrade project that, when completed, will make the operation of the reactor core more economical by allowing longer operating cycles. CY's next refueling and maintenance outage is scheduled to begin on November 12, 1994 and is expected to last 54 days. Major work activities will include auxiliary feedwater system modifications and motor-operated valve testing. The start date and length of this refueling outage may be impacted by an unplanned shutdown which occurred on February 12, 1994, when the plant was required to come off line to address integrity concerns in the safety-related service water system. CYAPC is reviewing the scope of work required and schedule for returning the unit to service from the unplanned outage. In October 1992, CYAPC filed an application with the FERC for wholesale rate relief. CYAPC requested the increase to become effective on January 1, 1993. The filing requested an increase in estimated decommissioning cost collections from $130 million to $309.1 million (in July 1992 dollars) and also proposed to adjust decommissioning accruals automatically on an annual basis beginning January 1, 1993. In December 1992, FERC accepted CYAPC's increased rates for filing, to become effective on June 1, 1993, subject to refund, and rejected the proposal to automatically adjust decommissioning accruals. A settlement between all the parties was reached in 1992 and was accepted by FERC in 1993. This included an accrual level for decommissioning of $294.2 million in 1992 dollars and an automatic increase of 5.5% annually in the decommissioning accrual for each of the next five years. MY. MY began a refueling and maintenance outage on July 31, 1993 and completed it in 75 days. During the outage, repairs were made to the reactor vessel thermal shield. VY. VY began a refueling and maintenance outage on August 27, 1993, and completed it in 59 days, including recovery from a dropped fuel bundle that suspended fuel movement for approximately 20 days. Yankee Rowe. In February 1992, YAEC's owners voted to shut down Yankee Rowe permanently and to begin preparations for an orderly decommissioning of the facility. The decision to close the generating plant eight years before the end of its operating license was based on an economic evaluation of the cost of a proposed safety review, the reduced demand for electricity in New England, the price of alternative energy sources and uncertainty about the regulatory requirements that the unit would need to meet in order to restart. See "Electric Operations-Nuclear Generation-Operations-Decommissioning" for information on YAEC's filing with FERC to collect for shutdown and decommissioning costs and the recovery of the remaining investment in the Yankee Rowe plant. The power contracts between CL&P, PSNH and WMECO and YAEC permit YAEC to recover from each its proportional share of these costs from CL&P, PSNH and WMECO. Management believes that, although Yankee Rowe was shut down eight years before the end of the unit's current license, CL&P, PSNH and WMECO will recover their investments in YAEC, along with any other costs associated with the shutdown and decommissioning of Yankee Rowe. Accordingly, the System has recognized these costs as a regulatory asset on its consolidated balance sheet and as a corresponding obligation to YAEC. NRC REGULATION As holders of licenses to operate nuclear reactors, CL&P, PSNH, WMECO, NAEC, North Atlantic, NNECO and the Yankee companies are subject to the jurisdiction of the NRC. The NRC has broad jurisdiction over the design, construction and operation of nuclear generating stations, including matters of public health and safety, financial qualifications, antitrust considerations and environmental impact. In its latest Systematic Assessment of Licensee Performance Report (SALP report) issued on October 19, 1993, the NRC gave the three Millstone nuclear plants a Category 1 rating in the area of radiological controls and a Category 2 rating in five of the seven areas rated: plant operations, maintenance/surveillance, emergency preparedness, security and engineering/technical support. The Millstone units received a Category 3 rating in the area of safety assessment/quality verification. Category 1 indicates "a superior level of performance," Category 2 indicates "a good level of performance" and Category 3 denotes "an acceptable level of performance." The evaluation covered plant activities for the period February 16, 1992 through April 3, 1993. Management expects to continue to improve performance, thereby raising these scores. The NRC issued its latest SALP report for Seabrook 1 on November 18, 1993. The report covered the interval from March 1, 1992 through August 28, 1993. This report reflects the recent revisions to the SALP program in which the number of functional evaluation areas has been reduced from seven to four: plant operations, maintenance, engineering and plant support. The evaluation rated Seabrook 1 a Category 1 in the engineering and plant support areas. In the areas of plant operations and maintenance, the unit was rated a Category 2. The NRC issued its latest SALP report for CY on May 21, 1993. The report covered the interval from July 14, 1991 through January 9, 1993. This evaluation recognized the superior performance of CY by awarding the unit a Category 1 in six of the seven areas rated: plant operations, emergency preparedness, security, engineering/technical support, safety assessment/quality verification and radiological controls. In the final area, maintenance/surveillance, CY was rated as a Category 2. Despite the overall improved performance of the Millstone units, there were a number of regulatory enforcement actions taken by the NRC in 1993. On May 4, 1993, the NRC issued to NNECO a Notice of Violation (NOV) identifying two potential violations. The first violation concerned NRC findings that a former employee was subjected to harassment and intimidation in 1989 for raising a nuclear safety concern and that senior management was not effective in dealing with the situation. The second violation involved NRC concerns that an employee may have deliberately delayed the processing of a contemplated substantial safety hazard evaluation conducted to fulfill the requirements of federal law. Following NNECO's response to the NOV, the NRC withdrew the second violation. To resolve this matter, NNECO paid a fine of $100,000 in connection with the first violation. On August 5, 1993, Millstone Unit 2 was shut down by plant personnel after extensive efforts to repair a leaking primary system valve proved unsuccessful, and a sudden increase in the leak rate was experienced. Following replacement of the damaged valve, the unit was returned to service on August 16, 1993. Recognizing the seriousness of this event and the potentially severe consequences of the failed repair efforts, NNECO performed a detailed evaluation of this event to consider potential deficiencies and identify the actions needed to prevent recurrence. The NRC also conducted a special investigation of this event and on September 22, 1993, identified to NNECO three apparent violations, related to work control planning and implementation, which were being considered for escalated enforcement. On December 3, 1993, the NRC informed NNECO that it was imposing a civil penalty of $237,500 for the three violations. NNECO has since paid the fine. On September 10, 1993, NNECO was informed by the NRC that, as a result of an investigation by the NRC Office of Investigation and a routine safety inspection of the Millstone Unit 1 nuclear power plant, two apparent violations arising from 1989 events were being considered for possible civil monetary penalties. The first issue concerned the alleged failure to initiate and perform a required engineering analysis to determine the operability of safety-related system in a timely manner. The second issue relates to allegations that the engineer who identified the system as being potentially inoperable was harassed and discriminated against in retaliation for the findings of his technical evaluations. These matters were investigated between early 1992 and June 1993 by a grand jury acting under the direction of the U.S. Attorney's Office in Bridgeport, Connecticut. The U.S. Attorney's office issued a letter on June 30, 1993, stating that no prosecutorial action would be initiated. On March 17, 1994, the NRC informed NNECO that further enforcement action with respect to this matter was not planned, because their review had determined that there was insufficient evidence to support the apparent violations. On September 20, 1993, the NRC issued to NNECO an NOV concerning two violations at the Millstone Station identified during its evaluation of the licensed operator requalification training (LORT) program. The first violation concerned an inspection finding that various licensed operators at Millstone 1 and 2 did not fully complete the LORT program for the 1991 and 1992 training periods. The second violation cited the failure of NNECO's internal nuclear review board to perform comprehensive audits of the training, retaining, requalification, and performance of the operations staff at Millstone 2 and 3. NNECO chose not to contest the violations nor the imposition of a $50,000 civil penalty. On December 15, 1993, the NRC issued an inspection report concerning the SLCRS and ABVS systems deficiencies that were identified during the 1993 Millstone 3 refueling outage. The report identified two apparent violations that are being considered for escalated enforcement. The apparent violations involve the inability of the systems to provide the necessary drawdown of secondary containment following a postulated accident and NNECO's failure to fully resolve these problems earlier, as a result of previous similar violations identified in September 1992. On March 11, 1994, the NRC notified NNECO that it proposed to impose a civil penalty of $50,000 in respect of these violations. NNECO has 30 days to respond to the NRC. In January 1994, the NRC issued a report finding that the overall Millstone 1 operator requalification training program was satisfactory. The NRC had previously found the program to be unsatisfactory. The recent conclusion was based on the results of a number of NRC inspections and the operator examinations conducted in September 1993. The NRC reviewed NNECO's corrective actions and determined that all actions necessary to obtain and maintain a satisfactory requalification training program had been completed and verified. INDUSTRY-WIDE NUCLEAR ISSUES The NRC regularly conducts generic reviews of technical and other issues, a number of which may affect the nuclear plants in which System companies have interests. Issues currently under review include individual plant examination programs to evaluate the likelihood and effects of severe accidents at operating nuclear plants, pipe crack phenomena, post-accident measures for controlling hydrogen, reactor vessel embrittlement, upgrading of emergency response facilities and communications, the ability of plants to cope with a total loss of power, emergency response planning, fitness for duty policies, operator requalification training, reactor containment suitability, maintenance adequacy, motor-operated valve testing, design basis reconstitution, diesel generator reliability, life extension, equipment procurement, electrical distribution system adequacy, reactor coolant pump seal integrity, plant risk during shutdown and low power operation, technical specification improvements, accident management, component aging, steam generator degradation phenomena, service water system adequacy, seismic qualification of equipment and other issues. At present, the outcome of the NRC's reviews of these and other technical issues, and the ways in which the different nuclear plants in which System companies have interests may be affected, cannot be determined. The cost of complying with any new requirements that may result from these reviews cannot be estimated at this time, but such costs could be substantial. Further, the NRC is currently evaluating a staff report on the reporting of nuclear safety concerns, which may result in changes in the way such concerns are addressed. The NRC has authorized the conduct of various regulatory activities designed to lower costs to its licensees while maintaining or improving public safety. Public controversy concerning nuclear power could affect the nuclear units in which System companies have ownership interests. Over the past decade, proposals to force the premature shutdown of nuclear units have become issues of serious and recurring attention in Maine, Massachusetts, Vermont and New Hampshire. States' efforts to deal with the siting of low level radioactive waste repositories have also stimulated negative reactions in communities being considered for those facilities. The continuing controversy about nuclear power may affect the cost of operating the nuclear units in which System companies have interests. While much of the public policy debate about nuclear power has been critical in the past, some trends in the energy environment have stimulated renewed support for nuclear power in the northeastern United States. Among these trends are the growing national environmental concerns and legislation about acid rain, air quality and global warming associated with fossil fuels. These concerns particularly affect the densely populated areas in the Northeast, downwind of coal-burning regions like the Midwest and mid-Atlantic states. In addition, at times when the price and availability of fuel oil have been volatile, the System's commitment to nuclear power has allowed it to minimize the oil-related rise in customers' bills. While the public controversy about nuclear power is not expected to disappear, recent trends suggest a more balanced public policy debate about the impacts of fossil fuel generation as well. NUCLEAR INSURANCE The NRC's nuclear property insurance rule requires nuclear plant licensees to obtain a minimum of $1.06 billion in insurance coverage. The rule requires that, although such policies may provide traditional property coverage, proceeds from the policy following an accident in which estimated stabilization and decontamination expenses exceed $100 million will first be applied to pay such expenses. The insurance carried by the licensees of the Millstone units, Seabrook 1, CY, MY and VY meets the requirements of this rule. YAEC has obtained an exemption for the Yankee Rowe plant from the $1.06 billion requirement and currently carries $25 million of insurance that otherwise meets the requirements of the rule. The Price-Anderson Act currently limits public liability from a single incident at a nuclear power plant to $9.4 billion. The first $200 million of liability would be provided by purchasing the maximum amount of commercially available insurance. Additional coverage of up to $8.8 billion would be provided by an assessment of $75.5 million per incident, levied on each of the 116 United States nuclear units that are currently subject to the secondary financial protection program, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. In addition, if the sum of all public liability claims and legal costs arising from any nuclear incident exceeds the maximum amount of financial protection, each reactor operator can be assessed an additional five percent, up to $3.8 million or $437.9 million in total for all 116 reactors. The maximum assessment is to be adjusted for inflation at least every five years. Based on CL&P's, PSNH's and WMECO's ownership interests in the three Millstone units and CL&P's and NAEC's interests in Seabrook 1, the System's current maximum direct liability would be $244.2 million per incident. In addition, through CL&P's, PSNH's and WMECO's power purchase contracts with the four Yankee regional nuclear electric generating companies, the System would be responsible for up to an additional $97.9 million per incident. These payments would be limited to a maximum in any year of $43.2 million per incident. Insurance has been purchased from Nuclear Electric Insurance Limited (NEIL) to cover: (1) certain extra costs incurred in obtaining replacement power during prolonged accidental outages with respect to CL&P's and WMECO's ownership interests in Millstone 1, 2, 3, and CY, CL&P's ownership interest in Seabrook, and PSNH's Seabrook Power Contract with NAEC; and (2) the cost of repair, replacement, or decontamination or premature decommissioning of utility property resulting from insured occurrences with respect to CL&P's ownership interests in Millstone 1, 2, 3, CY, MY, VY, and Seabrook 1; WMECO's ownership interests in Millstone 1, 2, 3, CY, MY, and VY; PSNH's ownership interest in Millstone 3, CY, MY and VY; and NAEC's ownership interest in Seabrook 1. All companies insured with NEIL are subject to retroactive assessments if losses exceed the accumulated funds available to NEIL. The maximum potential assessments against CL&P, PSNH, WMECO, and NAEC with respect to losses arising during current policy years are approximately $13.9 million under the replacement power policies and $29.9 million under the property damage, decontamination, and decommissioning policies. Although CL&P, PSNH, WMECO, and NAEC have purchased the limits of coverage currently available from the conventional nuclear insurance pools, the cost of a nuclear incident could exceed available insurance proceeds. Insurance has been purchased from American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters, aggregating $200 million on an industry basis, for coverage of worker claims. All companies insured under this coverage are subject to retrospective assessments of $3.2 million per reactor. The maximum potential assessments against CL&P, PSNH, WMECO, and NAEC with respect to losses arising during the current policy period are approximately $13.9 million. CYAPC expects that it will receive an insurance recovery for costs related to the CY thermal shield repair which occurred during the 1987 outage, and the removal which occurred during the 1989 outage, but the amount and time of payment are not certain. See "Rates-Connecticut Retail Rates-Adjustment Clauses." NUCLEAR FUEL The supply of nuclear fuel for the System's existing units requires the procurement of uranium concentrates, followed by the conversion, enrichment and fabrication of the uranium into fuel assemblies suitable for use in the System's units. These materials and services are available from a number of domestic and foreign sources. The System companies have predominantly relied on long term contracts with both domestic and foreign suppliers, supplemented with short term contracts and market purchases, to satisfy the units' requirements. Although the System has increased the use of foreign suppliers, domestic suppliers still provide the majority of the materials and services. The System companies have maintained diversified sources of supply, relying on no single source of supply for any one component of the fuel cycle, with the exception of enrichment services of which the majority of the System companies' requirements are provided under a long term contract with the U.S. Enrichment Corporation, a wholly-owned government corporation, established on July 1, 1993, in accordance with the Energy Policy Act and the successor to the U.S. DOE Uranium Enrichment Enterprise. The System expects that uranium concentrates and related services for the units operated by the System and for the other units in which the System companies are participating, that are not covered by existing contracts, will be available for the foreseeable future on reasonable terms and prices. As a result of the Energy Policy Act, the U.S. utility industry is required to pay to the DOE, via a special assessment for the costs of the decontamination and decommissioning of uranium enrichment plants operated by the DOE, $150 million each U.S. Government fiscal year for 15 years beginning in 1993. Each domestic utility will make a payment proportioned on its past purchases from the DOE's Uranium Enrichment Enterprise. Each year, the DOE will adjust the annual assessment using the Consumer Price Index. The Energy Policy Act provides that the assessments are to be treated as reasonable and necessary current costs of fuel, which costs shall be fully recoverable in rates in all jurisdictions. The System's total share of the estimated assessment was approximately $56.7 million. Management believes that the DOE assessments against CL&P, WMECO, PSNH and NAEC will be recoverable in future rates. Accordingly, each of these companies has recognized these costs as regulatory asset, with corresponding obligation on its balance sheet. Costs associated with nuclear plant operations include amounts for disposal of nuclear wastes, including spent fuel, and for the ultimate decommissioning of the plants. The System companies include in their nuclear fuel expense spent fuel disposal costs accepted by the DPUC, the NHPUC and the DPU in rate case or fuel adjustment decisions. Spent fuel disposal costs are also reflected in wholesale charges. Such provisions include amortization and recovery in rates of previously unrecovered disposal costs of accumulated spent nuclear fuel. HIGH-LEVEL RADIOACTIVE WASTES Under the Nuclear Waste Policy Act of 1982, the DOE is required to design, license, construct and operate a permanent repository for high level radioactive wastes and spent nuclear fuel. The act requires the DOE to provide, beginning in 1998, for the disposal of spent nuclear fuel and high level radioactive waste from commercial nuclear plants through contracts with the owners and generators of such waste. The System companies have entered into such contracts with the DOE with respect to Millstone 1, 2 and 3 and Seabrook 1, and have been advised that the Yankee companies have entered into similar contracts. The DOE has established disposal fees to be paid to the federal government by electric utilities owning or operating nuclear generating units. The System companies have been paying for such services for fuel burned starting in April 1983 on a quarterly basis since July 1983 in accordance with the contracts; the DPUC, the NHPUC and the DPU permit the fee to be recovered through rates. The disposal fee for fuel burned before April 1983 (previously burned fuel) is determined in accordance with a fee structure based on fuel burnup. Under the contract payment option selected, the System companies anticipate making payment to the DOE for disposal of previously burned fuel just before the first delivery of spent fuel to the DOE. That payment obligation is not a funded obligation. The liability under the selected payment option for previously burned fuel, including interest, through December 31, 1993, and the amounts recovered through rates for previously burned fuel through the end of 1993 for Millstone 1 and 2, are as follows: Previously Burned Fuel Liability, Amounts Recovered for Previously Including Interest, Thru 12/31/93 Burned Fuel Thru 12/31/93 (Millions) CL&P $136.1 $134.5 WMECO 31.9 32.3 Total $168.0 $166.8 Because Millstone 3 and Seabrook 1 went into service after 1983, there is no previously burned fuel liability for those units. In return for payment of the fees prescribed by the Nuclear Waste Policy Act, the federal government is to take title to and dispose of the utilities' high level wastes and spent nuclear fuel beginning no later than 1998. Until the federal government begins receiving such materials, operating nuclear generating plants will need to retain high-level wastes and spent fuel on-site or make some other provisions for their storage. With the addition of new storage racks or through fuel consolidation, storage facilities for Millstone 3 and CY are expected to be adequate for the projected life of the units. With the storage facilities for Millstone 1 and 2 are expected to be adequate (maintaining the capacity to accommodate a full-core discharge from the reactor) until 2000. Fuel consolidation, which has been licensed for Millstone 2, could provide adequate storage capability for the projected lives of Millstone 1 and 2. In addition, other licensed technologies, such as dry storage casks or on-site transfers, are being considered to accommodate spent fuel storage requirements. With the addition of new racks, Seabrook 1 is expected to have spent fuel storage capacity until at least 2010. Under the terms of a license amendment approved by the NRC in 1984, MY's present storage capacity of the spent fuel pool at the unit will be reached in 1999, and after 1996 the available capacity of the pool will not accommodate a full-core removal. After consideration of available technologies, MYAPC elected to provide additional capacity by replacing the fuel racks in the spent fuel pool at the unit and, on January 25, 1993, filed with the NRC seeking authorization to implement the plan. MYAPC believes that the replacement of the fuel racks, if approved, will provide adequate storage capacity through the unit's licensed operating life. While no intervention has occurred, MYAPC cannot predict with certainty whether the NRC authorization will be granted or whether or to what extent the storage capacity limitation at the unit will affect the operation of the unit or the future cost of disposal. Under the terms of a license amendment approved by the NRC in 1991, the storage capacity of the spent fuel pool at VY is expected to be reached in 2003, and the available capacity of the pool is not expected to be able to accommodate a full-core removal after 1998. Because the Yankee Rowe plant was permanently shut down effective February 26, 1992, YAEC is planning to construct a temporary facility to store the spent nuclear fuel produced by the Yankee Rowe plant over its operating lifetime until that fuel is removed by the DOE. See "Electric Operations - Nuclear Generation - Decommissioning" for further information on the closing and decommissioning of Yankee Rowe. LOW-LEVEL RADIOACTIVE WASTES Disposal costs for low-level radioactive wastes (LLRW) have continued to rise in recent years despite significant reductions in volume. Approximately $7.65 million was spent on LLRW disposal for the Millstone units and CY in 1993. In accordance with the provisions of the federal Low-Level Radioactive Waste Policy Act of 1980, as amended (the Waste Policy Act), on December 31, 1992 the disposal site at Beatty, Nevada closed, and the Richland, Washington facility closed to disposal of LLRW from outside its compact region. During 1992, the Barnwell, South Carolina site announced its intention to remain open for disposal of out-of-region LLRW until June 30, 1994. In November 1992, the Northeast Compact commission entered into an agreement with the Southeast Interstate Low-Level Radioactive Waste Management Compact (the Southeast Compact) commission providing for continued access to the Barnwell facility until June 30, 1994 by Connecticut LLRW generators, and the System agreed to pay, in addition to disposal fees, an access fee of $220 per cubic foot, with a minimum of $4.73 million, for the right to dispose of LLRW at Barnwell during this period. The Connecticut Hazardous Waste Management Service (the Service), a state quasi-public corporation, is charged with coordinating the establishment of a facility for disposal of LLRW originating in Connecticut. In June 1991, the Service announced that it had selected three potential sites in north-central Connecticut for further study. The Service's announcement provoked intense controversy in the affected municipalities and resulted in legislative action to stop the selection process. On February 1, 1993, the Service presented the legislature with a new site selection plan under which communities are urged to volunteer a site for a facility in return for financial and other incentives. The volunteer process is being continued in 1994. The Service's activities in this regard are funded by assessments on Connecticut's LLRW generators. The System was assessed approximately $1.8 million for the state's 1992-1993 fiscal year. Due to the change to a volunteer process, there was no assessment for the 1993-1994 fiscal year and the state projects no assessment for the 1994-1995 and 1995-1996 fiscal years. The System has plans to acquire or construct additional LLRW storage capacity at the Millstone and CY sites to provide for temporary storage of LLRW should that become necessary. The System can manage its Connecticut LLRW by volume reduction, storage or shipment at least through 1999. Management cannot predict whether and when a disposal site will be designated in Connecticut. Since January 1, 1989, the State of New Hampshire has been barred from shipping Seabrook LLRW to the operating disposal facilities in South Carolina, Nevada and Washington for failure to meet the milestones required by the Waste Policy Act. Seabrook 1 has never shipped LLRW but has capacity to store at least five years' worth of the LLRW generated on-site, with the capability to expand this on-site capacity if necessary. The Seabrook station accrued approximately $1.3 million in off-site disposal costs in 1993. New Hampshire is pursuing options for out-of-state disposal of LLRW generated at Seabrook. Massachusetts and Vermont have arranged for continued access to the Barnwell facility until mid-1994 for the nuclear waste generators in their states. YAEC is currently disposing of its LLRW at the Barnwell facility. MY has been storing its LLRW on-site since January 1993. VY and MY each has on-site storage capacity for at least five years' production of LLRW from its respective plants. Maine and Vermont are in the process of finalizing an agreement with the state of Texas to provide access to a facility that will be developed in that state. DECOMMISSIONING The System's most recent comprehensive site-specific updates of the decommissioning costs for each of the three Millstone units were completed in 1992 and for Seabrook was completed in 1991. The recommended decommissioning method reflected in the cost estimates continues to be immediate and complete dismantlement of those units at their retirement. The table below sets forth the estimated Millstone and Seabrook decommissioning costs for the System companies. The estimates are based on the latest site studies, escalated to December 31, 1993 dollars, and include costs allocable to NAEC's share of Seabrook recently acquired from VEG&T. CL&P PSNH WMECO NAEC NU System (Millions) Millstone 1 $312.5 $ - $ 73.3 $ - $385.8 Millstone 2 251.0 - 58.9 - $309.9 Millstone 3 223.0 12.0 51.6 - 286.6 Seabrook 1 14.9 - - 131.7 146.6 Total $801.4 $12.0 $183.8 $131.7 $1,128.9 Pursuant to Connecticut law, CL&P has periodically filed plans with the DPUC for financing the decommissioning of the three Millstone units. In 1986, the DPUC approved the establishment of separate external trusts for the currently tax-deductible portions of decommissioning expense accruals for Millstone 1 and 2 and for all expense accruals for Millstone 3. In its 1993 CL&P multi-year rate case decision, the DPUC allowed CL&P's full decommissioning estimate for the three Millstone units to be collected from customers. This estimate includes an approximately 16 percent contingency factor for each unit. The estimated aggregate cost of decommissioning the Millstone units is $1.1 billion in December 1993 dollars. WMECO has established independent trusts to hold all decommissioning expense collections from customers. In its 1990 WMECO multi-year rate case decision, the DPU allowed WMECO's decommissioning estimate for the three Millstone units ($840 million in December 1990 dollars) to be collected from customers. Due to the settlement in the 1992 WMECO rate case, the aggregate decommissioning estimate for the three Millstone units remains unchanged. The decommissioning cost estimates for the Millstone units are reviewed and updated regularly to reflect inflation and changes in decommissioning requirements and technology. Changes in requirements or technology, or adoption of a decommissioning method other than immediate dismantlement, could change these estimates. CL&P, PSNH and WMECO attempt to recover sufficient amounts through their allowed rates to cover their expected decommissioning costs. Only the portion of currently estimated total decommissioning costs that has been accepted by regulatory agencies is reflected in rates of the System companies. Although allowances for decommissioning have increased significantly in recent years, ratepayers in future years will need to increase their payments to offset the effects of any insufficient rate recoveries in previous years. New Hampshire enacted a law in 1981 requiring the creation of a state-managed fund to finance decommissioning of any units in that state. In 1992, the New Hampshire Nuclear Decommissioning Financing Committee (NDFC) established approximately $323 million (in 1991 dollars) as the decommissioning cost estimate for immediate and complete dismantlement of Seabrook 1 upon its retirement. On March 10, 1993, FERC approved this estimate. The estimated total decommissioning cost for Seabrook 1 is $366 million in December 1993 dollars. The NHPUC is authorized to permit the utilities subject to its jurisdiction that own an interest in Seabrook 1 to recover from their customers on a per-kilowatt-hour basis amounts paid into the decommissioning fund over a period of years. NAEC's costs for decommissioning are billed by it to PSNH and recovered by PSNH under the Rate Agreement. Under the Rate Agreement, PSNH is entitled to a base rate increase to recover increased decommissioning costs. See "Rates - New Hampshire Retail Rates" for further information on the Rate Agreement. North Atlantic submitted its annual update of the 1991 Decommissioning Study and Funding Schedule to the NDFC on March 31, 1993. It included an updated estimate for the prompt removal and dismantling of Seabrook station in 2026 at the end of licensed life and a review of the assumptions on inflation and rate-of-return on fund investments used to develop the joint owner contribution schedule. North Atlantic concluded that the 1991 estimate, escalated in accordance with these assumptions to 1993 dollars, is still valid. Although a schedule has not been set by the NDFC, public hearings on the decommissioning estimate and funding schedule will probably be held in the third quarter of 1994. The new Investment Guidelines for the Seabrook Nuclear Decommissioning Financing Fund, which were approved by the New Hampshire State Treasurer and would have gone into effect on November 1, 1993, have been put on hold by a recent decision of FERC. The October 20, 1993 FERC order effectively reinstated the so-called "black lung" investment restrictions on decommissioning funds subject to its jurisdiction, although Congress, in the Energy Policy Act, had repealed the IRS regulation which mandated them. Under these restrictions, investments are limited to public debt securities that are fully backed by the U.S. government, tax exempt obligations of state or local governments and time deposits with a bank or insured credit union. The new guidelines would allow equity holdings by the joint owners of Seabrook, beginning with a limit of 10 percent in 1994 and gradually increasing to a limit of 40 percent in 1997. The strategies also call for a gradual reduction in the equity position as the plant approaches the end of its licensed life. Implementation of new investment guidelines for the Millstone units and CY have also been delayed because of the FERC decision. The System is party to petitions filed with FERC in November 1993, seeking reconsideration of the FERC decision. As of December 31, 1993, the balances (at cost) in the external decommissioning trust funds were as follows: Millstone 1 Millstone 2 Millstone 3 Seabrook 1 (Millions of Dollars) CL&P........... $70.4 $45.5 $30.9 $ .9 PSNH........... * * 1.5 * WMECO.......... 24.0 16.5 8.6 * NAEC........... * * * 7.9 _____ _____ _____ ____ Total........ $94.4 $62.0 $41.0 $8.8 *PSNH has no ownership interest in the Millstone 1 and 2 units. WMECO has no ownership interest in Seabrook 1. NAEC's only ownership interest is in Seabrook 1. YAEC, MYAPC, VYNPC and CYAPC are all collecting revenues for decommissioning from their power purchasers. The table below sets forth the estimated decommissioning costs of the Yankee units for the System companies. The estimates are based on the latest site studies, escalated to December 31, 1993 dollars. For information on the equity ownership of the System companies in each of the Yankee units, see "Electric Operations - Nuclear Generation - General." CL&P PSNH WMECO NU System (Millions) CY $117.3 $17.0 $32.3 $166.6 MY 38.8 16.2 9.7 64.7 VY * * * * Yankee Rowe 68.7 19.6 19.6 107.9 ______ _____ _____ ______ Total $255.3 $65.6 $69.6 $390.5 *VYNPC is currently reestimating the cost of decommissioning VY. Based on recent estimates for comparable units, the projected cost is expected to fall into the $300 - $350 million range. The System's share of these costs is expected to be between $48 million and $56 million. The results of the VYNPC study are expected to be available in the spring of 1994. In June 1992, YAEC filed a rate filing to obtain FERC authorization for an increase in rates to cover the costs of closing and decommissioning the Yankee Rowe plant and for the recovery of the remaining investment in the unit over the remaining period of its NRC operating license. At December 31, 1993, the System's share of these estimated costs was approximately $132.8 million. A settlement agreement among YAEC, the FERC staff and intervenors to the FERC proceeding addressing all issues has been filed with and accepted by FERC. YAEC has submitted its decommissioning plan to the NRC for approval. Due to the unexpected continued availability of the low level waste disposal facility in Barnwell, South Carolina, YAEC requested NRC permission to use decommissioning funds prior to final NRC approval of the complete plan. On April 16, 1993, the NRC approved YAEC's request to use funds for removal of the steam generators, pressurizer and reactor internals. By December 31, 1993, all major components were successfully disposed of at Barnwell and only a small number of internals shipments remain to be made. YAEC will continue its dismantling of the plant in 1994. The NRC's review of the decommissioning plan is expected to be completed by December 31, 1994 at which time YAEC will, depending upon the availability of a low level waste site, move to completely dismantle the facility. CYAPC accrues decommissioning costs on the basis of immediate dismantlement at retirement. The most current estimated decommissioning cost, based on a 1992 study, is approximately $339.9 million in year-end 1993 dollars. As a result of a 1987 study approved by FERC, CYAPC has been accruing expenses based on an estimated decommissioning level of $130 million. On October 30, 1992, CYAPC filed with FERC a proposed change in rates to recover the increase in estimated decommissioning costs. On May 11, 1993, FERC approved a settlement agreement allowing a decommissioning estimate of $294.2 million (in July 1992 dollars) to be recovered in rates effective June 1, 1993. See "Electric Operations - Nuclear Generation - Operations - Yankee Units." In 1984, CYAPC established an independent irrevocable decommissioning trust fund, which was modified for tax purposes in 1987 to create two trusts. Each month, CYAPC's sponsors are billed for their proportionate share of decommissioning expense as allowed by FERC and payments are made directly to the trust. The combined balance of the trusts at December 31, 1993 was $137.8 million. The trust balances must be used exclusively to discharge decommissioning costs as incurred. MYAPC estimates the cost of decommissioning MY at $323.7 million in December 31, 1993 dollars based on a study completed in July 1993. NON-UTILITY BUSINESSES GENERAL In addition to its core electric utility businesses in Connecticut, New Hampshire and Massachusetts, in recent years the System has begun a diversification of its business activities into two energy-related fields: private power development and energy management services. PRIVATE POWER DEVELOPMENT In 1988, NU organized a new subsidiary corporation, Charter Oak, through which the System participates as a developer and investor in domestic and international private power projects. With the passage of the Energy Policy Act, Charter Oak can invest in cogeneration and small power production (SPP) facilities anywhere in the world. This legislation also expands Charter Oak's permissible involvement in exempt wholesale generators (EWGs) to include development, construction and ownership. Management currently does not permit Charter Oak to invest in facilities which are located within the System service territory or to sell its electric output to any of the System electric utility companies. For a discussion of certain highlights of the Energy Policy Act relating to EWGs, see "Regulatory and Environmental Matters - - Public Utility Regulation." Under the Public Utility Regulatory Policies Act of 1978 (PURPA), as a subsidiary of an electric utility holding company, Charter Oak is effectively limited to no more than 50 percent ownership in a QF within the United States. To work within this constraint, Charter Oak has made strategic alliances with several experienced developers to pursue development opportunities. Through these relationships, Charter Oak is pursuing development opportunities nationwide and internationally. Although Charter Oak has no full-time employees, eight NUSCO employees are dedicated to Charter Oak activities on a full-time basis. Other NUSCO employees provide services as required. Charter Oak owns, through a wholly-owned special purpose subsidiary, a ten percent equity interest in a 220 MW natural gas-fired combined cycle cogeneration QF in Texas which provides steam to Campbell Soup Company's Paris, Texas manufacturing facility and electricity to Texas Utilities Electric Company. Charter Oak also owns 56 MW of the 1,875 MW Teesside natural gas-fired cogeneration facility in the United Kingdom. Charter Oak is pursuing other project development opportunities in both the domestic and international markets with a combined capacity over 1,000 MW. Charter Oak is currently participating in the development stage of projects in Texas, the West Coast, the Midwest, Latin America and the Pacific Rim. NU's total investment in Charter Oak was approximately $23.0 million as of December 31, 1993. NU, Charter Oak and its subsidiary, Charter Oak Energy Development, have received approval from the SEC to increase NU's authorized investment in Charter Oak to up to $100 million and to increase Charter Oak's authorized investment in COE Development to up to $100 million for preliminary development activities in QFs, IPPs, EWGs and foreign utility companies. ENERGY MANAGEMENT SERVICES In 1990, NU organized a new subsidiary corporation, HEC, which acquired substantially all of the assets and personnel of an existing, non-affiliated energy management services company. In general, the energy management services that HEC provides are performed for customers pursuant to contracts to reduce the customers' overall energy consumption and reduce energy costs and/or conserve energy resources. HEC also provides demand side management consulting services to utilities. HEC's energy management and consulting services are directed primarily to the commercial, industrial and institutional markets and utilities in New England and New York, although the SEC's order under the 1935 Act that authorized NU to operate HEC also permits HEC to serve customers outside that area, so long as over half of its revenues are attributable to customers in New England and New York. NU's initial equity investment in HEC was approximately $4 million and NU has made additional capital contributions of approximately $300,000 through March 1, 1994. Under the SEC order authorizing HEC's participation in the Money Pool, HEC may borrow up to $11 million from the Money Pool. At December 31, 1993, HEC had $2.9 million outstanding from its borrowings from the Money Pool. REGULATORY AND ENVIRONMENTAL MATTERS PUBLIC UTILITY REGULATION NU is registered with the SEC as an electric utility holding company under the 1935 Act. Under the 1935 Act, the SEC has jurisdiction over NU and its subsidiaries with respect to, among other things, securities issues, sales and acquisitions of securities and utility assets, intercompany loans, services performed by and for associated companies, accounts and records, involvement in non-utility operations and dividends. The Energy Policy Act amended the 1935 Act to give registered holding companies, like NU, broadened authority to invest in small power production facilities qualifying under PURPA and to own a new class of IPPs known as EWGs. An EWG is an entity exclusively in the business of owning and/or operating generating facilities that sell electricity at wholesale. EWGs are exempt from most regulation under the 1935 Act. A registered holding company may also invest in foreign utility companies with SEC approval. EWGs, however, are subject to state regulation with respect to siting and financial regulation to prevent cross-subsidies and self-dealing among utilities and affiliated EWGs. The Energy Policy Act also amended the Federal Power Act to authorize FERC to order wholesale transmission wheeling services, including the enlargement of transmission capacity necessary to provide such services, unless such transmission would unreasonably impair the reliability of the electric systems affected or the utility ordered to provide transmission is unable to obtain necessary governmental approvals or property rights. Rates for transmission ordered under the Energy Policy Act are to be designed to protect the wheeling utilities' existing customers. FERC's authority to order wheeling does not extend to retail wheeling, and FERC may not issue a wheeling order that is inconsistent with state franchise laws. CL&P is subject to regulation by the DPUC, which has jurisdiction over, among other things, retail rates, accounting procedures, certain dispositions of property and plant, mergers and consolidations, securities issues, standards of service, management efficiency and construction and operation of generation, transmission and distribution facilities. Because of their ownership interests in the Millstone units, PSNH and WMECO are also subject to the jurisdiction of the DPUC with respect to their activities in Connecticut and their securities issues. PSNH and NAEC are subject to regulation by the NHPUC, which has jurisdiction over retail rates, accounting procedures, certain dispositions of property and plant, quality of service, securities issues, acquisitions of securities of other utilities, mortgages of property, declaration of dividends, contracts with affiliates, management efficiency, construction and operation of generation, transmission and distribution facilities, integrated resource planning and other matters. Although the Seabrook Power Contract between PSNH and NAEC is a wholesale contract subject to the jurisdiction of FERC, pursuant to the terms of the Rate Agreement, the NHPUC has the right to review the prudence of costs incurred by NAEC to determine whether they should be passed on to ratepayers through FPPAC, and the NHPUC and the State of New Hampshire have additional rights and limited jurisdiction over certain other Seabrook Power Contract issues. NU and its subsidiaries are subject to the general supervision of the NHPUC with respect to all dealings with PSNH and NAEC. Based upon PSNH's ownership of generating and transmission facilities in Maine and transmission and hydroelectric facilities in Vermont, PSNH is also subject to limited regulatory jurisdiction in those states. WMECO is subject to regulation by the DPU, which has jurisdiction over retail rates, accounting procedures, quality of service, contracts for the purchase of electricity, mergers, securities issues and other matters. The DPU has adopted regulations that provide for DPU preapproval of utility plant construction, procurement of non-utility generation (QFs and IPPs), and C&LM programs. HWP is subject to regulation by the DPU with respect to certain contracts and quality of service. NU and its subsidiaries are subject to the general supervision of the DPU with respect to all dealings with WMECO and HWP. CL&P is subject to the jurisdiction of the NHPUC for limited purposes in connection with its ownership interest in Seabrook. CL&P, PSNH, WMECO, NAEC and HWP are public utilities under Part II of the Federal Power Act and are subject to regulation by the FERC with respect to, among other things, interconnection and coordination of facilities, wholesale rates and accounting procedures. The System incurs substantial capital expenditures and operating expenses to identify and comply with environmental, energy, licensing and other regulatory requirements, including those described in the following subsections, and it expects to incur additional costs to satisfy further requirements in these and other areas of regulation. Because of the continually changing nature of regulations affecting the System, the total amount of these costs is not determinable. The System has active auditing programs addressing a variety of legal and regulatory areas, including an environmental auditing program. To the extent it is determined that a System operation or facility is not in full compliance with applicable environmental or other laws or regulations, the System attempts to resolve non-compliance through the auditing response process or other management processes. Compliance with existing and proposed regulations also affects the time needed to complete new facilities or to modify present facilities, and it affects System companies' rates, sales, revenues and net income, all in ways that may be substantial but are not readily calculable. NRC NUCLEAR PLANT LICENSING The operators of the Millstone 1, 2 and 3 units, the CY, MY and VY and Seabrook 1 all have full term full power operating licenses from the NRC. The following table sets forth the current license expiration dates for each unit: Operating License Unit Expiration Date (*) Millstone 1 October 6, 2010 Millstone 2 July 31, 2015 Millstone 3 November 25, 2025 Seabrook 1 October 17, 2026 CY June 29, 2007 MY October 21, 2008 VY March 21, 2012 _________________________ (*) For all units except Seabrook 1 and MY, the current operating license expires 40 years from the date the operating licensee was issued. The Seabrook license expires 40 years from the date on which the NRC issued a license for the unit to load nuclear fuel, which was about 3 1/2 years before the full power operating license was issued. MY's operating license expires 40 years from the date the construction license was issued, which was about four years before the operating license was issued. The System will determine at the appropriate time whether to seek to recapture these periods and add them to the operating license terms for those units. YAEC had been working with the NRC on a preliminary analysis to extend the license expiration date for Yankee Rowe from 2000 to 2020, but that effort was suspended when the unit was shut down for evaluation. YAEC received a "possession only" license from the NRC in August 1992. See "Electric Operations - Nuclear Generation - Operations - Yankee Units" for further information on the decision to shut down the Yankee Rowe unit permanently. Currently the NRC issues 40-year operating licenses to nuclear units. In December 1991, the NRC issued a final rule that establishes the requirements that must be met by an applicant for renewal of a nuclear power plant operating license, the information that must be submitted to the NRC for review, so that the agency can determine whether those requirements have in fact been met, and the application procedures that must be used to obtain an extension of a nuclear plant operating license beyond 40 years. A renewal license may be granted for not more than 20 years beyond the current licensed life. The licensing requirements for a nuclear plant during the renewal term will consist of the plant's current licensing requirements and new commitments to monitor, manage, and correct age-related degradation of plant systems, structures, and components that is unique to the license renewal term but will not encompass the higher licensing standards imposed on new plants. An opportunity for a formal public hearing is provided to permit interested persons to raise contentions on the adequacy of the renewal applicant's proposals to address age-related degradation and compliance with applicable requirements relating to an environmental impact statement. The NRC rule was challenged on antitrust grounds and upheld in the District of Columbia Court of Appeals. ENVIRONMENTAL REGULATION GENERAL The National Environmental Policy Act (NEPA) requires that detailed statements of the environmental effects of major federal actions be prepared by federal agencies. Major federal actions can include licenses or permits issued to the System by FERC, NRC and other federal agencies for construction or operation of generation and transmission facilities. NEPA requires that federal licensing agencies make an independent evaluation of the alternatives and environmental impacts of the proposed actions. Under Connecticut law, major generation or transmission facilities may not be constructed or significantly modified without a certificate of environmental compatibility and public need from the Connecticut Siting Council (CSC). After public hearings, CSC may issue the certificate, which addresses the public need for the facility and probable environmental impact of the facility and may impose specific conditions for protection of the environment. In New Hampshire, construction of major new generation or transmission facilities, or sizeable additions to existing facilities, requires a certificate of site and facility from the New Hampshire Site Evaluation Committee (NHSEC) and NHPUC under the state's energy facility siting law. In addition to review by all state agencies having jurisdiction over any aspect of the construction or operation of the proposed facility, the law requires full review by NHSEC of the environmental impact of the proposed site or route after allowing for public comment and conducting public hearings. Issuance of a certificate requires, among other findings, a finding that the proposed site and facility will not have an unreasonable adverse effect on environmental values. Massachusetts law requires all state agencies to determine the environmental impact of any projects proposed by private companies requiring state permits, or involving state funding or participation. Massachusetts state agencies are required to make a finding that all feasible measures have been taken to avoid or minimize the environmental impact of the project. In certain instances, Massachusetts law also requires the preparation and dissemination, among various state agencies, of an environmental impact report for the proposed project. Major generation or transmission facilities may not be constructed or significantly modified without approval by the Massachusetts Energy Facilities Siting Board; new transmission facilities also require approval by the DPU. The System anticipates that additional environmental legislation will be seriously considered by Congress and state legislatures in the coming years. The issues of global warming, air pollution, hazardous waste handling and disposal and water pollution control are receiving a significant amount of public and political attention and are likely areas for federal or state legislative activity in the near future. Until and unless any such legislation is enacted and implementing regulations are issued, the effects on the System cannot be determined. Compliance with environmental laws and regulations, particularly air and water pollution control requirements, may limit operations or require substantial investments in new equipment at existing facilities. Such laws and regulations may also require substantial investments that are not included in the estimated construction budget set forth herein. See "Resource Plans" for a discussion of the System's construction plans. SURFACE WATER QUALITY REQUIREMENTS The federal Clean Water Act (CWA) provides that every "point source" discharger of pollutants into navigable waters must obtain a National Pollutant Discharge Elimination System (NPDES) permit from EPA specifying the allowable quantity and characteristics of its effluent. To obtain an NPDES permit, a discharger must meet technology-based and biologically-based effluent standards and must also demonstrate that its effluent will not cause a violation of established standards for the quality of the receiving waters. Connecticut, Massachusetts and New Hampshire regulations contain similar permit requirements and these states can impose more stringent requirements. All of the System's steam-electric generating plants have NPDES permits in effect. Any of the permits may be reopened to incorporate more stringent regulations adopted by EPA or state environmental agencies. Compliance with NPDES and state water discharge permit requirements has necessitated substantial expenditures and may require further expenditures because of additional requirements that could be imposed in the future. The CWA requires EPA and state permitting authorities to approve the cooling water intake structure design and thermal discharge of steam-electric generating plants. All System steam-electric plants have received these approvals. In the renewed discharge permit for the three Millstone nuclear units, issued in 1992, CDEP included a condition requiring a feasibility study of various structural or operational modifications of the cooling water intake system to reduce the entrainment of winter flounder larvae. This study was submitted to CDEP in January 1993 and includes analyses of the costs and benefits of each alternative considered. The costs ranged from $1.8 million to $519 million. The study concluded that the substantial incremental costs of each of the alternatives studied are not justified by the small benefits to the winter flounder population. In a letter dated January 14, 1994, CDEP approved the report requiring only that Millstone station continue efforts to schedule refueling outages to coincide with the period of high winter flounder larvae abundance and that the station continue to monitor the Niantic River winter flounder population in accordance with existing NPDES permit conditions. Merrimack station's NHDES discharge permit requires site work to isolate adjacent wetlands from the station's waste water system. Plans have been approved by the New Hampshire Department of Environmental Services (NHDES), and PSNH is now preparing a permit application to begin construction. The new permit may require PSNH to perform further biological studies because significant numbers of migratory fish are being restored to lower reaches of the Merrimack River. Should the studies indicate that Merrimack Station's once-through cooling system interferes with the establishment of a balanced aquatic community, PSNH could be required to construct a partially enclosed cooling water system for Merrimack station. The amount of capital expenditures relating to the foregoing cannot be determined at this time. However, if such expenditures were to be required, they would likely be substantial and a reduction of Merrimack station's net generation capability could result. The ultimate cost impact of the CWA and state water quality regulations on the System cannot be estimated because of uncertainties such as the impact of changes to the effluent guidelines or water quality standards. Additional modifications, in some cases extensive and involving substantial cost, may ultimately be required for some or all of the System's generating facilities. In response to several major oil spills in recent years, Congress passed the Oil Pollution Act of 1990 (OPA 90). OPA 90 sets out the requirements for facility response plans and periodic inspections of spill response equipment at certain facilities. The requirements apply to facilities that can cause substantial harm or significant and substantial harm to the environment by discharging oil or hazardous substances into the navigable waters of the United States and adjoining shorelines. Pursuant to OPA 90, EPA has authority to regulate non-transportation-related fixed onshore facilities and the Coast Guard has the authority to regulate transportation-related onshore facilities. Response plans were filed for all System facilities believed to be subject to this requirement. EPA and the Coast Guard have reviewed these plans and accepted the information provided in them as certification of contracted resources for response to a worst case discharge. The Coast Guard expects to complete its review process by February 17, 1995, and EPA by August 18, 1995. Both agencies have authorized continued operation pending final plan approval. OPA 90 includes limits on the liability that may be imposed on persons deemed responsible for release of oil. The limits do not apply to oil spills caused by negligence or violation of laws or regulations. OPA 90 also does not preempt state laws regarding liability for oil spills. In general, the laws of the states in which the System owns facilities and through which the System transports oil could be interpreted to impose strict liability for the cost of remediating releases of oil and for damages caused by releases. The System and its principal oil transporter currently carry a total of $890 million in insurance coverage for oil spills. AIR QUALITY REQUIREMENTS Under the federal Clean Air Act, EPA has promulgated national ambient air quality standards for certain air pollutants, including sulfur dioxide, particulate matter, nitrogen oxides and ozone. EPA has approved a Connecticut implementation plan prepared by CDEP, a New Hampshire plan prepared by NHDES and a Massachusetts plan prepared by MDEP for the achievement and maintenance of these standards. The Connecticut, New Hampshire and Massachusetts plans impose limits on the amounts of various airborne pollutants that can be emitted from utility boilers. Under the Clean Air Act, emissions from new or substantially modified sources are limited by new source performance standards and very strict technology-based emission limits. The Clean Air Act Amendments of 1990 (CAAA) made extensive revisions and additions to the Clean Air Act and imposed many stringent new requirements on air emissions sources. The CAAA contains provisions further regulating emissions of sulfur dioxide (SO2) and nitrogen oxides (NOX) for the purpose of controlling acid rain, toxic air pollutants and other pollutants, requiring installation of continuous emissions monitors (CEMs) and expanding permitting provisions. Existing and additional federal and state air quality regulations could hinder or possibly preclude the construction of new, or modification of existing, fossil units in the System's service area, could raise the capital and operating cost of existing units, and may affect the operations of the System's work centers and other facilities. The ultimate cost impact of these requirements on the System cannot be estimated because of uncertainties about how EPA and the states will implement various requirements of the CAAA. NOX. The CAAA identifies NOX emissions as a precursor of ambient ozone for the northeastern region of the United States, much of which is in violation of the ambient air quality standard for ozone. Pursuant to the CAAA, Connecticut, New Hampshire and Massachusetts must implement plans to address ozone nonattainment. Probable actions include additional NOX controls that could impose costs on the System's generating units. The capital cost to comply with 1995's anticipated Phase I requirements is expected to approximate $10 million for CL&P, $11 million for PSNH, $1 million for WMECO and $3 million for HWP, while compliance costs for Phase II, effective in 1999, could be substantially higher depending on the level of NOX reductions required. Costs for meeting the 1999 NOX emission reduction requirements cannot be estimated at this time. Connecticut and New Hampshire have not as yet issued final regulations to implement NOX reduction requirements, although both have previously indicated that they will attempt to achieve NOX reduction requirements at the lowest possible costs. The System companies are in the process of reviewing compliance strategies and costs and of providing input to state environmental regulators. Massachusetts issued final NOX Reasonably Available Control Technology (RACT) rules in September, 1993. In December 1993, PSNH reached a revised agreement regarding NOX emissions with various environmental groups and the New Hampshire Business and Industrial Association. The agreement has been submitted to the New Hampshire Air Resources Division (NHARD) in the form of proposed regulations. The agreement provides for aggressive unit specific NOX emission rate limits for PSNH's generating facilities, effective May 31, 1995. The agreement no longer requires a PSNH commitment to retire or repower Merrimack Unit 2 by May 15, 1999, however more stringent emission rate limits equivalent to the range of 0.1 to 0.4 pounds of NOX per million Btu are required for the unit by that date. PSNH recently received an amendment to its Permit to Operate for Merrimack Unit 1 from NHARD to allow the testing of wood chips as a fuel. Testing has begun and if it is successful it may assist PSNH in compliance with the CAAA. SO2. The CAAA mandates reductions in sulfur dioxide (SO2) emissions to control acid rain. These reductions are to occur in two phases. First, high SO2 emitting plants are required to reduce their emissions beginning January 1, 1995. The only System units subject to the Phase I reduction requirements are PSNH's Merrimack Units 1 and 2. Management plans to meet the requirements of both Phase I and Phase II by burning low sulfur fuels and substituting (i.e. adding) Newington and Mt. Tom stations as Phase I units, if allowed by EPA regulations. On January 1, 2000, the start of Phase II, a nationwide cap of 8.9 million tons per year of utility SO2 emissions will be imposed and existing units will be granted allowances to emit SO2. These allowances are freely tradable. One allowance entitles a source to emit one ton of SO2 in a year. No unit may emit more SO2 in a particular year than the amount for which it has allowances. The System expects to be allocated allowances by EPA that substantially exceed its expected SO2 emissions for 2000 and subsequent years. In 1993, the System agreed to donate, subject to regulatory approval, 10,000 of its surplus SO2 allowances to the American Lung Association thereby effectively preventing 10,000 tons of SO2 from being emitted into the atmosphere. The System expects to be able to sell some of its surplus allowances. The price of allowances depends on the market. The amount of surplus allowances and the allocation of the revenues received from such sales between ratepayers and shareholders have not been determined. On February 15, 1993, as required by the CAAA, PSNH filed Phase I Acid Rain Permit Applications for Merrimack Station. In addition, as allowed by the CAAA, PSNH designated its Newington station unit, and HWP designated its Mt. Tom unit, as conditional Phase I substitution units. EPA is currently reviewing whether it will accept Newington and Mt. Tom as substitution units and the number of allowances each will be awarded. All Phase I units, including substitution units accepted by EPA, will be allocated SO2 allowances for the period 1995-1999. On December 31, 1992, pursuant to Connecticut Public Act 92-106, CL&P filed a report with the Energy and Public Utilities Committee of the Connecticut General Assembly and the DPUC describing its plan for allocation of revenues from sale of SO2 allowances. CL&P proposed that its shareholders receive 20 percent of the proceeds from sales of allowances to compensate for the risks they have taken to reduce CL&P's SO2 emissions and to provide appropriate incentive to CL&P to sell allowances at the maximum price. In 1993 the DPUC approved a proposal by The United Illuminating Company (UI) to grant an option to another utility for the purchase of SO2 allowances, and ruled that shareholders would receive 15 percent of the proceeds from the eventual sale. The DPUC opened a docket and held hearings to review the reports filed by CL&P and UI. This review is addressing development of a policy on allocation between shareholders and ratepayers of SO2 allowance proceeds as well as CL&P's allowance donation. CDEP's air quality regulations permit CL&P to burn 1.0 percent sulfur oil at oil-fired generating stations in Connecticut, except that 0.5 percent sulfur oil must be burned at Middletown station. Current CDEP policy requires CL&P to use 0.5 percent or lower sulfur oil when replacing older (1.0 percent sulfur oil fueled) plant auxiliary boilers needed for unit start-up and plant space heating. The regulations also permit the burning of coal with a sulfur content of up to 0.7 percent at CL&P's plants, or up to 1.0 percent if a special permit is obtained. New Hampshire air quality regulations permit PSNH to emit 55,150 tons of SO2 annually. The New Hampshire acid rain control law required a 25 percent reduction in SO2 emissions from the 1979-1982 baseline emissions at PSNH's units, which has been achieved. Compliance with New Hampshire's acid rain control law has brought PSNH very close to compliance with the SO2 emission limits of Phase I of the CAAA. PSNH may need to install additional pollution control equipment or use fuel with lower sulfur content in order to meet the requirements of the CAAA. The EPA has issued an order requiring modeling of the impact on ambient air quality of SO2 emissions from Merrimack Station. Work on this study has begun and the final results of the modeling are expected to be available in mid-1995. If the modeling study indicates that compliance with the primary ambient air quality standards for SO2 is not being achieved, additional control strategies, possibly including the addition of emission control devices or a higher stack, will be required. Management cannot at this time predict the results of the modeling or estimate the cost of any additional control strategies that may be required. The Massachusetts air quality regulations permit HWP to burn 1.5 percent sulfur coal with an ash content up to 9 percent at Mt. Tom Station. Coal with a higher ash content can be burned with MDEP approval. Mt. Tom Station is required to reduce sulfur emissions to the equivalent of 1.0 percent sulfur oil if certain air quality monitors show levels of SO2 approaching ambient air quality limits. WMECO's West Springfield station currently burns 1.0 percent sulfur oil or natural gas. The Massachusetts acid rain control law requires MDEP to adopt regulations to limit future sulfur dioxide emissions. These regulations limit the allowable SO2 emissions from utility power plants and other major fuel burning sources to 1.2 pounds per million BTUs averaged over all of the System's Massachusetts plants, effective January 1, 1995. The System's generating plants in Massachusetts on average emit approximately 1.9 pounds of SO2 per million BTUs. The System expects to meet the new sulfur dioxide limitation by using natural gas and lower sulfur oil and coal in its plants. The System could incur additional costs for the lower sulfur fuels it may burn to meet the requirements of this legislation. Under the existing fuel adjustment clauses in Connecticut, New Hampshire and Massachusetts, the System would be able to recover the additional fuel costs of compliance with the CAAA and state laws from its customers. Management does not believe that the acid rain provisions of the CAAA will have a significant impact on the System's overall costs or rates due to the very strict limits on SO2 emissions already imposed by Connecticut, New Hampshire and Massachusetts and on NOX limitations imposed by Connecticut and New Hampshire. EPA, Connecticut, New Hampshire and Massachusetts regulations also include other air quality standards, emission standards and monitoring, and testing and reporting requirements that apply to the System's generating stations. They require that new or modified fossil fuel-fired electric generating units operate within stringent emission limits. Air Toxics. Title III of the CAAA imposes new stringent discharge limitations on hazardous air pollutants. EPA is required to study toxic emissions and mercury emissions from power plants. Pending completion of these studies, power plants are exempt from the hazardous air pollutant requirements. Should EPA or Congress determine that power plant emissions must be controlled to the same extent as emissions from other sources under Title III, the System could be required to make substantial capital expenditures to upgrade or replace pollution control equipment, but the amount of these expenditures cannot be readily estimated. Connecticut and New Hampshire have enacted, and Massachusetts is considering, toxic air pollution regulations limiting emissions of numerous substances that may extend beyond those regulated under federal law. TOXIC SUBSTANCES AND HAZARDOUS WASTE REGULATIONS PCBs. Under the federal Toxic Substances Control Act of 1976 (TSCA), EPA has issued regulations that control the use and disposal of polychlorinated biphenyls (PCBs). PCBs had been widely used as insulating fluids in many electric utility transformers and capacitors before TSCA prohibited any further manufacture of such PCB equipment. System companies have taken numerous steps to comply with these regulations and have incurred increased costs for disposal of used fluids and equipment that are subject to the regulations. One disposal measure involves the System's burning of some waste oil with a low level of PCB contamination (up to 500 parts per million (ppm)) as supplemental fuel at CL&P's Middletown station Unit 3. EPA and CDEP have approved this disposal method. In general, the System sends fluids with concentrations of PCBs equal to or higher than 500 ppm but lower than 8,500 ppm to an unaffiliated company to dispose of using a chemical treatment process. Electrical capacitors that contain PCB fluid are sent offsite to dispose of through burning in high temperature incinerators approved by EPA. Currently, there are only four such approved incinerators operating in the United States, which has resulted in a sharp rise in the price of disposal through these facilities. The System disposes of solid wastes containing PCBs in secure chemical waste landfills. In 1993, the System incurred costs of approximately $450,000 for disposal of materials at these facilities. Asbestos. Federal, Connecticut, New Hampshire and Massachusetts asbestos regulations have required the System to expend significant sums on removal of asbestos including measures to protect the health of workers and the general public and to properly dispose of asbestos wastes. Areas of the System currently undergoing removal of asbestos include nuclear, fossil/hydro production, transmission and distribution and facilities operations. The System expects to expend approximately $3.4 million in 1994 on the removal of asbestos in nuclear units, fossil and hydro generating stations and buildings. Even greater costs are likely to be incurred annually in the future if federal and state asbestos regulations become more stringent and the System's need to remove asbestos grows. RCRA. Under the federal Resource Conservation and Recovery Act of 1976, as amended (RCRA), the generation, transportation, treatment, storage and disposal of hazardous wastes are subject to EPA regulations. Connecticut, New Hampshire and Massachusetts have adopted state regulations that parallel RCRA regulations but in some cases are more stringent. A change in interpretation of RCRA by EPA now requires that nuclear facilities obtain EPA permits to handle radioactive wastes that are also hazardous under RCRA (so-called mixed wastes). The notifications and applications required by these regulations have been made by all units to which these regulations apply. The procedures by which System companies handle, store, treat and dispose of hazardous wastes are regularly revised, where necessary, to comply with these regulations. CL&P has discontinued operation of surface impoundments in its four Connecticut wastewater treatment facilities used to treat hazardous waste. This is because CL&P was unable to obtain variances from EPA to exempt the facilities from the double lining requirement under the 1984 RCRA amendments. CL&P has constructed replacement above-ground concrete tanks at an estimated cost of approximately $22 million. It is expected that in early 1994, EPA and DEP will approve clean closure for CL&P's Montville Station's impoundment. Accordingly, CL&P will no longer be required to maintain liability insurance or financial assurance for closure and post-closure for this former impoundment site. EPA's final approval of the closure of the remaining three surface impoundments is pending. The System estimates that it will incur approximately $2 million in costs of monitoring and closure of the container storage areas for these sites in the future, but the ultimate amount will depend on EPA's final disposition. Underground Storage Tanks. Federal and state regulations regulate underground tanks storing petroleum products or hazardous substances. The System has about 130 underground storage tanks that are used primarily for gasoline, diesel, house-heating and fuel oil. To reduce its environmental and financial liabilities, the System has begun implementing a policy calling for the permanent removal of all non-essential underground vehicle fueling tanks. Costs for this program are not substantial. Hazardous Waste Liability. As many other industrial companies have done in the past, System companies have disposed of residues from operations by depositing or burying such materials on-site or disposing of them at off-site landfills or facilities. Typical materials disposed of include coal gasification waste and oils that might contain PCBs. In recent years it has been determined that deposited or buried wastes, under certain circumstances, could cause groundwater contamination or other environmental harm. The System continues to evaluate the environmental impact of its former disposal practices. Under federal and state law, government agencies and private parties can attempt to impose liability on System companies for such past disposal. Under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, commonly known as Superfund, EPA has the authority to clean up hazardous waste sites and to impose the cleanup costs on parties deemed responsible for the hazardous waste activities on the sites. Responsible parties include the current owner of a site, past owners of a site at the time of waste disposal, waste transporters and waste generators. It is EPA's position that all responsible parties are jointly and severally liable, so that any single responsible party can be required to pay the entire costs of cleaning up the site. As a practical matter, however, the costs of cleanup are usually allocated by agreement of the parties, or by the courts on an equitable basis among the parties deemed responsible, and several recent federal appellate court decisions have rejected EPA's position on strict joint and several liability. Superfund also contains provisions that require System companies to report releases of specified quantities of hazardous materials and require notification of known hazardous waste disposal sites. Management believes that the System companies are in compliance with these reporting and notification requirements. The System is or has recently been involved in eight Superfund sites. Three of these sites are in Connecticut, one is in Kentucky, one is in West Virginia and three are in New Hampshire. The level of study of each site and the information about the waste contributed to the site by the System and other parties differs from site to site. Where reliable information is available that permits the System to make a reasonable estimate of the expected total costs of remedial action and/or the System's likely share of remediation costs for a particular site, those cost estimates are provided below. All cost estimates were made, in accordance with Financial Accounting Standards Board Statement No. 5, where remediation costs were probable and reasonably estimable. Any estimated costs disclosed for cleaning up the sites discussed below were determined without consideration of possible recoveries from third parties, including insurance recoveries. Where the System has not accrued a liability, the costs either were not material or there was insufficient information to accurately assess the System's exposure. At two Connecticut sites, the Beacon Heights and Laurel Park landfills, the major parties formed coalitions to clean the sites and settled their suits with EPA and CDEP. The coalitions then attempted to join as defendants a large number of potential contributors, including "Northeast Utilities (Connecticut Light and Power)." Litigation on both sites was consolidated in a single case in the federal district court. In January 1993, Judge Dorsey denied the motion of the Laurel Park Coalition to join NU (CL&P). In December 1993, Judge Dorsey dismissed the claims of Beacon Heights Coalition against many of the defendants and directed the coalition to indicate which remaining defendants it intended to pursue claims against. In January 1994, the Beacon Heights Coalition filed a response listing NU (CL&P) as a defendant they would not continue to pursue. As a result of Judge Dorsey's rulings and the coalition's actions, it is not likely that CL&P will incur any cleanup costs for these sites. In June, 1993, EPA notified the System that it was a Potentially Responsible Party (PRP) at the Solvents Recovery Service of New England site in Southington, Connecticut. PSNH is a de minimis PRP at this site and does not expect its cost to be substantial. At the Maxey Flats nuclear waste disposal site in Fleming County, Kentucky, EPA has issued a notice of potential liability to NNECO and CYAPC. The System had sent a substantial volume of LLRW from Millstone 1, Millstone 2 and CY to this site. CL&P and WMECO had previously recorded a liability for future remediation costs for this site based on System estimates. To date, the costs have not been material with respect to their earnings or financial positions. In September 1991, EPA issued its record of decision for the Maxey Flats nuclear waste disposal site. The EPA-approved remedy requires pumping and treatment of leachate, installing of an initial cap, allowing materials in the trenches to settle and ultimately constructing a permanent cap. EPA estimated that the cost of the remedy is approximately $33.5 million. Based on that estimate and the volume contributed, the System's share would be approximately $0.5 million. However, the System believes that the cost of the remedy could be substantially higher. The System estimates that its total cost for cleanup could be approximately $1-$2 million. EPA provided an opportunity for PRPs, including certain System companies, to enter into a consent decree with EPA under which each PRP would reimburse EPA for its past costs and would undertake remedial action at the site or pay the costs of EPA undertaking remedial action. On October 20, 1992, PRPs that are members of the Maxey Flats PRP Steering Committee, including System companies, and several federal government agencies, including DOE and the Department of Defense, made a settlement offer to EPA involving a commitment to perform a substantial portion of the remedial work required by EPA in its record of decision. On that same date, the Commonwealth of Kentucky made a settlement offer. EPA rejected the settlement offers in December 1992, but gave the parties an additional 60 days to make a "good faith" offer. On March 16, 1993, the PRP Steering Committee and the federal government agencies made a revised offer to EPA. Since then all parties have been actively involved in settlement negotiations. PSNH has settled with EPA and other PRPs at sites in West Virginia and Kingston, New Hampshire. PSNH paid approximately $33,700 to cash out of these sites. PSNH has committed approximately $280,000 as its share of the costs to clean up municipal landfills in Dover and North Hampton, New Hampshire. Some additional costs may be incurred at these sites but they are not expected to be significant. Other New Hampshire sites include municipal landfills in Somersworth and Peterborough, and the Dover Point site owned by PSNH in Dover, New Hampshire. PSNH's liability at the landfills is not expected to be significant and its liability at the Dover Point site cannot be estimated at this time. PSNH contacted NHDES in December 1993 concerning possible coal tar contamination in the headwater of Lake Winnipesaukee near an area where PSNH formerly owned and operated a coal gasification plant which was sold in 1945. PSNH agreed to conduct an historical review and provide a report to NHDES in February 1994. PSNH, along with two other identified PRPs, most likely will be conducting a site investigation in the spring of 1994. In 1987, CDEP published a list of 567 hazardous waste disposal sites in Connecticut. The System owns two sites on this list. The System has spent approximately $0.5 million to date completing investigations at these sites. Both sites were formerly used by CL&P predecessor companies for the manufacture of coal gas (also known as town gas sites) from the late 1800s to the 1950s. This process resulted in the production of coal tar residues, which, when not sold for roofing or road construction, were frequently deposited on or near the production facilities. Site investigations are being carried out to gain an understanding of the environmental and health risks of these sites. Should future site remediation become necessary, the level of cleanup will be established in cooperation with CDEP. Connecticut is currently developing cleanup standards and guidelines for soil and groundwater. One of the sites is a 25.8 acre site located in the south end of Stamford, Connecticut. Site investigations have located coal tar deposits covering approximately 5.5 acres and having a volume of approximately 45,000 cubic yards. A final risk assessment report for the site was completed in January 1994. Several remedial options are currently being evaluated to clean up the site; however, CL&P is focusing on institutional and engineering controls, such as capping and paving, which would reduce the potential health risks and secure the site. The estimated costs of institutional controls range from $2 million to $3 million. As part of the 1989 divestiture of CL&P's gas business, site investigations were performed for properties that were transferred to Yankee Gas Services Company (Yankee Gas). As a result of those investigations, ten properties were identified for which negative declarations under the Property Transfer Act could not be filed. A negative declaration is a statement that there has been no discharge of hazardous wastes at the site, or that if there was such a discharge, it has been cleaned up or determined to pose no threat to health, safety or the environment and is being managed lawfully. Of the ten sites, CL&P agreed to accept liability for required cleanup for the three sites it retained. At one location, CL&P and Yankee Gas share the site and any liability for any required cleanup. Yankee Gas accepted liability for any required cleanup of the other sites. CL&P and Yankee Gas will share the costs of cleanup of sites formerly used in CL&P's gas business but not currently owned by either of them. In Massachusetts, System companies have been designated by MDEP as PRPs for ten sites under MDEP's hazardous waste and spill remediation program. The System does not expect that its share of the remaining remediation costs for any of these sites will be material. At some of these sites, the System is responsible for only a small portion or none of the hazardous wastes. For some of these and for other sites, the total remediation costs are not expected to be material. At one of the sites, the System has spent approximately $2 million for cleanup and it expects to incur approximately $250,000 for the remaining remediation costs. HWP has been identified by MDEP as a PRP in a coal tar site in Holyoke, Massachusetts. HWP owned and operated the Holyoke Gas Works from 1859 to 1902. It was sold to the city of Holyoke and operated by its Gas and Electric Department (HG&E) from 1902 to 1951. Currently, one third of the two acre property is owned by HG&E, with the remaining portion owned by a construction company. The site is located on the west side of Holyoke, adjacent to the Connecticut River and immediately downstream of HWP's Hadley Falls Station. MDEP has classified both the land and river deposit areas as Tier I priority waste disposal sites. Due to the presence of tar patches in the vicinity of the spawning habitat of the shortnose sturgeon (SNS) - an endangered species - the National Oceanographic and Atmospheric Administration (NOAA) and National Marine Fisheries Service have taken an active role in overseeing site activities. Although HWP denies that it is a PRP, it has cooperated with the agencies in investigating this problem. Both MDEP and NOAA have indicated they may require the removal of tar deposits from the vicinity of the SNS spawning habitat. To date, HWP has spent approximately $200,000 for river studies and construction costs for an oil containment boom to prevent leaching hydrocarbons from entering the Hadley Falls tailrace and the Connecticut River. The System has received other claims from government agencies and third parties for the cost of remediating sites not currently owned by the System but affected by past System disposal activities and expects to receive more such claims in the future. The System expects that the costs of resolving claims for remediating sites about which it has been notified will not be material, but cannot estimate the costs with respect to sites about which it has not been notified. If the System, regulatory agencies or courts determine that remedial actions must be taken in relation to past disposal practices on property owned or used for disposal by the System in the past, the System could incur substantial costs. ELECTRIC AND MAGNETIC FIELDS In recent years, published reports have discussed the possibility of adverse health effects from electric and magnetic fields (EMF) associated with electric transmission and distribution facilities and appliances and wiring in buildings and homes. On the basis of scientific reviews of these reports conducted by various state, federal and international panels, management does not believe that a causal relationship has been established or that significant capital expenditures are appropriate to minimize unsubstantiated risks. The System supports further research into the subject and is participating in the funding of the National EMF Research and Public Information Dissemination Program and other industry-sponsored studies. If further investigation were to demonstrate that the present electricity delivery system is contributing to increased risk of cancer or other health problems, the industry could be faced with the difficult problem of delivering reliable electric service in a cost-effective manner while managing EMF exposures. In addition, if the courts were to conclude that individuals have been harmed and that utilities are liable for damages, the potential monetary exposure for all utilities, including the System companies, could be enormous. Without definitive scientific evidence of a causal relationship between EMF and health effects, and without reliable information about the kinds of changes in utilities' transmission and distribution systems that might be needed to address the problem, if one is found, no estimates of the cost impacts of remedial actions and liability awards are available. Epidemiological studies, rather than laboratory studies, have been primarily responsible for increased scientific interest in and public concern over EMF exposures in the past decade. New epidemiological study results from international researchers were released and publicized in late-1992 and in 1993, but these only added to a picture of inconsistency from previous studies. Researchers from Sweden and Denmark concluded that their statistical results support the hypothesis that EMF may be a causative factor in certain types of cancer (although they disagreed on which types), while researchers from Finland and Greece found no evidence to support such a hypothesis. These researchers, as well as scientific review panels considering all significant EMF epidemiological and laboratory research to date, all agree that current information remains inconclusive, inconsistent and insufficient for risk assessment of EMF exposures. NU is closely monitoring research and government policy developments. In 1993, there were several notable events on the federal government level regarding EMF. The EPA has indefinitely postponed completion of a report on EMF, citing as its reasons high costs and the unlikelihood of shedding new light on the issue. Instead, it now plans to issue a 30-page "summary of science" in early 1994. In a related development, the Department of Energy has initiated a scientific review of EMF research by the National Academy of Sciences. Also on the federal level, the National EMF Research and Public Information Dissemination Program (created by the Energy Policy Act) moved forward in 1993 by establishing a federal interagency committee and an advisory committee, and by soliciting the required non-federal matching funds (through The Edison Electric Institute, NU will be making a voluntary contribution of approximately $62,000 for each year of the five-year program). The Connecticut Interagency EMF Task Force (Task Force) provided reports to the state legislature in March 1993 and in January 1994. The Task Force recognizes and supports the need for more research, and has suggested a policy of "voluntary exposure control," which involves providing people with information to enable them to make individual decisions about EMF exposure. Neither the Task Force, nor any Connecticut state agency, has recommended changes to the existing electrical supply system. Finally, the Connecticut Siting Council adopted a set of EMF "best management practices" in February 1993, which must now be considered in the justification, siting and design of new transmission lines and substations. EMF has become increasingly important as a factor in facility siting decisions in many states. Several bills were introduced in Massachusetts in January 1993, and were last reported to be pending before various legislative committees. It is not known whether there will be further action on the bills, which would require certain disclosures to real estate purchasers and utility employees, a scientific literature review, establishment of a fund to reduce certain field exposures, identification of schools and day care centers within 500 feet of transmission lines and development of EMF regulations. No action was taken on EMF bills previously pending in 1992. CL&P has been the focus of media reports charging that EMF associated with a CL&P substation and related distribution lines in Guilford, Connecticut, is linked with various cancers and other illnesses in several nearby residents. See Item 3, Legal Proceedings, for information about two suits brought by plaintiffs who now live or formerly lived near that substation. FERC HYDRO PROJECT LICENSING Federal Power Act licenses may be issued for hydroelectric projects for terms of up to 50 years as determined by FERC. Any hydroelectric project so licensed is subject to recapture by the United States for licensing to others after expiration of the license upon payment to the licensee of the lesser of fair value or the net investment in the project plus severance damages less certain amounts earned by the licensee in excess of a reasonable rate of return. Licenses are customarily conditioned on the licensee's development of recreational and other non-power uses at each licensed project. Conditions may be imposed with respect to low flow augmentation of streams and fish passage facilities. On September 28, 1993, the United States Fish and Wildlife Service (FWS) was petitioned to list the anadromous Atlantic salmon (Salmo salar) as an endangered species in the United States. After a 90-day review, the petition was found to be complete and was accepted. The National Marine Fisheries Service and FWS were given joint jurisdiction over this petition. Within the next 12 months, these agencies will decide if the petition is warranted. If salmon are listed as an endangered species, the System may be required to take a number of actions including increasing spillage over some dams during the salmon migration period resulting in loss of generation capacity at the affected hydroelectric facilities; modifying spillways to accommodate safe fish passage; curtailing pumping at Northfield Mountain during the salmon migration period; improving upstream and downstream passage facilities at all hydroelectric dams on the Connecticut and Merrimack Rivers; and modifying intake structures and curtailing operations during salmon migration periods at certain of the System's thermal structures. Although these are all possible implications of a listing, the System cannot estimate the impact on System facilities at this time. The System is continuing to conduct studies on the Connecticut River in fulfillment of the Memorandum of Agreement (MOA) concerning downstream passage of anadromous fishes (Atlantic salmon, American shad and blueback herring). The MOA was signed by the System and the Connecticut River Atlantic Salmon Commission and its member agencies in 1990. The System conducted studies in 1991 and 1992 of the entrainment of salmon smolts and juvenile shad and herring in water pumped to the upper reservoir of the Northfield Mountain Pumped Storage Project. Studies of entrainment of shad and herring indicated that Northfield's impact on these species is low, and further studies have not been conducted. Studies of salmon smolts, however, indicated the potential for unacceptable losses of smolts due to entrainment, but the results also indicated that firm conclusions could not be drawn. Accordingly, the System conducted a more definitive study indicating that about 10 percent of the 1993 smolt run was entrained at Northfield. The System will continue to pursue practical techniques to reduce salmon smolt entrainment at Northfield and has agreed to alter its 1994 maintenance schedule to reduce the amount of time when all four pump/turbine units will be pumping simultaneously during the smolt migration period. Should the system be unable to reduce smolt entrainment through operational changes or practical exclusion techniques, substantial additional costs are possible. The total cost cannot be determined at this time. The System operating companies hold licenses granted under Part I of the Federal Power Act for the operation and maintenance of thirteen existing hydroelectric projects, four of which are in Massachusetts (Northfield, Turners Falls, Gardners Falls and Holyoke [river and canal units]), three of which are in Connecticut (Scotland, Housatonic [encompassing Bulls Bridge, Rocky River, Shepaug and Stevenson] and Falls Village) and six of which are in New Hampshire (Merrimack [encompassing Garvins Falls, Hooksett and Amoskeag], Smith, Ayers Island, Eastman Falls, Canaan and Gorham). In 1992, FERC issued orders exempting from licensing WMECO's four Chicopee River projects: Dwight, Indian Orchard, Putts Bridge and Red Bridge. To date, FERC has not claimed jurisdiction over CL&P's Bantam, Robertsville, Taftville and Tunnel Projects or PSNH's Jackman project. Four of the System's FERC licenses expired at the end of 1993 (Gardners Falls, Ayers Island, Gorham and Smith). Relicensing efforts have been under way for these projects for several years. As no third parties have filed competing license applications with FERC for these projects, it is highly likely that FERC will grant renewal licenses for these projects to the System. However, certain operating, environmental and/or recreational conditions may be placed on these licenses. Because FERC was unable to complete its relicensing process prior to the December 31, 1993 expiration of these licenses, under the provision of section 15 of the Federal Power Act, FERC has issued one-year extensions to each of these licensees. FERC will continue to issue annual licenses until it completes the relicensing process. EMPLOYEES As of December 31, 1993, the System companies had approximately 9,697 full and part time employees on their payrolls, of which approximately 2,697 were employed by CL&P, approximately 1,452 by PSNH, approximately 656 by WMECO, approximately 119 by HWP, approximately 1,252 by NNECO, approximately 2,584 by NUSCO and approximately 937 by North Atlantic. NU and NAEC have no employees. Approximately 2,242 employees of CL&P, PSNH, WMECO and HWP are covered by union agreements, which expire between October 1994 and May 1996. Certain employees of North Atlantic negotiated a union contract in 1993. On August 3, 1993, the System announced that it intended to reduce its total workforce by 600 to 700 positions and offered a voluntary early retirement program to about 800 eligible employees. The program was available generally to all nonbargaining unit employees of NU's subsidiaries, NUSCO, CL&P, WMECO, HWP, PSNH and NAESCO, who would be at least age 55 with ten years of service as of November 1, 1993. Most nuclear-related job classifications at NUSCO and NAESCO were not eligible. The program enhanced pension benefits by adding an additional three years to age and service for the purpose of calculating pension benefits and early retirement reduction factors, as well as providing a supplemental payment to employees who retired prior to becoming eligible for social security benefits. Each program participant has retired or will retire on a date to be established by the employer between November 1, 1993 and November 1, 1994. A similar program was offered to approximately 300 bargaining unit employees working for System companies and 12 employees of NEPOOL/NEPEX. The workforce reduction affected approximately 811 employees, of which 498 individuals accepted the early retirement program and another 313 individuals who were involuntarily terminated. Involuntarily terminated employees were eligible to receive a lump sum severance payment of up to a maximum of 52 weeks salary, depending on years of credited service. In addition, as part of the System's reorganization of its Connecticut-based nuclear organization, 32 employees were involuntarily terminated through January 12, 1994. For more information on the reorganization see "Nuclear Generation - Operations - Nuclear Performance Improvement Initiatives." The total cost of the workforce reduction program and the nuclear reorganization was approximately $38 million, including pension, severance and other benefits. Item 2. Item 2. Properties The physical properties of the System are owned or leased by subsidiaries of NU. CL&P's principal plants and other properties are located either on land which is owned in fee or on land, as to which CL&P owns perpetual occupancy rights adequate to exclude all parties except possibly state and federal governments, which has been reclaimed and filled pursuant to permits issued by the United States Army Corps of Engineers. The principal properties of PSNH are held by it in fee. In addition, PSNH leases space in an office building under a 30-year lease expiring in 2002. WMECO's principal plants and a major portion of its other properties are owned in fee, although one hydroelectric plant is leased. NAEC owns a 35.98201 percent interest in Seabrook 1, and approximately 719 acres of exclusion area land located around the unit. In addition, CL&P, PSNH, and WMECO have certain substation equipment, data processing equipment, nuclear fuel, nuclear control room simulators, vehicles, and office space that are leased. With few exceptions, the System's companies' lines are located on or under streets or highways, or on properties either owned, leased, or in which the company has appropriate rights, easements, or permits from the owners. CL&P's properties are subject to the liens of CL&P's first mortgage indenture and, with respect to properties formerly owned by The Hartford Electric Light Company (HELCO), to the lien of HELCO's first mortgage indenture. PSNH's properties are subject to the lien of its first mortgage indenture. In addition, PSNH's outstanding term loan and revolving credit agreement borrowings are secured by a second lien, junior to the lien of the first mortgage indenture, on PSNH property located in New Hampshire. WMECO's properties are subject to the lien of its first mortgage indenture. NAEC's First Mortgage Bond are secured by a lien on the Seabrook 1 interest described above, and all rights of NAEC under the Seabrook Power Contract. In addition, CL&P's and WMECO's interests in Millstone 1 are subject to second liens for the benefit of lenders under agreements related to pollution control revenue bonds. Various ones of these properties are also subject to minor encumbrances which do not substantially impair the usefulness of the properties to the owning company. The System companies' properties are well maintained and are in good operating condition. Notes: 1. Until 1991, awards under the short-term programs of the Northeast tilities Executive Incentive Compensation Program (EICP) were made in restricted stock. In 1991, the Northeast Utilities Executive Incentive Plan (EIP) was adopted, which did not require restricted stock awards. Awards under the 1991 and 1992 short-term programs under the EIP were paid in 1992 and 1993, respectively, in the form of unrestricted stock and, in accordance with the requirements of the SEC, are included as "bonus" in the years earned. 2. The five executive officers listed in the table above each received an award of restricted stock in May, 1991 (which vested in January, 1993), under the EICP. The number of shares in each such award is shown below. All restricted stock awards under the EICP vested prior to December 31, 1993. Name Shares B. M. Fox 1,807 W. B. Ellis 2,585 J. F. Opeka 1,349 R. E. Busch 1,090 J. P. Cagnetta 847 3. "All Other Compensation" consists of employer matching contributions under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k) Plan), generally available to all eligible employees. In 1993, the employer match for non-union employees was 100 percent of the first three percent of compensation contributed on a before-tax basis. 4. Awards under the short-term program of the EIP have typically been made by NU's Committee on Organization, Compensation and Board Affairs in April each year. Based on preliminary estimates of corporate performance, and assuming that the individual performance levels of Messrs. Opeka, Busch and Cagnetta approximate those of other system officers, it is estimated that the five executive officers listed in the table above would receive the following awards: Mr. Fox - $180,780; Mr. Ellis - $160,693; Mr. Busch - $64,946; Mr. Opeka - $64,946; and Dr. Cagnetta - $43,828. 5. Mr. Fox served as President and Chief Operating Officer of CL&P, NAEC and WMECO and Vice Chairman and Chief Operating Officers of PSNH until July 1, 1993, when he became President and Chief Executive Officer of CL&P, NAEC and WMECO and Vice Chairman and Chief Executive Officer of PSNH. Mr. Ellis served as Chairman and Chief Executive Officer of these companies until July 1, 1993, when he became Chairman. Amounts listed in the "Long Term Incentive Program" column of the Summary Compensation Table for 1993 were received by these individuals prior to their change in responsibilities. $267,500 of Mr. Ellis's 1993 salary was paid prior to July 1, 1993, while he was Chief Executive Officer, and $253,750 was paid after July 1, 1993. $217,500 of Mr. Fox's 1993 salary was paid prior to July 1, 1993, and $261,275 was paid after Mr. Fox became Chief Executive Officer on July 1, 1993. PENSION BENEFITS The following table shows the estimated annual retirement benefits payable to an executive officer of NU, CL&P, WMECO, PSNH and NAEC upon retirement, assuming that retirement occurs at age 65 and that the officer is at that time not only eligible for a pension benefit under the Northeast Utilities Service Company Retirement Plan (the Retirement Plan) but also eligible for the "make-whole benefit" and the "target benefit" under the Supplemental Executive Retirement Plan for Officers of Northeast Utilities System Companies (the Supplemental Plan). The Supplemental Plan is a non-qualified pension plan providing supplemental retirement income to System officers. The "make-whole benefit" under the Supplemental Plan makes up for benefits lost through application of certain tax code limitations on the benefits that may be provided under the Retirement Plan, and is available to all officers. The "target benefit" further supplements these benefits and is available to officers at the Senior Vice President level and higher who are selected by the NU Board of Trustees to participate in the target benefit and who remain in the employ of NU companies until at least age 60 (unless the NU Board of Trustees sets an earlier age). Each of the executive officers of NU, CL&P, WMECO, PSNH and NAEC named in the summary compensation table above is currently eligible for a target benefit. If an executive officer were not eligible for a target benefit at the time of retirement, a lower level of retirement benefits would be paid. The benefits presented are based on a straight life annuity beginning at age 65 and do not take into account any reduction for joint and survivorship annuity payments. Years of Credited Service Final Average ------------------------------------------------------ Compensation 15 20 25 30 35 - ------------------ ------------------------------------------------------ $ 125,000 $ 45,000 $ 60,000 $ 75,000 $ 75,000 $ 75,000 $ 150,000 $ 54,000 $ 72,000 $ 90,000 $ 90,000 $ 90,000 $ 175,000 $ 63,000 $ 84,000 $105,000 $105,000 $105,000 $ 200,000 $ 72,000 $ 96,000 $120,000 $120,000 $120,000 $ 225,000 $ 81,000 $108,000 $135,000 $135,000 $135,000 $ 250,000 $ 90,000 $120,000 $150,000 $150,000 $150,000 $ 300,000 $108,000 $144,000 $180,000 $180,000 $180,000 $ 350,000 $126,000 $168,000 $210,000 $210,000 $210,000 $ 400,000 $144,000 $192,000 $240,000 $240,000 $240,000 $ 450,000 $162,000 $216,000 $270,000 $270,000 $270,000 $ 500,000 $180,000 $240,000 $300,000 $300,000 $300,000 $ 600,000 $216,000 $288,000 $360,000 $360,000 $360,000 $ 700,000 $252,000 $336,000 $420,000 $420,000 $420,000 $ 800,000 $288,000 $384,000 $480,000 $480,000 $480,000 Final average compensation for purposes of calculating the "target benefit" is the highest average annual compensation of the participant during any 36 consecutive months compensation was earned. Compensation taken into account under the "target benefit" described above includes salary, bonus, restricted stock awards, and long-term incentive payouts shown in the Summary Compensation Table above, but does not include employer matching contributions under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k)) Plan. In the event that an officer's employment terminates because of disability, the retirement benefits shown above would be offset by the amount of any disability benefits payable to the recipient that are attributable to contributions made by NU and its subsidiaries under long term disability plans and policies. As of December 31, 1993, the five executive officers named in the Summary Compensation Table above had the following years of credited service for retirement compensation purposes: Mr. Fox - 29, Mr. Ellis - 17, Mr. Opeka - 23, Mr. Busch - 20 and Dr. Cagnetta - 21. Assuming that retirement were to occur at age 65 for these officers, retirement would occur with 43, 29, 35, 38 and 25 years of credited service, respectively. NU has entered into agreements with Messrs. Ellis and Fox to provide for an orderly management succession. The agreement with Mr. Ellis calls for him to work with the NU Board of Trustees and Mr. Fox to effect the orderly transition of his responsibilities to Mr. Fox. In accordance with the agreement, Mr. Ellis stepped down as Chief Executive Officer of NU, CL&P, WMECO, PSNH and NAEC as of July 1, 1993. The agreement anticipates his retirement as of August 1, 1995. The agreement provides that, upon his retirement, Mr. Ellis will be entitled to receive from NU and its subsidiaries a target benefit under the Supplemental Plan. His target benefit will be based on the greater of his actual final average compensation or an amount determined as if his salary had increased each year since 1991 at a rate equal to the average rate of the increases of all other target benefit participants and as if he had received incentive awards each year based on this modified salary, but with the same performance as the Chief Executive Officer at the time. The agreement also provides specified death and disability benefits for the period before Mr. Ellis's 1995 retirement. The agreement with Mr. Fox states that if he is terminated as Chief Executive Officer without cause, he will be entitled to specified severance pay and benefits. Those benefits consist primarily of (i) two years' base pay, medical, dental and life insurance benefits, (ii) a supplemental retirement benefit equal to the difference between the target benefit he would be entitled to receive if he had reached the age of 55 on the termination date and the actual target benefit to which he is entitled as of the termination date, and (iii) a target benefit under the Supplemental Plan, notwithstanding that he might not have reached age 60 on the termination date and notwithstanding other forfeiture provisions of that plan. The agreement also provides specified death and disability benefits. The agreement terminates two years after NU gives Mr. Fox a notice of termination, but no earlier than the date he becomes 55. The agreements do not address the officers' normal compensation and benefits, which are to be determined by NU's Committee on Organization, Compensation and Board Affairs and the NU Board of Trustees in accordance with their customary practices. Item 12. Security Ownership of Certain Beneficial Owners and Management NU. Incorporated herein by reference are pages 5 through 12 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. As of February 28, 1994, the Directors of CL&P, PSNH, WMECO and NAEC, beneficially owned the following number of shares of each class of equity securities of NU. No equity securities of CL&P, PSNH or WMECO are owned by the Directors and Executive Officers. CL&P, PSNH, WMECO, and NAEC DIRECTORS AND NAMED EXECUTIVE OFFICERS Amount and Nature of Title Of Name of Beneficial Percent of Class Beneficial Owner Ownership (1) Class (2) NU Common Robert G. Abair (3) (621) 4,271 shares NU Common Robert E. Busch (772) 6,054 shares NU Common John P. Cagnetta (4) (581) 3,979 shares NU Common John C. Collins (5) 0 shares NU Common William B. Ellis (6) (1,259) 14,837 shares NU Common Ted C. Feigenbaum(7) 151 shares NU Common Bernard M. Fox (8) (1,072) 17,428 shares NU Common William T. Frain, Jr. 885 shares NU Common Cheryl W. Grise (221) 1,349 shares NU Common John B. Keane (9) (368) 1,146 shares NU Common Francis L. Kinney (10) (303) 3,781 shares NU Common Gerald Letendre (5) 0 shares NU Common Hugh C. MacKenzie (4)(11) (779) 4,277 shares NU Common Jane E. Newman (5) 0 shares NU Common Dale F. Nitzschke (5) 0 shares NU Common John W. Noyes (658) 2,789 shares NU Common John F. Opeka (4)(12) (1,075) 16,463 shares NU Common Robert P. Wax (5) (651) 1,436 shares Amount beneficially owned by Directors and Executive Officers as a group - CL&P (7,709) 77,259 shares - PSNH (6,790) 69,299 shares - WMECO (7,709) 77,259 shares - NAEC (7,088) 73,139 shares (1) Unless otherwise noted, each Director and Executive Officer of CL&P, PSNH, WMECO and NAEC has sole voting and investment power with respect to the listed shares. The numbers in parentheses reflect the number of shares owned by each Director and Executive Officer under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k) Plan), as to which the Officer has no investment power. (2) As of February 28, 1994 there were 134,208,461 common shares of NU outstanding. The percentage of such shares beneficially owned by any Director or Executive Officer, or by all Directors and Executive Officers of CL&P, PSNH, WMECO and NAEC as a group, does not exceed one percent. (3) Mr. Abair is a Director of CL&P and WMECO only. (4) Mr. Opeka and Dr. Cagnetta are not officers of PSNH, but each in his capacity as an officer (with the stated title) of NUSCO, an affiliate of PSNH, performs policy-making functions for PSNH. (5) Messrs. Collins, Letendre, Nitzschke and Wax and Ms. Newman areDirectors of PSNH only. (6) Mr. Ellis shares voting and investment power with his wife for 1,117 shares. (7) Mr. Feigenbaum is a Director and an Executive Officer of NAEC only. (8) Mr. Fox shares voting and investment power with his wife for 3,031 of these shares. In addition, Mr. Fox's wife has sole voting and investment power for 140 shares, as to which Mr. Fox disclaims beneficial ownership. (9) Mr. Keane is a Director of CL&P, WMECO and NAEC only. (10) Mr. Kinney shares voting and investment power with his wife for 2,155 shares. (11) Mr. MacKenzie shares voting and investment power with his wife for 1,259 shares. (12) Mr. Opeka shares voting and investment power with his wife for 1,718 shares. Item 13. Certain Relationships and Related Transactions NU. Incorporated herein by reference is page 14 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. No relationships or transactions that would be described in response to this item exist now or existed during 1993 with respect to CL&P, PSNH, WMECO and NAEC. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements: The Report of Independent Public Accountants and financial statements of NU, CL&P, PSNH, WMECO, and NAEC are hereby incorporated by reference and made a part of this report (see "Item 8. Financial Statements and Supplementary Data"). Reports of Independent Public Accountants on Schedules S-1 Consents of Independent Public Accountants S-3 2. Schedules: Financial Statement Schedules for NU (Parent), NU and Subsidiaries, CL&P, PSNH, WMECO, and NAEC are listed in the Index to Financial Statement Schedules S-5 3. Exhibits Index E-1 (b) Reports on Form 8-K: During the fourth quarter of 1993, the companies filed Form 8-Ks dated December 2, 1993 disclosing the following: o On December 2, 1993, the Northeast Utilities system announced a reorganization of its corporate structure. o On December 3, 1993, NNECO was informed by the NRC that it was being assessed a civil penalty in response to repair activities at Millstone 2. In addition, the Form 8-K dated December 2, 1993 which was filed by PSNH also discussed the following: o On June 8, 1992, PSNH changed its independent public accountant. NORTHEAST UTILITIES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NORTHEAST UTILITIES ------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------------- William B. Ellis Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Trustee and Chairman /s/ William B. Ellis - -------------- of the Board ------------------------- William B. Ellis March 18, 1994 Trustee, President /s/ Bernard M. Fox - -------------- and Chief Executive ------------------------- Officer Bernard M. Fox March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President and Chief ------------------------- Financial Officer Robert E. Busch March 18, 1994 Vice President and /s/ John B. Keane - -------------- Treasurer ------------------------- John B. Keane March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller ------------------------- John W. Noyes NORTHEAST UTILITIES SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Trustee /s/ Cotton Mather Cleveland - -------------- --------------------------- Cotton Mather Cleveland March 18, 1994 Trustee /s/ George David - -------------- --------------------------- George David March 18, 1994 Trustee /s/ Donald J. Donahue - -------------- --------------------------- Donald J. Donahue March 18, 1994 Trustee /s/ Eugene D. Jones - -------------- --------------------------- Eugene D. Jones March 18, 1994 Trustee /s/ Elizabeth T. Kennan - -------------- --------------------------- Elizabeth T. Kennan Trustee - -------------- --------------------------- Denham C. Lunt, Jr. March 18, 1994 Trustee /s/ William J. Pape II - -------------- --------------------------- William J. Pape II March 18, 1994 Trustee /s/ Robert E. Patricelli - -------------- --------------------------- Robert E. Patricelli Trustee - -------------- --------------------------- Norman C. Rasmussen Trustee - -------------- --------------------------- John F. Swope THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE CONNECTICUT LIGHT AND POWER COMPANY --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE 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. PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- ------------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ William T. Frain, Jr. - -------------- Operating Officer -------------------------- and Director William T. Frain, Jr. March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John C. Collins - ------------------- -------------------------- John C. Collins March 18, 1994 Director /s/ Gerald Letendre - ------------------- -------------------------- Gerald Letendre March 18, 1994 Director /s/ Hugh C. MacKenzie - ------------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ Jane E. Newman - ------------------- -------------------------- Jane E. Newman March 18, 1994 Director /s/ Dale S. Nitzschke - ------------------- -------------------------- Dale S. Nitzschke March 18, 1994 Director /s/ Robert P. Wax - ------------------- -------------------------- Robert P. Wax WESTERN MASSACHUSETTS ELECTRIC 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. WESTERN MASSACHUSETTS ELECTRIC COMPANY -------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- -------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes WESTERN MASSACHUSETTS ELECTRIC COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka NORTH ATLANTIC ENERGY 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. NORTH ATLANTIC ENERGY CORPORATION --------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ Robert E. Busch - -------------- Operating Officer -------------------------- and Director Robert E. Busch March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes NORTH ATLANTIC ENERGY CORPORATION SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John P. Cagnetta - -------------- -------------------------- John P. Cagnetta - -------------- Director -------------------------- Ted C. Feigenbaum March 18, 1994 Director /s/ William T. Frain. Jr. - -------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - -------------- -------------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - -------------- -------------------------- John B. Keane March 18, 1994 Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ John F. Opeka - -------------- -------------------------- John F. Opeka REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES We have audited in accordance with generally accepted auditing standards, the financial statements included in Northeast Utilities' annual report to shareholders and The Connecticut Light and Power Company's, Western Massachusetts Electric Company's, North Atlantic Energy Corporation's, and Public Service Company of New Hampshire's annual reports, incorporated by reference in this Form 10-K, and have issued our reports thereon dated February 18, 1994. Our reports on the financial statements include an explanatory paragraph with respect to the change in methods of accounting for property taxes, postretirement benefits other than pensions, income taxes, and employee stock ownership plans, as applicable to each company, as explained in Note 1 to the related company's financial statements. Our audits were made for the purpose of forming an opinion on each company's statements taken as a whole. The schedules listed in the index to financial statement schedules are the responsibility of each company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of each company's basic financial statements. The schedules have been subjected to the auditing procedures applied in the audits of each company's 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 each company's basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut February 18, 1994 S-1 INDEPENDENT AUDITORS' REPORT ON SCHEDULES The Board of Directors Public Service Company of New Hampshire: Under date of February 7, 1992, we reported on the balance sheet and statement of capitalization of Public Service Company of New Hampshire as of December 31, 1991 (not presented in the 1993 annual report to stockholders) and the related statements of income, cash flows and common stock equity for the periods January 1, 1991 to May 15, 1991 and May 16, 1991 to December 31, 1991, as contained in the annual report to stockholders of Public Service Company for the year 1993. These financial statements and our report thereon are incorporated by reference herein. In connection with our audits of the aforementioned financial statements, we have also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsiblity is to express an opinion on these financial statement schedules based on our audit. 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/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massachusetts February 7, 1992 S-2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference of our reports in this Form 10-K, into previously filed Registration Statement No. 33-13444, No. 33-46291 , No. 33-59430, and No. 33-50853 of The Connecticut Light and Power Company, No. 33-34886, No. 33-51185 and No. 33-25619 of Western Massachusetts Electric Company, and No. 33-34622 and No. 33-40156 of Northeast Utilities. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut March 18, 1994 S-3 INDEPENDENT AUDITORS' CONSENT The Board of Directors Public Service Company of New Hampshire: We consent to the use of our reports included or incorporated by reference herein. /s/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massaschusetts March 18, 1994 S-4 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedule Page - -------- ---- III. Financial Information of Registrant: Northeast Utilities (Parent) Balance Sheets 1993 and 1992 S-7 Northeast Utilities (Parent) Statements of Income 1993, 1992, and 1991 S-8 Northeast Utilities (Parent) Statements of Cash Flows 1993, 1992, and 1991 S-9 V. Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-10 -- S-12 The Connecticut Light and Power Company S-13 -- S-15 Public Service Company of New Hampshire S-16 -- S-20 Western Massachusetts Electric Company S-21 -- S-23 North Atlantic Energy Corporation S-24 -- S-25 V. Nuclear Fuel 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-26 -- S-28 The Connecticut Light and Power Company S-29 -- S-31 Public Service Company of New Hampshire S-32 -- S-36 Western Massachusetts Electric Company S-37 -- S-39 North Atlantic Energy Corporation S-40 -- S-41 VI. Accumulated Provision for Depreciation of Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-42 -- S-44 The Connecticut Light and Power Company S-45 Public Service Company of New Hampshire S-46 -- S-48 Western Massachusetts Electric Company S-49 North Atlantic Energy Corporation S-50 VIII. Valuation and Qualifying Accounts and Reserves 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-51 -- S-53 The Connecticut Light and Power Company S-54 -- S-56 Public Service Company of New Hampshire S-57 -- S-61 Western Massachusetts Electric Company S-62 -- S-64 S-5 Schedule Page - -------- ---- IX. Short-Term Borrowings 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-65 The Connecticut Light and Power Company S-66 Public Service Company of New Hampshire S-67 Western Massachusetts Electric Company S-68 North Atlantic Energy Corporation S-69 X. Supplementary Income Statement Information 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-70 The Connecticut Light and Power Company S-71 Public Service Company of New Hampshire S-72 Western Massachusetts Electric Company S-73 North Atlantic Energy Corporation S-74 All other schedules of the companies' for which provision is made in the applicable regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable, and therefore have been omitted. S-6 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- BALANCE SHEETS -------------- AT DECEMBER 31, 1993 AND 1992 ------------------------------ (Thousands of Dollars) S-7 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- STATEMENTS OF INCOME -------------------- YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 --------------------------------------------- (Thousands of Dollars Except Share Information) S-8 SCHEDULE III NORTHEAST UTILITIES (PARENT) FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Thousands of Dollars) S-9 S-10 S-11 S-12 S-13 S-14 S-15 S-16 S-17 S-18 S-19 S-20 S-21 S-22 S-23 S-24 S-25 S-26 S-27 S-28 S-29 S-30 S-31 S-32 S-33 S-34 S-35 S-36 S-37 S-38 S-39 S-40 S-41 S-42 S-43 S-44 S-45 S-46 S-47 S-48 S-49 S-50 S-51 S-52 S-53 S-54 S-55 S-56 S-57 S-58 S-59 S-60 S-61 S-62 S-63 S-64 S-65 S-66 S-67 S-68 S-69 S-70 S-71 S-72 S-73 S-74 EXHIBIT INDEX Each document described below is incorporated by reference to the files of the Securities and Exchange Commission, unless the reference to the document is marked as follows: * - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Reports on Form 10-K for CL&P, PSNH, WMECO and NAEC. # - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for CL&P. @ - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for PSNH. ** - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for WMECO. ## - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for NAEC. Exhibit Number Description 3 Articles of Incorporation and By-Laws 3.1 Northeast Utilities 3.1.1 Declaration of Trust of NU, as amended through May 24, 1988. (Exhibit 3.1.1, 1988 NU Form 10-K, File No. 1-5324) 3.2 The Connecticut Light and Power Company # 3.2.1 Certificate of Incorporation of CL&P, restated to March 22, 1994. # 3.2.2 By-laws of CL&P, as amended to March 1, 1982. 3.3 Public Service Company of New Hampshire @ 3.3.1 Articles of Incorporation, as amended to May 16, 1991. @ 3.3.2 By-laws of PSNH, as amended to November 1, 1993. 3.4 Western Massachusetts Electric Company 3.4.1 Certificate of Organization of WMECO, as amended, to August 31, 1954. (Exhibit 3.1, File No. 2-11114) 3.4.2 Amendments to Certificate of Organization of WMECO of May 19, 1966 and of December 5, 1967. (Exhibit 3.2, File No. 2-30534) E-1 3.4.3 Articles of Amendment dated December 9, 1981. (Exhibit 3.1.2, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.4 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated December 16, 1981. (Exhibit 3.1.3, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.5 Articles of Amendment dated April 7, 1983. (Exhibit 3.3.5, 1983 NU Form 10-K, File No. 1-5324) 3.4.6 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated April 12, 1983. (Exhibit 3.3.6, 1983 NU Form 10-K, File No. 1-5324) 3.4.7 Articles of Amendment dated January 29, 1987. (Exhibit 3.3.7, 1986 NU Form 10-K, File No. 1-5324) 3.4.8 Articles of Amendment dated February 11, 1987. (Exhibit 3.3.8, 1986 NU Form 10-K, File No. 1-5324) 3.4.9 Articles of Amendment dated February 19, 1988. (Exhibit 3.3.9, 1987 NU Form 10-K, File No. 1-5324) 3.4.10 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated February 23, 1988. (Exhibit 3.3.10, 1987 NU Form 10-K, File No. 1-5324) ** 3.4.11 By-laws of WMECO, as amended to February 24, 1988. 3.5 North Atlantic Energy Corporation ## 3.5.1 Articles of Incorporation of NAEC dated September 20, 1991. ## 3.5.2 Articles of Amendment dated October 16, 1991 and June 2, 1992 to Articles of Incorporation of NAEC. ## 3.5.3 By-laws of NAEC, as amended to November 8, 1993. 4 Instruments defining the rights of security holders, including indentures 4.1 Northeast Utilities 4.1.1 Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Debt Securities. (Exhibit 4.1.1, 1991 NU Form 10-K, File No. 1-5324) 4.1.2 First Supplemental Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Series A Notes. (Exhibit 4.1.2, 1991 NU Form 10-K, File No. 1-5324) 4.1.3 Second Supplemental Indenture dated as of March 1, 1992 between Northeast Utilities and IBJ Schroder Bank & Trust Company with respect to the issuance of 8.38% Amortizing Notes. (Exhibit 4.1.3, 1992 NU Form 10-K, File No. 1-5324) E-2 4.1.4 Warrant Agreement dated as of June 5, 1992 between Northeast Utilities and the Service Company. (Exhibit 4.1.4, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.1 Additional Warrant Agent Agreement dated as of June 5, 1992 between Northeast Utilities and State Street Bank and Trust Company. (Exhibit 4.1.4.1, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.2 Exchange and Disbursing Agent Agreement dated as of June 5, 1992 among Northeast Utilities, Public Service Company of New Hampshire and State Street Bank and Trust Company. (Exhibit 4.1.4.2, 1992 NU Form 10-K, File No. 1-5324) 4.1.5 Credit Agreements among CL&P, NU, WMECO, NUSCO (as Agent) and 19 Commercial Banks dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.38, 1992 NU Form U5S, File No. 30-246) 4.1.6 Credit Agreements among CL&P, WMECO, NU, Holyoke Water Power Company, RRR, NNECO and NUSCO (as Agent) dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.39, 1992 NU Form U5S, File No. 30-246) 4.2 The Connecticut Light and Power Company 4.2.1 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, Trustee, dated as of May 1, 1921. (Composite including all twenty-four amendments to May 1, 1967.) (Exhibit 4.1.1, 1989 NU Form 10-K, File No. 1-5324) Supplemental Indentures to the Composite May 1, 1921 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, dated as of: 4.2.2 April 1, 1967. (Exhibit 4.16, File No. 2-60806) 4.2.3 January 1, 1968. (Exhibit 4.18, File No. 2-60806) 4.2.4 December 1, 1969. (Exhibit 4.20, File No. 2-60806) 4.2.5 June 30, 1982. (Exhibit 4.33, File No. 2-79235) 4.2.6 June 1, 1989. (Exhibit 4.1.24, 1989 NU Form 10-K, File No. 1-5324) 4.2.7 September 1, 1989. (Exhibit 4.1.25, 1989 NU Form 10-K, File No. 1-5324) 4.2.8 December 1, 1989. (Exhibit 4.1.26, 1989 NU Form 10-K, File No. 1-5324) 4.2.9 April 1, 1992. (Exhibit 4.30, File No. 33-59430) 4.2.10 July 1, 1992. (Exhibit 4.31, File No. 33-59430) E-3 4.2.11 October 1, 1992. (Exhibit 4.32, File No. 33-59430) 4.2.12 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) 4.2.13 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) # 4.2.14 December 1, 1993. # 4.2.15 February 1, 1994. # 4.2.16 February 1, 1994. 4.2.17 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1986. (Exhibit C.1.47, 1986 NU Form U5S, File No. 30-246) 4.2.18 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of October 1, 1988. (Exhibit C.1.55, 1988 NU Form U5S, File No. 30-246) 4.2.19 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1989. (Exhibit C.1.39, 1989 NU Form U5S, File No. 30-246) 4.2.20 Loan and Trust Agreement among Business Finance Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1992. (Exhibit C.2.33, 1992 NU Form U5S, File No. 30-246) # 4.2.21 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.22 Series B (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.23 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.24 Series B (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.3 Public Service Company of New Hampshire 4.3.1 First Mortgage Indenture dated as of August 15, 1978 between PSNH and First Fidelity Bank, National Association, New Jersey, Trustee, (Composite including all amendments to May 16, 1991). (Exhibit 4.4.1, 1992 NU Form 10-K, File No. 1- 5324) E-4 4.3.1.1 Tenth Supplemental Indenture dated as of May 1, 1991 between PSNH and First Fidelity Bank, National Association. (Exhibit 4.1, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392). 4.3.2 Revolving Credit Agreement dated as May 1, 1991. (Exhibit 4.12, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.3 Term Credit Agreement dated as of May 1, 1991. (Exhibit 4.11, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.4 Series A (Tax Exempt New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.2, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.5 Series B (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.3, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.6 Series C (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.4, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7 Series D (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.5, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7.1 First Supplement to Series D (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1992. (Exhibit 4.4.5.1, 1992 NU Form 10-K, File No. 1-5324) 4.3.8 Series E (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.6, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) @ 4.3.8.1 First Supplement to Series E (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1993. @ 4.3.9 Series D (May 1, 1991 Taxable New Issue and December 1, 1992 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of October 1, 1992. @ 4.3.9.1 Amended and Restated Letter of Credit dated December 17, 1992. 4.3.10 Series E (May 1, 1991 Taxable New Issue and December 1, 1993 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of May 1, 1991. (Exhibit 4.8, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-5 @ 4.3.10.1 Amended and Restated Letter of Credit dated December 15, 1993. 4.4 Western Massachusetts Electric Company ** 4.4.1 First Mortgage Indenture and Deed of Trust between WMECO and Old Colony Trust Company, Trustee, dated as of August 1, 1954. Supplemental Indentures thereto dated as of: 4.4.2 March 1, 1967. (Exhibit 2.5, File No. 2-68808) 4.4.3 March 1, 1968. (Exhibit 2.6, File No. 2-68808) 4.4.4 December 1, 1968. (Exhibit 2.7, File No. 2-68808) 4.4.5 July 1, 1972. (Exhibit 2.9, File No. 2-68808) 4.4.6 May 1, 1986. (Exhibit 4.3.18, 1986 NU Form 10-K, File No. 1-5324) 4.4.7 December 1, 1988. (Exhibit 4.3.20, 1988 NU Form 10-K, File No. 1-5324.) 4.4.8 September 1, 1990. (Exhibit 4.3.15, 1990 NU Form 10-K, File No. 1-5324.) 4.4.9 December 1, 1992. (Exhibit 4.15, File No. 33-55772) 4.4.10 January 1, 1993. (Exhibit 4.5.13, 1992 NU Form 10-K, File No. 1-5324) ** 4.4.11 March 1, 1994. ** 4.4.12 March 1, 1994. ** 4.4.13 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and WMECO (Pollution Control Bonds) dated as of September 1, 1993. ** 4.4.14 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.5 North Atlantic Energy Corporation 4.5.1 First Mortgage Indenture and Deed of Trust between NAEC and United States Trust Company of New York, Trustee, dated as of June 1, 1992. (Exhibit 4.6.1, 1992 NU Form 10-K, File No. 1-5324) 4.5.2 Note Indenture dated as of May 15, 1991. (Exhibit 4.10, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-6 4.5.3 First Supplemental Indenture dated as of June 5, 1992 between NAEC, PSNH and United States Trust Company of New York, Trustee. (Exhibit 4.6.3, 1992 NU Form 10-K, File No. 1-5324) 10 Material Contracts 10.1 Stockholder Agreement dated as of July 1, 1964 among the stockholders of Connecticut Yankee Atomic Power Company (CYAPC). (Exhibit 13.1, File No. 2-22958) 10.2 Form of Power Contract dated as of July 1, 1964 between CYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 13.2, File No. 2-22958) 10.2.1 Form of Additional Power Contract dated as of April 30, 1984, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.4, 1984 NU Form 10-K, File No. 1-5324) 10.2.2 Form of 1987 Supplementary Power Contract dated as of April 1, 1987, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.6, 1987 NU Form 10-K, File No. 1-5324) 10.3 Capital Funds Agreement dated as of September 1, 1964 between CYAPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 13.3, File No. 2-22958) #@** 10.4 Stockholder Agreement dated December 10, 1958 between Yankee Atomic Electric Company (YAEC) and CL&P, HELCO, PSNH and WMECO. 10.5 Form of Amendment No. 3, dated as of April 1, 1985, to Power Contract between YAEC and each of CL&P, PSNH and WMECO, including a composite restatement of original Power Contract dated June 30, 1959 and Amendment No. 1 dated April 1, 1975 and Amendment No. 2 dated October 1, 1980. (Exhibit 10.5, 1988 NU Form 10-K, File No. 1-5324.) 10.5.1 Form of Amendment No. 4 to Power Contract, dated May 6, 1988, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.1, 1989 NU Form 10-K, File No. 1-5324) 10.5.2 Form of Amendment No. 5 to Power Contract, dated June 26, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.2, 1989 NU Form 10-K, File No. 1-5324) 10.5.3 Form of Amendment No. 6 to Power Contract, dated July 1, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.3, 1989 NU Form 10-K, File No. 1-5324) #@** 10.5.4 Form of Amendment No. 7 to Power Contract, dated February 1, 1992, between YAEC and each of CL&P, PSNH and WMECO. 10.6 Stockholder Agreement dated as of May 20, 1968 among stockholders of MYAPC. (Exhibit 4.15, File No. 2-30018) 10.7 Form of Power Contract dated as of May 20, 1968 between MYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.14, File No. 2-30018) E-7 #@** 10.7.1 Form of Amendment No. 1 to Power Contract dated as of March 1, 1983 between MYAPC and each of CL&P, PSNH and WMECO. #@** 10.7.2 Form of Amendment No. 2 to Power Contract dated as of January 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.7.3 Form of Amendment No. 3 to Power Contract dated as of October 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.7.3, 1985 NU Form 10-K, File No. 1-5324) #@** 10.7.4 Form of Additional Power Contract dated as of February 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.8 Capital Funds Agreement dated as of May 20, 1968 between Maine Yankee Atomic Power Company (MYAPC) and CL&P, PSNH, HELCO and WMECO. (Exhibit 4.13, File No. 2-30018) 10.8.1 Amendment No. 1 to Capital Funds Agreement, dated as of August 1, 1985, between MYAPC, CL&P, PSNH and WMECO. (Exhibit 10.6.1, 1985 NU Form 10-K, File No. 1-5324) 10.9 Sponsor Agreement dated as of August 1, 1968 among the sponsors of VYNPC. (Exhibit 4.16, File No. 2-30285) 10.10 Form of Power Contract dated as of February 1, 1968 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.18, File No. 2-30018) 10.10.1 Form of Amendment to Power Contract dated as of June 1, 1972 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 5.22, File No. 2-47038) #@** 10.10.2 Form of Second Amendment to Power Contract dated as of April 15, 1983 between VYNPC and each of CL&P, PSNH and WMECO. 10.10.3 Form of Third Amendment to Power Contract dated as of April 24, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.3, 1986 NU Form 10-K, File No. 1-5324) 10.10.4 Form of Fourth Amendment to Power Contract dated as of June 1, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.4, 1986 NU Form 10-K, File No. 1-5324) 10.10.5 Form of Fifth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.5, 1990 NU Form 10-K, File No. 1-5324) 10.10.6 Form of Sixth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.6, 1990 NU Form 10-K, File No. 1-5324) E-8 10.10.7 Form of Seventh Amendment to Power Contract dated as of June 15, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.7, 1990 NU Form 10-K, File No. 1-5324) 10.10.8 Form of Eighth Amendment to Power Contract dated as of December 1, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.8, 1990 NU Form 10-K, File No. 1-5324) #@** 10.10.9 Form of Additional Power Contract dated as of February 1, 1984 between VYNPC and each of CL&P, PSNH and WMECO. 10.11 Capital Funds Agreement dated as of February 1, 1968 between Vermont Yankee Nuclear Power Corporation (VYNPC) and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.16, File No. 2-30018) 10.11.1 Form of First Amendment to Capital Funds Agreement dated as of March 12, 1968 between VYNPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.17, File No. 2-30018) #@** 10.11.2 Form of Second Amendment to Capital Funds Agreement dated as of September 1, 1993 between VYNPC and CL&P, HELCO, PSNH and WMECO. 10.12 Amended and Restated Millstone Plant Agreement dated as of December 1, 1984 by and among CL&P, WMECO and Northeast Nuclear Energy Company (NNECO). (Exhibit 10.17, 1985 NU Form 10-K, File No. 1-5324) 10.13 Sharing Agreement dated as of September 1, 1973 with respect to 1979 Connecticut nuclear generating unit (Millstone 3). (Exhibit 6.43, File No. 2-50142) 10.13.1 Amendment dated August 1, 1974 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 5.45, File No. 2-52392) 10.13.2 Amendment dated December 15, 1975 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 7.47, File No. 2-60806) 10.13.3 Amendment dated April 1, 1986 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 10.17.3, 1990 NU Form 10-K, File No. 1-5324) 10.14 Agreement dated July 19, 1990, among NAESCO and Seabrook Joint owners with respect to operation of Seabrook. (Exhibit 10.53, 1990 NU Form 10-K, File No. 1-5324) 10.15 Sharing Agreement between CL&P, WMECO, HP&E, HWP and PSNH dated as of June 1, 1992. (Exhibit 10.17, 1992 NU Form 10- K, File No. 1-5324) 10.16 Form of Seabrook Power Contract between PSNH and NAEC, as amended and restated. (Exhibit 10.45, NU 1992 Form 10-K, File No. 1-5324) E-9 10.17 Agreement for joint ownership, construction and operation of New Hampshire nuclear generating units dated as of May 1, 1973. (Exhibit 13-57, File No. 2-48966) 10.17.1 Amendments to Exhibit 10.17 dated May 24, 1974, June 21, 1974 and September 25, 1974. (Exhibit 5.15, File No. 2-51999) 10.17.2 Amendments to Exhibit 10.17 dated October 25, 1974 and January 31, 1975. (Exhibit 5.23, File No. 2-54646) 10.17.3 Sixth Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.3, File No. 2-64294) 10.17.4 Seventh Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.4, File No. 2-64294) 10.17.5 Eighth Amendment to Exhibit 10.17 dated as of April 25, 1979. (Exhibit 5.4.5, File No. 2-64815) 10.17.6 Ninth Amendment to Exhibit 10.17 dated as of June 8, 1979. (Exhibit 5.4.6, File No. 2-64815) 10.17.7 Tenth Amendment to Exhibit 10.17 dated as of October 10, 1979. (Exhibit 5.4.2, File No. 2-66334) 10.17.8 Eleventh Amendment to Exhibit 10.17 dated as of December 15, 1979. (Exhibit 5.4.8, File No. 2-66492) 10.17.9 Twelfth Amendment to Exhibit 10.17 dated as of June 16, 1980. (Exhibit 5.4.9, File No. 2-68168) 10.17.10 Thirteenth Amendment to Exhibit 10.17 dated as of December 31, 1980. (Exhibit 10.6, File No. 2-70579) * 10.17.11 Fourteenth Amendment to Exhibit 10.17 dated as of June 1, 1982. 10.17.12 Fifteenth Amendment to Exhibit 10.17 dated as of April 27, 1984. (Exhibit 10.14.12, 1984 NU Form 10-K, File No. 1-5324) 10.17.13 Sixteenth Amendment to Exhibit 10.17 dated as of June 15, 1984. (Exhibit 10.14.13, 1984 NU Form 10-K, File No. 1-5324) 10.17.14 Seventeenth Amendment to Exhibit 10.17 dated as of March 8, 1985. (Exhibit 10.13.14, 1985 NU Form 10-K, File No. 1-5324) 10.17.15 Eighteenth Amendment to Exhibit 10.17 dated as of March 14, 1986. (Exhibit 10.13.15, 1986 NU Form 10-K, File No. 1-5324) 10.17.16 Nineteenth Amendment to Exhibit 10.17 dated as of May 1, 1986. (Exhibit 10.13.16, 1986 NU Form 10-K, File No. 1-5324) E-10 10.17.17 Twentieth Amendment to Exhibit 10.17 dated as of July 15, 1986. (Exhibit 10.13.17, 1986 NU Form 10-K, File No. 1-5324) 10.17.18 Twenty-first Amendment to Exhibit 10.17 dated as of November 12, 1987. (Exhibit 10.13.18, 1987 NU Form 10-K, File No. 1-5324) 10.17.19 Twenty-second Amendment to Exhibit 10.17 dated as of January 13, 1989. (Exhibit 10.13.19, 1989 NU Form 10-K, File No. 1-5324) 10.17.20 Twenty-third Amendment to Exhibit 10.17 dated as of November 1, 1990. (Exhibit 10.13.20, 1990 NU Form 10- K, File No. 1-5324) 10.17.21 Memorandum of Understanding dated November 7, 1988 between PSNH and Massachusetts Municipal Wholesale Electric Company (Exhibit 10.17, PSNH 1989 Form 10-K, File No. 1-6392) 10.17.22 Agreement of Settlement among Joint Owners dated as of January 13, 1989. (Exhibit 10.13.21, 1988 NU Form 10- K, File No. 1-5324) 10.17.22.1 Supplement to Settlement Agreement, dated as of February 7, 1989, between PSNH and Central Maine Power Company. (Exhibit 10.18.1, PSNH 1989 Form 10-K, File No. 1-6392) 10.18 Amended and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990. (Exhibit 10.4.7, File No. 33-35312) 10.18.1 Form of First Amendment to Exhibit 10.18. (Exhibit 10.4.8, File No. 33-35312) * 10.18.2 Form (Composite) of Second Amendment to Exhibit 10.18. 10.19 Agreement dated November 1, 1974 for Joint Ownership, Construction and Operation of William F. Wyman Unit No. 4 among PSNH, Central Maine Power Company and other utilities. (Exhibit 5.16 , File No. 2-52900) 10.19.1 Amendment to Exhibit 10.19 dated June 30, 1975. (Exhibit 5.48, File No. 2-55458) 10.19.2 Amendment to Exhibit 10.19 dated as of August 16, 1976. (Exhibit 5.19, File No. 2-58251) 10.19.3 Amendment to Exhibit 10.19 dated as of December 31, 1978. (Exhibit 5.10.3, File No. 2-64294) #** 10.20 Form of Service Contract dated as of July 1, 1966 between each of NU, CL&P and WMECO and the Service Company. 10.20.1 Service Contract dated as of June 5, 1992 between PSNH and the Service Company. (Exhibit 10.12.4, 1992 NU Form 10-K, File No. 1-5324) E-11 10.20.2 Service Contract dated as of June 5, 1992 between NAEC and the Service Company. (Exhibit 10.12.5, 1992 NU Form 10-K, File No. 1-5324) * 10.20.3 Form of Annual Renewal of Service Contract. 10.21 Memorandum of Understanding between CL&P, HELCO, Holyoke Power and Electric Company (HP&E), Holyoke Water Power Company (HWP) and WMECO dated as of June 1, 1970 with respect to pooling of generation and transmission. (Exhibit 13.32, File No. 2-38177) #** 10.21.1 Amendment to Memorandum of Understanding between CL&P, HELCO, HP&E, HWP and WMECO dated as of February 2, 1982 with respect to pooling of generation and transmission. 10.22 New England Power Pool Agreement effective as of November 1, 1971, as amended to November 1, 1988. (Exhibit 10.15, 1988 NU Form 10-K, File No. 1-5324.) 10.22.1 Twenty-sixth Amendment to Exhibit 10.22 dated as of March 15, 1989. (Exhibit 10.15.1, 1990 NU Form 10-K, File No. 1-5324) 10.22.2 Twenty-seventh Amendment to Exhibit 10.22 dated as of October 1, 1990. (Exhibit 10.15.2, 1991 NU Form 10-K, File No. 1-5324) 10.22.3 Twenty-eighth Amendment to Exhibit 10.22 dated as of September 15, 1992. (Exhibit 10.18.3, 1992 NU Form 10-K, File No. 1-5324) * 10.22.4 Twenty-ninth Amendment to Exhibit 10.22 dated as of May 1, 1993. 10.23 Agreements among New England Utilities with respect to the Hydro-Quebec interconnection projects. (See Exhibits 10(u) and 10(v); 10(w), 10(x), and 10(y), 1990 and 1988, respectively, Form 10-K of New England Electric System, File No. 1-3446.) 10.24 Trust Agreement dated February 11, 1992, between State Street Bank and Trust Company of Connecticut, as Trustor, and Bankers Trust Company, as Trustee, and CL&P and WMECO, with respect to NBFT. (Exhibit 10.23, 1991 NU Form 10-K, File No. 1-5324) 10.24.1 Nuclear Fuel Lease Agreement dated as of February 11, 1992, between Bankers Trust Company, Trustee, as Lessor, and CL&P and WMECO, as Lessees. (Exhibit 10.23.1, 1991 NU Form 10-K, File No. 1-5324) 10.25 Simulator Financing Lease Agreement, dated as of February 1, 1985, by and between ComPlan and NNECO. (Exhibit 10.52, 1985 NU Form 10-K, File No. 1-5324) E-12 10.26 Simulator Financing Lease Agreement, dated as of May 2, 1985, by and between The Prudential Insurance Company of America and NNECO. (Exhibit 10.53, 1985 NU Form 10-K, File No. 1-5324) 10.27 Lease dated as of April 14, 1992 between The Rocky River Realty Company (RRR) and Northeast Utilities Service Company (NUSCO) with respect to the Berlin, Connecticut headquarters (office lease). (Exhibit 10.29, 1992 NU Form 10-K, File No. 1-5324) 10.27.1 Lease date as of April 14, 1992 between RRR and NUSCO with respect to the Berlin, Connecticut headquarters (project lease). (Exhibit 10.29.1, 1992 NU Form 10-K, File No. 1-5324) * 10.28 Millstone Technical Building Note Agreement dated as of December 21, 1993 between, by and between The Prudential Insurance Company of America and NNECO. 10.29 Lease and Agreement, dated as of December 15, 1988, by and between WMECO and Bank of New England, N.A., with BNE Realty Leasing Corporation of North Carolina. (Exhibit 10.63, 1988 NU Form 10-K, File No. 1-5324.) 10.30 Note Agreement dated April 14, 1992, by and between The Rocky River Realty Company (RRR) and Purchasers named therein (Connecticut General Life Insurance Company, Life Insurance Company of North America, INA Life Insurance Company of New York, Life Insurance Company of Georgia), with respect to RRR's sale of $15 million of guaranteed senior secured notes due 2007 and $28 million of guaranteed senior secured notes due 2017. (Exhibit 10.52, 1992 NU Form 10-K, File No. 1-5324) 10.30.1 Note Guaranty dated April 14, 1992 by Northeast Utilities pursuant to Note Agreement dated April 14, 1992 between RRR and Note Purchasers, for the benefit of The Connecticut National Bank as Trustee, the Purchasers and the owners of the notes. (Exhibit 10.52.1, 1992 NU Form 10-K, File No. 1-5324) 10.30.2 Assignment of Leases, Rents and Profits, Security Agreement and Negative Pledge, dated as of April 14, 1992 among RRR, NUSCO and The Connecticut National Bank as Trustee, securing notes sold by RRR pursuant to April 14, 1992 Note Agreement. (Exhibit 10.52.2, 1992 NU Form 10-K, File No. 1-5324) 10.31 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 1 decommissioning costs. (Exhibit 10.80, 1986 NU Form 10-K, File No. 1-5324) 10.31.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.41.1, 1992 NU Form 10-K, File No. 1-5324) E-13 10.32 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 2 decommissioning costs. (Exhibit 10.81, 1986 NU Form 10-K, File No. 1-5324) 10.32.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.42.1, 1992 NU Form 10-K, File No. 1-5324) 10.33 Master Trust Agreement dated as of April 23, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 3 decommissioning costs. (Exhibit 10.82, 1986 NU Form 10-K, File No. 1-5324) 10.33.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.43.1, 1992 NU Form 10-K, File No. 1-5324) 10.34 NU Executive Incentive Plan, effective as of January 1, 1991. (Exhibit 10.44, NU 1991 Form 10-K, File No. 1-5324) 10.35 Supplemental Executive Retirement Plan for Officers of NU System Companies, Amended and Restated effective as of January 1, 1992. (Exhibit 10.45.1, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) * 10.35.1 Amendment 1 to Exhibit 10.35, effective as of August 1, 1993. * 10.35.2 Amendment 2 to Exhibit 10.35, effective as of January 1, 1994. 10.36 Loan Agreement dated as of December 2, 1991, by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $175 million to an ESOP Trust. (Exhibit 10.46, NU 1991 Form 10-K, File No. 1-5324) * 10.36.1 First Amendment to Exhibit 10.36 dated February 7, 1992. 10.36.2 Loan Agreement dated as of March 19, 1992 by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $75 million to the ESOP Trust. (Exhibit 10.49.1, 1992 NU Form 10-K, File No. 1-5324) * 10.36.3 Second Amendment to Exhibit 10.36 dated April 9, 1992. 10.37 Management Succession Agreement. (Exhibit 10.47, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 10.38 Employment Agreement. (Exhibit 10.48, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 13 Annual Report to Security Holders (Each of the Annual Reports is filed only with the Form 10-K of that respective registrant.) E-14 * 13.1 Portions of the Annual Report to Security Holders of NU (pages 17 - 54) that have been incorporated by reference into this Form 10-K. 13.2 Annual Report of CL&P. 13.3 Annual Report of WMECO. 13.4 Annual Report of PSNH. 13.5 Annual Report of NAEC. 21 Subsidiaries of the Registrant (Exhibit 22, 1992 NU Form 10-K, File 1-5324) E-15 Item 12. Security Ownership of Certain Beneficial Owners and Management NU. Incorporated herein by reference are pages 5 through 12 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. As of February 28, 1994, the Directors of CL&P, PSNH, WMECO and NAEC, beneficially owned the following number of shares of each class of equity securities of NU. No equity securities of CL&P, PSNH or WMECO are owned by the Directors and Executive Officers. CL&P, PSNH, WMECO, and NAEC DIRECTORS AND NAMED EXECUTIVE OFFICERS Amount and Nature of Title Of Name of Beneficial Percent of Class Beneficial Owner Ownership (1) Class (2) NU Common Robert G. Abair (3) (621) 4,271 shares NU Common Robert E. Busch (772) 6,054 shares NU Common John P. Cagnetta (4) (581) 3,979 shares NU Common John C. Collins (5) 0 shares NU Common William B. Ellis (6) (1,259) 14,837 shares NU Common Ted C. Feigenbaum(7) 151 shares NU Common Bernard M. Fox (8) (1,072) 17,428 shares NU Common William T. Frain, Jr. 885 shares NU Common Cheryl W. Grise (221) 1,349 shares NU Common John B. Keane (9) (368) 1,146 shares NU Common Francis L. Kinney (10) (303) 3,781 shares NU Common Gerald Letendre (5) 0 shares NU Common Hugh C. MacKenzie (4)(11) (779) 4,277 shares NU Common Jane E. Newman (5) 0 shares NU Common Dale F. Nitzschke (5) 0 shares NU Common John W. Noyes (658) 2,789 shares NU Common John F. Opeka (4)(12) (1,075) 16,463 shares NU Common Robert P. Wax (5) (651) 1,436 shares Amount beneficially owned by Directors and Executive Officers as a group - CL&P (7,709) 77,259 shares - PSNH (6,790) 69,299 shares - WMECO (7,709) 77,259 shares - NAEC (7,088) 73,139 shares (1) Unless otherwise noted, each Director and Executive Officer of CL&P, PSNH, WMECO and NAEC has sole voting and investment power with respect to the listed shares. The numbers in parentheses reflect the number of shares owned by each Director and Executive Officer under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k) Plan), as to which the Officer has no investment power. (2) As of February 28, 1994 there were 134,208,461 common shares of NU outstanding. The percentage of such shares beneficially owned by any Director or Executive Officer, or by all Directors and Executive Officers of CL&P, PSNH, WMECO and NAEC as a group, does not exceed one percent. (3) Mr. Abair is a Director of CL&P and WMECO only. (4) Mr. Opeka and Dr. Cagnetta are not officers of PSNH, but each in his capacity as an officer (with the stated title) of NUSCO, an affiliate of PSNH, performs policy-making functions for PSNH. (5) Messrs. Collins, Letendre, Nitzschke and Wax and Ms. Newman areDirectors of PSNH only. (6) Mr. Ellis shares voting and investment power with his wife for 1,117 shares. (7) Mr. Feigenbaum is a Director and an Executive Officer of NAEC only. (8) Mr. Fox shares voting and investment power with his wife for 3,031 of these shares. In addition, Mr. Fox's wife has sole voting and investment power for 140 shares, as to which Mr. Fox disclaims beneficial ownership. (9) Mr. Keane is a Director of CL&P, WMECO and NAEC only. (10) Mr. Kinney shares voting and investment power with his wife for 2,155 shares. (11) Mr. MacKenzie shares voting and investment power with his wife for 1,259 shares. (12) Mr. Opeka shares voting and investment power with his wife for 1,718 shares. Item 13. Item 13. Certain Relationships and Related Transactions NU. Incorporated herein by reference is page 14 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. No relationships or transactions that would be described in response to this item exist now or existed during 1993 with respect to CL&P, PSNH, WMECO and NAEC. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements: The Report of Independent Public Accountants and financial statements of NU, CL&P, PSNH, WMECO, and NAEC are hereby incorporated by reference and made a part of this report (see "Item 8. Financial Statements and Supplementary Data"). Reports of Independent Public Accountants on Schedules S-1 Consents of Independent Public Accountants S-3 2. Schedules: Financial Statement Schedules for NU (Parent), NU and Subsidiaries, CL&P, PSNH, WMECO, and NAEC are listed in the Index to Financial Statement Schedules S-5 3. Exhibits Index E-1 (b) Reports on Form 8-K: During the fourth quarter of 1993, the companies filed Form 8-Ks dated December 2, 1993 disclosing the following: o On December 2, 1993, the Northeast Utilities system announced a reorganization of its corporate structure. o On December 3, 1993, NNECO was informed by the NRC that it was being assessed a civil penalty in response to repair activities at Millstone 2. In addition, the Form 8-K dated December 2, 1993 which was filed by PSNH also discussed the following: o On June 8, 1992, PSNH changed its independent public accountant. NORTHEAST UTILITIES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NORTHEAST UTILITIES ------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------------- William B. Ellis Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Trustee and Chairman /s/ William B. Ellis - -------------- of the Board ------------------------- William B. Ellis March 18, 1994 Trustee, President /s/ Bernard M. Fox - -------------- and Chief Executive ------------------------- Officer Bernard M. Fox March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President and Chief ------------------------- Financial Officer Robert E. Busch March 18, 1994 Vice President and /s/ John B. Keane - -------------- Treasurer ------------------------- John B. Keane March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller ------------------------- John W. Noyes NORTHEAST UTILITIES SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Trustee /s/ Cotton Mather Cleveland - -------------- --------------------------- Cotton Mather Cleveland March 18, 1994 Trustee /s/ George David - -------------- --------------------------- George David March 18, 1994 Trustee /s/ Donald J. Donahue - -------------- --------------------------- Donald J. Donahue March 18, 1994 Trustee /s/ Eugene D. Jones - -------------- --------------------------- Eugene D. Jones March 18, 1994 Trustee /s/ Elizabeth T. Kennan - -------------- --------------------------- Elizabeth T. Kennan Trustee - -------------- --------------------------- Denham C. Lunt, Jr. March 18, 1994 Trustee /s/ William J. Pape II - -------------- --------------------------- William J. Pape II March 18, 1994 Trustee /s/ Robert E. Patricelli - -------------- --------------------------- Robert E. Patricelli Trustee - -------------- --------------------------- Norman C. Rasmussen Trustee - -------------- --------------------------- John F. Swope THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE CONNECTICUT LIGHT AND POWER COMPANY --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE 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. PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- ------------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ William T. Frain, Jr. - -------------- Operating Officer -------------------------- and Director William T. Frain, Jr. March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John C. Collins - ------------------- -------------------------- John C. Collins March 18, 1994 Director /s/ Gerald Letendre - ------------------- -------------------------- Gerald Letendre March 18, 1994 Director /s/ Hugh C. MacKenzie - ------------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ Jane E. Newman - ------------------- -------------------------- Jane E. Newman March 18, 1994 Director /s/ Dale S. Nitzschke - ------------------- -------------------------- Dale S. Nitzschke March 18, 1994 Director /s/ Robert P. Wax - ------------------- -------------------------- Robert P. Wax WESTERN MASSACHUSETTS ELECTRIC 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. WESTERN MASSACHUSETTS ELECTRIC COMPANY -------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- -------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes WESTERN MASSACHUSETTS ELECTRIC COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka NORTH ATLANTIC ENERGY 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. NORTH ATLANTIC ENERGY CORPORATION --------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ Robert E. Busch - -------------- Operating Officer -------------------------- and Director Robert E. Busch March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes NORTH ATLANTIC ENERGY CORPORATION SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John P. Cagnetta - -------------- -------------------------- John P. Cagnetta - -------------- Director -------------------------- Ted C. Feigenbaum March 18, 1994 Director /s/ William T. Frain. Jr. - -------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - -------------- -------------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - -------------- -------------------------- John B. Keane March 18, 1994 Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ John F. Opeka - -------------- -------------------------- John F. Opeka REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES We have audited in accordance with generally accepted auditing standards, the financial statements included in Northeast Utilities' annual report to shareholders and The Connecticut Light and Power Company's, Western Massachusetts Electric Company's, North Atlantic Energy Corporation's, and Public Service Company of New Hampshire's annual reports, incorporated by reference in this Form 10-K, and have issued our reports thereon dated February 18, 1994. Our reports on the financial statements include an explanatory paragraph with respect to the change in methods of accounting for property taxes, postretirement benefits other than pensions, income taxes, and employee stock ownership plans, as applicable to each company, as explained in Note 1 to the related company's financial statements. Our audits were made for the purpose of forming an opinion on each company's statements taken as a whole. The schedules listed in the index to financial statement schedules are the responsibility of each company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of each company's basic financial statements. The schedules have been subjected to the auditing procedures applied in the audits of each company's 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 each company's basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut February 18, 1994 S-1 INDEPENDENT AUDITORS' REPORT ON SCHEDULES The Board of Directors Public Service Company of New Hampshire: Under date of February 7, 1992, we reported on the balance sheet and statement of capitalization of Public Service Company of New Hampshire as of December 31, 1991 (not presented in the 1993 annual report to stockholders) and the related statements of income, cash flows and common stock equity for the periods January 1, 1991 to May 15, 1991 and May 16, 1991 to December 31, 1991, as contained in the annual report to stockholders of Public Service Company for the year 1993. These financial statements and our report thereon are incorporated by reference herein. In connection with our audits of the aforementioned financial statements, we have also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsiblity is to express an opinion on these financial statement schedules based on our audit. 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/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massachusetts February 7, 1992 S-2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference of our reports in this Form 10-K, into previously filed Registration Statement No. 33-13444, No. 33-46291 , No. 33-59430, and No. 33-50853 of The Connecticut Light and Power Company, No. 33-34886, No. 33-51185 and No. 33-25619 of Western Massachusetts Electric Company, and No. 33-34622 and No. 33-40156 of Northeast Utilities. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut March 18, 1994 S-3 INDEPENDENT AUDITORS' CONSENT The Board of Directors Public Service Company of New Hampshire: We consent to the use of our reports included or incorporated by reference herein. /s/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massaschusetts March 18, 1994 S-4 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedule Page - -------- ---- III. Financial Information of Registrant: Northeast Utilities (Parent) Balance Sheets 1993 and 1992 S-7 Northeast Utilities (Parent) Statements of Income 1993, 1992, and 1991 S-8 Northeast Utilities (Parent) Statements of Cash Flows 1993, 1992, and 1991 S-9 V. Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-10 -- S-12 The Connecticut Light and Power Company S-13 -- S-15 Public Service Company of New Hampshire S-16 -- S-20 Western Massachusetts Electric Company S-21 -- S-23 North Atlantic Energy Corporation S-24 -- S-25 V. Nuclear Fuel 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-26 -- S-28 The Connecticut Light and Power Company S-29 -- S-31 Public Service Company of New Hampshire S-32 -- S-36 Western Massachusetts Electric Company S-37 -- S-39 North Atlantic Energy Corporation S-40 -- S-41 VI. Accumulated Provision for Depreciation of Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-42 -- S-44 The Connecticut Light and Power Company S-45 Public Service Company of New Hampshire S-46 -- S-48 Western Massachusetts Electric Company S-49 North Atlantic Energy Corporation S-50 VIII. Valuation and Qualifying Accounts and Reserves 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-51 -- S-53 The Connecticut Light and Power Company S-54 -- S-56 Public Service Company of New Hampshire S-57 -- S-61 Western Massachusetts Electric Company S-62 -- S-64 S-5 Schedule Page - -------- ---- IX. Short-Term Borrowings 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-65 The Connecticut Light and Power Company S-66 Public Service Company of New Hampshire S-67 Western Massachusetts Electric Company S-68 North Atlantic Energy Corporation S-69 X. Supplementary Income Statement Information 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-70 The Connecticut Light and Power Company S-71 Public Service Company of New Hampshire S-72 Western Massachusetts Electric Company S-73 North Atlantic Energy Corporation S-74 All other schedules of the companies' for which provision is made in the applicable regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable, and therefore have been omitted. S-6 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- BALANCE SHEETS -------------- AT DECEMBER 31, 1993 AND 1992 ------------------------------ (Thousands of Dollars) S-7 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- STATEMENTS OF INCOME -------------------- YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 --------------------------------------------- (Thousands of Dollars Except Share Information) S-8 SCHEDULE III NORTHEAST UTILITIES (PARENT) FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Thousands of Dollars) S-9 S-10 S-11 S-12 S-13 S-14 S-15 S-16 S-17 S-18 S-19 S-20 S-21 S-22 S-23 S-24 S-25 S-26 S-27 S-28 S-29 S-30 S-31 S-32 S-33 S-34 S-35 S-36 S-37 S-38 S-39 S-40 S-41 S-42 S-43 S-44 S-45 S-46 S-47 S-48 S-49 S-50 S-51 S-52 S-53 S-54 S-55 S-56 S-57 S-58 S-59 S-60 S-61 S-62 S-63 S-64 S-65 S-66 S-67 S-68 S-69 S-70 S-71 S-72 S-73 S-74 EXHIBIT INDEX Each document described below is incorporated by reference to the files of the Securities and Exchange Commission, unless the reference to the document is marked as follows: * - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Reports on Form 10-K for CL&P, PSNH, WMECO and NAEC. # - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for CL&P. @ - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for PSNH. ** - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for WMECO. ## - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for NAEC. Exhibit Number Description 3 Articles of Incorporation and By-Laws 3.1 Northeast Utilities 3.1.1 Declaration of Trust of NU, as amended through May 24, 1988. (Exhibit 3.1.1, 1988 NU Form 10-K, File No. 1-5324) 3.2 The Connecticut Light and Power Company # 3.2.1 Certificate of Incorporation of CL&P, restated to March 22, 1994. # 3.2.2 By-laws of CL&P, as amended to March 1, 1982. 3.3 Public Service Company of New Hampshire @ 3.3.1 Articles of Incorporation, as amended to May 16, 1991. @ 3.3.2 By-laws of PSNH, as amended to November 1, 1993. 3.4 Western Massachusetts Electric Company 3.4.1 Certificate of Organization of WMECO, as amended, to August 31, 1954. (Exhibit 3.1, File No. 2-11114) 3.4.2 Amendments to Certificate of Organization of WMECO of May 19, 1966 and of December 5, 1967. (Exhibit 3.2, File No. 2-30534) E-1 3.4.3 Articles of Amendment dated December 9, 1981. (Exhibit 3.1.2, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.4 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated December 16, 1981. (Exhibit 3.1.3, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.5 Articles of Amendment dated April 7, 1983. (Exhibit 3.3.5, 1983 NU Form 10-K, File No. 1-5324) 3.4.6 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated April 12, 1983. (Exhibit 3.3.6, 1983 NU Form 10-K, File No. 1-5324) 3.4.7 Articles of Amendment dated January 29, 1987. (Exhibit 3.3.7, 1986 NU Form 10-K, File No. 1-5324) 3.4.8 Articles of Amendment dated February 11, 1987. (Exhibit 3.3.8, 1986 NU Form 10-K, File No. 1-5324) 3.4.9 Articles of Amendment dated February 19, 1988. (Exhibit 3.3.9, 1987 NU Form 10-K, File No. 1-5324) 3.4.10 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated February 23, 1988. (Exhibit 3.3.10, 1987 NU Form 10-K, File No. 1-5324) ** 3.4.11 By-laws of WMECO, as amended to February 24, 1988. 3.5 North Atlantic Energy Corporation ## 3.5.1 Articles of Incorporation of NAEC dated September 20, 1991. ## 3.5.2 Articles of Amendment dated October 16, 1991 and June 2, 1992 to Articles of Incorporation of NAEC. ## 3.5.3 By-laws of NAEC, as amended to November 8, 1993. 4 Instruments defining the rights of security holders, including indentures 4.1 Northeast Utilities 4.1.1 Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Debt Securities. (Exhibit 4.1.1, 1991 NU Form 10-K, File No. 1-5324) 4.1.2 First Supplemental Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Series A Notes. (Exhibit 4.1.2, 1991 NU Form 10-K, File No. 1-5324) 4.1.3 Second Supplemental Indenture dated as of March 1, 1992 between Northeast Utilities and IBJ Schroder Bank & Trust Company with respect to the issuance of 8.38% Amortizing Notes. (Exhibit 4.1.3, 1992 NU Form 10-K, File No. 1-5324) E-2 4.1.4 Warrant Agreement dated as of June 5, 1992 between Northeast Utilities and the Service Company. (Exhibit 4.1.4, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.1 Additional Warrant Agent Agreement dated as of June 5, 1992 between Northeast Utilities and State Street Bank and Trust Company. (Exhibit 4.1.4.1, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.2 Exchange and Disbursing Agent Agreement dated as of June 5, 1992 among Northeast Utilities, Public Service Company of New Hampshire and State Street Bank and Trust Company. (Exhibit 4.1.4.2, 1992 NU Form 10-K, File No. 1-5324) 4.1.5 Credit Agreements among CL&P, NU, WMECO, NUSCO (as Agent) and 19 Commercial Banks dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.38, 1992 NU Form U5S, File No. 30-246) 4.1.6 Credit Agreements among CL&P, WMECO, NU, Holyoke Water Power Company, RRR, NNECO and NUSCO (as Agent) dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.39, 1992 NU Form U5S, File No. 30-246) 4.2 The Connecticut Light and Power Company 4.2.1 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, Trustee, dated as of May 1, 1921. (Composite including all twenty-four amendments to May 1, 1967.) (Exhibit 4.1.1, 1989 NU Form 10-K, File No. 1-5324) Supplemental Indentures to the Composite May 1, 1921 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, dated as of: 4.2.2 April 1, 1967. (Exhibit 4.16, File No. 2-60806) 4.2.3 January 1, 1968. (Exhibit 4.18, File No. 2-60806) 4.2.4 December 1, 1969. (Exhibit 4.20, File No. 2-60806) 4.2.5 June 30, 1982. (Exhibit 4.33, File No. 2-79235) 4.2.6 June 1, 1989. (Exhibit 4.1.24, 1989 NU Form 10-K, File No. 1-5324) 4.2.7 September 1, 1989. (Exhibit 4.1.25, 1989 NU Form 10-K, File No. 1-5324) 4.2.8 December 1, 1989. (Exhibit 4.1.26, 1989 NU Form 10-K, File No. 1-5324) 4.2.9 April 1, 1992. (Exhibit 4.30, File No. 33-59430) 4.2.10 July 1, 1992. (Exhibit 4.31, File No. 33-59430) E-3 4.2.11 October 1, 1992. (Exhibit 4.32, File No. 33-59430) 4.2.12 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) 4.2.13 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) # 4.2.14 December 1, 1993. # 4.2.15 February 1, 1994. # 4.2.16 February 1, 1994. 4.2.17 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1986. (Exhibit C.1.47, 1986 NU Form U5S, File No. 30-246) 4.2.18 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of October 1, 1988. (Exhibit C.1.55, 1988 NU Form U5S, File No. 30-246) 4.2.19 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1989. (Exhibit C.1.39, 1989 NU Form U5S, File No. 30-246) 4.2.20 Loan and Trust Agreement among Business Finance Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1992. (Exhibit C.2.33, 1992 NU Form U5S, File No. 30-246) # 4.2.21 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.22 Series B (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.23 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.24 Series B (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.3 Public Service Company of New Hampshire 4.3.1 First Mortgage Indenture dated as of August 15, 1978 between PSNH and First Fidelity Bank, National Association, New Jersey, Trustee, (Composite including all amendments to May 16, 1991). (Exhibit 4.4.1, 1992 NU Form 10-K, File No. 1- 5324) E-4 4.3.1.1 Tenth Supplemental Indenture dated as of May 1, 1991 between PSNH and First Fidelity Bank, National Association. (Exhibit 4.1, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392). 4.3.2 Revolving Credit Agreement dated as May 1, 1991. (Exhibit 4.12, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.3 Term Credit Agreement dated as of May 1, 1991. (Exhibit 4.11, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.4 Series A (Tax Exempt New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.2, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.5 Series B (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.3, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.6 Series C (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.4, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7 Series D (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.5, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7.1 First Supplement to Series D (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1992. (Exhibit 4.4.5.1, 1992 NU Form 10-K, File No. 1-5324) 4.3.8 Series E (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.6, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) @ 4.3.8.1 First Supplement to Series E (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1993. @ 4.3.9 Series D (May 1, 1991 Taxable New Issue and December 1, 1992 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of October 1, 1992. @ 4.3.9.1 Amended and Restated Letter of Credit dated December 17, 1992. 4.3.10 Series E (May 1, 1991 Taxable New Issue and December 1, 1993 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of May 1, 1991. (Exhibit 4.8, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-5 @ 4.3.10.1 Amended and Restated Letter of Credit dated December 15, 1993. 4.4 Western Massachusetts Electric Company ** 4.4.1 First Mortgage Indenture and Deed of Trust between WMECO and Old Colony Trust Company, Trustee, dated as of August 1, 1954. Supplemental Indentures thereto dated as of: 4.4.2 March 1, 1967. (Exhibit 2.5, File No. 2-68808) 4.4.3 March 1, 1968. (Exhibit 2.6, File No. 2-68808) 4.4.4 December 1, 1968. (Exhibit 2.7, File No. 2-68808) 4.4.5 July 1, 1972. (Exhibit 2.9, File No. 2-68808) 4.4.6 May 1, 1986. (Exhibit 4.3.18, 1986 NU Form 10-K, File No. 1-5324) 4.4.7 December 1, 1988. (Exhibit 4.3.20, 1988 NU Form 10-K, File No. 1-5324.) 4.4.8 September 1, 1990. (Exhibit 4.3.15, 1990 NU Form 10-K, File No. 1-5324.) 4.4.9 December 1, 1992. (Exhibit 4.15, File No. 33-55772) 4.4.10 January 1, 1993. (Exhibit 4.5.13, 1992 NU Form 10-K, File No. 1-5324) ** 4.4.11 March 1, 1994. ** 4.4.12 March 1, 1994. ** 4.4.13 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and WMECO (Pollution Control Bonds) dated as of September 1, 1993. ** 4.4.14 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.5 North Atlantic Energy Corporation 4.5.1 First Mortgage Indenture and Deed of Trust between NAEC and United States Trust Company of New York, Trustee, dated as of June 1, 1992. (Exhibit 4.6.1, 1992 NU Form 10-K, File No. 1-5324) 4.5.2 Note Indenture dated as of May 15, 1991. (Exhibit 4.10, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-6 4.5.3 First Supplemental Indenture dated as of June 5, 1992 between NAEC, PSNH and United States Trust Company of New York, Trustee. (Exhibit 4.6.3, 1992 NU Form 10-K, File No. 1-5324) 10 Material Contracts 10.1 Stockholder Agreement dated as of July 1, 1964 among the stockholders of Connecticut Yankee Atomic Power Company (CYAPC). (Exhibit 13.1, File No. 2-22958) 10.2 Form of Power Contract dated as of July 1, 1964 between CYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 13.2, File No. 2-22958) 10.2.1 Form of Additional Power Contract dated as of April 30, 1984, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.4, 1984 NU Form 10-K, File No. 1-5324) 10.2.2 Form of 1987 Supplementary Power Contract dated as of April 1, 1987, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.6, 1987 NU Form 10-K, File No. 1-5324) 10.3 Capital Funds Agreement dated as of September 1, 1964 between CYAPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 13.3, File No. 2-22958) #@** 10.4 Stockholder Agreement dated December 10, 1958 between Yankee Atomic Electric Company (YAEC) and CL&P, HELCO, PSNH and WMECO. 10.5 Form of Amendment No. 3, dated as of April 1, 1985, to Power Contract between YAEC and each of CL&P, PSNH and WMECO, including a composite restatement of original Power Contract dated June 30, 1959 and Amendment No. 1 dated April 1, 1975 and Amendment No. 2 dated October 1, 1980. (Exhibit 10.5, 1988 NU Form 10-K, File No. 1-5324.) 10.5.1 Form of Amendment No. 4 to Power Contract, dated May 6, 1988, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.1, 1989 NU Form 10-K, File No. 1-5324) 10.5.2 Form of Amendment No. 5 to Power Contract, dated June 26, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.2, 1989 NU Form 10-K, File No. 1-5324) 10.5.3 Form of Amendment No. 6 to Power Contract, dated July 1, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.3, 1989 NU Form 10-K, File No. 1-5324) #@** 10.5.4 Form of Amendment No. 7 to Power Contract, dated February 1, 1992, between YAEC and each of CL&P, PSNH and WMECO. 10.6 Stockholder Agreement dated as of May 20, 1968 among stockholders of MYAPC. (Exhibit 4.15, File No. 2-30018) 10.7 Form of Power Contract dated as of May 20, 1968 between MYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.14, File No. 2-30018) E-7 #@** 10.7.1 Form of Amendment No. 1 to Power Contract dated as of March 1, 1983 between MYAPC and each of CL&P, PSNH and WMECO. #@** 10.7.2 Form of Amendment No. 2 to Power Contract dated as of January 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.7.3 Form of Amendment No. 3 to Power Contract dated as of October 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.7.3, 1985 NU Form 10-K, File No. 1-5324) #@** 10.7.4 Form of Additional Power Contract dated as of February 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.8 Capital Funds Agreement dated as of May 20, 1968 between Maine Yankee Atomic Power Company (MYAPC) and CL&P, PSNH, HELCO and WMECO. (Exhibit 4.13, File No. 2-30018) 10.8.1 Amendment No. 1 to Capital Funds Agreement, dated as of August 1, 1985, between MYAPC, CL&P, PSNH and WMECO. (Exhibit 10.6.1, 1985 NU Form 10-K, File No. 1-5324) 10.9 Sponsor Agreement dated as of August 1, 1968 among the sponsors of VYNPC. (Exhibit 4.16, File No. 2-30285) 10.10 Form of Power Contract dated as of February 1, 1968 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.18, File No. 2-30018) 10.10.1 Form of Amendment to Power Contract dated as of June 1, 1972 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 5.22, File No. 2-47038) #@** 10.10.2 Form of Second Amendment to Power Contract dated as of April 15, 1983 between VYNPC and each of CL&P, PSNH and WMECO. 10.10.3 Form of Third Amendment to Power Contract dated as of April 24, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.3, 1986 NU Form 10-K, File No. 1-5324) 10.10.4 Form of Fourth Amendment to Power Contract dated as of June 1, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.4, 1986 NU Form 10-K, File No. 1-5324) 10.10.5 Form of Fifth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.5, 1990 NU Form 10-K, File No. 1-5324) 10.10.6 Form of Sixth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.6, 1990 NU Form 10-K, File No. 1-5324) E-8 10.10.7 Form of Seventh Amendment to Power Contract dated as of June 15, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.7, 1990 NU Form 10-K, File No. 1-5324) 10.10.8 Form of Eighth Amendment to Power Contract dated as of December 1, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.8, 1990 NU Form 10-K, File No. 1-5324) #@** 10.10.9 Form of Additional Power Contract dated as of February 1, 1984 between VYNPC and each of CL&P, PSNH and WMECO. 10.11 Capital Funds Agreement dated as of February 1, 1968 between Vermont Yankee Nuclear Power Corporation (VYNPC) and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.16, File No. 2-30018) 10.11.1 Form of First Amendment to Capital Funds Agreement dated as of March 12, 1968 between VYNPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.17, File No. 2-30018) #@** 10.11.2 Form of Second Amendment to Capital Funds Agreement dated as of September 1, 1993 between VYNPC and CL&P, HELCO, PSNH and WMECO. 10.12 Amended and Restated Millstone Plant Agreement dated as of December 1, 1984 by and among CL&P, WMECO and Northeast Nuclear Energy Company (NNECO). (Exhibit 10.17, 1985 NU Form 10-K, File No. 1-5324) 10.13 Sharing Agreement dated as of September 1, 1973 with respect to 1979 Connecticut nuclear generating unit (Millstone 3). (Exhibit 6.43, File No. 2-50142) 10.13.1 Amendment dated August 1, 1974 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 5.45, File No. 2-52392) 10.13.2 Amendment dated December 15, 1975 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 7.47, File No. 2-60806) 10.13.3 Amendment dated April 1, 1986 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 10.17.3, 1990 NU Form 10-K, File No. 1-5324) 10.14 Agreement dated July 19, 1990, among NAESCO and Seabrook Joint owners with respect to operation of Seabrook. (Exhibit 10.53, 1990 NU Form 10-K, File No. 1-5324) 10.15 Sharing Agreement between CL&P, WMECO, HP&E, HWP and PSNH dated as of June 1, 1992. (Exhibit 10.17, 1992 NU Form 10- K, File No. 1-5324) 10.16 Form of Seabrook Power Contract between PSNH and NAEC, as amended and restated. (Exhibit 10.45, NU 1992 Form 10-K, File No. 1-5324) E-9 10.17 Agreement for joint ownership, construction and operation of New Hampshire nuclear generating units dated as of May 1, 1973. (Exhibit 13-57, File No. 2-48966) 10.17.1 Amendments to Exhibit 10.17 dated May 24, 1974, June 21, 1974 and September 25, 1974. (Exhibit 5.15, File No. 2-51999) 10.17.2 Amendments to Exhibit 10.17 dated October 25, 1974 and January 31, 1975. (Exhibit 5.23, File No. 2-54646) 10.17.3 Sixth Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.3, File No. 2-64294) 10.17.4 Seventh Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.4, File No. 2-64294) 10.17.5 Eighth Amendment to Exhibit 10.17 dated as of April 25, 1979. (Exhibit 5.4.5, File No. 2-64815) 10.17.6 Ninth Amendment to Exhibit 10.17 dated as of June 8, 1979. (Exhibit 5.4.6, File No. 2-64815) 10.17.7 Tenth Amendment to Exhibit 10.17 dated as of October 10, 1979. (Exhibit 5.4.2, File No. 2-66334) 10.17.8 Eleventh Amendment to Exhibit 10.17 dated as of December 15, 1979. (Exhibit 5.4.8, File No. 2-66492) 10.17.9 Twelfth Amendment to Exhibit 10.17 dated as of June 16, 1980. (Exhibit 5.4.9, File No. 2-68168) 10.17.10 Thirteenth Amendment to Exhibit 10.17 dated as of December 31, 1980. (Exhibit 10.6, File No. 2-70579) * 10.17.11 Fourteenth Amendment to Exhibit 10.17 dated as of June 1, 1982. 10.17.12 Fifteenth Amendment to Exhibit 10.17 dated as of April 27, 1984. (Exhibit 10.14.12, 1984 NU Form 10-K, File No. 1-5324) 10.17.13 Sixteenth Amendment to Exhibit 10.17 dated as of June 15, 1984. (Exhibit 10.14.13, 1984 NU Form 10-K, File No. 1-5324) 10.17.14 Seventeenth Amendment to Exhibit 10.17 dated as of March 8, 1985. (Exhibit 10.13.14, 1985 NU Form 10-K, File No. 1-5324) 10.17.15 Eighteenth Amendment to Exhibit 10.17 dated as of March 14, 1986. (Exhibit 10.13.15, 1986 NU Form 10-K, File No. 1-5324) 10.17.16 Nineteenth Amendment to Exhibit 10.17 dated as of May 1, 1986. (Exhibit 10.13.16, 1986 NU Form 10-K, File No. 1-5324) E-10 10.17.17 Twentieth Amendment to Exhibit 10.17 dated as of July 15, 1986. (Exhibit 10.13.17, 1986 NU Form 10-K, File No. 1-5324) 10.17.18 Twenty-first Amendment to Exhibit 10.17 dated as of November 12, 1987. (Exhibit 10.13.18, 1987 NU Form 10-K, File No. 1-5324) 10.17.19 Twenty-second Amendment to Exhibit 10.17 dated as of January 13, 1989. (Exhibit 10.13.19, 1989 NU Form 10-K, File No. 1-5324) 10.17.20 Twenty-third Amendment to Exhibit 10.17 dated as of November 1, 1990. (Exhibit 10.13.20, 1990 NU Form 10- K, File No. 1-5324) 10.17.21 Memorandum of Understanding dated November 7, 1988 between PSNH and Massachusetts Municipal Wholesale Electric Company (Exhibit 10.17, PSNH 1989 Form 10-K, File No. 1-6392) 10.17.22 Agreement of Settlement among Joint Owners dated as of January 13, 1989. (Exhibit 10.13.21, 1988 NU Form 10- K, File No. 1-5324) 10.17.22.1 Supplement to Settlement Agreement, dated as of February 7, 1989, between PSNH and Central Maine Power Company. (Exhibit 10.18.1, PSNH 1989 Form 10-K, File No. 1-6392) 10.18 Amended and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990. (Exhibit 10.4.7, File No. 33-35312) 10.18.1 Form of First Amendment to Exhibit 10.18. (Exhibit 10.4.8, File No. 33-35312) * 10.18.2 Form (Composite) of Second Amendment to Exhibit 10.18. 10.19 Agreement dated November 1, 1974 for Joint Ownership, Construction and Operation of William F. Wyman Unit No. 4 among PSNH, Central Maine Power Company and other utilities. (Exhibit 5.16 , File No. 2-52900) 10.19.1 Amendment to Exhibit 10.19 dated June 30, 1975. (Exhibit 5.48, File No. 2-55458) 10.19.2 Amendment to Exhibit 10.19 dated as of August 16, 1976. (Exhibit 5.19, File No. 2-58251) 10.19.3 Amendment to Exhibit 10.19 dated as of December 31, 1978. (Exhibit 5.10.3, File No. 2-64294) #** 10.20 Form of Service Contract dated as of July 1, 1966 between each of NU, CL&P and WMECO and the Service Company. 10.20.1 Service Contract dated as of June 5, 1992 between PSNH and the Service Company. (Exhibit 10.12.4, 1992 NU Form 10-K, File No. 1-5324) E-11 10.20.2 Service Contract dated as of June 5, 1992 between NAEC and the Service Company. (Exhibit 10.12.5, 1992 NU Form 10-K, File No. 1-5324) * 10.20.3 Form of Annual Renewal of Service Contract. 10.21 Memorandum of Understanding between CL&P, HELCO, Holyoke Power and Electric Company (HP&E), Holyoke Water Power Company (HWP) and WMECO dated as of June 1, 1970 with respect to pooling of generation and transmission. (Exhibit 13.32, File No. 2-38177) #** 10.21.1 Amendment to Memorandum of Understanding between CL&P, HELCO, HP&E, HWP and WMECO dated as of February 2, 1982 with respect to pooling of generation and transmission. 10.22 New England Power Pool Agreement effective as of November 1, 1971, as amended to November 1, 1988. (Exhibit 10.15, 1988 NU Form 10-K, File No. 1-5324.) 10.22.1 Twenty-sixth Amendment to Exhibit 10.22 dated as of March 15, 1989. (Exhibit 10.15.1, 1990 NU Form 10-K, File No. 1-5324) 10.22.2 Twenty-seventh Amendment to Exhibit 10.22 dated as of October 1, 1990. (Exhibit 10.15.2, 1991 NU Form 10-K, File No. 1-5324) 10.22.3 Twenty-eighth Amendment to Exhibit 10.22 dated as of September 15, 1992. (Exhibit 10.18.3, 1992 NU Form 10-K, File No. 1-5324) * 10.22.4 Twenty-ninth Amendment to Exhibit 10.22 dated as of May 1, 1993. 10.23 Agreements among New England Utilities with respect to the Hydro-Quebec interconnection projects. (See Exhibits 10(u) and 10(v); 10(w), 10(x), and 10(y), 1990 and 1988, respectively, Form 10-K of New England Electric System, File No. 1-3446.) 10.24 Trust Agreement dated February 11, 1992, between State Street Bank and Trust Company of Connecticut, as Trustor, and Bankers Trust Company, as Trustee, and CL&P and WMECO, with respect to NBFT. (Exhibit 10.23, 1991 NU Form 10-K, File No. 1-5324) 10.24.1 Nuclear Fuel Lease Agreement dated as of February 11, 1992, between Bankers Trust Company, Trustee, as Lessor, and CL&P and WMECO, as Lessees. (Exhibit 10.23.1, 1991 NU Form 10-K, File No. 1-5324) 10.25 Simulator Financing Lease Agreement, dated as of February 1, 1985, by and between ComPlan and NNECO. (Exhibit 10.52, 1985 NU Form 10-K, File No. 1-5324) E-12 10.26 Simulator Financing Lease Agreement, dated as of May 2, 1985, by and between The Prudential Insurance Company of America and NNECO. (Exhibit 10.53, 1985 NU Form 10-K, File No. 1-5324) 10.27 Lease dated as of April 14, 1992 between The Rocky River Realty Company (RRR) and Northeast Utilities Service Company (NUSCO) with respect to the Berlin, Connecticut headquarters (office lease). (Exhibit 10.29, 1992 NU Form 10-K, File No. 1-5324) 10.27.1 Lease date as of April 14, 1992 between RRR and NUSCO with respect to the Berlin, Connecticut headquarters (project lease). (Exhibit 10.29.1, 1992 NU Form 10-K, File No. 1-5324) * 10.28 Millstone Technical Building Note Agreement dated as of December 21, 1993 between, by and between The Prudential Insurance Company of America and NNECO. 10.29 Lease and Agreement, dated as of December 15, 1988, by and between WMECO and Bank of New England, N.A., with BNE Realty Leasing Corporation of North Carolina. (Exhibit 10.63, 1988 NU Form 10-K, File No. 1-5324.) 10.30 Note Agreement dated April 14, 1992, by and between The Rocky River Realty Company (RRR) and Purchasers named therein (Connecticut General Life Insurance Company, Life Insurance Company of North America, INA Life Insurance Company of New York, Life Insurance Company of Georgia), with respect to RRR's sale of $15 million of guaranteed senior secured notes due 2007 and $28 million of guaranteed senior secured notes due 2017. (Exhibit 10.52, 1992 NU Form 10-K, File No. 1-5324) 10.30.1 Note Guaranty dated April 14, 1992 by Northeast Utilities pursuant to Note Agreement dated April 14, 1992 between RRR and Note Purchasers, for the benefit of The Connecticut National Bank as Trustee, the Purchasers and the owners of the notes. (Exhibit 10.52.1, 1992 NU Form 10-K, File No. 1-5324) 10.30.2 Assignment of Leases, Rents and Profits, Security Agreement and Negative Pledge, dated as of April 14, 1992 among RRR, NUSCO and The Connecticut National Bank as Trustee, securing notes sold by RRR pursuant to April 14, 1992 Note Agreement. (Exhibit 10.52.2, 1992 NU Form 10-K, File No. 1-5324) 10.31 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 1 decommissioning costs. (Exhibit 10.80, 1986 NU Form 10-K, File No. 1-5324) 10.31.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.41.1, 1992 NU Form 10-K, File No. 1-5324) E-13 10.32 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 2 decommissioning costs. (Exhibit 10.81, 1986 NU Form 10-K, File No. 1-5324) 10.32.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.42.1, 1992 NU Form 10-K, File No. 1-5324) 10.33 Master Trust Agreement dated as of April 23, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 3 decommissioning costs. (Exhibit 10.82, 1986 NU Form 10-K, File No. 1-5324) 10.33.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.43.1, 1992 NU Form 10-K, File No. 1-5324) 10.34 NU Executive Incentive Plan, effective as of January 1, 1991. (Exhibit 10.44, NU 1991 Form 10-K, File No. 1-5324) 10.35 Supplemental Executive Retirement Plan for Officers of NU System Companies, Amended and Restated effective as of January 1, 1992. (Exhibit 10.45.1, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) * 10.35.1 Amendment 1 to Exhibit 10.35, effective as of August 1, 1993. * 10.35.2 Amendment 2 to Exhibit 10.35, effective as of January 1, 1994. 10.36 Loan Agreement dated as of December 2, 1991, by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $175 million to an ESOP Trust. (Exhibit 10.46, NU 1991 Form 10-K, File No. 1-5324) * 10.36.1 First Amendment to Exhibit 10.36 dated February 7, 1992. 10.36.2 Loan Agreement dated as of March 19, 1992 by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $75 million to the ESOP Trust. (Exhibit 10.49.1, 1992 NU Form 10-K, File No. 1-5324) * 10.36.3 Second Amendment to Exhibit 10.36 dated April 9, 1992. 10.37 Management Succession Agreement. (Exhibit 10.47, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 10.38 Employment Agreement. (Exhibit 10.48, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 13 Annual Report to Security Holders (Each of the Annual Reports is filed only with the Form 10-K of that respective registrant.) E-14 * 13.1 Portions of the Annual Report to Security Holders of NU (pages 17 - 54) that have been incorporated by reference into this Form 10-K. 13.2 Annual Report of CL&P. 13.3 Annual Report of WMECO. 13.4 Annual Report of PSNH. 13.5 Annual Report of NAEC. 21 Subsidiaries of the Registrant (Exhibit 22, 1992 NU Form 10-K, File 1-5324) E-15